FM NOTES BY HASHIM RAMEESH U 1

FM Introduction
The FM syllabus aims to develop the knowledge and skills required of a finance
manager, focusing on three key areas:
• Investment decisions
• Financing decisions
• Dividend policy decisions

This syllabus prepares candidates to manage the finance function within a business.
It also serves as a foundation for advanced studies in Advanced Financial
Management (AFM).

Overview of the Syllabus Content

1. Role of Financial Management:
o Understand the purpose and responsibilities of financial management in a
business context.
2. Economic Environment:
o Explore the external factors that influence financial decisions.
3. Investment Decisions:
o Working Capital Management: Managing short-term assets and
liabilities.
o Capital Investment Appraisal: Evaluating long-term investment
opportunities.
4. Financing Decisions:
o Identify various sources of finance.
o Understand dividend policies and internal financing.
o Learn about the cost of capital and how it affects financing choices.
5. Valuation Principles:
o Study how businesses and financial assets are valued.
o Examine the impact of cost of capital on business valuation.

FM NOTES BY HASHIM RAMEESH U 2

 6. Risk Management:
o Introduction to financial risk.
o Techniques used to manage and mitigate risk.

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 Table of Contents
Chapter
Topic Page no.
no.
1 Basics for FM 6
Investment appraisal:
2 Basic Investment appraisal techniques (DCF techniques) 18
3 Further aspects in Investment appraisal 31
4 Applications of DCF techniques 40
5 Risk & Uncertainty in Investment appraisal 48
Working capital management:
6 WC management introduction 57
7 Inventory management 67
8 Cash management 74
9 Receivable & Payable management 83
Business finance:
10 Source of finance 94
11 Cost of capital 112
12 Capital asset pricing model (CAPM) 123
13 Capital structure 131
14 Islamic finance 139
15 Dividend policy 142
Business valuation:
16 Business valuation 145
Risk management:
17 Foreign exchange risk management 162
18 Interest rate risk management 177
Other theory topics:
19 Financial management function 182
20 Financial environment 193
21 Economic environment 204

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Exam Structure
Section A
15 MCQs (multiple choice questions) with 2 marks each  15 x 2 = 30 marks
• It can be tested from any of the syllabus area.
Section B
3 MTQs (multiple task questions) each with 5 questions
worth 2 marks each  3 x 10 = 30 marks
Predicted syllabus area;
• One from “Business valuation”,
• One from “Risk management”, and
• Last one will be from the topic which is not tested in Section C
Section C
2 Constructed response type questions with 20 marks each  2 x 20 = 40 marks
Predicted syllabus area;
• Investment appraisal, Business finance, Working capital management

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 Basics for FM
Simple and Compound Increase
An amount can be increased by a % rate in two ways:
Simple increase
 The rate is applied to the initial amount (PV)
 The same amount is added repeatedly for ‘n’ times to find the future value (FV)
𝑭𝑽 = 𝑃𝑉 + (𝑃𝑉 × 𝑟 × 𝑛)

Compound increase
 The rate is applied to the initial amount (PV), but instead of adding a fixed amount
each time, the increase is applied to the growing value after each step
 This means that in each period, the new value becomes the base for the next
calculation.
 The process continues for ‘n’ times, leading to exponential growth.
𝑭𝑽 = 𝑃𝑉 × (1 + 𝑟)𝑛

Q1) $25,000 is deposited in a bank at an interest rate of 10%. What will be the value of
this investment after 5 years.
a) simple increase
b) compound increase

Q2) Find the future value based on compound increase in the following scenarios:
a) Invested $6,000 for 8 years at an interest rate of 9%
b) Invested $1,200 for 7 months at a monthly interest rate of 1.5%
c) Invested $5,000 for 3 years at a quarterly interest rate of 3%
d) Invested $12,000 for 9 months at a quarterly interest rate of 1%

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Annualised Interest rate
Compare the annualised rate for the following;
a) $10,000 invested for 1 year at 10% per annum, compounded annually
b) $10,000 invested for 1 year at 10% per annum, compounded quarterly

When the interest rate is stated for a period shorter than one year (sub-period), it can
be annualised in two ways:
1. Simple Annual Rate (SAR)
This method assumes a linear increase by multiplying the sub-period rate by the
number of sub-periods in a year
𝑺𝑨𝑹 = 𝑟 × 𝑛

2. Effective Annual Rate (EAR)

This method considers the effect of compounding over multiple sub-periods
𝑬𝑨𝑹 = (1 + 𝑟)𝑛 − 1

r – sub-period rate (rate per compounding period)

n – no. of sub-periods in one year
365 𝑑𝑎𝑦𝑠
𝑛=
𝑠𝑢𝑏 − 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑖𝑛 𝑑𝑎𝑦𝑠)
52 𝑤𝑒𝑒𝑘𝑠
𝑛=
𝑠𝑢𝑏 − 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑖𝑛 𝑤𝑒𝑒𝑘𝑠)
12 𝑚𝑜𝑛𝑡ℎ𝑠
𝑛=
𝑠𝑢𝑏 − 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑖𝑛 𝑚𝑜𝑛𝑡ℎ𝑠)

Q3) Find the EAR and SAR for the following:

a) 10% per year, compounded quarterly
r=
n=
SAR =
EAR =

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b) 8% per year, compounded weekly
r=
n=
SAR =
EAR =
c) 2% monthly interest rate
r=
n=
SAR =
EAR =
d) 1.5% for 2 months
r=
n=
SAR =
EAR =
e) 1% for 25 days
r=
n=
SAR =
EAR =
f) 4% for every 85 days
r=
n=
SAR =
EAR =
g) 6% for every 7.5 months
r=
n=
SAR =
EAR =

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Compounding and Discounting
Compounding

PV FV
Discounting

Compounding
𝑭𝑽 = 𝑃𝑉 × (1 + 𝑟)𝑛
Discounting
𝐹𝑉
𝑃𝑉 =
(1 + 𝑟)𝑛

1
𝑷𝑽 = 𝐹𝑉 × Discounting factor (DF)
(1 + 𝑟)𝑛

 ‘r’ is the discount rate used by the company (normally it will be the cost of
capital/required rate of return)
 Discounting factor can be found from PV table, which will be provided in the exam.

Q4) How much should be invested today to receive $38,465 after 5 years at an annual
interest rate of 9%?

Q5) Future value is $14,000 in 7 years’ time and discount rate is 16%. Find Present
value?

Q6) Future value is $90,000 in 10 years’ time and discount rate is 7.5%. Find Present
value?

Q7) Future value is $8,000 in 2 years’ time and discount rate is 12%. Find Present
value?

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Why 'Discounting' in business?
Purpose - To incorporate the Time Value of Money
Time Value of Money
A sum received today is worth more than the same amount received in the future date
due to the following reasons:
1) Inflation – The purchasing power of money decreases over time.
2) Liquidity Preference – Money received earlier can be invested in the business to
generate returns.
3) Certainty – Money received today is certain, whereas future payments involve risk.

Application of Discounting in Investment appraisal

When evaluating investment proposals in the present, future cash flows from the
project are considered in the decision-making process.
These future cash flows must reflect the time value of money before being used in the
appraisal process.
To incorporate this, we apply discounting, which converts future cash flows into
present value terms using the Discounting equation.

Q8) The cash flows associated with a project under consideration is as follows, find
the present values of these cash flows using a discount rate of 10%.
T0 T1 T2 T3 T4 T5
CF’s (250,000) 25,000 45,000 85,000 90,000 70,000

DF @ 10%

PV

Timing of cash flows

T0 -> Present | starting of Yr1
T1 -> Yr1 between | Yr1 end | Yr2 start
T2 -> Yr2 between | Yr2 end | Yr3 start

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PV of some special cash flows
Annuity cash flow
Same CFs every period for a definite period

1. Normal annuity (T1 – Tn)

These are annuity cash flows starting from one years’ time (T1) and end after ‘n’ years’
time (Tn)
The total present value of a normal annuity is,

𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹 × 𝐴𝐹𝑛

AFn is the Annuity factor, which is the sum of discounting factors for ‘n’ periods. It can
be found from the annuity table.
1−(1+𝑟)−𝑛
AFn =
𝑟

2. Advance annuity (T0 – Tn-1)

These are annuity cash flows for ‘n’ periods starting immediately (T0) and end at Tn-1
The total present value of an advance annuity is,

𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹 × (1 + 𝐴𝐹𝑛−1 )

3. Delayed annuity (T2/3/4…. – )

These are annuity cashflows for ‘n’ periods which starts from a period after year one
(i.e., T2/3/4….)
The total present value of a delayed annuity is,

𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹 × (𝐴𝐹𝑦𝑒𝑎𝑟 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑒𝑛𝑑𝑠 − 𝐴𝐹𝑦𝑒𝑎𝑟 𝑏𝑒𝑓𝑜𝑟𝑒 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑠𝑡𝑎𝑟𝑡𝑠 )

OR,

𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹 × 𝐴𝐹𝑦𝑒𝑎𝑟𝑠 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 × 𝐷𝐹𝑦𝑒𝑎𝑟 𝑏𝑒𝑓𝑜𝑟𝑒 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑠𝑡𝑎𝑟𝑡𝑠

Q9) A company will receive $70,000 a year for six years. Interest rates are 10%.
What is the present value of the total receipts?

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Q10) Fred receives $80,000 a year for nine years. The applicable discount rate is 12%,
and the first payment is immediately.
What is the present value of the money Fred receiving?

Q11) A company will receive $50,000 a year for six years. The first payment will be at
the end of year 4. Discount rate is 6%.
What is the present value of the total receipts?

Q12) We expect to receive $10m every year from year 1 to 4 while discount rate is 5%.
What is the present value of the total receipts?

Q13) We expect to receive $2000 every year for five years starting from year 0 while
discount rate is 8%.
What is the present value of the total receipts?

Q14) We expect to receive $1500 every year for 7 years starting from year 8 while
discount rate is 10%.
What is the present value of the total receipts?

Perpetuity cash flow

Same CF every period for infinite period (forever)

1. Normal perpetuity (T1 – T∞)

These are perpetuity cash flows starting from one years’ time (T1)
The total present value of a normal perpetuity is,
1
𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹 ×
𝑟
𝟏
is the annuity factor for infinite periods (sum of DF of infinite periods).
𝒓

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2. Advance perpetuity (T0 – T∞)
These are perpetuity cash flows starting immediately (T0)
The total present value of an advance perpetuity is,
1
𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹 × (1 + )
𝑟

3. Delayed perpetuity (T2/3/4…. – T∞)

These are perpetuity cash flows starting after year one (i.e., T2/3/4…)
The total present value of a delayed perpetuity is,
1
𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹 × ( − 𝐴𝐹𝑦𝑒𝑎𝑟 𝑏𝑒𝑓𝑜𝑟𝑒 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑠𝑡𝑎𝑟𝑡𝑠 )
𝑟
OR,
1
𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹 × × 𝐷𝐹𝑦𝑒𝑎𝑟 𝑏𝑒𝑓𝑜𝑟𝑒 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑠𝑡𝑎𝑟𝑡𝑠
𝑟

Q15) A company will receive $70,000 a year forever. Interest rates are 10%.
What is the present value of the total receipts?

Q16) Fred receives $40,000 a year forever. The applicable discount rate is 12%, and
the first payment is immediately.
What is the present value of the money Fred receiving?

Q17) A company will receive $50,000 a year forever. The first payment will be at the
end of year 6. Discount rate is 6%.
What is the present value of the total receipts?

Q18) We expect to receive $10m every year from year 1 to infinity while discount rate is
5%. What is the present value of the total receipts?

Q19) We expect to receive $2000 every year from year 0 to infinity while discount rate
is 8%. What is the present value of the total receipts?

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Q20) We expect to receive $1500 every year from year 8 to infinity while discount rate
is 10%. What is the present value of the total receipts?

4. Perpetuity with growth

This is a type of perpetuity where cash flows grow at a constant rate (g) from the initial
cash flow (T₀ CF) till infinity.
The total present value of a perpetuity with growth is,
𝐶𝐹 @ 𝑇1
𝑻𝒐𝒕𝒂𝒍 𝑷𝑽 =
𝑟−𝑔

𝐶𝐹 @ 𝑇1 = 𝐶𝐹 @ 𝑇0 × (1 + 𝑔)
r – discount rate
g – growth rate of CFs

Q21) Find the total present value of a perpetuity CF growing at 2% on initial CF of

$1,500 till infinity. Applicable discount rate is 8%.

Q22) Find the total present value of a perpetuity CF with growth at 2.8%. The first year
CF is $3,500. Applicable discount rate is 9%.

Q23) Ben will receive cash flows from an investment starting from end of year 5 to
infinity. The current stated CF is $2,800, which will grow by 4% per annum.
What is the total present value of the receipt? (applicable discount rate is 12%)

Q24) John is expected to receive infinite cash flows growing at 1.25% per annum. First
payment is at the start of year 5. CF stated at year 5 is $15,500.
What is the total present value of the receipt? (applicable discount rate is 7.5%)

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Q25) Aysha will receive cash flows from an investment which is like constant CFs for
the first four years of $5,000 and which will then grow by a constant growth rate of
1.5% per year for infinity.
What is the total present value of the receipt? (applicable discount rate is 10%)

Q26) Lijon will receive cash flows from an investment which is like constant CF of
$8,500 for years 3 to 7 and which will then grow by a constant growth rate of 3.25% per
year for infinity.
What is the total present value of the receipt? (applicable discount rate is 11%)

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FM NOTES BY HASHIM RAMEESH U 16
FM NOTES BY HASHIM RAMEESH U 17
 Basic Investment
Appraisal Techniques
Capital expenditure budgeting
Asset expenditure (capital expenditure) is when a company spends a lot of money on
things it plans to use for a long time, like equipment or machinery. The goal is to make
returns in the future. Before making these big investments, companies need to
carefully evaluate if they'll be profitable in the long term since once the money is
spent, it's not easy to undo the investment without losing some of the initial capital.
This evaluation comes under capital budgeting process.
There are several steps in the capital budgeting process:
1) Plan expenditure: Decide on long-term goals and how to achieve them
2) Identify possible projects: Identify all possible projects that align with the goals
3) Evaluate projects: Assess each project to see if it's worth investing in
(Investment appraisal)
4) Choose the best project: Select the most suitable project based on company’s
requirements
5) Begin the project: Start investing in the chosen project
6) Manage the project: Monitor costs and revenues compared to the budget

Cash flows and Profits

For decision making, cash flows from a project are considered over the profits it
generates for these reasons:
 Profits might look good on paper, but cash is what the company can actually spend
on.
 Profits are subjective: Accounting policies can affect how profits are calculated,
making them less reliable for decision making.
 Shareholders prefer cash: Shareholders benefit from cash through dividends, so
they prefer companies to invest in projects that generate cash flow rather than just
focusing on increasing profits.

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Project Evaluation Methods
Profit-based evaluation
Considers the profit generated from the project for appraisal.
 ROCE (Return on Capital Employed) or, ARR (Accounting Rate of Return) or, ROI
(Return on Investment)

Cash flow-based evaluation

Considers the cash flows (relevant cash flows) generated from the project for
appraisal.
Discounted Cash Flow (DCF) methods:
 NPV (Net Present Value)
 IRR (Internal Rate of Return)
 Payback period

ROCE / ARR / ROI

It is the average return (profit) of a project expressed as a percentage of the initial
investment or average investment. It can be calculated as;
𝐴𝑣𝑔. 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝐴𝑣𝑔. 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
𝑂𝑅,
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐴𝑣𝑔. 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑠𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

𝐴𝑣𝑔. 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
2

Q1) A company is considering investing in a project with initial investment of $100,000

and the residual value at the end of year 5 is $5,000. Company’s policy is to depreciate
the investment on a straight-line basis. The cash flows associated with the project is
shown below:
T1 T2 T3 T4 T5
CF’s 25,000 45,000 85,000 90,000 70,000

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Find the ARR for this project based on,
a) Initial investment
b) Average investment

Q2) A project requires an initial investment of $800,000 and then earns net cash
inflows as follows:
T1 T2 T3 T4 T5 T6 T7
CF’s
100 200 400 400 300 200 150
($000)
In addition, at the end of the seven year project the assets initially purchased will be
sold for $100,000.
Find the ROCE for this project based on,
a) Initial investment
b) Average investment

Decision rule for ARR:

We will compare the ARR of the project with ‘Target ARR’ set by the company. If the
project’s ARR > target ARR, we’ll accept the project.

Advantages Disadvantages
 Uses readily available accounting  Different calculation methods
information may cause confusion.
 Simple to calculate and  Based on profits rather than cash
understand flow, and profits are influenced by
 Commonly used by financial accounting policy choices.
analysts to appraise performance  Ignores the time value of money.
 Target rate is subjective.
 As a relative (percentage)
measure, it does not show the
absolute change in shareholder
wealth

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 Cash flow-based evaluations
Considers the relevant cash flows generated from the project for appraisal.

Relevant cash flows

Relevant cash flows are cash flows that arise directly from the decision to invest in
something.
Generally relevant cash flows are:
 Cash-based
 Future
 Incremental/Differential
 Avoidable (for e.g., specific OHs)
 Opportunity costs
Not relevant cash flows to ignore:
 Non-cash items (for e.g., depreciation)
 Sunk cost (past cost) (for e.g., research cost)
 Committed costs
 Unavoidable (for e.g., general OHs)

Relevant CFs relating to investment appraisal

 Initial investment
 Incremental revenue and costs relating to the investment (Operating CFs)
 Scrap value
 Cost savings
 Taxation related relevant CFs
 Working capital investments

Discounted cash flow (DCF) techniques

These techniques involve looking at the relevant cash flows of an asset expenditure
and discounting them to bring them back to their present value. Methods of
investment appraisal are:
1) Net present value (NPV)
2) Internal rate of return (IRR)
3) Payback period

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 Net Present Value (NPV)
NPV of a project is the sum of the present values of an investment’s relevant cash
flows. The relevant cash flows are normally discounted at company’s cost of capital
to find NPV
NPV gives the impact of the project on shareholder’s wealth
Decision rule:
If the NPV of a project, discounted at company’s cost of capital, is positive then
Accept the project,
Else Reject the project
If an organisation chooses between two or more mutually exclusive projects, it will
accept the project with the highest NPV

$$$ $$$

Source of Our Investments

Finance Co.

cost of capital returns

Basic rule;
Investment’s yield (return) > cost of capital

Advantages Disadvantages
 The NPV method considers the  The NPV method is complicated
time value of money for non-financial managers to
 NPV is an absolute measure of understand
return, presented in monetary  NPV relies on judgment regarding
terms and not as a percentage the discount rate used
 The NPV method uses cash flows  Determination of cost of capital is
rather than profit a difficult process

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  The NPV method considers the
whole life of the investment or
project
 Lead to maximisation of
shareholder wealth

Q3) Nyzot Co is considering investing in a new piece of machinery. The investment

would start immediately and last for six years. The following information about the
investment is available:
Yr1 Yr2 Yr3 Yr4 Yr5 Yr6
Sales volume
20,000 20,000 18,000 18,000 16,000 16,000
(units)
Selling price
12 12 14 14 16 16
per unit
Variable cost
5 5 5.5 5.5 6 6
per unit
Fixed costs ($) 30,000 30,000 35,000 35,000 35,000 35,000

Initial investment is $450,000 and the asset can be disposed for $80,000 at the end of
Yr6.
Depreciation is calculated on a straight-line basis.
Initial market research cost for acquiring information in relation to this project is
$20,000.
Company’s cost of capital is 12%.
Find the NPV of this project and comment on its financial viability?

Q4) An organisation is considering a capital investment in new equipment. Initial

investment is $240,000. The estimated cash inflows are as follows.
Yr1 Yr2 Yr3 Yr4 Yr5
Cash flows ($) 80,000 120,000 70,000 40,000 20,000

The company’s cost of capital is 9%.

Find the NPV of this project and comment on its financial viability?

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 Internal Rate of Return (IRR)
IRR of a project is the total ”discounted cashflow rate of return” offered by an
investment over its life.
Similarly, ARR is the “profit rate of return” offered by an investment.
For e.g., If a project has IRR of 10%, that means the project has the ability to generate a
maximum CF returns of 10% internally.
Decision rule:
IRR of the project need to be compared with the cost of capital of the company, which
is used to discount the cashflows while finding the NPV of the project.
 If IRR > cost of capital, the project will yield a positive NPV and hence the project is
financially viable
 If IRR < cost of capital, the project will yield negative NPV and hence the project is
not financially viable
 If IRR = cost of capital, the NPV of the project will be zero
So, IRR can also be defined as, this rate represents the discount rate at which the NPV
of the project is zero.

Q5) The CFs relating to an investment project is given below;

T0 T1 T2 T3 T4 T5 T6
(450,000) 110,000 110,000 118,000 118,000 125,000 205,000

a) If the cost of capital for the company is 11%, find the NPV of the project.
b) Find the IRR of this project using spreadsheet function.
c) Compare IRR with cost of capital and interpret it.
d) If the cost of capital for the company is 18%, comment on the financial viability of
this project.
e) What will be the NPV for this project if we discount these cashflows at its IRR

FM NOTES BY HASHIM RAMEESH U 24

Linear interpolation method to find IRR
Generally, at
Lower discount rate -> NPV will be higher (+ve)
Higher discount rate -> NPV will be lower (-ve)

1) Calculate two NPVs for the project at two different costs of capital (one +ve &
one -ve)
2) Use the following formula to find the IRR:

𝑁𝐿
𝑰𝑹𝑹 = 𝐿 + × (𝐻 − 𝐿)
𝑁𝐿 − 𝑁𝐻

L = lower discount rate

H = higher discount rate
NL – NPV at lower discount rate (+ve)
NH – NPV at higher discount rate (-ve)

FM NOTES BY HASHIM RAMEESH U 25

Q6) The CFs relating to an investment project is given below;

CFs

T0 (450,000)

T1 110,000

T2 110,000

T3 118,000

T4 118,000

T5 125,000

T6 205,000

Find the IRR of this project using linear interpolation method, use 14% and 20% as
lower and higher discount rates.

Advantages Disadvantages
 The IRR method considers the  IRR ignores the size of projects
time value of money. when appraising investments
 The IRR method is easy for non- since it is a relative measure.
financial managers to compare  Not suitable for mutually
against a target % (it is a relative exclusive projects decisions
measure).  For non-conventional
 The IRR method uses cash flows investments (multiple
rather than profit. investments throughout the
project’s life), There may be more
than one solution for IRR
 The reinvestment assumption
underlying IRR is not justifiable.

FM NOTES BY HASHIM RAMEESH U 26

Non-conventional investments
A conventional project starts with a net cash outflow (T0), followed by net cash
inflows, with cash flow direction changing only once (negative to positive).
However, some projects have unconventional cash flows, where cash flow alternates
between positive and negative due to additional investments in later years. Such
projects may have multiple IRRs. The number of IRRs will be equal to the number of
sign reversals in cash flows.
Example;
T0 T1 T2
(1900) 4590 (2735)

Discount Discount Discount

NPV NPV NPV
rate rate rate
0% -45.00 13% 20.04 26% 20.13
1% -36.56 14% 21.82 27% 18.47
2% -28.80 15% 23.25 28% 16.63
3% -21.69 16% 24.35 29% 14.61
4% -15.20 17% 25.12 30% 12.43
5% -9.30 18% 25.60 31% 10.09
6% -3.95 19% 25.78 32% 7.60
7% 0.86 20% 25.69 33% 4.97
8% 5.18 21% 25.35 34% 2.21
9% 9.01 22% 24.75 35% -0.69
10% 12.40 23% 23.92 36% -3.70
11% 15.35 24% 22.87 37% -6.83
12% 17.89 25% 21.60

FM NOTES BY HASHIM RAMEESH U 27

Reinvestment assumption
In any project, the cash flows (CFs) received in the earlier period are reinvested within
the business for the remaining duration. The reinvestment assumption determines the
rate at which these CFs are reinvested.
Under NPV method, the reinvestment return is assumed to be at the company’s cost of
capital. This assumption is justifiable as it is realistic.
However, under IRR method, the reinvestment return is assumed to be at the project’s
IRR. This assumption is not justifiable as it is unrealistic.

IRR of project with annuity CFs

To determine the IRR of a project with annuity CFs, we need to find the discount rate at
which NPV becomes zero.
When NPV = 0, the initial investment (outflow) equals the present value of inflows
(annuity). This can be expressed as:
Initial Investment = Annual CF × Annuity factor (AF)
Rearranging, we get:
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝐹 =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝐹

Using this annuity factor (AF), we refer to the annuity table to find the corresponding
discount rate. This rate represents the IRR of the project.

Q7) An investment of $6,340 will yield an income of $2,000 for four years.
Calculate the IRR of this investment.

Q8) An investment of $56,500 will yield cash flows of $10,000 for ten years.
Calculate the IRR of this investment.

FM NOTES BY HASHIM RAMEESH U 28

IRR of project with perpetual CFs
To determine the IRR of a project with perpetual CFs, we need to find the discount rate
at which NPV becomes zero.
When NPV = 0, the initial investment (outflow) equals the present value of inflows
(perpetuity). This can be expressed as:
Initial investment = Annual CF x 1/r
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝐹
𝑟 (𝐼𝑅𝑅) =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Q9) An investment of $15,000 today will provide $2,400 each year to perpetuity.
Calculate the IRR of this investment.

Payback period
The payback period is the duration it takes for a project to repay its initial investment
through the cash flows it generates. It is a straightforward method used to evaluate the
risk and liquidity of an investment, primarily focusing on how quickly the invested
money can be recovered.
Simple payback
This version of the payback method calculates the time needed to recoup the initial
investment from the net cash inflows of the project. It simply totals up the cash flows
year by year until the initial investment has been covered.
This method does not take into account the time value of money, which is its primary
limitation.
Discounted payback
The discounted payback period extends the simple payback method by incorporating
the time value of money. It calculates the time required to recover the initial
investment in present value terms.
This method provides a more accurate assessment of the payback period because it
reflects the reduced value of future cash inflows.
Decision rule:
If Payback period < Target payback set by the company, Accept the project.

FM NOTES BY HASHIM RAMEESH U 29

Q10) The CFs relating to an investment project is given below;
T0 T1 T2 T3 T4 T5 T6
(520000) 115000 184000 127000 127000 131000 211000
If the company’s cost of capital is 12%, find the simple payback and discounted
payback period of this project.

Q11) An expenditure of $1.8 million is expected to generate net cash inflows of

$350,000 each year for the next seven years.
What is the payback period for the project?

Advantages Disadvantages
 Simple to calculate and easy to  Simple payback does not
understand consider the time value of money
 It helps to maximise the liquidity,  Payback does not consider the
which helps organisations with cash flows that take place after
cash flow problems the payback period; it may
 Payback method uses cash flows underestimate the value of the
rather than profit project
 This method can be used in the  The payback method encourages
screening process of Project decisions to be made on short-
appraisal term factors rather than the long-
term benefit to the organisation
 It ignores profitability
 It is subjective – target payback is
set by the organisation

FM NOTES BY HASHIM RAMEESH U 30

 Further aspects in
Investment Appraisal
This chapter introduces additional aspects used in the investment appraisal process,
particularly in NPV calculation:
1. Taxation effects
2. Inflation effects
3. Working capital effects

Taxation Effects
Two relevant effects in NPV calculation (DCF analysis):
Tax on Operating Cash Flows
o Corporate tax is payable on Operating CFs.
o This tax payment is a relevant cash outflow.
o Tax payment = Operating CFs × tax rate
Tax Allowable Depreciation (TAD)
o Depreciation itself is not a cash flow.
o But TAD reduces corporate tax liability, creating a tax benefit.
o Tax benefit on TAD = TAD × tax rate

FM NOTES BY HASHIM RAMEESH U 31

Q1) Nyzot Co is planning to buy a CNC bending machine for $10,000 at the beginning
of an accounting period to undertake a five-year project.
Annual sales and operating costs for the project are as follows:
Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Sales 3,500 4,000 4,500 5,000 5,500
Operating costs 1,500 1,600 1,700 1,800 1,900

The company sells the CNC bending machine on the last day of the fifth year for
$2,000.
The corporation tax rate is 33%, and tax is paid in same year. Tax-allowable
depreciation is calculated on a reducing balance basis at 25%. The cost of capital is
10%.
Required:
Calculate the project's NPV and recommend whether Nyzot Co should accept or reject
the project.

Q2) Nyzot Co is considering an investment proposal to open a showroom in the heart

of the city, with an initial investment of $50,000. The project will last for 4 years, after
which the showroom will be sold for a scrap value of $10,000.
The projected sales volume, selling price per unit, variable cost per unit, and fixed
operating costs for each year are as follows:
• Year 1: Sales volume = 1,200 units, Selling price per unit = $50, Variable cost per unit
= $20, Fixed operating costs = $8,000
• Year 2: Sales volume = 1,300 units, Selling price per unit = $52, Variable cost per unit
= $21, Fixed operating costs = $8,500
• Year 3: Sales volume = 1,400 units, Selling price per unit = $54, Variable cost per unit
= $22, Fixed operating costs = $9,000
• Year 4: Sales volume = 1,500 units, Selling price per unit = $56, Variable cost per unit
= $23, Fixed operating costs = $9,500
The corporation tax rate is 20%, and tax is paid one year in arrears. Tax-allowable
depreciation is calculated on a reducing balance basis at 25%. The cost of capital is
8%.
Required:
Calculate the project’s Net Present Value (NPV) and recommend whether Nyzot Co
should proceed with opening the showroom.

FM NOTES BY HASHIM RAMEESH U 32

Q3) A company buys a new machine costing $50,000 with a disposal value of $25,000
at the end of four years. Tax-allowable depreciation is available on a straight-line basis,
with a balancing adjustment in the year of disposal. Corporate profits are taxed at 35%
and tax is paid without delay.
Required:
Calculate the tax effects associated with the machine and state their timings.

Q4) A company buys a new machine costing $50,000 with a disposal value of $25,000
at the end of four years. Tax-allowable depreciation is available on a straight-line basis
at 20% on cost, with a balancing adjustment in the year of disposal. Corporate profits
are taxed at 35% and tax is paid without delay.
Required:
Calculate the tax effects associated with the machine and state their timings.

Inflation Effects
Future inflation affects two key areas in DCF analysis:
• Operating CFs (sales, variable and fixed costs)
• Discount rate (WACC)
Inflation Effect on Operating CFs
Current CF: Price terms of the current year (without future inflation).
Nominal/Money CF: Includes specific inflation.
Nominal CF = Current CF × (1 + specific inflation)n
Real CF: Nominal CF with general inflation removed.
Real CF = Nominal CF ÷ (1 + general inflation)n
• Specific inflation: Inflation rate specific to an item (e.g., selling price, variable
cost).
• General inflation (i): Overall economy-wide inflation rate.
Example:
• Revenue in Year 4 (current terms): $28,000 → Current CF
• Specific inflation: 6% → Nominal CF = 28,000 × 1.06⁴ = $35,349
• General inflation: 4% → Real CF = 35,349 ÷ 1.04⁴ = $30,216

FM NOTES BY HASHIM RAMEESH U 33

Inflation Effect on Discount Rate (WACC)
Nominal/Money cost of capital (m): Discount rate including inflation.
Real cost of capital (r): Discount rate excluding inflation.

Fisher’s Formula:
(1 + m) = (1 + r) × (1 + i)

m = (1 + r)×(1 + i) – 1
r = (1 + m)÷(1 + i) – 1
Inflation in DCF Analysis
Nominal method: Use nominal CFs and discount at nominal rate (m) → Nominal NPV.
Real method: Use real CFs and discount at real rate (r) → Real NPV.

Q5) A new three-year project requires an initial investment of $5,000 at time 0, with a
scrap value of $1,000 at the end of year 3 in today’s money terms.
It is expected to generate sales revenues of $10,000 at current prices for each of the
next three years, growing at the general rate of inflation;
It is expected to incur costs of $5,000 in year 1, $4,000 in year 2 and $5,000 in year 3,
at current prices; these costs are expected to rise at the general inflation rate.
The general inflation rate is expected to be 5% for the next three years and the nominal
weighted average cost of capital is 15.5%.
Calculate the NPV of the project
a) Nominal method
b) Real method

Q6) A new three-year project requires an initial investment of $5,000 at time 0, with a
scrap value of $1,000 at the end of year 3 in today’s money terms.
It is expected to generate sales revenues of $10,000 at current prices for each of the
next three years, these revenues are expected to rise at 6.5% a year;
It is expected to incur costs of $5,000 in year 1, $4,000 in year 2 and $5,000 in year 3,
at current prices; these costs are expected to rise at 4% a year.
The general inflation rate is expected to be 5% for the next three years and the nominal
weighted average cost of capital is 15.5%.

FM NOTES BY HASHIM RAMEESH U 34

Calculate the NPV of the project
a) Nominal method
b) Real method

Q7) A company is considering a three-year project with an initial outlay of $10,000.

Material costs at current prices will be $1,500 a year for three years. Material costs
inflate at 8% each year.
Labour savings at current prices will be $4,000 a year for three years. Labour costs
inflate at 5% each year.
Overhead savings at current prices will be $2,000 a year for three years. Overhead
costs inflate at 10% each year.
The nominal cost of capital is 15.5%.
General inflation is 7%.
Calculate the net present value of the project (ignore taxation)

Q8) A company is considering a project which requires a machine costing $250,000

on 1 January 20X4. Net inflows from the project are expected to be $80,000 a year in
current price terms for the next four years. At the end of the project, the machine will
be sold for estimate cash proceeds of $50,000. The project flows are expected to
inflate at 5% and the company's nominal cost of capital is 15%.
The company has a December year end and pays tax one year in arrears at 33%. Tax-
allowable depreciation is available at 25% reducing balance.
Calculate the net present value of the project
a) Nominal method
b) Real method

Q9) Pinks Co

FM NOTES BY HASHIM RAMEESH U 35

Working Capital Investments Effects
Funds raised are invested in:
1. Non-current assets (NCA): Long-term investment.
2. Current assets (CA): Short-term investments for operational support (inventory,
receivables, cash).
Working Capital (WC) is the amount invested in Net current assets = CA – CL.
WC investments for a project are relevant CFs in DCF analysis.
Treatment:
o Initial WC investment (for Year 1) → cash outflow at T0.
o Increase in WC level → cash outflow.
o Decrease in WC level → cash inflow.
o At project end → full WC released as cash inflow.

Q10) A company anticipates sales for the latest venture to be 100,000 units per year.
The selling price is expected to be $3 per unit in the first year, inflating by 8% pa over
the three-year life of the project. Working capital equal to 10% of annual sales is
required and needs to be in place at the start of each year.
Calculate the working capital flows.

Q11) New product sales are forecast at $100,000 in the first year, increasing by a 10%
compound rate each year. The product has a four-year life cycle. Working capital equal
to 15% of annual sales is required at the start of each year. The company's
contribution margin is 40%, and no incremental fixed costs are expected.
Determine the relevant operating cash flows after allowing for working capital.

Q12) A four-year project requires an initial investment in working capital of $7.5m. The
level of working capital will increase in line with general inflation, which is expected to
be 3% each year.
Calculate the cash flows associated with working capital over the life of the
project.

FM NOTES BY HASHIM RAMEESH U 36

Q13) Nyzot Co is considering a potential project with the following forecasts:
Now T1 T2 T3
Initial investment ($ million) (1,000)
Disposal proceeds ($ million) 200
Demand (millions of units) 5 10 6

The initial investment will be made the first day of the new accounting period.

The selling price per unit is expected to be $100 and the variable cost $30 per unit.
Both of these figures are given in today's terms.

Tax is paid at 30%, one year after the accounting period concerned.

Working capital will be required equal to 10% of annual sales. This will need to be in
place start of each year.

Tax-allowable depreciation is available at 25% reducing balance.

The company has a real required rate of return of 6.8%.

General inflation is predicted to be 3% pa but the selling price is expected to inflate at

4% and variable costs by 5% pa.

Calculate the NPV of this project

Q14) Hebac Co

Financing Cash Flows in Investment Appraisal

Interest payments on financed initial investment and their tax benefits are relevant
items.
However, these CFs are not included in DCF analysis because their effect is already
incorporated when discounting CFs at the company’s WACC (after-tax cost of
capital).

FM NOTES BY HASHIM RAMEESH U 37

Q15) Nyzot Co is considering an investment project which will cost $60 m, payable in
full at the start of the first year of operation. The project life is expected to be five years.
This investment has a scrap value of $1 m at the end of the project life.
Forecast pre-tax profits for the project are as follows:
Year 1 2 3 4 5
Pre-tax profits ($000) 3,400 6,200 5,800 7,000 6,500
The following costs (in $000) have been included in the forecast pre-tax profits:
Year 1 2 3 4 5
Accounting depreciation 11,800 11,800 11,800 11,800 11,800
Marketing costs 3,000 2,500 1,800 1,200 800
Administration costs 1,200 1,150 1,000 1,100 900
Notes
1. Accounting depreciation is not same as tax-allowable depreciation.
2. Tax-allowable depreciation is available at 25% reducing balance with a balancing
adjustment at the disposal year.
3. Marketing costs of $3 m in year 1 include $1,200,000 relating to market and
consumer research that has already been carried out in relation to the project.
4. Administration costs include $300,000 in year 1 and $150,000 in year 2 of
training costs relating to the project, and $400,000 in each of years 1 to 5 of
other administration costs relating to the project. The remaining administration
costs are central costs apportioned to this project.
5. In addition to the initial investment working capital of $1.5 m is required at the
start of the project.
Nyzot Co pays corporation tax of 25% per year, with the tax liability settled one year
after the concerned period. Nyzot Co has an after-tax cost of capital of 11%.

Calculate the NPV of this project

FM NOTES BY HASHIM RAMEESH U 38

Q16) Nyzot Co is evaluating a proposed investment that will require an up-front cash
payment of $55 million at the beginning of the first operating year. The initiative is
planned to run for three years, and the estimated pre-tax profits are as follows:
Year 1 2 3
Pre-tax profit ($000) 4,000 5,900 6,300
These profit forecasts already incorporate the following cost (in $000) items:
Year 1 2 3
Accounting depreciation 18,000 18,000 18,000
Marketing spends 2,700 2,400 1,900
Administration costs 1,400 1,250 1,050
Additional Information
• The depreciation charge for each year matches the tax-allowable depreciation.
• Within the first-year marketing budget of $2.7 m, $0.7 m relates to market and
consumer analysis completed prior to the project start.
• Administration expenses include staff training of $250,000 in Year 1 and
$180,000 in Year 2, plus $350,000 per year (Years 1–3) of other project-specific
administration costs. Remaining administration expenses are corporate
overheads apportioned to this project.
Nyzot Co faces a 24% corporation tax rate, with tax payable in the same year as the
profit arises, and its after-tax cost of capital is 10%.

Calculate the NPV of this project

FM NOTES BY HASHIM RAMEESH U 39

 Applications of
DCF techniques
Capital rationing
Capital rationing occurs when a company has limited capital to invest in projects with
positive NPV. The objective is to allocate the available funds in the most efficient and
profitable way.
Types of capital rationing
1. Hard capital rationing (Externally imposed)
o Investors consider the company too risky.
o Depressed capital market conditions.
o High issue costs for raising capital.
o High financial risk due to excessive debt (high gearing).
o Lack of reliable independent information available about the company

2. Soft capital rationing (Internally imposed)

o Managers want to avoid dilution of control.
o Avoiding dilution of EPS (if bonuses are linked to EPS).
o Avoiding fixed interest payments from debt.
o Following a steady growth policy.
o Restricting funds to encourage better investment choices.

Divisible projects – Can be undertaken partially in any proportion.

Indivisible projects – Must be undertaken fully or not at all.

Dealing with Capital rationing

For Divisible projects:
1. Calculate Profitability Index (PI)
𝑁𝑃𝑉
𝑃𝐼 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
2. Rank projects based on PI.

FM NOTES BY HASHIM RAMEESH U 40

 3. Allocate available funds in order of ranking.
For Indivisible projects:
Use the trial-and-error method to find the best possible combination of projects
within the capital limit (with highest NPV).

Mutually exclusive projects are two or more projects that cannot be undertaken
simultaneously

Q1) Capital for investment is limited in Year 0 to $5,000 There are four investment
projects available with a positive NPV, but these require a total $10,000 for
investment. All four projects are fully divisible. The investment required for each
project and the project NPVs are as follows:
Project 1 2 3 4
NPV 6,250 4,200 1,540 1,950
Initial investment ($) 5,000 2,100 1,400 1,500

Which project should be selected for investment, in order to maximise the total
NPV?

Q2)

Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t0 (50) (10) (10) (15)
Additional information:
(1) Cash is rationed to $50,000 at t0.
(2) The projects are not divisible.
Determine the optimal investment plan.

Q3)

Projects P Q R
$000 $000 $000
Investment required 40 50 30
PV of inflows @ 20% 56.5 67 48.8

FM NOTES BY HASHIM RAMEESH U 41

Additional information:
(1) Cash is rationed to $95,000 at t0.
(2) The projects are not divisible.
Determine the optimal investment plan.

Q4) Capital for investment is limited in Year 0 to $5,000 There are four investment
projects available with a positive NPV, but these require a total $10,000 for
investment. All four projects are fully divisible. Project 2 & 4 are mutually exclusive.
The investment required for each project and the project NPVs are as follows:
Project 1 2 3 4
NPV 6,250 4,200 1,540 1,950
Initial investment ($) 5,000 2,100 1,400 1,500

Which project should be selected for investment, in order to maximise the total
NPV?

Q5) Nyzot Co’s board is considering undertaking three of the investment projects
detailed in A to E below. The total funds available for investment are restricted to $80
m. The following information relates to these projects:
Project Initial Outlay ($m) Net Present Value ($m)
A 21 14
B 20 18
C 25 20
D 26 17
E 33 19
Projects A, D and E are all independent, but Projects B and C are mutually exclusive.
All projects are indivisible and none can be delayed or repeated.
Determine the optimal investment plan.

Q6) Dysxa Co (Kaplan)

FM NOTES BY HASHIM RAMEESH U 42

Lease or Buy decision
The Lease or Buy decision is a financing choice where a company decides whether to
borrow money to purchase an asset or acquire it through a lease arrangement.

Decision Process
1. Investment decision (First step)
o Evaluate the cash flows from using the asset (sales, materials, labour,
overheads, tax on net cash flows).
o Discount these Operating CFs using the company’s WACC.
2. Financing decision (Second step)
o Compare the cash flows specific to each financing option.
o Discount these cash flows using the after-tax cost of debt, assuming bank loan
financing.
𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒅𝒆𝒃𝒕 = 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 × (1 − 𝑡)
o Choose the financing option with the lowest PV of cost.

Why after-tax cost of debt (kd)?

Interest on bank loan is a tax-allowable expense, there will be a tax benefit on interest.
So, the effective cost of interest will be after-tax interest.

Relevant CFs in Lease Vs Buy

If Buying the asset:
• Initial investment
• Tax benefit of TAD
• Scrap proceeds

If Leasing the asset:

• Lease payments (assumed as tax-allowable deductions).
• Tax benefit from lease payments.

Other costs may be relevant depending on the lease agreement terms. For e.g.,
maintenance and insurance costs could vary based on whether they are borne by the
lessee or lessor. These should be included if they differ from the purchase option.

FM NOTES BY HASHIM RAMEESH U 43

Non-financial factors
Buying is preferred if:
• The asset is essential and used constantly.
• Full control over the asset is needed.
• Upgrading or scaling is easy.
• Maintenance is simple (e.g., under warranty).
• The asset has good resale value.
Leasing is preferred if:
• The asset is needed short-term or its usage duration is uncertain.
• Maintenance is complex and handled by the lessor.
• Frequent upgrades are required (e.g., due to technology changes).
• The lease offers flexibility for upgrades.
• Disposal of the asset is difficult due to regulations.

Q7) The management of a company has decided to acquire Machine X which costs
$63,000 and has an operational life of four years. The expected scrap value would be
zero. Tax is payable at 30% on operating cash flows one year in arrears. Tax-allowable
depreciation is available at 25% a year on a reducing balance basis.
Suppose that the company has the opportunity either to purchase the machine or to
lease it under a finance lease arrangement, at an annual rent of $20,000 for four years,
payable at the end of each year. The company can borrow to finance the acquisition at
10%.
Should the company lease or buy the machine?

Q8) A new project is being considered:

The asset costs $200,000 on the first day of a new accounting period.
The scrap value is $25,000 on the last day of the next accounting period.
Operating inflows are $150,000 for two years.
The tax rate is 33% and taxes are paid one year in arrears.
The company's WACC is 10%.
Tax-allowable depreciation is at 25% on a reducing balance basis with a balancing
adjustment in the year of disposal.

FM NOTES BY HASHIM RAMEESH U 44

Finance options:
(1) using a bank loan at a 10.5% interest rate; or
(2) leasing for $92,500 a year in advance for two years (lease payments are tax
allowable).
a) Determine the operational benefit of the project.
b) Determine how the project should be financed.
c) Decide whether the project is worthwhile.

Q9) Dink Co (Kaplan)

Q10) Hawker Co (Kaplan)

Q11) ASOP Co is considering an investment in new technology that will reduce

operating costs through increasing energy efficiency and decreasing pollution. The
new technology will cost $1m and have a four-year life, at the end of which it will have
a scrap value of $100,000.
A licence fee of $104,000 is payable at the end of the first year. This licence fee will
increase by 4% per year in each subsequent year.
The new technology is expected to reduce operating costs by $5.80 per unit in current
price terms. This reduction in operating costs is before taking account of expected
inflation of 5% per year.
Forecast production volumes over the life of the new technology are expected to be as
follows:
Year 1 2 3 4
Production (units per year) 60,000 75,000 95,000 80,000

If ASOP bought the new technology, it would finance the purchase through a four-year
loan paying interest at an annual before-tax rate of 8.6% per year.
Alternatively, ASOP could lease the new technology. The company would pay four
annual lease rentals of $380,000 per year, payable in advance at the start of each year.
The annual lease rentals include the cost of the licence fee.

FM NOTES BY HASHIM RAMEESH U 45

If ASOP buys the new technology, it can claim tax-allowable depreciation on the
investment on a 25% reducing balance basis. The company pays taxation one year in
arrears at an annual rate of 30%. ASOP has an after-tax weighted average cost of
capital of 11% per year.
Required:
Determine the NPV of this project suggesting whether the new technology should
be bought or leased also comment on the financial acceptability of this project.

Asset replacement decision

A company may need to replace a non-current asset regularly to ensure continuous
use.
Over time, efficiency decreases while maintenance and running costs increase,
reducing profitability. Advancements in technology may make older assets outdated.
The key decision is how often to replace the asset for maximum efficiency and cost-
effectiveness. (Should the asset be replaced every 1 year, 2 years, 3 years, …)
The goal is to find the most cost-effective replacement cycle
Technique to determine the Optimal replacement cycle
1) Calculate NPV for different replacement cycles.
• Relevant cash flows are Initial investment, maintenance/running costs, and
scrap value.
• Operating cash flows (sales, variable costs, fixed costs) are not relevant.
• Discount at the company’s WACC.
2) Find Equivalent Annual Cost (EAC) for each cycle:
𝑁𝑃𝑉
𝐸𝐴𝐶 =
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟
3) Decision rule: The optimal replacement cycle is the one with the lowest EAC.
NPVs cannot be directly compared for projects with different durations. EAC accounts
for these differences, making comparisons possible.
The asset replacement decision is just one example of the application of the EAC
method. Other applications include choosing between mutually exclusive assets with
different lives (EAB method).
Limitations
• Exact like-for-like replacement is rarely possible as asset needs evolve over time.
• Technological advancements may require earlier replacements than planned.

FM NOTES BY HASHIM RAMEESH U 46

Q12) Nyzot Co is reviewing its asset replacement strategy for a key piece of
equipment, the mitre saw, which has the following costs and resale values over its
four-year life. Purchase cost is $25,000.
Yr 1 Yr 2 Yr 3 Yr 4
Running costs (cash expense) 7,500 11,000 12,500 15,000
Resale value (end of the year) 15,000 10,000 7,500 2,500

Nyzot Co aims to determine how frequently the mitre saw should be replaced to
minimize the total cost of ownership. As the equipment ages, its running costs
increase while its resale value decreases, presenting a challenge in balancing
operational costs and asset value recovery.
The organisation's cost of capital is 10%.
You are required to assess how frequently the asset should be replaced.

Q13) Melanie Co (Kaplan)

Q14) Cabreras Co (Kaplan)
Q15) Clover Co (Kaplan)

Equivalent Annual Benefit (EAB)

When choosing between mutually exclusive projects, the project with the highest NPV
is usually preferred.
However, if the projects repeat indefinitely and have different lifespans, the EAB
approach helps in making a fair comparison.
𝑁𝑃𝑉
𝐸𝐴𝐵 =
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟

Q16) Two mutually exclusive projects are being considered:

Project A has an NPV of $47m and is expected to last three years.
Project B has an NPV of $58m and is expected to last four years.
If either project is chosen it will be possible to repeat it for the foreseeable future.
The cost of capital is 13%.
Calculate which project the company should accept.

FM NOTES BY HASHIM RAMEESH U 47

Risk & Uncertainty in
Investment appraisal
Investment appraisal faces the following problems:
 All decisions are based on forecasts
 All forecasts are subject to uncertainty
 This uncertainty needs to be reflected in the financial evaluation

Risk & Uncertainty

Risk Uncertainty
• It refers to situations where the potential • It refers to situations where the
outcomes and their probabilities of outcomes and their probabilities are not
occurrence are known or can be known or cannot be reliably estimated
estimated with a reasonable degree of • Lack of historical data
confidence • Not measurable
• Historical data available to assign • In project appraisal, the uncertainty
probabilities increases with increase in project’s life
• Measurable
• In project appraisal, the major risk is the
variability of future cash flows. The
greater the variability, the greater the risk
Methods to incorporate this in project
Methods to incorporate this in project appraisal:
appraisal:
➢ Set shorter payback targets
➢ Expected values (probability analysis)
➢ Make prudent estimates of CFs to
➢ Simulation models assess the worst possible situation
➢ Adjusted payback ➢ Assess both best and worst possible
➢ Risk-adjusted discount rates situations to obtain a range of NPVs
➢ Sensitivity analysis

FM NOTES BY HASHIM RAMEESH U 48

Sensitivity analysis
Sensitivity analysis is the analysis of changes made to significant variables in order to
determine their effect on a planned course of action (a decision).
In project appraisal, sensitivity analysis is used to analyse the effect of changes in the
value of an input variable, assuming other variables are kept constant.
The CFs or cost of capital of the project are varied until the decision changes (i.e., NPV
becomes zero). This will show the sensitivity of the decision to changes in those
variables.
𝑁𝑃𝑉
𝑺𝒆𝒏𝒔𝒊𝒕𝒊𝒗𝒊𝒕𝒚 % 𝒐𝒇 𝒂 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 =
𝑃𝑉 𝑜𝑓 𝑟𝑒𝑙𝑒𝑣𝑎𝑛𝑡 𝐶𝐹

The lower the percentage, the more sensitive the NPV is to that project variable.
For each of the variable under consideration the relevant CFs are,
• If selling price changes, the revenue will change, so the relevant CF will be revenue.
• If variable cost changes, the total variable cost will change, so the relevant CF will
be total variable cost.
• If sales volume changes, this will affect both sales revenue and variable costs, so
the relevant CF will be total contribution.
• If fixed cost changes, the relevant CF will be total fixed cost.
• If initial investment changes, the relevant CF will be initial investment.
• If scrap value changes, the relevant CF will be scrap proceeds.
If taxation is included in the question, then it must also be considered. The PV of the
relevant CFs net of tax need to be considered.
To calculate the sensitivity to the discount rate, it is necessary to find the rate at which
the project NPV is zero, i.e., the IRR.
(𝐼𝑅𝑅 − 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒)
𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 % =
𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒

FM NOTES BY HASHIM RAMEESH U 49

Q1) Hashim has just set up a company, Nyzot a manufacturing company, and
estimates its cost of capital to be 15%. His first project involves investing $150,000 in
equipment which has a life of 7 years and a final scrap value of $15,000.
The equipment will be used to produce 20,000 pairs of shoes per year, generating a
contribution of $2.75 per pair (Selling price $8.5 per pair & Variable cost $5.75 per
pair). He estimates that annual fixed costs will be $15,000 per year.
Required:
a) Determine, on the basis of the above figures, whether the project is worthwhile using
NPV.
b) Calculate what percentage changes in the following factors would cause your
decision in (a) to change:
➢ Initial investment
➢ Selling price per unit
➢ Variable cost per unit
➢ Sales volume
➢ Fixed costs
➢ Scrap value
➢ Cost of capital

Q2) Nyzot Co plans to buy a new machine. The cost of the machine, payable
immediately, is $750,000, and the machine has an expected life of five years. An
additional investment in working capital of $85,000 will be required at the start of the
first year of operation. At the end of five years, the machine will be sold for scrap, with
the scrap value expected to be 6% of the initial purchase cost of the machine. The
machine will not be replaced.
Production and sales from the new machine are expected to be 120,000 units per
year. Each unit can be sold for $18 per unit and will incur variable costs of $12 per unit.
Incremental fixed costs arising from the operation of the machine will be $175,000 per
year.
Nyzot Co has an after-tax cost of capital of 10%, which it uses as a discount rate in
investment appraisal. The company pays profit tax one year in arrears at an annual rate
of 28% per year. Tax-allowable depreciation and inflation should be ignored.
Required:
a) Calculate the net present value of investing in the new machine and advise whether
the investment is financially acceptable.
b) Calculate the internal rate of return of this investment and advise whether the
investment is financially acceptable.

FM NOTES BY HASHIM RAMEESH U 50

c) Calculate the sensitivity of the investment in the new machine to changes in:
➢ Initial investment
➢ Selling price per unit
➢ Variable cost per unit
➢ Sales volume
➢ Fixed costs
➢ Scrap value
➢ Cost of capital

Q3) Warden Co (Kaplan)

Advantages
 It gives an idea of how sensitive the project is to changes in any of the original
estimates.
 It directs management attention to checking the quality of data for the most
sensitive variables.
 It identifies the critical factors for the project and directs project management.

Disadvantages
 Sensitivity analysis is normally used to examine what happens when one variable
changes and others remain constant. Variables are often interdependent, however.
 Probability of change in a variable is not considered.
 Sensitivity analysis does not provide a decision rule. Management must decide the
level of sensitivity that is acceptable.

Probability analysis (Expected values)

Expected value is the weighted average of all the possible outcomes, with the
weightings based on the probability estimates

𝐸𝑉 = ∑ 𝑥. 𝑝(𝑥)

x – value of an outcome
p(x) – probability of an outcome

EV is not the most likely outcome. It may not even be a possible outcome, but instead
it finds the long-run average outcome.

FM NOTES BY HASHIM RAMEESH U 51

Q4) The values in the table below show the NPV of three projects given three different
states of the market.
Project A Project B Project C
State of
Probability NPV NPV NPV
market
Recession 0.5 100 0 180
Stable 0.4 200 500 190
Growing 0.1 1400 600 200
EV of NPV

Q5) Degnis Co (Kaplan)

Advantages
 Deals with multiple outcomes
 Quantifies probabilities
 Relatively simple calculation
 Assists decision making.

Disadvantages
 Subjective probabilities
 Answer is only a long-run average
 Ignores variability of Cash flows
 Risk neutral decision, i.e. ignores investor’s attitude to risk

The EV technique is best suited to a problem that is repetitive and involves relatively
small investments (less risk). This method is not suitable to take decision in ‘one-off’
situations.

FM NOTES BY HASHIM RAMEESH U 52

Joint probability
Q6) An organisation is considering making a $40,000 investment in a project which is
estimated will generate cash inflows over the project’s two-year life as follows:
Year 1 Cash flow Probability
$20,000 0.4
$30,000 0.6
Year 2
If cash flow in there is a probability that cash flow in
year 1 is: of: year 2 will be:
$20,000 0.25 $10,000
0.75 $20,000
$30,000 0.30 $20,000
0.70 $25,000
The organisation’s cost of capital is 10%.
Calculate the EV of the project’s NPV and the probability that the NPV will be
negative.

Q7) Copper Co (Kaplan)

Q8) Hraxin Co (Kaplan)

Q9) Vyxyn Co (Kaplan)

Standard deviation
The standard deviation is a statistical measure of the variability of a distribution
around its mean (i.e. it measures the dispersion of possible outcomes about the EV).
The tighter the distribution, the lower this measure will be, and the risk is low.
The wider the dispersion, the riskier the situation.

FM NOTES BY HASHIM RAMEESH U 53

Simulation
Simulation is a technique which allows more than one variable to change at the same
time. Using mathematical models, it produces distribution of possible outcomes from
the project. The probability of different outcomes can be calculated.
Stages of simulation exercise
1) Specify major variables
2) Specify the relationships between variables to calculate an NPV
3) Simulate the environment many times in order to get a range of observations.
4) The results of a simulation exercise will be a probability distribution of NPVs
Instead of choosing between EVs, decision makers can now take the dispersion of
outcomes.
Advantages
 This provides more information about the possible outcomes and their relative
probabilities
 This data can be used to calculate an expected NPV, also the standard deviation to
find the dispersion

Disadvantages
 This does not help much in decision making, it only provides with information of
probability distribution
 Expensive and time consuming

FM NOTES BY HASHIM RAMEESH U 54

Adjusted payback
By using this method to deal with risk, we’ll shorten the payback period required. This
places more emphasis on the earlier cash flows, which are considered to be less risky.

Discounted payback
It is also possible to reflect risk by using discounted cash flows in the calculation of
payback period of a project. The cash flows are discounted by using a suitable
discount rate that reflects the risk profile of the project.

However, these two methods still have some of the disadvantages of the traditional
payback method.
Q10) A project has the following cash flows
T0 T1 T2 T3 T4
(20,000) 8,000 12,000 4,000 2,000
If the cost of capital is 8%. Find the discounted payback period of this project.

Risk-adjusted discount rate

If an individual project is perceived to be riskier, the increased risk could be used as a
reason to adjust the discount rate. A higher discount rate should be applied to projects
with higher risk. Project-specific discount rates can be found using the capital asset
pricing model (CAPM).

Q11) Pulorough Co produces household electrical goods for its home country market
and for markets in neighbouring countries. Pulorough Co is planning to make a major
investment in new production facilities in order to produce an upgraded model of its
cooker. Pulorough Co’s finance director has assigned probabilities to a number of
possible sales volumes of this new model, based on Pulorough Co’s previous
experience of launching product upgrades. He has calculated annual expected values
for sales for the four-year time period over which the investment will be assessed.
However, after a number of years of strong economic growth, Pulorough Co’s home
country and its neighbours appear likely to enter a period of recession, meaning that
consumers may be less willing to spend money on new kitchen goods.
The initial investment cost will be $39m. The finance director has assumed that there
will be zero realisable value at the end of the four years. Working capital can be
ignored.

FM NOTES BY HASHIM RAMEESH U 55

The expected volumes of sales are:
Year 1 2 3 4
60,000 150,000 140,000 80,000

The expected contribution from the upgraded cooker throughout the four years is $200
per cooker. This will not be affected by the rate of inflation.
Incremental fixed costs, excluding depreciation, are expected to be $2.5m in year 1.
They will increase by the rate of inflation in each of years 2 to 4, which are predicted to
be as follows:
Year 2 3 4
Inflation rate per year 6% 4% 3%

Pulorough Co pays corporation tax of 25% per year one year in arrears. No tax-
allowable depreciation is available on the investment expenditure.
Pulorough Co currently uses 11% as the after-tax discount rate to appraise
investments like this.
One of the other directors has commented that he thinks the level of contribution that
the finance director has assumed is too high. He also wondered that, with the
economic uncertainty, the cost of capital should be higher. The finance director has
said that he will prepare sensitivity calculations, showing in relative terms the level of
change in contribution and discount rate that would produce a nil net present value.
He will assume that the contribution will be lower by the same percentage each year.
Required:
a) Calculate the nominal net present value of the investment project and comment
on its financial acceptability
b) Calculate the sensitivity of the project's net present value to a change in the level of
contribution per unit
c) Calculate the sensitivity of the project's net present value to a change in the
discount rate

FM NOTES BY HASHIM RAMEESH U 56

 Working Capital
Management
Working capital
It is the capital represented by net current assets which is available for day-to-day
operating activities. It normally includes inventories, trade receivables, cash and cash
equivalents, less trade payables.
Working capital = Current assets – Current liabilities
Many businesses which appear profitable are forced to cease trading due to an
inability to meet short-term obligations when they fall due. To remain in business, an
organisation must successfully manage its working capital. Management of working
capital is difficult because their elements are often linked, means altering one item
may adversely affect other areas of business.
Management needs to ensure that the business has sufficient working capital to
avoid cash flow problems like going over the overdraft limit, failing to pay suppliers &
employees, loose the advantage of discounts for prompt payment, etc. But having too
much in working capital means lower returns on these investments (compared with
cost of financing), which isn’t good either.
Two major questions must be considered:
1) How much to invest in working capital? (Investment policy)
2) How to finance working capital? (Financing policy)

Objectives of WC management
The two main objectives of working capital management are:
1) to ensure the organisation has sufficient liquid resources to continue in business
(liquidity)
2) to increase its profitability
There is, however, a trade-off between liquidity and profitability

FM NOTES BY HASHIM RAMEESH U 57

Working capital investment policy
Companies will have different policies regarding the level of investment in working
capital, depending on management's attitude to risk.
 If a company is highly risk-averse, it takes a conservative approach. This means
keeping higher levels of inventory, offering generous credit terms to customers,
paying suppliers promptly, and holding more cash for safety. This is appropriate
when CFs are unpredictable. This approach reduces the risk of system breakdown.
However, this can lead to problems like inventory becoming obsolete and higher
financing costs (Profitability reduces).
 On the other hand, if a company is risk-seeker, it adopts an aggressive approach.
This involves keeping lower levels of inventory, offering less generous credit terms,
and holding less cash. This is appropriate when CFs are very predictable. While this
approach can be more profitable due to lower asset investment, it's riskier because
it may lead to inventory shortages or difficulties in meeting unexpected expenses.
This approach has a high chance for system breakdown.
 Some companies take a moderate approach, balancing between conservative and
aggressive strategies.

Financing
Whatever level of current assets the business decides to hold, they must be matched
by liabilities (financing options). This means management must decide whether to use
short-term or long-term financing, or a combination of both, based on factors like
cost. Short-term financing typically comes at a lower cost than long-term financing.
So, businesses need to carefully consider the mix of financing options to ensure
they're effectively managing their capital and minimizing costs.
Sources of finance
Short-term sources of finance include,
 Overdrafts offer flexibility but can be costly with variable interest rates.
 Short-term loans typically have lower interest rates than long-term debt but carry
the risk of renegotiation (bank may refuse to refinance on maturity).
 Accounts payable might seem cheap, but missing settlement discounts can be
costly, and relying too heavily on trade credit can strain relationships with suppliers.
Although short-term funding is relatively cheap, it can vanish suddenly, like if the bank
demands repayment of an overdraft or suppliers halt deliveries until outstanding

FM NOTES BY HASHIM RAMEESH U 58

invoices are settled (i.e., refinance risk high). It's smart to consider using some long-
term financing despite higher costs because it lowers the risk of renegotiation.
Long-term financing options include,
 equity, like issuing new shares or using retained profits, this doesn't require
repayment and avoids renegotiation risk
 debt, such as loan notes or long-term bank loans. This can provide protection
against rising interest rates if rates are fixed.

Permanent vs Fluctuating current assets

Some current assets might actually be more permanent than they seem. For example,
a business might keep a buffer stock of inventory to avoid stock-out, maintain a
precautionary cash balance for unexpected expenses, or have a minimum level of
trade receivables over the year.
Only the excess above these minimum levels is truly short-term (Fluctuating CA).

Working capital financing policy

 Matching policy: One approach is to match permanent current assets with long-
term finance and fluctuating current assets with short-term finance. This moderate-
risk strategy aligns the maturity of funds with maturity of assets.
 Aggressive strategy: Another approach is to use short-term finance for both
fluctuating and permanent current assets. While potentially cheaper (high
profitability), it indicates a high tolerance for risk (refinance risk) and can leave the
business vulnerable if short-term finance disappears suddenly.
 Conservative strategy: Conversely, using long-term finance for both types of
current assets, although more expensive (low profitability), reduces refinance risk
which avoids the need for constant financing renewal. This approach suits
businesses with a highly risk-averse management style.

Working capital ratios

Liquidity ratios
Current ratio = Current assets / Current liabilities
Quick ratio = (Current assets – Inventory) / Current liabilities

FM NOTES BY HASHIM RAMEESH U 59

If the current ratio drops below 1, it could signal trouble meeting obligations on time.
But even if it's above 1, it doesn't guarantee liquidity, especially if inventory moves
slowly. The ideal current ratio is assumed to be 2:1.
The quick ratio is useful when inventory is slow to sell. Ideally, a company with slow-
moving inventory should aim for a quick ratio of at least 1, while for those with fast-
moving inventory, it can be less than 1.
Efficiency ratios
Inventory turnover = Cost of sales / Inventory
Inventory turnover shows how quickly inventory is sold, with higher turnover reflecting
faster moving inventory.
Inventory holding period = (Inventory / Cost of sales) x 365 days
The inventory holding period estimates the time taken for inventory to be sold.
Management would prefer a lower number of days.
Receivables collection period = (Receivable / Credit sales) x 365 days
The receivables collection period estimates the time taken for a customer to pay.
Management would prefer a lower number of days.
Payables payment period = (Trade payable / Credit purchases) x 365 days
The payables payment period estimates the time taken to pay suppliers. Management
would prefer to increase the number of days credit taken, unless this proves expensive
in terms of lost discounts or leads to other problems such as reduced reliability or
quality of supplies.
Sales to Working capital ratio = Sales / Net working capital
Sales/working capital indicates how efficiently a business uses its working capital to
generate sales. Management would prefer this to rise.

Working capital cycle

The working capital cycle (also known as cash operating cycle) is the number of days
between paying suppliers and receiving cash from customers. It can be found from
standard ratios as,
inventory holding period + receivables collection period − payables payment
period.
Businesses aim to shorten this cycle to reduce liquidity issues. When inventory
turnover is slow, and it takes a while to collect cash from sales, or if payables are paid
quickly, the cycle lengthens, causing cash flow problems. A longer cycle means more
resources are tied up in working capital.

FM NOTES BY HASHIM RAMEESH U 60

Factors affecting cycle length
The length of the cash operating cycle depends on several factors:
 Industry type: For example, a supermarket chain may have a short cycle (even
negative) due to fast-moving fresh food, while a construction company may have a
longer cycle due to extensive work in progress.
 Industry norms: If competitors offer long credit periods, it's hard to reduce
receivables collection without losing business.
 Power of suppliers: Delaying payments may prompt suppliers to demand
immediate payment, shortening the payables period.
 Efficiency of working capital management: Weak credit control or holding excess
inventory lengthens the cycle.
 Terms of trade: Offering longer credit periods to customers can extend the cycle.

For a manufacturer, the calculation of the cash operating cycle can require a detailed
analysis of the three types of inventories (raw materials, work in progress and finished
goods).
Raw material holding period = (Raw material inventory / Raw materials purchase) x
365
WIP holding period = (WIP inventory / Production cost) x 365
WIP days estimates the length of the production cycle (i.e. the number of days to
convert raw materials into finished goods).
Finished goods holding period = (Finished goods inventory / Cost of sales) x 365

FM NOTES BY HASHIM RAMEESH U 61

Q1) Tipple Co has the following estimated figures for the coming year:
Sales $3,600,000
Accounts receivable $306,000
Gross profit margin 25%
Finished goods
inventory $200,000
Work-in-progress
inventory $350,000
Raw materials inventory $150,000
Accounts payable $130,000
Purchases represent 60% of production cost.
Calculate the length of the cash operating cycle.

Managing working capital

Working capital management is a key factor in an organisation’s long-term success.
Clear and effective policies for each component of working capital are therefore vital
and are the direct responsibility of the financial manager.
Managing inventory involves balancing costs. Holding inventory incurs costs like
storage, security, and potential losses from theft or obsolescence. Therefore, it's
crucial not to hold too much inventory. However, not having enough inventory to meet
demand can lead to lost sales and harm the business's reputation, potentially driving
customers to competitors. So, finding the right balance of inventory is key.
Managing receivables is crucial for maintaining cash flow. Businesses sometimes
focus too much on making sales and neglect collecting payments promptly, leading to
cash flow issues. Key areas of receivables management include evaluating customers'
creditworthiness, establishing credit terms, and actively monitoring and collecting
payments.
Managing trade payables is crucial for short-term funding in most businesses. While it
can seem like an interest-free loan, there are costs involved. Consistently exceeding
credit periods can harm a business's credit rating and even lead to legal action or
withdrawal of credit. Additionally, not taking advantage of early settlement discounts
adds to the cost of trade payables.

FM NOTES BY HASHIM RAMEESH U 62

Managing cash is crucial to avoid liquidity problems. Businesses often experience
fluctuations in cash flow over the period, i.e., some months there will be a surplus in
some there’ll be deficit cash balance. Planning ahead is essential to ensure there's
enough cash to cover expenses during deficit periods. Creating a cash budget helps to
predict cash flows, identifying surplus and deficit periods. Surplus cash can be
invested to earn interest, while deficits can be covered with a bank overdraft or loan.

Problems with small businesses

Small businesses, especially during their start-up phase, often face working capital
problems. As sales grow, they need more materials and workers, but cash from sales
takes time to arrive while immediate payments are needed for suppliers and
employees. This reliance on bank overdrafts and loans can be challenging. Over time,
as the business grows and stabilizes, better credit terms with customers and suppliers
can help alleviate these problems.

Overtrading
Overtrading (also known as undercapitalisation) happens when a company tries to
handle a lot of business with limited working capital. This often occurs when a
business grows rapidly without enough long-term finance. It can lead to liquidity crisis.
In new businesses, this can happen because they offer long credit periods to attract
customers, experience rapid sales growth, or lack management skills to control debt
collection period and production period. Companies in this situation struggle to get
long-term finance, leading to business failure.
Indicators of overtrading
 declining liquidity (current ratio & quick ratio will fall),
 rapid increase in revenue,
 longer inventory holding and receivables periods,
 increased reliance on short-term borrowing (like overdrafts & trade payables),
 only small increase in equity capital
 declining cash holdings,
 rapid increase in volume of current assets (inventory & receivables),
 lower profit margins, and
 a high “sales-to-non current assets” ratio.

FM NOTES BY HASHIM RAMEESH U 63

To tackle overtrading,
businesses aim to shorten the cash cycle by reducing inventory holding and
production periods, improving debt collection, extending credit from suppliers,
getting more long-term finance (equity from shareholders),
slowing down sales growth to a manageable level,
sell-off projects that are not strategically important.

Q2) Pumice Co

Q3) It is the middle of December 20X6 and Pangli Co is looking at working capital
management for January 20X7.
Forecast financial information at the start of January 20X7 is as follows:
Inventory $455,000
Trade receivables $408,350
Trade payables $186,700
Overdraft $240,250
All sales are on credit and they are expected to be $3.5m for 20X6. Monthly sales are
as follows:

November 20X6 (actual) $270,875

December 20X6 (forecast) $300,000

January 20X7 (forecast) $350,000

Pangli Co has a gross profit margin of 40%. Although Pangli Co offers 30 days credit,
only 60% of customers pay in the month following purchase, while the remaining
customers take an additional month of credit.
Inventory is expected to increase by $52,250 during January 20X7.
Pangli Co plans to pay 70% of trade payables in January 20X7 and defer paying the
remaining 30% until the end of February 20X7. All suppliers of the company require
payment within 30 days. Credit purchases from suppliers during January 20X7 are
expected to be $250,000.
Interest of $70,000 is due to be paid in January 20X7 on fixed rate bank debt. Operating
cash outflows are expected to be $146,500 in January 20X7. Pangli Co has no cash
and relies on its overdraft to finance daily operations. The company has no plans to
raise long-term finance during January 20X7.
Assume that each year has 360 days.

FM NOTES BY HASHIM RAMEESH U 64

Required:
a) Calculate the cash operating cycle of Pangli Co at the start of January 20X7.
b) Calculate the overdraft expected at the end of January 20X7.
c) Calculate the current ratios at the start and end of January 20X7.

Q4) The following financial information relates to Nyzot Co.

Statement of Profit or Loss (Extracts)

20X7 ($m) 20X6 ($m)
Revenue 1,530 900
Cost of sales 1,300 720
Profit before interest and tax 230 180
Interest 12 12
Profit before tax 218 168
Taxation 44 34
Profit after tax 174 134

Statement of Financial Position (Extracts)

20X7 ($m) 20X6 ($m)
Non-current assets 500 450
Current assets
Inventory 107 59
Trade receivables 252 111
Cash 0 44
Total current assets 359 214
Total assets 859 664
Current liabilities
20X7 ($m) 20X6 ($m)
Trade payables 143 63

FM NOTES BY HASHIM RAMEESH U 65

 20X7 ($m) 20X6 ($m)
Overdraft 11 0
Total current liabilities 154 63
Equity
20X7 ($m) 20X6 ($m)
Ordinary shares 240 240
Reserves 265 161
Total equity 505 401
Non-current liabilities
20X7 ($m) 20X6 ($m)
6% loan notes 200 200
Total liabilities 859 664

All sales are made on credit and the company operates for 365 days per year.
Required:
a) Using suitable working capital ratios and analysis of the financial information
provided, evaluate whether Nyzot Co can be described as overtrading.
(6 marks are available for calculations) (12 marks)
b) Explain the advantages and disadvantages of a conservative approach as
compared to an aggressive approach to the financing of Nyzot Co’s working capital
requirements. (8 marks)

Q5) Gorwa Co (overtrading)

FM NOTES BY HASHIM RAMEESH U 66

 Inventory
Management
Inventory control
Inventory control is about managing the right amount of inventory levels. Having too
much inventory can lead to additional costs and lower profits, while having too little
can result in lost sales and reduced profits.
Finding the optimum inventory level depends on factors like daily sales, lead times for
delivery, supplier reliability, type of goods, reorder costs, storage costs, and other
variables. Regular reviews of inventory levels and timely adjustments are crucial for
effective inventory management.
Reasons for holding inventory
Inventory may include raw materials, WIP, finished goods, goods for resale or even
consumables for use in business. These are held as inventory for various reasons:
 To meet demand by in times of unusually high consumption (to reduce the risk of
"stock-outs").
 To ensure continuous production.
 To take advantage of quantity discounts.
 To buy in ahead of an expected shortage or ahead of an expected price rise.
 For technical reasons (e.g. maturing whiskey in casks or keeping oil in pipelines).
 To reduce ordering costs.

Inventory levels
Re-order level (ROL)
Re-order level (ROL) is the level to which inventory should fall before placing a
purchase order for replenishment.
Lead time is the time between placing and receiving an order.
Re-order level (ROL) = maximum usage × maximum lead time

FM NOTES BY HASHIM RAMEESH U 67

 For e.g., if the usage is 200-600 units per day and lead time is 4-6 days,
ROL = 6 x 600 = 3600 units

Maximum inventory level

Inventory held above this level is incurring excessive holding costs.
Maximum inventory level = reorder level (ROL) + reorder quantity (Q) − (minimum
usage × minimum lead time)
Minimum inventory level
Also known as Buffer or Safety inventory. There is a severe risk of stockout if the
amount of inventory held is below this level.
Minimum inventory level = reorder level (ROL) − (average usage × average lead time)
Average inventory level
The level of inventory is somewhere between the maximum and minimum inventory
levels.
Average inventory level = minimum inventory + (reorder quantity / 2)

Q1) A company has an inventory management policy which involves ordering 50,000
units when the inventory level falls to 15,000 units. Forecast demand to meet
production requirements during the next year is 310,000 units. You should assume a
50-week year and that demand is constant throughout the year. Orders are received
two weeks after being placed with the supplier.
What is the average inventory level?

FM NOTES BY HASHIM RAMEESH U 68

Inventory costs
The costs associated with inventory include:
 Purchase costs: The price paid for purchasing inventory and any applicable tax &
charges.
Total purchase cost = Annual demand (D) x Purchase price per unit
 Holding costs: expenses related to holding inventory, such as cost of capital tied-
up, insurance, deterioration, theft, warehousing, and administration.
Total holding cost = Cost of holding one unit for one year (Ch) x Avg. inventory level
i.e., Ch x (min. inventory + Q/2)
Where Q is the re-order quantity
 Ordering costs: costs associated with reordering inventory, including
transportation, administrative expenses, and batch setup costs for goods produced
internally.
Total ordering cost = Cost per order (Co) x no. of orders
i.e., Co x D/Q
 Shortage costs: costs incurred due to inventory shortages, like production
stoppages, lost sales, and emergency reordering costs.
 Systems costs: expenses related to managing inventory, including personnel and
computer systems.
The benefits of holding inventory must outweigh the costs.

EOQ model
Economic Order Quantity is the optimal quantity of inventory to be ordered each time
to minimize total costs associated with ordering and holding inventory.

Co – cost of placing one order

Ch – cost of holding one unit for one year
D – annual demand

FM NOTES BY HASHIM RAMEESH U 69

Assumption of EOQ
 Purchase price per unit is constant.
 Constant demand and lead time.
 No risk of stock-outs.
 Order costs are independent of order quantity.
 Holding cost depends on average level of inventory.
Q2) Demand for glass is 10,000 square metres (m2) a year. The cost of placing an
order of any amount for glass is $50. The cost of holding one m2 of glass is $100 a
year.
What is the EOQ of glass?

Complications
1) Warehouse rental – The EOQ model calculates holding cost based on the average
inventory level. If a warehouse is rented on a long-term basis, it must accommodate
the maximum stock level, not just the average. To address this, we’ll double the
rental cost for one unit for the period.
2) Cost of capital - Financing inventory incurs a cost. This cost is considered a holding
cost in the EOQ model.

FM NOTES BY HASHIM RAMEESH U 70

Q3) Annual demand is 3,000 units, cost of placing an order is $25. The holding cost
per unit for one year is $3 per unit plus any associated costs.
Each unit occupies 3.0 square meters and the annual rental cost of the warehouse is
$0.65 per square meter.
The purchase price unit is $35 and the cost of capital is 8%.
Calculate the EOQ.

Quantity discounts
When suppliers offer bulk-buying discounts for quantities above the EOQ, the
purchase price becomes relevant to the decision.
To handle this, calculate the total annual cost for the EOQ order level and for
quantities that qualify for discounts. Then, choose the order quantity with the lowest
total cost.
Q4) The annual demand for an item of inventory is 125 units. The item costs $200 a
unit to purchase, the holding cost for one unit for one year is 15% of the unit cost and
ordering costs are $300 an order. The supplier offers a 3% discount for orders of 60
units or more, and a discount of 5% for orders of 90 units or more.
What is the cost-minimising order size?

Other inventory systems

Periodic review system
This is a method of inventory management that involves reviewing the inventory levels
of all items at fixed, regular intervals and then placing orders to replenish stock based
on a predetermined level which takes account of lead time and consumption.
Just-In-Time (JIT)
Just-in-Time (JIT) is an inventory management system aimed at reducing the costs
associated with holding inventory.
It focuses on ordering and producing goods only as they are needed. For retailers,
goods are ordered to match customer demand timings and for manufacturers,
components or raw materials are ordered just in time when they are needed for
production schedules.

FM NOTES BY HASHIM RAMEESH U 71

Goals of JIT
 Minimize inventory costs by reducing the storage of raw materials,
 Ensure a smooth flow from raw material to finished goods with minimal delay.
 Achieve nearly zero inventory by aligning purchases and production closely with
current sales demands.
Conditions necessary for JIT to work
 Flexibility of both suppliers and internal workforce to expand and contract output at
short notice.
 Since there’s no buffer stock, the quality of raw materials must be consistently high.
 Close coordination and possibly geographical closeness to suppliers are crucial for
timely deliveries.
 Facilities need modern technology to allow for short production runs and low set-up
costs.
 Employees must be willing to adjust their working hours as needed, often
supported by a mix of full-time and part-time or freelance workers.
 Contracts with suppliers must be tight, often including penalty clauses for delays or
quality issues, and usually involve long-term commitments.

Q5) Nyzot Co sells both Oven and Counter, with sales of both products occurring
evenly throughout the year.
Oven
The annual demand for Oven is 300,000 units and an order for new inventory is placed
each month. Each order costs $267 to place. The cost of holding Oven in inventory is
10 cents per unit per year. Buffer inventory equal to 40% of one month’s sales is
maintained.
Counter
The annual demand for Counter is 456,000 units per year and Nyzot Co buys in this
product at $1 per unit on 60 days credit. The supplier has offered an early settlement
discount of 1% for settlement of invoices within 30 days.
Other information
Nyzot Co finances working capital with short-term finance costing 5% per year.
Assume that there are 365 days in each year.
Required
a) Calculate the following values for Oven:
(i) The total cost of the current ordering policy; (3 marks)
(ii) The total cost of an ordering policy using the economic order quantity; (3 marks)

FM NOTES BY HASHIM RAMEESH U 72

 (iii) The net cost or saving of introducing an ordering policy using the economic order
quantity. (1 mark)
b) Calculate the net value in dollars to Nyzot Co of accepting the early settlement
discount for Counter. (5 marks)
c) Discuss how invoice discounting and factoring can aid management of trade
receivables. (6 marks)
d) Identify the objectives of working capital management and discuss the central role
of working capital management in financial management. (7 marks)

Q6) Kandy Co

Q7) KXP Co

Q8) Dusty Co

FM NOTES BY HASHIM RAMEESH U 73

 Cash
Management
Treasury management
Treasury management is the efficient management of liquidity and risk in a business
including the management of funds (generated from internal and external sources),
currencies and cash flow.
Nowadays, many companies have dedicated treasury departments to oversee all this.
They concentrate on efficiently using cash, like investing surplus cash and
withdrawing it when needed.
Centralised treasury management
Many organisations use centralised treasury management, which has several
advantages.
 Management by specialised staff with appropriate qualifications, expertise and
experience.
 Economies of scale is achieved as specialists are employed centrally, fewer total
staff are needed, reducing duplication and maximizing their output, thereby reduce
the costs.
 Ability to use "pooling", which is the netting of cash deficits against surpluses to
save interest expense from short-term financing.
 Increased negotiating power with banks as the amounts borrowed or deposited
would be more substantial as a group. So cheaper finance options will be available
from banks.
 More efficient foreign exchange risk management because the head office's
treasury department can assess the group's overall currency position and hedge
accordingly.
Within a treasury department of a large company, there may still be a degree of
decentralisation to ensure that decisions taken are appropriate to local
circumstances.

FM NOTES BY HASHIM RAMEESH U 74

Treasurer’s role
The treasurer's job is to ensure the company has the right amount of cash when it's
needed (i.e., the cash management). They do this by:
 Accurate cash flow forecasting, so that shortfalls and surpluses can be anticipated
 Arranging short-term loans if needed.
 Investing extra cash wisely.
 Managing cash transfers cost-effectively.
 Handling foreign currency matters.
 Optimizing banking relationships.
 Planning big finance-raising deals.
 Accounts receivable/accounts payable policies.
In addition, the treasurer is often involved in risk assessment and insurance.

Cash management
Cash liquidity needs
Companies keep cash for a few reasons:
 Transaction motive: to handle day-to-day expenses like paying employees and
buying materials.
 Precautionary motive: to be ready for unexpected costs. This reserve may be held
in the form of "cash equivalents", which are short-term, low risk, highly liquid
investments (e.g. Treasury Bills).
 Speculative motive: to seize investment opportunities quickly, like having money
ready for investing in a takeover target.
But having too much cash can be inefficient. Shareholders expect a good return on
their investment. So, extra cash should either be put into profitable projects with
positive NPV or given back to shareholders through dividends or share buy-back
programmes.

FM NOTES BY HASHIM RAMEESH U 75

Cash flow forecasts
A cash forecast details an organisation’s estimated cash inflows and outflows for a
future period. It includes the opening and closing cash balances of an organisation.
Q1 Q2 Q3 Q4 Total
$ $ $ $ $
Cash inflows x x x x x
Cash sales x x x x x
Cash from receivables x x x x x
Non-current asset disposals x x x x x
Share/debt issues x x x x x
Total inflow x x x x x
Materials x x x x x
Labour x x x x x
Variable overhead x x x x x
Fixed overhead x x x x x
Dividends x x
Capital expenditure/leases x x
Interest/principal on debt x x x x x
Total outflow x x x x x
Net cash flow x x x x x
Opening balance x x x x x
Closing balance x x x x x

Q1) Hashim has worked for some years as a sales representative, but has recently
been made redundant. He intends to start up in business on his own account, using
$15,000 which he currently has invested with a building society. Hashim maintains a
bank account showing a small credit balance, and he plans to approach his bank for
the necessary additional finance.
Hashim provides the following additional information.
a) Arrangements have been made to purchase non-current assets costing $8,000.
Payment will be made at the start of October, and the assets are expected to have a
five-year life, at the end of which they will possess a nil residual value.
b) Inventories costing $5,000 will be acquired on 28 September, and subsequent
monthly purchases will be at a level sufficient to replace forecast sales for the month.
c) Forecast monthly sales are $3,000 for October, $6,000 for November and
December, and $10,500 from January 20X4 onwards.
d) Selling price is fixed at the cost of inventory plus 50%.

FM NOTES BY HASHIM RAMEESH U 76

e) Two months’ credit will be allowed to customers, but only one month’s credit will be
received from suppliers of inventory.
f) Running expenses, including rent but excluding depreciation of non-current assets,
are estimated at $1,600 per month.
g) Hashim intends to make monthly cash drawings of $1,000.
h) He also intends to raise a bank loan of $10,000 in November.
Required:
Prepare a cash flow forecast for the six months to 31 March 20X4.

Q2) Nyzot Co has the following budgeted statement of profit or loss:

January February March April
($000) ($000) ($000) ($000)
Sales 35 45 47 50
Cost of sales (20) (22.5) (25) (27.5)
Gross profit 15 22.5 22 22.5
Salaries and wages (10) (10) (10) (10)
Other administrative
(5) (5) (5) (5)
costs
Depreciation (7.5) (7.5) (7.5) (7.5)
Profit (7.5) 0 (0.5) 0
Cash on 31 December was $5,000. The following assumptions have been made
relating to cash flows:
1. Half of the customers will pay in the month following the sale, and the other half
will pay two months after the sale. In November and December, the monthly
sales revenue was $40,000.
2. At the start of each month, there must be sufficient inventory to meet 50% of that
month's cost of sales. At the end of April, the closing inventory will be $15,000.
3. Purchases will be paid for one month after they are made. Purchases in
December were $27,500.
4. All salaries, wages, and other administrative costs are paid in cash in the month
they arise.
5. There will be no investments during the period.

FM NOTES BY HASHIM RAMEESH U 77

Required:
a) Prepare the cash budget for the months of January to April.
b) At the end of April, determine:
(i) Receivables
(ii) Cash
(iii) Payables
c) Find the forecast current ratio at the end of April.

Q3) Flit Co

Borrowing short term

Having completed a cash flow forecast the treasurer may identify a requirement to
borrow funds in the short term. Potential sources of short-term funding include:
 Debt factoring and invoice discounting;
 Bank overdraft, but a bank overdraft is technically repayable on demand and it
normally carries a flat charge for the facility and high variable interest rate on the
balance.
 Short-term loans

Investing short term

Alternatively, a treasurer may discover that the company has a cash surplus for a
short-term period. Surplus funds may arise due to:
 overfunding − proceeds which are not yet fully required may have already been
received from a share/debt issue;
 disposal of surplus assets or divisions; and/or
 operating surpluses.
When a company has extra money, it's smart to invest it wisely instead of just leaving it
in the bank. Long-term surpluses should be invested into positive NPV projects, or
used to pay a dividend. For short-term surpluses, the general rule is to invest in short-
term, low-risk, highly liquid investments (e.g. Treasury bills).
Factors to consider before investing surplus funds:
 How much money is available?
 How quickly can the investment be turned into cash if needed (liquidity)?

FM NOTES BY HASHIM RAMEESH U 78

 How much risk can the company handle? Investments shouldn't be too risky.
 What's the expected return on the investment (profitability)? It's limited because
safe investments are chosen.

Short-term investments
Money market deposits (bank deposits): These are safe, but you might need to wait
to withdraw your money (notice period).
Certificates of deposit: negotiable deposits issued by banks with maturities, you can
sell them before maturity, but you'll get lower returns. This is more liquid than money
market deposits.
Treasury bills: These are short term government debt which are very safe and easy to
sell (very liquid), but they don't give high returns.
Gilt-edged government securities (gilts): Long-term government investments
sensitive to interest rate changes.
Other government bonds: Tied to money markets and easy to sell.
Certificates of tax deposit: Deposited with UK tax authorities, can be used for tax
liability settlement or turned into cash.
Commercial paper: Short-term debt from trustworthy companies, good liquidity.
Corporate loan notes: Riskier than government bonds, longer maturity, fixed interest
security issued by corporate sector.
Equities (stocks): Risky for short-term investments.

Optimal cash balances

Baumol model
The Baumol model is derived from the EOQ model and can be applied in situations
where there is a constant demand for cash.
The model suggests that regular transfers are made from interest-bearing, short-term
investments into a current account as cash. This model uses the EOQ formula to
calculate the optimum amount of funds to transfer each time as short-term
investments are converted into cash.

FM NOTES BY HASHIM RAMEESH U 79

The model considers:
1) the annual demand for cash;
2) the cost of each transfer from short-term investments into cash; and
3) the interest rate difference between the rate paid on short-term investments and
the rate paid on a current account (Opportunity cost).
By optimising the amount of funds to transfer, the model minimises the opportunity
cost of holding cash in the current account, thereby reducing the costs of cash
management.

Economic transfer =

Where, D = annual requirement for cash

Co = transaction costs of selling a part of short-term investments
Ch = opportunity cost of holding cash (interest rate difference between short-
term investment and cash)
The assumptions of the model are:
 Cash requirements are funded by the sale of short-term investments.
 Constant annual demand for cash.
 Constant interest rates.
 Constant cost of each transfer.
Weaknesses
 The assumption of constant demand for cash is unrealistic.
 In reality interest rates and transactions costs are not constant and interest rates, in
particular, can change frequently.
 The model assumes that the business is constantly using cash and must finance
this by selling investments. However, a business will generate cash rather than
"burn" it.

Q2) A company has large deposits which currently earn interest of 15%. It has cash
needs of $300,000 in the next year.
Transaction costs are $120.
Calculate the economic transfer and the average cash balance.

FM NOTES BY HASHIM RAMEESH U 80

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

Where, Spread = the difference between the upper limit and lower limit
Transaction cost = the fixed cost of buying or selling marketable securities
Variance = variance of the net daily cash flows (standard deviation)2
Interest rate = daily interest rate on marketable securities (i.e. daily opportunity cost of
holding cash)
Upper limit = Lower limit + Spread
Return point = Lower limit + (⅓ * Spread)

FM NOTES BY HASHIM RAMEESH U 81

Miller-Orr model assumes that:
 Cash requirements are funded by the sale of short-term investments.
 There is a fixed transaction cost per sale/purchase of short-term investments.
Weaknesses
 Subjectivity in setting lower limit.
 In practice transaction cost for buying/selling short-term investments are likely to
be at least partly variable.
 Complexity of estimating future volatility of cash flows.

Q3) A company requires a minimum cash balance of $6,000 and the variance of daily
cash flows is estimated to be $2,250,000. The interest rate on securities is 0.025% per
day and the transaction cost for each sale or purchase of securities is $20.
Calculate:
a) the spread;
b) the upper limit;
c) the return point.

FM NOTES BY HASHIM RAMEESH U 82

 Receivable &
Payable
Management
Credit control
Receivables management—often called credit control—is the process of granting
credit to customers, monitoring outstanding balances, and ensuring timely collection.
Its goal is to increase sales while minimising the risk of bad debts and the cost of
financing customer credit.
Granting credit
Granting credit means selling goods or services on terms that allow customers to pay
later.
When deciding whether to grant credit, consider:
• Necessity of credit:
o Decide if credit should be granted to all customers.
o Even if credit is the industry norm, a business could restrict it.
o Where credit is uncommon, offering it may stimulate sales.
• True cost of customer credit:
o Evaluate risk of bad debts and financing costs of accounts receivable.

Credit periods and settlement discounts

Credit Period: The agreed time allowed for customers to pay.
• Influenced by trade custom and competitive pressures.
• Extending the period may boost sales but increases financing and bad-debt
costs.
Settlement Discount: A price reduction for early payment.

FM NOTES BY HASHIM RAMEESH U 83

 • Must ensure the benefit of faster cash inflow outweighs the cost of the discount.

Setting Credit Terms

Credit terms are the formal conditions under which credit is extended. We need to
look at;
Credit Limits:
o Set limits after credit checks.
o Senior management approval is required to exceed them.
Written confirmation to customers should include:
o Standard credit period (e.g., 30 days after invoicing).
o Discounts for prompt payment (e.g., 2.5% within 7 working days).
o Interest charges on late payments.

Monitoring Receivables
• Keep accurate customer records and send monthly statements.
• Use an aged receivables report to track how long debts have been outstanding
and identify breaches of credit terms.
• Prepare a credit utilisation report to show how much of each customer’s limit is
used and detect limit breaches.

Assessing creditworthiness
Evaluating a customer’s ability to pay before granting credit.
Assessment Techniques:
• Request a bank reference (basic information only).
• Seek a trade reference from another supplier.
• Obtain professional reports from credit rating agencies.
• Review the customer’s latest financial statements
• Gather intelligence from media and trade journals.
• Visit the customer to understand their operations and reliability.

FM NOTES BY HASHIM RAMEESH U 84

Cash collection procedures
Steps taken to collect outstanding payments promptly.
• Send accurate invoices immediately to avoid disputes.
• Issue monthly statements with tear-off remittance advice for easy payment.
• Send chasing letters or make follow-up phone calls to senior contacts.
• Temporarily stop supplies for persistent late payers.
• As a last resort, use legal action or a debt collection agency.

Additional Measures
• Some organizations adopt debt factoring or invoice discounting to speed up
cash inflow.
• Companies may charge interest or fixed compensation on overdue invoices to
discourage late payments.

Foreign receivables
When selling abroad, there's a higher risk of customers not paying (default risk).
Ideally, ask for payment upfront or a deposit, but customers might not agree. Export
credit periods are usually longer than domestic ones. So, exporters should choose
payment methods wisely to reduce the risk and manage finances effectively.
Payment methods
Organisations with foreign accounts receivable can be paid in various ways:
Bill of exchange
A bill of exchange is a document sent by the exporter to the customer, who signs to
promise payment on a set date. Documents of title to the goods aren't released until
the customer accepts the bill.
The exporter can:
 Hold the bill until it's due and get paid by the customer.
 Or, get cash earlier by discounting the bill with a bank. But if the customer doesn't
pay, the bank will have recourse to the exporter (i.e. default risk stays with the
exporter).
Forfaiting
Forfaiting involves a bank discounting a series of bills of exchange without recourse to
the exporter if the customer does not pay (i.e. default risk is transferred to the bank):

FM NOTES BY HASHIM RAMEESH U 85

  The non-recourse aspect makes this an attractive arrangement for businesses,
but as a result the cost of forfaiting is relatively high.
 Is usually only available for large receivable amounts (over $250,000), for major
convertible currencies and medium-term or longer transactions.
Letter of credit
A letter of credit is a bank-backed payment guarantee used in international trade.
 The importer and exporter agree on terms and conditions of the trade.
 The importer's bank issues a letter of credit to the exporter's bank, promising
payment upon meeting specified conditions.
 The exporter ships the goods and provides shipping documents to importer’s
bank.
 The importer's bank confirms receipt and issues a banker's acceptance, which
the exporter can hold till maturity or sell on the money market at a discounted
value.
Advantages Disadvantages
 Provides security for both  Time-consuming to set up.
parties.  Not available to risky buyers
 Minimal risk if terms are met. (importer).
 Costly to importer and restricts their
flexibility in payment.
Other methods
 Open account trading: Trusting the customer to pay within the credit period
without extra security.
 Cash against documents: Goods' title documents held until payment.
 Export credit houses: Give credit to overseas customers and ensure payment to
exporters.
 Export merchants: Intermediaries between exporter and customer, buying goods
at a discount and paying the exporter within days.
 Export credit insurance: Protects against risks of non-payment from foreign
customers, though premiums are high and coverage may not be complete.
 Export factoring: Factors buy exporter's receivables, charging a commission,
they also offer receivable ledger operation and credit insurance.
 Countertrade: Exchange goods or services instead of cash. Helps enter foreign
markets but has uncertainties, complex negotiations, and logistical challenges.

FM NOTES BY HASHIM RAMEESH U 86

Invoice discounting
Invoice discounting is selling selected sales invoices to a third party at a discounted
sum while keeping control of the receivable ledger.
A finance company gives a cash advance, usually around 80% of the invoice value. As
customers pay, the advance amount decreases or increases to maintain 80% of
receivables.
 The finance company charges a monthly fee and interest.
 They require a floating charge over receivables (as collateral) and they’ll reject
high-risk invoices.
 The process involves "with recourse," meaning the business is responsible for bad
debts.
 The business retains invoice issuance and credit control but provides regular
reports to the finance company.
Advantages Disadvantages
 Better cash flow and flexibility.  Costlier than overdrafts or bank loans.
 Confidentiality: customers don't  As the finance company takes a legal
know about borrowing against charge over the receivables ledger, the
invoices. business has fewer assets available for
other borrowings.

Debt factoring
Debt factors are businesses offering sales administration and debt collection services.
Like invoice discounting, the business receives immediate cash representing a portion
of the invoice value. Unlike invoice discounting, the business does not retain
responsibility for the management of its credit control system.
Factoring is an ongoing arrangement, unlike discounting, which is for temporary cash
needs.
Debt factors typically offers three services:
1) Accounting and collection: The factor pays the business as customers settle their
invoices or after agreed period and also, they manage the sales ledger.
2) Credit control: They chase customers for payment.
3) Finance against sales: They advance a percentage (usually 50-85%) of the sales
value upon invoicing. This is availed only if the company wishes, this is usually
more expensive than overdraft.

FM NOTES BY HASHIM RAMEESH U 87

Fees range from 0.5%-2.5% of the invoice value, plus a charge for cash advances.
Factoring lets businesses focus on making sales while a third-party handles cash
collection. It helps new businesses avoid cash flow issues by providing immediate
access to cash instead of waiting for payments. However, it's costly, and in the long
run, it might be cheaper for a business to manage its own receivables.
Advantages Disadvantages
 Saves on administration.  High charges.
 Provides flexible finance.  Loss of direct customer contact may
 Benefits from factor's expertise and harm relationships.
economies of scale.  Rebuilding own sales ledger function
later can be challenging.

Since outsourcing of non-core business activities is now a common business practice,

so using a factor doesn't necessarily signal cash flow problems.
 In factoring with recourse, the company remains responsible for bad debts,
meaning they bear the risk if the debt isn't paid.
 In non-recourse factoring, bad debts become the factor's problem, effectively
insuring the company against them. However, fees for non-recourse factoring are
typically higher.

Q1) Velmin Co has annual revenue of $700,000. The receivables collection period is
currently 48 days despite the company only offering 30 days’ credit, and bad debts are
currently 3% of revenue. Velmin Co finances its receivables using its overdraft with an
annual interest cost of 8%.
Velmin Co is considering the use of a factor:
• The factor would charge 2% of revenue for a non-recourse agreement.
• The factor expects to reduce the receivables collection period to 34 days and bad
debts to 2%.
• The factor would lend Velmin Co 75% of the outstanding receivables and charge
Velmin 1% above their current overdraft interest cost.
• Velmin Co anticipates a $6,000 reduction in administration costs.
Evaluate whether Velmin Co should use the factor under;
a) Velmin Co have the option to take the finance provided by the factor
b) Velmin Co should take the finance provided by the factor

FM NOTES BY HASHIM RAMEESH U 88

Q2) A Co makes annual credit sales of $2m. Customers take 60 days to pay and bad
debts are 1% of sales. A non-recourse factoring agreement is being considered. The
factor would charge a service fee of 2% of sales per year and reduce the accounts
receivable collection period to 40 days. Administration savings of $10,000 per year
would be made.
Assuming a cost of working capital of 15% per year, calculate the effect on annual
profit of the factoring option that is being considered.

Q3) Tipsy Co has annual sales of $500,000 and accounts receivable collection period
of 60 days. It pays overdraft interest at 17%.
It is approached by a factor who offers:
Immediate finance of 80% of sales at 18% interest.
A guaranteed collection period of 45 days.
$8,000 of administration savings.
A service fee of 2% of revenue.
Calculate the effect on annual profit (loss) of using the factor.

Q4) Oscar Co

Early settlement discounts

To determine if an early settlement discount is a good financial decision, you compare
the annual cost of offering the discount to the annual cost of financing the accounts
receivable (such as the interest rate on an overdraft).
An example for early settlement discount: a 2.5% discount for payments made within
7 days on a standard 30-day payment term.
Express the discount as an annualized rate: To compare it to annual financing costs
like an overdraft rate, calculate the annualized interest rate of offering the discount.

Simple annualised rate

𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑑𝑎𝑦𝑠/𝑤𝑒𝑒𝑘𝑠/𝑚𝑜𝑛𝑡ℎ𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝑆𝐴𝑅 = ( )×
𝑎𝑚𝑜𝑢𝑛𝑡 𝑙𝑒𝑓𝑡 𝑡𝑜 𝑝𝑎𝑦 𝑑𝑎𝑦𝑠/𝑤𝑒𝑒𝑘𝑠/𝑚𝑜𝑛𝑡ℎ𝑠 𝑒𝑎𝑟𝑙𝑖𝑒𝑟 𝑐𝑎𝑠ℎ 𝑖𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑

Effective annualised rate

𝑑𝑎𝑦𝑠/𝑤𝑒𝑒𝑘𝑠/𝑚𝑜𝑛𝑡ℎ𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
( )
𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑑𝑎𝑦𝑠/𝑤𝑒𝑒𝑘𝑠/𝑚𝑜𝑛𝑡ℎ𝑠 𝑒𝑎𝑟𝑙𝑖𝑒𝑟 𝑐𝑎𝑠ℎ 𝑖𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑
𝐸𝐴𝑅 = (1 + ) −1
𝑎𝑚𝑜𝑢𝑛𝑡 𝑙𝑒𝑓𝑡 𝑡𝑜 𝑝𝑎𝑦

FM NOTES BY HASHIM RAMEESH U 89

Q5) A company offers its customers 30 days credit but customers are taking 45 days
credit on average. To speed up cash collection, the company is considering
introducing a 1.5% discount for payment within 15 days. The company’s working
capital requirement is financed with an overdraft at an annual cost of 10%.
Determine whether the discount should be offered.

Q6) Customers normally take 60 days to pay their credit balance. A quick payment
discount of 1.5% is offered for payment within 20 days.
Calculate the annual effective cost of the discount and conclude whether the
discount should be offered if the overdraft rate is 15%.

Q7) A company is offering a cash discount of 2.5% to receivables if they agree to pay
debts within one month. The usual credit period taken is three months.
What is the effective annualised cost of offering the discount and should it be
offered, if the bank would loan the company at 18% pa?

Annual cost vs Annual benefit analysis

Q8) Melvin Co has annual revenue of $900,000 (90% of which is on credit) and the
receivables collection period is currently 42 days despite the company only offering
30-days’ credit. Melvin Co finances its receivables using its overdraft which has an
annual interest cost of 8% and has a contribution margin of 30%.
Melvin Co is considering introducing an early settlement discount at the same time as
extending their standard credit terms to 50 days. Under the scheme:
• Customers will be offered a 1% discount for payment within 14 days.
• It is anticipated that 40% of customers will take the discount, while those that do
not take the discount will keep to the new standard credit terms.
• As a result of the extended credit terms, credit sales are expected to rise by 10%.
• Due to the extra administration involved it is thought that administration costs will
rise by $10,000 per year.
Evaluate whether Melvin Co should offer the discount.

FM NOTES BY HASHIM RAMEESH U 90

Q9) Dodge Co has sales of $100,000 and accounts receivables collection period of 60
days. It pays overdraft interest at 18%.
It is considering a discount of 2% to customers who pay within 10 days. It is estimated
that 50% of customers will take the discount.
Calculate the effect on annual profit of the discount.

Q10) ZXC Co currently has income of $30 million per year, of which 80% is from credit
sales, and a net profit margin of 10%. Due to fierce competition, ZXC Co has lost
market share and is looking for ways to win back former customers and to keep the
loyalty of existing customers. The sales director has pointed out that a major
competitor of ZXC Co currently offers an early settlement discount of 0·5% for
settlement within 30 days, while ZXC Co itself does not offer an early settlement
discount. He suggests that if ZXC Co could match this early settlement discount,
annual income from credit sales would increase by 20%.
Credit customers of ZXC Co take an average of 51 days to settle invoices.
Approximately 0·5% of the company’s credit sales have historically become bad debts
each year and written off as irrecoverable. The finance director has been advised that
offering an early settlement discount of 0·5% for payment within 30 days would
increase administration costs by $35,000 per year, while 75% of credit customers
would be likely to take the discount. The credit controller believes that bad debts
would fall to 0·375% of credit sales if the early settlement discount were introduced.
ZXC Co has an average short-term cost of finance of 4% per year. Assume that there
are 360 days in each year.
Evaluate whether ZXC Co should introduce the early settlement discount.

Q11) KXP Co

Q12) Nyzot Co is a company that operates internationally and has two subsidiary
companies located in foreign countries. Business operations are undertaken in several
different currencies. The parent company and the two subsidiaries manage their own
financial affairs.
Nyzot Co has annual credit sales of $45m. Experience indicates that approximately
2% of credit sales become bad debts each year. The most recent financial statements
of Nyzot Co show trade receivables of $7.5m.
Nyzot Co is considering introducing an early settlement discount of 1.25% in exchange
for payment within 30 days. It believes that approximately 70% of credit customers
would take the discount, while the remaining 30% of credit customers would continue
to pay as at present. Bad debts would be expected to fall by $225,000 per year.

FM NOTES BY HASHIM RAMEESH U 91

Instead of introducing the early settlement discount, Nyzot Co could accept an offer it
has received from a factor. If the offer is accepted, the factor would take over
managing the trade receivables of the company, in exchange for an annual fee of 1.5%
of credit sales, and would advance 80% of the value of trade receivables at an interest
rate of 5% per year. The factor has indicated that it will reduce average trade
receivables days to 40 days and reduce bad debts to 0.5% of credit sales.
Annual credit sales are not expected to be affected by any change in trade receivables
management policy. Nyzot Co has a short-term finance cost of 4% per year. Assume
there are 360 days in each year.
Using the financial information provided about Nyzot Co.
a) Evaluate the financial effect of the early settlement discount.
b) Evaluate the financial effect of the factor’s offer.
c) Advice which proposal is financially preferable.

Accounts payable
Businesses generally use trade payables as a flexible source of short-term finance. but
it has some costs:
 The business may lose any discounts for prompt payment:
• The annual effective cost of refusing a discount should be calculated. This
should be compared to the alternative cost of financing working capital (e.g.
overdraft rate).
• If the cost of refusing the discount exceeds the overdraft rate, the discount
should be accepted.
 The supplier may charge interest on late payments or increase selling prices to
compensate for the finance provided.
Beyond these quantifiable costs, there are other potential drawbacks like loss of
goodwill with suppliers, suppliers might eventually require upfront cash payments,
which the business must then finance.

Q13) A supplier offers a 2% discount if the invoice is paid within 10 days of receipt but
offers no discount if the payment is delayed for a further 20 days.
Calculate the annual effective cost of refusing the discount.

FM NOTES BY HASHIM RAMEESH U 92

Q14) Alanis purchases $5,000 of goods from Celine. Celine offers all customers the
option of either 30 days' credit or a 1.5% discount if cash is received in five days. If
Alanis takes the cash discount, she will incur an overdraft on which interest is charged
at 20% per year.
Is the cash discount beneficial to Alanis?

Q15) A company currently takes 40 days' credit from its suppliers, believing this to be
"free" finance. Annual purchases are $100,000 and the company pays overdraft
interest at 13%.
Payment within 15 days would attract a 1.5% quick settlement discount.
Calculate the effect on the profit and loss account of accepting the discount.

Q16) Plot Co (Qn in Inventory management)

Advantages of trade credit as a source of finance

 Convenient and informal.
 Can be used if unable to obtain credit from bank.
 If settlement discounts are taken, it can result in a cheap source of financing − as
a period of time is still allowed before payment.

Foreign accounts payable

When importing, there may be specific complications (e.g. slow customs clearance,
unexpected import duties or quotas). In addition, the overseas supplier may be
concerned about the risk of non-payment and may demand, for example, cash against
documents, bills of exchange or documentary letters of credit.

FM NOTES BY HASHIM RAMEESH U 93

 Source of Finance
Sources of finance
 Different sources of finance?
 Characteristics?
 When to take each?
 Benefits? Drawbacks?

Factors affecting choice of finance source

• Duration - Short-term or long-term financing needs determine the suitable type and
source of finance.
• Cost - Compare interest rates, fees, and the overall cost-effectiveness of financing
options.
• Effect on Gearing - The choice of finance impacts the debt-to-equity ratio, affecting
financial risk and leverage.
• Term Structure of Interest - Consider current and expected interest rates and
relation with term of finance.
• Security and Covenants - Some financing requires collateral or adherence to
covenants, which may limit flexibility.
• Effect on Control - Equity financing can lead to control dilution, while debt generally
does not affect ownership structure.

Equity finance
Internal source
Retained earnings
The main internal source of finance is retained earnings (accumulated profits).
Using retained cash has advantages: no issue costs, flexible in terms of usage, and it
doesn't change ownership structure. But shareholders might not like it if dividends
decrease.

FM NOTES BY HASHIM RAMEESH U 94

Retained earnings on a company's SOFP may look good, but if there's no actual cash
available, the company can't use it for investment. So, it's the cash that matters when
it comes to financing (Retained cash).
Creating accounting profits does not guarantee the availability of internal equity
finance. A company's ability to generate internal finance therefore depends on its
ability to generate operating cash flow. Improved working capital management can
help to release more operating cash flows.

External equity
In order to finance its investment projects, company can issue new shares instead of
internal financing.
Features:
1) Ownership of the business
2) Voting rights
3) Pays a variable dividend, ranked last at the time of liquidation
4) Right to participate in any new issue of shares

Methods of share issue

Listed companies have various methods to issue new shares:
• Public issue (Offer for subscription): Selling directly to the general public, usually the
expensive option.
• Offer for sale: Selling shares indirectly through an issuing house
(merchant/investment bank), which then sells to the general public.
• Placing: Shares are sold to specific clients (pension funds & insurance company) by
a sponsor (investment bank), typically the cheapest method.
• Rights issue: Existing shareholders are offered new shares based on their current
holdings.
• Tender offer: Shares are sold through an auction-like process, useful when
determining a share price is challenging.

Options for unquoted (not listed) companies include:

• Becoming quoted through an IPO (initial public offering), which is costly and involves
methods like offer for subscription or sale, tender, or placing. It is an expensive
process.
• Remaining unquoted and raising funds through a rights issue or private placing (new
private investor), though limited funds can only be raised.

FM NOTES BY HASHIM RAMEESH U 95

• Opting for an "introduction", where no new shares are issued, but the company gains
a stock market listing if shares are widely held. Useful to gain greater marketability of
shares.

For an IPO,
Ordinary shareholders bear the highest risk as dividends are discretionary and they
rank last in the time of liquidation. Shareholders demand high returns to offset this
risk, making IPOs expensive.
Factors to consider before an IPO include legal restrictions, costs (underwriting, listing
fees, fees for issuing house, cost of prospectus, advertisement etc.), valuation of
shares, stock exchange rules, and timing
For a company to trade its shares on a stock exchange, it must be able to meet that
exchange’s listing requirements and pay both the exchange’s entry and yearly listing
fees.
Other types of share issue

Right issue
In a right issue, the existing shareholders are offered more shares (at a discounted
price) in proportion to their existing holding (no dilution of control).
The theoretical ex-rights price (TERP) can be calculated, representing the expected
share price after the rights issue. It's the forecasted total market value of the
company's equity after the rights issue divided by the number of shares after the right
issue.
𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑎𝑓𝑡𝑒𝑟 𝑟𝑖𝑔ℎ𝑡 𝑖𝑠𝑠𝑢𝑒
TERP =
𝑁𝑜.𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑎𝑓𝑡𝑒𝑟 𝑟𝑖𝑔ℎ𝑡 𝑖𝑠𝑠𝑢𝑒

Value of a right (VOR) = TERP – issue (subscription) price

𝑉𝑂𝑅
Value per existing share =
𝑛𝑜.𝑜𝑓 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛𝑎 𝑟𝑖𝑔ℎ𝑡 𝑖𝑠𝑠𝑢𝑒

Q1) Babbel Co, which has an issued capital of 2 million shares, having a current
market value of $2.70 each, makes a rights issue of one new share for every two
existing shares at a price of $2.10.
a) What is the value of the right in Babbel Co?
b) What is the value of the right in Babbel Co per existing share?

FM NOTES BY HASHIM RAMEESH U 96

Q2) At the close of trading, a company has 100,000 shares issued with a current
market price of $2 each.
After trading closes for the day, the company announces it will take on a project with a
NPV of $25,000
The project will be financed by a rights issue of one new share for every two existing
shares. The rights price is $1 per new share.
Ignore issue costs and assume that the equity market operates at a semi-strong level
of pricing efficiency.
Calculate the theoretical ex-rights price of the company's shares.

Q3) At the close of trading, a company has 100,000 shares issued with a current
market price of $2 each.
The company had announced it will take on a project with a NPV of $25,000 two days
ago
The project will be financed by a rights issue of one new share for every two existing
shares. The rights price is $1 per new share.
Ignore issue costs and assume that the equity market operates at a semi-strong level
of pricing efficiency.
Calculate the theoretical ex-rights price of the company's shares.

Q4) Alpha Co has issued share capital of 100 million shares with a current market
value of $0.85 each. It announces a 1 for 2 rights issue at a price of 40c per share. It
therefore plans to raise $20 million in new funds by issuing 50 million new shares.
Calculate the ex-rights price and for a shareholder, B, holding 1,000 shares in Alpha,
consider his wealth if he:
(1) takes up his rights
(2) sells his rights
(3) buys 200 shares and sells the rights to a further 300
(4) takes no action.

Q5) A company has 12 million ordinary $1 shares in issue, currently trading at $4 each.
It plans to raise capital through a 1-for-3 rights issue.
The calculated theoretical ex-rights price per share is $3.70.
Calculate the new funds raised (to the nearest $million).

FM NOTES BY HASHIM RAMEESH U 97

Q6) Riverton Ltd has announced a 1-for-2 rights issue at a subscription price of $2.50
per share.
The current market price is $3.40.
What is the theoretical value of one right per existing share?
A. $0.30
B. $0.45
C. $0.60
D. $0.90

Q7) Simon Co is planning a rights issue offering 1 new share for every 4 existing shares
held.
The current market price of Simon Co's shares is $7.00, and the value of each right has
been calculated as $0.40 per existing share.
Based on this information:
a) What is the theoretical ex-rights price (TERP) per share?
b) What is the subscription price (i.e., the price at which new shares are offered in
the rights issue)?

Bonus issue
In a bonus issue, reserves (revaluation surplus & share premium) are turned into
shares and given to existing shareholders based on their current holdings. No money is
raised in this situation. This boosts share marketability by increasing the number of
shares and lowering their price.
Bonus issues are also called "scrip issues" or a "capitalisation of reserves" and signal a
company's strength to the market.
Stock splits
Stock splits occur when ordinary shares are split in value (e.g. each $1 share is
converted into two 50-cent shares). This reduces the market price per share,
increasing their marketability.

FM NOTES BY HASHIM RAMEESH U 98

 Debt finance
Long-term finance
Preference shares
Preference shares are shares that come with a fixed dividend rate and have priority
over ordinary shares when it comes to profit distribution.
Although they are legally considered equity, preference shares are often treated like
debt due to their similarities to debt instruments (e.g., under IFRS Accounting
Standards).
Key features of preference shares:
• They pay a fixed dividend before ordinary dividends. This is expressed as a
percentage of the share's nominal value.
• Dividends are paid only if there are enough distributable profits. For cumulative
preference shares, unpaid dividends are carried forward and paid before ordinary
dividends.
• Preference dividends are not tax-deductible since they are considered a distribution
of profit, not an expense.
• In liquidation, preference shareholders are paid before ordinary shareholders but
after debt holders.
• Participating preference shares allow holders to receive extra dividends (under
certain conditions) in addition to the fixed dividend.
Advantages Disadvantages
• No voting rights, so control of the • Preferred dividends are not tax-
company is not diluted. deductible, unlike interest on
• Unlike debt, preferred dividends debt, making them less common
don’t have to be paid if profits are as a source of finance.
low, and preference shares aren’t • To attract investors, companies
tied to company assets. Also, not need to offer a higher return on
paying dividends doesn’t allow preference shares than on debt
holders to appoint a liquidator. due to the higher risk involved.

FM NOTES BY HASHIM RAMEESH U 99

Bonds (loan notes)
A bond is a negotiable security representing a debt, outlined by a contract that
specifies details like the interest rate (coupon), repayment schedule, security (if any),
principal value, seniority (if subordinate to other debt), and other covenants.
The terms "debenture," "loan note," and "bond" all generally refer to the same
concept—a written acknowledgement of a company's debt that can be traded. Bonds
can be secured by:
• A fixed charge over a specific asset (e.g., a building) that can’t be sold until the debt
is repaid.
• A floating charge over a class of changing assets (e.g., inventory). On default, this
charge turns into a fixed charge, and the asset class can no longer be traded until the
debt is repaid.
Bonds can be redeemable or irredeemable. Holders of unsecured bonds have the
same rights as unsecured trade creditors.
In the UK, bonds are typically issued with a “face” or “par” value of £100 and can be
traded on the bond market (at market price).
The interest is usually a fixed coupon expressed as a percentage of the bond's face
value (e.g., an 8% loan note pays $8 interest on a nominal value of $100).
Variable-rate (floating) loan notes adjust their interest payments based on a market
reference rate (e.g., Euro Short-Term Rate – “ESTER”).

Deep discount loan notes

Deep discount loan notes are loan notes issued at a significant discount to their
nominal value and are redeemable at their nominal value (or higher) when they
mature.
Investors in these loan notes receive a large capital gain at redemption but are paid a
low coupon during the loan period.
These loan notes provide a cash flow advantage to the borrower, which is particularly
helpful for financing projects with low cash flows in the early years.

FM NOTES BY HASHIM RAMEESH U 100

Zero-coupon loan notes
Zero-coupon loan notes are loan notes issued at a discount to their nominal value and
pay no coupon.
Advantages of zero-coupon loan notes:
• The issuing company pays no interest, with the only cash payout occurring at the
loan note's maturity.
• The investor's return comes entirely from the capital gain, which is the difference
between the issue price and the redemption price.

Mortgage loans
A mortgage is a legal agreement to lend money, secured by a legal charge over the
borrower’s property. Mortgage loans are typically long-term (15 to 30 years or more).
Advantages:
• Due to the security, mortgage loans have lower interest rates compared to short-
term debt.
• Lower monthly repayments over a longer term improve cash management, making
long-term budgeting easier.
• Any increase in the property's value benefits the company.
Disadvantages:
• There are likely to be restrictive covenants on the property's use and its potential
sale.
• If the borrower defaults, the lender can force the sale of the property to recover the
loan, posing a major risk to the business.
• A large portion of finance tied up in property may be unsuitable for businesses
needing liquid assets for investments or operations.
• The lengthy approval process makes mortgage loans unsuitable for urgent financing
needs.

Tax relief on debt interest

Interest expense is tax deductible; it reduces corporation tax payments. Therefore, the
issue of debt is preferable to the issue of shares, as dividends are not tax deductible.

FM NOTES BY HASHIM RAMEESH U 101

Convertibles and Warrants
Convertibles
Convertibles are loan notes or preference shares that can be converted into a pre-
determined number of ordinary shares.
Convertible loan notes and preference shares:
• Pay a fixed coupon or dividend until they are converted.
• Can be converted into ordinary shares by a set date, at a pre-determined conversion
rate, and at the holder's choice.
• May have a conversion ratio that changes during the loan term to encourage early
conversion.
Advantages:
• For investors, convertibles are relatively low-risk with the chance for high returns
when converted to ordinary shares.
• For issuers, they can offer a lower coupon rate than non-convertible loan
notes/preference shares, since the conversion option adds value.
• For newer companies, convertibles appeal to investors who may not want the risk of
equity but are willing to invest in less risky loan notes. If the company succeeds,
investors can convert and benefit from capital growth or keep the safer loan notes.

Warrants
A warrant gives the investor the right, but not the obligation, to purchase new shares at
a future date at a fixed price (the exercise or subscription price). (e.g., share options)
Features of warrants:
• They may be attached to loan notes to make them more appealing.
• They give the option to buy shares in the issuing company.
• They can be separated from the underlying debt, allowing the holder to sell them
independently.
Advantages for the issuing company:
• When attached to a loan note, the coupon rate on the loan note is lower compared
to straight debt because the investor has the added benefit of potentially buying
equity shares at an attractive price.
• They may enable the issuance of unsecured debt when the company's assets are
insufficient to secure the debt.

FM NOTES BY HASHIM RAMEESH U 102

• They provide a way to issue equity (with a delay) without the negative signals usually
associated with an equity issue.

Medium-term finance
Bank loans
Companies agree to borrow from the bank at a fixed rate for a set period with an
agreed repayment schedule.
Advantages:
• A fixed-term loan means no risk of early recall (unlike overdrafts, which are
repayable on demand), ensuring financial stability.
• A set repayment schedule makes it easier to plan and manage cash flow for loan
repayments.
• Interest is usually tax-deductible, reducing the company’s overall tax liability.
Disadvantages:
• Terms and conditions are often inflexible, with non-negotiable repayment
schedules. The loan may be restricted to its specific purpose unless re-negotiated.
• Banks may require security (collateral), putting valuable assets at risk if the
company defaults.
• Covenants may be required, imposing restrictions on the company (e.g., limits on
dividend payments or further borrowing) to protect the lender, which could also
lower the interest rate.
• Early repayment may incur penalties or fees, which could be a disadvantage if the
company wants to repay early to save on interest costs.

Leasing
Leasing allows a company to use an asset without buying it outright. Under a lease
contract, the lessee pays for the right to use an asset owned by the lessor through a
series of payments.
Advantages:
• Many providers, often linked to asset manufacturers, offer attractive terms.
• Leasing allows a company to use assets that may be too expensive to purchase
outright, matching finance to asset use.

FM NOTES BY HASHIM RAMEESH U 103

• Flexible packages are available, some including repairs and maintenance, reducing
costs and operational burden.
Disadvantages:
• Over time, leasing can be more expensive than buying, as cumulative lease
payments may exceed the asset's purchase cost.
• At the end of the lease, the company typically does not own the asset unless it pays
extra to purchase it.
• Leases may include restrictions on asset use or penalties for early termination,
which could limit operational decisions.

Sale and leaseback

In a sale and leaseback, a company sells property to an institution, like a pension
fund, and then leases it back.
Advantages:
• Immediate cash inflow can be used for investments, debt reduction (saving
interest), or working capital needs.
• Continued use of the asset without disruption.
• A profit on the sale may be realized (subject to IFRS requirements).
Disadvantages:
• The company won’t benefit from any future increase in the property's value.
• Future borrowing capacity is reduced, as there are fewer assets available as security
for loans.
• The effect is similar to secured borrowing. A right-of-use asset and a lease liability
will be recognized.

Short-term finance
Bank overdraft
A bank overdraft is a borrowing facility linked to a current account.
Advantages:
• Flexible borrowing and repayment terms allow businesses to borrow up to a set limit
and repay when cash flow allows.

FM NOTES BY HASHIM RAMEESH U 104

• Overdrafts can be set up quickly, giving immediate access to cash.
• Interest is only paid on the amount used, making it cost-effective.
Disadvantages:
• Banks can withdraw or reduce overdraft limits with little notice, as overdrafts are
repayable on demand.
• Overdrafts are not suitable for long-term financing or ongoing cash flow issues.
• Interest rates may be higher than other short-term financing options, making regular
use expensive.

Trade credit
Trade credit is a form of short-term finance where a business obtains goods or
services from suppliers but delays payment for an agreed period.
Advantages:
• Trade credit provides interest-free finance for a period by delaying payment.
• It helps improve cash flow management by extending the time between receiving
goods/services and payment.
• Using trade credit responsibly can strengthen supplier relationships, potentially
leading to better terms or discounts.
Disadvantages:
• The loss of prompt payment discounts can be costly.
• It is limited to purchases from suppliers and does not cover other short-term needs,
like payroll.
• Late payments may lead to penalties and harm supplier relationships.

Bills of exchange
A bill of exchange is an acknowledgment of a debt to be paid on a specified date.
In international trade, an exporter usually requires the customer to accept a bill before
releasing documents of title to the goods.
The exporter can either:
• Hold the bill until maturity and receive payment from the customer; or
• "Discount" the bill with a bank to get cash earlier

FM NOTES BY HASHIM RAMEESH U 105

Advantages:
• Bills of exchange provide short-term financing, helping to cover temporary cash flow
gaps.
• They facilitate payments between parties in different countries, supporting
international trade.
• As negotiable instruments, they can be bought, sold, or discounted in secondary
markets, offering liquidity.
Disadvantages:
• There's a risk that the payer may not accept the bill or may default, leading to
financial losses.
• The documentation and verification processes can be complex and time-
consuming.
• Since they are primarily used for trade, they may not be suitable for all short-term
financing needs.

Commercial paper
Commercial paper is a short-term, unsecured debt issued by reputable companies
and can be traded in the secondary market. It is commonly used to finance short-term
liabilities.
Advantages:
• It allows large sums to be raised at lower interest rates compared to other short-term
financing options.
• No security is required, as it depends on the company's creditworthiness.
• Commercial paper can be issued in different amounts and with varying maturities to
meet specific needs.
Disadvantages:
• It is only available to large companies with high credit ratings.
• Marketability may be affected if there are concerns about the issuing company.
• Issuers must comply with regulations, which adds administrative and legal costs.

FM NOTES BY HASHIM RAMEESH U 106

Short-term bank loans
A short-term bank loan provides a quick cash injection for companies needing working
capital, with repayment terms typically between three months and one year.
Advantages:
• Quick access to funds for immediate financial needs is available to most
companies.
• Usually unsecured.
• Short-term interest rates are generally lower than long-term rates due to lower credit
risk.
Disadvantages:
• Arrangement fees can be high when calculated as an annual effective cost.
• If security is required, valuable assets may be tied up.
• There is refinancing risk, meaning that when the loan matures, it may be difficult or
costly to replace or refinance it.

Small and Medium-sized Entities

(SMEs)

Characteristics of SMEs (small and medium-sized entities)

• They are usually unquoted.
• Ownership is limited to a few individuals, often a family.
• They are larger than micro businesses. (i.e. a very small business created for the self-
employment of its owners).
SMEs play a key role in many economies by generating significant income, creating
jobs, and fostering innovation and entrepreneurship, which support economic growth.
Difficulties in raising finance
• Limited Equity: SMEs often rely on a small group of shareholders, restricting how
much equity they can raise. They mostly depend on retained earnings, which are
limited if profits are low, leading to reliance on debt.

FM NOTES BY HASHIM RAMEESH U 107

• Perceived Risk: SMEs are seen as risky due to a lack of track record, limited internal
controls, and less public information compared to larger companies. Investors have
less information (asymmetry), increasing their perception of risk.
• Lack of Security: SMEs may have few physical assets to offer as collateral for loans,
especially in service sectors. Banks often require personal assets (like homes) as
security.
• Non-Marketable Shares: Shares in SMEs are unquoted and hard to sell, limiting the
ability to raise equity beyond family and friends.
• Tax Considerations: Tax systems may favour large institutional investments over
small companies (in many countries, personal tax incentives are offered on
contributions to pension funds), though some governments offer tax incentives to
encourage investment in SMEs.
• Funding and Maturity Gaps: SMEs often face a "funding gap," where available
finance is less than what they need. Medium-term loans are particularly hard to get,
leading to a mismatch (maturity gap) between maturity of their assets and short-
term loans.

Financing solutions (Equity)

Financing options for SMEs are influenced by government policies like taxation policy
and interest rate policy.
1. Venture Capital
Venture capitalists (firm or wealthy individuals) provide risk-bearing equity capital to
growing SMEs in exchange for partial control (ownership stake) (usually 25%–49%).
They look for innovative products, strong management, and high return and growth
potential.
They require a business plan (with medium-term cash flow and profit projections),
board representation (to gain a significant control), and an exit route (proposed time-
scale for seeking a market quotation - IPO).
Venture capital trusts (listed investment trust companies) also offer funding for SMEs.
2. Private Equity
Private equity firms seek to fully control a company, often restructuring it before
reselling or taking it public (re-list). They are not limited to SMEs but also buy and
restructure larger companies.
3. Business Angels

FM NOTES BY HASHIM RAMEESH U 108

Business angels are individuals who invest in promising SMEs. These investors
typically provide not only capital but also advice and business connections. They are
attracted to innovative products and strong management.
4. Government Assistance
Governments support SMEs through grants, guaranteeing loans, tax incentives for SME
investors, and equity investment programs (government backed VCs).
For example, the UK’s Enterprise Investment Scheme provides tax relief to private
investors in unlisted SMEs to encourage the investment in SMEs.
5. Crowdfunding
Crowdfunding allows SMEs to raise funds directly from a large number of individuals,
usually through online platforms. It is useful in the early stages of business and can
take several forms:
• Donation-based: No financial return for contributors (e.g., fundraising for disaster
relief).
• Reward-based: Pre-selling their product to investors to fund the business.
• Equity-based: Investors receive unlisted shares in return for their contributions.

Financing solutions (Debt)

Sources of debt finance available to SMEs include:
• Trade credit: Obtaining goods or services from suppliers on credit terms.
• Factoring and invoice discounting: Raising finance against outstanding
receivables.
• Leasing: A practical option for SMEs as it avoids the need to raise capital to acquire
assets.
• Bank finance: Typically in the form of overdrafts or longer-term loans secured on
major assets, often supported by business plans (cash flow forecast) and backed by
personal guarantees from the owner-manager.

Government sources
Grants and Subsidies
Depending on the location and nature of the SME, regional, national, or international
grants may be available to help start the business or support expansion costs.
Subsidies may include government loans offered at interest rates below commercial
levels.

FM NOTES BY HASHIM RAMEESH U 109

Government loan guarantee schemes
Various countries have government loan guarantee schemes to support businesses
and stimulate economic activity. In these schemes, the government acts as a
guarantor for commercial loans to SMEs.
Business angels
Business angels are wealthy individuals prepared to invest money and time in small
companies if they see high growth potential.
If prepared to invest in debt, they also may want the opportunity for future equity
participation Therefore, convertible debt or debt with warrants may be appropriate.
Supply chain financing
SCF uses financial instruments, practices, and technology to improve working capital
and liquidity in supply chains for both buyers and sellers. SCF provides short-term
credit, often through a tech platform that automates and tracks invoice approval and
payment processes from start to finish.
The growth of SCF is driven by the globalisation and complexity of supply chains,
especially in industries like automotive and retail.
Peer-to-peer (P2P) lending
P2P lending is a debt financing method where individuals lend money directly to small
businesses, bypassing traditional financial institutions.
Advantages
• Lenders earn interest income, often more than on a bank deposit.
• Borrowers can access funds even if banks deny credit or charge high rates.
• Removing the middleman allows for potentially better rates for both lenders and
borrowers.

Factors in choosing suitable Financing method

• Availability: Limited if performance is poor; SMEs often struggle to raise equity.
• Cash flow: Debt requires cash outflows for interest, so cash-generating ability is key.
• Control: Equity may affect control, while debt does not.
• Cost: Debt is cheaper than equity; if feasible, debt can provide a cost advantage.
• Ease and cost of issue: Equity is more challenging, time-consuming, and costly
than debt.
• Maturity: Finance term should match the need, considering existing debt maturity.

FM NOTES BY HASHIM RAMEESH U 110

• Risk: Directors must manage total risk; if business risk increases, financial risk may
need to decrease.
• Security and covenants: Debt may require security or covenants; availability and
acceptability matter.
• Yield curve: A steeper yield curve suggests rising rates, making fixed-rate debt
advantageous if additional debt is desired.

FM NOTES BY HASHIM RAMEESH U 111

 Cost of Capital
$$$ $$$
Finance Invest

Source of Our Investments

Finance Co.

• Ordinary shares
cost of capital returns
• Preference shares (WACC)
• Debt

Cost of capital
It is the cost incurred by the company for the funds borrowed (capital raised).
Investor perspective - It is the expected rate of return of the investors who invested in
our company in the form of Equity or Debt.

 Equity – cost of equity (ke)

 Debt – cost of debt (kd)

Weighted Average Cost of Capital (WACC)

It is the weighted average of ke and kd
Weights are based on their proportions in the capital structure (Ve & Vd).

FM NOTES BY HASHIM RAMEESH U 112

 Cost of debt (kd)
Loan notes
 Can be traded on an exchange at a market price (Po)
ex-int market price – is when interest just has been paid
cum-int market price – is when interest is about to pay
𝑒𝑥 𝑖𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 = 𝑐𝑢𝑚 𝑖𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
 Usually pays fixed coupon interest on “par”, “nominal” or “face” value (Typically,
par value = $100)
 Interest is a tax-deductible expense
So, the effective interest cost for the company:
Interest × (1 - tax rate)

Irredeemable loan notes

 Issued for an infinite period (in perpetuity)
 Also called undated loan notes or perpetual bonds
For a company issuing irredeemable loan notes, the general CFs will be;
T₀ ex-int market price (P0) X
T₁ – T∞ after-tax interest -> Int*(1-t) (X)

The after-tax cost of debt (kd) for irredeemable loan notes will be the IRR of underlying
CFs associated with that irredeemable loan notes.

Assumed knowledge;
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝐹
IRR (perpetuity) =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝐹

On applying this in this case,

𝐼𝑛𝑡×(1−𝑡)
kd (irredeemable loan note) =
𝑃0

where, P0 – ex-int market price

Q1) The 9% irredeemable loan notes of Nyzot Co are currently quoted at $120 ex-int.
Corporation tax is at 30%.
Find the cost of this irredeemable loan note?

FM NOTES BY HASHIM RAMEESH U 113

Q2) 12% undated loan notes with a nominal value of $100 are quoted at $92 cum-
interest. The rate of corporation tax is 33%.
a) Find kd?
b) Find the return required by the investor (interest yield)?

To find the debtholder’s required return (interest yield), find the IRR of the underlying
CFs by taking gross interest (not “Int*(1-t)”)
𝐼𝑛𝑡
Interest yield =
𝑃0

Redeemable loan notes

 Issued for a definite period
 Redeemed in cash at the end of the term (usually at “par” or at a “premium”)
For a company issuing redeemable loan notes, the general CFs will be;
T₀ ex-int market price (P0) X
T₁ – Tn after-tax interest -> Int*(1-t) (X)
Tn redemption value (X)

The after-tax cost of debt (kd) for redeemable loan notes will be the IRR of underlying
CFs associated with that redeemable loan notes.
IRR can be found for the CFs either by using Linear interpolation or using Spreadsheet
function.

Q3) 6% loan notes issued at $95 ex-int for 5 years redeemable at 6% premium.
Corporation tax is at 25%
Find the cost of this redeemable loan notes?

Q4) Nyzot Co has 10% loan notes quoted at $102 ex-int redeemable in 5 years’ time at
par. Corporation tax is at 30%.
Find Kd? (for linear interpolation take 5% and 7%)

FM NOTES BY HASHIM RAMEESH U 114

Q5) A company has in issue $200,000 7% loan notes redeemable at a premium of 5%
on 31 December 20X6. Interest is paid annually on 31 December. It is 1 January 20X3
and the loan notes are trading at $98 ex-interest per $100 nominal value. The
corporation tax rate is 33%.
a) Calculate the company’s cost of debt?
a) Calculate the required return of the debt holder?

To find the debtholder’s required return (gross redemption yield / yield to maturity),
find the IRR of the underlying CFs by taking gross interest (not “Int*(1-t)”)
Semi-annual interest payments
Q6) A company has 6% loan notes, the interest on which is paid on 30 June and 31
December each year. The loan notes are redeemable at $100 nominal value on 31
December 20X9. It is now 1 January 20X7 and the loan notes are quoted at $96.
Corporation tax rate is 20%.
Calculate the effective annual cost of debt, kd?

Convertible loan notes

These are loan notes which allows the investor at maturity to choose between
redemption into cash or conversion into a predetermined number of equity shares.
For a company issuing convertible loan notes, the general CFs will be;
T₀ ex-int market price (P0) X
T₁ – Tn after-tax interest -> Int*(1-t) (X)
Higher of;
Tn • redemption value (X)
• forecast conversion value

The after-tax cost of debt (kd) for convertible loan notes will be the IRR of underlying
CFs associated with that convertible loan notes.

Q7) A company has in issue 8% convertible loan notes currently quoted at $85 ex-
interest. The loan notes are redeemable at a 5% premium in five years or can be
converted into 40 equity shares at that date. The current ex-div market value of the
shares is $2 per share and share growth is expected at 7% per year. The corporation
tax rate is 33%.
Calculate the cost to the company of the convertible loan notes?

FM NOTES BY HASHIM RAMEESH U 115

Q8) 12% convertible loan notes, ex-int market price is $108, issued for 5 years
redeemable at par or can be converted into 30 ordinary shares. Current share price is
$2.5 and share price is expected to grow at 1.5% p.a. Tax rate is 30%
Find kd?

Q9) A company has 5% $100 loan notes in issue, which are redeemable at nominal
value in eight years. Alternatively, each loan note is convertible after seven years into
11 equity shares. The company's equity shares are currently trading at $6.50 per share,
which is expected to increase by 6% a year. The current market value of a loan note is
$88.70. The corporate tax rate is 30%.
Calculate the cost to the company of the convertible loan notes?

Non-tradable debt (Bank loan)

This do not have a market value and cannot be traded.
Company can claim tax relief on bank interest.

Kd (bank loan) = quoted interest rate * (1-t)

Cost of preference shares (kp)

 Preference shares have similarities to both ordinary shares (equity) and debt
instruments.
 The company pays a fixed dividend stated as % on its “par” value.
 Preference dividend is not a tax-deductible expense. No tax benefit for the issuing
company.
 It may be redeemable or irredeemable.
 It can be traded on an exchange so it has a market value (P0).
cum-div market price – is when dividend is about to pay
ex-div market price (P0) – is when dividend just been paid
𝑒𝑥 𝑑𝑖𝑣 𝑝𝑟𝑖𝑐𝑒 = 𝑐𝑢𝑚 𝑑𝑖𝑣 𝑝𝑟𝑖𝑐𝑒 − 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Irredeemable preference shares
For a company issuing irredeemable preference shares, the general CFs will be;
T₀ ex-div market price (P0) X
T₁ – T∞ preference dividend (D) (X)

FM NOTES BY HASHIM RAMEESH U 116

The cost of preference (kp) for irredeemable preference shares will be the IRR of
underlying CFs associated with that irredeemable preference shares.
𝐷
kp (irredeemable pref. shares) =
𝑃0

where, P0 – ex-div market price

D – preference dividend

Q10) A Co’s 10% $1 preference shares is currently trading at $0.9 cum-div.

Calculate the cost of this preference shares (kp)?

Redeemable preference shares

For a company issuing redeemable preference shares, the general CFs will be;
T₀ ex-div market price (P0) X
T₁ – Tn preference dividend (D) (X)
Tn redemption value (X)

The cost of preference (kp) for redeemable pref. shares will be the IRR of underlying
CFs associated with that redeemable pref. shares.
IRR can be found for the CFs either by using Linear interpolation or using Spreadsheet
function.

Q11) H Co’s 9% $1 preference shares are currently trading at $1.4 ex-div, which will be
redeemed after 6 years at a premium of 10%.
Find Kp?

Cost of equity (ke)

Ordinary shares
Ordinary shares of a listed company are traded on an exchange and will have a quoted
market price (P0).
cum-div market price – is when dividend is about to pay
ex-div market price (P0) – is when dividend just been paid
𝑒𝑥 𝑑𝑖𝑣 𝑝𝑟𝑖𝑐𝑒 = 𝑐𝑢𝑚 𝑑𝑖𝑣 𝑝𝑟𝑖𝑐𝑒 − 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

FM NOTES BY HASHIM RAMEESH U 117

 The issuing company pays ordinary dividends to the shareholders in return for their
investment. This dividend is variable (discretionary).
 To calculate cost of equity (ke), we need to estimate future dividends which is not
practical.
 So, we use the assumption from the Dividend Valuation Model (DVM):
Dividend is either;
• Constant, or
• Growing at a constant growth rate (g) in perpetuity

Zero growth model

Assumes constant dividend each year.
For a company issuing ordinary shares, the general CFs will be;
T₀ ex-div market price (P0) X
T₁ – T∞ ordinary dividend (D) (X)

The cost of equity (ke) for ordinary shares will be the IRR of underlying CFs associated
with those ordinary shares.
𝐷
ke =
𝑃0

where, P0 – ex-div market price

D – ordinary dividend

Q12) A company has issued ordinary shares currently trading at $20 (cum-div). The
company pays a constant annual dividend of $2 per share.
What is the cost of equity (ke)?

Constant growth model

Assumes dividend grows at a constant growth rate (g).
For a company issuing ordinary shares, the general CFs will be;
T₀ ex-div market price (P0) X
ordinary dividend (D0
T₁ – T∞ growing at a rate ‘g’ in (X)
perpetuity)

The cost of equity (ke) for ordinary shares will be the IRR of underlying CFs associated
with those ordinary shares.

FM NOTES BY HASHIM RAMEESH U 118

The IRR of this cash flows can be found using the assumed knowledge of perpetuity
with growth.
𝐶𝐹 @ 𝑇1
PV (perpetuity with growth) =
𝑟−𝑔

On applying this to find the IRR of the above CFs,

𝐷1
PV of future CFs (T1 – T∞) =
𝑟−𝑔
PV of T0 CF = P0
At IRR, PV of T0 = PV of (T1 – T∞)
𝐷1
i.e., P0 =
𝑟−𝑔
On rearranging this to find ‘r’ which is the IRR (ke)
𝐷1
ke = +𝑔
𝑃0

where, D1 = D0*(1+g)
P0 = ex-div market price

Q13) A company’s ordinary shares are trading at $25 (ex-div). The current dividend
paid is $2.50 per share, and it is expected to grow at 5% per annum.
What is the cost of equity (ke)?

Q14) Nyzot Co has declared dividend for the year and the dividend is about to pay of
14 cents per share. In recent years, annual dividend growth has been 3% per annum,
and the current share price is $1.62.
What is the cost of equity (ke)?

Estimation of dividend growth (g)

The growth rate (g) in the DVM can be estimated using two main methods:
(1) Using past dividends (Historic average growth)
This method estimates future growth based on the average historical increase in
dividends.
1⁄
𝑛𝑒𝑤 𝑑𝑖𝑣 𝑛
𝑔=( ) − 1
𝑜𝑙𝑑 𝑑𝑖𝑣

FM NOTES BY HASHIM RAMEESH U 119

Q15) A company paid the following dividends in the past years,
20X1 - $150,000
20X2 - $192,000
20X3 - $206,000
20X4 - $245,000
20X5 - $262,350
Estimate the annual dividend growth rate (g) using the historic average growth
method.

Q16) A company paid a dividend of $1.50 five years ago. The latest dividend paid is
$1.92.
Estimate the annual dividend growth rate (g) using the historic average growth
method.

(2) Gordon’s growth model

𝑔 =𝑏×𝑟
where, b = proportion of profits that are retained
r = rate of return on reinvested earnings (ROE)

Q17) A company retains 40% of its earnings and earns a 15% return on equity (ROE).
What is the expected growth rate of dividends?

Q18) A company has a dividend payout ratio of 70%, and its return on equity (ROE) is
12%. Estimate the expected dividend growth rate (g) using the earnings retention
model.

Q19) M Co paid a dividend of 6 cents per share eight years ago, and the current
dividend is 11 cents. The current share price is $2.58 ex-div. Find ke?

Q20) The ordinary shares of Nyzot Co are quoted at $5. A dividend of 40p is just about
to be paid. The company has an annual accounting rate of return of 12% and each year
pays 30% of its profit after tax as dividend.
Find ke?

FM NOTES BY HASHIM RAMEESH U 120

Q21) A company has 300,000 equity shares in issue with an ex-div market value of
$2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits of
$100,000.
Net assets at the year end were valued at $1.06m.
Estimate the cost of equity?

WACC calculation
𝑘𝑒×𝑉𝑒 + 𝑘𝑑×𝑉𝑑
WACC =
𝑉𝑒+𝑉𝑑

WACC can be calculated by taking weightings based on;

(i) Book values of Ve and Vd
(ii) Market values of Ve and Vd

Q22) Nyzot Co has 20 million, $1.5 ordinary shares quoted at $3, and $8 million of
loan notes quoted at $85. The cost of equity has already been calculated at 15% and
the cost of debt (net of tax) is 7.6%.
Find WACC (book value and market value)?

Book Value WACC vs. Market Value WACC

Preference:
• Market value is better than Book value for WACC calculation.
Reasons:
1. Book value of equity is subject to accounting policies used while preparing SOPL
(retained earnings under equity).
2. Book value of equity fails to capture the value of significant intangible assets
(internally generated goodwill).
3. Book value may be outdated.
4. On using book values, value of equity (Ve) will be understated, resulting the
weightage of equity in capital structure to be understated, and hence WACC will
also be understated.

FM NOTES BY HASHIM RAMEESH U 121

Limitations in WACC Calculation
• WACC calculation uses many inputs (ke, kd, Ve, Vd, tax rate) which is calculated
on different basis.
• The reliability of WACC calculated will be based on the accuracy of these inputs

Q23) AMH Co

Q24) Tufa Co

Q25) Dinla Co

FM NOTES BY HASHIM RAMEESH U 122

Capital Asset Pricing
Model (CAPM)
Investor and Investment Options
An investor needs to invest his money somewhere and requires returns.

Major investment options are:

• Government instruments (GILT, treasury bills)
• Secured debt
• Unsecured debt
• Preference shares
• Ordinary shares

Lowest Risk:
• Government securities are assumed to be risk-free.
• Return on these investments = Risk-free rate of return (Rf).

Every investment above this are Risky investments

Required Return on Risky Investments

• Any investment other than risk-free carries more risk.
• Therefore, investors require a higher rate of return than Rf.

Required return on risky investments = Rf + risk premium

Focus of this chapter: Finding investor’s expected return on ordinary shares → that is
the company’s cost of equity (ke).

FM NOTES BY HASHIM RAMEESH U 123

Investment Risk in Ordinary Shares
Investors in ordinary shares face investment risk (volatility of returns).
Risk is classified into:
Unsystematic Risk
• Unique to each company’s share.
• Also called “unique,” “company-specific,” or “diversifiable” risk.
• This risk can be eliminated by diversifying the portfolio → positive and negative
exposures cancel out. (Portfolio theory).
Systematic Risk
• Affects the market as a whole, not specific shares.
• Also called “market,” “economy-wide,” or “undiversifiable” risk.
• Cannot be eliminated through diversification.

Key CAPM Assumption

• Investors hold a well-diversified portfolio.
• Therefore, the risk relevant for ordinary shares is only the Systematic risk.

FM NOTES BY HASHIM RAMEESH U 124

Measurement of Systematic Risk – Beta Factor (β)
Beta factor measures the systematic risk of a security relative to the average market
risk (taken as 1).
Beta (β) Interpretation
β=1 Same risk as average market
β>1 Higher risk than market
β<1 Lower risk than market

Capital Asset Pricing Model (CAPM)

CAPM is a method of calculating the return required on an investment based on its
risk.
We use CAPM to find the required return by an investor on ordinary shares of a
company, which is the company’s cost of equity (ke).
CAPM Formula
Ri / ke = Rf + βe (Rm − Rf)
Where:
• Ri – Expected return on any investment (ordinary share)

• Rf – Risk-free rate of return

• Rm – Average return on the market
• (Rm – Rf) – Market risk premium (equity risk premium)
• βe – Equity beta: measure of systematic risk of a specific share relative to
average market risk
• βe (Rm – Rf) – Risk premium of the specific share

Q1) Find ke for the following company

Risk-free rate = 3%, Market return = 9%
a) Company A: βe = 1.2
b) Company B: βe = 1
c) Company C: βe = 0.7

FM NOTES BY HASHIM RAMEESH U 125

Security Market Line (SML)
A graph plotting required return (Ri) against systematic risk (βe).

• At β = 0, required return = Rf (risk-free return).

• At β = 1, required return = Rm (market return).
Investment decision using SML:
• If forecast return of a share is above SML (point A) → share is undervalued.
• If forecast return of a share is below SML (point B) → share is overvalued.

Q2) An investment has a forecast return over the next year of 12%. The beta of the
investment is estimated at 0.9. The risk-free rate is 5% and the market return is 15%.
Determine whether an investor should do this investment.

Drawbacks of CAPM
• Assumes investors are well diversified – not always practical.
• Some companies have company-specific risk that must be considered (e.g.,
small company failure risk).
• Beta estimation is complicated and based on historical results → less reliable.
• Considers only a single-period planning horizon.

Q3) Tinep Co

FM NOTES BY HASHIM RAMEESH U 126

Systematic Risk Components
Risk faced by an investor in a company = Systematic risk (βe – equity beta).
Classified into:
Business Risk (βa – Asset beta)
o Risk from inherent business activities.
o Same for every company within a sector.
Financial Risk
o Risk from debt in capital structure (gearing).
o More debt → higher gearing → higher financial risk.

Relationship Between Betas

Ungeared company (all equity, no debt):
o No financial risk.
o Total risk (βe) = Business risk (βa).
Geared company (with debt):
o Total risk (βe) = Business risk (βa) + Financial risk.

 Equity beta (βe) = geared beta (total risk).

 Asset beta (βa) = ungeared beta (business risk).

De-gearing and Re-gearing

De-gearing: Strip out financial risk from equity/geared beta to find asset/ungeared
beta.

Re-gearing: Add financial risk to asset beta to find equity/geared beta.

FM NOTES BY HASHIM RAMEESH U 127

Using current WACC for Project Appraisal
Current WACC is based on current business risk and financial risk.
It can be used in project appraisal only if:
• The project has the same business risk as current operations, and
• Financing does not change the debt-to-equity ratio (e.g., using existing funds or
external financing without altering gearing).
Otherwise → current WACC cannot be used.

Project in a Different Industry

If a project is in another industry, the business risk differs.
→ Need a project-specific WACC.
Steps:
1. Identify a proxy company in the new industry and obtain its equity beta (βe).
2. De-gear that βe to find the industry’s asset beta (βa).
3. Re-gear βa using your company’s capital structure to find the new βe.
4. Use this new βe in the CAPM formula to find the new ke (project-specific ke).
5. Use the new ke to calculate the project-specific WACC.

Q4) Fence Co

Q5) A company's debt to equity ratio, by market values, is 2:5. The corporate debt,
which is assumed to be risk free, yields 11% before tax. The beta value of the
company's equity is currently 1.1. The average returns on stock market equity are 16%.
The company is now proposing to invest in a project which would involve
diversification into a new industry, and the following information is available about this
industry.
(a) Average beta coefficient of equity capital = 1.59
(b) Average debt to equity ratio in the industry = 1:2 (by market value)
The rate of corporation tax is 30%.
What would be a suitable cost of capital to apply to the project?

FM NOTES BY HASHIM RAMEESH U 128

Q6) Acorn Co produces electronic components but is considering venturing into
computer manufacturing. Acorn Co is ungeared with an equity beta of 0.8.
The average equity beta of computer manufacturers is 1.4 and the average gearing
ratio is 1:4.
The risk-free return is 5%, the market return is 12%, and the corporation tax rate is
33%.
Calculate the discount rate Acorn Co should use to appraise a computer
manufacturing project, assuming it remains an equity-financed company.

Q7) Puggle Co plans to invest in a new project significantly different from its existing
business operations. Puggle Co financed 30% by debt and 70% by equity. It has
identified three companies with business operations similar to the proposed
investment:
A Co has an equity beta of 0.81 and is financed 25% by debt and 75% by equity.
B Co has an equity beta of 0.98 and is financed 40% by debt and 60% by equity.
C Co has an equity beta of 1.16 and is financed 50% by debt and 50% by equity.
The risk-free rate of return is 4% per year and the equity risk premium is 6% per year.
All companies pay tax at a rate of 30%.
Calculate a project-specific cost of equity for the proposed investment.

Assumptions of CAPM
1. Risk Split
Total risk can be separated into systematic risk and unsystematic risk.
2. Unsystematic risk can be diversified away entirely.
3. Well-Diversified Shareholders
o All of a company’s shareholders hold well-diversified portfolios.
o This is fundamental to ignoring unsystematic risk.
4. A risk-free security exists which provides the minimum level of return required
by investors.
5. Investors can borrow and lend at the risk-free rate, using the yield on short-
dated government debt as a proxy.

FM NOTES BY HASHIM RAMEESH U 129

 6. Returns on different securities (with different holding period) must be
comparable.
A standardised holding period (usually one year) is assumed.
7. A perfect capital market exists, so all securities are valued correctly, as
assumed in the dividend valuation model.

Advantages of CAPM
• Considers only systematic risk
Relevant for listed companies whose institutional investors have diversified
portfolios eliminating unsystematic risk.
• Generates a theoretically derived relationship between required return and
systematic risk.
• Better cost of equity estimate
A much better method than the dividend growth model, as it explicitly allows for
a company's level of systematic risk relative to the stock market.
• Superior to using the existing WACC as the discount rate for a project with
different business risks compared to existing operations.

Limitations of CAPM
• Single-period model
Company projects are often for multiple periods, while CAPM is a single-period
model.
• Single index model
Beta is the only variable used to explain different required returns on
investments.
• Lack of data
Particularly problematic in developing markets.
• Tends to overstate required return on high-risk companies and understate
return on low-risk companies.
• Unrealistic assumptions
For example, assuming investors can borrow and lend at the risk-free rate is
unrealistic since individual investor risk is higher than government risk.

FM NOTES BY HASHIM RAMEESH U 130

 Capital Structure
Gearing / Risk ratios
Operational gearing
Operational gearing measures how much of a firm's operating costs are fixed instead
of variable, this determines the firm’s business risk. This shows how fixed costs impact
the link between sales revenue and operating profits.
When operational gearing rises, profits fluctuate more with sales changes.
Operational gearing =
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠
OR,
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠
OR,
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑃𝐵𝐼𝑇

Financial gearing
Financial gearing measures financial risk by showing the extent to which a company
relies on debt compared to equity for funding its activities.
Financial gearing =
𝐷𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦

OR,
𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦

Interest cover ratio

This ratio assesses a company's capacity to pay interest on its debt, helping investors,
lenders, and creditors evaluate the risk of their financial interests in the company.
A declining interest cover ratio suggests a potential future difficulty in meeting debt
obligations.

FM NOTES BY HASHIM RAMEESH U 131

 𝑃𝐵𝐼𝑇
Interest cover ratio =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

Financial gearing effect on WACC

The current WACC shows the company's existing risk profile, including business and
financial risk.
Financial gearing is the level of debt a company uses relative to its equity, influencing
its risk profile and WACC.
As gearing rises, fixed interest payments increase regardless of profit levels, raising the
risk that little or no dividends may be available for shareholders. Shareholders will
demand a higher return (Ke rises).
Since cheaper debt added to the capital structure Kd is introduced.
(Kd < Ke)
Current WACC will have two effects:
1. The cost of equity (Ke) rises due to increased financial risk, pushing WACC up.
2. The debt-to-equity ratio increases, and since debt is cheaper than equity, this
pushes WACC down.

The effect of increased gearing on WACC depends on these two factors balancing
each other out.

FM NOTES BY HASHIM RAMEESH U 132

There are two views on gearing and capital structure
1. Traditional view
2. Modigliani and Miller's theories (without tax & with tax)
A company’s capital structure is the mixture of equity and debt finance that is used to
finance its assets. The decision on this mixture is called the financing decision.

Traditional view of Capital structure

This view has no theoretical foundation. It is based on the trade-off in gearing, where
using more, relatively cheap debt causes a rise in the cost of equity. This model
assumes:
• At low gearing levels, the cost of equity (Ke) rises slowly, so the benefit of using
cheaper debt outweighs the increase in Ke, WACC reduces.
• At higher gearing levels, the added financial risk causes the increase in Ke to
outweigh the benefit of cheaper debt, WACC starts to rise.
• At very high gearing, the cost of debt also rises due to the risk of debt default
(financial distress risk).

FM NOTES BY HASHIM RAMEESH U 133

The graph indicates an optimal gearing level (or capital structure) where WACC is
minimized, maximizing the NPV of all projects and, thus, the company's value.
Finance managers aim to find this optimal capital structure to achieve the lowest
WACC. However, calculating the optimal structure isn't straightforward and often
requires trial and error.

M&M’s theories
Modigliani and Miller (MM) developed a mathematical model to help company
managers with financing decisions. These models predict outcomes based on
simplifying assumptions.
MM's assumptions include:
• All investors are rational, share the same expectations, and are indifferent to
personal and corporate borrowing.
• Capital markets are perfect: all investors have equal access to information, there are
no transaction costs, and all securities can be bought or sold at fair market prices.
• The initial MM theory assumes no taxes (corporate or personal), although this
assumption is relaxed in later theories.
• There is a single risk-free borrowing rate (Rf).
• There is no financial distress risk, even at high debt levels.
• Corporate debt is irredeemable.

FM NOTES BY HASHIM RAMEESH U 134

• There are no agency costs related to conflicts of interest between shareholders and
management, meaning directors prioritize shareholders' interests even with high
debt levels.

Theory without tax

The increase in Ke exactly offsets the benefit of the cheaper debt finance and therefore
the WACC remains unchanged.
And hence the value of firm will remain same at every gearing levels.

FM NOTES BY HASHIM RAMEESH U 135

From the without-tax theory, we can draw the following conclusions:
• Only investment decisions impact the company's value.
• The company's value is independent of financing decisions, meaning capital
structure is irrelevant.
• There is no optimal gearing level.

However, these conclusions are overly simplistic and do not hold true in practice.
MM did not assert that gearing is unimportant in reality; rather, they argued that it
shouldn't matter in a world where their assumptions hold.
To examine how the model's predictions would change, they began relaxing these
assumptions, starting with the assumption of no corporate tax.

Theory with tax

When MM allowed for corporation tax, their conclusions regarding capital structure
were altered. This is because of the tax relief on debt interest.
So the benefit of cheaper debt outweighs the increase in Ke due to the tax relief on
debt interest.
Therefore, on increasing gearing levels the WACC reduces and hence the value of firm
increases.

FM NOTES BY HASHIM RAMEESH U 136

MM’s theory with tax suggests an optimal gearing level where maximizing debt in the
capital structure maximizes shareholder value.
However, this isn't practical because:
• High gearing increases bankruptcy risk; at very high levels, debt starts to carry
equity-like risk. This raises both the cost of debt and, even more, the cost of equity.
• Personal taxes may lead investors to prefer equity over debt if dividends are taxed
lower than interest income.

Practical influences on Capital structure

The following factors should be considered:
• The project's business risk. Financing high-risk projects with debt is unwise, as
interest payment is a legally binding commitment.
• The existing level of financial gearing.
• The existing level of operational gearing (i.e., the proportion of fixed to variable
operating costs). If already high, the company may prefer to avoid more debt as this
increases fixed costs even further.
• The type and quality of assets that the company can offer as security.
• The personal tax positions of the shareholders and debtholders.
• Tax exhaustion (i.e., not enough profit to fully utilize the interest tax shield).

FM NOTES BY HASHIM RAMEESH U 137

• Issue costs associated with new debt or equity finance, which links directly to
pecking order theory.
• Agency costs. At high levels of financial gearing, control of the company may shift
from shareholders to debt investors (e.g., restrictive debt covenants may limit
dividends or operations to low-risk areas). This creates agency issue with
shareholders.
• Costs of financial distress. At dangerous financial gearing levels, operating costs
may rise (e.g., suppliers may request advance payment, staff turnover may increase,
etc.,).

Pecking order theory

The Pecking Order Theory suggests companies follow a specific order to raise funds in
the simplest and most efficient way “the path of least resistance”.
1. Retained Earnings:
o Retained earnings are the cheapest source of finance, as there are no issue
costs.
o Advantages include faster to raise (no paperwork), no extra debt, no dilution of
control, and privacy over financial decisions (no need to publish a prospectus).
2. Issue Debt:
o If retained earnings aren’t enough, companies prefer debt as it is cheaper than
equity and provides a tax shield.
o Debt has lower issue costs and is quicker to arrange than equity.
3. Issue Equity:
o Equity is a last resort due to high costs, lack of tax benefits, and the time and
effort needed for a share issue.
o Equity investors bear more risk, making equity financing more expensive.
This theory suggests companies choose the lowest-cost option. However, it doesn't
mean internal finance is always best:
• Start-ups rely on equity as they lack retained earnings and debt options.
• Growing companies prefer debt over equity since it’s cheaper and faster, up to
their debt limit.
• Established companies often use retained earnings to fund growth, relying
mostly on equity

FM NOTES BY HASHIM RAMEESH U 138

 Islamic Finance
Islamic Finance
• Islamic finance is a banking system based on Islamic law (Sharia).
• Sharia prohibits:
o Payment or acceptance of interest (riba)
o Investments in businesses against Islamic principles

Islamic finance is based on Sharia, whose main sources are the Qur'an and sayings
of Prophet Muhammad. It emphasises justice and partnership.

Principles
• Wealth must come from legitimate trade (making money from money is
forbidden)
• Investments should benefit society, not just bring returns
• Risk should be shared
• Harmful (haram) activities must be avoided
• Islamic banks earn through profit-sharing or fee-based returns
• Lenders must share risk; earning anything over loaned amount is interest (riba)

The Sharia board

• Ensures all products and services follow Sharia principles
• Consists of Islamic scholars
• Reviews new products before launch
• Judges individual cases like checking if a business plan is Sharia-compliant

Developments
• No single global standard for Sharia compliance
• Interpretations vary, so contracts might later be ruled invalid
• Malaysia (largest sukuk market) uses the Sharia Advisory Council to ensure
consistency, AAOIFI in Bahrain also promotes common standards. But differences
between countries remain

FM NOTES BY HASHIM RAMEESH U 139

Prohibitions
• Interest (riba): charging interest without sharing risk violates justice and
partnership
o Islamic banking = profit sharing, not interest

• Investment in high-debt companies: debt over 33% of market value is prohibited

• Businesses involved in haram activities:
o Alcohol, gambling, drugs, pork, pornography, etc.

• Speculative transactions (gambling): Speculation on futures and options are not

allowed
• Uncertain contracts: subject matter and terms must be clear
o Selling something one doesn't own is not allowed
o Short selling and derivatives are prohibited

Islamic Instruments
Murabaha (trade credit):
o Bank buys asset, sells to customer at a fixed mark-up
o No increase allowed if customer delays taking the asset within the time agreed in
the contract

Ijara (lease finance):

o Bank buys item, leases to customer at an agreed price over time
o Example: HSBC Islamic mortgage – customer pays for rent, insurance, and
contribution to purchase price
o After the term, customer can own the property

Mudaraba (equity finance):

o Bank provides capital, customer provides management skills
o Profits shared in predetermined ratio, losses borne by the bank

Musharaka (venture capital):

o Joint venture (partnership)– all parties will provide capital and involves in the
business

FM NOTES BY HASHIM RAMEESH U 140

o Profits shared as agreed, losses by capital ratio

Sukuk (debt finance):

o Islamic bonds – returns come from income generated by assets
o Sukuk issuers will rent property to tenants to generate income, and distributing
rental income to sukuk holders
o Should avoid riba (interest), instead returns is from a physical asset

Hibah (gift):
o Banks may give customers a "gift" on savings account balances
o Gift = part of profits made from using those funds (not interest)

Qard hassan/Qardul hassan (good loan):

o Loan given on a goodwill basis
o Only principal repayment required
o Debtor may give an extra amount voluntarily

FM NOTES BY HASHIM RAMEESH U 141

 Dividend Policy
Dividend policy
The three key decision areas of financial management—investing, financing, and
dividend policy—are closely connected.
When dividends rise, less cash is retained, necessitating more external financing for
capital investment projects. Similarly, increasing capital expenditure increases the
need for financing, which can be met by reducing dividends.
Directors face the ongoing decision of when to distribute dividends versus retaining
earnings within the company

Practical factors have a significant influence on the company's dividend policy.

• Legal constraints: Dividends can only be paid if there are positive retained earnings
balance in the SOFP. This restriction could damage the company’s ability to attract
new investors.
• Liquidity requirements: Companies need to maintain liquidity for routine expenses
and investment opportunities, sometimes restricting dividend payments.
• Shareholder expectations: Quoted companies must manage investor
expectations to avoid negative reactions to changes in dividends.
If the company is owned by institutional investors, if a large dividend is paid in
current year this may create expectations within them and if the dividend reduces,
they’ll sell their shares.
• Signalling: Dividend announcements signal company strength or weakness to
investors, impacting share prices. If dividend is reduced, this may be interpreted as
a signal of liquidity problems even if it was for new investment. If dividend is
increased, this signals as company has strengthened
• Stability: Companies aim for stable dividends (constant or with growth) to avoid
share price volatility.
• Borrowing covenants: Loan agreements may limit dividend payments to secure
loans. Restricting dividends can improve liquidity and loan security.

FM NOTES BY HASHIM RAMEESH U 142

Alternative dividend policies
• Constant dividend: This policy involves maintaining a stable dividend payout over
time, which can reassure shareholders about the company's financial health and
consistency. However, if the company's earnings are increasing but dividends
remain constant, shareholders might be dissatisfied.
• Constant growth: Here, dividends grow at a steady rate over time, providing
shareholders with predictability. However, the growth rate of dividends might not
match the growth rate of earnings, potentially leading to a gap between what
shareholders expect and what they receive.
• Constant payout ratio: This policy aims to maintain a consistent proportion of
earnings paid out as dividends. While it seems logical, it can introduce uncertainty
since dividends would fluctuate with earnings.
• Residual dividend policy: This approach prioritizes using retained earnings to
finance profitable projects first. Whatever earnings remain after funding these
projects are then distributed as dividends. This aligns with the Pecking Order
Theory (i.e., retained earnings are the cheapest source and it should be used first).
• Zero dividend policy: In the early stages of high-growth companies, all surplus
cash is reinvested into the business to fuel expansion. However, as growth
opportunities diminish or the company matures, it starts to paying dividends to
shareholders.

Dividend theories
Clientele theory
The Clientele theory suggests that a company's dividend policy attracts specific types
of investors who prefer certain income streams or consider tax implications. For
example, pension funds (shareholders) rely on stable dividends for regular income.
Changing the dividend policy abruptly can disrupt investors' portfolios, leading them
to incur transaction costs (while changing their mix of share). Hence, companies often
maintain stable dividend policies to retain key investors.
“Bird-in-the-Hand” theory
The "Bird-in-the-Hand" theory suggests that investors prefer receiving higher dividends
now over potential future capital gains because dividends are certain while future
share price growth is uncertain.
However, this theory is flawed. Market forces usually ensure that a stock’s price
reflects the right balance between risk and return. If investors receive more dividends,
they must decide where to reinvest the money, either in higher-risk, higher-return

FM NOTES BY HASHIM RAMEESH U 143

investments or in lower-risk, lower-return ones. According to the capital asset pricing
model (CAPM), well-diversified investors should be indifferent to this, as higher
returns compensate for higher risks.
Dividend Irrelevance theory
Modigliani and Miller's Dividend Irrelevance theory suggests that dividend policy
doesn't affect shareholder wealth. If no dividend is paid, share prices should rise due
to reinvested earnings. Shareholders needing cash can sell shares to create their own
"home-made dividend."
However, this theory relies on assumptions that may not apply in reality:
• No differences in tax rates between dividends and capital gains.
• No transaction costs when selling shares.
• Perfect markets where share prices fully reflect the company's value.

Alternative to cash dividends

Share Buyback Programmes
• Companies can repurchase shares either through a tender offer (fixed price to
shareholders) or by buying shares in the market.
• Repurchased shares can be cancelled or held as treasury shares, which have no
voting rights or dividends.
• Buybacks reduce the number of shares, potentially increasing share price and
improving ratios like earnings per share (EPS) and return on equity (ROE).
• Investors may benefit from tax advantages if buybacks are treated as capital gains,
which may be taxed lower than income (if the buyback is treated as income).

Special Dividends
• A one-time larger dividend, separate from regular payments, is announced to
distribute excess cash without raising long-term dividend expectations.
• Unlike buybacks, all shareholders receive cash.

Scrip Dividends
• Shareholders can choose between a cash dividend or receiving additional shares.
• This allows the company to conserve cash while giving shareholders flexibility, with
no transaction costs for receiving new shares.

FM NOTES BY HASHIM RAMEESH U 144

 Business Valuation
Reasons for Business valuation:
Business valuation methods may be needed:
• To determine the value of a private company, such as in a management buyout
(MBO).
• To set the maximum price for acquiring a listed company, like in a merger or takeover.
The quoted share price only applies for a minority shareholding.
• To assist in decisions about buying or selling shares in private companies.
• To value companies entering the stock market (IPO).
• To assess subsidiaries or divisions for possible disposal.

Majority and Minority shareholders:

Since minority shareholders have limited power and no control, a 20% share of a
company is worth less than 20% of its total value.
In contrast, due to their power and control, an 80% share held by majority
shareholders is worth more than 80% of the total value.
As a result, majority shareholders should be willing to pay a premium for control.

Information requirements:
Information needed for a business valuation includes:
• Financial statements;
• Summaries of non-current assets;
• Summaries of working capital (inventory, debtors, creditors);
• Budgets and forecasts;
• Summaries of contracts like leases;
• Details about shareholders and their shareholdings;
• Industry and economic environment information.

FM NOTES BY HASHIM RAMEESH U 145

Limitations exist, such as financial statements being out of date, etc.

Nature of Business valuation:

Business valuation is complex, often with no single answer to what a business is worth
(e.g., the value for the current owner may differ greatly from a potential buyer’s
perspective).
Different valuation methods may yield varied values, helping to determine a relevant
price range between:
• the minimum price the current owner would likely accept; and
• the maximum price a buyer would likely to pay.
The final price is reached through negotiations between the parties.

Models for valuation of shares

1) Asset-based
2) Income-based
3) Cash flow-based

Asset based valuation methods

Net book value (NBV)
Equity = Assets - Liabilities
Problems and Weaknesses:
• Historical cost: Balance sheet values are usually based on historical cost, not
market value.
• Accounting policies: Net book values of non-current assets depend on
depreciation/amortisation policies.
• Unrecorded assets: Some assets, like internally generated goodwill, may not
appear in the statement of financial position.
• Market conditions: This method ignores market conditions and the company's
growth potential, which are important for share valuation.

FM NOTES BY HASHIM RAMEESH U 146

Net realisable value (NRV)
The NRV method estimates the liquidation value of the business,
Equity = estimated NRV of assets – liabilities
NRV = estimated selling price – selling costs
This value shows what would be left for shareholders if assets were sold and liabilities
settled. It may reflect the minimum price acceptable to the current owner.
Problems and Weaknesses:
• Selling prices: Estimating selling prices under forced or distress sale conditions is
difficult.
• Market values: The NRV of some assets may vary widely due to volatile market
values (e.g., commodities, financial instruments), and it's challenging to estimate
NRV for assets without an active market (e.g., patents or specialized equipment).
• It ignores unrecorded assets, like internally generated goodwill.

Net replacement cost

Net replacement cost estimates the cost of creating an identical business "from
scratch"
Equity = Estimated depreciated replacement cost of net assets
This could represent the maximum price a buyer is willing to pay.
Problems and Weaknesses:
• Challenging to apply: Finding comparable replacement assets can be difficult,
especially for unique or specialized assets.
• Overvaluation: Older, less efficient assets may be overvalued if priced at the current
market rates of new assets.
• Unrecorded assets: It doesn’t consider unrecorded assets, like goodwill.

FM NOTES BY HASHIM RAMEESH U 147

Q1) The following financial information relates to QK Co, whose ordinary shares have a
nominal value of $0.50 per share:
$m $m

Non-current assets 120

Current assets

Inventory 8

Trade receivables 12 20

Total assets 140

Equity

Ordinary shares 25

Reserves 80 105

Non-current liabilities 20

Current liabilities 15

Total equity and liabilities 140

On an historic basis, what is the net asset value per share of QK Co?

Cash flow based methods of valuation

Dividend valuation model (DVM)
Used to determine the market value of a share based on expected future dividends.
Ex-div Market value (P0) at Time 0:
Market Value = Present Value of Future Dividends discounted at the shareholder’s
required rate of return
1. Constant dividend model
Assumption: Dividend remains constant forever.
𝐷
P₀ =
𝑘𝑒

FM NOTES BY HASHIM RAMEESH U 148

 P₀ – Current ex-div market price
D – Annual constant dividend
ke – Shareholder’s required rate of return

2. Dividend Growth Model

Assumption: Dividends grow at a constant rate (g) in perpetuity.
𝐷0 ×(1+𝑔) 𝐷1
P₀ = OR P₀ =
𝑘𝑒 −𝑔 𝑘𝑒 −𝑔
D₀ – Most recent dividend
D₁ – Dividend in one year
ke – Shareholder’s required rate of return
g – Growth rate of dividends
Assumptions in DVM
 All investors have same expectations and require the same rate of return.
 Perfect capital market assumptions:
Rational investors;
No taxes or transaction costs;
Large number of buyers and sellers of shares;
No individual can affect the share price; and
Perfect information is freely available to all investors.
 Dividends are paid just once a year and one year apart.
 Dividends are either constant or are growing at a constant rate.

Advantages
 Easy to understand and can be applied to any dividend-paying share
 Useful for minority shareholders with no control over company policy
 Not subjective (dividends are clear vs earnings which are interpretative)
 Suitable for mature companies paying regular dividends
 Easier comparisons across companies, ignoring market conditions

Disadvantages
 Not usable for non-dividend-paying shares (e.g. startups, small businesses)
 Assumes no issue costs
 Does not incorporate risk explicitly
 Overly simplistic (real dividends may not grow at constant rate)
 Ignores non-dividend factors (e.g. brand value, intangible assets)
 Less relevant to majority shareholders (who can control dividend policy)

FM NOTES BY HASHIM RAMEESH U 149

 Highly sensitive to changes in ke (required return)
 Ignores tax implications
 Ignores capital gains tax on investors (though may be negligible if share ownership
doesn’t affect PV of dividends)
Application to Share Valuation
1. Identify the current dividend (D0).
2. Estimate the dividend growth rate (g) (via economic forecasts, historical trends, or
Gordon's growth approximation).
3. Determine the required return (ke) using CAPM or the growth model formula.
4. Calculate share value (P0) using these inputs in the model.

Q2) Cross Co, an unlisted company, has just paid a dividend of $0.12 per share. Its
historical dividend growth rate of 5% is expected to be maintained
The following is available for a suitable listed company (i.e. same business and same
gearing):
Share price $2.40
Dividend just paid $0.22
Historical dividend growth rate
(also expected to be maintained) 10%
Calculate the share value of Cross Co.

Q3) Wave Co, an unlisted company, is entirely equity financed. It has just paid a
dividend of $0.12 a share. Its historical dividend growth rate of 5% is expected to be
maintained in future.
The following information is available for a listed company in the same business:
Debt/Equity ratio 2:5
Beta 1.6
The risk-free rate is 5% and the return from the market is 15%.
The company profit tax rate is 25%
Value Wave Co’s equity.

FM NOTES BY HASHIM RAMEESH U 150

Q4) Claygrow Co is a company which manufactures flower pots. The following
information is available:
Current dividend $0.25 per share
Required return on equities in this risk class 20%
Calculate the value of one share in Claygrow Co under the following
circumstances:
1. No growth in dividends.
2. Constant dividend growth of 5% per year.
3. Constant dividends for five years and then growth of 5% per year to perpetuity.
4. Constant dividends for five years and then sale of the share for $2.00.

Q5) Current EPS = $0.30

Payout ratio = 40%
Number of shares in issue = 5m
Net assets in the statement of financial position = $12m
Risk-free rate = 4%
Market premium = 5%
Equity beta = 1.4
Value the company's equity using the dividend growth model.

Q6) A company has just paid a dividend per share of $0.32 and is expected to pay a
dividend of $0.336 in one year’s time. The company has a cost of equity of 13%.
What is the market price of the company’s shares on an ex-dividend basis?

Q7) Fernwell wants to buy shares of Gurst Co in two years. Fernwell uses the dividend
valuation model with an assumed dividend growth rate of 5%.
If Fernwell’s discount rate is 10% and Gurst has recently paid a dividend of $20 per
share, what is the price per share that Fernwell will pay?

Q8) TKQ Co has just paid a dividend of $0.21 per share and its share price one year
ago was $3.10 per share. The total shareholder return for the year was 19.7%.
What is the current share price?

FM NOTES BY HASHIM RAMEESH U 151

Q9) Cant Co has a cost of equity of 10% and has forecast its future dividends as
follows:
Current year: No dividend
Year 1: No dividend
Year 2 $0.25 per share
Year 3: $0.50 per share and increasing by 3% per year in subsequent years
What is the current share price of Cant Co using the dividend valuation model?

Q10) Bilbo Co is an unlisted company with 800,000 issued shares. Seema is one of
the founders and owns 20% of the issued shares.
Bilbo Co has just paid its annual dividend of $0.30 per share. It is expected that next
year's dividend will be $0.32 per share. After that it is expected that dividends will grow
indefinitely at 2% per year.
Shareholders expect a 12% return from their investment.
Using the dividend valuation model, calculate the value of Seema's shareholding.

Q11) Target paid a dividend of $250,000 this year. The current return to shareholders
of companies in the same industry as Target is 12%, although it is expected that an
additional risk premium of 2% will be applicable to Target, being a smaller and
unquoted company. Compute the expected valuation of Target, if:
a) The current level of dividend is expected to continue into the foreseeable future.
(b) The dividend is expected to grow at a rate of 4% pa into the foreseeable future.
(c) The dividend is expected to grow at a 3% rate for 3 years and 2% afterwards.

Discounted cash flow basis

A business can be valued as the present value of its expected future cash flows. This is
similar to valuing individual projects, where:
• Business value = Present value of future operating cash flows (using the company’s
WACC as the discount rate) (Value of assets).
• Equity value (Ve) = Value of assets − Value of debt.
DCF methods are generally considered superior to non-DCF methods in investment
appraisal as they incorporate the time value of money and provide a more detailed
understanding of the intrinsic value of a business based on expected cash flows.

FM NOTES BY HASHIM RAMEESH U 152

However, DCF-based valuation has certain limitations:
• Future cash flows and the discount rate can be difficult to estimate, particularly for
long-term forecasts.
• Minor adjustments in cash flow or discount rate assumptions can yield substantially
different results.
• While DCF valuations are based on intrinsic value, market prices may reflect other
influences like investor sentiment and market trends.
• DCF may not be suitable for startups or high-growth businesses where future cash
flows are uncertain.

Q12) Empire Co is considering the acquisition of Juicy Co. Empire's finance director
has forecast Juicy's post-acquisition operating cash flows for the next four years as
follows:
Year 1 2 3 4
Operating cash flow ($m) 15 16 18 20
Empire plans to dispose of Juicy's assets at the end of the fourth year for an estimated
$230m.
Juicy has $15m share capital, with a nominal value of $0.50 a share, and $50m loan
notes in issue.
Empire considers its current WACC of 10% appropriate as Juicy is in the same
business and relatively small compared with Empire.
Calculate the value to Empire Co of each share of Juicy Co. Ignore taxation.

Income based valuation methods

Price/Earnings ratio
𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛
P/E ratio = OR,
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝐸𝑃𝑆) 𝑡𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠

Market capitalisation = price per share x no. of shares

FM NOTES BY HASHIM RAMEESH U 153

The P/E ratio of a quoted company reflects its expected growth rate, showing the
market's outlook for that business. It shows the stock market’s confidence about the
company’s earnings.
Using P/E ratios from similar quoted companies can help estimate a reasonable price
for shares in unquoted companies.
Formula:
• Ordinary share price = P/E ratio × EPS
• Value of company = P/E ratio × profit after tax and preference dividends (total
earnings)

Valuing shares in an Unquoted company:

1. Select the P/E ratio of a similar quoted company.
2. Adjust the P/E ratio downwards to account for the higher risk and lower
marketability of unquoted shares.
3. Determine maintainable earnings for the unquoted company's EPS.
4. Multiply these earnings by the adjusted P/E to find the value of the unquoted
company's shares.

Problems and Weaknesses:

• Proxy: A similar quoted company may not exist, and even if it does, the stock market
may under- or over-value it.
• Subjective earnings: Accounting earnings can be influenced by non-cash items and
policies, making them less objective than cash flows.
• Earnings manipulation: Earnings may be inflated or might not represent future
earnings accurately;
the seller has more information about the company than the buyer (information
asymmetry).
• Historical data: The P/E ratio often reflects past earnings, which might not indicate
future potential, especially with fluctuating share prices.
• Shareholder influence: Valuing minority shares based on earnings may be less
relevant, as minority shareholders typically can't influence earnings.
• Loss-making companies: For a loss-making unquoted company, the P/E ratio would
yield a negative and meaningless equity value.

FM NOTES BY HASHIM RAMEESH U 154

Q13) Foodie Co, a small chain of UK-based grocery shops, has just reported post-tax
earnings of $200,000, out of which it paid a dividend of $50,000.
The P/E ratios of three large UK quoted supermarket chains are:
Morrison (Wm) 14.5
Sainsbury (J) 12.0
Tesco 17.0
Adjust the P/E ratio by reducing 5% to adjust for the unquoted nature of Foodie Co
What is the value of Foodie Co

Q14) Harken Co’s price earnings ratio is 10, its earnings in the current year is $5 per
share but the earnings forecast for the next year is $8 per share.
What is the current share price of Harken Co?

Q15) Tanglefoot Co is an unlisted company. Its most recent earnings per share (EPS)
was $0.53; next year’s EPS is forecast to be 10% higher. Tanglefoot Co has $50,000 of
issued share capital ($0.10 nominal value per share). The average price-earnings ratio
of listed firms in the same business sector is 12 times.
Estimate the total value of Tanglefoot Co using the price/earnings ratio method.

Earnings yield (EY)

Earnings yield is simply the reciprocal of the P/E ratio (and therefore has similar
problems and weaknesses).
𝐸𝑃𝑆 𝑡𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
Earnings yield = OR,
𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛

If a Co’s share price is $7.5, and EPS is $0.6. The EY will be 0.08 (8%).
Interpretation: This Co can yield 8% earnings on their share price
Therefore,
𝐸𝑃𝑆 / 𝑡𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
Ordinary share price / Value of firm =
𝐸𝑌
Since EY is a rate (%), the value of a firm can be calculated by finding the PV of future
earnings discounted at EY%.

FM NOTES BY HASHIM RAMEESH U 155

1. Constant earnings for infinity
𝐸𝑃𝑆
Value of a share =
𝐸𝑌
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
Value of firm (Ve) =
𝐸𝑌
2. Earnings growing at a constant growth rate ‘g’
𝐸𝑃𝑆×(1+𝑔)
Value of a share =
𝐸𝑌
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠×(1+𝑔)
Value of firm (Ve) =
𝐸𝑌

Q16) A company has the following results.

20X1 20X2 20X3 20X4
PAT ($) 6 million 6.2 million 6.3 million 6.3 million
The company’s earnings yield is 12%.
Calculate the value of the company based on the present value of expected
earnings

Problems and Weaknesses:

• Variability in yield: Earnings yield can fluctuate, making it an unstable metric. For
example, a high earnings yield may reflect a low share price due to financial distress,
not necessarily a good investment.
• High interest rates: An attractive earnings yield may still fall short of competing with
other investments when interest rates are high.
• Earnings quality: Reported earnings may not always be sustainable or high quality,
leading to inaccurate valuations.
• Non-earnings factors: Earnings yield overlooks other important factors for
investors, such as dividends, management quality, competitive advantages, and
industry-specific risks.

Practical factors in Business valuation

Marketability and Liquidity
• Shares in unquoted companies are less valuable due to lack of marketability, as they
aren’t traded on stock markets.
• Unquoted companies don't follow listing rules or governance codes, which
increases their risk and lowers their value.

FM NOTES BY HASHIM RAMEESH U 156

• P/E ratios of comparable quoted companies are often adjusted down by up to 40%
for unquoted shares.
• Even quoted shares can suffer from low marketability due to low liquidity in the
market.
Information sources and availability
• Investors have plenty of public information for quoted companies (e.g., published
financial reports, news, forecasts).
• Unquoted companies provide limited information and may not publish accounts,
leading to "information asymmetry"—where managers know complete information
about the true value of the company than investors, potentially leads to
undervaluation by investors.
Market Imperfections and Pricing Anomalies
DVM assumes perfect market conditions (i.e. many buyers/sellers of the share, zero
transaction costs, freely available information and rational investors), but real markets
aren’t perfect. Issues include:
o Irrational investor behaviour: (e.g. the belief that recent price rises will lead to
future price rises). This over-exuberance can lead to speculative bubbles.
o Pricing anomalies: Patterns like the “January effect” (tax-related selling in
December), “overreaction effect” (prices overreact to news).
Small-cap discount: Smaller companies are often overlooked by institutional
investors, keeping their values low.
Market Capitalisation
• Market capitalisation (total share value at current market prices) reflects the value
of a minority shareholding,
so, a premium is typically needed for control.
• In some cases, the entire equity may be acquired below market cap if major
shareholders are willing to sell off-market at a discount.
Behavioural Finance
Speculation by investors influences share price behaviour. Behavioural finance offers
an alternative view to the efficient market hypothesis and aims to explain:
o How managers make financial decisions in real life.
o Why these decisions might appear irrational and lead to unpredictable outcomes.
o This approach contrasts with traditional theories assuming investors make rational
decisions.

FM NOTES BY HASHIM RAMEESH U 157

 • Market Paradox: For markets to be efficient, investors must believe they are
inefficient. If investors thought markets were efficient, they wouldn't trade,
slowing information flow into market prices.
• Herding ("herd mentality"):
Driven by a desire to conform and avoid acting differently from others (e.g., fund
managers following each other's strategies).
Individual investors, lacking confidence, assume a large group of investors can't
be wrong.
This herd instinct can lead to stock market bubbles when many investors buy
shares in a particular sector, raising prices significantly.
• Noise Traders: Investors who make buy/sell decisions without rational analysis
(not using fundamental company data). They tend to have poor timing, follow
trends, and overreact to news.
• Loss Aversion: Some investors:
Avoid risky investments that could lead to losses, even if long-term gains are
expected.
Prefer stable, low-profit companies over those with fluctuating profits (high in
some years, low or losses in others).
• Momentum Effect: Optimism arises when investors believe price rises will
continue, leading to increased willingness to invest in growth companies. This
effect may lengthen stock market booms or busts.
• Overconfidence: An overconfident investor may overestimate their skills,
intellect, or abilities, leading to recklessness and mistakes.
• Illusion of Control: When an investor believes their actions will directly impact
the stock market, assuming a degree of control.
• Optimism Bias: Investors with a bias toward optimism often have an
unrealistically positive view of themselves and their futures.
• Confirmation Bias: Investors show confirmation bias when they seek only
information that supports their beliefs, focusing on data that reinforces their
opinions. This may lead to poor diversification.
Due to these biases, individuals may not make decisions based on rational analysis
of all available information. This can result in individual companies and the market
being valued too high or too low.

FM NOTES BY HASHIM RAMEESH U 158

 Debt valuation
Preference shares
The market value of any share (P0) should equal the present value of the future
dividend stream discounted at the investors' required return (kp).
𝐷
P₀ =
𝑘𝑝

P₀ – Current ex-div market price

D – Preference dividend
kp – Investor’s required return (yield)

Q17) A firm has in issue 12% preference shares with a nominal value of $1 each.
Currently the required return of preference shareholders is 14%.
What is the value of a preference share?

Q18) A company has in issue 5% preference shares, each with a $1 nominal value. The
financial press quotes the yield on these shares as 4.7%.
Calculate the market price of each preference share.

Irredeemable loan notes

The market value (P0) of any debt should equal the present value of the future
payments to the investor discounted at the required return (kd).
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
P₀ =
𝑘𝑑
P₀ – Current ex-int market price
kd – Investor’s required return (yield)
Q19) A company has in issue 7% undated loan notes, each with $100 nominal value.
The current yield is quoted as 7.42%.
Calculate the market price of each loan note.

FM NOTES BY HASHIM RAMEESH U 159

Redeemable loan notes
The ex-int market value (P0) of a redeemable loan note should equal the present value
of the coupon interest (paid each year until maturity) and the redemption price (paid
at maturity), discounted at the investors' required rate of return (kd) (also known as
yield to maturity, gross redemption yield or pre-tax cost of redeemable loan notes).

Q20) A company has in issue 8% $100 nominal value loan notes redeemable at a 5%
premium in 10 years. The bonds' yield to maturity is 10%.
Calculate the market price of each bond.

Q21) A company has issued some 9% bonds, which are now redeemable at par in
three years' time. Investors now require a redemption yield of 10%.
What will the current market value of each $100 of bond be?

Convertible loan notes

To estimate the market value, it is first necessary to predict whether the investor will
choose redemption or conversion.
The ex-int market value (P0) of a convertible loan note should equal to the present
value of the future interest payments till maturity and higher of; redemption value or,
forecast conversion value at maturity which is discounted at debtholder’s required
rate of return (kd).
Floor value of convertible loan notes is the PV of future CFs assuming redemption.
Conversion premium = ex-int market value (P0) – current conversion value

Q22) A company has 9% loan notes in issue, redeemable at their nominal value of
$100 in five years. Alternatively, each bond may be converted into 20 ordinary shares
on that date. The current ordinary share price of $4.45 is expected to grow at an annual
rate of 6.5% for the foreseeable future. The debtholders' required return is 7% a year.
Calculate the following for each $100 convertible loan note:
(i) market value;
(ii) floor value; and
(iii) conversion premium.

FM NOTES BY HASHIM RAMEESH U 160

Q23) A company has 7% loan notes in issue which are redeemable at their nominal
value of $100 per loan note in eight years. Alternatively, each loan note is convertible
after seven years into 11 ordinary shares. The company's ordinary shares are currently
trading at $6.50 per share. The before-tax cost of debt of the convertible loan notes is
8%.
Calculate the current market value of each loan note, assuming the share price
increases by:
1. 4% per year;
2. 6% per year.

FM NOTES BY HASHIM RAMEESH U 161

 Foreign exchange
Risk management
Foreign exchange rate (forex rate)
It is a rate which shows the relative conversion value between two currencies.
India – currency is ₹ (home currency)
USA – currency is $ (foreign currency)
Indian ₹ and US $ relative conversion value (Forex rate) can be represented as,
(i) ₹84 /$ (i.e., $1 = ₹84) (H/F)
(ii) $0.012 /₹ (i.e., ₹1 = $0.012) (F/H)
In a Forex rate –
Numerator currency (Variable currency)
Denominator currency (Base currency)
Forex rate will change over time,
 Strengthening / Appreciation – Value of a currency increases relative to other
currency.
 Weakening / Depreciation - Value of a currency decreases relative to other
currency.

Q1) Current Forex rate is ₹84 /$. This has changed to;
(i) ₹88 /$
(ii) ₹81/$
In each of the above circumstances, state which currency strengthened and which is
weakened?

FM NOTES BY HASHIM RAMEESH U 162

Q2) Convert these amounts into the following currencies;
(i) sales of DH 850,000
Translate this into $?
a. Forex rate: $0.27 /DH
b. Forex rate: DH3.7037 /$
(ii) purchase of Yn 450,000
Translate this into ₹?
Forex rate: ₹11.82 /Yn

Factors affecting foreign exchange rates

1) Inflation rates in respective economies
Inflation in an economy leads to reducing the purchasing power of their currency and
hence this depreciated the value of their currency
Consider an example of India (₹) and US ($). Current spot rate is ₹84 /$.
If the inflation rate in India and US is 4% and 7% respectively. Then,
$currency depreciated to more extent than ₹. (because inflation in US is more than in
India).
In relative terms, in effective $ currency weakened, or ₹ currency strengthened.

Purchasing power parity theory (PPPT)

Expected future spot exchange rate (S1) can be estimated from current spot rate (S0)
by using inflation rate differentials
(1 + 𝑖𝑛 )
𝑆1 = 𝑆0 ×
(1 + 𝑖𝑑 )
in - Inflation of numerator/variable currency
id - Inflation of denominator/base currency
PPPT can be applied into the above example to find Future spot rate (S1) from S0.

FM NOTES BY HASHIM RAMEESH U 163

Q3) Spot rate 1 January 20X6 = $1.90 per £1, so the $ is the variable currency and £ the
base currency.
Predicted inflation rates for 20X6 and 20X7:
US 2%
UK 3%
Calculate the predicted exchange rate:
a) at 31 December 20X6; and
b) at 31 December 20X7.

2) Interest rates in respective economies

The money (nominal) interest rate (m) of an economy is determined in relation to
inflation rate (i) of an economy.
As per International Fischer’s effect,
(1+m) = (1+r) x (1+i)
Assumption: Real interest rate (r) of all economies is same.
Money interest rate (m) of all economies is different because of differences in their
inflation rate.
If one country has high inflation rate then their money interest rate will also high
relative to another country.
So, interest rate of an economy & inflation rate is connected
So, as like ‘PPPT’ interest rate differentials can also be used to predict future forex rate.
Here, we are finding the ‘forward exchange rate (F0)’ using IRPT formula.
Interest rate parity theory (IRPT)
(1 + 𝑚𝑛 )
𝐹0 = 𝑆0 ×
(1 + 𝑚𝑑 )
mn – nominal interest rate of numerator/variable currency
md – nominal interest rate of denominator/base currency

Q4) The spot exchange rate is $1.78 per £ and the dollar and sterling one-year interest
rates are 3.25% and 4.5%, respectively.
Calculate the one-year forward exchange rate.

FM NOTES BY HASHIM RAMEESH U 164

In PPPT, we are finding future spot exchange rate (S1)
In IRPT, we are finding forward exchange rate (F0)
Theoretically S1 & F0 are same if real interest rate of all economies is same. Practically
will not be same.

Spot exchange rate (S) – the market exchange rate for buying/selling the currency for
immediate delivery.
Forward exchange rate (F) – the exchange rate for buying or selling the currency at a
specific date in the future.

Q5) Country X uses dollars ($) as its currency and country Y uses dinar (Dn). Country
X’s expected inflation is 5% p.a. compared to 2% p.a. in country Y.
Country Y’s nominal interest rate is 4% and the current spot exchange rate is Dn
1.5000 /$.
a) Find country X’s nominal interest rate?
b) What is the expected future spot rate after one year?
c) What is the 3 month forward exchange rate?

3) Balance of payment (BOP)

BOP of a country is the sum of all financial transactions with a foreign country.
• Current account transaction – flows relating to export & import (Balance of trade /
BOT)
• Capital account transactions – asset related transactions between countries. It
includes the foreign exchange market operations of a nation's central bank and loans
and investments between the country and the rest of the world.
Only considering export & import (current account) for BOP below.
If Export (inflow into economy) > Import (outflow from economy) then,
BOP surplus (net inflow into the economy)
If Export (inflow into economy) < Import (outflow from economy) then,
BOP deficit (net outflow from the economy)
Currency Impact:
• If home currency strengthens, then:
o Foreign currency weakens
o Our goods get expensive → Export demand ↓

FM NOTES BY HASHIM RAMEESH U 165

 o Their goods get cheaper → Import demand ↑
o Results in BOP moving to deficit (Import > Export)
• As import increases, conversion from home to foreign currency increases:
o Demand for foreign currency ↑
o Foreign currency strengthens
o This may cause a BOP surplus (Export > Import), and the cycle continues

Foreign Transactions
These are transactions invoiced in a currency other than the local currency.
Not all transactions with another country are foreign transactions.
It is only considered a foreign transaction if it is invoiced in another currency.

Foreign Exchange Risks (Forex risks)

• Companies face forex risks only when transactions are in different currencies
(Foreign transactions).
• The main reason for these risks is the varying nature of forex rates
Future forex rate is uncertain

Transaction Risk
Example:
• A UK firm
• On 1 Jan – purchases a non-current asset (NCA) from the US for $300,000
o Invoice to be settled on 31 March
o Forex rate on 1 Jan = $1.60/£
• On 31 March, the forex rate changed to:
(i) Strengthened to $1.75/£
(ii) Depreciated to $1.45/£
Illustrate the payment in £ for the two cases?
Transaction risk is the forex risk due to the change in forex rate between the
transaction date and the settlement date.
A gain or loss arises on conversion.

FM NOTES BY HASHIM RAMEESH U 166

This risk is faced due to a single foreign transaction.
The most common areas where transaction risk arises are in imports and exports.
To manage / mitigate this risk, several risk mitigation techniques (called hedging
techniques) are considered afterwards.

Economic Risk
Economic risk is the risk that cash flows will change due to long-term exchange rate
movements.
Since a company’s value = present value of its future cash flows, economic risk is a
major concern to financial managers.
Example,
• A UK company exports to the US and invoices in dollars.
• If sterling becomes stronger, the sterling value of dollar earnings falls.
This reduces cash inflow and company value.
Companies should carefully analyse potential exchange rate fluctuations so that they
minimise the risk of export revenue being damaged over longer-term due to sustained
exchange rate movements (or the cost of imported goods rising).
It’s difficult to hedge, but some actions can reduce exposure like:
• Diversifying customer and supplier base across different countries.
Economic risk affects the international competitive position of a company.

Translation Risk
Translation risk happens when a company has foreign-denominated assets or
liabilities, or has a foreign subsidiary or branch.
When these are presented at closing rate in the balance sheet, exchange rate changes
cause foreign exchange profits or losses.
This happens when converting foreign currency net assets:
• If domestic currency appreciates, a translation loss arises.
• If domestic currency depreciates, a translation gain arises.
Unlike transaction risk, these gains/losses are not cash flows (only affects profits).
This is an accounting risk.
But it is still a worry for some companies because of its potential profit impact.

FM NOTES BY HASHIM RAMEESH U 167

Bid and Offer prices
Currencies are exchanged from banks.
Banks do not give a single forex rate. Instead, they give two rates:
Lower rate = Bid price
Higher rate = Offer price
The bank acts like a retailer of currencies.
Example: Retailer of a pen
• Retailer buys pen at a lower rate, and sells at a higher rate.
• Price relevant for sellers of pen = lower rate
• Price relevant for buyers of pen = higher rate
Same for a bank (dealer) with currencies:
• To buy currency → use higher rate (Offer price)
• To sell currency → use lower rate (Bid price)

Forex Rate Formats:

If forex rate is in the format F/H:
• For payment – use lower rate
• For receipt – use higher rate
If forex rate is in the format H/F:
• For payment – use higher rate
• For receipt – use lower rate

Q6) A UK exporter receives a payment from a Danish customer of 150,000 kroner.

Current spot rate is quoted as Kr9.4340 – 9.5380 /£.

Q7) A UK importer buys goods from a Japanese supplier and pays 1 million yen.
Current spot rate is quoted as £0.0059 - 0.0061 /Y.

FM NOTES BY HASHIM RAMEESH U 168

How to deal with Transaction risk
To reduce this risk, we use Hedging techniques.
Aim: Keep our forex rate as certain as possible now.

Internal Hedging Techniques

(without third-party help)
• Invoice in home currency as much as possible
• Speculative methods:
o Leading – convert currency early if we expect a bad change
o Lagging – convert late if we expect a good change
• Match inflows and outflows in the same foreign currency
• Netting:
o For a group with parent and subsidiaries in different countries
o Net off receipts & payments to reduce currency conversions
• Use foreign bank accounts if you have many receipts & payments in one foreign
currency
• Do nothing if the risk is not significant

External Hedging Techniques

(with third-party help)
• Forward Exchange Contracts
• Money Market Hedging
• Derivatives:
o Currency futures
o Currency options
o Currency swap

FM NOTES BY HASHIM RAMEESH U 169

Forward Exchange Contracts
• Firm and binding contract with a bank
• To buy/sell:
o A specific amount
o Of a specific currency
o On an agreed future date (delivery date)
o At today’s agreed rate (forward rate)
• Rate is locked = no uncertainty = risk is reduced
Q8) The current spot rate for US dollars against UK sterling is $1.4525 - $1.4535 = £1
and the one-month forward rate is quoted as $1.4550 - $1.4565 = £1.
A UK exporter expects to receive $400,000 in one month.
a) If a forward exchange contract is used, how much will be received in sterling?
b) Calculate how much sterling would be received without a forward contract if the
actual spot rate in one-month is,
(i) $1.4530 - $1.4545 = £1
(ii) $1.4575 - $1.4585 = £1

Q9) Today is 1 January 20X1. A UK-based company expects to receive dividend income
of $200,000 from its US subsidiary on 31 March 20X1.

Spot rate 1 January 20X1 ($ per £) = 1.5123−1.5245

Three-month forward = 1.5323−1.5459

1. Calculate how much sterling will be received if forward contract is entered into.
2. Calculate how much sterling would be received without a forward contract if the
actual spot rate on 31 March 20X1 is 1.5247−1.5361.

FM NOTES BY HASHIM RAMEESH U 170

Forward contracts are not traded – they are agreements between a company and a
counterparty (like a bank).
These are OTC (Over the counter) instruments.
They are customised to match the company’s exact needs for quantity and date.
 No premium is paid to set up a forward hedge (unlike options).
 No margin or deposit is required (unlike futures contracts).
 There may be a small arrangement fee.
 The bank will assess creditworthiness of the company.
Major Disadvantage
• Physical delivery must happen – currency must be bought/sold on the agreed date
at the agreed rate,
even if the rate becomes unfavourable compared to the spot rate.
So, forward contracts are not flexible method of hedging.

Money Market Hedging (MMH)

A technique to lock in the value of a foreign currency transaction in terms of the
organisation’s domestic currency, by using a combination of:
 Investing (Deposit)
 Borrowing
 Spot currency exchange rate
A money market hedge creates a kind of "homemade" forward exchange rate.
This exchange rate depends on the interest rate difference (IRPT) between the two
currencies.
In MMH, we can hedge any amount (customised size contracts possible)

Q10) A UK importer imports goods worth $250,000 from US. Payment to be made after
3 months. Current spot rate is $1.5123 - $1.5245 /£. Relevant money market interest
rates; dollar interest rate is 4.6% - 4.9%, sterling interest rate is 5.1% - 5.4%.
a) What is the cost in sterling after 3 months by using MMH?
b) What is the effective forward rate underlying this MMH?
(validate the forward rate using IRPT formula)

FM NOTES BY HASHIM RAMEESH U 171

Steps:
1. Borrow £163,432 in UK @5.4% p.a. for 3 months
2. Convert it to $247,158 and deposit in US
3. After 3 months → deposit becomes $250,000 → used for payment
4. Repay UK loan after 3 months: £165,638
→ Cost with MMH = £165,638
→ Effective forward rate = $1.5093/£

Home Foreign
Payment Borrow Deposit
Receipt Deposit Borrow

MMH General Method

• Foreign currency → Discount
• Convert to home currency
• Home currency → Compound

Q11) A UK company is owed SFr 2,500,000 receivable in 3 months’ time from a swiss
co. The spot exchange rate is SFr 1.4498 – 1.4510 /£. The company can deposit in
sterling for 3 months at 8% p.a. and can borrow swiss fracs for 3 months at 7% p.a.
What is the receipt in sterling with a money market hedge and what effective forward
rate would this represent?

Q12) A UK-based company expects to receive $300,000 in three months.

Spot rate ($ per £): 1.7818−1.7822
One-year sterling interest rates: 4.9%(borrowing), 4.6% (investing)
One-year dollar interest rate: 5.4% (borrowing), 5.1% (investing)
Set up a money market hedge.

FM NOTES BY HASHIM RAMEESH U 172

Derivatives
It is a financial instrument which derives its value from the performance of an
underlying asset.
(e.g. underlying assets are currencies, interest rates, stocks, commodities)
Some of the derivative contracts are used for hedging Foreign exchange transaction
risk & Interest rate risk

Currency Futures
Futures contract is a standardised contract between buyer and seller.
The buyer has a binding obligation to buy a fixed amount (contract size) at a fixed
price (futures price) on a specified date (delivery date) for an underlying asset via a
recognised exchange.
They are traded on futures exchanges and have different delivery dates (e.g. March,
June, September, December).
A company can choose:
• Whether to buy or sell futures
• Which delivery date to use

The futures price shows the forward exchange rate for the currencies in the contract.
Spot exchange market Futures market
Today, (1 Feb) Today to hedge against this
UK exporter – $300,000 to be transaction risk,
received in 3 months We can use £ futures (June expiry)

If £ strengthens in the spot market,

If £ strengthens in 3 months’ time, the value of £ futures will also rise.
the exporter will receive less £ in So, we’ll buy £ futures now.
exchange to $.
After 3 months, (30 Apr)
After 3 months, (30 Apr) Futures price will rise and a gain is
Here arises a loss on exchanging $ booked in the futures market.
for £ in the spot market.

Hedging outcome
Buy £ futures now (1 Feb) → Sell them on 1 May – gain is realised here.
This hedge against a strengthening £ which would reduce the receipt value in £.

FM NOTES BY HASHIM RAMEESH U 173

Hedge set-ups in Currency futures
Look at what we are doing the contract currency (£ for above set-up) at the future
date?
 If buying – Open: buy futures | Close: sell futures
 If selling – Open: sell futures | Close: sell futures

If the futures hedge is correctly done, any gain from futures will offset a loss on the
spot market, and vice versa.
Basis
The difference between the futures price and the spot exchange rate is called the
basis.
The basis will naturally reduce to zero by the delivery date of the contract. The basis
might not reduce in a straight line (not linear), so result is uncertain → This is called
basis risk.

When buying/selling futures, a margin (initial deposit) must be placed with the
exchange.
• If losses happen (due to exchange rate changes), additional funds (called variation
margin) may be required.
• Profits are added daily to the margin account.

Forward contract → Always leads to physical delivery of currency at the end. While
Futures contract → Usually closed out before delivery date.
If you bought futures first, you will sell the same futures later to cancel.

Currency Options
A company may buy a currency option if it wants a more flexible hedge.
Options are derivatives contracts.
The purchaser of a currency option has the right, but not the obligation, to:
• Buy or sell
• A specified quantity
• Of a specified currency
• On or before a specified date (expiry date)
• At an exchange rate agreed today (called the exercise/strike price)

The owner of the option can either:

• Exercise the right, or
• Let it lapse

FM NOTES BY HASHIM RAMEESH U 174

But this flexibility has a cost (premium).
• Premiums are paid on the date of buying the option (non-refundable)

A company can buy options:

• On a derivatives market (ETC), or
• Directly from a bank – called OTC (Over-The-Counter)

• Call option → Right to buy the currency

• Put option → Right to sell the currency
• European-style → Can exercise only on expiry date
• American-style → Can exercise any time up to expiry

Spot exchange market Options market

Today, (1 Feb) To hedge against this risk, the
UK exporter – $300,000 to be exporter will buy £ call options with
received in 90 days. a strike price of $1.50/£.
Current spot rate is $1.40/£.
If £ strengthens in spot market (to
If £ strengthens in 90 days (e.g. to $1.60/£), The exporter will exercise
$1.60/£), fewer £s will be received the option.
when converting $ → £. → Gets better rate ($1.50/£)
→ So, loss in the spot market. → Protected from loss.

If £ weakens in 90 days (e.g. to If £ weakens in spot market (to

$1.20/£), more £s will be received $1.20/£), The exporter will let the
when exchanging the $ → £. option to lapse and use spot rate
→ So, gain in spot market. instead.
→ Can exploit the gain in the spot
market.

Options give flexibility. But, must pay a premium (non-refundable).

Hedge set-ups in Currency options
Look at what we are doing the contract currency (£ for above set-up) at the future
date?
 If buying – Buy Call options of contract currency
 If selling – Buy Put options of contract currency

FM NOTES BY HASHIM RAMEESH U 175

OTC & ETC
 Over the Counter Contracts (OTC) – These are customisable or tailor-made
contracts available over the counter (from banks).
➤ In this, any amount can be hedged.
➤ Examples: Forward exchange contracts, Money market hedging, Currency
options (from banks), Currency swap.
 Exchange Traded Contracts (ETC) – These are standardised contracts which are
traded on an exchange.
➤ Only available in standard sizes, so under/over hedging may happen.
➤ Examples: Currency futures, Currency options (exchange-traded).

Currency Swaps
A currency swap is an agreement where two parties exchange:
 the principal amount of a loan
 and the interest in one currency
 for the principal and interest in another currency.

How it works (removes transaction risk on foreign currency loans):

 At the start of the swap – principal amounts are exchanged at the spot rate.
 During the swap – interest payments are exchanged.
 At the end – the original principals are exchanged again at the same (original) spot
rate.
This removes the foreign currency risk.

FM NOTES BY HASHIM RAMEESH U 176

 Interest rate Risk
management
Interest rate risks
Exposure to Rising Interest Rates
The two main concerns if interest rates rise:
 If the company has floating (variable) interest rate borrowings, profits go down
due to higher interest costs.
 If the company has fixed interest rate investments, their value will fall as interest
income goes down.
Exposure to Falling Interest Rates
The two main concerns if interest rates fall:
 If the company has fixed-rate borrowings, it cannot benefit from lower rates.
 If the company holds floating-rate investments, income will go down.

Unbalanced Interest stream between Fixed and Floating rate

Borrowings or Deposits
If an adverse interest rate movement happens for the highest proportion of the
stream (borrowing or deposit), it will cause a loss.
If a favourable movement happens for the highest proportion, it will result in a gain.
Both situations are risky, due to the unbalanced interest streams.
To mitigate this risk:
Keep a balance between fixed and floating rate borrowings/investments.
(This is called Smoothing)

FM NOTES BY HASHIM RAMEESH U 177

Gap Exposure
Gap exposure = difference between interest-sensitive assets (interest income) and
liabilities (interest cost).
Found through gap analysis: grouping them by maturity date.
• Negative gap – liabilities > assets. Loss if interest rates rise.
• Positive gap – assets > liabilities. Loss if interest rates fall.
This exposure can be reduced by,
Matching – use the same interest rate type for assets and liabilities.
Asset & Liability management (match the size and maturity of borrowings & deposits)

Basis Risk
Even if assets and liabilities both use variable interest rates, they may be based on
different benchmarks (e.g. SOFR vs SONIA or 1-month SOFR vs 3-month SOFR).
This creates basis risk – rates won’t move the same way.

Interest rate risk

When a new borrowing or deposit is planned for a future date, there is a risk that the
interest rate on that future date (when the deposit or loan starts) may be uncertain or
different from expected.
To mitigate this risk, several external hedging techniques can be used.
Goal: Not to get the best return, but to reduce uncertainty so the business can plan
confidently.

External Hedging techniques

Forward Rate Agreements (FRAs)
A Forward rate agreement (FRA) is an agreement with a bank to take a notional loan
or make a notional deposit for a certain period.
It is settled by the difference between the agreed interest rate and the actual interest
rate when the loan/deposit starts.
FRAs help companies fix in advance a future borrowing or deposit rate for a notional
amount over a period.

FM NOTES BY HASHIM RAMEESH U 178

FRAs are cash-settled in advance, at the start of the FRA term, based on the present
value of the difference between:
• The fixed contract rate, and
• The reference interest rate (like SOFR).
The FRA can be made with the same or a different bank from the actual loan/deposit.
Other features of FRAs:
• Max maturity is about two years
• It’s a customised agreement (OTC)
• No premium or margin is needed

A 3-6 FRA means borrowing starts in 3 months and ends after 6 months.
A 4-7 FRA means borrowing starts in 4 months and lasts for 3 months.

Q1) Nero Co expects to borrow $2m in 4 months for 3 months. Interest rate is 5%.
What happens if the actual rate is:
(a) 6.5%
(b) 4%

Q2) A Co needs to borrow $30 million for 8 months, starting in 3 months’ time. A 3-11
FRA of 2.75% - 2.60% is available.
Show the interest payable if the market interest rate is;
(a) 4%
(b) 2%

Interest Rate Futures (IRFs)

IRFs are exchange-traded contracts whose value is based on interest rates. They also
have a notional principal and a futures price.
IRFs are priced as: (100 – implied interest rate)
So, if interest rates go up, futures price goes down
For a Borrower, adverse interest rate movement is when it rises.
For a Depositor, adverse interest rate movement is when it goes down.

FM NOTES BY HASHIM RAMEESH U 179

IRFs set-up
Set-up in a way that the loss/gain in the Underlying transaction (spot market) is
cancelled out in the Futures market.
 For a Borrower, we need to hedge against increasing interest rate. At that time
futures price goes down. So,
Open: sell futures | Close: buy futures
 For a Depositor, we need to hedge against decreasing interest rate. At that time
futures price goes up. So,
Open: buy futures | Close: sell futures
Futures creates;
• Selling a future → obligation to borrow/pay interest
• Buying a future → obligation to deposit/receive interest

Since, there is an obligation to the holder, he must close out the futures before expiry
date. This limits the flexibility. Protect against the bad rate change and the benefit
from good rate change is foregone.

The difference between contract rate and spot rate is called the basis.
This basis naturally goes to zero by the delivery date. The basis doesn’t fall in a straight
line → this is called basis risk.

Interest rate Options

An interest rate option protects against bad rate changes and lets you benefit from
favourable movements. These are exchange traded (ETC)
Holder has the right (not obligation) to deal at an agreed rate in the future. At expiry,
the buyer chooses whether to use the option (exercise) or allow it to lapse.
Holder needs to pay ‘Premium’ for this flexibility.
• Borrowers: buy put options → set a maximum interest rate
• Lenders/Depositors: buy call options → set a minimum interest rate

Example – Interest rate Options:

A call option on $1m at 5% gives the right to lend at 5%.
• If market rate is 4% → use the option
• If market rate is 6% → don’t use it, lend at 6%

FM NOTES BY HASHIM RAMEESH U 180

Interest rate Guarantees (IRGs)
OTC interest rate options can be purchased from banks and are tailor-made. Types
include:
• Cap (borrower) – if interest goes above a set rate (exercise the option), bank pays
difference. Else, allow it to lapse.
• Floor (depositor) – if interest goes below a set rate (exercise the option), bank
pays difference. Else, allow it to lapse.
• Collar – combines cap and floor to keep rate within a range. This reduces the
cost (net premium) to the holder.
Borrower: buy cap + sell floor (offsets cost of cap)
Depositor: buy floor + sell cap

Interest rate Swaps

An interest rate swap is an exchange of interest payments between two parties in the
same currency, based on a notional amount, for a fixed period.
It helps companies change interest rate type (fixed/floating) or hedge against rate
changes.
Fixed interest payments are swapped for floating interest payments, both on the
same notional amount.

FM NOTES BY HASHIM RAMEESH U 181

 Financial
Management
Function
Role of Financial Management
Nature and Purpose
Financial management is the management of activities related to getting and using
short- and long-term financial resources.
Key financial management decisions:
The three key financial management decisions are investing, financing and dividend
policy. More specifically:
• What types of funds to raise – equity or debt?
• How should the funds be raised?
• Where should the funds be spent (investment decisions)?
• How much dividend should be paid to shareholders?
• How much working capital is needed and how to finance it?
• How should risk be managed?
Decisions are connected:
• Increasing dividends reduces retained cash → more external finance needed for
investments.
• More capital expenditure → more finance needed.
• Finance can come from internal sources like cutting dividends.

FM NOTES BY HASHIM RAMEESH U 182

Relationship with Financial and Management
Accounting
Financial Accounting
Financial accounting affects financial management decisions:
o Quoted companies must consider how financing decisions affect financial
statements.
Example: Leases over 12 months increase financial gearing (debt vs. equity).
o Investment decisions affect key ratios like return on capital employed.

Management Accounting
Management accounting helps financial managers:
o Budgeting can show cash deficits/surpluses, helping with finance/investment
planning.
o Cost analysis (fixed vs. variable) supports financial decisions.
o Variance analysis helps control project costs.

Corporate Objectives, Financial

Objectives and Corporate Strategy
Strategy
• Strategy = action plan to achieve an objective
o Can be short-term or long-term depending on the objectives
• Corporate strategies guide the whole organisation

Corporate Objectives
• Corporate objectives apply to the entire organisation
Examples:
• Profit targets

• Market share targets

• Share price growth

FM NOTES BY HASHIM RAMEESH U 183

 • Environmental goals
• Happy workforce
• Short-term and long-term targets
Types of objectives:
• Profit goals – directly increase profit (e.g. cost cuts)
• Surrogate profit goals – indirectly increase profit (e.g. happy employees)
• Constraints on profit – limit profit for other reasons (e.g. environmental care)
• Dysfunctional goals – no real profit benefit, even in long-term (e.g. market
leadership at any cost)
Two approaches to objectives:
• Maximising – aiming for the best result
• Satisficing – settling for a satisfactory, not perfect, result

Financial Objectives
Financial objectives include targets like:
• Earnings per share (EPS)
• Dividend per share
• Gearing level
• Operating profitability

Maximisation of Shareholder Wealth

• The main theoretical financial objective is maximising shareholder wealth.
• This is measured by Total Shareholder Returns (TSR)

• Shareholder wealth increases when share price rises due to: Good profits out of
which;
o Dividends paid
o Reinvestment of profits for growth
• So, maximising share price is often used instead of directly maximising
shareholder wealth.

FM NOTES BY HASHIM RAMEESH U 184

Q1) An investor purchased 100 shares in ABC Co at the beginning of 20X0 at the
market price of $10 per share. During the year, the investor received a dividend of
$1.20 per share. At the end of 20X0, the shares had an ex-div market value of $12.90
per share.
Find TSR?

Why maximise shareholder wealth?

• Attracts finance easily
• Helps economic growth
• Avoids takeovers
• Directors have duty to shareholders

Profit Maximisation
In reality, companies often aim to maximise profits because:
• Share price can be affected by market conditions, not just performance

• Unlisted companies don't have share prices

Therefore, profit maximisation is often used as a proxy for shareholder wealth
maximisation.
Problems with profit maximisation:
• Profit doesn’t reflect cash generation
• Focus may shift to short-term gains
• Can lead to financial reporting manipulation
• Profit reports debt financing costs but not equity financing costs. Therefore,
profit will be maximised when there is no debt. As a result, it will lose the tax
shield on interest and more tax paid.

Earnings per Share (EPS) Growth

• Analysts use EPS growth (compared with prev. year) as a key indicator for
investment decision in a company.
Problems:

FM NOTES BY HASHIM RAMEESH U 185

 • EPS is based on accounting profit
• Can be boosted artificially (e.g. share consolidation or buyback)

Q2) During the year ended 31 March 20X5, George Co reported EPS of 10.3 cents. The
company had 400,000 shares in issue at 31 March 20X5.
On 1 October 20X5, George Co issued 60,000 shares at the market price. Profit (for the
year), for the year ended 31 March 20X6, was $57,000. There were no preference
dividends.
Find EPS for 31 March 20X6 and the EPS growth for the year?

Not-for-profit Organisations (NPOs)

Objectives
• NPOs = Charities, public sector, etc.
• Not focused on profits (other than profit objectives), but have many
stakeholders with conflicting goals.

Example – University:
Stakeholders = Students, government, employers
Conflicts:
o Students want quality education and facilities
o Government wants low costs
o Employers want skilled graduates
Hard to balance all goals
Must prioritise stakeholders and their objectives
Value for Money
NPOs aim to maximise benefits vs costs → called Value for Money.
Focus is on 3 Es:
1. Economy – Get resources at lowest cost
2. Efficiency – Maximise output/input ratio
3. Effectiveness – Meet objectives using resources

FM NOTES BY HASHIM RAMEESH U 186

Q3) Categorise the following measures of value for money for an international charity
as economy, efficiency or effectiveness:
1. Service delivery per dollar spent
2. Beneficiary satisfaction
3. Cost per project activity
4. Change in beneficiaries’ lives
5. Cost per beneficiary
6. Utilisation of volunteer hours
7. Resource consumption in programs
8. Procurement savings

Measuring Performance
NPOs (Non-Profit Organisations) often have multiple and conflicting objectives, and it
can be hard to measure their output in a meaningful way.
To handle this problem, performance can be measured by:
• Using expert judgments (even if it means the measure is partly subjective);
• Comparing results with similar organisations or with past performance;
• Measuring inputs – though this can be misleading.
Still, it is possible to measure output meaningfully in NPOs.

FM NOTES BY HASHIM RAMEESH U 187

Q4) Lewisville is a town with a population of 100,000 people. The town council of
Lewisville operates a bus service (Lewisville Bus Company, or LBC) which links all
parts of the town with the town centre. The service is non-profit seeking, and its
mission statement is "to provide efficient, reliable and affordable public transport to
all the citizens of Lewisville". Attempting to achieve this mission requires operating
services considered uneconomic by private-sector bus companies, due to the small
number of passengers travelling on some routes or the low fares charged.
However, one council member has recently criticised the performance of the
Lewisville bus service compared with those operated by private-sector bus companies
in other towns. She has produced the following information for the most recent
financial year:
Summarised Income and Expenditure Account
$000 $000
Passenger fares 1,200
Staff wages 600
Fuel 300
Depreciation 280
(1,180)
Surplus 20

Capital employed $2,210,000

Operating statistics for Lewisville bus service

Total passengers carried 2,400,000 passengers

Total passenger miles travelled 4,320,000 passenger miles

Industry average ratios for private sector bus companies

Return on capital employed 10%

Return on sales (operating margin) 30%

Asset turnover 0.33 times

Average cost per passenger mile $0.37

FM NOTES BY HASHIM RAMEESH U 188

a) Using the information provided above, compare the performance of the LBC to the
industry average for private sector companies.
b) Discuss the validity of comparing the performance of the LBC with private sector
bus companies.
c) Explain the meaning of the following terms in the context of performance
measurement and suggest a measure of each one appropriate to a public sector
bus service:
1. Economy;
2. Effectiveness; and
3. Efficiency.

Environmental Issues
• Environmental or "green" issues are growing concerns for everyone, including
companies.
• Managers must understand how operations affect the environment:
o To satisfy public concern
o To avoid penalties or costs due to regulations

• So, environmental reporting is becoming common in financial reports.

• Some companies use the triple bottom line approach (true cost accounting):
o Considers economic, environmental, and social value
o A sustainable triple bottom line = when a company creates all three
values together

Conflicts of Interest
Agency Theory
Agency theory looks at the duties and conflicts between parties in an agency
relationship. In a company, this includes:
• Shareholders and Directors
• Directors and Employees

FM NOTES BY HASHIM RAMEESH U 189

 • Loan creditors and Directors
A company can be seen as a set of contracts between these different groups. The
company will only succeed if all groups work toward the same goals.
Most research focuses on conflicts between directors and shareholders, but there
are also other tensions in a company.

Stakeholders
Companies have many interest groups (stakeholders) with different goals.

Groups of stakeholders:
• Internal – employees, directors
• Connected – shareholders, banks, customers, suppliers, competitors
• External – community, government, pressure groups
Conflicts can happen.
Reducing pollution (community goal) may reduce profits (shareholder wealth)
Modern corporate governance says:
• Directors should care about more than just shareholders.
• Should act responsibly towards:
o Creditors (fair payments)
o Employees (safety, health)
o Society (CSR – social investments, less pollution)

FM NOTES BY HASHIM RAMEESH U 190

So, the corporate goal may be satisficing = giving satisfactory returns, not maximum.
Ethical investors may accept lower returns if the company has ethical practices.

Directors and Shareholders

In large companies, there's a separation of ownership and control:
o Shareholders own, directors manage
Directors should act in shareholders’ best interests, while considering other
stakeholders
But directors may have personal goals, like:
• Increasing their pay or bonuses

• Empire building (growing company for power)

• Job security
Some directors don’t fulfil duties and may:
• Use creative accounting (window dressing)
• Use off-balance sheet financing (e.g. special purpose vehicles)
• Reject takeover offers to protect their jobs
• Ignore environmental issues (e.g. pollution, product testing on animal)
These actions lead to agency costs = lost potential returns for shareholders.
To reduce agency costs, use good corporate governance.
But governance has costs too, so use a cost-benefit approach.
Shareholders should monitor directors better.
Most shares are owned by institutional investors (e.g. pension funds), who often stay
passive. Until shareholder activism increases, some directors will act in their own
interests.

Encouraging Stakeholder Objectives – Managerial

Reward Schemes
Goal congruence = when manager goals match company goals
Managers should aim for long-term success, not just short-term profits.
Ways to encourage goal congruence:
• Performance-related pay → May lead to short-termism
• Executive share option schemes → Mixed results (share price may rise for other
market reasons)

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 • Long-term incentive plans (LTIPs) → Bonus based on performance over years
vs competitors
• Transparency in reporting
• Shareholder activism (e.g. using voting rights)
• Improved governance (e.g. independent non-executive directors)

Encouraging Stakeholder Objectives – Corporate

Governance
Corporate governance = how companies are directed and controlled
Keep agency costs at a level acceptable to shareholders
Principles of Good Governance
All governance codes follow these key ideas:
• Effective board should lead and control the company
• Clear roles: Chair runs the board, CEO runs the business
• Balance of executive and non-executive directors
• Directors must face regular re-election
• Remuneration committee should be independent
• Pay packages should attract, retain, motivate – not overpay
• Directors should not set their own pay
• Maintain internal control to protect shareholders’ money and assets
Government Regulation
In the UK, listing rules require:
o Companies must apply the UK Corporate Governance Code
o Must report how they follow the Code
o If not complying, must explain why

Listing Regulations
• Stock exchanges have rules for fair and efficient operation
• To be listed, a company must meet listing requirements

FM NOTES BY HASHIM RAMEESH U 192

 Financial
Environment
Banking System
Financial Intermediaries
Financial intermediaries are organizations that connect potential lenders and
borrowers.
Financial Institutions
The following financial institutions act as financial intermediaries:
• Commercial Banks (discussed in section below)
• Merchant/Investment Banks: These provide banking services to businesses,
such as advice on share issues and mergers.
• Building Societies: These take deposits and lend to people buying their own
house.
• Insurance Companies: These invest their premium income in long-term assets,
as their expenses are predictable.
• Investment Trusts and Unit Trusts/Mutual Funds: These attract investors and
invest the funds in other companies.
• Pension Funds: These receive regular premiums and invest long-term as their
cash outflows are predictable.
• Finance Companies: These offer credit, leasing, and factoring services to
businesses and individuals. They are often subsidiaries of other financial
institutions.
• Discount Houses: These trade in investments like bills of exchange.

FM NOTES BY HASHIM RAMEESH U 193

Role of Financial Intermediaries
Financial intermediaries have several important roles:
• Aggregation: Small deposits are combined and lent to large borrowers.
• Maturity Transformation: Short-term deposits are used to lend for the long term.
• Risk Diversification: The risk of each borrower is spread across many lenders.
• Liquidity: They provide a liquid market, offering flexibility and choice for lenders
and borrowers.
• Hedging: They offer tools to businesses for hedging risks (e.g., forward contracts,
options, and swaps).
However, the role of financial institutions is being challenged (threatened) by Fintech
(study later)

Commercial Clearing Banks

Commercial clearing banks perform these functions:
• Accept Deposits: They take deposits from customers into current or deposit
accounts.
• Issue Certificates of Deposit: These are related to large deposits with a term of at
least three months.
• Lend Money: They lend in various ways while ensuring enough liquidity is
maintained. They balance profitability with liquidity.
• Provide Money Transmission: They offer money transmission services through
the clearing system.

Bank Lending:
• Overdrafts and term loans to individuals and businesses.
• Investments in other financial intermediaries, like leasing companies.
• Purchase of short-term government securities.
• Purchase of trade or commercial bills.
• Lending to discount houses, which then lend in the long term.

FM NOTES BY HASHIM RAMEESH U 194

 Financial Markets
The financial markets include the capital markets (for medium- and long-term capital)
and the money markets (for short-term capital). The following activities take place in
these markets:
• Primary Market Activity: Selling new securities to raise funds.
• Secondary Market Activity: Trading existing securities.

Capital Markets
Capital markets involve long-term capital
The main UK capital markets are:
• The Official List at the London Stock Exchange.
• The Alternative Investment Market (AIM): Easier regulations, appealing to
smaller companies.
• The Eurobond Market: Bonds issued by large international companies, generally
with 10-15 year terms. They are denominated in a foreign currency.
Other countries have similar markets:
• US: New York Stock Exchange (NYSE) and NASDAQ (for tech companies).
• Japan: Tokyo Stock Exchange (TSE).
• Hong Kong: Hong Kong Stock Exchange (HKEX), key for international listings.
Capital markets provide equity and debt capital for long-term funding needs (5+
years).

Money Markets
The money market involves borrowing and lending by banks and financial institutions.
It’s not a physical market, but a network for short-term capital exchange.
Principal Roles of Money Markets
• Transfer money between surplus and deficit parties.
• Allow governments and businesses to raise short-term funds.
• Help implement monetary policy and set short-term interest rates.
• Provide businesses with tools to manage risk.

FM NOTES BY HASHIM RAMEESH U 195

Interest-bearing Instruments
1. Certificate of Deposit (CD): A savings certificate with a fixed interest rate and
maturity date.
2. Repurchase Agreements (Repo): Short-term loans (under two weeks) arranged
by selling securities to an investor with an agreement to repurchase them at a fixed
price on a specified date.
3. Municipal Notes: Short-term debt issued by cities in anticipation of future
revenues.
Discount Instruments
1. Bill of Exchange: Short-term financial instrument for goods transactions, which
are often used in international transactions, and the holder of such a bill may
convert it immediately into cash by selling it to a bank at a discount.
2. Commercial Paper: Unsecured, but high-quality, corporate debt with a fixed
maturity of one to 270 days. It is sold at a discount to nominal value and pays a
zero coupon. Commercial paper allows companies to raise large amounts of
finance quickly but is only available to those companies with very high credit
ratings.
3. Banker’s Acceptance: Short-term debt issued by a company which is guaranteed
by a commercial bank, used in international trade.
4. Treasury Bills: Short-term government debt issued at a discount.

Derivative Products
• Derivatives: Financial instruments whose value depends on underlying assets
like CDs and Treasury bills.
• Used for hedging to reduce risk in financial markets.

International Money and Capital Markets

• Eurocurrency Markets: International money markets (short-term) involving
currency deposits outside their home country.
• Eurobond Markets: International capital markets (long-term) where bonds are
issued by global companies.

FM NOTES BY HASHIM RAMEESH U 196

Stock Exchange Operations
Functions of Stock Exchange
The main function of a stock exchange is to ensure a fair, orderly, and efficient
market for:
• the transfer of securities, and
• the raising of new capital by issuing new securities.
To do this, stock exchanges set strict rules to make sure:
• Only suitable companies can trade their securities on the exchange.
• All relevant information is shared with the public as soon as possible. This helps
investors make good decisions, so money flows to the best companies.
• All investors trade on equal terms, at the same prices.
A fair and efficient stock exchange attracts more investors and becomes more
successful.
Who Owns Shares?
• Rise in institutional investors like pension funds owning large shares.
• Countries like the US, Canada, Australia, and Nordic countries have seen
institutional ownership dominate in the capital markets.

Buying and Selling Shares

• Brokers buy and sell shares, charging a fee.
• Market Makers profit through the bid-offer spread (difference between buying
and selling price).

Valuation of Shares
• Share prices are determined by market forces: how many people want to buy
versus sell.
• Some investors trade for speculation:
• A bullish investor thinks prices will rise, so they buy shares to sell later for a
profit.
• A bearish investor thinks prices will fall, so they sell shares hoping to buy them
back cheaper later.
When there are more bulls, prices rise.
When there are more bears, prices fall.

FM NOTES BY HASHIM RAMEESH U 197

 • Speculative buying/selling helps maintain market balance and liquidity.

Financial Market Efficiency

An efficient market is one where the market price of all securities reflects all available
information.
A perfect market is one that immediately responds to any new information.
An efficient and perfect market ensures that share prices are as fair as possible,
accurately reflecting a company’s financial performance, prospects, and any relevant
news or events.
Market efficiency can be viewed in different ways:
• Allocative Efficiency: Does the market allocate funds to the best companies?
• Operational Efficiency: Does the market have low transaction costs and a
convenient trading platform? This helps create a deep market with high liquidity (a
high volume of transactions with low transaction costs).
• Informational Efficiency: Is all relevant information available to investors at low
cost?
• Pricing Efficiency: Do share prices reflect all known information quickly and
accurately? This is also called information processing efficiency.

The Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) looks at information processing and pricing
efficiency. Three levels of efficiency are considered:
• Weak-form Efficiency:
Share prices reflect all information in past prices. Prices follow a random walk.
In this level, it's impossible to predict price movements based on past trends.
Chartists (technical analysts) who study trends should not consistently
outperform the market, but fundamental analysts can predict price movements.
• Semi-strong form Efficiency:
Share prices reflect all publicly available information. Prices only change with
new information.
If this level is achieved, only insider information can predict price movements,
but insider trading is illegal and unethical.
• Strong-form Efficiency:
Share prices reflect all information, both published and unpublished.
At this level, share prices cannot be predicted, and insider trading is impossible
because the market already knows everything.

FM NOTES BY HASHIM RAMEESH U 198

Major markets (like the London and New York Stock Exchanges) have strict rules
against insider trading, so they are considered semi-strong efficient.
The three levels describe how share prices react to new information. If prices don’t
react, there’s no efficiency.
Implications for Financial Managers
The market’s efficiency affects financial managers in the following ways:
• Timing of New Issues:
If the market is not fully efficient, the timing of new issues matters. Issuing
shares just before or after new information is released can give an advantage.
• Project Evaluation:
If the market is not fully efficient, share prices are not fair, and the required rate
of return is uncertain. It’s harder to decide what rate to use to evaluate new
projects.
• Creative Accounting:
In an inefficient market, creative accounting can be used to mislead investors.
• Mergers and Takeovers:
In an efficient market, share prices are fair. If a company is taken over at its
current share value, the purchaser can’t make a gain unless there are economies
of scale or rationalization during the merger.
• Validity of Current Market Price:
If the market is fully efficient, the share price is fair. Investors get a fair
risk/return, and the company can raise funds at a reasonable cost. No need to
discount new shares to attract investors.
The Paradox of Efficient Markets
Market efficiency depends on investors actively buying and selling shares to create a
liquid market where fair prices emerge. Investors trade when they believe there are
bargains (signals to buy) or overvalued shares (signals to sell).
But if the market is efficient, mispriced shares wouldn’t exist. This creates the paradox
of efficient markets – investors must believe the market is inefficient in order for it to
become efficient.

FM NOTES BY HASHIM RAMEESH U 199

Corporate Bond Market
Features
Corporate bonds are debt securities issued by companies to raise funds for large-
scale projects or replace bank financing. Their key features are; nominal value,
coupon rate, redemption date.
Methods of Issue
• Public Issue: Bonds issued through the stock exchange and can be traded and
reach at a market price. Examples of minimum public issue sizes by region:
o Eurozone: €100m–€500m or more.
o Japan: ￥10bn–￥100bn or more.
o UK: Typically, £100m–£200m.
o US: More than $500m for large corporations.
• Private Placement: Bonds issued to selected investors, like banks or pension
funds, to avoid public issue costs.

Interest Rates
Influences
Interest rates are influenced by various factors, including:
• Economic Interest Rates: Influenced by inflation, government policy, demand for
borrowing, and international factors.
• Risk: Higher risk leads to higher expected returns for investors.
• Loan Duration: Longer loans typically have higher interest rates due to increased
risk.
• Bank Profits: Banks charge borrowers more than they pay to depositors.
• Size of Loan: Larger loans may come with lower rates due to reduced
administrative costs.
• Term Structure of Interest Rates: Interest rates varies by the loan’s maturity and
affects the return on a security.

FM NOTES BY HASHIM RAMEESH U 200

The Term Structure of Interest Rates and Yield Curves
The term structure shows how yield (return) on a security changes based on how long
until it matures.
If you plot yield vs years to maturity, you get a yield curve.
Financial managers use the yield curve to understand how interest rates may change
in the future. This helps them choose the best financing method.
Even though yield curves are based on government securities, corporate borrowers’
curves follow a similar trend.
Theories that explain yield curves:
1. Liquidity Preference Theory:
o Investors want more return for locking money in long-term bonds.
o So, normal yield curve slopes upward.
2. Expectations Theory:
o If future interest rates are expected to rise → steep upward curve.
o If rates are expected to fall → inverted (falling) curve.
3. Market Segmentation Theory (Preferred Habitat Theory):
o Investors prefer certain parts of the yield curve:
▪ Banks like short-term securities.
▪ Pension funds prefer long-term bonds to match their long-term
payouts.
o This can create disturbances or jumps where preferences meet.
4. Risk:
o For government debt (like UK Gilts or US Treasuries), default risk is very
low.
o But corporate debt has more risk, so the corporate yield curve may rise
more sharply than government yield curves.

FM NOTES BY HASHIM RAMEESH U 201

Impact of Fintech
Fintech refers to technological innovations in financial services that affect markets
and institutions. Its focus areas include:
• Better use of data
• Frictionless customer experience
• Cryptocurrencies (e.g., Bitcoin)
One of the main features of Fintech is that it may reduce or eliminate the costs of
financial intermediation.
Fintech has affected all the primary functions of banks:
• Maturity transformation (through competition in lending)
• Capital allocation (e.g., robo-advisors)
• Payment services (new platforms)
• Information processing (e.g., big data, machine learning, AI)

Disintermediation
Fintech reduces the need for financial intermediaries by allowing direct transactions
between borrowers and lenders, or investors and investment opportunities.
Availability of Credit
Fintech expands credit access, especially through:

FM NOTES BY HASHIM RAMEESH U 202

 • Peer-to-Peer (P2P) Lending: Direct lending between individuals and businesses,
bypassing traditional banks. It can offer lower rates but carries risks, especially in
unregulated markets.

Security Token Offerings (STOs)

STOs use blockchain to issue digital tokens representing ownership of a share in an
asset (e.g. gold or property) or economic rights (e.g. a share of profits or revenue).
Whereas a traditional share in a company is issued in a physical document (a share
certificate), a security token is a digital certificate (and may be stored in a digital
wallet).

FM NOTES BY HASHIM RAMEESH U 203

 Economic
Environment
Macroeconomic Policy
Macroeconomic policy means the government sets economic goals (like full
employment, growth, low inflation) and uses tools like fiscal policy and monetary
policy to reach them.
Objectives
Macroeconomic policies try to achieve:
• Full employment
• Economic growth and better living standards
• Fair wealth distribution
• Price stability (low inflation)
• A strong balance of payments (avoiding long-term trade deficits)

Global Economic Events

Financial managers must know global economic trends, not just local policies,
because all economies are now more connected through trade and money flows.
Key recent global events:
• Emerging markets like Brazil, India, and China are becoming more important
• Technology-based fundraising (like crowdfunding) helps small businesses raise
money without banks
• COVID-19 pandemic (2020–2023) hurt tourism, travel, supply chains, and oil prices
• High global inflation after the pandemic caused stricter monetary policies

FM NOTES BY HASHIM RAMEESH U 204

Monetary Policy
Monetary policy refers to the actions taken by the government or central bank to
achieve economic goals using tools related to money.
Monetary policy actions can either:
• Directly control the money supply
• Control demand for money through interest rates
(For example, increasing interest rates raises borrowing costs, reduces demand for
goods, and lowers inflation.)
Monetary policies are seen as crucial for managing the economy, particularly by
monetarists.
Direct Control of the Money Supply
Governments or central banks can control the money supply in the following ways:
• Open Market Operations:
When the central bank sells government securities, the money supply contracts as
funds are absorbed. Buying back securities releases funds into the market.
• Reserve Asset Requirements:
The central bank sets a minimum amount of liquid assets banks must maintain,
limiting their ability to lend and reducing the money supply.
• Special Deposits:
The central bank can require banks to hold special deposits, limiting their reserve
base and lending capacity, which reduces the money supply.
• Direct Control:
The central bank can set limits on how much banks can lend, but this is harder to
enforce due to global capital movement.

Indirect Control of the Money Supply

Governments can reduce money demand by raising short-term interest rates. This
decreases the overall money supply.
Problems of Monetary Policy
There are several challenges with monetary policy:
• Time Lag:
There’s often a delay between when policies are implemented and when their
effects are seen.

FM NOTES BY HASHIM RAMEESH U 205

• Credit Control Issues:
Credit control is less effective in today’s global economy.
• Unpredictable Relationships:
The link between interest rates, investment, and consumer spending is unstable
and hard to predict.
• Side Effects of High Interest Rates:
o Less investment and higher unemployment, as companies face higher
borrowing costs.
o Reduced share prices, making it harder for companies to raise funds.
o Lower consumer demand.
o An overvalued currency that reduces demand for exports.

Fiscal Policy
Fiscal policy refers to government actions aimed at achieving economic goals through
taxation, public spending, and managing budget deficits or surpluses. By adjusting
these, governments regulate the demand in the economy.
Keynesian Approach
Keynesians, following economist John Maynard Keynes, believe fiscal policy is crucial
for controlling the economy.
In a recession, fiscal policy can help by:
• Increasing government spending to boost demand (e.g., road-building projects,
training schemes).
• Cutting taxes to encourage more consumption and investment.

Problems with reflating the economy:

• Government spending may misallocate resources (e.g., funding inefficient
industries).
• Delays between authorizing spending and its execution.
• Tax cuts may not boost domestic demand, as people may save or spend on imports.
• A large budget deficit and Public Sector Net Cash Requirement (PSNCR) are likely.
• Inflation could rise due to higher demand for limited resources.

FM NOTES BY HASHIM RAMEESH U 206

To reduce an overheating economy:
• Decrease government spending to reduce demand.
• Increase taxes to reduce consumption and redistribute wealth.

Problems with deflating the economy:

• Cutting spending in sectors like healthcare or education is difficult.
• Higher taxes discourage innovation and enterprise.
Keynesians prefer adjusting government spending over taxes for quicker economic
impact.

Relationship Between Fiscal and Monetary Policy

Fiscal and monetary policies work together. Governments use both to meet their
economic targets. Which policy dominates depends on the economic theory of the
government in power.
Examples of Keynesian policies in action:
• Australia: Used stimulus packages (infrastructure spending, cash transfers) during
the global financial crisis.
• Canada: Implemented infrastructure spending and tax cuts during the 2008 crisis.
• UK: From the 1930s to the 1970s, Keynesian approaches were used, but later shifted
due to “boom-bust” cycles.
• US: Used stimulus programs like TARP and ARRA during the 2008 recession.

Supply-side Policy
Supply-side policies focus on creating favourable conditions for private businesses to
grow, which increases the economy’s ability to meet demand.
Supply-side Policy Examples
Supply-side supporters believe the private sector is more efficient than the
government at meeting the economy's needs. Key policies include:
• Low corporate tax rates to encourage business growth.
• Stable, low inflation with minimal government interference.
• Limited government spending.
• Balanced fiscal budgets (government spending does not exceed tax receipts).

FM NOTES BY HASHIM RAMEESH U 207

• Deregulation of industries to allow more freedom.
• Reducing trade union power.
• More education and training for the workforce.
• Building more infrastructure (e.g., business parks).
• Reducing planning regulations for new businesses.

Supply-side Policies and Fiscal Policy

For supply-side policies to work, the economy needs stability, and fiscal policy should
be balanced. Government spending should match its tax income to avoid deficits.
To encourage businesses:
• Minimize tax rates and government spending.

Supply-side Policies and Monetary Policy

Monetary policy controls inflation, which helps maintain a stable environment where
businesses can thrive.

Problems with the Supply-side Approach

Challenges of supply-side policies:
• Time delays: It takes time before the effects of these policies are seen.
• Private sector limits: The private sector cannot provide all the goods and services
that society needs.

Exchange Rate Policy

Exchange rate policy is how a government manages its currency's value against foreign
currencies. It is closely related to monetary policy and depends on many of the same
factors.
Reasons for Controlling Exchange Rates
Governments may control exchange rates to:
• Fix a balance of trade deficit: If inflation is higher in one country than others, its
export prices become less competitive. A government may lower the exchange rate
to make exports cheaper.

FM NOTES BY HASHIM RAMEESH U 208

• Prevent a trade surplus: A government may increase the exchange rate to make
imports cheaper.
• Stabilize the exchange rate: By reducing exchange rate risks for importers and
exporters, confidence in the currency improves, encouraging international trade.

Floating Exchange Rate

A freely floating exchange rate means that a currency's value moves based on supply
and demand.
Sources of demand for a currency:
• Exports of goods and services
• Foreign investment inflows
• Speculative demand
Sources of supply for a currency:
• Imports of goods and services
• Foreign investment outflows
• Speculative selling
A floating exchange rate helps balance trade. If imports exceed exports, the currency’s
value falls, making exports cheaper and correcting the trade imbalance.
A managed float allows the currency to float freely, but the central bank may intervene
to avoid major fluctuations.
Fixed Exchange Rate
In a fixed exchange rate system, the value of the currency is tied to another currency
or a basket of currencies. The central bank intervenes to maintain this rate, with
occasional revaluations or devaluations as needed.
For example, during the 2008 financial crisis, many governments devalued their
currencies to promote growth through higher exports.
Crawling Peg
In a crawling peg system, a currency can fluctuate, but only within a narrow range
around a target rate. This target rate may be adjusted due to inflation.
Example (Mexico):
In the 1990s, Mexico fixed its peso against the US dollar. Due to inflation, the peso
needed devaluation. Instead of a sudden devaluation, Mexico used the crawling peg
system, adjusting the rate gradually to avoid instability.

FM NOTES BY HASHIM RAMEESH U 209

FM NOTES BY HASHIM RAMEESH U 210