Financial objectives

Financial objectives
For a profit-making company, a better objective is the
maximisation of shareholder wealth; this can be
measured as total shareholder return (dividend yield +
capital gain).
Profit maximisation is often assumed, incorrectly, to be
the main objective of a business.
Reasons why profit is not a sufficient objective
ü Investors care about the future
ü Investors care about the dividend
ü Investors care about financing plans
ü Investors care about risk management
 Despite its environmental/stakeholder
Financial strategy formulation obligations, the prime objective of a
profit making company is to
Maximisation of maximise shareholder wealth.
shareholder wealth Investments will increase shareholder
wealth if they cover the cost of
capital and leave a surplus for the
shareholders.

Investment Financing Dividend

decision decision decision

Risk
management
 Financing decision - gearing
Practical issues Explanation

Life cycle A new, growing business will find it

difficult to forecast cash flows with any
certainty so high levels of gearing are
unwise.
Operating gearing If fixed costs are a high proportion of
total costs then cash flows will be volatile;
so high gearing is not sensible.
Stability of revenue If operating in a highly dynamic business
environment then high gearing is not
sensible.
Security If unable to offer security then debt will
be difficult and expensive to obtain.
 Financing decision – Dividend policy

Dividend policy tends to change during the course of a business's

lifecycle.

Young company Mature company

Zero/Low dividend High stable dividend

High growth/investment needs Lower growth
Wants to minimise debt Able & willing to take on debt
Possibly share buybacks too
Cost of capital
 Cost of capital
The cost of the different forms of capital reflect their
risk; in the event of a company being unable to pay its
debts and going into liquidation, ordinary shareholders
rank after preference shareholders, who in turn rank after
the providers of debt finance.
This means that the cheapest type of finance is debt and the
most expensive type of financeis equity (ordinary shares).
 1 The cost of equity –
By looking at how much shareholders are prepared to pay
for a share, it is possible to estimate the return that
shareholders require.

This equation is given in the exam

P0 = today's share price

D1 = dividend in 1 year
g = annual dividend growth rate
Lecture example

Easy plc has just paid a 50p dividend; its share price is
£5.00 and its dividend growth rate is 10%.

Required
Estimate Easy's cost of equity.
Lecture example - Answer

The cost of equity is =

Assumption

Dividends are paid

and the company has a
share price
Estimating
There are two methods of estimating 'g' that you
need to know.
Estimating future dividend growth

Use Use current re-investment

levels

With the current re-investment level approach, the formula

g= br is given in the exam.
 Lecture example
a) AB plc has just paid a dividend of 40p per share, this has
grown from 30p four years ago.
Required
What is the estimated cost of equity capital if the share
price is £8.20?
b) RS plc has just paid a dividend per share of 30p. This was
50% of earnings per share. In turn, earnings per share
were 20% of net assets per share. The current share price
is 150p.
Required
What is the cost of equity capital?
Lecture example - Answer
2 The cost of equity – using the CAPM

Rational, risk averse investors will spread their investment

across a wide range of securities in order to reduce their
exposure to risk.
Unsystematic (or specific) risk is gradually eliminated as the
investor increases the diversity of the portfolio until a point
where it need not be considered (the “well-diversified
portfolio”).
Systematic (or 'market') risk is caused by factors which
affect all industries and businesses to some extent or other
such as: interest rates, tax legislation, exchange rates and
economic boom or recession
By continuing to diversify, shareholders can further reduce risk.

Portfolio
Risk
UNSYSTEMATIC RISK

SYSTEMATIC RISK

Diversity of Portfolio
The Capital Asset Pricing Model (CAPM) assumes that
investors have a broad range of investments, and are worried
about how a fall in the stock market as a whole would affect
their investments; some shares are very sensitive to stock
market downturns and because of this risk shareholders
would expect a high return on these shares.
Commercial databases monitor the sensitivity of firms to a
stock market downturn by calculating the average fall in the
return on a share each time there is a 1% fall in the stock
market as a whole; this is called a beta factor.
beta factors

Increasing risk

beta < 1.0 beta = 1.0 beta > 1.0

share < average risk share = average risk share > average risk
Ke < average Ke = average Ke > average
Having worked out the risk of a company, by measuring its beta,
the Capital Asset Pricing Model gives a formula for calculating
required return.

The CAPM is shown on your formula sheet as:

E(ri) = Rf +  (E(Rm – Rf))

where E(ri) = the expected (target) return on security

by the investor (ie Ke)
Rm = expected return in the market
β = the beta of the investment
Rf = the risk-free rate of interest
Rm – Rf = market premium
 Lecture example
Required
Assume there is a market premium for risk of 8%, and the risk-
free rate is 4%.
a) What is the required rate of return on a share with an equity
beta of 1.6?
b) What is the required rate of return on a share with an equity
beta of 0.8?
Lecture example - Answer

Use the beta of the company; 1.6

Ke = 4 + (8 × 1.6) = 16.8%
Use the beta of 0.8
Ke = 4 + (8 × 0.8) = 10.4%
 Limitations of the
Discussion
CAPM

Achieved by estimating comparing movements

Estimating in the stock market as a whole; this will be
market return volatile and will the returns achieved
because it will not pick up the firms that have
failed and have dropped out of the stock market.

Estimating Beta values are and will not give an

the beta factor accurate measure of risk if the firm has recently
changed its gearing or its strategy.
 3 Cost of redeemable debt

If the debt is redeemable, the cost of raising the debenture is

assessed by looking at the cash flows.

Note
It is easiest to assess one unit of £100 debt (or $100, €100 etc).
Internal rate of return (IRR) approach
IRR is used in project appraisal to calculate the % return given
by a project. You may find it to lay out the cash flows so that
they look like a project ie
Time £
0 (Market value)
1–n Interest  [1 – tax]
n Redemption value
Step 1 – calculate the NPV of the project, at say 5%
Step 2 – calculate the project, at say 10%
Step 3 – calculate the internal rate of return using the formula

IRR formula

(not given in the exam)

Lecture example
Mantra plc has $100,000 5% redeemable debentures in
issue. Interest is paid annually on 31 December. The
ex-interest market value of the stock on 1 January 2007
is $90 and the stock is redeemable at a 10% premium
on 31 December 2011. Corporation tax is 30%.

Required
What is the cost of debt?
Lecture example - Answer

Internal Rate of Return to Company

Time DF @ 10% PV DF @ 5% PV
$ $ $
0 (90) 1 (90) 1 (90)
1-5 5(1–0.3) 3.791 13.27 4.329 15.15
5 110 0.621 68.31 0.784 86.24
(8.42) 11.39

IRR = 5 + (11.39/19.81 × 5) = 7.87%

 4 Cost of preference shares
The preference shareholder will receive a fixed income,
based upon the nominal value of the shares held (not the
market value). These dividends are paid out of post-tax
profits and therefore do not receive tax relief. The cost
of preference share capital is calculated as:
5 WACC formula (given in the exam)

A third source of finance may have to be added in to the formula.

The WACC can only be used for project evaluation if:
a) In the long-term the company will maintain its existing
capital structure (ie financial risk is unchanged)
b) The project has the same risk as the company (ie
business risk is unchanged).
 Lecture example
Berlap plc is financed by 7m £1 ordinary shares and £8m
8% redeemable debentures; market values are £1.20 ex div
and £90% ex interest. A dividend of 10p has just been paid
and future dividends are expected to grow by 5%. The
debentures are redeemable at par in 5 years' time.

Required
If taxation is 30%, calculate the WACC.
Lecture example - Answer

Time 0 1-5 5 Total

per £100 –90 8(1–0.3) 100
df 5% 1 4.329 0.784
PV –90.00 24.24 78.40 12.64

df 10% 1 3.791 0.621

PV –90.00 21.23 62.10 –6.67
Lecture example - Answer

Using linear interpolation

DCF techniques
 NPV layout
Time
0 1 2 3 4 5
Sales receipts X X X X
Costs (X) (X) (X) (X)
Sales less costs X X X X
Taxation (X) (X) (X) (X) (X)
Capital expenditure (X)
Scrap value X
Tax benefit of Cas X X X X X
Working capital (X) (X) (X) X X
Net cash flows (X) X X X X X
Discount factors @ X X X X X X
post-tax cost of capital*
Present value (X) X X X X X
* this has already been covered
 Opportunity costs
Remember to include opportunity costs; these are the costs
incurred or revenues lost from diverting existing resources
from their existing use eg an overseas investment might
cause lost contribution from existing exports; this is a
relevant cost of the investment.
 Capital allowances

These are normally 25% writing down allowances on

plant & machinery. 【MJ：遵守题意】
Approach
1. Calculate the amount of capital allowance claimed in
each year.
2. Make sure that you remember the balancing
adjustment in the year the asset is sold.
3. Calculate the tax saved, noting the timing of tax
payments given in the question.
 Working capital
Projects need funds to finance the level of working capital
required (normally assumed to be stock). The relevant cash
flows are the incremental cash flows from one year’s
requirement to the next. At the end of the project, the full
amount invested will be released.
Inflation

Key terms Explanation

Real terms or current prices Ignoring inflation
Nominal or money Including inflation

Key
Include inflation if
, inflation
will have an impact on profit margins and therefore the
cash flows must be inflated and inflation must also
be incorporated into the cost of capital.
To incorporate inflation into the cost of capital the
following equation must be used:

[1 + real cost of capital] × [1 + general inflation rate] = [1 + inflated cost of capital]

or (1 + r) (1 + h) = (1 + i)
 Ignore inflation if
If there is one rate of inflation, inflation has no
impact on the NPV of a domestic investment. In
this case it is normally quicker to ignore inflation
in the cash flows (ie real cash flows) and to use an
uninflated (real) cost of capital.
 Ex - 201406 Q2
You have recently commenced working for Burung Co and
are reviewing a four-year project which the company is
considering for investment. The project is in a business
activity which is very different from Burung Co’s current
line of business.
The following net present value estimate has been made for the project:
All figures are in $ million
Year 0 1 2 3 4
Sales revenue 23·03 36·60 49·07 27·14
Direct project costs (13·82) (21·96) (29·44) (16·28)
Interest (1·20) (1·20) (1·20) (1·20)
Profit 8·01 13·44 18·43 9·66
Tax (20%) (1·60) (2·69) (3·69) (1·93)
Investment/sale (38·00) 4·00
Cash flows (38·00) 6·41 10·75 14·74 11·73
Discount factors (7%) 1 0·935 0·873 0·816 0·763
Present values (38·00) 5·99 9·38 12·03 8·95
Net present value is negative $1·65 million, and therefore the
recommendation is that the project should not be accepted.
In calculating the net present value of the project, the following
notes were made:
I. Since the real cost of capital is used to discount cash flows,
neither the sales revenue nor the direct project costs have
been inflated. It is estimated that the inflation rate
applicable to sales revenue is 8% per year and to the direct
project costs is 4% per year.
II. The project will require an initial investment of $38 million.
Of this, $16 million relates to plant and machinery, which is
expected to be sold for $4 million when the project ceases,
after taking any taxation and inflation impact into account.
III. Tax allowable depreciation is available on the plant and
machinery at 50% in the first year, followed by 25% per
year thereafter on a reducing balance basis. A balancing
adjustment is available in the year the plant and machinery
is sold. Burung Co pays 20% tax on its annual taxable
profits. No tax allowable depreciation is available on the
remaining investment assets and they will have a nil value
at the end of the project.
IV. Burung Co uses either a nominal cost of capital of 11% or a
real cost of capital of 7% to discount all projects, given that
the rate of inflation has been stable at 4% for a number of
years.
V. Interest is based on Burung Co’s normal borrowing rate
of 150 basis points over the 10-year government yield
rate.
VI. At the beginning of each year, Burung Co will need to
provide working capital of 20% of the anticipated sales
revenue for the year. Any remaining working capital
will be released at the end of the project.
VII. Working capital and depreciation have not been taken
into account in the net present value calculation above,
since depreciation is not a cash flow and all the
working capital is returned at the end of the project.
Required:
a) Calculate the adjusted present value (APV) for the
project, correcting any errors made in the net present
value estimate above, and conclude whether the project
should be accepted or not. Show all relevant calculations.
(15 marks)
b) Comment on the corrections made to the original net
present value estimate and explain the APV approach
taken in part (a), including any assumptions made.
(10 marks)
(25 marks)
 Answer
(a) All figures are in $ million
Year 0 1 2 3 4
Sales revenue (inflated, 8% p.a.) 24·87 42·69 61·81 36·92
Costs (inflated, 4% p.a.) (14·37) (23·75) (33·12) (19·05)
Incremental profit 10·50 18·94 28·69 17·87
(0·50) (3·39) (5·44) (3·47)
Working capital (W2) (4·97) (3·57) (3·82) 4·98 7·38
Investment/sale of machinery (38·00) 4·00
Cash flows (42·97) 6·43 11·73 28·23 25·78
W1 All figures are in $ million
Year 0 1 2 3 4
Incremental profit 10·50 18·94 28·69 17·87
Capital allowances 8·00 2·00 1·50 0·50
–––––– –––––– –––––– ––––––
Taxable profit 2·50 16·94 27·19 17·37
–––––– –––––– –––––– ––––––
Tax (20%) 0·50 3·39 5·44 3·47
–––––– –––––– –––––– ––––––
W2 All figures are in $ million
Year 0 1 2 3 4
Working capital
(20% of sales revenue) 4·97 8·54 12·36 7·38
Working capital
required/(released) 4·97 3·57 3·82 (4·98) (7·38)
Answer
Corrections made to the original net present value
The approach taken to exclude depreciation from the net
present value computation is correct, but capital allowances
need to be taken away from profit estimates before tax is
calculated, reducing the profits on which tax is payable.
The impact of the working capital requirement is included
in the estimate as, although all the working capital is
recovered at the end of the project, the flows of working
capital are subject to different discount rates when their
present values are calculated.
Interest is not normally included in the net present value
calculations. Instead, it is normally imputed within the cost
of capital or discount rate. In this case, it is included in the
financing side effects.
Cash flows are inflated and the nominal rate based on Lintu
Co’s all-equity financed rate is used (see below). Where
different cash flows are subject to different rates of inflation,
applying a real rate to non-inflated amounts would not give
an accurate answer.