The new Economy


  1. trace economic history of what the digital economy means
  2. Look at link between new economy and digitisation
  3. impact of new economy on strategy, organisation and management processes

What is the ‘New Economy’

Compuserver forums

  • 1980s – personal computesr
    1990s – Internet launch
    1995 – e-commerce

Post-industrial services

  • Birth of e-commerce in the 1990’s
  • The Internet as a socio-economic & socio-technical environment
  • Convergence of technologies around the Internet & E-commerce

Clicks & Mortar

  • Application of e-commerce to traditional value chains (Bricks & Mortar: physical assets)
  • Addition of digital channels to physical channels using existing infrastructure
  • Creation of virtual aspects to physical organisations of digitalisation of certain processes


  • The emergence of organisations with mostly virtual value chains and limited physical aspects
  • Digital-Physical (Amazon and e-tailers retailing physical goods)
  • Digital-Digital: Digital services as well as digital channels. (iTunes, Google, eBay)

Digitalisation & 5 forces (1) 

  • Increased industry based competition and innovation (Core rivals)
  • Larger threat of substitutes (indirect competition especially in service based industries
  • Schumpeter’s concept of ‘Creative Destruction’

Digitalisation & 5 forces (Contd)

  • Reduced barriers to entry in certain industries
  • Direct marketing & disintermediation
  • CRM technologies & interactive marketing
  • Lower switching costs
  • Increased buyer power and consumer information

Value chain Impacts

  • ‘Accelerated Marketing’ (Chen 2005)
  • Increased outsourcing & disaggregation (Network Value Chains)
  • Increased emphasis on CRM
  • Customer Lifetime Value (CLV)
  • New Media Channels

New Media & Web 2.0

  • Blogs, social networks & Self-evolving content
  • Media fragmentation extended the digital and online environments
  • Competing online media: Yahoo, MSN, Google & of course Facebook!


  • Changing parameters in macro and meso environments
  • Changing strategic practices such as network value chains
  • Evolution in strategic marketing: Digital marketing, online marketing and interactive marketing strategies

Bonds and interest rates

FBL661 Corporate Finance

Lecture 6

Bonds and interest rates

  • Outline

  • Government Bonds
  • Term Structure of Interest Rates
  • Floating Interest Rates
  • Managing Interest Rate Risk
  • Futures
  • Forwards
  • Swaps

Government Bonds

  • Gilt Edged Securities, Gilts, in the UK
  • Nominal value £100
  • Regular interest payments, coupon.
  • Fixed repayment date
  • Tradable
  • Default risk free
  • Shorts – redeemable within 5 years
  • Medium –  redeemable within 5 – 15 years
  • Long – redeemable over 15 years
  • Undated
  • Index linked

Term Structure of Interest Rates

Risks faced by Investors

  • Unexpected change in interest rates
  • Unexpected change in inflation
  • Default

Fixed Interest Investment

  • Known, fixed, interest (coupon) rate
  • Known time to maturity (fixed repayment date)
  • Tradable
  • Market value changes with change in market rates of interest

Relationship between changes in interest rates and market price

  • Price moves inversely to change in interest rate
  • Longer the maturity greater the price change
  • Price changes  increase with maturity but at a decreasing rate
  • Lower the coupon rate the greater the change in price

Term Structure of Interest Rates

P0    I    +       I      + ……. +   I + 100

(1+r)      (1+r)2                  (1+r)n

if you increase the interest rate the discounted cash-flow will decrease



P0 = current market price

I    = interest paid

r  = constant discount rate each year

Term Structure of Interest Rates

P0    I    +       I      + ……. +   I + 100

          (1+s1)    (1+s2)2                  (1+sn)n

this is more practical as every year you have different interest rates


P0 = current market price

I    = interest paid

sn  = spot interest rate for each year

s1   s2   sn

Spot Interest Rates

discount rate to use to discount any future rate, it is know now

  • The interest rate required to give a future cash flow its present value
  • Fair rate of return between now and period ‘n’
  • Different spot rates for different periods
  • Calculated by using Government Bonds
  • Plotted to give yield curve
today i will invest money, (spot rate)
UK Yield Curve – November 2010

Forward Interest Rates

estimation of the future interest rate


  • Required rate of return for an investment in period A that is repaid in period


  • Found from spot rates
  • To avoid arbitrage profits the return for a given period must equal the return for a shorter period followed by a reinvestment

Forward Interest Rates

calculation of forward rate from spot rates:

(1+SA)A*(1+AFB)B-A = (1+SB)B


SA    = spot rate for period A

SB    = spot rate for period B

AFB  = forward rate between periods A & B

Calculation of Spot & Forward Rates

Relationship between forward rates and future spot rates

  • Forward rates are best estimate of future spot rates
  • But are they biased?
  • Expectations
  • Liquidity premium <<
  • Inflation premium
  • Market segmentation, clientele effect <<

Floating Interest Rates

  • LIBOR <
  • London Inter Bank Offered Rate
  • Fixed daily for set periods – 6 months, 1 year, 1 month, overnight etc.
  • Average of 8, out of 16, leading London banks
  • LIBOR Rates – July 2010

Hedging interest rate risk

  • Hedging is important due to the size of the potential losses from adverse interest rate movements.
  • Interest rate risk depends on interest rate volatility, gearing and floating rate exposure.
  • Firms with significant floating rate debt are concerned about interest rate increases.
  • Firms with a lot of fixed rate debt may lose competitive advantage if interest rates fall.

Hedging techniques include:

  • Futures
  • Forwards
  • Swaps

Futures contracts

  • Futures are exchange-traded contracts to buy or sell a standard quantity of a financial instrument at an agreed price on an agreed date.
  • Company taking out futures contract places initial margin with the clearing house.
  • Contracts are marked to market so variation margin may be needed to meet the losses.
  • Hedging interest rate risk
  • Companies buy interest rate futures to hedge an interest rate fall and sell futures to hedge an interest rate rise.
  • Interest rate futures are priced by subtracting the interest rate from 100.
  • Gains and losses on interest rate changes are given in ticks (0.01% of contract price).
  • Futures position closed out by opposite trade.
  • Example of using interest rate futures
  • Company will borrow £0.5m for 3 months in 3 months time, interest rate now is 10%.
  • Company hedges by selling one £500 000 interest rate future at 90.
  • Assume interest rate in 3 months is 13% and that futures contract price has moved to 87.
  • Company closes out futures position by buying one interest rate future at 87.

Example of using interest rate futures

  • One tick = 500 000 × 0.0001 × 3/12 = £12.50
  • Tick movement = (90 – 87)/0.01 = 300 ticks
  • Gain on futures = 300 × 12.50 = £3750
  • This compensates for higher borrowing cost of 500 000 × 0.03 × 3/12 = £3750
  • Perfect hedge, since the contract price change mirrors the cash market change and the contract is equal to the borrowing amount and the period.


  • Returns ‘marked to market’
  • Readily tradable
  • Prices are  ‘transparent’
  • No up-front premium


  • Imperfect hedge due to over-or under-hedging
  • Cannot take advantages of favourable rates
  •  Allows borrower/lender to lock into an agreed interest rate at a future date for an agreed period
  • Short term, usually under 1 year
  • Start date and end date specified
  • An  FRA starting in 3 months and lasting for 3 months
  • Rate is determined from future rate
  • Over The Counter (OTC)


  • General definition of swap
  • An exchange of one stream of future cash flows for another stream of future cash flows with different characteristics.
  • Swaps are used extensively by banks and companies for hedging interest rate risk and exchange rate risk over long time periods.
  • Banks intermediate by warehousing swaps until counterparty is found.

Interest Rate Swaps

  • Started in 1980’s
  • Off balance sheet
  • Needed to find counterparty
  • Same principle and time period
  • OTC arrangement

Now arranged through bank

Interest Rate Swaps

  • Bank is counterparty – less risky
  • Any principle and time period
  • Bank will quote:
  • 5.25 – 5.62 against 6 month LIBOR
  • Company will either:
  • Pay bank 5.62% and receive LIBOR or
  • Pay bank LIBOR and receive 5.25%

Example of plain vanilla interest rate swap

  • Two companies A and B can borrow at:
  • Company A:     LIBOR   10% Fixed
  • Company B:      11% Fixed   LIBOR + 2%
  • A has a better credit rating than B
  • A wants floating rate debt, has comparative advantage in fixed rate debt
  • B wants fixed rate debt, has comparative advantage in floating rate debt.

Example of plain vanilla interest rate swap

  • A raises fixed rate loan at 10%
  • B raises floating rate loan at LIBOR + 0.2%
  • If servicing requirements are swapped, B is 1% better off and A is 0.2% worse off
  • Giving 0.2% of B’s 1% benefit to A makes A no worse off, giving half of remaining 0.8% benefit to A gives equal benefit to A and B
  • A pays LIBOR – 0.4%, B pays 10.6% fixed.

Interest Rate Swaps


  • Reduces cost of borrowing
  • Allows management of exposure to interest rate movements, hedging
  • Separates raising finance from cost of finance
  • Allows cash flows to be matched
  • Speculation


  • Swap locks company into agreed rates so cannot benefit from favourable rate changes.
  • Counterparty risk exists, as legal liability for interest payments stays with loan signatory.
  • Company exposed to interest and exchange rate risk if counterparty defaults.

Gordon Growth Model

 1.      Plover Plc and Lapwing Plc are two companies in the same business sector.   Plover Plc is entirely equity financed with 800,000 ordinary shares (par value 25p) with a current market price of £1.20.  Lapwing plc is a geared company with 500,000 ordinary shares (par value 25p), with a current market value of £1.00, and £600,000 of 8% irredeemable bonds currently quoted at par.   Both companies generate annual earnings before interest and tax of £120,000 and it is the policy of both companies to distribute all available earnings as a dividend.  It is envisaged that neither company will be liable to Corporation Tax in the foreseeable future.

Robin owns 5,000 shares in Lapwing Plc.   His friend has recommended he sells these shares and borrow £6,000, at a rate of 8%, and use the money to buy ordinary shares in Plover Plc.

Definition of ‘Gordon Growth Model’

A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends.

D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)


a)        Calculate the cost of equity and weighted average cost of capital for each company.

b)        Suggest reasons why these costs differ for each company.

c)         Advise Robin as to whether the proposed transaction is worthwhile.  You should consider both the risk and the return to Robin in your answer.

d)        Assuming all other prices remained constant calculate the price of the ordinary shares of Plover Plc that would eliminate any arbitrage profits.

current income from lapwing 5000 (number of shares he has) /500,000(number of shares total) x 72,000 = £720 income


Sell Shares:
5,000 shares @ £1 per share = 5,000

if he borrows in the same capital structure 5,000 equity 6,000 debt totaling £11,000



income of robin from plover = 720 after interest rate £1200


Plover =1200,000/800,000 = 15p


1,200 divided by dividend per share of 15
number of shares he should own to achieve 1200 = 8,000 shares to make 1,200


Income = 11,000 << money he has / 800,000 (which is the value of plover) x 1.2

e)        Calculate the cost of equity and weighted average cost of capital for each firm using the price of Plovers shares calculated above.

2. Partridge Plc and Pheasant Plc are two companies operating in the charter airline business.  Both companies shares are traded on the London Stock Exchange where they are generally assigned similar risk ratings.   Partridge, the larger of the two companies, has 3 million 75p ordinary shares in issue which currently stand at 180p (ex div.) in the market.  In addition, some years ago the company issued £10 million of 6% undated bonds to help finance a new holiday route and these are currently quoted at 75% (ex int.).  Their competitor, Pheasant Plc, operates on an all equity basis of 25 million 5p ordinary shares that have a current ex div. market value of 32p each.


Partridge Plc has annual earnings before interest and tax of £1.4 million, this level is generally expected to be maintained in the future.  Pheasant Plc has annual earnings before interest and tax of £1 million and this too is expected to remain stable.  Both companies follow a strict policy of not retaining any of their after tax earnings.


a)        Calculate the cost of equity capital and the weighted average cost of capital for both companies.  Suggest reasons why these costs of capital differ between the two companies.  Taxation is to be ignored.


The expected return for a security
The expected risk-free return in that market (government bond yield)
The sensitivity to market risk for the security
The historical return of the stock market/ equity market
The risk premium of market assets over risk free assets.

MV o Share = 3m * 1.8 = 5.4m
MV of Debt  = £10m * 75% = 7.5m

Ke = D1 / MV


Company A

Ke = 1.4 – (6% * 10m) / 5.4 = 1.4 -0.6/5.4 = 14.8%

Kd = 0.6/7.5 = 8%
WACC = 14.8% * 5.4 / 12.9 + 8% * 7.5 / 12.9 = 8.8%


Company B

Ke = 1m / 32 * 25 = 12.5%

b)        Explain what action you might take, if any, if you were a shareholder owning 10% of the share capital of Partridge and why.  Produce calculations to illustrate the effects of your actions stating any assumptions that you have made.  Comment on what the effect would be if other shareholder in Partridge took similar action.


c)         Comment briefly on what effect the presence of taxation and other capital market imperfections would be likely to make on your answer to part (b) above.


3)          There is a controversial debate in the literature about the dividends. Does the dividend policy affect the firm value? Discuss different empirical evidence which support relevance or irrelevance arguments.

Security Analysis of Equities

Prof. Mohammed Elgammal


  • Fundamental Analysis Technical Analysis
  • EMH
  • Market Anomalies
  • Active and Passive Management

Fundamental Analysis

  • Compare market price with “correct” price Determine “correct” price by using models
  • Ratio analysis
  • Gordon’s growth model
  • Market model
  • Capital asset pricing model
  • Cap M Model << to determine the expected return and if you have BETA
    R= P+ – P+ -1 / P+ -1
check with historical values to see if past values of the share price are correct

Technical Analysis

Study past share price movements to identify a pattern


Economic analysis:

  •  Global economy – political risks, exchange rates, etc
  •  Domestic economy – GDP, employment, inflation, interest rates, budget deficit, consumer sentiment, etc
  •  Supply / demand shocks – government spend, tax rates, oil prices, foreign export demand, etc
  •  Government policy – fiscal policy, monetary policy, supply-­‐side policies
  • Business cycles – economic indicators
All decisions depend on expected cash flows for the firms, as market as a whole are not doing well e.g. middle east crises, government spendings. if the government does not spend it sends a signal that they might increase unemployment and investment in infrastructure.
 Industry analysis: 
  1.  Defining an industry
  2.  Sensitivity to the business cycle – types of good and service sold
  3.  Industry life cycles – stage of business development and sensitivity to economy
  4.  Industry structure and performance , competitive strategy and profitability (Porter’s five forces)

Firm-­‐specific analysis:

  • Financial statement analysis Future cash flows generated
  • Dividends
  • Profits
  • Liabilities

Technical analysis

  • Concentrate on recurrent and predictable patterns in share prices
  • Does not discount the importance of new information on future prospects of the firm
  • BUT, if prices respond slowly enough the analyst can identify a trend that may be exploited during an adjustment period
  • Such trends have been found to exist in equities, bonds, currencies, commodities, and other classes of financial assets

analysis believe that past events will happen again, this approach tries to identify a trend in a period of time because there is a delay in data coming in and out of the market and because of this delay it could be possible to beat the market.

Dow Theory

Charles Dow is widely regarded as the grandfather of most technical analysis, the market is affected by:

  • Primary trend – the long-­‐term movement of prices, lasting for several months or years
  • Secondary / intermediate trend – caused by short-­‐term deviations of prices from the underlying trend line.Such deviations are eliminated via corrections when prices revert back to the trend value
  • Minor trends – daily fluctuations of little importance
There also tends to be a positive relationship between a trend and the volume of shares traded

The primary trend

Intermediate trend

Head and shoulders topping pattern:

Head and shoulders topping pattern:

  •  A head and shoulders pattern typically appears after an upward primary market trend
  •  By early February the neckline has been set at the previous low from mid-­‐December
  •  High trading volume in the decline of the right shoulder and low volume in the formation of the head are taken as signals of the pattern
  •  Once the neckline is broken the price is expected to further decline by the difference between the top of the head and the neckline

Trend/Tram Lines

  • The support trend line is formed when a share price decreases and rebounds at a pivot point that aligns with at least two previous support pivot points
  • A resistance trend line is formed when a share security price increases and then rebounds at a pivot point that aligns with at least two previous resistance pivot points

Moving average trading rules

  • Simple moving average trading rules are built on the basis of taking the arithmetic average of the share price over a specified number of days:
  • The market price is higher than the moving average price, so there is a momentum for it to further increase in the near future
  • The market price is lower than the moving average price therefore the trend is for the market price to reduce in the near future
As the price is lower then the moving average then sell

Efficient Market Hypotheses

Information efficiency

Identified by Fama in 1960’s

  • Three forms
  • Weak form
  • Semi-­‐strong form Strong form

Efficient Markets Hypothesis (EMH):

  •  The market price of a security reflects ‘all available information’ about the stock
  •  The expected return on the security is related to its risk
  •  So you can not make any abnormal returns in the long run.

Assumptions of EMH

There are a large number of profit-­‐maximizing market participants who, independently of one another, analyze and value stocks

New information on securities comes to the market in a random fashion

Profit maximizing investors adjust security prices rapidly to reflect the effect of new information

Random Walk

The outcome of the EMH is that share prices should follow a ‘random walk’

  •  Current prices reflect all available information
  •  Changes in prices occur in response to new information, which is random and unpredictable
  •  Under the random walk hypothesis, the best prediction for tomorrow price is today price.

Weak form market efficiency

Share prices reflect all information that can be derived by examining past market trading data: past share prices; trading volume, etc.

έt represents new information hitting the market, and is assumed to be random.

  •  Tradingstrategiesthataimtoexploitinformationonpast share price data cannot be used to make abnormal levels of profits
  •  Abnormalreturnscanonlybeearnedwhere:

Investors have public or private information about the firm’s present / future performance

Can be expressed as: Pt = Pt-­‐1 + έt

Semi-strong form market efficiency

  • Stock prices reflect all publicly available information about the company
  • Past share price data; trading data; financial statements; forecasts of future firm, industry and economic conditions
  • Trading strategies that aim to exploit information on past share price data AND publicly available data cannot be used to make abnormal profits
  • Abnormalreturnscanonlybeearnedwhere:
  • Investorshaveprivateinformationaboutthecompany’spresent/ future performance
  • Can be expressed as: Ωt-­‐1 represents the publicy available information set at t-­‐1

Pt = Pt-­‐1|Ωt-­‐1 + έt

Strong form market efficiency

Stock prices reflect all available information relevant to the firm, including private information

Past share price data; trading data; financial statements; forecasts of future firm, industry and economic conditions; insider information

  •  Trading strategies that aim to exploit information on past share price data, publicly available data, AND privately held data cannot be used to make abnormal profits
  •  Abnormal returns cannot be earned based on any of the information highlighted above:
  •  Even company directors left unregulated to trade would not be able to make abnormal profits in their

own company’s shares

Evidence on the EMH

Strong-­‐form market efficiency:

  • Insiders (such as company directors) have been found to make profits when they trade in their own company’s securities which rejects the notion that financial markets are strong-­‐form efficient

Semi-­‐strong and weak form market efficiency:

  • MIXED evidence that technical trading rules (weak form) and fundamental (semi-­‐strong) trading strategies have been used to make abnormal returns in the past

EMH forms and abnormal return

Market anomalies

  •  Overall, current evidence suggests that financial markets are less than strong form efficient. Markets are generally taken to be semi-­‐strong efficient, but with some anomalies to this.
  •  Anomalies to the EMH suggest a form of market inefficiency:Mainly relate to the semi-­‐strong form of the EMHTheoretically allow investors to systematically earn abnormally high returns from trading

Types of anomalies:

  • Firm anomalies
  •  Small firms Vs Bigfirms
  •  Value firms Vs Growth firms
  •  Winners Vs Losers Market anomalies
    Seasonal anomaliesJanuary or April
  • Event anomalies << Dividend before or after
  • Accounting anomalies
  • Earning momentum: Firms with reporting unexpectedly high earnings outperform firms reporting unexpectedly low earnings.
  • Accruals : firms with relatively high (low) levels of accruals to total assets experience negative (positive) future abnormal returns.

Active or passive fund management?

Passive Investment Management:

  •  Buy-­‐and-­‐hold management strategy
  •  No attempt to outsmart financial markets
  •  Setting up a well-­‐diversified portfolio with no attempt to identify mispricing of securities

Active Investment Management:

  •  Bottom-­‐up type approach to portfolio selection
  •  Regular trading of assets based on perception of under or overvaluation in financial markets
research as shown that passive approach is expected to gain more in the long term

EMH and asset management:

If the (semi-­‐strong) EMH holds then there is no value to active investment management

  • Regular trading incurs high transaction costs
  • Implications of Market Efficiency
  • The market cannot CONSISTENTLY be beaten
  • Market has no memory
  • All shares are the same
  • Correct return for given level of risk
  • Share price is good indicator of the future

Implications for Financial Manager

  •  There are no financial illusions
  •  Shares will be correctly priced by the market, nobetter time to issue new shares
  •  Current share price reflects current public knowledge
  •  To increase value of company undertake +NPV projects

What Makes Markets Efficient

  •  Large number of analysts
  •  Availability of information
  •  Company reports
  •  Legal, accounting and stock market requirements
  •  Credit agencies
Financial press, TV, internet, etc.

Expected rate of return

Page 425 of Essentials of investment

a.Computer stocks currently provide an expected rate of return of 16% MBI a large computer company, will pay a year-end dividend of $2 per share. if the stock is selling at $50 per share, what must be the market’s expectation of the growth rate of MBI dividends?

Po = D1 / K-g | $50 = $2 / 0.16 – g
(016-g) x 50 = 2 || g= 0.16 -2/50 = 0.12 or 12%

b) If dividend growth for case for MBI are revised downwards to 5% per year, what will happen to the price of MBI stock @ what qualitatively will happen to the company price-earnings ratio?
14. Even better products have come out with a new and improved product. as a result, the firm projects an ROE of 20%, and it will maintain a plowback ratio of .30. its earnings this year will be $2 per share. investors expect a 12% rate of return on the stock.

a) At what price and P/E ratio would you expect the firm to sell

Plowback ratio = Rentention ratio or 1 – Divident rayout ratio
G= ROE x b where b: plowback ratio
G= 0.2 x 0.3 = 0.06 or 6%

Po = D1 / K-g K is cost of equity or expected return
E1= $2
D1 = 0.70 x $2 = $1.40

Formula >> P0 = D1/K-g = D0(1+g)/K-g

P0 = 140/0.12-0.06 = $23.33

Po / E1 = 23.33/2 = 11.67

C. What would be the P/E ratio and the present value of growth opportunities if the first planned reinvest only 20% of its earnings?

P0 = 160/0.12-0.04 = $20

Po / E1 = 20/2 = 10

Page 431 CFA Exam

Q9 – Helen morgan, CFA. has been asked to use the DDM to determine the value of sun. morgan anticipated that sundanci’s earnings and dividends will grow at 32% for two years an 13% thereafter.

Calculate current value of a share of sundanci stock by using two stage dividend discount model and the data below

Formula Pt = Dt + 1 / K-g

T=1 D1 = D0 x (1+g1) = 0.286x (1.32) = 0.377
T2 = D2 = D1 x (1+g1) = o.377x(1.32)=0.497
P2= 0.497*(0.13 +1) / 0.14-0.13 = 56.31

R&D Expense as %
of Net Turnover
Average Number
Of Employees
Profit After Tax Net Turnover Personnel Expenses dvidided by Number of Employees Profits per Employee
0 £28,899,000 1,674 £7,583,000 £136,040,000 28,900,674 £4,529.87
0 £1,365,000 127 -£266,000 £3,350,000 1,365,127 -£2,094.49 NE vs NT 0.989833012
0 £2,641,000 211 £65,000 £13,645,000 2,641,211 £308.06 #emp vs Prof 0.107753812
0 £6,238,000 371 -£1,089,000 £15,345,000 6,238,371 -£2,935.31 P ex vs # emp 0.998357696
0 £8,536,000 666 -£1,261,000 £27,775,000 8,536,666 -£1,893.39 prof vs # emp 0.799340109
0 £20,077,000 790 £97,000 £71,988,000 20,077,790 £122.78
0 £57,979,000 2,781 £11,604,000 £138,511,000 57,981,781 £4,172.60
0 £10,160,000 549 £2,284,000 £31,531,000 10,160,549 £4,160.29
0 £44,034,000 2,117 -£5,890,000 £180,356,000 44,036,117 -£2,782.24
0 £46,635,000 2,351 £2,958,000 £221,137,000 46,637,351 £1,258.19
0 £8,751,000 575 -£914,000 £24,764,000 8,751,575 -£1,589.57
0 £5,185,000 276 £901,000 £16,848,000 5,185,276 £3,264.49
0 £44,518,000 2,309 £16,714,000 £253,347,000 44,520,309 £7,238.63
0 £1,189,000 69 £83,000 £4,298,000 1,189,069 £1,202.90
0 £17,375,000 1,087 £287,000 £60,424,000 17,376,087 £264.03
0 £22,596,000 1,699 £9,874,000 £95,796,000 22,597,699 £5,811.65
0 £30,100,000 1,338 £4,200,000 £110,600,000 30,101,338 £3,139.01
0 £30,100,000 1,338 £4,200,000 £110,600,000 30,101,338 £3,139.01
0 £8,716,000 488 £843,000 £28,438,000 8,716,488 £1,727.46
0 £5,791,000 243 £3,411,000 £22,878,000 5,791,243 £14,037.04
0 £139,200,000 6,649 -£30,900,000 £496,800,000 139,206,649 -£4,647.32
0 £24,214,000 1,462 £1,976,000 £79,245,000 24,215,462 £1,351.57
0 £6,683,000 361 £402,000 £18,933,000 6,683,361 £1,113.57
0 £14,839,000 678 -£5,927,000 £83,478,000 14,839,678 -£8,741.89
0.06 £13,482,000 729 £2,293,000 £61,940,000 13,482,729 £3,145.40
0.52 £138,117,000 6,551 £21,513,000 £470,688,000 138,123,551 £3,283.93
0.54 £6,461,000 458 £1,542,000 £26,316,000 6,461,458 £3,366.81
0.72 £24,843,000 895 -£2,868,000 £78,585,000 24,843,895 -£3,204.47
0.78 £214,050,000 9,515 £41,550,000 £745,936,000 214,059,515 £4,366.79
0.81 £216,400,000 10,805 £26,300,000 £934,000,000 216,410,805 £2,434.06
0.91 £8,636,000 573 -£235,000 £30,877,000 8,636,573 -£410.12
0.93 £59,186,000 2,773 £35,870,000 £203,917,000 59,188,773 £12,935.45
1.14 £21,799,000 949 £3,152,000 £130,217,000 21,799,949 £3,321.39
1.15 £255,500,000 11,414 £69,600,000 £1,180,100,000 255,511,414 £6,097.77
1.27 £18,677,000 1,046 £5,551,000 £98,683,000 18,678,046 £5,306.88
1.28 £389,400,000 18,303 £79,800,000 £1,501,800,000 389,418,303 £4,359.94
1.63 £5,185,000 267 £1,388,000 £27,549,000 5,185,267 £5,198.50
2.95 £6,505,000 289 £3,765,000 £25,835,000 6,505,289 £13,027.68



Calculate the correlation coefficient of a portfolio

The data that appear in the following exercises can be found in the Excel data file QF (4FBL663) Seminar 5 (Data).xlsx, which is posted on Blackboard.

The data refer to Profit after Tax, Personnel Expenses, Net Turnover, Number of Employees, and Research and Development (R&D) as a percentage of Net Turnover, for a sample of 38 firms.

Construct two new variables in your Excel file, i.e. Personnel Expenses divided by Number of Employees, a variable which could be interpreted as the average wage / salary paid by each firm, and Profits per Employee, which can be interpreted as a measure of profitability.

Question 1

Derive the following scatter plots (Excel XY graphs), and use Excel to calculate the correlation coefficient associated with each graph:

  1. (a)  Number of Employees against Net Turnover
  2. (b)  Profit per Employee against Number of Employees
  3. (c)  Personnel Expenses per Employee against Number of Employees
  4. (d)  Profit against Number of Employees
  5. (e)  Personnel Expenses per Employee against Profit per Employee
  6. (f)  Personnel Expenses against Net Turnover
  7. (g)  Profit per Employee against Research and Development (R&D) as apercentage of Net Turnover

(h) As for part (g), above, but only for firms with R&D greater than zero


Within the context of each of these scatter plots and associated correlation coefficients, discuss the notion of there being a relationship between each set of two variables, and, if the data supports a relationship, how such a relationship might be justified (or indeed how such an implied relationship might be nonsense).

Question 2

Use Excel to derive the regression output relating to the implied relationships in parts (b), (d), (e) and (h) in Question 1, above. Comment on the results from these regressions.


Virgin File QF (4BFBL663) Seminar 5 (Data)

Data after awnsering question Quantitative Finance week 5 excel file


Merger and Aquisitions

Learning Week 5 Seminar Questions

Question 1 (G. Arnold, Corporate Financial Management, Third edition, Financial Times Prentice Hall, 2005, Chapter 23, Questions and Problems: Question 1)

Large plc is considering the takeover of Small plc. Large is currently valued at £60m on the stock market while Small is valued at £30m. The economies of scale and other benefits of the merger are expected to produce a market value for the combined firm of £110m. A bid premium of £20m is expected to be needed to secure Small. Transaction costs (advisers’ fees, etc.) are estimated at £3m. Large has 30 million shares in issue and Small has 45 million. Assume the managers are shareholder-wealth maximisers.


1. Does this merger create value for Large plc?

E (value of combined) = 110
Value of L (60)
Value of S (30)
Synergistic bought = 20
Less Transaction costs = (3) < Often investment banks
total 17
Less Bid overpayment = 20
synergistic benefit = (3) << its not worth it as it is a loss

2. If the purchase is made with cash what will be the price offered for each of Small’s shares?

Value = £30m
+ bid premium = £20m
Total = £50m

No g share to acquire £45m

Price g each = £50m / £45m = £1.11

3. What would be the value of each of Large’s shares after this merger?

Large acquires S for Cash
L has 30m shares outstanding
Value – £110 -3 – (130+20) = £57m of L alone
=£57m /30m shares = £1.90 per shares vs previous £2 per share

Question 2 (G. Arnold, Corporate Financial Management, Third edition, Financial Times Prentice Hall, 2005, Chapter 23, Questions and Problems: Question 3).

Box plc is considering the acquisition of Circle plc. The former is valued at £100m and the latter at £50m by the market. Economies of scale will result in savings of £2.5m annually in perpetuity. The required rate of return on both firms and the combination is 11 per cent. The transaction costs will amount to £1m.


1. What is the present value of the gain from the merger?

Combined value of firm:

100m B
50m C
Plus synergy = 22.727
Less bid-pref = 0
Less transfer costs (1)
Value of combined firm = 150 + 21.727 = 171.727

2. If a cash offer of £70m is accepted by Circle’s shareholders what is the value created for Box’s shareholders

Cash offer accped for C = 70m

Bid = 70-50 = £20m premium
Value G = 150m + 21.7272m

3. If shares are offered in such a way that Circle’s shareholders would posses one-third of the merged entity, what is the value created for Box’s shareholders?

Cirle shares hold 1/3 of F B

Value B = 2/3 (100+50+21.7272) = 114

Question 3 (D. Watson and A. Head, Corporate Finance – Principles & Practice, Fourth edition, Financial Times Prentice Hall, 2007, Chapter 11, Questions for discussion: Question 1 / (a)).

The board of Hanging Valley plc wishes to take over Rattling Creek Ltd. Shown below are summarised financial data for the two companies.

Hanging Valley

Rattling Creek

Profit before interest and tax



Ordinary share dividends



Corporation tax rate



Balance sheet extracts:

Hanging Valley

Rattling Creek

Net fixed assets



Current assets



Current liabilities



Total assets less current liabilities



Long term debt at 10% per year
Long term liabilities




Financed by:
Ordinary shares, £1








Hanging Valley’s earnings and dividends have been increasing at approximately 15 per cent per year in recent times, while over the same period the earnings and dividends of Rattling Creek have remained static. The current market price of Hanging Valley’s ordinary shares is £1.60. The board of Hanging Valley considers that the shareholders of Rattling Creek will accept a share-for-share offer in the proportion of four shares in Hanging Valley for every five shares in Rattling Creek.


(a) Using three different valuation models[1], determine the effect on the wealth of Hanging Valley plc’s shareholders if Rattling Creek Ltd’s shareholders accept the proposed share exchange.

Net Assets Value = Fixed + current + sort term liability + long term liabilities
NAV based on book value

Value HV
Net assets 2.1m

Value RC
Net Assets 1.5m

Question 4 (D. Watson and A. Head, Corporate Finance – Principles & Practice, Fourth edition, Financial Times Prentice Hall, 2007, Chapter 11, Questions for discussion: Question 5).

It is 1 January 2012 and Magnet plc is in the process of divesting part of its operations via a proposed management buyout (MBO) The buyout team is currently looking for venture capital to finance the MBO. They have agreed a price of £25m with Magnet and have proposed that the financing will involve their putting up £5m of their personal funds to purchase an equity stake in the business with the remaining funds (£20m) coming from the venture capitalist in the form of long-term unsecured mezzanine debt finance.

The venture capitalist has indicated that it will require an interest rate on its debt investment of 11 per cent given that its finance will be unsecured. The four members of the MBO team have indicated that they intend to draw an annual salary of £150,000 each. The MBO team has just presented the venture capitalist company with the following five-year cash flow predictions (excluding directors’ salaries) which they consider to be on the pessimistic side:

Year ending






Predicted sales






Cash outflows








The new entity will pay corporation tax at a rate of 20 per cent in the year that profits arise. The reinvestment of £1.5m in 2014 will not qualify for capital allowances.


On the basis of this information, critically evaluate whether the proposed MBO is viable from a cash flow perspective in light of the two parties’ financial requirements and the predicted sales and costs. Support your answer with appropriate calculations.

[1] net asset valuation based on book values, capitalisation of earnings valuation (i.e. earnings yield valuation), and dividend yield method of share valuation


Diversification utilising hedging in a portfolio of assets


– If purchase shares in Company, how might returns on this asset be measures?

– We know price of shares in Company A at point of purchase, i.e. time period t, is Pt .

– Assume price of shares in Company A one period into future is Pt+1 .

– Return on investment will then be proportionate increase in Pt , hence:

rt =Pt+1Pt Pt


– However, this calculation implies share prices move in discrete manner.

– Recall from Lecture 1 that if invest £P at an annual interest rate of i, where interest compounded annually, then future value of investment would be:

F =Pe^it – After 1-year we would have:

F =Pei

– Therefore can generalise for any time period, where r denotes rate of return over period, as:

F =Pe^r


– Therefore, in terms of share price, we have: Pt+1 =Pter

– Hence rate of return can be derived as
ln P = ln P + ln er = ln P + r

( t+1) ( t ) ( ) ( t )
– Solving for r, we therefore obtain the log-return, i.e.:

r =ln P −ln P
( t+1) ( t )

– From now on, when we refer to returns, we are generally talking about log-returns.


– Can capture essential characteristics of these returns via their mean and variance, or standard deviation.

– The standard deviation of returns is used as a measure of the risk of the asset.

– Investors seek to maximise their returns on investments, however, will have to trade-off returns against risk.

– This means that asset that, on average, generates high returns will tend to do so with greater variability.

– Hence, high average return assets will be high risk assets and exhibit a large standard deviation, denoted σ.


– Simplest approach for calculating returns and risk is to use historical data on returns.

– Then use sample statistics of these historical returns as estimates of expected return and risk of asset.

– However, problems with using past data:
– How reliable are past returns as a guide to future returns? – How far back do you have to go?
– What about the impact of past shocks?



– Assume that an investor has two investments available to him, i.e. to hold shares in Company A and to hold shares in Company B.

– Let rA and rB denote the returns on Company A’s and Company B’s shares, respectively, where, in both cases, these returns are random variables.

– Hence, rA and rB will both have probability distributions, with expected values of E(rA) and E(rB), respectively.

– Assume that standard deviations of these distribution are σA and σB, respectively.

– Assume further that σB > σA, hence, E(rA) > E(rB).


– If investor is risk-averse, then Company A’s shares will be more attractive.

– If investor is risk-lover, then Company B’s shares will be more attractive.

– However, an alternative strategy would be to combine shares in some way, instead of just buying shares in one of the companies.

– This process of combining them is known as constructing an investment portfolio.


– Assume that investor has investment fund and forms an investment portfolio by investing a proportion, denoted α, in Company A’s shares.

– This proportion is known as the portfolio weight for A.
– Investor will then invest the remainder of investment

fund, i.e. 1 – α, in Company B’s shares.

– Now need to determine what the return this portfolio is?

– Return on portfolio will be a weighted average of returns on the individual shares, i.e.:

Er =Eαr+1−αr=αEr +1−αEr (P)A()B(A)()(B)


  • –  What about the risk on the portfolio?
  • –  Risk on portfolio will be reflected in the variance of the

returns on the portfolio, i.e. Var (rP).

– Important to note that variance of portfolio returns is not a simple weighted average of variances of the returns on individual assets in portfolio.

– In general, portfolio variance is less than the weighted average variances of individual asset returns, thereby indicating that you have effectively reduced risk.

– This is know as portfolio diversification, where by constructing a portfolio, you have reduced overall risk.


– The variance of the returns on the portfolio will be:

Varr =Varαr+1−αr (P)A()B

– It can be shown that: Var r =Var αr + 1−α r  ( P )  A ( ) B 

=α2σ2+1−α σ2+2α 1−α Cov r ;r  ABAB   ( )  ( ) ( )

– Or, alternatively:
Var r =α2σ2+1−α σ2+2α 1−α ρ σ σ  (P) A( )B( )A;BAB


– Assume that an investor is considering constructing a portfolio of two assets, i.e. Asset A and Asset B, where:

rA =0.05;σA =0.04;rB =0.1andσB =0.12

– The portfolio weight for asset A, i.e. α, is assumed to range between 0 and 1, i.e. between 0% and 100%, in increments of 0.05, or 5%.

– Thus, substituting 0.05 for E(rA) and 0.1 for E(rB), and the various assumed values for α, in the portfolio returns equation, will produce various returns on the portfolio.

– Portfolio variance formula is then used to derive corresponding values of portfolio sigma.



– Risk vs. return (assuming ρA;B = 1): Figure 5.3, Correlation=1


– Why does a combination of two perfectly negatively correlated assets produce a riskless portfolio?

– Essentially because any change in returns of one asset is entirely offset by a change in the other.

– In practice, perfectly negatively correlated assets are unlikely to occur, so not all risk can be diversified away.

– However, any negative correlation, and even zero correlation, will allow for some risk diversification.

– Given the possibility of short-selling, even positive correlations can allow for risk diversification.




– How do we identify the optimum portfolio?

– Firstly, can reject all portfolios below minimum variance point, denoted MV, on the combination line, as these are inefficient (as can still reduce variance and increase returns further).

– Efficient frontier therefore defined as segment of combination line that excludes inefficient portfolios.

– Optimum portfolio is therefore that portfolio on efficient frontier with preferred risk-return properties.

– This optimum point will essentially reflect an investor’s attitude to risk vs. return.


– However, if we assume that investor can borrow or lend at risk-free rate, then portfolio can be indentified that will form part of investor’s final portfolio.

– This borrowing / lending occurs as follows:
– Lend at risk-free rate by buying government bonds; and
– Borrow at risk-free rate by short-selling government bonds.

– Capital market line (CML) is defined as the line drawn from risk-free interest rate on the y-axis tangential to the efficient frontier.

– Point of tangency between CML and efficient frontier is known as market portfolio, denoted M.


– The CML allows us to either reduce risk beyond MV point or increase returns beyond what would be optimum on efficient frontier:

– If lend at risk-free, i.e. buy government bonds, can shift down CML to risk levels below MV point; while

– If borrow at risk-free rate, i.e. short-sell government bonds, can shift up CML to returns above the efficient frontier.

– Note that when asset are perfectly positively correlated, with possibility of short-selling, risk can be entirely diversified away, however, occurs at rate of return that is less than risk- free rate.

– CML is therefore effective way to reduce risk of positively correlated assets.



– Assume have constructed a portfolio of two assets with following efficient frontier and rF = 3%:

Figure 5.8 Identification of Market Portfolio with the Capital Market Line

Risk-free rate


– M is market portfolio with rM = 6.25% and σM = 3%.

– What if σM is too high for investor:

– Can’t move around efficient frontier as would increase risk; but

– CanmovedownCMLbylendingatrisk-freerate;where

– If σM = 2% is required, this can be achieved by investing 33% in risk-free asset and 67% in market portfolio.

– What if σM is too low for investor:

  • –  Can move round efficient frontier, and increase risk; but
  • –  BettersolutionismoveupCMLbyborrowingatrisk-freerate;

– If σM = 6% is required, this can be achieved by giving weight of – 100% to risk-free asset, and therefore a weight of 200% to market portfolio; where

– Results in rM = 9.5%, as opposed to rM = 8%, otherwise.


1. Wehaveexaminedtheconceptofriskininvestments.

2. We have highlighted the importance of constructing an investment portfolio in the market.

3. We have looked at how to implement the Efficiency frontier for a portfolio.

4. We have looked at how to construct the Capital Market Line for a portfolio.


Guided Independent Study Week
Guided Independent “Party” Week Readings to Be Done and May Be Examined


– Please ensure that you read:

– Lecture notes for Lecture 6;
– Beninga (Chapters 10 & 11)
– Haugen (Chapters 6, 8 and 9)
– Adams,etal.(Chapter12,pp.245-269,andChapter13) – Elton, et al. (Chapters 4 to 6)
– Jackson & Staunton (Chapter 7)

– For the seminar, please complete the exercises for Seminar 6.

Lecturer by Stefan Van Dellen at the University of Westminster <<<

Treasury management and working capital policy

The number one function of a Treasurer is

  • Corporate finance – capital markets, trading finance and risk
  • Equity management – investor relations, mergers and divestment


Most important source long-term financing is retained earnings
  • No dilution of existing shareholders or corporate control
  • avoids issuing costs
  • management may not have to explain to shareholders why dividend are not paid


  • limits firm profits
  • reduces divident payout
  • risk of not obtaining finance at a vital stage
  • managers may regard this essentially as free capital

Analysis of Assets:

  • Fixed Assets
  • Permanent current assets
  • Fluctuating current assets
  • Matching principle: long-term finance used for long-term assets, short-term finance used for short-term assets.

Methods of Financing:

  • short-term fluctuating current assets
  • long-term for permanent current assets and financing of fixed assets
  • increased use of longterm finance lowers risk

Financing: The currency of borrowing

Union Jack plc borrows £100m to invest in the USA.

Exchanges the £100m into $150m at the exchange rate of $1.5 to the pound.

Net cash flows in subsequent years are expected to be $30m per annum.

If the exchange rate remained constant Union Jack receives £20m per year.

If the rate of exchange moved to $2 for every pound the annual cash inflow would be £15m.

The risk attached to this project can be reduced by ensuring that the liabilities are in the same currency as the income flow.

Financing: The interest rate choice

Balance to be struck between fixed and floating interest-rate borrowings

Relationships with the financial community

A planned and sustained effort to maintain mutual understanding between shareholders and the organisation. Create a detailed and up-to-date picture of who the shareholders are. High-quality flow of information to enable shareholders to better appreciate the firm and its strategy in order to sustain their commitment.

Banking relationships.
Most firms make use of the services of more than one bank.
Any one bank may not have all the requisite skills and infrastructure. Banks have a tendency to join syndicates to make large loans to firms. Some companies operate in dozens of countries.

The treasurer at a strategic level    

Decision to merge with another firm or to purchase a major business (a trade purchase) will require some assessment of the ability of the organisation to finance such activity.

Treasurer will be able to advise on,

  • the sources of finance available;
  • the optimum mixture;
  • the willingness of the financial community to support the initiative.

Disposals of subsidiaries.

Advise on the course of interest rates and exchange rates and so decisions such as whether to establish a manufacturing facility or begin a marketing campaign in another country. Total amount of borrowing a firm should aim for.

Risk Management

Reasons firms sacrifice some potential profits in order to reduce the impact of adverse events:

-It helps financial planning;
-reduce the fear of financial distress;

-some risks are not rewarded

  • Liquidity risk; cash-flow risks
  • Credit risk; not being able to get capital
  • Market risk.
  • Risk retention;
  • Risk avoidance; only take risks that generate a profit, do not take risks for no return!
  • Risk reduction – Risk transfer:
-Diversify – don’t put your eggs all in one basket
-Insure – transfer the risk to other businesses
-Hedge – such as currency and derivatives ( forwards, futures, swaps and options)
Z-Score models

Discriminatory ratios – R1 to Rn will typically feature:

  • profitability;
  • asset turnover;
  • liquidity;
  • gearing.

They will frequently be ‘variants’ of more traditional financial ratios.
A score below a certain level indicates higher risk of corporate failure.

Relaxed strategy – liquidity is well addressed but taking less risks your return on capital employed will be low
Aggressive strategy – Taking more risks they are exposed to more liquidity risk but at the same time the company would be able to have a higher capital employed
This policy is reflected upon the managers risk exposure
Overtrading situations
  • Initial under-capitalisation of future operations, the company would not have sufficient funds to continue with the project.
  • Over-expansions – did not predict the higher demand from the market for your products and services
  • Poor utilisation of working capital resources – cash lying idle is a waist and has a very relaxed debtor policy and customers have the money which should be with the company or your paying your suppliers way to fast, always utilise any payment periods suppliers give you and utilise the capital for other low risk projects.
It could also be a combination of all three and have not used the capital and leads to overtrading.

Cost of capital

Questions for Seminar 4

1.         In October of 2011 when Carlsberg were proposing to take over Scottish and Newcastle they planned to raise 2.8bn GBP through a rights issue.  Critically analyse a rights issue and three other methods that a company can use to issue additional shares to raise finance.

2.         Jackdaw Plc has an issued share capital of 1 million ordinary shares (nominal value £1 each); it has also issued £800,000 of 8% bonds.  The market price of ordinary shares is £4.76 per share and bonds are priced at 69%.  Dividends and interest are payable annually and have both been paid recently.  Bonds are redeemable at par in ten years time.

Total dividend payment over the last few years has been:

2006               £200,000

2007               £230,000

2008               £230,000

2009               £260,000

2010               £300,000


Jackdaw Plc currently pays Corporation Tax at 30%.


a)         Estimate the cost of capital which Jackdaw Plc should use as a discount rate for purposes of investment appraisal.

b)         Discuss any difficulties and uncertainties in your estimation.