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Discuss what is meant by the term GAAP and whether it meets the needs of all UK entities.
Introduction

Generally accepted accounting principles or GAAP refers to a set of principles, rules, methods and conventions that provides detailed guidelines and procedures for the preparation, presentation and handling financial and accounting cases. Institute of Chartered Accountants in England and Wales (ICAEW) defines “Generally Accepted Accounting Practice (UK GAAP) as the body of accounting standards and other guidance published by UK Accounting standards Board (ASB)”. In the UK, Financial Reporting Council (FRC) is responsible for setting accounting standards by working closely with national and international accounting standard-setters in order to influence the development of standards. In 2009, ASB proposed a strategy for the future of UK/Irish GAAP and its convergence with International Financial Reporting Standards (IFRS). The intention was to work under the IASB framework which provides detailed guidelines and procedures in the need of all UK entities, hence, cease the existence of UK GAAP. The Board’s proposals set out a three Tier system of differential arrangement based upon public accountability. UK entities would need to determine the appropriate framework to transition, as well as the impact of change to their financial reporting, tax status, business processes and operations in general (Ernst & Young, 2011). Currently in the UK, only entities listed on the regulated market are required to file their accounts in accordance to IFRS, whereas all other UK entities are permitted to use wither IFRS or follow UK GAAP. ASB (2009) proposed three new standards, FRS 100, FRS 101 and FRS 102, that replace all current UK standards. By December 2014, UK GAAP will cease to apply to the financial statements and becomes mandatory for all UK entities for the year end December 2015 or from January 2015 but this is subject to early adoption provisions (ASB, 2009). Early adoption of FRS 101 is allowable without restriction whereas FRS 102 can be allowed on or after the accounting year end 31 December 2012 (PWC, 2013). The impact of each FRS is briefly discussed below.

Needs of UK entities

Entities are of different types of varied sizes with different shareholding and management. Every entity has its own properties but has to act in accordance to the local laws and accounting standards when reporting that gives a user clear picture and nature of business performance. In accounting, “True and Fair View” plays a pivotal role in reporting and presenting financial statements. It remains a fundamental part to accounting within the local and international laws. Under company law, an entity is a separate legal body from its owners. A large entity can be easily distinguished who the owner/manager is, unlike sole traders where it is quite difficult to get a clearer picture although the business forms a separate identity. Charitable organizations, government bodies and some entities have different ways of reporting and in some cases they do not follow UK GAAP in full. Instead, they follow the rules and guidance prescribed by the state and the civil law.

True and Fair view in terms of accounting standards may not be true and fair in terms of tax and to get a clear picture of business transactions, some items should be shown as expenses that wouldn’t be allowed for tax (Sweetman, 2009). Sweetman (2009, p.4) argues, “Very small businesses are unlikely to have fluctuations from year to year in most levels, and if in hard times the list of creditors grows then it seems reasonable to tax what is received rather than what may be received one day”.

Listed and regulated companies are already following IFRS guidelines and procedures for preparation and reporting financial statements but not all entities are in the regulated market and listed. GAAP varies from nation to nation and hence comes IFRS to come into action. Not all the needs of all UK entities are met by GAAP. It may be because of the nature of transactions an entity has. Trading has become global and most companies, from small to large, trade across the borders and in different countries that have different set of rules and regulations which are to be followed in terms of exchange, tax regimes and other accounting standards. Since the globalisation of the business, a single accounting system has been a major debate for all accounting standard setters in the world. There has been a long standing debate for the convergence of UK GAAP into the IASB framework and this has become a reality following the strategic approach taken by ASB in the past few years.

ASB’s Strategy for UK GAAP

In 2009, ASB proposed a “Three-Tier” approach to the transition of UK GAAP into IFRS to the fullest extent possible with the needs of UK entities. This three-tier approach was based on the public accountability.

Tier 1 – All listed and regulated market entities are to follow EU adopted IFRS under this accounting regime.

Tier 2 – All non-publicly accountable entities are to follow IFRS for SMEs under this regime

Tier 3 – All small entities such as private companies are to follow Financial Reporting Standards for smaller entities (FRSSE) under this regime.

Under this proposed change, all entities will have the option to voluntarily adopt a higher tier. One of the objectives of ASB is to offer a comprehensive and clear guidance for all entities by providing high levels of transparency and accountability (ASB, 2009).

ASB (2009) believes that the strategic change will improve the financial reporting in many ways such as simplifying the reporting requirements based on the entity’s accountability and size, basing UK GAAP on IFRS provides a consistent basis of preparation of financial statements with better understanding at all levels of users and improved comparability of financial reports will boost investors’ confidence in the capital markets.

UK GAAP v IFRS: Key Differences
Goodwill: Under IFRS, there is no amortisation used but annual impairment test.
Borrowing costs and development costs: If criteria are met then the costs are capitalised under IFRS but is optional under UK GAAP
Deferred Tax: Temporary differences are recorded under IFRS
Holiday pay accrual: This must be recognised under IFRS
Financial Instruments: Recognition of derivatives under IFRS but only recognised if FRS 26 adopted in UK GAAP
Impact of New Standards

The Financial Reporting Council (FRC) issued three financial reporting standards (FRSs) 100, 101 and 102 following several consultations to move from current FRSs to IFRS framework. Small entities remain unchanged to the standards as there will be no changes to FRSSE with exceptions to minor amendments (FRC, 2013). The FRC (2013) produced an impact assessment for all these new standards which are discussed below in brief.

FRS 100

Application of Financial Reporting Requirements, FRS 100, provides guidance about the reporting requirements for all entities. This tells the companies or LLPs which set of standards they may or must follow. Listed and regulated companies must use their IFRS in their group accounts. Small companies defined by Companies Act 2006 use FRSSE but a revised version from January 2015 with some minor amendments and other entities that are not small have various choices depending upon the situation. Such as FRS 102, the main new UK GAAP and FRS 101, the reduced disclosure framework or adopt the full IFRS. This suggests that companies which are currently using Statements of Standard Accounting Practices (SSAPs) and FRS will end up using FRS 102. FRC (2013) states that the introduction of new standards will have positive impact on the entities where the benefits are impossible to quantify. FRC believes that the main quantifiable cost is the transition costs for individual entities and those entities that apply for reduced disclosure framework.

FRS 101

FRS 101 Reduced Disclosure Framework creates a new type of standard in the UK. It allows subsidiaries of groups preparing consolidated financial statements in accordance with EU adopted IFRS to apply accounting policies that are consistent with the group accounts. FRS 101 allows some qualifying companies to use IFRS and such entities can take exemptions from following items.

Cash flow statements- entities are exempt from preparing cash flow statements
Share based payments- entities are exempt from most of the disclosure requirements by IFRS 2 except description is needed in some areas such as, options exercised in the year and outstanding in the year end
Business combinations- entities are exempt from most of the disclosure requirements but some basic information would still need to be disclosed on the acquisition
Discontinued operations- entities are exempt from the disclosure of net cash flows attributable to the operating, investing and financing activities
Financial instruments- entities which are adopting FRS 101 are exempt from all of the disclosure requirements of IFRS 7, except financial institutions
Fair Values- most entities are exempt from all of the disclosure requirements of IFRS 13 except financial institutions in relation to financial instruments
Impairments- entities are exempt from the disclosure of assumptions, valuation techniques and sensitivities arising from impairments
Related Party Disclosures- as part of the Companies Act 2006, directors’ remuneration is still required to be disclosed but entities are exempt in disclosing the related party transactions
Accounting policies, changes in accounting estimates and errors- entities are exempt from the disclosure and also exempt from disclosing the impact of the application of those standards
Comparatives information- entities are exempt from comparatives for movements on property, plant and equipment (PPE), share capital, intangible assets, and investment property
Capital Management- entities are exempt from the disclosure requirements of capital management but not available to financial institutions
FRS 102

FRS 102, the Financial Reporting Standard is based on IFRS for SMEs and mainly used IFRS language. There are some changes in the terminology of words used in the financial statements, such as, instead of fixed assets, property, plant and equipment has been introduced. There have been significant changes in the financial instruments. Previously, in the UK GAAP, derivatives with zero cost were not recognised but under the new standards, this will be recognised as even small entities have derivatives due to the global trading. ASB realized that FRS 26 (IAS 39) Financial Instruments: Recognition and measurement was not a proportionate solution for all UK entities and hence further areas were expected as part of the convergence process with EU-adopted IFRS. FRS 102 brings in significant improvements in the transparency of financial reporting of financial instruments (FRC, 2013). FRS 102 requires derivatives and some equity instruments to be measured at Fair Value Through Profit and Loss (FVTPL).

Conclusion

The ideas of convergence of UK/Irish GAAP into IFRS have been widely accepted ever since the debate started and it was warmly welcomed. The new UK GAAP will become mandatory for most entities which prepare financial statements for the year end December 2015. The three FRSs will be put in place that replace all the UK accounting standards. Most members were reasonably satisfied with the amendments proposed to the IFRS for SMEs with some unsatisfactory responses for negative goodwill and the removal of fair value option, based on conflicts with EU Directives (ACCA, 2011). Association of Chartered Certified Accountants (ACCA) stated in their report in 2010 following the ASB consultation paper that the new standards would inevitably benefit cross-border trade, reduce costs for companies by providing a single consistent basis of standards, and the cost and time involved in maintaining a separate UK GAAP would be avoided. There might be a number of reasons why convergence was necessary. The application of IFRS may also be driven by national GAAP because of inertia to minimise the changes in financial reporting for stakeholders caused by switching from one set of accounting rules to another (Nobes, 2006). Firms may choose to end their national accounting traditions following the adoption of IFRS (Haller and Wehrfritz, 2013). There might be variations in IFRS reporting due to country-specific factors (Haller and Wehrfritz, 2013).

In the wake of global business and trading relationships across the globe, new accounting standards had to be evolved for a consistent and transparent reporting. This not only creates and boosts confidence to users but also provides clear and concise understanding of the financial reporting systems to any stakeholders or users. The transition for UK GAAP to move and adopt IFRS has remained a huge success and widely accepted by all levels of institutions and individuals. There is no doubt that the standards have to evolve over time. The new level of UK GAAP will provide better understanding and try to remove any ambiguities that are engraved in the accounting standards.

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THE PECKING ORDER HYPOTHESIS

Determining the optimum capital structure which an organisation should have is a major financial decision, and the importance of decisions regarding capital structure have become even more apparent due to economic events such as the global financial crisis (Baker and Martin, 2011). Hossain and Ali (2012) state that all firms are highly susceptible to decisions regarding capital structure, owing to their internal and external effects on organisations. They further point out that capital structure policies are significant because of their impact on the level of risk and return of a firm. As such, a number of theories have been proposed to explain the capital structure of organisations. One of such is the Pecking order hypothesis. This essay shall examine this hypothesis and how it explains capital structure. Subsequently, it shall be compared to another theory of capital structure, the static trade-off theory, in order to find out how it differs from this theory. Studies testing both theories shall also be examined.

According to Chen and Chen (2011, p. 92), the Pecking order hypothesis is “one of the most influential theories of corporate finance”. Frank and Goyal (2003) further note that much of its influence is drawn from a view that logically fits with facts on how external finance is used by companies. This hypothesis suggests that in making a choice among alternative forms of finance, organisations have a certain order of priorities. In the first instance, firms prefer to make use of internal finance generated by their operating cash flow. When these internal sources are used up, they prefer to borrow. The third option, which is used as a last resort, is the sale of new shares of the company (Pike and Neal, 2009). The rationale for this preference order is the information asymmetry problem, i.e. the disparity between the information managers and potential investors have regarding the financial state of the firm and its prospects. As such, managers are less inclined to issue shares when they believe these shares to be undervalued, and more likely to issue them when it is believed that they are overvalued (Chen and Chen, 2011; Pike and Neale, 2009). As a result of this, shareholders, mindful of their relative ignorance of the firm’s financial state and of this possible behaviour by managers, will view a decision not to issue shares is a signal of good news, while the issuing of shares will be seen as bad, or relatively less good (Myers and Majluf, 1984). These signals are ‘noisy signals’ (Chen and Chen, 2011), and viewing issued shares as overvalued or ‘less good’ affect the price investors will be willing to pay for those shares, and they may consequently mark them down. This could therefore increase the cost of equity for firms (Pike and Neale, 2009). Transaction costs, as Chen and Chen (2011) point out, play a significant role in decisions regarding the firm’s capital structure. This is because the costs involved in obtaining finance internally are less than the transaction costs involved in securing new external financing, as internal funds do not incur transaction costs. As such, it is expected by investors that firms would first finance company investments using internal resources first, then by borrowing till the firm has a suitable debt to equity ratio, and finally, by issuing equity (Myers and Majluf, 1984; Pike and Neale, 2009). Frank and Goyal (2003, p. 218) note that “the financing deficit should normally be matched dollar for dollar by a change in corporate debt”, and as such, if the pecking order is followed by firms, then a slope coefficient of one results from a regression of net debt issues on financing debt. This prediction was strongly supported by results from a study by Shyam-Sunder and Myers (1999), using a sample of 157 which had traded continually from 1971 to 1989. However, it should be noted that this sample was relatively small, and consisted mainly of mature, public firms. Chen and Chen (2011) note that an assumption of the Pecking order theory is that there is no target capital structure.

The pecking order theory has been used widely to explain the financing decisions of organisations. One of its main advantages is that it correctly predicts the effects profits have (Frank and Goyal, 2009; Shyam-Sunder and Myers, 1999). However, there are some problems with this hypothesis. As Frank and Goyal (2003, 2009) observe, firm operations and their accounting structures are more complex than what is represented in the standard pecking order. Furthermore, contrary to what is usually suggested, Frank and Goyal (2003) report that internal financing is usually not enough to cover the average investment spending, and there is a heavy use of external financing among firms. They also note that the magnitude of debt financing does not overshadow equity financing. Additionally, while there is wide support for the pecking order theory among larger firms and in earlier years, with the increase in the number of small firms trading publicly, there has been a decline in the support for the pecking order hypothesis, as small firms tend not to follow the pecking order, leading to a shift in the overall average away from the pecking order (Frank and Goyal, 2003).

Nevertheless, the pecking order hypothesis still offers a useful explanation for the financing model followed by firms, especially larger firms. Some studies of the pecking order hypothesis will be discussed in the next section.

A COMPARISON OF THE PECKING ORDER HYPOTHESIS AND THE STATIC TRADE-OFF THEORY

Having discussed the Pecking order theory in detail, the static trade-off theory will be briefly discussed in this section, and a comparison made to show the differences between both.

The static-trade off theory acknowledges that firms aim to take advantage of the lower cost benefits borrowing offers, particularly the tax shield. However, at the same time, they are also hesitant to increase the financial risks which committing to contracts and making ongoing interest and capital repayments would involve. As such, the returns and cost benefits are traded off against the risks of financial distress from excess borrowing, and firms which have higher and more stable profits would likely operate at higher debt levels, as there would be a greater opportunity to shelter their profits from tax (Pike and Neale, 2009; Shyam-Sunder and Myers, 1999). Figure 1 below illustrates the static trade off theory of optimal capital structure.

FIGURE 1: THE STATIC TRADE OFF THEORY OF OPTIMAL CAPITAL STRUCTURE

Source: Shyam-Sunder and Myers (1999, p. 220)

For a value maximising-firm, benefits and costs would be equated at the margin, and it would operate at the highest point of the curve. For profitable, safe firms, which have higher taxes to shield and assets which would avoid relatively major damage to their asset values, the curve would top out at comparatively high debt ratios (Shyam-Sunder and Myers, 1999). Shyam-Sunder and Myers (1999, p. 220) note that this static trade off theory translates quickly to empirical hypothesis, it predicts that the actual debt ratio will reverse to an optimum or target level, and also predicts “a cross-sectional relation between average debt ratios and asset risk, profitability, tax status and asset type”.

As noted earlier, in the Pecking order theory, there is no target capital structure. However, from the explanation above, it can be observed that this is not the case with the static trade off theory, as it supposes an optimum/target capital structure. This is a key difference between the Pecking order hypothesis and the static-trade off theory. Myers (1984) observes that while in the static trade off there is a debt to value ratio target set by the firm, which it steadily works towards attaining, for the pecking order theory, there is no well-defined ratio of target debt to value, but instead, internal financing is used first, before debt, and then issuing equity, due to signalling issues associated with external funding and asymmetric information (Shyam-Sunder and Myers, 1999).

Hackbarth, Hennessy and Leland (2007) note that there is a debt ‘pecking order’ within the trade-off theory, with a preference for bank debt over market debt, as lower bankruptcy costs are implied. As such, small firms tend towards issuing privately placed debt, while larger firms are more prone to issuing market debt (Blackwell and Kidwell, 1988; Hackbarth et al, 2007).

While the static trade off theory places strong considerable emphasis on taxes and bankruptcy costs (Frank and Goyal, 2007), and the tax shield advantage of debt, the pecking order hypothesis does not really focus on this. However, this shield advantage is quite important, and as Chen and Chen (2011) report, based on their study of 305 Taiwanese electronic listed firms in 2009, large firms tend to take advantage of the tax shield which debt offers. They also point out that due to their lower information asymmetry and lower and more diversified risk, they tend to have relative advantages when raising finance from formal institutions. However, they note that firms still use internal capital to finance new projects, and turn to debt when internal capital is insufficient, in line with the pecking order hypothesis. This is also supported by Graham and Harvey’s (2001) survey of 392 chief financial officers. The results of the survey showed that the tax advantage of debt is seen as moderately important in making capital structure decisions, and for large companies in particular, this tax advantage was cited as ‘most important’.

A key point to note is that profitability, growth opportunities, asset structure and risk are key variables that influence the capital structure a firm adopts (Cassar and Holmes, 2003; Chen and Chen, 2011), and this could also possibly influence the model of capital structure firms appear to follow. The key variables influencing capital structure highlight another difference between both models, which is that while with the trade-off model, variances in an organisation’s leverage are driven by the costs and benefits of debt, with the pecking order theory, these are driven by the net cash flows of the firm (i.e. its cash earnings minus investment expenditures) (Fama and French, 2002).

A test of the static trade off theory and the pecking order hypothesis by Shyam-Sunder and Myers (1999) revealed that the pecking order model has a higher time-series explanatory power than the static trade-off theory. They note that it explains far more of the time-series variance in real debt ratios, rather than the static trade off theory’s target adjustment model. However, they also note that if a firm’s actual mode of financing adheres to the static trade off theory, then the pecking order hypothesis can be rejected, while in contrast, the static trade off theory appears to work when the financing model follows the pecking order as described earlier. Shyam-Sunder and Myers (1999) therefore state that while the pecking order offers a better initial explanation of firms decisions regarding debt-equity (particularly for mature, public firms as used in the sample of their study), the evidence for a definite optimum debt ratio as predicted by the trade-off theory is questionable.

In a test of the pecking order hypothesis and the trade-off theory using a cross-section of the largest listed firms in China, using three models: the determinants of leverage, the relationship between leverage and dividends, and the determinants of corporate investment, Tong and Green (2005) reported the following results: For the relationship between leverage and profitability, a significant negative correlation was observed, and a significant positive correlation was found for the relationship between current leverage and past dividends, both of which showed more support for the pecking order hypothesis over the trade-off theory. However, the results of the third model, corporate investment determinants, were not conclusive. Nevertheless, their conclusion was that the results tentatively supported the pecking order hypothesis in explaining how Chinese companies make their financing decisions. Studies by Myers (1984) and Fama and French (2002) show a lack of a positive correlation between profits and debt, and the researchers view this as a problem with the trade-off theory. Fama and French (2002) note that while the dividend pay-outs for firms which have higher profit levels and firms with fewer investments is higher, in line with predictions of both models, they note that firms which are more profitable are less levered. This is in line with the pecking order hypothesis, but contradicts the trade-off model. They further note that in line with the predictions of the pecking order model, short-term variances in investment and earnings are mainly covered by debt.

CONCLUSION

This essay has examined the pecking order hypothesis and how it explains the capital structure of firms. Its advantages and some of its drawbacks were also highlighted. It was subsequently compared with the static trade off theory, and the differences between both were pointed out, such as the proposition of an optimum/target capital structure, the focus on taxes and bankruptcy costs, and the factors which drive an organisation’s leverage. Tests of both theories highlight some of their strengths as well as their weaknesses, and it was noted that certain other factors, such as firm size, profitability etc. can also determine the explanatory powers of both models.

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One of the most significant contributions to the investment community has been Markowitz’s modern portfolio theory (MPT) and its foundations in risk return trade-offs and international asset diversification. The growing dependency of Emerging market countries on the US for its stable currency and export sales among other factors has increased their dependence on US markets for their GDP and market growth. This has caused a reduction in the diversification benefits in the Emerging markets. This paper will examine the various empirical evidence on emerging markets diversification and will also construct a portfolio to assess whether investment in these markets still provide benefits.

MPT is based on two key principles of investing, namely that an investor will seek to maximise expected return whilst also minimising risk. Its risk is measured by its standard deviations of returns around expected values. By considering “the expected return of each investment in relation to the impact that it has on the risk of the overall portfolio,” (Litterman (2004) p. 12) An investor can prevent weaknesses in one asset class from reducing the portfolio’s overall return. Therefore a portfolio that is invested in a range of industries or asset classes is more diversified against risks that may affect only one asset class. (Crescenzi (2008) p. 141) The implication is that portfolios are constructed with a rate of return equal to the weighted average rate of return of the holdings and yet its risk will be less than the weighted average return of the portfolio. (Litterman (Ibid) p.14)

Recent developments in Exchange Traded Funds (ETFs) and mutual funds have allowed investors to be invested across a range of markets and countries without being exposed to the potentially large risks of any one internationally traded company. (Crescenzi (Ibid) p.141) More specifically, Index ETF, such as those of iShares, which are designed to closely follow their relevant indices whilst being internationally invested. (Barclays (Ibid) p. 2)

MPT also demands investment in asset classes that correlate as little as possible with each other, as measured by their covariance. In fact, the covariance should be less than one in order to reduce the risk in the portfolio. Asset returns that have covariance equalling one are highly dependent on each other and a covariance of zero means they are independent of each other. Covariance is calculated by multiplying the correlations by the variances of their returns. (Litterman (Ibid) p. 12) A portfolio’s overall risk in relation to its benchmark is measured by its beta. A portfolio with a beta of 1 is has a volatility that is equal to that of its index, whereas a beta greater than one will have greater volatility than the index and is likely to achieve returns greater than the index. It is calculated by dividing a portfolio’s covariance with the index by the index’s variance. (MacKay Shields (2003) p.2)

Mean variance approach

MPT’s mean variance approach demonstrates efficient combinations of high expected returns with a specific level of risk. Any portfolios that exist below the frontier are considered inefficient because they are earning lower returns for the same amount of risk in comparison to those on the frontier. Unfortunately, this is difficult to apply in reality because it requires the use of an optimiser which is based on the calculation of expected returns to arrive at weights. The resulting weights are often considered extreme and inappropriate and the actual calculation of expected returns is also considered difficult to obtain, with the closest and most widely available data being historical returns. Additionally, the approach requires investment in the entire universe of stocks however oftentimes fund managers seek to create portfolios which are invested in a small universe, to attract local investors. (Zimmerman (Ibid) p. 282-262)

Another concern is the models static nature which requires action once the initial allocation of wealth to the securities is made, until the investment horizon is reached. The dynamic nature of stock markets and the wide ranging risks that underline them can greatly impact asset returns, making it crucial for the profitability of an investor to continually rebalance their portfolio according to changes in them. (Korn (1997) p. 12)

Empirical Evidence of Emerging Markets Diversification

There is extensive empirical evidence to support Markowitz’s theory that investment across the globe reduces portfolio risk levels. Cumby and Glen ((1990) cited in Aiello and Chieffe (1999) p. 29) find superior returns are gained by internationally diversified investment funds. Divecha, Drach, and Stefek ((1992) cited in Aiello (Ibid) p. 29) show more specifically that investment in the Emerging markets is likely to reduce a portfolios total risk. Moreover, Masters ((1998) cited in Aiello (Ibid) p. 29) recommend allocate of at least 6 percent in the Emerging markets, to benefit from the rapid economic growth in the region. Speidell and Sappenfield ((1992) Aiello (Ibid) p. 29) maintain that developed countries, unlike emerging markets, move in close tandem with each other and therefore provide less diversification.

A study by Aiello and Chieffe also finds that diversification in the Americas Free Index provides the lowest standard deviation of returns. However, Aiello also notes that the Emerging markets are characterised by high volatility due to asset and sector concentrations, small markets, insider trading and poor information. (Aiello (Ibid) p. 34)

Constructing the Portfolio

Initially a portfolio comprised of solely developed countries will be constructed using index ETFs. iShares Morgan Stanley Country Indices (MSCI) will be used for the purposes of this paper. Initially an assessment of the regional ETF index risk and returns will be made from which individual countries will be selected for investment. A portfolio of developed countries will first be selected followed by a selection of Emerging market countries to assess their impact on the portfolio’s overall risk and return. The period of investment which will be used for the construction of this portfolio will be 2nd January 2009 to 13 March 2009. Unfortunately, access to iShares MSCI data is limited to between 2008 and 2009 for the majority of countries which is insufficient given the significant downturn in the global economy. A time horizon of one year would not highlight the potential benefits, if any, of investing in the Emerging markets. Ideally a two or three year time horizon would be more appropriate.

The above table shows the various Index ETFs by global regions and their corresponding returns, standard deviations, variances and covariance. In comparing the returns it can be seen that the Emerging markets (-8.20%) and Latin America (-3.30%) had the best returns in comparison to Europe (-24.9%) and USA (-18.9%). However, these are also accompanied by high variances relative to developed countries. Covariances between the U.S. and other regions are all under unity and therefore have low dependency in their relationships. The Latin American and Emerging Markets regions proved to have the greatest covariances with the U.S. and therefore have the greatest dependency on American markets for their own performances. This is likely to due to their currencies being pegged to the US dollar and their strong dependency on export sales to the US.

Despite the higher risks associated with investment in the Emerging markets their returns are worthy of investment to diversify a global portfolio. Therefore investment in the Emerging markets will be added to the portfolio. Given the high dependency of Latin American markets on the US, this market will not be included in the portfolio.

Of the developed countries, those with covariances with the US, greater than 0.0007, such as Australia and France will not be included. The remaining countries: US, Canada, UK, Japan and Germany remain for consideration.

The choice of weights invested in the portfolio will depend on their individual risks and returns. The portfolio weights will reflect the risk averse nature of the investor. As can be seen from the table above, Japan and the US have the lowest risk levels but their returns vary greatly being -18.6% and -26.3% respectively. Additionally, the US and UK have similar returns and yet the former has a much lower variance and will not therefore be included in the portfolio. Similarly Germany has a slightly greater risk compared to Canada but with half the return, there is therefore no reason to invest in Germany.

The US and Canada have the highest returns with the US having the lowest standard deviation. It will therefore have a 50 percent weight in the fund leaving Canada 40 percent weight. Whilst Japan has the lowest return it also has the worst return of the three and therefore will have the smallest weight of 10 percent. Since the portfolio is made up of mostly the US index and is not greatly diversified internationally the most appropriate benchmark will be the S&P 500.

The portfolio return for the year to date comes to -16.7%, calculated by summing the weights of each country index multiplied by their returns, thereby outperforming the index by less than 3%. The portfolio beta is 1.01, calculated by dividing the portfolio covariance with the index, by the variance of the S&P500. The portfolio beta being marginally greater than unity implies it is slightly more volatile in comparison to the index, due in large part to the Japanese weighting.

Investing in the Emerging Markets

Given that the Emerging markets have been shown empirically to provide greater diversification benefits and are recommended by the MPT this region will also be considered for investment.

Choosing a set of Emerging market index ETFs will begin by taking out those with the highest covariances with the S&P 500, namely South Korea and South Africa. Taiwan has the strongest return with a risk level, as measured by its variance and standard deviation, close to that of Hong Kong and Singapore. It will therefore have a high weight in the Emerging Markets portion of the fund. Singapore’s returns is the lowest with an almost equal risk level to the other countries, therefore it will not be considered for investment. Malaysia whilst it has a slightly lower return does have the lowest risk level. This is likely to be due to its much more developed stock market and more stable political environment and will help to diversify the region’s risk level in the portfolio. The remaining countries are Taiwan, Hong Kong and Malaysia.

In considering weight allocations countries with low standard deviations, such as Malaysia (50%) will be given greatest weight. Taiwan and Hong Kong have only slightly differing variances but very different returns and therefore their weights, 10% and 40% respectively, will reflect Taiwan’s greater return. The combined return of these three countries is -6.8% which against the MSCI Emerging Markets Index, outperformed by 1.4%. Their combined beta is 0.60, half the volatility of the index. Moreover, its covariance with the S&P 500 is only 0.00051, making it very independent of the US market.

Given the positive returns, low risk and low dependency on the US market, the Emerging markets will be given a weight of 30% in the original developed countries portfolio. This improves the original portfolio return from -17% to -2% which against the S&P 500 benchmark, outperforms by over 16%, during one of the most tumultuous market downturns in recent history. Although the standard deviation of the new internationally diversified portfolio is the same, its beta is 0.90 and covariance is 0.0006 making it very independent of the US market.

Ongoingly investors must assess the risk and return of any of the country index ETFs that he or she is invested in, rebalancing the portfolio accordingly. Factors such as political unrest, financial fraud, poor macroeconomic management and manufacturing can all greatly increase country risks and reduce their returns.

Conclusion

This paper set out to assess whether the Emerging markets still have diversification benefits on a portfolio’s return and risk levels. The various empirical literature examined in the paper conclude that the Emerging markets do still add to portfolio diversification. The portfolio that was constructed also demonstrates the added benefits of investing in these markets to its performance.

Some of the limitations of this paper include the relatively short time frame chosen for the model portfolio. A period of two to three years would have been more ideal. Middle Eastern ETF representations were limited to only Israel and Turkey and therefore did not provide a reasonable representation of Emerging markets in the Middle East.

Bibliography
Aiello, S. and Chieffe, N. (1999) International index funds and the investment portfolio Financial Services Review 8, p. 27–35
Barclays Global Investors (2009) An Introduction to iShares: Exchange Traded Funds, www.ishares.com
Barclays Global Investors, (March 2009) iShares Products http://us.ishares.com/content/stream.jsp?url=/content/repository/material/product_expense_ratio_report.pdf&mimeType=application/pdf
Crescenzi, A. (2008) Investing From the Top Down: A Macro Approach to Capital Markets, McGraw-Hill Professional
Korn, R. (1997) Optimal portfolios: stochastic models for optimal investment and risk management in continuous time, World Scientific
Litterman, B. (2004) Modern Investment Management: An Equilibrium Approach, Quantitative Resources Group, John Wiley and Sons
MacKay Shields (2003) Managed Accounts: Modern PortfolioTheory, MacKay Shields Investment Management LLC
Zimmermann, H., Drobetz, W. and Oertmann, P. (2003) Global Asset Allocation: New Methods and Applications, John Wiley and Sons
iShare ticker symbols and index information sourced from iShares.com
Historical prices from which data was calculated was sourced from yahoo.com/finance

This work was produced by one of our professional writers as a learning aid to help you with your studies

INTRODUCTION

Corporate governance typically describes the way corporate power is exercised within business organisations. Good corporate governance practices are typically defined in terms of practices, processes, and sound economic performance (Turnbull 2010).

The present report examines the implementation of sound corporate governance management practices in William Hill, a U.K. sports betting company. Particular attention will be paid to the practices and processes prescribed by the Corporate Governance Code (2014), the leading template for good corporate governance practices in the U.K. The goal of this report is to enlighten Institutional Investors as to a potential investment in the company.

BRIEF COMPANY BACKGROUND

William Hill is a global sports betting and gaming company, and one of the most trusted brands in the sports gaming industry. According to the company’s latest available key financial statistics, total revenue ascends to ?1.61 billion, gross profit is ?1.32 billion, while EBITDA is ?385 million (Yahoo Finance 2015a). The company’s EBITDA is revealing as to the company’s financial soundness.

The above-mentioned sound financial statistics are clearly reflected in Figure 1 (Yahoo Finance 2015b), which depicts the 5-year stock price trajectory of William Hill. The company’s share price has almost tripled in value since January 2011. Notwithstanding, it should be pointed out that, for the sub-period between 2011 and 2013, the stock price soared; whereas, for the period 2013-2015, the stock price is relatively stable, which might point to the existence of impending regulatory shifts conditioning a potential demand weakness for its gaming products (e.g., the company is currently being affected by a significant decrease in profits accruing from gaming machines, in view of tougher gaming regulation (The Economist 2014)).

Figure 1: Stock Market Price of William Hill (5-year chart)

Source: Yahoo Finance; 5-year stock market prices (closing prices ?)

WILLIAM HILL: A CORPORATE GOVERNANCE ANALYSIS

The present section focuses on the following main five (5) topics of analysis that are relevant to the William Hill, where a more thorough examination of its corporate governance structure and practices are concerned. The first topic addresses the composition of the company’s Board of Directors (“Leadership”); the second topic refers to the company’s governance structures and Boardroom Practices (“Effectiveness”); the third focuses the reporting to shareholders and/or external audit procedures (“Accountability”); the fourth topic refers to the pay level of the company’s Directors and Senior Executives (“Remuneration”); finally, communications and relations with shareholders are also examined (“Relations with shareholders”). These topics are quite crucial to our assessment pertaining to the implementation of effective and sound governance procedures and mechanisms at William Hill.

Leadership – The Board of Directors

William Hill’s Board of Directors is composed of nine Board members (7 men and 2 women). The current Chief Executive Officer (CEO) is Mr. James Henderson, who heads “the Group’s overall strategic direction, the day-to-day management and profitability of the Group’s operations”(Hill 2015a). Mr. Henderson possesses extensive industry experience, having climbed the company’s corporate ladder through his appointment through several company roles. Moreover, the company’s CEO is seconded by the Mr. Neil Cooper, the Group’s Finance Director. Mr. Cooper possesses extensive finance experience, having performed various roles outside the Group. The Board is also composed by the Chairman, Mr. Gareth Davis, who is responsible for the company’s best corporate governance practices. Finally, the Board is also composed of a set of five independent non-executive Directors and a Company Secretary. The company had, in 2013, a number of female Board members compliant with best practices associated with fair gender treatment at the Board level (The Guardian, 2013). However, in the current year, the number of female members seems to have fallen below best industry practices (Tonello 2010), but care should be taken to further increase the percentage of women on Board beyond the prescribed legislation (according to U.K.’s Governance Code, that minimum percentage should equal 25% of women on Board). This might be a temporary setback, but it currently stands as a non-compliance issue (Financial Reporting Council 2014).

The above-mentioned corporate governance structure is compliant with the best practices currently being promoted in the UK, in strict accordance with the UK Corporate Governance Code of 2014 (Financial Reporting Council 2014). The Board’s composition seems to ensure that compliance with the Code is adequately assured. For example, there is a clear division of corporate responsibilities within William Hill, with no function overlap nor unfettered powers of decision held by any specific Board member. Moreover, the percentage of ‘outside’ Directors ensures proper oversight.

Effectiveness – Governance and Boardroom Practice

According to Tricker (2012), there are a number of factors that decisively influence the effectiveness of a company’s governance, the most relevant of which are related to the necessary skillset of the top management team, as well as functional flow of both internal and external communications with stakeholders.

On both counts, William Hill possesses the necessary requisites in order to comply with the outlined good practices of governance. As previously described, the company’s composition is quite diversified and experienced so as to effectively pursue the company’s ambitious goals (the previous section describes in more detail the profiles pertaining to the main Board members); at the same time, the inclusion of non-executive Board members vis a-vis the executive members clearly points out to a proper balance of powers within the sports betting group. That is, good governance practice dictates that ‘inside’ (i.e., executive) vs. ‘outside’ (i.e., non-executive) members co-exist, so that the latter typically do not possess a previous link to the company which might jeopardise their autonomous and independent business judgement.

On the other hand, the flow of information to outside investors seems to be quite proficient, most notably where the structure of communications through the Internet and social media is concerned. For example, the company’s website provides accurate and in-depth details pertaining to the company’s governance structure, balanced Board composition, the company’s articles of association and the company’s latest available annual accounts (for 2014), and the professional details of the company’s auditor and corresponding Annual Report and Accounts. Online transparency seems to be a major company policy, which thus sustains the argument in favor of an effective and balanced governance practice (Hill, 2015b).

It is hoped that this strategy of good corporate governance might also be applicable to the case of institutional investors, who typically require a greater insight into the company’s operations and accounts, information which is normally not available online. This topic might be of importance in the subsequent investment decision making process of institutional investors, insofar as this class of investors typically undertakes a significant proportion of equity into the company and require detailed company information. A major caveat associated with this report concerns the fact that such a subsequent investment position assumed by the institutional investor might be less positively construed by the company’s current management (i.e., it might be seen as a potential takeover of William Hill).

Finally, a formal and rigorous annual evaluation of the company’s top management team is also regularly conducted. The Report on Corporate Governance reveals that good corporate governance is linked to the performance of William Hill. The measures ensuring good corporate governance at the company, in compliance with the U.K. Governance Code, are the following: the induction of Board members through a bespoke program; Board members have full access to all the required information about the company; the Board members are subjected to re-election at least every three years (conditional on effective performance); and the Nomination Committee ensures the nomination for the Board constitutes a transparent process (Hill 2015c).

Accountability – Reporting to Shareholders /External Audit

The Financial Reporting Council prescribes that a truly effective corporate governance structure relies on a number of components, namely: accountability to shareholders and their rights; the full availability of information pertaining to the company’s performance and corresponding governance framework; finally, an ethical framework supporting a certain type of irreproachable behavior pattern by the companies, as evinced by either codes of conduct or statutes. In this respect, a distinction is maintained between the law as a stalwart of basic standards of conduct and corporate transparency and statutes or codes that are more efficient in encouraging best governance practice (Financial Reporting Council 2011).

Accordingly, William Hill’s website provides accurate and timely information to existing and prospective shareholders. This information is quite detailed in the ‘Investors’ area of the company’s website, a fact that reveals the company’s concern with upholding best governance practices. On the other hand, full details pertaining to the company’s auditor has also been properly disclosed, as well as the company’s latest accounts (Hill 2015c).

Remuneration – Directors and Senior Executives

The company’s levels of remuneration to top executives should be sufficiently attractive to attract, retain and motivate Board members with the necessary quality to manage the company successfully. Simultaneously, the pay level should not be substantially above current market prices. A further point concerns the fact that the latter pay level should be adequately linked to both corporate and individual performance (Tricker 2012).

Furthermore, pay levels should be subjected to a transparent and formal procedure, so that the executives involved are not directly responsible for deciding his or her remuneration.

According to publicly available information on this topic, the remuneration level of the leading Board members is available through the ‘Directors Remuneration Report’, which has been included in the company’s annual accounts for the latest year. A detailed breakdown of the accrued remuneration benefits is explicitly detailed in the report. This practice of publicly divulging remuneration levels of William Hill’s top management is quite compliant with U.K.’s best governance practices. Moreover, the remuneration decision process, although somewhat complex, is fully transparent as the existence of mechanisms that ensure that the pay level is not determined by the interested party, and is effectively linked to individual performance (Hill 2015c). A potential area of non-compliance resides in the fact that the ‘Remuneration Report’ does not fully disclose the remuneration levels for all the Board members, as well as in the fact that the disclosure of remuneration information pertaining to its CEO, although explained, is not entirely formulated in a simple and effective manner.

Relations with Shareholders

Effective governance practices dictate that relations with shareholders should be adequately based on the mutual understanding between the company’s top management and the heterogeneous set of interests pertaining to existing shareholders. Moreover, a transparent process of communications between these two structures should also be implemented, properly taking into account the pursuit of the company’s organisational goals (Tricker 2012).

According to publicly available information, The Board remains strongly committed to maintaining good relationships with external investors, through constant dialogue, presentation of financial results, and adequate availability of top management to discuss governance issues, thus indicating efficient governance procedures (Hill, 2015d).

RECOMMENDATION

Global demand for gaming products is typically growing, as the popularity of both gambling and online entertainment continues its expansion at a truly global level. This global expansion should stand to benefit William Hill, and its long-term growth expansion. There are, however, two caveats (KPMG 2010) that warrant an investor’s attention.

First, the online gaming market is undoubtedly a very attractive area of expansion for software developers, casinos and other land-based gambling operators, related suppliers, and industry newcomers and investors alike. This might increase a given company’s operating costs, dragging down future growth, as competitive pressures increase in the industry.

Second, there are several quite unpredictable political and legislative hurdles in place in many countries, and those obstacles might also condition future global growth. Nevertheless, online gaming seems to have a promising foothold in many European markets. Under this perspective, an investment in William Hill is also an investment into the future of online gambling, and the risk-return payoff might be quite interesting from a financial point of view. The online gaming industry thus possesses enormous growth potential, especially in advanced markets such the U.S. and the U.K.

Notwithstanding, an impending ethical governance issue within the company might be linked to the allegations that the company might be exploiting addicted gamblers, by further enticing them through the advertisement of credit services to problematic gamblers (news.co.au 2015). This might pose a serious legal risk that might ultimately result in the dampening of growth and should be vehemently addressed through the implementation of adequate governance procedures.

The present report sustains that an institutional investment in William Hill is thus justified by the company’s sound and promising financial standing, the existence of proper mechanism that ensure that effective and robust corporate governance procedures and mechanisms have been properly implemented, and, ultimately, by the very buoyancy of the sport gaming industry in advanced economies.

CONCLUSION

In view of the analysis provided by this report, it is our assessment that William Hill is quite compliant with the UK Corporate Governance Code of 2014 (notwithstanding the fact that some issues pertaining to the process of effectively communicating remuneration levels to interested external stakeholders should be made more transparent and the number of female members to the Board should be increased). Finally, an investment decision by our institutional investors should be pursued, taking into consideration the company’s financial soundness and its medium to long term growth prospects, notwithstanding the existence of impending regulatory issues that might condition the global growth of the sports betting industry.

REFERENCES
Hill, W., 2015a. Board of Directors [Online]. Available: http://www.williamhillplc.com/about/board-of-directors/
Hill, W., 2015b. Board and Governance. [Online]. Available: http://www.williamhillplc.com/investors/board-and-governance/
Hill, W., 2015c. William Hill Plc Annual Reports and Accounts 2014. [Online]. Available: http://files.williamhillplc.com/media/1832/2014-final-results-accounts.pdf
Hill, W., 2015d. Shareholder engagement. [Online]. Available: http://www.williamhillplc.com/investors/board-and-governance/shareholder-engagement/
Financial Reporting Council, 2011. Effective Corporate Governance. [Online]. Available: https://www.frc.org.uk/FRC-Documents/FRC/FRC-Effective-Corporate-Governance.aspx
Financial Reporting Council, 2014. The UK Corporate Governance Code. [Online] Available: https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Corporate-Governance-Code-2014.pdf
KPMG, 2010. Online Gaming: A Gamble or a Sure Bet? [Online] Available: http://www.kpmg.com/EU/en/Documents/Online-Gaming.pdf
News.co.au, 2015. William Hill offers customers $1000 credit. [Online]. Available: http://www.news.com.au/finance/money/william-hill-offers-customers-1000-credit/story-e6frfmci-1227286743077
The Guardian, 2013. FTSE 100 companies still 66 female directors short of boardroom target. [Online]. Available: http://www.theguardian.com/business/2013/oct/07/female-directors-boardroom-target-business-cable
The Economist, 2015. A risky business. [Online]. Available: http://www.economist.com/news/britain/21598671-gambling-machines-are-controversialand-increasingly-unpopular-risky-business
Tonello, M., 2010. Board Composition and Organization Issues. In: Baker, H.K. and Anderson, R., eds. Corporate Governance: A Synthesis of Theory, Research, and Practice. United States: John Wiley and Sons Inc., pp. 195-223.
Tricker, B., 2012. Corporate Governance. Principles, Policies and Practices. Second edition. United Kingdom: Oxford University Press.
Turnbull, C.S.S., 2010. What’s Wrong with Corporate Governance Best Practices?. In: Baker, H.K. and Anderson, R., eds. Corporate Governance: A Synthesis of Theory, Research, and Practice. United States: John Wiley and Sons Inc., pp. 79-96.
Yahoo Finance, 2015a. Key Statistics. [Online]. Available: https://uk.finance.yahoo.com/q/ks?s=WMH.L
Yahoo Finance, 2015b. Basic Chart. [Online]. Available: https://uk.finance.yahoo.com/q/bc?s=WMH.L&t=5y&l=on&z=l&q=l&c=

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Introduction

Power Up Plc is planning to set up a new power plant. The company has three options to choose from – gas power, nuclear energy or renewable energy power plant. This report analyses the financial viability of the three options by using the net present value method. The net present value is one of the most scientific methods for capital appraisals as it discounts the future cash flows. The results from the net present value method are also compared with three other capital appraisal methods – discounted payback period, accounting rate of return and internal rate of return methods. All calculations are based on the data provided in the case.

The capital appraisal methods are based on projected cash flows and discount rates and hence any changes in their values can have a significant impact on the value of a project. The report also discusses other information that would help in finalising one of the options as a preferred one.

Capital Appraisal

The net present value is one of the preferred capital appraisal methods as it gives the absolute net value of a project to a company. The net present value method discounts the future cash flows of an investment by its discount rate. The discount rate is based on the risk of the project and gearing ratio.

According to the Capital Asset Pricing Model, the expected return on equity is given by the following formula (McLaney, 2009, p. 199).

Expected return on equity = Risk-free return + Beta*(Market return – risk-free return)

The gilts (T-bills) have the lowest risk as it is backed by the government and is as good as risk-free. The return on gilts is taken as the risk-free return.

The Weighted Average Cost of Capital (WACC) is given by the following formula (Brealey & Myers, 2003, p. 389).

WACC = Rd*(1-T)*(D)/(D+E) + Re*(E/D+E)

Where

Rd = Return on debt
T = Taxation rate
Re = Return on equity
D = Value of debt
E = Value of equity
D/(D+E) is the gearing ratio of a company.

The expected return on equity and WACC calculations for the three options are shown in the table I. They are based on the data provided.

Table I – Cost of equity and WACC

The cost of equity is highest for the nuclear power plant because of its high beta. Even though the WACC of nuclear and renewable energy options are more than that of the gas plant option the differences are significantly less as compared to the differences in cost of equity. The high equity costs of the nuclear and renewable energy options are countered by their high gearing which limits the increase in the WACC due to lower cost of debt and tax deductibility of interest rates.

The net present value calculations for the three options are based on the following common assumptions:

The power plant starts operations at the beginning of the 4th year.

The direct, and licensing and ancillary revenues are increased annually by the rate of inflation. As an example, the revenues in the 4th year are calculated by compounding four times the current revenue estimates with the annual inflation rate.

All yearly clean-up costs are also increased by the annual inflation rates to take into account the likely increase in costs over years.

The depreciation is taken into account from the first year to spread the total cost of the project over the 25 years period.

It is assumed that the company will raise the full cost of loan in the first year itself and hence the interest costs are assumed from the first year itself.

The annual interest costs calculated by multiplying the total building cost and debt rate are more than the annual interest costs given in the case for the gas power and renewable energy plants. The annual interest costs given in the case are used for the net present value calculations assuming that the company will use debt less than 100% of the building cost in these options.

The annual capital allowance is 10% of the total building cost of the power plant. The capital allowance is used from the 4th year onwards when power plant starts operations.

The appendix I and II shows the profit and loss, and net present value calculations of the gas power plant option. The actual tax is calculated on the basis of the capital allowance as accounting depreciation is not recognised by the taxation authorities for income deductibility. The net cash flows in the appendix II are discounted by the WACC (10.72%) of the gas power plant option. The net present value of the gas power plant is ?1,636 million. The positive net present value of the power plant indicates that the firm’s value will increase by this amount if the project is run successfully over 25 years as per the projections.

The appendix III and IV shows the profit and loss, and net present value calculations of the nuclear power plant option. The WACC used for discounting the nuclear power plant cash flows is 12.10%. Even though the cost of equity for the nuclear power plant option is significantly higher than the equity for the gas power plant, the increase in the WACC is limited by the higher gearing of the nuclear power plant. The net present value of the nuclear power plant is ?1,062 million. This is ?574 million lower than the net present value of the gas power plant. Even though the nuclear power plant adds value to the firm, the gain is significantly lower than in the gas power plant. Hence the gas power plant is favoured over the nuclear power plant in the net present value capital appraisal method.

The appendix V and VI shows the profit and loss, and net present value calculations of the renewable energy plant option. The net cash flows in the appendix VI are discounted by the WACC of 11.05%. The net present value of the renewable energy power plant is ?1,052 million. This is similar to the net present value of the nuclear power plant but significantly lower than the gas power plant.

The gas power plant has the highest net present value among the three options and hence it is the preferred option under the net present value option. But the projections are based on a number of assumptions and these should be thoroughly checked before finalising the option. As an example, the net present value relies on the cost of capital which may not be simple to calculate in situations like varying inflation rates (Howe, 1992, p. 34).

The net present value is one of preferred capital appraisal methods as it gives the absolute value addition by a project. But there are other methods also which are less complex and need lesser calculations. They are used by managements for quick assessment of investments. The three other capital appraisal methods used for evaluating the power plant options are discounted payback period, accounting rate of return and internal rate of return.

The discounted payback period method calculates the period in which the cumulative discounted future cash inflows equal the discounted initial investment. Some companies use payback period method but the discounted payback period method is better than the payback period method as it discounts the future cash flows. If the cumulative discounted cash flows of the proposed investment turn positive in the year ‘n’, then the discounted payback period is given by the following formula. .

Discounted payback period = (n-1) years + (-Cumulative cash shortfall at the end of (n-1) year) / (Net cash flows in the year n)

Discounted payback period gives a quick assessment of the time when a company will receive back the cash invested in a project. But the discounted payback period method ignores all cash flows after the cut-off date (Brealey & Myers, 2000, pg. 97). Ignoring cash flows after the discounted payback year may result in opting for an option that would add lower value to the shareholders.

Accounting rate of return is the ratio of the average accounting profit over the duration of a project to the average investment. Average investment is calculated as the average of the initial investment and final value of investment at the end of the project. As the full value of all three power plants is depreciated by the end of the project, the final value of the investment is 0.

The internal rate of return gives the discounting rate at which the net present value is 0. It gives a quick measure of the return rate as compared to the cost of capital. Also it gives a measure of how much cost of capital can change before the project value becomes 0. But it has its limitations too as it does not take into account the scale of investment (Chang & Swales, 1999, p.133).

The appendix VII shows the gas power plant values in the above mentioned three capital appraisal methods. The investment in the gas power plant will be recovered in 5.84 years. As the period is less than the project life, the project is approved under the discounted payback period method. The option also has a very high accounting rate of return of 93.71%. The internal rate of return for the gas power plant is 33.77% which indicates that the cost of capital can increase substantially before the net present value of the project will become 0.

The appendix VIII shows the capital appraisal values of the nuclear power plant. The investment in the nuclear power plant will be recovered in 13.22 years, lower than the life of the project but higher than the gas plant. The accounting rate of return and internal rate of return are 18.72% and 16.25% respectively. The lower internal rate of return indicates that there is little scope for the cost of capital to increase before the net present value of the project will become 0.

The appendix IX shows the results of the three capital appraisal methods for the renewable energy option. The results are similar to that of the nuclear power option with even lower safety of margin in the internal rate of return.

The results of three capital appraisal methods also favour the gas power plant followed by the nuclear and renewable energy plants.

The external consultant has highlighted the varying degrees of risks associated with three alternatives. Nuclear power plants are regarded as higher risk than a gas or a renewable energy plant due to the potential losses if things go wrong. Any leakage or explosion in a nuclear plant can release hazardous radioactive particles that can cause severe damage to human lives and environment. The damage in a gas power plant explosion is likely to be less severe and even lower in a renewable energy option. But the risk factor is not extremely high in nuclear power plants as demonstrated by the successful operation of a large number of nuclear power plants across the globe.

The higher beta and expected rate of return for equity reflect the higher operational risks associated with the nuclear plant and renewable energy options, and also higher gearing risks. The operational risks are included in the discount rates for different options. The beta of Power Up with the nuclear plant option is 1.5 as compared to the beta of 0.8 with the gas plant option. The cost of equity in the nuclear plant option at 20.8% is significantly more than the 12.8% for the gas plant option to reflect higher commissioning risks of a nuclear plant. The beta for renewable energy option is also higher than the gas power option because of delays faced in regulatory approvals in setting up a large scale renewable energy project.

Partial increases in the equity returns of the nuclear and renewable energy options are due to increases in the gearing ratio. The return on equity increases with the increase in debt-equity ratio (Miller, 1988, p. 100). But the fact that nuclear option has a higher equity rate than the renewable energy even though it has lower gearing indicates that operational risks are included in the discount rate.

Also the rates of debt for both nuclear and renewable power plants are higher than the gas power plant which reflects the higher bankruptcy fears due to high gearing (Brealey & Myers, 2000, p. 482). The inclusion of different operational and financial risks in higher discounts rates means that there is no need to further increase the discount rates.

The above capital appraisal of the three options is based on certain assumptions which should be verified before making a decision. First, the net present value of the gas power plant is highly dependent upon the gas prices in the future. The net present value calculation assumes that the gas prices will grow at the 3% rate of inflation. But gas supplies are limited because they are non-renewable. The growing demand of electricity and power across the world, especially from developing countries like China and India has increased oil prices in the recent years (Dolbeck, 2008, p. 1). It is also likely to impact gas prices. Hence it is important to check the likely gas prices over a long-term with well-established institutions that are focused on trekking and projecting oil and gas prices.

Second, the weighted average cost of capital method assumes that the company is going to maintain same debt-to-equity ratio during the duration of the project (Massari et al., 2007, p. 153). It is most likely to change as the company generates profits and possibly invests in other projects. The future debt-to-equity ratios for the company should be checked with the finance department. If changes in the gearing ratio do happen over the period of the project then they should be reflected by using an appropriate capital appraisal method like the adjusted present value method.

Third, a significant part of revenues is to be generated from licensing and ancillary activities. This needs to be analysed in view of the government’s policies on climate change. The possibility of decline in gas power plant licensing and ancillary revenues in the medium to long-term future should be analysed and appropriate impact in terms of future cash flows should be built in the capital appraisal model.

Fourth, the gearing ratio of the gas power plant option is half or lower than half of the gearing ratios of the nuclear and renewable energy options. Modigliani and Miller (1963, p. 434) showed that the value of a firm increases with increase in debt due to tax benefits of interest. Hence it would be useful to check with the corporate finance department of the company the reason behind the low gearing ratio for the gas option.

Conclusion

The capital appraisal methods – net present value, discounted payback period, accounting rate of return and internal rate of return – favour the gas power plant over the nuclear and renewable energy plants. But the calculations are based on certain assumptions which should be thoroughly vetted before finalising the option. Any changes in revenues and/or costs will have an impact on the results of the capital appraisal methods.

Personal learning

The exercise to evaluate three power plants has increased my personal knowledge in the field of corporate finance. The things learnt in this module and as well as things learnt previously were reinforced during the analysis of this case study.

First, the cost of debt increases with the degree of gearing as lenders take more risk and debt assumes some of the characteristics of equity. At higher gearing levels, the lenders are exposed to more risk and have lower safety of margin. This is evident as the cost of debt in the renewable energy option is more than the cost of debt in the nuclear energy option due to higher gearing. The variation in the cost of debt across the three options is also in line with the Modigliani and Miller proposition II that states the cost of debt remains constant during the initial increases in gearing but then increases to reflect higher risks and bankruptcy costs (Brealey & Myers, 2000, p. 482). The cost of debt increases from 9% in gas power plant at 30% gearing to 10% in nuclear power plant with 60% gearing, a 1% increase in cost of debt when gearing increases by 30%. But the cost of debt then increases to 11% as gearing changes to 65% in the renewable energy power plant, same absolute 1% increase in the cost of debt when gearing increases by only 5%.

Second, the issue of new equity will result in dilution of earnings per share and would be a matter of concern for the management (Opler et al., 1997, pg. 21). This appears to be one of the reasons behind the higher gearing in both nuclear and renewable energy options as low gearing in these two options would result in issue of high amount of equity and significant dilution of earnings per share in the initial years of the investment.

Third, the net present value calculations depend on a number of factors and it is important to research them. As in this case, changes in gas prices in the future may dramatically impact the net present value of the gas plant but not of nuclear and renewable plants. Also, government regulations change over time and can impact values of a project. The focus on climate change may encourage the government to give more subsidies to renewable and nuclear plants in the future. This would put a gas power plant into disadvantage and the company may find it difficult to find buyers for its electricity. Hence such factors should also be taken into consideration before finalising an option.

Bibliography and references
Brealey, R. A. and Myers, S.C., 2000. Principles of Corporate Finance, 6th edition, Tata McGraw-Hill Publishing Company.
Brealey, R. A. and Myers, S.C., 2003. Capital Investment and Valuaion, McGraw-Hill Company.
Chang, C.E. and Swales, G.S., 1999. A Pedagogical Note on Modified Internal Rate of Return. Financial Practice & Education, Vol. 9, Issue 2, pp. 132-137.
Dolbeck, A., 2008. Valuation of the Oil and Natural Gas Industry. Weekly Corporate Growth Report, Issue 1473, pp. 1-12.
Howe, K.M., 1992. Capital Budgeting Discount Rates Under Inflation: A Caveat. Financial Practice & Education, Vol. 2, Issue 1, pp. 31-35.
Massari, M., Roncaglio, F. and Zanetti, L., 2007. On the Equivalence between the APV and the wacc Approach in a Growing Leveraged Firm. European Financial Management, Vol. 14, No. 1, pp. 152-162.
McLaney, E., 2009. Business Finance: Theory and Practice. Pearson Education Limited, 8th edition.
Miller, M.H., 1988. The Modigliani-Miller Propositions After Thirty Years. Journal of Economic Perspectives, Vol. 2, No. 4, pp. 99-120.
Modigliani, F. and Miller, M., 1963. Corporate Income Taxes and the Cost of Capital: a Correction. American Economic Review, Vol. 53, Issue 3, pp. 433-443.
Opler, T.C., Saron, M. and Titman, S., 1997. Designing capital structure to create shareholder value. Journal of Applied Corporate Finance, Volume 10, Number 1, pp. 21-32.

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The Budgeting Process and the use of Budgetary Information
Planning, Control & Budgeting

CIMA Official Terminology (2005) defines planning as: ‘The establishment of objectives, and the formulation, evaluation and selection of the policies, strategies, tactics and action required to achieve them. Planning comprises long term/strategic planning and short term/operational planning. The latter is usually for a period of up to one year.’

It further defines a budget as: ‘A quantitative expression of a plan for a defined period of time. It may include planned sales volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows.’

The above 2 definitions make the relationship between planning and budgeting relatively clear. A budget provides a numerical analysis of a plan. Planning can be both long and short term and budgets can cover the same timescales as the plan. However, longer term planning is generally both more aspirational and more uncertain as it requires significant assumptions to be made and this is equally reflected in longer term budgets.

CIMA also defined budgetary control as ‘The establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy, or to provide a basis for its revision’.In other words, budgetary control provides a measure by which objectives and assumptions can be verified and amended in order to improve business performance. The validity of the measure will only be appropriate if the budget setting process is appropriate and leads to a realistic budget given factors known at the time of preparation.

Gowthorpe (2011 p.359) recognised that ‘budgeting, for most organizations, is an important dimension of the processes of planning, controlling and evaluating outcomes’.

To summarise, planning is the establishment of objectives, strategies and tactics to meet the desired performance of the business. A budget is a financial translation of the plan. Plans will generally involve improvements to the business either in sales, growth, diversity or other business developments over the planning cycle and as such the budget shows what this will mean for the business after taking account of the costs involved in achieving the performance. Budgetary control allows a business to track its progress against its plan by comparing the budget to the actual finances.

Budgets can be established via a top down or a bottom up approach. Top down budgets are imposed from above by senior management/the board whereas bottom up are participative and involve managers in the budget setting process (Gowthorpe 2011).Further to the overall top down or bottom up approach there are numerous methods for establishing the budget.

Gowthorpe (2011) and Siyanbola (2013) both reviewed the variety of approaches to budgeting. These consisted of incremental budgeting, zero based budgeting (ZBB), base budgeting (BB) & activity based budgeting (ABB).

Many business adopt incremental budgeting which uses the previous budget as the base from which to begin the new budget. This type of approach may be as straightforward as determining an inflationary factor to all cost lines. It tends to be relatively simple and cuts down the time spent on budgeting however, the key disadvantage is that this approach may under or overestimate the required budget’. This means that individual departments may be disadvantaged compared to others or if this approach is applied over more than one year, budgets may become misaligned with the real world conditions. It can further lead to inefficiencies being perpetuated year after year.

A second method is ZBB. This ignores any previous budgets and starts the process from the very beginning. In this approach each department is required to justify their budget. This is obviously time consuming but can be very useful in raising financial awareness across the business and will tend to mean that inefficiencies are not perpetuated.

BB is a method that has 2 phases to it. In phase 1 the business calculates what resources would be needed to keep going and then any additional spend needs to be justified on a cost/benefit basis. This is less time consuming than ZBB but can still lead to problems in both determining what level of resource may be considered ‘just enough’ and it doesn’t account well for volume shifts in revenue or product mix.

ABB could also be adopted. This calculates the cost of producing each unit of activity. This type of budgeting tends to lead to better cost focus but it does require a lot of effort to measure and it assumes a linear relationship of costs to activities which may not apply in all cases.

Finally there is Kaizen budgeting which assumes anticipated cost improvements in the budget. In reality, all budgets in business today tend to have an element of Kaizen budgeting. Incremental budgeting may have inflationary increases which will often be overlaid with efficiency challenges. A department may find themselves justifying their case for an increase in budget for a new activity using ZBB and will then still be passed an efficiency challenge to achieve.

Process for Preparation of an Annual Master Budget

The process for preparation will differ depending upon the organisation but will normally incorporate the following:

Budget responsibilities – it will be necessary to determine the budget leader in an organisation. This is normally the Financial Controller or Corporate Finance Team but some organisations have a specific budget and planning team who coordinate all the budget activities.
Budget timescales – the entire timetable needs to be set out and published to all those people who have input to the budget setting process. The timetable will cover everything from the date that templates are expected to be published through to submission dates, review periods and re submission deadlines.
Budget assumptions – all budgets will generally require some key assumptions to be made at an overall company level in relation to items such as inflation, cost of capital, exchange rates if relevant, productive hours & growth. Some of these may be assumptions in individual budgets such as sales budgets but it is essential that the master budget process consolidates all the assumptions made. This is to ensure that budgets are aligned across the business. For example, if the sales department budgets for a 10% increase in sales based on assuming excellent marketing of the new product that is being launched in the middle of the year, then it is important that the business understands if marketing have budgeted for the campaign and if production are planning to launch on time and have the relevant production quantities planned. If this is not the case then the budgets are misaligned and potentially unrealistic.
Budget instructions / manual – instructions need to be compiled for use alongside any assumptions /pre-set criteria that people need to incorporate.
Budget templates – templates need to be designed and prepared. These are often locked spreadsheets with only certain fields being available for entry. Standard templates are critical for consolidation purposes and avoidance of errors in consolidation.
Review process (often 2 stages) – this can differ widely across organisations but is often in the form of a submission and first presentation to senior management and/or the FD followed by rework to incorporate requested changes which will then be consolidated into the master budget for presentation to the board of directors.

Further to the steps above the annual master budget is compiled by consolidating all the departmental and or functional budgets into one overall budget. Walther (2014) noted that ‘the budget construction process will normally follow the organizational chart. Each component of the entity will be involved in preparing budget information relative to its unit’. Depending upon the business this could include, production budgets, sales budgets, overhead department budgets, investment budgets but will also include the cash budget. The order in which the budgets are prepared is important however, as the outputs of each budget will make the inputs for the next budget. Below is a simple graphical representation of the order of completion of a master budget.

Potential Behavioural Issues Arising from the Budgeting Process and the use of Budgetary Information

Bruns (1975 p.178) stated that ‘budgets are potential means of influencing behaviour’ and that ‘control is the successful exercise of power to influence’, hence there are many potential behavioural problems that can emerge from the budgeting process. There has been significant research exploring the effects of type of approach on the behaviours. Merchant (1981) studied how the size, diversity and degree of decentralisation affected the choice of approach which in turn affected the behaviours.

Banks and Giliberti (2008) considered that top down budgets generally have less ownership within a business since those responsible for delivering have had little or no say in the setting process and as such may be more difficult to deliver. This will depend on how challenging the budget is of course. Conversely bottom up budgets tend to have more buy in from managers but this still doesn’t necessarily mean they will be achieved and nor does it necessarily mean the budget is more accurate. Furthermore, budgets that engage the management in their development may still not have ownership if managers don’t believe that the engagement is genuine.

If the budget being set is deemed to be unachievable by those expected to deliver it, then this can become demotivating. Setting a stretch target can be motivating for people but too much stretch and they will feel as though it is not worth any effort as they cannot achieve it even if they try.

Budget owners may try to build in budgetary slack in order to make it more likely they can achieve or outperform their budget. No matter the environment, it can be very difficult to avoid budgetary slack being built into the numbers as it can be very difficult to assess or prove the level of slack built in by an astute manager. Camman (1976) and Merchant (1985) found that a managers propensity to create slack is affected by the system adopted but that this propensity is generally lower in a more participative approach whereas Antle and Eppen (1985) and Lukka (1988) argued that high participation created slack.

However, Onsi (1973) suggested that slack was not necessarily always a bad thing. It could provide funds to be able to undertake valuable activities that would not necessarily be approved by stakeholders if more transparent due to requirements for returns from the business. He also found that slack was more likely in successful firms in good markets thereby making it possible to achieve efficiencies and continue to meet expectations of shareholders in more difficult times.

If incremental budgeting is used in a business, managers may either deliberately spend up to their budgets or in some cases overspend so they can get a bigger base to start from the following year. Clearly this is not necessarily optimising for a business and this is where good budgetary control can help. Analysis of variances should be against budget at the lowest level practicable so that it is clear whether the result is due to accurate budgeting or other factors that were not budgeted originally.

The temptation to spend up to budget will almost certainly happen if an organisation adopts a ‘use it or lose it’ approach to budgeting. In today’s world, there is increasing pressure in many businesses to drive down costs as a result of decreasing margins. As such, if a budget has not been used, it can be tempting to assume it is not needed and as such reduce the following years start baseline. If the manager has made a great effort to gain efficiencies during the year, then this does not necessarily feel like a suitable reward as it is simply likely to make it harder to achieve the following year. If the efficiencies are sustainable then this may be realistic but if they were one-off opportunities that the manager took advantage off, then they will not necessarily be repeatable. The budget setting process must include a certain amount of flexibility or the budget is likely to be either unrepresentative of the actual picture or it may cause inflexibility within the business in its ability to react apropriately to short term events and changes. Sudden market changes could lead to a need to increase production of one product at the expense of another and it may be that the margin on the increased product is not as profitable. However, the process must allow for a view of the bigger picture. It may well be that the margin per product is lower but the market change means that far more product can be sold thereby increasing profits overall. The budget process should not stop the right decision being made.

The above discussion highlights the importance of a company adopting a genuine and appropriate approach to their budget setting process as it is a time-consuming and as such an expensive exercise. It would be a shame if this time consuming and expensive exercise simply produced a document that no one felt ownership for and that was in reality neither achievable for the business nor representative of the best outcome that could actually be achieved.

References
Antle, R. & Eppen, G. D., 1985. Capital Rationing & Organizational Slack in Capital Budgeting. Management Science, 31(2), pp. 163-174.
Banks, A. & Giliberti, J., 2008. Behavioural Aspects of Budgeting. In: McGraw-Hill, ed. Budgeting. s.l.:McGraw-Hill, pp. 217-215.
Bruns, W. J. & Waterhouse, J. H., 1975. Budgetary Control & Organization Structure. Journal of Accounting Research, 13(2), pp. 177-203.
Cammann, C., 1976. Effects of the use of Control Systems. Accounting, Organizations & Society, 1(4), pp. 301-313.
CIMA, 2005. CIMA Official Terminology. 2nd ed. Oxford: CIMA Publishing.
Gowthorpe, C., 2011. Business Accounting & Finance. Third ed. Andover: Brendan George.
Lukka, K., 1988. Budgetary Biasing in Organizations. Accounting, Organizations & Society, 13(3), pp. 281-301.
Merchant, K. A., 1981. The Design of the Corporate Budgeting System: Influences on Managerial Behaviour and Performance. Accounting Review, 56(4), pp. 813-829.
Merchant, K. A., 1985. Budgeting & the Propensity to create Budgetary Slack. Accounting, Organizations & Society, 10(2), pp. 201-210.
Onsi, M., 1973. Factor Analysis of Behavioural Variables Affecting Budgetary Slack. Accounting Review, 48(3), pp. 535-548.
Siyanbola, T. T., 2013. The Impact Of Budgeting And Budgetary Control On The Performance of Manufacturing Company in Nigeria. Journal of Business Management & Social Sciences Research (JBM&SSR) , 2(12), pp. 8-16.
Walther, D. L., 2014. Chapter Twenty-One: Budgeting: Planning for Success. Available at: http://www.principlesofaccounting.com/chapter21/chapter21.html

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Introduction

The intention of this essay is to analyse the development of ‘Behavioural Finance’ within the field of finance and investment. It will highlight some of the literature that has come about as a result of research in the field, some of the implications it has had on historical theories and some of the implications it has had within the world of investment.

The Birth of Behavioural Finance

Behavioural Finance is considered by many to be a new field within finance, but it does have its origins in the early 20th century. One of the initial publications to highlight the importance of investor psychology was authored in 1912 by George Selden, the intention of this book was to discuss the “belief that the movements of prices on the exchanges are dependant to a very large degree on the mental attitude of the investing and trading public”(Selden, 1912, pp. Preface), this was a pioneering thought and began the start of linking psychological aspects within the world of finance.

Throughout the 20th century, many developments were made in relation to combining psychological aspects to the world of finance. Since George Selden, many have built upon this idea and “in 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance.”(Sewell, 2010, p.1). This was of importance as considering the dynamic nature of finance, a decision one makes can often be offset by the introduction of new and inconsistent information, this may often lead practitioners to make irrational decisions which in turn affects markets, pricings and causes inefficiencies. After this, John Pratt “considers utility functions [and] risk aversion”(Sewell, 2010, p.1), which considers how practitioners evaluate a monetary amount gained or lost and also how they feel about incurring various levels of risk and how this affects behaviour and decision making. From this point the research and developments entered rapid expansion as more researchers and prominent people within the fields began to take interest in this idea that psychology may play an important role within markets and practitioner behaviour..

In 1973, two psychologists, Amos Tversky and Daniel Kahneman put forth an article and within this paper they “explore[d] a judgmental heuristic in which a person evaluates the frequency of classes or the probability of events by availability, i.e., by the ease with which relevant instances come to mind.”(Tversky and Kahneman, 1973, p.207).

A heuristic is something that financial “practitioners use [as a] rule of thumb…to process data… they are generally imperfect. Therefore, practitioners hold biased beliefs that predispose them to commit errors.”(Shefrin, 1999, p. 4). This along with the earlier articles and research began to explore in more depth the affects of individuals’ cognitive errors and misjudgements which we now know can lead to market inefficiencies.

Then, in 1974, Tverky and Kahneman produced another article with the intention of further developing the field and gaining a more in depth determination of the heuristic identified in their previous paper, within this article they had identified and described three heuristics which can be seen to be in use when making decisions under uncertainty. These three heuristics are as follows; “representativeness, which is usually employed when people are asked to judge the probability that an object or event A belongs to class or process B,”(Tversky and Kahneman, 1974, p.1124) in simple terms this is when someone tries to predict the probability of an unknown event by comparing it to a known event and assuming the probabilities will be similar. This can and usually does lead to errors as practitioners may over or underestimate the probability, and also may misjudge the comparative example which in turn will lead to errors.

The second heuristic is that of “availability of instances or scenarios, which is often employed when are asked to assess the frequency of a class or the plausibility of a particular development,”(Tversky and Kahneman, 1974, p.1131) in simple terms they have described a way in which individuals are more inclined to assess the frequency of an event by the ease in which instances of the events can be brought to mind.

The third heuristic is that of “adjustment from an anchor, which is usually employed in numerical predication when a relevant value is available”(Tversky and Kahneman, 1974, p.1131) in simpler terms they have described how an individual will use an initial piece of information and then any other piece of information gained thereafter will encounter a bias based on the initial information. This leads the practitioner to hold on to their initial beliefs in regard to the scenario and leads to an inaccurate reading of the situation resulting in errors.

These are heuristics, which are mental-shortcuts which, through a lack of adequate mental analysis and evaluation, lead to an inaccurate reading of the situation, leading to a misjudgement. These heuristics are important as they began to form reasons why financial practitioners’ are prone to make mistakes, which in-turn lead to market inefficiencies and in the area of investment cause stock-prices to deviate from their fundamental value.

From this point, Tversky and Kahneman went on to produce another article in 1979 They discovered that people tended to value losses greater than equivalent gains; “An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights.”(Tversky and Kahneman, 1979, p. 263). This was named Prospect Theory. This was an important development as it showed further irrational behavioural of practitioners and put greater emphasis on the study of how human errors do affect the financial markets, something that was held in contrast to popular belief at the time, it also contributed further to the study of how practitioners deal with the evaluation of money.

Then, in 1985, Werner De Bondt and Richard Thaler published an article that discovered that “most people tend to ‘overreact’ to unexpected and dramatic news events.. The empirical evidence… is consistent with the overreaction hypothesis… market inefficiencies are discovered.”(De Bondt and Thaler, 1986, p.793). This discovery, aided by the previous advancements of the better part of a century’s worth of research effectively formed the start of what has become known as behavioural finance and was of great importance and the field now had empirical evidence which backed up theory to suggest that psychological errors contributed to market inefficiencies thereby putting into question historical theories which had once been considered valid.

To summarise, over the course of the 20th century there has been significant research within the field of psychology and then a merging of psychological research with the field of finance. Many consider Amos Tversky and Daniel Kahneman to be the pioneers with the vast amount of research they conducted in the field, which lead to Werner De Bondt and Richard Thaler producing empirical evidence, with the use of psychologically based background, in their paper; “Does the Stock Market Overreact?”which proved that at times there exists inefficiencies within the markets.

How it has Affected Historical Theories

The birth of Behavioural Finance has had many implications within the fields of finance and investment. One of its greatest and most important impacts is calling into question the rationality of financial practitioners, this notion that practitioners are rational provided an assumption which formed the foundation on which some of the most influential economic and financial hypothesis were created.

To analyse the full impact of behavioural finance as a topic is something that cannot be achieved within this essay, instead it will discuss its effect on Efficient Market Hypothesis (EMH), a theory put forth by Eugene Fama in 1970 titled “Efficient Capital Markets: A Review of Theory and Empirical Work,”(Fama, 1970) . Within the document Fama describes an efficient market as “a market in which prices always ‘fully reflect’ available information,”(Fama, 1970, p. 383) in order for markets to fully reflect available information an assumption is made that the markets and the investors within them are rational, this is one of the assumptions that provides a foundation for Efficient Market Hypothesis;

This notion of rational markets and investors has been seriously questioned by the development of ‘Behavioural Finance’ and due to the research that has been conducted and empirical evidence which proves that at times the markets both over and under react to information which results in inefficiencies; it can be stated that the Efficient Market Hypothesis isn’t entirely correct. This is important as since the theories inception; financial practitioners accepted it as valid and began to develop ideas, models and other theories with EMH as a foundation. Other theories such as Capital Asset Pricing Model have been put into question as they were developed and “buil[t] on the assumptions of EMH.”(Bell, 2010).

The development of ‘Behavioural Finance’ and the findings from various researches which put into question market efficiencies, it can now be stated that long held beliefs and theories about the way markets and financial practitioners operate can be considered false. It has also brought about an idea named ‘Adaptive Market Hypothesis (AMH)’ which was put forth in 2004 by Andrew Lo, he argues that “the emerging discipline of behavioural economics and finance has challenged [EMH], arguing that markets are not rational… [he] propose[s] a new framework that reconciles market efficiency with behavioural alternatives.”(Lo, 2004). This new hypothesis seems to make more sense and is in conjunction with behavioural finance issues and while we wait for it to be solidified by long-term empirical evidence, it seems that the future is more AMH than EMH.

Its implications for Investment

Since the development of ‘Behavioural Finance’ and the psychological aspects that are at play within the world of finance and within the investors psyche have been seen to “lead to unhelpful or even hurtful decisions. As a fundamental part of human nature, these biases affect all types of investors,”(Byrne and Utkus, 2013, p.4) and often lead to misjudgements and errors, the implications for this are that each and every investor will make use of these heuristics and inevitability will make mistakes. The world of investment has now recognised that this area of study is of great importance and can help explain not only investor behaviour, but also the behaviour of markets. One of the intentions of ‘Behavioural Finance’ is to identify these errors and their causes so that investors are in a position to work around them or profit from other investors’ mistakes.

There are now many heuristics and biases which have been discovered and have an impact on financial practitioners decision making ability and in turn have implications for markets, some of these are as follows; Availability Bias, Representativeness, Gamblers Fallacy, Frame Dependence, Mental Accounting, Loss Aversion and Overconfidence to name just small amount. One of these biases, ‘Overconfidence’, “has found that humans tend to have unwarranted confidence in their decision making. In essence, this means having an inflated view of one’s own ability.”(Byrne and Utkus, 2013, p.4). In terms of investment this can lead some investors to have placed an overestimation on their own investment choices and ability and as such, at times, disregard the overall external factors which have an impact on the market. Another affect that overconfidence may have on certain investors is in relation to trading, for example, too much confidence is placed within their own ability to trade. “Professors Brad Barber and Terry Odean studied US investors with retailed brokerage accounts and found that more active traders earned the lowest returns.”(Byrne and Utkus, 2013, p.6).

Another bias is that of the ‘loss aversion’ where “behavioural finance suggests investors are more sensitive to loss than to risk and return,”(Byrne and Utkus, 2013, p.8) where traditional finance theory tended to focus solely on the relationship between risk and return. Two professors, Hersh Shefrin and Meir Statman, developed theories put forth by Tversky and Kahneman in a paper titled “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence”where they found evidence to suggest that investors “sell winners too early and hold losers too long.”(Shefrin and Statman, 1985, p.777). This can negatively affect investor returns and depicts some form of short-termism within investors’ psychology down to the bias of loss aversion.

Conclusion

To conclude, ‘Behavioural Finance’ is a field that has had profound effects on the world of finance and investment, so much so it has put into question previous theories that were once considered valid and used as a foundation for most economic and financial hypotheses such as EMH and CAPM. As the field has developed practitioners have taken more notice of their own and others’ irrational behaviour, which is important considering prior to the introduction of psychological issues most were of the belief that themselves and others were rational. This can now be considered to be false, and as the dynamic nature of the financial work-environment induces mental and behavioural short-comings it is likely that the field will see further developments.

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Introduction

The intention of this essay is to explain how Bank of England monetary policy has affected inflation rates within Great Britain, we will take data for the time period 2009-the present, the reasoning for this is this was the time-period that ‘Quantitative Easing’ was introduced. It will state recent developments in regard to interest rate policies and highlight what ‘Quantitative Easing’ is and how it forms part of monetary policy. It will use recent data in regard to the setting of interest rates and inflation and how inflation and interest rates affect businesses and individuals.

What is the Bank of England?

The Bank of England is the Central Bank of the United Kingdom. The mission of the bank is “to promote the good of the people of the United Kingdom by maintaining monetary and financial stability”; she is sometimes referred to as the “Old Lady of Threadneedle Street” and was founded in 1694 (Bank of England, 2015).

A Central Bank “is nowadays primarily an agency for monetary policy. It usually also has important financial stability functions, and those become more prominent during times of financial turmoil,” (Ortiz and Yam, 2009, pp.17) and although it has many differing functions dependant on which country the central bank operates in “one could infer that the objective underlying all functions was “for the economic interests of the nation, consistent with government economic policy”” (Ortiz and Yam, 2009, pp.18).

The Bank of England is engaged in all of these functions, however the purpose of this essay is to highlight monetary policy and inflationary matters; as such we will now concentrate on the monetary policy function of the Bank of England.

What is Monetary Policy?

Monetary Policy has been defined as “the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side of economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity” (Economic Times, 2015). Within the United Kingdom, the Bank of England has a Monetary Policy Committee (MPC), “The MPC sets an interest rate it judges will enable the inflation target to be met,” (Bank of England, 2015) this target is “defined by the Government set inflation target of a 2 per cent year-over-year increase in the Consumer Prices Index” (Bank of England, 2015).

Monetary Policy is important as it is used to maintain and engineer stable prices and confidence in the currency through the setting of interest rates, again this is defined by the government’s inflation target. A central bank has two tools it can use to try to influence the economy in terms of monetary policy; the setting of interest rates and the expansion and contraction of the money supply.

One of the key elements of monetary policy is how a central bank tries to keep the supply and demand for goods in some form of equilibrium by changing its official interest rate. This is known as the ‘Base Rate’ or ‘Bank Rate’, and it signals and attempt to influence the overall level of activity in the economy. “When demand for goods and services in the economy exceed supply, inflation tends to rise above the Bank’s target rate of 2%. On the other hand, when supply exceeds demand, inflation tends to fall below the Bank’s 2% target” (Bank of England, 2015). By changing the interest rate the bank is able to influence other banks and building societies in their borrowing and lending activities and therefore affect spending in the economy. It does this in an attempt to keep inflation in line with its pre-determined target of 2%. “A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can also affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans.” (Bank of England, 2015)

Another, more unconventional, form of monetary policy is that of “Quantitative Easing”. This is when a “Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target.” (Bank of England, 2015) This was first used in the UK in March 2009 and involves the “cash injection [which] lowers the cost of borrowing and boosts asset prices to support spending and get inflation back to target. If inflation looks like being too high, the Bank of England can sell these assets to reduce the amount of money and spending in the economy.” (Bank of England, 2015) Considering the current state of the British economy with a transition from a majority of full-time to part-time workers (see Fig.2), a decrease in the real wage growth (see Fig.3) and a decrease in real average weekly earnings (see Fig.4) it can be stated that the Bank’s current monetary policy is acting against its own interests; “Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability” (Bank of England, 2015).

(Fig.2)

(Fig.3)

(Fig.4)

What is Inflation?

Inflation has been defined in a number of ways, one of these definitions is that it “is the rate of increase in prices for goods and services [and] there are a number of different measures of inflation in use. The most frequently quoted and most significant one [is] the Consumer Prices Index (CPI)” (BBC, 2015)

CPI is “the speed at which the prices of the goods and services bought by households rise or fall. Consumer price inflation is estimated by using price indices. The price index estimates changes to the total cost of this basket. Most ONS price indices are published monthly. (ONS, 2013)

Inflation is of great significance as it affects the prices of all goods and services, and as mentioned above it has an effect on real wages and their growth, its affects on businesses and therefore their employment policies i.e. full time as opposed to part-time employment, consumption and an ability to save.

Recent Monetary Policy

We have established that Monetary Policy consists of a setting of an Interest Rate or ‘Bank Rate’ and also a relatively new form of monetary policy called ‘Quantitative Easing’. Since ‘Quantitative Easing’ is new and was first introduced in 2009 we will use policy and the relevant interest rates relating to this time-period.

The following is an extract taken from the Bank of England’s website: “The previous change in Bank Rate was a reduction of 0.5 percentage points to 0.5% on 5 March 2009. A programme of asset purchases financed by the issuance of central bank reserves was initiated on 5 March 2009. The previous change in the size of that programme was an increase of ?50 billion to a total ?375 billion on 5 July 2012.” (Bank of England, 2015) As we can see the Bank has kept its interest rate policy at a constant for the last 6 years, a record-low.

Recent Inflation

Using the same time-period as above we can show the inflation rate and how it has fluctuated:

(Fig 1.)

As can be seen from the graph above the level of inflation began to appreciate with the setting of the 0.5% interest rate which is in conjunction with economic theory as individuals tend to borrow therefore spend more which leads companies to raise prices. However, during 2012 other factors came into effect and we have seen depreciation in inflation. Of late one such factor could be the decrease in oil prices which has lead “to significant revenue shortfalls in many energy exporting nations, while consumers in many importing countries are likely to have to pay less to heat their homes or drive their cars.” (BBC, 2015). This is of importance as consumers use oil and other natural resources and it makes up part of their essential consumption, for example, if oil prices decrease then the cost of travelling, heating and lighting becomes cheaper.

As can be seen from the graph and the monetary policy that has been implemented by the Bank of England we can see the bank has entered into an unknown territory in that it has encountered an inflation level very close to 0% and also have an interest rate policy close to 0%. The level of inflation is below its desired target of 2% and therefore they, ideally, would like to be in a position to lower the interest rate to generate an increase in inflation, however, should the Bank of England begin to increase interest rates we would see an increase in the payments of debt. This remains true for governments also, with Britain’s debt rapidly increasing as a percentage of GDP (see Fig.5) this would ensure if not increase the probability of the government itself defaulting on its debt. With many other factors such as lowering oil prices, high unemployment, and a decrease in consumers’ disposable income aiding in the depreciation of inflation it will be interesting to see the Bank of England’s next change in monetary policy and to observe its implications.

(Fig.5)

The Effects of Inflation

Inflation has many different effects on a variety of different practitioners such as businesses and individuals. For businesses high levels of inflation can lead to higher sales revenue and therefore higher profit margins, however, this can be a short-lived occurrence as the cost of sales will also be affected increasing business costs and lowering profit margins. It is also likely that employees will at some-point request an increase in wages to keep pace with the raising costs of goods and services. Business will also need to be aware of the changing conditions within central and commercial banks as if inflation is raising beyond a pre-determined level then the central banks will alter their interest rate to ensure they meet their targets. This in turn will affect commercial banks and therefore the general cost of borrowing; this can also effect debt repayments and eventually profit-margins.

Low levels of inflation can also lead to higher sales revenue as customers take advantage of an increase in purchasing power and are therefore more likely to make rapid purchases, however, when inflation levels are low this suggests that interest rates are high and therefore saving becomes more attractive however this is not always the case. This could then lead to lower sales revenue as consumers will tend to favour savings over spending.

For individuals, high levels of inflation mean that prices of goods and services are increasing therefore individuals on a fixed income are proportionately spending a larger amount of their income on essentials, leading to a lower amount of disposable income. This means that interest rates are low and therefore saving becomes unattractive leaving consumers at the behest of the macroeconomic environment. However, dependant on the levels of inflation it is quite likely that the central banks will adjust interest rates accordingly and raise them, allowing consumers to benefit from the possibility of saving.

There are some other external factors which are out of the control of the Bank of England which also have an effect on British consumers and inflation such as “currency exchange rates, other countries interest rates and oil prices.” (Ramady, 2009, pp.10)

Conclusion

In conclusion, we have discussed the Bank of England and its monetary policy and how the setting of interest rates has an effect on inflation and how this in turn affects businesses and individuals. We have seen that there are numerous different ways in which interest rates and inflation can be adjusted given the economic environment and how the central bank and commercial banks control monetary policy to meet a pre-determined inflationary target – this target is 2% within the United Kingdom.

We have also used data and recent policy to illustrate the affects, which has brought us to an interesting point in economic history in that the central bank, commercial banks, businesses – large and small – and consumers have entered into a predicament in that we have a situation where both inflation and interest rates have reached near or exactly 0%. The central banks, various other large financial and political institutions must now create and adapt to a different strategy as it seems they have exhausted the use of their monetary policy tools and although ‘Quantitative Easing’ tends to boost the economy short-term, we have still seen this new tool used on multiple occasions.

It seems that if their current strategy was working, why all around the world are we continuing to observe economic instability in various forms such as high unemployment, highly volatile inflation – and deflation in some areas -, a reduction in real wages and a shift from mainly full-time to part-time working hours, these different negative economic consequences of a policy that results in more instability whilst the stated of objective of the institution is “Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability”(Bank of England, 2015).

Bibliography
Bank of England. (2015). “About the Bank”. Available at: http://www.bankofengland.co.uk/about/Pages/default.aspx
Bank of England. (2015). “Bank of England maintains Bank Rate at 0.5% and the size of the Asset Purchase Programme at ?375 billion.” Available at: http://www.bankofengland.co.uk/publications/Pages/news/2015/004.aspx
Bank of England. (2015). “How does monetary policy work?” Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/how.aspx
Bank of England. (2015). “Monetary Policy Committee (MPC).” Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/overview.aspx
Bank of England. (2015). “Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability” http://www.bankofengland.co.uk/Pages/home.aspx
Bank of England. (2015). “What is Quantitative Easing?” Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx
Bank of England. (2015). “What we do.” Available at: http://www.bankofengland.co.uk/about/Pages/onemission/default.aspx
BBC. (2015). “Falling Oil Prices: Who are the winners and losers?” Available at: http://www.bbc.co.uk/news/business-29643612
BBC. (2015). “Q&A: Inflation Explained.” Available at: http://www.bbc.co.uk/news/business-12196322
Economic Times. (2015). “Definition of ‘Monetary Policy’”. Available at: http://economictimes.indiatimes.com/definition/monetary-policy
Ortiz, S. And Yam, J. (2009). “Issues in the Governance of Central Banks”, Central Bank Governance Group, pp.17, [PDF]. Available at: http://www.bis.org/publ/othp04.pdf
Telegraph. (2015). “Inflation: RPI, CPI and RPIJ explained.” Available at: http://www.telegraph.co.uk/finance/economics/9792480/Inflation-RPI-CPI-and-RPIJ-explained.html
Bank of England. (2015). “QE – Quantitative Easing (QE) – Injecting Money Into The Economy.” http://www.bankofengland.co.uk/education/Documents/resources/postcards/qecomp.pdf
Office of National Statistics (ONS), (2013). “Consumer Price Indices – A Brief Guide” http://www.ons.gov.uk/ons/guide-method/user-guidance/prices/cpi-and-rpi/consumer-price-indices–a-brief-guide.pdf
Bank of England. (2015). “Quantitative Easing (QE) – Injecting Money Into The Economy” [PDF] http://www.bankofengland.co.uk/education/Documents/resources/postcards/qecomp.pdf
Ramady, M. (2009). “External and Internal Determinants of Inflation: A Case Study of Saudi Arabia,” Middle East Journal of Economics and Finance, pp.10 [PDF] Available at: http://faculty.kfupm.edu.sa/FINEC/ramadyma/articles/External%20&%20Internal%20Determinants%20of%20inflation-A%20Case%20Study%20of%20Saudi%20Arabia.pdf
Illustrations

Figure 1. United Kingdom Inflation Rate (1915) [Image] Available at: http://www.tradingeconomics.com/united-kingdom/inflation-cpi

Figure 2. Three month average for the percentage of people working full and part time respectively, September-November 2000 to September-November 2013 [Image] pp.9 Available at: http://www.ons.gov.uk/ons/dcp171766_351467.pdf

Figure 3. AWE real wage growth and the range of real wage growth estimates using other ONS wages and price series, Q1 2001 to Q3 2013, per cent change on the same quarter a year ago [Image] pp.5 Available at: http://www.ons.gov.uk/ons/dcp171766_351467.pdf

Figure 4. Real Average Weekly Earnings and Real Average Hourly Wage, Index 2005=100 [Image] pp.8 Available at: http://www.ons.gov.uk/ons/dcp171766_351467.pdf

Figure 5. UK National Debt % GDP [Image] Available at: http://www.economicshelp.org/blog/334/uk-economy/uk-national-debt/

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Introduction

Sports Direct Plc is a profitable and successful with an immense potential for growth as indicated by the Price Earning ratio of 27.73 times (Appendix 1).

The purpose of this essay is to analyse the financial performance of Sports Direct Plc based on the calculation of the profitability, liquidity, efficiency, solvency and investor ratios. Thereafter, the essay will compare the financial performance and position of Sports Direct Plc with that of JD Sports Fashion Plc. Subsequently, the essay will provide a recommendation to the investors regarding the investment in Sports Direct’s shares. Finally, the essay will conclude by assessing the limitations of the financial analysis carried out based on the accounting ratios.

Analysis of the financial performance of Sports Direct Plc and Comparison to a competitor – JD Sports Fashion Plc

Sports Direct Plc’s revenue has grown by 23.8% from GBP 2,706m in 2013 to GBP 2,185.6m in 2014 (Sports Direct Plc, 2014). This success is underpinned by Sports Direct’s core strategy of expanding their product base (Sports Direct Plc, 2014). Sports Direct has not resorted to price cutting strategies in order to achieve this growth. This is evident by the improvement in its gross margin from 40.94% in 2013 to 42.68% in 2014 (Appendix 1). The product mix of Sports Direct is improving with its premium category products gaining greater acceptance in the market (Sport Direct Plc, 2014). Operating and net margins have witnessed a modest fall because the new stores that have opened to support the growing premium lifestyle divisions are performing slightly below the capacity (Sports Direct Plc, 2014).

Sports Direct Plc has significantly outperformed JD Sports Fashion Plc in terms of the overall profitability despite of JD Sports Fashion Plc having a better gross margin (Appendix 1 and Appendix 2). The sales channel mix of the two businesses is the key driver of the overall profitability. Although online sales grew for both the businesses, the growth in online sales was higher for Sports Direct Plc compared to JD Sports Fashion Plc contributing to the improved operating profit and net profit margin for Sports Direct Plc. Online sales typically attract lower overheads compared to the retail sales and can significantly contribute to improving profitability of a company (ICAEW, 2012).

Current ratio and liquidity ratio are identified as key indicators of liquidity in a business (Robertson, 2007). The current ratio of Sports Direct Plc has fallen from 1.64 in 2013 to 1.06 in 2014 (Appendix 1). The fall in the current ratio for Sports Direct Plc is not reassuring and the absence of cash is worrying. Furthermore, weak quick ratio of 0.35 is indicative of weak liquidity position and could be indicative of inability of Sports Direct Plc to meet its short-term liabilities in the future. JD Sports Fashion Plc has a better current and quick ratio compared to that of Sports Direct Plc. One of the important factors contributing to a poor liquidity position in Sports Direct Plc is the consumption of cash to facilitate expansion through opening new stores (Sports Direct Plc, 2014). Furthermore, higher inventory turnover days of 133 days for Sports Direct Plc compared to inventory turnover days of 105 for JD Sports Fashion Plc has also contributed to lower liquidity in Sports Direct Plc compared to the liquidity in JD Sports Fashion Plc (Appendix 1 and Appendix 2).

The purpose of calculating gearing ratios is to analyse the financing structure of the business (ICAEW, 2012). Gearing ratios reflect the level of risk attached to the company and the sensitivity of earnings and dividends to changes in profitability level (Grewal, 2014). The statements of financial position of the two businesses are significantly affected by their different capital structures. JD Sports Fashion Plc is more geared compared to Sports Direct Plc. Lower gearing compared to competitors for Sports Direct Plc can enhance its ability to raise more debt to fund future expansion. Sports Direct Plc inclination towards leasing assets and reliance on overdraft facilities contributes to its relatively low level of gearing. This may allow Sports Direct plc to have flexibility in operations and reduce its risk. Furthermore, the value of non-current assets in Sports Direct plc accounts is higher than the value of non-current assets in JD Sports Fashion Plc accounts (Sports Direct Plc, 2014: JD Sports Fashion Plc, 2015). This is indicative of its ability to raise capital through debt market to fund the future expansion.

The purpose of calculating interest cover ratio is to assess the ability of a company to meet its interest obligations out of profits (Goyal and Goyal, 2012). Although the interest cover ratio for Sports Direct Plc has fallen from 22 times to 13 times and is lower than the interest cover ratio of JD Sports Fashion Plc, it is still reflective of a healthy interest cover ratio and is indicative of Sport Direct Plc’s ability to meet the interest obligations out of its profits.

The purpose of calculating efficiency ratios is to analyse the management’s effectiveness in running the business efficiently (Grewal, 2007). Efficiency ratios reflect management’s ability to reduce the working capital requirement for a given level of activity (ICAEW, 2012a). Receivables collection days of 16 days highlight low level of credit sales, which is consistent with the retail nature of the business and enables Sports Direct Plc to manage its working capital efficiently. The increase in payables payment period from 48 days in 2013 to 56 days in 2014 further contributes to efficient working capital management (Appendix 1). This reflects Sports Direct Plc’s ability to negotiate better payment terms with its suppliers. Furthermore, this is also indicative of efficient management, as the gap of twenty-seven days in the payables payment period between the two companies in the prior year has been narrowed down to a gap of two days. The inventory turnover days are 133 days and 105 days for Sports Direct Plc and JD Sports Fashion Plc respectively (Appendix 1 and Appendix 2). Furthermore, the inventory turnover days has increased by seven days from 2013 for Sports Direct Plc (Appendix 1). This is reflective of increased inventory holding cost for Sports Direct Plc. Rapid innovation of new products contributes to making previous product lines obsolete (ICAEW, 2013). This can impact the future margins because of the net realisable value for these products may drop significantly below its production cost (ICAEW, 2013). Management needs to invest more time in clearing up stock and improving the inventory turnover days because it can contribute to increasing the working capital requirement in the future.

The purpose of calculating investor ratios is to enable investors to assess the level of future returns and growth (ICAEW, 2012). Earning per share reflects the level of profit allocated to each outstanding share. Price earning ratio is one of the most commonly used ratios by the investors and reflect their level of confidence in a business (ICAEW, 2012). Increase in price earning ratio from 17.51 times in 2013 to 24.19 in 2014 reflects investors expectations of significant future earning growth and their willingness to pay a large multiple of historic earnings (Appendix 1). Price earning ratio of Sports Direct Plc is 24.19 times compared to price earning ratio of 14.33 times for JD Sports Fashion Plc. Lower price earning ratio is indicative of lower growth expectations by the investors (ICAEW, 2012).

Advice to the investors regarding the purchase of Sports Direct Plc shares

Investors principal concern in respect of the investment in the shares of a company is to be able to earn a good rate of return. Sports Direct Plc is fundamentally a profitable business. Furthermore, a price-earning ratio of 24.19 is reflective of the investor’s faith in the growth potential of the company (Appendix 1). However, the sales growth in the third quarter of 2015 is short of the comparable growth in the third quarter of 2014 (Ficenec, 2015). The slowdown in the growth rate and no dividend offered on the shares may make it an expensive buy in the short term. Furthermore, investment in Sports Direct may be prone to the cyclical risk as the clothing industry is directly linked with the macro economic cycles (ICAEW, 2012a). Nonetheless, slower growth in the current year is impressive given the macro economic environment in the United Kingdoms and England’s early exit from the world cup (Guardian, 2014). Furthermore, the company has invested heavily in the expansion of its product base and its margins have improved despite of competitive environment and challenging macro economic environment (Sports Direct Plc, 2014). This investment in constant innovation has the potential to translate into benefits for the investors in the long term. Favourable capital structure of Sports Direct Plc as highlighted by the gearing ratios calculated in the appendix one also makes it an attractive investment. Based on the considerations above, the essay acknowledges that there are risks associated with the investment in the shares of Sports Direct Plc, nonetheless future returns from the investment is expected to outweigh the risks. Thus, the essay recommends investors to purchase the shares of Sports Direct Plc.

Weaknesses of Ratio Analysis

Although there are a lot of advantages of ratio analysis, it is not without weaknesses (Goyal and Goyal, 2012). One of the key weaknesses of ratio analysis is that the calculation of the ratios is contingent on the figures contained within the financial statements of a company. Thus, the results of the ratio analysis would be distorted if the underlying numbers in the financial statements are inaccurate (Grewal, 2014).

Furthermore, seasonality in a business could limit the usefulness of ratio analysis (ICAEW, 2012). To illustrate this better, consider a toy retailer with a 31 December year-end. Majority of its sales is likely to be made in the last quarter of the year leading up to the Christmas. As a result, the inventory levels at the year-end might be at its lowest point throughout the year. Thus, calculating the relationship between inventory and cost of sales at the year-end to analyse management’s efficiency in managing inventory levels would be misleading (ICAEW, 2012).

Financial statements of different companies are affected by different estimates and assumptions made by the management (Whittington, 2007). Furthermore, accounting standards also may permit different companies within the same industry to apply different accounting policies (Whittington, 2007). This may impair the comparability of accounting ratios of different companies and limit its usefulness.

Ratio analysis is historic in nature, while users of the financial statements are more concerned about the future (Gracia, 2007). It is common for businesses to have both good and bad ratios, which makes it difficult for the users of the financial statements to assess if it’s a good or a bad company (Grewal, 2014).

Lastly, non-existence of ideal level of ratio makes it difficult for user of the financial statements to assess whether a particular trend is good or bad (Grewal, 2014). For example, a company with high current ratio may be interpreted as a good sign, however it could also be indicative of lack of growth potential for a company as a result of which it is holding large reserves of cash (Grewal, 2014).

Conclusion

Sports Direct Plc has witnessed a significant growth over the past two years and has been profitable. However, declining profit margins in the past two years should be a key concern for the management of Sports Direct Plc. Nonetheless, despite the fall in the profit margin of Sports Direct Plc, it still outperforms the profit margins of its competitor – JD Sports Fashion Plc. The management of Sports Direct Plc should strive to strike a balance between achieving growth and improving the profit margins of the business.

Inefficient inventory management should be another key concern for the management of Sports Direct Plc. The inventory turnover period of 133 days seems to be high for a business in the fashion industry and could be indicative of aged obsolete inventory. The management should take immediate steps to clear up old stock to improve the working capital management.

Lastly, the essay recommends the investors to purchase the shares of Sports Direct Plc because high PE ratio, sales growth and expansion into new products are likely to translate into attractive returns for the shareholders in the future.

References
Ficenec, J., 2015, Questor share tip: Sell Sport Direct as growth slows, Telegraph. http://www.telegraph.co.uk/finance/markets/questor/11424054/Questor-share-tip-Sell-Sport-Direct-as-growth-slows.html
Gracia, L., 2007, Introduction to Financial Accounting, Harlow: Pearson.
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Goyal, V., and Goyal, R., 2012, Corporate Accounting, 3rd edn. New Delhi: PHI Learning Pvt. Ltd.
Guardian, 2014, Who should take the blame for England’s early World Cup exit? http://www.theguardian.com/football/2014/jun/24/blame-england-world-cup-exit
ICAEW, 2013, Financial Accounting and Reporting Study Manual, Exeter: Polestar Wheatons.
ICAEW, 2012, Financial Reporting Study Manual, 6th edn. Exeter: Polestar Wheatons.
ICAEW, 2012a, Financial Accounting Study Manual, 6th edn. Exeter: Polestar Wheatons.
JD Sports Fashion Plc, 2015, Share Price. http://www.jdplc.com/investor-relations/share-price.aspx
JD Sports Fashion Plc, 2015, 2015 – Annual Report. http://www.jdplc.com/investor-relations/reports.aspx
Robertson, J., 2007, Financial Ratio Analysis, 3rd edn. Lancaster: John Robertson.
Sports Direct, 2015, Share Price Chart. http://www.sportsdirectplc.com/investor-relations/share-information/share-price-chart.aspx
Sports Direct Plc, 2014, Annual Report 2014. http://www.sportsdirectplc.com/~/media/Files/S/Sports-Direct/annual-report/Annual%20Report%202014.pdf
Whittington, G., 2007, Profitability, Accounting Theory and Methodology, New York: Routledge
Appendix 1 – Sports Direct Plc
S.no.RatioYear End 27th April 2014Year End 28th April 2013
1Gross Profit Margin42.68%40.94%
2Operating Profit Margin9.21%9.75%
3Net Profit Margin6.64%6.94%
4Current Ratio1.061.64
5Quick Ratio0.350.60
6Interest Cover Ratio13.06 times22.39 times
7Financial Gearing8.15%41.52%
8Equity Gearing25.93%23.89%
9Earning per share32.1p26.9p
10Price Earning Ratio24.19 times17.51 times
11Receivables Collection16.6 days16.1 days
12Payables Payment Period56.35 days48.06 days
13Inventory Turnover Period133.07 days126.39 days

(Source: Sports Direct Plc, 2014)

Note:

The formulas used to calculate the ratios above are included in Appendix 3.
Share prices used for calculating price earning ratios are 776.50 pence and 471.1 pence for the year-end 27th April 2014 and 28th April 2013 respectively (Sports Direct, 2015).
Appendix 2 – JD Sports Fashion Plc
S.no.RatioYear End 31st Jan 2015Year End 1st Feb 2014
1Gross Profit Margin48.6%48.7%
2Operating Profit Margin6.1%6.4%
3Net Profit Margin3.5%3.4%
4Current Ratio1.221.15
5Quick Ratio0.540.50
6Interest Cover Ratio33.24 times48.46 times
7Financial Gearing19.9%18.05%
8Equity Gearing27.2%16.6%
9Earning per share35.17p29.08p
10Price Earning Ratio14.33 times13.88 times
11Receivables Collection Period12.9 days20 days
12Payables Payment Period58.1 days75.1 days
13Inventory Turnover Period104.9 days108.8 days

(Source: JD Sports Fashion Plc, 2015)

Note:

The formulas used to calculate the ratios above are included in Appendix 3.
Share prices used for calculating price earning ratios are 503.00 pence and 403.50 pence for the year-end 31st Jan 2015 and 1st Feb 2014 respectively (JD Sports Fashion Plc, 2015).
Appendix 3 – Formulas
S.no.RatioFormula
1Gross Profit MarginGross Profits/Revenue * 100
2Operating Profit MarginProfit from Operations/Revenue*100
3Net Profit MarginNet Profit/Revenue * 100
4Current RatioCurrent Assets/Current Liabilities
5Quick Ratio(Current Assets – Inventory)/Current Liabilities
6Interest Cover Ratio(Profit before interest Payable + Investment Income)/Interest Payable
7Financial GearingLong term liabilities/capital employed * 100
8Equity GearingNet Debt/Equity * 100
9Earning per share(Net Profit – Dividend on preference stock)/ No. Of shares
10Price Earning RatioMarket Value of Share/ Earning per share
11Receivables Collection PeriodTrade Receivables/Revenue*365
12Payables Payment PeriodTrade Payables/cost of sales*365
13Inventory Turnover PeriodInventory/Cost of Sales * 365

(Source: ICAEW, 2012)

Note: Capital Employed = Equity + Net Debt, where net debt = interest bearing debt (non-current and current) minus cash and cash equivalents

This work was produced by one of our professional writers as a learning aid to help you with your studies

Introduction

The essay intends to cover the development of capital structuring theory over the course of the 20th Century. It will highlight the different theories put forth by researchers, primarily Franco Modigliani and Merton Miller and their work during the 1950’s and 1960’s, and describe the differences in the theories and their implications and impact in the world of business and finance.

Background of Theory

In 1952, David Durand produced an article titled “Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement” (Durand, 1952), for the National Bureau of Economic Research. Within this publication he created what is now known as a ‘Traditional View’ of capital structuring which “according to this view, the value of the firm can be increased or the cost of capital can be reduced by the judicious mix of debt and equity capital” (Chand, 2015). This implies that the market valuation of a corporation can be altered depending on the capital structure used to finance the organisation.

The ‘Traditional View’ assumes that as debt capital increases the overall cost of capital decreases and thus the market valuation of a company can be increased through the benefit of a “Tax-shield of Debt” that is apparent when a company decides to finance through debt (FT Lexicon, 2015). This is due to the fact that interest payments on debt capital are treated as tax-deductable therefore a company will obtain more profit and shareholders are more inclined to accept a certain amount of debt finance. However, as leverage begins to increase beyond a certain amount – an optimal point – then shareholders are aware of bankruptcy risks, resulting in an increased cost of capital to compensate an increase in risk, lowering company market valuation. Furthermore, as you increase debt capital you are at the whim of some macro-economic factors, such as the setting of interest base-rates by the country’s central bank which of course would increase debt payments, perhaps beyond an efficient level, again increasing risk.

However, in 1958 Franco Modigliani and Merton Miller published a conflicting article in The American Economic Review titled “The Cost of Capital, Corporation Finance and the Theory of Investment” (Modigliani and Miller, 1958). Within this article they put forth different propositions in relation to how capital structuring affects the market value of a corporation and they criticised David Durand’s “assumption that the cost of equity remains unaffected by leverage up to some reasonable limit” as in their view the cost of equity is an increasing function of debt capital (Chand, 2015). This is likely to be because as bankruptcy risks are increasing shareholders are more inclined to request an increasing amount of returns to compensate, therefore the cost of equity will increase.

Within the 1958 article Modigliani and Miller had the view that an organisation’s weighted average cost of capital is not affected by changes in its capital structure. Modigliani and Miller also published an article in 1963 titled “Corporate Income Taxes and the Cost of Capital: A Correction” for the American Economic Association (Modigliani and Miller, 1963). Within this article they had back-tracked on statements made within their first article published in 1958 and now were stating that “among other things, that the tax advantages of debt financing are somewhat greater than we originally suggest and, to this extent, the quantitative difference between the valuations implied by our position and by the traditional view is narrowed” (Modigliani and Miller, 1963, pp.434). This modification leads Modigliani and Miller to “admit that tax relief on interest payments does lower the weighted average cost of capital.”(ACCA, 2012, pp.314)

Development of Theory

As we have stated, David Durand’s’ theory – the traditional view – is of the belief that a company can alter its market valuation by finding an optimal capital structure point which in turn would lower the Weighted Average Cost of Capital (WACC) and thus increase market valuation. This theory has been created on the basis of certain assumptions which are as follows;

“The company pays out all its earnings as dividends”
“The gearing of the company can be changed immediately by issuing debt to repurchase shares or by issues shares to repurchase debt. There are no transaction costs for issues.”
“The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations about these future earnings”
“Business risk is also constant, regardless of how the company invests its funds”
“Taxation, for the time being, is ignored”

(ACCA, 2012, pp.310-311)

This theory was used as a basic backdrop to the issues of debt and equity costing and finance. Durand had put forth a Net Income (NI) and Net Operating Income (NOI) in his article “Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement” (Durand, 1952). The combination of these ideas formed the basis of the ‘Traditional View’. That was until the creation of a publication in 1958, Modigliani and Miller put forth propositions which had built upon the theory created by David Durand in 1952 which assumed certain initial assumptions. The assumptions for the first proposition are as follows;

“A world without taxation”
“A world without transaction costs”
“A world without bankruptcy costs”
“A world without growth opportunities”
“A world without asymmetric information between insider and outsider investors” i.e. a perfect capital market exists
“A world where there are differences in risk between different firms and individuals”

(Frentzel, 2013, pp.13)

Within this theory Modigliani and Miller had rejected the idea put forth within the ‘Traditional View’ and they had believed “that the firm’s overall weighted average cost of capital is not influenced by changes in its capital structure” (ACCA, 2012, pp.310). This is likely to be because, in the absence of taxation, an organisations market value is determined by only two factors; i) The total earnings of a company and ii) the level of business risk attached to those earnings.

The WACC would then be determined “by discounting the total earnings at a rate that is appropriate to the level of operating risk” (ACCA, 2012, pp.312). Therefore capital structuring would be deemed to be of irrelevance, thus the name of this theory was deemed “Irrelevance Theory”.

However, after receiving large amount of criticism due to the unreasonable assumptions, mainly that of an omission of taxation, Modigliani and Miller had to produce a correction paper in 1963 – as mentioned earlier. This theory – a second proposition – had included corporation tax in their model and they had then concluded that capital structuring does affect WACC and therefore market valuation. The reason for their conclusion arises after “they [had] identified taxation as the primary reason why the combination of financing sources does matter because interests on debt may be deducted from the firm’s income and thereby reduces the net taxable earnings. As a result, this tax saving that constitutes an additional advantage to using debt capital lowers the effective cost of debt capital” (Frentzel, 2013, pp. 15-16), this is known as the ‘Tax Shield’. This would suggest a firm would benefit from funding their organisation entirely out of debt as they would lower their tax liability due to the savings incurred from interest payments that are tax-deductable.

This notion of a firm funding itself entirely out of debt in practice seems illogical considering; a) shareholders would deem the company a risky investment should it be completely funded by debt and would request a higher return to compensate and b) the bankruptcy costs and increased likelihood of insolvency should a company fund itself entirely out of debt even though the model rejects the idea of bankruptcy costs, in reality we know there are such costs.

This then brings us onto the next theory which has been named “Trade-Off Theory”. This theory arose out of the controversy surrounding the second proposition put forth by Modigliani and Miller which implied a company can and should fund itself entirely out of debt due to the benefits of the ‘Tax Shield’. This of course does not make sense and sounds extreme due to the reality of bankruptcy costs and therefore an off-setting mechanism is needed which comes in the form of “the tax advantages of borrowed money and the costs of financial distress when the firm finds it has borrowed too much” (Shyam-Sunder and Myers,1998, pp. 210).

This seems to make more sense in that an optimal point between equity and debt financing can be reached as well as including assumptions previously omitted from earlier theory such as the effects of corporation tax and that of bankruptcy.

The final theory highlighted in this essay is named “Pecking-Order Theory” and it has been developed as an alternative to ‘Traditional’ Theory. It made an appearance in an article titled “The Capital Structure Puzzle” (Myers, 1984) within the Journal of Finance and suggested that there exists a particular pecking order of funding which, put one way, is that “Firms prefer internal finance [retained earnings]…If external finance is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In this story, there is no well-defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom” (Myers, 1984, pp. 581). Put in simpler terms, “adverse selection implies that retained earnings are better than debt and debt is better than equity” (Murray and Vidhan, 2005, pp.19).

The “Pecking-Order Theory” is an “explanation of what businesses actually do, rather than what they should do” (ACCA, 2012, pp.315). This theory does not provide us with an optimal mix of finance but does provide us with a preferred method of funding for numerous reasons, for example, it is easier to use retained earnings as you have no external expectations set upon the company, there are also no issuing costs with retained earnings, issuing debt provides a signalling effect which is better than issuing equities. This final reason is because should a company start to issue equity, it could be sign that the managers believe that their equities are overvalued and are trying to cash in on the equities before they return to fundamental value, there is also a fixed income in regard to issuing debt whilst having a priority on liquidation.

Conclusion

In conclusion, there have been some productive developments concerning the area of capital structuring. In just over half a century various different hypothesis have developed which have contributed largely to the field, from an initial period where capital structuring was questioned to have any relevance at all to a view-point where a mix of debt and equity finance can achieve an optimal point of capital structuring. The importance of this cannot be underestimated as achieving an optimal point can lower the Weighted Average Cost of Capital so that a discount factor used in investment appraisals can lead a company to increase or decrease its market valuation. Reaching the optimal point is a case of trial and error for a company however once a company has reached this point the benefits can be profound, should a company increase its market valuation it may attract a different kind of investor or increase the possibility of a merger or an acquisition. Achieving the optimal point will allow a company to have a greater understanding of its Weighted Average Cost of Capital and therefore a discount factor; once this is achieved certain investment opportunities that may once have been out of reach may now be an acceptable possible idea to pool company resources or capital. This in turn may allow a company to enter into investment opportunities that it once thought it couldn’t, perhaps leading to the entrance into new markets, the development of new technology, or an avenue to achieve re-engineered growth, all leading the company to a position to move forward and most importantly keeping the current and possibility new shareholders content with the current business model and situation.

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