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Heriot-Watt Management Programme

Introduction to Finance

Michael A Kerrison

School of Management and Languages Heriot-Watt University Edinburgh EH14 4AS, United Kingdom. Version 2010.2

Heriot-Watt Management Programme School of Management and Languages Heriot-Watt University Edinburgh Scotland UK EH14 4AS Telephone Fax E-Mail +44(0) 131 451 3864 +44(0) 131 451 3865 external@sml.hw.ac.uk

http://www.sml.hw.ac.uk/external First published 2000 by Heriot-Watt Management Programme (ISBN: 0-273-63523-9). Republished 2009 (ISBN: 978-1-907291-10-4). This edition published in 2010 by Heriot-Watt Management Programme. Copyright Heriot-Watt Management Programme. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publishers. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.

Distributed by Heriot-Watt University. Heriot-Watt Management Programme : Introduction to Finance ISBN 978-1-907291-38-8 Printed and bound in Great Britain by Graphic and Printing Services, Heriot-Watt University, Edinburgh.

Acknowledgements
Michael A Kerrison is Director of Education at the College of Estate Management. Michael has been Director of Educational Policy at the IFS School of Finance and designed and developed the Heriot-Watt Management Programme. As a qualied Chartered Accountant, Michael combines his professional knowledge with his experience as a lecturer in nance and of international distance learning in designing materials for this module.

Contents
1 An Overview of the Subject of Finance 1.1 Introduction to Finance . . . . . . . . . 1.2 The Role of Capital Markets . . . . . . 1.3 Financial Interrelationships . . . . . . 1.4 Review . . . . . . . . . . . . . . . . . 1.5 Conclusion . . . . . . . . . . . . . . . 1.6 Short Problems . . . . . . . . . . . . . 1.7 Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 12 23 23 24 25 27 29 30 31 33 35 36 39 43 47 50 52 52 53 54 57 59 60 65 67 68 74 75 76 77 80 81 82 82 84 85 86 86

2 Basic Financial Concepts 2.1 Introduction . . . . . . . . . . . . . . . . . . . . . 2.2 The Concept of Self-interest . . . . . . . . . . . . 2.3 The Concept of Agency . . . . . . . . . . . . . . 2.4 The Concept of the Time Value of Money . . . . 2.5 The Concept of Maximising Shareholders Wealth 2.6 The Concept of Risk Aversion . . . . . . . . . . . 2.7 The Concept of Risk Diversication . . . . . . . . 2.8 Information Asymmetry and Financial Signalling 2.9 The Concept of Capital Market Efciency . . . . 2.10 The Concept of Option Pricing . . . . . . . . . . 2.11 Review . . . . . . . . . . . . . . . . . . . . . . . 2.12 Conclusion . . . . . . . . . . . . . . . . . . . . . 2.13 Short Problems . . . . . . . . . . . . . . . . . . . 2.14 Tutorial Questions . . . . . . . . . . . . . . . . . 3 Sources of Business Finance 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . 3.2 Business Structures . . . . . . . . . . . . . . . . 3.3 Ordinary Shares . . . . . . . . . . . . . . . . . . 3.4 Preference Shares . . . . . . . . . . . . . . . . . 3.5 Company Debt . . . . . . . . . . . . . . . . . . . 3.6 Convertible Securities and Warrants . . . . . . . 3.7 Sources of Finance through International Markets 3.8 Sale and Leaseback . . . . . . . . . . . . . . . . 3.9 The Distinction between Debt and Equity . . . . 3.10 Sources of Finance in Different Countries . . . . 3.11 Review . . . . . . . . . . . . . . . . . . . . . . . 3.12 Conclusion . . . . . . . . . . . . . . . . . . . . . 3.13 Short Problems . . . . . . . . . . . . . . . . . . . 3.14 Tutorial Questions . . . . . . . . . . . . . . . . .

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4 The Value of Money Over Time 4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 The Process of Compounding: Future Values . . . . . . . . . . . . . . . .

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4.3 4.4 4.5 4.6 4.7 4.8 4.9

Annuities . . . . . . . . . . . . . . . . . . . . . . . . . Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . Effects of Ination: Real and Nominal Rates of Interest Review . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . Short Problems . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . .

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97 100 102 105 106 106 109 111 112 112 121 128 129 129 129 132 133 134 135 140 143 155 155 155 159 161 162 162 169 178 181 182 182 185 187 189 189 196 200 202 203 203 205 206 210

5 Valuing Fixed Interest Securities 5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . 5.2 The Valuation of Government Gilt Edged Securities 5.3 Corporate Fixed Interest Securities . . . . . . . . . 5.4 An Introduction to Yield Curves . . . . . . . . . . . 5.5 Review . . . . . . . . . . . . . . . . . . . . . . . . 5.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . 5.7 Short Problems . . . . . . . . . . . . . . . . . . . . 5.8 Tutorial Questions . . . . . . . . . . . . . . . . . . 6 Valuation of Ordinary Shares 6.1 Introduction . . . . . . . . . . . . . . 6.2 Concepts of Value . . . . . . . . . . 6.3 Information and Value . . . . . . . . 6.4 Models for Valuing Ordinary Shares 6.5 Review . . . . . . . . . . . . . . . . 6.6 Conclusion . . . . . . . . . . . . . . 6.7 Short Problems . . . . . . . . . . . . 6.8 Tutorial Questions . . . . . . . . . .

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7 Stock Market and Investment Indicators 7.1 Introduction . . . . . . . . . . . . . . . . . 7.2 Measures of Investment Return and Risk 7.3 Key Financial Ratios . . . . . . . . . . . . 7.4 Stock Market Indicators . . . . . . . . . . 7.5 Review . . . . . . . . . . . . . . . . . . . 7.6 Conclusion . . . . . . . . . . . . . . . . . 7.7 Short Problems . . . . . . . . . . . . . . . 7.8 Tutorial Questions . . . . . . . . . . . . .

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8 Managerial Objectives and Decision Making 8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 8.2 Concepts of Value: Relationships . . . . . . . . . . . . 8.3 The Business Organisation as a Network of Contracts 8.4 Joe Xanadu: A Business Case Study . . . . . . . . . . 8.5 Review . . . . . . . . . . . . . . . . . . . . . . . . . . 8.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . 8.7 Tutorial Questions . . . . . . . . . . . . . . . . . . . .

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9 Raising Capital for Business 9.1 Different Business Structures . . . . . . . . . . . . . . . . . . . . . . . . . 9.2 Private Sources of Finance . . . . . . . . . . . . . . . . . . . . . . . . . .

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CONTENTS

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9.3 9.4 9.5 9.6 9.7

Public Sources of Finance - the Stock Market Trading Shares through the Main Market . . . Review . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . .

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212 226 235 235 236 237 238 238 245 249 254 255 256 257 261 261 265 274 280 285 288 291 295 297 299

10 Personal nancial planning 10.1 Introduction . . . . . . . . 10.2 The Financial Plan . . . . 10.3 Risk and protection . . . . 10.4 Returns on investments . 10.5 Review . . . . . . . . . . 10.6 Review Questions . . . . 10.7 Tutorial Questions . . . .

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11 Appendix 1: Financial Tables Answers to questions and activities 1 An Overview of the Subject of Finance . . . 2 Basic Financial Concepts . . . . . . . . . . . 3 Sources of Business Finance . . . . . . . . . 4 The Value of Money Over Time . . . . . . . . 5 Valuing Fixed Interest Securities . . . . . . . 6 Valuation of Ordinary Shares . . . . . . . . . 7 Stock Market and Investment Indicators . . . 8 Managerial Objectives and Decision Making 9 Raising Capital for Business . . . . . . . . . 10 Personal nancial planning . . . . . . . . . .

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Heriot-Watt University Introduction to Finance

Chapter 1

An Overview of the Subject of Finance


Contents
1.1 1.2 1.3 Introduction to Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Role of Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Interrelationships . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3.1 Individuals, Financial Institutions and Capital Markets . . . . . . 1.3.2 Business Organisations and the Capital Markets . . . . . . . . . 1.3.3 Business Organisations and the Physical Assets Market . . . . . 1.3.4 1.4 1.5 1.6 1.7 Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 3 12 12 17 21 23 23 23 24 25

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Learning Objectives On completion of this chapter students should be able to understand: the function of a capital market; the role of one particular capital market, the stock market; the operation of the stock market as a primary market; the operation of the stock market as a secondary market; the purpose of nancial intermediaries; the ow of funds between different sectors of the economy. Summary This section introduces readers to the role of capital markets and the interrelationships between individuals, business organisations and the markets for physical assets and capital.

Chapter 1. An Overview of the Subject of Finance

1.1

Introduction to Finance

The subject of nance is important for decisions made at every level of activity affecting our lives. At an individual level the choice between savings, investment and consumption is made daily. The investment could, for example, be physical in the form of a new car, or intellectual in the form of investment in an educational course. Decisions we take will involve the choice between the present and future allocation of nancial resources on the basis of our own objectives and preferences. In todays technologically advanced world the range of choice for saving, consumption and investment has never been greater. Increasingly global nancial markets provide us with ever more opportunities to invest in portfolios of nancial securities including a large number of different companies and countries with differing expectations of performance. An understanding of nance in a business context is crucial at all levels and sizes of organisation. Within large organisations an ability to express ideas in nancial terms can be an important factor affecting decisions involving the allocation of organisational resources. Many good business ideas are never accepted because they do not have sufciently rigorous nancial analysis outlining the potential risks and returns to the providers of funds or the management of the organisation. The importance of understanding the principles of nance for both a nance manager and non-nancial manager in any organisation can be crucial for the progression and development of sound business ideas. Finance, as a means of communication, will be a recurring theme of this module. Understanding nancial issues is equally important for publicly funded organisations and non-prot making bodies. Public service organisations involved in the provision of social welfare services or public health programmes, for example, are increasingly under pressure to account for their activities in nancial terms. Publicly funded activities are increasingly measured in terms of efciency, effectiveness and economy in combination with more traditional non-quantitative techniques. For example an organisation funded to provide public housing to elderly persons may include as an important measure of its success the reduction of waiting lists for new housing. This objective may be obtained in less economical ways however. Homes may be built in an area where the land is cheap to develop, although their location may mean transport and other social services are more costly to provide. Consequently the costs of providing these services may outweigh the nancial benet from the reduced land costs. Understanding nancial principles facilitates the communication process within a business and also between organisations, their external environment, and nancial markets. Learning about nance is akin to learning a foreign language. Mastering the principles will enable us to achieve more easily our aims and objectives on a personal and organisational level. As with learning a foreign language, understanding different verbs and sentence structures aids our verbal and written communication skills; so too knowledge of the underlying principles in nance assists the understanding of the usefulness of alternative nancial models and techniques and their effect on our nal decision. For example, there is an old English proverb that we should not put all our eggs in one basket. In other words risks should be spread. In the context of making an investment decision in nancial securities this is certainly true with regard to the effect on the relative risks involved in holding one nancial security compared to a portfolio containing a large number of nancial securities. An ability to calculate relevant statistical relationships of different investments and portfolios enables us to calculate Heriot-Watt University Introduction to Finance

1.2. The Role of Capital Markets

just how many eggs might be needed. The principles introduced in this module will be common to many questions raised in nancial decision making. For example: What affects the choices made by individuals between alternative investments? How are stock market prices set? Why do businesses choose to nance their activities through a variety of nancial packages? What factors affect this choice? Why might the choice differ in different countries? How do businessmen choose between alternative types of capital investment in buildings, machinery and equipment? Financial decisions made by individuals will be a function of their consumption preferences, attitude to risk and different levels of wealth. Buying private property to live in is, for many, one of the biggest nancial decisions of their lives. Consideration is normally given to the expected useful life, potential resale value and possibly even potential earning power if rooms are let to paying tenants. Financing the property purchase will require an understanding of the wide range of nancing instruments which may be used to cover the initial cost of purchase and associated interest payments. The process of buying property is greatly eased if we can master the effect of different nancial instruments and interest rates on our wealth in the future. For example, to what extent is nancial risk increased by nancing an investment with a loan at a variable rate rather than a xed rate of interest? An appreciation of nance and its role in decisions involving the allocation of resources, may at rst seem like common sense. It would be absurd for anyone to set a consumption pattern meaning they would continue to operate a bank overdraft into the foreseeable future. This is a costly form of nance. Consider the manager of a corporation nancing research and development into a product which may need a twenty year incubation period before it can be sold for a nancial return. He or she is unlikely to use a short-term, ve year, bank loan for such a purpose as the corporation will not have generated a return from their research and development to enable them to repay the loan. This module will explore the nancial theories and the concepts underpinning the allocation of resources at individual and organisational level. It will show that many of the most useful nancial techniques and models are based on relatively simple concepts. Mastering the key concepts and understanding how to apply them will enhance an individuals ability to communicate the effects of decisions to understand the allocation of resources in nancial terms.

1.2

The Role of Capital Markets

An organised nancial system involves savers, investors and nancial intermediaries operating through a network of capital markets transferring nance from sectors of society which have a surplus of funds to those which have a decit. The term capital Heriot-Watt University Introduction to Finance

Chapter 1. An Overview of the Subject of Finance

market encompasses a nancial system used to channel funds from one sector to another through a range of different nancial instruments. The equity market (or stock market) is the capital market through which ordinary shares (or common stock) are sold and traded. An increasingly utilised capital market in many countries is the derivative market on which nancial instruments such as nancial options and nancial futures are traded. In 1980 a Committee set up to review the functioning of nancial institutions in the United Kingdom under the chairmanship of Sir Harold Wilson*, presented a report to Parliament. It was a comprehensive review of the nancial system operating in the UK and in particular of the role and functioning of the UK capital markets. The Report identied four key objectives for a capital market. These were: 1. balancing saving and investment at a high level of economic activity and ensuring the effective application of savings; 2. facilitating saving and investment by providing the range of securities which borrowers may wish to issue and savers may wish to hold, so as to create a choice of ways of meeting the risk and other requirements of each; 3. valuing securities so as to reect consistently the returns expected from them, taking into account the risks that they involve for investors; 4. facilitating pressures on management to use the resources already under their control efciently. * Report by the Committee to Review the Functioning of Financial Institutions. Chairman: the Rt Hon Sir H Wilson, (1980) HMSO Cmnd 7937. A developed capital market meeting each of these objectives plays a crucial role both for providers of and for investors in funds in physical assets creating wealth. In some countries, for example in the UK and the USA, the capital market plays a more dominant role than in other developed economies, for example in Italy and Germany. In Germany the banking sector has traditionally provided signicantly more funding for investment in the economy than the capital markets. This is reected in the relative size of the stock markets (see Figure 1.1).

Heriot-Watt University Introduction to Finance

1.2. The Role of Capital Markets

Exchange Americas American SE Bermuda SE Buenos Aires SE Colombia SE Lima SE Mexican Exchange Nasdaq NYSE Group Santiago SE Sao Paulo SE TSX Group 1 Asia - Pacic Australian SE Bombay SE Bursa Malaysia Colombo SE Hong Kong Exchanges Jakarta SE Korea Exchange 2 National Stock Exchange India New Zealand Exchange Osaka SE Philippine SE Shanghai SE Shenzhen SE Singapore Exchange Taiwan SE Corp. Thailand SE Tokyo SE
3

2006 December 282801.0 2703.5 51240.1 56204.3 40021.8 348345.1 3865003.6 15421167.9 174418.8 710247.4 1700708.1

1095858.0 818878.6 235580.9 7768.9 1714953.3 138886.4 834404.3 774115.6 44816.5 3122518.4 67851.7 917507.5 227947.3 384286.4 594659.4 140161.3 4614068.8

Heriot-Watt University Introduction to Finance

Chapter 1. An Overview of the Subject of Finance

Europe - Africa - Middle East Athens Exchange BME Spanish Exchange Borsa Italiana Budapest SE Cairo and Alexandria SEs Cyprus SE Deutshe Borse Euronet Irish SE Istanbule Exchange JSE 4 Ljubljana SE London SE Luxembourg SE Malta SE Mauritius SE 5 OMX 6 Oslo Bors Swiss Exchange Tehran SE Tel Aviv SE Warsaw SE Wiener Brse Total 7 208256.1 1322915.3 1026504.2 41784.1 93496.4 16158.0 1637609.8 3708150.1 163269.5 162398.9 711232.3 15180.7 3794310.3 79496.5 4503.5 4958.5 1123042.5 279910.4 1212308.4 36314.6 161731.7 148775.1 192770.3 50635567.7 Figure 1.1: Domestic Market Capitalisation (in millions of US dollars) (Market value excludes investment funds) 1. TSX Group also includes TSX Venture market cap 2. Korea Exchange includes Kosdaq market data 3. Include Singapore-incorporated companies, foreign-incorporated companies with a primary listing, and foreign-incorporated companies with a secondary listing but with the majority of their trading taking place on SGX 4. JSEs gure include the market capitalisation of all listed companies, but exclude the listed warrants, convertibles and investment funds. 5. From Aug. 2006, data includes Development & Enterprise Market Heriot-Watt University Introduction to Finance

1.2. The Role of Capital Markets

6. OMX includes Copenhagen, Helsinki, Iceland, Stockholm, Tallinn, Riga and Vilnius Stock Exchanges. 7. Total excludes Osaka and National Stock Exchange of India to avoid doublecounting with Tokyo and Bombay SE respectively. Source: World Federation of Exchanges members While Figure 1.1 illustrates the relative size of stock markets around the world, Figure 1.2 compares the relative size of the economy (gross domestic product - 2005) of each country, compared to the value of all companies listed on the domestic stock market. This provides a broad gauge of the relative importance of the capital market as a source of nance for industry compared with, for example, the banking sector. You will notice that in terms of the European economies, that the UK is much higher than the more bank nance dependent countries such as France (33rd) and Germany (49th). As you might expect Hong Kong (1st) and many of the Eastern Tiger economies such as Singapore (7th) and Malaysia (14th) have utilised the capital markets to nance their growth, relatively more than many other developed economies. It is also noticeable that the top 20 also contains an increasing number of oil rich gulf states (Jordan; Saudi Arabia; UE; Qatar and Kuwait). Figure 1.2: Market capitalization of listed companies Country - 2005 Rank 1 2 3 4 5 6 7 8 9 10 Countries Hong Kong Jordan Switzerland South Africa Saudi Arabia Qatar Singapore Barbados Iceland United Arab Emirates Amount 5662.427 $ per $1,000 of GDP 2960.974 $ per $1,000 2557.353 $ per $1,000 of GDP 2360.359 $ per $1,000 of GDP 2085.695 $ per $1,000 of GDP 2056.291 $ per $1,000 of GDP 1783.943 $ per $1,000 of GDP 1783.794 $ per $1,000 of GDP 1757.883 $ per $1,000 of GDP 1739.13 $ per $1,000 of GDP current US$ (per $ GDP) by

Heriot-Watt University Introduction to Finance

Chapter 1. An Overview of the Subject of Finance

Rank 11 12 13 14 15 16 17 18 19 20 Rank 21 22 23 24 25 26 27 28 29 30 Rank 31 32 33 34 35 36 37 38 39 40

Countries Kuwait Luxembourg United Kingdom Malaysia United States Jamaica Bahrain Canada Chile Trinidad and Tobago Countries Netherlands Sweden Australia Finland Japan Papua New Guinea Israel Mauritania Korea, South Egypt Countries Belgium Spain France Malta Russia Zimbabwe Thailand Denmark India Norway

Amount 1610.281 $ per $1,000 of GDP 1405.436 $ per $1,000 1390.848 $ per $1,000 of GDP 1390.632 $ per $1,000 of GDP 1368.982 $ per $1,000 of GDP 1360.754 $ per $1,000 of GDP 1344.565 $ per $1,000 of GDP 1329.572 $ per $1,000 of GDP 1183.934 $ per $1,000 of GDP 1182.032 $ per $1,000 of GDP Amount 1165.512 $ per $1,000 of GDP 1129.348 $ per $1,000 of GDP 1097.713 $ per $1,000 of GDP 1084.616 $ per $1,000 of GDP 1044.673 $ per $1,000 of GDP 983.367 $ per $1,000 of GDP 973.102 $ per $1,000 of GDP 971.855 $ per $1,000 of GDP 911.831 $ per $1,000 of GDP 891.494 $ per $1,000 of GDP Amount 881.994 $ per $1,000 of GDP 853.627 $ per $1,000 804.103 $ per $1,000 of GDP 735.668 $ per $1,000 of GDP 718.299 $ per $1,000 of GDP 712.14 $ per $1,000 of GDP 699.407 $ per $1,000 of GDP 688.165 $ per $1,000 of GDP 686.44 $ per $1,000 of GDP 646.173 $ per $1,000 of GDP Heriot-Watt University Introduction to Finance

1.2. The Role of Capital Markets

Rank 41 42 43 44 45 46 47 48 49 50

Countries Greece Bermuda Brazil Ireland Morocco Peru Italy Turkey Germany Mauritius

Amount 643.91 $ per $1,000 of GDP 626.376 $ per $1,000 596.249 $ per $1,000 of GDP 565.534 $ per $1,000 of GDP 527.304 $ per $1,000 of GDP 453.455 $ per $1,000 of GDP 452.856 $ per $1,000 of GDP 445.618 $ per $1,000 of GDP 436.953 $ per $1,000 of GDP 416.137 $ per $1,000 of GDP

Source: World Development Indicators Database

Self Test 1.1


Explain in your own words the key objectives of capital markets.

Self Test 1.2


1. Consider Figure 1.1. Make a list of the largest stock markets in the world in 2006. (Americas; Asia-Pacic and Europe-Africa-Middle East) 2. Make a list of the ve largest stock markets in terms of the total value of stocks listed on the market, as at 31 December 2006. Stock markets in developed countries are among the most important capital markets. Capital market regulations, (for example in relation to the minimum size of a company seeking admission to the market), mean that some business organisations cannot use a capital market to obtain nance. Examples of business organisation structures are: a sole proprietor - a business owned and managed by the same person; a partnership - a business owned by a number of persons jointly; a limited liability company - a company formed by a number of persons whose liability for the company debts is limited to the cost of the shares they own. A company may be public or private. If the company has established itself as a public company in the UK it must have a minimum share capital of 55000 and at least 25% of its shares must be owned by the public. If the company is private it cannot issue its shares directly to the public; instead they will be transferred by private deals. A public company may be listed on a recognised stock exchange. In the UK a public limited company has plc after its name. If the company is a private limited company it will have Ltd after its name. Figure 1.3 illustrates the distinctions between these different business structures. Heriot-Watt University Introduction to Finance

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Chapter 1. An Overview of the Subject of Finance

Figure 1.3: Different business structures Sole proprietors, partnerships and some private and unlisted public companies will obtain a large proportion of their funds for investment through banks, their own personal savings and from internal funds generated by the business. As new business investment growth opportunities become available, there may be an increasing need to obtain extra nance external to the proprietors savings and borrowings from banks and other nancial institutions. Having their ordinary shares listed on a recognised stock market means a company can access nance for their growth by issuing nancial securities to the public through the stock market. Investment in physical assets within a business involves taking risks. Returns are unlikely to be certain and will be subject to general economic factors affecting their size and timing. As with the price of goods and services (which inuence the costs and revenues to the business) and taxes (which inuence prots retained by the business), returns will also be affected by specic factors unique to the organisation, affecting the efciency and effectiveness of the organisations activity. For example the manufacturing techniques used, (which inuence the productivity of the activity) and the policy of employee relations (which inuences the motivation, productivity and the rate of disruption of the organisations activities) will inuence the organisations protability. These general economic and business-specic risks affecting the returns from investment in physical assets of the organisation will be borne by the providers of nance to the organisation. For example a bank providing a loan to nance the replacement of equipment in the manufacturing process may set a ten year repayment date at a xed rate of interest payable each year. The bank would take some risk of the business activity failing. If the organisation using the equipment does well, the return to the bank does not increase but remains xed at the agreed rate of interest. If the organisation performs poorly the bank will still receive its interest return each year and capital sum after ten years as long as the business has sufcient funds to pay the interest and repay the loan capital. A shareholder in a business organisation takes a greater risk than a bank which has loaned funds to a company at an agreed rate of interest. Shareholders only receive a return after taxation and payments of interest have been made. Raising funds on a capital market will enable the sole proprietor, partnership or unlisted company to transfer some or all of the risk of the business activity by selling some or all of the shares to new shareholders. In return for their investment the new shareholders will receive increased returns if the business investments perform well and decreased Heriot-Watt University Introduction to Finance

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returns if performance is poor. The expectations of the new shareholders with regard to risk and return will be reected in the price of the shares. Issuing new shares on the stock market is called a primary issue. This raises nance to support the activities of the business organisation issuing the shares. A stock market on which new shares can be issued is known as a primary market. Operating as a primary market, a stock market is fullling its objective in providing an opportunity for savers to invest their funds for alternative risks and returns and for organisations to raise nance for physical asset investment. Physical asset investments undertaken by organisations can have varying life spans. Some investments will take a long time before they reach maturity and signicant returns are realised. Investment in the research and development of pharmaceutical products or drugs to cure diseases will have an indenite maturity in many cases. The expected returns from the substantial investment in the Channel Tunnel project linking Great Britain and France through an underwater rail link were very risky. Its success was dependent on technology for completing the tunnel and subsequently on the market attitude to this new mode of transport between the two countries. What price would customers be prepared to pay? How different would the time-scale be compared to ferry and air travel, the two alternative modes of transport? The initial investors in the Channel Tunnel were a consortium including the British and French Governments, the banking sector and the company Eurotunnel whose ordinary shares were primarily issued on the London and Paris stock markets in 1986. An investor in ordinary shares issued by Eurotunnel undertook to bear the risks involved with the investment, in exchange for an expected future return. An ordinary share has no maturity date for repayment and the physical assets for which the nance is used can have long and indenite maturity. How long is the useful life of the Channel Tunnel operator Eurotunnel? Investors in a primary issue of new shares may wish to realise their returns before the end of the expected life of the physical assets in which their nance has been invested. In order to do so ordinary shareholders require to sell their shares to a willing buyer at an agreed price. By providing an organised trading place for shares to be sold at an agreed price and hence bringing together willing buyers and sellers, the stock market is enabling providers of funds to transfer their waiting. The operation of the stock market in providing an organised trading place for willing buyers and sellers to transfer their waiting is referred to as a secondary market. The transfer of funds in the secondary market is between willing buyers and willing sellers. They are referred to as willing as it is presumed that they are satised in their transaction by an agreement with the opposite party (a buyer or seller) at a mutually agreed price. Without an organised market place, nding a buyer or seller could be time consuming and problematic for shareholders. The stock market is a major capital market in most developed economies and fulls an important function in providing an organised location for investors in physical assets of differing sizes, risks and maturity to raise nance (the primary market - see Figure 1.4). It also serves to meet the needs of providers of funds (savers) in offering a range of potential nancial investments with differing risks and returns, thus enabling the holder of such investments to transfer their waiting time for realising returns (the secondary market - see Figure 1.5).

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Chapter 1. An Overview of the Subject of Finance

Figure 1.4: The primary market

Figure 1.5: The secondary market

Self Test 1.3


Capital markets enable buyers and sellers to transfer two important factors affecting them. Can you recall what these two factors are? Write a sentence explaining how each factor is transferred.

1.3

Financial Interrelationships

The next three sections will consider the interrelationships between individuals, nancial institutions, organisations and the markets for capital and physical assets. An understanding of these complex relationships can lead to an appreciation of the important role of a capital market.

1.3.1

Individuals, Financial Institutions and Capital Markets

It is increasingly likely that individuals in countries with a developed capital market, have directly, or indirectly invested in nancial securities listed on the market. An example of a popular direct investment on developed capital markets is an ordinary share issued by an organisation which has obtained permission to have its shares listed and traded on the market. Another example in the UK is a government gilt edged security, (or Treasury Bill in the United States of America). This is a nancial security issued by the government which may be used to help nance public services such as education and health. An example of an indirect investment is a unit or investment trust. These are Heriot-Watt University Introduction to Finance

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funds managed by nancial institutions and consist of a portfolio of nancial securities. The income from the portfolio will be shared by the investors in the trust. Within Europe, in recent years, many countries have embarked on programmes of privatisation. Companies previously nanced from public money, raised by the government, have been sold to investors by issuing shares of the companies on domestic stock markets. This has meant that many individuals in such countries have become direct investors in nancial securities for the rst time. The need for nancial information to be provided to an increasingly wide population of shareholders is greater than ever. Understanding the information and its relevance for the nancial risk and return of the investment is important to both individuals and nancial institutions such as investment or unit trusts. The role of information in nancial decision making will be a key theme of this module. The discipline of nance is concerned with understanding the investment decision made by individuals and nancial institutions of different shapes and sizes. Individuals and nancial institutions can make investments to earn a nancial return in property, works of art, motor cars or ne wines. The risk and return may only be partly nancial. Owning a desirable work of art can give pleasure beyond that measurable in the appreciation of its nancial value at auction. Realising the nancial return will require a transaction to be made between a willing buyer and willing seller. This transaction will establish a price satisfying both parties to the transaction simultaneously. Investments made involving nancial securities traded on a capital market involve the simultaneous matching of willing buyers and willing sellers almost instantaneously. The discipline of nance is concerned with how the price is set for transactions between buyers and sellers and the role of the capital market in regulating such transactions. Such observable transactions provide important evidence to help understand the risk and return choices made by investors and embodied in the market price. One role of a capital market is to provide a mechanism for the orderly and timely ow of information relevant to investors in making their choices. The market also has a role in safeguarding investor condence in the nancial securities being traded. The provision of information and its quality play a key role in the operation of a well functioning capital market. Investment analysts are constantly responding to information relevant to the value of nancial securities issued by organisations through a capital market. Different categories of analyst use different sets of information to assess their nancial investment decision and advice to potential investors. Technical analysts rely heavily on identifying trends in past prices of the nancial security, (see Figure 1.6). Technical analysts look for patterns in security prices and general market movements in order to exploit an identied trend by buying, selling or holding nancial securities. If they believe that the price is high based on their study of price movements, they will sell their holding of the nancial security. Similarly if the price is considered low they will buy the nancial security. Between the high and low prices there will normally be a price band within which the analyst will be content to recommend that the nancial security be held.

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Chapter 1. An Overview of the Subject of Finance

Figure 1.6: Example of charting movements when the trend of the price of stock is increasing

Stock Price

Resistance Trendline

Support Trendline

Time
Figure 1.7: Example of charting movements when the trend of the price of stock is decreasing Chartists use a variety of techniques to analyse the price movements of stocks and to derive a trading strategy. Often chartists will use a technique known as plotting trend lines in stock price movements. They are used as a method to support the buy or sell decision connected with a stock. A trend line is drawn based on the observation of the movement in stock price over time (this may be over minutes in the day; days; weeks; months or even years - depending on the chartists investment horizon). Figure 1.6 and Figure 1.7 illustrate the trend lines drawn around the movement of a stock price over time, when it is broadly increasing and decreasing as a trend over a particular time horizon. The two lines are drawn on each graph represent the trend over time of the upper or lower values of the stock during the dened period. Broadly speaking the chartist will look to trigger a buy decision on the support line being hit and sell at the Heriot-Watt University Introduction to Finance

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resistance line. There are other price movement analyses charted by technical analysts that aim to trigger buy and sell decisions, known as head and shoulders and also the Elliott wave. Each has underlying assumptions to explain the charted movement in the stock price, and therefore used to predict the next movement. The Elliott wave for example, is based on an assumption that price movements are inuenced by bouts of optimism and pessimism mood swings or waves and that therefore a model can be developed to exploit the specic patterns observed. Specically the Elliott wave model expects stock prices to move with ve waves, in which 1,3 and 5 are impulse waves and 2 and 4 are corrective (ie moving in the opposite direction to 1,3 and 5). Figure 1.8 illustrates the basic principles, showing that the main wave structure is based on movements 1-5 and that the corrective waves are a-c. The use of charts in this way in technical analysis to make an unusually large prot by trading on stocks based solely on predicting future price movements, invalidates modern nance theory about efcient markets. This topic will be covered in chapter 2. The Elliott wave theory does however resonate with increasing evidence about the stock market overreaction effect, when there are signicant items of information that becoming known to the market and that will have an impact on stock prices. Examples are the events connected to the Iraq war and the US budget decit in 1987 and the recent impact of the global nancial crisis triggered by the sub-prime market in the United States. Research has found that for certain periods the stock market can overheat and potentially overreact at such times (and indeed can be overoptimistic on receipt of apparently positive news). The research on the efcient market hypothesis does however contradict the investors ability to trade protably on such events and this will be covered in chapter 2.

Figure 1.8: Elliott Wave Theory Fundamental analysts focus their energies on interpreting information about the organisation issuing the nancial security. They try to understand the fundamental changes in the value of the claims on physical assets of the organisation affecting the overall value of the business. Changes in the value of the physical assets will Heriot-Watt University Introduction to Finance

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Chapter 1. An Overview of the Subject of Finance

be incorporated in the prices of the nancial securities issued by the business. It is important to see nancial securities issued by businesses as being claims on the cash ows emanating from the physical assets acquired by the business. Any change in the value of a physical asset investment will be incorporated in the value of the claim to the asset. For example, improved cable networks in some countries could lead to an increase in the potential market for cable television. The increased sales from this development will increase the cash ow to a business and be incorporated positively in the price of nancial securities issued by the company providing the service. Fundamental analysts rely on business nancial reports as a main source of published information. Figure 1.9 illustrates some key information sources used for fundamental analysis. Factors affecting the performance of business activities will be incorporated into the value of an organisations share values once the information becomes known. For example a strike by the employees of an organisation can have a direct negative impact on the supply of the organisations products and services. Also a rise in oil prices may have an indirect affect on a UK retail company as its energy costs will probably increase in the future. The information a fundamental analyst needs to consider therefore is business and organisation specic but will also incorporate relevant market factors. Financial institutions provide an important role on capital markets for individuals and organisations saving and investing funds by acting as their nancial intermediaries. Examples of nancial intermediaries include banks, pension funds, life assurance companies and investment trusts. Each of these nancial institutions will offer services for their members who may be providers or end users of the funds (i.e. savers or investors). Members of a pension plan for example will pay in contributions from earnings during their working lives. The contributions will be invested by the pension fund manager in a portfolio of nancial and non-nancial securities and assets which will generate a nancial return to enable the fund to pay out members pension entitlements when the liability becomes due on retirement. Company information Prot and loss account Balance sheet Cash ow statement Notes to the accounts Directors Report Chairmans statement Five year summary Dividend policy Figure 1.9: Fundamental Analysis: Types of company specic and market information to establish the intrinsic value of a nancial security Banks are nancial intermediaries offering loans to borrowers and taking deposits from savers, paying them an interest rate return. There may be considerable risk of default for loans provided to some borrowers. Financial intermediaries also provide advice about nancial securities. In the UK two such categories of nancial intermediaries Heriot-Watt University Introduction to Finance Market information Economic forecasts Ination rates Interest rates Foreign exchange rates Stock market index movements Changes in legislation Levels of taxation

1.3. Financial Interrelationships

17

are agency brokers (who simply buy and sell nancial securities on behalf of a client) and dealer brokers (who can buy and sell nancial securities and hold securities for themselves). Financial intermediaries play an important role by transferring the risk of physical assets from the end user to the provider of funds. An example would be an individual borrowing money from a bank to buy a home, (which for many people is a relatively large risk). Finance for the home loan may be provided by a bank through funds generated by many relatively small private bank deposit accounts. A bank deposit account is traditionally one of the safest forms of nancial investment. The banks role is therefore important in bringing together providers and end users of funds. Imagine how difcult it would be for individuals wanting to buy their rst home and having to nd a willing lender of money who may know nothing at all about them! Investment Trusts and Unit Trusts are two forms of institutions existing to invest the shares of other companies. Investment Trusts in the UK are companies (there are hundreds of Investment Trusts listed on the London Stock Exchange). An investor holding a share in an Investment Trust therefore diversies his or her risk by holding a share in a fund made up of many different company investments. A Unit Trust is operated in a very similar manner and with similar objectives to an Investment Trust. The management costs of Investment Trusts and Unit Trusts are passed to investors in the form of a management fee which will reduce the return from the fund. Figure 1.10 illustrates the ow of cash between savers, lenders and nancial intermediaries.

Figure 1.10: The role of a nancial intermediary

Self Test 1.4


List three nancial institutions in your country which operate as nancial intermediaries in each of the following categories: Pension Fund managers; Life Assurance company; Bank.

1.3.2

Business Organisations and the Capital Markets

Business organisations in countries with developed capital markets rely heavily on such markets as an important source of nance for investment. In the UK the economy is divided into the following sectors for the purpose of statistical Heriot-Watt University Introduction to Finance

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Chapter 1. An Overview of the Subject of Finance

records: Personal sector; Industrial and commercial companies; Public sector: General Government: Central Government, Local authorities; Public corporations; Banking sector; Other nancial institutions; Overseas sector. The personal sector includes sole trader and partnership business structures as well as un-incorporated businesses (which will include family owned companies). It is the sector Industrial and commercial companies which relies on the efcient and effective operation of a capital market to enable them to invest in physical assets such as land, buildings, machinery and equipment. In the UK savings from the personal sector represent an important source of money for industrial and commercial company investment as well as for public sector activity (see Figure 1.11). Per cent of GDP at market prices Saving Personal sector Industrial and commercial companies Financial companies and institutions Public corporations Central government Local authorities Total domestic sectors Overseas sector 6.9 7.4 1.1 0.2 -3.6 0.4 12.5 0.7 Financial Investmentsurplus/ decit 3.3 6.8 0.8 0.2 1.9 0.3 13.2 3.7 0.6 0.4 0.0 -5.5 0.2 -0.7 0.7

The difference in the columns relate to the rounding in the percentage gures shown.

Source: Central Statistical Ofce Figure 1.11: UK Saving and Investment by Sector, 1992-95 It can be seen from Figure 1.11 that the central Government was a net borrower from the other sectors of the economy during the period from 1992-95. Different classications of economic sectors and nancing instruments make international comparisons difcult. Heriot-Watt University Introduction to Finance

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Capital markets provide an organised meeting place for providers and end users of funds to borrow and lend. Figure 1.12 shows the different sources of nance raised by UK industrial and commercial companies over the period shown (remember this category of businesses excludes sole proprietors, partnerships and public sector organisations). Figure 1.12 shows the relative importance of different sources of nance for companies able to raise nance on an organised capital market. In particular it is important to notice that the banking sector in the UK can be a signicant provider of nance in some years. In the 1990s banks have become net borrowers from companies as internal nance has been more increasingly used. In some years companies have used capital markets to a lesser extent, depending on their investment needs and the relative attraction of other sources of nance at the time. This decision will be a reection of wider economic circumstances. From 1987-1989 there were relatively few new issues of ordinary shares on the UK capital market. Market condence, evidenced by rising share prices, was halted with the October 1987 Stock Market Crash affecting stock markets all over the world. The crash clearly affected the decision to raise funds by issuing ordinary shares on the UK stock market in the years immediately following the crash. The features of each source of nance listed in Figure 1.12 will be discussed in chapter 3 of this Module.

Source: Central Statistical Ofce Figure 1.12: Sources of new nance for UK industrial and commercial companies Figure 1.12 illustrates the source of new nance raised in the UK by industrial and commercial companies, and in particular the relationship of internal and external nance used for investment. You will notice that the nancing of industrial and commercial companies, over the period 1992-1995, was increasing and a decreasing proportion was obtained from internal funds. Bank borrowing helped to fund this gap, as the rate for borrowing became relatively more attractive than raising nance through the stock market, during a period of rising stock prices. It is important for businesses raising nance from the personal, banking and other nancial institutional sectors to be provided with information about the businesses physical asset investments. The capital market provides a vital role in the regulation of the ow of this information ensuring it is available on a timely basis to all interested parties. Physical asset investments can include, for example, researching into new drug treatments, extending a leisure park, or buying more efcient machinery to improve production. Such investments managed well can lead to an increase in the wealth of the investors in the business. Information on the progress of such investments enables investors and potential investors to monitor their investment and make a nancial decision on whether to continue to hold, sell or to buy a nancial security. For companies which have

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Chapter 1. An Overview of the Subject of Finance

their ordinary shares listed and traded through a capital market such information is more regulated. Annual nancial accounting statements contain historical information regarding the revenues and expenses generated from companies physical asset investments and are presented to the company shareholders at the Annual General Meeting. Other information released by the company is regulated closely by the capital market on which the companies nancial securities are listed. When a company is raising nance on a capital market for the rst time, it is required to disclose information, for example, details about the companies activities, its forecast levels of prots and details of the management of the company. In the UK this information is contained in the Prospectus document which will enable potential investors to establish a value for the nancial securities issued. A Prospectus document is required to be available publicly to potential investors in the new issue of nancial securities in a capital market. Information contained within the prospectus includes the past trading history of the company, the management structure, and forecast prots and nancing of the business. It has already been mentioned that nancial intermediaries play an important role in bringing together providers and end users of money. Important to this function is the transferring of the risk and maturity of different nancial packages to the lender and the borrower. For example, the investment in the Eurodisney leisure park in Paris, (1985), was considerable and high in risk to the providers of nance. The investment banks provided signicant long-term funding. The project was extremely risky for the American parent company and also for the banks who provided substantial nancial support. The bank in this case effectively transferred the risk and transformed the maturity of the short-term bank deposit holders to earn a return for the bank on a high risk venture. This satises both the providers and end users of the nance. Crucial to this process is the price charged by the bank for the relative risks and maturity involved. Through the capital markets, companies can package the risks and expected returns from their activities into different nancial securities. By varying the maturity and risk, a company can attract individuals and other nancial institutions providing the funds and possessing different risk and return preferences. The pricing of nancial securities issued by companies operating in a wide sphere of industrial and commercial activities is inextricably bound to the provision of widely and cheaply available information about their activities. Without sufcient understanding and knowledge of the activities of the company issuing securities, capital market investors will have difculty establishing a fair value for buying and selling. The existence of a pricing mechanism for nancial securities is a key feature of a developed capital market. Fundamental to the operation of establishing up to date prices for traded nancial securities is a competitive market place with many potential buyers and sellers and the availability of information at low cost. The market has an insatiable capacity for digesting information. As new information is made available to the market, share prices will be adjusted accordingly to reect its expected effect on the company. The speed of the reaction ensures the freshness of the price. In todays global capital markets using sophisticated computer technology and alternative media, information has never been so widely and cheaply accessible. In the early years of the London Stock Exchange an infamous fraud created an articial price bubble in ordinary shares by falsely announcing the death of Napoleon and the fall of Paris to the Allied Forces in 1814. The perpetrator of the fraud, Colonel de Burgh, was estimated to have gained around 10000 from the subsequent rise in share prices as a consequence of the market hearing the news. The information media are totally different today and stock markets Heriot-Watt University Introduction to Finance

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are technologically more sophisticated, but we can still observe unscrupulous investors exploiting information for their own benet. In developed markets this information will be inside information to which the spectulator may have access. However the connection between changes in the value of nancial securities and the performance of the physical asset investments of the company issuing the securities is core to the understanding of business nance.

Self Test 1.5


List four alternative sources of new nance available to industrial and commercial companies.

1.3.3

Business Organisations and the Physical Assets Market

The rst objective of a capital market identied by the Wilson Committee is to balance savings and investment in the economy ensuring savings are applied effectively. Without a sufcient number of opportunities available to investors, savers would not be encouraged to place their money in nancial securities traded on the capital market. Investment within the private sector of the economy can range from the routine replacement of a machine in a manufacturing process to the realisation of a new business idea. Examples of successful business ideas this century include the Microsoft Windows operating system, compact discs and the jet engine. The decision of a company to invest in a business project will be based on its ability to earn a return. Trading consistently at a prot in a highly competitive market place will be dependent on a company satisfying market needs. Forecasting future expected cash ows from the investment and the associated costs of nancing the investment undertaken will form a signicant part of the investment decision. The physical assets market in this context is widely dened. It encompasses intangible assets such as business trademarks and tangible assets such as land and property. Internationally recognised brand names are important intangible assets for well known companies including Coca-Cola, McDonalds and Virgin. Brand names can be bought and sold by companies, their value being the expected earning power from future sales of the associated product or service. Virgin use their brand name to enter markets for mature products and services, such as air travel, soft drinks, (with their own label coke) and, more recently, nancial services. Competition for physical business assets is increasingly international. Business managers are constantly under pressure to nd consistently high returns from their physical asset investments in order to satisfy the providers of funds. The investment decision taken by industrial and commercial companies is affected signicantly by economic factors such as the stability of prices of goods and services and interest rates for borrowing and lending money. Also, if the company is involved in overseas trade, the movement in exchange rates between different countries becomes a relevant factor. The more competitive the market place, the more difcult it will be for a company to identify an investment opportunity which can achieve a return sufcient to cover the cost of funds for the investment and reect all of the risks involved. Returns from organisational investments are affected by ination, taxation and the cost of funds. In making an investment decision, the company will incorporate each of these factors into their assessment of an investment opportunity. The existence in

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Chapter 1. An Overview of the Subject of Finance

the UK of volatile ination in the 1970s created signicant uncertainty for managers forecasting the real value of expected future cash ows from investment (i.e. the value after ination has been taken into account). This problem was compounded by the volatility of interest rates over the same period (see Figure 1.13) which affected the cost of borrowing to companies. Taxation rates on company prots were also considerably higher in the 1990s in the UK and this too is an important factor on the protability of investment. The UK tax rates on company prots have been lowered since the 1990s. Government and the external environment can, therefore, play an important part in creating a stable economy in which investment decisions are taken. Stability of external factors such as interest rates enables managers to forecast cash ows expected from capital investments with greater condence. Year 1971 1976 1981 1986 1991 1996 2001 2006 2009 Interest Rates 4.50 14.00 14.57 11.00 10.50 5.75 4.00 5.00 0.50
Monthly average of the bank base rate in December. RPI% Annual ination (end December)

Ination Rates 9.0 15.1 12.0 3.7 4.5 2.5 0.7 4.4 2.9

Source: National Statistics Ofce Figure 1.13: UK Interest rates and ination rates, 1971-2006 Increasing the wealth of the providers of funds to industrial and commercial companies is a central theme in nance. Industrial, commercial and public sector organisations and nancial institutions all invest in physical assets. The industrial and commercial sectors invest in a wide variation of land, buildings, plant, machinery and equipment with the motive of earning prot for the providers of nance. Public sector organisations invest in physical assets such as schools and hospitals to support the provision of social service. Financial institutions invest in property, for example, which may be let to individuals or institutions for a rent or for development and resale at a prot. Investing in projects involving bundles of physical assets will involve organisations making an assessment of the potential return on the assets and comparing it with the cost of funds, (or putting it another way the required rate of return for the provider of the funds). The cost of funds to organisations will be its cost of capital. The nancial manager will be the key individual in any organisation providing the link between the market for physical assets and capital markets. In the physical asset markets the manager will need to compete with managers of other organisations to nd investment opportunities which will add value to the organisation. On the capital markets the manager can sell nancial claims on the value of the physical assets to the providers of funds.

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1.4. Review

23

1.3.4 Self Test 1.6


Give an example of an external and an internal factor which might affect the business performance of an industrial or commercial company. Outline briey how the factor might affect the performance, (e.g. is it likely to be positive or negative?)

1.4

Review

Key concepts and issues covered in this chapter. Capital market objectives; The use of nancial intermediaries to transfer risk and waiting; The purpose of a nancial intermediary; The ow of funds between different economic sectors; The importance of nancial information; The role of investment analysts; The primary and secondary capital market; The relationship between business organisations, individuals, nancial institutions, capital and physical asset markets.

1.5

Conclusion

Financial decisions are taken by individuals, business organisations, (of various shapes and sizes), governments and nancial institutions. An efcient and effective nancial system ensures that each sector of the economy has money available for end users of funds to invest in physical assets generating a return for the providers of funds. Capital markets play an important role in developed economies, bringing together the providers and end users of funds. Throughout this module the role of capital markets will be explored with particular reference to how values are established between buyers and sellers of nancial securities, how information is made available and how it is used to value the nancial securities issued on capital markets. Exploring the interrelationships between capital market participants and the physical asset markets is important to understanding nancial decision making and how resources are allocated between alternative investment opportunities. In chapter 8 the objective functions of organisations and individuals are explored and, in particular, the relative returns and risks from investing. Measuring and interpreting returns and risks is central to understanding nancial decision making. The availability of information which is timely and relevant and at little cost, through an efcient nancial system, is crucial to the estimation of relevant risks and returns and the pricing of nancial securities. Heriot-Watt University Introduction to Finance

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Chapter 1. An Overview of the Subject of Finance

In this module we will return many times to the objectives of capital markets and the relationship between the providers and end users of funds. Understanding the role of participants provides a framework for appreciating the resource allocation decisions made by them and their purpose. The next chapter is concerned with the key nancial concepts underpinning these resource allocation decisions.

1.6
Q1:

Short Problems
Which of the following is not an example of a nancial intermediary.

a) A bank. b) A life assurance company. c) A hospital managed by a Local Authority. d) A pension fund. Q2: Which of the following reasons would explain why a company would use a primary capital market? a) To trade in physical assets. b) To re-negotiate a loan from a bank. c) To raise nance for physical asset investments by issuing nancial securities. d) To buy and sell shares in nancial securities of other companies. Q3: Which of the following reasons would explain why an individual would use a secondary capital market? a) To invest in machinery and equipment. b) To place savings in a bank deposit. c) To pay contributions into a pension plan. d) To sell a nancial security. Q4: Which of the following is not an objective function of a capital market?

a) To set interest rates. b) To bring together the providers and users of funds. c) To put pressure indirectly on the management of a business organisation. d) To provide a framework for valuing different categories of nancial securities. Q5: Analysis of the movement of nancial security prices to establish a decision rule to buy, sell or hold individual nancial securities is undertaken by: a) a fundamental analyst; b) an agent broker; c) a dealer broker; d) a technical analyst.

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Q6: Analysis of information about an organisations performance, their protability and nancial position is undertaken by: a) a fundamental analyst; b) an agent broker; c) a dealer broker; d) a technical analyst. Q7: Providing investment advice and arranging nancial security transactions are functions of which of the following? a) A fundamental analyst. b) An agent broker. c) A dealer broker. d) A technical analyst. Q8: Buying and selling nancial securities for individuals or nancial institutions and being able to trade in nancial securities themselves denes the role of: a) a fundamental analyst; b) an agent broker; c) a dealer broker; d) a technical analyst.

1.7

Tutorial Questions

Q9: Dene what is meant by a primary capital market. Q10: Dene what is meant by a secondary capital market Q11: Is it possible that a capital market can operate only as a primary market and not as a secondary market? Explain your answer. Q12: Why is there a need for nancial intermediaries in a nancial system? Q13: Explain the difference between an individual making a direct and an indirect nancial investment.

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Chapter 1. An Overview of the Subject of Finance

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Chapter 2

Basic Financial Concepts


Contents
2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Concept of Self-interest . . . . . . . . . . . . . . . . . . . . . . . . . . The Concept of Agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Concept of the Time Value of Money . . . . . . . . . . . . . . . . . . The Concept of Maximising Shareholders Wealth . . . . . . . . . . . . . . The Concept of Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . The Concept of Risk Diversication . . . . . . . . . . . . . . . . . . . . . . Information Asymmetry and Financial Signalling The Concept of Option Pricing Review . . . . . . . . . . . . . . The Concept of Capital Market Efciency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 30 31 33 35 36 39 43 47 50 52 52 53 54

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Learning Objectives On completion of this chapter students should be able to understand and apply the following concepts: self interested behaviour; agency; the time value of money; maximising shareholders wealth; risk diversication; risk aversion; information asymmetry and nancial signalling; capital market efciency; option pricing.

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Chapter 2. Basic Financial Concepts

Summary This section introduces readers to the basic underlying nancial concepts affecting nancial decision making at individual, institutional and different organisational levels.

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2.1. Introduction

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2.1

Introduction

Many fundamental concepts underpin nancial decisions which involve the allocation of resources to alternative investment and consumption opportunities. Understanding these concepts and being able to see how they can be applied will help us understand choices made by individuals and organisations. Many of the concepts, such as the concept of self interested behaviour, will seem familiar. Others, such as the concept of pricing an option, may appear more abstract and difcult to apply. The concepts discussed in this chapter will be applied throughout the nancial modules in this course. As you progress through your study of nance you will appreciate that this chapter provides a sound foundation to many of the important nancial models and ideas to be developed in subsequent chapters. Understanding nance involves an appreciation and awareness of fundamental underlying principles which relate to nancial decision making at individual and at different organisational levels. A nance director of a multinational corporation appreciates the effect of different combinations of nancial investments on his companys protability. This high level awareness has its roots in foundation level nancial concepts and principles. The budding nance director is encouraged to understand early in his life that putting part of his savings in a bank account at one point in time will enable him to consume more in the future. In this chapter many of the fundamental principles underlying the subject of nance will be discussed. Some of these principles, such as the time value of money, have been well understood for many years. An individual faced with a choice of 1 today or one certain 1 in one years time would always prefer 1 today. Other principles described in the chapter relate to well established practices being applied more systematically to nancial decision making because of relatively recent changes in developed capital markets throughout the world. An example of this is the option pricing principle. Having choices to take, or indeed not to take, some course of action occurs many times every day in our lives. On holiday as children the option of going to the beach if it is sunny, or to the theme park or museum if it rains, is an all too familiar one. In nance, option pricing is concerned with expressing, in nancial terms, the value of a choice. This choice may be a nancial contract which allows the holder of the contract to buy a nancial security, such as an ordinary share, at some future specied date and at an agreed price. The holder may choose to buy the ordinary share, or not, depending on the performance of the company which has issued the share before the date specied by the contract. In other words individuals do not have to buy tickets in advance for a day pass to go to the museum on a particular day (i.e. to buy an ordinary share today). They can keep their options open by delaying a decision dependent upon the weather (i.e. buying an option to have the right to buy an ordinary share at some future date). Investing in an option to buy an ordinary share at some future date is only one application of the principle and it will be explained that there are many rights or options undertaken by individuals and organisations at an explicit or implicitly agreed price. Rather than commit to buying museum tickets or passes to the theme park for one specied day instinctively we like to retain the freedom to choose. If, however, there is a need to pre-book tickets for the theme park because of high demand, our options may be restricted and we are obliged to choose a day, or range of days, or take a chance that it is not full on the day that is best given the weather.

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Chapter 2. Basic Financial Concepts

Many of the principles identied in this chapter will seem to be an application of common sense. The concepts will be readily understood and clear. Some, however, will be more abstract and understanding will be reinforced by application of the principles to examples in everyday life. New students of nance are encouraged to return to this chapter if in need of clarication or reminding of some of the most important principles underlying nancial decision making.

2.2

The Concept of Self-interest

The concept of self-interest The concept of self-interest is concerned with the impact of an individuals behaviour, in his or her concern for their own welfare, before the interest of others. In the context of nance this concept is used to explain the choices an individual makes and the impact this has on the investment choice of individuals and the alternatives that have been foregone. In 1776 Adam Smith, the famous economist, wrote in the Wealth of Nations* It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from regard to their own self interest. Accepting that individuals, acting on their own, or on behalf of an organisation, will choose to engage in activities on the basis that they will gain something from the activity is the essence of the principle of self interest. While this principle may not seem particularly earth shattering, applied to nancial transactions it can help us understand actions of the transacting parties. Individuals would not invest in an ordinary share unless they expected to gain, (presumably nancially, although the motive may also be non-nancial in whole or in part). An individual or businessman would not buy property for a price which would not compensate for satisfaction in its use as a home or in the value of its use as an important part of a business. It is important to understand that the principle of self-interest does not exclude nonnancial benets as the motivation for an individual to take a course of action and engage in a nancial transaction with another individual or organisation. Decisions taken for the purchase of a new home may be based on aesthetic reasons, (e.g the external facade), or for practical reasons, (e.g. ruling out homes which may be located on a steep hill for an elderly relative). Such considerations will invariably, for most people, be a trade off against relative prices. In other words individuals will have a range of choices or opportunities for making decisions and in choosing one opportunity they will lose their next best opportunity. The value placed on the alternative investment may be largely nonnancial. For example if both investments are the same price, the chosen investment could be due to its more pleasing appearance or for stylistic reasons. If the alternative is cheaper then inevitably there will be a trade off between price and any aesthetic or style factors. The opportunity cost to the buyer is the value of the investment foregone, as a consequence of the house selected for purchase. The purchase of property for business purposes can be presumed, in most cases, to be nancial. The purchase of a warehouse for stock will be based largely on its Heriot-Watt University Introduction to Finance

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31

physical location vis-a-vis transport networks, expense of the land and building and how appropriate the structure is for the nature of the stock to be stored. A warehouse located at a long distance from the retail outlet will increase the transportation expense for an organisation moving the stock between the two locations. A warehouse with narrow passages may be inappropriate for the moving of stock items quickly as demand requires. This may involve a restructuring cost to improve access or more critically suffering increases in delivery time to retail stores and possibly lost sales as a consequence. In other words, each of the considerations has a potential nancial consequence which should be addressed prior to conducting a transaction. The concept of an opportunity cost from undertaking a transaction is fundamental to many areas of nancial decision making. For example, the decision to buy a particular make of motor car means that an individual will forego the opportunity to buy another make. The opportunity cost to the individual is the next best motor case that he or she could buy. To operate in their own self-interest it will be assumed that investors will take decisions which yield the best return from the alternative opportunities available for an equivalent risk. An individual, operating on behalf of an organisation as a nancial decision-maker, is in a position where he or she may have a potential moral dilemma. Acting as an agent for an organisation the decision maker is in a position to make decisions which should be in the best interests of the organisation. This may however create a dilemma as it may mean that it is not necessarily in the best interests of the decision maker. The moral dilemma facing managers taking nancial decisions in organisations is discussed in the concept of agency section. * An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith, 1776.

Self Test 2.1


Think of an example from your experience where individuals or organisations performed some action in their own self interest but which still beneted more people than the individuals or organisations concerned.

2.3

The Concept of Agency

The Concept of Agency The concept of agency involves the dynamics of the relationship between an owner the principal) and an employed person/organisation (the agent) who is asked to act on behalf of the principal. The core relationship involving a principal and agent in the context of nance is the shareholder (principal) who appoints the management (agent) to run the business. This is important as the behaviour of principal and agent helps us understand the key nancial decision making in organisations. There are many occasions in life when, either by choice or necessity, we place our faith in another person or institution to act in our best interests in a particular circumstance. Solicitors act as agents in holding legal documents on our behalf, negotiating a property price and defending our rights. Suppose an individual, Mr X, engages a solicitor, Miss C to act on his behalf to buy some land. Mr X is the principal in this arrangement,

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Chapter 2. Basic Financial Concepts

that is, he will purchase the land and take the risk. Miss C will act as the agent in the transaction, ensuring particulars of the land are as they should be and in a state as specied by the vendor. Also that the price which Mr X will ultimately pay is a fair one, given the particulars. An example of an agent-principal arrangement in nance is the relationship between a shareholder and a manager in an incorporated company. The principal in this relationship is the shareholder and the agent is the manager. The shareholder has invested funds in the organisation and the manager is the custodian of the funds on behalf of the shareholder. The manager will invest the funds in combinations of physical assets to satisfy the shareholders expectations. In a protmaking organisation the manager will be concerned with increasing the shareholder value. In a non-prot making organisation the manager will act on behalf of the fund holder as custodian of funds to support the activity of the entity. Relating the concept of agency to the shareholder-manager relationship is central to understanding nancial resource decisions. Understanding the factors affecting a decision made by an investor or institution to invest funds in nancial securities issued by prot motivated business organisations is important to help appreciate the values of nancial securities traded in the secondary markets. Being aware that nancial decisions are made by managers who may not be the sole or joint owner but appointed by shareholders to invest their money on their behalf can bring an important dimension to understanding choices made for resource allocation. In a world of increasingly global capital markets and increasing numbers of share owners, most of the largest wealth creating organisations have many millions of shareholders. How is a manager of such an organisation to act in the best interest of all shareholders? If a manager has control of the day-to-day nancial decision making is it likely that, as custodian of shareholders funds, he is as vigilant as he would be with his own funds? This issue was emphasised by Adam Smith writing in 1776*: It is unlikely that a manager of a joint stock will act with the same anxious vigilance when the funds used are not their own. Managers may be left with a moral dilemma. Should they allocate the organisations resources for an opportunity which leads to a shareholders benet, increasing the value of the shareholders nancial stake but which may involve taking a high risk? Or should they concern themselves with minimising risk as far as possible, to safeguard the security of their own position? To ensure the manager is acting on their behalf, shareholders will demand information about the organisations activities through annual nancial accounts. Annual accounts published by public companies are scrutinised by an independent auditor who is appointed by the shareholders. Such monitoring costs can be considerable and are incurred by shareholders as a consequence of the separation of ownership and management. Some agency costs, which are not so easy to calculate, are the lost values of opportunities foregone by lazy or incompetent managers who have not exercised the vigilance their principals might expect. These opportunity costs of lost values are also referred to as agency costs. The issues involved in the concept of agency will be discussed again later in this module as they shed light on the problem of explaining the actions of nancial decision-makers.

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2.4. The Concept of the Time Value of Money

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* An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith, 1776.

Self Test 2.2


List what you think are the main benets and drawbacks of the owner of a business recruiting a full-time manager, (or Board of Directors), to make the day-to-day decisions of business.

2.4

The Concept of the Time Value of Money

The Concept of Time Value of Money We know intuitively that 1 or $1 today is not the same as what it was worth 50 years ago or what it could be worth in 50 years time. The time value of money is an important concept in nance for our analysis of the options open to individuals and companies in making their decision to invest today and forgo consumption or to delay investment and consume immediately. Decisions will be inuenced by the perceived erosion of the value of money over time. The concept of the time value of money is central to understanding nancial decisionmaking. Many complex nancial models are based on the principle that the value of money changes over time. For the moment assume a world of perfect certainty and that you are facing a choice of receiving 1000 today or a certain 1000 in one years time. Which option would you choose? 1000 in one years time? I doubt it! I expect you to choose the 1000 today option. Why? Well, implicitly or explicitly you will have guessed that taking 1000 now means you have the choice of consuming the 1000 today (or at least before one year has passed), or you could invest today in a fairly safe investment and achieve a small return, such that after one year you have more than 1000. In other words you may have chosen the 1000 today because of your consumption preference (e.g. you could use it to help buy a new car today), or because you might be able to lend the money to a bank or nancial institution which will give you a real return, (i.e. a nancial return on your 1000 after general changes in prices over one year have been taken into account). The value of money may well change over time due to changes in the prices of consumable goods and services. This will make 1000 in one years time less valuable than 1000 today as you will be unable to consume the same combination of goods and services in one year as you could consume for 1000 today. In the real world there are no certain returns, (although we might like to think so!), due to the reality of risk and the occurrence of events that we cannot predict with accuracy, but which may affect the nancial returns from investments. It is important to note the distinction between risk and uncertainty. The risk of an investment can be measured in some objective systematic way. Uncertainty by denition cannot be. Here is an analogy. While walking your dog at night she runs into the woods. It is a misty night and difcult to see beyond two or three metres in front of you. To locate your dog you may be able to predict broadly where she is from the direction of her entry into the woods or the time she has gone. It may be that you have passed through the

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Chapter 2. Basic Financial Concepts

woods many times and know its layout very well. In other words you could reduce the risk of nding your dog by balancing your knowledge of each of these relevant factors thus narrowing your search area. The thickness of the mist will increase the difculty of your task in estimating the probable locations. Compare this with making a decision to invest in a nancial security listed on the Hong Kong Stock Exchange. It may be that you know the Hong Kong markets well from past investment experience, and have some view on the possible returns to be made from investing. The effect of the change from British to Chinese rule which took place in June 1997 is to create a more uncertain future economic environment. It is difcult to measure with great accuracy the effect of this dramatic change on the expected returns from nancial investments. In nance there are increasingly sophisticated tools of risk analysis but uncertainty cannot, by its very nature, be measured. The scale of this uncertainty which will affect the clarity of the investment decision made is analogous to the thickness of the mist in the woods. Ination is a term commonly used by Government economists and the nancial media. Ination measures the effect of the changes in value of goods and services over time. It is usually based on a typical basket of goods and services consumed by an average individual. The basket will clearly differ between different countries and is based on what in the UK is referred to as a retail prices index of goods and services. Ination affects what investors can consume with their nancial investment return. In other words, as you will see later in the module, ination will need to be taken account of in measuring the real return to investors, i.e. how much extra goods and services individuals can consume from the growth of their nancial investments. Figure 2.1 provides a reminder of the key factors affecting the value of money over time. Consumption preference Ination Risk Time value of money Figure 2.1: Factors affecting the value of 1 today and 1 in the future

Self Test 2.3


You are left 5000 from the inheritance of a relative. The condition of the will is that it is to be placed in a nancial investment for ve years after which time you will receive the investment plus the income and/or capital gain. You are considering three possible investment options. 1. Invest in a bank deposit account. 2. Invest in ordinary shares. 3. Invest in Government bonds. Which of the three options would you choose? Explain your answer. Heriot-Watt University Introduction to Finance

2.5. The Concept of Maximising Shareholders Wealth

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2.5

The Concept of Maximising Shareholders Wealth

The Concept of Maximising Shareholders Wealth This concept is linked to the agency relationship. Modern nance theory traditionally assumes that the agent (ie management) will act in the best interest of shareholders (the principal, and therefore their employer). The best interest of shareholders, it is assumed, is to maximise their wealth and therefore decisions need to be taken which will increase the present value of their wealth, as this is their primary objective. In the early chapters of almost every modern classical nancial management textbook is a section covering the important issues surrounding the objective function of a business organisation. Why should the objective of a business be so important? If we can understand the objective of a business organisation we can evaluate its performance in terms of the return yielded from the physical asset investments. Traditionally, maximising prots is seen as the business objective of most commercial and industrial companies. There are problems with this objective. Which prots should the manager focus on? This years prot? Prots over the next ve years? Prots over the life of the business? Also, in calculating the business prot, different measurement techniques, which can change the reported gure, can be applied. Although international accounting standards have minimised differences between countries, the interpretation of a reported business prot in one country is not necessarily the same as that reported in another country. Also because of the concept of the time value of money, 1 of prot in ve years time is not of the same value as 1 of prot earned today. In a business structure such as a sole trader and partnership, the owner/part owners are also (in many cases) the managers of the business, making the day to day investment decisions. Within their chosen business activity it may be reasonable to assume that decisions on the allocation of nancial resources are made on the basis of increasing the wealth of the owners or co-owners of the business. A business structure that has many hundreds, thousands or millions of individual and/or institutional shareowners presents a greater problem with regard to establishing an objective function for decision making. How can a nancial manager take account of all individual shareholders consumption and risk preferences before making a decision? More importantly academics in nance have debated whether managers should be concerned with maximising the shareholders wealth. Or, perhaps more realistically, whether managers should concern themselves with an objective function encompassing a broader dimension which takes account of the fact that there exist many interests in addition to those of shareholders. Increasingly the concept of organisations having a number of important stakeholders is becoming more popular. The term stakeholder embraces a wider denition of interested parties in an organisations nancial prosperity. Employees, communities, society as a whole, customers, suppliers, and government are some of the key stakeholders who can be identied alongside shareholders and managers. Combining the interests and needs of the various stakeholders identied into an operational objective function is far more complex than simply to maximise the shareholders wealth. However, adopting the unitary objective assumption has enabled nancial academics to develop models to support managerial decision making by assessing the effect on the risk and return of investments on one stakeholder alone, the shareholder. Heriot-Watt University Introduction to Finance

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Chapter 2. Basic Financial Concepts

We will return to the maximisation objective in more detail in a later chapter. The agency concept is crucial to the operation of the objective in practice. That is, how might the principal (or shareholder) ensure that the manager takes investment decisions consistent with his own objectives? Can the manager assume that all shareholders in the business organisation have the same objectives? How can the manager be motivated or disciplined to maximise shareholders wealth when the shareholders are separated from the management of the business? The importance of this concept in nance for understanding and interpreting nancial decisions cannot be overstated. You should be aware at this point that maximising shareholders wealth is not necessarily the same as maximising prots. Although shareholders receive the net prots of an organisation, after all the costs of the business activity have been deducted, short-term prots can be increased to the detriment of future prots and shareholder wealth. Cutting research and development expenditure can produce a signicant effect on the shortterm prots of a business operating in, for example, manufacturing or the pharmaceutical industry but, in the medium and longterm, market share and growth will potentially suffer. Shareholders wealth is connected to the income return on their shares, a dividend, and to the movement in share price (which is the unrealised gain until the share is sold). This is not in itself the same as prots, part of which are retained for investment in the business and part are paid out to shareholders as a dividend. It is the future growth from cash reinvested in the business that will affect the shareholders wealth position and have the greatest inuence on the share price.

Self Test 2.4


Think of a large company with which you are familiar. (It might be a retail shop, bank or manufacturing company. You may be familiar only in the sense that you regularly buy their products). List the persons, groups of persons or institutions associated with the company and briey explain how each is affected by the company you have chosen performing well or badly.

2.6

The Concept of Risk Aversion

The Concept of Risk Aversion This concept is linked to the concept of risk diversication. We assume that investors will want to avoid risk unless there is some reward for it. In nancial decisions this means that unless there is a higher expected return from investment with more risk, an individual will not invest in a riskier alternative. This concept has fundamental implications for the pricing of risky nancial securities such as ordinary shares, as it is through this rational process that earnings yields (ie the income and capital return) of the most risky shares will gravitate to a level that compensates the investor for taking the risk. Individuals attitudes towards risk are fundamental to understanding nancial decisionmaking. The principle of risk aversion is that individuals who make nancial decisions will prefer, ceteris paribus (everything else being equal), given the choice between

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2.6. The Concept of Risk Aversion

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two investments with identical expected returns, to choose the alternative offering the lower expected risk. Similarly if choosing between two investments with the same expected risk they will choose the investment offering the higher expected return. This concept is relatively uncontroversial though students often confuse risk aversion with risk preferences. For instance, we can probably think very quickly about a friend or relative who likes to take risks. Does this mean they are not risk averse? Of course it does not. Developed nancial systems require individuals and nancial institutions to take relatively high risks. By investing in high-risk opportunities it would be presumed that the investor is expecting at least as high an expected return as from the next best alternative investment with the same risk. For example, consider Emma, who is an interior designer working for a reputable design company. After several years of experience Emma has developed a good reputation with some of the companys best clients. Emma is considering quitting her position in the design company and setting up her own business. She is trying to decide whether it will be nancially more attractive to run her own company than receive her current salary. Her choice will involve deciding between a higher nancial risk option as she will lose some job security if choosing to set up her own business and the problems associated with setting up her own client base. What should Emma choose to do? Clearly Emma will need to establish how many clients she may reasonably expect and the anticipated size of her fees charged to them. She will also need to consider the costs of running and administering her own business. This will involve, for example, stationery costs, ofce rent and accountancy fees. This will enable Emma to compare her expected net income position with her current salary received. Remember however the concept of risk aversion. If her net income position is expected to be largely similar, whether she runs her own business or simply draws her existing salary, she will choose the opportunity offering the lower risk. Financially if Emma does not expect a higher return from setting up her own business she should opt to remain where she is. Being risk averse means that a decision maker will only undertake a higher risk alternative if it offers him, or in this case her, a higher return to compensate. Of course, in this example there are non-nancial factors contributing to the decision Emma will take, such as increased selfesteem and independence associated with her running her own business. Being risk averse however, does not mean that individuals can be expected always to choose the lowest risk alternative. In nance it means that the higher risk investment opportunities will require higher rates of return. Just how much higher the rates of return will need to be will depend upon investors risk preferences. Investors in developed capital markets are faced with a range of different risks and returns. During this last century the returns on ordinary shares traded on selected world stock markets are shown in Figure 2.2. Figure 2.3 indicates the relationship between risks and returns on xed interest government stock, xed interest corporate bonds and ordinary shares on the US stock market this century.

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Chapter 2. Basic Financial Concepts

Country USA UK Japan Sweden Holland

Period 1926 - 92 1919 - 92 1970 - 92 1919 - 90 1947 - 89

Risk Premium (%) 8.6 8.7 9.8 7.7 8.5

Variability (Standard Deviation) 21 24 28 20 21

Ibbotson Associates (USA), BZW/Dimson and Marsh (UK), Hamao/Ibbotson (Japan), Frennberg and Hansson (Sweden), Schalk (Netherlands) Figure 2.2: Returns and risks from investing in ordinary shares on selected world stock markets this century Variability (Standard deviation) 21 9 3 5

USA 1926-92 Shares Corporate bonds Treasury bills Ination

Nominal return 12.4 5.8 3.8 3.2

Risk premium (%) 8.6 2.0 0.0 n/a

Ibbotson Associates (1993) Figure 2.3: Average returns and risks on the US stock market this century In most developed stock markets the lowest risk investment is a xed interest, shortterm maturing security issued by the central government. The riskiest type of nancial security is an ordinary share (referred to as common stock in the United States). Over the dates shown in Figure 2.2 an investor holding a portfolio of all ordinary shares traded on the markets shown, (weighting the shares in proportion to their relative market values), would have achieved an average annual risk premium of between 8.5% and 9.8% per annum. The risk premium in this case is calculated as being the difference between the annual average return on a portfolio of ordinary shares listed on the market less the average annual return earned from investing on the most riskless form of government security listed on the market. Over the same period the standard deviation of a portfolio of all ordinary shares, which is a measure of the spread of actual returns around the average, was around 20% for most of the markets covered in Figure 2.2. In the US, the return from investing in Treasury Bills, (short-term government securities), during the years 1926-92 barely covered the average rate of ination. The standard deviation during this period was however signicantly lower than ordinary shares during the same period, it being 3% compared to 21% for ordinary shares. In other words, to achieve an average annual return of 8% higher than the most riskless form of investment an investor would have to undertake signicantly more risk, (measured by standard deviation of returns, an increase from 3% to 21% on the US

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2.7. The Concept of Risk Diversication

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market). Figure 2.3 illustrates how investors in the US stock market have differentiated the required returns from the different types of risky investment to compensate for the extra risk involved. Notice that even the most riskless form of investment, the Treasury Bill still has some risk, ie 3% during the period shown.At this stage it is important to understand that the concept of risk aversion has an important role in nance, helping to interpret rational behaviour of investors trading off risk and return. The concept of risk aversion is consistent with the evidence shown in the tables. Investors have earned progressively higher rates of return on stock markets from higher risk investments.

Self Test 2.5


Consider the following statements and choose which is an example of risk aversion and which is risk preferring. 1. Jim Wayne chooses lucky 7 every time when he plays roulette. After all he reasons it has an equal chance to every other number on the wheel. 2. Glenys Cooper has decided to invest her money in the Government gilt edged security promising to pay 7% on her investment in the next year in preference to the slightly higher 7.25% return offered by the South East Asia Bank over the same period. 3. Jo Stewart always insists on backing the favourite in horse races as he collects more frequently than backing outsiders.

2.7

The Concept of Risk Diversication

The Concept of Risk Diversication This concept is linked to the concept of risk aversion. We assume that investors will only commit their wealth if they are rewarded for any risk. We assume where they can, investors will aim to reduce their risk wherever possible. If an investor can reduce the risk of an investment without affecting their overall expected return this is an ideal. The concept is popularised in the familiar phrase dont put all your eggs in one basket (ie in case you drop the basket, (the risk), as they will all break). The old proverb that you should not place all your eggs in one basket encapsulates the concept of risk diversication. Investment decisions made by individuals, nancial institutions and business organisations involve risk. The concept of risk aversion holds that nancial decisionmakers will try and avoid risk unless the possible return from an alternative investment is sufciently high to compensate for the higher risk. Individuals and businesses can spread risks from individual nancial and physical asset investments by constructing a portfolio, (a collection of investments), with different types of risk. For example, individuals investing in ordinary shares of a soft drinks manufacturer are exposed to the risk of the summer weather being unseasonably cold and wet. To reduce this risk an investor might split his investment and invest part in ordinary shares of an umbrella manufacturer whose risk with regard to the weather is an unseasonably Heriot-Watt University Introduction to Finance

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hot and dry summer. The expected returns from the two nancial securities will be unaffected by the investor holding an ordinary share of each company in his portfolio, but the investor can reduce the risk of a poor return based on the risk of the weather. In the real world there are many different risks affecting individual companies based on the type of physical assets, the industrial sector of business activity and general market factors such as interest rates, ination and foreign exchange rates. The concept of risk diversication can be applied to business assets as well as to portfolios of nancial securities held by individuals or institutions. Hanson plc, the conglomerate industrial giant, grew through acquisitions of other companies throughout the 1980s. The activities of the multinational conglomerate ranged from mineral extraction, tobacco production and brick manufacture to retailing. Investors in ordinary shares of Hanson plc were automatically diversied among a number of different markets and countries although they held an ordinary share in only one company. When companies merge different business activities and become one company, however, there should be a greater value as a result of the two combined companies than the two companies operating separately. Otherwise, individuals or institutions can diversify themselves more cheaply by buying shares in two separate companies. When a company recognises that different business activities within the company would have a greater value separated than combined, as a whole the company can take the decision to divest itself of the separable activity. In fact Hanson took the decision in 1997 to do exactly that. Having grown in value through the acquisition of separate businesses, they decided to disaggregate their various businesses and sell them off on the basis that this would add more value for the shareholders than keeping all of the businesses in one company. Generally a diversied portfolio of investments in nancial securities is far easier and cheaper to achieve than diversifying physical assets. The fact that an investors risk can be signicantly reduced is a statistical paradigm which will be shown clearly in chapter 7 of this module. It is worth mentioning at this stage however that investors cannot diversify all of the risk from investing in nancial securities. No matter how extensively diversied they may be they will always be faced with the risk of general market movements in the economy in which they are trading. It is the unique or specic risk attached to the business activity of each company which individuals can diversify away. Going back to our previous example, an investor can diversify the risk of a poor or good summer by investing in a company facing the opposite risk (e.g. a soft drinks company or an umbrella manufacturer). However, investors will still be faced with the risk that if the country is in recession or interest rates are high this will affect their nancial return. If there is a recession, sale of soft drinks or umbrellas may, on the whole, be lower. If interest rates are high this may adversely affect the costs of either company by increasing the interest payments on outstanding loans which the company may have used to nance their activities. Either way the nancial return will be lower if these market conditions prevail, either initially in lower dividends, or in lower earnings retained for investment in future opportunities. Figure 2.4 indicates how investing in combinations of nancial securities affects the overall risk of different sized nancial portfolios. Standard deviation is a statistical measure encapsulating the spread of actual returns to an investor around the average return over a period of time. This calculation will be explained in chapter 7.

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Reproduced by kind permission from B. H Solnik Why not diversify internationally rather than domestically?, Financial Analysts Journal, vol 30, No4 July-August, pp48-54, 1974. Figure 2.4: The benets of risk diversication You will notice that the slope of the line is steeper with relatively small portfolios of nancial securities; this indicates that investors can reduce signicantly the unique risk from investing in individual companies by means of a relatively small number of nancial securities. In the study by Solnik, from which the Figure 2.5 is reproduced, the risk measured by the spread of actual returns could be reduced to a maximum of 34.5% of the average risk in holding only one security.

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Reproduced by kind permission from B. H Solnik Why not diversify internationally rather than domestically?, Financial Analysts Journal, vol 30, No4 July-August, pp48-54, 1974. Figure 2.5: The benets of international risk diversication Notice also that investors cannot reduce their risk below the lower line, which by denition will be the market risk. By holding all nancial securities listed on a capital market, investors are taking the whole of the market. Individual companies nancial performance will become relatively insignicant the larger is their portfolio of different nancial securities. Investing in international nancial securities increases the degree of risk diversication an investor can achieve. Investors can even diversify some of the risk they are exposed to from investing in a diversied portfolio of domestic nancial securities. The market risk of a portfolio diversied across many world markets will reect the most dominant economic factors affecting stock returns of the most dominant economies in the world portfolio. For example a UK investor will to a certain degree reduce the risk of the effect of the movement in the -$ exchange rate as he progressively invests more heavily in US stocks. What he will now be more exposed to are the market factors affecting the returns on US stocks, such as the US ination and interest rate movements. Through the process of diversication however, investing in an international portfolio can reduce the standard deviation of returns. This is illustrated in Figure 2.5. In summary, risk diversication is important to investors in both nancial securities and physical assets. It is important because of the concept of risk aversion. A rational investor will want to reduce his risk as far as possible for a given expected return. By the process of combining investments with different types of risk the investor can diversify some of the specic risk away. In most cases the investor in nancial securities will be able to diversify more easily and cheaply than a business organisation combining physical assets. Chapter 7 illustrates some of the basic mathematical techniques used in estimating measures of risk and return in nancial decision making.

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Self Test 2.6


Remember your 5000 inheritance. You now have the choice of investing in a fund which holds all of the ordinary shares of the top 50 largest companies in your country, or investing all of the 5000 in ordinary shares of a company of your choice. Which alternative would you choose? Explain your answer.

2.8

Information Asymmetry and Financial Signalling

The Concept of Information Asymmetry and Financial Signalling This concept is linked to the concept of maximisation of shareholders wealth. If we assume that managers will have greater information about the expected returns and risks from a business operations than a shareholder then a state of information asymmetry exists. If we assume that through the concept of self interest, a manager will want to signal positive information, as this will reect well on the value of the company and his/her own position. There are reasons why the managers behaviour and in particular the choices of nancial decision making, for example in the rate of dividends paid (a nancial signal), will be of high interest for the shareholders. The concept of information symmetry means that an information set is equivalent between two or more parties. In other words given a situation where there are two or more people concerned about an event or circumstance common to their interest, if there is information symmetry between the two parties, both will be assumed to have exactly the same information regarding the particular event or circumstance. Information asymmetry therefore, has the opposite meaning. The two parties concerned have a different set of information about the event or circumstance. A practical example of a situation where information asymmetry may exist is with regard to wine quality. Take for example, a bottle of wine bottled at a renowned Chateau in Saint-Emillion, France, 1991. Wine qualities vary from year to year, being dependent on factors such as the climate and methods used to harvest and ferment the grapes. The Chateau wine producer will know instinctively before tasting whether conditions have been suitable for an outstanding year. This information together with a tasting of the wine will enable the producer to compare the quality with previous vintages. Customers buying ne wine will have, to a greater or lesser extent, some or most of this information relating to a bottle of wine from the Chateau, vintage 1991. Typically interested and enthusiastic buyers will know the conditions for growing the grapes, the weather and the effect on harvesting. This information will provide a general guide fuelling the expectation of the quality of the vintage. Clearly what a buyer will not know with precision is the effect the general conditions have had on a particular Chateau. Some Chateaux will perform better than others in any one-year because of the positioning of the grapevines, which may benet from improved climatic conditions relative to other less well positioned Chateaux. Progressively after the grapes have been harvested and fermented, wine tasters will be invited to taste the wine and compare with other Chateaux from the same year the quality strength and expected maturity of the wine. As this information lters to the wine buying market information gaps between the wine producer and wine buyer will close, such that the information sets overlap close Heriot-Watt University Introduction to Finance

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to information symmetry. Of course we can observe naive buyers of wine who have not taken the care to nd out this information and buy the wine without regard to the comparative quality of the Chateau; in this case information asymmetry exists between the buyer and producer. What does this mean for the world of nance? Central to nancial decision making, on both individual and organisational levels, is the existence of relevant, costless, timely and accurate information about alternative investment opportunities. Central to establishing values for particular nancial or physical assets is information about the underlying investment. Recall the example from Chapter 1 of the fraudster who stimulated speculation in stock market prices on false information regarding Napoleons death. Certain information can be fundamental to the economic value underpinning nancial and physical assets. Relating this point to the analogy of the information relevant to the wine market, consider an investor making an investment in a nancial security. General information about movement in stock market prices, (e.g. whether the market is optimistic/bullish or pessimistic/bearish) and the economic climate (e.g. interest rate levels, foreign exchange rates, ination targets) are akin to information regarding the weather affecting the wine producers grapes. In other words this information will be useful to an investor in interpreting and forecasting performance of individual nancial securities whose value will be based on the underlying physical assets of the business. Performance of ordinary shares issued by a television and video retailer will be signicantly affected by high interest and ination rates, as these factors will reduce the amount of money available for consumers to spend. Similarly, businesses operating in the construction industry are seen as the barometers of the economy, being one of the rst business sectors to suffer as an economy moves into recession. Construction companies order books inevitably dry up as economic condence is reduced and costs to the business increased, leading to fewer individuals and businesses buying property. An investor can obtain further information on individual businesses through nancial reports and information published by the company. This information is akin to the reports on comparative wine tasting of different Chateaux helping the buyer distinguish the relative merits of the alternative opportunities and performance of any individual Chateau. Having utilised the relevant information, both general and specic, the choice between alternatives will be a function of the relative prices. We might reasonably expect the nest wine from the best Chateau to be the most expensive bottle. Equally the nancial securities offering the best prospects for future returns, will be priced accordingly by the market. The relative values can only be established based on the relevant information being made available and having been digested by the market. The process of digestion by the market will involve buying or selling based on the relative importance of the information made available. Let us look again at what has been said so far. Information about investment opportunities is important to a potential investor. The concept of information asymmetry is also important to a potential investor because it implies that some information which may be relevant to an investment, is not known by a potential buyer or seller. Knowledge of relevant information regarding an investment opportunity will enable buyers and sellers in the market to set a value for the nancial (e.g. ordinary share) or physical asset (e.g. bottle of wine). If there is information asymmetry where the market may not Heriot-Watt University Introduction to Finance

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know all the relevant information about a particular investment, the value at which the investment is traded will be affected. In other words the market price may be high or low relative to the market value if the information was known to investors. Related to this concept of information asymmetry is the concept of nancial signalling. Signalling in this context relates to the passing of information from one person or organisation to another, where there exists the condition of information asymmetry. It is the intention of the sender of the signal to alter the actions of the recipient. Let us consider again the wine producer to illustrate the application of this concept. The Chateau wine producer blends some grapes, taking alternative quantities of grape variety and quality, which have different avours. To produce the top quality bottles he will use a balance of the best grapes. So from the same Chateau in the same year there will be different standards of performance in different bottles of wine. The problem for the producer is that he wants to charge a high price for the best bottles from his Chateau. He requires a method for signalling which wines are his highest class and distinct from other bottles sold to the customer so that they know what to expect. In France there is a system for classifying Saint-Emilion wines as Grand Cru Classe (with ve categories in descending order). A consumer knows to expect a better performance from buying a Premier Grand Cru Classe (rst class) bottle than from a fth cru classe. This system signals clearly to the consumer the relative merit and quality of performance. There is however the potential for a moral dilemma when the wine producers from Saint-Emillion classify the wine into different categories. Because of the concept of self-interest the consumer might be sceptical that a rst class bottle is really only a second class quality charged at a higher price for the wine producers prot. In other words the wine producer may engage in false signalling. How can this problem be overcome? An independent classication body might reassure consumers that they are getting what they pay for. Also an independent system for awarding gold, silver and bronze medals to the best classications from different Chateaux each year will again possibly reassure consumers of the quality. In nance similar principles apply with regard to the concept of signalling information. Information asymmetry between investors and managers of business organisations exist due to the very nature of running a business. Most information available on the market is historical, being based on the past performance of the organisation. What the investor is really looking for is information which might be a signal to the future performance of the organisation. Forecast revenues and costs relating to the capital investments made by organisations can be very sensitive to market competitors. For example, a business may be considering re-pricing its products or services, or launching a new business idea. In a business structure other than a sole proprietor and partnership, it is likely that there will be shareholders not closely involved with the day to day running of the organisation. This will mean they will not be in a position to be aware of information relevant to forecasting expected future performance which managers will have. Information asymmetry will exist. The information could be generally good or bad. The market therefore may, at any point in time, nd that the value it places on a nancial security issued by the business is higher or lower than would have been the case had the information been known. As the wine producer will be motivated to signal information about his high quality wines to enhance the price at which they can be sold, a manager in a business organisation acting out of self-interest could be expected to signal good news about future expected returns to market investors. This might ensure a greater condence in the market and

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enhance the managers job security and progression. Financial accounting reports are available to shareholders on an annual basis and are a nancial expression from management of business performance over the year. Shareholders appoint independent auditors to check the nancial accounts presented to the shareholders, validating the information contained therein. This is akin to having a truly independent classication system of different grades of quality wine. As in the case of wine consumers, shareholders, (or potential investors in a business) may derive some reassurance from such validated information but it does not inform them of what is expected in the future. The wine may be rst class in terms of relative quality but 1991 was a poor year for the grapes and the wine may have a different maturity and avour to more exceptional years. Equally the shareholder will wish to know what the future performance of the business is likely to be. What new capital investments are planned? How is the business expecting to compete with other operators in the same industry? Some of this information may be available in a general sense, but due to its sensitivity much will not be known in detail. Instead the market may look to management to signal information to them about future expectations. If future forecasts indicate positive returns a manager is expected to communicate this to shareholders. To be an effective signal however, and avoid the dilemma of false signalling (i.e. sending a positive signal when the information is negative or neutral) it should have a cost attached to it. In other words the sender of the signal should be seen to be committing to something in order for the recipient of the signal to believe the information. Examples of signalling positive nancial information in this way by business organisation include changes in dividend policy(the nancial income return to shareholders) or nancial capital structure (how a business is nanced). The concept of signalling nancial information from managers to shareholders is linked with the concepts of agency and self-interest. Using an independent auditor to validate information passed from management to shareholders is an example of a monitoring cost of agents. In summary the existence of information asymmetry between two parties creates a condition which may motivate the party with the greater information set to communicate the information to the other interested party. There is a moral dilemma in that, if the information is negative and is known to one party but not the other, the information may be suppressed. Further, a positive signal may be given when the information is either negative or neutral. This may lead to a misinterpretation of the value of a nancial security for an investor in a business organisation.

Self Test 2.7


List what you consider to be the three most important items of information about a company to a potential investor in the ordinary shares of the company. Justify your answer.

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2.9

The Concept of Capital Market Efciency

The Concept of Capital Market Efciency This concept is a crucial assumption in modern nance theory, and in light of stock market crashes (such as those in 1929; 1987 and 2008), has been under close scrutiny and challenges from chaos theory proponents. The concept relies on the information in existence to investors when they make their decisions. The concept of information asymmetry (and common sense!) tells us that at any one point in time managers in organisations will know more than those external to the business. If this information is likely to have an impact of the value of the company (eg an engineering rm being granted a prestigious government contract), then we might assume that the price of the stock of such a company is not reecting all information. An efcient capital market in its strongest sense incorporates all information into a stock market at any point in time. This is one of the most fundamental concepts as it tells us whether or not we can trust the capital market. Well, do you? The process by which information is made available on a capital market and is incorporated into prices of nancial securities listed on it denes the degree of efciency of that market. Recall from chapter one that a key objective of a capital market is to value securities consistently in order to reect the expected returns and risks to investors through the security price. An efcient capital market is one in which information is widely and cheaply available and incorporated speedily in prices of nancial securities. Crucial to this process is the ability of the market to digest new information quickly and interpret its relevance to the relative risks and returns of the nancial security involved. Many developed nancial systems in the world rely heavily on an efcient capital market serving both providers and users of funds. It is in the interests both of organisations raising funds on an organised capital market and providers of funds for nancial securities traded on the capital market, to have market prices which reect their important intrinsic nancial characteristics: risk and return. Recall that the concept of risk aversion holds that investors wish to avoid risk if at all possible. The concept of risk diversication means that investors can avoid unique risk from investing in individual nancial securities by investing in a portfolio of nancial securities with different types of risk. The risk that becomes increasingly most important to an individual investing in a widely diversied portfolio is the market risk, the risk that cannot be avoided. Increasingly capital markets are becoming globalised. The London Stock Exchange is the worlds largest exchange for trading in foreign stocks. It is interesting to note that the size of turnover in international stocks on the London market was 43 per cent of the total turnover on the London Market (March 2006), providing further evidence that London has taken over New York as number one nancial centre in the world. What does this mean with regard to the efciency of a capital market? At this stage it is not appropriate to discuss the intricacies of modern portfolio theory and models developed to price nancial securities. They will be discussed in other nance modules in this course. What is important at this stage is that you appreciate that investors in nancial securities are concerned about risk and return from their investment. Their exposure to risk from a nancial security can be affected by diversication in other nancial securities without altering the expected return. We presume that rational Heriot-Watt University Introduction to Finance

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investors, being averse to risk, will reduce their risk as far as possible. The process of assessing the relative risks and returns of nancial securities relies on the availability of information about the performance of the underlying physical assets of businesses issuing the nancial securities. It is the efciency and effectiveness with which they are managed to provide a nancial return that will affect the return to an investor in a nancial security issued by the organisation. It is the speed with which this information is incorporated into prices of nancial securities which determines the efciency of the capital market. If a capital market is efcient we can rely on nancial security prices being fair with regard to the expected risk and return of the nancial security, because it has been based on all the known information relevant to the expected returns of the nancial security. You will recall from the concept of information asymmetry that information about business organisations forecasted nancial risks and returns is not typically widely available to the capital market. To gain this information we would have to be able to monitor different strategic decisions by locating a closed circuit video in every Boardroom involving meetings of Directors in every company listed on the market. Information relevant to assessing the nancial risk and return of nancial securities is typically classied in three sets: information about the movement of the price of the nancial security over time; publicly available information about the organisation; inside information. Figure 2.6 illustrates the relationship between the three sets.

Figure 2.6: Information sets for capital market efciency Past price information on nancial securities traded on capital markets is available on all world markets. Most newspapers with a nancial section will incorporate information about security prices, movements, highs and lows for the year, for example. Public information on different capital markets varies. One of the key sources of public information comprises the annual nancial accounts presented each year, reporting on the performance of the business. Other information, which may be public, consists of announcements of take-overs and mergers with other organisations, or signicant changes of business structure. Much of this information is required to be published due to government legislation or Stock Exchange regulations. Different accounting standards, government legislation, and Stock Exchange regulations within different countries with capital markets mean that the information set of publicly available information differs between countries. The

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differences in the provision of public information will therefore affect the degree of efciency of the capital market. Even the most developed capital markets require legislation to prevent privileged personnel in business organisations taking advantage of their knowledge of price sensitive inside information. The information set, inside information, is therefore only known by a privileged few insiders, (e.g. executive ofcers, business solicitors and external accountants). Thus in developed efcient capital markets such as the US, UK and Japanese markets, there will still be information asymmetry between privileged insiders (set C) and publicly available information (set B). The implications are that investors in developed capital markets will trade using their prices for nancial securities based on the information set B, which by denition is not a complete set. In less developed capital markets, public information relevant to valuing businesses is less comprehensively available than in many developed markets. The network of provision of public information is less well developed and so capital market efciency will be at a lower level. Harry Roberts dened capital market efciency in terms of the three information sets as weak form efciency (set A) semi-strong form efciency (set B) and strong form efciency (set C). It follows that, if capital market buyers and sellers are able to obtain information about the movement of past prices and incorporate this information quickly into market prices, the market will be weak form efcient. This is also referred to as random walk theory. In other words market prices will move randomly following no predictable pattern. If the price of a nancial security follows a random walk, the implication is that we will be unable to predict consistently whether the price will move upwards, downwards, or remain the same the following day. Studies of UK and US nancial security prices indicate that these markets operate on at least the weak form of efciency, with many recent studies indicating that UK and US markets approach semi-strong form efciency. This evidence implies that by using public information it will not be possible to achieve a greater than normal prot, only an expected return which compensates the investor for the risk of the stock.

Self Test 2.8


Using the three categories of information dened in Figure 2.6 choose which of the three information sets you believe the following three items belong to: 1. A company dividend announcement; 2. An analyst report listing seasonal movements in a company share price; 3. Forecast cash ows from company projects.

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2.10

The Concept of Option Pricing

The Concept of Option Pricing The development of nancial instruments that could be traded and which do not involve buying an ordinary share, but merely the right to do so under certain conditions, was not available on a regulated market place until 1973. Since then the ability to buy or sell an option has been utilised by nancial institutions and individuals to manage their risk. This is linked to the concepts of risk aversion and risk diversication. The key point is that this nancial instrument has a value in itself, provided that the conditions (ie the date and price that the underlying share can be bought or sold) are still capable of being exercised by the holder of the option. This concept also has implications for other nancial decisions such as making investments in physical assets, such as buying land, or prime real estate, and therefore with the option to do something with it, or to prevent a competitor (eg a retailer) from acquiring the site. The use and pricing of options and other nancial derivatives has been an important development in modern nance. Financial instruments called options are relatively new, with the Chicago Options Board Exchange the rst organised market for trading options on common stocks being set up in 1973. The term option in everyday language is clearly not new. Financial instruments called options are important to both individual and institutional investors as they increase the range of risk and return possibilities in which they can invest. Businesses have increasingly used options in recent years. One common method is to give employees nancial share options as bonuses which give them the choice to purchase or sell the underlying ordinary share at some specied time in the future at a specied price. If the business performs well the price of its ordinary shares should increase which would mean that the holders of the options would benet. An option is a right to do something but does not create an obligation for the holder. It gives the holder a choice. Typical everyday examples of options include paying a fee to reserve a new property being developed. Paying the fee will give the right to purchase the property when it is fully developed. If the potential purchaser decides before this date to purchase an alternative property, there will be no further obligation regarding the reserved property. The option is relinquished and there is no more left to pay. Another increasingly popular example to support the development of new sports stadiums is an option which bestows on the holder the right to rst refusal of tickets for each game held in the new stadium. Typically the stadium developer, to attract nance for the stadium, issues loans to nance the development and as part of the return to the holder of the loan will be the right to purchase tickets on specied seats for each game held. If the lender decides not to go to any of the games the seats will become available to other supporters and there is no further obligation to the lender. The option becomes worthless. To a committed supporter of a champion team, the option may be the only way to watch the team in live action. Hence the value of the option could be high. It is not appropriate at this stage to discuss the methods for valuing nancial options. This aspect will be covered in another nance module on this course. At this stage it is important to understand the concept that an option is a right to do something and does

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not impose an obligation on the holder. With regard to nancial options this right could be the right to buy or the right to sell the underlying nancial security. The option to sell a nancial security is called a put option, and the option to buy a nancial security is called a call option. So, for example, if today you believe the price of your ordinary shares in Imperial Chemical Industries (ICI) plc will fall in the next ve years you may buy a put option expiring in ve years, giving you the right to sell the ordinary shares at a predetermined price in ve years time. The pre-determined price is known as the exercise price. Say, for example, the exercise price for the option to sell ICI ordinary shares in ve years is 800 pence. If the price for ICI shares is 800 pence or higher in ve years the option will be worthless (you would be better selling your shares at the market price for the ordinary shares than for 800 pence, the exercise price in the option). If you are right and the share price falls to, say, 700 pence you will exercise the option as you can realise 100 pence more per share than if selling on the open market. The writer of the option will lose 100 pence. The market in options needs to have a sufcient number of participants who are willing to undertake opposite risk positions. Figure 2.7 indicates the gains and losses made from two different scenarios involving a put option.

Figure 2.7: Gains and losses from a put option What, you might say, is the difference between buying a put option and simply selling the ordinary shares today at their current market price, on the basis that you believe the market price will fall? The answer is, of course, that by selling today you take the risk that the market value does not fall. The put option provides the holder with the ability to reduce the risk of the market price falling over the ve years, without having to sell the underlying nancial security today. The call option provides the holder with a similar choice by having the right to buy the underlying nancial security in the future at a specied price. Figure 2.7 summarises the gain and loss position of the option writer and option holder in two scenarios of a put option for ICI shares. The concept of option pricing is important in nance. Although we have not at this stage looked in detail at the different models which can be used to value an option, the principle that an option is a right not an obligation has been emphasised. The option to do something can enable investors and businesses to reduce their risk exposure for Heriot-Watt University Introduction to Finance

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the price of the premium on the option. The option may become worthless if it is not exercised but it will not have a negative value.

Self Test 2.9


Explain the difference between a put and call option.

2.11

Review

In this chapter the following concepts were dened and introduced in terms of their relevance for nancial decision making. Self interest. Agency. The time value of money. Maximising shareholders wealth. Risk diversication. Risk aversion. Information asymmetry and signalling. Capital market efciency. Option pricing

2.12

Conclusion

Financial decision making at all levels from individual through to corporate, institutional and governmental relies on basic nancial concepts. In this chapter some of the most important concepts applicable to nancial decision making have been identied. Many of them are fundamental to understanding how resources are allocated. Throughout the different areas of nance, for example investment in nancial securities, corporate nance decision making, and allocation of funds by pension fund managers, key concepts underlie the decisions taken. These concepts will be used to underpin key nancial models developed to explain more clearly the important variables affecting nancial choices. In particular information asymmetry, risk diversication and maximisation of shareholder wealth will be returned to many times throughout this course, in the context of investment analysis, portfolio theory and corporate nancial decision making. A sound grasp of the concepts at this stage will enable you to appreciate their fundamental importance and to apply them in the different areas of nance which you will encounter in subsequent chapters and nance modules on this course.

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2.13

Short Problems

The following questions should be answered either yes or no. Q1: Ian and John are best friends. Ian is a keen swimmer and wants to use the school summer holidays to practise. He wants John to accompany him in order that he can race against him and improve his chances of being selected for next years swimming team. John injured his arm a year ago when swimming and although it is now fully healed, John is concerned about injuring it again. He has decided that instead of supporting Ian during the summer he will concentrate on his hobby of playing chess. Which of the following concepts apply to Johns decision?. a) Risk aversion b) Option pricing c) Risk diversication d) Self-interest Q2: The Herb Boys pop music band have just reached number 1 in 20 countries worldwide with their rst recorded song. Another popular all girl band have recently taken legal action to sue the Herb Boys band for copying one of their songs. The Herb Boys have employed a solicitor to act on their behalf to defend the action. The solicitor informs the boys that if the girls are successful it could cost them up to 10 million, (plus his fees, estimated at 500000 for the defence if it goes to court). The solicitor has informed the boys that he has spoken to the girls solicitor who says that she would accept an out of court settlement of 2 million (payable by the boys), on behalf of the girls and it would not go to court. The boys solicitor has advised them that the boys should defend the action in court and ignore the offer of the 2 million settlement. The boys are not sure what to do. Which of the following concepts apply to the Herb Boys decision?. a) Risk aversion b) Option pricing c) Agency d) Self-interest Q3: Gordon OSullivan has read about a merger which has taken place between two of Europes largest soft drinks companies, in the popular magazine Investor weekly. Gordon believes the possible benets from the combined company trading in a more integrated Europe would be great. He decides to telephone his stockbroker and invest in the combined company. After telephoning his stockbroker however he is dismayed to nd that the share price of the company has already dramatically increased over the last few days as the details of the merger were announced. Which level of market efciency is this example evidence of?. a) Weak b) Semi-strong c) Strong Heriot-Watt University Introduction to Finance

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Q4: Brian Manilow is constructing a personal nancial portfolio of investments. He is investing partly in US stocks, Japanese stocks, UK stocks and a selection of stocks listed on emerging markets located in the Far East. He believes that although some of these stocks are very risky because they have different risks to the developed markets he believes the overall risk of his portfolio will be reduced. He intends to allow a nancial specialist friend to manage the portfolio after he has made his initial selections. Which of the following concepts apply to Brians investment? (Please tick a box, either yes or no, against each concept). a) Risk aversion b) Risk diversication c) Agency d) Option pricing Q5: David Auteuil is a corporate nance executive of a company involved in recycling waste materials. To support the companys activity they hire wagons to transport the waste to the companys treatment plants. The existing arrangement with a local company, managed by Henry Auteuil, Davids brother, has recently come to the end of the original agreement. A competing wagon company has sent a proposal to David which offered to complete the work at a fee well below Henrys. David, wanting to protect his brothers business, decides to renew the contract with Henrys company despite the extra cost to the company. Which of the following concepts apply to Davids decision? a) Self interest b) Maximising shareholders wealth c) Agency d) Information asymmetry

2.14

Tutorial Questions

Q6: Consider the following parties who have an interest in the success of a business organisation and explain how the concept of self-interest applies to each of them in their role working with the business organisation: Shareholders; Management; Employees; Customers; Suppliers. Q7: a) Explain why shareholders may consider it necessary to monitor the decisions of a manager in an organisation in which they hold shares. Heriot-Watt University Introduction to Finance

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b) Discuss the methods a shareholder can use to ensure a manager is making decisions which are in the best interest of the shareholder. Q8: Your friend, Georgette, is exploring a business idea which she believes to be exciting. Together with a colleague she is developing a small video recording machine which can be incorporated into the rear seating area of a taxi and play advertisements continually to taxi passengers. Georgette would provide the videos to the taxi rms and would nance them by selling the advertising time to local businesses. Georgette is asking you to consider parting with 2 000 of your savings currently tied up in a bank account to nance the development of the idea over the next two years. At the end of the two year period Georgette believes she will be able to repay you the 2 000 from the initial advertising sales and give you 600 return on your investment. In trying to persuade you Georgette reasons that the most you would receive from the bank account as a return is 7% each year. This would mean your 2 000 would grow to 2 290 in two years time if you do not spend any of your capital or interest. Georgette reasons that her offer would more than double your return. Consider a response to Georgette indicating why her reasoning is incomplete. Q9: a) List and discuss some of the reasons why you believe a company should have as its objective function to maximise shareholders wealth. b) What alternative objectives might a company have? Q10: a) Consider two ordinary shares issued by companies which are familiar to you and which are listed on the same capital market. List for each what you consider to be the main risks faced by each company in the activities in which each is involved. b) Compare the lists of risks you made for each company in part (a). How similar or different are they? Are there any risks affecting one company but not the other? Are there any risks faced by the two companies chosen which have the opposite effect on each other? (e.g for a company selling garden hoses, the risk of a wet summer will have the opposite effect to a company selling raincoats). Q11: a) Explain the distinction between risk aversion and risk preferring. b) Assume you have recently inherited 1000. In which nancial investment would you most likely choose to invest this money? A government bond; A bank deposit account; One ordinary share; A portfolio of ordinary shares; A combination of any of the above.

Give reasons for your choice.

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Q12: a) Explain why a company nance manager may be motivated to signal information to shareholders in the company. b) Make a list of information you believe to be of relevance to shareholders of companies which is not normally made publicly available. Give reasons as to why the information you have identied is not normally available to the public. Q13: Dene the three levels of capital market efciency - weak, semi-strong and strong. Q14: List reasons why stock markets in some countries operate at different levels of capital market efciency than others. Q15: Explain what benets there may be to an investor through having the choice to invest in a nancial call or put option to buy or sell ordinary shares in the future rather than simply having the choice to invest or sell ordinary shares on a stock market.

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Contents
3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Business Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ordinary Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 Rights of Ordinary Shareholders . . . . . . . . . . . . . . . . . . Preference Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Company Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Convertible Securities and Warrants . . . . . . . . . . . . . . . . . . . . . Sources of Finance through International Markets The Distinction between Debt and Equity Review . . . . . . . . . . . . . Sale and Leaseback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sources of Finance in Different Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 60 65 65 67 68 74 75 76 77 80 81 82 82 84

Learning Objectives On completion of this chapter students should be able to understand the distinctive characteristics of the following: alternative business structures; ordinary shares; preferences shares; debt securities; convertible securities and warrants; international capital market nance; sale and leaseback arrangements; debt and equity nance.

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Summary This section introduces readers to the sources of nance available to businesses and their key distinctive features. In particular the classication of debt and equity nance will be considered.

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3.1

Introduction

Business managers are faced with an increasingly varied choice of alternative sources of nance for their activities. The growth in the number of multinational companies and increasingly global stock markets have meant that nance is raised through a number of different nancial securities on domestic and international markets. The type of business structure adopted, such as a sole proprietor, partnership or public company, will affect the availability of some sources of nance. The business manager needs to be aware of the important features of the nancial instruments chosen as they will have an impact on the cash ow requirements of the organisation and will inuence the nancial risk of the organisation. Understanding the key aspects of the different sources of nance available to businesses is a prerequisite to many areas of corporate nancial decision making discussed in later modules of this programme. Finance is concerned with the allocation of resources in the economy. In particular it is concerned with how providers of nancial resources allocate their savings and how users of nancial resources make choices in their investment decisions. The interrelationships between providers and users of funds were explored in chapter 1. You will recall that the UK economic sectors are categorised as follows. Personal sector. Industrial and commercial companies. Public sector (includes central and local government). Banking sector. Other nancial institutions. Overseas sector. Within different countries each of these sectors may be classied in a slightly different way and clearly will vary in size and relative importance, though many of the core principles relating to the nancing of activities are common. The nancing of the investment needs of each of these sectors is the subject of this chapter. It is essential that you understand the importance of linking the use for which the nance is required with the distinctive features of particular nancial instruments. This chapter will focus signicantly on the nancing of investment by large industrial and commercial companies. This is not, however, to ignore the importance of the personal sector which includes sole traders, partnerships and un-incorporated companies (e.g. some family run companies). The public sector is also an important user of funds in most economies and relies heavily on an organised nancial system to support its activities. Banks and other nancial institutions also play an important role both as providers and users of funds as nancial intermediaries. The relative UK sector nancial surpluses and decits are included in Exhibit 1.8 in chapter 1. There are many important issues in the choice of funding made for public sector activity, such as taxation (from the personal and corporate sectors), or borrowing, through the capital markets. The issues are particular to the provision of goods and services for public non-prot motives. The risks and returns of such activities are quite different from the nancing and investment decisions taken by industrial and commercial companies Heriot-Watt University Introduction to Finance

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or indeed prot motivated activities in the personal sector. Many of the key issues with regard to resource allocation decisions taken in the public sector are discussed in the economics modules of this course. Issues relating to the activity and role of banks and other nancial institutions are covered in the Introduction to Financial Institutions and Financial Services module of this course. In this chapter you will be introduced to the different sources of nance available and used by prot motivated businesses. Many of the nancial instruments covered will only be available to businesses large enough to have their nancial securities listed on a capital market.

3.2

Business Structures

Although legal denitions and regulations may affect the classication and activity of business structures in different countries, Figure 3.1 shows the main classications. Business Structure Sole Proprietor Usual Features Owner/Manager Unlimited liability Typical Examples Shopkeeper Electrician Hairdresser

Partnership

Partners are equally and Dentists severally liable for business debts Solicitors unless the partnership is a limited partnership Owners have unlimited liability Owners have limited liability Can be listed on a recognised stock market with the public having overall voting control Family company Multinational and conglomerate organisations

Unincorporated Companies Incorporated Companies

Figure 3.1: Different Business Structures Sole Proprietor A sole proprietor business structure is dened as being a business having only one owner. There are no other shareholders and the business, in most cases, is managed by the owner. An example of a sole proprietor business might be an electrician who has seen an unsatised demand for the provision of electrical security installations in a particular area. He decides to resign as an employee of the electrical company and become self-employed to utilise his business opportunity. Sole proprietors will typically start their business activity with any personal savings they may have and a loan from a bank. In some cases the individual may have redundancy funds from a previous employer who is unable to employ him any more. In the 1980s in the UK many Government incentive schemes targeted particular regions where unemployment was high in an attempt to stimulate individuals to set up businesses. Frequently the areas targeted were traditionally dependent on old industries such as coal, textiles and heavy engineering where many jobs were lost, leaving communities Heriot-Watt University Introduction to Finance

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deprived of their employment source. Enterprise zones were established to stimulate investment in the areas worst affected, in particular aiming to attract some of the newer technologies such as computers and microelectronics, as well as enable smaller, sole proprietor businesses to start up more easily. A sole proprietor business structure is the least formal and is suitable to a person who is able to run an organisation personally, without the need for a more complex organisational structure. Sources of nance other than personal savings or loans with preferential rates (offered for example by the Government as an incentive) are difcult for sole proprietors in their early years in business. Sole proprietors will often rely on their relationship with their bank managers to support the early development of their businesses until they have been able to earn sufcient funds to reinvest in the next stage of development. Sole proprietors have unlimited liability. This means that a sole proprietor can lose his or her home and personal possessions if the business cannot meet its obligations. This imposes a signicant burden on sole proprietors, particularly in the early years of business development.

Self test 3.1


List what you consider to be the advantages and disadvantages of being a sole proprietor. Partnership There are many examples of partnership business structures. Many professional activities such as legal work, dentistry, accountancy advice, and management consultancy are undertaken by a number of individuals who have combined their expertise and nancial resources to offer services. The advantage of this business structure over a sole proprietor structure is that the unlimited liability is spread among a number of partners rather than only one owner. The partnership may be limited in many countries. That is, the partners elect to have limited liability, which will mean they can limit their loss if the business is unable to pay its debts to the amount of funds that they have committed to the business. Their personal possessions will be protected. Clearly this has a distinct advantage to being a partner in an unlimited partnership; however there is a signicant drawback. Banks and other institutions providing a source of nance to the partnership activity will be less willing to provide funds if they are unable to recover debts from the partners personal possessions if the business fails. Partnership agreements will establish the pattern of management decision-making in the partnership business. They will establish the relative nancial sources and division of prots between partners. In many partnerships day-to-day management decisions are shared by the partners. The partners jointly control the resource allocation decisions and share in any benets. Finance for partnership activities will typically be from partners personal savings, banks and other nancial institutions. Also, in established partnerships, it may come from internal sources (i.e. cash from prots retained within the business). A partnership may develop into an incorporated company to limit their personal liability and also as a means to seek further nance for development. It could also be a source Heriot-Watt University Introduction to Finance

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of funding for partners attracting shareholders and potentially new management.

Self test 3.2


List what you consider to be the advantages and disadvantages of being a partnership business. What are the main differences compared to a sole proprietorship? Un-Incorporated Business An un-incorporated company is one that, by denition, has not become incorporated! In other words it is a business whose owners have decided not to become a separate legal identity which would give the owners limited liability. The difference between an un-incorporated company and a partnership is largely legalistic. Financial affairs of partnerships are covered by partnership law while an un-incorporated company is not. A shareholder of an un-incorporated company will be personally liable for a proportion of any debts the business is unable to settle and in this respect it is similar to a non-limited partnership. Incorporated Companies An incorporated company has, by denition, applied within the relevant country legislation to be incorporated. An incorporated company, by law, is a separate legal entity. Having a separate legal persona is signicant with regard to many aspects of the law. Most signicant for shareholders is the fact that their liability is limited to the nancial cost of their share holding. On incorporation a company needs to prepare a document which explains the nature of the business in which it is to be involved. The composition of the Board of Directors (the top management), the means by which its activities will be nanced and, in particular, what level of nance it is to raise through the issue of ordinary shares and debt must also be included in the incorporation document. An incorporated company may be either private or public. If the company is public, at least 25% of its ordinary shares must be issued to the public. If a company is not public (by denition in UK Companies Act legislation), it is private. The owners of a company, who do not wish to lose control of the decision-making authority in their organisation, will not wish to lose the voting control, which would result from issuing at least 25% of the ordinary shares to the public. The benets of a company becoming public include the wider access to investors through the issue of a larger number of ordinary shares. Typically a family managed company which does not wish to attract signicant outside inuence in its voting control will not wish to become public. To have ordinary shares issued by a company listed on a stock exchange, the company is also required to offer more than 50% of its issued share capital to the public.

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Figure 3.2: The different types of companies which exist. The issue of control has different meanings in company law. A simple majority of shares held (ie greater than 50%) will enable most operational decisions to be made within the parameters of the organisations strategy and therefore is the most crucial in terms of most decisions made. Such decisions are made through an ordinary resolution and included in this category is the appointment of directors; auditors and the bye-laws of a company. For more important decisions which may have a signicant impact on the company management and/or the business future a special resolution is made and this requires 75% approval by shareholders. Examples of such decisions, that require a minimum of 75% of the overall shareholding controlled to agree, include: the sale of most or all of the companys assets; dissolution of the business and a decision to change the companys name. The distinction of control for different decisions exercised by the companys directors means that some shareholders may combine to exercise a majority holding when voting together. Family companies often adopt a strategy of retaining control within an incorporated family company, to ensure overall strategic direction is controlled within the family. As a company expands and/or it wishes to separate a section of its operation a company may form a holding company with subsidiary companies to the parent. This may also happen through corporate activity, when a company merges or takes over another company, possibly through a joint venture (with another business). There are a number of different motives, which can include: the protection of the assets, which are moved into the holding company, from creditors of the subsidiary; to facilitate the takeover of another company through buying a controlling interest rather than formally merging; to take control of a specic asset from the balance sheet or to enable the subsidiary to make strategic decisions with other companies in their core business activity which may differ from that of another subsidiary of an organisation. There are considerable benets for a business choosing to become a publically listed limited liability company in terms of its ability to access capital markets for nance. (The role of capital markets in bringing together providers and users of nance was covered in chapter 1). Being able to attract savings from individual and institutional investors, who will have the advantage of limited liability, facilitates the exibility with which a business can raise nance for its activities. Because of the considerable advantages of being able to access nance through an organised stock market, many large companies are publicly traded and their shareholders enjoy limited liability.

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The downside of becoming an incorporated company is the inevitable separation of ownership from the day-to-day management of the resources of the organisation. Many people believe that the main distinctions between companies are size related, but this is by no means the only factor. An example of a successful Scottish private company, which has never sought to issue its ordinary shares publicly through a stock market, is DC Thomson which has an annual turnover of many millions of pounds. In some countries family controlled companies are a more dominant feature than in others due to cultural and/or historical reasons. Italy is an example of this situation. Creating a large number of individual and institutional shareholders can place a signicant administrative and nancial burden on an organisation. British Telecommunications plc, (British Telecom), became a public limited company in 1984. The company had previously been nanced by the government through the public sector budget. Today there are 2.4 million shareholders in British Telecom (as at 31 March, 1996) each of whom is entitled to vote and attend an Annual General Meeting at which the Board of Directors present the nancial results for the most recent year. The growth of institutional shareholders in the UK (see Figure 3.3 below for 2004) in recent years imposes an increasing level of accountability on the top management of a business organisation.

Source : National Statistics Ofce Figure 3.3: Share ownership: Foreign investors hold 1/3 of UK shares Despite the trend towards an increasingly large proportion of shares being held by nancial institutions, the number of individual ordinary shareholders has actually increased signicantly in the UK in recent years to an estimated 208 billion (in value terms) in 2006. Figure 3.4 compares the percentages of individual share ownership in a number of different countries. A sole proprietor who has built a business largely from his or her own resources to become a listed company with a widely held public share ownership may nd pressures of quite a different nature in being accountable to shareholders. Richard Branson of Virgin and Anita Roddick of the Body Shop are two successful entrepreneurs who have

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taken their businesses from humble beginnings through to full public limited company status with millions turnover on the London Stock Exchange. Country Australia Hong Kong Canada Finland Germany Great Britain Sweden Switzerland USA % of adult population 55% 24% 49% 37% 16% 14% 21% 20% 49% Source: ASX International share ownership (2005) Figure 3.4: Individual share ownership (2004)

Self test 3.3


List what you consider to be the advantages and disadvantages of being an incorporated company. What do you think are the main problems for entrepreneurs such as Richard Branson and Anita Roddick who have taken their companies from a sole proprietorship to the status of an incorporated company whose shares become listed on the London Stock Exchange?

3.3

Ordinary Shares

Ordinary shares are also referred to as common stock in the United States of America. They are nancial securities issued by companies to nance their business activities.

3.3.1

Rights of Ordinary Shareholders

An investor in an ordinary share has the right to vote at the companys Annual General Meeting (AGM) each year at which time the top management of the company is appointed (or re-appointed) and the annual accounts of the business are approved. An ordinary shareholder has the right to receive a dividend, which is the income return on an ordinary share, if one is declared. Typically a dividend is declared and paid in one, two or four instalments during a year. The dividend is not xed for an ordinary shareholder, and it may well change from year to year depending on business performance and the managers assessment of the cash needs for future investment. The ordinary shareholder has the right to receive annual reports each year and to attend the AGM. This right has become increasingly problematic for a modern corporation with widely held share holdings, as in the example of British Telecom quoted above.

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In the event of a company being unable to pay its debts, ordinary shareholders rank after all other creditors and claimants (such as employees and the Government) to receive any of their investment back. The ordinary shareholders take the largest risk of any investor in the company, as their income return is not xed and will vary according to the success of the business activity. There is no date at which their investment will be repaid and, if the business fails, they may lose most or all of their funds invested. Because of their collective voting rights to control the management of the business, the ordinary shareholders effectively control the cash ows of the organisation. The process by which ordinary shareholders can achieve what they want is dependent upon a number of factors. A shareholder in Imperial Chemical Industries plc, (ICI), holding 2 000 shares will have only 0.000003 % of the voting control. Financial institutions will have a greater ability to exercise control as they will typically hold larger proportions of the share holding. The nancial institution, Mercury Asset Management plc, (at 19/2/96), is a major shareholder in ICI, owning 80 million shares, representing 11% of the total shares held in ICI. Widely held share holdings intensify the agency problems referred to in Chapter 2 with regard to the separation of ownership and management. Issued and Authorised Ordinary Share Capital You will recall that when a company becomes incorporated it needs to make a statement with regard to its business activities and broadly how it will nance the activities. In the UK the documents which contain this information about different companies are called the Memorandum and Articles of Association. The company will state the maximum number of ordinary shares that it intends to issue to nance its activities. This is the authorised share capital of the company. Once the company has issued ordinary shares to shareholders, such shares will be referred to as issued share capital. If the ordinary shares have been fully paid for, the shares will be fully paid share capital. If only part of the sum has been paid the shares will be referred to as partly paid Share Capital. Figure 3.5 is a summary of the British Telecom share capital from their annual accounts. Authorised share capital Fully paid share capital 2625000001 1589000000

Figure 3.5: British Telecom share capital for the year ended 31/03/1997. Par Value and Market Value At the time that ordinary shares are issued the company will specify their par (or nominal) value. This has very little signicance to an investor as it is unlikely that it will be the same as the price paid for the ordinary shares. The Companies Act legislation in the UK, (and in many States legislation in the United States of America), stipulates that companies are not permitted to issue ordinary shares below their par value. Of greater signicance for a company raising nance from issuing ordinary shares is their market price at the time they require to raise the nance. For example, ICI currently have issued ordinary shares with a par value of 25 pence. The current market value of the ordinary shares is 986 pence (at the close of business on October 10, 1997). If the company intends to raise 10 million from a new issue of shares, they will need to issue approximately:
10 million 986 pence market price

1014199 ordinary shares

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It is important to understand that in annual accounts the ordinary share capital of the company is stated at its par value. If companies raise nance from ordinary shares, issuing them at a price above their par value, the difference is included in the annual accounting statements as share premium. In the United States it is called additional paid in capital. Different Categories of Ordinary Share Capital Some companies issue different categories of ordinary shares which have slightly different rights attached to each. For example one category of shares may have restricted voting rights relative to another class of shares (e.g. one vote for every ten shares held). Holders of the other class of shares (for example labelled A shares to distinguish them) would be able to exercise a greater control on the business decisionmaking. Deferred shares are another class of shares in the UK, used by a relatively small number of companies. The term refers to a particular class of shares which may have their dividend entitlements deferred until a later period. Clearly holders of the different classes of shares deferred, or designated A class, will pay a sum which reects the relative rights. Summary of the Main Features of Ordinary Shares Income to the shareholder is a dividend. A capital gain may be realised by an investor through selling the share. The ordinary share has no maturity date. Dividends are discretionary and not xed. Shareholders have voting rights. Shareholders rank after all other claimants if the company is unable to pay its debts. Shareholders appoint or re-appoint top management.

Self test 3.4


List the main reasons why you think companies may favour ordinary share capital as a source of nance.

3.4

Preference Shares

Preference shares are nancial securities issued by a company whose holders receive a dividend as income. Dividends for preference shareholders are paid before the ordinary shareholders dividend. The preferred dividend is xed, although it may be that the dividend is linked to a bank interest rate at a xed percentage. This would be a oatingrate preference share. As with ordinary shares, preference share dividends are an appropriation of the prots of the company and not a cost. The effect of this is that ordinary and preference shareholders receive their income return after company tax has been deducted. In the event of a company being unable to pay its debts the preference Heriot-Watt University Introduction to Finance

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shareholders rank after all other claimants, except for ordinary shareholders whom they rank above. Cumulative Preference Shares Companies issuing cumulative preference shares must pay all previous dividends due but not paid, before ordinary shareholders receive their dividend. In other words if the company has insufcient cash in any one year and is unable to pay the preference share dividend, the amount owed is carried forward until the following period(s) when it is paid out. Voting Preference Shares Unlike ordinary shareholders, most preference shareholders are not entitled to vote at company meetings unless their dividend has not been paid or it is a meeting affecting future preference dividends. Exceptionally some preference shares are issued with some limited or full voting rights. Redeemable Preference Shares Usually a preference shareholders investment will not have any date when it must be repaid. In other words it will be irredeemable. A redeemable preference share may be redeemed at the option of the company if so specied in its Articles of Association. Participating Preference Shares Most preference shares will have a xed dividend. A participating preference share will have an additional dividend on top of the xed dividend which will give its holder a share of the prots after the xed preference share dividends have been paid. Summary of the Main Features of Preference Shares Normally they have a xed dividend as the income return. They have the right to a dividend as an appropriation of prots not a cost of the company. They can be cumulative or non-cumulative. They can be redeemable or irredeemable. They can be voting or non-voting. They can be participating or non-participating.

Self test 3.5


List what you consider to be the main differences between ordinary shares and preference shares.

3.5

Company Debt

Companies borrowing money from banks, institutions or individuals agree to repay the capital sum of money borrowed at a pre-set date or range of dates in the future. The Heriot-Watt University Introduction to Finance

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company will also agree to pay interest at regular periods on the debt outstanding prior to the capital repayment. Interest paid on debt is a cost to the company and is deducted from the prots of the company before the business tax rate is applied. This means that for each 1 of interest paid on debt the company reduces its prots assessable to company tax by 1. If the company tax rate is 50% then the after tax cost of 1 of debt interest is 50p (ie: 1 - (1 - tax rate of 50%)). The effect of the difference between 1 of debt interest and 1 of a dividend payment is shown in Figure 3.6. Company A 000 Company prots before tax and debt interest Debt interest Prot before tax Tax @ 50% Prot after tax Dividends paid Retained prot 250 (100) 150 (75) 75 0 75 interest is 10% of the capital borrowed each year.
Company B is nanced by 100% ordinary shares: 1 million issued and fully paid.

Company B 000 250 0 250 (125) 125 (100) 25

Company A is nanced by 100% debt nance: 1 million borrowings. The debt

The dividend for the year is 100000. Figure 3.6: The effect of tax on debt interest and dividend payments. Figure 3.6 illustrates the difference between the two companies who are identical in every respect except for the type of nancing. Company A have 50000 more retained prot than company B as a result of the tax deductibility of the 100000 debt interest paid by company A. Although company B paid 100000 as a dividend, this is not deducted from prots before tax as it is an appropriation of the funds from the business, not a cost to the business. Company debt holders are paid out of prots before shareholders, and if a company cannot pay its debts, debt holders will rank before shareholders to be paid out. Debt holders may also take further security in the provisions of their loans to protect against the company management having insufcient funds to repay them. Debt holders do not have voting rights and their returns are xed. Typically the debt capital sum will require to be repaid at a xed date or range of dates in the future. It is important for the management to consider whether the activities for which the debt nance raised will be used will produce sufcient nancial returns to enable the company to repay each interest instalment and repay the capital sum on maturity (i.e. the date for repayment). Types of Debt Security There are many different methods by which a company may borrow money. Typically sole proprietors, partnerships and companies which are unlisted (i.e. do not have their nancial securities listed and traded on a recognised capital market) will borrow through a bank or other nancial institution. A company whose nancial securities are listed on a capital market can issue debt nancial securities in units (typically in 100 or 1000 denominations) to investors. Heriot-Watt University Introduction to Finance

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Debt Security The lenders of funds to a company take the risk that the business activity does not perform as well as expected with the result that the company is unable to repay the capital sum and/or interest instalments. To cover themselves against this possibility the lenders can take a xed or oating security over particular assets of the company. For example, a bank providing a loan to a company to buy a new factory can require the factory to be the xed security for the loan. If the company defaults in its interest and/or capital repayment(s) the bank can take possession of the factory and recover part or all of its loan from the sale of the factory. Another example would be holders of debt securities who have a oating charge over the plant and machinery of a coal merchant. If the company defaults on its payments the debt holders can arrange to sell any piece of plant and machinery in the business to repay their outstanding debt. The charge oats over the group of specied assets and, on default, crystallises on particular assets. Any xed or oating security is specied clearly in the terms of the debt nancing instrument or in the loan documentation so that any new lender is aware of the assets which already have securities over them. If a company issues debt securities or takes a loan which has no security it is called unsecured and ranks after the secured debt holders for repayment. Unsecured debt holders do, however, rank above ordinary and preferred shareholders for repayment. Restrictive covenants Lenders who take a nancial risk in providing nance to a company will attempt to reduce this risk by stipulating conditions the company must meet in exchange for the funds being provided. The conditions the lender stipulates are referred to as restrictive (or protective) covenants. These conditions are imposed by the lender to help ensure the company will have sufcient cash to repay the debt interest and capital sum at the date(s) of maturity. Typical examples of provisions in restrictive covenants are listed in Figure 3.7 below. A specied limit on dividends paid to shareholders. A specied limit on the level of debt borrowed by the company. Minimum levels of working capital (i.e. short term capital less liabilities of the company). A restriction on the issuing of a debt security which would have a higher ranking for repayment.

Figure 3.7: Examples of restrictive covenants.

Self test 3.6


List the different means by which lenders can protect their investment in a company.

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Maturity and Repayment In borrowing money, individuals, sole proprietors, partnerships or business organisations of any shape or size, will need to consider carefully the time at which they will be required to repay the lender(s). It is vital that borrowers concern themselves with matching the use to which the money will be put and their income from the earnings of their activities in the future. In general, companies will be increasing their nancial risk if they nance long-term projects with short-term debt (e.g. research into a drug to cure cancer, nanced using a ve-year maturing loan). Similarly, it can be very costly for a business to borrow with a longterm maturity debt for short-term assets (e.g. to purchase an executive motor car for each director of the business, debt securities with a 20 year maturity are issued). If the business is to survive it needs to generate sufcient cash from its activities to repay interest and the capital sum borrowed, (by instalment or at the end of its maturity). The manager of the business often will provide for the repayment of the capital sum by setting up a separate bank account for money to be deposited at regular intervals. The cash deposited will grow, earning interest until the nal maturity of the debt, at which time the lender(s) will be repaid. This cash provision for repayment is known as a sinking fund. The lender will be more reassured if a company provides for repayment in this way and it may be that, as a consequence, the interest rate charged on the debt will be slightly reduced. Some debt securities issued have no xed maturity date. They are irredeemable. The usual type of debt does have a maturity date. An irredeemable debt security provides the lender with a perpetual stream of income (the interest coupon) over time for his capital investment. An example of a UK irredeemable debt security is the government gilt edged security called War Loan 3 1 /2 % Stock which was issued originally to nance the First World War effort and in 1997 is still in issue. At the time of its issue the British Government, the borrower, did not know with any precision at what future time it would be able to repay the lenders from public money. Figure 3.8 below is taken from the annual accounts of ICI plc and it illustrates the different types of debt, coupon rates and maturity dates. Loan Secured by xed charge- bank loans Secured by oating charge- bank loans Unsecured loans 93 /4 % to 111 /4 % 87 /8 % Debentures (debt securities) Repayment date various various 1995/2002 2006 m 163 5 263 160

Figure 3.8: Example of a range of maturity dates of debt from the annual accounts of ICI plc year ended 31/12/1994 Some debt securities have a range of maturity dates over which they can be redeemed. The issuers of the debt securities have the exibility to repay the holders of the stock over the dates specied. They may wish to take advantage of the fact that interest rates could have fallen unexpectedly over the life of the debt, enabling it to redeem earlier than expected. To compensate the lender there are different prices for the years in which the

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company may redeem the debt. For example, if a debt security issue can be redeemed in any one of 5 years, (say, between the years 2010-2015), the repayment of each 100 nominal value of stock could be 105 if the stock is redeemed in the year 2010; 104 if redeemed in the year 2011, and so on, until the nal possible year for redemption, when the repayment will be the 100 nominal value in the year 2015. The 5 and 4 premiums are paid to compensate the investors for the early redemption of the stock. Some debt securities may be issued with the option for the company issuing the stock to redeem before the dates specied under certain specied conditions, and at a premium price to the lender, (ie a higher price than the nominal value). Interest Coupon Rate The percentage rate of return on debt securities paid to the lender is known as the interest coupon rate. Most debt securities have a nominal, or par value, which is 100 or 1000. A debenture stock is a form of debt security issued by UK companies. A 5% debenture stock issued at a 100 nominal value will provide the holder of the stock with an interest coupon of 5 per year, the coupon rate being 5%. The coupon rate may be xed or oating. In the example just given, the coupon rate to the lender is xed, at 5%. The coupon rate may however be attached to another rate, such as a standard bank rate of interest. This standard rate which the banks lend at to regular, known customers is also known as a prime rate. The standard rate with which international banks deal with one another is the London Interbank Offered Rate (or LIBOR). A business may therefore be offered a loan from a bank at a rate of, say, 3% above the LIBOR, or alternatively above the prime rate. As the LIBOR or prime rate changes, the return to the lender will also change. This form of coupon rate is known as a oating rate. The interest coupon rate on debt is a function of the nancial risk (i.e. the risk that the business or individual borrower may default on the repayments to the lender). It will also be a function of the expectation of interest and ination rates over the lifetime of the debt. The status of the debt instrument issued by a company vis-a-vis the other debt holders and any arrangements for a xed or oating security over any assets, may affect the coupon rate charged. Notice that in the different borrowings undertaken by ICI (see Figure 3.8) there are many different coupon rates reecting these factors. When the debt is repayable within one year it becomes classied as a current liability of the business. In the United States long-term bonds (or debt instruments) are categorised into investment grades. The grading is with regard to the relative risk of the issuer defaulting on the repayment of the debt. Financial institutions notably Moodys and Standard and Poors, provide ratings services which classify different issuers of the bonds from Aaa (the least risky borrowers) through to C which have the poorest rating. Bonds issued below the rating Baa (for Moody ratings) or Bbb (for Standard and Poors ratings) are classied as Junk Bonds. Figure 3.9 indicates a typical relationship between the yields of debt securities issued by different borrowers. The difference in the yields quoted reect the marginal increase in risk for each risk class of borrower. Clearly the Treasury Bonds issued by the central government have the lowest risk of default.

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Security US Treasury Bonds (30 year) Aaa rated bonds A rated bonds Baa rated bonds

Yield 6.50% 6.90% 7.40% 7.75%

Figure 3.9: Differential yields for borrowers of different risk classes The investment bank Drexel Burnham Lambert heavily invested in the 1980s in junk bonds issued by companies which required nance for potential high growth opportunities but had a poor rating which made it less easy to attract investors. The coupon rates of the junk bonds were extremely high to reect the increased possibility of default. Capital markets for debt securities and ordinary shares in the United States, in the early and mid 1980s, were bull markets (i.e. prices were rising). Drexel Burnham speculated on the success of businesses issuing junk bonds, in return for high coupon rates. Eventually Drexel Burnham went bankrupt as many of the businesses defaulted on repayments and Drexel became unable to pay its own debts.

Self test 3.7


What is the difference between the prime rate, LIBOR and the oating rate of interest? Debentures and Loan Stock In the UK the debt will typically be called debenture or loan stock. There are a number of features which each of these securities and other borrowings may have. The maturity dates (dates for repayment of the capital sum) may vary; the debt may be secured over assets of the company (like a mortgage on a private home); or the interest rate may be xed or variable. From Figure 3.8 notice how many different types of debt securities the company ICI has issued. These are just some examples of the total borrowings undertaken by the company. Summary of Debt Finance A business organisation can borrow from a bank or nancial institution or issue debt securities on capital markets. Debt nance consists of the borrowings for a business organisation. Debt holders normally have no voting rights. Debt nance may have a xed maturity date, be of variable maturity (within specied limits), or it may be irredeemable. Debt holders may take a xed or oating security over assets of the business. Debt holders rank above ordinary and preference shareholders for payment. Debt holders may impose restrictive covenants on the borrowers activities. The debt will have an interest coupon which can be at a xed or variable rate. The interest coupon rate on debt will be dependent upon the nancial risk of default by the borrower and expected interest and ination rates over the life of the debt. Heriot-Watt University Introduction to Finance

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Self test 3.8


Explain why debt securities may be preferred to ordinary shares as a source of nance to businesses.

3.6

Convertible Securities and Warrants

Convertible Securities As their name suggests, convertible securities are nancial instruments, typically loan stocks, which give the holder the option (but not the obligation) to exchange their loan stock for ordinary shares for some pre-determined price and at a pre-set date or range of dates. The company issuing the convertible securities will set a conversion date or range of dates at which the holder will be able to convert that loan stock to ordinary shares at the price set by the company at the time of issue. The issuer will also set a date or range of dates for the redemption of the loan stock, should the holders decide not to convert. The conversion and redemption date(s) may coincide or it may be, more typically, that the conversion date(s) is/are some years prior to the redemption date(s). If the company share price rises above the conversion price the holders will be attracted to convert. If the share price does not rise above the conversion price, the holders will not convert and the loan stock will remain in issue until the redemption date(s). The coupon rate on the convertible loan stock will be lower than a straight loan stock issued by the same company as the holder has the ordinary share incentive. The company therefore benets in raising nance with a relatively cheap annual cost and, if the company share price increases as expected, the company will not need to repay the capital sum of the loan stock at the redemption date. Convertible stock became very popular in the 1980s in the UK with ordinary shares on the stock market rising in price. To help encourage investors to hold convertible stock there was the attraction of participating in share price increases, while not having the same risk as an ordinary shareholder. The conversion price set by the issuer will, under normal circumstances, be higher than the price of the ordinary share at the time of issue. The company will expect, however, that the share price will rise as the companys earnings grow. An example of a convertible loan stock is given in Figure 3.10 which also illustrates the relationship between conversion and redemption dates and also the difference between the ordinary share price and the conversion price. ABC plc issued 80m of convertible loan stock in 2000. The coupon rate is 8.5% and the loan stock is redeemable in 2015. Each loan stock holder can convert the loan stock into ordinary shares of ABC plc at an exchange price of 125p. The price of ordinary shares in ABC plc at the time of issue in 2000 was 85p. If the price of ordinary shares does not rise above 125p before 2015 it is not protable for the loan stock holders to convert their holding. Figure 3.10: An example of conditions on convertible loan stock Heriot-Watt University Introduction to Finance

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Warrants A share warrant gives the holder the option to buy an ordinary share of the company issuing the warrant at a pre-determined price and date or range of dates. Many warrants are attached to the issue of debt loan stock as an incentive to the investor. The difference between a loan stock issue with attached warrants and convertible loan stock is that the debt issued is an ordinary loan stock which will continue in issue until its redemption date. If the warrant option is exercised, this will bring new nance into the company and the ordinary share capital of the company will be increased. Where a loan stock is issued with an attached warrant, the warrant is sometimes referred to as a sweetener or an equity kicker for investors. Summary of Convertible Securities and Warrants Convertible loan stock enables the holder to convert their loan into ordinary shares. The convertible will have a pre-set conversion date (or range of dates). The convertible will have a pre-set redemption date (or range of dates) in case the loan stock is not converted. There will be a pre-set price for the conversion of the loan stock into ordinary shares. The coupon rate on convertible loan stock will be lower than the coupon rate of a comparable loan stock with no conversion right. A warrant gives the holder the right to buy an ordinary share for a pre-set price at a pre-set date or range of dates. Warrants are typically attached to loan stock issues.

Self test 3.9


Why you think companies pay a lower coupon rate for a convertible loan stock than an ordinary loan stock with no conversion rights.

3.7

Sources of Finance through International Markets

Eurodollars Capital markets in countries throughout the world are increasingly interrelated. Many more companies are increasingly trading in more than one country. A UK company with a subsidiary in the United States of America, wanting to raise nance for its American activities may do so by borrowing American dollars from an American bank. The dollars earned from the business activities in America could be banked in a dollar account in a London bank rather than converted into UK sterling. The dollar would be termed Eurodollars as they would be dollar amounts held outside the United States of America. The Euro term refers to the fact that the currency in question is held outside the country issuing the currency. A company is therefore free to borrow cash from banks in currencies which are held in international banks outside the country issuing the currency. Heriot-Watt University Introduction to Finance

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In other words British Telecom can borrow American dollars from the American Bank Citicorp based in America, or Eurodollars from the National Westminster Bank in London. Eurobonds Eurobonds are debt securities issued in a currency different from the currency of the country of the issuer. For example a UK company wishing to nance a business activity in France could issue loan stock on the Paris Stock Market in French Francs (a Eurofranc issue). Interest on Eurobonds is paid to the holders gross of tax (normal loan stock interest payments have tax deducted from them, and are therefore received net of tax). Tax is paid by the holders of the bond, based on their personal circumstances and the countries in which they are domiciled. Receiving the interest gross gives investors more exibility. The Eurobonds are held in bearer form which means that they can be transferred without the holders needing to disclose their identities. Eurobonds enable a company to raise nance outside of their domestic capital markets. This is really only possible for the larger well known companies (blue chip companies) which are known in the country of the potential investors. The company issuing debt securities in a currency different from its domestic currency will need to consider the impact on its exposure to the movement in foreign exchange rates. The UK company issuing Eurobonds in French Francs will be exposed to an adverse movement in the French Franc and Sterling exchange rates. This could affect the effective cost of interest payments on the bonds (in French Francs) and the repayment of the Eurobond at the redemption date (in French Francs). It may also be that the interest rate in France is at a different level from that of the UK, which is likely to have a positive or negative effect on the cost of nance raised. The exchange rate and interest rate differences may be partly offset by the cash ows paid and received in French Francs by the business activity undertaken by the UK company in France. Euroequity Companies raising nance by issuing ordinary shares on international capital markets outside of the companies domestic capital market, will be issuing Euroequities. The key issues relevant to Euroequities are similar to the issues of Eurobonds, and again such issues tend to be available only to blue chip companies. An example of the issuing of shares on an international market was the selling of 90 million British Telecom shares in Switzerland in 1984. The shares sold were placed with investing institutions and individuals in the Swiss market rather than by an open issue to the general public.

Self test 3.10


Why do you think Eurobonds and Euroequities have become popular in recent years?

3.8

Sale and Leaseback

A business requiring nance for its activities, owning, for example, land or property used in its business and appreciating in value, can sell the asset for cash and lease it back from the purchaser. Leasing is a process whereby a lessor (the owner of an asset) agrees with the lessee (the user of an asset) to provide the asset for the use of the Heriot-Watt University Introduction to Finance

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lessee over a pre-staged period of time for an agreed annual rental. Leasing can be a popular means for a business to have the use of short and medium-term assets without the need for funds to buy the assets outright, or to have the responsibility for the upkeep and maintenance of the assets. As a source of long-term nance for the business, the sale and leaseback operation enables funds from a valuable appreciating long-term asset to be released into the business today. So, for example, a company with ofce buildings in a city centre site may decide to raise nance by selling the land and buildings at an agreed price, (say 250000) to a nancial institution. The institution (such as a pension fund), may then agree to allow the company to continue operating in the building for an agreed annual rental (say, 15000 per year) on, for example, a 50-year lease agreement. The pension fund acquires an appreciating property asset yielding an annual nancial return in terms of the lease rental payments. The company receives 250000 of cash to inject into its business activities. There will be a further discussion of the relative merits of leasing, as a short and medium term source of nance, in a higher level nance module of this course.

3.9

The Distinction between Debt and Equity

Summary of the Main Sources of Long-Term Business Finance It may be useful at this point to summarise the different types of long-term nance available to business organisations and incorporated companies. Figure 3.11 summarises some of the key features of the main sources of nance discussed in this chapter.

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Figure 3.11: Summary of the main features of long-term business nance Distinguishing features of debt and equity You will notice that in Figure 3.11 there are clear distinguishing features drawn between the main sources of long-term nance identied in this chapter. The three classications made are debt, equity and hybrid nance. Debt is characterised as being borrowings of cash, typically from a bank or nancial institution in the form of a loan or as an issue of nancial securities such as debenture or loan stock issued in units of 100 or 1000, and which can be traded on a capital market. The return on debt is xed, although it may be that the interest paid is attached to movements in a market interest rate such as LIBOR. Debt also typically is redeemable, which may be within a range of dates rather than on one date. It may also exceptionally be that an issue of debt securities is irredeemable. Almost all debt nance is non-voting.

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Equity is the term given to ordinary share and preference share nance. The returns to an ordinary share and preference shareholder are in the form of a dividend. The dividend is paid out of the prots of the business after taxes have been calculated and paid. Debt interest, on the other hand, is a cost to a business and is deducted from the prot of a business before tax is paid. Equity controls the cash ows of the business, in the sense that the combined votes of the equity shareholders will elect the top management to undertake the business decisions of the organisation. Remember, however, we did make a crucial distinction between preference shares and ordinary shares. Preference shares are typically nonvoting and normally have a xed dividend. This makes preference shares more akin to debt than to equity. In fact, it is less advantageous than nancing through debt for a company. The business needs to pay the xed dividend each year but it is not deducted from prots before tax is applied, so the company does not get the tax saving which it would get from paying debt interest. Ordinary shareholders, however, take the residue of the prots after all other claims have been met and therefore gain most if the business does well; however, it is their nancial stake which is at the greatest risk if the business underperforms. The return therefore has the greatest level of variability of all forms of long-term nance identied (refer to Figure 2.3 in Chapter 2). The hybrid securities such as convertible loan stock or convertible preference shares are called hybrid because they have an element of both equity and debt. Sources of Debt and Equity Issued in the UK Figure 1.12 (in chapter one) shows the different types of long-term nance used by UK industrial and commercial companies during the periods 1992 to 1996. Notice that for central statistical purposes preference shares are categorised with debenture stocks. It is important to note that the gures shown in Figure 1.12 do not include the personal sector. In the personal sector of the economy, categories of business include sole proprietors,partnerships and un-incorporated companies. Most of these forms of business structure will not be able to access capital markets and raise nance by issuing their nancial securities publicly. There are some important points to note at this stage regarding the gures shown in Figure 1.12. Internal nance relates to the prots retained by a business and invested on behalf of the shareholders. The internal nance is therefore categorised as part of the equity nance. You will notice that bank borrowings in some periods, (e.g. in 1993) are negative. This means that UK industrial and commercial companies were net lenders to banks (i.e. they had more money on deposit than was borrowed during the year). It was a feature commented upon by the Wilson Committee in their report that UK industrial and commercial companies nanced their operations with relatively little longterm debt. The high and volatile nature of interest rates during the 1970s meant that many companies tried to avoid locking themselves into paying high xed rates of interest on, for example a 15 to 20 year loan or debenture. It has been a feature of the UK government and of governments in many other developed nations, in recent years, to operate a monetary policy controlling the interest and ination rates in the economy and designed to facilitate business condence for long-term investment. Notice also in Figure 1.12 the relative importance of internal nance as a source of new

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nance. This has advantages for the business manager as a source of nance. It avoids the necessity of applying for borrowings to a bank or nancial institution which may impose controls on the company activities through restrictive covenants. It also avoids asking existing or new shareholders for extra cash by issuing on the capital market, a procedure which can be costly to administer and also may fail to produce the required nance. Such failure may signal a possible lack of condence in the manager and/or the future plans of the company. New issues of ordinary shares declined after 1987 when stock markets in October of that year suffered signicant falls in the value of stocks listed on them. There are many important items to consider based on the evidence of Figure 1.12. In particular it is important to relate the trends to the fundamental nancial concepts covered in Chapter two. For example, recall the agency concept. What effect is there on management that most of the funds of many companies are from retained shareholder prots? Does this affect the monitoring by shareholders of management actions? Recall the concept of capital market efciency. If share prices can be trusted at any point in time, why should managers be unwilling to raise nance when the price may be seen as too low (and therefore relatively expensive to the company) than when the price on the previous day was high? Recall the principle of self-interest. Will managers deliberately avoid new issues of nancial securities to avoid extra controls being imposed or public attention focused on their activities managing the company resources? These are big questions! We cannot solve them all here. They will be recurring themes in considering corporate nance and capital market operations throughout this degree course. It is important that you start to develop a questioning attitude to the nancial information you absorb through your own media about nancial decisionmaking affecting individuals and organisations in your own country. Try to relate some of the fundamental concepts to the information you experience.

Self test 3.11


List what you consider to be the main features of debt and the main features of equity.

3.10

Sources of Finance in Different Countries

The issues covered in this chapter regarding the important characteristics of debt, equity and hybrid nancial securities are common to companies from many countries around the world. There are cultural and historical reasons why some sources of nance and types of business structure are favoured in some countries more than others. The degree of development and regulation of the countrys domestic capital markets and stock trading systems will affect the extent to which businesses can access nance raised on capital markets and their condence in doing so. Providers of funds investing in capital market securities also require condence and a regulated network of information in order to be able to place their funds with condence. Is the capital market efcient? At what level is it efcient? Weak, semi-strong, or strong levels of efciency? The banking system in some countries plays a more important role than in others. Germany is an example of a country with a strong involvement of banks in the nancing of business activities. In the UK and USA capital markets play important roles in the Heriot-Watt University Introduction to Finance

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nancial systems of these countries. Figure 3.12 shows comparative debt ratios of industrial and commercial companies, (the proportion of short and long term debt nance compared to the total nance, i.e both the debt and equity nance of the company). Country UK US Germany Japan % 40 27 36 46

Source: OECD statistics Figure 3.12: Comparative countries ratios of debt to equity nance for all non-nancial companies: 2003 (based on market capitalisation) Because of classication differences in accounting reports between countries, the debt ratio shown in the OECD statistics in Figure 3.12 may not be a totally accurate representation of the real levels of debt nance. However, it does provide a general guide for relative differences and in particular the countries with relatively higher levels of debt. Germany and Japan, whose companies traditionally have very close connections with the banking communities, tend to have higher debt ratios. Equally, countries with highly developed capital markets such as the UK and the USA have relatively lower levels of debt. Remember that debt nance imposes a xed cost on a business in terms of an interest payment each year, and the repayment of the capital sum, usually at some xed maturity date. The higher the debt ratio of the business, the lower the exibility of a nance manager for the use of funds generated each year. The fact that dividends are variable allows managers some exibility in choosing the return to shareholders, but not to debt holders. There are many issues which are important in considering the use of debt or equity nance for business activities. The effect of different levels of debt nance and equity nance in companies nancial structures will be developed in corporate nance modules later in this degree course.

Self test 3.12


Consider a large company operating in the country in which you live. Is the company listed on a Stock market? Does it rely heavily on debt and/or equity nance? What do you think is the tradition for companies obtaining nance for growth opportunities in your country?

3.11

Review

Key concepts and issues covered in the chapter:

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Distinction of debt and equity nance. Rights, risks and returns of ordinary and preference shares. Rights, risks and returns of ordinary and preference shares. Features of debt. Restrictive covenants. Forms of security obtained by debt holders. Features of convertible securities and warrants. Sale and leaseback arrangements. Sources of international nance. Eurobond and Euroequity markets. Differences between countries in terms of debt and equity nance.

3.12

Conclusion

The nancial characteristics of debt and equity nance are critical in business nance. A nance manager raising nance for the investment opportunities of the organisation needs to be aware of the relative risks, returns and obligations connected with different categories of business nance. Increasingly global markets have widened the range of possible nancial instruments and potential number of investors for many companies which have an international dimension to their trading. The increase in the use of convertible securities and warrants during the 1980s is further evidence of innovative development in recent years in the world of business nance. The different characteristics of debt and equity investment, with an increasing choice of hybrid instruments, (e.g. convertibles and warrants), mean that investors have a wide choice in their risk and return decision. When ranked alongside debt ordinary shares have a relatively weak contract. Equity provides managers in most cases with the maximum degree of exibility and for the investor the greatest risk and uncertainty and the greatest expected return.

3.13

Short Problems

The following questions can all be answered with yes or no. Q1: Which of the following are typical features of ordinary shares ?

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Q2: Which of the following features can be incorporated into a preference share issue? a) Convertible b) Redeemable c) Participating d) Voting rights Q3: Which of the following statements is/are true regarding preference shares? a) The dividend paid is deducted from prots before the company tax is calculated b) Preference shares are part of the equity of a company c) Preference shareholders rank below ordinary shareholders for payment d) Participating shareholders are entitled to receive a larger dividend than a nonparticipating preference shareholder Q4: Which of the following are typical features of company debt securities? a) Fixed interest b) Maturity date(s) c) Secured charge d) Voting rights Q5: Which of the following statements is/are true with regard to features of company debt securities? a) A oating charge means a debt holder will receive a variable rate of return b) A debt security issued with a range of maturity dates, (e.g. 2010-2015), means that, in this example, the company will redeem them in ve instalments c) Restrictive covenants in a debt security agreement protect the company (the borrower) d) The greater the risk of the company issuing a debt security, the lower will be the interest coupon paid on the debt Q6: Which of the following are typical features of convertible loan stock ? a) Exercise price b) Interest coupon rate above the rate offered by an unconvertible loan stock c) Redemption date d) Voting rights Q7: Which of the following statements is/are true with regard to Eurodollars, Eurobonds and Euroequity? a) Eurodollars can only be deposited in American banks b) Euroequity refers to ordinary shares issued by a company on a capital market outside of its own domestic market c) Eurobonds are a form of debt nance to a company d) Eurodollar is the new term for the single European currency Heriot-Watt University Introduction to Finance

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Q8: Which of the following statements is/are true with regard to the features of different business structures? a) A sole proprietor has unlimited liability for the debts of his or her business b) A partnership business can be listed on a stock market c) A public limited company has more than 50% of its shares issued to the public d) A shareholder in a private limited company has unlimited liability

3.14

Tutorial Questions

Q9: Discuss the advantages and disadvantages of the following business structures: sole proprietor, partnership, private company, public listed company. Q10: List the rights attributable to ordinary shareholders in a company. Q11: Why might a company issue participating preference shares, convertible loan stock, or loan stock with warrants attached to them? Q12: What action could a bank or debenture holder take to reduce the risk of a company, to whom they have loaned money, defaulting on the repayments? Q13: Discuss the relative advantages and disadvantages to a company of issuing debt and equity nance. Q14: What attraction could there be for a company raising nance on an international capital market?

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Contents
4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Process of Compounding: Future Values . . . . . . . . . . . . . . . . Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effects of Ination: Real and Nominal Rates of Interest . . . . . . . . . . . Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 86 97 100 102 105 106 106 109

Learning Objectives On completion of this chapter students should be able to understand and apply: the process of compounding; the process of discounting; the process of calculating the present and future values of an annuity; the process of calculating the present value of a perpetuity; the relationship between nominal and real rates of return. Summary The aim of this chapter is to explore and demonstrate the effect of the change in the value of money over time and the process involved in calculating future and present values.

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4.1

Introduction

In Chapter two you were introduced to the concept of the time value of money and its importance to nancial decision making. As an individual, institution, or business organisation, the concept is crucial to the interpretation of alternative nancial decisions. Measuring the effect of the value of money over time involves the appreciation of basic mathematical techniques. In this chapter the main techniques for comparing cash ows paid and received over different time periods and for different types of nancial securities will be discussed. Many of the techniques used are fundamental to nancial decisions made by individuals, institutions and business organisations. Understanding the principles on which the different techniques are based, will enable you at this stage to apply effectively and appropriately the different principles and techniques covered in this chapter. In chapters ve and six mathematical techniques are applied to establish a value for ordinary shares and xed interest nancial securities. If you are not very numerate, be methodical in studying the next three chapters and ensure you understand the concepts underlying the techniques illustrated.

4.2

The Process of Compounding: Future Values

Many popular personal investments involve investing a capital sum for a long term to provide a regular income stream at some future date. The income released from such investments is typically to fund consumption needs at varying degrees of regularity. The income from some investments is reinvested along with the original capital sum providing an increased income return over time. An example of such an investment is a pension fund investment to provide a capital and/or income stream at some future date(s). The overall return on such an investment is known as the compounded rate of return. The future value of 1 placed in an investment today and left for n periods at an income rate of return of r per cent per period is solved by the equation in Figure 4.1. To solve for the future value of 1, invested at a compound rate of interest over n periods. 1+ where: r = interest rate of return per period; n = number of periods of the investment. Figure 4.1: Future value for an investment offering a compound rate of interest over time.
r n 100

Example : Compound Interest and Future Value James Cook inherits 1000 from his favourite aunt. He decides to invest the money in a bank account for ten years. The bank guarantees an annual rate of interest of 5% per year each year for ten years. What will be the value of Jamess investment in ten years time? Heriot-Watt University Introduction to Finance

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Assuming James does not withdraw any of his capital or interest earned and that the bank credits the interest to James account at the end of each year his investment will grow as shown in Figure 4.2. End of year 0 1 2 3 4 5 6 7 8 9 10 (1000 0.05) (1050 0.05) (1102.50 0.05) (1157.62 0.05) (1215.51 0.05) (1276.28 0.05) (1340.09 0.05) (1407.10 0.05) (1477.46 0.05) (1551.33 0.05) Interest earned () 50.00 52.50 55.12 57.89 60.77 63.81 67.01 70.36 73.87 77.56 Value of investment () 1000.00 1050.00 1102.50 1157.62 1215.51 1276.28 1340.09 1407.10 1477.46 1551.33 1628.89

Using the compound interest formula the value of the investment at the end of year 10 is: 1000(1 + 0.05) 10 = 1628.89 Figure 4.2: Compound interest calculation If James can nd an investment improving on his annual interest rate return by half of one per cent, (that is 5.5%), the nal value of his investment would increase to 1708.14, (try working this out for yourself using the formula shown in Figure 4.2). The future value of money invested today at a compounded rate of interest is sensitive to the number of periods invested and the annual interest rate of return. Figure 4.3 illustrates changes in the value of 1 at different rates of interest.

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Figure 4.3: Future values of 1 compounded at different rates of return and over different periods. Future values of investments and different rates of return can be calculated in a number of ways using the formula shown in Figure 4.3. To calculate the future value of 1000 invested at a compound interest rate of return of 5% per year for ten years.

METHOD 1: The hard way - without a calculator or using a calculator without an x 1. Calculate each years interest individually; 2. Add the interest to the account balance; 3. Calculate the interest for the next period and continue the process until the end of year 10. Answer: See Figure 4.2 for the calculation
y

function.

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METHOD 2: Using a calculator with an x y function key. Key in 5 Key in / Key in 100 Key in = Key in + Key in 1 Key in = Key in x Key in x to the power y Key in 10 Key in = Key in x Key in 1000 Key in = METHOD 3: Using future value tables (only available for whole percentages). Extract of Appendix 1.2 Future value of 1 = (1 + r /100 ) n where: n = no. of periods and r = rate of interest/period Periods of n 1% 1 10 1.010 1.105 Interest rate per period 2% 1.020 1.219 3% 1.030 1.344 4% 1.040 1.480 5% 1.050 1.629 1628.89 1.6289 1.05 0.05

a) Find the appropriate future value factor from the future value tables, given the number of periods (n) and interest rate per period (r) 1.629 (for 5% and 10 periods) b) Multiply the future value factor obtained in step 1 by the value of the capital sum invested 1.629 1000 = 1629 In the illustration above, a number of different methods are shown to solve a problem involving the compounding of a capital sum invested over a number of periods at different Heriot-Watt University Introduction to Finance

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rates of interest. Clearly Method 1 is the longest and most likely to have an error, because of the number of calculations made. A calculator with an xy function button is the quickest method normally. A spreadsheet package will normally allow a quick calculation using the arithmetic function facility. The future value tables, which are reproduced in Appendix 1.2, shorten Method 1. You will notice from the appendix that the tables only contain whole percentages (if the table in Appendix 1.2 contained a number of different decimal points for each whole interest rate the size of this module text would have doubled!). You will also notice that depending on the method used there will be slight rounding differences. For the purpose of the calculation the rounding is insignicant. (I do not suppose James is going to be too worried at being 1 pence away from what he might actually receive in ten years!). It is important for you to understand that the formula works for any period providing that the interest rate used in the formula is consistent with the period involved. In other words for Jamess example he earns a rate of interest annually, (ie per year), of 5% (rate r) and the period of investment is ten years (the period of n). If James was investing for ten six monthly periods (that is, for ve years) and the six monthly rate of interest is 5%, then the value of Jamess 1000 investment at the end of ve years, will be 1629. It is important that you become familiar with using one of the methods outlined and be condent of the process involved. It is always useful to ensure that you have not made an error in calculating by checking the logic in your answer. For example in Jamess example you can calculate the value of the investment at the end of ten years, assuming he is only earning simple interest. A simple interest calculation assumes the interest earned on the capital sum is not reinvested. Therefore the interest credited to the account each year will be exactly the same, on the assumption that only the capital sum is left intact each year. In this case the simple interest earned each year is 5% multiplied by the capital sum, 1000, (or 50). Assuming James withdraws the 50 as soon as it is credited to the account each year, then the interest credited over each year will be 50. At simple interest Jamess investment will grow to 1000 + simple interest of 50 x 10 years = 1500. If the answer you obtain from calculating the compounding of the interest earned over ten years is less than 1500, this would not be logical, as compounding includes the interest earned on the reinvested interest. It is always important to check intuitively whether the answer you obtain from whatever method makes sense. Compounding Different Period Interest Rates and the Annual Percentage Rate When buying goods or services on credit, or in comparing rates charged on credit cards, it is important as a consumer that we understand the true interest charge incurred. The period after which interest is charged to an account is important as interest will be charged in the following period on the interest charge from the previous month unpaid, as well as the original capital sum. Typically credit card accounts have interest charged to them on the basis of their monthly balance. If the balance is not paid until the following month, the cardholder will be charged interest on the capital plus the interest charged from the previous month. If the cardholder leaves the balance unpaid for twelve months the effective interest rate charged will be the compounded rate of interest charged each month. Here is an example.

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Example Duke Wellington pays for a laptop computer with his credit card on January 1. The cost of the laptop is 2 000 and the credit card company charge interest at the end of the month from the time the credit purchase was made until the end of the month. The current rate charged is 2.5% per month. If Duke plans to leave the balance unpaid until the end of the year, what will his unpaid balance be? What many consumers (and students!) confuse in such an example is the distinction between simple and compound interest. For example taking the monthly rate, 2.5% and multiplying by 12 months to nd the annual rate, ie 30%. This rate if then applied to the capital sum outstanding, 2000 x 30% = 600 interest charged. This answer is wrong. Because the credit card company charges interest each month there will be interest charged on the unpaid interest from the previous month(s), as well as the annual interest charge on the capital sum. This is illustrated in Figure 4.4. The effective rate of interest is Percentage Rate, or APR).
689.78 2000.00 =

34.5% (this is also known as the Annual

The impact of the credit card company charging interest at the end of each month rather than at the end of the year is to cost Duke an extra 89.78 (689.78 - 600.00). If Duke pays his interest as charged at the end of each month he will pay 50 per month. He will therefore pay a simple interest rate of 30% over the year (50 x 12 = 600 2000 = 30%). In the UK companies offering credit nance are required to disclose their APR to customers thus enabling them to compare alternative rates offered by different companies. Capital sum outstanding: January 1, 2000 Month January February March April May June July August September October November December Interest charged at end of the month 50 51.25 52.53 53.85 55.19 56.57 57.98 59.44 60.92 62.44 64.01 65.60 Balance outstanding at the end of the month 2050 (2000 + 50) 2101.25 2153.78 2207.63 2262.82 2319.39 2377.37 2436.81 2497.73 2560.17 2624.18 2689.78

Figure 4.4: Interest charges on a capital sum outstanding on a credit card account. Heriot-Watt University Introduction to Finance

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Figure 4.5 shows the difference to Duke if the credit card company charges the interest in different periods. Period interest charged Annually Six monthly Three monthly Monthly Weekly Daily Periods of n 1 2 4 12 52 365 Interest rate per period 30% 15% 7.5% 2.5% 0.577% 0.082% Annual factor for 1 invested 1.31 1.152 1.0754 1.02512 1.0057752 1.000822 365 APR 30.00% 32.25% 33.55% 34.49% 34.87% 34.97%

Figure 4.5: The annual percentage rate and the effect of compounding over different periods for interest charges.

The interest rate per period of n is simply the APR divided by the number of periods in which interest is to be charged. Continuous Compounding It is important to understand that by reducing the periods in which interest is credited or charged to an account, the APR will increase (that is, by reducing the period of interest charged from (say) 1 year to 6 months, the impact of compounding on the capital plus interest will mean the APR will increase). Taking the process of compounding to its ultimate limit, interest it is assumed will be credited or charged continuously. In other words there are no set periods for interest to be credited or charged. The interest is compounded continuously over the life of the capital invested or borrowed. The formula for calculating the future value of 1 invested at a continuously compound rate of interest is given in Figure 4.6. Formula Future value n = 1 e r where n = the number of periods over which the capital sum is invested; r = the rate of interest per period of n; e = the exponential function value = 2.71828 Figure 4.6: Formula for the future value of 1 invested at a continuously compound rate of interest Figure 4.7 shows a comparison of Dukes credit card balance on the assumption that interest is charged at a continuously compounded rate of interest.

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Period interest charged Annually Six monthly Three monthly Monthly Weekly Daily Continously

Periods of n 1 2 4 12 52 365 -

APR 30.00% 32.25% 33.55% 34.49% 34.87% 34.97% 34.99%

Value of 2000 at the end of one year 2600 2645 2671 2690 2697 2699 2700

Figure 4.7: The future value of a capital sum at different annual percentage rates. The period of n approaches innity with continuous compounding. You will notice that if Dukes 2000 has a continuously compounded rate of interest applied over the year in fact it is not far away from the daily application of interest which would in most cases be as frequent an interval as a bank or nancial institution would use.

Self test 4.1


a) What is the future value in 6 years time of 1500 invested at a 7% compound rate of interest? b) You are considering buying a mountain bike on credit and below are the different costs of credit based on different payment dates for the instalments. Complete the boxes in the following table. Period interest charged Annually Six monthly Three monthly Monthly Weekly Daily Periods of n Interest rate per period of n 25% 12.5% 6.26% 2.08% 0.481% 0.0685% Annual factor for 1 invested 1.25 APR

1 2 4 12 52 365

25.00%

The Process of Discounting: Present Values The process of discounting works in the opposite direction to the process of compounding. Discounting involves calculating the present value of a cash ow received at some future period, using a discount rate. The process of discounting is fundamental to many nancial decisions.

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Recall the concept of the time value of money. If 1 today is worth a different amount to 1 in one or two years time, how can we compare cash expected to be paid or received in different years? A decisionmaker can use present values to compare investment alternatives, taking account of the time value of money. You should recall the section in chapter two considering the concept of the time value of money. In chapter two I offered you 100 today or a guaranteed 100 in one years time, deposited with your solicitor for safekeeping. You must assume that you are living in an island miles from anywhere, where ination is non-existent! You can buy pineapples and coconuts in one year for the same price as you pay today. Which option would you choose? Take the 100 in one year? I expect you to prefer 100 today. Even with an assumption of certainty, (ie no risk or uncertainty and no erosion of the purchasing power of money), individuals still prefer to have the money today than in one years time. To persuade you to wait for one year, you will need to be compensated for waiting. Is 5 enough? Now your choice is 100 today or 105. The 5 would be a real increase in your purchasing power. This may be the price a banker decides to pay to attract individuals and organisations to delay consumption, in a zero ination economy. If we relax the assumption that purchasing power in the future will remain unchanged, but continue to assume that there is no risk that the bank may not pay the return promised, your required return for one years time will increase further to cover the expected decrease in purchasing power. In summary, the factors present in the real world which affect the return required on money to delay consuming today are listed in Figure 4.8. A return to compensate an investor for delaying consumption today until some future period (reecting the time value of money), ignoring ination and risk. A return compensating the investor for the expected change in the purchasing power of money in future periods (ination). A return compensating the investor for the possibility that the capital sum or expected income return may not be paid in full at the end of the investment (Risk).

Figure 4.8: Factors affecting the time value of money. Finding Present Values Earlier you were offered a choice between 100 today and 100 in one years time. Let us assume that there is some risk and the possibility of ination in prices over the next year and that you could earn an 8% return from investing 100 today in a bank over the next year. 8% is your opportunity cost. In other words if you choose to take the 100 in one years time you will have forgone the opportunity to invest 100 today to earn 8 over the year. I assume you would denitely choose the 100 today. Even if you choose not to consume today you can still invest the money in the bank and earn an 8% return. To compare the two alternatives we can calculate future values of the 100 invested today using the compound interest formula. Alternatively we can calculate present values by discounting the future cash ow at a discount rate. In this case we assume 8% to be the opportunity cost, which is the rate used for discounting and compounding. In

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using this rate we are using the assumption that the decision-maker will require a return of at least the opportunity cost rate to choose an alternative investment or consumption pattern. The formula for present value calculations is shown in Figure 4.9. Present Value = where: r = the discount percentage rate; n = the period in which the future value is paid or received. Figure 4.9: Calculating present values: Discounting Figure 4.10 illustrates the relationship between discounting and compounding in comparing the two options, (ie 100 to be received today or 100 to be received in one years time).
Future Value (1 + r)n

Figure 4.10: Comparison of present and future values Comparing present values or future values using the same interest rates over the same periods will produce the same decision. The benet to the decision-maker is that it systematically enables the individual to compare alternative investment opportunities. In other words if 8% is the one year opportunity cost, and I revised my offer, to give you 92.59 today, you may well be indifferent to receiving the 92.59 and waiting one year for 100. In other words taking 92.59 today, investing in the bank for an 8% return growing to 100 in one years time, becomes equivalent to option 2 in nancial terms, (92.59 1.08 1 = 100). Figure 4.11 will be familiar to you,as it is the opposite of Figure 4.3 illustrating the effect on future values of different compound interest rates. Figure 4.11 shows the effect on present values by using different discount rates on 1 received in the future at different periods.

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Figure 4.11: Present values of 1 compounded at different rates of return and over different periods. The process of discounting can be applied to a range of different problems. For example, consider Mary OSullivan who is saving to buy a new car. She is planning to use some of her savings to pay for the car she hopes to buy in 5 years time at an expected price of 5 000. What she needs to know is how much of her savings does she need to invest today in order to have a future value of 5 000 in 5 years time? To solve this problem Mary needs to know the interest rate return on her savings over the next ve years. Assume that Mary is advised that she can invest her savings today for ve years and earn 5% return per year (per annum). How much of her savings does Mary need to invest today to grow to 5 000 in 5 years at 5%? The future value of the 5 000 can be discounted to a present value as follows:
5000 (1 + 0.05)5

Mary therefore needs to invest 3917.63 today at 5% per year to have 5 000 to buy her car, in 5 years time. The methods for discounting are now shown. Problem: To calculate the present value of 5 000 in ve years time, to be invested at a rate of 5% per annum. METHOD 1: Without a calculator function of x y . 1. Multiply 1.05 by 1.05, ve times 2. Divide 5 000 by the product of 1.
5000 (1 + 0.05)5

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METHOD 2: With a calculator, using the x y function. Answer: Key in 1 Key in + Key in 0.05 Key in = Key in Key in x to the power y Key in 5 Key in = 3917.63 1.05

METHOD 3: Using present value tables (see Appendix 1.1)


1 (1 + r)n

Periods of n 1 2 5

1 0.9901 0.9803 0.9515

2 0.9804 0.9612 0.9057

3 0.9701 0.9426 0.8626

4 0.9615 0.9246 0.8219

5 0.9524 0.9070 0.7835

1. Take the present value factor for the appropriate period and discount rate (0.7835) 2. Multiply the present value discount factor of 1 by the future value. 3. 0.7835 5000 = 3917.5

Self test 4.2


What is the present value of 3000, received in ten years time at a discount rate of 15%?

4.3

Annuities

Present values of annuities Where payments or receipts is made on a regular basis for a number of periods the stream of regular payments or receipts are called an annuity. The formula for calculating the present value of the future stream of instalments is given below in Figure 4.12.

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Formula: PV(Annuity) where : A = the annuity instalment value r = discount rate for the annuity n = the number of periods of the annuity Figure 4.12: The formula for calculating the present value of the annuity As an alternative to using the formula in Figure 4.12, the Annuity present value table in Appendix 1.3 solves the equation for different rates of interest and different periods of n for a 1 unit. An example of the use of this calculation is to establish the present value of instalments for the repayment of a loan, where the loan agreement requires xed instalments, each of which will include capital and interest. For example, consider a nance arrangement to buy a new car, using a ve year loan, through ve equal instalments of 2 000 at the end of each year at a rate of 10% interest. What will be the present value of this loan arrangement? PV(Annuity) 1 1 0.10 0.10(1 + 0.10)5 2000 3.791 2000 A
1 r

r(1 1 + r)n

7582 ( Available from the table in Appendix 1.3; 5 periods of n and 10%) Comparing this present value calculated to the fair value of the car if bought today enables a customer to calculate the effective cost of the interest charges made. Calculating the Future Value of an Annuity There are many examples of savings scheme based on a contribution of a xed sum of money paid at regular intervals for a nite period of time. In some cases with an annuity of this nature it is important that the regular instalment grows to a particular lump sum of money at the end of its term. The instalment method used to repay this future value of the lump sum is known as a sinking fund. An example would be a company saving cash from its annual earnings each year to repay debenture stocks maturing in twenty years. In twenty years time the company will need to have a sum of money sufcient to repay the debenture stock to be redeemed. To achieve this systematically a regular payment each year can be paid into an account earning a rate of return each year exactly to repay the liability when it arises. To calculate the annuity required to pay a specied future value, the formula in Figure 4.13 can be applied:

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Annuity(instalment) where:

Future Value

r (1 + r)n

r = the average rate of interest return; n = the number of periods of the annuity. Figure 4.13: The formula for calculating the future value of an annuity Here is an example to illustrate how the formula in can be applied. Hazel Nelson is to start saving for a round the world trip for herself when she retires. She is currently 40 years old and expects to retire when she is sixty. She estimates the cost of her trip to be approximately 50000 (allowing for increases in prices over the twenty-year period). She needs to know how much money she will require to save from her earnings per month, in order to afford her trip in 20 years time. Hazel has been informed that she can invest her money in a savings plan expected to give her an 8% rate of return per annum, on average, for her savings for the twenty-year period. Based on these assumptions, what monthly amount would Hazel need in order to pay for the trip in 20 years time? Applying the formula in Figure 4.13: Monthly Annuity = 50000

1 +

0.08 / 12 (months)
0.08 20 12

12
= 84.89 20373.60 29626.40 50000.00

The monthly instalment = 50000 0.0016977 Hazel will pay 84.89 240 capital instalments: and earn interest over twenty-years of: A total of Figure 4.14 illustrates the growth in Hazels sinking fund.

Figure 4.14: The growth in value of a sinking fund

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Self test 4.3


What is the present value of an investment promising to pay 100 per year for 20 years at a discount rate of 10%?

4.4

Perpetuities

The Present Value of a Perpetuity An annuity continuing indenitely into the future provides a perpetual stream of cash. The investment return or payment has no nite life. The present value of an investment perpetuity is given by the formula in Figure 4.15. Figure 4.15: Formula for the present value of a perpetuity

Present value of a perpetuity = where: c = the regular cash income or payment; r = the rate of interest return over the period.

c r

Examples of perpetuities are government or corporate bonds issued with no redemption date providing perpetual streams of income to the investor. For example, consider a government gilt edged security issued 20 years ago by the British Government with no maturity date which is still being traded on the capital market. Assume the gilt pays 81/2% interest per annum for each 100 unit of stock and the market rate of interest has risen since the gilt was issued and is now 12.5%. What is the present value of the gilt edged security given the new required market rate of return? PV =
8.50 12.5%

68 (Per 100 nominal value)

If the market interest rates had fallen since the gilts were issued, there would be an increase in the price, (as the 81/2% would be better than the average return on the market). For example if the market interest rate is 5% the present value of the gilt would be: PV =
8.50 5%

170

A Growing Perpetuity In some cases the sum of money from an investment perpetuity may be expected to grow over time. This may be because the sum is not xed. An example of this is a dividend from an ordinary share which has uncertain future income cash ows and which might be expected to grow in the future. The formula for calculating the present value of a growing perpetuity is shown in Figure 4.16.

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PV of growing perpetuity = where: c = the regular cash income or payment; r = the rate of interest return over the period; g = the rate of growth expected in the perpetuity.

c r-g

Figure 4.16: Formula for calculating the present value of a growing perpetuity A growing perpetuity is where a capital sum of money is invested to provide an income return which is expected to increase over time. For example consider Jenny Wolfe, whose great uncle Robert Cromwell wishes a sufcient capital sum to be invested to pay Jennys school fees and to contribute to her living expenses for the rest of her life. School fees are currently 4 000 per annum. Robert has identied a suitable investment offering xed long-term rates of return of 10% per annum. How much should Uncle Robert invest as a sufcient capital sum to provide for Jenny to cover her school fees and continue to generate an income thereafter to support her living expenses? In this example Uncle Robert is not envisaging any growth in the income stream. So we can apply the perpetuity formula assuming no growth. Of course we are simplifying the assumption here that Jenny will live forever; the alternative is to put an estimate on Jennys expected life. Applying the present value perpetuity formula, (from Figure 4.15): Capital sum =
4000 10%

40000

If Uncle Robert invests 40000 and the investment continues to produce a return of 10% every year Jenny will be able to withdraw an income of 4 000 to cover her school fees and help her living expenses, without affecting the capital sum. If Uncle Robert took the view that the school fees may reasonably increase more than the rate of ination and he would like to provide Jenny with an income which covers the increase in fees, he will need to incorporate the rate of increase in his calculations. Assume Uncle Robert expects school fees to grow at 2% in the future, how much capital sum does he now need to provide to give Jenny a perpetual income stream to cover her fees? Applying the growing perpetuity formula, (from Figure 4.16): Capital sum =
4000 10 - 2

50000

In other words, to cover the expected extra growth in the income required to Jenny, to cover the expected fee increase, Uncle Robert requires to invest an extra 10000. Uncle Robert might reasonably expect that the 10% return covers general increases in the rate of ination, though it is important to incorporate in his calculation the expected increase in the fees, (which may be different from the change in general prices, measured by ination).

Self test 4.4


a) What is the present value of a cash payment of 50 per year to be paid forever at a discount rate of 7%?

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b) What is the present value of a cash sum to be received of 125 per year for an indenite period of time at a discount rate of 15% and expected to grow over time at a constant rate of 6%?

4.5

Effects of Ination: Real and Nominal Rates of Interest

One of the three factors affecting the time value of money is ination (see Figure 4.8). Ination is a term familiar to us through the news media. It is experienced by each of us in our weekly food shopping through changes in prices from one week to another! Ination is an expression of the increase in prices of goods and services consumed. Prices rising over time means investors need to earn at least the equivalent to the average rise in their goods and services consumed to be at the same standard of living as at the time the investment is made. Ination, therefore, plays a major role in our society wherever we may choose to live. If ination is rising at extremely high percentage rates from one year to another it can have a very destabilising effect on consumers and on industrial and commercial businesses faced with higher costs to produce or manufacture their output. Incorporating the effects of ination in nancial decision-making is essential in times of high and volatile ination rates. Ination affects the decisions made by investors on a capital market, individuals considering whether to consume today or delay consumption to a future period of time and businesses considering the allocation of resources and the nancing of their operations. Investing money to achieve a return less than ination over the life of the investment means the investor would have been better off consuming the cash rather than investing. If the investment generates a return exceeding the change in the purchasing power of money over the period of the investment, the investor will have earned a real return. This would enable the investor to consume more at the end, or during the life of the investment, than at the time when the capital sum was invested. The relationship between ination and real yields of UK and European countries is shown in Figure 4.17 and Figure 4.18.

Source: Bloomberg Figure 4.17: Real yields and expected ination for UK bonds

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Source: Bloomberg Figure 4.18: Real yields and expected ination The different returns from investments in nancial securities listed on the US stock market are shown in Exhibit 2.4 and Exhibit 2.5 of Chapter 2. The nominal return shown incorporates the real return and the ination rate. The nominal rate of return is sometimes referred to as the money rate of return as it is the return received by the investor in money terms. The real rate of return is the return to the investor after ination. In other words it gives the investor a measure of how much extra they can consume given the investment return. Exhibit 2.4 shows that investing in a portfolio of ordinary shares on developed capital markets over the last century would have yielded a premium return between 8% and 10% above the return on government stocks. The formula for calculating the nominal and real rates of return is shown in Figure 4.19. (1 + nominal rate of return) = (1 + real rate of return) (1 + ination rate) (1 + nominal rate of return) (1 + real rate of return) = (1 + ination rate) Figure 4.19: Formulae for calculating nominal and real rates of return Here is an example to apply the formula shown in Figure 4.19. A one-year Government Gilt edged security has a nominal rate of return of 8% per annum. Ination is expected to be 2.5% over the next year. What will an investors real rate of return be for the one-year investment? (1 + real rate of return) =
1.08 1.025

1.053658

The real rate of return = 5.37% Investors may also be interested in comparing cash expected at some future date with its present value based on expected ination over the life of the investment. For example, Geraldine Mathis is considering accepting an early retirement package involving a lump sum of 20000 to be received in ve years time. The ination rate over the next ve years is expected to be 3% per year on average. Geraldine wants to know how much the 20000 will be worth at todays prices. Using the present value formula:

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Present value =

20000 (1 + 0.03)5

The present value = 17252 This enables Geraldine to compare the purchasing power of her return in todays terms. Assume Geraldine eventually does retire and she has a sum of 40000 of savings to provide for her consumption needs in retirement (which she is hoping to be for a period of 35 years). Geraldine can invest her 40000 at an average annual rate of return of 7.5% and the expected long-term average ination rate is 3.5%. How much can Geraldine consume each year as a regular income so that the 40000 capital is reduced to zero after 35 years? To answer this question we will make a simplifying assumption that Geraldine will have a regular, consistent pattern of consumption each year. Applying the annuity formula for the real rate of return: (1 + real rate of return) =
(1 + 0.075) (1 + 0.035)

The real rate of return = 3.86% You will of course notice that you can approximate the real rate by deducting the ination rate from the nominal rate, i.e. 7.5% - 3.5% = 4.0%. This is only an approximate method and the approximation becomes less accurate, the higher the rate of nominal and ination rates used. To calculate the present value of the real annuity the formula in Figure 4.20 can be used. Present value of investment Annuity factor for the number of periods and interest rate for the instalment(s) Figure 4.20: Formula for calculating regular instalments for the repayment of a loan at different rates of interest The formula in Figure 4.20 can be adapted to nd the maximum which can be consumed by Geraldine in present value terms for 35 years without affecting her 40000 capital.
40000

1-

1 (1 + 0.0386)35

0.0386

40000 (19.0246)

2102.54

2102 is the maximum value for Geraldines annual consumption pattern, in present value terms, without affecting her 40000 capital. To consume the same equivalent basket of goods each year for 35 years, Geraldines consumption will increase by the annual ination rate, (2102 1.035) = 2176 in year 2; and so on through to year 35. Financial decision-makers can express returns as either nominal or real rates of return. What is crucial is the process of establishing the expected ination rate for the period of the investment. Where the return from the investment is less certain, judgement will have to be made on the effect of ination on the cash ows generated by the underlying investments. For example a businessman investing in a new car assembly plant may

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forecast future costs higher than the expected general ination rate on the basis that they expect wages to rise by higher than the ination rate over the life of the plant. It may also be that there is a delay in the manufacturer being able to pass on the effect of ination on his costs to customers through the price of the assembled product. It is important too that the best forecast of future ination is made to ensure an appropriate nominal discount rate is used (if nominal returns are being used). The volatile and high ination rates of the 1970s in the UK meant forecasting ination was difcult. A feature of the last ten years in many developed countries has been the importance placed by governments on the stabilisation of ination and interest rates. This is shown clearly in Figure 4.17 and Figure 4.18 for the main European economies over the last 14 years. Stabilising ination and interest rates facilitates decision-makers ability to plan future nancial resources and investment levels. This issue is explored further with regard to corporate capital investment decision making, in another nance Module on this course.

Self test 4.5


If a bank deposit account normally pays a real rate of return of 2.5% and currently it is offering an annual rate of return of 7%, what is the expected level of ination over the next year?

4.6

Review

Key concepts and issues covered in this chapter: Present values; Future values; Discounting; Compounding; Continuous compounding; Annual Percentage Rates; Annuities; Sinking funds; Perpetuities; Growing perpetuities; Real rates of return; Nominal rates of return.

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4.7

Conclusion

Fundamental to making nancial decisions is the ability to compare cash ows from investments over common time periods. The principle of discounting and compounding interest rate returns over different time periods facilitates decision making by recognising the change in the value of money over time. Perpetual and annual streams of income and payments can be discounted back to present value based on the relevant rate of discount. Cash ows received over longer periods into the future will have lower present values the greater is the discount rate used. A sum of money received in 25 years time has relatively little present value when discounted at a high discount rate. Thus the value of a 1 25-year annuity becomes close to the value of a 1 perpetuity, (1 received/paid over greater than 25 years having a progressively lower value in present value terms). Of particular importance is the relationship between real and nominal rates of return. Remember that there are three key factors affecting rates of return from investments: the expected ination rate; the time value of money; and a premium for the risk of the cash ows on the investment.

4.8
Q1:

Short Problems
What is the future value in ve years of 1000 invested at 5% per annum?

a) 1000 b) 1250 c) 1276 d) 1611 Q2: What is the future value in ten years of 500 invested at 8% per annum?

a) 500 b) 900 c) 1000 d) 1079 Q3: What is the future value in twenty years of 100 invested at 20% per annum?

a) 100 b) 120 c) 500 d) 3834 Q4: What is the present value of 1000 received in two years time at a discount rate of 5% per annum? a) 907 b) 950 c) 952 d) 1000 Heriot-Watt University Introduction to Finance

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Q5: What is the present value of 600 received in ve years time at a discount rate of 20% per annum? a) 97 b) 241 c) 500 d) 600 Q6: What is the present value of 100 received in twenty years time at a discount rate of 5% per annum? a) 0 b) 15 c) 38 d) 100 Q7: If interest is charged on a credit account at 7.5% each six monthly period, what is the Annual Percentage Rate (APR)? a) 7.5% b) 12.7% c) 15% d) 15.6% Q8: If interest charged on a credit account is 2.5% each month, what is the Annual Percentage Rate (APR)? a) 12.5% b) 25% c) 34.5% d) 47% Q9: If interest charged on a credit account is 0.08% daily, what is the Annual Percentage Rate (APR)? a) 0.1% b) 9.6% c) 29.2% d) 33.9% Q10: What is the present value of an investment with an annuity return of 50 per year over 10 years at an interest rate of 10%? a) 19 b) 307 c) 500 d) 550

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Q11: What is the present value of an investment with an annuity return of 100 per year over 3 years at an interest rate of 8%? a) 79 b) 258 c) 276 d) 324 Q12: What is the present value of an investment with an annuity return of 25 per year over 25 years at an interest rate of 20%? a) 0 b) 2 c) 124 d) 625 Q13: What is the present value of an investment offering a perpetual income return of 120 per year at an interest rate of 10%? a) 120 b) 1200 c) 12000 d) 120000 Q14: What is the present value of an investment offering a perpetual income return of 50 per year at an interest rate of 7.5%? a) 50 b) 54 c) 67 d) 667 Q15: What is the present value of a 30 payment made every year into perpetuity, at an interest rate of 5%? a) 30 b) 32 c) 600 d) 6 000 Q16: What is the present value of a perpetual annual dividend income stream from an ordinary share, currently of 5, and expected to grow at a rate of 6%, at a required rate of return of 15%? a) 5 b) 33 c) 56 d) 83 Heriot-Watt University Introduction to Finance

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Q17: What is the present value of an annual payment stream to pay a debt into perpetuity, currently of 25, and expected to grow at a rate of 2.5%, at an interest rate of 8%? a) 25 b) 312 c) 320 d) 455 Q18: The nominal rate of return of an investment you are considering is 10% and the expected level of ination is 4%. What is the real rate of return of the investment? a) 5.77% b) 6.00% c) 9.60% d) 10.00% Q19: The real rate of return of an investment you are considering is 2.5% and the expected level of ination is 3%. What is the nominal rate of return of the investment? a) -0.5% b) 1.20% c) 5.50% d) 5.57% Q20: The nominal rate of return of an investment you are considering is 20% and the real rate of return is 10%. What is the expected level of ination? a) 5.00% b) 8.09% c) 9.09% d) 10.00%

4.9

Tutorial Questions

Q21: What factors affect the time value of money? Q22: Explain what you understand by the term sinking fund, and give an example of how it may be used. Q23: What do you understand by the term Annual Percentage Rate, (APR)? Explain why an APR may be different from the percentage cost of credit quoted by a credit company. Q24: You are considering an investment offering an annual return over the next three years of 200 per year, receivable at the end of each year. The investment will cost 500 and would be payable immediately. To compensate you for the time value of money over the next three years you require a 10% rate of return from this type of investment. Is the investment acceptable? Give reasons for your answer. Heriot-Watt University Introduction to Finance

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Q25: A friend of yours, Paul Cetera, has decided to invest some cash in the ordinary shares of a local company. He intends to hold the shares indenitely into the future and the dividend return is intended to increase his pension income. The current dividend paid by the company is 25 pence per ordinary share. Paul expects that the dividend will grow in the future by 4% per year. He requires a return of 11% for this type of investment. The current price per ordinary share of the company selected by Paul is 3.00. Should Paul make this investment based on the nancial information given? Explain your answer. Q26: You are shopping for a new computer and have identied three stores selling the model you prefer, the Supersonic Multimedia Wizard. Each company will offer you credit terms to buy the computer. The three companies offer you credit for one year on the following terms: Astra Ltd offer you credit on the basis of 0.06% interest applied daily; Beta plc offer you credit on the basis of 2.3% interest applied monthly; Creda plc offer you credit on the basis of 8% interest applied quarterly. All three companies offer the credit for one year only and the price of the computer is the same in all three companies. Which company is offering you the best credit terms? Q27: Jack Lynne is saving for a new Ferrari motor car. He estimates that in ve years he should be able to afford to buy a new car at a cost of 80000 with his savings. He is planning to save in monthly instalments over the next ve years by depositing his savings in an investment offering a return of 8% per annum. What will Jack need to pay each month into the investment so that his savings grow to 80000 in ve years time? Q28: Marianna Carey is saving for her early retirement and has deposited savings of 10000 in an investment account paying a xed return of 7% per annum over the next ten years. Marianna is concerned about how much her standard of living will increase in ten years when she expects to retire. Although she understands her 7% return is xed she has recently read in a newspaper article that ination is expected to be 4% per year, on average, for the next ten years. Based on the ination forecast how much will her investment grow to in real terms over the next ten years?

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Valuing Fixed Interest Securities


Contents
5.1 5.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Valuation of Government Gilt Edged Securities . . . . . . . . . . . . . 5.2.1 An Example of Valuing Government Gilt Edged Securities . . . . 5.2.2 The Redemption Yield and the Interest Yield 5.3 5.4 5.5 5.6 5.7 5.8 . . . . . . . . . . . Corporate Fixed Interest Securities . . . . . . . . . . . . . . . . . . . . . . An Introduction to Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 112 114 117 121 128 129 129 129 132

Learning Objectives On completion of this chapter students should be able to understand and apply: the key features of government xed interest securities; the key features of corporate xed interest securities; relevant measures of risk and return associated with xed interest securities; the process of calculating the present value of a xed interest security; the principle underpinning yield curves. Summary The aim of this chapter is to introduce students to the important features of xed interest securities and the underlying principles involved with valuing them.

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5.1

Introduction

Financial securities issued by governments and business organisations are claims on future cash ows from the activities of the organisation issuing the security. In some cases the claim is xed as an annual percentage of the investment which is payable in one, two or four instalments during the year. It may also be that this xed return is receivable by the holder over a xed number of years. Other nancial securities have a more variable claim to the future cash ows from the issuers activities. For example at the time of issuing ordinary shares the issuer gives no guarantee as to what return investors will receive, or indeed when they are likely to receive it. The risk and uncertainty associated with xed interest nancial securities depends upon the organisation issuing the security. The risk and uncertainty of the xed interest security will be a function of the investment activities it is nancing. For example, a xed interest government security is relatively riskless as the issuer (ie the central government) is unlikely to have insufcient cash from its activities to pay the interest and capital. Fixed interest securities in a young company needing start up capital to invest in high technology investments have a greater risk and uncertainty than government xed interest securities as the cash ows from the business activities are riskier and more uncertain. Securities issued by a company which have a xed return have a lower risk to an investor than securities offered by the same company offering a variable return. An investor in a ten year loan stock offering a 10% annual rate of return has a lower risk than an investor in the ordinary shares of the same company. The ordinary shareholder will receive a dividend which may vary over time. Also the ordinary share has no maturity and the price at which the share can be sold in the future will be uncertain. Valuing nancial securities with returns varying in terms of risk and uncertainty is based on the principle of a willing buyer and a willing seller agreeing to a price. The valuation process involves a buyer and seller assessing the riskiness and uncertainty associated with the claim to a stream of future cash ows. The price of a security encapsulates the variability and period of the claim to future cash ows. Information about the expected future cash ows to which the nancial security holder is entitled is vital to the process of establishing the price between the buyer and seller. The availability of this information to all potential willing buyers is important in determining value. Chapter 7 considers some of the key concepts affecting valuation processes, focusing in particular on the importance of information availability in this context. The next two chapters consider the valuation process with relation to the pricing of xed interest securities and ordinary shares. The models discussed in the next two chapters are fundamental to understanding the process of valuing nancial securities.

5.2

The Valuation of Government Gilt Edged Securities

Financial securities issued by the UK Government are called government gilt edged securities, (gilts). The UK Government issues gilt edged securities to support the nancing of public sector activities. In the United States nancial securities issued by the US Government are called Treasury Bonds. Figure 5.1 and Figure 5.2 show the different categories of UK Government gilts issued and indicate some of the important

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features.

Figure 5.1: Features of a UK Government gilt edged security Category Shorts (lives up to 5 years) Five to fteen years Over fteen years Undated Index linked Features The gilts in this category have a xed maturity date within the next 5 years. The maturity date of the gilts is within 5 to 15 years The maturity date of the gilts is over 15 years. The gilts in this category have no xed maturity date. The gilts in this category have their coupon rate linked to movements in the retail price index.

Figure 5.2: Categories of UK Government Gilt edged securities In most countries, bonds issued by the central government of the country are the most riskless form of securities traded on capital markets because of the low risk of default. If a government in a less developed country is unstable, however, the risk of such a government defaulting on payment to investors is a greater possibility. The main risks associated with government stocks are identied as follows. Risks associated with Government Stocks Interest rate risk This is the possibility that interest rates may change unexpectedly over the life of the government stock. The coupon rate of the government stock is xed at the time of issue for the life of the stock. If interest rates in the economy rise unexpectedly, an investor holding a government stock issued before the unexpected rise will have a lower coupon rate than stocks which have been issued subsequently and therefore incorporate the rise. The market price of government stocks will be adjusted to incorporate unexpected changes in interest rates. Ination rate risk Unexpected increases in the rate of ination over the life of the government stock will also affect the value of the stock. If ination changes unexpectedly after a stock has been issued the real return on the gilt will also change. As with interest rates the

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important principle is that the change in the ination rate is unexpected. Expected changes in the level of interest and ination rates would be incorporated into the coupon rate which is xed over the life of the stock. The exception is, of course, the index-linked government stock whose return is linked to movements in the retail price index (which reects the general movement in the prices of goods and services consumed). Default risk If the issuer of a nancial security is unable to pay either the income instalment or the capital sum borrowed when it becomes due, they will have defaulted on the conditions of the security. The ability to repay the capital sum and income instalments will be a function of the activity of the organisation issuing the securities. For a government to default on a payment of income or capital would be extremely unlikely. Indeed the name of the government stocks in the UK, gilt edged, was attributed to them in the seventeenth century when they were rst issued because their return was guaranteed by the government. The original issue of gilts, in 1694, was to nance the war against France. William III raised over 1.2 million, as the National Debt had risen to over 15 million. For commercial or industrial companies, however, xed interest securities have varying degrees of default risk, being a function of the risk of the activities undertaken by the company issuing the security. In summary, xed interest government stocks are the most riskless form of nancial security available to investors on capital markets, due to their having a negligible default risk. Their market value does however change over time due to unexpected changes in ination and interest rates.

5.2.1

An Example of Valuing Government Gilt Edged Securities

Assume in 2007 the UK Government need to raise an extra 10 million to meet their public sector borrowing requirements (PSBR - this is the shortfall between the expenditure committed by the government and the available revenue from taxation and other sources of government nance). To meet their funding requirements, the government issue a 10 year government gilt (in 100 nominal value units) with a coupon rate of 8%. As with many government gilt edged security issues, the interest is paid in two equal instalments every six months. Jean Arc is an investor who is looking for a nancial investment providing a relatively safe return. She chooses to invest in the government gilt edged security at the time the government issues the new securities. Jean intends to invest 100. The positions of the Government and Jean are outlined in Figure 5.3.

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The Government 2007 2007-2017 2017 Jean Arc 2007 2007-2017 2017 Investment: (100) Income: 8 per year interest (8% of 100) Capital repaid: 100 Income: 10 million Cost: 800000 per year interest (8% of 10million) Cost: (10 million) Repayment of the borrowings

Figure 5.3: Cash ows to issuers and investors in government stocks: Example of Jean Arc The Government The Government need 10 million for public expenditure, and estimate they can repay in 10 years time (of course they can always nance the repayment with a new issue of government gilts, if the market is still willing to invest). The government pays 800000 each year (8% x 10 million; 8 per 100 unit), being the coupon interest payable on each gilt edged security. The government coupon payment of 8% per year is xed regardless of interest and ination rate movements over the ten years (it is not in this example an index linked gilt). The government will take a view on what they believe will be the average annual rate of ination and interest rates over the ten-year period. It may be, for example, that with a current interest rate of 6.75% at the time of issue they are anticipating a general rise in interest rates over the ten years. Jean Arc By investing in this government gilt issue, Jean will be paid an annual income of 8, in two equal instalments, (ie 4), during each year for ten years for her 100 investment. At the end of the ten-year period Jeans 100 investment will be repaid by the government. During the ten years Jean could sell the government gilt, though her return would depend on the prevailing market price which could be higher or lower than the 100 paid by Jean. The price will be a function of unexpected changes in and the expectations of interest and ination rates at the time of selling the stock. The value of the government gilt edged security at the time of issue is shown in Figure 5.4:

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Market value = where:

D (1 + r)1

D (1 + r)2

D (1 + r)n

(1NV + r)

r = the discount rate which is applied to the coupon and nominal value payments; D = the coupon payment for each period of n; n = the number of periods of maturity for the government gilt; NV = the nominal value of the government gilt stock issued, (in most cases, in the UK it will be 100).

Figure 5.4: Formula for valuing a government gilt edged security Valuing the 10-year Gilt Edged Security of Jean Arc At the Time of Issue 100 = Notes: i ii The market value is the same as the nominal value at the time of issue. The periods of n are six monthly, therefore the coupon payment is 8/2 = 4.
4 (1.04)1

4 (1.04)2

4 (1.04)20

100 (1.04)

20

iii Jeans only return is the coupon rate There is no capital gain if Jean holds the stock until the maturity date in ten years time. r must therefore equal the coupon rate percentage, i.e. 4%, (for six months). At the time of issue, assume the government receives the 10 million as planned from the market. The investors are assumed to be satised with the 8% annual rate of return (or more accurately the 4% six monthly rate). After ve years of the stock being issued, assume that interest rates rose to a rate far higher than was expected by the government and the investors at the time the stock was issued. Assume further that Jean could now invest in a ve-year gilt which gives a 10% annual return. What is likely to happen to the value of the 8% gilt? After an unexpected increase in interest rates, 5 years after the issue of the government stock The rate of r in the equation is known as the redemption yield (or yield to maturity). This is the required rate of return of the investor, the rate at which the future returns from the investment are discounted to the current market value. Jean has the option to sell her gilt in the secondary market, without having to wait ve more years for the maturity of the stock. What market price could she expect a willing buyer to pay? As an alternative gilt for ve years earns a return for an investor of 10% annually,(or 5% six monthly), the market value for the 8% gilt will now change. Calculating the market value after an unexpected increase in rates: Heriot-Watt University Introduction to Finance

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r is now 5%, (the six monthly rate), for the remaining 5 years of the gilt. (1.05) Market value = 92.28 Note: The market value has now decreased sufciently to compensate the investor for the lower rate of return offered on the 8% stock compared to the new 10% stock issued. Investors who buy at the new market price will now achieve a capital gain of 7.72 (100 -92.28), if they hold the gilt until maturity. Now suppose interest rates unexpectly fall nine years after the issue of the government gilts in 2007. What will happen to the market price? After an unexpected decrease in interest rates, 5 years after the issue of the government stock Assume now that Jean could invest in a new ve year gilt edged security offering only a 6% coupon rate. The return on Jeans 8% gilt is attractive compared to the alternative investment opportunity, offering 6% return. What will happen to the market value? Calculating the market value after an unexpected decrease in rates: r is now 3%, (the six monthly rate), for the remaining 5 years of the gilt. Market value = 4
1

Market value =

4
1

4 (1.05)
2

4 (1.05)
10

100 (1.05)10

(1.03) Market value = 108.53 Note:

4 (1.03)
2

4 (1.03)
10

100 (1.03)10

The market value has increased sufciently to reect the unexpected decrease in interest rate from 4% to 3% (six monthly). An investor would make a capital loss of 100 - 108.53 = 8.53, just equivalent, in present value terms, to offset the extra 1, (ie 4 -3), received each six monthly period for the next ve years. You will notice that the coupon payment on the government gilt (4) is an annuity and the nominal value has a future value of 100 received on maturity. To nd the market value using nancial tables (in Appendices 1 and 3) for this last case: Annuity = 4 8.530 Nominal Value = 100 0.7441 Market Value = 34.12 = 74.41 = 108.53

annuity factor n = 10, r = 3%, Appendix 1.3 present value factor n = 10, r = 3%, Appendix 1.1

5.2.2

The Redemption Yield and the Interest Yield

As has already been mentioned, the rate r which discounts the future cash ows receivable on the gilt edged security to the current market value is known as the redemption yield. The redemption yield includes the six monthly interest received, as well as the capital gain or loss (in present value terms) if the investor holds the stock Heriot-Watt University Introduction to Finance

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until it is redeemed. The interest yield of a government stock is calculated by dividing the interest coupon by the current market value. The interest yield =
D Market value

For the Jean Arc example, where interest rates unexpectedly fall, (case c), the annual interest yield is:
8 108.53

100

7.37

The interest yield calculation does not therefore incorporate the capital gain or loss on the maturity of the gilt. The interest yield will change as the market value changes over the lifetime of the gilt. Figure 5.5 shows the different interest and redemption yields for the 8% gilt investment of Jean Arc. Yield Interest At the time of issue Rise in interest rates (after 5 years) Fall in interest rates (after 5 years) 8.00% 8.67% 7.37% Redemption 8.16% 10.25% 6.09%

Figure 5.5: Example of different interest and redemption yields for an 8% gilt investment The annual redemption yield is calculated from the semi-annual redemption yield calculation by applying the formula: 1 (1 + R) = 1 (1 + r) 2 where: R = the annual redemption yield; r = the semi-annual redemption yield The calculation means the compounding effect is taken into account as the interest is received six monthly rather than in annual instalments. Government gilts issued at different times but having the same maturity dates may have differing coupon rates depending on the movement of interest rates; however they will have almost identical redemption yields. This is because at the time of issue expected interest and ination rates over the life of the gilt may have been marginally higher or lower than a gilt issued at a previous or later date. Investors will continually revise the market value of the gilts based on any unexpected change in ination or interest rates. In other words the redemption yields for gilts maturing at the same time with different coupon rates will be similar. There may be small differences based on the timing of the coupon payments and the actual month of redemption. Figure 5.6 illustrates this point.

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Figure 5.6: Interest and redemption yields for government gilts (2007) The three gilts noted were all issued at different times so have different coupon rates, but all are mature in 2012. The interest yields reect the different coupon rates but the redemption yield calculation indicates that the market price has been adjusted to reect the prevailing market interest rate, which on average is expected to be around 5.25% over the period to 2012. The Valuation of Undated Government Stocks Government stocks issued without a redemption date are called undated or irredeemable stocks. The government, the issuer, promises to pay the holder a xed rate of return indenitely. Governments may issue such a stock when they are uncertain about when they will have sufcient funds to repay the sum borrowed. For instance the UK government issued 31/2% War Loan gilt edged securities to help fund the rst and second world war efforts (originally issued n 1916). The 31/2% stock is still in issue and being traded on the UK capital market. As the interest coupon is a perpetual stream of income, the perpetuity formula is used to value irredeemable government stock as shown in Figure 5.7. Present value of the government stock = c r where: c = the interest coupon; r = the rate of interest return over the period. Figure 5.7: Formula for calculating the present value of an undated government stock At a moment in time the 3 1 /2 % War Loan stock was trading at a market price of 53 9 /32 (The fraction shown is the traditional market traders method of expressing gilt prices). Each 100 unit of the War Loan stock is therefore worth about half of its original value at this market price. Using the formula in Figure 5.7 we can establish the rate of return buyers and sellers on the market require in order to invest in this stock: 53 32
9

3.50 r

Rearranging the formula: r


3.50 53 32
9

6.57

In other words, at this point in time investors are only willing to invest in a stock offering a perpetual annual income of 3.50, providing that it represents 6.57% of their investment, (ie the market price). Clearly the market rate, r, changes as ination and interest rates change over time and this will have a consequent effect on the market price. One government gilt is the same as another to an investor, (except for their interest coupon and maturity). Figure 5.6 illustrated that gilts issued at different times but having

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the same maturity will be priced such that the redemption yields are equivalent. If this were not the case there would be an opportunity to invest in the stock offering the highest redemption yield, which in turn would exert an upward pressure on the market price until the difference in redemption yield disappeared. This principle is the same for undated stocks. We established that for the date chosen the market rate of return required from the undated 3 1 /2 % War Loan Stock was 6.57%. Consider another undated government gilt being traded at this date, with a different coupon rate of interest, Consolidation 4% stock. If we apply the required return r, using the formula for valuing a perpetuity it will give the present value of the undated stock. 4.00 6.75% Present value of Consolidated 4% stock = 59.26 Present value of Consolidated 4% stock = The market price quoted for the Consolidated 4% stock on this day was 59 8 /32 , which is approximately the gure from using the formula. Of course any other result would be worrying, as it would mean the market is pricing investments of identical risk and maturity differently. Summary: Valuation of Government Gilt Edged Securities Government xed interest nancial securities are the most riskless category of investments on most capital markets. Investors in government nancial securities are exposed to unexpected interest rate and ination rate movements. Valuation of gilt edged securities with a xed maturity and a xed coupon rate is based on the future income returns and nominal value received at the end of the maturity date, discounted to the present value at the redemption yield. The redemption yield will be the return sufcient to compensate investors over the lifetime of the gilt edged security. An undated gilt edged security promises to pay an innite stream of income to the holder. The coupon rate is normally xed and the value of the gilt edged security is calculated as a perpetuity.

Self test 5.1


Consider the following two gilt edged securities: market price Treasury 8% 2020 stock Treasury 10% 2009 stock 111 32 115 32
13 21

interest yield 7.16 8.66

redemption yield 6.87 7.09

Why is there a different coupon rate on the two stocks? Why do the interest and redemption yields of the two stocks differ?

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5.3

Corporate Fixed Interest Securities

In the UK, incorporated companies listed on the London Stock Exchange issue relatively few xed interest securities, such as debentures and loan stock. The development of the Eurobond market has enabled issuers to issue xed interest securities in different currencies to international investors. The Eurobond market is less regulated than the London Stock Exchange and is controlled by international banks and has developed in response to demand. Figure 5.8 illustrates the different scale of issues of equity nancial securities compared with xed interest securities on the London Stock Exchange.

Main Market Fact Sheet, London Stock Exchange Limited, London (2007) Figure 5.8: New and further issues by method (London Stock Exchange, 2006) Preference shares with largely xed dividends became unpopular in the UK after 1965, with the introduction of Corporation Tax on UK company prots. This created a difference between a dividend paid on preference shares (paid out of after tax prots) and interest (paid out of pre tax prots). Figure 5.9 shows a comparison of the tax treatment of 1 paid as a preference share dividend and 1 paid as interest on a debt security.

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1 paid as interest on debentures and loan stock Prot before tax and interest Interest Prot before tax Tax (at say, 40%) Prot after tax Dividends 2 (1) 1 (0.40) 0.60 nil 0.60

1 paid as a dividend on preference shares 2 nil 2 1 1 (1) 0

Figure 5.9: The differential tax treatment between a 1 interest payment and a 1 preference share dividend payment The 1 payment of interest reduces the tax bill by T (T = the tax rate), or in this case 0.40, as the tax rate is 40%. As the dividend is not a deduction from prot before tax is calculated, the cost to the company is 1. This differential tax treatment between interest and preference dividends has meant that preference shares are not so attractive compared to xed interest securities, as a source of corporate nance. Most of the principles regarding the valuation of corporate xed interest securities are the same as for valuing government gilt edged securities. One of the key distinctive features of corporate xed interest stocks is the size of risk premium applied by the market to different corporations issuing such stocks. Debentures and Loan Stock Investors in corporate debentures or loan stocks expose themselves to the ination and interest rate risk as does an investor in government gilt edged securities. The coupon rate is xed and therefore any unexpected changes in interest or ination rates over the life of the debenture or loan stock will affect the value of the stock. In addition to the interest and ination rate risk, there is the risk of the company issuing the stock defaulting on the payment of interest and/or capital payments. Recall that an investor in government gilts is secure in the knowledge that it is highly unlikely that the government will default on payment of the interest or capital. We know however that some companies do go bankrupt and are unable to pay all of their debts. The default risk for corporate xed interest securities is therefore positive, resulting in a default risk premium being added to the return required from government stocks which have little possibility of default. The formula for the valuation of debentures and loan stock issued by companies is exactly the same as for government gilt edged securities: Market value =
D (1 + r)1

D (1 + r)2

D (1 + r)n

(1NV + r)

Consider an example, valuing corporate xed interest securities. At the time of considering her investment in the 8% government gilt, (with a 10-year maturity), assume that Jean Arc has noticed that MXT plc have twenty-year debenture stocks currently in issue. The stocks have ten years remaining of their life and they offer a coupon interest rate of 12%. Heriot-Watt University Introduction to Finance

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The increased annual coupon return, (12% compared to 8%), above the government gilt return reects the fact that the two gilts were issued at different times and that therefore the coupon rate is reective of potentially different average coupon rates, but also a higher default risk for the MTX plc loan stock. Also the stock was issued at a different time, being already ten years old. MXT plc is a blue chip company, which means that it is a well-known and established company. The default risk premium is therefore relatively low compared to less well-known companies with a shorter trading record. Recall that in the United States the organisations Standard and Poors and Moodys classify corporate borrowers on scales from Aaa to C depending on their relative default risk. Assume MXT plc is an Aaa stock. Jean observes that the price of each 1000 unit of debenture stock in MXT plc is currently 1070. Jean wishes to compare the redemption yield (or yield to maturity) of the MXT plc stock with the 8% government gilt stock. Using the formula from Figure 5.4 (assuming interest is paid on the MXT plc stock annually): 1070 =
120 (1 + r)1

120 (1 + r)2

120 (1 + r)10

1000 (1 + r)

10

To nd r the process of trial and error is necessary. A calculator, computer program, or present value/annuity factor tables will perform this task more quickly but they will still require a number of iterations. To solve for this equation, using the present value and annuity factor tables in Appendix 1.1 and 3 at the back of this text, involves a number of steps. Step 1 Start with an estimate of r. Make an estimate of r using the following information: a) We know that if the market value is equal to the nominal (or redemption) value then r must equal the coupon rate. b) If the market value is less than the nominal value, there will be a capital gain on the stock if held to redemption and r will be greater than the coupon rate. c) If the market value is greater than the nominal value, there will be a capital loss on redemption meaning that r is less than the coupon rate. For the MXT plc stock therefore r must be less than 12%, (i.e. c holds true), as the current market price is greater than the nominal value. To nd r, try 11% as a discount rate to solve for the equation. Using the present value and annuity factor tables: Periods of n = 10; r = 11% Present value of 1000 Annuity of 120 Present value of future cash streams at 11% Heriot-Watt University Introduction to Finance = 0.3522 1000 = 5.889 120 = 352.20 = 706.70 = 1058.90

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Comparing this answer with the current market value: 1070 1058.90

It is however very close to the current market value. Step 2 If the rst estimate does not equal the current market value, solving for r, it is necessary to try a new estimate of r: a) If the estimate in Step 1 produces a present value greater than the current market value, the actual r must be greater than the discount rate estimate used in Step 1. b) If the estimate in Step 1 produces a present value lower than the current market value, the actual r must be lower than the discount rate estimate used in Step 1. As condition (a) holds for this example, a lower discount rate should be used as an estimate for r. Try 10%: Periods of n = 10; r = 10% Present value of 1000 Annuity of 120 Present value of future cash ow streams at 10% Comparing the answer with the current market value: 1070 Step 3 As r has not been found, it is necessary to continue the process of estimating r outlined in Step 2 until two estimates have been calculated whose products give present values one which is greater and another which is lower than the market value. In this case we have calculated the following: Present value of future cash ows at 11% Present value of future cash ows at 10% The current market value is = = 1058.90 1122.85 1070.00 1122.85 = 0.3855 1000 = 6.1446 120 = 385.50 = 737.35 = 1122.85

From this information we can now establish that r (or the redemption yield), of the MXT plc stock is slightly lower than 11%. To achieve a greater accuracy Step 4 is necessary. Step 4 To arrive at a closer approximation of the actual redemption yield a process known as linear interpolation can be used. This can only be used if two estimates have been reached which produce a present value either side of the current market value (see Heriot-Watt University Introduction to Finance

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Figure 5.10).

Figure 5.10: Linear Interpolation The formula for linear interpolation is shown in Figure 5.11. r = A% + (B% - A% ) where: A% = lowest estimate of r B% = highest estimate of r PVA = the present value of the future cash ows discounted at A% PVB = the present value of the future cash ows discounted at B% MV = the current market value For the MXT plc debentures: A% = 10% B% = 11% PVA = 1 122.85 PVB = 1058.90 MV = 1070 (PVA - MV) = 52.85 (MV- PVB) = 11.10 r = 10% + (11% - 10% ) r = 10.83% Figure 5.11: The formula for linear interpolation The linear interpolation formula simply weights the difference between the two estimates to nd the value of r. If the estimates are further away than the two shown in the example (say 2% and 20%), the linear interpolation formula would only give a very rough approximation of r. The formula involves effectively drawing a straight line between the Heriot-Watt University Introduction to Finance (1122.85 - 1070.00) (1122.85 - 1070.00)(1070.00 - 1058.90)
(PVA - MV) (PVA - MV) + (MV - PVB)

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two points estimated, in this case 10% and 11%, to nd r. Jean Arc has the choice between investing in the gilt offering a redemption yield of 8% (assuming no change in the market value since it was issued), or investing in a blue chip stock, MXT plc, with a redemption yield of 10.83%. The extra 2.83% (10.83% - 8%) reects the incremental default risk from investing in MXT plc compared to the default risk from investing in government gilt stocks. The Default Risk Premium As already mentioned there are relatively few issues of corporate xed interest stock in the UK. There is a more active market for corporate xed interest stock in the US however. As mentioned in Chapter 3 corporate stock (or bonds) in the US are typically categorised by the classication of the institutions, Standard and Poors or Moody. For example, companies classied as Aaa class, issuing xed interest bonds have the lowest risk of default. Companies rated as B class have a slightly higher risk of default and C class companies have the highest classication for the risk of default. The xed interest rate stocks issued by BB, B and C class companies are also known as junk bonds. Bonds in the different categories of risk will be expected to have redemption yields reecting their risk. Figure 5.12 and Figure 5.13 show the returns and volatility from the Merrill Lynch high yield index and the Lehman Brothers US Government Bond Index over the period from 1985 to 1995. The Merrill Lynch index incorporates the redemption yields from the Standard and Poors and Moodys indices for companies rated BBB-/Baa and below. The Lehman Brothers index incorporates a composite of redemption yields from US Government bonds of varying maturity over the period.

Source: Henry Schilling (1996), The International Guide to Security Market Indices, International Publishing. Reproduced with kind permission from International Publishing Figure 5.12: The International Guide to Security Market Indices

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1985 - 1995

Merrill Lynch high yield index 12.30 11.60

Lehman Brothers US Government Bond Index 9.57 6.67

Average Annual return (%) Standard Deviation (%)

Source: Henry Schilling (1996), The International Guide to Security Market Indices, International Publishing. Reproduced with kind permission from International Publishing Figure 5.13: The relationship between the returns and volatility of the Merrill Lynch high yield index and the Lehman Brothers US Government Bond Index over the period from 1985 to 1995 Figure 5.12 and Figure 5.13 indicate the differential returns and risk (as calculated by the standard deviation) of the two indices over the periods shown. The government bond index had a relatively low volatility over the period (with a standard deviation of 6.67%) though the average annual return was signicantly lower than the High Yield Index. Summary of the Valuation of Corporate Fixed Interest Securities Valuing corporate xed interest securities is a similar process to valuing government gilt edged securities, through the process of discounting the future cash ows by a rate which incorporates the risk of ination rate and interest rate changes and the risk of default. The rate which discounts the stream of cash ows to present value is known as the redemption yield or yield to maturity. The redemption yield incorporates both the income return and the capital gain or loss to the investor on redemption if an investor holds the bond until maturity. The interest yield (known as the current yield in the US) is only the interest coupon on the bond expressed as a proportion of the current market price. The key difference between valuing corporate xed interest securities and government gilts is the default risk premium required by investors in corporate bonds. This risk premium differs between companies issuing the bonds who will be perceived to have different risks of default by the market. Further, if the risk of default for a company issuing the bonds increases or decreases after the issue date of the bonds, the redemption yield is likely to change also. Recall that for Jean Arc investing in the government gilt involved principally only interest rate and ination rate risk.

Self test 5.2


Calculate the redemption yield of the following debenture stock (assume 10 years to maturity and that interest is paid in one annual instalment). 12% Debenture stock 2018 (market price is currently 975 per 1000 nominal value)

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5.4

An Introduction to Yield Curves

Comparing redemption yields of government gilts with differing maturities enables an investor to observe the market view of the expected movement in interest rates over time. At any point in time a yield curve can be drawn plotting the redemption yields of government gilts with different maturity. The slope of the curve plotted in such a way provides an indication of market expectations with regard to movements of future interest rates. In other words, if the market view of future interest rates is that they are likely to stay the same, the curve joining the redemption yields of gilts with different maturity, will take the form of a straight line. If interest rates are expected to increase over time, the curve will take the shape of an upward slope. If interest rates are expected to decrease over time, the curve will take the shape of a downward slope. Figure 5.14 illustrates the different shapes of the yield curve, under different assumptions of the movement of future interest rates.

Figure 5.14: Illustration of different shaped yield curves The relationship of the redemption yields and the time to maturity of government gilts is referred to as the term structure of interest rates. The theories underlying the different redemption yields on gilts of differing maturity will be considered more fully in another nance module on this course. What is important at this stage is to understand that issuers of long-term xed interest stocks, whether a government or corporate organisations, commit themselves to paying the coupon rate until the maturity date. High and volatile ination and interest rates experienced in the mid to late 1970s meant many UK companies were less inclined to issue debenture or loan stock with a xed coupon rate.

Self test 5.3


Do you think the yield curve for your country is currently at, upward or downward sloping at the moment? Explain your answer and in particular consider where you sought the information to give your answer.

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5.5

Review

Key concepts and issues covered in the chapter.: The valuation of government gilt edged securities. The valuation of corporate xed interest securities. Interest rate risk. Ination rate risk. Default risk. Interest yields. Redemption yields. Yield curves.

5.6

Conclusion

In most countries the least risky form of investments on capital markets consist of those securities issued by the central government. In the UK such investments are referred to as government gilt edged securities. In most cases government gilts are redeemable at some xed maturity date. If the gilt is irredeemable it offers the investor a perpetual stream of income. Gilts are valued on the basis of future interest receipts being discounted to a present value. The main risks from investing in government gilts are ination and interest rate risks, as there is virtually no risk of default. For corporate xed interest securities however, there is a greater default risk. The risk of default is correlated with the riskiness of cash ows from the activities of the organisations issuing the xed interest securities. Over time, markets expectations of interest and ination rates change and the yield curve of xed interest securities will reect this view. An investor can gauge the market expectations of interest rate movements by monitoring changes in the yield curve, (or redemption yields), of government gilts with different maturity.

5.7

Short Problems

Consider the following information with regard to questions 1 and 2. It relates to a government gilt edged security. Assume you are considering this information today, at time January 1, 19X0: Stock Exchequer 12% 19X9 Price (per 100 nominal unit) 110 Instalments Twice per year

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Q1:

What is the interest yield of the 12% stock?

A) 10.0% B) 10.9% C) 12.0% D) 13.3% Q2: What is the six monthly redemption yield of the 12% stock?

A) 5.1% B) 6.0% C) 10.2% D) 12.0% Consider the following information with regard to questions 3 and 4. It relates to a government gilt edged security. Assume you are considering this information today, at time January 1, 19X0: Stock Treasury 6% 19X5 Price (per 100 nominal unit) 95 Instalments Twice per year

Q3:

What is the interest yield of the 6% stock?

A) 6.0% B) 6.3% C) 12.0% D) 12.6% Q4: What is the six-monthly redemption yield of the 6% stock?

A) 3.6% B) 6.0% C) 6.3% D) 7.3% Consider the following information for answering questions 5 and 6. ABC Ltd issued corporate xed interest debentures in 1000 units, paying an annual coupon rate of 13%. The debentures have ten years until they mature. Their current market price is 1025 and ABC Ltd pay one annual instalment. Q5: What is the interest yield of the debentures issued by ABC Ltd?

A) 6.4% B) 12.0% C) 12.7% Heriot-Watt University Introduction to Finance

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D) 13.0% Q6: What is the redemption yield of the debentures issued by ABC Ltd? A) 1.0% B) 6.2% C) 12.5% D) 13.0% Q7: XYZ plc have xed interest loan stock issued in 1000 units, has six years until it matures. The loan stock pays 9% per annum in one instalment to investors. Since the stock was issued general interest rates have risen and investors now require 11% rate of return from the type of loan stock issued by XYZ plc. Using this information what is the present value of the loan stock of XYZ plc? A) 915 B) 959 C) 1000 D) 1085 Q8: The Consolidated 5% undated government gilt edged securities are currently priced at 65, per 100 nominal value. What is the market required rate of return? A) 5.0% B) 7.7% C) 12.7% D) 14.3% Q9: The market currently requires an 8% rate of return from undated government gilts. What is the market value, (per 100 nominal unit), of the Treasury 4% undated government gilt edged securities at this rate? A) 50 B) 100 C) 200 D) 1250 Q10: The market currently requires a 5% rate of return from undated government gilts. What is the market value, (per 100 nominal unit), of the Exchequer 6% undated government gilt edged securities at this rate? A) 83 B) 100 C) 120 D) 2000

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5.8

Tutorial Questions

Q11: Discuss the different risks to an investor from investing in xed interest nancial securities. Q12: Explain the differences between an interest yield and a redemption yield. What information do the two measures give to an investor in xed interest securities? Q13: What is the purpose behind the bond rating service provided by agencies such as Moodys and Standard and Poors in the United States(per 100 nominal unit) Why is such a service necessary?

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Chapter 6

Valuation of Ordinary Shares


Contents
6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concepts of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Information and Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Models for Valuing Ordinary Shares . . . . . . . . . . . . . . . . . . . . . Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 135 140 143 155 155 155 159

Learning Objectives On completion of this chapter students should be able to understand: the different concepts of value relevant to valuing ordinary shares; the importance of information availability and its value; different models for valuing ordinary shares. Summary The aim of this chapter is to introduce the key concepts and models which can be applied to establish the value of ordinary shares.

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6.1

Introduction

The problems underlying the valuation of ordinary shares has meant that establishing a valuation model has been a difcult task in the development of nance theory. The issues involved in establishing a price for ordinary shares is fundamental for many areas in nance covered in other modules of this course. It is a problem for the nancial manager of an organisation as well as an investor. The valuation of xed interest securities has fairly clear principles and implications for investors and organisations. The coupon rates are xed (or, if not, will be tied to the movement in the retail price index or the LIBOR) and normally there will be a xed maturity. Ordinary shares are more difcult to value because of the following factors. 1. There is income risk. Dividends are variable, not xed, and they have no xed maturity. Ordinary shares are also exposed to the risks covered in chapter 5: ination rate, interest rate and default risks. These factors usually have a different inuence on the returns from ordinary shares compared to their impact on xed interest security returns. For example dividends may increase in line with ination if the company can adjust its pricing to cover the impact of ination on its costs and sales. Fixed interest security investors, on the other hand, will suffer from any unexpected increase in ination over the life of their investment unless the return is index linked. 2. The rights of ordinary shareholders are wider than those of holders of other types of nancial securities in a company. There may be some extra value to an investor in holding a majority share holding of a company, in order to control the management in the organisation. So, for example, the market value of a collective majority holding of say 60% of the ordinary shares in a company may be greater than ten individual holdings of 6% added together. 3. Ordinary shareholders take the residual risk of the company. That is, they are entitled to share in what is left over of the annual prot earned by the business after all the other nancial security holders have been paid, and they share in what is left of the assets if the company is bankrupt. This means that the default risk of ordinary shares is larger than for other nancial securities. The risk of a business activity over its lifetime changes many times; nding a rate of return to discount the uncertain and risky future cash ows to a present value is problematic. 4. There are many different sources of information available which can be used to estimate the relevant future cash ows attributable to ordinary shareholders. This information can be of variable quality and relevance to a nancial decision-maker. Due to the risk and uncertainty associated with ordinary shares it is essential, for valuation purposes, that investors receive timely, relevant and quality information to enhance their estimates. For ordinary shares the theoretical valuation models rely heavily on the role of information to enable the nancial decision-maker to make an informed forecast of a risky and uncertain stream of future cash ows. In countries with developed capital markets there exists a signicant nancial services industry supporting the process of information dissemination. Analysts use various modes of analysis in order to interpret the effect of new information on the value of ordinary shares. In chapter 1 you will recall that we discussed briey two types of analyst, technical and fundamental, each of Heriot-Watt University Introduction to Finance

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whom use different information to establish a value for ordinary shares. Although problematic, the issues concerned with establishing values of ordinary shares make nance a challenging and interesting subject to study. It is a subject which helps to divide the practitioner dealing with the day to day advice and gathering of information relevant to the buying and selling of shares and the academic concerned with the principles underlying the valuation base. Chapter 7 will consider some of the mechanical processes of the stock market in terms of the availability and use of information and in particular the concept of an efcient stock market. The chapter will also cover the mechanisms for buying and selling ordinary shares through a capital market. For the moment we are concerned in this chapter with how shares are valued and the underlying concepts affecting an investors decision to buy, sell or hold ordinary shares.

6.2

Concepts of Value

There are many different concepts of value relating to ordinary shares. Later in the chapter, four bases for valuing ordinary shares; net assets, dividend, earnings and free cash ow will be discussed. It is important that you appreciate that the ordinary share is a claim on the future cash ows from the business and commercial activities of the company which issues the ordinary share. The risk of the ordinary share is linked inextricably with the risk of the cash ows from the activities in which the business is engaged. You will recall the concept of risk aversion from chapter 2. An investor will only invest if the expected return on the investment is at least equivalent to an investment in the next best investment of the same risk. If the expected return is less, the value of the share will fall until the expected return from the share is sufciently high to compensate for the risk undertaken by the investor. The valuation of an ordinary share is dependent on the investors perception of how an investment will inuence his or her own risk. This principle is fundamental in nance theory. There are, however, different values used with regard to business activities and relevant to establishing values of ordinary shares under different assumptions. Book Value Book value, in the context of valuing ordinary shares, refers normally to the values stated in the books of accounting records. An asset book value is the value of an asset in terms of the accounting principles used to record the asset and the changes in that value over time. Accounting records in the UK are based on the concept of historical cost. This means that for assets purchased for use in a business activity they will be recorded at their original cost. As the assets are used in the business activities, their costs will be matched to the revenue generated from their use. Consider the main categories of assets and liabilities and sources of long term nance in the balance sheet of many industrial and commercial companies, shown in Figure 6.1.

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Balance Sheet Fixed Assets Land and buildings Plant, machinery and equipment Motor vehicles Total xed assets Current Assets Stocks Debtors Cash Less Current Liabilities Loans repayable in 1 year Trade creditors Tax payable Dividends payable Net Current Assets (liabilities) Creditors due after more than 1 year Net Assets Financed by Share capital Retained prots Other shareholders reserves

( c)

d ( e) X

X Figure 6.1: Typical balance sheet categories of assets, liabilities and sources of nance The book value of all of the assets and liabilities in each category shown are recorded in the accounting records. Investors often compare the net asset value of a company with the net book value shown on the balance sheet from the accounting records. The net asset value refers to the value in open market from selling the asset (minus any costs of selling, hence net). Using net book values to establish the value of a company has the following problems: 1. Fixed asset book values are based on historical cost accounting principles Plant, machinery, equipment and motor vehicles will typically be recorded at their cost in the business accounting records. Each year a reduction in their book value is normally made to recognise the depreciation in the assets value. For example, a construction company buys an earth-digging machine, with an expected tenyear useful life. The machine costs 10000, and will have an expected re-sale value of 0 at the end of ten years. What will be the book value of the asset over each year of its useful life? Figure 6.2 illustrates the changes in book value of such a machine.

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Depreciation is 10000/ 10 years of useful life = 1000 per year. Figure 6.2: Example of the change in book value of the earth-digging machine Recording xed assets at their historical cost and depreciating their value over time is problematic. In some cases estimating the useful life of some assets such as land and buildings is very difcult. For example it could be argued that with continued business activity the value of a restaurant appreciates, rather than depreciates in value. There may therefore be a problem in writing off the cost of a restaurant over say a fteen or twenty year period. Increases and decreases in property prices can also cause problems if the value of land and buildings is stated at historic cost. If property prices fall (as they did in the early 1990s in the UK), many companies prudently reduce the value of their property to market value (i.e. less than historical cost). Accounting standards require managers to review the valuation of xed assets regularly. Book values may therefore reect a mixture of market and historical values of some assets. The problem for investors is to interpret the signicance of the net book values contained in a set of annual accounts as they will potentially contain a mix of historical costs, depreciated historical costs, and market values of different aged assets. 2. Intangible assets may or may not have a book value The collective book values of assets combined together in a business are only one aspect of the value of business activities. By combining together xed and current assets as a portfolio of physical assets, we must assume there is some greater value than if they were held independently. What this greater value may be may vary between companies and business activities. What is important is that there should be some added value. If there is not some added value, the businesses may be better off selling the assets separately rather than continuing their activities. Here is an example. Suppose you have developed an intelligent computer chip which can be programmed to discharge safely and efciently some of your household chores. For example, by providing details of your bank account, grocer, local theatre, favourite television programs and account numbers for payment of household bills, individuals can program the intelligent chip, when installed in a PC, to undertake a number of tasks such as paying all of your household bills, ordering groceries and arranging for their delivery, booking theatre tickets and programming the television and video and arranging for your favourite programs to be recorded. All of this without needing to lick a stamp to send letters! Patenting such a computer chip could be worth millions. The book value of the factory and equipment necessary to manufacture the chip may be a small fraction of what the business is worth.

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A patent to develop and sell a product or service is an intangible asset. Accountants struggle to measure objectively the value of intangible assets. An example of this is valuing a business brand name. Goods and services with a strong brand name may have a value to the business but this is not included in an accounting balance sheet because it does not have a historical cost attached to it and is difcult to estimate objectively. In 1990 Cadbury Schweppes valued brands such as Canada Dry and placed their values on the balance sheet as xed assets. The problem arising from such valuations is their reliability. As the company had not, in 1990, sold the brands separately, their value was subjectively estimated by the management of the company. The value of a brand name may uctuate signicantly. An example of this is the French company owning a common brand name of a bottled water product. In the 1980s the company was negatively affected by the announcement that the chemical benzene had leaked into one of its water treatment plants. The company took radical measures to retrieve all bottles of water which may have been affected from retailers shelves to minimise the damage to their brand name. The main point is that intangible assets may well have signicant value in some companies. The problem is that some companies value these assets; others do not. Also, the value at which such assets are recorded is inevitably subjective if they have not been recently purchased. 3. Working capital may be overstated Book values of current assets such as debtors (i.e. accounts receivable) and stock (i.e. inventory) may be overstated in the balance sheet. The current asset of debtors is only valuable providing that the debts can be recovered from customers. In other words if the customer is unable to pay the debt, debtors are not valuable. Bad debts may be a particular problem in retail companies selling a large proportion of their goods or services on credit. Companies making offers of buy now pay later to boost sales have found themselves in difculty in recovering all of their debts from credit customers. There should be an adjustment made to the debtors value by the accountant. The value of the current asset of stock can be reduced because of technical or physical obsolescence. In other words, the value of the stock may become less than the cost of producing or buying the stock, its book value. Fashion companies and highly technological companies are particularly prone to the effects of slow moving stock. Other companies exposed to potential problems in the book value of stock are construction and manufacturing companies with a relatively large proportion of their value invested in work-inprogress. Changes in retail values of property or nished goods may signicantly affect the working capital book values in such companies. In summary, net book values contained in business accounting statements are measured subject to the accounting principles applied. In reality, in a company balance sheet the book values may well be a mixture of both market and historical values. Market Values The concept of market value is central to nancial decision making. Market values are established through a process of a buyer and seller agreeing a price for an asset in an Heriot-Watt University Introduction to Finance

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open market. A business balance sheet based on the market values of the claims on future cash ows of the business activities, would look something like Figure 6.3. Balance Sheet based on market value Fixed assets values Current asset values Value of business investment opportunities Less market value of liabilities outstanding a b c ( d) X Market value of shareholder equity X

Figure 6.3: A market value balance sheet To try to understand the difference between book values and market values let us look at some companies listed on the London Stock Exchange comparing the net book values and market values of the shares. Figure 6.4 illustrates the differences in the book and market values of British Telecom. Book values as at 31 March 1997 (from the company balance sheet) Fixed assets Net current assets Less total long term liabilities Total equity shareholders funds Net book value per share; (12 018m/6 355m shares) Market value per share (at 31 March 1997) Figure 6.4: Comparing net book and market values The difference in the net book value and market value shown above illustrates the expected increase in value from British Telecom continuing in business. Biochemical, pharmaceutical and high technology industrial companies are examples of companies for which investors might be expected to pay relatively high market values compared to their net book values. Companies operating in mature industries with little prospect for future growth might be expected to have relatively low market values compared to net book values. Examples would be businesses operating in industries such as mineral extraction and tobacco product manufacture. Of concern to an investor is how the value of business investment opportunities can be measured. Forced Sale Values In 1991 the assets of a well known Scottish electrical retailer were handed over to the liquidator who was tasked with disposing of them to repay the creditors in the company. The company was primarily involved with retailing hi- and electrical goods and operated in many high street shops in major Scottish cities. Some of the prime high street sites Heriot-Watt University Introduction to Finance 21092 (4240) (4834) 12018 1.89 4.71

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were eventually sold off to one of their major competitors. Acquisition or rental of prime retail sites can be expensive for retailers. The sites were sold for a proportion of their book value, which represents the difference in value of an asset between it being used in business and as a forced sale. The companys creditors were at least fortunate that the companys assets were largely tangible, having alternative uses in other businesses. What value however might there be for a brand product name used by a company forced into liquidation? What if Pepsi-Cola nally succumbed to Coca-Cola and other soft drinks and could no longer operate as a going concern? (OK, this is probably an unrealistic example!). What though if the French bottled water company had not restored the condence of their consumers after the benzene scare in the 1980s? What might another mineral water company pay to sell bottles of this labelled water product? Intangible assets generally have a more uncertain value on forced sale. The use of a brand name can add signicant value of business investment opportunities when the product or service it is attached to is selling well. On liquidation this value becomes negligible for many brand names. An example of the successful use of a brand name across a variety of different products and services is Virgin. The name Virgin is clearly used positively in a wide range of different industrial and commercial activities from music publishing to air and rail travel, cola drinks, and nancial services. Where a company is continuing in business as a going concern valuing net assets on the basis of their worth on a forced sale is not so relevant for most investors. It may be of some use for comparing with market values, as a means of assessing a minimum return if the company encounters nancial distress. Remember however, that net book value is not the same as the forced sale value. In particular it may be difcult to recover book values of some stock items and xed assets. There will also be the associated costs of a liquidator and possibly considerable court costs in disposing of the assets on liquidation. Valuing a business on the basis of the price of assets on a forced sale, after deducting liabilities due and the associated costs of their disposal, is also referred to as the net realisable value of a business.

6.3

Information and Value

Information about the Value of Business Investment Opportunities Establishing market values for ordinary shares requires information about the value of business investment opportunities on which shareholders have a claim. Prospective ordinary shareholders of a company deciding to have its shares listed on a stock market are entitled to receive information about the companys prospects. This includes information about the management of the company, its business activities, the past trading record of the company and forecast prots. This information is made available in a document to all prospective investors and is known as a prospectus. The prospectus is used as the base from which the initial market value of the shares is calculated. In 1984 the British Telecom prospectus was issued in advance of the primary issue of the ordinary shares in the company on the London Stock Exchange. Before 1984, the company was nanced by the UK central government. At the time the British Telecom issue was the largest public issue of shares on the UK market. Investors eagerly awaited the issue price of each share establishing the price of the company. Once the company has shares listed on a stock market the main source of information about the value Heriot-Watt University Introduction to Finance

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of future investment opportunities is contained in the set of annual company accounts. A summary of the main features contained in a set of Annual accounts is shown in Figure 6.5. Contents of Annual Accounts

Chairmans Statement DirectorsReport

General statement about the performance of the company and its future prospects. Statement by the Directors explaining the key features of the prot performance by business area and analysing the nancial position. A statement of the company nancial position, with associated notes of explanation. Statement of the performance of the company over the past year, with associated notes indicating to shareholders how much prot attributable to them has been paid in dividends and how much has been retained in the business. A report showing the movement of cash in ows and outows over the period with associated notes explaining the source and use of cash. A statement by the auditor, appointed by the shareholders, giving an opinion on the nancial accounts presented by the management of the company.

Balance Sheet Prot and loss account

Cash ow statement

AuditorsReport

Figure 6.5: Summary content of reports in Annual Accounts Stock market regulations and company law legislation affect the ow of information required to the market and shareholders. Information relevant to the value of future investment opportunities may also come from sources outside of the company. For example, British Telecom is regulated by the governmental regulatory body, OFTEL, which monitors the business activities and pricing of telecommunications services. Other regulatory bodies, such as the Monopolies and Mergers Commission, monitor the effect of the business activities of British Telecom on the public interest, when they may involve merging with other companies. The ability of a company such as British Telecom to develop its business activities and future cash ow returns through the enhancement of technological developments, such as the information superhighway, can be signicantly affected by government regulatory agencies. Information about the decisions undertaken by such agencies is eagerly awaited by investors for assessing the value of future investment opportunities of British Telecom. Ordinary Share Analysis Assimilating, analysing and evaluating the importance of new information, relevant to the expected value of future investment opportunities, is the role of investment analysts. The methods employed by fundamental and technical analysts to arrive at investment

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decisions regarding ordinary shares were discussed briey in chapter 1. At this stage it is important to understand that, whatever the trading method used (e.g. using trends in share price movements, or dissecting fundamental company information), the task of the analyst is to evaluate a share price as being cheap, expensive or fair. Based on this evaluation the decision of the analyst will be to advise a buy, sell or hold of the ordinary share. Investment analysis of ordinary shares involves estimating an intrinsic value and calculating how far away market price is from the intrinsic value. Many analysts specialise in particular industrial and commercial sectors to build up knowledge of companies trading in specic sectors. Some smaller and medium sized companies, with ordinary shares listed on a recognised stock market, are targeted by some investment funds and analysts searching for shares which are either cheap or expensive. Such fund managers and analysts seek extra information to conrm that, based on a comparison of the intrinsic and market value of such shares, there will be an abnormal prot earned from buying or selling. An abnormal prot in this context means that by buying and selling the fund manager or analyst earns a return from dealing greater than is normal for the risk from such investments. The availability of regular market prices to compare intrinsic and market values exists only with shares listed on a recognised stock market. Unquoted Shares Companies whose ordinary shares have not been issued and listed on an organised stock market are referred to as unquoted shares. In countries with no developed stock markets ordinary shares will often be bought and sold through banks or other nancial intermediaries. Share dealings through such arrangements are referred to as being over-the-counter transactions. The banks, or nancial intermediaries, are concerned with matching buyers and sellers of the shares and such dealings do not have the same regulations as dealings made through a recognised stock market. Whether ordinary share values are listed on a stock market or not, shareholders will still require to transfer their waiting and sell part or all of their shareholding, rather than take dividends for an indenite period. The price at which the share will change hands between buyer and seller we can assume will be to each partys mutual satisfaction. Many Eurobonds are traded on the over-the-counter market. For many companies however there is no formal mechanism for nding willing buyers or sellers in unquoted shares. A valuation of a shareholding in such a company may be required in any of the following circumstances. 1. A shareholder in the company wants to acquire a greater shareholding, or to sell a proportion of his or her shares. 2. For taxation purposes the government may need to calculate the value of the transfer of shares in such a company to an individual inheriting or having shares transferred to him or her free of charge. 3. The company may be a target for a takeover or intend to become a listed company. For any of these purposes a business valuation is undertaken and the value of relevant shareholdings established. Countries such as Italy, for example, with a tradition for family managed companies may not be keen to relinquish control to a public ownership. Heriot-Watt University Introduction to Finance

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Many companies remain unquoted companies throughout their business life cycle. An example of a large Scottish unquoted company is DC Thomson Ltd. (whose principal business is newspaper publishing). The company has a turnover of millions and yet the companys shares have never been listed on a stock market. The voting control of the company for many years has remained within the control of the family dynasty. Establishing a value for an ordinary share in an unquoted company requires a model to be used in a valuation for one of the three instances referred to above. This is the purpose of the next section.

6.4

Models for Valuing Ordinary Shares

In this section four models for valuing ordinary shares will be described. As has already been mentioned, there is no easy method! The variability of income stream, and default risk associated with ordinary shares leads to problems of quite a different nature to valuing xed interest securities. What is important is that you understand that there are different concepts of value and that information plays an integral role in the valuation process. There are two important factors which you should remember about ordinary shares. 1. The nancial return is a dividend (which can be paid in instalments annually, semiannually or quarterly) paid from annual prots attributable to shareholders and/or a capital gain which is only received on selling the share at a price above the price paid for the share. 2. An ordinary share is a nancial security representing a claim on the future cash ows attributable to shareholders. You will recall that in Chapter 5 the important principle used in valuing xed interest securities was discounting the future expected cash ows, at the required rate of return of the investors, to a present value (i.e. their market value). The principle is exactly the same for ordinary shares, the process however being more complex. For ordinary shares it involves estimating what the variable cash ows will be, whether they will grow, and for how long they are likely to be received. This will involve estimating the expected future value of investment opportunities in the organisation under scrutiny. Net Asset Basis You will recall that the net book value of the net assets of a company is based on the accounting principles applied to the balance sheet assets and liabilities. The net assets basis of valuation assumes the net assets are disposed of in a forced salewith the expected disposal costs already taken into account. Consider an example, Toddler Products plc, a company manufacturing baby clothes. The current balance sheet net book values are shown in Figure 6.6, which also shows for comparison purposes the net realisable values if the net assets were sold.

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Toddler Products plc Balance sheet as at 19XX Net book value Fixed Assets Land and buildings Plant, machinery and equipment Motor vehicles Trademark Current Assets Stock Debtors Cash 20000 15000 5000 40000 Current Liabilities (30000) 10000 Less liabilities greater than one year old Net assets Financed by Share capital (50000 shares @ 2 par value) Prot and loss account 100000 200000 300000 Disposal costs 100000 52000 Notes: Net book value per share: 300000 50000 = 6.00 Net realisable value per share: 52000 50000 = 1.04 The number of ordinary shares in issue is 50000. Figure 6.6: Net book and net realisable values The calculation of the net realisable value of the companys net assets involves the following assumptions. The land and buildings have been independently revalued. Plant, machinery and equipment, and motor vehicles have been included at their estimated resale and scrap value. Heriot-Watt University Introduction to Finance (400000) 300000 10000 12000 5000 27000 (30000) (3000) (400000) 152000 500000 100000 50000 40000 690000 490000 40000 25000 0 555000 Net realisable value

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The company trademark is assumed to have a zero value if the company is liquidated. Stock value is estimated at forced sale value. The debtors value assumes that some of the debtors will not be recovered in a forced sale of the assets.; All liabilities will need to be paid in full and disposal costs have been estimated based on the costs of administering the forced sale. The net realisable value provides the investor with a minimum value for the company, Toddler Products plc. If the company is forced into liquidation immediately each shareholder will receive at least 1.04. This is a minimum value investors would expect as a return from their investment. It is relevant to shareholders in Toddler Products plc as it provides a value per share if the company goes bankrupt. It does not however give an indication about the future value of investment opportunities in the company. The next three methods attempt to place a value on shareholders share of the future opportunities and expected growth. Dividends Basis Holding Period Rate of Return A shareholder may hold shares in order to receive an unlimited stream of dividends. In other words, at the time of purchase if the shareholder has no intention to sell his shares at a future point in time and unless the company (which has issued the shares) has a nite life expectancy, the return to the shareholder will be a perpetual stream of dividends. Alternatively a shareholder may plan to hold the shares for a number of periods and sell at the end of the target period. If selling a share, the shareholder may expect to make a capital gain in addition to the dividends received from the share up to the date of sale. The shareholders expected holding period rate of return is shown is Figure 6.7 Expected holding period RoR = Expected Dividend Yield + Capital Appreciation Div n Pn - P0 P = P0 0 where: Div n = the expected dividends to be received over period(s) of n (the holding period) P0 = todays market price Pn = selling price of the share in period n Figure 6.7: Formula for a holding period rate of return (RoR) on an ordinary share For example, let us assume that a potential investor in the ordinary shares of Toddler Products plc is considering investing for one year. The expected dividend in the next year is 15p per ordinary share; the current market price is 500p and the investor expects the price to increase to 535p next year. What is the investors expected holding period rate of return?

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Expected holding period rate of return = HPR = 10%

15p + (535p - 500p) 500p

Figure 6.8: Holding period rate of return (HPR) for ordinary shares in Toddler Products plc The 10% is the investors expected holding period rate of return which clearly may be different to the actual holding period rate of return. With this information however, the investor can consider whether it is a reasonable return given the risk of Toddler Products plc. The investor may compare with other companies in the same category as Toddler Products plc and decide whether their return is reasonable. If 10% is too low the market price of Toddler Products plc will fall to compensate the investor sufciently to provide a comparable rate of return with the next best investment opportunity in the same risk class. Remember the concept of risk aversion. If the rate is higher than other investments in the same risk class, the market price of Toddler Products plc will rise until the return is equivalent to the next best opportunity. The Dividend Model - No Growth You will recall that the present value of a perpetuity is found by the formula shown in Figure 6.9. Valuing ordinary shares on the basis of a perpetual stream of dividends Formula for valuing ordinary shares using the dividend model (no growth):
Div 1 r

P0

where: Div 1 = the expected dividend in period 1 r = the required rate of return P0 = todays market price Figure 6.9: The Dividend Model: no growth For example, Early Days plc is a competitor of Toddler Products plc and has an expected dividend in the next year of 5p per share. 10% is the required rate of return for ordinary shares with the risk of Early Days plc. Applying the formula of the dividend basis no growth model would value one ordinary share in Early Days plc, at:
5p 0.10

50p

The problems with the dividend basis no growth model is that: it is too simplistic, allowing for no change in the expectation of future dividends; relatively small errors in forecasting the future perpetual dividend stream can be signicant in the effect on the share price. For example, trying a 7p dividend estimate in the competitors market value calculation leads to a share price of 70p. Dividend Basis: Constant Growth This basis is often referred to as Gordons growth model after Myron Gordon* who developed this model . The constant growth model alleviates one of the problems Heriot-Watt University Introduction to Finance

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with the no growth model. An estimate of growth is required to be forecast for future dividends. The formula is shown in Figure 6.10. * M.Gordon, Dividends, earnings and stock prices, Review of Economics and Statistics, May 1959 Formula for valuing ordinary shares using the dividend model (constant growth):

D1 (r - g)

P0

where: P0 = todays market price D1 = the next periods dividend r = the required rate of return g = the expected growth in the dividend Figure 6.10: The dividend model: constant growth As growth expectations in the expected dividend stream increase, the market value increases also. For example, the investor in Early Days plc may expect dividends to grow at a rate of 5% per annum. How will this change the value of one share?
5p (10% - 5% )

100p

The share price has doubled! The constant growth model assumes that the 5p dividend paid in the next period will continue growing at an annual growth rate of 5%. For example: Dividends in Early Days plc: Year 1: Year 2: 5p (1 + 5%) Year 3: 5.25 (1 + 5%) And so on indenitely. = 5p = 5.25p = 5.51p

Consider an investor choosing between Toddler Products plc and Early Days plc assumes the following information. The two companies are perfect competitors. Both companies are expected to pay a dividend of 15p in the next period. Toddler Products plc has a 7% expected growth in its dividend. Early Days plc has a 5% expected growth in its dividend. 10% is the required rate of return for the risk involved in the two companies. Valuing the two companies using the dividend model - constant growth:

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Toddler Products plc


15p (10% - 7% )

Early Days plc


15p (10% - 5% )

500p

00p

Rearranging the formula the expected return is: Dividend Yield + Growth =
15p 500p

15p 300p

In other words, the market prices will reect the perception of the expected future growth in dividends of the two companies. Investors assessing two competing companies with differential growth expectations will price the ordinary shares to incorporate the expected growth. Toddler Products with the higher growth expectations will therefore have the higher market value. Problems with the dividend basis constant growth model are the following: It does not allow for unequal growth. Is it likely for a company to have constant growth in its future investment opportunities? What about a company retaining all of its earnings and paying no dividend over the short term? In such cases valuing the returns as a share of future earnings expected from the growth in retained earnings may be more appropriate. If the growth rate exceeds the required rate of return there is a problem with the formula. Calculating the dividend basis with irregular growth rates is probably more reliable. Extremely high growth rates are unlikely to continue indenitely. The constant growth formula would give an innite sum for the present value of such an expected dividend growth rate. Dividend basis: Irregular Growth Given the fact that the dividend basis constant growth model is an oversimplication of reality, relaxing the assumption of constant growth allows a potentially more realistic model to be applied; this allows for varied growth rates between different future periods. The formula is shown in Figure 6.11.

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Formula for valuing ordinary shares using the dividend model (irregular growth): Div 1 (1 + r) and
1

Div 2 (1 + r)
2

Div n (1 + r)n

FVn (1 + r)n + 1

Po

FVn + 1 where:

Div n+1
n=i

r-g

Po = current market price Div 1 = dividend expected in period 1 Div n = dividend expected in period n Divn + 1 = dividend expected in the second period (n + 1) FVn +1 = the price of the ordinary share at the start of the second period n = the period over which growth is expected g = the growth rate in the second period r = the required rate of return of the investor i = the start period of the second period Figure 6.11: dividend model: Irregular growth For example assume that Poppett Products plc is a relatively young company with an expectation of high growth for ve years of 20% slowing to 8% thereafter. Assume that Poppett is in the same risk category as Toddler and Early Days, where r = 10% and that the dividend is 15p per share. How can we use the dividend irregular growth model to incorporate these growth assumptions? Using the formula in Figure 6.11 for irregular growth requires three key estimates. 1. The dividend expected in the next period. 2. The investors required rate of return. 3. The differential periods of growth. It is necessary to discount back the expected dividends to a present value (todays market value), using the required rate of return and the expected growth rates. Using these assumptions for Poppett Products and applying the formula in Figure 6.11: D1 = 15p r = 10% g (periods 1-5) = 20%

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Dividends D1 = 15p D2 = 15p (1.20) D3 = 18p (1.20) D4 = 21.6p (1.20) D5 = 25.92 p (1.20) g (periods 6 to perpetuity) = 8%: D6 = 31.10p (1.08)

= 15p = 18p = 21.6p = 25.92p = 31.10p

= 33.59p

FV =
n=6

33.59 (0.1 - 0.08)


1

P0 =

15p

(1.10) P0 = 1124p

18p (1.10)

21.6p (1.10)
3

25.92p 31.30p 1679.5 5 5 4


(1.10) (1.10) (1.10)

Using the formula, the expected dividends growing at 20% over the next ve years are discounted back to present value. At the end of ve years (if the investor is right!) they will be faced with an ordinary share with the expectation of a perpetual stream of dividends of 37.32p, growing at a rate of 8% per year. The last expression in the formula represents the present value of the perpetuity at the end of year 6. The most appropriate dividend basis to use clearly depends on the assumptions made with regard to the investors future cash ow expectations. In practice it is very difcult (for most mere mortals!) to estimate what the holding period is likely to be and the share price at that time. Estimating expected growth rates in dividends is not easy either. The key advantage of the dividend models is their relative simplicity. In practice, many managers do seem to use a long-term payment ratio for dividends. That is, many companies do not uctuate dividend payments wildly from year to year. This issue will be considered more fully in a later nance module of this course. Earnings Basis You will recall that in the process of valuing a nancial security, the security should be seen as a claim on future cash ows. If we can identify what the cash ows are likely to be, when they will be received and the rate required by the investor, we can calculate a present value. For the dividend bases the cash ows attributed to each shareholder are the dividends received, under different assumptions of growth. Dividends are the cash ows attributable to the ordinary shareholder. Earnings(or prots attributable to ordinary shareholders) are the income streams attributable to the company issuing the ordinary shares. As with dividends, unless the company has a nite life, the earnings stream will be a perpetual income stream to the company. To sustain the future income streams, the company will need to commit investment (which will need to be deducted from the future earnings streams). To calculate a price per ordinary share the present value is found by dividing by the number of ordinary shares. If the future growth assumptions applied in the dividend model are the same as those used in the earnings basis, the valuations will be equivalent.

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Investors in ordinary shares, you will recall, can receive their return in two ways: as a dividend or as a capital gain. Companies reinvesting most or all of their earnings to improve the future value of investment opportunities may be seen as having a high growth potential (i.e. the proportion of dividends to retained earnings, ie the pay-out ratio, will be relatively low). Some investors prefer to take their return from ordinary shares as a capital gain rather than mainly in the form of dividends. Investors requiring high cash dividends because of their consumption preferences will prefer high pay-out shares. The growth factor, g, will be adjusted to take account of the expected growth rates of ordinary shares with different dividend pay-out ratios. For example, consider two companies operating in the same form of business activity except for their dividend pay-out ratios. The company offering the lower pay-out ratio will have the higher growth rate applied. You will recall that as discussed in the previous section, the holding period rate of return on an ordinary share could be expressed as follows: HPR = Expected Dividend Yield + Expected Capital Gain Div 1 (P1 - P0 ) P0 P0 The expected capital gain incorporates the growth aspect in dividends beyond period 1. This assumes we can estimate the share price at the end of period 1. For Toddler Products plc the dividend yield is (from the holding period rate of return):
D1 P0 15p 500p

The capital gain was calculated as:


(535p - 500p) 500p

Adding the two rates together gives the expected return of the investor. If this is just sufcient for the investor given the risk of the activities of Toddler Products plc, then 10% is the required rate of return. If 10% is insufcient as a rate of return for investors the share price of 500p will fall until the rate of expected return will rise to a sufcient level to compensate the investors. If the rate of 10% is higher than that required by investors, the share price of 500p will rise with increased demand from investors, until it is at a level which gives an expected rate of return which is just sufcient to compensate investors for holding the share. The 7% represents the expected growth in expected return over the holding period. It is the expectation of an increase in return over and above the next periods dividend. In terms of earnings it will represent the return on the element of earnings by the company which is not paid out as a dividend, i.e. the retained earnings reinvested in the company to increase the future value of investment opportunities at some expected rate of growth. Let us assume Toddler Products plc has an earnings per share, (EPS), of 22.5p. The EPS = prots attributable to ordinary shareholders/number of ordinary shares in issue. The company is currently paying out 67% of its earnings, (15p / 22.5p = 67%). The remaining 7.5p per ordinary share is therefore being reinvested for growth. Toddler Products plc will earn a rate of return of 21.5% on the reinvested funds:

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Value of retained earnings =

Retained earnings Expected return on retained earnings Retained earnings = EPS (1 - payout ratio) = 22.5p (1 - 67% ) = 7.5p

The retained earnings will have a present value based on the expected rate of return from the business activities it is being used to nance. Assuming Toddler Products plc is to continue in business indenitely, the retained earnings stream is a perpetuity. You will recall that the investor is expecting a one period capital gain of 35p in addition to the dividend. This means that he is implicitly expecting a 21.5% rate of return for the retained earnings invested over the next period: Present value of retained earnings = 7.5p (y% ) 7.5p y= 35p y 21.5
7.5p (21.5% )

35p

Present value of retained earnings =

35p

We can now express the holding period rate of return formula as follows: D1 Present value of the retained earnings per share P0 P0 15p r= 35p 500p 500p r = 10% r We are back to where we started! All that we have done is to consider the implications of the investors assumption regarding expected dividend and capital gain return from holding an ordinary share in Toddler Products plc. Toddler Products plc will invest the 7.5p retained earnings in investment opportunities over time at a rate of 21.5%, if the present value of this perpetual stream to a shareholder is to be 35p. If investors expected the return from the retained earnings to grow by an extra 5%, the present value of the retained earnings would increase to:
7.5p (21.5% - 5% )

45.5p

The expected return on Toddler Products plc would now be:


15p 500p

45.5p 500p

3% + 9.1% = 12.1% Under this new assumption investors will buy the ordinary shares as the return expected is 2.1% higher than is needed to compensate for the risk in Toddler Products plc, 10%. The investor demand will increase the price to reect this expectation:

15p + 45.5p New market price

New market price = 605p Lets summarise the earnings basis. Earnings are the future income streams to a company. The EPS of most companies constitutes two aspects of return to an investor:

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a dividend and a return based on the use of the retained earnings within the company. In valuing the return from retained earnings in the company the investor will effectively estimate the return expected in the perpetual dividend stream received over time. The two bases should provide the same result. This may not however always be the case in practice because of the following problems. Earnings are calculated on the basis of accounting principles. The earnings gure is not necessarily cash. In almost all cases it will not be cash. Changes in the depreciation methods of xed assets provide one example of a non-cash item which may change earnings. Calculating the value of an ordinary share using an earnings basis requires an estimate of what the future maintainable earnings of the company may be. This gure is an estimate of what the company may reasonably attain based on their current investments and level of protability. Analysts calculating an earnings basis of valuation sometimes use a future maintainable earnings estimate. This estimate is then multiplied by a factor which gives an indication of expected future growth in the earnings estimate over time. This factor is called the price/earnings ratio: Price/earnings ratio (P/E) =
Market price Earnings per share

The average price/earnings ratio of different industrial sectors in the UK, as at March 4th 1998, is shown in Figure 6.12, together with the average net earnings yield, gross dividend yield and net dividend cover for each of the sectors as at the same dates. P/E Ratio General Industrials Consumer Goods Services Utilities Financials 16.46 24.90 24.28 17.53 23.80 Gross Dividend Yield % 3.52 2.58 2.63 4.21 2.77 Net Earnings yield % 3.02 2.34 2.13 3.37 2.27 Net Dividend Cover % 2.16 1.95 1.96 1.69 2.27

Figure 6.12: Industrial sector average ratios as at 4th March 1998. These ratios will be covered in more detail in Chapter 7. At this stage it is important for you to understand that an investor is concerned with the expected EPS. It may be the case that the most current EPS is not a good indicator for the future EPS. If the typical P/E ratio of a toy manufacturer (included in the sector, Consumer Goods)is currently 24.9, multiplying this with, say, the expected EPS of Toddler Products gives a very rough guide to what the market value of Toddler Products shares should be. We must be careful therefore in relying too heavily on reported EPS which may only be an approximation of what investors should really be interested in future cash ows.

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Free Cash Flows Basis The main principle, you will recall from valuing xed interest securities, was to establish the income received each year and the maturity date and then discount the cash ows back to a present value. This principle is the same for ordinary shares. We have looked at the dividend models which can be used under different assumptions of growth in the dividends received. Remember that the growth in dividends will be a function of the company increasing future cash ows over time from the business activities. In other words, the present value of a company can be expressed as the future cash ows from the existing business investments and all future business investment opportunities. Getting such information is not easy! For existing investments it may be possible to forecast future expected cash ows over their remaining expected lives, but what about any new investments which will replace them? What will be their expected growth? Free cash ow is dened as the positive cash ows generated by the business activity less the negative cash ows paid by the business. The negative cash ows includes the cost of investments made and all other outlays such as taxation and interest to debt holders before the ordinary shareholders can be paid. The present value of the expected free cash ows over time will equate to the value of the company. Unless the company has a nite life, this stream of free cash ows will be a perpetuity and can be expressed as shown in Figure 6.13. Formula for calculating the value of an ordinary share using the free cash ow basis: V0 = where: FCF = the free cash ow received into perpetuity; V0 = the present value of the company. Figure 6.13: The Free cash ow basis The problem of course is that we know that, in almost all cases, businesses have variable free cash ows because of the nature of their business and investment opportunities. In principle the free cash ow model is intuitively attractive as it embraces the concept of the time value of money and the importance of using cash ows rather than accounting prots. Using the model in practice is extremely problematic. The risk of the free cash ows can be addressed by the required rate of return but information regarding the free cash ow forecast per period is difcult to obtain. For these reasons the earnings and dividends basis of valuation is often used to approximate the expected growth in free cash ows over time.


n=1

FCF (1 + r)n

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6.5

Review

The key concepts learned in this chapter were the following. Net book values. Net realisable values. Market values. Net asset basis of valuation. Dividend basis with differing growth assumptions. Earnings basis. Free cash ows basis.

6.6

Conclusion

Establishing a value for ordinary shares is extremely difcult. Applying the same principles used for valuing xed interest securities, the free cash ows basis would be the preferred method. The problem with this method is the degree of uncertainty and risk associated with the future cash ows, creating difculties for forecasting. Also, it is unlikely that investors will have access to sufcient information to make forecasts for future cash ows. The ordinary shareholder takes the greatest risk that the company issuing the shares defaults on payments. The shareholder also has no guaranteed level of annual income, received in the form of a dividend. A number of alternative bases (to the free cash ow model) to value ordinary shares are used in practice. They include models based on the expected dividends and their likely future growth, earnings and net asset values attributable to the shareholder. The problem of each model is the difculty in estimating the expected growth factor. Net assets value is the most objective measure, although it is also the least informative for valuing a company existing as a going concern. The role of information in providing guidance to estimating the expected future value of growth opportunities in a company is vital. Chapter 7 will consider the functioning of the stock market in providing relevant information.

6.7

Short Problems

Q1: The most recent balance sheet of Charlton services plc indicates that it has a total net asset value of 1 500000. It has been estimated that selling the assets of the business separately, the asset values realised would reduce the total net asset value by 200000. It is also expected that there will be disposal costs of 150000 from selling the business. There are 50000 ordinary shareholders in Charlton Services plc. Using the net asset basis of valuation, what is the value of one share in Charlton Services plc? Heriot-Watt University Introduction to Finance

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A) 2.30 B) 23.00 C) 27.00 D) 30.00 Q2: Charlton Services plc has recently paid a dividend for the last nancial year, of 2.50 per ordinary share. The current required rate of return for the shareholders of Charlton Services plc is 10%. Assuming there is no expectation of growth in the dividend, using the dividend basis of valuation, what is the value of one share in Charlton Services plc? A) 2.50 B) 2.65 C) 25.00 D) 250.00 Q3: Charlton Services plc has recently paid a dividend for the last nancial year, of 2.50 per ordinary share. The current required rate of return for the shareholders of Charlton Services plc is 10%. Assuming there is an expectation of 3% growth in the dividend in future years, using the dividend basis of valuation with constant growth, what is the value of one share in Charlton Services plc? A) 2.58 B) 35.71 C) 36.79 D) 83.33 Q4: Charlton Services plc has recently paid a dividend for the last nancial year, of 2.50 per ordinary share. The current required rate of return for the shareholders of Charlton Services plc is 10%. Assuming there is an expectation of 3% growth in the dividend in the next two years and 2% thereafter, using the dividend basis of valuation with irregular growth, what is the value of one share in Charlton Services plc? A) 3 B) 30 C) 33 D) 83 Q5: Stiles plc is in the same industry as Charlton Services plc. The ordinary shares of Stiles plc are currently priced at 14.67. They are expected to pay a dividend of 1.10 in the next year and the ordinary shareholders in the company require a 10% rate of return. Using the dividend basis of valuation with constant growth, what is the expected growth in the dividends of Stiles plc? A) 2.50% B) 5.00% C) 7.50% D) 10.00% Heriot-Watt University Introduction to Finance

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Q6: Best plc operates in an industry which is declining. Ordinary shareholders expect to receive a dividend in the next period of 1. The dividend is expected to decline by 1% in future periods. Shareholders require a rate of return of 12% from the ordinary shares of Best plc. Using the dividend basis of valuation, what is the value of one ordinary share in Best plc? A) 0.88 B) 1.00 C) 7.69 D) 9.09 Q7: You intend investing today in one ordinary share of Stepney Contractors plc, and selling it after one year. The ordinary share price of Stepney Contractors plc is currently 8.50. You expect the share price to increase by 10% over the next year. You also expect to receive a dividend over the year of 0.75. What will be your holding period rate of return? A) 8.88% B) 10.00% C) 16.04% D) 18.82% Q8: You intend investing today in one ordinary share of Crerand plc, and to sell it after six months. You expect to receive a dividend during the six month period of 0.45 and the share price to increase by 20% to 6.00. What will be your holding period rate of return? A) 20.00% B) 20.07% C) 24.17% D) 29.00% Q9: You intend investing today in one ordinary share of Crerand plc, and selling it after six months. You expect to receive a dividend over the year of 0.45 and the share price to increase by 20% to 6.00. What will be your holding period rate of return in terms of an annual percentage rate of return? A) 40.00% B) 44.17% C) 58.00% D) 66.41% Q10: Giles Manufacturing plc has recently reported earnings per share of 1.00 per ordinary share and a dividend per share of 0.50 per ordinary share. Traditionally the company achieves a 17% rate of return on retained earnings. The current share price is 9.60. What is the rate of return investors require from Giles Manufacturing plc? A) 17% B) 17.5% Heriot-Watt University Introduction to Finance

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C) 34.5% D) 35.8% Consider the following information relating to questions 11 and 12. Jones Rivets plc has announced earnings per ordinary share for the most recent year of 50p. Shareholders require a rate of return from shares in Jones Rivets plc of 12%. Jones expects to earn a return of 20% from the investment in opportunities using their retained earnings. Q11: If Jones Rivets plc has a pay-out ratio of 40% what is the value of one share in Jones Rivets plc using this information? A) 2.50 B) 4.17 C) 13.50 D) 14.17 Q12: If Jones Rivets plc expects the return from investment opportunities, using retained earnings, to grow by 5% in the future; what is the value of one share in Jones Rivets plc using this information? A) 14.79 B) 18.33 C) 22.43 D) 24.29 Q13: Groovy Entertainment Ltd has been successful in being awarded the contract to set up a ve-year memorial exhibition for Duncan Revie, the founder of the town, Revieville. Groovy Entertainment Ltd has been set up specically for this purpose and will dissolve at the end of the ve-year contract. There are ten shareholders in Groovy Entertainment Ltd and they estimate that the future net cash ows over the next ve years will be: Free cash ows 0 - 200000 1 + 80000 2 + 80000 3 + 80000 4 + 80000 5 + 80000

The shareholders require a 13% rate of return from the free cash ows of this project. Based on the free cash ow estimates above what is the value of one share in Groovy Enterprises Ltd? A) 8136 B) 20000 C) 23328 D) 30328

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Q14: Arthur Clarke owns his own business, a newsagent shop, selling magazines, newspapers, tobacco and confectionery. He expects the business to have an indenite life and he expects his annual free cash ows to be 25000 per year. Based on a required rate of return of 12%, what would be the value of Arthur Clarkes business? A) 2083 B) 25000 C) 28000 D) 208333 Q15: Arthur Clarke owns his own business, a newsagent shop, selling magazines, newspapers, tobacco and confectionery. He expects the business to have an indenite life and he expects his annual free cash ows to be 25000 next year, and that they will grow at a rate of 5% per year in each subsequent year. Based on a required rate of return of 12%, what would be the value of Arthur Clarkes business? A) 3571 B) 26250 C) 357143 D) 500000

6.8

Tutorial Questions

Q16: Discuss the main problems in using the accounting net book values of business assets for establishing the value of an ordinary share using the net assets basis. Q17: Explain the main differences in the following methods for valuing an ordinary share: Net assets basis; Dividend basis; Earnings basis. Q18: Discuss the main problems in using either the dividend or earnings basis for valuing ordinary shares. Q19: Discuss the advantages and disadvantages in using the free cash ow basis for valuing ordinary shares.

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Stock Market and Investment Indicators


Contents
7.1 7.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Measures of Investment Return and Risk . . . . . . . . . . . . . . . . . . 7.2.1 Expected Return . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2.2 Variance and Standard deviation . . . . . . . . . . . . . . . . . . 7.3 Key Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3.1 Earnings Per Share . . . . . . . . . . . . . . . . . . . . . . . . . 7.3.2 Earnings Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3.3 Price/Earnings Ratio . . . . . . . . . . . . . . . . . . . . . . . . . 7.3.4 Dividend Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3.5 Dividend Cover . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3.6 Gearing Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4 7.5 7.6 7.7 7.8 Stock Market Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 162 163 166 169 170 171 171 172 174 174 178 181 182 182 185

Learning Objectives On completion of this chapter students should be able to understand: the calculation of expected returns from nancial investments; the calculation of the standard deviation of nancial investment returns; key nancial indicators about the performance of nancial investments and stock market performance; key nancial ratios relating to nancial investment. Summary The aim of this chapter is to introduce students to some of the fundamental nancial measures of risk and return and nancial ratios. The chapter will also cover some of the important features regarding the operation of a developed stock market.

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7.1

Introduction

The operation and performance of stock markets throughout the world are closely scrutinised. The performance of nancial securities listed on stock markets and the process by which they can be bought and sold affect an increasing number of individuals and industrial and commercial companies. Governments are concerned with the ow of funds through capital markets between the providers and users of nance and the degree of condence in the market. The number of persons owning shares directly or indirectly through a nancial intermediary, has increased in many European countries in recent years partly as a consequence of governments privatising public activities and services. In the UK the 1980s was a signicant decade for privatisation. The government was the only shareholder in British Telecom, the provider of domestic and business telecommunication networks in the UK, in 1980; however by 1986 there were 1.5 million investors. Shortly after British Telecom, British Gas, the electricity companies and the water authorities were also privatised. In the 1990s programmes of privatisation are continuing in other European countries such as France and Hungary. Privatisation has increased the ow of funds through stock markets and increased volumes of trading. Changes in technology have helped to change the nature of the buying and selling operations of many stock markets. Technological developments have also facilitated the ow of funds between world stock markets and investors in developed economies in the US and in Europe are increasingly investing in countries with an emerging stock market in order to nd opportunities for high future returns. Large multinational corporations during the 1980s and 1990s are using foreign capital markets to raise nance for their increasingly international businesses. In Europe the 1990s is witnessing another urry of cross-border corporate take-overs and mergers as the prospect of Europe becoming progressively more integrated with a unied currency becomes a fact. All of these developments have inuenced the operation of stock markets and the importance with which the performance of nancial securities listed on such markets is viewed. This chapter is concerned with understanding and interpreting signicant indicators of nancial securities listed on stock markets and the important measures of quality affecting the operations of stock markets. Acquiring a recent copy of the main daily nancial paper for your own country will help you relate and apply the concepts discussed in this chapter. In the UK the Financial Times is the main nancial daily paper containing individual share price and general market movements and indicators together with an invaluable nancial commentary on market and corporate issues. While this chapter does not aim to equip you with the necessary skills to be a market analyst or corporate nance executive, it will introduce you to some of the important features relevant for interpreting stock market movements and operations.

7.2

Measures of Investment Return and Risk

You will recall from chapter 2 the discussion on the concept of risk aversion. We said that rational individuals prefer to avoid risk unless they expect to be compensated for taking extra risk by a higher return. Applying this concept in making nancial decisions requires investors to have some measure of the risk and return of alternative opportunities for investment. To an investor the future expected risk and return from alternative Heriot-Watt University Introduction to Finance

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investments are critical in choosing between alternatives. Investing in ordinary shares has historically provided investors with the widest variation in possible risks and returns. You will recall from chapter 3 that the return on ordinary shares is not xed and that the ordinary shareholder ranks after all other providers of nance to the company for their annual return. If a company does well the ordinary shareholders are rewarded most; if the company does badly they suffer most. It is, however, important to distinguish risk from uncertainty. Few events in this world are certain. Many events we can observe do not have a nite list of possible outcomes. That is, if we toss a coin, roll a dice or spin a roulette wheel the possible outcomes from these actions can be measured. There is a fty-fty chance of the coin landing on a head. There is a one in six chance of the number two appearing on top after rolling the dice. There is a one in thirty-seven chance (including the number 0) of the ball landing on lucky seven on each spin of the roulette wheel. Business activities and share price movements do not, however, have such narrowly dened probabilities. You will recall from chapter 2 the analogy of the search for a dog in the forest. Knowledge gathered from hearing the bark of the dog, position and time of entry to the forest enabled the dog handler to make a probability assessment of the location of the dog, while the mist in the forest is analogous to the uncertainty of the location. Most business investment decisions will involve both risk and uncertainty. In other words businessmen will rarely be sure that all possible outcomes from an investment opportunity can be thought of in advance. This does not mean that in making decisions an investor will not attempt to assess the probabilities from alternative investment opportunities, it means only that the list is unlikely to be complete. For example consider the business investment decisions of the companies Eurotunnel and Eurodisney. Crossing the channel between England and France has been possible for many years by boat or aeroplane. The number of persons travelling annually provided Eurotunnel with some information about the size of the market they were to compete in, but before the link was opened the probabilities of the likely market share and possible extra running costs of the operation were extremely uncertain. Alternatively Disneyland and Disneyworld in the US could provide some information about possible costs and revenues in running large-scale theme parks, but what about the cultural differences in locating an American theme park on the outskirts of Paris, France? Not all outcomes can be objectively measured. This means that in most cases nancial decision-makers will be operating with uncertainty. We are concerned in this section, however, with what can be measured with regard to nancial investment and how to quantify the possible outcomes.

7.2.1

Expected Return

Suppose you were invited to participate in a dice game. The rules are simple. Each time the dice will be rolled you need to select one number, (from one to six). If the number you select comes up you win 5 from the dice thrower. If your number does not come up you lose 1. You will probably have realised already, (in fact I am almost certain!), that this is a zero sum game. In other words if you play this game long enough neither you nor the dice thrower will win or lose. Consider Figure 7.1 below which shows your nancial position given the possible outcomes if you select the number six.

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Number thrown 1 2 3 4 5 6 Total

Probability (equal chance of each number occurring) 0.166667 (or one in six) 0.166667 (or one in six) 0.166667 (or one in six) 0.166667 (or one in six) 0.166667 (or one in six) 0.166667 (or one in six) 1.0

Financial gain/(loss) -1 -1 -1 -1 -1 +5 0

Probability multiplied by the nancial outcome -0.166667 -0.166667 -0.166667 -0.166667 -0.166667 +0.833333 0

Figure 7.1: Financial outcomes from a dice game What does Figure 7.1 tell us about this game? It says that if you play the game long enough you will be no better off, or indeed worse off, than when you started the game. Your expected return is zero. In this context your expected return is synonymous with the average return. In other words it may be possible to play this game for a number of throws of the dice and be better off because number six appears more often than other numbers, but on average your return will equal zero. For example you may play for three throws of the dice and the number six appears once. Your payoff will be +5, -1, -1 = +3. Alternatively, after three throws if the number six does not appear, your nancial position will be -3. In other words although the probability will be that if you play the game long enough you will be no better off, it is possible that you may make a marginal gain or loss if playing for a relatively small number of throws of the dice. It is also important at this stage to consider that on each throw of the dice the possibility of a number six occurring is one in six. If number six occurs in six consecutive throws of the dice it does not mean that there is a lower probability of the seventh throw of the dice producing a number six. It will still have a probability of occurrence of one in six. The formula for calculating the expected return from an investment is shown in Figure 7.2.
n

Expected return =
j=1

Rj Pj

where R = The expected return if j occurs P = Probability of j occurring j = a possible outcome Figure 7.2: Formula for calculating the Expected return

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Now consider nancial securities. The concept of expected return in relation to ordinary shares will involve the combining of many probabilities of possible outcomes. The return on ordinary shares is not certain for the reasons outlined in chapter 3. Forecasting possible returns is complex. In chapter 1 you will recall that fundamental and technical analysts use different techniques to arrive at estimates. One starting point for a well established ordinary share is to observe previous period returns and construct probabilities based on previous period returns. Consider two securities, A and B. The returns from the two securities for the last six years are shown in Figure 7.3.

Figure 7.3: Previous percentage returns from two nancial securities Based partly on our observation of past returns, probabilities can be assigned to the possible returns in the future period. Of course we know that predicting returns on ordinary shares is not as simple as rolling a dice. There is uncertainty (the mist in the forest) which means that we cannot objectively determine all possibilities before investing. Figure 7.4 and Figure 7.5 illustrate the nature of the calculation of the expected return based on probabilities of the previous returns recurring. The calculation is simply the product of all the possible returns multiplied by their respective probability. Security A (%) (R) Probability (P) (j) -2 0.05 -0.1 +1 0.10 0.1 +7 0.35 2.45 +8 0.35 2.8 + 10 0.10 1.0 + 14 0.05 0.7

Expected return = 6.95% Figure 7.4: Expected return from Security A Security B (%) (R) Probability (P) (j) - 10 0.05 -0.5 +5 0.10 0.5 +9 0.35 3.15 + 12 0.35 4.2 + 18 0.10 1.8 + 25 0.05 1.25

Expected return = 10.40% Figure 7.5: Expected return from Security B You will notice that the expected return from each of the securities, 6.95% for security A and 10.40% for security B, is not expected to occur. In other words, if the possible returns identied are the only possible returns for each security, the return next year will not be exactly the expected return. The expected return simply tells investors that on average based on todays probabilities if they invest in security A for a period of ten years their average annual return from this security will be 6.95%.

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Self test 7.1


Using the information given in Exhibit 7.4 and Exhibit 7.5 which of the two securities, A and B, would you choose to invest in? Give reasons for your decision.

7.2.2

Variance and Standard deviation

Which security did you choose? In making your decision you should have noticed that although security B has the highest return it also has the widest possible spread of returns, (From -10% to +25% compared to security A which has a spread of returns from -2% to +14%). You may have chosen security A on consideration of this fact, as you prefer to take a lower risk alternative although the return is not so high. In this example the assessment of the risk involved in the two alternatives is relatively straightforward. As the number of probabilities of possible returns is increased for each security and the number of possible securities and combinations of securities are increased it becomes important to have a systematic measure of the dispersion of possible return around the expected (or average) return. The most common statistical measures used are the variance and standard deviation. Both these measures express the possible distance from the expected and can be used to estimate how far the actual return may be from the expected return. The possible returns need therefore to be assigned a probability of their occurrence. Although the issue of returns from investments and portfolios, (combinations of investments), will be discussed more fully in Level 2 modules it is important to note that many studies of portfolios of nancial securities nd that their returns over time conform to a bell-shaped pattern. Figure 7.6 shows a bell-shaped pattern of returns. It is also known as a normal distribution of returns. There are other shapes of distributions having a skewed appearance, with an incidence of a high number of low or negative returns or alternatively skewed to a high number of positive returns. These alternative shaped distributions of returns are discussed in later statistics modules. For the purposes of nance the normal distribution is most frequently used to calculate the measures of spread around the expected return. The shape of the curve indicates that a normal distribution of returns will have a larger cluster of possible returns in the middle and two thin tails of possible returns at the high and low ends of the spectrum. The variance and standard deviation formula is contained in Figure 7.7

Figure 7.6: A normal bell shaped distribution of returns around the expected return. Heriot-Watt University Introduction to Finance

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Variance =
j=1

(E(R) - Rj 2 Pj

Standard deviation =

Variance

The expression for the variance is the sum of the squares of dispersion of the possible returns, weighted by their respective probabilities. Figure 7.7: Formula for calculating the Variance and Standard Deviation Both of the securities A and B have relatively normal distributions. Security A has a 70% likelihood of yielding a return of 7% or 8% with a relatively low probability of a high (14%), or low percentage return (-2%). Similarly security B has a 70% probability of yielding a return of 9% or 12% and although the spread of returns are wider, there are still relatively thin tails for high or low returns. If distributions of possible returns conform to a normal distribution there is a 67% probability that the actual return will be within one standard deviation either side of the expected return and a 95% probability that the actual return will be within two standard deviations of the expected return. Of course this fundamentally depends upon the probabilities assigned to the range of possible returns forecast but it does provide the nancial decision-maker with a tool to consider risk systematically. Figure 7.8 illustrates the spread of possible returns and the respective probabilities for securities A and B.

Figure 7.8: Possible returns, from A and B Using the formula in Figure 7.7 the variance and standard deviations are calculated in Figure 7.9 and Figure 7.10 for securities A and B.

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Figure 7.9: Variance and standard deviation of Security A

Figure 7.10: Variance and standard deviation of Security B Figure 7.11 compares the expected returns and risks of the two securities. Security A Expected return Standard deviation 6.95% 3.37% Security B 10.40% 6.46%

Figure 7.11: Risks and returns of securities A and B Figure 7.11 conrms that security B is the riskier of the two investments, having a standard deviation almost double that of security A. An investor in security B, however, is compensated for the extra risk by a higher expected return. This principle of trading higher expected returns to compensate for extra risk was covered in chapter 2. You will recall that over most of the last century the standard deviations of a portfolio of ordinary shares on the major world stock markets, (ie investing in a weighted proportion of all shares listed on each market), was over 20%. The US was 21%; UK 24% and Japan 28%, (refer to Exhibit 2.4). Figure 7.12 illustrates the movements in the Financial Times FTSE 100 index over the ten years to illustrate the principle of price volatility.

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Source: FTSE Group, data as at March 30, 2007 Figure 7.12: FTSE 100 Index 10-year performance (GBP total return) The FTSE 100 is a share index of the top 100 shares traded on the London Stock Exchange. FT represents the Financial Times and ST is Stock Exchange. It is one of the most frequently used indices to measure the trend in the London Stock Exchange market. The FT All-share index represents all shares traded in the market. Measuring the risks and returns of nancial investments using the techniques discussed in this section will be covered in many other nance modules on this course. It is important that you understand the calculations discussed in this section.

Self test 7.2


Using the information given in Exhibit 7.11 which of the two securities, A and B, would you now choose to invest in? Give reasons for your decision.

7.3

Key Financial Ratios

Financial pages in a daily newspaper or magazine look fairly daunting to the inexperienced reader. Technological developments have improved the quality of information presentation. The volume of numbers and statistical analyses in the nancial pages can still be somewhat overwhelming. In this section we will look at some of the key nancial ratios which are most frequently quoted in the nancial media and consider their relevance to the nancial investor. In the next section we will consider the importance of more general market information and sector indices. You may already be aware of the importance of ratio analysis, also covered in the Accounting modules of this course. Ratios can be calculated to identify possible issues in the efciency or effectiveness of the management of company resources or in the availability of cash to pay the debts of a business. In this section we are concerned about a potential investor in a nancial security and what information may be relevant to him or her in making a nancial decision. There are vast quantities of accounting and other nancial information available about industrial and commercial activities of a general and company specic nature. It is Heriot-Watt University Introduction to Finance

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important that you do not get lost in the maze of information. It is therefore crucial that you ask yourself the purpose for which you are calculating a ratio in order to support a nancial decision. What extra information will the ratio provide? Is the ratio relevant in isolation or should it be compared? Should the comparison be against a trend or other competitors or indices to generate comparative information? It is only by asking such questions that you can properly evaluate your ratio calculation. As a nal word of warning be critical about the source of the information used for the components of the ratio calculation. If the ratio is based in part on accounting numbers, are the numbers based on sound and accepted accounting principles? If the numbers on which the ratios are based are reliable and if they are used with caution, nancial ratios can provide useful information. But beware of looking for one all encompassing gure to support your investment decision.

7.3.1

Earnings Per Share

An investor wants to know how his or her investment (or prospective investment) has performed. The return on an investment in a nancial security issued by a company will be linked to the performance of the company in its business activities. If the security is an ordinary share, its return is dependent on the cash ows emanating from the company activities. Typically business activity performance is reported on an annual basis. There are many ways for an investor to gather relevant information on the performance of a company which has issued the nancial security. The most signicant information about the business activities for most companies is in the form of their annual accounts. A summary of the content of a typical set of annual accounts is shown in chapter 6, Exhibit 6.5. The prot and loss account is contained in the annual accounts. This statement will reveal what proportion of the annual prot is shared by the ordinary shareholders of the company after all nancial claims have been paid. If the accounting statements record the prot for the year, (say, 5 million), is this not all you need to know as an investor? Well, not quite. You will want to know what share of the 5 million has been earned for you. If there are only 500 shareholders in the company, the prot attributable to you is 10000 (if you hold one share). If there are 5 million shareholders your prot share is 1. Earnings, in the context of the earnings per share (EPS) ratio, relate to the prots attributable to ordinary shareholders. This means it will be the prot gure after all costs, interest charges and company taxation liabilities relating to the prots for the period, have been deducted. The formula for the calculation is shown in Figure 7.13. Earnings per share =
Prot after tax Number of ordinary shares

Figure 7.13: Formula for calculating the Earnings Per Share It is important to note that earnings are not necessarily cash. Usually a company will retain a proportion of the earnings to re-invest in the future growth of the business and therefore only part of the earnings per share will be paid as a dividend. You will recall from the chapter on valuing ordinary shares, we said that, in nance, cash ows are important not accounting earnings. Well that is almost right. Increasingly companies are required to disclose information about the movement in cash ows over their accounting period. This is not as relevant as providing information about cash ow forecasts to an investor. Accounting earnings do however provide an investor with information on which to base a forecast of future cash ows and that is why the earnings per share is seen as an important indicator. Heriot-Watt University Introduction to Finance

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7.3.2

Earnings Yield

The EPS ratio gives the investor an indicator of business performance which, for one company, can be calculated over a number of different years to indicate a trend of performance. What happens when an investor wants to compare the performance of two different companies? Assume that there are two companies identical in every way except that one had 500 shareholders and the other had 5 million. As we have already seen the EPS will be 10000 for one company and 1 for the other. Does this mean that the rst company is a better investment? Of course not. It will mean that one share in the rst company will cost 10000 times as much as one share in the second company (if all else is equal between the two companies). How then can investors compare the earnings attributable to them as a proportion of what it will cost to invest in a share of these earnings? The earnings yield calculation is shown in Figure 7.14. Earnings Yield (% ) =
Earnings per share (EPS) Share Price

100

Figure 7.14: Formula for calculating the Earnings Yield (%) The earnings yield shows the EPS as a proportion of the share price. Both the EPS and the share price should be current. In other words it is the current market price of the share and the most recent EPS which are used for the earnings yield calculation. The earnings yield calculation provides investors with an indicator of the total return on their investment, as opposed to the dividend yield, which takes account only of the dividend return.

7.3.3

Price/Earnings Ratio

The Price/Earnings ratio (P/E ratio) is the inverse of the earnings yield. It shows how many times the most recent EPS is covered by the current share price. As with the earnings yield the most current EPS and share price are used. The P/E ratio can be interpreted in a number of different ways. One popular translation of its importance is that it is an indicator of a companys growth prospects. In other words, a company with a high P/E ratio has high growth potential and a company with a low P/E ratio has low growth potential. The underlying theory being that investors willing to pay a relatively high share price for a low EPS are expecting the current EPS to grow in the future. It is important that you treat this principle with some caution. The EPS can contain a number of different aspects of a companys performance. There will be the prots from normal operations of the company and also unusual transactions, not occurring in the companys normal pattern of trading. For example a company could report a windfall prot in any one nancial year from the sale of a business property, or subsidiary. This may be of such a scale that it signicantly alters the normal trading performance of the business. The reported EPS is high but it may be unlikely to remain as high in the future. Investors will build in this expectation into their valuation, which will be on the sustainable future prots. The P/E ratio for this company may therefore seem slightly lower than normal as the market realises that the current EPS is higher than it expects for the future periods. The calculation of the P/E ratio is shown in Figure 7.15.

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P/E ratio =

Share Price Earnings per share (EPS)

Figure 7.15: Formula for calculating the Price/Earnings ratio Investors tend to prefer using P/E ratios rather than the earnings yield to assess the future prospects of return from ordinary shares. It is however important to use caution if using the P/E ratio to support investment decisions. It is not necessarily the case that all high P/E ratio shares are sound investments and all low P/E ratio shares are poor investments. Some fund management rms rely on targeting low P/E ratio shares to pick potential bargains, (ie under-priced shares), for their investment portfolios. Consider also that P/E ratios between different market sectors are likely to differ, sometimes signicantly, because the industries have different growth prospects. For example a mature industry such as tobacco manufacturing does not have the same growth prospects as a highly technological market sector such as electronic and electrical equipment. On October 25, 1997 the UK Tobacco market sector in the Financial Times Actuaries share indices had a P/E ratio of 10.99 and the Electronic and Electrical Equipment sector had a P/E ratio of 20.53. Comparing the P/E ratio of a tobacco manufacturer with an electrical goods manufacturer would not really make much sense for an investor. It is more meaningful to compare a company P/E ratio with another in the same industry sector.

7.3.4

Dividend Yield

Investors wanting to know about the relationship between the income received from an ordinary share and the share price paid can calculate the dividend yield. The formula for a dividend yield is shown in Figure 7.16 Dividend Yield (% ) =
Dividend per share Share Price

100

Figure 7.16: Formula for calculating the Dividend Yield (%) You will recall that the ordinary shareholders in a company receive a dividend each year if the company declares one to be paid. The size of the dividend will depend on the company policy. The pay-out ratio is the proportion of the EPS paid as a dividend for the nancial year, the remainder of the EPS being re-invested by the company in investment opportunities for future growth. The dividend per share therefore is only one aspect of the shareholders return. You will recall, from the chapter on valuing ordinary shares, that the dividend model can be used to establish a current value per share under different growth assumptions. The share price will therefore incorporate the assumption of future growth in the return to shareholders. For example a company involved in high levels of long-term research and development, such as a bio-technology company, may well have small dividend pay-out ratios. The expected growth will be built into the share price, resulting in a correspondingly low dividend yield. It is important to use the same degree of caution with the dividend yield calculation as used for interpreting high and low P/E ratios. For example low dividend yields are the equivalent of high P/E ratios, in that they indicate that investors have an expectation of high rates of future growth in the current dividend per share. It is important to compare the dividend yield with companies in the same industrial sector and with sector averages to establish whether it seems relatively high or low. Has the pay-out ratio changed for the company over time? Assess any differences in the yield over time or in comparison with Heriot-Watt University Introduction to Finance

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other companies, against the information available from the company. Has the company diversied? Is it cutting back on some of its research and development activities? In other words compare the ratio calculation with the fundamental information about the company. Most nancial pages quote the gross dividend yield for each ordinary share listed. The calculation shown in Figure 7.16 is for the net dividend yield. The net dividend is what a company will pay to shareholders entitled to receive a dividend. For example if a dividend per share of 20 pence is declared for company X, each shareholder will receive a cheque for 20 pence multiplied by the number of shares held. In many countries a tax deduction is made by the company from the gross dividend per share, (ie the net dividend plus the tax payable on the dividend) before shareholders receives their return. To establish a gross dividend yield from the net dividend yield it is necessary to multiply the net dividend payable by a factor incorporating the basic rate of income tax. This is known as grossing up the dividend. The formula for grossing up a net dividend is 100/ (100-basic tax rate percentage deducted). For example if the basic rate of income tax is 20% the grossing up factor is 100/ (100 - 20) = 1.25. For company X their gross dividend will be the net dividend of 20p multiplied by 1.25, (which is equal to 25p). In other words the company is paying shareholders a dividend of 25p and deducting 20% as a collector of tax for the government, (ie 5p per share). The shareholder will receive 20p. If the shareholder normally pays the basic rate of income tax he or she will have no more tax to pay. If the shareholder pays no income tax, the 5p per share can be claimed back from the government. If the shareholder normally pays 40% income tax the government will require a further 5p per share of tax, (40% 25p = 10p, less the 5p already paid by the company). Figure 7.17 illustrates the process of cash movement in a UK company dividend payment. Company X Gross dividend 25 pence (Basic rate of income tax = 20%) Pays 20p to the shareholder Pays 5p to the government (20% 25p) Shareholder in Company X Receives 20p Shareholder paying no income tax: Receives 5p from the government (Total return 25p) Shareholder paying 20% income tax: (Total return 20p) Shareholder paying 40% income tax: Pays an extra 5p to the government(Total return 15p) Figure 7.17: The process of tax collection on UK company dividend payments Not all countries have the same process as the UK. Many investors prefer to gross up the dividend per share as there are many different categories of investors paying rates of tax below or above the basic rate. Because of this fact the net dividend yield only shows the return after tax for the basic rate tax-payer.

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7.3.5

Dividend Cover

Investors may be concerned about the sustainability of the dividend per share paid by a company. You will recall that the dividend yield does not take account of the element of the earnings attributable to ordinary shareholders which is re-invested in the company. To be reassured about the ability of the company to pay current dividends, the dividend per share needs to be compared to the EPS. The formula for dividend cover is shown in Figure 7.18. Dividend cover =
Earnings per share (EPS) Dividend per share

Figure 7.18: Formula for calculating the Dividend cover The calculation shown in Figure 7.18 will produce the net dividend cover. To nd the gross dividend cover the dividend per share needs to be grossed up as shown in the section on dividend yield. A dividend cover approaching 1 may be of some concern to an investor with regards both to the sustainability of current dividend levels and to future growth prospects, (as a dividend cover of 1 indicates that all of the EPS have been paid out). The same level of caution should be used in interpreting the dividend cover as is used in interpreting the EPS ratio.

7.3.6

Gearing Ratios

Gearing ratios (or leverage which is the American term) can be nancial or operational. A nancial or operational gearing ratio provides an indication to an investor of the degree of different xed commitments undertaken by a company as part of their business activities. Because a key concern for investors in a company issuing ordinary shares is the extent of the xed commitments to be paid in each nancial year before the shareholders are paid, such ratios can provide useful data. A company choosing to operate in a particular business activity effectively commits to nance the xed operating costs of the activity. The construction industry is an example of a heavily capitalised business sector where a company will need to nance high levels of long-term work-in-progress and equipment to conduct its business activity. A company in the construction industry would be an example of a company which is highly operationally geared. In other words the company has a high proportion of xed to variable costs of production, (ie costs which vary with the activity). A company which has high operational gearing has the difculty, in times of recession for the industry, of covering the high xed costs when they have lower levels of activity and therefore sales. An example of a relatively low level of operational gearing is management consultancy. The signicant assets of a company of management consultants are the skills of the consultants in supporting other companies business activities and problems. Financial gearing relates to the proportion of debt nance used by a company and the scale of the associated annual interest costs. You will recall that debt-holders are paid before ordinary shareholders. Investors are therefore concerned with how much debt interest is to be paid before they receive a share. To establish a broad indication of the level of debt nance a debt ratio can be calculated. This calculation takes the total debts owed by a company which are then divided by the total assets of the business, part of which are nanced by ordinary shareholders. There are a number of alternative ways of calculating the debt ratio. For example, in the formula in Figure 7.19, all of the long, medium and short-term debt nance is used to calculate the total debt. Some investors Heriot-Watt University Introduction to Finance

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and analysts prefer to use only long and medium term levels of debt. Other nancial gearing ratios take the total debt divided by the equity (shareholder nance). To provide some reassurance that the company can adequately cope with the current levels of debt, the interest cover ratio can be used. This ratio compares the prot before interest and tax and the interest payable in the nancial year. As with the dividend cover there is no one magical interest cover ratio to satisfy all investors. An interest cover approaching 1 would however clearly concern investors, as it would indicate that the company is currently earning just sufcient levels of prot to repay debt-holders. High interest cover ratios may indicate that the company has some exibility to cope with more debt nance should it need more for future expansion. As you will recall from chapter 3 there are however some tax advantages from debt compared with equity nance. A company which under-utilises its capacity for debt nance may therefore not necessarily be making the best decision for its shareholders. Figure 7.19 illustrates three common measures of gearing. It is important to note that there may not be sufcient information in the nancial accounts to make an accurate operating gearing calculation. This is because the ratio requires a breakdown of various costs into their behaviour with different levels of the business activity in order to establish if they are xed or variable costs.

Total debt 100 Net assets where total debt includes all short, medium and long term liabilities of the company. Financial gearing (Debt ratio) = Prots before interest and tax Debt interest payable

Interest cover =

Prot before xed costs Fixed costs Figure 7.19: Financial and operating gearing ratios Operating gearing = Figure 7.20 presents some nancial information extracted from two companies accounts -Locke plc and Voltaire plc. Figure 7.21 uses this information to calculate the nancial ratios discussed in this section.

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Balance sheet extract Fixed assets Current assets Current liabilities Net current assets Long term liabilities Net assets Financed by: Share capital Retained prots

Locke plc 10000000 1000000 -500000 500000 -3500000 7000000

Voltaire plc 9000000 1500000 -900000 600000 -1500000 8100000

5000000 2000000 7000000


Relates to short term bank loans

7000000 1100000 8100000

Ordinary share par value Number of ordinary shares Prot and Loss account extract Prot before interest and tax Interest payable Prot before tax Taxation (at 35% of prots) Prot after tax Dividends payable Retained prots Stock market information Current share price Market capitalisation

1 5000000 Locke plc 2000000 -480000 1520000 -532000 988000 247000 741000 Locke plc 3.95 19750000

0.50 14000000 Voltaire plc 2500000 -288000 2212000 -774200 1437800 862680 575120 Voltaire plc 1.57 21980000

Figure 7.20: Information for nancial ratio calculations of Locke plc and Voltaire plc

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Figure 7.21: Financial ratio calculations for Locke plc and Voltaire plc The usefulness of comparing the ratios calculated for the two companies is increased if the two operate in the same industrial sector of activity. If they are in the same industry, the earnings and dividend yields and P/E ratio comparison have a greater signicance. The P/E ratios of the two companies indicate that Locke plc has a greater expectation of future earnings growth than Voltaire plc. This is also reected in the dividend pay-out ratios of the two companies. Locke plc has a pay-out ratio of 25%, while Voltaire plc has paid out 60% of its EPS as a dividend. Notice that the earnings yield is a reciprocal of the P/E ratio, which means that the earnings yield of Voltaire plc is greater than the earnings yield of Locke plc. The reason for this is the same as for the difference in the P/E ratios. Investors perceive that the current earnings of Locke plc are expected to grow more than the current earnings of Voltaire plc. The dividend yields of the two companies reect the differences in payout ratios, which have already been mentioned. It is assumed that the share value has incorporated the differential growth expectation of the two companies, given the expected returns on the greater proportion of prots retained by Locke plc. The dividend cover clearly indicates that there is plenty of scope for future increases in dividend levels for Locke plc. Voltaire however has less scope for increasing its dividends at current earnings levels. Voltaire plc has greater exibility for raising more debt nance for investing in business opportunities as they have a low level of nancial gearing evidenced by their debt ratio and interest cover. Although Locke plc has a relatively high level of debt, a debt ratio of 57%, the interest payable on the debt is quite comfortably covered by current earnings levels. Investors may become concerned about Locke plc raising more debt nance, therefore increasing their nancial gearing. A dip in the current level of prots and greater levels of interest payable may concern existing shareholders about their return and the viability of the company if at some point it is unable to meet the interest payments. This issue is more complex than it may at rst appear. The important factors for consideration by a corporate manager deciding on the level of debt for the company are covered in more depth in a later nance module on this course. The current liabilities (short term bank loans) of each company are added to the long term liabilities, as they are interest paying.

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Self test 7.3


Acquire the most prominent nancial paper available in your country. Select a company with which you are familiar and which has its shares listed on the domestic stock market. Find the company in the share price listings in the nancial paper. Note the ratios in the paper for the company you have selected and compare them with companies in the same sector of industry. Write down what you notice when you compare the nancial ratios.

7.4

Stock Market Indicators

Movements in ordinary share prices are daily news in many countries. Routine movements in market prices of ordinary shares form part of the economic barometer for countries with a developed stock market. Emerging stock markets (ie those which may not yet be fully developed), are also increasingly scrutinised by world media as they attract overseas investment in search of potential growth opportunities. World stock markets are increasingly global in terms of the technology used in the transfer of shares between buyers and sellers. You will recall from chapters one and two that direct and indirect investment on stock markets has increased signicantly in many countries, spurred on in part by increases in the standard of living and the privatisation of many large previously government managed and nanced business and commercial activities. For many of these reasons the investors appetite for information to provide indications about stock market price movements and market growth expectations has increased in recent years. In this section of the chapter some of the key nancial indicators quoted in the media will be covered. The importance of comparing nancial indicators for companies operating in similar business activities has already been mentioned with regard to nancial ratios. Fortunately most nancial pages publishing nancial information about companies listed on a stock market categorise the companies into industrial sectors. This facilitates searching for close competitors for comparison of the key nancial ratios mentioned in the previous section. Figure 7.22 illustrates some of the nancial information about ordinary shares listed on a stock market typically available on a daily basis. Both companies, Aristotle plc and Plato plc, are operating in the Food producers sector. Of course in most markets there will be a longer list than two companies whose key ratios are shown.

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Figure 7.22: Stock market indicators for ordinary shares The information shown enables investors to compare relative differences in size, (market capitalisation), growth in current earnings, (P/E ratio), movement of share price and the income return as a proportion of the current share price (dividend yield). Investors in the two companies, Aristotle plc and Plato plc, have similar expectations of growth in the EPS of each company. Aristotle is the larger of the two companies in terms of market capitalisation and has a higher dividend yield than Plato plc. This is not necessarily a negative fact for either company. If Plato is reinvesting retained prots wisely in high growth business opportunities, the possible lower current dividend per share may be offset by future growth. It is worth noting at this point that investment analysts will typically re-calculate the reported EPS of a company. The analyst will attempt to express what may be termed a future maintainable EPS, which will be based on the performance of normal operating activities. Any future windfalls or costs associated with activities subsidiary to the normal operations will be incorporated but in a separate exercise to ensure the resulting earnings or losses are not confused with results from normal operations. Having compared the nancial information of comparative companies in the same industrial sector, an investor may wish to compare the nancial ratios of a company with the average ratios of the sector and against general market indices. A general market index is one which incorporates all of the shares, or a substantial number of the largest shares listed on the stock market. An example of the stock market indices in the UK is the Financial Times Stock Exchange top 100 index (known as the Footsie 100). This index shows the movement of the top 100 ordinary shares listed on the London Stock Exchange, ranked in terms of their market capitalisation. The FTSE All Share Index is an index of over 700 ordinary shares listed on the London Stock exchange. Invariably, because the FTSE All share index is weighted in terms of market capitalisation, movements on this index are caused most signicantly by the movements in the prices of the top 100 ordinary shares. Figure 7.23 illustrates the types of nancial information available in most stock markets with regard to stock market and sector indices.

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Figure 7.23: Stock market indicators for sector indices Investors in Aristotle plc and Plato plc can compare the nancial indicators of each company with the sector index and the general market indices. For example the P/E ratios of the two companies are lower than the sector average (calculated by weighting the P/E ratios of all companies in the sector in relation to their respective market capitalisation). The sector index would also suggest that Platos current dividend yield is quite well short of the average dividend yield for the sector. World market indices are now frequently quoted in daily nancial papers in many countries. This enables a truly international investor to compare relevant nancial ratios. Figure 7.24 illustrates some of the world market indices listed by the Financial Times and Standard and Poors World Indices service. The ratios shown are as at the end of the third week of October 1997. National and Regional Markets France Germany Hong Kong, China Japan Malaysia South Africa UK USA Pacic Basin US Dollar Index 227.28 221.55 356.89 114.24 248.65 320.77 321.05 387.77 124.50 Change on the day (%) -3.3 -4.1 -8.5 -3.3 -1.7 -5.5 -3.2 -1.8 -3.7 Gross dividend yield % 2.52 1.41 4.47 0.91 2.22 2.57 3.39 1.60 1.50 Year ago US Dollar Index 200.57 181.04 467.57 140.97 587.48 345.55 258.65 287.37 157.05

Figure 7.24: FT/S and P Actuaries World Indices: end of week 3, October 1997, Financial Times

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It is interesting to note the signicant differences in dividend yields between the different countries listed in Exhibit 7.24. Investors on the UK stock market have often been criticised for expecting high levels of dividend payments, which may be paid to the detriment of investment in long-term growth. When compared with the minimal yield paid by Japanese companies, the UK and Hong Kong yields are high. Also noticeable is the scale to which the stock market indices in Malaysia, Hong Kong and the Pacic Basin have fallen during the month of October 1997 when compared with their levels a year ago. The signicance of the movement in some stock market indices should not be overlooked. Investors often highlight signicant levels of P/E, earnings yield or dividend yield index movements as indicators that the market is overheating, or that there are bargains available. For example the October 1987 and October 1997 index falls in the UK were both preceded by the P/E ratio of the UK non-nancials sector index moving over 20. The analysis by some observers is that this is an indication that stock prices in the market have risen to include future EPS growth, which is unsustainable given the economic conditions.

Self test 7.4


Acquire the most prominent nancial paper available in your country. Turn to the page listing the sector and market indices for the Stock Exchange in your country. (If your country does not have an organised stock market purchase an international newspaper and turn to its nancial pages). Compare the returns and ratio data for the company you selected in self-test 7.2 and the sector and general market index ratios.

7.5

Review

The key concepts learned in this chapter were the following. Expected return. Variance and standard deviation. Normal distributions. Earnings per share. Earnings yield. Price/Earnings ratio. Dividend yield. Dividend cover. Financial gearing. Operating gearing. Interest cover. Stock Market indices. Heriot-Watt University Introduction to Finance

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7.6

Conclusion

Financial decision-makers require to understand and interpret key information associated with alternative investments. This chapter has considered some important mathematical tools and indicators which can be used to help provide greater insight into the investment decision. It is important that the tools are used with some caution to ensure they are used appropriately. For example, many nancial ratios rely on the EPS gure. This may be constructed from less generally accepted accounting principles. The EPS may be affected signicantly by nonroutine business operations, so that it cannot be relied on as a typical level of earnings. It should be remembered that many of the ratios are concerned with providing information to make a nancial investment decision today. It is therefore crucial that the most current measures of return and share prices are used. Comparison of ratios with relevant competitors and as a company trend over time may provide further information. Caution should be used in comparing company ratio information with companies in sectors with different expected growth.

7.7

Short Problems

Consider the following information with regard to questions 1-3. The following information relates to the possible return over the next year from an ordinary share investment: Return 3.00% 8.00% 11.00% 15.00% Q1: Probability 0.10 0.40 0.40 0.10

What is the expected return from the ordinary share?

A) 8.0% B) 9.4% C) 9.5% D) 11.0% Q2: What is the variance from the expected return of the ordinary share?

A) 3.01 B) 6.02 C) 9.04 D) 9.40 Q3: What is the standard deviation from the expected return of the ordinary share?

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B) 6.02% C) 9.04% D) 9.40% Consider the following nancial information relating to the company Copacabana plc, which is relevant for questions 4-10. This information is from the most recent nancial accounts and Stock Market listing information: Balance sheet extract Copacabana plc Fixed assets Current assets Current liabilities Net current assets Long term liabilities Net assets Financed by: Share capital Retained prots 750000 300000 1050000
Relates to short term bank loans

1000000 600000 -250000 350000 -300000 1050000

Ordinary share par value Number of ordinary shareholders Prot and Loss account extract

0.50 1500000 Copacabana plc

Prot before interest and tax Interest payable Prot before tax Taxation (at 35% of prots) Prot after tax Dividends payable Retained prots

450000 -66000 384000 -134400 249600 124800 124800

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Stock market information Current share price Market capitalisation

Copacabana plc 3.10 4650000

Q4:

What is the debt ratio of Copacabana plc?

A) 28.6% B) 45.4% C) 52.4% D) 54.5% Q5: What is the interest cover of Copacabana plc?

A) 1.9 B) 3.8 C) 5.8 D) 6.8 Q6: What are the earnings per share of Copacabana plc?

A) 16.64p B) 25.60p C) 30.00p D) 33.28p Q7: What is the earnings yield of Copacabana plc?

A) 5.37% B) 8.26% C) 9.68% D) 10.74% Q8: What is the price/earnings ratio of Copacabana plc?

A) 9.3 B) 10.3 C) 12.1 D) 18.6 Q9: What is the dividend yield of Copacabana plc?

A) 2.68% B) 5.37% C) 8.32% D) 11.89% Q10: What is the dividend cover of Copacabana plc? Heriot-Watt University Introduction to Finance

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A) 1.00 B) 2.00 C) 3.08 D) 3.61

7.8

Tutorial Questions

Q11: Discuss the benets and limitations of nancial ratio analysis to a potential investor in ordinary shares. Q12: Explain the difference between a net and gross dividend yield calculation. Q13: Discuss the use of sector and general market indices for an investor in ordinary shares. Q14: What is the difference between risk and uncertainty? Give an example of risk and uncertainty associated with a nancial investment to illustrate the distinction. Q15: What does the Price/Earnings ratio tell an investor about the prospects for an ordinary share investment?

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Contents
8.1 8.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concepts of Value: Relationships . . . . . . . . . . . . . . . . . . . . . . . 8.2.1 Economic Concept of Value . . . . . . . . . . . . . . . . . . . . . 8.2.2 Accounting Concept of Value . . . . . . . . . . . . . . . . . . . . 8.2.3 Financial Concept of Value . . . . . . . . . . . . . . . . . . . . . 8.2.4 Information and Value . . . . . . . . . . . . . . . . . . . . . . . . 8.2.5 The Finance Function . . . . . . . . . . . . . . . . . . . . . . . . 8.2.6 The Business Investment Decision . . . . . . . . . . . . . . . . . 8.2.7 The Business Financing Decision . . . . . . . . . . . . . . . . . . 8.2.8 The Dividend Decision . . . . . . . . . . . . . . . . . . . . . . . . 8.3 The Business Organisation as a Network of Contracts . . . . . . . . . . . 8.3.1 Implicit and Explicit Contracts . . . . . . . . . . . . . . . . . . . . 8.3.2 The Agent-Principal Relationship . . . . . . . . . . . . . . . . . . 8.3.3 Management Objectives . . . . . . . . . . . . . . . . . . . . . . . 8.4 8.5 8.6 8.7 Joe Xanadu: A Business Case Study . . . . . . . . . . . . . . . . . . . . . Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 189 189 191 191 192 193 194 195 195 196 196 198 199 200 202 203 203

Learning Objectives On completion of this chapter students should be able to understand: the role of a nancial manager in an organisational framework; the key nancial management decisions: Investment, nancing and dividend; the relationship between nance, economics and accounting theory; the relevance of the manager-shareholder, (agent-principal), relationship; the model of a rm as a network of implicit and explicit contracts;

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the relevance of the separation of ownership and management; the distinction between business and nancial risk. Summary The aim of this chapter is to introduce students to the organisational framework in which business nancial decisions are made and the important factors affecting the management objective function.

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8.1

Introduction

In chapter one of this module, some of the key relationships between nancial managers and the real and capital markets were discussed. In chapter two, some of the key concepts relating to nancial decision making were identied and explained. In this chapter we will consider the important concepts and issues affecting business decisions. Many of the ideas and concepts introduced in the rst two chapters are relevant to understanding the important features of business nancial decision-making. The agency concept will be re-visited when exploring the issues relevant to managers objectives. Also, the relevance of different business structures, identied in chapter one, to their effect on the separation of management and ownership of a business will be discussed. A nancial manager is concerned with making key decisions affecting the value of an organisation. The role of nancial manager involves allocating the resources of an organisation to achieve an objective. The key decisions made will therefore include the nancing of business activities and investing and distributing the resources generated from the activities. In later nance modules in this course there will be signicant attention focused on these key decisions taken by a nancial manager. Before it is possible to analyse these decisions more closely, it is essential that you understand the organisational context in which the decisions are made and the importance of the objective function in understanding how managers make choices. This chapter aims to introduce you to the organisational context and issues involved with making nancial decisions.

8.2

Concepts of Value: Relationships

In Chapter two you were introduced to the important concept of the time value of money and in Chapter four as to how we can measure the changes in the time value of money by calculating present and future values. Remember the important principle applied was the estimation of the timing of the receipt or payment of the cash ow attributed to the investment. Remember too, that it is future cash ows that are important to establishing the present value of an investment, not the past receipts or payments attributed to the investment.

8.2.1

Economic Concept of Value

An economist is concerned with the efcient allocation of resources within society. Economic income is based on the present value of future expected cash ows from an investment opportunity. Any change in a factor affecting the expected future cash ows should be reected in the present value of the investment opportunity. Economic income is consistent with the nance concepts already discussed and is relevant to a nancial decision-maker allocating resources. For example, consider a manufacturer of wool jumpers. In buying a new automated loom for knitting together wool jumpers, a manufacturer will consider the expected future costs of running the loom before investing (i.e. machine running costs, labour time operating the machine, material used and associated maintenance, heat and lighting costs). The manufacturer will also estimate the positive future cash ows from selling the

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jumpers. In performing this analysis it is presumed that the manufacturer will have regard for the time value of money. That is, they will consider the number of years expected life of the loom and when the expected sales and associated costs are likely to be received and paid. After this consideration, the manufacturer will be able to make a decision about whether the cost of the automated loom today is outweighed by the present value of expected future cash ows relating to the sales and costs of production from operating the machine. If there are more positive cash ows (in present value terms) than the cost of the machine, the manufacturer is likely to invest. If the cost of the investment is less than the positive cash ows, the manufacturer is unlikely to invest. Let us assume that the positive future cash ows do outweigh the cost of the loom, and the manufacturer invests. It is important to note that the expected future cash ows may well change over the life of the automated loom. If after one year of the investment in the machine the market for wool jumpers becomes buoyant, sales may increase. If the machine is less efcient than expected costs of maintenance, materials and fuel may increase. This will affect the present value of the investment, which will change from the original estimate. The difference in the present value of estimated future cash ows over the year represent economic income for the period. Figure 8.1 illustrates the concept of economic income in the context of making a capital investment decision. Based on a positive Net Present Value the manufacturer should invest. At period 0 the present value of expected future cash ows is 134937. At the end of period 1 the present value of expected future cash ows, discounted at 10%, will be: 25 25 2 + 25 3 + 25 4 + 25 5 + 1 (1.10) (1.10) (1.10) (1.10) (1.10) 25 25 25 25 + + + (1.10)6 (1.10)7 (1.10)8 (1.10)9 Present values (PV) = 128431

Figure 8.1: Automated Loom Machine: Ten year expected economic life Net present value (NPV) = + 34937 (+ 134937 - 100000)
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The present value change over period 1 will be equal to: 134937 - 128431 = 6506 This represents an ex ante (looking forward) economic income measurement. In other words the economic income for each period of the investment is calculated in terms of the decrease (or increase) in the expected value of the investment between each period.

8.2.2

Accounting Concept of Value

An accountant is concerned with making an ex-post measure of a business activity, in other words with looking at the historic returns achieved by a business. Accounting theory focuses on objective rather than subjective measures of business activity. The accountant will only therefore include a sale which has actually taken place in the accounting income (or prot), and not the forecasted income to be generated from a business activity. Another fundamental accounting concept is to match the costs and revenues associated with an activity over time. So, for example, a capital investment is matched with the expected useful life of the investment. Assuming a straight-line depreciation policy over the useful life of the machine (i.e for the loom investment, 100000 / 10 years) the depreciation of the capital asset will be 10000 per period. Figure 8.2 illustrates the accounting income from the loom investment over its useful life. For simplicity Figure 8.2 assumes that all of the cash ows from the loom (costs and revenues), are received and paid in each year, as expected. This means that the accounting income (before depreciation) is equal to the net cash ows for each period.

Figure 8.2: Accounting Income The economic income measure is different to accounting income. Economic income calculates the maximum amount the investor can effectively consume during a period such that they are as well off at the end of the period as they were at the beginning of the period. In the loom case, in period 1, this would be 6 506. Accounting income is concerned with calculating the performance of a business activity ex-post. Accounting income attempts to match the costs with revenues in the period of the business activity. The economic depreciation is effectively the difference between two periods in terms of the change in present values over the period. Economic income does not attempt to match costs with revenues.

8.2.3

Financial Concept of Value

The economic and nancial measures of value are closely related. The economic measure of income is forward looking, through the process of discounting future cash ows associated with investments to a present value. This is closely connected to nancial decisionmaking on the basis of calculating the net present value, in deciding whether to undertake an investment. Accounting income measures past Heriot-Watt University Introduction to Finance

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performance and may include accounting adjustments including depreciation and also timing differences in the receipt or payment of cash ows. The relevant concept of value in nance is to enable a nance manager to make decisions between alternative investment opportunities. In making such decisions, forecasted cash ows require to be estimated. You will recall the discussion with regard to the time value of money and the process of compounding and discounting from chapter 4. Calculating present values of future cash ows attributed to an investment opportunity is consistent with the economic income measure. Investment decisions made on the basis of the net present value calculation of future cash ows, is consistent with the economic concept of value.

Self test 8.1


Explain the difference between accounting and economic income.

8.2.4

Information and Value

In Chapter 2 you were introduced to the concept of an efcient capital market. Establishing values of nancial securities representing a claim on future cash ows from business activities requires an understanding of the activity and also some knowledge about the expected sales, costs and associated cash ows emanating from that activity. In the loom example (Figure 8.1), to establish a decision rule to invest it is necessary to forecast sales of wool jumpers, costs of production and the useful life of the process. The net present value placed on the business opportunity is a function of the quality of the information used. If forecasted sales have been too optimistic it may result in an investment yielding an actual return lower than that required for the opportunity. Over estimating the wool used in production process, may mean that costs of production are overstated and this will inuence the overall net present value and the investment decision made. In a world of perfect certainty all relevant information about the future cash ows will be known at the time of making the decision. In a world of uncertainty there will be imperfect knowledge of the different outcomes relevant to estimating future cash ows from investments. Information in an uncertain world, in the context of nancial decisionmaking is dened as the knowledge about probabilities relating to the outcome of factors relevant to investment decision. With this denition, it follows that imperfect knowledge of all relevant factors associated with estimating future cash ows from the investment may lead to an inappropriate allocation of resources. It is important to clarify at this point that although we may know all relevant factors at any one time relevant to making a decision, it does not necessarily mean our estimates will be the same as the actual result. In an uncertain world we cannot expect to be totally correct in estimating future cash ows. Valuation of nancial securities relies on the availability of an information set which includes knowledge of all relevant factors relevant to the claim on future cash ows associated with the nancial security. Let us assume that Tom and Jerry Ltd is the company considering investing in the automated loom. Both Tom and Jerry have equal shares in the company having this one project as its sole activity. Assume further that Tom and Jerry Ltd are a UK business and it sells all of its woollen jumpers to customers in the United States. Consider now the information listed in Figure 8.3.

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A rise in the US $ - exchange rate. A decline in the market demand for traditional woollen jumpers. An increase in energy prices. The introduction of a new competitor in the same market place.

Figure 8.3: Information affecting future cash ows from the automated loom Each of the four factors, indicated in Figure 8.3, could affect the future cash ows from the automated loom investment. The effect and probability of each of the factors should be incorporated into the expected future cash ows at the time the investment is being considered. For example, if the US $ - exchange rate changes from $1.5 - 1, to $2 - 1, this will mean that each woollen jumper is comparatively more expensive for the US customers who now must pay more dollars for the cost of each import priced in sterling. The change in exchange rate is therefore likely to have an impact on the sales of woollen jumpers and should be incorporated in the forecasted future cash ows expected from the automated loom project. The quality of the information used on which to base predicted exchange rate movements, and its impact on the sales demand of woollen jumpers, can be critical for the overall net present value of the project.

8.2.5

The Finance Function

Throughout this module we have referred to the nancial decision-maker in an organisation as the nance manager. In a sole proprietor business structure this is most likely to be the case. That is the owner of the business in many cases is the sales manager, production manager, purchasing manager, nance manager and, of course, chief executive! For a large business, with a sole proprietor, it is usual for some of the day-to-day operational decision making in the various functional areas to be delegated to persons employed as, for example, a nancial controller or sales representative. The strategic decisions of the organisation are taken by the sole proprietor, while he or she delegates the responsibility for carrying out the strategic plan to designated personnel (such as the nancial controller and sales representative). For example, a decision to target the sales of a new teddy bear teething product to a particular geographic area is a strategic decision. The frequency and type of contact with local retailers in the geographic area targeted is an operational decision for the sales representatives to make. In large incorporated companies the nance function is divided into different levels of decision-making also. As the ownership of a business organisation becomes separated from the management of the business activities, day-to-day operational decisionmaking is delegated. For an incorporated company the shareholders will appoint a board of directors, who are delegated with the authority to make the strategic decisions on behalf of the shareholders. This is illustrated in Figure 8.4

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Principal or Agent Shareholders Appoint Board of Directors

Decision-making authority Voting rights to appoint or re-appoint directors Strategic

Finance function

Finance director. Responsibility includes: the overall nancing strategy of the company, the capital investment strategy and dividend policy Financial controller or Treasurer. Responsibility includes: Day-to-day cash ow management, including the ow of working capital of the business and preparing capital investment appraisals

Appoint Line managers

Operational

Figure 8.4: The nance function in an incorporated company In a large incorporated company the nance function can involve large numbers of persons managing the day-to-day cash ows, reporting on the performance of the business activities (typically the accounting function) and preparing the capital investment appraisals of future business opportunities. A corporate treasurer (in some organisations referred to as a nancial controller) will be responsible for implementing the nancial strategy decided by the Board of Directors and he will report to the Finance Director. The corporate treasurer will have employees with varying responsibilities and seniority reporting to him and tasked with the operational implementation of the nancial strategy. It is the Finance Director who is responsible for managing the ow of cash between the real asset markets and the capital markets. The Finance Director has the responsibility to communicate information to the shareholders about the performance of the real assets and the nancial position of the company. The corporate treasury function will be involved with the collection of cost, revenue and cash ow information to enable the Finance Director to communicate a meaningful view of the business activities and for him to take strategic decisions affecting the future allocation of nancial resources.

8.2.6

The Business Investment Decision

The importance of understanding nancial implications of alternative investment opportunities is crucial for managers in business organisations of any size. Of course, this does not mean that all the major decisions are taken exclusively by nance managers! The sales, production, purchasing and personnel functions of an organisation all contribute in the generation of strategic ideas and to establish a nancial expression of expected cash ows from business investment opportunities. The nance function will need to ensure that the business opportunities available for investment are consistent with the objectives of the organisation, formulated into its Heriot-Watt University Introduction to Finance

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strategy. The business investment decision involves the organisation investing in real assets, managing them over their useful lives and generating a nancial return for the investors. The value added by the organisation in this process will be a measure of its success. Business investment decision making involves the selection of real asset capital opportunities for investment. This may involve acquiring tangible assets such as manufacturing equipment and property, or intangible assets such as the right to exploit a business idea or the right to use a brand name for a product or service. Examples of large business capital investments include: the channel tunnel project (building a tunnel underneath the channel between England and France); the Panama Canal project in South America; the construction of the Concorde aeroplane by Great Britain and France; the acquisition by the German company BMW, to manufacture and sell the brand name Rover motor cars.

8.2.7

The Business Financing Decision

To enable the business organisation to full its strategic objectives, investing in real assets, a company will sell nancial claims to the cash ows generated from the real assets. The nancial claims sold by a company take the form of nancial securities. The return on the nancial security may be xed or variable. Financial claims to the cash ows generated by business real assets may be traded on capital markets between investors. Examples of the type of nancial securities commonly issued by companies were discussed in chapter 3. The nance manager has the responsibility of raising nance by selling packages of nancial claims on capital markets. The process of selling nancial claims involves the nancial manager in disseminating information about the real assets of the business and their expected returns, to potential future investors. On developed capital markets the nature and process of the information provided to investors is closely regulated. For business structures unable to access capital markets, in order to sell nancial claims, the nance manager has a more restricted choice of nancial package. Unexpected changes to cash ows from real business assets can lead to short-term nancial problems. The nance manager will need to make an assessment of the forecasted cash ows from the real assets and ensure that the package of nancial claims sold can be repaid during the maturity of the real assets required. If real assets require a long time to yield the expected return, nancing their acquisition with xed interest securities requiring to be repaid quickly, can impose a critical nancial problem in the short-term. You will recall that an ordinary share is the most exible type of nancial security, as it has no maturity and the income return is not xed. Shareholders do, however, have an expectation of higher future returns to compensate them for the greater risk. A nancial manager is therefore in need of understanding capital markets and investors needs to most effectively nance business real assets.

8.2.8

The Dividend Decision

The need for a nance manager to understand shareholders is critical to the dividend decision. The cash ows generated from the capital investments in real assets can be re-invested by the business in real assets for future growth or held as cash within the business. Alternatively the cash may be used to pay an increased dividend to shareholders. The choice of dividend policy set by the nancial manager may provide Heriot-Watt University Introduction to Finance

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for relatively high or low dividends, stable or volatile dividends, as a function of the volatility and scale of the cash ows from the real asset investments. In reality, many academic studies in the US and the UK, have found that managers typically set a longterm dividend pay-out ratio. Short-term uctuations in the prots earned by real assets tend not to be reected in sharp upward or downward movements in dividends paid to shareholders. The most prominent of these studies was by J Lintner in 1956, who interviewed corporate managers in the US about their dividend payout ratio. Many studies in the US and the UK have conrmed Lintners ndings that managers do seem to prefer setting long-run sustainable dividends and they seem concerned that they do not decrease the dividend paid. Subsequent studies have found some evidence that dividends may be used as a nancial signal to capital markets about the future expected cash ows from real assets. In other words, nancial managers seem to behave as if the capital market will treat an unexpected movement in dividend policy (for publicly listed companies) as an indicator of future returns. The dividend debate will be considered in more detail in a later nance module on this course. At this stage it is important to understand that the dividend decision is not as straight-forward as a nancial manager checking whether there is some cash left in the bank to pay ordinary shareholders each year. Shareholders are likely to be concerned about their dividends. There are many factors as to why this may be, however. It is also worth noting, that average dividend yields on world stock markets can differ quite considerably, (refer to Figure 7.24).

8.3

The Business Organisation as a Network of Contracts

The nance function in a large company is required to serve a range of strategic and operational decisions. Managing the appraisal and acquisition of capital investments in the real assets markets and selling packages of nancial claims to the capital market is a complex task. Performing this task requires the nancial manager to engage in contracts on behalf of the organisation. In some cases the contractual obligations required of the organisation are very clear, such as the repayment of a bank loan by instalments. In other cases the obligation is less clear, such as shareholders expectations of a business organisation. Understanding the nature of the contracts engaged in by an organisation can help to explain the nature of the decision-making process faced by nancial managers. To make capital investment decisions on behalf of an organisation involves managers choosing alternative packages of real assets. To assess which investment to choose, nancial managers need an objective function. That is they require a method, which will discriminate between alternative investments. Some business investment opportunities may be very risky with the potential for expected high future returns, while other investment opportunities may offer relatively modest returns with low risk. Which type of investment should the nancial manager choose? We will look at this issue later in this section.

8.3.1

Implicit and Explicit Contracts

Consider an ordinary day in your life and consider the number of contracts you enter into. Let us assume that you have agreed with your living partner(s) that you will attend to the weekly food shopping on this day. In going to buy your food shopping, perhaps Heriot-Watt University Introduction to Finance

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you get on a bus. You buy a ticket. You get off the bus and purchase your groceries. You have made a number of contracts already. Buying a ticket for the bus is a contract you have engaged in with the bus company. The obligation for you is to pay the bus fare and for the bus company to take you safely to your destination. You have bought groceries, which is also another contract with the shop who agree to exchange the goods at a price and a quality to your satisfaction and you agree to pay for them. You have also engaged in an implicit contract with your living partner(s), to attend to the shopping. Although this is an informal contract, if you do not purchase the goods on this day you will not have fullled an obligation expected of you. Also do not forget that your home, however it may be nanced, is likely to involve some form of contract to purchase or rent. Your water and energy services, telephone and television are also provided under some form of contract, which affects your life on a daily basis. Imagine, therefore, the complex network of explicit and implicit contracts, which are engaged in by a nance manager on behalf of a business organisation. In Figure 8.5 there is a list of some of the main parties contracting with a business organisation. Customers Shareholders Creditors (accounts payable) Suppliers Government Employees Management Communities Society

Figure 8.5: Main interested parties in a business organisation. The list is in no particular order. Some of the categories listed have a very formal and explicit contract, such as customers and suppliers (with conditions of trade agreed at the point of sale). The government will stipulate in legislation the requirement of a business organisation to pay tax on specied dates at a specied rate and that a company should abide by the laws applying to their business activities. For a creditor providing a xed interest loan over a set period of years, the obligations of the organisation to repay the loan will be specied clearly, together with any restrictive covenants. Employees will normally have a contract, which will stipulate their wage or salary and job description. It may be however, that there is a less explicit contract in some cases, where the employee expects, implicitly, reward in the form perhaps of promotion after a set period of years of devoted service. Or perhaps the employee expects their role in an organisation to improve their self-esteem. It is also possible that an organisation can play a dominant role in a community, by helping to support other businesses, relying on their trading with the organisation in order to continue to exist. There can be a very high social cost if an organisation ceases to survive. It can Heriot-Watt University Introduction to Finance

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be sometimes difcult to quantify, as it could involve skilled tradesmen and women becoming unemployed and the decay of local infrastructure, such as schools and other public services, as a consequence of an organisation in an important industry ceasing to exist. This may seem a long way from the role of a nancial manager. The survival of the organisation is clearly in the interests of each of the parties listed in Exhibit 8.5. If we were to say however, that the objective of a business organisation is to survive, it only explains part of the story. What about the shareholders? You will recall that they shoulder the greatest share of the risk of a business. Would they be satised with a business surviving? The concept of risk aversion tells us that if an investor takes risk they expect a return from the investment to adequately compensate them. We would expect therefore, that the shareholder in a business organisation will expect some value added to their investment. How much value added is not known with certainty however, as the return on an ordinary share is not xed. Viewing a business organisation as a network of contracts between interested parties, enables us to appreciate that the task of a nancial manager is to manage the contracts such that each contracting party is satised that the obligation to be fullled by the organisation has been met. Viewed in this way, the manager can be seen as satiscing the contracting parties. Or, in other words, ensuring that each party is satised with their contribution from the business organisation.

8.3.2

The Agent-Principal Relationship

A common collective term for the interested parties identied in Figure 8.5 is stakeholders. In a business organisation owned and managed by the same person(s) (i.e. sole proprietors and partnerships), the manager can be assumed to make decisions which are consistent with the shareholders interest. What about organisations which have a separation of management and ownership? Once a business begins to expand, it becomes natural for the ownership of the organisation to separate from the management. Large public limited corporations, such as British Telecom in the UK and IBM in the US each have over 5 million shareholders. Is it possible that managers continue to pursue goals for all of the shareholders? In organisations with a separation of the management function from the ownership of the organisation, the relationship between the shareholders and the managers is known as the agentprincipal relationship, where the shareholder is the principal, who appoints the business organisations management, as their agent. What does this distinction actually mean? You will recall in chapter 2, that the agency concept was discussed in the context of the managershareholder relationship. Applying the concept of self-interest it would be reasonable to assume that shareholders want managers to maximise their wealth. In the context of their investment in the business this will translate to increasing the share price and/or the dividends paid. Applying the concept of self-interest to the manager it may be reasonable to assume that a manager will be concerned with his own survival and wealth position. This last statement may however be somewhat simplistic, as there are a number of factors which may mean that a lazy and incumbent manager may not survive for very long looking only after their own interest. Shareholders may vote against the reappointment of the manager or the organisation may be the subject of a takeover by another organisation, removing the existing management in the process. Is it reasonable therefore to suggest, that managers will be forced into adopting policies

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and taking decisions, which are consistent with maximising shareholders wealth? Well, not quite. In order to remove the existing management of an organisation it is necessary for shareholders to muster sufcient votes to appoint an alternative. In a large diversied shareholding it is very difcult to achieve this. However, there is still a question of whether normatively, the manager should be concerned solely with maximising the shareholders wealth?

8.3.3

Management Objectives

This chapter is concerned with exploring the role of the nance function and, in particular, the role of a nancial manager in a business organisation. Understanding the objective function of managers facilitates an understanding of their role. If it is accepted that maximising shareholders wealth is the objective function of managers, we can assume that the investment and other decisions they take as agents of the shareholders, will be on the basis of improving the share price and/or dividend return to the ordinary shareholder. If, however, it is considered that the managers objective should have a broader denition than exclusively maximising the shareholders wealth, the role of the manager in making decisions has a wider dimension. It is important to understand the implications of the objective function of managers. Does maximising prot mean maximising shareholder wealth? You will recall that maximising shareholders wealth is equivalent to increasing dividends and/or the share price. If a manager aims to maximise prots, there needs to be a denition of which years prots? This year? Next year? Every year? You will recall also that prots are not necessarily cash ows. Although they will include cash ows, they will also include accounting adjustments which managers decide to make, based on their accounting policies. Managers can therefore potentially manipulate accounting prots from one period to another, which creates a dilemma if the manager can manipulate the target he needs to achieve. Maximising prots, therefore, could lead to a manager achieving something less than maximising shareholders wealth. It has been a recurring theme of this module that it is cash ows, not accounting prots, which are important to nancial decision making. This does not mean that a manager does not (or should not) consider the impact of nancial decisions on reported prots. It does however mean that the manager should consider the timing of the receipt and payment of cash ows emanating from investment opportunities. If the manager is maximising shareholders wealth, it is the cash ows from the investment which are attributable to the shareholders which are important (after all deductions have been made). It is also the extra risk faced by shareholders which is important in considering whether to accept an investment opportunity. For example, a company producing steady and unspectacular results is faced with two investment opportunities. One investment involves the extension of the existing business, with similar risk and expected returns as the present business assets. The other investment opportunity would involve the company in a new business activity, involving a wide range of possible returns. It may lead the company to spectacular prots, or alternatively lead to nancial difculties if unsuccessful. The shareholders may take the view that they would wish the manager to take the risky option while the manager, concerned about the possibility of a nancial crisis, may favour the less risky option. Why might this be so? Shareholders, you will recall, have limited liability. This means that if the company is in nancial difculty they cannot be asked for more cash

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than the limit of their investment. Also shareholders will typically invest their wealth in more than one company, so that if the investment is unsuccessful they will not lose all of their wealth. This is consistent with the concepts of risk aversion and risk diversication. A manager, however, has a physical investment in the success of a company and is not therefore diversied. The objective of a nancial manager in a company, particularly one with a large number of shareholders, is a complex issue. It is important that you understand that the issue is crucial in assessing the performance of nancial managers in incorporated companies. In business structures such as partnerships and sole proprietors, the issue is less signicant as there is usually less, or no, separation of management and ownership of the business. We will return to the issue of management objectives in later modules of this course when considering the capital investment choices made by managers of incorporated companies.

8.4

Joe Xanadu: A Business Case Study

To appreciate some of the complex issues raised in this chapter it is helpful to try and understand their application to a business situation. In this section the development of a ctional business, formed by Joe Xanadu, is outlined. It is not designed to be typical or indeed the exclusive way in which a business structure evolves. It simply attempts to illustrate some of the key issues raised in this chapter. Stage 1 development Joe Xanadu develops a business idea selling interactive multimedia adult games, he has authored, as compact discs. The 10000 nancing requirements of the business is largely for the specialist equipment, as Joe works from home and has no employees. Joe invests his savings of 5000 and obtains a 5000 bank loan for the difference. The business achieves an average annual turnover of 50000 and prots of 30000 per year, in the rst ve years of business. Joe pays off his loan after ve years of trading Analysis: Joe Xanadu is a sole proprietor of the business. He is in total control of his business decisions. He is accountable to the bank manager for the relatively modest 5000 loan until it is repaid. He has relatively few overheads, with no employees and business premises. Joe can be assumed to be making business decisions in order to increase his own wealth. Stage 2 development After ve years Joe meets an old friend, Mary Atlantis, who has been operating a school for word processor training in a town centre site containing 100 modern computers. Joe makes a proposition to Mary, to form a partnership which will operate a virtual theme park using Joes multimedia interactive games and the computers at Marys premises. Mary agrees and the partnership is formed, requiring nance of 200000 to convert the premises and upgrade the equipment. Both Mary and Joe agree to invest 50000 from their business earnings and take Heriot-Watt University Introduction to Finance

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a bank loan for the remaining 100000. The business takes a couple of years for the market to take to the idea, but soon starts to make prots and after ve years the partnership prots grow quickly to 80000 per year. Analysis: Joe has developed his business, although he now shares the decisionmaking, with Mary. As both he and Mary are working partners, their motive is to increase their own wealth in the decisions they make. There is still no separation of ownership and management. If the business fails, both Joe and Mary would be liable equally for the debts of the business, which means that the bank and any other creditors could claim personal assets of Joe to settle outstanding debts. Both Joe and Mary therefore share the risk of the business. It is likely that the bank will have secured a charge on the business premises, in a restrictive covenant of the loan, to protect against the business defaulting on the repayment. Stage 3 development Pleased with their success Joe and Mary have ambitious plans to introduce their business idea to other town centre sites. This will require a considerable nancial investment of an estimated 400000, for two more sites. The partnership has 100000 cash to invest, although the bank loan is still outstanding (it has ve more years for repayment). Joe and Mary are also concerned about undertaking such an expansion with unlimited liability. They decide to incorporate the business and form a private limited liability company. The bank is unwilling to extend its loan, so the remaining 300000 needs to be raised from other sources. The total value of the combined business, (with all three sites), is tentatively valued at 600000, after the bank loan and other creditors have been paid. In other words the 600000 the value of the business to the shareholders. Four business associates of Joe and Mary, called the Eureka syndicate, decide to invest the remaining 300 000 for the expansion in return for 49% of the shares of the business. Joe and Mary will own 51% of the shares in the new company, Xanadu Ltd. Managers and employees are recruited to operate the two new sites, as the Eureka syndicate will not be involved in the day-to-day management. The two sites are set up and take some time to become protable. At the end of ten years prots are starting to improve. The bank loan has been renewed and has risen to 200000, to nance the operation of the two sites and replacement of equipment. Analysis: Joe and Mary now have limited liability, reducing their exposure to the business failing. The bank is therefore more concerned that they can recover their loan from the business assets if necessary. The business risk is now shared equally with the shareholders. Joe and Mary will now receive only half of the returns from their business venture, although they still make the management decisions, which are now implemented by a new tier of management in each town centre site. Controls are now necessary to ensure the managers of each site are performing such that their operations are driven to maximise the wealth of the six shareholders. In order to achieve this Heriot-Watt University Introduction to Finance

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performance bonuses are introduced to reward high performing managers. The business nancial risk has increased as the bank loan is twice its original level and this imposes a considerable interest cost on the business, which needs therefore to generate sufcient income to cover this interest cost. Stage 4 development: The business prots have increased steadily, although the shareholders believe expansion is needed into other selected town sites to market the business to a wider audience. Ambitious future expansion plans are estimated to require an investment in the region of 1.5 million to set up sites throughout the major towns in the country. Joe is approaching the age, at which he would like to take early retirement, at 55 years old. Most of his wealth is tied up in the business and he wishes to sell part of his share in the company to release cash for his retirement. The other shareholders are also keen to have more exibility to sell part of their shares through a stock market. It is agreed by the shareholders, after nancial advice, to move ahead and issue shares in the company on the domestic stock market. The stock market issue is a success, with the market valuing the company at 4 million. A new management team is in place as Mary nds that she too wishes to spend more time with her family. Joe sells half of his shares, leaving him with 250 000 in cash and retaining shares worth 250000 in the company Xanadu plc. Joe takes his early retirement and uses the cash to buy an apartment in the South of France. Analysis: Joe has now diversied his investments. Although he still has a signicant share in the company, if the business faces nancial difculties, he has restricted his exposure to the value of his shareholding. You will recall that an important feature of a stock market is to enable investors to transfer their risk and also transform their waiting. Joe has achieved this. He will still be able to exercise some voting control, but stock market regulations require that a minimum of 25% of the shares held in the company must be held by the public, so the voting control is now no longer held by Joe and Mary jointly. The growth of the business has now meant that the appointed management team will take the decisions taken previously by Joe and Mary. The shareholders will be anxious to monitor their performance to ensure that they maximise their wealth through dividends and share price. This is clearly less easy to do than when the major shareholders, Joe and Mary, were taking a closer involvement in the managerial decisions. The business has now reached a total separation between management and ownership.

8.5

Review

The key concepts learned in this chapter were the following. Financial, economic and accountancy concepts of value. The role of the nancial manager in an organisation. Heriot-Watt University Introduction to Finance

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Business investment, nancing and dividend decisions. Separating ownership and management. Maximising prots and maximising shareholders wealth. Agent-Principal relationship.

8.6

Conclusion

A modern corporation, with shares being widely held by large numbers of shareholders, has a separation of the ownership and management of the organisation. The role of a nancial manager in an incorporated company, as agent for the shareholder, is frequently referred to as having the objective function to maximise shareholders wealth. Any target other than maximising shareholders wealth, such as maximising prots, may be subject to managers inuencing the measure in order to present a more favourable picture of performance. Managers are involved in three key decision areas: investment, nancing and the dividends. In making decisions to allocate business resources, nance theory indicates that managers should take account of the time value of money and assess the expected future cash ows emanating from business investment opportunities and discount them to a present value, at a rate which reects the risk of the expected cash ows. Finance theory is related to the economic concept of business income, while accounting income is a measure which, when used for nancial reporting, attempts to measure objectively the performance over the most recent nancial period. The purpose of the accounting measure is different to the nancial values relevant for decision-making in organisations, which involves selecting between competing business investment opportunities. For nancial decision-making in business organisations, future cash ows not past cash ows are necessary to make decisions in the interests of achieving the business objective.

8.7

Tutorial Questions

Q1: Briey discuss the main differences between concepts of value used in accountancy, nance and economics. Q2: Discuss the three main business decisions undertaken by a nancial manager in an incorporated company. Q3: Explain what is meant by a company being a network of contracts. Q4: What is meant by the reference to a manager-shareholder relationship being an agent-principal relationship? Q5: What is the difference between the objective function of a company being to maximise prots or to maximise shareholders wealth?

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Contents
9.1 Different Business Structures . . . . . . . . . . . . . . . . . . . . . . . . . 9.1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.1.2 Summary of Financial and Regulatory Requirements . . . . . . . 9.2 Private Sources of Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 9.2.1 Bank Finance and Private Funds . . . . . . . . . . . . . . . . . . 9.2.2 Venture Capital Finance . . . . . . . . . . . . . . . . . . . . . . . 9.3 Public Sources of Finance - the Stock Market . . . . . . . . . . . . . . . . 9.3.1 The Choices for Companies in Sourcing Public Finance . . . . . 9.3.2 AIM for growing companies . . . . . . . . . . . . . . . . . . . . . 9.3.3 The Ofcial Stock Market List . . . . . . . . . . . . . . . . . . . . 9.4 Trading Shares through the Main Market . . . . . . . . . . . . . . . . . . . 9.4.1 Listing Requirements . . . . . . . . . . . . . . . . . . . . . . . . 9.4.2 Flotation of the Company on the Stock Exchange . . . . . . . . . 9.4.3 Continuing obligations as a public listed company . . . . . . . . . 9.5 9.6 9.7 Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206 206 206 210 210 211 212 212 214 218 226 227 229 233 235 235 236

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9.1
9.1.1

Different Business Structures


Introduction

In chapter 1 we covered the different business structures, relating to organisations set up to make prot (as distinct from charitable organisations and other not-forprot associations). You will recall that the broad distinctions were: sole proprietor; partnership and incorporated companies with limited liability. One of the key distinguishing features of the different business structures is the access to business capital; the liability of the owners to the debts of the company and corporate governance (or in other words the control of the business decision making). Sole proprietors; partnerships and private limited companies will be funded primarily out of private capital, while public limited companies have access to public funds by trading company securities on a stock market. Another type of business organisation includes co-operatives which are set up for the mutual benet of its membership. The Co-operative Group in the UK is the largest of this type and has traded for many years as a mutual organisation offering a range of retail grocery and nancial; funeral services for the mutual benet of its membership. There are many such organisations operating in different countries such as associations connected with housing; construction (eg Building Societies); and agricultural activities. Such organisations will make provision for the nancing of its business activities through its members, with benets divided amongst its membership, normally with relation to the capital each member has invested. In this chapter we will be looking at how practically business organisations can raise capital for their business activities and the rules that companies need to follow if they want to access public nance through a stock market. This will consider rstly some of the common sources of private nance and thereafter the inuences and requirements that a company faces when it seeks a listing to trade its nancial securities on a recognised stock exchange.

9.1.2

Summary of Financial and Regulatory Requirements

In chapter 1 you will recall that there were a number of examples provided for the sole proprietor and partnership business structures. Such forms of business structure typically have access only to private sources of nance (eg through banks or private nance institutions) or through reinvesting the prots from trade. The owners (or partners) are liable (jointly for partnerships) to all debts of the business. There is a form of partnership (limited liability partnership, with the acronym LLP) which has limited liability which is used by organisations such as the professional services rm Price Waterhouse and previously Arthur Andersen (the latter having transferred its operations after the Enron scandal). Table 9.1 illustrates some of the differences in requirements for organisations operating as private or public limited companies. Broadly speaking as a business grows there is a need to access nance to grow.

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Table 9.1: Comparative requirements for private and public limited companies in the UK Requirements Company Ofcers required Minimum share capital Ofcial documents Private Limited Company* One company secretary One director Public Limited Company* One company secretary Two directors 50000 (Of which 25% should be paid up) Memorandum and Articles of Association Companies House Annual Accounts) (for

1 Memorandum and Articles of Association Companies House Annual Accounts) (for

Accountability

HM Revenue and Customs (for payment of corporation tax and value added tax)

HM Revenue and Customs (for payment of corporation tax and value added tax)

*Designations in the UK will be Ltd for private limited companies and plc for public limited companies. You will recall the discussion in chapter 3 about the differences in accessing sources of debt or equity nance for the development of a business. You will recall that the downside of too much debt compared with equity will increase the nancial risk that the business will generate enough cash to repay its contractual debt payments. If the nancial risk of more debt is deemed too high a price and when the equity of private shareholders and retained prots (also equity) is insufcient to match the strategic growth ambitions for as business, the owners will need to seek public sources of nance. You will notice from the requirements listed in Table 9.1 that there is little information that is required of a private or public limited company to be released as published information. The annual accounts led at Companies House can be accessed by the public, but much of the business plans remain private. To incorporate a company the owners of the business must complete a Memorandum of Association, which states that the members of the company have formed to create a company which has hare capital and each has at least one share, as a joint owner. The law has become less stringent on greater detail in the Memorandum in the UK, with effect from 1 October 2009, (under the terms of the Companies Act 2006). Previously the company name and the scope of business activity were required to be stated in the Memorandum. This is no longer the case. The other important document required on incorporation of a company is the Articles of Association. Table 9.2 illustrates traditionally the key contents of the Memorandum and Articles of Association of an incorporated company. Since 1 October 2009 they are expressed in a more simplied memorandum.

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Table 9.2: Contents of the Memorandum and Articles of Association Document Details required

The Name The Registered Ofce Memorandum The Object of The Capital Association The Liability The Association The internal management of the company. What type of power / responsibilities / authority the investors have. The laws that govern management of internal affairs Denes duties / rights / powers / number of directors of the company.

Articles of Association

The discussion regarding private and public limited companies refers to their description in UK Companies Acts, though in many other countries worldwide there are broadly similar distinctions. It is important for individuals and institutions to understand the designations of companies, which reect their underlying legal structure. A debtor or creditor will need to understand whether a company has a limited liability and whether it can raise nance from public sources. To identify the distinction between each type of company Table 9.3 illustrates the designations that are used in different countries for private and public limited companies.

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Table 9.3: Different designations for private and public limited companies worldwide Country United Kingdom Private Company Ltd (Limited) Can also be LLC, which is a Ltd Liability Company but not a corporation SARL (Socit Responsabilit Limite) GmbH (Company with limited liability) SL (Sociedad Limitada) Pty Ltd Public Limited Company PLC (Public Limited Company) Inc/Corp (Incorporated/ Corporation) SA (Sociedad Anonime) AG (Stock Corporation) SA (Sociedad Anonima) PC Ltd

USA

France

Germany

Spain Australia Hong Kong India Singapore South Africa

Ltd may be used by both a private and public company Pvt Ltd (Private Ltd Company) Pvt Ltd (Private Ltd Company) Pty Ltd Ltd (public limited company) Ltd (public limited company) LTD

For the owner of a company the ability to limit liability for their investment is critical. For a bank or private investor in a business, however, it limits the scale of their investment recovery should the business fail. Lenders will normally therefore impose a xed or oating charge on the assets of the business. The charges become effective on the default of a business repaying interest or capital instalments. Fixed charges are secured on named assets (eg land or a building owned by the business) and oating charges are secured on non-specic assets (eg the stock or work-in progress of a business). The choice of legal structure for a business will be a crucial decision in its development. In the following sections we will explore the arguments for and against a private or public ownership structure and the relative responsibilities and obligations of each. Private companies are not always smaller than public companies. The choice is not one of size. Many private companies are passionate about the importance of maintaining control and keeping the business free from the costs; obligations and pressures of public shareholdings.

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9.2

Private Sources of Finance

You will recall from chapter one that the UK Wilson Committee Enquiry, reporting in 1983, identied an important gap in the provision of funding of smaller and medium sized rms. As a consequence of the enquiry provision was made by government for nancial support to stimulate targeted industries and locations. The recommendations also led to private nancing initiatives that continue in place today. There are now over 100 venture capital rms in the UK supporting the growth of small and medium sized rms with billions of s each year. UK Government schemes now join signicant European wide initiatives, which include loan guarantees and selected government assistance. Since the 1980s, the Alternative Investment Market (AIM) has successfully replaced the Unlisted Securities Market as a potential step for full public listing on the London Stock Exchange.

9.2.1

Bank Finance and Private Funds

For incorporated companies the key sources of debt nance outside of stock markets is through the banking sector. For selected companies operating in locations or industries that are designated as being in need of support, there are government assistance schemes which can provide access to nance on preferential business terms. This may include subsidies or preferential rates for business premises, for example in areas of high unemployment. UK and European government have used government assistance to assist the setting up of factories for example in new technologies (eg Livingston in Scotland) and service centres (eg call centres in traditionally industrial areas of Britain -Northern England; Wales and Scotland) and Europe wide (eg through European Local Energy Assistance aimed at supporting sustainable transport systems). It was discussed in chapter 3, that the proportion of debt and equity on business balance sheets differs between different countries in the world. Private companies without access to public nance rely heavily on either the private wealth of the owners and/or retained earnings of the business. The dOrnarno family in France, for example, have built up one of the worlds largest cosmetics and skincare companies, Sisley Paris, from their considerable inherited wealth and remains today one of Europes largest private rms, with an annual turnover of c300-400 million. The John Lewis partnership in the UK has a structure where the business is 100% owned by the employees and nancing much of the retail companys growth from retained prots. Many companies may seek nance for growth but are unable to draw upon retained earnings or the private wealth of their owners. The signicant cost of borrowing from banks, which stems from the default risk, means that some small and medium sized rms are faced with a potential gap in meeting their business funding requirements. The recent global crisis has meant banks have reduced the availability of business loans; increased rates of interest and shortened lines of credit and overdraft limits to many small and medium sized businesses, to reduce the risk of their loan books. Government loan guarantee schemes (effectively guaranteeing repayment of a business loan) have helped to mitigate some of the worse consequences in the UK and US, though many rms remain vulnerable when bank nance is their main or only source of funds. The Wilson Committee in the UK through their enquiries found that there was a critical need to have an available source of equity nance for small and medium sized rms. Two of the key instruments to remedy the small rm gap included: the growth in venture capitalist rms and the development of a regulated market for ordinary shares below the Heriot-Watt University Introduction to Finance

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requirements needed for a full listing, (the Alternative Investment Market - AIM).

9.2.2

Venture Capital Finance

Venture capital rms have grown particularly signicantly in number in the UK since the early 1980s, with over 100 rms supplying billions of s annually to businesses in need of growth capital. In the US venture capital rms helped to fuel the Silicon Valley development in the 1970s on the west coast of the US. Venture capital rms also helped to fuel the dotcom boom in the late 1990s. In the process of taking risks, a venture capitalist needs to see an exit sale in the future to extract the return for risk. For a business which by denition is not listed on a stock market, nding a future buyer for the equity stake is uncertain. While performing a role in closing the nancing gap in the economy, venture capitalists have been criticised for taking too short a view of in determining their exit strategy and the share taken. Typically their horizon is between 3 and 7 years and usually within 5. Table 9.4 lists the typical factors that are considered by venture capitalists before making an investment decision. Table 9.4: Factors for consideration for venture capitalists 1. Management experience 2. Does the product or service have a viable market 3. Sustainability of the business idea 4. Is the company resource sufcient for the business plan 5. What is the expected return 6. What are the business and nancial risks 7. Does the proposition meet the investment criteria After initial considerations on the business model and estimated returns the venture capitalist will undertake a due diligence exercise before formalising the investment. Table 9.5 lists the areas typically covered in a due diligence exercise for a venture capitalist. Table 9.5: Items for checking in a due diligence exercise for venture capitalists 1. Legal documents (including patents and intellectual property rights) 2. Employee contracts (including any company pension commitments) 3. Management information systems 4. Financial projections 5. Historical audited and management accounts 6. Loan agreements (including any secured or oating charge arrangements) 7. Does the proposition meet the investment criteria The nature of risk and uncertainty of returns on the exit value, will inuence the scale Heriot-Watt University Introduction to Finance

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of equity share required by a venture capitalist. The alternative for the business owner is to secure a listing and attract funding from a stock market. The size and scale of compliance costs of a full listing has traditionally put this form of nancing out of reach of most small and medium sized rms. The Alternative Investment Market in the UK provides a market to raise nance for rms unable to meet requirements of a full listing. The next section will consider the alternative sources of public nance from the stock market, for which AIM in the UK has a role.

9.3

Public Sources of Finance - the Stock Market

For some companies private sources of nance are insufcient for their ambitions and plans for business growth. The main source of publicly available nance for businesses is through an organised capital market. An organised stock market can provide a company with a regulated means to raise nance from a wider pool of investors than from private sources. In the remaining sections of this chapter we will look at some of the key issues for raising public sources of nance and an introduction to the rules and processes that require to be followed.

9.3.1

The Choices for Companies in Sourcing Public Finance

As a company grows, as part of its natural life cycle, it becomes increasingly important that it secures sufcient funding to move to the next level of its development. This could be to explore new and/or international markets for products or services. It may also be that the company sees the merger with or acquisition of a competitor as part of its strategy to secure growth. Sources of nance through private arrangements or through internally generated prots may be restrictive in the ambition for business development and growth. In making the choice to go public however, the owners of a company need to relinquish control. To gain access to public nance means that the ordinary shares of a company are listed on a recognised stock market. A minimum of 25% of the shares will need to be publicly held and signicant requirements for reporting information about the companys business performance leads to a signicant reduction in privacy relating to the management of the company and its business operations. A private company may nd that supplying information publicly which may attract press and media attention to be a signicant culture shift. The role of public shareholders seeking growth in their investments may also create tension for a company. One of the key reasons that large companies remain private and do not seek to list their nancial securities on the stock market is the signicant additional responsibilities imposed on the management of the company. Through the rules of the stock market, management are accountable for the stewardship of outside investors funds in their business activities. The extent of the responsibilities will be dealt with in more detail later in this chapter. Business decisions will however require approval by shareholders, who may not always appear to have the same views as the original owners of the company in terms of the short and long term good of the company. This loss of control can cause some tension. For this reason a number of companies retain their private status. Table 9.6 lists some Heriot-Watt University Introduction to Finance

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of the largest private companies operating in world markets. Table 9.6: Famous large private companies Key business activity Candy; pet foods; electronics to over 65 countries Brands: Snickers; Mars; Milky Way; Uncle Bens Toy and hobby stores; over 1,300 stores worldwide Automobile manufacturer - eg Jeep and Dodge brands Food and General Retailer; 1005 employee owned Airline and Tour Operator, Owned by Virgin Investments (51%) and Singapore Airlines (49%) Pharmaceutical retailer and wholesaler Automobile manufacturer Cosmetics and skincare; Family owned by the d Ornano family Size (Annual turnover and number of employees)

Country

Private Company

USA

Mars

c $19 billion (2007); 39000 employees

USA

Toys R Us

c $14 billion (2007); 70000 employees

USA

Chrysler

c $60 billion; c66000 employees

UK

John Lewis Partnership

c 6 billion (2008); c68000 employees

UK

Virgin Atlantic

c 2 billion (2008); c10000 employees

UK

Alliance Boots Fiat (Societa per azion - Joint stock company)

c 15 billion; 62000 employees c 50 billion (2009); 190000 employees

Italy

France

Sisley Paris

c 300-400m; c2000 employees

A public listing is not always a comfortable t for some businesses. The Virgin Group famously oated on the London Stock Exchange in 1986, only to become private again two years later in 1988. Sir Richard Branson complained about the short-termism of the shareholders and fund managers. In spite of the stock market crash in 1987 they were bought back at the same price (140p per share) as the otation price. Table 9.7 lists

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some of the common reasons for and against a public listing of ordinary shares. Table 9.7: Reasons for and against a listing on a stock exchange (Source: A Practical Guide to Listing - London Stock Exchange) Reasons for Access to growth capital Provides a market for selling shares Reasons Against Susceptibility to market conditions Potential loss of control Disclosure requirements and ongoing obligations

Employee commitment

Finance for acquisition opportunities Enhanced public prole Reassurance for customers and suppliers Greater efciency

Reduced privacy

Time commitment on management Directors responsibility and restrictions

It is important for a private company to demonstrate where it is to generate value in the market if it is to be successful as a listed company. You will recall from the coverage of the efcient market hypothesis, that information is key to investors seeking to assess the potential risk and return. The costs of providing the information required by a regulated stock exchange can be a signicant barrier to becoming public. This issue will be looked at in the nal section of this chapter. The next two sections will look briey at the UK AIM and worldwide stock exchanges from a viewpoint of a company seeking listing.

9.3.2

AIM for growing companies

Finding investors to take risks in a small or medium sized company provides a barrier to may developing businesses. You will recall that we discussed the denition between nancial and business risk in chapter 3, with regard to the choice of equity and debt nance. The increased nancial risk from taking too much debt nance prohibits a small or medium sized rm increasing its exposure to bank loans. The costs of obtaining a full listing to raise equity nance on most recognised stock exchanges worldwide can also lead to prohibitive costs for a small or medium sized rm. In the UK this dilemma (or small rm gap) was addressed by the development of the Alternative Investment Market (AIM) out of the previously less regulated Unlisted Securities Market in the 1980s. The key requirements for a company seeking to list its nancial securities on AIM, as compared to those for a full listing on the main market, are shown in Table 9.8.

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Table 9.8: Comparison of requirements between AIM and the Main Market AIM No prescribed level of shares to be in public hands Main Market Minimum 25 per cent shares in public hands Normally 3-year trading record required Prior shareholder approval required for substantial acquisitions and disposals

No trading record requirement

No prior shareholder approval for most transactions* Admission documents not pre-vetted by exchange or by the United Kingdom Listing Authority (UKLA) in most circumstances. The UKLA will only vet an AIM admission document where it is also a prospectus under the prospectus directive. Nominated adviser required at all times No minimum market capitalisation

Pre-vetting of prospectus by the UKLA

Sponsors needed for certain transactions Minimum market capitalisation

The practical steps to follow for a company seeking a listing on AIM are shown in Table 9.9. We will see how they compare when we look at the requirements for a main listing in the next section of this chapter. Companies seeking a full listing prior on the main market to a listing on AIM are given a quicker route than companies going direct to the main market.

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Table 9.9: Principal AIM Admission Documents

cover page including important information for investors in overseas jurisdictions summarised key information index Front section list of directors and advisers list of denitions and glossary of technical terms timetable placing statistics history of the business information about the present-day business summarised information about key personnel A detailed description of the key business and market trends business, in effect, the investment proposition intellectual property information about the placing or offer for subscription company policy on corporate governance use of funds share option arrangements and dividend policy risk factors relevant to the business City Code information (if applicable)

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audited historical nancial information, covering up to three complete years prior to otation. Sometimes it is necessary to include interim accounts to a later date, which may or may not be audited Historical nancial information an auditors or reporting accountants opinion as to whether the nancial information shows a true and fair view for the purposes of the AIM admission document if appropriate, pro forma nancial information experts reports (if necessary or desirable) directors responsibility statements (directors and proposed directors must accept responsibility for every statement contained in the AIM admission document) details of the incorporation and legal status of the company, its registered ofce and its objects information about share capital, including authorities to issue further shares summarised information about the companys memorandum and articles of association Appendices and detailed schedules directors interests in the company and directorships of other companies substantial shareholders share option plans material contracts related party transactions summarised tax position the working capital adequacy statement terms and conditions of any offer for the sale of shares sundry information

Other reports

In terms of scale the AIM has become an important source of nance with 64.5 billion market capitalisation of companies listed in 2010 and over 2 billion of annual turnover. Table 9.10 summarises the key comparative statistics from April 2000 to April 2010. You will notice the considerable growth in the number of companies using AIM to nance their business (a 139% increase in 10 years). During this period a number of AIM funds have been set up to encourage investors to hold companies listed on the AIM and therefore

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increase the liquidity (or depth of investment funds) of this market. Table 9.10: AIM Key Statistics 2000-2010

(Year to April 2000) million AIM Turnover AIM Market Capitalisation AIM Money Raised No of Companies 1445.099 14935.2 3073.8 524

(Year to April 2010) million 2217.531 64518.1 1428.3 1253

(Source www.londonstockexchange.com AIM Market Statistics)

9.3.3

The Ofcial Stock Market List

The most signicant source of equity funds for companies is through a main (or ofcial) listing on a recognised stock exchange. Table 9.11 illustrates the total sums of money raised on worldwide stock exchanges from 2000 to 2009 by geographic sector.

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Table 9.11: Total Value of share trading by worldwide regions

(Source: World Federation of (Stock) Exchanges: WFE 10 Years in Review 2000-2009)

Table 9.11 illustrates the total sums of shares traded during the nine years, illustrating a 61% increase in value (in spite of the market downturn in 2008 caused by the global nancial crisis). It is also interesting to note the relative increase in the value of the Asia-Pacic shares traded during this period, indicating that it has doubled in value terms. Trading value in stock markets provides a broad indicator of the markets liquidity and is important for a company seeking funds to be reassured of the strength of buyers and sellers willing to trade, providing a source of nance. The total number of trades over the same period indicates a more signicant increase Heriot-Watt University Introduction to Finance

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of over 700%, reecting the fact that the trades made were smaller in average value. Table 9.12 illustrates the relative increase in each geographic region. Table 9.12: Total number of trades in equity shares by worldwide regions

(Source: World Federation of (Stock) Exchanges: WFE 10 Years in Review 2000-2009) The total number of companies listed grew from 200 to 2009 by 41% across all regional stock exchanges (see Table 9.13).

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Table 9.13: Total number of listings by worldwide regions

(Source: World Federation of (Stock) Exchanges: WFE 10 Years in Review 2000-2009) In chapter 1 we considered the wider role of nancial institutions in the global world economy, providing nancial intermediation. For companies seeking growth and development of their business it is crucial that they can attract funds from savers who seek returns in return for risk. Institutional investors have become increasingly important as a source of investment in equity through recognised stock exchanges in recent years. Three of the main categories of institutional investors are: pension funds; insurance companies and mutual funds. Pension funds managers need to balance their liabilities or obligations to pay their members through the contributions and investment returns of their investments. Managers of insurance companies need to ensure contributions from members and returns from their nancial investments meet the payouts required from the realisation of risks insured. This process involves the balancing of event probabilities and risks of investment returns. Mutual funds are a popular vehicle in the US for individuals to invest in ordinary shares. Small investors provide funds to managers who decide upon the location of investments in worldwide markets. Pension funds in many countries have now become dened contributions rather than dened benet schemes. In dened contribution schemes the member pays a set amount of funds from their earnings each month which is invested by the pension fund managers in nancial or real (eg property) assets. At the time of retirement the value of the assets are transferred to the individual based on their total contributions. In dened benet schemes the individual receives a benet at the time of retirement usually in relation to their nal salary/wage. If investments in nancial or real assets have not been as expected the pension fund must cover the shortfall through increased contributions from other members or from realising other nancial assets. The key point is that in

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dened contribution schemes the individual member takes the risk of the underlying assets, while in the dened contribution schemes the pension fund is liable to make up any shortfall. Given the volatility of stock markets in the most recent 25 year period the relatively lower returns from equity investments has placed considerable pressure on pension funds with dened benet schemes. This has meant many have decits in the balance of contributions; investments and liabilities. In many countries this has been exacerbated by individuals living longer (therefore drawing pensions for a longer period of time); lower fertility rates (therefore lower contributions being made) and in many industries the reduced labour force as productivity has increased and lower numbers of employees are paying into the pension scheme. The majority of individual investment in stock markets is usually through an institutional scheme. The impact of changes by the three main types of institutional investors can therefore have an impact on the liquidity and volatility of ordinary shares and their price. Table 9.14, Table 9.15 and Table 9.16 illustrate the total nancial assets of institutional investors across different geographic regions and the proportion of nancial assets held by pension funds and insurance companies over the period 1995 to 2005.

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Table 9.14: Total nancial assets of institutional investors 1

In billions of US dollars. 2 For the Netherlands and United Kingdom, individual insurance companies and pension fund data are from different sources and hence do not add up to total insurance and pensions. 3 Mutual fund data are from the Investment Company Institute as the denition of mutual fund data varies across national nancial accounts. Funds of funds are not included except for France, Italy and Luxembourg after 2003. 4 Including Belgium, France, Germany, Italy, Luxembourg, the Netherlands and Spain; data are for 1995 and 2004. 5 Data for Korea and the United Kingdom are for 2004. 6 Data for Singapore are for 2000 and 2005 respectively. 7 Data for Switzerland are for 1999 and 2003 respectively. Sources: Investment Company Institute (http://www.ici.org/stats/mf/index.html); national sources

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Table 9.15: Asset allocation of insurance companies 1

As a percentage of total nancial assets. 2 Simple arithmetic average of ratios of Belgium, France, Germany, Italy, the Netherlands and Spain; data for Germany, Italy, the Netherlands and Spain are for 2004. 3 Data for 1995 in Japan are for end-nancial year. 4 Data for Korea and the United Kingdom are for 2004. 5 Data for Switzerland are for 2003. 6 Investments in mutual funds are included in equities. Sources: National data Heriot-Watt University Introduction to Finance

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Table 9.16: Asset allocation of pension funds 1

As a percentage of total nancial assets. 2 Simple arithmetic average of ratios of Belgium, France, Germany, Italy, the Netherlands and Spain; data for Germany, Italy, the Netherlands and Spain are for 2004. 3 Data for 1995 in Japan are for end-nancial year. 4 Data for Korea and the United Kingdom are for 2004. 5 Data for Switzerland are for 2003. Sources: National data

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If we look at the proportion of equity held by pension funds and insurance companies over the period you will notice that proportions vary considerably by region. Mexican pension funds, for example, hold almost all of their nancial assets in bonds (97%). In the Euro area (excluding the UK), where traditionally there is a lower reliance on returns from equity investments, relatively small proportions of nancial assets held are shares, (bonds; deposits and loans are higher). In the UK; US; Australia; Japan and Singapore signicantly higher holdings of equity investments are in evidence for the pension funds. Interestingly in the US mutual funds have become a much more popular option over the 10 year period for many pension fund managers (as they are in preference to equities in Germany and Belgium in the Euro zone). The use of stock exchange nance to businesses varies from country to country, as was noted in chapter 1. The importance of a well regulated stock exchange to provide for the transfer of risk and bringing together of savers and investors is critical in many countries to promote the growth of enterprise. In the next section we will look at the important requirements and process for a company seeking a listing of its nancial securities on the main (or ofcial) listing.

9.4

Trading Shares through the Main Market

A company seeking a listing of its nancial securities on the main market will normally have a motive to raise capital for its growth. A listing on a main market will mean that the prole of the company will by denition become more public. The liquidity of the market will provide a means with which the owners (shareholders) can realise their investment more easily by accessing buyers more easily than if the company were privately owned, (recall the relative merits we discussed earlier in the chapter of private and public ownership). The largest companies become part of the key indices of the market. The London Stock Exchange has a number of benchmark indices including: FTSE100 (the Footsie); FTSE 250; FTSE Small Cap; FTSE Fledgling; FTSE 350 and the FTSE All Share. Key indices for other worldwide markets, where similar principles apply, include the Dow Jones (New York); Hang Seng (Hong Kong) and the Nikkei Dow (Japan). The advantage of being in a recognised index is that institutional funds are duty bound to buy proportional weightings of ordinary shares for each company in the index. For the London Stock Exchange this has been valued at over 47 billion of investment in the key indices, for which over 60% is held by tracker funds (source www.trustnet.com - July 2006). A tracker fund is set up to hold a weighted proportion of a selected index and invest funds in order to passively track (or match) the relative movement. (You will recall the lesson of the efcient market hypothesis from chapter 2). Table 9.17 summarises the capital market pool in the main market through the various investing pools.

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Table 9.17: The potential capital pool available to Main Market companies (UK based funds) 2400 billion 89 billion 47 billion 29 billion In 5000 pension; insurance and mutual funds and investment trusts whose equity holdings are predominantly Main Market listed. In 14 million Individual Savings Accounts and Personal Equity Plans held by retail investors. In 240 institutional funds explicitly benchmarking the FTSE UK Index series. In 60 tracker funds that are obliged to have exposure to Main Market companies in the relevant FTSE UK index. (Source: London Stock Exchange , December 2006) Other nancial securities available to companies for listing on the main market include preference shares; convertible bonds; Eurobonds and securitised derivatives. To enable a company to gain access to three key advantages to support its growth: access to capital; increased prole and liquidity for its nancial securities a company needs to incur considerable costs from its obligations to the market in the provision of information. We will look at these obligations in the remaining sections of this chapter.

9.4.1

Listing Requirements

After a company has decided to raise nance on the main market it is required to provide information about its activities through documents known as listing particulars (or a prospectus), or alternatively as an offer to the public direct. While the context of this and the following sections of this chapter are within the context of the London Stock Exchange, the principles can be applied to most other recognised stock exchanges. The format and content of listing particulars are governed by the UK Listing Authority (UKLA), whose parent is the Financial Services Authority (FSA). There are two parallel processes to obtaining a listing in the UK. A company needs to apply for its nancial securities (including equity and debt). The second process requires that the London Stock Exchange admits the securities to trading mechanisms on the main market. Companies aiming for an equity listing can opt for a primary or secondary listing. This should not be confused with a primary or secondary market functioning of the stock exchange which we covered in chapter 1. Essentially a primary listing has the highest requirements for regulation and disclosure of information to potential investors. Only equity can be primary listed. A secondary listing meets lower threshold standards, such as those achieved from listing in recognised stock markets (eg through harmonised European standards). A secondary listing threshold does not require a company to be listed on a home or other stock exchange. Passporting-in occurs when a company uses its prospectus which has been approved through a recognised stock exchange in the European Economic Area (EEA). The key listing requirements for primary and secondary listings are shown in Table 9.18.

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Table 9.18: Key regulatory requirements for primary and secondary listings of the main types of security

Primary listing of shares

Secondary Specialist of shares securities; debt and depositary receipts (DRs) Minimum market capitalisation of 700k for equity (shares and depositary receipts) and 200k for debt Production of a prospectus for UKLA Admission to trading on the main market A minimum of 25% of shares must be in the public hands 3-year trading record normally required Clean annual report Clean working capital statement

Admission requirements all types of listing

x x

x x

The super-equivalent requirements for a primary listing

x x x

3-year revenue earning record covering at least 75% of the business

Passporting -in

(Source: A Guide to the Main Market - London Stock Exchange, February 2007) The London Stock Exchange sets down admission and disclosure standards for all companies seeking an admission to trading and to cover continuing obligations for all Heriot-Watt University Introduction to Finance

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members. The typical timetable for obtaining a listing is shown in Table 9.19. Table 9.19: Timetable for listing Pre-Float Preparation Develop a robust plan and a detailed review of ownership and tax issues, customer/supplier contracts, management information systems and operational and compliance controls. Acquire information about what a Main Market involves, review corporate governance and complete any strategic initiatives or acquisitions. Develop an investor relations strategy and ensure the necessary nancial statements and non-executive directors are in place. Decide on the method of otation and interview potential advisors. Appoint and instruct advisors and agree on the timetable. The company and its advisors review pricing issues, host analyst presentations and produce drafts of the key documents - including the prospectus. UKLA sees and approves all documents. The company and advisors complete their due diligence, hold PR meetings and analyst road shows. The company makes its formal application for listing and admission. Once this is granted trading begins.

36-24 months

24-12 months

12-6 months

The Listing Process

6-3 months

12-6 weeks

6 weeks-1 week 1 weekadmission

The process of obtaining a listing and satisfying the UKLA and London Stock Exchange of the company and its managements credentials is daunting. The timetable shown in Table 9.18 requires a considerable commitment to prepare detailed nancial and operational information. You will recall the nancial principle we discussed in chapter 2 - information asymmetry. One of the key objectives of the prospectus is to release to the market key price-sensitive information that enables potential investors to establish the value of a company. For some companies this is a major culture shift. Owners and management must be absolutely committed to the key reason for seeking a listing.

9.4.2

Flotation of the Company on the Stock Exchange

The complexities of the company; its management structures; markets and products/services may all inuence the time it takes a company to get to otation of its nancial securities on the stock market. As has been discussed the prospectus is the key document that will require publication as part of the approval process. The UKLA and the London Stock Exchange (for a UK listing) will be the authorities approving. To achieve the approval a company will need to use key external personnel, including: a sponsor; a lawyer; a broker and an accountant. The usage of external advisors and services can increase the cost of obtaining a listing to c500k (Source: London Stock Exchange: Practical Guide to Listing 2002) and which can increase considerably for a more complex and sizeable company. Heriot-Watt University Introduction to Finance

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In Table 9.20 the key participants in the otation on the London Stock Exchange are listed. Table 9.20: Key participants in a UK company otation

Participants London Stock Exchange UKLA Company Corporate Broker

Brief role Approve a companys application for admittance to trading. Admits securities to the Ofcial List of the Main Market. Preparation of the Prospectus. Provides an interface with investors in the stock market and the company. Their knowledge of the market and industrial sector will be important in gauging valuation. UKLA have an approved list of sponsors, whose role will be to champion the oat of the company on to the Main Market. The sponsor will understand the business and reasons for otation and be able to target potential investors and market valuations to raise the capital needed. The sponsor can be an investment bank or accountancy rm. The accountant will be separate from the companys auditors and will chiey be responsible for advising and reporting on the sort form nancial reports published in the prospectus and the long form nancial information which is not published and includes greater details about the history of the company and management experience. Normally two sets - one working with the company to advise on the otation and the other advising the sponsor. There will be a range of legal documents requiring to be prepared underpinning the relationship between the company and its shareholders - the articles of association and the verication of legal titles included in the prospectus document. PR advisers can be key in checking the publishing of information about the company as part of the otation ensuring that disclosure requirements are met. Depending on the industry and complexity of the companys assets and business operations other advisers needed as part of the prospectus development include: surveyors and valuers (for property); tax advisers; insurance brokers; and bankers/registrars for maintenance of the share register.

Sponsor

Accountant

Lawyer

Public Relations

Other Advisers

The otation of a company on the main market can be a complex business. It will involve most of the key professionals operating in the nancial services sector. In terms of nance theory it is important to understand the process as an important one in the process of redressing the information asymmetry between the market and the Heriot-Watt University Introduction to Finance

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company. This will enable the most appropriate assessment of company valuation to be made by the stock market investors. The prospectus is the key document that will express the key business and nancial risks and returns of the companys operations. Professional accountants ensure the validity of the information ensuring that the agent (management) provides the most accurate information in the prescribed format to the principal (shareholder). The UKLA set the regulations to ensure that all aspects of the information are complete and published to timescale. There are many costs of this process which can therefore be seen as agency costs as we dened in chapter 2, as the new shareholders are attracted to invest in the new company. If the process works to plan it provides a strong base for the operation of an efcient market as we dened in chapter 2 when considering the efcient market hypothesis. Table 9.21 illustrates a summary of the key role of each participant in the steps to otation.

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Table 9.21: Countdown to otation timetable

(Source: A Practical Guide to Listing - London Stock Exchange, 2002) Heriot-Watt University Introduction to Finance

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Once a company has successfully negotiated the otation, it needs to navigate the responsibilities associated with being a public limited company.

9.4.3

Continuing obligations as a public listed company

Efcient stock markets need information as a continuing source of oxygen supply to enable the effective free ow of capital between investors and savers. The process of information dissemination between a company and the market clearly cannot stop at otation. The agent-principal dilemma continues once a company has become publicly listed and to be semi-strong efcient, shareholders and potential investors need to know all price sensitive information about current and future plans. The UKLA and the London Stock Exchange, including the Regulatory Information Service (RIS) have responsibility for surveillance and regulation, not least through monitoring of share price movements (in the US the Securities and Exchange Commission -SEC - are the key industry regulator). The main domestic trading system on the UK stock exchange is SETS (which has different levels of trading frequency or liquidity). Alternatively there are trading systems such as the International Order Book for shares listed from other countries. You may recall that after the October 1987 crash that there was speculation that the crash had been caused by the pre-programmed sells on the automated market. While true that the speed of movement was enhanced by the automated systems there were signicant ows of information onto the market. You will recall our discussions in chapters 1 and 2 about the importance of the need for the timely release of information to the market and to outlaw those making a prot by dealing from privileged insider information. Much of the regulations set out by the UKLA as continuing obligations reect the need to have transparency of information to the market, ensuring the timely release to those making investment decisions. Table 9.22 summarises some of the key continuing obligations for companies listed on the London Stock Exchange. As previously discussed, the principles of the continuing obligations are similar in most recognised stock markets.

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Table 9.22: Continuing Obligations of the UKLA

1. Disclosure of pricesensitive information

Principles are to allow all shareholders and potential investors with the same information and reduce speculation. Certain public announcements (eg for takeover situations - also regulated through the City Code on Takeovers and Mergers and the Takeover Panel) require to be made through the RIS service. The Board of Directors need to make public any major decision within prescribed time limits.

Directors have responsibility as a collective body for all of the UKLA continuing obligations and ongoing compliance with the 2. Directors London Stock Exchange admission and disclosure requirements. responsibilities Appointments and resignations of directors need to be reported publicly. Insider dealing is a criminal offence. Share dealing for personal gain through the possession of price sensitive information is covered in detail in the Model Code and all company employees need to be bound by it. Directors in particular have onerous obligations for monitoring co-directors share dealings. The minimum requirement of over 25% being in the public hands must be adhered to at all times. Signicant shareholdings should be disclosed through the RIS (this is particularly important in times when shares are bought prior to a takeover bid). The requirements for annual accounts publication are enshrined within the Companies Act and require audited statements to be published within 6 months of the nancial year end.

3. Dealing restrictions

4. Shareholders 5. Annual Reports and accounting information

While subject to some variance between the size and complexity of different company organisations, the costs will include: annual fees 6. Compliance to the LSE and UKLA; legal fees; accountancy fees and other costs advisers as required (including PR advisers as the prole of the company becomes more public and attracting media interest).

(Source: A Practical Guide to Listing - London Stock Exchange) In addition to the requirements listed in Table 9.22 directors are expected to adhere to the corporate governance Combined Code which contain best practice in running a company. The effect of all of the regulations and combined codes of practice clearly make the business of running a public company more complex and costly, this needs to be weighed against the key driver for public listing to achieve access to capital; raise the prole of the company and to provide a more liquid market for the buying and selling of shares by the owners. The responsibilities imposed by continuing obligations provides for investor protection and the greater condence in transacting within a properly regulated and efcient market.

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9.5

Review

The key concepts and principles covered in this chapter: The important differences between a private and a public company; The increased access to public funds when a company lists its nancial securities on a recognised stock market; The alternative sources of private; bank and venture capitalist funds for growth; Important factors considered by venture capitalists in making investment decisions, such as management experience and nancial projections; The reasons for and against private and public ownership; The implications for a shift in control when shares are in public ownership; The different costs associated with a public listing of shares on a recognised stock market; The use of the AIM in the UK as a stepping stone to a full public listing on the London Stock Exchange; The growth in recent years of nance raised on worldwide stock markets; An overview of the listing requirements for companies oating on the London Stock Exchange; An outline of the continuing obligations leading from a public listing on the London Stock Exchange.

9.6

Tutorial Questions

Q1: What are the key differences between the private and public limited companies? Q2: Why do companies need a memorandum and articles of association? Q3: If a company is growing its business operations is it inevitable that it will become a public limited liability company? Q4: What is the role of a venture capitalist? Q5: What do you believe are the main reasons for and against a public listing of shares on a recognised stock market? Q6: What is the purpose of AIM on the London Stock Exchange? Q7: What are the key implications to the management of a public listed company having large pension funds as the principal shareholder compared to a larger proportion of individual shareholders? Q8: What are the requirements for obtaining a listing on the London Stock Exchange? Heriot-Watt University Introduction to Finance

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Q9:

Who are the key advisors in the process of a otation?

Q10: What are the main continuing obligations for directors after a company has obtained a listing? Q11: What is the difference between plc and ltd after a companys name in the UK? Q12: What is the minimum market capitalisation for a company to be listed on the London Stock Exchange Ofcial List? Q13: Outline the key steps in the timetable to otation for a company. Q14: Why is it important in continuing obligations for companies to make public announcements about their business? Q15: Once a company has become public is it prevented from reverting to private status in the future?

9.7

References

World Federation of (Stock) Exchanges http://www.world-exchanges.org London Stock Exchange http://www.londonstockexchange.com/ Bank for International Settlements - Committee on the Global Financial System http://www.bis.org/cgfs/index.htm New York Stock Exchange Listing Rules http://nysemanual.nyse.com/LCM/Sections/

New York Stock Exchange Fact book http://www.nyxdata.com/nysedata/asp/factbook/viewer interactive.asp?hidCategory=3&hidAction=interac Listing on Stock Exchange - blessing or curse? Future investment and banking trends Patrick Dixon http://www.youtube.com/watch?v=k yravnCJc8

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Contents
10.1 10.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Financial Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.2.1 Key components of nancial planning . . . . . . . . . . . . . . . 10.2.2 Establishing personal priorities and maturity of the plan . . . . . 10.2.3 Information gathering and identication . . . . . . . . . . . . . . 10.2.4 Establish alternative solutions and decide on a plan . . . . . . . 10.2.5 Implement; monitor and revise the plan . . . . . . . . . . . . . . 10.3 Risk and protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.3.1 Identifying risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.3.2 Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.3.3 Compensation schemes . . . . . . . . . . . . . . . . . . . . . . . 10.4 Returns on investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.4.1 Investment theory and the equity risk premium . . . . . . . . . . 10.4.2 Choosing the right investments . . . . . . . . . . . . . . . . . . . 10.5 10.6 10.7 Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tutorial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238 238 239 239 242 243 245 245 246 247 248 249 249 253 254 255 256

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10.1

Introduction

This module is an introduction to nance and considers the important theoretical models and concepts and how they apply to important decisions. The chapters in this module have so far been concerned with the application primarily to corporate nancial decision making, including: the choice of capital investments; the best sources of nance and the application of the maximisation of shareholders wealth objective. In this chapter we will focus on the application of some of the key principles of modern nance theory to practical personal nancial planning. The rst section of the chapter will cover: the key components of nancial plans; the gathering of relevant information; budgeting and identifying cash ows and the application of personal priorities and objectives to formulate a plan. We will look at risk and the forms of protection available to an individual investor. In later sections we will consider how to generate investment returns and the types of investments that can match risk preferences of investors. It is acknowledged that you may be studying this module and needing to apply your learning in different regions of the world where you choose to live. Many of the practical examples being used will be from a UK context though the chapter will be principles based. Many of the key messages will be applicable in most regions, though the relevant investment vehicle and their weighting of importance for a personal nancial plan may be signicantly different.

10.2

The Financial Plan

Ask your friends and relatives about their nancial plans and you will get some interesting responses. While nancial planning may be second nature to accountants and business managers, many individuals fail to complete more than the most rudimentary nancial budget. If you ask why your friend or family member does not have a nancial plan they may reply: Look what happened in New Orleans in 2000 when hurricane Katrina wiped out so many homes overnight. The people living there may have had the most sophisticated nancial plan but it wouldnt have helped them. Of course it is true that there are many uncertainties that we face in life, for which we could not possibly plan to cover all eventualities. There are however many known risks which we can plan for. The increasing longevity of most countys populations and the end of the baby boom in many western countries (commencing after the Second World War and lasting until the mid 1960s) means that the nancial burden on many individuals and state governments has changed. There are far more people in the world in need of care and support in the later years of their lives than previous generations. With many countries now recording lower birth rates this means progressively smaller proportions of the normal working adults are earning and therefore paying tax revenues for the state to support the older baby boomer generation coming through. Government worldwide have been struggling to cope with the issue. You may have noticed that many countries have begun shifting the statutory age of retirement. Recent news headlines about the plight of Greeces public nances have focussed on their relatively generous statutory retirement age of 61. In the UK it is likely that the government will shift the normal retirement age to 67 in future years. Many other Heriot-Watt University Introduction to Finance

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countries have either plans to or have already announced similar shifts in statutory retirement ages. It is also clear therefore that individuals will have to progressively plan to manage their nancial needs later in life than previous generations have needed to do.

10.2.1

Key components of nancial planning

As students of nance it should be second nature to understand the process and key components of personal nancial planning. Table 10.1 illustrates the typical steps in the process. Table 10.1: Steps in the nancial planning process

In step 1 an individual needs to establish a statement of priorities which will set the context for the plan. If an individual is 55 years old the priority may well be to plan sufcient funds for retirement. Alternatively a young person of 22 years old, recently married may well be concerned primarily with raising funds for housing and preparing for the nancial commitment of a young family, which may involve consideration of life assurance; medical cover; funds for education on top of the normal costs of living. Lets consider the key considerations in each of the steps of the process.

10.2.2

Establishing personal priorities and maturity of the plan

10.2.2 Establishing personal priorities and maturity of the plan Personal priorities will be driven by a range of personal preferences and circumstances. Table 10.2 illustrate four example proles, each of which will have their own nancial planning proles.

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Table 10.2: Example Personal Proles for Financial Planning

Alam Male aged 21 years old; Single young person who has just left College/University and commenced a new job. No partner; paying rent on an apartment; 25000 student loan to pay off. Brigitte Female aged 27 years old; living with a partner in a rented apartment; Has recently set up a small internet marketing business; Her partner has a part-time job and helps her in her business. Conrad Male aged 45 years old; Living with his wife and a child aged 16 years of age; He works full time for a professional business rm; His wife works part-time; He has a 25 year mortgage on a house he bought jointly 15 years ago. Donna Female aged 58 years old; working female with a full time job and married to her husband who also has a full-time job; They both jointly own their home and there is no mortgage to be repaid; Both children have completed their education and live away from the family home. The lifecycle of each nancial plan for the four example persons will have different maturities. For the younger two persons (Alam and Brigitte), the most immediate priorities are likely to be focussed on establishing a regular income and secure home. Calculating the progression of remuneration will be a key parameter for both their plans and affordability of buying their own home. For Brigitte the buying of a new home will be relatively more difcult as neither she nor her partner have a regular full time income. The income from her own business will have greater volatility than from salaried employment. For the more mature examples, Conrad and Donna, the nancial priorities will shift to considerations beyond establishing a regular income stream and a secure home, to the nancing of education (in Conrads case) for his young daughter (assuming she wishes to continue to College/University) and the management of nances to support their retirement plans, (particularly in the case of Donna). Financial advisors can assist the process of personal nancial planning. In the rst steps a dialogue will take place to ensure the advisor knows their customer (a requirement laid down by the Financial Services and Markets Act 2000 in the UK). The key priorities of each individual will be established - Table 10.3 illustrates what they may be for the four examples.

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Table 10.3: Examples of nancial planning priorities

Alam Payoff student loan in 5 years; Save for the deposit of a new house in 5-10 years; Enjoy a good lifestyle.

Brigitte Save for a deposit on a new house and emergency savings (next 5 years); Pool income with partner to enable business growth and remove need for partner to work part-time (5-10 years); Save funds for starting a family (next 5 years).

Conrad Fund daughter through University education (next 5 years); Start planning and increasing pension contributions for early retirement (5-7 years); Repay the mortgage - no later than the 10 year due date.

Donna Maximise retirement options; Downsize the house to help with retirement fund; Maximise return on savings to help with retirement income.

It is difcult not to stereotype the examples given, but hopefully it will help you see the practical issues. In reality an advisor would need to alert to individuals where they may need to direct their nancial attention. Donna, for example, should consider medical insurance as she gets older and potentially in need of greater medical attention. For tax purposes, in many countries, it will help her to equalise her capital (savings and investments) with her partner so that neither are taxed so heavily at higher rates of tax (in particular when planning for inheritance (ie in leaving investments and savings to her children). We have not the space to consider all of these issues here, but the impact of tax would in practice need to be part of the overall planning process. You will note too that Alam is going to need to nd a balanced compromise in competing priorities over the next ve years though one would hope there will be room for him enjoying himself! Conrad may also wish to consider unemployment insurance given the level of his mortgage debt and the increased costs he is expecting. In the nancial planning process there will be trade-offs between individual consumption and savings. Over time household savings rates will change due to changes in wider economic conditions as well as individual priorities. Table 10.4 illustrates general household savings rates in different worldwide geographic regions during 1995-2005 (just prior to the global crisis, characterised by high levels of personal debt). Heriot-Watt University Introduction to Finance

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Table 10.4: General worldwide household savings rates by geographic regions (as a proportion of disposable income) - Source OECD

30 Belgium France Germany Italy Netherlands Spain 25 Sweden Switzerland United Kingdom

30

25

20

20

15

15

10

10

0 1990 1992 1994 1996 1998 2000 2002 2004 30 Canada United States 25 Australia Japan Korea 1990 1992 1994 1996 1998 2000 2002 2004

0 30

25

20

20

15

15

10

10

0 1990 1992 1994 1996 1998 2000 2002 2004 1990 1992 1994 1996 1998 2000 2002 2004

You will note from Table 10.4 that the general trend in most countries is downward over the ten year period. The credit crisis in 2007 illustrated the signicant level of household debt that had built up (reected also in national debt in many countries). Financial planning can balance the competing interests and priorities; ensuring money is saved when income exceeds spending as security against higher interest rates; ination and unemployment.

10.2.3

Information gathering and identication

Information gathering is a key part of formulating alternative plans and the indentifying of nancial risks for alternative scenarios. If personal nancial planning is undertaken with a nancial advisor, the information gathering process will be key to the recommendations they provide. Information will include: details of employment remuneration; pension contributions and entitlement; personal insurance policies; mortgage payments and policy details; dependent children and their ages; and any outstanding loans and repayments. Once information has been gathered an assessment can be made of the key nancial risks. Table 10.5 illustrates some of the possible nancial risks of the four persons Heriot-Watt University Introduction to Finance

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introduced in Table 10.2. Table 10.5: Examples of key nancial risks

Alam Inability to repay loan; mortgage and enjoy lifestyle choices; Start to house buying may be delayed because of high interest rates; credit risk; insufcient deposit.

Brigitte Irregular income from business is insufcient for lenders to support a house purchase; May consider life assurance once a family is started as Brigitte and her partner will be jointly providing income and care. Donna Need to maximise return on investments - look at maturity of savings accounts; Need to ensure the pension fund is secured close to the retirement date (nal salary schemes have a guarantee but dened contribution/personal pensions require the individual to transfer to safe bonds from volatile equity funds prior to the retirement date).

Conrad Signicant competing demands on income; Income dependency on Conrad may mean some insurance priority needed - eg for unemployment; medical care; life assurance.

As mentioned previously the context and scale of the risks and associated issues will vary by geographic region. The key principle however is to identify the risks. The potential resolution is what will change based on local conditions - eg investment vehicle; insurance premiums; tax rates and savings rates of return.

10.2.4

Establish alternative solutions and decide on a plan

Consideration of the key information and appraisal of the nancial risks provides the foundation for considering alternative nancial plans. The key tools to assist with the information gathered will be a nancial expression of the key nancial facts, through a personal income and expenditure and nancial position statement. Ideally it will be possible to forecast the key elements over the maturity of the nancial plan lifecycle (eg increases in pay/self employed income; expenditure on living costs). Table 10.6 illustrates a summary of the potential income and expenditure and nancial position statement of Alam.

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Table 10.6: Example of Alams Income and Expenditure A/c and Financial Position

The information presented in Table 10.6 provides an important snapshot of nancial tensions. Forecasting income and expenditure and the movement of the nancial position can help an individual plan over the lifecycle of the nancial plan. Important assumptions will need to include: expected pay increases; impact of the change in ination on expenses; return on savings investments and major items of capital expenditure (eg car; property). Based on the information gathered and forecasting assumptions alternative plans can be formulated to match priorities. Alam may, for example, accept a compromise on his holiday expenditure to allocate a further 1.5k into savings, as an investment fund to pay for an initial deposit on a property. Progressive increments in his salary over a ve year Heriot-Watt University Introduction to Finance

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period may provide the deposit he requires to invest at the end of the ve year planning period.

10.2.5

Implement; monitor and revise the plan

Implementing the plan for Alam will mean nding a suitable investment vehicle (eg a short term xed bond or savings account) to maximise the savings return. It will help with discipline to transfer surplus cash from the bank account to savings at regular intervals to discipline the target investment fund. It will also be important to review during the year the assumptions on living expense changes to ensure they are in line (or no worse) than plan assumptions. For both Alam and Brigitte the earlier that retirement planning is thought through the better for the long term prospects of options over a 25 year plus planning horizon. For Brigitte, consideration should be made for increased expenses for planning a family, combined with the goal of investing in a property over a 5-10 year horizon and the need to consider childcare given that both partners currently work. It is likely that Alam and Brigitte will need to revise frequently their plans based on changes in their circumstances over the next ten years. It is likely that their income generated from their work will change signicantly over the planning period. For Conrad and Donna the planning horizon and priorities are different to Alam and Brigitte. Conrad has a range of important nancial commitments clear and present, requiring to be addressed. The security of his work and health well being are key risks that need to be considered. Insurance policies to reduce the impact of him losing his job and/or falling ill should be considered. Balancing the proportion of cash being used to pay off the mortgage on his property or to increase pension contributions for retirement will require to be monitored carefully. Donna meanwhile will be balancing security of the pension fund that she has built up and the rate of return from the fund. For most individuals a nancial advisor may be needed to provide guidance on the relative merits of the alternative options (particularly with regard to the taxation implications). The remaining sections of this chapter will consider some of the important considerations for risk; nancial protection and the different returns on investment vehicles available to an individual.

10.3

Risk and protection

One of the key aspects of personal nancial planning is the trading off between consumption needs; investment returns and forecasting key downside risks (eg becoming redundant; unexpected changes in a family). As with companies the balancing of nancial risk from the potential default of debt nance needs to be kept under control to ensure the income generated is sufcient to cover interest and capital repayment. The nancial crisis worldwide since 2007 has also heightened the importance for investor protection against banks becoming bankrupt or suffering signicant nancial distress. In some countries investor protection up to certain capital limits is provided through government compensation schemes. Bailouts of banks who have found themselves without sufcient capital to continue has also enabled individual savers Heriot-Watt University Introduction to Finance

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recover some or all of their investments. Individuals can also provide an important level of protection against risks through appropriate insurance cover. One of the more difcult tasks for individuals is however, to identify potential risks in the rst instance.

10.3.1

Identifying risk

One of the key aspects of personal nancial planning starts with the identication of risks. The impact of risks and the individuals attitude towards them will vary. Initially they must be identied and understood. Table 10.7 illustrates some of the key risks for individuals to consider for personal nancial planning. Table 10.7: Key risks to consider for personal nancial planning

Retirement - Including pension fund and expected pension income Unemployment Property - including capital risk for reductions in value Medical - including death or illness Ination - including impact on both expenses and real returns from investments/savings Taxation - including impact on net earnings; investment returns; capital gains from selling shares and bonds and on estate planning after death Interest rate - the impact on savings or debt of changes in interest rates Currency - if investments are held in other currencies changes in exchange rate movements can have adverse effects on assets (eg property or nancial investments)

The impact of the factors listed in Table 10.7 is more complex to assess for each individual and over their nancial planning lifecycle. Donna will score high on the risk considerations for protection of her capital sum from share and bond price movement and also from the income return on her pension (which may be guaranteed if she has a nal salary scheme). Donna will also need to consider the impact of ination and taxation on her investments and pension income. In terms of taxation she and her partner may be paying higher rates of tax depending on the territory in which they are resident. Given his age range Conrad will also be wise to consider medical risks if becoming critically ill as he is a dependent income for his family. Changes to the value of his jointly owned property will also gure as a risk as there is still debt to be repaid so he will be susceptible to shifts in house price movements. Alam and Brigitte will be less Heriot-Watt University Introduction to Finance

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dramatically affected by retirement risks, though planning at the earliest stage will be important. Any movement in house prices will impact upon their decision when to invest and the extent of savings they need towards deposit. Having identied potential risks and their scale, nding ways to minimise their impact will be the next important stage.

10.3.2

Insurance

Insurance products provide a range of alternative solutions to enable individuals to manage their nancial risks over the lifecycle of their plans. Table 10.8 illustrates some of the key and more popular products that are available for some of the risks identied in the last section. Table 10.8: Examples of typical insurance products for personal nance planning

Life Assurance - for a dependent relative Medical insurance - Including: critical illness; long term care Building and contents - eg for property in case of natural disaster; burglary or re Car - in case of accident or theft Travel - in case of nancial loss while on business or vacation trips Life assurance provides cover for the death of a named individual over a prescribed period of time or for the duration of the life of the individual. At the time a policy is taken out a premium (amount payable) is estimated based on the sum assured, which would be paid out in the event of an individual dying. Policies available provide for different levels of cover and therefore premiums to be paid. Uses of life assurance policies can include a policy which provides for the repayment of the outstanding mortgage if the key person whose income is the key source of payment were to die. In the case of Conrad and his wife both may be critical to the mortgage repayment and therefore a joint-life policy may be appropriate to protect nancially the surviving spouse. Medical cover can vary in terms of necessity based on geographic regions worldwide. In the US (notwithstanding President Obamas health care reform bill) medical care is dependent on private healthcare systems, as a contrast to countries such as the UK and France who have well developed national health care systems (with some private provision). The impact on critical illness however may not only result in signicant costs for an individual for the basic care and attention (if not covered by the state) but may also cause signicant loss of earnings. Diseases such as: heart attack; cancer and major organ failure can be covered by a critical illness insurance which provides for a lump sum on the diagnosis of stipulated critical conditions. The premiums will vary in scale depending on the age of each individual.

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Another form of insurance which is becoming increasingly popular and controversial (in terms of whether individuals or the state or government pay) is long term care. This form of insurance provides for the expenses associated with care once an individual gets to an age that they need assistance in the form of personal or specialist care as they are unable to do on their own. Increasing life expectancy rates in many countries in the world has meant governments are considering carefully the role of the government in paying increasing amounts for those in need of long term care and therefore is an increasing priority for individuals to provide for in their own personal nancial plan.

10.3.3

Compensation schemes

The recent global nancial crisis which commenced in 2007, has heightened the awareness of individual investors of the protection available for banks and other nancial institutions who found themselves unable to honour savers. Many international governments have emphasised the need for international co-operation on nancial regulations to minimise the impact of any future crisis. Investor protection is at the heart of most well regulated schemes. In the UK the Financial Services and Markets Act in 2000 outlines arrange of investor protection measures including complaints handling. The complaint handling includes a requirement for banks and nancial institutions to make information available to investors and savers and to provide a complaints handling system. Normally if the complaint is not dealt with in two months a customer can approach the Financial Ombudsman Service (FOS). FOS was established by the 2000 Act to receive and act on complaints about banks; insurance or other nancial institutions. FOS can award up to 100000 in compensation to a customer complainant and therefore has a role to play in the protection of investors. The Financial Services Compensation Scheme set up as a single scheme in 2001 has been updated in terms of the level of cover after the global crisis. Table 10.9 lists the level of maximum compensation. Table 10.9: Financial Services Compensation Scheme

Deposits 50000 per person per rm (from 7 October 2008) Investments 50000 per person per rm (from 1 January 2010) Home Finance (eg mortgage advice) 50000 per person per rm (from 1 January 2010) Insurance Business Unlimited The implication for individuals of the limits in Table 10.9 is to ensure that in their personal nancial planning decisions they should ensure that their investments are not above 50000 for any one rm. In addition to FOS UK investors also have cover for complaints and disputes about their pension plans and advice through the Pensions Ombudsman.

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10.4

Returns on investments

For a personal nancial plan at most stages of the individuals lifecycle, maximising returns on investments and savings accounts will normally gure high in terms of objectives. Before looking at the practical options open to investors lets start by recapping some of the lessons from nance markets and modern portfolio theory that we covered in earlier chapters.

10.4.1

Investment theory and the equity risk premium

John Maynard Keynes identied three reasons as to why individuals would hold cash: Transaction Precautionary and Speculative At the most basic level individuals need cash for goods and services. To deal with uncertainty cash can be held as a precautionary measure and also to speculate on possible investment opportunities. In recessionary periods cash can provide some security as the uncertainties of the economic conditions mean that an individuals income is not certain and ination and interest rate risks increase. In terms of comparing returns for an individual against the main investment classes, Table 10.10 illustrates the real returns for bills (government securities of the lowest risk class); bonds and equities over the period 1900-2007 in the UK.

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Table 10.10: Cumulative returns on UK asset classes in real terms 1900-2007

1000

Index value (start - 1900 = 0.1; log scale ) Equities 5.5% per year Bonds 1.3% per year 1.0% per year 328

100

Bills

10

10 4.1 3.0 1

0 1900 05 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 2000 05

(reference ABN AMBRO Global Investment Returns Yearbook 2008) The returns shown are the average annual rates but clearly show a signicant premium for equities. You will recall from earlier chapters in discussion of the importance of risk diversication and portfolio theory that there are risk reduction benets from spreading investments. We also know that from historic returns there is a risk premium on investments in equity investments. Table 10.11 illustrates the average annualised risk premium of equity compared to treasury (or government issued) bonds and bills over the period from 1900 to 2007 across a range of countries.

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Table 10.11: Worldwide annualised equity risk premia relative to bonds and bills 1900-2007 across a range of countries

Annualised percentage return Equity premium vs. bills


7.2 7

Equity premium vs. bonds


6.8 6.4 6.5 6.5

5.6 5.5

5.8 5.7 6.4 5.7 5.3

5 4.3 4.1 4 3.3 3 2.9 2.7 2 2.3 1.9 1 3.0 3.5 2.9 2.7 3.7 3.7 3.9 4.1 4.1 4.4

4.8 4.6 4.6

4.5 4.2 4.1 4.0

4.4 4.1

0 Bel Den Nor Spa Swi Ire Ger WxUS UK Can Neth WId US Swe SAf Jap Ita Fra Aus

(reference ABN AMBRO Global Investment Returns Yearbook 2008) On the face of it one might be drawn as a personal investor to equities given the signicant extra return (the premium for risk) achieved on average. As students of nance however you will be aware that it is important to measure the risk. Prices on stock markets worldwide vary considerably. World equities had a real return (ie after ination) of 5.8% over the period shown (1900-2007) while bonds have a 1.7% real return. Short term movements in equities can be dramatic however and the average standard deviation of most developed markets in the last century has been close to an average of 18-20% annually. In any one year the movement of world markets of equities have moved signicantly (eg real returns of -54% from 1929-1931 during the Wall St Cash and -47% in 1973-74 during the oil crisis). In 2000-2007 many equity markets showed a negative cumulative real return. The US markets were -0.4%; Japanese 0.7%; UK 0.5% and Germany 1.2% over the period from 2000-2007. It is important for personal investors therefore to consider the volatility of equities as an investment in terms of their lifecycle of their nancial plan. While it is true that there are currently no 20 year periods of equity price movements that show a negative return cumulatively, the recent returns on stock markets has caused many institutions to revise their expectation of equity price movements in the future. This is very important implication for most individuals as it will impact on the return from pension funds that affect most individuals and also any investments that attempt to track stock market movements. Elory Dimson, Paul March and Mike Staunton at the London Business

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School highlighted the reductions in expectations from equity over the late 1990s and 2001, as shown in Table 10.12 below. Table 10.12: Estimated arithmetic risk premia relative to bills 1998 and 2001

10

Arithmetic mean equity risk premium 8.8 Late 1998 7.9 7.1 August 2001

8.5

5.5

4 3.4

0 Ibbotson (1926 - 98) Key finance textbooks Perceived consensus Welch 1 Welch 30 Welch 30 year premium year premium year premium

(reference: Global Evidence on the Equity Risk Premium Journal of Applied Corporate Finance, September 2002 and reference to Welch, I Views of Financial Economists on the Equity Premium and Other Issues, Journal of Business, Volume 73, 2000) Table 10.11 illustrates a signicant reduction in the risk premia expected as a return from equities for the 8.8% historic returns recorded by Ibbotson (1926-1988) through to a more conservative 5.5% from Welchs 30-year premium estimate. Another important link to an individuals investment decision is the efcient market theory and portfolio theory which would point an individual in the direction of passively holding a world portfolio of shares. The weightings (based on market capitalisation) would be, for example, approximately 43% of your investment in US stocks; 2% in China and 8.7% in the UK (based on the end of 2009 market weightings). In other words rather than trying to pick winners in stock markets or particular companies who have listed their equities on public stock markets, passively invest and hold the world market in proportion of the relative company values. Practically this is not so easy to achieve for an individual unless they choose an institution who invests in market indices. OK thats enough of the theory what about the practice?

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10.4.2

Choosing the right investments

Investors seeking to apply nance theory should consider the key points covered in the last section: Some risks can be diversied by holding a range of nancial securities (though the risk of the market cannot by denition be avoided); Equities have a premium compared to bonds and bills which have less volatility though the expectation appears to be declining in recent years; The maturity of investment is important as equities can be very volatile over short periods of time; Efcient market and portfolio theory suggests a passive holding of the market portfolio to maximise risk diversication and costs of trading in trying to pick winners. For Alam and Brigitte looking to invest in a pension fund over 30+ years equities as part of their portfolio would appear important in terms of generating a real return. Over a short period of time Donna should think carefully if her pension fund is in equities that they may move downward more quickly than bills and bonds. Just prior to her retirement Donna would be wise in considering the transfer of investments into safer bills; bonds and near cash savings. This will ensure her pension income is more guaranteed. Conrad will need to consider carefully the expected returns on his pension. He has a number of years still to invest his contributions. If his scheme is not a guaranteed nal salary then the returns of the underlying investments will impact on his overall pension fund which will generate his income in retirement. The level of the state funded pension will also impact on his investment decision and the risk that he faces. The lower the rate of normal state pension (and the pensionable age that individuals are entitled to the state pension which is increasing in many countries) will also affect Conrads choices. If much of his pension fund is invested in equities (even though they may be diversied to minimise unsystemmatic risk) the return assumptions may well have changed (see table 12 for the Dimson; March and Staunton research). If the return expected from equities re nearer 5.5% rather than the traditional historic 8.5%+ then he will need to ensure the projections for his fund are amended accordingly. For short term savings and investments, more applicable to Alam and Brigitte to invest smaller amounts of short term cash savings Table 10.13 illustrates some of the more practical investments that are available in the UK and in most developed markets (in terms of their equivalents the names will be different).

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Table 10.13: Popular investments available for investors in the UK market

Gilt edged security Index linked savings bond Individual Savings Accounts (ISAs) Tracker Funds

Issued by the UK government - most risk free will be the shortest maturity and index linked against ination) Protected against ination Provides for an investment in cash or equities up to an annual maximum amount free from tax Offered by nancial institutions to track worldwide stock markets and provides an individual with an investment which spreads risk - can be short or longer term.

Individual investors need to ensure that they consider carefully the maturity of their planning horizon and that their investments meet their nancial needs in a timely manner. Holding too high a level of precautionary and speculative cash has an opportunity cost of lost interest or capital returns on investments. Most personal nancial investors need to seek nancial advice to identify and assess the most effective nancial investments available for their needs.

10.5

Review

Key concepts and principles in this chapter: The nancial planning process involves: Establishing personal priorities; Understanding the maturity of the plan; Gathering information; Identifying key risks; Establishing alternative solutions; Deciding on a plan; Implementing the plan; and Monitoring and revising the plan. Critical to the nancial planning process is the understanding of personal priorities and attitude to risk; A nancial advisor needs to get to know their customer as part of their role; Information gathering is important for an individual to understand the nancial risks they face and the nancial returns required to meet their priorities; Insurance products provide a method for an individual to reduce the impact of key risks in a nancial plan, such as: medical; unemployment and loss of property; Heriot-Watt University Introduction to Finance

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Compensation schemes can provide some protection from the collapse or failure of a nancial institution providing a nancial service for an individuals savings or pension scheme; In selecting investments for a personal nancial plan it is important to take account of the planning life cycle and matching the maturity. Equity investments may provide an appropriate investment return over a long term but can be volatile over short periods of time; The expected risk premium from equity investments has been lowered after reduced returns in most stock markets since the late 1990s and early 2000s and should be considered in expectations for long term returns; Modern nance and portfolio theory applying to personal nancial planning would consider the benets from diversifying risks of investments set up for long term returns; Tracker funds can provide a diversied solution for a small investor; All aspects of the nancial plan should consider any effects of tax on the returns or costs inherent in the plan, some investments have interest and dividends paid tax free; The impact of ination can be managed in part through selection of index linked funds, whose returns are calculated after ination; Retirement planning is becoming more critical in recent years with more people living longer and in many countries dened contribution schemes mean that individuals take the risk that their pension fund is sufcient when they retire; and Individuals should seek nancial advice from a qualied nancial advisor before completing their nancial plan.

10.6

Review Questions

Q1: Why is the maturity of the nancial plan life cycle important? Q2: What are the main nancial risks for most individuals over their lifetime? Q3: Do you have a nancial plan? Would you be able to calculate you Income and Expenditure statement over the last 12 months and current nancial position? Q4: What is the equity risk premium? Q5: What is the least risky form of investment in the country where you live? Q6: If you had a pension plan which was invested in equities from a recognised stock market what annual average rate of return would you expect to receive? Q7: Why might you consider taking out a life assurance policy? Q8: In what conditions might you wish to hold cash?

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10.7

Tutorial Questions

Q9: Jonjo is a self employed electrician. He is 35 years old; married; owns a small apartment with his wife (who looks after their 4 year old daughter); has less than 1000 savings and a 90000 mortgage, with 15 years to maturity. Jonjos net income from his business varies from 35000 to 45000 (net of taxation) in most years. Jonjo is considering an offer for a full time job which would pay a salary of 38000 (net of taxation) per annum and would enable him to contribute to a company pension dened contribution scheme (his employer would pay 10% of salary and Jonjo would consider matching this). Jonjo does not currently invest in a pension fund. Identify Jonjos nancial risks and assess his options from the perspective of options in a personal nancial plan. Q10: Henrietta is 54 years old and is a widow. She works full time as a marketing executive and is considering when she might retire. She earns a salary of 45000 per annum and a bonus annually of between 1000 and 2000. The life assurance payment on the death of her husband was used to clear the mortgage on her house which she now fully owns. The value of her house is 250000. She will be entitled to the full pension from her company scheme when she is 65 years old. She has other investments in savings schemes totalling 20000. She normally tries to save about 2000 per year from her salary after tax and expenses and uses her bonus as a holiday fund. Consider Henriettas current position, with a view to identifying options for a nancial plan. Q11: Edward and Julia are both employed and are looking to save money from their monthly budget towards a long holiday in ve years time which they expect will cost 25000. They have sought the best savings rate of return at 3%. How much will they have to save from their current monthly budget towards their holiday in ve years time?

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Chapter 11

Appendix 1: Financial Tables


Contents

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Chapter 11. Appendix 1: Financial Tables

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Answers to questions and activities


1 An Overview of the Subject of Finance
Self Test 1.1 (page 9) The key objectives identied in the Wilson Committee Report were the following. 1. The capital market brings together individuals, institutions and organisations who have surplus funds which can be placed in nancial investments, issued by organisations interested in investing the surplus funds in economic activities, creating wealth. 2. In order to appeal to investors with different risk and return preference, the capital market should provide a range of nancial investment opportunities to appeal to savers and enable the users of funds to package the risks of the underlying physical investments. 3. The nancial investments traded on the capital market should be valued to reect the relevant risks and returns to savers and investors transacting with each other. 4. Capital markets, through the process of constantly updating values of nancial securities issued by business organisations, based on information about their performance, will provide a pressure on the management of the organisations to allocate resources efciently.

Self Test 1.2 (page 9) The solution is in Figure 1.1

Self Test 1.3 (page 12) The capital market allows the providers and users of funds to transfer their waiting and risk. An investment in a project, such as the construction of a factory, may have many years of useful life to a business organisation. A provider of funds to the business organisation need not wait until the end of the useful life of the project, however, before he/she realises a return. He or she can sell their share in the business on the capital market at any time before the end of the useful life of the business activity. Owners of a business organisation can transfer some or all of the risk of their business activity by selling the rights to receive future returns from the business activities to nancial investors.

Self Test 1.4 (page 17) You can refer to the nancial pages of a suitable nancial daily newspaper, (such as the Financial Times in the UK or the Wall Street Journal in the US), or alternatively to the telephone directory, under Pension funds, Life Assurance, or Banks for example. Heriot-Watt University Introduction to Finance

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Self Test 1.5 (page 21) Figure 1.12 lists some of the main sources of new nance used by UK industrial and commercial companies. Included are: 1. Internal funds generated from business operations; 2. Bank borrowings; 3. Ordinary shares; 4. Preference shares; 5. Debenture stocks. The distinctive features of these sources of nances will be covered in Chapter 3.

Self Test 1.6 (page 23) Examples of external factors include: General ination in the economy; Interest rates; Foreign exchange rates. The movement of each of these external factors can have a positive or negative effect on a business organisation depending on the degree to which the business is exposed to the particular factors. For example, a UK company exporting products to American customers will be affected by the movement in the -$ exchange rate. If the exchange rate moves from 1-$1.50 to 1-$2.00 over a period of time, the UK company will nd that if the product is selling for $15 per unit in America before the exchange rate change, this would yield the company 10. After the change in exchange rate, if the price remains the same, (i.e. $15), it will return only 7.50 to the company. The company will therefore suffer a fall in their revenue, unless they are able to raise the price (e.g. to $20) and somehow maintain the same level of sales volume. Examples of internal factors include: A strike by the workforce of the organisation (affecting productivity and the completion of customer orders) Some internal factors affecting the nancial performance of a business organisation may well be a response to an external factor such as pressure from competitors.

Answers from page 24. Q1: C: A hospital managed by a Local Authority.

A Local Authority hospital (i.e. a hospital controlled by a government body and funded by public money) provides a non-nancial service to the public. Heriot-Watt University Introduction to Finance

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Q2: C: To raise nance for a physical asset investment by issuing nancial securities. The capital market enables business organisations, such as an incorporated company, to raise money for physical assets such as buildings and equipment. Q3: D: To sell a nancial security. An individual may wish to realise the nancial return on his or her investment. Q4: A: To set interest rates. Interest rates will normally be set by the central Government, as part of their economic policy. Q5: D: A technical analyst. A technical analyst charts the movement of nancial security prices to try and establish a trend on which to establish a trading pattern. Q6: A: A fundamental analyst. A fundamental analyst studies publicly available information about companies, who have issued nancial securities, with the objective of establishing a value for the securities. This information will be used to establish a trading decision for the nancial securities, i.e. buy, sell or hold. Q7: B: An agent broker. An agent broker acts on behalf of an individual or institution, each of whom may want to buy or sell a nancial security. The agent broker arranges the transaction with an authorised dealer in the nancial security. (Note the dealer broker, (C), may also do this task, but can also engage in other activity - see question 8 below) . Q8: C: A dealer broker. A dealer broker can arrange deals on behalf of individuals and institutions and also deal in shares for them or on their own behalf.

Answers from page 25. Q9: A primary capital market is where business organisations or governmental bodies can raise nance by selling nancial securities to providers of funds. The London Stock Exchange and New York Stock Exchange are examples of primary capital markets. Q10: A secondary capital market is where investors buy and sell nancial securities, which have been issued through the primary capital market. Q11: A capital market can act as a primary capital market without necessarily acting as a secondary capital market. Such a market would, however, have present serious drawbacks to an investor, as he or she would nd it more difcult to sell their investment when they wish to. The absence of a secondary capital market would also mean that market prices would not be so observable and quoted on a regular basis. This may also affect the willingness of investors to invest in primary capital market issues.

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Q12: Financial intermediaries bring together the providers and users of funds in a nancial system. This may broadly be by providing a mechanism for savings to be collected and a service or nancial return being generated (e.g. an investment trust or a life assurance company) or by giving advice on investments (e.g. a bank or stockbroker). Q13: An individual can make an investment in a nancial security directly, through a broker dealer. In this case the investor owns the security personally. Alternatively an individual can provide funds to a nancial institution, who will invest the funds in nancial securities on behalf of the individual. In this case the individual is an indirect investor in nancial securities. Examples of indirect nancial investments are unit or investment trusts and pension funds.

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2 Basic Financial Concepts


Self Test 2.1 (page 31) This answer is left for you to complete.

Self Test 2.2 (page 33) Here are some of the key benets and drawbacks: The main benets include: It enables the owner of the business to divest himself of the daily day-to-day decision-making, enabling them to concentrate on the general business strategic focus. It may enable the owner of the business to spend time away for the business (or take early retirement) without losing the control of the business organisation. It may be that the move is part of the business growth and that the process is part of the owner sharing the risks and rewards with other participants in the business and the decision-making with other management. The main drawbacks include: The managers become agents of the owners and may be expected to act in their own self interest rather than the interest of the owner. The owner will typically require to invest time and effort in a framework of monitoring the managers, to ensure that they are performing well and in the owners interest.

Self Test 2.3 (page 34) It is likely that your answer will have revealed something about your own attitude to risk and returns from nancial investments. Government bonds have the lowest risk and expected returns in most economies; closely followed by bank deposit accounts; while ordinary shares have very high risks and variable returns.

Self Test 2.4 (page 36) A typical list of interested persons, groups of persons or institutions, interested in the success of a business organisation is, as follows (in no particular order): Shareholders Management Employees Heriot-Watt University Introduction to Finance

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Customers Suppliers Creditors Government Local community Society

Self Test 2.5 (page 39) 1. Risk preferring This is because in the long run roulette is a gamble. The odds are stacked against the gambler as there are only 37 possible numbers on the wheel, although the gambler is only paid odds of 35/1 for each 1 stake (plus his original 1 stake back). This means that if Jim plays number 7 all night, with a 1 level stake on each spin of the wheel, his return (on average) for every 37 spins of the wheel will be 36. He will therefore lose 1 for every 37 spins of the wheel (37 staked - 36 return). Jim choses to play because he is a gambler (risk preferrer). 2. Risk aversion A government gilt edged security is the most riskless form of nancial security, for a UK investor. The extra 0.25% return offered by the South-East Asia bank reects the extra risk for an investor in the UK, investing in a bank which is not guaranteed by the UK government if it is unable to pay all of its depositors. In the UK in the 1980s, the Bank of Credit and Commerce International (BCCI) collapsed leaving many of its depositors unpaid. The UK government did not guarantee to pay the depositors in the event of the bank being unable to meet all of its debts. 3. Risk preferring For reasons similar to 1, horse racing odds are quoted to ensure the bookmaker (the person offering the odds) makes a prot in the long run. Joe is a gambler and although he may collect winnings more often than if he backed outsiders (as the favourite, by denition is considered by the betting market to have a greater chance of winning than the outsiders). There are few gamblers who claim to earn a living from simply betting on horse races!

Self Test 2.6 (page 43) As with question 2.3, it is likely that your answer will reveal something about your risk preferences. Ordinary shares have variable returns and a consequent high risk. Some ordinary shares have a higher degree of variability than others because of the nature of their business. Diversication can help to reduce some of the variability. This can be achieved by investing in shares whose nancial returns do not move in the same direction and at the same rate. For example, a soft drinks company will do well if there is a warm summer, selling more of their products. Conversely if the summer is warm, Heriot-Watt University Introduction to Finance

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an umbrella manufacturer will do comparatively badly. Selecting a portfolio including shares of both companies means that an investor will not be exposed to the risk of a very warm summer (by holding only the shares of the umbrella manufacturer) or to the risk of a cold and wet summer (which would negatively affect the returns from holding only shares in the soft drinks manufacturer). Investing in the shares of the 50 largest companies in your country will mean that your portfolio return will be affected signicantly by the movements in your countrys domestic economy. International economic factors may also affect the movement of share prices in the top 50 companies. For example the nancial returns of a company in Mexico, exporting goods to the US, will be affected by movements in the US$ - Peso exchange rate.

Self Test 2.7 (page 46) Information which you may have noted down may include: Share prices i.e. how much each ordinary share will cost and how much movement the price has made in the most recent period. Financial reports This is likely to include the most recently published annual accounts indicating the returns achieved for investors and a summary commentary on the business performance. It may also include analyst reports on the current status of the company. Business prole General economic and industrial sector information, concerning the market in which the company trades, whether the prospects are positive or negative in the current economic climate. Economic and fundamental analyst reports may provide detailed guidance on such factors.

Self Test 2.8 (page 49) 1. A dividend announcement is part of the public information set (B). 2. Movements in share prices are available to all investors and are the most basic set of information available to all investors and are the most basic form of information available (A). 3. Forecast cash ows are normally only available to people inside an organisation. Often the information is price sensitive and of interest to competitors. It is therefore described as inside information.

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Self Test 2.9 (page 52) A put option gives the holder the right to SELL an underlying asset or nancial security. A call option gives the holder the right to BUY an underlying asset or nancial security.

Answers from page 53. Q1: a) Yes. John is averting the risk of his arm being injured once again. b) No c) No d) Yes. John is acting in his own self-interest in order to protect his injury. Q2: a) Yes. It can be assumed that the Her Boys will take a decision which is consistent with the concept of risk aversion. The riskiest option open to them is to go to court, which could involve them being required to pay very high levels of costs, or potentially very low levels of cost. There is a wide spread of possible nancial costs. Paying the 2 million and avoiding a court appearance is therefore the least risky option. Being risk averse does not mean that the boys will simply chose the least risky option. If they had two options with the same level of expected return (or nancial cost) they would be expected to accept the option with the lowest risk. The choice in this case will therefore be a comparison of the combined probability of the possible costs in the court case and the 2 million out of court settlement and a comparison of the expected risk of each option. b) Yes. The decision taken by the Herb boys will involve them valuing the options available to them. If realised, the option to avoid the court case is 2 million. The option to avoid paying damages to the girls can have potentially high court costs and an award of damages in excess of 2 million. c) Yes. The Herb boys solicitor is their agent and should therefore be acting in the boys best interest. d) Yes. The decision taken by the Boys we can assume will be based on their selfinterest, attempting to reach the best deal for themselves, which will be opposite to the self-interest of the girls. Q3: a) For you to answer! b) Semi-strong. This is because the magazine is public information, widely available and should be quickly incorporated into the share price in a semi-strong efcient stock market. c) A strong form efcient market will ensure this information is quickly incorporated into the share price also.

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Q4: a) Yes. It can be assumed that Brian has taken the decision to avert the risk. The concept of risk diversication enables an investor to reduce their risk of holding only individual stocks by combining them in a portfolio of different shares. b) Yes. Combining stocks will diversify the individual unique risks of each individual stock. Investing in a world portfolio, will also enable the investor to diversify some of their individual country specic risks (e.g such as movements in the domestic ination and interest rates). c) Yes. Brians nancial specialist friend will act as the portfolio manager (Brians agent) trading in stocks so as to meet the objectives of Brians investment plan. d) No. Q5: a) Yes. David is acting in his personal self-interest, by using his brother rather than a contractor who will charge a lower price. b) Yes. The concept of a corporate nance managers objective function, being to maximise shareholders wealth, is brought into question in this example, as the shareholders will suffer the extra cost of Davids brothers service. c) Yes. The information that shareholders may wish to know, but which is unlikely to be brought to their attention, are the details of the contract terms vis-a-vis Henry and the alternative cheaper contract. d) Yes. If shareholders do not know the possible options open to the manager, in terms of value creation, there is an information asymmetry. Shareholders will be unaware of the extra cost incurred, referred to as agency cost.

Answers from page 54. Q6: Shareholders Shareholders have an implicit contract with the company in which they hold shares. Their nancial return is not specied. Implicitly it may be assumed that they expect managers of a business, acting as their agents, that they should aim to maximise their wealth and take business decisions which are consistent with their own riskreturn preferences. Management Management are the agents of the shareholders. As their agent, the managers can be assumed to be under some pressure to act in the best interest of the shareholders. The concept of self-interest, however, may mean that they attempt to take decisions which improve their own position. To ensure managers do not undertake self-interested action shareholders will seek to monitor managers performance. Linking the management rewards with shareholders rewards may help to promote goal congruency (for example offering ordinary share options to managers as part of their pay package). Managers wealth can therefore be tied to shareholders wealth. As share prices increase both managers and shareholders wealth will increase and vice versa. Heriot-Watt University Introduction to Finance

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Employees An employee of a business organisation has an explicit contract. The terms and conditions of an employees contract of employment will make explicit the payment terms and hours of work. It may be claimed that employees implicitly look for rewards which are wider and deeper than the terms stipulated in the contract, for example, to achieve self-fullment The employee contract may therefore include an element of implicit contractual obligation on the organisation and management to allow employees the opportunity to full higher level goals. Customers The customer is king. Customers have an explicit contract with a business organisation for the supply of goods and services. It is also likely that the customer will be protected through government laws which affect business contractual arrangements. If the business therefore fails to deliver goods or services to the requisite standard to a customer, the business may be faced with a nancial penalty. Suppliers A suppliers contract is explicit, similar to the customers. A business organisation will sign a contract for the delivery of the requisite quantity and quality of goods and services to the organisation and the associated documentation will stipulate the terms and conditions of the transaction. Q7: a) Shareholders and management share a principal-agent relationship. The concept of self-interest means that each partner in the relationship will try to maximise their own return. Shareholders may be presumed to have as their objective, to maximise their wealth (through an increased share price and/or dividend payments). A manager may have a different set of objectives. They may be less willing to invest in more risky investments, in order to ensure their own survival. Also they may consume corporate perks such as utilising business entertainment expense accounts for their own use. Because of the concept of self-interest and the privileged position of the manager, being in a position to allocate resources on behalf of the shareholder, shareholders will seek to monitor management decisions. b) The methods which a shareholder can use to ensure that the manager is making decisions in their best interest include the following: 1. Monitor managerial actions (e.g. through quarterly, halfyearly or yearly nancial reports). 2. Structure management responsibilities to minimise the consumption of corporate perks. 3. Compensate managers for actions which ensure the shareholders wealth is maximised (e.g. giving managers share options as part of their remuneration package). Managers may also be inuenced to act in the shareholders best interest by the threat of ring and of the company being taken over. Q8: Georgettes business idea is an interesting one. It does not, however, guarantee a rate of return on the 2 000 investment. The return on your 2 000, according to Georgettes estimates will be 30% (600/2 000) over the two year period (or Heriot-Watt University Introduction to Finance

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alternatively, an average annual return of 15%). This rate of return clearly compares favourably when compared with the bank rate of 7%. This analysis, however, does not consider the riskiness of the two alternatives. The bank deposit is relatively risk free, if the central government will pay depositors should the bank have insufcient funds. Georgettes project has risk. Or put another way, there are a spread of possible returns (both positive and negative) from her business idea. Being risk averse there is no one dominant alternative facing you, as there will be a trade off between more risk and more return expected if you transfer your funds from the least risk option of the bank deposit. You would be advised to ask of Georgette the foundations of her expected return and try to gauge a measure of the spread of possible returns facing you. Your own risk preference will determine whether you believe that the 8% (15%- 7%) increased expected annual return is sufcient to cover the extra risk involved. Q9: a) Maximising shareholders wealth is traditionally viewed as the goal of a protmotivated business organisation. This unitary objective focuses a mangers attention to increasing the value of the company shares and dividends paid. The key reasons why a shareholder is viewed as the most important stakeholder in an organisation is that they control the voting rights to appoint the top management of the organisation, and therefore in theory control the cash ows being generated by the organisation. b) In question 1 some alternative stakeholders to shareholders were listed. To this list could be added the government, creditors and society more generally. These stakeholders (i.e. persons or institutions having an interest or investment, physical or nancial in the progress of the organisation) can be seen as having an inuence on the actions of managers of the organisation in making their resource allocation decisions. A stakeholder approach to management decision-making seeks to take a wider view regarding managements objectives which is not conned with simply maximising the shareholders wealth, but satisces each of the stakeholders listed. Viewing an organisation as comprising a number of interested stakeholders with a network of implicit and explicit contracts is wider than the maximising shareholders wealth objective. Q10: No answer is provided here. Q11: 1. Risk aversion means that an individual faced with a choice of alternatives, each having the same expected return, they will choose the alternative having the least risk. Alternatively facing two investment options which have the same risk, an individual will choose the option with the highest expected return. Risk preferring on the other hand is where an individual will choose to invest in the riskiest alternative investment, although it may not provide a higher return than a less riskier alternative. Risk preferrers are therefor perceived to act irrationally. 2. The list shown involves investments with varying degrees of risk, from the least risky (a government bond to the most risky (holding one ordinary share. Your individual risk preferences will inuence your choice of investment for the 1000. The concept of risk aversion is important to your choice. It is presumed that you will only invest in riskier investments if your expected return is higher by doing so. Also, the concept of risk diversication is important as a portfolio of ordinary shares or Heriot-Watt University Introduction to Finance

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one with a mixture of all the available investments shown, will reduce the individual unique risk of ordinary shares held on their own. It is assumed therefore that investors will diversify in order to reduce their risk, wherever possible. Q12: a) The concept of an efcient market is important in understanding that information about the expected future cash ows from a business organisations activities will be of interest to investors and potential investors in ordinary shares. If a capital market is efcient in a weak, semi-strong or strong form this will have implications for the impact of information on an organisations share price. For example if a company has issued shares on a capital market which is weak form efcient, public information about the company will not be presumed to be included in the share price instantaneously. The concept of self-interest in a nancial context means that a manager will be motivated to communicate good information which reects well on their performance. Managers may therefore wish to signal positive information to shareholders to reect well on their performance. In a strong form efcient market shareholders know public and inside information so that the manager does not have an information set which is unknown to shareholders, and cannot consequently communicate new information to them. b) Your list may include: Forecast revenues and costs from business projects; Future price and competition sensitive strategic objectives; Possible take-over or merger targets; Results of current research and development of commercial opportunities.

Q13: Each of these levels of efciency are dened in the text. Q14: The role of information provision is crucial to the level of efciency at which a capital market can operate. Capital markets in developed countries typically have a highly developed regulatory structure and infrastructure of alternative technological media to ensure information from companies with shares listed on capital markets is easily available to as wide an audience as possible and incorporated in share prices instantaneously. There is a signicant body of evidence to suggest that developed capital markets in the UK, USA and Japan are semi-strong efcient. There is some evidence that a recently developed market, such as Malaysia (having been re-classied after having previously been classied as an emerging market), operates on at least a weak level of efciency. The regulatory infrastructure and capital market rules relating to information provision necessary for companies listed on the market will contribute signicantly to the level of efciency. Q15: A put option gives the shareholder a right to sell a specied ordinary share at some date or range of dates in the future. If an individual holding a put option decides not to sell the share in the future they will lose only the cost of the premium for the put option. Similarly for a call option (the option to buy a share at some point in the future) if the option is not exercised the holder loses only the premium, there is no obligation to buy the shares. For example, assume an investor believes that the shares of BusyB plc will rise in the future. He can invest in shares in BusyB plc today and hold them until he is satised with his return, or he could purchase a call option to give himself the right to buy the shares at some specied point in the future at a pre-set price, on the basis that the pre-set price will be below the price of buying the ordinary shares. For example Heriot-Watt University Introduction to Finance

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the current price of BusyB plc shares is 200p and which is expected to rise in the next year to 300p. A call option purchased today will give the holder the right to buy shares in BusyB plc in one years time at a price of 230p. The investor has the choice of investing in the shares today at a cost of 200p per share (taking the risk that the share price falls, reducing the value of the investment) or purchasing a call option which will enable him or her to buy at 230p in one years time and then sell at 300p making a prot. If the share price falls the investor only loses the call option premium as they would not wish to exercise the call option if the share price is below 230p.

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3 Sources of Business Finance


Self test 3.1 (page 61) Advantages Control over the cash ows of the organisation. Control over the decision-making. Zero/minimal monitoring costs of management actions. Low administration costs compared to an incorporated or publicly listed company. Disadvantages Unlimited liability for the business debts. Limited potential for raising nance for business activity. The business risks are borne by the proprietor.

Self test 3.2 (page 62) Similar in principle to a sole proprietorship. Advantages Control over the cash ows of the organisation. Control over the decision-making. Zero/minimal monitoring costs of management actions. Low administration costs compared to an incorporated or publicly listed company. The business risks are shared by the partners. Disadvantages The partners are jointly and severally liable for the debts of the business. A partnership does not have access to capital markets to raise nance for business activities.

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Self test 3.3 (page 65) Advantages Liability to the company debts is limited. Increased access to raising sources of nance. The business risks are shared with other investors in the company. Disadvantages High administration costs in complying with company law and capital market regulations (if listed). The sole proprietor/partner converting their company to an incorporated company lose some of their control over business decision making. Costs will be incurred by the shareholders to monitor management.

The dilemma for entrepreneurs such as Richard Branson and Anita Roddick is that they face a dilemma of reducing their control in business decision making and sharing the business risks with their shareholders. The problem is exacerbated because they are both retained an executive managerial role in their business which means that they are accountable to the Capital Market as agents of the shareholders.

Self test 3.4 (page 67) The main reasons: Ordinary shares are a exible form of nance as the return is not xed; It is an effective means of sharing the risk of a business operation; Finance from more traditional sources such as a bank or other nancial institution may be restricted or too expensive.

Self test 3.5 (page 68) The main differences are: The ordinary share return is not xed, while the return on preference shares normally is; There can be variations of types of preference shares, including the following features: voting rights; redeemable; participating. Preference share dividends are paid out before ordinary share dividends.

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Self test 3.6 (page 70) The main options open to lenders is to: invoke restrictive covenants (see Figure 3.7 for examples of typical covenants); attach a secured or oating charge to a loan.

Self test 3.7 (page 73) LIBOR (the London Interbank Offered Rate) is the standard rate at which international banks transact with one another. The prime rate is the rate at which the bank lends to regular customers. The Prime Rate is the rate at which the bank lends to regular customers. The Floating Rate of interest, as its name suggests, is a lending rate which changes based on movements in the prime lending rate. For example a customer may be given a loan on terms, such as 3% above the prime rate. The interest cost will change as the prime rate changes, in contrast to a xed lending rate loan, where the interest cost does not change as the prime rate changes.

Self test 3.8 (page 74) The main reasons include: Debt interest is tax deductible; Debt nance is normally cheaper than equity nance (the shareholders will expect a higher return to compensate for them taking more business risk); Debt nance does not dilute the voting control of a company.

Self test 3.9 (page 75) The return on loan stock, with no option for the holder to convert into ordinary shares at some point in the future, is the coupon payment made each period. The holder of a convertible loan stock security receives a xed interest return and has the value of the option to convert to ordinary shares if share prices rise above the specied exercise price at the date of conversion. The coupon rate of an ordinary loan stock will be higher than the coupon rate of a convertible loan stock issued by the same company and having the same maturity date (assuming the convertible loan stock holders do not convert). The difference will reect the value of the equity option.

Self test 3.10 (page 76) Eurobonds and Euroequities have grown in popularity since the 1960s as companies with world-wide business interests sought alternative means of raising nance outside of their own domestic capital markets. Both forms of security give exibility to the issuers as Heriot-Watt University Introduction to Finance

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they allow them to raise nance in different currencies which may reect the multinational nature of their business.

Self test 3.11 (page 80) See Figure 3.11.

Answers from page 82. Q1: a) No b) No c) No d) Yes Q2: a) Yes b) Yes c) Yes d) Yes Q3: a) No (after-tax) b) Yes c) No (above) d) Yes (Normally, as they are entitled to participate/share in some of the residual prots after the preference xed dividends have been paid out). Q4: a) Yes (though it may be a oating rate) b) Yes (though it may be irredeemable) c) Yes (though it may be unsecured) d) No Q5: a) No (This is true of a oating rate) b) No (It allows the company to redeem the stock at any time between the dates 2010-2015) c) No (vice-versa, it protects the lender) d) No. Q6: Heriot-Watt University Introduction to Finance

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a) Yes (For the price of converting from a loan stock into an ordinary share) b) No (Because of the value of the option the coupon rate will be lower than that of a non-convertible loan stock) c) Yes (Though the stock may be irredeemable - assuming it is not converted) d) No Q7: a) No (Any foreign bank) b) Yes c) Yes d) No (the Ecu) Q8: a) Yes b) No c) Yes d) No (by denition his/her liability is limited)

Answers from page 84. Q9: Private company Control can be held by a small number of private individuals; There is less expense of providing information compared with capital market listing requirements; Shareholders enjoy limited liability. Publicly listed company The company is subject to the listing requirements of the capital market which will include the provision of nancial information; More than 50% of the shareholding needs to be held publicly; Shareholders enjoy limited liability; The company has a wider access to capital market sources of nance.

Q10: Ordinary shareholders rights include: Voting rights; Entitlement to a dividend if one is declared; To sell their share; To a share of residual prots on the event of a company being wound up. Q11: Each of these three stocks have features which are designed to provide an element of variability in the return given to stockholders. The option to buy or convert to ordinary shares (subject to the warrant or conversion conditions) gives the holder of a xed interest loan stock the opportunity to participate in a greater nancial return if the company does well. The participating preference shareholder will receive a share of the residual prots after all xed preference share dividends have been paid out. Heriot-Watt University Introduction to Finance

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Q12: The main methods include: Restrictive covenants (see Figure 3.7); Credit checks on the borrower to establish their risk, (Standard and Poor and Moody are two institutions who offer a bond ratings service which categorises companies based on their perceived credit risk to lenders) Q13: Debt Advantages Interest payments are tax deductible, reducing the company tax payment; Normally cheaper than equity nance as lenders take a lower proportion of business risk. Disadvantages The return is xed and therefore needs to be paid regularly; If the company defaults on payments the debt-holder can apply to the courts; The debt-holder may impose restrictive covenants; Too much debt could lead to the company being in nancial distress to meet the payments. Equity Advantages Increases the nancial exibility as the dividend payment is exible; There is no maturity date for repayment. Disadvantages Equity holders will normally require a higher rate of return to compensate for the extra business risk; There is a cost of being accountable to shareholders, in terms of the reporting and annual general meeting costs; The dividends paid to shareholders are not tax deductible; The control of the company will be changed potentially for new issues of shares, if they do not go to the original shareholders. Q14: The main attractions include: Widening the potential for raising nance; The option to raise nance tends to be limited to well known international blue chip companies; Enables multinational companies to raise nance in different currencies to match the country in which their business activities reside.

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4 The Value of Money Over Time


Self test 4.1 (page 93) a) 1500(1.07) 6 = 2251.10 b) Period interest charged Annually Six monthly Three monthly Monthly Weekly Daily Periods of n 1 2 4 12 52 365 Interest rate per period of n 25% 12.5% 6.25% 2.08% 0.481% 0.0685% APR 25.00% 26.56% 27.44% 28.34% 28.27% 28.39%

Self test 4.2 (page 97)

Self test 4.3 (page 100) PV (Annuity) = 100


851.36

Self test 4.4 (page 101)


a)

b)

Self test 4.5 (page 105) (1 + nominal rate of return) = (1 + ination rate)(1 + real rate of return) (1.07) = (1 + ination rate)(1.025) (1 + ination rate) = (1.07) /(1.025) (1 + ination rate) = 1.044 The ination rate = 4.4%

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Answers from page 106. Q1: C 1276 1000 (1.05) 5 = 1276 Q2: D 1079 500 (1.08)10 = 1079 Q3: D 3834 100 (1.20)20 = 3834 Q4: A 907
1000 (1.05)2

Q5: B 241
600 (1.20)5

Q6: C 38
100 (1.05)20

Q7: D 15.6% (1.075)2 = 1.1556 = 15.6% Q8: C 34.5% (1.025)12 = 1.3449 = 34.5% Q9: D 33.9% (1.0008)365= 1.338946 = 33.9% Q10: B 307 PV(Annuity) 1 0.10(1 + 0.10)10 1 0.08(1 + 0.08)3 1 0.20(1 + 0.20)25

Q11: B 258 PV(Annuity)

Q12: C 124 PV(Annuity)

Q13: B 1200
120 1.10

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Q14: D 667
50 (0.075)

Q15: C 600
30 (0.05)

Q16: C 56
5 (0.15 - 0.06)

Q17: D 455
25 (0.08 - 0.025)

Q18: A 5.77% (1 + nominal rate of return) = (1 + ination rate)(1 + real rate of return) (1.10) = (1.04) (1 + real rate of return) (1 + real rate of return) = (1.10) (1.04) (1 + real rate of return) = 1.0577 The real rate of return = 5.77% Q19: D 5.57% (1 + nominal rate of return) = (1 + ination rate)(1 + real rate of return) (1 + nominal rate of return) = (1.025) (1.03) (1 + nominal rate of return) = 1.0557 The nominal rate of return = 5.57% Q20: C 9.09% (1 + nominal rate of return) = (1 + ination rate)(1 + real rate of return) (1.20) = (1 + ination rate) (1.10) (1 + ination rate) = (1.20) (1.10) (1 + ination rate) = 1.0909 The ination rate = 9.09%

Answers from page 109. Q21: Factors which affect the time value of money are covered in Figure 4.8. Q22: A sinking fund is a term used in nance to refer to the reduction of a capital sum of money repaid at some future date by the payment of regular instalments to an investment fund such that at some future date its value will have increased sufciently to repay the outstanding capital sum. An example of a sinking fund would be the repayment of a 20-year loan used to purchase a house by the payment of a regular payment per month of a sum of money to an investment fund, which will earn a rate of return such that at the end of the twenty years, the fund will have grown sufciently to repay the loan. Q23: An APR is the annual rate of interest charged on an outstanding debt, by a lender. If a credit company charges interest on outstanding balances to their customers on an annual basis the APR will be equivalent to the annual interest charge. For example, if a credit company charges 24% per annum interest on outstanding credit balances and Heriot-Watt University Introduction to Finance

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applies this charge once a year, 24% is the APR. If however, the company charges the interest monthly, (that is, 24%/12, or 2% per month), the APR will differ from the annual interest charge of 24%. This is because the APR takes account of the interest charged on the interest charges applied each month during the year. Assume a customer pays 1,000 for new clothes on January 1, using their credit card. The customer leaves the bill unpaid until December 31 of the same year. If the credit card company charges interest on the outstanding balance every three months, (assuming an annual interest charge of 24%, the quarterly charge will be 24%/4, which is 6%). The 1000 bill will grow as follows: Balance January 1 March 31 June 30 September 30 December 31 The APR is (1.06)
4

1000 1000 (1.06) 1060 (1.06) 1123.60 (1.06) 1191.02 (1.06) = 1.26248 = 26.25% 1060 1123.60 1191.02 1262.48

This compares with the 24% APR, if the interest is applied once annually. Q24: The present value = 200 (1.10)
1

The present value of 200 received each year for the next three years, discounted at the required rate of return of 10% per annum, is almost exactly equivalent to the cost of the investment, 500. This means that with the information given, this investment is just acceptable to you, as it yields a return of 10%, (ignoring the 2.63 slight loss as being immaterial). Q25: The present value of a perpetuity =

25p

Given Pauls expectation of growth and the future dividend, using his 11% required rate of return yields a present value of 3.57 for the investment. In other words if the investment is priced at 3 it is worth investing based on the estimates provided. Q26: The cost of credit is: Astra Ltd Beta plc Creda plc (1.0006)365 (1.023) 12 (1.08) 4 24.47% 31.37% 36.05%

Astra Ltd therefore, is currently offering the lower cost of credit.

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ANSWERS: Chapter 4

Q27: PV (Monthly Annuity) = 80000

0.08 12 months 0.08 12

= 65326.69 = 14673.31

The total monthly payments will therefore be: The remainder of the capital outstanding will be paid with the accumulated interest:

1088.78 60

80000.00 Q28: (1 + nominal rate of return) = (1 + ination rate)(1 + real rate of return) (1.07) = (1.04) (1 + real rate of return) (1 + real rate of return) = (1.07) / (1.04) (1 + real rate of return) = 1.0288 The real rate of return = 2.88% The future real value = 10000 (1.0288) 10 = 13283.41

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ANSWERS: Chapter 5

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5 Valuing Fixed Interest Securities


Self test 5.1 (page 120) The two government stocks have a different maturity date. The 8% stock matures in the year 2015 and the 10% stock matures in 2004. It may also be that the two stocks were issued in different years. The coupon rate of return offered for each stock will be reective of the expected average annual interest rates over the maturity at the time of the stock issue. As the time-scales of the stocks differ, the difference in the coupon rates is reective of the difference in the expected level of interest rates at the time of each stocks issue. Because the maturity of the two stocks differ, therefore, the interest yields will also potentially differ. As the interest yields are below the coupon rates of each stock respectively, it indicates that the market currently expects interest rates on average to be lower than the coupon rates over the remaining years to maturity for each stock. The redemption yields for each stock are different, again being a reection of the differing maturity. The redemption yields are lower than the respective interest yields for each stock as both stocks will yield a capital loss for an investor investing today. That is, for the 8% 21 13 stock there will be a capital loss of 11 32 and 15 32 for the 10% stock.

Self test 5.2 (page 127) Using the redemption yield equation: 975 =
120 (1 + r)1

120 (1 + r)2

120 (1 + r)10

1000 (1 + r)

10

The annual income is 12% of the nominal value of 1000. There are 10 periods of n. Trying an estimate of r = 12%: Trying an estimate of r = 13%: The present value = 1000 The present value = 945.74

Therefore we know that r is between 12% and 13%. Using linear interpolation: r = 12% + (13% - 12% ) r = 12.46% (1000 - 975) (1000 - 975)(975 - 945.74)

Self test 5.3 (page 128) If you have looked in your national nancial newspaper, there should be a section which shows the redemption yields (yields to maturity) of government stocks with different maturity dates. Observing the redemption yields for different maturity dates will indicate the general shape of the yield curve. For example, if you observe redemption yields increasing progressively upward for longer maturity dates, the yield curve will take the shape of an upward slope (see Figure 5.14 for alternative shapes). Heriot-Watt University Introduction to Finance

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ANSWERS: Chapter 5

Answers from page 129. Q1: B 10.9%


12 110

Interest yield = Q2: A 5.1% 6 (1 + r) r = 5.1%

100 = 10.9%

110 =

6 (1 + r)
2

6 (1 + r)
3

6 (1 + r)
18

100 (1 + r)18

Answers from page 130. Q3: B 6.3%


6 95

Interest yield = Q4: A 3.6% 3


1

100 = 6.3%

95 =

(1 + r) r = 3.6%

3 (1 + r)
2

3 (1 + r)
3

3 (1 + r)
10

100 (1 + r)10

Answers from page 130. Q5: C 12.7%


130 1025

Interest yield = Q6: C 12.5%

100 = 12.7%

1025 =

130
1

(1 + r) r = 12.5% A 915

130 (1 + r)
2

130 (1 + r)
3

130 (1 + r)
10

1000 (1 + r)10

Q7:

Present value =

90
1

(1 + 0.11) Present value = 915.39 B 7.7%

90 (1 + 0.11)
2

90 (1 + 0.11)
6

1000 (1 + 0.11)6

Q8:

65 =

5 r 5 r= 65 A 50

4 0.08

Q9:

Present Value = Q10: C 120 Present Value =

50

6 0.05

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Answers from page 132. Q11: There are three different types of risk involved when investing in xed interest securities: Ination rate risk; Interest rate risk; Default risk. These three types of risk are discussed in section 5.2 of the text. Q12: The interest yield is an expression of the income return from a xed interest security as a proportion of the current market price. The redemption yield is the rate of return required by an investor, which by denition discounts future coupon instalments and the repayment of the nominal value of the stock to a present, (or market), value. The redemption yield, therefore, includes the capital gain or loss on the maturity of the stock. Q13: In question 1 default risk was identied as one of the three types of risk involved with investing in xed interest securities. For most government stocks default risk will be negligible, providing that the government in question and the economy of the country it governs, is relatively stable. For corporate xed interest securities (i.e. those issued by incorporated companies) default risk can be a more signicant to an investor, depending on the importance of the following factors to the company issuing the corporate xed interest securities: the expected economic performance of the company; the nancial stability of the company; the stability and economic prospects of the industry in which the company is operating. These factors will contribute towards the perception of the investor, regarding the likelihood of a company defaulting on the repayment of their borrowings. The agencies, Moodys and Standard and Poors, categorise corporate borrowers with regard to their likelihood of default. Such a service enables an investor to consider the probability of default on their investment, which in turn affects the default risk premium that they require to compensate them for the probability of the company defaulting on the repayment.

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ANSWERS: Chapter 6

6 Valuation of Ordinary Shares


Answers from page 155. Q1: B 23

Net asset value = 1 500000 - 200000 - 150000 Net asset value = 1 150000 Per share = 1 150000 50000 = 23 Q2: C 25

2.50 0.10 = 25 Q3: C 36.79

2.50 (1 + 0.03) (0.10 - 0.03)

Q4: P0 = Note:

B 30 2.58 (1.10)
1

1.10

2.65
2

n=3

2.70 (10% - 2% )

Dividend in year 1: 2.50 (1.03) = 2.58 Dividend in year 2: 2.58 (1.03) = 2.65 Dividend in year 3: 2.65 (1.02) = 2.70 33.75 P0 = 2.34 + 2.19 + (1.10)3 P0 = 29.89 Q5: A 2.50%
D r-g

14.67 = where

D = 1.10 r = 10% g is unknown Re-arranging the formula: 1.10 g) 14.67 0.075 = (10% - g) g = 2.5% Q6: C 7.69
1 (0.12 - ( - 0.01))

Present value = Q7: D 18.82%

(8.50 1.10) - 8.50 + 0.75 8.50

Holding period rate of return =

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ANSWERS: Chapter 6

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Q8: D 29% Holding period rate of return = P0 = 100 120 6 = 5 Q9: D 66.41% Six months holding period rate of return = 29% Annual holding period rate of return = (1.29) 2 Annual holding period rate of return = 66.41% Q10: D 35.8% 0.50 1.00 Retained earnings = (50% ) 1 = 50p The payout ratio = Present Value of the retained earnings = r= 0.50 9.60 50p 0.17 2.94

2.94 9.60

Answers from page 158. Q11: D 14.17 The earnings per share = 0.50 The payout ratio = 40% Present Value of the retained earnings = Value of one share = Q12: B 18.33 Value of retained earnings = Dividend today = 20p 220p 1833p PCV = (0.12) Q13: A 8136 Calculate the Present Value (PV) of the Free Cash Flows: PV = - 200000 + Annuity of 80000 (5 years at 13% ) = - 200000 + (80000 3.517) = 81 360 81 360 = 8136 10 30p (0.20 - 0.05) 200p 1.50 + 0.20 0.12 30p 0.20 1.50

14.17

Per share =

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ANSWERS: Chapter 6

Q14: D 208333
25000 0.12

208333

Q15: C 357143
25000 (0.12 - 0.05)

357143

Answers from page 159. Q16: Accounting net book values of assets are based on accounting policies adopted by the company reporting them. The net book value will typically be based upon a historical asset cost, adjusted for an annual depreciation charge over the useful life of the asset. Certain assets may appear at their market value, revalued according to accounting principles. An example would be property owned by the company and having a market value signicantly different to the historical net book value. The net book value of assets may not therefore be based on a consistent value concept. For use to an investor the net assets basis of valuation should be based on an estimate of the net realisable value of the assets, (less the liabilities), of the company less costs of disposing of the assets. That is estimating a value for the company based on the forced sale of the business. Q17: These three concepts of value are discussed in section 6.2 of the text. Q18: The dividends basis of valuing ordinary shares is based upon estimating the future dividend payments and their expected growth in the future. Dividends on ordinary shares are not xed and therefore are subject to the risk and uncertainty of business activities. Estimating future dividends and levels of their growth is therefore problematic. In particular it is unlikely that future dividends of most companies will have a constant growth in dividends. Estimating future levels of earnings attributable to ordinary shareholders is a problem for the same reasons as estimating future dividends. There is a further problem with earnings being used to establish the value of a companys shares. Earnings are based on accounting policies. Earnings are not cash and therefore they will be affected by changes to non-cash items, such as changes in a depreciation policy for writing off the cost of an asset used in the business, more quickly or more slowly, depending on the direction of the change. Also earnings of companies can uctuate from period to period due to transactions taking place which are not part of the normal trading operations of the company. For example a manufacturing company making a prot from the sale of land to a property developer. This may distort the reported earnings but does not necessarily indicate future trends in the scale of earnings from normal manufacturing activities. Q19: The free cash ow method does not have many of the disadvantages of the earnings or dividend methods. It is based on estimating the actual cash ows generated by the business activities. You will recall from chapter 4 that the importance of cash receipts and payments and their timing were emphasised. This method is therefore most closely related to nancial and economic theory. In practice however, it is an extremely difcult method to use. The main reason is that it involves estimating future risky and uncertain cash ows from the business activities. This requires an advanced level of knowledge about the business current and future investment plans of the company. In reality this information is very difcult to access. Heriot-Watt University Introduction to Finance

ANSWERS: Chapter 7

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7 Stock Market and Investment Indicators


Self test 7.1 (page 166) Security B has a higher expected return than security A. On close inspection, however, security B has a wider possible range of possible returns, (-10% to +25%). Your choice between these two securities will therefore be affected by your risk preference between a high expected risk and return security or a low expected risk and return security.

Self test 7.2 (page 169) Figure 7.11 indicates through the standard deviation, the degree of extra spread of possible returns around the expected return. Using the standard deviation as the measure of spread indicates that security B has almost double the risk of security B in terms of nancial return. For this extra risk investors are offered the prospect of an extra 3.45% expected return. The standard deviation measure therefore allows a more systematic consideration of the risk return trade-off between the two securities. Neither security in this example dominates the other in terms of risk or return and your choice will therefore be a function of your risk preference.

Answers from page 182. Q1: B 9.4% (0.10 3%) + (0.4 8%) + (0.4 11%) + (0.10 15%) = 9.4% Q2: C 9.04%

Q3: A 3.01%

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ANSWERS: Chapter 7

Answers from page 184. Q4: C 52.4%

Debt ratio: 250000 + (3000001 050000) 100 = 52% Q5: D 6.8

Interest cover: 450000 66 000 = 6.8 Q6: A 16.64p

Earnings per share: 249 600 1 500000 = 0.1664 Q7: A 5.37%

Earnings yield: 0.1664 3.10 100 = 5.37% Q8: D 18.6

Price/ earnings ratio: 3.10 / 0.1664 = 18.63 Q9: A 2.68%

Dividend yield: (124 800 / 1 500000) / 3.10 100 = 2.68% Q10: B 2.00 Dividend cover: 0.1664 / (124 800 / 1 500000) = 2.00

Answers from page 185. Q11: Benets: Enables comparisons to be made of nancial performance of a company over time; Enables comparisons to be made of nancial performance of different sized companies; Ratios can be used to compare sector and company performance to gain a clearer picture of economic performance; Ratios may prove to be useful in signalling short-term survival problems for a business, stimulating remedial action by management. Limitations: Comparisons of company performance can be misleading when the companies being compared are from different industrial sectors; Ratios used for comparison purposes should be calculated consistently, otherwise they may be misleading; Ratios may be used to disguise true performance indicators (e.g. a 10% increase in sales of 1million does not sound as impressive as a 100% increase in sales of 100k. What is important is the resources used to generate the returns to make a fuller judgement about the relative merit);

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Companies can use different classications of factors used in ratio calculations (e.g. the classication of a permanent bank overdraft as short or long term debt). Q12: A net dividend yield is based on the dividend paid to shareholders and does not take account of any basic rate of tax deducted by the company before the shareholder receives his or her dividend. In the UK companies withold a basic rate of income tax from dividend payments. The shareholder therefore receives only a net amount. If the shareholder normally pays tax at the basic rate of income tax they will not need to account for the tax on the dividend received, (as the company will send the tax to the Inland Revenue responsible for tax collection in the UK). If however, the shareholder does not pay tax they are entitled to reclaim the tax deducted by the company. Grossing up a net dividend involves the application of a factor to the net dividend to calculate the gross dividend paid by the company. For example if 20% is the basic rate of income tax and a company decides to pay a gross dividend of 10 pence per share, each shareholder will receive 8 pence per share and 2 pence will be retained as tax. A shareholder receiving a net dividend of 8 pence can calculate his or her gross dividend by multiplying the net dividend by a factor of 100 / 100-basic rate of tax (in this case 8 pence 100 / (100 - 20) = 10 pence). Q13: Sector and general market indices are discussed in detail in section 7.4. They can help investors interpret economic activity over time and to provide useful comparative statistics for evaluating individual company performance. In many countries the general news media quotes the movement of the index of stock market shares listed on the domestic capital market, as a guide to current economic performance and condence. Considering movements of individual sectors can enable investors to establish trends and interpret economic downturns and booms. For example the construction sector tend to be one of the rst sectors to be affected from economic condence being high or low. Q14: Risk and uncertainty are very closely related in considering nancial decisions. Risk however is an objective measurement of the possible returns from a nancial investment opportunity, while uncertainty cannot by denition be objectively measured. Uncertainty is something we all live with. In the context of nancial investments consider the investment of a sum of money for ve years in a European bank deposit account. The return on the investment will be based, lets say, on the LIBOR. If the LIBOR moves your return will change. You wish to know what your likely return will be. You will need to know the expected movement in the LIBOR over the next ve years. You can objectively estimate alternative forecasts from economic forecasters based on expected economic trends affecting interest rates in the next ve years. This will give you a range of possible returns to expect. It may be however that none of the rates you identify are the actual rates you receive. The consequences of European Monetary Union (EMU) during the period of your investment may mean that the LIBOR uctuates more than is expected at the time you make your investment. The effects of EMU are uncertain. Q15: The price-earnings ratio (P/E) calculation is discussed in detail in section 7.3.3. It is a key indicator for use in the comparison of ordinary shares. Some analysts focus on seeking low P/E ratio stocks on the basis that they may be temporarily or permanently under-priced. It is important to note that low and high P/E ratios are relative measures, typically in the context of the industrial sectors of business. A low P/E stock may therefore indicate that the market does not have as high a growth expectation in earnings per share incorporated into the current price, when compared with other companies Heriot-Watt University Introduction to Finance

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ANSWERS: Chapter 7

in the same business activity. Alternatively the market may have underestimated the earnings growth of the low P/E stock and it be relatively cheap. It is important to be cautious when interpreting P/E ratios, not least for the reason just mentioned. Comparing P/Es in different sectors can be misleading. Companies engaging in signicant investment in long term research and development will have generally high P/E ratios (e.g. pharmaceutical companies who typically will have P/Es in excess of 20). Companies in well established industries with little prospect for high future growth will have generally low P/Es (e.g. the tobacco sector will typically have a P/E ratio of about 10 in the UK). Finally it is also important to consider carefully the earnings gure used in the P/E ratio calculation. If it is an unusual earnings performance it may lead to a misleading P/E ratio. In practice analysts forecast the future company earnings based on an assessment of maintainable operations, adjusting for any abnormal highs or lows in performance if they are not expected to recur.

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ANSWERS: Chapter 8

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8 Managerial Objectives and Decision Making


Self test 8.1 (page 192) Section 8.2 of the text deals with the key differences. It is important to recognise that accounting income is more objective and backward looking. How has the business performed? What prots have been realised over the last year? Accounting income is in most countries based on a historical concept of value. Economic income conversely is forward looking and measures the change in the value of a business based on its future expected income, as a result of decisions taken in the most recent period. An example of the difference between the two concepts is a company spending a signicant sum of money restructuring their core business activities. Typically this could involve closing under-performing shops or production facilities. For the year in which most of this activity is undertaken the accounting earnings would be poorer than normal as the costs are recognised in the year they are incurred. The effect on future cash ows of the re-organisation may well however have a positive impact on future earnings levels and economic income would reect this in measuring the performance of the period in which the decisions are made to improve future income levels.

Answers from page 203. Q1: The main differences between the three concepts of value are covered in section 8.2 of the text. Q2: The three main decisions taken by a nancial manager in an incorporated company are the investment, nancing and dividend decisions. The investment decision involves the manager making choices between alternative business opportunities to allocate the business resources. Investing resources in plant, machinery, equipment, research and know-how is part of the business investment decision. The manager will undertake such decisions in an incorporated company as an agent on behalf of the principal (the shareholders). The nancing decision involves the nancial manager selecting a suitable package of nancial claims to fund the capital investment of the company. Financial claims include ordinary shares, corporate xed interest securities and bank loans. Some claims are traded on capital markets, while others are nontransferrable. Some claims are xed and others are variable (e.g. ordinary shares). The nancial manager will ensure that the cash ows released from the business investments will satisfy the conditions of the nancial claimants and in particular that they are received within the maturity of the nancing package. Dividends on ordinary shares are variable not xed. The nance manager sets the dividend payout to ordinary shareholders. There may be a number of reasons why this decision is more than simply disbursing spare cash not invested at the end of each nancial year. You will study some of the views on dividend policy relevance in later nance modules on this course. For the moment it is important for you to understand that the dividend decision involves the manager allocating nancial resources as agent to the shareholders. The dividend paid will be balanced against the business investment opportunities and commitments and the other nancial claimants (such as the bank or corporate xed interest security holders). Q3: A business organisation set up with a prot motive has many interested parties in the success of the business activity. Many of the interested parties such as employees, Heriot-Watt University Introduction to Finance

296

ANSWERS: Chapter 8

management, customers and suppliers have very clear contracts with the business organisation to clarify their obligations and their returns from engaging in activity with the organisation. Business organisations choosing to become incorporated companies exist as a separate legal identity in most countries. This means that persons and institutions contract with the company as a separate entity. The company can be seen in this context as a nexus of contracts which imposes a role on the manager to manage the resources of the organisation such that each contracting party is satised. Conventional nance theory implicitly assumes that the manager as agent of the shareholders is tasked with a unitary objective of maximising shareholders wealth. More recently, there is some popularity for the view of the company consisting of a number of interested stakeholders with varying contracts, claims and obligations with the company and that the manager perhaps should not be tasked solely with allocating resources to maximise the wealth of only one of the stakeholders, namely the shareholders. Q4: Agency theory applies to the key relationship in incorporated companies which is that between the shareholder and the manager. In this context the shareholder is the principal and the manager is the agent, employed by the shareholder under contract to manage the resources invested by the principal. Finance theory has debated the proposition that there is an implicit contract between shareholders and managers, for managers to maximise the shareholders wealth. Section 8.3.2 of this text discusses this particular issue. Q5: In the discussion covering the difference between accounting, economic and nancial concepts of income you will recall the key issues regarding accounting prots, (or, earnings). A manager of a business organisation is required to prepare accounting statements and apply accounting policies to measure business performance. An objective function of a manager which allows him or her to inuence the objective measure leads to a moral dilemma that the manager is in a position to exploit. Also which prots should the manager maximise? Short-term prots or long-term prots? For example cutting current research and development programmes may save resources in the short term but could have a severe long term impact on company prots. The objective to maximise shareholders wealth focuses squarely on the shareholders as the key stakeholder with the potential for the manager to be assessed on their success in increasing dividends and/or share price. The manager could be encouraged to follow this objective by shareholders linking the managers pay to share options promoting goal congruency. The manager can also be threatened to follow this objective through the process of shareholders voting at Annual General Meetings to appoint the top management, and through the process of a takeover threat.

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ANSWERS: Chapter 9

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9 Raising Capital for Business


Answers from page 235. Q1: Table 1 illustrates the key differences between the two different company structures. Q2: Table 2 covers the key contents of each document. The key purpose is to communicate to other businesses and the wider market operators, of the purpose of the company and what it has been set up to do. In particular details on the management and ownership structure of the business is important for suppliers and creditors. Q3: Table 4 illustrates that there are many companies worldwide who have retained a private status for their company, (eg Mars; Virgin Atlantic; Toys R Us). In some cases growth has been nanced through private family wealth or benefactors and in others through internally generated prots. In many cases however companies seeking growth in their business lifecycle need to access public funds. Q4: A venture capitalist helps to bridge the small rm gap. Companies unable to meet the requirements or costs of continuing obligations from a full listing may need to access venture capitalist funding. Banks may not be so willing to take a risk through loan extensions and the nancial risk associated with debt may mean bank nance is not an option for businesses seeking growth opportunities. In the UK venture capitalists have provided a signicant role , most notably since the early 1980s. The downside for businesses is the extent of equity share the capitalist will seek for equity capital and degree of control in management decision making. Q5: Table 5 illustrates the key reasons for and against. Q6: In the UK AIM took over from thew Unlisted Securities Market in the 1980s to help provide an equity capital solution for the small rm gap for companies seeking to grow but unable to gain a full listing. Table 6 illustrates the key requirements and table 8 the scale of capital raised in recent years. Q7: Tables 12-14 illustrate the signicant holdings of institutional investors in worldwide markets in nancial securities. Management of publicly quoted companies, accountable to their shareholders, will have different challenges in dealing with a large institutional shareholder compared to many individual shareholders owning a signicant percentage shareholding. Movements in institutional shareholdings can impact the share price of a public company dramatically and careful management of the communication on business progress is normal with institutional shareholders. This is less possible with a wider and more dispersed shareholding where many thousands of shareholders may need to act collectively in voting resolutions or inuencing signicant share price movements. (Refer also to the concept of agent-principal in chapter 2). Q8: Table 16 illustrates the key requirements. Q9: Table 18 illustrates the different advisers required with most otations. Q10: Table 20 outlines the key continuing obligations for companies, including directors. Collectively directors will need to ensure that the company continues to full the continuing obligations and rules an regulations of the stock exchange. A key change will be the more public nature of interest in the companys activities which will mean greater communications and public relations. Heriot-Watt University Introduction to Finance

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Q11: plc = public limited company; ltd = private limited company Q12: 700000 Q13: Table 17 illustrates the key timetable to otation. Q14: Table 20 highlights all of the continuing obligations. You will recall from chapter 2 that the efcient market hypothesis relies on information asymmetry between agent (management) and principal (shareholder). Imposing public announcement rules and regulations over important developments in the business and ownership of shares ensures that all price sensitive information is made known to the market in a timely way, promoting semi-strong efciency and reassurance to market operators. Q15: No it is not prevented and as was covered in the chapter Virgin shifted from public to private due to some dissatisfaction with the short-term views of the city and the impact on the business.

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10 Personal nancial planning


Answers from page 255. Q1: Maturity is an important consideration in most forms of investments. Savings accounts offering the best rates of return are often linked to restricted withdrawal periods, meaning that the investor has to commit to leaving the savings for a specied period before gaining access. Bonds issued by banks or other nancial institutions may also be over 1 year; 3 years or 5 years for example meaning that funds are committed for a specied period of time in return for higher rates of interest. Individuals therefore need to plan carefully to ensure they are able to commit to longer periods to achieve higher rates of return. For investment in equities it is even more crucial that the maturity of the investment is considered as stock markets can be volatile over short periods of time. Q2: Key nancial risks for most individuals will include: loss of earnings (eg through unemployment); illness or critical injury which may restrict earning power (or of partner which may result in additional childcare costs or further loss of earnings); loss of property due to (eg) natural disaster or re; loss of nancial investments value due to price movements or nancial collapse of the nancial institution. Q3: Table 6 illustrates how to set out an income and expenditure and nancial position statement. Q4: The equity risk premium is the additional return from investing in equities compared to Treasury Bills (Short-term Government Gilts). Traditionally for most of the last century this has averaged at 8.8% in most developed stock markets though has fallen from the late 1990s to the early 2000s. Evidence from Dimson and Marsh suggests the expected risk premium is likely to be smaller in the future (on average nearer 5.5% per annum). Q5: Normally this is a short term Treasury Bill (US), or in the UK, short term government gilt edged security - where its name is derived. Q6: Related to the point on equity risk premium, if you held entirely equities and they were well diversied, you may reasonably expect a lower longer term rate of return that in the previous century (see table 12) - ie 5.5% per annum. Of course this is only an average and subject to assumptions about the future and the more recent past. Q7: A life assurance policy provides for cover and nancial security in the event of a person, on whom you are dependent nancially, dies. The period of cover and sum assured will vary based on an individuals conditions and the extent of the dependency. Q8: JM Keynes identied three reasons: Transaction; precautionary and speculative. The rst two are relatively self explanatory. Though with reference to review question 1 the higher the precautionary level of cash the higher is the opportunity cost of foregone interest. Speculative motives for holding cash would be to take advantage of investments with higher rates of return. For the precautionary motive an individual may convert long term retirement investments into cash in the period nearing retirement to avoid the risk of a stock market crash. Heriot-Watt University Introduction to Finance

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ANSWERS: Chapter 10

Answers from page 256. Q9: Jonjo needs to consider the increased nancial risk of running his own business compared to a stable salary in employment. If he were to accept the employed role his pension would be: Jonjos net income: 38000 less pension contribution (employees) 3800 = 34200 Employer contribution 3800 per year (Assume Jonjo also contributes 10%) 3800 per year Estimated pension fund in 30 years (ie 30 years annuity contributions) at, say 5.5% real rate of return. Rearranging the formula in exhibit 4.13 for the formula for the future value of an annuity: Utilising the future value of an annuity formula from chapter 4: Future value of the annuity =
7600
0.055 { (1 + 0.055) 30

= Fund value of 550509 in 30 years time This would not be guaranteed as it is dependent on the return from underlying investments (5.5% is used as the real rate of return in UK equities 1900-2007). Also it is simplied to assume the money is paid in annually rather than monthly. If Jonjo continues to avoid making pension contributions he will be reliant on any state pension provision which may limit his family lifestyle. The value of the employer contribution can be seen as part of the salary provision of 38000 per year (ie 41838). In reality Jonjo would also be able to reduce his tax by the amount of the employee contribution he makes, or in other words add the tax on to his own contribution. If his marginal tax rate is 25% this would mean he would have an additional annual contribution of 950 going in to his pension fund). Other risks to consider for Jonjo would be life assurance as the main nance provider. This is particularly an issue as he is a self employed worker and will therefore not earn if he is off sick. Q10: Henrietta has security with her property as an asset and the liquid funds of 20000 are useful if anything happens with her job security (it provides for approximately 5 months equivalent salary). It is important that Henrietta keeps this fund invested at the best rate available but allowing for immediate use if it is needed. Short term savings accounts or national savings growth bonds (UK) may be considered. In terms of her pension Henrietta may want to consider investing the 2000 per month (24000 per annum) into her pension fund (which would attract the additional marginal tax on top of her 2000 per month if in the UK). If investing all of the monthly savings over a 6 year period until Henrietta is sixty-three she may have the following fund (assuming a 5% return - lower than the average real rate as a shorter maturity): Future value of the annuity =
24000
0.05 { (1 + 0.05)6

= Fund value of 163245 in 6 years time Henrietta could therefore use the money to retire early (her net expenses without her holiday at present is 21000 per year - ie by deduction taking 24000 savings from her Heriot-Watt University Introduction to Finance

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net income of 45000). She would need to consider however the impact on her company scheme which would not have contributions for the nal ve years. A nancial advisor would need to assess the terms of the scheme. The sum saved would more than cover the annual expenses (subject to adjustment for ination) of 21000 + 1500 average annual holiday bonus - ie 112500 over 5 years). The other alternatives for Henrietta would be to sell her house and buy a smaller property which could release some of the 250000 equity that she has in the current property. Q11: Utilising the future value of an annuity formula from chapter 4: Monthly annuity = 25000 Monthly annuity = 387 60 instalments of 387 invested at a 3% annual rate of interest will generate a fund of 25000 in 5 years time.
(0.03/12 (months)) { 1 + (0.03/12)5 12

Heriot-Watt University Introduction to Finance

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