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ACCA F9 Workbook Lecture 1 Financial Strategy


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Shareholder Wealth - Illustration 1

Year 2007 2008 2009 2010 2011

Share Price 3.30 3.56 3.47 3.75 3.99

Dividend Paid 40c 42c 44c 46c 48c

There are 2 million shares in issue. ! ! ! ! ! ! ! ! ! ! Calculate the increase in shareholder wealth for each year: II. Per share III. As a percentage IV. For the business as a whole

Solution
Year Share Price Share Price Growth Div Paid Increase in Sholder Wealth As a Percentage Total Shareholder Return

2007 2008 2009 2010 2011

3.30 3.56 3.47 3.75 3.99 (3.56 - 3.30) = 26c (3.47 - 3.56) = -9c (3.75 - 3.47) = 28c (3.99 - 3.75) = 24c

40c 42c 44c 46c 48c (26 + 42) = 68c (-9 + 44) = 35c (28 + 46) = 74c (24 + 48) = 72c (68 / 330) = 20.6% (35 / 356) = 9.8% (74 / 347) = 21.3% (72 / 375) = 19.2% 2m x 68c = $1.36m 2m x 35c = $0.70m 2m x 74c = $1.48m 2m x 72c = $1.44m

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EPS - Illustration 2

2010 $000 PBIT Interest Tax Prot After Tax Preference Dividend Dividend Retained Earnings 2000 200 300 1500 300 800 400

2011 $000 2100 300 400 1400 400 900 100

Share Capital (50c) Reserves

5000 3000

5000 3100

Share Price

$2.50

$2.80

Calculate the EPS for 2010 and 2011.

Solution

2010 Prot After Tax Preference Dividend Earnings 1500 300 1200

2011 1400 400 1000

No. Ordinary Shares (5000 / 0.50)

10,000

10,000

EPS (Earnings / No. Ordinary Shares)

12c

10c

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are the 3 things that financial managers need to plan? Investments Financing Dividend Policy

2. What is Corporate Strategy? Corporate strategy is the overall direction that a firm decides to take and covers such areas as expansion into new markets, penetration of existing markets or diversification into different business areas.

3. Describe the Agency Problem. The managers of a firm act as the agents of the shareholders as they are the owners of the company. The managers are interested in maximising their short term interests through pay and benefits, whereas the shareholders are interested in the long term stability and success of their investment. As such, the goals of management are not the same as those of the shareholders, creating the agency problem.

4. What are the 3 main financial objectives of the financial manager? Maximisation of shareholder wealth. Maximisation of profit. EPS growth.

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5. How do you calculate the increase in shareholder wealth? Share price growth + dividends paid (Learn this now if you didnt know!).

6. How do you calculate EPS? (Profit after tax - Preference dividends) / Number of ordinary shares.

7. Outline 2 potential dividend payment strategies. Any 2 of: Pay a constant dividend. Pay a constant proportion of earnings. Pay an inflation linked dividend. Pay whatever is left after making planned investments.

8. Why did Miller & Modigliani say that dividends were irrelevant? M & M stated that whether the firm paid a dividend or chose to reinvest the money into the business the shareholders would get the same return. This is because if a dividend is paid the shareholders get their return in the form of revenue. If the money is reinvested in the business this should lead to more profit and thus an increased share price which increases shareholder wealth by the same amount.

9. Outline the Clientele Effect. A firm should choose a consistent dividend policy so that potential investors can choose their investment based on their preference for a return in the form of revenue or share price growth.

10. What is a script dividend? A dividend paid in the form of more shares rather than cash.

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If youve successfully answered all of the above questions then youre ready to do the exam questions below: December 2010 Q4 Part (d) June 2010 Q4 Part (c)

Now do it!
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Lecture 2 Performance Measurement


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Performance Analysis Illustration X1 X2 X3

Non Current Assets Current Assets

500 150 650

700 200 900

1000 300 1300

Ordinary Shares ($1) Reserves Loan Notes Payables

300 100 150 100 650

300 280 200 120 900

300 430 300 270 1300

Revenue COS Gross Prot Admin Costs Distribution Costs PBIT Interest Tax Prot After Tax Dividends Retained Earnings

3000 2000 1000 300 200 500 100 120 280 100 180

3500 2400 1100 350 250 500 150 90 260 110 150

4200 3200 1000 400 300 300 220 50 30 30 0

Share Price

$3.30

$4.00

$2.20

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Using the information on the previous page calculate and comment on the following Ratios: I. Return on Capital Employed II. Return on Equity III. Gross Margin IV. Net Margin V. Operating Margin VI. Revenue Growth VII. Gearing VIII. Interest Cover IX. Dividend Cover X. Dividend Yield XI. P/E Ratio

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Solution
ROCE
X1 Equity + LT Liabilities Shares Reserves LT Loan Notes Capital Employed 300 100 150 550 X2 300 280 200 780 X3 300 430 300 1030

Non Current Assets + Net Current Assets

Non Current Assets

500

700

1000

Net Current Assets (Current Assets Current Liabilities) Capital Employed

(150 - 100) = 50

(200 - 120) = 80

(300 - 270) = 30

550

780

1030

Total Assets Current Liabilities

Total Assets

650

900

1300

Current Liabilities Capital Employed

100 550

120 780

270 1030

PBIT

500

500

300

Return on Capital Employed

PBIT / Capital Employed

(500 / 550) = 90.91%

(500 / 780) = 64.10%

(300 / 1030) = 29.13%

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X1 Return on Capital Employed (ROCE) 90.91%

X2 64.10%

X3 29.13%

In the rst year the ROCE was 90.91%. At rst glance this would appear to be a good return, however without industry averages or prior period information we are unable to tell if this is the case. In year X2 the ROCE is 64.10%. This is a fall of 29.5% from the previous year indicating that the business in not able to make the same return on its assets that it has previously been able to do. In the year X3 the ROCE is 29.13%. This is a fall of 54.55% indicating that there may be some serious underlying problems which are affecting the ability of the business to generate the return on capital previously generated.

ROE

X1 Prot After Tax 280

X2 260

X3 300

Ordinary Shares Reserves Total

300 100 400

300 280 580

300 430 730

Return on Equity (PAT / Ord Shares + Reserves)

(280 / 400) = 70%

(260 / 580) = 44.8%

(300 / 730) = 41%

In the rst year the ROE was 70%. At rst glance this would appear to be a good return, however without industry averages or prior period information we are unable to tell if this is the case. In year X2 the ROE is 44.8%. This is a fall of 36% from the previous year indicating that the business in not able to make the same return on the shareholders funds that it has previously been able to do. In the year X3 the ROE is 41%. This is a fall of 8.4% indicating that the business may be having difculty generating the returns it was able to do previously.

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Margins
X1 Revenue 3000 X2 3500 X3 4200

Gross Prot PAT PBIT

1000 280 500

1100 260 500

1000 30 300

Gross Margin (Gross Prot / Revenue) Net Margin (PAT / Revenue) Operating Margin (PBIT / Revenue)

(1000 / 3000) = 33.33% (280 / 3000) = 9.3% (500 / 3000) = 16.66%

(1100 / 3500) = 31.42% (260 / 3500) = 7.4% (500 / 3500) = 14.28%

(1000 / 4200) = 23.89% (30 / 4200) = 0.7% (300 / 4200) = 7.1%

The Gross Margin is 33.33% in X1 and holds reasonably steady in X2 at 31.42%. However in X3 the Gross Margin falls to 23.89% indicating that the business has either had to cut prices to sell the greater volume it has, or the cost of its purchases have gone up. The Net Margin is 9.3% in X1 but begins to fall in X2 with 7.4% achieved, before falling dramatically to 0.7% in X3. The main reason for this is the fall in Gross Prot as other costs have risen in line with expectations given the increase in sales. However another point to note is that interest costs have risen with the increase in long term loans. The extra interest costs have put pressure on the business. The Operating Margin dropped slightly in X2 to 14.28% from 16.66% the previous year - a fall of almost 15%. In X3 the Operating Margin fell away to 7.1%, a decrease of over 50%. This is due to the decreasing Gross Margin achieved as well as rises in the other expenses.

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Gearing
X1 Debt 150 X2 200 X3 300

Equity

Number of Shares Share Price Market Value

300 3.30 (300 x 3.30) = 990

300 4 (300 x 4) = 1200

300 2.20 (300 x 2.20) = 660

Gearing (Debt / Equity)

(150 / 990) = 15%

(200 / 1200) = 16.66%

(300 / 660) = 45.45%

Gearing levels in year X1 are 15%. Without industry averages or prior year data we are unable to assess this level although at rst glance it does not seem excessive. In year X2 gearing increases slightly to 16.66%, an increase of 11% from year X1. This is due to debt levels increasing to 200 from 150, although this is offset by the increase in the share price from $3.30 to $4. In year X3 gearing increases dramatically to 45%, an increase of over 180%. This is due to debt levels rising to 300 from 200 and the share price dropping to $2.20 due to the deteriorating results of the business.

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Interest Cover
X1 PBIT 500 X2 500 X3 300

Interest

100

150

220

Interest Cover (PBIT / Interest)

(500 / 100) = 5 times

(500 / 150) = 3.33 times

(300 / 220) = 1.36 times

Interest coverage in year X1 is 5 times. Without industry averages or prior year data we are unable to assess this level although at rst glance it does not seem unreasonable. In year X2 interest coverage falls to 3.33 times. This has occurred due to the interest charge increasing in the period while PBIT has remained constant. In year X3 interest coverage has decreased again to 1.36 times. This is caused by the PBIT achieved decreasing to 300 combined with the increase in the interest charge to 220. The increase in interest is caused by the increase in the long term debt of the company as shown by the gearing ratios calculated above.

Dividend Cover
X1 PAT 280 X2 260 X3 30

Dividends

100

110

30

Dividend Cover (PAT / Dividends)

(280 / 100) = 2.8 times

(260 / 110) = 2.36 times

(30 / 30) = 1 time

Dividend coverage in year X1 is 2.8 times. Without industry averages or prior year data we are unable to assess this level although at rst glance it does not seem unreasonable. In year X2 dividend coverage falls to 2.36 times. This would not concern investors as although coverage has gone down slightly, the dividend paid this year is greater than last. In year X3 dividend coverage has decreased to 1 time. This is caused by the decrease in prot achieved by the company restricting the level of dividend payable. This will be of concern to investors and their concern is reected in the fall in the share price from $4 in year X2 to $2.20 in year X3.

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Dividend Yield
X1 Number of Shares (300 / 1) Dividends Dividends Per Share 300 100 (100 / 300) = 33c X2 300 110 (110 / 300) = 36c X3 300 30 (30 / 300) = 10c

Dividend Yield (Dividends Per Share / Share Price)

(33 / 330) = 10%

(36 / 400) = 9%

(10 / 220) = 4.5%

The Dividend Yield is 10% in year X1. Whilst we do not have comparatives, this seems a reasonable return. In year X2 the Dividend Yield falls to 9%. This will not be overly concerning to investors as the increase in share price over the year will have more than made up for the slightly lower yield. In year X3 the Dividend Yield has fallen to 4.5% which is 50% lower than the previous year. This, combined with the fall in share price and reduced protability will be a major concern to investors.

P/E Ratio
X1 Share Price $3.30 X2 $4 X3 $2.20

Prot After Tax No. Ordinary Shares EPS

280 300 (280 / 300) = 93c

260 300 (260 / 300) = 86c

30 300 (30 / 300) = 10c

P/E Ratio (Share Price / EPS)

(330 / 93) = 3.54

(400 / 86) = 4.65

(220 / 10) = 22

The P/E Ratio in year X1 is 3.54. We don not have industry comparatives or prior year information with which to compare this. In year X2 the P/E Ratio increases to 4.65. This indicates that the market expectations for this share have risen since X1 and that investors are now willing to pay 4.65 times what the business earns in a year to own the share. In year X4 the P/E ratio has increased dramatically to 22. This is unusual as the earnings have decreased to 12% of the previous year. The share price has fallen to reect this, but not by as much as would be expected. This may indicate that the market feels that the results in year X3 were perhaps a one-off and that next years results will improve.

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. In the ROCE calculation what are the 3 ways of calculating Capital Employed? PBIT / Capital Employed Equity + Long Term Liabilities. Non Current Assets + Net Current Assets. Total Assets - Current Liabilities.

2. What is the top line of the ROE calculation? Profit after tax - Preference Dividends.

3. Why do we use PAT - Pref DIvs in the ROE calculation? This is the distributable profits and thus the amount that the investors in the equity of the firm will be interested in.

4. What should we compare the ratios we calculate with? The same company in prior years. Industry average.

5. What does gearing tell us? The amount of financial risk that a firm is exposed to.

6. How do you calculate interest cover? Profit before interest and tax / Interest

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7. How do you calculate EPS? (Profit after tax - Preference dividends) / Number of ordinary shares

8. What does the P/E Ratio tell us? The number if times the current earnings that the market is currently willing to pay for the share. If the P/E ratio is high it indicates that the market expects strong future earnings. If the P/E ratio is low it indicates that the market expects weak future earnings.

9. How do you calculate dividend cover? Profit after tax / dividends paid

10. What does dividend yield tell us? The dividend paid as a proportion of the share price i.e. the amount of dividends that the share has yielded to investors.

If youve successfully answered all of the above questions then youre ready to do the exam question below: June 2009 Q4 (a)

Now do it!

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Lecture 3 Finance Sources


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Rights Issue - Illustration 1 XYZ Ltd. intends to raise capital via a rights issue. The current share price is $8. They are offering a 1 for 4 issue at a price of $6. Calculate the Theoretical Ex-rights Price.

Solution

Number of Shares 4 1 5

Share Price $8 $6

Total (4 x $8) = 32 (1 x $6) = 6 38

We now have 5 shares in issue at total value of $38 so the THERP is (38 / 5) = $7.60

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Rights Issue - Illustration 2 ABC Ltd. has decided to raise capital via a rights issue. The share price is currently $5.50 and ABC intends to raise $5m. There are currently 6.25m shares in issue and ABC is offering a 1 for 5 rights issue. Calculate the Theoretical Ex-Rights Price. Solution Amount of Capital to raise No. of shares issued (6.25m / 5) Share issue price ($5m / 1.25m) Number of Shares 5 1 6 Share Price $5.50 $4 $5m 1.25m $4 Total (5 x 5.50) = 27.5 (1 x 4) = 4 31.5

We now have 6 shares in issue at total value of $31.5 so the THERP is (31.5 / 6) = $5.25

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What 5 things will a company consider when choosing a source of finance? The cost of the finance to the firm. The length of time the firm needs the finance for. Any security that will need to be used. Current and future gearing levels. The availability of the finance to the firm.

2. What is the primary function of the stock market? To enable firms to raise capital and investors to buy equity.

3. What are the advantages to the company of being listed? It will lead to a better perception of the firm by potential investors. It will be easier for the firm to raise capital. It may well lower the cost of equity of the firm as investors will see it as a safer investment and thus accept a lower return.

4. Are there any disadvantages of being listed? It is expensive to become listed. There are ongoing costs of listing compliance. Control by the current owners will be diluted. It opens the firm up to a lot of public scrutiny - not all of it fair and balanced.

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5. A company has 10m shares in issue at a share price of $7 and undertakes a rights issue of 1 for 5 to raise $12m. What is the Theoretical ex-rights price? Amount of Capital to raise No. of shares issued (10m / 5) Share issue price ($12m / 2m) Number of Shares 10m 2m 12m Share Price $7 $6 $12m 2m $6 Total $70m $12m $82m

We now have 12m shares in issue at total value of $82m so the THERP is ($82m / 12) = $6.83

6. What is an IPO? An Initial Public Offering of shares to investors as a method of raising capital.

7. What are the disadvantages of an IPO? It can be very expensive (Legal fees, listing fees, compliance costs, advertising costs, corporate governance requirements, underwriting costs). It may need to be underwritten to ensure the shares are taken up. The share price achieved for the issue may not be as high as expected.

8. What is a placing? A placing of a new issue of shares with institutional investors such as insurance companies or pension funds.

9. Who demands covenants to be placed on debt? The bank who offers the finance.

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10. What is the function of the treasury department in a company? To set and achieve the financial objectives of the firm. To manage the liquidity of the firm. To determine the funding requirements of the firm. To manage any currency risk that the firm may be exposed to.

If youve successfully answered all of the above questions then youre ready to do the exam question below: June 2009 Q4 (b) & (c)

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Lecture 4 Economic Environment


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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are the 4 targets of economic policy? Full employment. Price stability. High, stable growth. Balance of payments.

2. Name 2 examples of cost-push inflation. Wage increases. Rising cost of commodities. Sales tax increases.

3. What is fiscal policy? Tax revenues raised by government and spent on services and subsidies.

4. How is an increase in interest rates likely to effect the economy? An increase in interest rates will increase the cost of financing to individuals and companies in the economy. This will decrease demand for goods as consumers will have less money to spend on goods because they are spending more money on the increased cost of financing (mortgages, credit cards etc.).

5. When might policy makers decide to decrease interest rates? When excessive consumer demand is causing inflation interest rates may be raised to decrease demand.

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6. What are the money markets? Banks borrow and lend to each other in the money markets.

7. How can financial intermediaries help to make the market more efficient? Financial intermediaries enable the transaction between buyers and sellers by providing finance to the buyers e.g. Banks & finance houses.

8. Name 5 types of securities? Treasury bills. Long term government bonds. Corporate bonds. Preference shares. Ordinary shares.

If youve successfully answered all of the above questions then youre ready to do the exam question below:

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Lecture 5 Working Capital


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Working Capital Illustration Balance Sheet $000 ASSETS Non Current Assets Inventory Receivables Cash 1000 300 200 300 1800 LIABILITIES Ordinary Shares Reserves Long term Liabilities Payables Overdraft 800 200 700 100 1800 Income Statement $000 Revenue COS Gross Prot Other Costs Net Prot Other Information: All sales are made on credit. Required: Calculate the Cash Operating Cycle for Inter Ltd. 1000 800 200 100 100

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Solution

Item Inventory Period Collection Period Less: Payables Period

Working 300/800 x 365 200/1000 x 365

Days 137 73

100/800 x 365

46 164

Working Capital Illustration Part II Show the journal entries and calculate the Revised Balance sheet if the operating cycle changes to:

Item Inventory Period Collection Period Less: Payables Period

Days 200 100

30 270

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Solution

Item Inventory Receivabl es Less: Payables

New Days 200 100

Old Days 137 73

Old Balance 300 200

Working 300 x 200/137 200 x 100/73

New Balance 438 274

Movemt 138 74

30 270

46 164

100

100 x 30/46

65

-35

Entries Dr Inventory Cr Cash Dr Receivables Cr Cash Dr Payables Cr Cash

Dr 138

Cr

138 74 74 35 35

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Revised Balance Sheet $000 ASSETS Non Current Assets Inventory Receivables Cash 1000 300 200 300 1800 LIABILITIES Ordinary Shares Reserves Long term Liabilities Payables Overdraft 800 200 700 100 0 1800 -35 800 200 700 65 0 1765 138 74 -247 1000 438 274 53 1765 Movement $000

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Working Capital Illustration Part III Show the journal entries and calculate the Revised Balance sheet if the operating cycle changes to:

Item Inventory Period Collection Period Less: Payables Period

Days 90 30

60 60

Solution

Item Inventory Receivabl es Less: Payables

New Days 90 30

Old Days 200 100

Old Balance 438 274

Working 438 x 90/200 274 x 30/100

New Balance 197 82

Movemt -241 -192

60 60

30 270

65

65 x 60/30

130

65

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Entries Dr Cash Cr Inventory Dr Cash Cr Receivables Dr Cash Cr Payables

Dr 241

Cr

241 192 192 65 65 498 498

Revised Balance Sheet $000 ASSETS Non Current Assets Inventory Receivables Cash 1000 438 274 53 1765 LIABILITIES Ordinary Shares Reserves Long term Liabilities Payables Overdraft 800 200 700 65 0 1765 65 800 200 700 130 0 1830 -241 -192 498 1000 197 82 551 1830 Movement $000

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are the components of working capital? Current Assets (Inventory, Receivables, Cash) Current Liabilities (Payables)

2. State 6 indicators of overtrading. Reliance on short term finance. Offering lax credit terms. Build up of inventory. Rapidly expanding sales. Deteriorating Current ratio. Deteriorating Quick Ratio.

3. What is the Quick Ratio and what does it tell us? (Current Assets - Inventory) / Current Liabilities

4. How do we calculate the cash operating cycle? Inventory Period + Receivables Period - Payables Period

5. If my inventory days go up from 100 to 150 will I need to invest more or less cash in the business? More cash as cash is being tied up in inventory.

6. What are permanent current assets? The level of inventory, receivables and cash that are required to support the day to day running of the business.

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7. What are fluctuating current assets? The levels of inventory, receivables and cash that are required to support seasonal fluctuations in business operations.

8. What is the matching principle? Matching short term assets with short term finance and long term assets with long term finance.

9. What are the advantages of an aggressive working capital financing policy? It will lead to more profit as financing short term finance is cheaper. It is more efficient.

10. What are the advantages of a conservative working capital financing policy? There is less chance of the firm running out of cash i.e. less liquidity risk. The firm is able to meet sales demand changes. By offering more credit the firm may well increase sales.

If youve successfully answered all of the above questions then youre ready to do the exam question below: June 2009 Q3 (a) & (b)

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Lecture 6 Managing Receivables


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Receivables - Illustration 1 Credit sales: 1200 3 month credit terms Overdraft rate = 10% New Policy 2% discount if paid in less than 10 days 2 month terms for everyone else. 20% will take the discount

Solution

Method = Compare the savings through reducing receivables by offering the discount to the prot lost by doing so. Working Receivables Before 1200 x 3/12 300

Receivables After

20% who take discount

(1200 x 10/365) x 20%

7 160 167

Everyone else (1200 x 2/12) x 80%

Saving = (Reduction in receivables x Overdraft rate)

(300 - 167) x 10%

13

Lost Prot = Amount of Discount

(1200 x 20%) x 2%

4.8

The saving made is greater than the prot lost so the discount should be offered

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Receivables - Illustration 2

Receivables are currently $4,600,000. Sales are $37,400,000 A factor has offered to take over the administration of trade receivables on a non-recourse basis for an annual fee of 3% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Gorwa Co will save $100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoring agreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%. The current overdraft rate is 5%

Difference on Receivables Current Receivables Receivables Under Factor Difference 37,400,000 x (30 / 365) 4,600,000 3,073,973 1,526,027

Benets & Costs of Factor Benets of Using Factor Reduced Overdraft Interest Admin Cost Savings Bad Debt Savings Total Benets Costs Of Using Factor Annual Fee Extra Interest Cost 37,400,000 x 0.03 3,073,973 x 80% x (7% - 5%) Total Costs 1,122,000 49,184 1,171,184 1,526,027 x 0.05 76,301 100,000 350,000 526,301

Total Benets Less Total Costs

-644,883

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. How can a company assess the credit worthiness of their customers? Get trade references from other suppliers or from banks. Use a credit rating agency. Offer initial low levels of credit. Maintain and review a file on the customer. Maintain an internal credit rating system.

2. Outline 3 ways of maintaining good credit control. Any 3 of: Maintain an aged debtors listing. Identify overdue accounts on a timely basis. Send regular statements to customers. Outline a clear policy to customers.

3. What are the benefits of offering a discount to customers? Better liquidity for the firm. Less interest as less or no overdraft will be required. Less bad debt as customers pay early. New customers as they take advantage of the discount.

4. How do you decide whether to offer a discount or not? Assess the saving through early payment (Change in receivables x Overdraft interest) Compared to the cost of the discount. 5. What is debt factoring? A factor (usually a bank) buys the debt of the company for a percentage of the invoice amount. The factor will charge a fee for the service and will charge interest on any amounts outstanding until the money is collected.

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6. What are the disadvantages of factoring for a company? It can be expensive. It creates a bad impression with customers because the debt is collected by the factor. It can lose the goodwill of customers.

7. What is invoice discounting? A factor forwards the company money secured against the debt ledger of the business but it is still collected by the business.

8. How can a company seek to ensure that foreign receivables are collected? Agree early payment. Bills of exchange. Letters of credit. References & credit checks. Insurance. Export factor.

If youve successfully answered all of the above questions then youre ready to do the exam question below:

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Lecture 7 Inventory Management


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EOQ - Illustration 1 Demand of 1200 units per month. Cost of making an order of $12. Cost of one unit $10. Holding cost per year of 10% of the purchase price of the goods. Calculate the EOQ & check that it is correct.

Solution

Working Annual Demand Holding Cost Ordering Cost EOQ Test Ordering Costs (Cost Per order x (Demand / EOQ)) Holding Costs (Cost Per Unit x (EOQ / 2)) 12 x (14,400 / 588) 1 x (588 / 2) 294 294 (2 x 12 x 14,400) / 1 1200 x 12 $10 x 10% 14,400 1 12 588

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Buffer Stock - Illustration 2

Company orders when the level of stock reaches 50,000 It takes 4 weeks to receive new stock from the time of ordering. The company uses 7,500 units on average per week. Calculate the buffer stock.

Solution
Buffer Stock = Re-order level less usage in lead time Re-order level Lead Time Usage per week 50,000 - (4 x 7,500) 50,000 4 weeks 7,500 20,000

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EOQ With Buffer Stock - Illustration 3

Dec 07 Exam Question The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production requirements during the next year is 625,000 units. The cost of placing and processing an order is 250, while the cost of holding a unit in stores is 050 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year. Calculate EOQ with buffer stock

Solution

Working Buffer Stock (Re-order level - (Lead time x amount used per week)) EOQ ignoring buffer stock Total cost Calculations Order Costs (Cost per order x No. Orders) Holding Costs (Holding cost p/unit x Average Stock) Holding Cost for Buffer (Holding cost p/unit x Buffer Stock) 250 x (625,000/25,000) 0.5 x (25,000 / 2) 0.5 x 10,000 Total Costs 6,250 6,250 5,000 17,500 35,000 - (2 weeks x 625,000/50) (2 x 250 x 625,000 / 0.5) 10,000 25,000

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EOQ with discounts - Illustration 4 Demand is 1000 units per month. Purchase cost per unit 11. Order cost 30 Holding cost 10% p.a. of stock value. Required Calculate the minimum total cost with a discount of 1% given on orders of 1500 and over

Solution
EOQ with Discounts 1) Calculate EOQ in normal way (and the costs) 2) Calculate costs at the lower level of each discount above the EOQ Working EOQ Total cost Calculations Order Costs (Cost per order x No. Orders) Holding Costs (Holding cost p/unit x Average Stock) Cost of Purchases 30 x (12,000 / 809) 1.1 x (809/2) 12,000 x 11 Total Costs If 1500 are ordered to take the discount: Total cost Calculations Order Costs (Cost per order x No. Orders) Holding Costs (Holding cost p/unit x Average Stock) Cost of Purchases 30 x (12,000 / 1500) (1.1 x 99%) x (1500/2) 12,000 x (11 x 99%) Total Costs 240 817 130,608 131,665 445 445 132,000 132,890 (2 x 30 x 12,000 / 1.1) 809

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are the two types of cost we are seeking to minimise? Ordering costs. Holding costs.

2. How do we calculate total ordering costs for the year? Cost per order x Number of orders (Annual Demand / EOQ)

3. How do we calculate total holding costs for the year? Holding cost per unit x Average stock held (EOQ / 2)

4. How do we calculate the buffer stock? Re-order level - usage in lead time

5. What are the problems with the EOQ method? Assumes constant ordering costs. Assumes constant demand. Assumes known annual demand. Assumes no bulk discounts. Assumes no buffer stock or lead time.

6. What are the steps in calculating the total costs when there is a buffer stock? Calculate the EOQ ignoring the buffer stock. Calculate the buffer stock. Add the holding cost for the buffer.

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8. Why might we not use the EOQ when there are bulk discounts available? The saving on the discount may mean that it is cost beneficial to order at that level.

If youve successfully answered all of the above questions then youre ready to do the exam questions below: June 2009 Q3 (d) December 2010 Q3 (a)

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Lecture 8 Cash Management


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Baumol Cash Model - Illustration 1

A business expects to move 500,000 from its interest bearing account into cash over the course of one year. The interest rate is 7% and the cost of making a transfer is $250. How much should the business transfer into cash each time it makes a transfer?

Solution

Working Annual Disbursements Interest Rate Cost of making a transfer Amount to transfer (2 x 250 x 500,000) / 0.07 $500,000 7% $250 $59,761

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Baumol Cash Model - Illustration 2

Using the information in illustration 1 calculate the total cost to the business each year of their cash management policy.

Solution

Working Holding Cost (Ave Cash Balance x Interest Rate) Trading Cost (Cost of Transfer x No. Transfers) ($59761 / 2) x 0.07 $250 x (500,000 / 59,761) Total Cost 2091 2091 4182

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Baumol Cash Model - Illustration 3

Subsonic Speaker Systems (SSS) has annual transactions of $9 million. The xed cost of converting securities into cash is $264.50 per conversion. The annual opportunity cost of funds is 9%. What is the optimal deposit size?

Solution

Working Annual Disbursements Interest Rate Cost of making a transfer Amount to transfer (2 x 264.5 x 9,000,000) / 0.09) Working Holding Cost (Ave Cash Balance x Interest Rate) Trading Cost (Cost of Transfer x No. Transfers) (230,000 / 2) x 0.09 $264.50 x (9,000,000 / 230,000) Total Cost 10,350 10,350 20,700 $9,000,000 9% $264.50 230,000

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Miller-Orr Model - Illustration 4

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

Solution

Working Lower Limit Spread Upper Limit (Lower Limit + Spread) Return Point (Lower Limit + (1/3 x Spread) Given in Question (3 x ((3/4 x 50 x 4,000,000) / 0.00025))1/3 8,000 + 25,303 8,000 + (1/3 x 25,303) 8,000 25,303 33,303 16,434

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are the three reasons to hold cash? Speculation Precaution Transaction

2. What does the Baumol Model tell us? The optimum cash amount to transfer from interest bearing investments into cash each time cash is transferred.

3. Why is there a cost of holding cash? By holding cash you are not earning interest so the cost is the opportunity cost of the interest you could have earned.

4. How do we calculate the total trading costs in the year? The cost of moving cash x number of movements (Total cash moved per year / amount moved each time)

5. How do we calculate the total holding costs in the year? Average cash balance (C / 2) x Interest rate.

6. What are the problems with the Baumol Model? Assumes constant cash disbursements Assumes that there are no cash receipts - just movements from interest bearing account to cash Assumes no safety buffer for cash

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7. Why does the Miller-Orr model tell us to buy securities with extra cash? To earn interest on excess cash.

8. How do we calculate the variance of cash flows? Standard Deviation of cash flows squared.

9. If the interest rate is 8% what figure should be included in the Miller-Orr model for i? 0.00022 (0.08 / 365)

10. How do we calculate the upper limit? Lower limit + spread.

If youve successfully answered all of the above questions then youre ready to do the exam questions below: Pilot Paper Q3 (You now know enough to do this all)

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Lecture 9 Investment Appraisal I


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ARR - Illustration 1 ABC Ltd are considering expanding their internet cafe business by buying a business which will cost $275,000 to buy and a further $175,000 to refurbish. They expect the following cash to come in: Year Net Cash Prots () 1 45,000 2 75,000 3 80,000 4 50,000 5 50,000 6 60,000 The equipment will be depreciated to a zero resale value over the same period and, after the sixth year, they can sell the business for $200,000 Calculate the ARR or ROCE of this investment

Solution

Total Prot over 6 years Total Depreciation Total Prots Average Prots Average Investment (Capital Investment + Residual Value) / 2 ROCE (Ave. Prot / Ave Investment)

45,000 + 75,000 + 80,000 + 50,000 + 50,000 + 60,000 Equipment of $175,000 fully depreciated

360,000 175,000 185,000

$185,000 / 6 years (450,000 + 200,000) / 2 30,833 / 325,000

30,833 325,000 9.5%

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Relevant Cash Flow Criteria - Illustration 2 A business is considering investing in a new project. They have already spent $20,000 on a feasibility study which suggests that the project will be protable. The headquarters of the company has spare oor space which will be allocated to the project with $7,000 of the current monthly rent allocated to the project. New equipment costing $2.5m will have to be bought and will be depreciated on a straight line basis over 10 years. A manager who earns $30,000 per year and currently runs a similar project will also manage the new project taking up 25% of his time. State whether each of the following items are relevant cash ows and explain your answer. I. II. The cost of the feasibility study. The rent charged to the project.

III. The new equipment. IV. The depreciation on the new equipment. V. The Managers salary.

Item Feasibility Study Rent New Equipment Depreciation Managers Salary

Relevant Cash Flow? No No Yes No No

Explain This is a sunk cost as it has already been paid. The rent is not relevant as it must be paid whether the project goes ahead or not. It is not incremental. This is a relevant cash ow. Depreciation is not a cash-ow but an accounting entry. The managers salary must be paid whether the project goes ahead or not so is not relevant.

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Payback Period - Illustration 3 Initial Investment of $5.8m. Annual Cash Flows of $400,000. Calculate the Payback Period.

Solution

Payback Period (Initial Investment / Annual Cash Flows)

$5.8m / $400,000

14.5 years

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Payback Period - Illustration 4 Initial Investment of $6.2m. Cash Flows of: Year 1: ! Year 2:! Year 3:! Year 4:! $1,200,000 $2,200,000 $2,500,000 $1,700,000

Calculate the Payback Period.

Solution

Year 1 2 3 4

Cash Flows 1,200,000 2,200,000 2,500,000 1,700,000

Cumulative Cash Flows 1,200,000 3,400,000 5,900,000 7,600,000

Payback period is between 3 and 4 years Additional amount required to return capital (6,200,000 - 5,900,000) = 300,000 Total cash ows in year 4 of 1,700,000 so it will take (300,000 / 1,700,000) x 12 = 2.11 months

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Discounted Cash-ows - Illustration 5 An investor wants a real return of 10%. Ination is 5% What is the MONEY/NOMINAL rate required?

Solution
Use Formula: 1+m = (1+r) x (1+inf) We are looking for m, therefore: 1+m = (1+0.10) x (1+0.05) 1+m = 1.155 m = 0.155 = 15.5%

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Discounted Cash-ows - Illustration 6 A company undertakes a project with the following cash-ows:

Year 1 2 3 4 5 6

Cash-Flows 5,000 7,000 8,000 10,000 11,000 9,000

The company has a cost of capital of 10%. Calculate the present value of the cash ows for each of the six years and in total.

Solution
Year 1 2 3 4 5 6 Cash-Flows 5,000 7,000 8,000 10,000 11,000 9,000 Discount Rate (From Tables) 0.909 0.826 0.751 0.683 0.621 0.564 Total Present Value 4,545 5,782 6,008 6,830 6,831 5,076 35,072

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Discounted Cash-ows - Illustration 7 A company undertakes a project with the following cash-ows:

Year 1 2 3 4 5 6

Cash-Flows 5,000 5,000 5,000 5,000 5,000 5,000

The company has a cost of capital of 10%. Calculate the present value of the total cash ows for the six years

Solution
Year 1 2 3 4 5 6 Cash-Flows 5,000 5,000 5,000 5,000 5,000 5,000 Discount Rate (From Tables) 0.909 0.826 0.751 0.683 0.621 0.564 Total Present Value 4,545 4,130 3,755 3,415 3,105 2,820 21,770

Years 1-6

Cash-ow 5,000

Discount Rate (Annuity Tables) 4.355

Present Value 21,775

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Discounted Cash-ows - Illustration 8 A company expects to receive $100,000 per year forever. Their cost of capital is 10%. Calculate the present value of the perpetuity.

Solution
Annual Cash Flow Cost of Capital (10%) Perpetuity (Cash-Flow / Cost of Capital) $100,000 0.10 100,000 / 0.10 = $1m

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are the 6 steps in investment appraisal? Identify investment opportunities. Screen the proposals to see that they fit with the organisation. Analyse and evaluate the proposals. Approval by the board. Implementation and monitoring. Post completion review or audit.

2. Why carry out a post-completion audit? To ensure that managers are more careful in future. To evaluate management performance on the project. To evaluate future projects.

3. What is the calculation for the ARR or ROCE? Average accounting profit / Average investment

4. How do you calculate the average investment? (Cost + Residual Value) / 2

5. What are the weaknesses of the ARR? The gain is expressed as a percentage so does not take into account the size of the investment. Uses accounting profit rather than cash so can be manipulated. Disregards the timing of cashflows. No discount rate to allow for inflation and risk.

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6. What are the 3 relevant criteria for cash-flows in investment appraisal? Cash Incremental (Caused by the project) Future

7. What are the advantages of using the payback period method? Simple. Minimises risk as it focuses on getting the capital invested back. Maximises liquidity, again as it focuses on getting the capital invested back. Uses cash rather than accounting profit. Good for conservative managers.

8. Why do we need to discount cash-flows? To allow for risk and inflation.

9. If the real discount rate is 7% and inflation is running at 3% what is the nominal/money discount rate? 1+m = (1+r) x (1+inf) 1+m = (1.07) x (1.03) 1+m = 1.10 m = 0.10 Money Discount Rate = 10%

10. If I am going to receive $8,000 per year for 6 years and my cost of capital (discount rate) is 8% what is the present value of the total of these cash-flows? $8,000 x 4.623 (from annuity tables) = $36,984

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If youve successfully answered all of the above questions then youre ready to do the exam questions below: June 2009 Q2 (a)

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Lecture 10 Investment Appraisal II


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WDA - Illustration 1 A business buys a piece of equipment for $100. Capital allowances are available at 25% reducing balance. The tax rate is 30% After the 4 year project the equipment can be sold for $25.

Solution
Period 1 2 3 4 Sale of Item Balance 100.00 75.00 56.25 42.19 -25.00 17.19 5.16 5 25% WDA 25.00 18.75 14.06 30% Tax Saving 7.50 5.63 4.22 Period 2 3 4

Period

Tax Saving

7.5

5.63

4.22

5.16

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Working Capital - Illustration 2 A business requires the following working capital investment into a four year project: Initial Investment:! ! Year 1 ! Year 2 ! Year 3 ! ! ! ! ! ! ! 30,000 35,000 45,000 32,000

Show the working capital line in the NPV calculation.

Solution
Period Total Invested 0 30,000 1 35,000 2 45,000 3 32,000 4

Movement to NPV Calculation

-30,000

-5,000

-10,000

13,000

32,000

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NPV - Illustration 3 A business is evaluating a project for which the following information is relevant: I. II. Sales will be $100,000 in the rst year and are expected to increase by 5% per year. Costs will be $50,000 and are expected to increase by 7% per year.

III. Capital investment will be $200,000 and attracts tax allowable depreciation of the full value of the investment over the 5 year length of the project. IV. The tax rate is 30% and tax is payable in the following year. V. Working Capital invested will be 20% of projected sales for the following year.

VI. General ination is expected to be 3% over the course of the project and the business uses a real discount rate of 9%. Calculate the NPV for the project.

Solution

Working 1 - WDAs

Initial Investment 200,000

WDAs (200,000 / 5) = 40,000

Tax Saving (40,000 x 30%) = 12,000

Periods 2-6

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Working 2 - Ination

Period Sales Ination Inated Sales

1 100,000 100,000

2 100,000 1.05 105,000

3 100,000 1.05 to power of 2 110,250

4 100,000 1.05 to power of 3 115,763

5 100,000 1.05 to power of 4 121,551

Costs Ination Inated Costs

50,000 50,000

50,000 1.07 53,500

50,000 1.07 to power of 2 57,245

50,000 1.07 to power of 3 61,252

50,000 1.07 to power of 4 65,540

Working 3 - Discount Rate

Working Real Discount Rate Ination Nominal Discount Rate In Question In Question 1 + m = (1 + 0.09) x (1 + 0.03) 1 + m = 1.12 m = 0.12 9% 3% 12%

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Working 4 - Working Capital

Period Inated Sales Working Capital Required (20%) Movement

1 100,000

2 105,000 22,050 -1,050

3 110,250 23,153 -1,103

4 115,763 24,310 -1,158

5 121,551

20,000 -20,000

21,000 -1,000

24,310

NPV

Period Inated Sales (W2) Inated Costs (W2) Prot Tax at 30% Tax Saving (W1) Capital Investment Working Capital (W4) Total Cash Flows Discount Rate 12% (W3) Discounted Cash Flows

3 110,250 -57,245 53,005 -15,450 12,000

4 115,763 -61,252 54,510 -15,902 12,000

5 121,551 -65,540 56,011 -16,353 12,000

100,000 105,000 -50,000 -53,500 50,000 51,500 -15,000 12,000 -200,000 -20,000 -220,000 1 -220,000 -1,000 49,000 0.893 43,757 -1,050 47,450 0.797 37,818

-16,803 12,000

-1,103 48,452 0.712 34,498

-1,158 49,451 0.636 31,451

24,310 75,968 0.567 43,074 -4,803 0.507 -2,435

NPV

-31,838

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are we comparing in NPV analysis? The initial investment in the project is being compared to the forecast cash-flows which are discounted to reflect the risk of the project and inflation.

2. Why do we need a period 0? The initial investment is made now - in the current time period and as such is not discounted as no inflation will have occurred.

3. Why do we assume that cash-flows occur at the end of each period? The discount rates given to us in the discount table applys to a whole year i.e. the discount rate for period one applies to cash flows that occur 1 year after the start of the project. If we did not assume that the cash we earn during year one occurred at the end of that period then we would have to adjust the discount rate for the month in which they occur (by using a fraction of the discount rate). This would be time consuming and difficult.

4. If I have profits in period 2 of $4,000 and a tax rate of 30% how much tax will I pay and when? Tax to pay: 4,000 x 0.3 = $1,200 This will be paid in period 3 - one year later.

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5. If I receive 25% capital allowances and have a tax rate of 20% what will my tax saving be in each year over a 5 year project if the capital investment is $7,500 with a residual value of $1,500?

Period 1 2 3 4 5 Sale of Item

Balance 7500 5625 4219 3164 2373 -1500

25% WDA 1875 1406 1055 791

30% Tax Saving 375 281 211 158

Period 2 3 4 5

873

175

6. What makes up working capital? Inventory, Receivables, Payables.

7. How do we account for working capital in NPV analysis? The initial working capital required is invested in period 0. We then adjust the working capital for the increase or decrease required in each period. The closing balance of working capital is returned at the end of the project so that the working capital line in the NPV calculation should add across to zero.

8. If my cash flows in my NPV analysis are inflated should I use the real or the nominal discount rate? The real rate. If the cash flows are inflated then the discount rate needs to be adjusted for inflation also.

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If youve successfully answered all of the above questions then youre ready to do the exam questions below: June 2010 Q3 (a) & (b)

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Lecture 11 Investment Appraisal III


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IRR - Illustration 1 ABC has evaluated a project and come to the following conclusions. At a discount rate of 10% the NPV will be $100,000 At a discount rate of 15% the NPV will be -$75,000 What is the IRR?

Solution

! !

100,000 10 + ! 100,000 - (75,000) (15 - 10)

IRR = !!

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are we trying to find with the Internal Rate of Return? We are trying to find the discount rate at which the NPV of the project would equal zero i.e. if we discounted the cash flows at that discount rate the project would have neither a positive or negative NPV but an NPV of 0.

2. What is the formula for the IRR? L + [(NPV L / (NPV L - NPV H)) (H - L)]

3. If a project has cash inflows of $5,000 per year for 5 years and had an initial investment of $17,000 what is the IRR? NPV at discount rate of 5%: Present value of cash flows (5,000 x 4.329) = 21,645 Initial investment = 17,000 NPV = 4,645 (21,645 - 17,000) NPV at discount rate of 15%: Present value of cash flows (5,000 x 3.352) = 16,760 Initial investment = 17,000 NPV = -240 (16,760 - 17,000) Fill into IRR 5 + [(4,645 / (4,645 - -240)) (15 - 5)] IRR = 14.5%

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4. What are the advantages of the IRR? IRR gives an answer in the form of an understandable percentage. IRR uses cash flows and not accounting profit. IRR covers the whole life of the project. IRR (like NPV) focuses on the maximisation of shareholder wealth.

5. What are the disadvantages of the IRR? The calculation is assumed to be complicated. It gives a percentage rather than an absolute figure as the result. All of the figures are based on forecasts. It is possible to get multiple IRRs depending on the timing of the cashflows. IRR assumes that all returns are re-invested in the project which is not necessarily the case.

If youve successfully answered all of the above questions then youre ready to do the exam questions below: June 2009 Q2 (b) & (c) December 2010 Q1 (a) & (b) December 2007 Q2 (a) & (b) Pilot Paper Q4

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Lecture 12 Further Appraisal


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Expected Values - Illustration 1

A business is considering 2 different projects. The likely prot made from each project is outlined below: Project A Projected Prot $10,000 $15,000 $20,000 $23,000 Percentage Likely-hood 10% 30% 40% 20% Project B Projected Prot $10,000 $15,000 $20,000 $23,000 Percentage Likely-hood 15% 25% 30% 30%

Calculate the expected value for each of the projects.

Solution

Project A Project ed Prot $10,000 $15,000 $20,000 $23,000 Percent age Likelyhood 0.1 0.3 0.4 0.2 1 Working EV Project ed Prot $10,000 $15,000 $20,000 $23,000

Project B Percent age Likelyhood 0.15 0.25 0.3 0.3 1 Working EV

(10,000 x 0.1) (15,000 x 0.3) (20,000 x 0.4) (23,000 x 0.2) EV

$1,000 $4,500 $8,000 $4,600 $18,100

(10,000 x 0.15) (15,000 x 0.25 (20,000 x 0.3) (23,000 x 0.3)

$1,500 $3,750 $6,000 $6,900

EV $18,150

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Sensitivity Margin - Illustration 2

A business is considering a project which will cost them an initial 20,000 The sales expected for the 2 year duration are 20,000pa. The variable costs are 2,000pa Cost of capital 10% Calculate the sensitivity margin of: I. II. The initial investment. The variable costs of the projects.

III. The sales of the project.

Solution

Working 1 - NPV of Project Period Capital Investment Cash-Flows Variable Cost Total Cash Flows Discount Rate 10% PV Cash Flows NPV -20,000 1 -20,000 11,230 0 -20,000 20,000 -2,000 18,000 0.909 16,362 20,000 -2,000 18,000 0.826 14,868 1 2

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Working 2 - PV of each item Period Variable Costs Discount Rate 10% Total 0 1 -2,000 0.909 -1,818 2 -2,000 0.826 -1,652

Present Value of Variable Costs (1,818 + 1,652) = $3,470

Sales Discount Rate 10% Total Present Value of Sales (18,180 + 16,520) = $34,700

20,000 0.909 18,180

20,000 0.826 16,520

Present Value of Initial Investment = $20,000

Sensitivity Margins Item Initial Investmen t Variable Costs Sales Working NPV / PV Initial Investment (11,230 / 20,000) NPV / PV Variable Costs (11,230 / 3470) NPV / PV Sales (11,230 / 34,700) Sensitivity Margin 56% Explanation The NPV is 56% of the initial investment. The Variable costs would need to rise by 323% to create a negative NPV Sales would need to drop by 32% before the NPV would be negative.

323%

32%

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Lease V Buy - Illustration 3

Machine cost $10,000 The Machine has a useful economic life of 5 years with no scrap value Capital allowancesavailable at 25% reducing balance Finance choices 1) 5 year loan 14.28% pre tax cost 2) 5 year Finance Lease @ $2,200 pa in advance If the machine is purchased then maintenance costs of $100 per year will be incurred. The tax rate is 30%. The leasing company will maintain the machine if it is leased. Should the company lease or buy the machine.

Solution
Buy Working 1 - Capital Allowances

Period 1 2 3 4 5

Balance 10000.00 7500.00 5625.00 4218.75 3164.06

25% WDA 2500.00 1875.00 1406.25 1054.69 3,164.06

30% Tax Saving 750.00 562.50 421.88 316.41 949.22

Period 2 3 4 5 6

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Working 2 - Maintenance Amount $100 per Year Tax Saving (100 x 30%) = $30

Working 3 - Discount Rate

Pre-tax Borrowing Rate Tax Rate Post Tax Borrowing Rate

14.28% 30% 14.28 x (1 - 0.3) = 10%

Working 4 - NPV

Period Capital WDA Tax Saving (W1) Maintenance Maintenance Tax Saving (W2) Total Cash Flows Discount Rate 10% (W3) PV Cash Flows NPV

0 -10,000

750 -100 -100 30 -10,000 1 -10,000 -8,214 -100 0.909 -91 680 0.826 562

562 -100 30 492 0.751 369

422 -100 30 352 0.683 240

316 -100 30 246 0.621 153

949

30 979 0.564 552

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Lease Period Capital Tax Saving on Lease Payment Total Cash Flows Discount Rate 10% (W3) PV Cash Flows NPV -2200 1 -2,200 -6,898 -2200 0.909 -2000 0 -2200 1 -2200 2 -2200 660 -1540 0.826 -1272 3 -2200 660 -1540 0.751 -1157 4 -2200 660 -1540 0.683 -1052 660 660 0.621 410 660 660 0.564 372 5 6

Based on the above, the company should lease the machine.

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Equivalent Annual Cost - Illustration 4

Machine Cost 30,000 Running costs Year 1 10,000 Year 2 11,500 Residual Value (if sold after..) Year 1 19,000 Year 2 16,000 Cost of capital = 10% Is it better to replace the machine every year or to replace it every 2 years?

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Solution
NPV for replacement after one year

Period Capital Investment Running Costs Residual Value Cash Flows Discount Rate 10% PV Cash Flows NPV Annuity Factor from tables (1yr at 10%)

0 -30,000

-10,000 19,000 -30,000 1 -30,000 -21,819 0.909 9,000 0.909 8,181

Equivalent Annual Cost (NPV / Annuity Factor) = (-21,819 / 0.909) = -$24,003

NPV for replacement after two years

Period Capital Investment Running Costs Residual Value Cash Flows Discount Rate 10% PV Cash Flows NPV Annuity Factor from tables (2yrs at 10%)

0 -30,000

-10,000 -30,000 1 -30,000 -35,373 1.736 -10,000 0.909 -9,090

-11,500 16,000 4,500 0.826 3,717

Equivalent Annual Cost (NPV / Annuity Factor) = (-35,373 / 1.736) = -$20,376

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What is the difference between risk and uncertainty? Risk can be quantified whereas uncertainty cannot.

2. How can we deal with each of risk and uncertainty in investment appraisal? Risk can be quantified using probabilities. This enables us to calculate an expected value and use this in our investment appraisal.

3. What is an operating lease? An operating lease is a leasing arrangement where a company does not take ownership of the item being leased but pays a periodic amount to use it. It will remain on the lessors balance sheet and they will be responsible for maintaining it.

4. Why might a company want to lease an item rather than buy it? There may be tax benefits to leasing the item. The lessor retains the risk of obsolescence and maintenance. It can be used as a form of off-balance-sheet finance. There is no requirement to take out a loan to finance the item.

5. What are the relevant costs of buying the item? The cost of the item. The residual value at the end of the useful life. Written down allowances against tax. Maintenance costs which will be incurred when the item is owned. Tax allowance on the maintenance costs (or any other tax allowable cost in a question).

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6. What are the relevant costs of leasing the item? The lease payments. Tax allowance on the lease payments.

7. If I have a pre-tax borrowing rate of 13% and the tax rate is 25% what is the post-tax borrowing rate? 0.13 x (1-T) 0.13 x (1 - 0.25) = 0.975 Answer = 9.75%

8. What does the equivalent annual cost method tell us? EAC tells us when best to replace assets as it shows us the cost per year to own and operate them.

9. What is the equation for the EAC? NPV / Annuity factor.

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10. I have an item of plant costing $30,000 new and $5,000 to maintain each year. The residual value after 3 years is $7,000 and after 4 years is $5,000. If I have a cost of capital of 10% after how long should I replace the asset? EAC for replacing after 3 years Period Capital Investment Running Costs Residual Value Cash Flows Discount Rate 10% PV Cash Flows NPV Annuity Factor from tables (3yrs at 10%) -30,000 1 -30,000 -37,178 2.487 -5,000 2.487 -12,435 0 -30,000 -5,000 7,000 7,000 0.751 5,257 1-3 3

Equivalent Annual Cost (NPV / Annuity Factor) = (-37,187 / 2.487) = -$14,953 EAC for replacing after 4 years Period Capital Investment Running Costs Residual Value Cash Flows Discount Rate 10% PV Cash Flows NPV Annuity Factor from tables (3yrs at 10%) -30,000 1 -30,000 -41,069 3.170 -5,000 3.170 -15,850 0 -30,000 -5,000 5,000 7,000 0.683 4,781 1-4 4

Equivalent Annual Cost (NPV / Annuity Factor) = (-41,069 / 3.170) = -$12,956 It is better to replace the plant every 4 years as the EAC is lower.

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If youve successfully answered all of the above questions then youre ready to do the exam questions below: December 2009 Q1 (a) & (b) December 2007 Q2 (c)

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Lecture 13 Further Appraisal II


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Protability Index - Illustration 1

A business has identied the following projects. They have $200,000 to invest and the projects are divisible. Project A B C D E Investment 90,000 110,000 50,000 75,000 70,000 NPV 15,000 25,000 10,000 22,000 -8,000

Which projects should the business undertake?

Solution
Project A B C D E Investment Project All of D All of B 30% of C (50,000 x 0.3) Total Investment Investment 75,000 110,000 15,000 200,000 Investment 90,000 110,000 50,000 75,000 70,000 NPV 15,000 25,000 10,000 22,000 -8,000 PI (NPV / Investment) 17% 23% 20% 29% Rank 4% 2% 3% 1%

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Investment Choices - Illustration 2

A business has identied the following projects. They have $200,000 to invest and the projects are non-divisible. Project A B C D Investment 90,000 110,000 50,000 75,000 NPV 15,000 25,000 10,000 22,000

Which projects should the business undertake?

Solution

Project A+B A+C A+D B+C B+D C+D

Investment 90,000 + 110,000 = 200,000 90,000 + 50,000 = 140,000 90,000 + 75,000 = 165,000 110,000 + 50,000 = 160,000 110,000 + 75,000 = 185,000 50,000 + 75,000 = 125,000

NPV 15,000 + 25,000 = 40,000 15,000 + 10,000 = 25,000 15,000 + 22,000 = 37,000 25,000 + 10,000 = 35,000 25,000 + 22,000 = 47,000 10,000 + 22,000 = 32,000

Rank 2 6 3 4 1 5

The business should undertake projects B and D as these will yield the highest NPV.

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Equivalent Annual Annuity - Illustration 3

NPVDuration

Project 13005 yrs Project 22003 yrs Project 33506 yrs Calculate the EEA of each project given a cost of capital of 10%

Solution

Project 1 2 3

NPV 300 200 350

Annuity Factor 3.791 2.487 4.355

Working (NPV / Annuity Factor) 300 / 3.791 200 / 2.487 350 / 4.355

EAA 79.13 80.42 80.37

Project 3 has the highest EAA.

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What is the difference between divisible and non-divisible projects? For divisible projects, the company can do a proportion of one project if they do not have the capital to do it all. Non divisible projects cannot be split i.e. they are all or nothing.

2. If the projects are divisible,which method should be used to decide which projects to undertake? Profitability index.

3. How do we calculate the Profitability Index? NPV of project / Cost of investment.

4. If projects are non divisible how do we make a decision? Trial and error.

5. What is the equivalent annual benefit? The EAB tells us what the NPV of the project would be the equivalent to as an annual amount.

6. What is capital rationing? Capital rationing refers to the fact that companies do not have an unlimited amount of capital available to invest.

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7. What is hard capital rationing? Hard capital rationing is externally imposed by factors outside of the organisation.

8. What is soft capital rationing? Soft capital rationing is imposed by factors internal to the organisation.

If youve successfully answered all of the above questions then youre ready to do the exam questions below: December 2009 Q1 (c) & (d)

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Lecture 14 Business Valuations


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Net Assets Valuation Method Illustration 1

Non Current Assets Current Assets Current Liabilities

550,000 170,000 -80,000

Share Capital Reserves 10% Loan Notes

300,000 200,000 150,000

The Market Value of property in the Non Current Assets is $50,000 more than the book value. The Loan Notes are redeemable at a 5% premium. What is the value of a 70% holding using the net assets valuation basis?

Solution

Working Non Current Assets Current Assets Current Liabilities 10% Loan Notes 150,000 x 105% 550,000 + 50,000 (Property value)

$ 600,000 170,000 -80,000 -157,500 532,500

Value of 70%

532,500 x 70%

372,750

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DVM - Illustration 2

ABC pays a constant dividend of 45c. It has 3m ordinary shares. The shareholders require a return of 15%. What is the Value of the business?

Solution

Working Constant Dividend Required Return (Cost of Equity or Ke) Share Price (Dividend / Ke) No. Ordinary Shares Value of the business In Question In Question 45 / 0.15 In Question 300c x 3m 45c 15% 300c 3m $9m

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DVM - Illustration 3

A business has Share Capital made up of 50c shares of $3 million Dividend per share (just paid) 30c Dividend paid four years ago 22c Required Return = 12% Calculate the Value of the business using the dividend valuation method.

Solution

Working 1 - Dividend Growth Dividend Paid Now Dividend Paid 4 Years Ago Dividend Growth 30c 22c (4(30 / 22)) =1.08 =8%

Working 2 - Business Valuation Dividend Paid Required Return (Ke) Dividend Growth Share Price (Dividend (1+g)) / (Ke - g) No Ordinary Shares Value of business 30c 12% 8% (30 x 1.08) / (0.12 - 0.08) = 810c ($3m / 0.5) = 6m (6m x 810c) = $48.6m

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P/E Ratio Method - Illustration 4

X1 $000 Revenue COS Gross Prot Admin Costs Distribution Costs PBIT Interest Tax Prot After Tax Dividends Retained Earnings 3000 2000 1000 300 200 500 100 120 280 100 180

X2 $000 3500 2400 1100 350 250 500 150 90 260 110 150

X3 $000 4200 3200 1000 400 300 300 220 50 30 30 0

Industry P/E Average

13

12

14

Calculate the Value of the Company for each of the 3 years using the P/E Ratio method.

Solution
Year 1 2 3 Industry P/E Ratio 13 12 14 Total Earnings 280,000 260,000 30,000 Value of Company (13 x 280,000) = $3.64m (12 x 260,000) = $3.12m (14 x 30,000) = $420,000

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P/E Ratio Method - Illustration 5 X1 $000 Revenue COS Gross Prot Admin Costs Distribution Costs PBIT Interest Tax Prot After Tax Dividends Retained Earnings 3200 2000 1200 300 200 700 100 120 480 100 380 X2 $000 3800 2400 1400 350 250 800 150 90 560 110 450 X3 $000 4800 3200 1600 400 300 900 220 50 630 150 480

Industry P/E Average Number of Shares

17 3m

15 3m

18 3m

Calculate the Earnings Per Share for each of the 3 years Calculate the Value of the Company for each of the 3 years using the EPS you calculate.

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Solution
Year 1 2 3 Earnings 480,000 560,000 630,000 No. Shares 3m 3m 3m EPS (Earnings / No. Ordinary Shares) 16c 18.66c 21c

Year 1 2 3

Industry P/E Ratio 17 15 18

EPS 16c 18.66c 21c

Share Price (EPS x P/E Ratio) $2.72 $2.80 $3.78

Value of Company (2.72 x 3m) = $8.16m (2.80 x 3m) = $8.4m (3.78 x 3m) = $11.34m

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Earnings Yield - Illustration 6 X1 $000 Revenue COS Gross Prot Admin Costs Distribution Costs PBIT Interest Tax Prot After Tax Dividends Retained Earnings 3100 2000 1100 300 200 600 100 120 380 100 280 X2 $000 3700 2400 1300 350 250 700 150 90 460 110 350 X3 $000 4600 3200 1400 400 300 700 220 50 430 150 280

Earnings Yield Number of Shares

0.15 4m

0.18 4m

0.17 4m

Calculate the Earnings Per Share for each of the 3 years and the share price using the earnings yield.

Solution
Year Earnings No. Shares 4m 4m 4m EPS (Earnings / No. Ordinary Shares) 9.5c 11.5 10.75 Earnings Yield 0.15 0.18 0.17 Share Price (EPS / Earnings Yield) 63.33c 63.88c 63.23c

1 2 3

380,000 460,000 430,000

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Present Value of Future Cash Flows - Illustration 7

ABC Company earned $100,000 in cash inows this year. They expect this to increase in each of the next 5 years by 5% and after that to increase by 2% forever. The company uses a cost of capital of 10%. Calculate the value of the company using the present value of future cash ows method.

Solution

Period Cash Inows Discount Rate 10% PV Cash Flows Total Period Years 0 - 5 Post Year 5

0 100,000 1 100,000 535,725

1 105,000 0.909 95,445

2 110,250 0.826 91,067

3 115,763 0.751 86,938

4 121,551 0.683 83,019

5 127,628 0.621 79,257

Working From Above (127,628 x (1+g)) / (Ke - g) (127,628 x 1.02) / (0.10 - 0.02) Total Value of Company

$ 535,725 1,627,257 2,162,982

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. When is it appropriate to use the Net Assets Valuation method? To value a property investment company. As the minimum price in a takeover. If asset stripping a company.

2. What are the downsides of using the Net Assets Valuation method? It ignores intangibles that are not shown on the balance sheet. It is not based on earnings which is usually the reason for buying a business. It will often lead to an under-valuation.

3. A company pays a constant dividend of 50c and has a cost of capital of 13%. Calculate the share price using DVM. 50 / 0.13 = $3.85

4. A company pays a dividend of 50c and paid a dividend of 40c 4 years ago. The company has a cost of capital of 13%. Calculate the share price using DVM. Growth = [4(50 / 40)] -1 = 0.057 (5.7%) Share Price = 50 (1+0.057) / (0.13 - 0.057) = $7.24

5. What are the downsides of using DVM? It assumes constant growth in the dividends. The future growth is estimated from historic data. The model is very sensitive to changes in any of the variables.

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6. Why do we use a proxy P/E Ratio when valuing a business with this method? To base our valuation on what the business should be achieving based on the industry it is in, rather that what it is achieving. If we buy the business we will intend to improve its performance at least to the industry average.

7. When and how can we adjust the P/E Ratio used? When we are valuing a risky company or an unlisted company we may adjust the P/ E ratio down by say 10% to reflect this.

8. The industry average P/E ratio for the fashion industry is 13. We are valuing an unlisted fashion business who have an EPS of 22c and 12m shares in issue. What is the value of the firm? A fashion business is risky as fashion changes and it is also unlisted so lets adjust the P/E ratio down to 12 and say: 22c x 12m = Total earnings of $2.64m $2.64 x 12 = $31.68

9. What are the downsides of using the P/E ratio method? Using a proxy company may be inaccurate. it is based on earnings which may be manipulated or include one-off items which distort the resulting valuation. The P/E ratio will be dependent on the view of the market which is not always correct.

10. A business is expected to earn $250,000 this year that is expected to grow at 4% forever. What is the value of the business using the present value of future cash flows if their cost of capital is 14%? We can use the growth formula in the DVM model to calculate this: 250,000 (1 + 0.04) / (0.14 - 0.04) = $2,600,000

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If youve successfully answered all of the above questions then youre ready to do the exam questions below: December 2007 Q1 (a) June 2008 Q2 (a) & (b) December 2008 Q1

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Lecture 15 WACC I
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Cost of Equity using DVM - Illustration 1

ABC Company has just paid a dividend of 35c. The current share price is $3.25. Calculate the Cost of Equity (Ke) using DVM.

Solution

Dividend Share Price Cost of Equity (Dividend / Share Price)

35 325 (35 / 325) = 10.76%

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Cost of Equity using DVM - Illustration 2

ABC Company has just paid a dividend of 35c. The dividend paid has grown by 4% per year for the past 5 years. The current share price is $3.25. Calculate the Cost of Equity (Ke) using DVM.

Solution

Dividend Share Price Dividend Growth Cost of Equity (Dividend (1+g) / Share Price) +g

35 325 4% ((35 x 1.04) / 325) + 0.04 = 0.152 = 15.2%

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Cost of Equity using CAPM - Illustration 3

Company A has a Beta of 1.2. Government bonds are currently trading at 4%. The average return than investors in the market can expect is 15%. Calculate the Cost of Equity using CAPM.

Solution

Rf (Risk Free Rate) Rm (Ave Return on the Market) Beta Ke = Rf + (Rm - Rf)

4 15 1.2 (4 + 1.2(15 - 4)) = 17.2%

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Cost of Equity using CAPM - Illustration 4

Company A has a Beta of 1.2. Company B has a Beta of 1. Government bonds are currently trading at 5%. The average return than investors in the market can expect is 12%. Calculate the Cost of Equity using CAPM for each company.

Solution

Company A Rf (Risk Free Rate) Rm (Ave Return on the Market) Beta Ke = Rf + (Rm - Rf) 5 12 1.2 (5 + 1.2(12 - 5)) = 13.4%

Company B 5 12 1 (5 + 1(12 - 5)) = 12%

Notice that when Beta is 1 (Company B) Ke is 12% which is the same as the average return on the market. Also notice that a higher Beta of 1.2 gives a higher Ke of 13.4% showing that a higher Beta means higher risk.

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Cost of Equity using CAPM Illustration 5

Company A has a Beta of 1.3. Company B has a Beta of 1.2. Government bonds are currently trading at 5%. The average market risk premium is 6%. Calculate the Cost of Equity using CAPM for each company.

Solution

Company A Rf (Risk Free Rate) Rm - Rf (Ave Market Risk Premium) Beta Ke = Rf + (Rm - Rf) 5 6 1.3 (5 + 1.3(6) = 12.8%

Company B 5 6 1.2 (5 + 1.2(6)) = 12.2%

Remember to look out for the market risk PREMIUM as this is always (Rm - Rf) rather than Rm (Average return on the market) Again notice that a higher Beta leads to a higher Ke i.e. more risk.

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What is the weighted average cost of capital? Each item of capital that a company has e.g. debt and equity has a cost. The cost for debt will be the interest that the company has to pay and the cost for equity will be the dividends paid. There may be more equity than debt so to get the average cost of these capital sources we need to weight the average based on the market value of each.

2. Set out the creditors hierarchy. Type 1 2 3 4 5 Fixed Charge Creditors Cost Interest Paid

Floating Charge Creditors Interest Paid Unsecured Creditors Preference Shareholders Ordinary Shareholders Interest Paid Pref. Dividend Ord. Dividend

3. Why is debt cheaper to service than equity (2 reasons!)? Debt holders take less risk as they are higher on the creditors hierarchy. Interest payments on debt are tax deductible.

4. If a company has a dividend of 40c and a share price of $3.45 what is the cost of equity? 40 / 345 = 11.59%

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5. If the dividend in question 4 is growing at a rate of 5% what is the cost of equity? [40 (1+0.05) / 345] + 0.05 = 17.17%

6. What are the two types of risk mentioned in the CAPM lecture? Systematic Risk & Unsystematic Risk.

7. Why can we ignore unsystematic risk? Unsystematic risk can be diversified away by the diversification of investors portfolios.

8. What type of risk is CAPM a measure of? The systematic risk of a particular company.

9. What does Beta tell us? How the shares of a company have historically fluctuated with the average of all the shares in the market.

10. What are the assumptions of CAPM? CAPM assumes that you can borrow at the risk free rate. CAPM assumes a perfect capital market with no transaction costs. CAPM assumes that all investors are diversified (so we can ignore unsystematic risk).

11. A company has a Beta of 1.3. The market risk premium is 6% and government bonds are trading at 4%. Calculate the cost of equity using CAPM. Ke = Rf + (Rm - Rf) Ke = 4 + 1.3(6) Ke = 11.8

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12. Is a company with a Beta of 1.2 a more risky or less risky investment than a company with a Beta of 1.6? The company with a Beta of 1.6 is more risky than the one with 1.2.

13. How is Beta calculated? Beta is calculated by plotting the historic data as to how that share price has fluctuated in the past on a graph against the average share price in the market. The past fluctuations are projected into the future.

14. What are the downsides of CAPM? Beta is based on historic data. CAPM is really supposed to be used for one period only and we may use it to evaluate a 5 year project. The assumptions it makes are not necessarily reflected in reality (see Q10)

If youve successfully answered all of the above questions then youre ready to do the exam questions below: Youre not Ready Yet - Do the next lecture!

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Lecture 16 WACC II
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Irredeemable Debt - Illustration 1

A company has issued 10% irredeemable debt. The market value of the debt is $90. The tax rate is 30% Calculate the cost of debt (Kd).

Solution

Interest paid (Per $100 nominal) Tax Rate After tax interest (Amount Paid (1 - t)) Market Value of Debt (Per $100 nominal) Cost of Debt (After tax interest / Market Value of Debt)

$10 30% $10 x (1 - 0.30) = $7 $90 (7 / 90) = 7.7%

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Redeemable Debt - Illustration 2

A Company has issued debt which is redeemable in 5 years time. Interest is payable at 8%. The current market value of the debt is $102. Ignore taxation. Calculate the Cost of Debt (Kd).

Solution

Perio d 1 -5 5

Item Interest Capital Market Value

$ 8 100

DR 5% 4.329 0.784

PV 34.63 78.40 -102 11.03

DR 15% 3.352 0.497

PV 26.82 49.70 -102 -25.48

IRR Calculation: 5 + (11.03 / (11.03 - (25.48)) (15 - 5) = 8.02%

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Redeemable Debt - Illustration 3

A Company has issued debt which is redeemable in 5 years time. Interest is payable at 10%. The current market value of the debt is $104. Tax is payable at 30%. Calculate the Cost of Debt (Kd).

Solution

Perio d 1 -5 5

Item Interest (10 x (1 - 0.3) Capital Market Value

$ 7 100

DR 5% 4.329 0.784

PV 30.30 78.40 -104 4.70

DR 15% 3.352 0.497

PV 23.46 49.70 -104 -30.84

IRR Calculation: 5 + (4.7 / (4.7 - (30.84)) (15 - 5) = 6.32%

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Convertible Debt - Illustration 4

A Company has issued debt which is convertible in 5 years time. Interest is payable at 10%. The current market value of the debt is $120. On conversion, investors will have a choice of either: I. II. Cash at a 15% premium; or 18 shares per loan note.

The current share price is $6 and it is expected to grow in value by 4% per year. Tax is payable at 30%. Calculate the Cost of Debt (Kd).

Solution

Working 1 - Cash or Convert? Working Cash (15% Premium) Shares Current Value Value in 5 years with 4% growth Number of shares per $100 Conversion Value 7.30 x 18 6 x (1.04 to the power of 5) $6 $7.30 18 $131.40 100 x 1.15 $115

The conversion value is higher than the cash so the investors will choose to convert. Do an IRR the same as for redeemable but lling $131.40 into the capital repaid

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Cost of Debt Perio d 1 -5 5 Item Interest (10 x (1 - 0.3) Conversion Value Market Value $ 7 131.4 DR 5% 4.329 0.784 PV 30.30 103.02 -120 13.32 DR 15% 3.352 0.497 PV 23.46 65.31 -120 -31.23

IRR Calculation: 5 + (13.32 / (13.32 - (31.23)) (15 - 5) = 8%

Preference Shares - Illustration 5

A company has issued 8% preference shares with a nominal value of $1. The market value of the shares is 80c. The tax rate is 30%. Calculate the cost of the preference shares (Kd).

Solution

Interest Paid Market Value of share Cost (Kd) (Interest Paid / Market Value)

8 80 (8 / 80) = 10%

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Bank Debt - Illustration 6

A company has a bank loan of $2m at an interest rate of 10%. The tax rate is 30%. Calculate the cost of debt (Kd).

Solution

Interest Rate before Tax Tax Rate After Tax Cost of Debt (10 x (1 - 0.3))

10 30% 7%

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WACC - Illustration 7

Company A is funded as follows: Item Equity Debt Capital Structure 85% 15% Cost 15% 7%

Calculate the Weighted Average Cost of Capital.

Solution

Item Equity Debt

Capital Structure 85% 15%

Cost 15 7 WACC

Ave 12.75 1.05 13.8

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WACC - Illustration 8

Company A is funded as follows: Balance Sheet Extract

Ordinary Shares (50c) Loan Notes Bank Loan

3000 2000 1000

The cost to the company of each of the above items has been calculated as:

Ordinary Shares Loan Notes Bank Loan

13% 8% 5%

The Loan notes are currently trading at $94. The current share price is $1.50 Calculate the Weighted Average Cost of Capital.

Solution
Working 1 - Calculate Cost of Capital for each item. Given in the Question Ordinary Shares Loan Notes Bank Loan 13% 8% 5%

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Working 2 - Calculate the Market Value of Debt and Equity. SFP Ordinary Shares (50c) Loan Notes 3000 2000 No. of shares (3000 / 0.50) = 6000 Share Price = $1.50 Loan Notes nominal value (on SFP) = 100 Market Value = 94 No market for this so use SFP value Market Value (6000 x $1.50) = 9000 (2000 x (94 / 100) = 1880 1000

Bank Loan

1000

Working 3 - Calculate the weighting of each item. Item Equity Loan Notes Bank Loan Market Value 9000 1880 1000 11880 Weighting (9000 / 11,880) = 75.75% (1880 / 11,880) = 15.82% (1000 / 11,880) = 8.41%

Working 4 - Weighted Average Cost of Capital Item Equity Loan Notes Bank Loan Market Value 9000 1880 1000 11880 Weighting (9000 / 11,880) (1880 / 11,880) (1000 / 11,880) Cost (W1) 13 8 5 WACC Ave (9000 / 11,880) x 13 = 9.85 (1880 / 11,880) x 8 = 1.27 (1000 / 11,880) x 5 = 0.42 11.54%

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WACC - Illustration 9

Company A is funded as follows: Balance Sheet Extract

Ordinary Shares (50c) 12% Loan Notes 8% Preference Shares ($1) Bank Loan Details on these are as follows.

2000 1500 500 750

The company has an equity beta of 1.2. Government bonds are currently trading at 6% and the average market risk premium is 7%. The Loan notes are currently trading at $106 and are redeemable at par in 5 years time. The preference shares are trading at 92c. The bank loan has an interest rate of 10%. The current share price is $1.25. The tax rate is 30%. Calculate the Weighted Average Cost of Capital.

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Solution
Working 1 - Calculate Cost of Capital for each item. Cost of Equity using CAPM

Rf (Risk Free Rate) (Rm - Rf)(Ave market risk premium) Beta Ke = Rf + (Rm - Rf)

6 7 1.2 (6 + 1.2(7)) = 14.4%

Cost of 12% Loan Notes Perio d 1 -5 5 Item Interest (12 x (1 - 0.3) Capital Market Value $ 8.4 100 DR 5% 4.329 0.784 PV 36.36 78.40 -106 8.76 DR 15% 3.352 0.497 PV 28.16 49.70 -106 -28.14

IRR Calculation: 5 + (8.76 / (8.76 - (28.14)) (15 - 5) = 7.37%

Cost of Preference Shares

Interest Paid Market Value of share Cost (Kd) (Interest Paid / Market Value)

8 92 (8 / 92) = 8.7%

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Cost of Bank Debt

Interest Rate before Tax Tax Rate After Tax Cost of Debt (10 x (1 - 0.3))

10 30% 7%

Working 2 - Calculate the Market Value of Debt and Equity. SFP Ordinary Shares (50c) 12% Loan Notes 8% Preference Shares ($1) Bank Loan 2000 1500 No. of shares (2000 / 0.50) = 4000 Share Price = $1.25 Loan Notes nominal value (on SFP) = 100 Market Value = 106 Preference shares nominal value (on SFP) = $1 Market Value = 92c No market for this so use SFP gure Market Value (4000 x $1.25) = 5000 (1500 x (106 / 100) = 1590 (500 x (92 / 1)) = 460 750

500

750

Working 3 - Calculate the weighting of each item. Item Equity Loan Notes Preference Shares Bank Loan Market Value 5000 1590 460 750 7800 Weighting (5000 / 7800) (1590 / 7800) (460 / 7800) (750 / 7800)

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Working 4 - Weighting & Weighted Average Cost of Capital Item Equity Loan Notes Preference Shares Bank Loan Market Value 5000 1590 460 750 7800 Weighting (5000 / 7800) (1590 / 7800) (460 / 7800) (750 / 7800) Cost (W1) 14.4 7.37 8.7 7 WACC Ave (5000 / 7800) x 14.4 = 9.23 (1590 / 7800) x 7.37 = 1.50 (460 / 7800) x 8.7 = 0.51 (750 / 7800) x 7 = 0.67 11.91%

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What is the nominal value of issued debt? $100

2. What is convertible debt convertible into? Shares.

3. What is the calculation for irredeemable debt? Annual Interest (1-T) / Market Value of debt

4. A company has 10% irredeemable debt in issue at a market value of $97. If the tax rate is 30% what is the cost of the debt? 10 (1-0.3) / 97 = 7.2%

5. A company has 5 year 8% redeemable debt in issue at a market value of $103. The tax rate is 25%. What is the cost of the debt?

Period 1 -5 5

Item Interest (8 x (1 - 0.25)) Capital Market Value

$ 6 100

DR 5% 4.329 0.784

PV 25.97 78.40 -103 1.37

DR 15% 3.352 0.497

PV 20.11 49.70 -103 -33.19

IRR Calculation: 5 + (1.37 / (1.37 - (33.19) (15 - 5) = 5.4%

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6. A company has 10% convertible debt in issue at a market value of $111 that is redeemable in 5 years at either cash or 5 shares per nominal. The current share price is $18 and is expected to grow at 2%. The tax rate is 30%. What is the cost of debt?

Working 1 - Cash or Convert? Working Cash Shares Current Value Value in 5 years with 4% growth Number of shares per $100 Conversion Value 19.87 x 5 18 x (1.02 to the power of 5) $18 $19.87 5 $99.35 $100

The conversion value is lower than the cash so the investors will choose not to convert.

Cost of Debt Perio d 1 -5 5 Item Interest (10 x (1 - 0.3) Conversion Value Market Value $ 7 100 DR 5% 4.329 0.784 PV 30.30 78.40 -111 -2.30 DR 15% 3.352 0.497 PV 23.46 49.70 -111 -37.84

IRR Calculation: 5 + (2.3 / (2.3 - (37.84)) (15 - 5) = 5.57%

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7. A company has 8% preference share in issue at a current value of 94c. What is the cost of the preference shares. 8 / 94 = 8.5%

8. A company has a bank loan of $7m at a rate of 6%. The tax rate is 35%. What is the cost of the bank debt? 6 (1-T) = 6 (1 - 0.35) or 3.9%

9. The company has each of the types of debt in questions 4 to 6 on their balance sheet at a book value of $10m for each of them except for the bank debt which is on the balance sheet at $7m. If the company has a market value of $110m with a cost of equity of 14% then what is the companys weighted average cost of capital? Working 1 - Calculate the Market Value of Debt and Equity. SFP Ordinary Shares Irredeemable Debt Redeemable Debt Convertible Debt 8% Preference Shares ($1) Bank Loan 10m 10m 10m Market Value given will be the value of the shares 10m x 97/100 10m x 103/100 Market Value 110m 9.7m 10.3m

10m

10m x 111/100

11.1m

10m 7m

10m x 94/100 No market for this so use SFP gure

9.4m 7m

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Item Ordinary Shares Irredeemable Debt Redeemable Debt Convertible Debt 8% Preference Shares ($1) Bank Loan

Market Value 110 9.7 10.3 11.1 9.4 7 157.5

Weighting (110 / 157.5) (9.7 / 157.5) (10.3 / 157.5) (11.1 / 157.5) (9.4 / 157.5) (7 / 157.5)

Cost 14 7.2 5.4 5.57 8.5 3.9 WACC

Ave 9.78 0.44 0.35 0.39 0.51 0.17 11.65

10. What if the company has each of the types of debt in questions 4 to 6 on their balance sheet at a book value of $8m for each of them except for the bank debt which is on the balance sheet at $7m. If the company has a market value of $99m with a cost of equity of 12% then what is the companys weighted average cost of capital? Working 1 - Calculate the Market Value of Debt and Equity. SFP Ordinary Shares Irredeemable Debt Redeemable Debt Convertible Debt 8% Preference Shares ($1) 8m 8m 8m Market Value given will be the value of the shares 8m x 97/100 8m x 103/100 Market Value 99m 7.76m 8.24m

8m

8m x 111/100

8.88m

8m

8m x 94/100

7.52m

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SFP Bank Loan 7m No market for this so use SFP gure

Market Value 7m

Item Ordinary Shares Irredeemable Debt Redeemable Debt Convertible Debt 8% Preference Shares ($1) Bank Loan

Market Value 99 7.76 8.24 8.88 7.52 7 138.4

Weighting (99 / 138.4) (7.76 / 138.4) (8.24 / 138.4) (8.88 / 138.4) (7.52 / 138.4) (7 / 138.4)

Cost 14 7.2 5.4 5.57 8.5 3.9 WACC

Ave 10.01 0.40 0.32 0.36 0.46 0.20 11.76

If youve successfully answered all of the above questions then youre ready to do the exam questions below: December 2008 Q3 (a) June 2010 Q2 June 2008 Q1

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Lecture 17 Capital Structure


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Capital Structure - Illustration 1

A company has total capital of $1,000 with debt making up $300 and equity making up $700 of the total. The companys cost of debt is 5% and cost of equity is 14%. I. II. Calculate the companys current WACC. Calculate the WACC if the company substitutes $200 of equity for $200 of debt causing their cost of equity to rise to 16%. III. Calculate the WACC if the company substitutes $300 of equity for $300 of debt causing their cost of equity to rise to 25%.

Solution
I. Item Debt Equity Market Value 300 700 1000 Weighting 300 / 1000 700 / 1000 Cost 5% 14% WACC 1.5 9.8 11.3

II. Item Debt Equity Market Value 500 500 1000 Weighting 500 / 1000 500 / 1000 Cost 5% 16% WACC 2.5 8 10.5

III. Item Debt Equity Market Value 600 400 1000 Weighting 600 / 1000 400 / 1000 Cost 5% 25% WACC 3 10 13

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What is capital structure? How much debt and equity a company has.

2. What does the traditional view suggest you can do with the WACC? Minimise it.

3. Why would you want to do this? The WACC is a cost to the business - as with any cost the company will wish to minimise it. 4. What other assumptions did M & M make in their no tax model? No risk of bankruptcy no matter how much debt the company has. No transaction charges. The company is able to borrow at the risk free rate.

5. What does the M&M model with tax suggest we should do with our capital structure? As the interest on debt is tax deductible and thus debt is cheaper, M&M suggested that a company should substitute Equity for Debt in order to take advantage of this fact. This will also have the effect of increasing the value of the business using the PV of future cash-flows method as the WACC and thus the discount rate will be lower leading to a higher valuation.

If youve successfully answered all of the above questions then youre ready to do the exam questions below:

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Pilot Paper Q1 (b) June 2009 Q1 (c)

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Lecture 18 Financing & Investment


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Project Specic Discount Rate - Illustration 1 Company A intends to undertake a project in an unrelated industry. The following details are relevant: Item Equity Beta (e) Value of Equity Value of Debt The risk free rate is 4%. The average return on the market is 12%. Calculate a project specic discount rate. Ignore Tax Company A 1.2 1000 400 Proxy Company 1.4 800 500

Solution

Working 1 - Un-gear the proxy e to get a.

Proxy Equity Beta Value of Equity of Proxy Value of Debt of Proxy a = e(Ve / (Ve + Vd))

1.4 800 500 1.4 (800 / (800 + 500)) = 0.86

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Working 2 - Re-gear a with our capital structure

a Value of Equity of Company A Value of Debt of Company A e = a (Ve + Vd ) / Ve)

0.86 1000 400 0.86 ((1000 + 400) / 1000) = 1.20

Working 3 - Fill into CAPM

Rf (Risk Free Rate) Rm (Ave return on the market) Beta Ke = Rf + (Rm - Rf)

4 12 1.2 (4 + 1.2(12 - 4)) = 13.6%

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Project Specic Discount Rate - Illustration 2 Company A intends to undertake a project in an unrelated industry. The following details are relevant: Item Equity Beta (e) Value of Equity Value of Debt The risk free rate is 4%. The average return on the market is 12%. The tax rate is 30%. Calculate a project specic discount rate. Ignore Tax Company A 1.1 1200 500 Proxy Company 1.3 900 450

Solution

Working 1 - Un-gear the proxy e to get a.

Proxy Equity Beta Value of Equity of Proxy Value of Debt of Proxy a = e(Ve / (Ve + (Vd x 1-t))

1.3 900 450 1.3 (900 / (900 + (450 x 0.7)) = 0.96

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Working 2 - Re-gear a with our capital structure

a Value of Equity of Company A Value of Debt of Company A e = a (Ve + (Vd x 1-t) / Ve)

0.96 1200 500 0.96 ((1200 + (500 x 0.7)) / 1200) = 1.24

Working 3 - Fill into CAPM

Rf (Risk Free Rate) Rm (Ave return on the market) Beta Ke = Rf + (Rm - Rf)

4 12 1.24 (4 + 1.24(12 - 4)) = 13.92%

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are the two types of risk included in a companys equity Beta? Business risk & financial risk.

2. When do we use the WACC as a discount rate? For a project in the same business area as the current business. No change in capital structure i.e. no issue of debt or equity to finance the project. The project is small in relation to the size of the company. The project has the same risk profile as the company.

3. What is capital structure? How much debt & equity a firm has.

4. What are the steps to calculate a project specific discount rate? Select a proxy company with the same business risk as the new project area. Un-gear the equity beta of the proxy to remove its financial risk and get the asset beta which just includes the business risk of the new project area. Re-gear the asset beta with our companys financial risk to get a new equity beta for that project. Fill the new equity beta into CAPM.

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5. Our business has a Beta of 1.2, debt with a market value of 100 and equity with a market value of 400. If the proxy has a Beta of 1.4, debt with a market value of 100 and equity with a market value of 200 calculate a project specific discount rate. The risk free rate is 4% and the average market risk premium is 7%. Ignore tax. Working 1 - Un-gear the proxy e to get a.

Proxy Equity Beta Value of Equity of Proxy Value of Debt of Proxy a = e(Ve / (Ve + (Vd x 1-t))

1.4 200 100 1.4 (200 / (200 + 100)) = 0.93

Working 2 - Re-gear a with our capital structure

a Value of Equity of Company A Value of Debt of Company A e = a (Ve + (Vd x 1-t) / Ve)

0.93 400 100 0.93 ((400 + 100 / 400) = 1.163

Working 3 - Fill into CAPM

Rf (Risk Free Rate) Rm (Ave return on the market) Beta Ke = Rf + (Rm - Rf)

4 12 1.24 (4 + 1.24(12 - 4)) = 13.92%

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6. What are the 3 types of market efficiency? Weak form, semi-strong form and strong form.

7. Describe weak form market efficiency. The share price reflects public data as well as historic data. Investors cannot therefore beat the market as the price responds only to new information that investors do not have.

If youve successfully answered all of the above questions then youre ready to do the exam questions below: December 2008 Q3 (c) June 2010 Q3 (c) (iii) December 2010 Q1 (c)

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Lecture 19 More Debt


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December 07 Exam Question (6 marks)


Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in ve years time. Alternatively, each bond may be converted on that date into 20 ordinary shares of the company. The current ordinary share price of Phobis Co is $445 and this is expected to grow at a rate of 65% per year for the foreseeable future. Phobis Co has a cost of debt of 7% per year. Required: Calculate the following current values for each $100 convertible bond: (i) market value; (ii) oor value; (iii) conversion premium.

Solution
i. Market Value Working 1 - Cash or Convert? Working Cash Shares Current Value Value in 5 years with 6.5% growth Number of shares per $100 Conversion Value Answer Period 1-5 5 Item Interest Conversion Value $ 9 122 DR 7% 4.1 0.713 PV 36.90 86.99 123.89 6.10 x 20 4.45 x (1.065 to the power of 5) $4.45 $6.10 20 $122 $100

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II. Floor Value Period 1-5 5 Item Interest Minimum Redemption $ 9 100 DR 7% 4.1 0.713 PV 36.90 71.30 108.20

III. Conversion Premium

Working Current Conversion Value Expected Value in 5 years (W1) Premium Premium Per share 34.89 / 20 4.45 x 20

Amount 89 123.89 34.89 1.74

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. How is the market value of convertible debt calculated? The present value of the interest and capital paid to debt holders, discounted at the cost of debt.

2. What will the capital repaid figure in the IRR calculation be the higher of? Cash or conversion value.

3. What is the floor value of convertible debt? The minimum value that the debt should ever be.

4. How is the floor value calculated? Discount the interest and the nominal capital to be repaid at the cost of the debt.

5. What is the conversion premium? The difference between the expected conversion value and the current conversion value.

If youve successfully answered all of the above questions then youre ready to do the exam questions below:

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Lecture 20 Currency Risk I


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Buy or Sell Currency - Illustration 1

You have an invoice to pay to a US business of $1250 and you are a UK business. The rate offered by the bank is $: 1.2500 - 1.3500 How many will it take to pay the $125?

Solution

Bank sells low For a receipt use the rate on the right Cost of $ (Amount of $ / FX Rate)

We want to buy $ with our and the bank will sell them to us at the low rate of 1.2500 We are making a payment so we use the rate on the left i.e. 1.2500 ($1250 / 1.25) = 1,000

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Buy or Sell Currency - Illustration 2

You have issued an invoice to a US customer of $2000 and you are a UK business. The rate offered by the bank is $: 1.4500 - 1.5500 How many will you receive for the $2000?

Solution

Bank sells low For a receipt use the rate on the right Value of $ (Amount of $ / FX Rate)

We want to sell the $ we will receive. The bank will buy them from us at the high rate of 1.5500 This is a receipt so use the rate on the right of 1.5500 ($2000 / 1.55) = 1,290

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Purchasing Power Parity Theory - Illustration 3

The current exchange rate is 2$ per . Ination in the US is 6%. Ination in the UK is 8%. What will the FX rate be in 1 years time?

Solution

Current Spot Rate Ination in Counter (US) Ination in Base (UK) Forecast (Spot Rate Counter x (1 + Inf in Counter / 1 + Inf in Base)

2 6% 8% 2 x ((1 + 0.06) / (1 + 0.08)) = 1.96

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Interest Rate Parity Theory - Illustration 4

The current exchange rate is 2$ per . The interest rate in the US is 3%. The interest rate in the UK is 2%. What will the FX rate be in 1 years time?

Solution

Current Spot Rate Interest rate in Counter (US) Interest rate in Base (UK) Forecast (Spot Rate Counter x (1 + Int in Counter / 1 + Int in Base)

2 3% 2% 2 x ((1 + 0.03) / (1 + 0.02)) = 2.02

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Forward Rate - Illustration 5

ABC Company has entered into a contract whereby they will receive $500,000 from a US customer in 3 months. ABC is a UK company. A 3 month forward rate is available at $: 1.6000 +/- 0.0500.

Calculate the amount of ABC would receive under the forward contract.

Solution

A rate quoted at $: 1.6000 +/- 0.0500 is the same as saying $: 1.5500 - 1.6500 Rate to use (For a receipt use the one on the right) Convert ($ amount / Forward rate) 1.6500 (500,000 / 1.6500) = 303,030

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Money Market Hedge - Illustration 6

A UK business needs to pay $350,000 to a US supplier in 3 months time. Exchange rate now: $: 1.6500 - 1.7000 Deposit rates UK 4% annual US 6% annual Borrowing rates UK 5% annual US 6.5% annual How much will the transaction cost using a money market hedge?

Solution

Step 1 - How much Foreign Currency?

Amount of $ to pay

350,000

We will deposit the money in the US where it will earn interest so that in 3 months we have $350,000. Deposit Rate in US per year Deposit Rate for 3 months (Annual rate x 3/12) Amount to deposit (Total $ discounted at 1.5%) 6% 6 x (3/12) = 1.5% 350,000 x (100 / 101.5) = $344,827

We will deposit $344,827 in the US where it will earn interest of 1.5% over the 3 months making it worth $350,000 when the payment becomes due. We transfer the money now so that there is no more FX risk. The transfer is made at the spot rate.

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Step 2 - Convert using the Spot Rate

Amount to Transfer (Step 1)

$344,827

We transfer the money now so that there is no more FX risk. The transfer is made at the spot rate. Spot rate (We are making a payment) Convert ($ Amount / Spot Rate) 1.6500 (344,827 / 1.6500) = 208,986

Step 3 - Borrow the Home Currency

Amount to Borrow (Step 2)

208,986

We will have to pay interest on the amount we have borrowed for 3 months. Borrowing Rate per year in UK Borrowing Rate for 3 months (Annual Rate x 3/12) 5% (5 x 3/12) = 1.25%

Total Cost of transaction

Amount transferred to US Interest on borrowings in UK ( amount x 3 month UK borrowing rate) Total Cost (Amount transferred + interest incurred)

208,986 (208,986 x 1.25%) = 2,612 (208,986 + 2,612) = 211,589

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Money Market Hedge Illustration 7

A UK business will receive $350,000 from a US supplier in 3 months time. Exchange rate now: $: 1.6500 - 1.7000 Deposit rates UK 4% annual US 6% annual Borrowing rates UK 5% annual US 6.5% annual How much will the business receive using a money market hedge?

Solution

Step 1 - How much foreign currency?

Amount of $ to receive We will borrow the money in the US now and transfer it home. Borrowing Rate in US per year Borrowing Rate for 3 months (Annual rate x 3/12) Amount to borrow (Total $ discounted at 1.625%)

350,000

6.5% 6.5 x (3/12) = 1.625% 350,000 x (100 / 101.625) = $344,403

We will borrow $344,403 in the US where it will earn interest of 1.625% over the 3 months making it worth $350,000 when the receipt becomes due. We will pay off the loan in the US when we receive the $350,000 in 3 months. We transfer the money now so that there is no more FX risk. The transfer is made at the spot rate.

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Step 2 - Convert into home currency using spot rate.

Amount to Transfer (Step 1)

$344,403

We transfer the money now so that there is no more FX risk. The transfer is made at the spot rate. Spot rate (We are receiving the foreign currency) Convert ($ Amount / Spot Rate) 1.7000 (344,403 / 1.7000) = 202,590

Step 3 - Place the money on deposit in the UK

Amount to Deposit (Step 2) We will receive interest on the money we deposit. Deposit Rate per year in UK Deposit Rate for 3 months (Annual Rate x 3/12)

202,590

4 (4 x 3/12) = 1%

Total Receipt

Amount transferred to UK Interest on deposit in UK ( Amount x 3 month UK borrowing rate) Total Receipt (Amount transferred + interest received)

202,590 (202,590 x 1%) = 2,026 (202,590 + 2,026) = 204,616

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Test Your Knowledge


If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. $/ 1.35 - 1.45 which currency is the counter currency? The dollar. Remember this as the base is always on the right or that this is dollars (plural) to the pound (singular).

2. UK company receiving $500. Spot rate is $/ 1.35 - 1.45. How many will the company receive? 500 / 1.45 = 344 For a receipt of foreign currency use the rate on the right.

3. UK inflation is 5%, US inflation is 2%. The spot rate is $/ 1.35. What will the FX rate be in one years time? Future rate = spot rate x (1 + inf in the counter) / (1 + inf in the base) Future rate = 1.35 x (1.02 / 1.05) = 1.31

4. What are the internal methods of hedging currency risk? Invoicing in the home currency. Leading - paying up front. Lagging - paying when the rate is favourable. Offsetting receipts & payments in a foreign bank account.

5. What are the disadvantages of a forward contract? Contractual commitment that you cannot renege upon. Cant take advantage of favourable movements in the currency.

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6. How many will a company receive if they take a forward contract at a rate of $/ 1.55 +/- 0.05 for an amount of $400,000? Rate to use: 1.55 + 0.05 = 1.6 $400,000 / 1.6 = 250,000

7. How does a money market hedge eliminate the foreign currency risk? The transfer is made today at the spot rate so no more exposure to the risk.

8. A UK company is going to pay $400,000 to a US supplier in 3 months time. The UK deposit rate is 4.5% and the borrowing rate is 5.5%. The US deposit rate is 5.5% and the borrowing rate is 6.5%. The spot rate is $/ 1.5 +/- 0.025. Calculate the cost of the payment if the company uses a money market hedge? Step 1 - How much Foreign Currency?

Amount of $ to pay

400,000

We will deposit the money in the US where it will earn interest so that in 3 months we have $350,000. Deposit Rate in US per year Deposit Rate for 3 months (Annual rate x 3/12) Amount to deposit (Total $ discounted at 1.375%) 5.5% 5.5 x (3/12) = 1.375% 400,000 x (100 / 101.375) = $394,575

We will deposit $394,575 in the US where it will earn interest of 1.375% over the 3 months making it worth $400,000 when the payment becomes due. We transfer the money now so that there is no more FX risk. The transfer is made at the spot rate.

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Step 2 - Convert using the Spot Rate

Amount to Transfer (Step 1)

$394,575

We transfer the money now so that there is no more FX risk. The transfer is made at the spot rate. Spot rate (We are making a payment) Convert ($ Amount / Spot Rate) 1.475 (394,575 / 1.475) = 267,508

Step 3 - Borrow the Home Currency

Amount to Borrow (Step 2)

267,508

We will have to pay interest on the amount we have borrowed for 3 months. Borrowing Rate per year in UK Borrowing Rate for 3 months (Annual Rate x 3/12) 5.5% (5.5 x 3/12) = 1.375%

Total Cost of transaction

Amount transferred to US Interest on borrowings in UK ( amount x 3 month UK borrowing rate) Total Cost (Amount transferred + interest incurred)

267,508 (267,508 x 1.375%) = 3,678 (267,508 + 3,678) = 271,186

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If youve successfully answered all of the above questions then youre ready to do the exam questions below: Pilot Paper Q2 (All except part (a)) December 2008 Q4 (a), (b) & (c)

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Lecture 21 Currency Risk II


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If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What are the 3 types of FX risk? Translation. Transaction. Economic.

2. Explain each of the 3. Translation risk is the risk that losses will be incurred in translating foreign assets or liabilities in the balance sheet at the year end. Transaction risk is the risk that in the period between agreeing a transaction and settling it fluctuations in currency rates lead to a loss. Economic risk is long term transaction risk i.e. the risk that your operations in a foreign currency make FX losses over the long term. 3. What is a futures contract? A futures contract is a contract to buy or sell currency in the future. It is exchange traded and can be closed out at any time for a profit or a loss. They operate on 3 monthly cycles and are for specific contract sizes of currency.

4. What are the advantages of a future? Low transaction costs. Can be traded and thus closed out at any time. It is an effective hedge.

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5. What are the disadvantages of a future? They can be arranged for standard contract sizes only. They are available for a limited range of currencies. There is no upside risk if the currency movement is in your favour.

6. How do you undertake a future contract? Call up the exchange. Buy or sell the future depending on the risk you wish to hedge. Pay the initial margin required. Top up the margin daily if required. Close out the transaction by trading in the opposite direction. Receive your profit or pay the loss accrued.

7. What is an option? An option is the right but not the obligation to buy or sell a currency at a certain price in the future.

8. What is the main advantage of an option? The user of an option can take advantage of upside risk if the currency movement is favourable to them by choosing not to exercise the option.

9. Are there any downsides to an option? The premium is expensive and has to be paid whether the option is exercised or not. Options are available for relatively few currencies.

10.What type of risk will an option hedge? Transaction risk.

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If youve successfully answered all of the above questions then youre ready to do the exam questions below: Pilot Paper Q2 (a) December 2008 Q4 (d)

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Lecture 22 Interest Rate Risk


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If you cant answer all of the questions below without looking at the answer then you need to do some more work on this area!
1. What internal methods may a firm use to manage interest rate risk? Smoothing. Matching. Netting.

2. What is an FRA? A forward rate agreement. Effectively this is a forward interest rate agreed with a bank.

3. Why might a firm use an interest rate option to manage interest rate risk? It means that they can take advantage of low rates, but secure against high rates.

4. What is an Interest Rate Swap? Sn arrangement organised through a bank whereby two parties swap interest rate commitments.

5. What are the disadvantages of an interest rate swap? There is a risk that one of the parties fails to pay their side of the swap. It is a binding agreement. The decision to move into the swap may be the wrong decision as interest rates may change unexpectedly. The transactions can be complex.

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6. What does a Yield Curve plot? Interest rates against the length of time or term of the debt.

7. In what way does a Yield Curve slope? In normal circumstances the curve is upward sloping.

8. What are the three ways in which theorists have sought to explain the slope of the yield curve? Expectations theory states that if debt is to be held for longer terms it is more likely that it wont get paid back so higher interest rates are demanded to compensate so as the term gets longer the interest rate rises = upward sloping curve. Liquidity preference theory states that because investors prefer cash, if they are going to tie capital up by lending it out for the longer term they will demand higher interest rates to compensate = upward sloping curve. Market segmentation theory suggests that different investors have different requirements based on their own circumstances and that long term investors want higher yields leading to the upward sloping curve.

If youve successfully answered all of the above questions then youre ready to do the exam questions below:

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Lecture 23 Islamic Finance


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1. What is the main principle behind islamic finance? Money should not generate money i.e. no interest is allowed.

2. What should money only be generated by? Labour.

3. What are the Islamic terms for forbidden and permitted? Forbidden - haraam. Permitted - halaal.

4. How will a mortgage work under islamic financial principles? The lender will own the property and the borrower will pay a rental amount and a capital repayment amount until the asset is owned.

5. What is the islamic term for a bank loan? Murabaha transaction.

6. How will lease finance (ijara) work under islamic finance? Party A will let party B use the asset. Rent will be paid from B to A. A is responsible for the major maintenance of the asset. B takes care of minor maintenance.

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7. What must debt finance relate to under islamic finance principles? An asset.

8. What is the islamic finance term for a joint venture? Musharaka.

If youve successfully answered all of the above questions then youre ready to do the exam questions below:

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