Modern Financial Investment Management [1 ed.] 1527542947, 9781527542945

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Modern Financial Investment Management

Modern Financial Investment Management By

Ephraim Matanda

Modern Financial Investment Management By Ephraim Matanda This book first published 2020 Cambridge Scholars Publishing Lady Stephenson Library, Newcastle upon Tyne, NE6 2PA, UK British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Copyright © 2020 by Ephraim Matanda All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. ISBN (10): 1-5275-4294-7 ISBN (13): 978-1-5275-4294-5

This book on Modern Financial Investment Management is dedicated to my family, my wife Vharawei and my children Fortune Ephraim, Emmanuel Tatenda, Elisha Nyasha, Elizabeth Paidamoyo and Tabeth Malon. Thank you guys for your invaluable love and encouragement of my legacy and indispensable publication endeavours.

TABLE OF CONTENTS

Acknowledgements .................................................................................. xii Foreword ................................................................................................. xiii Chapter One ................................................................................................ 1 The Investment Environment and the Financial System of an Economy 1.0 Objectives 1.1 Introduction 1.2 The Financial System 1.3 Real and Financial Assets 1.4 Financial Markets and their Participants 1.5 Money and Capital Market Frameworks 1.5.1 Money Market Securities 1.5.2 Capital Market Securities 1.5.3 Equity Securities 1.6 The Functions of the Financial System 1.7 Equilibrium in Financial Markets 1.8 Summary 1.9 Exercises Chapter Two ............................................................................................. 16 Trading of Money Market Securities 2.0 Objectives 2.1 Introduction 2.2 Functional Perspective 2.3 Valuation of Money Market Securities 2.4 The Time Value of Money 2.5 The Nominal and Equivalent Rates of Interest 2.6 Summary 2.7 Exercises Chapter Three ........................................................................................... 29 The Theory and Conventional Valuation of Bonds 3.0 Objectives 3.1 Introduction

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3.2 Theory of Bonds 3.3 Valuation of Bonds 3.4 Yields, Durations and Convexities of Bonds 3.5 Summary 3.6 Exercises Chapter Four ............................................................................................. 54 Advanced Bond Investment Portfolios and Yield Management Strategies 4.0 Objectives 4.1 Introduction 4.2 Bond Investments and Dedicated Portfolios 4.3 Bond Portfolio Management Strategies 4.4 Valuation of Shares 4.5 Calculation of Yield or Discount Rates 4.6 Summary 4.7 Exercises Chapter Five ............................................................................................. 72 Foreign Market Financial Investments 5.0 Objectives 5.1 Introduction 5.2 The Foreign Exchange Markets 5.3 Exchange Rates and the Trading of Currencies 5.4 Revaluation and Devaluation of Exchange Rates 5.5 Money Markets and the Protection of Foreign Market Investments 5.6 Forward Rate Agreements (FRAs) and Financial Dealings 5.7 Summary 5.8 Exercises Chapter Six ............................................................................................... 93 Financial Market Investments and Portfolio Theory 6.0 Objectives 6.1 Introduction 6.2 Quantification and Assessment of Investment Returns and Risks 6.3 Portfolio Theory and Risk-return Analysis 6.4 Risk and Return to Investment Portfolios 6.5 The N-Asset Portfolio 6.6 Diversification and Portfolio Value Addition 6.7 The Impact of Individual Stocks on Portfolio Risk 6.8 Summary 6.9 Exercises

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Chapter Seven......................................................................................... 110 The Capital Asset Pricing Model (CAPM) 7.0 Objectives 7.1 Introduction 7.2 The History of the CAPM 7.3 The Market Investment Portfolio 7.4 Derivation of the Market Portfolio 7.5 The Security Market Line (SML) 7.6 The Beta Coefficient and the CAPM 7.7 The Application of the CAPM 7.8 The CAPM and Cost of Capital (or Equity) 7.9 The Alpha Coefficient and Valuation of Securities 7.10 Summary 7.11 Exercise Chapter Eight .......................................................................................... 123 The Index and Arbitrage Pricing Models 8.0 Objectives 8.1 Introduction 8.2 The Arbitrage Pricing Theory or Model (APT/APM) 8.3 Derivation and Application of the Three Factor Model 8.4 The CAPM and the Simple Index Model 8.5 Derivation of the Simple Index Model 8.6 Application of the Simple Index Model 8.7 The Index Model and Total Returns to Financial Investments 8.8 Summary 8.9 Exercises Chapter Nine........................................................................................... 144 Capital Allocation and Investment Decisions 9.0 Objectives 9.1 Introduction 9.2 Risk Tolerance and Asset Allocations 9.3 Allocation of Funds Between Risk-free and Risky Asset Portfolios 9.4 The Optimum Risky Investment Portfolio 9.5 The Complete Financial Investment Portfolio 9.6 The Investor’s Budget and Reward to Variability Ratio 9.7 Summary 9.8 Exercises

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Chapter Ten ............................................................................................ 155 Valuation of Derivative Securities 10.0 Objectives 10.1 Introduction 10.2 The Theory of Forward and Futures Contracts 10.3 The Valuation of Forward and Futures Contracts 10.4 The Uses of Futures Contracts 10.5 The Theory of Options 10.6 Valuation of Option Contracts 10.7 Dynamic Asset Allocation (DAA) 10.8 Summary 10.9 Exercises Chapter Eleven ....................................................................................... 202 Hedging of Investments Using Derivative Securities 11.0 Objectives 11.1 Introduction 11.2 Hedging Using Option Contracts 11.3 Hedging With Foreign Currency Futures Contracts (FCFCs) 11.4 Hedging of Investment Portfolios Using Portfolio Insurance 11.5 Hedging Using Forward Contracts 11.6 Hedging Using Futures Contracts 11.7 Hedging With Interest Rate and Currency Swaps 11.8 Summary 11.9 Exercises Chapter Twelve ...................................................................................... 227 Market Efficiency and the Efficient Market Hypothesis (EMH) by Eugene Fama 12.0 Objectives 12.1 Introduction 12.2 The Concept of Market Efficiency 12.3 The EMH by Eugene Fama 12.4 Implications of Market Efficiency to Stock Exchange Operations 12.5 Tests of the EMH 12.6 Summary 12.7 Exercises

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Chapter Thirteen ..................................................................................... 243 Financial Mergers and Acquisitions 13.0 Objectives 13.1 Introduction 13.2 Strategies and Types of Mergers and Acquisitions 13.3 Pros and Cons for the Growth of Firms 13.4 Contemporary Developments in Mergers and Acquisitions 13.5 Legal Procedures and Mergers and Acquisitions 13.6 Market Valuations of Mergers and Acquisitions 13.7 Mergers’ Exchange Rates Based on the Market Values of Shares 13.8 Codes Used in Takeovers and Mergers of Firms 13.9 Tactics for Mergers and Acquisitions 13.10 Considerations for Mergers and Acquisitions 13.11 Successes and Failures of Mergers and Acquisitions 13.12 Summary 13.13 Exercises References .............................................................................................. 286

ACKNOWLEDGEMENTS

My thanks go to the following people without whom this book would not have been completed as scheduled. I extend special thanks to Reverend Nyasha Madzokere of the Baptist Church in Zimbabwe, a genuine friend of mine, for the spiritual, academic influence and support in coming up with this manuscript. I also give thanks to Ms. Miriam Saungweme, Ms. Josephine Mushonga and Mr Charles Muziri for the typing services and adjusting the soft copy of the book for corrections suggested by the typesetters. Messrs. Hlupeko Dube and Misheck Diza, my former students and work mates, are also worth mentioning for their professional and academic advice in the organization and sequencing of the chapters and the finalization of the manuscript for submission for publication. Lastly, I extend my utmost thanks to Edison Vengesai, a PhD in Finance graduate with the University of Kwa-Zulu Natal, South Africa for providing me with the indispensable editing services of the whole book.

FOREWORD

The author of the book, Modern Financial Investment Management, is a senior lecturer in Banking and Finance at the Great Zimbabwe University, Masvingo, Zimbabwe. It was the author’s observation that most developing economies the world over have failed to align their development processes towards the sustainable development path because of lack of financial resources and/or financial investment strategies. Therefore the writing of this book was motivated by the author’s need to equip economic players and the governments of emerging economies with the knowledge and expertise needed for making finance a tool for their growth and development. Countries without sufficient financial resources were just as weak as human bodies without enough blood, hence their continuous failure to grow and eradicate hunger, starvation, poverty and diseases amongst their people. The majority of governments of developing countries have failed to invest their countries’ financial resources since the attainment of political independence, hence their failure to innovate, grow and develop. The book is structured in such a way that it starts off with conventional notions of finance where operations of money and capital markets are put forward before the examination of financial models such as capital asset pricing, arbitrage pricing, and three factor and simple index models. Countries are introduced to conventional financial securities, mainly certificates of deposit, bills, bonds and shares or stocks which can be traded on financial markets and their indispensable use in the growth and development of nations. The book proceeds to evaluate the need for perfect and efficient market systems in an economy before considering the benefits that developing countries would draw from the introduction of derivative markets. Some of the specific benefits that countries would draw from the introduction of derivative markets were the improved financialization of the economy, efficiency, transparency, discipline, innovation and technical progress. Most developing countries have very shallow conventional financial markets yet on the other hand had abundant resource endowments which favoured the introduction of derivative markets immediately. The book concludes by exploring the framework on the acquisitions and mergers of financial firms and how these can be exploited in order to rescue small firms from liquidation and financial distress and/or lure much needed foreign capital for economic growth and development.

CHAPTER ONE THE INVESTMENT ENVIRONMENT AND THE FINANCIAL SYSTEM OF AN ECONOMY

1.0 Objectives By the end of this chapter one should be able to: Define the terms investment environment and financial system; Identify and explain the components of a financial system of an economy; State and illustrate the main functions played by financial markets in an economy; Differentiate between real and financial assets using specific examples; Distinguish between money and capital markets using various instruments traded on each type of market; Discuss the functions played by the financial system of an economy; Define the equity market and demonstrate how it is operated in an economy.

1.1 Introduction The relationship between the investment environment and the financial system is indispensable when it comes to the growth and development of nations, let alone capital accumulation for investment purposes. The financial system of an economy is central when it comes to getting the development process of a country on track. Financial markets and institutions offer a variety of securities for investment purposes by all economic players hence the need to explore the investment environment in much detail. It is critical to highlight the roles played by money, equity and

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capital markets in general in an effort to advance the major functions they perform in terms of the growth of nations towards sustainable development.

1.2 The Financial System A financial system or sector can be defined as a network of financial markets, institutions, instruments, services and non-financial economic units (NFE) which include people, institutions, corporations, quasigovernmental organizations and the public sector of an economy. The nonfinancial economic units can either be surplus or deficit units or savers and borrowers respectively. Bhole (1999) defines a financial system as a system comprising specialized and non-specialized financial institutions, of organized and unorganized financial markets, and of financial instruments and services which facilitate the transfer of funds from surplus units to deficit units. The parts of the financial system are not always mutually exclusive. For instance, financial institutions operate on financial markets and are therefore an integral part of such markets. According to Bhole (1999) the word “system” in “financial system” implies a set of complex and closely connected or interlinked institutions, agents, practices, markets, transactions, claims and liabilities in the economy. A financial system is therefore concerned about money, credit and finance which three terms are intimately related yet somewhat different from each other. Money refers to the current medium of exchange or the means of making payments in an economy. It can also be referred to as the notes and coins in circulation in a given economy. Credit or loan on the other hand is the sum of money to be returned normally with interest. The term also refers to the debt of an economic unit. Finance is the monetary resources and comprises the debt and ownership funds owned by the state institution, company or individual person. In other words, finance is made up of the notes and coins in circulation plus paper instruments also called financial assets or securities. Finance institutions are business organizations that act as mobilisers and depositors of savings as well as providers of credit finance to the community. These are different from non-financial business organizations in the state of their business. It is argued that while financial institutions deal in financial assets such as deposits, loans and securities, the industrial and commercial organizations on the other hand are involved in real assets such as machinery, the stock of assets and real estate. The structure of a financial system of an economy reflects its major components as financial markets, financial institutions, financial instruments or assets and financial services

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as alluded to earlier on. Financial institutions are divided into banking institutions and non-banking institutions. Banking institutions are providers of payment mechanisms and include central banks and co-operative and corporate banks. The non-banking financial institutions deal in non-banking financial transactions and services and include organizations such as life insurance companies, pension funds, unit trusts, micro-finance institutions (MFIs) and building societies. Financial institutions can also be classified into intermediaries and non-intermediaries. Intermediaries are go-betweens that stand between savers and investors (surplus and defects units respectively) when it comes to the transfer of monetary resources. Financial intermediaries on the other hand are classified as deposit-taking, non-deposit-taking, non-banking and portfolio institutions and other financial institutions. Deposit-taking intermediaries are banking intermediaries which mobilize financial resources from firms and individuals in an economy, such as commercial banks (taking deposits and loans), merchant banks (mobilisers of corporate, trade and investment finance), discount houses, development banks and central banks. Non-banking intermediaries are providers of financial services other than banking services and include POSB, building societies and microfinance institutions (MFIs).On the other hand, non-deposit-taking intermediaries are organizations that are outside the financial services sector framework and include contractual intermediaries such as insurance and life assurance companies, pension and provident funds organizations such as the National Social Security Authority (NSSA). Portfolio institutions are intermediaries that provide investment opportunities to firms, institutions and individuals for the construction of investment or asset portfolios and include unit trust organizations (for small investment savings), investment trust portfolios and asset management companies (for equity and wealth portfolios). The other financial institutions that act as intermediaries in an economy are finance houses or companies such as leasing corporations. Financial markets can be defined as centres or arrangements that provide facilities for buying and selling financial claims and services in an economy. The corporations, financial institutions, individuals and governments trade in financial products on these markets either directly or through brokers and dealers on organized exchanges. The financial markets are also classified as primary or secondary in nature. Primary markets are direct or initial public offer (IPO) markets for financial claims for new securities, and are also called new issue markets. Secondary financial markets refer to financial markets that deal with securities that have already been issued, are existing or outstanding in the financial system of an economy. It is also further

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argued that primary markets are mobilisers of savings and suppliers of new, fresh or additional capital to business units in an economy. On the other hand, secondary markets are known for contributing indirectly to the supply of additional funds in an economy by rendering all securities issued on the primary markets, liquid and easily marketable. Stock and bond markets also have both primary and secondary market segmentations. Financial markets are often classified as capital and money markets, which perform the same function of transferring financial resources to the producer.

1.3 Real and Financial Assets A security is a financial asset as opposed to a real asset, which is tradable on the market. A security can also be defined as a certificate representing a claim to cash flows generated by a real asset owned by a firm or government. Real assets are business assets that determine the productive capacity of a corporation or an economy as a whole. Such assets can also be defined as the physical assets possessed by a firm that are used for generating income and include plant and machinery as well as land and buildings. Financial assets on the other hand are certificates or securities that are issued by firms, institutions and governments in order to raise monetary resources for specific projects from the general investing public. Financial securities facilitate the transfer of financial resources from the investors to the corporations and include instruments such as bonds and shares. Financial assets are used by investors to make decisions between the immediate consumption of their incomes or investing in order to have enhanced consumption in the future. Reilly and Brown (1999) define an investment as the current commitment of an investor’s dollars in order to derive some future payments. Bonds for instance are issued by firms as instruments for borrowing funds from the investing public in an economy. On the other hand, shares are issued as a way of raising funds by way of creating an enlarged ownership capacity of the already existing corporation. Therefore bondholders are creditors to the firm while shareholders are owners of the firm. Firms grow wealth for their shareholders by using funds raised from the issuing of financial securities to buy real assets. Hence returns investors drawing from investments in securities depend on incomes generated by real assets financed through trading in financial assets. It can therefore be argued that the values given to financial securities or assets are derived from the values of the underlying or reference real assets.

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1.4 Financial Markets and their Participants The main economic players on financial markets are firms, households and government and financial intermediaries such as investment corporations, banks and the Central Bank.

1.4.1 Firms Firms issue financial securities to the investing public such as bonds and shares so as to use them to raise funds from the general public. The funds so generated are then used to buy real assets to be used in raising income for the firm.

1.4.2 Households The investing public includes households that are interested in a wide variety of real and financial assets. The investment preferences of households are influenced by various factors such as disposable incomes, tastes and risk appetite levels. For instance, high income households would normally invest in shares and real estate in order to generate wealth for future generations.

1.4.3 The Government Governments the world over require financial resources to finance public expenditures in their economies. This obligation can be met through borrowing from public taxation. Financial securities issued by governments, for example treasury bills and bonds by definition, are low-risk assets and can be issued at very low cost for the purposes of using them for borrowing from the investing public.

1.4.4 Investment Corporations These can be in the form of unit trusts or mutual fund corporations which pool together and manage the funds of many small investors to make money through the advantage of large-scale trading. Investment bankers for instance provide specialist services to businesses in an economy such as raising capital through the selling of shares and debentures, the underwriting of shares and the pricing of new share issues.

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1.4.5 Commercial Banks Banks raise monetary resources by taking deposits from the general public and issuing retail and wholesale loans to deserving economic players. Therefore, banks make profits through the spread between the rates they pay to depositors and receive from borrowers for credit facilities extended to them. The banks act as financial intermediaries between lenders (surplus units) and borrowers (deficit units) in the process of the transfer of funds in an economy.

1.4.6 Central Bank The Central Bank in an economy is the regulator and supervisor of all commercial banks and similar financial institutions in an economy. The role of the bank was extremely critical when it came to the protection of depositors’ funds and the growth and development of nations. The bank is the government banker and advisor and hence its efficiency and effectiveness in service provision were just as good as the success of the development process of the whole economy.

1.5 Money and Capital Markets Bodie (1999) argues that financial markets can be divided into money and capital markets. These financial markets are made up of securities such as those issued by government, local, municipal and corporate bodies. The main characteristics of money markets and capital markets are based on time, return and risk variables and are detailed below.

1.5.1 Money Markets These are markets for securities of a short-term maturity or nature, which is a life span of a year or less. The financial securities traded on money markets are risk-free, with low transaction costs and highly marketable and liquid assets. The common money market securities are certificates of deposit, treasury bills, commercial paper, repurchase agreements and bankers’ acceptances. 1.5.1.1 Certificates of Deposit (CDs) These are time deposits made with banks which may not be withdrawn on demand by the holders. Firms or households may have excess cash in their operations which they may not need or may not be certain as to when it may

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be required. Under such a scenario the firm or household may proceed and deposit the cash with a bank. The most common type of certificate of deposit is the negotiable certificate of deposit (NCD). The owner of the NCD can proceed and sell it on the market at any time before maturity. However, its market value will depend on the prevailing discount rate and the number of days remaining to maturity. 1.5.1.2 Treasury Bills (TBs) These are money market securities issued by monetary authorities (Central Bank) to the investing public on behalf of the government in an economy. Treasury bills are the most marketable and liquid instruments mainly because they are issued and backed by the government in an economy. These assets are used to control money supply, mainly inflationary and deflationary pressures, in order to attain equilibrium in the financial sector of an economy. 1.5.1.3 Commercial Papers These are short-term financial securities issued by large and reputable corporations to the investing public in place of borrowing directly from commercial banks. Most corporations have their issues to the investing public supported by lines of credit from banks. Such bank facilities accord the borrowers access to cash to pay off the notes at their maturity periods. 1.5.1.4 Bankers’ Acceptances (BAs) These arise from orders made by client firms to their banks to pay certain amounts of money at some future dates, and are arrangements similar to post-dated cheques. The banks would accept the clients’ orders by endorsing them and assuming responsibility to pay the bearers on the due dates. These acceptances are negotiable instruments because the holders can trade them on the secondary market at some discount from their face values. Bankers’ acceptances are commonly used in export and import transactions where the creditworthiness of trading partners is usually difficult to ascertain. 1.5.1.5 Repurchase Agreements (Repos) These are some form of short-term or overnight borrowing used by dealers in treasury bills. The dealers proceed to sell the treasury bills on an overnight basis and agree to purchase them back the following morning at prices slightly higher than those they were sold for then. The differences in

Chapter One

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the two sets of prices are the interest rates earned for the night. Dealers in such arrangements obtain one-day loans from the investors using treasury bills as collateral securities for the credit facilities, that is investors locate dealers with treasury bills and negotiate to purchase them. Finally investors agree to sell these papers or financial assets back to the dealers the following day at prices slightly higher than those they would have bought them for.

1.5.2 Capital Markets These are financial markets for long-term financial instruments and real assets that is assets with a lifespan of more than one year from the date of issue. Capital markets, like money markets, have both primary and secondary market segmentations. These financial markets are made up of fixed and variable income securities issued by both corporate organizations and the government (Bodie et al, 1999). Therefore, bonds and shares sold on capital markets represent fixed and variable income securities respectively. Capital markets are therefore financial market frameworks for the trading of securities such as bonds, shares and real assets. 1.5.2.1 Treasury Bonds (TBs) These financial assets are issued by the government in an economy for raising funds from the investing public in the long term usually for 10 to 30 year maturities. Treasury bonds may be callable in nature, implying that they provide room for the treasury (the issuer)to repurchase them at par value before maturity. Municipal and local bonds are issued by quasigovernmental bodies and traded in the same way that treasury bonds are traded on capital markets. 1.5.2.2 Corporate Bonds These financial assets are issued by corporations in order to borrow funds from the investing public for certain private investments. The bond pays a fixed amount of income to the holder or investor annually based on its face value. Redeemable bonds have a maturity date on which their face values will be paid to bondholders or investors by the issuers. Treasury bonds may be secured or unsecured through assets owned by their issuers. These bonds can also be callable like treasury bonds or convertible in nature. Bonds are said to be convertible if they give their holders the right but not the obligation to convert them into a specified number of ordinary shares of the company at an agreed price and after an agreed period of time.

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1.5.2.3 Equity Securities The markets for equities are made up of common and preferred stocks or shares. The returns to investments in these stocks are in the form of dividends and capital gains. Reilly and Brown (2000) argue that a shareholder is an investor with an ownership stake in a corporation. Ordinary shareholders are entitled to residual income from the profit after obligations to debt and preference equity providers have been settled. Preference shares may also be redeemable in nature, implying that corporations may be obliged to pay back the capital invested to the investors at the end of an agreed period of investment time. The difference between money and capital markets is arbitrary. A logical difference would be one focusing on each of them as segmentations of financial markets. Money markets mainly focus on non-financial economic (NFE) units (surplus and deficits units) rapid adjustment of actual liquidity positions to the levels desired at a given time. Capital markets on the other hand focus more on savings and investments that are vital to economic growth, stability and the provision of a bridge by which the savings of surplus units may be transformed into investment of deficit units such as asset acquisition. Hence capital markets focus mainly on economic stability and development by expanding the total amounts of savings and investment in all sectors of the economy.

1.6 Functions of the Financial Sector Financial institutions or intermediaries offer various steps of transformation services. They issue claims to their customers that have different characteristics from those of their own assets. For instance, banks accept deposits from the public as a liability and convert them into their own assets (loans) that is in this respect they perform a liability-asset transformation function. These institutions also choose and manage portfolios whose risk and return may alter by acquiring better information and reduce and overcome the transaction cost, they do so in forms of lending and borrowing. On the one side financial institutions also distribute risk through diversification and thereby reduce it for savers in the case of mutual funds (risk transformation functions).They also offer savers alternative forms of deposits according to their liquidity preferences and providers borrow with loans of requisite maturities(maturity transformation functions).Lastly, financial institutions also provide large volumes of finance and the basis of small deposits or unit k (these are called the size transformation function).

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1.7 Equilibrium in Financial Markets In a similar way to the general and relative price levels in commodities markets, we have the general price and structure of interest rates in an economy which govern the operations of financial markets. Equilibrium in financial markets is usually determined under the strict assumptions that there are perfect competition markets and forces of demand and supply that are applied in the economy. Therefore financial markets are said to be perfect when a large number of savers and investors operate on the markets and both savers and investors are rational in their behavior. It can also be argued that all operators on the markets have full information, freely available to them and they incur no transaction costs in their operations. On the other hand it is also assumed that all financial assets traded are infinitely invisible, participants on the markets have homogeneous expectations and no taxes are borne by investors in the economy. Under all the above ideal conditions, financial markets attain equilibrium conditions when supply and demand are equal to each other. According to the Classical Theory the supply of savings and the demand for investment determine the equilibrium level of the rate of interest to be obtained in the economy. The Loanable Funds Theory on the other hand, argues that the supply and demand for loanable funds determine the rate of interest to be obtained in an economy. Alternatively, the Keynesian Theory says that the equilibrium rate of interest is determined by forces of supply and demand for money in an economy. Therefore, on the whole it can be stated that equilibrium in the financial markets is established when the expected demand for funds (credit) for short-term and long-term investment matches the planned supply of funds generated out of savings and credit creation. Shifts in either supply or demand curve or both result in changes in market equilibrium positions as demonstrated below:

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Figure 1.1 Demand and Supply Curves on Money Demand and Supply

The interaction between supply and demand for funds in diagram A attains equilibrium at point (ܲா ; ܳ ா ).

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However under B, an increase in the supply of funds in the financial sector while demand is held constant, changes the equilibrium point from (ܲ଴ ;ܳ ଴ ) to a low݁‫ ݎ‬point (ܲா ; ܳ ா ).

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Assuming in the third instance above that supply is held constant and demand decreases, the equilibrium point will shift inwards from (ܲ଴ ; ܳ ଴ ) to ሺܲா ; ܳ ா ).

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Finally, when the government sets an interest rate such as Y above, lying below the equilibrium rate, this rate of interest results in excess demand which leads to market failure in the economy.

1.8 Summary There was a discussion that the investment environment and the financial system were the critical benchmarks for the growth and development of nations, let alone capital and shareholders’ wealth accumulation in an economy. The financial system of an economy was found to be made up of financial markets, financial institutions, services and instruments together with non-financial economic (NFE) units. These components of the financial system were indispensable when it came to the transfer of resources from surplus to deficit units in an economy. The discussion was extended to look at the assumptions and theories of equilibrium in financial markets. The roles played by money, credit and finance in money, equity and capital markets in general were discussed in detail as far as the growth of nations towards sustainable development was concerned.

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1.9 Exercises 1.9.1 What is meant by the term, financial system of an economy? 1.9.2 Identify and explain the major components of the financial sector of an economy. 1.9.3 Discuss the characteristics of money and capital markets of an economy and the types of securities that are traded on each of these markets. 1.9.4 Examine the assumptions that are laid down for market equilibrium to be obtained in financial markets of an economy. 1.9.5 Evaluate the theories that are used to explain supply and demand for financial resources in an economy. 1.9.6 Explain the main differences between the concepts of credit, money and finance. 1.9.7 Evaluate the relationship that exists between money and capital financial markets of an economy. 1.9.8 Discuss the concepts of increase and decrease in money supply or demand with respect to interest rates and equilibrium attainment in the financial sector of an economy. Use diagrammatic illustrations to explain your concept

CHAPTER TWO TRADING OF MONEY MARKET SECURITIES

2.0 Objectives By the end of this chapter one should be able to: Distinguish between discount and interest bearing money market securities; Explore the issuing mathematics of money market securities in an economy; Examine the dealing mathematics of money market securities on financial markets; Demonstrate the process of pricing money market securities; Define the concept of time value of money and use it to demonstrate the terms simple and compound interest; Distinguish the concept of nominal rates of investment interest from equivalent rates.

2.1 Introduction The trading of money market securities takes place on primary and secondary markets that exist in the financial system of an economy. Money market securities can be classified as discount or interest bearing securities depending on their nature. Before a lot is said about the trading of money market securities, it is critical to know how such securities are issued on financial markets. The issuing mathematics of money market securities is to be examined first before the dealing and pricing mathematics of such securities are dealt with. The chapter will proceed to discuss the concept of time value of money based on simple and compound interest before ending with concepts of nominal and equivalent rates of interest used on money markets.

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2.2 Functional Perspective This is concerned with the transformation of the initial endowment in the hands of an individual or institution, for instance an inheritance (or estate) into an investment on financial markets. An economic player operating on a financial market has much in terms of choice for enrichment through borrowing and lending activities or arrangements. Example 2.1 Assume we are given three individuals A, B and C each with an initial capital or endowment of $10 000 at the start of period zero (0).Each is entitled to receive another $10 000 at the start of period one (1). It is also given that Individual A is operating in a Primitive Economy where there are no formal financial markets. Individual B is in an advanced economy that allows for financial investment at a rate of return of 10% per period. The third, Individual C is in an economy that allows for both investment and borrowing at 10% per period. Determine the total investment to be realized by each individual at the beginning of period one (1) from today. Solution: Table 2.1 Showing Individual A’s Endowments Beginning of Period 0 1

Initial Endowment $10 000 $10 000

Maximum Consumption Opportunity $10 000 (at the end) $20 000 (at the beginning)

Table 2.2 Showing Individual B’s Endowments Beginning of Period 0

Initial Endowment $10 000

Maximum Consumption Opportunity $11 000 (at the end)

1

$10 000

$21 000 (at the beginning)

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Table 2.3 Showing Individual C’s Endowments Beginning of Period

Initial Endowment $10 000 $10 000

0 1

Max Consumption Opportunity $9 090.90 $20 090.90

The calculations for Individuals A and B above are more straightforward. However, for Individual C with the most choices on financial markets we suppose that C borrows $X initially against period one (1) dues such that X= X+ 0.1 X = 10 000, X = 9 090.90. Therefore, at the end of period zero (0), C’s total endowment = $10 000 + $9 090.90 + $1 000= $20 090.90. Individual C has the most choices relative to the other two Individuals and should therefore do one thing at a time. Therefore, developed financial markets offer their non-financial economic (NFE) units a greater variety of choices and standards of living than the other market types. Furthermore, they allow the NFE units to adjust their initial endowments or capital to levels that suit them through their ability to either borrow or invest on the markets. For a two period time horizon, a simple formula can be used to connect the current period consumption to that of the next period: C1 Co C1 Eo E1 r

= E1 + (Eo – Co) (1+r); = Consumption in period 0 (P0); = Consumption in period 1(P1); = Endowment to be received at the beginning of period zero (0); = Endowment to be received at the beginning of period one (1); = Interest rate for both lending and borrowing on financial markets.

Example 2.2 Suppose we have an individual firm facing the following financial endowments: Eo E1 r

= = =

$10 million; $10 .million; 15% per period.

Trading of Money Market Securities

19

(a) How would the firm invest or borrow to have a consumption of $15million in period 0? What would be the firm’s consumption at the beginning period 1? (b) How would the firm invest or borrow to have a consumption level of $15million at the beginning of period 1? What would be the firm’s consumption in period 0? Solution: (a) Eo =$10 million, Co = $15 million, R = 0.15, E1 =$10 million. C1= 10 million + (10-15) (1 + 0.15) million = (10 + -5 x 1.15) million = (10 – 5.75) million =$4 250 000. Therefore, the firm borrows $5 750 000 in period zero (0) including interest and the total amount borrowed of $5 000 000. The firm’s total consumption at the beginning of period 1would be $4 250 000. (b)

C1 =15 million. C1 = E1 + (Eo-Co) (1+r) 15 million = 10 million + (10-Co) (1 + 0.15) million = [10+ 11.5 – 1.15 Co] million 15 million = [21.15 – 1.15 Co] million ଺.ଵହ - 6.15 Million = - 1.15 Co million, Co = million, Co= $5 ଵ.ଵହ 826.00.

347

Total amount saved = $4 652174.00 at 15% per period.

2.3 Valuation of Money Market Securities Money market securities can be divided into two main categories namely interest bearing securities such as Certificate of Deposits (CDs) and discount instruments which include Treasury Bills(T-Bills), Bankers’ Acceptances (BAs), Commercial Paper and Trade Bills. Certificates of deposit for instance can either be negotiable or non-negotiable in nature. However Non-negotiable Certificates of Deposit are riskier and earn more than Negotiable Certificates of Deposit. The following illustrations show how money market securities are traded on financial markets.

Chapter Two

20

2.3.1 Mathematics of Issuing Non-negotiable Certificates of Deposit (NCDs) The formula for calculating the MV of an investment is based on the following variables: MV= Maturity Value or Amount to be received by the investor at maturity; D = Term to maturity (in days); I = Rate of interest % per annum (p.a); P = Principal amount investment. Therefore by formula MV =P (1+

ௗ ଷ଺ହ

×

௜

) = P( 1+rt)

ଵ଴଴

Example 2.3 Suppose an investor has a Principal of$10 million to invest on the money market. It is also given that the: Date of issue

=

Date of maturity =

31 August, 2015;

Rate of interest

25% p.a.

=

1 June, 2015;

Calculate the maturity value of the investor’s funds. Solution Maturity Value= $10 million (1+

ଽଵ ଷ଺ହ

×

ଶହ ଵ଴଴

) = $10 623 287.67.

2.3.2 The Dealing Mathematics of Financial Securities The mathematics of dealing in Certificates of Deposit is based on the following variables: C = Consideration or Proceeds to be put into investment. Therefore by formula, P = C=

ெ௏ ( ଵା

.

ವ ಺ × ) యలఱ భబబ

Example 2.4 Assume an investor on the money market is looking forward to a Maturity Value of $10 623 287.67 from an investment made as follows:

Trading of Money Market Securities

21

Investment date =30 July, 2015; Maturity date=31 August, 2015; Interest rate, i =22% p.a. Compute the Principal amount or Consideration invested on 30 July, 2015. Solution ଵ଴ ଺ଶଷ ଶ଼଻.଺଻

Consideration, C = $

యమ మమ × ) యలఱ భబబ

(ଵା

= $10 422 266.13

Alternatively, Consideration, C=P(

(௜ௗାଵ଴଴஻

(௬௧ାଵ଴଴஻)

) where

B t

= Number of days in a year (365 days); = Number of days remaining to maturity of investment (32 days); d = Initial tenure to maturity (91days); Y = Market yield, 22%p.a.; P = Par Value of the investment; Initial Yield, i = 25% p.a. Therefore by substitution, Consideration, C= $10 million (

(ଶହ×ଽଵାଵ଴଴×ଷ଺ହ) (ଶଶ×ଷଶାଵ଴଴×ଷ଺ହ)

= $10 422 266.13

2.3.3 Mathematics of Issuing Treasury Bills (TBs) The issuance of treasury bills in an economy is backed by the faith of Government and these are risk-free or zero-risk securities. Bids and offers on TBs are quoted on a bank discount and not a price basis. The formula for ଷ଺଴ ஽ calculating yield on a bank discount basis is given by: Y = × . ௧

ி

where Y = Annualized yield on a bank discount basis; D F t

= Dollar discount from the face or par value of security; = The face value of the security; = Number of days to maturity.

Example 2.5 Calculate the yield maturity at which a Treasury Bill is trading with a Face Value of $10 000, 120 days to maturity and selling at a price (P) of $975.

Chapter Two

22

Solution ଷ଺଴

Discount, D= Face Value – Current Price, YTM =

ଵଶ଴

×

ଵ ଴଴଴ିଽ଻ହ ଵ ଴଴଴

= 7.5% p.a.

2.3.4 The Dealing Mathematics of Treasury Bills In the secondary market TBs are traded on a discount basis and yield I ே×௜ ௗ agreed upon. The formula for calculating consideration, C= N –( × ) ଵ଴଴ ଷ଺ହ where C N i d

= Selling or Purchase Price; and = Face/Nominal Value; = Discount Rate; = Days Remaining to Maturity.

Example 2.6 Suppose an investor has invested in a Treasury Bill with the following financial characteristics: Nominal Value =$I0 million, yield, interest rate, i=16.5%; d =61 days. Compute the Treasury Bill’s Consideration. Solution ଵ଺.ହ

Consideration = $I0 million – ($10 million x

ଵ଴଴

×

଺ଵ ଷ଺ହ

) = $9 724 246.60.

2.3.5 The Pricing of Treasury Bills by Central Banks Treasury Bills are issued on a tender basis by Central Banks as demonstrated below. Example 2.7 Suppose we are given that RBZ has stipulated that tenders on a $1000 par value Treasury Bill should be tendered in multiples of $5.00 and a potential bidder has decided that the discount rate he intends to earn is 15%. Calculate his tender price for the Treasury Bill, the adjusted discount rate and the actual yield to accrue to the bidder.

Trading of Money Market Securities

23

Solution (a) Tender Price, P = $1000 - $1000×0.15 x

ଽଵ

= $962.60.

ଷ଺ହ

Therefore, bids will be entered by the bidder at $965.00 per Treasury Bill. (b) The bidder’s required discount rate would also change slightly as a result of the above specifications. ேି௉

Using the formula, discount rate =

ே

×

ଷ଺ହ (ଵ ଴଴଴ିଽ଺ହ) ଽଵ

=

ଵ ଴଴଴

×

ଷ଺ହ ଽଵ

=14.04% p.a.

(c) The actual rate the bidder would enjoy if his tender or bid is accepted and assuming he would hold the Treasury Bill to maturity would be higher than the nominal discount rate. This is due to the fact that it would be calculated on the basis of the actual price of the Treasury Bill and not its Face Value. To calculate the bidder’s actual yield on the Treasury Bill we use the formula: Yield

=

ிି௉ ௉

×

ଷ଺ହ ଽଵ

=

(ଵ ଴଴଴ିଽ଺ହ) ଽ଺ହ

×

ଷ଺ହ ଽଵ

×100%=14.54% p.a.

2.4 The Time Value of Money This is a concept which argues that a dollar received today is worth more than a dollar to be received tomorrow. Hence investors needed some compensation to be able to postpone the consumption of their moneys to some future date. Two types of interest emerge that are used as compensation to investors who are able to defer their consumption to a future date, and these are simple and compound interest. These two types of interest are illustrated mathematically below.

2.4.1 Simple Interest This is interest earned on the principal amount invested by investors on financial markets. ௉ோ்

Simple Interest, I = = Prt, where, P = Principal Amount invested (Present ଵ଴଴ Value, PV amount); R = Rate of interest per annum as a percentage or decimal, and T =Time or period of investment, in years. The total Amount

Chapter Two

24

to be collected at the end of the period of investment, A = P+I, where A = Amount or Future Value (FV) of the investment. Example 2.8 Calculate the simple interest and FV of $10 000 invested for 4 years at 10%p.a. simple interest. Solution ଵ଴଴଴଴ ×ଵ଴×ସ

Simple Interest, I = $

ଵ଴଴

= $4 000.

Amount = P+I = $10 000 +$4 000 = $14 000. Example 2.9t Determine the rate of simple interest that grows $4 000 to $7 780 over a five-year period. Solution Simple Interest, I = $7 780 - $4 000 = $3 380. ସ଴଴଴ ×௥×ହ

Therefore $1386 = $

ଵ଴଴

ଷଷ଼଴

; the rate of interest, r =

ଶ଴଴

= 16.9% p.a.

2.4.2 Compound Interest This is interest earned by the principal amount invested in the first year and by both the principal and interest components in subsequent years of investment or saving. The formula for compound interest which connects the principal (PV) and future value (FV) is obtained from the extension of the simple interest formula. It is given by the formula FV = PV(1 + ‫)ݎ‬௧ . Example 2.10 Calculate the FV of $10 000 invested at 10%p.a. for 4 years given that interest is compounded: a)

Annually; b) Semi-annually; c) Quarterly; d) Monthly; e) Daily; and f) Continuously.

Trading of Money Market Securities

25

Solution a) FV = PV(1 + ‫)ݎ‬௧ ,FV = $10 000(1 + 0.10)ସ = $14 641.00. ଴.ଵ଴ ଼ b) FV = PV(1 + ‫)ݎ‬௧ ,FV= $10 000(1 + ) = $14 774.55.

ଶ ଴.ଵ଴ ଵ଺ ) = $14 845.06. ସ ଴.ଵ଴ d) FV = PV(1 + ‫)ݎ‬௧ ,FV = $10 000(1 + )ସ଼ = $14 893.54. ଵଶ ଴.ଵ଴ e) FV = PV(1 + ‫)ݎ‬௧ ,FV =$10 000(1 + )ଵସ଺଴ = $14 917.43 ଷ଺ହ ௧ ௥௡ ଴.ଵ଴×ସ

c) FV = PV(1 + ‫)ݎ‬௧ ,FV = $10 000(1 +

f) FV = PV(1 + ‫ )ݎ‬, FV =PV×݁

= $10 000×݁

= $14 918.25

2.5 The Nominal and Equivalent Rates of Interest It should be noted that the quoted yield on a bank discount basis is not a meaningful measure of the return from holding a Treasury Bill because it is based on a Future Value investment as opposed to the actual dollar amount invested. The yield is annualized on the basis of a 360-day year as opposed to a 365-day calendar year. This makes it difficult to compare the yield of say a money market discount instrument like a Treasury Bill to that of a capital market instrument like Treasury Bonds, which are based on interest calculated over 365 days a year. It is also difficult to compare such a discount yield to coupon-paying money market instruments. In a bid to make the quoted discount yield comparable to that of coupon-paying instruments, two other yields were developed: namely the Bond equivalent yield (Bey) and the Certificate of Deposit equivalent yield (Cdey). The bond equivalent yield seeks to make the Treasury Bill yield comparable to that of Treasury Notes and Bonds, while the certificate of deposit equivalent yield seeks to make it comparable to yields on interest-bearing money market instruments.

2.5.1 Calculation of the Bond Equivalent Yield (Bey) The formula for calculating Bey =

ଷ଺ହ௬

ଷ଺଴ି௬௧

and that of CDey =

ଷ଺଴௬

ଷ଺଴ି௬௧

.

Example2.11 Calculate the bond equivalent yield on the money market instrument given in example 2.10 above assuming that its discount rate is 7.5%and it has 120 days remaining to maturity.

Chapter Two

26

Solution Bond equivalent yield, Bey =s

ଷ଺ହ×଻.ହ%

ଷ଺଴ି଻.ହ%×ଵଶ଴

= 7.8%.

2.5.2 Calculation of the Certificate of Deposit Equivalent Yield (CDey) Example 2.12 Using the financial information from example 2.11 above, calculate the instrument’s CDey. Solution Certificate of deposit equivalent yield, CDey=

ଷ଺଴௬

ଷ଺଴ି௬௧

7.6%.

=

ଷ଺ଽ×଻.ହ%

=

ଷ଺଴ି଻.ହ%×ଵଶ଴

2.6 Summary It was reiterated that the trading of money market securities takes place on both primary and secondary market segmentations that exist in the financial system of an economy. Money market securities were classified as discount or interest bearing securities depending on their nature. Before a lot was said about the trading of money market securities, it was critical to know how these securities were issued on financial markets. The issuing mathematics of money market securities was examined first before the dealing and pricing mathematics of such securities were dealt with in depth. The chapter proceeded to discuss the concept of time value of money based on simple and compound interest before ending with concepts of nominal and equivalent rates of interest used on money markets.

2.7 Exercises 2.7.1 Assume we are given three individuals A, B and C each with initial capital or endowment of $10 000 at the start of period zero (0).Each is entitled to receive another $8 000 at the start of period one (1). It is also given that Individual A is operating in a Primitive Economy where there are no formal financial markets. Individual B is in an advanced economy that allows for financial investment at a rate of return of 10% per period. The third Individual C is in an economy that allows for both investment and borrowing at 10% per period. Determine the total investment to be realized

Trading of Money Market Securities

27

by each individual at the beginning of period one (1) from today. Suppose an investor has a Principal of $20 million to invest on the money market. It is also given that the: Date of issue = 1 July, 2015; Date of Maturity= 30 September, 2016; Rate of interest= 20% p.a. Calculate the maturity value of the investor’s funds. 2.7.2 Assume an investor on the money market is looking forward to a Maturity Value of $10 000 from an investment made as follows: Investment date = 31 July, 2016; Maturity date=31 August, 2016; Interest rate, i = 22.5% p.a. Compute the Principal amount or Consideration invested on 31 July, 2016. 2.7.3 Calculate the yield to maturity at which a Treasury Bill is trading with a Face Value of $10 000, 120 days to maturity and selling at a price (P) of $9 750. 2.7.4 Suppose an investor has invested in a Treasury Bill with the following financial characteristics: Nominal Value = $20 million, yield, interest rate, i=17.5%; d = 81 days. Compute the Treasury Bill’s Consideration. 2.7.5 Suppose we are given that RBZ has stipulated that tenders on a $1 600 par value Treasury Bill should be tendered in multiples of $10.00 and a potential bidder has decided that the discount rate that he intends to earn is 12.5%. Calculate his tender price for the Treasury Bill, the adjusted discount rate and the actual yield to accrue to the bidder. 2.7.6 a) Calculate the simple interest and total Future Value of $16 000 invested for 4 years at 15%p.a. simple interest; b) Determine the rate of simple interest that is needed to grow a money market investment of $6000 to $9780 over a period of 4 years from now; c) Calculate the Future Value of $25000 invested at 16%p.a. for 5 years given that interest is compounded: a) Annually; b) Semi-annually; c) Quarterly; d) Monthly; e) Daily; and f) Continuously;

28

Chapter Two

2.7.7 Calculate the bond and certificate of deposit equivalent yields on a money market instrument with a discount rate of 7.5% with 120 days remaining to maturity.

CHAPTER THREE THE THEORY AND CONVENTIONAL VALUATION OF BONDS

3.0 Objectives By the end of the chapter one should be able to: State and explain the various types of bonds that can be traded on the capital markets of an economy; Explore the theory of bonds traded on capital financial markets; Examine the various types of bonds and how they can be valued on capital markets; Calculate the durations and convexities of various types of bonds; Evaluate the financial risks that can affect returns to bond investors and issuers in an economy.

3.1 Introduction A sound and well-funded capital market framework is one of the most important parameters needed in driving forward the development process of a nation. Capital markets like money markets have both primary and secondary segmentations. The discussion below is mainly centred on the valuation of bonds as formidable capital market securities. The development of the bond market and the trading of bonds in an economy were very essential as both the government and private sectors can borrow monetary resources from the public through this market. Funds drawn from the bond market were critical when it came to the use of idle capacity by firms and investment in infrastructure projects by the government of a country. Governments and firms needed to understand that good financial management depended on incorporation and sound risk management systems, which are covered towards the end of the chapter.

Chapter Three

30

3.2 The Theory of Bonds A bond is a fixed income security that is issued through the Central Bank by a company, quasi-governmental organizations or a government. Buyers of bonds become bond holders and originators or issuers remain the owners of these capital market securities. A bond is sold bearing a face value and a yield to maturity and earns coupons over a defined time period. Bonds are very popular capital market securities which are issued by various organizations in an economy to raise money for investment purposes. It should be noted from the onset however, that investors who purchase bonds on financial markets enjoy a buy and hold investment strategy. This is so because unlike shares, bonds have it that ownership rights remain in the hands of the issuers. The following are some of the common types of bonds issued the world over for the generation of finances from the investing public.

3.2.1 Issuable Bonds The types of bonds whose ownership is maintained by their issuers are as outlined below. 3.2.1.1 Treasury Bonds These are bonds that are issued by the government of a country through the Central Bank in order to raise income from the general public. Bonds are used for the generation of income to supplement income collected through various tax rate regimes. The need for issuing treasury bonds arises from government expenditures such as the financing of infrastructure development projects, national and foreign debts as well as balance of payment (BOP) obligations. The investing public is expected to buy and hold the securities for a defined investment period after which the issuers redeem them by paying cash to the investors. The marketability of treasury bonds depended mainly on the credibility of the government of the day and the autonomy of the Central Bank. The governments of most emerging economies were known for a lack of commitment, an abuse of authority, corruption, and a lack of upholding corporate governance and business ethics in their service delivery to the citizens. Hence in theory, treasury bonds are said to be risk-free but in practice this is not the case as was the case in Zimbabwe in 2007-08 before the country dollarized in 2009.

The Theory and Conventional Valuation of Bonds

31

3.2.1.2 Corporate Bonds These are bonds that are issued by companies in a country in order to raise income from the general public for investment purposes. These bonds are used for the generation of income to boost companies’ capital bases. Investors are expected to buy and hold the securities for a defined investment duration after which they are redeemed by their issuers by paying cash to the investors. Corporate bonds have become more popular than treasury bonds in most emerging economies. This is because the investing public has developed more faith and confidence in private players than in Central Banks which are non-autonomous, corruptible, nondisciplined and unethical in their service delivery to the public. The marketability of corporate bonds depended mainly on the credibility of issuing firms’ market share, corporate governance and ethics used in their business discharge to the public. Issuers of corporate bonds were keen to uphold the dictates of business ethics and corporate governance because they were motivated by the traditional objective of profit maximization. 3.2.1.3 Municipal Bonds These are bonds that are issued by the municipal authorities (for instance town or city councils) of a country in order to raise income from the general public for service delivery to the residents. Investors are expected to buy and hold the municipal bonds for a defined investment duration after which the issuers redeem them by paying cash to the investors. Municipal bonds are issued for generating income to provide clean water, sewerage works and regular rubbish dumping for sanitation and hygienic life sustenance. Municipalities are quasi-governmental organizations which were equally known for corruption, greed, a lack of transparency and the enrichment of senior management teams at the expense of the residents. Most senior management members appointed to run the affairs of the municipalities were just as corrupt as the governments that appointed them. Hence municipal bonds issued in most emerging economies were as unmarketable and non-credible as the treasury bonds because these securities were issued by stakeholders from the same background. Hence municipalities could not issue bonds to generate funding for their operations because these securities were not appealing in the eyes of potential takers. 3.2.1.4 Local Board Bonds These are bonds that are issued by the local board authorities (for instance growth points and rural district councils) of a country in order to raise

Chapter Three

32

income from the general public for service delivery to the residents or communities they are established to serve. Local board bonds are issued for generating income for the provision of clean water, sanitation and hygienic conditions to residents and communities. The investing public is expected to buy and hold the bonds for a defined duration after which authorities should redeem them from the investors on a cash basis. Local boards like municipalities are quasi-governmental organizations which were equally known for a lack of transparency, accountability, and discipline and the selfenrichment of senior management teams at the expense of the residents or communities to be served. Most senior management members running the affairs of local boards were just as corrupt as the governments that appointed them. Hence local board bonds like municipal bonds issued in most emerging economies were as unmarketable and non-credible as the treasury bonds. This was because these securities were issued by stakeholders from the same background and hence it was futile for local boards to issue these securities to the public to finance their operations.

3.2.2 Types of Bonds The bonds outlined above can be issued to the investing public in various types which could include the ones outlined below. 3.2.2.1 Zero Coupon Bonds These are bonds that are traded on financial markets but do not earn coupons from the date of issue until maturity. Investors in such bonds are only entitled to the face values of the bonds at maturity; hence there are no incentives that lure investors to buy more of these bonds. 3.2.2.2 Coupon Bonds These are bonds that are traded on the markets which entitle the investing public to periodic cash flows or earnings, called coupons, over and above the realization of the face values of the securities at maturity. Coupons therefore act as incentives to investors to have the appetite to buy such bonds because they promise more rewards between the date of purchase and the maturity date. 3.2.2.3 Convertible Bonds These are bonds that give the holder the option to convert their bond holding in a firm into a stated number of the firm’s shares at an agreed period of time and exercise price. Bonds that are converted into a firm’s shares cease

The Theory and Conventional Valuation of Bonds

33

to exist. The conversion of bonds into ordinary equity reduces the gearing ratio of the firm that is the debt to equity ratio. 3.2.2.4 Callable Bonds These are bonds that are issued to the investing public with the option of being demanded back by the issuers from the investors at any time after the date of issue to the date of maturity. In most cases bonds are called back by the issuers when they realize that the bond markets are bullish and they can make more from the securities. 3.2.2.5 Redeemable Bonds These are bonds that are issued with defined maturity dates on which the investing public will be paid the face values of the securities and will surrender them back to their issuers. Investors with high monetary appetite levels usually prefer redeemable bonds to irredeemable bonds. Such buy and hold bonds undertaken by the investing public are similar to ordinary money market financial investments in which the principal amounts invested have defined harvest-day terms. Under such bond investments one would be able to determine the promised or real yield before deciding whether to purchase the bond or not. 3.2.2.5 Irredeemable Bonds These are the complete opposite of the class of redeemable bonds. While redeemable bonds have both maturity values and terms to maturity, the opposite is true for irredeemable bonds. These are bonds that are traded on capital markets at a defined purchase price but do not have redemption dates, that is once one purchases them then they should be held in perpetuity. 3.2.2.6 Bonds with Warrants Warrants give the holder the right but not the obligation to buy a stated number of a company’s ordinary shares at an agreed (exercise) price within an agreed period of time. The difference between convertible bonds and bonds with warrants comes from the effect of each on the Statement of the Financial Position (Balance Sheet) of the firm. The effect of exercising warrants attached to bonds is to increase the share capital of a firm without reducing the firm’s debt level.

34

Chapter Three

3.3 Valuation of Bonds As alluded to earlier, there is a fixed income security on a bond that can be issued by a company, quasi-governmental organizations or a government through the Central Bank. Buyers of bonds become bond holders and the originators remain the owners of these financial assets or securities. A bond is sold on the market bearing a face value, earns coupons and has a yield to maturity. A bond is a debt instrument as opposed to an ownership or equity instrument in the eyes of an investor because its ownership cannot be surrendered to the investor as is the case under the trading of shares or stocks. The issuers of bonds remain the owners of the bonds and investors simply buy and hold the bonds and are called bond holders but do not assume ownership of the instrument. The main features or characteristics of a bond are:The Coupon (C)––This is a fixed amount of income payable on a bond usually as a percentage of its face value; The Face Value––This the capital amount of the bond that is redeemable at the maturity date, T; The Maturity Date (T)––This is the date at which the bond issuer would redeem the bond from the holder; Yield To Maturity (YTM, i)––This is the rate of interest on the cash flow generated by a similar risk paper; The Value of the Bond (P)––This is the present value of the future cash flows to be generated by the security discounted at the ܻܶ‫ ܯ‬of a similar risk paper. The valuation of bonds on financial markets assumes that bonds can be sold on the basis of three conditions namely at par value, at a discount or at a premium depending on their levels of marketability. A bond is said to be selling at par value when its market value is equal to its face or maturity value. On the other hand, a bond sells at a discount or a premium when its market values are below or above its face value respectively. A bond’s market value or price is its current or present price on the financial market. This market or present value is determined by discounting all its expected future cash flows, which are coupons and the instrument’s face value to be realized at the end of its maturity life.

The Theory and Conventional Valuation of Bonds

The formula for the valuation of bonds is given by ‫ܤ‬଴ = ஼య (ଵା௜)య

+െെെെെെെെ+

஼೙ ାெ (ଵା௜)೙

35 ஼భ (ଵ_ூ)భ

+

஼మ (ଵା௜)మ

+

.,

where C= The periodic coupon payment in dollars;

P0 =Present value or market price of the bond today in dollars; N=Number of periods to the maturity of the bond; I=Discount rate taking into account the time value of money; M=Redemption, maturity or face/par value of the bond. Example 3.1 A $10000 par value bond has 2 years to maturity and pays a coupon of 12% p.a. once every year. The economy’s market discount rate is 10%. Calculate the value of the bond on the market today. Solution Coupon value, C =12% x $10 000 = $1 200.

P0 = ଵ ଶ଴଴ +ଵଵ ଶ଴଴= $10 347.10. ଵ.ଵ଴భ

ଵ.ଵ଴మ

The bond’s current price is bigger than its face value and hence it is selling at a premium. This is always the case when the coupon rate on a bond is bigger than the discount or yield rate that the bond issuer expects to reap from the instrument. Example 3.2 Assuming that the bond in example 3.1 above pays its coupons semiannually, determine its present or market value. Solution ଵ

଴.ଵ଴

ଶ

ଶ

Coupon Value, C = 12% x 10 000 × =$600, Discount rate= Po=

ଷ଴଴

ଵ.଴ହభ

+

଺଴଴ ଵ.଴ହమ

+

଺଴଴ ଵ.଴ହయ

+

ଵ଴ ହ଴଴ ଵ.଴ସర

= $10 354.60.

= 0.05

Chapter Three

36

The effect of increasing the frequency of paying coupons is that the market price of the bond increases. The bond however still sells at a premium on the market as was the case in the example above.

3.3.1 Clean and Dirty Prices of Bonds When bond prices are quoted on the markets they do not reflect the actual prices that must be paid by the investor. In other words, bond prices do not include accrued interest but are quoted clean of such interest. However, when one buys a bond on the secondary market one has to pay the stated or clean price plus the accrued interest. Accrued interest refers to a portion of the next coupon payment that has been earned by the current bond holder, before selling the bond, but has not yet been received. Therefore the Dirty Price of the Bond = Clean Price+ Accrued Interest. Example 3.3 Calculate the accrued interest on the bond in the example above given that it was bought on 30 June and held up to 30 August, 2015 and interest is paid semi-annually. Solution Accrued interest = 0.5(12% x $10 000 x 60 ÷180) = $36 000 ÷180 = $200. The valuation of bonds in government or corporations requires that we have the face value of the bond, the coupon rate, the maturity date and the yield to maturity. In the above example the bond’s face value was $10 000, the annual coupon was 12%×$10 000= $1200 and the term to maturity was 5 years while the yield to maturity was 10% per annum. The market value of the bond is given as $950. However in practice, one of the features of the bond may be unknown and may require to be calculated from the given features. Bonds can either be priced on the market at par value, at discount or at a premium depending on the relationship between the coupon and the yield rates.

3.3.2 Valuation of Bonds at Interest Rate Dates The process of selling bonds on the markets can take place on interest rate dates, as explained below:

The Theory and Conventional Valuation of Bonds

37

Example 3.4 Assume we have a bond trading on a market which is defined by the following parameters:‫ = ݁ݑ݈ܸܽ ݁ܿܽܨ‬10 000 and ‫= ݁ݐܴܽ ݊݋݌ݑ݋ܥ‬ 11% ‫݌‬. ܽ. Interest Dates are 1 June and 1 December of each year. YTM = 15.60% p. a. Maturity date = 1 June, 2033 Settlement Date = Date of Purchase = 1 June, 2015 Calculate the market value of the bond, assuming that coupons are paid semi-annually to coincide with interest rate dates. Solution ଵ

Semi-annual coupon = 11% ‫ ݔ‬10 000 ‫ = ݔ‬$550.Semi-annual yield = ଶ 7.800% Market value of bond = 550(ܸܲ‫(ܨܫ‬7.800%; 36) +

ଵ଴ ଴଴଴ (ଵା଴.଴଻଼଴଴)యల

= $7

244.10. Another way of calculating the market value of the bond is given by: Po= ቂ

(ଵ.଴଻଼଴଴)యల ିଵ ଴.଴଻଼଴଴(ଵ.଴଻଼଴଴)యల

ቃ 550 +

ଵ଴ ଴଴଴ (ଵ.଴଻଼଴଴)యల

= $7 244.10.

This is the case when interest rate dates coincide with coupon payment dates. The bond above sells at a discount because its price is lower than its face or maturity value. This is the case when the coupon rate is lower than the yield or discount rate. On the other hand, for a bond to sell at par value the coupon rate must be equal to the discount or yield rate.

3.3.3 Valuation of Bonds at Dates Other than Interest Rate Dates A bond that is sold on the market at a date different from the interest date can be sold ex or cum-interest. A cum-interest bond is a bond that is sold on the market inclusive of the interest due on the next interest date. A bond sold cum-interest entitles its buyer to the next interest or coupon due as demonstrated mathematically below.

Chapter Three

38

Example 3.5 Suppose we are given the bond in example 3.4 above, calculate its value if it is sold cum-interest, given that the settlement date has changed to 31.03.2015 while the interest rate date remains as given above. Solution The settlement date in the example is different from the coupon date therefore the Present Value of the bond on 01/6/15= $7 244.10. The bond price has to incorporate the coupon that is due on the same date of $550 to give a total of $7 794.10. The above total price should be discounted to the settlement date of 31/03/15 using the remaining days to the next coupon date which is I June, 2015. The price discounted to the settlement date of the bond, the dirty price, which is equal to the dirty price given by 7794.10(1+i)-D/B, where D = days remaining to the next coupon, and B = days in the half-year period in which the settlement date falls. Present Value, PV of the Bond at 01/06/2015 = $7 244.10 We have not incorporated the coupons coming on 01/06/11 worth $550. బభ

PV of bond బల ଶ଴ଵହ Add coupon 01/06/15 Total value of the bond

= $7 244.10 = $550.00 = $7 794.10.

The above total price should be discounted to the settlement date i.e. 31/03/11 using the remaining days to the next coupon i.e. due on 01/06/2011. The price discounted to the settlement date is called the Dirty Price which ీ

is given by: Dirty Price = 7794.10(1 + i)ా where D= 62days, and B= 182 days (from 01/12/14 to 01/06/15) remaining to the next coupon. ୌିୖ ୆ିୈ )×C= ቀ Accrued Interest = ( ቁ×C ଷ଺ହ

ଷ଺ହ

The Theory and Conventional Valuation of Bonds

39

ଵ଼ଶି଺ଶ

Accrued Interest = ( ) × $1 100 = $301.60. ଷ଺ହ Clean Price = Dirty Price െ Accrued Interest Dirty Price = Clean Price + Accrued Interest = $7 597.10 െ 361.60= $7235.50. Therefore the dirty price is the price paid for the bond by the buyer. The clean price on the other hand is the price quoted on the market for the bond. The Accrued interest compensates the seller of the bond for not getting the next coupon payment. However, if the bond is purchased excoupon or interest the coupon coming after the settlement date would go to the seller. Example 3.6 Calculate the market price of the bond in example 3.5 above under the excoupon or interest case. Solution షలమ

Bond price on 01/06/2015= $7244.10. Bo = 7244.10(1.07800) భఴమ = $7 061.00 ିோ

ି଺ଶ

×‫= ܥ‬ × $1 100 = െ$186.80. Accrued Interest = ଷ଺ହ ଷ଺ହ Clean Price = Dirty Price െ Accrued Interest = $7061.00 + $186.80 = $7 247.80 In this case the accrued interest is the compensation received by the buyer for not receiving the next coupon payment. In other words, the buyer would pay the dirty price of the bond which in this case is lower than the clean price. Example 3.7 An investor buys a bond on 16/07 of a given year with coupon payments due on 02/07 and 02/01 of each year. If the coupon payable on each date is ଷ଴ $1500, calculate the accrued interest on the bond assuming a day count ଷ଺଴ convention. Solution Accrued interest =$1500 x

ଵସ

= $116.70

଼଴

Chapter Three

40

The modified bond pricing formula is used when coupon payment periods are inclusive of fractional periods. The modified bond pricing formula is ஻భ ஼మ ஼య ஼ಿ ାெ given by:‫ܤ‬଴ = ೑+ ೑శభ + ಷశమ + --------------------+ ೑శು.. (!ାூ)

Where C I N F P date.

(ଵା௜)

(ଵା௜)

(ଵାூ)

= Coupon amount; = Discount rate; = Number of years or periods to maturity; = 1–– Fraction of the accrued interest coupon period; = Number of whole coupon periods since the settlement

Example 3.8 Assume we have an investor who bought a $10 000 government bond (Par Value) on 16/07/15. The Treasury bond is set to mature on 02/01/18 and has a coupon rate of 10% payable semi-annually and a discount rate of 8%. Calculate the Treasury bond’s dirty price assuming an actual 365-day count convention and those coupons are paid on 02/01 and 02/07 of each year. Solution Since the bond is set to mature on 02/01/18, it means that 02/01 is one of the coupon dates and the other coupon date is 02/07. The settlement or purchase date of the bond is16/07/15, which is 14 days after the coupon date. Therefore, the length of the period between coupon dates 02/01 and 02/07/15= 29 + 28 + 31 + 30 + 31 + 30 +2= 181 days. The value of the fractional period, f=1-

ଵସ

=0.923

ଵ଼ଵ

ଵ଴%

Coupon amount, C=

ଶ

×× $1 000 = $500

The number of full periods between the settlement and maturity dates, n = 4 periods.

The Theory and Conventional Valuation of Bonds

41

Solution Table 3.1 Showing Periods, Discount Rates and Cash Flows of a Bond (Amounts in $) Date of Payment January 2, 2016 July 2, 2016 July 2, 2017 July 2, 2017 January 2, 2018 Total

Period

Discount Rate

0.923

Amount Paid 500

1.04 0 ,923

1.04

Discounted Cash Flow 482.20

1.923

500

1.041,923

1.08

463.70

2.923

500

1.04 2 ,923

1.12

445.80

3.923

500

1.04 3,923

1.17

428.70

4.923

10500

1.04 4 , 923

1.21

8 656.30 10 476.70

Therefore the dirty price of the bond = $10 476.70. Example 3.9 Suppose we are given a bond with a par value of $1 000, and a coupon rate equal to22%p.a. which is payable annually. The bond is convertible into 5 ordinary shares of Caps Private Limited at the end of 3 years from now. Assume that the firm’s current share price is $150 which is set to grow at 5% p.a. over the next 3-year period. Calculate the conversion value of the bond and its market value today assuming that the bond’s yield to maturity is 20%p.a. Solution The conversion value of the bond = Expected price of a share× Number of shares to be received per bond =$150(1.05)ଷ × 5= $868.22. Coupon amount= 22%× $1 000 = $220. ଶଶ଴

ଶଶ଴

ଶଶ଴

ଵ ଴଴଴

+ + + Therefore, present value of the bond = భ + ଵ.ଶ଴ ଵ.ଶ଴మ ଵ.ଶ଴య ଵ.ଶ଴య =$1 544.57.

଼଺଼.ଶଶ ଵ.ଶ଴య

Chapter Three

42

Example 3.10 Suppose an investor has a bond with a par value of $1 000, and a coupon rate equal to 22%p.a. The bond is redeemable at par in 10 years’ time but it has 5 warrants attached which can be exercised at a price of $60 each within the next 4 years. Assume that the firm’s current share price is $40 which is set to grow at 5% or 20% p.a. over the next 4-year period. (a) Calculate the present value of the bond using a yield to maturity of 20% p.a. and (b) Determine the anticipated gains to accrue to the investor from exercising the warrant option. Solution The present value of the bond = ଵ ଴଴଴ ଵ.ଶ଴భబ

ଶଶ଴ ଵ.ଶ଴భ

+

ଶଶ଴ ଵ.ଶ଴మ

+

ଶଶ଴ ଵ.ଶ଴య

+െെെെെ+

ଶଶ଴ ଵ.ଶ଴భబ

+

=$1 083.85.

The expected share price at the end of the 4th year at 5%p.a. =$40× 1.05ସ =$48.62. Therefore, the option will not be exercised because the share is cheaper on the market than in the company where it is worth $60. The expected share price at the end of the 4th year at 20%p.a. =$40× 1.20ସ =$82.90. The

net

value of interest coupons = 900(1.07)ଶ + 900(1.07)ଵ + 900(1.07) െ 2 700 = $193.40. ଴

Therefore, the option will be exercised because the share is cheaper in the company where it is worth $60.00 than it is on the market. The gain from exercising the warrants =$82.90× 5 െ $60.00 × 5 = $114.00.

3.4 Yields, Durations and Convexities of Bonds The yield to maturity (YTM) is a promised rate of return on a bond investment which can only be realized when interest rates in the economy do not change or are assumed to be constant over time. It is also assumed that the bond is bought and held to maturity by the investor. On the other hand the bond is not called before the maturity date or the issuer would not default on the settlement date or the maturity date of the bond. The realized

The Theory and Conventional Valuation of Bonds

43

return or yield on the other hand is the return that is actually earned at the horizon date of the investor, which must not coincide with the maturity date of the bond. Example 3.11 Suppose we have a non-callable and default-free bond that has a coupon of 9% per annum, a face value of $10000, a yield to maturity of 8% per annum and the maturity period is 4 years. Suppose we have a client purchasing the bond who has a horizon date (HD) of 3 years. It is also assumed that after purchase the bond’s yield to maturity will decrease to 7% per annum and remain at that level until the horizon date of the client. Determine the realized yield for such a bond investment. Solution ‫ = ݊݋݌ݑ݋ܥ‬9% × $10 000 = $900, ܶ = 4‫ݏݎܽ݁ݕ‬, ‫ = ܦܪ‬3 ‫ݏݎܽ݁ݕ‬. ‫= ݋ܤ‬

ଽ଴଴ ଵ.଴଼భ

+

ଽ଴଴ ଵ.଴଼మ

+

ଽ଴଴ (ଵ.଴଼)య

+

ଵ଴ଽ଴଴ (ଵ.଴଼)య

= $10 331.20.

Since the yield to maturity is less than the coupon rate, the bond is selling on the market at a premium of $331.20. 2. Determine the total coupon amount for 3 years to the horizon date of the client. The sum of coupons to the horizon date of the client= $900 × 3 = $2 700. 3. Determine the sum of interest coupons less the sum of nominal values. 4. Determine the client’s horizon date price of the bond, Bo= $10 186.90.

$ଵ଴ ଽ଴଴ ଵ.଴଻

=

5. Determine the total cash flows at the horizon date of the client, = $900 × 3 + 10186.90 + $193.40 = $13 080.30. 6. Calculation of the realized rate of return that is the realized rate of return య ଵଷ.଴଼଴.ଷ଴

on the bond = ට

ଵ଴ ଷଷଵ.ଶ଴

െ 1 = 8.2% per annum.

Chapter Three

44

3.4.1 The Sources of Bond Investment Risks The risks that face a bond investment may include the following types. 3.4.1.1 Default or Credit Risk This is the risk that the issuer of the bond may default or fail to deliver on a bond contract or obligation. Investors may minimize such types of risk by buying high grade bonds, which are high coupon earning bonds. 3.4.1.2 Call Risk This is the risk that a callable bond may be called before the horizon date of the client and will affect the returns to the client. The client can minimize this type of risk by purchasing deep discount bonds which are callable bonds whose prices are unlikely to rise and be callable by their issuers. 3.4.1.3 Interest Rate Risk This is the risk that the realized yield on a bond investment will not be equal to the promised yield due to interest rate fluctuations. Interest rates tend to vary over time, causing fluctuations in bond prices. A rise in interest rate will depress prices of outstanding bonds while a fall will push the market price of bonds upwards. This form of risk can be broken down into two components as demonstrated below. 3.4.1.3.1 Interest Rate Re-investment Risk This is the risk that coupons obtained on the bond may be re-invested and some interest rates may be different and lower than the initial yield to maturity. 3.4.1.3.2 Interest Price Risk The is risk that cash flows of the bond generated after the horizon date of the client may be discounted at a rate that is different from the original yield to maturity. Interest rate risk is market risk which is measured by the percentage of a bond in response to a given rate. It is a function of the maturity period of the bond and its coupon interest rate.

The Theory and Conventional Valuation of Bonds

45

3.4.2 Measurement of Duration of a Bond Duration measures the average age or life of the cash flows of a bond investment. It is also the period that is required by an investor to fully reclaim or recoup the initial capital outlay put into a bond investment from the future cash flows generated by the bond. The duration of a bond is calculated using the formula: ୘

‫ܦ‬o = ෍ ୲ୀଵ

t × PVt , where σPVt

t = period in which the cash flow is due; Do = durationof the bond; PVt = Present Value of theCash Flowdue at time, t; and T = Maturity life of the bond. Example 3.12 Suppose the investment advisor of Commercial Bank Limited has given the bank a green light to proceed and invest $10 000 for 5 years on the capital market. Determine the present value of the bond and hence its duration if it is set to earn a coupon of 9% per annum and if the ܻܶ‫ ܯ‬is also 9% per annum. Solution ࡼࢋ࢘࢏࢕ࢊ ࢚ 1 2 3 4 5 Total

࡯ࡲ (࡯࢕࢛࢖࢕࢔) 900 900 900 900 10900

ࡼࢂࡵࡲ ૢ% 0.9174 0.8417 0.7722 0.7084 0.6499

ࡼࢂ࢚ 825.70 757.50 695.00 637.60 7 083.90 10000

࢚ࡼࢂ࢚ 825.70 1 515.00 2 085.00 2 550.40 35 421.00 42 397.10

࢚ࡼࢂ࢚ σࡼࢂ࢚ 0.08257 015150 0.2085 0.25504 3.5421 4.24

Coupon Amount = 9%×$10 000.00 = $900.00.

Table 3.2 Showing Coupons, Discount Factors and Present Values of Coupons

46

Chapter Three

Therefore, the bond is bought at par value because its yield to maturity is equal to the coupon rate and it has a duration of 4.24 years. In other words, the investor would fully recover his initial investment in the bond in a period of 4.24 years. Hence, to guard against risk on a bond investment the investor may undertake bond investment immunization. If an investor has constructed a bond investment portfolio he can immunize the portfolio against small changes and parallel shifts in the yield curve. This can be achieved through equating the duration of the bond investment to the horizon date of the client’s liabilities. Therefore it can be concluded that: When the Duration of bond=the Horizon date of the investor, the investor is fully immunized against bond investment risk; When the Duration of bond > the Horizon date of the client, the dominant risk is interest rate price risk; and When the Duration of bond 1.00, the futures price of the CTD will be less volatile than the cash price of the bond. Thus, on 30 June when cash flows arise, the fund manager will sell 610 futures contracts and his position will be well-hedged.

11.7 Hedging with Interest Rate and Currency Swaps Interest rate and currency swaps can be used to hedge financial market obligations facing corporations as demonstrated below.

11.7.1 Hedging with Interest Rate Swaps Interest rate swaps are arrangements that involve two parties, for example a company with a fixed rate loan, which would have preferred a floating rate loan and another with a floating rate loan, which would have preferred a fixed rate loan. The two companies would then swap their interest rate payments which will enable both to achieve the interest rate that each would have preferred at a cheaper rate than otherwise would have been possible if each had gone directly to the alternative market. Example 11.10 Suppose two companies A and B face the following financial contingencies: Table 11.2 Showing Firms and Fixed and Floating Exchange Rates Faced Company Firm A Firm B

Fixed Rate 10.40% 11.60%

Floating Rate LIBOR + 0.25 LIBOR + 0.75

220

Chapter Eleven

Demonstrate how the two companies would undertake an interest rate swap and benefit together assuming the case for disintermediation or intermediation in arranging the swap. Assume that the companies undertake the interest rate swap such that company A borrows from the fixed rate market at 10.40% and company B from the floating rate market at LIBOR+0.75 and the two then share the gross cost savings equally. Solution (a) Case for Disintermediation From the above, company A has a cost advantage over company B in both fixed and floating rates and enjoys 1.20% (120 basis points) in the fixed rate market and 0.5% (50basis points) in the floating rate market. The net benefit between the two markets = 1.20% -0.5% =0.7%. Under these parameters we can have the following diagram illustrating the costs faced by each counterparty:

The floating rate used in swaps is the LIBOR (London Inter-bank Offer Rate). The all in cost (AIC) for company A = 10.40% +LIBOR-Y and that of company B =LIBOR + 0.75 + Y-LIBOR = 0.75+Y. Using the all in cost (AIC) for company A, we obtain the equation: 10.40% +LIBOR –Y= LIBOR+0.25-0.35, Y=10.40% +010%= 10.50%. Applying the AIC for Company B, 0.75 +Y= 11.60% - 0.35, Y = 11.60% 0.75-0.35 = 10.50%. Companies A and B therefore assume and pay LIBOR (a floating rate)and 10.50% (a fixed rate of interest) respectively to each other when the swap is undertaken in the absence of an intermediary. The intermediary then forwards LIBOR to B and 10.45% of fixed rate paid by B, to firm A.

Hedging of Investments using Derivative Securities

221

The Y value remains the same whether it is calculated using firm A or B’s all-in-cost (AIC). Hence company A saves 0.35% and Company B saves 1.10% by entering into the interest rate swap; (b) Case for Intermediation at a Commission of 0.1% (10 Basis Points) Assuming the two undertake the swap through an intermediary who demands a commission of 0.10% (10 basis points) the following diagram will be obtained:

AIC for company A=10.40+LIBOR – Y =LIBOR+0.25-0.30, Y=10.45%. AIC for company B= LIBOR+0.75+X-LIBOR = 0.75+X = 11.60% - 0.30% X = (11.60 - 0.30 - 0.75) %, X = 10.55% Companies A and B therefore assume LIBOR (a floating rate) and 10.55% (a fixed rate of interest) when they enter into an interest rate swap in the presence of an intermediary. The intermediary then forwards LIBOR to firm B and 10.45% of fixed rate paid by firm B to firm A. Hence, company A saves 0.30% and company B saves 1.05% by entering into the interest rate swap.

11.7.2 Hedging with Currency Swaps Hedging with a currency swap involves exchanging three different sets of cash flows namely: 1. At the initiation of the swap, the two counterparties actually exchange the principal amounts that are denominated in their respective domestic currencies;

222

Chapter Eleven

2. During the swap tenure the parties will exchange interest payments; 3. At the end of the swap, principal amounts will be re-exchanged based on the comparative advantage rule. Example 11.11 Suppose that companies Montana and Neuron Limited are offered 5 year rates in the US$ and Pound Sterling currencies as tabulated below: Table 11.3 Showing Firms and US Dollar and Pound Sterling Rates Faced Company Firm Montana Ltd. Firm Neuron Ltd. Net Position

US Dollar ($) 8% 10.4% 2.4%

Pound Sterling (£) 11.6% 12% 0.4%

Show how the two firms can arrange a currency swap and both benefit assuming the case for intermediation at a commission of 0.4% with Montana and Neuron sharing net benefits in the ratio 60% and 40% respectively. Assume that the currency swap is initiated by an intermediary and that Montana borrows from the American market and Neuron from the British market respectively. Solution In the presence of an intermediary, the following way of arranging the swap is possible. The intermediary must initially pay both firms what they owe and then levy them a commission of 0.4% from the net savings.

The AIC for company A = 8%$ + X%£-8%$= X%£ and company B = 12%£ + Y% $- 12% £= Y%. Using the all in cost for Company A, X%£ = 11.6%£

Hedging of Investments using Derivative Securities

223

- (60% x 1.60) = 10.64%£ and that of company B, Y%$ = 10%$ - $(40% x 1.60)= 9.36%$. Therefore if the currency swap is undertaken, Montana Limited will pay 10.64%£ and 9.36%$ will be paid by Neuron Limited and both companies are said to gain from the swap. Montana Limited’s benefit = 11.6%-10.64% =0.96% and Neuron Limited’s benefit =10.4%-9.36%=1.04%.

11.8 Summary Hedging has been defined as the use of financial markets and instruments by investors to gain protection against financial loss arising from fluctuations in derivative security prices. Modern financial market investment is therefore heavily premised on the use of advanced financial techniques and strategies by investors in order to improve efficiency, marketability and liquidity of products, market discipline and the overall financialisation of a country’s financial system over time. Under the hedging of equity portfolios and other exposures, derivative market investment mechanisms such as call and put options, forward and futures contracts as well as interest and currency swaps were good assets for use in hedging cash exposures and equity portfolios constructed on derivative market frameworks. Such derivative assets or securities are recommended for use by those investors with significance price or market exposures who wish to reduce the risk of financial loss that may result from adverse price, interest and exchange rate movements on financial markets.

11.9 Exercises 11.9.1 Compare and contrast the concepts of hedging and portfolio insurance in the context of derivative market operations. 11.9.2Write brief notes on the following terms used in derivative financial markets: (a) Call and put options; (b) European and American options; (c) Short and long security positions; (d) Forward and futures contracts; (e) Interest rate and currency swaps.

Chapter Eleven

224

11.9.3 Suppose that on 1 July of a given year the company Brown Limited’s shares are trading at $80 each on the market. The July $80 call option is trading at $12.00 and the July $80 put option is valued at $10.00. It is also given that the risk-free rate of return on the market is 8% per annum and ABC Limited has an annual dividend rate of 5% per annum to be paid quarterly. Evaluate any two hedging strategies that the hedger can use to hedge own investment in Brown Limited. 11.9.4 A Zimbabwean exporting firm Socrates Limited expects to receive Botswana Pula, BWP 4 800 000 (four million eight hundred thousand Pula) in 6 months’ time but is worried about adverse movements in exchange rate and wants to hedge against this development. Suppose that Socrates Limited has gathered the following financial information from the two countries’ markets: -

Spot exchange rate= $0.1864/BWP;

-

Three months’ forward rate =$0.1854/BWP

-

Zimbabwe’s borrowing interest rate= 16% p.a.;

-

Zimbabwe’s lending interest rate =12% p.a.;

-

Botswana’s borrowing rate=20% p.a.;

-

Botswana’s lending rate= 15% p.a.;

-

The three months’ forecast spot exchange rate = $0.1848/BWP.

Demonstrate how the firm can hedge its Pula exposure using forward and option market hedges assuming that the three months’ put option contract on the counter (OTC) market for BWP4 800 000 (four million eight hundred thousand Pula) has a strike price of $0.1880/BWP and a premium of 1.80%. 11.9.5 Montrose Private Limited is expecting a cash inflow of $360 000 which it intends to invest in a short-term deposit account when received. However the firm is concerned about short-term interest rates which are set to decline between now and then, hence the need to puta long hedge on the exposure. Suppose that the current deposit rate on the Zimbabwean money market is 16% per annum, each futures contract is worth $4 800 and the price of the futures contract is set at 90.5% today. Show the transactions to be obtained in both cash and futures markets assuming that the rollover date is 2months from today and the interest rate will be 12% per annum (400

Hedging of Investments using Derivative Securities

225

basis points) below the initial rate, to be quarterly apportioned at the time the cash flow is received. 11.9.6 Suppose that on 1 March of a given year Paramount Private Limited is uncertain about where the markets are going over the next three months and wishes to hedge £6 million of its equity portfolio, with a beta, B=1.25.On 1 March the Futures Trading Stock Exchange, ‫ܧܵܶܨ‬ଶ଴଴ is standing at 3288 and the value of the 31May contract of the same year on the London International Forward and Futures Exchange (LIFFE) would be 4 880.Since the firm is long in the cash market it should be short in the futures market to hedge its equity portfolio. Given that the initial‫ܧܵܶܨ‬ଶ଴଴ on the LIFFE is worth £4 000 calculate: a) The number of contracts to be sold by the firm to hedge the portfolio; b) The cost the firm incurs in putting the hedge on the equity portfolio; c) The value of the portfolio that the firm is locking-in through hedging; and (d) Determine the hedge ratios given a gain or loss position on the cash exposure based on a futures contract value of 6 880 or 2 880 on 31 May. 11.9.7 Suppose two companies Adams and Bridged Limited face the following financial contingencies: Table 11.4Showing Firms and Fixed and Floating Exchange Rates Faced Company Firm Adams Firm Bridged

Fixed Rate 12% 15%

Floating Rate LIBOR + 0.30 LIBOR + 0.80

Demonstrate how the two companies Adams and Bridged Limited would undertake an interest rate swap and both benefit together assuming the case for disintermediation or intermediation in arranging the swap. Assume that the companies undertake the interest rate swap such that company A borrows initially from the fixed rate market at 12% and company B borrows from the floating rate market at LIBOR+0.80 and the two then share the gross cost savings in the ratio 55% and 45% respectively. 11.9.8 Assume we are given Andrews and Bricks Limited that have been offered 5 year rates in the US$ and Pound Sterling currencies as tabulated below:

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Chapter Eleven

Table 11.5 Showing Firms and US Dollar and Pound Sterling Rates Faced Company Firm Andrews Ltd. Firm Bricks Ltd. Net Position

US Dollar ($) 8% 10% 2%

Pound Sterling (£) 10.8% 11.2% 0.4%

Show how Andrews and Bricks Limited can arrange a currency swap assuming there is an intermediary in the swap who demands a commission of 0.4% and the firms would share the net benefits in the ratio 56% and 44% respectively. Assume also that the currency swap is initially arranged by an intermediary and Andrews borrows from the American market and Bricks borrows from the British market respectively.

CHAPTER TWELVE MARKET EFFICIENCY AND THE EFFICIENT MARKET HYPOTHESIS (EMH) BY EUGENE FAMA

12.0 Objectives By the end of the chapter one should be able to: Define the term market efficiency from a financial perspective; State the concept of the EMH by Eugene Fama and illustrate its main features and forms; Explore the regulation and supervision processes of the Stock Exchange of an emerging economy; Examine the implications of the EMH to the Stock Exchange operations of an emerging economy; Critique the recent tests that have been carried out on the applicability of the EMH to stock valuation in emerging economies.

12.1 Introduction The concepts of market efficiency and the efficient market hypothesis (EMH) by Eugene Fama are interrelated and therefore need to be discussed together in financial theory and practices. The EMH by Fama is a concept that is heavily premised on stock valuation on capital markets. The theory or hypothesis argues that efficiency in stock valuation depends mainly on the nature of the information available to market players as and when they enter the financial markets. The hypothesis identifies three forms of information which it believes strongly influence investors’ stock pricing decisions and these are weak-form, semi-strong form and strong-form EMH. This chapter therefore starts by exploring the regulation and

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supervision of Stock Exchanges before it proceeds to look at the EMH and its implications to efficiency and effectiveness in stock pricing. The recent tests that have been performed on the applicability of the EMH to the pricing of stocks on financial markets come last but are attacked from both theoretical and empirical perspectives for comparison purposes.

12.2 The Concept of Market Efficiency According to Damodaran (2000), an efficient market is a market on which current security prices fully reflect all available financial information. In other words the current market price of a security is an unbiased estimate of the actual value of a security or stock. It can therefore be argued that the market prices of securities are not predictable and hence follow a random walk process. Any financial information that could be used to predict security prices on markets should have been assimilated and is already reflected in the market prices of such securities. Conversely, for inefficient markets security market prices would always deviate from their actual or exact values. In this respect some investors would earn higher market returns than others because of their expertise or ability to identify under and overvalued securities on the markets (exploitation of arbitrage opportunities). The process of studying the behaviour of firms or finding any other relevant information that may affect the market value of securities has come to be known as the Efficient Market Hypothesis (EMH).

12.3 The EMH by Eugene Fama The EMH was first propounded by Eugene Fama (1972) and is founded on the basis of financial information that should be available on markets for use in setting security prices. The term, EMH-It is a term that implies that markets assimilate and respond to new information that can enable an investor to gain an advantage over other investors. This has a bearing on terms like fundamental Analysis (FA) and Technical Analysis (TA). There are three forms of efficiency that are expected to be available on financial markets from time to time.

12.3.1 Allocative Efficiency One of the roles of FM is to allocate scarce resources between competing NFE units in a way that will ensure that the highest bidder gets the scarce resource and therefore presumably uses it productively. When markets achieve this level of efficiency then they are said to be allocative efficient.

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12.3.2 Operational Efficiency Markets are said to be operationally efficient when the transactional costs of buying and selling securities in securities markets are determined by forces of demand and supply as opposed to being fixed by the stock exchange. Where the transaction costs are fixed, the market makers tend to either earn abnormal S s as the transacting economics units are forced to pay inflated costs or experience reduced levels of business (or to be out of it) as the economic units begin to shun intermediaries. At the extreme end, the costs of making a market should be 0 (zero) net. However in reality this would mean that markets would cease to exist.

12.3.3 Informational Efficiency Markets are said to be efficient in the informational sense if the prices of sec/commodity traded in such markets instantaneously and fully reflect all relevant available information about a sec/commodity.

12.3.4 Perfectly Efficient Markets A market is perfectly efficient if it has all the 3 characteristics outlined above. N.B. In financial theory however it is the informational Eff that has provoked a lot of interest to the extent that most analyses have taken the term EMH to refer solely to this aspect of ME. This is probably because prices are driven by expectations by information as opposed to being conditioned by operational allocative parameters. The three sets of information that shape expectations are: (a) Weak-form information set (past information); (b) Semi-strong form information set (past and publicly known information); and (c) Strong-form information (all past or historical, publicly and privately known information). As a result there are three versions of the EMH that correspond to each of the information sets above.

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12.3.4.1 Weak-form Efficient Market Hypothesis (WFEMH) It says that security prices instantaneously and fully reflect all information contained in the past history of security or stock prices. Therefore past prices do not provide information about future prices that could allow investors to earn excess returns (over a simple buy and hold strategy) from using active trading strategies based on historical prices. Tests done on the WFEMH have proved that by and large, securities’ markets are weak-form efficient. In other words, security prices rapidly incorporate all information contained in past prices or records to the extent that an investor cannot come up with a trading or successful formula (or value) based on past prices. 12.3.4.2 Semi-strong Form Efficient Market Hypothesis (SSFEMH) The hypothesis states that current security prices instantaneously and fully reflect all publicly available information about stock markets (including past information). Therefore, ignoring transaction costs, no investor can contently earn excess returns, over a simple buy and hold strategy, by taking advantage of publicly available information. Any good news made public is set to increase share prices and vice versa. Once this has happened however, no further predictable price changes can be expected to occur on the markets. If news does not lead to any changes in security prices then it could be concluded that the news disseminated had no relevant information. Tests done on the SSFEMH suggest that sec. markets are not only WFE but also SSE. 12.3.4.3 Strong-form Efficient Market Hypothesis (SFEMH) It argues that current stock prices instantaneously and fully reflect all known information about a security including privileged and/or privately available information. It implies that markets respond so quickly that not even an investor with the most valuable piece of inside information can trade profitably on the basis of that information because insider dealing is illegal in most countries. Evidence by tests done on the SFEMH is conflicting although it has been proved that in some markets the hypothesis may hold. Example 12.1 Two firms, Euphrates and Tigris Limited are publicly listed and have 4 million and 2 million issued shares respectively. On day 1 of trading, the market value per share is $1.80 for Tigris and $3.00 for Euphrates Limited.

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On day 2 of operation, the Management of company Euphrates Limited decides at a private meeting to make a cash take-over bid for company Tigris Limited at a price of $3.00 per share. The takeover is set to produce operating savings with a present value of $3.6 million. On day 4, the management of company Euphrates Limited publicly announces an unconditional offer to purchase all shares of Tigris Limited at a price of $3.00 per share with settlement on day 15, but details of the large savings are not announced and are not made public knowledge. On day 10, company Euphrates Limited announces the details of the savings that will be derived from the takeover. Ignoring Taxes and the Time Value of Money (TVM) between days 1 and 15 of the month and assuming the details given above are the only factors having an impact on the share prices of Euphrates and Tigris Limited, determine the two firms’ share prices in each of the following circumstances: (a) The purchase price is on a cash basis as specified above, if the market is (i) semi-strong form efficient; and (ii) strong-form efficient; (b) The purchase consideration decided on day 2, and publicly announced on day 4, is one newly issued share of Euphrates for each share of Tigris Limited, if the market is (i) semi-strong efficient; and (ii) strong-form efficient. Solution a) (i) Cash Offer Under the SSFEMH Day 2 The market only assimilates publicly known information into the share price therefore on day 2 the market does not know anything and prices will not change, the Euphrates share price = $1.80and the Tigris share price = $3.00. Day 4 The market is informed of an unconditional offer of $3.00/share of Tigris by Euphrates Limited to purchase all Tigris company shares. However, details of operating cost savings are not announced and made public. Hence, the Tigris share price = $3.00 and the Euphrates share price =$2.60/share.

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The Euphrates share price is determined as follows Market value of Euphrates=$6 000 000 x 3.00 = $18 000 000 Add the market value of company Tigris = $3 600 000 Total Value of the Two Firms = $21 600 000 Less Cash Payment for company Tigris = ($6 000 000) Net Market Value of the New Look Firm = $15 600 000. The average price per share of EuphratesLimited =

$ଵହ ଺଴଴ ଴଴଴ ଺ ଴଴଴ ଴଴଴

= $2.60.

Day 10 The market is further informed of the cost savings of $3.2million that will accrue to company Euphrates as a result of taking over company Tigris Limited. Value of company Tigris’ share

= $3.00/share.

Value of company Euphrates’ share =

$(ଵହ ଺଴଴ ଴଴଴ାଷ ଺଴଴ ଴଴଴) ଺ ଴଴଴ ଴଴଴

= $3.20/share

(ii)Cash Offer under the SF The market assimilates all information (announced, public and private) into the share price as early as day two of operation. Days 2, 4 and 10 Even though the market has not been told the information officially it will somehow know everything that was discussed in company Euphrates Limited’s Management meeting and stock prices will shoot out to: Tigris’ share price = $3.00 and Euphrates’ share price=$3.20 for days 2,4 and 10.

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b) (i) Share Offer Under the SSF All shares of company Tigris are cancelled and the shares of new company Euphrates are issued to accommodate those of Tigris Limited being written off. The market only assimilates publicly known information into the share prices. Day 2 The market knows nothing about Euphrates’ intention to purchase company Tigris Limited and prices will not change. Euphrates’ share price=$3.00 and Tigris’ share price = $1.80. Day 4 The market is informed of the unconditional offer made by Euphrates Limited to purchase all shares of Tigris by issuing one share for every share of Euphrates, but details of operating cost savings are not announced and made public knowledge. It is critical to know that under a share offer, shares in one company cannot be priced differently. a) Number of Euphrates’ current shares in issue= 6 million. Number of Euphrates shares to be issued to take over Tigris= 2 million. The share prices of the two companies will converge since the takeover share offer is on a 1 to1 basis. Total shares of Euphrates after the takeover of Tigris = 8 million. Current market value of company Euphrates Current market value of company Tigris Total market value of new Euphrates Limited Share value of the merged company

= $18 000 000 = $3 600 000 = $21 600 000 $ଶଵ ଺଴଴ ଴଴଴ = = $2.70 ଼ ଴଴଴ ଴଴଴

Day 10 The market is further informed of the cost savings of $3.6 million that would accrue to Euphrates for the takeover of company Tigris Limited. The share prices of the two companies are set to move together since the benefit accrues to both sets of shareholders.

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$ଶହ ଶ଴଴ ଴଴଴

଼ ଴଴଴ ଴଴଴

଼ ଴଴଴ ଴଴଴

Share value of the merged company = $3.15

=

=

(ii) Share Offer Under the SF The market will assimilate all information and stock prices will shoot up as early as day 2 of operation. Hence the price per share for Tigris and Euphrates Limited = $3.15 from day 2 to day 10.

12.4 Implications of Market Efficiency to Stock Exchange Operations Under efficient market conditions, no one investor should be able to regularly beat the market using an ordinary investment strategy because equity research and valuation would be costly and of no advantage to such an investor. Investors under efficient market conditions should follow a passive investment strategy because market conditions would not allow any space for arbitrage opportunities to be exploited by some investors at the expense of others. It can however be postulated that efficient markets do not imply that security prices will not deviate from their true values from time to time. The main market condition which is pertinent is that security price deviations should be random and unpredictable and there should be a 50-50 percent chance for investors to beat the market at any moment in time. In other words, given the implications above it can be argued that markets have space for portfolio managers who are involved in the regular management of investment portfolios on behalf of individual investors and corporations for agreed returns as demonstrated below.

12.4.1 Technical and Fundamental Analyses and Stock Markets By technical analysis we mean the search for recurrent and predictable patterns that are observable in security prices over time. Technical analysts have come to be known as chartists mainly because they study records and chart the behaviour of security prices on a regular basis, for example daily, so as to find patterns which they can exploit to make arbitrage profits. Fundamental analysis on the other hand refers to the use of the quantitative variables of a firm in coming up with security market prices from time to time. Some of the quantifiable variables which firms can employ in setting security market prices are earnings per share, capital gains and dividend yields, price-earnings ratios, price-to-book value ratios, and standard deviation or coefficient of variation measures. According to Myron Gordon,

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zero and constant dividend growth models can be used for calculating the market price per share as alluded to earlier in the book.

12.4.2 Moving Averages Financial analysts can proceed and calculate the average price of a security over a defined period of time. The calculated average return is then assumed to be the true value of the security. In other words, if the current market price of a security happens to be above such a value, this will be taken to mean that the security price will be falling and vice versa.

12.4.3 Relative Strength Approach Financial analysts would proceed and compare the performance of the security over a recent time period to that of the market as a whole or to those of related securities traded on the same market. The ratio of the security price to the market will be used as a benchmark for decision making. If the ratio increases over time the security is said to be exhibiting relative strength because its price performance will be better than that of the market as a whole and the opposite is true.

12.4.4 Resistance Levels or Support Appeals By resistance level we mean the price above which it becomes difficult for a security price rise or below which it is very unlikely to drop. Such levels of security prices are determined by a mechanism called market psychology and not by forces of demand and supply. For instance, Wellington Limited is a Zimbabwean firm whose stock recently traded for several months at about $1.20 and then dropped to $0.90 per share. In other words, if the price of the stock eventually increases from $0.90, the price of $1.20 will then be considered as the resistance level of the stock. This is so because all those investors who initially bought the company’s shares for $1.20 will be willing to dispose of their shares as soon as they are able to break even on such an investment. Hence at stock prices close to $1.20 some selling pressure will develop on the market and the market will be said to have a memory that makes the past stock price history influence current stock prices and the behaviour of investors.

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12.4.5 Trading Volumes Financial analysts in this case believe that stock price declines together with large trading volumes on markets are a sign that the markets are bearish and the converse also holds. This development holds because stock price declines are considered as a representation of broader-based selling pressures on financial markets. The commonly used trading index has come to be known as the Trin index which is given by the formula: Trin Index ௏௢௟௨௠௘/ே௨௠௕௘௥஽௘௖௟௜௡௜௡௚ = . ௏௢௟௨௠௘/ே௨௠௕௘௥ ஽௘௖௟௜௡௜௡௚

When the ratio above has a value greater than 1.00, the markets are considered bearish because the shares whose values are falling have higher averages than those whose prices are increasing on the markets. This development would imply that the markets are dominated by more selling investors than those buying securities and the opposite holds for ratios lower than 1.00. Hence it can be concluded that the EMH implies that technical analysis in particular has no merits to investors and recommends the use of passive investment strategies in security trading on markets. Under such investment strategies investors can construct well-diversified portfolios without attempting to identify over and undervalued stocks trading on financial markets. These investment strategies are called buy-and-hold strategies because all securities traded are at fair market values, given all the financial information available on the markets. In other words, frequent buying and selling of securities on such markets will only mean large brokerage and transactional costs to be borne by investors relative to benefits to be realized from such investments. The passive investment strategies are implemented by constructing indexed investment portfolios, which replicate the performance of the broader market’s indexed portfolios. In other words, the proportions of investors’ funds put into specific portfolios are determined by allocated values relative to firms’ market capitalization levels.

12.5 Tests of the EMH Some of the modern financial investment EMH tests (Damodaran, 2000) are as illustrated below.

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12.5.1 Tests over the Short Horizon These tests are centred on the fact that firms’ security prices were observed over a defined time horizon to come up with a price trend. The price trend was then measured by determining the serial correlation between returns to specific securities traded on the same markets currently (related to past security returns). It was therefore concluded that positive serial correlation implied that positive security returns tended to follow positive trend returns (this is called momentum). On the other hand, negative serial correlation meant that positive returns tended to be followed by negative returns (case for correction). The filter trend investment rule can also be used and this is the investment decision in which the decision to buy or sell a security will depend on past security price movements, that is an investor will buy a security if the last two trades were both in a price increase (there is momentum in the market) and vice versa.

12.5.2 Small Firm Effect The EMH was also extended to cover the operations of small firms on financial markets. Tests carried out on such markets revealed that large firms had lower rates of return than small firms. Therefore it was suggested that it was more profitable for firms to invest in securities issued by smaller firms than investing in those issued by larger firms.

12.5.3 Tests Based on Book-to-Market Ratios Tests to do with the EMH were extended to cover returns to investments based on their book-to-market value ratios. The studies found that returns across securities could be predicted using their book-to-market ratios (that is, the value of equity as a ratio of market value). It was therefore concluded that firms with high book-to-market ratios had higher returns as compared to those with lower ratios.

12.5.4 Insider Information EMH tests based on investors that had inside information pertaining to the operations of stock markets found that insiders were able to trade profitably in their own securities. It was discovered that there was the tendency for security prices to rise after insiders had bought securities intensively or fall significantly after they had sold their securities. This therefore meant that

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other investors trading on the markets would benefit if and only if they followed the trading patterns and behaviours of insiders.

12.6 Summary It was therefore discovered that it was ideal for stock and other security markets to be perfectly efficient so that all investors would make informed and rational investment decisions. However in practice stock and other security markets were never real even in the strong-form sense of the EMH by Eugene Fama (1972). The discussion examined the market efficiency levels, for example allocative and distributive forms, before dwelling more on the informational efficiency level, which gave birth to the weak, semistrong and strong forms. The EMH was then brought forward based on the information efficiency level of market efficiency and reasons for equating the EMH to this form of efficiency were highlighted. The chapter finally looked at the implications of market efficiency to investors and stock prices before it ended with elaborating on the EMH tests carried out by Damodaran (2000) on the applicability of the theory or hypothesis on stock or related security markets.

12.7 Exercises 12.7.1 Define and explain the concept of perfect securities markets. 12.7.2 What do you understand by the term, EMH? 12.7.3 Discuss the efficiency levels that are needed for stock or security markets to be referred to as perfect markets. 12.7.4 Does the strong-form efficiency level of stock markets imply weakform efficiency? Discuss. 12.7.5 What are the main distinctions between technical and fundamental approaches of the valuation of stocks or securities on markets? 12.7.6 Examine the implications of market efficiency to the behaviour of investors and traded stocks or securities on financial markets. 12.7.7 In which form of the EMH does the Zimbabwe Stock Exchange lie? Justify your answer.

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12.7.8 Critique the various contemporary tests that were carried out by Damodaran (2000) on the applicability of the EMH to stock or security valuations and the benefits to accrue to investors. 12.7.9 Two firms A and B are publicly listed and have 6 million and 4 million issued shares respectively. On day 2 of a given month, the market value per share is $5 for A and $3 for B. On day 5, the management of company A decides at a private meeting to make a cash takeover bid for company B at a price of $5 per share. The takeover will produce operating savings with a present value of $12.8 million. On day 10, company A publicly announces an unconditional offer to purchase all shares of B at a price of $5 per share with settlement on day 20, but details of the large cost savings are not announced and are not made public knowledge. On day 18, company A announces the details of the savings that will be derived from the takeover of company B. Ignoring taxes and the time value of money (TVM) between days 2 and 18 and assuming the details given above are the ONLY factors having an impact on the share prices, determine the share values of A and B in each of the following circumstances: (a) The purchase price is on a cash basis as specified above, if the market is (i) semi-strong form efficient; and (ii) strong-form efficient; (b) The purchase consideration decided on day 2, and publicly announced on day 4, is one newly issued share of B for each share of A, if the market is (i) semi-strong efficient; and (ii) strong-form efficient. 12.7.10 Two companies Ephraim Limited, a levered firm and Torwood Limited, an unlevered firm with authorized share capital levels of 8 million and 4 million at $2.50 and $1.50 per share respectively, were listed on the Zimbabwe Stock Exchange (ZSE) on 1 January, 2015. Ephraim Private Limited is currently trading on both equity and bond secondary capital markets on the domestic bourse while Tigris Private Limited has restricted itself to the equity market only. The corporations are currently concerned with resisting stiff competition from other senior listed firms on the

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Exchange and growing market shares and capital bases. The firms are aware of some of the contemporary empirical tests in Stock or Financial Management carried out on the Efficient Market Hypothesis (EMH by Eugene Fama, 1952) by theorists such as Damodaran (2000) and their implications on the hypothesis’ impact on share pricing and valuation. The shares that Ephraim and Torwood Private Limited have already issued on the domestic Exchange are responding very well to changes in information made available and the efficiencies of the markets of operation. The companies are also convinced that the current prices of their issued stocks (or shares) are heavily dependent on their liquidity and marketability levels. The concept of the EMH has a bearing on terms such as fundamental and technical analyses which the two corporations are currently using in the pricing of their shares on Zimbabwean capital financial markets. Ephraim and Torwood Private Limited are fairly capitalised on the Zimbabwean capital markets though they are relatively new on the Stock Exchange. The companies’ success stories to date are based on their observations of the requirements of the EMH for the growth of market shares and shareholders’ wealth. The financial statuses of the two corporations captured in a domestic financial magazine at the end of March 2016 revealed that the capitalization of Ephraim Private Limited on the domestic capital markets was made up of 4 million issued shares valued at $2.50 each and $2 million worth of bonds at a yield rate of 10% per annum. On the other hand, company Torwood Private Limited’s capitalization on the same date comprised 2 million issued shares valued at $1.50 each. The companies’ share prices and performance levels were also highlighted in the public media at the end of March 2016 for public consumption by various stakeholders including potential investors. On day 1 of April 2016, the market value per share of Ephraim Private Limited was $2.50 and that of Torwood Private Limited was $1.50. On day 4 of the month, the management of Ephraim Company Limited decided at a private board meeting to make a cash takeover bid for company Torwood Limited at a price of $2.00 per share. The management of Ephraim Private Limited made the above proposal after it had observed the growth potential of the proposed merger, since the two firms were in the same line of business.

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On day 6 of the month, the Board of Directors and management of Ephraim Private Limited approached those of Torwood Private Limited to discuss the proposed merger and the costs and benefits both groups were going to draw from the amalgamation. The proposed takeover of Torwood Private Limited by Ephraim Private Limited was agreed on 6 April and set to produce operating cost savings with a present monetary value of $6.40 million if it sailed through. On day 8 of the month, Ephraim Private Limited publicly announced an unconditional offer to purchase all issued shares of Torwood Private Limited at a price of $2.50 per share with settlement on day 30 of April, but details of the large cost savings were not announced and made public knowledge to all stakeholders. On day 15 of the month, Ephraim Private Limited finally announced the details of the large cost savings of $2.60 million that it was going to derive from the takeover of Torwood Private Limited as agreed in the meeting of the boards and management teams of both companies on 6April, 2016. On day 20 of the month, financial brokers and underwriters were engaged by Ephraim Private Limited to process the purchase of Torwood Private Limited by Ephraim Private Limited through the consent of the shareholders of both firms, for the purposes of constituting a new enlarged corporation with better capital formation, management and employee base. a) Examine the various efficiency levels that are implied in the case above that must exist on the capital markets of an economy in its desire to grow towards sustainable development; b) Evaluate the system of perfect financial markets referred to in the case according to the postulations of the Efficient Market Hypothesis (EMH) by Eugene Fama (1952); c) Determine the share values of the two companies after taking into consideration all other market factors (other than taxes and the time value of money, TVM) that are implied in the context that would have influence on share prices on days 4, 8 and 15 of both Ephraim and Torwood Private Limited, under each of the following market circumstances: (i) semi-strong form efficient; (ii) strong-form efficient, assuming that the acquisition is on:

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1. Cash offer basis; or 2. A share offer of one share of Euphrates Limited for every two in the issue of Tigris Limited; (d) Discuss some of the factors that the management of Ephraim Private Limited could have taken into consideration before resolving to acquire Torwood Private Limited.

CHAPTER THIRTEEN FINANCIAL MERGERS AND ACQUISITIONS

13.0 Objectives By the end of the chapter one should be able to: Understand the forms that diversification can take in the context of choices concerning product and market development; State and explain the arguments for and against the growth of firms by mergers and acquisitions; Explore the attitudes of shareholders to growth by mergers and acquisitions; Examine the tactics that companies may adopt in takeovers, and the legal and regulatory framework within which they operate; Compare and contrast the forms of considerations that firms may be accorded in a merger or acquisition; Examine the arguments for the success and failure of mergers and acquisitions; Evaluate the effects of mergers and acquisitions on earnings per share.

13.1 Introduction When a firm is considering expanding, whether by organic growth (expansion, integration or diversification) or externally (through mergers or acquisitions) it must ensure that growth is properly evaluated and carefully planned and implemented. Managers must consider the impact on the company, its shareholders and employees, the environment in which it operates, the likely reactions of the target company’s investors and their advisors, the general view of the Stock Market and regulatory requirements. In addition, the current regulatory framework should be borne in mind and

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it is very important that the firm allows for a period of transition for success to be achieved.

13.2 Strategies and Types of Mergers and Acquisitions Strategies are the ways and means by which a company commits its resources in furtherance of its set goals and objectives. It is likely to involve decisions about products, markets, customers, competitive positioning and organization, together with corporate financing and investment decisions. Most companies’ goals and objectives involve growth and the development of reputation, the client base and market share in the industry of operation. The three main corporate strategies that a firm may adopt for growth and development are expansion, integration and diversification.

13.2.1 Expansion It is the growth or development of existing or new markets or products, in response to changes in technology, customer tastes and preferences or simply to exploit an opportunity in the market of operation.

13.2.2 Integration One form of business expansion is integration, which may exist in three various forms, namely horizontal, vertical and conglomerate integration. Horizontal integration is where a firm either adds new markets for its existing products, or introduces new products to its current markets. It may be undertaken so that the firm can benefit from economies of scale or scope. A firm therefore finds new markets for its existing products or introduces new products into its current markets, with the objective of gaining economies of scale or scope. Examples of horizontal mergers include the amalgamation of businesses in the same line of business, for example firms in retail, mining or financial services. Vertical integration on the other hand is where a firm expands along the supply chain. This can either be backward (the supply of components or raw materials) or forward (being one step closer to the end customer). It allows a firm to have greater control over the industry including quality, quantity, price and share of the profits, although it may become more prone to falls in demand within the industry as a whole. On the other side, conglomerate integration occurs when firms in different types of business decide to merge.

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The idea is to diversify the business activities. A typical example of a conglomerate would be the merging of the Breweries business with Edgars.

13.2.3 Diversification A firm’s business policy is also a form of expansion. Integration is sometimes referred to as related business diversification. Unrelated business diversification would normally comprise concentric and conglomerate diversification. Concentric diversification is the development of business products that offer synergies with current products. “Synergy” is an artificially constructed term, based on the Greek language, which means “working together”. The significance of the term synergies the idea that by combining two or more business activities it is possible for a firm to achieve more than would be possible if the activities remained separate, or to achieve what was achieved before but with fewer resources and/or at lower production costs. Conglomerate diversification on the other hand is the development of products with no marketing, technology or product synergy with the business’s current products. The firm may, however, expect to obtain management and operational synergies from such mergers or acquisitions. The objective of a merger may be to obtain operating benefits which exceed the scope of operations of the individual companies involved in the merger. The “excess benefit” is often referred to as the synergistic benefits. These synergistic benefits may be dealt with as illustrated below. a) The benefit may be apportioned pro-rata between the acquiring company and the target company; b) The benefits may be allocated entirely to the target company’s shareholders in arriving at the share offer price; c) The benefits may be allocated entirely to the acquiring company in arriving at the share offer price. Wherever the synergistic benefits are experienced, this may lead to the acquiring company calculating a maximum offer price (all synergistic benefits allocated to the target company) or a minimum offer price (all synergistic benefits retained by the acquiring company). 13.2.3.1 Advantages of Diversification The advantages that firms draw from diversification include the following:

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The firm can move quickly into high profit areas by acquiring a firm in that market; The resultant larger firm may have better access to funds; A larger firm may have greater influence in the market and in the political environment; Operating in different markets may spread risk; Profitability may improve as a result of the diversification; The acquisition of new businesses may facilitate withdrawal from existing markets; There may be cash synergies if cash surpluses from one business can be used to provide cash for others; The takeover of firms in the same industry may be referred to the Competition Commission because they increase market share and reduce competition. Conglomerate and concentric diversification, on the other hand, are not likely to be referred because they do not change the competitive situation.

13.2.3.2 Disadvantages of Diversification There are several problems associated with conglomerate diversification which would include the following: x x x

Profits in one subsidiary may be used to cross-subsidise other subsidiaries that are making losses. This may deprive successful businesses of resources and allow inefficiencies to persist elsewhere; Empirical evidence has shown that EPS are diluted when companies with high price/earnings (P/E) ratios are acquired and that risk may be increased rather than reduced; Empirical evidence has also shown that management synergies are often not obtained in practice.

13.3 Pros and Cons of the Growth of Firms through Mergers and Acquisitions Internal or organic growth is one method of growth of firms in an economy. Another method of firm growth would be by acquiring or merging with another company (which is known as external growth). The purchase of a controlling interest by one corporation in another is known as an acquisition or takeover. A merger or amalgamation is the combination of two separate companies into one single entity. It is often difficult to determine in practice

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whether a takeover or merger has occurred, especially when there is a difference in size between the organizations. While most such combinations are called mergers, and the two terms are often used interchangeably, in reality there are very few genuine mergers. Those that are genuine, tend to occur in industries with histories of poor growth and returns. Therefore, we should take care not to confuse acquisitions and mergers with joint ventures. In a joint venture the managers of two or more businesses joining together decide to establish a new company under their common ownership and management for the purposes of exploiting an opportunity which neither of them has the resources to exploit individually. There are several reasons why mergers and acquisitions may be worthwhile. One of the reasons is that they offer some kind of synergy. A firm must consider the cost and value of the merger or acquisition and the relationship between the two firms that are considering coming together. The common reasons for acquisitions and mergers in an economy are to: x x x x x x

x x x

Reduce competition (though in South Africa for example the Monopolies Commission exists to prevent this from happening); Enable standardization and reduction in the number of products; Acquire new product ranges or move into new markets; Obtain tax advantages (possibly by acquiring a loss-making company, whose past losses can be set off against the future profits of the combined entity); Spread risk by diversifying into countercyclical markets or products, so as to stabilize total sales or profits; Attain resources more quickly or cheaply than could be possible through internal growth. These resources could include assets that are undervalued or can be sold off (“asset stripping”), cash (if the target company is very liquid), access to capital, expert staff, management expertise, technology, innovation, access to supplies or production facilities; Achieve economies of scale in production, warehousing, purchasing or marketing; Act as a defense against being acquired itself, either by purchasing the predatory company or by making itself bigger and thus more difficult to take over; Obtain specialized skills, that is. managerial and technical skills obtained from an acquired corporation;

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Reduce the overall number of branches or outlets of a firm. The acquiring and the acquired companies may have outlets in the same area supplying the same or similar products or services (eradication of duplication); Consolidate individual research and development programmes (for example in motor or pharmaceutical industries); Lower financial costs, that is. larger organizations with reduced risk levels could borrow funds at lower interest rates; Use excess liquidity, that is excess finances invested at low interest rates could be utilized to acquire profitable ventures; Use shares for acquisition purposes rather than cash in terms of a policy of organic growth.

There are also major problems that are associated with acquisitions and mergers, for instance: x x x

x x

x x x

Many takeover bids are contested, which means that the directors of the target company may do their best to prevent the takeover; Shareholders of the target company may be unwilling to sell their shares or agree to the acquisition; There may be problems in integrating the work forces and there could be large-scale redundancies. Similarly, problems in integrating new products, markets, customers, suppliers, management and systems can also lead to management overload; There may be problems in unifying dividends, financial statements, their reporting and other policies affecting shareholders of both companies; Economies of scale, especially in parent company functions, often do not materialize, or indeed become diseconomies of scale. There can also be transportation problems when the acquired sites are geographically separated from existing sites; There may be public relations problems with customers and the general public boycotting the firm because they could be disagreeing with the takeover; There may be a need for expanded regulatory and supervisory intervention by the parent company of the subsidiary firm when acquired; The acquiring company may overpay for the company it acquires. In so doing, it may stretch its financial resources and even risk becoming bankrupt in the process.

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Therefore a bidder should consider the views of its own shareholders, as well as those of the shareholders of the target company and of the market. The company must also determine how it will pay for the target company; that is whether it will be on a cash basis, share exchange, loan stock or some combination. Unless the acquisition is financed purely by cash, the target company’s shareholders will have an interest in the newly merged firm. Some of the reasons that a company’s shareholders and the market may not approve of a takeover or merger may include the following: x x x

There may be social or moral disapproval of the target company, for example a firm may produce arms or deal with a firm in a country with an unpopular regime; The merger may result in a fall in earnings per share (EPS) or net asset backing per share; The merger may result in an increase in risk due to the nature of the target company’s industrial or financial profile.

A company may not need shareholder approval in its decisions, but a lack of shareholder and market backing can lead to a fall in the market price of the company’s shares. This development will not lead the organization to achieve the primary objective of maximizing shareholders’ wealth. Moreover, when a takeover is to be paid for by issuing new shares in the acquiring company, shareholder approval at an annual or extraordinary general meeting (AGM or EGM) would be required.

13.4 Contemporary Developments in Mergers and Acquisitions Financial literature on hand shows that there have been several very large mergers and acquisitions in recent years especially in emerging economies. The reasons for these large mergers and acquisitions include: x x x x

The globalization and deregulation of financial markets making it easier for firms to arrange finance for such deals; Buoyant equity markets, which may make share exchange schemes attractive and raising cash by rights issues relatively easy; Investors demanding growth in earnings, that is a merger is often the cheapest and most expedient way of attaining this; The globalization of business operations offering opportunities to achieve operating economies in some industries (such as oil);

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Market trends and rising costs of technical support, which may make it harder for smaller companies to compete. For instance, in the car industry a merger may provide an alternative to being taken over or the terminal decline in market share; Mergers and acquisitions may lead to economies of scale in overheads costs. For example, both of the merging firms have a major part to play in the justification and achievement of economies of scale in the research, development, testing and marketing of products.

13.5 Legal Procedures and Mergers and Acquisitions Mergers and acquisitions are backed by legal procedures in order to obtain the shares of “dissenting” shareholders: a) The Companies Act According to the Companies Act (Chapter 24:03 in Zimbabwe), a merger or takeover scheme sanctioned by the Courts may allow 75% of the shareholders present at a general meeting to vote in favour of acquiring the remaining shares at a reasonable price. b) Reduction of Capital If a special resolution is passed and sanctioned by the Courts the shares of minority shareholders could be cancelled out and any share premium will be credited to non-distributable reserves that is the shares are effectively expropriated.

13.6 Market Valuation of Mergers and Acquisitions It should be noted that the merger price often depends on the positions or strength of the negotiating powers of the parties involved in the merger or acquisition. The price at which the acquisition takes place may be based upon: a) b) c) d)

The market value of the relevant companies’ shares; The earnings per share attributable to the companies concerned; The valuation of the shares using the accounting rate of return; The valuation of the shares using the dividend growth model (that is, Gordon’s Constant Growth Model); e) The valuation of the shares using the free cash flows model (discounted cash flow approach);

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f) The valuation of the shares based on the underlying value of the assets (net asset value approach), including goodwill where applicable. Before a company makes an offer, it should decide on how much it is willing to pay. There are a number of ways by which companies can be valued. Some approaches are aimed at estimating market prices for the shares when there are none at present. An important example of this is for initial public offerings of shares to the public on financial markets. In the case of an acquisition, the purchaser needs to know what the target company is worth on the market so that he can judge whether he is likely to be able to acquire it at an acceptable price or not. In this situation, the target company is most likely to be valued on the basis of earnings, cash flows or assets in its possession.

13.6.1 Valuation of a Firm on the Basis of Market Value per Share This is a method that may be used to value shares in an acquisition, as well as for an Initial Public Offering which is given by the formula: Market share price = EPS x P/E ratio, where EPS= Earnings per share and P/E= Price-earnings ratio. The current value of EPS, based on the latest results, should be known and future values may be estimated on the basis of projected earnings. The P/E ratio to be used in the calculation is a matter of judgement, and depends on such factors as: x x x x x x x x

x x

The business sector and its prospects; P/E ratios of comparable companies in the same sector or industry; Whether the company is currently quoted or not; The company’s business and prospects; The size of the company; Asset backing; The reputation of the company and its management team; The security of cash flows and earnings, which are affected by business risk; financial risk, related to financial structure, in particular the level of gearing and the degree of dependence on a small number of key individuals; Economic conditions; Market sentiments;

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x

The make-up of shareholdings and the financial standing of the firm’s main shareholders.

13.6.2 Use of the Earnings per Share Method Acquiring companies often value potential acquisition targets in terms of earnings, and calculate the effect of the acquisition based on their own earnings per share. An acquisition that increases the earnings per share of the acquirer is described as an “earnings enhancing” acquisition. The estimated earnings of the new acquisition will take into account any improvements in profitability that the new management believes it can achieve, whether this would be by better operational and financial management or by achieving synergies from the combined businesses. It is just a matter of judgement whether the projected improvements in earnings will benefit the acquirer or see it achieve the same rates of growth in the earnings of the acquired company as it has done for itself before making the acquisition. There is however a potential weakness in the use of earnings per share to evaluate target firms, which we come across in discussing capital investment appraisals. The calculation of earnings per share depends on the accounting principles applied and the judgements exercised in preparing financial statements, so that the earnings per share figure is not absolute. The EPS-based estimates have a special disadvantage in connection with acquisitions. These are estimates of how the market values, or might value the shares rather than what they are worth to the acquirer on the market. This may be useful information for negotiating purposes, and may help the acquirer judge how much it may need to pay, particularly if the target company’s shares are not quoted on the market, but may not tell it much about whether the acquisition is worthwhile or not. Example 13.1 Alpha Private Limited wishes to make an offer to the shareholders of Beta Private Limited to acquire shares based on the following data: Variable Market Value per Share Price-Earnings Ratio Number of Issued Shares

Alpha Limited ($) 40.00 8 10 million

Beta Limited ($) 2.00 5 4 million

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Calculate the number of shares to be offered by Alpha Limited. to the shareholders of Beta Limited. based on the earnings per share of the respective companies. Solution ெ௔௥௞௘௧ ௏௔௟௨௘ ௣௘௥ ௌ௛௔௥௘

Earnings per share =

ು ோ௔௧௜௢ ಶ

= 500c and EPS for Beta Limited ==

$ଶ.଴଴ ହ

, EPS for Alpha Limited =

$ସ଴.଴଴ ଼

= 40c.

The number of shares to be issued by Alpha Limited to acquire Beta Limited ா௉ௌ ௢௙ ்௔௥௚௘௧ ஼௢௠௣௔௡௬ = × ܰ‫݉ݎ݅ܨ ݐ݁݃ݎܽܶ ݂݋ ݏ݁ݎ݄ܽܵ ݀݁ݑݏݏܫ ݂݋ ݎܾ݁݉ݑ‬. ா௉ௌ ௢௙ ஺௖௤௨௜௥௘௥ ஼௢௠௣௔௡௬

The number of shares to be offered to shareholders of Beta Limited. =

ସ଴௖ ହ଴଴௖

× 4 000 000 = 320 000 ‫ݏ݁ݎ݄ܽݏ‬.

Example 13.2 Company Alpha acquires Company Omega to form a new Company Alpha Limited. Use the following financial data to determine the share exchange ($) between the two firms: Variable Total earnings Number of shares EPS Share market price Market value of company P/E ratio

Company Alpha Company Omega $270 000 $ 270 000 1 000 000 1 200 000 27c 22.5c $4.05 $2.25 $4 050 000 $2 700 000 15 10

Solution Company Alpha has a higher P/E ratio than Company Omega because it is seen by the market to be better managed, with better growth prospects. $ ଶ ଻଴଴ ଴଴଴

The number of Alpha company shares to be issued= = 666 667. $ସ.଴ହ These newly issued shares of Alpha Ltd. would be exchanged for the 1 200 000 shares in Company Omega Limited. Determine the position of the new look firm after the merger.

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Solution After the merger, the position of the newly merged company would be: Variable New Alpha Limited. Total earnings of new firm $540 000 Total number of issued shares 1 666 667 $ ହସ଴ ଴଴଴ EPS = 32.4c ଵ ଺଺଺ ଺଺଻ Share market price $4.05 The market value of the company= 1 666 667× $4.05 = $6 750 000. $ସ.଴ହ

=12.50. On the basis of the pre-merger values of the P/E ratio = $଴.ଷଶସ companies and the number of shares in the issue, the new share price after the issue is still $4.05 and the P/E ratio is 12.50, a weighted average of the P/E ratios of Alpha and Omega Ltd. before the merger. This may not turn out to be the case in practice. Generally, the market will tend to place a higher P/E ratio on the combined companies than would be expected from the result of averaging those of the merging firms. The P/E ratio of the combined company New Alpha Ltd. may turn out to be higher than 12.50. It may even be something close to Alpha’s P/E ratio of 15 before the merger. Using the figure of EPS for the combined company New Alpha Ltd. of 32.4c, a P/E ratio maintained at 15 would give a share price for New Alpha of $4.86. This would reflect market expectations that the assets of Omega Ltd. will be managed similarly to those of Alpha, including the achievement of synergies and cost savings that Alpha Ltd. will have claimed in its offer documents. The shareholder profile and possibly the balance of voting control will change after a merger, as a result of the new shares in Company Alpha Ltd. issued as a consideration to acquire the shares of Company Omega. The make-up of shareholdings often changes after an acquisition, especially in the case of a reverse takeover, that is when a smaller company acquires a larger one and may need more than double its equity capital in order to fund the purchase.

13.6.3 Use of the Accounting Rate of Return (ARR) Approach The ARR method uses the following formula to calculate the value of the ா௦௧௜௠௔௧௘ௗ ி௨௧௨௥௘ ௉௥௢௙௜௧௦ shares: The value of the share = . ோ௘௤௨௜௥௘ௗ ோ௘௧௨௥௡ ௢௡ ஼௔௣௜௧௔௟ ா௠௣௟௢௬௘ௗ

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The required rate of return used in the formula above is a percentage figure calculated using accounting profits in the same way as the ARR. The estimated future profits used in the formula may take account of expected changes such as rationalization savings, resulting from the takeover. Example 13.3 Smooth Limited. is considering acquiring Jonnes Limited., whose current post-tax earnings are USD 5 million. The board of Smooth Ltd. believes that it could reduce operating costs significantly in Jonnes Limited., which will increase earnings by $0.5 million. The increased size of the firm means that its current loans can be renegotiated at a lower level of interest, saving $0.25 million per annum and the level of remuneration paid to directors will be cut by $0.15 million. If the post-tax accounting rate of return of Smooth Ltd. is 20 per cent, calculate the market value of Jonnes Limited. Solution First, let us calculate the estimated future profits: Current earnings of Jonnes Limited. Add Operating savings Savings in interest costs Savings in directors’ remuneration Estimated future profit Market Value of Jonnes Limited.=

$5.00 million. $0.50 million. $0.25 million $0.15 million

$ହ.ଽ଴ ௠௜௟௟௜௢௡ ଴.ଶ଴

$0.90 million $5.90 million.

= $29.5 ݈݈݉݅݅‫݊݋‬.

Valuations of firms based on earnings and ARR have a drawback similar to that of the Accounting Rate of Return in capital investment appraisal, of not reflecting the time value of money.

13.6.4 Use of Gordon’s Constant Growth Model The valuation of shares of a firm can be based upon the current dividend taking into account the potential future growth, g in such a dividend to give the formula: ܲ଴ =

஽బ (ଵା௚) ௞೐ ି௚

. This method of share valuation could be

relevant if the purchaser of shares in the target company does not aim to gain management control. It is appropriate if the person acquiring the shares expects the generation of earnings and dividend policy of the target company not to change into the foreseeable future. This is only likely to be

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the case if the acquirer is a portfolio investor who is not in a position to change the management or policies of the target company. It is likely to be relevant only if the purchaser intends to acquire a minority holding in the target company. Example 13.4 Amanda Ltd. wishes to make an offer to acquire the shares of Belinda Ltd. Variable Amanda Limited. Current dividend 1.20 Fair rate of return 20% Estimated Future Growth Rate 6% Number of issued shares 10million

Belinda Limited. 0.30 15% 5% 4million

Calculate the number of shares in Amanda Limited to be issued to acquire 100 000 shares in Belinda Limited. Solution Value of Amanda Limited Shares, P଴ = Value of Belinda Limited Shares, P଴ =

ଵଶ଴ୡ (ଵା଴.଴଺) ଴.ଶ଴ି଴.଴଺

ଷ଴ୡ (ଵା଴.଴ହ) ଴.ଵହି଴.଴ହ

= 908.6c.

= 315c.

Number of shares to be issued to the holders of 100 000 Belinda Ltd. Shares = ௏௟௨௘ ௢௙ ்௔௥௚௘௧ ஼௢௠௣௔௡௬ ᇲ ௦ ௌ௛௔௥௘ ௏௔௟௨௘ ௢௙ ஺௖௤௨௜௥௜௡௚ ஼௢௠௣௔௡௬ ᇲ ௦ௌ௛௔௥௘௦ ଷଵହ௖

=

ଽ଴଼.଺௖

ܰ‫݋‬. ‫ݐ݄݃ݑ݋ܤ ܾ݁ ݋ݐ ݕ݊ܽ݌݉݋ܥ ݐ݁݃ݎܽܶ ݂݋ ݏ݁ݎ݄ܽܵ ݂݋‬.

× 100 000 shares = 34 669 shares.

However the major drawback of using this method is the difficulty in arriving at a fair rate of return and a realistic growth rate for the company.

13.6.5 The Free Cash Flow Models Because of the problems associated with the use of accounting profits, potential target companies may often be valued on the basis of free cash flows to equity or the firm from their operations. Free cash flows represent the surplus cash generated by a company after the payment of interest, dividends and tax, and also after allowing for the capital investment needed to maintain the fixed assets and increase investment (fixed or current) to support the growth of the business. Estimates of future free cash flows will

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be based on estimates of the rate of growth of the target’s business and the scope for efficiency improvements. The acquiring company views the target as simply a machine for generating cash, and the value of the target is the present value of projected future cash flows. The present values of projected future cash flows are calculated using the target company’s weighted average cost of capital, on the grounds that this represents the cost of capital incorporating a level of risk appropriate for the target company’s business. The accuracy of an estimated value of a target company produced in this way will depend on the accuracy of the cash flow projections and the value of the discount rate used. The valuation may depend heavily on the level of cash flows in some years ahead, and because the uncertainty in projecting cash flows is likely to increase with the time ahead, cash flows after some cut-off point may be ignored. If the new owners have a different capital structure from the present one, the discount rate may need to be adjusted as well. 13.6.5.1 A Levered Firm in Financing Slack with Debt Ratio Below the Optimal Level A levered firm operating a Debt Ratio below its desired level, d, can afford to use more debt in financing its capital expenditures (CAPEX) and working capital (WC) needs until it reaches the target Debt Ratio (d). Valuation Using the Free Cash Flows to Equity (FCFE) Approach The free cash flows to equity (FCFE) of such a firm will be calculated as follows: Net Income Add Depreciation and Amortization Cash Flows from Operations CAPEX Change in WC Principal Repayments + Proceeds from new debt issues FCFE

XXX XXX XXX (XXX) (XXX) (XXX) XXX XXX

If the firm decides to increase its leverage towards the targeted level then the proceeds from new debt issues may be greater than the principal repayment plus the CAPEX and WC needs. (Proceeds from new debt)> Principal repayment + d (CAPEX + Change in WC). During the period when the firm is financing its investment needs disproportionately with

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debt, the FCFE of such a firm will exceed that of a firm which does not have such financing slack. The principal repayments are still financed with new debt issues and do not affect the firm’s FCFE. Example 13.5 Suppose a firm has reported the following financial information for years: Variable Net Income CAPEX Depreciation Change in WC Depreciation Principal Repayment Equity (Market Value)

2016 ($000) 900 400 80 50 250 70 800

2017 ($000) 1 500 600 100 55 --70 ---

The firm wants to increase this debt ratio to 40% which it considers optimal. To achieve this target it plans to finance 60% of its CAPEX and working capital (WC) needs with debt between 2015 and 2020. Determine the FCFE of the firm for the year 2017. Solution Variable Net Income + Depreciation Cash Flow from operations CAPEX Change in WC Principal repayment + Proceeds from new debt issues FCFE

2017 ($000) 1 500 100 1 600 (600) (55) (70) = 463 1 338

2016 ($000) 900 80 980 (400) (55) (70) --460

The proceeds from new debt issues ($000) = Principal Repayment + d (CAPEX + Change in WC) =70+ 0.60 (600+55)= $463.00. 13.6.5.2 A Levered Firm at a Debt Ratio Above the Desired Level The firm will have to use disproportionately more equity in financing its investment needs in order to reduce its debt ratio (d). It may also have to generate more equity in order to meet some or all of its principal

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repayments, increasing returned earnings reduce debt finance and dividend payment. The FCFE of such a firm would be calculated as follows: Net Income + Depreciation + Amortization CF from operations -CAPEX - Principal repayment -Change in WC needs + Proceeds from new debt FCFE

XXX XXX XXX (XXX) (XXX) (XXX) XXX XXX

If the Company decides to reduce its leverage towards the optional level, then Proceeds from new debt issues < Principal Repayment + d (CAPEX + Change in WC). The market value of the firm, ܲ଴ =

஽భ ௞೐ ି௚

‫݋‬r ܲ଴ =

ி஼ிிభ ௞೐ ି௚

.

In the period that the Company is raising disproportionately more equity to finance its Investment needs + the Principal repayment, the FCFE will be lower than the FCFE for an otherwise similar firm operating at its desired leverage (Debt level). Example 13.6 A firm reported the following financial data in the two years under review: Variable Net Income CAPEX Depreciation

' WC Market Value of Debt Market Value of Equity Principal Repayment New Debt Issues Current debt ratio

2016 ($000) 14 000 1 750 1 900

2017 ($000) 18 500 3 600 2 950

1 400 40 000 45 000 5 000 10 000

1 800 --------7 500 =

ସ଴ ଴଴଴ (ସ଴ ଴଴଴ାସହ ଴଴଴)

= 47%.

The company plans to reduce its debt ratio, d from 47% to 25% by 2017. To achieve this only the ST debt which was spending at $10 000 would be re-

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financed. All CAPEX and WC needs were financed primarily with 90% equity and 10% debt. Long-term outstanding debt was to be repaid with CFs from the equity. Calculate the firm’s FCFE for the years 2016 and 2017. Solution Proceeds from new debt issues =5 000 + 0.10(1 750 + 1 400) = $5 315. FCFE 2016 = $13 065. Proceeds from new debt issues (2016) =10 000 + 0.10 (3 600 + 1 800) FCFE in 2017 = $19 090. Hence, 10 000 (Short-term Debt) + $540 (Long-term Debt) = $10 540. Variable Net Income + Depreciation Cash Flows from Operations -CAPEX -Change in WC -Principal Repayment +New Debt Issues FCFE

2016 ($000) 14 000 1 900 15 900 (1 750) (1 400) (5 000) 5 315 13 005

2017 ($000) 18 500 2 950 21 450 (3 600) (1 800) (7 500) 10 540 19 090

13.6.5.3 Valuation of the Firm Using Free Cash Flows to the Firm (FCFF) The claimholders of a firm include Equity and Debt holders plus preferred stockholders. The cash flows to the firms are the total cash flows to all these claimholders. The FCFF claims are those left over after meeting operating expenses and taxes but before making only payments to any claim holders. FCFF

=

FCFE + Interest Expense (I-T) + Principal Repayments + New Debt Issues + Preferred Dividends

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Another approach which will give the same result as above is where we start with operating earnings and the formula becomes FCFF= EBIT (I-T) (CAPEX – DEP) -

' WC.

Example 13.7 A firm reported the following financial data for the two years 2014 and 2015: Variable EBIT Depreciation CAPEX

' WC Tax rate

2014 (000) 5 000 200 3 250 1300 40%

2015 (000) 10 500 350 4 500 2500 40%

Calculate the FCFF of the firm for the two years ended 2014 and 2015. Solution ($000) FCFF 2014 FCFF 2015

= $5000 (1-0.4) + (200 – 3250) – 1300 = ($1350) =10 500 (1-0.4) + (350-4500) -2500 = ($350)

Debt is used in the FCFF formula because FCFFs are before debt payments and these are not affected by the quantity of debt the firm would be using. However, this does not mean that the value of the firm is not affected by the amount of leverage because as the amount of debt increases the WACC (or cost of equity, ke) also increases. The differences between the FCFE and Net Income are due to: Non-cash charges that are added back to net income to arrive at cash flows from operations. Earnings reported by firms that take significant non-cash charges normally have net incomes that are lower than FCFEs; FCFEs are residuals realized after meeting CAPEX, included in the calculation of the significant CAPEX. Therefore increasing growth firms that have significant and growing.

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CAPEX and working capital needs might report positive and growing earnings, yet may have negative FCFEs. Investors however are interested in FCFEs.

13.6.6 The Price/Earnings Relative Valuation of Firms The central issue here is to estimate the firm’s Price/Earnings (P/E) ratio from its quantifiable fundamentals. The P/E of a firm will be used to explain the concept of the relative valuation of firms. This ratio of a firm can be related to some fundamentals that could determine a firm’s value using discounted cash flow (DCF) models. The firm’s fundamentals to be used in the valuation include the growth rate, the P/E ratio, the dividend payout ratio and risk as referenced in the cost of equity,݇௘ . The P/E ratio for a stable firm is one that grows at a rate comparable to the normal growth rate in the economy in which it is operating. For a stable firm, its value of equity is given by the following, ܲ଴ =

஽భ ௞೐ ି௚

and dividend per share in the following year, ‫ܵܲܦ‬ଵ , = ‫ܵܲܧ‬଴ (payout ratio) ா௉ௌబ (௉௔௬௢௨௧ ோ௔௧௜௢)(ଵା௚) . (1+g). Hence, the value of a firm’s share =: ܲ଴ = ௞೐ ି௚

Therefore, P/E ratio =:

௉బ

ா௉ௌబ

=

௉௔௬௢௨௧ ோ௔௧௜௢(!ା௚) ௞೐ ି௚೙

. Hence if the ratio is stated

in terms of expected future earnings in the next period, ௉௔௬௢௨௧ ோ௔௧௜௢ ௞೐ ି௚೙

௉బ ா௉ௌభ

=

௉బ ா௉ௌబ (ଵା௚)

=

.

This means that the P/E ratio of a firm is an increasing function of the dividend payout ratio and growth rate in earnings and a decreasing function of its riskiness as reflected by beta in the cost of equity or required rate of return (RRR). Hence the P/E ratio of a firm ௉௔௬௢௨௧ ோ௔௧௜௢ ௞೐ ି௚

௉బ ா௉ௌబ

=

௉[௔௬௢௨௧ ோ௔௧௜௢ (ଵା௚) ௞೐ ି௚

or

௉బ ா௉ௌభ

=

.

Example 13.8 Calculate the P/E ratio of a firm now and in period 1 given that its dividend payout is 25%, the cost of equity is 15% and the growth rate in earnings and dividends is 5%.

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Solution ௉బ ா௉ௌబ

଴.ଶହ(ଵା଴.଴ହ)

௉బ

଴.ଵହି଴.଴ହ

ா௉ௌభ

=

=2.625 and

=

଴.ଶହ

଴.ଵହି଴.଴ହ

= 2.50.

Hence the P/E ratio of a firm is an increasing function of its dividend payout ratio and growth rate in earnings and dividends and a decreasing function of its riskiness as measured and reflected by beta in the cost of equity or RRR.

13.6.7 Asset Underlying Value Approach Most companies are worth more than the assets shown in their Statements of Financial Positions (balance sheets).This is because intangible assets including brands and goodwill are not usually shown in a firm’s Statement of Financial Position. Goodwill for example is shown if it results from the acquisition of a company, but even then it is normally depreciated. It may be appropriate for a potential purchaser to value a takeover target on the basis of assets if it has identified undervalued assets which it believes it can realize at a price higher than the value of the business as a going concern. In the 1960s, “asset-strippers” such as Slater Walker would acquire a company whose assets, for instance land and buildings were undervalued in the balance sheet, sold the assets and either ran the business with minimal assets or closed it down. The above approach led companies to be more careful to show assets at realistic values in their balance sheets, with the result that share prices took account of the realizable values of assets and corporate predators were less likely to be able to gain control at prices that made asset stripping worthwhile. .In the 1980s and 90s, corporate predators such as Hanson valued targets on the basis of asset values in a slightly different context. They identified undervalued conglomerates or diversified businesses where the corporate management was not getting the best results from a range of often unrelated businesses. The predators acquired the shares of the conglomerate and sold the separate businesses as going concerns to other companies that were already operating in the same industries. These purchasers possessed relevant business expertise that allowed them to get a better return from the business than the previous management of the diversified conglomerate. One of the key skills of acquisitive companies like Hanson was their ability to value companies. A purchaser that wishes to incorporate the target company as a going concern in its own business may value the target on the basis of assets by

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putting a value on intangible assets such as brands that do not appear in the balance sheet. Methods for valuing brands are usually based on identifying the present values of the cash flows attributable to the brands, and are essentially the same as those described under “free cash flows” above.

13.7 Mergers’ Exchange Rates Based on Market Values of Shares The formula for determining an exchange rate based on market value is ெ௔௥௞௘௧ ௏௔௟௨௘ ௣௘௥ ்௔௥௚௘௧ ஼௢௠௣௔௡௬ᇱ௦ ௌ௛௔௥௘ , that is ‫= ்ܴܧ‬ given by, ‫= ்ܴܧ‬ ᇲ ெ௔௥௞௘௧ ௏௔௟௨௘ ௣௘௥ ஺௖௤௨௜௥௜௡௚ ஼௢௠௣௔௡௬ ௦ ௌ௛௔௥௘

ெ௉೅ ெ௉ಲ

where T and A represent the target and acquiring companies

respectively. An exchange rate based upon this formula assumes that there are no synergistic benefits. If there are synergistic benefits the takeover price will be at a premium to the market value of the target company’s shares That is Market premium =

ெ௉ಲ ×ாோ೅ ெ௉೅

െ 1.

Example 13.9 Suppose that Monrovia Limited .has decided to acquire Longitude Ltd. and the two firms’ market prices per share are $8.50 and $5.20 respectively. Determine the exchange rate based on the above share prices of the two firms and the market premium given that Monrovia Ltd. offers an exchange rate of 0.80:1.00 to Longitude Ltd. Solution Exchange ratio=

ହ.ଶ଴ ଼.ହ଴

= 0.612:1.00.

If the exchange ratio offered by Monrovia Limited. to Longitude Limited’s ଴.଼଴ shareholders was 0.80 : 1.00, the market premium would be given by ଴.଺ଵଶ -1 = 1.307-1.00 =0.307 =30.7%. Monrovia Limited would be paying Longitude Ltd.’s shareholders a premium of 30.7% for their shares. Hence if all the synergistic benefits are

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to be allocated to the target company’s shareholders the following formula ெ௏ ିெ௏ಲ would then be used: ‫ = ்ܴܧ‬ಾ . ே೅ ×ெ௉ಲ

‫ܸܯ‬ெ = Market value of merged firm; ‫ܸܯ‬஺ = Market value of acquiring firm; ்ܰ = Number of shares in issued share capital of target company; and ‫ܲܯ‬஺ = Market price per share of acquiring company. If the synergistic benefits are to be retained by the acquiring company the ெ௏೅ × ேಲ exchange ratio to be used will be given by: ‫= ்ܴܧ‬ ே೅ ( ெ௏ಾ ିெ௏೅ )

‫ = ்ܸܯ‬Market value of target firm; ܰ஺ =Number of shares in issued share capital of the acquiring company; ‫ܸܯ‬ெ = Market value of merged firm. Example 13.10 Aggressive Limited. is to acquire the business of Conservative Ltd. by making an offer of its shares for shares in Conservative Limited. The following financial information is given for the two firms: Company Market Price/Share Earnings per Share No of Shares P-E Ratio

Aggressive Limited $8.50 $0.85 10 million 10

Conservative Limited $5.20 $0.65 4 million 8

It is given that expected synergistic benefits are estimated to amount to $5.8million.If the synergistic benefits are to be allocated proportionately to the shareholders of the two companies the exchange ratio will be as per the example above, which is 0.612: 1.00. Calculate the value of the combined firm inclusive of the synergistic benefits. Breakdown the synergistic benefits between the acquiring and target companies. Solution The value of the combined organization including synergistic benefits:

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Aggressive Limited. 10 million x$8.50 Conservative imited.4 million x$5.20 Synergistic Benefits Market value of merged firm

= $85.0 million = $20.8 million = $5.8 million = $111.6 million

The synergistic benefits to be allocated to the target company are calculated ெ௏ ିெ௏ಲ $ଵଵଵ.଺ ௠௜௟௟௜௢௡ି଼ହ ௠௜௟௟௜௢௡ ଶ଺.଺ ௠௜௟௟௜௢௡ = = as below: =‫ = ்ܴܧ‬ಾ ே೅ ×ெ௉ಲ

ସ ௠௜௟௟௜௢௡ ×଼.ହ଴

ଷସ.଴ ௠௜௟௟௜௢௡

0.78235. The number of shares in Aggressive Ltd. to be issued to the shareholders of Conservative Ltd. = 0.78235 x 4 million = 3 129 400 shares. The synergistic benefits to be retained by the acquiring company are ெ௏೅ × ேಲ determined using the formula: ‫= ்ܴܧ‬ =

ଶ଴.଼ ௠௜௟௟௜௢௡ ×ଵ଴ ௠௜௟௟௜௢௡

ସ ௠௜௟௟௜௢௡ (ଵଵଵ.଺ ௠௜௟௟௜௢௡ିଶ଴.଼ ௠௜௟௟௜௢௡)

=

ଶ଴଼ ௠௜௟௟௜௢௡

ଷ଺ଷ.ଶ ௠௜௟௟௜௢௡

ே೅ ( ெ௏ಾ ିெ௏೅ )

=0.57269.

Hence 57.27 shares in Aggressive Limited .are earned for every 100 shares in Conservative Limited. The number of shares to be issued to the shareholders of Conservative Limited. = 4 million x 0.5727 = 2 290 800 shares.

13.8 Codes Used on Takeovers and Mergers of Firms The common codes used on takeovers and mergers include the ones outlined below.

13.8.1 Scope of Securities Regulation (SR) Code The Securities Regulation (SR) Code established in terms of Section 440B of the Companies Act No. 61 of 1973 (based on the London City Code on Takeovers) was issued in South Africa on 1 February 1991. The Code has statutory force and is intended to ensure fairness and the equal treatment of minority shareholders where a takeover or amalgamation is being considered. The Code applies to all domestic public companies both listed and unlisted as well as to private companies which have more than 10 beneficial shareholders whose share and loan capital exceeds ZAR5 000000. The panel is entitled to make rulings with regard to the duties and obligations of both the offeror and offeree in respect of transactions which may change control of the company. These are referred to as affected

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transactions (Section 440 A (1) of the South African Companies Act). For the purpose of these regulations, control constitutes a holding of at least 35% in the company. An affected transaction constitutes an acquisition or disposal during any 12 month period of at least 5% of the shares in the company which carry voting rights.

13.8.2 Persons Acting in Concert In terms of Section 440 A (2) of the South African Companies Act the Code applies to persons acting in concert with each other. A company will be regarded as acting in conjunction with its directors, its subsidiaries, its pension fund and any company controlled by one or more of its directors or in conjunction with a trust in which one of its directors is a beneficiary, with regard to any transaction which falls within the scope of the Securities Regulation Code.

13.8.3 General Principles of the Code The Code comprises eleven (11) general principles and 38 distinct rules. The eleven general principles can be summarized in four basic principles comprised as follows: a) Fair and equal treatment of all shareholders; b) Full and timeous disclosure to all interested parties of all relevant information in an amalgamation, reconstruction or takeover bid; c) Directors of the target company shall act in the best interests of shareholders. They may not attempt to frustrate, thwart or discourage any offer or takeover bid unless specifically authorized to do so by the shareholders in a general meeting; d) The establishment of a fair market for the shares is encouraged. The eleven general principles are summarized as follows: 1. All the holders of the same class of securities must be treated similarly by an offeror; 2. Neither the offeror, nor the offeree, nor their respective advisers, shall furnish information to certain holders of securities which is not made available to all holders of such securities;

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3. An offer, or an intention to make an offer, shall only be announced by an offeror after the most careful and responsible consideration. In particular, an announcement will only be made when the offeror has proper grounds for believing that it will be able to implement the offer. The financial adviser to the offeror has a responsibility to ensure that the offeror will be able to implement the offer; 4. Holders of relevant securities shall be given sufficient information, advice and time to consider an offer, and no information shall be withheld from them; 5. The offeror and the offeree, and their respective advisers, have a responsibility to ensure that documents and advertisements are prepared with the highest standards of care and accuracy; 6. Reasonable steps must be taken by all parties to an offer to prevent the creation of a false market in the securities of an offeror or an offeree company, and the parties should take care not to make any misleading statements; 7. The offeree’s directors may not take any action without the approval of the holders of the relevant securities in a general meeting which could result in a bona fide offer being frustrated or in the holders of the relevant securities being denied the opportunity to decide on the offer’s merits; 8. The rights of control shall be exercised in good faith and the oppression of a minority is unacceptable; 9. The directors of an offeror and offeree company shall, in advising holders of securities, act only in their capacity as directors and will have no regard to their personal holdings or relationships with the companies. The directors must consider the interests of the holders of the relevant securities as a whole when giving advice to such holders; 10. An affected transaction will normally result in a general offer to all other holders of the relevant securities. The part with such a potential obligation must ensure that he or she is, and will continue to be, able to implement such an offer; 11. Persons holding an equity interest in the offeree company, either through shares or other securities (whether or not such securities carry voting rights) shall be entitled to dispose of their interest on terms comparable to those of any affected transaction in the relevant securities. The Code serves to guide the actions and activities of all parties involved in a merger or takeover. The rules on the other hand are contained in the Code and supported by detailed notes.

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The following headings may be utilized in considering the rules: a) The approach announcement and independent advice; b) Dealings and restrictions on the acquisition of shares and the rights to shares; c) Terms of the mandatory offer; d) Conduct during the offer; e) Acquisition of shares. Rule 2.3 states that the offeror and its advisor must ensure that the offeror is able to implement the offer. If the offer includes a cash consideration then the financial adviser or another appropriate third party is required to include confirmation, in the announcement of a firm intention to make an offer, that there are sufficient resources to satisfy full acceptance of the offer. Rule 5 states that when an offeror or any party acting in concert has acquired shares in the target company within three months prior to the beginning of the offer period, then the offer to all shareholders shall be at the highest price paid within this period. Furthermore, if during the offer period the offeror or any person acting in concert purchases shares at a price above the offer price, then there shall be an immediate increase in the offer price to reflect the highest price paid for any shares acquired during the offer period. In terms of Rule 6.3, if the offeree is a pyramid company, and the pyramid structure came into being after 1 February 1991, then the offeror is required to extend the offer to shareholders in the controlled company. Rule 8 deals with the mandatory offer and its terms, and states that when any person acquires securities which, together with securities already held or acquired by persons acting in concert with him, carry 35% or more of the voting rights of a company, such a person shall extend offers to the holders of any class of equity capital, whether voting or non-voting, for the same or a comparable consideration. A mandatory offer is also required in terms of Rule 8 if a person, together with persons acting in concert with him, holds not less than 35% but not more than 50% of the voting rights of a company and such person, or any party acting in concert, acquires within any 12-month period additional shares carrying more than 5% of the voting rights of a company. Rule 9 specifies that an offer must include a cash offer or a cash alternative when shares carrying 10% or more of the voting rights have been acquired for cash by an offeror, or a party acting in concert, during the offer period

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or within a period of three months prior to the commencement of the offer period. Rules 5, 8 and 9 apply to the acquisition of shares by the offeror or persons acting in concert with the offeror. From a practical perspective, the determination of whether parties are concert parties has and will often form the basis of investigations by the panel into whether there has been a breach of the Code or not. Rule 10 restricts the use of conditions by an offeror. It states that an offer shall not be subject to conditions which depend solely on subjective judgements by the directors of the offeror, or the fulfillment of which is in their hands. This is in contrast to the position in the United States where the Williams Act for example does not restrict the use of conditions by the offeror. Rule 17 refers to management buy-outs and requires that the independent directors of the offeree company and its advisers should be provided with all information which has been submitted by the offeror to the external providers of finance for the management buy-out. An important aspect of the Code refers to the restrictions placed on the board of the target company to prevent it from undertaking actions which could frustrate the takeover bid. In effect, the Code restricts the use of defensive tactics by the management of the target company. In terms of Rule 19 it states that, during the course of an offer, or before the date of the offer, if the board believes that a bona fide offer will arise, then the board shall not, without the approval of the holders of relevant securities in a general meeting, undertake the following decisions: a) Issue any authorized but unissued securities; b) Issue or grant options in respect of any unissued securities; c) Create or issue any securities carrying rights of conversion into or subscription for other securities; d) Sell, dispose of, or acquire, or agree to sell, dispose of, or acquire assets of a material amount; e) Enter into contracts otherwise than in the ordinary course of business; or f) Pay any dividend which is abnormal as to timing and amount. It should however be noted that the Code does not prescribe that these actions shall not be undertaken. It simply states that these actions should not

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be undertaken without the prior approval of shareholders in a general meeting. Rules 20 to 24 deal with the Code’s requirements in relation to documents issued by the offeror and the offeree board. The board of the target company is obliged to disclose its views on the offer, or any alternative offers, and must make known to the shareholders the substance of advice given to it by its independent advisers. The board of the target company is required to comment on the statements in the offer document in respect to the offeror’s intentions regarding the target company and its directors. The circular from the board of the target company should disclose such information as the holdings of the target company in the offeror, and the holdings of securities in the target company and the offeror, in which the directors of the target company are interested. In terms of Rule 32, if an announced offer is withdrawn or lapses, then the offeror, or any concert party, may not make another offer for the shares within a period of 12 months. The rationale for this rule is to protect the management of a target company from being in a state of “siege” which may impact on the operations of the company. The above rules therefore set out the procedures to be followed in a takeover or merger.

13.9 Tactics for Mergers and Acquisitions A common acquisition tactic would be for the acquiring company to purchase shares in the target company quickly in the market, so as to anticipate a rise in the share price. This is known as a “dawn raid”. It is illegal for a “concert party” (that is a number of parties acting together) to buy shares. When the purchaser has obtained five per cent of the shares it must inform the target company of its holding. The Johannesburg Stock Exchange (JSE) Securities Exchange, South Africa publishes marketmakers’ holdings of five per cent or more in listed companies quoted either on the main Stock Market or the Alternative Exchange (Alt-Ex). When a company has acquired 35 per cent it must make an offer to the remaining shareholders in the target company. The company should then make an offer to the target’s board (either directly or through its merchant bank) in order to determine the board’s views of the bid. The price offered will be below what the predator feels the company is worth but above its current share price. If the predator continues with the bid a formal offer document is then sent to shareholders with details.

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13.9.1 Dawn raid This is a common acquisition tactic whereby the acquiring company purchases shares in the target company quickly in the market so as to anticipate a rise in the share price.

13.9.2 The Mandatory Offer and its Terms Various Rules lay down the requirements and mechanics of a formal offer, providing time limits in respect of acceptances, counter-offers, etc. The various options available to both the offeror and the offeree are also laid down and reflect the percentage of shareholders accepting or rejecting the offer. While you do not have to remember detailed prescriptions for your examination, you should remember that they exist and must be adhered to by all parties concerned.

13.9.3 Conduct during an Offer The Rules lay down the requirements of a code relating to the conduct of the parties to an offer while it is progressing. They are summarized as below: a) All shareholders must have equality of information; b) Advertisements must be cleared by the Panel before their publication; c) Details of all documents and announcements must be lodged with the Panel; d) Generally, no actions are to be taken that would mislead shareholders or the markets, including taking any action by the offeree that may frustrate the offer prior to a bid being underway; e) Transfers by the offeree must be promptly registered; f) Special care must be exercised with all documents, and the terms of the bid must be covered carefully, including conflicting views, and so forth. Offer documents should always be available and on display; g) Specific rules govern the way profit forecasts are stated and assets are valued; h) The offer document should normally be posted within 28 days of the announcement of a firm intention to make an offer. An offer must be open for at least 21 days after it is posted, and this period of time may be extended by further notice.

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13.9.4 Substantial Acquisition of Shares The Rules regulate the speed at which a person, or persons acting in concert (a concert party), may increase shareholdings between 15 per cent and 35 per cent of the voting rights of the company. They also invoke the accelerated disclosure of acquisitions of shares or rights over shares relating to such holdings.

13.9.5 The Companies Act (1973) The Companies Act prevents financial assistance being given by a company for the purchase of its own shares. This is done to prevent the manipulation of share prices and ownership in several scenarios including takeover and merger discussions. A company holding more than 90 per cent of the shares in another company may compulsorily purchase the remainder on the same terms. The minority shareholders can also insist that their shares are purchased on these terms. One should also note that the legislation dealing with insider dealing may also be invoked when considering a merger or takeover bid. It is illegal to buy shares on the basis of price sensitive information––unpublished information that could affect the share price.

13.9.6 Defensive Tactics To defend against an unwelcome takeover bid, the directors of a firm have to plan and take action as early as possible. They should keep a careful watch on dealings in the company’s shares to spot whether an individual (or group of individuals) is building up a significant holding. They must also review the market price of their shares constantly in relation to their earnings and asset values, to determine whether the company is undervalued by the market and therefore prone to a takeover. In addition, directors should assess the company’s position within its industry as regards technology, size, etc., to see whether it is uncompetitive and likely to attract a takeover bid by a major player in the industry. A further tactic is to maintain contact with a range of stockbrokers, analysts and merchant bankers who are most likely to hear of hints and rumours of any takeover strategies at an early stage. The majority of mergers and bids are masterminded and engineered by the merchant banking firms, and a defending company will almost invariably have to appoint its own merchant bank to act in its defense. The appointment

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of a merchant bank is just one of the substantial costs which may be incurred in contesting a takeover bid––others include advertising, public relations and underwriting costs. Similarly, the predator company will incur such costs. There is also the possibility of capital gains or losses on the sale and repurchase of shares in the target company. For a takeover bid to succeed enough shareholders must be willing to sell their stake. This will happen when they are attracted by the potential capital gain due to the high offer price, or when they are unhappy with the current share price performance. The tactics that may be adopted by the directors to contest a bid may include any or all of the following: a) Convincing the shareholders that the shares are valued too low and they should therefore not sell them, usually by circulating profit and dividend forecasts. They can also suggest that forecasts may be at risk on a change of management, by the issue of “defense documents” and press releases; b) Using additional shares either by issuing a block of shares to a friendly party, who will act in the directors’ interests making it almost impossible for the bidder to acquire 100 per cent control; or by issuing “A” shares, normally non-voting, so as to maintain shareholder control but increasing the funds required by the predator to purchase the company; c) Issue of bonus shares: a further inducement to shareholders not to sell their existing shares. Such an issue is subject to the Securities Regulation Code; d) Share split. There will be a larger number of shares in circulation resulting in a more widespread holding which in turn may make it more difficult for the acquiring company to obtain control; e) Enforcement of management contracts. The acquiring company may, on takeover, be obliged to honour contracts entered into by the acquired company which are subject to large lump sum payments on termination. This may act as a deterrent to an unfriendly takeover; f) Launching a strong publicity campaign, aimed at highlighting present strengths and potential, including promised improvements, for example in efficiency; g) Disposal of assets. If the company which is to be acquired is aware of the intention of the acquirer to obtain control in order to acquire valuable assets held by the former this company may divest itself of such assets. Such an action may not be in the interest of the existing shareholders; h) Revaluing the company’s assets (using independent expert valuers) to increase the asset backing and encourage upward movement in the share price;

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i) To invite a bid from another company (a white knight) which the directors believe would be friendlier than the initial offeror. This is called a defensive merger; j) To arrange a management buy-out; k) If the companies are of a similar size, then the target company could make a counter-bid for the predator; l) Launching an advertising campaign against the predator, its accounts and methods of operation; m) Amendments to the Memorandum and Articles of Association. Amendments may be passed (special resolution) to make it more difficult for the acquiring company to obtain control. This is known as the “poison pill” approach; n) Increased profitability. By improving performance the management of the company may induce shareholders not to accept the acquiring company’s offer; o) Increase dividends. By increasing the level of dividends the directors may endeavour to obtain the loyalty of shareholders. This requires the approval of the shareholders in a general meeting as such an action may be classified as a frustrating action in terms of the Securities Regulations; p) The target company could introduce a “poison pill” preventing a buildup of shares by causing a change in structure and rights to be triggered by “abusive” takeover tactics; q) Try to have the bid referred to the Competition Commission; r) Alternative mergers. The directors may investigate the possibility of alternative mergers on more acceptable terms generally referred to as “friendly mergers”; s) Review by the board of directors. The company directors are required to circularize shareholders (in terms of the Securities Regulations Code) advising whether the directors consider the offer to be fair and reasonable or whether they consider the offer to be inadequate. The underlying reasons should be furnished; t) Legal action. A company may take action through the Courts to stave off a takeover. Such an action could result in delaying tactics which could be detrimental to the takeover and may be in the interest of the management of the company which does not want the takeover to succeed. If a takeover of an unlisted company is resisted then the bid may simply fail. However in the case of a listed company some or all of its shareholders may wish to sell and there may be a greater likelihood that the takeover may succeed.

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If a takeover of an unquoted company is resisted then the bid may simply fail. However, with a quoted company some or all shareholders may wish to sell and there is more chance that the takeover may succeed.

13.10 Consideration for Mergers and Acquisitions Acquisitions may be financed by cash, shares, debentures or a mixture of the three. The choice of payment will be determined by individual circumstances. When a merger takes place, a share-for-share exchange occurs. The factors to be considered when deciding the form that the consideration for acquiring a firm will take are: a) A potential capital gains tax liability may arise when shareholders dispose of their shares for cash; b) The issue of new shares by the acquiring company may lead to a change in shareholder control; c) The issue of new shares will affect the purchasers’ earnings per share (see section 7 below); d) It may be cheaper to fund the takeover with debt rather than equity because interest is allowable against tax; e) Increases in borrowing or share capital may have to be formally approved by shareholders. Such increases will affect the level of gearing; f) The views of the shareholders in the target company should be considered; they may wish to maintain an investment in the firm and thus prefer shares, and they will want to ensure that the return from their investment does not fall––a fall in dividends will need to be matched by a capital gain. The price paid on an acquisition will reflect market forces and tend to be higher when there are several interested parties in competition. The package can be negotiated in such a way as to benefit both parties. This could involve staggering the purchase over a period of time to aid the purchaser’s cash flow, or offering shareholders in the target company the option of payments in loan notes instead of cash so as to allow them to determine the timing of any capital gains tax liability. The cost of the acquisition or merger will be the purchase price, plus any amounts to be invested in the target company, less the sale proceeds of any of its surplus assets. When considering the cost of the investment the

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projected returns and profits must be considered along with existing figures to ensure that the merger or acquisition is in the company’s best interests.

13.10.1 Shares A share (or paper) purchase involves the exchange of shares in the predator company for the shares in the target company. The shareholders of both companies are now shareholders in the predator company.

13.10.2 Cash The purchaser pays cash for the shares in the target company. The purchaser may already have cash available or may raise cash for the purchase from a Stock Market issue of shares or loan stock. A proportion of the cash may be generated by: x

x x x x

Increasing working capital, for example, by improving credit control. Long-term assets should not normally be funded with short-term finance. (In some instances this is not imprudent: supermarket companies, which have steady sales income and receive substantial credit from their suppliers, while making almost all their sales on a cash basis, may invest in new stores using as capital the credit extended by their suppliers.); Sale and leaseback of equipment or premises; Staff share purchase schemes or rights issues to existing shareholders; Disposal of surplus assets; and Bank borrowing,

13.10.3 Vendor Placing This is a mixture of the above two approaches. New shares in the acquiring company are “placed” with buyers by the company’s stockbrokers to raise the cash to pay the target company’s shareholders.

13.11 Successes and Failures of Mergers and Takeovers The successes and/or failures of mergers and acquisitions are based on the following factors.

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13.11.1 Company performance Following a merger or takeover, the planned advantages may not materialize. An expected sales increase or cost savings may not be achieved and increased administration costs and duplication of effort may outbalance benefits gained elsewhere. Research and preparation will help to reduce such risks. The selection of a target company with the following characteristics may help: x x x x x x x x x x x

A well-defined market niche; A balanced customer portfolio; A growth industry; Seasonal, fashion and economic cycle stability; A stable and motivated workforce; High value addition; Good technical know-how; A short production cycle; Located near the acquirer’s business; Matches the corporate strategic plan; Provides something the firm does not have for itself.

Issues that need to be addressed in the months following a merger would include: x x x x

Achieving cost savings; Harmonizing working practices and systems; Implementing organizational change; Changing corporate culture if the cultures of the merging companies are different.

Some mergers have failed because senior managers have not given sufficient attention to such matters. This may be a particular problem if the purpose of a merger is to achieve market power by increasing size and reducing competition, which may mean that the management’s attention is not to be focused on the issues above.

13.11.2 Employment Staff will want to talk to the new owner and be recognized for what they are able to contribute. It will be important for the new management to communicate with staff. Staff morale may fall when the sale is confirmed,

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especially if there is no more information forthcoming. Some of the most capable staff may be the first to go, because it will be easier for them to find new jobs. Competitors may even tempt them away, with a resulting loss of goodwill. One method of keeping key personnel is to require, as part of the purchase offer, that they sign service contracts (perhaps preventing them from selling their shares) for a period of time (often three years). In some cases new contracts of employment may be introduced for all staff to standardize procedures between the two firms. Example 13.11 Standard Limited.is a very successful engineering company that has made a bid for Atkinson Limited., a large but declining competitor. The following information is available for both companies, which are quoted on the Stock Exchange: Variable Share price No. of shares

Atkinson Limited. $5.00 10 million

Standard Limited $3.10 25 million

Standard Limited has offered Atkinson two of its shares for every share in Atkinson Ltd., with an alternative cash offer of $6.00 per share. Standard Limited expects the takeover to generate savings of $5 million in present value terms. a) Advise the shareholders of Atkinson Limited. on which offer to accept. Include financial and other factors in your advice; b) How might Standard Limited expect to achieve the extra value of $5million? What problems may Standard Limited face in achieving this figure? Solution We will consider briefly some points that could be suggested in the answer: a)

Cash offer: Cash received = 10 million × $6.00 = $60 million. Share offer: Shares in Standard Limited to be received = 10 million×2 = 20 million shares.

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At the current valuation of Standard shares, the market value of shares to be received= 20 million x $3.10 = $62 million. However, Standard Limited would now have a total of 45 million shares in issue, which would be likely to have an impact on earnings per share. In addition, the share price of the expanded company is likely to change as a result of the acquisition. Advice to shareholders of Atkinson Limited. The cash offer of $60 million is $10 million greater than the current value of the company’s shares, =10 m x $5.00. We are not given any information about the earnings per share of each company or about future growth in earnings, other than the projected savings of $5 million. The acquisition may result in a fall in earnings per share in Standard Limited. This in turn may reduce the share price. The cash proceeds are certain, that is the return from shares in Strachan Ltd. is less certain. However, if they take cash, shareholders in Atkinson Ltd. may face a tax liability on any capital gains (if they take the shares, any liability is deferred until they dispose of the shares in Standard Limited.). Standard Limited. is already a successful company and it is likely to have considered the acquisition of Atkinson Ltd. very carefully. Standard Limited must consider that it will be able to increase future earnings because of the acquisition. With a competitor removed from the market, there is a real possibility of increased turnover for Strachan Ltd. Accepting the cash offer may involve less risk for shareholders in Atkinson Ltd. Each shareholder should consider his individual tax position. b) x x x x

Savings may be achievable through: Economies of scale, e.g. one head office with fewer staff than in the two companies currently; Additional expertise from the staff of Atkinson Ltd., reducing training and development costs; A reduction of competition resulting in possible operating economies (for example the cost of advertising may be reduced) and––perhaps more importantly––higher sales prices. There may be tax advantages if Atkinson has losses to bring forward.

Problems likely to be faced by Standard Limited include:

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x x x x

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Economies of scale are often difficult to achieve in practice. Additional expenditure may be required, for example, to integrate the computer systems of the two companies; Staff redundancies may be necessary, incurring redundancy costs; Standard Limited may be keen to retain the skills of senior management of Atkinson Limited. Additional costs may be incurred in drawing up new management service contracts; If the operating units of the two companies are geographically separate, there may be increased transport and communication costs.

13.12 Summary When a firm is considering expanding, whether by organic growth (expansion, integration or diversification) or externally (through mergers or acquisitions) it must ensure that growth prospects are properly evaluated and carefully planned and implemented. Company managers must consider the impact on the company, its shareholders and employees and the environment in which it operates. Other factors that should also be considered would include the likely reactions of the target company’s investors and their advisors, the general view of the Stock Markets and the regulatory requirements. In addition, the current regulatory framework should be put into consideration and it is very important that firms allow for a period of transition for success to be achieved. Acquisitions and mergers are a fairly frequent occurrence particularly in emerging economies, and company managers and shareholders should read the financial presses for details of such synergies or acquisitions taking place in order to broaden their horizons before decisions for takeovers and mergers are put into considerations, adopted and implemented.

13.13 Exercises 13.13.1 There are several other potential advantages of conglomerate diversification. Can one think what they might be? 13.13.2 Examine some of the recent examples of: a) Horizontal integration; b) Vertical integration; c) Conglomerate diversification;

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and the reasons given by the management of the companies carrying out these developments to justify their actions. 13.13.3 Describe the main forms that a corporate growth strategy may assume. 13.13.4 What problems may a company encounter during and after the takeover of another company? 13.13.5 List the main points of takeover procedure and the Securities Regulations Code. 13.13.6 a) What advantages do firms derive from a successful takeover bid? b) What steps would a firm’s board of directors take to defend their company from a hostile takeover bid? 13.13.7 What codes, legal requirements or regulations govern the conduct of a company that makes a takeover bid? 13.13.8 Blue Ltd. and Yellow Ltd. have entered into negotiations to merge and to form Green Ltd. Details of the companies are as follows: Variable Blue Limited Yellow Limited Ordinary share capital (at 10c and 100c) $50 000 $300 000 respectively Estimated maintainable future earnings $200 000 $92 280 Agreed Price/Earnings ratio for amalgamation 15 13 Discuss possible ways in which new shares in Green Ltd. may be allocated between the shareholders of Blue Ltd. and Yellow Ltd. 13.13.9 Suppose a firm has reported the following financial information for the years 2016 and 2017: Variable Net Income CAPEX Depreciation Change in WC Depreciation Principal Repayment Equity (Market Value)

2016 ($000) 9 600 750 80 60 250 80 800

2017 ($000) 15 800 880 100 75 -80 ---

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The firm wants to increase this debt ratio to 40% which it considers optimal. To achieve this target it plans to finance 60% of its CAPEX and working capital (WC) needs with debt between 2016 and 2020. Determine the FCFE of the firm for the year 2016. 13.13.10 A firm operating at a debt level below optimal reported and projected the following financial information for the two years ended 2016 and 2017 respectively: Variable Net Income CAPEX Principal Prepayment Change in WC Depreciation Market Value––Dept. Market Value––Equity Proceeds from new debt issues

2016 ($000) 600 180 40 60 75 480 1 500 120

2017($000) 860 240 40 80 -------

The Company plans to increase its debt ratio to 35% by 2018. To reach this target it plans to finance 40% of its CAPEX and working capital (WC) needs between 2016 and 2019 with debt. Calculate the FCFE for 2016 and the projected FCFE for 2017 for the firm. 13.13.11 A firm has reported the following financial data for the two years 2016 and 2017: Variable EBIT Depreciation CAPEX Change in WC Tax rate

2016 ($000) 5 000 200 3 250 1 300 40%

2017 ($000) 10 500 350 4 500 2 500 40%

Calculate the FCFF of the firm for the two years ended 2016 and 2017. 13.13.12 AB Corporation Limited., which is investigating the possible acquisition of BB Conglomeration Ltd. for diversification purposes, has asked you to advise the firm on the basis of the following financial information:

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BB Conglomeration Limited. Summary Statement of Financial Position (Balance Sheet) as at 30 September 2016: Ordinary shares Land and buildings Reserves Plant (net of depreciation) 10 per cent debentures Investments Creditors Stock Debtors Cash Profits

$000 1 500 900 900 600 750 450 300 600 600 300 $3 450

2014––$350 000 2015––$300 000 2016––$450 000

The following additional financial information is also provided: i. ii. iii. iv. v.

It is estimated that the investments have a market value of $675 000, and that the stock could be sold for $750 000. The other assets have values as stated in the balance sheet; All of the investments and plant valued at $225 000 would not be needed by AB Corporation Limited.; The investments have produced an annual income of $45 000 per annum for the last five years, and are expected to continue to do so; AB Corporation Ltd. would repay the debentures at par, immediately after acquisition; AB Corporation Limited. requires a return on capital of 10 per cent. Calculate the maximum price which AB Corporation Limited. should be prepared to pay for BB Conglomeration Limited under each of the following bases:

a) Break-up value; b) Discounted cash flow, assuming that the operating cash flows to be discounted are as follows:($000) 450; 600; 450; 570.

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Time (in years) 2017, 2018, 2019, 2020 onwards. Present value factors at 10% are as given below: Year 2017- 0.9090. Year 2018 -0.8260. Year 2019 -0.7510 Year 2020 -0.6830.

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