Tutorial 3 (Week 4) Solutions

Ch03 - Holmes
 Exercises

1. Describe the uses which may be made of the capital asset pricing model in the financial
management of a business enterprise. Is there any reason to believe that these uses might
not exist in small enterprise financial management? q. 8
The major uses of the capital asset pricing model are to calculate required returns on securities and portfolios. The
required return on an individual security is, of course, equal to the cost of equity for the firm concerned. This then
enables the calculation of a weighted-average cost of capital.

The capital asset pricing model, however, cannot be applied to most small enterprises because their securities are
not listed on the stock market. It is not, therefore, possible to calculate the return since the return comprises not only
dividends but also price rises and falls. The use of surrogate betas and accounting betas has been suggested as a
way around this problem but both would at best be approximations. Generally speaking, the best thing that can be
done for a small, unlisted enterprise is to estimate a required return that should include a small enterprise risk
premium.

Another problem with applying the capital asset pricing model in small enterprises is that the assumption about
diversification does not hold. Most small enterprise owner-managers have all of their wealth invested in their
company and so are not able to spread their investments in a way that will eliminate unsystematic risk.

Ch07 - Holmes
 Exercises

1. Why do large enterprises typically have a relatively high level of financial control when
compared to small enterprises? q. 4
The reason for an increased level of financial control in large firms is the separation of the owners (shareholders)
from the management. The owners need to ensure that funds are being utilized in a manner consistent with company
objectives. Also, there are many more employees and therefore significantly increased risk of theft or fraud. Large
firms can afford the set-up and ongoing costs associated with financial systems and reporting and will have access
to in-house specialists to interpret and review information. Small firms do not necessarily need such levels of control
and often personal assets of owners are mixed in with business assets, making it much harder to establish and
operate such controls. Many small firm owners actively avoid formal structures and control as the whole purpose of
business ownership is to have less formal controls of one’s activities. Large enterprises typically have a relatively high
level of financial control when compared to small enterprises due to the following reasons:
(i) Empirical studies have indicated that in areas such as accounting systems, financial reporting, working capital
management, fixed asset management, and managerial planning & control, large enterprises are better organized.
(ii) Lack of awareness on the part of owner-managers of small enterprises.
(iii) The size of the small enterprise and the fact that owners also happen to be managers.
Most importantly, large enterprises have high levels of financial control, or perhaps more accurately greater use of
formal financial control systems, because they need them. Where direct control by residual claimants (shareholders)
is not possible it is necessary to increase monitoring of managers and employees to reduce ‘shirks’ and ‘perks’.
2. Why would inadequate financial management be a major cause of small enterprise failure?
q. 6
The term “inadequate financial information” requires definition. What is “adequate” for one business, may be
insufficient for another. However, in a general sense a failure to control cash flows in particular, could lead to a
lack of liquidity and therefore business failure. Often there are timing differences between the inflow and outflow
of cash. Information is required to ensure that such differences can be covered in terms of fulfilling the financial
commitments of the business as they fall due. This is even more acute for firms experiencing high growth, as
funds are channeled into supporting this growth and this often leads to liquidity stress. In fact, the second most
common reason for bankruptcy is liquidity stress. It could be argued that in a perfect market the firm should
survive as long as it is profitable and that the consequences of poor financial management would not be great.
For example, the level of leverage or liquidity should not affect the value of the firm nor should dividend policy.
Even if the firm failed, bankruptcy would be a costless reallocation of resources! In practice, in a less-than-perfect
market, good financial management does affect the value of the firm, bankruptcy is very costly and inadequate
financial management is to be avoided. Poor investment decisions can easily lead to poor profitability. The small
unquoted owner-managed firm may be better able to survive with lower profitability than a larger quoted firm
because it is less liable to be taken over. However, if investment decisions are so bad that they result in losses,
the firm’s days are likely to be numbered. The management of liquidity is particularly important for small
enterprises because their lack of access to the capital market is likely to result in their relying on short-term debt
and therefore having low liquidity. Poor financial management then puts the small enterprise in danger of being
unable to pay their debts when they fall due and this could lead to action by creditors to wind up the business
even though it may be profitable.

3. Are there any particular financial management practices a high-growth small enterprise
should employ to assist in the management of growth? q. 7
To manage growth, small enterprises need to be proactive in a number of areas of financial management
particularly liquidity management that in turn involves effective management of working capital. The main
elements that need to be well controlled are debtors and creditors. Rapid growth in sales will lead to a rapid
build-up of creditors. If this is accompanied by a high proportion of credit sales then there will be great pressure
on liquidity. In order to minimize problems, tight control will be required of debtors and good relationships
maintained with creditors. It will be important to use cash budgets and forecasts in order to predict problems
arising from rapid growth in sales and to ensure that activities are suitably scheduled to avoid liquidity crises or
that financing is arranged to deal with any shortfall.

 Case Study
Enterprise Experience: Controlling business growth, pp. 231-232
1. Why would Lisa and Margo prefer to opt for a model that basically limits the growth of their
partnership? Why wouldn’t they set up the additional outlets and employ people to operate them as
part of Lisa and Margo Framing?
Lisa and Margo are in business for the same reason that most small business owners opt to operate their own
business – life control. They want to earn a comfortable living and be successful, but their decisions are centered on
controlling the business. Although they could make more by establishing additional outlets, their preference is to
trade off total wealth for lifestyle. It is important to keep this in mind when observing the financial and management
practices of business owners.
2. It is proposed that the annual service fee be based on the financial performance of each outlet. How
should financial performance be measured?
Measuring financial performance is difficult because the choice of measure is subjective and can be open to
manipulation. Further, Lisa and Margo would want a measure which is simple and readily verifiable. As such, perhaps
the best measure is gross sales. Any other measure would require some form of calculation. The only problem with
gross sales is that this figure could be adjusted by not putting all sales through the sales ledger or by pocketing cash
sales.

3. The accountant suggests an alternative where they consider establishing another outlet and they each
take responsibility for an outlet; that they develop a business plan and then seek a bank loan to fund
this growth. Explain to Lisa and Margo the role of the business plan in the financial management of a
growth business. Will a business plan result in the successful growth of the business?
Remember this is not the preferred option for Lisa and Margo and new terms, such as business plan, are being
introduced, which will compound their concerns. A starting point would be for the accountant to prepare a simple
revenue and expenditure statement for an expanded set of operations and explain the financial benefits which would
flow to the owners. The business plan is about outlining operations, activities and strategies designed to meet the
financial projections. This should also be explained in simple terms and examples provided. At this point it would be
wise to discuss with Margo and Lisa whether they wanted to expand and make more money or if they are determined
to keep to the initial plan. If they would like to consider expanding, then they should be encouraged to work on parts
of the plan and be informed of all components of the plan.

4. What strategies could you recommend to Lisa and Margo that would allow them to cap their growth
and business activities to a single outlet, but ensure existing and new customers receive timely
service?
Lisa and Margo could consider a formal work schedule and the employment of part-time staff to meet peak times.
However, the reality is that one outlet operated by two people will reach a capacity from which any growth will
require additional staff, managers and outlets.
Ch11 – Ross et al.
Ch11