F9 All notes

Financial Management Function

Nature and Purpose
Purpose of Financial Management

Financial management is getting and using financial resources well to

meet objectives

Financial objectives

Profit maximisation is often assumed, incorrectly, to be the main objective of a business.

Reasons why profit is not a sufficient objective:

1. Investors care about the future

2. Investors care about the dividend

3. Investors care about financing plans

4. Investors care about risk management

For a profit-making company, a better objective is the maximisation of shareholder wealth;

this can be measured as total shareholder return (dividend yield + capital gain).

Key decisions:

1. Investment

(in projects or takeovers or working capital) need to be analysed to ensure that they are beneficial to the investor.

Investments can help a firm maintain strong future cash flows by the achievement of key corporate objectives
 e.g. market share, quality.

2. Finance

mainly focus on how much debt a firm is planning to use.

The level of gearing that is appropriate for a business depends on a number of practical issues:

Life cycle - A new, growing business will find it difficult to forecast cash flows with any certainty so high levels of gearing are
unwise.

Operating gearing- If fixed costs are a high proportion of total costs then cash flows will be volatile; so high gearing is not
sensible.

Stability of revenue- If operating in a highly dynamic business environment then high gearing is not sensible.

Security- If unable to offer security then debt will be difficult and expensive to obtain.

3. Dividends

how returns should be given to shareholders

4. Risk management

mainly involve management of exchange rate and interest rate risk and project management issues.

Key Objectives of Financial Management

Taking a commercial business as the most common organisational structure, the key objectives of financial management would
be to:

Create wealth for the business

Generate cash, and

Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested

3 key elements to the process of financial management

1. Financial Planning
 Management need to ensure that enough funding is available at the right time to meet the needs of the business.

In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit.

In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to
make acquisitions.

2. Financial Control

Financial control is a critically important activity to help the business ensure that the business is meeting its objectives.

Financial control addresses questions such as:

• Are assets being used efficiently?

• Are the businesses assets secure?
• Do management act in the best interest of shareholders and in accordance with business rules?

3. Financial Decision-making

The key aspects of financial decision-making relate to investment, financing and dividends:

• Investments must be financed in some way – however there are always financing alternatives that can be considered.

For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers

• A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via
dividends.

If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further

Financial management, financial and management accounting.

The relationship between financial management, financial and

management accounting

Financial Management

Looks at long term raising of finance and the control of resources.

Financial accounting
 Gives information about past events generally.

It is required legally and is determined by accounting standards.

Looks at the business as a whole

Management accounting

Provides information for day to day decisions generally, to aid management.

No strict rules or format.

Can focus on specific areas of business

Financial objectives and corporate strategy

Shareholder wealth maximisation (share price)

Maximisation of shareholder wealth is measured by the share price (if the company is listed of course). This is because the share
price is simply the value of all future dividends coming to the shareholders.

However, sometimes a business reports a profit increase and the share price falls due to the manner in which they made the
profit. This suggests that that profit is not sufficient as a business objective

Share price could also rise and fall due to potential investment decisions or the fact that a new loan is being taken out or that
dividends are to be increased or lowered

Corporate Strategies

Clearly corporate strategies are wider than purely financial, they look at the business as a whole. Once these are set appropriate
financial objectives can then be set and measured

Examples include:

Return on investment
Market share
 Growth
Customer satisfaction
Quality

Financial Objectives

Examples include:

1. Profit Maximisation

Focusing on profits could mean undue risk and short termism.

Also there is the problem that profits can be manipulated using financial accounting, unlike cash.

So maybe profit maximisation focuses on financial profit too much and not enough on cash generation.

2. Earnings Per Share Growth

This still uses earnings (profits) rather than cash unfortunately.

EPS looks at the amount of profits made in the year for each individual share.

Remember it is the ORDINARY shareholders who are interested in EPS. Therefore EPS is:

Profit after tax - preference dividends / Weighted average Ordinary shares

Illustration

What is the EPS in each year?

Last year Current year

Profits before interest and tax 22,300 23,726

Interest 3,000 3,000

Tax 5,790 6,218

Profits after tax 13,510 14,508

 Preference dividends 200 200

Number of ordinary shares issued 100,000 100,000

Solution

Last year:

Earnings (13,510 - 200) = 13,310

EPS = Earnings 13,310 / Shares 100,000 = 13.31p

Current year

Earnings (14,508 - 200) = 14,308

EPS = Earnings 14,308 / Shares 100,000 = 14.31p

Stakeholder Objectives
Total Shareholder Return

It is the dividend per share plus capital gain divided by initial share price
NB Always use the opening share price as the denominator!

Stakeholders interests

Stakeholders and impact on corporate objectives

We have just seen that the primary objective of a company is the maximisation of shareholder wealth.

However, there is an alternative known as the stakeholder view.

This means balancing shareholder wealth with the objectives of other stakeholders.

Let’s have a look at some stakeholders and their objectives:

Stakeholder Objective

Staff High salaries; safe job

Managers High bonuses

Shareholders High share price; dividend growth

 Banks Minimise company risk

Customer Quality service

Suppliers Good liquidity

Government Good accounting records; Training initiatives

Clearly meeting all stakeholders objectives entirely is impossible.

Often they are in conflict with each other. Therefore a degree of compromise is reached.

For example, Performance related pay for example is a means of satisfying both staff and shareholders.

There is a fundamental problem highlighted here. The owners of the business are generally not those who manage the business.

As both parties have different objectives this causes a problem.

The danger that managers may not act in the best interest of the owners is known as….

The Agency Problem

The managers are acting as agents for the owners.

So how can the owners ensure that the agents are working for the owners objectives and not just their own?

1. Fixed wages

Not always the optimal way to organise relationships between principals and agents.

A fixed wage might create an incentive for the agent to shirk since his compensation will be the same regardless of the quality of
his work or his effort level.

2. Performance related Pay

When agents have incentive to shirk, it is often more efficient to replace fixed wages with compensation based on the profits of
the firm, since it makes their compensation dependent on their performance.

However this can lead to individuals not working for the team as a whole by inflating budgets required etc.

Output may also be encouraged rather than quality. It disregards job satisfaction also

3. Share options

Seems like a great idea as if the share price goes up then both the managers and the owners benefit.
 However often shares go up and down in line with market movements regardless of how well the managers have performed so
many managers would not like to be measured and paid solely this way.

Some element of share options within their pay though would be a good thing and acceptable by all

Corporate Governance & Stakeholders

Stakeholders and Maximising Shareholder Wealth

Regulatory Requirements

These can be imposed through corporate governance codes of best practice and stock market listing regulations

CG codes try to reduce risk and increase directors accountability

CG codes ensure directors have to identify, assess and manage risks

CG codes ensure a balanced perspective by requiring NEDs on the audit, nominations and remuneration committees

Stock exchange listings ensure financial reports are produced annually

Stock exchange listings ensure that detailed information is given about directors pay

Stock exchange listings ensure companies pay attention to their corporate social responsibilities

Future prospects should be communicated to stakeholders

To show the company has enough working capital for its current needs and for at least the next 12 months
 A general description of the future plans and prospects must be given

Audited historical financial information covering latest three full years and any published later interim period

50% of board to be NEDs

Corporate governance - Best practice

Although UK corporate governance rules do not apply to the non-UK companies, investors would expect similar standard,
and an explanation for any differences.

UK companies are expected to:

Splitting the roles of Chairman and CEO

Have an independent audit committee, a remuneration committee and a nomination committee

Provide evidence of a high standard of financial controls and accounting system

SMEs and stakeholder interests

Here, often, shareholders are not different from directors

Differences to a listed company

1. Often Family owned

2. Often no separation between management and owners

3. Little differences between owner and director objectives

4. Smaller number of shareholders - who are often in contact with the company - so conflict less likely
In a listed Company it's different..

Objectives of shareholders and directors may be different

Asymmetry of information

Shareholders get less info than directors, making monitoring harder

A separation between ownership and control

Shareholders and directors are different people

Myopic Management

Managers are often accused of focusing on short-term rather than long-

term performance

This means possibly choosing quick returns over slower, but ultimately higher, one.

Problems caused by Myopic Management

1. Reduced investment returns

2. Destruction of shareholder value

3. Business collapses

4. Undermining of corporate governance

5. A loss of public trust in large businesses

6. A growing sense of unfairness in the way in which society is organised

Why focus on the short term?

1. Managers have a different time horizon to that of shareholders

2. eg bonuses based on short-term share performance

3. eg share options are about to mature

4. If contracts are short then managers will look to excel in that short period

What are the symptoms of a short-term approach?

Little R&D expenditure

Little training expenditure

Less spent on marketing / brand building

Frequent reporting of profits can intensify the pressure on managers to achieve quick results

Ratios can add to the problem

ROCE and ROI focus on the EFFICIENCY of capital investment - not the long term profitability

These ratios actually get worse when money is invested in assets

Similarly ratios that have a % output such as IRR, can make a short term focus

(Whereas NPV gives an absolute figure over the lifetime)

Efficient Market Hypothesis

EMH states that in an efficient market, the value of a share should reflect the long-term future cash flows of the share

However, stock markets are not always efficient and shareholders are not always rational when making investment decisions.

This can be seen in speculative share price bubbles and extended ‘bull’ runs in share prices

Remedies

These include

1. Management rewards and contracts

Share options with longer vesting periods

Fewer bonuses based on annual profits
Use non-financial targets as the basis for rewards
Longer contracts

2. The behaviour of shareholders

A loyalty dividend for those who hold shares for a long time
Rewards for fund managers linked to long-term performance
Additional reporting of long-term prospects in the annual accounts

3. Corporate governance

Get institutional shareholders to actively engage in corporate governance

Additional voting rights for long-term shareholders
4. Taxation policy

Introducing a tax on the transfer of shares

Higher rates of capital gains tax to deter shareholders from selling

Be careful of the remedies though!

Taxing shares transfer effects every trade even those with low volatility

Higher capital gains tax on selling shares may damage market liquidity

Not for Profit Objectives

Not for Profit objectives

Their mission permeates the way they do business

Primary goal is NOT shareholder wealth

A not-for-profit organisation’s primary goal is not to increase shareholder value; rather it is to provide some socially
desirable need on an ongoing basis.

A not-for-profit generally lacks the financial flexibility of a commercial enterprise because it depends on resource providers
who often gain no tangible benefit themselves.

Stewardship of resources given to it is more important

Thus the not-for- profit must demonstrate its stewardship of donated resources — money donated for a specific purpose
must be used for that purpose.

That purpose is either specified by the donor or implied in the not-for-profit’s stated mission.
Budgeting and cash management is very Important

Budgeting and cash management are two areas of financial management that are extremely important exercises for not-
for-profit organisations.

The organisation must pay close attention to whether it has enough cash reserves to continue to provide services to its
clientele.

Cashflow and funding is unpredictable

Cash flow can be extremely challenging to predict, because an organisation relies on revenue from resource providers that do
not expect to receive the service provided.

In fact, an increase in demand for a not-for-profit’s services can lead to a management crisis.

Funding is therefore a key objective.

Objectives hard to quantify

The non financial objectives are often more important in not for profit organisations.

However, they are harder to quantify

eg Quality of care

Value for money as an NFP objective

Economy – Buy goods at minimum cost (still paying attention to quality)

Efficiency – Use these goods to maximise output
Effectiveness – Use these goods to achieves objectives

Another way of looking at these is:

Economy - ‘doing things at a low price’

Efficiency - ‘doing things the right way’
Effectiveness - ‘doing the right things’

A final way of looking at these is as input - process - output

 Inputs - Economy - get as cheap as possible given quality
Process - Efficiency - perform the process as efficiently as possible
Outputs - Effectiveness - These match the objectives set

Input driven - Try to get as much out given limited inputs e.g. library

Output driven - Maintaining standards even when output changes eg Prison service

Ways to measure NFP objectives

Ways to measure NFP objectives

Use non financial info

Non-financial information is often better able than straight financial data to measure and justify the intangible goals of Not
for Profits.

The high level of non-financial reporting will come at a cost, however, in terms of the time and other resources which it
necessitates.

Popular types include:

Key performance indicators

Statistics related to service or activity delivery and performance, such as client numbers, user numbers, enquiry numbers,
occupancy levels and similar;

The performance and development of human resources, both staff and volunteers
 Reporting on external trends, including social and environmental impacts, also political and economic developments

Other creative forms of non-financial reporting include statistics on website use, complaint numbers, analysis of media coverage,
and measuring board visibility and recognition.

Economic Environment
Fiscal Policy

Decisions relating to taxation and government spending with the aim of

full employment, price stability, and economic growth

Discussion:

By changing tax laws, the government can alter the amount of disposable income available to its taxpayers. If taxes
increased consumers would have less money to spend.

This difference in disposable income would go to the government instead of going to consumers, who would pass the
money onto companies.

Or, the government could increase its spending by purchasing goods from companies. This would increase the flow of
money through the economy and would eventually increase the disposable income available to consumers.

Unfortunately, this process takes time, as the money needs to wind its way through the economy, creating a significant lag
between the implementation of fiscal policy and its effect on the economy.

Governments can borrow:

• Short-term, e.g. Treasury bills

• Long-term, e.g. National Savings certificates.

This can have bad effects on the economy by ‘crowding out’ private investment by pushing up interest rates

BUT: government spending can also boost the economy

Economic environment intro

Economic environment

The four major objectives are:

1. Full employment

2. Price stability

3. A high, but sustainable, rate of economic growth

4. Keeping the Balance of Payments in equilibrium.

Full Employment

Full employment was considered very important after the Second World War.

Unemployment in the 80s was seen as an inevitable consequence of the steps taken to make industry more efficient.

De-industrialisation made higher unemployment feel inevitable, and so this objective became much less important than it
had been.

Growth & Low Inflation

Growth and low inflation have always been important.

Without growth peoples’ standard of living will not increase, and if inflation is too high then the value of money falls
negating any increase in living standards.

Sustainable growth means growth without inflation.

Balance of payments

The total of all the money coming into a country from abroad less all of the money going out of the country during the same
period.

Policies to reduce a BOP deficit:

1. Higher Interest Rates

- will act to slowdown the growth of consumer demand and therefore lead to cutbacks in the demand for imports.

2. Fiscal policy

(i.e. increases in direct taxes) might also be used to reduce aggregate demand.

The risk is that a sharp fall in consumer spending might lead to a steep economic slowdown (slower growth of GDP) or an full-
scale recession

Is a BOP Deficit a bad Thing?

Yes because….

1. A current account deficit is financed through borrowing or foreign investment

2. Borrowing is unsustainable in the long term and countries will be burdened with high interest payments.

E.g Russia was unable to pay its foreign debt back in 1998. Other developing countries have experience similar
repayment problems Brazil, African c (3rd World debt)

Foreigners have an increasing claim on home assets, which they could desire to be returned at any time.

E.g. a severe financial crisis in Japan may cause them to repatriate their investments

3. Export sector may be better at creating jobs

4. A Balance of Payments deficit may cause a loss of confidence

No because….

1. Current Account deficit could be used to finance investment

 E.g. US ran a Current account deficit for a long time as it borrowed to invest in its economy.

This enabled higher growth and so it was able to pay its debts back and countries had confidence in lending the US
money

2. Japanese investment has been good for the UK economy not only did the economy benefit from increased investment
but the Japanese firms also helped bring new working practices in which increased labour productivity.

3. With a floating exchange rate a large current account deficit should cause a devaluation which will help reduce the level
of the deficit

4. It depend on the size of the budget deficit as a % of GDP, for example the US trade deficit has nearly reached 5% of
GDP at this level it is concerning economists

5. It may well be offset by foreign investment

NOTE: do not confuse objectives of macroeconomic policy with the instruments used to achieve these aims.

Low inflation is an objective, the rate of interest is an instrument used to control inflation.

Monetary Policy

The regulation of the money supply and interest rates by a central bank
in order to control inflation and stabilise currency

The volume of money in circulation is called the money supply

The price of money is called interest rates

Discussion:

Monetary policy is one of the ways the government can impact the economy.

By impacting the effective cost of money, the government can affect the amount of money that is spent by consumers and
businesses.

1. Affect on Growth

When interest rates are high, fewer people and businesses can afford to borrow, so this usually slows the economy down.

Also, more people will save (if they can) because they receive more on their savings rate.

When the central banks set interest rates it is the amount they charge other banks to borrow money.

This is a critical interest rate, in that it affects the entire supply of money, and hence the health of the economy.

High interest rates can cause a recession.

2. Affect on Exchange rates

High interest rates attracts foreign investment ⇨ increase in exchange rates:

• exports dearer
• imports cheaper.

3. Effect on Inflation

High interest rates should restrict growth and inflation

Exchange Rate Policy

Policy of government towards the level of the exchange rate of its

currency
Discussion:

It may want to influence the exchange rate by using its gold and foreign currency reserves held by its central bank to buy
and sell its currency.

A fall in the exchange rate will mean that the price of imports will rise while exporters should become more internationally
competitive. Import volumes should fall whilst export volumes should rise.

Output at home should rise, leading to higher economic growth and a fall in unemployment.

There should be an improvement in the current account of the balance of payments too as the gap between export values
and import values improves.

However, higher import prices will feed through to a rise in inflation in the economy.

Target Fiscal Policy Monetary Policy Exchange Rates

Growth in the Economy More Spending Lower Interest Rates Lower

Low Inflation Lower Spending Higher Interest Rates Higher

BOP deficit reduction Lower Spending Higher Interest Rates Lower

More policies

Competition policy

The Competition Commission prevents takeovers that are against the public interest
Competition policy aims to ensure:

1. Wider consumer choice

2. Technological innovation, and

3. Effective price competition

Government assistance for business

Government grants available for certain investments and small business in areas such as rural development, energy efficiency,
education etc

Green policies

Airfuel tax for example can threaten an airline business but create opportunities for other forms of transport or makers of new
greener aircraft.

Treasury Function
A company can raising money by selling commercial paper into the
MONEY market

It’s a relatively safe place to put money as everything is short term and highly liquid

Money market securities

These are essentially IOUs issued by governments, financial institutions and large corporations

Most trade in very high denominations

Let’s look at some in more detail..

1. Treasury Bills

(T-bills) are the most marketable money market security.

Short-term government securities that mature in one year or less

Issued at a discount and then the government pays the full par value on maturity
One of the few money market instruments that are affordable to individuals with investors denominations as low as $1,000
Considered safe as government backed, but this means a small return also
Might not get back all of your investment if you cash out before maturity

2. Certificates on Deposit

Normally issued by commercial banks but they can be bought through brokerages

Have a maturity date (from three months to five years), a specified interest rate, and can be issued in any denomination
Cannot be withdrawn on demand

3. Commercial Papers

For companies, borrowing from banks can be a pain (in the a**). This is where commercial papers on a money market comes in..

No security is needed, and they are short term. Normally 1 - 2 months. This makes them safe to invest in, though normally
only good credit companies issue these
They’re normally used to finance working capital (trade finance) such as receivables and inventories
They are normally in denominations of $100,000 or more - Therefore, smaller investors can only invest in commercial paper
indirectly through money market funds
They are normally issued at a discount and paid back at par value (the difference is obviously the interest)
4. Bankers Acceptance

A BA is a short-term credit investment, and a bank guarantees payment.

Companies use them for financing imports and exports, when the creditworthiness of a foreign trade partner is unknown
They don’t need to be held until maturity, and can be sold off in the secondary markets where investors and institutions
constantly trade BAs

Money Market Derivatives

These derive their value from Treasury bills, Eurodollars, certificates of deposits (CD) and interest rates.

They are commonly traded as futures, forwards, options and swaps as well as caps and floors.

Let's have a quick look at futures (there's more further on in the course for the others)

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

Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market’.

Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to
the initial futures transaction, ie if buying currency futures was the initial transaction, it is closed out by selling currency
futures.

A gain made on the futures transactions will offset a loss made on the currency markets and vice versa.

Advantages
Lower transaction costs than money market
They are tradable and so do not need to always be closed out
 Disadvantages
Cannot be tailored as they are standard contracts

Only available in a limited number of currencies

Still cannot take advantage of favourable movements in actual exchange rates (unlike in options)

A Money Market Fund

This provide investors with a safe place to invest easily accessible cash-equivalent assets

However the fund will provide only relatively low returns so it’s not a long-term investment option.

The Nature and Role of Financial Markets and

Institutions
Financial Markets

A financial market allows people to easily buy and sell financial securities
(such as stocks and bonds), commodities (such as precious metals) etc

General markets (many commodities) and specialised markets (one commodity) exist. Markets work by placing interested buyers
and sellers in one "place", thus making it easier for them to find each other

So, Financial markets facilitate

1. The raising of capital (in the capital markets)

2. The transfer of risk (in the derivatives markets)

3. International trade (in the currency markets)

4. Match those who want capital to those who have it

ypically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be
freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of
interest or dividends

As the financial markets are normally direct and no financial intermediaries used, this is called financial disintermediation

Euromarkets

An overall term for international capital markets dealing in offshore currency deposits held in banks outside their country of
origin

Euro means external in this context. For example, eurodollars are dollars held by banks outside the United States

It allows large companies with excellent credit ratings to raise finance in a foreign currency. This market is organised by
international commercial banks

Key Features

Size

Much bigger than the market for domestic bonds / debentures

Cheap debt finance

Can be sold by investors, and a wide pool of investors share the risk

Unsecured

Only issued by large companies with an excellent credit rating

 Long-term

Debt in a foreign currency Typically 5-15 years, normally in euros or dollars but possible in any currency

Less regulation

By using Euromarkets, banks and financiers are able to avoid certain regulatory aspects such as reserve requirements and
other rules

However, the reduction in domestic regulations have made the cost savings much less significant than before

As a result, the domestic money market and Eurocurrency markets are closely integrated for most major currencies,
effectively creating a single worldwide money market for each participating currency.

Functions of Stock and Bond markets

A stock market (also known as a stock exchange) has two main functions

Functions

1. ..is to provide companies with a way of issuing shares to people who want to invest in the company

2. ..is to provide a venue for the buying and selling of shares

The first function allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership
of the company in a public market

This enables investors the ability to quickly and easily sell securities. This liquidity is an attractive feature of investing in stocks,
compared to other less liquid investments such as real estate

Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee
payment to the seller of a security

This eliminates the risk to an individual buyer or seller.

Risk and Return of different securities

The term "risk and return" refers to the potential financial loss or gain
experienced through investments in securities

A profit is the "return". The "risk" is the likelihood the investor could lose money

If an investor decides to invest in a security that has a relatively low risk, the potential return on that investment is typically
fairly small and vice-versa

Different securities—including common stocks, corporate bonds, government bonds, and Treasury bills—offer varying rates of
risk and return

The different types are as follows

These are about as safe an investment as you can get. There is no risk of default and their short maturity means that the
prices of Treasury bills are relatively stable

Long-term government bonds

These on the other hand, experience price fluctuations in accordance with changes in the nation's interest rates. Bond prices
fall when interest rates rise, but they rise when interest rates drop

Government bonds typically offer a slightly higher rate of return than Treasury bills

Corporate bonds

Those who invest in corporate bonds have the potential to enjoy a higher return on their investment than those who stay
with government bonds. This is because the risk is greater. The company may default on the bond.

Investors want to make sure that the company plays fair.

Therefore, the bond agreement includes a number of restrictive covenants on the company

Ordinary shares / Common stock

Common stockholders are the owners of a corporation in a sense, for they have ultimate control of the company. Their votes
on appointments to the corporation's board of directors and other business matters often determine the company's
direction. Common stock carries greater risks than other types of securities, but can also prove extremely profitable
 Earnings or loss of money from common stock is determined by the rise or fall in the stock price of the company

Preference shares

While owners of preferred stock do not typically have full voting rights in the company, no dividends can be paid on the
common stock until after the preferred dividends are paid

The Role of Financial Intermediaries

A financial intermediary is an entity who performs intermediation

between two parties

This basically means that the lender gives money to the borrower indirectly as the financial intermediary sits inbetween (hence
the term)

It is typically an institution that allows funds to be moved between lenders and borrowers.

That is, savers (lenders) give funds to an intermediary institution (such as a bank), who then gives those funds to spenders
(borrowers). This may be in the form of loans or mortgages.

Alternatively, the savers may lend the money directly to the borrower, via the financial markets. Therefore there is no
intermediary and so this is known as financial disintermediation

The Roles include

1. Aggregating investments to meet needs of borrowers

To provide a link between many investors who may have small amounts of surplus cash and fewer borrowers who may need large
amounts of cash

2. Risk transformation

Intermediaries offer low-risk securities to primary investors to attract funds, which are then used to purchase higher-risk securities
issued by the ultimate borrowers

3. Maturity transformation

Investors can deposit funds for a long period of time while borrowers may require funds on a short-term basis only, and vice versa.
In this way the needs of both borrowers and lenders can be satisfied
The role of money and capital markets

Money Market

The money market is the global financial market for short-term borrowing and lending

The money market is where short-term obligations are bought and sold such as

Treasury bills

Commercial paper and

Bankers' acceptances

Here financial institutions either borrow or lend for short periods of time, typically up to thirteen months. This contrasts with the
capital market for longer-term funding, which is supplied by bonds and equity

Capital Market

A capital market includes the stock market, commodities exchanges and the bond market amongst others. The capital market is
an ideal environment for the creation of strategies that can result in raising long-term funds for bond issues or even mortgages.
Along with the stock exchanges, support organisations such as brokerage firms also form part of the capital market. These
outward expressions of the capital market make it possible to keep the process ethical and more easily governed according to
local laws and customs

Working Capital
The Basics
Cash Operating Cycle

Cash operating cycle (working capital cycle)

This is the time between cash paid for raw materials and cash received from customers.

Day 1 Buy an item on credit (Payable)

Day 5 Sell the item on credit (Receivable)
Day 8 Pay for the item
Day 10 Receive the cash for the item

How long is the item in stock for? 4 days

How long is the receivable period? 5 days

How long is the payable period? 7 days

How long between having to pay and receiving the cash? 2 days

The 2 days is the cash operating cycle. It is how long between paying for an item and eventually receiving the cash.
This period needs funding somehow

Look again at the illustration and you may see how it is calculated:

Inventory Days 4 days

Receivable days 5 days

Payable days (7 days)

Cash operating cycle 2 days

Note the CASH needed in the gap can get bigger by:

1. Cycle gets longer (need more cash in proportion to the extra days in cycle)

2. Sales increase (need more cash in proportion to the extra sales made)

The length of the cycle will depend upon:

1. Liquidity v profitability decisions (eg credit terms offered)

2. Management efficiency

3. Industry norms (supermarkets very short - construction industry very long)

An increase in the length of the cash operating cycle will increase the level of investment in working capital.
Nature of business operations

Different industries have, not surprisingly, different cash operating cycles.

My academies, for example, hold very little stock (because I’m tight?) - er no because we sell services!

Compare that to WeSellLotsofStuff plc who hold lots of stuff (inventories).

Many retailers sell direct to the smelly, unwashed public and so have very few receivables - others sell to other businesses
and so offer credit terms.

If an operating cycle is long, then there is lower accessibility to cash for satisfying liabilities for the short term.

A short cash cycle reflects sound management of working capital. A long cash cycle denotes that capital is occupied when
the commercial entity is expecting its clients to make payments.

Negative cash operating cycle

Here they are getting payments from the clients before any payment is made to the suppliers.

Instances of such business entities are commonly those companies, which apply Just in Time techniques, for example Dell, as well
as commercial enterprises, which purchase on credit and sell for cash, for instance Tesco.

Working Capital Management

Working Capital Management

What is it and why is it important?

Working capital is simply the money needed for day to day business.

This money is needed to keep the company alive so its importance cannot be over emphasised.

It is the management of each current asset and each current liability that is essential to the business.

Working capital = net current assets = current assets - current liabilities

 Current assets Current liabilities

Cash Overdraft

Inventories Payables <1 year

Receivables

Liquidity v profitability problem

Consider this.
You are the MD of a new company selling i-pads.
Demand is looking good.
Your natural inclination is probably to buy more in, to sell in the future.

We call this a short-term investment .

You have invested in inventory to boost profits - this is one of the objectives of working capital.

However, you know you also have to pay the lease on your office - luckily you have set aside a little for this.

We call this liquidity.

Maintaining enough to pay short term payables.

This is another of the objectives of working capital.
So we would like to use the working capital for both Short-term investment and Liquidity

Hopefully you can see that part of you wants to invest the money and another wishes to save to pay bills.

This is the conflict of working capital objectives.

Minimising the risk of insolvency while maximising the return on assets.

Managing working capital

The management of working capital is important to the financial health of businesses of all sizes.
The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these
amounts are used in an efficient and effective way.

However, there is evidence that small businesses are not very good at managing their working capital.

Given that many small businesses suffer from undercapitalisation, the importance of exerting tight control over working capital
investment is difficult to overstate.

The finance profession recognises the three primary reasons offered by economist John Maynard Keynes to explain why firms
hold cash.

All three of these reasons stem from the need for companies to possess liquidity

1. Speculation

To take advantage of special opportunities that if acted upon quickly will favour the firm.

An example of this would be purchasing extra inventory at a discount.

2. Precaution

As an emergency fund for a firm.

3. Transaction

Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have.

Efficient management of working capital is extremely important to any organisation.

Holding too much working capital is inefficient, holding too little is dangerous to the organisation’s survival.

Overtrading

Overtrading

Overtrading or undercapitalisation arises when a company has too small a capital base to support its level of business activity.

Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall
due.
Overtrading

is often associated with a rapid increase in turnover. Investment in working capital does not match the increase in sales.

could be indicated by a deterioration in inventory days. Possibly because of stockpiling in anticipation of a further increase
in turnover, leading to an increase in operating costs.

could also be indicated by deterioration in receivables days, possibly due to a relaxation of credit terms.

As the liquidity problem associated with overtrading deepens, the overtrading company increases its reliance on short-term
sources of finance, including overdraft, trade payables and leasing.

can also be indicated by decreases in the current ratio and the quick ratio.

The Ratios
Ratios and Strategy

Accounting Ratios

In your exam, you may be required to calculate some ratios in order to support your strategic analysis of the case.

You have already covered ratio analysis in other subjects of the ACCA syllabus.

This section shall therefore only present a summary and list of ratios that could potential be used in your exam for such purpose.

Ratios may be divided into the following categories:

PROFITABILITY RATIOS

These are measures of value added being generated by an organisation and include the following:
Total assets - current liabilities

ROCE Operating Profit (PBIT)/Capital Employed

Capital Employed Equity + LT liabilities

Capital Employed Non current assets + net current assets

Capital Employed Equity + LT liabilities

Gross margin Gross Profit/Sales

Net Margin Net Profit/Sales

ROE Profit After Tax - Preference dividends/Shareholders’ Funds (Ordinary shares + Reserves)

EFFICIENCY RATIOS

These are measures of utilisation of Current & Non-current Assets of an organisation. Efficiency Ratios consist of the
following:

Asset Turnover Sales/Capital Employed

ROCE Margin X Asset Turnover

Receivables Days (Receivables Balance / Credit Sales) x 365

Payables Days (Payable Balance / Credit Purchases) x 365

Inventory (Inventory / Cost of Sales) x 365

LIQUIDITY & GEARING RATIOS

Liquidity Ratios measure the extent to which an organisation is capable of converting assets into cash and cash
equivalents.
On the other hand, Gearing Ratios measure the dependence of an organisation on external financing as against shareholder
funds.

Liquidity and Gearing Ratios are outlined below:

Liquidity

Current Ratio Current Assets / Current Liabilities

Quick Ratio (Current Assets – Inventory) / Current Liabilities

Gearing

Financial Gearing Debt/Equity

Financial Gearing Debt/Debt + Equity

INVESTOR'S RATIOS

These ratios measures return on investment generated by stakeholders. Such ratios include:

Dividend Cover Profit After Tax / Total Dividend

Dividend Yield Dividends per share / Share price

Interest Cover PBIT / Interest

Earnings Per Share Profit After Tax and preference dividends / Number of Shares

PE Ratio Share Price / EPS

 In the exam you have to act like a detective. You have to sift through evidence and extract meaningful messages for
effective business decisions. The starting point is often the basic accounting documents that record the progress of any
business, the Income statement & SFP

These are closely related so need reading together.

The balance sheet is a snapshot of a business at one point in time.

The income statement is dynamic and describes the flow of money through the business over a period of time.

Current ratio

Current Ratio

Explanation of Current Ratio:

 What this ratio basically tells us is if the company had to sell all its readily available assets, would it be able to pay off its
immediate debt?

Importance of Current Ratio:

At a minimum, you would hope the company whose financial performance you are analysing could meet pay its current
liabilities if it were to liquidate all its current assets.

This would translate to a Current Ratio of 1.0.

As with all the other performance ratios, the Current Ratio value depends on the industry in which the company is
operating.

It is also important to know what assets make up most of the Current Assets.

Inventory and Accounts Receivable, which are part of the Current Assets, cannot always be counted on as easily transferred
to cash.

Cash and Marketable Securities comprising the majority of the Current Assets would definitely be favorable.

Knowing this, would the company you are analysing truly be able to meet its financial obligations if it in fact had to sell its
current assets?

The Current Ratio rising over time will be favorable.

acid test

Quick Ratio (acid test)

Explanation of Quick Ratio:

Not every company can quickly convert its Inventory into cash in the event it had to pay all its current liabilities.

Therefore, the Quick Ratio is a tougher way to test the company’s ability to meet its current debt load.

You can make the test even tougher by also subtracting off the accounts receivable and prepaid expenses. This will pretty
much leave only the truly current and liquidable assets.

Importance of Quick Ratio:

If a company you are analysing looks good while testing it against the Current Ratio, then the Quick Ratio should be your
next test to apply.

Companies with steadily rising Inventories may look good with the Current Ratio, but will have a deteriorating effect on the
Quick Ratio, since we subtract the Inventory out.

The Quick Ratio rising over time is favorable.

Inventory days

Inventory Days
Explanation of Inventory Days:

A financial measure of a company’s performance that gives investors an idea of how long it takes a company to turn its
inventory (including goods that are work in progress, if applicable) into sales.

Generally, the lower (shorter) the better, but it is important to note that the average varies from one industry to another.

This measure is one part of the cash conversion cycle, which represents the process of turning raw materials into cash.

Receivables Days

Receivables Days
The approximate amount of time that it takes for a business to receive payments owed.

The Average Collection Period measures the average number of days it takes for the company to collect revenue from its credit
sales.

The company will usually state its credit policies in its financial statement, so the Average Collection Period can be easily gauged
as to whether or not it is indicating positive or negative information.

Importance of Average Collection Period:

This ratio reflects how easily the company can collect on its customers. It also can be used as a guage of how loose or tight
the company maintains its credit policies.

A particular thing to watch out for is if the Average Collection Period is rising over time. This could be an indicator that the
company’s customers are in trouble, which could spell trouble ahead.

This could also indicate the company has loosened its credit policies with customers, meaning that they may have been
extending credit to companies where they normally would not have.

This could temporarily boost sales, but could also result in an increase in sales revenue that cannot be recovered, as shown
in the Allowance for Doubtful Debts.
Illustration

A company has total credit sales of $100,000 during a year and has an average amount of accounts receivables of $50,000.
Its average collection period is therefore 182.5 days

Possessing a lower average collection period is seen as optimal, because this means that it does not take a company very
long to turn its receivables into cash.

Payable days

Payable days

It means:
The approximate amount of time that it takes for a business to make payments owed.

It measures the average amount of time you use each dollar of your trade credit.

This measurement gauges the relationship between your trade credit and your cash flow

A longer average payable period allows you to maximize your trade credit.

This means that you are delaying spending cash and taking full advantage of trade credit.

Sales to Working Capital

Sales Revenue/Net Working Capital Ratio

Explanation of Sales to Working Capital:

The Sales to Working Capital ratio measures how well the company’s cash is being used to generate sales.

Working Capital represents the major items typically closely tied to sales, and each item will directly affect this ratio.

Importance of Sales to Working Capital:

An increasing Sales to Working Capital ratio is usually a positive sign, indicating the company is more able to use its working
capital to generate sales.

Although measuring the performance of a company for just one period reveals how well it is using its cash for that single
period, this ratio is much more effectively used over a number of periods.

This ratio can help uncover questionable management decisions such as relaxing credit requirements to potential customers
to increase sales, increasing inventory levels to reduce order fulfillment cycle times, and slowing payment to vendors and
suppliers in an effort to hold on to its cash.
Additional ratio points

1. If comparing between years , it is fine to use balance sheet (year end) figures instead of averages.

2. 'Turnover' ratios are the ‘day’ ratios inverted. (Do not multiply by 365)

3. Limitations of ratios are - y/e figures may not be representative, they can be manipulated, they are historic and ca be distorted by
inflation.

Managing Inventory
Economic Order Quantity

Economic order quantity

The level of inventory that minimises the total of inventory holding cost and ordering cost

Holding Costs

The more stock you hold the more it costs. So you should keep stock low.

Ordering costs

The more orders you make the more it costs. So you should order lots at a time, meaning fewer orders (but higher stock).

These two costs therefore work in opposite ways. One suggests keep stocks low, the other keep stock high (to keep orders
down).

So, this where the EOQ model will help.

It is mathematically the perfect position, the perfect amount to order. The position where total ordering and holding costs are at
their lowest

This happens also to be where holding costs = ordering costs.

So, to repeat, the EOQ level is where the total (ordering and holding) costs will be minimised.

How is this cute little baby calculated?:

(Well you lucky fruit nuts - this formula is given in the exam) - Anyway here it is….

Where Co = Order Costs; Ch = holding cost per unit and D = annual demand

Lets now see what these pesky HOLDING and ORDERING costs actually are

Holding costs

1. Warehouse
 2. Insurance

3. Obsolescence

4. Opportunity cost of capital

Ordering costs

1. Administration

2. Delivery costs

HOLDING AND ORDER COSTS

Calculating Holding Costs:

Holding Cost per unit x (Order amount / 2)

Calculating Order Costs:

Order costs per unit x (Annual Demand / Order amount)

Assumptions/Criticisms:

The ordering cost is constant.

The annual demand for the item is constant and it is known to the firm.

Quantity discounts don’t exist.

The order is received immediately after placing the order.

No buffer stock is required

Ignores hidden stock holding costs (unreliable suppliers etc)

 Ignores benefit of stock holding (choice etc)

EOQ with Discounts

EOQ with discounts

Bulk buying discounts may be available if the order quantity is above a certain size. To
calculate the best order quantity then we need to:

1. Calculate EOQ in normal way (and the costs)

2. Calculate costs at the lower level of each discount above the EOQ

3. Then choose the lowest cost option!

Illustration

Demand is 100 units per month. Purchase cost per unit £10. Order cost £20
Holding cost 10% p.a. of stock value.

Required
Calculate the minimum total cost with a discount of 2% given on orders of 350 and over

Solution

Calculate EOQ in normal way (and the costs)

Calculate costs at the lower level of each discount above the

EOQ
Sq root 2 x 20 x 1200 / 1 = 219

Ordering Costs
 = Order cost per unit x (Annual Demand / Order amount)
= 20 x 1200 / 219
= 110

Holding Costs
= Holding Cost per unit x (Order amount / 2)
= 1 x 219 / 2
= 110
= 220

At discount level 350

Ordering Costs
= Order cost per unit x (Annual Demand / Order amount)
= 20 x 1200 / 350 = 69

Holding Costs
= Holding Cost per unit x (Order amount / 2)
= 0.98 x 350 / 2 = 171.5
= 240.5

240.5 is higher than 220 (it would be as EOQ is the best level)

However we now need to take into account the 2% price discount

Discount = 2% x 1200 x 10 = 240

Clearly with the discount being offered the company should take the discount and order at 350

Buffer Stock

Buffer Stock

Let’s say we sell 10 items of stock a week, and stock takes 2 weeks to come in.
Hopefully you can see that we need to make an order when stock levels fall to 20

If we order when they fall to 30, this must mean we like to keep a buffer (safety) stock of 10

Re-order Level

Demand x Lead Time

So, EOQ looks at how much to order, now lets look at when.

The answer should be obvious - it is when you run out of stock.

However you need to reorder before that, to give the stock time to arrive.

So the RE-ORDER level is not zero it is DEMAND x Time it takes to arrive in stock.

This though presumes constant and known demand. Luckily that is all that is needed in this examination!

Buffer Stock

Can be calculated if not given:

Actual re-order level - Stock used in lead time

Using EOQ with Buffer Stock

1. Calculate Buffer stock (if not given)

2. Calculate EOQ and costs ignoring buffer stock

3. Add on HOLDING costs for buffer stock

Just-In-Time

Just-in-time (JIT)
An inventory strategy which reduces in-process inventory.

In order to achieve JIT the process must have signals of what is going on elsewhere within the process. These signals tell
production processes when to make the next part.
They can be simple visual signals, such as the presence of a part on a shelf.

Quick communication of the consumption of old stock which triggers new stock to be ordered is key to JIT and inventory
reduction.

JIT emphasises inventory as one of the seven wastes (overproduction, waiting time, transportation, inventory, processing,
motion and product defect), and so aims to reduce buffer inventory to zero.

Zero buffer inventory means that production is not protected from external shocks

5 Key aspects to JIT

1. Multi skilled workers

2. Close relationship with suppliers

3. Reduced set up times

4. Quality

5. Teams working in cells

Benefits

1. Lower level of investment in working capital

2. A reduction in inventory holding costs

3. A reduction in materials handling costs

4. Improved operating efficiency

5. Lower reworking costs due to the increased emphasis on the quality of supplies

Managing Receivables
Managing Receivables in Practice

Policy formulation

This is concerned with establishing the framework within which management of accounts receivable in an individual company
takes place.

The elements to be considered include:

1. establishing terms of trade, such as period of credit offered and early settlement discounts:

2. deciding whether to charge interest on overdue accounts

3. determining procedures to be followed when granting credit to new customers

4. establishing procedures to be followed when accounts become overdue.

Credit Analysis

Assessment of creditworthiness depends on the analysis of information relating to the new customer.

This information is often generated by a third party and includes bank references, trade references and credit reference
agency reports.

The depth of credit analysis depends on the amount of credit being granted, as well as the possibility of repeat business.
Credit Control

Once credit has been granted, it is important to review outstanding accounts on a regular basis so overdue accounts can be
identified. This can be done, for example, by an aged receivables analysis.

It is also important to ensure that administrative procedures are timely and robust, for example sending out invoices and
statements of account, communicating with customers by telephone or e-mail, and maintaining account records should
utilise the ‘Credit Policy’ to receive, record, maintain, and most importantly, control credit sales.

Collecting amounts owing

Ideally, all customers will settle within the agreed terms of trade. If this does not happen, a company needs to have in place
agreed procedures for dealing with overdue accounts.

These could cover logged telephone calls, personal visits, charging interest on outstanding amounts, refusing to grant further
credit and, as a last resort, legal action.

With any action, potential benefit should always exceed expected cost.

Two other commonly used methods of debt collection are:

1. Early settlement discounts

2. Debt factoring

Early Settlement Discounts

Offering early settlement discounts

There are four main reasons why a business may offer its customers discounts to pay early:

1. If cash is received earlier, it will improve the supplier’s liquidity position, because it reduces the length of its cash operating cycle.

This will be particularly important if a seller is suffering from cashflow problems.

2. If the cash from customers is received early, the cost of financing receivables is reduced.
 For example, if the supplier has an overdraft agreement under which it borrows at a cost of 10% per annum, then provided that
the cost of offering the discount is less than the cost of the overdraft, the supplier will be better off financially.

3. When customers are deciding which payments to make to suppliers and which ones to delay, they are likely to pay those suppliers
offering a discount for early payment first.

From the point of view of the supplier offering the discount, this means that the incidence of bad debts is likely to be reduced,
since customers will choose to pay them first if they are short of cash.

4. It is possible that offering a discount may provide an incentive to new customers, because the cost of the goods from a supplier
offering a discount may now be less than those of a supplier not offering a discount, provided that the potentially new customer
pays within the specified time limit.

Receivables aren’t cash. So they need funding.

Think of this being funded by an overdraft. Therefore, the overdraft rate x receivables is the cost.

In questions you will be asked to compare the current policy cost, to a new policy cost (offering early settlement discounts) to
see which is cheaper

Let’s have a think about this:

1. Early settlement will mean receivables will get smaller and so the cost less

2. However the discount is a cost to the company too so needs to be taken into account

The steps are as follows:

1. Step 1: Calculate current policy cost of receivables (receivables x Overdraft Interest rate)

2. Step 2: Calculate NEW policy cost of NEW receivables (New receivables x overdraft interest rate)

3. Step 3: Calculate cost of early settlement discount and add to the new policy cost

Illustration

Company has credit sales of 1200 and a 3 month credit policy.

New policy is 2% early settlement discount (within 10 days) and a new credit policy for others of 2 months
20% will take the discount. Cost of capital 10%
 1. Step 1: Old Policy cost of Receivables = 3/12 x 1200 = 300 x 10% = 30

2. Step 2: New Policy cost of Receivables after = 2/12 x 80% x 1200 = 160 x 10% = 16
+ 10/365 x 20% x 1200 = 7 x 10% = 0.7

3. Step 3: Cost of early settlement discount 2% x 20% x 1200 = 4.8

Cost of Old Policy = 30

Cost of New Policy = 16+0.7+4.8 = 21.5

The cost of the new policy is less and so should be taken

Increase the credit term?

Occasionally you may be told that a new policy of INCREASING the credit term will also increase sales (as a larger credit
term will attract more customers)

Remember here that the company is not better off by the full sales amount, but by the contribution (sales less variable
costs) that these sales bring in.

For example if extra sales are 100 and the contribution to sales ratio is 20%, then you will take an extra 20 income to the
new policy calculation

You then need to compare this to the extra cost caused by the extra credit term (new receivables x overdraft rate)

Illustration

A company currently has sales of 1,200 and a credit term of 1 month.

It is planning to offer a term of 2 months in order to attract more customers.

Their contribution to sales ratio is 20% and their overdraft rate is 10%. Sales are expected to increase by 20%
Is the change in policy a good idea?

Current Policy New Policy

 Cost of Receivables 1/12 x 1200 x 10% = 10 2/12 x 1,440 x 10% = 24

Extra Contribution 240 x 20% = (48)

The new policy has less costs than the current policy and so should be given the go-ahead

Debt Factor

Types of Arrangement

A factor can work in different ways…

It can simply be they take over a company’s credit control department for a fee

It may be that the factor forwards the company some money in advance, and then collects the money from the debtors
themselves and keeps the money.

The amount forwarded here would be like a loan and so the factor would also charge interest

Finally, if the factor does “buy” the company’s debts then the deal may be “with recourse”
or “without recourse”

1. With Recourse - Any bad debts get returned to the company

2. Without Recourse - Any bad debts are suffered by the Factor

Advantages Disadvantages
 Admin Costs Saved Can be expensive

Gets Cash Quickly Could lose customer goodwill

More cash available as sales grow May give a bad impression to customers

How to do the numbers…

Compare:

Current cost (Receivables x overdraft rate)

New cost with Factor (New receivables x overdraft rate, Fee, net cost of forwarding money less any increase in contribution,
less admin savings)

Illustration

A Company has credit sales of 200,000pa. Credit term is 30 days. The factor offers to buy for 80% at an interest rate of 9%. The
company can get an overdraft for 6%. The factor charges 1.5% of current credit sales.

The factor will offer customers an early settlement discount if paid in 15 days, 40% will accept this and the remainder will take 50
days to pay. Sales will increase by 5% and contribution to sales ratio is 40%

Should the factor’s offer be accepted?

Solution

Current cost

Receivables = 30/365 x 200000 =16,438

These are financed by an overdraft at 6% = 986

TOTAL = 986

Cost of Factoring
 New receivables = New sales x 15/365 x 40% = 3,452
New receivables = New sales x 50/365 x 60% = 17,260
Financed by overdraft cost at 6% = 1,242
Factor Fee = 200,000 x 1.5% = 3,000
Increase in contribution = sales increase x 40% = (4,000)
Forward Cost = new receivables x 80% x (9-6%) = 497.10

TOTAL = 739.1

The factor option costs less - so the factor’s offer should be taken up

Tricky bits

Forwarding of cash from Factor

You will notice in the question above, I didn’t add the full cost of this forwarding money (like a loan).

What I did was take the forwarding interest rate charged less the overdraft interest rate.

Think of it like this, the company has an overdraft of 6%. Then they get loaned some money for 9%.

They will put the money from the loan in the bank and so it will lower their overdraft.

This means they will be saving 6%. Therefore the net cost to them is 3%.

So always take the net cost of the forwarding interest rate less the overdraft rate

Bad Debts

1. With recourse

no change here then (the company still keeps the bad debt risk). Therefore, generally, as theres no change - keep bad debts
completely out of the workings. Easy-peasy-lemon-squeezy

Just be careful though if it stays with recourse but the bad debts reduce - in that case treat this as a saving in the factor policy

2. Without recourse
 here the company gives its bad debts risk to the factor. Therefore this is a saving for the company if they choose the factor option.

So treat it like this - show as a saving in the factor option

Invoice Discounting

Invoice Discounting

What is it?

An invoice discounter purchases your debts at a discount.

They do not take over their administration etc though.

They tend to be one off deals on high quality debts

Debt Factoring and Invoice discounting compared

Imagine you’re a business holder

1. Factoring

Financial services companies that provide businesses with debtor finance, secured against unpaid invoices are known as Factors
and Invoice Discounters.

Factors buy your trade debts and typically will pay 80% to 85% as soon as they receive a valid copy invoice.

The balance, less charges, is paid when the customer pays.

The Factor collects the debt from your customer directly but will usually agree collection policies with you, in order to ensure
faster customer payment without loss of goodwill. Some Factors also provide bad debt insurance.

2. Invoice Discounting

With invoice discounting responsibility for collection of debts remains with you and the service is normally undisclosed to
customers.

Payments that you receive are paid into a bank account administered by the Invoice Discounter and you are then credited with the
balance less charges.
 balance less charges.

Generally, invoice discounting is only available to businesses that already practice sound credit management and have the staff
and accounting systems to generate reliable customer collections.

Invoice Discounters, like Factors, will typically pay 80% to 85% against valid invoices.

Cost of Factoring and Invoice Discounting

For both factoring and invoice discounting there is a service charge, normally a proportion of turnover, and a discount
charge, based on the amount of finance provided.

Charges will be agreed in advance and form part of the factoring or invoice discounting agreement. For factoring the
service charge is normally between 0.75% and 2.5% of turnover, depending on the workload to be undertaken.

The charge for invoice discounting will usually be less, as less work is required.

The discount charge is calculated on day-to-day usage of funds. It is likely to be comparable with normal secured bank
overdraft rates.

Suitability of Factoring and Invoice Discounting

Debtor finance is most suitable for growing businesses; finance will grow in line with the growth in turnover. Conversely,
where turnover is falling the level of finance will fall.

The cost of the service needs to be weighed against the costs of in-house debt collection and, for example, having
sufficient cash to benefit from early payment discounts from suppliers.

Generally debt finance providers are looking for ‘clean’ invoices where there is clear evidence of delivery of the goods or
service and a low level of disputes or credit notes.

It may not be available for some industries, for example contracting, where there is a high level of retentions and variation
orders.

Providers of debt finance usually acquire your debts with recourse to you if the debtor does not pay.

This means they will reclaim the amount already advanced to you should your debtor not pay in a given time period.

Alternatively, you may take out insurance against non-payment by your debtors.

Many factors and invoice discounters can also provide bad debt insurance.
Managing Foreign Receivables

Managing Foreign Receivables

How to manage them

The more complex nature of trade transactions and their elements means foreign accounts receivable need more
investment than their domestic counterparts

The risk of bad debts is higher with foreign accounts receivable.

Exporters seek to reduce the risk of bad debt and to reduce the level of investment in foreign accounts receivable.

These are the options to help:

1. Agree early payment with an importer

For example by payment in advance, payment on shipment, or cash on delivery.

These terms of trade are unlikely to be competitive however

2. Use bills of exchange

A signed agreement to pay the exporter on an agreed future date, supported by a documentary letter of credit, can be discounted
by a bank to give immediate funds.

3. Documentary letters of credit

Are a payment guarantee backed by banks.

They carry almost no risk, provided the exporter complies with the terms and conditions

4. Assess the creditworthiness

Of new customers, such as bank references and credit reports.

5. Insurance

can also be used to cover some of the risks associated with giving credit to foreign customers.

This would avoid the cost of seeking to recover cash due from foreign accounts receivable through a foreign legal system, where
the exporter could be at a disadvantage due to a lack of local or specialist knowledge.
6. Export factoring

Can also be considered, where the exporter pays for the specialist expertise of the factor as a way of reducing investment in
foreign accounts receivable and reducing the incidence of bad debts.

Managing Payables
Early Settlement Discounts (Creditors)

Using Trade Credit Effectively

Clearly it is best to take as much advantage of trade credit as possible. Paying later is almost always beneficial.

However, a company needs to ensure it does not annoy its vital suppliers by missing deadlines and also the company may seek
to take advantage of early settlement discounts.

Early settlement discounts

Trade credit is a simple and often free source of finance. (It is not free, however, if an early payment discount is foregone)

Method

Simply compare:

1. Current Savings (the more payables the better)

2. New policy Savings (Less payables but receive an early settlement discount)
Illustration

Discount of 1% for an early settlement on goods worth 1,000,000pa if paid in 10 days (normal terms 30 days)

Overdraft interest rate is 10%

Current Savings

Payable saving:
30/365 x 1,000,000 x 10% = $8,219

New policy Savings

New Payables saving: 10/365 x 1,000,000 x 10% = $2,740

Discount saving: 1% x 1,000,000 = $10,000
TOTAL = $12,740

Company should take the discount as the savings are higher

How to quickly calculate an annual interest rate

Take 100 and divide it by 100-discount % offered

Multiply this by the power of 365/reduction in days

Take the 1 off and voila!

Illustration

5% early settlement discount if customers pay within 10 instead of 60 days.

As a percentage cost this is:

(100/95) power of 365/50 = 45.42%
Managing Cash
Cashflow Forecasts

The principles of cashflow forecasting

Cashflow forecasting enables you to predict peaks and troughs in your cash balance.

It helps you to plan borrowing and tells you how much surplus cash you’re likely to have at a given time.

Many banks require forecasts before considering a loan.

The forecast is usually done for a year or quarter in advance and divided into weeks or months.

In extremely difficult cashflow situations a daily cashflow forecast might be helpful.

It is best to pick periods during which most of your fixed costs - such as salaries - go out.

It is important to base initial sales forecasts on realistic estimates

Short term cash flow forecasts

Cash Forecast for the Three Months Ended 31 March 20X1

This is the proforma that could be produced for a big, cashflow forecast question, though there has not been one yet, it is a
minor topic so far

January February March

Cash Receipts
 Sales

Issue of Shares

Cash Payments

Purchases

Dividends

Tax

Non Current Assets

Wages

Cash Surplus/defecit

Cash b/f

Cash c/f

Note that not all expenses in the income statement are cash eg depreciation/accruals.

Not all sales are cash - only put them in the table when cash is RECEIVED.

Not all purchases of NCA are cash eg Finance leases - just put in the cash PAID to the lessor.

When preparing cashflow forecasts make sure your work is clearly laid out and referenced to workings.

There is nothing difficult just needs practice

Illustration

A lady decides to set her own business so needs to go to a bank with a cashflow forecast.

She has £6,000 to invest herself. She expects to buy some non current assets for 10,000, which have a 5 year life.

These will be bought immediately.

 Then she will need buffer stock of £1,000 acquired at the beginning of January and subsequent monthly stock to meet her
expected sales demand

Forecast sales are 5,000 in February and rising by 10% per month.

Selling price is calculated using a mark up of 50%. 1 months credit is allowed by suppliers and 1 month given to customers
also.

Operating costs are 500 per month plus drawings of 500.

Prepare a cashflow for Jan, Feb, March

January February March

Cash Receipts

Sales 5,000

Issue of Shares

Cash Payments

Purchases -1,000 -3,333

Dividends

Operating Costs -500 -500 -500

Non Current Assets -10,000

Drawings -500 -500 -500

Cash Surplus/defecit -11,000 -2,000 667

Cash b/f 6,000 -5,000 -7,000

Cash c/f -5,000 -7,000 -6,333

Treasury Management

Benefits of centralised Treasury management (Cash Control)

The treasury of a multinational corporation relies, to a certain extent, on the expertise of local business.

However, the benefits of centralisation sometimes come at the expense of losing touch with this vital regional knowledge.

This could be avoided by careful restructuring of treasury operations. Oh yes baby.

The road starts with the selection of the treasury processes most suitable to centralisation.

Each of the main treasury processes (short-term finance and liquidity management; long-term finance; risk management) should
be analysed to identify how centralisation could create additional benefits.

The key argument

for a centralised process is control and coordination of activities...

Risk is controlled when the philosophy of the company is clear and implemented from a central process.

This avoids the temptation of local management to put a local flair on company philosophy.

A sexy study

A recent study by Michael Gold and Andrew Campbell of the London Business School found that different and equally
successful corporations balanced local and corporate control in different ways.

Some emphasised strong centralised strategy development with local freedom to implement strategies; others set financial
standards at the corporate level and left business units to devise their own strategies and operational plans; others
practiced a mix.
 All of the companies in the study sought the benefits of local autonomy while not giving up corporate control.

Sorry it wasn’t THAT sexy…

Control v Responsiveness

Control versus responsiveness is the underlying issue to address when considering centralising or decentralising.

When controls and consistency are necessary to the organisation, centralisation provides the cornerstone.

Consistent reporting up and down the corporate chain and knowledge of where the information resides without
duplication, can be the greatest reason to keep certain functions in a central location.

Inherent in the concept of centralization is the potential delay in decision making and information processing.

Centralised decisions require the local manager to seek permission from central management.

The central manager has to deliberate and convey his decision back down to local management for implementation.

This process can take time and slow down decision making.

The overall responsiveness of the corporation may suffer, with potentially damaging results.

Baumol Model

How much cash should a company hold?

The target cash balance involves a trade off between the opportunity costs of holding too much cash and the trading costs of
holding too little.
For example if we know a division needs $100,000 during the year, how much should we transfer into their account (from their
deposit account)?

All of it would mean some of the cash lying in the current account doing nothing (not getting interest unlike in a deposit account)
at the early stages.

Whereas, transferring bits at a time (when the cash is needed) would mean lots of transaction costs.

Step forward the….Baumol model!

This works just like EOQ for stock. It tells you how much cash to order (sell investments / take from deposit account) at a time, in
order to minimise holding (losing out on deposit interest) and order costs (cost of transferring cash / selling investments)..

Holding Cost
= Average cash balance x Interest rate;
= Cash transferred in / 2 x interest rate
= HC/2 x i

Order Cost
= Total cash used during period / Cash transferred in X Transaction cost

(Annual Demand/Amount cash ordered (transferred) x Cost per Order

Total Cost = Opportunity cost + Trading cost

To calculate the optimum amount of cash to transfer use this equation:

√(2 x Order Cost x Annual demand for cash) / Holding cost (Interest)

Illustration

Subsonic Speaker Systems (SSS) has annual transactions of $9 million. The fixed cost of converting securities into cash is $264.50
per conversion. The annual opportunity cost of funds is 9%.

What is the optimal deposit size?

Square root (2 x 264.5 x 9,000,000 / 0.09)

= 230,000
Limitations of the Baumol model

Assumes a constant disbursement rate; in reality cash outflows occur at different times, different due dates etc.

Assumes no cash receipts during the projected period, obviously cash is coming in and out on a frequent basis

No safety stock of cash is allowed for, reason being it only takes a short amount of time to sell marketable securities

Miller-Orr Model

Miller-Orr Model

This model deals with cash inflows/outflows that change on a daily basis

The model works in terms of upper and lower control limits, and a target cash balance.

As long as the cash balance remains within the control limits the firm will make no transaction.

To use the Miller-Orr model, the manager must do 4 things

1. Set the lower control limits for the cash balance.

This lower limit can be related to a minimum safety margin decided by management

2. Estimate Standard deviation of daily cash flows

3. Determine Interest Rate

4. Estimate the trading costs of buying and selling marketable securities.

When the firm’s cash fluctuates at random and touches the upper limit, the firm buys sufficient marketable securities to come
back to a normal level of cash balance i.e. the return point
Similarly, when the firm’s cash flows wander and touch the lower limit, it sells sufficient marketable securities to bring the cash
balance back to the normal level i.e. the return point

The lower limit is set by the firm based on its desired minimum “safety stock” of cash in hand

Spread

Then the spread is calculated upper and then the upper limit and return point comes from this.

Spread = 3(3/4 x Transaction cost x Cashflow variance / interest rate) power of 1/3

The return point

Lower Limit + 1/3 x spread

Illustration

If a company must maintain a minimum cash balance of £8,000, and the variance of its daily cash flows is £4m (ie std deviation
£2,000). The cost of buying/ selling securities is £50 & the daily interest rate is 0.025%.

Required: Calculate the spread, the upper limit (max amount of cash needed) & the return point (target level)

Solution

Lower limit = 8,000 (per question)

Spread = 3(3/4 x 50 x 4,000,000 / 0.00025) power of 1/3 = 25,303
Upper limit = 8,000 + 25,303 = 33,303
Return point = 8,000 + (1/3 x 25,303) = 16,434

NOTE
The cashflow variance is DAILY. Also the standard deviation is the square root of the variance.

Therefore if given the standard deviation then you need to square it before putting it into the equation.

The interest rate is also a daily one. A quick (if oversimplified way) of reaching this simply to divide the annual rate by 365)
Benefits

1. Allows for net cash flows occurring in a random fashion.

2. Transfers can take place at any time and are instantaneous with a fixed transfer cost.

3. Produces control limits which can be used as basis for balance management.

Limitations

1. May prove difficult to calculate.

2. Monitoring needs to be continuous for the organisation to benefit.

Baumol Model - Deterministic model

Future cash requirements and disbursements are known with perfect certainty

Miller-Orr Model - Stochastic model

Daily cash flows vary according to a normal probability distribution with known variance

Working Capital Funding

WC Funding Policies

Working Capital Funding

Even companies in the same industry will have different levels of inventory and receivables, due to their differing policies.

An aggressive policy uses lower levels of inventory and trade receivables than a conservative policy, and so will lead to a shorter
cash operating cycle.

A conservative policy on the level of investment in working capital, in contrast, with higher levels of inventory and trade
receivables, will lead to a longer cash operating cycle.

The higher cost of the longer cash operating cycle will lead to a decrease in profitability while also decreasing risk, for example
the risk of running out of inventory.

Matching funding policy

1. Use long-term finance

For both permanent current assets and non-current assets

2. Use short-term finance

to cover the short-term changes in current assets represented by fluctuating current assets

Conservative funding policy

This will use a higher proportion of long-term finance than a matching policy, thereby financing some of the fluctuating
current assets from a long-term source.

This will be less risky and less profitable than a matching policy, and will give rise to occasional short-term cash surpluses.

Aggressive funding policy

This will use a lower proportion of long-term finance than a matching policy, financing some of the permanent current
assets from a short-term source such as an overdraft.

This will be more risky and more profitable than a matching policy
Management attitudes to risk, previous funding decisions and organisation size

Management attitudes to risk will determine whether there is a preference for a conservative, an aggressive or a matching
approach.

Previous funding decisions will determine the current position being considered in policy formulation.

The size of the organisation will influence its ability to access different sources of finance.

A small company, for example, may be forced to adopt an aggressive working capital funding policy because it is unable to
raise additional long-term finance, whether equity of debt.

Investment in current assets

The level of investment in current assets

This varies from company to company, depending on the following:

1) Length of working capital cycle

The working capital cycle or operating cycle is the period of time between when a company settles its accounts payable and
when it receives cash from its accounts receivable.

As the operating period lengthens, the amount of finance needed increases.

Companies with comparatively longer operating cycles than others in the same industry sector, will therefore require
comparatively higher levels of investment in current assets.

2) Terms of trade

These determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases,
and any penalties for late payment.

A company whose terms of trade are more generous than another company in the same industry sector will therefore need a
 comparatively higher investment in current assets.

3) Policy on level of investment in current assets

Even within the same industry sector, companies will have different policies regarding the level of investment in current
assets, depending on their attitude to risk.

A company with a comparatively conservative approach to the level of investment in current assets would maintain higher
levels of inventory, offer more generous credit terms and have higher levels of cash in reserve than a company with a
comparatively aggressive approach.

While the more aggressive approach would be more profitable because of the lower level of investment in current assets, it
would also be more risky, for example in terms of running out of inventory in periods of fluctuating demand or of failing to
have the particular goods required by a customer

4) Industry in which organisation operates

Some industries, such as aircraft construction, will have long operating cycles due to the length of time needed to
manufacture finished goods and so will have comparatively higher levels of investment in current assets than industries such
as supermarket chains, where goods are bought in for resale with minimal additional processing and where many goods have
short shelf-lives.

Calculating the cost of WC funding

Calculating the cost of WC funding

Basically the inventory and the receivables need to be financed somehow, either by an overdraft (1st) or by a long term loan
(2nd)
I guess even that’s not strictly true as they are firstly financed by

1. any trade payables (free)

2. then any bank overdraft

3. then any long term finance

Illustration

Calculate the cost of the investment in working capital

Inventory 800

Receivables 400

Payables 300

Overdraft (10%) 200

Long term finance 15%

Calculate the cost of the investment in working capital

Total Cost = 125

Amount Cost

Inventory + receivables 1200

 Payables (300) -

Overdraft (10%) (200) 20

Long term Finance (15%) (700) 105

Permanent & Fluctuating Current Assets

Permanent & Fluctuating Current Assets

When considering how working capital is financed, it is useful to divide assets into non-current assets, permanent current assets
and fluctuating current assets.

Permanent current assets

These represent the core level of working capital investment needed to support a given level of sales.

As sales increase, this core level of working capital also increases.

Fluctuating current assets

These represent the changes in working capital that arise in the normal course of business operations, for example when
some accounts receivable are settled later than expected, or when inventory moves more slowly than planned.

WC investment v Funding
You invest in current assets and you fund through finance

Working Capital Investment

You can compare this between companies

Analyses current assets into permanent and fluctuating

Permanent current assets represent the core level for a given level of business activity

Fluctuating current assets represent changes due to the unpredictability of business operations e.g. Higher stock as
demand less than predicted

Uses Matching policy where long-term assets should be financed by long-term finance

Can be Aggressive too. More short term finance used

Can be Conservative too. More long term finance used

It is more expensive but less risky than the aggressive approach

Working Capital Funding

Only look at a single company - to see how it is financed

1. Aggressive here means a lower level of investment in current assets

2. Conservative here means a higher level of investment in current assets

So working capital investment and financing policy use similar terminology, but mean different things.

A company could have an aggressive investment policy but a conservative financing policy
Investment Appraisal
Financing the Investments
Sources of Finance

Sources of Finance

Operating Leases

This is a useful source of finance for the following reasons:

1. Protection against obsolescence

Since it can be cancelled at short notice without financial penalty.

The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business.

This flexibility is seen as valuable in the current era of rapid technological change, and can also extend to contract terms and
servicing cover

2. Less commitment than a loan

There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided,
existing assets need not be tied up as security and negative effects on return on capital employed can be avoided

Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.

3. Cheaper than a loan

By taking advantage of bulk buying, tax benefits etc the lessor can pass on some of these to the lessee in the form of lower lease
rentals, making operating leasing a more attractive proposition that borrowing.

4. Off balance sheet finance

Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of the
leased asset does not appear in the balance sheet.

Debt v Equity

These are the things you need to think about when asked about raising finance - so just put all these in your answer and link
them to the scenario. Job done.

Gearing and financial risk

 Equity finance will decrease gearing and financial risk, while debt finance will increase them

Target capital structure

The aim is to minimise weighted average cost of capital (WACC).

In practical terms this can be achieved by having some debt in capital structure, since debt is relatively cheaper than equity,
while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company
suffers from the costs of financial distress)

Availability of security

Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a
specified class of assets).

Economic expectations

If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are
more attractive than when difficult trading conditions lie ahead.

Control issues

A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.

Rights Issues

A 1 for 2 at $4 (MV $6) right issue means….

The current shareholders are being offered 1 share for $4, for every 2 they already own.

(The market value of those they already own are currently $6)

Calculation of TERP (Theoretical ex- rights price)

The current shareholders will, after the rights issue, hold:

1 @ $4 = $4
2 @ $6 =$12

So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33

Effect on EPS

Obviously this will fall as there are now more shares in issue than before, and the company has not received full MV for
them

To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue
 To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue

Eg Using the above illustration

EPS x 5.33 / 6

Effect on shareholders wealth

There is no effect on shareholders wealth after a rights issue.

This is because, although the share price has fallen, they have proportionately more shares

Equity issues such as a rights issue do not require security and involve no loss of control for the shareholders who take up
the right

The factors considered when reducing the amount of debt by issuing equity :

As the proportion of debt increases in a company’s financial structure, the level of financial distress increases and with it the
associated costs.

Companies with high levels of financial distress would find it more costly to contract with their stakeholders.

For example, they may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods
or larger discounts, and may have to accept supplies on more onerous terms.

1. Less financial distress may therefore reduce the costs of contracting with stakeholders.

2. Having greater equity would also increase the company’s debt capacity.

This may enable the company to raise additional finance

3. On the other hand, because interest is payable before tax, larger amounts of debt will give companies greater taxation benefits,
known as the tax shield.

4. Reducing the amount of debt would result in a higher credit rating for the company and reduce the scale of restrictive covenants.

Appraisal Methods
Accounting Rate of Return
Return on capital employed (ROCE)

Note:

Right, first thing you need to remember about this is that this is the ONLY investment appraisal technique which uses profits
and not cash in the F9 exam.

This is a drawback of the method - as profits can be manipulated

The second thing to understand is that it has 2 names - ROCE (return on capital employed) and ARR (Accounting rate of
return)

Finally - there are 2 methods of calculating it:

1. Simple Method

This percentage is compared to the target return you would like to get.

Clearly it has to be higher than say the interest rate on the loan you used to buy the capital item.

More correctly it has to be higher than the company’s cost of capital (more of that later)

2. Average Method

The average investment is the average value it would be in the SFP over the length of the project

Illustration of 'average investment'

Cost 400 Residual Value 100

Average Investment = 400 + 100 / 2 = 250

Illustration
RCA are considering expanding their business into Canada by buying up a local college over there.
The local college purchase will cost £500,000 and a further £300,000 to make the premises sexy

Cashflow profits (ie not including depreciation) from the college over the next 5 years are expected to be:

Year Cash Profits (£)

 1 100,000

2 120,000

3 180,000

4 250,000

5 350,000

The sexiness of the premises will have disappeared by the end of the 5 years and so sadly have a zero resale value. This will make
RCA sad and so they expect to sell up in order to buy a funky new college somewhere else. When they sell they hope to get
£400,000 for the college

Required
Calculate the ROCE of this investment (using the average investment method)

Solution
Total profits = Cash - Depreciation

Depreciation = Cost - Residual value

So, Total profits = 1,000,000 - (500+300-400) = 600,000

Therefore Average profits = 600,000 / 5 = 120,000

Average Investment = (Cost + RV)/2

= (800+400) / 2 = 600,000

ARR = Average Profits / Average Investment = 120,000 / 600,000 = 0.2 = 20%

Points about ROCE

This is used when company’s are more interested in PROFITABILITY than liquidity

Unlike the other capital budgeting methods that we have discussed, the simple rate of return method does not focus on cash
flows. Rather, it focuses on accounting net operating income.

If a cost reduction project is involved, formula / Equation becomes:

(Cost savings − Depreciation on new equipment) / Initial investment*
*The investment should be reduced by any salvage from the sale of old equipment.

So how useful is this method?

The most damaging criticism of the accounting rate of return method is that it does not consider the time value of money. The
simple rate of return method considers a dollar received 10 years from now as just as valuable as a dollar received today. Thus,
the accounting rate of return method can be misleading if the alternatives being considered have different cash flow patterns.

Additionally, many projects do not have constant incremental revenues and expenses over their useful lives. As a result the
simple rate of return will fluctuate from year to year, with the possibility that a project may appear to be desirable in some years
and undesirable in other years. In contrast, the net present value method provides a single number that summarised all of the
cash flows over the entire useful life of the project.

In summary the benefits are:

1. Fairly simple

2. Understandable percentage figure

Drawbacks

It disregards the project life and when the cash flows actually come in.

It focuses on profits not liquidity.

It uses accounting profits (which can be manipulated) rather than cash.

There is no mention of the actual gain made (just a percentage figure)

NPV
Net Present Value method

This method is examined regularly

What it does is looks at all the projected future CASH inflows and outflows.

Obviously we hope the inflows are more than the outflows. If they are this is called a positive NPV

However, it also introduces the concept of the “time value” of money.

The idea that money coming in today is worth more than the same amount of money coming in in 5 years time. To do this we
“discount down” all future cash flows.

This “discounting” takes into account not only the time value of money but also the required return of our share and debt
holders.

This means that if we have a positive NPV (even after discounting the future cash flows) then the return beats not only the time
value of money but it also beats what the shareholders and debt holders require.

So they will be happy and the company value (and hence share price) will rise by the +NPV amount (divided by the number of
shares)

So, let’s look at how we calculate NPVs in an exam..

NPV Proforma

0 1 2 3 4

Sales x x x x

Costs (x) (x) (x) (x)

Profit x x x x

Tax (x) (x) (x) (x)

 Capital Expense (x)

Scrap x

WDA x x x x

Working capital (x) (x) (x) x x

Total Cashflows (x) x x x x

Discount Factors 1 0.9 0.8 0.7 0.6

Total Cashflows (x) x x x x

The Tax Effect

Tax on operating profits

Simply calculate the net profit figure (sales less costs in table) and multiply by the tax rate.

This is normally 30%.

Remember it is normally payable one year later. For example tax on year 1 profits is paid in year 2 (and so goes in the NPV in
yr 2)

WDAs

These REDUCE your tax bill!

They are the tax relief on your capital purchases.

These are normally 25% writing down allowances on plant & machinery

Calculation technique for WDA

Calculate the amount of capital allowance claimed in each year

Make a balancing adjustment in the year the asset is sold
by calculating the total tax relief that should have been given ((Cost - RV) x 30%) less tax benefits already allowed in step 1

Illustration

Year 0 Buy plant 100

Year 4 Sell plant 20
25% Reducing balance; Tax 30%;

Answer

Year 1 WDA 100 x 25% = 25 Tax benefit 7.5

Year 2 WDA 75 x 25% = 18.75 Tax benefit 5.625
Year 3 WDA 56.25 x 25% = 14 Tax benefit 4.2

Year 4 Total tax relief should be (100-20) x 30% = 24. Less benefits relieved so far (7.5 + 5.625 + 4.2) = 6.675

Balancing Allowance = Tax benefit 6.675

Working Capital

Think of this as like float in a restaurant. Each night in the restaurant represents a year.

So, lets say a float of 100 is needed at the start of the night (T0).

Then the following night an extra 20 is required, the following night 30 more & the final night 10 less

At the end of the project it all comes back to the owner

T0 T1 T2 T3 T4

Working capital -100 -20 -30 10 140

So the technique is for WC is….:

Always start at T0

Just account for increase or decrease

Final year it all comes back as income

The working capital line should always total zero

NPV v IRR

NPV v IRR

Relative merits of NPV and IRR

The net present value (NPV) method has several important advantages over the internal rate of return (IRR) method.

NPV is often simpler to use. As mentioned earlier, IRR may require hunting for the discount rate that results in a net present
value of zero.

This can be a very laborious trial-and-error process, although it can be automated to some degree using a computer
spreadsheet.

A key assumption made by IRR is questionable. Both methods assume that cash flows generated by a project during its
useful life are immediately reinvested elsewhere.

However, the two methods make different assumptions concerning the rate of return that is earned on those cash flow.

NPV assumes the rate of return is the discount rate

IRR assumes the rate of return is the internal rate of return on the project.

So, if the IRR is high, this assumption may not be realistic. It is more realistic to assume that cash can be reinvested at the
discount rate - particularly if the discount rate is the company’s cost of capital. For example, by paying off the company’s
creditors
 In short, when NPV and IRR do not agree, it is best to go with NPV. Of the two methods, it makes the more realistic
assumption about the rate of return that can be earned on cash flows from the project.

Absolute v percentage figure

IRR has several weaknesses as a method of appraising capital investments. Since it is a relative measurement of investment
worth, it does not measure the absolute increase in company value (and therefore shareholder wealth), which can be found
using the net present value (NPV) method

Mutually exclusive projects

There is a potential conflict between IRR and NPV in the evaluation of mutually exclusive projects, where the two methods
can offer conflicting advice as which of two projects is preferable.

For example a small project may have a higher IRR but a lower NPV than a very big project.

Where there is conflict, NPV always offers the correct investment advice

Payback method

Payback method

This method focuses on liquidity rather than the profitability of a product. It is good for screening and for fast moving
environments

The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it
generates.

This period is some times referred to as “the time that it takes for an investment to pay for itself.”

The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more
desirable is the investment.
The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be
used to calculate the payback period….

Formula / Equation:

Payback period = Investment required / Net annual cash inflow*

*If new equipment is replacing old equipment, this becomes incremental net annual cash inflow.

It simply measures how long it takes the project to recover the initial cost. Obviously, the quicker the better.

Illustration

Constant cashflow scenario

Initial cost $3.6 million

Cash in annually $700,000

What is the payback period?

Solution

3,600,000 / 700,000 = 5.1429

Take the decimal (0.1429) and multiply it by 12 to get the months - in this case 1.7 months

So the answer is 5 years and 1.7 months

So how useful is this method?

The payback method is not a true measure of the profitability of an investment.

Rather, it simply tells the manager how many years will be required to recover the original investment.

1. Whole life of Project?

Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another.
 For example it doesn’t look at the whole life of the project

2. Time value of money

Another criticism of payback method is that it does not consider the time value of money. A cash inflow to be received several
years in the future is weighed equally with a cash inflow to be received right now.

3. Screening

On the other hand, under certain conditions the payback method can be very useful. It can help identify which investment
proposals are in the “ballpark.”

That is, it can be used as a screening tool to help answer the question, “Should I consider this proposal further?” If a proposal does
not provide a payback within some specified period, then there may be no need to consider it further.

4. Cash poor companies

When a firm is cash poor, a project with a short payback period but a low rate of return might be preferred over another project
with a high rate of return but a long payback period.

The reason is that the company may simply need a faster return of its cash investment.

5. Quick changing environments

And finally, the payback method is sometimes used in industries where products become obsolete very rapidly - such as consumer
electronics.

Since products may last only a year or two, the payback period on investments must be very short.

In summary, the benefits are:

1. Simple

2. Good when the project is subject to quick change like technology.

This is because cashflows in the future become harder and harder to predict so recovering the money as soon as possible is vital.

3. It minimises risk (short term projects favoured)

4. It maximises liquidity

5. Uses cashflows not false profits

Drawbacks

1. the item with the quickest payback is simply that. What about afterwards, does it still do well or does it then become obsolete?

2. It ignores the whole profitability. Also the time value of money is ignored (more of that later).
Irregular Cashflows

When the cash flows associated with an investment project changes from year to year, the simple payback formula that we
outlined earlier cannot be used.

To understand this point consider the following data:

Cumulative

Capital out 800 -800

Cash in 100 -700

Cash in 240 -460

Cash in 200 -260

Cash in 250 -10

Cash in 120 110

When the cumulative cashflow becomes positive then this is when the initial payment has been repaid and so is the payback
period

So in the final year we need to make 10 more to recoup the initial 800. So, that’s 10 out of 120. 10/120 x 12 (number of months) =
1.

So the answer is 4 years 1 month

Extension of Payback Method:

The payback period is calculated by dividing the investment in a project by the net annual cash constant inflows that the
project will generate.
 If equipment is replacing old equipment then any scrap value to be received on disposal of the old equipment should be
deducted from the cost of the new equipment, and only the incremental investment should be used in payback
computation.

Investment appraisal process

Investment appraisal process

The nature of investment decisions and the appraisal process

Ok this is a bit dull, and a bit obvious, but hey not everything in life can be as cool as cows.. so just learn them and stop moaning,
you big fat money pants

Key stages:

1. Identifying investment opportunities

From an analysis of strategic choices, analysis of the business environment, research and development, or legal requirements.

The key requirement is that investment proposals should support the achievement of organisational objectives.

2. Screening investment proposals

Companies need to choose between competing investment proposals and select those with the best strategic fit and the most
appropriate use of economic resources.

3. Analysing and evaluating investment proposals

This is the stage where investment appraisal plays a key role, indicating for example which investment proposals have the highest
net present value.

4. Approving investment proposals

Very large proposals may require approval by the board of directors, while smaller proposals may be approved at divisional level

5. Implementing, monitoring and reviewing investments

The time required to implement the investment proposal or project will depend on its size and complexity.

Following implementation, the investment project must be monitored to ensure that the expected results are being achieved and
the performance is as expected.
 The whole of the investment decision-making process should also be reviewed in order to facilitate organisational learning and to
improve future investment decisions.

NPV Theory

NPV Theory

NPV Benefits

1. it considers the time value of money (that is in the discount rate used)

2. it gives an absolute figure not a percentage

3. it considers the whole life of the project

4. is based on real cashflows .

5. It maximises the wealth of shareholders as this increases through receiving dividends and rising share prices.

6. Positive NPV investments should increase the market value of the company by the amount of the NPV.

A company with a market value of $10 million investing in a project with an NPV of $1 million will have a market value of $11
million once the investment is made.

Shareholder wealth is therefore increased

NPV method also contributes towards the objective of maximising the wealth of shareholders by using the cost of capital of a
company as a discount rate when calculating the present values of future cash flows.

A positive NPV represents an investment return that is greater than that required by a company’s providers of finance, offering
the possibility of increased dividends being paid to shareholders from future cash flows (see later)

NPV drawbacks
 1. The reliance placed on the cost of capital - this can be tricky to calculate (as we shall see later)

2. Inflation rates are assumed to be constant in future periods. In reality, interaction between a range of economic and other forces
influencing selling price per unit and variable cost per unit will lead to unanticipated changes in both of these project variables

3. it is heavily dependent on the production and sales volumes forecasts

4. It does not adjust the cash flows in future years for their lack of predictability compared to earlier years

Miscellaneous Techniques
Inflation basics

Inflation

An increase in prices (just in case you really are a mentalist). This means, therefore, that the real value of the same amount of
money will decline over time

Now let’s compare that to another concept… that of interest ..

This is the rate of return required by a lender - this may be quoted at a rate that includes inflation (money rate) or a rate which
doesn’t (real).

The real rate then means that the lender wants this on top of the inflation rate. Anyway more of that in the next section - I just
wanted to introduce it to you here

Illustration

Let’s say that inflation is 2%. If you have £100 now and don’t spend it, the £100 won’t be able to buy as much as it could at
the start of the year because prices have increased by 2%.

Therefore to stop this fall in value, many people put the money in a bank. They may get an interest rate of say 5%. This
would represent a return over and above the inflation rate.

Although the calculation ISN’T quite this straightforward (see later), basically if you get a 5% interest rate, and inflation is
2%, then you have received around a 3% return over and above the inflation rate. We call this rate the REAL return
NPVs and Inflation

1. Include it in the cash flows, using the different rates given

2. Include an inflation adjustment even for year 1 (as this is strictly the END of year1)

3. Include the GENERAL inflation in the discount rate by using a money or nominal rate (see later)

Calculation

Eg Sales 100 per year in real terms for 3 years. Price inflation is 10% pa

Your NPV would show:

Year 1 110 (100 x 1.10)

Year 2 121 (110 x 1.10)

Year 3 133 (121 x 1.10)

Money & Real Rates

Real Rate
The rate you receive, not taking into account inflation (you want inflation on top of the real rate)

Money / Nominal return

A real return on top of inflation. This is often the discount rate given in NPV questions

Formula:

MONEY = REAL x INFLATION

1+m = (1+r) x (1+inf)

Illustration

An investor wants a real return of 10%. Inflation is 5%

What is the MONEY/NOMINAL rate required?

1+m = (1+r) x (1+inf)

1+m = 1.1 x 1.05
m = .155 = 15.5%

Discounting

Calculating a present value (from future values)

Ok - so we have seen how to work out future values from present values.

(Using inflation as the example)

However, when looking at whether we should invest in something we will be looking at future cashflows coming in.
We want to know what are these future cashflows worth now, in today’s money ideally.

To do this we need to work the other way around ie. Take the future value (FV) and work out the present value (PV). We do this
by:

Discounting

Discount Factors

It is the discounted cash flows that we want to end up with in an NPV question. So we put the future cash flows in, and
then discount them using a discount factor. These are given in discount factor tables in the exam but can be calculated as
follows:

If you want to calculate a 10% discount factor for year 1 - It is 1 divided by 1.10 = 0.909

If you want to calculate a 10% discount factor for year 2 - It is 1 divided by 1.10 divided by 1.10 = 0.826

If you want to calculate a 10% discount factor for year 3 - It is 1 divided by 1.10 divided by 1.10 divided by 1.10 = 0.751

If you want to calculate a 6% discount factor for year 1 - It is 1 divided by 1.06 = 0.943

If you want to calculate a 12% discount factor for year 1 - It is 1 divided by 1.12 = 0.893

Illustration

You are to receive £100 in one year’s time and the interest rate/discount rate is 10%. What is the PV of that money?

100 x 1 /1.10
= 90.9

Annuities & Perpetuities

Annuity
Lets us now look at discounting a future cash-flow that is constant every year for a specified number of years (an annuity).

Illustration

100 received at the end of every year for the next 3 years. If cost of capital is 10% what is the PV of these amounts together?

Strictly speaking it is:

Yr 1 100 x 1/ 1.1 = 91
Yr 2 100 x 1/1.1 power of 2 = 83
Yr 2 100 x 1/1.1 power of 3 = 75
All added together = 249

Annuity Discount Factors

This is easier is to calculate using an annuity discount factor - this is simply the 3 different discount factors above added together
- again luckily this is given to us in the exam (in the annuity table)

So using normal discount factors:

yr 1 1/1.1 = 0.909
yr 2 1/1.1/1.1 = 0.826
Yr 3 1/1.1/1.1/1.1 = 0.751
All added together 2.486 = Annuity factor (or get from annuity table!)

So 100 x 2.486 = 248.6 = 249

Perpetuities

This is a constant amount received forever

Calculating the PV of a perpetuity:

Cashflow / Interest rate

 Illustration

What is the PV of an annual income of 50,000 for the forseeable future, given an interest rate of 5%?

Answer
50,000 / 0.05 = 1,000,000

Perpetuity starting in the future

Don’t panic!

Just calculate the perpetuity as normal - then discount the answer down (discount factor for 3 years - for example - if the
perpetuity started at year 3)

Other Topics
Risk and Uncertainty
Risk & Uncertainty basics

Risk

This is present when future events occur with measurable probability

Uncertainty

This is present when the likelihood of future events is incalculable

Risk & Uncertainty

Risk refers to the situation where probabilities can be assigned to a range of expected outcomes arising from an
investment project and the likelihood of each outcome occurring can therefore be quantified

Uncertainty refers to the situation where probabilities cannot be assigned to expected outcomes. Investment project risk
therefore increases with increasing variability of returns, while uncertainty increases with increasing project life

The analysis so far has assumed that all of the future cash flows are known with certainty. However, future cash flows are often
uncertain or difficult to estimate.

A number of techniques are available for handling this complication. Some of these techniques are quite technical involving
computer simulations or advanced mathematical skills and are beyond the scope of F9.

However, we can provide some very useful information to managers without getting too technical.

So there are 4 techniques we are going to look at:

1. Sensitivity Analysis

2. Probability Analysis

3. Simulation

4. Adjusted Payback

Sensitivity Analysis

Change required to make NPV=0

Sensitivity analysis shows us which item is critical to the success of the project

The one which has to change the least to make the net present value no longer positive

Only one variable is considered at a time

Managers should then look at the assumptions behind this key item

Also focus on it in order to increase the likelihood that the project will deliver positive NPV

The calculation boyeeeeeeee

The smaller the percentage, the more sensitive the decision to go ahead is to the change in the variable
Illustration

ACCA colleges are considering a project which will cost them an initial 10,000

The cashflows expected for the 2 year duration are 10,000pa.

The variable costs are 1,000pa

Cost of capital 10%

Calculate the sensitivity analysis of all variables

Solution

PV of project as a whole:

Year 0 1 2

Investment (10,000)

Costs (1,000) (1,000)

Sales 10,000 10,000

Discount Factor 1 0.909 0.826

Discounted Cashflows (10,000) 8,181 7,434

So the NPV as a whole is 5,615

Sensitivity of Initial Investment

5,615 / 10,000 = 56%

Sensitivity of Costs
5,615 / (909 + 826) = 323%

Sensitivity of Sales
5,615 / (9,090 + 8,260) = 32%

Weakness of Sensitivity Analysis

Each variable must change in isolation

Yet they are often interdependent upon each other

It does not take into account probabilities of change occurring

Some factors management may not control

Probability analysis

Probability analysis

This is the assessment of the separate probabilities of a number of specified outcomes of an investment project.

For example, a range of expected market conditions could be formulated and the probability of each market condition arising in
each of several future years could be assessed.

The NPVs arising from these combinations could then be assessed and linked to their joint probabilities.

The expected net present value (ENPV) could be calculated, together with the probability of the worst-case scenario and the
probability of a negative net present value.

In this way, the downside risk of the investment could be determined and incorporated into the investment decision.

The term ‘probability’ refers to the likelihood or chance that a certain event will occur, with potential values ranging from 0 (the
event will not occur) to
1 (the event will definitely occur).
For example, the probability of a tail occurring when tossing a coin is 0.5, and the probability when rolling a dice that it will show
a four is 1/6 (0.166).

The total of all the probabilities from all the possible outcomes must equal 1, ie some outcome must occur

Calculating an EV

Formula

∑px

P = probability and X = Value of outcome

It finds the the long run average outcome rather than the most likely outcome

Illustration

A new product cashflows will depend on whether a substitute comes onto the market or not

Chance of substitute coming in 30%

NPV if substitute comes along (10,000)

NPV with no substitute 20,000

Solution

0.3 x (10,000) = (3,000)

0.7 x 20,000 = 14,000
EV = 11,000

Limitations of Probability Analysis

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.

A long term rather than short term average

 For example the EV of throwing a dice is 3.5!

And the average family in the UK has 2.4 children, now Ive never thrown a 3.5 nor met anyone with 2.4 children.

These are just long term averages, whereas in reality outcomes only occure once

Simulation

Simulation

This looks at many variables all changing at once

Illustration

Variable costs 4 5 6

Probability 30% 50% 20%

Cumulative probability 30% 80% 100%

Random number range 0-29 30-79 80-99

The random numbers represent the probability. So, 30 numbers are given to the 30% range, 50 to the 50% range etc.

A random number is generated - say 48

So NPV based on a variable cost of 5 is generated

This is repeated many times for all variables until we have a probability distribution
Advantages

1. Includes all possible outcomes

2. Easily understood

3. Wide variety of applications

Disadvantages

1. Model can become complex and expensive to set up

2. Probability distributions difficult to formulate

Adjusted Payback

This incorporates risk into the payback method we looked at earlier in

the course

2 Methods

Add payback to NPV - Only projects with +ve NPV and payback within specified time chosen

Discount cashflows used in payback with a risk adjusted discount rate

Illustration of method 2
Year Cashflow
 0 (1,700)

1 500

2 500

3 600

4 900

5 500

Calculate discounted payback at a rate of 12%

Solution

Year Cashflow 12% Cashflow Cumulative

0 (1,700) 1 (1,700) (1,700)

1 500 0.893 446.5 (1,253)

2 500 0.797 398.5 (855)

3 600 0.712 427.2 (427.8)

4 900 0.636 572.4 144.6

5 500 0.567 283.5 428.1

Discounted payback = 3 years 9 months

NPV = 428,100

Risk Adjusted Discount Rates

The discount rate should reflect:

 1. Cost of debt

2. Cost of equity

The mix of the 2 above adjusted for riskiness

If a project gives additional risks then the discount factor should be altered accordingly. This is called the risk premium

Specific Investment Decisions

Capital rationing - Single period- Types

Capital rationing - Types

Shareholder wealth is maximised by taking on positive NPV projects. However, capital is not always available to allow this to
happen.

In a perfect capital market there is always finance available - in reality there is not, there are 2 reasons for this:

HARD CAPITAL RATIONING

This is due to external factors such as banks won’t lend any more - why?

Reasons for Hard Capital Rationing

1. Industry wide factor (recession?)

2. Company has no/poor track record

3. Company has too low credit rating

4. Company has no assets to secure the loan

5. Capital in short supply (crowded out by government borrowing)

SOFT CAPITAL RATIONING

Company imposes it’s own spending restriction. (This goes against the concept of shareholder maximisation - which occurs by
always investing in positive NVP projects ) - why?

Reasons for Soft Capital Rationing

1. Limited management skills in new area

2. Want to limit exposure and focus on profitability of small number of projects

3. The costs of raising the finance relatively high

4. No wish to lose control or reduce EPS by issuing shares

5. Wish to maintain s high interest cover ratio

6. “Internal Capital market” - deliberately restricting funds so competing projects become more efficient

Capital rationing & divisible projects

Capital rationing & Divisible projects

Here, divisible investment projects can be ranked in order of desirability using the profitability index
Steps for the exam with divisible projects

1. It's assumed that part rather than the whole investment can be undertaken

If 70% of a project is performed, for example, its NPV is assumed to be 70% of the whole project NPV.

2. Then its profitability index is calculated

3. The profitability index is then used to rank the investment projects.

Illustration

A Company has 100,000 to invest and has identified the following 5 projects. They are DIVISIBLE.

Project Investment NPV

A 40 20

B 100 35

C 50 24

D 60 18
 E 50 10

Solution

Project Working Profitability Index Ranking

A 20/40 0.5 1

B 35/100 0.35 3

C 24/50 0.48 2

D 18/60 0.3 4

E who cares! 5

Plan

Funds Project NPV

100,000

(40,000) A 20,000

(50,000) C 24,000

(10,000) 10% of B 3,500

Capital rationing & INdivisible projects

Capital rationing & INdivisible projects

In this case ranking by profitability index will not necessarily indicate the optimum investment schedule, since it will not be
possible to invest in part of a project.

In this situation, the NPV of possible combinations of projects must be calculated.

Unfortunately with indivisible projects there is no model to help us! We simply have to look at all the possible combinations by
trial and error work out which would be the most profitable. (Highest NPV)

Surplus funds may be left over, but since the highest-NPV combination has been selected, the amount of surplus funds is
irrelevant to the selection of the optimal investment schedule

Illustration

A company has 100,000 to invest and has identified the following 5 projects. They are NOT DIVISIBLE.

Project Investment NPV

A 40 20

B 100 35

C 50 24

D 60 18
Solution

A+C is the best mix

Project Investment required NPV

A&C 90 44

A&D 100 38

B 100 35

Lease or Buy

Lease or Buy

Simply choose the one with the lowest NPV cost (as asset revenues will be the same for both methods)

Let’s have a look at what are the relevant costs here

LEASE BUY
 Rental Payment Cost of item

(Tax relief on these) (Residual Value)

(WDAs)

Unless the company does not pay tax - use the after tax cost of borrowing

= Interest rate x 70% (if tax is 30%)

*Note that the cost of the loan should not include the interest repayments on the loan

Illustration

Machine cost $6,400 (UEL 5 years)

Capital allowances 25% reducing balance

Finance choices

5 year loan 11.4% pre tax cost or

5 year Finance Lease @ $1,420 pa in advance

Solution

Buy using the Loan

Year WDA Tax benefit Timing

0 Cost 6,400

1 WDA 1,600 480 Year 2

2 WDA 1,200 360 Year 3

3 WDA 900 270 Year 4

4 WDA 675 203 Year 5

5 Balancing Allowance 2,025 608 Year 6

Post Tax borrowing

11.4% x 70% = 7.98% = 8%

Cost = (4,984)

Time 0 1 2 3 4 5 6

Cost (6400)

Tax Benefit 480 360 270 203 608

Discount Factor 1 0.926 0.857 0.794 0.735 0.681 0.630

Discounted Cashflows (6400) 411 286 198 138 383

Option 2 - Lease

Cost (4,548)

Cash Discount Factor Discounted Cashflows

0-4 Lease Payments (1,420) 1+3.312 (6,123)

 2-6 Tax saving 426 4.623 - 0.926 1,575

The cheapest option is the lease

Leasing benefits in general

1. Allows company to get the asset if they can’t get a bank loan

2. Some taxation benefits (Tax exhaustion)

3. Avoids regulations that other lending can give such as covenants etc

Operating Lease Features

1. Possibility of short term rental

2. No initial capital outlay

3. No risk of obsolescence

4. Often maintained & insured by the lessor

5. Off balance sheet finance

6. Can be expensive

Finance lease features

1. Long term rental

2. No need for initial capital outlay

3. Simply an alternative source of finance

4. May be cheaper

Asset Replacement Decision

Assets will need replacing but how often is best?

The different options open to us have different time scales so, in order to compare, we use an EAC (equivalent annual cost):

Steps:

1. Calculate the PV of costs for all options

2. Then the EAC for each option

3. Then choose the option with the lowest EAC

Key Assumptions

1. Although the operating revenues are deemed to be the same, using an older asset may not be as efficient

2. The assets are replaced in perpetuity

3. Tax & Inflation ignored

Illustration

Machine Cost 20,000

Running costs
Year 1 5,000
Year 2 5,500

Residual Value (if sold after..)

Year 1 16,000
Year 2 13,000

Cost of capital = 10%

Solution

Replaced Every Year

0 1

Machine (20,000)

Running Costs (5,000)

Residual Value 16,000

(20,000) 11,000
 Discount Factor 1 0.909

Discounted Cashflows (20,000) 9,999

NPV (10,001)

EAC = 10,001 / 0.909 = 11,002

Replacing Every 2 Years

0 1 2

Machine (20,000)

Running Costs (5,000) (5,500)

Residual Value 13,000

(20,000) (5,000) 7,500

Discount Factor 1 0.909 0.826

Discounted Cashflows (20,000) (4,545) 6,195

NPV (18,350)
EAC = 18,350 / 1.736 = 10,570
Machine should be replaced every 2 years as this is cheaper

Sources of Finance
Short Term Finance
Short term finance

Short term finance

The following are short terms forms of finance

- in the exam always remember to think about these when asked about possible ways of raising finance

1. Overdraft

2. Short term Loan

3. Trade Credit

4. Operating Lease

When recommending though - also think about how much overdraft they already have - what their short term commitments are
already

Operating Leases

This is a useful source of finance for the following reasons:

 Protection against obsolescence

Since it can be cancelled at short notice without financial penalty.

The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business.

This flexibility is seen as valuable in the current era of rapid technological change, and can also extend to contract terms
and servicing cover

Less commitment than a loan

There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be
avoided, existing assets need not be tied up as security and negative effects on return on capital employed can be avoided

Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.

Cheaper than a loan

By taking advantage of bulk buying, tax benefits etc the lessor can pass on some of these to the lessee in the form of lower
lease rentals, making operating leasing a more attractive proposition that borrowing.

Off balance sheet finance

Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of
the leased asset does not appear in the balance sheet.

The role of financial intermediaries in providing short-term finance is

to provide a link between investors who have surplus cash and borrowers who have financing needs.

to aggregate invested funds in order to meet the needs of borrowers.

to offer maturity transformation, in that investors can deposit funds for a long period of time while borrowers may require
funds on a short-term basis only

Long Term Finance

Debt or Equity?
Debt v Equity

These are the things you need to think about when asked about raising finance - so just put all these in your answer and link
them to the scenario. Job done.

Gearing and financial risk

Equity finance will decrease gearing and financial risk, while debt finance will increase them

Target capital structure

The aim is to minimise weighted average cost of capital (WACC).

In practical terms this can be achieved by having some debt in capital structure, since debt is relatively cheaper than equity,
while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers
from the costs of financial distress)

Availability of security

Debt will usually need to be secured on assets by either:

a fixed charge (on specific assets) or

a floating charge (on a specified class of assets).

Economic expectations

If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are
more attractive than when difficult trading conditions lie ahead.

Control issues
 A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.

Equity as Finance

Equity is generally more expensive than debts

Type of Finance Method Description Key Issues

Rights Issue For existing shareholders initially No dilution of control

Placing Fixed price to institutional investors Low cost - good for small issues

Public Underwritten & advertised Expensive - good for large issue

When a company issues shares to the public for the first time. They are often issued by smaller, younger companies looking to
expand, or large private companies wanting to become public.

For the individual investor it is tough to predict share prices on the initial day of trading as there’s little past data about the
company often, so it’s a risky purchase.

Also expansion brings uncertainty in any case

Gearing considerations

High Gearing problems

The higher a company’s gearing, the more the company is considered risky.

An acceptable level is determined by comparison to companies in the same industry.

A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to
service its debt regardless of how bad sales are.

A greater proportion of equity provides a cushion and is seen as a measure of financial strength.

The best known examples of gearing ratios include

1. debt-to-equity ratio (total debt / total equity),

2. interest cover (EBIT / total interest),

3. equity ratio (equity / assets), and

4. debt ratio (total debt / total assets).

Dangers associated with high gearing:

1. Need to cover high fixed costs, may tempt companies to increase sales prices and so lose sales to competition

2. Risk of non payment of a fixed cost and litigation

3. Risk of unsettling shareholders by having no spare funds for dividends

4. Risk of lower credit rating

5. Risk of unsettling key creditors

How finance can affect financial position and risk

Financial Position Gearing

Gearing can be a financially sound part of a business’s capital structure particularly if the business has strong, predictable cash
flows.

Operational gearing

Operating gearing is a measure which seeks to investigate the relationship between the fixed operating costs and the total
operating costs.

In cases where a business has high fixed costs as a proportion of its total costs, the business is deemed to have a high level
of operational gearing.

Potentially this could cause the business problems in as it relies on continuing demand to stay afloat.

If there is a fall in demand, the proportion of fixed costs to revenue becomes even greater. It may turn profits into serious
losses.

Normally, businesses cannot themselves do a great deal about the operational gearing, as it may be typical and necessary in
the industry, such as the airline business.

The normal equation used is:

Fixed operating costs / Total operating costs

 In this sense total operating costs include both fixed and variable operating costs.

Interest cover

Interest cover is a measure of the adequacy of a company’s profits relative to interest payments on its debt.

The lower the interest cover, the greater the risk that profit (before interest) will become insufficient to cover interest payments.

It is:

It is a better measure of the gearing effect of debt on profits than gearing itself.

A value of more than 2 is normally considered reasonably safe, but companies with very volatile earnings may require an even
higher level, whereas companies that have very stable earnings, such as utilities, may well be very safe at a lower level.

Similarly, cyclical companies at the bottom of their cycle may well have a low interest cover but investors who are confident of
recovery may not be overly concerned by the apparent risk.
Long term finance

Long term finance

These are:

1. Finance Lease

You will notice we have included both operating and finance leases as potential sources of finance - don’t forget too to mention
the possibility of selling your assets and leasing them back as a way of getting cash.

Be careful though - make sure there are enough assets on the SFP to actually do this - or your recommendation may look a little
silly ;)

2. Bank loans and bonds/debentures

3. Equity

4. Preference Share

5. Venture Capital - for companies with high growth and returns potential

This is provided to early/start up companies with high-potential.

The venture capitalist makes money by taking an equity share and then realising this in an IPO (Initial Public Offering) or trade sale
of the company

Equity as finance

Rights Issue For existing shareholders initially No dilution of control

Placing Fixed price to institutional investors Low cost - good for small issues

Public Underwritten & advertised Expensive - good for large issue

Rights Issue

For existing shareholders initially - means no dilution of control

A 1 for 2 at $4 (MV $6) right issue means….

The current shareholders are being offered 1 share for $4, for every 2 they already own.

(The market value of those they already own are currently $6)

Calculation of TERP (Theoretical ex- rights price)

Calculation of TERP (Theoretical ex- rights price)

The current shareholders will, after the rights issue, hold:

1 @ $4 = $4
2 @ $6 =$12

So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33

Effect on EPS

Obviously this will fall as there are now more shares in issue than before, and the company has not received full MV for them

To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue

Eg Using the above illustration

EPS x 5.33 / 6

Effect on shareholders wealth

There is no effect on shareholders wealth after a rights issue.

This is because, although the share price has fallen, they have proportionately more shares

Equity issues such as a rights issue do not require security and involve no loss of control for the shareholders who take up
the right
Placing (on the market)

Fixed price to institutional investors.

This means low cost - so good for small issues

Public Issues

These are underwritten & advertised.

This means they are expensive - so good for large issue

IPO - Initial public offering

When a company issues shares to the public for the first time.

They are often issued by smaller, younger companies looking to expand, or large private companies wanting to become public.
For the individual investor it is tough to predict share prices on the initial day of trading as there’s little past data about the
company often, so it’s a risky purchase.

Also expansion brings uncertainty in any case

Islamic Financing
Islamic Finance - Introduction

Islamic Finance - Introduction

Is it moral or ethical to wish wealth into existence without any underlying productive activity happening?
Islamic Finance is based on the principle that money must never spontaneously generate money. Instead capital must be made
fruitful or “fecundated” by labour, material or intellectual activity or be invested in a wealth creating activity.

Islam therefore prohibits the payment of interest on loans, so observant Muslims require specialised alternative arrangements
from their banks.

Many of the largest global financial companies, including Deutsche Bank and JPMorgan Chase, have established thriving
subsidiaries that strive to meet these requirements

Consequently Islamic Finance frowns upon speculation and applauds risk sharing.

The major difference between Islamic finance and the other finance

Equity Financing not Lending

Under Islamic finance laws, interest cannot be charged or received due to the lack of underlying activity

Therefore, Joint ventures under which the lender and the borrower share profits and risks are common because of the strict
prohibition of the giving and taking of interest.

Due to a ban on speculation, Islamic transactions must be based on tangible assets such as commodities, buildings or land.

Islamic banking has its emphasis on equity financing rather than lending

Investing in businesses that provide goods or services considered contrary to the principles of Islam is haraam (forbidden)
while those that are permitted are halaal.

The concept of interest (riba) and how returns are made

Interest is called riba and an instrument that complies with the dictates of Fiqh al-Muamalat (Islamic rules on transactions)
is described as sharia-compliant.

Instead of charging interest (deemed to be money making money), the lender agrees to buy the asset or part of the asset
themselves (asset making money)

Shariah-compliant mortgages, for instance, are typically structured so that the lender buys the property and leases it out to
the borrower at a price that combines a rental income and a capital payment.

At the end of the mortgage term, when the price of the property has been fully repaid, the house is transferred to the
borrower.

NB no calculations are required for this part of the exam

Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the perspective of the borrower, the lender
 and the economy.

For the borrower, riba can turn a profit into a loss when profitability is low.

For the lender, riba can provide an inadequate return when unanticipated inflation arises. In the economy, riba can lead to
allocational inefficiency, directing economic resources to sub-optimal investments

Ijara (leasing) and Murabaha (credit)

Trade credit (murabaha)

Let’s say that you, a small businessperson, wish to go into business selling cars.

A conventional bank would examine your credit history and, if all was acceptable, grant you a cash loan.

You would have to pay back funds on a specific maturity date, paying interest each month along the way.

You would use the proceeds to buy the car—and meet other expenses—yourself.

Murabaha

But in a murabaha transaction, instead of just giving you the cash, the bank itself would buy the cars.

You promise to buy them from the bank at a higher price on a future date.

The markup is justified by the fact that, for a period, the bank owns the property, thus assuming liability.

At no point in the transaction is money treated as a commodity, as it is in a normal loan.

A murabaha must be asset-based however, so it can’t help a small businessman who needs a working-capital loan to meet
payroll and other expenses.

To get such capital from an Islamic financial institution, an entrepreneur would have to sell the bank an equity interest in
his business.

This is far riskier for the bank and thus much harder to obtain.
Lease finance (ijara)

A transaction where a benefit arising from an asset is transferred in return for a payment, but the ownership of the asset
itself is not transferred.

Most often the lessee returns the asset (and its benefits) to the lessor.

Basically an operating lease.

An alternative is for the lessee to buy the asset at the end.

However some jurists do not permit this latter arrangement on the basis that it represents more or less a guaranteed
financial return at the outset to the lessor, in much the same way as a modern interest-based finance lease.

The terms of ijara are flexible enough to be applied to the hiring of an employee by an employer in return for a rent that is
actually a fixed wage.

Some generally agreed conditions for ijara are as follows :

1. The leased asset must continue to exist throughout the term of the lease.

Items which are consumed in the process of usage, ammunition for instance, cannot be leased

2. In contrast with most conventional finance leases, the responsibility for maintenance and insurance of the leased item under ijara
remains that of the lessor throughout

3. A price cannot be pre-determined for the sale of the asset at the expiry of the lease.

However, lessor and lessee may agree the continuation of the lease or the sale of the leased asset to the lessee under a new
agreement at the end of the initial lease period.

Mudaraba (equity), Sukuk (debt) & Musharaka (JV)

Equity finance (mudaraba)

eg. Profit sharing

A type of partnership in which one partner provides the capital while the other provides expertise and management.

Each gets a prearranged percentage of the profits, but the partner providing the capital bears any losses.

Mudaraba is a concept to provide capital to somebody undertaking the work.

It could be understood as being similar to the function of an employed manager of a company.

Legally this concept is established as permissible by the consensus of the scholars and not based on primary sources of the
Shariah.

As the profits are shared with the manager and the capital provider but the losses are beared only by the capital provider this
mode is also named profit sharing – loss bearing.

Before the manager gets his share, the losses, however, if any, needs to be recovered. A wage could be negotiated.

Debt finance (sukuk) eg. Bond issue

Sukuk is an Arabic term in plural (singular Sakk) meaning certificates.

It is the root of the English word for cheque.

Sukuk are securitised assets or business.

The company sells the certificate to the investor, who then rents it back to the company for a predetermined rental fee.

The company promises to buy back the bonds at a future date at par value.

Sukuks must be able to link the returns and cash flows of the financing to the assets purchased, or the returns generated
from an asset purchased.

This is because trading in debt is prohibited under Sharia.

As such, financing must only be raised for identifiable assets.

Venture capital(musharaka) eg Joint venture

Musharaka is the Islamic contract for establishing a joint venture partnership.

In musharaka, two or more parties contribute capital to a business and participate with the related profits and losses.

Simple Musharaka

The profit and the losses needs to be shared.

 This method is recommended by Muslim economists as being the most fair and just method.

In a Musharaka contract all parties may take part in the management or some parties may not take part in the
management (silent partnership).

Losses need to be born proportionately to the capital provided by each party (pro rata).

Regarding the profits there is a disagreement between the schools whether other than pro rata distribution is permissible.

Internal Sources of Finance

Retained Earnings & WC

Retained Earnings

Strictly speaking these are not ALL available as possible finance as many will have already been spent

Businesses make profits for either distribution back to their shareholders, paying off loans or re-investing in the business

The distribution back to shareholders (dividend policy) will be looked at later, but what about paying off a loan?

This should only occur where the ROCE made by the company is less than the interest they are paying on the loan.

Any further monies available can, of course, be used for investments.

The investments chosen though will need to at least match the needs of the shareholders and debtholders (the WACC)

Working Capital Management

By improving the recovery of receivables and delaying the payment of payables, business can free up cash short term to
invest

This is also aided by the quick turn around of inventory

Dividend policy

Dividend policy

A decision to increase capital investment spending will increase the need for financing, which could be met in part by reducing
dividends.

In a perfect market - Miller and Modigliani

Miller and Modigliani showed that, in a perfect capital market, the value of a company depended only on its
investment decision, and not on its dividend or financing decisions.

In a perfect market, the value of a company is maximised when all positive NPV projects are invested in.

This affects share price NOT dividend policy.

In a perfect market the share price reflects all future dividends, so shareholders who were unhappy with the level of
dividend declared by a company could gain a ‘home-made dividend’ by selling some of their shares.

This is possible since there are no transaction costs in a perfect capital market.

Bird in the hand view

Many say there is a clear link between dividend policy and share prices.

For example, it has been argued that investors prefer certain dividends now rather than uncertain capital gains in the future
(the ‘bird-in-the-hand’ argument).

Imperfect markets

The real world markets are semi strong, not perfect.

So information knowledge of managers and shareholders are not equal.

Therefore a change in dividend policy could be seen by investors (with less information than managers) as a ‘signal’ and so
affect the share price.
 Signalling effect

The size and direction of the share price change will depend on the difference between the dividend announcement and
the expectations of shareholders.

This is referred to as the ‘signalling properties of dividends’.

Clientele Effect

Apple shares have outperformed the market massively in the last few years.

This means that Apple shareholders are enjoying huge share price increases (capital growth).

These shareholders cannot get such returns by investing elsewhere so do not want their money back from Apple yet.

Consequently Apple’s dividend policy to date is zero dividends despite its huge cash balances

This is referred to as the ‘clientele effect’.

A company with an established dividend policy is therefore likely to have an established dividend clientele.

The existence of this dividend clientele implies that the share price may change if there is a change in the dividend policy of
the company, as shareholders sell their shares in order to reinvest in another company with a more satisfactory dividend
policy.

Legal Constraints

Three general rules are followed when paying dividends:

1. The Net Profit Rule

dividends can only be paid from current and past earnings

2. Capital Impairment Rule

prevents payment from the value of shares on the balance sheet

3. Insolvency Rule

dividends cannot be paid when insolvent or if the payment makes the firm insolvent
Forms of Dividends

Types of payment:

1. Cash dividends

2. Stock dividends: Corporations distribute dividends in the form of new shares to existing shareholders

3. Stock split: Issue new shares to existing shareholders by splitting existing shares (E.g., 2-for-1 split)

4. Reverse split: Issue new shares to replace out shares but results in a reduction in number of outstanding shares (E.g., 1-for-2 shares)

5. A scrip (or share) dividend is an offer of shares in a company as an alternative to a cash dividend.

It is offered pro rata to existing shareholdings.

Advantages of a Scrip dividend

From a company point of view, it has the advantage that, if taken up by shareholders, it will conserve cash, i.e. it will reduce
the cash outflow from a company compared to a cash dividend.

This is useful when liquidity is a problem, or when cash is needed to meet capital investment or other financing needs.

Another advantage is that a scrip dividend will lead to a decrease in gearing, whether on a book value or a market value
basis, because of the increase in issued shares.

This decrease in gearing will increase debt capacity.

A disadvantage of a scrip dividend is

1. that in future years, because the number of shares in issue has increased, the total cash dividend will increase, assuming the
dividend per share is maintained or increased.

Finance for small and medium sized entities

(SMEs)
Financing SMEs
SMEs can have trouble getting credit

Why problems?

1. No credit history

2. Little assets to use as capital

3. Tailored loans needed - so more admin

4. Their situation can change quickly

Large businesses are more price sensitive than SMEs as they have more choice - for SMEs the problem is not the cost but the
access to credit

Solution

Current liabilities

These are a major source of finance and must be carefully managed in order to ensure continuing availability of such finance

Cost of Capital
Cost of Captial Introduction
Cost of Capital - Basics

The cost of capital represents the return required by the investors (such
as equity holders, preference holders or banks)
Basically the more risk you take, the more return you expect.

This risk is the likelihood of actual returns varying from forecast.

The return for the investors needs to be at least as much as what they can get from government gilts (these are seen as being
risk free). On top of this they would like a return to cover the extra risk of giving the firm their investment.

The investors could be debt or share holders (debt and equity).

The cost of capital is made up of the cost of debt + cost of equity.

The cost of normal debt is cheaper than the cost of equity to the company. This is because interest on debt is paid out before
dividends on shares are paid. Therefore the debt holders are taking less risk than equity holders and so expect less return.

Also debt is normally secured so again less risk is taken.

Creditor hierarchy

When a company cannot pay its debts and goes into liquidation, it must pay its creditors in the following order:

1. Creditors with a fixed charge

2. Creditors with a floating charge

3. Unsecured creditors

4. Preference shareholders

5. Ordinary shareholders

Each of the above will cost the company more as it heads down the list. This is because each is taking more risk itself

Calculating the WACC

Calculating the WACC

Marginal Cost of Capital

If a company gets a specific loan or equity to finance a specific project then this loan/equity cost is the MARGINAL cost of
capital.

Average Cost of Capital

If a company is continuously raising funds for many projects then the combined cost of all of these is the AVERAGE cost of
capital.

Always use the AVERAGE cost of capital in exam questions, unless stated that the finance is specific

Calculating the WACC

Consider a company funded as follows:

Type Amount Cost of Capital

Equity 80% 10%

Debt 20% 8%

What is the weighted average cost of capital?

Equity 80% x 10% = 8%

Debt 20% x 8% = 1.6%
WACC 9.6%

What we have ignored here is how did we get to calculate how the ‘amount’ of equity and debt was calculated - using book or
market values?

Use MV where possible

Illustration

Statement of Financial Position

Ordinary Shares 2,000

Reserves 3,000

Loan 10% 1,000

Ordinary shares MV = 3.75; Loan note MV 80;

Equity cost of capital = 20%; Debt cost of capital = 7.5% (after tax)

Calculate WACC using:

1) Book Values
2) Market Values

Solution

Using Book Values:

 Equity

Ordinary Shares 2,000

Reserves 3,000

5,000

Debt

Loan 1,000

6,000

Equity 5,000/6,000 x 20% = 16.67%

Debt 1,000/6,000 x 7.5% = 1.25%

WACC 17.92%

Solution

Using Market Values:

Equity

Shares 2,000 x 3.75 7,500

 7,500

Debt

Loan 1,000 80/100 800

8,300

Equity 7,500/8,300 x 20% = 18.07%

Debt 800/8,300 x 7.5% = 0.72%

WACC 18.79%

SUMMARY

To Calculate WACC

1. Calculate weighting of each source of capital (as above)

2. Calculate each individual cost of capital

3. Multiply through and add up (as above)

Cost of Equity
DVM or CAPM?

CAPM is generally preferred out of the 2 methods

The dividend growth model allows the cost of equity to be calculated using empirical values readily available for listed
companies.

Measure the dividends, estimate their growth (usually based on historical growth), and measure the market value of the share
(though some care is needed as share values are often very volatile).

Put these amounts into the formula and you have an estimate of the cost of equity.

DVM

The current share price and dividend is easily known but..

it is very difficult to find an accurate value for the future dividend growth rate

using a historic growth rate as a predictor of the future isn't based on fact

The equation:

(Dividend next year / Share Price) + Growth

might suggest that the rate of return would be lowered if the company reduced its dividends or the growth rate.

That is not so. All that would happen is that a cut in dividends or dividend growth rate would cause the market value of the
company to fall to a level where investors obtain the return they require.

CAPM

has a sound theoretical basis, relating the required return of well-diversified shareholders to the systematic risk they face
through owning the shares of a company. However...

finding suitable values for the risk-free rate of return & equity beta can be difficult
DVM difficulties

The dividend growth model has several difficulties.

For example, it impractically assumes that the future dividend growth rate is constant.

The dividend decision depends on past trends but also current conditions.

The historic dividend growth rate is used as a substitute for the future dividend growth rate.

The model also assumes that business risk, and the cost of equity, are constant in future periods, but reality shows us that
companies are subject to constant change.

The dividend growth model does not consider risk explicitly in the same way as the CAPM.

Here, all investors are assumed to hold diversified portfolios and as a result only seek return for the systematic risk of an
investment.

The individual components of the CAPM are found by empirical research and so the CAPM gives rise to a much smaller
degree of uncertainty than that attached to the future dividend growth rate in the dividend growth model.

For this reason, it is usually suggested that the CAPM offers a better estimate of the cost of equity than the dividend
growth model.

Dividend Valuation Model

The cost of equity – the dividend growth model

DVM can be with or without growth.

What this means is that the share price can be calculated assuming a growth in dividends or not

Essentially this model presumes that a share price is the PV of all future dividends. Calculate this (with or without growth) and
multiply it by the total number of shares
It is similar to market capitalisation except it doesn’t use the market share price, rather one worked out using DVM

1. DVM (without growth)

The share price is calculated like this:

Constant Dividend / Cost of Equity (decimal)

Cost of Equity will be given, or calculated via CAPM

Take this share price and multiply it by the number of shares

2. DVM with growth

Dividend in year 1 / Cost of Equity - growth (decimal)

Or
Dividend just paid (1+g) / Cost of Equity - growth (decimal)

Illustration

Share Capital (50c) $2 million

Dividend per share (just paid) 24c
Dividend paid four years ago 15.25c
Current market return = 15%
Risk free rate = 8%
Equity beta 0.8

Solution

Dividend is growing so use DVM with growth model:

Calculating Growth

Growth not given so have to calculate by extrapolating past dividends as before:

24/15.25 sq root to power of 4 = 1.12 = 12%

 So Dividend at end of year 1 = 24 x 1.12

Calculate Cost of Equity (using CAPM)

8 + 0.8 (15-8) = 13.6%

Share price = 24x1.12 / 0.136 - 0.12 = 1,680c

Market cap = $16.8 x (2m / 0.5) = $67.2

capm

CAPM

This method also calculates the cost of equity (like dvm) but looks more closely at the shareholder’s rate of return, in terms of
risk.

The more risk a shareholder takes, the more return he will want, so the cost of equity will increase.

For example, a shareholder looking at a new investment in a different business area may have a different risk.

The model assumes a well diversified (see later) investor.

It suggests that any investor would at least want the same return return that they could get from a “risk free” investment such
as government bonds (Greece?!!).

This is called the risk free return

On top of the risk free return, they would also want a return to reflect the extra risk they are taking by investing in a market
share.

They may want a return higher or lower than the average market return depending on whether the share they are investing in
has a higher or lower risk than the average market risk

The average market premium is Market return - Risk free return

The higher or lower requirement compared to the average market premium is called the beta (β)

Required Return = Rf + β(Rm - Rf)

Rm = Average return for the whole market

Rm - Rf = Average market risk premium
 Beta (β )= How much of the average market risk premium (Rm - Rf) is needed

Systematic and non-systematic risk

More technically Beta (β ) = Systematic risk of the investment compared to the market

1. Systematic risk

Market wide risk - such as state of the economy

All companies, though, do not have the same systematic risk as some are affected more or less than others by external economic
factors

2. Non Systematic Risk

Risk that is unique to a certain asset or company.

An example of nonsystematic risk is the possibility of poor earnings or a strike amongst a company’s employees.

Non-systematic risk can be diversified away

One may mitigate nonsystematic risk by buying different securities in the same industry or different industries.

For example, a particular oil company has the diversifiable risk that it may drill little or no oil in a given year.

An investor may mitigate this risk by investing in several different oil companies as well as in companies having nothing to
do with oil.

Nonsystematic risk is also called diversifiable risk.

capm continued
CAPM continue

How risky is the specific investment compared to the market as a whole?

1. This is the ‘beta’ of the investment If beta is 1, the investment has the same risk as the market overall.

2. If beta > 1, the investment is riskier (more volatile) than the market and investors should demand a higher return than the market
return to compensate for the additional risk.

3. If beta < 1, the investment is less risky than the market and investors would be satisfied with a lower return than the market
return.

Illustration

Risk free rate = 5%

Market return + 14%

What returns should be required from investments whose beta values are:
(i) 1
(ii) 2
(iii) 0.5

Cost of Equity = Rf +beta(Rm - Rf)

(i) = 5 + 1(14 - 5) = 14%

The return required from an investment with the same risk as the market, which is simply the market return.

(ii) = 5 + 2(14 - 5) = 23%

The return required from an investment with twice the risk as the market.

A higher return than that given by the market is therefore required.

(iii) = 5 + 0.5(14 - 5) = 9.5%

The return required from an investment with half the risk as the market.

A lower return than that given by the market is therefore required.

CAPM assumptions

1. Diversified investors

2. Perfect market (in fact they are semi strong at best)

3. Risk free return always available somewhere

4. All investors expectations are the same

Advantages of CAPM

1. The relationship between risk and return is market based

2. Correctly looks at systematic risk only

3. Good for appraising specific projects and works well in practice

Disadvantages of CAPM

1. It presumes a well diversified investor .

Others, including managers and employees may well want to know about the unsystematic risk also

2. The return level is only seen as important not the way in which it is given.

For example dividends and capital gains have different tax treatments which may be more or less beneficial to individuals.

3. It focuses on one period only.

Some inputs are very difficult to get hold of.

For example beta needs a subjective analysis

4. Generally CAPM overstates the required return for high beta shares and visa versa

Cost of Debt
Convertible Debt

Convertible Debt
Here the investor has the choice to either be paid in cash or take shares from the company.

Hence, the debt is convertible into shares.

To calculate the cost of capital here, simply follow the same rules as for redeemable debt (an IRR calculation).

The only difference is that the ‘capital’ figure is the higher of:

1. Cash payable

2. Future share payable

Illustration

8% Convertible debt. Redeemable in 5 years at:

Cash 5% premium or
20 shares per loan note (current MV 4 and expected to grow at 7%)

The MV is currently 85.

Tax 30%.

Time Cash 5% PV 10% PV

1-5 Interest 5.6 4.329 24.24 3.791 21.23

5 Capital 112.2 0.784 87.96 0.621 69.68

MV -85 -85
 27.2 5.91

IRR = 5% + (27.2 / 27.2 - 5.91) x 5% (10-5) = 11.4%

Note :

Interest = 100 x 8% x 70% (tax adj) = 5.6

Capital = higher of 100 x 1.05% (premium) = 105 and 20 x 4 x 1.07 power 5 = 112.2

Terminology

Floor Value MV without conversion option (basically the above calculation using cash as capital)

Conversion Premium MV of loan - convertible shares @ today’s price

Irredeemable, preference shares and Bank loans

Irredeemable debt

The company just pays back the interest (NOT the capital)

So the MV should just be all the expected interest discounted at the investor’s required rate of return.

Therefore, the cost of debt (the debtholder’s required return) can be calculated as follows:

Annual Interest / Market Value

Preference Shares

Treat the same as irredeemable debt except that the dividend payments are never tax deductible

Annual Dividend / Market Value

Illustration

50,000 8% preference shares.

MV 1.20.

What is the cost of capital for these?

(8% x 50,000) / (50,000 x 1.2) = 6.67%

Bank Debt

The cost of debt is simply the interest charged. Do not forget to adjust for tax though if applicable.

Illustration

$1,000,000 10% Loan. Tax 30%.

What is the cost of debt?

7%
Redeemable debt

Redeemable debt

The company pays the interest and the original amount (capital) back.

So the MV is the interest and capital discounted at the investor’s required rate of return.

Remember the cost of debt to the company is the debtholder’s required rate of return. (Tax plays a part here as we shall see
later)

To calculate the cost of debt in an exam an IRR calculation is required as follows:

1. Guess the cost of debt is 10 or 15% and calculate the present value of the capital and interest.

2. Compare this to the correct MV

3. Now do the same but guess at 5%

4. Use the IRR formula to calculate the actual cost of capital

Illustration

5 years 12% redeemable debt. MV is 107.59

Time Cash 5% PV 15% PV

1-5 Interest 12 4.329 51.95 3.352 40.22

5 Capital 100 0.784 78.40 0.497 49.7

 MV -107.59 -107.59

22.76 -17.67

IRR = 5% + (22.76 / 22.76+17.67) x 10% (15-5) = 10.63

The Tax Effect

Tax reduces the cost of capital to a company because interest payments are tax deductible.

It was ignored in the last example, but let’s say that that tax was 30%, then the actual interest cost was not 12 but 12x70% =
8.40

Simply take the interest figure and multiply it by 1 - tax rate%.

Illustration

20% Redeemable debt.

Tax 30%.

What is the interest charge to be used in a cost of capital calculation for a company?

20% x 70% = 14%

Now let’s rework that last example but this time use 10% as a guess and let’s assume tax of 30%

Time Cash 5% PV 10% PV

 1-5 Interest 8.4 4.329 36.36 3.791 31.84

5 Capital 100 0.784 78.40 0.621 62.1

MV -107.59 -107.59

7.17 -13.65

IRR = 5% + (7.17 / 7.17 + 13.65) x 5% (10-5) = 6.72

The cost of capital is lower than the original example as tax effectively reduces the cost to the company as interest is a tax
deductible expense.

Bringing it all together

WACC - Putting it all Together

WACC - Putting it all Together

So, you have studied all the bits in isolation, here’s where we get sexy and bring it all together..

So, this is kind of the proforma you need to set up, when you get a “Calculate the WACC..” question

DEBT/EQUITY COST Market Value “Interest”

Equity 10% 1,000 100

Loan 6% 800 48
 Total 1,800 148

So we have paid “interest’ of 148 on capital of 1,800…

So the WACC is 148/1,800 = 8.2%

Final Flourishes
Capital structure theories

These are 3 theories (& pecking order) to see if there is a perfect capital
structure

This simply means - is there a perfect Debt to Equity ratio?

For example, 40% Debt and 60% Equity?

Well there are 3 theories here we go..

The Traditional Theory

suggests that using some debt will lower the WACC, but if gearing rises above an acceptable level then the cost of equity will rise
dramatically causing the WACC to rise.

The cheap cost of debt (as it is ranked before equity in terms of distribution of earnings and on liquidation), combined with its
tax advantage, will cause the WACC to fall as borrowing increases.

However, as gearing increases past a certain point, shareholders increase their required return (i.e., the cost of equity rises).

This is because there is much more interest to be paid before they get their dividends.

At high gearing the cost of debt also rises because the chance of the company defaulting on the debt is higher (i.e., bankruptcy
risk).

So at higher gearing, the WACC will increase.

The main problem with the traditional view is that there is no underlying theory to show by how much the cost of equity should
increase because of gearing worries or the cost of debt should increase because of default risk.

In the traditional view of capital structure, ordinary shareholders are relatively indifferent to the addition of small amounts of
debt in terms of increasing financial risk and so the WACC falls as a company gears up.

As gearing up continues, the cost of equity increases to include a financial risk premium and the WACC reaches a minimum value.

Beyond this minimum point, the WACC increases due to the effect of increasing financial risk on the cost of equity and, at higher
levels of gearing, due to the effect of increasing bankruptcy risk on both the cost of equity and the cost of debt.

Although it is more or less realistic, the traditional view remains a purely descriptive theory.

This view can be represented by a U shaped graph, where the vertical axis is the WACC and the horizontal the amount of debt
finance.

Next, Modigliani and Miller (MM)

the use of debt transfers more risk to shareholders, and this makes equity more expensive so that the use of debt does not
reduce finance costs ie does not reduce the WACC.
Modigliani and Miller views

In order to demonstrate a workable theory, MMs 1958 paper made a number of simplifying assumptions:

The capital market is perfect;

There are therefore no transactions costs and the borrowing rate is the same as the lending rate and equal to the so-called risk
free rate of borrowing;

Taxation is ignored

Risk is measured entirely by volatility of cash flows.

Main idea

Debt or Equity - it doesn’t matter

The WACC remains the same throughout

As a company takes on more debt, the equity holders take on a little more risk

The more debt brings the WACC down but the extra risk for equity holders, increases Cost of Equity and so the WACC
comes back up again
M&M (with tax)

If debt also saves corporation tax then it does reduce finance costs, which benefits shareholders ie it reduces the WACC.

This suggests that a company should use as much debt finance as it can.
Main idea

Taxation

If Debt gets tax relief and equity doesn't then the straight line graph is wrong

The tax will make debt cheaper than equity and so more debt is advantageous at all levels

However, this still presumes a perfect market where people don't worry about bankruptcy risk - they do!

Therefore at higher levels of debt, WACC would actually rise in the real, imperfect market

Pecking Order Theory

Pecking Order Theory

This simply suggests that firms do not look for an optimum capital structure rather they raise funds as follows:

1. Internally generated funds

2. Debt

3. New share issue

This is because internally generated funds have no issue costs and needs no time and effort in persuading others.

Debt is better accepted by the markets than looking for cash via a share issue which can seem desperate. Issue costs moderate.

Debt finance may also be preferred when a company has not yet reached its optimal capital structure and it is mainly financed
by equity, which is expensive compared to debt.

Issuing debt here will lead to a reduction in the WACC and hence an increase in the market value of the company.

One reason why debt is cheaper than equity is that debt is higher in the creditor hierarchy than equity, since ordinary
shareholders are paid out last in the event of liquidation.

Debt is even cheaper if it is secured on assets of the company.

The cost of debt is reduced even further by the tax efficiency of debt, since interest payments are an allowable deduction in
arriving at taxable profit.

Debt finance may be preferred where the maturity of the debt can be matched to the expected life of the investment project.

Equity finance is permanent finance and so may be preferred for investment projects with long lives.

Ungearing & Regearing

Ungearing & Regearing

When to use WACC to appraise investments

The WACC calculations we made earlier were all based on CURRENT costs and amounts of debt and equity.

So use this as a cost for other future projects where:

1. Debt/equity amounts remain unchanged

2. Operating risk of firm stays same

3. Finance is not project specific (so the average is applicable)

4. Project is relatively small so any changes to the company are insignificant.

If any if the above do not apply - then we cannot use WACC. We then have to use CAPM..
adapted…
Ungearing & Regearing

The betas we have been looking at so far are called Equity Betas

These represent :

Business Risk

Our Financial Risk (Our gearing)

If we are looking to invest into a different industry we need to use a different beta, one
which represents:

Business Risk (of new industry)

Financial Risk (Ours still as we are using our debt and/or equity)

To do this - follow these 2 simple steps

1. Ungearing

Take the equity beta of a business in the target industry.

Remember, this will represent their business risk and their financial risk (gearing).

We only want their business risk.

So we need to take out the financial risk - this is called ungearing

Business equity beta x Equity / Equity + Debt

This will leave us with business risk only (asset beta)

2. Re-Gearing

Take this asset beta and regear it using our gearing ratio as follows:

Asset Beta x Equity + Debt / Equity

*Remember Debt is tax deductible

Illustration

Tax = 30%

Main company Proxy company

Equity beta 1⋅1 1⋅4

Gearing 2⋅5 1⋅4

Find the appropriate beta for the main company to use in its CAPM for investing in an
industry different to its own but the same as the proxy company

1. STEP 1

Ungear the ß of the proxy company:

ßu = ßg [Ve/(Ve + Vd (1 - t))]

= 1⋅4 x 4/4⋅7 = 1⋅1915

2. STEP 2

Regear the ß:

ßg = 1⋅1915 x (5 + 2 (1 - 0⋅3))/5
= 1⋅525

THEN APPLY THIS TO THE CAPM FORMULA

Types of Risk

Let's look at 3 commonly examined types of Risk

Business Risk

comes from the nature of a company’s business operations

1. The variability of returns due to business operations

2. The way operating profit changes as revenue changes

3. Looks at operational gearing

How much variable compared to fixed costs the business has

4. Can be calculated as (Sales - variable costs) / Operating profit

Then shown as a %

Financial Risk

Looks at the amount of debt as a source of finance

1. The variability of returns due to having to pay interest

2. Debt/equity ratio - using either book or market values

3. Interest cover also - PBIT / Interest

Systematic Risk

the sum of business risk and financial risk (to the shareholder)

1. The risk relating to the market as a whole (individual company risk diversified away)

2. Also known as Market risk and Undiversifiable risk

3. Can be assessed by the equity beta of the company (which includes both finance and business risks)
Business Valuations
Valuation overview
Valuations - Introduction

When are Valuations needed?

1. Takeovers (Price paid would be MV + a takeover premium)

2. When setting a price for an I.P.O (Initial Public Offer)

3. Selling ‘private’ shares

4. When using shares as loan security

5. When negotiating a sale of a private company

6. For liquidation purposes

What information helps Valuation?

Financial statements

Non current asset summaries

Investments held

Working capital listing (debtors, creditors and stock)

Lease agreements

Budgets

Current industry environment

What are the limitations of the information provided?

 Does the PPE need a costly revaluation?

Are there any contingent liabilities not taken into account?

Has deferred tax been calculated appropriately?

How has stock been valued?

Are all debtors receivable?

Are there any redundancy costs?

Any prior charges on assets?

What shareholding is being sold? Does it mean the business carries on?

Efficient Market Hypothesis (EMH)

Stock market efficiency usually refers to the way in which the prices of
traded financial securities reflect relevant information

Weak Form

1. Share prices reflect past information only

2. Investors cannot generate abnormal returns by analysing past information

3. Share prices appear to follow a ‘random walk’ by responding to new information as it becomes available

Semi- Strong

Share prices reflect past and current public information

 Investors cannot generate abnormal returns by analysing public information as share prices respond quickly and accurately
to new information as it becomes publicly available

Strong

1. Share prices reflect public, past and private information

2. Even investors with access to insider information cannot generate abnormal returns in such a market

Stock markets are semi-strong

Managers will not be able to deceive the market by the timing or presentation of new information, such as annual reports or
analysts’ briefings, since the market processes the information quickly and accurately to produce fair prices.

Managers should therefore simply concentrate on making financial decisions which increase the wealth of shareholders.

Income Based Valuations

Using PE ratio

Take the earnings of the company you are trying to value and multiply it
by the average P/E ratio of their industry

Income based methods like this are best used when

When taking control of a company

When more interested in earnings than dividend policy

Price Earnings Ratio
It essentially tells us is how long it would take the earnings to repay the share price
Ok so this is how it is calculated...

But what we are more concerned with here is how to use this to calculate the value of a business, again here is the formula to
use to calculate the value of ONE share..

How to calculate the value of ONE share

How to calculate the value of the WHOLE business

Or...
Both of these give the value of the company as a whole..

HOWEVER, to value a target company you need to use THEIR earnings and our own P/E ratio or at least a P/E ratio from their
industry

Also note: The PE can be adjusted down by 10 - 20%

If private company (as less liquid shares)

If risky company (fewer controls etc)

Share Capital (25c) $100,000

Profit before tax $260,000
Tax (120,000)
Preference Dividend ($20,000)
Ordinary Dividend ($36,000)
Retained $84,000

PE (for similar company) = 12.5

What is the value of 200,000 shares?

Solution
Value of Company = PE x Earnings (PAT - Pref divs)

Total Earnings (of 200,000 shares)

140,000 - 20,000 = 120,000 x 200/400 = 60,000

PE 12.5

60,000 x 12.5 = $750,000

Drawbacks Of PE model

1. Finding a quoted company that is similar in activity (most have a wide range)

2. A single year’s PE ratio may not be representative

3. The quoted company used to get the PE ratio from may have a totally different capital structure

Earnings Yield

This is the inverse of the PE ratio

Basically this is how much your earnings are as a % of your share price

Value of Company using Earnings Yield = Total Earnings x 1/Earnings yield

PAT 300,000; Earnings yield 12.5%

What is the value of this company?

Solution
300,000 x 1/0.125 = $2,400,000

Discounted Cashflows

This is the PV of future cashflows - value of debt

Ok so this example is difficult but let's take it one step at a time..

PBT 80 (all cash)

Capital Investment each year 48
Debt 10 ($120)
Tax = 30%
WACC = 10%

The profits are expected to continue for foreseeable future (perpetuity)

What is the value of equity?

First of all you need to know how to calculate the value of something that lasts forever (like the profits here)

Well this is called a perpetuity

And calculating its PV is easy! Just Divide it by the discount factor!

So say it's a perpetuity of 60 at a discount rate of 4% = 60 / 0.04 = 1,500

In this question the income needs taxing remember!

Solution
Cash inflow 80 x 70% = 56 - 48 = 8 (in perpetuity)

Value of business = 8 / 0.1 = 80m

So the Equity is the value of all the cashflows less value of debt remember

Equity = 80m - (10 x 1.2) = 68m

Advantages of DCF Method

1. Theoretically best method

2. Can value part of a company

Disadvantages of DCF Method

1. Need to estimate cashflows and discount rate

2. How long is PV analysis for?

3. Assumes constant tax, inflation and discount rate

Other Valuation techniques
Market Capitalisation

This is very straightforward and is often referred to as “Market Cap”

It is calculated as follows:

Share Price x Number of shares

Illustration

Share Price 96c

Share Capital (nominal value 50c) $60million

Solution

96 x (60/.5) = $115.2 million

Dividend Valuation

Essentially this model presumes that a share price is the PV of all future
dividends

Calculate this (with or without growth) and multiply it by the total number of shares

It is similar to market capitalisation except it doesn’t use the market share price, rather one worked out using DVM
DVM can be with or without growth.

DVM without Growth

Note:

Cost of Equity will be given, or calculated via CAPM

Take this share price and multiply it by the number of shares

DVM with growth

Note:

Dividend + growth = Dividend end of year 1

Share Capital (50c) $2 million

Dividend per share (just paid) 24c
Dividend paid four years ago 15.25c
Current market return = 15%
Risk free rate = 8%
Equity beta 0.8

Solution
Dividend is growing so use DVM with growth model:

Calculating Growth
Growth not given so have to calculate by extrapolating past dividends as before:

24/15.25 sq root to power of 4 = 1.12 = 12%

So Dividend at end of year 1 = 24 x 1.12

Calculate Cost of Equity (using CAPM)

8 + 0.8 (15-8) = 13.6%

So using DVM with Growth model

Dividend + growth / Cost of Equity - growth (decimal)

Share price = 24x1.12 / 0.136 - 0.12 = 1,680c

Market cap = $16.8 x (2m / 0.5) = $67.2

Asset Based Valuations

Valuing a business by looking at its assets only is a troublesome affair..

When is it a good technique then - cow face?

oooh cheeky, anywhere here goes..

1. When looking to asset strip the company

2. As a minimum price

3. When valuing Investment companies

NB. If a company is quoted on a market AND is a going concern then the minimum valuation is..

Market price + Acquisition premium

There are different ways of measuring assets:

Book Values

This is poor as it uses Historic costs and not up to date values. It can give a ball park figure though

Net Realisable Value

This would represent the minimum value of a private company - as it is what the assets alone could be sold for. However, even
here there is the problem of needing to sell quickly may mean the NRV might be difficult to value

Another weakness of this is that this gives a value for the assets when SOLD not when IN USE. Therefore, not good for a
situation of partial disposal where business and hence assets will carry on

Replacement Cost

Here the valuation difficult - need similar aged assets value. It also ignores goodwill

If assets are to be sold on an ongoing basis

Illustration

NCA 450

Current Assets 150

Current Liabilities (50)

Share capital ($1) 200

Reserves 250

6% Loan 100

Loan is redeemable at 2% premium

MV of property is $30,000 more than carrying value
What is the value of an 80% holding using assets basis?

Solution
NCA 450+30 = 480

Current Assets 150

Current Liabilities (50)

6% Loan (100 x 1.02) = (102)

6% 478

X 80% = 382,400

Foreign Exchange and Interest

Foreign Exchange
Types of foreign currency risk

Types of foreign currency risk

Translation

Risk that there will be losses when a subsidiary is translated into the parent company currency when doing consolidated
accounts

Transaction

Risk of exchange rates moving against you when buying and selling on credit, between the transaction date and actual
payment date
Economic

Long term cashflow risk caused by exchange rate movements.

For example a UK exporter will struggle if sterling appreciated against the euro.

It is like a long term transaction risk

Options to manage these risks

1. Only deal in home currency ! (commercially acceptable?)

2. Do nothing ! (Saves transaction costs but is risky)

3. Leading - Receive early (offer discount) - expecting rate to depreciate

4. Lagging - Pay later if currency is depreciating

5. Matching - Use foreign currency bank account - so matching receipts with payments then risk is against the net balance

6. Another way of managing the risk is using:

Hedging, options, futures, swaps and forward rates - more of these later!

Forward Rates

Forward Rates

So, remember what we are looking at here are ways to negate the risk that, in the future, the exchange rates may move against
us

So we have bought or agreed a sale now in a foreign currency, but the cash won’t be paid (or received) until a future date

With a forward rate we are simply agreeing a future rate now.

Therefore fixing yourself in against any possible future losses caused by movements in the real exchange rate
However - you also lose out if the actual exchange rate moves in your favour as you have fixed yourself in at a forward rate
already

Illustration

UK importer has to pay $1,000 in a months time

He takes the forward rate of $1.8-1.9:£
The bank then has agreed to SELL the dollars (counter currency) to the importer.

Remember the bank SELLS LOW

The exchange rate would therefore be $1.8:£

So, the bank will give the exporter $1,000 in return for £555.

The importer must pay £555

NOTE

If importer cannot fulfill the forward contract agreed (maybe because he didnt receive the goods) the bank will sell the
importer the currency and then buy it back again at the current spot rate.

This closes out the forward contract

Advantages of forward rate

1. Flexibile

2. Straightforward

Disadvantages of forward rate

1. Contracted commitment (even if you haven’t received money)

2. Cannot benefit from favourable movements

Money Market Hedges - payment

Money Market Hedges - payment

The whole idea of a money market hedge is to take the exchange rate NOW even though the payment is in the future.

By doing this we eliminate the future exchange risk (and possible benefits too of course)

So. the foreign payment is in the future, but we are going to get some foreign currency NOW to pay for it.

We do not need the full amount though, as we can put the foreign money into a foreign deposit account to earn just enough
interest to make the full payment when ready

We, therefore, calculate how much is needed now by taking the full amount and discounting it down at the foreign deposit rate

Now we know how much foreign currency we need NOW, we can convert that into home currency using the spot rate

We now know how much home currency we need. This needs to be borrowed. So, the cost to
us will eventually be:

Amount of home currency borrowed + interest on that until payment is made.

(Obviously here we use the home borrowing rate)

Steps:

1. Calculate how much foreign currency needed (discount @ foreign deposit rate)

2. Convert that to home currency

3. Borrow that amount of home currency

4. The cost will be the amount borrowed plus interest on that (home currency borrowing rate)

Illustration

Let’s say we are a UK company and need to pay $100 in 1 year.

UK borrowing rate is 8% and US deposit rate is 10%.

Exchange rate now $2 - 2.2 :£

 Need to pay $100 in 1 year so we borrow 100 x 1/ 1.10 = 91

Borrow just $91 as we then put it on deposit and it attracts 10% interest - to pay off the whole $100 at the end

Convert $91 dollars now. We need dollars, so bank SELLS us them. They always SELL LOW. So 91 / 2 = £45.5

£45.5 is borrowed now. We will then have to pay interest on this in the UK for a year.

So £45.5 x 1.08 = 49.14

£49.14 is the total cost to us

Money Market Hedge - Receipt

Money Market Hedge - Receipt

The whole idea of a money market hedge is to take the exchange rate NOW even though the receipt is in the future.

By doing this we eliminate the future exchange risk (and possible benefits too of course)

The foreign receipt is in the future, we are going to get eliminate rate risk by getting that foreign currency NOW.

To do this we need to borrow it abroad.

We do not borrow the full amount though, as the receipt will pay off this loan plus interest.

We, therefore, calculate how much is needed now by taking the full amount and discounting it down at the foreign borrowing
rate

Now we know how much foreign currency we need NOW, we can convert that into home currency using the spot rate.

Here the bank are buying foreign currency off us and so will BUY HIGH

We then take this home currency and put it on deposit at home

The eventual receipt is the amount converted plus the interest earned at home
Steps:

1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)

2. Convert that to home currency

3. Deposit that amount of home currency

4. The receipt will be the amount converted plus interest on that (home currency deposit rate)

Illustration

Will receive $400,000 in 3 months

Exchange rate now: $1.8250 - 1.8361:£
Forward rates $1.8338 - 1.8452:£
Deposit rates (3 months) UK 4.5% annual US 4.2% annual
Borrowing rates (3 months) UK 5.75% US 5.1% annual

1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)

Interest = 5.1% x 3/12 = 1.275%

$400,000 x 1/ 1.01275 = $394,964

2. Convert that to home currency

The UK company now needs to sell $394,964 from the bank. The bank will BUY HIGH

394,964 / 1.8361 = £215,110

3. Deposit that amount of home currency

This amount will be deposited at home at 4.5% for 3/12 = 1.125% = 215,110 x 1.125% = £217,530

Currency Futures

What is this little baby all about then?

It’s a standard contract for set amount of currency at a set date

 It is a market traded forward rate basically

*Calculations of how these work are NOT required in the exam

Explanation

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

Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market’.

Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to the
initial futures transaction, ie if buying currency futures was the initial transaction, it is closed out by selling currency futures. A
gain made on the futures transactions will offset a loss made on the currency markets and vice versa.

Advantages

1. Lower transaction costs than money market

2. They are tradeable and so do not need to always be closed out

Disadvantages

1. Cannot be tailored as they are standard contracts

2. Only available in a limited number of currencies

3. Still cannot take advantage of favourable movements in actual exchange rates (unlike in options…next!)
Currency Options

Currency Options

Features of currency options

A currency option gives its holder the right to buy (call option) or sell (put option) a quantity of one currency in exchange for
another, on or before a specified date, at a fixed rate of exchange (the strike rate for the option).

Currency options can be purchased over-the-counter or on an exchange. In practice, companies buying call or put currency
options do so in over-the- counter deals with a bank.

They protect against adverse movements in the actual exchange rate but allow favourable ones!

Clearly, because of this, the option involves buying at a premium.

Disadvantages

1. The premium

2. Must be paid up immediately

3. Not available in every currency

Advantages

1. Currency options do not need to be exercised if it is disadvantageous for the holder to do so.

2. Holders of currency options can take advantage of favourable exchange rate movements in the cash market and allow their
options to lapse. The initial fee paid for the options will still have been incurred, however.

Currency Swaps

What are they?

What are they?

The exchange of debt from one currency to another

2 companies agree to exchange payments on different terms (eg different currency)

Advantages

1. Easy

2. Low transaction costs

3. Spread debt across different currencies

How to use them

Currency swaps are better for managing risk over a longer term (than currency futures or currency options)

A currency swap is an interest rate swap (between 2 companies) where the loans are in different currencies.

It begins with an exchange of principal, although this may be a notional exchange rather than a physical exchange.

During the life of the swap agreement, the companies pay each others’ foreign currency interest payments. At the end of the
swap, the initial exchange of principal is reversed.

Understanding Exchange Rates

Understanding Exchange Rates

£ : $1.5
Here £ = Base Currency; $ = Counter Currency

£0.67:$

Here $ = Base Currency; £ = Counter currency

Normally the “foreign” currency is the counter currency

Banks BUY HIGH and SELL LOW

Here we are referring to the foreign / counter currency

If a company needs to make a foreign currency payment

Banks SELL the foreign currency at the LOWER rate

If a company needs to make a foreign currency receipt

Banks will BUY that foreign currency from them at the HIGHER rate

Translating Currencies

1. If you are given the counter currency:

DIVIDE the amount by the exchange rate

Eg A UK company has to pay $1,500.

£ : $1.5
Solution = $1,500 / 1.5 = £1,000

2. If you are given the Base currency:

MULTIPLY the amount by the exchange rate

 Eg A UK company has to pay £1,000 in $.
£ : $1.5
Solution = £1,000 x 1.5 = $1,500

Interest Rates
Interest Rate Risk

Interest Rate Risk

Fixed rate borrowing - risk that variable rates drop

Variable rate borrowing - risk that variable rates rise

Yield Curves (Return to debtholder)

Normal

Long term loans - higher yields (more risk)

Inverted

Longer term loans - Less yield (upcoming recession)

Flat

Yields are same for short and long term loans

The shape of the curve depends on:

In a bit more detail, the shape of the yield curve and thus the expectations of what the interest rates will be depends on…

1. Liquidity preference

Investors want their cash back quickly therefore charge more for long term loans which tie up their cash for longer and thus
expose it to more risk

2. Expectations

Interest rates rise (like inflation) - so longer term more charged

NB. Recession expected means less inflation and less interest rates so producing an inverted curve

3. Market segmentation

If demand for long-term loans is greater than the supply, interest rates in the long-term loan market will increase

Differing interest rates between markets for loans of different maturity can also explain why the yield curve may not be smooth,
but kinked

4. Fiscal policy

Governments may act to increase short-term interest rates in order to reduce inflation

This can result in short-term interest rates being higher than long-term interest rates,

Why is yield curve important?

It predicts interest rates.

Normal curves are upward sloping.

Therefore, in these circumstances, use short term variable rate borrowing and long term fixed rate.
 Gap Exposure?

The risk of an adverse movement in the interest rates reducing a company’s cashflow

Interest Rate - Forwards & Futures

Interest Rate - Forwards & Futures

Forward rate

This locks the company into one rate (no adverse or favourable movement) for a future loan

If actual borrowing rate is higher than the forward rate then the bank pays the company the difference and vice versa

They are usually only available on loans of at least £500,000

Procedure

1. Get loan as normal

2. Get forward rate agreement

3. Difference between 2 rates is paid/received from the bank

Illustration

Company gets 6% 600,000 FRA

Actual rate was 10%

Solution
 FRA receipt from bank (10%-6%) x 600k 24,000

Payment made (10% x 600,000) (60,000)

Net payment 36,000

Interest Futures

Standard contract for set interest rate at a set date

It is a market traded forward rate basically

Calculations of how these work are NOT required in the exam

As interest rates rise - bond prices fall

Let’s say you are expecting interest rates to rise.

You would sell a bond futures contract, and when the interest rate rises, the value of the bond futures contract will fall.

You would then buy the return of the contract at a normal price, making a profit.

As interest rates fall - bond prices increase

Let’s say you are expecting interest rates to decline in the near future.

You would buy a futures contract for bonds.

When interest rates fall, the price of bonds increase, and so does the bonds futures contract.

You then sell the bond futures contract at a higher price.

Borrowers sell futures to hedge against rises

Lenders buy futures to hedge against falls

Market Value of Bonds

Market Value of Bonds

Have a think (or even better) a look at when we calculated the cost of debt for Irredeemable debts (bonds)

You will see that we took the capital and interest and discounted it (at a guessed rate) then compared it to the MV of the
bond..and so on

This is because you calculate the MV of a loan or a bond by taking its Capital and Interest and discounting it down by the cost of
debt

Therefore the MV of Bonds is affected by:

1. Amount of interest payment

The market value of a traded bond will increase as the interest paid on the bond increases, since the reward offered for owning
the bond becomes more attractive.

2. Frequency of interest payments

If interest payments are more frequent, say every six months rather than every year, then the present value of the interest
payments increases and hence so does the market value.

3. Redemption value

If a higher value than par is offered on redemption, the reward offered for owning the bond increases and hence so does the
market value.

4. Period to redemption

The market value of traded bonds is affected by the period to redemption, either because the capital payment becomes more
distant in time or because the number of interest payments increases.

5. Cost of debt
 The present value of future interest payments and the future redemption value are heavily influenced by the cost of debt, i.e. the
rate of return required by bond investors.

This rate of return is influenced by the perceived risk of a company, for example as evidenced by its credit rating.

As the cost of debt increases, the market value of traded bonds decreases, and vice versa.

6. Convertibility 


If traded bonds are convertible into ordinary shares, the market price will be influenced by the likelihood of the future conversion
and the expected conversion value, which is dependent on the current share price, the future share price growth rate and the
conversion ratio.

Interest Options and Swaps

Which theory best explains why yield curves are normally upwards
sloping (longer term more expensive)?

Interest Rate Options

Grants the buyer the right (no obligation) to deal at a specific interest rate at a future date. At that date the buyer decides
whether to go ahead or not

These protect against adverse movements in the actual interest rate but allow favourable ones!

Clearly, because of this, the option involves buying at a premium.

Interest rate Swaps

2 companies agree to exchange interest rate payments on different terms (eg fixed and variable)

Advantages

1. Easy
2. Low transaction costs (compared to getting a different loan)

Predicting
Predicting Exchange Rates

Purchasing Power Parity (PPP theory)

Why do exchange rates fluctuate?

“The law of one price”

Illustration

Item costs $1,000

$2:€ (base)
However inflation in US is 5% and Europe is 3%

According to law of one price what is the predicted exchange rate in 1 year?

Solution

So next year - Item in US costs $1,050 and in Europe €515

“The law of one price” = $1,050 = €515

So, forward exchange rate = 1,050 / 515 = $2.039:€1

PPPT “High inflation leads to depreciation of currency”

Another way of calculating this is as follows:

Exchange rate now x 1+ Inf (counter) / 1 + inf (base)

2 x 1.05 / 1.03 = 2.039

Limitations

1. Future inflation is an estimate

2. Market is ruled by speculative not trade transactions

3. Governments often intervene

Interest Rate Parity (IRP theory)

Why do exchange rates fluctuate?

An investor will get the same amount of money back no matter where he deposits his money

Illustration

US Interest rate = 10%

European Interest rate = 8%
Exchange rate = $2:€

Investor has $1,000 to invest for 1 year

What is the future exchange rate as predicted by IRPT?

Solution

In US he will receive $1,100 in one years time

In Europe he will receive €540
Forward rate will therefore be 1,100 / 540 = $2.037:€

IRPT “High interest rates leads to depreciation of currency”

Another way of calculating this is as follows:

Exchange rate now x 1+ Int (counter) / 1 + int (base)

2 x 1.10 / 1.08 = 2.037

Limitations

1. Government intervention

2. Controls on currency trading