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a few years。
The weakness of CAPM is that it assumes all investors are rational and
well informed； that markets are perfect and that there is an unlimited supply
of risk…free money。 There are even more plex models for calculating the
cost of equity capital； but none are without their critics。
Weighted average cost of capital
Having identified the cost of equity and the cost of borrowed capital （and
that of any other long…term source of finance such as hire purchase or mortgages）；
we need to bine them into one overall cost of capital。 This is
primarily for use in project appraisals as justification of those that yield a
return in excess of their cost of capital。
72 The Thirty…Day MBA
An average cost is required because we do not usually identify each
individual project with one particular source of finance。 Because equity and
debt capital have very different costs； we would make illogical decisions and
accept a project financed by debt capital only to reject a similar project next
time round when it was financed by equity capital。 Generally businesses
take the view that all projects have been financed from a mon pool
of money except for the relatively rare case when project…specific finance
is raised。 The weightings used in the calculations should be based on
the market value of the securities and not on their book or balance sheet
values。
Example
Assume your pany intends to keep the gearing ratio of borrowed capital
to equity in the proportion of 20 ： 80。 The nominal cost of new capital
from these sources has been assessed； say； at 10 per cent and 15 per cent
respectively and corporation tax is 30 per cent。 The calculation of the overall
weighted average cost is as follows：
Type of capital Proportion （a） A。。er…tax cost （b） Weighted cost （a × b）
10％ loan capital 0。20 7。0％ 1。4％
Equity 0。80 15。0％ 12。0％
13。4％
The resulting weighted average cost of 13。4 per cent is the minimum rate
that this pany should accept on proposed investments。 Any investment
that is not expected to achieve this return is not a viable proposition。 Risk
has been allowed for in the calculation of the beta factor used in the CAPM
method of identifying the cost of equity。 This relates to the risk of the
existing whole business。 If a pany embarks on a project of significantly
different risk； or has a divisional structure of activities of varying risk levels；
then a single cost of equity for the whole pany is inappropriate。 In this
situation； the average beta of proxy panies operating in the same field
as a division can be used。
INVESTMENT DECISIONS
The cost of capital is an important figure as it is in essence the threshold
for future investments。 Taking the figures shown above； if our weighted
average cost of capital is 13。4 per cent then taking on any new activity that
makes a lower profit ratio will be lowering the performance； hardly an
MBA type of activity。
Investment decisions； where the decisions have cost and revenue implications
for years； perhaps even decades； fall into a number of categories：
Finance 73
。 Bolt…on investments： These are where an investment will be supporting
and enhancing an existing operation。 For example； if part of a production
process is being slowed down for want of some new equipment to
eliminate a bo。。leneck。
。 Standalone single project： This involves a simple accept or reject
decision。
。 peting projects： This requires a choice of which produces the best
results； either because only one can be pursued or because of limited
finance。 In the la。。er case this is described as capital rationing。
What follows is an examination of the financial aspects of investment
decisions。 There may well be other strategic reasons for taking investment
decisions； including those that might be more important than finance
alone。 For example； it could be imperative to deny a petitor a particular
opportunity； or if part of achieving a national or global strategy calls for
disproportionate expenses in one or more areas。 However； there are NO
circumstances when any investment decision should not be subjected to
proper financial appraisal and so at least see the cost of accepting a lower
return than required by the cost of capital being used。
Also； it’s important to note that any methodology for appraising investments
requires that cash is used rather than profits； for reasons that will
bee apparent as the techniques are explained。 Profit is not ignored； it is
simply allowed to work its way through in the timing of events。
COBRA BEER
In 1990； Cambridge…educated and recently qualified accountant Karan
Bilimoria started importing and distributing Cobra beer； a name he
chose because it appeared to work well in lots of different languages。
He initially supplied his beer to plement Indian restaurant food in
the UK。 Lord Bilimoria； as he now is； started out with debts of ￡20；000；
but from a small flat in Fulham and with just a Citroen CV by way of
assets he has grown his business to sales of over ￡100 million a year。
Three factors have been key to its success。 Cobra was originally sold in
large 660ml bottles and so were more likely to be shared by diners。 Also；
as Cobra is less fizzy than European lagers； drinkers are less likely to feel
bloated and can eat and drink more。 The third factor was Bilimoria’s
extensive knowledge； through his training as an accountant； of sources
of finance for a growing business。 He was fortunate in having an oldstyle
bank manager who had such belief in Cobra that he agreed a
loan of ￡30；000； but since then he has had to tap into every possible
type of funding （see Figure 2。1）； including selling a 28 per cent stake in
his firm in 1995。
Figure 2。1 Cobra Beer’s financing strategy
0
10
20
30
40
50
60
70
80
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Jul 89 ￡7K
Overdraft
Nov 89
￡4K
Overdraft
Dec 89
￡5K
Overdraft
Jul 90
￡55K
SFLGS
Loan
Feb 91
￡100K Bill
of
Exchange
Jan 92
￡50K
Preference
Shares
Feb 93
75％
Advance
Factoring
Facility
Oct 93 5％
Equity for
￡50K
Dec 93
￡190K SFLGS
Loan
Oct 94
￡200K
Convertible
Preference
Shares
Dec 95
￡500K
Private
Placement
Sold 23％
Equity
May 96 OD
increased to
￡30K
Jun 96
Invoice
Finance 80％
Advance
Sep 96 DD
Facility
￡75K
Dec 97 OD
increased to
￡60K
Jan 98 DD
Facility
￡125K
Jul 98
￡100K
Convertible
Preference
Shares
Sep 98 NMB
Heller
Invoice
Facility
85％
Advance
Nov 98
￡750K
Convertible
Preference
Shares
Apr 99 OD
raised to
￡150K
Aug 99
DD
Facility
￡250K
Jan 00
Trade
Finance
Facility
￡450K
Universal
Impex
Aug 00 DD
Facility
￡350K
Feb 01 DD
Facility
￡600K
Jan 02 DD
Facility
￡1。6m
Oct 2002
OD facility
￡400K HBOS
￡1。65m loan
HBOS
￡2。5m
replacement of
Invoice
discounting
facility
Apr 2003
￡4m New
Preference
Shares
￡2m DD facility
Sales ￡millions
Finance 75
Payback period
The most popular method for evaluating investment decisions is the payback
method。 To arrive at the payback period you have to work out how
many years it takes to recover your cash investment。 Table 2。2 shows two
investment projects that require respectively ￡20；000 and ￡40；000 cash now
in order to get a series of cash returns spread over the next five years。
Table 2。2 The payback method
￡ ￡
Investment A Investment B
Initial cash cost NOW （Year 0） 20；000 40；000
Net cash flows
Year 1 1；000 10；000
Year 2 4；000 10；000
Year 3 8；000 16；000
Year 4 7；000 4；000
Year 5 5；000 28；000
Total cash in over period 25；000 68；000
Cash surplus 5；000 28；000
Although both propositions call for different amounts of cash to be invested；
we can see that both recover all their cash outlays by year 4。 So we
can say these investments have a four…year payback。 But as a ma。。er of fact
Investment B produces a much bigger surplus than the other project and it
returns half our initial cash outlay in two years。 Investment A has returned
only a quarter of our cash over that time period。
Payback may be simple； but it is not much use when it es to dealing
with the timing or with paring different investment amounts。
Discounted cash flow
We know intuitively that ge。。ing cash in sooner is be。。er than ge。。ing it in
later。 In other words； a pound received now is worth more than a pound
that will arrive in one； two or more years in the future because of what we
could do with that money ourselves； or because of what we ourselves have
to pay out to have use of that money （see Cost of capital above）。 To make
sound investment decisions we need to ascribe a value to a future stream
76 The Thirty…Day MBA
of earnings to arrive at what is known as the present value。 If we know
we could earn 20 per cent on any money we have； then the maximum we
would be prepared to pay for a pound ing in one year hence would
be around 80p。 If we were to pay one pound now to get a pound back in a
year’s time we would in effect be losing money。
The technique used to handle this is known as discounting。 The process
is termed discounted cash flow （DCF） and the residual discounted cash is
called the net present value。
Table 2。3 Using discounted cash flow （DCF）
￡ Discount factor Discounted
Cash flow at 15％ cash flow
A B A × B
Initial cash cost NOW （Year 0） 20；000 1。00 20；000
Net cash flows
Year 1 1；000 0。8695 870
Year 2 4；000 0。7561 3；024
Year 3 8；000 0。6575 5；260
Year 4 7；000 0。5717 4；002
Year 5 5；000 0。4972 2；486
Total 25；000 15；642
Cash surplus 5；000 Net present
value
（4；358）
The first column in Table 2。3 shows the simple cash…flow implications of
an investment proposition； a surplus of ￡5；000 es a。。er five years from
pu。。ing ￡20；000 into a project。 But if we accept the proposition that future
cash is worth less than current cash； the only question we need to answer is
how much less。 If we take our weighted average cost of capital as a sensible
starting point； we would select 13。4 per cent as an appropriate rate at which
to discount future cash flows。 To keep the numbers simple and to add a
small margin of safety； let’s assume that 15 per cent is the rate we have
selected （this doesn’t ma。。er too much； as you will see in the section on
internal rate of return）。
The formula for calculating what a pound received at some future date
is：
Present Value （PV） = ￡P X 1
（1＋r）n
Finance 77
where ￡P is the initial cash cost； r is the interest rate expressed in decimals
and n is the year in which the cash will arrive。 So if we decide on a discount
rate of 15 per cent； the present value of a pound received in one year’s time
is：
Present Value = ￡1 X 1
（1 ＋ 0。15） 1 = 0。87 （rounded to two decimal places）。
So we can see that our ￡1；000 arriving at the end of year 1 has a present
value of ￡870； the ￡4；000 in year 2 has a present value of ￡3；024 and by
year 5 present value reduces cash flows to barely half their original figure。
In fact； far from having a real payback in year 4 and generating a cash
surplus of ￡5；000； this project will make us ￡4；358 worse off than we had
hoped to be if we required to make a return of 15 per cent。 The project； in
other words； fails to meet our criteria using DCF but might well have been
pursued using payback。
Internal rate of return （IRR）
DCF is a useful starting point but does not give us any definitive information。
For example； all we know about the above project is that it doesn’t
make a return of 15 per cent。 In order to know the actual rate of return we
need to choose a discount rate that produces a net present value of the entire
cash flow of zero； known as the internal rate of return。 The maths is time
consuming but Solutions Matrix website （solutionmatrix） has a
tool for working out payback； discounted cash flow； internal rate of return；
and a whole lot more calculations relating to capital budgeting。 You have
to register on the site first before downloading their free capital budgeting
spreadsheet suite and tutorial。 From the home page you should click on
‘Download Center’ and ‘Download Financial Metrics Lite for Microso。。
Excel’。
Using this spreadsheet you will see that the IRR for the project in question
is slightly under 7 per cent； not much be。。er than bank interest and certainly
insufficient to warrant taking any risks for。
BUDGETS AND VARIANCES
Budgeting is the principal interface between the operating business units
and the finance department。 As a staff function （see Chapter 4 for more
on line and staff functions）； the finance department will assist managers
in preparing a detailed budget for the year ahead for every area of the
organization and is in effect the first year of the business plan。 MBAs are
invariably expected to play a role in facilitating the process within their
78 The Thirty…Day MBA
departments。 Budgets are usually reviewed at least halfway through the
year and o。。en quarterly。 At that review a further quarter or half year ca