A2 1StrategicCorporatefinance

INSTITUTE OF CERTIFIED
PUBLIC ACCOUNTANTS
OF RWANDA
CPA
A2.1
STRATEGIC CORPORATE
FINANCE
Study Manual
2nd edition February 2020,

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Acknowledgement
We wish to officially recognize all parties who contributed to revising and updating this Manual, Our thanks are extended
to all tutors and lecturers from various training institutions who actively provided their input toward completion of this
exercise and especially the Ministry of Finance and Economic Planning (MINECOFIN) through its PFM Basket Fund
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INSTITUTE OF CERTIFIED PUBLIC
ACCOUNTANTS OF RWANDA
Advanced Level
A2.1 STRATEGIC CORPORATE FINANCE
2nd Edition February 2020
This Manual has been fully revised and updated in accordance with the current syllabus/
curriculum. It has been developed in consultation with experienced tutors and lecturers.
TABLE OF CONTENTS
Unit
Title Page
Introduction to the course 5
1. Financial environment 6
Introduction 7
Ageny theory 8
Nationalised industries/public sector 13
Corporate social responsibility (csr) 14
Conclusion 16
Impact of government on activities 16
Composition of shareholders 16
Corporate governance 16
Rationale for corporate governance 16
Best practice 17
Efficient markert hypothesis ( emh) 17
Types of efficiency 17
A. Allocative efficiency 17
B. Operational efficiency 18
C. Information efficiency 18
Forms of information efficiency 18
A. Weak form level of efficiency 18
B. Semi-strong form level of efficiency 18
C. Strong form level of efficiency 19
Implications of emh for financial decision makers 19
A. The timing of financial policy 19
B. Project evaluation based upon npv 19
C. Creative accounting 19
D. Mergers and takeovers 20
E. Validity of the current market price 20
2. Mergers and acquisitions 21
Introduction 22
2 A2.1 STRATEGIC CPA EXAMINATION

CORPORATE FINANCE STUDY MANUAL
Types of combinations 22
Arguments for mergers and acquisition ( reasons for mergers and acquisition) 22
Arguments against mergers and acquisition reasons behind failed
Mergers and acquisition 23
Impact of acquisition 24
The overall merger & acquisition process 24
Phase 3 - investigate & value the target: 25
Phase 4 - acquire through negotiation: 25
Phase 5 - post merger integration: 26
Methods of financing mergers and takeovers ( purchase consideration) 26
Financial terms of exchange 27
Valuing the target firm 30
Due diligence 32
Management buyout ( mbo) 33
How to finance a management buyout 34
Funding the purchase 34
Funding operations 35
Management buy-in (mbi) 36
Post - acquisition issues 38
Ethical considerations 38
3. Corporate failure 39
Financial distress 40
Corporate failure 40
4. Sources of finance 46
Short -term sources of finance 47

Venture capital 57
Introduction 57
Case study 59
Financial & operational gearing 66
Financial gearing 66
Illustration 66
5. Financial risk management 73
Introduction 74
CPA EXAMINATION A2.1 STRATEGIC 3

STUDY MANUAL CORPORATE FINANCE
The internal technique 86
Risk management - main techniques/instruments 89
Financial futures 96
6. Portfolio theory 99
Introduction 100
Arbitrage pricing theory ( apt) 106
7. Financial analysis and business planning 111
Business plans 112

Introduction 112
Contents of business plan 112
8. International managerial finance 154
Introduction 155
9. Sundry definitions 170
Introduction 171
Sundry definitions 171

INTRODUCTION TO THE COURSE
Stage: Advanced Level 2
Subject Title: A2.1 Strategic Corporate Finance
Aim
The aim of this subject is to enable students to understand the key responsibilities and financing
decisions facing today’s strategic financial manager. Students should be able to develop
detailed business plans, to assess the potential financial risks and to advise on suitable risk
management strategies for entrepreneurial activities and established organisations.
Strategic Corporate Finance as an Integral Part of the Syllabus

Strategic Corporate Finance develops the financial management skills acquired by students
in Managerial Finance Intermediate and other disciplines acquired in the earlier examination
stages. Strategic Corporate Finance requires students to integrate and expand that knowledge
so as to provide a framework for strategic financial management analysis and decisions.
Learning Outcomes
On successful completion of this subject students should be able to:
• Evaluate the financial objectives of an organisation, explain how they are determined and
interrelate with the non-financial objectives and stakeholder interests.
• Discuss the legal regulations, the professional and ethical considerations facing
financial managers.
• Value shares / businesses in the context of a proposed merger, acquisition or
management buyout.
• Analyse reasons for and advise on actions to prevent corporate failure.
• Evaluate and advise as to the optimum capital gearing structure, term structure and dividend
policy for an organisation.
• Advise as to appropriate exchange risk and interest rate risk management strategies and
• discuss the use of derivatives in long term risk management.
• Discuss the relevance of portfolio theory and the Capital Asset Pricing Model to
financial managers.
• Prepare a business plan for an organisation given prescribed information.
• Evaluate the financial management of an organisation over a period of time and/or relative to
competitors / industry norms.

Study Unit 1
FINANCIAL ENVIRONMENT
Contents
• Determining financial objectives within the strategic planning process.
• Identify key stakeholders of organizations and the interests of each stakeholder group.
• Corporate Social Responsibility, its relationship to the objective of organisation
• Maximising shareholder wealth.
• Agency theory and its relevance to financial managers.
• The professional, regulatory and legal framework relevant to financial requirements, money
laundering, directors’ responsibilities.
• Monetary regulation and its effect on Capital Markets.
• The key activities undertaken by treasury managers.
• Centralized treasury management and the arguments for and against.
• The efficient market hypothesis

INTRODUCTION
Corporate finance is the field of finance dealing with financial decisions that business
enterprises make and the tools and analysis used to make these decisions. The primary goal of
corporate finance is to maximize corporate value while managing the firm's financial risks
a. Corporate Finance and the Finance Manager ie what do you as the financial manager
what do?
• Identify Long term investment ; identify investment opportunities with value for money
• Decide on a financial mix (debt and equity) which maximizes value
• Manage working capital , for the benefit of the organization
• Other goals of a firm may exist like survive, maximize market share, maximize profits etc, all
these are in line with maximizing shareholder interest
b. Corporate Finance and the different business forms
• Liability – Unlimited and Limited

»» Unlimited liability – Sole proprietorship & partnerships
»» Limited liability - incorporated bodies
• Considerations on the business form include cost, continuity, control, liability & tax issues
It is often assumed that the single objective of commercial entities is:
To Maximise the Value of the Firm

Or
To Maximise the Wealth of the Shareholders
In reality, firms have multiple, and often conflicting, objectives and will seek to optimise
among those. The modern corporation is a complex entity which is responsible not only to
shareholders but to all stakeholders.
The main stakeholders are:
1. Shareholders
2. Loan Creditors – seek security, repayment of loan interest and principal.
3. Employees – seek fair wages, promotional opportunities, welfare & social facilities =>
improved motivation.
4. Management - job security; fair reward; job satisfaction.
5. Trade Creditors - payment within credit terms.
6. The Community - sponsorship; charities; install environmental measures.
7. The Government - payment of taxes, rates, provide employment.
8. Customers - provision of service/goods at fair price; quality; on time etc.
The relative importance of the various groups may differ, possibly depending on company size
and management style.
Management will be concerned with the value of the firm as it satisfies one of the important
stakeholders (shareholders). A low valuation may increase the possibility of an unwanted
takeover bid. Also, finance must be adequately rewarded and its market value maintained, so
that further finance is obtainable when required.

Non-financial objectives may conflict with financial objectives – e.g. provision of staff
recreational facilities; modern, safe working environment etc.
AGENCY THEORY
The managers/directors act as agents for the shareholders (owners) in running the company.
This separation of ownership from control may lead to certain problems if managers are not
monitored or constrained - e.g. management working inefficiently; adopting risk averse policies
such as ‘safe’ short-term investments and low gearing; empire building for power/status; rewarding
themselves with high salaries and fringe benefits; increased leisure time etc
Managers’ and shareholders’ interests can be aligned by a number of measures - introducing
profit-related remuneration for management; offering bonus shares; share option schemes;
scrutiny of performance by the board of directors and banks who provide finance etc. However,
care must be taken to ensure that management does not take action to boost performance in the
short-term to the detriment of the long-term wealth of the shareholders (‘short-termism’).
An agency relationship arises where one or more parties called the principal contracts/hires
another called an agent to perform on his behalf some services and then delegates decision
making authority to that hired party (Agent) In the field of finance shareholders are the owners of
the firm. However, they cannot manage the firm because:
• They may be too many to run a single firm.

• They may not have technical skills and expertise to run the firm
• They are geographically dispersed and may not have time.
Shareholders therefore employ managers who will act on their behalf. The managers are
therefore agents while shareholders are principal.
Shareholders contribute capital which is given to the directors which they utilize and at the
end of each accounting year render an explanation at the annual general meeting of how the
financial resources were utilized. This is called stewardship accounting.
• In the light of the above shareholders are the principal while the management are the agents.
• Agency problem arises due to the divergence or divorce of interest between the principal and
the agent.
• The conflict of interest between management and shareholders is called agency
problem in finance.
• There are various types (Focus on first two) of agency relationship in finance exemplified as
follows:
1. Shareholders and Management
2. Shareholders and Creditors
3. Shareholders and the Government
4. Shareholders and Auditors
5. Headquarter office and the Branch/subsidiary.
1. Shareholders and Management

There is near separation of ownership and management of the firm. Owners employ
professionals (managers) who have technical skills. Managers might take actions, which are
not in the best interest of shareholders. This is usually so when managers are not owners of
the firm i.e. they don’t have any shareholding.

The actions of the managers will be in conflict with the interest of the owners. The actions of
the managers are in conflict with the interest of shareholders will be caused by:
i. Incentive Problem
Managers may have fixed salary and they may have no incentive to work hard and
maximize shareholders wealth. This is because irrespective of the profits they make,
their reward is fixed. They will therefore maximize leisure and work less which is
against the interest of the shareholders.
ii. Consumption of “Perquisites”

Prerequisites refer to the high salaries and generous fringe benefits which the
directors might award themselves. This will constitute directors remuneration which
will reduce the dividends paid to the ordinary shareholders. Therefore the
consumption of perquisites is against the interest of shareholders since it reduces their
wealth.
iii. Different Risk-profile
Shareholders will usually prefer high-risk-high return investments since they are
diversified i.e they have many investments and the collapse of one firm may have
insignificant effects on their overall wealth.
Managers on the other hand, will prefer low risk-low return investment since they
have a personal fear of losing their jobs if the projects collapse. (Human capital is
not diversifiable). This difference in risk profile is a source of conflict of interest since
shareholders will forego some profits when low-return projects are undertaken.
iv. Different Evaluation Horizons
Managers might undertake projects which are profitable in short-run. Shareholders on
the other hand evaluate investments in long-run horizon which is consistent with the
going concern aspect of the firm. The conflict will therefore occur where management
pursue short-term profitability while shareholders prefer long term profitability.
v. Management Buy Out (MBO)
The board of directors may attempt to acquire the business of the principal. This
is equivalent to the agent buying the firm which belongs to the shareholders. This is
inconsistent with the agency relationship and contract between the shareholders and
the managers.
vi. Pursuing power and self esteem goals
This is called “empire building” to enlarge the firm through mergers and acquisitions
hence increase in the rewards of managers.
vii. Creative Accounting
This involves the use of accounting policies to report high profits e.g stock valuation
methods, depreciation methods recognizing profits immediately in long term
construction contracts etc.
Solutions to Shareholders and Management Conflict of Interest

Conflicts between shareholders and management may be resolved as follows:
1. Pegging/attaching managerial compensation to performance

This will involve restructuring the remuneration scheme of the firm in order to enhance the
alignments/harmonization of the interest of the shareholders with those of the management
e.g. managers may be given commissions, bonus etc. for superior performance of the firm.

2. Threat of firing
This is where there is a possibility of firing the entire management team by the shareholders
due to poor performance. Management of companies have been fired by the shareholders
who have the right to hire and fire the top executive officers e.g the entire management team
of Unga Group, IBM, G.M. have been fired by shareholders.
3. The Threat of Hostile Takeover

If the shares of the firm are undervalued due to poor performance and mismanagement.
Shareholders can threatened to sell their shares to competitors. In this case the management
team is fired and those who stay on can loose their control and influence in the new firm. This
threat is adequate to give incentive to management to avoid conflict of interest.
4. Direct Intervention by the Shareholders

Shareholders may intervene as follows:
• Insist on a more independent board of directors.

• By sponsoring a proposal to be voted at the AGM
• Making recommendations to the management on how the firm should be run.
5. Managers should have voluntary code of practice, which would guide them in the
performance of their duties.
6. Executive Share Options Plans
In a share option scheme, selected employees can be given a number of share options, each
of which gives the holder the right after a certain date to subscribe for shares in the company
at a fixed price.
The value of an option will increase if the company is successful and its share price goes
up. The theory is that this will encourage managers to pursue high NPV strategies and
investments, since they as shareholders will benefit personally from the increase in the share
price that results from such investments.
However, although share option schemes can contribute to the achievement of goal
congruence, there are a number of reasons why the benefits may not be as great as might be
expected, as follows:
Managers are protected from the downside risk that is faced by shareholders. If the share
price falls, they do not have to take up the shares and will still receive their standard
remuneration, while shareholders will lose money.
Many other factors as well as the quality of the company’s performance influence share price
movements. If the market is rising strongly, managers will still benefit from share options,
even though the company may have been very successful. If the share price falls, there is a
downward stock market adjustment and the managers will not be rewarded for their efforts in
the way that was planned.
The scheme may encourage management to adopt ‘creative accounting’ methods that will
distort the reported performance of the company in the service of the managers’ own ends.
Note
The choice of an appropriate remuneration policy by a company will depend, among other
things, on:
• Cost: the extent to which the package provides value for money
• Motivation: the extent to which the package motivates employees both to stay with the

company and to work to their full potential.
• Fiscal effects: government tax incentives may promote different types of pay. At times of wage
control and high taxation this can act as an incentive to make the ‘perks’ a more significant
part of the package.
• Goal congruence: the extent to which the package encourages employees to work in such a
way as to achieve the objectives of the firm – perhaps to maximize rather than to satisfy.
7. Incurring Agency Costs

Agency costs are incurred by the shareholders in order to monitor the activities of
their agent. The agency costs are broadly classified into 4.
a. The contracting cost. These are costs incurred in devising the contract between
the managers and shareholders.
The contract is drawn to ensure management act in the best interest of
shareholders and the shareholders on the other hand undertake to compensate
the management for their effort.
Examples of the costs are:
• Negotiation fees
• The legal costs of drawing the contracts fees.
• The costs of setting the performance standard,
b. Monitoring Costs This is incurred to prevent undesirable managerial actions.
They are meant to ensure that both parties live to the spirit of agency contract.
They ensure that management utilize the financial resources of the shareholders
without undue transfer to themselves.
Examples are:
• External audit fees
• Legal compliance expenses e.g. Preparation of Financial statement
according to international accounting standards, company law, capital
market authority requirement, stock exchange regulations etc.
• Financial reporting and disclosure expenses
• Investigation fees especially where the investigation is instituted by
the shareholders.
• Cost of instituting a tight internal control system (ICS).
c. Opportunity Cost/Residual Loss This is the cost due to the failure of both parties
to act optimally e.g.
• Lost opportunities due to inability to make fast decision due to tight
internal control system
• Failure to undertake high risk high return projects by the manager leads to
lost profits when they undertake low risk, low return projects.
d. Restructuring Costs – e.g. new I.C.S., business process reengineering etc.
2. SHAREHOLDERS AND CREDITORS/bond/debenture holders

Bondholders are providers or lenders of long term debt capital. They will usually give debt
capital to the firm on the strength of the following factors:
• The existing asset structure of the firm

• The expected asset structure of the firm
• The existing capital structure or gearing level of the firm
• The expected capital structure of gearing after borrowing the new debt.

Note
• In raising capital, the borrowing firm will always issue the financial securities in form of
debentures, ordinary shares, preference shares, bond etc.
• In case of shareholders and bondholders the agent is the shareholder who should ensure
that the debt capital borrowed is effectively utilized without reduction in the wealth of the
bondholders. The bondholders are the principal whose wealth is influenced by the value of
the bond and the number of bonds held.
• Wealth of bondholders = Market value of bonds x No. of bonds /debentures held.
• An agency problem or conflict of interest between the bondholders (principal) and the
shareholders (agents) will arise when shareholders take action which will reduce the market
value of the bond and by extension, the wealth of the bondholders. These actions include:
a. Disposal of assets used as collateral for the debt in this.

In this case the bondholder is exposed to more risk because he may not recover the loan
extended in case of liquidation of the firm.
b. Assets/investment substitution
In this case, the shareholders and bond holders will agree on a specific low risk project.
However, this project may be substituted with a high risk project whose cash flows have
high standard deviation. This exposes the bondholders because should the project
collapse, they may not recover all the amount of money advanced.
c. Payment of High Dividends
Dividends may be paid from current net profit and the existing retained earnings.
Retained earnings are an internal source of finance. The payment of high dividends
will lead to low level of capital and investment thus reduction in the market value of the
shares and the bonds.
firm may also borrow debt capital to finance the payment of dividends from which no
returns are expected. This will reduce the value of the firm and bond.
d. Under investment
This is where the firm fails to undertake a particular project or fails to invest money/
capital in the entire project if there is expectation that most of the returns from the project
will benefit the bondholders. This will lead to reduction in the value of the firm and
subsequently the value of the bonds.
e. Borrowing more debt capital
A firm may borrow more debt using the same asset as a collateral for the new debt.
The value of the old bond or debt will be reduced if the new debt takes a priority on the
collateral in case the firm is liquidated. This exposes the first bondholders/lenders to
more risk.
f. Solutions to agency problem
The bondholders might take the following actions to protect themselves from the actions
of the shareholders which might dilute the value of the bond. These actions include:
1. Restrictive Bond/Debt Covenant
In this case the debenture holders will impose strict terms and conditions on the
borrower.

These restrictions may involve:
a. No disposal of assets without the permission of the lender.
b. No payment of dividends from retained earnings
c. Maintenance of a given level of liquidity indicated by the
amount of current assets in relation to current liabilities.
d. Restrictions on mergers and organisations
e. No borrowing of additional debt, before the current debt is
fully serviced/paid.
f. The bondholders may recommend the type of project to be
undertaken in relation to the riskness of the project.
2. Callability Provisions
These provisions will provide that the borrower will have to pay the debt before the expiry
of the maturity period if there is breach of terms and conditions of the bond covenant.
3. Transfer of Asset
• The bondholder or lender may demand the transfer of asset to him on
giving debt or loan to the company. However the borrowing company
will retain the possession of the asset and the right of utilization.
• On completion of the repayment of the loan, the asset used as a collateral
will be transferred back to the borrower.
4. Representation
The lender or bondholder may demand to have a representative in the board of directors
of the borrower who will oversee the utilization of the debt capital borrowed and
safeguard the interests of the lender or bondholder.
5. Refuse to lend
If the borrowing company has been involved in un-ethical practices associated with the
debt capital borrowed, the lender may withhold the debt capital hence the borrowing firm
may not meet its investments needs without adequate capital.
The alternative to this is to charge high interest on the borrower as a deterrent
mechanism.
6. Convertibility: On breach of bond covenants, the lender may have the right to convert
the bonds into ordinary shares.
NATIONALISED INDUSTRIES/PUBLIC SECTOR

The objectives of nationalised industries are likely to be strongly influenced by the government
and not primarily financial. These organisations exist to provide a service and to ensure that social
needs are satisfied and financial requirements may be seen as constraints and not objectives.
They are not usually profit maximising, although subsidiary objectives may be concerned with
earning an acceptable return on capital employed.
In the private sector the effects of investments (and associated financing and dividend decisions)
on share price and shareholder wealth will be considered. As there are no share prices in
a nationalised industry and investor wealth maximisation is not the assumed objective, some
private sector investment appraisal techniques will not be appropriate. However, some private
sector financial management techniques can be used in the public sector - e.g. discounted cash
flow is often used.

CORPORATE SOCIAL RESPONSIBILITY (CSR)
Corporate Social Responsibility (CSR) is often used to describe the actions of a private,
commercial organisation assuming a responsible view of its wider obligations to society.
Corporate Social Responsibility has been otherwise defined as:
“fulfilling a role wider than your strict economic role” or “acting as a good corporate citizen”.
The theory of business finance is that the prime objective of management of a listed company is
to maximise the wealth of its ordinary shareholders. Agency theory dictates that management,
as agents of the company’s owners, must act in their best interests and, thus, strive to maximise
shareholders wealth at all times. In their attempt to achieve this prime objective management will
set financial objectives, including:
»» Profit levels
»» Sales and profit growth
»» Margin improvement
»» Cost releasing efficiency savings
»» EPS growth
Management will also set non-financial objectives, which should complement and support the
financial objectives. These may include:
»» Brand awareness levels

»» Research & development successes
»» New product development
»» New markets entered
»» Customer satisfaction levels
»» Employee motivation levels
Such objectives may also include the following:
»» Providing for the welfare of employees and management

»» Upholding responsibilities to customers and suppliers
»» Provision of a service.
»» Contributing to the welfare of society as a whole
»» Environmental protection
Which may be loosely described as acting in a socially responsible manner. This has led to the
development of the concept of Corporate Social Responsibility (CSR).
Examples of acting in a socially responsible manner may include:
Such as KPMG International’s policy of purchasing over 90% of its electricity from
renewable sources.
Junior Achievement Awards initiative.

Likewise, companies have been alleged to have acted in a less than socially responsible manner.
Examples include clothing and sports goods companies using sub-contractors who employ child
labour practices.

The extent to which organisations subscribe to CSR varies greatly both ideologically and in
practice. Recent research has shown that 90% of companies believed that CSR should be part
of a company’s DNA, yet only 30% thereof actually did anything about it.
Many organisations view CSR as a strategic investment and consider it necessary in order to
achieve the reputation that is gaining importance in attracting and retaining key staff and to
winning and retaining prestigious contracts and clients. Many such companies have moved to
operationalise CSR. This has been achieved in many ways including:
Incorporating CSR in their mission statements
Appointing a ‘champion’ of CSR
Formally incorporating CSR objectives into its strategic planning process
Dissemination of CSR targets and reporting of key performance indicators
Retaining consultants to advise on existing performance and to recommend

improvements
Appointment of committees to implement and reviews CSR related policies.

Whilst, some organisations see social responsibility as a passing trend and are content to get
by with a bit of ‘lip service’ and tokenism, other organisations view CSR as the preserve of
multinationals and government. Part of the challenge in pursuing CSR related objectives lies
in the relative novelty of the concept. The critical debate is whether or not CSR detracts from
the objective of maximising shareholder wealth. As with all debates there are opposing views
including:
Arguments in favour of CSR include that it:
• Creates positive Public Relations for the organisation, or, as a minimum avoids bad P.R.
• Helps attract new and repeat custom
• Improves staff recruitment, motivation and retention
• Helps keep the organisation within the law,
All of which may be considered to support the drive to maximise profits.

However, there are many writers who vigorously oppose the notion that private organisations
should embrace social responsibility. Some of the main arguments against CSR are:
• Market capitalism is the most equitable form of society that has ever appeared
• The ethics of doing business are not those of wider society
• Governments are responsible for the well- being of society
• An organisation’s maximum requirement is to remain within the law, no more than this is required.
Ultimately, they argue that business organisations are created and run in order to maximise
returns for their owners and that CSR detracts from the profit maximization

Conclusion
The broad philosophical debate on the role of companies in society is still in its early days.
Depending on your viewpoint, CSR may be considered to support or detract from the
objective of maximising shareholder wealth. Neither viewpoint is definitive.
As the public debate on CSR and the changing role of business in society intensifies,
companies will need to determine their own view on CSR and adopt their own stance on the
subject. Ultimately, they will have to make policy decisions that are in the best interests of the
company and its owners, their shareholders
IMPACT OF GOVERNMENT ON ACTIVITIES

There are a number of areas where the Government plays a role in the financial arena:
»» Taxation - Corporate (Capital Allowances etc.) & Personal (Business Expansion

Scheme, etc.)
»» Monetary Policy – Rates of Inflation, Interest Rates, Exchange Rates etc.
»» Investment Incentives Offered - Grants, etc.
»» Legislation - Monopolies, Competition, Environmental etc.
»» Wage Controls
»» Duties, Tariffs etc.
COMPOSITION OF SHAREHOLDERS
Is there anything to be gained from a company knowing the composition of its shareholders.
Generally, it is useful as it may assist the company in framing its policy/approach in a number of
areas e.g.
• Dividend Policy
• Attitude to Risk/Gearing
• Unwelcome Bid - support critical
• How Performance is Measured
• Recent Shareholder Changes => Price Movements
CORPORATE GOVERNANCE
Corporate governance, “Refers to the manner in which the power of the corporation is exercised
in the stewardship of the corporation total portfolio of assets and resources with the objective of
maintaining and increasing shareholders value through the context of its corporate vision”
Corporate Governance can be defined as the system by which organizations are directed and
controlled.
Rationale for corporate governance

The organization of the world economy (especially in current years) has seen corporate
governance gain prominence mainly because:
• Institutional investors, as they seek to invest funds in the global economy, insist on high
standard of Corporate Governance in the companies they invest in.
• Public attention attracted by corporate scandals and collapses has forced stakeholders to
carefully consider corporate governance issues.

Corporate governance is therefore important as it is concerned with:
• Profitability and efficiency of the firm.

• Long-term competitiveness of firms in the global economy.
• The relationship among firm’s stakeholders
BEST PRACTICE
Financial aspects of corporate governance have introduced a “Code of Best Practice”
Some of the main recommendations are:
1. The roles of chairman and chief executive should generally be separate.
Whether or not the roles are combined, a senior non-executive director should be
identified.
2. Non-executive directors should comprise at least one-third of the membership of

the board and the majority of non-executive directors should be independent.
3. Boards should establish a Remuneration Committee, made up of independent

non- executive directors, to develop policy on remuneration and devise
remuneration packages for individual executive directors.
4. Each company should establish an Audit Committee of at least three non-

executive directors, at least two of them independent. The audit committee
should keep under review the overall financial relationship between the
company and its auditors, to ensure a balance between the maintenance of
objectivity and value for money.
5. Disclosure of directors’ total emoluments, including pension contributions and

stock options. Separate figures for salary and performance-related elements and
the basis on which performance is measured.
6. Directors should report on internal controls.
7. The accounts should contain a statement of how the company applies the
corporate governance principles and explain the policies, including any
circumstances justifying departure from best practice
EFFICIENT MARKET HYPOTHESIS (EMH)
Types of Efficiency
Efficient market hypothesis can be explained in 3 ways:
a) Allocative Efficiency
A market is allocatively efficient if it directs savings towards the most efficient productive
enterprise or project. In this situation, the most efficient enterprises will find it easier to raise
funds and economic prosperity for the whole economy should result. Allocative efficiency will be
at its optimal level if there is no alternative allocation of funds channelled from savings that would
result in higher economic prosperity. To be allocatively efficient, the market should have fewer
financial intermediaries such that funds are allocated directly from savers to users, therefore
financial disintermediation should be encouraged.

b) Operational Efficiency
This concept relates to the cost, to the borrower and lender, of doing business in a particular
market. The greater the transaction cost, the greater the cost of using financial market and
therefore the lower the operational efficiency. Transaction cost is kept as low as possible where
there is open competition between broker and other market participants. For a market to be
operationally efficient, therefore, we need to have enough market markers who are able to play
continuously.
c) Information Efficiency
This reflects the extent to which the information regarding the future prospect of a security is
reflected in its current price. If all known (public information) is reflected in the security price,
then investing in securities becomes a fair game. All investors have the same chances mainly
because all the information that can be known is already reflected in share prices. Information
efficiency is important in financial management because it means that the effect of management
decision will quickly and accurately be reflected in security prices. Efficient market hypothesis
relates to information processing efficiency. It argues that stock markets are efficient such that
information is reflected in share prices accurately and rapidly.
Forms of Information Efficiency

Informational efficiency is usually broken down into 3 different levels (forms):
a. Weak form level of efficiency

This level states that share prices fully reflect information in historic share price movement and
patterns (past information/historic information). If this hypothesis is correct, then, it should be
possible to predict future share price movement from historical patterns. E.g. If the company’s
shares have increased steadily over the past few months to the current price of RWF .30, then
this price will already fully reflect the information about the company’s growth and therefore
the next change in share prices could either be upward, downward or constant with equal
probability. It therefore follows that technical analysis or Chartism will not enable investors to
make arbitrage profits. In markets that have achieved this level then security prices follow a
trendles random walk.
Studies to test this level have been based on the principle that:
• The share price changes are random

• That there is no connection between share price movement and new share price changes. It
is possible to prove statistically that there is no correlation between successive changes in
price of shares and therefore trend in share price changes cannot be detected. This can be
done by using serial correlation (or auto-correlation) test such as Durbin Watson Statistics.
b. Semi-Strong form level of Efficiency
This level states that share prices reflects all available public information. (past and present
information). If the market has achieved this level, then fundamental analysis will not enable
investors to earn consistently higher than average returns. Fundamental analysis involves the
study of company’s accounts to determine its theoretical value and thereby find any undervalued
share. Fundamental theory states that every share in the market has an intrinsic value, which is
equal to the present value of cash flows expected from the security.

Tests to prove semi-strong form of efficiency have concentrated on the ability of the market
to anticipate share price changes before new information is formally announced. These tests
are referred to as Event Studies. E.g. if two companies plans to merge, share prices of the 2
companies will change once the merger plans are made public. The market would show semi-
strong form of efficiency if it were able to anticipate such changes so that share prices of the
company would change in advance of the merger plans being confirmed. Other events that can
affect share prices are:
a) Stock splits
b) Death of CEO of company
c) Investment in major profitable projects
d) Changes in dividend policy, etc
c. Strong form level of Efficiency

This level states that price reflects all the available public and private information (past, present
and future information). If the hypothesis is correct, then, the mere publication of information
that was previously confidential should not have impact on share prices. This implies that
insider trading is impossible. It follows therefore, that in order to maximize shareholders’ wealth,
managers should concentrate on maximizing the NPV of each investment.
Tests that have been carried out on this level have concentrated on activities of fund managers
and individual investors. If the markets have reached the strong form levels, then fund managers
cannot consistently perform better than individual investors in the market.
IMPLICATIONS OF EMH FOR FINANCIAL DECISION MAKERS
a. The Timing Of Financial Policy

Some financial managers argue that there is a right or wrong time to issue securities i.e. new
shares should only be issued when the market is at the top rather than the bottom. If the market
is efficient, however, price follows a trendless random walk and its impossible for managers to
know whether today’s price is the highest or the lowest. Timing other policies e.g release of
financial statements, announcement of stock splits, etc has no effect on share prices.
b. Project Evaluation Based Upon NPV

When evaluating new projects, financial managers use the required rate of return drawn from
securities traded in the capital market. For example, the rate of return required on a particular
project may be determined by observing the rate of return required by shareholders of firms
investing in projects of similar risk. This assumes that securities are fairly priced for the risks that
they carry (i.e. the market is efficient).
If the market is inefficient, however, financial managers could be appraising projects on a wrong
basis and therefore making bad investment decisions since their estimate on NPV is unreliable.
c. Creative Accounting
In an efficient market, prices are based upon expected future cash flow and therefore they
reflect all current information. There is no point therefore in firms attempting to distort current
information to their advantage since investors will quickly see through such attempts. Studies
have been done for example to show that changes from straight-line depreciation to reducing

balance method, although it may result to increasing profit, may have no long-term effect on share
prices. This is because the company’s cash flows remain the same. Other studies support the
conclusion that investors cannot be fooled by manipulation of accounting profit figure or charges
in capital structure of company. Eventually, the investors will know the cash flow consequences
and alter the share prices consequently.
d. Mergers and Takeovers

If shares are correctly priced then the purchase of a share is a zero NPV transaction. If this is
true then, the rationale behind mergers and takeovers may be questioned. If companies are
acquired at their correct equity position then purchasers are breaking even. If they have to
make significant gains on the acquisition, then they have to rely on synergy in economies of
scale to provide the saving. If the acquirer (or the predator) pays the current equity value plus
a premium, then this may be a negative NPV decision unless the market is not fully efficient and
therefore prices are not fair.
e. Validity of the current market price

If markets are efficient then they reflect all known information in existing share prices and investors
therefore know that if they purchase a security at the current market price they are receiving a fair
return and risk combination. This means that under or over valued shares or market securities do
not exist. Companies shouldn’t offer substantial discounts on security issues because investors
would not need extra incentives to purchase the securities.

Study Unit 2
MERGERS AND ACQUISITIONS
Contents
• Organic and acquisitive corporate growth.
• Mergers and acquisitions, the arguments for and against.
• Procedures to be complied with during an acquisition.
• Valuation of an organization in the context of a potential takeover using the earnings
,cashflow and assets based methodologies.
• The significance of Value Gaps and the information efficiency of capital markets.
• Methods of financing mergers and takeovers including cash, debt, equity and hybrids.
• Defense tactics used during a hostile takeover.
• The role of legal and financial due diligence during a merger/acquisition.
• The attractions and risks associated with Management Buy-outs(MBOs).
• Sources of finance for MBOs.
• The advantages and disadvantages of management buy-ins.
• The arguments for and against a quoted company going private.

INTRODUCTION
When an organisation decides on expansion the choice is between organic growth or acquisition.
Organic growth is internal growth by expansion of the existing business (e.g. opening more outlets,
major marketing/sales campaign, reduce prices to achieve additional sales etc.) or investment
in new projects. The alternative is to acquire a competitor (thus reducing competition), or other
companies in related or non-related lines of business. Acquisition achieves the objective more
quickly and avoids the risk of start-up. However, it is generally more expensive than organic
growth.
Merger – this is generally where two companies unite to form a single entity.
Acquisition/Takeover – generally where one company purchases a controlling interest in another

company.
TYPES OF COMBINATIONS
Generally, the combinations can be categorised as follows:
Vertical Integration - combination of two firms in the same industry but at different
levels - e.g. a production company acquires its supplier of raw materials.
Horizontal Integration - combination of two firms in the same industry and at the
same level - e.g. the acquisition of a direct competitor.
Conglomerate Merger/Takeover - combination of two firms in unrelated/indirectly related

industries - e.g. a tobacco company acquires an insurance company.
ARGUMENTS FOR MERGERS AND ACQUISITION (REASONS FOR MERGERS AND

ACQUISITION)
There are many reasons why one company may wish to acquire another. The following list is not
in any particular order as priorities may vary from one acquisition to another
Synergy => 2 + 2 = 5 (benefits accrue due to increased earnings or reduction in costs e.g.
reduced advertising & distribution costs; disposal of one H.O. etc.)
Economies of Scale - Fixed operating costs spread over larger production volume; equipment
used more efficiently; bulk purchasing (production, marketing, administration, R & D, finance
etc).
New Market - quick entry

Management Acquisition - a company with a weak management team acquires a company
with a strong team.
Diversification - reduction of risk. This may not be beneficial to shareholders who already hold
diversified portfolios. Can be beneficial if the acquired company is one in which the shareholder
could not previously invest.
Increased Market Share & Market Power - gain some monopoly power which may increase
profitability (e.g. price leadership). In some markets to operate effectively requires the
achievement of a “critical mass” size. Beware of Monopolies legislation.

Bolster Asset Backing - a company with a high level of earnings relative to its assets may wish
to improve the overall risk profile by acquiring a company with substantial assets.
Growth - growth through acquisition may be cheaper and quicker than internal expansion.
Taxation - a company with unused tax allowances may wish to combine with a company
with large taxable profits. Similarly, a company with accumulated tax losses may be acquired so
that the losses can be offset against the taxable profits of the acquiring company.
Reduction of Competition – consider Monopolies legislation and attitude of

Competition Authority
Asset Stripping – company broken up and assets sold off.
Use of Surplus Cash – acquire “earnings enhancing” company.
Lower Costs Of Financing - improved credit-rating following reduced variability of returns may
make it easier/cheaper to raise finance.
Improvement In Gearing – highly geared company links up with “cash-rich”
company.
Purchase of Patents/Brands
Note: Evidence suggests that many acquisitions are financially unsuccessful. There is often
some abnormal return for the shareholders of the target (premium paid for their shares) but very
little for the bidding company shareholders. Also, acquisitions often experience difficulties in
integrating the operations of the companies. Research by the London Business School indicates
that 75% fail to reach their financial targets and 50% of acquiring companies fail to recoup the
premium they pay above market value.
ARGUMENTS AGAINST MERGERS AND ACQUISITION - REASONS BEHIND FAILED

MERGERS AND ACQUISITION
Mergers and acquisitions are extremely difficult. Expected synergy values may not be realized
and therefore, the merger is considered a failure. Some of the reasons behind failed mergers
are:
Poor strategic fit - The two companies have strategies and objectives that are too different and
they conflict with one another.
Cultural and Social Differences - It has been said that most problems can be traced to “people
problems.” If the two companies have wide differences in cultures, then synergy values can be
very elusive.
Incomplete and Inadequate Due Diligence - Due diligence is the “watchdog” within the M & A
Process. If you fail to let the watchdog do his job, you are in for some serious problems within
the M & A Process.
Poorly Managed Integration - The integration of two companies requires a very high level
of quality management. In the words of one CEO, “give me some people who know the drill.”
Integration is often poorly managed with little planning and design. As a result, implementation

fails.
Paying too Much - In today’s merger frenzy world, it is not unusual for the acquiring company to
pay a premium for the Target Company. Premiums are paid based on expectations of synergies.
However, if synergies are not realized, then the premium paid to acquire the target is never
recouped.
Overly Optimistic - If the acquiring company is too optimistic in its projections about the Target
Company, then bad decisions will be made within the M & A Process. An overly optimistic forecast
or conclusion about a critical issue can lead to a failed merger.
IMPACT OF ACQUISITION
On Shareholders in Bidding Company
Approval may not be forthcoming if the shareholders regard the bid as unattractive because:
»» It might reduce EPS

»» The target company is in a risky business
»» It might reduce the net asset backing per share
»» It might dilute their control.
On Directors & Shareholders in Target Company

The Board and/or shareholders in the target company may regard the bid as unattractive
because: They regard the terms of the offer as poor
THE OVERALL MERGER & ACQUISITION PROCESS

The Merger & Acquisition Process can be broken down into five phases
Phase 1 - Pre Acquisition Review:
The first step is to assess your own situation and determine if a merger and acquisition strategy
should be implemented. If a company expects difficulty in the future when it comes to maintaining
core competencies, market share, return on capital, or other key performance drivers, then a
merger and acquisition (M & A) program may be necessary.
It is also useful to ascertain if the company is undervalued. If a company fails to protect its
valuation, it may find itself the target of a merger. Therefore, the pre-acquisition phase will often
include a valuation of the company - Are we undervalued? Would an M & A Program improve
our valuations?
The primary focus within the Pre Acquisition Review is to determine if growth targets (such as
10% market growth over the next 3 years) can be achieved internally. If not, an M & A Team should
be formed to establish a set of criteria whereby the company can grow through acquisition. A
complete rough plan should be developed on how growth will occur through M & A, including
responsibilities within the company, how information will be gathered, etc.
Phase 2 - Search & Screen Targets:

The second phase within the M & A Process is to search for possible takeover candidates. Target
companies must fulfill a set of criteria so that the Target Company is a good strategic fit with the
acquiring company. For example, the target’s drivers of performance should compliment the
acquiring company. Compatibility and fit should be assessed across a range of criteria - relative
size, type of business, capital structure, organizational strengths, core competencies, market
channels, etc.

It is worth noting that the search and screening process is performed in-house by the Acquiring
Company. Reliance on outside investment firms is kept to a minimum since the preliminary
stages of M & A must be highly guarded and independent.
Phase 3 - Investigate & Value the Target:

The third phase of M & A is to perform a more detail analysis of the target company. You want
to confirm that the Target Company is truly a good fit with the acquiring company. This will
require a more thorough review of operations, strategies, financials, and other aspects of the
Target Company. This detail review is called “due diligence.” Specifically, Phase I Due Diligence
is initiated once a target company has been selected. The main objective is to identify various
synergy values that can be realized through an M & A of the Target Company. Investment Bankers
now enter into the M & A process to assist with this evaluation.
A key part of due diligence is the valuation of the target company. In the preliminary phases of
M & A, we will calculate a total value for the combined company. We have already calculated a
value for our company (acquiring company). We now want to calculate a value for the target as
well as all other costs associated with the M & A.
Phase 4 - Acquire through Negotiation:

Now that we have selected our target company, it’s time to start the process of negotiating a M
& A. We need to develop a negotiation plan based on several key questions:
• How much resistance will we encounter from the Target Company?

• What are the benefits of the M & A for the Target Company?
• What will be our bidding strategy?
• How much do we offer in the first round of bidding?
The most common approach to acquiring another company is for both companies to reach
agreement concerning the M & A; i.e. a negotiated merger will take place. This negotiated
arrangement is sometimes called a “bear hug.” The negotiated merger or bear hug is the preferred
approach to a M & A since having both sides agree to the deal will go a long way to making the M
& A work. In cases where resistance is expected from the target, the acquiring firm will acquire a
partial interest in the target; sometimes referred to as a “toehold position.” This toehold position
puts pressure on the target to negotiate without sending the target into panic mode.
In cases where the target is expected to strongly fight a takeover attempt, the acquiring company
will make a tender offer directly to the shareholders of the target, bypassing the target’s
management. Tender offers are characterized by the following:
• The price offered is above the target’s prevailing market price.

• The offer applies to a substantial, if not all, outstanding shares of stock.
• The offer is open for a limited period of time.
• The offer is made to the public shareholders of the target.
A few important points worth noting:
• Generally, tender offers are more expensive than negotiated M & A’s due to the resistance of
target management and the fact that the target is now “in play” and may attract other bidders.
• Partial offers as well as toehold positions are not as effective as a 100% acquisition of “any
and all” outstanding shares. When an acquiring firm makes a 100% offer for the outstanding
stock of the target, it is very difficult to turn this type of offer down.

Another important element when two companies merge is Phase II Due Diligence. As you may
recall, Phase I Due Diligence started when we selected our target company. Once we start
the negotiation process with the target company, a much more intense level of due diligence
(Phase II) will begin. Both companies, assuming we have a negotiated merger, will launch a very
detailed review to determine if the proposed merger will work. This requires a very detail review
of the target company - financials, operations, corporate culture, strategic issues, etc.
Phase 5 - Post Merger Integration:

If all goes well, the two companies will announce an agreement to merge the two companies.
The deal is finalized in a formal merger and acquisition agreement. This leads us to the fifth and
final phase within the M & A Process, the integration of the two companies.
Every company is different - differences in culture, differences in information systems, differences

in strategies, etc. As a result, the Post Merger Integration Phase is the most difficult phase within
the M & A Process. Now all of a sudden we have to bring these two companies together and
make the whole thing work. This requires extensive planning and design throughout the entire
organization. The integration process can take place at three levels:
Full: All functional areas (operations, marketing, finance, human resources, etc.) will be merged
into one new company. The new company will use the “best practices” between the two companies.
Moderate: Certain key functions or processes (such as production) will be merged together.
Strategic decisions will be centralized within one company, but day to day operating decisions
will remain autonomous.
Minimal: Only selected personnel will be merged together in order to reduce redundancies. Both
strategic and operating decisions will remain decentralized and autonomous.
If post merger integration is successful, then we should generate synergy values. However,
before we embark on a formal merger and acquisition program, perhaps we need to understand
the realities of mergers and acquisitions.
The employees are strongly opposed to it.
The takeover has no obvious advantages
METHODS OF FINANCING MERGERS AND TAKEOVERS (PURCHASE CONSIDERATION)

There are a number of ways that the acquiring company can pay for the target. Briefly, these
are:
• Cash
• Share Exchange – e.g. three shares in company A for every five shares in company B
• Loan Stock - e.g. RWF100k of 10% Loan Stock for forty shares in company B
• Combination – some cash plus some shares etc.
• Deferred Expenditure - Performance Related.
Before deciding on the method of consideration there are a number of factors to consider:
1. Factors - Bidding Company & Shareholders
»» Dilution in EPS - may occur in certain circumstances when the consideration is equity (if
the target company is bought on a higher P/E Ratio than the bidder).

»» Cost - may be less with loan stock as the interest is allowable for Corporation
Tax. Also, dilution of EPS may be avoided.
»» Gearing - a highly geared company may find it difficult to issue additional loan stock.
»» Control - may be diluted if a large number of shares is issued. Cash causes less dilution
of ownership.
»» Cash Resources - use of equity conserves cash resources and may be the only real
alternative when the target company is large in relation to the bidding company. The issue
of Loan Stock will also conserve liquidity but will increase gearing.
»» Price - if equity is offered the value of the bid is dependent upon the share price - fluctuations
causing the attractiveness of the bid to alter. The cost of the bid is more precise when
cash is the consideration. Where shares are offered the bidding company will be
concerned that the market value of their shares should not fall before the target company’s
shareholders have accepted.
2. Factors - Shareholders in Target Company
»» Taxation - if cash is offered an immediate C.G.T./Income Tax liability arises. If paper

(shares/stock etc.) is offered the tax liability is deferred.
»» Income - if paper is offered, the bidding company should generally ensure that the
shareholders’ income is at least maintained.
»» Future Investment - shareholders may prefer equity to maintain a continued interest
in their company, albeit as part of a larger group, without incurring transaction costs
of purchasing in the new group. Unless Loan Stock is issued as “convertibles” or with
warrants attached the shareholders will not maintain an equity interest in the group.
»» Cash - if cash is offered the value is certain and the shareholder is free to invest
elsewhere, without incurring transaction costs of selling shares.
»» Value - evidence suggests that the consideration is higher when equity rather than cash is
used as consideration.
»» Risk - the receipt of fixed interest stock will change the risk of the shareholders’
»» portfolios which they may not wish.
FINANCIAL TERMS OF EXCHANGE

When two companies are combined, a ratio of exchange occurs, denoting the relative
weighting of the firms. The ratio of exchange can be considered in respect to earnings, market
prices and the book values of the two companies involved.
a. Earnings
In evaluating possible acquisition, the acquiring firm must at least consider the effect
the merger will have on the earnings per share of the surviving company. We can
discuss this through an illustration:
Example 1 cash settlement

Company Atu is considering the acquisition by shares of Company Bote. The following
information is also available.

Company ATU Company BOTE
Present earnings frw 20,000,000 frw 5,000,000
Shares 5,000,000 2,000,000

Earnings per share frw 4 frw2.50
Price/earning ratio 16 12
Price of shares frw 64 frw 30
Company Bote has agreed to an offer of frw 35 a share to be paid in Company Atu shares.
REQUIRED:
Consider the effect of the acquisition to the earnings per share.
SOLUTION
The exchange ratio = 35/64 = 0.546875 shares of Company A’s stock for
each share of Company B’s stock.
The total number of shares needed to acquire company Bote’s share

= 0.546875 X 2,000,000 = 1,093,750 shares of Company Atu
The earnings per share therefore can be computed as follow:
EPS combined Companies = Earnings of Atu + Earnings of BOTE / Total No. of shares
20,000,000 + 5,000,000
=
5,000,000 + 1,093,750

25,000,000
=
6,093,750
= frw 4.10
Therefore the earnings for share of the combined firm is frw 4.10.
There is therefore an immediate improvement in earnings per share for Company Atu as a
result of add from RWF 4 to RWF 4.1.
However, Company Bote’s former shareholders experience a reduction in earnings per share.
These EPS will be given by
0.546875 X 4.10 = frw 2.24 from frw 2.50
b. Future Earnings
If the decision to acquire another company were based solely on the initial impact on
earnings per share, an initial dilution in earnings per share would stop any company
from merging with another. However, due to synergetic effects discussed earlier, the
merger may result in increased future earnings and therefore a high EPS in future.

c. Market Value
The major emphasis in the bargaining process is on the ratio of exchange of market
price per share. The market price per share reflects the earnings potential of the
company, dividends, business risk, capital structure, asset values and other factors that
bear upon valuation. The ratio of exchange of market price is given by the following
formula:
Market price per share of acquiring company X
No. of shares offered of exchange
Market price ratio =
Market price per share of the acquired company
Considering the previous example

64 X 0.546875
Market price ratio = = 1.167.
30

Therefore, Company Bote receive more than its market price per share. It is common for the
company being acquired to receive a little more than the market price per share. Shareholders
of the acquired company would therefore benefit from the acquisition because their shares were
originally worth frw 30 but they receive frw 35.
Example 2 share Exchange

The following information relates to Company X and Y.
Company X Company Y
Present earnings frw 20,000,000 frw 6,000,000
No. of shares 6,000,000,000 2,000,000

Earnings per share frw 3.33 frw3.00
Market price per share frw 60.00 frw 30.00

Price/earning ratio 18 10
Company X offers 0.667 shares for each share of Company Y to acquire the company.
The market price exchange ratio = 60 X 0.667 = 1.33

3
Shareholders of Y are being offered a share with a market value of frw 40 for each share they
own (i.e. 1.333 X 30). They benefit from acquisition with respect to market price because their
shares were formerly worth frw 30. We can consider the combined effect.

Combined Effect
Total earnings frw 26,000,000
No. of shares 7,333,333

Earnings per share frw 3.55
Price/earning ratio 18
Market price per share frw 63.90
Note:
Both companies tend to benefit due to the merger. This can be seen by the increased market
price per share for both company. This is due to the assumption that the price earnings ratio
of the combined company will remain 18. If this is the case, companies with high price/earning
ratios can be able to acquire companies with lower price/earnings ratio to obtain an immediate
increase in earnings per share (even if they pay a premium for the share.)
d. Book value
Book value per share is not a useful basis for valuation in most mergers. However, it
may be important if the purpose of an acquisition is to obtain the liquidity of another
company. The ratio of exchange of book value per share of the two companies are
calculated in the same manner as is the ratio for market values computed above.
The application of this ratio in bargaining is usually restricted to situations in
which a company is acquired for its liquidity and asset values rather than for its earning
power.
VALUING THE TARGET FIRM

To determine the value of the target firm, two key items are needed:
a. A set of proforma financial statements which develop the incremental cashflows
expected from the merger, and
b. A discount rate or cost of capital, to apply to these projected cashflows.
CASH FLOW STATEMENTS

In a pure financial merger, the post-merger cash flows are simply the sum of the
expected cashflows of the two firms if they were to continue operating
independently. If the two firm’s operations are to be integrated however, forecasting
future cashflows is a more complex task.
The following illustration can be used to determine the value of target company.
Example
XYZ Ltd. is considered acquiring ABC Ltd. The following information relates to ABC Ltd.
for the next five years. The projected financial data are for the post-merger period. The
corporate tax rate is 40% for both companies.
Amounts are in Frw `000’

2014 2015 2016 2017 2018
Net sales 1,050 1,260 1,510 1,740 1,910

Cost of sales 735 882 1,057 1,218 1,337
Selling & admn. expenses 100 120 130 150 160

Interest expenses 40 50 70 90 110

Other information
a. After the fifth year the cashflows available to XYZ from ABC is expected to grow by 10%
per annum in perpetuity.
b. ABC will retain frw 40,000 for internal expansion every year.
c. The cost of capital can be assumed to be 18%.

REQUIRED:
i. Estimate the annual cash flows.

ii. Determine the maximum amount XYZ would be willing to acquire ABC at.
SOLUTION:
XYZ LTD
i. PROJECTED POST-MERGER CASHFLOWS FOR ABC LTD.
Amounts are in Frw `000’

2014 2015 2016 2017 2018
Net sales 1,050 1,260 1,510 1,740 1,910

Less cost of sales 735 882 1,057 1,218 1,337
315 378 453 522 573
Less selling and admn. costs 100 120 130 150 160
EBIT 215 258 323 372 413

Less interest 40 50 70 90 110
EBT 175 208 253 282 303
Less tax 40% 70 83.2 101.2 112.8 121.2
Net income 105 124.8 151.8 169.2 181.8
Less Retention by ABC 40 40.0 40.0 40.0 40.0
Cash available to XYZ 65 84.8 91.8 129.2 141.8
Add terminal value . . . 1,949.75
Net cash flows 65 84.8 91.8 129.2 2,091.55
Computation of terminal value
141.8 (1 + 0.1)
TV = = frw 1,949.75
0.18- 0.1

ii. Assuming the discount rate of 18%, the maximum price of ABC can be determined by
computing the PV of the projected cashflows.

Year Cashflow PVIF18% PV
1 65 0.847 55.055
2 84.8 0.718 60.886
3 91.8 0.607 55.723
4 129.2 0.516 66.667
5 2,091.55 0.437 914.24
1,152.57
The maximum price will therefore be frw 1,152,570
DEFENCE TACTICS
Where an unwelcome or hostile bid is received a number of steps can be taken to :
• Reject the bid on the basis that the terms are not good enough.
• Issue a forecast of attractive future profits and dividends to persuade shareholders to
hold onto their shares
• Revalue any undervalued assets.
• Attempt to have the offer referred under Monopolies legislation - at minimum this will
delay the bid.
• Mount an effective advertising and P.R. campaign.
• Find a “White Knight” that is more acceptable – where a company finds a more suitable
acquirer and deals with them rather than the original bidder.
• Make a counter bid - only possible if the companies are of a similar size.
• Arrange a Management Buyout.
• Attack the credibility of the offer or the offeror itself, particularly if shares are offered - e.g.
commercial logic of the takeover, dispute any claimed synergies, criticize the track record,
ethics, future prospects etc. of the offeror.
• Appeal to the loyalty of the shareholders.
• Encourage employees to express opposition to the merger
• Persuade institutions to buy shares.
Note: In fighting the bid, the company may be restricted by a Rwandan Stock Exchange
(RSE) Code on Takeovers and Mergers.
DUE DILIGENCE
The main objective of Due Diligence is to confirm the reliability of the information which has
been provided and has been used in making an investment decision. Changes in these
primary assumptions may have a significant impact on the price to be paid and possibly even
raise questions on the wisdom of proceeding with the transaction. This is a very useful
process and at minimum will provide additional information on the potential target.

The following should be considered:
1. Earnings – audited financial statements are prepared to comply with statutory/tax

requirements. To assess the true quality of earnings an in-depth review of the business
and detailed management accounts must be performed. Adjustments may need to be
made for one-off events, lost customers, discontinued products, changes in cost
structure etc. Also, evaluate non-financial information e.g. quality of risk management,
quality of management, corporate governance etc.
2. Forecasts – may be prepared on a high-level basis with oversimplified assumptions.

The assumptions may be difficult to reconcile with historical performance.
3. Assets – write-offs for aged debtors, obsolete stock, idle assets, capitalised costs etc.
may need to be made. Also, clarify which assets are to be included in the transfer and
agree valuations.
4. Undisclosed Liabilities – substantial hidden tax liabilities, penalties and exposures

may subsequently arise. Evaluate and possibly, seek protection by obtaining warranties or
indemnities against future potential tax issues.
5. Trading Performance – related party transactions are often conducted under special
pricing terms (e.g. business support services not charged by parent company). The
impact on the business of a change in ownership should be assessed to reflect normal
commercial arrangements.
6. Controls – additional investment in new reporting systems may be required to obtain

the quality of information needed to properly monitor performance. Also, ensure the
necessary staff are locked-in for an appropriate period.
7. Balanced View – issues should be weighed against the upside potential in a balanced
way. Examples of the upside might include, synergies, optimal financing structure, access
to new markets, new management team etc.
8. Tax Structure – effective tax planning is a key component in delivering value as quickly
as possible.
MANAGEMENT BUYOUT (MBO)

This is the purchase of all or part of a business by one or more of its executive management.
The main factors to consider are the riskiness and the problems which may arise when the new
company becomes independent (e.g. loss of H.O. support; customers may go elsewhere if they
regard the firm as too risky.
Management put up some of the capital themselves and obtain the remainder from other sources
(e.g. Venture Capital organisations). Equity from external investors will often be in a form other
than ordinary shares e.g. convertible redeemable preference shares.
They will also require board representation and options on future share issues. Management will
to keep effective control by ceding <50% of voting rights to external equity holders.
External investors will need some potential exit route e.g. future listing, refinancing, sale of entire

business to another company or the management team.
Originally used to dispose of poor performing subsidiaries at a discount but nowadays, mostly
used to dispose of successful operations which do not fit the “core” business.
An MBO may also arise where a company or subsidiary is threatened with closure.
There are usually three parties to an MBO:
• The management team who must possess the necessary skills and ability.
• The directors/owners who are willing to dispose of the entity.
• The financial backers (possibly more than one) who will usually require an
equity stake. They will review strategic business plans & cash flow projections
and assess the personal commitment and quality of the management team.
The main reasons for an MBO are:
• The subsidiary no longer fits the group’s overall strategy.

• The parent’s desire to sell a loss-maker (MBO possibly cheaper than liquidation).
• The parent needs cash urgently.
• The subsidiary is too small for the level of time involved in managing it.
• Management is unable to devote the time/capital necessary to develop the subsidiary.
Rather than run it down or sell it to a competitor it may arrange an MBO (possibly on generous terms) in
order to retain trading contacts with the subsidiary in the future.
• A new parent wishes to sell unwanted parts, following acquisition.

• The best offer may come from the management team.
• There will generally be better co-operation in an MBO.
The main advantages of an MBO are:
• Although high-risk, the potential for rewards is high

• Less risky than starting from scratch
• MBO firms tend to operate at a higher level of efficiency
How to Finance a Management Buyout

A management buyout (MBO) is a type of business acquisition in which the managers of a
company purchase the business from the current owners or parent company. Management
buyouts can be structured in a number of ways such as a conventional purchase or a leveraged
buyout model.
Leveraged buyouts are often used because few management teams have the financial resources
to buy the target company outright. They need external financing to facilitate the purchase, and
are often interested in leveraging some of the assets of the target company.
Funding the purchase

The type of funding that is available to purchase the company is based on the size, brand
recognition, assets, and cash flow of the company. Larger transactions, such as when a
corporation is selling off a division, may be able to use a number of products such as bonds,
senior and mezzanine loans, private equity injections, and so on.
Smaller companies or turnaround situations usually have fewer options than their larger or better-

established counterparts. However, it is possible to finance the buyout of a small company if the
management team is willing to use alternative financing. Such options include:
1. Equity from new management team: Perhaps the most important type of financing comes
from the managers who are making the purchase. The management team that is organizing the
buyout must contribute some of their own cash and assets to purchase the target company. It is
not unusual for managers to raise the funds by selling off certain assets (e.g., stocks) or getting
a second mortgage on their home.
The management team’s financial contribution is very important. Funding companies consider it
a gauge of how committed the team is to the transaction.
2. Seller financing: One of the most common options to finance a management buyout is for
the seller to provide financing (also known as deferred consideration). Usually, the seller creates
a note that is amortized over a period of time. This option is an advantage for the management
buyout team because sellers are usually more willing than banks to provide the funding.
Additionally, as a condition of financing the transaction, some lenders may insist that a portion of
the sale be financed by the seller. This condition provides a measure of confidence to the lenders
because it shows that the seller believes that the business will remain a viable concern once the
sale is completed.
3. Bank loan: Although often hard to get, a bank loan is an effective way to finance a management
buyout. The obvious benefit is that bank loans are cheaper than most other options.
4. Assumption of debt: Part of the acquisition cost can be paid by assuming some or all of the
liabilities of the target company.
5. Private equity: In some cases, the management team may be able to secure financing
through a private equity firm. However, private equity firms prefer scale and tend to invest in
larger transactions. Their investment may consist of buying shares and/or providing additional
funding such as loans and asset-based financing.
Keep in mind that the private equity firm may have objectives that differ from those of the
management team. Private equity firms usually want a liquidity event after 3 to 6 years. They
look to exit the transaction in that time frame, allowing them to realize their gains. Consequently,
their funding programs often include stipulations of how the company is to be run and what
objectives have to be met.
Remember that the private equity firm is looking to maximize its short-term rate of return – often
at the expense of future opportunities. Therefore, management teams must be careful to align
themselves with the right funding partners.
Funding operations
Once the management team has acquired the business, they will likely need financing to operate
the company. Six options that are commonly used to finance operations are:
1. Bank lines of credit: The most popular product to finance operations is a regular commercial
line of credit. These lines offer great flexibility at a very competitive cost. Unfortunately, getting
a line of credit can be difficult, especially if you had to encumber a lot of assets to finance
the management buyout. Also, lines of credit have covenants that must be met to remain in
compliance with the facility. This compliance can be difficult in the initial stages of operations. .

2. Accounts receivable financing: Accounts receivable financing can help a company that has
cash flow problems due to slow-paying accounts receivable. This solution can help finance your
MBO immediately after the purchase, when cash is tight. It helps provide the working capital to
make payroll and pay suppliers. Receivables financing can also help later on, once the company
starts growing.
3. Inventory financing: Another way to get funds for your company is to finance your current
inventory. While inventory financing can free up funds, it comes at a relatively high cost. This
solution is more expensive than other alternatives and best used as a last resort – or in combination
with other solutions.
4. Purchase order financing: One of the challenges of getting a large order is that the company
may not have enough working capital to cover supplier expenses. Purchase order financing can
help you pay suppliers and deliver large orders.
However, purchase order financing can only help companies that re-sell third-party goods. They
must use a third-party manufacturing facility and must have a minimum gross profit margin of
20%.
5. Asset-based loans: Asset-based loans (ABLs) are umbrella facilities that combine accounts
receivable financing, inventory financing, and equipment financing. In terms of price and flexibility,
ABLs stand somewhere between a line of credit and a conventional accounts receivable financing
line. Generally, ABLs have fewer covenants than conventional lines of credit.
6. Vendor financing: One form of financing that should not be overlooked is your own vendors.
If the new company is well funded, vendors may be able to extend more generous terms than
they did to the seller’s original company. Changes in vendor payment terms, such as going from
net-30 to net-45 (or higher), can have a quick and positive effect on your cash flow. Also, vendors
don’t charge interest for offering terms, which makes it very cost effective.
Management Buy-In (MBI)

This is a variation on the MBO theme and occurs when a team of outside managers mounts
a takeover bid and then assumes the executive responsibilities for running the business
themselves.
Advantages of MBI
• The buyers, in many cases, get undervalued companies in MBI. The value of which can be
unlocked and sold at much higher prices later.
• If the current owners of a company are not able to manage the company, MBI is a win-win
situation for both buyers as well as the sellers.
• The new management team might have better knowledge, contacts, experience, etc. It might
actually help the company grow and maximize the shareholder’s wealth.
• Current employees may get motivated because of new changes in the management.
Disadvantages of MBI
• The new management team may also fail to bring the required growth in the company.
• There are chances that even after changing the management, companies may not be
successful.

• The existing employees of the company may feel demotivated.
• The buyer may end up paying way more than required if they estimate the value of the
company incorrectly.
DEMERGERS
A demerger results in the splitting up of a firm into smaller legally separate firms.
A demerger may arise:

• Where one part of a firm is of an unusual level of risk.
• Where one part of a firm has unusual financing requirements.
• Where a firm has grown too large for its management structure.
Among the financial advantages are:
• Ensures the continued survival and viability of the profitable parts of a firm whose existence
could otherwise be threatened by a loss-making division.
• Enables management to have a direct investment in their activities and to observe their
performance as evidenced by the share price behaviour for their part of the firm.
• May enable the separate and smaller firms to take advantage of lower tax rates, government
subsidies etc. applicable only to smaller firms.
• May enable risky but worthwhile activities to be separated from the rest of the less risky firm.
This will enable shareholders to choose the level of risk of their investments.
Among the financial disadvantages are:
• Any economies of scale may be lost.

• Total overheads may be greater.
• Total borrowing capacity may be reduced. Before demerger the portfolio effect of many
activities will help to smooth cash flows and, therefore, will assist in boosting borrowing
capacity.
MEZZANINE FINANCE
This is a layer of funding between senior debt and equity.
It ranks behind senior debt and usually has little or no asset backing.
To compensate for the higher risk it normally carries an enhanced coupon rate together with
some participation in the equity of the business.
In an MBO this allows the percentage of true equity in the total package to be smaller and
control of the company can be left in the hands of the management group.
The major characteristics are:
• Floating interest rate, normally higher than senior debt.

• Equity participation, either by way of warrants or initial subscription, to give a total return

somewhere below straight equity but above straight debt.
• Repayment terms of eight to ten years or more.
• Security on the basis of second fixed and floating charges behind similar charges in favour of
senior lenders.
POST-ACQUISITION ISSUES
When one company successfully acquires another company it is very important to consider the
issues which may arise following the acquisition. Amongst these are:
• Organisation Structure
• Change Management
• Key Employees
• Major Customers
• Cultural Issues
• Technology
• Control
ETHICAL CONSIDERATIONS
When a company receives a bid from another company it is important that the board of the
target company take account of any ethical considerations. Examples might include:
• Any Issues which might be Illegal

• Any Issues which may Distort the Markets (price-manipulation)
• Insider Dealing
• Use of Price-Sensitive Information
• Terms of Confidentiality Agreements
• Any Incentives Offered to Ensure the Bid is Accepted (e.g. seats on the board of the bidding
company; enhanced salaries, bonuses)
• Impact on Shareholders and Other Stakeholders
• Impact on Employees

Study Unit 3
CORPORATE FAILURE
Contents
• The symptoms and causes of corporate failure.
• Avoidance of corporate failure.
• The nature, scope and elements of working capital and the importance of effective working
capital management to corporate survival.
• Overtrading- symptoms, causes and remedies.

Financial Distress
Financial distress is the condition where a firm makes decision under pressure to satisfy its legal obligations
to creditors. Financial distress is a condition in which a company or individual cannot generate revenue
because it is unable to meet or cannot pay its financial obligations. This could be due to high fixed cost,
illiquid assets or revenues sensitive to economic downturns
Not all firms in financial distress ultimately enter into the legal status of bankruptcy.
Extreme financial distress may very well lead to bankruptcy.
When more debt financing is used, fixed legal obligations increase and the ability of the firm to satisfy
these increasing fixed payments decreases – therefore as more debt financing is used the probability of
financial distress and bankruptcy increases.
Another factor to consider in assessing the probability of distress is the business risk – uncertainty
associated with earnings from operations
Corporate Failure
The term corporate failure entails discontinuation of company’s operations leading to inability
to reap sufficient profit or revenue to pay the business expenses. It happens due to poor
management, incompetence, and bad marketing strategies.
Symptoms of Corporate failure
• Failure to focus on a specific market because of poor research
• Failure to control cash by carrying too much of stock, prompt payment of suppliers and allowing
customers to take long to pay
• Failure to control costs
• Failure to adapt your products to meet customer needs
• Failure to carry out decent market research
• Failure to build a team which is compatible and has the skills to finance, produce, sell and
market
• Failure to pay taxes
• Failure of business need to grow
Causes of Corporate Failure
• Inefficient utilisation of economic resources at the disposal of the management characterized by:
 Underutilization of assets
 Over-extension of credit or long term periods of collection of accounts from customers
 Excessive stock pilling of inventories
• Inefficient financial management leading to poor portfolio management marked by:
 Overinvestment in fixed assets
 Excessive borrowing

 Inability of the business to pay its long term debts as they fall due without having to sell
some assets
 Deficiency in working capital
• Inefficient human resources management leading to under-utilization of human resource at the

disposal of the business and personality conflicts in management
• Inefficient marketing, selling and distribution strategies leading to loss of markets to competitors
or yielding to pressure of competitors.
• Severe austerity of government economic, taxation and regulatory policies leading to

unavailability of raw material and contraction of market outlets.
• Continued operating losses or inadequacy of the profits of the business to cover the cost of
sales and operating expenses and leave some surplus to the owners/shareholders.
• Extraneous factors such as fire, world economic melt-down, burglaries, theft, sophisticated
internet fraud etc
Avoiding Failure
• Restructuring
• Selling off unproductive assets
• Discarding projects which are no longer financially viable
• Implementing cost reduction program e.g layoffs
• You must have a strategy – to revive the business
• You must have controls – effective working controls
• The board must participate – active
• You must avoid one man rule
• There must be management in depth
• Keep informed of and react of change
• The customer is the king – prioritize the customers
• Do not manipulate your accounts
• Avoid misuse of Assets - Do not misuse computers
• Organize to meet employees needs
Predicting corporate failure
Corporate failure models can be broadly divided into two groups: quantitative models, which are based
largely on published financial information; and qualitative models, which are based on an internal
assessment of the company concerned. Both types attempt to identify characteristics, whether financial
or non-financial, which can then be used to distinguish between surviving and failing companies

1. Quantitative models
Altman Z-Score Bankruptcy Model
• The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who
was, at the time, an Assistant Professor of Finance at New York University.
• The formula may be used to predict the probability that a firm will go into bankruptcy within two
years.
• Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for
the financial distress status of companies in academic studies.
• The Z-score uses multiple corporate income and balance sheet values to measure the
financial health of a company.
The Altman formula for prediction of bankruptcy is given as follows:
Z score = 1.2X1 + 1.4X2 + 3.3X3 +0.6X4 + 1X5
X1, X2, X3, X4 and X5 are ratios as indicated below:
Where: X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and tax/Total assets
X4 = Market value of Equity/book value of Liabilities
X5 = Sales/Total assets
In this model, a Z-Score of 2.7 or more indicates non-failure and a Z-Score of 1.8 or less indicates
failure.
Example
Two companies have the following financial characteristics:
Wendo Ltd Chaka Ltd
Frw ‘000’ Frw ‘000’
Working capital 10500 -1600
Total assets 50000 21000
Total liabilities 22000 13000
Equity value (market) 38000 5100
Retained earnings 19000 3000
Sales 86000 23000
Earnings before interest & tax 12000 1300

Required:
Using Altman model for predicting bankruptcy , determine the Z score index for each company explain
on likelihood of failure
2. Qualitative models
This category of model rests on the premise that the use of financial measures as sole indicators
of organisational performance is limited. For this reason, qualitative models are based on non-
accounting or qualitative variables. One of the most notable of these is the A score model attributed
to Argenti (1976), which suggests that the failure process follows a predictable sequence:
Defects can be divided into management weaknesses and accounting deficiencies as follows:
Management weaknesses:
• autocratic chief executive (8)

• failure to separate role of chairman and chief executive (4)
• passive board of directors (2)
• lack of balance of skills in management team – financial, legal, marketing, etc (4)
• weak finance director (2)
• lack of ‘management in depth’ (1)
• poor response to change (15).
Accounting deficiencies:
• no budgetary control (3)

• no cash flow plans (3)
• no costing system (3).
Each weakness/deficiency is given a mark (as shown) or given zero if the problem is not present.
The total mark for defects is 45, and Argenti suggests that a mark of 10 or less is satisfactory.
If a company’s management is weak, then Argenti suggests that it will inevitably make mistakes which may
not become evident in the form of symptoms for a long period of time. The failure sequence is assumed to
take many years, possibly five or more. The three main mistakes likely to occur (and attached scores) are:
i. high gearing – a company allows gearing to rise to such a level that one unfortunate
event can have disastrous consequences (15)

ii. overtrading – this occurs when a company expands faster than its financing is capable
of supporting. The capital base can become too small and unbalanced (15)
iii. the big project – any external/internal project, the failure of which would bring the
company down (15).
The suggested pass mark for mistakes is a maximum of 15.
The final stage of the process occurs when the symptoms of failure become visible. Argenti
classifies such symptoms of failure using the following categories:
»» Financial signs – in the A score context, these appear only towards the end of the
failure process, in the last two years (4).
»» Creative accounting – optimistic statements are made to the public and figures are altered
(inventory valued higher, depreciation lower, etc). Because of this, the outsider may not
recognise any change, and failure, when it arrives, is therefore very rapid (4).
»» Non-financial signs – various signs include frozen management salaries, delayed capital
expenditure, falling market share, rising staff turnover (3).
Terminal signs – at the end of the failure process, the financial and non-financial signs become
so obvious that even the casual observer recognises them (1).
The overall pass mark is 25. Companies scoring above this show many of the signs preceding
failure and should therefore cause concern. Even if the score is less than 25, the sub-score
can still be of interest. If, for example, a score over 10 is recorded in the defects section, this
may be a cause for concern, or a high score in the mistakes section may suggest an incapable
management. Usually, companies not at risk have fairly low scores (0–18 being common),
whereas those at risk usually score well above 25 (often 35–70).
The A score has therefore attempted to quantify the causes and symptoms associated with
failure. Its predictive value has not been adequately tested, but a misclassification rate of 5%
has been suggested. While Argenti’s model is perhaps the most notable, a large number of
non-accounting or qualitative variables have been included in other studies. These include:
• company-specific variables – such as management experience, customer concentration,

dependence on one or a few suppliers, level of diversification, qualified audit opinions, etc
• general characteristics – such as industry type
• factors in the external environment – such as the macroeconomic situation, including interest
rates, the business cycle, and the availability of credit
.
Overtrading/Undercapitalisation
This occurs where a company is attempting to expand rapidly but doesn‟t have sufficient
long-term capital to finance the expansion. Through overtrading, a potentially profitable business
can quite easily go bankrupt because of insufficient cash.
Output increases are often obtained by more intensive use of existing fixed assets and growth is financed
by more intensive use of working capital. Overtrading can lead to liquidity problems that can cause
serious difficulties if they are not dealt with promptly.
Overtrading companies are often unable or unwilling to raise long-term capital and rely more heavily on
short-term sources (e.g. creditors/overdraft). Debtors usually increase sharply as credit is relaxed to

win sales, while stocks increase as the company attempts to raise production at a faster rate ahead of
increases in demand.
Symptoms of Overtrading
• Turnover increases rapidly

• The volume of current assets increases faster than sales (fixed assets may also increase)
• Increase in stock days and debtor days
• The increase in assets is financed by increases in short-term funds such as creditors and
bank overdrafts
• The current and quick ratios decline dramatically and Current Assets will be far lower than
Current Liabilities
• The cash flow position is heading in a disastrous direction.
Causes of Overtrading
• Turnover is increased too rapidly without an adequate capital base (management may be
overly ambitious)
• The long-term sources of finance are reduced
• A period of high inflation may lead to an erosion of the capital base in real terms and
management may be unaware of this erosion
• Management may be completely unaware of the absolute importance of cash flow
planning and so may get carried away with profitability to the detriment of this aspect of their
financial planning.
Possible means of alleviating overtrading are:
• Postponing expansion plans

• New injections of long-term finance either in terms of debt/equity or some combination
• Better stock/debtor control
• Maintaining/increasing proportion of long-term finance

Study Unit 4
SOURCES OF FINANCE
Contents
• Short term funding.
• Equity and debt financing. (the attractions and risks associated with each).
• Optimizing the gearing structure of an organization.
• The optimum term structure , taking into account strategic plans.
• Dividend policy-key considerations. Including theories of Mogdalini & Miller and Myers
Pecking Order Hypothesis.
• Advise on dividend policy.
• Investment from overseas.
• Weighted Average Cost of Capital(WACC)-calculate and discuss its uses and limitations

Short -Term Sources of Finance
Bank Overdraft
This is one of the most important sources of short-term finance. It is a very useful tool in
cash management, particularly for companies involved in seasonal trades.
The main advantages are:
• Cost may be lower than other sources (generally, short-term finance is cheaper than
long-term).
• Less security required than for term loans - overdraft can be recalled at short notice.
• Repayment is easier as there are no structured repayments - funds are simply paid into the
account as they become available.
• Interest is only charged on the amount outstanding on a particular day.
• Extra flexibility is provided as all of the facility may not be used at any one time. The unused
balance represents additional credit which can be obtained quickly and without formality.
The main disadvantages are:
• Renewal is not guaranteed.

• Technically, the advance is repayable on demand - could lead to a strain on the
company‟s cash flow.
• Variable rate of interest – the facility may be renewed on less favourable terms.
Term Loan
Finance is made available for a fixed term and usually, at a fixed rate of interest. Repayments
are in equal instalments over the term of the loan. Early repayment may result in penalties.
The main advantages are:
The term can be arranged to suit the borrower‟s needs.
The repayment profile may be negotiable to suit the expected cash flow profile of the company
(e.g. interest only basis to keep ongoing repayments lower).
Known cash flows assist financial planning.
The interest rate is fixed, so the company is not exposed to increases in rates.
Factoring
This involves the sale of trade debts for immediate cash to a “factor” who charges
commission. Factoring companies are financial institutions often linked with banks. Unlike an overdraft
the level of funding is dependent, not upon the fixed assets of the company, but on its success, for
as the company grows and sales increase the facility offered by the factor grows, secured against the
outstanding invoices due to the company. Three basic services are offered, although a company need
not use all of them:
1. Finance - instruction on invoices that payment is to be made to the factor, who is responsible
for collection of the debt. When the factor receives the invoices 80% approx. of value is
advanced. The balance (less charges, including interest) is paid, either when the invoice is
settled or after a specified period.

2. Sales Ledger Management - the factor takes the place of the client‟s accounts department.
Duplicate invoices are sent to the factor who maintains a full sales ledger for each client, handles
invoices, chases outstanding payments etc. Commission of 1%
- 2% is usually charged.
3. Credit Insurance - in return for a commission the factor provides a guarantee against bad
debts.
Recourse Factoring - the factor will reclaim the money advanced on any uncollected debt so the
business will retain the risk of non-recovery and, depending on the contract terms, perhaps the
administration burden as well.
Non-Recourse (Full) Factoring - the factor runs credit checks on the company‟s customers and agrees
limits dependent on their creditworthiness. These can be adjusted in the light of experience, once a
pattern has been established. The factor will protect the client against bad debts on approved sales
and will also take on all the administration burden. The balance over the 80% advance is paid to the
client an agreed number of days after the initial advance.
Recourse v Non-Recourse Factoring - with non-recourse factoring the business knows that it will get
paid, no matter what happens but protection only applies to credit-approved debts and it is not always
easy to get this approval for doubtful ones. Recourse factoring allows more funding to be made available
against less credit-worthy debtors and the business is in control of when and how individual debts are
to be pursued and collected.
The cost of finance through factoring is usually slightly above overdraft rates. The administration
charges vary between 0.6% and 2.5% approx.
Advantages of Factoring
1. It is an alternative source of finance if other sources are fully utilised, particularly for a
company with a high level of debtors.
2. It is especially useful for growth companies where debtors are rising rapidly and funds available
from the factor will rise in tandem.
3. Security for the finance is the company‟s debtors, leaving other assets free foralternative
forms of debt finance.
4. The factor may be able to manage the company‟s sales ledger more efficiently by employing
specialist staff, leading to lower costs for the company and freeing management to concentrate on
growing the business.
5. Bad debts will be reduced or guaranteed by credit insurance.
6. Due to the greater guarantee of cash flow the company will have a better opportunity for taking
up cash discounts from suppliers.
7. The factor will be more efficient in collecting monies. Evidence in Europe suggests that, on
average, it takes over 75 days for an invoice to be paid, whereas the average debt turn of
companies using factoring is 60 days.
8. The company replaces a great many debtors with one - the factor - who is a prompt payer.

Disadvantages of Factoring
1. It may be more expensive than other sources.
2. When fixing credit terms and limits the factor will be concerned with minimising risk and,
therefore,certain risky but potentially profitable business may be rejected.
3. The factor may be “pushy” when collecting debts. This may lead to ill-feeling by customers.
4. Use of a factor might reflect adversely on a company‟s financial stability in the eyes of some
ill-informed people. Factoring is more acceptable nowadays but this problem could be overcome
by undisclosed factoring, which leaves the company to collect payment as agent for the factor.
Invoice Discounting
This is similar to factoring but only the finance service is used. Invoices are discounted (like
Bills Receivable) and immediate payment, less a charge, is received. The company still collects the
debt as agent for the financial institution and is also liable for bad debts. The service tends to be used
on an ad hoc basis and is provided by factors for clients who need finance but not the administrative
service or protection. Invoice Discounting is confidential and solely a matter between the lender and
borrower, unlike Factoring where the bank assumes a direct and visible role between the company
and its debtors. Also, the company retains full control over the management of its debtor‟s ledger,
including credit control.
EQUITY FINANCE
For small companies, this is personal savings (contribution of owners to the company). For large
companies equity finance is made of ordinary share capital and reserves; (both revenue and capital
reserves). Equity finance is divided into the following classes:
a) Ordinary share capital – this is raised from the public from the sale of ordinary shares to the
shareholders. This finance is available to limited companies. It is a permanent finance as the
owner/shareholder cannot recall this money except under liquidation. It is thus a base on which
other finances are raised.
b) Ordinary share capital carries a return that is variable (ordinary dividends). These shares carry
voting rights and can influence the company’s decision making process at the AGM.
c) These shares carry the highest risk in the company (high securities – documentary claim to)
because of
»» Uncertainty of return
»» Cannot ensure refund
»» Have residual claims – claim last on profits, claim last on assets.
However this investment grows through retention.
Rights of ordinary shareholders

1. Right to vote
a. elect BOD
b. Sales/purchase of assets

2. Influence decisions:
a) Right to residual assets claim
b) Right to amend company’s by-laws
c) Right to appoint another auditor
d) Right to approve merger acquisition
e) Right to approve payment of dividends
Reasons why ordinary share capital is attractive despite being risky

• Shares are used as securities for loans (a compromise of the market price of a share).
• Its value grows.
• They are transferable at capital gain.
• They influence the company’s decisions.
• Carry variable returns – is good under high profit
• Perpetual investment – thus a perpetual return
• Such shares are used as guarantees for credibility.
Advantages of using ordinary share capital in financing.

• They facilitate projects especially long-term projects because they are permanent..
• Its cost is not a legal obligation.
• It lowers gearing level – reduces chances of receivership/liquidation.
• Used with flexibility – without preconditions.
• Such finances boost the company’s credibility and credit rating.
• Owners contribute valuable ideas to the company’s operations (during AGM by professionals).
b) RETAINED EARNINGS
i) Revenue Reserves
These are undistributed earnings. Such reserves are retained for the following reasons:
• To make up for the fall in profits so as to sustain acceptable risks.
• To sustain growth through plough backs. They are cheap source of finance.
• They are used to boost the company’s credit rating so they enable further finance to be
obtained.
• . It lowers the company’s gearing ratio – reduces chances of receivership/liquidation.

ii) Capital Reserves
1. It is raised by selling shares at a premium. (The difference between the market price (less
floatation costs) and par value is credited to the capital reserve).
2. Through revaluation of the company’s assets. This leads to a fictitious entry which is of the
nature of a capital reserve.
3. By creation of a sinking fund.
SHARE CAPITAL
This can be effected best by way of an example:
RWF‟000 Average Poor Excellent

Profits 100 20 300
(i) Interest (200 x 10%) 20 20 20
80 0 280
Corporation Tax (20%) 16 0 56
Profits After Tax 64 0 224
(ii) Preference Dividend 10 0 10
(iii) Available for Equity 54 0 214
Note:
Comparing the Average with the Excellent performance it should be noted that while Profits
increase by 200%, the amount Available [at number (iii)] to Equity increases by almost
300%.
No matter what the level of performance, a fixed amount is paid to the Lenders and the
Preference Shareholders.
Interest on borrowings is allowable for Corporation Tax. Note the ranking of the different providers of
capital.
The Ordinary Shareholders (equity) are entitled to the “residue” after all others have been
rewarded.
Ordinary Shares
The main features are:
• Issued to the owners of the company (equity).

• Nominal or “face” value (e.g. 1000rwf.).
• Market value moves with market‟s view of the company‟s performance/prospects.
• Shareholders are not liable for the company‟s debts on a winding-up (limited liability).
• Carry voting rights
Ordinary shareholders are entitled to the residue after other parties are rewarded. This applies
to both annual profits and capital on a winding-up.

Subscription privileges apply in the event of a new issue of shares (“pre-emptive rights”).
Shareholders may be rewarded by dividends (income), or retained profits (capital gain).
Some companies offer concessions on their products to shareholders - e.g. discounts or

vouchers.
Some companies have different classes of ordinary shares. For example, Non-Voting
similar to other shares in every respect, except holders cannot vote.
Advantages to the Company
• No fixed annual charges are payable - no legal obligation to pay a dividend.

• Do not have a maturity date and are not normally redeemable.
• Usually more attractive to investors than fixed interest securities.
• Might increase the creditworthiness of a company as they reduce gearing.
Disadvantages to the Company
• Issue might reduce EPS, especially if the assets acquired do not produce immediate
earnings.
• Extend voting rights to more shareholders.
• Lower gearing as a result of the issue might result in a higher overall cost of capital than is
necessary.
• Issues often involve substantial issue and underwriting costs.
• Dividends are not a tax allowable expense.
Preference Shares
• Holders are entitled to a fixed maximum dividend.

• Dividends are only paid if sufficient profits are available.
• Rank prior to ordinary shares (both dividends and capital on a winding-up).
• Cumulative Preference Shares the right to any arrears of dividend carried forward and they
must be paid before any dividend is paid to the ordinary shareholders. Preference Shares
are cumulative, unless expressly stated to be non-cumulative.
• Restricted voting rights - usually only available in a situation where the rights attaching to the
shares are being amended or if dividends are in arrears.
Some companies have different classes of preference shares. For example,
Redeemable - generally redeemable subject to sufficient profits being available or

sufficient cash being raised from a new issue.
Convertible - the right to convert to ordinary shares as per the terms of the issue.

• A fixed percentage dividend per year is payable no matter how well the company
performs, but only at the discretion of the company‟s directors.
• Do not normally give full voting rights to holders.
• Preference shares are mostly irredeemable.
•
Disadvantages to the Company
• Cumulative arrears of dividend are payable.

• Dividends are not a tax allowable expense.
LOAN CAPITAL
The main types are Loan Stock and Debentures.
Loan Stock - long-term debt (usually > 10 years duration) on which a fixed rate of interest
(coupon rate) is paid. Generally unsecured.
Debentures - a form of loan stock, legally defined as a written acknowledgement of debt.

Usually secured. Trustees appointed to look after investors‟ interests. Can be redeemable or
irredeemable.
Loan capital ranks prior to share capital (both interest and capital on a winding-up).
The ranking of individual debt will depend upon the specific conditions of each issue.
Restrictive covenants are often included in the lending agreement (e.g. restrictions on further
borrowings, the payment of dividends, or major changes in operations; the maintenance of certain
key ratios in the accounts etc.).
If security is provided the cost to the company may be cheaper. Security may be in the form of a
fixed or floating charge.
Interest payments are allowable for Corporation Tax.
If the net cost of debt is low why do companies not borrow more and more? Some of the reasons
are:
• A high level of debt will increase the financial risk for the shareholders.
• Interest charges at a particular point in time may be high.
• The company may have insufficient security for new debt.
• There may be restrictions on further debt - Articles of Association; restrictive covenants; credit
lines fully used etc.
Redemption of Loan Capital
Most redeemable stocks have an earliest and a latest date for redemption.
Redemption is at the company’s option anytime between these two dates.
When should the company redeem? Generally, if the coupon rate is below current interest
rates delay to the later date and vice versa. However, the following factors should be considered:

• If internally generated funds are to be used, consider their availability.
• If a further issue of debt is to be used, consider issue costs.

• The trend in future interest rates.
• If new equity is to be used, shares should be issued when the price is relatively high.
Convertible Loan Stock
This is debt paying a fixed rate of interest but also providing the option to convert to equity at
a pre-determined rate on pre-determined date(s).
• Conversion is at the option of the holder.

• Conversion terms usually vary over time.
• Once stock is converted it cannot be converted back.
• It is cheaper than straight debt due to the conversion rights. The lower coupon rate may suit
projects with low cash flows in the early years.
• A high-risk company may have difficulty raising long-term finance no matter what
• coupon rate is offered. Convertibles may attract investors due to the “upside potential”.
• If conversion takes place, the debt is self-liquidating. Conversion will reduce gearing and
enable further debt to be raised in the future.
• Interest payments are tax deductible.
• Convertibles are often not secured and have less restrictive covenants than straight
debentures.
•The number of shares eventually issued on conversion will be smaller than if straight equity
is issued.
Advantages to the Investor
• If the market value of the company’s shares falls the value of the convertibles will not
fall below the market value of straight debt with the same oupon.
• If the market value of the company’s shares rises the value of the convertibles will rise also.
• Convertibles rank before shares on a winding-up.
• If the company’s fortunes improve dramatically investors can share in this by
exercising their ption.
Floating Rate Bonds
These are debt securities whose interest is not fixed but is re-fixed periodically by
reference to some independent interest rate index - e.g. a fixed margin over National
Bank of Rwanda Interbank Rate. These are commonly referred to as Floating Rate Notes or
FRNs. Coupons are re-fixed, and coupon payments made, usually every six months.
When market interest rates fall the issuer (borrower) is not saddled with high fixed coupon
payments. Likewise, when interest rates rise the investor is not stuck with a fixed income but will
see his income rise in line with market rates.
The market value of such securities should be fairly stable as interest rates will rise/fall in line with
market interest rates.

Deep Discount Bonds
These are debt securities which are issued at a large discount to their nominal value but will generally
be redeemable at par on maturity. To compensate for the fact that a large capital gain accrues on
maturity, the ongoing coupon rate is substantially lower than other types of loan stock. An example
might be: 2% Bond 2015, which was issued in 2005 at a price of RWF70 per cent.
The price of the bond in the secondary market will gradually appreciate as the maturity date
approaches.
Many projects require funding up-front, but are unlikely to give rise to an income stream to
service interest costs for some period of time - e.g. a building project where income from rentals
or sale of the building would be received much later. A Deep Discount Bond can be a useful
source of funding for such a project as it helps to match cash flows.
An attraction to the investor is the advantageous taxation treatment in certain countries
- e.g. the capital gain at maturity is subject to CGT, which may be at a lower rate than
income tax, or the gain is taxed as income in one lump sum on maturity or sale rather than as
interest each year.
Zero Coupon Bonds
Zero Coupon Bonds are very similar to Deep Discount Bonds except that no interest is paid during the
life of the bond and are, therefore, issued at a large discount to their nominal value. An example might
be:
0% Bond 2020, which was issued in 2010 at a price of RWF50 per cent.
Instead of interest payments the investor receives as a return the difference between the issue price
and the higher redemption proceeds.
WARRANTS
Holder has the right (but not the obligation) to purchase a stated number of shares, at a
specified price, anytime before a specified date.
If not exercised the warrants lapse.
Warrants are often issued as a “sweetener” to make a loan stock issue more attractive, or to
enable the company to pay a lower coupon rate.
The warrant-holder is not entitled to dividends/voting rights.
Unlike convertibles, new funds are generated for the company if the warrants are exercised.
Generally, the warrant is detachable from the stock and can be traded separately.
The value of the warrant is dependent on the underlying share price.
Leasing
A lease is a contract between a lessor (bank/finance house) and a lessee (person/company to whom
the asset is leased) for the hire of a specific asset. The lessor retains ownership but gives the lessee
the right to use the asset for an agreed period in return for the payment of specified rentals.

OPERATING AND FINANCE LEASES Operating Lease
The lessee hires the asset for a period which is normally substantially less than its useful
economic life. The lessor retains most of the risks and rewards of ownership. Generally, there will
be more than one lessee over the life of the asset. An operating lease is “Off Balance Sheet” finance.
Finance Lease
This transfers substantially all the risks and rewards of ownership, other than legal title, to
the lessee. It usually involves payment to the lessor over the lease term of the full cost of the asset
plus a commercial return on the finance provided by the lessor.
Both the leased asset and the corresponding stream of rental liabilities must be shown on the
lessee‟s Balance Sheet. Other features include:
The lessee is responsible for the upkeep, maintenance etc. of the asset.
The lease has a primary period, covering the whole or most of the economic life of the asset. The
asset will be almost worn out at the end of the primary period, so the lessor will ensure that the
cost of the asset and a commercial return on the investment will be recouped within the primary
period.
At the end of the primary period the lessee has the option to continue to lease at a very small rent
(“peppercorn rent”). Alternatively, he can sell the asset and retain about 95% of the proceeds.
ADVANTAGES OF LEASING
1. The lessee‟s capital is not tied up in fixed assets, so a cash flow advantage accrues.
2. Liquidity is improved as no down-payment is required.
3. The lessor can obtain capital allowances and pass the benefit to the lessee in the
form of lower lease rentals. This is especially important for a company with
insufficient taxable profits.
4. The whole of the rental payment is tax deductible.
5. Security is usually the asset concerned. Other assets are free for other forms of
borrowing.
6. Traditional forms of borrowing often impose restrictive covenants.
7. The cost of other forms of borrowing may exceed the cost of leasing.
SALE AND LEASEBACK
This is an arrangement whereby a firm sells an asset, usually land or a building, to a financial institution
and simultaneously enters an agreement to lease the property back from the purchaser. The
seller receives funds immediately and retains use of the asset but is committed to a series of
rental payments over an agreed period. Thus, it is suited to capital- rationed companies who are eager
to finance expansion programmes before the opportunity is lost.
The main disadvantages are the loss of participation in any capital appreciation and the loss of a
valuable asset which could have been used as security for future borrowing.

HIRE PURCHASE (HP)
The user pays a periodic hire charge to a finance house which purchases the asset. The charge
includes both interest and capital. Generally, the hirer must pay a deposit up-front. Ownership of the
asset passes to the user at the end of the contract period, unless he defaults on repayments when the
finance house will repossess the asset. The user can claim capital allowances on the cost of the asset
and the interest element of the periodic charge is tax deductible.
Venture Capital
Introduction
Many new business ventures are considered too risky for traditional bank lending (term loans, overdrafts
etc.) and it is this gap that Venture Capital usually fills.
Venture Capital could be described as a means of financing the start-up, expansion or purchase of
a company, whereby the venture capitalist acquires an agreed proportion of the share capital (equity) of
the company in return for providing the requisite funding. To look after its interests the venture capitalist
will usually want to have a representative appointed to the board of the company.
The venture capitalist,s financing is not secured – he takes the risk of failure just like other shareholders.
Thus, there is a high risk in providing capital in these circumstances and the possibility of losing the entire
investment is much greater than with other forms of lending. The venture capitalist also participates in
the success of the company by selling his investment and realising a capital gain, or by the company
achieving a flotation on the Stock Market in usually five to seven years from making his investment.
As a result, it will generally take a long time before a return is received from the investment but to
compensate there is the prospect of a substantial return.
Venture Capital has grown in popularity – for instance in the UK in 1979 venture capital investments
amounted to GBP20m., whereas this had grown to GBP1,000m. by 1991.
STAGES OF INVESTMENT
The various stages of investment by a venture capitalist can be defined as follows:
Seed Capital – finance provided to enable a business concept to be developed, perhaps involving
production of prototypes and additional research, prior to bringing the product to market.
Start-Up – finance for product development and initial marketing. Companies may be in the
process of being set up or may have been in business for a short time but have not sold their
product commercially.
Expansion – capital provided for the growth of a company which is breaking even or possibly,
trading profitably. Funds may be used to finance increased production capacity, market or product
development and/or provide additional working capital. Capital for “turnaround” situations is also
included in this category.
Management Buy Out (MBO) – funds provided to enable current operating management
and investors to acquire an existing business.
Management Buy In (MBI) – funds provided to enable a manager or group of managers

from outside the company to buy into the company

SPECIALIST AREAS
Venture Capitalists may specialise in areas in which they will invest. These may relate to:
Preferred Business Sectors – e.g. consumer services, Information Technology, property

etc.
Stage of Investment – many venture capitalists will finance expansions, MBO‟s and MBI‟s but
far fewer are interested in financing “Seed Capital,” start-ups and other early stage companies,
due to the additional risks and time/costs involved in refinancing smaller deals as compared with
the benefits.
Regional Preferences – the preferred geographical location of the investee.
Amount of Investment – varies with the stage of the investment. Start-up and other early stage
investments are usually lesser in amount than expansion and MBO/MBI investments. RWF
BUSINESS PLAN
Before deciding whether an investment is worth backing the venture capitalist will expect to see a
Business Plan. This should cover the following:
Product/Service – what is unique about the business idea? What are the strengths compared
to the competitors?
Management Team – can the team run and grow a business successfully? What are their ages,
relevant experience, qualifications, track record and motivation? How much is invested in the
company by the management team? Are there any non-executive directors? Details of other
key employees.
Industry – what are the issues, concerns and risks affecting the business area?
Market Research – do people want to buy the idea?
Operations – how will the business work on a day-to-day basis?
Strategy – medium and long-term strategic plans.
Financial Projections – are the assumptions realistic (sales, costs, cash flow etc.)?
Generally, a three year period should be covered. Alternative scenarios, using different economic
assumptions. Also state how much finance is required, what it will be used for and how and when
the venture capitalist can expect to recover his investment?
Executive Summary – should be included at the beginning of the Business Plan. This is most
important as it may well determine the amount of consideration the proposal will receive.
METHODS OF WITHDRAWAL BY VENTURE CAPITALIST
The various means by which an investment may be withdrawn after a number of years include:
• The company is acquired by another company (probably through an arranged deal).

• A management buy out occurs and the venture capitalist‟s shares are purchased by the
existing management team.
• A management buy in occurs.
• The investment is refinanced, possibly by another venture capitalist organisation.
• The company obtains a listing on a Stock Market.

• A minority equity stake is purchased in the company, possibly by a customer or other
company in the same industry. This is sometimes referred to as “Corporate Venturing.”
• The company is liquidated.
CASE STUDY
Balderton Capital Management, with $19bn. in assets under management is one of Europe’s largest.
In March 2008 it made more than nine times its initial investment when it sold a
15.7% stake in Bebo to Time Warner for $140m. It had made the investment less than two years
earlier.
The following is from an interview with Barry Moloney, MD Balderton Capital Management
29.11.2009 The Sunday Times, England
Balderton sold a stake in MySQL, a software company, to Sun Microsystems for a hefty multiple and then
made ten times its original stake when Cisco Systems bought Scansafe, an online security business.
Yoox, an online fashion retailer and another Balderton investment, will be the first IPO on the Milan
bourse for 18 months. Next year Balderton could yield one of its biggest ever paydays when the online
betting exchange Betfair debuts on London’s Stock Market.
Balderton’s model is “labour intensive” investing in early-stage companies with a view to big returns.
The goal for every investment is nine or ten times return. Of ten investments we would expect three or
four to lose money and three or four to return twice or three times our money. Then we would expect
two of the ten to make a return of eight, nine or ten times. It’s not a fool-proof formula, however. In the
past two years Balderton had two spectacular blowouts Payzone and Setanta Sports. Payzone is still
a live investment but the company is so burdened with debt that equity holders are likely to be wiped
out in an upcoming restructuring. A $75m - $80m. loss at Setanta Sports is balanced by an earlier
$50m. gain that Balderton made from NASN, the sports network that Setanta sold to ESPN. The risk
did not pay off but that’s par for the Venture Capital course – if you are not prepared to take risk, you
shouldn’t be in the game.
Balderton has 67 investments, many of them in the “new economy” – wonga.com, a loans company;
Bling Nation, a mobile payments company; figleaves.com, which sells lingerie and LoveFilm, a movie
rentals business. It has backed a disproportionately high number of Irish companies, with almost a
quarter of its total funds ($450m) invested in them.
Optimal capital structure - Optimizing the gearing structure of an organization.
Is it possible to increase shareholder wealth by changing the capital structure?

The first question to address is what is meant by capital structure. The capital structure of a
company refers to the mixture of equity and debt finance used by the company to finance its
assets. Some companies could be all-equity-financed and have no debt at all, whilst others could
have low levels of equity and high levels of debt. The decision on what mixture of equity and debt
capital to have is called the financing decision.
The financing decision has a direct effect on the weighted average cost of capital (WACC). The
WACC is the simple weighted average of the cost of equity and the cost of debt. The weightings
are in proportion to the market values of equity and debt; therefore, as the proportions of equity
and debt vary, so will the WACC. Therefore the first major point to understand is that, as a
company changes its capital structure (ie varies the mixture of equity and debt finance), it will

automatically result in a change in its WACC.
However, before we get into the detail of capital structure theory, you may be thinking how the
financing decision (ie altering the capital structure) has anything to do with the overall corporate
objective of maximising shareholder wealth. Given the premise that wealth is the present value
of future cash flows discounted at the investors’ required return, the market value of a company
is equal to the present value of its future cash flows discounted by its WACC.
Market value of a company = Future cash flows / WACC
It is essential to note that the lower the WACC, the higher the market value of the company – as
you can see from the following simple example; when the WACC is 15%, the market value of the
company is 667; and when the WACC falls to 10%, the market value of the company increases
to 1,000.
Market value of a company
100/ 0.15 = 667

100/0.10 = 1,000
Hence, if we can change the capital structure to lower the WACC, we can then increase the
market value of the company and thus increase shareholder wealth.
Therefore, the search for the optimal capital structure becomes the search for the lowest
WACC, because when the WACC is minimised, the value of the company/shareholder wealth is
maximised. Therefore, it is the duty of all finance managers to find the optimal capital structure
that will result in the lowest WACC.
What mixture of equity and debt will result in the lowest WACC?
As the WACC is a simple average between the cost of equity and the cost of debt, one’s instinctive
response is to ask which of the two components is the cheaper, and then to have more of the
cheap one and less of expensive one, to reduce the average of the two.
Well, the answer is that cost of debt is cheaper than cost of equity. As debt is less risky than
equity, the required return needed to compensate the debt investors is less than the required
return needed to compensate the equity investors. Debt is less risky than equity, as the payment
of interest is often a fixed amount and compulsory in nature, and it is paid in priority to the
payment of dividends, which are in fact discretionary in nature. Another reason why debt is
less risky than equity is in the event of a liquidation, debt holders would receive their capital
repayment before shareholders as they are higher in the creditor hierarchy (the order in which
creditors get repaid), as shareholders are paid out last.
Debt is also cheaper than equity from a company’s perspective is because of the different
corporate tax treatment of interest and dividends. In the profit and loss account, interest is
subtracted before the tax is calculated; thus, companies get tax relief on interest. However,
dividends are subtracted after the tax is calculated; therefore, companies do not get any tax
relief on dividends. Thus, if interest payments are $10m and the tax rate is 30%, the cost to the
company is $7m. The fact that interest is tax-deductible is a tremendous advantage.
Let us return to the question of what mixture of equity and debt will result in the lowest WACC.
The instinctive and obvious response is to gear up by replacing some of the more expensive
equity with the cheaper debt to reduce the average, the WACC. However, issuing more debt (ie
increasing gearing), means that more interest is paid out of profits before shareholders can get
paid their dividends. The increased interest payment increases the volatility of dividend payments

to shareholders, because if the company has a poor year, the increased interest payments must
still be paid, which may have an effect the company’s ability to pay dividends. This increase in
the volatility of dividend payment to shareholders is also called an increase in the financial risk
to shareholders. If the financial risk to shareholders increases, they will require a greater return
to compensate them for this increased risk, thus the cost of equity will increase and this will lead
to an increase in the WACC.
In summary, when trying to find the lowest WACC, you:

issue more debt to replace expensive equity; this reduces the WACC, but
more debt also increases the WACC as:
• gearing
• financial risk
• beta equity
• keg WACC.
Remember that Keg is a function of beta equity which includes both business and financial risk,
so as financial risk increases, beta equity increases, Keg increases and WACC increases.
The key question is which has the greater effect, the reduction in the WACC caused by having
a greater amount of cheaper debt or the increase in the WACC caused by the increase in the
financial risk. To answer this we have to turn to the various theories that have developed over
time in relation to this topic.
1. M + M (No Tax): Cheaper Debt = Increase in Financial Risk / Keg

2. M + M (With Tax): Cheaper Debt > Increase in Financial Risk / Keg
3. Traditional Theory: The WACC is U shaped, ie there is an optimum gearing ratio
4. The Pecking Order: No theorised process; simply the line of least resistance first
internally generated funds, then debt and finally new issue of equity
FIGURE 1: MODIGUANI AND MILLER -NO-TAX MODEL
Cost % kg $
value of
company
WACC
keu
kd vg
vu
10%
Level of gearing Level of gearing
FIGURE 2: MODIGUANI AND MILLER -NO-TAX MODEL
Cost % kg $
vg
value of
company
keu
vu
7% WACC
kd(1-t)
Level of gearing
Level of gearing

Modigliani and Miller’s no-tax model
In 1958, Modigliani and Miller stated that, assuming a perfect capital market and ignoring
taxation, the WACC remains constant at all levels of gearing. As a company gears up, the
decrease in the WACC caused by having a greater amount of cheaper debt is exactly offset by
the increase in the WACC caused by the increase in the cost of equity due to financial risk.
The WACC remains constant at all levels of gearing thus the market value of the company is
also constant. Therefore, a company cannot reduce its WACC by altering its gearing (Figure 1).
The cost of equity is directly linked to the level of gearing. As gearing increases, the financial
risk to shareholders increases, therefore Keg increases. Summary: Benefits of cheaper debt =
Increase in Keg due to increasing financial risk. The WACC, the total value of the company and
shareholder wealth are constant and unaffected by gearing levels. No optimal capital structure
exists.
Modigliani and Miller’s with-tax model
In 1963, when Modigliani and Miller admitted corporate tax into their analysis, their conclusion
altered dramatically. As debt became even cheaper (due to the tax relief on interest payments),
cost of debt falls significantly from Kd to Kd(1-t). Thus, the decrease in the WACC (due to the
even cheaper debt) is now greater than the increase in the WACC (due to the increase in the
financial risk/Keg). Thus, WACC falls as gearing increases. Therefore, if a company wishes to
reduce its WACC, it should borrow as much as possible (Figure 2).
Summary: Benefits of cheaper debt > Increase in Keg due to increasing financial risk.
Companies should therefore borrow as much as possible. Optimal capital structure is 99.99%
debt finance.
Market imperfections
There is clearly a problem with Modigliani and Miller’s with-tax model, because companies’ capital structures
are not almost entirely made up of debt. Companies are discouraged from following this recommended
approach because of the existence of factors like bankruptcy costs, agency costs and tax exhaustion. All
factors which Modigliani and Miller failed to take in account.
Bankruptcy costs
Modigliani and Miller assumed perfect capital markets; therefore, a company would always be
able to raise funding and avoid bankruptcy. In the real world, a major disadvantage of a company
taking on high levels of debt is that there is a significant possibility of the company defaulting
on its increased interest payments and hence being declared bankrupt. If shareholders and
debt-holders become concerned about the possibility of bankruptcy risk, they will need to be
compensated for this additional risk. Therefore, the cost of equity and the cost of debt will increase,
WACC will increase and the share price reduces. It is interesting to note that shareholders suffer
a higher degree of bankruptcy risk as they come last in the creditors’ hierarchy on liquidation.
If this with-tax model is modified to take into account the existence of bankruptcy risks at high
levels of gearing, then an optimal capital structure emerges which is considerably below the
99.99% level of debt previously recommended.

Agency costs
Agency costs arise out of what is known as the ‘principal-agent’ problem. In most large companies,
the finance providers (principals) are not able to actively manage the company. They employ
‘agents’ (managers) and it is possible for these agents to act in ways which are not always in the
best interest of the equity or debt-holders.
Since we are currently concerned with the issue of debt, we will assume there is no potential
conflict of interest between shareholders and the management and that the management’s
primary objective is the maximisation of shareholder wealth. Therefore, the management may
make decisions that benefit the shareholders at the expense of the debt-holders.
Management may raise money from debt-holders stating that the funds are to be invested in a
low-risk project, but once they receive the funds they decide to invest in a high risk/high return
project. This action could potentially benefit shareholders as they may benefit from the higher
returns, but the debt-holders would not get a share of the higher returns since their returns are
not dependent on company performance. Thus, the debt-holders do not receive a return which
compensates them for the level of risk.
To safeguard their investments, debt-holders often impose restrictive covenants in the loan
agreements that constrain management’s freedom of action. These restrictive covenants may
limit how much further debt can be raised, set a target gearing ratio, set a target current ratio,
restrict the payment of excessive dividends, restrict the disposal of major assets or restrict the
type of activity the company may engage in.
As gearing increases, debt-holders would want to impose more constrains on the management
to safeguard their increased investment. Extensive covenants reduce the company’s operating
freedom, investment flexibility (positive NPV projects may have to be forgone) and may lead to a
reduction in share price. Management do not like restrictions placed on their freedom of action.
Thus, they generally limit the level of gearing to limit the level of restrictions imposed on them.
Tax exhaustion
The fact that interest is tax-deductible means that as a company gears up, it generally reduces
its tax bill. The tax relief on interest is called the tax shield – because as a company gears
up, paying more interest, it shields more of its profits from corporate tax. The tax advantage
enjoyed by debt over equity means that a company can reduce its WACC and increases its
value by substituting debt for equity, providing that interest payments remain tax deductible.
However, as a company gears up, interest payments rise, and reach a point that they are equal
to the profits from which they are to be deducted; therefore, any additional interest payments
beyond this point will not receive any tax relief.
This is the point where companies become tax - exhausted, ie interest payments are no
longer tax deductible, as additional interest payments exceed profits and the cost of debt rises
significantly from Kd(1-t) to Kd. Once this point is reached, debt loses its tax advantage and a
company may restrict its level of gearing.

The WACC will initially fall, because the benefits of having a greater amount of cheaper debt
outweigh the increase in cost of equity due to increasing financial risk. The WACC will continue
to fall until it reaches its minimum value, ie the optimal capital structure represented by the
point X.
Benefits of cheaper debt > increase in keg due to increasing financial risk
If the company continues to gear up, the WACC will then rise as the increase in financial risk/Keg
outweighs the benefit of the cheaper debt. At very high levels of gearing, bankruptcy risk causes
the cost of equity curve to rise at a steeper rate and also causes the cost of debt to start to rise.
Increase in Keg due to financial and bankruptcy risk > Benefits of cheaper debt
Shareholder wealth is affected by changing the level of gearing. There is an optimal gearing
level at which WACC is minimised and the total value of the company is maximised. Financial
managers have a duty to achieve and maintain this level of gearing. While we accept that the
WACC is probably U-shaped for companies generally, we cannot precisely calculate the best
gearing level (ie there is no analytical mechanism for finding the optimal capital structure). The
optimum level will differ from one company to another and can only be found by trial and error.
Pecking order theory

The pecking order theory is in sharp contrast with the theories that attempt to find an optimal
capital structure by studying the trade-off between the advantages and disadvantages of debt
finance. In this approach, there is no search for an optimal capital structure. Companies simply
follow an established pecking order which enables them to raise finance in the simplest and most
efficient manner, the order is as follows:
• Use all retained earnings available;

• Then issue debt;
• Then issue equity, as a last resort.
The justifications that underpin the pecking order are threefold:
• Companies will want to minimise issue costs.

• Companies will want to minimise the time and expense involved in persuading outside
investors of the merits of the project.
The existence of asymmetrical information and the presumed information transfer that result from
management actions. We shall now review each of these justifications in more detail.

Minimise issue costs
• Retained earnings have no issue costs as the company already has the funds
• Issuing debt will only incur moderate issue costs
• Issuing equity will incur high levels of issue costs
Minimise the time and expense involved in persuading outside investors

• As the company already has the retained earnings, it does not have to spend any time
persuading outside investors
• The time and expense associated with issuing debt is usually significantly less than that
associated with a share issue
The existence of asymmetrical information

This is a fancy term that tells us that managers know more about their companies’ prospects
than the outside investors/the markets. Managers know all the detailed inside information, whilst
the markets only have access to past and publicly available information. This imbalance in
information (asymmetric information) means that the actions of managers are closely scrutinised
by the markets. Their actions are often interpreted as the insiders’ view on the future prospects
of the company. A good example of this is when managers unexpectedly increase dividends,
as the investors interpret this as a sign of an increase in management confidence in the future
prospects of the company thus the share price typically increases in value.
Suppose that the managers are considering how to finance a major new project which has been
disclosed to the market. However managers have had to withhold the inside scoop on the new
technology associated with the project, due to the competitive nature of their industry. Thus the
market is currently undervaluing the project and the shares of the company. The management
would not want to issue shares, when they are undervalued, as this would result in transferring
wealth from existing shareholders to new shareholders. They will want to finance the project
through retained earnings so that, when the market finally sees the true value of the project,
existing shareholders will benefit. If additional funds are required over and above the retained
earnings, then debt would be the next alternative.
When managers have favourable inside information, they do not want to issue shares because
they are undervalued. Thus it would be logical for outside investors to assume that managers
with unfavourable inside information would want to issue share as they are overvalued. Therefore
an issue of equity by a company is interpreted as a sign the management believe that the shares
are overvalued. As a result, investors may start to sell the company’s shares, causing the share
price to fall. Therefore the issue of equity is a last resort, hence the pecking order; retained
earnings, then debt, with the issue of equity a definite last resort.
One implication of pecking order theory that we would expect is that highly profitable companies
would borrow the least, because they have higher levels of retained earnings to fund investment
projects. Baskin (1989) found a negative correlation between high profit levels and high gearing
levels. This finding contradicts the idea of the existence of an optimal capital structure and gives
support to the insights offered by pecking order theory.
Another implication is that companies should hold cash for speculative reasons, they should
built up cash reserves, so that if at some point in the future the company has insufficient retained

earnings to finance all positive NPV projects, they use these cash reserves and therefore not
need to raise external finance.
As the primary financial objective is to maximise shareholder wealth, then companies should
seek to minimise their weighted average cost of capital (WACC). In practical terms, this can
be achieved by having some debt in the capital structure, since debt is relatively cheaper than
equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too
much gearing (the company suffers from bankruptcy costs, agency costs and tax exhaustion).
Companies should pursue sensible levels of gearing.
Companies should be aware of the pecking order theory which takes a totally different approach,
and ignores the search for an optimal capital structure. It suggests that when a company wants
to raise finance it does so in the following pecking order: first is retained earnings, then debt and
finally equity as a last resort.
FINANCIAL & OPERATIONAL GEARING

FINANCIAL GEARING
In financial management the term financial gearing (leverage) is used to describe the way in
which owners of the firm can use the assets of the firm to gear up the assets and earnings
of the firm. Employing debt allows the owner to control greater volume of assets than they
could if they invested their own money only. The higher the debt equity ratio, the higher the
firm equity and therefore the firm level of financial risk. Financial risk occurs due to the higher
proportion of financial obligations in the firms cost structure. The degree to which the firm is
financially geared can be measured by the degree of financial gearing given by:
Degree of Financial Gearing (DFG) = (% D in EPS)
(% D in EBIT)
The degree of financial gearing indicates how sensitive a firm’s E PS is to changes in earnings before
changes in interest and taxes (EBIT).
ILLUSTRATION
The financial manager of ABC Ltd expects earnings before interest and taxes of RWF50,000
in the current financial year and pays interest of 10% as long-term loan of RWF200 000.
The company has 100 000 ordinary shares and the tax rate is 20%. The finance manager is
currently examining 2 scenarios.
A case where EBIT is 25% less than expected.

A case where EBIT is 25% more than expected.
REQUIRED
Compute the EPS under the 3 cases and the degree of financial gearing for both scenario 1 and 2.

Solution:
Scenario 1 Base Case Scenario 2
(-25%) RWF (+25%)
EBIT 37 500 50 000 62 500
Interes 20 000 20 000 20 000
EBT 17 500 30 000 42 500
Tax (20%) (3 500) (6 000) 8 500
EAT 14 000 24 000 34 000
EPS RWF0.14 RWF0.24 RWF0.34
DFG = %D in EPS
%D in EBIT
Scenario 1 DFG = (0.24 – 0.14) / 0.24 = 1.67
0.23
Scenario 2 DFG = (0.34 – 0.24) / 0.24 = 1.67
0.25
The degree of financial gearing can be calculated more easily using the following formulae.
DFG = EBIT
EBT
= 50 000 = 1.67
30 000
Note that this formulae should be used for the base case only.
A degree of financial gearing greater than one indicates that the firm is financially geared. The
higher the ratio, the more vulnerable the firm’s earnings available to shareholders are to changes
in firm’s EBIT.
Operating Gearing
Financial gearing is related to the proportion of fixed financial cost in the firm’s overall cost
structure. Operating gearing however relate to the proportion of fixed operating cost in the firm’s
overall cost structure. Operating gearing mainly considers the relationship between changes in
EBIT and changes in sales. The degree to which a firm is operationally geared can be measured
as follows:

D.O.G. = %D in EBIT
%D in Sales
D.O.G. therefore measures the sensitivity or vulnerability of EBIT to changes in sales. It can also
be used to measure Business Risk. If D.O.G is more than one, then the business is operationally
geared.
Illustration:
Assume that the finance manager of ABC Ltd expects to generate sales of RWF50 000 in
the current financial year. Analysis of the firms operating cost structure reveals that variable
operating cost is 40% of sales and fixed operating cost at RWF250 000.
The manager wishes to explore the effect of changes in sales and has developed 2 scenarios.
Sales revenue is 10% less than expected

Sales revenue is 10% greater than expected
Required:
Compute EBIT for each of the scenarios and the degree of operating gearing.
Scenario 1 Base Case Scenario 2
(-10%) RWF (+10%)
Sales 450 000 500 000 550 000
Variable cost 180 000 200 000 220 000
Contribution 270 000 300 000 330 000
Fixed cost 250 000 250 000 250 000
20 000 50 000 80 000
D. O. G. = (50 000 – 20 000) / 50 000 =6
(500 000 – 450 000) / 500 000
For the Base Case the degree of operating gearing can be given by the following formulae:
D.O.G. = Contribution
EBIT
= 300 000
50 000
= 6
Total Gearing
Its possible to obtain an assessment of the firms total gearing by combining its financial
gearing and operating gearing so that the degree of total gearing (D.T.G) is equal to degree of
operating gearing multiplied by degree of financial gearing.

D.T.G. = D.O.G. X D. F. G.
= %D in EPS
%D in sales
D.T.G. therefore measures the sensitivity (vulnerability) of EPS to changes in company’s sales.
ILLUSTRATION
Consider the ABC illustration and compute the degree of total gearing.
Solution:
Base case Scenario 2
RWF +10%
Sales 500 000 550 000
Variable cost 200 000 220 000
Contribution 300 000 330 000
Fixed cost 250 000 250 000
EBIT 50 000 80 000
Interest 20 000 20 000
EBT 30 00 60 000
Less Tax(10%) 6 000 12 000
EAT 24 000 48 000
EPS 0.24 0.48
D.T.G = (0.48 – 0.24) / 0.24 = 10

(550 000 – 500 000) / 500 000)
For the base case,
D.T.G = Contribution
EBT
= 300 000 = 10
30 000
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The WACC is the overall cost of using the various forms of fund. It can be given by:
WACC = Net operating Earnings (NOE)

Total Market Value of the firm
It can also be expressed as
Where D P E

Ko= Kd  + K p  + Ke  
V  V  V 
Ko is the weighted average cost of capital

Kd is the cost of debt
Kp is the cost of preference shares
Ke is the cost of equity
D, P, E are the proportions of debt, preferred stocks

V V V and equity in capital structure
For easy analysis we shall assume that the firm uses only debt and equity. The overall cost of capital
will therefore be given by:
D E
Ko= Kd  + Ke  
V  V 
D
= K e - ( K e - K d )
V
With this background we can look at what happens to Kd, Ke and Ko as the degree of leverage (denoted
by D/E changes). This will be done by looking at the theories of capital structure.
Weaknesses of WACC as a discounting rate

WACC/Overall cost of capital has the following problems as a discounting rate:
• It can only be used as a discounting rate assuming that the risk of the project is equal to the
business risk of the firm. If the project has higher risk then a percentage premium will be
added to WACC to determine the appropriate discounting rate.
• It assumes that capital structure is optimal which is not achievable in real world.
• It is based on market values of capital which keep on changing thus WACC will change over
time but is assumed to remain constant throughout the economic life of the project.
• It is based on past information especially when determining the cost of each component e.g
in determining the cost of equity (Ke) the past year’s DPS is used while the growth rate is
estimated from the past stream of dividends.
Note When using market values to determine the weight/proportion in WACC, the cost of
retained earnings is left out since it is already included or reflected in the MPS and thus the
market value of equity. Retained earnings are an internal source of finance thus, when they are
high there is low gearing, lower financial risk and thus highest MPS.
PRACTICAL CONSIDERATIONS
There are a number of practical considerations which a company must take into account in setting
its particular dividend policy. Chief among these are:
Taxation – Income Tax v Capital Gains Tax. If shareholders pay high marginal rates of Income
Tax they may prefer low dividends. If subject to low tax rate or zero tax, they may prefer high
dividends.
Investment Opportunities – “Residual Theory” => retain sufficient funds until all profitable
investments (those with a positive NPV) have been funded. Balance to be paid as dividends.
Drawback is that dividends may vary dramatically from year to year. Also, consider the timing of
the cash flows from the investments as these will be required to pay future dividends.

Availability of Finance – If the company is highly geared it may have little option but to retain.
Retentions will build up the equity base, thus reducing gearing and assisting future borrowing.
Certain types of company (e.g. small/unquoted) may not have access to external funds and may
need to retain.
Liquidity – Profits do not equal cash. Adequate cash must be available to pay dividends.
Also, for growth companies, sufficient liquidity must be available for reinvestment in fixed
assets.
Cost of New Finance – The costs associated with raising new equity/debt can be quite high. If
debt is raised interest rates may be high at that particular point in time.
Transaction Costs – Some shareholders may depend on dividends. If earnings are retained
they can create “home-made” dividends by selling some shares (capital). However, this may
be inconvenient and costly (brokerage fees etc.).
Control – If high dividends are paid the company may subsequently require capital and this may
be obtained by issuing shares to new shareholders. This may result in a dilution of control for
existing shareholders.
Inflation – In periods of high inflation companies may have to retain funds in order to maintain
their existing operating capability. On the other hand, shareholders require increased dividends
in order to maintain their purchasing power.
Information Content – The declared dividend provides information to the market about the
company‟s current performance and expected future prospects. An increase or a reduction will
be reflected in the share price.
Existing Debt – Restrictive covenants in existing loan agreements may limit the dividend
payout or prohibit the company from arranging further borrowing. Existing debt which may be due
for repayment will require funds and may cause a reduction in the level of dividend.
Legal Restrictions – Dividends can only be paid out of realized profits. Past losses must first
be made good.
Perceived Risk – The earnings from retained dividends may be perceived as being a more risky
return than actual cash dividends, thereby causing their perceived value to be lower (the “Bird in
the Hand Theory”).
Stable Dividends – Generally, shareholders require a stable dividend policy and hopefully,
steady dividend growth.
Note: Some companies adopt a constant payout ratio, whereby a fixed percentage of earnings
is paid out as dividends. This has the drawback that dividends will rise and fall with earnings. However,
this may not be a problem for a company which is not subject to cyclical factors and whose earnings
grow steadily.
Conclusion: There is unlikely to be a single dividend policy which will maximize the wealth of
all shareholders. The company should try to ascertain the composition of its shareholders in order to
pursue a dividend policy which is acceptable. Maybe, the best is to adopt a consistent policy and hope
to attract a “clientele of shareholders” to whom it appeals.

INVESTMENT FROM OVERSEAS
Overseas expansion may be achieved by:
(i) Exporting – often used as a first step to direct investment.
Advantages: uses spare capacity at existing plants; safe way to enter new market as costs
are relatively low if strategy fails.
Disadvantages: high transportation costs; may be difficult or expensive due to imposition

of tariffs, quotas, taxes etc; consumers may prefer locally produced goods; service, spare
parts etc. normally less reliable with exports.
(ii) Foreign Direct Investment (FDI) – establish a new subsidiary or acquire existing local company.
Advantages: establish new markets & demand; benefit from economies of scale; take
advantage of relatively cheap labour or land; avoid tariffs and restrictions; international
diversification; highly skilled or educated workforce; use foreign
raw materials & avoid high transport costs; take advantage of undervalued foreign
currency; exploit monopolistic or competitive advantage; react to overseas investment by
competitors.
Disadvantages: commitment of substantial capital; significant risk.
(iii) Licensing - local company manufactures in return for a royalty. Often used where countries
have high import barriers.
Advantages: penetration of foreign markets without large capital outlay; political risk reduced
as product is manufactured locally; transportation costs avoided
Disadvantages: difficult to ensure quality control; local company might export and compete
with multinational’s exports; problems of technology transfer or licensee may become a
significant competitor when licence expires.
(iv) Joint Venture – two or more independent companies cooperate in an agreed manner in a
project/projects.
Advantages: access to new markets at relatively low cost; use of joint venture partner’s
knowledge of the local environment, distribution network, technology, patents, brands,
marketing or other skills; risk and cost shared; easier access to local capital markets/tax
incentives/ grants in overseas country; may be the only way to enter some markets - host
government may impose requirements that any direct investment must be a joint venture.
Disadvantages: agreement on terms - percentage ownership of each partner, transfer

pricing rules, reinvestment decisions, nationality of key managers, where raw materials and
components are to be purchased etc; may be time consuming and difficult to find a reliable
partner; managerial freedom may be reduced.

Study Unit 5
Financial Risk Management
Contents
• The key financial risks facing an enterprise.
• Currency risk - transaction, translation and economic exposure.
• The workings of the foreign exchange markets.
• The relationship between foreign exchange rates and interest rates in different countries.
• Forward Exchange Contract and Money Market hedges.
• Other forms of exchange rate risk management including, netting, leading and lagging,
currency swaps, currency futures and currency options.
• Exchange risk management strategies.
• Interest rate options, swaps, forwards and futures .
• Interest rate risk management strategy.

INTRODUCTION
In this study unit we will be looking at the workings of the foreign exchange market, and examining
the more practical aspects of the subject, such as the different exchange rate systems, the
calculation of exchange rates, the impact of international trade on an organisation, various
methods of expansion overseas, exchange risk and the various techniques used to reduce
this risk.
Exchange Rates
An exchange rate is the rate at which a unit of one currency can be exchanged for another -
for any currency there is an exchange rate for each currency it can be traded with.
Foreign Exchange Market (Forex)
The foreign exchange market is a world market and competition is freely applied. However,
governments do intervene in the market to influence prices, and some currencies are not
freely dealt in the market. The largest dealing centre is London followed by New York and Tokyo.
The main dealers on forex markets are banks.
Some countries have strict exchange control regulations and fix the exchange rate, often in an
arbitrary manner. Nevertheless the foreign exchange market exists to buy and sell currencies
and this it does efficiently and effectively.
Exchange Rate Systems
Governments have a choice of exchange rate policies that they can adopt in order to achieve
their economic (and political) aims.
The main exchange rate policies are:
Fixed exchange rates, where governments which are members of the international monetary
system use their official reserves (which comprise foreign currency and gold) to maintain a fixed
exchange rate. By adding to, or using, the official reserves the government ensures that the
demand for, and the supply of, their currency are balanced (thus maintaining its price). The
exchange rate of each member currency is generally set against a standard - which could be
gold, a major currency (e.g. the US $) or a basket of currencies. It is also possible for each
currency in the system to be set against each other. Fixed exchange rate systems encourage
international trade by removing uncertainty. However, they restrict member states’ independence
in setting domestic economic policies by requiring them to take appropriate action to maintain
their exchange rate.
Floating exchange rate systems are those whereby exchange rates are left to, and are determined
by, market forces, there being no use of the official reserves in maintaining the exchange rate
level. Floating exchange rate systems may be either free floating or, more commonly, managed
floating. Wide fluctuations of exchange rate values can occur under floating exchange rate
systems creating problems of uncertainty for international trade. However, it is likely that the
underlying economic conditions creating these fluctuations would have created severe problems
for the working of a fixed exchange rate system - even creating instability.

Adjustable (or moveable) peg system is a fixed exchange rate system which has provisions
for the devaluation and revaluation of currencies for countries with persistent balance of
payments’ deficits or surpluses. Adjustable peg systems allow more flexibility than a fixed
exchange rate system but still limit the choice of government action to either maintaining the
exchange rate or devaluing/revaluing the currency.
FACTORS TO CONSIDER – INTERNATIONAL TRADE
Risk Factors
Apart from the normal problems which occur in any type of business there are further
complications when the organisation is involved in international trade. Among these are:
Credit Risk - usually higher risk for foreign trade
Physical Risk – there is a greater risk of goods in transit being lost, stolen or destroyed.
Exchange Controls - may hinder movement of funds.
Foreign Laws & Customs - different practices in certain countries.
Taxation - different tax rates/rules. Double Taxation Treaty may apply.
Political Risk - actions of a foreign government may prevent/delay payment being

made. This can take many forms, ranging from bureaucratic delays to war (e.g. Iran/
Iraq).
Exchange Rate Risk - losses due to unforeseen movement in currency exchange rates.
Some forms of risk may be reduced/eliminated by insurance - e.g. normal commercial

insurance (physical risk), export credit insurance (credit risk). Credit risk may also be
reduced by screening customers or by the terms of trade (e.g. irrevocable letter of credit).
Methods of Expansion Overseas
Overseas expansion may be achieved by:
(i) Exporting – often used as a first step to direct investment.
Advantages: uses spare capacity at existing plants; safe way to enter new market as costs
are relatively low if strategy fails.
Disadvantages: high transportation costs; may be difficult or expensive due to imposition

of tariffs, quotas, taxes etc; consumers may prefer locally produced goods; service, spare
parts etc. normally less reliable with exports.
(ii) Foreign Direct Investment (FDI) – establish a new subsidiary or acquire existing local company.
Advantages: establish new markets & demand; benefit from economies of scale; take
advantage of relatively cheap labour or land; avoid tariffs and restrictions; international
diversification; highly skilled or educated workforce; use foreign raw materials &
avoid high transport costs; take advantage of undervalued foreign currency; exploit
monopolistic or competitive advantage; react to overseas investment by competitors.

Disadvantages: commitment of substantial capital; significant risk.
(iii) Licensing - local company manufactures in return for a royalty. Often used where countries
have high import barriers.
Advantages: penetration of foreign markets without large capital outlay; political risk
reduced as product is manufactured locally; transportation costs avoided
Disadvantages: difficult to ensure quality control; local company might export and
compete with multinational’s exports; problems of technology transfer or licensee may
become a significant competitor when licence expires.
(iv) Joint Venture – two or more independent companies cooperate in an agreed manner in a
project/projects.
Advantages: access to new markets at relatively low cost; use of joint venture partner’s
knowledge of the local environment, distribution network, technology, patents, brands,
marketing or other skills; risk and cost shared; easier access to local capital markets/tax
incentives/ grants in overseas country; may be the only way to enter some markets - host
government may impose requirements that any direct investment must be a joint venture.
Disadvantages: agreement on terms - percentage ownership of each partner, transfer

pricing rules, reinvestment decisions, nationality of key managers, where raw materials and
components are to be purchased etc; may be time consuming and difficult to find a reliable
partner; managerial freedom may be reduced.
C. EXCHANGE RISK
Exchange Rate Volatility
As an example of the volatility of exchange rates look at the US$/RWF exchange rate in the
period January 2006 – January 2012:

Average Bid % change % change since
price for month from
RWF/GBP previous Jan 2006
Jan 2006 933.6
Jan 2007 1009.43 8.12% 8.12%
Nov 2007 1086.44 7.63% 16.37%
Jan 2008 1029.94 2.03% 10.32%
Jan 2009 784.944 -23.79% -15.92%
Jan 2010 890.19 13.41% -4.65%
May 2010 820.194 -7.86% -12.15%
Jan 2011 905.957 1.77% -2.96%
Jan 2012 934.662 3.17% 0.11%
The movements during the intervening period have been quite dramatic. In the period January
2006 – January 2012 there was almost no change against the GB pound. But, within each year the
movements were quite volatile – Jan 2008 to Jan 2009 saw a 23.8% increase in the value of the Rwf. In
Jan 2008 GBP1,000 could have been exchanged for Rwf 1,029,100 but in Jan 09 the same GBP1,000
would have been exchanged for Rwf 785,000, a difference of almost 240,000 francs. If you are selling
in the currency of your purchaser volatility of this magnitude can be expensive

Examples – Impact of Rate Movements
Before deciding what action, if any, we should take it is necessary to appreciate where the
problem arises. We shall examine a few very simple examples:
Example 1
An importer buys from the USA. He receives an invoice for $10,000, which must be paid
immediately. The importer must exchange his RWF’s for Dollars (he buys Dollars). His bank
quotes a selling rate of, for argument say, RWF560 per USD. The cost to the importer is:
$10,000 x RWF560 = RWF5,600,000
Example 2
An exporter to the USA invoices his customer in Dollars ($10,000), which is paid
immediately. The exporter must exchange his Dollar receipt for RWF (he sells Dollars). His
bank quotes a buying rate of 540RWF per USD. The receipt to the exporter is:
$100,000 x RW F540 = RWF5,400,000
The difference between the payment and the receipt of RWF200,000 is the bank’s turn/profit. This
is achieved by quoting different buying and selling rates. In addition, the bank may also charge
a commission.
Examples 1 and 2 are quite straightforward. The account is settled immediately and the value of
the payment/receipt is known using the “spot” rate (basically, the current rate). However, most
international trade involves credit. Thus, there is a risk that the exchange rate may move
against the importer/exporter during the credit period. We will now restate examples 1 and 2
allowing for credit:
Example 3 (similar to Example 1)
An importer from the USA receives an invoice for $10,000. The supplier allows 90 days credit.
His bank quotes a “spot” (current) rate (selling) of 560RWF. Using the “spot” rate the cost to the
importer is RWF5,600,000 (as Example 1). However, during the 90 days credit period assume
that the Dollar strengthens and the rate settles at 565RWF. The cost to the importer has now
risen to:
$100,000 x 565 = RWF5,650,000 (an increase of RWF50,000)
Example 4 (similar to Example 2)

An exporter to the USA invoices his customer in Dollars ($10,000) and to remain
competitive allows 90 days credit. His bank quotes a “spot” rate (buying) of 540RWF. Using the
“spot” rate the receipt to the exporter is RWF5,400,000 (as Example 2). However, during the 90
days credit period assume that US $ weakens (the USD buys fewer RWF) and the rate settles
at 525RWF. The value of the receipt for the exporter has now fallen to:
$10,000 x 525 = RWF5,250,000 (an decrease of RWF150,000)

Examples 3 and 4 examine the situation where the spot rate moves against the importer/
exporter. Equally, the spot rate could turn out to be favourable and a windfall gain would arise.
In international trade either the importer or the exporter must trade in a foreign currency.
Alternatively, both parties may if the deal is denominated in a third currency - e.g. an
company imports oil from a Mexican company and payment is in US$.
Classification of Exposure
Transaction Exposure - The above exposure is known as Transaction Exposure, which

exists because of the time lag between the initiation of the transaction and the actual payment/
receipt of the foreign currency.
Translation Exposure - The risk of profits and losses arising from the conversion of foreign
currency assets and liabilities from one Balance Sheet date to the next is known as
Translation Exposure.
Economic Exposure - This exists where there is the possibility that the value of the company
will change due to unexpected changes in exchange rates. Unexpected currency fluctuations
can affect both the future cash flows and their riskiness. Both of these are likely to result in a
change in the value of the company.
Exchange Rates – Spot v Forward

An exchange rate is the price of a currency expressed in terms of another currency. The spot
rate is the current rate of exchange. Two prices will be quoted by the bank - a buying rate and a
selling rate. The difference between the two prices is known as the “spread” and represents the
bank’s profit or turn.
For example, if the spot rate for GBP is quoted as:

$1.50 - $1.52
One is the bank’s buying rate and the other is the bank’s selling rate, but which is which? Firstly,
the rates are quoted from the bank’s perspective. Secondly, remember the phrase HELLO :
BYE-BYE. This translates to SELL LOW: BUY HIGH.
Thus, the bank’s rates are:

Sell Buy
$1.50 - $1.52
If an exporter receives $100, 000 he can exchange it (the bank will buy) at the rate of $1.52
and receive GBP65,789. On the other hand, an importer who is due to pay an invoice of
$100,000 can buy (the bank sells) these at the rate of $1.50 and pay GBP66,666.
If a company wishes to contract to buy/sell foreign currency at some future date. The bank in
this case will quote a forward rate. Thus, the bank might quote:
Spot Rate $1.50 - $1.52

1 Month Forward $1.51 - $1.53
3 Month Forward $1.54 - $1.56
At these rates a customer could contract to buy $’s in 3 months at $1.54 or sell $’s at $1.56

An alternative way of quoting forward rates is to express them as an adjustment to the spot
rate. For example, the above may be quoted as:
Spot Rate $1.50 - $1.52

1 Month Forward 1 cent - 1 cent
3 Month Forward 4 cents - 4 cents
Therefore, to determine the outright forward rates, add or subtract 1 cent or 4 cents to/from
the spot rate. If the forward rates are quoted at a Discount => add to the spot rate. If quoted
at a Premium => subtract from the spot rate. Using the above example, the forward rates are
quoted at a discount. To recollect the approach, remember the word ADDIS (the tooth-brush
manufacturer) => Add a Discount (abbreviated to “dis”); Subtract a Premium (abbreviated to
“pm”). Note that the premiums and discounts are quoted in fractions of a currency – the $ is
quoted in cents, Sterling in pence etc.
Beware the decimal point. If, in the above example, the 3 month forward rate was quoted as
.4 cents discount then the forward rate could be derived as
Spot Rate 1.500

Plus 3 month discount 0.004
3 month Forward Rate 1.504
METHODS OF REDUCING RISK
Exposure can, to a certain degree, be managed by “hedging”, which is the taking of any
action that protects against adverse movements in exchange/interest rates. This “action” may
take a number of forms, several of which we shall discuss.
Essentially there are three general courses of action available to the treasurer:
• Do nothing, i.e. leave exposed positions uncovered.

• Hedge everything.
• Hedge selectively.
The course taken will depend on the organisation’s philosophy, the treasurer’s perception as to
future movements and the value of the potential exposure.
Remember that not all rate movements are detrimental; fortuitous gains often arise. A
company may seek to hedge or to be partially hedged in the hope of achieving high profits.
Risk management consists of the techniques and policies adopted by an organisation to minimise
its exposure to risk, and takes two main forms:
The internal management of risks, or pooling. Here risks are aggregated and offset against
each other; this is the general method of dealing with normal business risks, and is also used in
areas such as insurance and portfolio diversification.
The external management of risk, or hedging. This is where two or more parties make an
agreement in which their risks cancel each other out. This is used in areas outside the company’s
control, e.g. in exchange rate and interest rate risk. The parties involved may be those facing the
same risk but in opposite directions, or may include one or more speculators.

Forward Exchange Contract
With this technique we take action to-day so as to “lock-in” a rate which will apply in the
future.
A Forward Exchange Contract is an agreement between two parties to exchange (buy/sell) one
currency for another at some future date. The exchange rate, amount involved, and delivery
date are agreed up-front but funds do not change hands until delivery date.
It is a straightforward contract and one of the most commonly used risk hedging mechanisms.
It is one of the best means of establishing a perfect hedge - full insurance is provided against
adverse rate movements. However, it is important to remember that these contracts are
binding on both parties and must be carried out. At the date that the agreement matures (the
value date), if rates have moved in the customer’s favour he cannot decide that he no longer
needs the forward contract.
It allows an importer/exporter to calculate up-front the precise domestic currency value of the
underlying commercial transaction.
Contracts are available in most markets for maturities up to one year in all major currencies. For
large amounts some banks will contract for several years forward, if they can match buyers
and sellers.
Advantages
• Facilitates perfect hedging of foreign currency payables/receivables.

• Can be tailor-made to suit a customer’s requirements (amount, currency, and timing).
• Simple implementation and standardised documentation.
Disadvantages
• Legally binding contract which must be performed. It is usually non-transferable and

can only be cancelled with the consent of the counterparty and payment of a penalty.
• Opportunity costs arise if rates do not move as anticipated (see example below).
Example:
An company is due to receive $150,000 in June. It is now January and the following rates are quoted:
Spot $1.00=RWF562
Six Month Forward $1.00=RWF585
Assume that the company arranges a forward contract.

In June when the $150,000 is received the then spot rate may be lower, higher or the same as
the spot rate in January. Let us examine the consequences:
Spot Rate 1st June
1. Worsens to RWF555/ No Action Sell $’s at spot Forward Rate FixedDelivery
USD $’s to bank at $1.50
Proceeds RWF83,250,000 Proceeds RWF87,750,000

2. Improves to RWF590 Sell $’s at spot Proceeds As above RWF87,750,000
RWF88,500,000
3. Static at RWF562 Sell $’s at spot As above RWF87,750,000

Proceeds RWF84,300,000
No matter what happens to the spot rate in June an amount of RWF87,750,000 is guaranteed if
the forward rate is fixed. In scenario 2, with hindsight this turns out to be a disadvantage as an
additional RWF750,000 could be gained if the $’s are sold at the more favourable spot rate.
However, this only becomes known with the benefit of hindsight – scenarios 1 and 3 produce
higher values with the forward contract.
If a Forward Contract is entered into and its ultimate performance cannot be carried out due to
a change in circumstances, what can happen?
Close Out The Contract - if an exporter had contracted to sell $1m forward but the customer will
not now make payment to the exporter (e.g. due to bankruptcy) the bank will arrange for the
exporter to buy the “missing” currency at the spot rate and thus perform his part of the contract.
The exporter will:
(1) Buy $1m at the prevailing spot rate, and

(2) Immediately sell $1m to the bank at the contracted forward rate.
A loss or a gain may arise depending on current spot rate at no.1 above.
Extend The Contract - if an exporter had contracted to sell $1m forward but the customer will
not now make payment until say, one month later. The bank will accept a request to
extend the period of the existing contract, changing its rate to a new rate applicable to the
forward date when performance is now expected.
Option Dated Forward Contract - where a future cash flow is not known with certainty to the
day the “fixed” forward contract, as above, may cause problems. The option dated contract
allows the customer to call for settlement:
(1) At any date from contract date up to a specified future date,

or
(2) At any date between two specified future dates.
However, there is a cost as the bank will quote the more favourable of the two applicable
rates (or less favourable to the customer).
Note: The option is not on the ultimate performance of the contract, it is on when it may be
performed.

Foreign Currency Option
A currency option gives the holder the right (but not the obligation) to buy or sell an
underlying currency at an agreed exchange rate (known as the “strike price”). Depending on
the terms, the option can be exercisable on a single date at expiry (European Option) or over a
period of time on any day (American Option).
Option is the key word because this particular instrument offers a good deal of flexibility. An
option is purchased for an up-front payment, known as a Premium (usually a flat percentage fee
of the amount to be covered). Thereafter, the holder exercises the option if it is in his interest to
do so, or allows it to lapse if the transaction can be carried out at a more favourable rate in the
spot market.
A Call Option is the right to buy the underlying currency. A Put Option is the right to sell the
underlying currency.
Options differ fundamentally from traditional risk-management tools such as forward cover,
as the company is not obliged to deal at an exchange rate which may turn out to be quite
unfavourable depending on how rates subsequently move. It is like a forward contract from
which the holder can walk away. Thus, it provides a mix of protection (guaranteed rate) and
opportunity (to trade at the spot rate if this turns out to be more favourable).
Note: Currency options are not the same as Forward Exchange Option contracts, which must
be completed at some date.
Advantages
• Highly flexible.
• Suited to uncertain cash flows.
• Does not absorb foreign exchange line, once the premium has been paid.
Disadvantages
• Cost can be relatively high and must be paid up-front (cash flow?).
• Tailor-made options (OTC – Over The Counter) lack negotiability.
Example 1
An importer needs to buy $10k in three months. The following rates are quoted:
RWF/USD Spot 575

3 Month Forward 584
The importer essentially has three alternatives:
(1) Leave The Exposure Open (do nothing) - he will gain if the $ weakens (pick them up
more cheaply), but lose if the $ strengthens.
Arrange a Forward Contract - he will gain if the $ strengthens (pick them up at the fixed
(2)
forward rate), but lose if the $ weakens (lose the opportunity to pick them up at the
relatively cheap spot rate, as he must deal at the agreed fixed rate).

(3) Arrange An Option - he is protected if the $ strengthens but he also retains the opportunity to
benefit from a weaker $.
Suppose that the company buys a Call Option for $10k., expiring in 3 months time (European), at
a strike price of RWF579/$ for a premium of RWF10 per $. Therefore, a premium of RWF100,000
must be paid up-front.
(i) If in 3 months time the spot rate has appreciated to, say 595/$, the company will exercise
its option at the more favourable rate of RWF584 and pay RWF5,840,000 ($10k
x 584). The cost of $10k at the spot rate of 595/$ would have been RWF5,950,000. Thus,
the company saves RWF110,000 over the cost of spot $’s or a net saving of RWF10,000 if
the premium is taken into account.
(ii) If in 3 months time the spot rate has weakened to, say RWF568/$, the company will allow
the option to lapse and buy the $10k at the more favourable spot rate of RWF568, paying
RWF5,680,000. The cost of forward cover would have been RWF5,840,000, so the company
saves RWF160,000 or a net RWF60,000, if the premium is taken into account.
An option can never perform quite as well as forward cover if the spot moves against the company,
or an open exposure if the spot moves in its favour (because a premium must be paid for
the option). However, in a world of volatile and unpredictable exchange rates an option can
significantly outperform an unfavourable forward contract or an open position. At the same time,
it can capture a high percentage of the gains provided by a favourable covered or open exposure,
especially if there is a major move in the spot rate
Example 2
A construction company regularly tenders for contracts abroad. These are in $’s yet it often
does not know for quite some time in advance whether or not it will win the contract. If it
sells the anticipated $ income forward and the $ strengthens it runs the risk of being left with an
exchange loss if it is not awarded the contract.
On the other hand, if it neglects to sell the anticipated $ income forward and the $ weakens
then the company loses if it is awarded the contract.
The solution - purchase a put option on $’s with a strike price based on the spot rate
prevailing on the day of tender. Thus, the company will be able to sell the anticipated income
at a pre-determined rate, while the option may be allowed to expire without being exercised
should the tender be unsuccessful.
Another example of where options may be useful is where an exporter needs to have a pre-
determined exchange rate upon which to prepare accurate price lists in advance.
The premium payable on an option depends upon:
• How favourable the strike price is in relation to the outright forward rate - the more
favourable the higher the premium.
• The term of the option - the longer the time to expiry the higher the premium.
• The volatility of the exchange rate involved - e.g. RWF/USD expensive.
• Whether the option is European or American style.

Money Market Cover
This involves borrowing in one country, converting the funds borrowed at the spot rate into
the currency in which payment is due and investing it in the second country. The total
proceeds will then be used to make the payment or repay the loan.
Example 1
An exporter to the Burundi is due to receive BIF1m in 3 months time. The borrowing rate
for $BIFs is 8% per annum and RWF deposits can earn 10% per annum. The BIF/RWF spot
rate (buy) is 1.50.
1. Arrange a BIF loan to-day for 3 months. The cost is 8% per annum or 2% over the 3
month period. Sufficient BIF are borrowed to mature at $BIF1m in 3 months time.
This can be found by: RWF1m1.02 = BIF980,392
2. Convert the $BIF980,392 to RWF’s at the spot rate of 1.50, which will equate
to RWF653,595. This can be placed on deposit at 10% per annum to earn RWF16,
340 over the 3 months (or possibly used to reduce an overdraft, depending on
the company’s circumstances).
3. The eventual receipt of $BIF1m from the customer in 3 months can be used to repay
the $ loan which, with interest will mature at exactly BIF1m.
Thus, the exporter is guaranteed the value of his receipt and is not exposed to
movements in the BIF/RWF rate.
Example 2
An importer buying from the Burundi is due to pay BIF1m in 3 months time. The deposit
rate for BIF is 5% per annum and RWF’s can be borrowed at 12% per annum. The BIF/RWF
spot rate (sell) is 1.50.
1. Deposit sufficient $BIF to-day which, with interest, will grow to BIF1m. in 3 months
time. Burundi francs earn 5% per annum or 1.25% over the 3 month period. The
required amount to place on deposit can be found:
RW F1m
= BIF987,654
1.0125
2. To obtain the BIF987,654 we must buy at the spot rate. This will cost RWF658,436
(BIF987,654/1.50).
3. The BIF deposit will mature in 3 months for a guaranteed BIF1m and will be used to
pay the supplier. The importer also knows that his cost is fixed at RWF658,436.
Note: If one wishes to compare the cost of Money Market Cover, under example 2, with other
techniques (e.g. Forward Cover) it is necessary to add the cost of borrowing RWF658,436 for
3 months at 12% per annum. This is because the cost of acquiring the $ is incurred up-front,
whereas under a Forward Contract the terms are agreed up-front but the cost will not be
incurred until the end of the 3 month period.

The total cost will be:
Cost of Buying BIF spot RWF658,436

Interest Cost (RWF658,436 x 12% x 3/12) RWF19,753
RWF678,189
Currency Swap
In a currency swap two counterparties exchange principal amounts of different currencies,

usually at the prevailing spot exchange rate. On the maturity of the swap the principal amounts
will be re-exchanged at the same exchange rate. Over the term of the swap the counterparties
make periodic exchanges of fixed rate interest in the different currencies.
Companies enter into currency swaps because it allows them to exploit their relative strength
(comparative advantage) in different markets and reduce each party’s funding costs.
Example:
SM Inc. (a U.S. corporation) is about to commence operations in the EAC. It is well known
in the U.S. debt markets but relatively unknown in the East African markets. SM Inc. can borrow
at better rates in the $US than in the East African markets. If the company or its bank can find
an EAC company with the opposite profile (e.g. KK Ltd, wishing to finance a US subsidiary but
not well known in the US credit markets), both companies can obtain funds in the currencies they
want at cheaper cost by using a currency swap than if they raised them directly themselves as
follows:
SM Inc. can raise $100m from a 10 year bond issue in the US markets at 7.50%.
Alternatively, it could raise RWF50bn. in the Rwanda bond market at 4.25%.
KK Ltd can raise RWF50bn for 10 years in the Rwanda market at 3.75%. It could raise
$100m at 8.20%.
SM Inc. will, therefore, issue a $US domestic bond and KK Ltd will make a Rwanda bond issue.
The two parties agree to swap the proceeds of these issues and to make periodic payments
to reflect each other’s interest liability in currency to the holders of the bonds. The swap will be
reversed after 10 years when the bonds are due for redemption.
The cash flows can be shown diagrammatically:
$100m.
RWF Interest - 3.75% p.a.
SM Inc. KK Ltd.
RWF50bn.
$ Interest - 7.5% p.a.
$ Interest $100m. RWF Interest RWF50bn.

7.5% p.a. Principal 3.75% p.a. Principal
$ Domestic
Bondholders
Rwanda Bond Holders

The cash saving to SM Inc. is the difference between the RWF interest paid on the swap and
what would be payable if it made its own RWF issue (4.25% - 3.75% = 0.50% per annum).
Similarly, the saving to KK Ltd is 8.20% - 7.50% = 0.70% per annum.
It is possible that the rates would be adjusted so that both parties shared equally in the saving
or the stronger party (in this case SM Inc.) receives more of the saving.
A bank may take a position between the two parties and make a profit by taking a turn
out of the funds paid on to one or both parties. Alternatively, the bank may act purely
as a broker and charge a fee or commission to one or both parties.
Currency Swaps offer several advantages:
• Companies have a greater access to funds as they can borrow in any currency and swap it
into the currency they need.
• They are off-balance sheet instruments.
• They can enable a company to source cheap funding in one currency by borrowing
another currency and swapping it into the currency needed.
• They can be tailored in terms of start date, maturity, principal, interest rates, currencies
etc.
THE INTERNAL TECHNIQUE
Home Currency Invoicing
One way of avoiding exchange risk is for an exporter to invoice the customer in his domestic
currency, or for an importer to be invoiced in his domestic currency.
However, only one party can deal in his domestic currency, the other must accept the exchange
risk.
It is more usual for the exporter to invoice in his own currency and the importer to be
invoiced in a foreign currency.
Consideration must be given to the bargaining position of the exporter/importer; the company’s
policy on price revisions etc.
Netting
A Rwandan company with receipts and payments in the same foreign currency should plan to
net them off against each other, where possible. Thus, it does not matter whether the currency
strengthens or weakens against the RWF as there is no purchase or sale of the currency.
There is very little cost with this approach but it is only practicable to the extent that receipts and
payments can be matched. Any mismatch could be covered by some other method e.g. forward contract.
Matching
Matching is an asset and liability management technique in which a company matches, say,
its dollar outflows with its dollar inflows, such that they correspond in size and the period in which they
occur. This particular strategy is valuable if the firm wishes to minimize the impact of unanticipated
exchange rate changes on its net cash flows. If the matching is complete in terms of currency, size
and timing, then changes in values of outflows will be offset by equivalent changes in values of inflows.

An example is where the purchase of a U.S. subsidiary or property by a Rwandan company
would be financed by a U.S. $ loan, rather than a RWF loan.
Leading & Lagging

This involves altering the normal receipts/payments schedule by accelerating or delaying
foreign currency payments, in anticipation of exchange rate fluctuations.
Lead Payment - where the foreign currency is strengthening it may be worthwhile making
an early payment of an outstanding liability, rather than taking an extended credit period and
running the risk of having to pay more in RWF’s. However, account must be taken of any
additional financing costs, due to the early payment.
Lagged Payment - if it is felt that the foreign currency is weakening it may be worthwhile
delaying payment for as long as possible to obtain the benefit of a more favourable exchange
rate.
Purchasing Power Parity Theory (PPP)

This theory is based on the idea that in terms of an international price a product should cost
the same wherever it is produced. Using this basic idea, expected exchange rate changes
and forecast inflation differentials can be linked. If the expected rate of inflation in country A
is greater than that in country B then the rate of exchange of the currency of country A will fall
against the currency of country B.
Example
The current $/RWF exchange rate is 1/550. The rate of inflation next year is expected to be
3% in the Rwanda and 9% in the USA. The Purchasing Power Parity Theory suggests that the value
of the $ will fall by approximately 6% (9% - 3%) against the RWF. This can be shown more accurately
as:
1.09
= 1.058 =5.8%
1.03
Thus, the rate of exchange next year is predicted at 550/ 1.058 = $1 /RWF520
INTEREST RATE MANAGEMENT

Question
Suppose that you are the Finance Director of a large organisation wishing to raise RWF100m.
to finance a project for the next ten years. Your bank has evaluated the proposal and
approved the loan.
A number of options are open to you as follows:
1. A ten year term loan at a fixed rate of interest – 7%

2. A floating rate loan at a margin of 2% over 6-month INTERBANK (6-month
INTERBANK is currently 4.25%).
3. RWF5m ten year term loan at a fixed rate of 7% (as 1 above).
RWF5m floating rate loan at a margin of 2% over 6-month INTERBANK (as 2 above).
4. A five year term loan at a fixed rate of 6.5%.

REQUIREMENT:
Which would you choose and why?
Answer
• In deciding how one should manage interest rate movements it is necessary to
understand where the exposure arises and what would be the impact of change(s) in
interest rates.
• It is also important to appreciate that a depositor of surplus funds can be exposed
to a change in interest rates in the same manner as a borrower. We tend to only think
of borrowers.
An understanding of where the exposure lies may be gleaned from the following:
Interest Movement Exposure – Borrower Exposure – Depositor

Increase Variable Rate Fixed Rate
Decrease Fixed Rate Variable Rate
The following simple example of two companies with RWF15m. variable (floating)
rate borrowings may illustrate the impact of interest rate sensitivity:
Company A Company B
Profit (RWF’000) 3,000 1,600
Interest @ 10% p.a. 1,500 1,500
Net Profit 1,500 100
Suppose that interest rates increase to 11% for the year, this would imply an additional interest
cost of RWF150,000 and Net Profit/Loss would be revised as follows:
Company A Company B
Profit (RWF’000) 3,000 1,600
Interest @ 11% p.a. 1,650 1,650
Net Profit/Loss 1,350 (50)
Percentage Change -10% -150%
Thus, the management of interest rates is more critical for Company B.
The above example examines the negative aspect - where interest rates increase.
Should interest rates fall by 1% the percentage change in Net Profit would be Company
A + 10% and Company B + 150%. Variable rates are a twin-edged sword.
The company can elect to carry the risk itself by doing nothing or decide to manage the
risk by using some of the techniques which we shall now examine. Much will depend on
the attitude of management to risk. Most management teams are risk-adverse.

RISK MANAGEMENT -MAIN TECHNIQUES/INSTRUMENTS
Interest Rate Guarantee (IRG)/Option
These provide a degree of flexibility which is not provided by certain other

instruments. They protect one from adverse interest rate movements but also allow
one to profit from favourable movements.
(i) Interest Rate Cap - Borrower agrees with bank a ceiling to the interest rate on a
loan. If the interest rate turns out to be higher the bank pays the difference to
compensate. If the interest rate turns out to be lower than the agreed rate, the
company benefits by borrowing at the lower market rate. The effect of the Cap
is to ensure that the borrower pays no more than the agreed rate, no matter how

high interest rates move.
Unlike certain other techniques the buyer of the Cap must pay a premium (price)
up-front, when the agreement is set.
Example:
A borrower buys a Cap at 8%.
(1) If actual interest rates turn out to be 10% the borrower will receive
compensation of 2%.
(2) If actual interest rates turn out to be 7% the borrower will deal at this
favourable rate.
(ii) Interest Rate Floor - Similar to the Cap. Here an investor is protected by receiving
compensation if rates fall below an agreed floor. However, the investor can take advantage
of any upward movement in interest rates.
Example:
An investor sells a Floor at 5%.
(1) If actual interest rates turn out to be 4% the investor will receive
compensation of 1%.
(2) If actual interest rates turn out to be 6% the investor will deal at this
favourable rate.
(iii) Interest Rate Collar - An amalgamation of a Cap and a Floor. Simultaneously, a borrower
buys a Cap to limit the maximum rate of interest and sells a Floor to fix the minimum borrowing
cost. Thus, the borrower gives up the benefit of interest rates falling below the floor. To
compensate, the cost (premium) is less than the equivalent Cap.
Thus, the company will know both the maximum and minimum interest rate it would
have to pay during the life of the Collar.
Example:
A borrower buys a Cap at 8% and sells a Floor at 6%.
The difference represents a band of interest rates that the borrower might pay.

Future Rate Agreement (FRA)
A Future Rate Agreement (sometimes called a Forward Rate Agreement) is an

agreement between a bank and a customer made to-day (contract date), whereby:
The customer can secure an agreed interest rate (contract rate) On an

agreed amount of its borrowings (principal amount)
For an agreed duration (period)
Commencing on an agreed future date (settlement date)
The FRA does not require any outlay of cash.
The guaranteed interest rate is achieved by the exchange of an amount of money
(settlement amount) between the parties.
The FRA is ideal for:
Depositors seeking protection against a fall in interest rates, or
Borrowers who want to protect against a rise in interest rates.
(i) FRA Example - Deposit
On the 1st January a corporate treasurer places a deposit of RWF10m. for one month
fixed at 11%. He reckons interest rates will fall significantly over the coming months and
he wants to protect his current level of income. The six month FRA rate, for the period
commencing one month hence is quoted at 10%. He decides to do an FRA for the period in
question for RWF10m.
If interest rates fall as he predicts:
1st January FRA agreed at

Contract Rate (10%)
1st February
Six month period of
FRA commences. Fix

Settlement Rate (say, 9%).
31st July FRA cover period ends
At the start of the FRA period (1st February) interest rates have fallen and the Settlement Rate
turns out to be 9%. The bank will pay compensation of the difference between the Contract
Rate (10%) and the Settlement Rate (9%) for the six month period.
Thus, the position is:

Actual rate received on deposit 9%
Compensation paid by bank under FRA (10% - 9%) 1%
Total Yield 10%

Should the Settlement Rate at the start of the FRA period on the 1st February rise
to, say, 13% the position would be:
Actual rate received on deposit 13%

Compensation paid to bank under FRA (13% - 10%) (3%)
Total Yield 10%
Having entered into the FRA on the 1st January the total yield will always be
10%, by virtue of the compensation paid by/to the bank under the FRA, no matter what the
actual rate turns out to be on the 1st February.
(ii) FRA Example - Loan
On the 1st January a corporate treasurer realises that a loan of RWF10m. which had been
borrowed on a six month rollover basis has one month to run to the next rollover. Currently, the
loan is based upon an interbank rate of 10%. He reckons interest rates will rise significantly
over the coming months and he wants to protect his current position. The six month FRA rate,
for the period commencing one month hence is quoted at 11%. He decides to do an FRA for
the period in question for RWF10m.
If interest rates rise as he predicts:
1st January FRA agreed at

Contract Rate (11%)
1st February
Six month period of
FRA commences. Fix
Settlement Rate (say, 12%).
31st July FRA cover

period ends
At the start of the FRA period (1st February) interest rates have risen and the
Settlement Rate turns out to be 12%. The bank will pay compensation of the
difference between the Contract Rate (11%) and the Settlement Rate (12%) for the six
month period.
Thus, the position is:

Actual rate paid on loan 12%
Compensation paid by bank under FRA (12% - 11%) 1%
Total Cost 11%

Should the Settlement Rate at the start of the FRA period on the 1st February fall
to, say, 8% the position would be:
Actual rate paid on loan 8%

Compensation paid to bank under FRA (11% - 8%) 3%
Total Cost 11%
Having entered into the FRA on the 1st January the total cost will always be
11%, by virtue of the compensation paid by/to the bank under the FRA, no matter what
the actual rate turns out to be on the 1st February.
The position can be summarised:
Settlement Rate
**
14% Borrower
13% Compensated
12% By Bank
Contract Rate 11% --------------------

10% Borrower
9% Makes Payment
8% To Bank
*
*
Rather than wait for six months to elapse (31st July in above examples) before payment,
a convention has developed that the settlement is paid on the FRA start date (1st February), by
discounting the settlement amount at the Settlement Rate.
An FRA makes interest rate risk management possible by enabling one to protect one’s business
against adverse interest rate movements in the future.
An FRA allows one to support one’s own views on interest rate movements and as a result
manage one’s affairs with a degree of certainty. Where forward interest rates are attractive FRA’s
can be used to lock in these rates.
There is no need to borrow or lend cash to do an FRA, so it has very little impact on existing
bank credit lines.
FRA’s are off Balance Sheet and extremely flexible as to size and maturity.

It is important to appreciate that an FRA is not a source or use of funds and can only be used to
manage the interest rate risk associated with an underlying borrowing or investment.
The FRA is ideal for:
– Borrowers who want to protect against a rise in interest rates.
– Depositors seeking protection against a fall in interest rates.
– Project managers who want to fix interest costs for the duration of a project but cannot
get a fixed rate loan.
– Fund managers who want to guarantee an interest rate to investors.
Interest Rate Swap
An Interest Rate Swap is a transaction in which two parties agree to exchange their respective
fixed interest rate and floating rate borrowings at periodic intervals over a
specified time period in order to reduce the cost of borrowing for both. This may be
arranged to exploit different interest rates available in different markets or to change the profile
of the company’s debt.
The Swap is based on a notional amount and does not involve any exchange of principal
- each party will still pay on its primary debt but they settle the adjustment in the cash flows
of interest rates between themselves. Interest payments are usually netted so that only one
payment has to be made between the parties.
Example
Company A has borrowings of RWF100m on which the rate is fixed at 11% per annum
for the next five years. The treasurer expects interest rates to fall and requests an Interest Rate
Swap from fixed to floating rate. Company B, on the other hand, (e.g. a Hire Purchase company)
has similar borrowings at a floating rate but is anxious to borrow fixed more readily to match the
fixed nature of its Hire Purchase advances.
The companies enter a five year Interest Rate Swap for a notional RWF100m for a five year
term.
The position might turn out as follows:
Company A
Borrowing: Pay Fixed (11%)
Swap: (i) Pay Floating INTERBANK

(ii) Receive Fixed 11%
Net Cost INTERBANK
Company B
Borrowing: Pay Floating INTERBANK
Swap: (i) Pay Fixed (11%)
(ii) Receive Floating INTERBANK

Net Cost (11%)
At End of First 6-Month Period
Let us assume that INTERBANK turns out to be 9%.
Company B pays A (11% - 9%) x 6/12 x RWF100m = RWF1m.
The net result of combining the loan with the interest rate swap is that Company B’s effective rate
is 11% fixed (9% on borrowings + 2% on swap).
Company A’s effective rate is 9% (11% on borrowings less 2% from swap), which is the same
as INTERBANK.
The settlement figure will be adjusted every 6 months to reflect changes in the 6- month
INTERBANK rate. This will leave Company B with a fixed rate (11%) over the entire five year
period and Company A with a floating rate.
Conceptually, a swap is the same as a series of FRA’s but it allows corporations to hedge
interest rate exposures for 10 years or longer.
Swaps are easy to arrange, flexible (any size, maturity and can be reversed if required)
and transaction costs are low.
The swap does not have to be arranged with the same bank from whom the original borrowings
have been arranged.
There are many applications for, and variations of, an Interest Rate Swap. Swaps are useful
from both a liability management as well as an asset management perspective. Companies that
borrow on a fixed or floating rate basis can use a swap to alter the interest rate profile (i.e. from
floating to fixed or vice versa). Asset managers that desire to alter the frequency at which their
investments are re-priced can use the swap market for this purpose.
In addition to assisting in the management of interest rate risk, swaps offer several other
advantages including:
• Swaps can often reduce all-in financing costs or increase investment yields, relative to
alternative sources and uses of funds.
• Once credit approval has been obtained, swaps can be executed in a matter of minutes.
Documentation is standard, resulting in reduced administration.
• Swaps are typically off-balance sheet transactions.
• Swaps are customised transactions to meet the specific needs of the client, including
notional principal amount, tenor, indices (fixed/floating), frequency of settlement etc.
• A liquid market exists making it easy to unwind transactions or close out transactions
early should interest rate views change.
Some of the reasons why a swap may be used are:
• Borrowing costs may end up lower than direct borrowing in the market.
• The company can change its debt profile, without involvement in further debt.
• Availability of finance markets that are not open to the company directly.

Note: An Interest Rate Swap is not a source or use of funds.
A swap is used to manage the interest rate risk associated with an underlying transaction.
Swaption (Option on Swap)
Swaptions are hybrid derivative products that integrate the benefits of swaps and options.
The buyer of a swaption has the right, but not the obligation, to enter an interest rate or
currency swap during a limited period of time and at a specified rate.
Swaptions require the payment of a premium, normally upfront.
Example:
You have borrowed RWF500,000 for a three year period. You want to protect your
firm against rising interest rates and guarantee a maximum cost of funds of 8%. At the same time
you want to be able to take advantage of any possible fall in interest rates. You buy a Swaption
from your bank at a rate of 8% for a three month period.
(1) Assume that in three month’s time the Interest Rate Swap rate for 2 3/4 years is at
8.5%. You make use of your Swaption and arrange an Interest Rate Swap for this period
at the agreed rate of 8%. Thus, your 8% cost of funds for the period is protected.
(2) Assume that in three month’s time the Interest Rate Swap rate for 2 3/4 years is at
7.5%. You do not want to take up your Swaption and instead you will borrow at the cheaper
rate of 7.5%. In these circumstances the Swaption protected you against a higher borrowing
cost and also allowed you to take advantage of the fall in rates.
Swaptions can also be used for cash managers (depositors) to protect against falling
interest rates while providing the freedom to enjoy any increase in interest rates.
The Swaption will provide full protection against rising interest rates but the freedom to benefit
if rates move lower.
Swaptions can be tailored to meet one’s needs.
Swaptions can be provided in all major currencies for a wide range of maturities. The option
period can last for any length of time, but generally no longer than 12 months.
A Swaption can be negotiated with any bank. It does not have to be with the bank who lent the
money.
The premium will depend on the guaranteed rate compared with the Interest Rate Swap rate, the
duration of the Swaption and how interest rates may perform in the future.

Financial Futures
The Futures Market has long been a risk management tool in the commodities markets, used
for forward buying/selling of everything from coffee beans to tin. Its advantages will be familiar
to a manufacturer who relies on raw materials whose prices are susceptible to cyclical variances.
A futures contract can be described as a binding agreement to buy/sell through an

established Exchange, at a specified price, on a definite date, a standard quantity of a commodity
of predetermined quality on fixed conditions of delivery.
In the case of Financial Futures the commodity is currency or financial paper. They were first
traded in the International Money Market in Chicago in 1972. In the U.K. the London International
Financial Futures Exchange (LIFFE) opened in September 1982.
Futures contracts are standardised - the size of each contract and the maturity dates are
standard. They offer an alternative covering mechanism for currency and interest rate risk. Actual
or anticipated risks in money or foreign exchange markets (cash markets) can be minimised by
taking an equal and opposite position in the futures market. Any cash market loss resulting from
adverse exchange or interest rate movements should be offset by profits on futures contracts
(and vice versa).
Although each futures deal is negotiated between the buying and selling parties, the actual
financial transaction is conducted by the Exchange’s clearing house. By interposing itself
between the two transacting parties it provides a guarantee against default.
Note: No exchange of principal takes place.
To avoid the risk of default by holders of contracts a purchaser/seller of a futures contract

must deposit an Initial Margin with the clearing house, effectively as security. This Initial Margin
is very small relative to the size of the contract. As prices fluctuate each day the value of the
outstanding contracts will change. If the price has moved in favour of the contract-holder, the
surplus (called a variation margin) is added to the Margin Account and is available for distribution
to the contract-holder. Similarly, if the price moves against the contract-holder he must cover any
losses to ensure that at the close of every business day his total margin, net of losses, is equal
to the Initial Margin. The Initial Margin is set at a level which is unlikely to be exceeded by losses
arising from the price movement of any one day
Example
It is 1st June and a company treasurer has a RWF10m. loan which is rolled over every
quarter. The next rollover is end of August and he fears that rates will rise in the interim. He
wishes to hedge his exposure, using interest rate futures. The current price of September RWF
three month time deposit futures is 88.00. The standard contract size is RWF500,000.

Cash Market Futures Market
1st June
RWF10m borrowing – rollover end
August
Sell 20 INTERBANK September Futures contracts Rate = 12%

At 88.00 (Futures rate = 12%)
End August
Rollover loan Buy 20 INTERBANK September Futures contracts
Current rate = 14% At 86.00 (Futures rate = 14%)
Higher Cost of Borrowing: Profit on Futures contracts:
RWF10m x 2% x 3/12 20 contracts x interest rate movement x
3/12
= RWF50,000 = RWF50,000
* The additional cost of borrowing is offset by the profit on the Futures contracts.
Using the above example, if the treasurer gets it wrong and interest rates fall the position
is:
Cash Market Futures Market
1st June
RWF10m borrowing – rollover end
August
Sell 20 INTERBANK September Futures contracts
Rate = 12% At 88.00 (Futures rate = 12%)
End August
Rollover loan Buy 20 INTERBANK September Futures contracts
Current rate = 10% At 90.00 (Futures rate = 10%)
Lower Cost of Borrowing: Loss on Futures contracts:
RWF10m x 2% x 3/12 10 contracts x interest rate movement x
3/12
= RWF50,000 = RWF50,000
* The unexpected “saving” on borrowing is offset by the loss on the Futures

contracts.

The Futures Market can also be used to cover Foreign Exchange risk.
Example
A U.K. company which imports from the U.S.A. is due to pay $4m. in February. It is now
November and the company wishes to protect against a strengthening of the $.
The spot rate is $1.603 - $1.605 /£
The March $/£ Futures is quoted at $1.60 (Note: contracts are in units of £25,000).
Based on the spot rate $4m = £2,495,321 [$4m./1.603 (sell rate)].
The company can sell 100 March contracts at $1.60 ($4m/1.60 = £2.5m, requiring 100
£25,000 contracts).
Assume that in February the $ has strengthened and the following rates are quoted: Spot
Rate: $1.5500 - $1.5523
Futures Price: $1.5525
The company will:
1. Buy $4m. in the spot market at 1.5500 (sell rate). The cost is £2,580,645 (£85,324 dearer
than the spot cost on 15th November.
2. Close-out the Futures contracts at 1.5525, by buying 100 Sterling March contracts.
The cost is $3,881,250 (£2.5m. x 1.5525). Thus, the gain on the Futures contracts is
$118,750 ($4m. - $3,881,250) or £76,499 [$118,750/1.5523 (spot buying rate)]. This would be
taken in margin surplus during the life of the contract.
Summary:
Cost – Spot Market £2,580,645
Gain on Futures £76,499
Net Cost £2,504,146
* Compared with the spot cost in November this is only £8,825 dearer.

Study Unit 6
PORTFOLIO THEORY
Contents
• Portfolio diversification, estimate the risk and return of a portfolio
• The relevance of portfolio theory to practical financial management.
• The Capital Assets Pricing Model (CAPM) – application and limitations.
• APT Arbitrage pricing theory application and limitations.
• Portfolio management strategies

INTRODUCTION
A portfolio is a collection of different investments which comprise an investor’s total
investments. For example, a property investor’s portfolio may consist of many investment
properties in different locations and which are used for varied purposes. Other examples of a
portfolio are an investor’s holding of shares, or a company’s investment in many different capital
projects. Portfolio Theory is concerned with setting guidelines for selecting suitable shares,
investments, projects etc. for a portfolio.
PORTFOLIO RISK AND RETURN
By investing all of one’s funds in a single venture the whole investment may be lost if the
venture fails. However, by spreading the investment over a number of ventures the risk
of losing everything will be reduced. If one of the ventures fails only a proportion of the
investment will be lost and hopefully, the remainder will provide a satisfactory return.
Example
An investor has RWF100,000 to invest. He is considering two companies A and B but is

unsure as to which company to select. He expects that either company will produce a return
of 12%, which is acceptable. As he is a little worried about the risk of the investments he
eventually decides to invest RWF50,000 in each company.
What actually transpires is that company A produces a return of 22% but company B
produces a disappointing return of only 2%. By diversifying – i.e. by holding shares in both
companies - the investor achieves an overall return of 12% (1/2 x 22% + 1/2 x 2%). If he had
invested all of the RWF100,000 in company B a return of only 2% would have been
achieved. Thus, the risk of achieving a less than satisfactory return has been reduced by
investing in both companies. The exceptional return of company A has offset the poor return of
company B.
Investors are generally risk-averse and will seek to minimise risk where possible. The
objectives of portfolio diversification are to achieve a satisfactory rate of return at minimum risk
for that return.
A portfolio is preferable to holding individual securities because it reduces risk whilst still
offering a satisfactory rate of return – i.e. it avoids the dangers of “putting all your eggs in
one basket”
When investments are combined, the levels of risk of the individual investments are not
important. It is the risk of the portfolio which should considered by the investor. This
requires some measure of joint risk and one such measure is the coefficient of correlation.
The relationship between investments can be classified as one of three main types:
1. Positive Correlation – when there is positive correlation between investments if one performs
well (or badly) it is likely that the other will perform similarly. For example, if you buy shares in
one company making umbrellas and another which sells raincoats you would expect fine weather
to mean that both companies suffer. Likewise, bad weather should bring additional sales for both
companies.
2. Negative Correlation – if one investment performs well, the other will do badly and vice versa.
Thus, if you hold shares in one company making umbrellas and another which sells ice-cream, the
weather will affect the companies differently.

3. No Correlation – the performance of one investment will be independent of how another
performs. If you hold shares in a mining company and a leisure company it is likely that there
would be no obvious relationship between the profits and returns from each.
The Coefficient of Correlation can only take values between –1 and +1. A figure close to +1
indicates high positive correlation and a figure close to –1 indicates high negative correlation. A
figure of 0 indicates no correlation.
It is argued that if investments show high negative correlation then by combining them in a
portfolio overall risk would be reduced. Risk will also be reduced by combining in a
portfolio securities which have no significant correlation at all. If perfect negative correlation
occurs, portfolio risk can be completely eliminated but this is unlikely in practice.
Basic assumptions of CAPM
1. Investors are rational and they choose among alternative portfolios on the basis of each
portfolio’s expected return and standard deviation.
2. Investors are risk averse.
3. Investors maximise the utility of end of period wealth. Thus CAPM is a single period model.
4. Investors have homogeneous expectations with regard to asset return. Thus all investors will
perceive the same efficient set.
5. There exist a risk-free asset and all investors can borrow and lend at this rate.
6. All assets are marketable and perfectly divisible.
7. The capital market is efficient and perfect.
EFFICIENT PORTFOLIO AND THE EFFICIENT FRONTIER
Efficient portfolios can be defined as those portfolio which provide the highest expected return
for any degree of risk, or the lowest degree of risk for any expected return.
The investor should ensure that he holds those assets which will minimise his risk. He should
therefore diversify his risk.
The risk can be divided into two:
a. The diversifiable (unsystematic) risk;
b. The non-diversifiable (systematic) risk.
The diversifiable risk is that risk which the investor can be able to eliminate if he held an efficient portfolio.
The non-diversifiable risk on the other hand is those risks that still exist in all well diversified efficient portfolios.

The investor therefore seeks to eliminate the diversifiable risk. This can be shown below:
From the graph shown above as the number of assets increases, the portfolio risk reduces
up to point M. At this point the lowest risk has been achieved and adding more assets to the
portfolio will not reduce the portfolio risk.
An efficient portfolio therefore is well diversified portfolio.

Note: The non-diversifiable risk can also be referred to as the market risk.
EFFICIENT SET OF INVESTMENT
If consider many assets, the feasible set of investment will be given by the following graph

The shaded area is the attainable set of investment. However, investors will invest in a
portfolio with the highest return at a given risk or the lowest risk at a given return. The efficient
set of investment, therefore, will be given by the frontier B C D E. This frontier is referred to as
the Efficient Frontier.
Any point on the efficient frontier dominates all the other points on the feasible set.
SYSTEMATIC AND UNSYSTEMATIC RISK
When securities are combined in a portfolio part of each security‟s total risk (its standard
deviation) is eliminated. This is the basis of diversification. That part of an individual security‟s
total risk which can be eliminated by combining that security with an efficient portfolio is called
unsystematic (or specific) risk. The balance of an individual security‟s total risk (that part which
cannot be eliminated by diversification) is called systematic (or market) risk.
Unsystematic Risk – risk which can be eliminated by diversification. It is the variation in a

company‟s returns due to specific factors affecting that company and not the market as a
whole, e.g. strikes, the breakdown of machinery, changes in fashion for that company‟s products
etc. This specific risk is a random fluctuation uncorrelated with the returns on the market
portfolio (the market as a whole). Therefore, when a large number of shares are held these
random fluctuations tend to cancel out – i.e. there is risk reduction.
Systematic Risk – risk which cannot be eliminated by diversification. This is the fluctuation
in returns due to general factors in the market affecting all companies e.g. inflation, government
policy, economic conditions etc. It is that part of the fluctuations in returns which is correlated with
those of the market portfolio.
When a capital asset (S) is combined with no other assets, the risk of the portfolio is simply the
standard deviation of (S). When further assets are added, however, the contribution of (S) to the
portfolio risk is quickly reduced – diversification is eliminating the unsystematic risk.
It takes a surprisingly low number of shares in a portfolio to eliminate the majority of unsystematic
risk (twenty shares in a portfolio will eliminate approximately 94% of unsystematic risk). All
unsystematic risk could only be eliminated when the market portfolio is held.
Only systematic risk is relevant in calculating the required return on capital assets. This is because,
on the assumption that investors hold efficient portfolios, unsystematic risk is automatically
eliminated when another asset is incorporated within that portfolio. The only effect an asset has
on portfolio risk is through its systematic risk.
Some investments may be regarded as risk-free – such as investment in government bonds. .

Investors in risky investments should expect to earn a higher return than investors in risk-free
investments, to compensate for the risks they are taking. Thus, if investors in Bonds can
obtain a return of, say, 6%, an investor in a risky asset should expect a yield in excess of 6%. The
Capital Asset Pricing Model uses this approach of rewarding investors in risky assets with a
premium on top of the yield on risk-free assets. The CAPM is:
Rs = = Rf+ β(Rm-Rf)
Where:
Rs = The expected return on a capital asset(s)
Rf = The risk-free rate of return

β= A measure of the systematic risk of the capital asset (the
Beta factor)
Rm = The expected return from the market as a whole
This is a very important formula. Note that the expected return (Rs) is equal to the risk-free rate
of return (Rf) plus an excess return or premium (Rm - Rf ) multiplied by the asset‟s Beta
factor. You may see different symbols in many textbooks but the same principles apply.
The Beta factor is a measure of the systematic risk of the capital asset. Thus, if shares in
ABC Ltd tend to vary twice as much as returns from the market as a whole, so that if market
returns increase by, say, 3%, returns on ABC Ltd shares would be expected to increase by
6%. Likewise, if market returns fall by 3%, returns on ABC Ltd shares would be expected to fall
by 6%. The Beta factor of ABC Ltd shares would, therefore, be 2.0.
R1 security market line
RF
0 B
All correctly priced assets will lie on the security market line. Any security off this line will either
be overpriced or underpriced.
The security market line therefore shows the pricing of all asset if the market is at equilibrium.
It is a measure of the required rate of return if the investor were to undertake a certain amount
of risk.
Example
The returns from the market as a whole have been 15% for some time, which compares with
a risk-free rate of return of 7%. Alpha Ltd‟s shares have a Beta factor of 1.25. What would be
the expected returns for Alpha‟s shares if:

Market returns increased to 16% Market returns slumped to 9%
1. Rs= = Rf+ β(Rm-Rf)

= 7% + 1.25(16% - 7%)
= 7% + 11.25%
= 18.25%
2. Rs = Rf+ β(Rm-Rf)
= 7% + 1.25(9% - 7%)
= 7% + 2.5%
= 9.5%
The CAPM provides a useful technique for calculating costs of capital and discount rates
appropriate to capital projects based on their individual levels of risk. However, there are two
drawbacks to the practical application of the CAPM. Firstly, the data necessary to calculate
Beta factors and the difficulty in obtaining them. Secondly, the assumptions on which the
model is based, which question the validity of the model itself.
In conclusion, although the CAPM can be criticised it is nevertheless a very useful model in
dealing with the problem of risk.
LIMITATIONS OF CAPM
CAPM has several weaknesses e.g.
a. It is based on some unrealistic assumptions such as:
i. Existence of Risk-free assets
ii. All assets being perfectly divisible and marketable (human capital is not divisible)
iii. Existence of homogeneous expectations about the expected returns
iv. Asset returns are normally distributed.
b. CAPM is a single period model—it looks at the end of the year return.
c. CAPM cannot be empirically tested because we cannot test investors expectations.
d. CAPM assumes that a security’s required rate of return is based on only one factor (the stock market—
beta). However, other factors such as relative sensitivity to inflation and dividend payout, may influence
a security’s return relative to those of other securities.
The Arbitrage pricing theory is designed to help overcome these weaknesses.

ARBITRAGE PRICING THEORY (APT)
Formulated by Ross(1976), the Arbitrage Pricing Theory(APT) offers a testable alternative to the
capital market pricing model(CAPM). The main difference between CAPM and APT is that CAPM
assumes that security rates of returns will be linearly related to a single common factor- the rate
of return on the market portfolio. The APT is based on similar intuition but is much more general.
APT assumes that, in equilibrium, the return on an arbitrage portfolio (i.e. one with zero
investment, and zero systematic risk) is zero. If this return is positive, then it would be eliminated
immediately through the process of arbitrage trading to improve the expected returns. Ross
(1976) demonstrated that when no further arbitrage opportunities exist, the expected return
(E(Ri)) can be shown as follows:
E(Ri)=Rf + β1(R1-Rf)+β2(R2 -Rf)+--------+ βn(Rn-Rf)+έi
Where,
E(Ri) is the expected return on the security
Rf is the risk free rate
Βi is the sensitivity to changes in factor i
έi is a random error term.
APT and CAPM compared
The Arbitrage Pricing Theory (APT) is much more robust than the capital asset pricing model
for several reasons:
a. The APT makes no assumptions about the empirical distribution of asset returns.
CAPM assumes normal distribution.
b. The APT makes no strong assumption about individuals’ utility functions (at least
nothing stronger than greed and risk aversion).
c. The APT allows the equilibrium returns of asset to be dependent on many factors, not
just one (the beta).
d. The APT yields a statement about the relative pricing of any subset of assets; hence
one need not measure the entire universe of assets in order to test the theory.
e. There is no special role for the market portfolio in the APT, whereas the CAPM requires
that the market portfolio be efficient.
f. The APT is easily extended to a multi-period framework.
Since APT makes fewer assumptions than CAPM, it may be applicable to a country like Kenya.
However, the model does not state the relevant factors. Cho(1984) has, however, shown the
security returns are sensitive to the following factors: Unanticipated inflation, Changes in the
expected level of industrial production, Changes in the risk premium on bonds, and Unanticipated
changes in the term structure of interest rates
Illustration
Security returns depend on only three riskfactors-inflation, industrial production and the
aggregate degree of risk aversion. The risk free rate is 8%, the required rate of return on
a portfolio with unit sensitivity to inflation and zero-sensitivity to other factors is 13.0%, the
required rate of return on a portfolio with unit sensitivity to industrial production and zero
sensitivity to inflation and other factors is 10% and the required return on a portfolio with unit

sensitivity to the degree of risk aversion and zero sensitivity to other factors is 6%. Security i
has betas of 0.9 with the inflation portfolio, 1.2 with the industrial production and-0.7 with risk
bearing portfolio—(risk aversion)
Assume also that required rate of return on the market is 15% and stock i has CAPM beta of
1.1
REQUIRED:
Compute security i’s required rate of return using
a. CAPM
b. APT
Using APT Ri = 8% + (13% - 8%)0.9 + (10% - 8%)1.2 + (6% - 8%)(-.7)
= 16.3%
Using CAPM Ri = RF + (E(RM) - RF)ßi
Ri = 8% + (15% - 8%)1.1 = 15.7%
LIMITATIONS OF APT
APT does not identify the relevant factors that influence returns nor does it indicate how many
factors should appear in the model. Important factors are inflation, industrial production, the
spread between low and high grade bonds and the term structure of interest rates.
PORTFOLIO MANAGEMENT PROCESS

Investment management also known as portfolio management is a complex activity though
most of us hold several portfolios. Almost all of you have some sort of investments though they
may not be as sophisticated as financial assets. A portfolio is a basket of various Assets or an
Asset Mix. The following process applies to portfolio management:
The investment process undergoes several steps as follows:
1. Determine or specify the investment objectives and constraints. The typical objectives
sought by investors are current income capital appreciation, and safety of principal. The relative
importance of each should be determined. The constraints arising from each asset such as
its liquidity, time horizon, tax, convenience and special circumstances should be identified
beforehand.
2. Choice of the Asset Mix; The most important decision in portfolio management is the asset
mix. This is concerned with the proportions of stocks (equity shares, mutual fund shares) and
bonds (fixed income securities). This can be likened to identifying a “pool” of potential investment
assets. The appropriate stock-bond mix depends on the risk-tolerance and investment horizon
of a particular investor.
3. Formulation of Portfolio strategy; Once a certain asset mix is chosen an appropriate portfolio
strategy is formulated. There are two broad avenues:
 The active portfolio strategy: this strives to earn superior risk-adjusted returns through
appropriate market timing (buying and selling at right market times), sector rotation

(changing from underperforming to superior performing sectors) and security selection.
These enjoy playing the game of investing.
 The passive portfolio strategy: Involves holding a broadly diversified asset mix and
maintaining a predetermined level of risk exposure.
4. Selection of securities: Generally, investors pursue the active portfolio strategy to select the
securities. The factors considered to select bonds (fixed income securities) are yield to maturity,
credit rating, term to maturity, tax shelter and liquidity.
5. Portfolio execution/implementation: This is concerned with actual buying and selling of

assets in given amounts.
6. Portfolio revision: The value of an asset or portfolio as well as its composition i.e. the relative
proportions of stock-bond instruments, may change as stock and bond value fluctuate. In
response to such normal and regular changes, especially with stock, it is necessary to review
the portfolio mix regularly. This may call for sector rotation or security switching (selling some
category assets and investing in a different category of security)
7. Performance evaluation: The performance of a portfolio should be evaluated periodically. The

key factor in performance evaluation is the Risk-Return assessment. Such assessment may
provide useful indicators in order to improve investment/portfolio management.
A simpler version of the above process would be:
i. Determine the investment objectives and constraints
ii. Undertake Security Analysis
iii. Construct Portfolio
iv. Review Portfolio
v. Evaluate Performance of the portfolio
Performance evaluation
Performance evaluation is a term for assessing how well a money/fund manager achieves a balance
between high returns and acceptable risks.
Can anyone consistently earn an “excess” return, thereby “beating” the market?Performance Evaluation
Measures
The raw return on a portfolio, RP, is simply the total percentage return on a portfolio.
The raw return is a naive performance evaluation measure because:
The raw return has no adjustment for risk.
The raw return is not compared to any benchmark, or standard.
Therefore, the usefulness of the raw return on a portfolio is limited.

1. Treynor ratio
The Treynor ratio is a reward-to-risk ratio that looks at systematic risk only.
It is computed as a portfolio’s risk premium divided by the portfolio’s beta coefficient.
Rp − Rf
Treynor ratio =
âp
• Risk premium per unit of market risk

• The higher, the better the performance
• Implies a diversified portfolio
2 The Sharpe ratio
The Sharpe ratio is a reward-to-risk ratio that focuses on total risk.

It is computed as a portfolio’s risk premium divided by the standard deviation for the portfolio’s
return.
Rp − Rf
Sharpe ratio =
óp
– Risk premium per unit of risk
– The higher, the better the performance
Provides a ranking measure for portfolio
3 Jensen’s alpha
Jensen’s alpha is the excess return above or below the security market line. It can be
interpreted as a measure of how much the portfolio “beat the market.”
It is computed as the raw portfolio return less the expected portfolio return as predicted by the
CAPM.
á p = R p − { R f + â p × [E(R M ) −R f ] }
“Extra” Return Actual return CAPM Risk-Adjusted ‘Predicted’ Return
EXAMPLE
The return of the market portfolio is 14.7% and the treasury bill rate is 8.4%. The Manager of
convection investor’s ltd has gathered the following data on three stock portfolios:
Stock Portfolio Expected return (%) Beta of the portfolio Std. Dev. of the portfolio return

X 12.6 0.95 1.9
Y 16.8 1.10 2.3
Z 18.9 1.26 2.4
The standard deviation of the returns of the market portfolio is 2.1%.

Required
Evaluate the performance of each portfolio using:
(i) Treynor’s portfolio measure
(ii) Sharpe’s portfolio measure
(iii) Jensen’s portfolio measure

Study Unit 7
FINANCIAL ANALYSIS AND BUSINESS PLANNING
Contents
• Preparation of long-term business plans from prescribed information.

• Appraise capital investment options using NPV,IRR,APV and Pay back criteria.
• Evaluation of a business plan from the perspective of an equity investor or provider of debt
funding.
• Assessment current financial position.
• Comparison and evaluation of the financial management of an organization with that of
competitorsand industry norms.
• Preparation, evaluation and discussion of key financial management indicators based on
the published financial statements of an enterprise..
• Benchmarking of selected financial KPIs against companies in the same industry sector.

Business Plans
INTRODUCTION
There are many reasons why companies prepare Business Plans. One of the most common
reasons is where the promoters of the company are intending to raise finance and a detailed
Business Plan is required for presentation to potential investors.
CONTENTS OF BUSINESS PLAN

The Business Plan must be well constructed and provide sufficient detail to enable a potential
investor to decide in principle, whether the company is a candidate for investment.
The Business Plan should include the following:
1. Executive Summary
Potential investors often make an initial judgement based on the content of the
Executive Summary and their decision to read the detailed content of the Business Plan will
depend on its content.
While the Executive Summary is shown at the front it should not be completed until the Business
Plan has been written. It will highlight all milestones in the company’s development over the next
five years. At minimum, it should summarise the following:
Purpose of the Plan
Product or Service and its advantages
Market Opportunity
Management Team
Track record, if any
Financial Projections – sales, net profit before tax, investment etc.
Funding Requirements
2. Company Description Promoters and

Shareholders Promoters
Management structure and areas of responsibility
Shareholders names, % shareholding, cash invested to date
Advisors
Financial, legal and other advisors with contact details
Products and Services Explain

the product/service Background to
development Benefits and features
Unique selling point Advantages to

customers Disadvantages or weak

points Future developments
Long Term Aim of Business
Objectives
Specific objectives to be achieved over next five years (sales, exports, employment,
product development etc.)
SWOT Analysis
Analyse the strengths and weaknesses of the business and product/service, the
opportunities that exist in the marketplace and the threats to the viability of the project.
3. Market Analysis
This covers market research and competitor analysis and demonstrates that the research
undertaken justifies the projections made in the plan and indicates a viable market exists for
the product/service.
Target Market
Analyse the market:
Size of each segment
Is the segment growing or declining?
Characteristics of potential customers in each segment
Total Market Valuation
Show the total potential value of the market for the product/service, in all targeted
markets (domestic and international).
Target Company Revenue
The basis for the sales figures in the financial projections and must be based on realistic
assumptions. Include average deal size, length of sales cycle, recurring revenues.
Market Trends
Recent changes Future predictions
Drivers – demographic changes, economic and legislative factors
Implications for company product/service
Plans to meet future demands and changes in the market

Profile of Competitors
What are the competing products/services
Profile of key players (size, turnover, profitability etc.) and their market share
Advantages and disadvantages of competitors’ offerings
Competitive Advantage
Why potential customers will choose company’s product
Unique features
Price
New technologies or systems
Better value (efficiency, ROI, cost/benefit) Greater

compatibility with existing systems Include any
independent validation
Benefits to Clients
What does product/service provide to potential customers?
Increase sales Increase

efficiencies Save money
Save time
Maximise resources Reduce

errors Reduce downtime
Improve customer service, increase loyalty
4. Marketing/Sales Strategy
Strategies for reaching target market, generating interest in the product/service and
actually achieving sales.
Marketing Strategy
Which segments of the market will be targeted first and why
How will product/service be differentiated
What potential customers have already been targeted
Is test site in operation and what is feedback
What contacts can be used to generate market awareness and sales
Who will do the marketing – staff, agency, representatives
Sales Strategy

How will product/service be sold
Directly Retail
Distributor Agent
Sales Representatives
Website
State the advantages of the methods chosen
Pricing
How will price charged be set? Consider
Competitors’ prices
Level of competition in market
Perception of quality-price relationship by customers
Production costs and overheads
Marketing and Communications Strategy
How will product/service be promoted in the marketplace?
Advertising – where, when, how and whom
Public Relations
Direct Marketing
Website and internet marketing

Exhibitions and conferences Word of
mouth
5. Research and Development
Intended future development of product/service. Detail plans for new
products/services. List all technical partners and indicate nature of involvement.
State any protection available for product/service – patented, copyright or trademark

registration and brand image to be built up as protection against competition.
6. Staffing and Operations
Outline intended structure of the company – management, number of employees and

physical operations.
Management (including Board) Organisation Chart
Areas of responsibility of each manager
Staffing
What employees will be hired over the next three years, skills and in which areas?

Training
Planned employee and management development. Should tie-in with future
product/market developments.
Operations
Premises
Equipment
Production facilities
Infrastructure
Communications facilities
Suppliers
7. Financial Projections
Key Assumptions
Income sources
Number of employees projected for each year and their salaries
Projected investment in equipment and materials
Projected R & D costs
Depreciation policy
Expected rent and rates charges Creditor

and Debtor days expected Expense
calculations
Profit & Loss Accounts
Projected for first three years of operations
Balance Sheets
Projected for first three years of operations
Cash flow
Monthly cash flow predicted for the first two years of operations
8. Sales Pipeline
Analyse pipeline business – customer, size of deal, date expected, probability of
achieving sale etc.

9. Funding Requirements
Total funding requirements and how these are to be provided. Also state approximate
breakdown of how funds are to be spent.
Sources Promoters’ funds

Bank lending
Grants or loans from agencies

Investment already received
Investment sought
Spending
Equipment R & D
Marketing Staffing
10. Appendices
Provide detailed data on which the main text of the plan is based and extra information
of interest to the readers. Details will vary from business to business but may include:
Promoters’ CVs
Detailed financial assumptions
Most recent company audited accounts Share

capital table and investment history Term sheet
from potential investors Detailed market research
findings Promotional literature
Product or service information
Details of company website
Testimonials or letters of intent from customers
INVESTMENT APPRAISAL TECHNIQUES
There are many techniques for evaluating investment proposals. These can be broadly
classified as:
Non-Discounting
Payback Period
Accounting Rate of Return (ARR)
Discounted Cash Flow

Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Definition: The time taken in years for the project to recover the initial investment. The shorter the
payback, the more valuable the investment.
Example
An initial investment of RWF50,000 in a project is expected to yield the following cash flows:
Cash Flow
Year 1 RWF20,000
Year 2 RWF15,000
Year 3 RWF10,000
Year 4 RWF10,000
Year 5 RWF8,000
Year 6 RWF5,000
The Payback Period is 3 1/2 years - the cash inflows for that period equal the initial outlay of
RWF50,000.
Is 3 1/2 years acceptable? - It must be compared to the target which management has set. For example,
if all projects are required to payback within, say, 4 years this project is acceptable; if the target payback
is 3 years then it is not acceptable.
Although of limited use it is the most popular technique. It is often

used in conjunction with other techniques.
It may be used as an initial screening device.
Advantages
• Calculation is simple.
• It is easily understood
• It gives an indication of liquidity.
• It gives a measure of risk - later cash flows are more uncertain.
• It considers cash flow rather than profit – profit is more easily manipulated.
Disadvantages
• Cash flows after the Payback Period are ignored.

• It ignores the timing of the cash flows (“Time Value of Money”).
• No clear decision is given in an accept/reject situation.

Accounting Rate of Return (ARR)
Definition:
Average Annual Accounting Profits *100

ARR =
initial investment
(Alternative definitions may be used occasionally - e.g. „Average Investment‟ may replace
„Initial Investment‟).
The Accounting Rate of Return is based upon accounting profits, not cash flows.
Example
A company is considering an investment of RWF100,000 in a project which is expected to last for

4 years. Scrap value of RWF20,000 is estimated to be available at the end of the project. Profits
(before depreciation) are estimated at:
Year 1 RWF50,000
Year 2 RWF50,000
Year 3 RWF30,000
Year 4 RWF10,000
Find the Accounting Rate of Return
Total Profits Before Depreciation RWF140,000
Less Total Depreciation (RWF80,000)
Total Accounting Profits RWF60,000
Average Annual Profits (4 years) RWF60,000 = RWF15,000
ARR = RWF15,000 = 15%
RWF100,000
To ascertain if the project is acceptable the ARR must be compared to the target rate which
management has set. If this target is less than 15% the project is acceptable; if greater than 15%
the project is unacceptable.
Advantages
• Calculation is simple.
• It is based upon profits, which is what the shareholders see reported in the annual

accounts.
• It provides a % measure, which is more easily understood by some people.
• It looks at the entire life of the project.
Disadvantages
• It is a crude averaging method.

• It does not take account of the timing of the profits.
• It is based on accounting profit which can be manipulated by creative accounting.
Shareholders‟ wealth is determined by cash.
Varied Definitions are used.
Discounted Cash Flow (DCF)
The main shortcomings of the non-discounting techniques of Investment Appraisal can be
summarised as:
• They do not allow for the timing of the cash flows/accounting profits
• They do not evaluate cash flows after the payback period
• They do not allow for the changing value of money over a medium to long term
Discounted Cash Flow addresses these shortcomings, by allowing for the “time-value of money” and
looking at all cash flows. So what is discounting? Discounting can be regarded as Compound Interest
in reverse. To understand Compound Interest let us take a simple example.
Example
If you invest RWF100 and are guaranteed a return of 10% per annum we can work out how much
your investment is worth at the end of each year.
PRESENT VALUE FUTURE VALUE
End of Year 1 RWF100 x (1.10) = RWF110.00
End of Year 2 RWF100 x (1.10)(1.10) = RWF121.00
End of Year 3 RWF100 x (1.10)(1.10)(1.10) = RWF133.10
For simplicity this can be re-written
End of Year 1 RWF100 x (1.10)1 = RWF110.00
1.1 to power of 1
1.1 to power of 2
1.1 to power of 3

In general terms we can express this as:
n
PV (1 + i) = FV
Where:PV = Present Value
i = Rate of Interest
n = Number of Years/Periods
FV = Future Value
We are starting with a Present Value (RWF100) and depending on the rate of interest used (i) (above
10%) and the duration of the investment (n) we can find the Future Value, using Compound Interest.
As mentioned above, Discounting is Compound Interest in reverse. Thus, using the

statement
PV (1 + i)n = FV we can turn it around to get
FV 1
--------- = PV or FV x ------- = PV (1 + i)
n (1 + i)n
Again, taking the example above, if you are given the Future Value and asked to find the
Present Value
FUTURE VALUE PRESENT VALUE
End of Year 1 1 = RWF100

RWF110.00 x
1
(1.10)
End of Year 2 = RWF100

RWF121.00 x 1
2
(1.10)
End of Year 3 = RWF100

RWF133.10 x 1
3
(1.10)
In effect, what you are doing is ascertaining the amount which must be invested now at 10% per
annum to accumulate to RWF110 in a year‟s time (or RWF121.00 in two years; or RWF133.10 in
three years).

In converting the Future Value to a Present Value it is multiplied by a factor (Discount
Factor), which varies depending on the discount rate (i) selected and the number of years/periods
(n) into the future. Fortunately, it is not necessary individually to calculate each factor, as these
can be easily obtained from DISCOUNTING TABLES (attached). These tables supply a factor
for all % rates and periods.
The previous example is reproduced using the Discounting Tables, at 10%
FUTURE VALUE PRESENT VALUE
End of Year 1 RWF110.00 x. 909 = RWF100
End of Year 2 RWF121.00 x 826 = RWF100
End of Year 3 RWF133.10 x 751 = RWF100
The compounding and discounting features shown above relate to single payments or receipts
at different points in time. Similar calculations can be done for a series of cash flows, where
a single present value can be calculated by aggregating the present value of several future
cash flows.
ANNUITIES
An annuity is where there is a series of cash flows of the same amount over a number of
years.
The present value of an annuity can be found by discounting the cash flows individually (as
above).
Example
Using a discount rate of 10% find the present value of an annuity of RWF2,000 per annum
for the next four years, with the first payment due at the end of the first year.
Year Cash Flow Disc. Factor Present Value

(10%)
1 RWF2,000 RWF1,819
0.909
2 RWF2,000 0.826 RWF1,653
3 RWF2,000 0.751 RWF1,502
4 RWF2,000 0.683 RWF1,366
Net Present RWF6,340
Value
However, a much quicker approach is to multiply the annual cash flow by an annuity factor.
The annuity factor is simply the sum of the discount factors for each year of the annuity. In
this example the annuity factor is 3.17 (0.909 + 0.826 + 0.751 + 0.683). If you multiply the
RWF2,000 by the annuity factor of 3.17 you get RWF6,340, which is the same Net Present Value
as the longer approach adopted in the example. Annuity factors are available for all % rates and
periods in Annuity Tables (attached) and you will see the factor of 3.17 at period 4 under the
10% column.
In the above example the first receipt arose at the end of the first year. If this is not the case
you can still use the Annuity Tables but you must modify your approach. The present value
can be found by multiplying the annual cash flow by the annuity factor for the last date of the
annuity less the annuity factor for the year before the first payment.

Example
Using a discount rate of 10% find the present value of an annuity of RWF5,000 per annum,
which starts in year 5 and ends in year 10.
Annuity Factor Years 1 – 10 6.145
Therefore, the Present Value is RWF5,000 x 2.975 = RWF14,875.
PERPETUITIES
A perpetuity is an annuity which continues forever. To find the present value of a perpetuity
which starts at year 1 you use the following simple formula:
a
PV = i
where: a = amount for perpetuity i =

the discount rate
Example
The present value of a payment in perpetuity of RWF1,000 per annum, which commences at
the end of year 1, at a discount rate of 10% is:
a FRW 1,000
PV = = 10 = RWF10,000
i
If the payment commences at a time other than year 1 a further calculation is required.
Example
Using a discount rate of 10% find the present value of a payment in perpetuity of
RWFRWF1,000 per annum, if it commences (a) end of year 1, (b) immediately - year 0, or
(c) end of year 6.
(a)
A FRW 1,000
PV = I = 10 = RWF10,000
(b) PV = RWF10,000 as at (a) + PV of RWF1,000 in year 0
= RWF10,000 + RWF1,000 = RWF11,000
(c) We can find this in two stages.

The PV in year 5 of a perpetuity of RWF1,000 from year 6 onwards is
a FRW 1,000
PV = i = = RWF10,000
10
We must now convert this to a year 0 value, by discounting the RWF10,000 (year 5 value) at
10%.
PV = RWF10,000 x .621(Discount Factor for year 5 @ 10%) = RWF6,210
Net Present Value (NPV)

This technique converts future cash flows to a common point in time (Present Value), by
discounting them. The present values of the individual cash flows are aggregated to arrive at
the Net Present Value (NPV).
The NPV figure represents the change in shareholders’ wealth from accepting the project. It
produces an absolute value (RWF) and therefore, the impact of the project is identified.
For independent projects the decision rule is:
• Accept if the NPV is positive

• Reject if the NPV is negative
For mutually exclusive projects (where it is only possible to select one of many choices) -
calculate the NPV of each project and select the one with the highest NPV.
In calculating the NPV, the selection of a discount rate is vitally important. It is generally
taken as the cost to the business of long-term funds used to fund the project.
Example 1 - Independent Project

A company is considering a project, which is expected to last for 4 years, and requires an
immediate investment of RWF20,000 on plant. Inflows are estimated at RWF7,000 for each of
the first two years and RWF6,000 for each of the last two years. The company‟s cost of capital
is 10% and the plant would have zero scrap value at the end of the 4 years.
Calculate the NPV and recommend if the project should be accepted.
YEAR CASH FLOWS DISC. FACTOR 10% PRESENT VALUE

0 (20,000) 1.0 (20,000)
1 7,000 .909 6,364
2 7,000 .826 5,785
3 6,000 .751 4,508
4 6,000 .683 4,098
Net Present +755
Value
The project should be accepted as it produces a positive NPV. This indicates that the project
provides a return in excess of 10% (the discount rate used).

Example 2 - Mutually Exclusive Projects
A company has RWF100,000 to invest. It is considering two mutually exclusive projects
whose cash flows are estimated as follows:
YEAR PROJECT A PROJECT B

0 (100,000) (100,000)
1 50,000 70,000
2 60,000 50,000
3 40,000 30,000
Which project should the company select if its cost of capital is 10%
YEAR DISC FACTOR 10% PRESENT VALUE PROJECT B
0 1.0 (100,000) (100,000)

1 .909 45,450 63,630
2 .826 49,560 41,300
3 .751 30,040 22,530
Net Present Value + 25,050 + 27,460
Project B should be selected as it has the higher NPV.
Advantages
• Correctly accounts for the time value of money.

• Uses all cash flows.
• Is an absolute measure of the increase in wealth
• Consistent with the idea of maximising shareholder wealth i.e. telling managers to
maximise NPV is equivalent to telling them to maximise shareholder wealth.
• It can be used for benchmarking in post-audit review.
Disadvantages
Difficult to estimate cost of capital.
Not easily interpreted by management i.e. managers untrained in finance often have
difficulty in understanding the meaning of a NPV.
Internal Rate of Return (IRR)

The NPV method produces an absolute value in currency (RWF). A positive NPV indicates that
the project earns more than the required rate of return and should be accepted; a negative NPV
indicates a return less than the required rate and rejection of the proposal.
The IRR is another discounted cash flow technique. It produces a percentage return or yield,
rather than an absolute value. It is the discount rate at which the NPV would be zero - where the
present value of the outflows = present value of the inflows. It can, therefore, be regarded as the
expected earning rate of the investment.

If the IRR exceeds the company’s target rate of return it should be accepted. If less than the target
rate of return it should be rejected.
The IRR can be estimated by a technique called ‘Linear Interpolation‟. This requires the following
steps:
1. Calculate two NPV’s, using two different discount rates.
2. Any two rates can be used but, ideally, one calculation will produce a positive NPV and the other
a negative NPV.
3. Choosing the discount rate is a ‘shot in the dark.’ However, if the first attempt produces a positive
NPV, generally a higher discount rate will be required to produce a negative NPV and vice versa.
Example 3 - Internal Rate of Return

Using the cash flows from example 1, a discount rate of 10% produced a positive NPV of
RWF755. In an attempt to find a negative NPV try a higher rate of 15%.
YEAR CASH FLOWS DISC. FACTOR 15% PRESENT VALUE

0 (20,000) 1.0 (20,000)
1 7,000 .869 6,083
2 7,000 .756 5,292
3 6,000 .658 3,948
4 6,000 .572 3,432 Net
Present Value ( 1,245)
We now know that the real rate of return is > 10% (+ NPV) but < 15% (- NPV). The IRR is calculated
by ‘Linear Interpolation.’ It will only be an approximation of the actual rate as it assumes that the NPV
falls in a straight line (linear) from + RWF755 at 10% to - RWF1,245 at 15%. The NPV, in fact, falls in
a curved line but nevertheless the interpolation method is accurate enough. In this example the IRR is:
755
10% + x (15% - 10%) = 11.9%
755 + 1,245
Advantages
• Often gives the same decision rule as NPV.

• More easily understood than NPV.
• Doesn‟t require an exact definition of “r” in advance.
• Considers the time value of money.
• Considers all relevant cash flows over a project‟s life.

Disadvantages
• Relative, not absolute return -> ignores the relative size of investments.
• If there is a change in the sign of the cash flow pattern, one can have multiple IRR‟s.
• NPV is much easier to use for benchmarking purposes in a post-audit situation than
IRR.
• It looks at projects individually – the results cannot be aggregated.
• It cannot cope with interest rate changes
DCF Techniques v Non-DCF Techniques
DCF techniques have advantages over non-DCF techniques:
1. They allow for the ‘time value of money.’
2. They use cash flows, which result from an investment decision. The ARR technique is affected
by accounting conventions (e.g. depreciation, deferred expenditure etc.) and can be susceptible
to manipulation.
3. They take account of all cash flows. The Payback Period disregards cash flows after the payback
period.
4. Risk can be easily incorporated by adjusting the discount rate (NPV) or cut-off rate (IRR).
Advantages of IRR Compared To NPV
• It gives a percentage rate or return, which may be more easily understood by some.
•To calculate the IRR it is not necessary to know in advance the required rate of return
or discount rate, as it would be to calculate the NPV.
Advantages of NPV Compared To IRR
• It gives an absolute measure of profitability (RWF) and hence, shows immediately the change
• in shareholders’ wealth. This is consistent with the objective of shareholder wealth
maximisation. The IRR method, on the other hand, ignores the relative size of investments.
• It always gives only one solution. The IRR can give multiple answers for projects with non-
conventional cash flows (a number of outflows occur at different times).
• It always gives the correct ranking for mutually exclusive projects, whereas the IRR
technique may give conflicting rankings.
Changes in interest rates over time can easily be incorporated into NPV calculations but not
IRR calculations.
REPLACEMENT OF ASSET
An organisation may be faced with a decision on the best policy regarding the replacement of
assets. If the asset is to be replaced with an “identical asset” the question is how long to
retain the asset and the optimum interval between replacement ?
When making this decision the cash flows which must be considered are:

Capital Cost – the more frequent the replacement cycle, the more frequently this will be
incurred.
Maintenance/Running Cost – this tends to increase with the age of the asset.
Resale/Residual Value – this tends to decrease with the age of the asset.
EQUIVALENT ANNUAL COST
One method of identifying the optimum replacement cycle for an asset is to calculate the
Equivalent Annual Cost (EAC).
This technique examines the various replacement options and calculates the present value of
the total costs, over one cycle only. For example, if a machine has a life of three years there
are only three options – replace every year, every two years or every three years. For each
option identify the cash flows over one cycle:
• Replace every year - identify cash flows over a one year cycle
• Replace every two years – identify cash flows over a two year cycle
• Replace every three years – identify cash flows over a three year cycle
Finally, having obtained the present value of the cash flows over each cycle, convert them to an
Equivalent Annual Cost by dividing the total costs by the appropriate annuity factor (one year;
two year or three year).
Example
A machine has a life of three years and the following running costs and resale value are
estimated:
Year 1 Year 2 Year 3
Running Costs 15,000 20,000 25,000
Resale Value 35,000 25,000 15,000
The machine costs RWF50,000 and the company‟s cost of capital is 10%. Identify how
frequently the asset should be replaced. The Cash Flows for each cycle are:
Year Replace Replace Replace

Every Every 2 Every 3
Year Years Years
0 (50,000) (50,000) (50,000)
1 20,000 (15,000) (15,000)

2 5,000 (20,000)
3 (10,000)
The Present Values of the Cash Flows at 10% are:

Year Replace Replace Replace
Every Year
Every 2 Every 3
Years Years
0 (50,000) (50,000) (50,000)
1 18,180 (13,635) (13,635)
2 4,130 (16,520)
3 (7,510)
PV Total Costs (31,820) (59,505) (87,665)
(31,820) (59,505) (87,665)

Equivalent Annual Cost 0.909 1.736 2.487
= (35,005) (34,227) (35,249)
The optimum replacement cycle is every two years as this has the lowest cost
Capital Rationing
Capital Rationing is a situation where a company has insufficient capital to complete all
projects which it would like to undertake (e.g. those with a positive NPV).
Broadly, Capital Rationing can be described as:
Soft Capital Rationing – due to factors internal to the organisation. For example, projects
are limited to funds available from retentions; management are unwilling to commit to additional
debt due to the risk involved; the capacity of management to undertake many projects etc.
Hard Capital Rationing – due to factors external to the organisation. For example, restrictions
imposed on further borrowing due to a credit squeeze or lenders unwilling to provide further
funds due to risk factors; stock market depressed and share issue not acceptable etc.
RANKING OF PROJECTS
Example
A company is reviewing its capital expenditure budget and has identified five projects. Its
cost of capital is 10% and it has calculated the NPV of each project as follows:
Project Capital Investment NPV

A 100,000 10,000
B 400,000 36,000
C 300,000 21,000
D 600,000 51,000
E 700,000 62,000
The company only has RWF1.6m available for investment. Assume that the projects are
divisible and calculate the optimum solution.

If capital was not rationed the company should undertake all projects because they all have
positive NPV‟s. As capital is rationed (RWF2.1m. required to undertake all projects but only
RWF1.6m. available) it is necessary to use a technique which links the NPV with the Capital
Investment – calculate the Profitability Index (NPV per RWF of investment) and then rank the
projects by their Profitability Index.
Project Investment NPV Prof. Index Ranking

A 100,000 10,000 10,000/100,000 1
= 0.10
B 400,000 36,000 36,000/400,000 = 0.09 2
C 300,000 21,000 21,000/300,000 = 0.07 5
D 600,000 51,000 51,000/600,000 = 0.085 4
E 700,000 62,000 62,000/700,000 = 0.088 3
Optimum Solution
Project Investment NPV

A 100,000 10,000
B 400,000 36,00
E 700,000 62,000
D 400,000 (2/3rd) 34,000 (2/3rd)
1,600,000 142,000
rd
Thus, undertake all of projects A, B, and E and 2/3 of project D. Project C is not
undertaken. By doing only 2/3 of project D (the projects are divisible) the entire RWF1.6m. of
available funds are used.
If the projects are not divisible we must deal in whole projects. Calculate by “trial and error” the
combination of various projects which will use up to RWF1.6m. and select the combination with
the highest NPV. For example,
Projects Investment NPV

A, B, C, D 1,400,000 118,000
A, B, C, E 1,500,000 129,000
C, D, E 1,600,000 134,000
Thus, by undertaking projects C, D and E the highest combined NPV of RWF134,000 is

achieved.

POSSIBLE WAYS OF SOLVING CAPITAL RATIONING
1. Defer one or more projects to a later period when capital is not rationed
2. Share project(s) with another partner
3. Outsource part of a project (e.g. component)
4. Consider licensing/franchising
5. Seek alternative sources of funding (e.g. venture capital, sale & leaseback)
F. LEASE v BUY DECISION

The Traditional Method breaks the decision into two stages – Acquisition & Financing
Decisions:
1. Acquisition Decision - Is the asset worth acquiring? Operational cash flows are
discounted by the cost of capital normally applied to project evaluations – after-tax
cost of capital. If a positive NPV results, then proceed to Financing Decision
2. Financing Decision – Cash flows of the financing decision (lease v buy) are discounted
by the after-tax cost of borrowing.
Example
PP wishes to replace a piece of equipment, costing RWF120,000.This will produce

operating savings of RWF50,000 per annum and will have a life of five years. PP‟s after-tax
cost of capital is 15% and operating cash flows are taxed at 30%, one year in arrears.
PP can borrow funds at 13% to purchase the machine or alternatively, it could acquire it by
means of a finance lease costing RWF28,000 per annum for five years, the lease rentals
payable in advance. The machine is expected to have zero scrap value at the end of the five
years.
The machine qualifies for capital allowances on a reducing balance basis at the rate of 25%
per annum. However, due to its tax position PP is unable to utilise any capital allowances on
the purchase until year one.
Should PP replace the equipment and if so, should it buy or lease it?
Capital Allowances
1 RWF120,000 x 25% 30,000
2 RWF30,000 x 75% 22,500

3 RWF22,500 x 75% 16,875
4 RWF16,875 x 75% 12,656
82,031
Balancing Allowance: RWF120,000 - RWF82,031 37,969
120,000

Taxation
Savings Cap. Allowance Taxable Tax @ 30%
1 50,000 30,000 20,000 6,000
2 50,000 22,500 27,500 8,250
3 50,000 16,875 33,125 9,937
4 50,000 12,656 37,344 11,203
5 50,000 37,969 12,031 3,609
1. Acquisition Decision
Equipment Savings Taxation Net D.F. Pres. Val.

15%
0 (120,000) (120,000) 1.000 (120,000)
1 50,000 50,000 0.870 43,500
2 50,000 (6,000) 44,000 0.756 33,264
3 50,000 (8,250) 41,750 0.658 27,471
4 50,000 (9,937) 40,063 0.572 22,916
5 50,000 (11,203) 38,797 0.497 19,282
6 (3,609) (3,609) 0.432
(1,559)
24,874
As the NPV is positive PP should acquire the machine.
Now examine the Financing Decision (Lease v Buy).
2. Financing Decision
The cash flows associated with the two options (Lease and Buy) are discounted by a rate
appropriate to a financing decision => the after-tax cost of borrowing. We concentrate on
the financing cash flows – ignore any cash flows which are common e.g. sales revenue.
After-Tax Cost of Borrowing:
13% x (1 – t)
13% x 0.7
= 9.1% (say, 9%)

Buy:
Item Cash Flow D.F. 9% Pres.

Val.
1 Purchase (120,000) 1.000 (120,000)
2 Allowance 30,000 x 30% 9,000 0.842 7,578
3 Allowance 22,500 x 30% 6,750 0.772 5,211
4 Allowance 16,875 x 30% 5,063 0.708 3,585
5 Allowance 12,656 x 30% 3,797 0.650 2,468
6 Allowance 37,969 x 30% 11,390 0.596 6,788
Present Value of Cost (94,370)
Lease:
Lease Rental TAX Saving D.F. 9% Pres Val.
0-4 (28,000) 4.239 (118,692)

1-5 8,400 3.890 32676
Present Value of Cost (86,016)
Note: The discount factor for years 0-4 can be found by adding 1.0 (for the first instalment of
rental paid up-front) to 3.239 from the 9% Annuity Tables – year 3 (for the remaining three
rentals paid at the beginning of years 1, 2 and 3).
* Conclusion: It is cheaper to lease the machine rather than purchase

Investment Appraisal – Risk & Uncertainty
Definition of Risk
(a) (i) Risk occurs where it is not known what the future outcome will be but
where the
likelihood of various possible future outcomes may be assessed with some
degree
of confidence, probably based on a knowledge of past or existing events.
In other words, probabilities of alternative outcomes can be estimated.

(ii) Uncertainty occurs where the future outcome cannot be predicted with a
degree of confidence from a knowledge of past or existing events, so that
no probability
estimates are available.
Risk and uncertainty are the business risk of an investment.
(b) Business risk can be defined as the potential volatility of profits caused by the nature and
types of business operations.
There are three elements of business risk:
• The inherent risk of the industry or market itself

• The stage of the product life-cycle
• The proportion of fixed costs in total costs
METHODS OF TREATING RISK OR UNCERTAINTY
1. Adjust The Discount Rate
This method requires that risky projects should earn a higher return than that required
for ongoing operations. By adding a safety margin into the discount rate, what were marginally
profitable projects, i.e. the riskier projects, are less likely to have a positive NPV.
If, for example, the company’s cost of capital is 10% a premium of say, 5% might be added for
risk and the project evaluated using a discount rate of 15%. If the project still produces a positive
NPV at 15% it would be considered acceptable, even allowing for its risk.
The main advantage of this method is that it recognises that risky projects should earn a higher
return to compensate for the additional risk. The main drawback is in deciding the size of the
premium to be added. Thus, it is subjective and some may regard the method as unreliable.
2. Payback Period – Applying A Time Limit
In addition to requiring projects to yield a positive NPV when discounted at the cost of
capital, management may apply a payback period as a means of limiting risk. Thus, projects
may be required to:
Provide a positive NPV when discounted at, say 10%
and
Have a Payback Period of, say, 5 years or less
One of the drawbacks to this approach is that projects with very good long-term prospects
may be rejected because they do not offer the required return in the short- term.

3. Sensitivity Analysis
The impact of changes in individual variables is measured to see the extent of the
leeway before a project would only just breakeven. What would have to happen to the variable
for the NPV to change to zero?
In this way the key variables are highlighted so that management is aware of the dangers
of incorrect estimating and can perhaps make contingency plans in the event of this happening.
Example
Your company is considering a project with the following cash flows:
Year Machinery Running Costs Savings

0 (11,000)
1 (2,000) 6,000
2 (3,000) 8,000
3 (4,000) 9,000
The cost of capital is 10%. You are asked if the project should be accepted and what is the scope
for error as some of the estimates of cash flow may be open to question. Ignore taxation.
Firstly, work out the present value of the cash flows:
Year PV - PV – Costs PV – Savings PV Cash

Machinery Flows
0 (11,000) (11,000)
1 (1,818) 5,455 3,637
2 (2,479) 6,611 4,132
3 (3,005) 6,762 3,757
(11,000) (7,302) 18,828 526
The project has a positive NPV and would appear to be acceptable.
Secondly, check each of the variables (machinery, costs and savings) to see how sensitive they
are to change – i.e. by how much can they alter before the NPV is just zero. This can be done
by relating the NPV to the present value of each of the variables.
Machinery
526
= 4.8%
11,000
The cost of machinery could increase by 4.8%
Running Costs

526
= 7.2%
7,302
Running costs could increase by 7.2%
Savings
526
= 2.8%
18,828
Savings could reduce by 2.8%
If asked how sensitive the project is to changes in the cost of capital this can be found by calculating
the Internal Rate of Return (IRR). In the above example, the IRR is
12.5%. Thus, the cost of capital could increase by 25%, from the existing level of 10%, before the
NPV is just zero.
The conclusion is that savings are the most sensitive and particular attention must be paid by
management to the estimates of these as the margin for error is only 2.8%. They could take
measures in advance to ensure that they will be achieved – e.g. by insisting on fixed price contracts.
Some of the drawbacks to Sensitivity Analysis are:
It treats variables as if they are independent and does not consider the inter- relationships
that might exist between variables.
There is no measure of the probability of changes in any of the variables occurring.
There is no automatic decision rule for managers. Managers do not know whether their
decisions should be altered because of the level of sensitivity of a variable.
4. Certainty Equivalent
The expected cash flows of the project are converted to riskless equivalent amounts.
The greater the risk of an expected cash flow, the smaller the certainty equivalent value
(for receipts) or the larger the certainty equivalent value (for payments).
Example:
Year
Cash Certainty D.F. 10% Pres.
Flow Equivalent Value

0 (12,000) (12,000) 1.0 (12,000)
1 7,000 x 90% = 6,300 0.909 5,727

2 5,000 x 80% = 4,000 0.826 3,304
3 5,000 x 70% = 3,500 0.751 2,629
The main drawback is that the adjustment to each cash flow is subjective.
(340)
5. Expected Values
Instead of just estimating individual cash flows for a project, probabilities could be
assigned to various outcomes and these could be used to find expected values.
Example
A company is considering the addition of a new product to its range. The marketing
manager has estimated sales for the next four years as:
Probability Annual Sales (units)

.10 2,000
.30 4,000
.25 5,000
.20 7,000
.15 10,000
Once sales are established for the first year they will be maintained at that level. Selling price
and variable costs are estimated at RWF20 and RWF15 per unit respectively. New machinery
costing RWF70,000 must be purchased immediately and this is expected to have a scrap value of
RWF10,000 at the end of the project in four years’ time. Additional fixed costs of RWF5,000 per
annum will be incurred. The cost of capital is 10%. Calculate the expected NPV.
Firstly, calculate the expected value of sales volume per annum.

Probability Sales (units) Expected Value (units)
.10 2,000 200
.30 4,000 1,200
.25 5,000 1,250
.20 7,000 1,400
.15 10,000 1,500

5,550
Secondly, calculate the expected value of contribution => 5,550 units x (RWF20 - RWF15)
= RWF27,750 per annum. Deducting fixed costs of RWF5,000 per annum gives net cash
flow of RWF22,750 per annum.
The expected value of NPV is:

Year Cash Flow D.F. 10% Pres.
Value
0 (70,000) 1.000 (70,000)
1-4 22,750 3,170 72,118
4 10,000 0.683 6,830

8,948
The expected NPV is positive and the project would be acceptable.
The drawback to this technique is the difficulty in estimating probabilities of the various
outcomes for the key variables.
6. Standard Deviation of the NPV
It is unlikely that you will be expected to calculate the standard deviation of a project,
but you must be able to:
(a) Understand how a standard deviation might be used for risk analysis of individual
investment projects.
(b) Understand the relevance of standard deviations to risk measurement.
Example
Y Ltd is considering which of two mutually exclusive projects, A or B, to undertake.
There is some uncertainty about the running costs with each project and a probability
distribution of the NPV for each has been estimated as follows:
Project A Project B
Probability Probability
NPV NPV
RWF’000 RWF’000
-20 0.15 +5 0.2
+10 0.20 +15 0.3
+20 0.35 +20 0.4
+40 0.30 +25 0.1

Which project should the company choose, if either?
Begin by calculating the EV (Expected Value) of the NPV for each project.

Project A Project B
NPV Probability EV NPV Probability EV
RWF’000 RWF’000 RWF’000 RWF’000
-20 0.15 (3.0) 5 0.2 1.0
10 0.20 2.0 15 0.3 4.5
20 0.35 7.0 20 0.4 8.0

40 0.30 12.0 25 0.1 2.5
EV = 18.0 EV = 16.0
Project A has a higher EV of NPV, but what about the risk - i.e. the possible variations in NPV
above or below the EV that might occur? This can be measured by the standard deviation.
The of the project NPV, S, can be calculated as:
S = p (x x) 2
where x is the EV of the NPV.
Project A
Xi Pi Xi*Pi M Xi-x Pi*(Xi-M)2
-20 0.15 -3 18 -38 216.6
10 0.2 2 18 -8 12.8
20 0.35 7 18 2 1.4
40 0.3 12 18 22 145.2
18 376

S= 376 = 19.39
Project B
Xi Pi Xi*Pi M Xi-x Pi*(Xi-M)2
5 0.2 1 16 -11 24.2
15 0.3 4.5 16 -1 0.3
20 0.4 8 16 4 6.4
25 0.1 2.5 16 9 8.1
16 39

S= 39 = 6.24
i.e. RWF19,390 approx i.e. RWF6,240 approx
Although Project A has a higher EV of NPV, it also has a larger standard deviation of
NPV, and so has greater business risk associated with it.
Which project should therefore be selected? Clearly it depends on the attitude of the
company’s management to business risk.

7. Simulation
The Monte Carlo simulation technique is most appropriate for modelling cash flow forecasting
problems where there are several independent uncertain cash flows for which discrete
probability distributions can be estimated. The more independent cash
flows there are, the more likely it is that simulation will be the only practical method available to
model the system.
Random numbers are allocated to the cash flows in proportion to their relative probabilities. A
stream of random numbers is then fed into the system to simulate actual cash flows during
a number of periods.
The numerical output from the application of simulation techniques is a range of possible
cash flow outcomes with an indication of the likelihood of each outcome – i.e. a probability
distribution of possible outcomes. This can be used to assess the probabilities of particular
events occurring during the review period.
ADJUSTED PRESENT VALUE (APV)

It has been noted that the company’s gearing level has an implication for both the value of
equity and the overall cost of capital. The viability of an investment project would depend partly
on how it is financed and partly on how the method of financing affects the company’s gearing.
Investment projects can be evaluated using NPV method by discounting the cash flows at the
projects overall cost of capital or the risk adjusted discount rate. An alternative method of carrying
out project appraisal is use of NPV method involving 2 stages:
Evaluate a project as if its an all equity financed to determine the base case NPV
Make adjustments to allow for the effect of the method of financing that has been used
APV = Base case NPV + PV of financing effect
Illustration
Assume XYZ ltd is considering a project which costs sh.100 000 to be financed by 50% equity
with a cost of 21.6% and 50% debt with a pre-tax cost of 12%.
The financing method would maintain the company’s overall cost of capital to remain
unchanged. The project is estimated to generate cash flows of $.36 000 p.a. before interest
charges and corporate tax at 33%.
Required:
Evaluate the project using:
NPV method
APV method
Solution:
1 Ko = Kd (I – T) (B/V) + Ko (E/V)
= 0.12 (1 – 0.33) 0.5 + 0.216 (0.5)
= 14.82%

After tax cash flows = 36 000 (1 – 0.33) = 24120
NPV = (24120) -100 000
0.1482
= $ 62 753
Amounts of debt = 50% (162 753) = $81376.5
Amount of equity = 50% (162 753) = $81376.5
2. Kel = Keu + (1 – T) (Keu – Kd) B/E
0.216 = Keu + (1- 0.33) (Keu – 0.12) 0.5/0.5
Keu = 0.177485029
Step 1 Base Case NPV = 24120 – 100 000
0.177485029
= 35899
APV =Base case NPV + PV of the interest tax shield (tcB)
= 35899 + 0.33 (81376.5)
= $ 62753
Decision:
Accept because NPV > 0
Note:APV and NPV method produce the same conclusion since the capital structure remains
constant. However, the NPV and APV method will produce different results in cases where the
financing method used changes the firm’s capital structure.
Illustration:
Assumes in the above illustration that the entire project were to be financed by debt.
The APV would be:
APV = 35899 + 0.33 (100 000)
=$ 68 899
APV is a better method where initial capital is raised in such a way that it changes the capital
structure proportions. It can be used to evaluate the effect of the method of financing a project
and therefore is better than NPV.
However, APV has the following Limitations:

• Computation of the cost of a no equity-financed company may not be easy.
• Identifying all costs associated with the method of financing would be difficult e.g. the
transaction costs, agency cost, etc.
Performance Appraisal
To judge the performance of a company or group of companies the analysis of financial

statements is normally based largely on ratio analysis.
You may be expected to carry out a performance analysis on a set of company accounts.
Generally, this will require you to extract the relevant figures from financial statements and notes
to the statements. Having done this you must then calculate suitable trends and ratios. Finally,
and most importantly, you must be able to analyse and interpret the figures, trends and ratios.
This may require you to draft a report with supporting appendices.
You should be familiar with many of the important ratios from your other studies. This note is
intended to pull all the ratios together and to comment on their usefulness.
The purpose of ratio analysis is:
1. To appraise the performance of a business.
2. To highlight significant changes.
3. To reveal a company’s strengths and weaknesses.
4. To illustrate underlying trends in a company’s activities.
Financial analysis is undertaken by four main groups:
1. The company itself for management control.
2. Current and potential shareholders in order to make investment decisions.
3. Suppliers of capital (banks, trade creditors etc.).
4. Financial analysts (stockbrokers, business journalists etc.).
A ratio expresses the relationship of one figure to another. A change in the ratio represents a
change in the relationship. Ratios once computed should then be subjected to comparison.
The two broad areas of comparison are:
Internal - present performance is compared with past performance and with budgets.
External - present performance is compared with similar firms in the same industry or with
industry averages.
Ratio analysis has many limitations and care must be exercised in their use. Among the
limitations are:
1. Ratios are only a guide, they cannot be used to make absolute statements. For example, if the
Debtors Collection Period is lengthening it might be concluded that there is poor credit control with
additional costs incurred by the company. However, if other aspects of performance are checked

it may become apparent that longer credit has been used as a marketing tool, which in turn has
led to increased sales and profitability. Thus, ratios should be used to provide support for other
information.
2. A ratio represents the relationship between figures. Thus, both figures can alter the ratio and
this should be taken into account when indicating the reason for change. Also,
note that proportionate changes in both figures will leave the ratio unaltered. For example:
10 100
= 10% As is
100 1,000
3. For ratios to be fully comparable the figures used must be computed in like manner from
year to year or from firm to firm. Changes in accounting policies or firms adopting different
accounting policies will render the ratios not comparable.
4. A Balance Sheet represents a company’s financial position at one particular point in time.
A Balance Sheet drawn up one month, or even a day, earlier or later might reveal a sharply
contrasting situation, particularly for current assets and liabilities.
CATEGORIES OF RATIOS
Broadly, the basic ratios can be grouped into four categories:
1. Profitability
2. Debt & Gearing
3. Liquidity
4. Shareholders’ Investment Ratios
1. Profitability
To assess properly a company’s profits or profit growth it is necessary to relate them to
the capital employed in producing them. The most important profitability ratio is, therefore, the
Return on Capital Employed (ROCE), which shows the profit as a percentage of the amount of
capital employed.
PBIT
ROCE = x 100% Capital
Employed
Where: PBIT = Profit Before Interest and Tax.
Capital Employed = Total Assets - Current Liabilities (Looking at the Liability side of the Balance
Sheet this is the same as Shareholders Funds + Long Term Debt).
ROCE is a measure of the efficiency with which the company is using its funds.
To look more deeply into the ROCE it can be divided into two secondary ratios:
(1) PBIT
Profit Margin = x 100%
Sales
(2) Sales
Asset Turnover = x times
Capital employed

It may be appreciated that:
Profit Margin x Asset Turnover = ROCE
PBIT x Sales PBIT

=
Sales Capital Employed Capital Employed
Example
A company with net assets of RWF10m earns profits before interest and tax of
RWF2.5m on a turnover of RWF40m.
2.5m
ROCE = = 25%
10m
2.5m
Profit Margin = = 6.25%
40m

40m
Asset Turnover = = 4 times
10m
Profit Margin x Asset Turnover = ROCE

6.25% x 4 times = 25%
A low profit margin can be caused by relatively low selling prices, high costs or both. Asset
Turnover indicates the efficiency with which the business is using its assets. A low turnover
shows that the volume of business is too low relative to the value of the assets used.
Other profitability ratios used are:

(1) Gros profit
Gross Profit Margin = x 100% Sales
sales
This gives an indication of the total margin available to cover operating expenses and yield
a profit.
(2) Net profit

Net Profit Margin = x 100% Sales
sales
This shows the after-tax profits per RWF of sales. Low profit margins indicate that the
sales prices are relatively low or that costs are relatively high or both.
(3) Earnings Available to Equity Equity

Return on Equity = x 100%
Equity Capital (including
Reserves)
This shows the rate of return available to equity on their investment

2. Debt & Gearing
Gearing Ratio
This is concerned with a company’s long-term capital structure. There is no absolute
limit to what the gearing ratio ought to be. Many companies are highly geared but if such
companies wish to borrow further they may have difficulties unless they can also boost
shareholders’ capital, either with retained profits or a new share issue.
Gearing Ratio can be expressed as:
(1) Prior Charge Capital Equity

Capital (including Reserves)
or
(2) Prior Charge Capital Total

Capital Employed
* Prior Charge Capital refers to long-term debt and includes Preference Shares but does not
normally include Bank Overdraft.
Interest Cover
This shows the financial risk in terms of profit rather than capital values. It
demonstrates whether a company is earning enough profits before interest and tax to pay its
interest costs comfortably.
PBIT
Interest Cover = Interest
Charges
As a general guide, an interest cover of less than 3 times is considered low, indicating that
profitability is too low given the gearing of the company.
3. Liquidity
A company requires liquid assets in order to meet its debts as they fall due. Liquidity is
the amount of cash a company can put its hands on quickly to settle its debts and possibly
meet other unforeseen demands.
Current Ratio
Indicates the extent to which the claims of short-term creditors are covered by assets
that are expected to be converted to cash in a period which corresponds roughly to the maturity
of the liabilities.
Current Assets Current
Current Ratio =
Liabilities
A benchmark of 2:1 is often quoted but this should not be adopted rigidly as organisations have
vastly different circumstances (e.g. operating in different industries, seasonal trade etc.).

Quick Ratio (“Acid Test”)
This is a measure of the company’s ability to pay off short-term obligations without
relying upon the sale of its stocks, which may not be disposed of easily and for the value at
which they are being carried.
Current Assets – Stock

Quick Ratio =
Current Liabilities
A benchmark of 1:1 is often quoted but, again, this should not be adopted rigidly.
Debtors Collection Period
This is a measure of the average length of time it takes for a company’s debtors to pay
what they owe. The credit period allowed may depend on the industry in which the company
operates.
Creditors
Debtors Collection Period = x 365 days
Purchases
Creditors Payment Period
This is a measure of the average credit period that a company takes before paying its
suppliers.
Creditors
Creditors Collection Period = x 365 days
Purchases
Stock Turnover Period
This shows the number of times the stock is turned over during the year and indicates
how vigorously a business is trading.

Cost of Sales
Stock Turnover Period = x times
Stock
Alternatively:
Stock
Stock Period = x 365 days
Cost of Sales
4. Shareholders’ Investment Ratios
These ratios help equity shareholders and other investors to assess the value and quality
of an investment in the ordinary shares of the company.

Earnings Per Share (EPS)
EPS is the profit in Rwandan Francs attributable to each equity share. Following the
publication of FRS 3 this is the profit after tax, minority interests and extraordinary items and
after deducting preference dividends; divided by the number of equity shares in issue and ranking
for dividend.
EPS on its own does not tell us too much but it is widely used to measure a company’s performance
and to compare the results over a number of years.
Fully Diluted EPS can be calculated where a company has securities that might be converted
into equity at some future date. A hypothetical EPS is calculated as if the options, warrants or
convertible loan stock were converted and thus, the investor can appreciate by how much the EPS
may change.
Price Earnings Ratio (P/E Ratio)

Market Price per Share
P/E Ratio = EPS
All quoted companies have a P/E Ratio. It is equal to the number of years earnings needed
to cover the current market price. The value of the P/E Ratio reflects the market’s appraisal of
the share’s future prospects. A high P/E Ratio indicates strong shareholder confidence in the
company and its future (e.g. profit growth etc.), and a lower P/E Ratio indicates lower confidence.
The P/E Ratio of one company can be compared with the P/E Ratio of other companies in the
same business sector or other companies generally.
Dividend Cover
This is the number of times the actual dividend could be paid out of current earnings. A
high rate of dividend cover means that a high proportion of earnings are being retained.
EPS Total Earnings

Dividend Cover = Dividend per Share or Total Dividends = x times
Dividend Yield
Gross Dividend per Share

Dividend Yield = x 100%
Market Price per Share
The gross dividend is the dividend paid plus the appropriate tax credit. The Gross Dividend
Yield is used so that investors can make a direct comparison with (gross) interest yields from loan
stock and Government Stocks (gilts).
Z-SCORES
One of the limitations of Ratio Analysis is that each ratio is examined in isolation and the combined
effects of several ratios are based solely on the judgement of the financial analyst. Therefore, to overcome
these shortcomings it is necessary to combine different ratios into a meaningful predictive model.

Professor Altman established a model for predicting bankruptcy in the U.S. Using a sample of sixty-six
manufacturing firms, half of which went bankrupt, he identified five key variables which contributed
most. Each ratio is given a weighting to arrive at the Z-Score.
Z = 1.2x1 + 1.4x2 + 3.3x3 +0.6x4 +1.0x5
Where: x1 = Working Capital/Total Assets

x2 = Retained Earnings/Total Assets
x3 = PBIT/Total Assets
x4 = Market Capitalisation/Book Value Of Debt
x5 = Sales/Total Assets
A score of 2.7 or greater indicates that the company should be safe. A score below 1.8 indicates
potential problems. A score between 1.8 and 2.7 is a “grey area,” indicating that remedial action may
be required.
KEY PERFORMANCE INDICATORS
Key Performance Indicators, or KPIs, help determine the condition and sustainability of your
current business model. Think of Financial KPIs as your business’ health checkup. Regularly
reviewing them will help you spot potential problems before they become serious, allowing you to
manage proactively. More specifically, KPIs help you determine which aspects of your business
are underperforming, be they products, departments or something else, and address them before
the loss to your business in revenue is substantial.
All Financial KPIs have a common goal: keeping your business fine-tuned for financial success.
However, how they go about this can vary dramatically. KPIs can and should track accuracy,
speed, and efficiency in all departments, whether they deal with customers, manufacturing,
billing, etc. Of course, this is only half the battle. Business leaders must also learn how to read
KPIs effectively. In short, it does a manager no good to see sales cold call numbers if he or she
doesn’t understand the impact that those numbers have on the overall business.
If you’re a finance manager, getting a full view of your company’s financial landscape is
particularly important for increasing your competitive advantage. Finances provide some of the
most quantifiable KPIs, making them easier to read and act on. Use financial KPIs to track the
processing and reporting of transactions, billing, collections, and more. Then, use the insight
you gain from these financial management performance indicators to roll-out changes that
address any weaknesses. The more insight and efficiency you bring to this process, the bigger
your competitive advantage. If you’re eager to assess your business’s financial health, consider
starting with the following twenty essential KPIs for finance directors.
1. Working Capital KPI
Immediately available cash is known as working capital. The Working Capital KPI, calculated by
subtracting current liabilities from current assets, includes assets such as on-hand cash, short-
term investments, and accounts receivable and liabilities such as loans, accounts payable, and
accrued expenses. It creates a picture of your business’s financial health by evaluating available
assets that meet short-term financial liabilities. If you were to only choose a sample KPI for your
finance manager to use, this one would be easy calculate and be immediately meaningful.

2. Operating Cash Flow KPI
The Operating Cash Flow KPI is another important way to monitor the financial health of your
business. In analyzing this financial KPI, it’s crucial to compare it to the total capital employed.
This analysis helps you find out if the operational aspect of your business is producing enough
cash to sustain the capital investments that you are putting into your business. The operating cash
flow to total capital employed ratio analysis allows you to dive a little bit deeper into the financial
health of your business to see beyond just your profits, making it an ideal KPI for finance directors.
3. Current Ratio KPI

It’s no mystery that your company needs to meet its financial obligations on time to maintain the
positive credit rating that is so crucial for growth and expansion. The Current Ratio KPI weights
your assets, such as accounts receivable, against current liabilities, including accounts payable,
to help you understand the solvency of your business.
4. Payroll Headcount Ratio KPI
How many of your employees are engaged in payroll processing? The Payroll Headcount Ratio
displays the number of employees your company supports per dedicated full-time payroll employee.
Obviously, the bigger your company, the bigger your payroll department. However, if you have
one employee in payroll processing for every three employees in other parts of the business, you
may have a problem with payroll efficiency. More than just a financial management performance
indicator, this KPI helps you evaluate whether your human resources in this area are being used
to their full advantage and informs future staffing decisions.
5. Return on Equity KPI
Return on Equity (ROE) is a financial KPI that measures your organization’s net income against
each unit of shareholder equity (or net worth). ROE tells you if your net income is enough for a
company of your size by comparing it to the overall wealth of your business. Basically, it doesn’t
matter what you’re worth right now (net worth) if you aren’t generating enough net income, because
the latter will determine how much you’ll likely be worth in the future. Therefore, the return on
equity ratio not only provides a measure of your organization’s profitability, but also its efficiency. A
high or improving ROE demonstrates to your shareholders that you’re optimizing their investments
to grow your business.
6. Quick Ratio/Acid Test KPI
The Quick Ratio KPI measures the ability of your organization to use highly liquid assets to
immediately satisfy all financial obligations or current liabilities. It can determine your ability to
meet short-term financial obligations by measuring both your company’s wealth and financial
flexibility. It’s considered a more conservative assessment of your fiscal health than the current
ratio because it excludes inventories from your assets. This KPI gets its nickname from the nitric
acid tests used for detecting gold. Similar to those tests, it’s considered a quick and easy trick to
assess the vitality and wealth of a company. If you’re just getting started with KPIs, this sample
KPI for finance managers can give you a quick and easy glimpse of your business’s overall
health.

7. Debt to Equity Ratio KPI
The debt to equity ratio measures how your organization is funding its growth and how effectively
you are using shareholder investments. Calculated by taking your company’s total liabilities
against shareholder equity (net worth), it’s the other side of the coin to the REO KPI mentioned
in number five. Only instead of telling your shareholders how profitable you are, it’s telling them
how much debt you’ve accrued in trying to become profitable. A high debt-to-equity ratio is
evidence of an organization fueling growth by accumulating debt. This financial KPI keeps you
accountable.
8. Accounts Payable Turnover KPI

Accounts payable turnover shows the rate at which your company pays off their suppliers. This
ratio is calculated by taking total costs of sale during a specified period, costs incurred by your
company when supplying goods or services, against average accounts payable during the same
period. This ratio is most informative when taken over several periods and compared. A falling
accounts payable turnover KPI could mean that the amount of time it takes your company to pay
off suppliers is increasing and action should be taken.
9. Accounts Receivable Turnover KPI
If the accounts payable turnover KPI shows you the rate at which your company is paying its
dues, then the accounts receivable turnover KPI shows you the rate at which your company is
collecting what’s due to it. Calculate this KPI by taking your total earnings through sales in a
given time period against your average accounts receivable in the same time period. This KPI
for finance directors can alert you to outstanding payments and help you maximize the efficiency
of your payment collections.
10. Inventory Turnover KPI
Obviously, to meet demand, companies must keep inventory flowing in and out seamlessly. Thus,
it can sometimes seem like you’re never fully selling off your inventory because you always have
more coming in. The inventory turnover KPI helps you see how much of your average inventory
you’ve effectively sold off in a given time period regardless of what your storage rooms may look
like. This KPI is calculated by dividing sales within a given time period over average inventory
in the same time period. It can help you determine the strength or weakness of your sales. Just
one data sample of this KPI can tell you quite a bit.
Related: What is Cloud Based ERP Software
11. Net Profit Margin KPI

The Net Profit Margin KPI calculates your business’s effectiveness at generating profit on
each dollar of revenue made. This financial management performance indicator is calculated
by dividing the net profit of your company within a certain timeframe by your company’s total
revenue in the same timeframe. This net profit considers not only costs of sale, but also other
more nuanced expenses, like administration. This financial KPI is an excellent snapshot of the
profitability of your business, and it is useful for making both long-term and immediate financial
decisions

12. Gross Profit Margin KPI
The gross profit margin is like the net profit margin. However, it only factors in the costs of sale
when calculating the gross profit. The gross profit for a certain timeframe is then divided by the
revenue for that same timeframe. The gross profit margin is easier to calculate than the net profit
margin, but it’s less accurate. Still, it can be a great snapshot of data for finance managers and
directors.
13. Finance Error Report KPI

The Finance Error Report is the tattletale of financial KPIs, calling out finance reports that require
clarification or contain obvious errors. This helps build confidence in the validity of your company’s
reporting. It also indicates a need for improvement, be it in software, employee training or other
aspects of financial report generation.
14. Payment Error Rate KPI

The Payment Error Rate is a percentage of incoming or outgoing payments that were not
completed due to a processing error. This could mean no purchase order was referenced, no
approval was given, documentation is missing, etc.
15. Budget Variance KPI

How realistic are your budget projections? The budget variance KPI compares projected budget
totals to actual operating budget totals. This financial KPI can help businesses more effectively
predict budget needs by calculating and analyzing the differences between their projections and
actual data.
16. Line Items in Budget KPI

This KPI gives you the total number of line Items in your budget and illustrates its relative
complexity and depth.
17. Budget Creation Cycle Time KPI

While taking time to plan your annual budget is important, it is also important to remember that
time spent on budget creation is also money spent on budget creation. The Budget Creating
Cycle Time KPI includes the number of days needed to research, produce and publish the firm’s
budget. It provides an important benchmark for year-to-year improvement. Of all the KPIs for
finance directors, this one may be one of the hardest to calculate, but it’s value is without question.
18. Expense Management KPI

Employee expenses can make up a significant chunk of your overall expenses. It benefits you
to look closely at how these expenses are managed. The percentages of travel and expense
vouchers submitted by employees that contain errors – such as insufficient documentation,
wrong charge codes, or no receipts – are tracked through Expense Management KPI. This
financial management performance indicator is a particularly helpful KPI for finance directors in
that it measures processes that can easily be modified.
19. Internal Audit Cycle Time KPI

Management and stakeholders can view the amount of time required to perform a full internal
audit on Internal Audit Cycle Time reports
.
20. Customer Satisfaction KPI
CFOs often consider budget and time targets as benchmarks for successful project delivery.
While those KPIs are important, the ultimate test is customer satisfaction. The Net Promoter

Score is a simple and effective measurement of how well you are serving your clientele. This
score is calculated from responses on a scale of 1-10 given to a single question: How likely is
it that you would recommend our company/product/service to a friend or colleague? More than
just a financial KPI, this widely applicable measure is informative for many different departments.
What You Want To Avoid
There is no specific KPI that you need to steer clear from. While some KPIs are more informative
than others, all Financial KPIs provide insights that can prove beneficial. What you really want
to avoid is KPI misuse. In other words, if you do not calculate a KPI correctly or interpret the
information in the wrong way, you’ll do your business more harm than good.
KPI failures can happen for a variety of reasons. However, they are most noticeably the result
of human error or poor planning; overworked or undertrained employees are significantly more
likely to make mathematical errors. Customized KPIs that have not been thoroughly vetted for
their value to the business can distract from true KPIs and send a business down the wrong
path. Finally, KPIs can also be misused when too much emphasis is placed on the result, the
magic KPI number, and not enough attention is paid to how those numbers are made and what
business strategies would have the most impact on improving them.
BENCHMARKING
Benchmarking is a process of measuring the performance of a company’s products, services,

or processes against those of another business considered to be the best in the industry, aka
“best in class.” The point of benchmarking is to identify internal opportunities for improvement.
By studying companies with superior performance, breaking down what makes such superior
performance possible, and then comparing those processes to how your business operates, you
can implement changes that will yield significant improvements.
That might mean tweaking a product’s features to more closely match a competitor’s offering, or
changing the scope of services you offer, or installing a new customer relationship management
(CRM) system to enable more personalized communications with customers.
There are two basic kinds of improvement opportunities: continuous and dramatic. Continuous
improvement is incremental, involving only small adjustments to reap sizeable advances. Dramatic
improvement can only come about through reengineering the whole internal work process.
Step-by-Step Benchmarking
Benchmarking is a simple, but detailed, five-step process:
• Choose a product, service, or internal department to benchmark

• Determine which best-in-class companies you should benchmark against – which
organizations you’ll compare your business to
• Gather information on their internal performance, or metrics
• Compare the data from both organizations to identify gaps in your company’s performance
• Adopt the processes and policies in place within the best-in-class performers
Benchmarking will point out what changes will make the most difference, but it’s up to you to actually put
them in place.

First Steps
In order to benchmark anything, you need to have quantitative data available to study. That means
breaking down internal processes to calculate performance metrics. Quantify everything, because only
quantifiable information can be accurately compared.
Key Benefits
In addition to helping companies become more efficient and profitable, benchmarking has other benefits,
too, such as:
• Improving employee understanding of cost structures and internal processes

• Encouraging team-building and cooperation in the interests of becoming more competitive
• Enhancing familiarity with key performance metrics and opportunities for improvement
company-wide
In essence, benchmarking helps employees understand how one small piece of a company’s processes
or products can be the key to major success, just as one employee’s contributions can lead to a big win.

Study Unit 8
International Managerial Finance
Contents
• International capital markets
• International money markets
• Project Finance
• Currency Cocktails
• Foreign financial intermediaries
• International financial institutions
• Bilateral, multilateral and regional financial institutions
• Integration& Segmentation of financial markets

INTRODUCTION
Foreign currencies have a habit of changing relative to the domestic currency and therefore
add risk to dealing with foreign countries as sales markets or sources of supplies.
Foreign companies also can be a source of capital to facilitate capital investment and growth
Some foreign currencies are seen as more stable than domestic currencies and can be a more
predictable source of long term debt.
B. INTERNATIONAL CAPITAL MARKETS
Many developing countries do not have sufficient resources to finance their investment
needs. To meet these needs, they are depending on international capital markets, either from
official sources or from private capital sources. Governments in developed countries and the
international financial institutions (IFIs) are examples of official capital sources for developing
countries.
Examples of private sources are banks and companies. The latter, in particular, can play an
important role as suppliers of capital through Foreign Direct Investment.eg. Viz Heineken in
Bralirwa
For instance, Bralirwa is part owned by Heineken and a Belgian company whilst 25% is
owned by “others” who trade on the Rwandan Stock Exchange (RSE)
Foreign financial intermediaries
Banks, both domestic and international, play a part in the transfer of funds from overseas into
Rwanda, as Money Market Instruments (liquid) and Bonds (less liquid); but there other financial
institutions which arrange the transfer of capital from/to foreign organisations.
These could be Insurance companies, asset managers such as JP Morgan or BNY Mellon
The Financial Intermediary is important as an adviser as well as means of transferring funds.
Foreign Financial Intermediaries specialise in foreign funds and are very important in the
integration of financial markets.
Integrated financial markets
Financial markets all over the world have witnessed growing integration within as well as across
boundaries, spurred by globalisation and advances in information technology. Central banks in
various parts of the world have made concerted efforts to develop financial markets, especially
after the experience of several financial crises in the 1990s. As may be expected, financial markets
tend to be better integrated in developed countries. At the same time, deregulation in emerging
market economies (EMEs) has led to removal of restrictions on pricing of various financial assets,
which is one of the pre-requisites for market integration. Harmonisation of regulations in line with
international best practices, by enabling
competitive pricing of products, has also strengthened the market integration process.
Capital has become more mobile across national boundaries as nations are increasingly relying
on savings of other nations to supplement their domestic savings.

Integrated financial markets assume importance because:
Integrated markets can transmit important price signals – necessary for an efficient market
Efficient and integrated financial markets constitute an important vehicle for promoting domestic
savings, investment and consequently economic growth (Mohan, 2005).
Financial market integration fosters the necessary condition for a country’s financial sector to
emerge as an international or a regional financial centre (Reddy, 2003).
Financial market integration, by enhancing competition and efficiency of intermediaries in their

operations and allocation of resources, contributes to financial stability (Trichet,
2005).
Integrated markets lead to innovations and cost effective intermediation, thereby improving
access to financial services for members of the public, institutions and companies alike
(Giannetti et al., 2002).
Integrated financial markets induce market discipline and informational efficiency.
C. INTERNATIONAL FRANCHISES AND LICENCES
A business wishing to expand might consider being a franchisee for an international company
or a Rwandan company wanting to set up in a foreign country might consider offering a
franchise to a business in that foreign country
Franchise businesses
] for which franchising work best have one or several of the following
characteristics :
• A good track record of profitability

• Ease of duplication
• Detailed systems, processes and procedures
• A unique or unusual concept
• Broad geographic appeal
• Relative ease of operation
• Relatively inexpensive operation.
As practiced in retailing, franchising offers franchisees the advantage of starting up business quickly
based on a proven brand or trademark, and immediate access to the tooling and infrastructure, as
opposed to having to develop them. Also the franchisor usually provides publicity and advertisements
and can offer preferential loans to help the franchisee get started. The agreement is usually for a
defined term and penalty clauses may be added to discourage early departure from the agreement.
An alternative is for a local business to purchase a licence to make a product associated with an
international company. For instance Guinness is brewed all over the world and Bralirwa has a
licence to brew Guinness. At the same time it also brews local beer.
The Bralirwa story is a little more complicated. Heineken owns 45% of Bralirwa and
Heineken would have brought in overseas currency when the shares were acquired. So another
way to raise foreign finance is to sell part of the business to a foreign and probably multi-national,
however the local shareholders may lose control of their business.

D. INTERNATIONAL MONEY MARKETS
Simply a market for the lending and borrowing foreign currencies. This, for a business,
would be carried out through a financial intermediary such as Bank of Kigali or KCB.
E. INTERNATIONAL FOREIGN BONDS
Again these would probably be purchased through a bank, but a member of the Rwandan
Stock Exchange should be able to effect the transaction.
The foreign bond would effectively be a loan from a bank or financial institution in a foreign
currency. The advantage might be lower and more stable interest rates and bonds are of
normally fixed interest rate – predictability helps with budgeting and pricing.
Variable interest rates such as might be offered with an overdraft can leave a financial
controller having to estimate for a more uncertain future.
Suppose Business A knew he had to pay GBP10,000 for a foreign supply, he could borrow
GBP10,000 by means of a bond
F. INTERNATIONAL CERTIFICATES OF DEPOSIT
The opposite of a Foreign Bond is an International Certificate of Deposit. This is really a deposit
in a foreign bank in the local currency of that bank.
A Certificate of Deposit (CD) is a time deposit, a financial product commonly offered to

businesses or other clients by banks.
CDs are similar to savings accounts; they are “money in the bank”.
They are different from savings accounts in that the CD has a specific, fixed term (often monthly,
three months, six months, or one to five years) and usually at a fixed interest rate. It is intended
that the CD be held until maturity, at which time the money may be withdrawn together with the
accrued interest.
Sometimes CDs may be indexed to the stock market, the bond market, or other indices. A few
general guidelines for interest rates are:
A larger principal should receive a higher interest rate.
A longer term will usually receive a higher interest rate, except in the case of an inverted
yield curve (i.e. preceding a forecast recession)
Smaller institutions tend to offer higher interest rates than larger ones.
Buying and selling bonds and shares on the RSE are done through a stock broker who is
registered as a member of the RSE

G. MULTICURRENCY BONDS
A multi-currency is a type of bond, when interest is charged in one currency, but the payment is made
in another (based on a predetermined exchange rate, taking into account a certain percentage of
depreciation rates).
Dual currency bonds
•Traditional dual currency bonds: The traditional form for a dual currency bond specifies that interest
will be paid in the investor’s domestic currency, with the principal amount of the bond denominated in
the issuer’s domestic currency.
•Reverse dual currency bonds: A variant on the dual currency bond, the reverse dual currency bond
pays interest in the issuer’s domestic currency, while the principal amount of the bond is denominated
in the currency of the investor.
H. MULTICURRENCY COCKTAIL BONDS
Are bonds where the investor’s income is a mixture of several currencies at predetermined proportions,
usually correlated with the special drawing rights (SDRs), or other international institution/unit such as
the ECU.
Example
Multicurrency Cocktail bonds Sperry Corporation issued a US$56 million dual currency bond in February,
1985
• he interest rate, payable annually in dollars, was 6 3/4%.

• The principal was equal to 100 million Swiss francs. The final maturity was February, 1995.
• The spot exchange rate at the time was SF 1.7857 per US dollar, making SF100 million
equivalent to $56 million.
• The 10 year US dollar and Swiss franc interest rates at the time were 9.1% and 6.2 %.
Multicurrency Cocktail bonds: We need the Swiss franc/ US dollar 10-year forward exchange
rate to see what the repayment really cost Sperry. From interest rate parity, the forward rate can be
calculated as follows:

I. FOREIGN EXCHANGE RISK – HEDGING
When companies conduct business across borders, they must deal in foreign currencies. Companies
must exchange foreign currencies for home currencies when dealing with receivables, and vice versa
for payables. This is done at the current exchange rate between the two countries. Foreign exchange
risk is the risk that the exchange rate will change unfavourably before the currency is exchanged.
Hedging and financial markets
Hedging is defined here as risk trading carried out in financial markets. Businesses do not
want market-wide risk considerations – which they cannot control – to interfere with their economic
activities. They are, therefore, willing to trade the risks that arise from their daily conduct of business.
Whether in industrial, commercial or financial businesses, the financial assets – loans, bonds, shares,
stocks, derivatives – they trade, allow them to hedge the risks that accumulate in their balance sheets
in the course of business.
Investors’ holdings of securities – or long positions in shares, stocks, bonds or loans – expose them
to the sort of risks with which the securities are associated. Part of this risk stems from the unique
features of the security, but part is related to more common characteristics shared across securities. Two
common macroeconomic risks are those associated with the exchange rate and the interest rate risk in
a given economy.
Pooling securities together in portfolios takes advantages of the idiosyncratic nature of the risks they bear
to reduce the overall risk that investors face. For example, including the shares of exporting companies
and non-tradable services in an equity portfolio helps to reduce the overall risk of the portfolio to a fall
in external demand. From the economy’s point of view, portfolio pooling spreads risk across investors.
Two cash markets typically help in the development of derivatives markets. The first is the foreign
exchange market.
A second market is the local currency bond market.
Hedging took a gigantic step forward with the development of derivative products in global financial
markets.
Derivatives are financial contracts that commit counterparties to exchange cash payments related to
the value of a commodity or financial asset (underlying asset) with no actual delivery of the underlying
asset (Kohn (2004)). They allow investors to deal with individual sources of risks, or a more limited set
of risks than other financial assets. There are four main financial contracts: futures, forwards, swaps and
options.
Futures are exchange-traded contracts for the sale or purchase of an asset at a future date. They
are written over a large range of underlying assets such as commodities, foreign currency or
interest rates. Forwards are also contracts that trade an underlying asset at a future date but differ
from futures in that they are traded in OTC (over the counter) markets rather than on exchanges.
A swap is a contract in which the parties agree to a stream of payments determined with reference to the
price of an asset over time. In the case of all three contracts, payments are netted and settled in cash.
Finally, options are contracts where one party buys/sells (for the payment of a fee) to the counterparty
the right to trade in the underlying asset.

Foreign Exchange (FX):
Currencies are traded on international exchanges in a similar manner to stocks and shares. The
forces of supply and demand dictate the relative prices of each currency.
Exchange rates are the relative prices of different currencies.
Fixed exchange rates:
This is where a government intervenes in the international exchanges in such a way as to
keep the price of its currency stable. For example, if the price of its currency rises, it may sell reserves
of the currency.
This, effectively, increases the supply to the international markets and therefore keeps the price
down. Alternatively it may buy up currency and hold it if the price is becoming too low. The price of the
currency is usually calculated by reference to another major currency (US$), a basket of currencies or
a major commodity (usually gold).
E.g. The government of Utopia decide that they wish to maintain an exchange rate of 1
Utopian Dollar to 1 Euro. If the price of the Utopian Dollar climbs against the Euro (possibly due to a
growing demand for Utopian exports), the government will sell off some of their reserves of Utopian
dollars on the international exchanges until the rate returns to 1=1.
One of the advantages of fixing an exchange rate is that it promotes stability within the economy. If, in
the above example, Utopian Dollars rose sharply against the Euro, this would make the cost of buying
Utopian exports more expensive for Europeans. This would therefore have an adverse effect on exports
from Utopia and therefore profits and employment etc. If the value of the Utopian dollar fell sharply, it
would become very expensive for Utopians to import supplies or goods as their dollars would be worth
much less in terms of the Euro.
The problem with adopting a policy of fixing exchange rates is that if the value of the local currency
is depreciating, the government cannot keep buying it forever to keep the exchange rate fixed.
Eventually it will have to stop buying and when this happens, the value of the local currency can
depreciate rapidly. In Argentina, the government had to abandon fixing exchange rates in
December 2001. The value of the peso fell by over 70% in a few months. The risk to importers is that
big and sudden devaluation can be devastating.
(ii) Floating exchange rates:
Floating exchange rates can be either free floating or managed floating.
Under a free floating FX system, governments do not intervene in FX rates. Under a managed
floating FX system, governments will only intervene when the currency goes above or below a
certain value.
(iii) Adjustable peg system:
This is similar to the fixed rate system except that, on occasion, the government will move to revalue/
devalue the currency to what it believes is the real value of the currency (i.e. the price that the currency
would be if the exchange rates were floating).

E.g. Following a period of high inflation, the Utopian government may decide to revalue the currency
so that 1 Utopian Dollar equalled €0.80. The idea behind this method of FX system is that currency
movements take place in deliberate, once-off movements rather than constantly moving up and down.
It also keeps the FX rate in line with the real relative values of the currencies.
Understanding FX rates:
1. “Spot rate” and FX “spread”.
The spot rate is the current rate that a bank is offering. However, banks quote two rates – a buy rate
and a sell rate. Rates quoted by banks are always from the banks point of view. Therefore if a bank
quotes the following:
US Dollars:
We buy $0.0017
We sell $0.0015
This means that the bank will buy dollars from you and pay you Rwf1for every $0.0017 you sell them
and will sell dollars to you and charge you Rwf1for every $0.0015 you buy.
The foreign currency is effectively a product that the bank is buying and selling. Naturally, if they want
to make a profit, they will buy low and sell high. The rates banks quote (as shown above) are not prices
per se. Instead they are quantities of the product they are selling. The price on their board will always in
terms of the local currency; in Rwandan banks this will obviously be Rwf.
The spread is the difference between the buy and sell rates and is effectively the profit the bank
makes on the transaction.
2. “Forward” rates
Companies can contract with a bank to buy or sell FX at a date in the future at an agreed price. In
this case the bank might quote as follows:
We Buy We Sell
Spot rate $0.0018 $0.0015
1 month forward rate $0.0019 $0.0016
6 month forward rate $0.0020 $0.0018
Forward rates can be quoted also be quoted at discounts and premiums to the spot rate. If quoted at a
discount, that means the forward rates are cheaper (discounted) and therefore the number of dollars per
Rwf will be higher (since they are worth less). The opposite is true for a premium. Based on this, the
above rates could be quoted as follows:
We Buy We Sell
Spot rate $0.0018 $0.0015
1 month forward rate $0.0001 $0.0001 Discount
6 month forward rate $0.0002 $0.0003 Discount

International Trade:
Companies engage in international trade through a variety of means:
1. Exporting:
Goods are shipped abroad and sold through an agent or wholesaler. This is the simplest and
most common method of carrying out international trade.
Advantages:
• Little or no set-up costs – only the cost of shipping – therefore low risk;
• Takes advantage of the local knowledge of the agent or wholesaler;
Disadvantages:
• Import duties may be expensive;

• Transport costs may be high depending on the nature of the product;
• Customers may prefer locally produced goods.
2. Foreign Direct Investment (FDI)
This is where a company establishes a branch, manufacturing facility or other direct presence in the
foreign country.
Advantages:
• Eliminates or reduces shipping costs and import duties;

• Shorter lead-time in getting goods to market;
• May be advantages to the business environment in the foreign country (fewer
regulations, lower taxes, cheaper raw materials);
• Eliminates the commission/cut taken by an agent or wholesaler;
Disadvantages:
• Expensive set-up costs – therefore high risk;

• Involves book-keeping as well as dealing in foreign currencies;
• Lack of knowledge of regulations, culture and local ethics etc. which are local to the
foreign country;
Licensing:
A licence is given to a foreign company to produce your patented/trademarked goods/services in their

country in return for an agreed royalty payment. E.g. Guinness is produced under licence all over the
world. In Rwanda the Bralirwa brew and sell Guinness.
Advantages:
• Low set-up costs - therefore low risk;

• Shipping costs are avoided;
• Takes advantage of the local knowledge of the foreign company.

Disadvantages:
• The foreign company takes a high proportion of the profits;

• Quality control – If the foreign company produces sub-standard versions of the products,
the product brand names could be weakened;
• It involves handing over expertise to the foreign company.
FX Risk:
Any company that has any dealings in a foreign currency is exposed to the risk that the exchange rate
between the foreign currency and the company’s local currency could move in such a way as to affect
adversely the company’s profitability.
E.g. A Rwandan company which imports from the USA is invoiced in US$ as per agreement with the
supplier. (Generally goods are paid for in the currency of the supplier).
The supplier issues an invoice for goods shipped totalling $100,000 and allows 30 days credit. The
spot rate on the date the invoice is received is $1=Rwf1,000. When the Rwandan company arranges to
make payment (30 days later) the spot rate has changed to $0.50 = Rwf1,000. It now costs the company
Rwf200,000,000 instead of Rwf100,000,000.
The risk of FX exposure to a company can be classified into three types:
1. Transaction exposure – As illustrated in the above example, this is the exposure

resulting from the time lag between the time the goods are ordered (at an agreed price)
and the time that the goods are paid for.
2. Translation exposure – This is the exposure that exists where a company has assets/
liabilities denominated in foreign currencies. E.g. A Rwandan company could have taken
out a loan in the USA to fund a marketing campaign. The liability (in Francs) could increase
or decrease over time simply as a result of FX movements. This obviously affects the
value of the company.
3. Economic exposure – This is the exposure of future cash flows to movements in FX

rates. E.g. A Rwandan company exports coffee to the USA. If the value of the Franc
moves up against the US Dollar, it will be more expensive for Americans to import coffee.
Therefore the expected future sales and profits of the company will decline and, in turn, the
value of the company will decline.
Methods of minimising FX risk:
Forward Exchange Contract
A forward contract is where a company agrees to buy or sell a given amount of foreign
currency at an agreed rate at an agreed date in the future. This is a very common method of managing
FX risk.

Advantages:
• By estimating its FX requirements for a given period, a company can completely cover itself
against any FX rate movements for that period;
• The company can budget in advance without fear of the budget becoming inaccurate due to
FX movements
Disadvantages:
• The contract is legally binding and must be carried out – even if the FX rates turn out to be more
favourable than the rate contracted for or if the company incorrectly estimates
• its foreign currency requirements;
• Banks usually charge a premium on what they expect the rate to be at the date in the future
(E.g. Assume an economic environment where FX rates rarely move and that Rwf1,000=$1.
The bank may expect the same rate to rule in 3 months’ time but may contract with a company
to sell it dollars at the rate of Rwf1,100=$1 in 3 months). The spot rate may turn out to be more
or less favourable than the forward contract rate at the date of maturity. Companies know this
but still tend to enter into FX forward contracts. The reason is that by entering into FX forward
contracts, the companies know what rate they can get in the future.
This eliminates risk. If a company with foreign currency exposure does not hedge against the risk of
FX rate movements, capital markets will perceive the company as having a higher risk profile than
might otherwise be the case and the company’s cost of capital will increase. Special types of forward
contracts called “Option dated forward contracts” are available. These are similar to forward contracts
except that the contracts can be completed at any point during a range of dates. However, they are
still legally binding and must be completed at some point during the agreed range.
If it happens that a company cannot complete a contract, the following options are available: (i) Close
out the contract:
Assume a company has contracted with a US supplier to buy a shipment of chairs for
$100,000 at the end of 2011. In order to protect itself against currency fluctuations, at the end of 2010 it
contracts with the bank to buy $100,000 for Rwf66,000,000. If the contract falls through for any reason
(US supplier goes bankrupt), the company has the option simply to buy the $100,000 from the bank as
contracted for and sell it back to the bank at the same rate. However, depending on what the spot rate
is at the end of 2010, the company could make a profit or loss on the transaction.
(ii) Extend the contract:
Take the example given above except that, instead of going bankrupt, the US supplier cannot supply the
chairs until 3 months later than expected for some reason. The company can extend the contract
for three months. The drawback with this method is that the bank will charge a premium on the original
price.
Foreign Currency Option
This is similar to a forward contract except that the holder has the option either to exercise the option
to buy/sell the foreign currency or allow it to lapse.

Example
In January 2011 a company buys a FX option to purchase $100,000 on 30 June 2011 for
Rwf100,000,000. On 30/6/11 the spot rate turns out to be $1=RWF500. By simply allowing the option to
lapse, the company can buy the $100,000 for Rwf50,000,000. If the company had purchased a forward
contract, it would have been obliged to pay Rwf100,000,000.
A FX option can either be “European” – the option can only be exercised on a given date or
“American” – the option can be exercised at any point during a range of dates. A “Put”
option is the option to sell currency;
A “Call” option is the option to buy currency.
The FX option has the obvious advantage over a forward contract of not having to be exercised. The
disadvantage is that a premium is charged on options. The premium is usually a fixed percentage of the
amount of currency to be bought/sold.
Money Market Cover
If a company is contracted to purchase from, say, the USA for a fixed price in Dollars at
some date in the future, it is exposed to a potential loss if the Dollar appreciates against the Rwf in the
intervening period. Therefore, to balance out this risk, a company can borrow money in Rwf and use it
to purchase dollars. If the dollar appreciates the gain will cancel out the loss due to the higher costs of
paying the US company.
Example
A company is contracted to purchase a shipment of chairs from a US supplier at the end of
June 2012 for $100,000. The spot rate is currently Rwf1,000=$1. To cover against fluctuations, the
company immediately borrows Rwf100,000,000 and buys $100,000. At
31/6/12, the spot rate turns out to be Rwf1,000=$0.50. The company can now use the
$100,000 to pay the US. The cost of buying the chairs is therefore Rwf100,000,000. If the company had
done nothing and simply waited until 31/6/12, it would have cost Rwf200,000,000 to buy the $100,000
necessary to pay the US company.
The borrowing of Rwf100,000,000 will attract interest. However, the $100,000 can be invested and the
return on investment will help offset the interest on the loan.
Example
A company is contracted to sell a shipment of chairs to the USA for $100,000 at the end of
2011. The spot rate is currently Rwf1,000=$1. The company borrows $100,000 and buys
Rwf100,000,000. The spot rate at 31/12/2011 turns out to be Rwf1,000=$1.50. When the company
receives the payment of $100,000 from the US customer, it uses this to repay the loan of $100,000. It
then keeps the Rwf100,000,000 for itself. If the company had done nothing and waited until 31/12/11,
the receipt from the US customer of $100,000 would have been converted at the spot rate and the
company would only have received Rwf66,666,667 instead of Rwf100,000,000.

Advantages:
• Completely shelters the company against currency fluctuations;

• Easy to arrange, low transaction fees;
Disadvantages:
• The interest on the loan may not be completely matched by the return on the investment;
Foreign Currency Invoicing
Another method that a company can use to hedge against FX fluctuations is to arrange for its
customers to pay in its domestic currency and its suppliers to invoice it in its domestic currency.
Example
A company has contracted to purchase a shipment of chairs from the USA for $100,000. The
current FX rate isRwf1,000=$1. The company is worried about fluctuations in the FX rate and changes
the terms with the US supplier so that it will be invoiced Rwf100,000,000 (instead of $100,000) for
the chairs. The US company is now exposed to FX rate fluctuations instead of the Rwandan company.
Note that the norm in business is for goods to be paid for in the currency of the supplier.
Advantages:
• Cheap to arrange – no transactions fees as no banks or other 3rd parties are involved;
• Completely shelters a company against FX rate fluctuations.
Disadvantages:
• May be difficult to convince the foreign supplier/customer to invoice/pay in your

domestic currency (relative bargaining power of the companies will usually decide this
issue);
• This will not usually work if FX rates change substantially or for a long period as the price
in domestic currency will be forced to change.
• Netting
If a Rwandan company buys and sells in US$ then the effects on the profitability of the
company are offset in terms of both increased/decreased costs and increased/decreased

revenues.
Example
A Rwandan company has annual sales to the USA of $100,000 and sales to Europe of
€50,000. It buys stock from the USA which is used for sales in both USA and Europe and its costs for
the year are $100,000 (for stock) and Rwf20,000,000 (for overheads). At the beginning of the year, the
FX rate is Rwf1,000=$1. Therefore the company budgets for a profit for the year of Rwf30,000,000.
Unexpectedly, the FX rate immediately moves to Rwf1,000=$2. The Euro rate stays unchanged.

The sales to the USA now transpire to be worth only Rwf50,000,000 ($100,000 =
Rwf50,000,000). Similarly, the costs of buying the stock are also Rwf50,000,000.
The company’s profits are therefore as follows:

Revenues:
USA Rwf50,000,000
Europe Rwf50,000,000
------------------- --------
Rwf100,000,000
Costs:
Stock Rwf50,000,000
Overheads Rwf20,000,000
------------------
(Rwf70,000,000)
---------------------
Profits Rwf30,000,000
The movement in the FX rate therefore has had no effect whatsoever on the profits of the company.
Advantages:
• Cheap to arrange – no banks or 3rd parties involved;
Disadvantages:
• Rarely possible in practice exactly to match foreign currency inflows and outflows (any
mismatch should be hedged using some other means such as a forward contract);
Matching
This method involves trying to ensure that the value of a company’s foreign currency assets
and liabilities are matched. E.g. If a company was investing in property in the UK, it may choose to
borrow the funds in Sterling. If the Rwf value of the property was to rise/fall as a result of a move in FX
rates, the Rwf value of the loan would rise/fall by an equivalent amount.
Leading and Lagging
Under this method a company tries to predict movements in the FX rates and time its cash
inflows and outflows accordingly.

Lead Payment:
If a Rwandan company expects, say, dollars to strengthen against the Franc over the coming month, it
may decide to pay its US supplier immediately before dollars get too expensive. This may be done
even if payment isn’t due until the end of the month.
Lagged Payment:
A lagged payment is made where a company is expecting the foreign currency to weaken against the
domestic currency. Therefore by waiting a while before making payment, the company can buy the
required amount of foreign currency cheaper.
The above technique is usually only used in relation to payments. It is not usually possible to time
receipts.
Advantages:
• Cheap method of hedging – banks and other 3rd parties not involved;
• Enables a company to profit from FX movements;
Disadvantages:
• Can be a risky business trying to predict FX movements;

• Can result in dis-satisfied suppliers;
• Limited in terms of timeframe – a company can only alter the timing of its payments by a few
weeks, any more than that could result in being sued by a supplier.
• Market integration promotes the adoption of modern technology and payment systems and
vice versa.
J. INTERNATIONAL PROJECT FINANCE
Project finance is finance for a particular project, such as a mine,

railway, pipeline, power station, hospital or prison, which is repaid from
the cash-flow of that project.
Project financing techniques have been used on many high-profile corporate projects, including Euro
Disneyland. Increasingly, project financing is evolving as the preferred alternative to conventional
methods of financing infrastructure and other large-scale projects internationally.
Project Financing includes understanding:-
• The basis for project financing

• How to prepare the financial plan
• Assess the Risks
• Design the financing mix
• Raise the funds
Project finance is different from traditional forms of finance because the financier principally looks to
the assets and revenue of the project in order to secure and service the loan. A most important point
to remember in project financing is the identification, analysis, allocation and management of every risk

associated with the project. Financiers and their advisers will go to substantial measures to ensure
that the risks associated with the project are reduced or eliminated as far as possible.
The cost of project finance is generally higher and it is more time consuming for such finance to be
provided.
Possible risks associated with project finance would include:-
• Project not being finished on time, on budget, or at all

• Project not functioning at its full capacity
• Project failing to generate sufficient revenue to service the debt
• Project hastily comes to an end
Each project gives rise to its own unique risks and hence poses its own unique challenges, therefore in
every case all parties and those advising them need to act creatively to meet those challenges and to
effectively and efficiently minimise the risks embodied in the project in order to ensure that the project
financing will be a success.

Study Unit 9
Sundry Definitions
Contents:
A. Introduction
B. Sundry Definitions

A. INTRODUCTION
You may be expected to write briefly on a number of topics, as part of one of the questions.
This is an opportunity to gain some very valuable marks for a small amount of effort. There is
a limited range of areas that can be examined and certain topics may repeat over a number of
examination sessions.You do not need to write a thesis on the subject but a couple of well chosen
sentences (as below in Section B) will suffice. Where appropriate a numerical example will help
you to get your message across and put some order on your solution.
This section can also assist you in your revision, immediately prior to the exam.
B. SUNDRY DEFINITIONS
Adjusted Present Value
Adjusted Present Value (APV) represents an alternative approach to WACC in terms of

valuing a business and its operations. All DCF calculations involve discounting forecast future
cash flows to a present value equivalent at a discount rate which reflects accurately the particular
risk of the business. The approach taken under APV is to separate operational and financial
effects, and to discount the former at some base-line cost of capital in order to arrive at a basic
calculation of present value. As a separate and subsequent step, the cash flow consequences
of alternative project financing options are discounted and added to the base- line present value.
In effect the introduction of the term “adjusted” in APV reflects a concern to evaluate separately,
the side effects of project financing. The attempt to identify and trace the consequence of each
side effect involves the APV analyst in a series of separate DCF calculations. This added
computational burden might help to explain some earlier reluctance to use APV, although the
widespread use of sophisticated spreadsheets in recent years tends to diminish the significance
of this argument.
Altman’s Z-Scores
Professor I Altman researched 66 companies that experienced corporate failure to determine

whether or not their ultimate failure could have been predicted? His summarised findings are
known as Altman’s Z-Score Model. This model suggests that if five key financial ratios are
calculated and weighted, and, if the result lies outside stated parameters, then the business faces
a heightened risk of future corporate failure. The model is used by investors and analysts to
inform them of the financial risk associated with potential investments because of its usefulness
in predicting corporate failure.
Beta as a Measure of Market Risk
One of the fundamental principles of financial theory is that individual shares (or more
generally individual securities) will relate to the average market risk in a fairly consistent manner.
Empirical statistical research of a shares actual performance (in terms of its returns and the
variation in such returns) will indicate whether it is more prone to variation than the market as a
whole- i.e. either more or less risky than the market. The risk of a particular share relative to
the market as a whole is measured by that share’s unique “beta” value. The beta value reflects
differences in systematic risk characteristics and is most frequently used in CAPM calculations.
The beta value for the market as a whole is usually set at 1.0, and so any share with a Beta greater
than 1.0 is considered to a relatively riskier investment than a portfolio of shares representative
of the market as a whole.

Call Option
A call option gives its owner the right to buy a financial instrument at a specified price -
sometimes referred to as the striked price. Where the call option can only be exercised on a given date
in the future, it is known as a European call option. Where the option can be exercised on any day
up to and including a defined future date, it is known as an American call option. Where the exercise
price of a call option is below the current market price of the financial instrument in question, the option
is said to be “in the money”. Conversely where the exercise price of the option is above the current
market price of the financial instrument in question, it is said to be “out of-the money”.
Options are a secondary market activity affecting only the two parties involved - there are no consequences
for the company which originally issued the financial instrument. The party which issues the call option
is known as the “writer” of the call.
Capital Asset Pricing Model
The CAPM is a model which sets out in mathematical form the relationship between the
return on any individual security, the risk free rate of return, and the return on the market portfolio. It
may be summarised as follows:
Rp = Rf + ( Rm - Rf)
in the equation above (the ‘Beta’ factor) is a variable which attempts to capture the Systematic
Risk associated with the business activity of a company. The model is significant in that it is premised
on the view that the return on any given security is associated with the non-diversifiable (systematic)
risk associated with the security.
Centralised Treasury Management
Companies of significant size are often diverse in terms of trading activities and/or
geographic spread. Many such companies choose to centralise their treasury function. This involves
expert staff conducting the treasury management function for all parts of the business, however
diverse. This decision will be reached for a combination of the following reasons:
• Ability to afford specialist staff

• Increased purchasing power given the increased value of borrowings/investments
• Foreign currency set-off potential

• Better control over activities
• Improved risk monitoring
• Improved tax planning
Convertible Loan Stock
Convertible loan stock is a debt instrument issued by firms which offers the holder the right
to have the debt redeemed in the usual way at the redemption date. Alternatively, the holder of the loan
stock may exercise a right to convert the debt into equity at some pre-determined conversion rate. The
buyer of convertible loan stock usually accepts a slightly lower rate of interest on the instrument as part
of the price to be paid for holding what amounts to a bet on the future movement of the share price - the

holder of loan stock in effect enjoys an option on the firm’s equity. This lower rate of interest makes loan
stock attractive to the issuer, as does the fact that conversion into equity represents an in-built form of
liquidation of the instrument and removes the necessity to raise further debt in order to redeem the initial
loan stock.
Corporate Raider
Corporate raider is a title given to organisations/individuals who target companies to acquire, and, if
successful, will in the post acquisition period carve the business into its component parts with a view to
selling/strip the individual parts at a profit. Ultimately, the corporate raider may retain ownership of a
small element (if any) of the acquired enterprise.
Corporate raiders are also known as ‘asset strippers.’ Example of such a business would be
Hanson Industries Plc, quoted in the U.K.
Deep Discount Bonds
A Deep Discount Bond is a bond which is usually issued at a price considerably lower than
its par value. The investor in these bonds is, therefore given the opportunity to buy a bond at a very
cheap price. Typically, the trade-off for this benefit is that the bond will carry a lower coupon rate of
interest than other comparable debt instruments. The investor, therefore is essentially attracted by a
potential capital gain, while the issuer of the loan stock will be attracted by the relatively lower service
costs of the loan stock. This latter feature can be particularly attractive to companies which wish to
raise capital for a new business venture and where the future cash flows may be uncertain in the early
years of the project, thereby putting a strain on servicing a higher cost loan stock.
Dividend Policy – Considerations In Determining
It should always be remembered that ordinary shareholders are not prima facie entitled to
receive an annual dividend. The decision whether or not to declare a dividend and if declared,
the extent of same, rests with the Board of Directors. Each year the Board will consider the dividend
decision. The key considerations when making this decision will include:
• Profitability – what are the profits for the period for which the dividend is to be
decided?
• Legality – in short, only realised gains can be distributed
• Cash Flow – has the company the cash reserves from which to pay dividends?
• Taxation – is it more tax efficient for equity shareholders to receive dividends or
capital growth, or the optimum mix thereof?
• Signalling Effect – what will the declaration of any size dividend (including a nil
declaration) signal to the investment community?
• Expectations – what are shareholders expecting as a dividend and how any change
therefrom will impact on their investment behaviour?
• Residual Theory – can the company use profits to invest in projects which will
increase the capital value of shares by more than the dividend that could be paid?

Dividend Yield as a Method of Company Valuation
The dividend yield is the ratio of the most recent dividend to the market price of the security
under review. In this sense the dividend yield is a measure of the “rate of return” on equity capital which
might serve as a comparable ratio to the percentage yield on loan stock. However, as dividends
are paid net, it is usually necessary to calculate the grossed up equivalent of the dividend and use
this figure in working out the dividend yield. Such an approach allows yields on equity to be compared
more directly to yields on interest bearing loan stock. By convention, a normal yield gap implies that the
return on equity should be higher than that on debt. Nevertheless it can occasionally be observed that
the dividend yield can be less than yields on debt. In the long run, however, it is true to say that investors
expect their return on equity, in terms of dividend yield and capital gains, to exceed the yield debt.
Due Diligence
This is the process which should confirm the reliability of the information which has been
provided and has been used in making an investment decision. Changes in these primary assumptions
may have a significant impact on the price to be paid and possibly even raise questions on the wisdom
of proceeding with the transaction. This is a very useful process and at minimum will provide additional
information on the potential target.
Efficient Market Hypothesis
The efficiency of a stock market means the ability of the market to price shares quickly and
fairly to reflect all the available public information in respect of each share.
The Efficient Market Hypothesis proposes that a particular stock market is an efficient stock market. This
is because of the role that well informed institutional investors and their market analysts’ play. Thus, the
possibility of a “speculative bubble” is minimised.
How efficient the market is at responding to such information is considered to vary between:
• Strong form efficiency

• Semi-strong form efficiency
• Weak form efficiency
There has been much research carried out on the topic of measuring market efficiency, with varying and
sometimes contradictory findings.
Factoring of Debtors
The factoring of debtors is a financial service usually provided by a specialist agency, such as
a department within a bank. Typically, it involves the administration of a client companies
debtors, the collection of its debts, the elimination or at least tighter control of bad debts, and the
advancement of certain sums of cash on the basis of invoices issued to date.
The provision of factoring services therefore represents - on the part of the Factor - the ability to
develop specialist expertise, operating economies of scale, and an access to a level of
liquidity which is only likely to be available to a major financial institution such as a bank.
Factoring services are not however simply a means of resolving the problems of financially
distressed or illiquid companies, but rather are only likely to be available to reputable

companies with an established trading record. Most banks will be reluctant to take onthe
administration of a particularly troublesome debtors ledger containing many unknown client firms.
Flotation Costs
Flotation costs arise in the context where a company is offering its securities - either debt or
equity - for sale in the capital market. These costs can be significant and in most cases the amount of
funds the firm receives is less than the aggregate value suggested by the price at which the issue in
question has been sold. Typically flotation costs can involve all or any of the following items - underwriting
expenses, audit and legal fees, fees to corporate bankers or their financial advisors, stamp duties, public
relations fees, costs of printing, advertising and circulating the offer for sale, and stock market fees.
Although these costs can be significant, most firms tend to take the prudent view that they cannot afford
to avoid them entirely. This is particularly so in relation to underwriting costs and the fees associated
with professional advice on the issue price for the particular security in question. This latter aspect is
especially important as failure to strike the correct issue price could undermine the success of the entire
issue
Foreign Exchange Exposure
Foreign exchange exposure arises from exchange rate functions. Transaction exposure arises
where an exporter or importer is vulnerable to adverse movements in foreign exchange rates when there
is a period of credit involved (as there almost always is). For example if an exporter sells goods to the
USA for US$57,600 when the exchange rate is US $1.6 to RWF1, he would expect to earn RWF36,000
from the sale.
However if the customer is allowed credit of three months and the exchange rate alters to US
$1.8 to RWF1 in this time, the eventual income would be only RWF32,000, which is
RWF4,000 less than expected.
Forward Exchange Rate
The risk inherent in foreign exchange dealings can be overcome by entering a forward
exchange contract which involves an importer/exporter in buying or selling a specified amount

of foreign currency, at some specified date in the future, and at an agreed and fixed rate of exchange
to be determined when the contract is established. Under these arrangements therefore, the
importer/exporter can lock in to a certain financial outcome and does not have to live with the uncertainty
of not knowing what spot rate may prevail on the date of the anticipated transaction, thereby remaining
unsure of the financial consequence of the transaction itself. The Forward Exchange Rate is derived
by adjusting the spot rate (ie the rate prevailing on the day when the contract is made) by the interest
rate differential which exists between the two currencies. It always remains possible however that an
importer/exporter who enters into a Forward Rate agreement, may discover that s/he would have been
better off to have completed the transaction at the eventual spot rate on the date set for final payment.

Forward Exchange Contracts
These are contracts entered into with a financial institution to reduce the risk associated with foreign
currency transactions. An organisation can guarantee the domestic currency value of a future foreign
currency receipt or payment. The rate agreed is essentially the spot rate as adjusted by a premium
or discount to allow for the differential in the interest rates between the economies of the two relevant
currencies.
Interest Rate Options
Organisations with debt commitments will have to pay interest thereon. They may have
negotiated a fixed or variable rate of interest. However, such an organisation may wish to purchase an
option to vary the basis of their interest rate exposure at/by a future date. This is known as an interest
rate option.
An example would be in times of falling interest rates, an organisation presently paying interest at a fixed
rate may wish to exercise the interest rate option in order to pay interest at the lowering variable rate
Interest Rate Parity Theorem
The Interest Rate Parity Theorem essentially says that differences in forward and spot rates of
exchange are caused by differences in interest rates in the economies in question. This may be
summarised as follows:
(1+r$) / (1+rRWF) = (For rate $ to RWF) / (Spot rate $ to RWF)
Under the terms of this relationship therefore, only a divergence between interest rates in the
$ and RWF economies will cause a difference to occur between the forward and spot rates. Specifically,
if interest rates are higher in the domestic country than in the foreign country, then the foreign country’s
currency will sell at a premium in the forward market. If on the other hand, interest rates are lower in the
domestic country, then the foreign currency will sell at a discount in the forward market.
Interest Rate Swap
An interest rate swap arises where two parties (usually two firms) agree to exchange interest
repayment commitments on existing loans. This would often involve a situation where one company
with fixed rate interest commitments might wish to change to floating rate interest commitments, and it
would therefore seek out a counter-party with the correct fit. Swaps are usually arranged by banks on
behalf of client companies. Despite the fact that a Swap might e arranged, both parties retain legal
responsibility for the cost of servicing the original loans taken out.
Internal Rate of Return
The internal rate of return is the discount rate that equates the present value of cash inflows with the
present value of cash outflows (often the initial investment associated with the project ). In other
words, it is the discount rate that yields an NPV of zero for the project. For the investor, the IRR of a
project represents a form of cut off rate for project financing. If the investor concerned can manage to
raise funds at a rate lower than the IRR, the NPV of the project will be positive and the investor would
proceed with the proposed investment. If on the other hand the cost of funds was greater than the
IRR then the investor would recognise that the return on the investment would not be sufficient even to
remunerate the capita, committed, much less create additional wealth by way of a positive NPV outcome.

Management Buyouts (MBOs)
When an organisation decides to divest itself of part of its business for whatever reason (cash absorber,
lack of strategic fit etc.) it may receive offers from many parties. Occasionally, the management of the
part of the business being sold may decide to mount a bid for the purchase. This is known as a
management buyout. Research has shown than MBOs tend to be more successful than 3rd party
acquisitions. This is for many reasons including, knowledge of the industry and the specific business
being bought as well as increased levels of motivation to make the business a success.
Often with MBOs the most difficult challenge is to raise sufficient finance.
Money Markets and Capital Markets
The capital market is the market where various long term financial instruments (ordinary
shares, bonds etc.) are initially raised and subsequently traded. It is the market where business
seeks long term financial capital which will support the company and its ongoing operations. The
capital market also represents a structured interface between those with surplus funds who are seeking
out remunerative opportunities (investors), and those agents with a capital deficit who need to raise
additional finance (borrowers). By contrast, the money market is essentially a market for short
term investments only. The money market does not necessarily need a physical location in which to
operate, and is better understood as a loose network of traders and financial institutions engaged in
an ongoing process of electronic trading. Typically the instruments traded mature in a matter of days or
months, and usually involve investors with short term surplus cash or those interested in tactical
or speculative trading. The instruments traded do not form part of the fundamental financial structure
of a business. Typical instruments traded on the money market are, short dated government stock,
certificates of deposit, repurchase agreements, and commercial paper.
Operating Gearing
Operating gearing describes the relationship between the fixed and variable costs of production.
Operating gearing can be measured either as the percentage change in earnings before interest and tax
for a percentage change in sales, or as the ratio of fixed to variable costs. Companies whose costs
are mostly fixed are said to have high operating gearing. These companies are highly vulnerable to
the need to generate consistently high revenue earnings in order to cover the high fixed costs. High
operating gearing therefore is perceived to increase business risk, and empirical tests have tended to
support the view that such companies should have relatively higher betas. In terms of an influence on
a companies beta, the analogy between financial and operating gearing is quite strong.
Operating Lease
An operating lease is distinguished from a finance lease in that the lease period is usually less
than the useful life of the asset. The lessor therefore relies upon either subsequent leasing or the
eventual sale of the asset to cover the initial outlay involved in acquiring the asset. Under an operating
lease, the lessor is usually responsible for repairs and maintenance, and therefore retains the risks and
rewards of ownership of the asset. In effect then, an operating lease involves the short term rental of
an asset

Overtrading
The term “overtrading” refers to a situation where a company is unable to finance the level of operations
which it has achieved. Usually this can arise where a company is under- capitalised at the
outset, or where providers of long-term capital remain unwilling to inject further funds as the business
grows and expands in volume terms. In such cases, the continued growth of the business will put
increasing strains upon working capital, as the company realises it has little option but to have further
recourse to short term borrowing and securing finance through the non payment of creditors. Very often,
overtrading occurs where a company significantly expands its sales (and accordingly its volume of
operations) through the introduction of generous credit terms without enjoying any corresponding credit
concessions from its creditors. Such an arrangement will inevitably place a strain on the company’s
liquidity which is only likely to be finally resolved through some form of financial restructuring involving
access to long term capital.
Portfolio Theory
A portfolio is the collection of different investments that make up an investor’s total holding. A portfolio
might be the investment in stocks and shares of an investor or the investments in capital projects of a
company. Portfolio theory is concerned with establishing guidelines for building up a portfolio of stocks
and shares, or a portfolio of projects. The same theory applies to both stick market investors and to
companies with capital projects to invest in.
There are five major factors to be considered when an investor chooses investments, no matter
whether the investor is an institutional investor, a company making an investment or a private individual
investor:
• Security. Investments should at least maintain their capital value.

• Liquidity. Where the investments are made with short-term funds, they should be
convertible back into cash at short notice.
• Return. The funds are invested to make money. The highest return compatible with safety
should be sought.
• Spreading Risks. The investor who puts all his funds into one type of security risks
everything on the fortunes of that security. If it performs badly his entire investment will
make a loss.
• Growth Prospects. The most profitable investments are likely to be businesses with good
growth prospects.
Price Earnings Multiple
This is a way of determining the worth of a share/a business. It is normally used in the context of
an acquisition whereby the target company is valued at a multiple of its profit before tax. It is a widely
recognised indicator of value by the investment community. The multiple which will be used in each
case is normally industry dependent. For example an IT based industry may have a different P/E
multiple than the retail industry, given the differences in the two industries such as; risk profile,
life cycle stage etc. In practice, the final agreed multiple paid would be influenced greatly by the
negotiation skills of both parties. It should be noted that using the P/E multiple is not the only
way in which shares/business can be valued. Other methods include asset-based valuations.

Public/Private Funding Partnerships
This is a new and increasingly popular method of funding public capital projects e.g. schools, infrastructure
projects etc. In essence, the capital cost of the project is borne by the private enterprise and the public
body will pay for the use of the facility over an extended contractual period. At the end of the period
the facility will revert to public ownership. The attraction to the private enterprise is the security, and
hopefully, the guaranteed financial return of contracting with government departments. Examples of
public/private partnerships include the much delayed and much publicised new Cork School of Music.
Reverse Yield Gap
A Yield Gap refers to a position whereby it is normally expected that the yield on equities
will be greater than that available on debt. This is so because equity is considered to be more risky
than debt, and so in order to compensate shareholders for accepting this extra risk, a higher level of
reward must be offered. In some rare instances though, it can emerge to be the case that the yield
on debt is actually greater than the yields on equity - this position is referred to as a reverse yield gap.
However such a situation should emerge as a temporary phenomenon only. If the yield position did not
correct itself (i.e. showing a higher return on equities once again),then the entire investment market for
equities would eventually collapse. It is likely that such a build up of sentiment against equities would
serve as the very stimulus necessary to depress share prices and so bring dividend yields into a more
normal position.
Scrip Dividends
Scrip dividends are shares given to shareholders instead of - or in addition to - cash. Firms
may elect to pay a scrip dividend in circumstances where competing pressures on cash reserves might
render it unattractive to make a more conventional cash payment - this could be the case where
the firm is experiencing liquidity difficulties or where surplus cash may be target on a potential capital
investment. In such circumstances a firm may pay a scrip dividend in order to be seen to be remunerating
shareholders investment in the firm without placing an unwelcome strain on current cash resources.
Semi-strong form Efficiency in Capital Markets
Semi-strong form efficiency is one of three categories described in that aspect of capital market
theory concerned with the efficiency with which the market processes relevant information. This is a
significant question as it allows analysts to arrive at a view as to how well informed a particular capital
market is. In this context, the phrase ‘well informed’ can be taken to mean that actors on the market
have access to all pertinent information, and that they enjoy the capacity to understand and interpret
that information with a view to basing subsequent trade decisions on that insight. Semi-strong efficiency
refers to a context where investors are in possession of all historical information pertaining to a particular
financial instrument, as well as all published information relating to the instrument. This is considered
to be the circumstance which best describes most capital markets. To make any stronger claims
would move the investor into a position of privileged or insider information, which would in turn move the
market towards strong form efficiency.
Strong Form Efficiency
Strong form efficiency refers to a position in the capital markets where the market is considered
to be so efficient at filtering relevant information, whether of a public or private nature, that the prices of
all financial securities traded on that market are thought to embody all such information. In this sense
then, and under conditions of strong form efficiency, “insider trading” could not conceivably happen,

since no sooner would an individual have identified a reason to adopt a particular trading position, than
market prices would have immediately adjusted to reflect this rationale, and any envisaged gains from
trade in such securities would thereby be dissipated.
Systematic Risk
Systematic risk refers to the inherent risk of a particular investment which cannot be diversified
away. This systematic risk simply reflects the fact that some business activities are naturally more
risky than others and any investor wishing to invest in the financial securities of such a business,
must accept the associated level of risk which cannot be detached from the business. Normally,
investors will expect to earn a higher reward for taking this additional level of risk. This need to earn
a higher reward is captured by the beta term of the capital asset pricing model which serves to quantify
the amount of risk premium to be associated with the particular financial security.
Traditional View of Gearing and the WACC
The traditional view of the relationship between gearing and the weighted average cost of capital
is that the two variables are directly correlated. Graphically this relationship is shown as a “U” shaped
curve, suggesting that as the level gearing rises from an initial level of zero indebtedness, the WACC
initially falls, bottoms out to a minimum position, and then begins to rise again as the level of gearing
rises with more and more debt being added to the capital mix. The simple reason for this characterisation
of events was that because the return on debt was necessarily lower than the return on equity (because
of the different risk profiles), then introducing debt into the capital mix must inevitably lead to a fall in
the overall cost of capital. This view, of course, presupposes that that at low levels of gearing, equity
holders would not be alarmed by the initial introduction of debt and that accordingly their expected rate
of return would not change. However at high levels of gearing, the equity holders begin to perceive a
significantly changed risk environment and they therefore seek compensation by way of higher returns.
This then leads to a subsequent rise in the WACC.
The particular significance of the traditional view was that because it suggested that the WACC could
possess minimum point (i.e. a gearing level where the WACC was at its lowest), then this in turn
implied that the value of the firm would alter in line with changes in gearing and that management could,
by virtue of some creative financial engineering, manipulate the value of the firm.
Value Gap
A Value Gap refers to a situation where the publicly quoted price for a company’s ordinary share
differs from the value which might be attributed to that share based upon one of the conventional share
valuation models (e.g. fundamental share valuation of price = d/r, P/E basis , or free cash flows).
Value gaps can arise in cases where a particular economic significance might be attached to information
about the business and its operations (e.g investment in brands, new technologies, know how
etc), but where capital markets aresufficiently information inefficient to allow the significance remain
concealed. In such cases investors on the capital market remain unaware of the underlying economic
potential of a particular company and so its share price might remain unduly low. Value gaps can also
arise in circumstances of poor “corporate parenting” where a business may simply be badly managed
thereby allowing a potential predator to believe that the company, under new and improved management
could be made to perform more profitably. In these circumstances the predator could be motivated to
make a take-over offer for the company in question at a price in excess of the share’s publicly quoted
market price. This would be done in the belief that such a Value Gap will be more than adequately
redeemed by way of an improved operating performance.

Venture Capital
A Venture Capitalist, as the name suggests is an organisation which provides finance for new and
developing businesses. Venture Capitalists typically take the form of a department of an established
financial services organisation or as private asset management experts e.g. Hibernia Capital Partners.
Venture Capitalists carefully vet proposals put to them by businesses that require funding. Only those
businesses that are operationally and technologically feasible, have market appeal and are financially
viable are likely to be backed by the Venture Capitalist.
Once backing is agreed the Venture Capitalist will fund an agreed percentage of the venture. This funding
typically will be a mixture of equity and debt. Venture Capitalists will require board representation in
order to help protect their interest by having influence (voting rights) over policy and strategic decision-
making. Venture Capitalists do not expect to retain interests in businesses they back for the long
term. A typical “get-out” to liquidate their investment would be in the form of “going public”. A classic
example of a successful Venture Capital backing would be Cisco Systems, a Californian base
internet infrastructure provider, the most successful global company in its field.

Present Value Table
182
-n
Present value of 1 i.e. (1 + r)
Where r = discount rate

n = number of periods until payment
Periods Discount rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
A2.1 STRATEGIC
CORPORATE FINANCE
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751
STUDY
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621
MANUAL
CPA EXAMINATION
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467
9 0·914 0·837 0·766W 0·703 0·645 0·592 0·544 0·500 0·460 0·424
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279
STUDY
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194
CPA EXAMINATION
MANUAL
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078
CORPORATE FINANCE
A2.1 STRATEGIC
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065
183
Annuity Table
184
1 – (1 + r)–n
Present value of an annuity of 1 i.e.
r
Where r = discount rate
n = number of periods until payment
A2.1 STRATEGIC
Periods Discount rates (r)
CORPORATE FINANCE
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736
STUDY
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170
MANUAL
CPA EXAMINATION
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145
11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495
12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814
13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103
14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367
15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837
STUDY
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192
CPA EXAMINATION
MANUAL
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675
CORPORATE FINANCE
A2.1 STRATEGIC
185

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INSTITUTE OF CERTIFIED

2nd edition February 2020,

All copy right reserved

2nd Edition February 2020

Introduction to the course 5

2. Mergers and acquisitions 21

2 A2.1 STRATEGIC CPA EXAMINATION

Short -term sources of finance 47

5. Financial risk management 73

CPA EXAMINATION A2.1 STRATEGIC 3

7. Financial analysis and business planning 111

Business plans 112

8. International managerial finance 154

9. Sundry definitions 170

4 A2.1 STRATEGIC CPA EXAMINATION

Strategic Corporate Finance as an Integral Part of the Syllabus

CPA EXAMINATION A2.1 STRATEGIC 5

6 A2.1 STRATEGIC CPA EXAMINATION

b. Corporate Finance and the different business forms

• Liability – Unlimited and Limited

It is often assumed that the single objective of commercial entities is:

To Maximise the Value of the Firm

The main stakeholders are:

CPA EXAMINATION A2.1 STRATEGIC 7

• They may be too many to run a single firm.

1. Shareholders and Management

8 A2.1 STRATEGIC CPA EXAMINATION

ii. Consumption of “Perquisites”

Solutions to Shareholders and Management Conflict of Interest

1. Pegging/attaching managerial compensation to performance

CPA EXAMINATION A2.1 STRATEGIC 9

3. The Threat of Hostile Takeover

4. Direct Intervention by the Shareholders

• Insist on a more independent board of directors.

6. Executive Share Options Plans

10 A2.1 STRATEGIC CPA EXAMINATION

7. Incurring Agency Costs

2. SHAREHOLDERS AND CREDITORS/bond/debenture holders

• The existing asset structure of the firm

CPA EXAMINATION A2.1 STRATEGIC 11

a. Disposal of assets used as collateral for the debt in this.

12 A2.1 STRATEGIC CPA EXAMINATION

NATIONALISED INDUSTRIES/PUBLIC SECTOR

CPA EXAMINATION A2.1 STRATEGIC 13

Corporate Social Responsibility has been otherwise defined as:

»» Brand awareness levels

Such objectives may also include the following:

»» Providing for the welfare of employees and management

Examples of acting in a socially responsible manner may include:

Junior Achievement Awards initiative.

14 A2.1 STRATEGIC CPA EXAMINATION

Incorporating CSR in their mission statements

Appointing a ‘champion’ of CSR

Formally incorporating CSR objectives into its strategic planning process

Dissemination of CSR targets and reporting of key performance indicators

Retaining consultants to advise on existing performance and to recommend

Appointment of committees to implement and reviews CSR related policies.

Arguments in favour of CSR include that it:

All of which may be considered to support the drive to maximise profits.