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ACCA
Paper F9 | FINANCIAL MANAGEMENT
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ACCA
PAPER F9
FINANCIAL MANAGEMENT
STUDY SYSTEM
JUNE 2012
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CONTENTS
Page
Introduction (v)
Syllabus (vi)
19 Glossary 1901
Index 2001
INTRODUCTION
This Study System has been specifically written for the Association of Chartered Certified
Accountants fundamentals level examination, Paper F9 Financial Management
It provides comprehensive coverage of the core syllabus areas and is designed to be used
both as a reference text and as an integral part of your studies to provide you with the
knowledge, skill and confidence to succeed in your ACCA examinations
About the author: Mike Ashworth is ATC International’s lead tutor in financial
management and has more than 10 years’ experience in delivering ACCA exam-based
training.
You should first read through the syllabus, study guide and approach to examining the
syllabus provided in this session to familiarise you with the content of this paper. The
sessions which follow include:
A bank of practice questions is contained in the Study Question Bank provided. These are
linked to the topics of each session and should be attempted after studying each session.
SYLLABUS
AFM (P4)
Advanced Financial Management
MA (F2)
Management Accounting
Aim
Main capabilities
B Assess and discuss the impact of the economic environment on financial management
F Explain and calculate the cost of capital and the factors which affect it
Financial
management function
(A)
Working capital
management (C)
Investment appraisal
(D)
Business finance
(E)
Risk management
(H)
RATIONALE
The syllabus for Paper F9, Financial Management, is designed to equip candidates with the
skills that would be expected from a finance manager responsible for the finance function of
a business. The paper, therefore, starts by introducing the role and purpose of the financial
management function within a business. Before looking at the three key financial
management decisions of investing, financing, and dividend policy, the syllabus explores
the economic environment in which such decisions are made.
The next section of the syllabus is the introduction of investing decisions. This is done in
two stages - investment in (and the management of) working capital and the appraisal of
long-term investments.
The next area introduced is financing decisions. This section of the syllabus starts by
examining the various sources of business finance, including dividend policy and how much
finance can be raised from within the business. Cost of capital and other factors that
influence the choice of the type of capital a business will raise then follows. The principles
underlying the valuation of business and financial assets, including the impact of cost of
capital on the value of the business is covered next.
The syllabus finishes with an introduction to, and examination of, risk and the main
techniques employed in the management of such risk.
DETAILED SYLLABUS
D Investment appraisal
E Business finance
F Cost of capital
G Business valuations
H Risk management
The syllabus for Paper F9 aims to develop the skills expected of a finance manager who is
responsible for the finance function of a business.
The paper also prepares candidates for more advanced and specialist study in Paper P4,
Advanced Financial Management.
15 minutes for reading and planning is given at the start if the examination. During this
time candidates may make notes on the question paper but may not write in the answer
booklet.
Candidates are provided with a formulae sheet and tables of discount and annuity factors.
ACCA Support
For examiner’s reports, guidance and technical articles relevant to this paper see
http://www.acca.co.uk/students/acca/exams/f9/
The ACCA’s Study Guide which follows is referenced to the Sessions in this Study System.
STUDY GUIDE
A FINANCIAL MANAGEMENT Ref: Ref:
FUNCTION
1. The nature and purpose of financial Explain ways to encourage the
§1 achievement of stakeholder §1
management
objectives, including:
Explain the nature and purpose of
financial management. − managerial reward schemes
such as share options and
Explain the relationship between
performance-related pay
financial management and financial
and management accounting. − regulatory requirements such
as corporate governance codes
2. Financial objectives and the §1 of best practice and stock
relationship with corporate strategy exchange listing regulations
Discuss the relationship between
financial objectives, corporate 4. Financial and other objectives in §1
objectives and corporate strategy. not-for-profit organisations
Identify and describe a variety of Discuss the impact of not-for-profit
financial objectives, including: status on financial and other
objectives.
− shareholder wealth
maximisation Discuss the nature and importance
of Value for Money as an objective
− profit maximisation
in not-for-profit organisations.
− earnings per share growth
Discuss ways of measuring the
3. Stakeholders and impact on achievement of objectives in not-
§1 for-profit organisations.
corporate objectives
Identify the range of stakeholders B FINANCIAL MANAGEMENT
and their objectives. ENVIRONMENT
Discuss the possible conflict 1. The economic environment for §2
between stakeholder objectives. business
Discuss the role of management in Identify and explain the main
meeting stakeholder objectives, macroeconomic policy targets.
including the application of agency Define and discuss the role of fiscal,
theory. monetary, interest rate and
Describe and apply ways of exchange rate policies in achieving
measuring achievement of §18 macroeconomic policy targets.
corporate objectives including: Explain how government economic
− ratio analysis, using policy interacts with planning and
appropriate ratios such as decision-making in business.
return on capital employed,
return on equity, earnings per
share and dividend per share
− changes in dividends and share
prices as part of total
shareholder return
Calculate net present value and Ref: 6. Specific investment decisions (Lease Ref:
discuss its usefulness as an §4 or buy; asset replacement; capital §6
investment appraisal method. rationing)
Calculate internal rate of return and Evaluate leasing and borrowing to
§4
discuss its usefulness as an buy using the before-and after-tax
investment appraisal method. costs of debt.
Discuss the superiority of DCF Evaluate asset replacement
methods over non-DCF methods. §4 decisions using equivalent annual
cost.
Discuss the relative merits of NPV
and IRR. §4 Evaluate investment decisions
under single-period capital
Calculate discounted payback and §7 rationing, including:
discuss its usefulness as an
investment appraisal method − the calculation of profitability
4. Allowing for inflation and taxation indexes for divisible
in DCF investment projects
− the calculation of the NPV of
Apply and discuss the real-terms §5 combinations of non-divisible
and nominal-terms approaches to investment projects
investment appraisal.
− a discussion of the reasons for
Calculate the taxation effects of §5 capital rationing
relevant cash flows, including the
tax benefits of capital allowances E BUSINESS FINANCE
and the tax liabilities of taxable
1. Sources of and raising short-term
profit.
finance
Calculate and apply before- and
§10 Identify and discuss the range of §9
after-tax discount rates.
short-term sources of finance
5. Adjusting for risk and uncertainty in §7 available to businesses, including:
investment appraisal
− overdraft
Describe and discuss the difference − short-term loan
between risk and uncertainty in − trade credit
relation to probabilities and
− lease finance
increasing project life.
Apply sensitivity analysis to 2. Sources of and raising, long-term
investment projects and discuss the finance
usefulness of sensitivity analysis in
Identify and discuss the range of
assisting investment decisions. §8,9
long-term sources of finance
Apply probability analysis to available to businesses, including:
investment projects and discuss the
usefulness of probability analysis in − equity finance
assisting investment decisions. − debt finance
Apply and discuss other techniques − lease finance
of adjusting for risk and uncertainty − venture capital
in investment appraisal, including:
− simulation
− adjusted payback
− risk-adjusted discount rates
3. The valuation of debt and other Ref: Describe and discuss different types Ref:
financial assets of interest rate risk: §17
Apply appropriate valuation − gap exposure
§10
methods to: − basis risk
− irredeemable debt
− redeemable debt
2. Causes of exchange rate differences §17
and interest rate fluctuations
− convertible debt
− preference shares Describe the causes of exchange
rate fluctuations, including:
4. Efficient Market Hypothesis (EMH) − balance of payments
and practical considerations in the − purchasing power parity
valuation of shares theory
Distinguish between and discuss §2 − interest rate parity theory
weak form efficiency, semi-strong − four-way equivalence
form efficiency and strong form
efficiency. Forecast exchange rates using: §17
Discuss practical considerations in − purchasing power parity
the valuation of shares and §10
− interest rate parity
businesses, including:
− marketability and liquidity of Describe the causes of interest rate §2
shares fluctuations, including:
− availability and sources of − structure of interest rates and
information yield curves
− market imperfections and − expectations theory
pricing anomalies
− liquidity preference theory
− market capitalisation
− market segmentation
Describe the significance of investor
3. Hedging techniques for foreign
speculation and the explanations of §10 §17
currency risk
investor decisions offered by
behavioural finance. Discuss and apply traditional and
basic methods of foreign currency
H RISK MANAGEMENT risk management, including:
1. The nature and types of risk and §17
− currency of invoice
approaches to risk management
− netting and matching
Describe and discuss different types − leading and lagging
of foreign currency risk:
− forward exchange contracts
− translation risk − money market hedging
− transaction risk − asset and liability management
− economic risk
Compare and evaluate traditional
methods of foreign currency risk
management.
Ref:
Identify the main types of foreign
currency derivatives used to hedge
foreign currency risk and explain
how they are used in hedging. (No
numerical questions will be set on
this topic)
4. Hedging techniques for interest rate §17
risk
Discuss and apply traditional and
basic methods of interest rate risk
management, including:
− matching and smoothing
− asset and liability management
− forward rate agreements.
Formula Sheet
2Co D
=
Ch
1
3 3
4 × transaction cost × variance of cash flows
Spread = 3
interest rate
E(ri) = Rf + βi(E(rm)–Rf)
e V d V (1 − T )
βa = βe + βd
(
eV + Vd (1 − T )) e Vd (1 − T ))
(V +
D O (1 + g )
PO =
(re − g )
Gordon’s growth approximation
g = bre
V V
K d (1 − T )
e d
WACC = K e +
V
e + Vd +
e Vd
V
(1 + h c ) (1 + i c )
S1 = S 0 x F0 = S0 x
(1 + h b ) (1 + i b )
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
Annuity table
1 − (1 + r ) − n
Present value of an annuity of 1 i.e.
r
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.586 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
EXAM TECHNIQUE
Reading and planning time
During the 15 minutes reading and planning time you may write on the question paper but
not in your answer booklet.
Try to rank the four questions in their level of difficulty – plan to attempt the easiest
question first and the most difficult last. This should help keep your confidence high during
the exam.
Although you may use your calculator during the reading and planning time it would be
more effective to draft bullet points for the written elements of the questions.
Any calculations done in the reading and planning time should be restricted to the first
calculation required in each question.
Time allocation
To allocate your time multiply the marks for each question by 1.8 minutes.
You should also apportion your time carefully between the parts of each question.
Do not be tempted to go over the time allocation on each question - remember the “law of
diminishing returns” the longer you spend the lower your efficiency in gaining marks. It is
more effective to move onto the next question.
Attempt all parts of each question. DO not attempt to pass the exam by only performing
calculations or by only attempting three questions.
Numerical elements
¾ Before starting a computation, picture your route. Do this by noting down the steps
you are going to take and imagining the layout of your answer.
¾ Use a columnar layout if appropriate (e.g. when forecasting a project’s cash flows). This
helps to avoid mistakes and is easier for the marker to follow.
¾ Include all your workings and cross-reference them to the face of your answer.
¾ A clear approach and workings will help earn marks even if you make an arithmetic
mistake.
¾ If you later notice a mistake in your answer, it is not worthwhile spending time
amending the consequent effects of it. The marker of your script will not punish you for
errors caused by an earlier mistake.
¾ If you write good comments based on calculations which contain errors, you can still
receive all the marks for the comments.
¾ If you could not complete the calculations required for comment then assume an answer
to the calculations. As long as your comments are consistent with your assumed
answer you can still pick up all the marks for the comments.
¾ Write your assumptions – if you are not sure how to interpret something in the question
then state your assumed interpretation.
Written elements
Planning
¾ Read the requirements carefully at least twice to identify exactly how many points you
are being asked to address.
¾ Give your plan a structure which you will follow when you write up the answer.
Presentation
¾ Use headings and sub-headings to give your answer structure and to make it easier to
read for the marker. The examiner does not want a long, continuous monologue.
¾ Use short paragraphs for each point that you are making.
¾ Use bullet points where this seems appropriate (e.g. for a list of advantages/disadvantages) –
however each bullet point must be followed by a full sentence.
¾ Separate paragraphs by leaving at least one line of space between each. Write legibly.
Style
¾ Concise, easily understood language scores good marks and requires less writing.
¾ Many points briefly explained tend to score higher marks than one or two points
elaborately explained.
OVERVIEW
Objective
¾ Corporate objectives
ORGANISATIONAL
¾ Maximisation of shareholder
OBJECTIVES wealth
¾ Public sector organisations
¾ Environmental impacts
¾ Agency theory
CONFLICTS OF
¾ Stakeholders
INTEREST ¾ Directors and shareholders
¾ Goal congruence
Definition
The management of activities associated with the efficient acquisition and use
of short and long-term financial resources.
¾ How much working capital should the organisation have and how should it be
financed?
Financial accounting may influence financial management in various ways. For example:
¾ Directors of quoted companies need to consider the impact of financing decisions on the
published financial statements (e.g. operating leases are “off balance sheet” whereas
finance leases would increase reported financial gearing).
Management accounting information can often assist the financial manager. For example:
¾ The budgeting process may identify potential cash deficits/surpluses which the
financial manager must plan to finance/invest.
¾ Analysis of costs into fixed and variable elements may assist financial management
decisions.
2 ORGANISATIONAL OBJECTIVES
2.1 Corporate objectives
In practice companies are likely to have a variety of different objectives which may include a
number of the following:
¾ profit targets;
¾ market share targets;
¾ share price growth;
¾ local and environmental concerns;
¾ contented workforce;
¾ meeting short-term targets;
¾ long-term plans.
¾ Profit goals – objectives which lead directly to increased profits (e.g. cost reduction
measures);
¾ Surrogate profit goals – objectives which lead indirectly to increased profits (e.g.
maintaining a contented workforce);
¾ Constraints on profit – objectives which actually restrict profit (e.g. ensuring that the
company’s operations do no harm to the environment);
¾ Dysfunctional goals – objectives which do not provide a benefit even in the long run
(e.g. the pursuit of market leadership at all costs).
In theoretical terms a single corporate objective is assumed and this is “the maximisation of
shareholder wealth”.
Shareholder wealth is the combination of dividend and share price growth – together
referred to as Total Shareholder Returns (TSR).
The objective of maximising shareholder wealth can be justified in the following ways:
¾ The company which provides the highest returns for its investors will find it easiest to
raise new finance and grow in the future. If a company does not provide competitive
returns it will inevitably decline.
¾ The directors of a company have a legal duty to run the company on behalf of the
shareholders. It is generally considered a reasonable assumption that the shareholders
of listed companies (mainly institutional investors) seek to maximise wealth.
8 In the case of unlisted companies even the shareholders may not require maximised
returns (e.g. some closely held companies are run as “lifestyle firms” whose main
objective is to create prestige for the owners).
The objective of public sector organisations is to provide the service for which the
organisation was established. These organisations are frequently called “Not for Profit
Organisations” (NPOs). Such organisations are not constrained by cost/profit objectives to
the same extent as companies. However they are often constrained by having multiple
stakeholders with potentially conflicting objectives.
Agent University
management
¾ Students may desire small class sizes, a large library and courses that meet their
personal interests,;
¾ Potential employers may want graduates with relevant skills for industry (e.g.
engineering graduates as opposed to anthropology graduates).
NPOs are sometimes said to have as their objective the maximisation of the difference
between the benefits they generate and the costs of their operations. However it is often
very difficult to quantify the benefits that such organisations produce.
There is an increasing emphasis on Value For Money (VFM) and achieving Economy
Efficiency, and Effectiveness - the “3 Es”:
Illustration 1
University
Example 1
However, one member of the council has recently criticised the performance of
the Lewisville bus service as compared to those operated by private sector bus
companies in other towns. She has produced the following information for the
most recent financial year:
$000 $000
Passenger fares 1,200
Staff wages 600
Fuel 300
Depreciation 280
_____
1,180
_____
Surplus 20
_____
Summarised Statement of financial position
$000 $000
Assets
Non-current assets (net) 2,000
Current assets
Inventories 240
Cash 30
_____
270
_____
Total assets 2,270
_____
Equity and liabilities
Ordinary share capital ($1 shares) 2,000
Reserves 210
_____
2,210
Current liabilities 60
_____
Total equity and liabilities 2,270
_____
Example 1 — continued
Required:
(a) Using the information provided above, compare the performance of the
Lewisville Bus company to the industry average for private sector
companies.
(b) Discuss the validity of comparing the performance of the Lewisville Bus
Company with private sector bus companies.
(c) Explain the meaning of the following terms in the context of performance
measurement and suggest a measure of each one appropriate to a public
sector bus service.
(i) Economy;
(ii) Effectiveness;
(iii) Efficiency.
Solution
An area of growing concern to all parties, companies included, is that of the environment or
“green” issues.
It is important that managers understand the impact of the operations of the organisation on
the environment, in order to satisfy public concerns and, increasingly, to avoid any penalties
or costs due to environmental regulations.
For these reasons environmental reporting is becoming more common as part of general
company financial reporting.
The “triple bottom line” approach - a method of “true cost accounting” which considers the
impact of production decisions in terms of ecological and social value, as well as economic
value. Those firms that create environmental and social value alongside economic value are
often considered to have a sustainable triple bottom line.
3 CONFLICTS OF INTEREST
3.1 Agency theory
Agency theory examines the duties and conflicts that occur between the parties within a
company that have an agency relationship.
A company can be viewed as a set of contracts between each of these various interest
groups. The company will not succeed unless all of the groups are working towards the
same objectives.
Whilst most research has focused on the potential conflicts between directors and
shareholders there are other potential sources of tension within a firm.
For example when a firm’s assets are close to the level of its liabilities the debt investors will
pressurize the directors to only undertake low risk projects. This is because the debt
investors have nothing to gain from risky projects (they receive fixed returns) but everything
to lose (if assets fall below liabilities the firm may become unable to service its debts).
Equity investors, on the other hand, may encourage the directors to take on risky projects.
This is because equity investors participate in any excess returns but, due to the protection
provided by their limited liability status, they cannot be forced to cover any losses.
3.2 Stakeholders
COMPANY
While shareholders are clearly the key stakeholder modern corporate governance suggests
that directors should take into account the objectives of a wider range of interested parties.
Directors are therefore expected to show responsibility to creditors (e.g. reasonable payment
terms), responsibility to employees (e.g. health and safety) and ultimately to society as a
whole (e.g. minimising pollution, investing in social projects – Corporate Social
Responsibility (CSR)).
Therefore the overall corporate objective may become “satisficing” (i.e. producing
satisfactory rather than maximum returns for shareholders). With the rise of the “ethical
investor” on world stock markets it appears that many shareholders are in fact willing to
accept slightly lower returns in exchange for their companies following a wide range of both
financial and non-financial objectives.
In larger companies the shareholders entrust the management of the company to the
directors – referred to as the separation of ownership from control. The directors are
managing the company on behalf of the shareholders and should therefore always act in the
best interests of the shareholders, while taking into account the objectives of other
stakeholder groups.
This may not always be the case as the directors may have other personal objectives such as:
In addition to the personal aspects shown above a small number of directors have been
guilty of not fulfilling their fiduciary duties by:
¾ creative accounting, by choosing creative accounting policies the directors can flatter the
accounts – known as “window dressing”;
¾ “off balance sheet” finance (e.g. via the use of “special purpose vehicles”);
¾ takeovers; in defending the company from takeovers some directors have been accused
of trying to protect their own jobs rather than acting in the interests of their
shareholders;
¾ disregard for environmental issues; directors may allow processes which emit pollution
or test products on animals.
If directors follow personal objectives which conflict with those of their shareholders this
leads to “agency costs” (i.e. lost potential returns for shareholders). This can be referred to
as “the agency problem”.
It can be argued that the actual return to shareholders = maximum potential return – agency
costs – cost of following Corporate Social Responsibility.
Goal congruence is where each of the parties in an organisation seek to achieve personal
objectives which are also in the best interests of the company as a whole.
For example managers should be encouraged to aim for long-term growth and prosperity
rather than short-term reported profitability.
¾ Executive Share Option Plans (ESOPs) – although the evidence is mixed regarding the
success of such schemes in motivating directors to improve performance (e.g. a
company’s share price may rise due to a general rise in the stock market rather than the
quality of its management).
¾ Long Term Incentive Plans (LTIPs) – paying a bonus to directors if over several years
the company’s performance is good when benchmarked against that of competitors.
4 CORPORATE GOVERNANCE
4.1 Definition
Various countries have developed their own codes on corporate governance. Although
detailed knowledge of specific codes is not required candidates should have an awareness of
the main principles:
¾ Every company should be headed by an effective board which should lead and control
the company.
¾ Chairman and CEO – there should be a clear division of responsibilities at the head of
the company between running the board (chairman) and running the business (CEO);
no single individual should dominate.
¾ The board should have a balance of executive and independent non-executive directors.
¾ All directors should be required to submit themselves for re-election on a regular basis.
¾ Remuneration committees should provide the packages needed to attract, retain and
motivate executive directors and avoid paying more.
¾ The board should maintain a solid system of internal control to safeguard shareholders’
investment and the company’s assets.
The UK Combined Code is included in the Listing Rules of the London Stock Exchange.
Although compliance is not obligatory, any listed company which does not comply with the
Combined Code must explain its reasons for non-compliance.
The US Sarbanes – Oxley Act applies to all companies listed on a US stock market –
including their foreign subsidiaries. Compliance is mandatory.
Key points
³ In the corporate sector the key stakeholders are clearly the shareholders.
Most traditional finance theory is therefore built on the assumption that a
company4 objective is to maximise the wealth of its shareholders.
FOCUS
You should now be able to:
¾ discuss the nature and scope of financial objectives for private sector companies;
¾ discuss the role of social and non-financial objectives in private sector companies and
identify their financial implications;
EXAMPLE SOLUTIONS
Solution 1
(a) Performance of the Lewisville Bus Service compared with the private sector
When looking at profitability, the Lewisville Bus Service (LBS) has performed poorly
compared to the industry averages for the private sector. Return on capital employed is
0.9% compared to 10% for private companies. Profit margins are also low – 1.7% is the
net profit margin compared to 30% for private companies. This is probably due to the
fact that being a public sector provider, LBS has to provide services on less profitable
routes. It also charges lower fares than private sector. However, given that LBS is not a
commercial enterprise, and that its mission is to provide efficient, affordable transport
to the residents of Lewisville, such profitability measures are not relevant.
Asset turnover is higher for LBS than for the private sector – revenue is 0.54 times
capital employed, compared to 0.33 for the private sector. This suggests that the LBS
busses achieve higher utilisation than private sector busses. This may be because LBS
fares are lower compared with the private sector. The busses are probably utilised to a
greater extent, with more journeys per day than private sector busses. This is a good
sign as it shows that LBS is achieving greater utilisation of its capital than the private
sector busses in terms of revenue.
Cost per passenger mile, at 27.3¢ is only 73% of the industry average of 37.4¢. This is a
good sign as it means that the company is managing to provide more journey distance
for a lower cost, which represents a better use of resources. The main reason may well
be the higher number of passengers, or the bus routes may also be longer, particularly if
LBS is covering routes to outlying suburbs that are far from the city centre.
The fares per passenger mile charged by LBS are only 52% of the fares charged by the
private sector bus companies. As already discussed, this reduces the profitability of
LBS. However, low fared are likely to be appreciated by the users of the bus. The lower
fares are part of the policy of providing affordable public transport.
Operating profit 20
× 100 = × 100 = 0.9%
Capital Employed 2 ,210
Net margin
Operating profit 20
× 100 = × 100 = 1.7%
Sales 1,200
Asset turnover
Sales 1,200
× 100 = × 100 = 0.54 times
Capital employed 2 ,210
There are several reasons why comparing the performance of LBS with the average
ratios for the private sector is not a valid exercise. Firstly, the objectives of LBS, as
stated in its mission are to provide efficient, reliable and affordable public transport to
the citizens of Lewisville. Private sector companies are more likely to wish to maximise
the wealth of shareholders. This means that direct comparisons become less meaningful
for the following reasons:
Calculation of return on capital and profit margin are not relevant for LBS, as the
organisation does not exist to make a profit.
Private sector bus companies may “cherry pick” the most profitable routes, and
avoid providing services on less populated routes. A public sector company such
as LBS may provide services on less populated routes as part of its mission of
providing services to all citizens.
The public sector bus company may aim to charge lower fares – particularly to
certain groups such as pensioners and children. Private sector companies may not
feel obliged to do this, and will use a pricing policy that will maximise profits.
In spite of these limitations, some benefits can be obtained by comparing the two. Areas
related to the costs of running the services, quality, and utilisation could lead to some
benefits whereby the public sector could use the private sector as a benchmark.
However, account would still need to be taken of the lower profit routes that are served.
Economy is an input measure and is normally based around the expenditure of the
organisation. In the case of the Lewisville bus service it could be measured by total
expenditure as compared to budget.
Effectiveness is an output measure and looks at what the organisation achieves in terms
of its objectives. In the case of the Lewisville bus service it could be measured by the
number of passengers carried, or the number of passenger miles travelled.
OVERVIEW
Objective
THE FINANCIAL
MANAGEMENT
ENVIRONMENT
FINANCIAL
ECONOMIC IMPACT ON BANKING
MARKETS
POLICY BUSINESS SYSTEM
THEORY
¾ Macroeconomic ¾ Inflation ¾ Financial ¾ The financial markets
policy ¾ Government intermediaries ¾ Stock exchange
¾ Monetary policy intervention ¾ Commercial clearing operations
¾ Fiscal policy ¾ The Euro banks ¾ Financial market
¾ Supply side ¾ Credit creation efficiency
approach ¾ Money market interest
rates
ISLAMIC
FINANCE
¾ Background
¾ The prohibitions
¾ Islamic Instruments
¾ The Shariah board
¾ Developments
1 MACROECONOMIC POLICY
1.1 Definition
The above objectives can often be in conflict (e.g. economic growth can lead to excess
demand for resources and lead to an increase in inflation).
Financial managers must understand not only national government economic policy but,
due to the increasing interdependence of economies through both the movement of trade
and capital, world macroeconomic trends.
¾ the “dot.com bubble” – following over-optimism by both business and investors of the
potential returns from the high technology sector.
¾ the launch of the European single currency – the Euro – in which UK is not currently
participating.
¾ the growing importance of emerging economies (e.g. the BRIC countries (Brazil, Russia,
India and China)).
¾ the 2007 US sub-prime meltdown which, coupled with “financial contagion” (i.e. high
interdependence between countries) led to frozen debt markets and the global recession.
Some countries, such as Russia, initially believed they were sufficiently “de-coupled”
from the US economy to escape the worst effects of the credit crunch. Regrettably this
was not the case as many companies in Russia (and throughout Central and Eastern
Europe) had large amounts of foreign debt which could not be easily refinanced.
¾ volatile commodity prices, interest rates, exchange rates and capital markets.
2 MONETARY POLICY
2.1 Definition
Governments or central banks can directly control the money supply in the following ways:
¾ If the central bank sells government securities the money supply is contracted, as some
of the funds available in the market are “soaked up” by the purchase of the government
securities.
¾ Equally, if the central bank were to buy back securities then funds would be released
into the market. The sale of government securities will lead to a reduction in bank
deposits due to the level of funds that have been “soaked up”.
¾ This in turn can lead to a further reduction in the money supply, as the banks’ ability to
lend is reduced. This is known as “the multiplier effect”.
¾ The central bank can set a minimum level of liquid assets which banks must maintain.
This limits their ability to lend and thereby reduces the money supply.
¾ The central bank can have the power to call for “special deposits”. These deposits do
not count as part of the bank’s reserve base against which it can lend. Hence they have
the effect of reducing the bank’s ability to lend and thereby reducing the money supply.
¾ The central bank may set specific limits on the amount which banks may lend.
¾ Credit controls are difficult to impose as, with fairly free international movement of
funds, they can easily be circumvented.
Governments can reduce the demand for money, and therefore indirectly the money supply,
by encouraging an increase in short-term interest rates.
8 there is often a significant time lag between the implementation of a policy and its
effects;
8 the fact that the relationship between interest rates, level of investment and consumer
expenditure is not actually stable and predictable;
If governments want to control the money supply it is necessary to be able to measure the
supply of money in the economy.
¾ Whilst M5 may be the most suitable measure to use it is the hardest to control.
Commentary
3 FISCAL POLICY
3.1 Definition
Commentary
If the economy is in recession fiscal policy can be used to reflate the economy and the
following actions could be taken:
9 increase government spending in order to directly increase the level of demand in the
economy (e.g. if a government agrees a number of large road-building projects, the
demand for goods and services in the economy is increased);
8 government spending is an intervention into the free market and can easily lead to the
misallocation of resources (e.g. support for inefficient industries);
8 there is often a significant time lag between the authorisation of additional spending
and its actual occurrence;
8 tax cuts are not efficient at boosting domestic demand, as in times of recession some of
the extra disposable income made available will be saved, and of the extra monies
actually spent some of it will be on imports;
8 a large budget deficit is likely to occur which will lead to a large Public Sector
Borrowing Requirement (PSBR);
8 the rate of inflation is likely to rise, as demand may increase for resources which are in
limited supply and for which the prices will therefore tend to increase.
If there is too much demand in the economy (it is overheating), then fiscal policy can be used
to depress demand or deflate the economy, and the following actions could be taken:
9 reduce government spending in order to decrease directly the level of demand in the
economy;
9 increase taxation in order to reduce consumption and to assist with the redistribution of
wealth.
Fiscal and monetary policies are interdependent and governments will use both fiscal and
monetary policies to achieve their monetary and budgetary targets. Which policies
dominate depends on the economic theory preferred by the government of the day. In the
UK there was a Keynesian approach to the management of the economy from the 1930s to
the 1970s. However, this was believed to have contributed to the “boom-bust” economic
cycles that were experienced. Hence recent governments have followed a more monetarist
approach.
4.1 Definition
Supply side policies are policies which focus on creating the right conditions in
which private enterprise can grow and therefore raise the capacity of the
economy to provide the output demanded. The private sector, being driven by
the profit motive, is deemed to be more efficient at providing the output
required than the public sector.
Supporters of supply side policies believe that, if business is to flourish, the economy must
be in a stable condition and therefore fiscal policy should be in equilibrium. In other words,
government spending should not exceed government receipts from taxation. Additionally,
if the private sector is to be encouraged, tax rates should be kept to a minimum and
government expenditure also should be kept to a minimum.
Monetary policy is used to control inflation to provide the stable economy, in which
business can flourish.
8 the private sector will not provide all the goods and services required by society – for
example health care provision.
5 INFLATION
5.1 Definition
5.2 Measurement
The normal way of measuring inflation is to use the Consumer Price Index (CPI) which
attempts to measure changes over time in the monetary cost of a representative “basket” of
goods and services. The CPI relates to retail goods and services, and hence only gives a
broad indication of how fast prices are rising across the economy.
Alternative measures of inflation also exist which, for instance, look at the increases in the
costs of manufacturing industry.
¾ Inflation arises due to demand exceeding the maximum output of the economy with full
employment.
¾ Increases in the cost of raw materials or the cost of labour lead to increases in the unit
costs of firms, and therefore inevitably leads to an increase in prices as these higher
costs are passed on to the consumer. The increased costs suffered by industry may be as
a result of the increase in the cost of imported goods, in which case the term imported
cost-push inflation is used.
Monetarists, on the other hand, believe that inflation arises as a result of “too much money
chasing too few goods”. Therefore, in the short term inflation should be controlled by
controlling the money supply, whilst in the long term inflation should be controlled by
enhancing the ability of the economy to produce goods and services.
¾ Where inflation reaches very high levels money is no longer able to carry out its key
functions of being a medium of exchange and a store of value;
¾ International competitiveness suffers where prices rise faster than those of foreign
competitors;
¾ Higher interest rates reduce the number of profitable investment opportunities and
therefore the level of investment;
¾ In periods of rapid inflation the need to search for the best price currently available for
the purchases required and the need to be constantly updating selling prices adds
significant costs to industry.
Conventional historic cost accounts have the following problems during periods of
significant inflation:
¾ Gains arising from holding assets are treated as being fully distributable.
The result of the above is that profits become overstated (current revenues are charged with
a measure of historic cost), and capital becomes understated and therefore ROCE (return on
capital employed) is also overstated.
¾ The use of Current Purchasing Power (CPP) or Current Cost Accounting (CCA) in order
to eliminate the above distortions and ensure the maintenance of the shareholders’
funds in real terms.
Governments intervene in the operation of the free market for the following reasons:
¾ Where monopolies, mergers or restrictive practices operate against the public interest;
¾ Where companies fail to take account of the effect of their actions which impact outside
of the company, these are known as “externalities”; a common example is the pollution
which a company may cause;
¾ Where the free market fails to provide sufficient public goods, such as health care or
education;
¾ Where the free market is unable to provide the amount of capital required (e.g. when a
large infrastructure project, such as the construction of a new tunnel or bridge, is being
undertaken).
Governments develop competition policies in order to increase the efficiency of the economy
by stimulating competition.
¾ The creation of internal markets within certain areas of the public sector (e.g. hospitals
or schools) must compete for the resources they require based on the services they
provide to their users.
6.3 Privatisation
In the UK a large number of state-owned firms have been sold to the private sector either by
sale to the general public, direct sale to another company or management buy-out.
Examples include British Telecom, British Gas and the electricity distribution companies.
¾ many privatisations have replaced state monopolies with private sector monopolies,
which have then required regulation to ensure that their monopoly position is not
abused;
¾ the breaking-up of large businesses into smaller companies results in the loss of
economies of scale;
Governments also intervene in the economy through the use of official aid schemes. These
aid schemes include the use of cash grants, consultancy advice and tax incentives in order to
encourage investment in high technology or investment in areas of particularly high
unemployment.
Grants may also be available from transnational institutions. For example, the European
Regional Development Fund has assisted with many infrastructure projects in the remoter
regions of the UK.
¾ Carbon credits – where the government allocates each polluting firm a quota of the
number of tonnes of greenhouse gasses that it can emit. If a firm then switches to
“greener” production techniques it may find it has a surplus of carbon credits which can
then be sold to a firm that is exceeding its quota (i.e. carbon trading).
Detailed knowledge of specific corporate governance codes is not required for the
examination. The material below is provided to give an idea of the main principles.
The UK Combined Code is included in the Listing Rules of the London Stock Exchange.
Although compliance is not obligatory, any listed company which does not comply with the
Combined Code must explain its reasons for non-compliance.
¾ Every listed company should be headed by an effective board which should lead and
control the company.
¾ Chairman and CEO – there should be a clear division of responsibilities at the head of
the company between running the board and running the business; no single individual
should dominate.
¾ The board should have a balance of executive and independent non-executive directors.
¾ All directors should be required to submit themselves for re-election at least every three
years.
¾ Remuneration committees should provide the packages needed to attract, retain and
motivate executive directors and avoid paying more.
The US Sarbanes – Oxley Act was introduced in 2002 and represented the most significant
review of US corporate governance since the Securities Exchange Act of 1934. It applies to
all companies listed on a US stock market – including their foreign subsidiaries. Compliance
is mandatory.
One of the main provisions of Sarbanes – Oxley is that the CEO and CFO should sign off
personally on company accounts. Fraudulent certification (i.e. signing accounts known to be
inaccurate) leads to criminal penalties – fines of up to $5m and up to 20 years in prison.
However some CEO’s and CFO’s have tried to avoid their responsibilities under the
Sarbanes – Oxley Act by asking divisional heads to certify their division’s accounts before
they are sent to head office.
7 THE EURO
¾ From 1 January 2002 Euro notes and coins replaced the national currencies of Euro-
block countries. The value of the Euro was set by reference to the relative value of the
component currencies. The exchange rate between those currencies is therefore now
fixed.
¾ The UK has not joined the single currency, Therefore UK companies that trade with
“Euroland” face foreign exchange risk as sterling rises and falls against the Euro.
Although short–term “transaction exposure” can be hedged (e.g. using forward
contracts) it is far more difficult to protect against exposure to long-term exchange rate
changes (i.e. “economic exposure”).
¾ The introduction of the Euro allows easier comparison of prices between member
countries. This should reduce price differentials in Europe and increase competition.
¾ If the UK decides to join the Euro then UK interest rates will fall towards those in the
Euro region. This will have implications for company finance as debt becomes cheaper.
¾ Within the Euro region there is also a move towards tax harmonisation (e.g. introducing
the same corporation tax rates across the area). This obviously has implications for
financial management (e.g. project appraisal).
8 FINANCIAL INTERMEDIARIES
8.1 Definition
¾ Commercial banks.
¾ Building societies, which take deposits from the domestic sector and lend
to those buying their own house.
¾ Pension funds, which receive regular premiums and thus have predictable
cash outflows and can invest in the long term.
Financial intermediaries are important as they carry out the following roles:
¾ The risk of each particular borrower is effectively spread across many lenders.
¾ Providing a liquid market with flexibility and choice for both lenders and borrowers.
¾ Providing instruments to business for hedging risk (e.g. forward contracts, options and
swaps).
¾ They accept deposits from their customers which are held in current or deposit
accounts.
¾ They issue Certificates of Deposit, which may then be traded. These relate to large
deposits which have a term to maturity of at least three months.
¾ They lend money in a number of different ways, thus ensuring that adequate returns
are made. At the same time some cash must be held in order to ensure that sufficient
liquidity is maintained. Banks therefore have to find the right balance between
profitability and liquidity.
¾ The lending of money in the very short term to discount houses which will re-lend in
the longer term, as not all of their borrowings are likely to be called in at any one time.
10 CREDIT CREATION
Banks need to keep only a small proportion of their assets in the form of cash as only a small
proportion of their depositors will require repayment on any particular day. The rest of
their assets can be in the form of investments with which the bank hopes to make the returns
required by their shareholders.
Hence, if a bank has $10,000 deposited with it and it only needs to maintain 12% of its funds
as cash, then the bank is able to invest up to $10,000 × (1 – 0.12) = $8,800. Let us assume that
this investment is made in the form of a loan to a customer and that the full $8,800 is loaned.
Consider now the total funds available in the market. The initial depositor will be able to
call on and spend the original $10,000 and that the borrower has the ability to spend $8,800.
Thus in total $18,800 is available to be spent.
This process can be repeated as the $8,800 in circulation is likely to be spent and finally
deposited back with a bank, which will then be able to loan up to $8,800 × (1 – 0.12) = $7,744,
thus creating additional credit.
The proportion of deposits that a bank retains as cash or other very liquid assets is known as
the “liquidity ratio” or “reserve asset ratio”. Where the liquidity ratio is known, the
following formula can be used to determine the total final deposits and hence the credit
created from an initial deposit:
1
Final deposits = Initial deposit ×
Liquidity ratio
1
Final deposits = $10,000 × = $83,333
0.12
Central banks, such as the Bank of England, will often want to control the creation of credit,
and therefore the growth in the money supply, as part of their monetary policy. One of the
policy tools available to them is to specify a minimum liquidity ratio which the banks must
maintain.
¾ Primary market activity – the selling of new securities to raise new funds.
¾ The Alternative Investment Market (AIM), which has fewer regulations and less cost
than the Official List and is therefore attractive to smaller companies.
¾ The Eurobond market – bonds denominated in any currency other than that of the
national currency of the issuer. Eurobonds are generally issued by large international
companies and have a 10 to 15 year term.
Capital markets exist in many other countries, and large international companies may trade
and raise funds in more than one capital market. In the US the NASDAQ market was set up
in order to provide a market where rapidly expanding, high technology and generally high-
risk companies could raise funds - “The Stock Market for the twenty-first century”.
These markets provide long-term capital in the form of equity capital, ordinary and
preference shares for example, or loan capital such as debentures. Companies requiring
funds for five years or more will use the capital markets.
The money market is not actually a physical market but is the term used to describe the
trading between financial institutions. The main areas of trading include:
¾ The inter-bank market – where banks lend each other short-term funds.
¾ The Eurocurrency market – where banks trade in foreign currencies, usually in the form
of certificates of deposit.
¾ The local government market – where local authorities trade in debt instruments.
¾ The finance house market – where short-term loans raised by finance houses are traded.
¾ The Commercial Paper market – commercial paper is short-term unsecured debt issued
by high quality companies.
These markets are for short-term lending and borrowing where the maximum term is
normally one year.
Companies requiring medium term (one to five years) capital will generally raise these
funds through banks.
The primary function of the Stock Exchange is to ensure a fair, orderly and efficient market
for the transfer of securities, and the raising of new capital through the issue of new
securities. In order to do this the Stock Exchange has stringent regulations which are
designed to ensure that:
¾ only suitable companies are allowed to have their securities traded on the Stock
Exchange;
¾ all relevant information is made publicly available as soon as possible – in this way
investors can make informed decisions and thus that funds will be attracted to the most
successful companies;
¾ all investors deal on the same terms and at the same prices.
The more efficient and fair the Stock Exchange is seen to be, the more willing people will be
to invest their money in the Exchange and the more successful it will become.
Since the Second World War the importance of the private investor in the UK has declined
and the importance of the institutional investor, for instance pension funds, has risen. Since
1979 it has been government policy to encourage private share ownership, the privatisation
programme reflected this in that private investors were given priority. However, it is
estimated that only about 25% of shares are held by private investors and only about 5% of
individuals hold a reasonable portfolio of shares.
If an investor wants to buy or sell shares he contacts a “broker”. The broker will either act as
an agent and deal through a “market maker” or he may deal himself, in which case he is
known as a “broker dealer”. The broker will charge a fee for his services, whilst a market
maker will generate a profit through the “bid-offer spread”, which is simply the difference
between the price he is willing to pay for a share and the price at which he is willing to sell
it.
Shares are valued using market forces at the price at which there are as many willing sellers
as there are willing buyers. For instance, if a share is overvalued there will be more people
keen to sell their holding than there will be willing to buy, and this will inevitably depress
the market price.
¾ A “bull” is someone who believes that prices will rise. He buys shares in the hope of
selling them in the future for a profit.
¾ A “bear” is someone who believes prices will fall. He sells shares in the belief he will be
able to buy them back later for less.
Commentary
When there are more bulls than bears prices will rise, and when there are more bears
than bulls prices will fall.
¾ it reduces fluctuations in the market; for instance, as the market falls and prices fall,
more and more speculators will become “bullish” and start to buy again, thus arresting
the fall in the market
¾ it ensures that there is always a ready market in all shares; in other words, there will
always be someone willing to buy or sell at the right price.
An efficient market is one in which the market price of all securities traded on it reflects all
the available information. A perfect market is one which responds immediately to the
information made available to it.
An efficient and perfect market will ensure that quoted share prices are as fair as possible, in
that they accurately and quickly reflect a company’s financial position with respect to both
current and future profitability.
¾ Allocative efficiency:
¾ Operational efficiency:
Does the market have low transaction costs and a convenient trading platform? These
promote a “deep” market with high liquidity (i.e. a high volume of transactions
withlow transaction costs).
¾ Informational efficiency:
¾ Pricing efficiency:
Do share prices quickly and accurately reflect all known information about the
company? This is also referred to as “information processing efficiency”.
¾ Share prices reflect all the information contained in the record of past prices. Share
prices will follow a “random walk”.
If this level of efficiency has been achieved it should not be possible to forecast price
movements by reference to past trends (i.e. “chartists”, also called technical analysts)
should not be able to consistently out-perform the market.
Share prices reflect all information currently publicly available. Therefore the price will
alter only when new information is published.
If this level of efficiency has been reached, price movements can only be forecast by
using “inside” information (i.e. material non-public information). This is known as
insider trading which is illegal in most markets and is unethical in all markets.
¾ Share prices reflect all information, published and unpublished, that is relevant to the
company.
If this level of efficiency has been reached, share prices cannot be predicted and gains
through insider dealing are not possible as the market already knows everything!
In major markets (e.g. London and New York Stock Exchanges) there are strict rules
outlawing insider dealing. Therefore such markets are regarded as semi-strong efficient.
The level of efficiency of the stock market has implications for financial managers:
Unless the market is fully efficient the timing of new issues remains important. This is
because the market does not reflect all the relevant information, and hence advantage
could be obtained by making an issue at a particular point in time just before or after
additional information becomes available to the market.
¾ Project evaluation:
If the market is not fully efficient, the price of a share is not fair, and therefore the rate of
return required from that company by the market cannot be accurately known. If this is
the case, it is not easy to decide what rate of return to use to evaluate new projects.
¾ Creative accounting:
Unless a market is fully efficient creative accounting can still be used to mislead
investors.
Where a market is fully efficient, the price of all shares is fair. Hence, if a company is
taken over at its current share value the purchaser cannot hope to make any gain unless
economies can be made through scale or rationalisation when operations are merged.
Unless these economies are very significant an acquirer should not be willing to pay a
significant premium over the current share price.
If the market is fully efficient, the share price is fair. In other words, an investor receives
a fair risk/return combination for his investment and the company can raise funds at a
fair cost. If this is the case, there should be no need to discount new issues to attract
investors.
Different financial instruments offer different interest rates. In order to understand why this
is, it is necessary to appreciate the factors which determine the appropriate interest rate for a
particular financial instrument.
Inflation.
Government monetary policy.
The demand for borrowing.
Investors’ preference for cash.
International factors such as interest rates overseas and exchange rate movements.
¾ Level of risk:
The higher the level of risk the greater return an investor will expect.
If it is assumed that in the long-term interest rates are expected to remain stable then the
longer the length of the loan the higher the interest rate will be. This is because lending
money in the longer term has additional risk for the lender (e.g. the risk of default
increases).
For instance, a depositor at a building society will receive a lower rate of interest than a
borrower will be charged.
¾ Size:
If a large sum of money is lent or borrowed, there are administrative savings; hence a
higher rate of interest can be paid to a lender and a lower rate of interest can be charged
to a borrower than would normally be the case.
The return provided by a security will alter according to the length of time before the
security matures.
If, for example, a graph is drawn showing the yield to maturity/gross redemption yield of
various government securities against the number of years to maturity, a “yield curve” such
as the one below might result.
Yield
Years to maturity
It is important for financial managers to be aware of the shape of the yield curve, as it
indicates to them the likely future movements in interest rates and hence assists in the choice
of finance for the company.
¾ Yields will need to rise as the term to maturity increases, as by investing for a longer
period the investor is deferring his consumption and needs higher compensation.
Hence a “normal” yield curve slopes upwards, as shown above.
¾ If interest rates are expected to increase in the future, the curve may rise even more
steeply. On the other hand the curve may fall (i.e. invert if interest rates are expected to
decline).
¾ Different investors are interested in different segments of the yield curve. Short-term
yields, for example, are of interest to financial intermediaries such as banks. Hence the
shape of the yield curve in that segment is a reflection of the attitudes of the investors
active in that sector. Where two sectors meet there is often a disturbance or apparent
discontinuity in the yield curve as shown in the above diagram.
¾ This can also be referred to as “preferred habitat theory” (i.e. different investors have a
preference for being in different segments of the yield curve).
¾ Pension fund managers often have a preference for investing in long-dated bonds – to
match against the long term liabilities of the fund. This can drive up the price of long-
dated bonds which brings down their yield, possibly resulting on an inversed (falling)
yield curve
14.3.4 Risk
¾ However default risk may be more significant on corporate debt, therefore the corporate
yield curve may rise more steeply than the government yield curve.
15 ISLAMIC FINANCE
Definition
15.1 Background
Islamic finance is based on Islamic law, or Shariah, whose primary sources are the Qur’an
and the sayings of the Prophet Muhammad. Shariah emphasises justice and partnership.
¾ Wealth must be generated from legitimate trade (i.e. simply making money from money
is forbidden).
¾ Investment should also have a social and an ethical benefit to wider society beyond
pure return.
¾ Islamic banks must obtain their earnings through profit-sharing investments or fee-
based returns. When loans are given the lender should take part in the risk, otherwise
the receipt of any gain over the amount loaned is regarded as interest.
8 Investment in companies that have too much borrowing (debt totalling more than 33%
of the firm’s stock market value).
8 Transactions which involve speculation, or extreme risk - this is seen as gambling. This
prohibits speculating on the futures and options markets. On the other hand mutual
insurance is permitted as members contribute to a fund, not for profit, but in case one of
the members suffers misfortune.
8 Uncertainty about the subject matter and terms of contracts – this includes a prohibition
on selling something that one does not own Therefore, complex derivative instruments
and short selling are prohibited under Islamic finance.
¾ Murabaha: trade credit for asset acquisition that avoids the payment of interest. A bank
buys the asset and then sells it to the customer on a deferred basis at a price that
includes an agreed mark-up. The mark-up cannot be increased, even if the client does
not take the asset within the time agreed in the contract.
¾ Ijara: lease finance whereby the bank buys an item for a customer and then leases it
back over a specific period at an agreed amount. In 2003, HSBC was the first bank to
offer UK mortgages designed to comply with Shariah. HSBC’s Islamic mortgage
involves the bank purchasing a house and then leasing it out to the customer. The
customer’s payments include a contribution to the purchase price, a rent for use of the
property and insurance charges. At the end of the finance term the customer can
exercise an option to have the property transferred into their name.
¾ Mudaraba: a form of equity finance. A bank provides all the capital and its customer
provides expertise, manages the investment project and may provide labour. Profits
generated are distributed according in a predetermined ratio. Any losses are borne by
the provider of capital, who has no control over the management of the project.
¾ Musharaka: joint venture or partnership between two parties who both provide capital
towards the financing of new or established projects. Profits are shared on a pre-agreed
ratio with losses shared on the basis of the relative amounts of equity invested.
¾ Sukuk: Islamic bonds. The sukuk holders’ return for providing finance is a share of the
income generated by the project’s assets. Typically, an issuer of the sukuk would
acquire property to be leased to tenants to generate income. The issuer collects the
income and distributes it to the sukuk holders. This entitlement to a share of the income
generated by the assets can make the arrangement Shariah-compliant. However the
rental income is often linked to market interest rates (e.g. the London Interbank Offered
Rate (“LIBOR”) as opposed to the returns from the underlying asset, and hence many
Islamic scholars state that such bonds violate the prohibition on riba. Indeed it does
appear that Sukuk bonds are often structured to “make money from money” rather than
making returns from a physical asset.
¾ Hibah (gift): where Islamic banks voluntarily pay their customers a “gift” on savings
account balances, representing a portion of the profit made by using those balances in
other activities.
Commentary
Advocates of Islamic finance claim that it avoided much of the recent financial crisis
because of its prohibitions on speculation and its emphasis on risk sharing and justice.
The Shariah board has the responsibility for ensuring that all products and services offered
by an institution are compliant with the principles of Shariah law. Boards are made up of a
committee of Islamic scholars.
An institution’s Shariah board will review and oversee all new product offerings before they
are launched. It can also be asked to deliver judgments on individual cases referred to it,
such as whether a specific customer’s business proposals are Shariah-compliant.
15.5 Developments
The main current problem is the absence of a single, worldwide body to set standards for
Shariah compliance. Some financial aspects of Shariah law can be open to interpretation and
therefore a contract might unexpectedly be declared incompatible with Shariah law and thus
be invalid.
In Malaysia, the world’s biggest market for sukuk, the Shariah advisory council, ensures
consistency to help creating certainty across the market. Some industry bodies, notably the
Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in
Bahrain, have also been working towards common standards.
However, despite these movements towards consistency, some differences between national
jurisdictions are likely to remain.
Key points
³ The key theories to learn are the Efficient Markets Hypothesis and the
Term Structure of Interest Rates.
FOCUS
You should now be able to:
¾ identify the factors which influence inflation and exchange rates, including the impact
of interest rates;
¾ identify the implications of monetary, inflation and exchange rate policy for business;
¾ explain how government economic policy may affect planning and decision-making in
business;
¾ explain the role of commercial banks as providers of funds (including creation of credit);
¾ outline the Efficient Markets Hypothesis and assess its broad implications for corporate
policy and financial management;
¾ explain the major difference between Islamic finance and conventional finance;
¾ explain the concept of interest (riba) and how returns are made by Islamic securities;
¾ briefly discuss a range of short and long term Islamic financial instruments.
OVERVIEW
Objective
¾ To assess an investment using the payback period and the ARR methods.
INVESTMENTS
DECISION
EVALUATION
MAKING PROCESS
¾ Capital expenditure
¾ Revenue expenditure
¾ Stages in capital budgeting
process
¾ Role of investment appraisal in
the capital budgeting
process
PAYBACK ACCOUNTING
PERIOD RATE OF RETURN
¾ Definition ¾ Definition
¾ Advantages ¾ Calculation
¾ Disadvantages ¾ Advantages
¾ Possible Improvements ¾ Disadvantages
1 DECISION-MAKING PROCESS
1.1 Capital expenditure
Definition
Definition
Definition
¾ Approving investment proposals - the most suitable proposals are passed to the
relevant level of authority (e.g. the board of directors) for consideration and approval.
¾ Implementation - the time required will depend on project size and complexity.
¾ Investment appraisal plays a key role at the stage of analysing and evaluating
investment proposals.
¾ On the assumption that the firm’s main financial objective is to maximise (or at least
produce satisfactory) shareholder wealth then the key investment appraisal technique
must be Net Present Value (NPV). This is because NPV shows the theoretical absolute
change in shareholder wealth due to a project.
¾ Managers may also require other measures as part of their decision-making package
(e.g. payback as a liquidity measure and Accounting Rate of Return (ARR)) to judge the
impact on published financial statements.
¾ Providers of finance may wish to know the project’s Internal Rate of Return (IRR). In
particular banks compare project IRR to the interest rate on proposed loans in order to
measure the “headroom” on the project and hence the risk of default on the debt.
2 PAYBACK PERIOD
2.1 Definition
The time it takes for the operating cash flows from a project to pay back the
initial investment.
Decision rule
Illustration 1
Investment $1.4m
Solution
1.4
Payback period = = 4.7 years
0.3
(or five years if cash flows are assumed to arise at year ends.)
9 Simple to calculate.
9 Easy to understand.
9 Concentrates on earlier flows:
more certain;
more important if firm has liquidity concerns.
¾ First discount the cash flows to present value and then calculate the payback period
¾ This takes into account the time value of money (see p0708)
¾ This takes into account the estimated scrap/disposal value of the asset if the project is
abandoned early
3.1 Definition
3.2 Calculation
¾ This is a financial accounting measure based on the income statement and statement of
financial position.
¾ It therefore includes:
¾ Calculated as:
Where:
Decision rule
Example 1
Required:
Solution
8 Based on profits rather than cash. Profits are easily manipulated by accounting policy.
Example 2
Required:
(a) ARR;
(b) ARR using the average investment approach;
(c) payback period;
(d) payback period incorporating the bail-out factor.
Solution
(a)
(b)
(c)/ (d)
Payback period =
Key points
³ As well as being able to calculate payback and ARR it is therefore vital that
you can also explain why they are not acceptable methods of project
appraisal
FOCUS
You should now be able to:
EXAMPLE SOLUTIONS
Solution 1
Average investment
17.5
ARR on average investment × 100 = 15.91%
110
(a) ARR
Average annual earnings = (3 × 20,000 + 3 × 15,000)
= $17,500
6
(c)/ (d)
Payback period = 4 15
13
years
OVERVIEW
Objective
INTEREST
¾ Comparison
1 SIMPLE INTEREST
Key point
Illustration 1
¾ A single principal sum, P invested for n years at an annual rate of interest, r (as a
decimal) will amount to a future value FV.
Where FV = P (1 + nr)
2 COMPOUND INTEREST
Key point
Illustration 2
If Zarosa placed $100 in the bank today (t0) earning 10% interest per annum,
what would this sum amount to in three years’ time?
Solution
Commentary
Formula
FV = P (1 + r) n
where
P = initial principal
r = annual rate of interest (as a decimal)
n = number of years for which the principal is invested
Example 1
Required:
Solution
FV =
FV =
Example 2
Solution
2.2 Annuities
¾ Many saving schemes involve the same amount being invested annually.
¾ There are two formulae for the future value of an annuity. Which to use depends on
whether the investment is made at the end of each year or at the start of each year.
(1 + r )n − 1 (1 + r )n + 1 − 1
(i) FV = a
(ii) FV = a − 1
r r
Commentary
Illustration 3
Andrew invests $3,000 at the start of each year in a high interest account
offering 7% pa. How much will he have accumulated after a fixed 5 year term?
Solution
(1.07 )6 − 1
FV = $3,000 × − 1 = $3,000 × 6.153 = $18,460
0.07
¾ Where interest is charged on a non-annual basis it is useful to know the effective annual
rate.
¾ For example, interest on bank overdrafts (and credit cards) is often charged on a
monthly basis. To compare the cost of finance to other sources it is necessary to know
the EAIR (also called “Annual Percentage Rate” (APR)).
Formula
1 + R = (1 + r) n
R = annual rate
r = rate per period (month/quarter)
n = number of periods in year
Illustration 4
Borrow $100 at a cost of 2% per month. How much (principal + interest) will
be owed after a year?
Using FV = P (1 + r)n
⇒ = $100 × (1.02)12
= $100 × 1.2682 = $126.82
EAIR is 26.82%
3 DISCOUNTING
3.1 “Compounding in reverse”
¾ Discounting calculates the sum which must be invested now (at a fixed interest rate) in
order to receive a given sum in the future.
Illustration 5
If Zarosa needed to receive $251.94 in three years’ time (t3), what sum would
she have to invest today (t0) at an interest rate of 8% per annum?
Solution
1
Rearranging this: P = FV ×
(1 + r ) n
1
Alternatively, PV = CF ×
(1 + r ) n
1
In this case PV = $251.94 × = $200
(1.08) 3
1
¾ is known as the “simple discount factor” and gives the present value of $1
(1 + r) n
receivable in n years at a discount rate, r.
¾ The formula for simple discount factors is provided at the top of the present value
table.
¾ For a cash flow arising now (at t0) the discount factor will always be 1.
¾ Always assume that cash flows arise at the end of the year to which they relate (unless
told otherwise).
Example 3
Solution
Present value =
Present value =
Risk – cash received today is safe, future cash receipts may be uncertain.
Inflation – cash today can be spent at today’s prices but the value of future cash
flows may be eroded by inflation
Key point
³ DCF techniques take account of the time value of money by restating each
future cash flow in terms of its equivalent value today.
¾ DCF techniques can be used to evaluate business projects (i.e. for investment appraisal).
Despite the theoretical superiority of DCF techniques it appears that in practice many
company managers prefer to use non – DCF methods of appraisal such as payback or ARR.
8 The potentially complex and time consuming process of calculating NPV and/or IRR;
8 Difficulty in explaining DCF techniques to non-financial managers;
8 Complexity of estimating an appropriate discount rate, particularly for unquoted firms;
8 Managers may feel little connection between DCF techniques and their own reported
performance and bonus systems.
¾ Estimate the required return of investors (i.e. the discount rate). The required return of
investors represents the company’s cost of finance, also referred to as its cost of capital.
¾ Discount each cash flow (receipt or payment) to its present value (PV).
¾ If NPV is positive then accept the project as it provides a higher return than required by
investors.
5.2 Meaning
¾ NPV shows the theoretical change in the $ value of the company due to the project.
¾ Therefore NPV must be considered the key technique in business decision making.
Time 0 1 2 3
$000 $000 $000 $000
Capital expenditure (X) – – X
Cash from sales – X X X
Materials (X) (X) (X) –
Labour – (X) (X) (X)
Overheads – (X) (X) (X)
Advertising (X) – (X) –
Grant – X – –
___ ___ ___ ___
Net cash flow (X) X X X
___ ___ ___ ___
r% discount factor 1 1 1 1
1+ r (1 + r ) 2 (1 + r )3
NPV = X
Example 4
Elgar has $10,000 to invest for a five-year period. He could deposit it in a bank
earning 8% pa compound interest.
Required:
Solution
Time Description Cash flow 8% DF PV
$ $
0 Investment (10,000)
1 Net inflow 3,000
2 Net inflow 3,000
3 Net inflow 3,000
4 Net inflow 5,000
5 Net inflow 1,000
_____
NPV =
_____
5.5 Annuities
Definition
An annuity is a stream of identical cash flows arising each year for a finite
period of time.
1 1
¾ The present value of an annuity is given as: CF × 1 −
r (1 + r) n
1 1
¾ 1 − is known as the “annuity factor” or “cumulative discount factor”.
r (1 + r) n
It is simply the sum of a geometric progression.
1 - (1 + r) −n
¾ The formula is given in the exam as
r
¾ Remember that the formula and tables are based on the assumption that the cash flow
starts after one year.
Illustration 6
Calculate the present value of $1,000 receivable each year for 3 years if interest
rates are 10%.
Commentary
Example 5
Solution
5.6 Perpetuities
Definition
¾ As n → ∞
(1 + r)n → ∞
1
→0
(1 + r) n
1 1 1
1 − →
r (1 + r ) n r
1
¾ is known as the “perpetuity factor”.
r
1
The present value of a perpetuity is given as CF ×
r
Key point
³ The formula is based on the assumption that the cash flow starts after one
year.
Illustration 7
Solution
Example 6
Solution
Definition
¾ It therefore shows the highest finance cost that can be accepted for the project.
Commentary
Decision rule
Illustration 8
Example 7
Required:
Solution
6.2 Annuities
¾ To give an NPV of zero, the present value of the cash inflows must equal the initial cash
outflow.
Cash outflow
Annuity factor =
Cash inflow
¾ Once the annuity factor is known the discount rate can be established from the
appropriate table.
Illustration 9
Solution
Year Description CF DF PV
0 Initial investment (6,340) 1 (6,340)
1-4 Annuity 2,000 AF1-4 years 6,340
_____
NPV Nil
_____
6 ,340
AF1-4 years = = 3.17
2 ,000
From the annuity table, the rate with a four year annuity factor closest to 3.17 is 10% and this
is therefore the approximate IRR for this investment.
Example 8
An immediate investment of $10,000 will give an annuity of $1,000 for the next
15 years.
Required:
Solution
______
Method
¾ If NPV is positive, recalculate NPV at a higher discount rate (i.e. to get closer to IRR).
NA
IRR ~ A + (B − A)
NA − NB
Illustration 10
Solution
NA
IRR ~ A + (B – A)
NA − NB
64 ,237
IRR ~ 10% + (20 – 10)%
64 ,237 − ( −5,213)
IRR ~ 19%
Commentary
The answer should always be appropriately rounded due to the inherent inaccuracy of
this method. The IRR thus calculated is only approximate, based on the simplifying
assumption that there is a linear relationship between NPV of a project and discount
rate. However, this is not so and the following diagram illustrates the true situation.
Graphically
NPV
NA
Discount rate
A B
NB Actual NPV as
discount rate varies
Actual IRR
Example 9
An investment opportunity with uneven cash flows has the following net
present values
$
At 10% 71,530
At 15% 4,370
Required:
Solution
Formula
NA
IRR ~ A + (B – A)
NA − NB
IRR ~
Graphically
¾ If there are cash outflows, followed by inflows are then more outflows (e.g. suppose at the
end of the project a site had to be decontaminated), the situation of “multiple yields”
may arise (i.e. more than one IRR).
NPV
Actual NPV as
discount rate varies
Actual IRR
¾ The project appears to have two different IRR’s – in this case IRR is not a reliable
method of decision making.
NPV IRR
Key points
FOCUS
You should now be able to:
¾ explain the difference between simple and compound interest rate and
calculate future values;
¾ apply discounting principles to calculate the net present value of an investment project
and interpret the results;
¾ calculate present values including the application of annuity and perpetuity formulae;
¾ explain what is meant by, and estimate the internal rate of return, using a graphical and
interpolation approach, and interpret the results;
¾ identify and discuss the situation where there is conflict between these two methods of
investment appraisal;
EXAMPLE SOLUTION
Solution 1 — 7% simple and compound interest
Solution 5 — Annuity
WORKING
Solution 6 — Perpetuity
WORKING
2 , 400
IRR = × 100 = 16%
15 ,000
Thus if $10,000 could be otherwise invested for a return of 6% or more, this annuity is not
worthwhile.
Formula
Commentary
The formula always works but take care with + and – signs.
NA
IRR ~ A + (B – A)
NA − NB
71,530
IRR ~ 10 + (15 – 10)
71,530 − 4 ,370
IRR ~ 10 + 5.325
Graphically
NPV
$
Actual
NPV
71,530
Actual
IRR
4,370
Discount rate
10 15 (%)
IRR using
formula
(extrapolated)
OVERVIEW
Objective
¾ To recognise the costs that are relevant to a discounted cash flow analysis.
¾ To be able to deal with inflation using either the money method, real method or
effective method.
WORKING
TAXATION INFLATION
CAPITAL
Include only those costs and revenues which are affected by the decision. This means using
only:
¾ future;
¾ incremental;
¾ operating cash flows.
Operating cash flows means the cash flows generated from operating the project (e.g. cash
from sales, less operating costs such as materials and labour).
Do not include financing cash flows because the cost of finance is measured in the cost of
capital/discount rate – finance costs are taken into account by the discounting process.
Specifically, exclude:
¾ unavoidable costs (i.e. money already committed, including apportioned fixed costs);
¾ finance costs such as interest (as discounting the operating cash flows already deals with
this).
However, include:
¾ all opportunity costs and revenues (e.g. “cannibalisation” – where the launch of a new
product will reduce the sales if an existing product).
Key point
Example 1
A research project, which to date has cost the company $150,000, is under
review.
Shown below are the additional expenses which the managing director
estimates will be necessary to complete the work.
Materials
This material has just been purchased at a cost of $60,000. It is toxic and, if not
used in this project, must be disposed of at a cost of $5,000.
Labour
Research staff
It has already been decided that, when work on this project ceases, the research
department will be closed. Research wages for the year are $60,000, and
redundancy and severance pay has been estimated at $15,000 now or $35,000 in
one year’s time.
Equipment
The project utilises a special microscope which cost $18,000 three years ago. It
has a residual value of $3,000 in another two years, and a current disposal
value of $8,000. If used in the project it is estimated that the disposal value in
one year’s time will be $6,000.
The project is charged with $35,000 per annum to cover general building
expenses. Immediately the project is discontinued, the space occupied could
be sub-let for an annual rental of $7,000.
Required:
Solution
$
(1) Costs to date –
(2) Materials –
Absorption of overheads –
(5) Equipment
A company invests $10,000 today in a machine. It expects to earn $7,000 per year for two
years as a result. Discount rate = 15%.
or
(ii) 0 1 2
Machine (10,000)
Income 7,000 7,000
______ ______ ______
(10,000) 7,000 7,000
15% factor 1 0.870 0.756
______ ______ ______
Present
value (10,000) 6,090 5,292
NPV
= $1,382
______
Commentary
In complex exam questions it is usually better to present your answer using the
second format (i.e. with columns for years).
2 TAXATION
2.1 Basic effect of the UK tax system
NEGATIVE POSITIVE
EFFECT EFFECT
WRITING DOWN
ALLOWANCES
2.2 Timing
The timing of tax cash flows is complex. Some exam questions will specify that tax is paid in
the year of taxable profits, other questions will state that tax is paid “one year in arrears” (i.e.
in the following year):
T0 Year 1 T1 T2
¾ Assume net revenues (revenues minus operating costs) are received at the end of year 1
(T1)
Tax assessed at T1
Tax paid T2 (assuming tax is paid one year in arrears)
¾ However if the asset is bought on the last day of the previous year (i.e. on the date of a tax
assessment) the first WDA would be received immediately (i.e. at T0) which reduces the
tax payment at T1.
Illustration 1
Corporation tax is 30% and paid one year in arrears. Writing down allowances
are available at 25% reducing balance.
Calculate the tax savings available and state when they arise.
Solution
Commentary
The tax saving is not the WDA. It is the WDA × tax rate.
¾ Sufficient taxable profits are available to use all tax deductions in full.
¾ Working capital flows have no tax effects (e.g. if the level of accounts receivable rises
this does not change the tax situation as tax is charged when revenues are recorded
rather than when the cash is received).
Commentary
See additional notes on working capital in the last section of this session.
REVENUE
Step 2 (a) Put in revenues Revenue x x
and operating costs
Operating costs (x) (x)
— — — —
CAPITAL
Step 3 Put in capital outlay and any Investment (x)
disposal value Scrap proceeds x
Example 2
2 Net cash inflows received at the end of year 1 and year 2 are $5,000.
3 The company sells the asset on the last day of the second year for $6,000.
Required:
Solution
T0 T1 T2 T3
Asset
Scrap proceeds
Tax savings on WDAs (W)
_______ _______ _______ _______
Net cash flow
Discount factor
Present value
WORKING
T0 T1 T2
Profits in
year 1
Year 2 Proceeds
_______
Balancing allowance
_______
Example 3
1 A company buys an asset for $10,000 at the end of the previous accounting
period (31 December 20X0) to undertake a two-year project.
2 Net cash inflows received at the end of year 1 and year 2 are $5,000.
3 The asset has zero scrap value when it is disposed of at the end of year 2.
Required:
Solution
T0 T1 T2 T3
Net cash inflows 5,000 5,000
Tax @ 33% (1,650) (1,650)
Asset (10,000)
Tax saving on WDA (W)
_______ _______ _______ _______
Net cash flow
Discount factor
Present value
NPV =
WORKING
Tax computation
T0 T1 T2
Profits in
year 0
Year 2 Proceeds –
_______
Balancing allowance
_______
3 INFLATION
3.1 Why inflation is a problem for project appraisal
¾ It causes governments to take actions which may impact on business (e.g. raising
interest rates, cutting state spending).
¾ Differential inflation rates will occur; different costs and revenues will inflate at
different rates.
¾ Real rate of interest reflects the rate of interest that would be required in the absence of
inflation.
¾ Money (or nominal) rate of interest reflects the real rate of interest adjusted for the effect
of general inflation (measured by the CPI – the Consumer Price Index).
Illustration 2
Suppose you invest $100 today for one year and, in the absence of inflation,
you require a return of 5%. The CPI is expected to rise by 10% over the coming
year.
15.50
You therefore require a money return of = 15.5% over the year.
100
¾ Money rates, real rates and general inflation (CPI) are linked by the Fisher formula:
i = 15.5%
¾ A specific inflation rate is the rate of inflation on an individual item (e.g. wage inflation,
materials price inflation).
¾ The general inflation rate is a weighted average of many specific inflation rates (e.g.
CPI).
If there is inflation in the economy there are three ways in which the cash flow forecast for
project appraisal can be performed:
¾ Cash flows expressed at today’s prices (i.e. before the effects of inflation).
¾ Cash flows are inflated to future price levels using the specific inflation rate for each type
of revenue/cost.
¾ This produces a forecast of the physical amount of money that will move in/out of the
company.
3.5 Discounting
Commentary
There are three methods of discounting if there is inflation. Each method results in the
same NPV.
¾ Adjust each cash flow for specific inflation to convert to nominal/money cash flows (i.e.
physical amounts of cash to be paid/received).
¾ Remove the effects of general inflation from money cash flows to generate real cash
flows.
Illustration 3
Sales for the year are expected to be $10m in current terms, with an expected
specific inflation rate of 5%.
Costs for the year are expected to be $3m in current terms, with an expected
specific inflation rate of 3%.
Solutions
Money method
T0 T1
Outlay (5)
Sales 10 × 1.05 = 10.5
Costs (3) × 1.03 = (3.09)
___ _____
Money flows (5) 7.41
7.41
NPV = (5) + 1.06 = $1.99m
Real method
T0 T1
Money cash flow (5) 7.41
7.41
RPI 4% 1.04
(1 + i) = (1 + r) (1 + h)
(1.06) = (1 + r) (1.04)
r = 1.92307%
7.125
NPV = (5) + = $1.99m
1.0192307
Commentary
⇒ As money flows are needed to do this, the money method might just as well be
used – it gives the same result.
⇒ Net cash flow expressed in current terms ($7m) is not the same as real cash flow
($7.125m), because sales and costs are not changing at CPI.
Effective method
for sales:
(1.06) = (1 + e) (1.05)
e = 0.95238%
10 (3)
NPV = (5) + + = $1.99m (as before)
1.0095238 1.0291262
Example 4
A project produces a cash inflow at the end of years 1–3 of $10,000 (at t0 prices).
CPI = 5%
Required:
Solution
(1 + i) = (1 + r) (1 +h)
=
i=
t $ DF PV
$
1
2
3
______
______
(ii) Real method
t $ DF PV
$
1 (W)
2
3
______
______
WORKING
e=
t $ DF PV
$
1–3 (W)
______
WORKING
Example 5
2 Material costs at current prices will be $1,500 per year for three years
Material costs inflate at 8% per year.
3 Labour savings at current prices will be $4,000 per year for three years
Labour costs inflate at 5% per year.
4 Overhead savings at current prices will be $2,000 per year for three years
Overhead costs inflate at 10% per year.
Required:
Ignore taxation.
Solution
T0 T1 T2 T3
$ $ $ $
Investment (10,000)
Materials
Labour savings
Overhead savings
______ _____ _____ _____
Net cash flow
Discount factor
______ _____ _____ _____
Present value
______ _____ _____ _____
NPV =
Materials =
e =
Labour =
e =
Overheads =
e =
Overhead saving †
1−3
_____
Net present value
_____
† from tables
T0 T1 T2 T3
Money cash flows (10,000) 4,780 5,080 5,403
÷
Real cash flows
Discount factor
Present value
NPV =
Example 6
The company has a December year end and pays tax at 33%, 12 months after
the end of the accounting period. The project flows are expected to inflate at
5%, and the company’s money cost of capital is 15%. Writing Down
Allowances are given at 25% reducing balance.
Required:
Solution
WDAs
Project appraisal
T0 T1 T2 T3 T4 T5
Inflows
Tax @ 33%
Initial investment
Scrap
Tax saving on
WDAs
_______ _______ _______ _______ _______ _______
DF
_______ _______ _______ _______ _______ _______
PV
_______ _______ _______ _______ _______ _______
NPV =
Therefore,
4 WORKING CAPITAL
A project usually starts with a cash outflow for the investment in non-current assets (e.g.
plant and equipment). However many projects will also require an investment in net current
assets (i.e. working capital). For project appraisal working capital is defined as inventory +
accounts receivable – accounts payable.
Commentary
This definition excludes cash; the cash flow is found as the change in the level of
inventory + accounts receivable – accounts payable.
For example, at the start of the project inventory must be purchased, causing a cash outflow.
Over the life of the project the level of accounts receivable may rise, with the result that cash
inflows are less than the sales revenues. On the other hand the level of accounts payable
may also rise, reducing the required investment in working capital and improving the cash
flows because payments to suppliers are below the level of purchases. At the end of the
project the inventory levels may be reduced to zero, all receivables may be collected,
creating a cash inflow.
¾ It is assumed also that changes in the level of working capital have no tax effects.
Commentary
This is a realistic assumption because tax will be charged when net revenues accrue
rather than when the cash is received.
Example 7
Sales of a new product are forecast at $100,000 in the first year, increasing by
10% compound per annum. The product has a four year life cycle. Working
capital equal to 15% of annual sales is required at the start of each year. The
company’s contribution margin is 40% and no incremental fixed costs are
expected.
Required:
Solution
T0 T1 T2 T3 T4
$ $ $ $ $
Contribution
Cash re working capital (W)
Total cash flow
(W)
Sales
Level of working capital
Cash re working capital
Key points
³ The golden rule – only discount future, incremental, operating cash flows.
³ Never discount depreciation – it is not a cash flow.
³ Do not discount finance costs – the cost of finance is measured in the
discount rate and is therefore already taken into account.
FOCUS
You should now be able to:
¾ calculate the effect of Writing Down allowances and corporation tax on project cash
flows;
¾ explain the relationship between inflation and interest rates, distinguishing between
real and nominal rates;
¾ distinguish general inflation from specific price increases and assess their impact on
cash flows;
EXAMPLE SOLUTIONS
Solution 1 — Relevant costs
$
(1) Costs to date of $150,000 sunk – ∴ ignore. –
(2) Materials – purchase price of $60,000 is also sunk.
Opportunity benefit is disposal costs saved. 5,000
(3) Labour cost – direct cost of $40,000 will be incurred
regardless of whether or not the project is undertaken–
and so is not relevant. Opportunity cost of lost
contribution = 150,000 – (100,000 – 40,000) (90,000)
Absorption of overheads – irrelevant as it is merely an –
apportionment of existing costs
(4) Research staff costs
Wages for the year (60,000)
Redundancy pay increase (35,000 – 15,000) (20,000)
(5) Equipment
Deprival value if used in the project = disposal value (8,000)
T0 T1 T2 T3
Net cash inflows 5,000 5,000
Tax @ 33% (1,650) (1,650)
Asset (10,000)
Scrap proceeds 6,000
Tax savings on WDAs (W) 825 495
_______ _______ _______ _______
Net cash flow (10,000) 5,000 10,175 (1,155)
10% discount factor 1 0.909 0.826 0.751
Present value (10,000) 4,545 8, 405 (867)
WORKING
Tax computation
T0 T1 T2
Profits in
year 1
T0 T1 T2 T3
Net cash inflows 5,000 5,000
Tax @ 33% (1,650) (1,650)
Asset (10,000)
Tax saving on WDA (W) 825 619 1,856
_______ _______ _______ _______
Net cash flow (10,000) 5,825 3,969 206
10% discount factor 1 0.909 0.826 0.751
Present value (10,000) 5,295 3, 278 155
WORKING
Tax computation
T0 T1 T2
Profits in
year 0
(1 + i) = (1 + r) (1 + h)
= 1.1 × 1.05
= 1.155
m = 15.5%
T $ DF (15.5%) PV
$
1 10,800 0.866 9,353
2 11,664 0.75 8,748
3 12,597 0.649 8,175
______
26,276
______
(ii) Real method
T $ DF (10%) PV
$
1 10,286 (W) 0.909 9,350
2 10,580 0.826 8,739
3 10,882 0.751 8,172
______
26,261
______
WORKING
10 ,800
1.05
1.155 = (1 + e) 1.08
e = 6.94
T $ DF PV
$
1–3 10,000 2.627 (W) 26,270
______
WORKING
1 1
1 − = 2.627
0.0694 1.0694 3
T0 T1 T2 T3
$ $ $ $
Investment (10,000)
Materials (8%) (1,620) (1,750) (1,890)
Labour savings (5%) 4,200 4,410 4,631
Overhead savings (10%) 2,200 2,240 2,662
______ _____ _____ _____
Net cash flow (10,000) 4,780 5,080 5,403
Discount factor @ 15.5% 1 1 1 1
2 3
1155
. .
1155 .
1155
______ _____ _____ _____
Present value (10,000) 4,139 3,808 3,507
______ _____ _____ _____
NPV = $1,454
WORKING
1 1
3 year 6.94% annuity factor = 1− 3
= 2.627
0.0694 1.0694
T0 T1 T2 T3
Money cash flows (10,000) 4,780 5,080 5,403
÷ 1 1.07 1.072 1.073
Real cash flows (10,000) 4,467 4,437 4,410
Discount factor @ 7.944% 1 0.926 0.858 0.795
Present value (10,000) 4,136 3,807 3,506
NPV = $1,449
WDAs
Project appraisal
T0 T1 T2 T3 T4 T5
Inflows 84,000 88,200 92,610 97,241
Tax @ 33% (27,720) (29,106) (30,561) (32,090)
Initial investment (250,000)
Scrap 50,000
WDAs 20,625 15,469 11,602 18,305
_______ _______ _______ _______ _______ _______
(250,000) 84,000 81,105 78,973 128,282 (13,785)
DF @ 15% 1 0.870 0.756 0.658 0.572 0.497
_______ _______ _______ _______ _______ _______
PV (250,000) 73,080 61,315 51,964 73,377 (6,851)
_______ _______ _______ _______ _______ _______
NPV = $2,885
T0 T1 T2 T3 T4
$ $ $ $ $
Contribution 40,000 44,000 48.400 53,240
Cash re working capital (W) (15,000) (1,500) (1,650) (1,815) 19,965
_______ _______ _______ _______ _______
Total cash flow
(15,000) 38,500 42,350 46,585 73,205
_______ _______ _______ _______ _______
(W)
Sales 100,000 110,000 121,000 133,100
Level of working capital 15,000 16,500 18,150 19,965 0
Cash re working capital (15,000) (1,500) (1,650) (1,815) 19,965
_______ _______ _______ _______ _______
OVERVIEW
Objective
DCF
APPLICATIONS
ASSET
CAPITAL
REPLACEMENT LEASE v BUY
RATIONING
DECISIONS
¾ Definition ¾ The issue ¾ The issue
¾ Methods ¾ Limitations ¾ Decision-making
¾ Investment decision
¾ Financing decision
¾ Decision criterion
¾ Pre-tax cost of debt
1 CAPITAL RATIONING
1.1 Definition
¾ Hard capital rationing is where the capital markets impose limits on the amount of
finance available (e.g. due to high perceived risk of the company).
¾ Soft rationing is where the company sets internal limits on finance availability (e.g. to
encourage divisions to compete for funds).
¾ Single-period capital rationing is where capital is in short supply in only one period.
1.2 Methods
A divisible project is where the company can undertake between 0-100% of the project -
infinite divisibility. However a project cannot be repeated.
Example 1
Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t0 (50) (10) (10) (15)
Required:
Solution
Projects A B C D
$000 $000 $000 $000
NPV
Cash flow at t0
NPV
Investment
Rank
___
___
___ _____
_____
Example 2
Solution
A mutually exclusive project is where two or more particular projects cannot be undertaken
at the same time (e.g. because they use the same land).
¾ Divide projects into groups; with one of the mutually-exclusive projects in each group.
¾ Calculate the highest NPV available from each group (assume projects are divisible
unless told otherwise).
Example 3
Solution
Group 1 Group 2
$000 $000
A B C A B D
NPV
$
___ ___ ___ ___ ___ ___
Index
___ ___ ___ ___ ___ ___
Rank
Plan
NPV Capital NPV Capital
Accept Accept
___ ___
Accept Accept
___ ___ ___ ___
___ ___
¾ If finance is limited in several periods then a linear programming model would have to
be set up and solved in order to find the optimal investment strategy.
Commentary
¾ Assume that the company has already decided it requires a particular non-current asset.
¾ For example, how often should the company replace its fleet of motor vehicles or its
computer equipment?
Method
Example 4
Required:
Determine whether the machine should be replaced each year or every two
years.
Solution
Annual equivalent =
Conclusion.
8 Non-financial factors (e.g. employees may be more satisfied if their company cars are
replaced more often).
3 LEASE v BUY
3.1 The issue
Operating lease; where the asset is simply rented for a relatively short part of its
useful economic life;
Finance lease (also called capital lease); where the asset is leased for most of its life.
¾ Although the distinction between operating and finance lease is currently important in
financial reporting, it is not so relevant in financial management.
¾ The important issue for financial management is the cash flows created by a lease, as
compared to a straight purchase of the asset.
3.2 Decision-making
Two decisions
Discount these cash flows using a rate Discount these cash flows using
which reflects operating risk of after-tax cost of borrowing
investment (e.g average cost of capital)
Commentary
The approach is to distinguish financing cash flows from operating cash flows and use
separate discount rates for each.
The after-tax cost of borrowing = pre-tax cost × (1 – tax rate). This takes into account
the “tax shield” on debt (i.e. interest reduces taxable profits and saves tax).
¾ Discount the cash flows from using the asset (sales, materials, labour, overheads, tax on
net cash flows, etc) at the firm’s weighted average cost of capital (WACC).
¾ Discount the cash flows specific to each financing option at the after-tax cost of debt.
Commentary
¾ The preferred financing option is that with the lowest NPV of cost.
Commentary
Under UK tax law all lease payments (operating and finance) are tax allowable
deductions.
³ If the PV of the cost of the best finance source is less than the PV of the
operating cash flows, then the project should be undertaken.
Example 5
New project
Finance options:
Solution
________
Present value
________
Therefore:
Post-tax cost of debt = pre-tax cost of debt × (1 – tax rate) = 10.5% × (1 – 0.33) = 7%
________
________
(W) WDAs
________
PV of leasing
________
$
PV of operating flows
PV of cheaper finance
________
NPV
________
If a firm is not in a tax paying position there are implications for a lease vs buy evaluation:
¾ no tax savings would be available from capital allowances if the asset was bought;
¾ no tax savings would be available on lease payments (either under an operating or
finance lease);
¾ there would be no “tax shield” on debt (i.e. interest expense on borrowings would not
lead to tax savings).
The last point means that the discount rate to use to evaluate the financing options should be
the pre-tax cost of debt (i.e. the gross interest rate quoted on a bank loan, or gross
redemption yield if borrowing would be in the form of bonds).
Example 6
A machine costs $500,000 and has $150,000 residual value at the end of three
years. Annual repairs and maintenance costs are $20,000 in the first two years
and zero in the third year.
Financing options:
The machine is required for a three year project in a tax-free high-tech park.
The project has strong positive NPV.
Required:
Solution
________
(2) Leasing flows
Conclusion:
Key points
³ With asset replacement decisions, the key is the use of Annual Equivalent
Cost to compare cycles of different lengths.
³ With lease vs. buy decisions, the key is to separate the financing decision
from the investment decision and analyse each at a discount rate reflecting
the risk of the cash flows. Also remember all lease payments are tax
deductible expenses in the UK.
FOCUS
You should now be able to:
EXAMPLE SOLUTIONS
Solution 1 — Divisible projects
Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t0 (50) (10) (10) (15)
NPV 100 ( 50 ) 84 45
Investment 50 10 10 15
Rank 3 1 2
Solution 2 — Non-divisible
Combinations NPV
$000
A only 100
C+D 129
Therefore choose C + D.
Group 1 Group 2
$000 $000
A B C A B D
NPV 100 (50) 84 100 (50) 45
$ 50 10 10 50 10 15
___ ___ ___ ___ ___ ___
Index 2 (5) 8.4 2 (5) 3
___ ___ ___ ___ ___ ___
Rank 2 Reject 1 2 Reject 1
Plan
NPV Capital NPV Capital
50 50
Accept C 84 (10) Accept D 45 (15)
___ ___
Accept 0.8 A 80 (40) Accept 0.7 A 70 (35)
___ ___ ___ ___
164 115
___ ___
Post-tax cost of debt = pre-tax cost of debt × (1 – tax rate) = 10.5% × (1 – 0.33) = 7%
$
PV of operating flows 182,289
PV of leasing flows (cheaper finance – see (b)) (127,431)
________
NPV 54,858
________
The asset should be acquired using a lease.
OVERVIEW
Objective
¾ Definitions
RISK AND
¾ Sources of risk
UNCERTAINTY
REDUCTION OF
RISK ¾ Risk management
1.1 Definitions
Commentary
Although the terms are often used interchangeably only risk is measurable.
The major risks to the success of an investment project will be the variability of the future
cash flows. This could be the variability of income streams or the variability of cost cash
flows or a combination of both.
2 SENSITIVITY ANALYSIS
Definition
Commentary
¾ The cash flows, probabilities, or cost of capital are varied until the decision changes (i.e.
NPV becomes zero). This will show the sensitivity of the decision to changes in those
elements.
¾ Therefore the estimation of IRR is an example if sensitivity analysis, in this case on the
cost of capital.
2.1 Method
Step 1 Calculate the NPV of the project on the basis of best estimates.
Step 2 For each element of the decision (cash flows, cost of capital)
calculate the change necessary for the NPV to fall to zero.
NPV
Sensitivity = × 100%
PV of flow considered
Commentary
For change in sales volume, the factor to consider is contribution. This may involve
combining a number of flows.
Example 1
Williams has just set up a company, JPR Manufacturing Co, and estimates its
cost of capital to be 15%. His first project involves investing in $150,000 of
equipment with a life of 15 years and a final scrap value of $15,000.
The equipment will be used to produce 15,000 deluxe pairs of rugby boots per
annum generating a contribution of $2.75 per pair. He estimates that annual
fixed costs will be $15,000 per annum.
Required:
(a) Determine, on the basis of the above figures, whether the project is
worthwhile.
(b) Calculate what percentage changes in the following factors would cause
your decision in (a) change:
Solution
_______
(b) The sensitivity of the decision in (a) can be calculated by expressing the
NPV as a percentage of the various factors.
Sensitivity =
Sensitivity =
Sensitivity =
Sensitivity =
IRR NPV1
= r1 + (r2 − r1 )
NPV1 − NPV2
9 It directs management attention to checking the quality of data for the most sensitive
variables.
9 It identifies the Critical Success Factors for the project and directs project management.
2.3 Limitations
8 Although it can be adapted to deal with multi-variable changes, sensitivity is normally
used to examine what happens when one variable changes and others remain constant.
3 SIMULATION
3.1 Use of simulation
Simulation is a technique which allows more than one variable to change at the same time.
Commentary
Calculations will not be required in the exam; an awareness of the stages suffices.
(3) Attach probability distributions to each variable and assign random numbers to reflect
the distribution.
(6) Repeat simulation many times to obtain a probability distribution of the possible outcomes.
3.3 Advantages
9 It gives more information about the possible outcomes and their relative probabilities.
9 This data can be used to calculate expected NPV and the standard deviation of NPV
3.4 Limitations
8 It is not a technique for making a decision, only for obtaining more information about
the possible outcomes.
8 It could prove expensive in designing and running the simulation, even on a computer.
8 Simulations are only as good as the probabilities, assumptions and estimates made.
4 STATISTICAL MEASURES
4.1 Expected values
Definition
4.1.1 Calculation
Example 2
Required:
Solution
4.1.2 Advantages
9 It reduces the information to one value for each choice.
4.1.3 Limitations
8 The probabilities of the different possible outcomes may be difficult to estimate.
8 Unless the same decision has to be made many times, the average will not be achieved;
it is therefore not a valid way of making a decision in “one-off” situations.
8 The average gives no indication of the spread of possible results (i.e. it ignores risk).
¾ It is a measure of spread (i.e. an indicator of the likely spread of values from an expected
value).
Commentary
Exam questions are more likely to provide a standard deviation for interpretation,
rather than require its calculation.
4.2.1 Calculation
σ = standard deviation =
∑ (x − x ) 2
prob ( x )
X = each observation
x = mean of observations
Example 3
Using the information from Example 2, calculate the standard deviation for
each project.
Solution
Project 1
Project 2
Project 3
4.2.2 Advantages
9 It can be used in further mathematical analysis. For example, estimating Value at Risk
(VaR) on an investment (i.e. the potential loss in value at a given level of confidence).
Commentary
4.2.3 Limitations
5 DISCOUNTED PAYBACK
5.1 Limitations of payback
8 Standard payback period ignores the time value of money and hence gives equal
weighting to cash flows irrespective of the year in which they are received.
Illustration 1
Two alternative projects each require an initial investment of $1,000m and have
the following forecast operating cash flows ($m):
Project A Project B
Year 1 600 100
Year 2 200 300
Year 3 200 600
Year 4 205 205
Year 5 150 150
Each project has a payback period of 3 years and, based on this measure,
would be ranked equally in terms of liquidity and risk. However project A
produces strong cash flows in early years which may be considered to carry a
lower level of uncertainty than more distant returns.
¾ This limitation can be dealt with by using discounted payback period (i.e. first discount
the project returns at a rate that reflects the level of operating risk, and recalculate the
payback period).
5.2 Definition
Discounted payback is the period of time for the discounted returns from a
project to recover the initial investment. Also referred to as the adjusted
payback period.
Example 4
The firm’s weighted average cost of capital of 10% is believed to reflect the risk
attached to both project A and project B in illustration 1 above.
Required:
Solution
Project A 10% DF PV Cumulative
Year 0 (1,000)
Year 1 600
Year 2 200 Year 3 200 Year 4 205
Year 5 150
Discounted payback =
Discounted payback =
6 REDUCTION OF RISK
6.1 Risk management
Commentary
¾ Select projects with a combination of acceptable expected NPV and relatively low
standard deviation of NPV.
¾ Focus attention on the Critical Success Factors indicated by sensitivity analysis.
Key points
³ Adjusting the discount rate to reflect a project’s risk is dealt with later in
Session 13 on the Capital Asset Pricing Model (CAPM).
FOCUS
You should now be able to:
¾ explain the role of simulation in generating a probability distribution for the NPV of a
project;
¾ apply the probability approach to calculating expected NPV of a project and the
associated standard deviation.
¾ suggest ways in which a firm can reduce the risk of its investments
EXAMPLE SOLUTIONS
Solution 1 — Sensitivity analysis
If the initial investment rises by more than $5,329, the project would be
rejected.
5,329
Sensitivity = × 100 = 3.6%
150 ,000
(ii) Volume
5 ,329
Sensitivity = × 100 = 2.2%
241,189
5,329
Sensitivity = × 100 = 6.1%
87 ,705
5 ,329
Sensitivity = × 100 = 289%
1,845
5,329
= 15% + (16% − 15%)
5,329 + 2,036
= 15.7%
If the cost of capital rises from 15% to more than 15.7% the project
would be rejected.
Project 1 Expected value = 100 × 0.4 + 200 × 0.3 + 1,000 × 0.3 = 400
Project 2 Expected value = 0 × 0.4 + 500 × 0.3 + 600 × 0.3 = 330
Project 3 Expected value = 180 × 0.4 + 190 × 0.3 + 200 × 0.3 = 189
Project 3 ( 180 − 189 ) 2 × 0.4 + (190 − 189) 2 × 0.3 + (200 − 189)2 × 0.3
= 69 = 8.3
OVERVIEW
Objective
EQUITY
FINANCE DIVIDENDS
EQUITY FOR
SMES
¾ Introduction
¾ Difficulties in raising finance
¾ Funding gap and maturity gap
¾ Venture capital
¾ Private equity funds
¾ Business angels
¾ Enterprise Investment Scheme (EIS)
If a company is already listed the following methods are available for the issue of new
shares:
Method Explanation
Offer for subscription A sale direct to the general public. This is generally the most
(public issue) expensive method of issuing new shares.
Offer for sale A sale indirect to the public by selling shares directly to an issuing
house (merchant/investment bank) which then sells them to the
public. (The issuing house guarantees to buy the shares.)
Offer for sale or Like an auction – the public is invited to bid for shares. Useful
subscription by tender where setting a price for the shares is difficult.
¾ Become quoted (i.e. raise new equity finance at the same time as becoming listed) This is
known as an Initial Public Offering (IPO). The method could be an offer for
subscription or sale, tender, or placing. It is an expensive process.
¾ Stay unquoted. Use rights issue or private placing. However there may be a limited
source of funds from either existing owners or new private investors.
Commentary
The terms “quoted”, “floated” and “listed” all refer to the same thing (i.e. shares which
are traded on a stock exchange).
¾ Legal restrictions.
¾ Cost (e.g. fees must be paid to an investment bank to underwrite/guarantee the share
issue; share prospectus must be produced and published). Total fees for an IPO in
London are in the range 6-11%.
¾ Valuation (i.e. setting the price for the new shares to be issued).
¾ Timing.
Before the shares of a company can receive an official listing (i.e. become traded on the full
London Stock Exchange) the following requirements must be met:
The costs of acquiring and maintaining an Official Listing mean that it is not really a
possibility for Small or Medium-sized Enterprises (SMEs). These companies may find the
AIM market more attractive.
Commentary
The AIM market has fewer regulations and in this way is attractive to SMEs. Investors
recognise that due to the more limited regulation, investment in AIM companies carries
additional risk.
¾ Companies must have public limited company (“plc”) or equivalent (if non-UK) status;
¾ A prospectus must be published prior to the initial quotation and any following issue of
securities;
¾ The company must appoint a “nominated advisor” which may be an investment bank,
accountancy or law firm to ensure that it understands and obeys the rules of the market.
In a rights issue existing shareholders are offered more shares (usually at a discount to the
current market price) in proportion to their existing holding.
UK company law guarantees shareholders “pre-emptive rights” (i.e. the right to purchase
new shares before they can be offered to other investors). This is to protect shareholders
from dilution of their control
You may be asked to calculate the theoretical ex-rights price of a share (“TERPS”) (i.e. the
expected share price following the rights issue). Although the formula is not published it is
simply the forecast total market value of the firm’s equity divided into the number of shares
that will be in issue
Points to note:
¾ proceeds of the rights issue should be added net of any issue costs;
¾ if the project has already been announced , and if the market is operating at the semi-
strong level of efficiency, project NPV will already be reflected in the existing share price
and hence should not be included again in the formula above.
Example 1
The project will be financed by a rights issue of one new share for every two
existing shares. The rights price is $1 per new share.
Ignore issue costs and assume the equity market operates at the semi-strong
level of pricing efficiency.
Required:
Example 2
Required:
Therefore
______
Therefore
$
Wealth prior to rights issue
______
Therefore
¾ Reserves (e.g. revaluation surplus or share premium account are converted into share
capital which is distributed as new shares to existing shareholders in proportion to their
existing holdings).
¾ No finance is raised.
Commentary
¾ Where ordinary shares are split in value (e.g. $1 shares converted into two 50 cent
shares).
¾ This reduces the market price per share, increasing their marketability.
SMEs contribute in a significant way to many economies in the world. Besides generating
income, in often large proportions in relation to gross national product, they are frequently
major employers and the sector which is most identified with new ideas and entrepreneurial
spirit. It is these latter factors that help sustain and support growth rates in many
economies.
¾ However much owners or managers inform their banks of what they are doing there is
always an element of uncertainty remaining that is not a feature of larger businesses.
¾ Also, larger businesses conduct more of their activities in public than do SMEs. If
information is public, there is less uncertainty. For example, a larger business might be
quoted on an exchange and therefore be subject to press scrutiny, exchange rules
regarding the provision of certain of its activities, and has to publish accounts that have
been audited. Many SMEs do not have to have audits, certainly do not publish their
accounts to a wide audience and the press are not really interested in them.
¾ The fact that potential investors in an SME have much less information about the
business than its managers is known as “asymmetry of information”. This leads to high
perceived risk in the view of potential investors.
¾ If SMEs wish to take loans then banks will look to see what security is available for any
loan provided. This is likely to involve an audit of the firm’s assets. Collateral is
important because it can reduce the level of risk a bank is exposed to in granting a loan
to a new business.
¾ Many SMEs are based in the service sector where the main asset is likely to be human
capital as opposed to physical assets. Hence the firm may lack adequate collateral and
the directors may be asked to pledge personal assets (e.g. their homes) to secure
business loans.
¾ The equity issued by small companies is difficult to buy and sell, and sales are usually
on a matched bargain basis, which means that a shareholder wishing to sell has to wait
until an investor wishes to buy.
¾ This lack of marketability means that small companies are likely to be very limited in
their ability to offer new equity to anyone other than family and friends.
¾ Individuals with cash to invest may be encouraged by the tax system to invest via large
institutional investors rather than directly into small companies. In many countries
personal tax incentives are offered on contributions to pension funds.
¾ These institutional investors themselves usually invest in larger companies (e.g. listed
companies) in order to maintain what they see as an acceptable risk profile, and in order
to ensure a steady stream of income to meet on-going liabilities. This reduces the
potential flow of funds to small companies, although the government may try to
mitigate this effect by also offering tax advantages for investment in SMEs.
Initial owner finance is nearly always the first source of finance for a business, whether from
the owner or from family connections. At this stage many of the assets may be intangible in
which case external financing is difficult to obtain. This is referred to as the “funding gap”.
Bank loans may become available at a later stage but with small businesses, longer term
loans are often easier to obtain than medium term loans because the longer loans are easily
secured with mortgages against property. The fact that medium term loans are hard to
obtain is a well-known feature of SMEs and is known as the “maturity gap”.
Due to the funding gap and the maturity gap an SME may have to take an innovative
approach not only to its business but also to its financing. Possible financing solutions are
discussed below.
¾ What is it?
“Venture capital” simply means equity capital for small and growing businesses.
Typically $1m minimum is involved.
Specialist venture capital providers (e.g. “Investors In Industry”; the “3i Group”);
Banks, insurance companies, pension funds;
Local authorities and development agencies.
Commentary
VCTs are listed investment trust companies which invest at least 70% of their funds
in a spread of small unquoted trading companies.
¾ A private equity fund attempts to gain control over a company in order to put it
through a restructuring programme before either selling to another fund or listing the
company on the stock market.
¾ The difference between private equity and venture capital is that private equity funds
usually seek total control of the target company, whereas venture capitalists provide
growth finance in return for partial control.
Commentary
Private equity funds do not only target SMEs, they also buy large quoted companies,
take them off the stock market then restructure before re-listing.
¾ Business angels are private individuals (or small groups of individuals) who are
prepared to invest equity (or perhaps debt) into small businesses with big potential.
¾ Angels are often entrepreneurs who made their own fortunes in the high-tech sector,
were wise enough to sell before the “dot.com” bubble burst, and now invest in small
business as a hobby (although they do expect to make gains).
¾ Angel’s not only provide finance but also advice, experience and business contacts. A
typical business angel will hold a portfolio of investments and may, for example, add an
investment in a firm that makes health drinks if they already have an investment in
fitness clubs.
¾ However such angels receive many applications for finance and will only be prepared
to invest in a business with an innovative product and talented management.
¾ Maximum investment is £500,000 per annum (i.e. maximum reduction in personal tax
liability = £500,000 × 20% = £100,000).
As an alternative to issuing new shares (or debt) a company can finance its investment
projects using retained earnings (i.e. using internal finance rather than external finance).
Commentary
Microsoft did not pay any dividends for many years - it reinvested all cash to produce
growth of the company and its share price. Any shareholder that required a dividend
could simply sell some shares to take a capital gain and create a “home-made
dividend”.
Company managers may prefer to use internal finance rather than external finance for the
following reasons:
¾ a belief that using internal finance costs nothing – in fact this is not true as retained
earnings belong to the shareholders who expect significant returns.
¾ taxation position of shareholders - they may prefer to make a capital gain rather than
receive current income via dividends (e.g. in the UK individuals are given a large tax-
free limit on capital gains).
¾ discretion – sensitive information about projects does not need to be released (as
compared to a share issue which could require a prospectus).
¾ speed – as compared to a share issue, for example, which can take many months.
This preference for internal finance is known as “Pecking Order Theory” and is supported
by research that found company directors often choose “the path of least resistance” when it
comes to financing.
Creating accounting profits does not guarantee the availability of internal equity finance –
the company must be converting profits into positive cash flows.
As interest and tax are committed costs the focus must be on maximising operating cash
flows.
¾ Reducing the time taken to receive payments from customers (e.g. by offering discounts
for quick payment or outsourcing debt collection to a factor).
¾ Reduction in the “sea of inventory” (e.g. through improved supply chain management
or even moving to Just-in-Time (JIT) production).
¾ Raking increased credit from suppliers – although care must be taken not to lose
settlement discounts or compromise relationships with key suppliers.
Commentary
4 DIVIDEND POLICY
4.1 Practical influences on the dividend decision
¾ In most countries a dividend can only be paid if there is a credit balance on retained
earnings in the statement of financial position. If a company has brought forward losses
from previous years this may result in a debit or “wrong way” balance on retained
earnings even if the firm has moved into profits in the current year.
¾ This restriction on paying dividends for the foreseeable future could damage the firm’s
ability to attract new equity investors to finance its growth. Therefore some countries
allow the debit balance on retained earnings to be written-off against other reserves,
allowing the firm to resume payment of dividends.
¾ The firm may wish to hold significant cash to meet both routine and any unexpected
expenses, and also to be able to move quickly into investment opportunities.
Illustration 1
As at June 2011 Apple Computers held an astonishing $76 billion of cash and
cash equivalents – partly to be able to buy in advance large quantities of key
components and ensure continuous production, and partly as a “war chest” to
finance the quick acquisition of other innovative high-tech firms.
¾ Most shares in quoted companies are held by powerful institutional investors (e.g.
pension funds). Therefore the directors of quoted companies have to carefully manage
investor expectations regarding the level of dividends.
¾ If a large dividend is paid in the current year this may create expectations of the same,
or even higher, in future. If these expectations are then not met then key investors may
sell their shareholdings.
¾ In smaller owner-managed firms there is no such agency problem and the dividend
decision would be influenced more by the personal tax position of the owner-managers
than sensitivity over expectations.
4.1.4 “Signalling”
¾ In quoted firms where there is significant “divorce of ownership and control” investors
do not have access to all information about the firm’s operations and prospects, they
only have what is publically available. Therefore public announcements of the level of
proposed dividend are seen as key signals of company strength or weakness:
Commentary
The above practical factors will therefore have a large influence on the firm’s dividend
policy. Alternative policies are discussed below.
4.2 Stable
¾ Stable level of dividends or constant level of growth to avoid sharp movements in share
price.
Commentary
¾ Not particularly suitable as dividends will fluctuate (which can cause a volatile share
price).
¾ Remaining earnings, after funding all attractive projects, are paid out as dividend (i.e.
dividend = cash generated from operations – capital expenditure).
¾ Links to Pecking Order Theory (i.e. a dividend is only paid if more cash is available than
required for reinvestment back into the business).
¾ However it is likely to lead to fluctuating dividends and may not particularly suitable
for quoted companies.
¾ The company’s historical dividend policy may have attracted particular investors to
whom the policy is suited in terms of tax, need for current income, etc.
¾ The company should then maintain a stable dividend policy or risk losing key investors.
Commentary
¾ Shareholders may prefer higher dividends (and therefore lower potential capital gains)
as a cash dividend today is without risk whereas future share price growth is uncertain.
¾ Modigliani and Miller (finance theorists) argue that shareholders are indifferent to
dividend policy.
¾ If a company pays no dividend then the share price should rise due to reinvestment of
earnings. Any shareholder that requires a dividend can sell part of their holding to
create a capital gain (i.e. to manufacture a “home-made dividend”).
¾ However Modigliani and Miller made a series of assumptions which may not hold in
practice:
No distortions from the personal tax system (i.e. dividends and capital gains are
taxed at the same rate in the hands of investors);
No transactions costs (i.e. investors can sell shares to create a home-made dividend
without incurring any trading costs);
Perfect markets (i.e. if the firm defers the payment of dividend the current share
price will fully reflect its value).
¾ In recent years there has been a trend for traditional dividend payments to be replaced
by share repurchase schemes.
¾ With approval from shareholders the company uses surplus cash to buy back part of its
share capital, on the assumption that shareholders can reinvest this cash more
effectively than the company.
¾ The buyback can be performed either by writing directly to all shareholders with an
offer to buy shares at a fixed price (a “tender offer”) or by purchasing shares via the
stock market at the prevailing price.
¾ The shares are either cancelled as held by the company as Treasury Shares for possible
future reissue. If held by the company the shares carry no voting rights or dividend.
¾ The result of a buyback programme is that there will be fewer shares in issue, and hence
the share price should rise.
¾ Ratios such as Earnings Per Share (EPS) and Return on Equity (ROE) should also
improve.
¾ In many countries a share buyback is treated as a capital gain in the hands of the
investor rather than as income. This can have tax advantages if capital gains are taxed
more lightly than dividends.
¾ If a quoted company announces a larger than expected dividend this may raise market
expectations of at least the same in future.
¾ The company is telling the markets that, from time to time, any exceptional cash surplus
will be returned in this way, but that this should not be built into dividend per share
forecasts.
¾ This preserves corporate liquidity and releases cash for reinvestment back into the
business ( linking to Pecking Order Theory).
Key points
³ Ordinary shareholders take more risk than any other type of investor in a
company because:
(i) ordinary dividends are discretionary (i.e. the company has no legal
obligation to pay an ordinary dividend); and
³ Shareholders require high returns to compensate for this risk and therefore
issuing new shares is an expensive source of finance.
FOCUS
You should now be able to:
¾ explain the purpose and impact of a bonus issue, scrip dividends and stock splits;
¾ discuss the financing problems of small and medium sized enterprises (SMEs);
¾ suggest appropriate sources of equity finance for SMEs (e.g. AIM, venture capital, EIS).
EXAMPLE SOLUTIONS
Solution 1
Ex-rights price:
Commentary
Commentary
If the market price of the existing shares had been given post the announcement of the
project, then the NPV of $25,000 would already be included in the MV of the old
shares.
Solution 2
$
Wealth prior to rights issue 2,000
______
OVERVIEW
Objective
¾ To appreciate the options available to a company for long, medium and short-term debt
finance.
DEBT
FINANCE
CONVERTIBLES
AND WARRANTS
¾ Convertibles
¾ Effect on EPS
¾ Warrants
1 LONG-TERM FINANCE
1.1 Preference shares
Definition
Shares with a fixed rate of dividend having a prior claim on profits available
for distribution.
Also called “preferred shares” these are legally equity; they are often treated as debt (e.g.
under International Financial Reporting Standards) as they are similar in nature to debt.
1.1.1 Features
¾ Shares which have a fixed percentage dividend payable before ordinary dividend.
¾ The dividend is only payable if there are sufficient distributable profits. However if the
shares are cumulative preference shares the right of dividend is carried forward. Any
arrears of dividend are then payable before ordinary dividends.
¾ As with ordinary dividends, preference dividends are not deductible for corporate tax
purposes – they are a distribution of profit rather than an expense.
1.1.2 Advantages
1.1.3 Disadvantages
8 To attract investors the company needs to pay a higher return to compensate for
additional risk compared to debt.
1.2 Debentures
Definition
¾ No voting rights.
Amount of ¾ A fixed amount per unit of loan stock ¾ A fixed amount per unit of loan
capital or debenture. stock or debenture.
In the UK debentures are usually issued with a face value of £100. They can then be traded
on the bond market and reach a market price. Hence, if a debenture is said to be selling at a
premium of £15%, this means that a debenture with a face value of £100 is currently selling
for £115. This indicates that the rate of interest on this debenture is attractive when
compared with current market rates, creating demand for the debenture and a rise in price.
Commentary
The terms “debenture”, “loan stock” and “bond” all basically refer to the same thing
(i.e. a written acknowledgement of a company’s debt which can then be traded). Also
“face value” can also be referred to as “par value” of “nominal value”.
Definition
Loan stock issued at a large discount to nominal value (i.e. issued well below
face value) − redeemable at par on maturity.
¾ Investors receive large capital gain on redemption, but low rate of interest, if any,
during term of the loan.
¾ Cash flow advantage to the borrower – useful for financing projects which produce
weak cash flows in early years.
Illustration 1
A five year $1000 3% Bond issued at $800 would generate the following cash
inflows/(outflows) for the issuing company:
t0 t1 t2 t3 t4 t5
Issue price 800
Interest (30) (30) (30) (30) (30)
Redemption (1000)
Definition
Bonds issued at a discount to face value and which pay zero annual interest
¾ No interest is paid.
¾ Investors gain from the difference between issue and redemption price.
¾ Advantages to borrowers:
¾ Interest expense is tax deductible and therefore reduces corporate tax payments.
¾ Regarding the tax system the Issue of debt is preferable to the issue of shares as
dividends are not allowable for tax.
Illustration 2
CoA CoB
Profit before tax 100 100
Interest − (10)
___ ___
100 90
Corporation tax 30% (30) (27)
___ ___
70 63
$7 difference
Effective cost of debt in CoB
Interest 10
Less Tax relief (3)
___
$7
___
¾ The fact that interest on debt is tax allowable is referred to as the “tax shield”
Definition
¾ Conversion ratio may change during the period of convertibility − to stimulate early
conversion.
9 Advantages to investors − a relatively low risk investment with the opportunity to make
high returns on conversion to ordinary shares.
9 Advantages to issuing company − can offer a lower rate of interest than on “straight”
debentures.
Convertible debentures require a “fully diluted” EPS to be calculated to indicate what EPS
might be if debt is converted into equity.
Method
¾ Recalculate EPS
2.3 Warrants
Definition
A right given to an investor to subscribe cash for new shares at a future date at
a fixed price − the exercise (or subscription)price.
¾ Warrants are sometimes attached to loan stock, to make the loan stock more attractive.
¾ The holder of the warrants may sell them rather than keep them.
9 The warrants themselves do not involve the payment of any interest or dividends.
9 When they are initially attached to loan stock, the interest rate on the loan stock will be
lower than for comparable straight debt. This due to the additional benefit for the
investor of potential equity shares at an attractive price.
9 May make an issue of unsecured loan stock possible where no adequate security exists.
3 MEDIUM-TERM FINANCE
3.1 Bank loans
3.1.1 Advantages
3.1.2 Disadvantages
8 Inflexible;
8 May require security,
8 May require “covenants” – restrictions on the company (e.g. limits on dividend
payments, limits on further borrowing).
3.2 Leasing
3.2.1 Advantages
3.2.2 Disadvantage
8 Can be costly.
Property is sold to an institution, such as a pension fund, and then leased back to the
company.
3.3.1 Advantages
3.3.2 Disadvantages
8 No longer own property and hence cannot participate in any future increase in value;
8 Risk of lease payments increasing.
3.4.1 Advantages
9 Given the security, the loan will attract a lower interest rate than other debt;
9 Institutions will be willing to lend over a longer term;
9 Still participate in the growth in value of the property.
3.4.2 Disadvantage
4 SHORT-TERM FINANCE
4.1 Bank overdraft
4.1.1 Advantages
9 Flexible;
9 Provides instant finance.
4.1.2 Disadvantages
4.2.1 Advantages
9 Generally cheap;
9 Flexible.
4.2.2 Disadvantages
Definition
4.3.1 Advantages
4.3.2 Disadvantages
8 Fees.
Illustration 3
X sells $2m worth of goods to Y. X writes out (“draws”) a bill of exchange for
$2m payable in 2 months (say) which it sends to Y. Y signs the bill to
acknowledge the debt and returns it to X.
X can either hold the bill for 2 months until Y pays the debt or sell it at a
discount (e.g. at 98% of face value). The buyer of the bill then receives the $2m
and makes a gain.
Definition
Commercial paper is short-term (usually less than 270 days) unsecured debt
issued by high quality companies. The paper can then be traded by investors
on the bond markets.
4.4.1 Advantages
4.4.2 Disadvantages
Commentary
The following are particularly suitable for small and medium sized enterprises (SMEs)
which are of particular interest to the examiner as they often have difficulty finding
debt finance. Such difficulties may be caused by ”asymmetry of information” – where
banks fear making loans to companies which are not well known and without published
credit ratings.
5.1 Grants
Depending on the location and nature of the business local, regional, national or European
grant assistance may be available.
Just as small/medium sized companies find it hard to raise equity, they can also find it hard
to raise debt, due to their high perceived risk. The Loan Guarantee Scheme is a UK
government-backed scheme where, for a fee, a substantial proportion of the loan may be
guaranteed by the state. Hence potential providers of that loan are willing to lend, as most
of their risk has been eliminated.
Business angels are rich individuals who are prepared to invest money and time in small
companies if they see high potential for growth
Such angels are often retired businesspeople who became wealthy as entrepreneurs in the
high-tech sector.
They may also give useful advice as well as finance and may even be able to use their
contacts to obtain new business for the companies they invest in.
If they are prepared to invest debt they may also want the opportunity of equity
participation in the future. Hence convertible debt or debt with warrants attached may be
appropriate.
Key points
³ However banks and bondholders take even lower risks, as they rank
ahead of preference shareholders on bankruptcy, and their debts may be
secured by fixed or floating charge over assets. Providers of loans
therefore require lower returns than other providers of finance.
³ Hence loans are the least expensive source of finance for a company,
particularly if the effect of the tax system is introduced (loan interest is a
tax allowable expense, unlike dividends.)
³ Unfortunately debt also has a dark side – too much debt may increase the
risks faced by shareholders to unacceptable levels.
FOCUS
You should now be able to:
¾ explain the features of preference shares and the reasons for their issue;
¾ explain the features of different types of long-term debt and the reasons for their issue;
¾ explain the features of convertible debt and warrants and the reasons for their issue;
¾ suggest appropriate sources of debt finance for SMEs (e.g. leasing, loan guarantee
scheme and business angels);
OVERVIEW
Objective
¾ To use this model to estimate the cost of equity and the cost of debt.
DIVIDEND
VALUATION COST OF DEBT
MODEL
¾ General model ¾ Terminology of debentures
¾ Constant dividend ¾ Irredeemable debentures
¾ Constant dividend growth ¾ Redeemable debenture
¾ Assumptions ¾ Semi-annual interest payments
¾ Uses ¾ Convertible debentures
¾ Practical influences
on share prices
COST OF EQUITY
The relative risk/return relationship of equity and debt is based on their relative priority for
repayment on liquidation – the creditor hierarchy:
ORDINARY Residual
SHARES left (if any)
On liquidation, the firm’s assets are sold and the cash raised flows in a cascade from the top
of the creditor hierarchy downwards:
¾ Secured loans and secured bonds are repaid first. Some may be secured by “fixed
charge” over a specific asset such as property, others by “floating charge” over classes
of assets such as working capital. Secured creditors would expect to receive most, if not
all, of what they are owed in the event of liquidation.
¾ Trade creditors and unsecured debt are repaid next. If a company is forced into
liquidation then, by definition, the value of its assets is likely to be below the value of its
liabilities. In this case unsecured creditors may not receive everything they are owed.
¾ If there are any preference shares in issue they would be repaid next should there be
any cash remaining after paying all creditors.
In practice other stakeholders may have claims on liquidation (e.g. employees, tax
authorities and the liquidator). Exam questions would state where in the hierarchy these
would rank as it depends on the laws of the particular country.
Commentary
The risk faced by each class of investor drives the required return of that investor, and
the required return drives the firm’s cost of each source of finance:
¾ Debt investors have legally binding contracts with the firm for the payment of interest
and repayment of principal. Whilst the firm is trading interest must be paid in priority
to dividends and, if the goes into liquidation, secured creditors are repaid first.
Therefore secured debt can be considered a low risk investment; investors in secured
debt require relatively low returns, creating relatively cheap finance for the firm.
¾ This is also a legally binding contract and its interest must be paid prior to dividends,
However as there is no guarantee of full repayment on liquidation the required return
will be higher than on secured debt and hence the cost higher.
¾ Although preference dividends are paid after interest on debt, they are a fixed
percentage of the share’s par value and paid before any ordinary dividends. On
liquidation, preference shares rank between creditors and ordinary shares, hence the
required return of preference shareholders (and hence the firm’s cost of preference
capital) will be higher than on debt but lower than on ordinary shares.
Equity Debt
Rank on liquidation Last Higher
Servicing of finance Discretionary Committed
Dividend Interest
Risk to investor High Lower
Return required High Lower
Cost to company High Lower
Cost of equity > cost of debt
Servicing tax allowable? No Yes
Post-tax cost of debt < pre-tax cost of debt
Speed of issue Slow Faster
Issue costs 6–11% (IPO) Bonds 1–2%
Bank loan – arrangement fees
Key point
³ “The market value of a share or other security is equal to the present value
of the future expected cash flows from the security discounted at the
investor’s required rate of return.”
¾ Ex-div market value is the market value assuming that a dividend has just been
paid.
¾ Let:
D1 D2 D3 Dn
Po = + + .....
(1 + ke) (1 + ke) (1 + ke)
2 3
(1 + ke)
n
D
Po =
ke
¾ This version of the model can be used to determine the theoretical value of a share
which pays a constant dividend (e.g. a preference share) or an ordinary share in a zero
growth company.
¾ If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate
D0(1 + g) D1
Po = =
ke − g ke − g
D O (1 + g )
PO =
(re − g )
Where re = required return of equity investors = ke
¾ Rational investors.
¾ All investors have the same expectations and therefore the same required rate of return.
no transactions costs;
large number of buyers and sellers of shares;
no individual can affect the share price;
all investors have all available information.
¾ Dividends are paid just once a year and one year apart.
¾ The model can be used to estimate the theoretical fair value of shares in unlisted
companies where a quoted market price is not known.
¾ However if the company is listed, and the share price is therefore known, the model can
be used to estimate the required return of shareholders (i.e. the company’s cost of equity
finance).
Illustration 1
A share has a current ex-div market value of 80 cents and investors expect a
dividend of 10 cents per share to be paid each year as has been the case for the
past few years.
Using the dividend valuation model the investors’ required return can be
determined:
D
Po =
ke
10c
80c =
ke
10c
ke =
80c
ke = 12.5%
Investors will all require this return from the share as the model assumes they
all have the same information about the risk of this share and they are all
rational.
If investors think that the dividend is due to increase to 15 cents each year then
at a price of 80 cents the share is giving a higher return than 12.5%. Investors
will therefore buy the share and the price will increase until, according to the
model, the value will be:
15c
Po = = 120 cents
0.125
Alternatively suppose that the investors’ perception is that the dividend will
remain at 10 cents per share but that the risk of the share has increased and so
requires a 15% return. If the share only gives a return of 12.5% (on an 80 cents
share price) then investors will sell and the price will fall. The fair value of the
share according to the model will be:
10c
Po = = 66.7 cents
0.15
¾ The dividend valuation model gives a theoretical value, under the assumptions of the
model, for any security.
¾ In practice there will be many factors other than the present value of cash flows from a
security that play a part in its valuation. These are likely to include:
market sentiment;
press comment and rumour;
speculation;
government restrictions (e.g. on foreign ownership of shares);
anomalies such as the “January effect” where prices fall at the end of December (as
investors sell shares to crystallise tax losses) and rise at the start of January;
the rise of “dark pools” (i.e. share trading networks set up by investment banks to
allow their clients to buy/sell shares outside of the public exchanges).
¾ Behavioural finance theory has also identified psychological factors that influence
share prices. For example:
“herd mentality” (i.e. fund managers tend to follow each other’s strategies);
“the momentum effect” (i.e. investors believe recent price rises will continue into
the future). This may lead to a speculative bubble (e.g. in high-tech shares in the
1990s).
3 COST OF EQUITY
3.1 Shareholders required rate of return
D
Po =
ke
D
ke =
Po
¾ If ke is the return required by the shareholders in order for the share value to remain
constant then ke is also the return that the company must pay to its shareholders.
Therefore ke also equates to the cost of equity of the company.
¾ Therefore the cost of equity for a company with a constant annual dividend can be
estimated as the dividend divided into the ex-div share price (i.e. the dividend yield).
¾ The ex-div market value is the market value of the share assuming that the current
dividend has just been paid. A cum-div market value is one which includes the value of
the dividend just about to be paid. If a cum-div market value is given then this must be
adjusted to an ex-div market value by taking out the current dividend.
Example 1
A company’s shares have a market value of $2.20 each. The company is just
about to pay a dividend of 20c per share as it has every year for the last ten
years.
Solution
¾ The model can also deal with a dividend that is growing at a constant annual rate of g.
D 0 (1 + g) D1
Po = =
ke − g ke − g
D0(1 + g)
ke = +g
Po
Illustration 2
0.12 (1.05)
ke = + 0.05 = 12.2%
1.75
¾ The growth rate of dividends can be estimated using either of two methods.
Two methods
¾ This method analyses historical growth and use this to predict future growth.
Examples
¾ If dividends grew at 5% each year for the last 10 years, predicted future growth is 5%.
¾ For an uneven but steady growth take an average overall growth rate.
¾ If there is a discontinuity in the growth rate – take the most recent evidence.
¾ Take care with a new company with very high growth rates. It is unlikely to produce
such high growth in perpetuity.
¾ If there is no pattern (i.e. dividends up one year, down the next) this method should not
be used.
Example 2
A company has paid the following dividends over the last five years:
Cents per share
20X0 100
20X1 110
20X2 125
20X3 136
20X4 145
Estimate the growth rate and the cost of equity if the current (20X4) ex-div
market value is $10.50 per share.
Solution
¾ This model states that growth is achieved by retention and reinvestment of profits:
g = bre
¾ An average of r and b over the preceding years is used to estimate future growth:
Retained profit
b =
Profit after tax
¾ These figures can be obtained from the statement of financial position and income
statement.
Example 3
A company has 300,000 ordinary shares in issue with an ex-div market value of
$2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits
of $100,000.
Solution
Illustration 3
A Co, which is listed on a stock exchange, is all equity financed and has 1m
shares quoted at $2 each ex-div. It pays constant annual dividends of 30c per
share.
It is considering adopting a project which will cost $500,000 and which is of the
same risk as its existing activities. The cost will be met by a rights issue. The
project will produce inflows of $90,000 pa in perpetuity. All inflows will be
distributed as dividends.
Required:
Calculate the new value of the equity in A Co and the gain to the shareholders.
Ignore tax.
0.30
ke = = 15%
2.00
New dividend:
$000
Existing total dividend 300
Dividends from the project 90
New total dividend 390
390 ,000
Value of equity = = $2,600,000
0.15
= $100,000
90 ,000
Project NPV = ($500,000) + = $100,000
0.15
¾ Therefore the NPV of a project serves to increase the value of the company’s shares (i.e.
the NPV of a project shows the increase in shareholders’ wealth).
¾ This proves that NPV is the correct method of project appraisal – it is the only method
consistent with the assumed objective of maximising shareholders’ wealth.
D
Ke =
Po
¾ Preference dividends are normally quoted as a percentage (e.g. 10% preference shares).
This means that the annual dividend will be 10% of the nominal value, not the market
value.
Example 4
A company has 100,000 12% preference shares in issue (nominal value $1).
Solution
4 COST OF DEBT
4.1 Terminology of debentures
It may be traded on the bond market and will reach a market price.
Commentary
The terms debenture, bond and loan stock all basically refer to the same thing (i.e.
traded corporate debt); unlike bank loans which are not traded.
¾ The coupon rate is the interest rate printed on the debenture certificate.
¾ Nominal value is also known as par or face value. In the exam the nominal value of one
debenture is usually $100.
¾ Market value (MV) is normally quoted as the MV of a block of $100 nominal value.
Commentary
For example, 10% debentures quoted at $95 means that a $100 block is selling for $95
and annual interest is $10 per $100 block.
¾ Market value (cum-int) includes the value of accrued interest which is just about to be
paid.
¾ Irredeemable debentures are a type of debt finance where the company will never repay
the principal but will pay interest each year until infinity. They are also referred to as
undated debentures.
¾ The market value of undated debt can be calculated using the same logic as the
Dividend Valuation Model:
Key point
I
¾ MV (ex-int) =
r
I
¾ r = = Interest yield
MV (ex int)
¾ The company gets tax relief on the debenture interest it pays, which reduces the cost of
debentures to the company – known as the “tax shield” on debt.
Illustration 4
Consider two companies with the same earnings before interest and tax (EBIT).
The first company uses some debt finance, the second uses no debt.
$ $
EBIT 100 100
Debt interest (10)
___ ___
Profits before tax 90 100
$3.30 difference
Therefore
Effective cost of debt
$
Debt interest 10.00
Less Tax shield (3.30)
_____
Effective cost of debt 6.70
_____
¾ Because of tax relief, the cost to the company is not equal to the required return of the
debenture holders.
Commentary
In practice, there will be a time lag (e.g. a minimum of nine months under the UK tax
system).
¾ Kd can be used to denote the cost of debt – but care is needed as to whether it is stated
pre-tax or post-tax.
Example 5
12% undated debentures with a nominal value of $100 are quoted at $92 cum-
interest. The rate of corporation tax is 33%.
Required:
Find:
Solution
¾ The cash flows are not a perpetuity because the principal will be repaid. However the
following rule is derived from the dividend valuation model:
Key point
³ The cost of any source of funds is the IRR of the cash flows associated with
that source.
¾ Looking at the return from an investor’s point of view, interest payments are included
gross.
¾ Looking at the cost to the company, interest payments are included net of corporation
tax. Assume instant tax relief.
¾ Assume that the final redemption payment does not have any tax effects.
¾ To find the cost of debt for a company find the IRR of the following cash flows:
Time $
0 Market value (ex-interest) x
1−n Post-tax interest (x)
n Redemption value (x)
Example 6
Solution
_______ _______
IRR =
Kd =
¾ Care should be taken not to confuse the required return of the debenture holders with
the cost of debt of the company.
¾ The cost of debt of the company is then determined by finding the IRR of the market
value, net of tax interest payments and redemption value:
Key point
Example 7
Solution
DF @ 10% PV DF @ 5% PV
$ $
t0
t1–10
t10
______ ______
______ ______
IRR =
Therefore Kd =
¾ In practice debenture interest is usually paid every six months rather than annually.
This practical aspect can be built into our calculations for the cost of debt.
¾ If interest payments are being made every 6 months then when the IRR of the debenture
cash flows is calculated it should be done on the basis of each time period being 6
months.
¾ The IRR, or cost of debt, will then be a 6 monthly cost of debt and must be adjusted to
determine the annual cost of debt.
Example 8
What is the effective annual cost of debt for the company? Ignore corporation
tax.
Solution
______ ______
IRR =
¾ Convertible debentures allow the investor to choose between redeeming the debentures
at some future date or converting them into a pre-determined number of ordinary
shares in the company.
¾ To estimate the market value it is first necessary to predict whether the investor will
choose redemption or conversion. The redemption value will be known with certainty
but the future share price can only be estimated.
Key points
Example 9
A company has in issue 9% bonds which are redeemable at their par value of
$100 in five years’ time. Alternatively, each bond may be converted on that
date into 20 ordinary shares. The current ordinary share price is $4.45 and this
is expected to grow at a rate of 6.5% per year for the foreseeable future.
Bondholders’ required return is 7% per year.
Required:
Solution
¾ To find the post-tax cost of convertible debt for a company find the IRR of the
following cash flows:
Time $
0 Market value (ex-interest) x
1−n Post-tax interest (x)
n Higher of redemption value/forecast conversion value (x)
Example 10
A company has in issue some 8% convertible loan stock currently quoted at $85
ex-interest. The loan stock is redeemable at a 5% premium in five years’ time,
or can be converted into 40 ordinary shares at that date. The current ex-div
market value of the shares is $2 per share and dividend growth is expected at
7% per annum. Corporation tax is 33%.
Solution
DF @ 5% PV DF @ 10% PV
$ $
t0
t1−5
t5
______ ______
______ ______
IRR =
¾ Unless the exam question states otherwise the interest rate quoted on a bank loan can be
assumed to be the pre-tax cost.
¾ A profitable company should be able to claim a tax shield on bank loan interest and
hence the firm’s post-tax cost of bank loans = quoted interest rate ×(1 – corporate tax
rate)
¾ As bank loans are not traded their book value must be taken as a proxy for market value
when including them in the weighted average cost of capital (WACC).
Key points
³ If the market price of a security is already known then the model can be re-
arranged to find the required return of investors’ (i.e. the company’s cost
of equity/debt finance).
³ Care must be taken with the cost of debt as interest, unlike dividends, is a
tax allowable expense form the side of the company.
FOCUS
You should now be able to:
EXAMPLE SOLUTIONS
Solution 1
Po (cum-div) = $2.20
Po (ex-div) = $2.00
D 20
Ke = = × 100% = 10%
Po 200
Solution 2
145
(1 + g)4 =
100
145
1+g = 4 = 1.097
100
g = 9.7%
D1
ke = +g
P0
145 (1.097 )
= + 0.097 = 24.8%
1,050
Solution 3
b = % profit retained
60 ,000
= = 60%
100 ,000
re = Return on equity
100,000
= × 100% = 10%
1,060,000 − 60,000
Commentary
= 6%
D1 40 ,000 (1.06)
ke = +g = + 0.06 = 11.2%
P0 300 ,000 × 2.70
Solution 4
D
Ke =
Po
12
= × 100% = 10.4%
115
Solution 5
Int
r =
MV ex int
12
= × 100% = 15%
92 − 12
Int (1 − Tc ) 12 (1 − 0.33)
Kd = = = 10.05%
MV ex int 92 − 12
Solution 6
11.41 (5.05)
_______ _______
5.05
IRR = 5 + × (10 − 5)
5.05 + 11.41
Kd = 6.5%
Solution 7
To find the cost to the company, it is necessary to know the market value of the debentures.
This is found by discounting the future flows at the debenture-holder’s required return.
An IRR calculation, including the effects of tax relief, is used to find the cost to the company:
DF @ 10% PV DF @ 5% PV
$ $
t0 89.69 1 89.69 1 89.69
t1–10 (8) × 0.67 6.145 (32.94) 7.722 (41.39)
t10 (105) 0.386 (40.53) 0.614 (64.47)
______ ______
16.22 (16.17)
______ ______
16.17
IRR = 5+ × (10 – 5) = 7.5%
16.17 + 16.22
Therefore Kd = 7.5%
Solution 8
30 June X7 Time 1
31 Dec X7 Time 2
30 June X8 Time 3
31 Dec X8 Time 4
30 June X9 Time 5
31 Dec X9 Time 6
Each interest payment will be just half of the coupon rate, $3 each 6 months.
(3.95) 6.17
______ ______
3.95
IRR = 3+ × ( 5 − 3) = 3.78%
3.95 + 6.17
Solution 9
Today’s market value is the PV of future interest payments, plus the PV of the forecast
conversion value:
Floor value is the PV of future interest payments, plus the PV of the redemption value:
This is often expressed on a per share basis (i.e. 34.89/20 = $1.75 per share).
Solution 10
First decide whether or not the loan stock will be converted five years by comparing the
expected value of 40 shares in five years’ time with the cash alternative.
Assuming that the MV of shares will grow at the same rate as the dividends:
To find the cost to the company, find the IRR of the post-tax flows.
DF @ 5% PV DF @ 10% PV
$ $
t0 (85) 1 85.00 1 85.00
t1−5 (8) × 0.67 4.329 (23.20) 3.791 (20.32)
t5 (112.4) 0.784 (88.12) 0.621 (69.80)
______ ______
(26.32) (5.12)
______ ______
26.32
IRR = 5+ × (10 – 5) = 11.2%
26.32 − 5.12
Therefore cost to the company = 11.2%.
OVERVIEW
Objective
¾ To understand the weighted average cost of capital (WACC) of a company and how it is
estimated.
¾ To discuss the traditional view of capital structure, Modigliani and Miller’s models and
Pecking Order Theory.
WEIGHTED AVERAGE
COST OF CAPITAL
AND GEARING
WEIGHTED
FINANCIAL
AVERAGE COST
GEARING
OF CAPITAL
¾ Calculation of WACC
¾ Limitations of WACC
¾ Marginal cost of capital
PRACTICAL
EFFECTS FACTORS
TRADITIONAL MODIGLIANI
PECKING ORDER
VIEW OF CAPITAL AND MILLER’S
THEORY
STRUCTURE THEORIES
¾ Reasoning ¾ Introduction
¾ Conclusions ¾ Theory without tax
¾ Project finance – implications ¾ Theory with tax
¾ Approach
¾ Companies are usually financed by both debt and equity (i.e. they use some degree of
financial/capital gearing). The weighted average cost of capital (WACC) represents a
company’s average cost of long-term finance. This provides a potential discount rate for
project appraisal using NPV.
Simplified to:
KegE + KdD E D
WACC = OR WACC = Keg + Kd
E+ D E+D E+D
Where:
V V
k d (1 − T )
e d
WACC = k e +
V
e + Vd +
e Vd
V
Where:
Commentary
¾ For a redeemable bond the IRR of its post-tax cash flows must be calculated to find the
post-tax cost of debt.
¾ Market values of equity/debt (where available) are used to weight the individual costs
of capital. However if the firm’s shares are not listed on the stock market then the book
value of equity will have to be used. Similarly for debt (i.e. if the firm has issued bonds
then use the market value but for bank loans the book values would have to be used).
Proportion of
debt to equity
does not change
So, a company’s existing WACC can only be used as the discount rate for a potential project
if that project does not change the company’s:
¾ Business risk.
Commentary
Important concepts of these risks are dealt with in the next section.
Example 1
Solution
LIMITATIONS
THEORETICAL PRACTICAL
Assumes CALCULATION
− market value of shares OF Ke
Estimation of “g”
= present value of dividend stream
− market value of debt
− historical data used to
= present value of interest/principal
estimate future growth rates
− Gordon’s model assumes all
Current WACC can only be used to
growth is financed by retained
assess projects
earnings
which
Share price may not be in
− have similar operating risk to equilibrium
that of the company
− are financed by the company’s pool Ignores impact of personal
of funds, ie have same financial risk taxation
A h
CALCULATION OF Kd
¾ Marginal cost of capital (MCC) is the cost of raising the most recent dollar of finance.
¾ At first glance it may seem reasonable to use MCC as the discount rate for project
appraisal but this can lead to problems:
8 project finance may be drawn from the firm’s “pool” of funds and not from a
specific source;
Definition
Business risk is the variability in the operating earnings of the company (i.e. the
volatility of EBIT due to the nature of the industry).
WACC = Ke E + Kd D
E+D
¾ The effect of increased gearing on the WACC depends on the relative sizes of these two
opposing effects.
Traditional view
Modigliani and Miller’s theories
¾ The traditional view has no theoretical foundation – often described as the “intuitive
approach”. It is based on the trade-off caused by gearing (i.e. using more, relatively
cheap, debt results in a rising cost of equity). The model can also be referred to as the
“static trade-off model”.
¾ It is believed that Ke rises only slowly at low levels of gearing and therefore the benefit
of using lower cost debt finance outweighs the rising Ke.
¾ At higher levels of gearing the increased financial risk outweighs this benefit and
WACC rises.
Cost of
capital Ke
WACC
Kd
D/E
Optimal
gearing
¾ At very high levels of gearing the cost of debt rises. This is due to the risk of default on
debt payments (i.e. credit risk).
¾ This is referred to as financial distress risk – not to be confused with financial risk which
occurs even at relatively safe levels of debt.
3.2 Conclusions
¾ There is an optimal gearing level at which WACC is minimised and hence the NPV of
projects is maximised (i.e. the value of the firm is maximised).
¾ If the company is optimally geared: raise finance so as to maintain the existing gearing
ratio.
¾ If the company is sub-optimally geared: raise debt finance so as to increase the gearing
ratio towards the optimal.
3.4 Approach
If marginal cost of the finance > WACC the finance is not appropriate and should
be rejected.
If this was the case the company could raise finance in the existing gearing ratio
and the WACC would not rise.
¾ Modigliani and Miller (MM) constructed a mathematical model to provide a basis for
company managers to make financing decisions.
Rational investors;
Perfect capital markets;
No tax (either corporate or personal) – although the assumption of no corporate tax
was later relaxed;
Investors are indifferent between personal and corporate borrowing;
No financial distress risk (i.e. no risk of default even at very high levels of debt);
There is a single risk-free rate of borrowing (Rf);
Corporate debt is irredeemable.
¾ MM considered two companies; both with the same size and with the same level of
business risk:
¾ MM’s basic theory was that in the absence of corporation tax the market values (V) and
hence WACC’s of these two companies would be the same.
Vg = Vu
WACCg = WACCu
¾ MM argued that the individual costs of capital would change as gearing changed in the
following manner:
Cost of
capital
Ke
WACC
Kd
D/E
¾ Conclusion
¾ This is not true in practice because the assumptions are too simplistic. There are
differences between the real world and the model.
¾ MM never claimed that gearing does not matter in the real world. They said that it
would not matter in a world where their assumptions hold. They were then in a
position to relax the assumptions to see how the model’s predictions would change.
¾ When corporation tax is introduced MM argue that the individual costs of capital will
change as follows:
As gearing increases there is upward pressure due to the rising cost of equity but
even stronger downward pressure due to the very low cost of debt.
Cost of Ke
capital
WACC
Kd
D/E
¾ Conclusion
The logical conclusion to be drawn from MM’s theory with tax is that there is an
optimal gearing level and that this is at 99.9% debt in the capital structure.
This implies that the financing decision for a company is vital to its overall market
value and that companies should gear up as far as possible.
¾ This is not true in practice; companies do not gear up to 99.9%. Why not?
at high levels of gearing the risk of default on debt becomes significant (i.e. the cost
of debt rises);
the existence of not only corporate tax but also personal taxes; investors may prefer
to inject equity rather than debt if dividends are taxed less than interest income.
¾ Thus in practice there are many factors that a company will need to consider in deciding
how to raise finance.
¾ Level of operational gearing – the proportion of fixed to variable operating costs. If this
is high then the company may not wish to use debt as this increases the level of fixed
costs even further.
¾ Market sentiment (e.g. frozen debt markets following the 2007 US sub-prime meltdown).
¾ Tax exhaustion (not enough profit to fully utilise the tax shield).
¾ Issue costs.
¾ Agency costs – at high levels of financial gearing the control of the firm may move away
from the shareholders towards the debt investors (e.g. restrictive debt covenants may
restrict dividends or limit operations to low-risk areas).
Commentary
¾ Costs of financial distress. At dangerous levels of financial gearing the firm may find its
costs of doing business start to rise (e.g. suppliers may ask for payment in advance, staff
turnover may rise, customers may lose faith in the warranties on the firm’s products).
¾ If debt cannot be raised (e.g. due to lack of assets for security) then a share issue is
unfortunately inevitable. A new share issue ranks last in pecking order theory as:
8 cost of equity is high as equity investors are exposed to high risk (business and
operating risk);
8 issue costs are high (e.g. 6-11% in the case of an Initial Public Offering (IPO) in the
UK);
8 share issues take a lot of time and effort to organise – at least 6 months in the case of
an IPO, after which time the issue may have to be cancelled due to a change in
market sentiment.
Key points
³ There are various, and conflicting, models of how financial gearing affects
the WACC – traditional trade-off theory, Modigliani and Miller without
tax and MM with corporate tax. Each model has useful elements even if
the conclusions of such models lack practical relevance.
FOCUS
You should now be able to:
¾ discuss the traditional view of capital structure as well as the models of Modigliani and
Miller;
¾ discuss practical factors that influence the choice of capital structure, including Pecking
Order Theory.
EXAMPLE SOLUTION
Solution 1
Do(1 + g)
Ke = +g
Po
0.15 × 1.05
= + 0.05 = 15.5%
1.50
45 × 1.50 55
WACC = 15.5% × + 6.67% × = 11.54%
( 45 × 1.50) + 55 ( 45 × 1.50) + 55
OVERVIEW
Objective
¾ To understand the Capital Asset Pricing Model and its uses in financial management.
¾ Measurement
BETA FACTORS ¾ Interpretation
¾ Formula
CAPITAL ASSET
¾ Security Market Line
PRICING MODEL
DEGEARING AND
USES EVALUATION
REGEARING BETA
unsystematic risk;
systematic risk.
Definitions
Unsystematic risk is the risk that is unique to each company’s shares. (Also
called “unique” or “industry-specific” risk.)
Systematic risk is the risk that affects the market as a whole rather than a
specific company’s shares. (Also known as “market” risk.)
¾ Systematic risk cannot be diversified away; systematic risk still remains even in a well-
diversified portfolio.
¾ A well-diversified portfolio of shares still has some degree of risk or variability. This is
due to the fact that all shares are affected by systematic risk (i.e. to macro-economic
changes).
¾ Systematic risk will affect the shares of all companies although some will be affected to
a greater or lesser degree than others.
2 BETA FACTORS
2.1 Measurement
¾ Beta factors for quoted shares are measured using historic data and published in “beta
books”. They are determined by comparing changes in a share’s returns to changes in
the stock market returns over a period of many years (at least five years).
¾ This can be illustrated by the “security characteristic line” which gives an indication of
the share’s sensitivity to market changes.
¾ The beta factor is estimated from these observations by determining the gradient or
slope of the “line of best fit” through the observed points. The steeper the slope the
more volatile the share and the higher the beta factor.
Slope = β
Intercept = α
(Rm - Rf)
Where (Ri − Rf) = the excess return of the share over the risk free return
(Rm − Rf) = the excess return of the stock market over the risk free return
Rf = the return on a risk-free investment
¾ The security characteristic line should in the long run pass through the point where the
two axes meet.
¾ However in the short run this may not always be the case and any short term difference,
or abnormal return, is known as the alpha factor.
2.2 Interpretation
¾ A beta factor therefore simply describes a share’s degree of sensitivity to changes in the
market’s returns, caused by systematic risk:
Beta factor = 1 − this indicates that the share is as sensitive as the market to
systematic risk
Beta factor > 1 − this means that the share is more sensitive than the market.
Therefore if the market in general rises by 10% then the returns
from this share are likely to be more than 10%.
Beta factor < 1 − the share is less sensitive than the market and is likely to rise and
fall in value less than the market in general.
¾ The return these shareholders require therefore is only a return to cover the systematic
risk of an investment.
¾ Systematic risk is measured by a beta factor - therefore the required return from an
investment must be related to the beta factor of that investment.
¾ This is brought together in the Capital Asset Pricing Model which is a formula that
relates required returns to beta factors as measures of systematic risk.
E(ri) = Rf + βi(E(rm)–Rf)
The Market Portfolio is a portfolio containing every share on the stock market.
(E(rm)–Rf) = the equity market premium. That is, the extra return an investor expects for
holding a diversified portfolio of shares rather than a risk-free security (e.g. treasury
bills).
¾ The Security Market Line is a graph that indicates the required return from any
investment given its beta factor. Forecast returns from investments can be compared to
the figure from the security market line to indicate whether that investment is under or
overvalued.
Return
x Rb
Rm
x Ra
Rf
Beta
0 Ba 1 Bb
Where Ra = the forecast return from investment A
¾ The required return of an investment with a beta of zero (risk free) will be the risk free
return.
¾ The required return of an investment with a beta of 1 will be the market return.
¾ Consider investment A – it is forecast to earn higher returns than the CAPM would
predict given its beta. It is therefore temporarily under-priced. This is referred to as a
“positive alpha” investment.
¾ In the long run market forces should ensure that all investments do give the returns
predicted by the Security Market Line.
¾ The investor will be satisfied only if a potential investment gives a high enough return
given its sensitivity to market risk as measured by its beta factor.
Example 1
An investment has a forecast return over the next year of 12%. The beta of the
investment is estimated at 0.9. The risk free rate is 5% and the market return is
15%.
Solution
4.2 Companies
¾ Companies should not diversify their activities simply to reduce the risk of their
shareholders. Shareholders can diversify their shareholdings much more easily than a
company can diversify its activities.
¾ If the project is the same risk as that of the existing activities of the company then the
existing WACC can be used.
¾ However if the project is of a different risk type to the existing activities then the
existing WACC will not be appropriate. In these instances a tailor-made discount rate
for that type of project must be determined using the CAPM.
¾ Any company is made up of its assets or activities. These assets will have a certain
amount of risk depending on their nature. These assets will have a beta factor that
recognises the sensitivity of such assets to systematic risk.
¾ This beta factor is the asset beta and measures the systematic business risk of the
company.
Commentary
¾ The equity beta measures the sensitivity to systematic risk of the returns to the equity
shareholders in a company.
¾ In an all-equity financed company, or ungeared company, the only risk that is incurred
is business risk.
¾ Therefore in an ungeared company the asset beta and the equity beta are the same.
¾ However in a geared company the equity shareholders face not only business risk,
measured by the asset beta, but also a degree of financial risk.
¾ Therefore in a geared company the equity beta > the asset beta.
Commentary
¾ The equity beta measures the sensitivity to market risks of the equity shareholders’
returns. If the equity beta is used in the CAPM this gives the required return for the
equity shareholders.
¾ The CAPM can therefore be used as an alternative to the Dividend Valuation Model for
estimating the cost of equity of a company.
Example 2
The equity beta of a company is estimated to be 1.2. The risk free return is 7%
and the return from the market is 15%.
Solution
¾ It has already been noted that a company’s existing WACC is only a relevant discount
rate for a project with the same level of business risk as existing activities..
¾ If the project is in a different industry (or country) then a discount rate to reflect the
business risk of that industry is required.
¾ A company in a similar industry can be found and its beta discovered. If that company
is geared then its equity beta will contain both business risk and financial risk.
However that company will probably have a different level of gearing compared to our
company.
¾ First beta must be “degeared” to find the asset beta, and then “regeared” to reflect the
company’s level of financial risk
¾ The following formula (based on Modigliani and Miller’s models) can be used to
convert an equity beta to an asset beta (and vice-versa):
Ve Vd(1 − T )
βa = βe + βd
(Ve + Vd(1 − T )) (Ve + Vd(1 − T ))
Commentary
If the exam question does not give a beta factor for debt then assume that debt is risk
free. That is, βd = 0.
Example 3
The average equity beta of computer manufacturers is 1.4 and the average
gearing ratio is 1:4.
The risk free return is 5%, the market return 12% and the rate of corporation
tax 33%.
Solution
Example 4
Calculate the discount rate that A Co should use for a computer manufacturing
project.
Solution
6 EVALUATION OF CAPM
6.1 Assumptions
¾ Total risk can be split between systematic risk and unsystematic risk.
¾ Unsystematic risk can be completely diversified away.
¾ All of a company’s shareholders hold well-diversified portfolios.
¾ A risk-free security exists.
¾ Perfect capital markets.
6.2 Advantages
9 It considers only systematic risk (i.e. is relevant for listed companies whose institutional
investors have diversified portfolios from which unsystematic risk has been eliminated).
9 It is generally seen as a much better method of calculating the cost of equity than the
dividend growth model in that it explicitly takes into account a company’s level of
systematic risk relative to the stock market as a whole.
9 It is superior to the existing WACC in providing the discount rate for a project with
different business risk compared to existing operations.
6.3 Limitations
8 It is a single index model – beta being the only variable to explain different required
returns on different investments.
8 CAPM tends to overstate the required return on very high risk companies and under-
state the returns on very low risk companies.
Key points
³ Beta factors measure systematic risk and therefore CAPM should only be
used if the company’s shareholders have themselves used portfolio theory
to diversify way unsystematic risk
FOCUS
You should now be able to:
EXAMPLE SOLUTIONS
Solution 1
Solution 2
Solution 3
Using MM formula find the asset beta of the computer industry:
Ve Vd(1 − T )
βa = βe + βd
(Ve + Vd(1 − T )) (Ve + Vd(1 − T ))
4
Ba = 1.4
4 + (1 × 0.67)
Asset beta = 1.2
As A Co is ungeared then this asset beta is the appropriate beta for use in the CAPM to
determine the discount rate that A Co should use for a computer manufacture project:
Required return = 5 + 1.2(12 − 5) = 13.4%
Solution 4
Using MM formula find the asset beta of the computer industry:
Ve Vd(1 − T )
βa = βe + βd
(Ve + Vd(1 − T )) (Ve + Vd(1 − T ))
4
Ba = 1.4
4 + (1 × 0.67)
Asset beta = 1.2
to find the discount rate for A Co this asset beta must be converted into an equity beta
appropriate to A Co:
2
1.2 = Be = 0.749 × Be
2 + (1 × 0.67)
Be = 1.6
The discount rate that A Co must use is the WACC that it would have if its Ke were 16.2%.
In the absence of any other information assume Kd is 5% (risk free rate).
OVERVIEW
Objective
¾ To appreciate the importance of working capital and therefore its effective management.
WORKING ¾ Importance
CAPITAL ¾ Optimum level
¾ Liquidity ratios
RATIOS ¾ Efficiency ratios
¾ Calculation and interpreting
MANAGING ¾ Inventory
WORKING ¾ Receivables
CAPITAL ¾ Trade payables
¾ Cash and bank balances
¾ Problems for small businesses
¾ Overtrading
¾ Summary
1 WORKING CAPITAL
1.1 importance
Definition
The capital represented by net current assets which is available for day-to-day
operating activities. It normally includes inventories, trade receivables, cash
and cash equivalents, less trade payables.
Many businesses that appear profitable are forced to cease trading due to an inability to
meet short-term obligations when they fall due. To remain in business it is essential that an
organisation successfully manages its working capital. Too often however, this is an area
which is ignored.
Working capital comprises a number of different items and its management is difficult since
these are often linked. Hence, altering one item may impact adversely on other areas of the
business.
Illustration 1
A reduction in the level of inventory will see a fall in storage costs and reduce
the danger of goods becoming obsolete. It will also reduce the level of
resources that an organisation has tied up in inventory. However, such an
action may damage an organisation’s relationship with its customers as they
are forced to wait for new inventory to be delivered, or worse still may result
in lost sales as customers go elsewhere.
Illustration 2
Extending the credit period might attract new customers and lead to an
increase in turnover. However, to finance this new credit facility an
organisation might require a bank overdraft. This might result in the profit
arising from additional sales actually being less than the cost of the overdraft.
Management must ensure that a business has sufficient working capital. Too little will
result in cash flow problems highlighted by exceeding the agreed overdraft limit, failing to
pay suppliers on time and being unable to claim discounts for prompt payment. In the long
run, a business with insufficient working capital will be unable to meet its current
obligations and will be forced to cease trading even if it remains profitable on paper.
On the other hand, if an organisation ties up too much of its resources in working capital it
will earn a lower than expected rate of return on capital employed. Again this is not a
desirable situation.
Regarding the level of working capital every firm faces a trade-off between liquidity and
profitability:
LIQUIDITY v PROFITABILITY
For each company there will be an optimal level of working capital. However this can only
be found by trial and error, and in any case it is constantly changing.
¾ overtrading – an insufficient working capital base to support the level of activity. This
can also be described as under-capitalisation;
As a guide many text books suggest that to be safe an organisation requires a 2:1 ratio of
current assets to current liabilities. That is for every $1 of current liabilities, $2 of current
assets is required to ensure that the organisation does not run into cash flow problems.
However, this is much too simplistic, and the required level of working capital will vary
from industry to industry. This is demonstrated in Illustration 3 which shows a breakdown
of the working capital for three UK public limited companies operating in different sectors.
The figures are taken from published annual reports and the given ratios calculated as
follows:
Current assets
Current ratio =
Current liabilities
Illustration 3
Analysis
Each of these companies is profitable and is considered successful in its field. However, it is
apparent that only Manchester United meets the “suggested” current ratio of 2:1. Indeed
Tesco appears to be in real trouble with only 35 cents of current assets and 13 cents of
“quick” assets for every $1 of current liabilities.
Worse still, considering the ratio of cash to current liabilities, Tesco has only one cent of cash
coverage for every $1 of current liabilities suggesting severe liquidity problems. Yet Tesco is
the largest supermarket chain in the UK with over 600 stores and an annual profit before
taxation in excess of $800 million.
Airtours also falls well short of the suggested current ratio of 2:1, although its quick assets
ratio of 1:1 is satisfactory. These figures illustrate that the 2:1 ratio is inappropriate, and the
amount of working capital required by an organisation will vary depending on the nature of
its business and the industry in which it operates.
Tesco
Although Tesco’s level of working capital appears low, this must be evaluated in the context
of the nature of its business. Each day throughout the UK and Europe, millions of customers
will purchase their groceries from Tesco paying for their goods in cash before they leave the
store.
Most items sold by Tesco have a shelf life of only a few days. As market leader Tesco can
rely on regular deliveries of inventory from suppliers at fairly short notice. In addition the
use of forecasting techniques will enable managers to reliably predict daily sales levels. All
of these factors enable Tesco to operate with relatively low levels of inventory.
Since almost all sales are on a cash rather than credit basis, the level of receivables is also
low. In addition, the company is able to invest surplus cash balances in short-term
investments (usually on the money markets), hence maximising the return to its investors.
Considering current liabilities, Tesco will purchase most of its inventory on credit resulting
in trade payables of $826million. Indeed most inventory will have been sold and realised a
profit before Tesco even pays its suppliers. Few organisations are in such a fortuitous
position. Other payables will include corporation tax and dividends, amounts which Tesco
will know with certainty when they are to be paid.
Due to the nature of its business, and in particular an abundance of cash sales, few
receivables, low levels of inventory, and most purchases being for credit, cash flow is not
likely to be a problem, and hence Tesco is able to operate with negative working capital.
Airtours
Customers will usually pay for their holidays well in advance of departure ensuring that
cash flow is not a problem whilst also minimising the incidence of bad debts. Unlike Tesco,
Airtours’ sales are seasonal with most cash being received during the period January to
June. However, expenses will be incurred throughout the year and careful planning is
necessary to ensure that Airtours is able to meet its current liabilities as they fall due.
Being a tour operator, inventory levels are relatively low. Receivables mostly comprise
amounts paid in advance in respect of hotel accommodation and balances owing from
customers for holidays. Payables comprise amounts owing for accommodation and advance
payments made by customers.
Like Tesco, Airtours can operate with a lower current ratio than the suggested 2:1, however
due to the seasonal nature of its business, good budgeting and forecasting is essential to
ensure that liabilities can be met even during the quiet season.
Manchester United
There is little evidence of any working capital problems, with the company having a current
ratio of 2:1. In addition the company has 79 cents of cash for every $1 of current liabilities.
This is not surprising given the nature of Manchester United’s business. During the period
August to May cash flow is not likely to be a problem since almost every week over 50,000
fans will crowd into Old Trafford to watch their team play. Many of these fans pay for their
seats in advance, purchasing a season ticket before the season commences. In addition the
club will receive cash from sponsors, television companies and the sale of merchandise.
However, as with Airtours, business is seasonal and careful planning is necessary to ensure
that all liabilities are met as they fall due.
A review of the club’s working capital shows that inventory and receivables are relatively
small, with the majority of working capital comprising short-term investments and cash,
reflecting the cash received from season ticket sales.
A review of Table 1 shows that the optimum level of working capital varies depending on
the industry in which an organisation operates and the nature of its transactions.
Whatever level of current assets the business decides to hold, they must be matched by
liabilities (i.e. current assets must be financed).
Management must decide whether to use short-term or long-term finance or, if a mix is used,
in what proportions. A key factor is the relative cost of various sources of finance.
It is generally true that the cost of short-term finance is below the cost of long-term finance.
This is due to the term structure of interest rates
If, for example, a graph is drawn showing the yield to maturity (gross redemption yield) of
various government securities against the number of years to maturity, a “yield curve” such
as below might result.
Yield
Years to maturity
Although yield curves are usually constructed by reference to government interest rates the
curve for a corporate borrower will obviously follow a similar trend.
¾ Yields will need to rise as the term to maturity increases, as by investing for a longer
period the investor is deferring his consumption and needs higher compensation.
Hence a “normal” yield curve slopes upwards, as shown above.
¾ If interest rates are expected to increase in the future, the curve may rise even more
steeply. However, the curve may fall (i.e. invert) if interest rates are expected to decline.
¾ Pension fund managers often have a preference for investing in long-dated bonds – to
match against the long term liabilities of the fund. This can drive up the price of long-
dated bonds which brings down their yield, possibly resulting on an inversed (falling)
yield curve
This can also be referred to as “preferred habitat theory” (i.e. different investors have a
preference for being in different segments of the yield curve).
2.2.4 Risk
¾ However default risk may be more significant on corporate debt, therefore the corporate
yield curve may rise more steeply than the government yield curve.
2.3.1 Short-term
Short-term loans ¾ Lower interest rate than long-term debt (unless yield curve is
inverted).
¾ Renegotiation risk (i.e. bank may refuse to refinance on maturity).
Although short-term finance may, in some cases, be relatively cheap there is a danger that it
can quickly disappear. For example:
¾ key suppliers may put the firm on a “stop list” and refuse further deliveries until all
outstanding invoices are paid (and future deliveries may have to be paid for in
advance).
Therefore it may be wise to at least partly use long-term finance as, although generally more
expensive, it reduces exposure to renegotiation risk.
2.3.2 Long-term
Equity ¾ New share issues or, to avoid issue costs, retained profits.
¾ No legal commitment to repay (i.e. no renegotiation risk).
Part of the classification of “current” assets on the statement of financial position may in fact
be permanent in nature. Possible reasons include:
¾ Holding of “buffer stock” (i.e. a minimum level of inventory held throughout the year
as protection against “stockouts”);
Over the year the total level of current assets will naturally fluctuate above the minimum
permanent level – only this excess is truly short-term in nature.
There is an argument that any permanent segment of currents assets should be matched
with long-term finance and the fluctuating segment of current assets be matched with short-
term finance. This is referred to as a “matching” policy to the financing of working capital.
A matching policy is consistent with management being prepared to accept a moderate level
of risk.
An “aggressive” financing strategy would be to use short-term finance not only for the
fluctuating balance of current assets but also for some, if not all, of the permanent balance.
This is potentially a cheap financing strategy but indicates that management have a high,
and potentially dangerous, tolerance for risk. Short-term finance can quickly evaporate,
leaving the firm in financial distress. Lessons should be learned from cases such as
“Northern Rock”, a UK bank that exclusively relied on short-term interbank financing for its
operations. In the financial crisis of 2008 Northern Rock found its only source of finance was
completely cut off, causing the bank to collapse.
A “conservative” financing strategy would be to use long-term finance not only for the
permanent level of current assets but also for part, if not all, of the fluctuating balance. This
may be a relatively expensive but is lower risk for the firm and gives management the
chance to breathe rather than having to continually rollover finance. A conservative policy
is therefore consistent with a highly risk-averse attitude of management, for example in an
owner-managed business.
Current assets
Current ratio =
Current liabilitie s
If the current ratio falls below 1 this may indicate problems in meeting obligations as they
fall due. Even if the current ratio is above 1 this does not guarantee liquidity, particularly if
inventory is slow moving. On the other hand a very high current ratio is not to be
encouraged as it may indicate inefficient use of resources (e.g. excessive cash balances).
The quick ratio is particularly relevant where a firm’s inventory is slow moving.
Cost of sales
Inventory turnover =
Average inventory
This shows how quickly inventory is sold – higher turnover reflects faster moving inventory.
Working capital ratios are often easier to interpret if they are expressed in “days” as
opposed to “turnover”:
Average inventory
Inventory days = × 365
Annual cost of sales
Inventory days estimates the time taken for inventory to be sold. Everything else being equal a firm
would prefer lower inventory days.
Average accounts receivable
Accounts receivable days = × 365
Annual credit sales
Receivables days estimates the time taken for customer to pay. Everything else being equal a firm
would prefer lower receivables days.
Average accounts payable
Accounts payable days = × 365
Annual credit purchases
Payables days estimates the time taken to pay suppliers. A firm would prefer to increase its payables
days, unless this proves expensive in terms of lost discounts or leads to other problems such as
reduced reliability or quality of supplies.
Annual sales
Sales/working capital =
Average working capital
Sales/working capital indicates how efficiently a firm uses its working capital to generate
sales. Everything else being equal the firm would prefer sales/working capital to rise.
¾ Seasonal and other factors may mean that statement of financial position values may
not be typical.
¾ There may be “window-dressing” (e.g. the finance director may make a large payment
to suppliers at the year end to reduce the reported payables days).
¾ Ratios are of little value unless used in comparison to industry average data.
The working capital cycle (also known as the cash conversion cycle or the cash operating
cycle) is the number of days between paying suppliers and receiving cash from customers.
It can be found from standard ratios as inventory days + receivables days – payables days.
Inventory is purchased on credit from suppliers and is sold for cash and on credit. When
cash is received from customers it is used to pay suppliers, wages and any other expenses.
In general a business will want to minimise the length of its working capital cycle thereby
reducing its exposure to liquidity problems. Obviously, the longer that a business holds its
inventory and the longer it takes for cash to be collected from credit sales, the greater cash
flow difficulties an organisation will face.
The longer the cycle the greater the level of resources tied up in working capital. Whilst it is
desirable to have as short a cycle as possible, it is often difficult to differ significantly from
competitors in the same trade.
Cash payment
CASH SUPPLIERS
Cash
collection
Purchases
Sales
Production
FINISHED GOODS
WORK-IN-PROGRESS
Production
¾ type of industry - a supermarket chain may have low inventory days (fresh food), low
receivables days (perhaps just the time to receive settlement from credit card
companies) and significant payables days (taking credit from small farmers). In this
case the operating cycle could be negative (i.e. cash is received from sales before
suppliers are paid). On the other hand a construction firm may have a very long
operating cycle due to the high levels of work in progress.
¾ efficiency of working capital management (e.g. weak credit control and holding of
excess inventory will both lead to a longer working capital cycle).
For a manufacturing firm the calculation of the operating cycle can requires detailed analysis
of the three types of inventory days (raw materials, work in progress and finished goods).
In this case the cycle can be calculated as below:
accounts receivable
Accounts receivable days = × 365 = x
annual credit sales
accounts payable
Accounts payable days = × 365 = (x)
annual credit purchases
Commentary
Use statement of financial position year-end figures if averages are not available.
WIP days estimates the length of the production cycle (i.e. the number of days to
convert raw materials into finished goods). This methodology is per the examiner’s
book “Corporate finance practice and principles” (Denzil Watson and Antony Head)
3rd edition.
Example 1
Tipple Co has the following estimated figures for the coming year:
Sales $3,600,000
Accounts receivable $306,000
Gross profit margin 25%
Finished goods inventory $200,000
Work in progress inventory $350,000
Raw materials inventory $150,000
Accounts payable $130,000
WIP is 80% complete. Purchases represent 60% of production cost.
Required:
Solution
Days
Raw materials days
____
WIP days
_____
_____
Commentary
Having discussed what comprises working capital, this section considers some of the
methods that can be employed to assist in its management. Each of the key elements
that comprise working capital is examined in turn.
5.1 Inventory
The cost of holding inventory is relatively easy to measure and will include:
¾ storage;
¾ security;
¾ losses due to theft, obsolescence, and goods perishing.
What is less easy to quantify is the cost of not holding sufficient levels of inventory to meet
the demand from customers. For example, if an organisation has insufficient inventory to
meet demand, it will initially result in lost sales. In the longer term it may also damage a
business’s goodwill, with long-standing customers turning to other, more reliable suppliers.
For most organisations the difficulty is determining the optimum level of inventory. This
will depend on a number of factors including:
It is essential that systems are in place to ensure that inventory levels are reviewed regularly
and where necessary appropriate action taken.
5.2 Receivables
Too often, especially during their start-up period, businesses concentrate on generating sales
and pay little attention to the collection of money from receivables. As a result, although
sales exist on paper, the cash generated by these sales takes too long to materialise and cash
flow problems occur. Additionally, the longer a debt is outstanding the greater the
likelihood it will become bad.
¾ Before allowing credit, an organisation should check the credit rating of potential
customers, where necessary seeking references from a third party. Often this will
involve using the services of a credit agency such as Dunn and Bradstreet.
¾ Based on the results of a credit check, credit limits can be set. Once the credit limit is
reached it cannot be exceeded without the authorisation of senior management.
¾ Credit customers should be informed in writing of the normal credit period (e.g. 30
days after the invoice date).
Effective credit control will ensure that disputes are settled quickly without damaging the
relationship with a customer, whilst at the same time reducing the occurrence of bad debts.
However, such a system is often expensive and time consuming to set up, hence many
organisations, especially those which have only recently commenced trading, utilise debt
factoring.
Debt factoring involves an organisation passing responsibility for the management and
collection of its trade receivables to a third party. If the factor also offers a financing service
the organisation sells its invoices to the factor and in return the factor immediately advances
cash equal to between 50 and 85% of the total invoice value. The balance of the invoice
value, less a charge for the factoring service, is paid when the debts are collected. In
addition the factor is responsible for the administration of an organisation’s receivables, and
can offer protection against bad debts.
Invoice discounting is becoming increasingly common. Like debt factoring the business
immediately receives cash representing a proportion of the total invoice value. Unlike debt
factoring the business retains responsibility for the management of its credit control system.
When deciding the credit period offered to customers an organisation must consider several
factors. A longer credit period (e.g. 45 days compared to 30 days offered by competitors)
may generate additional sales; however these must be compared against the additional costs
incurred by the business. These costs might include an increase in bad debts, higher
administration costs and bank overdraft charges. If the profits arising from the additional
credit period are less than the costs incurred, the credit period should be reviewed.
The practice of businesses extending trade credit to one another is probably the most
important source of short-term funding available to most organisations. At first glance trade
credit appears to represent a short-term interest free loan which enables a higher level of
trade than if everything was paid for immediately in cash.
However, there are costs associated with trade credit. Most suppliers offer customers a
discount for early payment. Thus a supplier might allow 30 day’s credit on all sales.
However, to encourage early settlement of debts, customers paying within seven days are
offered a cash discount equating to 2.5% of the invoice total. On an invoice of $10,000
(excluding VAT) this would equate to a saving of $250.
Even if an organisation has an overdraft it may still be beneficial to take advantage of a cash
discount.
Illustration 4
Alanis purchases $5,000 of goods from Celine. Celine offers all customers the
option of either 30 days’ credit or a 1.5% discount if cash is received within 5
days. If Alanis takes the cash discount she will incur an overdraft on which
interest is charged at 20% per annum. Is the cash discount beneficial to Alanis?
If Alanis takes the cash discount she will save $5,000×1.5% = $75
However, she will incur an overdraft for 25 days (30 - 5 days) which will cost:
$5,000× [20%×25/365] = $68.49
Alanis will benefit by $6.51 if she pays the invoice within 5 days.
Another cost of trade credit, which is often ignored, is its impact on the creditworthiness of a
business. If a business consistently exceeds the credit period imposed by suppliers, in the
long term its credit rating will be damaged. In the worst case scenario, suppliers will be
forced to take legal action and may even withdraw their credit facility, requiring cash on
delivery.
Whilst trade credit is undoubtedly a useful facility, it is important that businesses do not
become too dependent on it.
Liquidity problems often arise because inflows and outflows of cash do not coincide. For
example, a small tour operator is likely to be “flush” with cash from January to June as
customers book and pay for their summer holidays. From July to December sales and hence
cash balances will be lower. However, business expenses such as wages and salaries, heat
and light, rent, and loan interest will remain more or less the same throughout the year. It is
therefore essential that businesses plan ahead to ensure that sufficient cash is available to
meet expenses in the off-peak period.
The preparation of a cash budget will indicate the flow of receipts and payments and will
forecast periods of surplus and deficit cash balances thereby reducing the level of
uncertainty. If a large surplus is forecast, cash can be invested in an interest earning account
until it is required. If a deficit is forecast, the business can arrange a bank overdraft or loan.
However, wherever possible overdrafts and loans should be avoided due to their high cost
As sales increase, small businesses are required to acquire more raw materials to produce
enough goods to meet the increase in demand, whilst workers are required to work longer
hours necessitating the payment of overtime wages. However, the cash from credit sales
may not be received for several weeks, whilst suppliers and employees require immediate
payment. In this situation a business is heavily dependent on its bank overdraft and loans.
In the long term, if the business survives, the problem will be reduced through negotiating
better credit terms with customers and suppliers.
5.6 Overtrading
¾ Overtrading occurs when a company tries to support a large volume of trade from a
small working capital base.
¾ if the business has found a “niche market”, rapid sales expansion may occur;
¾ smaller companies which are growing quickly will often lack the management skills to
maintain adequate control of the debt collection period and the production period.
For the above reasons the amount of cash required will increase. However, companies in
this position will often find it hard to raise long-term finance and hence overtrading and
business failure may result.
Indicators of overtrading
8 Decline in liquidity;
8 Rapid increase in turnover;
8 Increase in inventory days;
8 Increase in accounts receivable days;
8 Increase in short-term borrowing and a decline in cash holdings;
8 Large and rising overdraft
8 Reduction in profit margin;
8 Increase in ratio of sales to fixed assets.
If a business is suffering from liquidity problems, then the aim will be to reduce the length
of the cash operating cycle. Possibilities to consider include:
9 reducing the inventory-holding period for both finished goods and raw materials ;
9 reducing the production period – not easy to do but it might be worth investigating
different machinery or working methods;
9 reducing the credit period extended to accounts receivable, and tightening up on cash
collection;
9 an increase in the level of long-term finance (i.e. an equity or debt issue). A new share
issue is probably preferable to increasing debts in a risky company;
5.7 Summary
This session has examined the items which make up working capital and considered how
organisations can improve their management of working capital. Although an ideal level of
working capital is difficult to calculate and will vary from one organisation to another,
depending on the industry in which they operate, it is essential that a business avoids
having too little or too much working capital.
However, in the long term a business is unlikely to survive without a combination of:
¾ new capital from shareholders/proprietor;
¾ better control of working capital;
¾ the building up of an adequate capital base through retained profits.
It must be remembered that the shorter an organisation’s working capital cycle, the faster
cash, and hence profits, from credit sales will be realised. To achieve this organisation must
regularly review its working capital, taking action where necessary
Example 2
2006 2011
$000 $000
Fixed Assets 115 410
Current Assets 650 1,000
Current Liabilities 513 982
Long Term Liabilities 42 158
Total 210 270
Capital and Reserves 210 270
2006 2011
$000 $000
Sales 1,200 3,010
Cost of sales, expenses and interest 1,102 2,860
Profit before tax 98 150
Tax and distributions 33 133
Retained earnings 65 17
Notes:
Cost of sales was $530,000 for 2006 and $1,330,000 for 2011.
Receivables are 50% of current assets and trade payables are 25% of current
liabilities for both years.
Required:
Using suitable financial ratios, and paying particular attention to growth and
liquidity, discuss the significant changes faced by the company since 2006.
Comment on the capacity of the company to continue trading.
Key points
³ The key issues are (i) what level of current assets should a business hold
and (ii) how should current assets be financed?
FOCUS
You should now be able to:
¾ calculate appropriate ratios to analyse the liquidity and working capital management of
a business;
¾ explain the relationship between working capital management and business solvency.
EXAMPLE SOLUTIONS
Solution 1
In the five year period from 2006 to 2011 sales for Stalla have grown by 150%. The pressures
of such growth in terms of supporting the business by adequate working capital can be
substantial. Thus, in the same period current assets have expanded by 53% and current
liabilities by 91%. Whilst this aspect of the business will be dealt with in more detail below
it is worthwhile questioning at this stage whether sufficient funding for working capital is
available to support the growth in sales.
Whilst there has been significant growth in sales during the period PBT as a percentage of
sales has actually declined from 8% to about 5%. This must seriously call into question the
management either of costs (operational or financial) or whether there is an inability to force
price increases onto customers. Given the information available, the most likely source of
this problem appears to relate to interest costs. Both current and long term liabilities have
increased substantially (91% and 276%, respectively) against a background of barely
increased equity funding. Debt funding (both long and short term) looks to have increased
(see detail below) and this will have an associated interest burden. This has an importance
in relation to the sustainability of the business.
Earnings retentions do not appear sufficient to fund business growth and hence it is clear
that borrowings have been increased to deal with this problem. However, a balance must be
kept in the business between its earnings capability and its capacity to service its debt
commitments. Whilst PBT has increased by 53% over the period, retentions have declined
by about 74%. This may be partly explained by an increased tax burden, but is obviously
due mainly to excessive distributions. In other words, not enough funds are being retained
in the business to support its growth or funded from increased equity issues.
The impact of excessive growth in relation to its funding base will have potentially a severe
impact on liquidity. Net current assets are not seriously out of line if a ratio of current assets
to current liabilities of unity is considered acceptable. However, when current assets are
looked at in relation to sales a different picture emerges. The ratio was 54% in 2006 and only
33% in 2011. This suggests, in combination with the other information, that inventory,
receivables and cash resources might be insufficient in relation to sales. It might be argued
that this reflects greater efficiency in current asset management which it does when
receivables days are compared over the period (they declined from 99 to 60) but not in
relation to payables days which also declined (from 96 to 67 during the period).
Because it is debt rather than equity funding that has grown, the business faces a potentially
critical situation. Current assets are mainly comprised of inventory and receivables (because
the business has substantial borrowings it is unlikely to simultaneously have large cash
balances) and this is being funded by borrowing rather than retained earnings. The reason
why this is the case is because the business is not generating adequate profits and it is
distributing too much of earnings. The outlook is for greater borrowing. The poor profit
figures suggest that a critical point has been reached in terms of liquidity and solvency. This
is reflected in debt/equity ratios which have increased from 2·19 in 2006 to 4·22 in 2011
(current and long term liabilities used as debt and capital and reserves used as equity).
Unless a capital reorganisation can take place quickly, either through injected funds or
conversion of debt into equity, the business is likely to become insolvent.
2006 2011
PBT/Sales 98/1,200 = 8% 150/3,010 = 5%
Current Assets / Current liabilities 650/513 = 1·3 1,000/982 = 1·0
Current Assets / Sales 650/1200 = 54% 1,000/3,010 = 33%
Sales/working capital 1,200/(650-513) = 9 3010/(1000-982) = 167
Debt/Equity (513+42)/253 = 2·19 (982+158)/270 = 4·22
OVERVIEW
Objective
¾ To understand the costs and benefits of holding inventory and determine the Economic
Order Quantity (EOQ) which minimises costs.
INVENTORY ¾ Importance
CONTROL ¾ Reasons for holding inventory
¾ Costs associated with inventory
OTHER
EOQ MODEL RE-ORDER LEVEL INVENTORY
SYSTEMS
¾ Definition ¾ Definitions ¾ Periodic review system
¾ Determination of EOQ ¾ Constant demand in ¾ ABC system
¾ Complications lead time ¾ Just-in-time (JIT)
¾ Quantity discounts ¾ Uncertain demand in ¾ Perpetual inventory
lead time ¾ MRP
¾ Service levels
1 INVENTORY CONTROL
1.1 Importance
Definition
Commentary
Inventory may be raw materials, WIP, finished goods, goods for resale or even
consumables (e.g. machine lubricants) for use in production processes.
9 For technical reasons (e.g. maturing whisky in casks or keeping oil in pipelines).
¾ Purchase price;
¾ Holding costs:
¾ Re-order costs:
transport costs;
clerical and administrative expenses;
batch set-up costs for goods produced internally.
¾ Shortage costs:
Key point
2 EOQ MODEL
2.1 Definition
¾ The Economic Order Quantity (EOQ) is the quantity of inventory that should be ordered
each time a purchase order is made.
¾ EOQ aims to minimise the costs which are relevant to ordering and holding inventory.
2.2.1 Formula
x = order quantity
CH = cost of holding one unit for one year
D = annual demand
CO = cost of placing an order
2C 0 D
x= Exam formula
CH
$
Cost
Total cost
holding cost
ordering cost
¾ Constant demand.
¾ No risk of stockouts.
Example 1
D = 40,000 units
CO = $2
CH = $1
Solution
EOQ =
2.3 Complications
¾ The EOQ model is based on the assumption that holding costs vary with the average
inventory level.
(x/2)
¾ This is dealt with by doubling the floor space used by each unit when calculating holding
cost, and then use the normal EOQ formula.
Example 2
Solution
D = 3,000
CO = 5
CH =
EOQ =
¾ Inventory, like any other asset, must be matched by a liability. Therefore there must be
a cost of financing inventory.
Illustration 1
¾ The supplier may offer a “bulk-buying” discount on each unit purchased for specified
quantities above the EOQ
¾ In this case the purchase price obviously becomes relevant to the decision.
for the order level calculated by EOQ as well as for order quantities above EOQ for
which discounts are available.
Example 3
Required:
Solution
EOQ =
x
Holding CH =
2
D
Reorder CO =
x
Purchase cost
_____
Total
_____
x
Holding CH =
2
D
Reorder CO =
x
Purchase cost
_____
_____
Conclusion:
3 RE-ORDER LEVEL
3.1 Definitions
¾ Re-order level (ROL) is the level to which inventory should fall before a purchase order
is made.
¾ For example if demand is 40 units per day and lead time is two days - when inventory
levels fall to 80 units then inventory would be re-ordered. This can be shown
graphically:
Inventory
level
ROL
{
Time
Lead
time
¾ A “buffer” or “safety” inventory will need to be held to reduce the risk of a stockout.
Method
where
xi = level of demand
p (xi) = probability of level of demand
(2) Take each level of demand ≥ expected lead time demand as a possible
reorder level and calculate the expected annual stockout cost.
(3) For each possible ROL calculate the expected annual buffer holding
cost.
(4) Choose the ROL with the lowest sum of stock out and holding cost.
Example 4
The company operates for 50 weeks per annum and weekly demand is given
by:
xi p(xi)
Demand Probability
40 0.1
50 0.2
60 0.4
70 0.2
80 0.1
Required:
Solution
70 10
__ ___ ___
Average =
__ ___ ___ ___
80 20
__ ___ ___
¾ Setting a “service level” of 98% implies that the firm accepts a 2% chance of a stock-out.
Example 5
Average weekly demand for an item of inventory is 300 units with a standard
deviation of 40 units. The lead time is one week.
Normal distribution tables show that 5% of observations lie 1.645 standard
deviations above the mean.
Required:
Solution
The inventory levels are reviewed at fixed time intervals, and variable quantities will be ordered
as appropriate.
The order size made is sufficient to return inventory levels to a pre-determined level.
A very simple method of inventory control – ideal where inventory control is only one of a
person’s responsibilities.
The aim is to reduce the work involved in inventory control in a business which may have
several thousand types of inventory items.
The inventory is categorised into class A, B or C according to the annual cost of the usage of
that inventory item, or the difficulty of obtaining replacements, or the importance to the
production process.
Class A will then take most of the inventory control effort, Class B less and Class C less still.
Commentary
Whilst this seems acceptable for inventory of finished goods, it may cause problems for
raw materials. There may be an item which has a very small cost but which is vital for
the manufacture of the finished product. Such an item would have to be included in
with the Class A items because of its inherent importance, rather than its cost.
In a JIT system production and purchasing are linked closely to sales demand on a week-to-
week basis. The aim is to create a continuous flow of raw materials inventory into work in
progress, which becomes finished goods to go immediately to the customer. This means
that negligible inventory needs to be held.
Necessary conditions
¾ Flexibility of both suppliers and internal workforce to expand and contract output at
short notice.
¾ A low inventory level normally requires short production runs. This is only
appropriate, therefore, where set-up costs are low. High-technology production
methods have made this easier to achieve.
¾ The workforce must be willing to increase or decrease its working hours from one
period to another. This could be done by having a core workforce with a group of part-
time or freelance workers.
¾ The design of the factory must be such that JIT deliveries to all areas are possible.
¾ Total reliance on suppliers for quality and delivery, and therefore very tight contracts
with penalty clauses.
Where a firm keeps perpetual inventory records, there will frequently be a replenishment
point that triggers an order. Such a system relies on the accuracy of the records, not on
physical counts.
It is possible to use point of sale (POS) terminals that automatically update inventory
records as each successive sale is made.
One advantage of such a system is the data it provides to management to determine which
product lines are moving rapidly. Sales managers may also use the data to make tactical
decisions on special prices to sell slow-moving items.
A system that uses the production schedule to decide what is needed and when. This is then
linked in with suppliers’ discounts, lead times, etc to devise an optimal inventory holding
and ordering policy.
Key points
³ They formula for the Economic order Quantity is provided in the exam –
the key is to identify the relevant data.
³ Do not confuse the Economic Order Quantity (EOQ) with the Re –Order
Level (ROL). EOQ specifies how large each order should be; ROL specifies
when an order should be placed.
FOCUS
You should now be able to:
EXAMPLE SOLUTIONS
Solution 1 — EOQ
2 × $2 × 40 ,000
EOQ =
$1
x = 400 units
D = 3,000
CO = 5
CH = $3.33 + (2 × 3 × 5) = $33.33
2 × 5 × 3 ,000
EOQ = = 30 units
33.33
2 × 30 × 7 ,000
EOQ = = 200 units
7.50
D 5,000 750
Reorder CO = × 30
x 200
x 300 1,125
Holding CH = × 7.50
2 2
D 5,000 500
Reorder CO = × 30
x 300
Since the EOQ = 150, there will be 3 ,000 = 20 orders per annum.
150
70 10 80 10 0.1 1 1 × $3 × 20 10 × $8
__ ___ ___
Average 1 60 80 140
__ ___ ___ ___
80 20 80 – – – 0 20 × $8
__ ___ ___
0 160 160
__ ___ ___ ___
SD = 40
45%
5%
300
ROL
OVERVIEW
Objective
¾ To understand the importance of cash flow and methods of controlling cash flows, the
theoretical models relating to optimal cash balances and the importance of treasury
management.
1 CASH MANAGEMENT
1.1 Reasons for holding cash
However it is important that a firm does not hold excessive levels of cash as this leads to
inefficiency. Cash balances belong to the shareholders who are expecting to receive
significant return on their investment in the firm.
Any long-term surplus of cash should therefore be either reinvested into positive NPV
projects or returned to shareholders via:
Profits are accounted for on an accruals basis and a company must be profitable to continue
in existence. However, profitability is not enough; companies must also have enough cash
flow available to meet all their day to day payments and longer-term commitments in order
to survive.
2 TREASURY MANAGEMENT
Definition
As companies and financial markets have become larger, more sophisticated and
increasingly international, there has been a trend towards the establishment of separate
treasury departments where the control of cash is centralised in order to ensure its efficient
use. For example, surplus cash is invested in appropriate funds and realised when cash is
required.
Advantages
9 “Pooling” – netting cash deficits against surpluses in order to save interest expense.
9 More efficient foreign exchange risk management – the treasury department at head
office can find the group’s net position on each currency and then consider an external
hedge on this balance.
The aim of good cash management is to have the right amount of cash available at the right
time. The treasurer will be involved in:
¾ accurate cash flow forecasting, so that shortfalls and surpluses can be anticipated;
¾ planning short-term borrowing when necessary;
¾ planning investments of surpluses when necessary;
¾ cost efficient cash transmission;
¾ dealing with foreign currency issues;
¾ optimising banking arrangements;
¾ planning major finance-raising exercises;
¾ accounts receivable/accounts payable policies.
A major task of the treasurer is cash flow budgeting. A simple pro-forma is given below:
¾ Forecast:
– Sales volume;
– Revenue;
– Costs;
– One-off expenses (e.g. capital expenditure).
¾ Typical format
Q1 Q2 Q3 Q4 Total
Cash inflows $ $ $ $ $
Cash sales x x x x x
Cash from receivables x x x x x
Fixed asset disposals x x x x x
Share/debt issues x x x x x
___ ___ ___ ___ ___
Total inflow x x x x x
___ ___ ___ ___ ___
Cash outflows
Materials x x x x x
Labour x x x x x
Variable overhead x x x x x
Fixed overhead x x x x x
Dividends x x
Capital expenditure/leases x x
Interest/principal on debt x x x x x
___ ___ ___ ___ ___
x x x x x
___ ___ ___ ___ ___
¾ Sensitivity analysis can deal with uncertainty in cash budgeting by finding the effect of
a change in:
timing of other receipts (e.g. sale of fixed assets, rights issues, debt issues, etc);
other costs (e.g. labour, overheads) or timings of outflows (e.g. fixed overhead
payments, dividends, capital expenditure);
interest rates where borrowings are at variable rates. A worst-case scenario should
be forecast.
¾ Simulation models can perform more dynamic analysis by incorporating possible inter-
relationships between variables (e.g. if interest rates rise there may be a fall in sales).
¾ Unlike sensitivity analysis, simulation models (e.g. Monte Carlo) can simulate a range of
possible future economic scenarios to estimate the probability of cash flows being
higher/lower than expected. Through generating probabilities such models provide
better analysis of cash flow risk.
Example 1
The company has used Monte Carlo analysis to produce the following
forecasts of net cash flows for the next two periods, together with their
associated probabilities.
Required:
Solution
______ ______
1
______ ______
Commentary
Having completed a cash flow forecast the treasurer may identify a requirement to
borrow funds in the short term.
is technically repayable on demand (although the bank may offer a “revolving line
of credit”);
normally carries a flat charge for the facility and high variable interest rate on the
balance.
Commentary
Need for a permanent level of overdraft indicates a need for a more permanent, and less
costly, form of borrowing. (Overdrafts are expensive due to the flexibility they offer.)
¾ Short-term loans:
Commentary
Alternatively a treasurer may discover that the company has a cash surplus for a short-
term period.
¾ Over funding – proceeds which are not yet fully required may have already been
received from a share/debt issue;
¾ Operating surpluses.
¾ Liquidity – how quickly can the investment be converted back into cash?
¾ Risk – the treasurer should not gamble with the shareholders’’ funds
¾ Return on the proposed investment – obviously this will be limited by the requirement
to select low risk investments.
Commentary
The general rule is to select short-term, low risk, highly liquid investments (e.g.
treasury bills).
¾ Money market deposits (i.e. bank deposits). There may be a notice period for
withdrawals and therefore should only be used if there is high certainty of cash flows.
¾ Treasury bills – 2, 3, and 6 month UK government debt, very low risk and very liquid,
but even lower returns.
¾ Gilt-edged government securities (“gilts”) – the long term version of Treasury Bills with
maturities usually greater than 5 years. It is not recommended that short-term cash
surpluses are invested in newly-issued gilts as their market prices are very sensitive to
interest rate changes.
Commentary
¾ Other government bonds (e.g. UK local authority bonds) – rates are tied to money
markets. These have good liquidity.
¾ Certificates of tax deposit – deposits with UK Inland Revenue that may be surrendered
for cash or used in settlement of tax liabilities.
¾ Commercial paper – short term (7 days - 3 months) unsecured debts issued by high
quality companies, good liquidity
¾ Corporate bonds – longer maturity fixed interest securities issued by the corporate
sector. Liquidity can be poor and risk higher than on government bonds or commercial
paper.
¾ Equities – investing short term cash surpluses on the stock market is not recommended
as high risk.
Commentary
Most businesses will be looking for a variety of investments in order to minimise the
risks involved, and also to ensure that some cash is available at short notice and that
some is invested longer term to obtain higher interest rates.
5.1.1 Introduction
¾ The Baumol model is derived from the EOQ model and can be applied in situations
where there is a constant demand for cash. The model suggests that regular transfers are
made from interest-bearing short-term investments (or bank deposit accounts) into a
current account.
¾ The model then uses the EOQ formula to calculate the optimum amount of funds to
transfer each time short-term investments are converted into cash.
¾ By optimising the amount of funds to transfer, the model minimises the opportunity
cost of holding cash in the current account, thereby reducing the costs of cash
management.
5.1.2 Assumptions
5.1.3 Formula
2fs
¾ Economic transfer =
h
5.1.4 Weaknesses
8 The assumption of constant demand for cash is unrealistic. A cash management model
which can accommodate a variable demand for cash, such as the Miller-Orr model, may
be more relevant.
8 In reality interest rates and transactions costs are not constant and interest rates, in
particular, can change frequently
8 The model assumes that the business is constantly using cash and must finance this by
selling investments. However any worthwhile business must, at some point, generate
cash rather than “burn” it.
Illustration 1
Required:
Solution
s = 300,000
f = 120
h = 0.15
5.2.1 Introduction
¾ The assumption made by the Baumol model of constant demand for cash is unrealistic.
A cash management model which can accommodate a variable demand for cash may be
more relevant. This is the strength of the Miller-Orr model.
¾ The Miller-Orr model takes account of uncertainty in relation to cash receipts and
payments. The firm’s cash balance is allowed to vary between a lower limit set by
management judgement and an upper limit calculated by the model:
If the lower limit is reached an amount of cash equal to the difference between a
default “return point” and the lower limit is raised by selling short-term investments.
If the upper limit is reached an amount of cash equal to the difference between the
upper limit and the return point is used to buy short-term investments.
¾ The model therefore helps the firm to decrease the risk of running out of cash, while
avoiding the loss of profit caused by having unnecessarily high cash balances.
make investments
Return point
convert investments
back into cash
Lower limit
Time
5.2.2 Assumptions
5.2.3 Formula
Spread = the difference between the upper limit and lower limit
Transaction costs = the fixed cost of buying or selling marketable securities
Variance = variance of the net daily cash flows
Interest rate = daily interest rate on marketable securities (i.e. the daily opportunity
cost of holding cash).
5.2.4 Weaknesses
Example 2
Required:
Calculate:
– the spread;
– the upper limit;
– the return point,
and interpret the results.
Solution
Key points
³ The only reason for a business to exist is if it can generate positive cash
flows from operations.
³ However cash surpluses should not simply be left in the company’s bank
account as this produces a very low return. Long term surpluses should
be invested into positive NPV projects, or used to pay a dividend.
FOCUS
You should now be able to:
¾ describe the functions of and evaluate the benefits from centralised cash control and
treasury management;
EXAMPLE SOLUTIONS
Solution 1
Discussion
The expected value analysis has shown that, on an average basis, Zombie Co will have a
positive cash balance at the end of period 2 of $2·85 million. However, the actual cash
balances that could occur are any of the specific closing balances shown above, rather than
the average of these balances.
There could be serious consequences for the firm it exceeds its overdraft limit. For example,
the overdraft facility could be withdrawn. There is a 20% chance that the overdraft limit will
be exceeded at the end of period 2. To guard against exceeding its overdraft limit the firm
must find additional finance of up to $7 million ($12m – $5m).
The expected value analysis has been useful in illustrating the cash flow risks faced by
Zombie Co. However the assumptions used in the simulation model must be reviewed
before decisions are made based on the forecast cash flows and their associated probabilities.
Furthermore expected values are more useful for repeat decisions rather than one-off
activities, as they are based on averages. They illustrate what the average outcome would be
if an activity was repeated a large number of times.
In fact, each period and its cash flows will occur only once and the expected values of the
closing balances are not values that are forecast to arise in practice. For example, the
expected value closing balance of $2·85m is not forecast to actually occur, while a closing
balance of $1·1 million has a 20% chance of occurring.
Solution 2
1
3 3
4 × transaction cost × variance of cash flows
Spread = 3
interest rate
1
3 3
4 × 20 × 2 ,250 ,000
= 3 = 15,390
0.00025
Interpretation:
¾ if cash balance rises to $21,390 then invest $10,260 ($21, 390 – $11, 130) in securities. This
reduces the cash balance to $11, 130
¾ if cash balance falls to $6, 000, sell $5,130 of securities to replenish cash.
OVERVIEW
Objective
¾ To consider the factors involved in the granting and accepting of trade credit.
AC CO U N TS
RECEIVABLE
INVOICE
CREDIT SETTLEMENT
DISCOUNTING
CONTROL DISCOUNTS
AND FACTORING
¾ Granting credit ¾ Invoice discounting ¾ Annual effective cost
¾ Credit periods and ¾ Debt factoring
settlement discounts
¾ Credit rating
¾ Collection procedures
¾ Interest on overdue
invoices
OVERSEAS ACCOUNTS
RECEIVABLES PAYABLE
1 CREDIT CONTROL
1.1 Granting credit
¾ Should credit be granted at all? Consider normal trade practice, but also consider
leading a change. Providing credit may stimulate sales.
¾ What is the true cost to the business of customer credit? This will be influenced by the
risk of bad debts and the cost of financing accounts receivable.
¾ Credit periods can be changed to respond to competition but will be largely influenced
by trade custom.
¾ Settlement discounts (also called “cash” discounts) are influenced largely by accepted
practice within the industry. The company must ensure the discounts allowed expense
does not exceed the benefit of reduced finance costs.
¾ Having defined the credit periods and settlement discounts, the company must make
sure that customers are aware of them by stating the terms:
on orders;
on invoices;
on statements.
¾ The settlement discount policy must be enforced, since some customers will attempt to
take the settlement discount whether they pay on time or not.
Commentary
This is a crucial policy area. The company must balance the risk inherent in granting credit
against the necessity to allow enough credit to support the level of business.
¾ the use of credit rating agencies (e.g. Dun and Bradstreet); credit ratings should be
reviewed regularly;
¾ contacting credit managers in other firms to exchange information (members alert each
other as soon as problems are identified);
¾ references from the customer’s bank or accountant, although these may be of limited
value;
¾ review of the aged accounts receivables ledger to identify customers who have
significant debts outstanding for long periods.
¾ Establish timings for issuing letters of demand, making chasing telephone calls, and the
point when further deliveries should stop.
¾ Ensure credit controllers liaise with sales management to avoid insensitive collection
procedures that may damage customer relations.
¾ Decide when outside assistance is needed to collect overdue debts. Lawyers, trade
associations and debt collection agencies may be considered.
Some powerful companies have a reputation for paying their small suppliers very slowly.
Therefore in November 1998 the UK government introduced the Late Payment Act.
This legislation allows small suppliers to charge large companies 8% above central bank
interest rate on invoices unpaid after 30 days.
2 OVERSEAS RECEIVABLES
2.1 Default risk
Risk of default on exports may be higher than on domestic sales. Ideally cash in advance
should be requested, or at least a percentage deposit – however such terms may not be
acceptable to the customer.
In fact credit periods on exports are often longer than for those on domestic sales. Therefore
the exporter needs to carefully consider the method of payment both with a view to
minimizing default risk and to financing the export.
¾ This means simply trusting the customer to pay within the stated credit period with no
additional collateral or security.
¾ Documents of title to the goods are not released to the customer until payment is made.
Definition
¾ Often the documents of title to the goods will not be released to the customer until he
has accepted a bill of exchange.
to hold the bill until maturity (and then receive payment from the customer); or
to discount the bill with a bank to receive the cash earlier.
However if the customer does not pay the bill the bank will have recourse to the
exporter (i.e. default risk stays with the exporter).
2.2.4 Forfaiting
¾ This is where a bank discounts a series of bills of exchange without recourse to the
exporter if the customer does not pay (i.e. default risk is transferred to the bank).
Definition
¾ The exporter must present the documents stated in the letter, such as shipping
documents and bills of exchange, when seeking payment by the bank.
¾ As each supporting document relates to a key aspect of the overall transaction, letters of
credit give security to the importer as well as the exporter.
¾ These give credit to the overseas customer and guarantee payment to the exporter.
¾ The merchant buys the goods (at a discount) from the exporter, sells them to the final
customer and pays the exporter (usually within 7 days).
¾ Factors buy the trade receivables from the exporter and charge commission on the
transaction. Other services such as operating the receivables ledger and credit
insurance may also be offered.
¾ UK exporters can obtain guarantees from the ECGD on bank loans taken to finance
exports.
Definition
Selling selected sales invoices to a third party for a discounted cash sum, while
retaining full control over the receivables ledger.
¾ The finance company will charge a monthly fee for the service, and charge interest on
the amount advanced.
¾ The lender will require a floating charge over the trade receivables of the business and
may refuse to lend against some invoices, if it believes the customer is a high credit
risk. Therefore discounting is most suitable for companies which are selling to
customers with high credit ratings and a good payment record.
¾ The process operates “with recourse” (i.e. the business keeps the risk of bad debts and
must repay amounts advanced if a customer defaults).
¾ Responsibility for issuing sales invoices and for credit control stays with the business,
but the finance company will often require regular reports on the receivables ledger and
the credit control process.
3.1.1 Advantages
9 Improved cash flow.
9 Flexibility; the amount of financing rises and falls with the level of activity.
9 Confidentiality; customers are unaware that the business is borrowing against sales
invoices.
3.1.2 Disadvantages
8 An expensive form of financing compared to an overdraft or bank loan.
8 Finance company takes a legal charge over the receivables ledger and hence the
business has fewer assets available to use as collateral for other forms of borrowing.
(The interest rate charged by the discounter should be compared to the overdraft rate.)
Definition
(1) Accounting and collection – the company is paid by the factor as customers settle their
invoices or after an agreed settlement period. The factor will maintain the sales ledger
accounting function.
(2) Credit control – the factor is responsible for chasing the customers and speeding up the
collection of debts.
(3) Finance against sales – the factor advances (e.g. 80% of the value of sales immediately
on invoicing).
Accounting and collection is often carried out together with credit control. The finance that
the factor then makes available is only taken if required, as it is typically slightly more
expensive than a bank overdraft.
Factoring is becoming increasingly competitive; generally, factors will act for customers with
turnover in excess of $100,000 and invoices over $100.
The usual fees are between 0.5% – 2.5% of invoice value, plus a charge for cash advances.
3.2.1 Advantages
9 Administrative savings;
9 Provides a flexible source of finance;
9 Obtain benefits from the factor’s economies of scale;
9 Obtain benefits from the factor’s expertise.
3.2.2 Disadvantage
8 Cost;
8 Loss of customer contact/goodwill;
8 Possible damage to company reputation.
¾ Factoring with recourse – bad debts remain the company’s problem (i.e. the supplier
takes the risk of the debt not being paid).
¾ Non-recourse factoring – bad debts are the factor’s problem – in effect the company is
insured against bad debts. Fees are higher.
A Co makes annual credit sales of $2m. Customers take 60 days to pay and
bad debts are 1% of sales.
Required:
Assuming a cost of working capital of 15% per year, calculate the effect on
annual profit of the factoring option that is being considered.
Solution
Annual (costs)/savings
$
Administration savings
Bad debt reduction
Factor’s fee
Reduction in financing cost (W)
______
WORKING
Tipsy Co has annual sales of $500,000 and accounts receivable days of 60. It
pays overdraft interest at 17%.
Required:
Solution
Finance cost
$
Finance by factor
Finance by overdraft
______
______
Service fee
______
______
4 SETTLEMENT DISCOUNTS
4.1 Annual effective cost
¾ In the UK it is common to offer credit customers a discount if they pay within a certain
number of days.
¾ To decide if this is a good policy the cost of the discount must be compared to the cost
of financing accounts receivable (e.g. overdraft rate).
¾ To allow a fair comparison the cost of the discount must be expressed as an annual
effective cost.
Example 3
Required:
Calculate the annual effective cost of the discount and conclude whether the
discount should be offered if the overdraft rate is 15%.
Solution
Conclusion:
Example 4
Dodgy Co has sales of $100,000 and accounts receivable days of 60. It pays
overdraft interest at 18%.
Required:
Solution
$
Reduced interest expense
_____
¾ Firms can use trade credit as a flexible source of short-term finance. The firm may even
decide to pay suppliers late.
Associated costs
¾ Possible loss of goodwill such that the supplier might give low priority to the firm’s
future orders, with consequent disruption of activities.
¾ The supplier may raise prices to compensate for the finance which he is involuntarily
supplying.
the annual effective cost of refusing a discount should be calculated. This should be
compared to the alternative cost of financing working capital (e.g. overdraft rate);
if the cost of refusing discount exceeds the overdraft rate then the discount should
be accepted.
Example 5
Required:
Solution
Example 6
A company currently takes 40 days credit from its suppliers, believing this to
be “free” finance.
Annual purchases are $100,000 and the company pays overdraft interest at
13%.
Required:
Calculate the effect on the profit and loss account of accepting the discount.
Solution
$
Increased interest expense
Discounts received
_____
Effect on profit
_____
Conclusion:
¾ When importing there may be specific complications (e.g. slow customs clearance,
unexpected import duties or quotas).
¾ In addition the overseas supplier may be concerned about the risk of non-payment and
may demand, for example, cash against documents, bills of exchange or documentary
letters of credit.
Key points
FOCUS
You should now be able to:
EXAMPLE SOLUTIONS
Solution 1 — Factoring (service only)
Annual (costs)/
savings
$
Administration savings 10,000
Bad debt reduction 20,000
Factor’s fee (40,000)
Reduction in financing cost (W) 16,438
______
Net annual saving 6,438
______
WORKING
Commentary
The current level of receivables has been stated gross of bad debts. This is the
examiner’s approach as per his model answers and his book “Corporate Finance
Principles and Practice”.
60
Current accounts receivable × 500 ,000 = 82,192
365
45
New accounts receivable × 500 ,000 = 61,644
365
$
Finance by factor = 61,644 × 80% × 18% 8,877
Finance by overdraft = 61,644 × 20% × 17% 2,096
______
10,973
______
Conclusion: This is below the overdraft rate and therefore the discount should be offered.
Commentary
The annual effective rate has been calculated above using compound interest to
compare to the cost of overdraft where interest is also charged on a compound basis.
However the examiner has said that he would also accept the use of simple interest (i.e.
1.52% × 9.125 = 13.87%).
Current accounts = 60
100,000 × = 16,438
receivable 365
New accounts = 10 60
(100,000 × 50% × ) + (100,000 × 50% × )
receivable 365 365
= 1,370 + 8,219
= 9,589
$
Reduced interest expense (16,438 – 9,589) × 18% 1,233
Discounts allowed expense 100,000 × 50% × 2% (1,000)
_____
Increased profit 233
_____
Commentary
This solution follows the examiner’s approach as shown in his model answers and in
his book “Corporate Finance Principles and Practice”.
However there is a strong argument that the new level of accounts receivable should be
stated net of discounts allowed:
10 60
(100,000 × 50% × 98% × ) + (100,000 × 50% × ) = 9, 561
365 365
The examiner has stated that he would accept this alternative approach.
If a company receives an invoice of $1,000 and decides to pay after 30 days it will:
365 / 20
20
This is an equivalent compound rate of 1 + − 1 = 44.6%pa
980
Commentary
If this exceeds the cost of financing working capital, then refusing the discount is
expensive and the discount should be accepted.
Trade credit can therefore be a very expensive form of financing when a cash discount is
offered but refused.
Commentary
The cost of trade credit decreases as the allowed payment period becomes longer relative
to the discount period.
Solution 6 — Discount
40
Current accounts payable = 100,000 × = 10,959
365
15
New accounts payable = 100,000 × = 4,110
365
$
Increased interest expense (4,110 – 10,959) × 13% (890)
Discounts received (100,000 × 1½%) 1,500
_____
Increase in profit 610
_____
Conclusion: The discount should therefore be accepted.
OVERVIEW
Objective
RISK
MANAGEMENT
FORECASTING
EXCHANGE
EXCHANGE TYPES OF RISK
RATE RISK
RATES
¾ Four-way equivalence model ¾ Types of risk ¾ Sources of exposure
¾ Purchasing Power Parity (PPP) ¾ Translation risk ¾ Internal management
¾ Interest Rate Parity (IRP) ¾ Economic risk
¾ Fisher effect ¾ Transaction risk
¾ International Fisher effect ¾ Internal management
¾ Expectations theory EXTERNAL
¾ Balance of payments HEDGING OF
INTEREST RATE
EXTERNAL ¾ Forward rate agreements (FRAs)
HEDGING OF ¾ Interest rate options
TRANSACTION RISK ¾ Interest rate futures
¾ Interest rate swaps
¾ Forward exchange contracts
¾ Money market hedges
¾ Currency options
¾ Currency futures contracts
¾ Currency swaps
¾ The key models for forecasting future exchange rates focus either on inflation rate
differences, or interest rate differences.
¾ Spot exchange rate – the market exchange rate for buying/selling the currency for
immediate delivery.
¾ Forward exchange rate – the exchange rate for buying or selling the currency at a
specific date in the future.
¾ Absolute PPP states that the exchange rate simply reflects the different cost of living in
two countries. For example if a representative basket of goods and services costs $1, 700
in the US and £1,000 in the UK, the exchange rate should be $1.70 to £1.
¾ While absolute PPP exchange rates may represent the long-run equilibrium rate
between two currencies, they are of limited practical use in financial management.
¾ Financial managers are more interested in market exchange rates than theoretical rates.
This is where relative PPP is useful.
¾ Relative PPP claims that changes in market exchange rates are caused by the rate of
inflation in different countries.
¾ For example if the rate of inflation is higher in the US than in the UK, relative PPP
predicts that the value of the dollar will fall.
(1 + h c )
S1 = S 0 x
(1 + h b )
where:
Example 1
US 2%
UK 3%
Required:
Solution
¾ IRP states that the forward exchange rate is based on the spot rate and the interest rate
differential between the two currencies:
Forward rate = spot rate × (1+overseas interest rate/1+ domestic interest rate)
(1 + i c )
¾ F0 =S0 x
(1 + i b )
where:
Example 2
If spot $ per £ = 1.78 and the dollar and sterling one year interest rates are
3.25% and 4.5% respectively, calculate the one-year forward exchange rate.
Solution
¾ If this theory did not hold it would be possible for investors to make a risk-free profit
using a process referred to as covered interest rate arbitrage.
Definition
¾ Countries with a higher rate of inflation have higher nominal interest rates in order to
offer the same real return as countries with low inflation:
¾ States that the spot exchange rate will change to offset interest rate differences between
countries.
¾ Differences between forward and spot rates reflect the expected change in spot rates.
¾ The current account shows the net amount a country is earning if it is in surplus, or
spending if it is in deficit. Its main component is the balance of trade – net earnings on
exports minus payments for imports.
¾ The capital account records the net change in ownership of foreign assets and includes
the foreign exchange market operations of a nation’s central bank, along with loans and
investments between the country and the rest of world.
¾ Any current account surplus will be balanced by a capital account deficit of equal size –
and vice-versa.
¾ A rise in the value of a nation’s currency will make exports less competitive and imports
cheaper and so will tend to correct a current account surplus. A fall in the value of a
nation’s currency makes it more expensive for its citizens to buy imports and increases
the competitiveness of their exports, thus helping to correct a deficit.
¾ Exchange rates tend to change in the direction that will restore balance. When a country
is selling more than it imports, the demand for its currency will tend to increase as other
countries need the selling country’s currency to make payments for the exports. The
extra demand tends to cause a rise of the currency’s price relative to others.
¾ When a country is importing more than it exports, the supply of its own currency on the
international market tends to increase as it tries to exchange it for foreign currency to
pay for its imports, and this extra supply tends to cause the price to fall.
¾ In order to consolidate the subsidiary’s financial statements into the group accounts,
they must first be translated into the reporting currency of the parent company. The
exact method for doing this depends on the relevant financial reporting standards.
¾ If the home currency has appreciated against the foreign currency, it is likely to produce a
translation loss when converting the value of overseas net assets.
¾ If the home currency has depreciated against the foreign currency, it is likely to produce
a translation gain when converting the value of overseas net assets.
¾ Although such gains/losses can be significant in size, they do not represent actual cash
gains/losses for the group – they are simply caused by financial accounting methods for
consolidating overseas subsidiaries.
¾ Therefore the financial manager should ensure that the nature of translation
gains/losses is clearly explained (e.g. in the annual report, at shareholder meetings).
¾ However the financial manager does not need to hedge translation risk, because it is not
a cash flow.
¾ Economic risk is the risk that cash flows will be affected by long-term exchange rate
movements.
¾ As the value of a firm is the present value of its future cash flows, economic risk is a
significant issue for the financial manager. Unfortunately it is difficult to hedge against.
Illustration 1
¾ Increase the dollar price of the exports – however this may not be
practical, particularly when exporting to a competitive market.
¾ Diversify exports into other markets – in the hope that sterling will fall
against some currencies while rising against the dollar.
¾ Attempt to convert the cost base into dollars (e.g. by importing materials
from the US or setting up operations in the US). However these may not
be practical options for many companies.
Commentary
Economic risk can affect a company even if it does not export or import. Domestic
producers may face tougher competition from overseas firms if the home currency
appreciates. Again there is no easy method of protecting against this.
¾ It is the risk that the exchange rate changes between the date of a specific export/import
and the related receipt/payment of foreign currency.
¾ Like economic risk this affects cash flows and hence affects the value of the firm. It is
therefore a significant issue for financial management.
¾ Transaction risk can be effectively managed using both internal and external techniques.
¾ Invoicing in the domestic currency – an exporter could denominate sales invoices in its
domestic currency, effectively transferring the transaction risk to the customer.
However this may lead to lost sales.
¾ Netting is where there are both sales and purchases in a foreign currency and an external
hedge is only considered on the net difference between receivables and payables.
¾ Asset and liability management – if overseas subsidiaries borrow locally rather than
receiving finance from the parent company this reduces the net assets of the subsidiary.
Commentary
This can also be referred to as a “balance sheet hedge” and reduces exposure to
translation risk on consolidation of the subsidiaries’ net assets into the group accounts
(although, as mentioned above, translation risk should not affect the value of the
group).
a specified quantity;
of a specified currency;
on an agreed future date (“delivery date”);
at an exchange rate fixed today.
¾ Forward contracts are not traded but agreed between a company and a bank. This
means they are customised agreements which can match the exact requirements of the
company regarding quantity and delivery date.
¾ Forward contracts are not bought, they are entered into. Therefore no premium needs to
be paid to set up a forward hedge (unlike options).
¾ Forward contracts do not require any margin to be posted (i.e. no deposit of cash is
required when setting up a forward hedge, unlike futures contracts). However there
will usually be a small arrangement fee to set up a forward contract.
¾ The major disadvantage of forward contracts is that physical delivery must occur (i.e. if a
company signs a forward contract to buy/sell foreign currency then it must physically
exchange currency on the agreed date at the agreed rate, even if that rate has become
unattractive compared to the spot rate).
Example 3
Required:
(a) Calculate how much sterling will be received if forward cover is taken out.
Solution
¾ Money market hedges involve either borrowing or investing foreign currency in order
to protect against transaction risk. Whether to borrow or invest depends on whether the
company is exporting or importing.
¾ Suppose a UK company has dollar export earnings. A money market hedge could be
set up as follows:
Example 4
Required:
Solution
¾ If a company wants a more flexible hedge it may consider buying a currency option.
¾ The purchaser of a currency option has the right, but not the obligation, to buy or sell:
a specified quantity;
of a specified currency;
on or before a specified date (expiry date);
at an exchange rate agreed today (exercise price/strike price).
¾ However the owner of an option must pay for this flexibility. The cost of an option is
known as its premium
¾ Premiums are paid at the date the option is bought and are non-refundable.
a derivatives market; or
directly from a bank – known as OTC (“over-the-counter”).
Key points
³ A call option gives its owner the right to buy the underlying asset.
³ A put option gives its owner the right to sell the underlying asset.
³ European style options can only be exercised on the expiry date.
³ American style options can be exercised at any time until the expiry date.
3.4 Currency futures contracts
¾ Currency futures contracts are standardised contracts for the buying or selling of a
specified quantity of a specified currency. They are traded on a futures exchange and
have various “delivery dates” (e.g. March, June, September and December).
¾ A company can choose whether to buy or sell futures and can choose which delivery
date to use.
¾ The price of a currency futures contract represents the forward exchange rate for the
currencies specified in the contract.
¾ When a currency futures contract is bought or sold, the buyer or seller is required to
deposit a sum of money with the exchange, called initial margin. If losses are incurred
(as exchange rates and hence the prices of currency futures contracts change), the buyer
or seller may be called on to deposit additional funds (variation margin) with the
exchange.
¾ Any profits are credited to the margin account on a daily basis as the contract is
“marked to market”.
¾ Although the definition of a futures contract is basically the same as a forward contact,
there is a significant practical difference between hedging with forwards and futures:
With forward contracts there is always physical delivery (i.e. a company that signs a
forward contract will physically buy or sell the underlying currency when the
contract reaches its delivery date).
However most currency futures contracts are “closed out” before their delivery
dates. The company simply executes the opposite transaction to the initial futures
position (e.g. if buying currency futures was the initial transaction, it is later closed
out by selling currency futures).
¾ If a futures hedge is correctly performed any gain made on the futures transactions will
offset a loss made on the spot currency markets (and vice versa).
Illustration 2
The company is worried that sterling will appreciate, leading to a loss on the
spot market sale of dollars in 3 months.
If sterling has risen against the dollar, there will be a gain on sterling futures
(bought sterling low, sold sterling high) to offset the loss on the spot market.
¾ A currency swap is a formal agreement between two parties to exchange principal and
interest payments in different currencies over a stated time period.
¾ Currency swaps can be used to eliminate transaction risk on foreign currency loans.
At the end of the swap; a re-exchange of principals, usually at the original spot rate
(thereby removing foreign currency risk).
¾ There are two main situations where a company may fear rising interest rates:
If a company has a significant proportion of floating interest rate debt it will fear a
rise in interest rates as this obviously leads to lower profits. However higher
interest expense also leads to higher financial risk (i.e. more volatile future profits
due to a larger block of committed interest expense to be covered). An extreme
interest rate rise could even cause financial distress risk (i.e. bankruptcy).
If a company has a significant amount of surplus cash invested in fixed interest rate
securities (e.g. government bonds).
¾ There are two main situations where a company may fear falling interest rates:
when it has a significant proportion of fixed interest rate debt and therefore does not
participate in the benefits of falling rates (unlike its competitors, for example);
when it holds significant floating rate investments (e.g. money market investments).
¾ Even if a company has floating rate assets and floating rate liabilities of similar size,
they may be linked to different reference rates which may change at different times
and/or by different amounts.
¾ If a company has floating rate assets and floating rate liabilities of similar size that are
all linked to the same reference rate (e.g. LIBOR) it can still face risk.
¾ It is possible that the interest rate is reset at different intervals on assets and liabilities
(e.g. every 6 months on assets but every 3 months on liabilities).
¾ “Smoothing” involves maintaining a balance between fixed rate and floating rate
borrowings.
¾ “Matching” is attempting to have a common interest rate for both assets and liabilities.
Commentary
This is more practical for financial institutions than for industrial companies.
¾ FRAs allow companies to fix, in advance, either a future borrowing rate or a future
deposit rate, based on a notional principal amount, over a given period.
¾ FRAs are cash-settled, in advance, based on the present value of the difference on
settlement date between:
¾ The maximum maturity period for an FRA is usually around two years.
Illustration 2
¾ If actual interest rates are higher than 7% in 3 months’ time then the bank
pays the company the difference between 7% and the actual rate (i.e. cash
settlement is made at the start of the FRA period). The compensation
would be calculated as the present value of the interest rate difference on a
$20m 6 month loan (discounted at the actual interest rate).
¾ If actual interest rates are lower than 7% then the company pays the bank
the difference.
No matter what the actual interest rate the company will pay interest at a rate
of 7% on the underlying $20 million loan.
Various OTC interest rate options can be purchased from financial institutions and tailor-
made to meet company requirements. The major types are:
¾ Cap - if the reference interest rate rises above a pre-determined level, the financial
institution pays the difference to the company, based on an agreed notional principal
and time period. This puts a cap or ceiling on the interest rate paid by the company. If
the reference rate stays below the pre-determined rate the cap will not be exercised.
¾ Floor - if the reference interest rate falls below a pre-determined level, the financial
institution pays the difference to the company. This would be relevant for a company
with floating rate investment income that wishes to guarantee a minimum return.
¾ Collar – combination of a cap and a floor and therefore keeps an interest rate between
an upper and lower limit. This is a cheaper hedge than just using a cap or floor.
¾ The most common futures contract to use for interest rate hedging is a “three-month”
contract. This contract is referenced to short-term interest rates (e.g. three month
LIBOR).
¾ Interest rate futures contacts are priced at 100 minus the implied interest rate. Therefore
if interest rates rise, the price of interest rate futures falls.
¾ If a company wishes to hedge against rising interest rates it should use futures as
follows:
“Close out” the futures position by buying the same contracts that were originally
sold;
There should be a gain on futures (as we sold high and bought low) to offset higher
interest expense on company debts.
Commentary
In the above futures are sold and bought later. This is called taking a “short position”
and is absolutely possible in futures markets because of the ability to close out positions
before contracts reach their delivery date (i.e. physical delivery does not occur).
¾ Interest rate swap - an exchange between two parties of interest obligations or receipts
in the same currency on an agreed amount of notional principal for an agreed period of
time.
¾ Interest rate swaps are a flexible method for companies to change the interest rate
profile of their underlying loans or investments.
¾ The most common is a plain vanilla swap where fixed interest payments based on a
notional principal are swapped for floating interest payments based on the same
notional principal.
Key points
FOCUS
You should now be able to:
¾ forecast exchange rates using purchasing power parity and interest rate parity;
¾ discuss the various types of exchange rate risk and interest rate risk;
¾ discuss and apply both internal and external methods of hedging against currency or
interest rate risk.
EXAMPLE SOLUTIONS
Solution 1
(1 + h c )
s1 = s0 x
(1 + h b )
(1 + 0.02 )
s1 = 1.90 x = 1.88
(1 + 0.03)
This is a predicted fall in the value of sterling.
Solution 2
(1 + i c )
f0 = S 0 x
(1 + i b )
(1 + 0.0325)
f0 = 1.78 x = 1.76
(1 + 0.045)
Sterling is weaker in the forward market than the spot market
Solution 3
$200,000
= £129,374
1.5459
$200,000
(b) = £130,200
1.5361
Solution 4
Dollars to borrow now to have $300,000 liability after 3 months = 300,000/ 1.0135 = $296,004
OVERVIEW
Objective
BUSINESS
VALUATION AND
RATIO ANALYSIS
BUSINESS RATIO
VALUATION ANALYSIS
VALUATION
PRACTICAL
METHODS
FACTORS
1 BUSINESS VALUATION
1.1 Reasons for
¾ To determine the value of a private company (e.g. for a Management Buy Out (“MBO”)
team).
¾ To determine the maximum price to pay when acquiring a listed company (e.g. in a
merger or takeover).
Commentary
The quoted share price is only relevant for taking a minority shareholding.
¾ To place a value on companies entering the stock market (i.e. Initial Public Offerings –
IPOs).
¾ When a business is valued it is not a precise exercise and there is often no unique
answer to the question of what it is worth (e.g. the value to the existing owner may be
significantly different to the value to a potential buyer).
¾ There are a variety of different methods of valuing businesses which may produce
different overall values. These can be used to determine a range of prices.
¾ The final price will result from negotiations between the parties.
asset-based valuations;
earnings-based valuations;
dividend-based valuations.
¾ This method simply uses the “balance sheet” equation (also called “accounting”
equation:
Problems
8 Balance sheet (i.e. “carrying”) values are often based on historical cost rather than
market values.
8 Significant assets may not be recorded in the statement of financial position (e.g.
internally-generated goodwill will not be recognised).
Commentary
For these reasons a valuation based on balance sheet net assets is unlikely to be
suitable.
¾ This may represent the minimum price that might be acceptable to the present owner of
the business.
Problems
8 Estimating the NRV of assets for which there is no active market (e.g. a specialist item of
equipment).
¾ This can be viewed as the cost of setting up an identical business “from scratch”:
¾ This may represent the maximum price a buyer might be prepared to pay.
Problems
8 Technological change means it is often difficult to find comparable assets for the
purposes of valuation.
The published P/E ratio of a quoted company takes into account the expected growth rate of
that company (i.e. it reflects the market’s expectations for the business).
Using published P/E ratios as a basis for valuing unquoted companies may indicate an
acceptable price to the seller of the shares.
Therefore:
Step 2 Adjust downwards to reflect the additional risk of an unquoted company and the
non-marketability of unquoted shares.
EPS
Earnings Yield = × 100
Market price per share
Therefore:
EPS
Ordinary share price =
Earnings Yield
Example 1
¾ Extract from income statement for the year ended 31 July 20X4:
$ $
Profit before taxation 260,000
Less: Taxation (120,000)
_______
Profit after taxation 140,000
Less: Preference dividend 20,000
Ordinary dividend 36,000
______
(56,000)
_______
Retained profit for year 84,000
_______
Required:
Solution
Step 3 Adjust this dividend yield upwards to reflect the greater risk of an unquoted
company and the non-marketability of unquoted company shares.
¾ This method fails to take growth in to account and therefore can lead to an under-
valuation
¾ It also has little relevance for valuing a majority shareholding as such an investor has the
ability to change the dividend policy.
Example 2
G Co has 50,000 shares in issue and the latest dividend payment was 12 cents
per share.
Required:
Suggest a price that the individual might pay for the 2,000 shares in G Co.
Solution
Commentary
If dividends are forecast to grow at a constant annual rate to perpetuity then use the
published valuation formula:
D O (1 + g )
PO =
(re − g )
where PO = today’s ex-div share price
Do= most recent dividend
g = growth rate
re = required return of equity investors
Step 2 Estimate the growth rate of dividends. Three methods may be available:
(i) economic forecasting (i.e. the exam question may give a growth rate);
(ii) using the historic dividend growth rate and assuming it will apply into the
future;
Commentary
The abbreviation re is used both in the valuation formula (where it refers to the required
return of shareholders) and in Gordon’s formula (where it refers to the actual return on
reinvested profits). It can be argued that, in competitive markets, the actual return on
equity will, in the long run, equal the required return. In this case the CAPM-based
return can also be used in Gordon’s formula.
Problems
8 Determining growth rate of dividends;
8 It is of little relevance for valuing a majority shareholding as such an investor has the
ability to change the dividend policy.
Example 3
Required:
Solution
_______
(iv) PV of five years’ dividend
_______
Example 4
Risk-free rate = 4%
Market premium = 5%
Required:
Solution
Retention ratio =
Return on equity =
Growth =
Required return =
PO =
¾ Shares in unquoted companies are not traded via the stock market and this lack of
marketability reduces their value relative to shares in quoted companies.
¾ Furthermore unquoted companies are not required to comply with stock market listing
rules or corporate governance codes, increasing their perceived risk and further
depressing their value.
¾ Some analysts adjust the P/E ratio of a comparable quoted company downwards by as
much as 40% when valuing unquoted shares.
¾ Even shares in quoted companies can suffer from a lack of marketability where there are
periods of “thin trading” (i.e. a lack of liquidity in the market).
¾ However much less information may be available for unquoted companies – they may
not be required to publish accounts (or have exemptions from producing group
accounts or showing statement of cash flows) and are also unlikely to be watched by
analysts or news agencies.
¾ Although the dividend valuation model gives an idea of the fundamental fair value of a
share it is based on perfect market assumptions (i.e. many buyers/sellers of the share,
zero transaction costs, freely available information and rational investors).
¾ Even major markets such as the New York or London Stock Exchanges are not perfect
markets, as evidenced by the following:
Irrational investor behaviour (e.g. the belief that recent price rises will lead to future
price rises). This over exuberance can lead to speculative bubbles (e.g. the over-
valuation of high-tech shares during the 1990s).
Pricing anomalies such as the “January effect” where investors sell shares at the end
of December to utilise any tax losses of them, then buy back the shares at the start
of January.
Another anomaly is the “overreaction effect” where share prices appear to initially
over-react to unexpectedly good/bad news and then slowly move back toward
their fundamental value.
¾ Market capitalisation refers to the total market value of a quoted company (i.e. number
of issued ordinary shares × market price per share).
¾ However market capitalisation is not necessarily the amount that would have to be paid
for the firm’s entire equity. The quoted share price is for a minority shareholding – if
control is required a significant premium would usually have to be paid.
¾ On the other hand there may be situations where the entire capital can be acquired at
below market capitalisation (e.g. where a large proportion of the target firm’s shares are
held by a small group of people). If the existing investors tried to dispose of their
holdings via the market they would cause a major price fall, hence they may be willing
to sell “off exchange” at a small discount to the current quoted price.
6 RATIO ANALYSIS
6.1 Profitability ratios
Gross profit
Gross profit margin = × 100
Sales
Current assets
Current ratio =
Current liabilities
Average inventory
Inventory days = × 365
Annual cost of sales
Sales
Total asset turnover =
Total assets
Sales
Fixed asset turnover =
Fixed assets
Sales
Sales/working capital =
Working capital
¾ Financial gearing:
Commentary
¾ Operational gearing:
Diluted EPS should also be calculated where a company has a complex capital structure that
includes Potentially Dilutive Securities (PDS’s). These are securities in issue which involve
an obligation to issue shares in the future (e.g. convertible debt, warrants).
Ordinary dividend
Dividend payout ratio =
Profit after tax - preference dividend
EPS
Earnings yield = × 100
Ordinary share price
Example 5
Using the information for Cathcart Inc which follows calculate the ratios listed.
Example 5
Solution
(c) ROCE
(l) EPS
Key points
³ You need to enter the exam with a range of methods at your disposal and
choose the most relevant depending what data is available and whether
you are required to value a minority stake or a business in total.
FOCUS
You should now be able to:
EXAMPLE SOLUTIONS
Solution 1
(140,000 − 20,000)
= 200,000 × 12.5 ×
400,000
= $750,000
Solution 2
Dividend
Share price =
Dividend yield
12
Share value = = 92 cents per share
0.13
Solution 3
0.25
(i) Constant dividend Po = = $1.25
0.2
0.25 (1.05)
(ii) Constant growth in dividend Po = = $1.75
(0.2 − 0.05)
Solution 4
1 .5
Return on equity = × 100 = 12.5%
12
0.12(1.075)
PO = = $3.69
(0.11 − 0.075)
Total value of equity = $3.69 × 5m = $18.45m
Alternative approach (assuming actual return on reinvested profit will equal the minimum required
return as per CAPM):
0.12(1.066)
PO = = $2.91
(0.11 − 0.066)
Total value of equity = $1.91 × 5m = $14.55m
Solution 5
600
(a) Gross profit margin = × 100 = 20%
3 ,000
400
(b) Operating profit margin = × 100 = 13.3%
3 ,000
400
(c) ROCE = × 100 = 15.4%
1,000 + 200 + 800 + 600
160 - 20
(d) Return on equity = × 100 = 7.8%
1800
1,000
(e) Current ratio = = 1.67: 1
600
600
(f) Acid test ratio = = 1: 1
600
500
(g) Receivables days = × 365 = 61 days
3,000
3,000
(h) Total asset turnover = = 0.94
3,200
3,000
(i) Fixed asset turnover = = 1.4
2,200
800
(j) Proportion of debt finance = × 100 = 44.4%
1800
800
OR = × 100 = 30.8%
800 + 1800
400
= = 6.67
60
160 − 20
(l) EPS = = 14 cents
1,000
160 - 20
(m) Dividend cover = = 1.1
125
12.5 cents
= = 8.9%
$1.40
Accounting Rate of Return (ARR) – the average annual operating profit generated by a project
expressed as a percentage of the initial (or average) investment. Also referred as Return On
Investment (ROI) or Return on Capital Employed (ROCE).
Agency costs – the reduction in shareholders’ returns below the maximum possible level due
to company managers following personal objectives not in the best interests of shareholders.
Alpha – a measure of abnormal return from a security (i.e. where the forecast return is higher
or lower than expected by CAPM).
Asset beta – measures the risk created by operating the firm’s assets (i.e. business risk).
Asymmetry of information – the fact that potential investors know less about a company than
its managers and may therefore over-estimate the risk of providing finance. This can be a
particular problem for SMEs.
Basis risk – the risk that interest rates on assets and liabilities are referenced to a different
benchmark.
Bill of exchange –a document containing an instruction to a third party to pay a stated sum of
money at a designated future date or on demand. Mainly used in foreign transactions and is
usually negotiable (i.e. the holder of the bill can resell it at a discount).
Bird in the hand theory – suggest that shareholders may prefer the certainty of a cash dividend
today rather than reinvestment of profits to create an uncertain capital gain in the future.
Bonus issue – issue of new shares to existing shareholders, without any subscription of new
funds. Also referred to as a scrip issue.
Business risk – the volatility of operating profits, caused by the volatility of revenues and the
level of operational gearing.
CAPM – Capital Asset Pricing Model. A model that relates the systematic risk of an
investment to the required return.
Capital allowances – tax allowable deductions given on capital expenditure. Also known as
writing down allowances.
Capital rationing – where insufficient finance is available to undertake all available positive
NPV projects.
Cash conversion cycle – time period between paying suppliers and receiving cash from
customers. Also known as the cash operating cycle or working capital cycle.
Certificate of deposit – a tradable security issued by banks to investors who deposit a fixed
amount for a fixed period.
Clientele theory – suggest that a company’s historical dividend pattern may have attracted
particular investors. Changing the pattern in future may cause this “clientele” to sell their
holdings and lead to a fall in share price.
Collar – an agreement that keeps either a borrowing or lending rate between specified upper
and lower limits.
Convertible debt – debt that can, at the option of the investor, be either redeemed or converted
into ordinary shares.
Conversion premium – market value of convertible debt minus current conversion value.
Corporate Social Responsibility (CSR) – a model which suggests that company managers
should take into account the objectives of a wide range of stakeholders and not just the
shareholders.
Cost of debt – a firm’s cost of borrowing. If expressed post-tax then it takes into account the
tax shield.
Cost of equity - the required return of the firm’s ordinary shareholders. Can be estimated
from CAPM or the Dividend Valuation Model.
Coupon – the interest rate printed on a bond certificate, applied to the face value of the debt.
Current yield – the annual coupon from a bond expressed as a percentage of the bond’s
market price. Also known as running yield or interest yield.
Discounted payback – the period taken for the discounted cash flows generated by a project to
recover the initial investment. Also known as adjusted payback.
Dividend irrelevance theory – Modigliani and Miller’s claim that the timing of dividend
payments has no effect on share price.
Dividend valuation model – states that the value of a share is the present value of future
expected dividends, discounted at the investors’ required return.
Economic risk – the risk that long-term changes in exchange rates affects a company’s
profitability.
Efficient Markets Hypothesis (EHM) – a theory which asks what information is reflected in
share prices.
Equity beta – measures the risks faced by equity investors due to the nature of the firm’s
assets (business risk) and the level of its liabilities (financial risk)
Financial gearing – the proportion of debt in the capital structure. Also referred to as capital
gearing.
Financial risk – the increased volatility of returns to ordinary shareholders due to interest on
debt being a fixed committed cost.
Financial distress risk – the risk of bankruptcy caused by dangerously high levels of financial
gearing. Also referred to as credit risk or default risk, it increases the cost of debt.
Floor value – the value of convertible debt assuming that it will be redeemed rather than
converted.
Forfaiting – where an exporter discounts a series of bills of exchange without recourse (i.e. the
discounter takes the bad debts risk).
Forward contract – a legally binding contract between a company and a bank to buy or sell a
fixed amount of foreign currency at a fixed exchange rate on a fixed date in the future.
Forward Rate Agreements – contracts which allow companies in advance to fix future
borrowing or lending rates, based on a notional principal over a given period.
Gap exposure – the risk that interest rates on assets and liabilities are reset at different
intervals.
Gordon’s growth model – states that the forecast growth rate of a company’s dividend =
proportion of profits retained × return on equity.
IRR – Internal Rate of Return; the discount rate where NPV equals zero.
Letter of credit - a letter issued by a bank authorizing the person named to draw money up to
a specified amount from the bank's branches, providing the conditions set out in the letter
are met. Often used in international trade and, if the letter is irrevocable, provides an
exporter with guarantee of payment.
Marginal cost of capital – the cost of the last dollar of finance raised.
Money cost of capital – required return including the general inflation rate. Also known as the
nominal cost of capital.
Nominal discount rate – required return including the general inflation rate. Also known as
the money discount rate.
NPV – Net Present Value; the change in shareholders’ wealth due to an investment project.
Operational gearing – the proportion of fixed operating costs to variable operating costs.
Option –the right, but not the obligation, to buy/sell an underlying asset at a fixed price.
Payback – the period of time required for the operating cash flows from a project to equal the
cost of investment.
Pecking order theory – a theory which suggests that company managers have a preference for
using internal finance (i.e. retained earnings) rather than external finance. A key cause may
be asymmetry of information.
Placing – a method for a firm to sell its shares on the primary market. Shares are offered to
the sponsor’s or broker’s private clients and/or a narrow group of investors.
Pre-emptive rights – the right of existing shareholders to be offered new shares before they
can be offered to new investors. Also known as pre-emption rights.
Rights issue – an offer of new shares to existing shareholders who hold pre-emptive rights.
Sale and leaseback – where property is sold and simultaneously rented back.
Scrip dividend – issue of new shares to existing shareholders in lieu of a cash dividend.
Secondary market – trading in securities after they have been issued onto the primary market.
Securities – financial instruments that can be traded (e.g. shares, bonds and derivatives).
Share buyback – where a firm repurchases its own shares, an alternative method of retuning
cash to investors compared to a dividend,
SMEs – Small and Medium-sized Enterprises. No official definition exists but generally
these are unlisted companies.
Special dividend – a substantial dividend payment that is not expected to be repeated in the
near future.
Systematic risk – the relative effect on the returns of an individual security of changes in the
market as a whole. Also known as market risk. It cannot be removed by diversification but
can be measured using beta factors.
Tax shield – interest on debt is a tax allowable expense for a company and leads to lower
corporate tax payments.
Term structure of interest rates – the relationship between short and long term interest rates.
Total Shareholder Returns (TSR) – the total return to shareholders via dividend and capital
gain, usually measured over a one year period.
Transaction risk – the risk that exchange rates change between the date of an import/export
and the related payment/receipt of foreign currency.
WACC – Weighted Average Cost of Capital; the average cost of long-term finance.
Warrants – share options attached to debt to make the debt more attractive to investors.
Writing down allowances – tax allowable deductions given on capital expenditure. Also
known as capital allowances.
Yield To Maturity (YTM) – the average annualized return on a debt security, taking into
account both income and capital gains. Also known as gross redemption yield.
Zero coupon bond – a bond issued at a discount to face value, paying no annual interest but
redeemed at par.
S T
Sale and leaseback 907, 908 Tax relief 904
Scrip dividends 815, 816 Tax shield 905
Scrip issue 806 Taxation 506
Security characteristic line 1203 Tender 802
Security Market Line 1204 Term structure of interest rates 221
Segmentation theory 221, 1307 Time value 407
Sensitivity analysis 702, 1504 Trade credit 1611
Settlement discounts 1602, 1609, 1602, 1609 Trade creditors 1610
Share buyback 814 Traded forward contracts 1711
Share issue 802 Transaction exposure 1707
Shareholder expectations 812 Translation risk 1706
Shareholders 109 Treasury management 1502
Shares 217 Triple bottom line 108
Shariah board 224
Short-term investments 1507 U
Signalling 812
Uncertainty 702
Simple interest 402
Undated debt 1013
Simulation 705
Uneven cash flows 414
Single-period capital rationing 602
Unsystematic risk 1202
Small and Medium-sized Enterprises 806
Source of finance 1610
V
Sources of finance 1307
Sources of risk 702 Value for money 105
Special deposits 203 Variation margin 1711
Special dividends 815 VCT 809
Stakeholders 109 Vendor placings 802
Standard deviation 707 Venture capital 808
Static trade-off model 1106
Statistical measures 706 W
Stock Exchange 216 Warrants 905
Stock market ratios 1813 Weak-form efficiency 218
Stock splits 806 Wealth maximisation 103
Strong-form efficiency 219 Weighted average cost of capital 1102
Subsidies 211 Well-diversified 1205
Sukuk 224 With recourse 1607
Supply side policies 206 Working capital 1302
Surplus funds 1506 Writing down allowances 506
Swaps 1712
Systematic risk 1202 Y
Yield curve 1307
Yield curves 221
Yield to maturity 1016
Z
Zero coupon bonds 904
• Accounting
• International Financial Reporting
• Project Management
• Continuing Professional Education
®
This ACCA Study System has undergone a Quality Assurance review by ACCA and includes:
• An introductory session containing the ACCA Syllabus and Study Guide and approach to examining
the syllabus to familiarize you with the content of this paper
• Coverage of the core syllabus areas
• A visual overview at the beginning of each session showing how topics are related
• Definitions of terms
• Illustrations
• Examples with solutions
• Key points drawing attention to rules, underlying concepts and principles
• Commentaries providing additional information
• Focus on learning outcomes
• A bank of practice questions
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