MANAGEMENT ACCOUNTING

AND
FINANCE
Ms. B. Abeysekara
CImA (UK)
UNIT 1
Business Unit
Types of business organizations
Major sources of finance for business
Working capital
Capital Structure
Types of Business Organizations
Different types of business organisations
Advantages and disadvantages of each type
key issues:
Ability to raise finance
Control of the business
Business aims and objectives

Introduction
A business is always owned by one person, or
thousands
ownership is depending on the aims and
objectives of the owners
Most businesses main objective to make profit
for their owners
To survive a business need make a profit in the
long term
Some organisations however will be not-for-
profit, such as charities or government-run
corporations.
Types of Business Organisation
Sole trade
Partnership
Private Limited Company (Ltd)
Public Limited Company (plc)
Co-operatives
Franchises
Public sector
Measuring Size of a Business
Several ways to measure the size of a business
E.g.
Number of employees
Number of outlets (e.g. shops)
Total revenues (or sales per year)
Profit
Capital employed
Market value
Business size is relative
Sole Trade
Owned by one person
The most common form of ownership for SMEs
Often succeed
Offer specialist services to customers
Sensitive to the needs of customers
Cater for the needs of local people
Key legal points
Keep proper business accounts and records for the Inland
Revenue
Comply with legal requirements that concern protection of
the customer (e.g. Sale of Goods Act)
Operating as a Sole Trader
ADVANTAGES
Total control by owner
Quicker decision-making
Cheaper and easy to start up
Keep all profit
DISADVANTAGES
Unlimited liability
Difficult to raise finance
May be difficult to specialise or enjoy economies of
scale
Problems with continuity of business
Unlimited Liability
Risk will tolerate by the owner
Business owner responsible for all debts of
business
May have to sell own possessions to pay creditors
May lose personal assets if the business fails
Sole Trader forming a Partnership
Spreads risk across more people
Partner may bring money and resources to
business
E.g. better premises to work from
Increased credibility with potential customers
and suppliers who may see dealing with
business as less risky
Partnership
Ownership of business shared between partners
Most partnerships have between two and twenty members
Rules of the partnership described in the Deed of
Partnership. This contains:
Amount of capital each partner should provide
How profits or losses should be shared among the partners
How many votes each partner has (usually based on proportion
of capital provided)
Rules on how to take on new partners
How the partnership is brought to an end, or what happens if a
partner leaves/dies
Advantages of Partnership
Spreads the risk across more people
Partner may bring money and resources to the
business
Increased reliability with potential customers
and suppliers
Disadvantages of a Partnership
Have to share profits
Less control of business for individual
Disputes over workload / roles
Partnerships are difficult businesses to run.
The partners need to trust each other

Limited Company
Business owned by shareholders
Run by directors (who may also be
shareholders)
Liability is limited (important)
Setting up a Limited Company
Register with Company Registra
Company is a separate legal person so far as the law
is concerned i.e. it is separate from its shareholders
Issued with a Certificate of Incorporation
Date of incorporation
Company number
Memorandum of Association - describes what
company has been formed to do
Articles of Association - internal rules covering:
What directors can do
Voting rights of shareholders
Controls of a Company
Shareholders own company
Company employs directors to control management of
business
The directors may also be shareholders
Directors are responsible to shareholders
Have a duty to act in best interests of shareholders
Have to account for their decisions and performance
Have to prepare financial statements and directors report for
shareholders each year
Why Employ Directors?
Shareholders who may not want to get involved in day-to-day
decision-making
Special skills and experience
Importance of Limited Liability
Limited liability an important concept
Shareholders can only lose money they have invested
Encourages people to invest in companies lower risk
than operating as a sole trader or partnership
Those who have a claim against company:
Remember the company is a separate legal person
you have to sue the company, not the shareholders
Limited liability means that they can only recover money
from existing assets of business
They cannot claim personal assets of shareholders to
recover amounts owed by company
Private and Public Limited Companies
Shares in a plc can be traded on Stock
Exchange and can be bought by members of
general public
Shares in a private limited company are not
available to general public
A private limited company may have a smaller
(or larger) capital.
Should a Private Company Become a
PLC?
Becoming a PLC is mainly about making it
easier to raise money
Shares in a private company cannot be offered for
sale to general public
Restricts availability of finance, especially if
business wants to expand
It is also easier to raise money through other
sources of finance e.g. from banks
Disadvantages of Being a PLC
Costly and complicated to set up as a plc
Certain financial information must be made
available for everyone, competitors and
customers included
If the PLC offers its shares on the Stock
Exchange
Shareholders in public companies expect a steady
stream of income from dividends
Increased threat of takeover
Greater public scrutiny and profile (e.g. analyst
reports, press reports)
Buying Shares in a Company
Why buy shares?
Shares normally pay dividends = a share of profits
Over time value of share may increase and so can
be sold for a profit (known as a capital gain)
However - price of shares can go down as well as
up, so investing in shares is risky.
If they have enough shares they can influence
management of company
Risks faced by Shareholders
Remember shareholders liability is limited
However, there are still risks in investing:
Company reduces its dividend or pays no
dividend
Value of share falls below price shareholder
paid
Company fails and investor loses money
invested
Franchises
Franchisor a business whose sells the right to another
business (franchisee) to operate a franchise
Franchisor may run a number of their own businesses, but also
may want to let others run the business in other parts of the
country
A franchise is bought by the franchisee
Franchisee required to invest to acquire the franchise licence
and setting up the business
Once they have purchased the franchise they have to pay a
proportion of their revenues (commission) to the franchisor
on a regular basis
Franchisor usually provides support through training,
management expertise and marketing
May also supply the raw materials and equipment.
Advantages and Disadvantages of
Franchising
Advantages
Tried and tested market place, so should have a customer base
Easier to raise money from bank to buy a franchise
Given right and appropriate equipment to do job well
Normally receive training
National advertising paid for by franchisor
Tried and tested business model
Disadvantages
Cost to buy franchise
Have to pay a percentage of your revenue to business you have
bought franchisor
Have to follow franchise model, so less flexible
Examples of Franchises in Sri Lanka
McDonalds
KFC
Pizza Hut
Why Franchising is Popular
An attractive option for businesses that want to
grow rapidly but dont want to invest in opening
in lots of different locations
Franchisee provides most of finance reduces
investment in expansion
Local entrepreneur with inherited or redundancy
money sees opportunity to set up business with
reduced risk
Banks like combination of large company and
small local business as a reduced lending risk.
Public Sector Organisations
What are they?
Publicly-owned organisations
Provide goods and services to the public at national
and local government local levels
Organisations owned and controlled by the
government or local authority
Why do they exist?
Provide essential services not fully provided by private
sector
Protect jobs and maintain key industries
Privatisation
What was it?
Sale of public sector organisations to private investors
Why did it happen?
State run firms perceived to be inefficient - little incentive
to cut costs or provide high quality services because there
is no competition
Financial burden on government and selling them off
raised valuable money for government

Disadvantages
Private companies may put prices up
Cut jobs and reduce services that are not profitable
Major sources of finance for business
Different ways a business can obtain money

Sources of finance can be classified into:
Internal sources (raised from within the
organisation)

External (raised from an outside source)


Internal Sources
There are five internal sources of finance:
Owners investment (start up or additional capital)
Retained profits
Sale of stock
Sale of fixed assets
Debt collection
Internal Sources
Owners investment
This is money which comes
from the owner/s own
savings
It may be in the form of
start up capital - used when
the business is setting up
It may be in the form of
additional capital perhaps
used for expansion
This is a long-term source of
finance
Advantages
Doesnt have to be repaid
No interest is payable

Disadvantages
There is a limit to the
amount an owner can invest
Internal Sources
Retained Profits
This source of finance is
only available for a business
which has been trading for
more than one year
It is when the profits made
are ploughed back into the
business
This is a medium or long-
term source of finance
Advantages
Doesnt have to be repaid
No interest is payable

Disadvantages
Not available to a new
business
Business may not make
enough profit to plough
back
Internal Sources
Sale of Stock
This money comes in from
selling off unsold stock
This is what happens in the
January sales
It is when the profits made
are ploughed back into the
business
This is a short-term source
of finance
Advantages
Quick way of raising finance
By selling off stock it
reduces the costs
associated with holding
them

Disadvantages
Business will have to take a
reduced price for the stock
Internal Sources
Sale of Fixed Assets
This money comes in from
selling off fixed assets, such
as:
a piece of machinery that is
no longer needed
Businesses do not always
have surplus fixed assets
which they can sell off
There is also a limit to the
number of fixed assets a
firm can sell off
This is a medium-term
source of finance
Advantages
Good way to raise finance
from an asset that is no
longer needed

Disadvantages
Some businesses are
unlikely to have surplus
assets to sell
Can be a slow method of
raising finance
Internal Sources
Debt Collection
A debtor is someone who
owes a business money
A business can raise finance
by collecting the money
owed to them (debts) from
their debtors
Not all businesses have
debtors
This is a short-term source
of finance
Advantages
No additional cost in getting
this finance, it is part of the
businesses normal
operations

Disadvantages
There is a risk that debts
owed can go bad and not be
repaid
External Sources
There are five internal sources of finance:
Bank Loan or Overdraft
Additional Partners
Share Issue
Leasing
Hire Purchase
Mortgage
Trade Credit
Government Grants
External Sources
Bank Loan
This is money borrowed at
an agreed rate of interest
over a set period of time
This is a medium or long-
term source of finance
Advantages
Set repayments are spread
over a period of time which
is good for budgeting
Disadvantages
Can be expensive due to
interest payments
Bank may require security
on the loan
External Sources
Bank Overdraft
This is where the business is
allowed to be overdrawn on its
account
This means they can still write
cheques, even if they do not have
enough money in the account
This is a short-term source of
finance
Advantages
This is a good way to cover the
period between money going out
of and coming into a business
If used in the short-term it is
usually cheaper than a bank loan
Disadvantages
Interest is repayable on the
amount overdrawn
Can be expensive if used over a
longer period of time
External Sources
Additional Partners
This is sources of finance
suitable for a partnership
business
The new partner/s can
contribute extra capital
Advantages
Doesnt have to be repaid
No interest is payable
Disadvantages
Diluting control of the
partnership
Profits will be split more
ways
External Sources
Share Issue
This is sources of finance
suitable for a limited
company
Involves issuing more
shares
This is a long-term source
of finance
Advantages
Doesnt have to be repaid
No interest is payable
Disadvantages
Profits will be paid out as
dividends to more
shareholders
Ownership of the
company could change
hands
External Sources
Leasing
This method allows a business
to obtain assets without the
need to pay a large lump sum
up front
It is arranged through a
finance company
Leasing is like renting an asset
It involves making set
repayments
This is a medium-term source
of finance
Advantages
Businesses can have the use of
up to date equipment
immediately
Payments are spread over a
period of time which is good
for budgeting

Disadvantages
Can be expensive
The asset belongs to the
finance company
External Sources
Hire Purchase
This method allows a business to
obtain assets without the need to
pay a large lump sum up front
Involves paying an initial deposit
and regular payments for a set
period of time
The main difference between hire
purchase and leasing is that with
hire purchase after all
repayments have been made the
business owns the asset
This is a medium-term source of
finance
Advantages
Businesses can have the use of up
to date equipment immediately
Payments are spread over a
period of time which is good for
budgeting
Once all repayments are made
the business will own the asset

Disadvantages
This is an expensive method
compared to buying with cash
External Sources
Mortgage
This is a loan secured on
property
Repaid in instalments over a
period of time typically 25
years
The business will own the
property once the final
payment has been made
This is a long-term source of
finance
Advantages
Business has the use of the property
Payments are spread over a period
of time which is good for budgeting
Once all repayments are made the
business will own the asset
Disadvantages
This is an expensive method
compared to buying with cash
If business does not keep up with
repayments the property could be
repossessed
External Sources
Trade Credit
Trade credit is summed
up by the phrase:

buy now pay later

Typical trade credit
period is 30 days

This is a short-term
source of finance
Advantages
Business can sell the goods
first and pay for them later
Good for cash flow
No interest charged if
money is paid within agreed
time
Disadvantages
Discount given for cash
payment would be lost
Businesses need to carefully
manage their cash flow to
ensure they will have
money available when the
debt is due to be paid
External Sources
Government Grants
Government
organisations such as
Invest NI offer grants to
businesses, both
established and new
Usually certain
conditions apply, such
as where the business
has to locate
Advantages
Dont have to be repaid
Disadvantages
Certain conditions may
apply eg location
Not all businesses may
be eligible for a grant
Factors Affecting Choice of Source of Finance
The source of finance chosen will depend on a
number of factors:
Purpose what the finance is to be used for
Time Period how long the finance will be needed
for
Amount how much money the business needs
Ownership and Size of the business
The risk/return characteristics of long-term
capital
Return
Risk
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Working Capital
Working Capital
Assets/liabilities required to operate business on
day-to-day basis
Cash
Accounts Receivable
Inventory
Accounts Payable
Accruals

Short-term in natureturn over regularly
Working Capital and the Current Accounts

Gross working capital = Current assets
Gross Working Capital (GWC) represents
investment in current assets

(Net) working capital =
Current assets Current liabilities
Objective of Working Capital Management
To run firm efficiently with as little money as
possible tied up in Working Capital
Involves trade-offs between easier operation and
cost of carrying short-term assets
Benefit of low working capital
Money otherwise tied up in current assets can be invested in
activities that generate higher payoff
Reduces need for costly financing

Cost of low working capital
Risk of shortages in cash, inventory
Working Capital Needs of Different Firms
Working Capital Financing Policies
Working Capital Financing Policies
Capital Structure
Equity
Shares
Ordinary shares
Rights issue
Retained earnings
Debt
Loans
Bonds
Debentures
Lease
Finance Lease
Operating Lease

Advantages of Debt
Interest is tax deductible (lowers the effective
cost of debt)
Debt-holders are limited to a fixed return so
stockholders do not have to share profits
Debt holders do not have voting rights
Disadvantages of Debt
Higher debt ratios lead to greater risk and
higher required interest rates (to compensate
for the additional risk)
What is the optimal debt-equity
ratio?
Need to consider two kinds of risk:
Business risk
Financial risk
Business Risk
Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)
Financial Risk
The additional risk placed on the common
stockholders as a result of the decision to
finance with debt
Example of Business Risk
Suppose 10 people decide to form a
corporation to manufacture disk drives.
If the firm is capitalized only with common
stock and if each person buys 10% -- each
investor shares equally in business risk
Example of Relationship Between
Financial and Business Risk
If the same firm is now capitalized with 50%
debt and 50% equity with five people
investing in debt and five investing in equity
The 5 who put up the equity will have to bear
all the business risk, so the common stock will
be twice as risky as it would have been had
the firm been all-equity (unlevered).
Business and Financial Risk
Financial leverage concentrates the firms
business risk on the shareholders because
debt-holders, who receive fixed interest
payments, bear none of the business risk.
Financial Risk
Leverage increases shareholder risk
Leverage also increases the return on equity
(to compensate for the higher risk)
Capital Structure
When a firm issues debt and equity securities
it splits cash flows into two streams:
Safe stream to bondholders
Risky stream to stockholders
Modigliani and Miller (MM)
MM prove, under a very restrictive set of
assumptions, that a firms value is unaffected
by its financing mix.
Therefore, capital structure is irrelevant.
Any increase in ROE resulting from financial
leverage is exactly offset by the increase in
risk.

MM
Modigliani and Miller (1958) show that
financing decisions dont matter in perfect
capital markets
M&M Proposition 1:
Firms cannot change the total value of their
securities by splitting cash flows into two different
streams
Firm value is determined by real assets
Capital structure is irrelevant
M&M (Debt Policy Doesnt Matter)
Modigliani & Miller
When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
Therefore, the market value of a company does
not depend on its capital structure.
M&M (Debt Policy Doesnt Matter)
Assumptions
By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
Investors do not need choice, OR
There are sufficient alternative securities
Capital structure does not affect cash flows e.g...
No taxes
No bankruptcy costs
No effect on management incentives
An Example of the Effects of Leverage
D and E are market values of debt and equity
of Wapshot Marketing Company. Wapshot has
issued 1000 shares and these are currently
selling at $50 a share. Wapshot has borrowed
$25,000 so Wapshots stock is levered
equity.
E = 1000 x $50 = $50,000
D= $25,000
V = E + D = $75,000
Effects of Leverage
What happens if WPS levers up again by borrowing
an additional $10,000 and at the same time paying
out a special dividend of $10 per share, thereby
substituting debt for equity?
This should have no impact on WPS assets or total
cash flows:
V is unchanged
D= $35,000
E= $75,000 - $35,000 = $40,000
Stockholders will suffer a $10,000 capital loss which
is exactly offset by the $10,000 special dividend.
Effects of Leverage
What if instead of assuming V is unchanged
we allow V it rise to $80,000 as a result of the
change in capital structure?
Then E = $80,000 - $35,000 = $45,000
Any increase or decrease in V as a result of the
change in capital structure accrues to the
shareholders
Modigliani and Miller
Any combination of securities is as good as
any other.
Example:
Two Firms with the same operating income who
differ only in capital structure

Firm U is unlevered: V
U
=E
U

Firm L is levered: E
L
= V
L
-D
L
Modigliani and Miller
Four Strategies
Strategy 1
Buy 1% of Firm Us Equity
Dollar investment = .01V
U
Dollar Return= .01 Profits
Strategy 2
Buy 1% of Firm Ls Equity and Debt
Dollar investment= .01D
L
+ .01E
L
= .01V
L
Dollar Return=
From owning .01 D
L
.01 interest
From owning .01 E
L
.01 (Profits interest)
Total .01 Profits
Both Strategies give the same payoff
Modigliani and Miller
Strategy 3
Buy 1% of Firm Ls Equity
Dollar investment = .01E
L
= .01(V
L
-D
L
)

Dollar Return= .01 (Profits interest)
Strategy 4
Buy 1% of Firm Us Equity and borrow on your own
account .01D
L
(home-made leverage)

Dollar investment= .01(Vu D
L)
Dollar Return=
From borrowing .01D
L
-.01 interest
From owning .01 E
U
.01 (Profits)
Total .01 (Profits interest)
Both Strategies give the same payoff

Modigliani and Miller
It does not matter what risk preferences are
for investors.
Just need that investors have the ability to
borrow and lend for their own account (and at
the same rate as firms) so that they can
undo any changes in firms capital structure
M&M Proposition 1: the value of a firm is
independent of its capital structure.
Leverage and Returns
securities all of ue market val
income operating expected
r assets on return Expected
a
= =
|
.
|

\
|

+
+
|
.
|

\
|

+
=
E D A
r
E D
E
r
E D
D
r
r
D
E
r
D
r
E
M&M Proposition II
r
A
Risk free debt Risky debt
M&M Proposition 2
Bonds are almost risk-free at low debt levels
r
D
is independent of leverage
r
E
increases linearly with debt-equity ratios and the
increase in expected return reflects increased risk
As firms borrow more, the risk of default rises
r
D
starts to increase
r
E
increases more slowly (because the holders of risky debt
bear some of the firms business risk)
The Return on Equity
The increase in expected equity return reflects
increased risk
The increase in leverage increases the
amplitude of variation in cash flows available
to share-holders (the same change in
operating income is now distributed among
fewer shares)
We can understand the increase in risk in
terms of Betas
Leverage and Returns
|
.
|

\
|

+
+
|
.
|

\
|

+
=
E D A
B
E D
E
B
E D
D
B
( )
D A A E
B B
E
D
B B + =
The Traditional Position
What did financial experts think before M&M?
They used the concept of WACC (weighted
average cost of capital)
WACC is the expected return on the portfolio of all
the companys securities
WACC
|
.
|

\
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+
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.
|

\
|
= =
E D A
r
V
E
r
V
D
r WACC
WACC is the traditional view of capital
structure, risk and return.
WACC
.10=r
D
.20=r
E
.15=r
A
B
E
B
A
B
D
Risk
Expected
Return
Equity
All
assets
Debt
WACC
Example - A firm has $2 mil of debt and 100,000
of outstanding shares at $30 each. If they can
borrow at 8% and the stockholders require
15% return what is the firms WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
WACC
Example - A firm has $2 mil of debt and 100,000 of outstanding
shares at $30 each. If they can borrow at 8% and the
stockholders require 15% return what is the firms WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
12.2% or 122 .
15 .
5
3
08 .
5
2
=
|
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|

\
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+
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=
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+
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=
E D
r
V
E
r
V
D
WACC
The Traditional Position
The return on equity (r
E
) is constant
WACC declines with increasing leverage
because r
D
<r
E
Given the two assumptions above, a firm will
minimize the cost of capital by issuing almost
100% debt
This cant be correct!
r
D
V
r
D
r
E
r
A
=WACC
WACC (if r
E
does not change with
increases in leverage

)
An intermediate position
A moderate degree of financial leverage may
increase the return on equity (but less than
predicted by M&M proposition 2)
A high degree of financial leverage increases the
return on equity (but by more than predicted by
M&M proposition 2)
WACC then declines at first, then rises with
increasing leverage (U-shape)
Its minimum point is the point of optimal capital
structure.
r
D
E
r
D
r
E
WACC
WACC (intermediate view)
The intermediate position
Investors dont notice risk of moderate borrowing
They wake up with debt is excessive
The problem with this view is that it confuses default
risk with financial risk.
Default risk may not be serious for moderate amounts of
leverage
Financial risk (in terms of increased volatility of return and
higher beta) will increase with leverage even with no risk
of default

Modigliani and Miller Revisited
M&M proposition 1: A firms total value is
independent of its capital structure
Assumptions needed for Prop 1 to hold:
1. Capital markets are perfect and complete
2. Before-tax operating profits are not affected by capital
structure
3. Corporate and personal taxes are not affected by capital
structure
4. The firms choice of capital structure does not convey
important information to the market
Modigliani and Miller Revisited
M&M Proposition 2: The return on equity will
rise as the debt-equity ratio rises in order to
compensate equity holders for the additional
(financial) risk.
Note: Proposition 2 does not rely on default
risk r
E
rises because of the rise in financial
risk
r
D
E
r
D
r
E
WACC
WACC (M&M view)
Financial Risk - Risk to shareholders resulting from the
use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.

Capital Structure and Corporate Taxes
Example - You own all the equity in a company. The
company has no debt. The companys annual cash
flow is $1,000, before interest and taxes. The
corporate tax rate is 40%. You have the option to
exchange 1/2 of your equity position for 10% bonds
with a face value of $1,000.

Should you do this and why?
Capital Structure and Corporate Taxes
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
Capital Structure and Corporate Taxes
Total Cash Flow
All Equity = 600

*1/2 Debt = 640
(540 + 100)
Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x r
D
x Tc
r
D
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400
Capital Structure
Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400

Firm Value with 1/2 Debt = $6,400
Capital Structure and Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy
or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
Weighted Average Cost of Capital
without taxes (traditional view)
r
D
E
r
D
r
E
Includes Bankruptcy Risk
WACC