E4 Finance and Investment

A. Strategy, markets and fintech

The finance, investment and dividend decisions are linked to corporate strategy. Profit maximisation looks at accounting profit, usually in the short term, and ignores timing, risk and the cost of capital, while shareholder wealth maximisation looks at the value of the shares and dividends over time and takes account of risk. Corporate objectives, such as growth and market share, set the direction, and financial objectives turn them into measures. The achievement of objectives is assessed using return on capital employed (ROCE), return on equity (ROE), earnings per share (EPS), dividend per share (DPS) and total shareholder return (TSR), which is the share price change plus dividends divided by the opening share price. Under agency theory, managers act for shareholders but may follow their own interests. Stakeholder objectives can conflict, for example between shareholders who want dividends and lenders who want cash retained.

The economic environment affects planning through fiscal, monetary, interest rate and exchange rate policies, and through competition regulation and sustainability initiatives, such as carbon taxes. Over-trading means that a business is growing faster than its working capital can support, and over-capitalisation means that it holds more working capital than it needs. They can be assessed from indicators such as the current and quick ratios, the working capital cycle and the ratio of revenue to net working capital.

Financial intermediaries, such as banks, pool savings and lend them. A stock market raises equity and gives liquidity to investors, with the shares bearing a residual risk, while a corporate bond market raises debt with fixed returns and a lower risk to the investor. Fintech (technology applied to finance) changes markets and institutions by allowing peer-to-peer lending, crowdfunding, digital payments and platforms that bypass banks, and by lowering costs and raising speed, while raising issues of regulation, security and the stability of the system. Money markets give short-term liquidity, trade finance and the means to manage foreign currency and interest rate risk, using interest-bearing instruments, discount instruments (such as treasury bills) and derivatives.

Worked figures

TSR: a share price rises from $5.00 to $5.60 and a dividend of $0.20 is paid. TSR = (5.60 - 5.00 + 0.20) / 5.00 = 16%.

Key terms

• Total shareholder return: Share price increase plus dividends, divided by the opening share price.
• Over-capitalisation: Holding more working capital than the business needs.
• Fintech: Technology that changes how financial services are delivered.

Study tip: For strategy questions, link the objective to a measure, for example EPS growth or TSR, and say how it could conflict with another objective.

Practice questions for section A

B. Investment appraisal: risk, simulation and rationing

Probability analysis uses the estimated chance of different outcomes. The expected NPV is the sum of each NPV multiplied by its probability, and the standard deviation shows how far outcomes are spread around it. The probability of a negative NPV can be read from the outcomes, or estimated using a normal distribution. A project with a higher expected value but a much wider spread is riskier, and the decision depends on the investor's attitude to risk. Expected values are suitable for repeated decisions and not for one-off, high-impact projects.

Simulation (for example Monte Carlo) repeats the appraisal many times using random values for the uncertain variables, based on their probability distributions, which gives a distribution of possible NPVs, the expected NPV and the probability of making a loss. It handles many variables at once, and shows risk better than a single figure. Its disadvantages are the cost, the need for the distributions, which may be hard to estimate, and the lack of a clear decision rule.

Adjusting for risk. Adjusted payback shortens the maximum acceptable payback period for riskier projects, or discounts the cash flows. A risk-adjusted discount rate adds a premium to the cost of capital for riskier projects, and it is easy to use but the premium is subjective and it assumes that risk grows at a constant rate over time. Sensitivity analysis shows how far each variable can change before the NPV is zero but does not give probabilities.

Specific decisions. For leasing versus borrowing to buy, compare the cost of the lease and the cost of borrowing, both before and after tax, discounting at the after-tax cost of debt. For asset replacement, use equivalent annual cost for assets with different lives, and the equivalent annual benefit where benefits differ. Under single-period capital rationing, divisible projects are ranked by profitability index (NPV per unit of capital) and the available capital is spent in order, with the last project taken in part. For indivisible projects, the combinations of whole projects that fit within the capital limit are compared by total NPV. If capital is limited in more than one period, linear programming is needed.

Worked figures

Probability analysis: NPVs of +$50,000 (probability 0.3), +$20,000 (0.5) and -$40,000 (0.2) give an expected NPV of 0.3 x 50,000 + 0.5 x 20,000 + 0.2 x (-40,000) = $17. The standard deviation is $31. The probability of a negative NPV is 20 percent.

Capital rationing: project A has NPV $30,000 for $100,000 invested (index 0.30), and project B has NPV $25,000 for $50,000 (index 0.50). With $120,000 available and divisible projects, B is taken first, then A in part: 70/100 of A, with NPV 21,000, for a total NPV of $46,000.

Key terms

• Expected NPV: The probability weighted average of the possible NPVs.
• Simulation: Repeated appraisal using random values drawn from probability distributions.
• Profitability index: NPV divided by the capital invested.

Study tip: Do not rank indivisible projects by profitability index. Test combinations.

Practice questions for section B

C. Cost of capital and capital structure

Portfolio theory shows that holding a diversified portfolio reduces total risk, because unsystematic (specific) risk is removed by diversification, and what is left is systematic (market) risk. The capital asset pricing model (CAPM) says that investors are paid only for systematic risk, measured by beta: cost of equity = risk-free rate + beta x (market return - risk-free rate). Its advantages are that it is based on risk, uses market data and can give a project-specific cost of equity, and its weaknesses are that it assumes a single period, perfect markets and rational investors, and that beta and the market premium are hard to estimate. The dividend growth model gives the cost of equity as the next dividend divided by the share price plus the growth rate, where growth can be estimated as the retention rate multiplied by the return on retained funds. The dividend valuation model is the special case with no growth.

The cost of debt depends on the type. For irredeemable debt, it is interest x (1 - tax rate) divided by the market price. For redeemable debt, it is the internal rate of return of the after-tax interest payments and the redemption value, against the market price. For convertible debt, the cost is the IRR using the higher of the redemption value and the conversion value at the conversion date. For preference shares, it is the dividend divided by the market price, with no tax relief. For bank debt, it is the interest rate x (1 - tax rate). The weighted average cost of capital (WACC) weights these costs using book values or market values, and market values are generally preferred.

WACC can be used as the discount rate for a project only if the project has the same business risk as the company and does not change its financial risk. Where a project has different risk, CAPM is used to find a project-specific cost of equity, by taking the beta of a company in the same business (an asset beta, adjusted for gearing), and a project-specific cost of capital.

Theories of capital structure. The traditional view says that there is an optimal gearing at which the WACC is lowest and the company value is highest, because debt is cheaper than equity until financial risk raises the cost of both. Modigliani and Miller, in a world without tax, say that gearing does not affect the WACC or value, because shareholders can adjust gearing themselves. With tax, they say that value increases with gearing because of the tax shield on interest, which would imply 100 percent debt. Market imperfections, such as bankruptcy costs, agency costs and differences in borrowing rates, limit this in practice. Pecking order theory says that companies prefer to use retained earnings first, then debt, then new equity, because of the costs of issue and information asymmetry.

Worked figures

Dividend growth: retention of 40 percent at a return of 15 percent gives growth of 6%. With a next dividend of $0.30 and a share price of $5.00, the cost of equity is 0.30 / 5.00 + 6% = 12%.

Redeemable debt: price $95, coupon 8 percent, tax 25 percent and redemption at par after 5 years. The after-tax interest is $6 a year. The IRR of the cash flows (-95, 6, 6, 6, 6, 106) is about 7.23%.

Key terms

• Systematic risk: Market risk that cannot be removed by diversification.
• Asset beta: The beta of a business before the effect of gearing.
• Pecking order theory: The view that firms prefer retained earnings, then debt, then new equity.
• Tax shield: The tax saved because interest is deductible.

Study tip: For a redeemable debt cost, set up the after-tax cash flows and find the IRR by interpolation. Do not just adjust the coupon.

Practice questions for section C

D. Valuation and hedging with derivatives

Valuation models. Asset-based models use the carrying amount, the net realisable value or the net replacement cost of the assets, and they ignore future earnings and goodwill. Income-based models use the price earnings ratio (P/E) or the earnings yield. Cash flow-based models use the dividend valuation or dividend growth models, or discounted free cash flows. Each has limitations: asset values may not reflect earning power, a P/E depends on a comparable company, and cash flow models are sensitive to the growth and discount rate assumptions. The information used must be reliable, and users should understand its limits.

Market efficiency. Weak-form efficiency means that past prices cannot be used to earn abnormal returns, semi-strong means that public information is already in the prices, and strong means that even private information is. Practical points include the marketability and liquidity of shares, the availability of information, imperfections, market capitalisation and pricing anomalies. Investor speculation and behavioural finance (for example herding and overconfidence) can cause prices to move away from fundamental values.

Foreign currency hedging. Exchange-traded currency futures are standardised contracts, traded on an exchange with daily margin payments, that can be bought or sold and closed out before expiry, and the hedge may be imperfect because of the standard sizes and dates and because the futures price may not move exactly with the spot rate (basis risk). Over-the-counter (OTC) currency options give the right but not the obligation to buy or sell currency at a set rate, so the holder is protected against an adverse move but keeps the benefit of a favourable one, in return for a premium. A forward contract fixes the rate and removes both the risk and the possible gain. A money market hedge uses borrowing or depositing in the foreign currency, so that today's spot rate is used.

Interest rate hedging. Matching and smoothing, and asset and liability management, are traditional methods. A forward rate agreement fixes the rate for a future loan or deposit. Exchange-traded interest rate futures and OTC interest rate options give a similar protection. The choice depends on the size and timing of the exposure, the cost, the risk the organisation is prepared to bear, flexibility, and the accounting and treasury skills needed.

Worked figures

Money market hedge: a company must pay FC 600,000 in 3 months. The spot rate is FC 3.00 to $1 and the foreign deposit rate is 2 percent for the 3 months. It deposits 600,000 / 1.02 = FC 588,235 now, which costs $196,078 at the spot rate, so the cost of the payment is fixed at $196,078 (before any financing cost).

Key terms

• Currency future: A standardised exchange-traded contract to buy or sell currency at a future date.
• Currency option: The right, but not the obligation, to buy or sell currency at a set rate.
• Basis risk: The risk that the hedge does not move exactly with the exposure.

Study tip: For each hedge, state what it fixes, what it costs, and what it leaves open.

Practice questions for section D