Annuity factor NPV of Asset Equivalent annual cost = P H (£000s) (£000s) Net present value Annuity factor EAC CHAPTER 3 – ADVANCED DISCOUNTED CASH FLOW TECHNIQUES 51 CAPITAL RATIONING A limit on the level of funding available to a business, there are two types: Hard capital rationing Externally imposed by banks. Due to: 1. Wider economic factors (e.g. a credit crunch) 2. Company specific factors (a) Lack of asset security (b) No track record (c) Poor management team. Soft capital rationing Internally imposed by senior management. Issue: Contrary to the rational aim of a business which is to maximise shareholders‟ wealth (i.e. to take all projects with a positive NPV) Reasons: 1. Lack of management skill 2. Wish to concentrate on relatively few projects 3. Unwillingness to take on external funds 4. Only a willingness to concentrate on strongly profitable projects. Single period capital rationing There is a shortage of funds in the present period which will not arise in following periods. Note that the rationing in this situation is very similar to the limiting factor
This is a confidential agreement that is by negotiation between both parties. Traded investments Debt instruments sold by the company, through a broker, to investors. Typical features may include: 1. The debt is denominated in units of £100, this is called the nominal or par value and is the value at which the debt is subsequently redeemed. 2. Interest is paid at a fixed rate on the nominal or par value. 3. The debt has a lower risk than ordinary shares. It is protected by the charges and covenants. CHAPTER 4 – LONG TERM SOURCES OF FINANCE 66 Types of issued debt They include: Debentures Debt secured with a charge against assets (either fixed or floating), low risk debt offering the lowest return of commercially issued debt. Unsecured loans No security meaning the debt is more risky requiring a higher return. Mezzanine finance High risk finance raised by companies with limited or no track record and for which no other source of debt finance is available. A typical use is to fund a management buy-out. CHAPTER 4 – LONG TERM SOURCES OF FINANCE 67 OTHER SOURCES Sale and Leaseback 1. Selling good quality fixed assets such as high street buildings and leasing them back over many (25+) years. 2. Funds are released without any loss of use of assets. 3. Any potential capital gain on assets is forgone.
Example 10 – Pennant The return earned by Pennant is presently 17.5%, this represents a beta value of 1.5. The return on short-dated government bonds is presently 10%. Required What is the expected market return? Example 11 – Agger plc Presently market return is 16%. Agger earns a return of 12% and has a beta value of 0.5. Presently market return is 16%. Agger earns a return of 12% and has a beta value of 0.8. Required What is the present risk-free return? CHAPTER 5 – COST OF CAPITAL 85 KD – THE COST OF DEBT The cost of debt is the rate of return that debt providers require on the funds that they provide. We would expect this to be lower than the cost of equity. The value of debt is assumed to be the present value of its future cash flows. Terminology 1. Loan notes, bonds and debentures are all types of debt issued by a company. Gilts and treasury bills are debt issues by a government. 2. Traded debt is always quoted in $100 nominal units or blocks 3. Interest paid on the debt is stated as a percentage of nominal value ($100 as stated). This is known as the coupon rate. It is not the same as the cost of debt. 4. Debt can be: (i) Irredeemable – never paid back (ii) redeemable at par (nominal value) (iii) or redeemable at a premium or discount (for more or less). 5. Interest can be either fixed or floating (variable). All questions are likely to give fixed rate debt. Kd for irredeemable debt
15% debentures 20X4 – 20X7 (5.0) ____ 15.0 ==== Capital and reserves Ordinary shares (25p par value) 5.0 Reserves 10.0 ____ 15.0 ==== Required (a) Calculate appropriate gearing ratios for Newsam plc using: (i) book values; and (ii) market values. (3 marks) (b) Assess how close Newsam plc is to breaching the debenture covenants. (3 marks) (c) Discuss whether Newsam plc‟s gearing is in any sense „dangerous‟. (4 marks) (d) Discuss what financial policies Newsam plc might adopt: (i) in order to lower its capital gearing; and (ii) to improve its interest cover. (10 marks) (Total: 20 marks) CHAPTER 7 – RATIO ANALYSIS 114 STOCK MARKET RATIOS Earnings per share (EPS) Example 6
Chapter 12 Risk CHAPTER 12 – RISK 166 CHAPTER CONTENTS FOREIGN CURRENCY RISK --------------------------------------------- 168 THE EXCHANGE RATE --------------------------------------------------- 169 SPOT RATE 169 SPOT RATE WITH SPREAD 169 EXCHANGE RATE SYSTEMS -------------------------------------------- 170 FIXED (OR PEGGED) RATE SYSTEMS 170 FLOATING RATE SYSTEMS 170 MANAGED OR „DIRTY‟ FLOAT 170 TYPES OF FOREIGN CURRENCY RISK --------------------------------- 171 TRANSACTION RISK 171 ECONOMIC RISK 171 TRANSLATION RISK 171 WHAT MAKES EXCHANGE RATES FLUCTUATE? ---------------------- 172 BALANCE OF PAYMENTS 172 CAPITAL MOVEMENTS BETWEEN COUNTRIES 172 PURCHASING POWER PARITY THEORY (PPPT) 172 INTEREST RATE PARITY THEORY (IRPT) 173 THE INTERNATIONAL FISHER EFFECT 174 HEDGING EXCHANGE RATE RISK ------------------------------------- 176 INTERNAL HEDGING TECHNIQUES ----------------------------------- 177 INVOICE IN OWN CURRENCY 177 LEADING PAYMENT 177