AA

FINANCIAL MANAGEMENT
STUDY NOTES 2024

NAVAVI SABAKA
 1
Financial Management

Introduction to Financial Management

You'll develop the knowledge and skills expected of a finance manager, in
relation to investment, financing and dividend policy decisions. The syllabus is
designed to equip you with the skills that would be expected from a finance
manager responsible for the finance function of a business.

Table of contents
Chapter Page number
1. Financial management function 2
2. Investment appraisal 7
3. The cost of capital 54
4. Business valuations 65
5. Capital Structure 77
6. Financial ratios 89
7. Working capital management 95
8. Risk management 122
9. Financial market and the treasury function 144
10. Sources of finance 150
11. The economic environment for business 162
12. Dividend policy 168
13. Sec C Theories 172
 2
Financial Management

Chapter 1

Financial Management Function

The relationship between financial management, financial accounting
and management accounting

Financial Management

• Financial management is concerned with the acquisition and

deployment of financial resources both in the short term and in the
long term in an effective and efficient manner to achieve the
objectives of the organisation

Financial accounting

• Generally, gives information about past events.

• It is required legally and is determined by accounting standards.
• Its purpose is to keep the stake holders informed of the overall
financial position of the business.

Management accounting

• Generally, provides information for day-to-day decisions to aid

management. This includes budgeting, cost accounting, variance
analysis etc…
• No strict rules or format.
• Can focus on specific areas of business

Financial objectives
For a profit-making company, primary objective is the maximisation of
shareholder wealth. Maximisation of shareholder wealth is measured by
the share price and the dividend per share. This is because the share price
is simply the value of all future dividends coming to the shareholders.

However, sometimes a business reports a profit increase and the share

price falls due to the manner in which they made the profit. This suggests
that that profit is not sufficient as a business objective.

Share price could also rise and fall due to potential investment decisions or
the fact that a new loan is being taken out or that dividends are to be
increased or lowered.
 3
Financial Management

Other objectives
• Profitability
• Liquidity
• Minimisation of risk
• Sales growth
• Market share
• Customer satisfaction
• Employee welfare
• Environment friendliness.

Key Decisions of Financial Management

1. Investment Decision: The finance manager has to take a decision

regarding the selection of the assets, i.e., long-term assets and short-
term assets, in which the firm’s money is to be invested. While long-term
investment decision is known as capital budgeting, the short-term
investment decision is called as working capital management.
2. Financing Decision: The firm’s financing decision is related to the
capital structure of the business, i.e., the proportion of the debt and
equity capital in the business. The decisions are made in the light of
the cost of capital, risk factor involved and returns to the shareholders.
3. Dividend Decision: As the name suggest, dividend decisions of the firm
reflect the distribution of firm’s profits among the owners, i.e.,
shareholders. The decision will be based on certain factors such as
shareholder’s preferences, future expansion opportunities and
investment opportunities for the firm.
 4
Financial Management

Relationship between the three key financial management

decisions

• A decision to increase dividends might lead to a reduction in retained

earnings and hence a greater need for external finance in order to
meet the requirements of proposed capital investment projects.
• Investing in the most appropriate projects will enable company to pay
high dividends and provide greater returns to shareholders.
• The return required by investors (cost of capital) will be used in
determining whether the project is worthwhile or not (under investment
appraisal). If the return generated by the project is below the cost of
capital, the project is rejected. Hence the choice of finance has an
impact on the investment decision.
• The investment decisions made by the company has an impact on
operating profits, which is used by investors to measure the business
risk. (More volatile returns means greater risk).
The risk as perceived by investors has a direct impact on the required
return (cost of capital).

Stakeholders and impact on corporate objectives

We have just seen that the primary objective of a company is the
maximisation of shareholder wealth.
However, there is an alternative known as the stakeholder view.
This means balancing shareholder wealth with the objectives of other
stakeholders.

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

Stakeholder Objective

Staff High salaries; safe job

Managers High bonuses

Shareholders High share price; dividend growth

Banks Minimise company risk

Customer Quality service

Suppliers Good liquidity

Government Good accounting records; Training

initiatives
 5
Financial Management

Stake holder Conflict

Clearly meeting all stakeholder’s objectives entirely is impossible.
Often, they are in conflict with each other. Therefore, a degree of
compromise is reached.

Examples of stake holder conflict:

• Managers want promotions and better rewards which may compromise
the profitability of the company.
• Lenders wish to impose greater degree of control through covenants and
other restrictions but this may restrict the flexibility of the management and
consequently returns to shareholders.

Role of management – Agency theory

There is a fundamental problem highlighted here. The owners of the
business are generally not those who manage the business.
As both parties have different objectives this causes a problem.
The danger that managers may not act in the best interest of the owners is
known as The Agency Problem.
The managers are acting as agents for the owners. So how can the
owners ensure that the agents are working for the owners’ objectives
and not just their own?

• Design suitable managerial reward scheme to encourage managers to

adopt the same risk attitude as investors and to match the manager’s time
horizon with that of the shareholders.
• Executive share option scheme, where by managers are given the option to
buy shares in the future, at a pre agreed price. This will encourage
managers to work towards maximising share price and consequently
shareholders wealth.
• Presence of non-executive directors on the board
• Having committees, composed of non-executive directors, as defined by
the relevant corporate governance code.
• Annual general meetings and review of financial statements

Corporate governance - best practice

UK companies are expected to:
• Splitting the roles of Chairman and CEO – segregation of responsibility.
• At least half the board to be independent NEDs
• Have an independent audit committee, a remuneration committee and a
nomination committee
• The Board should use the AGM to communicate with investors and to
encourage their participation.
• Remuneration of directors should be designed to promote the long-term
success of the company.
 6
Financial Management

Not-for-profit organisation
A not-for-profit organisation’s primary goal is not to increase shareholder
value; rather it is to provide some socially desirable need on an ongoing
basis.
The non-financial objectives are often more important in not-for-profit
organisations. However, they are harder to quantify.
Example: For hospitals how effectively, they are providing health care to
their patients. For schools and universities, the quality of education they are
providing to their students.

Value for money

It can be used to measure the performance in not-for-profit organisation.
Three important aspects of performance to measure are economy,
efficiency and effectiveness (three Es).

Economy – ‘doing things at a low price’

obtaining the appropriate quantity and quality of resources at the lowest
cost possible.

Efficiency – ‘doing things the right way’

maximising the output generated from units of resource used; optimising
the process by which inputs are turned into outputs. (Ratio of output to
input).
For example, if the number of teachers employed by two schools is the
same, but the first school has twice as many pupils as the second, we
could say the first school is more efficient, because the staff costs per pupil
will be lower.

Effectiveness – ‘doing the right things’

Getting the expected results from the outputs.
For example, one of the indicators which is often used to measure schools’
performance is exam results, and this provides a measure of effectiveness.
Is the tuition which pupils receive building their knowledge and, in turn,
helping them to pass their exams?

Example:
Economy – wages of school teacher
Efficiency – Cost per student
Effectiveness – Exam results
 7
Financial Management

Chapter 2

Investment appraisal and capital

budgeting
Investment decisions
The Investment Decision relates to the decision made by the top-level
management with respect to the amount of funds to be deployed in the
investment opportunities. Simply, selecting the type of assets in which the
funds will be invested by the firm is termed as the investment decision.
These assets fall into two categories:

1. Long Term Assets

2. Short-Term Assets

Capital budgeting
The decision of investing funds in the long-term assets such as machinery,
land, building etc. is known as Capital Budgeting. Thus, Capital Budgeting
is the process of selecting the asset or an investment proposal that will
yield returns over a long period.
 8
Financial Management

Capital budgeting process

1. Identification of Potential Investment Opportunities.
2. Evaluation: Once the investment proposals have been identified, they
should be evaluated. This phase involves estimation of cash inflows
and outflows and Investment appraisal techniques are used to
appraise the proposals.
3. Selection: considering the returns and risks associated with the
individual projects, the organisation will choose among projects so as
to maximise shareholders’ wealth.
4. Implementation: As part of the implementation process, the firm must
obtain the necessary funds to finance the projects.
5. Monitoring: After a project has been implemented, it should be
monitored over time. The project’s actual costs and benefits should be
compared with the estimates made before the project was
implemented. The monitoring process may detect errors in the previous
estimation of the project’s cash flows.

Investment appraisal Techniques

In analysing and evaluating investment proposal, the following investment
appraisal techniques are commonly used:
a) Basic investment appraisal techniques
1. Payback period
2. Accounting Rate of Return (ARR) / ROCE
b) Discounted cashflow techniques
1. Discounted payback period
2. Net Present Value (NPV)
3. Profitability index
4. Internal Rate of Return (IRR)
 9
Financial Management

Basic investment appraisal techniques

1. Payback method
It refers to the period within which the entire cost of the project is expected
to be completely recovered by way of cash flows.
It simply measures how long it takes the project to recover the initial cost.
more quickly the cost of an investment can be recovered, the more
desirable is the investment.

Example 1: Initial cashflow 100,000 (0th year).

Cash inflow: - Y1 50,000
Y2 30,000
Y3 20,000
Y4 18,000
Y5 15,000
Payback period = 3 years
= Y1+Y2+Y3
= 50,000+30,000+20,000 = 100,000

Calculation of payback period

A. Constant annual cashflows:

𝒊𝒏𝒊𝒕𝒊𝒂𝒍 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒇𝒍𝒐𝒘

Payback period =
𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉𝒇𝒍𝒐𝒘

Example 2: assume initial investment of the project is 50,000 and annual

cash flows are 12500 for 7 years calculate payback period?
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤
Answer: payback period =
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

50000
=
12500

= 4 years
 10
Financial Management

B. Uneven annual cash flows

In this case payback period can be find out by adding up the cash inflows
until the total cash flows equal to the cash outflows.
Example 3: initial investment 20,000 cash inflows Y1-8000, Y2-7000, Y3-
4000, Y4-3000
Answer: payback period = 3 years cashflow = 8000+ 7000+ 4000 = 19000
remaining amount recovered from 4th year that is 1000
1000/3000=0.333
Payback period = 3.333 years OR 0.333*12 = 4 Months
3 years and 4 months

Decision rule: if expected payback period less than or equal to target

payback period, the company should accept the project.

Advantages of payback
1. Good when the project is subject to quick change like technology. This
is because cashflows in the future become harder and harder to predict
so recovering the money as soon as possible is vital.
2. It minimises risk (short term projects favoured)
3. It maximises liquidity
4. Uses relevant cashflows not accounting profits.

Disadvantages of payback
1. Ignores cashflows after the payback period.
2. Subjective decision making – cannot take a decision without a target
payback period.
3. Time value of money is ignored.
4. Does not necessarily maximise shareholders’ wealth.

Question 1: Company C is planning to undertake a project requiring

initial investment of $105 million. The project is expected to generate
$25 million per year in net cash flows for 7 years. Calculate the payback
period of the project?

Question 2: Company C is planning to undertake another project

requiring initial investment of $50 million and is expected to generate
$10 million net cash flow in Year 1, $13 million in Year 2, $16 million in
year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the
payback period of the project?
 11
Financial Management

2. ARR (Accounting Rate of Return) / ROCE (return on

capital employed)

This method focuses on the average profit generated from a project in

relation to the project’s investment cash outflow.
Note: First thing you need to remember about this is that this is the ONLY
investment appraisal technique which uses profits and not cash in the F9
exam. This is a drawback of the method as profits can be manipulated.
Formula:

Average annual Profits Before Interest and Tax

ARR = ∗ 100
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

(Unless otherwise specified in the exam, you should use this formula)

Or

Average annual Profits Before Interest and Tax

∗ 100
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

initial investment+scrap value

average investment =
2

Example 4: Initial investment 1000,000

Annual Profit Before Interest and Tax - Y1-80,000, Y2-160,000, Y3-
180,000, Y4-60,000
calculate ARR (based on average investment)?
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝐵𝐼𝑇
Answer: ARR = *100
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
120000
= *100
500000

= 24%

Decision rule: If expected ARR is greater than target ARR, the company
should accept the project.
 12
Financial Management

Advantages of ARR:
1. Linked to accounting profits – easy to obtain information.
2. Understandable percentage figure.
3. It considers the whole life of the project.

Disadvantages of ARR:
1. It disregards the project life.
2. It uses accounting profits (which can be manipulated) rather than cash.
3. Profits varies depending on accounting policies.
4. Ignore time value of money.
5. Subjective decision making – cannot take a decision without a target
ARR.
6. Incorporates irrelevant cashflows as well (sunk cost e.g.- market
research)

Question 3: calculate the accounting rate of return for project A and B

based on average investment.
A B
Initial investment 25,000 36,000
Life 4 5
Year Annual PBIT Annual PBIT
Y1 2500 3750
Y2 1875 3750
Y3 1875 3900
Y4 1250 3850
Y5 - 2750

If the target rate of return is 16%. Which project should be selected?

Question 4: A project requires an initial investment of $700,000 and then
earns net cash inflows as follows:
Year 1 2 3 4 5 6
Cash inflows ($000) 200 300 250 300 200 250
at the end of the six-year project the assets initially purchased will be sold
for $100,000. Depreciation is charged on a straight-line basis. Determine
the project’s ROCE using:
(a) initial capital costs (b) average capital investment.
 13
Financial Management

Question 5: RCA are considering expanding their business into Canada.

An investment of £600,000 is required to purchase the necessary
equipment needed for the manufacture of the new product. Cashflows (not
including depreciation) from the project over the next 5 years are expected
to be:

Years Cash inflows

1. 100,000
2. 120,000
3. 180,000
4. 250,000
5. 350,000

The equipment will have £200,000 scrap value at the end of the project.
Depreciation is charged on a straight-line basis. Ignore taxation effects.
Calculate ARR based on both average investment and initial investment?
Question 6: A project costs 500,000 and has a scrap value of 100,000
after 5 years. Depreciation is charged on a straight-line basis. The
cashflows for the five years period are expected to be 100,000, 120,000,
140,000, 160,000 and 200,000. You are required to calculate the return on
capital employed (ROCE):
a) based on Initial investment?
b) based on average investment?

Question 7: A project costs 110,000 and has a scrap value of 5,000 after 5
years. Depreciation is charged on a straight-line basis. The operating
profits for the five years period are expected to be 10,000, 20,000, 40,000,
60,000 and 20,000.
The company has a target return on capital employed (ROCE) of 25% and
a target payback period of 2.5years.

i. What is the return on capital employed (ROCE) (using the average

investment method)
ii. Assuming operational cashflows arise evenly over the year, what is
the payback period for this investment (to the nearest month)?
ii. Under which investment appraisal method(s), using the company's
targets, will the project be accepted?
 14
Financial Management

Relevant Cash flows

For all methods of investment appraisal, with the exception of ROCE, only
relevant cash flows should be considered. These are:

1. Future
Past costs are irrelevant, decisions are about now and the future
2. Incremental
Only include extra costs incurred or avoided as a result of making the
decision.
3. Cash Flow
Depreciation isn't a cash flows and therefore not relevant.
4. Opportunity cost
An opportunity cost is the benefit foregone by choosing one
opportunity instead of the next best alternative.

Irrelevant cashflows
1. Common Costs
Costs which will be identical for all alternatives are irrelevant
e.g., rent or rates on a factory would be incurred whatever decision is
made
2. Sunk Costs
Another name for past costs, which are always irrelevant
e.g., development costs already incurred.
3. Committed Costs
A future cash outflow that will be incurred anyway (and so isn't relevant),
whatever decision is taken now.
e.g., contracts already entered into which cannot be altered.

Relevant (must be considered) Irrelevant (must be excluded)

• Incremental cashflows • Common costs

e.g.- revenue, variable costs • Committed costs
arising from the project • Allocated costs
• opportunity cost • sunk costs
• stepped fixed cost • unavoidable cost
• investment in capital asset • interest on debt
• incremental working capital • dividend
• scrap value or residual value
 15
Financial Management

Example 5: Relevant cost of machinery

Some years ago, a company bought a machinery for $500,000. The net
book value of the machine is currently $50,000. The company could spend
$140,000 on updating the machine and the products subsequently made
on it could generate a contribution of $200,000. The machine would be
depreciated at $25,000 per annum. Alternatively, if the machine is not
updated, the company could sell it now for $85,000.

On a relevant cost basis, should the company update and use the
machine or sell it now?

Solution:
Immediately we can say that the $500,000 purchase cost is a sunk cost
and the $50,000 book value and $25,000 depreciation charge are not cash
flows and so are not relevant.

If the investment in the machinery is made, then the following cash flow
changes are triggered:

• Machine update cost: $140,000

• Contribution from products: $200,000
• Sales proceeds: $85,000

Therefore, the relevant cashflows are:

Contribution (additional benefit) = 200,000
Machine update costs (additional costs) =(140,000)
Sales proceeds foregone (opportunity cost) = (85,000)
Net cash outflow = (25,000)

As the relevant cashflow is a net cash outflow, the machine should be sold
rather than updated and used.

Question 8: Relevant cost of machinery

A business rents a factory for $80,000 per annum. Only half of the floor
space is currently used and the company is considering installing a new
machine in the unused part. The machine would cost $3.5m and be
depreciated over 10 years at $350,000 per annum.
What is the relevant costs of the new machine purchase?
 16
Financial Management

Question 9: Relevant cost of materials

A company is considering making a new product which requires several
types of raw material:

Units
in inventory Units Additional information
required

Material Nil 50 Current purchase price is

A $8/unit.

Material 100 150 Current purchase price is

B purchased $15/unit. The material
for $10/unit has no use in the
company other than for
the project under
consideration. Units in
inventory can be sold for
$12/unit.

Material 50 120 Current purchase price is

C purchased $22/unit. The material is
for $20/unit regularly used in current
manufacturing
operations.

What is the relevant cost of the materials required for manufacture of the
new product?
 17
Financial Management

Question 10: Relevant cost of labour

A company has a new project which requires the following three types of
labour:

Hours Additional information

required

Unskilled 12,000 Paid at $8 per hour and existing staff

are fully utilised. The company will hire
new staff to meet this additional
demand.

Semi- 2,000 Paid at $12 per hour. These employees

skilled are difficult to recruit and the company
retains a number of permanently
employed staff, even if there is no work
to do. There is currently 800 hours of
idle time available and any additional
hours would be fulfilled by temporary
staff that would be paid at $14/hour.

Skilled 8,000 Paid at $15 per hour. There is a severe

shortage of employees with these skills
and the only way that this labour can be
provided for the new project would be
for the company to move employees
away from making Product X. A unit of
Product X takes 4 hours to make and
makes a contribution of $24/unit.

What is the relevant cost of the labour hours required for the new project?
 18
Financial Management

Time value of money

As per financial management the worth of $1 earned today is not equal
to $1 to be earned tomorrow. This is known as time value of money.
This time value of money concept indicate that money earned today will
be more than its value in the near future. This is due to the potential for
earning interest, impact of inflation and risk.
Example: if a bank holder deposit $100 in the account, the expectation will
be to receive more than $100 after 1 year.
There are two main calculations that we encounter in the situations of time
value of money that is compounding and discounting.

Compounding
The process of computing future value based on present cash
flow is known as compounding.

Formula: FV = PV(1+r)n
r = discount rate
n = number of years

Example 6: Basil invests $1000 for 3 years in a savings account. Which

pay 10% interest per annum. If Basil allows the interest income to be
reinvested, the investment will grow as follows.
FV = PV (1+r)n
year 3’s cashflow = 1000*(1.1)3
= 1000 * 1.331
= 1331
 19
Financial Management

Discounting
The process of arriving at the present value based on future
cash flows is known as discounting.

Formula: PV = FV/(1+r)n
Or
PV = FV * (1/(1+r)n )

Example 7: cash flow will be received 1331 at the end of year 3 and
interest rate 10%. calculate present value?
Alternative -1:
PV= FV/ (1+r) n = 1331/(1.1)3 = 1331/1.331 = 1000
Alternative - 2:
PV= FV * 1 / (1+r) n = 1331*(1/(1.1)3) = 1331 *0.7513148 = 1000
PV Discount factor = 1/(1+r)n in this example 0.751 is discount factor.

Discounting calculations:
1. single cashflow
2. multiple uneven cashflows
3. annuities
4. advanced annuities
5. delayed annuities
6. perpetuities
7. advanced perpetuities
8. delayed perpetuities.
 20
Financial Management

1. Single cash flow:

Example 8: Find out present value of $20,000 to be earned at the end of
year 5 discounted at 15% per annum.

PV= FV/ (1+r) n = 20,000/(1.15)5

= 9944

2. Multiple uneven cashflows

Example 9: Find out the present value of the following stream of cashflows
to be received for 5 years.
Year 1 - 20,000
Year 2 - 25,000
Year 3 - 38,000
Year 4 - 40,000
Year 5 - 42,000
Discount rate 8%

Following are the discounted cashflows of each year:

Y1 = 1/(1.08)1 = 0.926 * 20,000 = 18520
Y2 = 1/(1.08) 2 = 0.857 * 25,000 = 21425
Y3 = 1/(1.08) 3 = 0.794 * 38,000 = 30,172
Y4= 1/(1.08) 4 = 0.735 * 40,000 = 29,400
Y5 = 1/(1.08) 5 = 0.681 * 42,000 = 28,602
Sum of the PV of cashflows = 128,119 (approx.)
 21
Financial Management

3. Annuities

An annuity is a constant annual cashflow for a number of years.

Example 10: Compute the present value of $15000 per year to be received
for next 5 years. Discount rate 12% per annum. Calculate sum of the
present value of cashflows?

Annuity discount factor of 12% for 5 years = 3.605

Sum PV of cashflows = 15,000 * 3.605
= 54,075 approx.

4. Advanced annuities

Constant annual cashflow for a number of years starting from year 0.

Example 11: Compute the present value of $25000 per year to be received
for 6 years starting now. Discount rate 15%.
Annuity discount factor of 15% for 5 years = 3.352
25,000 * 3.352 + 25,000 = 108,800

5. Delayed annuities
Constant annual cashflow for a number of years begins after Y1.
Formula:
PV = annual cashflow * Annuity factor for repetitions * discount factor of the
year before the first cashflow.
Example 12: Compute the present value of $50,000 per year to be
received for 4 years starting 8 years from now. Discount rate 12%.
Annuity factor of 12% for 4 years = 3.037
50,000 * 3.037 = 151,850
151,850 * 0.452 = 68636.2
(0.452 the Present value factor of year 7)
 22
Financial Management

6. Perpetuities

Perpetuity is an annual constant cashflow that occurs forever.

Formula:
Annual cashflow
Present value of a perpetuity =
𝑟

Example 13: What is the PV of an annual cashflow of 50,000 for the

foreseeable future, given an interest rate of 5%?

50,000 / 0.05 = 1,000,000

7. Advanced perpetuities

If a perpetuity starting from year 0.

𝐀𝐧𝐧𝐮𝐚𝐥 𝐜𝐚𝐬𝐡𝐟𝐥𝐨𝐰
Present value of an advanced perpetuity = 𝒓
+ 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤

Example 14: What is the PV of an annual cashflow of 20,000 for the

foreseeable future, starting today, given an interest rate of 5%?

20,000 / 0.05 = 400,000 + 20,000 = 420,000

8. Delayed perpetuities

If a perpetuity begins after year 1.

𝐀𝐧𝐧𝐮𝐚𝐥 𝐜𝐚𝐬𝐡𝐟𝐥𝐨𝐰
PV of an advanced perpetuity = 𝒓
∗ 𝐷𝐹 𝑦𝑒𝑎𝑟 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡ℎ𝑒 1𝑠𝑡 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤

Example 15: What is the PV of an annual cashflow of 40,000 for the

foreseeable future, starting at the end of year 6, given an interest rate of
5%?

40,000 / 0.05 = 800,000 * 0.784 = 627,200

Discount rate
In the above discussions, we referred to the rate of interest. There are a
number of alternative terms used to refer to the rate a firm should use to
take account of the time value of money are Cost of capital OR Required
return.
Whatever term is used, the rate of interest used for discounting reflects the
cost of the finance that will be tied up in the investment.
 23
Financial Management

Question 11: You are offered an annuity that will pay $24,000 per year for
11 years. the appropriate discount rate is 13%, what is the annuity worth to
you today?

Question 12: You are offered an annuity that will pay $17,000 per year for
7 years. the appropriate discount rate is 11%, what is the annuity worth to
you today?

Question 13: If you wish to accumulate $197,000 in 5 years, how much

must you deposit today in an account that pays an annual interest rate of
13%?
Question 14: If you lend me $75,000 today, I promise to pay you back in
10 annual instalments of $10,000, starting five years from today (that is, my
first payment to you is five years from today). You can earn 6% on your
investments. Will you lend me the money?

Question 15: You have choice when subscribing to our magazine: you can

A. pay $100 now for a four years subscription,

B. pay $28 at the beginning of each year for four years, or

C. pay $54 today and $54 again two years from today.

Which is the best deal for you, the subscriber, if your opportunity cost of
funds is 10%?

Question 16: Suppose you are given a choice of the following two
investment opportunities: (a) an annuity that pays $10,000 at the end of
each of the next 6 years; or (b) a perpetuity that pays $10,000 forever, but
the first cash payment is 11 years from today.

Which option do you choose if the annual interest rate is 5%?

 24
Financial Management

Discounted cashflow techniques

1. Discounted payback period
It refers to the period within which the entire cost of the project is expected
to be completely recovered by way of discounted cash inflows.
Example 16: initial investment (100,000), discount rate=12%
Year Cash inflows discount discount CF
factor
Y1 50,000 0.893 44650
Y2 30000 0.797 23910
Y3 20000 0.712 14220
Y4 15000 0.635 9525
Y5 12000 0.567 6804
Y6 10000 0.507 5060

DPBP = (100,000) + 44650+23910+14220+9525+6804 = 891

891/5060 = 0.176 = 5.176
Question 17: Calculate Payback period and discounted payback period
for the following if discount rate 8%?
a. Initial investment - (430,000)
Future cash inflows 115,000 per year for 5 years.

b. Initial investment - (450,000)

Future annual cash inflows 125000, 115000, 135000, 130000 and
145000 respectively for 5 years.

c. Initial investment - (100,000)

Future annual cash inflows 30000, 25000, 15000, 20000, 22000,
26000, 32000 respectively for 7 years.

2. Net present value (NPV)

The net present value method uses a specified discount rate to bring all
subsequent net cash inflows after the initial investment to their present
values, and reduce initial investment from the present value of cashflows.
NPV = Present value of net cashflows – Initial investment
 25
Financial Management

Example 17: initial investment = 5000, Cost of capital =10%

Y1 – 3,000, Y2 – 2,000, Y3 – 5000
Y1 = 3000 * 0.909 2727
Y2 = 2000 * 0.826 1652
Y3 = 5000 * 0.751 3755
Sum of PV cash inflow 8134
NPV = PV of net cash inflow - Initial investment

= 8134 - 5000 = 3134

NPV of the project is positive, so project is financially acceptable.

NPV method contributes towards the objective of maximising the wealth of

shareholders by using the cost of capital of a company as a discount rate
when calculating the present values of future cash flows.
A positive NPV represents an investment return that is greater than
that required by a company’s providers of finance, offering the
possibility of increased dividends being paid to shareholders from future
cash flows.
• if the NPV is positive – the project is financially viable
• if the NPV is zero – the project breaks even (just returning enough
money to cover the funding costs)
• if the NPV is negative – the project is not financially viable
Decision rule:
If NPV is greater than or equal to zero then accept the project.
Advantages of NPV
1. it considers the time value of money
2. it gives an absolute measure of return i.e., figure not a percentage
3. it considers the whole life of the project
4. it is based on relevant cashflows, not profits
5. It maximises the wealth of shareholders.

Limitations of NPV
1. it requires knowledge of the cost of capital.
2. it is heavily dependent on the production and sales volumes forecasts.
3. Non-financial managers may have difficulty to understanding the
concept.
4. It is relatively complex.
 26
Financial Management

Question 18: Calculate the net present value and discounted payback
period of a project which requires an initial investment of $243,000 and it is
expected to generate annual net cash flow of $60,000 for 10 years. The
required rate of return is 12% per annum.

Question 19: An initial investment of 8,320 on plant and machinery is

expected to generate net cash flows of 5411, 4070, 5824 and 2,965 at the
end of first, second, third and fourth year respectively. Calculate the net
present value of the investment if the cost of capital is 15%.

Question 20: Initial investment - 720,000, Life of the project is 5 years.

Annual cashflows 210,000, 220,000, 240,000, 260,000, and 220,000
respectively for five years.
a. Calculate NPV if discount rate is 10%?
b. Calculate NPV if discount rate is 20%?
c. What happens to NPV when discount rate increases?

3. Profitability index
It is the ratio of present value of cash inflows to the initial investment
or the NPV to the initial investment.
𝑃𝑉 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
Profitability Index =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑁𝑃𝑉
Or =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

This technique is used to compare a number of proposals each

involving different amount of initial investment.
Question 21:
Years Project A Project B Project C Project D
0 (550,000) (1020,000) (970,000) (420,000)
1 175,000 275,000 225,000 175,000
2 140,000 220,000 300,000 135,000
3 190,000 350,000 275,000 180,000
4 185,000 375,000 285,000 240,000
5 165,000 300,000 295,000 220,000

Cost of capital is 9%, Calculate profitability index? Rank the projects

according to preference using profitability index?
 27
Financial Management

4. Internal rate of return (IRR)

IRR method considers the time value of money, Initial investment and
all cash inflows from the investment. But unlike the NPV method, the IRR
does not use the desired rate of return. But estimate the discount rate that
makes the present value of cash inflows equal to the initial investment.
In short, the discount rate that makes NPV is equal to zero is called IRR.

The internal rate of return (IRR) is the percentage of annual rate of return
that an investment will generate within a period to cover its initial
investment.

Calculation of IRR
1. Calculate two NPVs for the project at two different discount rates.
2. Use the following interpolation formula to find the IRR:

𝑁𝑃𝑉 𝑎𝑡 𝐿𝑅
LR + [
𝑁𝑃𝑉 𝑎𝑡 𝐿𝑅−𝑁𝑃𝑉 𝑎𝑡 𝐻𝑅
] * (HR-LR)

Example 18: If a project had an NPV of 50,000 when discounted at 10%,

and -10,000 when discounted at 15% - what is the IRR?

Answer:

10 + (50,000/60,000) x 5% = 14.17%

If you have a positive NPV, increase the discount rate to get a smaller
NPV.
If you have a negative NPV, decrease the discount rate to get a bigger
NPV.

Little Tricks

▪ If all the cashflows are the same, this is an annuity - simply take the
Initial Cost / annual inflow - this gives you the cumulative discount
factor (annuity factor). Then go to the annuity table and look for this
figure (in the row for the number of years the project is for) - the column
in which the figure is found is the IRR!
▪ If the cashflows are the same and go on forever, this is a perpetuity -
simply take the Annual inflow / Initial cost and turn it into a
percentage. That’s the IRR! Done.
 28
Financial Management

Decision rule:
If IRR is greater than or equal to cost of capital then accept the project.
Note: if we use IRR for discounting future cash inflow NPV will be 0. If we
use a DR that is less than IRR the NPV will be positive.
Advantages of IRR
1. It considers the time value of money
2. Easily understood percentage
3. It considers the whole life of the project
4. It is based on relevant cashflows, not profits
5. It maximises the wealth of shareholders.

Disadvantages of IRR
1. Does not produce an absolute figure (percentage only).
2. Interpolation only provides an estimate and an accurate estimate
requires the use of a spreadsheet programme.
3. Fairly complicated to calculate.
4. Non-conventional cashflows can produce multiple IRRs.

Example: Initial investment – 10,000

Cashflows Year 1 – 23,000
Year 2 – (13,200)

Both 10% and 20% are IRR.

5. Contains an inherent assumption that cash returned from the project will
be re-invested at the project’s IRR, which may be unrealistic.

Question 22: Calculate IRR?

a. Initial investment - 600,000

Future annual cashflows 150,000 for 5 years.

b. Initial investment - 750,000

future annual cashflows 200,000 for 5 years.

c. Initial investment - 190,000

Future Annual cashflows 50,000 for 6 years.

 29
Financial Management

d. Initial investment - 400,000

Future Annual cashflows 60,000 for 10 years.

e. Initial investment - 15,00,000

Future Cash flows 400,000 per year for 5 years.

f. Initial investment = 120,000

Future cash inflows 40,000 per year for 4 years.

Question 23: Calculate IRR?

a. Initial investment - (430,000)

Future annual cash inflows 150,000, 130,000, 145,000, 135,000 and
160,000 respectively for 5 years.
LR – 15% and HR – 20%

b. Initial investment - (450,000)

Future annual cash inflows 125000, 115000, 135000, 130000 and
145000 respectively for 5 years.
LR – 10% and HR – 15%

c. Initial investment - (100,000)

Future annual cash inflows 30000, 25000, 15000, 20000, 22000,
26000, 32000 respectively for 7 years.
LR – 12% and HR – 16%

NPV versus IRR

Both NPV and IRR are considered time value of money and are superior to
the basic appraisal techniques.
There is a potential conflict between IRR and NPV in the evaluation of
mutually exclusive projects (a company can choose only one project to
exclusion of all others), where the two methods can offer conflicting advice
as which of two projects is preferable.
Where there is conflict, NPV always offers the correct investment
advice.
 30
Financial Management

Example 19:
Project A Project B
Initial investment (5,000) (5,000)
Year 1 4,000 1,000
Year 2 1,000 1,000
Year 3 800 1,900
Year 4 600 2,200
Year 5 300 2,300
Cost of capital – 12%

Calculate NPV & IRR? Which project do you choose?

Answer:
Project A Project B
NPV 489.5 745.6
IRR 18.5% 16.96%

Choose project B based on NPV.

Question 24: Following are the cashflows of project A and project B.

Project A

Initial investment - (126,000)

Future cashflows- 20,000, 30,000, 50,000, 35,000 and 45,000 respectively

for 5 years.

Project B

Initial investment - (126,000)

Future cashflows- 30,000, 35,000, 45,000, 30,000 and 25,000 respectively

for 5 years.

Cost of capital 8%

1. Calculate NPV. Which project selected?

2. Calculate IRR. Which project selected?
 31
Financial Management

Question 25: Suppose there are two projects – Project A and project B
under consideration. The cashflows associated with these projects are as
follows:
Year Project A Project B
0 (100,000) (300,000)
1 50,000 140,000
2 60,000 190,000
3 40,000 100,000

Cost of capital – 10%, which project should be accepted as per NPV and IRR?

Question 26: Suppose there are two projects – Project X and project Y
under consideration. The cashflows associated with these projects are as
follows:
Year Project X Project Y
0 (250,000) (300,000)
1 200,000 50,000
2 100,000 100,000
3 50,000 300,000

Cost of capital – 10%, which project should be accepted as per NPV and IRR?
Question 27: A lease agreement has an NPV of ($98,500) at a rate of
10%. The lease involves an immediate down payment of $22,000 followed
by 5 equal annual payments. What is the amount of the annual payment?

Question 28: Calvin plans to buy an asset in five years' time for cash. He
estimates the cost will be $2m. He plans to set aside the same amount of
funds each year for five years, earning a rate of 10% interest per year
compound. How much does he need to set aside each year?
 32
Financial Management

Allowing for tax, working capital and

inflation
Format of cashflows computation
years 0 1 2 3 4
Sales revenue xxx xxx xxx xxx
Less: Variable cost (xxx) (xxx) (xxx) (xxx)
Fixed cost (xxx) (xxx) (xxx) (xxx)
Net operating xxx xxx xxx xxx
cashflow
Taxation* (xxx) (xxx) (xxx) (xxx)
Initial investment (xxx)
Scrap proceeds xxx
Incremental working (xxx) (xxx) (xxx) (xxx) xxx
capital
Free cashflows (xxx) xxx xxx xxx xxx

NPV and IRR calculation for the constructed response questions

NPV “=npv (discount rate, free cashflows from year 1 onwards)-initial

investment”.
IRR “=irr (free cashflows from year 0 onwards)”

The impact of taxation on cash flows

Corporation tax charged on a company’s profits is a relevant cash flow for
NPV purposes. It is assumed, unless otherwise stated in the question, that:
• operating cash inflows will be taxed at the corporation tax rate
• operating cash outflows will be tax deductible and attract tax relief at the
corporation tax rate
• investment spending attracts tax-allowable depreciation
• Tax is charged on the net operating profit (not operating cashflow) either
in same year or arrears.

Net operating cashflow xxx

Less: Tax Allowable Depreciation (xxx)
Taxable profit/(loss) xxx
Tax paid/(benefit) xxx
 33
Financial Management

Tax allowable depreciation

• Note that the tax-allowable depreciation is not a cash flow. The effect of
tax-allowable depreciation is on the amount of tax payable, the change
in which is the relevant cash flow.

Example:
With consider Without consider
depreciation depreciation
Operating cashflow/ Taxable 200,000 200,000
cashflow
Less: Tax Allowable 50,000 -------
Depreciation (TAD)
Taxable profit before tax 150,000 200,000
Less: Tax (30%) 45,000 60,000
Profit After Tax 105,000 140,000
Add: Depreciation 50,000 -------
cashflow 155,000 140,000

If we consider depreciation tax payment will be 45,000, without consider

depreciation tax payment will be 60,000. Which means we save 15,000 in
tax payment if we consider depreciation which is called depreciation tax
benefits or savings.
Depreciation tax benefit = Depreciation x Tax %
= 50,000 x 30% = 15,000

Conclusion: Depreciation is a non cash item and itself does not affect the
cash flow. However, we must consider tax benefit or savings from
depreciation in our analysis. Since this benefit reduces cash outflow for
taxes it is considered as cash inflow.

• Tax allowable depreciation (also known as a writing down allowances or

WDA) is calculated based on the written down value of the assets either
through the straight-line basis or the reducing balance basis.
• You will need to deduct the scrap value from the investment which will
give rise to a balancing allowance or a charge if we calculate
depreciation through the reducing balance basis.
 34
Financial Management

Original cost of asset xxx

Cumulative tax-allowable depreciation claimed (xxx)
Written down value of the asset xxx
Disposal value of the asset (xxx)
Balancing allowance or balancing charge xxx

Important - We will not reduce interest expense while calculating annual

cashflows because we will discount the cashflows using cost of capital.
Cost of capital include interest on long term debt and dividends on ordinary
shares and preference shares.
In short, we have to reduce the interest expense at the calculation of
present value.

Question 29: Company considering to purchase an asset and cost of the

asset is 500,000. Depreciation is charged on a straight-line basis. The
project life is expected to be 5 years and the company expects zero scrap
proceeds at the end of the project.
tax rate is 30% and will pay in the year cashflow arise. Cost of capital is
10%.

Years Year 1 Year 2 Year 3 Year 4 Year 5

Taxable 220,000 250,000 260,000 230,000 210,000
cashflows

Calculate NPV? Should company make the purchase?

Question 30: Raphael Restaurant is considering the purchase of a

$10,000 souffle maker. The souffle maker has an economic life of five
years and will be fully depreciated by the straight-line method.
The company expects zero scrap proceeds at the end of the project.
The machine will produce 2,000 souffle per year, with each costing $2 to
make (variable costs) and priced at $5. Company also spends annual fixed
costs of $2000 per year. Assume that the discount rate is 15 percent and
the tax rate is 30 percent, tax will pay in the year cashflow arise. Calculate
NPV? Should Raphael make the purchase?

Question 31: Company considering to purchase an asset and cost of the

asset is 200,000. Depreciation is charged on a straight- line basis. The
project life is expected to be 5 years and the company expects scrap
proceeds of 10,000 at the end of the project. Selling price of the product is
$50, Variable cost per unit is $15, annual fixed costs $5000 per year.
tax rate is 30% and will pay in the year cashflow arise. cost of capital is
10%.
 35
Financial Management

Years 1 2 3 4 5
Sales units 1500 2000 2100 2200 1900

Required:
1. Calculate NPV and IRR of the project and comment on the acceptability
of the project.

2. If tax allowable depreciation would be available on the cost of the

investment on a 25% reducing balance basis instead of straight-line
basis.
Calculate NPV and IRR of the project and comment on the acceptability
of the project.

Question 32: Down Under Boomerang, Inc. is considering a new three-

year expansion project that requires an initial fixed asset investment of $2.7
million. The fixed asset will be depreciated straight-line to zero over its
three-year tax life, after which it will be worthless. The project is estimated
to generate $2400,000 in annual sales, with annual costs of $960,000. The
tax rate is 35% and the required return is 15%. Tax will pay in the year
cashflow arise. Calculate NPV? Should company make the purchase?

Incorporating working capital Investment

In a new project often requires an additional investment in working
capital,
The treatment of working capital is as follows:
• initial investment is a cash outflow at the start of the project
• if the investment is increased during the project, the increase is a
relevant cash outflow
• if the investment is decreased during the project, the decrease is a
relevant cash inflow
• at the end of the project all the working capital is ‘released’ and treated
as a cash inflow.

To calculate the working capital cashflows you should:

Step 1: Calculate the absolute amounts of working capital needed in each
period
Step 2: Work out the incremental cash flows required each year

Question 33: In the previous question Down Under Boomerang Inc.

Suppose the project required the initial investment in net working capital
equal to 10% of sales revenue and would be recovered at the end of the
project life. What is the project's NPV?
 36
Financial Management

Question 34: Company considering to purchase an asset and cost of the

asset is 10,000. Depreciation is charged on a straight- line basis. The
project life is expected to be 4 years and the company expects zero scrap
proceeds at the end of the project. Selling price of the product is $10,
Variable cost per unit is $3, annual fixed costs $4000 per year.
tax rate is 30% and will pay in the year cashflow arise. cost of capital is
15%.

Years Year 1 Year 2 Year 3 Year 4

Sales units 1000 1500 1700 2000

Working capital required which is equal to 20% of the annual sales.

This will need to be in place at the start of each year and would be
recovered at the end of the project life.
Required:
Calculate NPV and IRR of the project and comment on the
acceptability of the project.

Question 35: ABC Company is considering to invest in a new project with

a cost of 500,000. The project life is expected to be 4 years and the
company expects scrap proceeds of 50,000 at the end of the project.
Following are the estimated sales units for years.
Year 1 Year 2 Year 3 Year 4
Sales units 4000 5000 7000 8000

The selling price per unit is 80 and the variable cost per unit is 30. The
annual incremental cash fixed cost is estimated to be 100,000.
Company pays tax one year in arrears at an annual rate of 30%.
Working capital required which is equal to 10% of the annual sales.
This will need to be in place at the start of each year and would be
recovered at the end of the project life.
Tax allowable depreciation would be available on the cost of the investment
on a 25% reducing balance basis. Company has a cost of capital of 8%.
Required:
Calculate NPV and IRR of the project and comment on the
acceptability of the project.
 37
Financial Management

The impact of inflation on cashflows and return

Inflation is a general increase in prices leading to a general decline in the
real value of money.

Methods of dealing with inflation:

1. Real method
2. Money/Nominal method

1. Real method
The cashflows are not adjusted for inflation, and are instead
expressed in real terms i.e., in today’s prices (real flows).
The net cashflows are then discounted using the real rate.

2. Money method
The cashflows are increased by inflation to reflect that actual cash
paid or received (money flows).
The net cashflows are then discounted using the money rate.

Real cashflows and nominal cashflows

• Where cash flows have not been increased for expected inflation they
are described as being in current prices, or today's prices.
• Where cash flows have been increased to take account of expected
inflation they are known as money cash flows, or nominal cash flows.
• You can assume that cash flows you are given in the exam are the
money cash flows unless told otherwise.

Nominal cashflows = real cashflows*(1+inflation rate)n

Real cashflow = nominal cashflow/(1+inflation rate)n
if the specific inflation rate used for the cash flow is the same as the general inflation rate.

Real and money (nominal) returns

Fishers Formula
(1+money rate)=(1+real rate)(1+inflation rate)
(1+real rate)= (1+money rate)/(1+inflation rate)
 38
Financial Management

Specific and general inflation rates

In practice, inflation does not affect all cash flows to the same extent, each
cashflow is affected by a specific rate. In some investment appraisal
questions, you may be given information on both specific inflation rates and
general inflation rates.

Note that the real method only applies if the rate of inflation of the specific
cash flows involved is the same as the general rate of inflation i.e., single
inflation rate.
Under the ideal circumstances, the NPV computed using money method
and the real method would yield the same answer.

Where multiple inflation rates are given in the question, it is

necessary to use money method.

Question 36:
initial investment - 350000
real annual cashflows 100000
life 6 years
real cost of capital 8%
general inflation rate 3%
calculate NPV under nominal method and real method?

Example of calculating nominal cash flows using specific inflation

Selling price (current price terms) $5.30 per unit

Variable cost (current price terms) $3.15 per unit
Selling price inflation 5% per year
Variable cost inflation 4% per year

Forecast sales volume is 300,000 units per year, increasing by 50,000 units
per year, and the investment project is expected to last for four years.

Inflated selling prices

Year 1: 5.30 x 1.05 = $5.57 per unit
Year 2: 5.30 x 1.052 = $5.84 per unit
Year 3: 5.30 x 1.053 = $6.14 per unit
Year 4: 5.30 x 1.054 = $6.44 per unit

Inflated sales revenue

Year 1: 5.57 x 300,000 = $1,671,000
Year 2: 5.84 x 350,000 = $2,044,000
Year 3: 6.14 x 400,000 = $2,456,000
Year 4: 6.44 x 450,000 = $2,898,000
 39
Financial Management

Inflated variable costs

Year 1: 3.15 x 1.04 = $3.28 per unit
Year 2: 3.15 x 1.042 = $3.41 per unit
Year 3: 3.15 x 1.043 = $3.54 per unit
Year 4: 3.15 x 1.044 = $3.69 per unit

Inflated total variable cost

Year 1: 3.28 x 300,000 = $984,000
Year 2: 3.41 x 350,000 = $1,193,500
Year 3: 3.54 x 400,000 = $1,416,000
Year 4: 3.69 x 450,000 = $1,660,500

Nominal terms total contribution

Year 1: 1,671,000 – 984,000 = $687,000
Year 2: 2,044,000 – 1,193,500 = $850,500
Year 3: 2,456,000 – 1,416,000 = $1,040,000
Year 4: 2,898,000 – 1,660,500 = $1,237,500

Real cash flows are found by deflating nominal cash flows by the
general rate of inflation.

Example of calculating real cash flows by deflating nominal cash

flows
Using the nominal cash flows calculated above and a general rate of
inflation of 4.8%:

Real terms total contribution

Year 1: 687,000/ 1.048 = $655,534
Year 2: 850,500/ 1.0482 = $774,376
Year 3: 1,040,000/ 1.0483 =$903,544
Year 4: 1,237,500/ 1.0484 = $1,025,888
 40
Financial Management

Specific Investment Decisions

Lease versus buy
Once the decision has been made to acquire an asset for an investment
project, a decision has to be made as to whether the asset should be
purchased or leased.
• The NPVs of the both options are found and compared and the lowest
cost option selected.
• The operating costs and revenues from the investment will be common
in each case.
• Only the relevant cash flows are included in the NPV calculation.
Let’s have a look at what are the relevant cashflows here

LEASE BUY
• the lease payments – cash • the purchase cost – cash
outflows during the year. outflow at 0th year.
• tax relief on the lease • any residual value – cash
payments – cash inflows inflow at the end of the life.
during the year. • any associated tax
implications due to tax
allowable depreciation –
cash inflows during the year.

As the interest payments attract tax relief, we must use the post-tax cost of
borrowing as our discount rate.
Post-tax cost of borrowing = Cost of borrowing × (1 – Tax rate).
Example 20: Machine cost $6,400 (life 5 years)
Capital allowances 25% reducing balance
Tax – 30% one year in arrears.
Finance choices
1. 5 years loan 11.4% pre-tax cost or
2. 5 years Finance Lease @ $1,420 p.a. in advance
Answer:
Cost of borrowing = (4,984)
Cost of lease = (4,548)

The cheapest option is the lease.

 41
Financial Management

Asset Replacement Decision

Once the decision has been made to acquire an asset, it is quite likely that
the asset will need to be replaced periodically throughout the life of the
project.
Assets will need replacing but how often is best?
The different options open to us have different time scales, when we
deciding which replacement strategy is best, we must compare the possible
replacement strategies available.

In order to compare, we use an EAC (equivalent annual cost):

𝑷𝑽 𝑶𝑭 𝑪𝑶𝑺𝑻𝑺
𝐀𝐍𝐍𝐔𝐈𝐓𝐘 𝐅𝐀𝐂𝐓𝐎𝐑
Choose the option with the lowest EAC
Steps:

1. Calculate the PV of costs for all options

2. Then the EAC for each option
3. Then choose the option with the lowest EAC

Key Assumptions
1. Cashflows from trading are ignored - revenue, variable cost and fixed
cost. since they will be similar regardless of the replacement decision.
2. The assets are replaced in perpetuity
3. Tax & Inflation ignored

Relevant cashflows
1. Initial investment
2. Maintenance cost
3. Scrap proceeds

Equivalent annual benefits

Calculating the EAB is particularly useful when trying to compare projects
with unequal lives.

𝑵𝑷𝑽 𝑶𝑭 𝑷𝑹𝑶𝑱𝑬𝑪𝑻
𝐀𝐍𝐍𝐔𝐈𝐓𝐘 𝐅𝐀𝐂𝐓𝐎𝐑
Choose the project with the highest EAB
 42
Financial Management

Example 21:
Machine Cost 20,000

Replacement cycle Maintenance cost Residual value

Every 1 year 5,000 16,000
Every 2 years 5,500 13,000

Cost of capital = 10%

Replacing Every Year

NPV (10,001)
EAC = 10,001 / 0.909 = 11,002

Replacing Every 2 Years

NPV (18,350)
EAC = 18,350 / 1.736 = 10,570

Machine should be replaced every 2 years as this is cheaper.

Question 37:
Purchase price of a new lorry is $40000.
each lorry generates revenue $525 per trip and make 600 trips in a year.
the fuel and running cost are $325 per trip. cost of capital - 10%.
optimal replacement cycle?
Replacement Maintenance salvage
cycle cost value
every 1 year 1500 30000
every 2 years 2500 22000
every 3 years 5500 14000
 43
Financial Management

Capital rationing
Shareholder wealth is maximised if a company undertakes all possible
positive NPV projects. Capital rationing is where there are insufficient funds
to do so.
there are 2 reasons for this:

1. Hard capital rationing

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

Reasons for Hard capital rationing

1. Industry wide factor (recession)
2. Company has poor track record
3. Company has too low credit rating
4. Company has no assets to secure the loan

2. Soft capital rationing

Company imposes its own spending restriction. (This goes against the
concept of shareholders’ wealth maximisation, which occurs by always
investing in positive NPV projects) - why?

Reasons for Soft capital rationing

1. Limited management skills in new area
2. Want to limit exposure and focus on profitability of small number of
projects
3. The costs of raising the finance relatively high
4. No wish to lose control or reduce EPS by issuing shares
5. Wish to maintain s high interest cover ratio

Single and multi-period capital rationing

Single period capital rationing – shortage of funds for one period only.
Multi period capital rationing – shortage of funds in more than one period.
 44
Financial Management

Capital rationing with Divisible projects

If a project is divisible, any fraction of the project may be undertaken and
the returns from the project are expected to be generated in exact
proportion to the amount of investment undertaken.
If 70% of a project is performed, for example, its NPV is assumed to be
70% of the whole project NPV.

Here, divisible investment projects can be ranked in order of desirability

using the profitability index.

𝑵𝑷𝑽 𝑶𝑭 𝑷𝑹𝑶𝑱𝑬𝑪𝑻
Profitability index =
𝐈𝐍𝐕𝐄𝐒𝐓𝐌𝐄𝐍𝐓

Steps for the exam with divisible projects

1. Profitability index is calculated
2. The profitability index is then used to rank the investment projects.
3. allocating funds according to the projects’ rankings until capital is used
up.

Capital rationing & Indivisible projects

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

Unfortunately, with indivisible projects there is no model to help us! We

simply have to look at all the possible combinations by trial-and-error work
out which would be the most profitable (Highest NPV).

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

Capital rationing & mutually exclusive projects

Sometimes the taking on of projects will preclude the taking on of another.
If projects are mutually exclusive, we can only choose one project at a time.
In these circumstances, each combination of investments is tried to identify
which earns the higher level of returns.
 45
Financial Management

Example 22:
A Company has 100,000 to invest and has identified the following 4
projects.
project Investment NPV
A 40,000 20,000
B 100,000 35,000
C 50,000 24,000
D 60,000 18,000
Required: which projects should be chosen to maximise
shareholders’ wealth?
1. if the projects are divisible
2. if the projects are indivisible
3. if the projects are indivisible and A and C are mutually exclusive.

Solution:
1. If divisible
Project Profitability index Ranking
A 0.5 1
B 0.35 3
C 0.48 2
D 0.3 4

Plan
Funds Project NPV
100,000
(40,000) A 20,000
(50,000) C 24,000
(10,000) 10% of B 3,500 (35,000*10%)

2. If indivisible
Project Investment required NPV
B 100,000 35,000
A+C 90,000 44,000
A+D 100,000 38,000
A+C is the best combination and provide highest NPV. We would choose
A+C.

3. If mutually exclusive
If A and B are mutually exclusive, we chose next best option of A and D.
 46
Financial Management

Adjusting for risk and uncertainty in

investment appraisal
Risk
This is present when future events occur with measurable probability.
Risk refers to the situation where probabilities can be assigned to a range
of expected outcomes arising from an investment project and the likelihood
of each outcome occurring can therefore be quantified.
Uncertainty
This is present when the likelihood of future events is incalculable.
Uncertainty refers to the situation where probabilities cannot be assigned to
expected outcomes.

Risk of investment project increases with increasing variability of returns,

while uncertainty increases with increasing project life.

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

A number of techniques are available for handling this complication. Some

of these techniques are quite technical involving computer simulations or
advanced mathematical skills and are beyond the scope of F9.

However, we can provide some very useful information to managers

without getting too technical.

So there are 6 techniques we are going to look at:

1. Sensitivity Analysis
2. Probability Analysis
3. Simulation
4. Payback and discounted payback
5. Risk adjusted discount rates
6. Certainty equivalents
 47
Financial Management

1. Sensitivity Analysis
Sensitivity analysis indicates which project variable is the key or critical
variable, i.e., the variable where smallest relative change makes the NPV
zero. we want to know how much the variable could change before the
project should be rejected i.e., before the NPV becomes zero.
It basically shows as a percentage, managers should give more focus on
the variable which has small percentage of sensitivity.

The Calculation
𝑵𝑷𝑽
∗ 𝟏𝟎𝟎
𝑷𝑽 𝒐𝒇 𝒄𝒂𝒔𝒉𝒇𝒍𝒐𝒘 𝒖𝒏𝒅𝒆𝒓 𝒄𝒐𝒏𝒔𝒊𝒅𝒆𝒓𝒂𝒕𝒊𝒐𝒏

This would be calculated for each input individually.

we should use separate formula for sensitivity to the discount rate:
𝑰𝑹𝑹−𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝒓𝒂𝒕𝒆
∗ 𝟏𝟎𝟎
𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝒓𝒂𝒕𝒆

The smaller the percentage, the more sensitive the decision is to a

change in the variable. i.e. small changes in the estimate could change the
project decision from accept to reject.
Example 23: XYZ are considering a project which will cost them an initial
10,000. The Sales revenue expected for the 2 years duration are 10,000
per annum. The variable costs are 1,000 per annum. Cost of capital 10%.
Ignore taxation.
Calculate the sensitivity analysis of all variables?

Solution
Years 0 1 2

Investment (10,000)

Sales 10,000 10,000

Costs (1,000) (1,000)

Operating cashflow 9,000 9,000

Discount Factor 1 0.909 0.826

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

NPV = 5,615
 48
Financial Management

Sensitivity of Initial Investment

5,615 / 10,000 = 56%

Sensitivity of Costs
5,615 / (909 + 826) = 324%

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

Sensitivity of discount rate

IRR- 50%
(50-10)/10 = 400%

Question 38:
Initial investment – 5,000,000, Annual sales units 50,000 units.
Selling price -100, Variable cost/Unit – 40, Total fixed cost 500,000 per
year. Discount rate 10% and tax rate 30%, Life of the project - 4 years.
Requirement: Calculate NPV and sensitivity of the project to the following:

d. Initial investment
e. Selling price per unit
f. Sales volume
g. Discount rate

Advantages of Sensitivity Analysis

• No complicated theory to understand
• provides more information to allow management to make a better
decision.
• Identifies areas that are crucial to the success of the project. If the
project is chosen, those areas can be carefully monitored.

Disadvantages of Sensitivity Analysis

• assumes variables change independently of each other
• It does not take into account probabilities of change occurring
• does not directly identify a correct decision.
 49
Financial Management

2. Probability analysis
When there are several possible outcomes for a decision and probabilities
can be assigned to each, a probability distribution of expected cash flows
can often be estimated, recognising there are several possible outcomes,
not just one.
The EV is the weighted average of all the possible outcomes, with the
weightings based on the probability estimates.

Formula
Expected Value (EV) = ∑px

P = probability and X = Value of outcome

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

Example 24:

Cash flows Probability

300,000 0.3
200,000 0.6
120,000 0.1

Expected net cashflows = 300,000*0.3 + 200,000*0.6 + 120,000*0.1

= 222,000

Example 25:
A new product’s cashflows will depend on whether a substitute comes to
the market or not. Chance of substitute coming in 30% - this will lead to an
NPV of (10,000). NPV with no substitute is 20,000
Solution

Substitute does come in = 0.3 x (10,000) = (3,000)

Substitute does NOT come in = 0.7 x 20,000 = 14,000
Expected NPV = 11,000
 50
Financial Management

Question 39:
Initial investment 10,000, discount rate 10%, life 3 years
Year 1
Cash flow 2,000 4,000 6,000 8,000
Probability 0.1 0.2 0.3 0.4
Year 2
Cash flow 5,000 7,000 4,500 5,500
Probability 0.2 0.3 0.4 0.1
Year 3
Cash flow 6,500 8,000 7,500 10,000
Probability 0.3 0.4 0.2 0.1
Calculate NPV?
Question 40:
Cost of the asset - 50,000, Life 4 years, discount rate 10%
Annual sales units probability
10,000 0.25
12,000 0.25
15,000 0.35
20,000 0.15
Selling price - $15, Variable cost - $8/unit, Total Fixed cost 25000/year,
scrap value of the asset at the end of the life is expected to be 25,000.
tax rate 30%. Ignore Tax allowable depreciation. Calculate NPV?

Question 41:
Annual cashflow probability
150,000 0.2
170,000 0.4
180,000 0.3
190,000 0.1
Initial investment – 500,000, life of the project 6 years. Scrap value of the
asset at the end of the life – 50,000. Discount rate – 15%.
Calculate NPV?
 51
Financial Management

Advantages of expected values

• Incorporates all possible outcomes.
• Assign weights based on probability of an outcome occurring, so highly
probable outcomes are given more importance.
• Assists decision-making.

Limitations of expected values

• Expected values are more useful for repeat decisions rather than one-off
decisions, as they are based on averages.
• Subjective probabilities.
• A long term rather than short term average
• EV computed is not an actual outcome. It’s just an average of all the actual
outcomes. For example, the expected value of the average family in the UK
has 2.4 children.

Joint probabilities
An outcome with a certain probability of occurrence may be linked to
another outcome with a different probability of occurrence, the combined
probability is known as joint probability.

Question 42:
Initial investment – 80,000
Life – 2 years
After tax cashflow of the first year can be 50,000 (40% probability)
Or 60,000 (60% probability)
After tax cashflow of the second year depends on the outcome of the
year one.
Discount rate – 10%
Expectation of the cashflow of second year is given below
If after tax cashflow 50,000 If after tax cashflow 60,000

Cashflow of Probability Cashflow of Probability

year 2 year 2
24,000 20% 40,000 40%
32,000 30% 50,000 50%
44,000 50% 60,000 10%

Calculate expected NPV under Joint probability?

 52
Financial Management

3. Simulation
Sensitivity analysis considers the effect of changing one variable at a time.
Simulation improves on this by looking at the impact of many variables
changing at the same time. it is generally a computer aided technique. it
uses repeated random sampling to calculate a range of most likely
outcomes for the project.

Example 26:
Variable costs 4 5 6

Probability 30% 50% 20%

Cumulative probability 30% 80% 100%

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

The random numbers represent the probability. So, 30 numbers are given
to the 30% range, 50 to the 50% range etc.
A random number is generated - say 48, So NPV based on a variable cost
of 5 is generated. This is repeated many times for all variables until we
have a probability distribution

Advantages of simulation
• Includes all possible outcomes
• Easily understood

Disadvantages of simulation
• Model can become complex and expensive to set up
• Probability distributions difficult to formulate

4. Adjusted Payback
One way of dealing with risk is to shorten the payback period required. The
logic here is that as uncertainty (risk) increases with the life of the
investment project, shortening the payback period for a project that is
relatively risky will require it to pay back sooner, putting the focus on cash
flows that are more certain (less risky) because they are nearer in time.
Payback can also be adjusted for risk by discounting future cash flows with
a risk‐ adjusted discount rate, i.e., by using the discounted payback
method.
 53
Financial Management

5. Risk Adjusted Discount Rates

The discount rate in capital budgeting usually represents the cost of
capital or Required Rate of Return. Project with higher risk is generally
expected to provide higher return and vice versa.
So, all projects should not be discounted at the same rate. Project with
higher risk should be discounted with a higher discount rate. This
adjustment in discount rate is referred as risk adjusted discount rate.

6. Certainty Equivalents
Under this approach the riskless cashflows are discounted by a riskless
discount rate that is risk free rate of return.
Riskless cashflow = risky cashflow * certainty equivalent factor

Question 43:
Initial investment 4,500,000,
risk free rate 5%, risk premium 3%.
expected cash flows 1000,000, 1500,000, 2000,000 and 2500,000
respectively for 4 years and certainty equivalent factor 0.9, 0.85, 0.82, and
0.78 respectively. Calculate NPV under certainty equivalent technique?
 54
Financial Management

Chapter 3

THE COST OF CAPITAL

We have seen that when appraising investment projects, a firm may evaluate
a project’s returns using the company’s cost of capital to establish the net
present value (NPV).

The cost of capital represents the return required by the investors. The
investors could be equity shareholders, preference shareholders or debt
holders.
The cost of capital is made up of the cost of equity + cost of preference
shares + cost of debt.

Risk and Return

The greater the risk of an investment, the greater return would be demanded
by the investor. The return for the investors needs to be at least as much as
what they can get from government gilts (these are seen as being risk free).
On top of this they would like a return to cover the extra risk of giving the firm
their investment.
The cost of debt is cheaper than the cost of equity to the company. This is
because interest on debt is paid out before dividends on shares are paid.
Therefore, the debt holders are taking less risk than equity holders and so
expect less return.

Estimating the cost of equity – the Dividend Valuation

Model (DVM)

The cost of equity is the return expected from the equity shareholder.

Assumptions:
• Future income stream is the dividends paid out by the company
• Dividends will be paid in perpetuity
• Dividends will be constant or growing at a fixed rate.

DVM (assuming constant dividends)

re = D/P0

D = constant dividend from year 1 to infinity

P0 = current share price (year 0) (ex div share price)
re = shareholders’ required return
 55
Financial Management

DVM (assuming dividend growth at a fixed rate)

re = D0(1+g)/P0 + g = D1/P0 + g

g = constant rate of growth in dividends

D1 = dividend to be received in one year – i.e. at year 1
D0(1+g) = dividend just paid, adjusted for one year’s growth (equivalent to
D1).

If the first dividend is receivable immediately, then the share is termed cum
div. In such a case the share price would have to be converted into an ex div
share price, i.e. by subtracting the dividend due for payment.

Ex div share price = Cum div share price – dividend due

Example 1: PL Co has just paid a dividend of $0.5. PL Co’s current share

price is $10.

re = 0.5/10 = 5%

Example 2: AG Co’s current share price is $10 and a dividend of 0.5 is due to
be paid shortly.

Ex div share price = 10 – 0.5 = 9.5

re = 0.5/9.5 = 5.26%

Example 3: The market value of XYZ plc shares is $10. It has paid a dividend
of 0.8. the expected growth in dividend is 10%.

re = 0.8(1.1)/10 + 0.1 = 18.8%

Question 1: The market value of ABC plc shares 5.5. it is due to pay a
dividend of 0.5 next week. The company expect to pay a similar dividend
every year in the future. Calculate cost of equity?

Question 2: Market value of the share = 6. Dividend has been paid = 0.4.
Growth rate = 12%. Calculate cost of equity?

Question 3: Market value of the share = 10. Dividend has been announced
and due to be paid shortly = 0.5.
Growth rate = 15%. Calculate cost of equity?
 56
Financial Management

Estimating growth
Two ways of estimating the likely growth rate of dividends are:
• extrapolating based on past dividend patterns
• assuming growth is dependent on the level of earnings retained in the
business.

1. Past dividends
This method assumes that the past pattern of dividends is a fair
indicator of the future.

Where: n = number of years of dividend growth.

2. The earnings retention model (Gordon’s growth model)

Assumption
The higher the level of retentions in a business, the higher the potential growth
rate.
g = bre

where: b = earnings retention rate (proportion of retained earnings).

re = rate of returns on the reinvested funds.

Question 4: Y plc has paid the following annual dividends over the past 5
years.

2021 - 0.45
2020 - 0.40
2019 - 0.36
2018 - 0.32
2017 - 0.28

Current market value of the share = 8

Calculate cost of equity?
 57
Financial Management

Question 5: Z plc has paid the following annual dividends over the past 5
years.

2020 - 0.50
2019 - 0.45
2018 - 0.39
2017 - 0.32
2016 - 0.26

Current market value of the share = 10

Calculate cost of equity?

Question 6: X plc has paid the following annual dividends over the past 4
years.

2010 - 0.54
2009 - 0.50
2008 - 0.45
2007 - 0.43

The current year (2011) proposed dividend 0.6 due to be paid soon.
Current market value of the share = 8
Calculate cost of equity?

Question 7: Market value of the share = 10. Dividend payout ratio = 25%
Dividend has been paid = 0.4. return on reinvested funds = 15%.
Calculate cost of equity?

Question 8: Market value of the share = 15. Dividend payout ratio = 30%
Dividend due to be paid shortly = 0.45. return on reinvested funds = 15%.
Calculate cost of equity?

Estimating the cost of preference shares

Cost of preference shares is the returns expected by the preference
shareholders. Preference shares usually have a constant dividend. So the
same approach can be used as we saw with estimating the cost of equity with
no growth in dividends.

Kp = D/P0

where: D = the constant annual preference dividend

P0 = ex div MV of the share
Kp = cost of the preference share.

The fixed dividend is based on the nominal value of the preference share,
which may vary. Do not assume the nominal value is always $1.
 58
Financial Management

Question 9: Current market value of AR Co preference shares is 25. These

shares coupon rate is 8%. Nominal value is 10 per share.
Calculate cost of preference share?

Question 10: Current market value of AR Co preference shares is 70 cents.

These shares coupon rate is 10%. Face value is 60 cents per share.
Calculate cost of preference share?

Estimating the cost of debt

Types of debt
Traded Non-traded
• Irredeemable debt • Bank loans
• Redeemable debt
• Convertible debt

Irredeemable debt
The company does not intend to repay the principal but to pay interest forever.

Kd net = i(1-t)/P

Kd net = Kd(1-t) = after tax cost of debt

i = annual interest in $ starting in one year's time
t = tax rate
P = current market price of debt (year 0), (ex-interest).
• The company gets corporation tax relief so the cost of debt calculation for the
company is based on interest after tax.
• Debt is always quoted in $100 nominal value blocks.
• Interest paid on debt is stated as a percentage of nominal value – called the
coupon rate.
• The terms ex-interest and cum-interest are used in much the same way as ex-
div and cum-div was for the cost of equity calculations.

Question 11: A company has in issue 12% irredeemable debt quoted at $90
ex-interest. The corporation tax rate is 30%.
What is the post-tax cost of debt to the company?
Question 12: SD plc has issued 10% irredeemable bonds quoted at $100
cum interest. Tax rate is 30%. Calculate cost of debt?
 59
Financial Management

Redeemable debt
Redeemable debt the company will pay interest for a number of years and
then repay the principal (sometimes at a premium or a discount to the original
loan amount).
the market value of redeemable loan notes is the sum of the PVs of the
interest and the redemption payment and the investor’s required return is the
internal rate of return (IRR) for the investment in the loan notes.

Kd net = IRR

The cost of debt can therefore be found by calculating the IRR of the
investment flows:
T0 Current Market price (x)
T1 – n Interest payments (1-t) x
Tn Capital repayment x
Question 13: DG plc has issued 5years 10% redeemable debenture. Current
market value is 98. Tax rate 30%. Calculate cost of debt?
Question 14: AB plc has issued 7% redeemable debenture, redemption at a
10% premium in 8 years. Current market value is 97. Tax rate 30%. Calculate
cost of debt?
Question 15: AY plc has issued 10% redeemable debenture, redemption at a
11% premium in 4 years. Current market value is 98 cum interest. Tax rate
30%. Calculate cost of debt?

Convertible debt
A form of loan note that allows the investor to choose between taking the
redemption proceeds or converting the loan note into a pre-set number of
shares.
To calculate the cost of convertible debt you should:
(1) Calculate the value of the conversion option using available data
(2) Compare the conversion option with the cash option. Assume all investors
will choose the option with the higher value.
(3) Calculate the IRR of the flows as for redeemable debt.
 60
Financial Management

Question 16: BL Co has finance raised from an issue of 10% loan notes,
issued at nominal value of $100 per loan note and Current market value is
$95. These loan notes will be redeemable after five years at nominal value or
convertible at that time into ordinary shares with a value expected to be $115
per loan note.
Tax – 30%.

Question 17: CS Co has finance raised from an issue of 8% loan notes,

issued at nominal value of $100 per loan note and Current market value is
$105. These loan notes will be redeemable after six years at 10% premium or
convertible at that time into 3 ordinary shares for each loan notes with a value
expected to be $35 per shares. Tax – 30%.

Question 18: AH Co has issued 9% loan notes, issued at nominal value of

$100 per loan note and Current market value is $98. These loan notes will be
redeemable after eight years at 12% premium or convertible at that time into 4
ordinary shares for each loan notes with a value expected to be $30 per
shares. Tax – 30%.

Question 19: CM Co has issued 6% loan notes, issued at nominal value of

$100 per loan note and Current market value is $105. These loan notes will be
redeemable after five years at 8% premium or convertible at that time into 20
ordinary shares for each loan notes. Co’s shares are currently worth $3.5 per
share but this is expected to grow at the rate of 10% per annum. Tax – 30%.

Non-tradeable debt
Bank and other non-tradeable fixed interest loans simply need to be adjusted
for tax relief.

Kd net = interest rate × (1 – t)

Market value of the non-tradeable debt = book value.

 61
Financial Management

Weaknesses of the DVM

1. the input data used may be inaccurate:
a. current market price - this can be subject to other short-term influences,
such as rumours.
b. future dividend patterns- in fact dividend growth cannot be constant and
growth estimates based on the past are not always useful.
2. the growth in earnings is ignored - earnings should be an indicator of the
company’s long-term ability to pay dividends.
3. DVM does not consider the risk associated with an investment while
calculating the return.
To overcome the limitations of the DVM an alternative method called
CAPM may be used to calculate the cost of equity.
Estimating the cost of equity – the Capital Asset Pricing
Model (CAPM)
Systematic and Unsystematic risk
1. Systematic risk
Market wide risk - such as interest rate risk, inflation risk, exchange rate
risk etc.,
All companies, though, do not have the same systematic risk as some are
affected more or less than others by external economic factors.

2. Unsystematic Risk
Risk that is unique to a certain asset or company. It is specific to an
individual company, due to their management, financial obligations or
location.
An examples of unsystematic risk is high rate of employee turnover,
employee strike, higher costs of operational activities etc..

Un-systematic risk can be diversified away

One may mitigate unsystematic risk by buying different securities in the
same industry or different industries. For example, a particular oil company
has the diversifiable risk that it may drill little or no oil in a given year. An
investor may mitigate this risk by investing in several different oil
companies as well as in companies having nothing to do with oil.
unsystematic risk is also called diversifiable risk.
 62
Financial Management

The CAPM
This method also calculates the cost of equity (like DVM) but looks more
closely at the shareholder’s rate of return, in terms of risk.

The more risk a shareholder takes, the more return he will want, so the cost
of equity will increase. For example, a shareholder looking at a new
investment in a different business area may have a different risk.

It suggests that any investor would at least want the same return that they
could get from a “risk free” investment such as government bonds. This is
called the risk-free return. On top of the risk-free return, they would also
want a return to reflect the extra risk (systematic risk) they are taking by
investing is called the market risk premium.

Ke = Rf + β(Rm - Rf)

Rm = Average return for the whole market

Rf = Risk free rate
Rm - Rf = Average market risk premium
Beta (β )= How much of the average market risk premium (Rm - Rf) is needed

Beta (β ) = measures systematic risk of the investment compared to

the market. The beta value for UK companies traded on the UK capital
market can be readily found on the internet.
investors may want a return higher or lower than the average market return
depending on whether the share they are investing in has a higher or lower
risk than the average market risk.
The higher or lower requirement compared to the average market premium
is called the beta (β).
 63
Financial Management

Understanding beta:
1. If an investment is riskier than average (i.e. the returns are more
volatile than the average market returns) then the β > 1.
2. If an investment is less risky than average (i.e. the returns are less
volatile than the average market returns) then the β < 1.
3. If an investment’s risk is same as average market risk.
4. If an investment is risk free then β = 0.

Question 20: The current average market return being paid on risky
investments is 16%, compared with 7% on Treasury bills. What is the
required return of an equity investor in AZ Co?
1. If beta = 0.5
2. If beta = 1
3. If beta = 1.5
4. If beta = 0
Question 21: The current average market return being paid on risky
investments is 14%, compared with 5% on Treasury bills. What is the
required return of an equity investor in AR Co?
1. If beta = 0.7
2. If beta = 1
3. If beta = 1.8
4. If beta = 0

Assumptions of CAPM:
• well-diversified investors
• perfect capital market
• unrestricted borrowing or lending at the risk-free rate of interest

Advantages:
• works well in practice
• focuses on systematic risk
• is useful for appraising specific projects.

Disadvantages:
• less useful if investors are undiversified
• ignores tax situation of investors
• actual data inputs are estimates and may be hard to obtain.
 64
Financial Management

Calculating the weighted average cost of capital (WACC)

After calculate the cost of equity, preference shares and debt separately, it
is now possible to calculate the WACC of all the costs of long-term finance.
Calculating weights
When using market values to weight the sources of finance, you should use
the following calculations:

Equity = Number of shares × Market value of each share

Preference share = Number of shares × Market value of each share
Debt = Total nominal value/ $100 × Market value of each loan note
Question 22:

Book values Market values Cost of capital

Equity - FV - $7 per MV - $10 per
share $70000 share 12%

Preference shares - MV - $1.5 per

FV- $1 per share $10000 share 9%

Debt - Nominal value- MV - $105 per

100 per loan note $20000 loan note 8%

What is the weighted average cost of capital using book or market

values?

Question 22: Butch Co has $1 million loan notes in issue, quoted at $50
per $100 of nominal value; 625,000 preference shares quoted at 40c
and 5 million ordinary shares quoted at 25c. The cost of capital of these
securities is 9%, 12% and 18% respectively. This capital structure is to
be maintained. Calculate the weighted average cost of capital?

Question 23: B Co has 10 million 25c ordinary shares in issue with a

current price of 155c cum div. An annual dividend of 9c has just been
proposed. The company earns an accounting rate of return to equity (ROE)
of 10% and pays out 40% of the return as dividends. The company also
has 13% redeemable loan notes with a nominal value of $7 million, trading
at $105. They are due to be redeemed at nominal value in five years’ time.
If the rate of corporation tax is 33%, what is the company’s WACC?
 65
Financial Management

Chapter 4

BUSINESS VALUATIONS AND

MARKET EFFICIENCY
Businesses need to be valued for a number of reasons such as their
purchase and sale, obtaining a listing, inheritance tax and capital gains tax
computations. Generally, valuation difficulties are restricted to unlisted
companies because listed companies have a quoted share price. However,
even listed companies can present valuation challenges for example when
one is trying to predict the effect of a takeover on the share price.

When are Valuations needed?

• Takeovers and mergers

• When setting a price for an I.P.O (Initial Public Offer)
• Selling ‘private’ shares
• When using shares as loan security
• For liquidation purposes

It should be noted that whatever valuation is calculated, this may not be the
actual price that is paid in the transaction. Therefore, the valuations should
be used as a guide.

MODELS FOR THE VALUATION OF EQUITY SHARES

(VALUATION OF A COMPANY)
There are three broad approaches to share valuation:

1. Assets-based
2. Income-based
3. Cash flow-based.
 66
Financial Management

1. ASSET BASED METHODS

Here, the business is estimated as being worth the value of its net assets.
However, there are three common ways of valuing its net assets: book
values, net realisable values and replacement values.
Net asset OR Value of equity = Total assets – total liabilities

In calculating net asset value, preference share capital is included with

long‐term liabilities, as it is considered to be prior charge capital.

a. Net Book Value: The book value approach is practically useless.

The book value of non-current assets is based on historical (sunk)
costs and relatively arbitrary depreciation. These amounts are
unlikely to be relevant to any purchaser (or seller). The book values
of net current assets (other than cash) might also not be relevant as
inventory and receivables might require adjustment.

Book value of assets – book value of liabilities

b. Net Realizable Value (NRV): Net realisable values of the

assets less liabilities. This amount would represent what should be
left for shareholders if the assets were sold off and the liabilities
settled. However, if the business being sold is successful, then
shareholders would expect to receive more than the net realisable
value of the net assets because successful businesses are more
than the sum of their net tangible assets: they have intangible assets
such as goodwill, knowhow, brands and customer lists – none of
which is likely to be reflected in the net realisable value of the assets
less liabilities. Net realisable value therefore represents a ‘worst
case’ scenario because, presumably, selling off the tangible assets
would always be available as an option. The selling shareholders
should therefore not accept less than the net realisable amount
– but should usually hope for more.

Net Realizable Value of assets – settlement value of liabilities

c. Replacement cost: The approach tries to determine what it

would cost to set up the business if it were being started now. The
value of a successful business using replacement values is likely to
be lower than its true value unless an estimate is made for the value
of goodwill and other intangible assets, such as brands.
Furthermore, estimating the replacement cost of a variety of assets
of different ages can be difficult.
 67
Financial Management

Strength and weaknesses

Methods Strength Weaknesses

Net book value • Book values are • Historic cost value

relatively easy to
obtain
Net realisable value • Minimum • Valuation
acceptable to problems
owners • Ignores goodwill
• Asset stripping

Replacement cost • Maximum to be • Valuation

paid for assets by problems
buyer • Ignores goodwill

Note: If we are valuing a profitable quoted company, in reality the minimum

price that shareholders will accept will probably be the market capitalisation
plus an acquisition premium and not the net asset valuation.
Market capitalisation = Current share price * number of shares in
issue

Question 1: calculate the value of equity using NBV and NRV?

ASSETS
Non-current Assets 500,000
Current Assets:
Inventories 65,000
Receivables 40,000
Cash 15,000
120,000
Total assets 620,000
EQUITY AND LIABILITIES
Share capital ($1) 200,000
Reserves 50,000
370,000
Non-current liabilities
8% debentures 200,000
Current liabilities 50,000
Total equity and liabilities 620,000

Other information:
• Current realizable value of the non-current assets is 630,000
• Obsolete inventory is 15,000 and could be sold for 3500.
 68
Financial Management

Question 2: The owners of a private company wish to dispose of their

entire investment in the company. The company has an issued share
capital of $5m of $0.50 nominal value ordinary shares. The owners have
made the following valuations of the company’s assets and liabilities.
Non‐current assets (book value) $60m
Current assets $25m
Non‐current liabilities $30m
Current liabilities $10m
The net realisable value of the non‐current assets exceeds their book value
by $8m. The current assets include $2m of accounts receivable, which are
thought to be irrecoverable. What is the minimum price per share that the
owners should accept for the company?

Question 3: calculate the value of equity using NBV, NRV and

Replacement cost?
Non‐current assets $800,000
Current assets $90,000
Bank Loans $240,000
Current liabilities $60,000

Other information:
• Included in non‐current assets is machinery that has a NBV of
$200,000, would cost $500,000 to replace but would only be able to be
sold for scrap of $80,000 if disposed of.
• Current assets have a net realisable value of $80,000.

2. INCOME OR EARNINGS BASED METHODS

• PE ratio method
PE ratios are quoted for all listed companies and calculated as:

Price per share/Earnings per share (EPS)

This can then be used to value shares in unquoted companies as:

Value of company = Total earnings × PE ratio
Value per share = EPS × PE ratio

using an adjusted PE ratio from a similar quoted company (or industry

average).

Earning should be adjusted for Synergies.

 69
Financial Management

Example: Let’s say that the market value of a small chain of UK-based
grocery shops has to be estimated. The company has just has just enjoyed
post tax earnings of $200,000, out of which it paid a dividend of $50,000.

Then the average P/E of the selected listed companies in the supermarket
industry is calculated. Suppose if it is 10.2 it means that anyone who buys
a share is buying it for 10.2 times its last published earnings.

Therefore, as the target company’s post tax earnings are $200,000, its
market value would be estimated at: 10.2 x $200,000 = $2,040,000.

However, the current earnings can be flattered by cutting back on

‘discretionary’ costs such as research and development, maintenance,
training and recruitment. Although this will make current earnings look
good.

Here are some points to consider:

• When you buy a company, you are buying an entitlement to its future
earnings, not its past earnings. Even if the earnings of $200,000 were
not deliberately distorted, the buyer should still consider whether that
figure is a fair representation of future earnings.
• Quoted companies are more desirable investments because they are
quoted. Shares in quoted companies are easy to sell on the market,
whereas unquoted shares are much more difficult to sell because
buyers have to be found and a price negotiated.
• Are the risk, stability, and expertise present in large, highly
professional quoted companies comparable to those of a small
company? Generally, large quoted companies will have advantages
and should be valued on a higher multiple of their earnings than the
small company.

Question 4:
Share Capital (50c) $150,000
Profit before tax $350,000
Tax (170,000)
Preference Dividend ($30,000)
Ordinary Dividend ($50,000)
PE (for similar company) = 15
What is the value of 150,000 shares?

Strength
• Takes into account earning capacity of the entity.
• Permit boot strapping.
 70
Financial Management

Weaknesses
• May require adjustment to P/E ratio of a similar company to make it
suitable to the target company.
• P/E ratio is based on historic earnings and may not reflect the true
earning capacity of the company.

• Earnings yield
The earnings yield is simply the inverse of the PE ratio:

EPS/ Price per share

It can therefore be used to value the shares or market capitalisation of a

company in exactly the same way as the PE ratio:
Value of company = Total earnings × (1 /earnings yield)
Value per share = EPS × (1/ earnings yield)
If there is a growth in earnings
Value of company = (total earnings*(1+g))/(earnings yield-g)

3. CASHFLOW BASED METHODS

a. dividend valuation model (or growth model)
This model suggests that the market value of a share is the PV of all future
dividends discounted at the shareholders’ required rate of return.
DVM can be with or without growth.

DVM without Growth

P = D /re
Note:
• re - This is the return required by ordinary shareholders. Just as with
P/E ratios, re would be estimated from appropriate listed companies.
This will be given in question, or calculated via CAPM
• Take this share price and multiply it by the number of shares

DVM with growth

P = D0(1 + g)/(re– g)
Note: Dividend + growth = Dividend at the end of year 1.
 71
Financial Management

Question 5: A company has the following financial information available:

Share capital in issue: 4 million ordinary shares at a nominal value of 50c.
Current dividend per share (just paid) 24c. Dividend four years ago 15.25c.
Current equity beta 0.8.
You also have the following market information:
• Current market returns 15%.
• Risk-free rate 8%.
Find the market capitalisation of the company.

Question 6: A company has the following financial information available:

Share capital in issue: 2 million ordinary shares at a nominal value of $1.
Current dividend per share (just paid) 18c. Current EPS 25c. Current return
earned on assets 20%. Current equity beta 1.1.
You also have the following market information:
• Current market returns 12%.
• Risk-free rate 5%.
Find the market capitalisation of the company.

Strengths
• Can be used to value any proportion of shareholdings
• Theoretically sound

Weaknesses
• It relies on the estimates of growth rates and the discount rates.
• Assume growth rate to be constant
• Does not take into account earnings.

b. DISCOUNTED CASHFLOWS
The maximum value of the business is: PV of future cash flows
Vco = Annual cashflow / WACC
With growth:
Vco = CF0(1+g)/ WACC – g
Ve = vco – vd
Advantages
• theoretically the best method.
• can be used to value part of a company.
• based on free cashflows and can incorporate any synergies.
 72
Financial Management

Weaknesses
• it relies on estimates of both cash flows and discount rates – may
be unavailable
• assumes that the discount rate, tax and inflation rates are constant
through the period.

Question 7: ABC Co is considering acquiring the ordinary share capital of

XYZ Co. XYZ Co has for years generated an annual cash inflow of $20m.
ABC Co has a cost of capital of 10%. What is the value of XYZ Co?
For a one-off investment of $10m in new machinery, earnings for XYZ Co
can be increased by $4m per year. What is the value of XYZ Co?

Question 8: Revenue - $200m, cost of sales - $110m, Distribution &

admin - $20m, Tax allowable depreciation - $40m, annual capital spending
50m, tax rate - 30%, value of the debt - $17m, nominal WACC - 14.4%,
general inflation rate - 4%. These cashflows are expected to continue every
year for foreseeable future. Calculate value of equity?

Valuation of preference shares and debt

• Preference shares
P0 = d/kp
d = % dividend * nominal value per share
Question 9: A firm has in issue 10% preference shares with a face value of
$100. The return required by preference shareholders is 12%. Calculate
the value of one preference share of the company?
• Irredeemable debt
P0 = interest/ kd
Nominal value = $100
Interest should be before tax
Question 10: Coupon rate of irredeemable bond is 9%. Required return of
the investors is 7%. Calculate the value of the debt of the company?
 73
Financial Management

• Redeemable debt
Value of redeemable debt = present value of interest and redemption value
discounted at required rate of return.
Question 11: 9% redeemable debt, redeemable at a premium of 10% of
the nominal value of $100 after 10 years. Required return by the investor is
5%. Tax rate 40%. Calculate the value of the debt of the company?

• Convertible debt
The market value of a convertible is the higher of its value as debt and its
converted value. This is known as its formula value. Additional values you
may be asked for regarding convertible debt are:

Floor value = market value without the conversion option

= PV of future interest and redemption value, discounted at the debt
holders’ required return.

Conversion premium = market value – current conversion value.

Question 12: 9% of bond, redeemable at their par value of $100 in five
years’ time. Alternatively, each bond may be converted on that date into 20
ordinary shares of the company. Current ordinary share price of the
company is 4.45 and this is expected to grow at a rate of 6.5% per year.
Cost of debt of the company is 7%. Calculate Market value, Floor value and
Conversion premium for each bond?
 74
Financial Management

EFFICIENT MARKET HYPOTHESIS (EMH)

EMH is concerned with how efficient the stock markets are at pricing
shares; it measures how much information is incorporated in the shares.
This provides us an indication of the extent to which the market price is a
true measure of the company’s worth.

Level of efficiency;
No efficiency
In stock market with no efficiency, share prices do not reflect any
information (not even historic information).
Implications- it is possible to earn above-average returns by anyone
analyzing past (historic) information.

Weak form efficiency

In its weak form the stock market is said to reflect all information from past
share prices.
• Share prices reflect past information only
• Investors cannot generate abnormal returns by analysing past
information
• Share prices appear to follow a ‘random walk’ by responding to new
information as it becomes available

Implications- it is possible to earn above-average returns by anyone

analyzing current publicly available information.

Semi-strong form efficiency

In its semi-strong form, the market is said to reflect all historic
information and all information available in public domain. As new
information is released publicly, the share price will respond (move up or
down) accordingly. Investors cannot generate abnormal returns by
analysing public information as share prices respond quickly and accurately
to new information as it becomes publicly available
Implications- it is possible to earn above-average by anyone accessing
private information.
Strong form efficiency
In its strong form the market is said to reflect all information; past, public
and private information.
Even investors with access to insider information cannot generate
abnormal returns in such a market

Implications- it is not possible to earn above-average returns.

 75
Financial Management

SUMMARY
The more efficient the market is the more managers and investors can rely
on the stock market prices to reflect the value of debt and equity.

Stock markets are semi-strong

Managers will not be able to deceive the market by the timing or
presentation of new information, such as annual reports or analysts’
briefings, since the market processes the information quickly and
accurately to produce fair prices.
Managers should therefore simply concentrate on making financial
decisions which increase the wealth of shareholders.

BEHAVIORAL FINANCE
Behavioral finance attempts to explain how decision makers take financial
decisions in real life, and why their decisions might not appear to be
rational every time and, hence, have unpredictable consequences.
Behavioral finance describes as ‘the influence of psychology on the
behavior of financial practitioners.’

Herding
Herding refers to when investors buy or sell shares in a company or sector
because many other investors have already done so. Explanations for
investors following a herd instinct include social conformity, the desire not
to act differently from others. Following a herd instinct may also be due to
individual investors lacking the confidence to make their own judgment,
believing that a large group of other investors cannot be wrong.
If many investors follow a herd instinct to buy shares in a certain sector.
This can result in significant price rises for shares in that sector and lead to
a stock market bubble.

Market paradox
One aspect to understand is the market paradox. This occurs because in
order for markets to be efficient, investors have to be believed that they are
inefficient. This is because if investors believe markets are efficient, have
would be no point in actively trading shares - which would mean that
markets would not react efficiently to new information.
 76
Financial Management

Noise traders
There is also evidence to suggest that stock market ‘professionals’ often do
not base their decisions on rational analysis. Studies have shown that there
are traders in stock market who do not base their decisions on fundamental
analysis of company performance and prospects. They are known as noise
traders. Characteristics associated with noise traders include making poorly
timed decisions and following trends.

Loss aversion
Some investors may have loss aversion, avoiding investment that have the
risk of making losses, even though expected value analysis suggest that, in
the long-term, they will make significant capital gain. Investors with loss
aversion may also prefer to invest in companies that look likely to stable,
but low, profits, rather than companies that may make higher profits in
some years but possibly losses on others. Traditional finance assumes that
a rational investor is risk averse (not loss averse).

Momentum effect
There may be momentum effect in stock markets. A period of rising share
prices may result in a general feeling of optimism that prices will continue to
rise and an increased willingness to invest in companies that show
prospects for growth. If a momentum effect exists, then it is likely to
lengthen periods of stocks market boom or bust.
 77
Financial Management

Chapter 5

CAPITAL STRUCTURE
The capital structure of a company refers to the mixture of equity and debt
finance used by the company to finance its assets. Some companies could
be all-equity-financed and have no debt at all, whilst others could have low
levels of equity and high levels of debt. The decision on what mixture of
equity and debt capital to have is called the financing decision.
The financing decision has a direct effect on the weighted average cost of
capital (WACC). The WACC is the simple weighted average of the cost of
equity and the cost of debt. The weightings are in proportion to the market
values of equity and debt; therefore, as the proportions of equity and debt
vary, so will the WACC. Therefore, the first major point to understand is
that, as a company changes its capital structure (i.e., varies the mixture of
equity and debt finance), it will automatically result in a change in its
WACC.

Operational gearing
Operating gearing is a measure which seeks to investigate the relationship
between the fixed operating costs and the total operating costs.

• In cases where a business has high fixed costs as a proportion of its

total costs, the business is deemed to have a high level of operational
gearing. The greater the operating gearing the greater the EBIT
variability.

• If there is a fall in demand, the proportion of fixed costs to revenue

becomes even greater. It may turn profits into serious losses.
 78
Financial Management

Question 1: Two firms have the following cost structures:

X Y
Sales 100,000 100,000
Variable cost 60,000 20,000
Fixed cost 20,000 60,000
EBIT 20,000 20,000

What is the level of operating gearing in each and what would be the
impact on each of a 10% increase in sales?
Financial gearing
Financial gearing is a measure of the extent to which debt is used in the
capital structure.
Note that preference shares are usually treated as debt.
It can be measured in a number of ways:

• Since preference shares are treated as debt finance, preference

dividends are treated as debt interest in this ratio
• capital gearing is used more often than equity gearing
• interest gearing inverse form as the interest cover ratio

• Interest cover is a measure of the adequacy of a company’s profits

relative to interest payments on its debt. The lower the interest cover,
the greater the risk that profit (before interest) will become insufficient
to cover interest payments.
 79
Financial Management

Optimum capital structure

Is it possible to increase shareholder wealth by changing the capital
structure?
wealth is the present value of future cash flows discounted at the investors’
required return; the market value of a company is equal to the present
value of its future cash flows discounted by its WACC.

Market value of a company = Future cash flows / WACC

It is essential to note that the lower the WACC, the higher the market value
of the company – as you can see from the following simple example; when
the WACC is 15%, the market value of the company is 667; and when the
WACC falls to 10%, the market value of the company increases to 1,000.

Market value of a company

100/ 0.15 = 667

100/0.10 = 1,000

Hence, if we can change the capital structure to lower the WACC, we can
then increase the market value of the company and thus increase
shareholder wealth.

Therefore, the search for the optimal capital structure becomes the search
for the lowest WACC, because when the WACC is minimised, the value of
the company/shareholder wealth is maximised. Therefore, it is the duty of
all finance managers to find the optimal capital structure that will result in
the lowest WACC.

What mixture of equity and debt will result in the lowest WACC?
To answer this, we have to turn to the various theories that have developed
over time in relation to this topic.
 80
Financial Management

Capital structure Theories

1. The Traditional Theory

Here, suggests that using some debt will lower the WACC, but if gearing
rises above an acceptable level then the cost of equity will rise dramatically
causing the WACC to rise. Taxation is ignored in the traditional view.

At low levels of gearing the cheap cost of debt (as it is ranked before
equity in terms of distribution of earnings and on liquidation), will cause the
WACC to fall as borrowing increases.

However, as gearing increases after a certain point, shareholders

increase their required return (i.e., the cost of equity rises). This is because
there is much more interest to be paid before they get their dividends.

At very high levels of gearing the cost of debt also rises because the
chance of the company defaulting on the debt is higher (i.e., bankruptcy
risk).

So, at higher gearing, the WACC will increase.

Conclusion
There is an optimal level of gearing, the overall return required by investors
(debt and equity) is minimised.
 81
Financial Management

Implication for finance

Company should gear up until it reaches the optimal point and then raise a
mix of finance to maintain this level of gearing in the future.

Problem
There is no method, apart from trial and error, available to locate the
optimal point.

2. Modigliani and Miller ‘s Theory (MM) (without tax)

The use of debt transfers more risk to shareholders, and this makes
equity more expensive so that the use of debt does not reduce the
WACC.

Modigliani and Miller views

In order to demonstrate a workable theory, MMs made a number of

simplifying assumptions:

1. The capital market is perfect

2. No transaction costs
3. Taxation is ignored
4. Debt is risk free
 82
Financial Management

Main idea
Debt or Equity - it doesn’t matter. The WACC remains the same
throughout.
As a company takes on more debt, the equity holders take on a little more
risk.
The more debt brings the WACC down but the extra risk for equity holders,
increases Cost of Equity and so the WACC comes back up again.

Conclusion
The WACC and therefore the value of the firm is unaffected by changes in
gearing levels and gearing is irrelevant.

Implication for finance

choice of finance is irrelevant to shareholder’s wealth; company can use
any mix of funds.

3. M&M (with tax)

If debt also saves corporation tax, then it does reduce finance costs, which
benefits shareholders i.e., it reduces the WACC.

This suggests that a company should use as much debt finance as it can.
 83
Financial Management

Main idea
If Debt gets tax relief and equity doesn't then the straight-line graph is
wrong. The tax will make debt cheaper than equity and so more debt is
advantageous at all levels.
However, this still presumes a perfect market where people don't worry
about bankruptcy risk - they do!
Therefore, at higher levels of debt, WACC would actually rise in the real,
imperfect market.

Conclusion
Gearing up reduces the WACC and increases the MV of the company. The
optimal capital structure is 99.9% gearing.

Implications for finance: The company should use as much debt as

possible.

Market imperfections
There is clearly a problem with Modigliani and Miller’s with-tax model,
because companies’ capital structures are not almost entirely made up of
debt. Companies are discouraged from following this recommended
approach because of the existence of factors like bankruptcy costs, agency
costs and tax exhaustion. All factors which Modigliani and Miller failed to
take in account.

The problems of high gearing

In practice, firms are rarely found with very high levels of gearing. This is
because of:

• bankruptcy risk

• agency costs

• tax exhaustion

• the impact on borrowing/debt capacity

• differences in risk tolerance levels between shareholders and directors

• restrictions in the articles of association

• increases in the cost of borrowing as gearing increases.

 84
Financial Management

Tax exhaustion
as company gears up, interest payments rise, and reach a point that they
are equal to the profits from which they are to be deducted; therefore, any
additional interest payments beyond this point will not receive any tax relief.

Agency costs
As gearing increases, debt-holders would want to impose more constrains
on the management to safeguard their increased investment. Extensive
covenants reduce the company’s operating freedom, investment flexibility
(positive NPV projects may have to be forgone) and may lead to a
reduction in share price.

4. Pecking Order Theory

This simply suggests that firms do not look for an optimum capital structure
rather they raise funds as follows:

1. Use all retained earnings available;

2. Then issue debt;
3. Then issue equity, as a last resort.

The justifications of the pecking order are:

1. Minimise issue costs

a. Retained earnings have no issue costs as the company already
has the funds
b. Issuing debt will only incur moderate issue costs
c. Issuing equity will incur high levels of issue costs

2. Minimise the time and expense involved in persuading outside

investors
a. As the company already has the retained earnings, it does not
have to spend any time persuading outside investors
b. The time and expense associated with issuing debt is usually
significantly less than that associated with a share issue
 85
Financial Management

Creditor hierarchy
When a company cannot pay its debts and goes into liquidation, it must pay
its creditors in the following order:
1. Creditors with a fixed charge
2. Creditors with a floating charge
3. Unsecured creditors
4. Preference shareholders
5. Ordinary shareholders

Each of the above will cost the company more as it heads down the
list. This is because each is taking more risk itself.

When to use WACC to appraise investments

The WACC calculations we made earlier were all based on current costs
and amounts of debt and equity.

So use this as a cost for other future projects where:

1. Debt/equity amounts remain unchanged – Financial risk is

unchanged
2. Operating risk (business risk) of the firm will not be changed
(otherwise ke will change and so will the WACC)
3. Finance is not project specific (so the average is applicable)
4. Project is relatively small so any changes to the company are
insignificant.

If any of these criteria are not met, it will not be appropriate to appraise a
project using the historic WACC.

If Capital structure is changed by a finance raised for an investment

project, it may be appropriate to use the marginal cost of capital rather than
the WACC.

Marginal Cost of Capital

It is the additional cost the firm will pay to raise an additional dollar of
capital. If a company gets a specific loan or equity to finance a specific
project then this loan/equity cost is the marginal cost of capital.

Marginal Cost of Capital = Cost of New Capital Raised

 86
Financial Management

Example: Company present capital structure has funds from three different
sources i.e., equity capital, preference share capital and the debt. Now the
company wants to expand its current business and for that purpose, it
wants to raise the funds of $100,000. The company decided to raise capital
by issuing equity in the market as according to the present situation of a
company it is more feasible for the company to raise capital through the
issue of equity capital rather than the debt or preference share capital. The
cost of issuing equity is 10%. then marginal cost of capital is 10%.

If investment is of a different risk profile, it may be appropriate to use

Risk adjusted WACC.
Risk adjusted WACC (Project specific discount rate)
A risk adjusted WACC is needed to calculate a project NPV if the financial
risk of the company is expected to stay constant but the business risk
is expected to change significantly as a result of undertaking a project.
If the business risk of the new project is different from the business risk of
a company's existing operations, the company's shareholders will expect a
different return to compensate them for this new level of risk.
Hence, the appropriate WACC which should be used to discount the new
project's cash flows is not the company's existing WACC, but a "risk
adjusted" WACC that incorporates this new required return to the
shareholders (cost of equity).
Calculating a risk-adjusted WACC

there are two types of beta:

Asset beta – measures the business risk of a company (Ungeared beta).
Equity beta – measures the business risk and financial risk of a company
(Geared beta).
Example: all-equity financed company has only asset beta and geared
company has both asset beta and equity beta.

(1) Find the appropriate equity beta to match the business activities of the
project from a suitable similar quoted company.
(2) Adjust the available equity beta to convert it to an asset beta –
de-gear it.
(3) Readjust the asset beta to reflect the project (i.e. its own) gearing levels
- regear the beta.
(4) Use beta to find Ke using CAPM.
(5) Use this Ke to find the WACC.
(6) Evaluate the project by calculating a NPV
 87
Financial Management

Find an appropriate asset beta

asset beta formula given to you in the exam:

Ve
βa = βe ×
Ve + Vd (1– T)
where:
Ve = market value of equity
Vd = market value of debt
T = corporation tax rate.

Question 2: Soft wash company is a soap manufacturer whose equity:

debt ratio is 4:2. Equity beta of the company is 1.2. The company is
considering a shoe manufacturing project. Adidas is a shoe manufacturing
company. It has an equity beta of 1.8 and equity: debt ratio is 5:2. Soft
wash maintains its existing capital structure after the implementation of the
new project. Risk free rate - 6%, average return on stock market - 15%,
Tax rate -30%. What would be a suitable risk adjusted cost of equity apply
to the project?
Question 3: B Co is a hot air balloon manufacturer whose equity: debt ratio
is 5:2. The corporate debt, which is assumed to be risk-free, has a gross
redemption yield of 11 %. The beta value of the company’s equity is 1.1.
The average return on the stock market is 16%. The corporation tax rate is
30%. The company is considering a water bed manufacturing project.
S Co is a water bed manufacturing company. It has an equity beta of 1.59
and an equity: debt ratio of 2:1.
B Co maintains its existing capital structure after the implementation of the
new project. What would be a suitable risk adjusted cost of equity to apply
to the project?
 88
Financial Management

Question 4: AD Co’s equity: debt ratio is 4:2. The beta value of the
company’s equity is 1.3. The average return on the stock market is 18%.
Risk free rate of return is 8%. The corporation tax rate is 30%. The
company is considering a new manufacturing project. S Co is
manufacturing company (proxy company).
It has an equity beta of 1.4 and an equity: debt ratio of 3:2.
AD Co maintains its existing capital structure after the implementation of
the new project. What would be a suitable risk adjusted cost of equity to
apply to the project?
Question 5: Two companies are identical in every respect except for their
capital structure. XY plc has a debt: equity ratio of 1:3 and an equity beta of
1.2. PQ plc has a debt: equity ratio of 2:3. Corporation tax is 30%. What is
an appropriate equity beta for PQ plc?
Question 6: DR Co’s equity: debt ratio is 6:3. The beta value of the
company’s equity is 1.7. The average return on the stock market is 19%.
Risk free rate of return is 7%. The corporation tax rate is 30%. The
company is considering a new manufacturing project. Z Co is
manufacturing company (proxy company).
It has an equity beta of 1.2 and an equity: debt ratio of 2:2.
DR Co maintains its existing capital structure after the implementation of
the new project. What would be a suitable risk adjusted cost of equity to
apply to the project?
Question 7: SD Co’s equity: debt ratio is 3:2. The beta value of the
company’s equity is 1.3. The average return on the stock market is 20%.
Risk free rate of return is 8%. The corporation tax rate is 30%. The
company is considering a new manufacturing project. QR Co is
manufacturing company (proxy company).
It has an equity beta of 1.3 and an equity: debt ratio of 4:3.
SD Co maintains its existing capital structure after the implementation of
the new project. What would be a suitable risk adjusted cost of equity to
apply to the project?
 89
Financial Management

Chapter 6
FINANCIAL RATIOS
The importance of financial ratios
Ratio analysis is the process of comparing and quantifying relationships
between financial variables, such as those variables found in the statement
of financial position and statement of profit or loss of a company.
The ability to carry out effective ratio analysis and to be able to interpret
the meaning of ratios is fundamental to the FM syllabus.

Categories of ratios
▪ PROFITABILITY RATIOS
These are measures of value added being generated by an organisation
and include the following:

ROCE Operating Profit (PBIT)/Capital Employed

Capital Employed Equity + LT liabilities

Capital Employed Non-current assets + net current assets

Capital Employed Total assets - current liabilities

Gross margin Gross Profit/Sales

Net Margin Net Profit/Sales

ROE Profit After Tax - Preference

dividends/Shareholders’ Funds (Ordinary shares
+ Reserves)
 90
Financial Management

▪ EFFICIENCY RATIOS
These are measures of utilisation of Current & Non-current Assets of
an organisation. Efficiency ratios consist of the following:

Asset Sales/Capital Employed

Turnover
ROCE Margin X Asset Turnover
(Dupont)
Receivables (Receivables Balance / Credit Sales) x 365
Days
Payables (Payable Balance / Credit Purchases) x 365
Days
Inventory (Inventory / Cost of Sales) x 365
Days

▪ LIQUIDITY & GEARING RATIOS

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

Liquidity
Current Ratio Current Assets / Current Liabilities
Quick Ratio (Current Assets – Inventory) / Current Liabilities
Gearing
Financial Debt/Equity
Gearing
Financial Debt/(Debt + Equity)
Gearing
Operational Contribution / PBIT
gearing
 91
Financial Management

▪ INVESTOR'S RATIOS
These ratios measures return on investment generated by stakeholders.
Such ratios include:

Dividend Profit After Tax / Total Dividend

Cover
Dividend Dividends per share / Share price
Yield Or
Total annual dividend/ Market capitalisation
Interest PBIT / Interest
Cover
Interest (Interest rate / market price) x 100%
yield
Earnings Profit After Tax and preference dividends / Number
Per Share of Shares
PE Ratio Share Price / EPS
Total DPS + change in share price /Share price at start of
shareholder period
return
(TSR)

Return on Capital employed (ROCE)

It shows the profit that is generated from each $1 of assets employed. A
high ROCE is desirable.

Return on Equity (ROE)

It shows the profit that is generated from each $1 of equity share capital
and reserves employed. A high ROE is desirable.

Inventory days
• A financial measure of a company’s performance that gives investors
an idea of how long it takes a company to turn its inventory (including
goods that are work in progress, if applicable) into sales.
• Generally, the lower (shorter) the better, but it is important to note
that the average varies from one industry to another.
• This measure is one part of the cash conversion cycle (operating
cycle), which represents the process of turning raw materials into
cash.
 92
Financial Management

Raw material inventory holding period

The length of time raw materials are held between purchase and being
used in production.
Calculated as: = Raw material inventory / Material usage × 365
NB. Where usage cannot be calculated, purchases give a good
approximation.
WIP holding period
The length of time goods spends in production.
Calculated as: = Work-in-progress inventory held / Production cost × 365
NB. Where production cost cannot be calculated, cost of goods sold gives
a good approximation.
Finished goods inventory period
The length of time finished goods are held between completion or purchase
and sale.
Calculated as: = Finished goods inventory held / Cost of goods sold × 365
Inventory turnover
For each ratio, the corresponding turnover ratio can be calculated as:
Inventory turnover (no of times) = Cost / Average inventory held
Generally, this is less useful in the examination.

Receivables days
The Average Collection Period measures the average number of days it
takes for the company to collect revenue from its credit sales.
This ratio reflects how easily the company can collect on its customers.
It also can be used as a gauge of how loose or tight the company maintains
its credit policies.
This could temporarily boost sales, but could also result in an increase in
sales revenue that cannot be recovered, as shown in the Allowance for
Doubtful Debts.
 93
Financial Management

Payable days
It measures the average amount of time you use each dollar of your trade
credit.
A longer average payable period allows you to maximize your trade credit.
This means that you are delaying spending cash and taking full advantage
of trade credit.

Working capital Cycle (Cash conversion cycle or Cash Operating

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

Net operating cycle = Inventory days + Receivable days - Payable days

Day 1 Buy an item on credit (Payable)

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

How long is the item in stock for? 4 days

How long is the receivable period? 5 days
How long is the payable period? 7 days
How long between having to pay and receiving the cash? 2 days

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

Current Ratio
What this ratio basically tells us is if the company had to sell all its readily
available assets, would it be able to pay off its immediate debt?
At a minimum, you would hope the company whose financial performance
you are analysing could meet pay its current liabilities if it were to liquidate
all its current assets.
As with all the other performance ratios, the Current Ratio value depends
on the industry in which the company is operating.

Quick Ratio
Not every company can quickly convert its Inventory into cash in the event
it had to pay all its current liabilities. Therefore, the Quick Ratio is a tougher
way to test the company’s ability to meet its current debt load.
If a company you are analysing looks good while testing it against the
Current Ratio, then the Quick Ratio should be your next test to apply.
 94
Financial Management

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

Price earnings ratio (P/E ratio)

This is an indicator of investor confidence in future prospects of the
company. A high P/E ratio indicates that shareholders are willing to pay a
higher price for the share relative to its earnings as they have more
confidence in the company.

Total shareholder returns

It is a measure of the performance of a company’s shares over time.
It combines share price appreciation and dividends paid to show the total
return to the shareholder expressed as a percentage.
 95
Financial Management

Chapter 7
Working Capital Management
Working capital is simply the money needed for day-to-day operations of an
organisation, normally excess of current assets over current liabilities.

Working capital = current assets - current liabilities

Liquidity vs profitability problem

Examples:
1. Offering credit to customers – attracts more customers so improves
profitability but reduces liquidity)
2. Offering an early settlement discount to customers – (improves liquidity
but reduces profitability)
3. Consider this: You are the MD of a new company selling i-pads. The
demand is looking good, your natural inclination is probably to buy more
in, to sell in the future. We call this a short-term investment. You have
invested in inventory to boost profits. But you should maintain enough
to pay short term payables. We call this liquidity.
So, you would like to use the working capital for both Short-term
investment and Liquidity. Hopefully you can see that part of you wants to
invest the money and other wishes to save to pay bills.

This is the conflict of working capital objectives.

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

Company should find the right balance between profitability and liquidity.

Managing working capital

The investment made in the current assets or short-term assets is termed
as Working Capital Management. The working capital management deals
with the management of current assets that are highly liquid in nature.

The amounts invested in working capital are often high in proportion to the
total assets employed and so it is vital that these amounts are used in an
efficient and effective way.

Holding too much working capital is inefficient, holding too little is

dangerous to the organisation’s survival.
 96
Financial Management

There are two decisions that a business must make with regards to its
working capital:

1. The level of investment required in current assets.

2. The type of finance used to fund these assets.

1. The level of investment required in current assets

1. A high level of investment in current assets brings the advantage of
being able to respond the changes in the needs of an organisation
but at the same time increases the cost of holding high levels of
current assets such as inventory, receivables and cash.
2. If too little is invested in current assets, the company may not be able
to respond the changes in demand and business conditions but it
may be less expensive alternative.

Factors that must be considered when determining the level of

investment in current assets:

a. Length of working capital cycle

The working capital cycle or operating cycle is the period of time
between when a company settles its accounts payable and when it
receives cash from its accounts receivable. Operating activities
during this period need to be financed and as the operating period
lengthens, the amount of finance needed increases.

b. Industry in which organisation operates

Another factor that influences the level of investment in current
assets is the industry within which an organisation operates. Some
industries, such as aircraft construction, will have long operating
cycles due to the length of time needed to manufacture finished
goods and so will have comparatively higher levels of investment in
current assets than industries such as supermarket chains, where
goods are bought in for resale with minimal additional processing and
where many goods have short shelf lives.

c. Terms of trade
These determine the period of credit extended to customers, any
discounts offered for early settlement or bulk purchases, and any
penalties for late payment. A company whose terms of trade are
more generous than another company in the same industry sector
will therefore need a comparatively higher investment in current
assets.
 97
Financial Management

d. Policy on level of investment in current assets

Even within the same industry sector, companies will have different
policies regarding the level of investment in current assets,
depending on their attitude to risk. A company with a comparatively
conservative approach to the level of investment in current assets
would maintain higher levels of inventory, offer more generous credit
terms and have higher levels of cash in reserve than a company with
a comparatively aggressive approach. While the more aggressive
approach would be more profitable because of the lower level of
investment in current assets, it would also be more risky.

2. The type of finance used to fund current assets

1. Short term finance – generally cheaper, but carries high refinancing
risk. Examples: Trade credit, overdraft, commercial bank loans,
commercial paper etc…
2. Long term finance – more expensive, but carries lower refinancing
risk. Examples: equity shares, preference shares, debentures, etc…

WORKING CAPITAL FINANCING STRATEGY OR WORKING CAPITAL

FINANCING POLICY
When considering the financing of working capital, it is useful to divide
current assets into fluctuating current assets and permanent current assets.
Fluctuating current assets represent changes in the level of current
assets due to the unpredictability of business activity. Permanent
current assets represent the core level of investment in current assets
needed to support a given level of revenue or business activity,
example - a buffer level of inventory, a minimum level of cash kept in the
bank etc.
The financing choice as far as working capital is concerned is between
short‐term and long‐term finance. Short‐term finance is more flexible than
long‐term finance: an overdraft, for example, is used by a business
organisation as the need arises and variable interest is charged on the
outstanding balance. Short‐term finance is also more risky than long‐term
finance: an overdraft facility may be withdrawn, or a short‐term loan may be
renewed on less favourable terms. In terms of cost, the term structure of
interest rates suggests that short‐term debt finance has a lower cost than
long‐term debt finance.
 98
Financial Management

The matching principle suggests that long‐term finance should be used for
long‐term investment. Applying this principle to working capital financing,
long‐term finance should be matched with permanent current assets and
non‐current assets.
The different financing strategies are provided below:
1. Conservative Financing Strategy OR Conservative Financing policy
2. Aggressive Financing Strategy OR Aggressive Financing policy
3. Moderate Financing Strategy OR Moderate Financing policy

An aggressive financing policy means that fluctuating current assets and a

portion of permanent current assets are financed from a short‐term finance
source. A conservative financing policy means that permanent current
assets and a portion of fluctuating current assets are financed from a long‐
term source.
An aggressive financing policy will be more profitable than a conservative
financing policy because short‐term finance is cheaper than long‐term
finance, as indicated for debt finance by the normal yield curve (term
structure of interest rates).
However, an aggressive financing policy will be riskier than a conservative
financing policy because short‐term finance is riskier than long‐term
finance. For example, an overdraft is repayable on demand, while a short‐
term loan may be renewed on less favourable terms than an existing
loan. Provided interest payments are made, however, long‐term debt will
not lead to any pressure on a company and equity finance is permanent
capital.
Moderate financing policy (Matching) means that fluctuating current assets
are financed by short term finances source and permanent current assets
are financed by long term finance source, which means the duration of the
finance is matched to the duration of the investment.
 99
Financial Management

Risks
There are two main risks of not monitoring working capital:

1. Overtrading
2. Over-capitalisation

Overtrading Or Under-capitalisation
Overtrading arises when a company has too little capital to support its level
of business activity which means company is excessively reliant on short
term finance for funding working capital.

Difficulties with liquidity may arise as an overtrading company may have

insufficient capital to meet its liabilities as they fall due.
Indicators of overtrading are

• Is often associated with a rapid increase in turnover.

Investment in working capital does not match the increase in sales.
• Rapid decreases in the current ratio and the quick ratio.
• Significant percentage of short-term finance (CL) is used to fund CA.

Over-capitalisation
Over-capitalisation means that an entity has an excess of working capital.
Entities that carry excessive inventories, receivables and cash with few
payables have over-invested in current assets.
This presents an opportunity cost since such resources could be used to
generate returns elsewhere in the entity.
 100
Financial Management

Inventory Management
What Is Inventory Management?
Inventory management refers to the process of ordering, storing and using
a company's inventory.

A company's inventory is one of its most valuable assets. In retail,

manufacturing, food service and other inventory-intensive sectors, a
company's inputs and finished products are the core of its business. A
shortage of inventory can be extremely detrimental. At the same time a large
inventory carries the risk of spoilage, theft, damage or shifts in demand.

For these reasons, inventory management is important for businesses of any

size.

The objective of good inventory management is therefore to determine:

• the optimum re-order quantity – how many items should be ordered
when the order is placed, and
• the optimum re-order level – how many items are left in inventory when
the next order is placed.

Economic order quantity (EOQ)

The order quantity that minimises the total of inventory holding cost and
ordering cost.

Holding Costs
The more inventory you hold the more it costs. So, you should keep lower
inventory.
Example: Warehouse, Insurance, Obsolescence and Opportunity cost of
capital.

Ordering costs
• The more orders you make the more it costs.
So, you should order lots at a time, meaning fewer orders (but higher
stock). Example: Administration and Delivery costs.
• These two costs therefore work in opposite ways.
One suggests keep stocks low, the other keep stock high (to keep
orders down).

So, this where the EOQ model will help.

It is mathematically the perfect position, the perfect amount to order.

The position where total ordering and holding costs are at their lowest
This happens also to be where holding costs = ordering costs.
 101
Financial Management

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

How is this calculated?

(this formula is given in the exam) - Anyway here it is….

Where Co = Cost of placing one order; Ch = Cost of holding one unit for
one year. and D = annual demand

• Total annual Holding Costs:

Holding Cost per unit x (Order Quantity/ 2 + Buffer stock)

• Total annual Ordering Costs:

Order costs per order x (Annual Demand / Order Quantity)

• Total annual Purchasing Cost:

Total annual purchasing cost = Purchase price per unit x Annual
demand
Total annual cost = annual holding cost + annual ordering cost +
Annual purchasing cost.
 102
Financial Management

Re-order Level and Buffer Stock

The ROL is the quantity of inventory on hand when an order is placed.
When demand and lead-time are known with certainty the ROL = demand
in the lead-time.

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

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

Buffer Stock Can be calculated if not given:

• Actual re-order level - Stock used in lead time

Example 1: reorder level without safety stock

The David IT Store sells 500 laptops on an average in a week. The
maximum demand in a week is 523 laptops. If, the lead time is 4.5 week
then the reorder level would be:

Reorder level = Maximum weekly usage × Lead time in weeks

= 523 units × 4.5 weeks
= 2,354 units

It means that every time the number of laptops decreases to 2,354, the
David IT Store must place a new order.

Example 2: with safety stock

The following information belongs to Kim Kardashian Clothing Outlet:

• Maximum demand: 435 sweaters per month

• Safety stock: 120 sweaters
• Maximum lead time: 1.75 months

Required: Compute reorder level of Kim Kardashian Clothing Outlet.

Solution

Reorder level = (Maximum demand × Maximum lead time) + Safety stock

= (435 units × 1.75 weeks) + 120 units
= 761 units + 120 units
= 881 units
 103
Financial Management

Example 3: The material RX is used uniformly throughout the year. The

data about annual requirement, ordering cost and holding cost of this
material is given below:

• Annual requirement: 2,400 units

• Ordering cost: $10 per order
• Holding cost: $0.30 per unit

Required: Calculate the economic order quantity (EOQ), Total annual

holding cost and ordering cost of material RX using above data?

Solution:

Number of orders per year

= Annual demand/EOQ
= 2,400 units/400 units
= 6 orders per year

Ordering cost

= Number or orders per year × Cost per order

= 6 orders × $10
= $60

Holding cost

= Average units × Holding cost per unit

= (400/2) × 0.3
= $60
 104
Financial Management

Trial and error approach of determining economic order quantity

Example 4: The John Sports Inc. purchases tennis balls at $20 per dozen
from its suppliers. The John Sports will sell 34,300 dozens of tennis balls
evenly throughout the year. The total cost to handle a purchase order is
$10. The insurance, property tax and rent for each dozen tennis balls in the
average inventory is $0.40. The company wants a 5% return on average
inventory investment.

Required:

1. Compute the economic order quantity.

2. Compute the total annual inventory expenses to sell 34,300 dozens
of tennis balls if orders are placed according to economic order
quantity computed in part 1.

Solution:

1. Economic order quantity:

= 700 dozens

*$0.40 + ($20 × 5/100) = $1.4

 105
Financial Management

2. Total annual inventory expenses to sell 34,300 dozen of tennis

balls:

Number of orders to be placed: 34,300/700 = 49 orders

= Annual purchase cost + Annual ordering cost + Annual holding cost

= (purchase price × Annual demand) + (Number of orders × Cost per order)
+ (Average units × Holding cost per unit)
= ($20 × 34300) + (49 × $10) + [(700/2) × $1.4]
= $686,000 + $490 + $490
= $686,980

Question 1: Demand for the Child Cycle at Best Buy is 500 units per
month. Best Buy incurs a fixed order placement, transportation, and
receiving cost of $4,000 each time an order is placed. Each cycle costs
$500 and the retailer has a holding cost of 20 percent.

a. Evaluate the number of cycles that the store manager should order in
each replenishment lot?
b. Compute the total annual holding cost and ordering cost if orders are
placed according to economic order quantity
c. Compute the new annual holding cost if the company places an order
when inventory falls to 304 units and it takes 10 days for the supplier
to deliver the cycle.

Question 2: ABC Ltd. uses EOQ logic to determine the order quantity for
its various components and is planning its orders. The Annual consumption
is 80,000 units, Cost to place one order is Rs. 1,200, Cost per unit is Rs. 50
and carrying cost is 6% of Unit cost. Find EOQ, No. of order per year,
Ordering Cost and Carrying Cost and Total Cost of Inventory.

Question 3: A local TV repairs shop uses 36,000 units of a part each year
(A maximum consumption of 100 units per working day). It costs Rs. 20 to
place and receive an order. The shop orders in lots of 400 units. It cost Rs.
4 to carry one unit per year of inventory.

Requirements:
(1) Calculate total annual ordering cost
(2) Calculate total annual carrying cost
(3) Calculate total annual inventory cost
(4) Calculate the Economic Order Quantity
(5) Calculate the total annual cost inventory cost using EOQ inventory
Policy
(6) How much save using EOQ
(7) Compute ordering point assuming the lead time is 3 days
 106
Financial Management

EOQ with discounts

Bulk buying discounts may be available if the order quantity is above a
certain size.

To calculate the best order quantity then we need to:

1. Calculate EOQ in normal way (and the costs)
2. Calculate costs at the discount available units above EOQ.
3. Then choose the lowest cost option!

Example 5: Demand is 100 units per month. Purchase cost per unit $10.
Order cost $20
Holding cost 10% p.a. of stock value.

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

Solution

1. Calculate total cost at EOQ

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

• Ordering Costs
= Order cost per unit x (Annual Demand / Order amount)
= 20 x 1200 / 219 = $110
• Holding Costs
= Holding Cost per unit x (Order amount / 2)
= 1 x (219 / 2) = $110
• Annual purchase cost
= 100*12*10 = $12,000
Total cost = $12,220

2. Total cost at discount level of 350 units

Ordering Costs
= Order cost per unit x (Annual Demand / Order amount)
= 20 x 1200 / 350 = 69
• Holding Costs
= Holding Cost per unit x (Order amount / 2)
= 0.98 x 350 / 2 = 171.5
• Annual purchase cost
= 100*12*10*98% = 11,760
Total cost= 12000.5
Total cost at the discount level of 350 units is lower than the total cost at
EOQ. Company should take the discount and order at 350 units.
 107
Financial Management

Question 4: BIKO is a bike retailer located in the outskirts of Paris. BIKO

purchases bikes from PMX in orders of 250 bikes which is the current
economic order quantity. PMX is now offering the following bulk discounts
to its customers:
• 4% discount on orders above 500 units
• 6% discount on orders above 600 units
BIKO is wondering if the EOQ model is still the most economical and
whether increasing the order size would actually be more beneficial.
Following information is relevant to forming the decision:
• Annual demand is 5000 units
• Ordering cost is $100 per order
• Annual holding cost is comprised of the following:
5% insurance premium for the average inventory held during the year
calculated using the net purchase price. Warehousing cost of $6 per unit
Purchase price is $200 per unit before discount.
Requirement: compare the total inventory cost of the order quantities at
the various discount levels with that of the economic order quantity. Which
order size is more beneficial?

Just-in-time (JIT)
It is an inventory management method in which goods are received from
suppliers only as they are needed.
The main objective of this method is to reduce inventory holding
costs.
In order to achieve JIT the process must have signals of what is going on
elsewhere within the process. These signals tell production processes
when to make the next part. They can be simple visual signals.
Quick communication of the consumption of old stock which triggers new
stock to be ordered is key to JIT and inventory reduction.
JIT emphasises inventory as one of the wastes, and so aims to reduce
buffer inventory to zero.

Characteristics of a JIT system

1. Multi skilled workers
2. Close relationship with suppliers
3. Nil/negligible stock levels and stock costs.
4. Quality
5. Teams working in cell
6. Frequent deliveries of small orders
 108
Financial Management

Benefits of JIT system

1. Lower level of investment in working capital
2. A reduction in inventory holding costs
3. An improved relationship with suppliers
4. A reduction in materials handling costs
5. Improved operating efficiency
6. Lower reworking costs due to the increased emphasis on the quality
of supplies

Receivables Management
The receivable management concerned with determining optimum credit
policy associated to a firm, such that the benefit from extension of credit is
greater than the cost of maintaining investment in accounts receivables.
KEY ELEMENTS OF A RECEIVABLES MANAGEMENT SYSTEM
The key elements of a receivables management system may be described
as establishing a credit policy, credit assessment, credit control and
collection of amounts due.
Establishing credit policy
The credit policy provides the overall framework within which the
receivables management system of a company operates and will cover key
issues such as the procedures to be followed when granting credit, the
usual credit period offered, the maximum credit period that may be granted,
any discounts for early settlement, whether interest is charged on overdue
balances, and actions to be taken with accounts that have not been settled
in the agreed credit period.
Credit assessment
In order to minimise the risk of irrecoverable debts, company should assess
potential customers as to their creditworthiness before offering them credit.
The depth of the credit check depends on the amount of business being
considered and the potential for repeat business. The credit assessment
requires information about the customer, whether from a third party as in a
trade reference, a bank reference or a credit rating agency report. The
benefits of granting credit must always be greater than the cost involved.
There is no point, therefore, company paying for a detailed credit report
from a credit reference agency for a small credit sale.
 109
Financial Management

Credit control
Based on credit analysis, certain credit limits may be set for each customer.
Once the limit has been reached, no further goods are sold to the
customer.
Once company has granted credit to a customer, it should monitor the
account at regular intervals to make sure that the agreed terms are being
followed. An aged receivables analysis is useful in this respect since it
helps the company focus on those clients who are the most cause for
concern.
It is also important to ensure that administrative procedures are timely and
robust. Customers should be reminded of their debts by prompt despatch
of invoices and regular statements of account. Customers in arrears should
not be allowed to take further goods on credit.
Collection of amounts due
All customers of company should ideally settle their accounts within the
agreed credit period.
If this does not happen, a company needs to have in place agreed
procedures for dealing with overdue accounts. These may involve reminder
phone calls, personal visits, charging interest on outstanding amounts,
refusing to grant further credit and, as a last resort, legal action. With any
action, potential benefit should always exceed expected cost.
Factoring of trade receivables
Some companies choose to outsource management of trade receivables to
a factoring company, which can bring expertise and specialist knowledge to
the tasks of credit analysis, credit control, and collection of amounts owed.
In exchange, the factoring company will charge a fee, typically a
percentage of annual credit sales. The factoring company can also offer an
advance of up to 80% of trade receivables, in exchange for interest.
 110
Financial Management

Two commonly used methods of debt collection are:

1. Early settlement discounts

2. Debt factoring

Offering early settlement discounts

Cash discounts are given to encourage early payment by customers. The
cost of the discount is balanced against the savings the company receives
from having less capital tied up due to a lower receivables balance and a
shorter average collection period. Discounts may also reduce the number
of irrecoverable debts.

Receivables aren’t cash. So they need funding. Think of this being funded
by an overdraft. Therefore, the “overdraft rate x receivables” is the cost.

Early settlement discounts - $ Method

You need to compare the monetary cost of offering the discount with the
benefit that will be received (the lower financing costs resulting from the
reduced receivables balance).
Evaluation of change in credit policy
Benefits
Decrease in Financing cost (Interest savings)
Increased Contribution from additional sales
Decrease in irrecoverable debt
Costs
Cost of discount
Incremental cost
Increase in Financing cost (Interest expense)
Increase in irrecoverable debt

Decision rule: When Benefits ˃ Costs then discount should be offered

Question 5:
Credit sales – 20,000, Receivables – 4,500.
Company is now considering a new credit policy wherein customers would
be offered a 1.5% discount if payments are made within 20 days and 3% if
payments are made in 10 days. 20% and 30% of the customers are
expected to pay up within 10 days and 20 days respectively. Company
currently borrows from its lead bank at 13%. Evaluate whether the change
in policy is to be implemented or not by company?
 111
Financial Management

Question 6:
Credit sales – 35,000, Receivables – 5,000.
Company is now considering a new credit policy wherein customers would
be offered a 2% discount if payments are made within 20 days and 4% if
payments are made in 10 days. 15% and 20% of the customers are
expected to pay up within 10 days and 20 days respectively. Company
currently borrows from its lead bank at 12%. Evaluate whether the change
in policy is to be implemented or not by company?

Early settlement discounts - % Method

The calculation of the annual cost can be expressed as a formula:

Decision rule: If the cost of offering the discount exceeds the interest rate
of overdraft, then the discount should not be offered.
Question 7: A company is offering a cash discount of 2.5% to receivables
if they agree to pay debts within one week. The usual credit period taken is
nine weeks. 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?
Question 8: A company is offering a cash discount of 2% to receivables if
they agree to pay debts within 10 days. The usual credit period taken is 60
days. What is the effective annualised cost of offering the discount and
should it be offered, if the bank would loan the company at 14% pa?
Question 9: A company is offering a cash discount of 1.5% to receivables
if they agree to pay debts within 15 days. The usual credit period taken is
55 days. What is the effective annualised cost of offering the discount and
should it be offered, if the bank would loan the company at 16% pa?
Question 10: A company is offering a cash discount of 1.5% to receivables
if they agree to pay debts within one month. The usual credit period taken
is two months. What is the effective annualised cost of offering the discount
and should it be offered, if the bank would loan the company at 20% pa?
 112
Financial Management

Factoring
A third party (factor) take over a company’s credit control department for a
fee and forwards the company some money in advance, and then
collects the money from the debtors and keeps the money. The amount
forwarded here would be like a loan and so the factor would also charge
interest.

The deal may be “with recourse” or “without recourse”

1. With Recourse - the client must bear the loss from any irrecoverable
debt, and so has to reimburse the factor for any money it has already
received for the debt.
2. Without Recourse - Any bad debts are suffered by the Factor. factor
provides protection for the client against irrecoverable debts

Credit protection is provided only when the service is non-recourse

and this is obviously more costly.

Advantages Disadvantages
Admin Costs Saved Can be expensive
Reduction in the need for Could lose customer goodwill
management control.
Particularly useful for small and fast- May give a bad impression to
growing businesses where the credit customers
control department may not be able
to keep pace with volume growth.
Gets Cash Quickly The company may give up the
opportunity to decide to whom credit
may be given (non-recourse
factoring).
 113
Financial Management

Evaluating factoring deals

Benefits:
1. the savings on administration
2. any interest cost savings due to reduction in receivables
3. any reduction in bad debts.
Additional costs:
1. factoring fee
2. extra interest payable to factor on advanced funds.
Decision rule: When Benefits ˃ Costs then accept the factor’s offer.
Question 11: ABC Ltd currently has credit sales of $25m. Receivables
days is currently 40 days. Interest is charged on the overdraft at 12%. A
factoring company has offered its services on a recourse basis for an
annual fee of 0.85% of sales or on a non-recourse basis for an annual fee
of 1% of sales.
The factoring company can reduce receivables days to 15 days.
The factoring company will also provide an advance of 75% of the revised
receivables amount at an interest rate of 15%. As a result of the factors
expertise, the bad debts will fall from 1% of sales to 0.6% of sales.
The factor also generates an admin savings for the company of $15000.
Required: whether ABC Ltd should accept the factor’s offer either on:
a) Recourse basis
b) Non-recourse basis

Question 12: XYZ Ltd currently has credit sales of $10m. Receivables
days is currently 50 days. Interest is charged on the overdraft at 10%. A
factoring company has offered its services on a recourse basis for an
annual fee of 1% of sales or on a non-recourse basis for an annual fee of
1.5% of sales.
The factoring company can reduce receivables days to 20 days.
The factoring company will also provide an advance of 80% of the revised
receivables amount at an interest rate of 13%. As a result of the factors
expertise, the bad debts will fall from 2% of sales to 1% of sales.
The factor also generates an admin savings for the company of $3000.
Required: whether XYZ Ltd should accept the factor’s offer either on:
a) Recourse basis
b) Non-recourse basis
 114
Financial Management

Invoice Discounting
An invoice discounter purchases your debts at a discount. They do not
take over administration. Responsibility for collection of debts remains
with you and the service is normally undisclosed to customers.

Managing Foreign Receivables

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

These are the options to help:

1. Early payment
For example: by payment in advance, payment on shipment, or cash
on delivery. However, these terms of trade are unlikely to be
competitive.

2. Forfaiting
Forfaiting is a means of financing that enables exporters to receive
immediate cash by selling their medium and long-term receivables (the
amount an importer owes the exporter) at a discount through an
intermediary. The exporter eliminates risk by making the sale without
recourse. It has no liability regarding the importer's possible
default on the receivables.

The forfaiter is the individual or entity that purchases the receivables.

The importer then pays the amount of the receivables to the forfaiter. A
forfaiter is typically a bank or a financial firm that specializes
in export financing.

3. Export factoring
An export factor provides the same functions in relation to foreign
accounts receivable as a factor covering domestic accounts
receivable and therefore can help with the cash flow of a business.
However, export factoring can be more costly than export credit
insurance and it may not be available for all countries, particularly
developing countries.
Factoring deals in the receivable that falls due within 90 days. On the
other hand, Forfaiting deals in the accounts receivables whose
maturity ranges from medium to long term. Factoring involves the
sale of receivables on ordinary goods. Conversely, the sale of
receivables on capital goods are made in forfaiting.
 115
Financial Management

4. Countertrading
In a countertrade arrangement, goods or services are exchanged for
other goods or services instead of for cash.

5. Letter of credit
A letter of credit is a letter from a bank guaranteeing that a buyer's
payment (importer) to a seller (exporter) will be received on time and
for the correct amount. In the event that the buyer is unable to make
a payment on the purchase, the bank will be required to cover the full
or remaining amount of the purchase.

6. Export credit insurance

Export credit insurance protects a business against the risk of non-
payment by a foreign customer. Exporters can protect their foreign
accounts receivable against a number of risks that could result in
non-payment.
Export credit insurance usually insures the seller against commercial
risks, such as insolvency of the purchaser or slow payment, and also
insures against certain political risks, for example war, riots, and
revolution, which could result in non-payment.
It can also protect against currency inconvertibility and changes in
import or export regulations.

Accounts payable – managing trade credit

Trade credit is the simplest and most important source of short-term
finance for many companies.
Trade credit is normally seen as a ‘free’ source of finance. Whilst this is
normally true, it may be that the supplier offers a discount for early
payment. In this case delaying payment is no longer free, since the cost will
be the lost discount.
Decision rule for accepting discount offer: If the discount exceeds the
interest rate of overdraft, then the discount should be acceptable.
Question 13: One supplier has offered a discount to Box Co of 2% on an
invoice for $7,500, if payment is made within one month, rather than the
three months normally taken to pay. If Box’s overdraft rate is 10% pa, is it
financially worthwhile for them to accept the discount and pay early?

Question 14: Work out the equivalent annual cost of the following credit
terms: 1.75% discount for payment within three weeks; alternatively, full
payment must be made within eight weeks of the invoice date. Assume
there are 50 weeks in a year.
 116
Financial Management

By delaying payment to suppliers, companies face possible

problems:
• supplier may refuse to supply in future
• supplier may only supply on a cash basis
• there may be loss of reputation
• supplier may increase price in future.

Cash Management
Businesses needs to hold enough cash to ensure that they can meet their
short-term liabilities. However, surplus cash should not be held if it can
earn a higher return elsewhere.
Reasons for holding cash
• transactions motive - cash required to meet day-to-day expenses, e.g.
payroll, payment of suppliers, etc.
• precautionary motive - cash held to give a cushion against unplanned
expenditure.
• investment (speculative) motive - cash kept available to take
advantage of market investment opportunities, such as the opportunity to
buy a strategically useful piece of land.
Failure to carry sufficient cash levels can lead to:
• loss of settlement discounts
• loss of supplier goodwill
• poor industrial relations
• potential liquidation.

Cash budget
A cash budget is an estimation of the cash flows of a business over a
specific period of time. This could be for a weekly, monthly, quarterly, or
annual budget. This budget is used to assess whether the entity has
sufficient cash to continue operating over the given time frame. The cash
budget provides a company insight into its cash needs (and any surplus)
and helps to determine an efficient allocation of cash.
 117
Financial Management

Question 15:

Cash Management models

How much cash should a company hold?
The target cash balance involves a trade-off between the opportunity costs
of holding too much cash and the trading costs of holding too little.
For example: if we know a division needs $100,000 during the year, how
much should we transfer into their account (from their deposit account)?
All of it would mean some of the cash lying in the current account doing
nothing (not getting interest unlike in a deposit account) at the early stages.
Whereas, transferring bits at a time (when the cash is needed) would mean
lots of transaction costs.
 118
Financial Management

There are two cash management models:

• The Baumol model
• The Miller Orr model

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

Cost of holding cash (Opportunity cost)

= Average cash balance x Interest rate;
= Cash transferred in / 2 x interest rate

Transaction Costs
= Total cash used during period / Cash transferred in X Transaction cost
(Annual Demand/Amount cash ordered (transferred) x Cost per Order)

Total Cost = Opportunity cost + Transaction cost

To calculate the optimum amount of cash to transfer use this

equation:

Example 7:
Subsonic Speaker Systems (SSS) has annual transactions of $9 million.
The fixed cost of converting securities into cash is $264.50 per conversion.
The annual opportunity cost of funds is 9%. What is the optimum amount
of cash to be invested in each transaction?
Square root (2 x 264.5 x 9,000,000 / 0.09)
= 230,000
 119
Financial Management

Assumptions:
• cash use is steady and predictable
• cash inflows are known and regular
• day-to-day cash needs are funded from current account
• buffer cash is held in short-term investments.

Miller-Orr Model
This model deals with cash inflows/outflows that change on a daily basis
The model works in terms of upper and lower control limits, and a target
cash balance.

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

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

This lower limit can be related to a minimum safety margin decided
by management
2. Estimate Standard deviation of daily cash flows
3. Determine Interest Rate
4. Estimate the trading costs of buying and selling marketable
securities.

When the firm’s cash fluctuates at random and touches the upper limit, the
firm buys sufficient marketable securities to come back to a normal level of
cash balance i.e. the return point

Similarly, when the firm’s cash flows wander and touch the lower limit, it
sells sufficient marketable securities to bring the cash balance back to the
normal level i.e. the return point

The lower limit is set by the firm based on its desired minimum
“safety stock” of cash in hand.
 120
Financial Management

Spread = 3 x (3/4 x Transaction cost x Cashflow variance / interest

rate) power of 1/3

It is the difference between Upper limit and lower limit.

Return point = Lower Limit + (1/3 x spread)

Upper limit = lower limit + spread

Example 8:
If a company must maintain a minimum cash balance of £8,000, and the
variance of its daily cash flows is £4m (ie std deviation £2,000). The cost of
buying/ selling securities is £50 & the daily interest rate is 0.025%.
Required: Calculate the spread, the upper limit (max amount of cash
needed) & the return point (target level)

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

NOTE: The cashflow variance is daily. the standard deviation is the square
root of the variance. Therefore, if given the standard deviation then you
need to square it before putting it into the equation.
The interest rate is also a daily one. A quick (if oversimplified way) of
reaching this simply to divide the annual rate by 365)
 121
Financial Management

Calculate the spread, upper limit & return point for the following
questions?

Question 17: The management of Stilmill Inc. has set a safety cash
balance of $50,000.
The standard deviation (σ) of the daily cash balance during the last year
was $37,500, and the transaction cost was $75.
The company also has the opportunity to invest idle cash in marketable
securities at an annual interest rate of 8%.

Question 18: XYZ's management has put the minimum cash balance to be
equivalent to $10, 000. The standard deviation of daily cash flow is of $2,
500 and the interest rate on marketable securities is 9 percent per
annum. The transaction cost used for each sale or purchase of securities
is of $20.

Question 19: ABC's management has put the minimum cash balance to be
equivalent to $20,000.
The standard deviation of daily cash flow is of $3,000 and
the interest rate on marketable securities is 0.03% per day.
The transaction cost used for each sale or purchase of securities is of $50.
 122
Financial Management

Chapter 8

Risk Management
FOREIGN EXCHANGE RISK
Exchange rate risk arises as a result of purchasing and selling goods and
services internationally.
Changes in exchange rates result from changes in the demand and supply
of the currency. These changes may occur for a variety of reasons e.g. due
to changes in international trade or capital flows between economies.
Balance of payments
Since currencies are required to finance international trade, changes in
trade may lead to changes in exchange rates. In principle:
• demand for imports in the US represents a demand for foreign currency
or a supply of dollars
• overseas demand for US exports represents a demand for dollars or a
supply of the overseas currency.
Thus, a country with a current account deficit where imports exceed
exports may expect to see its exchange rate depreciate, since the
supply of the currency (imports) will exceed the demand for the currency
(exports).
Capital movements between economies
There are also capital movements between economies. These transactions
are effectively switching bank deposits from one currency to another.
These flows are now more important than the volume of trade in goods and
services.
Thus, supply/demand for a currency may reflect events on the capital
account. Several factors may lead to inflows or outflows of capital:
• changes in interest rates: rising (falling) interest rates will attract a capital
inflow (outflow) and a demand (supply) for the currency
• inflation: asset holders will not wish to hold financial assets in a currency
whose value is falling because of inflation.
 123
Financial Management

Types of foreign currency risk

1. Transaction risk
This is the risk arising on short-term foreign currency transactions that
the actual receipt or payments may be different from the receipt or
payment expected when the transaction was agreed.
• If value of the domestic currency appreciates – exporters will suffer
and their receipt will lower
• If value of domestic currency depreciates – importers will suffer
and their payments will higher.
2. Translation risk
Where the reported performance of an overseas subsidiary in home-based
currency terms is distorted in consolidated financial statements because of
a change in exchange rates.
Example: Assets value – decrease and Liabilities value - increase.
NB: This is an accounting risk rather than a cash-based one.
3. Economic risk
Economic risk refers to the risks accruing to a company due to the long-
term fluctuations in exchange rates. These fluctuations result in companies
in certain countries becoming more competitive and companies in other
countries becoming less competitive.
Understanding exchange rate
If you are given the exchange rate of one unit of foreign currency in units
of domestic currency, then multiply it with foreign currency to know how
much the amount of domestic currency.
If your local currency is EUR and foreign currency is USD
1 USD = 0.92 EUR
If you pay 500 USD, then EUR = 500*0.92 = 460 EUR
If you are given the exchange rate of one unit of domestic currency in
units of foreign currency, then divide it.
1 EUR = 1.087 USD
If you pay 500 USD, then EUR = 500/1.087 = 460 EUR
 124
Financial Management

Spot rate – the exchange rate for transaction of immediate delivery.

Forward rate – a deal which is agreed upon today but the exchange of
currency will not take place until an agreed future date.
Bid – the rate at which the bank buys from the customer.
Offer – the rate at which bank sells to customers.
Bank always buys high and sells low.
Spread – difference between buying and selling rate.
Receipt – Multiply – Small
Payment – Multiply – Big
Receipt – divide – Big
Payment – divide – small

Purchasing Power Parity (PPP theory)

PPPT claims that the rate of exchange between two currencies depends on
the relative inflation rates within the respective countries.
PPPT can be used as best predictor of future spot rates.
If inflation of the domestic currency is more than the inflation of the foreign
currency - Value of Domestic currency will depreciate.
If inflation of the domestic currency is less than the inflation of the foreign
currency - Value of Domestic currency will appreciate.
Theory holds in the long term.

Interest Rate Parity (IRP theory)

IRP predicts that the exchange rate will vary to compensate for the interest
rate differences between countries.
IRP can be used to predict forward rate. Theory holds in the long term and
in short term.
 125
Financial Management

Example PPP theory:

Item costs $1,000

$2: € (base)
However inflation in US is 5% and Europe is 3%
According to law of one price what is the predicted spot rate in 1
year?

Solution
So next year - Item in US costs $1,050 and in Europe €515
“The law of one price” = $1,050 = €515
So, expected future spot = 1,050 / 515 = $2.039 : €1

Another way of calculating this is as follows:

Exchange rate now (counter) x (1+ Inf (counter) / 1 + inf (base))
2 x 1.05 / 1.03 = 2.039

PPPT “High inflation leads to depreciation of currency”

Example IRP theory:

US Interest rate = 10%
European Interest rate = 8%
Spot rate = $2:€
Investor has $1,000 to invest for 1 year

What is the forward exchange rate as predicted by IRPT?

Solution
In US he will receive $1,100 in one year time
In Europe he will receive €540
Forward rate will therefore be 1,100 / 540 = $2.037:€
Another way of calculating this is as follows:
Exchange rate now x (1+ Int (counter) / 1 + int (base))
2 x 1.10 / 1.08 = 2.037

IRPT “High interest rates leads to depreciation of currency (Forward

rate)”
 126
Financial Management

The Fisher Effect

This states that the nominal interest rate is made up of two parts, real
interest rate and a premium to allow for inflation.
Nominal rate = ((1+real rate) x (1+inflation rate))-1

The international Fisher Effect

This assumes that all countries will have the same real rate, although
nominal rate may differ due to expected inflation rate.
Thus, expected interest rate differential between two countries should be
equal to the expected differentials of inflation rate.

Conclusion:
1. Real rate of all countries is same
2. Interest rate difference = Inflation rate difference
3. Forward rate = future spot rate

Four Way Equivalence Model

It is a relationship between interest rates and inflation rates keeping in view
the foreign exchange rates and also the changes that are expected to take
place in spot rates. It gives the idea that how these things are
interconnected and how increase in one factor would affect the other.

Managing foreign exchange transaction risk – Internal techniques

a. Dealing in your home currency
Insist all customers pay in your own home currency and pay for all
imports in home currency.
This method:
• transfers risk to the other party
• may not be commercially acceptable.
b. Doing nothing
c. Leading Receipts – If an exporter expects that the currency it is due to
receive will depreciate over the next few months it may try to obtain
payment immediately. This may be achieved by offering a discount for
immediate payment.
d. Lagging Payments – If an importer expects that the currency it is due
to pay will depreciate, it may attempt to delay payment.
e. Matching payments and receipts
When a company has receipts and payments in the same foreign
currency due at the same time, it can simply match them against each
other. It is then only necessary to deal on the foreign exchange (forex)
markets for the unmatched portion of the total transactions.
 127
Financial Management

f. Foreign currency bank accounts

Where a firm has regular receipts and payments in the same currency, it
may choose to operate a foreign currency bank account. This operates
as a permanent matching process. The exposure to exchange risk is
limited to the net balance on the account.
Managing foreign exchange transaction risk – External techniques
1. Forward Exchange contracts
A forward contract is an arrangement wherein the rate at which the
company would transact or buy/sell a particular currency is fixed today.
So, remember what we are looking at here are ways to hedge the risk that,
the exchange rates may move against us in the future So, we have bought
or agreed a sale now in a foreign currency, but the cash won’t be paid (or
received) until a future date.
With a forward rate we are simply agreeing a future rate now.
Therefore, fixing yourself in against any possible future losses caused by
movements in the real exchange rate
However - you also lose out if the actual exchange rate moves in your
favour as you have fixed yourself in at a forward rate already.

Benefits
1. certainty on the future transaction rate
2. Easy to obtain
3. OTC can be tailor made
Limitations
1. Inflexible
2. Lose out if exchange rate moves favourably

Example 6:
UK importer has to pay $1,000 in a months’ time
He takes the forward rate of $1.8-1.9 :£
The bank then has agreed to SELL the dollars (counter currency) to the
importer. Remember the bank SELLS LOW
The exchange rate would therefore be $1.8:£
So, the bank will give the exporter $1,000 in return for £555.
The importer must pay £555.

Question 1: The current spot rate for US dollars against UK sterling is

$1.6 – $1.7 = £1, and the one-month forward rate is quoted as $1.75 –
$1.85 = £1.
A UK exporter expects to receive $100,000 in one month. If a forward
exchange contract is used, how much will be received in sterling?
 128
Financial Management

Question 2: The current spot rate for US dollars against UK sterling is

$1.2 – $1.22 = £1, and the one-month forward rate is quoted as $1.28 –
$1.31 = £1.
A UK importer expects to pay $220,000 in one month. If a forward
exchange contract is used, how much will be paid in sterling?

Question 3: The current spot rate for UK sterling against US dollars is

£1.225 – £1.229 = $1, and the one-month forward rate is quoted as £1.32 –
£1.35 = $1.
A UK exporter expects to receive $200,000 in one month. If a forward
exchange contract is used, how much will be received in sterling?

Question 4: The current spot rate for UK sterling against US dollars is £1.2
– £1.25 = $1, and the one-month forward rate is quoted as £1.35 – £1.38 =
$1.
A UK importer expects to pay $400,000 in one month. If a forward
exchange contract is used, how much will be paid in sterling?

Question 5: The current spot rate for UK sterling against US dollars is

£1.2 ± 0.0015 = $1, and the one-month forward rate is quoted as £1.15 ±
0.0018 = $1.
A UK importer expects to pay $100,000 in one month. If a forward
exchange contract is used, how much will be paid in sterling?

Question 6: The current spot rate for UK sterling against US dollars is

£1.2 ± 0.0015 = $1, and the one-month forward rate is quoted as £1.15 ±
0.0018 = $1.
A UK exporter expects to receive $120,000 in one month. If a forward
exchange contract is used, how much will be paid in sterling?

2. Money Market Hedges

A money market hedge is an arrangement where the aim is to avoid
transacting in a foreign currency at a future date.
The transaction is undertaken today by either borrowing or investing in
the foreign currency today.
The whole idea of a money market hedge is to take the exchange rate
NOW even though the payment is in the future.
If receipt – take loan from foreign bank and deposit it in domestic bank
If payment – take loan from domestic bank and deposit it in foreign
bank
 129
Financial Management

Money Market Hedges payment

Steps:
1. Borrow in home currency
2. convert it to foreign currency at spot rate
3. invest till due date in foreign currency
4. withdraw foreign investment and pay to supplier
5. Repay the domestic loan

Calculation steps:
1. Calculate how much foreign currency needed (discount @ foreign
deposit rate)
2. Convert that to home currency
3. Borrow that amount of home currency
4. The cost will be the amount borrowed plus interest on that (home
currency borrowing rate)

Example 7:
Let’s say we are a UK company and need to pay $100 in 1 year.
UK borrowing rate is 8% and US deposit rate is 10%.
Exchange rate now $2 - 2.2 :£

• Need to pay $100 in 1 year so we borrow 100 x 1/ 1.10 = 91

• Borrow just $91 as we then put it on deposit and it attracts 10% interest
- to pay off the whole $100 at the end
• Convert $91 dollars now. We need dollars, so bank SELLS us them.
They always SELL LOW. So 91 / 2 = £45.5
• £45.5 is borrowed now. We will then have to pay interest on this in the
UK for a year. So, £45.5 x 1.08 = 49.14
£49.14 is the total cost to us

Question 7: Let’s say we are a UK company and need to pay $5200 after
6 months. UK borrowing rate is 6% per year and US deposit rate is 4% per
year. Exchange rate now $5 - 5.2: £
Calculate the expected sterling payments in six months using a money
market hedge?
 130
Financial Management

Money Market Hedge - Receipt

Steps:
1. Borrow in foreign currency
2. Convert to home currency at spot rate
3. Invest till due date in home currency
4. repay the borrowings using the receipt of the customer
5. withdraw the investment and keep the money

Calculation steps:
1. Calculate how much foreign currency needed (discount @ foreign
borrowing rate) – borrow foreign currency
2. Convert that to home currency
3. Deposit that amount of home currency
4. Withdraw domestic investment and use receipt to payoff overseas loan.

Example 8:
Will receive $400,000 in 3 months
Exchange rate now: $1.8250 - 1.8361:£
Deposit rates (3 months) UK 4.5% annual US 4.2% annual
Borrowing rates (3 months) UK 5.75% US 5.1% annual

1. Calculate how much foreign currency needed (discount @ foreign

borrowing rate)
Interest = 5.1% x 3/12 = 1.275%
$400,000 x 1/ 1.01275 = $394,964
2. Convert that to home currency
The UK company now needs to sell $394,964 from the bank. The bank
will BUY HIGH
394,964 / 1.8361 = £215,110
3. Deposit that amounts of home currency
This amount will be deposited at home at 4.5% for 3/12 = 1.125% =
215,110 x 1.125% = £217,530

Payment Receipt

Borrow domestic currency Borrow foreign currency

1. Discounting using foreign deposit 1. discounting using foreign
rate borrowing rate
2. Converting it to home currency 2. Converting it to home currency
3. Compounding using domestic 3. Compounding using domestic
borrowing rate deposit rate
 131
Financial Management

Benefits
1. Tailor made - Tailored to requirements
2. Economical/ No or limited fee
3. Avoids future transaction risk as money is
converted today.
Limitations
1. Complicated to execute
2. Affected by interest rate - Borrow at high interest rate and invest at low
interest rate.
3. ability to borrow and invest at foreign country

Payments
Question 8: UK based company. Will pay $300,000 in 3 months.
Exchange rate now: $1.85 - 1.86: £
Deposit rates UK 6% annual US 5.5% annual
Borrowing rates UK 7% US 6.5% annual
Calculate the expected sterling payments in three months using a money
market hedge?

Question 9: UK based company. Will pay $250,000 in 3 months

Exchange rate now: £0.9 - 0.95: $
Deposit rates UK 6% annual US 5.5% annual
Borrowing rates UK 7% US 6.5% annual
Calculate the expected sterling payments in three months using a money
market hedge?

Receipts
Question 10: UK based company. Will receive $300,000 in 3 months.
Exchange rate now: $1.85 - 1.86 :£
Deposit rates UK 6% annual US 5.5% annual
Borrowing rates UK 7% US 6.5% annual
Calculate the expected sterling receipts in three months using a money
market hedge?

Question 11: UK based company. Will receive $250,000 in 3 months.

Exchange rate now: £0.9 - 0.95 :$
Deposit rates UK 6% annual US 5.5% annual
Borrowing rates UK 7% US 6.5% annual
Calculate the expected sterling receipts in three months using a money
market hedge?
 132
Financial Management

3. Currency futures
Each contract provides a simultaneous right and obligation to buy or sell
on a specific future date a standard amount of a particular currency at a
price that is known at the time of entering the contract.
• It is a binding contract
• Futures traded on futures exchanges
• Right and obligation
• settlement takes place in three monthly cycles - March, June, Sept or
Dec
• Standardised contract - standard size
Example - Standard size - $50000, receivables - $200000, number of
contracts = 200000/50000 = 4
• They are only available in limited currency combinations
The standardised nature of futures contracts means that over‐ or under‐
hedging is very likely (an imperfect hedge).
Buy futures now and sell them on close out
If sterling to be bought on a date in the future
Sell futures now and buy them back
If sterling to be sold on a date in the future
Gain or Loss of futures always opposite direction of Gain or Loss of Exchange
rates. Ideally the movement in spot rate is matched by a corresponding
movement in future rate which will offset the losses/gains. However, in reality
there may be a slight difference in the rate movements. This can create hedge
inefficiency and is referred to as 'Basis Risk'.

4. Currency options
A call/put option gives the buyer of that option the right, but not the
obligation, to buy/sell currency in the future at a particular exchange
rate.
A currency option gives its holder the right to Buy (Call option) the
contracted currency or Sell (Put option) the contracted currency on or
before a specified date, at a fixed rate of exchange (the strike rate for the
option).
 133
Financial Management

If the exchange rate moves against you - then take the option which is
more favourable
If the exchange rate moves in your favour - then ignore the option (which
would be adverse)... You can't lose!
Clearly, because of this, the option involves buying at a premium at the
beginning.

• Right but not the obligation

• Traded on exchanges
• Purchase at a premium amount
• Exercise the option if adverse movements in exchange rate
• Lapse the option if favourable movements in exchange rate
• Put option - option to sell
• Call option - option to buy
• If we want to buy pound - buy pound call option
• If we want to sell pound - buy pound put option

5. Currency Swap
In a currency swap, one party borrows in its local currency and then
swaps the principal with the other party to obtain the desired foreign
currency at the start.
Currency swap can be used to hedge exchange rate risk over longer
periods
An agreement in which two parties exchange the principal amount and
interest of a loan in one currency for principal and interest in another
currency.
 134
Financial Management

INTEREST RATE RISK

Interest rate risk refers to the change in interest rates resulting in losses for
the company.
Interest rate risk may exist in the following circumstances:
• When the company wishes to borrow or invest at a future date and is
unsure of what interest rates will be on that date.
• When the company has a variable rate borrowing or investment and
is unsure of what the exact pay-out will be at the next reset date.
• When the company has a fixed rate borrowing or investment and is
unsure of what will be the market interest rates, that is if market
interest rate change is favourable which will sacrifice by the company
(opportunity cost).
Interest rate Risk increases when interest rate increase/decrease
Fixed investor – Risk increases when interest rate increase
Floating investor – Risk increases when interest rate decrease
Fixed borrower – Risk increases when interest rate decrease
Floating borrower – Risk increases when interest rate increase
Gap exposure and basis risk
Gap exposure considers groups of interest-sensitive assets and
liabilities with similar maturities and determines whether liabilities exceed
assets (a negative gap) or assets exceed liabilities (a positive gap), in
evaluating sensitivity to interest rate increases and decreases.
Even if interest-sensitive assets and liabilities are matched, interest rate
risk can arise if variable interest rates on assets and liabilities are
determined on different bases (basis risk).
A negative gap occurs when interest-sensitive liabilities maturing at a
certain time are greater than interest-sensitive assets maturing at the same
time. This results in a net exposure if interest rates rise by the time of
maturity

A positive gap occurs is the amount of interest-sensitive assets maturing

in a certain period exceeds the amount of interest-sensitive liabilities
maturing at the same time. In this situation, the firm will lose out if interest
rates fall by maturity.
 135
Financial Management

What Is a Yield Curve?

The Yield Curve is a graphical representation of the interest rates on debt
for a range of maturities. It shows the yield an investor is expecting to earn
if he lends his money for a given period of time. The graph displays a
bond’s yield on the vertical axis and the time to maturity across the
horizontal axis. The curve may take different shapes at different points
in the economic cycle, but it is typically upward sloping.

A fixed income Analyst may use the yield curve as a leading economic
indicator, especially when it shifts to an inverted shape, which signals
an economic downturn, as long-term returns are lower than short-term
returns.

There are three main types of yield curve shapes: normal, inverted, flat or
humped.

1. Normal yield curve

This is the most common shape for the curve and, therefore, is referred to
as the normal curve. longer maturity bonds have a higher yield compared
with shorter-term bonds due to the risks associated with time.
If you are lending your money for a longer period of time, you expect to
earn a higher compensation for that.

2. Inverted yield curve

An inverted curve appears when long-term yields fall below short-
term yields which can be a sign of upcoming recession. An inverted yield
curve occurs due to the perception of long-term investors that interest rates
 136
Financial Management

will decline in the future. This can happen for a number of reasons, but one
of the main reasons is the expectation of a decline in inflation.
When the yield curve starts to shift toward an inverted shape, it is
perceived as a leading indicator of an economic downturn.

3. Flat yield curve

A flat curve happens when all maturities have similar yields. This means
that the yield of a 10-year bond is essentially the same as that of a 30-year
bond.
 137
Financial Management

4. Humped yield curve

A humped yield curve occurs when medium-term yields are greater than
both short-term yields and long-term yields. A humped curve is rare and
typically indicates a slowing of economic growth.

The shape of the yield curve at any point in time is the result of the three
following theories acting together:

• liquidity preference theory • expectations theory • market segmentation

theory.

Liquidity preference theory

Investors have a natural preference for more liquid (shorter maturity)
investments. They will need to be compensated if they are deprived of cash
for a longer period.

Expectation theory
Expectation theory suggest that the shape of the yield curve depends upon
the expectation of investors regarding future interest rates. An upward
sloping yield curve indicates an expectation that interest rates will rise in
the future, while a downward sloping yield curve indicates that interest
rates are expected to fall in the future.
 138
Financial Management

Market segmentation theory

The market segmentation theory is a theory that long and short-term
interest rates are not related to each other. It suggests that there are
different players in the short-term end of the market and the long-term end
of the market. The yield curve is therefore shaped according to the supply
and demand of securities within each maturity length.

Hedging interest rate risk

Interest rate risk exposure can be minimised by adopting the following
hedging techniques.
• Forward rate agreement
• Interest rate guarantee
• Interest rate futures
• Interest rate options
• Interest rate swaps
• Matching
• Smoothing
• Asset and liability management

1. Forward rate agreements (FRAs)

• lock the company into a target interest rate
• hedge both adverse and favourable interest rate movements. The
company enters into a normal loan but independently organises a
forward rate agreement with a bank.
• interest is paid on the loan in the normal way
• if the interest is greater than the agreed forward rate, the bank pays
the difference to the company
• if the interest is less than the agreed forward rate, the company pays
the difference to the bank.
Example 1: Company needs to borrow 600,000 for 1 year, starting in three
months’ time. A 3-15 FRA at 6.00 - 5.75 is available.
If market rate is 10%.
Solution
Compensation receivable from bank 24,000
(10%-6%) x 600,000
Payment made (10% x 600,000) (60,000)
Net payment 36,000
 139
Financial Management

Example 2: ABC plc needs to borrow £30 million for eight months, starting
in three months' time. A 3-11 FRA at 2.75 – 2.60 is available. Show the
interest payable if the market rate is (a) 4%, (b) 2%.

Question 1: BG plc needs to borrow £10 million for three months, starting
in six months' time. A 6-9 FRA at 5.3 – 5.25 is available. Show the interest
payable if the market rate is (a) 6.5%, (b) 4.5%.
Question 2: BG plc needs to deposit £10 million for three months, starting
in six months' time. A 6-9 FRA at 5.3 – 5.25 is available. Show the interest
receivable if the market rate is (a) 6.5%, (b) 4.5%.

2. Interest rate guarantees (IRGs)

An IRG is an option on an FRA. It allows the company the option to take on
an FRA at a set price. It is a contract with a bank to fixing a maximum/
minimum rate for a stated period from a stated future date, in exchange
for an upfront fee. IRGs protect the company from adverse movements and
allow it to take advantage of favourable movements.

Decision rules: if there is an adverse movement, the company will

exercise the option to protect themselves from adverse movement. If there
is a favourable movement, the company will allow the option to lapse to
take advantage of the favourable movement in the interest rates.

IRGs are more expensive than the FRAs, as one has to pay for the
flexibility to be able to take advantage of a favourable movement.
 140
Financial Management

If the company treasurer believes that interest rates will rise:

• they will use an FRA, as it is the cheaper way to hedge against the
potential adverse movement.
If the treasurer is unsure which way interest will move:
• they may be willing to use the more expensive IRG to be able to benefit
from a potential fall in interest rates.

3. Interest rate futures

IRFs are similar in practice to forward rate agreement. They are tradable
contracts. How they work as with an FRA, a loan is entered into in the
normal way. Suitable futures contracts are then entered into as a separate
transaction in the future market, in such a manner that any losses or gains
due to the movements in the interest rate is set off by gains or losses due
to buying or selling futures.
A futures contract is a promise, e.g.:
• If you sell a futures contract, you have a contract to borrow money –
what you are selling is the promise to make interest payments. However,
the borrowing is only notional.
• We close out the position by reversing the original deal, before the real
borrowing starts, i.e. before the expiry date of the contract.
• This means buying futures, if you previously sold them, to close out the
position. The contracts cancel each other out, i.e. we have contracts to
borrow and deposit the same amount of money.
Rules for whether to buy or sell interest rate futures contracts:
• For a Borrowing, Sell futures now and buy them back on close out (BS)
• For a Deposit, Buy futures now and sell them on close out (DB).

As interest rates rise - futures prices fall

• Let’s say you are expecting interest rates to rise.
You would sell a futures contract, and when the interest rate rises, the
value of the futures contract will fall.
You would then buy the return of the contract at a normal price, making
a profit.
 141
Financial Management

As interest rates fall - futures prices increase

• Let’s say you are expecting interest rates to decline in the near future.
You would buy a futures contract.
When interest rates fall, the price of future contract increase.
You then sell the bond futures contract at a higher price.

Borrowers sell futures to hedge against rises

Lenders buy futures to hedge against falls

Basis risk
The gain or loss on the futures contracts may not exactly offset the cash
effect of the change in interest rates, i.e. the hedge may be imperfect. This
is known as basis risk.

4. Interest Rate Options

▪ Borrowers may additionally buy options on futures contracts.
▪ Grants the buyer the right (no obligation) to deal at a specific interest
rate at a future date. At that date the buyer decides whether to go ahead
or not
▪ Instead of having the option to borrow at a particular contracted rate with
the bank, the company transacts in the options market.
▪ These protect against adverse movements in the actual interest rate but
allow favourable ones!
▪ Clearly, because of this, the option involves buying at a premium.

Interest rate caps, floors and collars

Borrowers/investors can use interest rate options to set maximum rates,
minimum rates or a confined range of interest rates to meet their needs.

• An interest rate cap (PUT Option) is where an option is used to set a

maximum rate (useful for borrowers). If the actual interest rate is lower, the
option is allowed to lapse.

• An interest rate floor (CALL Option) is where an option is used to set a

minimum rate (useful for investors). If the actual rate is higher, the option is
allowed to lapse.

• An interest rate collar is where options are used to set both a maximum
and a minimum range for the interest paid or earned. From a borrowing
company’s point of view, this means that while the company’s maximum
interest rate is restricted, the minimum interest it must pay is also
prescribed.
 142
Financial Management

If market rates exceed the maximum rate, then the collar provider will make
payments to the buyer sufficient enough to bring its rate back to the
maximum rate.

If rates fall below the floor, then the borrower makes payments to the collar
provider to bring its rate back to the floor.

When rates are between the floor and the ceiling the borrower pays the
market rate of interest.

A borrower would buy a cap and sell a floor - Collar

A depositor would buy a floor and sell a cap - Collar

5. Interest rate Swaps

An interest rate swap is an agreement whereby the parties agree to swap a
floating stream of interest payments for a fixed stream of interest payments
and vice versa. There is no exchange of principal.

Example: Party A agrees to pay the interest on party B's loan, while party B
reciprocates by paying the interest on A's loan.

If the swap is to make sense, the two parties must swap interest which has
different characteristics.

A swap may be arranged with a bank, or a counterparty may be found

through a bank or other financial intermediary.

Example 3:
Company A
- has a loan at FLOATING rate (LIBOR + 0.8%) from Bank A
- thinks that the interest rates go up so wants FIXED rate
Company B
- has a loan at FIXED rate (8%) from Bank B
- thinks that the interest rates go down so wants FLOATING rate

Solution
Company A can use a swap to change from paying interest at a floating
rate of LIBOR + 0.8% to one of paying fixed interest of 8%.
So the Company A will pay 8% to Company B
And will receive LIBOR + 0.8% form Company B and Pay Libor + 0.8% to
Bank A. Company B will pay 8% to Bank B
 143
Financial Management

6. Matching
This approach requires a business to have both assets and liabilities with
the same kind of interest rate (Floating rate OR Fixed rate). The closer the
two amounts the better.

7. Smoothing
Smoothing is where a company keeps a balance between its fixed rate and
floating rate borrowing.
A rise in interest rates will make the floating rate loan more expensive but
this will be compensated by the less expensive fixed rate loan. But
company may incur increased transaction and arrangement costs.

8. Asset and Liability management

This relates to the periods or durations for which loans (liabilities) and
deposits (assets) last. Matching is where liabilities and assets with a
common interest rate are matched. Problems arise if interest rates are fixed
on liabilities for periods that differs from those on offsetting assets. To avoid
this, companies attempt to match the duration of their assets and liabilities.
 144
Financial Management

Chapter 9

Financial markets and the treasury

function
INTRODUCTION
The ‘financial system’ is an umbrella term covering the following:
1. Financial markets
2. Financial securities
3. Financial institutions
Financial markets – e.g. stock exchange, money markets
The financial market refers to the market where the sale and purchase of
financial securities including shares, bonds, derivatives etc. It acts as a
platform for sellers and buyers to connect and deal in their desired financial
assets at a price determined by market forces.
Financial securities – e.g. shares, bonds
Financial security is a medium of investment, for example, a share, a
corporate bond or a money market instrument. Many securities are traded
on market. For every security there is a buyer (the investor who is providing
the finance) and a seller (the receiver of the finance)
Financial Institutions – e.g. Banks, building societies, insurance
companies, pension funds.
A financial institution is an organization that provides service as an
intermediary for different types of financial and monetary transactions such
as deposits, loans, investments, pension funds, currency exchange etc.

Financial Markets
ROLE OF FINANCIAL MARKETS
The role of stock markets is as follows:
1. Facilitate trade in stocks
2. Allocate capital in the industry
3. Determine a fair price for the assets traded
 145
Financial Management

Within each sector there are cash surpluses and deficit. In the case of
surplus, the party will be concerned with investing, depositing or lending. In
the case of deficit, the party will be concerned with borrowing funds to
manage their liquidity situation.
The financial markets are mechanism where those requiring finance (deficit
units) can get in touch with those able to supply it (surplus units), i.e.
allowing the buyers and the sellers of finance to get together.
There are two main types of financial markets: capital and money markets,
and within each of these are primary and secondary markets:
1. Primary market- deals in new securities
2. Secondary market- deals in ‘secondhand’ securities

SECONDARY MARKETS
Secondary markets help investors achieve the following ends
1. Diversification
By giving investors the opportunity to invest in a wide range of
enterprises, it allows them to spread their risk. This is the familiar ‘don’t
put all your eggs in one basket’ strategy.
2. Risk shifting
Deficit units, particularly companies, issue various types of security on
the financial markets to give investors the choice of the degree of risk
they take. For example, company loan stocks or bonds, secured on the
assets of the business offer low risk with relatively low returns, whereas
equities carry much higher risk with correspondingly higher returns.
3. Hedging
Financial markets offer participants the opportunity to reduce risk
through hedging, which involves taking out counterbalancing contracts
to offset existing risks. Hedging will be discussed in detail in the chapter
on risk management.
4. Arbitrage
Arbitrage is the process of buying a security at low prices in one market
and simultaneously selling in another market at a higher price to make a
profit.
 146
Financial Management

Although it is only the primary markets that raise new funds for deficit
units, well developed secondary markets are required to fulfill the above
roles for lenders and borrowers.

CAPITAL MARKETS
Capital market deals in long term finance, mainly via stock exchange.
The major type of securities dealt on capital markets are as follows:
➢ public sector and foreign stocks
➢ company securities (shares and corporate bonds)
➢ Eurobonds
Eurobonds are bonds denominated in a currency other than that of
national currency of the issuing company (nothing to do with Europe or the
euro). They are called international bonds.
International capital markets - an international financial market exist
where domestic funds are supplied to a foreign user or foreign funds are
supplied to a domestic user. The currencies used need not be those of
either the lenders or the borrower.

MONEY MARKET
Money market deals in short term finance.
Role of Money markets:
• Providing short term liquidity to companies, banks and the public sector.
• Providing short term trade finance.
• Allowing an organization to manage its exposure to foreign currency risk
and interest rate risk.

MONEY MARKET INSTRUMENTS

A money market security is a type of security that is traded in the money
market.

1. Coupon bearing securities: Coupon bearing securities have a fixed

maturity and a specified rate of interest
➢ Certificate of deposit
➢ Repos
 147
Financial Management

Certificates of deposit (CDs)

• CDs are evidence of a deposit with an issuing bank (or building society).
• They are fully negotiable and hence attractive to the depositor since they
ensure instant liquidity if required.
• They provide the bank with a deposit for a fixed period at a fixed rate of
interest.

Sale and repurchase agreements (‘repos’)

In a repo transaction, X sells certain securities (treasury bills, bank bills
etc.) to Y and simultaneously agrees to buy them back at a later date at a
higher price.

2. Discount securities:
In the discount market, funds are raised by issuing bills at a discount to
their eventual redemption or maturity value.
➢ Treasury bills
➢ Commercial bills
➢ Commercial paper
➢ Banker’s acceptance
Treasury bills
• Issued mainly by governments via central banks.
• Usually one- or three-month maturity.
Commercial bills
• Similar to treasury bills except issued by large corporations.
Commercial paper
• Initial maturity usually between seven and forty-five days.
• May be unsecured so credit ratings important.
• High issue costs so only suitable for larger amounts.
Banker’s acceptances
A Bankers acceptance is a short-term credit investment, and a bank
guarantees payment.
• Companies use them for financing imports and exports, when the
creditworthiness of a foreign trade partner is unknown.
• They don’t need to be held until maturity, and can be sold off in the
secondary markets where investors and institutions constantly trade
Banker’s acceptances.
 148
Financial Management

3. Derivatives:
They are commonly traded as futures, options as well as caps and floors.

FINANCIAL INTERMEDIATION
Intermediation refers to the process whereby potential borrowers are
brought together with the potential lenders by a third party, the
intermediary.
There are many types of institutions and other organizations that act as
intermediaries in matching firms and individuals who need finance with
those who wish to invest.
➢ Banks (clearing banks, investment banks, savings banks)
➢ Building societies
➢ Finance companies (finance houses, leasing companies, factoring
companies)
➢ Pension funds
➢ Insurance companies
➢ Investment trusts and unit trusts.
Financial intermediaries have a number of important roles:
• Risk reduction
• Aggregation
• Maturity transformation
• Financial intermediation

The emergence of disintermediation (reduction in the use intermediaries)

and securitization (conversion into marketable securities), where
companies lend and borrow funds directly between themselves, has
provided a further means of dealing with cash flow surpluses and deficits.
 149
Financial Management

ROLE OF TREASURY FUNCTIONS

The treasury function of a firm are as follows:
➢ Short term management of resources- this relates to short term lending
and borrowing funds as required and currency management

➢ Long term maximization of shareholders wealth

→ Raising long term finance
→ Management debt capacity
→ Debt and equity structure
→ Investment decision
→ Dividend policy

➢ Risk management
→ assessing risk exposure
→ Interest rate risk management
→ hedging of foreign exchange risk

Compare and contrast the roles of the treasury and finance department
with respect to a proposed investment.
1. Treasury:
➢ Treasury is the function concerned with the provision and use of finance
and thus handles the acquisition and the custody of funds
➢ Treasury will quantify the cost of capital to be used in assessing the
investment
➢ Treasury will establish corporate financial objectives and will identify
sources and the types of finance

2. Finance:
➢ Finance department has responsibility for accounting, reporting and
control
➢ The finance department will estimate the project cash flows
➢ The finance department will be involved with the preparation of budgets
and budgetary control, the preparation of periodic financial statement.
 150
Financial Management

Chapter 10

Sources of finance
DIVISION OF SOURCE OF FINANCE
1. Equity:
➢ internally generated (retained earnings)
➢ ordinary shares

2. debt and other

➢ debt
➢ preference shares
➢ leasing
➢ trade credit (payables)
➢ Overdraft
SELECTING THE SOURCE OF FINANCE
The need for finance
The firm needs funds to:
• Provide working capital
• Invest in non-current assets
The main source of funds available is retained earnings, but these are
unlikely to be sufficient to finance all business needs.
CRITERIA FOR CHOOSING BETWEEN SOURCES OF FINANCE
A firm must consider the following factors:
➢ Cost: the higher the cost of funding the lower the firm’s profit. Debt
finance tend to be cheaper than equity. This is because providers of
debt take less risk compared to equity providers. This is due to the
interest payment that is guaranteed to be received compared to the
dividends that the equity holders receive which is highly dependable on
profit that is earned. Secondly the interest of the debt finance is tax
deductible whereas the equity finance is not.

➢ Matching the duration: firms usually match duration of finance to asset

purchased. Long term finance is more expensive than short term
finance. This is because lenders normally perceive the risk as being
higher on long term loans. But however, long term finance has got the
 151
Financial Management

advantage over the security whereas the source of short-term finance

can be withdrawn at short notice. Usually, long term assets should be
financed by long term funds and short-term assets by short term funds.

➢ Term structure of interest rates: term structure of interest rates

describes the relationship between the interest rates charged for loans
of differing maturities. Normally we refer short term funds to be cheaper
than long term funds

➢ Gearing: gearing is the ratio of the debt-to-equity finance. High gearing

indicates that the company has used cheap debt finance but the
disadvantage that it brings along high risk of meeting repayment of
interest and principals at regular intervals.

➢ Accessibility: not all companies have access to all sources of finance.

Especially small companies where they find it difficult to raise equity and
long-term finance. No company has unlimited choices of funding
arrangements. Most of the company’s capital and finance are rationed.

RELATIONSHIP BETWEEN RISK AND RETURN

The basic rule is that the if the investment carries high level of risk which
may be due to the uncertainty involved in the investment, then in that case
the expected returns would also increase. Therefore, the higher the risk
involved, the higher the returns the fund lender would expect.
Each time an investor demands a higher return on the finance they have
provided; this is reflected in a higher cost of that finance to the company.
 152
Financial Management

Short-term sources of finance

As discussed earlier, working capital is usually funded using short-term
sources of finance.
Sources of short-term finance include:
• bank overdrafts
• bank loans
• better management of working capital
• squeezing trade credit
• leasing
• sale and leaseback.

LEASING
A lease is a contract between a lessor and a lessee for the hire of a
particular asset. lessor retains ownership of the asset. lessor conveys the
right to the use of the asset to the lessee for an agreed period, in return,
lessor receives specified rental payments.
There are two main types of lease agreement:
• short-term • long-term.
Sale and lease back
a company that owns its own premises can obtain finance by selling the
property for cash and renting it back off the acquirer which would typically
be an insurance company or a pension fund.

LONG TERM FINANCE

Ordinary shares:
➢ Equity shareholders are the owners of the business and exercise
ultimate control,
➢ They have voting rights in general meetings
➢ They are ranked after all the creditors and preference shares in right to
assets on liquidation.
➢ Dividend payable at the discretion of the directors from profit remaining.
➢ They have the right to all surplus funds after prior claims have been met.
 153
Financial Management

Preference shares
➢ They are not considered as part of equity as their characteristics bear
more resemblance to debt finance.
➢ They receive a fixed amount of dividend every year irrespective of the
profits earned.
➢ They are ranked after all creditors but usually before the ordinary
shareholders in liquidation.
➢ Preference shares can be divided into the following:
• Cumulative preference shares- the arrears on dividend can be
accumulated over the years and need to be paid their dividends
before paying the ordinary shareholder.
• Non-cumulative preference shares- the arrears on dividend cannot be
accumulated.

RAISING EQUITY
There are three main sources of equity finance;
➢ Internally generated funds- retained earnings
➢ Issuing shares to new shareholders- placing, offer for sales etc.
➢ Issuing shares to the existing shareholders- right issue, bonus issue
INTERNALLY GENERATED FUNDS
➢ Retained earnings
Internally generated funds are earnings retained in the business.
Such finance requires no transaction costs, professional assistance
or time delay.
Retained earnings can be increased by paying out lower dividend.
➢ Increasing working capital efficiency
 154
Financial Management

ISSUING SHARES TO NEW SHAREHOLDERS

There are several ways in which a company can issue new shares to new
shareholders.
1. A placing: placing is whereby the companies sell or place their
shares to financial institutions. If the public wishes to acquire the
shares, they must buy it from the financial institutions.

2. Public offer: A public offer is an invitation to apply for shares in a

company based upon information contained in a prospectus, either at
a fixed price or by tender.
Fixed price: shares are offered at a fixed price to the general public.

Tender: shares are offered to the general public but at no fixed price.
Potential investors bid for shares at a price of their choosing. The
highest bidder will be able to buy the shares.

3. Offer for sale: the companies wishing to raise capital by offer for sale
would first get in touch with issuing house which specialized in this
kind of business. The issuing house purchase outright a block of
shares from a company and then makes an offer for sale to the
public.

4. An introduction (initial public offer) - introduction is the process that

allows a company to join a stock exchange.

ISSUING SHARES TO EXISTING SHAREHOLDERS

RIGHT ISSUE
A right issue is an offer to existing shareholders to subscribe for new
shares at a discount to the current market value in proportion to their
existing shareholding.
The main factors to consider / calculate with regard to a right issue are:
➢ Price issue
➢ Issue quantity
➢ Terms of issue
➢ Theoretical ex rights price (TERP)
➢ Value of a right
➢ Value of a right per existing share
 155
Financial Management

TERP
The new share price after the issue is known as the theoretical ex rights
price and is calculated by finding the weighted average of the old price and
the rights price, weighted by the number of shares. the formula is:

Value of a right = theoretical ex rights price – issue price

Value of a right per existing share = Value of a right /number of shares
needed to obtain a right.
Question 1: X LTD has a current market price of $8.00 per share and
wishes to raise $1280,000 via right issue at a 20% discount to market price.
there are currently 600,000 shares in issue. Calculate the TERP? Calculate
value of a right? Calculate value a right per existing share?
Question 2: ABC 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. Calculate the
TERP?
Question 3: XYZ Co announces a 2 for 5 rights issue at $2 per share.
There are currently 10 million shares in issue, and the current market price
of the shares is $2.70. Calculate the TERP.
Shareholders’ options
The shareholder’s options with a rights issue are to:
1) take up their rights by buying the specified proportion at the price offered
2) take up their rights and sell them in the market
3) take up their rights and sell part of their rights
4) do nothing.
Question 4: PQ 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 they:
(1) takes up their rights (2) sells their rights (3) buys 200 shares and sells
the rights to a further 300 (4) takes no action.
 156
Financial Management

SCRIP ISSUE
A scrip (bonus) issue is when shares are offered to existing shareholders in
proportion to their existing shareholding, but there is a zero-purchase
consideration i.e. the shares are offered for free!

LONG TERM FINANCE DEBT

Bonds
➢ Bonds are also known as debentures, loan notes or loan stock
➢ They are traded on the stock markets
➢ They must be secured or unsecured
➢ They may be redeemable or irredeemable
Redeemable debt is whereby the principal and the interest is repayable at a
future date.
Irredeemable debt is not repayable at any specified time in the future.
Instead, interest is payable in perpetuity
Advantages and disadvantages of loans notes and other long term
debt
Advantages:
From the view point of investor;
➢ Low risk
➢ Predictable income
From the view point of company;
➢ Cheap
➢ Has predictable cash flow
➢ Does not dilute control
Disadvantages
From the view point of investor;
➢ Has no voting right
➢ Fixed returns
From the view point company;
➢ Inflexible
➢ Increase risk at high level of gearing
➢ Must be repaid
 157
Financial Management

DIFFERENT TYPES OF BONDS

➢ Deep discount bonds: these are loan notes issued at a price that is a
large discount to the nominal value of the notes and which will be
redeemable at par or above par when they mature.

➢ Zero coupon bonds: these are bonds that are issued at discount to their
redemption value but no interest if paid on them.

➢ Convertible loan notes: these loan notes give the holder the right to
convert to ordinary shares at either the predetermined price or ratio

Conversion premium: the conversion premium occurs when the

market value of the convertible loan note is greater than market
price of the shares of the stock is to be converted into.

Floor value: it is the minimum market price of the loan note that
has an option for conversion as opposed to the redemption
attached to it. Its computation is similar to that of market value of a
share except with the assumption that the share gets redeemed.

➢ Loan notes with warrants: warrants give the holder the right to subscribe
at a fixed future date for a certain number of ordinary shares a pre-
determined price. If the warrants are issued with loan notes, the loan
notes are not converted into equity. Instead the bond holder makes cash
payment for the shares and retains the loan notes until redemption.

FACTORS AFFECTING THE INTEREST RATE ON NEW ISSUE OF

BOND
Some of the factors affecting the interest rate on the new issue of the
bonds are:
➢ General economic conditions: in poor economic environment, funding is
scarce and hence the interest rate tends to raise

➢ Risk profile of the company: a company perceived to be of high risk will

have a greater interest cost

➢ Availability of security: if adequate security in the form of asset is not

available, the investors might need to be provided higher interest rates
in return.
 158
Financial Management

➢ Duration of the bond: longer the duration, higher tends to be interest

rate.

➢ Conversion clauses: if the bond has a conversion clause, it may be

possible to keep investors happy with lower interest rates.

FINANCE FOR SMALL AND MEDIUM ENTERPRISES

SME’s, and especially those which are newly established do not always
have access to the same types, or levels of funding that are available to
larger, more well established companies due to lack of proper financial
controls and systems, not having established record, lack of security and a
market standing.
This gives rise to a funding and maturity gap due to these small companies
being unquoted as well as when the SME’s want to expand beyond their
means of finance.
This funding gap can be bridged through the following ways:
➢ Financial investors:
→ Business angels: SME’s can raise finance through approaching
private individual who has a business background. These private
individuals tend to provide small amounts of equity capital. They are
known as business angels. Business angels are willing to make
investments in small business in return for an equity stake. They can
also offer the business the benefit of their own management
expertise.

→ Venture capitalist: venture capitalist are companies who provide

finance to SME.

➢ Government solutions:
→ Alternative investment market: the SME tend to have good
business idea and growth potential but is unable to enter into the
stock markets due to the lack of fulfilling the requirements.

Alternatively, the government has introduced the alternative

investment market whereby these SME’s can enter into these
markets and thereby can raise finance through marketing their
shares in these markets.
→ Other forms of assistance like government grants.
 159
Financial Management

➢ Supply chain financing: similar to reverse factoring, where the buyer

allows invoices to be paid earlier to the supplier, via a factor. (refer the
working capital management chapter for a detailed understanding on
factoring)

➢ Crowdfunding is a way to source money for a company by asking a

large number of backers to each invest a relatively small amount. In
return, backers receive equity shares of the company.

➢ Peer to peer lending (P2P) is a method of debt financing that enables

companies to borrow and lend money- without the use of an official
financial institution as an intermediary.

Islamic finance
Islamic finance has the same purpose as other forms of business finance
except that it operates in accordance with the principles of Islamic law
(Sharia).
The basic principles covered by Islamic finance include:
• Sharing of profits and losses.
• No interest (riba) allowed.
• Finance is restricted to Islamically accepted transactions. i.e. No
investment in alcohol, gambling etc.

Therefore, ethical and moral investing is encouraged. Instead of interest

being charged, returns are earned by channelling funds into an underlying
investment activity, which will earn profit. The investor is rewarded by a
share in that profit, after a management fee is deducted by the bank.
The main sources of finance within the Islamic banking model include:
Fixed income
• Murabaha (trade credit)
• Ijara (lease finance)
• Sukuk (debt finance)
Equity modes of finance
• Mudaraba (equity finance)
• Musharaka (venture capital).
 160
Financial Management

Murabaha (trade credit)

Murabaha is a form of trade credit or loan. The key distinction between a
murabaha and a loan is that with a murabaha, the bank will take actual
constructive or physical ownership of the asset. The asset is then sold onto
the 'borrower' or 'buyer' for a profit but they are allowed to pay the bank
over a set number of instalments. The period of the repayments could be
extended but no penalties or additional mark-up may be added by the
bank. Early payment discounts are not welcomed (and will not form part of
the contract) although the financier may choose (not contract) to give
discounts.

Ijara (lease finance)

Ijara is the equivalent of lease finance; it is defined as when the use of the
underlying asset or service is transferred for consideration. Under this
concept, the Bank makes available to the customer the use of assets or
equipment such as plant, office automation, or motor vehicles for a fixed
period and price.

Some of the specifications of an Ijara contact include:

• The use of the leased asset must be specified in the contract.
• The lessor (the bank) is responsible for the major maintenance of the
underlying assets (ownership costs).
• The lessee is held for maintaining the asset in good shape.

Sukuk (debt finance)

Within other forms of business finance, a company can issue tradable
financial instruments to borrow money. Key feature of these debt
instruments are they:
• Don’t give voting rights in the company
• Give right to profits before distribution of profits to shareholders
• May include securities and guarantees over assets
• Include interest based elements.
All of the above are prohibited under Islamic law. Instead, Islamic bonds (or
sukuk) are linked to an underlying asset, such that a sukukholder is a
partial owner in the underlying assets and profit is linked to the
performance of the underlying asset. So for example, a sukukholder will
participate in the ownership of the company issuing the sukuk and has a
right to profits (but will equally bear their share of any losses).
 161
Financial Management

Mudaraba (equity finance)

Mudaraba is a special kind of partnership where one partner gives money
to another for investing it in a commercial enterprise. The investment
comes from the first partner (who is called 'rab ul mal'), while the
management and work is an exclusive responsibility of the other (who is
called 'mudarib'). The Mudaraba (profit sharing) is a contract, with one
party providing 100% of the capital and the other party providing its
specialist knowledge to invest the capital and manage the investment
project. Profits generated are shared between the parties according to a
pre-agreed ratio. In a Mudaraba, only the lender of the money has to take
losses. This arrangement is therefore most closely aligned with equity
finance.

Musharaka (venture capital)

Musharaka is a relationship between two or more parties, who contribute
capital to a business, and divide the net profit and loss pro rata. It is most
closely aligned with the concept of venture capital. All providers of capital
are entitled to participate in management, but are not required to do so.
The profit is distributed among the partners in pre-agreed ratios, while the
loss is borne by each partner strictly in proportion to their respective capital
contributions.
 162
Financial Management

Chapter 11

The economic environment for

business
MACROECONOMIC POLICY
Macroeconomic policy is the management of the economy by government
in such a way as to influence the performance and the behavior of the
economy. The principal objectives of macroeconomic policy will be to
achieve the following:
➢ Full employment of resources
➢ Price stability
➢ Economic growth
➢ Balance of payment equilibrium
➢ An appropriate distribution of income and wealth
MONETARY POLICY
Monetary policy is concerned with influencing the overall monetary
conditions in the economy:
➢ The volume of money in circulation i.e. the money supply
➢ The price of money i.e. interest rates, influencing the rate of inflation in
the economy.

IMPACT OF CHANGES IN MONETARY POLICY

➢ The availability of finance: credit restrictions achieved via the banking
system or by direct legislation will reduce the availability of loans. This can
make it difficult for small – or medium sized new businesses to raise
finance. The threat of such restrictions in the future will influence financial
decisions by companies, making them more likely to seek long term finance
for projects.

➢ The cost of finance: any restrictions on the stock of money, or restrictions

on credit, will raise the cost of borrowing, making fewer investment projects
worthwhile and discouraging expansion by companies. Also, any increase
in the level of general interest rate will increase shareholder’s required rate
of return so unless companies can increase their return, share prices will
fall as interest rate rise. Thus, in times of ‘tight’ money and high interest
rates, organizations are less likely to borrow money and will probably
contract rather than expand operations.
 163
Financial Management

➢ The level of consumer demand: periods of credit control and high interest
rates reduce consumer demand. Individuals find it more difficult and more
expensive to borrow to fund consumption, whilst savings become more
attractive. This is another reason for organizations to have to contract
operations.

➢ The level of exchange rates: monetary policy which increases the level of
domestic interest rates is likely to raise exchange rate as capital is attracted
into the country. Very many organizations now deal with both suppliers and
customers abroad and thus cannot ignore the effect of future exchange rate
movements. Financial managers must consider methods of hedging
exchange rate risk and the effect of changes in exchange rates on their
positions as importers and exporters.

➢ The level of inflation: monetary policy is often used to control inflation.

Rising price levels and uncertainty as to future rates of inflation make
financial decisions more difficult and more important. As prices of different
commodities change at different rates, the timing of purchase, sale,
borrowing and repayment of debt becomes critical to the success of
organizations and their projects. This is discussed further below:

IMPACT OF INFLATION ON BUSINESS CASH FLOW AND PROFITS

The real effect on the level of profits and the cash flow position of a
business of a sustained rate of inflation depend on the form that inflation is
taking and the nature of the markets in which the company is operating.
One way of analyzing inflation is to distinguish between demand-pull
inflation and cost-push inflation.
➢ Demand-pull inflation might occur when excess aggregate monetary
demand in the economy and hence demand for particular goods and
services enable companies to raise prices and expand profit margins.

➢ Cost-push inflation will occur when there are increases in production

costs independent of the state of demand, e.g. rising raw material costs or
rising labor costs. The initial effect is to reduce profit margins and the
extent to which these can be restored depends on the ability of companies
to pass on cost increases as price increases for customers.
 164
Financial Management

INTEREST RATE SMOOTHING

Interest rate smoothing is the policy of some central banks to move official
interest rates in a sequence of relatively small steps in the same directions,
rather than waiting until making a single larger change.
FISCAL POLICY
Fiscal policy is the manipulation of the government budget in order to
influence the level of aggregate demand and therefore the level of activity
in the economy. It covers:
➢ Government spending
➢ Taxation
➢ Government borrowing
Which are linked as follows:
Public expenditure = taxes raised + government borrowing (+ other
income)
GOVERNMENT SPENDING
Three budget positions can be identified.
➢ A balanced budget: total expenditure is matched by total taxation
income.
➢ A deficit budget: total expenditure exceeds total taxation income and the
deficit must be financed by borrowing.
➢ A surplus budget: total expenditure is less than total taxation income
and the surplus can be used to pay back public debt incurred as a result
of previous deficits.
TAXATION
The government receives the bulk of its income from taxation.
Taxes are divided into broad groups.
➢ Direct taxes are taxes levied directly on income receivers whether they
are individuals or organizations. These include income tax, NICs,
corporation tax, and inheritance tax

➢ Indirect taxes are levied on one set of individuals reorganizations but

may be partly or wholly passed on to others and are largely related to
consumption not income. These include VAT and excise duties. By their
very nature, indirect taxes tend to be regressive which means they have
a relatively greater impact on individuals with lower incomes.
 165
Financial Management

GOVERNMENT BORROWING
Broadly the government can undertake two types of borrowing:
➢ From the public: it can borrow directly or indirectly from the public by
issuing relatively illiquid debt. This includes national savings certificates,
premium bonds, and long-term government bonds. This is referred to as
‘funding’ the debt.
➢ From the banking system: it can borrow from the banking system by
issuing relatively liquid debt such as treasury bills. This is referred to as
‘unfunded’ debt.
CROWDING OUT
It is suggested that fiscal policy can lead to ‘financing crowding out’
whereby government borrowing leads to a fall in private investment. This
occurs because increased borrowing leads to higher interest rates by
creating a greater demand for money and loanable funds and hence a
higher ‘price’.
The private sector, which is sensitive to interest rates, will then reduce
investment due to a lower rate of return. This is the investment that is
crowded out.

GOVERNMENT INTERVENTIONS AND REGULATION

As well as the general measures to impact business operations discussed
above, governments can also take more specific measures to regulate
business.
These measures will cover aspects such as:
➢ Competition policy
➢ Provision of government assistance
➢ Green policies
➢ Corporate governance guidelines.
 166
Financial Management

COMPETITION POLICY
Formal competition policy has typically centered upon the control of two
broad issues.
➢ Monopolies and mergers
➢ Restrictive practices
The concern for monopolies is with firms which have a degree of monopoly
power (defined as having more than 25% of the market for a good or
service) or with mergers which may produce a new company with more
than 25% of market share. The underlying presumption is that monopolies
are likely to be inefficient and may act against the interests of customers.
The concern over restrictive practices is with trading practices of firms
which may be deemed to be uncompetitive and act against the interest of
consumers.
Legislation typically prohibits:
➢ Anti-competitive agreements (such as price-fixing cartels); and
➢ Abuse of a dominant position in a market.

GOVERNMENT ASSISTANCE
The political and social objectives of a government, as well as its economic
objectives, could be pursued through official aid intervention such as grants
and subsidies. The government provides support to businesses both
financially, in the form of grants, and through access to networks of expert
advice and information.
For example to:
➢ Boost enterprise
➢ Encourage innovations
➢ Speed urban renewal
➢ Revive flagging industries
➢ Train labor force
➢ Sponsor important research.
There is always competition for the grants and the criteria for awards are
stringent. These vary but are likely to include the location, size and industry
sector of the business.
 167
Financial Management

GREEN POLICIES
When a firm appraises a project, it may, rationally, only include those costs
it will itself incur. However, for the good of society, external costs (such as
damage to wildlife) need to be taken into account.
This has led to:
➢ Green legislation
➢ Punitive taxation on damaging practices
➢ Which force companies to consider the negative impacts of potential
projects in any appraisals.
Externalities are costs (benefit) which are not paid (received) by the
producers or consumers of the products but by other members of society.
An example is river pollution from various manufacturing processes or
motor vehicle emissions causing air pollution and health hazards.
CORPORATE GOVERNANCE
Corporate governance is defined as ‘the system by which companies are
directed and controlled’ and covers issues such as ethics, risk
management and stakeholder protection.
A variety of rules have been introduced in different countries but the
principles, common to all, contain regulations on:
➢ Separation of the supervisory function and the management function.
➢ Transparency in the recruitment and remuneration of the board.
➢ Appointment of non-executive directors (NEDs)
➢ Establishment of an audit committee and a remuneration committee.
➢ Establishment of risk control procedures to monitor strategic, business
and operational activities.
 168
Financial Management

Chapter 12

DIVIDEND POLICY
Dividend Decision
The dividend decision is concerned with how much is pay to investors and
how much is retained in the business. It is important to understand the
factors to be considered in taking the dividend decision. There are some
factors which encourage the declaration of dividends, and some others that
inhibit dividends. A decision to increase capital investment spending will
increase the need for financing, which could be met in part by reducing
dividends.
Types of payment:

1. Constant pattern
a. Paying out a constant dividend every year - It gives investors a
clear expectation, but does not compensate for inflation.
b. Maintaining a constant growth in dividends for every year
Compensate for inflation, but even challenging years, put pressure on
the company to maintain the pattern.
c. Maintaining a constant payout ratio - Depends on the earnings.

2. Residual dividend policy (Irregular dividend)

The dividends paid are equivalent to the funds available after all
investments have been made in positive NPV projects.

3. Zero dividend policy (fully reinvested)

Nothing is paid to the investors in the form of dividends and all free
cashflows generated put back into other positive NPV projects.

4. Scrip dividends: A scrip dividend is where a company allows its

shareholders to take their dividends in the form of new shares rather
than cash. If investors need cash, they can sell their shares.
Home-made dividends or manufacturing dividends - sell shares and
convert it to cash.
 169
Financial Management

Advantages
From a company point of view,
➢ If taken up by shareholders, it will conserve cash, i.e. it will reduce the
cash outflow from the company compared to a cash dividend. This is
useful when liquidity is a problem, or when cash is needed to meet
capital investment or other financing needs.

➢ A scrip dividend will lead to a decrease in gearing, whether on a book

value or a market value basis. Because of the increase in issued shares.
This decrease in gearing will increase debt capacity.
Disadvantages
➢ The number of shares in issue will increase and therefore the total cash
dividend will also increase, assuming the dividend per share is
maintained or increased.
Share- buyback or repurchase:
a company buy-backs shares at the prevailing market price and cancel
the shares, it is an alternative to a dividend. EPS will increase, because of
lower number of shares and gearing also will increase, because of lower
equity.

Factors to be consider when formulating the dividend policy of

companies

1. Profitability
Companies need to remain profitable and dividends are a distribution of
after-tax profit. A company cannot consistently pay dividends higher
than its profit after tax. A healthy level of retained earnings is needed to
finance the continuing business needs of the company.

2. Liquidity
A company must ensure it has sufficient cash to pay a proposed
dividend and that paying a dividend will not compromise day to day
financing needs of cash.

3. Legal and other covenant restriction

A dividend can only be paid out in accordance with statutory
requirements and it must also not violate any covenants.

4. Availability of finances for further investment and the existence of

investment opportunities.
 170
Financial Management

5. Level of financial risk

If financial risk is high due to high level of gearing, maintaining a low level
of dividend payments can result in a high level of retained earnings, which
will reduce gearing by increase in reserves. Also, Cashflow can be used to
pay debt and reduce the gearing.
Other factors also need to considered – Market factors, Tax implications
etc…

The relevant theories related to dividends are:

A. The dividend valuation model
B. The Gordon growth model
C. Modigliani and Miller’s dividend irrelevancy theory.

A. The dividend valuation model

• This states that the value of a company’s shares is sustained by the
expectation of future dividends.
• Shareholders acquire shares by paying the current share price and
they would not pay that amount if they did not think that the present
value of future inflows (ie dividends) matched the current share price.
• P0 = D0 (1+ g)/(re – g)

B. The Gordon growth model

• This model examines the cause of dividend growth.
• Apart from raising more outside capital, expansion can only happen if
some earnings are retained. If all earnings were distributed as
dividend the company has no additional capital to invest, can acquire
no more assets and cannot make higher profits.
• If earnings are constant, so are dividends and so is the share price.
g = b*re

C. Dividend Irrelevancy theory- Modigliani and Miller

• Modigliani and Miller showed that, in a perfect capital market, the
value of a company depended only on its investment decision,
and not on its dividend or financing decisions.
• In a perfect market, the value of a company is maximised when all
positive NPV projects are invested in.
• Share price is unaffected by changes in dividend streams.
 171
Financial Management

• In a perfect market the share price reflects all future dividends, so

shareholders who were unhappy with the level of dividend declared by
a company could gain a ‘home-made dividend’ by selling some of their
shares. This is possible since there are no transaction costs in a
perfect capital market.
• Many say there is a clear link between dividend policy and share
prices. For example, it has been argued that investors prefer certain
dividends now rather than uncertain capital gains in the future

Imperfect markets
The real-world markets are not perfect. So, information and knowledge of
managers and shareholders are not equal. Therefore, a change in dividend
policy could be seen by investors (with less information than managers) as
a ‘signal’ and so affect the share price.

Signalling effect
The direction of the share price change will depend on the difference
between the dividend announcement and the expectations of
shareholders. This is referred to as the “signalling properties of dividends”.

Not paying dividends may be seen in bad light by investors and as a sign of
financial distress.

Clientele Effect

Apple shares have outperformed the market massively in the last few
years. This means that Apple shareholders are enjoying huge share price
increases (capital growth). These shareholders cannot get such returns by
investing elsewhere so do not want their money back from Apple
yet. Consequently, Apple’s dividend policy to date is zero dividends despite
its huge cash balances.

This is referred to as the ‘clientele effect’. A company with an established

dividend policy is therefore likely to have an established dividend clientele.

The existence of this dividend clientele implies that the share price may
change if there is a change in the dividend policy of the company, as
shareholders sell their shares in order to reinvest in another company with
a more satisfactory dividend policy.

A sudden change in the dividend policies of the company based on the

availability of projects for investment may upset the investors.
 172
Financial Management

Sec C Constructed Response

Questions - Theories
A. Investment Decisions and Capital budgeting
There are many reasons that could be discussed in support of the view
that net present value (NPV) is superior to other investment appraisal
methods.
NPV considers cash flows
This is the reason why NPV is preferred to return on capital employed
(ROCE), since ROCE compares average annual accounting profit with initial
or average capital invested. Financial management always prefers cash flows
to accounting profit, since profit is seen as being open to manipulation.
Furthermore, only cash flows are capable of adding to the wealth of
shareholders in the form of increased dividends. Both internal rate of return
(IRR) and Payback also consider cash flows.
NPV considers the whole of an investment project
In this respect NPV is superior to Payback, which measures the time it takes
for an investment project to repay the initial capital invested. Payback
therefore considers cash flows within the payback period and ignores cash
flows outside of the payback period. If Payback is used as an investment
appraisal method, projects yielding high returns outside of the payback period
will be wrongly rejected. In practice, however, it is unlikely that Payback will be
used alone as an investment appraisal method.
NPV considers the time value of money
NPV and IRR are both discounted cash flow (DCF) models that consider the
time value of money, whereas ROCE and Payback do not. Although
Discounted Payback can be used to appraise investment projects, this method
still suffers from the criticism that it ignores cash flows outside of the payback
period. Considering the time value of money is essential, since otherwise cash
flows occurring at different times cannot be distinguished from each other in
terms of value from the perspective of the present time.
NPV is an absolute measure of return
NPV is seen as being superior to investment appraisal methods that offer a
relative measure of return, such as IRR and ROCE, and which therefore fail to
reflect the amount of the initial investment or the absolute increase in
corporate value.
 173
Financial Management

NPV links directly to the objective of maximising shareholders’ wealth

The NPV of an investment project represents the change in total market value
that will occur if the investment project is accepted. The increase in wealth of
each shareholder can therefore be measured by the increase in the value of
their shareholding as a percentage of the overall issued share capital of the
company. Other investment appraisal methods do not have this direct link with
the primary financial management objective of the company.
NPV always offers the correct investment advice
With respect to mutually exclusive projects, NPV always indicates which
project should be selected in order to achieve the maximum increase on
corporate value.
NPV can accommodate non‐conventional cash flows
Non‐conventional cash flows exist when negative cash flows arise during the
life of the project. For each change in sign, there is potentially one additional
internal rate of return. With non‐conventional cash flows, therefore, IRR can
suffer from the technical problem of giving multiple internal rates of return.
Why net present value (NPV) is regarded as superior to internal rate of
return (IRR) as an investment appraisal technique.
In most simple accept or reject decisions, IRR and NPV will select the same
project. However, NPV has certain advantages over IRR as an investment
appraisal technique.

NPV and shareholder wealth

The NPV of a proposed project, if calculated at an appropriate cost of capital,
is equal to the increase in shareholder wealth which the project offers. In this
way NPV is directly linked to the assumed financial objective of the company,
the maximisation of shareholder wealth. IRR calculates the rate of return on
projects, and although this can show the attractiveness of the project to
shareholders, it does not measure the absolute increase in wealth which the
project offers.

Absolute measure
NPV looks at absolute increases in wealth and thus can be used to compare
projects of different sizes. IRR looks at relative rates of return and in doing so
ignores the relative size of the compared investment projects.
 174
Financial Management

Non‐conventional cash flows

In situations involving multiple reversals in project cash flows, it is possible
that the IRR method may produce multiple IRRs (that is, there can be more
than one interest rate which would produce an NPV of zero).

Mutually‐exclusive projects
In situations of mutually‐exclusive projects, it is possible that the IRR method
will (incorrectly) rank projects in a different order to the NPV method. This is
due to the inbuilt reinvestment assumption of the IRR method. The IRR
method assumes that any net cash inflows generated during the life of the
project will be reinvested at the project’s IRR. NPV on the other hand
assumes a reinvestment rate equal to the cost of capital. Generally, NPV’s
assumed reinvestment rate is more realistic and hence it ranks projects
correctly.

CAPITAL RATIONING
Theoretically, a company should invest in all projects with a positive net
present value in order to maximise shareholder wealth. If a company has
attractive investment opportunities available to it with positive net present
values, it will not be able to maximise shareholder wealth if it does not invest
in them, for example, because investment finance is limited or rationed.
Capital rationing can be divided into hard capital rationing, which is externally
imposed, or soft capital rationing, which is internally imposed.
Hard capital rationing is the term applied when the restrictions on raising
funds are due to causes external to the company. For example, potential
providers of finance may refuse to provide further funding because they
regard a company as too risky.
In practice, large established companies seeking long‐term finance for capital
investment are usually able to find it, but small and medium‐sized enterprises
will find raising such funds more difficult.
Reasons for Hard capital rationing
1. Potential providers of finance may refuse to provide further funding,
because of the following reasons:
• this may be in terms of financial risk, for example if the company’s
gearing is too high or its interest cover is too low,
• Or may be in terms of business risk if they see the company’s
business prospects as poor or its operating cash flows as too variable.
• Or because Company has poor track record or has too low credit
rating or has no assets to secure the loan
 175
Financial Management

2. It is also true to say that companies could struggle to secure investment

when the capital markets are depressed, or when economic prospects are
poor, for example, during a recession.
Soft capital rationing refers to restrictions on the availability of funds that
arise within a company and are imposed by managers. There are several
reasons why managers might restrict available funds for capital investment:
• Want to limit exposure and focus on profitability of small number
of projects
Managers may prefer slower organic growth rather than sudden
increase in size arising from accepting several large investment
projects.
• Limited management skills in new area.
• Managers may wish to avoid raising further equity finance if this will
dilute the control of existing shareholders and potential dilution of
earnings per share if new equity finance were raised, whether from
existing or new shareholders.
• Managers may wish to maintain high interest cover ratio.
Managers and directors may limit investment finance in order to avoid
some consequences of external financing, such as an increased
commitment to fixed interest payments if new debt finance were raised.
• Managers may wish to avoid issuing new debt if the costs of raising the
finance relatively high.
RISK AND UNCERTAINTY
The terms risk and uncertainty are often used interchangeably in financial
management.
However, there is a clear difference between them in relation to investment
appraisal.
Risk refers to the situation where an investment project has several outcomes,
all of which are known and to which probabilities can be attached, for
example, on the basis of past experience. Risk can therefore be quantified
and measured by the variability of returns of an investment project.
Uncertainty refers to the situation where an investment project has several
possible outcomes but it is not possible to assign probabilities to their
occurrence. It is therefore not possible to say which outcomes are likely to
occur. The difference between risk and uncertainty, therefore, is that risk can
be quantified whereas uncertainty cannot be quantified.
Risk increases with the variability of returns, while uncertainty increases with
project life.
 176
Financial Management

Sensitivity analysis
Sensitivity analysis assesses how the net present value of an investment
project is affected by changes in project variables. Considering each project
variable in turn, the change in the variable required to make the net present
value zero is determined. In this way, the key or critical project variables are
determined. However, sensitivity analysis does not assess the probability of
changes in project variables and so is often dismissed as a way of
incorporating risk into the investment appraisal process.

Probability analysis
Probability analysis refers to the assessment of the separate probabilities of a
number of specified outcomes of an investment project. For example, a range
of expected market conditions could be formulated and the probability of each
market condition arising in each of several future years could be assessed.
The net present values arising from combinations of future economic
conditions could then be assessed and linked to the joint probabilities of those
combinations. The expected net present value (ENPV) could be calculated,
together with the probability of the worst‐case scenario and the probability of a
negative net present value. In this way, the downside risk of the investment
could be determined and incorporated into the investment decision.

Risk‐adjusted discount rate

It appears to be intuitively correct to add a risk premium to the ‘normal’
discount rate to assess a project with greater than normal risk. The theoretical
approach here would be to use the capital asset pricing model (CAPM) to
determine a project‐ specific discount rate that reflected the systematic risk of
an investment project. This can be achieved by selecting proxy companies
whose business activities are the same as the proposed investment project:
removing the effect of their financial risk by ungearing their equity betas to
give an average asset beta; regearing the asset beta to give an equity beta
reflecting the financial risk of the investing company; and using the CAPM to
calculate a project‐specific cost of equity for the investment project.

Adjusted payback
Payback can be adjusted for risk, if uncertainty is considered to be the same
as risk, by shortening the payback period. The logic here is that as uncertainty
(risk) increases with the life of the investment project, shortening the payback
period for a project that is relatively risky will require it to pay back sooner,
putting the focus on cash flows that are more certain (less risky) because they
are nearer in time. Payback can also be adjusted for risk by discounting future
 177
Financial Management

cash flows with a risk‐ adjusted discount rate, i.e. by using the discounted
payback method.

Leasing benefits in general

1. Allows company to get the asset if they can’t get a bank loan
high accessibility of financing for businesses due to the financing being
secured with the leased asset and the asset being owned by the financing
company

2. fixed-rate funding makes budgeting easy as the lessee has clear sight of
future expenditures
3. Some taxation benefits (Tax exhaustion)
financing asset purchases can be more tax efficient than standard-
term loans due to lease payments being booked as expenses. Although
asset depreciation also provides tax benefits, the useable lifetime of the
asset will vary depending on the asset and on local regulation

4. Avoids regulations that other lending can give such as covenants

5. leasing prevents the risk of an asset’s value depreciating quickly and
provides flexibility to enter into a new contract at the end of the original
lease’s fixed term
 178
Financial Management

B. BUSINESS FINANCE AND COST OF CAPITAL

Difference between systematic and unsystematic risk in relation to
portfolio theory and the capital asset pricing model
Portfolio theory suggests that the total risk of a portfolio of investments can be
reduced by diversifying the investments held in the portfolio, e.g. by investing
capital in a number of different shares rather than buying shares in only one or
two companies.
Even when a portfolio has been well‐diversified over a number of different
investments, there is a limit to the risk‐reduction effect, so that there is a level
of risk which cannot be diversified away. This undiversifiable risk is the risk of
the financial system as a whole, and so is referred to as systematic risk or
market risk.
Diversifiable risk, which is the element of total risk which can be reduced or
minimised by portfolio diversification, is referred to as unsystematic risk or
specific risk, since it relates to individual or specific companies rather than to
the financial system as a whole.
Portfolio theory is concerned with total risk, which is the sum of systematic
risk and unsystematic risk.
The capital asset pricing model assumes that investors hold diversified
portfolios, and so is concerned with systematic risk alone.
The circumstances under which the weighted average cost of capital
(WACC) can be used as a discount rate in investment appraisal and
alternative approaches that could be adopted when using the WACC is
not appropriate
The weighted average cost of capital (WACC) is the average return required
by current providers of finance. The WACC therefore reflects the current risk
of a company’s business operations (business risk) and way in which the
company is currently financed (financial risk).
When the WACC is used as discount rate to appraise an investment project,
an assumption is being made that the project’s business risk and financial risk
are the same as those currently faced by the investing company. If this is not
the case, a marginal cost of capital or a risk adjusted WACC (project‐specific
discount rate) must be used to assess the acceptability of an investment
project.
The business risk of an investment project will be the same as current
business operations if the project is an extension of existing business
operations, and if it is small in comparison with current business operations. If
 179
Financial Management

this is the case, existing providers of finance will not change their current
required rates of return.
If these conditions are not met, a risk adjusted WACC (project‐specific
discount rate) should be calculated, for example by using the capital asset
pricing model.
The financial risk of an investment project will be the same as the financial risk
currently faced by a company if debt and equity are raised in the same
proportions as currently used, thus preserving the existing capital structure. If
this is the case, the current WACC can be used to appraise a new investment
project.
Where the capital structure is changed by finance raised for an investment
project, it may be appropriate to use the marginal cost of capital rather than
the WACC.

key concepts of the capital asset pricing model (CAPM), systematic risk,
business risk and financial risk. (Ungearing and regearing)
The capital asset pricing model (CAPM) assumes that investors hold
diversified portfolios, so that unsystematic risk has been diversified away.
Companies using the CAPM to calculate a project‐specific discount rate are
therefore concerned only with determining the minimum return that must be
generated by an investment project as compensation for its systematic risk.
The CAPM is useful where the business risk of an investment project is
different from the business risk of the investing company’s existing business
operations. In such a situation, one or more proxy companies are identified
that have similar business risk to the investment project.
The equity beta of the proxy company represents the systematic risk of the
proxy company, and reflects both the business risk of the proxy company’s
business operations and the financial risk arising from the proxy company’s
capital structure.
Since the investing company is only interested in the business risk of the
proxy company, the proxy company’s equity beta is ‘degeared’ to remove the
effect of its capital structure. ‘Degearing’ converts the proxy company’s equity
beta into an asset beta, which represents business risk alone.
The asset beta can then be ‘regeared’, giving an equity beta whose
systematic risk takes account of the financial risk of the investing company as
well as the business risk of an investment project.
 180
Financial Management

The project‐specific equity beta resulting from the regearing process can then
be used to calculate a project‐specific cost of equity using the CAPM.
This can be used as the discount rate when evaluating the investment project
with a discounted cash (DCF) flow investment appraisal method such as net
present value or internal rate of return.

The significance of the efficient market hypothesis (EMH) for the

financial manager.
Market efficiency is concerned with pricing efficiency when weak form, semi‐
strong form and strong form efficiency are being discussed.
In relation to pricing efficiency, the efficient markets hypothesis (EMH)
suggests that share prices fully and fairly reflect all relevant and available
information.
Relevant and available information can be divided into past information, public
information and private information.
Significance of EMH to financial managers If the EMH is correct and share
prices are fair, there is no point in financial managers seeking to mislead the
capital market, because such attempts will be unsuccessful.
Because share prices are always fair, there are no bargains to be found on
the stock market, i.e. companies whose shares are undervalued.
It should be noted, however, that if real‐world capital markets are semi‐strong
form efficient rather than strong form efficient, insider information may
undermine the strength of the points made above. For example, a company
which is valued fairly by the stock market may be undervalued or overvalued if
private or insider information is taken into account.
To maximise shareholder wealth, financial managers should not only invest in
positive NPV projects but should communicate this as soon as possible to the
market as, in an efficient market, this news will rapidly be incorporated into the
share price.
 181
Financial Management

Islamic finance- the concept of riba (interest) and how returns are made
by Islamic financial instruments.
Interest (riba) is the predetermined amount received by a provider of finance,
over and above the principal amount of finance provided. Riba is absolutely
forbidden in Islamic finance. Riba can be seen as unfair from the perspective
of the borrower, the lender and the economy.
For the borrower, riba can turn a profit into a loss when profitability is low. For
the lender, riba can provide an inadequate return when unanticipated inflation
arises. In the economy, riba can lead to allocational inefficiency, directing
economic resources to sub‐optimal investments.
Islamic financial instruments require that an active role be played by the
provider of funds, so that the risks and rewards of ownership are shared.
In a Mudaraba contract, for example, profits are shared between the partners
in the proportions agreed in the contract, while losses are borne by the
provider of finance.
In a Musharaka contract, profits are shared between the partners in the
proportions agreed in the contract, while losses are shared between the
partners according to their capital contributions.
With Sukuk, certificates are issued which are linked to an underlying tangible
asset and which also transfer the risk and rewards of ownership. The
underlying asset is managed on behalf of the Sukuk holders.
In a Murabaha contract, payment by the buyer is made on a deferred or
instalment basis. Returns are made by the supplier as a mark‐up is paid by
the buyer in exchange for the right to pay after the delivery date.
In an Ijara contract, which is equivalent to a lease agreement, returns are
made through the payment of fixed or variable lease rental payments.
 182
Financial Management

C. Working capital management

FACTORS THAT DETERMINE THE LEVEL OF INVESTMENT IN CURRENT
ASSETS
Length of working capital cycle
The working capital cycle or operating cycle is the period of time between
when a company settles its accounts payable and when it receives cash from
its accounts receivable. Operating activities during this period need to be
financed and as the operating period lengthens, the amount of finance needed
increases.
Terms of trade
These determine the period of credit extended to customers, any discounts
offered for early settlement or bulk purchases, and any penalties for late
payment. A company whose terms of trade are more generous than another
company in the same industry sector will therefore need a comparatively
higher investment in current assets.
Policy on level of investment in current assets
Even within the same industry sector, companies will have different policies
regarding the level of investment in current assets, depending on their attitude
to risk. A company with a comparatively conservative approach to the level of
investment in current assets would maintain higher levels of inventory, offer
more generous credit terms and have higher levels of cash in reserve than a
company with a comparatively aggressive approach. While the more
aggressive approach would be more profitable because of the lower level of
investment in current assets, it would also be more risky.
Industry in which organisation operates
Another factor that influences the level of investment in current assets is the
industry within which an organisation operates. Some industries, such as
aircraft construction, will have long operating cycles due to the length of time
needed to manufacture finished goods and so will have comparatively higher
levels of investment in current assets than industries such as supermarket
chains, where goods are bought in for resale with minimal additional
processing and where many goods have short shelf lives.
 183
Financial Management

WORKING CAPITAL FINANCING STRATEGY OR WORKING CAPITAL

FINANCING POLICY
When considering the financing of working capital, it is useful to divide current
assets into fluctuating current assets and permanent current assets.
Fluctuating current assets represent changes in the level of current
assets due to the unpredictability of business activity. Permanent
current assets represent the core level of investment in current assets
needed to support a given level of revenue or business activity, example
- a buffer level of inventory, a minimum level of cash kept in the bank etc.
The financing choice as far as working capital is concerned is between short‐
term and long‐term finance. Short‐term finance is more flexible than long‐term
finance: an overdraft, for example, is used by a business organisation as the
need arises and variable interest is charged on the outstanding balance.
Short‐term finance is also more risky than long‐term finance: an overdraft
facility may be withdrawn, or a short‐term loan may be renewed on less
favourable terms. In terms of cost, the term structure of interest rates suggests
that short‐term debt finance has a lower cost than long‐term debt finance.
The matching principle suggests that long‐term finance should be used for
long‐term investment. Applying this principle to working capital financing, long‐
term finance should be matched with permanent current assets and non‐
current assets.
The different financing strategies are provided below:
4. Conservative Financing Strategy OR Conservative Financing policy
5. Aggressive Financing Strategy OR Aggressive Financing policy
6. Moderate Financing Strategy OR Moderate Financing policy

An aggressive financing policy means that fluctuating current assets and a

portion of permanent current assets are financed from a short‐term finance
source. A conservative financing policy means that permanent current assets
and a portion of fluctuating current assets are financed from a long‐term
source.
An aggressive financing policy will be more profitable than a conservative
financing policy because short‐term finance is cheaper than long‐term finance,
as indicated for debt finance by the normal yield curve (term structure of
interest rates).
However, an aggressive financing policy will be riskier than a conservative
financing policy because short‐term finance is riskier than long‐term finance.
For example, an overdraft is repayable on demand, while a short‐term loan
 184
Financial Management

may be renewed on less favourable terms than an existing loan. Provided

interest payments are made, however, long‐term debt will not lead to any
pressure on a company and equity finance is permanent capital.
Moderate financing policy (Matching) means that fluctuating current assets are
financed by short term finances source and permanent current assets are
financed by long term finance source, which means the duration of the finance
is matched to the duration of the investment.

DIFFERENCE BETWEEN WORKING CAPITAL INVESTMENT POLICY

(POLICY ON LEVEL OF INVESTMENT IN CURRENT ASSETS) AND
WORKING CAPITAL FINANCING POLICY (WORKING CAPITAL
FINANCING STRATEGIES)
1. Working capital investment policy is concerned with the level of
investment in current assets, with one company being compared with
another. Working capital financing policy is concerned with the
relative proportions of short‐term and long‐ term finance used by a
company.

2. Working capital financing policy uses an analysis of current assets

into permanent current assets and fluctuating current assets.
Working capital investment policy does not require this analysis.
Fluctuating current assets represent changes in the level of current assets
due to the unpredictability of business activity. Permanent current assets
represent the core level of investment in current assets needed to support
a given level of revenue or business activity, example - a buffer level of
inventory, a minimum level of cash kept in the bank etc.

3. Working capital financing policy relies on the matching principle,

which is not used by working capital investment policy. The matching
principle suggests that long‐term finance should be used for long‐term
investment. Applying this principle to working capital financing, long‐term
finance should be matched with permanent current assets and non‐current
assets.

4. Both working capital investment policy and working capital financing

policy use the terms conservative, moderate and aggressive.
In investment policy, the terms are used to indicate the comparative
level of investment in current assets on an inter‐ company basis. One
company has a more aggressive approach compared to another company
 185
Financial Management

if it has a lower level of investment in current assets, and vice versa for a
conservative approach to working capital investment policy.
In working capital financing policy, the terms are used to indicate the
way in which fluctuating current assets and permanent current assets are
matched to short‐term and long‐term finance sources. An aggressive
financing policy means that fluctuating current assets and a portion of
permanent current assets are financed from a short‐term finance source. A
conservative financing policy means that permanent current assets and a
portion of fluctuating current assets are financed from a long‐term
source. An aggressive financing policy will be more profitable than a
conservative financing policy because short‐term finance is cheaper than
long‐term finance, as indicated for debt finance by the normal yield curve
(term structure of interest rates).
However, an aggressive financing policy will be riskier than a conservative
financing policy because short‐term finance is riskier than long‐term
finance. For example, an overdraft is repayable on demand, while a short‐
term loan may be renewed on less favourable terms than an existing
loan. Provided interest payments are made, however, long‐term debt will
not lead to any pressure on a company and equity finance is permanent
capital.
Overall, therefore, it can be said that while working capital investment
policy and working capital financing policy use similar terminology, the two
policies are very different in terms of their meaning and application. It
is even possible, for example, for a company to have a conservative
working capital investment policy while following an aggressive working
capital financing policy.

KEY ELEMENTS OF A RECEIVABLES MANAGEMENT SYSTEM

The key elements of a receivables management system may be described as
establishing a credit policy, credit assessment, credit control and collection of
amounts due.
Establishing credit policy
The credit policy provides the overall framework within which the receivables
management system of a company operates and will cover key issues such
as the procedures to be followed when granting credit, the usual credit period
offered, the maximum credit period that may be granted, any discounts for
early settlement, whether interest is charged on overdue balances, and
actions to be taken with accounts that have not been settled in the agreed
credit period.
 186
Financial Management

Credit assessment
In order to minimise the risk of irrecoverable debts, company should assess
potential customers as to their creditworthiness before offering them credit.
The depth of the credit check depends on the amount of business being
considered and the potential for repeat business. The credit assessment
requires information about the customer, whether from a third party as in a
trade reference, a bank reference or a credit rating agency report. The
benefits of granting credit must always be greater than the cost involved.
There is no point, therefore, company paying for a detailed credit report from a
credit reference agency for a small credit sale.
Credit control
Based on credit analysis, certain credit limits may be set for each customer.
Once the limit has been reached, no further goods are sold to the customer.
Once company has granted credit to a customer, it should monitor the account
at regular intervals to make sure that the agreed terms are being followed. An
aged receivables analysis is useful in this respect since it helps the
company focus on those clients who are the most cause for concern.
It is also important to ensure that administrative procedures are timely and
robust. Customers should be reminded of their debts by prompt despatch of
invoices and regular statements of account. Customers in arrears should not
be allowed to take further goods on credit.
Collection of amounts due
All customers of company should ideally settle their accounts within the
agreed credit period.
If this does not happen, a company needs to have in place agreed procedures
for dealing with overdue accounts. These may involve reminder phone calls,
personal visits, charging interest on outstanding amounts, refusing to grant
further credit and, as a last resort, legal action. With any action, potential
benefit should always exceed expected cost.
Factoring of trade receivables
Some companies choose to outsource management of trade receivables to a
factoring company, which can bring expertise and specialist knowledge to the
tasks of credit analysis, credit control, and collection of amounts owed. In
exchange, the factoring company will charge a fee, typically a percentage of
annual credit sales. The factoring company can also offer an advance of up to
80% of trade receivables, in exchange for interest.
 187
Financial Management

Benefit from the services offered by the factoring company as follows:

1. Reduction in the need for management control / Free up management
time
Factoring can free up management time and allow them to focus on more
important tasks. This could be a major benefit for company, where directors
are currently spending a large amount of time attempting to persuade
customers to pay on time.
2. Particularly useful for small and fast-growing businesses where the
credit control department may not be able to keep pace with volume
growth.

3. Bad debts insurance

The insurance against bad debts shields clients from non‐payment by
customers; although this comes at a cost, it can be particularly attractive to
small companies who may not be able to stand the financial shock of a large
bad debt.
4. Accelerate cash inflow/ Gets cash quickly
Factor finance can be useful to companies who have exhausted other sources
of finance.
5. Economies of specialisation
Factors specialise in trade receivables management and therefore can offer
‘economies of specialisation’. They are experts at getting customers to pay
promptly and may be able to achieve payment periods and bad debt levels
which clients could not achieve themselves.
6. Scale economies
In addition, because of the scale of their operations, factors are often able to
do this more cheaply than clients could do on their own. Factor fees, even
after allowing for the factor’s profit margin, can be less than the clients’ own
receivables administration cost.
7. Savings of administration cost
 188
Financial Management

Management of foreign receivables (granting credit to foreign customers

could be managed and reduced)
When credit is granted to foreign customers, two problems may become
especially significant.
First, the longer distances over which trade takes place and the more complex
nature of trade transactions than their domestic counterparts. Longer
transaction times increase accounts receivable balances and hence the level
of financing and financing costs.
Second, the risk of bad debts is higher with foreign accounts receivable than
with their domestic counterparts.
In order to manage and reduce credit risks, therefore, exporters seek to
reduce the risk of bad debts and to reduce the level of investment in foreign
accounts receivable.
1. Early payment:
One way to reduce investment in foreign accounts receivable is to agree early
payment with an importer, for example by payment in advance, payment on
shipment, or cash on delivery. These terms of trade are unlikely to be
competitive, however, and it is more likely that an exporter will seek to receive
cash in advance of payment being made by the customer.
2. Letter of credit:
A letter of credit is a letter from a bank guaranteeing that a buyer's payment
(importer) to a seller (exporter) will be received on time and for the correct
amount. In the event that the buyer is unable to make a payment on the
purchase, the bank will be required to cover the full or remaining amount of
the purchase.
3. Export credit insurance:
Insurance can also be used to cover some of the risks associated with giving
credit to foreign customers. This would avoid the cost of seeking to recover
cash due from foreign accounts receivable through a foreign legal system,
where the exporter could be at a disadvantage due to a lack of local or
specialist knowledge.
4. Export factoring
Factoring can also be considered, where the exporter pays for the specialist
expertise of the factor as a way of reducing investment in foreign accounts
receivable and reducing the incidence of bad debts.
 189
Financial Management

5. Forfaiting
Forfaiting is a means of financing that enables exporters to receive immediate
cash by selling their medium and long-term receivables (the amount an
importer owes the exporter) at a discount through an intermediary. The
exporter eliminates risk by making the sale without recourse.
6. Open account
Many foreign transactions are on ‘open account’, which is an agreement to
settle the amount outstanding on a predetermined date. Open account reflects
a good business relationship between importer and exporter. It also carries
the highest risk of non‐payment.
7. Bills of exchange
One way to accelerate cash receipts is to use bill finance. Bills of exchange
with a signed agreement to pay the exporter on an agreed future date,
supported by a documentary letter of credit, can be discounted by a bank to
give immediate funds.
8. Countertrading
In a countertrade arrangement, goods or services are exchanged for other
goods or services instead of for cash.

BENEFITS OF JIT SYSTEM

1. Lower level of investment in working capital
2. A reduction in inventory holding costs
3. An improved relationship with suppliers
4. A reduction in materials handling costs
5. Improved operating efficiency
6. Lower reworking costs due to the increased emphasis on the quality of
supplies