Help and Support from HMRC about becoming an employer

Emails

You can get emails from HMRC on how to become an employer.

E-learning

An online course on becoming an employer.

Webinars and videos

Live webinars last for an hour. You can ask questions during the presentation and get answers from the HMRC host.
Register and log in at least 5 minutes before the start time, for live webinars.
You don’t need to register to watch the YouTube videos.

Getting started as an employer

Registering with HMRC, taking on your first employee, running payroll, paying HMRC.

Live webinar
18 May 2015, 10am to 11am
2 June 2015, 10am to 11am
10 June 2015, 11am to midday
19 June 2015, 11am to midday
25 June 2015, 11am to midday

Video on YouTube
Getting started as an employer

PAYE using Basic PAYE Tools

A demonstration of Basic PAYE Tools, HMRC’s free payroll software for businesses with fewer than 10 employees.

Live webinar
18 May 2015, midday to 1pm
2 June 2015, 12pm to 1pm
10 June 2015, 1pm to 2pm
19 June 2015, 1pm to 2pm
25 June 2015, 1pm to 2pm

Employers: how to avoid in year penalties

This webinar is aimed at employers and includes information on:

• why HMRC charge penalties
• how to avoid in year penalties for late filing
• how to avoid in year penalties for non filing

Live webinar
18 May 2015, 2pm to 2:30pm
11 June 2015, 1pm to 1:30pm

National Minimum Wage for employers

Real-life scenarios to show how it’s calculated, what happens if you don’t pay it and how to get more help and support.

Watch a recording of this webinar, from 24 March 2015. You still need to register.

Care and support employers

Payroll and expenses and benefits if you have a personal assistant or carer.

Live webinar
8 June 2015, midday to 1pm

Video on YouTube
Care and support employers

Statutory Sick Pay

What happens when an employee is off sick, deciding when to pay Statutory Sick Pay and how to work it out.

Live webinar
9 June 2015, 9am to 10am
24 June 2015, 11am to midday

Watch a recording of this webinar from 27 October 2014. You’ll still need to register.

Statutory payments for births

For businesses with employees who’ve had or are having a baby. What payments you can make and how to work them out.

Live webinar
19 May 2015, 4pm to 5pm
1 June 2015, midday to 1pm
18 June 2015, 11am to midday

Watch a recording of this webinar from 23 December 2014. You’ll still need to register.

Statutory Shared Parental Pay and Leave

This webinar covers Statutory Shared Parental Pay and Leave, introduced in April 2015 as part of the reform of pay and leave entitlements for employed parents.

Live webinar
28 May 2015, 11am to midday
4 June 2015, 3pm to 4pm
23 June 2015, 10am to 11am

Watch a recording of this webinar from April 2015. You’ll still need to register.

Expenses and benefits for employers

Paying expenses to employees, providing benefits.

Live webinar
27 May 2015, 11am to midday
3 June 2015, 1pm to 2pm
5 June 2015, 11am to 12pm
11 June 2015, 3pm to 4pm
18 June 2015, 9am to 10am
24 June 2015, 3pm to 4pm
30 June 2015, 10am to 11am

Video on YouTube
Expenses and benefits for employers

Company directors: understanding your responsibilities

Overview of your responsibilities to Companies House and HMRC.

Live webinars
22 May 2015, 9am to 10am
2 June 2015, 4pm to 5pm
15 June 2015, midday to 1pm

Watch a recording of this webinar from 14 November 2014. You’ll still need to register.

Tax and change of career or retirement

Changing jobs or retiring, tax codes and rates, starting a new job or business, redundancy.

Live webinars
29 June 2015, 2pm to 3pm

You can watch recordings of these webinars from October 2014. You’ll still need to register.
Part 1: Redundancy
Part 2: Retirement
Part 3: Starting in business

Business record keeping

Record keeping for sole traders, partnerships and limited companies.

Live webinar
Please note that there are currently no live dates for this webinar.

You can watch a recording of this webinar from 19 December 2013. You’ll still need to register.

Embassies and international organisations

A demonstration of Basic PAYE Tools if you’re employing people in an embassy.

You can watch a recording of this webinar from 16 April 2014. You’ll still need to register.

Advice and help

To watch webinars, your computer and software will need to meet minimum requirements.
Search for help if you’re having any other technical problems with webinars.
If you still need help, you can contact HMRC online.

Rates and Thresholds for Employers

Unless otherwise stated, the figures quoted apply between 6 April 2015 and 5 April 2016.

PAYE tax and Class 1 National Insurance contributions

You normally operate PAYE as part of your payroll so HM Revenue and Customs (HMRC) can collect Income Tax and National Insurance from your employees.
Your payroll software will calculate how much tax and National Insurance (NI) to deduct from your employees’ pay.

Tax thresholds, rates and codes

The amount of Income Tax you deduct from your employees depends on their tax code and how much of their taxable income is above their Personal Allowance.

PAYE tax rates, thresholds and codes	2015 to 2016
Employee personal allowance	£204 per week £883 per month £10,600 per year
Basic tax rate	20% on annual earnings above the PAYE tax threshold and up to £31,785
Higher tax rate	40% on annual earnings from £31,786 to £150,000
Additional tax rate	45% on annual earnings above £150,000
Emergency tax codes	1060L W1, 1060L M1 or 1060L X

Class 1 National Insurance thresholds

You can only make National Insurance (NI) deductions on earnings above the Lower Earnings Limit (LEL).

Class 1 NI thresholds	2015 to 2016
Lower Earnings Limit (LEL)	£112 per week £486 per month £5,824 per year
Primary Threshold (PT)	£155 per week £672 per month £8,060 per year
Secondary Threshold (ST)	£156 per week £676 per month £8,112 per year
Upper Accrual Point (UAP)	£770 per week £3,337 per month £40,040 per year
Upper Secondary Threshold (under 21) (UST)	£815 per week £3,532 per month £42,385 per year
Upper Earnings Limit (UEL)	£815 per week £3,532 per month £42,385 per year

Class 1 National Insurance rates

Employee (primary) contribution rates

Deduct primary contributions (employee’s National Insurance) from your employees’ pay through PAYE.

NI category letter	Earnings at or above LEL up to and including PT	Earnings above the PT up to and including UAP	Earnings above UAP up to and including UEL	Balance of earnings above UEL
A	0%	12%	12%	2%
B	0%	5.85%	5.85%	2%
C	NIL	NIL	NIL	NIL
D	1.4% rebate	10.60%	12%	2%
E	0%	5.85%	5.85%	2%
I (under 21)	1.4% rebate	10.60%	12%	2%
J	0%	2%	2%	2%
K (under 21 - deferment)	1.4% rebate	2%	2%	2%
L	1.4% rebate	2%	2%	2%
M (under 21)	0%	12%	12%	2%
Z (under 21 - deferment)	0%	2%	2%	2%

Employer (secondary) contribution rates

You pay secondary contributions (employer’s National Insurance) to HMRC as part of your PAYE bill.
Pay employers’ PAYE tax and National Insurance.

NI category letter	Earnings at or above LEL up to and including ST	Earnings above ST up to and including UAP	Earnings above UAP up to and including UEL/UST	Balance of earnings above UEL/UST	NICs rebate on earnings above LEL, up to and including ST	NICs rebate on earnings above ST, up to and including UAP
A	0%	13.80%	13.80%	13.80%	N/A	N/A
B	0%	13.80%	13.80%	13.80 %	N/A	N/A
C	0%	13.80%	13.80%	13.80%	N/A	N/A
D	0%	10.40%	13.80%	13.80%	3.40%	NIL
E	0%	10.40%	13.80%	13.80%	3.40%	NIL
I (under 21)	0%	0%	0%	13.80%	3.40%	3.40%
J	0%	13.80%	13.80%	13.80%	N/A	N/A
K (under 21 - deferment)	0%	0%	0%	13.80%	3.40%	3.40%
L	0%	10.40%	13.80%	13.80%	3.40%	NIL
M (under 21)	0%	0%	0%	13.80%	N/A	N/A
Z (under 21 - deferment)	0%	0%	0%	13.80%	N/A	N/A

Class 1A National Insurance: expenses and benefits

You must pay Class 1A National Insurance on work benefits you give to your employees, eg a company mobile phone. You report and pay Class 1A at the end of each tax year.

NI class	2015 to 2016 rate
Class 1A	13.8%

Pay employers’ Class 1A National Insurance.

Class 1B National Insurance: PAYE Settlement Agreements (PSAs)

You pay Class 1B National Insurance if you have a PSA. This allows you to make one annual payment to cover all the tax and National Insurance due on small or irregular taxable expenses or benefits for your employees.

NI class	2015 to 2016 rate
Class 1B	13.8%

Pay Class 1B National Insurance.

National Minimum Wage

The National Minimum Wage is the minimum pay per hour almost all workers are entitled to by law. Use the National Minimum Wage calculator to check if you’re paying a worker the National Minimum Wage or if you owe them payments from past years.
The rates below apply from 1 October 2014 and are likely to change again on 1 October 2015.

Category of worker	Hourly rate
Aged 21 and above	£6.50
Aged 18 to 20 inclusive	£5.13
Aged under 18 (but above compulsory school leaving age)	£3.79
Apprentices aged under 19	£2.73
Apprentices aged 19 and over, but in the first year of their apprenticeship	£2.73

See National Minimum Wage rates for previous years.

Statutory maternity, paternity and adoption pay

Use the maternity and paternity calculator for employers to calculate your employee’s SMP, paternity or adoption pay, their qualifying week, average weekly earnings and leave period.

Type of payment or recovery	2015 to 2016 rate
Statutory maternity pay (SMP) - weekly rate for first six weeks	90% of the employee’s average weekly earnings
SMP - weekly rate for remaining weeks	£139.58 or 90% of the employee’s average weekly earnings, whichever is lower
Ordinary statutory paternity pay (OSPP) and Additional Statutory Paternity Pay (ASPP) - weekly rate	£139.58 or 90% of the employee’s average weekly earnings, whichever is lower
Statutory adoption pay (SAP) - weekly rate	£139.58 or 90% of the employee’s average weekly earnings, whichever is lower
SMP/OSPP/ASPP/SAP - proportion of your payments you can recover from HMRC	92% if your total Class 1 NI (both employee and employer contributions) is above £45,000 for the previous tax year 103% if your total Class 1 NI for the previous tax year is £45,000 or lower

Statutory Sick Pay (SSP)

The same weekly SSP rate applies to all employees. However, the amount you must actually pay an employee for each day they’re off work due to illness (the daily rate) depends on the number of ‘qualifying days’ (QDs) they work each week.
Use the SSP calculator to work out your employee’s sick pay, or use the rates below.

Unrounded daily rates	Number of QDs in week	1 day to pay	2 days to pay	3 days to pay	4 days to pay	5 days to pay	6 days to pay	7 days to pay
£12.6357	7	£12.64	£25.28	£37.91	£50.55	£63.18	£75.82	£88.45
£14.7416	6	£14.75	£29.49	£44.23	£58.97	£73.71	£88.45
£17.6900	5	£17.69	£35.38	£53.07	£70.76	£88.45
£22.1125	4	£22.12	£44.23	£66.34	£88.45
£29.4833	3	£29.49	£58.97	£88.45
£44.2250	2	£44.23	£88.45
£88.4500	1	£88.45

Student loan recovery

If your employees’ earnings are above the earnings threshold, record their student loan deductions in your payroll software. It will automatically calculate and deduct repayments from their pay.

Rate or threshold	2015 to 2016 rate
Employee earnings threshold	£17,335 per year £1,444 per month £333 per week
Student loan deductions	9%

Company cars: Advisory Fuel Rates (AFRs)

Use AFRs to work out mileage costs if you provide company cars to your employees.
The rates below apply from 1 March 2015.

Engine size	Petrol	LPG
1400cc or less	11p	8p
1401cc to 2000cc	13p	10p
Over 2000cc	20p	14p

Engine size	Diesel
1600cc or less	9p
1601cc to 2000cc	11p
Over 2000cc	14p

Employee vehicles: Mileage Allowance Payments (MAPs)

MAPs are what you pay your employees for using their own vehicle for business journeys.
You can pay your employees an ‘approved amount’ of MAPs each year without having to report them to HMRC. To work out the ‘approved amount’, multiply your employee’s business travel miles for the year by the rate per mile for their vehicle.
Find out more about reporting and paying MAPs.

Type of vehicle	Rate per business mile 2015 to 2016
Car	For tax purposes: 45p for the first 10,000 business miles in a tax year, then 25p for each subsequent mile For NI purposes: 45p for all business miles
Motorcycle	24p for both tax and NI purposes and for all business miles
Cycle	20p for both tax and NI purposes and for all business miles

SAGE VAT codes

There are varying VAT tax codes available within Sage and knowing what is what can lead to confusion or an

incorrect VAT return being generated by Sage.

The key is allowing Sage to correctly identify the transactions so that they appear in the correct section of the

VAT return.

Dealing with staff sickness

How to deal with staff sickness
It has recently been reported that nearly 25% of companies said that absence has increased over the last 12 months. Over 33% believe that their employees were abusing their sickness absence process.
It is important to be understanding and sympathetic to those who are genuinely ill, but how can you protect your business from those abusing the system?
Reporting sickness absences:
You must have clear absence policies, which should be included in an employment manual or contract of employment. The information should be readily available to all staff, and the rules must be enforced consistently.
This should show the process of reporting an absence, the amount of paid absence an employee is entitled to, and what you consider to be a disciplinary matter. You may want to include specific policies such as sick pay will not be paid for more than 5 individual days absence in any 12 month period (this only applies to company sick pay, not SSP. For more details on Statutory Sick Pay see below).
Tell employees that they (or someone else) must notify you by telephone that they are sick by, say, 10am on each day of sickness. The employee should speak to a manager, rather than leave a message with reception/another employee.
When an employee telephones in, you should ask them why they are unable to work, and when they expect to return to work.
If an employee is absent for 7 days or less they should be given a self-certification form to complete upon returning to work. You can customise this Sample sickness self-cert form or download self-certification form SC2 from HMRC. It is worth noting however that form SC2 does not state that giving false information is a disciplinary offence, and has no place for a manager or supervisor to sign, which you may want to include.
When an employee is absent for more than 7 days, the employee should provide a doctors certificate, also known as a ‘fit note’.
You should also consider interviewing employees who have been off sick on their return. There may be things you can do to prevent a recurrence. For example, providing better seating for an employee with back problems.
Return to work interviews are the first line of defence against abuse of the system. They can also provide a starting point for helping those genuinely ill stay in work.
Detecting sickness patterns
It is important to record every instance of absence, no matter how long the employee is off for or the reason. This can help you detect trends, such as regular Friday afternoon or Monday morning absences. If you suspect that there is abuse of your sickness absence procedure, you should follow your disciplinary procedure to deal with the misconduct.
Statutory Sick Pay (SSP) 
Statutory Sick Pay (SSP) is paid to employees who are unable to work because of illness. SSP is paid at the same time and in the same way as you would normally pay wages for the same period. The weekly rate of SSP from 6 April 2013 is £86.70.
Statutory Sick Pay should be paid to employees who meet certain criteria, when they are not entitled to company sick pay, or where your company does not pay sick pay. 
There are various criteria that must be met in order for you to pay SSP. Full details can be found on the HMRC website www.hmrc.gov.uk/payerti/employee/statutory-pay/ssp-overview.htm
SSP is only payable if there is a PIW (Period of Incapacity to Work). SSP isn’t payable for the first 3 days of absence, these are called waiting days. SSP is payable from the fourth day of absence, also known as the first qualifying day. For more details on PIW, waiting days and qualifying days, please get in touch or see the HMRC website.
An employee can only be paid for the first 28 weeks of absence. If an employee is still off after this time you should complete form SSP1 so that the employee can make a claim for Employment and Support Allowance from their local Jobcentre Plus.
As an employer, you may also be able to recover some or all of the SSP you pay from HM Revenue and Customs.
Employer Helpbook E14 (2013) will provide some useful information, and can be downloaded here.
Disclaimer – Please note: The ideas shared with you in this article are intended to inform rather than advise. This article does not intend to replace the need to take professional advice. If you do or do not take action as a result of reading this article, we will accept no responsibility or liability arising from any reliance placed on this article.

Year end Payroll

Payroll year end is nearly here
Since 6 April 2013 employers have been operating RTI – this means they are reporting to HMRC in real time. In theory, this will make Payroll Year End a lot simpler than it has been in previous years.
You must now set up payroll records using payroll software, some of which is free. If you are a small employer you can use HMRC’s Basic PAYE Tools, which is designed for employers with nine or fewer employees.
For a list of free payroll software, click here. www.hmrc.gov.uk/softwaredevelopers/paye/rti-software-forms.htm
To download HMRC’s Basic PAYE Tools, click here. www.hrmc.gov.uk/payerti/payroll/bpt/paye-tools.htm
All employees must be set up on your payroll, even those earning below the £111 per week NIC’s Lower Earnings Limit (2014-15) and those paid just once a year.
Accuracy is key
When transferring personnel details to a new payroll system, you must make sure that you accurately enter the details. If it is wrong it will cause you and HMRC problems, and may affect your employees too.
For more information on transferring your employees to the Basic PAYE Tools, you can download HMRC’s three step guide here. www.hmrc.gov.uk/payerti/payetoolshelp/switching-to-rti.pdf
Income Tax and National Insurance rate changes
As well as making sure you have RTI enabled software you need to update your payroll software to reflect rate changes that apply from 6 April 2014.
If you use commercial software, your supplier will send you a software update for rate changes. You can read more in our year end guides for Sage and Iris.
After 6 April 2014, you must ensure that your payroll calculations for Income Tax and NICs are done using the following 2014-15 rates and thresholds:
PAYE tax threshold (2014-15)

£192 per week
£833 per month
£10,000 per year
Basic tax rate
20% on annual earnings above the PAYE threshold and up to £31,865
Higher tax rate
40% on annual earnings from £31,866 to £150,000
Additional tax rate
45% on annual earnings above £150,000
Emergency tax code
1000L
Class 1 NICs: Thresholds (2014-15)
Lower earnings limit (LEL)
£111 per week
£481 per month
£5,772 per year
Primary Threshold (PT)
£153 per week
£663 per month
£7,956 per year
Secondary Threshold (ST)
£153 per week
£663 per month
£7,956 per year
Upper accrual point (UAP)
£770 per week
£3,337 per month
£40,040 per year
Upper earnings limit (UEL)
£805 per week
£3,489 per month
£41,865 per year
The basic rates for NICs category letter A, up to the Upper earnings limited are:
Employees 12%
Employers 13.8%
The rates vary depending on the NICs category letter, and level of earnings. You should always ensure that you are using the correct letter and rate by checking the HMRC website.
If you are unsure please feel free to contact us, we would be happy to help.
Tax code changes
Most employers will receive notification of tax code changes online rather than in the post. Your payroll software should allow you to read these notices directly, however you can also access them by:

• Logging onto PAYE Online and choosing the ‘tax code notices’ option
• Using the PAYE Desktop viewer (PDV) which can be downloaded and installed from the HMRC website

If you have previously opted out of receiving tax code changes online, you will still receive them by post. You can opt back in at any time.
Form P9X – this tells you about tax codes to be used from 6 April due to changes in Income Tax and NICs rates. This will be used along with the employee’s tax code from the previous tax year’s record.
Form P9(T) – this will tell you if an individual’s tax code changes from 6 April. You won’t receive a P9(T) for each employee – only those you need to use a new code for.
Form P6 – this can be issued at any time of the year, and will give you the employee’s new tax code, as well as a date to start using it.
Form P7X – this tells you about changes in tax codes following the budget.
If you receive a tax code after the date you are required to use it from, you should contact HMRC.
If you are using commercial software or HMRCs Basic PAYE Tools you should follow the instructions on your tax code form to update an employee’s records.

Budget 2014 in Summary

Budget 2014 – In Summary
Chancellor George Osborne has today announced the budget for 2014, here are the key points

• GDP forecast to grow by 2.7% this year and 2.3% next year, then by 2.6% in 2016 and 2017 and by 2.5% in 2018
• Fuel duty rise planned for September will not happen
• Beer duty cut by 1p a pint
• Duty on spirits and ordinary cider frozen
• Tobacco duty to rise by 2% above inflation and this escalator to be extended beyond the next general election
• £7bn package to cut energy bills, including £18 per ton cap on carbon price support, predicted to save medium-sized manufacturers £50,000 and families £15 a year
• Cash and shares Isas to be merged into a single new Isa with annual tax free savings limit of £15,000 from 1 July
• The 10p tax rate for savers abolished
• Cap on Premium Bonds to be lifted from £30,000 to £40,000 in June, and to £50,000 next year
• The point at which people start paying income tax will be raised to £10,500
• Bingo duty will be halved to 10%
• Threshold for 40p income tax to rise from £41,450 to £41,865 next month
• Threshold for 40p income tax to rise a further 1% to £42,285 next year
• Inheritance tax to be waived for members of the emergency services who give their lives on the job
• Tax on homes owned through a company to be extended from a residential properties worth more than £2m to those worth more than £500,000
• All long-haul flights to carry a lower rate of air duty currently charged on flights to the US
• The new twelve-sided £1 coin to be introduced in 2017
• Welfare budget to be capped at £119bn for 2015-16, rising in line with inflation to £127bn in 2018-19. The cap includes child benefit, incapacity benefit, winter fuel payment and income support – but does not include state pension and Jobseeker’s Allowance
• Public borrowing deficit forecast to be 6.6% of GDP this year, 5.5% in 2014-15 then falling to 0.8% by 2017-18 with a surplus of 0.2% in 2018-19
• Borrowing forecast to be £108bn this year and £95bn next year, leading to a surplus of almost £5bn in 2018-19
• A new charter for budget responsibility to be brought in this autumn
• Promises to make a permanent £1bn reduction in government department overspends
• All tax restrictions on pensioners’ access to their pension pots to be removed, ending the requirement to buy an annuity
• Taxable part of pension pot taken as cash on retirement to be charged at normal income tax rate, down from 55%
• Increase in total pension savings people can take as a lump sum to £30,000
• New Pensioner Bond, paying “market-leading” rates, available from January to over-65s, with possible rates of 2.8% for one-year bond and 4% for three-year bond – up to £10,000 to be saved in each bond
• Direct lending from government to UK businesses to promote exports doubled to £3bn and interest rates on that lending cut by a third
• Business rate discounts and enhanced capital allowances in enterprise zones extended for three years
• Help to buy equity scheme for new-build homes extended to 2020
• Support for building of more than 200,000 new homes
• £270m guarantee for Mersey Gateway bridge
• Legislation to give Welsh government tax and borrowing powers to fund infrastructure needs, including improvements to M4
• £140m extra for flood defence repairs and maintenance
• £200m made available to fix potholes

Does financing affects the market value of a company?

Corporation tax offers a valuable tax shield that allows interest payments on corporate debts to be deductible for income tax purposes. It enhances the firm’s value by lowering the cost of debt, thus lowering WACC.

The difference can be seen between two companies with similar pre-tax operating cash flows but different capital structure will differ in tax payments as debt offers a tax shield. Thus, the value of a levered company is higher than the unlevered company, which makes debt financing attractive.

Although Modigliani and Miller (Berk, 2011) argued that the market value of a company is not affected by the way it finance its investment, but debt finances increases bankruptcy risk thus causing financial distress. Therefore managers may choose to limit taking on too much debt finance. In the long run, investment and operating decisions are the main drivers in enhancing a firm’s market value. This implies the importance of maintaining a healthy liquidity to secure good investment opportunities

Homemade Leverage

Homemade leverage is the use of borrowing or lending to alter financial leverage of the company the investor is exposed to (Bhatnagar, 2009). The MM proposition demonstrates that if investors prefer an alternative capital structure different to the chosen leverage of the firm, investors may achieve same results by homemade leverage (Wilkinson, 2003).

We will now illustrate that a firm’s capital structure choice becomes irrelevant as any investor who favours the proposed capital structure can simply create it using homemade leverage model (Berk, 2011:455-458). For example, an investor who prefers to hold levered equity as opposed to the wholly equity firm can do so by adding leverage onto his portfolio i.e. buying stock on margin.

	Recession	Initial cost	Expansion
Unlevered equity	$900	$1000	$1400
Margin loan	(£525)	($500)	($525)
Levered equity	$375	$500	$875

While the cash flows of the unlevered equity serve as a security for the margin loan, the loan becomes risk free and investors may borrow at 5% risk free rate. The investor is able to replicate the payoffs to the levered equity using homemade leverage as illustrated in the table above for a cost of $500. Thus, by the Law of One Price, the levered equity must be valued at $500.

Supposing that the entrepreneur of the unlevered firm introduces debt, but the investor prefers to hold unlevered equity. The investor can replicate the payoffs of the unlevered equity by purchasing both of the firm’s debt and equity. Combining the cash flows of both stocks produces cash flows identical to unlevered equity ($1000) as illustrated below.

	Recession	Initial cost	Expansion
Debt	$525	$500	$525
Levered equity	$375	$500	$875
Unlevered equity	$900	$1000	$1400

In this scenario, a firm’s capital structure choice becomes irrelevant in respect of homemade leverage. However, under perfect market assumptions, different choices of capital structure offer no advantage to investors as they do not affect the firm’s value.

Net Present Value (NPV) or Internal Rate of Return (IRR)?

Although the popularity of NPV is growing in recent years, internal rate of return and payback period methods are commonly used in practice. A survey study conducted by John Graham and Campbell Harvey in 2001 shows that 75% of firms surveyed use the NPV for making investment decisions. This contrasts with a similar study done by LJ. Gitman and JR. Forrester, who argued that only 10% of firms use NPV (Berk, 2011:158-159) and Cohen & Yagil claims that IRR is more popular than NPV (Atrill, 2012)

F. Alkaraan and D. Northcott’s study agrees with Graham and Campbell (Atrill, 2012:155-157). They surveyed 83 senior financial managers from large manufacturing corporations and concluded that NPV is seen the most popular, followed by IRR and payback method. However, as capital budgeting decisions often involve major undertakings, therefore risk and rewards had to be carefully weighed, Alkaraan and Northcott also found out that 98% of the managers do not rely on just one investment appraisal technique and 88% have used more than three methods.

In my view, each appraisal method has its advantages and shortcomings as discussed in previous postings, its beneficial to include a combination of alternative methods in evaluating an investment opportunity and using own business judgement as well. Sometimes using alternative rules may give the same answer as NPV, but other times they may differ. In the case the rules conflict, following the alternative rule means undertaking a negative NPV project, thus leading to bad decisions that reduces wealth.

Systematic and Unsystematic Risk

While investing in a stock market, one must take into account the risk that affects the stock return i.e. systematic risk and unsystematic risk. This can be differentiated as below:

Systematic Risk

Systematic risk refers to risk that cannot be diversified away (non-diversifiable risk). It is uncontrollable by an organisation and is macro in nature e.g. interest rate risk, inflations, war. Investors have to face the systematic risks, regardless. For instance, a global recession affects the whole share market and not just one single share. Similarly, interest rates increase affects every stock in the market. For example, Black Monday in 1987, stock markets crashed and almost all stock dropped in significant value in that single day (Colombo, 2012).

Unsystematic Risk

Unsystematic risk is unique to an industry which affects the variability in stock or security return. It is also known as “unique risk” as it is due to influence of internal factors prevailing within a company. From an organisation’s point of view, this is controllable. i.e. business risk, financial risk and operational risk. For example, the long running row over cost cutting caused staff at British Airways to go on strike in 2010, causing a loss of £142m in revenues, subsequently causing it share value to suffer (R.Massey, 2010).

Investors may mitigate this risk by diversifying their portfolio.  Following an increase of securities in a portfolio, the portfolio’s standard deviation of the rate of return reduces. It is said that unsystematic risk can be fully diversified by holding 15–20 asset portfolio (Wiley, 2004).

CAPM calculation

According to CAPM (Shapiro, 2003), if an asset is correctly priced, it should be positioned on the SML. However, in reality, the expected returns may differ from what it should be according to CAPM. Using the information given, the required returns are calculated using the formula below:

Required returns = Risk free rate + (Share’s beta x market Risk premium)

Stock A: CAPM = 4% + 1.5 (6%) = 13%

Stock B: CAPM = 4% + 0.5 (6%) = 7%

On the basis of the above calculations, investors would require a return of 13% to justify buying Stock A and 7% for Stock B. Using the derived CAPM, this is plotted on to the SML chart to analyse if the expected returns given reflect the correct price.

Shares should be bought if the security is plotted above the SML as it is undervalued and investors can expect greater takings. Vice versa, the stock should be sold if it is plotted below the line as it means it is overvalued and the returns are not enough to compensate for the risk.

Applying the above calculations and information given, Stock A is undervalued (required return is 13% against 19%), while Stock B is also undervalued (7% against 8%), therefore both stock should be bought.

CAPM is an equilibrium model. This then pushes the market to move towards equilibrium, meaning that all assets would be correctly priced and the expected and required return would be equal. The market is efficient when no investor can recognise any mispriced assets (Zivot, 2006).

Security Market Line (SML) and Capital Market Line (CML)

Security Market Line (SML)

According to Brearley (2012), the SML represents the CAPM equation and implies a linear connection between the expected return and systematic risk (beta). The SML intercept on the Y-axis (expected returns) represents the risk free rate when beta equals to 0. CAPM states that the market portfolio is efficient, thus all stocks should lie on the SML (Berk, 2011). Shares should be bought if the security is plotted above the SML as it is undervalued and investors can expect greater takings. Vice versa, the stock should be sold if it is plotted below the line as it means it is overvalued and the returns are not enough to compensate for the risk. This will push back the market to equilibrium.

Capital Market Line (CML)

The CML represents the best possible group of portfolio assets that makes the most out of the expected level of returns at a  given level of risk (as defined by volatility/ standard deviation). Thus, investors should choose a portfolio with a combination of both risk free investments and market portfolio (RiskLearn, 2012). It is noted that when investors have identical expectations the market portfolio and efficient frontier coincides (JM Samuels, 1995:258-262). This is known as the tangency portfolio.

Beta

Beta is a measure of the stock’s volatility and is used to evaluate the expected rate of return i.e. the amount of return that investors required to compensate for the risk (KSigman, 2005). Generally, representative index e.g. S&P 500 for US stocks can be used to obtain beta. With the given information, this can be applied to the above CAPM equation to obtain the stock’s beta.

E(r) = Rf + B(Rm – Rf)

8% = 2% + B (8%)

B = 0.75

The beta obtained shows that it is less volatile than the market as a whole and a beta less than 1.0 implies stocks from a utility company(Little, 2013). So during a bear market, when the market moves down by 10%, the stock price will tend to fall by 7.5%. Vice versa, during a bull market, it may not give the highest returns.

In general, a mix of high and low beta stocks aids as an adequate diversification. Like most financial prediction tools, the beta only measures the volatility of the stock in the past using historical data. Beta fluctuates all the time, thus it may not be an accurate measure to predict its current volatility.

CAPM

The CAPM model (Berk, 2011:357) explains the relationship between risk and expected returns. The following assumptions are applied:

·         Investors can borrow and lend at risk free rates

·         All investors are rational and risk adverse

·         All investors receives the same information and that information are costless

·         The markets are perfect, thus no tax, inflations or transaction cost are taken into account

·         Investors have same expectations regarding risk and expected returns of security

With the given information and assumptions, the expected returns can be derived using the CAPM formula as below:

E(r) = Rf + B(Rm – Rf)

Where:

E(r) = 3% + (1.2) (12% – 3%) = 3% + (1.2 x 9%) = 13.8%

Based on the calculations above, investors can expect a rate of return of 13.8% to compensate for the stock’s individual risk, stock market’s risk and the risk free rate interest. From the beta given, it denotes volatility greater than 1 and implies that the stock probably represents stock from a technology company.

A limitation to note is that the expected return derived is based on historical data and may not guarantee the returns as expected. (Investors Chronicle, 2001)

Internal Rate of Return (IRR)

The Internal rate of return is the discount rate which yields a zero net present value (P.Atrill, 2012:157). The higher the IRR, the more desirable to undertake the project. Thus, projects can be ranked accordingly and the highest will be selected. An attribute of the IRR is that it takes into account the power of compounding interest and assumes that all cash flows are reinvested at the IRR.

To obtain the IRR, the trial and error approach is applied. At 3% interest rate, we obtained the following:

Now: Present value (PV) = -$1350k

Year 1: PV = $700k / 1.03 = $679.63k

Year 2: PV = $750k / 1.03² = $706.95k

Adding those up gets NPV = -$1350k + $679.63k + $706.95k = $36.58k

The results shows a positive NPV, thus a larger interest rate is needed to derive a negative NPV in order to calculate the IRR. For this purpose, a 10% interest rate is selected.

Now: PV = -$1350k

Year 1: PV = $700k / 1.10 = $636.37k

Year 2: PV = $750k / 1.10² = $619.8k

Adding those up gets NPV = -$1350k + $636.37k + $619.8k = -$93.83k

Using the figures obtained, this can be tabulated into the table below:

Year	Cash Flow ($’000)	DF@3%	DF@10%	PV@3%	PV@10%
0	(1350)	1	1	(1350)	(1350)
1	700	0.9709	0.9091	679.63	636.37
2	750	0.9426	0.8264	706.95	619.8
				36.58	(93.83)

Using the above calculations, we could easily derive the IRR using the following formula and plot it into a graph.

IRR = NPV1 + (DR2-DR1) x NPV1 / (NPV1 – NPV2)

IRR = 3% + (10% - 3%) x 36.58/ 130.41

       = 3% + 1.96% = 4.96% = 5%

According to Berk (2011), the company should undertake the project since its IRR (5%) exceeds the cost of capital (3%).