Business finance : theory and practice

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Openmirrors.com Contents 15.3 Problems of internationalisation 418 15.4 International investment appraisal 425 15.5 Risks of internationalisation, management of those risks and portfolio theory 427 Summary 429 Further reading 432 Review questions 432 Problems 432 16 Small businesses 434 Objectives 434 16.1 Introduction 434 16.2 Corporate objectives 437 16.3 Organisation of small businesses 438 16.4 Taxation of small businesses 438 16.5 Investment decisions 439 16.6 Risk and the discount rate 440 16.7 Sources of finance 441 16.8 Valuation of small businesses 444 16.9 Gearing 447 16.10 Dividends 448 16.11 Working capital and small businesses 448 Summary 449 Further reading 451 Relevant websites 451 Review questions 452 Problems 452 Appendix 1 Present value table 459 Appendix 2 Annuity table 460 Appendix 3 Suggested answers to review questions 461 Appendix 4 Suggested answers to selected problem questions 474 Glossary 500 References 506 Index 512 xi
Guided tour of the book Objectives Bullet points at the start of each chapter show what you can expect to learn from that chapter, and highlight the core coverage. Objectives Chapter 2 A framework for financial decision making In this chapter we shall deal with the following: ‘ the steps in financial decision making ‘ the various objectives that, it has been suggested, might be followed by businesses ‘ some evidence on objectives that UK businesses actually follow ‘ the problem that arises from businesses being run by professional managers on behalf of the shareholders ‘ some theoretical rules for financial decision making; the separation theorem 2.1 Financial decision making Like any other decision-making area, financial decisions involve choices between two or more possible courses of action. If there is only one possible course of action, no decision is needed. Often, continuing with a situation that has existed until the time of the decision is one option open to the decision maker. All decision making should involve the following six steps. Step 1: Define objectives The decision maker should be clear what the outcome of the decision is intended to achieve. A person leaving home in the morning needs to make a decision on which way to turn into the road. To do this, it is necessary to know what the immediate objective is. If the objective is to get to work, it might require a decision to turn to the right; if it is a visit to the local shop, the decision might be to turn left. If our decision maker does not know the desired destination, it is impossible to make a sensible decision on which way to turn. Likely objectives of businesses will be considered later in this chapter. Key terms The key concepts and techniques in each chapter are highlighted in colour where they are first introduced, with an adjacent icon in the margin to help you refer back to the most important points. Step 2: Identify possible courses of action The available courses of action should be recognised. In doing this, consideration should be given to any restrictions on freedom of action imposed by law or other forces not within the control of the decision maker. Bullet point chapter summary Each chapter ends with a ‘bullet point’ summary. This highlights the material covered in the chapter and can be used as a quick reminder of the main issues. 19 Chapter 5 • Practical aspects of investment appraisal Chapter 5 • Practical aspects of investment appraisal Examples At frequent intervals throughout most chapters, there are examples that pose a problem and provide step-by-step workings to follow through to the solution. Multi-period capital rationing Linear programming Where the constraint operates for more than one time period, a more sophisticated ‘ approach needs to be adopted. Linear programming (LP) is such an approach. Example 5.7 Listed below are the cash flow characteristics of four investment projects. Investment finance is rationed at years 0 and 1 to £100,000 at each time. Projects cannot be delayed nor can they be brought forward. The cost of finance is 10 per cent. Project Year 0 Year 1 Year 2 Year 3 NPV (at 10%) £000 £000 £000 £000 £000 W (70) (20) 60 60 6.44 X – (90) 60 50 5.30 Y (80) 10 60 30 1.18 Z – (50) 30 30 1.86 (Note that the NPVs are as at year 0 (now) even for Projects X and Z, which, even if selected, will not commence until year 1. Also note that Project W requires cash outflows in both year 0 and year 1.) Set out the various statements that must be satisfied so as to maximise NPV, but meet the financing constraints. Solution We should seek to undertake such a combination of the four projects as would give the highest possible total NPV, subject to the capital constraints at years 0 and 1. Letting w, x, y and z be the proportions of each of the four projects that it is desirable to undertake, we are seeking to maximise the function NPV = 6.44w + 5.30x + 1.18y + 1.86z subject to 70w + 80y ≤ 100 – that is, the total outlays at year 0 on W and Y being £100,000 or less, and 20w + 90x − 10y + 50z ≤ 100 – that is, the total outlays on projects W, X and Z, less the inflow from Project Y at year 1, must not exceed £100,000. In fact, further constraints will have to be applied since each of the proportions must be positive or zero and cannot (presumably) exceed 1. Thus: 1 ≥ w ≥ 0 1 ≥ x ≥ 0 1 ≥ y ≥ 0 1 ≥ z ≥ 0 Summary Cash/accounting flows l Net present value (NPV), internal rate of return (IRR) and payback period (PBP) all require the use of cash flows. l Need to adjust accounting flows for depreciation, by adding it back to accounting profit. l Capital expenditure and disposal proceeds cash flows need to be identified as to amount and timing. l Working capital (WC) needs to be treated as a cash outflow early in the project and an inflow at the end. Relevant cash flows l Only those that will differ according to the decision should be taken into account. This means that: l all past costs should be ignored; l all future costs that will be the same irrespective of the decision should be ignored; and l differential opportunity costs should be included. Taxation l Taxation must be taken into account where the decisions will lead to different tax cash flows. l Depreciation is not a tax-deductible expense. Capital allowances replace depreciation for tax purposes. Inflation l Inflation must be taken into account when using NPV. Either: l real cash flows must be discounted using a real discount rate; or l money (nominal) cash flows must be discounted using a money (nominal) discount rate. The two cannot be mixed. l In practice, it is usually easier to use money cash flows and discount rate. l (1 + money discount rate) = (1 + real discount rate) × (1 + inflation rate). Carrying out an NPV appraisal involves five steps 1 Identify all the relevant cash flows and their timing. 2 Total the cash flows for each point in time. 3 Discount each total, according to the appropriate time into the future that the cash flow will occur. 4 Total the present values of the various discounted values to derive the NPV for the project. 5 If the NPV is positive, the project is acceptable, presuming a shareholder wealth maximisation objective. 128 144 xii
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Capital rationing Example 5.6 A bus
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Investment appraisal and strategic
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Value-based management Select strat
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Value-based management Corporation
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Real options 5.13 Real options ‘
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Summary Capital rationing l l l l M
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Problems PROBLEMS Sample answers to
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Use of probabilities Clearly, these
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Use of probabilities Solution This
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Expected value Possible outcome NPV
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Systematic and specific risk If, ho
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Utility theory Figure 6.2 Utility o
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Summary Summary Risk l Risk is of v
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Problems REVIEW QUESTIONS Suggested
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Problems Project Initial outlay NPV
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Problems Estimates of the various f
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Security investment and risk Exampl
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Portfolio theory portfolio. Further
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Portfolio theory Table 7.1 Risk and
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Portfolio theory Figure 7.4 The ris
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Chapter 8 Sources of long-term fina
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Ordinary (equity) capital Figure 8.
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Cost of individual capital elements
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Is debt finance as cheap as it seem
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l Evidence on gearing a shareholder
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Glossary Accounting rate of return
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References Aharony, J. and Swary, I
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Index Mehrotra, V. 314 Memoranda of
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Index Stock Exchange Automated Quot
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