F9 Atc 2012

2012 EDITION | Study System
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Paper F9 | FINANCIAL MANAGEMENT
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ACCA

PAPER F9
FINANCIAL MANAGEMENT

STUDY SYSTEM

JUNE 2012

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SESSION 00 CONTENTS
2012 DeVry/Becker Educational Development Corp. All rights reserved. (iii)
CONTENTS
Page
Introduction (v)
Syllabus (vi)
Study guide (xi)
Tables and formulae (xix)
Exam technique (xxii)
1 The Financial Management Function 0101
2 The Financial Management Environment 0201
3 Investment Decisions 0301
4 Discounted Cash Flow Techniques 0401
5 Relevant Cash Flows for Discounted Cash Flow Techniques 0501
6 Applications of Discounted Cash Flow Techniques 0601
7 Project Appraisal under Risk 0701
8 Equity Finance 0801
9 Debt Finance 0901
10 Security Valuation and Cost of Capital 1001
11 Weighted Average Cost of Capital and Gearing 1101
12 Capital Asset Pricing Model 1201
13 Working Capital Management 1301
14 Inventory Management 1401
15 Cash Management 1501
16 Management of Accounts Receivable and Payable 1601
17 Risk Management 1701
18 Business Valuation and Ratio Analysis 1801
19 Glossary 1901
Index 2001
SESSION 00 CONTENTS
(iv) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

SESSION 00 SYLLABUS
2012 DeVry/Becker Educational Development Corp. All rights reserved. (v)
INTRODUCTION
This Study System has been specifically written for the Association of Chartered Certified
Accountants fundamentals level examination, Paper F9 Financial Management
It provides comprehensive coverage of the core syllabus areas and is designed to be used
both as a reference text and as an integral part of your studies to provide you with the
knowledge, skill and confidence to succeed in your ACCA examinations
About the author: Mike Ashworth is ATC Internationals lead tutor in financial
management and has more than 10 years experience in delivering ACCA exam-based
training.
How to use this Study System
You should first read through the syllabus, study guide and approach to examining the
syllabus provided in this session to familiarise you with the content of this paper. The
sessions which follow include:
An overview diagram at the beginning of each session.
This provides a visual summary of the topics covered in each Session
and how they are related

The body of knowledge which underpins the syllabus. Features of the
text include:

Definitions Terms are defined as they are introduced.

Illustrations These are to be read as part of the text. Any solutions
to numerical illustrations follow on immediately.

Examples These should be attempted using the proforma
solution provided (where applicable).

Key points Attention is drawn to fundamental rules and
underlying concepts and principles.

Commentaries These provide additional information.

Focus These are the learning outcomes relevant to the
session, as published in ACCAs Study Guide.

Example solutions are presented at the end of each session.
A bank of practice questions is contained in the Study Question Bank provided. These are
linked to the topics of each session and should be attempted after studying each session.
SESSION 00 SYLLABUS
(vi) 2012 DeVry/Becker Educational Development Corp. All rights reserved.
SYLLABUS

Advanced Financial Management

Financial Management

Management Accounting

Aim
To develop the knowledge and skills expected of a finance manager, in relation to
investment, financing, and dividend policy decisions.
Main capabilities
On successful completion of this paper, candidates should be able to:
A Discuss the role and purpose of the financial management function
B Assess and discuss the impact of the economic environment on financial management
C Discuss and apply working capital management techniques
D Carry out effective investment appraisal
E Identify and evaluate alternative sources of business finance
F Explain and calculate the cost of capital and the factors which affect it
G Discuss and apply principles of business and asset valuations
H Explain and apply risk management techniques in business.

AFM (P4)
FM (F9)
MA (F2)
SESSION 00 SYLLABUS
2012 DeVry/Becker Educational Development Corp. All rights reserved. (vii)

Financial management environment (B)

Working capital
management (C)
Investment appraisal
(D)
Business finance
(E)
Cost of capital
(F)
Risk management
(H)
Business valuations
(G)
Financial
management function
(A)

RATIONALE
The syllabus for Paper F9, Financial Management, is designed to equip candidates with the
skills that would be expected from a finance manager responsible for the finance function of
a business. The paper, therefore, starts by introducing the role and purpose of the financial
management function within a business. Before looking at the three key financial
management decisions of investing, financing, and dividend policy, the syllabus explores
the economic environment in which such decisions are made.
The next section of the syllabus is the introduction of investing decisions. This is done in
two stages - investment in (and the management of) working capital and the appraisal of
long-term investments.
The next area introduced is financing decisions. This section of the syllabus starts by
examining the various sources of business finance, including dividend policy and how much
finance can be raised from within the business. Cost of capital and other factors that
influence the choice of the type of capital a business will raise then follows. The principles
underlying the valuation of business and financial assets, including the impact of cost of
capital on the value of the business is covered next.
The syllabus finishes with an introduction to, and examination of, risk and the main
techniques employed in the management of such risk.
SESSION 00 SYLLABUS
(viii) 2012 DeVry/Becker Educational Development Corp. All rights reserved.
DETAILED SYLLABUS
A Financial management function
1. The nature and purpose of financial management
2. Financial objectives and relationship with corporate strategy
3. Stakeholders and impact on corporate objectives
4. Financial and other objectives in not-for-profit organisations
B Financial management environment
1. The economic environment for business
2. The nature and role of financial markets and institutions
C Working capital management
1. The nature, elements and importance of working capital
2. Management of inventories, accounts receivable, accounts payable and cash
3. Determining working capital needs and funding strategies
D Investment appraisal
1. The nature of investment decisions and the appraisal process
2. Non-discounted cash flow techniques
3. Discounted cash flow (DCF) techniques
4. Allowing for inflation and taxation in DCF
5. Adjusting for risk and uncertainty in investment appraisal
6. Specific investment decisions (lease or buy, asset replacement, capital rationing)
SESSION 00 SYLLABUS
2012 DeVry/Becker Educational Development Corp. All rights reserved. (ix)
E Business finance
1. Sources of, and raising short-term finance
2. Sources of, and raising long-term finance
3. Raising short and long term finance through Islamic financing
4. Internal sources of finance and dividend policy
5. Gearing and capital structure considerations
6. Finance for Small and Medium-size Entities (SMEs)
F Cost of capital
1. Sources of finance and their relative costs
2. Estimating the cost of equity
3. Estimating the cost of debt and other capital instruments
4. Estimating the overall cost of capital
5. Capital structure theories and practical considerations
6. Impact of cost of capital on investments
G Business valuations
1. Nature and purpose of the valuation of business and financial assets
2. Models for the valuation of shares
3. The valuation of debt and other financial assets
4. Efficient Markets Hypothesis (EMH) and practical considerations in the valuation of
shares
H Risk management
1. The nature and types of risk and approaches to risk management
2. Causes of exchange rate differences and interest rate fluctuations
3. Hedging techniques for foreign currency risk
4. Hedging techniques for interest rate risk
SESSION 00 SYLLABUS
(x) 2012 DeVry/Becker Educational Development Corp. All rights reserved.
APPROACH TO EXAMINING THE SYLLABUS
The syllabus for Paper F9 aims to develop the skills expected of a finance manager who is
responsible for the finance function of a business.
The paper also prepares candidates for more advanced and specialist study in Paper P4,
Advanced Financial Management.
The syllabus is assessed by a three-hour paper-based examination consisting of four
compulsory 25-mark questions. All questions will have computational and discursive
elements. The balance between computational and discursive content will continue in line
with the pilot paper.
15 minutes for reading and planning is given at the start if the examination. During this
time candidates may make notes on the question paper but may not write in the answer
booklet.
Candidates are provided with a formulae sheet and tables of discount and annuity factors.
Candidates should bring a scientific calculator to the examination.
ACCA Support
For examiners reports, guidance and technical articles relevant to this paper see
http://www.acca.co.uk/students/acca/exams/f9/
The ACCAs Study Guide which follows is referenced to the Sessions in this Study System.
SESSION 00 STUDY GUIDE
2012 DeVry/Becker Educational Development Corp. All rights reserved. (xi)
STUDY GUIDE
A FINANCIAL MANAGEMENT
FUNCTION
1. The nature and purpose of financial
management
Explain the nature and purpose of
financial management.
Explain the relationship between
financial management and financial
and management accounting.
2. Financial objectives and the
relationship with corporate strategy
Discuss the relationship between
financial objectives, corporate
objectives and corporate strategy.
Identify and describe a variety of
financial objectives, including:
shareholder wealth
maximisation
profit maximisation
earnings per share growth

3. Stakeholders and impact on
corporate objectives
Identify the range of stakeholders
and their objectives.
Discuss the possible conflict
between stakeholder objectives.
Discuss the role of management in
meeting stakeholder objectives,
including the application of agency
theory.
Describe and apply ways of
measuring achievement of
corporate objectives including:
ratio analysis, using
appropriate ratios such as
return on capital employed,
return on equity, earnings per
share and dividend per share
changes in dividends and share
prices as part of total
shareholder return
Ref:

1

1

1

18

Explain ways to encourage the
achievement of stakeholder
objectives, including:
managerial reward schemes
such as share options and
performance-related pay
regulatory requirements such
as corporate governance codes
of best practice and stock
exchange listing regulations

4. Financial and other objectives in
not-for-profit organisations
Discuss the impact of not-for-profit
status on financial and other
objectives.
Discuss the nature and importance
of Value for Money as an objective
in not-for-profit organisations.
Discuss ways of measuring the
achievement of objectives in not-
for-profit organisations.
B FINANCIAL MANAGEMENT
ENVIRONMENT
1. The economic environment for
business
Identify and explain the main
macroeconomic policy targets.
Define and discuss the role of fiscal,
monetary, interest rate and
exchange rate policies in achieving
macroeconomic policy targets.
Explain how government economic
policy interacts with planning and
decision-making in business.
Ref:

1

1

2

(xii) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

Explain the need for, and the
interaction with, planning and
decision-making in business of:
competition policy
government assistance for
business
green policies
corporate governance
regulation.

2. The nature and role of financial
markets and institutions
Identify the nature and role of
money and capital markets, both
nationally and internationally.
Explain the role of financial
intermediaries.
Explain the functions of a stock
market and a corporate bond
market.
Explain the nature and features of
different securities in relation to the
risk/return trade-off.
C WORKING CAPITAL
MANAGEMENT
1. The nature, elements and
importance of working capital
Describe the nature of working
capital and identify its elements.
Identify the objectives of working
capital management in terms of
liquidity and profitability, and
discuss the conflict between them.
Discuss the central role of working
capital management in financial
management.
Ref:

2

9

13

2. Management of inventories,
accounts receivable, accounts
payable and cash
Explain the cash operating cycle
and the role of accounts payable
and accounts receivable.
Explain and apply relevant
accounting ratios, including:
current ratio and quick ratio
inventory turnover ratio,
average collection period and
average payable period
sales revenue/net working
capital ratio

Discuss, apply and evaluate the use
of relevant techniques in managing
inventory, including the Economic
Order Quantity model and Just-in-
Time techniques.
Discuss, apply and evaluate the use
of relevant techniques in managing
accounts receivable, including:
assessing creditworthiness
managing accounts receivable
collecting amounts owing
offering early settlement
discounts
using factoring and invoice
discounting
managing foreign accounts
receivable.

Discuss and apply the use of
relevant techniques in managing
accounts payable, including:
using trade credit effectively
evaluating the benefits of
discounts for early settlement
and bulk purchase
managing foreign accounts
payable.
Ref:

13

13

14

16

16

2012 DeVry/Becker Educational Development Corp. All rights reserved. (xiii)

Explain the various reasons for
holding cash, and discuss and
apply the use of relevant techniques
in managing cash, including:
preparing cash flow forecasts
to determine future cash flows
and cash balances
assessing the benefits of
centralised treasury
management and cash control
cash management models, such
as the Baumol model and the
Miller-Orr model
investing short-term.

3. Determining working capital needs
and funding strategies
Calculate the level of working
capital investment in current assets
and discuss the key factors
determining this level, including:
the length of the working
capital cycle and terms of trade
an organisations policy on the
level of investment in current
assets
the industry in which the
organisation operates

Describe and discuss the key factors
in determining working capital
funding strategies, including:
the distinction between
permanent and fluctuating
current assets
the relative cost and risk of
short-term and long-term
finance
the matching principle
the relative costs and benefits
of aggressive, conservative and
matching funding policies
management attitudes to risk,
previous funding decisions and
organisation size.
Ref:

15

13

D INVESTMENT APPRAISAL
1. The nature of investment decisions
and the appraisal process
Distinguish between capital and
revenue expenditure, and between
non-current assets and working
capital investment.
Explain the role of investment
appraisal in the capital budgeting
process.
Discuss the stages of the capital
budgeting process in relation to
corporate strategy.
2. Non-discounted cash flow
techniques
Identify and calculate relevant cash
flows for investment projects.
Calculate payback period and
discuss the usefulness of payback as
an investment appraisal method.
Calculate return on capital
employed (accounting rate of
return) and discuss its usefulness as
an investment appraisal method.
3. Discounted cash flow (DCF)
techniques
Explain and apply concepts relating
to interest and discounting,
including:
the relationship between
interest rates and inflation, and
between real and nominal
interest rates
the calculation of future values
and the application of the
annuity formula
the calculation of present
values, including the present
value of an annuity and
perpetuity, and the use of
discount and annuity tables
the time value of money and
the role of cost of capital in
appraising investments.
Ref:

3

5

3

3

5

4

4

4

(xiv) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

Calculate net present value and
discuss its usefulness as an
investment appraisal method.
Calculate internal rate of return and
investment appraisal method.
Discuss the superiority of DCF
methods over non-DCF methods.
Discuss the relative merits of NPV
and IRR.
Calculate discounted payback and
investment appraisal method
4. Allowing for inflation and taxation
in DCF
Apply and discuss the real-terms
and nominal-terms approaches to
investment appraisal.
Calculate the taxation effects of
relevant cash flows, including the
tax benefits of capital allowances
and the tax liabilities of taxable
profit.
Calculate and apply before- and
after-tax discount rates.
5. Adjusting for risk and uncertainty in
investment appraisal
Describe and discuss the difference
between risk and uncertainty in
relation to probabilities and
increasing project life.
Apply sensitivity analysis to
investment projects and discuss the
usefulness of sensitivity analysis in
assisting investment decisions.
Apply probability analysis to
investment projects and discuss the
usefulness of probability analysis in
assisting investment decisions.
Apply and discuss other techniques
of adjusting for risk and uncertainty
in investment appraisal, including:
simulation
adjusted payback
risk-adjusted discount rates
Ref:
4

4

4

4

7

5

5

10

7

6. Specific investment decisions (Lease
or buy; asset replacement; capital
rationing)
Evaluate leasing and borrowing to
buy using the before-and after-tax
costs of debt.
Evaluate asset replacement
decisions using equivalent annual
cost.
Evaluate investment decisions
under single-period capital
rationing, including:
the calculation of profitability
indexes for divisible
investment projects
the calculation of the NPV of
combinations of non-divisible
investment projects
a discussion of the reasons for
capital rationing

E BUSINESS FINANCE
1. Sources of and raising short-term
finance
Identify and discuss the range of
short-term sources of finance
available to businesses, including:
overdraft
short-term loan
trade credit
lease finance

2. Sources of and raising, long-term
finance
Identify and discuss the range of
long-term sources of finance
available to businesses, including:
equity finance
debt finance
lease finance
venture capital

Ref:
6

9

8,9

2012 DeVry/Becker Educational Development Corp. All rights reserved. (xv)

Identify and discuss methods of
raising equity finance, including:
rights issue
placing
public offer
stock exchange listing

3. Raising short and long term finance
through Islamic financing
Explain the major difference
between Islamic finance and the
other conventional finance.
Explain the concept of interest
(riba) and how returns are made by
Islamic financial securities.
(calculations are not required).
Identify and briefly discuss a range
of short and long term Islamic
financial instruments available to
businesses including:
trade credit (murabaha)
lease finance (ijara)
equity finance (mudaraba)
debt finance (sukuk)
venture capital (musharaka)

4. Internal sources of finance and
dividend policy
Identify and discuss internal
sources of finance, including:
retained earnings
increasing working capital
management efficiency

dividend policy and the financing
decision.
Discuss the theoretical approaches
to, and the practical influences on,
the dividend decision, including:
legal constraints
liquidity
shareholder expectations
alternatives to cash dividends
Ref:

8

2

8

5. Gearing and capital structure
considerations
Identify and discuss the problem of
high levels of gearing.
Assess the impact of sources of
finance on financial position and
financial risk using appropriate
measures, including:
ratio analysis using statement
of financial position gearing,
operational and financial
gearing, interest coverage ratio
and other relevant ratios
cash flow forecasting
effect on shareholder wealth

6. Finance for small and medium sized
entities (SMEs)
Describe the financing needs of
small businesses.
Describe the nature of the financing
problem for small businesses in
terms of the funding gap, the
maturity gap and inadequate
security.
Explain measures that may be taken
to ease the financing problems of
SMEs, including the responses of
government departments and
financial institutions.
Identify appropriate sources of
finance for SMEs and evaluate the
financial impact of different sources
of finance on SMEs.
F COST OF CAPITAL
1. Sources of finance and their relative
costs
Describe the relative risk-return
relationship and the relative costs of
equity and debt.
Describe the creditor hierarchy and
its connection with the relative costs
of sources of finance.
Ref:

11

18

8,9

9

(xvi) 2012 DeVry/Becker Educational Development Corp. All rights reserved.
2. Estimating the cost of equity
Apply the dividend growth model
and discuss its weaknesses.
Apply the capital asset pricing
model (CAPM) and describe and
explain the assumptions and
components of the CAPM.
Explain and discuss the advantages
and disadvantages of the CAPM.
3. Estimating the cost of debt and
other capital instruments
Calculate the cost of capital of a
range of capital instruments,
including:
irredeemable debt
redeemable debt
convertible debt
preference shares
bank debt

4. Estimating the overall cost of capital
Distinguish between average and
marginal cost of capital.
Calculate the weighted average cost
of capital (WACC) using book
value and market value weightings.
5. Capital structure theories and
practical considerations
Describe the traditional view of
capital structure and its
assumptions.
Describe the views of Miller and
Modigliani on capital structure,
both without and with corporate
taxation, and their assumptions.
Identify a range of capital market
imperfections and describe their
impact on the views of Miller and
Modigliani on capital structure.
Explain the relevance of pecking
order theory to the selection of
sources of finance.
Ref:

10

12

12

10

11

11
6. Impact of cost of capital on
investments
company value and cost of capital.
Discuss the circumstances under
which WACC can be used in
investment appraisal.
Discuss the advantages of the
CAPM over WACC in determining
a project-specific cost of capital.
Apply the CAPM in calculating a
project-specific discount rate.
G BUSINESS VALUATIONS
1. Nature and purpose of the
valuation of business and financial
assets
Identify and discuss reasons for
valuing businesses and financial
assets.
Identify information requirements
for valuation and discuss the
limitations of different types of
information.
2. Models for the valuation of shares
Asset-based valuation models,
including:
net book value (statement of
financial position basis).
net realisable value basis.
net replacement cost basis.

Income-based valuation models,
including:
price/earnings ratio method
earnings yield method.

Cash flow-based valuation models,
including:
dividend valuation model and
the dividend growth model.
discounted cash flow basis.
Ref:

10

11

12

12

18

18

2012 DeVry/Becker Educational Development Corp. All rights reserved. (xvii)
3. The valuation of debt and other
financial assets
Apply appropriate valuation
methods to:
irredeemable debt
redeemable debt
convertible debt
preference shares

4. Efficient Market Hypothesis (EMH)
and practical considerations in the
valuation of shares
Distinguish between and discuss
weak form efficiency, semi-strong
form efficiency and strong form
efficiency.
Discuss practical considerations in
the valuation of shares and
businesses, including:
marketability and liquidity of
shares
availability and sources of
information
market imperfections and
pricing anomalies
market capitalisation

Describe the significance of investor
speculation and the explanations of
investor decisions offered by
behavioural finance.
H RISK MANAGEMENT
1. The nature and types of risk and
approaches to risk management
Describe and discuss different types
of foreign currency risk:
translation risk
transaction risk
economic risk
Ref:

10

2

10

10

17

Describe and discuss different types
of interest rate risk:
gap exposure
basis risk

2. Causes of exchange rate differences
and interest rate fluctuations
Describe the causes of exchange
rate fluctuations, including:
balance of payments
purchasing power parity
theory
interest rate parity theory
four-way equivalence

Forecast exchange rates using:
purchasing power parity
interest rate parity

Describe the causes of interest rate
fluctuations, including:
structure of interest rates and
yield curves
expectations theory
liquidity preference theory
market segmentation

3. Hedging techniques for foreign
currency risk
Discuss and apply traditional and
basic methods of foreign currency
risk management, including:
currency of invoice
netting and matching
leading and lagging
forward exchange contracts
money market hedging
asset and liability management

Compare and evaluate traditional
methods of foreign currency risk
management.
Ref:
17

17

17

2

17

(xviii) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

Identify the main types of foreign
currency derivatives used to hedge
foreign currency risk and explain
how they are used in hedging. (No
numerical questions will be set on
this topic)
4. Hedging techniques for interest rate
risk
Discuss and apply traditional and
basic methods of interest rate risk
management, including:
matching and smoothing
asset and liability management
forward rate agreements.

Identify the main types of interest
rate derivatives used to hedge
interest rate risk and explain how
they are used in hedging. (No
numerical questions will be set on
this topic).
Ref:

17

SESSION 00 TABLES AND FORMULAE
2012 DeVry/Becker Educational Development Corp. All rights reserved. (xix)
Formula Sheet

Economic order quantity
=
h
o
C
D C 2

Miller Orr Model
Return point = Lower limit + (
1
/
3
spread)
Spread =
3
1
rate interest
flows cash of variance cost n transactio
3
4
3

The Capital Asset Pricing Model
E(r
i
) = R
f
+
i
(E(r
m
)R
f
)
The asset beta formula
a =
( ) ( )

+
e
d e
e
T 1 V V
V
+
( )
( ) ( )

+

d
d e
d
T 1 V V
T 1 V

The Growth Model
P
O
=
( )
( ) g
g
+
e
O
r
1 D

Gordons growth approximation
g = br
e

The weighted average cost of capital
WACC =
e
d e
e
K
V V
V
+
+ ( ) T 1 K
V V
V
d
d e
d

+

The Fisher formula
(1+i) = (1+r) (1+h)
Purchasing power parity and interest rate parity
S
1
= S
0
x
( )
( )
b
c
h 1
h 1
+
+
F
0
= S
0
x
( )
( )
b
c
i 1
i 1
+
+

(xx) 2012 DeVry/Becker Educational Development Corp. All rights reserved.
Present value table
Present value of 1 i.e. (1 + r)
n

where r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
2012 DeVry/Becker Educational Development Corp. All rights reserved. (xxi)
Annuity table
Present value of an annuity of 1 i.e.
1 1 +

( ) r
r
n

where r = discount rate
n = number of periods
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10

11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.586 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
SESSION 00 EXAM TECHNIQUE
(xxii) 2012 DeVry/Becker Educational Development Corp. All rights reserved.
EXAM TECHNIQUE
Reading and planning time
During the 15 minutes reading and planning time you may write on the question paper but
not in your answer booklet.
Try to rank the four questions in their level of difficulty plan to attempt the easiest
question first and the most difficult last. This should help keep your confidence high during
the exam.
Although you may use your calculator during the reading and planning time it would be
more effective to draft bullet points for the written elements of the questions.
Any calculations done in the reading and planning time should be restricted to the first
calculation required in each question.
Time allocation
To allocate your time multiply the marks for each question by 1.8 minutes.
So each 25 mark question should take you 25 1.8 = 45 minutes.
You should also apportion your time carefully between the parts of each question.
Do not be tempted to go over the time allocation on each question - remember the law of
diminishing returns the longer you spend the lower your efficiency in gaining marks. It is
more effective to move onto the next question.
Attempt all parts of each question. DO not attempt to pass the exam by only performing
calculations or by only attempting three questions.
Numerical elements
Before starting a computation, picture your route. Do this by noting down the steps
you are going to take and imagining the layout of your answer.
Use a columnar layout if appropriate (e.g. when forecasting a projects cash flows). This
helps to avoid mistakes and is easier for the marker to follow.
Use lots of space.
Include all your workings and cross-reference them to the face of your answer.
A clear approach and workings will help earn marks even if you make an arithmetic
mistake.
If you later notice a mistake in your answer, it is not worthwhile spending time
amending the consequent effects of it. The marker of your script will not punish you for
errors caused by an earlier mistake.
2012 DeVry/Becker Educational Development Corp. All rights reserved. (xxiii)
Dont ignore marks for written recommendations or comments based on your
computation. These are easy marks to gain.
If you write good comments based on calculations which contain errors, you can still
receive all the marks for the comments.
If you could not complete the calculations required for comment then assume an answer
to the calculations. As long as your comments are consistent with your assumed
answer you can still pick up all the marks for the comments.
Write your assumptions if you are not sure how to interpret something in the question
then state your assumed interpretation.
Written elements
You should aim for good quality in discursive aspects.
Planning
Read the requirements carefully at least twice to identify exactly how many points you
are being asked to address.
Note down relevant thoughts on your plan.
Give your plan a structure which you will follow when you write up the answer.
Presentation
Use headings and sub-headings to give your answer structure and to make it easier to
read for the marker. The examiner does not want a long, continuous monologue.
Use short paragraphs for each point that you are making.
Use bullet points where this seems appropriate (e.g. for a list of advantages/disadvantages)
however each bullet point must be followed by a full sentence.
Separate paragraphs by leaving at least one line of space between each. Write legibly.
Style
Long philosophical debate does not impress markers.
Concise, easily understood language scores good marks and requires less writing.
Many points briefly explained tend to score higher marks than one or two points
elaborately explained.
Give real life examples to support our comments.
Make sure your handwriting is clear consider using block capitals.
(xxiv) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

SESSION 01 THE FINANCIAL MANAGEMENT FUNCTION
2012 DeVry/Becker Educational Development Corp. All rights reserved. 0101
OVERVIEW
Objective
To understand the nature of financial management.
To appreciate the various stakeholders in an organisation and their respective
objectives.

NATURE OF
FINANCIAL
MANAGEMENT
ORGANISATIONAL
OBJECTIVES

CONFLICTS OF
INTEREST
Corporate objectives
Maximisation of shareholder
wealth
Public sector organisations
Environmental impacts
Agency theory
Stakeholders
Directors and shareholders
Goal congruence
Financial management decisions
Relationships between financial
management, financial and
management accounting

0102 2012 DeVry/Becker Educational Development Corp. All rights reserved.
1 NATURE OF FINANCIAL MANAGEMENT
Definition

The management of activities associated with the efficient acquisition and use
of short and long-term financial resources.

1.1 Financial management decisions
Decisions that are within the scope of financial management include:
What types of funds should be raised equity capital or debt capital?
How should the funds be raised?
On which proposed investments should the funds be spent?
How much dividend should be paid to the shareholders?
How much working capital should the organisation have and how should it be
financed?
How should risk be managed?
1.2 Relationships between financial management, financial and
management accounting
Financial accounting may influence financial management in various ways. For example:
Directors of quoted companies need to consider the impact of financing decisions on the
published financial statements (e.g. operating leases are off balance sheet whereas
finance leases would increase reported financial gearing).
Directors of quoted companies need to consider the impact of investment decisions on
key ratios such as return on capital employed.
Management accounting information can often assist the financial manager. For example:
The budgeting process may identify potential cash deficits/surpluses which the
financial manager must plan to finance/invest.
Analysis of costs into fixed and variable elements may assist financial management
decisions.
Variance analysis may help to control the costs of new projects.
2 ORGANISATIONAL OBJECTIVES
2.1 Corporate objectives
In practice companies are likely to have a variety of different objectives which may include a
number of the following:
profit targets;
market share targets;
share price growth;
local and environmental concerns;
contented workforce;
meeting short-term targets;
long-term plans.
These objectives can be classified as follows:
Profit goals objectives which lead directly to increased profits (e.g. cost reduction
measures);
Surrogate profit goals objectives which lead indirectly to increased profits (e.g.
maintaining a contented workforce);
Constraints on profit objectives which actually restrict profit (e.g. ensuring that the
companys operations do no harm to the environment);
Dysfunctional goals objectives which do not provide a benefit even in the long run
(e.g. the pursuit of market leadership at all costs).
A company may aim at either maximising or satisficing these objectives:
Maximising involves seeking the best possible outcome;
Satisficing involves finding an adequate outcome.
2.2 Maximisation of shareholders wealth
In theoretical terms a single corporate objective is assumed and this is the maximisation of
shareholder wealth.
Shareholder wealth is the combination of dividend and share price growth together
referred to as Total Shareholder Returns (TSR).
The objective of maximising shareholder wealth can be justified in the following ways:
The company which provides the highest returns for its investors will find it easiest to
raise new finance and grow in the future. If a company does not provide competitive
returns it will inevitably decline.
The directors of a company have a legal duty to run the company on behalf of the
shareholders. It is generally considered a reasonable assumption that the shareholders
of listed companies (mainly institutional investors) seek to maximise wealth.
Criticisms of the above include the following:
Maximizing TSR ignores the interests of other stakeholders such as employees,
customers and arguably, society as a whole ;
In the case of unlisted companies even the shareholders may not require maximised
returns (e.g. some closely held companies are run as lifestyle firms whose main
objective is to create prestige for the owners).
2.3 Public sector organisations
2.3.1 Not-for-Profit Organisations
The objective of public sector organisations is to provide the service for which the
organisation was established. These organisations are frequently called Not for Profit
Organisations (NPOs). Such organisations are not constrained by cost/profit objectives to
the same extent as companies. However they are often constrained by having multiple
stakeholders with potentially conflicting objectives.
Consider a state funded university as an example:

Principals

Students

Government

Employers
University
management
Agent

The university management is accountable to multiple stakeholders (i.e. students,
government and potential employers).
However the requirements of the principals may conflict e.g.
Students may desire small class sizes, a large library and courses that meet their
personal interests,;
The government may wish to minimise costs per student;
Potential employers may want graduates with relevant skills for industry (e.g.
engineering graduates as opposed to anthropology graduates).
Designing a performance measurement system where multiple and conflicting objectives
exist is obviously very difficult. Management must try to rank its principals/stakeholders
and prioritise objectives.
NPOs are sometimes said to have as their objective the maximisation of the difference
between the benefits they generate and the costs of their operations. However it is often
very difficult to quantify the benefits that such organisations produce.
2.3.2 Value for money
There is an increasing emphasis on Value For Money (VFM) and achieving Economy
Efficiency, and Effectiveness - the 3 Es:
Economy minimizing the input costs of the organisation;
Efficiency maximizing the output/input ratio;
Effectiveness in meeting the organisations objectives.
Illustration 1

University
Area Economy Efficiency Effectiveness
Possible
measure
Minimising
costs per student
Maximising
student/staff ratio
Quality of
degrees awarded


Example 1

Lewisville is a town with a population of 100,000 people. The town council of
Lewisville operates a bus service which links all parts of the town with the
town centre. The service is non-profit seeking and its mission statement is to
provide efficient, reliable and affordable public transport to all the citizens of
Lewisville. Attempting to achieve this mission often involves operating
services that would be considered uneconomic by private sector bus
companies, due either to the small number of passengers travelling on some
routes or the low fares charged.
However, one member of the council has recently criticised the performance of
the Lewisville bus service as compared to those operated by private sector bus
companies in other towns. She has produced the following information for the
most recent financial year:
Summarised Income and Expenditure Account
$000 $000
Passenger fares 1,200
Staff wages 600
Fuel 300
Depreciation 280

_____
1,180

_____

Surplus 20

_____

Summarised Statement of financial position
$000 $000
Assets
Non-current assets (net) 2,000
Current assets
Inventories 240
Cash 30

_____
270

_____

Total assets 2,270

_____

Equity and liabilities
Ordinary share capital ($1 shares) 2,000
Reserves 210

_____

2,210
Current liabilities 60

_____

Total equity and liabilities 2,270

_____


Example 1 continued

Operating Statistics for Lewisville Bus Service
Total passengers carried 2,400,000 passengers
Total passenger miles travelled 4,320,000 passenger miles

Industry average ratios for private sector bus companies
Return on capital employed 10%
Return on sales (net margin) 30%
Asset turnover 033 times
Average cost per passenger mile 374c

Required:
(a) Using the information provided above, compare the performance of the
Lewisville Bus company to the industry average for private sector
companies.
(b) Discuss the validity of comparing the performance of the Lewisville Bus
Company with private sector bus companies.
(c) Explain the meaning of the following terms in the context of performance
measurement and suggest a measure of each one appropriate to a public
sector bus service.
(i) Economy;
(ii) Effectiveness;
(iii) Efficiency.

Solution
2.4 Environmental impacts
An area of growing concern to all parties, companies included, is that of the environment or
green issues.
It is important that managers understand the impact of the operations of the organisation on
the environment, in order to satisfy public concerns and, increasingly, to avoid any penalties
or costs due to environmental regulations.
For these reasons environmental reporting is becoming more common as part of general
company financial reporting.
The triple bottom line approach - a method of true cost accounting which considers the
impact of production decisions in terms of ecological and social value, as well as economic
value. Those firms that create environmental and social value alongside economic value are
often considered to have a sustainable triple bottom line.
3 CONFLICTS OF INTEREST
3.1 Agency theory
Agency theory examines the duties and conflicts that occur between the parties within a
company that have an agency relationship.

PRINCIPAL

AGENT
AGENTS RESPONSIBILITY
Shareholders
Directors
Directors
Employees
Loan creditors
Shareholders
Generate maximum
return for
shareholders
Work to
maximum
efficiency
Minimise risk
from uses of
borrowed funds

A company can be viewed as a set of contracts between each of these various interest
groups. The company will not succeed unless all of the groups are working towards the
same objectives.
Whilst most research has focused on the potential conflicts between directors and
shareholders there are other potential sources of tension within a firm.
For example when a firms assets are close to the level of its liabilities the debt investors will
pressurize the directors to only undertake low risk projects. This is because the debt
investors have nothing to gain from risky projects (they receive fixed returns) but everything
to lose (if assets fall below liabilities the firm may become unable to service its debts).
Equity investors, on the other hand, may encourage the directors to take on risky projects.
This is because equity investors participate in any excess returns but, due to the protection
provided by their limited liability status, they cannot be forced to cover any losses.
3.2 Stakeholders
Companies are made up of a variety of different interest groups or stakeholders all of
whom are likely to have different interests in and objectives for the company:
Equity shareholders

maximum wealth
Directors

remuneration
power
esteem
Employees

pay and conditions
job security
COMPANY
Loan creditors

security
cash flow
long term prospects
Trade creditors

short term
cash flow
Community

environmental
issues

While shareholders are clearly the key stakeholder modern corporate governance suggests
that directors should take into account the objectives of a wider range of interested parties.
Directors are therefore expected to show responsibility to creditors (e.g. reasonable payment
terms), responsibility to employees (e.g. health and safety) and ultimately to society as a
whole (e.g. minimising pollution, investing in social projects Corporate Social
Responsibility (CSR)).
Therefore the overall corporate objective may become satisficing (i.e. producing
satisfactory rather than maximum returns for shareholders). With the rise of the ethical
investor on world stock markets it appears that many shareholders are in fact willing to
accept slightly lower returns in exchange for their companies following a wide range of both
financial and non-financial objectives.
3.3 Directors and shareholders
In larger companies the shareholders entrust the management of the company to the
directors referred to as the separation of ownership from control. The directors are
managing the company on behalf of the shareholders and should therefore always act in the
best interests of the shareholders, while taking into account the objectives of other
stakeholder groups.
This may not always be the case as the directors may have other personal objectives such as:
increasing personal remuneration levels;
maximising bonus payments;
empire building;
job security.
In addition to the personal aspects shown above a small number of directors have been
guilty of not fulfilling their fiduciary duties by:
creative accounting, by choosing creative accounting policies the directors can flatter the
accounts known as window dressing;
off balance sheet finance (e.g. via the use of special purpose vehicles);
takeovers; in defending the company from takeovers some directors have been accused
of trying to protect their own jobs rather than acting in the interests of their
shareholders;
disregard for environmental issues; directors may allow processes which emit pollution
or test products on animals.
If directors follow personal objectives which conflict with those of their shareholders this
leads to agency costs (i.e. lost potential returns for shareholders). This can be referred to
as the agency problem.
Good corporate governance procedures should be implemented to minimise the impact of
agency costs. Unfortunately the implementation of corporate governance brings its own
costs (particularly in the case of the Sarbanes-Oxley Act) and hence a cost-benefit approach
should be followed to determine an appropriate level of control over directors.
It can be argued that the actual return to shareholders = maximum potential return agency
costs cost of following Corporate Social Responsibility.
To some degree shareholders should be more active in monitoring the behaviour of
directors. Most shares in listed companies are held by institutional investors (e.g. pension
funds). Fund managers have often been guilty of operating in a very passive way, for
example not even using the proxy voting rights given to them by the funds investors. Until
there is a rise in shareholder activism it remains likely that some directors will continue to
work in their own best interest.
3.4 Goal congruence
Goal congruence is where each of the parties in an organisation seek to achieve personal
objectives which are also in the best interests of the company as a whole.
For example managers should be encouraged to aim for long-term growth and prosperity
rather than short-term reported profitability.
Methods of encouraging goal congruence between directors and shareholders:
Executive Share Option Plans (ESOPs) although the evidence is mixed regarding the
success of such schemes in motivating directors to improve performance (e.g. a
companys share price may rise due to a general rise in the stock market rather than the
quality of its management).
Long Term Incentive Plans (LTIPs) paying a bonus to directors if over several years
the companys performance is good when benchmarked against that of competitors.
Transparency in corporate reporting.
Increased shareholder activism (e.g. using voting rights).
Improved corporate governance (e.g. through the appointment of truly independent
non-executive directors).
4 CORPORATE GOVERNANCE
4.1 Definition

Corporate governance is defined as the system by which companies are
directed and controlled.
The objective of corporate governance may be considered as the reduction of
agency costs to a level acceptable to shareholders.

4.2 Principles of good governance
Various countries have developed their own codes on corporate governance. Although
detailed knowledge of specific codes is not required candidates should have an awareness of
the main principles:
Every company should be headed by an effective board which should lead and control
the company.
Chairman and CEO there should be a clear division of responsibilities at the head of
the company between running the board (chairman) and running the business (CEO);
no single individual should dominate.
The board should have a balance of executive and independent non-executive directors.
All directors should be required to submit themselves for re-election on a regular basis.
Remuneration committees should comprise independent non-executive directors.
Remuneration committees should provide the packages needed to attract, retain and
motivate executive directors and avoid paying more.
No director should be involved in setting his own remuneration.
The board should maintain a solid system of internal control to safeguard shareholders
investment and the companys assets.
4.3 Government regulation
The UK Combined Code is included in the Listing Rules of the London Stock Exchange.
Although compliance is not obligatory, any listed company which does not comply with the
Combined Code must explain its reasons for non-compliance.
The US Sarbanes Oxley Act applies to all companies listed on a US stock market
including their foreign subsidiaries. Compliance is mandatory.

Key points

The first step in developing the objectives of financial management is to
identify the relevant stakeholders in the organisation
In the corporate sector the key stakeholders are clearly the shareholders.
Most traditional finance theory is therefore built on the assumption that a
company4 objective is to maximise the wealth of its shareholders.
However modern Corporate Social Responsibility (CSR) suggests that
directors should also take into account other stakeholders and therefore
also follow a range of non-financial objectives (e.g. employee satisfaction,
reducing environmental impacts).
Such non-financial objectives may be in conflict with maximising
shareholder wealth. Therefore the overall objective may be to produce
satisfactory returns for shareholders, whilst attempting to meet the
demands of other interest groups.
In practice managers may also have personal objectives which conflict
with their responsibilities as agents of the shareholders. Some managers
may try to maximise personal wealth (e.g. through manipulating bonus
schemes or even theft of company assets).
This creates agency costs for the shareholders. Good corporate
governance systems should reduce these costs to an acceptable level.

FOCUS
You should now be able to:

discuss the nature and scope of financial objectives for private sector companies;
discuss the role of social and non-financial objectives in private sector companies and
identify their financial implications;
discuss the problems of multiple stakeholders in financial management and the
consequent multiple objectives and scope for conflict;
identify objectives (financial and otherwise) in not-for-profit organisations and identify
the extent to which they differ from private sector companies.
EXAMPLE SOLUTIONS
Solution 1
(a) Performance of the Lewisville Bus Service compared with the private sector
When looking at profitability, the Lewisville Bus Service (LBS) has performed poorly
compared to the industry averages for the private sector. Return on capital employed is
0.9% compared to 10% for private companies. Profit margins are also low 1.7% is the
net profit margin compared to 30% for private companies. This is probably due to the
fact that being a public sector provider, LBS has to provide services on less profitable
routes. It also charges lower fares than private sector. However, given that LBS is not a
commercial enterprise, and that its mission is to provide efficient, affordable transport
to the residents of Lewisville, such profitability measures are not relevant.
Asset turnover is higher for LBS than for the private sector revenue is 0.54 times
capital employed, compared to 0.33 for the private sector. This suggests that the LBS
busses achieve higher utilisation than private sector busses. This may be because LBS
fares are lower compared with the private sector. The busses are probably utilised to a
greater extent, with more journeys per day than private sector busses. This is a good
sign as it shows that LBS is achieving greater utilisation of its capital than the private
sector busses in terms of revenue.
Cost per passenger mile, at 27.3 is only 73% of the industry average of 37.4. This is a
good sign as it means that the company is managing to provide more journey distance
for a lower cost, which represents a better use of resources. The main reason may well
be the higher number of passengers, or the bus routes may also be longer, particularly if
LBS is covering routes to outlying suburbs that are far from the city centre.
The fares per passenger mile charged by LBS are only 52% of the fares charged by the
private sector bus companies. As already discussed, this reduces the profitability of
LBS. However, low fared are likely to be appreciated by the users of the bus. The lower
fares are part of the policy of providing affordable public transport.
Appendix calculation of ratios
Return on capital employed
Employed Capital
profit Operating
100 =
210 , 2
20
100 = 0.9%
Net margin
Sales
profit Operating
100 =
200 , 1
20
100 = 1.7%
Asset turnover
employed Capital
Sales
100 =
210 , 2
200 , 1
100 = 0.54 times
Average cost per passenger mile
miles Passenger
costs Operating
=
000 , 320 , 4
000 , 180 , 1
= 27.3c
Fares charged by bus services
Lewisville fare per passenger mile = passenger fares passenger miles
= $1,200,000 4,320,000 = 278c
Private sector = Average cost (1 net margin)
= 374c (1 03) = 534c
(b) Validity of comparison
There are several reasons why comparing the performance of LBS with the average
ratios for the private sector is not a valid exercise. Firstly, the objectives of LBS, as
stated in its mission are to provide efficient, reliable and affordable public transport to
the citizens of Lewisville. Private sector companies are more likely to wish to maximise
the wealth of shareholders. This means that direct comparisons become less meaningful
for the following reasons:
Calculation of return on capital and profit margin are not relevant for LBS, as the
organisation does not exist to make a profit.
Private sector bus companies may cherry pick the most profitable routes, and
avoid providing services on less populated routes. A public sector company such
as LBS may provide services on less populated routes as part of its mission of
providing services to all citizens.
The public sector bus company may aim to charge lower fares particularly to
certain groups such as pensioners and children. Private sector companies may not
feel obliged to do this, and will use a pricing policy that will maximise profits.
In spite of these limitations, some benefits can be obtained by comparing the two. Areas
related to the costs of running the services, quality, and utilisation could lead to some
benefits whereby the public sector could use the private sector as a benchmark.
However, account would still need to be taken of the lower profit routes that are served.
(c) Economy, Effectiveness and Efficiency.
When measuring the performance of public sector organisations it is sometimes
suggested that they should be assessed on the basis of the 3 Es; economy,
effectiveness and efficiency.
Economy is an input measure and is normally based around the expenditure of the
organisation. In the case of the Lewisville bus service it could be measured by total
expenditure as compared to budget.
Effectiveness is an output measure and looks at what the organisation achieves in terms
of its objectives. In the case of the Lewisville bus service it could be measured by the
number of passengers carried, or the number of passenger miles travelled.
Efficiency is a combination of the above two measures. It considers output in relation to
input. In the case of the Lewisville bus service it could be measured by cost per
passenger mile travelled.

SESSION 02 THE FINANCIAL MANAGEMENT ENVIRONMENT
OVERVIEW
Objective
To understand the economic environment within which organisations operate.
To understand the financial environment in which financial management is practised.

ECONOMIC
POLICY
FINANCIAL
MARKETS
THEORY
THE ECONOMIC
ENVIRONMENT
BANKING
SYSTEM
Macroeconomic
policy
Monetary policy
Fiscal policy
Supply side
approach
IMPACT ON
BUSINESS
Inflation
Government
intervention
The Euro
Financial
intermediaries
Commercial clearing
banks
Credit creation
The financial markets
Stock exchange
operations
Financial market
efficiency
Money market interest
rates
THE FINANCIAL
ENVIRONMENT
THE FINANCIAL
MANAGEMENT
ENVIRONMENT
ISLAMIC
FINANCE
Background
The prohibitions
Islamic Instruments
The Shariah board
Developments

1 MACROECONOMIC POLICY
1.1 Definition

The setting of economic objectives by the government (e.g. full employment,
economic growth, the avoidance of inflation) and the use of control
instruments to achieve those objectives (e.g. fiscal policy and monetary policy).

1.2 Objectives of macroeconomic policy
Macroeconomic policies are adopted in order achieve the following objectives:
full employment;
economic growth and thereby improved living standards;
an acceptable distribution of wealth;
price stability and therefore limited inflation;
a solid balance of payments a continual external deficit, where a country is importing
more goods and services than it is exporting, is unsustainable and is likely to lead to an
exchange rate crisis.
The above objectives can often be in conflict (e.g. economic growth can lead to excess
demand for resources and lead to an increase in inflation).
1.3 Global economic events
Financial managers must understand not only national government economic policy but,
due to the increasing interdependence of economies through both the movement of trade
and capital, world macroeconomic trends.
Recent world economic events include:
the dot.com bubble following over-optimism by both business and investors of the
potential returns from the high technology sector.
the launch of the European single currency the Euro in which UK is not currently
participating.
the growing importance of emerging economies (e.g. the BRIC countries (Brazil, Russia,
India and China)).
the 2007 US sub-prime meltdown which, coupled with financial contagion (i.e. high
interdependence between countries) led to frozen debt markets and the global recession.
Some countries, such as Russia, initially believed they were sufficiently de-coupled
from the US economy to escape the worst effects of the credit crunch. Regrettably this
was not the case as many companies in Russia (and throughout Central and Eastern
Europe) had large amounts of foreign debt which could not be easily refinanced.
volatile commodity prices, interest rates, exchange rates and capital markets.
2 MONETARY POLICY
2.1 Definition

Monetary policy can be defined as those actions taken by the government or
the central bank to achieve economic objectives using monetary instruments.
These actions may either directly control the amount of money in circulation
(the money supply) or attempt to reduce the demand for money through its
price (interest rates). For instance, if the rate of interest on funds is increased,
the cost of borrowing is increased and therefore the demand for goods is
decreased and the result of this tends to be a decrease in the rate of inflation.
By exercising control in these ways governments can regulate the level of
demand in the economy. Those who see the use of monetary policies as crucial
in the control of macroeconomic activity are known as monetarists.

2.2 Direct control of the money supply
Governments or central banks can directly control the money supply in the following ways:
2.2.1 Open market operations
If the central bank sells government securities the money supply is contracted, as some
of the funds available in the market are soaked up by the purchase of the government
securities.
Equally, if the central bank were to buy back securities then funds would be released
into the market. The sale of government securities will lead to a reduction in bank
deposits due to the level of funds that have been soaked up.
This in turn can lead to a further reduction in the money supply, as the banks ability to
lend is reduced. This is known as the multiplier effect.
2.2.2 Reserve asset requirements
The central bank can set a minimum level of liquid assets which banks must maintain.
This limits their ability to lend and thereby reduces the money supply.
2.2.3 Special deposits
The central bank can have the power to call for special deposits. These deposits do
not count as part of the banks reserve base against which it can lend. Hence they have
the effect of reducing the banks ability to lend and thereby reducing the money supply.
2.2.4 Direct control
The central bank may set specific limits on the amount which banks may lend.
Credit controls are difficult to impose as, with fairly free international movement of
funds, they can easily be circumvented.
2.3 Reducing the demand for money
Governments can reduce the demand for money, and therefore indirectly the money supply,
by encouraging an increase in short-term interest rates.
2.4 Problems of monetary policy
Problems arise due to the following:
there is often a significant time lag between the implementation of a policy and its
effects;
the ineffectiveness of credit control in the modern global economy;
the fact that the relationship between interest rates, level of investment and consumer
expenditure is not actually stable and predictable;
the undesirable side effects of increasing interest rates:
less investment, leading to reduced industrial capacity, leading to increased
unemployment (as higher interest rates increases the cost of capital for a company
using debt finance);
an overvalued currency which reduces demand for exports.
2.5 How the money supply may be measured
If governments want to control the money supply it is necessary to be able to measure the
supply of money in the economy.
In the UK a number of alternative indicators have emerged including the following:
M0 Notes and coins in circulation and in banks tills.
M3 M0 plus deposits at banks.
M4 M3 plus deposits at building societies.
M5 M4 plus private sector holdings of certain types of government debt.
Whilst M5 may be the most suitable measure to use it is the hardest to control.
Equally, whilst M0 is the easiest measure to control it is probably the least
representative of overall economic activity.
Commentary

In recent times UK governments have attempted to monitor both M0 and M4.

3 FISCAL POLICY
3.1 Definition

Action by the government to achieve economic objectives through the use of
the fiscal instruments of taxation, public spending and the budget deficit or
surplus. Governments can use public expenditure and taxation to regulate the
level of demand within the economy. Those who view fiscal policy as crucial
in the control of macroeconomic activity are known as Keynesians.

3.2 The Keynesian approach
Commentary

Named after the economist John Maynard Keynes.

If the economy is in recession fiscal policy can be used to reflate the economy and the
following actions could be taken:
increase government spending in order to directly increase the level of demand in the
economy (e.g. if a government agrees a number of large road-building projects, the
demand for goods and services in the economy is increased);
reduce taxation in order to boost both consumption and investment.
However, problems can occur due to the following:
government spending is an intervention into the free market and can easily lead to the
misallocation of resources (e.g. support for inefficient industries);
there is often a significant time lag between the authorisation of additional spending
and its actual occurrence;
tax cuts are not efficient at boosting domestic demand, as in times of recession some of
the extra disposable income made available will be saved, and of the extra monies
actually spent some of it will be on imports;
a large budget deficit is likely to occur which will lead to a large Public Sector
Borrowing Requirement (PSBR);
the rate of inflation is likely to rise, as demand may increase for resources which are in
limited supply and for which the prices will therefore tend to increase.
If there is too much demand in the economy (it is overheating), then fiscal policy can be used
to depress demand or deflate the economy, and the following actions could be taken:
reduce government spending in order to decrease directly the level of demand in the
economy;
increase taxation in order to reduce consumption and to assist with the redistribution of
wealth.
However, problems can arise due to the following:
it is not possible to cut government spending dramatically in sectors such as healthcare
or education;
increasing taxation discourages enterprise.
Keynesians favour adjusting the level of government spending in preference to adjusting tax
rates, as they believe it has a quicker and greater impact on the level of demand in the
economy.
3.3 The relationship between fiscal and monetary policy
Fiscal and monetary policies are interdependent and governments will use both fiscal and
monetary policies to achieve their monetary and budgetary targets. Which policies
dominate depends on the economic theory preferred by the government of the day. In the
UK there was a Keynesian approach to the management of the economy from the 1930s to
the 1970s. However, this was believed to have contributed to the boom-bust economic
cycles that were experienced. Hence recent governments have followed a more monetarist
approach.
4 SUPPLY SIDE APPROACH
4.1 Definition

Supply side policies are policies which focus on creating the right conditions in
which private enterprise can grow and therefore raise the capacity of the
economy to provide the output demanded. The private sector, being driven by
the profit motive, is deemed to be more efficient at providing the output
required than the public sector.

4.2 Supply side policy examples
Supply side policies include:
low corporate tax rates to encourage private enterprise;
the promotion of a stable, low inflation economy with minimal government
intervention;
limited government spending;
a balanced fiscal budget;
deregulation of industries;
a reduction in the power of their trade unions;
an increase in the training and education of the workforce;
an increase in the provision of the infrastructure required by business for example
business parks;
a reduction in planning legislation.
4.3 Supply side policies and fiscal policy
Supporters of supply side policies believe that, if business is to flourish, the economy must
be in a stable condition and therefore fiscal policy should be in equilibrium. In other words,
government spending should not exceed government receipts from taxation. Additionally,
if the private sector is to be encouraged, tax rates should be kept to a minimum and
government expenditure also should be kept to a minimum.
4.4 Supply side policies and monetary policy
Monetary policy is used to control inflation to provide the stable economy, in which
business can flourish.
4.5 Problems with the supply side approach
Problems with using supply side policies include the following:
there is a time delay before the policies have any impact;
the private sector will not provide all the goods and services required by society for
example health care provision.
5 INFLATION
5.1 Definition

The rate of increase of the general level of prices in the economy.

5.2 Measurement
The normal way of measuring inflation is to use the Consumer Price Index (CPI) which
attempts to measure changes over time in the monetary cost of a representative basket of
goods and services. The CPI relates to retail goods and services, and hence only gives a
broad indication of how fast prices are rising across the economy.
The maintenance of a low level of inflation is a key economic objective.
Alternative measures of inflation also exist which, for instance, look at the increases in the
costs of manufacturing industry.
5.3 Causes of inflation
Keynesians consider the following to be the major causes of inflation:
5.3.1 Demand-pull inflation
Inflation arises due to demand exceeding the maximum output of the economy with full
employment.
5.3.2 Cost-push inflation
Increases in the cost of raw materials or the cost of labour lead to increases in the unit
costs of firms, and therefore inevitably leads to an increase in prices as these higher
costs are passed on to the consumer. The increased costs suffered by industry may be as
a result of the increase in the cost of imported goods, in which case the term imported
cost-push inflation is used.
Monetarists, on the other hand, believe that inflation arises as a result of too much money
chasing too few goods. Therefore, in the short term inflation should be controlled by
controlling the money supply, whilst in the long term inflation should be controlled by
enhancing the ability of the economy to produce goods and services.
Inflation is also thought to be brought about by peoples expectations, as anticipation of
future price increases is built into wage negotiations in order to protect future real incomes.
In turn, expected increases in costs such as wage costs are built into output prices. This is
sometimes known as the wage-price spiral and it suggests that inflation is on-going and
inevitable.
5.4 The general economic consequences of inflation
The general economic consequences of inflation include the following:
The redistribution of income from those in a weak bargaining position to those in a
strong bargaining position who are therefore able to maintain the real value of their
income;
A disincentive to save as the purchasing power of investments may be reduced;
Where inflation reaches very high levels money is no longer able to carry out its key
functions of being a medium of exchange and a store of value;
A fall in the exchange rate;
A need for higher nominal interest rates.
5.5 Consequences of inflation for companies
Entrepreneurial activity is reduced as it is harder to estimate the likely returns from a
new venture and higher interest rates make borrowing more expensive;
International competitiveness suffers where prices rise faster than those of foreign
competitors;
Uncertainty is increased and hence new investment by existing businesses is reduced;
Higher interest rates reduce the number of profitable investment opportunities and
therefore the level of investment;
In periods of rapid inflation the need to search for the best price currently available for
the purchases required and the need to be constantly updating selling prices adds
significant costs to industry.
5.6 How does inflation distort the evaluation of business performance?
Conventional historic cost accounts have the following problems during periods of
significant inflation:
The historic cost of assets understates the value of the assets;
Changes in asset values are ignored until they are realised;
Gains arising from holding assets are treated as being fully distributable.
The result of the above is that profits become overstated (current revenues are charged with
a measure of historic cost), and capital becomes understated and therefore ROCE (return on
capital employed) is also overstated.
Alternative approaches which have been suggested include the following:
The valuation of assets at their deprival value;
The use of Current Purchasing Power (CPP) or Current Cost Accounting (CCA) in order
to eliminate the above distortions and ensure the maintenance of the shareholders
funds in real terms.
6 GOVERNMENT INTERVENTION IN THE ECONOMY
6.1 Why do governments intervene in the operation of the free market?
Governments intervene in the operation of the free market for the following reasons:
Where monopolies, mergers or restrictive practices operate against the public interest;
Where an industry is of key national strategic importance;
Where the free market creates social injustice;
Where companies fail to take account of the effect of their actions which impact outside
of the company, these are known as externalities; a common example is the pollution
which a company may cause;
Where the free market fails to provide sufficient public goods, such as health care or
education;
Where the free market is unable to provide the amount of capital required (e.g. when a
large infrastructure project, such as the construction of a new tunnel or bridge, is being
undertaken).
6.2 Competition policy
Governments develop competition policies in order to increase the efficiency of the economy
by stimulating competition.
The key components of competition policy in the UK have been as follows:
Monopolies and mergers legislation to prevent the development of monopolies which
would have the power to act against the public interest;
Restrictive practices legislation to eliminate practices such as the setting of retail
prices by manufacturers;
Deregulation in certain industries to remove regulations which restrict competition in
the industry. An example of deregulation in the UK is that of the stock market which
took place in 1986, causing dealing costs to reduce and therefore the volume of trading
to increase greatly;
The creation of internal markets within certain areas of the public sector (e.g. hospitals
or schools) must compete for the resources they require based on the services they
provide to their users.
The UK Competition Commission a government department which investigates
situations which may be against the public interest (e.g. excessive market power). The
Competition Commission uses 25% market share as an indicator of potential unfair
influence. See www.competition-commission.org.uk
6.3 Privatisation
In the UK a large number of state-owned firms have been sold to the private sector either by
sale to the general public, direct sale to another company or management buy-out.
Examples include British Telecom, British Gas and the electricity distribution companies.
The arguments in favour of privatisation include:
an increase in competition where a state monopoly is split into a number of operating
companies prior to sale or where the monopoly position is removed;
a short-term boost to government revenues and therefore a favourable impact on the
PSBR;
a widening of share ownership, thereby increasing individuals stake in the economy as
a whole;
reduction in the PSBR in future as borrowings by the newly-privatised industries are no
longer public borrowings.
The arguments against privatisation include:
many privatisations have replaced state monopolies with private sector monopolies,
which have then required regulation to ensure that their monopoly position is not
abused;
the breaking-up of large businesses into smaller companies results in the loss of
economies of scale;
the quality of service may deteriorate.
6.4 Grants and subsidies
Governments also intervene in the economy through the use of official aid schemes. These
aid schemes include the use of cash grants, consultancy advice and tax incentives in order to
encourage investment in high technology or investment in areas of particularly high
unemployment.
Grants may also be available from transnational institutions. For example, the European
Regional Development Fund has assisted with many infrastructure projects in the remoter
regions of the UK.
6.5 Green policies
Governments are increasingly taking active steps to improve the environmental
performance of firms. Measures include:
Carbon credits where the government allocates each polluting firm a quota of the
number of tonnes of greenhouse gasses that it can emit. If a firm then switches to
greener production techniques it may find it has a surplus of carbon credits which can
then be sold to a firm that is exceeding its quota (i.e. carbon trading).
Government environment agencies the UK Environment Agencys stated purpose is,
to protect or enhance the environment, taken as a whole so as to promote the
objective of achieving sustainable development.
6.6 Corporate governance
Detailed knowledge of specific corporate governance codes is not required for the
examination. The material below is provided to give an idea of the main principles.
The UK Combined Code is included in the Listing Rules of the London Stock Exchange.
Although compliance is not obligatory, any listed company which does not comply with the
Combined Code must explain its reasons for non-compliance.
It sets out the following Principles of Good Governance:
Every listed company should be headed by an effective board which should lead and
control the company.
Chairman and CEO there should be a clear division of responsibilities at the head of
the company between running the board and running the business; no single individual
should dominate.
The board should have a balance of executive and independent non-executive directors.
All directors should be required to submit themselves for re-election at least every three
years.
Remuneration committees should be 100% independent non-executive directors.
Remuneration committees should provide the packages needed to attract, retain and
motivate executive directors and avoid paying more.
Executive service contracts should be for one year or less.
No director should be involved in setting his own remuneration.
The US Sarbanes Oxley Act was introduced in 2002 and represented the most significant
review of US corporate governance since the Securities Exchange Act of 1934. It applies to
all companies listed on a US stock market including their foreign subsidiaries. Compliance
is mandatory.
One of the main provisions of Sarbanes Oxley is that the CEO and CFO should sign off
personally on company accounts. Fraudulent certification (i.e. signing accounts known to be
inaccurate) leads to criminal penalties fines of up to $5m and up to 20 years in prison.
However some CEOs and CFOs have tried to avoid their responsibilities under the
Sarbanes Oxley Act by asking divisional heads to certify their divisions accounts before
they are sent to head office.
Furthermore the level of detail required in reporting compliance with Sarbanes-Oxley is
very high. Such high compliance costs have discouraged many companies from listing their
shares in New York often choosing London where corporate governance codes are based
more on principles than detail.
7 THE EURO
From 1 January 2002 Euro notes and coins replaced the national currencies of Euro-
block countries. The value of the Euro was set by reference to the relative value of the
component currencies. The exchange rate between those currencies is therefore now
fixed.
The UK has not joined the single currency, Therefore UK companies that trade with
Euroland face foreign exchange risk as sterling rises and falls against the Euro.
Although shortterm transaction exposure can be hedged (e.g. using forward
contracts) it is far more difficult to protect against exposure to long-term exchange rate
changes (i.e. economic exposure).
The introduction of the Euro allows easier comparison of prices between member
countries. This should reduce price differentials in Europe and increase competition.
If the UK decides to join the Euro then UK interest rates will fall towards those in the
Euro region. This will have implications for company finance as debt becomes cheaper.
Within the Euro region there is also a move towards tax harmonisation (e.g. introducing
the same corporation tax rates across the area). This obviously has implications for
financial management (e.g. project appraisal).
8 FINANCIAL INTERMEDIARIES
8.1 Definition

Organisations which bring together potential lenders and potential borrowers.
The following financial institutions act as financial intermediaries:
Commercial banks.
Merchant/Investment banks, which provide banking services, including
advice on items such as share issues and mergers, for business customers.
Building societies, which take deposits from the domestic sector and lend
to those buying their own house.
Insurance companies, which can invest much of their premium income in
long-term assets, as their outgoings are reasonably easy to predict.
Investment trusts and unit trusts/mutual funds, which attract investors
and then reinvest the funds raised in other companies.
Pension funds, which receive regular premiums and thus have predictable
cash outflows and can invest in the long term.
Finance companies, which provide business and domestic credit, leasing
finance and factoring/invoice discounting services. These companies are
often a subsidiary of another financial institution.
Discount houses, which trade in investments such as bills of exchange.

8.2 The role of financial intermediaries
Financial intermediaries are important as they carry out the following roles:
Aggregation small deposits are combined and lent to large borrowers.
Maturity transformation a continuing stream of short-term deposits can be used to
lend monies in the long term.
The risk of each particular borrower is effectively spread across many lenders.
Providing a liquid market with flexibility and choice for both lenders and borrowers.
Providing instruments to business for hedging risk (e.g. forward contracts, options and
swaps).
9 COMMERCIAL CLEARING BANKS
The commercial clearing banks carry out the following roles:
They accept deposits from their customers which are held in current or deposit
accounts.
They issue Certificates of Deposit, which may then be traded. These relate to large
deposits which have a term to maturity of at least three months.
They lend money in a number of different ways, thus ensuring that adequate returns
are made. At the same time some cash must be held in order to ensure that sufficient
liquidity is maintained. Banks therefore have to find the right balance between
profitability and liquidity.
They provide a money transmission service through the clearing system.
Bank lending takes the following forms:
Overdraft facilities and term loans to individuals and business customers.
Investments in other financial intermediaries, such as leasing companies.
The purchase of short-term government securities.
The purchase of trade or commercial bills.
The lending of money in the very short term to discount houses which will re-lend in
the longer term, as not all of their borrowings are likely to be called in at any one time.
10 CREDIT CREATION
Banks need to keep only a small proportion of their assets in the form of cash as only a small
proportion of their depositors will require repayment on any particular day. The rest of
their assets can be in the form of investments with which the bank hopes to make the returns
required by their shareholders.
Hence, if a bank has $10,000 deposited with it and it only needs to maintain 12% of its funds
as cash, then the bank is able to invest up to $10,000 (1 0.12) = $8,800. Let us assume that
this investment is made in the form of a loan to a customer and that the full $8,800 is loaned.
Consider now the total funds available in the market. The initial depositor will be able to
call on and spend the original $10,000 and that the borrower has the ability to spend $8,800.
Thus in total $18,800 is available to be spent.
This process can be repeated as the $8,800 in circulation is likely to be spent and finally
deposited back with a bank, which will then be able to loan up to $8,800 (1 0.12) = $7,744,
thus creating additional credit.
This process is known as the multiplier effect.
The proportion of deposits that a bank retains as cash or other very liquid assets is known as
the liquidity ratio or reserve asset ratio. Where the liquidity ratio is known, the
following formula can be used to determine the total final deposits and hence the credit
created from an initial deposit:
Final deposits = Initial deposit
ratio Liquidity
1

Credit created = Final deposits Initial deposit
Using the figures in the above illustration:
Final deposits = $10,000
12 . 0
1
= $83,333
Credit created = $ (83,333 10,000) = $73,333
Central banks, such as the Bank of England, will often want to control the creation of credit,
and therefore the growth in the money supply, as part of their monetary policy. One of the
policy tools available to them is to specify a minimum liquidity ratio which the banks must
maintain.
11 THE FINANCIAL MARKETS
The financial markets include both the capital markets and the money markets. The
following activity takes place on these markets:
Primary market activity the selling of new securities to raise new funds.
Secondary market activity the trading of existing securities.
11.1 The capital markets
The main UK capital markets are:
The Official List at the London Stock Exchange.
The Alternative Investment Market (AIM), which has fewer regulations and less cost
than the Official List and is therefore attractive to smaller companies.
The Eurobond market bonds denominated in any currency other than that of the
national currency of the issuer. Eurobonds are generally issued by large international
companies and have a 10 to 15 year term.
Capital markets exist in many other countries, and large international companies may trade
and raise funds in more than one capital market. In the US the NASDAQ market was set up
in order to provide a market where rapidly expanding, high technology and generally high-
risk companies could raise funds - The Stock Market for the twenty-first century.
These markets provide long-term capital in the form of equity capital, ordinary and
preference shares for example, or loan capital such as debentures. Companies requiring
funds for five years or more will use the capital markets.
11.2 The money markets
The money market is not actually a physical market but is the term used to describe the
trading between financial institutions. The main areas of trading include:
The discount market where bills of exchange are traded.
The inter-bank market where banks lend each other short-term funds.
The Eurocurrency market where banks trade in foreign currencies, usually in the form
of certificates of deposit.
The certificate of deposit market where certificates of deposit are traded.
The local government market where local authorities trade in debt instruments.
The inter-company market where companies lend directly between themselves.
The finance house market where short-term loans raised by finance houses are traded.
The Commercial Paper market commercial paper is short-term unsecured debt issued
by high quality companies.
These markets are for short-term lending and borrowing where the maximum term is
normally one year.
Companies requiring medium term (one to five years) capital will generally raise these
funds through banks.
12 STOCK EXCHANGE OPERATIONS
12.1 The functions and purpose of the Stock Exchange
The primary function of the Stock Exchange is to ensure a fair, orderly and efficient market
for the transfer of securities, and the raising of new capital through the issue of new
securities. In order to do this the Stock Exchange has stringent regulations which are
designed to ensure that:
only suitable companies are allowed to have their securities traded on the Stock
Exchange;
all relevant information is made publicly available as soon as possible in this way
investors can make informed decisions and thus that funds will be attracted to the most
successful companies;
all investors deal on the same terms and at the same prices.
The more efficient and fair the Stock Exchange is seen to be, the more willing people will be
to invest their money in the Exchange and the more successful it will become.
12.2 Who owns shares?
Since the Second World War the importance of the private investor in the UK has declined
and the importance of the institutional investor, for instance pension funds, has risen. Since
1979 it has been government policy to encourage private share ownership, the privatisation
programme reflected this in that private investors were given priority. However, it is
estimated that only about 25% of shares are held by private investors and only about 5% of
individuals hold a reasonable portfolio of shares.
12.3 How are shares bought and sold?
If an investor wants to buy or sell shares he contacts a broker. The broker will either act as
an agent and deal through a market maker or he may deal himself, in which case he is
known as a broker dealer. The broker will charge a fee for his services, whilst a market
maker will generate a profit through the bid-offer spread, which is simply the difference
between the price he is willing to pay for a share and the price at which he is willing to sell
it.
12.4 How are shares valued?
Shares are valued using market forces at the price at which there are as many willing sellers
as there are willing buyers. For instance, if a share is overvalued there will be more people
keen to sell their holding than there will be willing to buy, and this will inevitably depress
the market price.
Some trading will be done for speculative reasons:
A bull is someone who believes that prices will rise. He buys shares in the hope of
selling them in the future for a profit.
A bear is someone who believes prices will fall. He sells shares in the belief he will be
able to buy them back later for less.
Commentary

When there are more bulls than bears prices will rise, and when there are more bears
than bulls prices will fall.

Such speculative dealing has an important role as:
it reduces fluctuations in the market; for instance, as the market falls and prices fall,
more and more speculators will become bullish and start to buy again, thus arresting
the fall in the market
it ensures that there is always a ready market in all shares; in other words, there will
always be someone willing to buy or sell at the right price.
13 FINANCIAL MARKET EFFICIENCY
13.1 Introduction
An efficient market is one in which the market price of all securities traded on it reflects all
the available information. A perfect market is one which responds immediately to the
information made available to it.
An efficient and perfect market will ensure that quoted share prices are as fair as possible, in
that they accurately and quickly reflect a companys financial position with respect to both
current and future profitability.
Efficiency can be looked at in several ways:
Allocative efficiency:

Does the market attract funds to the best companies?
Operational efficiency:

Does the market have low transaction costs and a convenient trading platform? These
promote a deep market with high liquidity (i.e. a high volume of transactions
withlow transaction costs).
Informational efficiency:
Is all relevant information available to all investors at low cost?
Pricing efficiency:

Do share prices quickly and accurately reflect all known information about the
company? This is also referred to as information processing efficiency.
13.2 The Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) considers information processing efficiency/pricing
efficiency. In order to test this hypothesis three potential levels of efficiency are considered.
13.2.1 Weak-form efficiency
Share prices reflect all the information contained in the record of past prices. Share
prices will follow a random walk.

If this level of efficiency has been achieved it should not be possible to forecast price
movements by reference to past trends (i.e. chartists, also called technical analysts)
should not be able to consistently out-perform the market.
Semi-strong form efficiency:

Share prices reflect all information currently publicly available. Therefore the price will
alter only when new information is published.
If this level of efficiency has been reached, price movements can only be forecast by
using inside information (i.e. material non-public information). This is known as
insider trading which is illegal in most markets and is unethical in all markets.
13.2.2 Strong-form efficiency
Share prices reflect all information, published and unpublished, that is relevant to the
company.

If this level of efficiency has been reached, share prices cannot be predicted and gains
through insider dealing are not possible as the market already knows everything!
In major markets (e.g. London and New York Stock Exchanges) there are strict rules
outlawing insider dealing. Therefore such markets are regarded as semi-strong efficient.
13.3 Implications for financial managers
The level of efficiency of the stock market has implications for financial managers:
The timing of new issues:

Unless the market is fully efficient the timing of new issues remains important. This is
because the market does not reflect all the relevant information, and hence advantage
could be obtained by making an issue at a particular point in time just before or after
additional information becomes available to the market.
Project evaluation:

If the market is not fully efficient, the price of a share is not fair, and therefore the rate of
return required from that company by the market cannot be accurately known. If this is
the case, it is not easy to decide what rate of return to use to evaluate new projects.
Creative accounting:

Unless a market is fully efficient creative accounting can still be used to mislead
investors.
Mergers and takeovers:

Where a market is fully efficient, the price of all shares is fair. Hence, if a company is
taken over at its current share value the purchaser cannot hope to make any gain unless
economies can be made through scale or rationalisation when operations are merged.
Unless these economies are very significant an acquirer should not be willing to pay a
significant premium over the current share price.
Validity of current market price:

If the market is fully efficient, the share price is fair. In other words, an investor receives
a fair risk/return combination for his investment and the company can raise funds at a
fair cost. If this is the case, there should be no need to discount new issues to attract
investors.
14 MONEY MARKET INTEREST RATES
14.1 Introduction
Different financial instruments offer different interest rates. In order to understand why this
is, it is necessary to appreciate the factors which determine the appropriate interest rate for a
particular financial instrument.
14.2 Factors determining interest rates
General level of interest rates in the economy:

These are affected by:
Inflation.
Government monetary policy.
The demand for borrowing.
Investors preference for cash.
International factors such as interest rates overseas and exchange rate movements.

Level of risk:

The higher the level of risk the greater return an investor will expect.
Duration of the loan:

If it is assumed that in the long-term interest rates are expected to remain stable then the
longer the length of the loan the higher the interest rate will be. This is because lending
money in the longer term has additional risk for the lender (e.g. the risk of default
increases).
The need for the financial intermediaries to make a profit:

For instance, a depositor at a building society will receive a lower rate of interest than a
borrower will be charged.
Size:

If a large sum of money is lent or borrowed, there are administrative savings; hence a
higher rate of interest can be paid to a lender and a lower rate of interest can be charged
to a borrower than would normally be the case.
14.3 Term Structure of Interest Rates
The return provided by a security will alter according to the length of time before the
security matures.
If, for example, a graph is drawn showing the yield to maturity/gross redemption yield of
various government securities against the number of years to maturity, a yield curve such
as the one below might result.

Yield
Years to maturity

It is important for financial managers to be aware of the shape of the yield curve, as it
indicates to them the likely future movements in interest rates and hence assists in the choice
of finance for the company.
The shape of the curve can be explained by the following:
14.3.1 Liquidity preference theory
Yields will need to rise as the term to maturity increases, as by investing for a longer
period the investor is deferring his consumption and needs higher compensation.
Hence a normal yield curve slopes upwards, as shown above.
14.3.2 Expectations theory
If interest rates are expected to increase in the future, the curve may rise even more
steeply. On the other hand the curve may fall (i.e. invert if interest rates are expected to
decline).
14.3.3 Segmentation theory
Different investors are interested in different segments of the yield curve. Short-term
yields, for example, are of interest to financial intermediaries such as banks. Hence the
shape of the yield curve in that segment is a reflection of the attitudes of the investors
active in that sector. Where two sectors meet there is often a disturbance or apparent
discontinuity in the yield curve as shown in the above diagram.
This can also be referred to as preferred habitat theory (i.e. different investors have a
preference for being in different segments of the yield curve).
Pension fund managers often have a preference for investing in long-dated bonds to
match against the long term liabilities of the fund. This can drive up the price of long-
dated bonds which brings down their yield, possibly resulting on an inversed (falling)
yield curve
14.3.4 Risk
On high quality government/sovereign debt (e.g. UK Gilt-Edged Securities or Gilts)
the risk of default is not significant even for long-dated bonds.
However default risk may be more significant on corporate debt, therefore the corporate
yield curve may rise more steeply than the government yield curve.
15 ISLAMIC FINANCE
Definition

A system of banking consistent with the principles of Islamic law (Sharia).
Sharia prohibits:
the payment or acceptance of interest (riba);
investing in businesses that provide goods or services considered contrary
to its principles.

15.1 Background
Islamic finance is based on Islamic law, or Shariah, whose primary sources are the Quran
and the sayings of the Prophet Muhammad. Shariah emphasises justice and partnership.
The main principles of Islamic finance are that:
Wealth must be generated from legitimate trade (i.e. simply making money from money
is forbidden).
Investment should also have a social and an ethical benefit to wider society beyond
pure return.
Risk should be shared.
All harmful activities (haram) should be avoided.
Islamic banks must obtain their earnings through profit-sharing investments or fee-
based returns. When loans are given the lender should take part in the risk, otherwise
the receipt of any gain over the amount loaned is regarded as interest.
15.2 Prohibited activities
Charging and receiving interest (riba) - a lender making a straight interest charge,
irrespective of how the underlying assets perform, violates the concepts of risk sharing,
partnership and justice. The definition of riba in classical Islamic law was to ensure
equivalency in real value. During this period, gold and silver currencies were the
benchmark metals that defined the value of all other materials being traded. Applying
interest to the benchmark itself made no sense as its value remained constant relative to
all other materials. Hence Islamic banking operates on the basis of profit sharing rather
than interest.
Investment in companies that have too much borrowing (debt totalling more than 33%
of the firms stock market value).
Investments in businesses dealing with alcohol, gambling, drugs, pork, pornography or
anything else that the Shariah considers unlawful or undesirable (haram).
Transactions which involve speculation, or extreme risk - this is seen as gambling. This
prohibits speculating on the futures and options markets. On the other hand mutual
insurance is permitted as members contribute to a fund, not for profit, but in case one of
the members suffers misfortune.
Uncertainty about the subject matter and terms of contracts this includes a prohibition
on selling something that one does not own Therefore, complex derivative instruments
and short selling are prohibited under Islamic finance.
15.3 Islamic instruments
Murabaha: trade credit for asset acquisition that avoids the payment of interest. A bank
buys the asset and then sells it to the customer on a deferred basis at a price that
includes an agreed mark-up. The mark-up cannot be increased, even if the client does
not take the asset within the time agreed in the contract.
Ijara: lease finance whereby the bank buys an item for a customer and then leases it
back over a specific period at an agreed amount. In 2003, HSBC was the first bank to
offer UK mortgages designed to comply with Shariah. HSBCs Islamic mortgage
involves the bank purchasing a house and then leasing it out to the customer. The
customers payments include a contribution to the purchase price, a rent for use of the
property and insurance charges. At the end of the finance term the customer can
exercise an option to have the property transferred into their name.
Mudaraba: a form of equity finance. A bank provides all the capital and its customer
provides expertise, manages the investment project and may provide labour. Profits
generated are distributed according in a predetermined ratio. Any losses are borne by
the provider of capital, who has no control over the management of the project.
Musharaka: joint venture or partnership between two parties who both provide capital
towards the financing of new or established projects. Profits are shared on a pre-agreed
ratio with losses shared on the basis of the relative amounts of equity invested.
Sukuk: Islamic bonds. The sukuk holders return for providing finance is a share of the
income generated by the projects assets. Typically, an issuer of the sukuk would
acquire property to be leased to tenants to generate income. The issuer collects the
income and distributes it to the sukuk holders. This entitlement to a share of the income
generated by the assets can make the arrangement Shariah-compliant. However the
rental income is often linked to market interest rates (e.g. the London Interbank Offered
Rate (LIBOR) as opposed to the returns from the underlying asset, and hence many
Islamic scholars state that such bonds violate the prohibition on riba. Indeed it does
appear that Sukuk bonds are often structured to make money from money rather than
making returns from a physical asset.
Hibah (gift): where Islamic banks voluntarily pay their customers a gift on savings
account balances, representing a portion of the profit made by using those balances in
other activities.
Qard hassan/Qardul hassan (good loan/benevolent loan): a loan extended on a
goodwill basis, and the debtor is only required to repay the amount borrowed.
However, the debtor may, at his or her discretion, pay an extra amount to the creditor.
Commentary

Advocates of Islamic finance claim that it avoided much of the recent financial crisis
because of its prohibitions on speculation and its emphasis on risk sharing and justice.

15.4 The Shariah board
The Shariah board has the responsibility for ensuring that all products and services offered
by an institution are compliant with the principles of Shariah law. Boards are made up of a
committee of Islamic scholars.
An institutions Shariah board will review and oversee all new product offerings before they
are launched. It can also be asked to deliver judgments on individual cases referred to it,
such as whether a specific customers business proposals are Shariah-compliant.
15.5 Developments
The main current problem is the absence of a single, worldwide body to set standards for
Shariah compliance. Some financial aspects of Shariah law can be open to interpretation and
therefore a contract might unexpectedly be declared incompatible with Shariah law and thus
be invalid.
In Malaysia, the worlds biggest market for sukuk, the Shariah advisory council, ensures
consistency to help creating certainty across the market. Some industry bodies, notably the
Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in
Bahrain, have also been working towards common standards.
However, despite these movements towards consistency, some differences between national
jurisdictions are likely to remain.

Key points

Ensure you can discuss how changes in economic conditions (e.g.
inflation) affect business.
The impact of government policy on business is also important (e.g.
competition policy).
The key theories to learn are the Efficient Markets Hypothesis and the
Term Structure of Interest Rates.
The major difference between Islamic finance and conventional finance is
that, under Islamic law, interest (riba) cannot be charged.

FOCUS

identify and explain the main macro-economic policy targets;
identify the main tools of fiscal policy;
explain how public expenditure is financed and the meaning of PSBR;
identify the implications of fiscal policy for business;
identify the main tools of monetary policy;
identify the factors which influence inflation and exchange rates, including the impact
of interest rates;
identify the implications of monetary, inflation and exchange rate policy for business;
identify examples of government intervention and regulation;
explain the requirement for and the role of competition policy;
explain how government economic policy may affect planning and decision-making in
business;
identify the general role of financial intermediaries;
explain the role of commercial banks as providers of funds (including creation of credit);
explain the functions of the money and capital markets;
explain the functions of a stock market and corporate bond market;
outline the Efficient Markets Hypothesis and assess its broad implications for corporate
policy and financial management;
explain the term structure of interest rates;
explain the major difference between Islamic finance and conventional finance;
explain the concept of interest (riba) and how returns are made by Islamic securities;
briefly discuss a range of short and long term Islamic financial instruments.
SESSION 03 INVESTMENT DECISIONS
OVERVIEW
Objective
To appreciate the stages in the investment decision-making process.
To assess an investment using the payback period and the ARR methods.

DECISION
MAKING PROCESS
PAYBACK
PERIOD
ACCOUNTING
RATE OF RETURN
INVESTMENTS
Capital expenditure
Revenue expenditure
Stages in capital budgeting
process
Role of investment appraisal in
the capital budgeting
process
Definition
Advantages
Disadvantages
Possible Improvements
EVALUATION
Definition
Calculation
Advantages
Disadvantages

1 DECISION-MAKING PROCESS
1.1 Capital expenditure
Definition

Capital expenditure (CAPEX) refers to the acquisition of non-current assets or
their improvement.

1.2 Revenue expenditure
Definition

Revenue expenditure is incurred to maintain non-current assets (e.g. repairs).

1.3 Stages in the capital budgeting process
Definition

The key stages in the CAPEX decision are identifying investment
opportunities, screening proposals, analysing and evaluating proposals,
approving proposals, and implementing, monitoring and reviewing projects.

Identifying investment opportunities for example from analysis of strategic choices,
the business environment or research and development. The key requirement is that
investment proposals should support the achievement of organisational objectives.
Screening investment proposals - companies are often restricted in the amount of
finance available for capital investment. Companies therefore need to select those
proposals with the best strategic fit and the most appropriate use of resources.
Analysing and evaluating investment proposals - proposals need to be analysed in
depth and evaluated to determine which offer the most attractive opportunities to
achieve organisational objectives.
Approving investment proposals - the most suitable proposals are passed to the
relevant level of authority (e.g. the board of directors) for consideration and approval.
Implementation - the time required will depend on project size and complexity.
Monitoring - to ensure that the expected results are being achieved.
Review - the whole of the investment decision-making process should be reviewed in
order to facilitate organisational learning and to improve future investment decisions.
1.4 Role of investment appraisal in the capital budgeting process
Investment appraisal plays a key role at the stage of analysing and evaluating
investment proposals.
On the assumption that the firms main financial objective is to maximise (or at least
produce satisfactory) shareholder wealth then the key investment appraisal technique
must be Net Present Value (NPV). This is because NPV shows the theoretical absolute
change in shareholder wealth due to a project.
Managers may also require other measures as part of their decision-making package
(e.g. payback as a liquidity measure and Accounting Rate of Return (ARR)) to judge the
impact on published financial statements.
Providers of finance may wish to know the projects Internal Rate of Return (IRR). In
particular banks compare project IRR to the interest rate on proposed loans in order to
measure the headroom on the project and hence the risk of default on the debt.
2 PAYBACK PERIOD
2.1 Definition

The time it takes for the operating cash flows from a project to pay back the
initial investment.

Decision rule

If payback period < target ACCEPT
If payback period > target REJECT

Illustration 1

Investment $1.4m
Annual cash flows (before depreciation but after tax) $0.3m
Project life 10 yrs

Solution
Payback period =
0.3
1.4
= 4.7 years
(or five years if cash flows are assumed to arise at year ends.)
2.2 Advantages of payback
Simple to calculate.
Easy to understand.
Concentrates on earlier flows:
more certain;
more important if firm has liquidity concerns.
2.3 Disadvantages of payback
Ignores cash flows after payback period;
Target period is subjective;
Ignores time value of money
Gives no information about the change in shareholder wealth.

2.4 Possible improvements
2.4.1 Discounted payback period
First discount the cash flows to present value and then calculate the payback period
This takes into account the time value of money (see p0708)
2.4.2 Payback with bail-out
This takes into account the estimated scrap/disposal value of the asset if the project is
abandoned early
3 ACCOUNTING RATE OF RETURN (ARR)
3.1 Definition

Average annual operating profit expressed as a percentage of the initial (or
average) investment

Also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI).
3.2 Calculation
This is a financial accounting measure based on the income statement and statement of
financial position.
It therefore includes:
Sunk costs (money already spent);
Net book values of assets;
Depreciation and amortisation;
Allocated fixed overheads.
Calculated as:

investment Initial
profit operating annual Average
100
OR
investment Average
profit operating annual Average
100
Where:
Average investment =
2
value scrap investment Initial +

Decision rule

If ARR > target ACCEPT
If ARR < target REJECT

Example 1

Initial investment $200m
Scrap value $20m
Operating cash flows:
Year 1 $100m
Year 2 $50m
Year 3 $50m
Year 4 $50m

Required:
Calculate ARR on:
(i) initial investment; and
(ii) average investment.

Solution
3.3 Advantages of ARR
Uses readily available accounting information;
Simple to calculate and understand;
Often used by financial analysts to appraise performance.

3.4 Disadvantages of ARR
Different methods of calculation may cause confusion;
Based on profits rather than cash. Profits are easily manipulated by accounting policy.
Ignores time value of money;
Target rate is subjective;
A relative measure (%) gives no information about the absolute $ change in
shareholders wealth.
Example 2

A project being considered would require a machine costing $80,000. Market
research of $8,000 has already been carried out and has been capitalised. The
result is that the project is expected to last for six years and produce net cash
earnings of $20,000 for each of the first three years and then $15,000 for each of
the last three years. The anticipated scrap proceeds of the machine at various
stages in its life are as follows:
After year 1 $40,000
After year 6 $4,000

Required:
Evaluate the project using:
(a) ARR;
(b) ARR using the average investment approach;
(c) payback period;
(d) payback period incorporating the bail-out factor.
Assume that cash flows arise evenly during the year.

Solution
(a)

(b)

(c)/ (d)
Time Flow Cumulative
flow
Scrap Net cumulative
flow
0
1
2
3
4
5
6
(88,000)
20,000
20,000
20,000
15,000
15,000
15,000

40,000
30,000
20,000
13,000
10,000
4,000

Payback period =
Payback period with bail-out =


Key points

Payback and ARR are commonly used in practice. However neither
method informs management of the absolute change in shareholders
wealth due to a particular project
As well as being able to calculate payback and ARR it is therefore vital that
you can also explain why they are not acceptable methods of project
appraisal

FOCUS

define and distinguish between capital and revenue expenditure;
describe the stages in the capital investment decision-making process;
calculate payback and assess its usefulness as a measure of investment worth;
calculate ARR and assess its usefulness as a measure of investment worth.
EXAMPLE SOLUTIONS
Solution 1
Average annual profit
5 . 17
4
180 250
years project of No
on depreciati Total flows cash Total
=

Average investment
110
2
20 200

2
value Scrap + investment Initial
=
+
=
ARR on initial investment % 75 . 8 100
200
5 . 17
=
ARR on average investment % 91 . 15 100
110
5 . 17
=
Solution 2 ARR and Payback
(a) ARR
Average annual earnings =
6
15,000) 3 20,000 (3 +
= $17,500
Average annual depreciation =
6
000 , 4 8,000 + 80,000
= $14,000
ARR =
000 , 88
000 , 14 17,500
= 4%
(b) Average investment =
2
000 , 4 88,000 +
= $46,000
ARR =
000 , 46
000 , 14 17,500
= 7.6%

(c)/ (d)
Time Flow Cumulative
flow
Scrap Net cumulative
flow
0
1
2
3
4
5
6
(88,000)
20,000
20,000
20,000
15,000
15,000
15,000
(88,000)
(68,000)
(48,000)
(28,000)
(13,000)
2,000
17,000

40,000
30,000
20,000
13,000
10,000
4,000
(88,000)
(28,000)
(18,000)
(8,000)

12,000
21,000

Payback period
= 4
15
13
years
Payback period with bail-out = 4 years

SESSION 04 DISCOUNTED CASH FLOW TECHNIQUES
OVERVIEW
Objective
To apply the time value of money to investment decisions.

DISCOUNTING SIMPLE
INTERNAL RATE
OF RETURN (IRR)
Single sum
Annuities
Effective Annual Interest Rates
(EAIR)
Procedure
Meaning
Cash budget pro forma
Tabular layout
Annuities
Perpetuities
DISCOUNTED
CASH FLOW (DCF)
TECHNIQUES
COMPOUND
NET PRESENT
VALUE (NPV)
Compounding in
reverse
Points to note
Time value of money
DCF techniques
Limitations
Definition and decision
rule
Perpetuities
Annuities
Uneven cash flows
Unconventional cash
flows
NPV vs. IRR
Comparison
INTEREST

1 SIMPLE INTEREST
Key point

Interest accrues only on the initial amount invested.

Illustration 1

If $100 is invested at 10% per annum (pa) simple interest:
Year Amount on deposit Interest Amount on deposit
(year beginning) (year end)
1 $100 0.1 100 = 10 $110
2 $110 0.1 100 = 10 $120
3 $120 0.1 100 = 10 $130

A single principal sum, P invested for n years at an annual rate of interest, r (as a
decimal) will amount to a future value FV.
Where FV = P (1 + nr)
2 COMPOUND INTEREST
Key point

Interest is reinvested alongside the principal.

2.1 Single sum
Illustration 2

If Zarosa placed $100 in the bank today (t
0
) earning 10% interest per annum,
what would this sum amount to in three years time?

Solution
In 1 years time, $100 would have increased by 10% to $110
In 2 years time, $110 would have grown by 10% to $121
In 3 years time, $121 would have grown by 10% to $133.10

Commentary

Conversely, the present value of $133.10 receivable in 3 years time is $100.

Formula
FV = P (1 + r)
n

where
P = initial principal
r = annual rate of interest (as a decimal)
n = number of years for which the principal is invested

Example 1

$500 is invested in a fund on 1.1.X1.
Required:
Calculate the amount on deposit by 31.12.X4 if the interest rate is:
(a) 7% per annum simple;
(b) 7% per annum compound.

Solution
The $500 is invested for a total of 4 years
(a) Simple interest FV = P (1 + nr)
FV =
(b) Compound interest FV = P (1 + r)
n

FV =

Example 2

$1,000 is invested in a fund earning 5% per annum on 1.1.X0. $500 is added to
this fund on 1.1.X1 and a further $700 is added on 1.1.X2. How much will be
on deposit by 31.12.X2?

Solution
Date Amount
invested
Compound
interest factor
= Compounded
cashflow
$ $

1.1.X0 1,000
1.1.X1 500
1.1.X2 700

_________
Amount on deposit =

_________

2.2 Annuities
Many saving schemes involve the same amount being invested annually.
There are two formulae for the future value of an annuity. Which to use depends on
whether the investment is made at the end of each year or at the start of each year.

(i) first sum paid/received at the end of each year
(ii) first sum paid/received at the beginning of each year

(i) FV =
( )
|
|
.
|
\
| +
r
r
n
1 1
a (ii) FV =
( )
|
|
.
|
\
|
|
|
.
|
\
| +
+
1
1 1

1
r
r
n
a

where a = annuity (i.e. annual sum)
r = interest rate (interest payable annually in arrears)
n = number of years annuity is paid/invested

Commentary

These formulae will not be provided in the examination.

Illustration 3

Andrew invests $3,000 at the start of each year in a high interest account
offering 7% pa. How much will he have accumulated after a fixed 5 year term?

Solution
FV = $3,000
( )
|
|
.
|
\
|
|
|
.
|
\
|
1
07 . 0
1 07 . 1
6
= $3,000 6.153 = $18,460
2.3 Effective Annual Interest Rates (EAIR)
Where interest is charged on a non-annual basis it is useful to know the effective annual
rate.
For example, interest on bank overdrafts (and credit cards) is often charged on a
monthly basis. To compare the cost of finance to other sources it is necessary to know
the EAIR (also called Annual Percentage Rate (APR)).
Formula
1 + R = (1 + r)
n

R = annual rate
r = rate per period (month/quarter)
n = number of periods in year

Illustration 4

Borrow $100 at a cost of 2% per month. How much (principal + interest) will
be owed after a year?
Using FV = P (1 + r)
n
= $100 (1.02)
12

= $100 1.2682 = $126.82

EAIR is 26.82%

3 DISCOUNTING
3.1 Compounding in reverse
Discounting calculates the sum which must be invested now (at a fixed interest rate) in
order to receive a given sum in the future.
Illustration 5

If Zarosa needed to receive $251.94 in three years time (t
3
), what sum would
she have to invest today (t
0
) at an interest rate of 8% per annum?

Solution
The formula for compounding is: FV = P (1 + r)
n

Rearranging this: P = FV
1
1 ( ) + r
n

Alternatively, PV = CF
1
1 ( ) + r
n

where PV = the present value of a future cash flow (CF)
r = annual rate of interest/discount rate.
n = number of years before the cash flow arises

In this case PV = $251.94
3
(1.08)
1
= $200
The present value of $251.94 receivable in three years time is $200.
3.2 Points to note

n
r) 1 (
1
+
is known as the simple discount factor and gives the present value of $1
receivable in n years at a discount rate, r.
A present value table is provided in the exam
The formula for simple discount factors is provided at the top of the present value
table.
For a cash flow arising now (at t
0
) the discount factor will always be 1.
t
1
is defined as a point in time exactly one year after t
0
.
Always assume that cash flows arise at the end of the year to which they relate (unless
told otherwise).

Example 3

Find the present value of:
(a) 250 received or paid in 5 years time, r = 6% per year;
(b) 30,000 received or paid in 15 years time, r = 9% per year.

Solution
(a) From the tables: r = 6%, n = 5, discount factor =
Present value =
(b) From the tables: r = 9%, n = 15, discount factor =
Present value =
4 DISCOUNTED CASH FLOW (DCF) TECHNIQUES
4.1 Time value of money
Investors prefer to receive $1 today rather than $1 in one year.
This concept is referred to as the time value of money
There are several possible reasons:
Liquidity preference if money is received today it can either be spent or
reinvested to earn more in future. Hence investors have a preference for having
cash/liquidity today.
Risk cash received today is safe, future cash receipts may be uncertain.
Inflation cash today can be spent at todays prices but the value of future cash
flows may be eroded by inflation

Key point

DCF techniques take account of the time value of money by restating each
future cash flow in terms of its equivalent value today.

4.2 DCF techniques
DCF techniques can be used to evaluate business projects (i.e. for investment appraisal).
Two methods are available:
NET PRESENT
VALUE

INTERNAL RATE
OF RETURN

4.3 Limitations of DCF techniques
Despite the theoretical superiority of DCF techniques it appears that in practice many
company managers prefer to use non DCF methods of appraisal such as payback or ARR.
Possible reasons for this reluctance to use DCF methods include:
The potentially complex and time consuming process of calculating NPV and/or IRR;
Difficulty in explaining DCF techniques to non-financial managers;
Complexity of estimating an appropriate discount rate, particularly for unquoted firms;
Managers may feel little connection between DCF techniques and their own reported
performance and bonus systems.
5 NET PRESENT VALUE (NPV)
5.1 Procedure
Forecast the relevant cash flows from the project.
Estimate the required return of investors (i.e. the discount rate). The required return of
investors represents the companys cost of finance, also referred to as its cost of capital.
Discount each cash flow (receipt or payment) to its present value (PV).
Sum present values to give the NPV of the project.
If NPV is positive then accept the project as it provides a higher return than required by
investors.
5.2 Meaning
NPV shows the theoretical change in the $ value of the company due to the project.
It therefore shows the change in shareholders wealth due to the project.
The assumed key objective of financial management is to maximise shareholder wealth.
Therefore NPV must be considered the key technique in business decision making.
5.3 Cash budget pro forma
Time 0 1 2 3
$000 $000 $000 $000
Capital expenditure (X) X
Cash from sales X X X
Materials (X) (X) (X)
Labour (X) (X) (X)
Overheads (X) (X) (X)
Advertising (X) (X)
Grant X
___ ___ ___ ___
Net cash flow (X) X X X
___ ___ ___ ___
r% discount factor 1
1
1 + r

1
1
2
( ) + r

1
1
3
( ) + r

Present value (X) X X X

NPV = X
5.4 Tabular layout
Discount Present
Time Cash flow factor value
$000 @ r% $000
0 CAPEX (X) 1 (X)
110 Cash from sales X x X
09 Materials (X) x (X)
110 Labour and overheads (X) x (X)
0 Advertising (X) x (X)
2 Advertising (X) x (X)
1 Grant X x X
10 Scrap value X x X
___
Net present value X
___

Example 4

Elgar has $10,000 to invest for a five-year period. He could deposit it in a bank
earning 8% pa compound interest.
He has been offered an alternative: investment in a low-risk project that is
expected to produce net cash inflows of $3,000 for each of the first three years,
$5,000 in the fourth year and $1,000 in the fifth.
Required:
Calculate the net present value of the project.

Solution
Time Description Cash flow 8% DF PV
$ $
0 Investment (10,000)
1 Net inflow 3,000
2 Net inflow 3,000
3 Net inflow 3,000
4 Net inflow 5,000
5 Net inflow 1,000
_____
NPV =
_____

5.5 Annuities
Definition

An annuity is a stream of identical cash flows arising each year for a finite
period of time.

The present value of an annuity is given as: CF
(
(
n
r) + (1
1
1
r
1

where CF is the cash flow received each year commencing at t
1
.

(
(
n
r) + (1
1
1
r
1
is known as the annuity factor or cumulative discount factor.
It is simply the sum of a geometric progression.
The formula is given in the exam as
1 - (1+ r)
r
n

Annuity factor tables are also provided in the exam.
Remember that the formula and tables are based on the assumption that the cash flow
starts after one year.
Illustration 6

Calculate the present value of $1,000 receivable each year for 3 years if interest
rates are 10%.
Time Description Cash flow 10% Annuity factor PV
$ $
t13 Annuity 1,000
(

3
1.1
1
1
0.1
1
= 2.486 2,486

Commentary

An annuity received for the next three years is written as t
13
.

Example 5

Calculate the present value of $2,000 receivable for each of 10 years
commencing three years from now. Assume interest at 7%.

Solution

5.6 Perpetuities
Definition

A perpetuity is a stream of identical cash flows arising each year to infinity.

As n
(1 + r)
n

0
r) + (1
1
n

r
1
) r 1 (
1
1
r
1
n

|
|
.
|
\
|
+

r
1
is known as the perpetuity factor.
The present value of a perpetuity is given as CF
r
1

where CF is the cash flow received each year.
Key point

The formula is based on the assumption that the cash flow starts after one
year.

Illustration 7

Calculate the present value of $1,000 receivable each year in perpetuity if
interest rates are 10%.

Solution
$ $
t
1
Perpetuity 1,000
1
01 .
= 10
10,000


Example 6

Calculate the present value of $2,000 receivable in perpetuity commencing in
10 years time. Assume interest at 7%.

Solution

6 INTERNAL RATE OF RETURN (IRR)
Definition

Internal rate of return (IRR) is the discount rate where NPV = 0.

IRR represents the average annual % return from a project.
It therefore shows the highest finance cost that can be accepted for the project.
Commentary

It is a break-even interest rate.

Decision rule

If IRR > cost of capital, accept project.
If IRR < cost of capital, reject project.

6.1 Perpetuities
If a project has equal annual cash flows receivable in perpetuity then
IRR =
investment Initial
inflows cash Annual
100%
Illustration 8

An investment of $1,000 gives income of $140 per annum indefinitely, the
return on the investment is given by:
IRR = 140/1000 100% = 14%


Example 7

An investment of $15,000 now will provide $2,400 each year to perpetuity.
Required:
Calculate the return inherent in the investment.

Solution

6.2 Annuities
To give an NPV of zero, the present value of the cash inflows must equal the initial cash
outflow.
That is, annual cash inflow Annuity factor = Cash outflow
Annuity factor =
inflow Cash
outflow Cash

Once the annuity factor is known the discount rate can be established from the
appropriate table.
Illustration 9

An investment of $6,340 will yield an income of $2,000 for four years.
Calculate the internal rate of return of the investment.

Solution
Year Description CF DF PV
0 Initial investment (6,340) 1 (6,340)
1-4 Annuity 2,000 AF
1-4
years

6,340
_____
NPV Nil
_____
AF
1-4
years =
000 , 2
340 , 6
= 3.17
From the annuity table, the rate with a four year annuity factor closest to 3.17 is 10% and this
is therefore the approximate IRR for this investment.
Example 8

An immediate investment of $10,000 will give an annuity of $1,000 for the next
15 years.
Required:
Calculate the internal rate of return of the investment.

Solution
Time Description Cash flow Discount factor PV
$ $
0 Investment (10,000)
1-15 Annuity 1,000
______

______

6.3 Uneven cash flows
Method
Calculate the NPV of the project at a chosen discount rate.
If NPV is positive, recalculate NPV at a higher discount rate (i.e. to get closer to IRR).
If NPV is negative, recalculate at a lower discount rate.
The IRR can be estimated using the formula:
A) (B
N N
N
A ~ IRR
B A
A
+

Where A = Lower discount rate
B = Higher discount rate
N
A
= NPV at rate A
N
B
= NPV at rate B

This method is known as linear interpolation.

Illustration 10

The NPVs of a project with uneven cash flows are as follows.
Discount rate NPV
$
10% 64,237
20% (5,213)

Estimate the IRR of the investment.

Solution
IRR ~ A +
B A
A
N N
N
(B A)

IRR ~ 10% +
) 213 , 5 ( 237 , 64
237 , 64

(20 10)%
IRR ~ 19%

Commentary

The answer should always be appropriately rounded due to the inherent inaccuracy of
this method. The IRR thus calculated is only approximate, based on the simplifying
assumption that there is a linear relationship between NPV of a project and discount
rate. However, this is not so and the following diagram illustrates the true situation.

Graphically
NPV
Discount rate
IRR using formula
(interpolated)
B A
Actual IRR
N
A
N
B Actual NPV as
discount rate varies


Example 9

An investment opportunity with uneven cash flows has the following net
present values
$
At 10% 71,530
At 15% 4,370

Required:
Estimate the IRR of the investment.

Solution
Formula
IRR ~ A +
B A
A
N N
N
(B A)
IRR ~

Graphically

6.4 Unconventional cash flows
If there are cash outflows, followed by inflows are then more outflows (e.g. suppose at the
end of the project a site had to be decontaminated), the situation of multiple yields
may arise (i.e. more than one IRR).
NPV
Discount rate IRR1
Actual IRR
Actual NPV as
discount rate varies
IRR2

The project appears to have two different IRRs in this case IRR is not a reliable
method of decision making.
However NPV is reliable, even for unconventional projects.
7 NPV vs. IRR
7.1 Comparison
NPV IRR
An absolute measure ($) A relative measure (%)
If NPV 0 ,accept If IRR target %, accept
If NPV 0, reject
Shows $ change in value of
company/wealth of shareholders
A unique solution (i.e. a project has only
one NPV)
Always reliable for decision making
If IRR target %, reject
Does not show absolute change in
wealth
May be a multiple solution

Not always reliable


Key points

Discounted cash flow techniques are arguably the most important
methods used in financial management.
DCF techniques have two major advantages:
they focus on cash flow, which is more relevant than the accounting
concept of profit
they take into account the time value of money.
NPV must be considered a superior decision-making technique to IRR as it
is an absolute measure which tells management the change in
shareholders wealth expected from a project.

FOCUS

explain the difference between simple and compound interest rate and
calculate future values;
calculate future values including the application of annuity formulae;
calculate effective interest rates;
explain what is meant by discounting and calculate present values;
apply discounting principles to calculate the net present value of an investment project
and interpret the results;
calculate present values including the application of annuity and perpetuity formulae;
explain what is meant by, and estimate the internal rate of return, using a graphical and
interpolation approach, and interpret the results;
identify and discuss the situation where there is conflict between these two methods of
investment appraisal;
compare NPV and IRR as decision-making tools.
EXAMPLE SOLUTION
Solution 1 7% simple and compound interest
The $500 is invested for a total of 4 years
(a) Simple interest FV = P (1 + nr)
FV = 500 (1 + 4 0.07) = 500 1.28 = $640
(b) Compound interest FV = P (1 + r)
n

FV = 500 (1 + 0.07)
4
= 500 1.3108 = $655.40

Solution 2 5% compound interest
Date Amount Compound Compounded
invested interest factor = cashflow
$ $

1.1.X0 1,000 (1 + 0.05)
3
1,157.63
1.1.X1 500 (1 + 0.05)
2
551.25
1.1.X2 700 (1 + 0.05)
1
735.00

_________
Amount on deposit = 2,443.88

_________

Solution 3 Present value
(a) From the tables: r = 6%, n = 5, discount factor = 0.747
Present value = 250 0.747 = $186.75
(b) From the tables: r = 9%, n = 15, discount factor = 0.275
Present value = 30,000 0.275 = $8,250
Solution 4 Net present value
Time Description Cash flow 8% DF PV
$ $
0 Investment (10,000) 1 (10,000)
1 Net inflow 3,000
) 08 . 1 (
1

2,778
2 Net inflow 3,000
2
) 08 . 1 (
1

2,572
3 Net inflow 3,000
3
) 08 . 1 (
1

2,381
4 Net inflow 5,000
4
) 08 . 1 (
1

3,675
5 Net inflow 1,000
5
) 08 . 1 (
1

681
_____
NPV = 2,087
_____

Solution 5 Annuity
$ $
t
3-12
Annuity 2,000 6.135 (W) 12,270
WORKING
Cdf
3-12
@ 7% = CDF
1-12
@ 7% CDF
1-2
@ 7%
= 7.943 1.808 (per tables)
= 6.135

Solution 6 Perpetuity
$ $
t
10-
Perpetuity 2,000 7.771 (W) 15,542

WORKING
Cdf
10-
@ 7% = CDF
1-
@ 7% - CDF
1-9
@ 7%
=
07 . 0
1
6.515 (per tables)
= 14.286 6.515
= 7.771

Solution 7 IRR (perpetuity)
IRR =
000 , 15
400 , 2
100 = 16%
Solution 8 IRR (annuity)
Time Description Cash flow Discount factor PV
$ $
0 Investment (10,000) 1 (10,000)
1-15 Annuity 1,000 Cdf
1-15
= 10 (al) 10,000
______
Nil
______
From the annuity table the rate with a 15 year annuity factor of 10 lies between 5% and 6%.
Thus if $10,000 could be otherwise invested for a return of 6% or more, this annuity is not
worthwhile.
Solution 9 IRR (uneven cash flows)
Formula
Commentary

The formula always works but take care with + and signs.
IRR ~ A +
B A
A
N N
N
(B A)
IRR ~ 10 + |
.
|
\
|
370 , 4 530 , 71
530 , 71
(15 10)
IRR ~ 10 + 5.325
say 15.4% (rounded up)
Graphically
4,370
71,530
10 15
NPV
Discount rate
(%)
Actual
IRR
IRR using
formula
(extrapolated)
$
Actual
NPV
SESSION 05 RELEVANT CASH FLOWS FOR DISCOUNTED CASH FLOW TECHNIQUES
OVERVIEW
Objective
To recognise the costs that are relevant to a discounted cash flow analysis.
To be able to determine the taxation effects of a new investment.
To be able to deal with inflation using either the money method, real method or
effective method.
To do able to deal with cash flows relating to working capital.

RELEVANT
COSTS
WORKING
CAPITAL
TAXATION
General rule
Layout of cash flows
INFLATION

Why inflation is a problem
Real and money interest rates
General and specific rates
Cash flow forecasts
Discounting
Basic effect of
UK tax system
Timing
Other assumptions
Dealing with taxation

1 RELEVANT COSTS FOR DISCOUNTING
1.1 General rule
Include only those costs and revenues which are affected by the decision. This means using
only:
future;
incremental;
operating cash flows.
Operating cash flows means the cash flows generated from operating the project (e.g. cash
from sales, less operating costs such as materials and labour).
Do not include financing cash flows because the cost of finance is measured in the cost of
capital/discount rate finance costs are taken into account by the discounting process.
Specifically, exclude:
sunk costs (i.e. money already spent);
non-cash costs (e.g. depreciation);
book values (e.g. FIFO/LIFO inventory values);
unavoidable costs (i.e. money already committed, including apportioned fixed costs);
finance costs such as interest (as discounting the operating cash flows already deals with
this).
However, include:
all opportunity costs and revenues (e.g. cannibalisation where the launch of a new
product will reduce the sales if an existing product).
Key point

Lost contribution is an opportunity cost and should be shown as a cash
outflow.


Example 1

A research project, which to date has cost the company $150,000, is under
review.
If the project is allowed to proceed, it will be completed in approximately one
year, when the results would be sold to a government agency for $300,000.
Shown below are the additional expenses which the managing director
estimates will be necessary to complete the work.
Materials
This material has just been purchased at a cost of $60,000. It is toxic and, if not
used in this project, must be disposed of at a cost of $5,000.
Labour
Skilled labour is hard to recruit. The workers concerned were transferred to
the project from a production department, and at a recent meeting the
production manager claimed that if the men were returned to him they could
generate sales of $150,000 in the next year. The prime cost of these sales would
be $100,000, including $40,000 for the labour cost. The overhead absorbed into
this production would amount to $20,000.
Research staff
It has already been decided that, when work on this project ceases, the research
department will be closed. Research wages for the year are $60,000, and
redundancy and severance pay has been estimated at $15,000 now or $35,000 in
one years time.
Equipment
The project utilises a special microscope which cost $18,000 three years ago. It
has a residual value of $3,000 in another two years, and a current disposal
value of $8,000. If used in the project it is estimated that the disposal value in
one years time will be $6,000.
Share of general building services
The project is charged with $35,000 per annum to cover general building
expenses. Immediately the project is discontinued, the space occupied could
be sub-let for an annual rental of $7,000.
Required:
Advise the managing director as to whether the project should be allowed to
proceed, explaining the reasons for the treatment of each item.
(Ignore the time value of money.)

Solution
Costs and revenues of proceeding with the project.
$
(1) Costs to date
(2) Materials

(3) Labour cost

Absorption of overheads
(4) Research staff costs
Wages redundancy pay

(5) Equipment

(6) General building services
Apportioned costs
Opportunity costs

_______

Sales value of project

Increased contribution from project
_______

_______

Advice:
1.2 Layout of cash flows
A company invests $10,000 today in a machine. It expects to earn $7,000 per year for two
years as a result. Discount rate = 15%.
Calculate the net present value of the investment:
(i) Time Narrative Cash flow 15% Present
Discount factor/
annuity factor
0 Machine (10,000) 1 (10,000)
12 Project
income 7,000 1.626 11,382

______

NPV $1,382

______

or
(ii) 0 1 2
Machine (10,000)
Income 7,000 7,000

______

______

______

(10,000) 7,000 7,000
15% factor 1 0.870 0.756

______

______

______

Present
value (10,000) 6,090 5,292

NPV

= $1,382

______

Commentary

In complex exam questions it is usually better to present your answer using the
second format (i.e. with columns for years).

2 TAXATION
2.1 Basic effect of the UK tax system
Taxation has two effects in investment appraisal:

Tax charged
on operating
results
Tax relief given on
non-current assets via

WRITING DOWN
ALLOWANCES
NEGATIVE
EFFECT
POSITIVE
EFFECT

Operating results = revenues
less operating costs
Any tax relief on finance costs is
taken into account in the
discount rate/cost of capital.
Depreciation expense from the financial
statements is not a tax allowable
deduction in the UK.
Instead companies can claim Writing
Down Allowances (WDAs), also called
Capital Allowances.
WDAs are usually given at 25% reducing
balance but exam question will specify.
No WDA in year of sale; balancing
allowance/charge given instead,
representing a tax loss/gain on disposal.

2.2 Timing
The timing of tax cash flows is complex. Some exam questions will specify that tax is paid in
the year of taxable profits, other questions will state that tax is paid one year in arrears (i.e.
in the following year):
T0 Year 1 T1 T2

Assume net revenues (revenues minus operating costs) are received at the end of year 1
(T
1
)
Tax assessed at T
1

Tax paid T
2
(assuming tax is paid one year in arrears)
If asset bought at start of year 1
First WDA received at T
1
(date of next tax assessment)

Reduces tax payment at T
2

However if the asset is bought on the last day of the previous year (i.e. on the date of a tax
assessment) the first WDA would be received immediately (i.e. at T
0
) which reduces the
tax payment at T
1
.
Illustration 1

An asset is bought for $5,000 at the start of an accounting period. It is sold at
the end of the third accounting period for $1,000.
Corporation tax is 30% and paid one year in arrears. Writing down allowances
are available at 25% reducing balance.
Calculate the tax savings available and state when they arise.

Solution
Tax saving
@ 30%
Timing
$ $ $
Cost
Year 1 WDA 25%
5,000
(1,250)

375

T
2

______

WDV c/f
Year 2 WDA 25%
3,750
(938)

281

T
3

______

WDV c/f
Year 3 Disposal
2,812
(1,000)

Balancing allowance
______

1,812
______

544

T
4

Commentary

The tax saving is not the WDA. It is the WDA tax rate.
2.3 Other assumptions
Tax rate is constant.
Sufficient taxable profits are available to use all tax deductions in full.
Working capital flows have no tax effects (e.g. if the level of accounts receivable rises
this does not change the tax situation as tax is charged when revenues are recorded
rather than when the cash is received).
Commentary

See additional notes on working capital in the last section of this session.

2.4 Dealing with taxation
Step 1 Set up table
T0 T
1
T
2
T
3

REVENUE
Step 2 (a) Put in revenues Revenue x x
and operating costs
Operating costs (x) (x)

(b) Total columns for net Net revenue x x
revenues

(c) Calculate tax payable on net Tax @ 30% (x) (x)
revenues

CAPITAL
Step 3 Put in capital outlay and any Investment (x)
disposal value Scrap proceeds x

Step 4 Calculate tax saving on WDAs WDA tax savings x x

(x) x x (x)

Step 5 Total columns for net cash flows
and discount Discount factor r% x x x x

Present value (x) x x x


Example 2

1 A company buys an asset for $10,000 at the beginning of an accounting
period (1 January 20X1) to undertake a two year project.
2 Net cash inflows received at the end of year 1 and year 2 are $5,000.
3 The company sells the asset on the last day of the second year for $6,000.
4 Corporation tax is 33% (paid one year in arrears).
Writing down allowance is 25% reducing balance.
5 Cost of capital = 10%
Required:
Calculate the projects NPV.

Solution
T
0
T
1
T
2
T
3

Net cash inflows
Tax @ 33%

Asset
Scrap proceeds
Tax savings on WDAs (W)

Net cash flow
Discount factor
Present value
_______

_______

_______

_______

WORKING

T0 T1 T2
Profits in
year 1
Asset purchased 1 Jan 20X1
First WDA will be set off
against profits in year 1 (T1)
First tax saving at T2
Asset sold 31 Dec 20X2
No WDA in year of sale
Balancing allowance/
charge

$ Tax relief at
33%
Timing
T
0
Investment in asset
Year 1 WDA @ 25%

_______

Year 2 Proceeds

_______

Balancing allowance
_______

Example 3

1 A company buys an asset for $10,000 at the end of the previous accounting
period (31 December 20X0) to undertake a two-year project.
2 Net cash inflows received at the end of year 1 and year 2 are $5,000.
3 The asset has zero scrap value when it is disposed of at the end of year 2.
4 Corporation tax is 33% (paid one year in arrears).
WDA is 25% reducing balance.
5 Cost of capital = 10%
Required:
Calculate the projects NPV.

Solution
T
0
T
1
T
2
T
3

Net cash inflows
Tax @ 33%
Asset
Tax saving on WDA (W)

(10,000)
5,000

5,000
(1,650)

(1,650)

Net cash flow
Discount factor
Present value
_______

_______

_______

_______

NPV =
WORKING
Tax computation

T0 T1 T2
Profits in
year 0
Asset purchased 31 Dec 20X0
First WDA will be set off against
profits earned in prior year
First tax relief at T1
Asset scrapped 31 Dec 20X2

$
Tax relief at
33%
Timing
T
0

Year 0
Investment in asset
WDA @ 25%
10,000
(2,500)

825

_______

7,500
Year 1 WDA @ 25%

_______

Year 2 Proceeds

_______

Balancing allowance
_______

3 INFLATION
3.1 Why inflation is a problem for project appraisal
It is hard to estimate, especially when rates are high.
It causes governments to take actions which may impact on business (e.g. raising
interest rates, cutting state spending).
Differential inflation rates will occur; different costs and revenues will inflate at
different rates.
It alters the cost of capital (in nominal terms).
It makes historic costs irrelevant and therefore causes ROCE to be overstated.
It creates uncertainty for customers, which may lead to lower demand.
It encourages managers to become short-term in outlook.
3.2 Real and money (or nominal) interest rates
Real rate of interest reflects the rate of interest that would be required in the absence of
inflation.
Money (or nominal) rate of interest reflects the real rate of interest adjusted for the effect
of general inflation (measured by the CPI the Consumer Price Index).
Illustration 2

Suppose you invest $100 today for one year and, in the absence of inflation,
you require a return of 5%. The CPI is expected to rise by 10% over the coming
year.
In one year, in the absence of inflation, you require:
$100 1.05 = $105
To maintain the purchasing power of your investment (i.e. to cover inflation)
you require:
$105 1.1 = $115.50
You therefore require a money return of
100
50 . 15
= 15.5% over the year.

Money rates, real rates and general inflation (CPI) are linked by the Fisher formula:
(1+money rate) = (1+real rate) (1+general inflation rate)
(1+i) = (1+r) (1+h) Learn this formula.
i = nominal/money interest rate
r = real interest rate
h = general inflation rate
In the example above:
(1 + i) = (1.05) (1.1) = 1.155
i = 15.5%
3.3 General and specific inflation rates
A specific inflation rate is the rate of inflation on an individual item (e.g. wage inflation,
materials price inflation).
The general inflation rate is a weighted average of many specific inflation rates (e.g.
CPI).
3.4 Cash flow forecasts
If there is inflation in the economy there are three ways in which the cash flow forecast for
project appraisal can be performed:
3.4.1 Current cash flows
Cash flows expressed at todays prices (i.e. before the effects of inflation).
3.4.2 Money (or nominal) cash flows
Cash flows are inflated to future price levels using the specific inflation rate for each type
of revenue/cost.
This produces a forecast of the physical amount of money that will move in/out of the
company.
3.4.3 Real cash flows
Money cash flows with the effect of general inflation removed.
3.5 Discounting
Commentary

There are three methods of discounting if there is inflation. Each method results in the
same NPV.

3.5.1 Money method
Adjust each cash flow for specific inflation to convert to nominal/money cash flows (i.e.
physical amounts of cash to be paid/received).
Discount using the nominal/money cost of capital.
3.5.2 Real method
Remove the effects of general inflation from money cash flows to generate real cash
flows.
Discount using the real cost of capital.
3.5.3 Effective method
Express each type of cash flow in current terms (i.e. at t
0
prices).
Discount at the effective rate for that cash flow:
(1+money rate) = (1+effective rate) (1+specific inflation rate)


Illustration 3

One year project with outlay at T
0
of $5m.
Sales for the year are expected to be $10m in current terms, with an expected
specific inflation rate of 5%.
Costs for the year are expected to be $3m in current terms, with an expected
specific inflation rate of 3%.
CPI expected to rise by 4%.
Nominal cost of capital is 6%.

Solutions
Money method
T0 T1
Outlay (5)
Sales 10 1.05 = 10.5
Costs (3) 1.03 = (3.09)

___

_____

Money flows (5) 7.41

NPV = (5) +
7.41
1.06
= $1.99m

Real method
T0 T1
Money cash flow (5) 7.41

RPI 4%
7.41
1.04

Real cash flow (5) 7.125

(1 + i) = (1 + r) (1 + h)
(1.06) = (1 + r) (1.04)
r = 1.92307%

NPV = (5) +
0192307 . 1
125 . 7
= $1.99m

Commentary

As money flows are needed to do this, the money method might just as well be
used it gives the same result.
Net cash flow expressed in current terms ($7m) is not the same as real cash flow
($7.125m), because sales and costs are not changing at CPI.

Effective method
Effective discount rates:
for sales:
(1.06) = (1 + e) (1.05)
e = 0.95238%

for costs (1.06) = (1 + e) (1.03)
e = 2.91262%

Technique: Discount cash flows expressed in current terms at effective rates:
NPV = (5) +
1.0291262
(3)
1.0095238
10
+ = $1.99m (as before)

Effective method can be useful where an annuity is given in todays prices.
Example 4

A project produces a cash inflow at the end of years 13 of $10,000 (at t
0
prices).
Real cost of capital = 10%
CPI = 5%
Inflation of project cash flows = 8%
Required:
Calculate NPV using:
(i) money method
(ii) real method
(iii) effective method.

Solution
(i) Money method
(1 + i) = (1 + r) (1 +h)
=
i =

t $ DF PV
$
1
2
3

______

______
(ii) Real method
t $ DF PV
$
1
2
3
(W)

______

______

WORKING

(iii) Effective method

e =

t $ DF PV
$
13 (W)
______

WORKING


Example 5

1 A company buys a machine today for $10,000.
2 Material costs at current prices will be $1,500 per year for three years
Material costs inflate at 8% per year.
3 Labour savings at current prices will be $4,000 per year for three years
Labour costs inflate at 5% per year.
4 Overhead savings at current prices will be $2,000 per year for three years
Overhead costs inflate at 10% per year.
5 Money cost of capital is 15.5%.
6 General inflation is 7%.
Required:
Calculate the NPV of the project, using:
(i) the money method;
(ii) the effective method;
(iii) the real method.
Ignore taxation.

Solution
(i) Money method
T
0
T
1
T
2
T
3
$ $ $ $
Investment
Materials
Labour savings
Overhead savings
(10,000)

______

_____

_____

_____

Net cash flow
Discount factor

Present value

______

______

_____

_____

_____

_____

_____

_____

NPV =
(ii) Effective method
(a) Calculation of effective rates
Materials
e
=
=

Labour
e
=
=

Overheads
e
=
=

(b) Discount flows at effective rates
Time Cash flow Discount/
annuity
factor
Present
value
0
13
13
13
Investment
Material cost
Labour saving
Overhead saving
(10,000)

1
(W)

(10,000)

Net present value

_____

_____

from tables
(iii) Real method
T
0
T
1
T
2
T
3
Money cash flows (10,000) 4,780 5,080 5,403

Real cash flows
Discount factor
Present value

NPV =

Real rate: (1+i) = (1+r)(1+h)
=
r =

Example 6

A company is considering a project which requires the purchase of a machine
costing $250,000 on 1 January 20X4. Net inflows from the project are expected
to be $80,000 per annum in current terms for the next four years. At the end of
the project it is estimated that the machine will be sold for cash proceeds of
$50,000.
The company has a December year end and pays tax at 33%, 12 months after
the end of the accounting period. The project flows are expected to inflate at
5%, and the companys money cost of capital is 15%. Writing Down
Allowances are given at 25% reducing balance.
Required:
Determine whether the company should proceed with the project.

Solution
WDAs
$ Tax @ 33% Time
y/e 31 December 20X4
Purchase
WDA @ 25%

250,000

______

WDA @ 25%

______

WDA @ 25%

______

Sales proceeds

Balancing allowance
______

______

Project appraisal
T
0
T
1
T
2
T
3
T
4
T
5

Inflows
Tax @ 33%
Initial investment
Scrap
Tax saving on
WDAs

_______

_______

_______

_______

_______

_______

DF

_______

_______

_______

_______

_______

_______

PV
_______

_______

_______

_______

_______

_______

NPV =
Therefore,
4 WORKING CAPITAL
A project usually starts with a cash outflow for the investment in non-current assets (e.g.
plant and equipment). However many projects will also require an investment in net current
assets (i.e. working capital). For project appraisal working capital is defined as inventory +
accounts receivable accounts payable.
Commentary

This definition excludes cash; the cash flow is found as the change in the level of
inventory + accounts receivable accounts payable.

For example, at the start of the project inventory must be purchased, causing a cash outflow.
Over the life of the project the level of accounts receivable may rise, with the result that cash
inflows are less than the sales revenues. On the other hand the level of accounts payable
may also rise, reducing the required investment in working capital and improving the cash
flows because payments to suppliers are below the level of purchases. At the end of the
project the inventory levels may be reduced to zero, all receivables may be collected,
creating a cash inflow.
Movements in working capital need to be incorporated into investment appraisals. Cash
flows are derived as follows:
Increase in net working capital = cash outflow
Decrease in net working capital = cash inflow
Unless an exam question specifies otherwise working capital is assumed to be
released at the end of a project (i.e. the investment in working capital falls to zero,
creating a cash inflow).
It is assumed also that changes in the level of working capital have no tax effects.
Commentary

This is a realistic assumption because tax will be charged when net revenues accrue
rather than when the cash is received.

Example 7

Sales of a new product are forecast at $100,000 in the first year, increasing by
10% compound per annum. The product has a four year life cycle. Working
capital equal to 15% of annual sales is required at the start of each year. The
companys contribution margin is 40% and no incremental fixed costs are
expected.
Required:
Determine the total cash flow for each year.

Solution
T
0
T
1
T
2
T
3
T
4

$ $ $ $ $

Contribution
Cash re working capital (W)
Total cash flow

(W)
Sales
Level of working capital
Cash re working capital


Key points

The golden rule only discount future, incremental, operating cash flows.
Never discount depreciation it is not a cash flow.
Do not discount finance costs the cost of finance is measured in the
discount rate and is therefore already taken into account.
Exam questions will be in the environment of the UK tax system.
Depreciation expense is not a tax allowable deduction in the UK instead
companies can claim Writing Down Allowances/Capital Allowances.
Discounting with inflation is a difficult area. The key here is consistency
(i.e. if inflation is included in the cash flow forecast then it must be
included in the discount rate).
Adjusting for changes in working capital is relevant if a question presents
accruals-based accounting information which needs to be converted to a
cash flow basis.

FOCUS

distinguish relevant from non-relevant costs for investment appraisal;
calculate the effect of Writing Down allowances and corporation tax on project cash
flows;
explain the relationship between inflation and interest rates, distinguishing between
real and nominal rates;
distinguish general inflation from specific price increases and assess their impact on
cash flows;
evaluate capital investment projects on a real terms basis;
evaluate capital investment projects on a nominal terms basis;
evaluate capital investment projects on a current/effective terms basis;
incorporate cash flows relating to changes in the level of working capital.
EXAMPLE SOLUTIONS
Solution 1 Relevant costs
Costs and revenues of proceeding with the project.
$
(1) Costs to date of $150,000 sunk ignore.
(2) Materials purchase price of $60,000 is also sunk.
Opportunity benefit is disposal costs saved.

5,000
(3) Labour cost direct cost of $40,000 will be incurred
regardless of whether or not the project is undertaken
and so is not relevant. Opportunity cost of lost
contribution = 150,000 (100,000 40,000)

(90,000)
Absorption of overheads irrelevant as it is merely an
apportionment of existing costs

(4) Research staff costs
Wages for the year
Redundancy pay increase (35,000 15,000)
(60,000)
(20,000)
(5) Equipment
Deprival value if used in the project = disposal value

Disposal proceeds in one year
(8,000)

6,000
(6) General building services
Apportioned costs irrelevant
Opportunity costs rental forgone

(7,000)

________
(174,000)
Sales value of project 300,000

Increased contribution from project
________

126,000
________

Advice: Proceed with the project.
Solution 2 Tax cash flows
T
0
T
1
T
2
T
3

Net cash inflows
Tax @ 33%
Asset
Scrap proceeds
Tax savings on WDAs (W)

(10,000)
5,000 5,000
(1,650)

6,000
825

(1,650)

495

Net cash flow
10% discount factor
Present value

NPV = $2, 083
Accept project
_______

(10,000)
1
(10,000)
_______

5,000
0.909
4,545
_______

10,175
0.826
8, 405
_______

(1,155)
0.751
(867)

WORKING
Tax computation

T0 T1 T2
Profits in
year 1
Asset purchased 1 Jan 20X1
First WDA will be set off
against profits in year 1 (T1)
Asset sold 31 Dec 20X2

$ Tax relief at
33%
Timing
T
0
Investment in asset 10,000
Year 1 WDA @ 25% (2,500) 825 T
2

_______

7,500
Year 2 Proceeds (6,000)

_______

Balancing allowance (1,500) 495 T
3

Solution 3 Tax cash flows
T
0
T
1
T
2
T
3

Net cash inflows
Tax @ 33%
Asset
Tax saving on WDA (W)

(10,000)
5,000

825
5,000
(1,650)

619

(1,650)

1,856

Net cash flow
10% discount factor
Present value

NPV = $(1, 272)
Reject project
_______

(10,000)
1
(10,000)
_______

5,825
0.909
5,295
_______

3,969
0.826
3, 278
_______

206
0.751
155

WORKING
Tax computation

T0 T1 T2
Profits in
year 0
Asset purchased 31 Dec 20X0
First WDA will be set off against
profits earned in prior year
Asset scrapped 31 Dec 20X2

$
Tax relief at
33%
Timing
T
0

Year 0
Investment in asset
WDA @ 25%
10,000
(2,500)

825

T
1

_______

7,500
Year 1 WDA @ 25% (1,875) 619 T
2

_______

5,625
Year 2 Proceeds

_______

Balancing allowance 5,625 1,856 T
3

Solution 4 Money, real and effective methods
(i) Money method
(1 + i) = (1 + r) (1 + h)
= 1.1 1.05
= 1.155
m = 15.5%
T $ DF (15.5%) PV
$
1
2
3
10,800
11,664
12,597
0.866
0.75
0.649
9,353
8,748
8,175
______
26,276
______
(ii) Real method
T $ DF (10%) PV
$
1
2
3
10,286 (W)
10,580
10,882
0.909
0.826
0.751
9,350
8,739
8,172
______
26,261
______
WORKING
05 . 1
800 , 10

(iii) Effective method
1.155 = (1 + e) 1.08
e = 6.94
T $ DF PV
$
13 10,000 2.627 (W) 26,270
______

WORKING
|
.
|
\
|

3
0694 . 1
1
1
0694 . 0
1
= 2.627
Solution 5 Money, real and effective methods
(i) Money method
T
0
T
1
T
2
T
3
$ $ $ $
Investment
Materials (8%)
Labour savings (5%)
Overhead savings (10%)
(10,000)
(1,620)
4,200
2,200

(1,750)
4,410
2,240

(1,890)
4,631
2,662

______

_____

_____

_____

Net cash flow (10,000) 4,780 5,080 5,403
Discount factor @ 15.5% 1 1
1155 .

1
1155
2
.

1
1155
3
.

Present value

______

(10,000)
______

_____

4,139
_____

_____
3,808
_____

_____

3,507
_____

NPV = $1,454
(ii) Effective method
(a) Calculation of effective rates
Materials (1.155)
e
=
=
(1 + e)(1.08)
6.94%
Labour (1.155)
e
=
=
(1 + e)(1.05)
10%
Overheads (1.155)
e
=
=
(1 + e)(1.05)
5%
(b) Discount flows at effective rates
Time Cash flow Discount/
annuity
factor
Present
value
0
13
13
13
Investment
Material cost
Labour saving
Overhead saving
(10,000)
(1,500)
4,000
2,000
1
2.627(W)
2.487
2.723
(10,000)
(3,941)
9,948
5,446

Net present value

_____

1,453
_____

from tables
WORKING
3 year 6.94% annuity factor = 627 . 2
0694 . 1
1
1
0694 . 0
1
3
=
(

(iii) Real method
T
0
T
1
T
2
T
3
Money cash flows (10,000) 4,780 5,080 5,403
1 1.07 1.07
2
1.07
3
Real cash flows (10,000) 4,467 4,437 4,410
Discount factor @ 7.944% 1 0.926 0.858 0.795
Present value (10,000) 4,136 3,807 3,506

NPV = $1,449
Real rate : (1+i) = (1+r)(1+h)
1.155 = (1+r)(1.07)
r = 7.944%

Solution 6 Tax and inflation
WDAs
Tax @ 33% Time
Purchase
WDA @ 25%

250,000
(62,500)

20,625

T
2

______
187,500

WDA @ 25%

(46,875)

15,469

T
3

______
140,625

WDA @ 25%

(35,156)

11,602

T
4

______
105,469

Sales proceeds

(50,000)

Balancing allowance
______
55,469
______

18,305

T
5

Project appraisal
T
0
T
1
T
2
T
3
T
4
T
5

Inflows 84,000 88,200 92,610 97,241
Tax @ 33% (27,720) (29,106) (30,561) (32,090)
Initial investment (250,000)
Scrap 50,000
WDAs 20,625 15,469 11,602 18,305

_______

_______

_______

_______

_______

_______

(250,000) 84,000 81,105 78,973 128,282 (13,785)
DF @ 15% 1 0.870 0.756 0.658 0.572 0.497

_______

_______

_______

_______

_______

_______

PV (250,000) 73,080 61,315 51,964 73,377 (6,851)

_______

_______

_______

_______

_______

_______

NPV = $2,885
Therefore, accept the project
Solution 7 Working capital
T
0
T
1
T
2
T
3
T
4

$ $ $ $ $
Contribution
Cash re working capital (W)
Total cash flow

(W)
Sales
Level of working capital
Cash re working capital

(15,000)
_______

(15,000)
_______

15,000
(15,000)
_______

40,000
(1,500)
_______

38,500
_______

100,000
16,500
(1,500)
_______

44,000
(1,650)
_______

42,350
_______

110,000
18,150
(1,650)
_______

48.400
(1,815)
_______

46,585
_______

121,000
19,965
(1,815)
_______

53,240
19,965
_______

73,205
_______

133,100
0
19,965
_______

SESSION 06 APPLICATIONS OF DISCOUNTED CASH FLOW TECHNIQUES
OVERVIEW
Objective
To apply discounted cash flow techniques to specific areas.

LEASE v BUY
CAPITAL
RATIONING
Definition
Methods
ASSET
REPLACEMENT
DECISIONS
The issue
Limitations
The issue
Decision-making
Investment decision
Financing decision
Decision criterion
Pre-tax cost of debt
DCF
APPLICATIONS

1 CAPITAL RATIONING
1.1 Definition

A situation where there is not enough finance available to undertake all
available positive NPV projects.

Hard capital rationing is where the capital markets impose limits on the amount of
finance available (e.g. due to high perceived risk of the company).
Soft rationing is where the company sets internal limits on finance availability (e.g. to
encourage divisions to compete for funds).
Single-period capital rationing is where capital is in short supply in only one period.
Multi-period is where capital is rationed in two or more periods.
1.2 Methods
1.2.1 Divisible projects
A divisible project is where the company can undertake between 0-100% of the project -
infinite divisibility. However a project cannot be repeated.
Calculate a profitability index for each project = NPV/Initial Investment.
Rank projects according to their index.
Allocate funds to the most effective projects in order to maximise NPV.
Example 1

Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t
0
(50) (10) (10) (15)

Cash is rationed to $50,000 at t
0
Projects are divisible.
Required:
Determine the optimal investment plan.

Solution
Projects A B C D
$000 $000 $000 $000
NPV
Cash flow at t
0

Investment
NPV

Cost benefit ratio

Rank

Plan: Cash NPV

___

___

___

_____

_____

1.2.2 Non-divisible projects
A non-divisible/indivisible project must be done 100% or not at all.
Do not calculate a profitability index.
Simply list all possible combinations of projects.
Choose combination with highest NPV.
Example 2

Detail as for Example 1 but assume that projects are non-divisible.
Solution

1.2.3 Mutually-exclusive projects
A mutually exclusive project is where two or more particular projects cannot be undertaken
at the same time (e.g. because they use the same land).
Divide projects into groups; with one of the mutually-exclusive projects in each group.
Calculate the highest NPV available from each group (assume projects are divisible
unless told otherwise).
Choose the group with the highest NPV.
Example 3

As for Example 1 but C and D are mutually exclusive.
Solution
Group 1 Group 2
$000 $000
A B C A B D
NPV
$

Index
___

___

___

___

___

___

___

___

___

___

___

___

Rank

Plan
NPV Capital NPV Capital

Accept Accept

___

___

Accept Accept

___

___

___

___

___

___

1.2.4 Multi-period capital rationing
If finance is limited in several periods then a linear programming model would have to
be set up and solved in order to find the optimal investment strategy.
Commentary

This is outside of the scope of the F9 syllabus

2 ASSET REPLACEMENT DECISIONS
2.1 The issue
Assume that the company has already decided it requires a particular non-current asset.
A secondary decision is about how often to replace the asset.
For example, how often should the company replace its fleet of motor vehicles or its
computer equipment?
This is referred to as an asset replacement decision.
Method
(1) Calculate the NPV of each possible replacement cycle.
(2) Calculate the Annual Equivalent Cost (AEC) of each cycle:
AEC = NPV/Annuity factor
(3) Choose the cycle with the smallest AEC.

Example 4

The following information is available for a machine which costs $20,000:
Running costs Scrap proceeds
Year 1 5,000 16,000
Year 2 5,500 13,000

Companys cost of capital = 10%
Required:
Determine whether the machine should be replaced each year or every two
years.

Solution
Replace every year
Time Cash flow Discount factor PV
0
1
1

______
NPV =

______

Annual equivalent cost =
Replace every two years
Time Narrative Cash flow
@ 10%
Discount factor
value
Present
0
1
2
2

______
NPV

______

Annual equivalent =
Conclusion.
2.2 Limitations of replacement analysis
Changing technology (e.g. it may be advisable to replace IT equipment more often than
suggested by the above analysis).
Asset requirements may change over time.
Non-financial factors (e.g. employees may be more satisfied if their company cars are
replaced more often).
3 LEASE v BUY
3.1 The issue
A company may acquire an asset through:
a straight purchase (i.e. borrowing to buy); or
a lease.

There are two main types of lease:
Operating lease; where the asset is simply rented for a relatively short part of its
useful economic life;
Finance lease (also called capital lease); where the asset is leased for most of its life.
Although the distinction between operating and finance lease is currently important in
financial reporting, it is not so relevant in financial management.
The important issue for financial management is the cash flows created by a lease, as
compared to a straight purchase of the asset.
3.2 Decision-making

Two decisions
Investment decision Financing decision
Does the asset give operational benefits?
Focus on the NPV of the
operating cash flows
Is it cheaper to buy or lease?
Focus on the relative beefits of
WDAs from buying and the tax
relief on the lease payments
Discount these cash flows using a rate
which reflects operating risk of
investment (e.g average cost of capital)
Discount these cash flows using
after-tax cost of borrowing

Commentary

The approach is to distinguish financing cash flows from operating cash flows and use
separate discount rates for each.
The after-tax cost of borrowing = pre-tax cost (1 tax rate). This takes into account
the tax shield on debt (i.e. interest reduces taxable profits and saves tax).

3.3 Investment decision
Discount the cash flows from using the asset (sales, materials, labour, overheads, tax on
net cash flows, etc) at the firms weighted average cost of capital (WACC).
3.4 Financing decision
Discount the cash flows specific to each financing option at the after-tax cost of debt.
Commentary

It is assumed that shareholders view borrowing and leasing as equivalent in terms of
financial risk, so the after-tax cost of debt is an appropriate discount rate for both
options.

The preferred financing option is that with the lowest NPV of cost.
Relevant cash flows
Buy asset

Purchase cost
Tax saving on WDAs
Scrap proceeds
Lease asset (operating
or finance lease)

Lease payments
Tax saving on lease payments

Commentary

Under UK tax law all lease payments (operating and finance) are tax allowable
deductions.

3.5 Decision criterion

If the PV of the cost of the best finance source is less than the PV of the
operating cash flows, then the project should be undertaken.

Example 5

New project
Asset costs $200,000 on the first day of a new accounting period.
Scrap value $25,000 on the last day of the next accounting period.
Operating inflows $150,000 for two years.
Tax at 33% and paid one year in arrears.
Weighted average cost of capital 10%.
Capital allowances at 25% reducing balance.
Finance options:
(1) using a bank loan at a 10.5% interest rate;
(2) lease for $92,500 per year in advance for two years (lease payments
are tax allowable).
Required:
(a) Determine the operational benefit of the project.
(b) Determine how the project should be financed.
(c) Decide whether the project is worthwhile.

Solution
(a) Operational benefit
Time Cash flow Narrative DF @ 10% PV
$ $

Present value

________

________

Therefore:
(b) Financing decision
(1) Borrow and buy flows
Post-tax cost of debt = pre-tax cost of debt (1 tax rate) = 10.5% (1 0.33) = 7%
$ $

________

________

(W) WDAs
Time Tax effect
at 33%
Time
$ $

(2) Leasing flows
$ $

PV of leasing

________

________

(c) Final decision
$
PV of operating flows
PV of cheaper finance

NPV
________

________

3.6 Evaluating at the pre-tax cost of debt
If a firm is not in a tax paying position there are implications for a lease vs buy evaluation:
no tax savings would be available from capital allowances if the asset was bought;
no tax savings would be available on lease payments (either under an operating or
finance lease);
there would be no tax shield on debt (i.e. interest expense on borrowings would not
lead to tax savings).
The last point means that the discount rate to use to evaluate the financing options should be
the pre-tax cost of debt (i.e. the gross interest rate quoted on a bank loan, or gross
redemption yield if borrowing would be in the form of bonds).
Situations where a firm is not in a tax-paying position include:
losses in current year;
brought forward losses from prior years;
incorporation in a tax-free special economic zone;
tax holidays granted by the host government;
tax-exempt charitable status.
Example 6

A machine costs $500,000 and has $150,000 residual value at the end of three
years. Annual repairs and maintenance costs are $20,000 in the first two years
and zero in the third year.
Financing options:
bank loan at 8% interest rate;
an operating lease at $160,000 per annum for three years, payable in
arrears.
The machine is required for a three year project in a tax-free high-tech park.
The project has strong positive NPV.
Required:
Determine whether the machine should be bought or leased.

Solution
$ $
0
1
2
3

________

________

(2) Leasing flows
$ $
1 3
________

Conclusion:

Key points

With capital rationing it is essential to identify the nature of the projects
(i.e. divisible or non-divisible, mutually exclusive or not).
With asset replacement decisions, the key is the use of Annual Equivalent
Cost to compare cycles of different lengths.
With lease vs. buy decisions, the key is to separate the financing decision
from the investment decision and analyse each at a discount rate reflecting
the risk of the cash flows. Also remember all lease payments are tax
deductible expenses in the UK.

FOCUS

distinguish between hard and soft capital rationing;
apply profitability index techniques for single period divisible projects;
use DCF to analyse asset replacement decisions;
apply DCF methods to projects involving lease or buy problems.
EXAMPLE SOLUTIONS
Solution 1 Divisible projects
Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t
0
(50) (10) (10) (15)

Investment
NPV

50
100

10
) 50 (

10
84

15
45

Cost benefit ratio = 2 Reject = 8.4 = 3

Rank 3 1 2

Plan: Cash NPV

___

___

Available 50
C (10) 84

___

40
D (15) 45

___

25
50% A (25) 50

___

_____

179

_____

Solution 2 Non-divisible
Combinations NPV
$000
A only
C + D
100
129

Therefore choose C + D.
Solution 3 Mutually exclusive
Group 1 Group 2
$000 $000
A B C A B D
NPV
$
100
50
(50)
10
84
10
100
50
(50)
10
45
15

Index
___
2
___

___
(5)
___

___
8.4
___

___
2
___

___
(5)
___

___
3
___

Rank 2 Reject 1 2 Reject 1
Plan
NPV Capital NPV Capital
50 50
Accept C 84 (10) Accept D 45 (15)

___

___

Accept 0.8 A 80 (40) Accept 0.7 A 70 (35)

___

___

___

___

164 115

___

___

Therefore accept C and 0.8A.
Solution 4 Machine replacement
Replace every year
Time Cash flow Discount factor PV
0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909 (4,545)
1 Scrap proceeds 16,000 0.909 14,544

______
NPV = (10,001)

______

Annual equivalent cost =
factor annuity year 1
NPV
= 11,002 $
909 . 0
001 , 10
=
Replace every two years
Time Narrative Cash flow
@ 10%
Discount factor
value
Present
0
1
2
2
Purchase
Running costs
Running costs
Scrap proceeds
(20,000)
(5,000)
(5,500)
13,000
1
0.909
0.826
0.826
(20,000)
(4,545)
(4,543)
10,738

______
NPV = (18,350)
Annual equivalent = 570 , 10 $
736 . 1
350 , 18
AF 10% year 2
350 , 18
= =
Conclusion. Replace every two years.
Solution 5 Lease or Buy
(a) Operational benefit
$ $
12
23
150,000
(49,500)
Project returns
Tax on above
1.736
1.578
260,400
(78,111)

Present value

_______

182,289
_______

(b) Financing decision
Post-tax cost of debt = pre-tax cost of debt (1 tax rate) = 10.5% (1 0.33) = 7%
$ $
0
2
2
3
(200,000)
25,000
16,500
41,250
Purchase cost
Sale proceeds
(W)
(W)
1
0.873
0.873
0.816
(200,000)
21,825
14,405
33,660

________

(130,110)
________

(W) WDAs
Time Tax effect
at 33%
Time
$ $
0
1
Purchase
WDA at 25%
200,000
(50,000)

16,500

2

________

WDV b/f
Sale
150,000
25,000

2

Balancing allowance
________

125,000
________

41,250

3
(2) Leasing flows
$ $
01
23
(92,500)
30,525
Lease payments
Tax relief thereon
1.935
0.873 + 0.816
= 1.689
(178,988)
51,557

PV of leasing flows

________

(127,431)
________

Conclusion: The cheapest method of finance is to lease.
(c) Final decision
$
PV of operating flows
PV of leasing flows (cheaper finance see (b))
182,289
(127,431)

NPV
________

54,858
________

The asset should be acquired using a lease.

Solution 6 Evaluation using the before tax cost of debt
$ $
0
1
2
3
(500,000)
(20,000)
(20,000)
150,000
Purchase cost
Maintenance
Maintenance
Disposal
1
0.926
0.857
0.794
(500,000)
(18,520)
(17,140)
119,100

________

(416,560)
________

(2) Leasing flows
$ $
1 - 3

(160,000)

Lease payments

2.577

(412,320)
________

Conclusion: The cheapest method of finance is to lease.
SESSION 07 PROJECT APPRAISAL UNDER RISK
OVERVIEW
Objective
To appraise investment projects where the outcome is not certain.

RISK AND
UNCERTAINTY
DISCOUNTED
PAYBACK
SENSITIVITY
ANALYSIS
Definition
Method
Advantages
Limitations
SIMULATION
Use
Stages
Advantages
Limitations
Expected values
Standard deviation
Definitions
Sources of risk
REDUCTION OF
RISK
STATISTICAL
MEASURES
Limitations of
payback
Definition
Risk management

1 RISK AND UNCERTAINTY
1.1 Definitions

Risk is a condition in which several possible outcomes exist, the probabilities of
which can be quantified from historical data.
Uncertainty is the inability to predict possible outcomes due to a lack of
historical data (i.e. information) being available for quantification.

Commentary

Although the terms are often used interchangeably only risk is measurable.
1.2 Sources of risk in projects
The major risks to the success of an investment project will be the variability of the future
cash flows. This could be the variability of income streams or the variability of cost cash
flows or a combination of both.
2 SENSITIVITY ANALYSIS
Definition

Sensitivity analysis is the analysis of changes made to significant variables in
order to determine their effect on a planned course of action.

Commentary

In project investment it is used to analyse the risk of the various elements.
The cash flows, probabilities, or cost of capital are varied until the decision changes (i.e.
NPV becomes zero). This will show the sensitivity of the decision to changes in those
elements.
Therefore the estimation of IRR is an example if sensitivity analysis, in this case on the
cost of capital.
Sensitivity analysis can also be referred to as what if? analysis.
2.1 Method
Step 1 Calculate the NPV of the project on the basis of best estimates.
Step 2 For each element of the decision (cash flows, cost of capital)
calculate the change necessary for the NPV to fall to zero.
The sensitivity can be expressed as a % change.
For an individual cash flow in the computation:
Sensitivity = % 100
considered flow of PV
NPV

Commentary

For change in sales volume, the factor to consider is contribution. This may involve
combining a number of flows.

Example 1

Williams has just set up a company, JPR Manufacturing Co, and estimates its
cost of capital to be 15%. His first project involves investing in $150,000 of
equipment with a life of 15 years and a final scrap value of $15,000.
The equipment will be used to produce 15,000 deluxe pairs of rugby boots per
annum generating a contribution of $2.75 per pair. He estimates that annual
fixed costs will be $15,000 per annum.
Required:
(a) Determine, on the basis of the above figures, whether the project is
worthwhile.
(b) Calculate what percentage changes in the following factors would cause
your decision in (a) change:
(i) initial investment;
(ii) sales volume;
(iii) fixed costs;
(iv) scrap value;
(v) cost of capital.

Comment on your results.
Ignore tax.

Solution
(a) Time Cash flow DF @ 15% PV
$ $
0
1 15
1 15
15
Initial cost
Contribution
Fixed costs
Scrap value

_______

_______

(b) The sensitivity of the decision in (a) can be calculated by expressing the
NPV as a percentage of the various factors.
(i) Initial investment
Sensitivity =

(ii) Sales volume
The PV figure of contribution is directly proportional to volume.
Sensitivity =

(iii) Fixed costs
Sensitivity =
(iv) Scrap value
Sensitivity =
(v) Sensitivity to cost of capital
This can be found by calculating the projects IRR:
Year Cash flow factor Present value
$ $
0
1-15
15
(150,000)
26,250
15,000
1

NPV
_______

_______

IRR
= r
1
+ ) r (r
NPV NPV
NPV
1 2
2 1
1

=

2.2 Advantages of sensitivity analysis
It gives an idea of how sensitive the project is to changes in any of the original estimates.
It directs management attention to checking the quality of data for the most sensitive
variables.
It identifies the Critical Success Factors for the project and directs project management.
It can be easily adapted for use in spreadsheet packages.
2.3 Limitations
Although it can be adapted to deal with multi-variable changes, sensitivity is normally
used to examine what happens when one variable changes and others remain constant.
Assumes data for all other variables is accurate.
Without a computer it can be time-consuming.
Probability of changes is not considered.
3 SIMULATION
3.1 Use of simulation
Simulation is a technique which allows more than one variable to change at the same time.
One example of simulation is the Monte Carlo method.
Commentary

Calculations will not be required in the exam; an awareness of the stages suffices.
3.2 Stages in a Monte Carlo simulation
(1) Specify the major variables.
(2) Specify the relationship between the variables.
(3) Attach probability distributions to each variable and assign random numbers to reflect
the distribution.
(4) Simulate the environment by generating random numbers.
(5) Record the outcome of each simulation.
(6) Repeat simulation many times to obtain a probability distribution of the possible outcomes.
3.3 Advantages
It gives more information about the possible outcomes and their relative probabilities.
This data can be used to calculate expected NPV and the standard deviation of NPV
3.4 Limitations
It is not a technique for making a decision, only for obtaining more information about
the possible outcomes.
It can be very time-consuming without a computer.
It could prove expensive in designing and running the simulation, even on a computer.
Simulations are only as good as the probabilities, assumptions and estimates made.
4 STATISTICAL MEASURES
4.1 Expected values
Definition

An expected value is the quantitative result of weighting uncertain events by the
probability of their occurrence.

4.1.1 Calculation
Expected value = weighted arithmetic mean of possible outcomes.
=
p(x) x

Where x = value of an outcome, p(x) = probability of that outcome , = sum
Example 2

State of market Diminishing Static Expanding
Probability 0.4 0.3 0.3
Project 1 $100 $200 $1000
Project 2 $0 $500 $600
Project 3 $180 $190 $200

Payoffs represent net present value.
Required:
Determine which is the best project based on expected values.

Solution
Project 1 Expected value =

The best project based on expected values is
4.1.2 Advantages
It reduces the information to one value for each choice.
The idea of an average is readily understood.
4.1.3 Limitations
The probabilities of the different possible outcomes may be difficult to estimate.
The average may not correspond to any of the possible outcomes.
Unless the same decision has to be made many times, the average will not be achieved;
it is therefore not a valid way of making a decision in one-off situations.
The average gives no indication of the spread of possible results (i.e. it ignores risk).
4.2 Standard deviation
Standard deviation is a measure of variation of numerical values from a mean value.
It is a measure of spread (i.e. an indicator of the likely spread of values from an expected
value).
Commentary

Exam questions are more likely to provide a standard deviation for interpretation,
rather than require its calculation.

4.2.1 Calculation
= standard deviation =
) ( prob ) (
2
x x x
X = each observation
x
= mean of observations
Prob (x) = probability of each observation
Note that variance =
2

Example 3

Using the information from Example 2, calculate the standard deviation for
each project.

Solution
Project 1

Project 2

Project 3

4.2.2 Advantages
It gives an idea of the spread of possible results around the average.
It can be used in further mathematical analysis. For example, estimating Value at Risk
(VaR) on an investment (i.e. the potential loss in value at a given level of confidence).
Commentary

VaR is outside of the F9 syllabus.
4.2.3 Limitations
The calculation of standard deviation can be time consuming.
The exact meaning is not widely understood by non-financial managers.
5 DISCOUNTED PAYBACK
5.1 Limitations of payback
Standard payback period ignores the time value of money and hence gives equal
weighting to cash flows irrespective of the year in which they are received.
This seriously damages the usefulness of payback as a measure of project risk.

Illustration 1

Two alternative projects each require an initial investment of $1,000m and have
the following forecast operating cash flows ($m):
Project A Project B
Year 1 600 100
Year 2 200 300
Year 3 200 600
Year 4 205 205
Year 5 150 150
Each project has a payback period of 3 years and, based on this measure,
would be ranked equally in terms of liquidity and risk. However project A
produces strong cash flows in early years which may be considered to carry a
lower level of uncertainty than more distant returns.

This limitation can be dealt with by using discounted payback period (i.e. first discount
the project returns at a rate that reflects the level of operating risk, and recalculate the
payback period).
5.2 Definition

Discounted payback is the period of time for the discounted returns from a
project to recover the initial investment. Also referred to as the adjusted
payback period.

Example 4

The firms weighted average cost of capital of 10% is believed to reflect the risk
attached to both project A and project B in illustration 1 above.
Required:
Calculate the discounted payback period of each project.

Solution
Project A 10% DF PV Cumulative
Year 0 (1,000)
Year 1 600
Year 2 200 Year 3 200 Year 4 205
Year 5 150
Discounted payback =
Project B 10% DF PV Cumulative
Year 0 (1,000)
Year 1 100 Year 2 300
Year 3 600
Year 4 205
Year 5 150
Discounted payback =
6 REDUCTION OF RISK
6.1 Risk management
Methods of keeping project risk within acceptable levels:
Setting a maximum (discounted) payback period in the initial screening process of
potential projects.
Use of risk adjusted discount rates for both NPV and discounted payback. A higher
discount rate should be applied to projects of higher risk, therefore reducing the
influence of more distant cash flows. Project-specific discount rates can be found using
the Capital Asset Pricing Model (see Session 12).
Use conservative forecasts. Reduce the forecast returns downwards to reflect the
guaranteed minimum inflows from a project (certainty equivalents). Discount these
at the risk-free interest rate (i.e. risk is removed from the cash flows rather than adjusted
for in the discount rate).
Commentary

Calculations using this method will not be required in the F9 exam.

Select projects with a combination of acceptable expected NPV and relatively low
standard deviation of NPV.
Focus attention on the Critical Success Factors indicated by sensitivity analysis.

Key points

Exam calculations on project risk are likely to focus on sensitivity analysis
(i.e. finding the value of key variables at which NPV = 0).
Adjusting the discount rate to reflect a projects risk is dealt with later in
Session 13 on the Capital Asset Pricing Model (CAPM).

FOCUS

distinguish between risk and uncertainty;
evaluate the sensitivity of project NPV to changes in key variables;
explain the role of simulation in generating a probability distribution for the NPV of a
project;
apply the probability approach to calculating expected NPV of a project and the
associated standard deviation.
calculate discounted payback period
suggest ways in which a firm can reduce the risk of its investments
EXAMPLE SOLUTIONS
Solution 1 Sensitivity analysis
(a) Time Cash flow DF @ 15% PV
$ $
0
1 15
1 15
15
Initial cost
Contribution
Fixed costs
Scrap value
(150,000)
41,250
(15,000)
15,000
1
5.847
5.847
0.123
(150,000)
241,189
(87,705)
1,845

_______

5,329
_______

The project is worthwhile as NPV is positive

(b) The sensitivity of the decision in (a) can be calculated by expressing
the NPV as a percentage of the various factors.
(i) Initial investment
If the initial investment rises by more than $5,329, the project would be
rejected.
Sensitivity =
000 , 150
329 , 5
100 = 3.6%
(ii) Volume
The PV figure of contribution $241,189 is directly proportional to
volume. If this PV is reduced by more than $5,329, the project would
be rejected.
Sensitivity =
189 , 241
329 , 5
100 = 2.2%
(iii) Fixed costs
Sensitivity =
705 , 87
329 , 5
100 = 6.1%
(iv) Scrap value
Sensitivity =
845 , 1
329 , 5
100 = 289%
From the above calculations the decision to accept the project is
extremely sensitive to most of the figures given in the question. The
project will be rejected in the event of small rises in the initial
investment or fixed cost figures or falls in contribution or volume. It
could be seen, for instance, that the project just breaks even if fixed
costs become $15,000 1.06 = $15,900.
The scrap value is relatively irrelevant to the investment decision we
would have to pay to have the plant taken away before the project
would be rejected.
(v) Sensitivity to cost of capital
This can be found by calculating the projects IRR, which is probably
only marginally above 15%.
Year Cash flow 16% factor Present value
$ $
0
1-15
15
(150,000)
26,250
15,000
1
5.575
0.108
(150,000)
146,344
1,620

NPV at 16%
_______

(2,036)
_______

IRR
= r
1
+ )
1 2
(
2 1
1
r r
NPV NPV
NPV

= 15% + 15%) (16%
2,036 + 5,329
5,329

= 15.7%
If the cost of capital rises from 15% to more than 15.7% the project
would be rejected.

Solution 2 Expected values
Project 1 Expected value = 100 0.4 + 200 0.3 + 1,000 0.3 = 400
Project 2 Expected value = 0 0.4 + 500 0.3 + 600 0.3 = 330
Project 3 Expected value = 180 0.4 + 190 0.3 + 200 0.3 = 189

Therefore, based on expected values, Project 1 should be adopted.
Solution 3 Standard deviation
Project 1
3 400) (1,000 + 0.3 400) (200 + 0.4 ) 400 100 (
2 2 2

= 156,000 = 395

Project 2
0.2 330) (600 + 0.3 330) (500 + 0.4 ) 330 0 (
2 2 2

= 100 , 74 = 272

Project 3
0.3 189) (200 + 0.3 189) (190 + 0.4 ) 189 180 (
2 2 2

= 69 = 8.3

Solution 4 Discounted payback
Project A 10% DF PV Cumulative
Year 0 (1,000) 1 (1,000) (1,000)
Year 1 600 0.909 545 (455)
Year 2 200 0.826 165 (290)
Year 3 200 0.751 150 (140)
Year 4 205 0.683 140 -
Year 5 150 0.621 93 93
Discounted payback = 4 years
Project B 10% DF PV Cumulative
Year 0 (1,000) 1 (1,000) (1,000)
Year 1 100 0.909 91 (909)
Year 2 300 0.826 248 (661)
Year 3 600 0.751 451 (210)
Year 4 205 0.683 140 (70)
Year 5 150 0.621 93 23
Discounted payback = 4 + 70/93 = 4.75 years

SESSION 08 EQUITY FINANCE
OVERVIEW
Objective
To understand the options available to a company considering an issue of equity funds.

DIVIDEND
POLICY
METHODS OF
SHARE ISSUE
EQUITY FOR
SMES
Quoted companies
Unquoted companies
IPO
Official listing requirements
AIM listing
Rights issue
Shareholder wealth
Bonus issue
Stock splits
INTERNAL
EQUITY FINANCE
Practical influences
Stable
Constant payout ratio
Residual dividend policy
Clientele theory
Bird in the Hand Theory
Dividend Irrelevance Theory
Share buy-back programmes
Special dividends
Scrip dividends
EQUITY
FINANCE DIVIDENDS
Introduction
Difficulties in raising finance
Funding gap and maturity gap
Venture capital
Private equity funds
Business angels
Enterprise Investment Scheme (EIS)
Pecking order theory
Link with working
capital management

1 METHODS OF SHARE ISSUE
1.1 Quoted companies new shares
If a company is already listed the following methods are available for the issue of new
shares:
Method Explanation
Offer for subscription
(public issue)
A sale direct to the general public. This is generally the most
expensive method of issuing new shares.
Offer for sale A sale indirect to the public by selling shares directly to an issuing
house (merchant/investment bank) which then sells them to the
public. (The issuing house guarantees to buy the shares.)
Placing In a placing the sponsor (normally a merchant bank) places the
shares with its clients. At least 25% of shares placed must,
however, be made available to the general public. This is
generally the least expensive method of issuing new shares.
Rights issue An offer to existing shareholders to buy shares in proportion to
their existing holdings.
Offer for sale or
subscription by tender
Like an auction the public is invited to bid for shares. Useful
where setting a price for the shares is difficult.
Vendor placing Sometimes used in takeovers when a predator company buys a
target company by offering its own shares but pre-arranges third
party buyers for those shares. The result is that the target
company shareholders are confident that they will be able to sell
the shares they receive in the predator company.
1.2 Options for unquoted companies
Become quoted (i.e. raise new equity finance at the same time as becoming listed) This is
known as an Initial Public Offering (IPO). The method could be an offer for
subscription or sale, tender, or placing. It is an expensive process.
Stay unquoted. Use rights issue or private placing. However there may be a limited
source of funds from either existing owners or new private investors.
Introduction. Existing shares are given permission to be traded/floated on the Stock
Exchange. No new finance is raised. Public must already hold at least 25% of the shares
in the company.
Commentary

The terms quoted, floated and listed all refer to the same thing (i.e. shares which
are traded on a stock exchange).

1.3 Factors to consider before an IPO
Legal restrictions.
Cost (e.g. fees must be paid to an investment bank to underwrite/guarantee the share
issue; share prospectus must be produced and published). Total fees for an IPO in
London are in the range 6-11%.
Valuation (i.e. setting the price for the new shares to be issued).
Stock Exchange rules as contained in the Yellow Book.
Timing.
1.4 Official listing requirements
Before the shares of a company can receive an official listing (i.e. become traded on the full
London Stock Exchange) the following requirements must be met:
The market capitalisation (value) is at least 700,000;
There is a three year trading record;
At least 25% of the shares are made available to the general public;
Detailed disclosure requirements are met;
Any new issue of shares is accompanied by a detailed prospectus.
The costs of acquiring and maintaining an Official Listing mean that it is not really a
possibility for Small or Medium-sized Enterprises (SMEs). These companies may find the
AIM market more attractive.
Commentary

This listing is also referred to as a full listing.

1.5 Alternative Investment Market (AIM) listing requirements
The AIM market has fewer regulations and in this way is attractive to SMEs. Investors
recognise that due to the more limited regulation, investment in AIM companies carries
additional risk.
The requirements include:
Companies must have public limited company (plc) or equivalent (if non-UK) status;
The financial statements must conform to UK or US accounting standards;
A prospectus must be published prior to the initial quotation and any following issue of
securities;
The company must appoint a nominated advisor which may be an investment bank,
accountancy or law firm to ensure that it understands and obeys the rules of the market.
1.6 Rights issue
In a rights issue existing shareholders are offered more shares (usually at a discount to the
current market price) in proportion to their existing holding.
UK company law guarantees shareholders pre-emptive rights (i.e. the right to purchase
new shares before they can be offered to other investors). This is to protect shareholders
from dilution of their control
You may be asked to calculate the theoretical ex-rights price of a share (TERPS) (i.e. the
expected share price following the rights issue). Although the formula is not published it is
simply the forecast total market value of the firms equity divided into the number of shares
that will be in issue
TERPS =
rights - ex shares of No.
NPV project + issue rights of proceeds + equity of alue Existing v

Points to note:
proceeds of the rights issue should be added net of any issue costs;
if the project has already been announced , and if the market is operating at the semi-
strong level of efficiency, project NPV will already be reflected in the existing share price
and hence should not be included again in the formula above.
Example 1

A company has 100,000 shares with a current market price of $2 each.
It then announces that it is to take on a project with a NPV of $25,000.
The project will be financed by a rights issue of one new share for every two
existing shares. The rights price is $1 per new share.
Ignore issue costs and assume the equity market operates at the semi-strong
level of pricing efficiency.
Required:
Calculate the theoretical ex-rights price of the companys shares.

1.7 Shareholder wealth and rights issues
Example 2

Assume in Example 1 above that Mr X owns 1,000 shares in the company.
Required:
Show Mr Xs position if:
(i) he takes up his rights;
(ii) he sells his rights;
(iii) he does nothing.

(i) Takes up rights
$
Wealth prior to rights issue

______

Wealth post-rights issue
Less: Rights cost

______

Therefore
(ii) Sells rights
$

______
Shares
Sale of rights

______

______

Therefore
(iii) Does nothing
$

______


______

Therefore
1.8 Bonus issue
Reserves (e.g. revaluation surplus or share premium account are converted into share
capital which is distributed as new shares to existing shareholders in proportion to their
existing holdings).
No finance is raised.
Purpose Increases the marketability of the shares, as it increases the number in
existence and reduces their price. This creates a more active secondary market for the
shares which will help future issues to raise cash (e.g. rights issues).
Bonus issues can also be referred to as scrip issues or a capitalisation of reserves.
Commentary

These also signal a companys strength to the market.
1.9 Stock splits
Where ordinary shares are split in value (e.g. $1 shares converted into two 50 cent
shares).
This reduces the market price per share, increasing their marketability.
2 EQUITY FOR SMES
2.1 Characteristics
There is no official definition of what is a Small and Medium-sized Enterprise (SME).
McLaney (2000) identifies three characteristics:
(1) the firm is likely to be unquoted;
(2) ownership of the business is restricted to few individuals, typically a family group; and
(3) they are not micro businesses (those very small businesses that act as a medium for self-
employment of the owners).
SMEs contribute in a significant way to many economies in the world. Besides generating
income, in often large proportions in relation to gross national product, they are frequently
major employers and the sector which is most identified with new ideas and entrepreneurial
spirit. It is these latter factors that help sustain and support growth rates in many
economies.
2.2 Why SMEs face difficulties in raising finance
2.2.1 Business uncertainty
However much owners or managers inform their banks of what they are doing there is
always an element of uncertainty remaining that is not a feature of larger businesses.
Larger businesses have a track record especially in terms of a long-term relationship
with their bankers. New businesses, typically SMEs, obviously do not have a track
record.
Also, larger businesses conduct more of their activities in public than do SMEs. If
information is public, there is less uncertainty. For example, a larger business might be
quoted on an exchange and therefore be subject to press scrutiny, exchange rules
regarding the provision of certain of its activities, and has to publish accounts that have
been audited. Many SMEs do not have to have audits, certainly do not publish their
accounts to a wide audience and the press are not really interested in them.
The fact that potential investors in an SME have much less information about the
business than its managers is known as asymmetry of information. This leads to high
perceived risk in the view of potential investors.
2.2.2 Lack of assets for collateral
If SMEs wish to take loans then banks will look to see what security is available for any
loan provided. This is likely to involve an audit of the firms assets. Collateral is
important because it can reduce the level of risk a bank is exposed to in granting a loan
to a new business.
Many SMEs are based in the service sector where the main asset is likely to be human
capital as opposed to physical assets. Hence the firm may lack adequate collateral and
the directors may be asked to pledge personal assets (e.g. their homes) to secure
business loans.
2.2.3 Lack of marketability of unquoted shares
The equity issued by small companies is difficult to buy and sell, and sales are usually
on a matched bargain basis, which means that a shareholder wishing to sell has to wait
until an investor wishes to buy.
This lack of marketability means that small companies are likely to be very limited in
their ability to offer new equity to anyone other than family and friends.
2.2.4 Tax considerations
Individuals with cash to invest may be encouraged by the tax system to invest via large
institutional investors rather than directly into small companies. In many countries
personal tax incentives are offered on contributions to pension funds.
These institutional investors themselves usually invest in larger companies (e.g. listed
companies) in order to maintain what they see as an acceptable risk profile, and in order
to ensure a steady stream of income to meet on-going liabilities. This reduces the
potential flow of funds to small companies, although the government may try to
mitigate this effect by also offering tax advantages for investment in SMEs.
2.3 Funding gap and maturity gap
Initial owner finance is nearly always the first source of finance for a business, whether from
the owner or from family connections. At this stage many of the assets may be intangible in
which case external financing is difficult to obtain. This is referred to as the funding gap.
Bank loans may become available at a later stage but with small businesses, longer term
loans are often easier to obtain than medium term loans because the longer loans are easily
secured with mortgages against property. The fact that medium term loans are hard to
obtain is a well-known feature of SMEs and is known as the maturity gap.
Due to the funding gap and the maturity gap an SME may have to take an innovative
approach not only to its business but also to its financing. Possible financing solutions are
discussed below.
2.4 Venture capital
What is it?
Venture capital simply means equity capital for small and growing businesses.
Typically $1m minimum is involved.
Who provides it?
Specialist venture capital providers (e.g. Investors In Industry; the 3i Group);
Banks, insurance companies, pension funds;
Local authorities and development agencies.
What do they look for?
Product with strong potential (e.g. a new innovation);
Solid management;
High returns.
What conditions are normally attached?
Providers of funds would normally expect:
a business plan with medium-term cash flow and profit projections ;
board representation;
a dividend policy which promotes growth (i.e. high reinvestment of earnings);
an exit route (e.g. proposed time-scale for seeking a market quotation);
provision of regular management accounting information.

Commentary

Venture capitalists need an exit route a method of selling their investment.

Venture Capital Trusts (VCTs)
VCTs are listed investment trust companies which invest at least 70% of their funds
in a spread of small unquoted trading companies.
The UK government gives tax incentives to individual investors in VCTs.
2.5 Private equity funds
A private equity fund attempts to gain control over a company in order to put it
through a restructuring programme before either selling to another fund or listing the
company on the stock market.
The difference between private equity and venture capital is that private equity funds
usually seek total control of the target company, whereas venture capitalists provide
growth finance in return for partial control.
Commentary

Private equity funds do not only target SMEs, they also buy large quoted companies,
take them off the stock market then restructure before re-listing.

2.6 Business angels
Business angels are private individuals (or small groups of individuals) who are
prepared to invest equity (or perhaps debt) into small businesses with big potential.
Angels are often entrepreneurs who made their own fortunes in the high-tech sector,
were wise enough to sell before the dot.com bubble burst, and now invest in small
business as a hobby (although they do expect to make gains).
Angels not only provide finance but also advice, experience and business contacts. A
typical business angel will hold a portfolio of investments and may, for example, add an
investment in a firm that makes health drinks if they already have an investment in
fitness clubs.
However such angels receive many applications for finance and will only be prepared
to invest in a business with an innovative product and talented management.
2.7 Enterprise Investment Scheme (EIS))
A UK scheme designed to encourage private investors to buy shares in unlisted trading
companies.
Tax relief, at an income tax rate of 20%, is available for investors.
Maximum investment is 500,000 per annum (i.e. maximum reduction in personal tax
liability = 500,000 20% = 100,000).
Shares must be held for at least three years.
3 INTERNAL EQUITY FINANCE
3.1 Pecking order theory
As an alternative to issuing new shares (or debt) a company can finance its investment
projects using retained earnings (i.e. using internal finance rather than external finance).
Commentary

Microsoft did not pay any dividends for many years - it reinvested all cash to produce
growth of the company and its share price. Any shareholder that required a dividend
could simply sell some shares to take a capital gain and create a home-made
dividend.

Company managers may prefer to use internal finance rather than external finance for the
following reasons:
a belief that using internal finance costs nothing in fact this is not true as retained
earnings belong to the shareholders who expect significant returns.
asymmetry of information external investors do not have as much knowledge of the
business as the management and are therefore often reluctant to provide finance or will
only provide it at high cost. This is particularly significant for SMEs which often have
problems attracting new investors due to little public knowledge of the business. Using
internal finance avoids the problem.
no issue costs on internal finance
no change in control structure
taxation position of shareholders - they may prefer to make a capital gain rather than
receive current income via dividends (e.g. in the UK individuals are given a large tax-
free limit on capital gains).
discretion sensitive information about projects does not need to be released (as
compared to a share issue which could require a prospectus).
speed as compared to a share issue, for example, which can take many months.
This preference for internal finance is known as Pecking Order Theory and is supported
by research that found company directors often choose the path of least resistance when it
comes to financing.
3.2 Working capital management and internal equity finance
Creating accounting profits does not guarantee the availability of internal equity finance
the company must be converting profits into positive cash flows.
Potential internal finance available = operating cash flow interest tax
As interest and tax are committed costs the focus must be on maximising operating cash
flows.
Earnings before interest and tax, depreciation and amortisation (EBITDA) x
Rise/fall in inventory (x)/x
Rise/fall in receivables (x)/x
Rise/fall in payables x/(x)
______
Operating cash flow x
______
Therefore improved working capital management can help to release more internal equity
finance. Potential areas for improvement include:
Reducing the time taken to receive payments from customers (e.g. by offering discounts
for quick payment or outsourcing debt collection to a factor).
Reduction in the sea of inventory (e.g. through improved supply chain management
or even moving to Just-in-Time (JIT) production).
Raking increased credit from suppliers although care must be taken not to lose
settlement discounts or compromise relationships with key suppliers.
Commentary

Working capital management is considered further in Session 13.
4 DIVIDEND POLICY
4.1 Practical influences on the dividend decision
4.1.1 Legal constraints
In most countries a dividend can only be paid if there is a credit balance on retained
earnings in the statement of financial position. If a company has brought forward losses
from previous years this may result in a debit or wrong way balance on retained
earnings even if the firm has moved into profits in the current year.
This restriction on paying dividends for the foreseeable future could damage the firms
ability to attract new equity investors to finance its growth. Therefore some countries
allow the debit balance on retained earnings to be written-off against other reserves,
allowing the firm to resume payment of dividends.
4.1.2 Liquidity requirements
The firm may wish to hold significant cash to meet both routine and any unexpected
expenses, and also to be able to move quickly into investment opportunities.
Illustration 1

As at June 2011 Apple Computers held an astonishing $76 billion of cash and
cash equivalents partly to be able to buy in advance large quantities of key
components and ensure continuous production, and partly as a war chest to
finance the quick acquisition of other innovative high-tech firms.

4.1.3 Shareholder expectations
Most shares in quoted companies are held by powerful institutional investors (e.g.
pension funds). Therefore the directors of quoted companies have to carefully manage
investor expectations regarding the level of dividends.
If a large dividend is paid in the current year this may create expectations of the same,
or even higher, in future. If these expectations are then not met then key investors may
sell their shareholdings.
In smaller owner-managed firms there is no such agency problem and the dividend
decision would be influenced more by the personal tax position of the owner-managers
than sensitivity over expectations.
4.1.4 Signalling
In quoted firms where there is significant divorce of ownership and control investors
do not have access to all information about the firms operations and prospects, they
only have what is publically available. Therefore public announcements of the level of
proposed dividend are seen as key signals of company strength or weakness:
a surprise cut in dividend may be interpreted as a signal of liquidity problems,
even if the cut is actually to finance attractive projects;
a surprise increase in dividend may be taken as a signal of company strength,
although some investors may question why the directors have not found suitable
strategies for reinvestment of surplus cash.
Commentary

The above practical factors will therefore have a large influence on the firms dividend
policy. Alternative policies are discussed below.

4.2 Stable
Stable level of dividends or constant level of growth to avoid sharp movements in share
price.
Maintains the level of dividends in the face of fluctuating earnings.
Very common approach for quoted companies.
Commentary

Financial markets like a stable dividend profile.
4.3 Constant payout ratio
Constant proportion of earnings paid out as dividend.
Not particularly suitable as dividends will fluctuate (which can cause a volatile share
price).
4.4 Residual dividend policy
Remaining earnings, after funding all attractive projects, are paid out as dividend (i.e.
dividend = cash generated from operations capital expenditure).
Links to Pecking Order Theory (i.e. a dividend is only paid if more cash is available than
required for reinvestment back into the business).
However it is likely to lead to fluctuating dividends and may not particularly suitable
for quoted companies.
4.5 Clientele theory
The companys historical dividend policy may have attracted particular investors to
whom the policy is suited in terms of tax, need for current income, etc.
The company should then maintain a stable dividend policy or risk losing key investors.
Management should view shareholders as their clientele
Commentary

Major shareholders are usually financial intermediaries (e.g. insurance companies,
pension funds).

4.6 Bird in the Hand Theory
Shareholders may prefer higher dividends (and therefore lower potential capital gains)
as a cash dividend today is without risk whereas future share price growth is uncertain.
4.7 Dividend Irrelevance Theory
Modigliani and Miller (finance theorists) argue that shareholders are indifferent to
dividend policy.
If a company pays no dividend then the share price should rise due to reinvestment of
earnings. Any shareholder that requires a dividend can sell part of their holding to
create a capital gain (i.e. to manufacture a home-made dividend).
Under this theory the pattern of dividends is irrelevant to shareholder wealth.
However Modigliani and Miller made a series of assumptions which may not hold in
practice:
No distortions from the personal tax system (i.e. dividends and capital gains are
taxed at the same rate in the hands of investors);
No transactions costs (i.e. investors can sell shares to create a home-made dividend
without incurring any trading costs);
Perfect markets (i.e. if the firm defers the payment of dividend the current share
price will fully reflect its value).
4.8 Share buyback programmes
In recent years there has been a trend for traditional dividend payments to be replaced
by share repurchase schemes.
With approval from shareholders the company uses surplus cash to buy back part of its
share capital, on the assumption that shareholders can reinvest this cash more
effectively than the company.
The buyback can be performed either by writing directly to all shareholders with an
offer to buy shares at a fixed price (a tender offer) or by purchasing shares via the
stock market at the prevailing price.
The shares are either cancelled as held by the company as Treasury Shares for possible
future reissue. If held by the company the shares carry no voting rights or dividend.
The result of a buyback programme is that there will be fewer shares in issue, and hence
the share price should rise.
Ratios such as Earnings Per Share (EPS) and Return on Equity (ROE) should also
improve.
In many countries a share buyback is treated as a capital gain in the hands of the
investor rather than as income. This can have tax advantages if capital gains are taxed
more lightly than dividends.
4.9 Special Dividends
If a quoted company announces a larger than expected dividend this may raise market
expectations of at least the same in future.
To avoid raising expectations to an unsustainable level the dividend may be announced
as a special dividend basically a bonus dividend.
The company is telling the markets that, from time to time, any exceptional cash surplus
will be returned in this way, but that this should not be built into dividend per share
forecasts.
4.10 Scrip dividends
Shareholders are offered extra shares instead of a cash dividend.
This preserves corporate liquidity and releases cash for reinvestment back into the
business ( linking to Pecking Order Theory).

Key points

Ordinary shareholders take more risk than any other type of investor in a
company because:
(i) ordinary dividends are discretionary (i.e. the company has no legal
obligation to pay an ordinary dividend); and
(ii) ordinary shareholders rank last in the event of bankruptcy/liquidation.
Shareholders require high returns to compensate for this risk and therefore
issuing new shares is an expensive source of finance.
However sometimes a new share issue is the only available source of
finance and therefore you need to be familiar with the methods of issue
available to both listed and unlisted companies.

FOCUS

describe the methods available for issuing new shares;
describe ways in which a company may obtain a stock market listing;
calculate the theoretical ex-rights price of a share;
explain the importance of internally generated funds;
discuss the main dividend policies followed by companies;
explain the purpose and impact of a bonus issue, scrip dividends and stock splits;
discuss the financing problems of small and medium sized enterprises (SMEs);
suggest appropriate sources of equity finance for SMEs (e.g. AIM, venture capital, EIS).
EXAMPLE SOLUTIONS
Solution 1
Ex-rights price:
=
rights - ex shares of No.
NPV + issue rights of Proceeds + issue rights - pre shares old of MV

=
000 , 50 000 , 100
000 , 25 $ ) 1 $ 000 , 50 ( ) 2 $ 000 , 100 (
+
+ +
= $1.83
Commentary

NPV represents the theoretical increase in market value produced by a project.
Value of a right per new share:
= Ex-rights price Subscription price
= $1.83 $1 = 83c
Value of a right per existing share: = 83c 2 = 41c
Commentary

If the market price of the existing shares had been given post the announcement of the
project, then the NPV of $25,000 would already be included in the MV of the old
shares.

Solution 2
(i) Takes up rights
$
Wealth prior to rights issue 1,000 $2 2,000

______

Wealth post-rights issue 1,500 $1.83
1
/
3
2,750
Less: Rights cost 500 $1 (500)

______
2,250

______
Therefore, $250 better off.
(ii) Sells rights
$
Wealth prior to rights issue 1,000 $2 2,000

______
Shares 1,000 $1.83
1
/
3
1,833
1
/
3

Sale of rights 500 $0.83
1
/
3
416
2
/
3

______
2,250

______

Therefore, $250 better off.
(iii) Does nothing
$
Wealth prior to rights issue 2,000

______

Wealth post-rights issue 1,833
1
/
3

______

Therefore loss of $166.
SESSION 09 DEBT FINANCE
OVERVIEW
Objective
To appreciate the options available to a company for long, medium and short-term debt
finance.

LONG-TERM
FINANCE
DEBT FOR
SMEs
SHORT-TERM
FINANCE
MEDIUM-TERM
FINANCE
Bank loans
Leasing
Sale and
leaseback
Mortgage loans
Bank overdraft
Trade credit
Bills of exchange
Commercial paper
Grants
Loan guarantee
scheme
Business angels
CONVERTIBLES
AND WARRANTS
Convertibles
Effect on EPS
Warrants
DEBT
FINANCE
Preference shares
Debentures
Deep discount bonds
Zero coupon bonds
Tax relief on interest

1 LONG-TERM FINANCE
1.1 Preference shares
Definition

Shares with a fixed rate of dividend having a prior claim on profits available
for distribution.

Also called preferred shares these are legally equity; they are often treated as debt (e.g.
under International Financial Reporting Standards) as they are similar in nature to debt.
1.1.1 Features
Shares which have a fixed percentage dividend payable before ordinary dividend.
The dividend is only payable if there are sufficient distributable profits. However if the
shares are cumulative preference shares the right of dividend is carried forward. Any
arrears of dividend are then payable before ordinary dividends.
As with ordinary dividends, preference dividends are not deductible for corporate tax
purposes they are a distribution of profit rather than an expense.
On liquidation of the company, preference shareholders rank before ordinary
shareholders.
1.1.2 Advantages
No voting rights; therefore no dilution of control.
Compared to the issue of debt:
Dividends do not have to be paid if profits are poor;
Not secured on company assets;
Non-payment of dividend does not give holders the right to appoint a liquidator.
1.1.3 Disadvantages
Dividends are not tax deductible (unlike interest on debt).
To attract investors the company needs to pay a higher return to compensate for
additional risk compared to debt.
1.2 Debentures
Definition

A written acknowledgement of a debt, usually given under the companys seal,
containing provisions for payment of interest and repayment of principal. The
debt may be secured on some or all of the companys assets

Type Secured debentures Unsecured debentures
Security and
voting rights
Can be secured on one or more
specific assets - a fixed charge (e.g.
over property);
Or a floating charge can be offered
over a class of assets (e.g. net current
assets or working capital);
On default the assets are sold and
debt repaid;
No voting rights.
No security.
Holders have the same rights as
ordinary creditors.
No voting rights.
Income A fixed annual amount, usually
expressed as a % of nominal value.
A fixed annual amount, usually
expressed as a % of nominal value.
Amount of
capital
A fixed amount per unit of loan stock
or debenture.
A fixed amount per unit of loan
stock or debenture.

In the UK debentures are usually issued with a face value of 100. They can then be traded
on the bond market and reach a market price. Hence, if a debenture is said to be selling at a
premium of 15%, this means that a debenture with a face value of 100 is currently selling
for 115. This indicates that the rate of interest on this debenture is attractive when
compared with current market rates, creating demand for the debenture and a rise in price.
In the US the face value of each debenture is usually $1000.
Commentary

The terms debenture, loan stock and bond all basically refer to the same thing
(i.e. a written acknowledgement of a companys debt which can then be traded). Also
face value can also be referred to as par value of nominal value.

1.3 Deep discount bonds
Definition

Loan stock issued at a large discount to nominal value (i.e. issued well below
face value) redeemable at par on maturity.

Investors receive large capital gain on redemption, but low rate of interest, if any,
during term of the loan.
Cash flow advantage to the borrower useful for financing projects which produce
weak cash flows in early years.
Illustration 1

A five year $1000 3% Bond issued at $800 would generate the following cash
inflows/(outflows) for the issuing company:
t0 t1 t2 t3 t4 t5
Issue price 800
Interest (30) (30) (30) (30) (30)

Redemption (1000)

1.4 Zero coupon bonds
Definition

Bonds issued at a discount to face value and which pay zero annual interest

No interest is paid.
Investors gain from the difference between issue and redemption price.
Advantages to borrowers:
No cash payout until maturity;
Cost of redemption known at time of issue.
1.5 Tax relief on debt interest
Interest expense is tax deductible and therefore reduces corporate tax payments.
Regarding the tax system the Issue of debt is preferable to the issue of shares as
dividends are not allowable for tax.


Illustration 2

CoA CoB
Profit before tax 100 100
Interest (10)
___ ___
100 90
Corporation tax 30% (30) (27)
___ ___
70 63

Effective cost of debt in CoB

Interest 10
Less Tax relief (3)

___
$7

___

$7 difference

After-tax cost of debt = Pre-tax cost of debt (1 Tax rate)
The fact that interest on debt is tax allowable is referred to as the tax shield
2 CONVERTIBLES AND WARRANTS
2.1 Convertibles
Definition

Bonds or preference shares that can be converted into ordinary shares.

Pay fixed interest or dividend until converted.
They may be:
converted into ordinary shares;
on a pre-determined date;
at a pre-determined rate;
at the option of the holder.
Conversion ratio may change during the period of convertibility to stimulate early
conversion.
Advantages to investors a relatively low risk investment with the opportunity to make
high returns on conversion to ordinary shares.
Advantages to issuing company can offer a lower rate of interest than on straight
debentures.
2.2 Effect on EPS (Earnings Per Share) of convertible debt
Convertible debentures require a fully diluted EPS to be calculated to indicate what EPS
might be if debt is converted into equity.
Method
Increase earnings by the loan interest saved, net of tax.
Increase the number of shares due to conversion.
Recalculate EPS
2.3 Warrants
Definition

A right given to an investor to subscribe cash for new shares at a future date at
a fixed price the exercise (or subscription)price.

Warrants are sometimes attached to loan stock, to make the loan stock more attractive.
Warrants are basically share options
The holder of the warrants may sell them rather than keep them.
Advantages to issuing company
The warrants themselves do not involve the payment of any interest or dividends.
When they are initially attached to loan stock, the interest rate on the loan stock will be
lower than for comparable straight debt. This due to the additional benefit for the
investor of potential equity shares at an attractive price.
May make an issue of unsecured loan stock possible where no adequate security exists.
3 MEDIUM-TERM FINANCE
3.1 Bank loans
3.1.1 Advantages
The loan will be for a fixed term: no risk of early recall;
Interest rate may be fixed.
3.1.2 Disadvantages
Inflexible;
May require security,
May require covenants restrictions on the company (e.g. limits on dividend
payments, limits on further borrowing).
3.2 Leasing
3.2.1 Advantages
Many willing providers;
Remains off-balance sheet if an operating lease;
Matches finance to the asset ;
Very flexible packages available, some of which include maintenance.

3.2.2 Disadvantage
Can be costly.
3.3 Sale and leaseback
Property is sold to an institution, such as a pension fund, and then leased back to the
company.
3.3.1 Advantages
Releases significant funds;
May improve ratios such as ROCE (Return on Capital Employed).
3.3.2 Disadvantages
No longer own property and hence cannot participate in any future increase in value;
Risk of lease payments increasing.
3.4 Mortgage loan a loan secured on property.
3.4.1 Advantages
Given the security, the loan will attract a lower interest rate than other debt;
Institutions will be willing to lend over a longer term;
Still participate in the growth in value of the property.

3.4.2 Disadvantage
Default may result in a key asset being liquidated
4 SHORT-TERM FINANCE
4.1 Bank overdraft
4.1.1 Advantages
Flexible;
Provides instant finance.

4.1.2 Disadvantages
Repayable on call, unless the bank offers a revolving line of credit
High and variable interest rate.
4.2 Trade credit
4.2.1 Advantages
Generally cheap;
Flexible.

4.2.2 Disadvantages
May lose settlement (quick payment) discounts;
May lose suppliers goodwill.

4.3 Bills of exchange

Definition

An acknowledgement of a debt to be paid at some time in the future (e.g. by a
customer). Such a bill may then be discounted (i.e. sold to a third party for a
% of face value).

4.3.1 Advantages
Improves cash flow.
Flexible.
4.3.2 Disadvantages
Fees.

Illustration 3

X sells $2m worth of goods to Y. X writes out (draws) a bill of exchange for
$2m payable in 2 months (say) which it sends to Y. Y signs the bill to
acknowledge the debt and returns it to X.
X can either hold the bill for 2 months until Y pays the debt or sell it at a
discount (e.g. at 98% of face value). The buyer of the bill then receives the $2m
and makes a gain.

4.4 Commercial Paper
Definition

Commercial paper is short-term (usually less than 270 days) unsecured debt
issued by high quality companies. The paper can then be traded by investors
on the bond markets.

4.4.1 Advantages
Large sums can be raised and relatively cheaply
No security required

4.4.2 Disadvantages
Only available to large companies with very good credit ratings
5 DEBT FOR SMES
Commentary

The following are particularly suitable for small and medium sized enterprises (SMEs)
which are of particular interest to the examiner as they often have difficulty finding
debt finance. Such difficulties may be caused by asymmetry of information where
banks fear making loans to companies which are not well known and without published
credit ratings.

5.1 Grants
Depending on the location and nature of the business local, regional, national or European
grant assistance may be available.
5.2 Loan guarantee scheme
Just as small/medium sized companies find it hard to raise equity, they can also find it hard
to raise debt, due to their high perceived risk. The Loan Guarantee Scheme is a UK
government-backed scheme where, for a fee, a substantial proportion of the loan may be
guaranteed by the state. Hence potential providers of that loan are willing to lend, as most
of their risk has been eliminated.
5.3 Business angels
Business angels are rich individuals who are prepared to invest money and time in small
companies if they see high potential for growth
Such angels are often retired businesspeople who became wealthy as entrepreneurs in the
high-tech sector.
They may also give useful advice as well as finance and may even be able to use their
contacts to obtain new business for the companies they invest in.
If they are prepared to invest debt they may also want the opportunity of equity
participation in the future. Hence convertible debt or debt with warrants attached may be
appropriate.


Key points

Preference shares are in substance debt as they pay a fixed committed
dividend in priority to any ordinary dividend. They also rank ahead of
ordinary shareholders on liquidation (although after real debt such as
bank loans and debentures).
Preference shareholders therefore face lower risk than ordinary
shareholders and require lower returns
However banks and bondholders take even lower risks, as they rank
ahead of preference shareholders on bankruptcy, and their debts may be
secured by fixed or floating charge over assets. Providers of loans
therefore require lower returns than other providers of finance.
Hence loans are the least expensive source of finance for a company,
particularly if the effect of the tax system is introduced (loan interest is a
tax allowable expense, unlike dividends.)
Unfortunately debt also has a dark side too much debt may increase the
risks faced by shareholders to unacceptable levels.

FOCUS

explain the features of preference shares and the reasons for their issue;
explain the features of different types of long-term debt and the reasons for their issue;
explain the features of convertible debt and warrants and the reasons for their issue;
assess the effect on EPS of conversion and option rights;
suggest various sources of short-term finance;
suggest appropriate sources of debt finance for SMEs (e.g. leasing, loan guarantee
scheme and business angels);
compare the risk/return characteristic of debt compared to equity.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
OVERVIEW
Objective
To develop a model for the valuation of shares and bonds.
To use this model to estimate the cost of equity and the cost of debt.
To consider further practical influences on the valuation of securities.

COST OF DEBT
DIVIDEND
VALUATION
MODEL
General model
Constant dividend
Constant dividend growth
Assumptions
Uses
Practical influences
on share prices
Terminology of debentures
Irredeemable debentures
Redeemable debenture
Semi-annual interest payments
Convertible debentures
COST OF EQUITY
Shareholders required rate of return
Dividend with constant growth
Growth from past dividends
Gordons growth model
Cost of equity and project appraisal
Cost of preference shares
RELATIVE COSTS
OF EQUITY AND
DEBT
Creditor hierarchy
Risk, required return and cost
of finance
Summary of equity vs. debt

1 RELATIVE COSTS OF EQUITY AND DEBT
1.1 Creditor hierarchy
The relative risk/return relationship of equity and debt is based on their relative priority for
repayment on liquidation the creditor hierarchy:
SECURED CREDITORS
UNSECURED
CREDITORS
PREFERRED
SHARES
ORDINARY
SHARES
Unsecured
loans/bonds
Trade
payables
Residual
left (if any)

Secured bank loans
Secured bonds

On liquidation, the firms assets are sold and the cash raised flows in a cascade from the top
of the creditor hierarchy downwards:
Secured loans and secured bonds are repaid first. Some may be secured by fixed
charge over a specific asset such as property, others by floating charge over classes
of assets such as working capital. Secured creditors would expect to receive most, if not
all, of what they are owed in the event of liquidation.
Trade creditors and unsecured debt are repaid next. If a company is forced into
liquidation then, by definition, the value of its assets is likely to be below the value of its
liabilities. In this case unsecured creditors may not receive everything they are owed.
If there are any preference shares in issue they would be repaid next should there be
any cash remaining after paying all creditors.
Ordinary shareholders rank last on liquidation and would be unlikely to receive
anything.
In practice other stakeholders may have claims on liquidation (e.g. employees, tax
authorities and the liquidator). Exam questions would state where in the hierarchy these
would rank as it depends on the laws of the particular country.
1.2 Risk, required return and cost of finance
Commentary

The risk faced by each class of investor drives the required return of that investor, and
the required return drives the firms cost of each source of finance:

1.2.1 Secured loans and secured bonds
Debt investors have legally binding contracts with the firm for the payment of interest
and repayment of principal. Whilst the firm is trading interest must be paid in priority
to dividends and, if the goes into liquidation, secured creditors are repaid first.
Therefore secured debt can be considered a low risk investment; investors in secured
debt require relatively low returns, creating relatively cheap finance for the firm.
1.2.2 Unsecured debt
This is also a legally binding contract and its interest must be paid prior to dividends,
However as there is no guarantee of full repayment on liquidation the required return
will be higher than on secured debt and hence the cost higher.
1.2.3 Preference shares
Although preference dividends are paid after interest on debt, they are a fixed
percentage of the shares par value and paid before any ordinary dividends. On
liquidation, preference shares rank between creditors and ordinary shares, hence the
required return of preference shareholders (and hence the firms cost of preference
capital) will be higher than on debt but lower than on ordinary shares.
1.2.4 Ordinary shareholders
Equity shareholders have no guarantee of receiving dividends (ordinary dividends are
discretionary, whereas preference dividends are committed) and rank last on
liquidation. Therefore ordinary shareholders face high risk and expect high returns to
compensate; leading to the firms cost of equity being relatively high.
1.3 Summary of equity vs debt
Equity Debt
Rank on liquidation Last Higher
Servicing of finance Discretionary Committed
Dividend Interest
Risk to investor High Lower
Return required High Lower
Cost to company High Lower
Cost of equity > cost of debt
Servicing tax allowable? No Yes
Post-tax cost of debt < pre-tax cost of debt
Speed of issue Slow Faster
Issue costs 611% (IPO) Bonds 12%
Bank loan arrangement fees
2 DIVIDEND VALUATION MODEL
2.1 General model
Key point

The market value of a share or other security is equal to the present value
of the future expected cash flows from the security discounted at the
investors required rate of return.

A security is any traded investment (e.g. shares and bonds).
2.2 Constant dividend

The formula for share valuation can be developed as follows:
Ex-div market value at time 0 = Present value of the future dividends
discounted at the shareholders
required rate of return
Ex-div market value is the market value assuming that a dividend has just been
paid.
Let:
Po = Current ex-div market value
Dn = Dividend at time n
ke = Shareholders required rate of return/companys cost of equity
The model then becomes:
Po =
ke) (1
D
ke) (1
D
ke) (1
D
3
3
2
2 1
+
+
+
+
+
.....
ke) (1
Dn
n
+

If the dividend is assumed to be constant to infinity this becomes the present
value of a perpetuity which simplifies to:
Po =
ke
D

This version of the model can be used to determine the theoretical value of a share
which pays a constant dividend (e.g. a preference share) or an ordinary share in a zero
growth company.
2.3 Constant dividend growth
If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate
Po =
g ke
g) (1 D0
+
=
g ke
D1

where D
o
= most recent dividend
D
1
= dividend in one year
The formula is published in the exam in the following format:
P
O
=
( )
( ) g
g
+
re
1 D
O

Where re

= required return of equity investors = ke
2.4 Assumptions behind the dividend valuation model
Rational investors.
All investors have the same expectations and therefore the same required rate of return.
Perfect capital market assumptions:
no transactions costs;
large number of buyers and sellers of shares;
no individual can affect the share price;
all investors have all available information.
Dividends are paid just once a year and one year apart.
Dividends are either constant or are growing at a constant rate.
2.5 Uses of the dividend valuation model
The model can be used to estimate the theoretical fair value of shares in unlisted
companies where a quoted market price is not known.
However if the company is listed, and the share price is therefore known, the model can
be used to estimate the required return of shareholders (i.e. the companys cost of equity
finance).

Illustration 1

A share has a current ex-div market value of 80 cents and investors expect a
dividend of 10 cents per share to be paid each year as has been the case for the
past few years.
Using the dividend valuation model the investors required return can be
determined:
Po =
ke
D

80c =
ke
10c

ke =
80c
10c

ke = 12.5%
Investors will all require this return from the share as the model assumes they
all have the same information about the risk of this share and they are all
rational.
If investors think that the dividend is due to increase to 15 cents each year then
at a price of 80 cents the share is giving a higher return than 12.5%. Investors
will therefore buy the share and the price will increase until, according to the
model, the value will be:
Po =
0.125
15c
= 120 cents
Alternatively suppose that the investors perception is that the dividend will
remain at 10 cents per share but that the risk of the share has increased and so
requires a 15% return. If the share only gives a return of 12.5% (on an 80 cents
share price) then investors will sell and the price will fall. The fair value of the
share according to the model will be:
Po =
0.15
10c
= 66.7 cents

2.6 Practical influences on share prices
The dividend valuation model gives a theoretical value, under the assumptions of the
model, for any security.
In practice there will be many factors other than the present value of cash flows from a
security that play a part in its valuation. These are likely to include:
market sentiment;
press comment and rumour;
speculation;
government restrictions (e.g. on foreign ownership of shares);
anomalies such as the January effect where prices fall at the end of December (as
investors sell shares to crystallise tax losses) and rise at the start of January;
the rise of dark pools (i.e. share trading networks set up by investment banks to
allow their clients to buy/sell shares outside of the public exchanges).
Behavioural finance theory has also identified psychological factors that influence
share prices. For example:
herd mentality (i.e. fund managers tend to follow each others strategies);
the momentum effect (i.e. investors believe recent price rises will continue into
the future). This may lead to a speculative bubble (e.g. in high-tech shares in the
1990s).
3 COST OF EQUITY
3.1 Shareholders required rate of return
The basic dividend valuation model is:
Po =
ke
D

This can be rearranged to find ke:
ke =
Po
D

If ke is the return required by the shareholders in order for the share value to remain
constant then ke is also the return that the company must pay to its shareholders.
Therefore ke also equates to the cost of equity of the company.
Therefore the cost of equity for a company with a constant annual dividend can be
estimated as the dividend divided into the ex-div share price (i.e. the dividend yield).
The ex-div market value is the market value of the share assuming that the current
dividend has just been paid. A cum-div market value is one which includes the value of
the dividend just about to be paid. If a cum-div market value is given then this must be
adjusted to an ex-div market value by taking out the current dividend.

Example 1

A companys shares have a market value of $2.20 each. The company is just
about to pay a dividend of 20c per share as it has every year for the last ten
years.
Calculate the companys cost of equity.

Solution

3.2 Dividend with constant growth
The model can also deal with a dividend that is growing at a constant annual rate of g.
The formula for valuing the share is as seen earlier:
Po =
g ke
g) (1 D
0
+
=
g ke
D
1

where D
o
D
1
= dividend in one year
Rearranged this becomes
k
e
= g
Po
g) (1 D0
+
+

where g = growth rate (assumed constant in perpetuity)
P
o
= ex-div market value
Therefore the cost of equity = dividend yield + estimated growth rate.

Illustration 2

D
o
= 12c, Po (ex-div) = $1.75, g = 5%.
What is the value of k
e
?
k
e
=
75 . 1
) 05 . 1 ( 12 . 0
+ 0.05 = 12.2%

The growth rate of dividends can be estimated using either of two methods.
Two methods
Extrapolation of
past dividends
Gordons growth model

3.3 Growth from past dividends
This method analyses historical growth and use this to predict future growth.
Examples
If specific information is given about future growth, use that.
If dividends grew at 5% each year for the last 10 years, predicted future growth is 5%.
For an uneven but steady growth take an average overall growth rate.
If there is a discontinuity in the growth rate take the most recent evidence.
Take care with a new company with very high growth rates. It is unlikely to produce
such high growth in perpetuity.
If there is no pattern (i.e. dividends up one year, down the next) this method should not
be used.
Example 2

A company has paid the following dividends over the last five years:
Cents per share
20X0 100
20X1 110
20X2 125
20X3 136
20X4 145

Estimate the growth rate and the cost of equity if the current (20X4) ex-div
market value is $10.50 per share.

Solution

3.4 Gordons growth model
This model states that growth is achieved by retention and reinvestment of profits:
g = br
e

where b = proportion of profits retained
r
e
= return on equity

An average of r and b over the preceding years is used to estimate future growth:
r
e
=
funds rs' Shareholde
tax after Profit
=
assets Net
tax after Profit

b =
tax after Profit
profit Retained

These figures can be obtained from the statement of financial position and income
statement.
Example 3

A company has 300,000 ordinary shares in issue with an ex-div market value of
$2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits
of $100,000.
Net assets at the year end were valued at $1.06m.
Estimate the cost of equity.

Solution

3.5 Cost of equity and project appraisal
Illustration 3

A Co, which is listed on a stock exchange, is all equity financed and has 1m
shares quoted at $2 each ex-div. It pays constant annual dividends of 30c per
share.
It is considering adopting a project which will cost $500,000 and which is of the
same risk as its existing activities. The cost will be met by a rights issue. The
project will produce inflows of $90,000 pa in perpetuity. All inflows will be
distributed as dividends.
Required:
Calculate the new value of the equity in A Co and the gain to the shareholders.
Ignore tax.
k
e
=
00 . 2
30 . 0
= 15%
New dividend:
$000
Existing total dividend 300
Dividends from the project 90
New total dividend 390
Value of equity =
15 . 0
000 , 390
= $2,600,000
Shareholders gain = $(2,600,000 2,000,000) $500,000
= $100,000
Project NPV = ($500,000) +
15 . 0
000 , 90
= $100,000
Therefore, new value of equity = Existing value + Equity outlay + NPV
= Existing value + PV of additional
dividends

Therefore the NPV of a project serves to increase the value of the companys shares (i.e.
the NPV of a project shows the increase in shareholders wealth).
This proves that NPV is the correct method of project appraisal it is the only method
consistent with the assumed objective of maximising shareholders wealth.
3.6 Cost of preference shares
By definition preference shares have a constant dividend:
Ke =
Po
D

where D = constant annual dividend
Preference dividends are normally quoted as a percentage (e.g. 10% preference shares).
This means that the annual dividend will be 10% of the nominal value, not the market
value.
Example 4

A company has 100,000 12% preference shares in issue (nominal value $1).
The current ex-div market value is $1.15 per share.
Calculate the cost of the preference shares.

Solution

4 COST OF DEBT
4.1 Terminology of debentures
A debenture is a written acknowledgement of a companys debt.
It usually pays a fixed rate of interest.
It may be secured or unsecured.
It may be traded on the bond market and will reach a market price.
Commentary

The terms debenture, bond and loan stock all basically refer to the same thing (i.e.
traded corporate debt); unlike bank loans which are not traded.

The coupon rate is the interest rate printed on the debenture certificate.
Annual interest = coupon rate nominal value
Nominal value is also known as par or face value. In the exam the nominal value of one
debenture is usually $100.
Market value (MV) is normally quoted as the MV of a block of $100 nominal value.
Commentary

For example, 10% debentures quoted at $95 means that a $100 block is selling for $95
and annual interest is $10 per $100 block.

Market value (ex-int) is where interest has just been paid.
Market value (cum-int) includes the value of accrued interest which is just about to be
paid.
4.2 Irredeemable debentures
Irredeemable debentures are a type of debt finance where the company will never repay
the principal but will pay interest each year until infinity. They are also referred to as
undated debentures.
The market value of undated debt can be calculated using the same logic as the
Dividend Valuation Model:
Key point

MV (ex-interest) = PV of future interest payments discounted at the debt
holders required rate of return.

For irredeemable debentures the interest is a perpetuity.
MV (ex-int) =
r
I

where I = annual interest
r = return required by debenture holder
r =
int) (ex MV
I
= Interest yield
The company gets tax relief on the debenture interest it pays, which reduces the cost of
debentures to the company known as the tax shield on debt.

Illustration 4
Consider two companies with the same earnings before interest and tax (EBIT).
The first company uses some debt finance, the second uses no debt.

$ $
EBIT 100 100
Debt interest (10)
___ ___
Profits before tax 90 100

Tax @ 33% 29.70 33

$3.30 difference
Therefore
Effective cost of debt
$
Debt interest 10.00
Less Tax shield (3.30)

_____
Effective cost of debt 6.70

_____

Because of tax relief, the cost to the company is not equal to the required return of the
debenture holders.
Unless told otherwise, assume that tax relief is instant.
Commentary

In practice, there will be a time lag (e.g. a minimum of nine months under the UK tax
system).

If the debt is irredeemable then:
Cost of debt to the company (also
known as the post-tax cost of debt)
=

=
Return required by the debenture
holders (1T
c
)

Interest yield (1T
c
)

Where T
c
= corporate tax rate as a decimal
K
d
can be used to denote the cost of debt but care is needed as to whether it is stated
pre-tax or post-tax.

Example 5

12% undated debentures with a nominal value of $100 are quoted at $92 cum-
interest. The rate of corporation tax is 33%.
Required:
Find:
(a) the return required by the debenture-holders;
(b) the cost to the company.

Solution

4.3 Redeemable debentures/dated debentures
The cash flows are not a perpetuity because the principal will be repaid. However the
following rule is derived from the dividend valuation model:
Key point

The cost of any source of funds is the IRR of the cash flows associated with
that source.

Looking at the return from an investors point of view, interest payments are included
gross.
Looking at the cost to the company, interest payments are included net of corporation
tax. Assume instant tax relief.
Assume that the final redemption payment does not have any tax effects.
To find the cost of debt for a company find the IRR of the following cash flows:
Time $
0 Market value (ex-interest) x
1 n Post-tax interest (x)
n Redemption value (x)

The IRR is found as usual using linear interpolation.

Example 6

A company has in issue $200,000 7% debentures redeemable at a premium of
5% on 31 December 20X6. Interest is paid annually on the debentures on 31
December. It is currently 1 January 20X3 and the debentures are trading at $98
ex-interest. Corporation tax is 33%.
What is the cost of debt for this company?

Solution
Time Cash flow PV @ 10% PV @ 5%
0
1 4
4
_______ _______

_______ _______
IRR =
K
d
=
Care should be taken not to confuse the required return of the debenture holders with
the cost of debt of the company.
Required return of the
redeemable debenture
holder
= IRR of pre-tax cash
flows from the
debenture
= Gross redemption
yield

Gross Redemption Yield is also referred to as the Yield To Maturity (YTM)
The cost of debt of the company is then determined by finding the IRR of the market
value, net of tax interest payments and redemption value:
Key point

MV (ex-interest) = PV of future interest payments and redemption value
discounted at the debenture-holders required rate of return.


Example 7

A company has 8% debentures redeemable at a 5% premium in ten years.
Debenture-holders require a return of 10%. Corporation tax is 33%.
Calculate the cost to the company.

Solution
DF @ 10% PV DF @ 5% PV
$ $
t
0

t
110

t
10

______

______

______

______

IRR =
Therefore K
d
=
4.4 Semi-annual interest payments
In practice debenture interest is usually paid every six months rather than annually.
This practical aspect can be built into our calculations for the cost of debt.
If interest payments are being made every 6 months then when the IRR of the debenture
cash flows is calculated it should be done on the basis of each time period being 6
months.
The IRR, or cost of debt, will then be a 6 monthly cost of debt and must be adjusted to
determine the annual cost of debt.
Effective annual cost = (1 + semi-annual cost)
2
-1
Example 8

A company has in issue 6% debentures the interest on which is paid on 30 June
and 31 December each year. The debentures are redeemable at par on 31
December 20X9. It is now 1 January 20X7 and the debentures are quoted at
96% ex-interest.
What is the effective annual cost of debt for the company? Ignore corporation
tax.

Solution

0
1 6
6
______ ______

______ ______
IRR =
This is the 6 monthly cost of debt.
The effective annual cost of debt is
4.5 Convertible debentures
Convertible debentures allow the investor to choose between redeeming the debentures
at some future date or converting them into a pre-determined number of ordinary
shares in the company.
To estimate the market value it is first necessary to predict whether the investor will
choose redemption or conversion. The redemption value will be known with certainty
but the future share price can only be estimated.
Key points

MV (ex-interest) = PV of future interest payments and the higher of
(i) redemption value;
(ii) forecast conversion value,
discounted at the debenture-holders required rate of return.

Other amounts that may be calculated for convertibles:
Floor value = the value assuming redemption;
Conversion premium = market value current conversion value.


Example 9

A company has in issue 9% bonds which are redeemable at their par value of
$100 in five years time. Alternatively, each bond may be converted on that
date into 20 ordinary shares. The current ordinary share price is $4.45 and this
is expected to grow at a rate of 6.5% per year for the foreseeable future.
Bondholders required return is 7% per year.
Required:
Calculate the following values for each $100 convertible bond:
(i) market value;
(ii) floor value;
(iii) conversion premium.

Solution
(i) Market value

(ii) Floor value

(iii) Conversion premium

To find the post-tax cost of convertible debt for a company find the IRR of the
following cash flows:
Time $
0 Market value (ex-interest) x
1 n Post-tax interest (x)
n Higher of redemption value/forecast conversion value (x)


Example 10

A company has in issue some 8% convertible loan stock currently quoted at $85
ex-interest. The loan stock is redeemable at a 5% premium in five years time,
or can be converted into 40 ordinary shares at that date. The current ex-div
market value of the shares is $2 per share and dividend growth is expected at
7% per annum. Corporation tax is 33%.
Calculate the cost to the company of the convertible loan stock.

Solution

DF @ 5% PV DF @ 10% PV
$ $
t
0

t
15

t
5

______

______

______

______

IRR =
Therefore cost to the company =
4.6 Bank loans
Unless the exam question states otherwise the interest rate quoted on a bank loan can be
assumed to be the pre-tax cost.
A profitable company should be able to claim a tax shield on bank loan interest and
hence the firms post-tax cost of bank loans = quoted interest rate (1 corporate tax
rate)
As bank loans are not traded their book value must be taken as a proxy for market value
when including them in the weighted average cost of capital (WACC).

Key points

If capital markets are perfect the sale/purchase of any security must be a
zero NPV transaction (i.e. market price = present value of future cash
flows discounted at investors required return).
This general rule can be specifically applied to shares to develop the
dividend valuation model (DVM) and also to bond valuation.
If the market price of a security is already known then the model can be re-
arranged to find the required return of investors (i.e. the companys cost
of equity/debt finance).
Care must be taken with the cost of debt as interest, unlike dividends, is a
tax allowable expense form the side of the company.

FOCUS

understand and use the dividend valuation model;
estimate the cost of equity and cost of debt for a company;
understand the practical factors that affect share prices.
EXAMPLE SOLUTIONS
Solution 1
Po (cum-div) = $2.20
Po (ex-div) = $2.00
K
e
=
Po
D
=
200
20
100% = 10%
Solution 2
20X020X4 four changes in dividend:
100 (1 + g)
4
= 145
(1 + g)
4
=
100
145

1 + g =
4
100
145
= 1.097
g = 9.7%
k
e
=
0
1
P
D
+ g
=
050 , 1
) 097 . 1 ( 145
+ 0.097 = 24.8%
Solution 3
Growth rate g = br
e

b = % profit retained
=
000 , 100
000 , 60
= 60%
r
e
= Return on equity
=
assets net Opening
tax after Profit

=
60,000 1,060,000
100,000

100% = 10%
Commentary

Return on average equity could be used instead of return on opening equity.
g = 0.6 0.1 = 0.06
= 6%
k
e
=
0
1
P
D
+ g =
70 . 2 000 , 300
) 06 . 1 ( 000 , 40
+ 0.06 = 11.2%
Solution 4
12% preference shares: dividend is 12% nominal value
K
e
=
Po
D

=
115
12
100% = 10.4%
Solution 5
r =
int ex MV
Int

=
12 92
12
100% = 15%
(a) Return required by debenture-holders is 15%.
(b) Cost to the company:
K
d
=
int ex MV
) T (1 Int
c
=
12 92
) 33 . 0 1 ( 12
= 10.05%
Solution 6
Time Cash PV @ 10% PV @ 5%
flow
0 98 98 98
(7) 0.67
1 4 = (4.69) (14.87) (16.63)
4 (105) (71.72) (86.42)
_______ _______
11.41 (5.05)
_______ _______
IRR = 5 +
41 . 11 05 . 5
05 . 5
+
(10 5)
K
d
= 6.5%
Solution 7
To find the cost to the company, it is necessary to know the market value of the debentures.
This is found by discounting the future flows at the debenture-holders required return.
MV = (8 6.145) + (105 0.386) = $89.69
An IRR calculation, including the effects of tax relief, is used to find the cost to the company:
DF @ 10% PV DF @ 5% PV
$ $
t
0
89.69 1 89.69 1 89.69
t
110 (
8) 0.67 6.145 (32.94) 7.722 (41.39)
t
10 (105)
0.386 (40.53) 0.614 (64.47)

______

______

16.22 (16.17)

______

______

IRR = 5 +
22 . 16 17 . 16
17 . 16
+
(10 5) = 7.5%
Therefore K
d
= 7.5%
Solution 8
Time 0 is 1 January 20X7. Interest payments due:
30 June X7 Time 1
31 Dec X7 Time 2
30 June X8 Time 3
31 Dec X8 Time 4
30 June X9 Time 5
31 Dec X9 Time 6
Each interest payment will be just half of the coupon rate, $3 each 6 months.
0 96 96 96
1 6 (3) (16.25) (15.23)
6 (100) (83.70) (74.60)
______ ______
(3.95) 6.17
______ ______
IRR = 3 + ) 3 5 (
17 . 6 95 . 3
95 . 3

+
= 3.78%
This is the 6 monthly cost of debt.
The effective annual cost of debt is (1.0378
2
) 1 = 7.7%
Solution 9
(i) Market value
Expected share price in five years time = 4.45 x 1.0655 = $6.10
Forecast conversion value = 6.10 x 20 = $122
Compared with redemption at par value of $100, conversion will be preferred.
Todays market value is the PV of future interest payments, plus the PV of the forecast
conversion value:
= (9 x 4.100) + (122 x 0.713) = $123.89
(ii) Floor value
Floor value is the PV of future interest payments, plus the PV of the redemption value:
= (9 x 4.100) + (100 x 0.713) = $108.20
(iii) Conversion premium
Current conversion value = 4.45 x 20 = $89.00
Conversion premium = $123.89 89.00 = $34.89
This is often expressed on a per share basis (i.e. 34.89/20 = $1.75 per share).
Solution 10
First decide whether or not the loan stock will be converted five years by comparing the
expected value of 40 shares in five years time with the cash alternative.
Assuming that the MV of shares will grow at the same rate as the dividends:
MV/share in five years = 2(1.07)
5
= $2.81
MV of 40 shares $2.81 = $112.40
Cash alternative = $105
Therefore all loan stockholders will choose the share conversion.
To find the cost to the company, find the IRR of the post-tax flows.
DF @ 5% PV DF @ 10% PV
$ $
t
0

(85) 1 85.00 1 85.00
t
15
(8) 0.67 4.329 (23.20) 3.791 (20.32)
t
5
(112.4) 0.784 (88.12) 0.621 (69.80)

______

______

(26.32) (5.12)

______

______

IRR = 5 +
12 . 5 32 . 26
32 . 26
(10 5) = 11.2%
Therefore cost to the company = 11.2%.

SESSION 11 WEIGHTED AVERAGE COST OF CAPITAL AND GEARING
OVERVIEW
Objective
To understand the weighted average cost of capital (WACC) of a company and how it is
estimated.
To understand the effect of gearing on the WACC of a company.
To discuss the traditional view of capital structure, Modigliani and Millers models and
Pecking Order Theory.

WEIGHTED
AVERAGE COST
OF CAPITAL
WEIGHTED AVERAGE
COST OF CAPITAL
AND GEARING
FINANCIAL
GEARING
Calculation of WACC
Limitations of WACC
Marginal cost of capital
EFFECTS
PRACTICAL
FACTORS
TRADITIONAL
VIEW OF CAPITAL
STRUCTURE
Reasoning
Conclusions
Project finance implications
Approach
Introduction
Theory without tax
Theory with tax
MODIGLIANI
AND MILLERS
THEORIES
PECKING ORDER
THEORY

1 WEIGHTED AVERAGE COST OF CAPITAL
1.1 Calculation of WACC
Companies are usually financed by both debt and equity (i.e. they use some degree of
financial/capital gearing). The weighted average cost of capital (WACC) represents a
companys average cost of long-term finance. This provides a potential discount rate for
project appraisal using NPV.
WACC =
+ + + +
+ + + +
... D D E
... D K D K E K
2 1
2 d2 1 d1 eg

Simplified to:
WACC =
D E
D K E K d eg
+
+
OR WACC = K
eg

D E
E
+
+ K
d

D E
D
+

Where:
E = Total market value of equity
D = Total market value of debt
K
eg
= Cost of equity of a geared company
K
d
= Average cost of debt to the company (i.e. the post-tax cost of debt)
In the exam the formula is given as:
WACC =
e
d e
e
k
V V
V
+
+ ( ) T 1 k
V V
V
d
d e
d

+

Where:
V
e
= Total market value of equity V
d
= Total market value of debt
K
e
= Cost of equity geared
K
d
= Pre-tax cost of debt T = corporation tax rate
Commentary

The post-tax cost of debt = K
d
(1 T) for irredeemable debentures or bank loans.
For a redeemable bond the IRR of its post-tax cash flows must be calculated to find the
post-tax cost of debt.
Market values of equity/debt (where available) are used to weight the individual costs
of capital. However if the firms shares are not listed on the stock market then the book
value of equity will have to be used. Similarly for debt (i.e. if the firm has issued bonds
then use the market value but for bank loans the book values would have to be used).

Project has same
business risk as
existing operations
Project is financed
by existing pool of funds
Proportion of
debt to equity
does not change
Current WACC is used as the discount rate only if:

So, a companys existing WACC can only be used as the discount rate for a potential project
if that project does not change the companys:
Gearing level (i.e. financial risk);
Business risk.
Commentary

Important concepts of these risks are dealt with in the next section.
Example 1

A company has in issue:
45 million $1 ordinary shares
10% irredeemable loan stock with a book value of $55million
The loan stock is trading at par.
Share price $1.50
Dividend 15c (just paid)
Dividend growth 5% pa
Corporation tax 33%
Estimate the WACC.

Solution
1.2 Limitations of WACC

LIMITATIONS
THEORETICAL PRACTICAL
CALCULATION
OF Ke
Assumes perfect capital market

Assumes
market value of shares
= present value of dividend stream
market value of debt
= present value of interest/principal

Current WACC can only be used to
assess projects
which

have similar operating risk to
that of the company
are financed by the companys pool
of funds, ie have same financial risk
Estimation of g

historical data used to
estimate future growth rates
Gordons model assumes all
growth is financed by retained
earnings

Share price may not be in
equilibrium

Ignores impact of personal
taxation

A h
CALCULATION OF Kd
Assumes constant tax rates

Bond price may not be in equilibrium

Difficulty in incorporating all
forms of long term finance, eg
BANK OVERDRAFT CONVERTIBLE
LOAN STOCK
FOREIGN LOANS
Current liability but often
has permanent core

Must be aplit between fixed and
variable element

Put fixed element in calculation

Final cash flow is uncertain

Investor has option of

(i) taking the redemption
value, or
(ii) converting into shares

Assume it will be redeemed
unless data is available to
suggest conversion
Exchange rates will
affect the value of
the loans to be
included and
interest payments

1.3 Marginal cost of capital
Marginal cost of capital (MCC) is the cost of raising the most recent dollar of finance.
At first glance it may seem reasonable to use MCC as the discount rate for project
appraisal but this can lead to problems:
project finance may be drawn from the firms pool of funds and not from a
specific source;
even if a project is financed from a specific source it may not be appropriate to
evaluate it at the MCC. For example if a project is financed by debt the discount
rate for NPV should not be the cost of debt as this ignores the fact that the surplus
cash flows belong to the equity investors and are exposed to business risk. Hence
the cost of debt understates the risk of the project and would lead to an
overstatement of NPV.
Therefore it is considered that the WACC is a more appropriate discount rate than the
MCC, as the WACC is an average of the cost of equity (which measures business risk)
and the cost of debt.
2 THE EFFECTS OF GEARING
The current WACC

reflects the current risk profile of the company; both business risk
and financial risk.
Definition

Business risk is the variability in the operating earnings of the company (i.e. the
volatility of EBIT due to the nature of the industry).
Financial risk is the additional variability in the return to equity as a result of
introducing debt (i.e. using financial gearing). Interest on debt is a committed
fixed cost which creates more volatile bottom line profits for shareholders.

As a company gears up two things happen:

WACC = Ke E + Kd D
E + D
Ke increases due to
the increased financial
risk.

All else equal, this
pushes up the value
of WACC.
The proportion of
debt relative to equity
in the capital
structure increases.

Since Kd < Ke this
pushes the value of
WACC down, all else
equal.

The effect of increased gearing on the WACC depends on the relative sizes of these two
opposing effects.
There are two main schools of thought
Traditional view
Modigliani and Millers theories
3 TRADITIONAL VIEW OF CAPITAL STRUCTURE
3.1 Reasoning
The traditional view has no theoretical foundation often described as the intuitive
approach. It is based on the trade-off caused by gearing (i.e. using more, relatively
cheap, debt results in a rising cost of equity). The model can also be referred to as the
static trade-off model.
It is believed that K
e
rises only slowly at low levels of gearing and therefore the benefit
of using lower cost debt finance outweighs the rising K
e
.
At higher levels of gearing the increased financial risk outweighs this benefit and
WACC rises.
Cost of
capital
Ke
WACC
Kd
D/E
Optimal
gearing

At very high levels of gearing the cost of debt rises. This is due to the risk of default on
debt payments (i.e. credit risk).
This is referred to as financial distress risk not to be confused with financial risk which
occurs even at relatively safe levels of debt.
3.2 Conclusions
There is an optimal gearing level at which WACC is minimised and hence the NPV of
projects is maximised (i.e. the value of the firm is maximised).
However there is no straightforward method of calculating K
e
or WACC or indeed the
optimal capital structure. The latter can only be found by trial and error.
3.3 Project finance implications
If the company is optimally geared: raise finance so as to maintain the existing gearing
ratio.
If the company is sub-optimally geared: raise debt finance so as to increase the gearing
ratio towards the optimal.
If the company is supra-optimally geared: raise equity finance so as to reduce the
gearing ratio back to the optimal.
3.4 Approach
Appraise the project at the existing WACC:
If the NPV of the project is positive the project is worthwhile.
Appraise the finance:
If marginal cost of the finance > WACC the finance is not appropriate and should
be rejected.
If this was the case the company could raise finance in the existing gearing ratio
and the WACC would not rise.
4 MODIGLIANI AND MILLERS THEORIES
4.1 Introduction
Modigliani and Miller (MM) constructed a mathematical model to provide a basis for
company managers to make financing decisions.
Mathematical models predict outcomes that would occur based on simplifying
assumptions.
Comparison of the models conclusions to real world observations then allows
researchers to understand the impact of the simplifying assumptions. By relaxing these
assumptions the model can be moved towards real life.
MMs assumptions include:
Rational investors;
Perfect capital markets;
No tax (either corporate or personal) although the assumption of no corporate tax
was later relaxed;
Investors are indifferent between personal and corporate borrowing;
No financial distress risk (i.e. no risk of default even at very high levels of debt);
There is a single risk-free rate of borrowing (R
f
);
Corporate debt is irredeemable.
4.2 Theory without tax
MM considered two companies; both with the same size and with the same level of
business risk:
One company was ungeared Co u
One company was geared Co g
MMs basic theory was that in the absence of corporation tax the market values (V) and
hence WACCs of these two companies would be the same.
Vg = Vu
WACCg = WACCu
MM argued that the individual costs of capital would change as gearing changed in the
following manner:
ke would increase at a constant rate as gearing increased due to the perceived
increased financial risk
kd would remain constant (at R
f
) whatever the level of gearing
the rising ke would exactly offset the benefit of cheaper debt in order for the WACC
to remain constant.
This can be shown as a graph:

Cost of
capital
WACC
D/E
Ke
Kd

Conclusion
There is no optimal gearing level;
The value of the company is independent of the financing decision;
Only investment decisions affect the value of the company.
This is not true in practice because the assumptions are too simplistic. There are
differences between the real world and the model.
MM never claimed that gearing does not matter in the real world. They said that it
would not matter in a world where their assumptions hold. They were then in a
position to relax the assumptions to see how the models predictions would change.
The first assumption they relaxed was regarding corporate tax.
4.3 Theory with tax
When MM considered corporation tax their conclusions regarding capital structure
were altered. This is due to the tax relief available on debt interest the tax shield.
When corporation tax is introduced MM argue that the individual costs of capital will
change as follows:
Ke increases as gearing levels increase to reflect additional perceived financial risk
K
d
is now the post-tax cost of debt (i.e. R
f
(1 tax rate))
As gearing increases there is upward pressure due to the rising cost of equity but
even stronger downward pressure due to the very low cost of debt.
Overall the WACC falls.

Cost of
capital
WACC
D/E
Ke
Kd

Conclusion
The logical conclusion to be drawn from MMs theory with tax is that there is an
optimal gearing level and that this is at 99.9% debt in the capital structure.
This implies that the financing decision for a company is vital to its overall market
value and that companies should gear up as far as possible.
This is not true in practice; companies do not gear up to 99.9%. Why not?
at high levels of gearing the risk of default on debt becomes significant (i.e. the cost
of debt rises);
the existence of not only corporate tax but also personal taxes; investors may prefer
to inject equity rather than debt if dividends are taxed less than interest income.
Thus in practice there are many factors that a company will need to consider in deciding
how to raise finance.
5 PRACTICAL FACTORS INFLUENCING CAPITAL STRUCTURE
Business risk of the project it is not wise to finance high risk projects with debt as
payment of interest is a legally binding commitment.
Existing level of financial gearing.
Level of operational gearing the proportion of fixed to variable operating costs. If this
is high then the company may not wish to use debt as this increases the level of fixed
costs even further.
Quality of assets available for security on debt.
Personal tax position of the shareholders and debt holders.
Market sentiment (e.g. frozen debt markets following the 2007 US sub-prime meltdown).
Tax exhaustion (not enough profit to fully utilise the tax shield).
Issue costs.
Agency costs at high levels of financial gearing the control of the firm may move away
from the shareholders towards the debt investors (e.g. restrictive debt covenants may
restrict dividends or limit operations to low-risk areas).
Commentary

This may reduce returns to shareholders.
Costs of financial distress. At dangerous levels of financial gearing the firm may find its
costs of doing business start to rise (e.g. suppliers may ask for payment in advance, staff
turnover may rise, customers may lose faith in the warranties on the firms products).

6 PECKING ORDER THEORY
When choosing project finance managers often follow the path of least resistance (i.e. the
most convenient source). Research has shown the following hierarchy emerges:
Internal finance (i.e. reinvestment of profit) is preferred to raising external finance.
There are several practical advantages of using internal finance:
management time is not consumed by paperwork;
no issue costs;
no change in the firms control structure;
privacy (e.g. no need to publish prospectus);
external finance may not be available, particularly for SMEs due to asymmetry of
information (perceived high risk due to lack of public information about the
business).
If internal finance is not sufficient, perhaps because existing shareholders require a
significant dividend, then external finance must be raised. Here the preference is for
debt as:
debt is cheaper than equity;
interest is tax allowable the tax shield;
issue costs are lower on debt than equity;
debt can be raised more quickly than equity.
If debt cannot be raised (e.g. due to lack of assets for security) then a share issue is
unfortunately inevitable. A new share issue ranks last in pecking order theory as:
cost of equity is high as equity investors are exposed to high risk (business and
operating risk);
dividends do not give the firm a tax shield;
issue costs are high (e.g. 6-11% in the case of an Initial Public Offering (IPO) in the
UK);
share issues take a lot of time and effort to organise at least 6 months in the case of
an IPO, after which time the issue may have to be cancelled due to a change in
market sentiment.
Key points

WACC estimates the companys average cost of long-term finance.
It is therefore a potential discount rate to use for the calculation of the
NPV of possible projects. However the existing WACC should only be
used if the project would not change the companys business risk or level
of gearing (i.e. financial risk).
There are various, and conflicting, models of how financial gearing affects
the WACC traditional trade-off theory, Modigliani and Miller without
tax and MM with corporate tax. Each model has useful elements even if
the conclusions of such models lack practical relevance.

FOCUS

understand the weighted average cost of capital, how it is estimated and
when it should be used;
discuss the traditional view of capital structure as well as the models of Modigliani and
Miller;
discuss practical factors that influence the choice of capital structure, including Pecking
Order Theory.
EXAMPLE SOLUTION
Solution 1
Ke = g
Po
g) Do(1
+
+

= 05 . 0
50 . 1
05 . 1 15 . 0
+
= 15.5%
K
d
= 10% (1 0.33) = 6.67%
WACC = 15.5%
55 ) 50 . 1 45 (
55
% 67 . 6
55 ) 50 . 1 45 (
50 . 1 45
+
+
+

= 11.54%
SESSION 12 CAPITAL ASSET PRICING MODEL
OVERVIEW
Objective
To understand the Capital Asset Pricing Model and its uses in financial management.

BETA FACTORS
USES
Measurement
Interpretation
Formula
Security Market Line
Well-diversified investor
Companies
Asset betas
Equity betas
Use of the equity beta
EVALUATION
CAPITAL ASSET
PRICING MODEL
DEGEARING AND
REGEARING BETA
Project appraisal in a
new industry
MM and betas
Assumptions
Advantages
Limitations
SYSTEMATIC AND
UNSYSTEMATIC
RISK
Variability of returns
Measurement of systematic risk

1 SYSTEMATIC AND UNSYSTEMATIC RISK
1.1 Variability of returns
Risk, the variability of returns, can be split into two elements:
unsystematic risk;
systematic risk.
Definitions

Unsystematic risk is the risk that is unique to each companys shares. (Also
called unique or industry-specific risk.)
Systematic risk is the risk that affects the market as a whole rather than a
specific companys shares. (Also known as market risk.)

Unsystematic risk is the element of risk that can be potentially eliminated by
shareholders building a diversified portfolio.
Systematic risk cannot be diversified away; systematic risk still remains even in a well-
diversified portfolio.
1.2 Measurement of systematic risk
A well-diversified portfolio of shares still has some degree of risk or variability. This is
due to the fact that all shares are affected by systematic risk (i.e. to macro-economic
changes).
Systematic risk will affect the shares of all companies although some will be affected to
a greater or lesser degree than others.
This sensitivity to systematic risk is measured by a beta factor.
2 BETA FACTORS
2.1 Measurement
Beta factors for quoted shares are measured using historic data and published in beta
books. They are determined by comparing changes in a shares returns to changes in
the stock market returns over a period of many years (at least five years).
This can be illustrated by the security characteristic line which gives an indication of
the shares sensitivity to market changes.
The beta factor is estimated from these observations by determining the gradient or
slope of the line of best fit through the observed points. The steeper the slope the
more volatile the share and the higher the beta factor.
(Ri - Rf)
Security characteristic line
Intercept =
Slope =
(Rm - Rf)

Where (R
i
R
f
) = the excess return of the share over the risk free return
(R
m
R
f
) = the excess return of the stock market over the risk free return
R
f
= the return on a risk-free investment
The security characteristic line should in the long run pass through the point where the
two axes meet.
However in the short run this may not always be the case and any short term difference,
or abnormal return, is known as the alpha factor.
2.2 Interpretation
A beta factor therefore simply describes a shares degree of sensitivity to changes in the
markets returns, caused by systematic risk:
Beta factor = 1 this indicates that the share is as sensitive as the market to
systematic risk
Beta factor > 1 this means that the share is more sensitive than the market.
Therefore if the market in general rises by 10% then the returns
from this share are likely to be more than 10%.
Beta factor < 1 the share is less sensitive than the market and is likely to rise and
fall in value less than the market in general.
3 CAPITAL ASSET PRICING MODEL
3.1 Formula
If the shareholders of a company hold well-diversified portfolios then they are
concerned only with systematic risk.
The return these shareholders require therefore is only a return to cover the systematic
risk of an investment.
Systematic risk is measured by a beta factor - therefore the required return from an
investment must be related to the beta factor of that investment.
This is brought together in the Capital Asset Pricing Model which is a formula that
relates required returns to beta factors as measures of systematic risk.
The CAPM formula is :
E(r
i
) = R
f
+ i(E(r
m
)R
f
)
E(r
i
) = expected/required return from an investment
R
f
= risk free return
E(r
m
) = expected return from the market portfolio
=
beta of the investment
The Market Portfolio is a portfolio containing every share on the stock market.
(E(r
m
)R
f
) = the equity market premium. That is, the extra return an investor expects for
holding a diversified portfolio of shares rather than a risk-free security (e.g. treasury
bills).
3.2 Security Market Line
The Security Market Line is a graph that indicates the required return from any
investment given its beta factor. Forecast returns from investments can be compared to
the figure from the security market line to indicate whether that investment is under or
overvalued.
Return
Rm
Rf
x Ra
x Rb
Security market line
Beta
0 Ba 1 Bb

Where Ra = the forecast return from investment A
The required return of an investment with a beta of zero (risk free) will be the risk free
return.
The required return of an investment with a beta of 1 will be the market return.
Consider investment A it is forecast to earn higher returns than the CAPM would
predict given its beta. It is therefore temporarily under-priced. This is referred to as a
positive alpha investment.
Consider investment B it would appear to be temporarily over-priced a negative
alpha investment.
In the long run market forces should ensure that all investments do give the returns
predicted by the Security Market Line.
4 USES OF THE CAPM
4.1 Well-diversified investors
If an investor already holds a well-diversified portfolio then that investor will be
concerned only with systematic risk. The CAPM is therefore relevant.
The investor will be satisfied only if a potential investment gives a high enough return
given its sensitivity to market risk as measured by its beta factor.
Example 1

An investment has a forecast return over the next year of 12%. The beta of the
investment is estimated at 0.9. The risk free rate is 5% and the market return is
15%.
Determine whether a well-diversified investor should buy this investment.

Solution

4.2 Companies
Companies should not diversify their activities simply to reduce the risk of their
shareholders. Shareholders can diversify their shareholdings much more easily than a
company can diversify its activities.
If shareholders are already well-diversified then the company should be concerned, on
behalf of the shareholders, simply with the systematic risk of potential projects.
Therefore the aim of a company, with well-diversified shareholders, should be to
determine the required return from its investment projects and then compare this to the
forecast return.
If the project is the same risk as that of the existing activities of the company then the
existing WACC can be used.
However if the project is of a different risk type to the existing activities then the
existing WACC will not be appropriate. In these instances a tailor-made discount rate
for that type of project must be determined using the CAPM.
4.3 Asset betas
Any company is made up of its assets or activities. These assets will have a certain
amount of risk depending on their nature. These assets will have a beta factor that
recognises the sensitivity of such assets to systematic risk.
This beta factor is the asset beta and measures the systematic business risk of the
company.
Commentary

It can also be referred to as an ungeared beta factor.
4.4 Equity betas
The equity beta measures the sensitivity to systematic risk of the returns to the equity
shareholders in a company.
In an all-equity financed company, or ungeared company, the only risk that is incurred
is business risk.
Therefore in an ungeared company the asset beta and the equity beta are the same.
However in a geared company the equity shareholders face not only business risk,
measured by the asset beta, but also a degree of financial risk.
Therefore in a geared company the equity beta > the asset beta.
Commentary

Equity betas can also be called geared betas.
4.5 Use of equity beta
The equity beta measures the sensitivity to market risks of the equity shareholders
returns. If the equity beta is used in the CAPM this gives the required return for the
equity shareholders.
The required return of shareholders = the cost of equity geared (Keg).
The CAPM can therefore be used as an alternative to the Dividend Valuation Model for
estimating the cost of equity of a company.
Example 2

The equity beta of a company is estimated to be 1.2. The risk free return is 7%
and the return from the market is 15%.
Estimate the cost of equity of the company.

Solution

5 DEGEARING AND REGEARING BETA
5.1 Project appraisal in a new industry
It has already been noted that a companys existing WACC is only a relevant discount
rate for a project with the same level of business risk as existing activities..
If the project is in a different industry (or country) then a discount rate to reflect the
business risk of that industry is required.
A company in a similar industry can be found and its beta discovered. If that company
is geared then its equity beta will contain both business risk and financial risk.
However that company will probably have a different level of gearing compared to our
company.
First beta must be degeared to find the asset beta, and then regeared to reflect the
companys level of financial risk
5.2 MM and betas
The following formula (based on Modigliani and Millers models) can be used to
convert an equity beta to an asset beta (and vice-versa):
a =
( ) ( )

+
e
T 1 Vd Ve
Ve
+
( )
( ) ( )

+

d
T 1 Vd Ve
T 1 Vd

where a = asset beta
e = equity beta
d = beta of corporate debt
Ve = market value of equity
Vd= market value of debt
T = corporation tax rate
Commentary

If the exam question does not give a beta factor for debt then assume that debt is risk
free. That is, d = 0.


Example 3

A Co produces electronic components but is considering venturing into the
manufacture of computers. A Co is ungeared with an equity beta of 0.8.
The average equity beta of computer manufacturers is 1.4 and the average
gearing ratio is 1:4.
The risk free return is 5%, the market return 12% and the rate of corporation
tax 33%.
If A Co is to remain an equity-financed company determine the discount rate it
should use to appraise a computer manufacture project.

Solution

Example 4

Suppose that A Co in Example 3 has a gearing ratio of 1:2. It still wishes to
enter into the same computer manufacturing project.
Calculate the discount rate that A Co should use for a computer manufacturing
project.

Solution

6 EVALUATION OF CAPM
6.1 Assumptions
Total risk can be split between systematic risk and unsystematic risk.
Unsystematic risk can be completely diversified away.
All of a companys shareholders hold well-diversified portfolios.
A risk-free security exists.
Perfect capital markets.

6.2 Advantages
It considers only systematic risk (i.e. is relevant for listed companies whose institutional
investors have diversified portfolios from which unsystematic risk has been eliminated).
It generates a theoretically-derived relationship between required return and systematic
risk.
CAPM has been subject to frequent empirical research and testing.
It is generally seen as a much better method of calculating the cost of equity than the
dividend growth model in that it explicitly takes into account a companys level of
systematic risk relative to the stock market as a whole.
It is superior to the existing WACC in providing the discount rate for a project with
different business risk compared to existing operations.
6.3 Limitations
It is a single period model whereas company projects are often multi-period.
It is a single index model beta being the only variable to explain different required
returns on different investments.
Lack of data for the model particularly in developing markets.
CAPM tends to overstate the required return on very high risk companies and under-
state the returns on very low risk companies.
Assumptions may not hold in the real world.

Key points

CAPM is an alternative to the Dividend Valuation Model (DVM) for
estimating a companys cost of equity.
Beta factors measure systematic risk and therefore CAPM should only be
used if the companys shareholders have themselves used portfolio theory
to diversify way unsystematic risk
Despite its assumptions and limitations CAPM is a more flexible model
than DVM as it allows the estimation of project-specific discount rates

FOCUS

understand the meaning and significance of systematic and unsystematic risk;
appreciate the uses of the CAPM for financial management;
discuss the assumptions, advantages and limitations of CAPM.
EXAMPLE SOLUTIONS
Solution 1
Required return = 5 + 0.9 (15 5) = 14%
Expected return = 12%
Therefore the investor should not invest.
Solution 2
Ke = 7 + 1.2 (15 7) = 16.6%
Solution 3
Using MM formula find the asset beta of the computer industry:
a =
( ) ( )

+
e
T 1 Vd Ve
Ve
+
( )
( ) ( )

+

d
T 1 Vd Ve
T 1 Vd

Ba = 4 . 1
) 67 . 0 1 ( 4
4
+

Asset beta = 1.2
As A Co is ungeared then this asset beta is the appropriate beta for use in the CAPM to
determine the discount rate that A Co should use for a computer manufacture project:
Required return = 5 + 1.2(12 5) = 13.4%
Solution 4
Using MM formula find the asset beta of the computer industry:
a =
( ) ( )

+
e
T 1 Vd Ve
Ve
+
( )
( ) ( )

+

d
T 1 Vd Ve
T 1 Vd

Ba = 4 . 1
) 67 . 0 1 ( 4
4
+

Asset beta = 1.2
to find the discount rate for A Co this asset beta must be converted into an equity beta
appropriate to A Co:
1.2 = Be
0.67) 1 ( 2
2
+
= 0.749 Be
Be = 1.6
Ke of A Co if in computer manufacture = 5 + 1.6 (12 5) = 16.2%
The discount rate that A Co must use is the WACC that it would have if its Ke were 16.2%.
In the absence of any other information assume K
d
is 5% (risk free rate).
Discount rate = (16.2% ) + (5 (1 0.33) ) = 11.92%
SESSION 13 WORKING CAPITAL MANAGEMENT
OVERVIEW
Objective
To appreciate the importance of working capital and therefore its effective management.

WORKING
CAPITAL
WORKING
CAPITAL CYCLE
Liquidity ratios
Efficiency ratios
Calculation and interpreting
Inventory
Receivables
Trade payables
Cash and bank balances
Problems for small businesses
Overtrading
Summary
FINANCING
Term structure of interest rates
Yield curves
Sources of finance for current assets
Permanent vs fluctuating current assets
Policies for financing current assets
RATIOS
MANAGING
WORKING
CAPITAL
Importance
Optimum level
Cash operating cycle
Factors affecting length

1 WORKING CAPITAL
1.1 importance
Definition

The capital represented by net current assets which is available for day-to-day
operating activities. It normally includes inventories, trade receivables, cash
and cash equivalents, less trade payables.

The definition of working capital is fairly simple; it is the difference between an
organisations current assets and its current liabilities. Of more importance is its function
which is primarily to support the day-to-day financial operations of an organisation,
including the purchase of inventory, the payment of salaries, wages and other business
expenses, and the financing of credit sales.
Many businesses that appear profitable are forced to cease trading due to an inability to
meet short-term obligations when they fall due. To remain in business it is essential that an
organisation successfully manages its working capital. Too often however, this is an area
which is ignored.
Working capital comprises a number of different items and its management is difficult since
these are often linked. Hence, altering one item may impact adversely on other areas of the
business.
Illustration 1

A reduction in the level of inventory will see a fall in storage costs and reduce
the danger of goods becoming obsolete. It will also reduce the level of
resources that an organisation has tied up in inventory. However, such an
action may damage an organisations relationship with its customers as they
are forced to wait for new inventory to be delivered, or worse still may result
in lost sales as customers go elsewhere.

Illustration 2

Extending the credit period might attract new customers and lead to an
increase in turnover. However, to finance this new credit facility an
organisation might require a bank overdraft. This might result in the profit
arising from additional sales actually being less than the cost of the overdraft.

Management must ensure that a business has sufficient working capital. Too little will
result in cash flow problems highlighted by exceeding the agreed overdraft limit, failing to
pay suppliers on time and being unable to claim discounts for prompt payment. In the long
run, a business with insufficient working capital will be unable to meet its current
obligations and will be forced to cease trading even if it remains profitable on paper.
On the other hand, if an organisation ties up too much of its resources in working capital it
will earn a lower than expected rate of return on capital employed. Again this is not a
desirable situation.
Working capital management is crucial to the effective management of a business because:
current assets comprise over half the assets of some companies;
failure to control working capital, and therefore liquidity, is a major cause of business
failure.
Two major questions must be considered:
How much to invest in working capital?
How to finance working capital?
1.2 Optimum level
Regarding the level of working capital every firm faces a trade-off between liquidity and
profitability:

Is there an OPTIMAL level of working capital?
LIQUIDITY v PROFITABILITY
High investment
in working
capital

more liquid
But may not be using
working capital efficently
less profitable
Low investment
in working
capital

less liquid
But may be using
working capital efficiently
more profitable

For each company there will be an optimal level of working capital. However this can only
be found by trial and error, and in any case it is constantly changing.
Businesses must avoid the extremes:
overtrading an insufficient working capital base to support the level of activity. This
can also be described as under-capitalisation;
over-capitalisation too much working capital, leading to inefficiency.
As a guide many text books suggest that to be safe an organisation requires a 2:1 ratio of
current assets to current liabilities. That is for every $1 of current liabilities, $2 of current
assets is required to ensure that the organisation does not run into cash flow problems.
However, this is much too simplistic, and the required level of working capital will vary
from industry to industry. This is demonstrated in Illustration 3 which shows a breakdown
of the working capital for three UK public limited companies operating in different sectors.
The figures are taken from published annual reports and the given ratios calculated as
follows:
Current ratio =
s liabilitie Current
assets Current

Quick (acid test) ratio =
assets Quick
=
inventory assets Current

Illustration 3

Comparison of working capital by industry
Tesco Airtours Manchester
United
$m $m $000s
Current assets
Inventory 584 17.0 3,565
Receivables 133 413.8 10,731
Short terms investments 196 11.1 22,400
Cash at bank and in hand 29 364.2 23,244
______ ______ _______
942 806.1 59,940
______ ______ _______
Payables: amounts falling due
within one year 2,712 802.0 29,468
______ ______ _______
Working capital (1,770) 4.1 30,472
______ ______ _______
Profit before taxation 832 140.3 27,577

Current ratio 0.35 1.01 2.03
Acid test 0.13 0.98 1.91
Cash to current liabilities 0.01 0.45 0.79

Analysis
Each of these companies is profitable and is considered successful in its field. However, it is
apparent that only Manchester United meets the suggested current ratio of 2:1. Indeed
Tesco appears to be in real trouble with only 35 cents of current assets and 13 cents of
quick assets for every $1 of current liabilities.
Worse still, considering the ratio of cash to current liabilities, Tesco has only one cent of cash
coverage for every $1 of current liabilities suggesting severe liquidity problems. Yet Tesco is
the largest supermarket chain in the UK with over 600 stores and an annual profit before
taxation in excess of $800 million.
Airtours also falls well short of the suggested current ratio of 2:1, although its quick assets
ratio of 1:1 is satisfactory. These figures illustrate that the 2:1 ratio is inappropriate, and the
amount of working capital required by an organisation will vary depending on the nature of
its business and the industry in which it operates.
Tesco
Although Tescos level of working capital appears low, this must be evaluated in the context
of the nature of its business. Each day throughout the UK and Europe, millions of customers
will purchase their groceries from Tesco paying for their goods in cash before they leave the
store.
Most items sold by Tesco have a shelf life of only a few days. As market leader Tesco can
rely on regular deliveries of inventory from suppliers at fairly short notice. In addition the
use of forecasting techniques will enable managers to reliably predict daily sales levels. All
of these factors enable Tesco to operate with relatively low levels of inventory.
Since almost all sales are on a cash rather than credit basis, the level of receivables is also
low. In addition, the company is able to invest surplus cash balances in short-term
investments (usually on the money markets), hence maximising the return to its investors.
Considering current liabilities, Tesco will purchase most of its inventory on credit resulting
in trade payables of $826million. Indeed most inventory will have been sold and realised a
profit before Tesco even pays its suppliers. Few organisations are in such a fortuitous
position. Other payables will include corporation tax and dividends, amounts which Tesco
will know with certainty when they are to be paid.
Due to the nature of its business, and in particular an abundance of cash sales, few
receivables, low levels of inventory, and most purchases being for credit, cash flow is not
likely to be a problem, and hence Tesco is able to operate with negative working capital.
Airtours
Customers will usually pay for their holidays well in advance of departure ensuring that
cash flow is not a problem whilst also minimising the incidence of bad debts. Unlike Tesco,
Airtours sales are seasonal with most cash being received during the period January to
June. However, expenses will be incurred throughout the year and careful planning is
necessary to ensure that Airtours is able to meet its current liabilities as they fall due.
Being a tour operator, inventory levels are relatively low. Receivables mostly comprise
amounts paid in advance in respect of hotel accommodation and balances owing from
customers for holidays. Payables comprise amounts owing for accommodation and advance
payments made by customers.
Like Tesco, Airtours can operate with a lower current ratio than the suggested 2:1, however
due to the seasonal nature of its business, good budgeting and forecasting is essential to
ensure that liabilities can be met even during the quiet season.
Manchester United
There is little evidence of any working capital problems, with the company having a current
ratio of 2:1. In addition the company has 79 cents of cash for every $1 of current liabilities.
This is not surprising given the nature of Manchester Uniteds business. During the period
August to May cash flow is not likely to be a problem since almost every week over 50,000
fans will crowd into Old Trafford to watch their team play. Many of these fans pay for their
seats in advance, purchasing a season ticket before the season commences. In addition the
club will receive cash from sponsors, television companies and the sale of merchandise.
However, as with Airtours, business is seasonal and careful planning is necessary to ensure
that all liabilities are met as they fall due.
A review of the clubs working capital shows that inventory and receivables are relatively
small, with the majority of working capital comprising short-term investments and cash,
reflecting the cash received from season ticket sales.
A review of Table 1 shows that the optimum level of working capital varies depending on
the industry in which an organisation operates and the nature of its transactions.
2 FINANCING WORKING CAPITAL
2.1 Term structure of interest rates
Whatever level of current assets the business decides to hold, they must be matched by
liabilities (i.e. current assets must be financed).
Management must decide whether to use short-term or long-term finance or, if a mix is used,
in what proportions. A key factor is the relative cost of various sources of finance.
It is generally true that the cost of short-term finance is below the cost of long-term finance.
This is due to the term structure of interest rates
If, for example, a graph is drawn showing the yield to maturity (gross redemption yield) of
various government securities against the number of years to maturity, a yield curve such
as below might result.

Yield
Years to maturity

2.2 Yield curves
Although yield curves are usually constructed by reference to government interest rates the
curve for a corporate borrower will obviously follow a similar trend.
The shape of the curve can be explained by various theories:
2.2.1 Liquidity preference theory
Yields will need to rise as the term to maturity increases, as by investing for a longer
period the investor is deferring his consumption and needs higher compensation.
Hence a normal yield curve slopes upwards, as shown above.
2.2.2 Expectations theory
If interest rates are expected to increase in the future, the curve may rise even more
steeply. However, the curve may fall (i.e. invert) if interest rates are expected to decline.
2.2.3 Segmentation theory
Pension fund managers often have a preference for investing in long-dated bonds to
match against the long term liabilities of the fund. This can drive up the price of long-
dated bonds which brings down their yield, possibly resulting on an inversed (falling)
yield curve
This can also be referred to as preferred habitat theory (i.e. different investors have a
preference for being in different segments of the yield curve).
2.2.4 Risk
On high quality government/sovereign debt (e.g. UK Gilt-Edged Securities; Gilts) the
risk of default is not significant even for long-dated bonds.
However default risk may be more significant on corporate debt, therefore the corporate
yield curve may rise more steeply than the government yield curve.
2.3 Sources of finance for current assets
2.3.1 Short-term
Overdraft

Usually expensive but flexible (i.e. level of finance fluctuates to
meet requirements).
Variable interest rate exposes firm to rate rises.
Repayable on demand.
Short-term loans

Lower interest rate than long-term debt (unless yield curve is
inverted).
Renegotiation risk (i.e. bank may refuse to refinance on maturity).

Accounts payable Appears cheap but refusing settlement discounts can be
expensive.
Taking excessive credit may lead to lost goodwill with supplier
and even penalties for late payment.
Trade credit can disappear (i.e. if too much credit is taken from
suppliers they may lose patience and refuse to give credit in
future).
Although short-term finance may, in some cases, be relatively cheap there is a danger that it
can quickly disappear. For example:
the bank may ask for the overdraft to be repaid; and
key suppliers may put the firm on a stop list and refuse further deliveries until all
outstanding invoices are paid (and future deliveries may have to be paid for in
advance).
Therefore it may be wise to at least partly use long-term finance as, although generally more
expensive, it reduces exposure to renegotiation risk.
2.3.2 Long-term
Equity New share issues or, to avoid issue costs, retained profits.
No legal commitment to repay (i.e. no renegotiation risk).
Debt Bond issues and/or long-term bank loans.
If interest rates are fixed then, at least until maturity, provides
protection against rising rates.

2.4 Permanent vs fluctuating current assets
Part of the classification of current assets on the statement of financial position may in fact
be permanent in nature. Possible reasons include:
Holding of buffer stock (i.e. a minimum level of inventory held throughout the year
as protection against stockouts);
Holding a minimum precautionary balance of cash to meet any unexpected
payments;
A minimum level of trade receivables over the business cycle.
Over the year the total level of current assets will naturally fluctuate above the minimum
permanent level only this excess is truly short-term in nature.
2.5 Policies for financing current assets
There is an argument that any permanent segment of currents assets should be matched
with long-term finance and the fluctuating segment of current assets be matched with short-
term finance. This is referred to as a matching policy to the financing of working capital.
A matching policy is consistent with management being prepared to accept a moderate level
of risk.
An aggressive financing strategy would be to use short-term finance not only for the
fluctuating balance of current assets but also for some, if not all, of the permanent balance.
This is potentially a cheap financing strategy but indicates that management have a high,
and potentially dangerous, tolerance for risk. Short-term finance can quickly evaporate,
leaving the firm in financial distress. Lessons should be learned from cases such as
Northern Rock, a UK bank that exclusively relied on short-term interbank financing for its
operations. In the financial crisis of 2008 Northern Rock found its only source of finance was
completely cut off, causing the bank to collapse.
A conservative financing strategy would be to use long-term finance not only for the
permanent level of current assets but also for part, if not all, of the fluctuating balance. This
may be a relatively expensive but is lower risk for the firm and gives management the
chance to breathe rather than having to continually rollover finance. A conservative policy
is therefore consistent with a highly risk-averse attitude of management, for example in an
owner-managed business.
3 WORKING CAPITAL RATIOS
3.1 Liquidity ratios
Current ratio =
assets Current

If the current ratio falls below 1 this may indicate problems in meeting obligations as they
fall due. Even if the current ratio is above 1 this does not guarantee liquidity, particularly if
inventory is slow moving. On the other hand a very high current ratio is not to be
encouraged as it may indicate inefficient use of resources (e.g. excessive cash balances).
Quick (acid test) ratio =
assets Quick
=

The quick ratio is particularly relevant where a firms inventory is slow moving.
3.2 Efficiency ratios
Inventory turnover =
inventory Average
sales of Cost

This shows how quickly inventory is sold higher turnover reflects faster moving inventory.
Working capital ratios are often easier to interpret if they are expressed in days as
opposed to turnover:
Inventory days = 365
sales of cost Annual
inventory Average

Inventory days estimates the time taken for inventory to be sold. Everything else being equal a firm
would prefer lower inventory days.
Accounts receivable days = 365
sales credit Annual
receivable accounts Average

Receivables days estimates the time taken for customer to pay. Everything else being equal a firm
would prefer lower receivables days.
Accounts payable days = 365
purchases credit Annual
payable accounts Average

Payables days estimates the time taken to pay suppliers. A firm would prefer to increase its payables
days, unless this proves expensive in terms of lost discounts or leads to other problems such as
reduced reliability or quality of supplies.
Sales/working capital =
capital working Average
sales Annual

Sales/working capital indicates how efficiently a firm uses its working capital to generate
sales. Everything else being equal the firm would prefer sales/working capital to rise.
3.3 Advice on calculating/interpreting ratios
Seasonal and other factors may mean that statement of financial position values may
not be typical.
There may be window-dressing (e.g. the finance director may make a large payment
to suppliers at the year end to reduce the reported payables days).
Ratios concern the past and do not predict the future.
Ratios are of little value unless used in comparison to industry average data.
4 WORKING CAPITAL CYCLE
4.1 Cash operating cycle
The working capital cycle (also known as the cash conversion cycle or the cash operating
cycle) is the number of days between paying suppliers and receiving cash from customers.
It can be found from standard ratios as inventory days + receivables days payables days.
Inventory is purchased on credit from suppliers and is sold for cash and on credit. When
cash is received from customers it is used to pay suppliers, wages and any other expenses.
In general a business will want to minimise the length of its working capital cycle thereby
reducing its exposure to liquidity problems. Obviously, the longer that a business holds its
inventory and the longer it takes for cash to be collected from credit sales, the greater cash
flow difficulties an organisation will face.
The longer the cycle the greater the level of resources tied up in working capital. Whilst it is
desirable to have as short a cycle as possible, it is often difficult to differ significantly from
competitors in the same trade.

CASH
CUSTOMER
SUPPLIERS
RAW MATERIALS
WORK-IN-PROGRESS
FINISHED GOODS
Cash
collection
Sales
Production
Production
Purchases
Cash payment
THE CASH OPERATING CYCLE

4.2 Factors affecting the length of the cycle
The length of the operating cycle is affected by various factors e.g.
type of industry - a supermarket chain may have low inventory days (fresh food), low
receivables days (perhaps just the time to receive settlement from credit card
companies) and significant payables days (taking credit from small farmers). In this
case the operating cycle could be negative (i.e. cash is received from sales before
suppliers are paid). On the other hand a construction firm may have a very long
operating cycle due to the high levels of work in progress.
efficiency of working capital management (e.g. weak credit control and holding of
excess inventory will both lead to a longer working capital cycle).
For a manufacturing firm the calculation of the operating cycle can requires detailed analysis
of the three types of inventory days (raw materials, work in progress and finished goods).
In this case the cycle can be calculated as below:
Accounts receivable days =
sales credit annual
receivable accounts
365 = x
Accounts payable days =
purchases credit annual
payable accounts
365 = (x)
Finished goods days =
sales of cost annual
inventory goods finished
365 = x
WIP days =
WIP of completion
of degree sales of cost annual
progress in work
365 = x
Raw materials days =
usage material annual
inventory materials raw
365 = x
___
Length of cycle x
___

Commentary

Use statement of financial position year-end figures if averages are not available.
WIP days estimates the length of the production cycle (i.e. the number of days to
convert raw materials into finished goods). This methodology is per the examiners
book Corporate finance practice and principles (Denzil Watson and Antony Head)
3
rd
edition.

Example 1

Tipple Co has the following estimated figures for the coming year:
Sales $3,600,000
Accounts receivable $306,000
Gross profit margin 25%
Finished goods inventory $200,000
Work in progress inventory $350,000
Raw materials inventory $150,000
Accounts payable $130,000
WIP is 80% complete. Purchases represent 60% of production cost.
Required:
Calculate the length of the cash operating cycle.

Solution

Days
Raw materials days
Credit taken from suppliers

____

WIP days
Finished goods days
Credit given to customers

_____

_____

5 MANAGING WORKING CAPITAL
Commentary

Having discussed what comprises working capital, this section considers some of the
methods that can be employed to assist in its management. Each of the key elements
that comprise working capital is examined in turn.

5.1 Inventory
The cost of holding inventory is relatively easy to measure and will include:
storage;
security;
losses due to theft, obsolescence, and goods perishing.
It is therefore important not to hold excessive levels of inventory.
What is less easy to quantify is the cost of not holding sufficient levels of inventory to meet
the demand from customers. For example, if an organisation has insufficient inventory to
meet demand, it will initially result in lost sales. In the longer term it may also damage a
businesss goodwill, with long-standing customers turning to other, more reliable suppliers.
For most organisations the difficulty is determining the optimum level of inventory. This
will depend on a number of factors including:
the average level of daily sales (adjusted for seasonal variations);
the lead time between ordering goods and their delivery;
the reliability of suppliers;
the type of good and the danger of their perishing or becoming obsolete;
the cost of re-ordering inventory;
storage and security costs;
other factors such as rumours of a shortage or an increase in price.
It is essential that systems are in place to ensure that inventory levels are reviewed regularly
and where necessary appropriate action taken.
5.2 Receivables
Too often, especially during their start-up period, businesses concentrate on generating sales
and pay little attention to the collection of money from receivables. As a result, although
sales exist on paper, the cash generated by these sales takes too long to materialise and cash
flow problems occur. Additionally, the longer a debt is outstanding the greater the
likelihood it will become bad.
With this in mind an effective credit control policy is necessary.
5.2.1 Effective credit control policy
This should include the following:
Before allowing credit, an organisation should check the credit rating of potential
customers, where necessary seeking references from a third party. Often this will
involve using the services of a credit agency such as Dunn and Bradstreet.
Based on the results of a credit check, credit limits can be set. Once the credit limit is
reached it cannot be exceeded without the authorisation of senior management.
Credit customers should be informed in writing of the normal credit period (e.g. 30
days after the invoice date).
A small cash discount is often used as an incentive to encourage early payment by
receivables. For example, many firms offer a discount of 2.5% of the invoice value for
payment within seven working days of the invoice date.
It is essential that an organisation maintains accurate records detailing all transactions
with customers and the amounts owing. An aged receivables list detailing the length
of time that a debt has been owing is useful since it highlights those debts which
management needs to concentrate on.
An organisation should issue regular statements (normally monthly), and where
necessary these should be followed up with reminders and phone calls/letters.
Effective credit control will ensure that disputes are settled quickly without damaging the
relationship with a customer, whilst at the same time reducing the occurrence of bad debts.
However, such a system is often expensive and time consuming to set up, hence many
organisations, especially those which have only recently commenced trading, utilise debt
factoring.
5.2.2 Debt factoring
Debt factoring involves an organisation passing responsibility for the management and
collection of its trade receivables to a third party. If the factor also offers a financing service
the organisation sells its invoices to the factor and in return the factor immediately advances
cash equal to between 50 and 85% of the total invoice value. The balance of the invoice
value, less a charge for the factoring service, is paid when the debts are collected. In
addition the factor is responsible for the administration of an organisations receivables, and
can offer protection against bad debts.
The advantage of factoring is that it enables an organisation to concentrate on generating
sales and leaves the collection of cash to a third party. Most importantly it reduces the cash
flow problems often experienced by new businesses and can give access to cash immediately
rather than having to wait 30 or more days. However, factoring is expensive and in the long
term it may be cheaper for an organisation to establish its own receivables management
systems.
Invoice discounting is becoming increasingly common. Like debt factoring the business
immediately receives cash representing a proportion of the total invoice value. Unlike debt
factoring the business retains responsibility for the management of its credit control system.
When deciding the credit period offered to customers an organisation must consider several
factors. A longer credit period (e.g. 45 days compared to 30 days offered by competitors)
may generate additional sales; however these must be compared against the additional costs
incurred by the business. These costs might include an increase in bad debts, higher
administration costs and bank overdraft charges. If the profits arising from the additional
credit period are less than the costs incurred, the credit period should be reviewed.
5.3 Trade payables
The practice of businesses extending trade credit to one another is probably the most
important source of short-term funding available to most organisations. At first glance trade
credit appears to represent a short-term interest free loan which enables a higher level of
trade than if everything was paid for immediately in cash.
However, there are costs associated with trade credit. Most suppliers offer customers a
discount for early payment. Thus a supplier might allow 30 days credit on all sales.
However, to encourage early settlement of debts, customers paying within seven days are
offered a cash discount equating to 2.5% of the invoice total. On an invoice of $10,000
(excluding VAT) this would equate to a saving of $250.
Even if an organisation has an overdraft it may still be beneficial to take advantage of a cash
discount.

Illustration 4

Alanis purchases $5,000 of goods from Celine. Celine offers all customers the
option of either 30 days credit or a 1.5% discount if cash is received within 5
days. If Alanis takes the cash discount she will incur an overdraft on which
interest is charged at 20% per annum. Is the cash discount beneficial to Alanis?
If Alanis takes the cash discount she will save $5,0001.5% = $75
However, she will incur an overdraft for 25 days (30 - 5 days) which will cost:
$5,000 [20%25/365] = $68.49
Alanis will benefit by $6.51 if she pays the invoice within 5 days.

Another cost of trade credit, which is often ignored, is its impact on the creditworthiness of a
business. If a business consistently exceeds the credit period imposed by suppliers, in the
long term its credit rating will be damaged. In the worst case scenario, suppliers will be
forced to take legal action and may even withdraw their credit facility, requiring cash on
delivery.
Whilst trade credit is undoubtedly a useful facility, it is important that businesses do not
become too dependent on it.
5.4 Cash and bank balances
Liquidity problems often arise because inflows and outflows of cash do not coincide. For
example, a small tour operator is likely to be flush with cash from January to June as
customers book and pay for their summer holidays. From July to December sales and hence
cash balances will be lower. However, business expenses such as wages and salaries, heat
and light, rent, and loan interest will remain more or less the same throughout the year. It is
therefore essential that businesses plan ahead to ensure that sufficient cash is available to
meet expenses in the off-peak period.
The preparation of a cash budget will indicate the flow of receipts and payments and will
forecast periods of surplus and deficit cash balances thereby reducing the level of
uncertainty. If a large surplus is forecast, cash can be invested in an interest earning account
until it is required. If a deficit is forecast, the business can arrange a bank overdraft or loan.
However, wherever possible overdrafts and loans should be avoided due to their high cost
5.5 Problems for small businesses
Although working capital problems can be experienced by businesses of any size, it is
usually small businesses which have most problems, especially during their start-up phase.
As sales increase, small businesses are required to acquire more raw materials to produce
enough goods to meet the increase in demand, whilst workers are required to work longer
hours necessitating the payment of overtime wages. However, the cash from credit sales
may not be received for several weeks, whilst suppliers and employees require immediate
payment. In this situation a business is heavily dependent on its bank overdraft and loans.
In the long term, if the business survives, the problem will be reduced through negotiating
better credit terms with customers and suppliers.
5.6 Overtrading
Overtrading occurs when a company tries to support a large volume of trade from a
small working capital base.
It can also be referred to as under-capitalisation and often occurs when a business
grows very rapidly without increasing its level of long-term finance.
The result can be a liquidity crisis.
This can often happen at the start of a new business, since:
there is no reputation to attract customers, so a long credit period is likely to be
extended to break into the market;
if the business has found a niche market, rapid sales expansion may occur;
smaller companies which are growing quickly will often lack the management skills to
maintain adequate control of the debt collection period and the production period.
For the above reasons the amount of cash required will increase. However, companies in
this position will often find it hard to raise long-term finance and hence overtrading and
business failure may result.
Indicators of overtrading
Decline in liquidity;
Rapid increase in turnover;
Increase in inventory days;
Increase in accounts receivable days;
Increase in short-term borrowing and a decline in cash holdings;
Large and rising overdraft
Reduction in profit margin;
Increase in ratio of sales to fixed assets.
If a business is suffering from liquidity problems, then the aim will be to reduce the length
of the cash operating cycle. Possibilities to consider include:
reducing the inventory-holding period for both finished goods and raw materials ;
reducing the production period not easy to do but it might be worth investigating
different machinery or working methods;
reducing the credit period extended to accounts receivable, and tightening up on cash
collection;
increasing the period of credit taken from suppliers;
an increase in the level of long-term finance (i.e. an equity or debt issue). A new share
issue is probably preferable to increasing debts in a risky company;
reducing the level of sales growth to a more sustainable level.
5.7 Summary
This session has examined the items which make up working capital and considered how
organisations can improve their management of working capital. Although an ideal level of
working capital is difficult to calculate and will vary from one organisation to another,
depending on the industry in which they operate, it is essential that a business avoids
having too little or too much working capital.
Too little working capital (over-trading) is common when a business is starting up or is
experiencing a period of rapid growth. The level of sales might grow very quickly, but
inadequate working capital is available to support this growth. The situation will then arise
whereby a business may be profitable on paper but has insufficient funds available to pay
debts as they become due. In the short term this situation can be solved through a
combination of measures including:
obtaining an increased overdraft facility;
negotiating a longer credit period with suppliers;
encouraging receivables to pay faster.
However, in the long term a business is unlikely to survive without a combination of:
new capital from shareholders/proprietor;
better control of working capital;
the building up of an adequate capital base through retained profits.
Almost as bad is too much working capital or over-capitalisation. Poor management of
working capital will result in excessive amounts tied up in current assets. Such a scenario
will lead to a business earning a lower than expected return.
It must be remembered that the shorter an organisations working capital cycle, the faster
cash, and hence profits, from credit sales will be realised. To achieve this organisation must
regularly review its working capital, taking action where necessary

Example 2

The following are summary financial statements for Stalla Co:
2006 2011
$000 $000
Fixed Assets 115 410
Current Assets 650 1,000
Current Liabilities 513 982
Long Term Liabilities 42 158
Total 210 270
Capital and Reserves 210 270

2006 2011
$000 $000
Sales 1,200 3,010
Cost of sales, expenses and interest 1,102 2,860
Profit before tax 98 150
Tax and distributions 33 133
Retained earnings 65 17

Notes:
Cost of sales was $530,000 for 2006 and $1,330,000 for 2011.
Receivables are 50% of current assets and trade payables are 25% of current
liabilities for both years.
Required:
Using suitable financial ratios, and paying particular attention to growth and
liquidity, discuss the significant changes faced by the company since 2006.
Comment on the capacity of the company to continue trading.


Key points

The key issues are (i) what level of current assets should a business hold
and (ii) how should current assets be financed?
There are not always unique answers to these questions; it is a matter of
opinion. Therefore you need an appreciation of:
(i) the advantages/disadvantages of holding cash, inventory and
receivables;
(ii) the relative advantages of using short vs long-term finance.
Good knowledge of ratio analysis is essential in many exam questions on
working capital management (e.g. estimating the length of the operating
cycle).
There is no official definition of overtrading but it refers to a situation
where a business is growing at an unsustainable rate compared to its level
of long-term finance; it is also associated with poor working capital
management.

FOCUS

explain the nature and scope of working capital management;
calculate appropriate ratios to analyse the liquidity and working capital management of
a business;
calculate the length of the operating cycle of a business;
explain the relationship between working capital management and business solvency.
EXAMPLE SOLUTIONS
Solution 1
Cost of sales = 75% 3,600,000 = 2,700,000
WORKINGS Days
Raw materials days

60% 2,700,000
150,000

365
34
Credit taken from suppliers

60% 2,700,000
130,000

365
(29)

___

5
WIP days

80% 2,700,000
350,000

365
59
Finished goods days

2,700,000
200,000
365
27
Credit given to customers

3,600,000
306,000
365
31

___

Number of days between payment and receipt 122

___

Solution 2
In the five year period from 2006 to 2011 sales for Stalla have grown by 150%. The pressures
of such growth in terms of supporting the business by adequate working capital can be
substantial. Thus, in the same period current assets have expanded by 53% and current
liabilities by 91%. Whilst this aspect of the business will be dealt with in more detail below
it is worthwhile questioning at this stage whether sufficient funding for working capital is
available to support the growth in sales.
Whilst there has been significant growth in sales during the period PBT as a percentage of
sales has actually declined from 8% to about 5%. This must seriously call into question the
management either of costs (operational or financial) or whether there is an inability to force
price increases onto customers. Given the information available, the most likely source of
this problem appears to relate to interest costs. Both current and long term liabilities have
increased substantially (91% and 276%, respectively) against a background of barely
increased equity funding. Debt funding (both long and short term) looks to have increased
(see detail below) and this will have an associated interest burden. This has an importance
in relation to the sustainability of the business.
Earnings retentions do not appear sufficient to fund business growth and hence it is clear
that borrowings have been increased to deal with this problem. However, a balance must be
kept in the business between its earnings capability and its capacity to service its debt
commitments. Whilst PBT has increased by 53% over the period, retentions have declined
by about 74%. This may be partly explained by an increased tax burden, but is obviously
due mainly to excessive distributions. In other words, not enough funds are being retained
in the business to support its growth or funded from increased equity issues.
The impact of excessive growth in relation to its funding base will have potentially a severe
impact on liquidity. Net current assets are not seriously out of line if a ratio of current assets
to current liabilities of unity is considered acceptable. However, when current assets are
looked at in relation to sales a different picture emerges. The ratio was 54% in 2006 and only
33% in 2011. This suggests, in combination with the other information, that inventory,
receivables and cash resources might be insufficient in relation to sales. It might be argued
that this reflects greater efficiency in current asset management which it does when
receivables days are compared over the period (they declined from 99 to 60) but not in
relation to payables days which also declined (from 96 to 67 during the period).
When working capital is measured as a proportion of sales a decline is observed (from
114% in 2006 to 05% in 2011) which looks to be a reflection of reduced current asset
investment and overdraft increases.
Because it is debt rather than equity funding that has grown, the business faces a potentially
critical situation. Current assets are mainly comprised of inventory and receivables (because
the business has substantial borrowings it is unlikely to simultaneously have large cash
balances) and this is being funded by borrowing rather than retained earnings. The reason
why this is the case is because the business is not generating adequate profits and it is
distributing too much of earnings. The outlook is for greater borrowing. The poor profit
figures suggest that a critical point has been reached in terms of liquidity and solvency. This
is reflected in debt/equity ratios which have increased from 219 in 2006 to 422 in 2011
(current and long term liabilities used as debt and capital and reserves used as equity).
Unless a capital reorganisation can take place quickly, either through injected funds or
conversion of debt into equity, the business is likely to become insolvent.
Sales growth: (3,0101,200)/1,200 = 150%
Current asset growth: (1,000650)/650 = 53%
Current liability growth: (982513)/513 = 91%
Long term liabilities growth: (15842)/42 = 276%
PBT growth: (15098)/98 = 53%
Retained earnings decline: (6517)/65 = 74%

2006 2011
PBT/Sales 98/1,200 = 8% 150/3,010 = 5%
Current Assets / Current liabilities 650/513 = 13 1,000/982 = 10
Current Assets / Sales 650/1200 = 54% 1,000/3,010 = 33%
Sales/working capital 1,200/(650-513) = 9 3010/(1000-982) = 167
Debt/Equity (513+42)/253 = 219 (982+158)/270 = 422

Receivables at 50% of current assets $325,000 $500,000
Sales per day (365 days) $3,287 $8,246
Receivables days 325,000/3,287 = 99 500,000/8,246 = 61

Payables at 25% of current liabilities $139,000 $245,000
Cost of sales per day (365 days) $1,452 $3,643
Payables days 139,000/1,452 = 96 245,000/3,643 = 67

SESSION 14 INVENTORY MANAGEMENT
OVERVIEW
Objective
To understand the costs and benefits of holding inventory and determine the Economic
Order Quantity (EOQ) which minimises costs.
To appreciate other possible inventory control systems.

INVENTORY
CONTROL
OTHER
INVENTORY
SYSTEMS
EOQ MODEL
Importance
Reasons for holding inventory
Costs associated with inventory
Definition
Determination of EOQ
Complications
Quantity discounts
RE-ORDER LEVEL
Definitions
Constant demand in
lead time
Uncertain demand in
lead time
Service levels
Periodic review system
ABC system
Just-in-time (JIT)
Perpetual inventory
MRP

1 INVENTORY CONTROL
1.1 Importance
Definition

Inventory control is the systematic regulation of inventory levels.

If inventory is too high
Inefficient profit reduced
If inventory is too low
Insufficient to satisfy customers profit reduced.
1.2 Reasons for holding inventory
Commentary

Inventory may be raw materials, WIP, finished goods, goods for resale or even
consumables (e.g. machine lubricants) for use in production processes.

To meet demand by acting as a buffer in times of unusually high consumption (i.e. to
reduce the risk of stockouts).
To ensure continuous production.
To take advantage of quantity discounts.
To buy in ahead of a shortage or ahead of a price rise.
For technical reasons (e.g. maturing whisky in casks or keeping oil in pipelines).
To reduce ordering costs.
1.3 Costs associated with inventory
Purchase price;
Holding costs:
cost of capital tied up;
insurance;
deterioration, obsolescence and theft;
warehousing;
stores administration.
Re-order costs:
transport costs;
clerical and administrative expenses;
batch set-up costs for goods produced internally.
Shortage costs:
production stoppages caused by lack of raw materials;
stockout costs for finished goods anything from a delayed sale to a lost customer;
emergency re-order costs.

Systems costs people and computers.
Key point

The benefits of holding inventory must outweigh the costs.

2 EOQ MODEL
2.1 Definition
The Economic Order Quantity (EOQ) is the quantity of inventory that should be ordered
each time a purchase order is made.
EOQ aims to minimise the costs which are relevant to ordering and holding inventory.
2.2 Determination of EOQ
2.2.1 Formula
x = order quantity
C
H
= cost of holding one unit for one year
D = annual demand
C
O
= cost of placing an order
The total annual relevant cost to be minimised:
= annual holding cost + annual order cost
= the cost of holding one unit in
inventory for one year the
average number of units held
+ the cost of an order the
number of orders in a year
=
2
x
C
H

+
D
Co
x

Total cost is minimized when:
x =
H
0
C
D C 2
Exam formula
2.2.2 EOQ graph

$
Cost
Total cost
holding cost
ordering cost
EOQ
x
Order quantity

2.2.3 Assumption of EOQ
Purchase price per unit is constant.
Constant demand.
No risk of stockouts.
Example 1

Using the following data calculate the EOQ

D = 40,000 units
C
O
= $2
C
H
= $1

Solution
EOQ =
2.3 Complications
2.3.1 Warehouse rental
The EOQ model is based on the assumption that holding costs vary with the average
inventory level.
However if a warehouse is rented on a long-term contract (rather than daily) then it
needs to be large enough to hold the maximum level of stock, rather than the average.

Must rent sufficient floor space to meet
this quantity
(x/2)
x

This is dealt with by doubling the floor space used by each unit when calculating holding
cost, and then use the normal EOQ formula.
Example 2

Annual demand = 3,000 units
Reorder cost = $5
Holding cost = $3.33 per unit + rental of warehouse
Each unit occupies 3m
2
rented on annual contracts for $5 per m
2

Solution
D =
C
O
=
C
H
=
3,000
5

EOQ =
2.3.2 Cost of capital
Inventory, like any other asset, must be matched by a liability. Therefore there must be
a cost of financing inventory.
This is a type of holding cost.
Illustration 1

Cost of Capital = 10%
Price per unit = $100
Therefore, holding cost = $100 0.1 = $10
This is in addition to any other holding costs.

2.4 Quantity discounts
The supplier may offer a bulk-buying discount on each unit purchased for specified
quantities above the EOQ
In this case the purchase price obviously becomes relevant to the decision.
To deal with this, calculate:

Total annual cost =
cost purchase
Annual

cost
order Annual

cost
holding Annual
+ +

for the order level calculated by EOQ as well as for order quantities above EOQ for
which discounts are available.
Choose the order quantity with the lowest total cost.
Example 3

Annual demand = 5,000
Holding cost = $7.50
Reorder cost = $30
Purchase price = $1.10
A discount of 3% is available on orders of 300 units or more.
Required:
Determine whether or not the discount is worthwhile.

Solution
EOQ =

Total cost at EOQ $
Holding
2
x
C
H
=

Reorder
x
D
C
O
=

Purchase cost

Total
_____

_____

Total cost at order quantity = 300 units

Holding
2
x
C
H
=

Reorder
x
D
C
O
=

Purchase cost

_____

_____

Conclusion:
3 RE-ORDER LEVEL
3.1 Definitions
Re-order level (ROL) is the level to which inventory should fall before a purchase order
is made.
Lead time is the time between placing and receiving an order.
There are two possible situations to be dealt with:

(1) Constant demand in lead time
(2) Uncertain demand in lead time
3.2 Constant demand during lead time
Re-order level (ROL) = lead time (days) demand per day
For example if demand is 40 units per day and lead time is two days - when inventory
levels fall to 80 units then inventory would be re-ordered. This can be shown
graphically:

Inventory
level
ROL
Time
{
Lead
time

3.3 Uncertain demand during lead time
There will be an expected level of demand, not a known level of demand.
A buffer or safety inventory will need to be held to reduce the risk of a stockout.
Method
(1) Calculate expected demand in the lead time.
Expected lead time demand = x
i
p(x
i
)
where
x
i =
level of demand
p (x
i
) = probability of level of demand
(2) Take each level of demand expected lead time demand as a possible
reorder level and calculate the expected annual stockout cost.
(3) For each possible ROL calculate the expected annual buffer holding
cost.
(4) Choose the ROL with the lowest sum of stock out and holding cost.


Example 4

The following information relates to inventory levels of component XL5:
Holding cost = $8
Stockout cost = $3
Lead time = 1 week
EOQ = 150

The company operates for 50 weeks per annum and weekly demand is given
by:
xi p(xi)
Demand Probability
40 0.1
50 0.2
60 0.4
70 0.2
80 0.1

Required:
Calculate the optimum reorder level.

Solution
Average demand in the lead time =
Average annual demand =
Orders per annum =
ROL Buffer Demand Units
short
Probability Average
units
short
Annual
stockout
cost
Annual
buffer
holding
cost
Total
annual
cost
$
60 0 70 0
80

__

___

___

Average =

__

___

___

___

70 10

__

___

___

Average =

__

___

___

___

80 20

__

___

___

___

___

___

3.4 Service levels
Setting a service level of 98% implies that the firm accepts a 2% chance of a stock-out.
Example 5

Average weekly demand for an item of inventory is 300 units with a standard
deviation of 40 units. The lead time is one week.
Normal distribution tables show that 5% of observations lie 1.645 standard
deviations above the mean.
Required:
Calculate the ROL needed to provide a service level of 95%.

Solution

4 OTHER INVENTORY SYSTEMS
4.1 Periodic review system
The inventory levels are reviewed at fixed time intervals, and variable quantities will be ordered
as appropriate.
The order size made is sufficient to return inventory levels to a pre-determined level.
A very simple method of inventory control ideal where inventory control is only one of a
persons responsibilities.
4.2 ABC inventory control system
The aim is to reduce the work involved in inventory control in a business which may have
several thousand types of inventory items.
The inventory is categorised into class A, B or C according to the annual cost of the usage of
that inventory item, or the difficulty of obtaining replacements, or the importance to the
production process.
Class A will then take most of the inventory control effort, Class B less and Class C less still.
Commentary

Whilst this seems acceptable for inventory of finished goods, it may cause problems for
raw materials. There may be an item which has a very small cost but which is vital for
the manufacture of the finished product. Such an item would have to be included in
with the Class A items because of its inherent importance, rather than its cost.

4.3 Just-in-time (JIT)
In a JIT system production and purchasing are linked closely to sales demand on a week-to-
week basis. The aim is to create a continuous flow of raw materials inventory into work in
progress, which becomes finished goods to go immediately to the customer. This means
that negligible inventory needs to be held.
Necessary conditions
Flexibility of both suppliers and internal workforce to expand and contract output at
short notice.
Raw material inventory must be of guaranteed quality indeed, quality must be
maintained at every stage.
Close working relationship with suppliers and, if possible, geographically proximity in
order to make immediate deliveries.
A low inventory level normally requires short production runs. This is only
appropriate, therefore, where set-up costs are low. High-technology production
methods have made this easier to achieve.
The workforce must be willing to increase or decrease its working hours from one
period to another. This could be done by having a core workforce with a group of part-
time or freelance workers.
The design of the factory must be such that JIT deliveries to all areas are possible.
Total reliance on suppliers for quality and delivery, and therefore very tight contracts
with penalty clauses.
Significant investment by suppliers, and therefore long-term contracts.
4.4 Perpetual inventory methods
Where a firm keeps perpetual inventory records, there will frequently be a replenishment
point that triggers an order. Such a system relies on the accuracy of the records, not on
physical counts.
It is possible to use point of sale (POS) terminals that automatically update inventory
records as each successive sale is made.
One advantage of such a system is the data it provides to management to determine which
product lines are moving rapidly. Sales managers may also use the data to make tactical
decisions on special prices to sell slow-moving items.
4.5 Material requirements planning (MRP)
A system that uses the production schedule to decide what is needed and when. This is then
linked in with suppliers discounts, lead times, etc to devise an optimal inventory holding
and ordering policy.

Key points

They formula for the Economic order Quantity is provided in the exam
the key is to identify the relevant data.
Do not confuse the Economic Order Quantity (EOQ) with the Re Order
Level (ROL). EOQ specifies how large each order should be; ROL specifies
when an order should be placed.
Just-In-Time (JIT) is the other main inventory system to be familiar with.

FOCUS

apply the tools and techniques of inventory management.
EXAMPLE SOLUTIONS
Solution 1 EOQ
EOQ =
1 $
000 , 40 2 $ 2

x = 400 units
Solution 2 Floor space
D =
C
O
=
C
H
=
3,000
5
$3.33 + (2 3 5) = $33.33

EOQ =
33 . 33
000 , 3 5 2
= 30 units
Solution 3 Quantity discount
EOQ =
50 . 7
000 , 7 30 2
= 200 units

Total cost at EOQ $
Holding
2
x
C
H
=
2
200
7.50
750

Reorder
x
D
C
O
=
200
5,000
30

750

Purchase cost 5,000 1.10

5,500

Total
_____
7,000
_____

Total cost at order quantity = 300 units
Holding
2
x
C
H
=
2
300
7.50
1,125

Reorder
x
D
C
O
=
300
5,000
30

500

Purchase cost 5,000 1.10 0.97

5,335

_____
6,960
_____

The discount is therefore worthwhile.
Solution 4 Re-order level
Average demand in the lead time = 60 units
Average annual demand = 60 50 = 3,000 units
Since the EOQ = 150, there will be
150
000 , 3
= 20 orders per annum.
ROL Buffer Demand Units
short
Probability Ave
units
short
Annual
stockout
cost
Annual
buffer
holding
cost
Total
annual
cost
$
60 0 70 10 0.2 2 2 $3 20 0
80 20 0.1 2 2 $3 20

__

___

___

Average 4 240 0 240

__

___

___

___

70 10 80 10 0.1 1 1 $3 20 10 $8

__

___

___

Average 1 60 80 140

__

___

___

___

80 20 80 0 20 $8

__

___

___

0 160 160

__

___

___

___

The optimum ROL is therefore 70 units.
Solution 5 Service level

ROL
SD = 40
300
45%
5%

z = 1.645 (using normal distribution tables)
ROL = 300 + (1.645 40) = 300 + 65.8 = 366
SESSION 15 CASH MANAGEMENT
OVERVIEW
Objective
To understand the importance of cash flow and methods of controlling cash flows, the
theoretical models relating to optimal cash balances and the importance of treasury
management.

TREASURY
MANAGEMENT
OPTIMAL CASH
BALANCES
BORROWING IN
THE SHORT-TERM
Centralised treasury management
The role of the treasurer
Cash flow budgeting
Risk and uncertainty
Sources
INVESTING IN
THE SHORT-TERM
Why surplus funds arise?
Factors to consider
Short-term investments
Baumol model
Miller-Orr model
CASH
MANAGEMENT
Reasons for holding cash
Cash and profits

1 CASH MANAGEMENT
1.1 Reasons for holding cash
Transactions motive to provide sufficient liquidity to meet current day-to-day
financial obligations (e.g. payroll, the purchase of raw materials, etc).
Precautionary motive a cash reserve to give a cushion against unplanned expenditure,
rather like buffer/safety level of inventory. This reserve may be held in the form of
cash equivalents - short-term, low risk, highly liquid investments (e.g. treasury bills).
Speculative motive to quickly take advantage of investment opportunities that may
arise (e.g. some firms build a war chest of cash ready to use if a suitable takeover
target appears).
However it is important that a firm does not hold excessive levels of cash as this leads to
inefficiency. Cash balances belong to the shareholders who are expecting to receive
significant return on their investment in the firm.
Any long-term surplus of cash should therefore be either reinvested into positive NPV
projects or returned to shareholders via:
Dividends possibly as a special dividend; or
Share buy-back programme.
1.2 Cash and profits
Profits are accounted for on an accruals basis and a company must be profitable to continue
in existence. However, profitability is not enough; companies must also have enough cash
flow available to meet all their day to day payments and longer-term commitments in order
to survive.
2 TREASURY MANAGEMENT
Definition

The efficient management of liquidity and risk in a business including the
management of funds (generated from internal and external sources),
currencies and cash flow.

As companies and financial markets have become larger, more sophisticated and
increasingly international, there has been a trend towards the establishment of separate
treasury departments where the control of cash is centralised in order to ensure its efficient
use. For example, surplus cash is invested in appropriate funds and realised when cash is
required.
2.1 Centralised treasury management
Advantages
Management by specialised staff.
Economies of scale (e.g. less staff required in total).
Pooling netting cash deficits against surpluses in order to save interest expense.
Increased negotiating power with banks.
More efficient foreign exchange risk management the treasury department at head
office can find the groups net position on each currency and then consider an external
hedge on this balance.
Within a treasury department of a large company there may still be a degree of
decentralisation in order to ensure that the decisions taken are appropriate to local
circumstances.
2.2 The role of the treasurer
The aim of good cash management is to have the right amount of cash available at the right
time. The treasurer will be involved in:
accurate cash flow forecasting, so that shortfalls and surpluses can be anticipated;
planning short-term borrowing when necessary;
planning investments of surpluses when necessary;
cost efficient cash transmission;
dealing with foreign currency issues;
optimising banking arrangements;
planning major finance-raising exercises;
accounts receivable/accounts payable policies.

In addition, the treasurer is often involved in risk assessment and insurance.
2.3 Cash flow budgeting
A major task of the treasurer is cash flow budgeting. A simple pro-forma is given below:
Forecast:

Sales volume;
Revenue;
Costs;
One-off expenses (e.g. capital expenditure).
Typical format
Q1 Q2 Q3 Q4 Total
Cash inflows $ $ $ $ $
Cash sales x x x x x
Cash from receivables x x x x x
Fixed asset disposals x x x x x
Share/debt issues x x x x x

___

___

___

___

___

Total inflow x x x x x

___

___

___

___

___

Cash outflows
Materials x x x x x
Labour x x x x x
Variable overhead x x x x x
Fixed overhead x x x x x
Dividends x x
Capital expenditure/leases x x
Interest/principal on debt x x x x x

___

___

___

___

___

x x x x x

___

___

___

___

___

Net cash flow x x x x x
Opening balance x x x x x

___

___

___

___

___

Closing balance x x x x x

___

___

___

___

___

2.4 Dealing with risk and uncertainty
Sensitivity analysis what if a key variable changes?
Sensitivity analysis can deal with uncertainty in cash budgeting by finding the effect of
a change in:
payment patterns by credit customers. The worst-case scenario should be
examined;
timing of other receipts (e.g. sale of fixed assets, rights issues, debt issues, etc);
materials costs. If prices are uncertain, a worst-case scenario should be examined;
other costs (e.g. labour, overheads) or timings of outflows (e.g. fixed overhead
payments, dividends, capital expenditure);
interest rates where borrowings are at variable rates. A worst-case scenario should
be forecast.
Simulation models can perform more dynamic analysis by incorporating possible inter-
relationships between variables (e.g. if interest rates rise there may be a fall in sales).
Unlike sensitivity analysis, simulation models (e.g. Monte Carlo) can simulate a range of
possible future economic scenarios to estimate the probability of cash flows being
higher/lower than expected. Through generating probabilities such models provide
better analysis of cash flow risk.
Example 1

Zombie Co is worried about breaking its overdraft limit of $5 million.
The company has used Monte Carlo analysis to produce the following
forecasts of net cash flows for the next two periods, together with their
associated probabilities.
Period 1cash flow Probability Period 2 cash flow Probability
$000 $000
6,000 20% 8,000 35%
3,000 50% 4,000 40%
(2,500) 30% (8,000) 25%

Zombie Co expects to be overdrawn at the start of period 1 by $1.5 million.
Required:
Calculate the following values:
(i) the expected value of the period 2 closing balance;
(ii) the probability of a negative cash balance at the end of period 2;
(iii) the probability of exceeding the overdraft limit at the end of period 2.
Discuss whether the above analysis can assist the company in managing its
cash flows.

Solution
Period 1 Period 2 Combined probability Closing balance Expected value

______ ______
1
______ ______
3 BORROWING IN THE SHORT-TERM
Commentary

Having completed a cash flow forecast the treasurer may identify a requirement to
borrow funds in the short term.

3.1 Sources of short-term borrowing
Debt factoring and invoice discounting;
Bank overdraft - however this:
is technically repayable on demand (although the bank may offer a revolving line
of credit);
normally carries a flat charge for the facility and high variable interest rate on the
balance.
Commentary

Need for a permanent level of overdraft indicates a need for a more permanent, and less
costly, form of borrowing. (Overdrafts are expensive due to the flexibility they offer.)

Short-term loans:
may require security;
can have fixed or variable rates of interest.
4 INVESTING IN THE SHORT-TERM
Commentary

Alternatively a treasurer may discover that the company has a cash surplus for a short-
term period.

4.1 Why do surplus funds arise?
Over funding proceeds which are not yet fully required may have already been
received from a share/debt issue;
Disposal of surplus assets or divisions;
Operating surpluses.
4.2 Investing surplus funds factors to consider
Amount of funds available.
Liquidity how quickly can the investment be converted back into cash?
Risk the treasurer should not gamble with the shareholders funds
Return on the proposed investment obviously this will be limited by the requirement
to select low risk investments.
Commentary

The general rule is to select short-term, low risk, highly liquid investments (e.g.
treasury bills).

4.3 Short-term investments
Money market deposits (i.e. bank deposits). There may be a notice period for
withdrawals and therefore should only be used if there is high certainty of cash flows.
Certificate of deposit - negotiable deposits issued by banks and building societies,
maturities from 28 days to 5 years. The holder can sell the certificate before its maturity
date, hence more liquid than money market deposits but lower returns.
Treasury bills 2, 3, and 6 month UK government debt, very low risk and very liquid,
but even lower returns.
Gilt-edged government securities (gilts) the long term version of Treasury Bills with
maturities usually greater than 5 years. It is not recommended that short-term cash
surpluses are invested in newly-issued gilts as their market prices are very sensitive to
interest rate changes.
Commentary

It would be more sensible to invest in gilts which are close to maturity.
Other government bonds (e.g. UK local authority bonds) rates are tied to money
markets. These have good liquidity.
Certificates of tax deposit deposits with UK Inland Revenue that may be surrendered
for cash or used in settlement of tax liabilities.
Commercial paper short term (7 days - 3 months) unsecured debts issued by high
quality companies, good liquidity
Corporate bonds longer maturity fixed interest securities issued by the corporate
sector. Liquidity can be poor and risk higher than on government bonds or commercial
paper.
Equities investing short term cash surpluses on the stock market is not recommended
as high risk.
Non-sterling instruments - most of the above have non-sterling counterparts (e.g. US
treasury bills, etc); beware exchange risk.
Commentary

Most businesses will be looking for a variety of investments in order to minimise the
risks involved, and also to ensure that some cash is available at short notice and that
some is invested longer term to obtain higher interest rates.

5 OPTIMAL CASH BALANCES
5.1 Baumol model
5.1.1 Introduction
The Baumol model is derived from the EOQ model and can be applied in situations
where there is a constant demand for cash. The model suggests that regular transfers are
made from interest-bearing short-term investments (or bank deposit accounts) into a
current account.
The model considers:
the annual demand for cash;
the cost of each transfer from short-term investments into cash; and
the interest rate difference between the rate paid on short-term investments and the
rate paid on a current account.
The model then uses the EOQ formula to calculate the optimum amount of funds to
transfer each time short-term investments are converted into cash.
By optimising the amount of funds to transfer, the model minimises the opportunity
cost of holding cash in the current account, thereby reducing the costs of cash
management.
5.1.2 Assumptions
Cash requirements are funded by the sale of short-term investments.
Constant annual demand for cash.
Constant interest rates.
Constant cost of each transfer.
5.1.3 Formula
s = cash needs for the period
f = transaction costs (brokerage, commission etc) of selling a
parcel of short-term investments
h = Opportunity cost of holding cash (interest rate difference
between short-term investments and cash)

Economic transfer =
h
2fs

5.1.4 Weaknesses
The assumption of constant demand for cash is unrealistic. A cash management model
which can accommodate a variable demand for cash, such as the Miller-Orr model, may
be more relevant.
In reality interest rates and transactions costs are not constant and interest rates, in
particular, can change frequently
The model assumes that the business is constantly using cash and must finance this by
selling investments. However any worthwhile business must, at some point, generate
cash rather than burn it.
Illustration 1

A firm has large deposits which currently attract interest of 15%.
It has cash needs of $300,000 in the next year.
Transaction costs are $120.
Required:
Calculate the economic transfer and the average cash balance.

Solution
s = 300,000
f = 120
h = 0.15
Economic transfer
=
0.15
300,000 120 2
= $21,909
Average balance
=
2
$21,909
= $10,954

5.2 Miller-Orr model
5.2.1 Introduction
The assumption made by the Baumol model of constant demand for cash is unrealistic.
A cash management model which can accommodate a variable demand for cash may be
more relevant. This is the strength of the Miller-Orr model.
The Miller-Orr model takes account of uncertainty in relation to cash receipts and
payments. The firms cash balance is allowed to vary between a lower limit set by
management judgement and an upper limit calculated by the model:
If the lower limit is reached an amount of cash equal to the difference between a
default return point and the lower limit is raised by selling short-term investments.
If the upper limit is reached an amount of cash equal to the difference between the
upper limit and the return point is used to buy short-term investments.
The model therefore helps the firm to decrease the risk of running out of cash, while
avoiding the loss of profit caused by having unnecessarily high cash balances.

Cash
balance
Upper limit
Return point
Lower limit
Time
convert investments
back into cash
make investments

5.2.2 Assumptions
Cash requirements are funded by the sale of short-term investments.
Fixed transaction cost per sale/purchase of short-term investments.
5.2.3 Formula
The following formulae are provided in the examination:
Return point = Lower limit + ( spread)
Spread =
3
1
rate interest
3
4
3

Where:
Spread = the difference between the upper limit and lower limit
Transaction costs = the fixed cost of buying or selling marketable securities
Variance = variance of the net daily cash flows
Interest rate = daily interest rate on marketable securities (i.e. the daily opportunity
cost of holding cash).
5.2.4 Weaknesses
Subjectivity in setting lower limit.
In practice commissions for buying/selling short-term investments are likely to be at
least partly variable.
Complexity of estimating future volatility of cash flows.
Example 2

A company requires a minimum cash balance of $6,000 and the variance of
daily cash flows is estimated to be $2,250, 000. The interest rate on securities is
0.025% per day and the transaction cost for each sale or purchase of securities
is $20.
Required:
Calculate:
the spread;
the upper limit;
the return point,
and interpret the results.

Solution

Key points

The only reason for a business to exist is if it can generate positive cash
flows from operations.
However cash surpluses should not simply be left in the companys bank
account as this produces a very low return. Long term surpluses should
be invested into positive NPV projects, or used to pay a dividend.
Short term surpluses should be invested in low risk, highly liquid
investments such as Treasury Bills. The Baumol and Miller-Orr models
provide detailed models on how to manage transactions between cash and
short-term investments.

FOCUS

explain the role of cash in the working capital cycle;
describe the functions of and evaluate the benefits from centralised cash control and
treasury management;
apply the tools and techniques of cash management;
calculate optimal cash balances.

EXAMPLE SOLUTIONS
Solution 1
(i) EV of period 2 closing balance
Period 1 Period 2 Combined probability Closing balance Expected value
6,000 8,000 0.2 0.35 = 0.07 (1500) + 6,000 + 8,000 = 12,500 0.07 12,500 = 875
6,000 4,000 0.08 8,500 680
6,000 (8,000) 0.05 (3,500) (175)
3,000 8,000 0.175 9,500 1,662.5
3,000 4,000 0.2 5,500 1,100
3,000 (8,000) 0.125 (6,500) (812.5)
(2,500) 8,000 0.105 4,000 420
(2,500) 4,000 0.12 0 0
(2,500) (8,000) 0.075 (12,000) (900)
______ ______
1 2,850
______ ______
The expected value of the period 2 closing balance is $2.85 million
(ii) Probability of a negative cash balance
Probability of negative cash balance at the end of period 2 = 0.05 + 0.125 + 0.075 = 0.25 = 25%
(iii) Probability of exceeding the overdraft limit
Probability of exceeding the overdraft limit at the end of period 2 = 0.125 + 0.075 = 0.2 = 20%
Discussion
The expected value analysis has shown that, on an average basis, Zombie Co will have a
positive cash balance at the end of period 2 of $285 million. However, the actual cash
balances that could occur are any of the specific closing balances shown above, rather than
the average of these balances.
There could be serious consequences for the firm it exceeds its overdraft limit. For example,
the overdraft facility could be withdrawn. There is a 20% chance that the overdraft limit will
be exceeded at the end of period 2. To guard against exceeding its overdraft limit the firm
must find additional finance of up to $7 million ($12m $5m).
The expected value analysis has been useful in illustrating the cash flow risks faced by
Zombie Co. However the assumptions used in the simulation model must be reviewed
before decisions are made based on the forecast cash flows and their associated probabilities.
Furthermore expected values are more useful for repeat decisions rather than one-off
activities, as they are based on averages. They illustrate what the average outcome would be
if an activity was repeated a large number of times.
In fact, each period and its cash flows will occur only once and the expected values of the
closing balances are not values that are forecast to arise in practice. For example, the
expected value closing balance of $285m is not forecast to actually occur, while a closing
balance of $11 million has a 20% chance of occurring.
Solution 2
Spread =
3
1
rate interest
3
4
3

=
3
1
0.00025
000 , 250 , 2 20
3
4
3

= 15,390
Upper limit = lower limit + spread
= 6,000 + 15,390 = 21, 390
Return point = Lower limit + ( spread)
= 6,000 + (15, 390/3) = 11, 130
Interpretation:
if cash balance rises to $21,390 then invest $10,260 ($21, 390 $11, 130) in securities. This
reduces the cash balance to $11, 130
if cash balance falls to $6, 000, sell $5,130 of securities to replenish cash.
SESSION 16 MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE
OVERVIEW
Objective
To consider the factors involved in the granting and accepting of trade credit.

SETTLEMENT
DISCOUNTS
CREDIT
CONTROL
Default risk
Open account trading
Cash against documents
Bills of exchange
Forfaiting
Letters of credit
Export credit houses
Export merchants
Export factors
ECGD
INVOICE
DISCOUNTING
AND FACTORING
Credit as a source of finance
Trade credit as a source of finance
Overseas payables
Granting credit
Credit periods and
settlement discounts
Credit rating
Collection procedures
Interest on overdue
invoices
OVERSEAS
RECEIVABLES
ACCOUNTS
PAYABLE
Invoice discounting
Debt factoring
ACCOUNTS
RECEIVABLE
Annual effective cost

1 CREDIT CONTROL
1.1 Granting credit
Should credit be granted at all? Consider normal trade practice, but also consider
leading a change. Providing credit may stimulate sales.
What is the true cost to the business of customer credit? This will be influenced by the
risk of bad debts and the cost of financing accounts receivable.
1.2 Credit periods and settlement discounts
Credit periods can be changed to respond to competition but will be largely influenced
by trade custom.
Settlement discounts (also called cash discounts) are influenced largely by accepted
practice within the industry. The company must ensure the discounts allowed expense
does not exceed the benefit of reduced finance costs.
Having defined the credit periods and settlement discounts, the company must make
sure that customers are aware of them by stating the terms:
on orders;
on invoices;
on statements.
The settlement discount policy must be enforced, since some customers will attempt to
take the settlement discount whether they pay on time or not.
Commentary

The policy must therefore be formal, in writing, dated and quantified.
1.3 Credit rating
This is a crucial policy area. The company must balance the risk inherent in granting credit
against the necessity to allow enough credit to support the level of business.
Credit limits should be set for all accounts, based on:
an assessment of the customers financial statements (e.g. calculate liquidity ratios);
the use of credit rating agencies (e.g. Dun and Bradstreet); credit ratings should be
reviewed regularly;
contacting credit managers in other firms to exchange information (members alert each
other as soon as problems are identified);
references from the customers bank or accountant, although these may be of limited
value;
the impression of credit-worthiness gained when visiting customers premises and
meeting the management;
review of the aged accounts receivables ledger to identify customers who have
significant debts outstanding for long periods.
1.4 Collection procedures
Establish timings for issuing letters of demand, making chasing telephone calls, and the
point when further deliveries should stop.
Ensure credit controllers liaise with sales management to avoid insensitive collection
procedures that may damage customer relations.
Consider using a stop list (i.e. suspending supplies).
Decide when outside assistance is needed to collect overdue debts. Lawyers, trade
associations and debt collection agencies may be considered.
1.5 Charging interest on overdue invoices
Some powerful companies have a reputation for paying their small suppliers very slowly.
Therefore in November 1998 the UK government introduced the Late Payment Act.
This legislation allows small suppliers to charge large companies 8% above central bank
interest rate on invoices unpaid after 30 days.
2 OVERSEAS RECEIVABLES
2.1 Default risk
Risk of default on exports may be higher than on domestic sales. Ideally cash in advance
should be requested, or at least a percentage deposit however such terms may not be
acceptable to the customer.
In fact credit periods on exports are often longer than for those on domestic sales. Therefore
the exporter needs to carefully consider the method of payment both with a view to
minimizing default risk and to financing the export.
2.2 Payment methods
2.2.1 Open account trading
This means simply trusting the customer to pay within the stated credit period with no
additional collateral or security.
2.2.2 Cash against documents
Documents of title to the goods are not released to the customer until payment is made.
2.2.3 Bills of Exchange
Definition

A bill of exchange is a document drawn by the exporter and sent to the
customer who signs to accept responsibility to pay the amount specified on the
stated date.

Often the documents of title to the goods will not be released to the customer until he
has accepted a bill of exchange.
The exporter may choose:
to hold the bill until maturity (and then receive payment from the customer); or
to discount the bill with a bank to receive the cash earlier.
However if the customer does not pay the bill the bank will have recourse to the
exporter (i.e. default risk stays with the exporter).
2.2.4 Forfaiting
This is where a bank discounts a series of bills of exchange without recourse to the
exporter if the customer does not pay (i.e. default risk is transferred to the bank).
2.2.5 Letters of credit
Definition

Documentary letters of credit are a payment guarantee backed by one or more
banks. They carry almost no risk, provided the exporter complies with the
terms and conditions contained in the letter of credit.

The exporter must present the documents stated in the letter, such as shipping
documents and bills of exchange, when seeking payment by the bank.
As each supporting document relates to a key aspect of the overall transaction, letters of
credit give security to the importer as well as the exporter.
2.2.6 Export credit houses
These give credit to the overseas customer and guarantee payment to the exporter.
2.2.7 Export merchants
Operate as intermediaries between the exporter and the overseas customer.
The merchant buys the goods (at a discount) from the exporter, sells them to the final
customer and pays the exporter (usually within 7 days).
2.2.8 Export factors
Factors buy the trade receivables from the exporter and charge commission on the
transaction. Other services such as operating the receivables ledger and credit
insurance may also be offered.
2.2.9 The Export Credits Guarantee Department (ECGD)
UK exporters can obtain guarantees from the ECGD on bank loans taken to finance
exports.
3 INVOICE DISCOUNTING AND FACTORING
3.1 Invoice discounting
Definition

Selling selected sales invoices to a third party for a discounted cash sum, while
retaining full control over the receivables ledger.

When a business enters into an invoice discounting arrangement, a finance company
will provide a cash advance as a percentage of the outstanding sales invoices usually
in the region of 80%. As customers pay their invoices, or new sales invoices are issued,
the amount advanced will fall or rise to maintain the level of finance at 80% of the
receivables.
The finance company will charge a monthly fee for the service, and charge interest on
the amount advanced.
The lender will require a floating charge over the trade receivables of the business and
may refuse to lend against some invoices, if it believes the customer is a high credit
risk. Therefore discounting is most suitable for companies which are selling to
customers with high credit ratings and a good payment record.
The process operates with recourse (i.e. the business keeps the risk of bad debts and
must repay amounts advanced if a customer defaults).
Responsibility for issuing sales invoices and for credit control stays with the business,
but the finance company will often require regular reports on the receivables ledger and
the credit control process.
3.1.1 Advantages
Improved cash flow.
Flexibility; the amount of financing rises and falls with the level of activity.
Confidentiality; customers are unaware that the business is borrowing against sales
invoices.
3.1.2 Disadvantages
An expensive form of financing compared to an overdraft or bank loan.
Finance company takes a legal charge over the receivables ledger and hence the
business has fewer assets available to use as collateral for other forms of borrowing.
(The interest rate charged by the discounter should be compared to the overdraft rate.)
3.2 Debt factoring
Definition

A range of services in the area of sales administration and the collection of
amounts due from customers

Debt factors may offer three closely integrated elements:
(1) Accounting and collection the company is paid by the factor as customers settle their
invoices or after an agreed settlement period. The factor will maintain the sales ledger
accounting function.
(2) Credit control the factor is responsible for chasing the customers and speeding up the
collection of debts.
(3) Finance against sales the factor advances (e.g. 80% of the value of sales immediately
on invoicing).
Accounting and collection is often carried out together with credit control. The finance that
the factor then makes available is only taken if required, as it is typically slightly more
expensive than a bank overdraft.
Factoring is becoming increasingly competitive; generally, factors will act for customers with
turnover in excess of $100,000 and invoices over $100.
The usual fees are between 0.5% 2.5% of invoice value, plus a charge for cash advances.
3.2.1 Advantages
Administrative savings;
Provides a flexible source of finance;
Obtain benefits from the factors economies of scale;
Obtain benefits from the factors expertise.
3.2.2 Disadvantage
Cost;
Loss of customer contact/goodwill;
Possible damage to company reputation.
3.2.3 Recourse vs non-recourse
Factoring with recourse bad debts remain the companys problem (i.e. the supplier
takes the risk of the debt not being paid).
Non-recourse factoring bad debts are the factors problem in effect the company is
insured against bad debts. Fees are higher.
Example 1 Factoring (service only)

A Co makes annual credit sales of $2m. Customers take 60 days to pay and
bad debts are 1% of sales.
A non-recourse factoring agreement is being considered. The factor would
charge a service fee of 2% of sales per year and reduce the accounts receivable
collection period to 40 days. Administration savings of $10,000 per annum
would be made.
Required:
Assuming a cost of working capital of 15% per year, calculate the effect on
annual profit of the factoring option that is being considered.

Solution
Annual (costs)/savings
$
Administration savings
Bad debt reduction
Factors fee
Reduction in financing cost (W)

______
Net annual saving

______

WORKING
Reduction in cost of financing working capital
$
Current average accounts receivable
Revised average accounts receivable

_______

One-off cash flow improvement

Annual saving thereon at 15%
_______


Example 2 Factoring (with finance)

Tipsy Co has annual sales of $500,000 and accounts receivable days of 60. It
pays overdraft interest at 17%.
It is approached by a factor who offers:
Immediate finance of 80% of sales at 18% interest
A guaranteed collection period of 45 days
$8,000 of administration savings
A service fee of 2% of turnover
Required:
Calculate the impact on annual profit of using the factor.

Solution
Current accounts receivable
Finance cost
New accounts receivable
$
Finance by factor
Finance by overdraft

______

______

Impact on annual profit:
$
Reduced interest expense
Saved admin expense
Service fee

______

______
4 SETTLEMENT DISCOUNTS
4.1 Annual effective cost
In the UK it is common to offer credit customers a discount if they pay within a certain
number of days.
To decide if this is a good policy the cost of the discount must be compared to the cost
of financing accounts receivable (e.g. overdraft rate).
To allow a fair comparison the cost of the discount must be expressed as an annual
effective cost.
Example 3

Customers normally take 60 days credit. A quick payment discount of 1.5% is
offered for payment within 20 days.
Required:
Calculate the annual effective cost of the discount and conclude whether the
discount should be offered if the overdraft rate is 15%.

Solution
40 day interest rate =
Annual effective rate =
Conclusion:
Example 4

Dodgy Co has sales of $100,000 and accounts receivable days of 60. It pays
overdraft interest at 18%.
It is considering a discount of 2% to customers who pay within 10 days. It is
estimated that 50% of customers will take the discount.
Required:
Calculate the impact on annual profit of the discount.

Solution
Current accounts receivable =
New accounts receivable =
=
$
Reduced interest expense
Discounts allowed expense

_____

_____

5 MANAGEMENT OF TRADE ACCOUNTS PAYABLE
5.1 Credit as a source of finance
Firms can use trade credit as a flexible source of short-term finance. The firm may even
decide to pay suppliers late.
Trade credit is not, however, without cost.
Associated costs
Possible loss of goodwill such that the supplier might give low priority to the firms
future orders, with consequent disruption of activities.
The supplier might eventually demand cash in advance-
The supplier may raise prices to compensate for the finance which he is involuntarily
supplying.
The firm may lose any discounts for prompt payment:
the annual effective cost of refusing a discount should be calculated. This should be
compared to the alternative cost of financing working capital (e.g. overdraft rate);
if the cost of refusing discount exceeds the overdraft rate then the discount should
be accepted.
Example 5

A supplier offers a 2% discount if the invoice is paid within 10 days of receipt,
but offers no discount if the payment is delayed for a further 20 days.
Required:
Calculate the annual effective cost of refusing the discount.

Solution
Equivalent compound rate

Example 6

A company currently takes 40 days credit from its suppliers, believing this to
be free finance.
Annual purchases are $100,000 and the company pays overdraft interest at
13%.
Payment within 15 days would attract a 1 % quick settlement discount.
Required:
Calculate the effect on the profit and loss account of accepting the discount.

Solution
Current accounts payable
New accounts payable
$
Increased interest expense
Discounts received

Effect on profit

_____

_____
Conclusion:

5.2 Advantages of trade credit as a source of finance
Convenient and informal.
Can be used if unable to obtain credit from financial institutions.
If settlement discounts are taken, it can result in a cheap source of financing as a
period of time is still allowed before payment.
Can be used on a short-term basis to overcome unexpected cash flow crises.
5.3 Overseas payables
When importing there may be specific complications (e.g. slow customs clearance,
unexpected import duties or quotas).
In addition the overseas supplier may be concerned about the risk of non-payment and
may demand, for example, cash against documents, bills of exchange or documentary
letters of credit.


Key points

Many exam questions on this area require candidates to use working
capital management ratios in reverse (e.g. to re-arrange the formula for
accounts receivable days and then use it to move from the sales figure to
the estimated level of receivables).
The other key technique is to calculate the annual effective cost of
settlement discounts. Use compound interest, not simple and bring a
scientific calculator to the exam.

FOCUS

explain the role of accounts receivable in the working capital cycle;
explain how the credit-worthiness of customers may be assessed;
explain the role of factoring and invoice discounting;
explain the role of settlement discounts;
explain the management of trade payables.
EXAMPLE SOLUTIONS
Solution 1 Factoring (service only)
Annual (costs)/
savings
$
Administration savings
Bad debt reduction
Factors fee
Reduction in financing cost (W)
10,000
20,000
(40,000)
16,438

______
Net annual saving 6,438

______

WORKING
Reduction in cost of financing working capital
$
Current average accounts receivable 2,000,000
365
60

328,767
Revised average accounts receivable 2,000,000
365
40

(219,178)

_______

One-off cash flow improvement 109,589

Annual saving thereon at 15% 16,438
_______

Commentary

The current level of receivables has been stated gross of bad debts. This is the
examiners approach as per his model answers and his book Corporate Finance
Principles and Practice.

Solution 2 Factoring (with finance)
Current accounts receivable
000 , 500
365
60
= 82,192
Finance cost (82,192 17%) = 13,973
New accounts receivable
000 , 500
365
45
= 61,644
$
Finance by factor = 61,644 80% 18%
Finance by overdraft = 61,644 20% 17%
8,877
2,096
______
10,973
______

Impact on annual profit:
$
Reduced interest expense (13,973 10,973)
Saved admin expense
Service fee (500,000 2%)
3,000
8,000
(10,000)

Increased profits

______
1,000
______
Solution 3 Settlement discount
It costs 1.5% to receive 98.5% of accounts receivable 40 days sooner.
40 day interest rate =
5 . 98
5 . 1
= 1.52%
Annual effective rate =
40
365
0152 . 1 1 = 1.0152
9.125
1 = 14.8%
Conclusion: This is below the overdraft rate and therefore the discount should be offered.
Commentary

The annual effective rate has been calculated above using compound interest to
compare to the cost of overdraft where interest is also charged on a compound basis.
However the examiner has said that he would also accept the use of simple interest (i.e.
1.52% 9.125 = 13.87%).

Solution 4 Settlement discount
Current accounts
receivable
=
100,000
365
60
= 16,438
New accounts
receivable
=
(100,000 50%
365
10
) + (100,000 50%
365
60
)
= 1,370 + 8,219
= 9,589
$
Reduced interest expense (16,438 9,589) 18%
Discounts allowed expense 100,000 50% 2%
1,233
(1,000)

Increased profit

_____
233
_____

Commentary

This solution follows the examiners approach as shown in his model answers and in
his book Corporate Finance Principles and Practice.

However there is a strong argument that the new level of accounts receivable should be
stated net of discounts allowed:
(100,000 50% 98%
365
10
) + (100,000 50%
365
60
) = 9, 561
The examiner has stated that he would accept this alternative approach.
Solution 5 Supplier finance
If a company receives an invoice of $1,000 and decides to pay after 30 days it will:
lose the 2% discount;
effectively have the use of $980 ($1,000 $20) for the additional 20 days.
This is an equivalent compound rate of pa % 6 . 44 1
980
20
1
20 / 365
=
+
This should be compared with the cost of financing working capital.
Commentary

If this exceeds the cost of financing working capital, then refusing the discount is
expensive and the discount should be accepted.

Trade credit can therefore be a very expensive form of financing when a cash discount is
offered but refused.
Commentary

The cost of trade credit decreases as the allowed payment period becomes longer relative
to the discount period.

Solution 6 Discount
Current accounts payable = 100,000
365
40
= 10,959
New accounts payable = 100,000
365
15
= 4,110
$
Increased interest expense (4,110 10,959) 13%
Discounts received (100,000 1%)
(890)
1,500

Increase in profit

_____
610
_____
Conclusion: The discount should therefore be accepted.
SESSION 17 RISK MANAGEMENT
OVERVIEW
Objective
To explain the causes of exchange rate fluctuations.
To apply hedging techniques for foreign currency risk.
To apply hedging techniques for interest rate risk.

INTEREST RATE
RISK
CURRENCY
RISK
EXCHANGE
RATE RISK
FORECASTING
EXCHANGE
RATES
RISK
MANAGEMENT
Forward exchange contracts
Money market hedges
Currency options
Currency futures contracts
Currency swaps

EXTERNAL
HEDGING OF
TRANSACTION RISK
Types of risk
Translation risk
Economic risk
Transaction risk
Internal management
TYPES OF RISK
EXTERNAL
HEDGING OF
INTEREST RATE
Forward rate agreements (FRAs)
Interest rate options
Interest rate futures
Interest rate swaps
Four-way equivalence model
Purchasing Power Parity (PPP)
Interest Rate Parity (IRP)
Fisher effect
International Fisher effect
Expectations theory
Balance of payments
Sources of exposure
Internal management

1 FORECASTING EXCHANGE RATES
1.1 Four-way equivalence model
The key models for forecasting future exchange rates focus either on inflation rate
differences, or interest rate differences.
The relationships between these macro-economic variables can be summarised in the
four-way equivalence model shown below:

Differences in
interest rates
Expected difference
in inflation rates
Interest rate
parity
Fisher
effect
International
Fisher effect
Purchasing power
party
Expectations
theory
Difference between spot
and forward exchange
rate
Expected change
in spot exchange rate

Spot exchange rate the market exchange rate for buying/selling the currency for
immediate delivery.
Forward exchange rate the exchange rate for buying or selling the currency at a
specific date in the future.
1.2 Purchasing Power Parity (PPP)
Absolute PPP states that the exchange rate simply reflects the different cost of living in
two countries. For example if a representative basket of goods and services costs $1, 700
in the US and 1,000 in the UK, the exchange rate should be $1.70 to 1.
While absolute PPP exchange rates may represent the long-run equilibrium rate
between two currencies, they are of limited practical use in financial management.
Financial managers are more interested in market exchange rates than theoretical rates.
This is where relative PPP is useful.
Relative PPP claims that changes in market exchange rates are caused by the rate of
inflation in different countries.
For example if the rate of inflation is higher in the US than in the UK, relative PPP
predicts that the value of the dollar will fall.
Formula for relative PPP:
S
1
= S
0
x
( )
( )
b
c
h 1
h 1
+
+

where:
S
1
= expected spot exchange rate after one year
S
0
= todays spot exchange rate
h
c
= foreign inflation rate (as a decimal)
h
b
= domestic inflation rate
Spot rates should be put into the formula in the format:
Units of foreign currency/units of domestic currency.
Example 1

Spot rate 1 January 20X6 = $1.90 per 1
Predicted inflation rates for 20X6:
US 2%
UK 3%

Required:
Calculate the predicted exchange rate at 31 December 20X6.

Solution

1.3 Interest rate parity (IRP)
IRP states that the forward exchange rate is based on the spot rate and the interest rate
differential between the two currencies:
Forward rate = spot rate (1+overseas interest rate/1+ domestic interest rate)
F
0
=S
0
x
( )
( )
b
c
i 1
i 1
+
+

where:
F
0
= forward exchange rate
S
0
= spot exchange rate
i
c
= overseas interest rate
i
b
= domestic interest rate
Example 2

If spot $ per = 1.78 and the dollar and sterling one year interest rates are
3.25% and 4.5% respectively, calculate the one-year forward exchange rate.

Solution

If this theory did not hold it would be possible for investors to make a risk-free profit
using a process referred to as covered interest rate arbitrage.
Definition

Covered interest rate arbitrage is simultaneously borrowing domestic
currency, transferring it into foreign currency at the spot exchange rate,
depositing the foreign currency, and signing a forward exchange contract to
repatriate the foreign currency into domestic currency at a known forward
exchange rate.

1.4 Fisher effect
Countries with a higher rate of inflation have higher nominal interest rates in order to
offer the same real return as countries with low inflation:
(1+i) = (1+r) (1+h)
Where i = nominal interest rate
r = real interest rate
h = inflation rate
1.5 International Fisher effect
States that the spot exchange rate will change to offset interest rate differences between
countries.
The calculations are basically as per Interest Rate Parity theory.
1.6 Expectations theory
Differences between forward and spot rates reflect the expected change in spot rates.
1.7 Balance of payments surpluses/deficits
Balance of payments accounts are a record of all monetary transactions between a
country and the rest of the world. The two principal parts of the balance of payments
are the current account and the capital account.
The current account shows the net amount a country is earning if it is in surplus, or
spending if it is in deficit. Its main component is the balance of trade net earnings on
exports minus payments for imports.
The capital account records the net change in ownership of foreign assets and includes
the foreign exchange market operations of a nations central bank, along with loans and
investments between the country and the rest of world.
Any current account surplus will be balanced by a capital account deficit of equal size
and vice-versa.
A rise in the value of a nations currency will make exports less competitive and imports
cheaper and so will tend to correct a current account surplus. A fall in the value of a
nations currency makes it more expensive for its citizens to buy imports and increases
the competitiveness of their exports, thus helping to correct a deficit.
Exchange rates tend to change in the direction that will restore balance. When a country
is selling more than it imports, the demand for its currency will tend to increase as other
countries need the selling countrys currency to make payments for the exports. The
extra demand tends to cause a rise of the currencys price relative to others.
When a country is importing more than it exports, the supply of its own currency on the
international market tends to increase as it tries to exchange it for foreign currency to
pay for its imports, and this extra supply tends to cause the price to fall.
2 EXCHANGE RATE RISK
2.1 Types
There are three types of exchange rate risk to consider:
(1) translation risk;
(2) economic risk; and
(3) transaction risk.
2.2 Translation risk
This occurs where a parent company holds an overseas subsidiary.
In order to consolidate the subsidiarys financial statements into the group accounts,
they must first be translated into the reporting currency of the parent company. The
exact method for doing this depends on the relevant financial reporting standards.
In particular translating the statement of financial position of overseas subsidiaries can
lead to significant translation gains/losses.
If the home currency has appreciated against the foreign currency, it is likely to produce a
translation loss when converting the value of overseas net assets.
If the home currency has depreciated against the foreign currency, it is likely to produce
a translation gain when converting the value of overseas net assets.
Although such gains/losses can be significant in size, they do not represent actual cash
gains/losses for the group they are simply caused by financial accounting methods for
consolidating overseas subsidiaries.
As long as users of financial statements understand that translation differences do not
represent cash flows, they should not affect the value of the group.
Therefore the financial manager should ensure that the nature of translation
gains/losses is clearly explained (e.g. in the annual report, at shareholder meetings).
However the financial manager does not need to hedge translation risk, because it is not
a cash flow.
2.3 Economic risk
Economic risk is the risk that cash flows will be affected by long-term exchange rate
movements.
As the value of a firm is the present value of its future cash flows, economic risk is a
significant issue for the financial manager. Unfortunately it is difficult to hedge against.
Illustration 1

A UK company exports to the US and therefore has dollar export earnings.
Over time, sterling becomes stronger against the dollar. The sterling value of
export earnings will fall, damaging the cash flow and the value of the
company. What can the company do to reduce this risk?
Increase the dollar price of the exports however this may not be
practical, particularly when exporting to a competitive market.
Diversify exports into other markets in the hope that sterling will fall
against some currencies while rising against the dollar.
Use hedging techniques such as forward contracts however, in the long
run this will not give effective protection. As sterling rises over time in the
spot markets it also rises in the forward markets and the value of exports
still falls.
Attempt to convert the cost base into dollars (e.g. by importing materials
from the US or setting up operations in the US). However these may not
be practical options for many companies.

Commentary

Economic risk can affect a company even if it does not export or import. Domestic
producers may face tougher competition from overseas firms if the home currency
appreciates. Again there is no easy method of protecting against this.

2.4 Transaction risk
Transaction risk is the short-term version of economic risk.
It is the risk that the exchange rate changes between the date of a specific export/import
and the related receipt/payment of foreign currency.
Like economic risk this affects cash flows and hence affects the value of the firm. It is
therefore a significant issue for financial management.
Transaction risk can be effectively managed using both internal and external techniques.
2.5 Internal management of exchange rate risk
Invoicing in the domestic currency an exporter could denominate sales invoices in its
domestic currency, effectively transferring the transaction risk to the customer.
However this may lead to lost sales.
Leading and lagging means paying overseas suppliers:
earlier (leading), if the home currency is expected to fall; or
later (lagging), if the home currency is expected to appreciate.
Netting is where there are both sales and purchases in a foreign currency and an external
hedge is only considered on the net difference between receivables and payables.
Matching considers using foreign currency loans to finance overseas subsidiaries.
Overseas earnings can be used to pay the loan interest and repay principal, reducing the
net foreign currency cash flow exposed to risk in the event of repatriation to the parent
company. This may be effective as a longer-term hedge against economic risk.
Asset and liability management if overseas subsidiaries borrow locally rather than
receiving finance from the parent company this reduces the net assets of the subsidiary.
Commentary

This can also be referred to as a balance sheet hedge and reduces exposure to
translation risk on consolidation of the subsidiaries net assets into the group accounts
(although, as mentioned above, translation risk should not affect the value of the
group).

3 EXTERNAL HEDGING OF TRANSACTION RISK
3.1 Forward exchange contracts
Forward contract a legally binding agreement to buy or sell:
a specified quantity;
of a specified currency;
on an agreed future date (delivery date);
at an exchange rate fixed today.
Forward contracts are not traded but agreed between a company and a bank. This
means they are customised agreements which can match the exact requirements of the
company regarding quantity and delivery date.
Forward contracts are not bought, they are entered into. Therefore no premium needs to
be paid to set up a forward hedge (unlike options).
Forward contracts do not require any margin to be posted (i.e. no deposit of cash is
required when setting up a forward hedge, unlike futures contracts). However there
will usually be a small arrangement fee to set up a forward contract.
The major disadvantage of forward contracts is that physical delivery must occur (i.e. if a
company signs a forward contract to buy/sell foreign currency then it must physically
exchange currency on the agreed date at the agreed rate, even if that rate has become
unattractive compared to the spot rate).
Therefore forward contracts are not a flexible method of hedging.
Example 3

Today is 1 January 20X1. A UK-based company is expecting dividend income
of $200,000 to be received from its US subsidiary on 31 March 20X1.
Spot rate 1 January 20X1 ($ per ) = 1.51231.5245
Three month forward = 2.002.14 cents discount
Required:
(a) Calculate how much sterling will be received if forward cover is taken out.
(b) Calculate how much sterling would be received if no forward cover is
taken out and the actual spot rate on 31 March 20X1 = 1.52471.5361.

Solution

3.2 Money market hedges
Money market hedges involve either borrowing or investing foreign currency in order
to protect against transaction risk. Whether to borrow or invest depends on whether the
company is exporting or importing.
Suppose a UK company has dollar export earnings. A money market hedge could be
set up as follows:
(1) Today borrow dollars.
(2) Exchange these dollars into sterling, which can then be invested.
(3) Use the dollar export earnings to repay the dollar loan.

Example 4

A UK-based company expects to receive $300,000 in 3 months.

Spot rate ($ per ): 1.7820 0.0002

One year sterling interest rates: 4.9%(borrowing) 4.6% (investing)
One year dollar interest rate: 5.4% (borrowing) 5.1% (investing)

Required:
Set up a money market hedge.

Solution

3.3 Currency options
If a company wants a more flexible hedge it may consider buying a currency option.
Options are an example of derivatives (i.e. a financial instrument based on an underlying
asset). In the case of currency options the underlying asset is a currency.
The purchaser of a currency option has the right, but not the obligation, to buy or sell:
a specified quantity;
of a specified currency;
on or before a specified date (expiry date);
at an exchange rate agreed today (exercise price/strike price).
The owner of the option can either:
exercise their right; or
allow it to lapse (i.e. not exercise it).
However the owner of an option must pay for this flexibility. The cost of an option is
known as its premium
Premiums are paid at the date the option is bought and are non-refundable.
A company may buy options on:
a derivatives market; or
directly from a bank known as OTC (over-the-counter).
Key points

A call option gives its owner the right to buy the underlying asset.
A put option gives its owner the right to sell the underlying asset.
European style options can only be exercised on the expiry date.
American style options can be exercised at any time until the expiry date.

3.4 Currency futures contracts
Futures are simply traded forward contracts.
Currency futures contracts are standardised contracts for the buying or selling of a
specified quantity of a specified currency. They are traded on a futures exchange and
have various delivery dates (e.g. March, June, September and December).
A company can choose whether to buy or sell futures and can choose which delivery
date to use.
The price of a currency futures contract represents the forward exchange rate for the
currencies specified in the contract.
When a currency futures contract is bought or sold, the buyer or seller is required to
deposit a sum of money with the exchange, called initial margin. If losses are incurred
(as exchange rates and hence the prices of currency futures contracts change), the buyer
or seller may be called on to deposit additional funds (variation margin) with the
exchange.
Any profits are credited to the margin account on a daily basis as the contract is
marked to market.
Although the definition of a futures contract is basically the same as a forward contact,
there is a significant practical difference between hedging with forwards and futures:
With forward contracts there is always physical delivery (i.e. a company that signs a
forward contract will physically buy or sell the underlying currency when the
contract reaches its delivery date).
However most currency futures contracts are closed out before their delivery
dates. The company simply executes the opposite transaction to the initial futures
position (e.g. if buying currency futures was the initial transaction, it is later closed
out by selling currency futures).
If a futures hedge is correctly performed any gain made on the futures transactions will
offset a loss made on the spot currency markets (and vice versa).

Illustration 2

Today is 1 February. A UK exporter expects to receive $300,000 in three
months time and is considering the use of sterling futures to protect against
transaction risk.
The company is worried that sterling will appreciate, leading to a loss on the
spot market sale of dollars in 3 months.
It therefore needs to set up a futures position that would produce a gain on a
rise in sterling.
On 1 February it should buy sterling futures contracts. It needs to hedge until 1
May and hence June contracts should be used (March contacts would only
hedge until the end of March)
On 1 May the company should:
sell June sterling futures;
sell the $300,000 export receipts on the spot market.
If sterling has risen against the dollar, there will be a gain on sterling futures
(bought sterling low, sold sterling high) to offset the loss on the spot market.

3.5 Currency swaps
A currency swap is a formal agreement between two parties to exchange principal and
interest payments in different currencies over a stated time period.
Currency swaps can be used to eliminate transaction risk on foreign currency loans.
The steps are as follows:
On commencement of the swap; an exchange of agreed principal amounts, usually
at the prevailing spot rate.
Over the life of the swap; an exchange of interest payments.
At the end of the swap; a re-exchange of principals, usually at the original spot rate
(thereby removing foreign currency risk).
4 TYPES OF INTEREST RATE RISK
4.1 Sources of exposure
4.1.1 Exposure to rising interest rates
There are two main situations where a company may fear rising interest rates:
If a company has a significant proportion of floating interest rate debt it will fear a
rise in interest rates as this obviously leads to lower profits. However higher
interest expense also leads to higher financial risk (i.e. more volatile future profits
due to a larger block of committed interest expense to be covered). An extreme
interest rate rise could even cause financial distress risk (i.e. bankruptcy).
If a company has a significant amount of surplus cash invested in fixed interest rate
securities (e.g. government bonds).
4.1.2 Exposure to falling interest rates
There are two main situations where a company may fear falling interest rates:
when it has a significant proportion of fixed interest rate debt and therefore does not
participate in the benefits of falling rates (unlike its competitors, for example);
when it holds significant floating rate investments (e.g. money market investments).
4.1.3 Basis risk
Even if a company has floating rate assets and floating rate liabilities of similar size,
they may be linked to different reference rates which may change at different times
and/or by different amounts.
4.1.4 Gap exposure
If a company has floating rate assets and floating rate liabilities of similar size that are
all linked to the same reference rate (e.g. LIBOR) it can still face risk.
It is possible that the interest rate is reset at different intervals on assets and liabilities
(e.g. every 6 months on assets but every 3 months on liabilities).
4.2 Internal management of interest rate risk
Smoothing involves maintaining a balance between fixed rate and floating rate
borrowings.
Matching is attempting to have a common interest rate for both assets and liabilities.
Commentary

This is more practical for financial institutions than for industrial companies.

5 EXTERNAL HEDGING OF INTEREST RATE RISK
5.1 Forward rate agreements (FRAs)
FRAs allow companies to fix, in advance, either a future borrowing rate or a future
deposit rate, based on a notional principal amount, over a given period.
FRAs are cash-settled, in advance, based on the present value of the difference on
settlement date between:
the fixed contract rate;
the reference interest rate (e.g. LIBOR).
The maximum maturity period for an FRA is usually around two years.
Customised agreement is reached with a bank (i.e. OTC).
No premium is paid for the FRA and no margin needs to be posted.
Illustration 2

A company plans to borrow $20 million in 3 months time for a period of 6
months and wishes to pay 7% interest no matter what happens to interest rates
during the next 3 months.
It can enter into an FRA with a bank at an agreed rate of 7% on a notional
principal amount of $20 million, starting in 3 months and lasting for 6 months.
This is known as a 3v9 FRA.
If actual interest rates are higher than 7% in 3 months time then the bank
pays the company the difference between 7% and the actual rate (i.e. cash
settlement is made at the start of the FRA period). The compensation
would be calculated as the present value of the interest rate difference on a
$20m 6 month loan (discounted at the actual interest rate).
If actual interest rates are lower than 7% then the company pays the bank
the difference.
No matter what the actual interest rate the company will pay interest at a rate
of 7% on the underlying $20 million loan.

5.2 Interest Rate Options
Various OTC interest rate options can be purchased from financial institutions and tailor-
made to meet company requirements. The major types are:
Cap - if the reference interest rate rises above a pre-determined level, the financial
institution pays the difference to the company, based on an agreed notional principal
and time period. This puts a cap or ceiling on the interest rate paid by the company. If
the reference rate stays below the pre-determined rate the cap will not be exercised.
Floor - if the reference interest rate falls below a pre-determined level, the financial
institution pays the difference to the company. This would be relevant for a company
with floating rate investment income that wishes to guarantee a minimum return.
Collar combination of a cap and a floor and therefore keeps an interest rate between
an upper and lower limit. This is a cheaper hedge than just using a cap or floor.
5.3 Interest Rate Futures
The most common futures contract to use for interest rate hedging is a three-month
contract. This contract is referenced to short-term interest rates (e.g. three month
LIBOR).
Interest rate futures contacts are priced at 100 minus the implied interest rate. Therefore
if interest rates rise, the price of interest rate futures falls.
If a company wishes to hedge against rising interest rates it should use futures as
follows:
Today sell interest rate futures;
Wait for interest rates to rise;
If interest rates rise, the price of futures must fall;
Close out the futures position by buying the same contracts that were originally
sold;
There should be a gain on futures (as we sold high and bought low) to offset higher
interest expense on company debts.
Commentary

In the above futures are sold and bought later. This is called taking a short position
and is absolutely possible in futures markets because of the ability to close out positions
before contracts reach their delivery date (i.e. physical delivery does not occur).

5.4 Interest Rate Swaps
Interest rate swap - an exchange between two parties of interest obligations or receipts
in the same currency on an agreed amount of notional principal for an agreed period of
time.
Interest rate swaps are a flexible method for companies to change the interest rate
profile of their underlying loans or investments.
The most common is a plain vanilla swap where fixed interest payments based on a
notional principal are swapped for floating interest payments based on the same
notional principal.

Key points

Risk management is a topic that is introduced in this paper and taken to a
higher level in the Advanced Financial Management syllabus.
It is important to understand the various types of foreign exchange and
interest rate risk.
Calculations will focus on forecasting exchange rates and performing
relatively simple hedges such as forward contracts, money market hedges
or FRAs for interest rate management.
An appreciation of more complex derivatives such as futures, options and
swaps should be sufficient.

FOCUS

forecast exchange rates using purchasing power parity and interest rate parity;
discuss the various types of exchange rate risk and interest rate risk;
discuss and apply both internal and external methods of hedging against currency or
interest rate risk.
EXAMPLE SOLUTIONS
Solution 1
s
1
= s
0
x
( )
( )
b
c
h 1
h 1
+
+

s
1
= 1.90 x
( )
( ) 03 . 0 1
02 . 0 1
+
+
= 1.88
This is a predicted fall in the value of sterling.
Solution 2
f
0
= S
0
x
( )
( )
b
c
i 1
i 1
+
+

f
0
= 1.78 x
( )
( ) 045 . 0 1
0325 . 0 1
+
+
= 1.76
Sterling is weaker in the forward market than the spot market
Solution 3
(a) Forward rate = 1.5245 + 0.0214 = 1.5459

1.5459
$200,000
= 129,374
(b)
1.5361
$200,000
= 130,200
Solution 4
Expected receipt after 3 months = $300,000
Dollar interest rate over three months = 5.4/ 4 = 1.35%
Dollars to borrow now to have $300,000 liability after 3 months = 300,000/ 1.0135 = $296,004
Spot rate for selling dollars = 1.7820 + 0.0002 = $1.7822 per
Sterling deposit from borrowed dollars = 296,004/ 1.7822 = 166,089
Sterling interest rate over three months = 4.6/ 4 = 1.15%
Value in 3 months of sterling deposit = 166,089 x 1.0115 = 167,999
SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
OVERVIEW
Objective
To estimate the value of one share or of a companys equity in total.
To be familiar with all ratios commonly used in business analysis.

BUSINESS
VALUATION
RATIO
ANALYSIS
BUSINESS
VALUATION AND
RATIO ANALYSIS
Profitability
Liquidity
Efficiency
Gearing
Investor ratios
ASSET BASED EARNINGS BASED DIVIDEND BASED
Price/Earnings
Earnings yield
Dividend yield
Dividend valuation model
PRACTICAL
FACTORS
Reasons for
Nature
VALUATION
METHODS
Marketability and liquidity
Information
Market imperfections
Market capitalization

Net book value
Net realisable value
Replacement cost

1 BUSINESS VALUATION
1.1 Reasons for
To determine the value of a private company (e.g. for a Management Buy Out (MBO)
team).
To determine the maximum price to pay when acquiring a listed company (e.g. in a
merger or takeover).
Commentary

The quoted share price is only relevant for taking a minority shareholding.
To aid in decisions on buying/selling shares in private companies;
To place a value on companies entering the stock market (i.e. Initial Public Offerings
IPOs).
To value shares in a private company for tax/legal purposes.
To value subsidiaries/divisions for possible disposal.
1.2 Nature of business valuation
When a business is valued it is not a precise exercise and there is often no unique
answer to the question of what it is worth (e.g. the value to the existing owner may be
significantly different to the value to a potential buyer).
There are a variety of different methods of valuing businesses which may produce
different overall values. These can be used to determine a range of prices.
The relevant range of values is:
the minimum price the current owner is likely to accept;
the maximum price the bidder is likely to pay.
The final price will result from negotiations between the parties.
In the following sections the following methods of valuation will be considered:
asset-based valuations;
earnings-based valuations;
dividend-based valuations.

2 ASSET-BASED VALUATION METHODS
2.1 Net book value (NBV)
This method simply uses the balance sheet equation (also called accounting
equation:
Equity = assets - liabilities
Problems
Balance sheet (i.e. carrying) values are often based on historical cost rather than
market values.
Net book value of non-current assets depends on depreciation/amortisation policies.
Significant assets may not be recorded in the statement of financial position (e.g.
internally-generated goodwill will not be recognised).
Commentary

For these reasons a valuation based on balance sheet net assets is unlikely to be
suitable.

2.2 Net realisable value (NRV)
This estimates the liquidation value of the business:
Equity = estimated net realisable value of assets liabilities
This may represent the minimum price that might be acceptable to the present owner of
the business.
Problems
Estimating the NRV of assets for which there is no active market (e.g. a specialist item of
equipment).
It ignores unrecorded assets (e.g. internally-generated goodwill).
2.3 Replacement cost
This can be viewed as the cost of setting up an identical business from scratch:
Equity = estimated depreciated replacement cost of net assets
This may represent the maximum price a buyer might be prepared to pay.
Problems
Technological change means it is often difficult to find comparable assets for the
purposes of valuation.
It ignores unrecorded assets.
3 EARNINGS-BASED VALUATION METHODS
3.1 Price/Earnings ratios
The published P/E ratio of a quoted company takes into account the expected growth rate of
that company (i.e. it reflects the markets expectations for the business).
Using published P/E ratios as a basis for valuing unquoted companies may indicate an
acceptable price to the seller of the shares.
Price/Earnings (P/E) ratio =
Share Per Earnings
share ordinary per price Market

Earnings per Share (EPS) =
shares ordinary issued of Number
dividends preference and tax after Profit

Therefore:
Ordinary share price = P/E ratio EPS
This can be used for valuing the shares in an unquoted company.
Step 1 Select the P/E ratio of a similar quoted company.
Step 2 Adjust downwards to reflect the additional risk of an unquoted company and the
non-marketability of unquoted shares.
Step 3 Determine the maintainable earnings to use for EPS.
3.2 Earnings yield
Earnings yield is simply the reciprocal of the P/E ratio.
Earnings Yield =
share per price Market
EPS
100
Therefore:
Ordinary share price =
Yield Earnings
EPS


Example 1

You are given the following information regarding Accrington Co, an
unquoted company.
Issued ordinary share capital is 400,000 25c shares.
Extract from income statement for the year ended 31 July 20X4:
$ $
Profit before taxation 260,000
Less: Taxation (120,000)

_______
Profit after taxation 140,000
Less: Preference dividend 20,000
Ordinary dividend 36,000

______
(56,000)

_______

Retained profit for year 84,000

_______

P/E ratio applicable to a similar type of business (suitable for an unquoted
company) is 12.5.
Required:
Value 200,000 ordinary shares in Accrington Co on an earnings basis.

Solution

4 DIVIDEND-BASED METHODS OF VALUATION
4.1 Dividend yield
Dividend yield =
share pre price Market
share per Dividend
100
Therefore share price =
yield Dividend
share per Dividend

Step 1 Determine the dividend for the unquoted company.
Step 2 Choose a published dividend yield for a similar quoted company.
Step 3 Adjust this dividend yield upwards to reflect the greater risk of an unquoted
company and the non-marketability of unquoted company shares.
This method fails to take growth in to account and therefore can lead to an under-
valuation
It also has little relevance for valuing a majority shareholding as such an investor has the
ability to change the dividend policy.
Example 2

An individual is considering the purchase of 2,000 shares in G Co.
G Co has 50,000 shares in issue and the latest dividend payment was 12 cents
per share.
G Co is similar in type of business, size and gearing to H Co, a company listed
on a stock exchange. H Co has a published dividend yield of 10%.
Required:
Suggest a price that the individual might pay for the 2,000 shares in G Co.

Solution

4.2 Dividend Valuation Model
Commentary

This was first introduced in Session 10.

If dividends are forecast to grow at a constant annual rate to perpetuity then use the
published valuation formula:
P
O
=
( )
( ) g
g
+
e
O
r
1 D

where P
O
= todays ex-div share price

D
o
g = growth rate
r
e
= required return of equity investors
Step 1 Identify current dividend.
Step 2 Estimate the growth rate of dividends. Three methods may be available:
(i) economic forecasting (i.e. the exam question may give a growth rate);
(ii) using the historic dividend growth rate and assuming it will apply into the
future;
(iii) Gordons growth approximation (i.e. growth is a function of reinvestment and
return on equity). Use the given formula, g = br
e
where:
b =
tax after Profit
profit Retained
=
tax after Profit
dividend - tax after Profit

r
e
=
funds rs' Shareholde
tax after Profit
=
assets Net
tax after Profit

Step 3 Determine the required return (e.g. using CAPM).
Commentary

The abbreviation r
e
is used both in the valuation formula (where it refers to the required
return of shareholders) and in Gordons formula (where it refers to the actual return on
reinvested profits). It can be argued that, in competitive markets, the actual return on
equity will, in the long run, equal the required return. In this case the CAPM-based
return can also be used in Gordons formula.

Problems
Determining growth rate of dividends;
Determining the required return for an unquoted company;
It is of little relevance for valuing a majority shareholding as such an investor has the
ability to change the dividend policy.
Example 3

Claygrow Co is a company which manufactures flower pots. The following
information is available:
Current dividend 25c per share
Required return on equities in this risk class 20%

Required:
Value one share in Claygrow Co under the following circumstances:
(i) No growth in dividends;
(ii) Constant dividend growth of 5% per annum;
(iii) Constant dividends for five years and then growth of 5% per annum to
perpetuity; and
(iv) Constant dividends for five years and then sale of the share for $2.00.

Solution
(i) Constant dividend Po
(ii) Constant growth in dividend Po

(iii) PV of five years dividend
plus
PV of growing dividend from year 6 onwards

_______

_______

(iv) PV of five years dividend
PV of $2.00 in five years time

_______

_______

Example 4

Current EPS = 30 cents
Payout ratio = 40%
Number of shares in issue = 5m
Net assets per statement of financial position = $12m
Risk-free rate = 4%
Market premium = 5%
Equity beta = 1.4
Required:
Value the firms equity using the dividend growth model.

Solution
Current dividend per share =
Retention ratio =
Profit after tax =
Return on equity =
Growth =
Required return =
P
O
=
Total value of equity =

5 PRACTICAL FACTORS IN BUSINESS VALUATION
5.1 Marketability and liquidity of shares
Shares in unquoted companies are not traded via the stock market and this lack of
marketability reduces their value relative to shares in quoted companies.
Furthermore unquoted companies are not required to comply with stock market listing
rules or corporate governance codes, increasing their perceived risk and further
depressing their value.
Some analysts adjust the P/E ratio of a comparable quoted company downwards by as
much as 40% when valuing unquoted shares.
Even shares in quoted companies can suffer from a lack of marketability where there are
periods of thin trading (i.e. a lack of liquidity in the market).
5.2 Availability and sources of information
Potential investors generally have plenty of publically available information when
deciding whether to buy/sell quoted shares (e.g. published accounts, earnings forecasts,
research reports, news and analysis in the financial press and data services such as
Bloomberg and Reuters).
However much less information may be available for unquoted companies they may
not be required to publish accounts (or have exemptions from producing group
accounts or showing statement of cash flows) and are also unlikely to be watched by
analysts or news agencies.
This leads to asymmetry of information between the managers and potential
investors in unquoted companies (i.e. managers have full information about the true
value of the business but potential investors have very little). The resulting uncertainty
leads to investors potentially under-valuing the shares.
5.3 Market imperfections and pricing anomalies
Although the dividend valuation model gives an idea of the fundamental fair value of a
share it is based on perfect market assumptions (i.e. many buyers/sellers of the share,
zero transaction costs, freely available information and rational investors).
Even major markets such as the New York or London Stock Exchanges are not perfect
markets, as evidenced by the following:
Irrational investor behaviour (e.g. the belief that recent price rises will lead to future
price rises). This over exuberance can lead to speculative bubbles (e.g. the over-
valuation of high-tech shares during the 1990s).
Pricing anomalies such as the January effect where investors sell shares at the end
of December to utilise any tax losses of them, then buy back the shares at the start
of January.
Another anomaly is the overreaction effect where share prices appear to initially
over-react to unexpectedly good/bad news and then slowly move back toward
their fundamental value.
The small capitalisation discount is a pricing anomaly caused by the behaviour of
institutional investors (the main buyers of quoted shares). Companies with market
values of just a few million dollars tend to stay under the radar of fund managers
and in fact some pension funds will even be restricted from buying such shares.
This can lead to a small cap firm always remaining relatively low in value.
5.4 Market capitalization
Market capitalisation refers to the total market value of a quoted company (i.e. number
of issued ordinary shares market price per share).
However market capitalisation is not necessarily the amount that would have to be paid
for the firms entire equity. The quoted share price is for a minority shareholding if
control is required a significant premium would usually have to be paid.
On the other hand there may be situations where the entire capital can be acquired at
below market capitalisation (e.g. where a large proportion of the target firms shares are
held by a small group of people). If the existing investors tried to dispose of their
holdings via the market they would cause a major price fall, hence they may be willing
to sell off exchange at a small discount to the current quoted price.
6 RATIO ANALYSIS
6.1 Profitability ratios
Gross profit margin = 100
Sales
profit Gross

Operating profit margin = 100
Sales
tax and interest before Profit

Return on capital employed (ROCE) = 100
s liabilitie current - non + funds rs' Shareholde

Return on equity (ROE) = 100
funds rs' shareholde Ordinary
dividends preference - tax after Profit

6.2 Liquidity ratios
Current ratio =
assets Current

Quick or acid test ratio = =

6.3 Efficiency/activity ratios
Accounts receivable days = 365
sales credit Annual
receivable accounts Average

Accounts payable days = 365
purchases credit Annual
payable accounts Average

Inventory days = 365
sales of cost Annual
inventory Average

Cash conversion cycle = inventory days + receivables days payables days
Total asset turnover =
assets Total
Sales

Fixed asset turnover =
assets Fixed
Sales

Sales/working capital =
capital Working
Sales

6.4 Gearing/Risk ratios
Financial gearing:
Debt to equity = 100
reserves Capital
s liabilitie current - Non
+

Debt to total capital = 100
employed Capital
s liabilitie current - Non

Commentary

Gearing is also referred to as leverage.
Operational gearing:
100
costs operating Variable
costs operating Fixed
or 100
costs operating Total
costs operating Fixed

Interest cover =
expense Interest

Cash flow coverage =
expense Interest
operations from generated Cash

6.5 Investor ratios
Earnings per ordinary share (EPS):
issue in shares ordinary of number average Weighted
dividends preference - tax after Profit
=
Diluted EPS should also be calculated where a company has a complex capital structure that
includes Potentially Dilutive Securities (PDSs). These are securities in issue which involve
an obligation to issue shares in the future (e.g. convertible debt, warrants).
Diluted EPS =
g outstandin s PDS' shares ordinary average Weighted
s adjustment PDS dividends preference - tax after Profit

+
+

Dividend cover =
dividend Ordinary
dividend preference - tax ater Profit

Dividend payout ratio =
dividend preference - tax after Profit
dividend Ordinary

Dividend yield = 100
price share Ordinary
share ordinary per Dividend

Price/earnings ratio (P/E ratio) =
EPS

Earnings yield =
EPS
100
Total Shareholder Return (TSR) =
year of start at price Share
dividends price share end - Year +
100

Example 5

Using the information for Cathcart Inc which follows calculate the ratios listed.


Example 5

Cathcart Inc: Statement of financial position at 31 December 200X
$000 $000
Non-current assets: Cost less depreciation 2,200
Current assets
Inventory 400
Receivables 500
Cash 100
_____
1,000

_____
3,200

_____
Equity
Ordinary shares ($1 par) 1,000
Retained earnings 800
Non-current liabilities
10% bond 600
Preferred shares (10%) ($1 par) 200
Current liabilities
Payables 400
Taxation 200

_____
600

_____

3,200

_____

Income statement for the year ended 31 December 200X
$000
Turnover 3,000
Cost of sales (2,400)

_____

Gross profit 600
Operating expenses (200)

_____

Profit before interest and tax 400
Interest (60)

_____

Profit before tax 340
Income tax (180)

_____

Profit after tax 160

_____

Dividends: Ordinary 125
Preference 20

Current quoted price of $1 ordinary share $1.40

_____

Solution
(a) Gross profit margin

(b) Operating profit margin

(c) ROCE

(d) Return on equity

(e) Current ratio

(f) Acid test ratio

(g) Receivables days

(h) Total asset turnover

(i) Fixed asset turnover

(j) Proportion of debt finance

(k) Interest cover

(l) EPS

(m) Dividend cover

(n) Dividend yield

(o) Price earnings ratio

Key points

Business valuation is not a science different analysts use different
techniques.
You need to enter the exam with a range of methods at your disposal and
choose the most relevant depending what data is available and whether
you are required to value a minority stake or a business in total.
Ratio analysis is also a subjective area different analysts calculate ratios
in slightly different ways. If the exam question does not define exactly
how a certain ratio should be calculated then state your definition, show
your workings and be consistent between companies/years. Often it is the
change in ratios which is more relevant than their absolute amount.

FOCUS

prepare and justify a range of prices for valuing a business in a variety of
different circumstances;
calculate and interpret all key ratios for a business.
EXAMPLE SOLUTIONS
Solution 1
Valuation of 200,000 shares = 200,000 P/E ratio EPS
= 200,000 12.5
400,000
20,000) (140,000

= $750,000
Solution 2
Share price =
yield Dividend
Dividend

Dividend yield to be adjusted upwards to reflect greater risk and non-marketability of
unquoted company say 13% (subjective)
Share value =
13 . 0
12
= 92 cents per share
Estimated value of 2,000 shares = $1840
Solution 3
(i) Constant dividend Po =
0.2
0.25
= $1.25
(ii) Constant growth in dividend Po =
0.05) (0.2
(1.05) 0.25

= $1.75

(iii) PV of five years dividend ($0.25 2.991) $0.748
plus
PV of growing dividend from year 6 onwards

0.05) (0.20
(1.05) 0.25

1.2
1

5
= $0.703

_______
$1.451

_______

(iv) PV of five years dividend ($0.25 2.991) $0.748
PV of $2.00 in five years time ($2.00
1.2
1

5
) $0.804

_______

$1.552

_______
Solution 4
Current dividend per share = $0.30 0.4 = $0.12
Retention ratio = 60%
Profit after tax = $0.30 5m = $1.5m
Return on equity = 100
12
5 . 1
= 12.5%
Growth = 0.6 0.125 = 0.075 i.e. 7.5%
Required return = 4 + (1.4 5) = 11%
P
O
=
( )
( ) 075 . 0 11 . 0
075 . 1 12 . 0
= $3.69
Total value of equity = $3.69 5m = $18.45m
Alternative approach (assuming actual return on reinvested profit will equal the minimum required
return as per CAPM):
Growth = 0.6 0.11 = 0.066 i.e. 6.6%
P
O
=
( )
( ) 066 . 0 11 . 0
066 . 1 12 . 0
= $2.91
Total value of equity = $1.91 5m = $14.55m
Solution 5
(a) Gross profit margin = 100
000 , 3
600
= 20%
(b) Operating profit margin = 100
000 , 3
400
= 13.3%
(c) ROCE = 100
600 800 200 000 , 1
400
+ + +
= 15.4%
(d) Return on equity = 100
1800
20 - 160
= 7.8%
(e) Current ratio =
600
1,000
= 1.67: 1
(f) Acid test ratio =
600
600
= 1: 1
(g) Receivables days = 365
3,000
500
= 61 days
(h) Total asset turnover =
3,200
3,000
= 0.94
(i) Fixed asset turnover =
2,200
3,000
= 1.4
(j) Proportion of debt finance = 100
1800
800
= 44.4%
OR = 100
1800 800
800
+
= 30.8%
(k) Interest cover =
charge Interest

=
60
400
= 6.67
(l) EPS =
1,000
20 160
= 14 cents
(m) Dividend cover =
125
20 - 160
= 1.1
(n) Dividend yield = 100
share ordinary per Dividend

=
$1.40
cents 12.5
= 8.9%
(o) Price earnings ratio =
EPS
price Share
=
14
140
= 10

SESSION 19 GLOSSARY
Accounting Rate of Return (ARR) the average annual operating profit generated by a project
expressed as a percentage of the initial (or average) investment. Also referred as Return On
Investment (ROI) or Return on Capital Employed (ROCE).
Adjusted payback see discounted payback.
Agency costs the reduction in shareholders returns below the maximum possible level due
to company managers following personal objectives not in the best interests of shareholders.
Alpha a measure of abnormal return from a security (i.e. where the forecast return is higher
or lower than expected by CAPM).
Asset beta measures the risk created by operating the firms assets (i.e. business risk).
Asymmetry of information the fact that potential investors know less about a company than
its managers and may therefore over-estimate the risk of providing finance. This can be a
particular problem for SMEs.
Basis risk the risk that interest rates on assets and liabilities are referenced to a different
benchmark.
Beta factor a measure of the sensitivity of a securitys returns to systematic risk.
Bill of exchange a document containing an instruction to a third party to pay a stated sum of
money at a designated future date or on demand. Mainly used in foreign transactions and is
usually negotiable (i.e. the holder of the bill can resell it at a discount).
Bird in the hand theory suggest that shareholders may prefer the certainty of a cash dividend
today rather than reinvestment of profits to create an uncertain capital gain in the future.
Bond a written acknowledgement of a firms debt. Also referred to as a debenture or loan
stock.
Bonus issue issue of new shares to existing shareholders, without any subscription of new
funds. Also referred to as a scrip issue.
Business risk the volatility of operating profits, caused by the volatility of revenues and the
level of operational gearing.
CAPM Capital Asset Pricing Model. A model that relates the systematic risk of an
investment to the required return.
Cap an agreement that fixes a maximum rate of interest.
Capital allowances tax allowable deductions given on capital expenditure. Also known as
writing down allowances.
Capital rationing where insufficient finance is available to undertake all available positive
NPV projects.
Cash conversion cycle time period between paying suppliers and receiving cash from
customers. Also known as the cash operating cycle or working capital cycle.
SESSION 19 GLOSSARY
Certificate of deposit a tradable security issued by banks to investors who deposit a fixed
amount for a fixed period.
Clientele theory suggest that a companys historical dividend pattern may have attracted
particular investors. Changing the pattern in future may cause this clientele to sell their
holdings and lead to a fall in share price.
Collar an agreement that keeps either a borrowing or lending rate between specified upper
and lower limits.
Convertible debt debt that can, at the option of the investor, be either redeemed or converted
into ordinary shares.
Conversion premium market value of convertible debt minus current conversion value.
Corporate governance controls and procedures implemented to reduce agency costs to an
acceptable level.
Corporate Social Responsibility (CSR) a model which suggests that company managers
should take into account the objectives of a wide range of stakeholders and not just the
shareholders.
Cost of debt a firms cost of borrowing. If expressed post-tax then it takes into account the
tax shield.
Cost of equity - the required return of the firms ordinary shareholders. Can be estimated
from CAPM or the Dividend Valuation Model.
Coupon the interest rate printed on a bond certificate, applied to the face value of the debt.
Current yield the annual coupon from a bond expressed as a percentage of the bonds
market price. Also known as running yield or interest yield.
Discounted payback the period taken for the discounted cash flows generated by a project to
recover the initial investment. Also known as adjusted payback.
Dividend irrelevance theory Modigliani and Millers claim that the timing of dividend
payments has no effect on share price.
Dividend valuation model states that the value of a share is the present value of future
expected dividends, discounted at the investors required return.
Economic risk the risk that long-term changes in exchange rates affects a companys
profitability.
Efficient Markets Hypothesis (EHM) a theory which asks what information is reflected in
share prices.
Environmental Management Accounting (EMA) attempts to measure the full environmental
impact of a companys operations (e.g. the cost of inefficient energy usage due to poor
insulation of buildings).
SESSION 19 GLOSSARY
Equity beta measures the risks faced by equity investors due to the nature of the firms
assets (business risk) and the level of its liabilities (financial risk)
Financial gearing the proportion of debt in the capital structure. Also referred to as capital
gearing.
Financial risk the increased volatility of returns to ordinary shareholders due to interest on
debt being a fixed committed cost.
Financial distress risk the risk of bankruptcy caused by dangerously high levels of financial
gearing. Also referred to as credit risk or default risk, it increases the cost of debt.
Floor an agreement that fixes a minimum rate of interest.
Floor value the value of convertible debt assuming that it will be redeemed rather than
converted.
Forfaiting where an exporter discounts a series of bills of exchange without recourse (i.e. the
discounter takes the bad debts risk).
Forward contract a legally binding contract between a company and a bank to buy or sell a
fixed amount of foreign currency at a fixed exchange rate on a fixed date in the future.
Forward Rate Agreements contracts which allow companies in advance to fix future
borrowing or lending rates, based on a notional principal over a given period.
Futures contract a traded forward contract.
Gap exposure the risk that interest rates on assets and liabilities are reset at different
intervals.
Gordons growth model states that the forecast growth rate of a companys dividend =
proportion of profits retained return on equity.
Gross Redemption Yield see Yield to Maturity.
IRR Internal Rate of Return; the discount rate where NPV equals zero.
Letter of credit - a letter issued by a bank authorizing the person named to draw money up to
a specified amount from the bank's branches, providing the conditions set out in the letter
are met. Often used in international trade and, if the letter is irrevocable, provides an
exporter with guarantee of payment.
Marginal cost of capital the cost of the last dollar of finance raised.
Money cost of capital required return including the general inflation rate. Also known as the
nominal cost of capital.
Nominal discount rate required return including the general inflation rate. Also known as
the money discount rate.
NPV Net Present Value; the change in shareholders wealth due to an investment project.
SESSION 19 GLOSSARY
Operational gearing the proportion of fixed operating costs to variable operating costs.
Option the right, but not the obligation, to buy/sell an underlying asset at a fixed price.
Payback the period of time required for the operating cash flows from a project to equal the
cost of investment.
Pecking order theory a theory which suggests that company managers have a preference for
using internal finance (i.e. retained earnings) rather than external finance. A key cause may
be asymmetry of information.
Placing a method for a firm to sell its shares on the primary market. Shares are offered to
the sponsors or brokers private clients and/or a narrow group of investors.
Pre-emptive rights the right of existing shareholders to be offered new shares before they
can be offered to new investors. Also known as pre-emption rights.
Primary market the market for new issues of securities.
Real cost of capital required return excluding general inflation.
Rights issue an offer of new shares to existing shareholders who hold pre-emptive rights.
Sale and leaseback where property is sold and simultaneously rented back.
Scrip dividend issue of new shares to existing shareholders in lieu of a cash dividend.
Scrip issue see bonus issue.
Secondary market trading in securities after they have been issued onto the primary market.
Securities financial instruments that can be traded (e.g. shares, bonds and derivatives).
Share buyback where a firm repurchases its own shares, an alternative method of retuning
cash to investors compared to a dividend,
SMEs Small and Medium-sized Enterprises. No official definition exists but generally
these are unlisted companies.
Special dividend a substantial dividend payment that is not expected to be repeated in the
near future.
Stakeholders groups of people who have some type of interest in an organization.
Shareholders are the key stakeholder but other groups include employees, customers,
suppliers and, arguably, even society as a whole.
Swap an agreement to exchange one stream of cash flows for another.
Systematic risk the relative effect on the returns of an individual security of changes in the
market as a whole. Also known as market risk. It cannot be removed by diversification but
can be measured using beta factors.
SESSION 19 GLOSSARY
Tax shield interest on debt is a tax allowable expense for a company and leads to lower
corporate tax payments.
Term structure of interest rates the relationship between short and long term interest rates.
Total Shareholder Returns (TSR) the total return to shareholders via dividend and capital
gain, usually measured over a one year period.
Transaction risk the risk that exchange rates change between the date of an import/export
and the related payment/receipt of foreign currency.
Translation risk gains/losses caused by translating the financial statements of overseas
subsidiaries into the reporting currency of the parent on consolidation.
Treasury bills virtually risk-free short-dated debt securities issued by governments.
Unsystematic risk risk that can be removed via portfolio diversification.
WACC Weighted Average Cost of Capital; the average cost of long-term finance.
Warrants share options attached to debt to make the debt more attractive to investors.
Writing down allowances tax allowable deductions given on capital expenditure. Also
known as capital allowances.
Yield To Maturity (YTM) the average annualized return on a debt security, taking into
account both income and capital gains. Also known as gross redemption yield.
Zero coupon bond a bond issued at a discount to face value, paying no annual interest but
redeemed at par.

SESSION 19 GLOSSARY

SESSION 20 INDEX
A
ABC inventory control 1410
Accounting rate of return (ARR) 304
Agency theory 108
AIM listing 803
Allocative efficiency 218
Alpha factor 1203
Annual equivalent cost 605
Annuities 404, 410, 413
Asset betas 1206
Asset replacement decision 605
Asset-based valuation 1803
B
Balance of payments 1705
Bank loans 907, 1020, 1308
Bank overdraft 908, 1506
Basis risk 1713
Baumol model 1508
Bear 217
Behavioural finance theory 1007
Beta factors 1202
Bill of exchange 213, 909
Bills of exchange 1604
Bird in hand 813
Bond valuation 1013, 1016, 1018
Bonus issue 806
Borrowing 1506
Bull 217
Business angels 809, 910
Business risk 1105
C
Cap 1715
Capital allowances 506
Capital asset pricing model 1201
Capital Asset Pricing Model 1203
Capital budgeting 302
Capital expenditure 302
Capital markets 215
Capital rationing 602
Capital structure 1106
Capitalisation issue 806
Carbon credits 211
Cash budget pro forma 408
Cash flow budgeting 1503
Cash management 1502
Cash operating cycle 1310
Clearing banks 214
Clientele theory 813
Collar 1715
Collection procedures 1603
Competition policy 209
Compound interest 402
Constant dividend 1004
Constant dividend growth 1005
Conversion premium 1018
Convertible debentures 1018
Convertibles 905
Corporate governance 111, 211
Corporate objectives 103
Corporate social responsibility 109
Cost of capital 1406
Cost of debt 1012
Cost of equity 1007
Cost-push inflation 208
Covered interest rate arbitrage 1704
Credit control 203, 1314, 1602
Credit creation 214
Credit rating 1602
Credit terms 1602
Cumulative preference dividends 902
Currency risk 1706
Current cash flows 513
D
Debentures 903
Debt factoring 1315, 1506, 1606
Decision-making 607
Deep discount bonds 904
Demand for money 204
Demand-pull inflation 207
Direct control 203
Directors 109
Discounted cash flow techniques 407
Discounted payback 304, 709
Discounting 405
Dividend growth 1008
Dividend irrelevance 814
Dividend policy 811
Dividend valuation model 1004
Dividend yield 1806
Dividend-based valuation 1806
Divisible projects 602
SESSION 20 INDEX
E
Earnings yield 1804
Earnings-based valuation 1804
Economic order quantity 1403
Economic risk 1706
Effective annual interest rates 404
Effective method 513
Efficiency ratios 1309, 1812
Efficient Market Hypothesis 218
EIS 809
Enterprise Investment Scheme 809
Environmental issues 108
EOQ 1403
Equity betas 1206
EURO 212
Eurobond market 215
European Regional Development Fund 211
Exchange rate risk 1706
Expectations theory 221, 1307, 1705
Expected values 706
Export financing 1603
F
Finance lease 606
Financial distress risk 1106, 1107
Financial intermediaries 213, 220
Financial management 102
Financial market efficiency 218
Financial risk 1105, 1206
Financing gearing 1812
Fiscal policy 205, 207
Fisher effect 1704
Fisher formula 513
Floor 1715
Floor value 1018
Forfaiting 1604
Forward contracts 1708
Forward rate agreements 1714
Four-way equivalence model 1702
Funding gap 808
Futures 1711, 1715
G
Gap exposure 1713
Gearing 1105
Gilts 1507
Gordons growth model 1010
Government intervention 209
Grants 211, 910
Green policies 211
Gross redemption yield 1016, 1306
H
Hassan 224
Hibah 224
I
Ijara 223
Inflation 207, 511
Informational efficiency 218
Initial margin 1711
Interest rate arbitrage 1704
Interest rate parity 1703
Interest rate risk 1713
Interest rates 220
Interest yield 1013
Internal equity finance 810
Internal rate of return 412
International Fisher effect 1705
Inventory control 1402
Investment decisions 301
Invoice discounting 1605
IPO 803
Irredeemable debt 1013
Islamic finance 222
Islamic instruments 223
J
Just-in-time system 1411
K
Keynesian approach 205
L
Lagging 1708
Lead time 1407
Leading 1708
Lease v buy 606
Leasing 907
Letters of credit 1604
Linear interpolation 414
Liquidity 1307
Liquidity preference theory 221
Liquidity ratios 1309, 1811
Liquidity vs profitability 1303
Loan guarantee scheme 910, 911
SESSION 20 INDEX
M
Macroeconomic policy 202
Marginal cost of capital 1105
Mark to market 1711
Market capitalization 1811
Matching 1708
Material requirements planning (MRP)
1411
Maturity gap 808
Miller-Orr model 1510
Modigliani and Miller 1107
Monetarists 208
Monetary policy 203, 206, 207
Money market 220
Money market hedge 1709
Money markets 216
Money method 513
Money rates 512
Money supply 203, 204
Monte Carlo 705
Mortgage loan 908
Mudaraba 223
Multiplier effect 214
Murabaha 223
Musharaka 223
Mutually-exclusive projects 604
N
Net present value 408
Net realisable value 1803
Netting 1708
Nominal cash flows 513
Nominal rate 512
Non-divisible projects 603
Non-recourse factoring 1607
Not-for-Profit Organisations 104
O
Objectives 103
Offer for sale 802
Offer for subscription 802
Official listing 803
Official Listing 803
Open market operations 203
Operating lease 606
Operational efficiency 218
Operational gearing 1812
Options 1710, 1715, 1716
Overdue invoices 1603
Overseas payables 1612
Overseas receivables 1603
Overtrading 1303, 1317, 1318
P
Past dividends 1009
Payback period 303
Payback with bail-out 304
Pecking order theory 810, 1110
Periodic review system 1410
Perpetual inventory methods 1411
Perpetuities 411, 412
Placing 802
Post-tax cost of convertible debt 1019
Preference shares 902, 1012
Pre-tax cost of debt 610
Pricing efficiency 218
Private equity 809
Privatisation 210
Profitability index 602
Profitability ratios 1811
Project appraisal 407, 1011
Public sector organisations 104
Purchasing power parity 1702
Q
Quantity discounts 1406
R
Real cash flows 513
Real method 513
Real rates 512
Redeemable debentures 1015
Relevant costs 502
Re-order level 1407
Replacement analysis 605, 606
Replacement cost 1803
Reserve asset requirements 203
Residual dividend 813
Retail Price Index 207
Revenue expenditure 302
Rights issue 802, 804
Risk 222, 702
Risk management 710
SESSION 20 INDEX
S
Sale and leaseback 907, 908
Scrip dividends 815, 816
Scrip issue 806
Security characteristic line 1203
Security Market Line 1204
Segmentation theory 221, 1307
Sensitivity analysis 702, 1504
Settlement discounts 1602, 1609, 1602, 1609
Share buyback 814
Share issue 802
Shareholder expectations 812
Shareholders 109
Shares 217
Shariah board 224
Short-term investments 1507
Signalling 812
Simple interest 402
Simulation 705
Single-period capital rationing 602
Small and Medium-sized Enterprises 806
Source of finance 1610
Sources of finance 1307
Sources of risk 702
Special deposits 203
Special dividends 815
Stakeholders 109
Standard deviation 707
Static trade-off model 1106
Statistical measures 706
Stock Exchange 216
Stock market ratios 1813
Stock splits 806
Strong-form efficiency 219
Subsidies 211
Sukuk 224
Supply side policies 206
Surplus funds 1506
Swaps 1712
Systematic risk 1202
T
Tax relief 904
Tax shield 905
Taxation 506
Tender 802
Term structure of interest rates 221
Time value 407
Trade credit 1611
Trade creditors 1610
Traded forward contracts 1711
Transaction exposure 1707
Translation risk 1706
Treasury management 1502
Triple bottom line 108
U
Uncertainty 702
Undated debt 1013
Uneven cash flows 414
Unsystematic risk 1202
V
Value for money 105
Variation margin 1711
VCT 809
Vendor placings 802
Venture capital 808
W
Warrants 905
Weak-form efficiency 218
Wealth maximisation 103
Weighted average cost of capital 1102
Well-diversified 1205
With recourse 1607
Working capital 1302
Writing down allowances 506
Y
Yield curve 1307
Yield curves 221
Yield to maturity 1016
Z
Zero coupon bonds 904

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This ACCA Study System has undergone a Quality Assurance review by ACCA and includes:
An introductory session containing the ACCA Syllabus and Study Guide and approach to examining
the syllabus to familiarize you with the content of this paper
Coverage of the core syllabus areas
A visual overview at the beginning of each session showing how topics are related
Denitions of terms
Illustrations
Examples with solutions
Key points drawing attention to rules, underlying concepts and principles
Commentaries providing additional information
Focus on learning outcomes
A bank of practice questions

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