Working Capital Management Notes

PAper F9
Revision Notes
WORKING CAPITAL (1)

GENERAL IDEA:
WORKING CAPITAL IS NECESSARY FOR COMMERCIAL REASONS.
RECEIVABLES:
Competitors offer credit
INVENTORY:
Raw materials to avoid break in production
Work-in-progress due to length of production process
Finished Goods to avoid turning away customers
Transaction motive to pay bills

CASH:

Precaution motive to cover unexpected payments
Speculative motive to be able to take advantage of special situations (eg buy more if
prices are low)
BUT COSTS ATTACHED:

administration; bad debts
RECEIVABLES:
INVENTORY:
inventory costs; obsolescence
AND OVERALL COST:

Either:
extra money borrowed to finance working capital
Or:
money could (if released) be invested in fixed assets (producing more earnings)
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PAper F9
Revision Notes
WORKING CAPITAL (2)

GOOD MANAGEMENT:
RECEIVABLES:
*
Efficient debt collection
Factor debts (BUT COST)
Offer discount for early payment (BUT COST)
Proper credit checks before giving credit
INVENTORY:
*
Economic Order Quantity
Just-in-Time
CASH:
*
Proper cash budgeting
Investment of surplus balances (`Treasury function)
PAYABLES:
*
(But *
*
Delay payment
loss of discounts can be expensive
suppliers may refuse to supply)
PAper F9
Revision Notes
WORKING CAPITAL MEASURES (1)

LIQUIDITY:
CURRENT RATIO
QUICK RATIO
Current Assets
Current Liabilities
Current Assets - Inventory
Current Liabilities
OVERALL LEVEL:
SALES
WORKING CAPITAL
[Higher sales should mean

higher working capital]
WORKING CAPITAL
FIXED ASSETS
[Higher fixed assets `need

higher working capital]
PAper F9
Revision Notes
WORKING CAPITAL MEASURES (2)

SPECIFIC ITEMS OF WORKING CAPITAL:
RECEIVABLES:
Receivables days/Receivables collection period:
Receivables
Credit sales per day
INVENTORY:
Inventory holding period
Finished Goods:
Raw Materials:
Inventory
Cost of sales per day
Inventory
Purchases per day
PAYABLES:
PAYABLES period:
Payables
Credit purchases per day
CASH OPERATING CYCLE / WORKING CAPITAL CYCLE / WORKING CAPITAL FUNDING REQUIREMENT

Receivables days + Inventory holding period Payables days
PAper F9
Revision Notes
PRO FORMA CASH BUDGET
January
February
March
Receipts
Cash sales
Receipts from receivables
30 day
60 day
90 day
Sale of assets
Payments
Cash purchases
Payments to payables
Expenses
Purchase of assets
Tax
Dividends
Interest
Net cash inflow/(outflow)

Balance b/f
Balance c/f
Remember: It is receipts and payments which we need here, not sales and purchases
Note: You often require preparation of sales/production budgets, etc. before you can produce cashflow.
PAper F9
Revision Notes
THE FUNDING OF WORKING CAPITAL

The amounts of each part of Working Capital (Receivables, Cash, etc.) will obviously change from day to day.
However, the overall level should remain reasonably constant on average.
The funding of the overall constant level of Working Capital (permanent working capital) should come from longterm finance.
Day-to-day fluctuations (fluctuating working capital) should come from short term finance (bank overdraft).
Overtrading is when the level of long-term finance is too low and as a result even permanent working capital is
financed by expensive short-term finance.
PAper F9
Revision Notes
JUST-IN-TIME INVENTORY MANAGEMENT

The objective is to remove the need to keep inventory.
The main steps in order to achieve this are:

*
total quality management

if there is no waste or damage to materials, there is less need for stock
if all finished goods are perfect there is less need for stock
fast production
the faster the production the less work-in-progress
goods can be produced to order, rather than being produced for stock
frequent, guaranteed deliveries of raw materials

it is the supplier who then has to keep stock, rather than the company
PAper F9
Revision Notes
WORKING CAPITAL ARITHMETIC (1) RECEIVABLES

Sales are currently $5,000,000 p.a., of which 50% are on credit.
Receivables currently pay as follows:
1 month 20%
2 months 30%
3 months 40%
4 months 10%
The company is considering employing a factor to collect their debts. The factor will take on average 2 months
to collect debts. They will advance 70% of the invoice value immediately, and the balance will be received after 2
months.
Employing the factor will save administrative costs of $40,000.
The factor charges 1% of credit sales, and interest on advances at the rate of 18% p.a.
The cost of capital of the company is 15% p.a..
Should the company employ the factor?
Factors cost (1% x $2.5M)

Factors interest charge
(18% x 2/12 x 70% x $2.5M
Net benefit so do employ the factor
Costs p.a.
25,000
52,500
$77,500
Benefits p.a.
Saved admin costs
Interest saved on lower receivables:
(15% x (500,000 125,000))
Average receivables currently

1 x 20% =
2 x 30% =
3 x 40% =
4 x 10% =
0.2
0.6
1.2
0.4
2.4month
Average receivables = 2.4/12 x $2.5M = $500,000

Average receivables new
0 x 70% =
2 x 30% =
0
0.6
0.6month
Average receivables = 0.6/12 x $2.5M = $125,000
40,000
56,250
$96,250
PAper F9
Revision Notes
WORKING CAPITAL ARITHMETIC (2) Inventory

X plc needs to purchase 1800 units per year. The purchase price of each unit is $25.
However, the supplier will give quantity discounts as follows:
Order quantity
0 199 units
200 499 units
500 units and above
Discount
0%
1%
2%
Delivery costs are $32 per order, and inventory holding costs are 18% p.a. of inventory value.
Calculate the optimum order quantity.
Answer
EOQ =
21,80032
= 160 units
18%25
Total cost at EOQ

Holding costs: 160/2 x (18% x (99% x 25)) =
Order costs: 1800/160 x $32 =
Purchase cost: 1,800 x $25
Total cost at 200 units

Holding costs: 200/2 x (99% x 25) =
Order costs: 1800/200 x $32 =
Purchase cost: 1,800 x (99% x $25)
Total cost at 500 units

Holding costs: 500/2 x (18% x (99% x 25)) =
Order costs: 1800/500 x $32 =
Purchase cost: 1,800 x (98% x $25)
$p.a.
360
360
720
45,000
$45,720
$p.a.
446
288
734
44,550
$45,284
$p.a.
1,103
115
1,218
44,100
$45,318
Best is to order 200 units each time
PAper F9
Revision Notes
WORKING CAPITAL ARITHMETIC (3) CASH

A company has decided that it needs a minimum cash balance of $10,000.
The transaction cost (of making transfers to/from deposit) is $5 per transaction.
The standard deviation of cash flows is $2,000 per day, and the interest rate is 5.11% p.a. (or 5.11 / 365 = 0.014% per
day).
What should be the upper and lower limits, and the return point?
Answer
Lower limit = $10,000
Spread = 3[
5(2,000)
0.00014
] = 4,750
1
3
Upper limit = 10,000 + 4,750 = $14,750

Return point = 10,000 + (1/3 x 4,750) = $11,583
PAper F9
Revision Notes
DISCOUNTED CASH FLOW INFLATION AND TAX

Company is considering buying a machine in order to produce new product.
Machine costs: $1,200,000
Lasts 3 years; scrap value:
$400,000
Production:
50,000 units p.a.
Cost card for first year:

S.P.
Materials
Labour
Variable o/h
$ p.u.
$ 30
8
6
4
$18
Revenue and materials will increase at the rate of 5% p.a..

All other costs will inflate at 10% p.a.
Fixed overheads of the company currently amount to $600,000. The management accountant has decided that
20% of these should be absorbed into the new product.
An additional $100,000 of working capital will be required at the start of the project.
Capital allowances: 25% reducing balance
Tax: 25%, 1 year in arrears
Cost of Capital: 10%
PAper F9
Revision Notes
DISCOUNTED CASH FLOW INFLATION AND TAX (Answer)
0
Revenue
Materials
Labour
Variable o/h
Tax on operating flows
Cost
(1,200)
Scrap
Tax saving on Cap Allowances
Working Capital
(100)
(1,300)
d.f. at 10%
1
(1,300)
Present value
1
1,500
(400)
(300)
(200)
600
2
1,575
(420)
(330)
(220)
605
(150)
75
600
530
0.909
0.826
545
438
NPV = +387
3
1,654
(441)
(363)
(242)
608
(151)
400
56
100
1,013
0.751
761
(152)
69
(83)
0.683
(57)
PAper F9
Revision Notes
SENSITIVITY ANALYSIS
A company is considering a new machine which will cost $250,000, have a life of 5 years and have a scrap value at
end of 5 years of $50,000.
The machine is expected to produce 10,000 units a year and the contribution per unit is estimated to be $8.
There will be additional fixed overheads incurred of $15,000 p.a.
d.f.
0
1 5 contribution
1 5 fixed costs
5
scrap
(250,000)
80,000
(15,000)p.a.
50,000
PV @ 10%
1
3.791
3.791
0.621
NPV $
(250,000)
303,280
(56,865)
31,050
27,465
Answer
Sensitivities
Contribution per unit:
27,465
100% = 9.06%
303,280
Sales units p.a.:
27,465
100% = 9.06%
303,280
Fixed costs p.a.:
27,465
100% = + 48.3%
56,865
Initial cost:
27,465
100% = + 11.0%
250,000
Scrap value:
27,465
100% = 88.5%
31,050
PAper F9
Revision Notes
CAPITAL RATIONING
Below are the expected cash flows for each of 3 projects:
A
0
1
2
(2,000)
3,340
NPV @ 10%
(The cost of capital is 10%)
760
(5,000)
4,000
3,590
(3,000)
2,500
2,500
1,600
1,340
There is only $8500 available for investment at time 0.

(a) If the project are infinitively divisible, how should the company invest
(b) If the projects are not infinitively divisible, how should the company invest?
Answer
(a)
Profitability index
760
2,000
= 0.38
(2)
1,600
5,000
= 0.32
(3)
1,340
3,000
= 0.45
(1)
Investment:
Investment
C
A
B
(b)
Choices:
A+B
A+C
or B + C
100%
100%
(balance)
3,000
2,000
3,500
8,500
NPV
1,340
760
1,120
3,220
(3,500 x 0.32)
Total NPV
2,360
2,100
2,940
Best is B + C
HARD capital rationing

SOFT capital rationing
PAper F9
Revision Notes
DCF AND REPLACEMENT

A machine costs $100,000 and lasts for 3 years.
Maintenance costs and scrap values are as follows:
Year
Maintenance
1
25,000
2
30,000
3
40,000
The cost of capital is 15% p.a.
Scrap
75,000
60,000
20,000
Should the machine be replaced every 1 year, every 2 years or every 3 years?
PAper F9
Revision Notes
DCF AND REPLACEMENT (AnsweR)

1 year replacement:
0
Cost
Maintenance
Scrap
(100,000)
(25,000)
75,000
50,000
0.870
43,500
(100,000)
1
(100,000)
d.f @ 15%
P.V.
(56,500)
Equivalent cost (EAC) =
56,500
0.870
= $64,943 p.a.
2 year replacement:
0
Cost
Maintenance
Scrap
(100,000)
(25,000)
(100,000)
1
(100,000)
d.f @ 15%
P.V.
(25,000)
0.870
(21,750)
(30,000)
60,000
30,000
0.756
22,680
(99,070)
99,070
1.626
= $60,929 p.a.
3 year replacement:
0
Cost
Maintenance
Scrap
(100,000)
1
(100,000)
d.f @ 15%
P.V.
(100,000)
(25,000)
(30,000)
(25,000)
0.870
(21,750)
(30,000)
0.756
(22,680)
(40,000)
20,000
(20,000)
0.658
(13,160)
(157,590)
157,590
2,283
= $69,028 p.a.
Best is to replace every 2 years
PAper F9
Revision Notes
DISCOUNTING WITH INFLATION

Two approaches:
1.
Inflate cash flows and then discount at actual (nominal) Cost of Capital
Flows before inflation
0
1
2
3
2.
(50,000)
20,000
30,000
40,000
Inflation at 5%
Actual cash flows
1.05
(1.05)2
(1.05)3
(50,000)
21,000
33,075
46,305
x
x
x
=
=
=
Discount factor at
15%
x
x
x
Present value at
15%
(50,000)
0.870
=
18,270
0.756
=
25,005
30,469
0.658
=
NPV
$23,744
Discount current price flows at effective (real) Cost of Capital.

1+m 1.15
1+r =
=
= 1.095
1+l
1.05
r = 9.5% (say 10%)
df @ 10%
0
1
2
3
(50,000)
20,000
30,000
40,000
0.909
0.826
0.751
NPV
PV @ 10%
(50,000)
18,180
24,780
30,040
$23,000
In exam:
*
Either approach is accepted
For short project with different inflation rates, use approach 1
For long project with single inflation rate use approach 2
Always discount using tables at nearest %
PAper F9
Revision Notes
NPVs
Proforma:
0
Sales receipts
Costs
Net operating flow
1
x
(x)
x
Tax on operating flows

Capital Expenditure
Scrap proceeds
Tax saved on Cap.
Allowances
Working Capital
Discount factors
Present value
2
x
(x)
x
3
x
(x)
x
4
x
(x)
x
5
x
(x)
x
(x)
(x)
(x)
(x)
(x)
x
x
x
(x)
(x)
(x)
x
(x)
(x)
x
x
x
x
x
(x)
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
N.P.V.
show referenced workings.
PAper F9
Revision Notes
INVESTMENT APPRAISAL NOTES

Relevant costs:
*
Looking for all future cash flow effects on the company
Sunk cost: money already spent not relevant
Opportunity cost: lost income as a result of doing the project is relevant
Timing of flows:
*
Time 1 is one year from now (not a one year period)
Initial cost of project is at time 0 (now); the first years operating flows are assumed to be at the end of the
first year, i.e. Time 1 (unless told different)
Working capital:
*
Usually required immediately outflow at time 0
Assume it all comes back inflow at the end of the project (unless told different)
Inflation:
*
Inflate cash flows by multiplying by (1+i) each year
If told the flow is at current prices then inflate in first year and each year thereafter
If told the amount of the flow in the first year, then only inflate in second year onwards
Taxation:
*
Calculate tax on operating flows, and tax saved on capital allowances separately
If machine is bought on the first day of an accounting period then the first capital allowance saving is at
time 2 (assuming the standard one year delay in payment of tax applies)
If machine is bought on the last day of an accounting period then the first capital allowance saving is at
time 1 (assuming the standard one year delay in payment of tax applies)
If not given date of purchase of machine, then assume it is bought on the first day of an accounting
period (but state assumption)
Long / short project:

*
Usually project is 4 or 5 years short project. In this case set up columns for time 0, time 1 etc., List flows
for each year, and discount each year separately
If project is 10 or 15 years long project then use annuity discount factors
PAper F9
Revision Notes
INVESTMENT APPRAISAL
ACCOUNTING RATE OF RETURN:
Average Profit p.a.
Average Investment
100%
Important because looks at effect on published accounts - shareholders look at Return on Capital
Employed.
Target: current Return on Capital Employed
PAYBACK PERIOD:
*
Time taken to recover cash invested
Important
a) if company has liquidity problems
b) the shorter the payback period the less worried about uncertainty of future flows.
DISCOUNTED CASH FLOW:

*
Normally NPV: discount cash flows at cost of capital (cost of borrowing)
Important because looks at cash flows, and cash (not profits) are needed to expand the company and to
pay dividends
IRR (breakeven discount rate for zero NPV) is useful to give a margin for error if unsure of Cost of Capital
PAper F9
Revision Notes
VALUATION OF DEBT
Example 1
D plc has in issue 8% irredeemable debentures.
Investors required return is 10%
What is Market Value of debt?
mkt. value =
0.10
= $80 p.c.
Example 2
E plc has in issue 6% debentures, convertible in 4 years time to 20 shares in the company. Debenture holders
required rate of return is 8%. Currently the share price is $3.50 per share and it is expected to increase to $5.80 per
share in 4 years time.
(a)
What is market value of the debentures?
(b) What is the interest yield?
Answer
(a) In 4 years time, investors either take cash of $100 or 20 shares expected to be worth 20 x $5.80 = $116.
Therefore they expect to convert
On $100 nominal
1 4 Interest
4 Redemption
(b)
Interest yield =
d.f. at 8%
6p.a.
116
105.13
3.312
0.735
Mkt value
PV
19.87
85.26
$105.13 p.c.
x 100% = 5.71%
PAper F9
Revision Notes
SOURCES OF FINANCE: RIGHTS ISSUES

The current market value of shares in W plc is $4.50 per share.
They make a 1 for 4 rights issue at $3.
(i)
what will be the theoretical ex-rights price?
(ii) what will be the value of the rights?
Answers
(i)
Existing
Rights
4shares x
1share
5shares
$4.50 =
costs
Theoretical ex-rights market value =

(ii)
Ex-rights market value

Cost of rights
Value of right
or
18.00
3.00
$21.00
21
= $4.20 per share
5
4.20
3.00
$1.20 per new share
$1.20
= $0.30 per existing share
4
PAper F9
Revision Notes
SHARE VALUATION
(a) The required return of shareholders in B plc is 12%. B pays a constant dividend of 30c per share.

What is the market value of shares in B?
P0 =
(b) (i)

D0 (1 + g)
30
=
= $2.50 per share
re g
0.12
The dividends per share of K plc over the past 5 years have been as follows:
1997 10c
1998 9c
1999 12c
2000 12c
2001 13c
What is the average rate of growth per annum?
1+ g = 4
13
= 1.068
10
g = average rate of growth = 6.8% p.a.
(ii) What will the market value be of shares in K plc if the shareholders required rate of return is
14%. (assuming now is 2001)
P0 =
D0 (1 + g)
=
re g
13 (1.068)
0.14 0.068
= $1.93 per share
PAper F9
Revision Notes
SOURCES OF FINANCE
CONSIDERATIONS:
*
EXPENSE OF RAISING MONEY (issue costs)
LOSS OF CONTROL (`DILUTION OF OWNERSHIP) (any new shareholders?)
SECURITY REQUIRED (has the company any security to offer?)
MARKETABILITY (how easy will it be for the investor to sell their shares or debt?)
MARKET LIQUIDITY (are funds available)
SIGNALLING/PERCEPTION (how will the market react)
INTEREST/DIVIDEND COST
EFFECT ON GEARING (RISK)
MATCH LENGTH OF BORROWING TO LIFE OF ASSET
(dont finance fixed assets with a short term overdraft)
PAper F9
Revision Notes
SOURCES OF FINANCE: EQUITY

(less gearing!!)
NEW ISSUE: expensive /Loss of Control/ Difficult for private company/ May be the only way to
raise large amounts / AIM
RIGHTS ISSUE: Less expensive than new issue/ Shareholders have choice / less loss of control/
Signaling -boosts confidence.
REDUCE DIVIDEND:
(Retained earnings)
No issue cost / no loss of control / small amounts

signalling fall in dividend might worry shareholders
[BONUS/SCRIP ISSUES: Issue of free shares and so NOT a source of finance. However if market value of shares
is currently hight, a bonus issue will reduce the value. This can make it then easier to
issue new shares.]
SCRIP DIVIDEND Shareholders are given the choice of taking new shares instead of cash dividend.
This is a way of encouraging shareholders to leave cash in the company (a source of
finance) without needing to reduce the level of dividend announced.
PAper F9
Revision Notes
SOURCES OF FINANCE: DEBT

*
Cheap (less risk to lender + tax relief )
Higher gearing, therefore more risk for shareholders
BONDS
LOAN STOCK
DEBENTURES
Different names, but all debt!
ISSUE DEBT AT A DISCOUNT
e.g. $100 debentures issued at $95.
ZERO COUPON BONDS Issued at large discount on redemption value, but no interest. Good for start up companies.
FLOATING RATE DEBENTURES
Interest rate changes
CONVERTIBLE LOAN STOCK
Holders can convert to shares at a later date.
SECURED / UNSECURED
MEZZANINE FINANCE
If secured on property, then MORTGAGE LOAN.
Unsecured loans
PAper F9
Revision Notes
SOURCES OF FINANCE: OTHER SOURCES

PRIVATE LOANS:
For small private companies / wealthy relative!!
VENTURE CAPITAL:
Usually for short-term in new company.
(BUSINESS ANGEL)
Usually equity.
Aim is to go on stock-exchange in (say) 5 years and for venture capitalist to
leave (sell shares) at a profit!
LEASING /SALE & LEASEBACK
gearing effect
GRANTS Regional/ Government/ E.U.
REDUCTION IN WORKING CAPITAL
SALE OF ANY SURPLUS FIXED ASSETS
PAper F9
Revision Notes
STOCK EXCHANGE TERMINOLOGY

Shares: Dividend per share

Earnings per share
Dividend Yield
Dividend cover
PE ratio
Debt:
Coupon rate
Interest yield
Redemption yield
Gilts

Relevance of gilts
Yield curve
PAper F9
Revision Notes
EFFICIENT MARKET HYPOTHESIS

At any point in time, the value of a share is based on shareholders expectations from the company in the future.
How accurate the share price is depends on how much information the shareholders have on which to base their
expectations.
STRONG FORM EFFICIENT
Shareholders have access to all

relevant information (whether or not
it has been published)
so share price reacts to every

decision made by company
SEMI-STRONG FORM
Shareholders have access to all

information that has been published
so share price reacts

whenever company makes an
announcement
WEAK FORM
Shareholders have access to no

information except the published
accounts.
so share price only reacts after

results are published, Any other
movements are at random
PAper F9
Revision Notes
BUSINESS VALUATION
Net assets basis:
Value the business at the value of its net assets.
Book values
Realisable values
Replacement values
But: problem with goodwill etc..
PE ratio basis:
Multiply the current earnings by the PE of a company in a similar business
But: assumes company has similar expected rate of growth, and if unquoted value needs to be reduced (shares less
attractive because not as easily traded)
Dividend growth formula:

Use the formula on the formula sheet
But: how to estimate future growth rate
PAper F9
Revision Notes
FINANCIAL GEARING
Example:
Current position:
Profits
Debt interest
If profit falls 10%

Company
A
200
40
Available for
shareholders
Fall in dividend
Company
B
200
100
$160
A=
B=
Profits
Debt interest
Available for
shareholders
$100
Higher gearing more fixed payments
If company is doing well, there is a multiplier effect: more profit bigger increase for shareholders
BUT more risk, if profits fall
Gearing ratio =
$140
Company
B
180
100
$80
20
100% = 12.5%
160
20
100% = 20%
100
Long term debt

Equity
(shareholders funds)
Company
A
180
40
or
Long term debt

Equity + Debt
Book values or Market values? Should use Market Values, but sometimes only Book Values available.
PAper F9
Revision Notes
OPERATING GEARING
Current:
A
$100,000
20,000
60,000
$80,000
$20,000
Sales
Variable costs
Fixed costs
Profit
Fall in profits:
B
$100,000
60,000
20,000
$80,000
$20,000
If sales fall by 20%

Co.A
Co. B
$80,000
$80,000
16,000
48,000
60,000
20,000
$76,000
$68,000
$4,000
$12,000
16,000
100% = 80%
20,000
8,000
100% = 40%
B=
20,000
A=
If sales increase then there is a bigger increase in profits

(`multiplier effect)
BUT
- more risk if sales fall
- higher breakeven if higher operating gearing
Measure
either:
Fixed costs
Total costs
or:
Fixed costs
Variable costs
PAper F9
Revision Notes
THEORIES OF GEARING
Debt finance is cheaper than equity finance because it is less risky (so investors require a lower return) and the
interest payments are allowable for tax, making the cost of debt to the company lower.
As a company introduces more debt finance (higher gearing), the risk to shareholders increases, and therefore
shareholders will require a higher return, thus increasing the cost of equity to the company.
Traditional theory
The weighted average cost of capital (WACC) will change with different levels of gearing. The company should aim
for the level of gearing that reduces the WACC to a minimum level.
Modigliani and Miller - without taxes.
The level of gearing has no effect on the WACC - it will be the same for all levels of gearing.
It is therefore irrelevant how a company raises finance. There is no optimum level of gearing.
Modigliani and Miller - with company tax.
The WACC will fall with higher levels of gearing due to the fact that debt interest gets the benefit of tax relief.
A company should be as highly geared as possible.
PAper F9
Revision Notes
CAPITAL ASSET PRICING MODEL GEARED / UNGEARED s

Equity (geared ) measures the risk of a share, but includes the effect of gearing.
Asset (ungeared ) measures the risk of the business (ignoring the effect of gearing).
Example 1
The of a share in X plc is 1.4.
X has a gearing ratio (debt to equity) of 0.4.
What is the asset for X?
(Tax is 30%)
Example 2
Y plc has a gearing ratio (debt to total long term capital) of 0.5.
A company operating a similar business, Z plc, has an equity of 1.1 and a gearing ratio (debt to total long term
capital) of 0.3.
The risk free interest rate is 5%, the market return is 12%, and the tax rate is 30%.
Estimate a cost of equity for Y plc.
Answer 1
ve
e
ve + vd(1 T)
=
100
x 1.4
100 + 40 (1 0.3)
=1.09375
a =
Answer 2
Asset of Z:
ve
e
ve + vd(1 T)
=
70
x 1.1
70 + 30 (1 0.3)
=0.846
a =
50
50 + 50 (1 0.3) e
e =1.438
Equity of Y : 0.846 =
Cost of equity for Y = 5% + 1.438 x (12% 5%) = 15.07%
PAper F9
Revision Notes
CAPM FORMULA
E (ri) = Rf + i [E (rm) Rf ]
[given]
Example 1
If there is a market premium for risk of 12% and the risk free rate is 6%, what is the required return on a share with
an equity beta of 1.5?
Example 2
If market return is 10% and the risk rate is 5%, what is the required rate of return, kd, on debt which has a debt beta
of 0.3? What is the cost of debt to the company if tax rate is 33%?
[In words, measures the systematic risk of an investment relative to the market (stock exchange) as a whole. of
1.2 means that the investment is 1.2 times as risky (volatile) as the market. Or that fluctuations in returns will be 1.2
times as great.]
Answer 1
Required return = 6% + (1.5 x 12%) = 24%
Answer 2
Required return = 5% + (0.37 x (10% 5%)) = 6.85%
Cost of debt = 6.85% x (1 0.33) = 4.59%
PAper F9
Revision Notes
CAPITAL ASSET PRICING MODEL

SUMMARY
*
If shareholders are well-diversified then they are only concerned with the systematic risk of investments.
Therefore (for large quoted companies where we assume shareholders overall are well-diversified) it is
the systematic risk that determines the required return (and therefore the Cost of Equity)
When appraising new investments, it is the systematic risk of the investment that that should therefore
determine the appraisal rate.
Systematic risk is usually measured relative to the risk of the market (stock exchange as a whole) and
quoted as a factor.
( of 0.8 means investment is 80% as risky as the market)
PAper F9
Revision Notes
LIMITATIONS OF CAPM.
*
Assumes investors have well-diversified portfolios
Perfect capital market

-
-
-
-
rational investors
perfect information
no transaction costs
investors can invest/borrow at same rate of interest
Single-period model
Estimates of risk free return

market return
factor
PAper F9
Revision Notes
FOREIGN EXCHANGE
Methods of reducing exchange risk:
*
Invoice in own currency
Leading and Lagging
Netting
Matching
Forward contracts
Money markets
Futures
Options
PAper F9
Revision Notes
EXCHANGE RATES - PREDICTING FUTURE SPOT RATES

Purchasing power parity
S1 = S0
(1+ hc )
(1+ hb )
where hb is the inflation rate in the home (base) country,

hc is the inflation rate in the other country
Interest rate parity
In theory, interest rates move with inflation rates. Therefore, same formula with i = interest rate.
For exam:
for predicting future spot rates, inflation rates (if available) are better
Example
Current spot rate 1.52 $/
Inflation:
US 4% p.a.
UK 2% p.a.
What will be the spot rate in 1 and 2 years time?
Answer
Spot rate in 1 year = 1.52 x
1.04
= $1.55
1.02
Spot rate in 2 years = 1.52 x (1.04/1.02)2 = $1.58
PAper F9
Revision Notes
EXCHANGE RATE RISK Forward Contract

Example
1 January, UK exporter sells to US customer for $10M on 3 months credit.
$/ 1.4700 0.0005
Spot US
3m forward
$/ 1.4658 0.0006
$/ 1.4634 0.0004
6m forward
Answer
3m forward rates: 1.4652 1.4664
Transaction in 3 months time:
$10M 1.4664 = 6819422 (receipt)
PAper F9
Revision Notes
EXCHANGE RATE RISK MONEY MARKET

Example
UK company to receive $100K in 3 months time.
Current 3 months interest rates:

US 2.7% (p.a.) UK 1.8% (p.a.)
Current exchange rate $1.47 to
How can company hedge against exchange rate risk?
[Note: to get quarterly interest rate, divide annual rate by four.
No need to allow for compounding effect.]
Answer
Borrow $s at 2.7 x 3/12 = 0.675%

$100,000 1.00675 = $99,330
Convert $99,330 to s at spot

99,330 1.47 = 67,571
Deposit s at 1.8 x 3/12 = 0.45%

67571 x 1.0045 = 67,875 (fixed receipt in 3 months)
PAper F9
Revision Notes
COST OF CAPITAL
Equity
(not given)
ke =
D 0 (1+ g)
+ g
P0
(shareholders required return = cost of equity)
Debt
I
(not given) k d = (irredeemable)
P0

or IRR of flows (redeemable)

(debt lenders required return)

Cost of debt = k d (1 T ) or
I(1 T )
(assuming debt intterest tax allowable)
P0
Weighted average
(given)
WACC =
Ve
Ve
ke +
k d (1 T )
Ve + Vd
Ve + Vd
[But strictly the formula for WACC is only correct for irredeemable debt. If debt is redeemable then kd(1-t)
should be replaced by the IRR of the after-tax cash flows]
Dividend growth rate

(not given) Growth in dividends:
Depending on the information given,
Either:
Average growth rate of past dividends
D
g = n n 1
D0

or: g = rb

(b = rate of retention

r = rate of return on re-investment)
PAper F9
Revision Notes
COST OF CAPITAL (Example )

A company is financed as follows:
Equity:
Debt:
5M $0.10 shares quoted at $0.37 ex div.

$2M 8% loan stock quoted at 95 pc ex int, redeemable at par in 5 years time
The company has paid dividends over the past 5 years as follows (current years dividend first): $250,000; $240,000;
$220,000; $218,000; $200,000
Calculate the WACC of company
(Corporation Tax is 30%; ignore Income Tax)
Answer
Dividend growth rate
250,000
1+ g = 4
= 1.0574
200,000

g = 5.74% p.a.
Cost of equity =
D0(1 + g)
+g
P0
= 5(1.0574)
+ 0.0574
37
= 0.20 / 20%
Cost of debt
0
1 5
5
(95)
1
5.6 p.a. 3.791
100
0.621
Cost of debt = IRR = 5% +
PV @ 10%
(95)
21.23
62.10
(11.67)
1
4.329
0.784
PV @ 10%
(95)
24.24
78.40
7.64
7.64
5% = 6.98%
19.31
W.A.C.C.
Mkt Value
Equity
1.85M
Debt
1.9M
3.75M
Cost
1.85
= 9.87
3.75
1.9
= 3.54
6.98% x
3.75
WACC 13.41%
20% x
PAper F9
Revision Notes
Sources of finance islamic finance

Under the principles of Islamic law, wealth must be generated from legitimate trade and asset-based investment.
Also, investments must have a social and ethical benefit. Speculative investments are not allowed, and investments
in such areas as alcohol and gambling are forbidden.
Riba
As a consequence of the laws regarding the generation of wealth, it is strictly forbidden to use money for the
purpose of making money i.e. it is forbidden to charge interest (riba).
Financial institutions cannot therefore make money by charging interest, but instead provide services for a fee or
enter into a form of agreement with the client in which the risk and the profits or losses are shared between the
institution and the client.
Islamic financial instruments

You should be aware of the following Islamic financial instruments and be able to briefly discuss them:
Murabaha
This is effectively a form of credit sale, where the customer receives the goods but pays for them later on a fixed
date.
However, instead of charging interest, a fixed price is agreed before delivery the mark-up effectively including the
time value of money.
Ijara
This is effectively a lease, where the lessee pays rent to the lessor to use the asset.
Depending on the agreement, at the end ot he rental period the lessor might take back the asset (effectively an
operating lease) or might sell it to the lessee (effectively a finance lease Ijara-wa-Iqtina).
Whatever the agreement, the lessor remains the owner of the asset and is responsible for maintenance and
insurance, thus incurring the risk of ownership.
Muduraba
This is similar to equity finance, or a special kind of partnership. The investor provides capital and the business
partner runs the business. Profits are shared between both parties, but all losses are attributable to the investor
(limited to the capital provided).
Musharaka
This again is similar to a partnership, but here both parties provide both capital and expertise. Profits are shared
between the parties according to whatever ratio is agreed in the contract, but losses are shared in proportion to
the capital contributions.
It is regarded as being similar to venture capital.
Sukuk
This is the equivalent of debt finance (Islamic bonds).
Sukuk must have an underlying tangible asset, and the holders of the Sukuk certificates have ownership of a
proportional share of the asset, sharing revenues from the asset but also sharing the ownership risk.
An example may be where the financial institution purchases a property financed by Sukuk certificates and rents it
out at fixed rent. The certificate holders receive a share of the rent (instead of interest) and a share of the eventual
sale proceeds.
The Sukuk manager is responsible for managing the assets on behalf of the Sukuk holders (and can charge a fee).
The Sukuk holders have the right to dismiss the manager.
(Although there can be a secondary market as with conventional debt (the purchase and sale of certificates on the
stock exchange) it is currently very small. Most Sukuk are bought and held virtually all of any trading is done by
institutions.)
PAper F9
Revision Notes
Lease versus Buy

Example
A company is considering whether to buy a new machine at a cost of $100,000 or alternatively to lease it for
$35,000 p.a. (lease payments payable at the start of each year).
Buying it will involve borrowing money at an after tax interest cost of 7% p.a.
If the machine is bought, it will be bought on the last day of current financial year.
The machine will be needed for 4 years, and (if purchased) will have a scrap value after 4 years of $10,000.
Corporation Tax is 30% (payable one year after the end of the financial year)
Capital allowances are 25% (reducing balance).
Should the machine be leased or purchased?
Answer
Lease
Lease payments
Tax saving at 30%
d.f. at 7%
Present value
0
1
2
3
(35,000) (35,000) (35,000) (35,000)
10,500 10,500
(35,000) (35,000) (24,500) (24,500)
1
0.935
0.873
0.816
(35,000) (32,725) (21,389) (19,992)
(93,607)
10,500
10,500
0.763
8,012
10,500
10,500
0.713
7,487
Buy
Cost
Scrap
Tax saving on capital allowances
d.f. at 7%
Present value
0
(100,000)
(100,000)
1
(100,000)
7,500
(7,500)
0.935
7,013
5,625
(5,625)
0.873
4,911
(69,960)
4,219
4,219
0.816
3,443
10,000
13,164
0,763
0.763
10,044
6,492
6,492
0.713
4,629
Cheaper to buy the machine
PAper F9
Revision Notes
Formulae Sheet
Economic order quantity
2C0D
CH
Miller Orr Model

Return point = Lower limit + (
1
spread)
3
1
3 transaction cost variance of cash flows 3
Spread = 3 4
interest rate
The Capital Asset Pricing Model
(( ) )
()
E ri = Rf + i E rm Rf
The asset beta formula
Vd 1 T
Ve
a =
e +
d
V
+
V
T
V
V
1
+
1
T
d
d
e
e
))
))
The Growth Model

Po =
D0 1 + g
(r
Gordons growth approximation

g = bre
The weighted average cost of capital
V
e
d
ke +
k 1 T
WACC =
Ve + Vd
Ve + Vd d
The Fisher formula
(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity
S1 = S0
(1 + h )
(1 + h )
c
F0 = S0
(1 + i )
(1 + i )
c
PAper F9
Revision Notes
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
2
3
4
5
0990
0980
0971
0961
0951
0980
0961
0942
0924
0906
0971
0943
0915
0888
0863
0962
0925
0889
0855
0822
0952
0907
0864
0823
0784
0943
0890
0840
0792
0747
0935
0873
0816
0763
0713
0926
0857
0794
0735
0681
0917
0842
0772
0708
0650
0909
0826
0751
0683
0621
1
2
3
4
5
6
7
8
9
10
0942
0933
0923
0941
0905
0888
0871
0853
0837
0820
0837
0813
0789
0766
0744
0790
0760
0731
0703
0676
0746
0711
0677
0645
0614
0705
0665
0627
0592
0558
0666
0623
0582
0544
0508
0630
0583
0540
0500
0463
0596
0547
0502
0460
0422
0564
0513
0467
0424
0386
6
7
8
9
10
11
12
13
14
15
0896
0887
0879
0870
0861
0804
0788
0773
0758
0743
0722
0701
0681
0661
0642
0650
0625
0601
0577
0555
0585
0557
0530
0505
0481
0527
0497
0469
0442
0417
0475
0444
0415
0388
0362
0429
0397
0368
0340
0315
0388
0356
0326
0299
0275
0305
0319
0290
0263
0239
11
12
13
14
15
(n)
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
2
3
4
5
0901
0812
0731
0659
0593
0893
0797
0712
0636
0567
0885
0783
0693
0613
0543
0877
0769
0675
0592
0519
0870
0756
0658
0572
0497
0862
0743
0641
0552
0476
0855
0731
0624
0534
0456
0847
0718
0609
0516
0437
0840
0706
0593
0499
0419
0833
0694
0579
0482
0402
1
2
3
4
5
6
7
8
9
10
0535
0482
0434
0391
0352
0507
0452
0404
0361
0322
0480
0425
0376
0333
0295
0456
0400
0351
0308
0270
0432
0376
0327
0284
0247
0410
0354
0305
0263
0227
0390
0333
0285
0243
0208
0370
0314
0266
0225
0191
0352
0296
0249
0209
0176
0335
0279
0233
0194
0162
6
7
8
9
10
11
12
13
14
15
0317
0286
0258
0232
0209
0287
0257
0229
0205
0183
0261
0231
0204
0181
0160
0237
0208
0182
0160
0140
0215
0187
0163
0141
0123
0195
0168
0145
0125
0108
0178
0152
0130
0111
0095
0162
0137
0116
0099
0084
0148
0124
0104
0088
0074
0135
0112
0093
0078
0065
11
12
13
14
15
[P.T.O.
PAper F9
Revision Notes
Annuity Table
(1 + r)n
Present value of an annuity of 1 i.e. 1
r
Where
r = discount rate
n = number of periods
Discount rate (r)
Periods
(n)
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
2
3
4
5
0990
1970
2941
3902
4853
0980
1942
2884
3808
4713
0971
1913
2829
3717
4580
0962
1886
2775
3630
4452
0952
1859
2723
3546
4329
0943
1833
2673
3465
4212
0935
1808
2624
3387
4100
0926
1783
2577
3312
3993
0917
1759
2531
3240
3890
0909
1736
2487
3170
3791
1
2
3
4
5
6
7
8
9
10
5795
6728
7652
8566
9471
5601
6472
7325
8162
8983
5417
6230
7020
7786
8530
5242
6002
6733
7435
8111
5076
5786
6463
7108
7722
4917
5582
6210
6802
7360
4767
5389
5971
6515
7024
4623
5206
5747
6247
6710
4486
5033
5535
5995
6418
4355
4868
5335
5759
6145
6
7
8
9
10
11
12
13
14
15
1037
1126
1213
1300
1387
9787
1058
1135
1211
1285
9253
9954
1063
1130
1194
8760
9385
9986
1056
1112
8306
8863
9394
9899
1038
7887
8384
8853
9295
9712
7499
7943
8358
8745
9108
7139
7536
7904
8244
8559
6805
7161
7487
7786
8061
6495
6814
7103
7367
7606
11
12
13
14
15
(n)
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
2
3
4
5
0901
1713
2444
3102
3696
0893
1690
2402
3037
3605
0885
1668
2361
2974
3517
0877
1647
2322
2914
3433
0870
1626
2283
2855
3352
0862
1605
2246
2798
3274
0855
1585
2210
2743
3199
0847
1566
2174
2690
3127
0840
1547
2140
2639
3058
0833
1528
2106
2589
2991
1
2
3
4
5
6
7
8
9
10
4231
4712
5146
5537
5889
4111
4564
4968
5328
5650
3998
4423
4799
5132
5426
3889
4288
4639
4946
5216
3784
4160
4487
4772
5019
3685
4039
4344
4607
4833
3589
3922
4207
4451
4659
3498
3812
4078
4303
4494
3410
3706
3954
4163
4339
3326
3605
3837
4031
4192
6
7
8
9
10
11
12
13
14
15
6207
6492
6750
6982
7191
5938
6194
6424
6628
6811
5687
5918
6122
6302
6462
5453
5660
5842
6002
6142
5234
5421
5583
5724
5847
5029
5197
5342
5468
5575
4836
4988
5118
5229
5324
4656
4793
4910
5008
5092
4486
4611
4715
4802
4876
4327
4439
4533
4611
4675
11
12
13
14
15
End of Question Paper

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PAper F9

WORKING CAPITAL (1)

Competitors offer credit

Raw materials to avoid break in production

Work-in-progress due to length of production process

Finished Goods to avoid turning away customers

Transaction motive to pay bills

BUT COSTS ATTACHED:

inventory costs; obsolescence

AND OVERALL COST:

extra money borrowed to finance working capital

WORKING CAPITAL (2)

Efficient debt collection

Factor debts (BUT COST)

Offer discount for early payment (BUT COST)

Proper credit checks before giving credit

Economic Order Quantity

Proper cash budgeting

Investment of surplus balances (`Treasury function)

WORKING CAPITAL MEASURES (1)

[Higher sales should mean

[Higher fixed assets `need

WORKING CAPITAL MEASURES (2)

Receivables days + Inventory holding period Payables days

PRO FORMA CASH BUDGET

Net cash inflow/(outflow)

THE FUNDING OF WORKING CAPITAL

JUST-IN-TIME INVENTORY MANAGEMENT

The main steps in order to achieve this are:

total quality management

frequent, guaranteed deliveries of raw materials

WORKING CAPITAL ARITHMETIC (1) RECEIVABLES

Should the company employ the factor?

Factors cost (1% x $2.5M)

Average receivables currently

Average receivables = 2.4/12 x $2.5M = $500,000

Average receivables = 0.6/12 x $2.5M = $125,000

WORKING CAPITAL ARITHMETIC (2) Inventory

Total cost at EOQ

Total cost at 200 units

Total cost at 500 units

Best is to order 200 units each time

WORKING CAPITAL ARITHMETIC (3) CASH

Upper limit = 10,000 + 4,750 = $14,750

DISCOUNTED CASH FLOW INFLATION AND TAX

50,000 units p.a.

Cost card for first year:

Revenue and materials will increase at the rate of 5% p.a..

DISCOUNTED CASH FLOW INFLATION AND TAX (Answer)

Sales units p.a.:

Fixed costs p.a.:

There is only $8500 available for investment at time 0.

HARD capital rationing

DCF AND REPLACEMENT

DCF AND REPLACEMENT (AnsweR)

Equivalent cost (EAC) =

Equivalent cost (EAC) =

Equivalent cost (EAC) =

Best is to replace every 2 years

DISCOUNTING WITH INFLATION

Actual cash flows

Discount current price flows at effective (real) Cost of Capital.

Either approach is accepted

PAper F9