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MFIN Programme
MFIN 6663
Financial Management
Module 1:
The finance function in the organization and society
Dr. J Colin Dodds
Reading

Chapter 1 of the text

Osler (2008): Key lessons from the BCE Decision (2019)

Gellar D and D. Yaffer Bellany 2019, Shareholder value is no longer
everything, Top CEO‟s say, New York Times

The Economist (2019), What companies are for, August 19th

Zingales L (2015), Does Finance Benefit Society, A.F.A Presidential Address
2
Contents

Quotations

Learning Objectives
1. Introduction
2. What is Financial Management
3.How do the various tasks of the financial manager hang together

Summary

Risk Management

Discussion Questions
3
Quotations

The financial world is becoming increasingly more complex, integrated
globally, dangerous and exciting

A fool is someone who knows the price of everything and the value of nothing
(various claimants)

“There is one and only one social responsibility of business – to use its
resources and engage in activities designed to increase profits so long as it
stays with the rules of the game, which is to say, engages in open and free
competition without deception or fraud†– Milton Friedman
4
Learning Objectives
After studying this module and class lectures, you should be able to:

Understand that there are many types of enterprises from SME‟s, often family
owned, non-profit, cooperatives e.g. agricultural, financial institutions,
income trusts, often in real estate, as well as the corporation/firm that can
be both private and publicly owned. Our focus in this programme is
predominantly on the larger corporation that may or may not be listed on a
stock exchange(s) and in most cases has a growth objective through organic or
M&As, including offshore or both. However, there is an increasing trend in the
USA in particular for hedge funds and others to take listed firms private, often
through LBOs.

Appreciate that as a firm grows from a start-up/family business, there will
likely be a separation of ownership from management/control. This creates
an agency issue as shareholders and managers‟ interests often diverge.
5
Learning Objectives (Cont.)

Define the subject matter of financial management and start to answer 3 key
questions:
1.
What long-term investment strategies should an enterprise take on? How would
they balance onshore and offshore through FDI, thus becoming a multinational and
organic vis-à-vis M&A? How do they identify and manage the risks that may
emerge.
2.
How can funds (cash) be raised for this capital investment domestically and
globally, and what are the implications of debt versus equity – but more of this in
MFin6664? What are the issues too of retaining funds versus dividends?
3.
How much short-term cash – working capital, does a firm need to pay its bills?

Appreciate how the enterprise fits into the resource allocation process in an
economy/society. Sub-optimal investment by a firm, particularly from
retained earnings will affect not only the performance of the firm, but the
overall performance of an economy, There may be „zombie‟ firms.

Understand the decision functions within the enterprise, particularly to the
extent that it affects the financial management function and thus the key
role the finance function plays
6
Learning Objectives (Cont.)

Understand how the various functions of the financial manager in an
enterprise fit together and are integrated as part of the governance structure
of the enterprise -what is the balance of power among the stakeholders of the
firm‟s shareholders (including institutional activists – more on this later), top
executives, the board (in North America in particular on gender balance and
diversity), the labour force and unions (if organized) and governments as
representing the interests of society as a whole. On the latter this could be on
negative externalities such anti-trust and ESG effects (environmental, social
responsibility and governance).

An enterprise needs funds/cash to survive – for a firm from sales and loans
and issuing securities (bonds and equities) and how it manages those funds in
both the short-medium to long-term will play a crucial role in the
performance of the firm. If it is raising these externally, then this will require
an interaction with financial institutions such as banks and financial markets.

Understand the importance of risk analysis and its management and this can
lead to interactions with and direction from Boards of Directors.
7
Learning Objectives (Cont.)

Appreciate that a thorough knowledge of the foundations of finance theory
will lead not only to better policy pre-requisites for an enterprise, but to
practical applications. But there is a counterpoint to this – does finance as a
discipline benefit society (see the Readings on this). We can pose the question
now, but other courses will return to this topic and you will cover a lot on
Modern Portfolio Theory (MPT) et al and its relevance or otherwise.
8
1. Introduction
ïµ
So far in the programme you have studied Microeconomics and Financial Accounting
with the micro course studying among other things, factor inputs and product/services
outputs. Both enterprises and household are seeking to maximize profits and utility
respectively. But is reality this is in a world of uncertainty and risk.
ïµ
This course is the first of the „Finance‟ disciplines and is a direct precursor to MFin
6664 and we will be using the same textbook.
ïµ
The Accounting Model of the firm seeks to maximize the reported Earnings Per Share
(EPS).
ïµ
However, this is challenged in Finance theory which has the objective of maximizing
shareholder value with a focus on expected after tax free cash flow in excess of what is
required to fund all projects that have positive Net Present Values (NPV) – covered later
in this course in Module 4 – when discounted at the relevant cost of capital. Such a
model is claimed to not only give better performance and a measurement guide to both
internal and external analysts, but will lead to a better allocation of resources in the
economy as a whole – a welfare gain for society. This is a fundamental justification of a
market economy as opposed to the allocation of capital by central planning.
9
1. Introduction (Cont.)

To carry out its central function in our market society/economy, the enterprise needs
funds. A feature of the market economy is the ability of individuals (and through them,
financial institutions) to accumulate wealth. If it is consumed, then this is covered
through a study of product/services markets as in your Microeconomics course.

If it is reinvested, then it is a matter of concern for financial managers of a business,
and financial institutions and markets that have lent funds (see Module 2) and other
enterprises e.g. Not-for-profit and Cooperatives. We are therefore concerned with
obtaining an optimal resource allocation of these funds invested in projects. Investors
can through financial markets directly place their funds with enterprise/firms – both
domestic and global, say through an IPO to obtain a return on their investment or
indirectly through a financial intermediary such as a bank or mutual fund.
10
1. Introduction (Cont.)

Figure 1 illustrates, both the direct and indirect funding of firms.
Funds Suppliers
Deposits
Funds Suppliers
Financial
Intermediaries
Financial
Intermediaries
Loans
Funds
Demanders
Funds
Demanders
Indirect Finance
Direct Finance
Source: Text, Pg. 17
11
Introduction (Cont.)
Five related questions:

What is financial management?

How should we best understand the nature of the enterprise, including the
types of enterprise that exist?

How should we understand how the financial management function operates
within the enterprise?

How do the various tasks of the financial manager hang together?

How are risks identified and incorporated into the decisions of the firm?
12
2. What is Financial Management?
ïµ
Accounting is concerned with the processing and interpretation of information
whether inside the enterprise – management accounting or from outside –
financial accounting
ïµ
Financial management is concerned with the management of the financial
aspects of the enterprise. It is a management, not a service function
Principal boundaries of systems analysis,
with breaks representing filters
Figure 2 shows the Information Inputs:
ïµ
Cost of raising funds
ïµ
Current exchange rates
T
Two-way transformation linkages between
different characterizations of system
Flows of inputs and outputs measured in terms of
various characteristics
ïµ
Short-term interest rates
ïµ
New investment opportunities
ïµ
Financial innovation
Figure 2: Substantive Environment to the enterprise
Flows of inputs and outputs measured in terms of
various characteristics
13
2. What is Financial Management? (Cont.)

Figure 2 portrays the organization as a financial-economic system in terms of:
a.
Decision and control
b.
Funds
c.
Operations sub-systems.
The information inputs to a financial manager include

The cost of raising funds on capital markets: these markets both domestic and
international can allow an enterprise to raise long-term capital – bond and equity
financing. Short-term financing could be sourced from banks or issuing
commercial paper and factoring accounts receivables. We will cover more of this
in Module 5.
14
2. What is Financial Management? (Cont.)

Currency Exchange rates – As business is increasingly international through
trade (exporting/importing) and sourcing funds, FDI and portfolio
investments, then managing exchange rate exposure becomes important.
While more of this will be covered in later courses, including the International
Finance course, sufficice to say at this juncture that financial managers will
have to decide whether to hedge the risk and if so, how – using derivatives
such as options/futures, swaps, forward currency transactions and if a large
multinational, in its global treasury by matching exposure in currencies across
its subsidiaries. For interest rate risk there are swaps say to switch a fixed
loan to floating and vice versa.

Short-Term interest rates on the money market – The enterprise can borrow
short-term to fund working capital requirements and can, if it has surplus
cash available, lend by buying short-term securities such as a commercial
paper or government securities such as Treasury bills. Handling a reserve of
cash can be for precautionary motives or portfolio purposes of future
investments, including M&A‟s
15
2. What is Financial Management? (Cont.)

Information of new investment opportunities – When we look at the capital
budgeting decisions of firms, potential investment opportunities may be
known to an enterprise or more likely to search for them. A financial manager
will have to be aware of a future cash drain on liquid resources and/or the
need to borrow and seek advice on the potential investment opportunities
and how they will impact on existing and other planned projects

Financial Innovation and the emergence of new financial instruments, crypto
currencies such as Bitcoin and new payment systems – Many of these have
resulted from the structural changes that have occurred in financial systems
with de-regulation as well as increased globalization and the need for more
efficient risk management instruments. Some are off-balance sheet with the
consequent difficulty of assessing risk from financial statements, and by
regulators. Enron was a case in point. Developments in „Finance‟ theory have
played a critical role in providing the theoretical awareness for such
innovation, but also its practical applications. Here there is less divergence
between academics and practitioners recognizing the major contributions of
theory in the area of capital investments in plant/machinery in „investments‟
and in managing risks. You will cover these in more detail in the later courses
starting with Corporate Finance (MFIN 6664)
16
2. What is Financial Management? (Cont.)
The outputs from the financial management decision sub-system would include:

Information about the rates at which the enterprise will lend money

Information about the rates at which the enterprise will borrow money

Forecast information about the future cash needs of the enterprise

Advice on whether to raise new long-term debt or equity or a combination
short-term debt or rely on internally generated funds

The availability of risk management techniques

Forecasts of economic aggregates and the impact of externalities on existing
and planned projects of the firm
17
2. What is Financial Management? (Cont.)
Examples of the:


Inputs of the financial funds sub-system would include:

Cash receipts from customers i.e. A/R

Interest or dividends received i.e. investments

Fresh inflows of debt or equity capital
Outflows of the financial funds sub-system would include:

Cash payments to customers i.e. A/P

Dividends to shareholders

Interest payments to banks and bond holders
This is summarized in Figure 3.
18
What is Financial Management? (Cont.)

The financial manager is part of the decision and control sub-system of the enterprise
managing the funds sub-system – information on inputs/outputs and financial funds. The
enterprise is an entity and the finance function assists in the process of focusing on the
firm as a whole. Systems represent the inputs, processes and outputs
Sub-system
Decision and control
Financial funds
Information on interest rates
Cash from debtors
Information on capital availability
Interest received on invested funds
Information on exchange rates
Return of capital from invested funds
Information on new financial instruments
Dividends received on corporate investments
Information on new investment
opportunities for the enterprise
Inflows of funds from new issues of
bonds/equities and bank financing
Decisions on the future debt/equity ratio
of enterprise
Cash to creditors
Information on the interest rate at which
the enterprise will be prepared to lend
funds
Dividend payments to shareholders
Interest payments to lenders
Figure 3
19
2. What is Financial Management? (Cont.)

For many countries the task of a financial manager would be more domestic
focused, although less so for Canada which has a close trade relationship with the
USA and international trade is a high percentage of GDP thus more of a competitive
dynamic.

These functions are taking place in the world where the pace of change is changing
and increasingly global and risky with both opportunities and potential losses :

Internationalization of capital markets to raise and invest funds – look at the cross listing
of stocks and the offshore ownership of many stock exchanges

New financial products/financial innovation and payment systems and virtual currencies
referred to earlier

Growth of multinational enterprises and global supply chains but now increased
protectionism and nationalism and shifts in those supply chains from China

deregulation of many domestic financial systems
20
Primacy of Value
But Value is a slippery concept and just as value is created, it can be lost, often quite
quickly.

Accountants – focus on earnings and their growth

Finance – on how capital markets set corporate stock prices

Is there a new approach to value, when there is no history of recent cash flow data
or profits: Dot com, Tesla, some High tech companies, Fintech, Cannabis.
The finance function plays a critical role in an enterprise/firm given the volatility of
financial and currency markets. The ability to understand the implications of
internationalization/globalization can make for the success or failure of an enterprise.
Decisions on currency – when to buy or sell and whether to hedge can have a large
impact on profitability, often more than decisions to buy/sell raw materials and other
products

Finance function captures the relationship between financing (including offbalance sheet) – the acquisition of finance – liability management – short and longterm financing and the investment decisions –the (asset side of the balance sheet) –
with short-term and capital budgeting decisions, including M&As and divestitures
21
3. How should we best understand the nature
of the enterprise?
First we need to examine the business organization forms:

Sole Proprietorship – Typically family structured, many large corporations have
started in this way and it is easy to form but there is unlimited liability. Many small
businesses organized this way and stay small by virtue of the type of business
practiced. There are issues of succession as owners age.

Partnership – Popular in the professions of law, accounting, medical, etc. Some can
have limited liability.

Corporations – is the most recognized form of organization. As owners of the business
seek to expand, they will generally encounter several issues. The need for funds and
professional managers, particularly financial. The corporation offers limited liability,
can vary in size and remain/become privately owned or listed on one or more stock
markets. As firms seek new capital, this will often dilute the ownership of the
founders, but in North America voting and super voting shares and non-voting shares
(say for these families) are not uncommon.
22
3. How should we best understand the nature
of the enterprise? (Cont.)

Cooperatives – a legally incorporated entity owned and controlled(?) by its members –
often found in retail. Financial services, agriculture. Some Coops are very large so
agency issues arise with separation of management and owners. See the recent
acquisition of Mountain Equipment Coop (MEC), which had filed for creditor protection
by Kingswood Capital Management, a US private investment firm. A BC Court rled
against a petition by Save MEC, a group of members and others. This could have
implications on a go forward basis for the coop model.

Income Trusts – found in Canada, particularly in real estate (REITs), oil and gas. Until
2006, income trusts as they were not corporations, were not subject to corporate tax.
This loophole was closed. But there are still some tax advantages as part of their
distributions to unit holders are considered as return of capital therefore creating less
tax liability to investors. Subsequently many have converted to corporation status.
Nevertheless, their market capitalization in Canada on the TSX and Venture exchanges
are not insignificant
23
3. How should we best understand the nature
of the enterprise? (Cont.)

Participant stakeholder approach: workforce, customers, owners, lenders, and the
general public. The rewards that go to each are related to various factors and
from the value created by their efforts. Management has to arbitrate among those
groups and to allocate resources in such a way to ensure the continued existence
of the enterprise. For shareholders, the dividend decision and the investment of
retained earnings are examples. For workers, decisions eg., collective bargaining.
There may be externalities – both positive and negative (e.g., Environmental
sustainability, social responsibility (ESG) – giving back to communities). Does this
lead to greater ROE‟s? Some mutual funds have an ethical investment objective?

Unitary ownership approach: this fits better with the traditional approach to
finance and was reinforced for Canada in the Supreme Court decision concerning
BCE in 2008. – see the reading on this. But the recent move by CEO‟s in the USA
are now more in line with the participant approach.

The underlying assumption is that resources will be allocated to their optimal use
through a market mechanism. The supplier of funds – personal, institutional (both
domestic and foreign) are aiming for a return on their funds from the enterprise
that receives these funds to undertake projects
More on this later…
24
See Figure 4 that illustrates the linkages for
investors through linkages and the projects
The investor can invest with an individual but
typically in a firm and the investor has to decide
in which enterprise/firm to invest and to

Select which type of security

Understand that there is an agency problem
of the separation of ownership and control
In essence a firm is a collection of projects, and
these will vary by type of industry e.g. energy,
retail. Conglomerate firms cover many different
industry sectors – however, conglomerates are
less popular now in the western world with many
spinning-off subsidiaries to focus on core
activities.
Figure 4
25
Linkages for investors through linkages and
the projects (Cont.)

An enterprise (firm) typically will have to search for those projects, although some
may flow from the normal course of business. This will be covered in Module 4. They
could cause the firm to grow organically and/or by mergers and acquisitions, and the
firm could be vertically integrated, grow horizontally within a given industry or be a
conglomerate. The latter were popular in the UK and North America – “barbarians at
the gate†with larger than life serial acquisitors who built large empires. As was
mentioned earlier, conglomerates are not in vogue in many countries with
divestitures – just like the colonial empires of old

From the point of view of an investor they have to
1.
Decide what type of asset fits their needs/liability structure. For corporate securities,
these would include equities, preferred and corporate bonds. With the emergence of new
financial instruments, the traditional distribution that applies to say debt and equity and
between short and long-term securities no longer applies. More on that later.
2.
Which industry sector and in which enterprise(s) to invest. This will depend on the
assessment of risk – for equities, dividends versus capital appreciation, the marketability
of the securities via secondary markets.
3.
While there is separation of ownership and management, increasingly management
performance pay has included not just short-term bonuses, but options granted or DSU‟s
26
Linkages for investors through linkages and
the projects (Cont.)

Deferred stock units which gives the recipient the rights to receive common shares
at a future date, such as on retirement. They can earn the equivalent of any cash
dividends into more DSU‟s. This means that there can be a class of „insider‟
shareholders and in the case of many former family firms as mentioned earlier, the
family may still retain control through the ownership of the voting/super voting
shares.
27
How should we best to understand how the
financial management function within the
enterprise operates?

The financial management function can best be understood by focusing on the
total system. In large firms in particular, managers can be focused with the subsystems for which they are responsible whereas the financial manager is
concerned with the finance function of the enterprise and decisions in production,
marketing/sales, etc., will impinge on her/him and likewise decisions by the
financial manager will affect the sub-systems.

In Figure 5, the firm is shown as a „black box‟ will inputs and outputs and the
management process within the box produces decisions and actions in response to
the objective(s) and needs of the enterprise.

Figure 6 shows the key importance of feedback loops. So if there is a variance in
the expected return on a capital investment – say 12% instead of 16%, then what is
the cause of that? It could be production or marketing problems or by factors
outside the control of the firm – the actions of competitors, technical advances,
government policies, geopolitical, or unforeseen external shocks eg Covert-19
28
How should we best to understand how the
financial management function within the
enterprise operates? (Cont.)

Four main stages in the decision making process:
i.
Recognizing and defining the need: e.g. gap between desired and actual
ii.
Search for alternative solutions
iii.
Evaluation of alternatives: See Figure 7
iv.
The decision: the act of choosing
29
How should we best to understand how the financial
management function within the enterprise
operates? (Cont.)
Feedback data:
Figure 5
ïµ
Forecast and actual data
ïµ
Accounting data
ïµ
Sales records
Figure 6
Figure 7
30
The decision – the act of choosing
ïµ
The best alternatives should be the chosen, e.g., capital
investment decisions and how to finance these – the optimal
choice of capital structure covered in MFin 6664.
ïµ
When uncertainty exists – management cannot necessarily choose
optimal choices. Managers may have to resort to satisficing
behaviour, so may have to set target rates of returns
ïµ
Some decisions involve repetitive behavior where others are
unique and discrete with a lack of information from past decisions
Financial decisions within the enterprise: Strategic and operating
Strategic: Time and Knowledge
ïµ
Time: the firm over time – short-term and long-term decisions here and
there may be a conflict. Short-terminism based on quarterly results
(feed the beast – Enron) may lead to a neglect of longer-term returns –
Japan and some other countries focus on the longer term given their
financial architecture
31
ïµ
Ultimately the value of the firm is decided by the market, but firms will of
course influence this with their strategic decisions, including their project
selection, financial decisions and dividend policy
Knowledge: Information flows and the risk and uncertainty the organization faces as
it often has to make non-repetitive decisions which can have a major impact on the
enterprise
Operating: more concerned with the internal resource allocation to translate the
strategic decisions into effective action. Often more short-term and standardized
ïµ Figure 8 illustrates the inter-relationships
within the finance function which is more
outward looking with key decisions of the
impact of the environment (financial and
capital investments –both domestic and
global)
ïµ Capital budgeting and financing decisions,
although shown as separate are intertwined
ïµ Planning and control elements provide
feedback loops
Objectives: the conventional objective of the
firm as found in most western text books is to
maximize shareholder value which we refer
to as the unitary approach.
Figure 8
32
The unitary objective can be challenged:
ïµ
Cognitive: problems of complexity and uncertainty including in maximizing anything
ïµ
Motivational: Managers may have other objectives, some of which may be personal–
agency theory again. In micro economics this is referred to as X inefficiency and in
management theory, managerial slack
ïµ
The move to include ESG factors into the decision making of the firm
Agency Theory: with asymmetric information, some people have information that others
do not, eg insiders so how can investors (the principals) know that their interests are
being looked after by the Board and managers of the enterprise (the agents)? The
Managers and the Board will have access to internal information/reports and the market
does not have this amount of detail. Though analysts attempt to predict what future
earnings will look like. Even if information, good or bad, is given by a firm to the market,
say in analyst‟s meetings, press releases, will the market believe it? What of activist
investors and corporate control mechanisms, In addition managers may lack information
on their shareholder base.
Share options, repayable bonuses tied to firm performance and other long-term retention
plans can provide an incentive for managers to act in the interests of the shareholders.
But there are monitoring (agency) costs and these can be reduced for small shareholders
by the media and by activist investors – the market for corporate control.
33
Although this implies that value is central to a firm (private or public),as illustrated
earlier, it may have a series of other objectives as mentioned earlier, including
corporate social responsibility which may add to longer term value
Shareholders, including institutional are concerned to earn a return equal or greater
than the alternatives they could invest in for a given level of risk. But there is
information asymmetry in how those investment decisions are taken.
34
4. How do the various tasks of the financial
manager hang together?
ïµ
Raising Capital: Equity
Long-term debt
Short-term debt
1.
Should funds be raised at all? – rely
on retained earnings?
2.
How can the firm structure its
financing across the three broad
categories? What of the impact of
leverage?
3.
Given the enterprise has a
continual flow of funds in and out,
to what extent should
discretionary payments be made of
dividends, share buybacks etc.
Figure 9
35
How do the various tasks of the financial
manager hang together? (Cont.)
Project Evaluation
ïµ
As mentioned earlier, projects usually have to be searched for. They usually do
not just present themselves for appraisal.
ïµ
Focus on cash (free cash flow) – but the cash will flow over time, so it has to be
discounted back to achieve a present value. With low interest rates as now, this
is less of an issue than in the 1980‟s when interest rates were double digit.
Negative rates as found in some countries are an interesting issue – both for
theory and practice. You may wish to raise that in your Macro course.
ïµ
We do not live in a risk free world and it would seem that it is even riskier
today.
36
The Central Linkages
There are two ways in which the functions of the financial manager are linked
together:
i.
The cost of capital – all funds whether retained earnings or borrowed funds
have a cost so projects selected must earn at least that. Only in this way can
the value of the enterprise be increased.
ii.
Modern Portfolio Theory (MPT) – market efficiency: that markets are efficient in
allocating resources and at comprehending the nature of enterprise. It links
investors, financing policies and capital project appraisal into an integrated
whole. This is covered in Module 3.
A cautionary note, although MPT is very persuasive, and you will be exposed to it in
many future courses, it is not definitive.
37
Summary

The finance function is critical to an enterprise – it encompasses a wide variety of tasks and in
carrying them out, it must be integrated carefully with the rest of management‟s functions
permitting a more holistic approach to the organization, so cannot be considered in isolation.

The finance managers perform a management function – decisions and control over the financial
affairs of the enterprise, but this is not in a vacuum and the issue of ESG is now assuming
greater traction for investors and there for managers.

The exteanl environment facing the financial manager is constantly changing and there are new
markets and new financial instruments combined with increased volatility in financial markets
and which are increasingly globalized.

Although the enterprise/firm may be seen as a coalition of participant groups, financial theory
and the Supreme Court of Canada have taken the view of a unitary ownership approach to value
with a focus on shareholders. But managers cannot be relied upon to maximize the welfare of
the owners: Agency issues including costs.

The financial management function can be classified into strategic and operating decisions, but
fully integrated into the other management functions of the firm/enterprise,

The presence of risk and uncertainty (see the next section) adds to the complexity of the world
of a financial manager. But while we usually associate risk with a negative lens, there is the risk
of gain from opportunities that may arise, typically from an external shock. The Covid-19
pandemic is a case in point of many negatives for some sectors/firms and opportunities for
others.

Readings listed

Text: Chapters 1-3
38
Risk Management Process

Risk Identification: an annual review of risk should be carried out with at least an
annual management meeting to review and assess risks. Overall, risk and changes to
the organizational risk profile should be a regular topic at bi-weekly core
management team meetings.

Risk Assessment: All identified risks are assessed for probability (likelihood) and
potential impact(materiality), enabling management to prioritize risks and mitigation
strategies.

Mitigation Strategies: Existing mitigation efforts are reviewed and new/additional
efforts identified where needed. Mitigation strategies are assessed on a cost-benefit
basis.

Dissemination and Training: Risk analysis is shared widely across the organization in
order to refine the analysis, and ensure that all staff are contributing towards
effective risk management.

Ongoing Risk Management: The management team monitors identified risks on an
ongoing basis. As well, changes to risks should be discussed at the bi-weekly core
management team meetings. A detailed annual review of risk needs to be carried out
and an updated risk report presented to the Board.

Many enterprises have now renamed their Board Audit Committee as Audit and Risk
Committees.
39
Risk Register

1.
Enterprises should maintain a risk register that sets out identified risks, analyzes risks in order
of impact and likelihood, details mitigation measures and assesses the residual level of risk. Risk
Assessment: All identified risks are assessed for probability (likelihood) and potential
impact(materiality), enabling management to prioritize risks and mitigation strategies.
Risks are assessed by probability (a function of time horizon and likelihood):
• Low: An event that could occur within the next three to five years.
• Medium: An event that could occur within the next two years.
• High; An event that will likely occur within the next year.
2.
Risks are also assessed by Materiality (consequence to the organization for not managing the
risk) Clearly the larger the firm the greater the materiality just as in the audit function.
• Minor: An event which the organization can endure, requires relatively minor management
effort to minimize impact, and has a financial impact of, say for a SME of up to $100,000.
• Moderate: An event which can be endured with significant management effort, and has a
financial impact of up to $250,000.
• Major: An event which can be endured with significant management effort, and has a
financial impact over $250,000 or a critical event that will have a major impact upon a firm‟s
operations and Its ability to fulfill its mission, even with significant management effort.
• Financial impact refers to the value of direct financial consequence, plus the value of lost
future opportunities. Covid-19 – an exteral nlshiock
40
Risk Register (Cont.)
3.
Mitigation Strategies used are directed at reducing the materiality and or probability related to
the risk and must be balanced with the level of resources (cost) needed to implement the strategy.
Mitigation measures include:
Risk avoidance: developing an alternative strategy that has a higher probability of success, but at a
higher cost
• Risk sharing: sharing responsibility for the risk activities
• Risk reduction: investing funds to reduce the risk (based on cost-benefit)
• Risk transfer: shifting the risk to another party
Identified risks can be shown in a „heat‟ map and are assessed for probability (P) and materiality (M)
using a three point scoring matrix, where 1 is low/minor and 3 is high/major. An overall risk score is
calculated as P x M. After mitigation strategies are identified, residual probability (RP) and residual
materiality (RM) are determined. Residual risk is calculated as RP x RM.
41
Risk Tolerance

Risks can be evaluated on the basis of materiality and probability, analyze initial
and residual risk (following mitigation), and establish thresholds, above which:
Risk Assessment: All identified risks are assessed for probability (likelihood) and
potential impact(materiality), enabling management to prioritize risks and
mitigation strategies.
1. Additional analysis, mitigation and or approval measures are required; or
2. the firm will not undertake the proposed initiative and
3. risk analysis through dissemination and training is shared widely across the
organization in order to refine the analysis and ensure that all staff are contributing
towards effective risk management.

If the initial risk of any proposed initiative is low to moderate, a firm can
proceed with normal mitigation measures. If the initial risk is moderate to high,
then additional mitigation, analysis and or approval measures are required.
These additional measures may include initiative specific risk registers,
consultations with ad hoc committees of the Board, consultations with the Audit
and Risk Committee, etc. So a key part of the governance of the firm.
42
Risk Tolerance (Cont.)

Categories for which initial risk may be high, requiring additional analysis, planning,
mitigation and or approval measures in order to reduce residual risk, include:
• New line of business and or financial models, for which the firm does not have
recent experience and/or must develop additional expertise/capacity to
manage
• Significant financial growth from one year to the next, exceeding 25%.
• Mergers and/or acquisitions of other organizations, or significant financial
investments requiring debt and/or equity.
Subsequent to the mitigation and analysis, if the residual risk is moderate, assessment of
the initiative will be based on the rate of return and/or strategic or reputational
consequence to the organization.
Where the residual risk is significant to high, further mitigation will be assessed based on
the rate of return of the mitigation measures. If residual risk remains high following
these measures, then the firm will not proceed with this initiative.
Once each risk has been reviewed, the collective effect of the risks should be analyzed
for concentration within a particular objective area, portfolio, risk type and or risk
score. Based on that analysis furthermitigation measures may be put in place to reduce
the collective effect of the risks.

You will cover risk management in Module 7 of the programme in July/August 2021.
43
Key Terms and concepts:

Agency theory and costs

Cost of Capital

Leverage

Information asymmetry

Signaling

Unitary and participant approach

Inside/outside shareholders

Strategic and operating objectives

Wealth maximization

Feedback loops

Financial innovation

Risk identification and management

ESG ( environmental, social responsibility and governance)
44
Discussion Questions
1.1 Finance is emerging as the business function that holds the corporation together
at the top management level.‟ Discuss in terms of the firm‟s strategic direction and
its finance function
1.2 The shareholders are theoretically in control of the affairs of a company, so why
do they actually have little input into the decision-making process apart from
activists?
1.3 Discuss the problem that the financial manager faces when many textbooks
suggest that s/he should maximize shareholder wealth, yet the vast array of
literature which deals with the motivational assumptions of firms rejects this
unitary approach.
1.4 Models for financial management decision making generally take, as the basis
for their objective function, the maximization of shareholder wealth. Do you
consider this to be an appropriate objective in this context in the light of theory
and current practice? How does
1.5 Discuss how the actions of investors and the media can influence financial
managers of firms and have an impact on the economy and financial system.
45
Discussion Questions (Cont.)
1.6 Distinguish between a profit maximization objective as specified by the
microeconomic theorist and value maximization as propounded by a financial
theorist.
1.7 Do profits ensure the survival of the firm?
1.8 Can the management group act as an arbitrator among the various competing
interest groups of the firm?
1.9 Why is it that to ensure that managers act in the best interests of shareholders
the latter have to incur agency costs?
1.10 What remedies do shareholders have in pursuing their rights as the de jure
controllers of the firm if they feel these rights have been threatened?
1.11 What policies can managers pursue to accommodate their own ‘self–interest’?
How relevant are the internal and external constraints and controls that may exist
to limit such actions and how might this change with a greater concentration of
offshore investors?
1.12 How might the interest of shareholders, bond holders, management,
employees and society coincide, and how might they be in conflict? The BCE case
for Canada illustrates this.
46
Discussion Questions (Cont.)
1.13 Profit maximization as an objective is often criticized for being
non-operational, yet how is it possible to operationalize value maximization?
1.14 To pursue ‘value’ maximization a large number of assumptions are necessary,
not least that the share price reflects the value of the firm. How do the decisions
taken by the firm translate into the market price of the shares?
1.15 The shareholder retains the ultimate power of veto on a board of directors.
Examine this fact with the emergence of large blocks of institutionally controlled
shares, including those of activists
1.16 The shareholder can diversify his risk of investment by holding at the very
least a randomly selected portfolio of shares. The manager’s interests by and large
cannot be diversified. Examine the asymmetry that exists here.
1.17 Does and should social responsibility and other issues in ESG have a role in the
formulation of the objective(s) of the firm?
1.18 The risk of the shareholder is taken for granted, but the bond-holder is often
exposed to risk. Illustrate how this occurs and what remedies are available to the
bond-holder. This was an issue in the BCE case before the Supreme Court of Canada
47
Discussion Questions (Cont.)
1.19 Discuss the differences between an „economic value‟ model and an
„accounting value‟ model.
1.20 Executive compensation can act as a mechanism which induces insiders to act
in a way „which is more nearly suited to outsiders‟ interests‟. Discuss
1.21 Many firms have growth objectives and some CEO‟s promote a serial M & A
policy despite the litany of well documented failures. Why might this be the case
and what constraints are there in place to caution firms against paying too much for
an acquisition? More on this in later courses.
1.22 With the emergence of multinational firms, how has this changed the financial
management function of a firm? More on this in MFin 6676.
1.23 Board of enterprises can play a key governance role in protecting the interests
of shareholders. Yet many Boards by their composition fail in the oversight and
primary role! Why might this be the case?
1.24 With the growth of international trade and two way offshore capital flows,
what are the implications of these trends for financial managers and the finance
function of an enterprise?
48
Discussion Questions (Cont.)
1.25 With the growth of crypto and digital currencies as a well as alternative payment
platforms, what are the implications for those innovations on a financial manager and a
firm?
1.26 With the many avenues of risk that face firms, discuss the need to identify and
quantify risks and how might financial managers choose to mitigate/manage these risks?
1.27 Many firms reward their top management with share purchase schemes and stock
options. This is meant to reduce agency costs to the external shareholders. Discuss.
1.28 Top managers if they are shareholders are „insiders‟. How could this change their
policy decisions and their relationship to the other shareholders, including institutional?
1.29 Risk is two sided – risk of gain and risk of loss. For a shareholder this will be
reflected in the movement of the stock market and the shares and investor holds.
However, for a firm it is far more complex as it will involve capital investment and
financing decisions. Discuss.
1.30 Give some examples of the risk of gain a firm may experience.
49
MFIN Programme
MFIN 6663
Financial Management
Module 2:
Securities markets in financial management
Reading: Text, Chapter 4.
Dr. J Colin Dodds
Learning Objectives

Understand the nature of the markets that face the financial manager-the
borrowing-lending decisions;

Appreciate the purposes of these markets;

Place recent developments, (including international) in financial markets in
focus, and realize how they affect the corporate financial manager;

Provide a linkage to later modules and courses in the programme e.g.
Investments, Applied Portfolio. Fixed Income, Financial markets and
Institutions.
2
1. Introduction

In Module 1 we introduced the fact the funds
owned by individuals and other investors can
be invested via financial intermediaries or
invested directly (Figure 1) are made use of
in real productive assets. Figure 4 showed
this with two major classes of decision
makers;

the investors who can be personal and
institutional and

the corporate executives who are entrusted
with the management of these funds which
brings about agency issues.
Figure 4
3
1. Introduction (Cont.)

For individuals they have a choice to make between spending on consumption includes
borrowing (e.g. mortgages) and saving funds through banks and/or investing in financial
markets

For financial institutions such as pension funds, life insurance companies, mutual funds,
they are investing funds on behalf of their clients

Financial managers have an interest in financial markets for various reasons;

Firms are reliant on these markets for funds (the liabilities side of the balance sheet.)

They deploy funds (asset side of the balance sheet) in working capital and long-term
capital projects.

Markets (if the firm is listed), do provide signals and valuations of both the equity and
debt instruments as do specialist institutions such as bond rating agencies(in the USA
Fitch, Moody’s, S&P)
4
Introduction (Cont.)

ABC is financed by 2m shares and 3m bonds the latter carrying a 6% coupon. The
share price at 21 Apr 20xx is $1.20 and the price of a $1000 bond stands at $920.
There are no other liabilities.

The value of the firm on that day is simply;
(2,000,000 x $1.20) + 3,000,000 x 920/1000 = $5,160,000
5
Introduction (Cont.)

In Module 1 we raised the objective of the firms as being the maximization of the
wealth of the shareholders, although we provided a caution to this in terms of other
participants and their claims on the firms such as short-term financing e.g. bank
loans, commercial paper, employees, society.

Also the firm exists in a world of uncertainty so this makes it difficult to value a
firm. However, that is what financial markets do and in the example just given,
where the bonds were selling at a discount, this would reflect the level of the
prevailing interest rate structure (unless the bond was sold at a discount at $920,
then interest rates have risen over the intervening period or the credit risk the
market perceives of the bonds has increased.

With the very low rates that exist currently, bonds can be trading at a premium.

Later in the course we will be discussing how efficiently markets perform their role
in estimating the value of a firm (Module 3).
6
Introduction (Cont.)

Given the prevailing finance literature, we will be limiting ourselves to the key
importance of shareholders, but see the Readings from Module 1 on this.

For society as a whole, Bloomberg, S&P and Dow Jones now reports on
Environmental, Social and Governance (ESG) scores and some investors shun stocks
eg oil, pipelines that are perceived as having negative effects on the environment
and other aspects of society.

There are moves by some activists for pensions funds and foundations, etc., to
divest themselves of such stocks. There are ethical mutual funds and ETF’s that only
invest in securities that are perceived not to have negative externalities.
7
2. Stock Market

Investors have an array of assets they can invest their funds in from equities,
government/corporate bonds to GIC’s and other alternatives and perhaps more
“exotic†assets. The latter’s underlying value will depend on investor interest
rather than intrinsic value and prices can change dramatically as fashion and
demographics change.

The stock exchange (as a primary and secondary market); is really a series of
markets where securities can be bought and sold. These are from corporate
securities such as equities and bonds both corporate and governmental bonds – in
Canada provincial and federal. The latter are seen as “default risk freeâ€Â. There are
markets for commodities as well as derivatives such as options and futures. (There is
a course on this in Module 4 of the programme)
8
2. Stock Market (Cont.)

The stock exchange as a primary market;

A primary market offers companies both existing quoted companies and these seeking a
listing the opportunity to raise large amounts of capital.

A key issue is how to price the stock of a new entrant (IPO), and this can lead to both a
high premium over the listing price eg Canada Goose which is effectively a loss to the
company or a discount which is a loss to the underwriters. There is a whole literature on
this issue.

Remember from Module 1 that the firm is a collection of projects that need funds. If the
issue is for a company already quoted, then this is called a “seasoned†issue and there is
less of pricing issue as there is current market price, but there will be a discount from the
price. Other factors arise over the dilution of earnings and dividends that can occur.

However, a firm can raise additional funds through a rights issues to existing shareholders
which if taken up allows them to retain their percentage share of the firm
9
2. Stock Market (Cont.)

The stock exchange as a secondary market;
Once the stocks are issued they will trade. This does not directly affect the
firms as the buying and selling is among investors, although firms do care about
their stock price as;

it can affect a future issue of stocks and bonds.

it can affect the insider investors (e.g. stock options)

it will affect the debt to equity ratio of the firm and lenders may command an
additional premium for the risk as a high D/E ratio can cause financial distress.
Remember, debt has to be serviced and if the fall in share price is due to falling
earnings, then this could trigger the potential for a default.
10
2. Stock Market (Cont.)

Investors buy equities for a number of reasons, but their returns can come
in two forms: – Capital gains/losses
– Dividends.

Some investors have a long-term horizon eg. pension funds, but will still
trade while others may be short-term, including at the short extreme of
“day tradersâ€Â

Markets typically have “bull†and “bear†cycles and markets can crash –
1929,1987, 2008-09 ,the COVI-19 impact in March of this year are examples,
and with increasing offshore investors and the integration of economics,
market contagion can spread globally.

Future courses – Investments, Applied portfolio etc. will cover this in more
detail.
11
2. Stock Market (Cont.)

Other securities;

Fixed income; corporate bonds and government securities(both provincial and
federal)

Options/futures covered in particular in MFIN 6667.

Commercial paper – covered in this course in Module 5(b).
12
3. Stock markets in Canada

The Toronto Stock Exchange (TSX) is the largest exchange in Canada
covering equities, ETF’s, income trusts and investment funds.

The index (the compilation of which is a subject in itself) that covers the
TSX is the S&P/TSX Composite that replaced the earlier TSE 300. It covers
70% of the total market capitalization with about 250 companies listed.

The TSX Venture Exchange replaced the Vancouver and Alberta Stock
Exchanges and is a venture capital market for emerging companies that are
not of a size for a full listing. It is similar to NASDAQ in the USA

Canadian Securities Exchange (CSE) covers 200 or so companies hoping to
access capital
13
3. Stock markets in Canada (Cont.)

Montreal Exchange (MA); a derivatives exchange for future/ options.

There are two other exchanges – NASDAQ Canada and the Aequitas Neo
Exchange established in 2015).
You will cover more on this in later courses.
14
Summary

This short Module is meant as an overview of financial markets as they are
vital to the finance function of the firm

There are many investors in these markets often with different liability
structures and needs whether by maturity, type of security and risk

Securities markets will be covered in a little more detail in the context of
the financial manager’ role in Module 5 of this course.

This Module and Module 5 will provide a linkage to future courses in the
programme
15
Key terms and concepts

ESG scores and investing

Stock exchange as a primary and secondary market

Bull and bear cycles to markets

IPO’s

Seasoned issue

Rights Issue
16
MFIN 6663
Module 3
Dr. J Colin Dodds
Market Efficiency
Contents
• Quotation
• Learning Objectives
1. Introduction
2. The Stock Market
3. The notion of Market Efficiency
4. The Efficient Market Hypothesis (EMH)
5. The Evidence and counter evidence
• Summary
• Key issues and concepts
• Discussion Questions
2
Quotation
Any boardroom sitter with a taste for Wall Street lore has heard
of the retort that J.P. Morgan the Elder is supposed to have
made to a naive acquaintance who had ventured to ask the
great man what the market was going to do: “It will fluctuateâ€Â
replied Morgan dryly.
(John Brooks)
3
Learning Objectives
After this module you should be able to;
• Appreciate the nature of financial securities’ markets.
• Understand the difference between chartism, fundamental
analysis and efficient markets theory as ways of
understanding share price valuation;
• Appreciate the difference among the three forms of market
efficiency ( weak, semi-strong and strong);
• Consider the evidence for and against market efficiency, and
the problems of testing the Efficient Markets Hypothesis.
4
1. Introduction
• In Module 2 we made the case that the main justification for a
stock market is that it provides opportunities for firms to raise
long-term capital and in the case of a secondary market, a
meeting place for buyers and sellers providing liquidity.
• Stocks unlike other traded goods such as coffee, tin, soya
beans etc, which are ultimately used or stored for future sale,
have no intrinsic value (except in the case of the liquidation of
the company). Rather their value lies in the prediction of what
will happen to that future price and any income paid such as
dividends.
5
1. Introduction (Cont.)
• So there is a market for analysts and the media to advise
on future movements in stock prices. They can be advising
for a financial intermediary such as pension funds, mutual
funds and as professional managers advising private
investors.
• They claim to be able to provide better advice better than
uninformed investors hence will charge a fee for their
services.
6
Fundamental Analysis;
• From an analysis of the firm itself – its financial
statements, information from news releases, analysis of
industry trends and the market itself.
• Typically they are using public information and provide an
assessment on buy /hold/sell advice. Of course the firm
itself has more accurate inside information that is not
available until it is released to the market or used and/or
leaked by insiders.
7
Technical analysis or Chartism
1. This pays less attention in the intrinsic value of the company as
demonstrated by the financial numbers and forecasters. Rather
it concentrates on the previous pattern of price movements.
arguing that there is;
i.
ii.
a pattern to share prices and
they can interpret, understand and predict those patterns better
than others so can identify undervalued and overvalued stocks. They
acknowledge there may be surprises so they are not always correct in
their forecasts, but rather unexpected changes are evidence of
irrationality of a market.
8
Technical analysis Or Chartism
• Trends are very important to technical analysis and the result of
real buyers and sellers buying and selling and not just random
processes. So examine Figure 1 which shows fluctuations in a
share price derived not from actual stock price data, but from a
combination of two random processes.
9
Figure 1
10
2. The Stock Market
• The stock market has one particular characteristic in common with games of chance: if
you can tell what is going to happen, you can make lot of money. Gaming chances all
exhibit randomness.
• Those involved with stock markets will frequently argue that market prices are not like
that at all and they are not random because they are the result of human actions. If
positive information hits the market, it will likely go up as traders will perceive future
gains.
• Also, market prices are the prices of real companies producing good and services,
management actions to increase profits so profitability is not random. It depends on the
skill of the management and the Board of Directors.
• We saw with technical analysis that with sufficient skill, market movement for and
individual stocks and the whole market can be predicted from trends
• In Figure 1. The share price we generated by a wholly random process, but it looks into
the chart of an individual stock. So perhaps share prices are random in their movements
11
2. The Stock Market (Cont.)
• But market prices are the result of an interaction of supply and
demand and the equilibrium price incorporates the buyers and
sellers beliefs and their actions. But how good a price is it? Does it
reflect the best possible estimate of the risk and expected
earnings of the firm? In other words, is the market pricing
mechanism efficient and does the price adjust quickly to new
information to reflect the best possible estimate of the underlying
enterprise’s future prospects? With many analysts looking for
over/under valued stocks, you would imagine that they would
spot mispricing quickly and act accordingly causing the price to
adjust to the ‘proper’ level.
12
3. The notion of market Efficiency
In the context of this module and market efficiency, we do not mean though
the other valid uses of the word, efficiency
1. Efficiency is the conventional idea of inputs and outputs, nor
2. The allocative efficiency of an economy through capital markets are
supposed to allocate capital to its most efficient use and hence higher
profits. See Figure 2
3. Efficient allocation of the resources in an economy
Figure 2:
The use of market efficiency we are concerned with is the way that securities market
respond to information.
Assumptions underlying the proposal that market allocate societal resources
efficiently
13
3. Market Efficiency (Cont.)
• The assumption here is that profits and efficiency go hand in
hand. In highly competitive product and equity markets, they do.
But most markets have frictional elements and the profits may
be for example, the result of market power from being a
monopoly. Plus it assumes that the projects are genuine and not
manipulated before they are communicated to the market
(Enron is an example to the contrary)and that even if resources
have been used efficiently in the past will this continue to do so
in the future?
14
4. The Efficient Market Hypothesis (EMH)
We need to distinguish between a perfect capital market and an efficient capital market.
Conditions for a Perfect Capital Market:
1. There are no transaction costs;
2. There are no taxes;
3. All assets are perfectly divisible and marketable;
4. There are no regulations governing the market’s operations;
5. Information is costless and received simultaneously by all market participants.
6. All are rational expected-utility-maximizers (recall your Microeconomics course)
7. Both product and securities markets are perfectly competitive. In each there are many
buyers and sellers, with the inability of any individual to influence price.
15
4. The Efficient Market Hypothesis (EMH) (Cont.)
• Both product and securities markets will be fully efficient and
sufficient conditions, but this is not necessary for an efficient capital
market.
– Efficient Capital Market:
– We are only asking that the prices reflect all relevant available
information so no investors can consistently make abnormal profits as
a result of their skills.
– There are 3 forms reflective of what information is incorporate into
the price of a share:
i. Weak form( purely a technical term)
ii. Semi-strong form.
iii. Strong form.
16
4. The Efficient Market Hypothesis (EMH) (Cont.)
Weak form efficiency:
• If the market is weak form efficient, there are no predictable trends, it
has no memory and the path a security follow is a ‘random walk’
• All information about the company and the domestic and global
economies for that matter is already impounded into the share price
so in the absence of new information, the price tomorrow is the price
today- it is in equilibrium. The market has cleared.
• New information by definition is unpredictable otherwise if you have
predicted it, then it was not new and therefore it is random. Investors
are rational as they impound new information into their actions of
buying/selling.
17
4. The Efficient Market Hypothesis (EMH) (Cont.)
• Semi-strong form efficiency:
It incorporates the weak form, but adds a further claim that the market
quickly (what if it overreacts on there is a delayed response – see text
p.386) and without bias impounds all newly published relevant information
into the stock price. Since the changes are unbiased, nobody on average can
consistently beat the market. We use the word consistently as a trader can
do well but cannot continue to do so systematically because all relevant
information has already been taken into account unbiasedly by the market
in setting the share price.
• Strong form efficiency:
Same as semi-strong form except there is a further requirement, that the
market impounds not only published but all information, including insider.
Quite a stretch.
18
5. The evidence and counter evidence
• There is an extensive literature on testing for EMH. For academic
studies they fall into four categories:
1.
2.
3.
4.
Are stock prices predictable or random?
Event studies
How do professional investment managers perform?
Can insiders beat the market?
• Large markets are typically liquid and ‘fat’ in the sense that large
volumes of stocks can be traded and they are well researched and
tested. Buyers are price takers not makers. But even here there can be
‘thin’ trading in some stocks.
• Large markets are generally thought to be weak form efficient and often
semi- strong too, particularly smaller stocks not followed as closely.
• Small markets are more prone to ‘thin’ trading and insider issues.
19
5. The evidence and counter evidence (Cont.)
Testing for weak form efficiency:
1. Serial correlation; if there are patterns/trends, the movement of the
price in one direction will tend to be followed by other movements
x(t) = Rx(t-1) + e(t)
where;
x(t) is the movement in price.
x(t-1) the previous movement etc.
e(t) is the error term.
If R (representing the correlation ) is significantly different from zero,
then the changes do not follow a random walk.
20
5. The evidence and counter evidence(Cont.)
2. Run tests; plot each change in terms of its direction up or
down and if the random walk hypothesis is true, there will
be no pattern in the changes; DUDDUOUUUUDUUODDD
3. Filter tests; if a filter trading rule leads to profits after
transaction costs, e.g. if it goes up 5%, buy and if it drops
5% then sell.
21
5. The evidence and counter evidence(Cont.)
Testing for semi-strong form efficiency:
1. Direct tests; eg, market reaction to stock splits. Is there a signal here
of good news ? Use event studies or market reaction to changes in
accounting reporting methods used in financial statements often
buried in the notes ? Can they fool the market or can the market
adjust to any cosmetic changes? (See text pp. 393 – 394)
2. Indirect tests; for example can market funds such as mutual funds
or hedge funds out perform a passive buy and hold strategy after
allowing for MER’s? (What of Warren Buffet with Berkshire
Hathaway Inc ?)
22
5. The evidence and counter evidence(Cont.)
Testing for strong form efficiency:
• This is a difficult one to prove and the high profile cases in the media
would signal that insiders can trade profitably.
• Insiders have to report after the fact their trades and there are black
out periods in the quarterly cycle of earning announcements where
they cannot trade. Some investors follow these insider trading reports
with great interest as they can indicate confidence or lack of in the
firm.
• Of course insiders can tip off relatives and friends as to good/bad
news or can deliberately try and deceive the market- pump and run
operations.
23
5. The evidence and counter evidence(Cont.)
Counter Evidence:
a. Low p/e – small firm effect; buy low p/e shares, low book-to-price
firms (see text pg. 400)
b. The January/ Monday effect (day of the week effect); can a filter
rule lead to abnormal profits? Surely if it is found to exist then it
should be arbitraged away. But will it be? The market is made up of
professional and amateur investors who may hold contrarian views.
c. The behavioral challenge to market efficiency: are people really
rational? What of market exuberance?
Bubbles and crashes e.g. Dotcom bubble. More on this in later courses.
24
Summary
• There is a folk-lore belief that abnormal profits can be made on the
stock market. This requires that the exchange be inefficient, because
if it were efficient, all such opportunities would have evaporated
through the market pricing mechanism.
• There are various people employed to try to beat the market, in
particular chartists and fundamental analysts. If markets are indeed
efficient, they cannot achieve what they claim; indeed, it is they who
make the market efficient through constant watchfulness.
• Market efficiency does not mean the market is efficient in at
allocating resources through the economy or good at forecasting
what will happen in the future. It is based on informatiom flows.
25
Summary (Cont.)
• Market efficiency exists in three forms. The weak form, which just
says the price movements are random, seems almost certainly true
for all large markets. In the main there is also strong evidence for the
validity of the semi-strong – although it is concerned with speed of
reaction rather than with “appropriate†reaction. The latter cannot
be tested because there is no exogenous concept of what might
constitute “ appropriateâ€Â. Strong form efficiency does not exist.
• The EMH has marked implications for financial reporting and
accounting standard setting, so long as market pricing is seen as the
most important criterion for financial reports. This may not always be
acknowledged by the various accounting standard committees.
26
Key terms and concepts
Efficient Market Hypothesis (EMH)
–Weak Form
— Semi-Strong form
Random walk
Abnormal Returns
Event Studies
Filter Tests
Stock prices reflect underlying value
27
Discussion Questions
3.1 What can make markets inefficient?
3.2 What does it mean to say that the price for stock is fair?
3.3 Is it true that investing in equities is gambling, in just the same way as betting on
horse races?
3.4 Why might an investor from Canada buy shares in an offshore market?
3.5 Go back to Figure 4 in Module 1 where it was suggested (and in Module 2 too) that
this was a fundamental model linking investors to projects. So what is the place of a
financial intermediary in this model?
3.6 Test have tended to show that the market does not react to information received
form of current cost accounts. Since they contain information that was not available
before, it is clear that this is evidence that the market is inefficient.
‘No, you have it all how wrong. I agree about the findings of the tests, but that only
shows how efficient the market was in impounding that information before the
companies published it.’ Who is right?
28
Discussion Questions (Cont.)
3.7 If I had bought equities in 20XX when the market stood around 150, I would
consistently over the following ten years have made profits, since the market
index was then over 1000 Does this consistent profit making invalidate the
EMH?
3.8 Does the efficient markets hypothesis mean that all investors have the
same expectations?
3.9 A company’s financial manager explains to you that he only issues new
securities when his share price is riding high. This maximizes the funds he
raises per share. Is this a sensible strategy?
3.10 If a share tipster recommends an investment, is this just a reworking of
existing information, or does the very recommendation itself constitute new
information?
29
Discussion Questions (Cont.)
3.11 Does the evidence that open end mutual funds cannot outperform a
passive strategy of buy and hold suggest that you should avoid holding them?
3.12 If everybody believed what chartists say. Would this not make them right
since their predictions would become self-fulfilling prophecies?
3.13 Does the evidence that mutual funds cannot consistently outperform a
passive strategy of buy and hold suggest that you should avoid buying them?
30
MFIN 6663
Module 4 (a)
Time preference, Bond valuation, Investment
Appraisal Methods
Dr. J Colin Dodds
2
Contents
• Learning Objectives
b) Internal Rate of return (IRR)
ï‚´ 1.Introduction
c) NPV and IRR compared
ï‚´ 2.Time preference
d) NPV and IRR are non-additive
ï‚´ 3.a) Calculation of Present Value
ï‚´
b) PV of series of receipts
ï‚´
c) Other Variants
ï‚´ 4. Bond Valuation
ï‚´ 5.Investment appraisal methods
a) Net Present value
e) There might be more than one IRR for a
given project.
ï‚´ 6. Discussion
•
Summary
• Key terms & Concepts
• Discussion Questions
• Worked Problems
3
Learning Objectives
ï‚´Introduce the concept of time preference and the notion of
discounting future income streams to their present values.
ï‚´Understand compounding of annuities.
ï‚´Bond valuation .
ï‚´Investment appraisal methods, including NPV and IRR and their
relationship. In Module 4(b) we will return to these and they will
also be covered in MFin 6664 – Corporate Finance.
4
1.
Introduction
ï‚´ In a world of no risk, all future cash flows will be
known with certainty so no assets in this world
would generate more or less than the prevailing
interest rate. However, while some assets are
default risk free and may guarantee a specific
income e.g. Federal government bonds, most other
assets will contain some element of default risk and
many will face other aspects of risk, including
capital market risk, currency risk etc.
ï‚´ Recall Figure 4 from Module 1 where investors are
selecting projects to invest in.
5
•
While an enterprise/firm, whether a SME or any multinational is in
practice, the norm in an economy, we actually do not need their
existence to examine the subject matter of this module.
6
2. Time Preference
ï‚´In general it can be said that a sum of money received now is preferred to that sum
receivable at a future date – not because of inflation or risk – rather opportunity cost.
It can be invested in a project or lent which will yield an expected return. A deferral of
receipt will still mean the opportunity to invest is loot so the difference between
present and future receipt can thus be understood as the opportunity cost of the
investment opportunity forgone.
ï‚´However, in some countries there are negative interest rates which turns time
preference on its head to defer receipt. There are now negative mortgages!
7
Numerical example
ï‚´ Pam Hill who is 17 today is going to receive $10,000 promised to her
from her uncle‟s estate and will be paid to her when she is 18 year‟s of
age.
ï‚´ If she had received the amount now, she could have invested it in a
GIC at 1.25% interest. Her opportunity cost is $125.
ï‚´ Discuss the issue of inflation and taxation on her terminal value if she
had received the money today and invested in the GIC.
8
3.(a) Calculation of present value
– We can calculate the PV of future receipts using the mechanism of compound
interest. If you have $100, the principal (P), now(t0) invested at 10% (i) will
grow to $110 so we have $ P(1+i) after 1 year.
For the present value of $110 received in 1 year‟s time;
ð‘·
(ðŸ + ðÂ’Š)
– And for $100 receivable in one year‟s time at a rate of interest of 10%, is
100/1.1 = $ 90.91. Of course this can be extended into future periods as
illustrated below;
9
3.(a) cont
10
3.(b) PV of series of receipts;
So $500 x 10.594= $5297.14
11
3(b) Deferred annuity;
12
3.(c) Other variants;
13
4.Bond valuation;
ï‚´Bonds are regarded as fixed income securities, usually with a fixed maturity and are
issued by a number of entities – governments and companies and with the increased
integration of capital markets, off shore.
ï‚´Bond markets are huge and will be covered in the Fixed Income Securities course Module 4 of the programme.
ï‚´ Bonds form the base of many portfolio. Let us imagine the issue of a corporate bond
of $1000 face value at a coupon of 7% and it is for 12 years. An investor will receive
$70 annually in arrears. If the prevailing interest rates at time of issue for a similar
bond are say 7.8%, so instead of adjusting the coupon, the issue price can be
adjusted and issued at a discount. For a negative yielding bond, it would be issued at
a premium. In reality bonds pay their coupon payments semi-annually or quarterly.
4. cont.
14
• Suppose there is a 17-year bond with 6% coupon that was issued 4 years ago
at $970 redeemable at par ($1000) and similar current bonds are yielding 11% (gross
redemption yield or yield to maturity), then what is its price today?
We are only concerned with future receipts and the $60 annuity will be received
over 13 years so, it is $60 x 6.7499 and the $1000 is a single time repayment so
$1000 x 0.2575.
The price is ; $405 + $257.5 = $662.5
It is selling at a major loss from its issue price of $970 as interest rates have
gone up over the period. (Bond Price Theorem 1 that bond yields and bond
prices are inversely related). Currently with a low interest rate structure,
including yield inversion and with some major central banks eg the Fed and ECB have cut
rates to almost zero, bond prices have been rising. This brings up the question of holding
period yields as opposed to yields to maturity. Investors may not hold the bonds until they
repay the principal. HPY = selling price – beginning price /beginning price.
When normality returns to government bond markets and rates go up, bond
prices will fall. So this has implications for fixed income investors depending
whether they are looking for income/capital appreciation or both.
15
4. cont
• Bonds provide 3 key aspects ;
i. coupon payments-though they can be stripped of the coupon.
ii. reinvestment of coupon- these can be spent or reinvested. The problem
with the latter is that market interest rates are volatile, so the interest
received from investing can be larger/smaller than the coupon.
iii. potential capital gain, from its issue price or if purchased part way
through its life if its selling at a discount.
For Government of Canada Bonds, they are default free (AAA Rating).
But they can lead to capital losses too!
The gross redemption yield on a bond is its Internal Rate of Return
(IRR) which assumes reinvestment of the coupon and we cover this in
Module 4 of this course and in later courses.
16
4.Deep discount(DDB) and zero coupon
bonds (ZCB)
ï‚´A deep discount bond is issued at a very low coupon and at a discount so a large
proportion of the redemption yield will come from capital appreciation. For a zero coupon
bond it is a 100% price play.
ï‚´Examples;
ï‚´ABC issued a 7 year (DDB) with 2% coupon payment annually in arrears. If current
yields are 6%, what price should it have been issued at?
ï‚´Issue price = ( $20 x
5.5824) + ( $1000 x 0.6651) = $111.648 + $665.1= $776.75
ï‚´XYZ issued a 7 year (ZCB) bond to yield 6%. What should its issue price
have been?
$1000 x 0.6651 = $665.10
17
4.cont.
• Returning to the 3 aspects of conventional bonds, with ZCB as there are
no coupons, including for reinvestment then an investor is left with capital
gain only. However there are advantages of ZCB‟s to investors;
i. Reinvestment risk reduction – there is no uncertainty about
reinvestment . All the yield is locked in the capital appreciation.
ii. There is high volatility for a given change in market interest rates so
both DDB and ZCB will fluctuate more than a conventional bond and for
speculators this is desirable.
iii. Call protection – some conventional bonds can contain a call
provision that the issuer can force redemption if interest rates have fallen.
They can redeem the bond and issue a new bond at a lower coupon. With
a DDB, as the coupon is already low, then this will be an unlikely provision.
iv. Immunization – covered in your fixed income course.
18
4.cont
Advantages to the issuers of DDB‟s of ZCB‟s;
1. helps cash flows given the low coupon, but an issuer might wish to set up a
sinking fund with the savings to redeem the bond when it expires.
2. Yields on ZCB‟s and DDB‟s may be lower given the advantages to investors
covered earlier.
ï‚´ Why might an investor consider buying a DDB or ZCB?
19
5.Investment Appraisal methods;
ï‚´ We are now at a point of discussion to how capital funds are to be invested in the
potential project available to the firm (recall Figure 4 of Module 1)
ï‚´ Assumptions have to be made that can be relaxed later.
-Each project is independent of the other i.e. not joint
-None of the projects are alternatives to the other i.e they are mutually exclusive.
ï‚´ We commence with two principal methods
-Net Present value (NPV)
-Internal rate of return (IRR)- sometimes known as the yield method.
20
5.Investment Appraisal methods (cont.)
ï‚´a)
Net present value(NPV);
ï‚´3 step process;
i) find the PV of the project‟s cash inflows.
ii) find the PV of the cash outflows.
iii) invest in the project if (1) exceeds (2).
21
5.cont
22
5.cont
ï‚´But what does that NPV of $1185.6 actually mean?
ï‚´It is the extra wealth given from undertaking the investment. Of course she does not
receive this all at once, but she could conceivably sell it to somebody else if the
information is disclosed.
ï‚´In a perfect market, the price would be that of the NPV.
ï‚´ For a firm, the NPV represent the increase in the value of the firm and the stock price
(if the firm is listed) should increase by the amount of the NPV divided by the number
of shares. But how is this information passed onto the market – for current and
potential investors? Insiders are aware of this information, but what signals can the firm
give to the market?
ï‚´Of course to use NPV one has to know the discount rate and this in itself is a topic of
its own.
23
5.cont
b) Internal rate of return (IRR); For the IRR, conceptually it is no more difficult
to understand than the NPV but the discount rate is the gross redemption
yield, as in the bond valuation model and it has to be calculated as shown
below.
Ms. Green is offered an investment which required her to invest $7000 immediately
followed by $4000 after 1 year and $3000 after 2 years and $2000 after the 3rd
year. Her personal discount rate is 6%. If the decision rule is that the IRR should be
greater than the personal discount rate then, the NPV is $1122.8. To find the IRR
without the use of a calculator, one has to interpolate by trial and error.
24
5.cont
ï‚´If we try 15% the NPV is $61.70.
ï‚´If we try 16% it is -$40.60.
ï‚´So the IRR lies between 16 and 15%.
ï‚´Try 15.5% the NPV is $10.55 so it is about 15.6%. You can check the exact
number with your financial calculator.
25
5.cont
ï‚´ c) NPV and IRR compared; it should be clear that when just one project is being
considered, both methods must always give the same accept/reject signal. If the NPV
is positive, the IRR will be greater than the personal discount rate and vice versa.
However, IRR has a number of important deficiencies. We mention two here;
ï‚´
Internal rates of return are non-additive
ï‚´
There maybe more than one IRR for a given project.
26
5. (c. i) Internal rates of return are non-additive
• Additivity is an important quality in functions such as these,
since we may wish to combine projects. Not only is this
impossible with IRR, but some very odd results can occur when
projects are looked at together. Figure 1 is an example modified
from Treynor and Black (1976).
Figure 1;
Project
A
B
C
A+C
B+C
t0
$
-1,000
-1,000
-1,000
-2,000
-2,000
t1
$
0
1,100
1,300
1,300
2,400
t2
$
1,250
0
1,250
0
0
IRR(%)
11.8
10
30
18
20
27
5. (c.i) Internal rates of return are non-additive
ï‚´Suppose that the choice is between the mutually exclusive projects A and B. The
IRR of A is higher, and hence this is a preferable investment. But now suppose C
becomes available, and there are sufficient funds to combine A with C or B with C.
Now we see that A combined with C does not offer such a good IRR as B combined
with C. In other words, once C is added as a possibility, B becomes preferable. This
is disturbing: why should the existence of C affect the choice between A and B?
28
5. (c.ii) There maybe more than one IRR for a given project
 To understand this intuitively, IRR is a polynomial. The most familiar polynomial
is, of course, the quadratic equation, and we are aware from elementary
mathematics that such equations always have two roots (although on occasion
the two roots may be identical). Now on many occasions one root will be
positive, one negative. In such cases we are able in practice to ignore the
negative root in investment analysis, since we do not concern ourselves with
negative rates of interest. But, for instance, the equation x 2 -5x + 6 = 0 has the
two positive roots 2 and 3. Similarly, the IRR problem that reduces to the
equation 15,200 – 35,000/(1 + i) + 20,000/(1 + i) 2 = 0 has the two solutions
such that i is both 5.25% and 25%. This is graphed later in Figure 3 .
5. (c. ii) There maybe more than one IRR for a given project.
29
• If the personal discount rate is 10% this makes an acceptance somewhat
awkward? Should the IRR be taken as 5.25% (reject) or 25% (accept)?
(Curiosity Corner: It will be seen that in this equation there are two changes
of sign: positive to negative, and back again. In general, it can be shown for
n changes of sign there will be a maximum of n real, positive roots.)
• This example is not just an armchair invention. It can in fact be argued that
this kind of pattern of cash flows is the normal one. After all, people will
normally pay income tax on the returns on their investment, and the net of
cash flows should be considered after deduction of that tax. Now income
tax is payable some time after the end of the year to which it relates (the
rules governing the exact date at which payment is due are somewhat
complicated, and in Canada it is April 30th for individuals they may be
required to make quarterly payments if they have large dividend and/or
capital gains). This means that a typical pattern of after-tax cash will be:
5. (c. ii) There maybe more than one IRR for a given project.
30
• Initially negative, as the investment is made;
• Subsequently positive as the returns on the investment flow in;
•
Maybe negative again in the final year which succeeds the final operating year of the
project cash flow.
– when a factory is closed there are costs of making the workforce redundant and
abandonment costs.
– when a drilling platform has exhausted economic reserves there is the cost of
removing it eg Sable Island off Nova Scotia or the North Sea.
There maybe examples part-way through a project too, as when a product needs a
refresh and relaunch to extend its product life-cycle (that is, to counteract the falling off of
consumer demand)
31
5.cont.
d) Mapping NPV and IRR graphically);
• So far NPV and IRR have been treated as if they were two separate methods
that give the same signal under many circumstances. However, they are closely
related to each other, and in fact it can be shown that the relationship is even
closer than we have so far suggested.
• A helpful way of seeing the relationship between NPV and IRR is to plot the
returns from a project on a graph at various rates of discount. Consider Figure 2.
The curve plotted here is for the investment opportunity offered Ms. Green. If the
discount rate is zero, then the NPV will be the undiscounted net sum of the
inflows and outflows, that is:
-$7,000 + $4,000 + $3,000 + $2,000 = $2,000
32
5.cont.
• If the NPV is zero, then the relevant rate of
discount is, of course, the internal rate of
return of the project – in this case,15.5%. Now
any rate of discount could be applied to this
project, and the resulting curve would show
the NPV of the project at each different
discount rate
– the curve becomes smooth because the
discount rate can change continuously. It
will be seen too that the curve is concave to
the origin. This will always be the
case. Finally it can be seen that the curve
can continue below the axis where NPV = 0.
Afterall,negative NPVs are found if a discount
rate is chosen that is higher than the IRR.
32
33
5.cont.
• Something else is made clear by using
a graph of this kind. We have already
seen that there can be two or more
solutions when seeking the IRR of a
project. This can be explained further
by the use of a similar graph. Consider
the project :
$15,200 – $35,000/(1 + i) + $20,000/(1 + i) 2
This is the equation used in the earlier
example. Its graph looks roughly as in
Figure 3.
33
34
5.cont.
It will be seen that the graph cuts the horizontal axis at two points, reaching a
minimum value between those two points, This minimum value can be found easily
if required; it is just a matter of differentiating the equation of the curve and finding
the minimum value in the usual way (that is, where the slope of the curve is zero).
In this case, for example, we can set NPV = f(v) from which we may write:
f(v) = 15,200 – 35,000 v + 20,000 v2
and hence:
f'(v) = -35,000 + 40,000v
Thus, setting f'(v) = 0 we have:
40,000v – 35,000 = 0
and hence:
v = 0.875
from which we deduce that the NPV reaches its minimum value where: i = 14.3%
35
5.cont
e) Comparing two projects;
We have seen that NPV and IRR will always give the same signal (accept or
reject) when they are used to assess a single project. Frequently, however, if
may be necessary to compare two or more projects. It is then that problems
can arise. Consider the following pair of possible projects, which we shall
assume to be mutually exclusive.
Project
Outlay period
Inflow period
0
1
2
3
4
Project A
$
(15,000)
7,000
5,000
4,000
4,000
Project B
$
(15,000)
2,000
3,000
7,000
10,000
36
4.cont
• It is necessary to decide which is the more desirable project. Now suppose that
the appropriate discount rate is 10%. In this case the present values are: NPV(A)
= $1,233; NPV(B) = $1,387. The better project appears to be B. However,
suppose instead that the ‘hurdle’ rate (that is, the rate over which an investment
must give a return in order to be desirable) was 2%.Then the present values
would be NPV(A) = S625; NPV(B) = S515. Thus, the project with the higher
present value in these circumstances is project A.
• To understand why these results, differ, it is necessary to graph the two projects
as we have done in Figure 4 . To do this the IRR of each project is required: it
turns out that IRR(A) is about 14% and IRR(B) is about 13.25%. Thus, mapping
them both on to a graph gives the result in Figure 4.
37
5.cont
• The two curves cross (at a
discount rate of about
11.25%). Above this rate,A is
a superior investment.
Below this rate, B is
superior.
• The reason for this is that
the bulk of the cash inflows
from B arrive in the later
years, and hence at higher
rates of interest they are
discounted more heavily.
33
38
6. Discussion
• In this Module we have made a number of unrealistic, simplifying
assumptions. We have supposed that there is no risk and that there are
no companies in the economy so that investors are faced with projects
themselves. This has been done for a purpose: to emphasize that these
are the basic building blocks and that the corporate firm, which is so
pervasive, is just a way (so far as finance theory is concerned at any rate)
of bundling projects together in a more efficient form (because, for
instance, there are managers who one hopes can organize the projects
more capably than individual investors could, though agency issues then
arise because of this).
39
6. cont
• The principles of compound interest that we have considered are extremely
general. Time preference is common to all factors in the economy, and hence
all decisions made will, in so far as they are concerned with future costs
and/or benefits, be made subject to discounting. We have seen that there are
two principal mechanisms of discounting, NPV and IRR, though we have also
seen that they are closely linked. It has been emphasized that NPV is the
better method of the two, for at least three reasons:
1. because it is simpler to calculate;
2. because IRR‟s are non-additive (important when there are multiple
projects to consider);
3. because projects can have multiple internal rates of return.
However since NPV is in dollar amount, this can be confusing and we will return
to this later in Module 4(b).
40
6. cont
• There are deeper reasons still for preferring NPV. We shall examine
these later.
• Before turning to the summary, let us make one or two cautionary
points about the ideas developed in this Module.
41
5. cont
 First, when we talk about ‘net cash flows’ that are to be discounted, where do
they come from? There is a danger that you will assume that the collection of
this information is a straightforward affair, and the mathematics and problems
we have considered are the difficult part. Not so. Indeed the reverse is true, for
the uncertainty of the real world is such that the experts in the marketing and
production departments, who provide most of the data to be incorporated into
these methods, have the difficult problem. Plugging their numbers into
discounting methods is comparatively straightforward with a financial calculator.
• We have said nothing about this problem because:
1.
the skills involved in estimating future cash flows are outside the scope of
financial management; and
2.
it is difficult to tie down methods of working. These methods will depend
on the particular problem concerned eg., size and complexity of the firm.
42
6. cont
 Second, there is a likelihood that our method of exposition has implied
that investment in itself will lead to a series of positive cash flows.
Wrong again. The positive future cash flows may be attributable to the
buying decision concerning, say, a new machine, but they will only
result from the purchase of that machine if the rest of the organization
is in good order – in particular in marketing the product/services of the
firm that come from the investment in that machine.
43
Summary
1. All financial flows involve the flow of funds from investors to enterprises either directly or through
financial intermediaries.
2. People have a time preference: that is, they prefer a benefit sooner rather than later (and, of
course, a cost later rather than sooner). This is quite independent of risk and inflation. However,
in the real world, these complications exists. It can be taken as a general characteristic of all
people, and it arises because of the opportunity cost of deferring the benefit.
3. Hence receipts and payments at different times in the future will have different discount rates
depending on how far into the future they occur. As they stand, they are not comparable with each
other. They can be made comparable by discounting them back to the present time. However, with
the current low interest rate environment and business uncertainty, discounting may assume less
importance to investment decisions. Rather it is on how would you get your initial investment
repaid. We cover this payback issue in Module 4(b).
44
Summary
4. This is achieved by the use of compound interest. In the Module we saw how a single sum
is compounded: how a single sum is discounted back to the present, how a series of equal
sums is discounted back to the present; and how that series can be accumulated to a
terminal value. We also discovered how to treat constantly changing series of sums.
5. These principles are based on the (unrealistic) assumption that all sums are received or
paid at the end of the period (usually the year). This can be corrected by the use of
continuous compounding. Usually there is no need to use this because the discrete case
gives a sufficiently good approximation.
45
Summary
6. These principles can be used to assess an investment, whether the investment of an individual in
a business firm or the investment of an enterprise in a project. There are two ways this can be done:
the net present value method and the internal rate of return method. Analysis shows that they are
closely intertwined, and this can be demonstrated graphically.
7. When we compare two projects, we may find that the decision as to which is preferable will
depend on the discount or hurdle rate chosen, hence the need for a discussion around that.
8. Finally projects have to be searched for as they do not necessarily just appear. Even before a
financial analysis of their worthwhile in itself would not be an easy task, a discussion needs to occur
as to how they fit and do they need to fit into the core activities and competencies of the firm. This is
particularly the case for M&A‟s as the acquiring firm will expect synergies (2+2=5 or 6) which may not
occur. As we will see in other courses, synergies may be negative – the merger from hell!
Net Present value (NPV)
Internal Rate of Return
Compounding
Mutually Exclusive Projects
ZCB and DDB
Coupon
Annuities
Reinvestment Rate assumption
Agency Issues
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4.1 What could you write in the context that “when just one project is being
considered both methods (NPV and IRR) must always give the same
accept/reject signal�
4.2 Suppose a director says the following to you: “ I can‟t accept the superiority of
NPV over IRR. When I consider an investment, I want to know about profitability
rather than profit. NPV is sum of funds, like profit, so it is meaningless.†How
would you reply to that line of argument?
4.3 Would a typical share provide cashflows more like an annuity or more like an
uneven cash flow stream?
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4.4 Would you rather invest in an account that pays 7% with annual compounding or
7% with monthly compounding? Would you rather borrow at 7% and make annual or
monthly payments?
4.5 You are thinking of buying a second hand car in 2 years time. The expected cost will
be $5000. If you can earn 7% in a 2 year at GIC, how much should you deposit now?
4.6 Why are capital investment decisions so important to a firm?
4.7 What is the difference between „independent‟ and „mutually exclusive‟ projects?
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4.8 Why is NPV regarded as being the primary capital budgeting decision
criterion?
4.9 In what sense is the IRR on a capital project is related to the yield to maturity
on a bond?
4.10 How does the „reinvestment rate‟ assumption in the IRR differ from the NPV
method?
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Worked Problems
The interest rates used are high by current standards to illustrate the concepts in the
questions.
4.1 You wish to borrow $500 to buy a second-hand scooter. Your father agrees to lend
you this, charging just 3% interest. He says that when you complete your studies in
three years‟ time, you can repay him. How much will you need then to do so?
4.2 Fred will receive $4,000 when he is 25. under the terms of his aunt‟s will. If he has
just turned 18 and he wishes to sell this right to a broker, then, if the broker discounts
the right at 18%, how much will he offer Fred?
4.3 You invest $800 in a bank, receiving $74 per annum interest. What is the annual
interest rate being paid by the bank?
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Worked Problems
4.4 Suppose Claudia was entitled to an annuity of $1500 in perpetuity immediately with
an interest rate applicable of 16%. What would be its present value?
4.5 Calculate the present value of a series of receipts of $1500, for six years at an
interest rate of 16%..
4.6 You decide to place $200 each year in a credit union. If it pays interest at 8% per
annum, to how much will your investment have grown after seven years if you put in
these sums (i)at the end of each year, (ii)at the beginning of each year?
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Worked Problems
4.8 Suppose now that Claudia has received the annuity from the trust fund for ten years, the
trustees propose to hand over to her the capital sum. What will be the present value of her
rights?
It is suggested that you answer this question by finding out:
(i) the value of the annuity from the age of 25 to 35 right now
(ii) the value of the capital sum at age 35 by capitalizing the infinite series of sums still due.
(iii) discounting the amount in (ii) back to the present
(iv) adding the result of (i) to the result of (iii).
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MFIN 6663
Module 4 (b)
Valuing equities and Project
Evaluation
Dr. J Colin Dodds
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Contents
Learning Objectives
1.Introduction
5. The problem of unequal lives.
2.Dividend Valuation
6. Capital Rationing
3. Capital Growth and Stock valuation
7. Application of Inflation
4. Alternatives to DCF project valuation
8. Taxation
– Payback
Summary
– Discounted Payback
•
Key terms & Concepts
– Accounting rate of return
•
Discussion Questions
– Profitability Index
– NPV per dollar invested
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Learning Objectives
After studying this model, you should be able to
 understand the method of valuing equities
 describe and evaluate the non-DCF method of investment appraisal.
 understand the issue of capital rationing
 appreciate the implications of inflation and tax issues.
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1. Introduction
ï‚´While investors can invest directly in a project, they typically invest in a collection of
projects in a firm by buying the securities issued by a fir…
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