2021-2022 F9 (FM) Financial Management Workbook

q
G H
ACCA
Approved
Workbook
Financial Management (FM)
For exams in September 2021,
December 2021, March 2022

and June 2022
Free access to eBook & additional digital content
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ACCA
Applied Skills
Financial
Management
(FM)
G H
Workbook
For exams in September
2021, December 2021, March
2022 and June 2022
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Secondedition2021
ISBN 9781509738106 Anoteaboutcopyright
InternalISBN9781509738090 DearCustomer
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Contents
Introduction
Helping you to pass v
Chapter features vi
Introduction to the Essential reading vii
Introduction to Financial Management (FM) viii
The syllabus ix
The Exam xii
Essential skillsareas to be successful in Financial Management xiii
Specific FMskills xiii
Question practice xx
1 Financial management function 1

2 Financial management environment 21
3 Working capital investment 39
4 Cash management and workingcapital finance 71
Skillscheckpoint 1 91
5 Investment decision 99
G
6 Allowingfor tax, workingcapital and inflation 125 H
7 Project appraisal and risk 145

8 Specific investment decisions 159
9 Sources of finance 185
10 Dividendpolicy 205
11 The cost of capital 217
12 Capital structure 245
13 Business valuations 275
14 Foreign currency risk 307
15 Interest rate risk 335
Essential Reading
Financial management function 355
Financial management environment 369
Working capital investment 379
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Cash management and workingcapital finance 395
Investment decision 403
Allowingfor tax, workingcapital and inflation 417
Project appraisal and risk 423
Specific investment decisions 429
Sources of finance 441
Dividendpolicy 459
The cost of capital 463
Capital structure 469
Business valuations 483
Foreign currency risk 493
Interest rate risk 501
Further question practice 509

Further question solutions 543
Appendix1:Formulae, ratios and mathematical tables 595
Glossary 603
Index 609
Bibliography 615
G H
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Helping you to pass
BPP Learning Media – ACCA Approved Content Provider

Asan ACCAApprovedContentProvider,BPPLearningMediagivesyou the opportunityto use
study materialsreviewedby the ACCAexaminingteam. Byincorporatingthe examiningteam’s
commentsand suggestionsregardingthe depth and breadth of syllabuscoverage,the BPP
LearningMediaWorkbookprovidesexcellent,ACCA-approved supportforyourstudies.
Thesematerialsare reviewedby the ACCAexaminingteam. Theobjectiveof the reviewis to
ensurethat the materialproperlycoversthe syllabusand study guideoutcomes,used by the
examiningteam insettingthe exams,inthe appropriatebreadth and depth. Thereviewdoes not
ensurethat everyeventuality,combinationor applicationof examinabletopicsis addressed by
the ACCAApprovedContent.Nordoes the reviewcomprisea detailedtechnicalcheckof the
contentas the ApprovedContentProviderhas its ownqualityassurance processesinplace inthis
respect.
BPPLearningMediado everythingpossibleto ensurethe materialis accurate and up to date
whensendingto print.Inthe eventthat any errorsare foundafter the printdate, they are
uploadedto the followingwebsite:www.bpp.com/learningmedia/Errata.
The PER alert
Beforeyou can qualifyas an ACCAmember,you not onlyhaveto pass allyourexamsbut also
fulfila three-yearpracticalexperiencerequirement(PER).Tohelpyou to recogniseareas of the
syllabusthat you mightbe able to apply inthe workplaceto achievedifferentperformance
objectives,wehaveintroducedthe ‘PERalert’feature (seethe nextsection).Youwillfindthis
feature throughoutthe Workbookto remindyou that what you are learningto pass yourACCA
examsis equallyusefulto the fulfilmentof the PERrequirement.Yourachievementof the PER
shouldbe recordedinyouronlineMyExperiencerecord.
G H
Financial
Management
(FM)v
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Chapter features
Studyingcan be a dauntingprospect,particularlywhenyou havelotsof othercommitments.This

Workbookis fullof usefulfeatures,explainedinthe keybelow,designedto helpyou to get the
mostout of yourstudiesand maximiseyourchances of examsuccess.
Keyterm
Centralconceptsare highlightedand clearlydefinedinthe Keytermsfeature.
Keytermsare also listedinboldinthe Index,forquickand easy reference.
Formulato learn
Thisboxedfeature willhighlightimportantformulawhichyou need to learnfor
yourexam.
PERalert
Thisfeature identifieswhensomethingyou are readingwillalso be usefulforyour
PERrequirement(see‘ThePERalert’sectionaboveformoredetails).
Realworldexamples
Thesewillgivereal examplesto helpdemonstratethe conceptsyou are reading
about.
Illustration
Illustrationswalkthroughhowto apply keyknowledgeand techniquesstep by step.
G
Activity H
Activitiesgiveyou essentialpracticeof techniquescoveredinthe chapter.
Essentialreading
Linksto the Essentialreadingare giventhroughoutthe chapter. TheEssential
readingis includedinthe freeeBook,accessed viathe ExamSuccessSite(seeinside
coverfordetailson howto access this).
Atthe end of each chapter you willfinda Knowledgediagnostic,whichis a summaryof the main
learningpointsfromthe chapter to allowyou to checkyou haveunderstoodthe keyconcepts.You
willalso finda Furtherstudy guidancecontainssuggestionsforwaysinwhichyou can continue
yourlearningand enhance yourunderstanding.Thiscan include:recommendationsforquestion
practicefromthe Furtherquestionpracticeand solutions,to test yourunderstandingof the topics
inthe Chapter; suggestionsforfurtherreadingwhichcan be done,such as technicalarticlesand
ideas foryourownresearch.TheChapter summaryprovidesmoredetailedrevisionof the topics
coveredand is intendedto assistyou as you prepare foryourrevisionphase.
Introduction vi
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Introduction to the Essential reading
Theelectronicversionof the Workbookcontainsadditionalcontent,selectedto enhance your

studies.Consistingof revisionmaterials,activities(includingpracticequestionsand solutions)and
backgroundreading,it is designedto aid yourunderstandingof keytopicswhichare coveredin
the mainprintedchapters of the Workbook.TheEssentialreadingsectionof the eBookalso
includesfurtherillustrationsof complexareas.
Asummaryof the contentof the Essentialreadingis givenbelow:
Chapter Summary of Essential reading content
1 Financialmanagement • Discussionof otherissuesinfinancialmanagement:
function planning&control
• Furtherexplanationof issuesconcerningprofit-based
targets such as EPS
• Furtherdiscussionof stakeholdersand rationanalysis
includingnumericalillustrations
• Furtherdiscussionof not-for-profitorganisationsand value
formoney
2 Financialmanagement • Furtherdiscussionof fiscalpolicy,monetarypolicyand
environment exchangerate policy
• Extraexamplesof supplysidepolicy
3 Workingcapital • Discussionof differentapproaches used indifferenttypes
investment of business
• Extraillustrationsof workingcapital ratiosand overtrading
• Furtherillustrationof the effect of bulkbuyingdiscounts,
G
and of inventorybuffers H
• Exampleof just-in-time(JIT)
• Furtherdiscussionand illustrationsrelatingto receivables
policy
4 Workingcapital finance • Furtherillustrationof cash flowforecasting
• Extradiscussionof investingcash surpluses
5 Investmentdecision • Discussionof investmentexpenditurecomparedto revenue
expenditure,and of investmentdecisionsinnot-for-profit
organisations
• Discussionof the principlesof discounting
• Extradiscussionof the drawbacksof IRRand of the
advantages of DCFmethodsof investmentappraisal
6 Allowing fortax, working • Supplementaryillustrationof tax cash flows
capital and inflation • Deflatinga cost of capital
• Furtherillustrationof handlingmorethan one rate of
inflation
7 Projectappraisaland • Furtherdiscussionand illustrationof conservative
risk forecastingand simulation
8 Specificinvestment • Furtherdiscussionand numericalillustrationsrelatingto
decisions leasing,includingthe lessorand lessee
• Extraillustrationof capital rationing
9 Sourcesof finance • Furtherexamplesand discussionof sourcesof short- and
long-termfinance
vii Financial
Management
(FM)
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Chapter Summary of Essential reading content
• Discussionof the advantages, methodsand costs of a stock
marketlisting
• Discussionof Islamicfinance
10 Dividendpolicy • Furtherdiscussionof dividendpolicy
11 Cost of capital • Generaldiscussionof riskand return
• Furtheranalysisof the dividendgrowthmodeland CAPM
12 Capital structure • Furtherdiscussionand illustrationsof practicalfinancial
ratiosand of net operatingincomeand peckingorder
theory
• Extraillustrationof a projectspecificcost of capital
• Furtherdiscussionof financeforSMEs
13 Businessvaluations • Furtherdiscussionof informationneeded forvaluations
• Extraillustrationsof the valuationof debt
• Furtherdiscussionof marketefficiency
14 Foreigncurrencyrisk • Furtherdiscussionand illustrationof basic and more
complexhedgingtechniques
• Furtherdiscussionof purchasingpowerparity theory
15 Interestrate risk • Furtherillustrationof FRAsand discussionof future
• Furtherdiscussionof the yieldcurve
G
Introduction to Financial Management (FM) H
Overall aim of the syllabus

Thisexamaimsto developthe knowledgeand skillsexpectedof a financialmanager, relatingto
issuesaffectinginvestments,financing,and dividendpolicydecisions.
Introduction viii
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The syllabus
Thebroad syllabusheadingsare:
A Financialmanagementfunction
B Financialmanagementenvironment
C Workingcapital management
D Investmentappraisal
E Businessfinance
F Businessvaluations
G Riskmanagement
H Employabilityand technologyskills
Main capabilities
On successfulcompletionof thisexam,candidates shouldbe able to:
• Discussthe roleand purposeof the financialmanagementfunction
• Assessand discussthe impactof the economicenvironmenton financialmanagement
• Discussand apply workingcapital managementtechniques
• Carry out effectiveinvestmentappraisal
• Identifyand evaluatealternativesourcesof businessfinance
• Explainand calculatethe cost of capital and the factorswhichaffect it
G
• Discussand apply principlesof businessand asset valuations H
• Explainand apply riskmanagementtechniquesinbusiness

• Applyemployabilityand technologyskills
Links with other exams
Strategic Business Advanced Financial

Leader (SBL) Management (AFM)
Financial
Management (FM)
Management
Accounting (MA)
Thediagramshowswheredirect(solidlinearrows)and indirect(dashedlinearrows)linksexist
betweenthisexamand otherexamsprecedingor followingit.
TheAdvancedFinancialManagement(AFM) syllabusassumesknowledgeacquiredinFinancial
Management(FM),and developsand appliesthisfurtherand ingreater depth.
ix Financial
Management
(FM)
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Achieving ACCA’s Study Guide Learning Outcomes
ThisBPPWorkbookcoversallthe FMsyllabuslearningoutcomes.Thetables belowshowinwhich
chapter(s)each area of the syllabusis covered:
A Financialmanagementfunction
A1 Thenature and purposeof financialmanagement Chapter 1

A2 Financialobjectivesand the relationshipwithcorporatestrategy Chapter 1
A3 Stakeholdersand impacton corporateobjectives Chapter 1
A4 Financialand otherobjectivesinnot-for-profitorganisations Chapter 1
B Financialmanagementenvironment
B1 Theeconomicenvironmentforbusiness Chapter 2
B2 Thenature and roleof financialmarketsand institutions Chapter 2
B3 Thenature and roleof moneymarket Chapter 2
C Workingcapital management
C1 Thenature, elementsand importanceof workingcapital Chapter 3

G
C2 Managementof inventories,accounts receivable,accounts payable Chapter 3 H
and cash
C3 Determiningworkingcapital needs and fundingstrategies Chapter 4
D Investmentappraisal
D1 Investmentappraisaltechniques Chapter 5
D2 Allowing
forinflationand taxationinDCF Chapter 6
D3 Adjustingforriskand uncertainty Chapter 7
D4 Specificinvestmentdecisions Chapter 8
E Businessfinance
E1 Sourcesof and raisingbusinessfinance Chapter 9, 10

E2 Estimatingthe cost of capital Chapter 11
E3 Sourcesof financeand theirrelativecosts Chapter 11
E4 Capital structuretheoriesand practicalconsiderations Chapter 12
E5 Financeforsmalland medium-sizedenterprises Chapter 12
Introduction x
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F Business
valuations
F1 Nature
andpurpose
ofthevaluation
ofbusiness
andfinancial
assets Chapter
13
F2 forthevaluation
ofshares Chapter
13Models
F3 Thevaluation
ofdebtandotherfinancial
assets Chapter
13
F4 markethypothesis
andpractical
considerations
inthe Chapter
13Efficient
valuation
ofshares
RiskmanagementG
G1 Thenature
andtypesofriskandapproaches
toriskmanagement Chapter
14,15
G2 Causesofexchange
ratefluctuations
andinterest
ratefluctuations Chapter
14,15
G3 Hedging
techniques
forforeign
currency
risk Chapter
14
G4 Hedging
techniques
forinterest
raterisk Chapter
15
H Employability
andtechnology
skills
H1 Usecomputertechnology
toefficiently
accessandmanipulate Examskill
relevant
information
G
H2 onrelevant
response
options,usingavailable
functions
and ExamskillWork H
technology,
aswould
berequired
intheworkplace
H3 Navigate
windows
andcomputer
screenstocreateandamend Examskill
responses
toexamrequirements,
usingtheappropriate
tools
H4 Present
dataandinformation
effectively,
usingtheappropriate
tools Examskill
Thecomplete
syllabus
andstudyguidecanbefoundbyvisiting
theexamresource
finder
onthe
ACCAwebsite:
www.accaglobal.com/gb/en.html.
xi Financial
Management
(FM)
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The Exam
Computer-basedexams
Applied
Skillsexams
areallcomputer-based
exams
(CBE).
Approachto examiningthe syllabus
TheFinancial
Managementsyllabus
isassessedbya three-hour
exam.Thepassmarkis50%and
allquestions
intheexamarecompulsory.
Youwillbeexpected
todemonstrate
a broadknowledge ofthesyllabus
topics,
andanabilityto
applyyourknowledgeandunderstanding
ofthesubjecttoanswer numerical
anddiscussion-
basedquestions.
Thebalanceoftheexamwillbeapproximately
50:50intermsofthenumber ofmarksavailable
fordiscussion
andthenumber ofmarksavailable
fornumerical
calculations.
Formatof theexam Marks
Section Fifteen
objectivetestquestions
worthtwomarkseach. 30
A Questions
willbeselectedfromtheentire
syllabus.
Someofthe
questions
willbenumericalandsomewillbediscussion
based.
Theresponses toeachquestion
aremarked automatically
as
either
correctorincorrect
bycomputer.
Section Threeminicase-study
questions worth10marks each. 30
B Eachminicase-study
question consists
offiveobjective
test
questions
worthtwomarks each.
Someofthequestionswillbenumericalandsomewillbe
discussion
based.
G H
Theresponsestoeachquestion aremarked automatically

as
either
correct
orincorrect
bycomputer.
Eachminicase-study
question willbemainlybasedona single
syllabus
section.
Case-studyquestions
canbebasedonanyareaofthesyllabus
Section Twocompulsory 20-mark questions 40
C Each20-mark questionwillconsist ofa variety
ofnumerical
sections
(tobecompleted ina spreadsheet)andalsodiscussion
sections.
Section
C questionswillmainly focusonthefollowingsyllabus
areasbuta minorityofmarks canbedrawn fromanyotherarea
ofthesyllabus:
• Working capitalmanagement (syllabus
areaC)
• Investmentappraisal(syllabus areaD)
• Businessfinance(syllabusareaE)
Theresponsestothesequestions arehuman marked.
100
Introduction
xii
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Essential skills areas to be successful in Financial
Management
Wethinktherearethreeareasyoushould
develop
inorder
toachieve
examsuccess
inFinancial
Management(FM).
These
areshown inthediagram below:
(1) Knowledge application
(2) SpecificFMskills
(3) Examsuccess skills
msuccess
Exa skills
swer
An planning
n cFM
ecifi sk
ills Co
tio Sp o rre
ma f c
or reqtin
f u ter
gin
in Approach
to for Technique irem
i nvestment
pr
eta
ag objective
test appraisal e
n
n
a (OT)
questionscalculations s tino
t
M
How
to Handling
G approach
o your
FM complex
calculations sis
y
o
d exam l
a
tim Effective an
l
em discussion a
an ofkey
meric
ag financial
topics nu
em nt
ent cie
G
Effi H
Eff
ective g
writin
andpresentat
ion
Specific FM skills
These aretheskillsspecific
toFMthatwethinkyouneedtodevelop inorder topasstheexam.
InthisWorkbook,therearefiveSkillsCheckpoints
whichdefine eachskillandshowhowitis
appliedinanswering a question.
Abriefsummaryofeachskillisgivenbelow.
xiii Financial
Management
(FM)
Page 14 of 641
q
Skill 1:Approachto objectivetest (OT) questions
Section A oftheexamwillinclude 15OTquestionsworthtwomarks each.Section
B oftheexam
willincludethreeOTcases,worth 10markseach.EachOTcasecontains a groupoffiveOT
questions basedaround a singlescenario.
60%ofyourFMexamistherefore madeupofOT
questions.Itisessential
thatyouhavea goodapproach toansweringthesequestions.
OT
questions areauto-marked;yourworkings willtherefore
notbeconsidered;
youhavetoanswer
thewhole question
correctlytoearntheirtwomarks.
Astep-by-step techniquefortacklingOTquestionsisoutlined
below:
GeneralguidanceforapproachingOTquestions
STEP1:Answer thequestions youknow first.
Ifyou’re
having
difficulty
answeringaquestion,
move
onandcome backtotackle
it
onceyou’veansweredallthequestions
youknow.
Itisoften
quicker
toanswer discursive
style
OTquestions
first,
leaving
moretime
forcalculations.
General guidanceforapproaching OTquestions

STEP2:Answer allquestions.
There isnopenaltyforanincorrect
answerinACCAexams; thereisnothing
tobe
gained byleavinganOTquestion unanswered.
Ifyouarestuckonaquestion,
asa
lastresort,
itisworthselecting
theoptionyouconsidermostlikely
tobecorrect
andmoving on.Flagthequestion,
soifyouhave timeafter
you’veanswered
the
restofthequestions,youcanrevisit
it.
G
Guidance
foransweringspecific
OTquestions H
STEP3:Readtherequirementfirst!
Therequirement
willbestated
inboldtextintheexam.Identify
whatyouare
being
askedtodo,anytechnical
knowledgerequired
andwhattypeofOT
question
youaredealingwith.
Lookforkeywordsintherequirement
such
as
"which
TWOofthefollowing,"
or" whichofthefollowing
isNOT".
Guidanceforanswering
specificOTquestions
STEP4:Applyyourtechnical
knowledge tothedatapresented
inthequestion.
Takeyour
timeworkingthroughcalculations,
making
suretoreadthrough
each
answeroption
withcare.
OTquestionsaredesigned
sothateachanswer
option
isplausible.
Work througheachresponse
option
andeliminate
those
youknow
areincorrect.
SkillsCheckpoint
1covers thistechnique
indetailthrough
application
toanexam-standard OT
casequestion.
Itwillalsolookatthedifferent
typesofOTquestionsyouarelikelytoseeinyour
FMexam.
Introduction
xiv
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Skill 2: Techniquefor investmentappraisalcalculations
SectionC oftheFMexamoftenincludes a question
oninvestment
appraisal.
Youmaybeaskedto
calculate
thenetpresentvalue(NPV)ofa project
andadvise whether
theinvestment
isfinancially
acceptable.Section
C ishuman markedandthereforeitisimportant
thatyourcalculations
are
laidoutclearly.
KeystepsinpreparinganNPVcalculationareoutlined
below:
STEP1:
Useastandard
NPVproforma.Thiswillhelpthemarkertounderstand
your
workings
andallocate
themarkseasily.
Itwillalsohelpyoutowork
through
the
figures
inamethodical
andtime-efficient
way.
STEP2:
Input
easynumbersfromthequestion
directly
ontoyour
proforma.
Thiswillmake
sure
thatyoupickupasmanyeasymarks
aspossible
before
dealing
withmore
detailed
calculations.
STEP3:
Always
useformulae toperform
basic
calculations.
Don't
write
outyourworking
in
asingle
cell;thiswastes
timeandyoumaymake amistake.
Usethespreadsheet
formulae
instead!
G
STEP4: H
Showclear
workings
foranycomplexcalculations.
Morecomplexcalculations
suchasthetaxrelief
ontaxallowable
depreciation
will
require
aseparateworking.
Keepyourworkingsasclear
andsimple
aspossible
and
ensure
theyarecross-referenced
toyourNPVproforma.
SkillsCheckpoint
2 covers
thistechnique
indetailthrough
application
toanexam-standard
question.
Skill 3: Handlingcomplexcalculations
Thebusiness
finance
section
ofthesyllabusofteninvolves
complex
calculations
suchasthe
weighted
average
costofcapital(WACC)orungearingandre-gearing
betafactors.
Financial
Management
(FM)xv
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q
Astep-by-step
technique
forhandling
complex
calculations
isoutlined
below:
STEP1:Understanding thedatainthequestion
Where aquestionincludes asignificant
amount ofdata,readtherequirements
carefully
tomake surethatyouunderstand clearly
whatthequestion isasking
youtodo.Youcanusethehighlighting function
topulloutimportantdatafrom
thequestion.
Usethedataprovided tothinkaboutwhat formulayouwillneedto
use.Forexample ifyouaregiven abetafactor
youwilluseCAPMtocalculate the
costofequity,
ifyouaregiven adividendgrowthrateitwillbethedividendgrowth
model.Ifthequestionstatesthatthedebtisredeemable youwillneedtousethe
IRRformulatocalculatethecostofdebt.
STEP2:Useastandard proformaworking.
Forexample,
ifyouareaskedtocalculate
theWACCuseyour
standardproforma
orapproach
forcalculating
WACCandseparatelywork
throughtheindividual
parts
ofthecalculation
(Ke,Kd,Ve,Vd).
STEP3:Usespreadsheet
formulae
toperform
basiccalculations.
Donotwrite
outyour
workings,
thiswastes
Use
thespreadsheet
formulae
instead!
SkillsCheckpoint
3 covers
thistechnique
indetailthrough
application
toanexam-standard
question.
Step 4: Effectivediscussionof key financialtopics
G H
Thebalance oftheFMexamwillbeapproximately 50:50interms ofthenumber ofmarks

available
fordiscussion
andthenumber ofmarks available
fornumerical calculations.
Itisvery
temptingtoonlypractise
numericalquestions,
astheyareeasytomarkbecause theanswer can
onlyberightorwrong, whereaswritten
questionsaremoresubjective,anda rangeofdifferent
answerswillbegivencredit.
Evenwhenattempting written
questions,itistempting towritea brief
answerplanandthenlookattheanswer rather
thanwritinga fullanswertoplan.Unless you
practise
writtenquestions
infulltotime,youwillneveracquirethenecessary skillstotackle
discussion
questions.
Introduction
xvi
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q
Astep-by-steptechniqueforeffectivediscussionof keyfinancialtopicsis outlinedbelow:
STEP1: Readandanalysethe requirement.

Theactiveverbusedoftendictatestheapproachthatwrittenanswersshould
take.Forexample,'discuss'meansto examineindetailbyusingargumentsin
favouroragainst.
Workouthowmanyminutesyouhaveto answereachsubrequirement.
STEP2: Readandanalysethe scenario.

Identifythetypeofcompanyyouaredealingwithandhowthefinancial topicsin
therequirementrelateto thattypeofcompany.Asyougo throughthescenario
youshouldbe highlightingimportantinformation
whichyouthinkwillplaya key
roleinansweringthespecificrequirements.
STEP3: Planyouranswer
Ensureyouranswerisbalancedintermsofidentifyingthepotentialbenefitsand
limitations
oftopicsthatarebeingdiscussedorrecommended.
Step4: Writeyouranswer
Asyouwriteyouranswer,trywhereverpossibleto applyyouranalysisto the
scenario,insteadofsimplywritingaboutthefinancial
topicingeneric,
technicalterms.
Asyouwriteyouranswer,explainwhatyoumean–inone(ortwo)sentence(s) –
andthenexplainwhythismattersinthe givenscenario.Thisshouldresultina
seriesofshortparagraphsthataddressthespecificcontextofthescenario.
G H
SkillsCheckpoint4 coversthistechniqueindetailthroughapplicationto an exam-standard

question.
Skill 5: How to approach your FM exam
Youcan answeryourFMexaminwhateverorderyou prefer.Itis importantthat you adopt a
strategy that worksbest foryou.Wewouldsuggest that you decideon yourpreferredapproach
and practiceit by doinga timedmockexambeforeyourreal exam.
Asuggestedapproach to tacklingyourFMexamis outlinedbelow.
CompleteSectionAfirst– allocated time54 minutes
Tackleany easierOTquestionsfirst.Oftendiscursivestylequestionscan be answeredquickly,
savingmoretimeforcalculations.Donot leaveany questionsunanswered.Evenifyou are unsure
makea reasonedguess.
CompleteSectionBnext – allocated time54 minutes
Youwillhave18minsof examtimeto allocateto each of the three OTcase questionsinSectionB.
Usethe same approach to OTquestionsas discussedforSectionA.
Therewillnormallybe three discursiveand twonumericalquestionswithineach case. Again,it is
better to tacklethe discursivetype questionsfirstand makea reasonedguess forany questions
you are unsureon.
Finally,completeSectionC – allocated time72 minutes
Start withthe questionyou feelmostconfidentwith.Thefirstsub requirementwillnormallyinvolve
somedetailedcalculations;these tend to be verytimepressured.Donot spend so muchtimeon
the calculationsthat you loseout on the easierdiscursivemarks.
SkillsCheckpoint5 coversthistechniqueinmoredetail.
xvii Financial
Management
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Page 18 of 641
q
Examsuccess skills
PassingtheFMexamrequires morethanapplying syllabus
knowledge
anddemonstratingthe
specific
FMskills.
Italsorequiresthedevelopment ofexcellent
examtechniquethroughquestion
practice.
Weconsiderthefollowingsixskillstobevitalforexamsuccess.TheSkillsCheckpoints
showhow
eachoftheseskillscanbeapplied intheexam.
Examsuccess skill1
Managing information
Questionsintheexamwillpresentyouwitha lotofinformation.Theskillishowyouhandle this
informationtomakethebestuseofyourtime.Thekeyisdetermining howyouwillapproach the
examandthenactively reading
thequestions.
Adviceondeveloping Managinginformation
Youmusttakeanactiveapproach toreadingeachquestion.Focusontherequirement first,
underlining
keyverbssuchas‘evaluate’,‘analyse’,
‘explain’,
‘discuss’,
toensure youanswer the
questionproperly.Thenreadtherestofthequestion,underlining
(usingtheWordprocessing
functionality)
andannotating importantandrelevantinformation,
andmaking notesofany
relevant
technicalinformation
youthinkyouwillneed(usingthescratch padprovided).
Examsuccess skill2
Correctinterpretation oftherequirements
Theactiveverbusedoftendictates theapproach thatwritten
answersshouldtake(eg‘explain’,
‘discuss’,
‘evaluate’).Itisimportant youidentifyandusetheverbtodefine yourapproach.
Correctly interpreting therequirements means correctlyproducing
onlywhatisbeingaskedfor
bya requirement. Anything notrequired willnotearnmarks.
Adviceondeveloping theCorrectinterpretation oftherequirements
G
Thisskillcanbedeveloped byanalysing question requirements
andapplying thisprocess: H
Step1:Readtherequirement
Firstly,
readtherequirement a couple oftimes slowlyandcarefully,
highlighting
theactiveverbs.
Usetheactiveverbstodefine whatyouplantodo.Makesureyouidentify anysub-requirements.
InFM,itisimportant thatyoudothisnotonlyforsection C questions
butalsoforOTquestions
in
sections AandB.
Step2:Readtherestofthequestion
Byreading therequirement first,youwillhaveanideaofwhatyouarelooking outforasyouread
through thecaseoverview andexhibits. Thisisa greattimesaverandmeans youdonotendup
having toreadthequestion infulltwice.Youshould dothisinanactiveway– seeExamsuccess
skill1:Managing Information.
Step3:Readtherequirement again
Readtherequirement againtoremind yourself oftheexactwordingbeforestarting
yourwritten
answer. Thiswillavoidanymisinterpretation oftherequirementsoranymissing ofentire
requirements.Thisshould become a habitinyourapproach and,withrepeatedpractice,
youwill
findthefocus,relevance anddepthofyouranswer planwillimprove.
Examsuccess skill3
Answer planning: Priorities,
structureandlogic
Thisskillrequires theplanning ofthekeyaspects ofananswer whichaccurately
andcompletely
responds totherequirement.
Adviceondeveloping Answer planning: Priorities,
structure
andlogic
Everyone willhavea preferred styleforananswer plan.Forexample,
itmaybea mindmap,
bullet-pointed listsorsimplyannotating thequestion paper.
Choosetheapproach thatyoufeel
mostcomfortable withor,ifyouarenotsure,tryoutdifferent approaches
fordifferent
questions
untilyouhavefoundyourpreferred style.
Introduction
xviii
Page 19 of 641
q
Fora discussion
question,
annotating
thequestion
paperislikelytobeinsufficient.
Itwould
be
better
todrawupa separate answer
planintheformat
ofyourchoosing (ega mindmapor
bullet-pointed
lists).
Examsuccess skill4
Efficientnumerical analysis
Thisskillaimstomaximise themarks awarded bymaking cleartothemarker theprocess of
arrivingatyouranswer. Thisisachieved bylayingoutananswer suchthat,evenifyoumakea
fewerrors, youcanstillscoresubsequent marks forfollow-on calculations.
Itisvitalthatyoudo
notlosemarks purely because themarker cannot followwhatyouhavedone.
Adviceondeveloping Efficient
numerical analysis
Thisskillcanbedeveloped byapplying thefollowing process:
Step1:Usea standard proforma workingwhere relevant
Ifanswers canbelaidoutina standard proforma thenalwaysplantodoso.Thiswillhelpthe
marker tounderstand yourworking andallocate themarks moreeasily.Itwillalsohelpyouto
workthrough thefigures ina methodicalandtime-efficient way.
Step2:Showyourworkings
Keepyourworkings asclearandsimple aspossible andensure theyarecross-referenced tothe
mainpartofyouranswer. Where ithelps,providebriefnarrative
explanations tohelpthemarker
understand thestepsinthecalculation. Thismeans that,ifa mistake
ismade,youdonotloseany
subsequent marks forfollow-oncalculations.
Step3:Keepmoving!
Itisimportant toremember that,inanexamsituation, itcansometimes bedifficulttogetevery
number 100%correct. Thekeyistherefore ensuringyoudonotspendtoolongonanysingle
calculation.Ifyouarestruggling witha solutionthenmakea sensible assumption, stateitand
move on.
G H
Examsuccess skill5
Effective
writingandpresentation
Writtenanswersshould bepresented sothatthemarker canclearlyseethepoints youare
making,presented intheformat specified
inthequestion.Theskillistoprovideefficientwritten
answerswithsufficientbreadth ofpointsthatanswer thequestion, intherightdepth,inthetime
available.
Adviceondeveloping Effectivewriting andpresentation
Step1:Useheadings
Usingtheheadings andsub-headings fromyouranswer planwillgiveyouranswer structure,
orderandlogic.Thiswillensure youranswer linksbacktotherequirement andisclearly
signposted,
making iteasierforthemarker tounderstand thedifferentpointsyouaremaking.
Underlining
yourheadings willalsohelpthemarker.
Step2:Writeyouranswer inshort,butfull,sentences
Useshort,clearsentences toavoidwaffle, andaimtomakeeachsentence saysomething
different
togenerate marks. Writeinfullsentences;ensuringyourstyleisprofessional.
Step3:Doyourcalculations firstandexplanation second
Questionsoftenaskforanexplanation withsuitable
calculations.
Thebestapproach istoprepare
thecalculation
firstbutpresent itonthebottom halfofthepageofyouranswer, oronthenext
page.Thenaddtheexplanation beforethecalculation.
Performing thecalculation
firstshould
enableyoutoexplain whatyouhavedone.
xix Financial
Management
(FM)
Page 20 of 641
q
Examsuccess skill6
Goodtimemanagement
Thisskillmeans planningyourtimeacrossalltherequirements sothatalltaskshavebeen
attempted attheendofthethreehours available andactively checking ontimeduring your
exam.Thisissothatyoucanflexyourapproach andprioritise
requirementswhich, inyour
judgement, willgeneratethemaximum marks intheavailable timeremaining.
Adviceondeveloping goodtimemanagement
Theexamisthreehours long,whichtranslates to1.8minutes permark.EachOTquestion in
SectionA should beallocated3.6mins.SomeOTquestions involvingcalculations
maytake
slightly
longer thanthis,however thiswillbebalanced outwithotherdiscursivetypeOTquestions
thatcanbeanswered morequickly. EachOTcaseinSection B should beallocated18minutes to
answer thefivequestions totalling
tenmarks. EachSection C question isworth20marks and
thereforeshould beallocated36minutes. Itisalsoimportant toallocate timebetween eachsub-
requirement.
Keepaneyeontheclock
Aimtoattempt allrequirementsbutbereadytoruthlessly move onifyouranswer isnotgoingas
planned. Thechallenge formanyissticking toplanned timings.Beawarethisisdifficultto
achieve intheearlystagesofyourstudies andbereadytoletthisskilldevelop overtime.
Ifyoufindyourself runningshortontimeandknowthata fullanswer isnotpossible inthetime
youhave,consider recreating
yourplaninoverview formandthenaddingkeyterms anddetails
astimeallows. Remember, somemarks maybeavailable, forexample, forsimplystating a
conclusion whichyoudonothavetimetojustify infull.
Question practice
Question
practice
isa corepartoflearning
newtopicareas.Whenyoupractice questions,
you
G
should
focusonimprovingtheExamsuccess skills– personal
toyourneeds– byobtaining H
feedback
orthrougha processofself-assessment.
Introduction
xx
Page 21 of 641
q
G H
xxi Financial
Management
(FM)
Page 22 of 641
q
1
Financial management
function
1
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
Thenature
andpurpose offinancial
management
• Explain
thenatureandpurposeoffinancial
management. A1(a)
• Explain
therelationship
betweenfinancial andfinancial A1(b)
management
andmanagement accounting.
Financial
objectives
andtherelationshipwithcorporate
strategy
• Discusstherelationship
between financial
objectives,
corporate A2(a)
G
objectives
andcorporatestrategy. H
• Identify
anddescribea variety
offinancial
objectives,
including: A2(b)
shareholder
wealth maximisation,
profit
maximisation,
earnings
per
sharegrowth.
Stakeholders
andimpact oncorporate objectives
• Identify
therangeofstakeholdersandtheirobjectives. A3(a)
• Discuss
thepossibleconflict
between stakeholderobjectives. A3(b)
• Discuss
theroleofmanagement inmeeting stakeholder
objectives, A3(c)
including
theapplication
ofagencytheory.
• Describeandapplywaysofmeasuring achievementofcorporate A3(d)
objectives
including:
ratioanalysis(usingappropriateratiossuchas
ROCE,ROE,EPSandDPS)andchanges individends
andshareprices
aspartoftotalshareholderreturn.
• Explain
waystoencourage theachievement ofstakeholderobjectives, A3(e)
including:
managerialrewardschemes (suchasshareoptions and
performance-related
pay),regulatoryrequirementssuchascorporate
governance codesofbestpracticeandstockexchange listing
regulations.
Financial
andotherobjectives
innot-for-profit
organisations
• Discusstheimpactofnot-for-profit
(NFP)status andother A4(a)
onfinancial
objectives.
• Discussthenature
andimportance ofvalueformoneyasanobjective A4(b)
inNFPorganisations.
• Discusswaysofmeasuringtheachievementofobjectives
inNFP A4(c)
organisations
1
Page 23 of 641
q
Exam context
Thischapter coversSectionA ofthesyllabus

(thefinancial
management function).
Thisisanimportant chapterthatiscommonly examinedinSectionA oftheexamandcouldalso
featureina SectionB minicasestudyscenario question.
Partofa SectionC examquestioncould
examine someofthethemes ofthischapter,
buttheseareaswillnotbethemainfocusofa
SectionC question.
Thischapter alsosetsoutthemainthemes offinancial
management; thesewillbecovered
inlater
chapters.
G H
2 Financial
Management
(FM)
Page 24 of 641
q
1
Chapter overview
Financialmanagementfunction
Definition Framework
formaximising Encouraging
shareholder
shareholder
wealth wealth
maximisation
Total
shareholder
return
(TSR) Investment
decision Agency
theory
Maximisation
of Financing
decision Incentive
schemes
shareholder
wealth
Dividend
decision Corporate
governance
EPS
Risk
management
Other Not-for-profit Financial

management
stakeholders organisations compared
to
management
and
G
financial
accounting H
Internal
stakeholders Profit
ratios Value
formoney Different
from
management
accounting
Connected
stakeholders Debt
ratios
Different
fromfinancial
External
stakeholders Liquidity
ratios accounting
Shareholder
ratiosNon-financial
performance
measures
1:Financial
management
function 3
Page 25 of 641
q
1 Purpose of financial management
1.1 Definition of financial management
Financial
management:
Theacquisition
anddeployment
offinancial
resources
toachieve
key
KEY
TERM objectives.
Wecananalyse
thisdefinition
bybreaking
itdownintoitsseparate
parts.
1.1.1 Acquisitionoffinancialresources
Thisinvolvesobtaining
suitable
sources offinance
andisa financing
decision.
Inselectingsourcesoffinance,
riskwillbea consideration
sincesomesources
offinancecreate
riskfora business
(ega variable
ratebankloanmayexpose a company
totheriskofinterest
rate
increases).
1.1.2 Deployment offinancialresources
Thisinvolves
usinga business’sfinancial
resources
effectively
andcaninvolve
deciding
whetheror
nottoinvest
inprojects(theinvestmentdecision),
andwhether ornottoreturn
surplus
cashto
shareholders
(thedividenddecision).
Whenmaking investments,
riskwillagainbea consideration.
1.1.3 Keyfinancialobjectives– profits
Profitmaximisationisoftenassumedtobethemainfinancialobjective
ofa business.
Infactthisisnottheassumption madeinfinancial
management and,inreality,
shareholders
oftenexpressdisappointmentina company’sperformanceevenwhenprofits
arerising;this
suggeststhatprofitisnotsufficient
asa financial
objective.
Activity1:Financialobjectives
G H
BCohasjustreleaseditsfinancial
results
fortheyearanditsprofits before
taxincreased
by38%
overtheprevious
year.Thiswasduelargelytoa doublingofsalesinSouth-East
Asia.However,
the
sharepriceinBCofellbyalmost20%immediately aftertheprofitannouncement.
Required
Whichofthefollowing
istheLEASTlikelyexplanation
forthefallinshareprice?
 SalesinSouth-East
Asiahadbeenexpected toincreasebymorethan100%.
 Thedepreciation
chargewashigher duetoa changeinaccounting policy.
 ThelevelofBCo’sbusiness
riskhasincreasedovertheyear.
 Delaysinthelaunchofnewproducts areexpectedinthecoming year.
Profit,asa financial
objective,
hasa number ofdrawbacks:
(a) Itishistoric
andisnotfuture-oriented
(i) Ittherefore
doesnotmeasure thefuturepotential
ofa company
(b) Itdoesnotmeasure liquidity
orrisk
(i) Bothareimportantcommercial issues
(c) Itcanbemanipulated
(i) egbytheuseofaccounting policies
However, profit
andprofit-based
ratiossuchasearningspersharewillcontinue
tobemonitored
byinvestors astheyareevidenceofthereturnsthathaveactually
beenachieved bya company.
Earnings
pershare(EPS):Profits
distributable
toshareholders/Number
ofordinary
shares
KEY
TERM
4 Financial
Management
(FM)
Page 26 of 641
q
Distributable
profits
willbeafterinterest,
taxandpreference
dividends.
Otherprofit-based
ratios(suchasreturn
oncapitalemployed)
arecoveredlaterinthechapter.
1.1.4 Keyfinancialobjectives– shareholder wealthmaximisation
Fora for-profit
company, maximisationofshareholder wealth isassumed tobethemain
financial
objective, although
profit-basedobjectivesarestillimportant.
Thewealth oftheshareholders ina company comes from:
• Dividends received
• Market valueoftheshares
Themarket valueofshareswilldepend ontheforecast future cashflowsofthecompany, andthe
perceivedriskofthesecashflows. These forecastswillresult
froma financial analysis
ofthe
impact ofa firm’slong-term
business plans,ieitscorporatestrategy.
Theabilityofa firmtocreatewealth forshareholdersismeasured bytotalshareholder
return
(TSR).
Totalshareholder
return:
Dividend
+changeinshareprice/Share
priceatthestartoftheyear
KEY
TERM
Illustration1:TSR
Ashareholder
purchased1,000shares
inSJG Coon1January20X1ata marketpriceof$2.50
pershare.
On31December 20X1theshares
hada market
valueof$2.82pershare.
Thedividend
paidduring20X1was$0.28pershare.
Required
Calculate
totalshareholder
return.
Solution
G H
Capitalgainduring
theyearis$2.82- $2.50=$0.32
Thetotalshareholder
return
is:
($0.28+$0.32)/$2.50
=0.24or24%
Thisismadeupofthecapitalgainof$0.32/$2.50
=0.128or12.8%
andthedividend
return
ordividendyieldof$0.28/$2.50
=0.112
or11.2%
Examfocus point
Studentsoftenforgettousethestartofyearsharepriceasthedenominator
whencalculating
thetotalshareholderreturn.
Thestartoftheperiodsharepriceneedstobeused,asthereturn
beingcalculatedisthereturn
onthesharepricepaidatthestartoftheperiod.
Activity2: Calculation of financialobjectives
Magneto plchasobjectives
toimprove
earnings
pershare(EPS)anddividends
pershare(DPS)by
10%p.a.
1:Financial
management
function 5
Page 27 of 641
q
Lastyear Current
year
$m $m
Profits
before
interest
andtax 22,300 23,726
Interest 3,000 3,000
Tax 5,790 6,218
Profits
afterinterest
andtax 13,510 14,508
Preference
dividends 200 200
Dividends 7,986 8,585
Retained
earnings 5,324 5,723
No.ofordinarysharesissued
(millions) 00,000 100,000
Ordinarysharepriceatthe
endoftheyear $4.70pershare $5.16pershare
Required
1 Whatisthecurrent
yearearnings
perordinary
share?
 14.5cents
 14.3cents
 5.7cents
 5.3cents
G
2 Whatisthegrowth
inthedividend
perordinary
share? H
 0%
 8.0%
 8.6%
 7.5%
3 Whatisthetotalshareholder
return
inthecurrent
year?
 11.6%
 10.6%
 9.8%
 1.8%
Solution
6 Financial
Management
(FM)
Page 28 of 641
q
Essentialreading
SeeChapter1Section1oftheEssential
reading
forfurther
discussionoffinancial
management
andfinancial
ratios.
TheEssential
readingisavailable
asanAppendixofthedigitaledition
oftheWorkbook.
2 A framework for maximising shareholder wealth
Financial
management isbasedona framework
ofdecisions
thataredesigned
tomaximise
shareholder
wealth.
Maximisation
of
shareholder
wealth
Investment
decision Financing
decision Dividend
decision
Riskmanagement
2.1 Investment decision

Firstly,
andmostimportantly, theinvestment decision
(eginprojects)
analyses
proposed
investments
toensuretheyarebeneficial totheinvestor
andmaximiseshareholder
wealth;
thisis
G
mainly covered
inChapters3,5–8and13. H
Investments
arealsocrucialinhelpinga firmtoachievekeycorporate
objectives
suchasmarket
shareandquality,
andinachieving financial
objectivessuchasimproving
earningspershare.
2.2 Financing decision
Financingdecisions
mainlyfocusonhowmuchdebta firmshould
use,anda keyaimisto
minimisethecostofcapital.
ThisareaisfocusedoninChapters4 and9–12.
2.3 Dividend decision
Thedividenddecisionconsiders
howmuchtopayouttoshareholders. Itisdetermined
byhow
mucha firmhasdecided tospendoninvestments(theinvestmentdecision)
andhowmuchofthe
finance
needed forthisithasdecidedtoraiseexternally
(thefinance
decision)
andisa good
exampleoftheinterrelationship
between thesekeydecisions.
Thedividend
decisioniscoveredinChapter 10.
2.4 Risk management
Riskneedstobeconsidered
indetermining
whattypeoffinance
toraise,howtoinvest
itand
whethertopaya dividend.
Riskmatters
toshareholders
andtherefore
needstobecarefully
managed.
Riskmanagementismainly
coveredinChapters
14–15.
1:Financial
management
function 7
Page 29 of 641
q
3 Encouraging shareholder wealth maximisation
3.1 Agency theory
Agencyrelationship:
Adescription
oftherelationship
betweenbusiness
owners(eg
KEY shareholders)
andthose
TERM thatmanagers actingasagents o ntheir
b ehalf
(egmanagers),
expressing
theidea
actasagentsfortheowners, usingdelegated
powerstorunthecompany in
theowners’
bestinterests.
Ina for-profit
company, theordinary
shareholders(equityshareholders)
aretheownersofthe
company towhom theboardofdirectorsisaccountable,
theactualpowers ofshareholders
tend
toberestricted,
except incompanieswhere theshareholdersarealsothedirectors.
Theday-to-
dayrunning ofa company istheresponsibility
ofmanagement.
Managers cantherefore besaidtobeactingastheagentsofshareholders.
However,managers (unless
theyhavea significant
equitystakeina business)
maynotbehave in
a waythatislikelytomaximise shareholder
wealth.Thedanger thatmanagers maynotactinthe
bestinterest
ofowners (egshareholders)
isreferred
toastheagencyproblem.
Examplesoftheagencyproblem
Maximisation
ofshort-term
profits
atthe Forexample,bycuttingbackoninvestments
expense
oflong-term
profits
(short-termism)– toensure
short-term
profit
targets
aremet
andtoensure profit-related
bonuses
arepaid
Minimise
dividend
payments Tofreeupfundstousewithin
thebusiness
Neglect
riskmanagement There
isoftena greater
focusonprofit
Boosttheirownpayandperks Remuneration
maybesetatexcessively
generous
levels,
thatdamageshareholder
G H
wealth
Agencyproblems
canbeaddressedbymonitoring
theactions
ofmanagement
(corporate
governance)
orbytheuseofincentive
schemes.
3.2 Corporate governance
Inmanycountries,
including
theUK,thecorporate
governance
regulations
havebeendeveloped
tomonitor
theactions
ofmanagement.
Corporate
governance:
Therulesandprocesses
bywhichthebehaviour
ofa firmisdirected.
KEY
TERM
Herearesomecommon features,
whicharepartofthelistingrequirements
formajor
stock
exchangessuchastheLondonStockExchange:
Boardof directors Key committees
• SeparateMDandchairman (toreducethe Remuneration
committee
powerofa singleindividual) • Payandincentives
ofexecutive
directors
• Significant
%oftheboardconsisting of setbyNEDs
non-executive
directors
(NEDs– part-time Auditcommittee
directors
whomonitor theactions
of
executives) • Monitors
riskmanagementprocesses
• NEDsshould beindependent(three-year • NEDsonly
contract,
noshareoptions) Nomination
committee
• Choiceofnewdirectors
byNEDs
8 Financial
Management
(FM)
Page 30 of 641
q
3.2.1 Otherstockexchangeregulations
Inaddition,
otherstockexchangerequirements
increasethescrutiny
ofdirectors
byshareholders;
forexample:
• Theregularpublication
offinancial
accounts(including
information
onfuture
strategy
andrisk
managementpolicies)
• Regularupdatestothestockexchangeontradingperformance.
Activity3: Corporategovernance
Thefollowing
statements
havebeenmadeaboutcorporate governance.
(1) Soundsystemsofcorporategovernanceinvolve
theestablishment
ofriskmanagement
and
internal
control
proceduresfortheorganisation.
(2) Goodcorporategovernancerequires
theorganisation
toalwaysactinanethically
acceptable
manner evenifthatiscontrary
tothelaw.
(3) Anon-executive
director
should notbepaidforhisservices
totheorganisation
inorder
to
keephimindependent.
Required
Whichofthesestatements
is/arecorrect?
 (1)and(2)only
 (1),(2)and(3)
 (1)only
 (3)only
G 3.3 Incentive schemes H
Goalcongruence:
Thealignment
betweentheobjectives
ofagentsactingwithin
an
KEY organisation
andtheobjectives
oftheorganisation
asa whole.
TERM
Goalcongruence maybebetter achieved andthe‘agencyproblem’ better dealtwithbyoffering
organisational
rewards(more payandpromotion) fortheachievement ofcertainlevels
of
performance.
Examples ofsuchremuneration incentives are:
(a) Performance-relatedpay(PRP)
Payorbonuses areusuallyrelated tothesizeofprofits,butotherperformance indicatorsmaybe
used.PRPmaycreateproblems ifrewards arebasedonshort-term profits
because thismay
encourage managers tofocusonshort-term profitsattheexpense oflong-term profits.
Itmaybe
bettertoawardpayona broader rangeoftargets (includingforexample, totalshareholder
return
andkeynon-financialmeasures).
Cashorshareawards maybegivenforachieving goodperformance.
(b) Shareoptions
Ina shareoptionscheme, selected employees aregivena number ofshareoptions,eachofwhich
givestheholdertherightaftera certain datetosubscribe forshares inthecompany ata fixed
price.Thevalueofanoption willincrease ifthecompany issuccessful anditssharepricegoesup.
So,managers nowhaveaninterest thatalignswithshareholders (iea highershareprice).
However,itisdebatablewhether shareoptions arereallymotivational because somemanagers
mayfeelthattherearemorepowerful forcesthantheirownperformance thatdriveshareprices
andthatthesearelargelybeyond theircontrol(egmarket sentiment).
1:Financial
management
function 9
Page 31 of 641
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4 Needs of other stakeholders
Stakeholders:
Groupsorindividuals
whose
interests
areaffected
bytheactivities
ofa firm.
KEY
TERM
4.1 Types of stakeholder
Stakeholderscanbeclassifiedas:
(a) Internal
– staff,managers
(b) Connected – finance
providers(shareholders,
banks),customers, suppliers
(c) External– government,tradeunions, pressure
groups
Shareholders arenormally
themostimportant stakeholder group,buttheinterests
ofother
stakeholdersareoftenimportanttoo.
Adifficulty
inmeeting stakeholderneedsisthatthereisoftena conflictbetweenstakeholder
objectives,
egthereisa short-term conflict
between achievingprofit
forshareholders
and
delivering
payrisestostaff.Resolving thisconflict
willrequire
thedevelopmentofacceptable
compromises, egpayrisescouldbelinked toproductivitygains.
4.1.1 Examplesofstakeholder
conflict
Between different
shareholdergroups
Someshareholdersmighthavea preference
forshort-term
dividends,
others
forlong-term
capital
gain(requiring
morecashtobereinvested,
andlesstobepaidasa dividend).
Shareholdersandstaff/customers/suppliers
Pursuit
ofshort-term
profits
mayleadtodifficult
relationships
withotherstakeholders.
For
example,relationships
withsuppliers
andcustomersmaybedisrupted bydemands forchanges
tothetermsoftrade.Employees
maybemaderedundant ina drivetoreducecosts.
Thesepolicies
mayaidshort-term
profits,
butattheexpense ofdamaging long-term
relationships
G H
andconsequentlydamaging shareholder
valueinthelongterm.
Shareholders
andexternalstakeholders
Theimpactofa company’s
activities
mayimpact
adversely
onitsenvironment,
egnoise,
pollution.
Managers andshareholders
Thishasbeendiscussed
earlier,
insection
3.1(agencytheory).
4.2 Non-financial performance measures
Toensure thattheinterests ofotherstakeholder
groupsarenotneglected,
non-financial
measures
canbeusedinaddition tofinancialmeasures.Herearesomeexamples:
(a) Staff– staffturnover(percentageofstaffleaving
during
a year)
(b) Customers – liquidity
ratios,
complaints,
market share
(c) Suppliers– payables (creditor)
days
4.3 Financial performance measures
Financial
ratiosarenormally splitintofourcategories;
eachtypeislikelytobeofinterest
to
different
stakeholders (notethattheseratiosneedtobelearnt):
(a) Profitability
ratios– important toassessmanagerialperformance
(b) Debtratios– important tobanks
(c) Liquidity
ratios– important tosuppliers
andcustomers
(d) Shareholderinvestor ratios– important
toshareholders
10 Financial
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4.3.1 Profitabilityratios
Profitability
ratiosinclude:
Return oncapitalemployed (ROCE)= (Profitfromoperations/Capitalemployed) %
Profitfromoperations=before interestandtax
Capitalemployed =equitypluslong-term debt(ortotalassetslesscurrent
liabilities)
Thisisanimportant ratiobecause youcannotassessprofitsorprofitgrowth properly without
relatingthemtotheamount offunds(thecapital)employed inmaking theprofits.
ROE(return onequity) =Profitsafterinterest
andtax/Shareholders funds
Another measure ofthefirm’soverall
performanceisreturnonequity.Thiscompares netprofit
afterinterest
andtaxwiththeequitythatshareholders haveinvested inthefirm.
4.3.2 Debtratios
Debtratiosinclude:
Gearing = Bookvalueofdebt/Book valueofequity
(alternatively
thiscouldbecalculated asdebt/(debt +equity)
andcouldusebookormarket
values,
soreadthequestion carefully)
Debtratiosareconcerned withhowmuchthecompany owesinrelationtoitssizeandwhether it
isgettingintoheavierdebtorimproving itssituation.
Themaindebtandgearing ratiosare
coveredinChapter 12.
Theinterestcoverorcoverage ratioisa measure oftheaffordability
ofinterest payments.
Interest
cover= Profitfromoperations/interest
Asa general guide,aninterestcoverage ratiooflessthanthreetimesisconsidered low,indicating
thatprofitability
istoolowgiventhegearing ofthecompany. However, a betterbenchmark would
betheindustry average interest
cover,andthisisoftengivenina question.
G
4.3.3 Liquidityratios H
Liquidity
ratiosinclude:
Current
ratio=Current assets/Current liabilities
AcidTestratio=Currentassets(lessinventory)/Currentliabilities
Acompany shouldhaveenough current assetsthatgivea promise of‘cashtocome’tomeetits
commitments topayitscurrentliabilities.
Superficially,
a currentratioinexcess
of1implies that
theorganisation
hasenough cashandnear-cash assetstosatisfyitsimmediateliabilities.
Companies areunabletoconvert alltheircurrentassetsintocashveryquickly.Insome
businesseswhereinventory
turnover isslow,mostinventoriesarenotveryliquidassets.Forthis
reason,
wecalculate anadditional liquidity
ratio,known asthequickratiooracidtestratio.
4.3.4 Shareholder investorratios
Shareholderinvestor ratiosinclude:
Dividendyield=(Dividend pershare/Marketpricepershare)×100
Earningspershare(EPS)= Profits distributable
toordinaryshareholders/Numberofordinary
sharesissued
Price/earnings(P/E)ratio=Market pricepershare/EPS
ThevalueoftheP/Eratioreflects themarket’sappraisal
oftheshare’sfuture
prospects
– themore
highlyregarded a company, thehigher
willbeitssharepriceanditsP/Eratio.
1:Financial
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Activity4: Calculation of financialobjectives
Summary
financial
information
forRobertson
plcisgivenbelow,
covering
thelasttwoyears.
Previous
year Current
year
$’000 $’000
Turnover 43,800 48,000
Costofsales 16,600 18,200
Salaries
andwages 12,600 12,900
Othercosts 5,900 7,400
Profitbefore
interest
andtax 8,700 9,500
Tax 2,400 2,800
Profitafterinterest
andtax 5,100 5,700
Dividends
payable 2,000 2,200
Shareholders’
funds 22,600 25,700
Long-term
debt 11,300 9,000
Numberofshares
inissue(‘000) 9,000 9,000
P/Eratio(average
foryear)Robertson
plc 17.0 18.0
G H
Required
Review
Robertson’s
performance
bycalculating
ROCE,interest
coverandtotalshareholder
return.
Solution
Essentialreading
SeeChapter1Section2 oftheEssential
reading
forfurther
discussionofstakeholders
andratio
analysis.
TheEssential
readingisavailable
oftheWorkbook.
12 Financial
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5 Not-for-profit organisations
5.1 Value for money
Valueformoney:Thiscanbedefined
asgetting
thebestpossible
combination
ofservices
from
KEY
TERM theleast
r esources,
whichmeansm aximising
thebenefits
forthelowest
possible
cost.
Manyorganisations
arenotforprofit.
Inthiscasetheirkeyobjective
willbetoensure
thatthe
organisation
isgetting
goodvalueformoney.
5.1.1 Valueformoney
Valueformoney involves
measuringeconomy,efficiency
andeffectiveness.
(a) Economy – purchaseofinputsofappropriate
quality
atminimum cost
(b) Efficiency– useoftheseinputstomaximise
output
(c) Effectiveness– useoftheseinputs
toachieve
itsgoals(quality,
speedofresponse)
Theexistenceofnot-for-profit
organisations
means thatweneedtorecognisethatfinancial
management isnotalwaysaboutshareholderwealth maximisation.
Essentialreading
reading
forfurther
discussionofthisarea.
TheEssential
readingisavailable
oftheWorkbook.
Activity5: Objectives
Whichofthefollowing
statementsistrue?
G H
 Theagencyproblem isnotimportant fora publicsector

organisation
because
thereareno
shareholders.
 Maximisationofshareholder
wealth istheprimary objective
offinancial
management.
 Valueformoney isnotrelevanttoa for-profit
company.
 Theagencyproblem means thatshareholder wealthisnotbeingmaximised.
6 Financial management compared to management and

financial accounting
Fromyourearlier
studies
youwillbeawareofthekeyfunctions
ofmanagement
andfinancial
accounting.
These arerecapped
andcontrastedinthefollowing
table.
Financialaccounts Managementaccounts
Details
theperformanceofanorganisation Usedtoaidmanagement tocontrol
activities
overa defined
period. andtohelpindecision
making.
Limited
companies
must,bylaw,prepare There
isnolegalrequirement
toprepare
financial
accounts. managementaccounts.
Format
ofpublished
financial
accounts
isset Theformatofmanagement
accounts
is
bylawandaccounting
standards. entirely
atmanagement
discretion.
Mostfinancial
accounting
information
isofa Management
accounts
incorporate
non-
monetarynature. monetary
measures.
1:Financial
management
function 13
Page 35 of 641
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Financialaccounts Managementaccounts
Financial
accountspresent
anessentially Managementaccountsarebotha historical
historic
picture
ofpastoperations. record
anda future
planning
tool.
Havingintroducedthescopeoffinancial
management, wecanidentify
somedifferencesbetween
financial
management andmanagement accounting becausefinancial
managementis:
• externallyfocused(analysis
isfocusedonwhatisbestforshareholders)
• concerned withlonger-term
decision-makingissues.
Also,wecansaythatfinancialmanagement differsfromfinancial
accounting
because itis:
• Forward looking
• Usefulatprovidinginformation
thatisdirectlyusedfordecision
making
• Hasnosetformat.
Activity6: Financialmanagement
Mount
Coisplanning
tomoveintoa newforeign
market.
Thiswillinvolve
acquiring
a new
warehouse,
organising
newsuppliers
anda newdistribution
network.
Required
Whichofthefollowing
aspects oftheinvestment
inCountry A would
youexpect tobethe
responsibility
offinancial
management?
 Recordingtheacquisitionofnewnon-currentassetsinMountCo’sfinancial
statements.
 Producing regular
profit
forecastsforthenewoperationinCountryA
 Managing theexchangerateriskfacedbythenewoperation
G
 Choosing thenewsuppliersthatwillbeused H
14 Financial
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Chapter summary
Financial management function
Definition Frameworkfor maximising Encouragingshareholder

shareholderwealth wealthmaximisation
Theacquisition
anddeployment Investment
decision Agencytheory
offinancial
resources
toachieve Doprojects
generatea high Managers'
goalsmaynotbe
keyobjectives enoughreturn? aligned
withowners
Totalshareholderreturn(TSR) Financing
decision Incentive
schemes
(Dividend
+capitalgain(orloss)) Howbesttoraisefinance? Mayhelpaddresstheagency
/sharepriceatstartofperiod problem(options
and
performance-related
pay)
Dividend
decision
Maximisation
ofshareholder Payoutorreinvest?
wealth Corporategovernance
Asmeasured
byTSR Especially
theuseof
Riskmanagement independent
non-executive
Ageneralconcern
for directors
EPS shareholders
Profitbasedmeasures
arealso
relevant
G H
Other Not-for-profit Financialmanagement

stakeholders organisations comparedto
managementand
financialaccounting
Internal
stakeholders Profitratios Valueformoney Different
from
Employees, ROCE, ROE Economy,efficiency, management
management effectiveness accounting
Longer-term
and
Debtratios external
focus
Connectedstakeholders Financialgearing,
Customers,
suppliers, interest
cover
bank,shareholders Different
fromfinancial
accounting
Liquidity
ratios • Forwardlooking,
no
External
stakeholders Current
ratio,quickratio setformat
Public,
government, • Directly
usedfor
pressure
groups decision
making
Shareholderratios
• P/Eratio,TSR,
Non-financial dividend
yield
performance
measures • EPS,dividendyield
Useful
formonitoring
stakeholders
1:Financial
managementfunction 15
Page 37 of 641
q
Knowledge diagnostic
1.Financialmanagement
Financialmanagement
concerns
theacquisition
anddeployment
offinancial
resources
toachieve
keyobjectives
tomaximise
shareholder
wealth;
thiscanbemeasured
bytotalshareholder
return
fora for-profit
company.
2. Frameworkformaximisingshareholder
wealth
Theinvestment
decision
isthekeymechanism
forincreasing
shareholder
wealth,
theotherkey
decisions
include
thefinancing,
dividend
andriskmanagementdecisions.
3. Agencyissues
Corporategovernance
regulations
andincentive
schemes
areusedtocombat
theagency
problem.
4. Ratioanalysis
Toassesstheimpact ofdecisions
onshareholders
andotherstakeholders,
itisimportant
to
monitor
profit,
debt,liquidity
andshareholder
ratios.
These
ratiosneedtobelearnt.
5. Valueformoney
Economy – purchaseofinputsofappropriate
quality
atminimum cost
Efficiency
– useoftheseinputstomaximise
output
Effectiveness
– useoftheseinputs
toachieve
itsgoals(quality,
speedofresponse)
G H
16 Financial
Management
(FM)
Page 38 of 641
q
Further study guidance
Question practice
Nowtry the followingfromthe Furtherquestionpracticebank (availableinthe digitaleditionof
the Workbook):
SectionAquestions
Q1,Q2, Q3
G H
1:Financial
managementfunction 17
Page 39 of 641
q
Activity answers
Activity1:Financial objectives
Thecorrectansweris:SalesinSouth-EastAsiahad been expectedto increaseby morethan
100%.
Theshare pricewillfallif:
• expected futurereturnsfall;or
• if riskrises.
Thisis the case withthe otheroptions.
Activity2: Calculation of financial objectives

1 Thecorrectansweris:14.3cents
Earningsafter preferencedividendsdividedby the numberof shares.$14,308m/100,000=
14.3cents
2 Thecorrectansweris:7.5%
Dividendper share has increasedfrom8 cents per share to 8.6 cents, a 7.5%increase.
3 Thecorrectansweris:11.6%
Dividendper share =8.6 cents
Increaseinshare price(516- 470)=46 cents
Asa percentage of the openingshare pricethisis (8.6+46)/470=11.6%.
Activity3: Corporate governance

Thecorrectansweris:(1)only
G H
Soundcorporategovernancedoes not includebreakingthe lawand a non-executivedirectorcan

expectto be paid fortheirservicesbut not insuch a waythat impairstheirindependence(egin
shares or share options).
Activity4: Calculation of financial objectives

Thequestiondoes not tellus what the share pricehas been overthe period,but it does provide
the price/earnings(P/E)ratio.Wecan derivethe share priceat the timeof the announcementof
the resultsby multiplyingthe EPSof the companyby its P/Eratiowhichshowsthe share priceas
a multipleof its EPS:
Previous year Current year
Interestcover 8,700/1,200=7.25 9,500/1,000=9.5
ROCE 8,700/33,900=25.7% 9,500/34,700=27.4%
Shareprice 17×5,100/9,000=9.63 18×5,700/9,000=11.40
Totalshareholder (0.244dividend+1.77increaseinshare
return price)/9.63start of year share price=
21%
• Thedebt leveldoes not appear to be a problem,as interestcoveris high.

• TheP/Eratio,whichis influencedby perceivedgrowthpotential,has improved.
• Totalshareholderreturnlooksimpressive,althoughwewouldneed to knowthe shareholders’
expectedreturn(coveredinChapter 11)to be sureof this.
18 Financial
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(FM)
Page 40 of 641
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Activity5: Objectives
Thecorrectanswer is:Theagencyproblem means thatshareholder
wealthisnotbeing
maximised.
Ifthereisanagencyproblem, itmeans thattheagentsoftheshareholders(egmanagers)arenot
actinginthebestinterestofshareholders.
Notesonincorrectanswers:
Theagencyproblem alsorefers tomanagers notworkinginthebestinterest
oftheorganisation;
thiscanalsohappen inthepublicsector.
Maximisationofshareholder wealth istheprimary objective
offinancial
management – thisistrue
butonlyforprofit-seekingcompanies, nottruefornot-for-profit
companies.
Valueformoney isrelevant toa for-profit
company; eventhough thetermismorecommonly
associatedwithnot-forprofitcompanies
Activity6: Financialmanagement
Thecorrect answer is:Managingtheexchange rateriskfacedbythenewoperation
Riskmanagement isa keyfunction
offinancial management, andexchangerateriskislikelytobe
anissuehere.
Notesonincorrect answers:
Recordingtheacquisition ofnewnon-current assetsinthefinancial
statementsisthe
responsibility
ofthefinancial
accounting function.
Producingregular profit
forecasts
forthenewoperation inCountryA isa management
accounting role.
Financial
management maybeinvolved intheterms oftradethatwillbeusedwithnewsuppliers,
butnotthechoiceofsuppliers (thiswillbemanaged bya purchasingdepartment).
G H
1:Financial
management
function 19
Page 41 of 641
q
G H
20 Financial
Management
(FM)
Page 42 of 641
q
2
environment
2
Learning objectives
On completionof thischapter, you shouldbe able to:
Syllabusreference
Theeconomicenvironmentforbusiness
• Identifyand explainthe mainmacroeconomicpolicytargets. B1(a)
• Defineand discussthe roleof fiscal,monetary,interestrate and B1(b)
exchangerate policiesinachievingmacroeconomicpolicytargets.
• Explainhowgovernmenteconomicpolicyinteractswithplanning B1(c)
and decision-makinginbusiness.
• Explainthe need for,and the interactionwith,planningand B1(d)
decision-makinginbusinessof:competitionpolicy,government
assistanceforbusiness,green policiesand corporategovernance
G H
regulation.
Thenature and roleof financialmarketsand institutions
• Identifythe nature &roleof money&capital markets,nationally& B2(a)
internationally
• Explainthe roleof financialintermediaries. B2(b)
• Explainthe functionsof a stockmarketand a corporatebond B2(c)
market.
• Explainthe nature and featuresof differentsecuritiesinrelationto B2(d)
the risk/returntrade-off.
Thenature and roleof moneymarkets
• Describethe roleof the moneymarketsinprovidingshort-term B3(a)
liquidityto the privateand the publicsector,providingshort-term
trade finance,allowingan organisationto manage its exposureto
foreigncurrencyand interestrate risk.
• Explainthe roleof banks&otherinstitutionsinthe operationof the B3(b)
moneymarkets.
• Explain&apply the characteristics&roleof the principalmoney B3(c)
marketinstruments:interest-bearingand discountinstruments,and
derivativeproducts.
Page 43 of 641
q
Exam context
ThischaptercoversSection B ofthesyllabus(Financial
Management Environment).
Thetopicsinthischapterintroduce someofthekeyissues inthefinancial
management
environmentwhichimpact ona business.Itisa veryfactualchapter
andintroduces
several
terms
thatareexamined mainly insectionA andBoftheexamandmainly asdiscussion-based
OT
questions.
Partofa section C examquestion couldexamine someofthethemes
ofthischapter
butwouldnottesttheseareasasthemainfocusofa section C question.
G H
22 Financial
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Page 44 of 641
q
2
Chapter overview
Financialmanagementenvironment
Theeconomic
environment
forbusiness Financial
markets
andinstitutions
Macroeconomic
policy
targets Competition
policy Financial
intermediary
Macroeconomic
policies Supply
side
policy Financial
markets
Other
economic
policies
Money Capital International

markets markets financial
markets
Types Share
capital Eurocurrency
market
G H
Interest
bearing Debt
capital Eurobond
market
Discount
instruments Reverse
yield
gap
Derivatives
2:Financial
management
environment
23
Page 45 of 641
q
1 The economic environment for business
Examfocus point
Thisisnotanexamthatwilltesteconomic
theories.
However,youdoneedtobeawareof
whata government’s
maineconomic objectives
andpolicies
are,andhowthesepolicies
(or
changesintheeconomy)canimpactona business.
1.1 Macroeconomic policy targets
Macroeconomics:
Concerned
withissues
affecting
theeconomy
asa whole
egeconomic
KEY
TERM growth,
inflation,
unemployment.
Thepolicies
pursued
bya government
aimtoachieve
various
targets
fortheeconomy
asa whole.
Economic Control
growth inflation
AIMS
Balance
of Full
payments
stability employment
(a) Economic growth – ‘Growth’ implies anincrease innational income, whichisusually

interpretedasa risingstandard ofliving.
(b) Control priceinflation– Thismeans managing priceinflationtoa low,stablelevel.One
G H
reason thatinflationisviewed asa problem isthatifa country hasa relativelyhighrateof

inflation,
thencompanies inthiscountry canbecome lesscompetitiverelativetoits
international
trading rivals.
(c) Fullemployment – Sothateveryone whowants a jobhasone.
(d) Balance ofpayments stability – Itisverydifficult
fora country tospendmoreonimports
thanitearnsfromexports fora sustained periodoftime.Where importsexceed exports,this
isoftencalleda balance ofpayments deficit,
andgovernments willoftenacttocorrect this
situationbymanipulating theexchange ratetoswitch spending awayfromimports and
towards exports(sometimes calledanexpenditure switching policyandcovered inthenext
section).
Expansionary macroeconomic policies canbeadopted inorder toincrease demand (spending)in
theeconomy inorder tostimulate economic growth andcreatetheneedfornewjobs.
Contractionary macroeconomic policies arerequiredtokeepinflation withinacceptable limits
or
toreduce domestic spending onimported goods(andsotoimprove thebalance ofpayments).
24 Financial
Management
(FM)
Page 46 of 641
q
1.2 Macroeconomic policies
Inorder
toachieve
itsobjectives,
a government
willusea number
ofdifferent
policies.
Policytype Definition
Fiscalpolicy Involves
usinggovernment
spending
andtaxation
inorder
tomanage
demand inorder
toachieve
macroeconomic
targets.
Monetary
policy Aimstoinfluence
monetary
variables
suchastheinterest
rateandthe
money supplyinorder
tomanagedemandtoachievemacroeconomic
targets.
Exchange
rate Governmentsmaytryto:
policy • fixtheexchangerate(fixedratepolicy)
• allowittochangeinresponse tomarketforces
(afloating
ratepolicy)
• takeactiontoinfluenceitsvalue(amanagedexchangeratepolicy)
These
policytoolsarenotmutually exclusive,
anda governmentwilladopta policymixof
monetary
policy,fiscalpolicyandexchangeratepolicytoachieve
itsmacroeconomictargets.
1.2.1 Impactonbusinessoffiscalpolicy
Agovernment mightintervene
intheeconomy by:
(a) Spendingmore(orless)money egonservices suchashospitals andeducation,oronbenefit
payments
(b) Changing therateofdirecttaxesegtaxesonindividual orcorporateincome
(c) Changing therateofindirect
taxesegtaxesonspending (egVAT)
Eachofthesemayhavea directimpactona business (egchanging therateoftaxoncorporate
income)oranindirect impactstemmingfromchanges tothelevelofoverall
(oraggregate)
demand within aneconomy asa result
offiscalpolicy(egincreased governmentspending
or
G H
lowertaxeswillboostaggregatedemand andislikelytoincreasesales).
Essentialreading
SeeChapter 2 Section
1oftheEssentialReading,
available
inthedigitaledition
oftheWorkbook,
forfurther
discussion
offiscalpolicy.
TheEssential
readingisavailable
oftheWorkbook.
1.2.2 Impactonbusinessofmonetarypolicy
Interest
ratechanges brought aboutbygovernmentpolicyaffecttheborrowing
costsof
businesses.
Increasesininterest
rateswillmeanthatfewerinvestmentsshowpositive
returns,
deterring
companies fromborrowing tofinance expansion.
Increasesininterest
rateswillalsoexerta downward
pressureonshareprices,makingitmore
difficult
forcompanies toraisemonies fromnewshareissues.
Businesseswillalsobeindirectlyaffectedbydecreases
inconsumer demandthatresultfrom
increasesininterest
rates.
Essentialreading
2 oftheEssential
Reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
discussion
ofmonetary policy.
TheEssential
readingisavailable
oftheWorkbook.
2:Financial
management
environment
25
Page 47 of 641
q
1.2.3 Impactonbusinessofexchangeratepolicy
Exchangeratechanges broughtaboutbygovernment
policyaffectthevalueofsalesrevenue
andcoststhatareina foreign
currency.
Real life example

Imaginea European carmakeristryingtosellcarsintheUSA.Therequiredrevenue percaris
30,000Euros. Iftheexchangerateis$1.2perEuro,thena priceof30,000x1.2=$36,000is
charged.
However,ifthevalueoftheEurofallsto$1.0perEurothena priceofa carfallsto$30,000
(30,000x1).
Thepricein$shasfallensignificantly,
sodemand fromUScustomers
willincrease,andmorecars
willbeexported totheUSAasa resultofa fallinthevalueoftheEuro.
Conversely,a highexchangeratemeans thatanygivenpriceinEurosresultsina higherpricein
$s.So,demand intheUSAforexportsfromEurope willbelower.
Fluctuating
exchange rates(resulting
fromexchange ratesbeingdeterminedpartlyorcompletely
bymarketforces)
createuncertaintiesforbusinesses
involvedininternational
trade,anda fixed
exchangeratepolicymaybehelpful inreducingthislevelofuncertainty.
Impactofa lowerexchangerate Impactofa higherexchangerate
Domestic
goodsarecheaperinforeign Domestic
goodsaremoreexpensive inforeign
markets
sodemand forexports
increases. markets
sodemand forexports
falls.
Foreign
goodsaremoreexpensive
sodemand Foreign
goodsarecheaper
sodemand
for
G
forimports
falls. imports
rises. H
Importedrawmaterials
aremoreexpensive Imported
rawmaterials
arecheaper
socosts
whichincreases
production
costs. ofproduction
fall.
Essentialreading
3 oftheEssential
Reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
discussion
ofexchange ratepolicy.
TheEssential
readingisavailable
asanAppendix ofthedigitaledition
oftheWorkbook.
Activity1:Macroeconomicissues
Thefollowing
statements havebeenmadeinconnection withmacroeconomicpolicy.
Whichiscorrect?
(1) Acontractionaryfiscalpolicyinvolves
inpartthereduction ofgovernment
spending.
(2) Businesses
withvariable ratedebtarelikelytoseetheirinterest
expense
increase
intheevent
ofanexpansionary monetary policy.
 (1)only
 (2)only
 Both(1)and(2)
 Neither(1)nor(2)
26 Financial
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1.3 Competition policy
1.3.1 Marketfailure
Marketfailure:
Saidtooccurwhenthemarket
mechanism
failstoworkefficiently
and
KEY
TERM therefore
theoutcomeissub-optimal.
Typesofmarketfailure
Imperfect Socialcosts Imperfect Fairness
competition information
Where one These areimpactson Thisiswhere false Thegovernment may
company’s large a thirdparty(other informationisbeing alsoresortto
market shareis thanthebuyeror putintothepublic regulationtoimprove
leadingto seller)
ofaneconomicdomain and socialjusticeeg
inefficiency
or transaction(eg distorting
consumer concerns aboutthe
excessiveprofits,the pollution),
where choice(eg fairnessofexpensive
statemayintervene theseeffectsociety advertisements housing.
tostimulate asa whole theyare making falseclaims).
competition callednegative
(seenextsection for externalities.
furtherdetail). These costsmay
requireregulations
eg
controlsonemissions
ofpollutants,
restrictions
oncaruse
inurbanareas.
G H
1.3.2 Imperfectcompetition
Therearetwomarket structures
wherelargefirmsareoftenviewed ashavingexcessive
market
powerthatmayrestrict consumer choice,
andwhere competitionisoftenweak.
(a) Oligopoly– thisiswherea fewlargefirmsdominate themarket.
(b) Monopoly – thisiswhereonelargefirmdominates themarket;intheory
thisimplies
100%
market sharebutinpractice anyfirmwitha market shareofabove25%isviewed ashaving
monopoly power.
Thispower canallowlargecompanies tochargehighprices,andthelackofincentiveof
competitionmaymeancompanies havenoincentive toimprovetheirproducts
oroffera wider
rangeofproducts ortoimprove theefficiencyofitsuseofresources.
However,thesemarket structures
arenotalwaysviewed asbeingsuboptimal
becausea large
company isoftenabletobenefitfromthekindsofeconomies ofscale(benefits
ofconducting
operationsona largescale)thatcanminimise prices(which benefitsconsumers).
1.3.3 Competition policy
Government regulatoryauthorities
(egtheCompetition andMarketsAuthority
intheUK)canbe
askedtoinvestigatewhatcouldbecalled‘oligopolysituations’
involving
explicit
orimplicit
collusion
between firms,whotogether control
themarket. TheAuthority
mustdecidewhetherthe
monopoly isacting‘againstthepublicinterest’.
Ifso,thismayresult
inseveral
measures,
including:
• Pricecuts
• Priceandprofit controls
• Thebreaking upofthefirm(rarely)
Aprospectivemerger between twoormorecompanies maybereferredtotheregulatory
authority.
IntheUK,a referralmaybemadetotheCompetition andMarketsAuthority
for
investigation
ifa largercompany willgainmorethan25%market shareandwhere a merger
2:Financial
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Page 49 of 641
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appears likelyto lead to a substantiallesseningof competitioninone or moremarketsinthe UK.
Manyothercountrieshavesimilarregulatoryauthorities.
Ifa potentialmergeris investigated,the authorityagain mustdeterminewhetherthe merger
wouldbe against the publicinterest.Aswithmonopolies,it willassess the relativebenefitsand
costs inorderto arriveat a decision.
1.4 Supply side policies
Supplyside policiesaimto improveefficiency,motivationor productivecapacity.
Examplesincludederegulation,re-training,privatisationand cuttingincomeand corporationtax.
Competitionpolicyis another exampleof a supply-sidepolicy.
Essential reading
SeeChapter 2 Section4 of the EssentialReading,availableinthe digitaleditionof the Workbook,

forfurtherdiscussionof supply-sidepolicies.
TheEssentialreadingis availableas an Appendixof the digitaleditionof the Workbook.
1.5 Other economic policies

(a) Corporate governanceregulation– thishas been introducedinthe previouschapter. Tighter
regulationimposescosts on a businessbut increasesthe confidenceof investorsand may
benefitbusinessesby makingit easierto attract finance.
(b) Governmentassistance for business– grants may be availableto attract firmsto investin
depressedareas.
(c) Green policies– the failureof the freemarketto recognisepositiveand negativeexternalities
(egpollution)may lead to governmentaction;thismay eitherthreaten a business(egtax on
G
petrolso ‘thepolluterpays’)or create opportunities(egsubsidiesforloftinsulation). H
2 Financial markets and institutions
Whena firmis makingits financingdecisionit has tworoutesto obtainingfinance:

• directlyfrominvestorsthroughfinancialmarkets,or
• indirectlythroughfinancialinstitutionsthat investorshavedepositedtheirmoneyin;these
financialinstitutionsact as financialintermediaries.
2.1 Financial intermediaries
Financialintermediary: Aninstitutionbringingtogetherprovidersof financeand usersof

KEY
TERM finance.
Investor(surplusunit) Financialintermediary Borrower(deficitunit)

savesfunds eg bank borrowsfunds
Afinancialintermediarylinkslenderswithborrowersby obtainingdepositsfromlendersand then

re-lendingthemto borrowers.
28 Financial
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2.1.1 Examplesoffinancialintermediaries
• Retailbanks– offerservicestothegeneral public(whether branch-basedoronline)
• Investment(orwholesale) banks– offerfinance, services
andadvicetolargecorporate clients
• Mutual societies
– offerbankingfacilities
toitsmembers andthoseowned byitsmembers, for
example buildingsocieties
• Institutional
investorssuchaspension funds(investingfundsbuiltupfrompension
contributions),
insurance companies(investing fundsbuiltupfrominsurance policypayments)
andinvestment trusts
andunittrusts(investing shareholdersmoney).Institutional
investors
arethebiggestinvestors inthestockmarkets.
2.1.2 Benefitsoffinancialintermediaries
Financial
intermediaries
provide
thefollowing
functions
(remember
asMAP):
Functions Description
Maturity Mostimportantly,financial
intermediaries
provide
maturity
transformation transformation,
ieborrowingmoney onshortertimeframes thanthey
lendout.Theybridgethegapbetween thewishofmostinvestors/lenders
forliquidity
andthedesireofmostborrowersforloansoverlonger
periods.
Ega bankcanmakea ten-year loan(longterm)whilestillallowing
its
depositors
totakemoney outwhenever theywant;soshort-term
depositsbecome long-terminvestments.
Aggregation
of Afinancial
intermediary
canaggregate
smaller
savings
deposited
by
funds savers
andlendontoborrowers
inlargeramounts.
Pooling
losses Riskforindividual
lenders
isreduced bypooling.
Sincefinancial
intermediaries
lendtomanyindividualsand
organisations,
anylossessufferedthrough default
byborrowers or
G H
capitallosses
areeffectively
pooled andborneascostsbythe
intermediary.
Riskyinvestmentsarethereforeeffectively
changed intolowrisk
investmentsforindividual
investors,
thisissometimesreferred
toasrisk
transformation.
2.2 Financial markets

Afinancialmarket
bringsa firmintodirectcontact
withitsinvestors.
Thetrendtowards
borrowing
directly
frominvestors
issometimes calleddisintermediation.
Disintermediation:
Describes
a decline
inthetraditional
depositandlendingrelationship
KEY betweenbanks
TERM ultimate a ndtheir
c ustomers
andanincrease indirect
r elationships
between the
suppliers
andusersoffinancing.
Acontributingfactortothedevelopment ofdisintermediationistheabilityofcompaniesto
convertexisting
illiquidassetsintomarketablesecurities;
thisisoftenreferredtoassecuritisation.
Financial
markets aresplitintothosethatprovideshort-termfinance(foruptooneyear)and
thosethatprovide medium andlong-termfinance.
Themoney market isthemarket forshort-termfinance.
Thecapitalmarket isthetermusedtodescribe themarket(s)formedium tolong-termfinance.
Inbothmoney andcapitalmarkets thereisa distinction
between:
• primary markets (where companiesissuenewsecuritiestoinvestorstoraisenewfunding),
and
• secondary markets (where investors
buyandsellfrom/to eachother).
2:Financial
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3 Money markets
3.1 Types of money market instruments

Therearethreedifferent
typesofmoney
market
instruments:
interest-bearing,
discount
instruments
andderivatives.
3.1.1 Interest-bearing
instruments
Theseinstruments
payinterest
andtheinvestor
receives
facevalueplusinterest
atmaturity.
3.1.2 Discountinstruments
Theseinstruments
donotpayinterest.
Theyareissuedandtraded
ata discount
tothefacevalue
andtheyareredeemed attheirparvalueatmaturity.
Thediscountisequivalent
tointerest
andisthedifference
between
theissuepriceofthe
instrument
andtheredemptionpriceatmaturity.
Illustration1:Discountinstruments
Abillwitha facevalueof$100isissuedata priceof$98.50andredeemed

atmaturity
attheface
valueof$100.00 inoneyears’time(assume360days).
Required
1 Calculate
theannualised
yieldonthisbill.
2 Calculate
theannualised
yieldifthisbillwasduetomature
in120days’time.
Solution
1 Thediscount
of$1.50represents
interest
ontheinvestment of$98.50.Thisisaninterest
rateof
G
1.5÷98.5×100=1.52%peryear(assumingthatthebillisredeemedinoneyears’time). H
2 Ifthebillwasredeemablein120days’time,andassuming
a 360-dayyear,theannual
implied
interest
rateiscalculated
as1.52%×360/120 = 4.56%.
3.1.3 Derivatives
These instruments
derive theirvaluefromthevalueofanother assetorvariable
suchasexchange
ratesandinterestrates.Examples ofderivatives
include
futures,
optionsandswaps.
Asummary ofsomeofthemaininterest-bearing anddiscountinstruments
isgiveninthefollowing
table(derivatives
instrumentsarediscussed inChapters14and15).
Notethatwhere aninstrument issaidtobea negotiable
instrument,
itmeans thattheinstrument
istradeableandtherefore canbesoldbefore maturity.
Interest-bearing
instruments Discountinstruments
Money market deposits
– veryshort-termloans Treasury
bill– debtinstruments
issued
normallybetween banks. bytheGovernment withmaturities
Therateatwhichbankslendtoeachotherinthe ranging
fromonemonth tooneyear.
London market iscalledtheLondon interbank offer
rate(LIBOR).
Interbankratesareoftenquoted as2 rateseg2.0–
2.2%.Thehigher rateshows theinterest
rateatwhich
a bankwilllendthatcurrency toanother bank(called
theofferrateorLIBOR), thelower number istherate
atwhichthebankwillpaytoborrow thatcurrency
fromanother bank(calledthebidprice,alsoknown as
theLondon interbankbidrateorLIBID).
30 Financial
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Interest-bearing
instruments Discountinstruments
Certificates
ofdeposit – a certificate
ofreceiptfor Bankbillsoracceptancecredits
– sold
fundsdeposited ata financialinstitution
fora byandguaranteed bya bankon
specified
termandpayinginterest (calledthecoupon behalfofa company forupto180
rate)ata specifiedrate(inannual terms) ona daysofcredit.Theyarenottiedtoa
specified
date. specific
transaction.
Forexample, ifthecoupon onthree-month USdollar Anegotiableinstrument.
CDsis2%,thismeans thattheinterestpayment after
threemonths willbe0.5%(ieonequarter of2%).
Anegotiable instrument.
Repurchase agreements (Repo)– anagreement Commercialpaper– short-term
between twoparties
under whichonepartyagreesto unsecured
corporate debtwith
sella financial
instrumenttotheotheronanagreed maturity
ofupto270days.Usually
dateforanagreed priceandsimultaneouslybuy issued
bythelargest organisations
backtheinstrument ata laterdatefora higher
price withgoodcreditratings.
(agreed inadvance). Anegotiable
instrument.
Billofexchange – anIOUsigned bya
customer.Itcanbesoldonthemoney
market toraisefinance.
Billsof
exchange areonlyusedforsignificant
transactions(egabove£75,000).
Anegotiable instrument.
3.1.4 Riskandreturn
Notallmoney market instrumentsofferthesamereturntoinvestors.
G
Higherriskinvestmentsrequire
a higher return
tobepaidandinstruments
thatarenon- H
negotiablerequire
a higherreturnbecause theycannot
besoldon.
risktotheinvestorIncreasing
1.Treasury
bills(issued
bygovernments)
2.Certificates
ofdeposit
(shows
anentitlement
toadeposit)
3.Commercial
paper(issued
bycompanies
withahighcredit
rating)
4.Billsofexchange
(higher
riskunless
guaranteed
or‘accepted’
byabank).
Activity2: Moneymarkets
Hoddor
Coisa largecompany
andfrequently
participates
inthemoney
markets
asbotha lender
andborrower.
Required
Indicate
whichofthefollowing
instruments
aredescribed
intheboxbelow.
Repurchase
agreement Money
market
deposit Commercial
paper
2:Financial
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31
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Instruments
1 HoddorComakes a short-term
loantoa bank.The
interest
ratehasbeenagreedinadvance along
withthematurity
date.
2 HoddorCosellsanunsecureddebtinstrument
whichmatures
in180days,afterwhichitredeems
theinstrument
atfacevalue.
3 HoddorCosellssomeshares
toCerseiCofor$1m
on1May20X6andagreestobuytheshares back
fromCerseiCofor$1.05m
on1November 20X6.
Prominent
Note
LIBOR(theLondon inter-bankrate)hasbeenthenamegiventothebenchmark rateatwhich
bankslendtoeachother(ina variety ofdifferent currencies).
During
2021/2022
itwillbereplaced
bycountry specific
ratessuchas:
• SONIA (theSterling
overnight indexaverage) intheUK
• ESTR(theEuroshort-term rate)inEurope
• TONAR (Tokyoovernightaverage rate)inJapan
• SARON (Swissovernightrate)inSwitzerland
• SOFR(thesecured overnightfinancing rate)intheUS.
G Essentialreading H
5 oftheEssential
reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
discussion
ofmoney marketinstruments.
TheEssential
readingisavailable
asanAppendix
ofthedigitaledition
oftheWorkbook.
4 Capital markets
Capitalmarkets
aremarketsforraising
long-term finance,intheformoflong-term financial
instruments
suchasequities
andcorporate bondsorloannotes.
IntheUK,theprincipal
capitalmarketsare:
(a) TheStockExchange‘mainmarket’(forcompanies witha fullstockmarket
listing)
(b) Themoreloosely
regulated‘secondtier’Alternative
Investment Market
(AIM)
4.1 Capital market instruments
Firmsobtain long-termormedium-term capitalinoneofthefollowing ways:
(a) Byissuing sharecapital.Mostnewissues ofsharecapitalareintheformofordinary
share
capital.Firmsthatissueordinary
sharecapitalareinvitinginvestors
totakeanequitystakein
thebusiness, ortoincrease
theirexisting
equitystake.
(b) Byissuing debtcapital.Long-termdebtcapitalmightberaised intheformofloannotes
whichareIOUscommitting a company topayinginterest
overa significant
timeperiods,
normally 5 yearsormore.
32 Financial
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4.1.1 Riskandreturn
Notallcapitalmarket
instruments
offerthesamereturntoinvestors,
higher
riskinvestments
require
a higherreturn
tobepaid.
Increasing
risktotheinvestor
1.Bonds/loan
notes
(secured
onanasset
orbycovenants)
2.Junkbonds
(unsecured)
3.Shares
traded
onthemain
stock
market
4.Shares
intheAlternative
Investment
Market
4.1.2 Reverseyieldgap
Because debtinvolves
lowerriskthanequityinvestment, wemightexpect yields(iethereturn
received asinterest
ordividendasa percentage ofthemarket priceoftheasset)ondebttobe
lower thanyieldsonshares.Moreusually, however, theoppositeappliesandthedividend yieldon
shares islowerthantheinterestyieldonlow-riskdebt;thissituation
isknown asa reverse yield
gap.
Areverse yieldgapcanoccurbecause shareholders maybewilling toacceptlower returns
on
theirinvestmentintheshortterm,inanticipationthattheywillmakecapitalgainsinthefuture. It
canalsoariseiffirmsthataredesperate toraisefinanceoffera yieldontheirdebtinexcess of
theyieldonshares.
Wereturn tothelinkbetweenriskandreturn againinChapter 11.
5 International financial markets
G
5.1 Eurocurrency market H
Theeurocurrency markets
involve
theborrowing
offundsfromordepositing
fundswitha bank
outside
thecountry ofthecurrency
inwhichthefundsaredenominatedfora shortterm,
typically
threemonths.
Forexample,ifa UKcompany borrowsUS$50,000fromitsUKbank,theloanwillbea ‘eurodollar’
loan.
5.2 Eurobonds
TheEurobondmarketinvolves
theborrowing
offundsfromordepositing
fundswitha bank
outside
thecountry
ofthecurrency
inwhichthefundsaredenominated
fora long-term,
typically
betweentenandtwentyyears.
Eurobond:
Abonddenominated
ina currency
whichoftendiffers
fromthatofthecountry
of
KEY
TERM issue.
Eurobondsare,ineffect,long-term
loansraisedbyinternational
companies orotherinstitutions
andsoldtoinvestors
inseveralcountriesatthesametime.Eurobonds arenegotiable,ietheycan
besoldbyoneholder toanother.
Aborrowerwhoiscontemplating a eurobond issuemustconsidertheexchange riskofa long-
termforeign
currencyloan.Ifthemoney istobeusedtopurchase assetsthatwillearnrevenuein
a currency
different
tothatofthebondissue,theborrower willruntheriskoflosses from
unfavourableexchangeratemovements.
Ifthemoney istobeusedtopurchase assetswhichwillearnrevenue inthesamecurrency, the
borrower
canmatchtheserevenues withpayments onthebond,andsoremove orreduce the
exchangerisk.
2:Financial
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33
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Chapter summary
Financialmanagementenvironment
Theeconomic
environment
forbusiness Financial
markets
andinstitutions
Macroeconomic
policy
targets Competition
policy Financial
intermediary
• Economic
growth,
inflation, • Market
failures • Maturity
transformation
employment,
balanceof • Imperfect
competition • Aggregation
payments (oligopoly
andmonopoly) • Pooling
• Expansionary
and • Price
andprofit
controls
contractionary
policies • Restrictions
ontakeovers
Financial
markets
• Disintermediation
and
Macroeconomic
policies Supplyside
policy securitisation
• Fiscal
policy • Deregulation • Moneymarket
• Monetary
policy • Privatisation • Capital
market
• Exchange
rate
policy • Cutting
direct
taxes • Primary
market
• Secondary
market
Other
economicpolicies
• Regulation
ofcorporate
governance
• Grants
• Green
policies
G H
Money Capital International

markets markets financial
markets
Types Share
capital Eurocurrency
market
• Interest
bearingordiscount Main
stockmarketorAIM Short-term
foreign
currency
instruments
orderivatives investments
orloans
• Negotiable
ornon-negotiable
Debt
capital
Loan
notes Eurobond
market
Interest
bearing Long-term
foreign
currency
Money market deposits,
CDs, investments
orloans
Repos Reverse
yield
gap
Dividend
yield
isoften
less
than
bondyield
Discount
instruments
Treasury
bill,bank
bill/
acceptancecredit,
commercial
paper,
billofexchange
Derivatives
Futures,
options,
swaps
34 Financial
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1.Macroeconomicpolicies
Toachieve
thesemacroeconomic policytargets,
governments
usefiscalpolicy,monetary
policy,
andexchangeratepolicy.Suchpolicies
maybeexpansionary
orcontractionary.
2. Supplysidepolicies
These
aimtoimprove efficiency
andmotivation.
Keypolices
include
competition
policy,
deregulation
andprivatisation.
3. Financial
intermediaries
Banksandinstitutional
investors
actasa third-party
channelling
fundsfrominvestors
to
borrowers.
4. Moneymarket
Short-term
instruments
- either
discount
instruments,
interest-bearing
orderivatives.
5. Capitalmarket
Long-term
debtandequitycanberaised
onthecapitalmarkets.
G H
2:Financial
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35
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Question practice
Nowtrythefollowing
fromtheFurther
question
practice
bank(available
inthedigitaledition
of
theWorkbook):
Section
A questions
Q4,Q5,Q6,Q7,Q8,Q9
G H
36 Financial
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Page 58 of 641
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Activity answers
Activity1:Macroeconomic issues
Thecorrectansweris:(1)only
Acontractionary
fiscalpolicyincludes
theraising
oftaxesand/or
cutting
governmentexpenditure.
Interest
ratesgodowniftheGovernment pursuesanexpansionarymonetary
policy.
Activity2: Moneymarkets
Instruments
HoddorComakes a short-term
loantoa bank.The Money
market
deposit
interest
ratehasbeenagreedinadvance along
withthematurity
date.
2 HoddorCosellsanunsecureddebtinstrument Commercial
paper
whichmatures
in180days,afterwhichitredeems
theinstrument
atfacevalue.
3 HoddorCosellssomeshares
toCerseiCofor$1m Repurchase
agreement
on1May20X6andagreestobuytheshares back
fromCerseiCofor$1.05m
on1November 20X6.
G H
2:Financial
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37
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G H
38 Financial
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3
Working capital
investment
3
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
Thenature,elements
andimportance ofworkingcapital
• Describethenature ofworking
capitalandidentify
its C1(a)
elements.
• Identify
theobjectivesofworking
capitalmanagement in C1(b)
termsofliquidity
andprofitability,
anddiscusstheconflict
between them.
• Discuss
thecentral roleofworking
capitalmanagement in C1(c)
G
financial
management. H
Management ofinventories,
accounts receivable,
accounts
payableandcash(cashiscovered inthenextchapter)
• Explain
thecashoperating cycleandtheroleofaccounts C2(a)
payable &receivable.
• Explain
andapplyrelevant accounting ratios,
including: C2(b)
current
ratioandquickratio,inventory turnoverratio,
averagecollection
period andaverage payable period,sales
revenue/networkingcapitalratio.
• Discuss,
applyandevaluate theuseofrelevant techniques
inmanaging inventory,including
theEOQmodel andjust- C2(c)
in-time
techniques.
• Discuss,
applyandevaluate theuseofrelevant techniques
inmanaging accounts receivable,
including:assessing C2(d)
creditworthiness,
managing accounts receivable,collecting
amounts owing,offeringearlysettlementdiscounts,using
factoring
andinvoice discounting,
andmanaging foreign
accountsreceivable.
• Discussandapplytheuseofrelevant techniques in C2(e)
managing accountspayable, including:usingtradecredit
effectively,
evaluatingthebenefitsofearlysettlement and
bulkpurchase discounts,managing foreignaccounts
payable.
Determining
working
capitalneedsandfundingstrategies
• Calculate
thelevelofworking incurrent C3(a)
capitalinvestment
assetsanddiscuss
thekeyfactorsdetermining
thislevel,
Page 61 of 641
q
Syllabus
reference
including:
thelengthoftheworking
capitalcycleand
termsoftrade,anorganisation’s
policyonthelevelof
investment
incurrent
assetsandtheindustry
inwhichthe
organisation
operates.
3
Exam context
Thischaptercovers
issuesrelating
totheinvestment inworking
capitalwhichispartofSectionC
ofthesyllabus(Working
capitalmanagement). Thisisanimportantchapterthatisexaminablein
allsections
oftheexam,includingSectionA (2-mark questions),
B(10-mark question)andSection
C (20-markquestion).
Questionswon’tjustinvolve
calculations;
examquestions (especially
in
SectionC) mayaskyoutodiscuss themanagement ofworking
capital(asa partofa question)
ortoexplainthemeaningofa numerical analysis
thatyouhaveperformed.
G H
40 Financial
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3
Chapter overview
Workingcapitalinvestment
Objectives
ofworking Working
capitalplanning
capitalmanagement
Profitability Influences
oninvestment
in Operating
cycle
working
capital
Liquidity Sales
tonetworking
capital
ratio
Aggressive
working
capital
management
Conflict Overtrading
Conservative
working
capital
management
Working
capital
ratios
Inventory Receivables Payables

G H
EOQ
model Policy
formulation Maintaining
relationships
Discounts Management
framework Evaluating
discounts
Buffer
stock Foreign
accounts
receivable
Foreign
accounts
payable
JIT Evaluation
3:Working
capital
investment
41
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1 Working capital
Networking capital:Thenetworking
capitalofa business
isitscurrent
assetslessitscurrent
KEY
TERM
liabilities.
Currentassets– examples Currentliabilities– examples

Cash Overdraft
Inventory Short-term
loans
Amounts
receivable
fromcustomers Amounts
payable
tosuppliers
1.1 Objectives of working capital management

Workingcapitalmanagementhastwomainobjectives:
(a) Toincrease
theprofits
ofa business
(b) Toensure
sufficient
liquidity
tomeetshort-term
obligations
astheyfalldue.
1.1.1 Profitability
Ifa business
operates
withexcessively
lowlevelsofworking
capitalthenthismayleadtotrading
problems,andlowerprofits.
Examplesofproblems
ofoperatingwithexcessively
lowworkingcapital
Lowinventory Thismaymeanthatdelivery leadtimestocustomers
areexcessively
high,
orthata businessdoesnothaveenough inventory
tomeetpeaksin
G demand. Thisislikelytoleadtolostsales. H
Lowreceivables Ifthismeansthata business’s

creditterms
areoverly
strictandthatlong
creditperiodsarenotbeingmadeavailable
toitscustomer,thismaylead
tolostsales.
Oneofthecentral concerns
ofworking
capitalmanagement ishowmuchmoney toinvest
in
short-termassetstoaddresstheproblems
ofoperatingwithexcessively
lowlevelsofworking
capital;thiscanbethoughtofasa working
capitalinvestmentdecision
andisthemainfocusof
thischapter.
1.1.2 Liquidity
Everybusiness needsadequateliquidresources
tomaintain
daytodaycashflowsuchaswages
andpayments tosuppliers.
Ifmoney istiedupinshort-term
assetssuchasinventory
andreceivables,
thismaycauseliquidity
problems. Liquidity
canbemaintained byensuring
thattheamounts ofcashtiedupininventory
andreceivables isnotexcessive.
Thisisthemainfocusofthenextchapter whichlooksatcashflowforecasting
andhowworking
capitalfinance shouldbeapproached.
Workingcapitalfinance:
Theapproach
takentofinancing
thelevel,andfluctuations
inthe
KEY
TERM level,
ofnetworking capital.
1.1.3 Conflictbetweenobjectivesofliquidityandprofitability
Theobjectives
ofliquidity
andprofitability
mayconflict.
Forexample,
ifa decision
ismadetoinvest inhigher inventory
(egtoreduce
delivery
leadtimes)
orreceivables
(toallowlongercreditterms)
inorder toboostsalesandprofits,
thenthiswilltieup
fundsinhigher
networking capitalandthiswillreduceliquidity.
42 Financial
Management
(FM)
Page 64 of 641
q
However,
therewillnotalwaysbea conflictbetween theobjectives
ofliquidity
andprofitability.
Forexample,ifthelevelsofinventory
andreceivablesarehighbecauseworkingcapitalisnot
beingmanaged well,thenimprovedmanagement ofthewarehouse(tokeepinventory
lower and
reduceobsolescence) andcreditcontrol
(tokeepreceivableslower
andreduce baddebts)may
allowbothhigherliquidityandhigherprofitability.
1.1.4 Roleofworkingcapitalinfinancialmanagement
Working
capitalmanagementinvolves
aninvestment
decision
anda financing
decision.
Wehave
already
seeninChapter
1thatthesetwodecisions
arefundamental
tofinancial
management
in
general.
Essentialreading
SeeChapter3 Section
1oftheEssential
reading
formorebackground information
onthisarea.
TheEssential
readingisavailable
oftheWorkbook.
2 Working capital planning
2.1 Influences on the level of investment in working capital

Different
businesseswillhavedifferent
approaches
toworking capitalinvestment,
ietothelevel
ofnetworkingcapitalheld,dueto:
• generalfactors(egtheindustry);
and
• company-specificfactors(egdifferent
working
capitalstrategies).
2.1.1 Generalfactorsaffectingworkingcapitallevels
G
(a) Thenature oftheindustry H
Thelevelofworking capitalrequiredwillbeinfluencedbythenature oftheindustry.

Ega supermarket willreceive
muchoftheirsalesincash(orcreditordebitcard),soitwillbeable
tooperatewithminimal receivables.
However,thiswould notbepossible fora foodwholesaler
(supplyingsupermarkets) whichislikelytobeselling
mainly oncredit.
(b) Policies
ofcompetitors
Acompany willbeunwillingtolosebusinesstoa rivaloffering
itscustomersmorefavourable
creditterms.
(c) Seasonal factors
Theremaybea needtoallowinventory tobehigher asa season ofpeaksalesapproaches.
2.1.2 Companyspecificfactors
Thelevelofnetworkingcapitalwillalsodepend ona company’s salesanditsworking capital
strategy.
Ifsalesarehigher,
thennetworking capitalwillnormally
risetoo(asreceivablesandinventory
will
rise).However,
different
companies willplantoallownetworking capitaltoriseatdifferent
rates
depending ontheirworking
capitalinvestment strategy.
Aggressive
strategy– minimises
net Conservative
strategy– maximises
net
workingcapital workingcapital
Aimstokeepinventories
andreceivables
as Allows
highlevels
ofinventories
and
lowaspossible. receivables
andplanstopaysuppliers
ontime
Payablesaremaximised
(suppliers
paidas (whichkeepspayables
low).
lateaspossible).
Thisprioritises
liquidity
butmaycreate Thisaimstoreduce
theriskoftrading
3:Working
capital
investment
43
Page 65 of 641
q
Aggressive
strategy– minimises
net Conservative
strategy– maximises
net
workingcapital workingcapital
trading
problems. problems
(egstock-outs)butmay
compromise
liquidity.
2.2 Planning overall working capital needs

2.2.1 Workingcapitalratios
Acompany’s working
capitalpolicies
canbequantified
byanalysing:
• inventory
days(theamount ofdaysofsalesorproductionheldasinventory)
• payablesdays(thelengthoftimetakentopaysuppliers)
• receivables
days(thelengthoftimetakenbycustomerstopay)
These
ratioscanbeusedtoquantify thelevelofworking
capitalrequired
tosupport
future
sales.
Formulato learn
(a) Inventory
days(orinventory
turnover
period):(Finished
goods/Cost
ofsales)× 365
(b) Inventory
turnover:
Costofsales/Average
inventory
(c) Receivables
days:(Receivables/(credit)
sales)× 365
(d) Payables
days:(Payables/(credit)
purchases)×365
Examfocus point
G
Normally,intheexam,inventorycanbeassumed tobeoffinished
goods.Ifthisisnotthe H
case,ieinventory
israwmaterialorWIP,thenthecalculation
willneedtobeadjusted toreflect
thecostsincurredinbringing
theinventory
toitspresent
locationandcondition
asfollows:
WIP:(WIP/Cost ofProduction)
×365=daysofWIP
Rawmaterial:(Rawmaterial/Raw material
purchases)
×365=daysofrawmaterial inventory
Examfocus point
Number ofdays.Anexamquestionmayspecifythat360days,not365,should beassumed.
Itisevenpossible
thatyouaregivenworkingcapitalbalances
fora six-month
periodinwhich
case180daysmaybeappropriate touseincalculating
workingcapitaldays.So,readthe
questioncarefully!
Activity1:Forecasting
Management Co’scustomerspayafter73days,onaverage.
Nextyear,salesareforecast
tobe$864,000.
Required
Whatistheamountofreceivables
Management
Coshould
forecast
fornextyear,assuming
365
daysintheyear?
44 Financial
Management
(FM)
Page 66 of 641
q
Solution
Basicliquidity
ratios(covered
inChapter
1)canalsobeexamined
alongwiththeseworking
capital
ratios.
Activity2: Combinationof ratios
Abusiness hasa current

ratioof2.Current
assetsconsist
ofinventory
of$10millionandcurrent
liabilities
of$15million.
Thecompany givesonaverage36.5days’credittoitscustomers.
Required
Assumingthatthebusinesshasa zerocashbalance
andthatthereare365daysina year,what
istheannual
creditsalesrevenue?
 $150m
 $2
 $20m
 $200m
G H
Solution
2.2.2 Thecashoperatingcycle
Theratioanalysis
fromtheprevioussectioncanalsobeusedtoanalysetheimpactofhigher
salesonliquidity
usingthecashoperating cycle(alsoknownastheworking
capitalcycle).
Thecashoperating cyclemeasuresthelengthoftime(indays,weeks
ormonths),
followingthe
receipt
ofa customer orderfor:
(a) Cashtobereceived: measured asinventorydaysplusreceivables
days
(b) Cashtobepaidouttosuppliers: measured aspayablesdays
Thecashoperating cycleisthencalculated
as:
Cashtobereceived (indays)minusCashtobepaidout(indays)
3:Working
capital
investment
45
Page 67 of 641
q
Cashoperating
cycle:Theperiod
oftimethatelapses
between thepointatwhichcashbegins
KEY tobeexpended
TERM customer. onthe production
ofa productorservice
a ndthecollection
ofcashfroma
Illustration1:Cash operatingcycle
WNSCoisa manufacturer.
Itbuysfromsuppliers
thatallowWNS2.5months’
credit.
Theraw
materials
remainininventory
foronemonth,andittakesWNStwomonthstoproducethegoods.
Thegoodsaresoldimmediately
afterproduction
iscompletedandcustomers
takeonaverage1.5
months
topay.
Required
Calculate
WNS’scashoperating
cycle.
Solution
Cashoperating
cycle
Months
Theaverage
timethatrawmaterials
remain
ininventory 1.0
Thetimetakentoproduce
thegoods 2.0
Thetimetakenbycustomers
topayforthegoods 1.5
Thetimetakentopaysuppliers (2.5)
Cashoperating
cycle 2.0
G H
Activity3: Operatingcycle
Thetablebelow
givesinformation
extracted
fromtheannual
accounts
ofManagement
Coforthe
pastyear.
$
Inventory:
Finished
goods 86,400
Receivables 172,800
Payables 96,400
Purchases 518,400
Costofgoodssold 756,000
Sales 864,000
Required
Calculate
thelength
ofthecashoperating
cycle(assuming
365daysintheyear).
46 Financial
Management
(FM)
Page 68 of 641
q
Solution
2.2.3 Thecashoperatingcycle:useandmeaning
Thereisnooptimal lengthoftheoperating cycleforeverycompany (asdiscussed,working
capitalinvestment
levelsdepend ongeneral andcompany-specific factors).
However,by
comparing thecashoperating cyclefromoneperiod tothenextoronecompany toanother,
it
shouldbepossibletoidentifyunwelcome trends.
Thecashoperating cyclecanalsobeusedto
identifythepossibility
ofa cashshortfall
ifsalesrisetoorapidly
(thisissometimescalled
G
overtradingandiscovered laterinthischapter). H
Essentialreading
SeeChapter9Section
1oftheEssential
reading
forfurther
discussionofbasicliquidity
ratios.
TheEssential
reading
isavailable
oftheWorkbook.
2.2.4 Salestonetworkingcapitalratio
Amoredirectwayofidentifying
thepossibility
ofa cashshortfall
ifsalesrisetoorapidly
istouse
thesales/net
workingcapitalratio.
Formulato learn
Theratioof:
Salesrevenue/(Receivables
+Inventory
– Payables)
Thisshows thelevelofworking capital(excludingcash)required tosupport sales.
Forexample, ifthisratiowas5,thenforevery$5increase insalesanextra$1ofcashisrequired
tofinance therequired increaseinnetworking capital.
Thesalestonetworking capitalratioisa keyratioindemonstrating a company’soverall
working
capitalinvestment policybecause itconsidersthelevelofnetcurrent assetsusedtosupport
revenue generation.
Acompany adopts anaggressive working capitalinvestmentpolicyrelative
toanother
company
ifitusesa lowerlevelofnetcurrent assetstosupport a similar
levelofrevenuegeneration,
ora
3:Working
capital
investment
47
Page 69 of 641
q
conservative
workingcapitalinvestment
policyrelative
toanother
company ifitusesa higher
levelofnetcurrent
assetstosupporta similar
levelofrevenue
generation.
Examfocus point
TheACCAexamining teamhasconfirmed
thatifcashisincluded
inthecalculation
ofnet
workingcapital(which
would
follow
thenormalinterpretation
oftheterm‘net’working
capital)
thenstudents
willnotbepenalised.
Activity4: Sales/networkingcapital
Management
Co– Extracts
fromannual
accounts
Year1
$
Sales 864,000
Inventory:
Finished
goods 86,400
Receivables 172,800
Payables (96,400)
Networking
capital 162,800
Sales/net
working
capitalratio=864,000/162,800 =5.3071
G Required H
Whatincreaseinthelevelofnetworking
capital(iecash)isneeded
tosupport
higher
sales,if
salesareforecast
toriseby$200,000overthenextyear?(Workingtothenearest
$100)
Solution
48 Financial
Management
(FM)
Page 70 of 641
q
2.3 Risk of overtrading
Ifa business
failstoplanhowtosupplyitsforecast
levelofcashflowneeds,
itwillbeindanger
of
overtrading.
Overtrading:
Asituation
where
a business hasinadequate
cashtosupport
itslevelofsales
KEY
TERM (also
knowna sundercapitalisation).
2.3.1 Symptomsofovertrading
Symptoms ofovertradingareasfollows:
(a) Arapidincreaseinsalesrevenue,andoftena fallinprofitmarginsasdiscountsareusedto
chasehighersales.
(b) Arapidincreaseinreceivablesandinventory,eghighreceivables
asbetter creditterms
are
usedtochasenewsales,higher inventorytosupporthighersales.
(c) Rapidincreaseintradepayables anda risingbankoverdraftindicating
liquidity
problems.
(d) Worseningliquidity
ratioscausing
a significant
increase
intheoperating cycle.
2.3.2 Managingtheriskofovertrading/undercapitalisation
Todealwiththisriska businessmusteither:
(a) Plantheintroduction
ofnewlong-term capital
(b) Improveworkingcapitalmanagement
(c) Reduce businessactivity
Notethatitisalsopossiblefora business
toholdexcessive
levels
ofcash,thisiscalled
overcapitalisation.
Essentialreading
G H
SeeChapter3 Section
3 oftheEssential
reading
fora numericalillustration
ofovertrading.
TheEssential
readingisavailable
oftheWorkbook.
3 Managing inventory
Thischapter
nowmoves ontoconsidereachspecific
componentofworking capitalandtheissues
surrounding
thelevelofinvestment
thatwillberequired
ineachtype,startingwithinventory.
Theinventory
daysratio(seeearlier)
givesanoverview ofa company’soverall
inventory
position,
butcompaniesmayhavethousands ofitems ininventory,
andwillwanttocalculatehowmuchto
holdofeachindividualitem.
Thiscanbeestablishedbytheeconomic orderquantity(EOQ)model whichlinksthelevelof
inventory
tothequantity ofanorder
placedwithsuppliersandaimstominimise thetotal
inventory
related
costsofa company bychoosing theoptimal
ordersize.
3.1 EOQ model
Theeconomicorderquantity
(EOQ):Theoptimal
ordering
quantity
foranitemofinventory
KEY
TERM which
will
m inimise
inventory
related
c osts.
TheEOQmodel
linkstheorder
quantity
placedwitha supplier
toinventory
related
costs.
3:Working
capital
investment
49
Page 71 of 641
q
Inventoryrelatedcosts
Holdingcosts Orderingcosts Purchasingcosts
Egwarehousing,
insurance, Egcostsofadministering Egtheamount
paidfor
obsolescence,
and orders,
anddelivery
costs. purchases
fromsuppliers.
opportunity
costofcapital.
Holdingcostsincrease
ifthe Ordering
costsdecreaseif Purchasingcostsmay
ordersizeincreases. theordersizeincreases. decreaseiftheordersize
increases
ifbulkdiscounts
areoffered(although
discounts
areignoredbythe
simple
EOQmodel).
3.1.1 Quantifyinginventoryholdingcosts
Ifa firmorders
anamount (Q)froma supplier,
holdszeroopeninginventory
andreceives
theorder
immediatelythenthelevelofinventory
atthestartoftheperiodisQ.
Bytheendoftheperiod wecanassume thattheinventory
levelhasbeenrundowntozero.
Thiscanbeillustrated
asfollows:
Inventory
level
Q
Average
=Q/2
G
0 Time H
Theaverage
inventory
levelis(starting
inventory
+closing
inventory)/2
whichcanbeexpressed
as
Q/2.
Formulato learn
Totalholding
costscantherefore
becalculated
as:
C ×h Q
2
Where
Q istheinitial
order
andCh=Annual
costofholding
oneunitininventory
3.1.2 Quantifyinginventoryorderingcosts
Ifa firmholdszeroinventory
atthestartoftheperiod,
thenumber oforders thatitwillneedto
placewillbedetermined bytheannual demand inunits(D)andtheorder size(Q).
Forexample, if120unitsarerequired
(iedemanded)andtheorder sizeis20unitsthentherewill
be120÷20=6.Thiscanbeexpressed asD/Q.
Formulato learn
IfCo=Costofplacinganorder,
thentotalordering
costscanbecalculated
as:
Co × D
Q
50 Financial
Management
(FM)
Page 72 of 641
q
3.1.3 Quantifyingpurchasingcosts
Iforder
sizeaffectsthepurchase
price,purchasing
costswillneedtobeconsidered.
Purchasingcostsarecalculated
asannualdemand × purchasepriceofoneunit.
3.1.4 EOQformula
Tominimise
totalinventory
related
costsofa company,thereisanideal(economic)
order
size
whichcanbeidentified
usingtheEOQformula (which
isgivenintheexam).
Formulaprovided
Economic
order
quantity
(EOQ)=
Q = 2CoD
Ch
Thisformula
givestheidealorder
quantity
tominimise
totalinventory
related
costs.
Examfocus point
Thevariables
intheEOQformula needtobebasedona consistent
timeperiod;normally
this
isannual.
Bealertforquestions
thatpresent
someinformation,
forexample D,innon-annual
terms.
Wherethisoccursyouwillneedtoadjust
thevariable
sothatitisinannualterms.
Illustration2: Inventorycosts
Thedemand
fora commodityis3,000unitsa month,
ata steadyrate.Itcosts$20toplacean
G
order,
and$0.40toholda unitfora year. H
Required
Findtheorder
sizetominimise
inventory
costs.
Solution
Annualdemand
is3,000×12months
=36,000units
Q = 2CoD
Ch
Q= 2 × 20× 36,000= 1,897units

0.4
(rounded
tothenearest
whole
unit)
Activity5: EOQ
FirmXfacesregular
demand of150unitspermonth.
Itorders
fromitssupplier
ata purchase
cost
perunitof$25.Eachorder
costs$32,andannual
holding
costis$4.50perunit.
Required
1 Calculate
theeconomic
order
quantity,
andtheaverage
inventory
level.
2 Calculate
totalinventory-related
costatthiseconomic
order
quantity.
3:Working
capital
investment51
Page 73 of 641
q
Solution
3.2 Drawbacks of EOQ model

Thedrawbacks oftheEOQmodel arethatit:
(a) Assumes zeroleadtimes,andnobulkpurchase discounts– althoughthesecanbeadjusted
for(seenextsection)
(b) Ignorestheneedtoincrease ordersizesifthereisa possibility
ofsupplier
shortages
orprice
rises
(c) Ignoresthepossibility
offluctuations
indemand (theorderquantity
isconstant)
(d) Ignoresthebenefit
ofholdinginventorytocustomers (egshorter
leadtimes)
(e) Ignoresthehiddencostsofholdinginventory(seejust-in-time,
section
3.5).
3.3 Bulk purchase discounts
Ifbulkpurchase discounts
areavailable,
thesimpleEOQformula cannot
beusedandweneedto
adjustourapproach asfollows:
G
(a) CalculateEOQinnormal wayandinventoryrelated
costsattheEOQ H
(b) Calculateinventory
related
costsatthelowerboundaryofeachdiscount
abovetheEOQ
(c) Selecttheorderquantity
thatminimisesinventory
related
costs
Activity6: Bulkpurchasediscounts
Usingthesameinformation
givenintheprevious
activity,
calculate
whether
either
ofthefollowing
bulkpurchase
discounts
shouldbeaccepted:
(1) Discount
of2%givenonorders of300andover
(2) Discount
of4%givenonorders of800andover
Solution
52 Financial
Management
(FM)
Page 74 of 641
q
Essentialreading
SeeChapter3 Section
4 oftheEssential
reading
forfurther
illustration
relating
tothisarea.
TheEssential
readingisavailable
oftheWorkbook.
3.4 Buffer inventory

Inreality,
anorganisation
wouldnotwaitforinventory tofalltozerobefore
placinga neworder
withitssuppliers.
Onereason forthisistheriskofdemand beinghigherthanexpected while
waitingfora newdelivery,
whichcreates theriskofstock-outs.
Todealwiththisanorganisationmayholdbuffer inventory
(shown asBinthefollowing
diagrams).Thishasanimpact ontheaverage inventory
level.
Q+B
B
G H
0 Time Time
Ifbuffer
inventory
(B)isrequired,
theaverage
inventory
levelbecomes
B+Q/2
3.5 Just-in-time (JIT)
Just-in-time
(JIT)isa philosophy
whichinvolves
theelimination
ofinventory.
3.5.1 JIT procurement
Thisisa policyofobtaining
goodsfromsuppliers
atthelatestpossible
time(iewhentheyare
needed) andsoavoidingtheneedtocarryanymaterialsorcomponents asinventory.
3.5.2 JIT production
Thisdescribes
manufacturing‘toorder’.
Asorders
arereceived,
manufacturing
istriggered
tofulfil
thoseorders.
Thisenables
better productcustomisation,
noriskofobsolescence
andfewholding
costs.
Itdoes,however,
require
a highlyflexible
andreliable
manufacturingprocess
(interms ofwhat
andhowmuchismade).
3.5.3 BenefitsofJIT
ProponentsofJIT suggestthata keyproblemwithholdinginventory
isthatitallowsa firmto
compensate forinefficient
processesbyholdingbufferinventory;
thisfailure
todealwith
inefficient
processesisseenashidden costsofholding
inventory.
3:Working
capital
investment
53
Page 75 of 641
q
Examplesofhidden costsinclude:failingtodealwithunreliable
suppliers,
defective
production
processes
andpoorlabour relations.
Inaddition,
JIT willreduce inventoryholding costs.
3.5.4 DrawbacksofJIT
JIT willnotbeappropriate
ifproduction
processes
andsuppliers
areunreliable,
andespecially
where theconsequences ofa stock-out
areserious.
Forexample,
ina hospital,
a stock-out
could
quiteliterally
befatalandsoJIT would
bequiteunsuitable.
Essentialreading
SeeChapter 3 Section5 oftheEssential

reading
forfurther
discussionofre-order
levels
anda
real-life
example
ofJIT.
TheEssential
Reading isavailable
oftheWorkbook.
4 Managing receivables
4.1 Policy formulation

Acompany willhavetodecidewhether tooffercredittoitscustomersandifsoonwhatterms.
Theseareimportant decisionsandneedtobecarefully consideredbysenior management.
Thedecision tooffercreditcanbeviewed asaninvestment decision,
intendedtoresultinhigher
profits.
Formanybusinesses, offering
generous payment terms(orcreditperiod)
tocustomers is
essential
inorder tobecompetitive.
However, offeringcreditcomesata cost,egthevalueoftheinterest chargedonanoverdraft to
fundtheperiod ofcredit,andthepossibility
ofbaddebts.So,thedecision tooffercreditwillneed
tobecarefully assessed toseeifthebenefitfromthepolicyisgreater thanitscost.
G H
Insomebusinesses itispossible
thattheriskofbaddebts,orthecostofmanaging receivables,
willmeanthatitisnotcommercially viabletooffercredittocustomers.
4.1.1 Extendingthecreditperiod
Thedecisiontoofferextended creditcanalsobeviewedasaninvestment
decision,
intended
to
boostsalesandprofits.
Thecostofextended creditisthevalueoftheinterest
chargedonanoverdraft
tofundtheperiod
ofextracredit.
Thebenefitislikelytobehigher salesandtherefore
higher
profit.
Thepolicywillbeassessed bycomparing whetherthebenefit
fromhigher
salesisgreater
than
thefinancecostsassociated withhigherreceivables.
Illustration3: Extendingthe creditperiod
Enticement Cocurrentlyexpectssalesof$50,000a month.

Variable
costsofsalesare$40,000a
month (allpayableinthemonth ofsale).
Itisestimatedthatifthecreditperiod
allowed
tocustomerswastobeincreased
from30daysto
60days,salesvolume wouldincreaseby20%.
Allcustomerswould beexpected totakeadvantageoftheextended
credit.
Thecostofcapitalis
12.5% a year.
Required
Evaluate
whether
theextension
ofthecreditperiod
isjustifiable
infinancial
terms.
54 Financial
Management
(FM)
Page 76 of 641
q
Solution
Evaluation
Workings $
Current
accounts
receivable
(1month) 50,000
Accounts
receivable
afterimplementing
theproposal
(2months)
(50,000×1.2×2) 120,000
Increase
inaccounts
receivable 70,000
Cost
Financing
cost(12.5%) 8,750
Benefit
Annual
contribution
fromadditionalsales($10,000
× 12months
×contribution/
salesratioof20%)
The20%contribution
tosalesratioiscalculated
as$10,000
contribution
(sales–
variable
costs)÷$50,000salesrevenue. 24,000
Annual
netbenefit
fromextending
creditperiod 15,250
Activity7: Extendedcreditterms
GreedyCoisconsidering a proposal
tochangeitscreditpolicyfromallowing
debtorscreditof
twomonths tocreditofthreemonths.
Salesarecurrently
$600,000p.a.andasa resultoftheproposed changewillincrease
by15%.
G
Thecontribution/sales
ratiois20%andthecostofcapitalis10%. H
Required
Should
theproposed
changebemade?
Solution
4.1.2 Earlysettlement discount

Anotheraspectofcreditpolicyiswhethertooffercustomers
a discountforearlysettlementof
amounts due.
Earlysettlement
discounts
willresult
ina cost(thediscount)
butwillresult
inlowerreceivables
whichcanbenefita company byreducing thecostoftheinterest
charged onanoverdraft,since
money isbeingreceived
fromcustomers earlier.
Thispolicycanbeassessedbycomparing thecostofthediscounttothebenefit oflowerfinance
costsassociated
withlowerreceivables.
3:Working
capital
investment
55
Page 77 of 641
q
Illustration4: Early settlementdiscount
LoweandPriceCohasannual creditsalesof$12,000,000,
andthreemonths
areallowed
for
payment.Thecompany decidestooffera 2%discountforpayments
madewithin
tendaysofthe
invoice
beingsent,andtoreduce themaximum timeallowed
forpayment
totwomonths.Itis
estimatedthat50%ofcustomers willtakethediscount.
Assumethatthevolume ofsaleswillbeunaffectedbythediscount,
andthecompany hasan
overdraft
costing10%peryear.
Required
Evaluate
theeffectofthediscount.
Solution
Theamount ofaccounts
receivable,
ifthecompanypolicyremains
unchanged,
wouldbe:
3/12×$12,000,000=$3,000,000.
Ifthepolicyischanged
theamountofaccountsreceivable
wouldbe:
(10/365× 50%×$12,000,000)
+(2/12×50%×$12,000,000) =$164,384
+$1,000,000
=$1,164,384
Examfocus point
Theeffectofthesettlement
discountisnotincluded
inthecalculation
ofnewreceivables.
This
assumesthatsalesarerecordedbeforetheeffectofthesettlement
discount
(which
is
normally
recordedseparately).
Thisistheapproach thathasbeenadoptedinpastACCA
G H
Financial
Management examquestions.
$
Current
accounts
receivable 3,000,000
Accounts
receivable
afterimplementing
theproposal 1,164,384
Reduction
inaccounts
receivable 1,835,616
Benefit
ofpolicy
Sincethecompany hasanoverdraft
costing
10%peryear,thevalueofa reductioninaccounts
receivable
(asource
offunds)is10%of$1,835,616
eachyearinperpetuity,
thatis,$183,562
a
year.
Costofpolicy
Discounts
allowedeachyear(2%×50%×$12,000,000)=$120,000
Summary
$
Benefit
ofpolicy 183,562
Lesscostofpolicy 120,000
Netbenefit
ofnewdiscount
policyeachyear 63,562
Theproposed
policybringsa netfinancial
benefit
andtherefore
should
beaccepted.
56 Financial
Management
(FM)
Page 78 of 641
q
Activity8: Early settlementdiscounts
PipsCoisconsideringoffering
a cashsettlement
discount
toitscustomers.
Currently itsannual
salesare$10million
anditsnormal payment terms
are90days.Customerswillbeabletotakea
2%discountforpayments within10days.Pipsanticipates
that20%ofcustomerswilltakethe
discount.
Currently
Pipshasanoverdraft onwhichitispaying10%interest.
Required
Assess
whether
Pipsshould
offerthediscount
(assume
a 365-dayyear).
Solution
G H
4.2 Framework for managing receivables

Aftera creditpolicyhasbeenagreed,a framework
isneeded
toensure
thatitisimplemented
effectively.
Thiswillinvolve
threestages:
(a) Planning stage
(b) Monitoring stage
(c) Collectionstage
4.2.1 Planningstage:creditanalysis
Beforeoffering credittoa particular
customer,
itisimportanttoanalyse theriskoftradingwith
thatcustomer byaskingforbankreferences andtradereferences.
Acreditratingagencywillalsoprovide details
ona customer’strading
history,debtlevels
and
payment performance.
Adecision willthenneedtobetakenonthecreditlimittobeoffered. Anewcustomer’s credit
limitshould befixedata lowlevelandonlyincreased iftheirpaymentrecord subsequently
warrantsit.
Forlargevaluecustomers, a fileshould
bemaintained ofanyavailablefinancial
information
aboutthecustomer. Thisfileshouldbereviewedregularly.
Information
isavailablefromthe
company’s annual reportandaccounts andpresscomments maygiveinformation aboutwhata
company iscurrentlydoing(asopposed tothehistorical
results
inpublished
accounts whichonly
showwhatthecompany hasdoneinthepast).
3:Working
capital
investment
57
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q
4.2.2 Monitoring stage:creditcontrol
Creditcustomersshould bemonitoredtoensure
thattheyarecomplyingwiththeagreed credit
period.Itisimportant
thatthisisnotexceeded
without
senior
management approval.
Creditanalysisshouldalsobeperiodically
re-applied,
especially
ifdealing
witha largecustomer.
4.2.3 Collectionstage
Aclearprocess needstobeinplaceforchasing latepayment.Forexample,ona regular
basisa
company could:
(a) Prepare anagedlistingofreceivables
(b) Issueregularstatements andreminders
(c) Impose sanctionsaftera certain
timelimit(eglegalactionorcharging
interest)
(d) Consider theuseofa debtfactor.
Factoring:
Anarrangement
tohavedebtscollected
bya factorcompany,
whichadvances
a
KEY
TERM proportion
ofthemoney
itisduetocollect.
Adebtfactorcanbeusedsimply tochaselatepayment ortohavea wider roleinmanaging

receivables.
Adebtfactoroffers a rangeofpotential services:
(a) Administrationoftheclient’s
invoicing,
salesaccounting anddebtcollectionservice.
(b) Creditinsurance whereby thefactortakesovertheriskoflossfrombaddebtsandso
‘insures’
theclientagainstsuchlosses.Thisisknown asa non-recourseservice.
Notallfactoringagreements arenon-recourse. Ifthisservice
isnotbeingoffered,thenthisis
a with-recourseservice.
(c) Making payments totheclientinadvance ofcollectingthedebts.Afactorwillpurchase
selectedinvoicesandadvance a percentage oftheirvalue(charging
interestontheamount
advanced).Whenthecustomer pays,thefactorwillpayoverthebalance, lesscharges.This
G issometimes referred
toasinvoice discounting. H
Non-recourse
factoring:
Thedebtfactorhasnorecourse
totheclientintheevent
ofnon-
KEY payment,
iebaddebtsinsurance
isbeingprovided
bythedebtfactor.
TERM
Advantagesof debtfactor Disadvantagesof debtfactor

Savingininternal
administration
costs. Thefeescharged
bya debtfactorforits
services.
Expertise
increditanalysis
willreduce
the Possiblelossofcustomer
goodwill
ifthe
potential
forbaddebts. factoristooaggressive
inchasing
for
payment.
Aflexible
sourceoffinance,
especially
ifcash Inthepast,wasviewed asanindicationthat
flowsareunder
pressureduetorisingsales(ie thecompany usingthefactorisinfinancial
overtrading). difficulty.
Asthepopularity
offactoringhas
increased,thishasbecomelessofanissue.
Activity9: Debt factor
Acompany withsalesof$240million p.a.hasanaverage collection

periodofthreemonths;bad
debtsare2%.Afactoring company willprovidenon-recourse
factoringfora feeof5%ofrevenue.
Asa result
ofthis,administration
savings willbemadeof$8million p.a.andthecreditperiodwill
falltotwomonths. Thefactorwillalsoadvance 75%ofthevalueofinvoicesincashforthe
durationofthecreditperiod.
Theinterest rateontheseadvances is13%.
Thecompany hasa costofborrowing of10%.
58 Financial
Management
(FM)
Page 80 of 641
q
Required
Assess
whether
thefactorshould
beused.
Solution
4.3 Managing foreign accounts receivable

Foreign debtsraisethefollowingspecial
problems.
(a) Itmaybeharder tobuildanaccurate creditanalysis
ofa company ina distant
country.
G H
(b) Itmaybeharder tochaseforeigncustomers forpayments (different

timezonesand
languages).
(c) Ifa foreign
debtor refusestopaya debt,theexportermustpursue thedebtinthedebtor’s
owncountry andmaylackanunderstanding oftheprocedures andlawsofthatcountry.
Somebusinesses maydecidetotrusttheforeign receivable
andnottakeanyspecial measures to
reduce thenon-payment risk.Thismethodisknown asopenaccount andmaybesuitable for
smalltransactions.
However, thereareseveralmeasures available
toexporterstohelpovercome therisksofnon-
payment orlatepayment onlargertransactions.
Methodsofreducingrisks
Billofexchange AnIOUsigned bythecustomer.Untilitispaid,shipping
documents
thattransfer
ownership tothecustomer arewithheld.
Asnoted
in
Chapter2,a BillofExchange
canalsobesoldtoraisefinance.
Letter
ofcredit Thecustomer’s
bankguarantees
itwillpaytheinvoice
afterdelivery
ofthegoods.
Invoice
discounting Saleofselected
invoices
toa debtfactor,
ata discount
totheirface
value.
Debtfactoring Alocaldebtfactorbasedintheexportmarket
canbeespecially
useful
inperformingcreditanalysis
andchasing
forpayment.
3:Working
capital
investment
59
Page 81 of 641
q
Essential reading
SeeChapter 3 Section6 of the Essentialreadingforfurtherdiscussionof thisarea.

TheEssentialReadingis availableas an Appendixof the digitaleditionof the Workbook.
5 Managing trade payables
Effectivemanagementof trade accounts payable involvesseekingsatisfactorycredittermsfrom

supplierand maintaininggood relationswithsuppliers.
Timelypaymentof invoices,inlinewithagreed paymentterms,willpreventthe possibilitythat
late paymentof invoicesendangersthe firm’slong-termrelationshipwiththe supplier.
5.1 Evaluating discounts
Ifa supplieroffersa discountforthe earlypaymentof debts, the evaluationof the decision
whetherto accept the discountis the mirrorimageof the evaluationof the decisionwhetherto
offera discountto customers.
Acceptingearlysettlementdiscountsfroma supplierwillresultina benefit(the discount)but will
resultinlowerpayables whichwillincura cost to the companyby increasingthe cost of the
interestcharged on an overdraft,sincemoneyis beingpaid to suppliersearlier.
Thiscan be assessed by comparingthe benefitof the discountto the cost of higherfinance
costs associated withlowerpayables.
Activity 10: Discounts
G
PipsCo has been offereda discountof 2.5%foran earlysettlementby a majorsupplierfrom H
whichit purchasesgoodsworth$1,000,000each year. Pip’snormalpaymenttermsare 30 days;

earlysettlementrequiresthe paymentto be made within10days.
CurrentlyPipshas an overdrafton whichit is paying10%interest.
Required
Whatis the net benefitof acceptingthe earlysettlementdiscount(assuminga 365-day year)?
 $54,795
 $25,000
 $19,520
 $5,480
Solution
60 Financial
Management
(FM)
Page 82 of 641
q
5.1.1 Evaluatinga supplierdiscountusingpercentages
Thebenefit
ofanearlypayment discount
canbeexpressed
inpercentage
terms.
Illustration5: Supplierdiscounts
Acompany whichhasanoverdraft
costing
10%peryear,isevaluating
whether
toaccepta 1%
discount
forpayingitsinvoices
30daysearlier.
Assumea 360-dayyear.
Required
Evaluate
whether
toacceptthediscount.
Solution
No$ amounts aregivenhere,sowemustlookatthisinpercentage
terms.
Ifthecompany acceptedtheofferanddidpay30daysearly,itreceives
a benefit
thatcanbe
expressedasa percentage
asfollows:
Discountreceived × 100
Amountpaidifdiscounttaken
Herethisis1%/99% = 0.0101
or1.01%,where 1%isthediscountand99%isthepercentage ofthe
amount duethatispaid(afterthe1%discount).
Thisisthebenefit ofaccepting theofferexpressedovera 30-dayperiod(sincethecompany is
paying30daysearly).Thiscanbeconverted intoanannualequivalent
rateusingthefollowing
formula. (Thisformula isnotgivenintheexam).
(1+R)= (1+r)
n
R=annual rate
r=period rate(here30days)
G
n=no.ofperiods ina year(here360/30=12) H
Inannual terms thisis1.0101

^ 12=1.1282soR=12.82%.
Sincethebenefit ofthediscount of12.82%isabovethecostoftheoverdraft(10%peryear)the
discount should beaccepted.
Thesameformula canbeusedforaccounts receivable.
Activity11:Discountas a percentage
HanselCoistomakea payment of$10,000

toa supplier.
A2%discount
isavailable
forpaying
afteronemonth
insteadofthestandard
termofthreemonths.
Required
Whatistheannual
percentage
costofthediscount?
 27.4%
 12.9%
 26.8%
 12.6%
3:Working
capital
investment61
Page 83 of 641
q
Solution
5.2 Managing foreign accounts payable

Toavoidtheriskofanadverse
exchange ratemovement
bythetimea foreign
currencyinvoice
is
duetobepaid,companiessometimes paytheinvoice
early.Thisissometimes
calledleading.
Themanagement ofexchange
rateriskiscovered
inChapter 14.
PER alert
Performance objective
10requires
youto‘prepare
andmonitor anorganisation’s
cashflow,
creditfacilities
andadvise
onappropriate
actions’.
Thissection
covers
themanagement of
accounts payable andcreditterms.
6 Final exam standard example
G
Thisfinalexample
shows
howthischapter
couldbetested
asa partofa Section
C examquestion. H
Activity12: Homeworkexample
VelmCosellsstationery
andofficesupplies
ona wholesale basisandhasannual revenue
of
$4,000,000.
Thecompany employs fourpeopleinitssalesledgerandcreditcontrol
department
atanannual salaryof$12,000
each.Allsalesareon40days’creditwithnodiscount forearly
payment.Baddebtsrepresent3%ofrevenue andVelmCopaysannual interest
of9%onits
overdraft.
Themostrecentaccountsofthecompany offerthefollowingfinancial
information:
VELMCO:STATEMENT OFFINANCIAL POSITION ASAT31DECEMBER 20X2
$’000 $’000
Tangible
non-current
assets
Tangible
non-current
assets 17,500
Current
assets
Inventory
ofgoodsforresale 900
Receivables 550
Cash 120
1,570
Totalassets 19,070
Equityandliabilities
Ordinary
shares 3,500
62 Financial
Management
(FM)
Page 84 of 641
q
$’000 $’000
Reserves 11,640
15,140
Non-current
liabilities
12%bondsdue20Y0 2,400
Current
liabilities
Trade
payables 330
Overdraft 1,200
1,530
Totalequityandliabilities 19,070
VelmCoisconsidering offeringa discount
of1%tocustomers payingwithin
14days,whichit
believeswillreducebaddebtsto2.4%ofrevenue. Thecompany alsoexpects
thatoffering
a
discount forearlypayment willreducetheaveragecreditperiod
takenbyitscustomersto26
days.Theconsequent reduction inthetimespentchasingcustomerswherepayments areoverdue
willallowonemember ofthecreditcontrolteamtotakeearlyretirement.
Two-thirds
ofcustomers
areexpected totakeadvantage ofthediscount.
Required
Usingtheinformation
provided,
determine
whether
a discount
forearlypayment
of1%willleadto
anincreaseinprofitability
forVelmCo.Assume
a 365-dayyear.
Solution
G H
3:Working
capital
investment
63
Page 85 of 641
q
Chapter summary
Workingcapitalinvestment
Objectives
ofworking Working
capitalplanning
capitalmanagement
Profitability Influences
oninvestment
in Operating
cycle
Increasing
theprofits
ofa working
capital Time
taken
toreceive
cashless
business • General
factors
(nature
of time
topaysuppliers
industry,
policy
ofrivals,
Liquidity seasonal
factors) Sales
tonetworking
capital
ratio
Considering
impactonability • Company-specific
(sales, Used
toforecast
financing
tomeetshort-term
liabilities policies) impact
ofsales
increases
(next
chapter)
Aggressive
working
capital Overtrading
Conflict management
Minimise
networking
capital • Indicated
byrapid
increases
in
• Possible
conflict
asinvesting increases
assales
rise sales
inworking
capital
toimprove • Andfalling
margins
andworse
profits liquidity
• Maycauseliquidity
issues Conservative
working
capital • Rising
operating
cycle
is
management another
indicator
High
levels
ofnetworking
capital • Also
calledundercapitalisation
Working
capital
ratios
Quantify
working
capital
policies/needs
G H
Inventory Receivables Payables
EOQ model Policy

formulation Maintaining
relationships
• Formula
given • Whether
tooffer
credit Avoid
latepayment
• Assumes
constant
demand • Credit
terms
• Assumes
zero
lead
times
• Assumes
nodiscounts Managementframework Evaluating
discounts
in$sor%s
• Credit
analysis
Discounts • Credit
control
Consider
impact
oninventory • Debt
collection Foreign
accounts
payable
related
costs • Use
ofadebtfactor Leading
Buffer
stock Foreign accounts
receivable
Increases
average
inventory • Billofexchange
• Letterofcredit
JIT • Invoicediscounting
• Zero
inventory
approach • Debt factor
• Addresses
hidden
costs
of
inventory Evaluation
• Credit
period
• Early
settlement
discounts
• Factoring
64 Financial
Management
(FM)
Page 86 of 641
q
1.Objectives
ofworkingcapitalmanagement
Thetwomainobjectives
ofworking capitalmanagement
aretoincrease
theprofitsofa business
andtoprovide
sufficient
liquidity
tomeetshort-term
obligations
astheyfalldue.Thesetwo
objectives
maysometimes conflict.
2. Cashoperating
cycle
Thecashoperating
cyclecanbeusedtodetermine theamount ofworkingcapitalinvestment
neededatanysaleslevel,andtoidentify
thepossibility
ofa cashshortfall
ifsalesrisetoorapidly.
3. Inventory
Theeconomic
order quantity
model
attemptstoidentify
theoptimallevelofinvestment
in
inventory
thatisrequired.
TheEOQmodelignoresthehiddencostsofinventory.
JIT suggests
that
inventory
shouldbedriven
downtoasclosetozeroaspossible.
4. Receivables
Requires
a four-stepapproach:
(a) Areceivables
policy
(b) Aplanning(creditanalysis)
system
(c) Amonitoring(credit
control)
system
(d) Adebtcollectionsystem
5. Payables
Involves
controlling
thetimingofthepayment ofinvoices
toexploit
attractive
earlypayment
discounts,
andthecreditperiodoffered
bysuppliers;
butensuringthatinvoices
arenotpaidso
lateastoendanger long-term
supplier
relationships.
G H
3:Working
capital
investment
65
Page 87 of 641
q
Question practice
Nowtrythefollowing
fromtheFurther
question
practice
bank(available
inthedigitaledition
of
theWorkbook):
Section
A questions
Q10,Q11,Q12,Q13
Section
C questions
Q38Gustaffson
Q39Hfinance
Q40Victory
Q41ZX
Further reading
There
isa useful
TechnicalArticle
written
bya memberoftheFMexamining
teamthatisavailable
onACCA’swebsite;itiscalled‘Management
offoreign
accounts
receivable’.
Werecommend that
youreadthisarticleaspartofyourpreparation
fortheFMexam.
G H
66 Financial
Management
(FM)
Page 88 of 641
q
Activity answers
Activity1:Forecasting
$864,000× 73/365=$172,800
Activity2: Combination ofratios

Thecorrect answeris:$200m
Currentassets/Currentliabilities
=2
(10+Receivables)/15=2
Receivables=(2×15)– 10
=20
(Receivables/Credit
sales)× 365=36.5
(20×365)/Credit sales=36.5
Creditsales=(20×365)/36.5
=$200m
Activity3: Operatingcycle
46.8days
1 Inventory
days
Finished
goods 86,400/756,000 ×365 =41.7days
2 Receivables
days 172,800/864,000 ×365 =73.0days
G
3 Payables
days 96,400/518,400 ×365 =(67.9)
days H
Cashoperating
cycle= 46.8
Activity4: Sales/networkingcapital
Thecorrectansweris:$37,700
$864,000+ $200,000=$1,064,000
$1,064,000/5.3071
=$200,486
Thisisanincrease
of$200,486 – $162,800
= $37,686
or$37,700tothenearest
$100
Thisrepresents
theincreaseincashduetomovements inworking
capital.
Alternative
solution:
$200,000/ 5.3071
= $37,685or$37,700tothenearest
$100
Activity5: EOQ
1 Annual
demand
= 12×150=1,800
EOQ=
Q= 2C0D 2 × 32× 1,800= 160=

Ch 4.5
Average
inventory
=Q/2=80units.
2 Totalinventory
related
cost=Ch×Q/2+ Co×D/Q+purchasing
cost
=$4.50×160/2+$32×1,800/160+$25×1,800
3:Working
capital
investment
67
Page 89 of 641
q
=$45,720
Activity6: Bulkpurchasediscounts
Ifnodiscountistaken,
inventory
related
costsare$45,720
(previous
activity).
Q Ordercost Holding
cost Purchase
cost Total
(Co×D/Q) (Ch×Q/2) D×P) $
300 192 675 44,100 44,967
800 72 1,800 43,200 45,072
∴ Order300unitsata timeandacceptthe2%discount.
Activity7: Extendedcreditterms
Thecorrect answeris:$10,750
benefit
Cost
Financecostwas600,000×2/12×10%=$10,000
Financecostwillbe600,000×1.15× 3/12×10%=$17,250
Additional
cost=$7,250
Benefit
Additional
contribution=600,000×15%×20%=$18,000
Netbenefit =$10,750
Activity8: Earlysettlement discounts

G
Thecorrect answeris:$3,836benefit H
Cost
$10m×0.2×0.02=$40,000
Benefit
Currentreceivables=90/365×$10m=$2,465,753
Newreceivables =(0.2×10/365×$10m) +(0.8×90/365×$10m) =$54,795+ $1,972,603
=
$2,027,398
Note.Theeffectofthesettlement discount
isnotincludedinanalysing
thenewreceivables.
This
assumes thatsalesarerecorded beforetheeffectofthesettlement
discount(thisisnormally
recordedseparately).Thisistheapproach thathasbeenadopted inpastACCAFinancial
Management examquestions.
Reductioninreceivables=$438,355
Savinginoverdraftinterest=$43,836
Netbenefit =$3,836
Salesmayalsoriseasa result ofthepolicy.
Thepolicyshould beintroduced.
Activity9: Debtfactor
Costofdebtfactor
$m
Factors
charge
$240m×5% 12.0
Interest
onadvances
(13%– 10%)× 75%×$240m×2/12 0.9
68 Financial
Management
(FM)
Page 90 of 641
q
$m
12.9
Alternative
solution
forinterest
onadvances:
Amount advanced=0.75×annual sales=$180m.
Thisisadvanced
for2 months
atanannualcostof3%(13%netof10%)ie$180m×2/12×0.03=$0.9m.
Benefit
ofthedebtfactor
Impact
oflower
receivables
Current
receivables $240m×3/12=$60m
Newreceivables $240m×2/12=$40m
Reduction
inreceivables $20mleadstointerest
savedof$20m×0.1=$2m 2.0
Baddebts
$240m×2% 4.8
Administration
savings 8.0
14.8
∴ Usethefactorasitisestimated
tosave$1.9m
p.a.
Activity10:Discounts
Thecorrectansweris:$19,520
Cost
G Currentpayables=30/365×1,000,000 = $82,192 H
Newpayables =10/365×1,000,000 = $27,397

(aswithreceivables
thediscount
isignoredinthiscalculation)
Reductioninpayablescausesanincreaseinoverdraftinterest
of$54,795
× 0.1=$5,480
Benefit
0.025×$1,000,000 =$25,000
NetSaving=$19,520
Activity11:Discountas a percentage
Thecorrect answeris:12.9%
Paying$9,800onemonth earlyinstead of$10,000isa benefit
of$200.
Thisisa benefit
of200/9,800 = 0.0204or2.04%overa two-month period.
Orasa %=2%/98% =0.204
There aresixtwo-month periodsina yearsothisisanannual benefit
of1.0204^ 6 =1.129
ie12.9%
Incorrectanswers:
12.6% iscalculated
as200/10,000 =1.02andthen1.02^ 6 =1.126ie12.6%
26.8%iscalculatedas200/10,000 =1.02andthen1.02^ 12=1.268ie26.8%
27.4% iscalculated
as200/9,800 = 1.0204andthen1.0204^ 12=1.274ie27.4%
Activity12:Homework example
Receivables
arecurrently
takingonaverage($550,000/$4,000,000)×365=50daystopay.This
isinexcessofVelm’s
stated
terms.Thediscount,tobetakenupby2/3ofcustomers, willcostthe
company $4,000,000
× 1%×2/3=$26,667.Itisstated
thatthiswillbringthereceivables
payment
3:Working
capital
investment
69
Page 91 of 641
q
perioddownto26days,whichisrepresented bya newreceivables
levelof$4,000,000
× 26/365=
$284,932.
Thisisa reduction
inreceivablesof$265,068.
Atcurrentoverdraft
costsof9%,thiswould bea savingof$265,068× 0.09=$23,856.
Baddebtswould decrease from3%to2.4%ofrevenue, whichsavesa totalof$4,000,000× 0.006
=$24,000.Therewould alsobea salarysavingfromearlyretirement
of$12,000.
SotheneteffectonVelm’s profitability
isasfollows:
$
Savingonoverdraft
costs 23,856
Decreased
baddebts 24,000
Salarysaving 12,000
Lesscostofdiscount (26,667)
Netsaving 33,189
G H
70 Financial
Management
(FM)
Page 92 of 641
q
4
Cash management and
working capital finance
4
Learning objectives
Oncompletion
ofthischapter
youshould
beableto:
Syllabus
reference
Managementofinventories,
receivables,
payables andcash(continued)
• Explain
thevarious
reasons forholding
cash,anddiscussandapplythe C2(f)
useofrelevant
techniquesinmanaging cash,including:
- preparingcashflowforecaststodeterminefuture
cashflowsandcash
balances
- assessingthebenefits
ofcentralised
treasurymanagementandcash
control
- cashmanagement models, suchastheBaumol andtheMiller-Orr
G H
models
- investing
short-term.
Determining
working capitalneedsandfunding strategies
• Describe
anddiscuss thekeyfactors indeterminingworkingcapital C3(b)
funding
strategies,
including:
- thedistinction
between permanent andfluctuatingcurrentassets
- therelative
costandriskofshort-term andlong-term finance
- thematching principle
- therelative
costsandbenefits ofaggressive,conservative
and
matchingfunding policies
- management attitudestorisk,previous
fundingdecisions
&
organisation
size.
4
Exam context
Thischaptercoversissuesrelatingtoliquidity
andthefinance ofworkingcapital,whicharepart
ofSectionC ofthesyllabus (Working capitalmanagement)andcompletes thissyllabussection.
Likethepreviouschapter,thissyllabusareaisexaminableinallsections
oftheexamandexam
questionswon’tjustinvolve
calculations(eginsectionC partofanexamquestion mayaskyouto
discusstypesofworking capitalfunding strategies
ortoexplainthemeaning ofa numericalcash
flowanalysis
thatyouhaveperformed).
Page 93 of 641
q
4
Chapter overview
Workingcapital finance
Cashmanagement Mathematical
models
Motives
forholding
cash Baumol
Cash
flow
forecasting Miller-Orr
Easing
cash
shortages
Managing
cashsurpluses
Working
capitalfinance Treasury
management
G
Asset
types Functions H
Aggressive
financing
strategy Centralised
Conservative
financing
strategy Decentralised
72 Financial
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1 Cash management
PER alert
Performance objective
10requires
youto‘prepare
andmonitoranorganisation’s
cashflow,
creditfacilities
andadvise
onappropriate
actions’.
Thischapter
covers
themanagement of
cashandcashflowforecasts.
Wesawintheprevious chapter thatworking

capitalmanagementhastwomainobjectives:
(a) Toincrease
theprofits ofa business
(b) Toensuresufficient
liquidity
tomeetshort-term
obligations
astheyfalldue
Thischapter
mainly focusses onliquidity
andcoverstheimportance
ofcashflowmanagement
anddifferent
strategies
thatcanbefollowed toprovideworking
capitalfinance
1.1 Motives for holding cash
There
arethreemainmotives
forholding
cash.
Transactionsmotive Precautionarymotive Speculationmotive
Abusiness primarily
needsto Cashmayalsobeneeded to Somebusinessesholdsurplus
plantomaintainsufficient meetunexpected occurrencescashtotakeadvantage of
cashtomeetitsforecast (eganunforeseen downturn attractiveinvestment
transactions
egpaying insales,ordisruption to opportunities
ifthesearise.
suppliers,
employeesetc. production). Forexample,theopportunity
Cashrequirementstocover Thisoftenmeans thata totakeoveranothercompany
thismotivecanbeplanned businesswillarrange an atanattractive
price.
usinga cashflowforecast. overdraftfacility,orshort-
G
terminvestments whichcan H
easilybeconverted intocash
(discussedinsection 1.4).
However,
holding
cash(ornearequivalents
tocash)hasa cost:thelossofprofitswhichwould
otherwise
havebeenobtained
byusingthefundsinanother way.So,asever,thefinancial
manager
musttrytobalance
liquidity
withprofitability.
1.2 Cash flow forecasting
Cashflowforecast:
Adetailed
forecast
ofcashinflows
andoutflows
incorporating
both
KEY revenue
andcapitalitems.
TERM
Cashflowforecasts
willbeprepared
continuously
during
theyearandwillallowa business
to
planhowtodealwithexpectedcashflowsurpluses
orshortages.
1.2.1 Formatofcashflowforecast
Acashflowforecastwilltabulateestimatedfuture cashreceiptsandpayments insucha wayas
toshowtheforecastcashbalance ofa businessatdefined intervals.
Thereisno‘set’format
that
youarerequiredtousebutitissensible tofollowtheseguidelines:
(a) Havetwoseparate sections,oneforcashinflows andoneforcashoutflows
(b) Don’treproduce
theforecast separatelyforeachtimeperiod (instead
adda newcolumn for
eachtimeperiodbeinganalysed)
(c) Finish
eachcolumn bynetting offthecashflowfortheperiod andaddingittocashbrought
forwardtocreatea finalcashflowcarriedforward figure.
Thiscanbedoneeasilyintheexam
usingthespreadsheet functionality
availableintheconstructiveresponseworkspace.
4:Cashmanagement
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Hereisanexample
ofa cashforecast,
illustrating
a sensible
format.
CASHFORECASTFORTHETHREEMONTHS
ENDED31MARCH20X1
January February March
Cashreceipts
Salesreceipts
(W1) X X X
Issueofshares X
Cashpayments
Purchase
payments
(W2) (X) (X) (X)
Dividends/Taxes (X)
Purchase
ofnon-current
assets (X)
Wages (X) (X) (X)
Cashsurplus/deficit
formonth X (X) X
Cashbalance,
beginning X X (X)
Interest
onopening
cash
balance X X (X)
Cashbalance,
ending X (X) X
Working
January February March
G
1. Timing
ofsalesreceipts H
Revenue
fromsales1monthago(assuming
1- FromDec FromJan FromFeb
monthcreditperiod) sales sales sales
2. Timing
ofsupplier
payments
Supplier
invoices
from2 months
ago(assuming FromNov FromDec FromJan
2-monthcreditperiod) purchases purchases purchases
Examfocus point
Intheexamyouwillneedtothinkcarefully
abouttheexpectedtimingofreceipts
and
paymentsofcashduringtheperiodandwhether
a costisa cashitemegdepreciation.
Activity1:Cash forecast
Benisa wholesalerofmotorcycle
helmets.
Itis1January20X2.
Creditsalesinthelastquarter
of20X1wereasfollows:
Helmets
October 2,000
November 2,000
December 2,500
74 Financial
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q
Hiscreditsalesinthefirstquarter
willbeasfollows:
Helmets
January 3,000
February 5,000
March 4,500
Customers aregiven60days’creditandtheaverage sellingpriceis$10,a priceriseof$1is
planned inFebruary. Hisbiggestcustomer,Mickster,
isgivena 2%discount forpayingcashwhen
thesaleismade.Mickster isplanning
tobuy150helmets inJanuaryand250Helmets inMarch.
ThesalestoMickster areinadditiontothosecreditsalesstatedabove.
Purchases (anaverage of30days’credit) are$4perhelmet. Benplanstobuyinthehelmets a
month inadvance ofsellingthem.Totaloverheadsare$2,000permonth; thisincludes$400
depreciationandwagesof$1,000.Allotheroverheads arepaidforaftera creditperiod of30
days.
Benplanstoinjecta further $5,000ofhisownmoney intothebusiness inMarchtohelptobuy
non-current assetsfor$29,000.Theseassetswillbedepreciatedoverfiveyears.
Opening cashflowisnegative $4,550whichisclosetoBen’soverdraft limitof$5,500.
Required
Prepare
a monthly
cashflowforecast
forthefirstquarter
of20X2andcomment
onyourresults.
Solution
G H
4:Cashmanagement
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1.2.2 Workingcapitalmovements
Ifa questionprovides
youwithoperating cashflowsandworking capitalmovements,youmay
berequired toadjust
theoperating cashflowsforthecashflow impactofworkingcapital
movements tocalculate
monthly cashflows.
Takingthepreviousactivity,
ifyouhadbeengiventheoperating cashflowsinJanuaryasbeing
$17,270andhadbeentoldthat,during Januaryreceivablesareforecasttoincrease
by$10,000
(meaning that$10,000ofrevenue isdeferredtothenextperiod),
tradepayablesareforecast
to
increaseby$7,400(meaning that$7,400ofcostisdeferred tothenextperiod)andinventory
is
forecasttoriseby$7,400(incurring $7,400ofcostinthisperiod);
thenthenetcashflowin
G
Januarycouldbecalculated as: H
$
Original
operating
cashflows 17,270
Lessincrease
inreceivables (10,000)
Plusincrease
inpayables 7,400
Lessincrease
ininventory (7,400)
NetcashflowforJanuary 7,270
Essentialreading
1oftheEssential
Reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
practice
onthisarea.
TheEssential
readingisavailable
asanAppendix
ofthedigitaledition
oftheWorkbook.
1.3 Methods of easing cash shortages

Thestepsthatareusually
takenbya company whena needforcasharises,
andwhenitcannot
obtain
resourcesfromnewsourcesoffinance,couldinclude
thefollowing:
(a) Delaying
non-essential
capitalexpenditure
Somenewnon-currentassetsmightnotbeneeded forthedevelopmentandgrowthofthe
business,
butitmaynotbepossible todelaysomecapitalexpenditures
without
serious
consequences.
76 Financial
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Forexample, ifa company’s policyistoreplace company carseverytwoyears,butthecompany
isfacinga cashshortage, itmightdecidetoreplace carseverythreeyears.
(b) Accelerating cashinflows whichwouldotherwise beexpected ina laterperiod.
Itmightbepossible toencourage creditcustomers topaymorequickly byofferingdiscounts
for
earlier
payment. Thiswascovered inChapter 3.
(c) Reversing pastinvestment decisions bysellingassetspreviously acquired
Someassetsarelesscrucialtoa business thanothers.Ifcashflowproblems aresevere,
theoption
ofselling
investments orpropertymighthavetobeconsidered. Saleandleaseback ofproperty
couldalsobeconsidered.
(d) Negotiating a reductionincashoutflows topostpone orreduce payments
Thereareseveral waysinwhichthiscouldbedone:
• Longer creditmightbetakenfromsuppliers. Suchanextension ofcreditwouldhavetobe
negotiatedcarefully:therewould bea riskofhaving furthersuppliesrefused.
• Loanrepayments couldberescheduled byagreement witha bank.
• Dividend payments couldbereduced. Dividendpayments arediscretionary
cashoutflows,
however cutting thedividendislikelytobeinterpreted assignofweakness bythefinancial
markets sothiscouldbeconsidered asa lastresort.
1.4 Managing cash surpluses
Ifcashsurpluses
areonlyforecastfortheshort-term
(egduetoseasonal factors)
andwillbe
required
tooffsetcashdeficits
inthenear-future,
thenitwillbeimportant
toinvest
thesecash
surpluses
ina waythatminimises risk(because
thefundswillbeneeded soon).
Desirable
investments
wouldgenerally belowriskandliquid(ieeasytoturnintocash).These
couldinclude:
Definition
G H
Treasury
bills Short-term
government
IOUs,canbesoldwhenneeded
Termdeposits Fixedperiod
deposits
Certificates
ofdeposit Issued
bybanks,
entitle
theholder
tointerest
plusprincipal,
canbe
soldwhenneeded
Commercial
paper Short-term
IOUsissued
bycompanies,
unsecured
Ifcashsurplusesareforecast
forthelong-term(egduetoseasonal
factors)
thena different
perspective
canbetaken. Long-term cashsurpluses
maybeusedtofund:
(a) Investments– newprojectsoracquisitions
(b) Financing– repaydebt,buybackshares
(c) Dividends– returning
fundstoshareholders
These areasarecoveredinlaterchapters.
Essentialreading
2 oftheEssential
reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
discussion
ofthisarea.
TheEssential
readingisavailable
asanAppendix
ofthedigitaledition
oftheWorkbook.
2 Mathematical models
Anumber
ofdifferent
cashmanagement
models
indicate
theoptimum
amount
ofcashthata
company
shouldhold.
4:Cashmanagement
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2.1 Baumol model
TheBaumol model isbasedontheideathatdecidingonoptimum cashbalancesislikedeciding
onoptimum inventorylevels.
Itassumesthatcashissteadily
consumedovertimeanda business
holdsa stockofmarketable
securities
thatcanbesoldwhencashisneeded. TheBaumol modelis
anadaptation oftheEOQmodel tomanage cash.
Formulaprovided
Economicorder quantity = 2CoD

Ch
Thecostofholdingcash(Ch)isthecostofobtaining
thefundsnetofanyinterest
earned
by
investing
thefunds.
Thecostofplacinganorder(Co)istheadministration
costincurred
whenselling
thesecurities.
Thedemand (D)istheannualcashrequired.
Illustration1:Baumolapproachto cash management
Finder
Cofacesa fixedcostof$400toobtain
newfunds.Itrequires
$240,000ofcasheachyear.
Theinterest
costonnewfinance is12%peryearandtheinterest
earnedonshort-term
securities
is
9%peryear.
Required
Howmuchfinance
should
Finder
raiseata time?
G
Solution H
Thecostofholdingcashis12%– 9%=3%
Thecostofplacinganorderis$400
Theannualdemand is$240,000
Applying
theEOQformula, theoptimum
levelofQ(the‘reorder
quantity’)
is:
2 × 400× 240,000= $80,000
0.03
Theoptimumamount ofnewfundstoraiseis$80,000.Thisamount
israised
threetimes
every
year(240,000÷80,000).
Activity2: Baumolmodel
Adivision
requires
$1.5m
peryear;cashuseisconstant
throughout
theyear.Transaction
costsare
$150pertransaction
anddeposit
interest
isgenerated
at7.5%andinterest
onshort-term
financial
securities
is12%.
Required
Whatistheoptimaleconomicquantity
ofcashtransfer
intothisdivision’s
sub-account
andhow
frequently?
 $1,500,000oncea year
 $77,500,
19times a year
 $61,200,25timesa year
 $100,000,15timesa year
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2.1.1 DrawbacksoftheBaumolmodel
(a) Inreality,
itisdifficult
topredict
amounts required
overfuture
periods
withmuchaccuracy.
(b) Itisunlikelythatcashwillbeusedata constant
rateoveranygivenperiod
(there
willpoints
intimewhencashoutflowswillspikeasmachinery isboughtoraninterest
paymentona
loanismadeetc).
2.2 Miller-Orr model
Anothercashmanagement model istheMiller-Orrmodel,whichrecognises thatcashinflowsand
outflowsvaryconsiderablyona daytodaybasis.Thisisclearlymorerealistic thantheBaumol
model’sassumption ofconstant usageofcashduring a period.
Itworksasfollows:
(a) Asafetylevel(lowerlimit)ofcashisdecided upon(oftenthiswillbeimposed bya bank).
(b) Astatistical
calculation
iscompleted toestablish
theupperlimit(themaximum cashthatwill
berequired)takingintoaccount thevariability
ina firm’s
cashflows. Thedifference
between
thelowerandupperlimits iscalleda spread,thisiscalculated
usinga formula(whichis
given):
( Interest
rate )1
Spread = 3 3 × Transactioncost × Varianceofcashflows 3
4
Theupperlimit= lowerlimit+ spread

(c) Thecashbalance ismanaged toensure thatthebalance atanypointintimeiskeptbetween
thelower andupperlimits.
Ifthecashbalance reaches anupperlimit(point Ainthefollowing diagram) thefirmbuys
sufficient
securitiestoreturnthecashbalance toa normallevel(calledthe‘return
point’).
Whenthecashbalance reaches a lowerlimit(point
B),thefirmsellssecurities
tobringthe
balance backtothereturn point.
G
Cash A
H
balance Upper
limit
Thefirm
buyssecurities
Return
point
Thefirm
sells
securities
Lower
limit
B
0 Time
Formulaprovided
Thereturn
pointiscalculated
as:Lower
limit+ (1/3×spread)
Thisformula
isalsogiven.
Illustration2: Miller-Orr
Thefollowing
dataapplies
toa company.
(1) Theminimum
cashbalance is$8,000.
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(2) Thevariance
ofdailycashflowsis$4,000,000,
equivalenttoa standard
deviation
of$2,000
perday(note:standarddeviation
isthesquare
rootofthevariance).
(3) Thetransaction
costforbuyingorselling
securities
is$50.Theinterest
rateis0.025%per
day.
Required
Youarerequired
toformulate
a decision
ruleusingtheMiller-Orr
model.
Solution
(1) Thespread between
theupperandlowercashbalance
limits
iscalculated
asfollows.
( )1
Spread = 3 3 × Transactioncost× Varianceofcashflows
3
4 Interest
rate
( )1
Spread = 3 3 × 50× 4,000,000
3
4 0.00025 =
3 × (6 × 10 11) 1 = 3 × 8,434.33 = $25,303 say $25,300
3
(2) Theupperlimitandreturn pointarenowcalculated.
Upperlimit= lower
limit+ $25,300=$8,000+$25,300=$33,300
Returnpoint= lowerlimit+ 1/3×spread= $8,000+1/3×$25,300
=$16,433,
say$16,400
(3) Thedecisionrulesareasfollows.
• Ifthecashbalance reaches $33,300,buy$16,900(=33,300- 16,400)
inmarketable
securities.
• Ifthecashbalance fallsto$8,000,sell$8,400ofmarketable
securities
forcash.
G H
Examfocus point
Variance=standarddeviation
2soifyouaregiventhestandarddeviation,
youwillneedto
squareittocalculate
thevariance.
Ifyouaregiventheannualinterest
rate,youwillneedtodivide
itby365toobtainthedaily
interest
rate.
2.2.1 DrawbacksoftheMiller-Orrmodel
Theusefulness
oftheMiller-Orrmodel islimited
bytheassumptions onwhichitisbased:
• Theestimatesused(forexample ofvariability)
arelikelytobebasedonhistoric information
whichmayunreliable asa predictoroffuture
variability
(forexample
iftheeconomic or
competitive
environmentchanges).
• Themodeldoesnotincorporate theimpact ofseasonality:forexample,
fora retailer,
seasonal
factors
arelikelytoaffectcashinflows.
3 Working capital finance

Asa business
grows,itsnon-current
assetandcurrent
assetbaseneedtogrowandthishas
implications
forfinancing.
Hereweconsider
different
strategies
forfinancing
working
capital.
Workingcapitalfinance:
Theapproach
takentofinancing
thelevel,andfluctuations
inthe
KEY
TERM level,
ofnetworking capital.
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Inordertounderstand workingcapitalfinancing
decisions,
assetswillbedividedintothree
different
types.
(a) Non-current(fixed)assets
Long-term assetsfromwhichanorganisationexpectstoderivebenefitovera number ofperiods;
forexample,buildingsormachinery.
(b) Permanent currentassets
Theminimum current
assetbase(eginventory,receivables)
required
tosustain normaltrading
activity.
(c) Fluctuatingcurrentassets
Thevariationincurrentassetsduring
a period,
forexampleduetoseasonal variations.
3.1 Working capital finance strategies
Therearedifferent
waysinwhichlong-andshort-termsourcesoffundingcanbeusedtofinance
current
andnon-current
assets.
Chapter9willexamine
specific
typesofshort-andlong-term
finance inmoredetail,herewe
discuss
someofthegeneralcharacteristics
ofshort-andlong-term finance.
3.1.1 Long-termfinanceandshort-termfinancecompared
Long-term financeisusually
moreexpensive thanshort-termfinance
becauseinvestors
require
a
higherreturnforlockingtheirmoneyawayforlongertimeperiods.
However,long-term financeprovides
highersecurity
totheborrower thanshort-term
finance,
because thereisnoguarantee thatshort-term
financewillbeavailable
tothemwhenitisneeded
inthefuture.
3.1.2 Aggressiveandconservative workingcapitalfinancingstrategies
Intheprevious
chapterweidentified
thatworking
capitalinvestment
strategies
canbe
G aggressive
(lownetworkingcapital)
orconservative
(highnetworkingcapital). H
Similar
terminology
exists
whenwediscuss working
capitalfinancing
strategies.
Aggressive
financingstrategy Conservative
financingstrategy
Minimallong-term
finance
forworking Highleveloflong-term
finance
forworking
capital capital
Mainlyusescheaper short-termsourcesof Mainlyusesmoresecure long-termsources
finance
– short-termfundsareusedto offinance– long-termfundsareusedto
finance
fluctuating
currentassetsanda financepermanent currentassetsanda
proportionofpermanentcurrent assets. proportion
offluctuating current
assets.
Leadstoproblemsifshort-termfinanceisnot Thisstrategyissaferbutcanbeexpensive
available
whenrequired.Thisstrategy
is
therefore
risky
Thefollowingdiagramrelates
thesetypesofstrategytotheinvestmentinnon-current
assetsand
currentassetsofa business.
Thecurved linerepresents
thefinancerequiredatanypointintime.
Thedotted linesA,BandC aredifferentpossible
levelsoflong-term
finance,
dependingonthe
workingcapitalfinance
strategybeingfollowed.
Assets
abovetherelevant dottedlinearefinancedbyshort-term funding
whileassetsbelowthe
dottedlinearefinancedbylong-term funding.
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Assets
($)
A
Fluctuating
current
assets
C
B
Permanent
current
assets
Non-current
assets
0 Time
Aisa conservative
(a) Policy working capitalfinance strategy.
Allnoncurrent assetsandpermanent current assets,aswellasa significant
partofthe
fluctuatingcurrentassets,arefinanced bylong-term funding.
Attimes whenfluctuatingcurrent assetsarelowandtotalassetsfallbelow lineA,therewillbe
surpluscashwhichthecompany willbeabletoinvest inmarketable securities.
(b) PolicyBisanaggressive working capitalfinancestrategy.
Allfluctuatingcurrentassetsallfinanced outofshort-term sources,andalsosomeofthe
permanent current
assets.Minimal long-term finance isused.
(c) PolicyC isa matching (ormoderate) approach.
Abalance between riskandreturn isachieved bypolicyC, a policyofmaturitymatching in
whichlong-term fundsfinance permanent assetswhileshort-term fundsfinancenon-permanent
assets.Thismeans thatthematurity ofthefundsmatches thematurity
oftheassets.
G H
Examfocus point
Becareful
nottoconfuseworkingcapitalinvestmentandworking capitalfinancing
strategies.
Theamountofworkingcapitalthata company choosestohaveisaninvestment
decision
whereasthetypeoffinancing
itusesforitsworking capitalisa financing
decision.
Inexamquestions,
manystudentsdonotdemonstrate knowledge oftheconservative,
aggressive
andmatchingapproachestoworking capitalfinancing.
3.2 Choice of working capital finance strategy

Theworking capitalfinancestrategythatismostappropriate toa company depends on
(a) Management attitudetorisk– short-term financeishigherrisktotheborrowerbecause it
maynotbeavailable inthefuturewhenneeded. Forexample,itmaynotbepossible to
accesstradecreditfromsuppliers whenitisrequired.
(b) Strength ofrelationshipwiththebankproviding anoverdraft– ifstrongthiswillencourage
theuseofshort-term financeasitmakes itmorelikelythata bankoverdraft willbeavailable
whenrequired toprovide short-termfinance.
(c) Abilitytoraiselong-term finance– ifthisisweak(perhaps because theorganisationissmall
and/or hasnotusedlong-term finance wisely inthepast)thiswillmeanthereisa greater
needtouseshort-term financebecause long-term financeishardtoaccess.
4 Treasury management
Theresponsibility
forarranging
short-andlong-term
finance
ispartoftheresponsibility
ofthe
Treasury
department.
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4.1 Functions of treasury management
Treasury
management
normally
hasfourfunctions
Liquidity Risk
management management
Treasury
management
Funding Corporate
finance
4.1.1 Liquiditymanagement
Thisistheshort-term
management ofcashthatwehavereferredtoatthestartofthischapter.
Theaimistoensure thata companyhasaccesstothecashthatitneedsbutdoesnothold
unnecessarily
highlevels
ofcashanddoesnotincurhighcostsfromneedingtoorganise
unforeseenshort-term
borrowing.
4.1.2 Funding
Thisinvolves
deciding
onsuitable
formsoffinance
andorganising
suitable
bankandcapital
marketdebt.
Sourcesoffinancewillbecovered
inChapter9.
4.1.3 Corporatefinance
Thisistheexaminationofa company’s financial
strategies.
Forexample,
isthecapitalstructure
appropriate,
howareinvestments appraised,andhowarepotential
acquisitions
valued?
These areasareallcoveredinlaterchapters.
G H
4.1.4 Riskmanagement
Thisinvolves
understanding
andquantifying
therisksfacedbya company.
Inthisexamthemainfocusisoncurrency
riskandinterest
raterisk(covered
inChapters
14and
15).
4.2 Centralisation of treasury management
Withina centralised
treasury
department,
thetreasurydepartmentisnormally
basedatHead
Officeandactsasanin-house bankserving
theinterests
ofthegroup.
Thishasa number ofadvantagescomparedtothealternative
ofallowing
eachdivision
to
organisetheirown(decentralised)
treasury
operations:
Advantagesof centralisation
Economies
ofscale Borrowingrequired
fora number ofsubsidiaries
canbe
arranged
inbulk(meaning lower administration
costsand
possibly
a betterloanrate),alsocombined
cashsurpluses
canbeinvestedinbulk.
Improved
riskmanagement Foreign exchange riskmanagement islikelytobeimproved
because a central
treasury
department canmatchforeign
currency income earnedbyonesubsidiary withexpenditure
inthesamecurrency byanothersubsidiary.Inthisway,the
riskoflosses onadverseexchangeratemovements canbe
avoided withoutincurring
thetimeandexpense inmanaging
foreignexchange risk.
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Advantagesof centralisation
Reduced
borrowing Cashsurpluses
inoneareacanbeusedtomatchtothecash
needsinanother,
soanorganisation
avoids
havinga mixof
overdrafts
andcashsurpluses
indifferent
localised
bank
accounts.
Lower
cashbalances Thecentralised
pooloffundsrequired
forprecautionary
purposes
willbesmallerthanthesumofseparate
precautionary
balanceswhichwouldneedtobeheldunder
decentralised
treasuryarrangements.
Expertise Experts
canbeemployedwithknowledge
ofthelatest
developments
intreasury
management.
However,somecompanies prefer
todecentralise
treasurymanagementbecause:
(a) Sourcesoffinancecanbediversified
andcanmatchlocalassets.
(b) Greaterautonomy canbegiventosubsidiaries
anddivisions
becauseofthecloser
relationships
theywillhavewiththedecentralised
cashmanagementfunction.
(c) Adecentralised
treasuryfunction
maybemoreresponsivetotheneedsofindividual
operating
units.
G H
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Chapter summary
Workingcapital finance
Cashmanagement Mathematical
models
Motives
forholding
cash Baumol
Transaction,
precautionary
andspeculation • Uses
EOQmodel
motives • Assumes
constant
useofcash
which
isunlikely
Cashflowforecasting Miller-Orr
• Neat
layout • Recognises
cash
variability
• Carewith
timings
andnon-cash
items • Establishes
upper
andlower
cashlimits
Easing
cashshortages
• Practical
steps
designed
nottodamagethe
business
long-term
• Where
possible
avoiddividend
cuts
orcuts
to
important
capital
expenditure
Managing cashsurpluses
• Short-term
investments
inlowrisk,
highly
liquid
assets
• Long-term
surplus
needstobeusedtocreate
G
shareholder
value
orreturned
toshareholders H
Working
capitalfinance Treasury
management
Assettypes Functions
• Non-current
assets • Liquidity
management
• Permanent
current
assets • Funding
• Fluctuating
current
assets • Risk
management
• Corporate
finance
advice
Aggressive
financing
strategy
• Mainly
usesshort-term
finance
forcurrent Centralised
assets
andeven forsomepermanent
current • Economies
ofscale
assets • Improved
risk
management
• Cheaper
butrisky • Reduced
borrowing
• Lower
cashbalances
• Expertise
Conservative
financing
strategy
• Mainly
useslong-term
finance
fornon-current
assets,
permanent
current
assets
andalso Decentralised
somefluctuating
current
assets • Local
finance
used
• Safer,
butmoreexpensive • Autonomy
forsubsidiaries
• More
responsive
4:Cashmanagement
andworking
capital
finance 85
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1.Cashflowforecasting
Thisisthekeytoolforcashmanagement.
Becareful
withcashflowtimings
andnon-cash
items.
2. Cashsurpluses
andshortages
Cashshortages
canbeeasedbypostponingcapitalexpenditure,
sellingassets,takinglonger
to
payaccounts
payableandpressingaccounts
receivable
forearlier
payment.
Temporary
cashsurpluses
canbeinvested
ina variety
oflowriskandhighlyliquidfinancial
instruments.
Longer-term
surpluses
should
bereturnedtoshareholders ifthereisa lackof
investment
opportunities.
3. Mathematical
models
Optimalcashholding
levels
canbecalculated
fromformal
models,
suchastheBaumol
model
and
theMiller-Orr
model.
4. Workingcapitalfinancestrategies
Aggressive
strategyrelies
mainly
onshort-termfinance
tofinanceworking
capital,a conservative
strategy
relies
moreonlong-term finance
tofinanceworkingcapital.
5. Treasury
management
Alargeorganisation
willhavea treasury
department tomanage liquidity,
funding,
risk
managementandcorporate financeadvice.
Thisisoftencentralised.
G H
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Question practice
Nowtrythefollowing
fromtheFurther
question
practice
bank(available
inthedigitaledition
of
theWorkbook):
Section
A questions
Q14
Section
C questions
Q42Velm
G H
4:Cashmanagement
andworking
capital
finance 87
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Activity answers
Activity1:Cashforecast
Cashflowforecast
Jan Feb Mar
Inflows $ $ $
Sales
– Mickster
(Cash)
(98%×$10×150; 2,695
98%×$11×250) 1,470
Salesreceipts
(W1) 25,000
20,000 30,000
Capital
– – 5,000
Totalinflows 21,470 25,000 37,695
Outflows $ $ $
Purchases
(W2) 12,600 20,000 19,000
Overheads
(2,000– 400– 1,000) 600 600 600
G Wages 1,000 1,000 1,000 H
Non-current
assets – – 29,000
Totaloutflows 14,200 21,600 49,600
Netcashflow 7,270 3,400 (11,905)

Balance
b/f (4,550) 2,720 6,120
Balance
c/f 2,720 6,120 (5,785)
Working
Jan Feb Mar
Salesreceipts
from
2 monthsago
November
credit
sales 2,000×$10=20,000
December
credit
sales 2,500×$10=25,000
Januarycredit
sales 3,000×$10=30,000
88 Financial
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Jan Feb Mar
Supplier
invoices
from1month
ago
Decpurchases
for
Jan sales
(credit
&cash) 3,150×$4=12,600
Jan purchasesfor
Febsales(credit
only) 5,000×$4=20,000
Febpurchases
for
Marchsales
(credit
&cash) 4,750×$4=19,000
Activity2: Baumolmodel
Thecorrect answeris:$100,000,
15times
a year
Thecalculationisasfollows:
EOQ = 2 × 150× 1,500,000 = $100,000
0.045
ie15transfers
of$100,000
areneeded.
G H
4:Cashmanagement
andworking
capital
finance 89
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q
G H
90 Financial
Management
(FM)
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q
Skills checkpoint 1
Approach to objective test
(OT) questions
Chapter overview
msuccess
Exa skills
wer
Ans planning
n ecific
FM skills Co
tio Sp o rre
a
o
frm freqctin
in u te
g Technique ir e rpr
n
i
g
Approach
to
objective
test forinvestment m eneta
a (OT)
questions appraisal
n
a
M calculations ts tio n
How
to Handling
G approach complex
o
o
d
your
FM
exam calculations ly sis
a
tim Effective an
l
G
em discussion ca H
an
ag
ofkey
financial
topics meri
u
em
ent ntn
ie
c
Effi
Effectiv ting
ewri
andpresentation
Introduction
BothSections AandBoftheFMexamconsist ofOTquestions.

SectionA – SingleOTquestions
OTquestions aresingle,shortquestions
thatareauto-marked andworth twomarks each.You
mustanswer thewhole questioncorrectly
toearntheirtwomarks. There
arenopartialmarks.
TheOTquestions inSectionA aimfora broadcoverage ofthesyllabus,
andsoallareasofthe
syllabus
needtobecarefully studied.
Youneedtoworkthrough asmanypractice objective
test
questionsaspossible,reviewingcarefully
toseehowcorrect answersarederived.
Thefollowing typesofOTquestion commonly appearintheFMexam:
Questiontype Explanation
Multiple
choice(MCQ) Youneedtochoose
onecorrect
answer
fromfourgivenresponse
options.
Multiple
response
(MRQ) Thesearea kindofmultiple
choicequestion,
exceptyouneedto
selectmorethanoneanswerfroma numberofgivenoptions.
The
question
willspecifyhowmanyanswers
needtobeselected,but
Page 113 of 641

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Question type Explanation
the systemwon’tstop you fromselectingmoreanswersthan this.
Itis importantto read the requirementcarefully.
Fillinthe blank(FIB) Thisquestiontype requiresyou to type a numericalanswerintoa
box.Theunitof measurement(eg$) willsit outsidethe box,and if
there are specificroundingrequirementsthese willbe displayed.
Dragand drop Dragand drop questionsinvolveyou draggingan answerand
droppingit intoplace. Somequestionscouldinvolvematching
morethan one answerto a responsearea and somequestions
may havemoreanswerchoicesthan responseareas, whichmeans
not allavailableanswerchoicesneed to be used.
Dropdownlist Thisquestiontype requiresyou to selectone answerfroma drop
downlist.Someof these questionsmay containmorethan one
drop downlistand an answerhas to be selectedfromeach one.
SectionB– OTCase questions

Similarly,to SectionA,questionscan comefromany area of the syllabus,reinforcingthe need for
candidates to study the wholesyllabus.SectionBwillincludethree OTcase questions.
EachOTCase containsa groupof fiveOTquestionsbased around a singlescenario.Thesecan
be any combinationof the singleOTquestiontypes and they are auto-markedinthe same way
as the singleOTquestions.
OTCases are worth10marks(each of the fiveOTswithinit are worthtwomarks,and as withthe
OTquestionsdescribedabove,studentswillreceiveeithertwomarksor zeromarksforthose
individualquestions).
G
OTcases are writtenso that there are no dependenciesbetweenthe individualquestions.So,if H
you did get the firstquestionwrong,thisdoes not affect yourabilityto get the otherfourcorrect.
TheOTCase scenarioremainson screenso you can see it whileansweringthe questions.
EachOTcase normallyconsistsof twonumericaland three discursivestylequestions.Itis often
quickerto tacklethe discursivequestionsfirstleavingsomeadditionaltimeto tacklecalculations.
92 Financial
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Skills Checkpoint 1: Approach to OT questions
FM Skill: Approach to OT questions

Astep-by-step
technique forapproachingOTquestions
isoutlined
below.
Eachstepwillbe
explained
inmoredetailinthefollowing
sections
astheOTcasequestion
‘RingCo’isanswered
in
stages.
GeneralguidanceforapproachingOTquestions
STEP1:Answer thequestions youknow first.
Ifyou’re
having
difficulty
answeringaquestion,
move
onandcome backtotackle
it
onceyou’veansweredallthequestions
youknow.
Itisoften
quicker
toanswer discursive
style
OTquestions
first,
leaving
moretime
forcalculations.
General guidanceforapproaching OTquestions

STEP2:Answer allquestions.
There isnopenaltyforanincorrect
answerinACCAexams; thereisnothing
tobe
gained byleavinganOTquestion unanswered.
Ifyouarestuckonaquestion,
asa
lastresort,
itisworthselecting
theoptionyouconsidermostlikely
tobecorrect
andmoving on.Flagthequestion,
soifyouhave timeafter
you’veanswered
the
restofthequestions,youcanrevisit
it.
Guidance
foransweringspecific
OTquestions
G STEP3:Readtherequirementfirst! H
Therequirement
willbestated
inboldtextintheexam.Identify
whatyouare
being
askedtodo,anytechnical
knowledgerequired
andwhattypeofOT
question
youaredealingwith.
Lookforkeywordsintherequirement
such
as
"which
TWOofthefollowing,"
or" whichofthefollowing
isNOT".
Guidanceforanswering
specificOTquestions
STEP4:Applyyourtechnical
knowledge tothedatapresented
inthequestion.
Takeyour
timeworkingthroughcalculations,
making
suretoreadthrough
each
answeroption
withcare.
OTquestionsaredesigned
sothateachanswer
option
isplausible.
Work througheachresponse
option
andeliminate
those
youknow
areincorrect.
Exam success skills
Thefollowing questionisa Section B OTcasequestion froma pastexamworth 10marks.The

technical
knowledge required forthisquestion
iscoveredlaterinthecourse (inchapter13),weare
lookingatitherefroma technique viewpointnota knowledge viewpoint.
Forthisquestion,wewillalsofocusonthefollowing examsuccess skills:
• Managing information. Itiseasyfortheamount ofinformationcontained inanOTcase
questions insection B tofeela littleoverwhelming.
Activereading isa useful technique
touse
toavoidthis.Thisinvolves focusing oneachofthefiverequirements first,onthebasisthatuntil
youhavedonethisthedetailinthequestion willhavelittlemeaningandwillseemmore
intimidating asa result.
Skills
Checkpoint
1:Approach
toobjective
test(OT)questions93
Page 115 of 641

q
Focuson the requirements,highlightingkeyverbsto ensureyou understandthe requirement
properlyand correctlyidentifywhat type of OTquestionyou are dealingwith.Thenread the
rest of the scenario,underliningand annotatingimportantand relevantinformation,and
makingnotes of any relevanttechnicalinformationyou thinkyou willneed
• Correct interpretationof requirements.Identifyfromthe requirementthe differenttypes of OT
question. Thisis especiallyimportantwithmultipleresponsequestionsto ensureyou selectthe
correctnumberof responseoptions.
• Good timemanagement.CompleteallOT’sinthe timeavailable.EachOTis worth2 marks
and shouldbe allocated3.6 minutes.
Skill activity
Thefollowingscenariorelates to questionsa–e.
RingCo has inissueordinaryshares witha nominalvalueof $0.25per share. Theseshares are
traded on an efficientcapital market.Itis now20X6and the companyhas justpaid a dividendof
$0.450per share. Recentdividendsof the companyare as follows:
Year 20X6 20X5 20X4 20X3 20X2
Dividendper $0.450 $0.428 $0.408 $0.389 $0.370
share
RingCo also has inissueloannotes whichare redeemablein7 years’timeat theirnominalvalue

of $100per loannote and whichpay interestof 6%per year.
Thefinancedirectorof RingCo wishesto determinethe valueof the company.
RingCo has a cost of equityof 10%per year and a before-taxcost of debt of 4%per year. The
companypays corporationtax of 25%per year.
G
(a) Usingthe dividendgrowthmodel,what is the marketvalueof each ordinaryshare? H
• $8.59
• $9.00
• $9.45
• $7.77
Note.Thisis an MCQrequiringone correctanswerto be selected.Acalculationof the market
valueof RingCo’sshare usingthe dividendgrowthmodelis required.Therequiredformulais
giveninthe exam.
(b) What is the marketvalueof each $100loan note? (giveyouranswerto two decimalplaces)
$
Note.Thisis a FIBquestion,it is importantyou insertyouranswerto twodecimalplaces. A
calculationof the MVof RingCo’sloannotes is required.Thisis a popularquestioninthe FM
exam.Youwillneed to discountthe CF’sassociatedwiththe loannote to calculatethe market
value.
(c) Thefinancedirectorof RingCo has been advisedto calculate the net asset value(NAV)of
the company. Whichof the followingformulaecalculates correctlythe NAVof RingCo?
• Totalassets lesscurrentliabilities
• Non-currentassets plusnet currentassets
• Non-currentassets pluscurrentassets lesstotal liabilities
• Non-currentassets lessnet currentassets lessnon-currentliabilities
Note.Thisis another MCQ,you need to selectone correctdefinitionof the net asset value.
94 Financial
Management
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(d) Whichof the followingstatements about valuationmethodsis true?
• Theearningsyieldmethodmultipliesearningsby the earningsyield.
• Theequitymarketvalueis numberof shares multipliedby share price,plusthe marketvalueof
debt.
• Thedividendvaluationmodelmakesthe unreasonableassumptionthat averagedividend
growthisconstant.
• Theprice/earningsratiomethoddividesearningsby the price/earningsratio.
Note.Thisis an MCQquestionrequiringyou to selectone validstatement.
(e) Whichof the followingstatements about capital marketis/are correct?
Insiderinformationcannot be used to makeabnormalgains ina strong
formefficientcapital market.
Ina weakformefficientcapital market,RingCo’sshare pricereacts to new
informationthe day after it is announced.
RingCo’sshare pricereacts quicklyand accuratelyto newlyreleased
informationina semi-strongformefficientcapital market.
Pulldownlist
Correct
Incorrect
STEP
1 Answerthequestionsyouknowfirst.
Ifyou’rehavingdifficultyansweringa question,moveon and comeback to tackleit once you’ve
answeredallthe questionsyou know.Itis oftenquickerto answerdiscursivestyleOTquestions
first,leavingmoretimeforcalculations.
Questionsc, d and e are discursivestylequestions. Itwouldmakesense to answerthese three
G
questionsfirstas it is likelythat you willbe able to completethemcomfortablywithinthe 10.8 H
minutesallocatedto them. Anytimesavedcouldthen be spent on the morecomplexcalculations

requiredto answerquestionsa and b.
STEP
2 Answerallquestions.
Thereis no penaltyforan incorrectanswerinACCAexams,there is nothingto be gained by
leavingan OTquestionunanswered.Ifyou are stuckon a question,as a last resort,it is worth
selectingthe optionyou considermostlikelyto be correct,and movingon. Makea note of the
question,so ifyou havetimeafter you haveansweredthe rest of the questions,you can revisitit.
Threeof the fivequestionsinthe OTcase are MCQs.Withan MCQyou havea 25%chance of
gettingthe questioncorrectso don’tleaveany unanswered. Itis obviouslymoredifficultto get a
fillinthe blankquestion(likequestionb) correctby guessing.
STEP
3 Readtherequirement first!
Therequirementwillbe stated inboldtextinthe exam.Identifywhat you are beingaskedto do,
any technicalknowledgerequiredand what type of OTquestionyou are dealingwith.Lookfor
keywordsinthe requirementsuch as ‘whichTWOof the following,’ ‘whichof the followingis NOT’.
Questionb is a FIB(fillinthe blanks)question,you need to followthe instructionscarefullyand
insertyouranswerto twodecimalplaces.Questionsc and d ask you to identifywhichstatements
are correct. Readthrougheach statementcarefullyknowingthat you are lookingto identifythe
statementthat is correct.
STEP
4 Applyyourtechnicalknowledge to thedata presentedinthequestion.
SkillsCheckpoint
1:Approach
toobjective
test(OT)questions 95
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q
Workthroughcalculationstakingyourtimeand read
througheach answeroptionwithcare. OTquestionsare
designedso that each answeroptionis plausible.Work
througheach responseoptionand eliminatethose you
knoware incorrect.
Toanswerquestionsa and b you need to analyse the
data giveninthe question.
Let’slookat questiona indetail.Thequestionasks you
to calculatethe marketvalueof RingCo’sshares using
the dividendgrowthmodel.Youwillthereforeneed to
findD0, g and the cost of equity(re)fromthe data inthe
question.
RingCo has inissueordinaryshares witha nominal
valueof $0.25per share. Theseshares are traded on an
efficientcapital market.Itis now20X6and the
companyhas justpaid a dividendof1$0.450per share. 1D0=$0.450
Recentdividendsof the companyare as follows:2
2Historical
dividend
growth
rate=100x
((0.450/0.370)^0.25
–1)=5%
G
Year 20X6 20X5 20X4 20X3 20X2 H
Dividendper $0.450 $0.428 $0.408 $0.389 $0.370

share
RingCo also has inissueloannotes whichare

redeemablein7 years’timeat theirnominalvalueof
$100per loannote and whichpay interestof 6%per
year.
Thefinancedirectorof RingCo wishesto determinethe
valueof the company.
RingCo has a cost of equityof 10%per3year and a 3r=0.10
before-taxcost of debt of 4%per year. Thecompany
pays corporationtax of 25%per year.
Takingall3 variablesfromthe questionyou can now
use the dividendgrowthmodelto calculatethe valueof
RingCo’sshare.
P0= D0(1+g)/(re– g)
Shareprice=(0.450×1.05)/(0.1– 0.05)=$9.45
96 Financial
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Toanswerquestionc you can start by eliminatingthe
responseoptionsthat do not correctlydefinethe net
asset valueof a company.
Thefinancedirectorof RingCo has been advisedto
calculatethe net asset value(NAV)of the company.
Whichof the followingformulaecalculates correctly
the NAVof RingCo?
4
• Totalassets lesscurrentliabilities 4Thisdefinition
wrongly
excludes
non-
• Non-currentassets plusnet currentassets5 current
liabilities
• Non-currentassets pluscurrentassets lesstotal 5Thisdefinition

wrongly excludes
current
liabilities andnon-currentliabilities
• Non-currentassets lessnet6currentassets lessnon-
6Thisdefinition
wrongly
deducts
net
currentliabilities current
assets.
Thecorrectdefinitionof net asset valueis:
• Non-currentassets pluscurrentassets lesstotal
liabilities
Exam success skills diagnostic
Everytimeyou completea question,use the diagnosticbelowto assess howeffectivelyyou
G demonstratedthe examsuccessskillsinansweringthe question.Thetable has been completed H
belowforthe RingCo activityto giveyou an idea of howto completethe diagnostic.

Exam success skills Your reflections/observations
Managinginformation Didyou read each of the fiverequirementsfirst?
Didyou activelyread the scenariohighlightingrelevantdata
requiredsuch as the dividendjustpaid, cost of equityand
dividendgrowthpattern?
Correct interpretationof Didyou identifythe correcttechnicalknowledgeneeded to
requirements answereach requirement?Forexample,usingthe dividend
growthmodelformulato answerquestiona.
Didyou identifywhat type of OTquestionyou weredealing
with?Forexample,knowingthat onlyone correctansweris
requiredfora multiplechoicequestion.
Good timemanagement Didyou manage to answerallfivequestionswithin18mins?
Didyou manage yourtimewellby answeringquestionsthree,
fourand fivefirst?
Mostimportantaction pointsto apply to yournext question
SkillsCheckpoint
1:Approach
toobjective
test(OT)questions 97
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q
Summary
60%of the FMexamconsistof OTquestions.Keyskillsto focuson throughoutyourstudieswill

thereforeinclude:
• Alwaysread the requirementsfirstto identifywhat you are beingaskedto do and what type of
OTquestionyou are dealingwith
• Activelyread the scenariohighlightingkeydata needed to answereach requirement.
• AnswerOTquestionsina sensibleorderdealingwithany easierdiscursivestylequestionsfirst.
G H
98 Financial
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5
Investment decision
5
Learning objectives
Oncompletion
ofthischapter
youshould
beableto:
Syllabus
reference
• Identify
andcalculate
relevant
cashflowsforinvestmentD1(a)
projects
• Calculate
payback
period anddiscuss
itsusefulness
as D1(b)
aninvestment
appraisal
method
• Calculate
discounted
paybackanddiscuss
itsusefulnessD1(c)
asaninvestment
appraisal
method
• Calculate
return
oncapitalemployed
(accounting
rateof D1(d)
return)
anddiscussitsusefulness
asaninvestment
G H
appraisal
method
• Calculate
netpresent
valueanddiscuss
itsusefulness
as D1(e)
aninvestment
appraisal
method
• Calculate
internal
rateofreturn
anddiscuss
its D1(f)
usefulness
asaninvestment
appraisal
method
• Discuss
thesuperiority
ofdiscounted
cashflow(DCF) D1(g)
methodsovernon-DCFmethods
• Discuss
therelative
merits
ofNPVandIRR D1(h)
5
Exam context
Thischapterintroducesa variety
ofinvestmentappraisal
techniquesthatareimportant
inSection
Dofthesyllabus (Investment
appraisal),
itisoneoffourchapters(alongwithChapters
6–8)that
coversthisimportantsyllabus
section.
Thetopicscovered herearecommonly examined
inall
sections
oftheexamincluding section
C. Questions
won’tjustinvolve
calculations;
youmaybe
askedtodiscusstheproblems withthemethods youhaveused,ortheirmeaning.
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5
Chapter overview
Investment decision
Investmentdecision Simpletechniques Timevalueand discounting
Decision-making
process Payback
period
Relevant
cashflows Discounted
paybackperiod
ROCE/ARR
Netpresent value Internalrate of return NPVvsIRR
IRRadvantage
NPV
advantages
G H
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1 Investment decision-making
1.1 Investment decision-making process
PER alert
Performanceobjective9 requiresyou to ‘valueprojects,financialsecuritiesand instruments
and adviseon theircosts and benefitsto the organisation’.Thischapter concentrateson
valuingprojectsusingdiscountedcash flowtechniques
Capitalinvestmentprojectsinvolvethe outlayof large sumsof moneyinthe expectationof
benefitsthat may take severalyears to accrue.
Thedecisionwhetherto proceedwitha capital investmentprojectis normallymade by a capital
expenditurecommitteeoverseeinga process that includesthe followingphases:
(a) Idea creation (b) Screening (c) Financial (d) Review
analysis
Proposalscan be Toscreenout Adetailed appraisal Apost-completion
stimulatedby a unsuitableproposals of the project’srisk review(oraudit)
regularreviewof the by lookingat the and return,howit will aimsto learn from
company’s impact of the project be financed,any mistakesthat have
competitive on stakeholdersand alternativesto it and ariseninthe project
environmentand can whetherthey support the implicationsof appraisalprocess.
be encouragedby the organisation’s not acceptingthe
incentiveschemes. strategy. project.
TheFinancialManagementsyllabusmainlyfocusseson financialanalysisand thisarea is further

G
consideredinthis,and the followingthree chapters. H
1.2 Relevant cash flows

Mostfinancialanalysistechniquesthat are used foranalysingprojectsare based on the use of
relevantcash flows.
Relevantcash flow:Afutureincrementalcash flowcaused by a decision(egto investina

KEY
TERM project).
Youwillcomeacross many examplesinthischapter, and infollowingchapters,of cash flowsthat
clearlyrelateto a project.However,a specificand lessobvioustype of relevantcash flowto look
out foris an opportunitycost.
Opportunitycost: Acost incurredfromdivertingexistingresourcesfromtheirbest use.

KEY
TERM
Illustration 1: Opportunity cost
Ifa team of workers,costing$300,000 per year, isdivertedto workon a newprojectthen they will
stop workon existingproductswhichearn contribution(iesales revenuelessvariablecost)of
$500,000,thiscontributionwillthereforebe lost(notethat thisassumesthat labouris a variable
cost).
Required
Calculatethe relevantcost associatedwithusingthe team of workerson the newproject.
5:Investment
decision 101
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Solution
Therelevantcost is the opportunitycost ie the $500,000 of lostcontributionplusthe cost of the
workers.Thisgivesa total relevantcost of $800,000.
1.2.1 Non-relevant costs examples

Questionswillexpectyou to be able to identifycosts that are not relevantto decision-making.
Someexamplesare includedinthe followingtable.
Examples Explanation
Non-cashflows Depreciationand apportionedoverheads(ieoverheadsthat are
not directlyattributableto a project)are not cash flows.
Sunkand committedcosts Acost incurredin the past (iesunk),or committedto, willnot
change whethera projectgoes ahead or not and is therefore
not a relevantcash flow(marketresearchis oftenan example
of this).
Historiccost of materials Ifmaterialsthat are used by a projectneed to be replaced,the
relevantcost of the materialsis the replacementcost of the
material- not the priceoriginallypaid to acquirethe material
(iethe historiccost).
Ifsuch materialsdo not need to be replaced,the relevantcost is
zero(unlessthere is an opportunitycost fromlostrevenueifthe
materialcouldhavebeen soldas scrap).
Thehistoriccost of materialsshouldonlybe treated as
‘relevant’ifno indicationof scrap valuesor replacementcosts
are givenina question.
G H
Cost of labour Iflabourused by a projectis:

(a) Idle,then the relevantcost of usingthat labouris zero
(b) Atfullcapacity, then the cost is wages paid +contribution
lost on the workthat they havehad to stop doing.
Onlyuse the labourcost as a relevantcost ifno indicationof
capacity issuesare givenina question.
Financecosts Anyfinancecosts (egdividendpayments,interestpayments)
shouldnot be consideredas a cash flowbecause they are
includedinthe cost of capital used to discounta project
(coveredinsection3).
Activity 1: Relevant costing
Brendaand Eddieare consideringexpandingtheirrestaurantbusinessthroughan investmentina

newrestaurant,the ParkwayDiner.Brendaand Eddiehaveanalysed the profitmade inthe first
year and are concernedthat the projectcouldbe lossmaking.
TheirYear1costs and revenuesare forecastas follows:
Year1 $
Revenue 200,000
Depreciation 25,000
Materials(note1) 49,000
Labour(note2) 100,000
102 Financial
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Year1 $
Overheads(note3) 100,000
Profit/(loss) (74,000)
Notes.
1 Thematerialsinclude$10,000of surplusinventorythat Brendaand Eddiehaveintheirexisting
restaurants.Thisinventoryhas a scrap valueof $1,000.
2 Labourincludes20%of the $50,000 salary of a manager of an existingbranch, whowillassist
the existingmanager of the restaurantinits firstyear of operation.
3 Thisis an allocationof corporateoverheads.
Required
Assessthe relevantcash flowsof the projectinthe firstyear to Brendaand Eddieand advise
Brendaand Eddiewhetherthey are rightto be concerned.
Solution
G H
Essential reading
SeeChapter 5 Section1of the EssentialReading,availableinthe digitaleditionof the Workbook,

forfurtherdiscussionof thisarea
2 Simple techniques
2.1 Payback period
Payback period:Ameasureof howlongit takes forthe cash flowsaffected by the decisionto

KEY investto repay the cost of the originalinvestment.
TERM
Paybackis oftenused as part of an initialscreeningof projects.Ifa projectgets throughthe
payback test it shouldbe evaluatedusinga moresophisticatedprojectappraisal technique.
Aprojectwitha longpayback periodis consideredto be uncertain because it relieson cash flows
that are inthe distantfutureand are thereforehighlyuncertain.
Acompanywillreject a projectwitha payback periodthat is abovethe company’starget
payback period.
Paybackis especiallyusefulifa companyhas cash flowconcernsbecause it focusseson shorter-
terminvestments.
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Paybackis based on relevantcash flowsso any non-cash flowcost items(egdepreciation)
shouldbe ignored.
Activity 2: Payback period
Brendaand Eddieare worriedabout the lengthof timeit willtake forthe cash flowsfromthe
ParkwayDinerto repay theirtotal investmentof $500,000 ($350,000to take overthe business
and $150,000to refurbishit).
Cash flowprojectionsfromthe projectare estimatedas:
Operatingcash flows
Year $
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
Afterthe sixthyear, Brendaand Eddieconfidentlyexpectthat they couldsellthe businessfor
$350,000.
Required
Calculatethe payback periodforthe project.
G
Solution H
2.1.1 General problems with payback

(a) Itignoresthe timingof cash flowswithinthe payback period(egignoresthat a projectis
moreuncertainifmostof the cash is receivedat the end of the payback period).
(b) Itignoresthe cash flowsafter the end of the payback periodand thereforethe total project
return.
(c) Itignoresthe timevalueof money(a concept incorporatedintomoresophisticatedappraisal
methods).Thismeans that it does not take intoaccount that the valueof moneyis lowerthe
furtherintothe futurethat the moneyis received.
(d) Thechoiceof any cut-off payback periodby an organisationis arbitrary.
(e) Itmay lead to excessiveinvestmentinshort-termprojects.
Becauseof these drawbacks,a projectshouldnot be evaluatedusingpayback alone.
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2.1.2 Discounted payback period
Paybackcan be based on discountedcash flows(coveredinSection3),inwhichcase it is called
discountedpayback (oradjustedpayback)period.Asidefrombeingbased on discountedcash
flows,the calculationis the same and mostof the drawbacksremain.
2.2 Return on capital employed
Returnon capital employed(ROCE)is also calledaccountingrate of return(ARR) and returnon
investment(ROI).ROCEis another simple,traditional,approach to evaluatinginvestments.
ROCEcomparesthe profitfroman investmentprojectto the amountinvestedinthe project,
expressingthe resultas a percentage.
Usingthismethod,a companywillaccept a projectifit has a ROCEabovethe company’starget.
2.2.1 Calculation (formulae are not given and need to be learnt)
Profitiscalculatedafter depreciationwhichwehaveseen isnot a relevantcash flow,thisfailure
to distinguishbetweenrelevantand non-relevantcash flowsis one of the many drawbacksof this
technique.
ROCE = Averageannualprofit
Initialinvestment
or
ROCE = Averageannualprofit
Averageinvestment
Whereaverageinvestment=
Initialoutlay+ scrapvalue
2
G H
Illustration 2: ROCE
Anasset costing$120,000is to be depreciatedover5 years to a nilresidualvalue.Profitsafter

depreciationforthe 5 years of the projectare as follows.
Year 1 2 3 4 5
Profits 12,000 17,000 28,000 37,000 8,000
Required
Whatis the averageaccountingrate of returnforthisproject?(Giveyouranswerto the nearest
percentage.)
Solution
Averageinvestment= [$120,000(start)+$0 (end)]÷2 =$60,000
Averageprofits=[12,000+17,000+28,000 +37,000+8,000]÷5 (years)=$20,400
ARR=$20,400÷$60,000 =34%(thiscan also be referredto as ROIor ROCE).
Activity 3: ARR
Brendaand Eddieare consideringexpandingtheirrestaurantbusinessthroughpurchaseof the

ParkwayDiner,whichwillcost $350,000to take overthe businessand a further$150,000to
refurbishthe premiseswithnewequipment.Cash flowprojectionsforthisprojectare as forthe
previousactivity.
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Theequipmentwillbedepreciated
toa zeroresale
valueoverthesameperiodand,afterthesixth
year,Brenda
andEddieconfidently
expectthattheycouldsellthebusiness
for$350,000.
Required
WhatistheROCEofthisinvestment
(usingtheaverage
investment
method)?
 13.0%
 15.3%
 18.0%
 21.2%
Solution
2.2.2 BenefitsofusingROCE/ARR
ROCEmethod isa quickandsimplecalculation
thatinvolves
thefamiliarconcept
ofa percentage
return.
Unlikepayback perioditdoesconsider
thewholeofa project’s
life.
Thefactthatitgivesa percentagemeasure meansthatROCEmakes iteasytocompare two
G
investment
options eveniftheyareofdifferent
sizes. H
2.2.3 GeneralproblemswithROCE/ARR
(a) Itisbasedonaccounting profits
andnotrelevantcashflows.ROCEistheonlyinvestment
appraisaltechnique
notbasedonrelevant cashflows.
(b) Itisa relative
measure
(iea percentage)
rather
thananabsolute measure
andtherefore
takesnoaccount ofthesizeoftheinvestment.
(c) Likethepayback method,ROCEignores thetimevalueofmoney.
Examfocus point
ROCE/ARR istheonlyproject
appraisal
techniquethatisbasedonprofit
instead
ofcashflow.
So,inthistechnique
(only)youwillneedtoincludedepreciation
inyourcalculations.
3 Time value of money and discounting

Akeyproblem withbothpayback andROCEisthattheybothignorethetimevalueofmoney;
thisisanimportantconcept
thatisusedinthemoresophisticated
investment
appraisal
techniquesthatarecovered
intheremainderofthischapter.
3.1 Time value of money
Theideathatreceiving
$100inthefutureisworthlessthanhaving
$100todayisanexample
of
theconcept
ofmoney havinga ‘timevalue’.
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Illustration 3: Time value
Ifa projectinvolvedthe outlayof $20,000today and provideda definitereturnof $21,000inone

year’stime.
Required
Wouldyou accept it ifyou couldget a returnof 6%on investmentsof similarrisk?
Solution
Wecan lookat thisintwoways:
Firstly,ifyou had $20,000today and investedit forone year ina projectof similarriskat 6%then
you wouldhave$20,000×1.06=$21,200(thisapproach is calledcompounding).
Thisis morethan is generated by the project,so the projectis not acceptable.
Alternatively,wecan reducethe futurecash flowof $21,000to reflectits worthifit was received
today:
$21,000×1/1.06=$19,811
Thisapproach is calleddiscounting.
$19,811 is the valuetoday, or the present value,of receiving$21,000inone year’stimeto reflect
the returnavailableto investors.
Again,wecan see that the projectis unacceptable because thispresentvalueis belowthe cost
(today)of the projectof $20,000.
3.1.1 Discounting and present values

Theprocessof discountingfuturecash flowsback to theirpresent valueis oftencalleddiscounted
cash flow(DCF)analysis.Itis importantinprojectappraisalbecause many projectsinvolve
investingmoneynowand receivingreturnsin many differenttimeperiodsin the future.
G H
DCFanalysisis an importanttoolinallowingthe valueof futurecash flowsto be compared

against moneyinvestedtoday.
Presentvalue:Thecash equivalentnowof moneyreceived(orpaid)inthe future.

KEY
TERM
3.2 Discount factors
Inthe previousillustration,a futurecash flowreceivedin1year was discountedback to a present
valueby multiplyingby 1/1.06.
Thisis the same as multiplyingthe cash flowsby 0.943(ie1/1.06=0.943),and thisfigureis an
exampleof a discountfactor.
Thisdiscountfactor reflectsthe investor’srequiredreturn(alsoreferredto as a cost of capital)of
6%and the timingof the futurecash flow(inone year’stime).
Inthe examyou are providedwitha table of discountfactors to apply dependingon the rate of
returnexpectedand the timingof the futurecash flow.
Theseare shownas an Appendixat the back of thisworkbookas a present valuetable.
Aswellas includinga widerange of discountfactors,thistable also showsthe formulafor
calculatingany discountfactor.
Formula provided
Discountfactor =(1+ r)–n

Wherer =discount/interestrate and n =timeperiodof cash flow
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Examfocus point
Discount
tablesareprovided
intheexam,buttheycoveronlyintegervalues
ofrandupto15
yearsahead.Ifyouneedtocalculate
a discount
ratethatisnotaninteger
(eg10.5%)
orisnot
intherangeofvalues
coveredbythetables,youwillneedtousethediscounting
formula
provided.
3.3 Conventions used in DCF

• Time0 istoday,itisusualtoassume thattime0 isthefirstdayofa project,
iethestartofits
firstyear.
• Time1isthelastdayofthefirstperiod(normally a year).
• Acashflowwhichoccurs during thecourse ofa timeperiodisassumedtooccurallatonceat
theendofthetimeperiod (attheendoftheyear).
• Acashflowwhichoccurs atthestartofa timeperiod istakentooccurattheendofthe
previoustimeperiodega cashoutlayof$5,000atthestartoftimeperiod 2 istakentooccur
attheendoftimeperiod 1.
Activity4: Discounting
Calculate
thepresent
valueof$100,000received
inseven
years’time,ifthecostofcapitalis12%.
(Giveyouranswer
tothenearest$100.)
Solution
G H
3.4 Annuities
Annuity:
Aseries
ofequalcashflows.
KEY
TERM
Ifa project
involves
equalannualcashflows(orannuities)
theneachfuturecashflowcanbe
discountedseparately
backtoa presentvalue,butitisquicker
tousea singlediscount
factor
(calledanannuityfactorora cumulative
discountfactor).
Illustration4: Annuities
Ifa project
involved
theoutlayof$20,000todayandprovided
a definitereturn
of$8,000per
yearforthreeyearswouldyouaccepttheproject?
Assume thatyoucouldgeta returnof6%oninvestments
ofsimilar
risk.
Solution
Thiscanbeanalysed asa series
ofindividual
calculations,
obtaining thediscount
factors
fromthe
present
valuetable(fromthe6%column fortimeperiods
1,2 and3):
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Time 0 1 2 3
Cash flow (20,000) 8,000 8,000 8,000
Discountfactors 0.943 0.890 0.840
Presentvalue (20,000) 7,544 7,120 6,720
Netpresentvalue +1,384
Alternatively,this couldbe analysed morequicklyby usinga singlediscountfactor providedin
the annuitytable giveninthe Appendixto thisworkbook(hereusingthe 6%columnand time
period3).Thefigureobtainedis 2.673:thisis calledan annuity(orcumulativediscount)factor.
Time 0 1to 3
Cash flow (20,000) 8,000
Annuityfactor 2.673
Presentvalue (20,000) 21,384
Netpresentvalue +1,384
Theannuityfactor of 2.673representsthe additionof the individualdiscountfactorsused inthe

firstmethod(0.943+0.890+0.840).
Formula provided
Formulaforan annuityfactor:
1−(1+ r)−n
G
r H
Exam focus point

Annuitytables are providedinthe exam,but again onlycoverintegervaluesof r and up to 15
years ahead. Ifyou need to calculatea discountrate that is not an integeror is not inthe
range of valuescoveredby the tables, you willneed to use the formulaprovided.
Activity 5: Annuities
Afirmhas arranged a 10-yearlease at an annual rent of $17,264.Eachrentalpaymentis to be

made at the start of the year.
Required
Whatis the presentvalueof the lease at 12%?(Giveyouranswerto the nearest $.)
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Solution
3.4.1 Perpetuities
Perpetuity:
Anannuity
thatoccurs
fortheforeseeable
future.
KEY
TERM
Iftheseries
ofcashflowsdoesnothaveanenddate(ieitisexpected fortheforeseeable
future)
thenthisiscalleda perpetuity.
Thiscanbedealtwithbyapplying
a singlediscount
factor,
but
thisrequires
theuseofa formulawhichyouwillneedtolearn:
Formulato learn
Theformula
fordiscounting
a perpetuity
is:
1
r
G
Illustration5: Perpetuities H
Ifa project
involved
a definite
return
of$3,000peryear
fortheforeseeable
future.
Required
Wouldyouaccepttheproject?
(Again,assume
thatyoucouldgeta return
of6%oninvestments
ofsimilar
risk.)
Solution
Theperpetuity
factorhereis:
1/0.06
So,thepresent
valueofthefuturecashflowsis$3,000×1/0.06=$50,000
Andthepresent
valueoftheinflows
exceedsthecostoftheproject,
sotheproject
isacceptable.
3.4.2 Delayedannuitiesandperpetuities
Theapproaches demonstrated
intheprevioussections
forannuities
andperpetuitiesassumethat
thecashflowsbeginintime1andvaluetheseannuitiesorperpetuities
fromtheperspective
of
theprecedingtimeperiodtowhenthecashflowsbegin(ietime0,a present value).
Wherethefirstcashflowinanannuityisnotreceived
fromtime1thisiscalleda delayed
annuity.
Wherethisisthecase,theapproachtovaluinganannuityorperpetuitymustbeslightly
adjusted.
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Illustration6: Delayed perpetuity
Ifa project
involved
a definite
return
of$3,000peryear
fortheforeseeable
future
startinginthreeyears’time.
Required
Wouldyouaccepttheproject?
(Again,assume
thatyoucouldgeta return
of6%oninvestments
ofsimilar
risk.)
Solution
Asbefore, theperpetuityfactorhereis:1/0.06
So,thevalueofthefuture cashflowsis$50,000,asbefore.
However, thisvalueisfromtheperspective ofthepreceding timeperiod
towhenthecashflows
beginandherethecashflowsbeginattime3 sothevalueisfromtheperspective oftime2 (the
preceding timeperiod).
Thiscanbeadjusted toa time0 presentvaluebytreatingthe$50,000asa one-offcashflow
receivedintime2 andmultiplying itbythediscount factorfromthepresent
valuetableforperiod
2 at6%of0.890.
$50,000×0.890=$44,500
Thisisnowa present valueand,because thisishigher
thanthecashoutflowof$20,000,the
projectisacceptable.
Activity6: Delayed annuity

G H
Anannuityof$3,000perannum
foreightyearsstartsattheendofthethirdyearandfinishes
at
theendofthetenthyear.
Required
Whatisthepresent
valueoftheannuity
ifthediscount
rateis6%?(Giveyouranswer
tothe
nearest
$.)
Solution
3.4.3 Constantgrowth
Ifa series
ofcashflowsdoesnothaveanenddate(ieitisexpected fortheforeseeable
future)
and
isgrowing ata constantrate,thenthiscanbeconverted
intopresentvalueterms
byapplying
a
singlediscountfactorandisknown asa growing perpetuity.
Thisrequirestheuseofthefollowingformulafortheannuity
factor,
thisiscovered
numerically
in
section4 ofChapter13.
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Formulato learn
Theformula
fordiscounting
a constantly
growing
cashflowis:
1
r−g
Essentialreading
2 oftheEssential
Reading,
available
inthedigitaledition
oftheWorkbook,
forfurtherdiscussion
ofthisareamainly
foranyonewhohasnotstudied thisareafora whileand
wouldlikesomefurther background,
theapproachusedforevaluating
constantly growing
cashflowsisalsointroduced.
TheEssentialreadingisavailable
asanAppendix
ofthedigitaledition
oftheWorkbook.
4 Net present value (NPV)
TheNPVmethod usestheconcept ofdiscountingandrecognisesthetimevalueofmoney.

Thismethod comparesthepresent valueofallthecashinflowsfroma project
withthepresent
valueofallthecashoutflows
froma project. Thedifference,
theNPV,representsthechangein
wealthoftheinvestor
asa result
ofinvesting intheproject.
NpvValue
NPVpositive Return
frominvestment’s
cashinflows
inexcess
ofcostofcapital(undertake
project)
G H
NPVnegative Return
frominvestment’s
cashinflows
below
costofcapital(don’tundertake
project)
NPV=0 Return
frominvestment’s
cashinflows
sameascostofcapital(theproject
will
beonlyjustworthundertaking)
Note.Weassume thatthecostofcapitalistheorganisation’s
targetrateofreturn
forproposed
investment
projects.
Oneoftheadvantages ofNPVisthatitgivesa clearandobjective
decisionrulewhichisthata
project
isacceptable
ifitsNPViszeroorabove.
Activity7: NPV
LCHmanufactures product
Xwhichitsellsfor$5perunit.Variable
costsofproductionare
currently
$3perunit.SalesofproductXareestimated tobe75,000unitsperannum.
Anewmachine isavailable
whichwould cost$90,000butwhichcouldbeusedtomakeproductX
fora variable
costofonly$2.50perunit.Fixedcosts,however,
would increase
by$7,500per
annum asa directresult
ofpurchasing
themachine.
Themachine would haveanexpectedlifeoffouryearsanda disposalvalueof$10,000.
LCHexpects toearnatleast12%perannum fromitsinvestments.
Required
UsingNPVanalysis,
should
LCHacquire
themachine?
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Solution
G H
NPVisa veryimportantmethodofappraising
investments,
thatiscommonly
examined.
NPVwill
bediscussedfurther
insection
6 anddeveloped
further
inChapters6-8.
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5 Internal rate of return (IRR)
TheIRRmethodalso uses the concept of discountingand recognisesthe timevalueof money.
Internalrate of return(IRR):Adiscountedcash flowtechniquethat calculatesthe percentage

KEY returngivenby a project.Ifthisreturnis used to discounta project’scash flows,it would
TERM deliveran NPVof zero.
Internalrate of return(IRR)calculatesthe exact rate of returnwhicha projectis expectedto

achieve;inotherwords,the rate which,ifused as a discountfactor,woulddeliveran NPVof zero.
IRR
IRRis greater than the required Returnfromthe investmentis abovethat whichis required
return (costof capital) (undertakeproject)
IRRis less than the required Returnfrominvestmentis belowthat whichis required
return (costof capital) (don’tundertakeproject)
IRRis equal to the requiredreturn Returnfrominvestmentis the same as cost of capital (the
of capital) projectwillbe onlyjust worthundertaking)(cost
5.1 Calculating IRR

5.1.1 Computer based exam method
Ina computer-basedexamyou can use the =IRRfunctionto calculatethe project’sIRR.
Real life example

Fromthe previousactivitythe projectcash flowsforthe NPVcalculationcouldbe shownon a
G H
spreadsheet as follows:
A B C D E F
1 Time 0 1 2 3 4
2 Cash flow ($90,000) 30,000 30,000 30,000 40,000
3 Discountfactors 1.0 0.893 0.797 0.712 0.636
4 Presentvalue ($90,000) 26,790 23,910 $21,360 $25,440
Tocalculatethe IRRthe correctinstructionwouldbe =IRR(B2:F2)
Inthisexample,thiswouldgivean IRRof 15.7%.
Note.Theundiscountedcash flowsare used forthe IRRcalculation.Also,the spreadsheetIRR
formuladoes not workifthe cash flowsare set up as annuities(egone cash flowof $30,000for
time1-3inthe previousillustration).
5.1.2 Interpolation
Ifa questionprovidestwoprojectNPVsthen these can be used to estimatethe internalrate of
returnof a project.Thisapproach is sometimescalledinterpolation.
Exam focus point

Thisapproach to IRRis morelikelyto be tested inan OTquestion.
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Formula to learn
IRR = a% + NPVa (b% - a%)

NPVa-NPVb
Wherea is the lowerdiscountrate givingNPVaand b is the higherdiscountrate givingNPVb
Real life example

Fromthe previousactivityifyou had been toldthat the NPVof the projectcashflowswas +$7.500
at a cost of capital of 12%and -$540 at 16%then the IRRcan be estimatedas:
IRR = a% + NPVa (b%−a%)
NPVa−NPVb
IRR = 12 + 7,500 (16 - 12)

7,500+ 540
=15.7%
Note.IfNPVbis a negativenumber,then NPVa-NPVb becomesNPVa+NPVb sincesubtractinga
negativeis the same as an addition.Althoughthe interpolationmethodis slowerthan the formula
method,it does allowsomemarksto be scoredifa minorerroris made (follow-through marks)
whereasthe formulaapproach willeitherbe 100%corrector willscore0. So,ifyou are at all
unsureabout the formulaapproach then the interpolationmethodwouldbe better to use inthe
exam.
Activity 8: Interpolation
Aprojecthas a positiveNPVof $15,000whendiscountedat 6%and a negativeNPVof $3,000

G H
whendiscountedat 12%.
Required
Calculatethe internalrate of return.
Solution
Exam focus point

Itis easy to confuseinternalrate of return(IRR)and accountingrate of return(ARR).
One way
of rememberingthe differenceis that accountingrate of returnis based on accountingprofits
(whereasIRRis based on relevantcash flows).
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Essentialreading
3 oftheEssential
Reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
discussion
ofIRR.
TheEssential
readingisavailable
asanAppendix
ofthedigitaledition
oftheWorkbook.
6 NPV compared to IRR
BothNPVandIRRaresuperior methodsforappraisinginvestments
comparedtothesimpler
techniques
coveredinsection2 because:
(a) TheyareDCFmethods ietheyaccountforthetimevalueofmoney (unlike
non-DCF
methodslikeROCEandpayback)
(b) Theyfocusonrelevant
cashflows(unlike
ROCE)
(c) Theylookatthecashflowsoverthewholelifeoftheproject
(unlike
payback)
Giventhattherearetwomethods ofusingDCF,theNPVmethod andtheIRRmethod, therelative
merits
ofeachmethod havetobeconsidered.
6.1 Advantage of IRR over NPV
IRRgivesthepercentage
return
ofa project;
thisconcept
iseasyfornon-financial
managers
to
understand.
6.2 Advantages of NPV over IRR
G
6.2.1 Comparingprojectsofdifferentsizes H
Because
IRRisa percentage
measureitcanleadtoincorrect
choices
beingmadewhenchoosing
between
mutuallyexclusive
projects.
Real life example:Projectsof differentsizes

Project
A Project
B
Cost,year0 $350,000 $35,000
Annualsavings,
years1–6 $100,000 $10,000
IRR 18% 18%
NPVatcostofcapitalof10% $85,500 $8,550
Ifa company hadtochoose between project
AandprojectB,thenitwould
choose
projectA
whichis10timesbigger(asreflected
intheNPV).Butiftheonlyinformation
onwhichtheprojects
werejudged weretobetheirIRRof18%,projectBwould bemadetoseemjustasbeneficial
as
project
A,whichisnotthecase.
6.2.2 Non-conventional cashflows

Theprojects wehaveconsidered sofarhavehadconventional
cashflows(aninitialcashoutflow
followedbya seriesofinflows).
Whenflowsvaryfromthistheyaretermed‘non-conventional’.
Ingeneral,ifthesignofthenetcashflowchangesinsuccessive
periods
(inflow
tooutflow orvice
versa),
itispossibleforthecalculations
toproduceasmanyIRRsastherearesignchanges.
ThiscanmakeIRRdifficult tointerpret.
Therearenoissues withNPVandnon-conventionalcashflows.
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6.2.3 Re-investment assumption
Anassumptionunderlyingthe NPVmethodis that any net cash inflowsgenerated duringthe life
of the projectwillbe reinvestedelsewhereat the cost of capital (that is,the discountrate).
TheIRRmethod,on the otherhand, assumes these cash flowscan be reinvestedelsewhereto
earn a return equal to the IRRof the originalproject.Assumingthat the projectisattractive,so
that the IRRis abovethe cost of capital then ifthisassumptionis not valid,the IRRmethod
overestimatesthe project’sactual return.
6.3 Conclusion
Thereis a generalconsensusthat NPVis the superiortechniquefroma technicalviewpoint.
However,IRRis stillextremelyusefulforexplainingthe appraisalof an investmentto non-financial
managers.Thisis whyboth NPVand IRRare both widelyused inpractice.
Thisis not to say that NPVisperfect;likeany financialtechnique,there is the danger that the
non-financialbenefitsof an investmentare ignoredor that the financialestimatesare
inaccurate.
Activity 9: NPV&IRR
DEFCo has a cost of capital of 12%.

ProjectAhas a positiveNPVof $5,000 whendiscountedat 12%and a positiveNPVof $3,600when
discountedat 16%.
ProjectBhas a positiveNPVof $8,000 whendiscountedat 12%and a negativeNPVof $1,000
whendiscountedat 16%.
Theprojectsare mutuallyexclusive.
Required
G 1 Whatis the internalrate of returnforprojectsAand B? H
 ProjectAhas an IRRof 26.3%and Ban IRRof 16.5%.

2 Whichof the followingstatementsis correct?
 BothNPVand IRRindicatethat ProjectAis the morefinanciallyviableproject.
 Inorderto maximiseshareholderwealthProjectAis the better project.
 NeitherProjectAnor ProjectBshouldbe accepted froma financialperspective.
 ProjectBwillincreaseshareholderwealthmorethan ProjectAat the currentcost of capital.
Solution
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Essential reading
SeeChapter 5 Section4 of the EssentialReading,availableinthe digitaleditionof the Workbook,

forfurtherdiscussionof DCFmethods.
G H
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Chapter summary
Investmentdecision
Investment
decision Simple
techniques Timevalueanddiscounting
Decision-making
process Payback
period • Discounting
takes
into
account
Not
only
involving
financial Based
onundiscounted thetimevalueofmoney
analysis cashflows • Annuities
areequal
cashflows
• Perpetuities
areannuities
that
lastindefinitely
Relevant
cashflows Discounted
payback
period
• Future,
incremental
cashflows Based
ondiscounted
cashflows
arising
fromadecision
• Ignore
sunk,
committed
and
finance
costs ROCE/ARR
• Based
onprofits
notcashflows
• Normally
based
onaverage
investment
Netpresent
value Internal
rateofreturn NPVvsIRR
IfNPV
isgreater
than
orequal
to • IfIRRisgreater
thanorequal Bothaccount
fortime
value
and
0aproject
isattractive tothecostofcapital
(required arebased
onrelevant
cash
flows
return)aproject
isattractive
G H
• Use =IRRorinterpolation
to
calculate IRRadvantage
Simple
toexplain
NPV advantages
• Easier
tocompareprojects
of
different
sizes
• IRRishard
touseifcash
flows
arenon-conventional
• IRRhasapotentially
unrealistic
reinvestment
assumption
NPVisconsidered
tobe
technically
thebest
technique
5:Investment
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1.Relevantcosts
Relevantcosts includefuturecash flowsand includeopportunitycosts.Non-relevantcosts include
sunkcosts,committedcosts,and financecosts.
2. Simplemethodsof projectappraisal
Thepayback methodof investmentappraisaland the ROCE/ARR/ROI methodsof investment
appraisalare popularappraisaltechniquesdespitetheirlimitations(ofwhichyou shouldbe
aware).
3. DCFmethods
IRRand NPVare both DCFmethodsand considerthe timevalueof money.
4. Perpetuitiesand annuities
Aperpetuityis a constant annual cash flow(an annuity)that willlast forever.
5. Internalrate of return
• Theinternalrate of return(IRR)of an investmentis the cost of capital at whichits NPVwouldbe
exactly$0.
• TheIRRmethodof investmentappraisalis an alternativeto the NPVmethodforinvestment
appraisal.Thismethod’sdecisionruleis to accept investmentprojectswhoseIRRexceedsthe
cost of capital.
G H
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Question practice
the Workbook):
SectionAquestions
Q15,Q16,Q17,Q18
SectionBquestions
Q33sub-questionsa–e
SectionC questions
Q43KnuckleDown
Q44 Mezen
G H
5:Investment
decision 121
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Activity answers
Activity1:Relevant costing
Relevantcash flows
Year1 $
Revenue 200,000
Depreciation 0
Materials(49,000– 10,000not relevant+1,000scrap value) 40,000
Labour(100,000– 10,000not relevant) 90,000
Overheads(nota cash flow) 0
Cash flow 70,000
Thisis lessconcerningthan the lossesfigureof $74,000that westarted withbut requiresfurther
analysisto see ifthe projectis worthpursuing(eganalysisof later timeperiods).
Activity2: Payback period

Payback period
Year Cumulativecash flow Workings
$
0 (500,000)
G 1 (430,000) Calculatedas (500,000)+70,000 H
2 (360,000) Calculatedas (430,000)+70,000

3 (280,000) Calculatedas (360,000)+80,000
4 (180,000) Calculatedas (280,000)+100,000
5 (80,000) Calculatedas (180,000)+100,000
6 40,000 Calculatedas (80,000)+120,000
Paybackoccursbetweenyear 5 and year 6.
Afteryear 5 a further$80,000 is needed forthe investmentto pay back.
Duringthe 6thyear $120,000of cash is generated (ignoringthe residualdisposalvaluethat occurs
at the end of thisyear).
So,ifcash flowsariseevenlyused duringthe year then approximately80/120of the 6thyear is
needed forthe projectto pay back.
Thepayback periodcan be estimatedas
∴ Payback=5 years +(80/120)or 5 years 8 months
Thismay be consideredto be a longpayback period(althoughweare not toldthe payback
periodthat Brendaand Eddiewillfindacceptable)and means that ifthere is no buyerforthe
businessinsixyears’time,then they willonlyjusthaverecoupedtheircosts.
Thisprojectis beginningto lookrisky,but it may not be rejectedbecause thisanalysishas not
consideredall of the cash flowsof the project.
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Activity3: ARR
Thecorrectansweris:15.3%
Profitcalculation:
$
Totalcash flowsfromoperations 540,000
Totaldepreciation(500,000– 350,000) (150,000)
Totalprofits 390,000
Averageprofits(÷6) 65,000 p.a.
Investmentcalculation
(500,000+350,000)/2=425,000
ARR=65/ 425 =15.3%
Activity4: Discounting
$45,200
100,000/(1+0.12)7=45,234or $45,200to the nearest $100
Or usingtables:
100,000×0.452(the discountfactor fromthe 12%columnand the time7 row)=$45,200
Activity5: Annuities
$109,247
Whendiscountingweare assumingthat cash flowsarisethe end of the year, so the paymentsat
G the start of years 1-10can be viewedas a paymentat time0 and then ninepaymentsat the end H
of each fo the years 1-9.So,whenweuse the annuitytable weare lookingat timeperiods1-9.

r =12%
n =9 (1stpaymentnow,10thpaymentat the end of time9)
Annuityfactor =5.328fortimeperiods1-9at 12%.
PV=17,264(the firstpaymentis not discountedbecause it is paid inadvance)+(5.328×17,264)=
109,247
Activity6: Delayed annuity

$16,581
Annuityfactor for8 years at 6%=6.210
PresentValue=3,000 ×6.210=$18,630
Thisis a valuefromthe perspectiveof the precedingtimeperiodto the annuity(iea presentvalue
at time2).
Discountingat time2 discountfactor of 0.890givesa presentvalueat time0 of 18,630×0.890=
$16,581.
Thereis an alternativeapproach whichyou can use ifpreferredwhichis to subtract the annuity
factor fortimes1-2(whenthe cash flowis not received)fromthe annuityfactor fortimes1-10
(time10is the finalyear of the cash flow).
Annuityfactor fortime3–10=(annuityfactor fortime1–10)– (annuityfactor fortime1–2)
=7.360– 1.833=5.527
Presentvalue=3,000 ×5.527=$16,581
5:Investment
decision 123
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Activity7: NPV
Thecorrect answeris:$7,470
Savingsare75,000×($3– $2.50)= $37,500 perannum.
Additionalcostsare$7,500perannum.
Netcashsavings aretherefore$30,000perannum. (Remember,depreciation
isnota cashflow
andmustbeignored asa ‘cost’.)
ThefirststepincalculatinganNPVistoestablishtherelevant
costsyearbyyear.Allfuturecash
flowsarisingasa directconsequenceofthedecisionshould
betakenintoaccount.Itisassumed
thatthemachine willbesoldfor$10,000attheendofyear4.
Itisquickertouseanannuity approachforthenetcashsavingsintimeperiod
1-4.
Time 0 1to4 4
Cashflow$s (90,000) 30,000 10,000
Discount
factors 1.0 3.037 0.636
Present
value$s (90,000) 91,110 6,360
Netpresent
value=(90,000)+ 91,110
+6,360=$7,470
Alternatively,
thiscouldbeshown as:
Time 0 1 2 3 4
Cashflow$s (90,000) 30,000 30,000 30,000 40,000
Discount
factors 1.0 0.893 0.797 0.712 0.636
Present
value$s (90,000) 26,790 23,910 21,360 25,440
G
Netpresent
value=(90,000)+ 91,110
+6,360=$7,500(difference
duetorounding). H
TheNPVispositive
andsotheproject isexpected
toearnmorethan12%perannumandis
therefore
acceptable.
Activity8: Interpolation
11%
IRR=6 +(15/(15 +3)×6)=11%
Activity9: NPV&IRR
1 Thecorrect
answeris:Project
AhasanIRRof26.3%andBanIRRof15.6%.
IRR(A)=12+5,000/(5,000– 3,600)× (16– 12)= 26.3%
IRR(B)=12+8,000/(8,000+ 1,000)× (16– 12)= 15.6%
2 Thecorrect
answeris:Project
Bwillincreaseshareholder
wealth morethanProject
Aatthe
current
costofcapital.
TheNPVatthecurrentcostofcapitalwillbethemovement inshareholder
wealthasa result
of
theproject
beingaccepted.Project
B(notA)willgenerate
moreshareholderwealth.
NPVsuggeststhatProject
Bisbetter,buttheIRRisbetter
forProject
A.
124 Financial
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capital and inflation6
Allowing for tax, working
6
Learning objectives
Syllabusreference
• Applyand discussthe real-termsand nominal-terms D2(a)
approaches to investmentappraisal
• Calculatethe taxationeffectsof relevantcash flows,including D2(b)
the tax benefitsof tax-allowabledepreciationand the tax
liabilitiesof taxableprofit
• Calculateand apply before-and after-tax discountrates D2(c)
G
6 H
Exam context
Thischapter covershowto allowfortax and inflationindiscountedcash flowcalculations
(introducedinthe previouschapter)and is part of SectionDof the syllabus(Investment
Appraisal).
Thisis an importantchapter that is examinableinallsectionsof the examand is commonly
examinedas a corefeature of one of the sectionC examquestions.
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6
Chapter overview
Allowingfortax, workingcapital and inflation
Taxation Working
capital
Corporation
taxonprofits
Taxsaved
from
taxallowable
depreciation
NPVlayout Inflation
Single
inflation
rate
More
than
onerate
ofinflation
G H
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1 Taxation
Sofar, inlookingat projectappraisal,wehaveignoredtaxation.However,paymentsof tax, or

reductionsintax payments,are relevantcash flowsand ought to be consideredinDCFanalysis.
Theexistenceof tax on corporateprofitsgivesriseto two cash flowsthat need to be takeninto
account inprojectappraisal.
Totaltaxcashflow
1.Taxpayments(benefits) 2.Taxbenefitsfromtaxallowable
onoperatingprofits(losses) depreciationoncapitalexpenditure
1.1 Corporation tax on profits

Thetax rate to be appliedwillbe giveninan examquestion.
Taxon profitswilleitherbe payable inthe same year as the taxable profitsare earned or in the
followingyear; the appropriatetimingto apply willbe specifiedinan examquestion.
Exam focus point

Checkany questioninvolvingtax carefullyto see what assumptionsabout the timingof tax
paymentsshouldbe made.
1.2 Tax allowable depreciation

G Wheretax-allowabledepreciation(alsocalledcapital allowanceor writingdownallowance)can H
be claimed,thiswillreducetaxableprofits,and the consequentreductionina tax paymentshould

be treated as a cash saving.
Tax-allowabledepreciation(TAD)is not the same as the accountingdepreciationcharge forthe
purposeof reportingprofitinthe financialstatements.
TADmay be appliedas straight-linedepreciation(the same amounteach year)or on a reducing
balance basis based on the writtendownvalue(WDV)of the asset at the start of year.
Assuminga zerodisposalvalue,inthe finalyear of an asset’slifeTADwillreduce the WDVof the
asset to zero.ThisfinalTADclaimis calleda balancingallowanceand means that the fullcapital
cost of the asset is claimedoverthe asset’susefullife.
Exam focus point

Theappropriatebasis fortax allowabledepreciation,includingthe rate to claimand the
timingof tax cash flowswillbe specifiedinan examquestion.
Real life example: Tax allowable depreciation

Iftax allowabledepreciationis availableon the cost of plant and machineryat a rate of 25%on
the writtendownvalue(WDV)(ieon a reducingbalance basis)and a companypurchases
machinerycosting$80,000,witha 4 year usefullifeand zeroresidualvaluethe subsequentTAD
wouldbe:
6:Allowing
fortax,working
capitalandinflation 127
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Time 1 2 3 4
WDVb/f $80,000 $60,000 $45,000 $33,750
TAD $20,000 $15,000 $11,250 $33,750
(25%of $80,000) (25%of $60,000) (25%of $45,000) (balancing
allowance)
c/f $60,000 $45,000 $33,750 $0WDV
1.2.1 Impact of disposal value

Whenthe asset is eventuallysold,the balancingallowanceis based on the writtendownvalueat
the start of the year less the disposalvalueobtained fromthe sale of the asset.
Real life example: Impact of disposal value

Continuingthe previousexample,ifthe asset is soldat the end of year 4 for$25,000the tax
allowabledepreciationintime4 wouldchange (the othertimeperiodsare unaffected)to:
Time 4
WDVb/f $33,750
Disposalvalue ($25,000)
TAD(balancingallowance) $8,750
WDVc/f $0
G
Ifthe scrap valueis greater than the WDVat the start of the year, there wouldbe no TADand the H
excesswouldbe taxed (thisis calleda balancingcharge).
1.2.2 Tax saved on tax allowable depreciation

Initself,tax allowabledepreciationis not a cash flow.However,the tax saved due to TADis a cash
flowand thisneed to be recognised.
Thecash savingon tax-allowabledepreciationis calculatedby multiplyingthe amountof the
tax-allowabledepreciationby the tax rate.
Iftax cash flowsoccurinthe year followingthe year inwhichthe itemgivingriseto the tax
occurs,the cash flowforthe tax savingfromtax-allowabledepreciationwilloccurinthe year
followingthe year inwhichthe allowanceis claimed.
Real life example: Tax allowable depreciation (continued)

Usingthe informationfromthe previousillustration,ifthe rate of tax on profitsis 20%,the tax
saved fromTADis as follows:
Time 1 2 3 4
TAD $20,000 $15,000 $11,250 $8,750
Tax $4,000 $3,000 $2,250 $1,750
saved (20%of $20,000) (20%of $15,000) (20%of $11,250) (20%of $8,750)
Taxsavingsmay occur a year after the TADis claimeddependingon whethertax on profitsis
payable inthe same year as the taxable profitsare earned or in the followingyear. The
appropriatetimingto apply willbe specifiedinan examquestion.
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1.2.3 ApproachtoapplytoTADintheexam
Intheexam,youshouldidentify
thecashflowsrelating
toTADby:
(a) Calculate
theamountofTADclaimed ineachyear.
(b) Makesurethatyouremember thebalancingallowance
intheyeartheassetissold.
(c) Calculate
thetaxsaved,noting
thetiming
oftaxpayments giveninthequestion.
Examfocus point
Acommon mistakeinexams istoincludethetax-allowable
depreciation
itselfintheNPV
calculation;
itisthecasheffect(iethetaxsaved)oftheallowance
thatshould beincluded.
Activity1:Tax cash flows
QuitongoCoisconsideringa majorinvestment
programme
whichwillinvolve
thecreation
ofa
chainofretailoutlets
throughout
theUK.
Thefollowing
schedule ofexpected
cashflowshasbeenprepared
foranalysis:
Time 1 2 3 4
$’000 $’000 $’000 $’000
Revenue 1,000 1,750 2,500 3,200
Direct
costs 970 1,350 1,700 1,800
Officeoverheads 100 100 100 100
Additional
information:
G
(1) 40%ofofficeoverhead isanallocationofheadofficeoperatingcosts. H
(2) Thepost-taxcostofcapitalis7%.
Quitongo Coispayingtaxat30%andisexpected todosofortheforeseeable
future.
Taxis
payable oneyearafterprofits
areearned.
Thecostsofinvestmentinclude$750,000 onfittingsandequipment.Taxallowable
depreciation
is
available
onfittings
andequipment (only)at25%ona reducing balancebasis.
Itisestimated
thattheresaleproceeds forfittings
andequipmentwillbe$200,000.
Quitongo Cohasanaccounting yearendof31December; expenditure
ontheinvestment
programme willtakeplaceinJanuary.
Required
Calculate
thetaxcashflowstobeincluded
intheNPVforthisproject
(iethetaxpaidonoperating
cashflowsandtaxsavedontaxallowable
depreciation).
Solution
6:Allowing
fortax,working
capital
andinflation129
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1.2.4 Cost of capital
Whentaxation is ignoredinDCFcalculations,the discountrate willreflectthe pre-tax rate of
returnrequiredon capital investments.
Whentaxation is includedinthe cash flows,a post-tax requiredrate of returnshouldbe used.
Cost of capital is coveredinChapter 11.
Essential reading
SeeChapter 6 Section1of the EssentialReading,availableinthe digitaleditionof the Workbook,

fora furtherillustrationof thisarea.
2 Working capital
Investmentprojectswillrequirean injectionof fundsto financethe levelof workingcapital
required(eginventory).Theeffect on cash flowsis due to the change inworkingcapital required
duringthe lifeof the project.
Therelevantcash flowassociatedwithworkingcapital is the change in workingcapital.
• Anincreasein workingcapital requiredwillcause a cash outflow
• Adecrease in workingcapital requiredwillcause a cash inflow.
2.1 Impact of working capital movements on project appraisal
2.1.1 Start of project
Ininvestmentappraisal,an investmentinworkingcapital at the beginningof the investment
G
periodis treated as an outflowof cash. H
2.1.2 Each year of operation

Ineach year of operationof a projectthe followingadjustmentis made:
$
Post tax cash flowfromprofitsinthe period X
Minusworkingcapital increase (X)
or Plusworkingcapital reduction X
Equalsadjustedcash flowforthe period X
2.1.3 End of project

Workingcapital willbe releasedat the end of a project’slife,and so there willbe a cash inflow
arisingout of the eventualrealisationintocash of the project’sinventoryand receivablesinthe
finalyear of the project.
Exam focus point

Examquestionswillshowthe total amountof workingcapital requiredineach year of the
project.TheDCFworkingshouldonlyshowthe incrementalcash flowsfromone year’s
requirementto the next.
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Activity 2: Working capital cash flows
Continuationof activity1.
QuitongoCo plcexpectsthe followingworkingcapital requirementsduringeach of the fouryears
of the investmentprogramme(allfiguresin$’000).
Year 1 Year 2 Year 3 Year 4
250 300 375 400
Quitongoplchas an accountingyear end of 31December;expenditureon the investment

programmewilltake place inJanuary.
Required
Calculatethe relevantcash flowsrelatingto workingcapital.
Solution
G H
3 Net present value (NPV) layout
Aneat layoutwillgain credibilityinthe examand willhelpyou makesense of the many different

cash flowsthat you willhaveto deal with.
Thepointsinboldinthe spreadsheet-styletable beloware the areas already coveredinthe
previoussectionsof thischapter; the timingsof someof the cash flowsmay alter (egtaxation)
dependingon the wordingof the question.
A B C D E F G
1 Time 0 1 2 3 4 5
2 Sales X X X X
3 Costs (X) (X) (X) (X)
4 Operatingcash flow X X X X
5 Taxation (X) (X) (X) (X)
6 Capital expenditure (X)
7 Scrapvalue X
8 Taxbenefitof TAD X X X X
9 Workingcapital changes (X) (X) (X)(X) X
6:Allowing
fortax,working
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A B C D E F G
1 Time 0 1 2 3 4 5
10 Netcash flows (X) X X X X X
11 Discountfactors@post-tax cost of X X X X X X
capital
12 Presentvalue (X) X X X X X
13 Netpresentvalue X
Exam focus point

Youcan use the spreadsheetfunction=NPVinthe examto discountthe net cash flowsarising
fromtime1onwards(spreadsheetcellsC10to G10inthe previoustable)and then subtract the
time0 cash flowsto determinethe overallprojectNPV.Thistwostage approach is required
because the NPVfunctionassumesthat the firstcash flowarisesat time1(and so ignoresthe
time0 net cash flow).
Ifusingthisapproach, you willneed to insertthe cost of capital (iethe discountrate) intothe
formulatoo.
Forexample,ifthe cost of capital is 10%then the NPVof the cash flowsfromtime1onwardsin
the previoustable wouldbe calculatedas:
=NPV(0.1,C10:G10) and then the cash outflowat time0 wouldbe deducted to calculatethe
projectNPV.
Youmay preferto use thismethodinthe examas it can be quickerthan usingthe discount
G
tables, but eithermethod(iethe =NPVapproach or usingdiscounttables)is acceptable. H
Activity 3: NPVlayout
Continuationof activities1and 2.
Extrainformation:
QuitongoCo’sinvestmentprogrammewillalso involvethe followinginvestmentcosts and disposal
values.
Time 0 1 2 3 4
$’000 $’000 $’000 $’000 $’000
Landand buildings 3,250
Fittingsand equipment 750
Thecost of land and buildingsincludes$120,000whichhas already been spent on surveyors’and
otheradvisers’fees.
QuitongoCo expectsto sellthe chainat the end of Year4 for$4,500,000after tax (thisincludes
resaleproceedsof $200,000forfittingsand equipment).
Thepost-taxcost of capital is7%.
Required
Completethe NPVpro-formabelow(whichincludesthe resultsof activities1and 2) to calculate
the NPVof thisproject.
132 Financial
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Time 0 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000 $’000
Turnover 1,000 1,750 2,500 3,200
Direct
costs (970) (1,350) (1,700) (1,800)
Overheads
(60%) (60) (60) (60) (60)
Operating
cashflow (30) 340 740 1,340
Taxation@30% 9 (102) (222) (402)
Fittings
&equipment
Saleofbusiness
Landandbuildings
TaxsavedfromTAD 56 42 32 35
Working
capitalchanges (250) (50) (75) (25) 400
Netcashflow
7%discount
factors 1 0.935 0.873 0.816 0.763 0.713
Present
value
NPV=
4 Inflation
G H
Real:Theterm‘real’whenapplied
tocashflowsortothecostofcapital,means
basedon
KEY
TERM current
pricelevels.
Nominal:Theterm‘nominal’,
whenappliedtocashflowsortothecostofcapital,means
after
adjusting
fortheimpactofexpectedinflation.
4.1 Impact of inflation on project appraisal

Sofar,wehavenotconsidered
theeffectofinflation
ontheappraisal
ofcapitalinvestment
proposals.
Inflation
hastwoimpacts
onNPV:
Time 0 1onwards
Cashflow Cashflows
rise,making
theproject
more
attractive
Discount
factor Thecostofcapital
rises,
making
theproject
lessattractive
Present
value Thenetimpact
ontheNPVmaybeminimal
4.2 One rate of inflation

Ifthereisonerateofinflation,
inflation
hasnonetimpactona project’s
NPVbecausetheimpact
ofanincrease inpricesonproject
cashinflows
isexactly
offsetbytheimpact
ofinflation
on
increasingthecostofcapital.
6:Allowing
fortax,working
capital
andinflation133
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Inthiscase it is normallyquickerto ignoreinflationinthe cash flows(ieto use real cash flows,
sometimesthese are referredto as beingat ‘currentprices’)and to use a ‘real’cost of capital (ie
ignoringthe impactof inflationon investors’requiredreturn).
Illustration 1: One rate of inflation
BistroCo is a brewingcompanytryingto decidewhetherto buy a newbottlingmachinefor$10m

to save on rentalcosts whichare currently$6.6mp.a.
Runningcosts forthe newmachinewouldbe $1.2mp.a.
Thebottlingmachinehas no resalevalueand has an expectedlifeof three years.
Allcash flowsare quoted incurrentprices(ieinreal terms)and are expectedto riseinlinewith
the consumerpriceindex(orCPI,a measureof inflation)at 5.26%p.a.
Bistro’sreal cost of capital is 14%,and its nominalcost of capital is20%.Ignoretax.
Required
Evaluatewhetherthe newbottlingmachineshouldbe purchased.
Solution
Becausethere is onlyone rate of inflation,inflationcan be ignoredin the cash flowsand the cost
of capital.
Time 0 1–3
$m $m
Runningcosts (1.20)
Savings 6.60
G Purchasecosts (10.00) H
Net (10.00) 5.40

DF@14% 1.0 2.322
PV (10.00) 12.54
NPV +2.54
Notethat ifwehad decidedto includeinflation,wewouldget the same answer,but it wouldtake
longerto calculate and thereforeis unnecessarywherethere is onlyone rate of inflation.This
approach is shownbelow.
Time 0 1 2 3
Runningcosts (×1.0526p.a.) (1.26) (1.33) (1.40)
Savings(×1.0526p.a.) 6.95 7.31 7.70
Purchasecosts (10.00)
Net (10.00) 5.69 5.98 6.30
DF@20% 0.833 0.694 0.579
PV 4.74(10.00) 4.15 3.65
NPV +2.54
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4.3 More than one rate of inflation
Ifthere is morethan one rate of inflation,inflationwillhavean impacton profitmargins(as
revenueand costs are changingat differentrates) and thereforeinflationneeds to be includedin
projectappraisal.
Inthiscase the cash flowsmust be inflated,and inflationmust also be incorporatedintothe
cost of capital.
4.3.1 Inflating project cash flows
Thiswillinvolveadjustingthe cash flowsby multiplyingthemby (1+inflationrate) foreach year
that inflationis beingapplied.Forexample,inflatinga cash flowat time2 willinvolvemultiplying
it by (1+inflation).
2
4.3.2 Inflating the cost of capital
Asthe inflationrate increases,so willthe returnrequiredby an investor.Forexample,you might
be happy witha returnof 5%inan inflation-freeworld,but ifinflationwererunningat 15%you
wouldexpecta considerablygreater yield.
Thenominal(ormoney)interestrate incorporatesinflation.
Therelationshipbetweenreal and nominalrates of interestis givenby the Fisherformula.
Formula provided
(1+i)=(1+r)(1+h)
Where h =generalrate of inflation
r =real rate of interest
i =nominal(money)rate of interest
Thegeneralinflationrate is oftengiveninan examquestionas the retailpriceindex(RPI)or

G H
consumerpriceindex(CPI).
4.3.3 Using real cash flows and a real cost of capital if there is more than one rate of
inflation
Ifthere is morethan one rate of inflation,it is stillpossibleto calculate an NPVin real terms,but
this has to start by an adjustmentto nominalcash flowsbecause wherethere are multiplerates
of inflationthen there willbe an impacton profitmarginsdue to inflation(as revenueand costs
are changingat differentrates).
Theapproach requiredis to:
(a) Deflatenominal(ieinflated)cash flowsusingthe generalrate of inflationso that they
becomereal cash flows
Realcash flow=Nominalcash flow÷(1+inflationrate) ^n
(b) Discountthe real cash flowsat the real cost of capital.
Exam focus point

Thisapproach is morecomplicatedthan usingnominalcash flowsand thereforeis rarelyused.
Illustration 2: More than one rate of inflation
Wewilluse the detailsfromthe previousillustrationforBistroCo withthe followingamendments:

(1) Runningcosts riseat the generalrate of inflationof 5.26%,but rentalcosts beingsavedare
expectedto increaseat 2%p.a.
(2) Weare onlytoldthat Bistro’sreal cost of capital is 14%.
6:Allowing
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Required
Evaluatewhetherthe newbottlingmachineshouldbe purchased.
Solution
Herethere is morethan one rate of inflation,so inflationneeds to be incorporatedintothe cash
flowsbecause profitmarginsare affected by the savingson rentalcosts inflatingat a lowerrate
than costs are increasingby.
Time 0 1 2 3
Runningcosts (×1.0526p.a.) (1.26) (1.33) 1.40)
Savings(×1.02p.a.) 6.73 6.87 7.00
Purchasecosts (10.00)
Net (10.00) 5.47 5.54 5.60
DF@20%(Seeworking) 0.833 0.694 0.579
PV (10.00) 4.56 3.84 3.24
NPV +1.64
Working
1+Inflated(nominal)cost of capital =(1+0.14)×(1.0526)= 1.20ie 20%
Thesame answercan also be obtainedifthe nominalcash flowsare deflated and a real cost of
capital is used. Thisis a slowermethodand shouldonlybe used ifrequestedina question.
Thisis demonstratedbelow:
Time 0 1 2 3
G H
Nominalcash flows(as before) 5.47 5.54 5.60

Deflated÷(1.0.526)^n 0.9500 0.9026 0.8575
Realcash flows
Net (10.00) 5.20 5.00 4.80
DF@14%(realcost of capital) 0.877 0.769 0.675
PV (10.00) 4.56 3.84 3.24
NPV +1.64
4.3.4 Working capital and inflation

Theworkingcapital requirementeach year isa functionof sales and costs.Itfollowsthat ifthe
sales and purchasesfiguresare to be inflated,then any figureresultingfromthem(receivables,
payables, inventory)shouldalso be inflated.
Onlyonce the total (inflated)workingcapital requiredhas been calculatedshouldyou calculate
the incrementalcash flowsforDCFcalculationsbased on the change inworkingcapital.
Activity 4: Supplementary activity with tax, working capital and inflation
SC Co is evaluatingthe purchaseof a newmachineto produceproductP, whichhas a short

productlifecycledue to rapidlychangingtechnology.Themachineis expectedto cost $1m.
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Productionand sales of productP are forecastto be as follows:
Year 1 2 3 4
Productionand sales (units/year) 35,000 53,000 75,000 36,000
Thesellingpriceof productP (incurrentpriceterms)willbe $20 per unit,whilethe variablecost of

the product(incurrentpriceterms)willbe $12per unit.
Sellingpriceinflationis expectedto be 4%per year and variablecost inflationis expectedto be
5%per year.
Noincreaseinexistingfixedcosts is expectedsinceSC Co has spare capacity inboth space and
labourterms.
Producingand sellingproductP willcallforincreasedinvestmentinworkingcapital.Analysisof
historicallevelsof workingcapital withinSC Co indicatesthat at the start of each year,
investmentinworkingcapital forproductP willneed to be 7%of sales revenueforthat year.
SC Co pays tax of 30%per year inthe year inwhichthe taxableprofitoccurs.Liabilityto tax is
reducedby capital allowances(taxallowabledepreciation)on machinery,whichSC Co can claim
on a straight-linebasis overthe four-yearlifeof the proposedinvestment.Thenewmachineis
expectedto haveno scrap valueat the end of the four-yearperiod.
SC Co has a real cost of capital of 9.8%,and the generalrate of inflationis 2%.
Required
1 Calculatethe net presentvalueof the proposedinvestmentinproductP. (13marks)
2 Adviseon the acceptabilityof the proposedinvestmentinproductP. (17marks)
(Total=30 marks)
G Solution H
Essential reading
SeeChapter 6 Section2 of the Essentialreading,availableinthe digitaleditionof the Workbook,

forfurtherdiscussionof thisarea.
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Chapter summary
Allowing for tax, working capital and inflation
Taxation Workingcapital
Corporation
taxonprofits • Relevantcashflowisthechangein
Apply asanexpense
usingtherateandtiming workingcapital
giveninanexamquestion • Startyear:investinworking capital
• Eachyearofa project:
increaseinworking capital=cashoutflow
Taxsavedfromtaxallowable depreciation decreaseinworking capital=cashinflow
• CalculatetheamountofTAD toclaimin • Finalyear:assumeworking capitalisreduced
eachyear tozero(unlesstoldotherwise ina question)
• Finalyearbalancing
allowance
• Calculatetaxsavednotingthetimingof
taxpayments
NPVlayout Inflation
• Anyneatlayoutisacceptable Singleinflation
rate
• Sensibletogroupitemsaffectingoperating Easiertousea realcostofcapitalandnotto
cashflows(affectingtaxpaid)at thetop,and inflatethecashflows
G
capitalitemsat thebottom H
Morethanonerateofinflation
• Usea nominal costofcapital
• Inflateeachcashflowat theappropriate
rate
(ordeflatethenominalcashflowsandusea
realcostofcapital)
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1.Taxation
Taxrates and timingswillbe giveninthe exam.
Don’tforgettax is savedon tax allowabledepreciation.
2. Workingcapital
Therelevantcash flowis the change inworkingcapital.
3. Singleinflationrate
Usereal cash flowsand a real cost of capital.
4. Morethan one rate of inflation
Usenominalcash flowsand a nominalcost of capital.
5. NPVlayout
Anyneat layoutwillbe fine,sensibleto start withoperatingcash flows(whichaffect tax paid)and
then to deal withcapital items.
G H
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Question practice
the Workbook):
SectionAquestions
Q19
SectionC questions
Q46Bridgeford
Q47Dinard
Further reading
Thereis a usefulTechnicalArticleavailableon ACCA’swebsite,called‘Inflationand investment
appraisal’,writtenby a memberof the FinancialManagementexaminingteam. Werecommend
that you read thisarticleas part of yourpreparationforthe FMexam.
G H
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Activity answers
Activity1:Taxcashflows
Taxcashflowcalculations:
(1) Taxpaidonoperating
cashflows
Only60%ofoverheads area relevant
cashflow,theother40%isnota cashflowbecause
itisan
apportionmentofanexisting
overhead.
Time 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000
Revenue 1,000 1,750 2,500 3,200
Direct
costs (970) (1,350) (1,700) (1,800)
Overheads
(60%) (60) (60) (60) (60)
Operating
cashflow (30) 340 740 1,340
Taxation
@30% 9 (102) (222) (402)
(2) Calculation
oftaxallowable
depreciation
Time 1 2 3 4
WDVb/f($’000) 750 562 421 316
Scrap($’000) 200
TAD($’000) 188 141 105 *116
WDVc/f($’000) 562 421 316 0
G H
Time 2 3 4 5
Taxsaved
(WDVxtaxrate) 56 42 32 35
*FinalyearTAD=WDVattime3 – scrapproceeds
=316– 200=116
Activity2: Workingcapitalcashflows
Calculationofworking
capitalflows
Time 0 2 3 4
Working
Capital 250 300 375 400 0*
Changeinworking
capital 250 50 75 25 (400)
Changeincashflow (250) (50) 75) (25) 400
*Normal
assumption
Activity3: NPVlayout
Time 0 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000 $’000
Turnover 1,000 1,750 2,500 3,200
Direct
costs (970) (1,350) (1,700) (1,800)
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Time 0 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000 $’000
Overheads(60%) (60) (60) (60) (60)
Operatingcash flow (30) 340 740 1,340
Taxation@30% 9 (102) (222) (402)
Fittings&equipment (750)
Saleof business 4,500
Landand buildings
(3,250lesssunkcost of
120) (3,130)
TaxsavedfromTAD 56 42 32 35
Workingcapital changes (250) (50) (75) (25) 400
Netcash flow (4,130) (80) 330 655 6,050 (367)
7%discountfactors 1 0.935 0.873 0.816 0.763 0.713
Presentvalue (4,130) (75) 288 534 4,616 (262)
NPV=+$971(000)
Alternativesolutionusingthe spreadsheet=NPVfunction:
Ifthe net cash flowsfromtime1-5inthe table wereinspreadsheetcellsC10to G10then the
presentvalueof these cash flowscouldbe calculatedas =NPV(0.07,C10:G10) whichgivesa value
of 5,102.
G
Subtractingthe time0 cash flowsof 4,130then givesthe overallNPVas +$972(000). H
Thisis slightlymoreaccurate than usingdiscounttables because discountfactorsinthese tables

are roundedto 3 decimalplaces but eithermethodis accepted inthe exam.
Activity4: Supplementary activity with tax, working capital and inflation

Markingguide Marks
Inflatedsales revenue 2
Inflatedvariablecosts 2
Taxation 1
Workingcapital 3
Discountfactors 2
Netpresentvaluecalculation 1
13
2 Netpresentvaluecomment 1
Discussionof limitations 3
Maximum 4
17
Total 30
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1 Calculationof NPV
Year 0 1 2 3 4
$ $ $ $ $
Salesrevenue(W1) 728,000 1,146,390 1,687,500 842,400
Variablecosts (W2) (441,000) (701,190) (1,041,750) (524,880)
Contribution 287,000 445,200 645,750 317,520
Taxation@30% (86,100) (133,560) (193,725) (95,256)
Capital expenditure (1,000,000)
Workingcapital (W3) (50,960) (29,287) (37,878) 59,157 58,968
Taxbenefitof tax
depreciation(W4) 75,000 75,000 75,000 75,000
Netcash flow (1,050,960) 246,613 348,762 586,182 356,232
Discountfactor (W5) 1.000 0.893 0.797 0.712 0.636
Presentvalue (1,050,960) 220,225 277,963 417,362 226,564
NPV 91,154
Alternativesolutionusingthe spreadsheet =NPVfunction:
Ifthe net cash flowsfromtime1-4inthe table wereinspreadsheetcellsC10to F10then the
presentvalueof these cash flowscouldbe calculatedas =NPV(0.12,C10:F10) whichgivesa
valueof 1,141,846.
Subtractingthe time0 cash flowsof 1,050,960then givesthe overallNPVas +$90,886.
G
Thisis slightlymoreaccurate than usingdiscounttables because discountfactorsinthese H
tables are roundedto 3 decimalplaces but eithermethodis accepted inthe exam.

Workings
1 SalesRevenue
Year 1 2 3 4
Sellingprice(×1.04) $20.80 $21.63 $22.50 $23.40
Salesvolumeinunits 35,000 53,000 75,000 36,000
Salesrevenue $728,000 $1,146,390 $1,687,500 $842,400
2 Variablecosts
Year 1 2 3 4
Variablecost (×1.05) $12.60 $13.23 $13.89 $14.58
Salesvolumeinunits 35,000 53,000 75,000 36,000
Variablecosts $441,000 $701,190 $1,041,75 $524,880
3 Workingcapital
Year 0 1 2 3 4
$ $ $ $ $
Salesrevenue 728,000 1,146,390 1,687,500 842,400
Workingcapital req @7% 50,960 80,247 118,125 58,968
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Year 0 1 2 3 4
$ $ $ $ $
Incrementalworking
capital cash flow (50,960) (29,287) (37,878) 59,157 58,968
4 Taxbenefitof tax depreciation
Depreciation=$1,000,000/4=$250,000per year
Taxbenefit=30%×$250,000=$75,000
(W5)Cost of capital
1+Inflated(nominal)cost of capital =(1+0.098)×(1.02)=1.12ie 12%
Anominalcost of capital needs to be used, as inflationhas been includedinthe cash flows
(becausethere is morethan one rate of inflation)
2 TheNPVis positiveso the proposedinvestmentcan be recommendedon financialgroundsas
the projectgivesa returnthat is abovethe cost of capital of 12%used by SC Co forinvestment
appraisalpurposes.
Limitationsof the evaluations
Forecastsales volumeshavebeen used forboth investmentappraisalmethodsand the
accuracy of the resultsis thereforeheavilydependenton the accuracy of these forecasts.
ProductP has a short productlifecyclewhichmakesforecastsales volumesparticularly
unpredictable.
Theanalysishas used predictedinflationrates forsales priceand variablecosts whichdo not
change overthe four-yearperiod.Thisis unlikelyinrealityas priceincreaseswillvary
accordingto prevailingeconomicconditionsand unexpectedevents.
Fixedcosts havenot been includedinthe investmentappraisal.Thisis because SC has spare
G capacity inboth space and labourtermsso it is assumedthat fixedcosts willnot change as a H
resultof the investment.

Thisassumptionmay be questionableinthe longerterm,especiallyas productionof productP
inYear3 willbe doublethat inYear1.
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risk7
Project appraisal and
7
Learning objectives
Syllabusreference
Describeand discussthe differencebetweenriskand D3(a)•
uncertaintyinrelationto probabilitiesand increasing
projectlife
• Applysensitivityanalysisto investmentprojectsand D3(b)
discussthe usefulnessof sensitivityanalysisinassisting
ininvestmentdecisions
• Applyprobabilityanalysisto investmentprojectsand D3(c)
G
discussthe usefulnessof probabilityanalysisinassisting H
investmentdecisions.
• Applyand discussothertechniquesof adjustingforrisk D3(d)
and uncertaintyininvestmentappraisal,including:
- simulation
- adjustedpayback
- risk-adjusteddiscountrates.
7
Exam context
Thischapter covers‘adjustingforriskand uncertaintyininvestmentappraisal’whichis part of
SectionDof the syllabus(InvestmentAppraisal),it introducesthe conceptsof riskand uncertainty
and evaluatestheirimpacton investmentappraisal.
Thisis an importantchapter that is oftenneglected.Rememberthat thischapter coversa
syllabussectionthat is examinableinallsectionsof the exam,includingSectionC.
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7
Chapter overview
Projectappraisaland risk
Riskand Riskanalysis Uncertainty

analysis
uncertainty techniques techniques
Risk Expected
values Sensitivity
analysis
Uncertainty Probability
analysis Weaknesses
Drawbacks Other
techniques
Other
methods
G H
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1 Risk and uncertainty
Investmentdecisionsare based on predictionsof what willhappen inthe futureand therefore

involvean elementof unpredictability.
Thisunpredictabilitycouldbe describedas riskor uncertainty. However,forthisexamthere is an
importanttechnicaldistinctionmade betweenthese two concepts.
1.1 Risk
Risk:Ariseswherethere are severalpossibleoutcomesand, based on past relevantexperience,

KEY
TERM probabilitiescan be assigned to the possibleoutcomes.
Riskincreasesas the variabilityof a project’scash flowincreases.
Riskcan be quantifiedand builtintoa net present value(NPV).
1.2 Uncertainty
Uncertainty:Ariseswherethere are severalpossibleoutcomesand no information(eg

KEY
TERM experience)upon whichto create probabilitiesso the degree of uncertaintycannot be
quantified.
Theuncertaintyof projectcash flowsincreasesas the lengthof a projectrises,sincecash flows

inthe distantfutureare lesscertainthan cash flowsinthe short-term.
Uncertaintycannot be quantifiedbut it can be described/analysed.
Exam focus point

G H
Makesureyou can explainthe differencebetweenriskand uncertainty,thishas been

examinedina part of severalSectionC questions.
2 Risk analysis
Thereare a numberof techniquesforquantifyingthe riskof a project’scash flows.
2.1 Probability analysis and expected values
Aprobabilityanalysisof expectedcash flowscan oftenbe estimated(forexampleusingpast
experienceof similarprojects)and used both to calculatean expected NPVand to measurerisk.
2.1.1 Expected values
Anexpectedvalueis a weightedaveragethat is calculatedusingprobabilities.Itis likelythat you
haveused thistechniquebefore.
Activity 1: Expected NPV
HarryCo is choosingbetweentwomutuallyexclusiveprojects.TheNPVof these projectsin$m

depends on the rate of growthof the economyoverthe nextfiveyears. ForecastNPVis shown
underscenariosof low,mediumand highgrowth:
Project A Project B
Probability Forecast NPV$m NPV$m
0.25 Lowgrowth 1.00 –8.00
0.50 Mediumgrowth 2.50 4.00
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ProjectA ProjectB
Probability Forecast NPV$m NPV$m
0.25 Highgrowth 4.00 16.00
1.00 Expected
value
Required
Complete
thetable(working
totwodecimal
places)tocalculate
eachproject’s
expected
NPVand
consider
whichproject
would bechosen.
Solution
2.1.2 Riskandjointprobabilities
Aprobability
distribution
of‘expected cashflows’canalsobeusedtomeasure risk,forexample
by:
G
(a) calculating
theworstpossibleoutcome anditsprobability H
(b) calculating
theprobabilitythattheprojectwillfailtoachieve
a positive
NPV
Thismayinvolve analysingtheriskofa singleoutcome (egthe25%riskofproject
Bfailingto
achievea positive
NPVintheprevious activity).
Alternatively,
riskmaybemeasured byanalysing theriskoftworiskyoutcomesoccurringatthe
sametime;thisiscalleda jointprobability.
Jointprobability:
Theprobability
oftworiskyoutcomes
occurring
atthesametimeandis
KEY
TERM calculated
astheprobability
ofone outcomemultiplied
bytheprobability
oftheother.
Illustration1:Joint probabilities
Aninvestment
ina newproductisbeingplanned.
Theproducthasanexpectedlifeoftwoyears.
Ananalysis
ofsimilar
projects
hasresultedinthefollowing
annualcashflowprojections:
Year1 Year2
Cashflowprojection
1(high) $56mp.a. 60%chance $44mp.a. 30%chance
Cashflowprojection
2 (low) $44mp.a. 40%chance $36mp.a. 70%chance
Theoutcome inYear2 isnotdependent

ontheoutcomeinYear1.
Set-upcostsof$77marepayableimmediately.
Thecostofcapitalis10%.
Youarethemanagement accountant
andyouareworried
abouttheriskoftheproject.
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Thepossible
outcomes
havebeenfurther
analysed
asfollows:
Year1 Year2 NPV
$44m(low) $36m(low) $–7,268m
$44m(low) $44m(high) $–660m
$56m(high) $36m(low) $+3,640m
$56m(high) $44m(high) $+10,248m
Ignore
theimpact
oftaxation.
Required
Identify
themean(expected)
NPVoftheproject.
(Giveyouranswer
tothenearest
$’000.)
Solution
ExpectedNPV
Possible
outcome Probability
Year1 Probability
Year2 Jointprobability
Year1low&Year2 low 0.4 0.7 0.4×0.7=0.28
Year1low&Year2 high 0.4 0.3 0.4×0.3=0.12
Year1high&Year2 low 0.6 0.7 0.6×0.7=0.42
Year1high&Year2 high 0.6 0.3 0.6×0.3=0.18
1.0
Expected
NPV=(–7,268× 0.28)+(–660×0.12)+ (3,640×0.42)+ (10,248
× 0.18)= +1,259
G H
Alternative
calculation
ofexpected
NPV
Time 0 1 2
Cashflow (56,000×0.6)+(44,000×0.4) (44,000×0.3)+(36,000×0.7)
($’000) –77,000 =51,200 =38,400
DF@10% 1 0.909 0.826
PV –77,000 46,541 31,718
NPV +1,259
Activity2: Joint probabilities
Usingtheinformation
fromtheprevious
illustration;
Required
1 Identify
theprobability
oftheproject
having
a negative
NPV.(Giveyouranswer
asa
percentagetoonedecimalplace.)
2 Identify
theNPVofthemostlikelyoutcome.
(Giveyouranswer
tothenearest
$’000.)
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Solution
2.1.3 Problemswithprobabilityanalysis
Therearea number ofproblems withusingexpectedvalues inmaking investment decisions.
• Aninvestment maybeone-off,andthe‘expected’ NPVmaynever actually occur.Egifthereis
a 50%probability thattheNPVwillbe+$10,000 anda 50%probability thatitwillbe$(2,000),
theEVoftheNPVis+$4,000.Onthisbasistheproject willgoahead.However, anNPVof
$4,000isnotexpected tohappen.TheNPVwillbeeither positive
$10,000 ornegative $2,000.
• Assigning probabilities
tofuture
eventsandoutcomes isusuallyhighlysubjective.
• Expected valuesdonotevaluate therangeofpossible NPVoutcomes. Ifa company hasa
neutralattitudetoriskitcanbeassumed thatitwillselectaninvestment thatisforecastto
createthehighest expected netpresentvalue.However, ifa company isespecially risk-averse
orifitisrisk-seeking
(inthehopeofhighreturns)thena company’s decision-making willbe
influencedbythisriskappetite.
2.2 Other techniques for managing risk
G Techniques Description H
Simulation Random numbers areassignedtodifferent

valuesofvariables
to
reflect
theirprobability.
Riskisassessedasthestandarddeviation
offorecastNPVs(fromrepeated simulations),
andtheprobability
ofa negativeNPV.
However,because random numbers arebasedonprobabilities,
thereisa dangerthattheymaybehighlysubjective.
Conservative
forecastingAtraditionalwayofdealing withriskistoreduce estimatedproject
cashinflows toanultra-safe level(iethecashcouldbenoworse
than...)
These cashflowsarethendiscounted asiftheyare‘riskfree’using
a low(riskfree)costofcapital.
Thisissometimes calleda certainty-equivalent method.
There isa danger withthistechnique thatthelikelybenefits
of
investments maybeunderstated, andpotentially attractive
investments maytherefore berejected.
Finally,laterinthisWorkbook(inChapter12)wewillseehowa costofcapitalcanbeadjusted
to
recognise thatinvestors
willwanta higher
return
onriskier
projects.
Thisissometimes referred
toasa risk-adjusted
costofcapital.
Essentialreading
SeeChapter 7Section
1oftheEssential
reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
discussion
ofthisarea.
TheEssential
reading
isavailable
oftheWorkbook.
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3 Uncertainty analysis
There
areseveral
techniques
foranalysing
theuncertainty
ofa project’s
cashflows.
3.1 Sensitivity analysis
Sensitivity
analysis:
Akeymethod ofanalysingtheuncertainty surrounding
a capital
KEY expenditure
project
TERM NPVistochanges andenables anassessment tobemade ofhow responsive
theproject’s
ina singlevariable
thataffectsa project’s
NPV.
Aproject’s
NPVwilldepend ona number ofuncertainvariables
(egselling
price,salesvolume,
operatingcostsetc).
Thebasicapproach ofsensitivity
analysis
istocalculate
whatthevalueofa singlevariable
wouldhavetochangeby,tochangea project’s NPVtozero.
Sensitivity
analysistherefore
provides anindicationofwhichvariablesa project’s
NPVismost
sensitive
to.
Management shouldreview
criticalvariables
toassesswhether
ornotthereisa strong possibility
ofeventsoccurringwhichwillleadtoa negativeNPV.Management should alsopayparticular
attention
tocontrolling
thosevariablestowhichtheNPVisparticularly
sensitive,
oncethedecision
hasbeentakentoaccepttheinvestment.
Asimpleapproach tocalculatingsensitivity
isasfollows:
Sensitivity
%=
ProjectNPV × 100
Present
valueofprojectvariable
Thelower
thepercentage,
themoresensitive
theNPVistothatproject
variable,
asthevariable
G
wouldneedtochangebya smaller
amounttomaketheprojectnon-viable. H
Illustration2: Sensitivityanalysis
KenneyCoisconsideringa project
whichrequiredaninitial
investment
of$7million
andis
expectedtoresult
insalesof100,000unitsperyearata selling
priceof$65anda variable
cost
perunitof$20.Kenney Cohasa costofcapitalof8%.
Thepresentvalue(PV)ofeachthesevariables
hasbeencalculated asfollows:
PVofinitial PVofvariable PVofnet
Year Discount
factor8% investment costs PVofsales cashflow
$’000 $’000 $’000 $’000
0 1.000 (7,000) 7,000)
1 0.926 (1,852) 6,019 4,167
2 0.857 - (1,714) 5,571 3,857
Theproject
hasa positive
NPVof+$1,024
(000)andtherefore
would
appear
tobeworthwhile.
Theproject’s
IRRhasbeenestimatedas18.5%.
Taxcanbeignored
Required
Measure thesensitivity
oftheproject
tochanges
in:
(a) Theinitial
investment
(b) Salesvolume
(c) Selling
price
(d) Variablecosts
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(e) Costofcapital
Solution
(a) Initialinvestment
Sensitivity=(1,024/7,000)×100=14.6%
Thismeans thattheproject willonlyjustprovide therequired investment returnifthecostof
theinvestment is14.6%higher thanestimated, assuming allothervariables areunchanged.
(b) Salesvolume
Thiswillaffectthevalueofsalesrevenue andvariable costs(iecontribution).
Sensitivity=(1,024/(11,590 - 3,566))× 100=12.8%
Theproject willonlyjustprovide therequired investmentreturn ifsalesvolume is12.8%lower
thanestimated, assuming allothervariables areunchanged.
(c) Sellingprice
Thiswillaffectthevalueofsalesrevenue only.
Sensitivity=(1,024/11,590)×100=8.8%
Theproject willonlyjustprovide therequired investmentreturn ifthesalespriceis8.8%lower
thanestimated, assuming allothervariables areunchanged.
(d) Variable costs
Sensitivity=(1,024/3,566)×100=28.8%
Theproject willonlyjustprovide therequired investmentreturn ifvariablecostsperunitare
28.8%higher thanestimated, assuming allothervariablesareunchanged.
(e) Costofcapital
Theproject’s IRRis18.5% whichis10.5% abovethecostofcapitalof8%.
G
Thecostofcapitalcantherefore increaseby(10.5% / 8%)×100=135%before theNPV H
becomes negative.
Theelements towhichtheNPVappears tobemostsensitive aretheselling pricefollowed
by
thesalesvolume. Management should payparticular attention tothesefactors sothatthey
canbecarefully monitored.
Notethattaxwasignored inthisillustration.
Iftaxisgivenina question, thesensitivity
analysis should beperformed onthepost-tax presentvalueofthecashflows.
Activity3: Sensitivityanalysis
Acompany
isevaluating
a three-year
project,
theNPVhasbeenassessed
asfollows:
Time 0 1 2 3
$’000 $’000 $’000 $’000
Sales 4,200 4,900 5,300
Variable
costs (2,850) (3,100) (4,150)
Pre-tax
cashflow 1,350 1,800 1,150
Tax@21% (284) (378) (242)
Investment (2,000)
Netcashflow (2,000) 1,066 1,422 908
DF@7% 1 0.935 0.873 0.816
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Time 0 1 2 3
$’000 $’000 $’000 $’000
PV (2,000) 997 1,241 741
NPV=$979,000
Required
Calculatethesensitivity
oftheNPVtothechangesinsalesvolume,
andtochanges
intheselling
price.(Giveyouranswerstoonedecimal
place.)
Solution
3.1.1 Weaknessesofsensitivityanalysis
These areasfollows.
(a) Themethod requiresthatonlyonevariablechanges ata time.However,management may
bemoreinterested inthecombination oftheeffects
ofchanges intwoormorekeyvariables.
G
(b) Lookingatfactorsinisolation
isunrealistic
sincetheyareofteninterdependent (egifdemand H
fora productislowthenthismayalsomeanthattheselling pricewillnotbeashighas

expected).
(c) Itdoesnotprovide a decisionrule.Parameters
defining
acceptabilityofaninvestment
project,
giventheuncertainty,mustbelaiddownbymanagers usingtheirjudgement.
3.2 Other techniques for managing uncertainty
Othertechniques
tobeawareofinclude
thefollowing:
Techniques Description
Scenario
building Ananalysisofthepotential
NPVofa project
underdifferent
scenarios
– unlike
sensitivity
analysis
thiscanbeusedtoshowtheimpact
ofmorethanonevariable changing (eg
marketshareandsalesprice).
However,thereisthedangerthatthechosen
scenariosmaybeunrealisticieunlikely
to
occur.
Paybackperiod
&discounted
(oradjusted) Covered inChapter 5, thequickerthe
paybackperiod payback thelessrelianta project
isonthe
later,moreuncertain,
cashflows.
7:Project
appraisal
andrisk 153
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Chapter summary
Projectappraisaland risk
Riskand Riskanalysis Uncertainty

analysis
uncertainty techniques techniques
Risk Risk
increases
with
thevariability Uncertainty
increases
asthelife
Quantifiableprobabilities ofthecash
using flows oftheproject
rises
Uncertainty Expected
values Sensitivity
analysis
• Not
quantifiable Weighted
average
ofpossible Required
change
inasingle
• Canbedescribed outcomes variable
tochangetheNPV
tozero
Probability
analysis
• Analyses ofNPV Weaknesses
theprobability
notbeing
positive
forexample • Only
considers
onevariable
at
• Also
themost
likely
outcome atime
• Often
makesuseofjoint • Ignores
interdependency
probabilities between
variables
• Nodecision
rule
Drawbacks
• Probabilities
aresubjective Othertechniques
• Expected
valuemaynotbea • Scenario
building
possible
outcome • Payback
anddiscounted
payback
G H
Othermethods
• Simulation
• Conservative
forecasting
(certainty
equivalents)
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1.Riskanalysis
Thiscan be appliedto a proposedcapital investmentwherethere are severalpossibleoutcomes
and, based on past relevantexperience,probabilitiescan be assignedto the variousoutcomes
and estimatedcash flowsthat couldprevail.
2. Uncertaintyanalysis
Thiscan be appliedto a proposedcapital investmentwherethere are severalpossibleoutcomes
but there is littlepast relevantexperienceto enable the probabilityof the alternativeoutcomesto
be predicted.
3. Sensitivityanalysis
Thisanalyses uncertaintyby assessinghowresponsivethe project’sNPVis to changes inthe
variablesused to calculatethat NPV.
4. Expectedvalues
Ariskanalysistechniquethat uses probabilitiesto calculatean expectedNPV.
5. Probabilityanalysis
Aprobabilityanalysisof expectedcash flowscan oftenbe estimatedand used both to calculate
to measurerisk.Thisofteninvolvesthe use of jointprobabilities.
G H
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Question practice
the Workbook):
SectionAquestions
Q20,Q21
SectionC questions
Q45 Auriga
Q48 Muggins
G H
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Activity answers
Activity1:Expected NPV
Expectedvaluescan be calculatedas follows
ProjectA ProjectB
Expected (1×0.25)+(2.5×0.50)+(4 ×0.25)= (–8 ×0.25)+(4 ×0.50)+(16×0.25)=
value 2.5 4.0
ProjectBhas a higherexpectedvalueand wouldthereforebe chosenon the basis of this
technique.
However,ifthe companyis riskaverse,it may be deterredfromprojectBby the 25%change of a
negativeNPV.
Activity2: Joint probabilities

1 40.0%
Cash flowsare lowinYears1and 2, whichhas a probabilityof 0.28 or 28%.
Cash flowsare lowinYear1and highinYear2, whichhas a probabilityof 0.12or 12%.
Totalprobability=0.28 +0.12=0.40or 40%
2 3,640
Themostlikelyoutcomeintermsof the highestjointprobabilityis that the cash flowinYear1is
highand Year2 is low.So,the mostlikelyoutcomeis +3,640($’000).
G
Activity3: Sensitivity analysis H
Volume
PVof contribution=ProjectNPV+Outlay=$979,000+$2,000 =$2,979,000or the PVof net cash
flowforyears 1-3(997+1,241+741)
Sensitivity=$979,000/$2,979,000 × 100%=32.9%
Afallof 32.9%insales volumeis requiredforthe projectNPVto fallto zero.Thiswillprobablybe
consideredto be unlikelywhichmeans that the uncertaintyassociatedwiththisprojectlookslow
withregard to sales volume.
Sellingprice
PVof sales (includingthe impacton taxableprofit)
t1 t2 t3
$’000 $’000 $’000
Sales 4,200 4,900 5,300
Tax@21% (882) (1,029) (1,113)
Posttax cash flow 3,318 3,871 4,187
DF@7% 0.935 0.873 0.816
PV 3,102 3,379 3,417
TotalPVof sales =$9,898,000
Sensitivity=$979,000/$9,898,000× 100%=9.9%
Afallof 9.9%insales priceis requiredforthe projectNPVto fallto zero.Thiswillprobablybe
consideredto be unlikelywhichmeans that the uncertaintyassociatedwiththisprojectalso looks
lowwithregard to sales price.
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G H
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decisions8
Specific investment
8
Learning objectives
Oncompletion
ofthischapter
youshould
beableto:
Syllabus
reference
• Evaluateleasing
andborrowing
tobuyusingbefore-
and D4(a)
after-tax
costsofdebt.
• Evaluate
assetreplacement
decisions
usingequivalent D4(b)
annual
costandequivalent
annual benefit.
• Evaluate
investmentdecisions
under single-period
capital D4(c)
rationing,
including:
- thecalculation
ofprofitability
indexes fordivisible
G
investmentprojects H
- thecalculation
oftheNPVofcombinations ofnon-
divisible
investmentprojects
- a discussion
ofthereasonsforcapitalrationing
8
Exam context
Thischaptercovers
‘specific
investment decisions’
whichispartofSectionD ofthesyllabus
(Investment
appraisal).
Inthischapter,weconsiderspecific
applications
ofdiscountedcashflow
(DCF),including
whether toleaseorbuyanasset,whentoreplace anassetandhowtoassess
projects
whencapitalisa scarceresource.
Thisisanimportantchapter thatisoftenneglected.
Remember thatthischaptercoversa
syllabus
section
thatisexaminable inallsections
oftheexam,including
SectionC.
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8
Chapter overview
Specific investment decisions
replacement Leasevs buyAsset Capital rationing
Equivalent
annualcost Approach
1– twoNPVs Hardrationing
Equivalent
annualbenefit Approach
2– singleNPV Softrationing
Divisible
projects
Indivisible
projects
G H
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1 Asset replacement decisions
1.1 Asset replacement cycle

DCFtechniquescan be usefulinasset replacementdecisionsto assess howfrequentlya non-
currentasset that isin continualuse ina business(egdeliveryvehicles)shouldbe replaced.
Ifan asset is replacedless frequently,then it has a longerreplacementcycle(the lengthof time
betweenan asset beingpurchasedand the asset beingreplaced).
Shorterreplacementcycle Longerreplacementcycle
• loweroperatingcosts • reducedcapitalexpenditure
• a higherresidualvaluewhenthe (sincetheassetisbeingbought
isdisposedof lessfrequently)asset
• butincreasedcapital • but astheassetgetsolder,it
expenditure(astheassetis maycostmoreto operate,and
boughtmorefrequently) residualvaluewillbe lowerbeing
Theidealreplacementcyclewillminimisethe costs per year overthe replacementcycle.Thisis

calculatedas an equivalentannual cost (EAC).
Formula to learn
EAC = NPVofcostsoverthereplacementcycle
Annuityfactor
forthelifeoftheasset
Anyrevenueresultingfromthe use of the asset willbe disregardedas thisrevenuewilloccurin
any case, whateverthe replacementcycle,and is thereforenot a relevantcash flow.
G H
Equivalentannual cost: Expressesthe presentvalueof the costs of an asset replacementcycle

KEY
TERM as a cost per year.
Illustration 1: Asset replacement
Acompanyuses machinerywhichhas the followingcosts and resalevaluesoverits three-yearlife

(permachine).
Year1 Year2 Year3
$ $ $
Purchasecost:$25,000
Runningcosts (cash expenses) (7,500) (11,000) (12,500)
Resalevalue(endof year) 15,000 10,000 7,500
Theorganisation’scost of capital is 10%.
Required
Identifyhowfrequentlythe asset shouldbe replaced.
Solution
Calculationsas follows.
8:Specificinvestment
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Step1
Replace
every2 Replace
every3
Replace
everyyear years years
Discount Cash PVat Cash PVat Cash
Year factors flow 10% flow 10% flow PVat10%
$ $ $ $ $ $ $
0 – (25,000) (25,000) (25,000) (25,000) (25,000) (25,000)
1 0.909 (7,500) (6,818) (7,500) (6,818) (7,500) (6,818)
15,000 13,635
2 0.826 (11,000) (9,086) (11,000) (9,086)
10,000 8,260
3 0.751 (12,500) (9,388)
7,500 5,633
PVofcostoverone
replacementcycle (18,183) (32,644) 44,659)
Step2 Calculate
theequivalent
annualcost(EAC).
Weusea discountrateof10%andanannuity (cumulative
discount)
factorforeach
replacement
cycle.
(1) Replacement
everyyear:
EAC=$(18,183)/0.909
=$(20,003)
(2) Replacement
everytwoyears:
EAC=$(32,644)/1.736
=$(18,804)
G H
(3) Replacement
everythreeyears:
EAC=$(44,659)/2.487
=$(17,957)
Theoptimumreplacementpolicyistheonewiththelowest
EAC.Here,thisiseverythree
years.
Activity1:EAC
Naurfoldregularly
buysnewdelivery vans.Eachvancosts$30,000,hasrunning
costsof$3,000
anda scrapvalueof$10,000initsfirstyear.Initssecond
yearthevanhashigher
runningcosts
of$4,000,anda lowerscrapvalueof$7,000.
Vehicles
arenotkeptformorethantwoyearsforreliabilityreasons.
Required
UsingNaurfold’s
costofcapitalof15%,identify
howoftenthevanshould
bereplaced
(ignore
tax).
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Solution
1.1.1 Assetswithdifferentusefullives
Thesametechnique isalsousefulfordecidingwhether,
whenconsidering
non-currentassetsthat
areincontinualusewithin
a business,itisbetter
toinvest
ina cheaper
assetwitha shorter
expectedlifeora moreexpensive
assetwitha longerexpectedlife.
Again,theidealreplacementcyclewillminimise
thecostsperyearoverthereplacementcycle,ie
theequivalentannualcost(EAC).
1.1.2 Drawbacks
Thisapproach
onlyfocuses oncostandfailstorecognise
thatasanassetgetsoldertherecould
beproblemswithreliability
orquality
astheassetages(orthatitbecomes
obsolete
asnew
technology
emerges,ornewmarkets emerge).
Examfocus point
Acommon error
isthatstudents
includetheresidual
valueinmorethanoneyear.Becareful
to
G
onlyinclude
theresidual
valueonce,inthefinalyear. H
1.2 Equivalent annual benefit (EAB)
Equivalent
annual
benefit:
Expresses
theNPVfroma project
asanannuity,
iea constant
cash
KEY flowperyear.
TERM
Theequivalent
annual
benefit
=NPVofproject/Annuity
factor
Real life example

Project
AhasanNPVof$8.22m andanexpected lifeofsixyears.
Givena discountrateof12%,theannuityfactorforsixyearsat12%is4.111 soproject
Awillhave
anequivalentannual annuityof8.22/4.111
=2.00
Analternative
projectBwithanNPVof$8.90m andanexpected lifeofseven yearswillhavean
equivalent
annual annuityof8.90/4.564
=1.95
(theannuityfactorforsevenyearsat12%is4.564)
Project
Awillthereforeberanked higher
thanproject B,despite
having a lowerNPV.
Thismethodisa usefulwayofcomparing projectswithunequallives.
1.2.1 Drawbacks
Thisapproachonlymakes
senseiftheprojects
arebeingcontinuallyrenewed (thisassumption
of
continual
replacement
wasalsousedintheEACapproach). Ifthisisnotthecasethentheproject
withthehighest
NPV(Project
Binthepreviousillustration)
would bechosen.
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2 Lease vs Buy
Afterdecidingon the viabilityof an investmentusingNPVanalysis,a separate decisionmay be

needed to determinewhethera lease wouldbe a moresuitablesourceof financethan an outright
purchaseusinga loan.
Terminology:
Lessor:Alessorreceiveslease payments.
KEY Lessee:Alesseemakeslease payments.
TERM
2.1 Types of leases

2.1.1 Leases that minimise risk to the lessee
Someleases,oftenshort-termleases,are rentalagreementsbetweena lessorand a lesseethat
are structuredso that the lessorretainsmostof the risksof ownership,ie the lessoris responsible
forservicingand maintainingthe leased equipment.
Theriskof ownershipis also minimisedforthe lesseebecause ifthere is a change intechnology
then the lesseecan exitfromthe rentalagreementat the end of the lease termand is therefore
not tied into usingassets that are technologicallyout of date.
2.1.2 Leases that are purely a source of finance
Someleasesare long-termarrangementsthat transferthe risksand rewardsof ownershipof an
asset to the lessee.Theseare agreementsbetweenthe lesseeand the lessorformostor allof the
asset’sexpectedusefullife.
Thelessee is responsibleforthe upkeep,servicingand maintenanceof the asset.
Thiscan be a cheaper sourceof financethan a bank loanifthe lessorbuys a large quantityof
G assets (egaircraft)and obtainsbulkpurchasediscountsas a result;someof the savingsfrom H
such discountscan be shared withthe lesseeinthe formof lowerrentalpayments.

2.2 Benefits of leasing
Thebenefitsof any type of lease to the lessee include:
Benefits Discussion
Availability Afirmthat cannot get a bank loanto fundthe purchaseof an asset
(capitalrationing– see nextsectionforfurtherdiscussion);the same
bank that refusedthe loanwilloftenbe happy to offera lease.
Avoidingloan Loancovenantsmay act as a restrictionon the abilityof a companyto
covenants borrowinfuture.
2.3 Numerical analysis

Thebenefitsof leasingcomparedto usinga loanto buy an asset can be assessed usinga
discountedcash flowapproach.
Notethat the assessmentof the cost of the loanshouldnot includethe interestrepaymentson
the loan.
Forexample,the NPVof the repaymentson a loanfor$10,000that is repayableinone year at
10%interestis calculatedas: $10,000×1.1×0.909=$10,000.
Thepresentvalueof the loanrepaymentis thereforethe same as the amountborrowed.So,the
cost of a loan is simplythe initialamountof the loan, here $10,000.
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2.3.1 Approach1:TwoseparateNPVs
Thisevaluates
theNPVofthecostoftheloanandtheNPVofthecostoftheleaseseparately, and
simplychoosesthecheapestoption.
Step1 Thecostsofleasingusingthepost-tax costofdebtasthediscount factor
Thiscouldinclude
leasepayments,andthetaxsavedonleasepayments.
Step2 Thecostsoftheloanusingthepost-tax costofdebtasthediscount factor
Thiscouldinclude
thecostoftheloan(ietheinitial
amount oftheloan),nettedagainst
thesavingsfromthescrapvalueoftheassetandthetaxsavedontaxallowable
depreciation.
Comparingstep1tostep2 shows whethera leaseora bankloanisthecheaper costoffinance.
Illustration2: Simplelease vs buy
BrownCohasdecided toinvest
ina newmachine whichhasa ten-year
lifeandnoresidual
value.
Themachinecaneither be:
• Purchasednowfor$50,000witha bankloan;or
• Itcanbeleased fortenyearswithleaserental
paymentsof$8,000perannum payableatthe
endofeachyear.
Thecostofcapitaltobeapplied is9%andtaxation should
beignored.
Required
Comparethecostofthetwofinancing
options.
Solution
Presentvalueofleasingcosts
G
Cashispaidintimeperiods 1–10 H
PV=Annuity factorat9%for10years×$8,000
=6.418× $8,000=$51,344
Presentvalueofpurchase witha loan
Thisissimplytheamount oftheloan,ie$50,000.
Ifthemachine waspurchased now,itwouldcost$50,000(thecostofa bankloanissimply
the
amount borrowed).
Thepurchase witha loanisthereforetheleast-cost
financing
option.
Examfocus point
Becarefulwiththetiming
ofthecashflowswithleasepayments;
sometimes leasepayments
aremadeatthestartoftheyear(ieinadvance).Intheprevious
illustration
thiswould
mean
thatthecashflowswouldbereceivedintimeperiods
0–9,whichwouldaffectthediscount
factorused.
2.3.2 Approach2: SingleNPV

Analternative
method istoevaluate
theNPVofthecostandbenefitsofusinga leaseinone
calculation.
Step1 Thecostsofleasing
Thiscouldincludeleasepayments,
andtheopportunity costsofnotbuyingtheasset
including
losttaxallowable
depreciation
andlostscraprevenue.
8:Specific
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Step2 Thebenefitsofleasing
Byleasing,thelessee
avoidstheneedtobuytheassetandtherefore savesmoneybynot
havingtopayfortheinitial
outlay(which,
asdiscussed
earlier,
reflects
thepresent
value
oftheloanrepayments thataresaved).
Thelesseemayalsosaveonmaintenance costs,
ifmaintenanceisprovided
bythelessor.
Step3 Discountthenetcashflows(iethecostsnetofthebenefits)
Thepost-taxcostofdebtisused.
Iftheresulting
NPVispositive,
itmeans
theleaseischeaperthanthepost-taxcostofa
loan.
Examfocus point
Acommon erroristousetheweightedaverage costofcapital(WACC)ina leasevsbuy
analysis.
ThisisincorrectbecausetheWACCishigher thanthecostofdebtbecause itisused
todiscountprojectcashflowsthathavea measureofrisk;however,
finance cashflowsarenot
risky.
Remember tousethepost-taxcostofdebtforleasevsbuycalculations.
Activity2: Leasevs buy
Acompany hasdecided toundertake aninvestmentproject

whichinvolvestheacquisition
ofa
machine whichcosts$10,000.Themachine hasa five-year
lifewith0 scrapvalue;20%straight-
linewriting
downallowances areavailable.
Itcouldfinance
theacquisitionwitha bankloanat7.143%pre-taxandpurchase theasset
outrightormakefiveequalleasepayments of$2,500inarrears.
G Taxis30%payable inthesameyearinwhichprofits aremade. H
Required
Evaluate
theleasefromthelessee’s
viewpoint.
Solution
2.4 Benefits to the lessor
Attractcustomers Companies(egcarmakers) offerleases

toattractcustomers
to
acquire
theirfinalproduct.
Returnsonfinance Thelessor
invests
finance
bypurchasingassetsandmaking a return
outoftheleasepayments
fromthelessee.
Thelessor
willalsogettax-
allowable
depreciation
onthepurchaseoftheequipment.
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Essential reading
SeeChapter 8 Section1of the Essentialreading,availableinthe digitaleditionof the Workbook,

formorebackgroundinformationon thisarea.
TheEssentialreadingisavailableas an Appendixof the digitaleditionof the Workbook.
3 Capital rationing
Capital rationing:Ariseswhenthere isinsufficientcapital to investinallavailableprojects

KEY
TERM whichhavepositiveNPVs,ie capital is a limitingfactor.
Exam focus point

Inthisexam,you onlyneed to be able to analyse situationswherethisis a problemina single
year.
3.1 Reasons
Capitalrationingarisesfortwomainreasons:
(a) Hardcapital rationing
Thisis wherea firmcannot get financefromthe capital markets,because:
• Investorsare unwillingor unableto investmoreequityfinance,or
• Lendinginstitutionsconsideran organisationto be too riskyto be granted funds,or
G • Capitalmarketsare depressed and reluctantto lendto businessesbecause of fear of an H
economicdownturn.
(b) Softcapital rationing
Thisis an internalmanagementdecisionto restrictcapital spendingand may happen because:
• Managementmay be reluctant to issueadditionalshare capital because of a concernthat
thismay lead to outsidersgainingcontrolof the businessor due to the dilutiveimpacton
earningsper share.
• Managementmay not want to raise additionaldebt capital because they do not wishto be
committedto large fixedinterestpaymentsand wantto keepthe firm’sgearingundercontrol.
• Creatingcompetitionfor a limitedpoolof funds encouragesdivisionsto search forthe very
best possibleprojects.
Notethat whenan organisationadopts a policythat restrictsfundsavailableforinvestment,such
a policymay be lessthan optimalas the organisationmay rejectprojectswitha positiveNPVand
forgoopportunitiesthat wouldhaveenhanced the marketvalueof the organisation.
3.2 Capital rationing techniques
Capitalrationing
ifprojectsaredivisible: Iftheprojectsarenot divisible,

workoutthePVofthecash workouttheNPVoftheaffordable
inflowsper$ invested combinationsofprojects
ietheprofitability
index
decisions 167
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3.2.1 Divisibleprojects
Divisible
projects:
Aproject
thatcanbescaleddownanddoneinpart.
KEY
TERM
Whenprojectsaredivisible,
investmentfundsarea limiting
factorandmanagement should
follow
thedecision
ruleofmaximising theuseofthislimiting
factorbyselecting
theprojects
whose
cash
inflows
havethehighestreturn (inpresent
valueterms)per$1ofcapitalinvested.
Thisismeasured
bytheprofitability
index(PI).
Formulato learn
Theprofitability
index= Presentvalueofcashinflows/Initial
cashoutflow.
ThecriticalvalueofthePIis1.Anyvalueabovethisindicates
thattheproject
hasa positive
netpresentvalue(iethepresentvalueofthecashinflows
isgreaterthanthecashoutflows);
thehigherthePIthehigher thereturndelivered
bya project
per$1invested.
Illustration3: Profitabilityindex
SupposethatHardTimes
Coisconsidering
fourprojects,
W,X,YandZ.Relevant
details
areas
follows:
InvestmentPresent
valueof ProfitabilityRanking
as Ranking
as
required cashinflows NPV index(PI) perNPV perPIProject
$ $ $
W (10,000) 11,240 1,240 1.12 3 1
G X (20,000) 20,991 991 1.05 4 4 H
Y (30,000) 32,230 2,230 1.07 2 3

Z (40,000) 43,801 3,801 1.10 1 2
Required
Calculate
theNPVfrominvesting
intheoptimal
combination
ofprojects
ifonly$60,000was
available
forcapitalinvestment.
Solution
Ifweadopttheprofitability
indexapproach,
theselection
ofprojects
willbeasfollows:
Project Priority Outlay
$
W 1st 10,000
Z 2nd 40,000
Y(balance) 3rd 10,000 (1/3of$30,000)
60,000
Because
only1/3ofproject
Ycanbeafforded,
thismeans
thattotalNPVwillbe:
Project NPV
$
W 1,240
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Project NPV
$
Z 3,801
Y(balance) 743 1/3of $2,230)
5,784
Bychoosingprojectsaccordingto the PI,the resultingNPV(ifonly$60,000 is available)is $5,784.
3.2.2 Non-divisible projects
Non-divisibleproject:Aprojectthat mustbe undertakencompletelyor not at all;ie it is not

KEY possibleto scale downthe projectand do it inpart.
TERM
Wherea projectcannot be done inpart, the choicefacinga companyis not howto spend each
$1so the PIshouldnot be used.
Theappropriatetechniquehere is to:
• Identifywhichprojectcombinationsare affordable
• Selectthe projectcombinationwiththe highestNPV
Exam focus point

Thetechniquethat needs to be applieddepends on whetherprojectsare divisibleor not, so
lookout forthisinassessmentquestions.
G H
Illustration 4: Non-divisible projects
ShortO’Fundshas capital of $95,000availableforinvestmentinthe forthcomingperiod.The

directorsdecideto considerprojectsP, Q and Ronly.Theywishto investonlyinwholeprojects.
Project Investment required Present value of inflows at 20%
$’000 $’000
P 40 56.5
Q 50 67.0
R 30 48.8
Required
Whichcombinationof projectswillproducethe highestNPVat a cost of capital of 20%?
Solution
Theinvestmentcombinationsweneed to considerare the variouspossiblepairsof projectsP, Q
and R.
TheNPVof each affordablecombinationof projectsiscalculatedas the total PresentValue(PV)of
inflowsfromeach projectminusthe requiredinvestmentforeach project.
decisions 169
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Projects Requiredinvestment PV of inflows NPVfromprojects
$’000 $’000
PandQ 90 123.5 33.5
PandR 70 105.3 35.3
QandR 80 115.8 35.8
Thehighest
NPVwillbeachieved
byundertaking
projects
QandR.
Activity3: Capital rationing
Acompany hasmaximum capitaltoinvest

of$800,000.Fivecapitalprojects
havebeenidentified
whichareofsimilar
risk.Theinitial
analysis
shows
thefollowing:
Project Requiredinitialoutlay NPV Profitabilityindex
No1 $298,000 $128,000 1.4295
No2 $240,000 $100,000 1.4166
No3 $400,000 $160,000 1.4000
No4 $160,000 $60,000 1.3750
No5 $798,000 $239,000 1.3000
G Projects
cannot
bepostponed,
andmultiples
ofthesameproject
arenotallowed. H
Required
Whatistheoptimalcombinationofprojects
tomaximise
NPV,assuming:
(1) Projects
aredivisible?
(Include
a working
todemonstrate
howtheprofitability
indexnumbers
havebeencalculated
foroneoftheprojects.)
(2) Projects
arenotdivisible?
Solution
170 Financial
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3.3 Drawbacks of methods

Themethodsused fordealingwithcapital rationingmakea numberof assumptions.Thesecan be
regardedas limitations.Theseinclude:
• Capitalrationingisfora singleperiodonly.
• Projectsare independent,ie the successof one projectis not affected ifanother projectdoes
not proceed.
• Itis not possibleto delay any projects.
• Multiplesof a singleprojectare not allowed.
• Itis not possibleto share the investmentinany projectswithanother organisation(egby
forminga jointventure).
3.3.1 Practical points
Thedrawbacksof the methodshintat somepracticalissuesthat can be used to manage capital
rationing,including:
(a) Delayingone or moreprojectsto a subsequentperiodwherecapital rationingmay be lessof
an issue.
(b) Findingnewsourcesof finance,such as leasingor governmentgrants to get around the
unwillingnessof capital marketsto providefinance.
(c) Enteringintoa jointventurewitha partner to share the capital outlayon one or more
projects.
G
(d) Issuingnewcapital(ifsoft capital rationingexists,thismay be possible). H
Essential reading
SeeChapter 8 Section2 of the Essentialreading,availableinthe digitaleditionof the Workbook,

forfurtherpracticeon thisarea.
decisions 171
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Chapter summary
Specific investmentdecisions
Assetreplacement Leasevsbuy Capitalrationing
Equivalent
annual
cost Ofteneasier
toorganise
than
a Hard
rationing
• Usedtoestablish
theoptimal bankloanbecause
thelessor Imposed
bythecapital
markets
replacement
cycle retains
legal
ownership
• Also
forevaluating
assets
with
different
useful
lives Softrationing
Approach 1– twoNPVs Amanagementdecision
• Assess
PVofleasing
Equivalent
annualbenefit • Assess
PVofpurchasing with
Forevaluating
assetswith aloan Divisible
projects
different
useful
lives,
assuming • Choosethecheaper • Canbescaled
down
continual
replacement • Useposttaxcostofdebt • Use
profitability
index
• Costofloan =initial
outlay
Approach2– singleNPV Indivisible

projects
• Costs
oflease vsbenefits
of • Cannot
bescaleddown
lease • Choose
bestaffordable
• Discounted
attheposttaxcost combination
ofprojects
ofdebt
• Accept
leaseif+NPV
G H
172 Financial
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1.Equivalentannual cost (orbenefit)

Whereassets are continuallyreplaced,quantifyingtheircosts (orbenefits)overa replacement
cycleallowsthe lifetimecosts (orbenefits)to be translatedintoa cost (orbenefit)per year. This
can be helpfulindecisionmakingwhereasset livesare different.
2. Leasevsbuy
Thisshouldbe evaluatedusinga post-taxcost of debt.
3. Divisibleprojects
Theprofitabilityindex(PI)needs to be calculatedto assess the optimalapproach to investing
wherecapital is rationedand projectsare divisible.
4. Non-divisibleprojects
ThePIapproach cannot be used here,insteadthe best combinationof projectsneeds to be
identifiedusinga trialand errorapproach.
5. Drawbacksof methodsfor managingcapital rationing
Themethodsused assumethat the capital rationingis fora singleperiodonly,that there is no
interrelationshipbetweenthe projectsand that no projectcan be delayed.
G H
decisions 173
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Question practice
the Workbook):
SectionAquestions
Q22
SectionC questions
Q49Banden
Q50 ANT
Further reading
Thereis a usefulTechnicalArticlethat is availableon ACCA’swebsite;it is called‘Equivalent
annual costs and benefits’.Werecommendthat you read thisarticleas part of yourpreparation
forthe FMexam.
G H
174 Financial
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Activity answers
Activity1:EAC
Yearlycyclescompared:
Everyyear Time 0 1
$ (30,000) 7,000
DF@15% 1.0 0.870
PV 6,090
TotalPV 23,910
Annuityfactor for1year 0.870
EAC (27,483)
Every2 years Time 0 1 2

$ 30,000) (30,000) 3,000
DF@15% 1.0 0.870 0.756
PV 30,000) (2,610) 2,268
TotalPV 30,342
2-year annuityfactor 1.626
G
EAC 18,661) H
Thetwo-yearreplacementcycleis cheaper.
Activity2: Lease vs buy

Post-taxcost of debt =7.143%x (1- 0.3)=5%
Taxallowabledepreciation(TAD)=$10,000/5=$2,000 per year
Taxsavedon tax allowabledepreciation=$2,000 ×0.3 =$600
Taxsavedon lease payment=$2,500×0.3 =$750
Approach1:two separate NPVs
Cost of a lease
Time0 Time1–5
Lease –2,500
Taxsaved 750
Total –1,750
DF5% 4.329
PV –7,576
NPV –7,576
decisions 175
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Costofpurchase
witha loan
Time0 Time1–5
Outlay (10,000)
TaxsavedonTAD 600
Total (10,000) 600
DF5% 1.000 4.329
PV (10,000) 2,597
NPV –7,403
∴ theleaseismoreexpensive
by$173
Approach 2:onesingleNPV
Benefits
andcostoflease
Time0 Time1–5
Costsaved 0,000
Taxbenefit
ofTAD –600
Lease –2,500
Taxsavedonlease 750
Total 0,000 –2,350
DF5% 1.000 4.329
G
PV 0,000 –10,173 H
NPV –173
∴ theleaseismoreexpensive
by$173
Either
approach1orapproach2 canbeused;thereisnoneedtouseboth.
Activity3: Capitalrationing
Calculationsasfollows:
(1) Profitability
indexofproject
no1=(128,000
+ 298,000)/298,000
=1.4295
NPVperunitoflimitingfactor
Amountof
Rank Project NPVperlimiting
factor Outlay project
% NPV
1st No1 1.4295 $298,000 100 $128,000
2nd No2 1.4166 $240,000 100 $100,000
3rd No3 1.4 $262,000 65.5 $104,800
$800,000 $332,800
(2) Project
5 givesanNPVof$239,000.
CumulativeNPVfromProjects
1,2 and4 =$288,000
Fromprojects2,3,4 =$320,000– thisisthebestcombination.
176 Financial
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Skills checkpoint 2
Technique for investment
appraisal calculations
Chapter overview
msuccess
Exa skills
werplanning
Ans
Co
ion Specific
FM skills r
m
r
at frerect
o
fo qu inte
gin Technique
to forinvestment em
Approach
ir rp
gn
i objective
test appraisal enreta
a (OT)
questionscalculations ts tio
an
M n
How
to Handling
G approach
oo your
FM complex sis
d exam calculations lny
a
tim Effective a
em discussion al
c
i
G H
an ofkey mer
ag financial
topics u
em n
ent nt
ie
c
Effi
Effectiv ting
ewri
andpresentation
Introduction
Investingina projectwitha positiveNPVis consistentwiththe keyobjectiveof maximising
shareholderwealth.Youneed to be able to completean NPVcalculationand analyse investments
usinga range of othertechniquessuch as ROCE,IRRand payback.
SectionDof the FMsyllabusis ‘Investmentappraisal’and directlyfocuseson the skillof
‘analysinginvestmentdecisions’.TheFMexamwillnormallycontaina questioninSectionC that
willfocuson thissyllabusarea, so thisskillis extremelyimportant.OTquestionscovering
investmentappraisalcan also appear inSectionsAand Bof the exam.
Analysisof investmentdecisionsrequiresa soundknowledgeof the techniquesof investment
appraisal.Thismeans that as wellas beingable to apply techniquesnumericallyyou need to be
able to discussthe reasonsforapplyingthem,comparethe techniquesand highlighttheir
limitations.
AnNPVcalculationis normallyquitetimepressuredto completeinthe exam,so you need to be
able to approach the questionina practicaland time-efficientway, makinggood use of the
spreadsheetfunctionsavailableinthe exam.
Page 199 of 641

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Skills checkpoint 2: Technique for investment appraisal
calculations
FM Skill: Technique for investment appraisal calculations

Thekeysteps inapplyingthisskillare outlinedbelowand willbe explainedinmoredetailinthe
followingsectionsas the past examquestion‘BQK’is answered.
STEP1:
Usea standardNPVproforma.Thiswillhelpthemarkerto understandyour
workingsandallocatethemarkseasily.Itwillalsohelpyouto workthroughthe
figuresina methodicalandtime-efficient
way.
STEP2:
Inputeasynumbersfromthequestiondirectlyontoyourproforma.Thiswillmake
surethatyoupickupasmanyeasymarksaspossiblebeforedealingwithmore
detailedcalculations.
STEP3:
Always useformulaeto performbasiccalculations.
Don'twriteoutyourworkingin
a singlecell;thiswastestimeandyoumaymakea mistake.Usethespreadsheet
formulaeinstead!
G H
STEP4:
Showclearworkingsforanycomplexcalculations.
Morecomplexcalculationssuchasthetaxreliefontaxallowabledepreciationwill
requirea separateworking.Keepyourworkingsasclearandsimpleaspossibleand
ensuretheyarecross-referenced
to yourNPVproforma.
Exam success skills

Thefollowingquestionisan extractfroma past examquestion;thisextractwas worth
approximately13marks.
Forthisquestion,wewillalso focuson the followingexamsuccess skills:
• Managinginformation.Itis easy forthe amountof informationcontainedina SectionC
questionto feeloverwhelming.Activereading is a usefultechniqueto use to avoidthis.This
involvesfocusingon the requirementfirst,on the basis that untilyou havedone thisthe detail
inthe questionwillhavelittlemeaning.
• Thisis especiallyimportantininvestmentappraisalquestionswherethere is likelyto be a high
levelof numericalcontentand questionscan be veryconfusingto read throughunlessyou first
havea clearidea of the nature of the requiredanalysis.
• Correct interpretationof requirements.Atfirstglance,it lookslikethe followingquestionjust
containsone requirement.However,on closerexaminationyou willdiscoverthat it contains
two.
• Efficientnumericalanalysis.Thekeyto successhere is applyinga sensibleproformafor
typicalinvestmentappraisalcalculations,backedup by clear,referenced,workingswherever
needed. Workingthroughthe numericaldata ina logicalmannerwillensurethat you stay
focused.
• Good timemanagement.Completealltasks inthe timeavailable.
178 Financial
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Skills activity
BQKCo,a house-buildingcompany, planstobuild100houses ona development

siteoverthe
nextfouryears.Thepurchasecostofthedevelopmentsiteis$4,000,000,
payableatthestartof
thefirstyearofconstruction.
Twotypesofhouse willbebuilt,withannual
salesofeachhouse
expected tobeasfollows:
Year 1 2 3 4
Number
ofsmallhouses
sold: 15 20 15 5
Number
oflargehouses
sold: 7 8 15 5
Housesarebuiltintheyearofsale.Eachcustomerfinances
thepurchase ofa home
bytakingout
a long-term
personalloanfromtheirbank.Financial
information
relating
toeachtypeofhouseis
asfollows:
Smallhouse Largehouse
Selling
price: $200,000 $350,000
Variable
costofconstruction: $100,000 $200,000
Sellingpricesandvariable costofconstruction areincurrentpriceterms,beforeallowing
for
sellingpriceinflationof3%peryearandvariable costofconstruction
inflation
of4.5%peryear.
Fixedinfrastructurecostsof$1,500,000 peryearincurrent pricetermswould beincurred.These
would notrelate toanyspecific house, butwould befortheprovisionofnewroads,gardens,
drainage andutilities.Infrastructure costinflationisexpected
tobe2%peryear.
BQKCopaysprofit taxoneyearinarrears atanannual rateof30%.Thecompany canclaim
tax-allowable depreciationonthepurchase costofthedevelopment siteona straight-line
basis
G overthefouryearsofconstruction. H
BQKCohasa realafter-tax costofcapitalof9%peryearanda nominal after-tax

costofcapital
of12%peryear.
Required
Calculate thenetpresent valueoftheproposed investment
andcomment onitsfinancial
acceptability. Worktothenearest $1,000. (13marks)
1 Useastandard
STEP NPVproforma. Thiswillhelpthemarker tounderstand
yourworkingsandallocate
themarks
easily.
Itwillalsohelpyoutowork through thefiguresinamethodical
andtime-efficient
way.
Thisisa 13-mark questionandat1.8minutes a mark,itshouldtakeapproximately 23minutes.
Usinga standard NPVproforma willhelpyoutoworkthrough theinformationinthequestionina
methodical, timeefficient
way.
Yourproforma should looklikethis:
Skills
Checkpoint
2:Technique
forinvestment
appraisal
calculations
179
Page 201 of 641

q
A B C D E F G
1 0 1 2 3 4 5
2 $’000 $’000 $’000 $’000 $’000 $’000
3 Revenue
4 Variable
costs
5 Fixed
costs
6 TaxableCF
7 Tax@30%
8 Taxrelief
onTAD
9 Capital
cost
10 NetCF
11 DF@12%
12 PV
13 NPV
14
15 Workings
16
17
18
2 Input
STEP easynumbers fromthequestion directly
ontoyourproforma.Thiswillmakesure
thatyoupickupas
many easymarks aspossiblebefore dealing
withmore
detailedcalculations.
Therearesomeeasynumbers fromthequestionthatyoucandownload straight
ontoyour
proforma suchasthecapitalcostoftheinvestment, fixedcostsandusingthenominal costof
capitaltodiscount. Thiswillensurethatyoupickupsomeeasymarks before
dealingwithmore
G
complex calculations. H
3 Always
STEP useformulae toperform basiccalculations.
Donotwrite outyourworkinginasingle
cell;this
wastestimeandyoumaymake amistake.
Usethespreadsheetformulaeinstead!
Forinflatedfixedcostsshown inthefollowingspreadsheet inyear1,themarker willbeabletosee
yourworking veryclearlybyclicking oncellD5forexample andviewing thespreadsheet
formulae.
180 Financial
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Thismeans thatthereisnovalueinspending
timeondetailed
explanations
ofthesesimple
calculations
inrows16and17.
D5 fx =C5*1.02
A B C D E F G
1 0 1 2 3 4 5
2 $’000 $’000 $’000 $’000 $’000 $’000
3 Revenue 5,614 7,214 9,015 7,034
4 Variable
costs
5 Fixed
costs -1530 -1561 -1592 -1624
6 TaxableCF
7 Tax@30%
8 Taxrelief
onTAD
9 Capital
cost -4000
10 NetCF
11 DF@12% 1 0.893 0.797 0.712 0.636 0.567
12 PV
13 NPV
14
15 Workings
16 Fixed
costs -1500 -1530 -1561 -1592 -1624
17 x1.02 x1.02 x1.02 x1.02
18
4 Show
STEP clearworkingsforanycomplex calculations.
More complexcalculations
suchasthetaxrelief
ontaxallowable
depreciation
willrequire
aseparate
working.Keep yourworkings
asclear andsimple
aspossible
andensuretheyarecross-referenced
toyour
G H
NPVproforma.
Clearworkings areneeded hereforsalesrevenueandvariablecosts.
Takeinformation fromthequestion, suchassellingpriceandthequantityofeachtypeofhouse
sold,intoa clearworking.Makeuseofthespreadsheet formulaetocalculate totalrevenue
and
linkthecellfromyourworking backintotheNPVproforma. Thismakesiteasier foryourmarker
to
clearlyfollowthrough yourlogic.
Skills
Checkpoint
2:Technique
forinvestment
appraisal
calculations
181
Page 203 of 641

q
Forexample,
wecanclearlyseefromtheworkingthatrevenue
foryear3 isthetotalofsmall
houseandlargehouse
sales,inflated
at3%forthreecumulative
years.
D28 fx =D27*1.03*1.03*1.03
A B C D E
19 Revenue
20 Year 1 2 3 4
21 Smallhousesselling
price 200 200 200 200
22 SmallhousessalesquanƟty 15 20 15 5
23 Smallhouserevenue 3000 4000 3000 1000
24 Largehousesselling
price 350 350 350 350
25 LargehousessalesquanƟty 7 8 15 15
26 Largehouserevenue 2450 2800 5250 5250
27 Total
sales
revenue 5,450 6,800 8,250 6,250
28 Inflated
salesrevenue 5,614 7,214 9,015 7,034
Everytimeyoucompletea question,usethediagnostic
belowtoassesshoweffectively
you
demonstratedtheexamsuccess skillsinanswering
thequestion.
Thetablehasbeencompleted
belowforthe‘BQK’activity
togiveyouanideaofhowtocomplete thediagnostic.
Examsuccessskills Yourreflections/observations
Managing
information Didyouidentify
thatthecashflowsweregiveninrealterms
andthatyouwould needtobuildininflation
eachyear?
Correctinterpretation
of Youneedtocalculate
theNPVandcomment
onwhether
itis
G H
requirements financially
acceptable.
Didyouremembertocomment?
Efficient
numerical
analysis Didyouranswerpresent
a neatNPVina proforma
thatwould
havebeeneasyfora marker
tofollow?
Goodtimemanagement Didyoumanage
yourtimetoensure
youtackledallworkings
andcompleted
theNPVinthetimeavailable?
Mostimportant
actionpoints
toapplytoyournextquestion
Summary
SectionC oftheFMexamcouldcontain a question

thatfocuses
oninvestment appraisal
andasks
youtoperform anNPVcalculation.
Thisisanimportant areatorevise andtoensurethatyouunderstand thevariety
oftechniques
available(including
theirlimitations).
Itisalsoimportanttobeawarethatintheexamyouaredealing withdetailed
calculations
under
timed examconditionsandtimemanagement isabsolutelycrucial.
Youthereforeneedtoensure
thatyou:
• Usea clear,standard NPVproforma.
182 Financial
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q
• Usespreadsheetformulaetoperformbasiccalculations.
• Scorewellontheeasierpartsofthequestion
• Showclearworkingsformorecomplex areas.
Rememberthattherearenooptional questions
intheFMexamandthatthissyllabus
section
(investment
appraisal)
willdefinitely
betested!
G H
Skills
Checkpoint
2:Technique
forinvestment
appraisal
calculations
183
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G H
184 Financial
Management
(FM)
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9
Sources of finance
9
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
Identify
anddiscusstherangeofshort-term sources
of E1(a)•
finance
availabletobusinesses, including
overdraft,
short-
termloan,tradecredit,leasefinance
• Identify
anddiscusstherangeoflong-termsourcesoffinance E1(b)
available
tobusinesses,
including:
equityfinance,
debt
finance,
leasefinance,
venture
capital
• Identifyanddiscussmethods ofraising
equityfinance, E1(c)
G including:
rightsissue,placing,
publicoffer,stockexchange H
listing
• Identifyanddiscuss methodsofraisingshort-andlong-term E1(d)
Islamicfinance,including:
- major differencesbetweenIslamicfinance
andotherforms
ofbusiness finance.
- theconcept ofribaandhowreturns aremadebyIslamic
financialsecurities.
- Islamic financialinstruments
available
tobusinesses
including:murabaha, ijara,mudaraba,sukuk,musharaka.
(note:calculationsarenotrequired)
9
Exam context
Thefinancingdecision
isa keypartoffinancialmanagement andiscoveredinSection E ofthe
syllabus.
Thissyllabus
sectioniscoveredinChapters 9–12andcanbetested inanypartofthe
exam,includingSectionC where oneofthequestions normallyfocuses
onthissyllabusarea.
Fromthischapter,youmaybeaskedtodescribe appropriate
sourcesoffinancefora company,
ortodiscussingeneraltermsthecharacteristicsofdifferent
typesofshort-term,
long-term and
Islamic
finance.Themechanics ofa rightsissueareespecially
important.
Thischapteris
examinableinallsections
oftheexam.
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9
Chapter overview
Sourcesof finance
Short-term Long-term Methodsofraising Islamic

finance finance equityfinance finance
Overdraft Long-term
debt Internal
finance Riba
isforbidden
Short-term
loan Equity
finance Rights
issue Murabaha
Trade
credit Preference
shares Placing Musharaka
Short-term
lease Venture
capital Public
offer Mudaraba
Ijara
Sukuk
G H
186 Financial
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1 Short-term finance
Chapter4 considered
theuseofshort-termfinance
aspartofa matchingpolicytofinance
fluctuating
current
assets.
AsnotedinChapter 4,short-term
financeisusually
cheaperthanlong-termfinance,
sosome
companiesadoptan‘aggressive’
approach andrelymainlyonshort-term
financeaspartofan
aggressive
workingcapitalfinancestrategy.
Herewebriefly
review
typesofshort-termfinance.
PER alert
Performance
objective
10requires
youto‘source
short-term
finance
toimprovean
organisation’s
liquidity’.
Youcanapplytheknowledge
fromthischapter
tohelpto
demonstrate
thiscompetence.
1.1 Types of short-term finance
Overdraft Thebankgrantsanoverdraft facility(usually fora fee).Thisfacilitycanbe

usedbytheborrower (uptoanagreed limit)butdoesnothavetobe.
Overdrafts arethemostimportantsource ofshort-term financeavailable
tobusinesses.Theycanbearranged relativelyquicklyandoffera levelof
flexibility
withregardtotheamount borrowed atanytime,whileinterest is
onlypaidwhentheaccount isoverdrawn.
Overdrafts arerepayable
ondemand.
Short-term Thisisdrawninfullatthebeginning
oftheloanperiodandrepaid ata
loan specified
timeorindefinedinstalments.
Oncetheloanisagreed, thetermoftheloanmustbeadhered to,
G
providedthatthecustomerdoesnotfallbehind
withtheirrepayments. H
Itisnotrepayableondemand bythebank.
Tradecredit Amajorsource ofshort-term
financefora business.
Currentassetssuch
asrawmaterialsmaybepurchased oncredit,andthistherefore
represents
aninterest-free
short-termloan.
However,
itisimportanttotakeintoaccountthelossofdiscountssuppliers
mayofferforearlypayment.
Unacceptabledelaysinpayment willworsena company’s
creditrating
andadditional
creditmaybecome difficult
toobtain.
Short-term Rather
thanbuyinganassetoutright, usingeither
available
cash
lease resources
orborrowed funds,a business
mayleaseanasset.Leasing
isa
popular
sourceoffinance.
Leasing
wascovered inthepreviouschapter.
Essentialreading
SeeChapter9Section
1oftheEssential
reading,available
inthedigitaledition
oftheWorkbook,
formorebackground
information
onthisarea.
TheEssential
reading
isavailable
oftheWorkbook.
9:Sources
offinance187
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2 Long-term finance
Where finance isrequired

overa longertimeperiod,itispossible
torelyonshort-term
finance
andtorenew itsothatitprovidesfinanceovera longer timeperiod.
However,
thisexposesthe
borrowertotheriskthatthisshort-termfinancemaynotbeavailable (ormaybeexpensive)atthe
pointthatitisbeingrenewed. Forthisreason,
itismorelikelythata source
oflong-termfinance
willbeappropriate wherefinanceisrequired
overa longer timeperiod.
Term
ofinvestment Term
offinance
Where a long-term investment

isbeingconsidered bya firm,thereisa strongargument for
matching thetermoftheinvestment tothetermofthefinance byusinglong-term finance
because:
(a) Thereturns beinggenerated bytheinvestment mayberequired torepaythedebt.
Ifreturnsarebeinggraduallygenerated bya project over,forexample, tenyears,thenitmaybe
difficult
torepaya loanthatmatures infouryears(soa ten-year loanmaybemoreappropriate).
(b) Aloanwhose maturitydatewaslonger thanthetermoftheinvestment would expose the
company toa potentially
unnecessarily longperiod overwhichinterestrepayments mustbe
made.
Here,webriefly reviewthetypesoflong-term financethatareavailable, someofwhichhave
alreadybeenintroduced inChapter 2.Chapter 12willthenconsider theadvisabilityofusing
different
mixtures ofthesesources oflong-term finance,mostnotably themixoflong-term debt
andequityfinance, iethecapitalstructure.
2.1 Long-term debt finance
2.1.1 Bankloans
G
Toobtain a bankloana firmmayneedto: H
• Present a convincingbusinessplan(including
informationoncashflowforecasts,the
management teamandinvestment proposals)
• Provide security
byeithera fixedorfloatingchargeagainst a firm’s
assetsorprovidepersonal
collateral,
egdirector’s
home.
Because thebankwillbecommitting itsfundstoa customer
forseveral years,itmayinsiston
buildingcertainwritten
safeguards,known asloancovenants, intotheloanagreement, to
preventthecustomer frombecoming overextendedwiththeirborrowingduring thecourseofthe
loan.
Loancovenant:
Acondition
thattheborrowermustcomply
with.Iftheborrower
doesnotact
KEY inaccordance
withthecovenants,
theloancanbeconsidered
indefaultandthebankcan
TERM demand payment.
Examples ofloancovenants include:

• Positivecovenants
Maintaining certain
levelsofparticular
financial
ratios,egthedebt/equity
ratio,interest
cover
ratio– notethatinterest
coveriscalculatedas:
Profitbefore
interest
andtax(oroperatingprofit)
Interest
paid
• Negative covenants
Limita borrower’s
behaviour,
egprevent borrowing
fromanother
lender,
disposal
ofkeyassets,
payingdividends
abovea certain
level,acquiring
another
company.
188 Financial
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Activity1:Debt covenants
Acompany isfunded by5 million

$1equityshares anda $10million
bankborrowingcarryinga
fixedrateofinterestof10%.
Thebankborrowing carries
a covenant specifying
thefollowing
twoconditions:
(1) Interest
coverlimitof2.5
(2) Debt/cash flowfromoperations limitof3
Thecompany currentlyhasnootherdebtfinance andtherateofcorporateincometaxis20%.
Thecompany isabouttoborrow $5million ataninterest
rateof12%inordertofunda new
project.
Theproject isexpectedtoincrease annualoperating
profit
by20%fromitscurrent levelof
$4millionandannual cashflowfromoperations by15%fromitscurrentlevelof$5million.
Thedirectorswishtoassesstheimpact ofthenewfinancingandinvestment
decisions
onthebank
covenantsbefore commencing withtheproject.
Required
Whatwillbetheimpactonthebankcovenants?
 Covenant (1)breached,
Covenant
(2)notbreached
 Covenant (1)notbreached,
Covenant(2)breached
 Covenant (1)breached,
Covenant
(2)breached
 Covenant (1)notbreached,
Covenant(2)notbreached
Solution
G H
2.1.2 Loannotes
Following
thebankingcrisisof2008–9,bankshavegenerally
beenmorecautiousaboutlending
tocompanies.Thishasledtoanincreaseintheuseofloannotesasa source
offinance.
In
Chapter2 wesawthatbypassing bankfinanceissometimes
referred
toasdisintermediation.
Conventional
loannotesarefixedrateIOUsthataresoldontheStockMarket;theyarealso
referred
toasbondsordebentures.
Real life example

Hereisanexample
ofa loannotethatwasissued
in2013byRoyalDutchShell.
9:Sources
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q
Royal
Dutch
Shellplc Bondprices
arequoted
per$100
nominal
value.
Aprice
of$98.65
or98.65%
means
amarket
IOU$100 price
of$98.65
per$100nominal
value.
Interest
of1.9%paidp.a. The1.9%
rate iscalled
acouponrate.
The
investor
will
receive $1.9
interest
each
year.
Therate
quoted isthegross
rate,
before
tax.
Redeemable
in10years'
timeat$100
Redemption
isusually
5–15years
ahead,
andis
usually
attheparornominalvalue.
Canoften
beredeemed early
atthecompany's
discretion
(not
thepurchaser
ofthebond).
Featuresof loannotes
Coupon
rate Thecoupon rateisfixedatthetimeofissueandwillbesetaccording
toprevailing
market conditions
giventhecreditratingofthe
companyissuing thedebt.
Marketable Theabilitytosellthedebtcanmeanthatinvestors
accepta lower
return
compared tothecostofa bankloan.
Redeemable Loannotesarenormally
redeemable.
Someloannotesare
‘irredeemable’
or‘undated’.
These
areoftencalledperpetual
bonds
andarenormallyissued
bybanks.
Secured Loannotesarenormallysecured– ifunsecured,
theyarelikelyto
carrydebtcovenants(seeearlier).
Investors
arelikelytoexpecta
G
higheryieldwithunsecured
bondstocompensate fortheextrarisk. H
Convertibleloannotes:Givetheloannoteholders theright(butnotanobligation)
toconvert
KEY
TERM their
l oannotesa ta specified
future
d ateintonewequityshareso fthecompany,ata
conversionratethatisalsospecified
whentheloannotesareissued.
Thepossibility
oftheconvertibleloannoteholders beingabletoselltheseshares ata favourable
pricemeans thatthecoupon rateofinterest isoftenconsiderably lowerthanonsimilar
conventionalloannotes.
Iftheloannoteholders choose nottoconvert theirloannotesintoshares,theloannoteswillbe
redeemed atmaturity, asfora conventionalloannote.
Thecurrentmarket valueofordinary sharesintowhicha loannotemaybeconverted isknown as
theconversion value.Theconversion valuewillbebelow thevalueoftheloannoteatthedateof
issuebutwillbeexpected toincrease asthedateforconversion approaches,ontheassumption
thata company’s sharesoughttoincrease inmarket valueovertime.
Conversionratio=number ofshares a singleconvertible
loannotecanbeconverted to
Conversionvalue=Conversion ratio×market pricepershare
Conversion
premium:
Conversion
premium
= Current
market
valueofloannote– current
KEY
TERM conversion
value
ofshares
Acompany willaimtoissueloannoteswiththegreatestpossibleconversionpremium,
asthiswill
meanthatfortheamount ofcapitalraised
itwill,onconversion,
havetoissuethelowest
number
ofnewordinaryshares.
Thepremium thatwillbeaccepted bypotential
investors
willdependon
thecompany’sgrowthpotential
andsoonprospects fora sizeable
increase
intheshareprice.
190 Financial
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q
Activity2: Convertibleloan notes
Cleethorpe
Cohasa 3%convertible
bondinissue,witha nominal
valueof$100.Eachbondcan
beconverted
into25ordinary
shares
atanytimeoverthenext3 years.Thebondiscurrently
trading
at$120(ex-interest),
andthesharepriceiscurrently
$3.80.
Required
Answerthefollowing
questions.
(a) Calculate
theconversion
value.
(b) Calculate
theconversion
premium,
andcomment onitsmeaning.
(c) Discuss
whyCleethorpemayhaveissued
a convertible
bond.
Solution
2.1.3 Long-termlease
Long-term
leases
havebeencovered
intheprevious
chapter.
2.2 Equity finance
G H
Equitycapitalreferstofinanceprovidedbytheownersofthebusiness,
andassuchnormally
referstothecapitalinvestedbyordinaryshareholders.
Ordinary shareowners havetherighttovoteondirectors’
appointments,
andtoreceivea shareof
anydividend thatisagreed bytheboard.Themechanics ofraising
equityfinance
arediscussed
laterinthischapter.
2.3 Preference shares
Preference
shareholders
receivedividends,
normally
ata fixedrate;somepreference
shareswill
alsopayanextradividendasa fixedpercentage
oftheordinarydividend
(inthiscasetheyare
calledparticipating
preference
shares).
Hereisanexample ofa preference
sharethatBarclays
Bankhasissued.
Barclays
Bank
plc
$25redeemable Preference
sharesmay
beredeemable
(theentity
hastorepay
theprincipal)
preference
shares orirredeemable.
8.125%
paidp.a.ona
non-cumulative
basis
Ifcumulative,
ifthere
areinsufficient
distributable
profits
topaythedividend
inthe
current
year,
theentity
mustpayitinfuture
years
whensufficient
distributable
profits
arise.
Ifnon-cumulative,
ifthere
areinsufficient
distributable
profits
topay
thedividend
in
thecurrent
year,
theentity
neverhas
topay
this
dividend.
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Advantagesof preferenceshares
Compared
todebt Compared
toordinary
shares
Moreflexible
thandebtfinance(iflosses
are Nodilutionofcontrol
(preference
sharescarry
made,thedividendisnotpaid). novotingrightsexcept
inexceptional
circumstances,
ega proposedliquidation).
Disadvantagesof preferenceshares
Compared
todebt Compared
toordinary
shares
Notaxreliefisreceived
ondividend Createsextrariskforordinary
shareholders
payments,whereas debtinterest
reduces becausethepreferencedividend
hastobe
taxable
profitandtherefore
attracts
taxrelief. paidbefore
theordinary dividend.
2.4 Venture capital
Venture
capital:Riskcapital,normally
provided
bya venture
capitalfirmorindividual
venture
KEY
TERM capitalist,
inreturn
foranequity s take.
Venturecapitalists
seektoinvestcashinreturnforsharesinprivatecompanies withhighgrowth
potential.
Theyseeka highreturn,whichisoftenrealised
through a stockmarketlisting,
and
acceptthatthiswillmeanthattheinvestmentsareoftenhighrisk.
Venturecapitalmaybeinvestedinyoungstart-up companies butismorecommonly investedin
smallcompanies thatalreadyhavea trackrecordofbusiness developmentandwhichneed
additional
financetogrow.These companies mayhaveborrowed asmuchmoney astheirbanks
areprepared tolend,anddonothaveenough equitycapital(fromtheexisting
owners orretained
profits)
toexpand attherateorscalerequired.
G H
Failure
tohittargetssetbytheventurecapitalist
canleadtoextrashares beingtransferred to
theirownershipatnoadditional
cost.Thisiscalledanequityratchet.
Essentialreading
SeeChapter9Section
2 oftheEssential
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
information
onthisarea.
TheEssential
reading
isavailable
oftheWorkbook.
3 Methods of raising equity finance
Companies oftendecidetoretaincashwithin
thebusinesstofinancetheirinvestment
needs
(instead
ofpayingthiscashtoshareholdersasa dividend).
Thiscashrepresentsequityfinance
becauseitcouldhavebeenpaidouttoshareholders andisa significant
sourceofequityfinance.
Forlargerprojects
itmaybenecessary toraisenewequitybyissuing newordinary
shares.
Therearethreemainwaysofissuing newshares:
(1)A rightsissue Alegalrightforexisting
shareholders
(2) A placing Shares
areissued
ata fixedpricetoinstitutional
investors
(3) A publicoffer Anofferforsaletothepublic,either
ata fixedpriceorbytender
192 Financial
Management
(FM)
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q
3.1 Rights issues
Rightsissue:Ina rightsissue,ordinary shareholders

areinvited
toapplyforshares
in
KEY
TERM proportion totheir e xisting
s hareholdings.
Ina rightsissue,shareholders havea numberofchoices;
theycan:
• Buythenewshares
• Selltheir‘right’tobuyshares
• Doa mixoftheabove
Arightsissuewillnormally beata significant
discount
(eg20%)totheexisting
shareprice,so
thesharepriceaftertherightsissuewillbebelow thepre-rights
shareprice.However,
thisdoes
notinitselfdamage shareholder wealthbecauseshareholders
alsobenefit
frombuyingthe
shares ata discount (orbysellingtherights).
Real life example
InMarch2014Babcock,
theUKdefence
support
andengineering
services
group, This
wasa40% discount
totheshareprice.
Itis
agreed
toacquire
helicopter
transport normal
forrights
issues
tobepricedatasignificant
services
firm
Avincis,
fundingthedeal discount
tothecurrent
share
pricetocreate
the
witha£1.1bn
rights
issue. impression
that
shareholders
aregetting
abargain.
Thefully
underwritten
rights
issue
offered Rights
issues
arecheaper
than
apublic share
shareholders
5newshares at issue,
butunderwriting
costs
arestill
significant
790pforevery13held. (approximately
2%oftheamounts
raised).
G H
Cumrightsprice:A ‘cumrights’pricemeans thatthepurchaser ofexistingshares

hasthe
KEY
TERM right
t oparticipate
inthe rights
i ssue
(iethepriceprior
t otherights
i ssue).
Issueprice:Thepriceatwhichthenewshares arebeingoffered forsale.
Theoretical
ex-rightsprice(TERP):Thetheoretical
priceaftertherightsissue.
Valueofa right:Thepriceatwhicha rightcanbesold(calculate asTERP– issueprice).
Valueofa rightperexistingshare:Thevalueofa rightdividedbythenumber ofshares
that
needtobepossessed inordertoowna right.
Illustration1:TERP
Fundraiserhas1,000,000 ordinary
shares
of$1inissue,whichhavea market priceon1
September of$2.10pershare.
Thecompany decidestomakea rightsissueandoffersits
shareholderstherighttosubscribe
foronenewshareat$1.50eachforeveryfourshares already
held.Aftertheannouncement oftheissue,thesharepricefellto$1.95,
butbythetimejustpriorto
theissuebeingmade,ithadrecovered to$2pershare.
Required
Whatisthetheoretical
ex-rights
price?
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q
Solution
Valueoftheportfolio
fora shareholder
withfourshares
before
therightsissue:
$
4 shares
@ $2.00 8.00
1share@$1.50 1.50
5 shares 9.50
So,thevaluepershareaftertherightsissue(orTERP)is9.50/5=$1.90.
Thevalueofrightsisthetheoreticalgaina shareholderwould makebyexercisingtheirrights.
Here,thevalueattachingtoa rightis$1.90– $1.50(issueprice)=$0.40.A shareholder
would
therefore
beexpected togain40centsforeachnewsharetheybuy.
Iftheydonothaveenough money tobuythesharethemselves, theycouldselltherightto
subscribe
fora newsharetoanother investor
andreceive40centsfromthesale.Thisother
investor
would thenbuythenewsharefor$1.50,sothattheirtotaloutlaytoacquire theshare
would be$0.40+$1.50=$1.90, thetheoretical
ex-rights
price.
Thefollowingformulacanbeusedbutisnotessential
TERP=[(N×cum-rights price)+Issueprice]/(N+1)
Where Nisthenumber ofshares requiredtohavetherighttobuy1newshare
Usingtheformula:TERP=[(4x$2)+$1.50]/(4 +1)=$1.90
Thevalueofrightsattaching toexistingsharesiscalculatedina similar
way.
Ifthevalueofrightsona newshareis40cents,andthereisa oneforfourrightsissue,thevalue
oftherightsattachingtoeachexisting shareis40/4=10cents.
G H
Activity3: Fantasia
Fantasia
plcisanallequityfinancedcompany specialising
inanimatedfilms.Itneedstoraise
$164mandhasdecided ona rightsissueata discount
of18%toitscurrentmarket price.
Currently
Fantasia
has500millionshares inissueanda market
priceof$2.00/share.
Required
Answer thefollowing
questions.
(a) Calculatethetermsoftherightsissue.
(b) Calculatethetheoretical
ex-rights
price(thepriceaftertherightsissue).
(c) Calculatethevalueofa rightandthevalueofa rightperexistingshare
(d) Assesstheimpactonthewealth ofa shareholderwhoowns10,000shares andcanonly
affordtotakeuphalfoftheirrights
Solution
194 Financial
Management
(FM)
Page 216 of 641

q
G H
Examfocus point
Aquestion
couldaskfordiscussion
oftheeffectofa rightsissue,aswellascalculations.
3.2 Placing
Thecheapest andquickestwayofraising
equityfromnewinvestors
istoselllargeblocks
ofshares
ata fixedpricetoa narrow
groupofexternal
institutional
investors.
3.3 Offer for sale – fixed price
Here,a prospectusisproduced
outlining
thecompany’sfutureplansandpastperformance.
The
issueisadvertised
inthenational
pressandisnormallyunderwritten.
Thisisnormally
usedfor
largershareissues.
Aplacingdoesnotincursuchsignificant
underwriting
andadvertising
costs.
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3.4 Offer for sale – tender
Here,nopriorissuepriceisannounced;instead
shareholdersareinvited
tobidforsharesata
variety
ofdifferent
prices.Theshareissueisunderwritten
ata guaranteedminimum price.Thisis
designedtominimisetheriskofunder-pricing
theshareissue.
Essentialreading
reading,
available
inthedigitaleditionoftheWorkbook,
formorediscussion
ofthemotives for,andmechanics
of,stockexchange listings.
TheEssential
reading
isavailable
oftheWorkbook.
4 Islamic finance
Islamic
finance
isfinance
thatiscompliant
withSharialaw.Islamic
finance
hasgonethrough
a
period
ofrapidgrowthinrecentyears.
4.1 Principles of Islamic finance
Islamicfinance transactions
arebasedontheconcept ofsharing
riskandreward betweenthe
investorandtheuseroffunds.
‘Conventional’financeproviders
makea profitfromthedifferencebetween interest
paidon
money deposits andinterest
receivedfrommoney lenttocustomers.
However,making profits
by
lending aloneandthecharging ofinterest
(riba)isforbiddenunderSharialaw.Making money
withmoney isconsideredtobeimmoral, andwealth shouldbegeneratedviatradeorinvestments.
Islamicfinance isarranged
insucha waythatthebank’sprofitabilityiscloselytiedtothatofthe
client.Thebankstands totakeprofit
ormakelossinlinewiththeprojects theyarefinancingand
G
assuchmustbemoreinvolved intheinvestment decision-making. H
4.2 Islamic financial instruments
Financial Explanation
instrument
Murabaha Thisisa deferred
payment saleoraninstalment
creditsale.Itisusedmainly
(tradecredit) forthepurchase ofgoods(egmaterials)
forimmediatedeliveryondeferred
payment.
Theselleroftheassetdelivers
thegoodsimmediatelyandthebuyerpaysfor
thegoodslater.
TobeShariacompliant a salescontract
mustsatisfytheobjectinquestion
anditsexchange maynotbeprohibited bySharia.
Musharaka Thisisa partnership agreement wherebyallpartners
providecapitaland
(jointventure) know-how.
Profits
areshareda ccording
toa pre-agreed
contract.
Thereare
nodividends
paid.Lossesareshared according
tocapitalcontribution.
Mudaraba Acontract inwhichoneofthepartners (investor)
contributes
capitalandthe
(equity) other(manager) contributes
skillsandexpertise.
Thepartnerwhocontributes
capitalhasnoorlittleinvolvementinoperational
decisionsandisliableupto
thelevelofcapitaltheyprovided.Profitsaresharedina pre-agreedratioand
lossesaresolelyattributable
totheinvestor.
Ijara Thelessor
isstilltheowner oftheassetandincurstheriskofownership.
This
(leasing) means thatthelessorwillberesponsible
formajormaintenanceand
insurance.
Thelessee musttakeresponsibility
forday-to-day maintenance,
wearandtearanddamage, however.
196 Financial
Management
(FM)
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q
Financial Explanation
instrument
Sukuk Similar
toa bondbutinIslamic
finance,thereisanunderlying
tangible
asset.
(bonds) TheSukukholdersharesintheriskandrewards ofownership,
whichgivesa
Sukukproperties
ofequityaswellasdebt.
Activity4: Islamicfinance
DanaandAlihavesigned a partnershipcontract
thatisShariacompliant.Danahascontributed
allthecapitalandAliwillcontributetheexpertise
andmanagement know-how.Profits
willbe
shared ina ratioof3:1between DanaandAlirespectively.
Inthefirstyearthepartnership
venture
makes a lossof$10,000.
Alialsoholdsa sukuk whichislinkedtothefuture
profits
ofa property whichisco-managed with
Farid.Under thecontractAlihastherightto20%ofthenetincome fromtheproperty.Inthefirst
yeartheproperty generateda lossof$12,500.
Required
1 WhatkindofSharia’a
compliant
contract
doDanaandAlihavebetween
them?
 Mudaraba
 Musharaka
 Ijara
 Sukuk
2 Howmuchofthebusinesslosswillbeattributed
toDanaandAlirespectively?
 $7,500toDana,$2,500toAli
G H
 $10,000toDana,nonetoAli
3 Howmuchofthelossontheproperty
willbeattributed
toAli?
 Nil
 $2,500
 $6,250
 $12,500
Solution
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q
Essentialreading
SeeChapter9Section
4 oftheEssential
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
information
onthisarea.
TheEssential
reading
isavailable
oftheWorkbook.
G H
198 Financial
Management
(FM)
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q
Chapter summary
Sourcesof finance
Short-term Long-term Methodsofraising Islamic

finance finance equityfinance finance
Overdraft Long-termdebt Internal

finance Ribaisforbidden
Flexible • Bankloan Couldhave been
paidas Simple payment of
–Mayrequire loan adividend interest
isnotpermitted
covenants
Short-term
loan –Banks may be
Secure
source reluctanttolendto Rights
issue Murabaha
abusiness • Issued
atadiscount Trade credit
• Loannotes • Calculation
ofTERP
Trade
credit –Mayrequire loan
Impact
oncredit
rating covenants Musharaka
anddiscounts –Normally Placing Partnership
withactive
redeemable • Issued
toinstitutionalinvestor
–Convertibleloan investors
Short-term
lease notesissued ata • Cheapandquick
Availability significant Mudaraba
conversionpremium Equity
• Long-termlease Public
offer
–Availability • Fixed
price
• Tender Ijara
Equity
finance Lease
G
Fromordinary H
shareholders Sukuk
Islamic
bond withsome
Preferenceshares characteristics
ofequity
Normallyfixedratebut
sometimes participating
Venture
capital
Seeking
high
returns
and
accepting
highrisk
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q
1.Short-term finance
andworking capital
Short-termfinanceismostappropriate
forfinancing
short-term
cashflowneedssuchasworking
capitalfluctuations.
Avariety
offormsofshort-term
financeexist,eachwithdifferent
advantages
anddisadvantages.
2. Long-term finance
Long-term finance
ismostappropriate
forfinancing
long-term
cashflowcommitments suchas
capitalinvestments.
Avariety
offorms
oflong-termfinanceexist,eachwithdifferent
advantages
anddisadvantages.
3. Loannotes
Loannotesarea keytypeoflong-termdebtfinance.
Convertible
loannotesarea typeofloan
notethatallows
firmstoissuedebtthatpaysa lowcoupon
rate.Convertible
loannotesareissued
ata conversion
premium.
4. Accessing equityfinance
Thiswilloftenrequire
theissueofnewshares viaa rightsissue,a placingora publicoffer.Arights
issuewillnormallybeata significant
discounttotheexistingshareprice,sothetheoretical ex-
rightspricewillbebelowthepre-rights
shareprice.However, thisdoesnotinitselfdamage
shareholderwealth becauseshareholders
alsobenefitfrombuyingtheshares ata discount (orby
selling
therights).
5. Islamic
finance
Thisrequires
investors
toshareriskandreturn
withthecompany
thattheyareinvesting
in–
G
simplycharging
interest
isnotallowed. H
200 Financial
Management
(FM)
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q
Question practice
Nowtrythefollowing
fromtheFurther
question
practice
bank(available
inthedigitaledition
of
theWorkbook):
Section
A questions
Q23–24
Section
C questions
Q51Sagitta
Further reading
Thereisa useful
Technical
Article
available
onACCA’swebsite, called‘Introduction
toIslamic
finance’.
Werecommend thatyoureadthisarticleaspartofyourpreparation
fortheFMexam.
G H
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q
Activity answers
Activity1:Debtcovenants
Thecorrect answer is:Covenant (1)notbreached,Covenant (2)notbreached
Interest
cover:
Operating profit
=$4m×1.2=$4.8m
Interest
=($10m ×10%)+ ($5m×12%)=$1.6m
Interest
cover= $4.8m/$1.6m =3
Covenant isaninterest coverlimitof2.5,therefore
theinterest
coverneedstoexceed
2.5,whichit
does.Covenant notbreached.
Debt/Cash flowfromoperations:
Debt= $10m+$5m=$15m
Cashflowfromoperations =$5m×1.15 = $5.75m
Debt/Cash flowfromoperations =$15m/$5.75m =2.6
Covenant isa limitof3,thereforeDebt/(Cash flowfromoperations)
needstobebelow3 whichit
is.Covenant notbreached.
Activity2: Convertibleloannotes
(a) 25×$3.80=$95
(b) Conversionpremium = marketvalueofbond– conversion
value:
$120– $95=$25or$25/$95= 26.3%.
Thesharepricewould havetoriseby26.3%beforetheconversion
rightsbecame attractive;
if
G
thispremiumissettoohighthentheconvertible
bondmaynotbepopular withinvestors. H
(c) Itmaybecheaper thana straight

loan.Itmaybepreferred
toanissueofequityifequityis
currently
undervalued.
Activity3: Fantasia
(a) $2.00×0.82=$1.64
So$164m/1.64 =100mshares
A1for5 rightsissueisneededat$1.64
(b) Usingtheformula: 1/6[(5×$2)+$1.64]=$1.94
Alternatively,
notusingformula:
Valuebefore rightsissue
500mshares × $2=$1,000m
Rightsissue
100mshares × $1.64=$164m
Valueafterrightsissue
600mshares worth $1,164m
SoTERP=$1,164m/600m shares
= $1.94
(c) Valueofa right= TERP– issueprice=$1.94
– $1.60=$0.30
Valueofa rightperexisting
share=$0.30/5=$0.06perexisting
share
202 Financial
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q
(d) Pre-rights
issue,wealth
= 10,000×$2=$20,000
Aftertheissue
Aftertherightsissue $
Existing
shares
= 10,000×$1.94 19,400
Newshares(halfof2,000entitlement)
=1,000x$1.94 1,940
Lesspayment
fortheseshares
= 1,000x$1.64= (1,640)
Saleofrights(halfof2,000entitlement)
=1,000×$0.30valueofa right= $300 300
Total 20,000
There isnoimpact onshareholder
wealth(ieshareholdersarenotharmedbecausetheycan
selltheirrights).
Alternatively,
thesaleoftherightscanbecalculated asnumber ofshares
towhichthe‘rights’
arebeingsold×valueofa rightperexisting share,ie5,000×0.06=$300.
Activity4: Islamicfinance
1 Thecorrect
answer
is:Mudaraba
Apartnership
where
onepartner
contributes
capitalandtheothercontributes
management
expertise.
2 Thecorrect
answer
is:$10,000
toDana,nonetoAli
Losses
ina mudarabacontract
areattributed
totheinvestor
partner
andnonetothemanager
partner.
3 Thecorrect
answeris:$2,500
G
Losses
areattributed
tothesukuk
holders
inthesamewayasprofits. H
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G H
204 Financial
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q
10
Dividend policy
10
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
Identify
anddiscussinternal
sources offinance,
including: E1(e)•
- retainedearnings
- increasedworkingcapitalefficiency
- therelationship
betweendividend policyandthe
financingdecision
- thetheoretical
approaches to,andpracticalinfluences
on,thedividenddecision
including legalconstraints,
liquidity,
shareholderexpectationsandalternatives
to
cashdividends.
G H
10
Exam context
Inthepreviouschapter welooked atexternal
sources offinance. Inthischapter
wewillconsider
internal
finance intheformofsurpluscash.
Thereisa clearlinkbetweenfinancing
decisionsandthewealth ofa company’sshareholders.
Dividendpolicyplaysa bigpartina company’s relations withitsequityshareholders,
anda
company mustconsider howthestockmarket willviewitsresults.
Thedividend decision
isanother keypartofFinancial Management. Youmaybeaskedto
describethefactorsaffectingdividend
policyina discussionelement ofa question
inSection
C of
theexamfora significantnumber ofmarks.
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q
10
Chapter overview
Dividendpolicy
Internal
sources Dividend Dividend Alternatives
to
offinance policies irrelevance cashdividends
Advantages Considerations Assumption

1– notaxes Scrip
dividend
Disadvantages Types
ofpolicy Assumption
2– efficient Share
repurchase
capital
markets
Assumption
3– no
transaction
costs
Assumption
4– perfect
information
G H
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1 Internal sources of finance
Ifa business
isgeneratingsurplus
cashfromitsoperations,thenthisisanobviousandpotentially
importantsourceof‘internal’
finance (rememberthata profitable
businessmaynotnecessarily
begenerating surplus
cashifitscapitalexpenditure
ishigh).
Linking
backtotheworking capitalsection
ofthesyllabus,
itisimportantnottoforgetthat
internal
financecanbegenerated frommoreefficientmanagement oftradereceivables,
inventory,
andtradepayables.
1.1 Advantages and disadvantages of internal finance
Themainadvantages ofinternal
financearethatitisimmediately available
andisobtained
without
theneedtopayissuecosts.
However,thisdoesnotmeanthatinternal finance is‘free’.
Themaindisadvantage ofusinginternal
finance isthatthiscashcouldhavebeenpaidoutasa
dividend
andthatinthatsenserepresents theuseofshareholders’ funds(equity).
Aswewillseein
thenextchapter,
shareholderfunds(ieequity)areanexpensive source
offinanceinthesense
thatshareholders
expecthighreturns.
Shareholdersmay,infact,prefer
surplus
cashtobereturned tothemasa dividend.
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
informationonthisarea.
TheEssential
readingisavailable
oftheWorkbook.
G
2 Dividend policies H
Whendecidingontheamount ofdividendtopayouttoshareholders,
twoofthemain
considerations
ofthedirectors
willbetheamount ofcashneededtomeetinvestment
needsand
theimplications
ofthepayment ofa dividendfora company’s
financing
needs.Otherpractical
considerations
willalsoneedtobeconsidered.
2.1 Investment decision
Ifthecompany isgoingthrougha growthphase,itisunlikely
tohavesufficient
liquidity
topay
dividendsbecauseoftheneedtoinvestinnon-currentassets.
Inthiscase,shareholder
expectations
maywellbeforthedividendtoremain loworzero.Thiswill
notbea problem forthemiftheinvestments
beingmadearecreating valueforshareholdersand
therefore
increasing
theshareprice.
2.2 Financing decision
Ifa companycanfinance
itsinvestments
byborrowing,itcanfinance
itsinvestments
andstillpay
dividends
aslongasithasaccumulatednetrealised
profits.
However,
theremayproblems
associated
withhigher
borrowing
levels;
theseareconsideredinChapter12.
2.3 Shareholder expectations
Atitssimplest,
increasesindividendareseenasa positivesignbyshareholders, although
sometimesa fallindividendscanbeinterpreted asa positive
signalifitindicates
thatattractive
investment
opportunities arebeingpursued.
Whateverthelevelofthedividend, ifitisnotatthelevelexpectedbyshareholders thenthis
createsanunexpected signalthatsomething iswrong,
andthisfailure tomeetshareholder
expectationswillgenerallycausethesharepricetofall.
10:Dividend
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Becauseshareholdersdonothavethesameinformation asdirectors
aboutthefuture
prospects
ofcompany, thedividend
declaredcanbeinterpreted
asa signalfromdirectors
toshareholders
aboutthestrengthofunderlying
project
cashflows.
Thismeansthatwhere possible
itisgenerally
better
fora company tofollow
a consistent
dividend
policy.
2.4 Types of policy
Policy Explanation
Constant
payoutratio Payment ofa constant%ofprofit
asa dividend islogicalbutcan
createvolatile
dividend
movements ifprofits
areunstable.
Stablegrowth Dividendsareincreased
ata levelthatdirectors
thinkissustainable;
thissignals
thegrowthprospects
ofthecompany.
Residual
policy Adividendispaidonlyifall+NPVprojects
havebeenfunded. Thisis
oftenusedbycompanies whichhavedifficulty
raising
debtfinance.
2.5 Life cycle issues
Young companies (orany Mature companiesoftenfollow

a
companies withvolatile
cash flows)
oftenfollow
aresidual policy stablegrowth orconstant
payout policy
• Investments
oftenoffer
• Investmentsoffer
lowerreturns
highreturns
earlyinthelifeof laterinthelifeofacompany
acompany
• Thesecompanies often
prefer • These companiesareoftenmore
toavoiddebtfinance likely
tousedebtfinance
G H
Asdiscussedearlier,whichever
policyisformulated,
thisshould
beconsistent. Ifa policyis
consistent
itwillattractshareholders
whopreferthatparticular
policy;thisissometimes calleda
clientele
effect.
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
andMiller
(M&M)
proposed
thatina taxM
free
odigliani
world,
shareholders
areindifferent
3 Dividend irrelevance theory
betweendividends
andcapitalgains,andthevalueofa companyisdetermined
solelybythe
‘earning
power’
ofitsassetsandinvestments.
Thisissometimes
referred
toasdividendirrelevancy
theory(Modigliani
andMiller,
1961).
Thistheory
implies
thatthedividend
policythata companychoosestofollow
doesnotmatter.
Real life example:Dividendirrelevancy1

Acompany withattractive
investment
opportunities
decidestocutthedividend,tofinance
these
investments.
Thisdoesnotmattertoshareholders
because
ifshareholdersdorequirecash,theycan
manufacture
dividendsbyselling
shares
whichwillhaveriseninvaluebecauseoftheinvestments.
208 Financial
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Theincrease
inthevalueoftheshares
compensates
forthelossofdividend.
Real life example:Dividendirrelevancy2

Acompany withattractiveinvestment
opportunitiesdecidestopaya dividend,
sothatitrequires
externalfinancetofundsome/all ofitsinvestments.
Although shareholderswillhavethebenefit ofreceiving
thedividend,
theshortfall
infundswillbe
madeupbyobtaining additionalfundsfromoutside sources.
Asa result
ofobtaining
outside
financetherewillbea lossinthevalueofthefirmtotheoriginal shareholders.
Thelossinvaluewillbeequaltotheamount ofdividendpaid,soshareholders
havenotgained
orlostoutoverallcompared toExample 1.
3.1 Assumptions of M&M dividend irrelevancy theory

M&M
madea number
ofsimplifying
assumptions:
Assumptions
Notaxesexist
Capitalmarkets
areperfectly
efficient:
egfundswillalwaysbemadeavailable
tofinance
attractive
(ie+NPV)investments.
Notransactions
costs:eginissuing
newshares,
ortakingouta bankloan,orselling
shares.
Information
isfullyandfreelyavailable
toshareholders.
G H
Examfocus point
Intherealworld,
dividendsdoseemtomatter whichsuggests thatthecaseinfavour
ofthe
relevance
ofdividendpolicyisa strongone.Notethatthisareacouldbea discussion
partofa
section
C questionandwastested inthiswayinthespecimen (pilot)exam.
3.2 Limitations of M&M dividend irrelevancy theory

Thearguments
againstM&M’sviewthatdividend
policyisirrelevant
asa means
ofaffecting
shareholders’
wealthreflect
theunrealistic
nature
oftheassumptions made:
Assumptions Criticismof assumptions(ie limitations)
Notaxesexist Differing
ratesoftaxationondividendsandcapital
gainscancreatea preferenceforeither
a high
dividendorhighearningsretention.
Thisisoneof
thekeyreasons whydifferent
clientele
areattracted
bydifferent
dividendpolicies.
Capitalmarkets
areperfectly
efficient Companies mayfindthatfundsarenotalways
availabletofinanceattractive
investments.
Where
capitalrationing
isanissue,dividend
retention
may
bepreferred bycompanies.
Notransactions
costs Because oftransaction
costsonthesaleofshares,
investors
whowantsomecashfromtheirinvestments
willprefer
toreceive
dividends
rather
thantosell
someoftheirsharestogetthecashtheywant.
10:Dividend
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Assumptions Criticismof assumptions(ie limitations)
Information
isfullyandfreelyavailable Shareholdersareoftennotfullyawareofthefuture
investmentplansandexpected profits
oftheir
company. Evenifmanagement weretoprovidethem
withprofit
forecasts,
theseforecastswould not
necessarily
beaccurate orbelievableunlessbacked
upwitha signalofconfidence intheformofa rising
dividend.
So,shareholders mayprefer a current
dividendtofuturecapitalgains(ordeferred
dividends)
because thefutureismoreuncertain.
Thisisknown asthebird-in-the-handtheory.
Activity1:Dividendirrelevancy
Thefollowing
information
relates
toGerrin
Co.
20X5 20X6 20X7
Earnings
aftertax($’000) 25,000 28,000 37,000
Preference
dividend (1,000) (1,000) (1,000)
Ordinary
shares
inissue(‘000) 10,000 14,000 14,000
Ordinary
dividend
pershare($) 0.588 0.42 0.42
Capitalexpenditure 6,000 72,000 17,000
GerrinCohashighdebtlevels andhasbeenunable totakeonanynewdebtoverthisperiod.

G
In20X6GerrinCo’sinvestment planshadtobescaledbackbecause ofcapitalrationing
issues. H
Thefollowing
statementshavebeenmadeinrelation toGerrinCo’sdividend
policy.
(1) Thecompany ispursuing a dividend
policyconsistent
withModigliani
andMiller’s
irrelevancy
theory.
(2) Thecompany’s totaldividendpayouthasfallenbetween20X5and20X7.
Required
Whichofthesestatements
is/aretrue?
 (1)only
 (2)only
 Both(1)and(2)
 Neither(1)nor(2)
Solution
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4 Alternatives to cash dividends
4.1 Scrip dividends
Scripdividend:
Adividend
paidbytheissueofadditional
company
shares,
rather
thanby
KEY
TERM cash.
Ascrip(orshare)
dividendmaybeoffered toexisting
shareholders
either
asa choice(iea choice
between shares
orcash)orasanalternative toa cashdividend.
Froma company’s pointofview,thishasthefollowing
advantagesanddisadvantages:
Advantages Disadvantages
Iftakenupbyshareholders,
itwillconserve Ifthedividendpershareismaintainedor
cash.Thisisuseful
whenliquidity
isa increased,
infutureyearsthetotalcash
problem,orwhencashisneeded for payment willincrease.
investment.
Duetoanincreaseinissued
shares,itcould Duetoanincreaseinsupplyofshares,
the
leadtoa decrease
ingearing.
Thiswill priceofanindividual
sharemayfall.
increase
debtcapacity.
4.2 Share repurchases

Asanalternative
toa cashdividend,a company canchoose toreturn
significant
amounts ofcash
toshareholders
bymeans ofa sharerepurchase (orsharebuy-back).
Sharerepurchasemaybeappropriate inthefollowingcircumstances:
• Ifthereisone-off
cashsurplusgenerated fromassetsales(higherdividendswouldincrease
expectations
offurtherincreases).
G H
• Thecompany wants togiveanexitroutetodisaffected shareholders;

inthissenseitisa
defence against
a takeover.
10:Dividend
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Chapter summary
Dividendpolicy
Internal
sources Dividend Dividend Alternatives
to
offinance policies irrelevance cashdividends
Advantages Considerations Assumption

1– notaxes Scrip dividend
Immediately
available, • Investment
decision Different
taxrates
affect Dividendpaid
inshares
noissuecosts –Better
toreinvest
in dividend
policy
+NPV
investments?
• Financing
decision Sharerepurchase
Disadvantages –Attitude
to Assumption
2– efficient Ifcashsurplus
isa
• Useofshareholder borrowing capital
markets one-off
funds • Shareholder Capital
rationing
may
• Couldbepaidasa expectations beaproblem
dividend –Dividend
asasignal
Assumption
3– no
Typesofpolicy transaction
costs
• Constant
payout Maymake raising
–Possibly
volatile external
finance
difficult
• Stable
growth
–Setatasustainable
rate Assumption
4– perfect
• Residual
policy information
–Investments
are • Dividend
asasignal
prioritised • Bird-in-the-hand
theory
G H
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1.Internal
finance
isnota freesource
offinance
Usingsurplus
cashcarriesanimplied
costbecause
itrepresents
theuseofshareholders’
funds.
2. Different
policies
Whichever
policyischosen
needstofitthelifecycleofa company
andneedtobeconsistent.
3. Lifecycle
Normally, dividends
arelikelytoriseoverthecourseofa business’s
life.Initsearlyyearscash
flowswillbemorevolatile
soexternalborrowingwillbelesssuitable.
4. Dividend
irrelevancy
M&M suggestthatdividend
policyisirrelevant
- however
thisisbasedona number
offlawed
assumptions
anddoesnotseemtobetrueinreality.
5. Alternativestocashdividends
Ifliquidity
ispoor,thenscripdividends
maybeappropriate.
Ifliquidity
isunusuallyhigh,thena sharerepurchase
maybesuitable.
G H
10:Dividend
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Question practice
Nowtrythefollowing
fromtheFurther
question
practice
bank(available
inthedigitaledition
of
theWorkbook):
Section
A questions
Q25
Section
C questions
Q53ABC
Further reading
Thereisa useful
Technical
Article
available
onACCA’swebsite,
called‘Dividend
theory’.
We
recommend thatyoureadthisarticleaspartofyourpreparation
fortheFMexam,although it
touchesonBusinessValuation
andthereforemaybemoresensibletoreadaftercoveringChapter
13ofthisworkbook.
G H
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Activity answers
Activity1:Dividendirrelevancy
Thecorrectansweris:Neither
(1)nor(2)
Ifthepolicywasconsistent
withModigliani
andMiller’s
theory,
therewouldbenodividend
in20X6
because therewereinvestment
opportunities
available
thenthatwerenotfunded.
Thetotalpayoutisconstant.
In20X5itwas10,000×$0.588=$5,880andin20X6and20X7the
dividendpayoutwas14,000×$0.42=$5,880.
G H
10:Dividend
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G H
216 Financial
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11
The cost of capital
11
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
• Estimate
thecostofequityincluding: E2(a)
- applicationofthedividend growth model,its
assumptions,advantages anddisadvantages
- explanationanddiscussion ofsystematicand
unsystematic risk
- relationship
between portfolio
theory andthecapital
assetpricingmodel
- applicationoftheCAPM,itsassumptions, advantages
anddisadvantages.
G H
• Estimatingthecostofdebtincluding irredeemabledebt, E2(b)

redeemable debt,convertible
debt,preference sharesand
bankdebt
• Estimatingtheoverallcostofcapitalincluding: E2(c)
- distinguishing
between average&marginal costof
capital(Chapter 12)
- calculatingWACCusingbookvalueandmarket value
weightings.
• Describetherisk-return
relationship
andtherelative
costsof E3(a)
equityanddebt.
• Describethecreditor
hierarchy
andtherelative
costsof E3(b)
sourcesoffinance.
• Impactofcostofcapitaloninvestments
including: E3(e)
- relationship
betweencompany valueandcostofcapital.
- circumstancesunder whichWACCcanbeusedin
investmentappraisal
11
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Exam context
Thischapter covers‘estimatingthe cost of capital’and ‘sourcesof financeand theirrelativecosts’

whichare importantparts of SectionEof the syllabus(BusinessFinance).
Thisis an importantchapter that is commonlyexaminedinallsectionsof the exam.InSectionC
of the examyou may be askedto calculatethe weightedaverage cost of capital. Questionswon’t
justinvolvecalculations;you may be askedto discussthe problemswiththe methodsyou have
used, or theirmeaning.
Theformulaeinthischapter are challengingat first,but mostare giveninthe examand so don’t
haveto be memorised.Withpracticeyou willbecomefamiliarwiththem.
G H
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11
Chapter overview
Cost of capital
Risk Cost of equity: Cost of equity:

and return dividendgrowthmodel CAPM
Creditor
hierarchy Disadvantages Disadvantages
Cost of debt WACC
Irredeemable
loannotes
Redeemable
loannotes
Convertible
loannotes
G H
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1 Risk and return
PER alert
Performanceobjective9 requiresyou to ‘adviseon the appropriatenessand cost of different
sourcesof finance’.Thischapter coversthe cost of finance.
Tocalculatea net presentvalue(NPV),a cost of capital is needed. Inthischapter you willsee an

approach to calculatinga cost of capital or, to put it another way, to assessingthe return
demandedby investors.
Themainprincipleis that the higherthe riskfaced by the investor,the higherthe returnthey will
expectto be paid; thisis the risk-returnrelationship.
1.1 Risk-return relationship
Thecost of financewilldepend on the levelof riskthat an investoris takingwhenthey provide
fundsto a company. Thehigherthe riskfaced, the higherthe returnthat willbe expected.
Inreality,differenttypes of investorswillface differentlevelsof risk.
1.1.1 Debt finance
Providersof debt financewillface relativelylowrisk,because:
• it isobligatoryto makeinterestpayments(unlikedividendpayments)each year
• inthe eventof liquidationdebt holdersare paid off beforeprovidersof share capital.
Debtis especiallylowriskif:
• it issecured on a specificasset (calleda fixedcharge)
• it issecured on the generalassets of a business(a floatingcharge)
G
• it isdue to be repaidinthe short-term. H
Sincedebt is a relativelylowrisksourceof financethen the returnexpectedby providersof debt

willbe relativelylow,so debt is a relativelycheap sourceof finance.
Inaddition,debt interestis also corporationtax deductible(unlikepreferencedividendsor equity
dividends),makingit evencheaper to a taxpayingcompany.
1.1.2 Preference shareholders
Preferenceshareholdersface higherriskbecause a dividendwillonlybe paid ifit can be afforded
after the providersof debt havebeen paid, and because ina liquidationthe debt holderswillbe
paid beforepreferenceshareholdersreceiveanything.
1.1.3 Ordinary shareholders
Equity(ordinary)shareholdersface the highestriskbecause a dividendwillonlybe paid after the
providersof debt and preferenceshareholdershavebeen paid, and because ina liquidationthe
debt holdersand preferenceshareholderswillbe paid beforeordinaryshareholdersreceive
anything.Therefore,equityis a relativelyexpensivesourceof finance.
220 Financial
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1.1.4 Creditor hierarchy
Thedifferingrisklevelsfaced by investorsis sometimesdescribedby the creditorhierarchy.This
showsthat, inthe eventof a companybeingunableto pay its debts and goingintoliquidation,
there is an orderinwhichit mustrepay its creditorsand investors.
1.Creditorswitha fixedcharge
ks 2.Creditorswitha floatingcharge
rig
ni 3.Unsecuredcreditors
sa
er 4.Preferenceshareholders
cn
I 5.Ordinaryshareholders
1.2 Implications and terminology

Thecheapest financeis debt (especiallyifsecuredand short-term)– the returnexpectedby
debtholdersis denotedby the termKdor r .
d
Themost expensivefinanceis equity(ordinaryshares)–the returnexpectedby shareholders(ie
the cost of equity)is denotedby the termKeor re.
Thecost of preferenceshares willbe abovethe cost of debt and belowthe cost of equity– thisis
denotedby Kprefor Kp.
Essential reading
SeeChapter 11Section1of the EssentialReading,availableinthe digitaleditionof the Workbook,

G H
1.3 Reverse yield gap

On rare occasions,shareholdersmay be prepared to receiveloweryieldsthan lenders.Inthe
short-termshareholdersmay be willingto accept lowshort-termrewards(dividendyield)inthe
hope of gettinggreater gains later. Itcan also ariseiffirmsthat are desperate to raisefinance
offera yieldon theirdebt inexcessof the yieldon shares.Thiscalleda reverseyieldgap and was
coveredinChapter 2.
2 The cost of equity (1) – the dividend growth model
Shareholdersoftenexpecta dividendto be paid at the end of the year. Thisis referredto as D1(ie
the dividendin1years’time)or as D0(1+g) (whereD0is the latest dividendpaid and g is the
annual dividendgrowthrate).
Shareholderswillalso expectfurtherdividendgrowthinfutureyears.
Bylookingat howmuchshareholdersare prepared to pay fora share today (Po),it is possibleto
estimatethe returnthat they are expectingusingthe followingformula(whichis giveninthe
exam):
D (1+g)
re= 0 +g
P0
Expected
dividend
yield Expected
futuredividend
growth
Ifthe expectedreturnisnot achievedby a firmthen its share pricewillfallwhichwilldamage

shareholderwealth.
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Illustration1:Dividendgrowthmodel
Asharehasa current
market
valueof96c,andthelastdividend
was12c.Theexpected
annual
growth
rateofdividends
is4%.
Required
Calculate
thecostofequitycapital.
Solution
Costofequity
12(1.04)+ 0.04=
96
=0.13+0.04
=0.17
=17%
Activity1:Dividendgrowthmodel
WrightCohasjustpaida dividend
of60candhasa market
valueof$5.50.Thedividend
growth
rateis8%.
Required
WhatisWright
Co’scostofequity?
 11.8%
G  21.2% H
 18.9%
 19.8%
Solution
222 Financial
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2.1 Assumptions of the dividend growth model
Thismodelmakesa numberof assumptions,whichmay not alwaysbe validand thereforecan be
viewedas weaknesses.
D (1+g)
re= 0 +g
P0
Dividends
arepaid Dividend
growthcanbeestimated
Thecompany
hasashareprice Dividend
growth
isconstant
2.1.1 Cum div and ex div share prices

Ifthere is a dividendabout to be paid the share priceis said to be cumdiv.
Inthiscase, the share priceneeds to be adjustedby strippingthe dividendout of the share price
to create an exdivprice.
Thisis needed because the real investmentbeingmade by the shareholderis not the cumdiv
pricepaid forthe share ifthey willimmediatelyreceivea dividend.
Ifthe share priceis exdiv(whichis normallythe case) then there isno imminentdividendand
thereforethisadjustmentdoes not need to be made.
2.2 Estimating the dividend growth rate (g)
Ifthe dividendgrowthrate is not giveninthe question,you may need to calculateit.
Thereare twomethodsof estimatingdividendgrowththat you need to know.
Estimating
futuredividendgrowth
G H
1.Usinghistoricgrowth 2.Usingcurrentreinvestment
levels
2.2.1 Using historic growth

Thefuturegrowthrate can be predictedfroman analysisof the growthin dividendsoverthe past
fewyears.
Real life example: Historic growth

Year Dividendper share
$
20X1 1.50
20X2 1.92
20X3 2.06
20X4 2.45
20X5 2.62
Dividendshaverisenfrom$1.50in20X1to $2.62in20X5.Theincreaserepresentsfouryears’
growth.(Checkthat you can see that there are fouryears’growth,and not fiveyears’growth,in
the table.)
The(geometric)averagegrowthrate, g, may be calculatedas follows.
Dividendin20X1×(1+g)4=Dividendin20X5
∴ (1+g)4=Dividendin20X5/Dividend 20X1=$2.62/1.50=1.747
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q
1 + g = 4 1.747 = 1.15
Alternatively
1+g =1.747 1/4
=1.15
∴ g =0.15,ie15%
Thegrowth rateoverthelastfouryearsisassumed
tobeexpected
byshareholders
intothe
indefinite
future.
Clearlyusinghistoric
datatopredict
future
growthassumesthatpastgrowth
achieved
isan
indication
offuturegrowth
potential;
thismaynotalwaysbevalid.
Formulato learn
1 + g = n latestdividend
earliestdividend
or
( earliestdividend)
1
latestdividend
1+ g= n
Where
n =thenumber
ofgrowth
periods
Examfocus point
Ifyouareusinga spreadsheettocalculatehistoric
growth,
itiseasiest
tousethesecond
of
G
theaboveformulae.Notethat: H
(a) The^ symbolisusedto‘raisetothepower of’

(b) 1/nshould
eitherbeinputinbracketsieas(1/n)orasa decimal.
Activity2: Historicgrowth
PBCo
Todayis1January20X7.
PBCohasjustpaida dividend
of39.25centspershare.
Itscurrent
sharepriceis$8.31,exdiv.
Previous
dividends
havebeenpaidon31December asfollows:
20X2 30.00c
20X3 32.40c
20X4 35.40c
20X5 36.50c
Required
Whatisthegrowth
ratetobeusedinPBplc’scostofequitycalculation?
 6.76%
 6.95%
 14.38%
 30.83%
224 Financial
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Solution
2.2.2 Usingcurrentreinvestment levels

Thefuturegrowthratecanbepredicted
fromananalysis oftheamount
ofprofit
beingre-
invested
intoa business
andtheexpectedreturn
onthisinvestment.
Formulaprovided
Aformulaisprovidedintheexamtoenable youtoapplythismethod:
g =bre
whereb =balance (%)ofprofits
reinvested
andr=returnonreinvested
funds
Note.Notethatbr means b ×r
e e
Real life example:Currentreinvestmentlevels

Ifa companyretains
65%ofitsearnings
forcapitalinvestment
projects
ithasidentified,
andthese
projects
areexpectedtohaveanaverage
return
of8%,thendividendgrowth
canbeestimated as:
G H
g =bre=65%×8%=5.2%
Activity3: Examstandard
RBCo
RBCo’scurrent
cumdivsharepriceis$1.45,
whichwillfallto$1.25afterthedividend
ispaid.RB
Co’sdividend
payoutratiois60%andtheexpectedreturn onfundsthatarereinvestedis30%.
Required
WhatisthecostofequityofRBCo?
 29.92%
 36.88%
 17.92%
 28.00%
11:Thecostofcapital225
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Solution
Essential reading
SeeChapter 11Section2 of the Essentialreading,availableinthe digitaleditionof the Workbook,

3 The cost of equity (2) – using CAPM
Theother methodof calculatingthe cost of equity(Keor re) is by usingthe capital asset pricing
model(CAPM).
Thismodelis based on portfoliotheorywhichassumesthat investorsdiversifytheirinvestments
across a wideportfolioto reducetheirexposureto risk.
Risk
G H
No.ofinvestments
Thebenefitsof diversificationcan be seen fromthisgraph. Risk(as measuredby the standard
deviationof the returnsfromthe investmentportfolio)decreases rapidlyat firstas the numberof
investmentsrises.Theshape of the graph suggeststhat the benefitsof furtherdiversification
becomemarginalafter a diverseportfoliohas been created (approximately15-20investments).
3.1 Unsystematic risk
Thereason forthe reductioninriskshowninthe graph above,is that the impactof company-
specificrisksis spread overthe wholeinvestmentportfolio(and may actuallycreate benefitsto
otherparts of the portfolio).
Unsystematic(orspecific)risk:Thecomponentof riskthat is associatedwithinvestingina

KEY particularcompany.
TERM
3.2 Systematic risk

Althoughdiversificationhelpsthe investorto eliminatevirtuallyallof the risksthat are uniqueto
particularindustriesor types of business,it does not offerany escape fromgeneralmarket
factorsthat can affect allcompanies.
226 Financial
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Forexample,a recessionwillnormallyhavean adverseeffect on everycompany.
Systematic(ormarket)risk:Thecomponentof riskthat willstillremainevenifa diversified

KEY portfoliohas been created.
TERM
Thepresenceof unsystematicand systematicriskisillustratedbelow:
Risk
Unsystematicrisk
(theriskspecific
toashare)
Systematic
risk
No.ofinvestments
Thisillustratesthat a diversifiedinvestorwillonlybe concernedwithsystematicrisk.Investorsare
thereforeassumedto be onlyexposedto the riskthat there is a fallinthe stockmarketas a whole.
However,somefirms’shares are moresensitiveto marketdownturnsthan othersare. The
sensitivityof a firm’sshare priceto a stockmarketdownturnis calculatedby measuringthe
average change in the returnon a share each timethere is a change in the stock marketas a
whole.Thismeasureis calleda beta factor.
Exam focus point

Commonerrorson thistopicinexamsinclude:
G
• Mixingup systematicand unsystematicrisk.Rememberthat the stockmarketis a ‘system’ H
so systematicriskis linkedto movementsinthe stockmarket.
3.3 Beta factors
Beta factors: Measuresthe averagechange inthe returnon a share each timethere is a

KEY change inthe stockmarketas a whole.
TERM
3.3.1 Range of beta factor values
Increasingrisk
Betafactor< 1 Betafactor= 1 Betafactor> 1

Belowaveragerisk Averagerisk Aboveaveragerisk
Movesinthesamedirection Movesinlinewiththemarket Movesinthesamedirection
asthemarket,butnotby asthemarket,butbymore
asmuch
(ega stockwitha ß of0.2 (ifthemarketrisesby1%then (ega stockwitha ß of1.5
wouldincreasebyonly0.2%if thatsecurityisexpectedto wouldfallby1.5%ifthe
themarketincreasedby1%). risebythesameamount). marketsuffereda 1%drop).
Thereturnexpectedby Thereturnexpectedby Thereturnexpectedby

shareholders
willbe lessthan shareholders
willbe thesame shareholders
willbe more
themarketaverageasriskis asthemarketaverage. thanthemarketaverage
lessthanthemarketaverage. asriskismorethanthe
marketaverage.
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3.4 Cost of equity

TheCAPMmakes useoftheprinciple
thatreturns onshares
inthemarket asa wholeare
expectedtobehigherthanthereturns
onriskfreeinvestments
(suchasTreasuryBills).
Thedifferencebetweenthemarket
returnandtheriskfreereturn
iscalleda market
orequityrisk
premium.
Forexample,ifthereturn
ongovernmentstocks is3%andmarketreturnsare8%,themarketrisk
premium is5%.
Market
riskpremium/equity
riskpremium:Thisisthedifference
between
theexpected
average
KEY market
return andtherisk-free
rateofreturn
overthesameperiod.
TERM
Themarketriskpremiumshowstheexcessreturn
forthemarket asa wholetocompensatefor
systematic
risk.
Tocalculate
theextrareturn
required
tocompensatefortheriskofanindividual
sharethemarket
riskpremiumismultiplied
bythatshare’s
betafactor.
TheCAPMisshown onyourformulasheetas:
Formulaprovided
= Rf + β(E(rm)−Rf)E(ri)
E(r)=expected
i return
(egKe)
β=thebetaoftheinvestment
Rf = riskfree rate
rm = marketreturn
G H
(E(rm)−Rf) = marketriskpremium
Illustration2: CAPM
SharesinLouieCohavea betaof0.9.Theexpected
market
return
is10%andtherisk-free
rateof
return
is4%.
Required
WhatisthecostofequitycapitalforLouieCo?
Solution
= R +β(E(rE(r)
) – R ) =4 +0.9(10
– 4)=9.4%
i f m f
Activity4: CAPM Techniquedemonstration
Themarket
riskpremium
is8%,andtherisk-free
rateis3%:
Required
1 Whatistherequired
rateofreturn
ona sharewithanequitybetaof1.6?
2 Whatisbetafactorofa company
thathasa costofequityof10%?
228 Financial
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Solution
Examfocus point
Mixing
uptheterms
market
return
andmarket
riskpremium
isa common
error
onthistopicin
exams.
3.5 Drawbacks of CAPM
Drawbacks Discussion
Singleperiod
model CAPMdoesnotadjust fordifferent
planninghorizons.
Inreality
investors
willdemanda longerreturn
forinvestment
thathavea
longer
planninghorizon.
Estimating
thebetafactor Betavalues arehistoric
andwillnotgiveanaccuratemeasure
ofriskifthefirmhasrecently
changed itsgearing
orits
G
strategy.Theimpactofgearingonbetafactorsiscovered
in H
thenextchapter.
Otherriskfactors IthasbeenarguedtheCAPMignores theimpactof:
• Sizeofthecompany (theextrariskoffailure
forsmall
companies)
• Theratioofbookvalueofequitytomarket valueofequity
(shares
withbookvalues thatareclosetotheirmarket
values
aremorelikelytofail)
Assumes diversified Abetafactormeasures
systematic
risk.However,
if
portfolios shareholders
donotholddiversified
portfolios
thentheyare
exposedtobothsystematic
andunsystematicrisk.
3.6 CAPM compared to the dividend growth model

Despitethesedrawbacks,
CAPMisgenerallyperceivedasbeinga morerobust
andstablemethod
forcalculating
thecostofequity,comparedtothedividendgrowthmodel.
ThisisbecauseCAPMgivesa clearlinkbetweenriskandexpectedreturn,
andalsobecause
CAPMdoesnotrelyonpotentially inaccurate
estimatesofthefuture
dividend
growthrate.
Essentialreading
Reading,
available
inthedigitaledition
oftheWorkbook,
formorebackgroundinformationonthisarea.
TheEssential
readingisavailable
oftheWorkbook.
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4 Cost of debt
Wehaveseenthatdifferenttypesofdebthavedifferent
costsbecause
theywillexpose investors
todifferent
levels
ofrisk.Herewecoverhowtocalculate
thecostofdebtfordifferent
typesof
debtfinance.
4.1 Cost of irredeemable loan notes
Irredeemable(undated)
loannotesentitletheholder toreceiveinterest
overanindefinite
period.
Loannotesarebought onthestockmarket (likeshares)andsoanapproach thatissimilar
tothe
dividendgrowthmodel canbeused(however thereturn isintheformofinterest
notdividendand
thereisnogrowthastheinterestisata fixedrate).
Theformula usedhereisnotgivenintheexambutisanadaption ofthedividendgrowthformula
usedearlier
(whichisgivenintheexam):
Formulato learn
Kd(pre - tax) = I
P0
I =interest
paid
P0=market valueofthedebt
Illustration3: Irredeemableloan notesignoringtax
ChappyCohas8%undated
loannotesinissuethataretrading
at82%oftheirnominal
valueof
$100.
G
Required H
Whatisthecostofdebt?
Solution
Costofirredeemable
debt= 8/82=9.8%(ignoring
tax)
4.1.1 Impactofcorporation tax

Whena company paysinterest,
thiswillreduceitstaxable
profits
whichreduces
thetaxpaidon
itsprofits.
Thishastheimpact ofreducing thenetcostofthedebttothecompany.
Theformula thenneedstobeadaptedtoinclude thetaxsaving:
Formulato learn
Kd(post - tax) = I(1−t)

P0
where
t isthetaxrateandP0isthemarket
valueofdebtex-interest.
Activity5: Techniquedemonstration
Recalculate
thecostofdebtforChappyCo(seeprevious
illustration)
giventhattaxonprofits
is
at20%.
230 Financial
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Solution
4.2 Cost of redeemable debt

Redeemable (dated)loannotesentitle
theholder toreceive
interestovera definedperiod.
Loannotesarebought onthestockmarket (likeshares)andarenormally redeemed attheirparor
nominalvalue.However,becausetheyaresoldtoinvestors atthemarket pricetherewillnormally
bea capitalgainorlosswhentheyareredeemed. Thiscapitalgain/loss
onredemption isnot
capturedbythedividend growthmodel approach, soanotherapproach isneeded toassessthe
costofredeemable debt.
Examfocus point
(a) Easiest
toassessoneunitof$100debt,notthetotalamount
ofdebtin$000s.
(b) Taxonlyaffectsthecostoftheinterest
payments,
notthedebt’smarket
valueorits
redemptionvalue.
G
4.2.1 Internalrateofreturn(IRR)approach H
Inearlier
chaptersyouhaveusedinternalrateofreturn(IRR)tocalculate
thepercentagereturn
givenbya project.
Thesametechnique canbeapplied toassessthecostofredeemabledebt.
Here,insteadofaskingwhat%return isbeingdelivered
bya project(theapproachtakenin
Chapter 5),weareaskingwhat%costisbeingincurred byusingdebt.
Aswithprojectappraisal,
theIRRapproach requires
thecashflowstobelaidoutforeachyear.
Forredeemable debtthecashflowswillbethemarket valueofthedebt(thisisreceived
bythe
company), thepost-tax
interest
(paidbythecompany) andthecashflow(paidbythecompany)
onredemption.
Forexample, thecashflows
froma two-yearredeemable loannoteare:
Time 0 1 2
Market
value (Interest
×[1– tax]) (Interest
×[1– tax])
(Redemption
value)
Ina computer-based
examthe‘=IRR’spreadsheet function
canbeusedtocalculate
theIRR.This
wascoveredinChapter5.
Alternatively,
theIRRformulacanbeused- thisislessimportant
butcanbeuseful
iftwoNPVsare
provided
inanOTquestion orifyouprefer
usingthisapproach.
Formulato learn
IRRformula
( NPVa−NPVb)
NPVa × (b%−a%)
IRR = a% +
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Activity6: Redeemabledebt
Nowis1January20X5.
Willcoplchas$100,000
5%20X8redeemable
loannotesinissue.
Interest
ispaidannually
on31December.
Theex–interest
marketvalueofa loannoteon1January
20X5is$90andtheloannotesareredeemable
ata 5%premium.
Taxonprofitsis20%.
Required
Whatisthecostofdebt?
Solution
4.2.2 CAPMapproach
Redeemable loannotesaretradedandhavea market price.Thismeans
a betafactorcanbe
calculated
fora loannote.
G
Ifanexamquestion givesyoua debtbeta,thenthecostofdebtcanbeestimatedusingthe H
CAPM.
Illustration4: Debt beta and the cost of debt
Ifthemarketreturn
isexpected
tobe10%andtherisk-free
rateis5%,ondebtwhichhasa debt
betaof0.3.
Required
Whatisthecostofdebttothecompany
ifthetaxrateis20%?
Solution
rD=5 +0.3×(10– 5)=6.5%
Thisisthepre-tax
return
onthedebt,soyouneedtomultiply
by(1-t)tocreatea post-tax
costof
debt:
6.5%×(1- 0.2)=5.2%
4.3 Cost of convertible debt

Convertibledebtisdebtthatcanbeconverted,
ifthedebtholders
wish,toequityinthefuture.
Theapproach toanalysing
convertible
debtisthesameasforredeemabledebtexcept thatyou
willhavetouseinformation
inthequestion
toanalysewhether
ornotthedebtwillbeconverted
intosharesinthefuture.
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Real life example:Convertibledebt
If,inthepreviousactivity
onredeemabledebt,debtholders
hadtherighttoconvert each$100
nominal valueofdebtinto20shares andyouweretoldtoassume thatthesharepriceatthe
redemption datewas$4,conversionofdebtintoshares
would nothappen (because
20shares
would beworth $80whichislessthantheamount available
onredemption) andthecalculations
would thereforenotchange.
However, ifthesharepricewas$6thenconversionwouldhappen (because 20shareswould be
worth $120whichismorethantheamount dueonredemption) soyouwould needtoredotheIRR
usingthesameapproach butbasedonthesecashflows(notethatthecashonredemption isthe
market valueoftheshare+interestintime4):
Time 0 1 2 3 4
Per$100 90 (4) (4) (4) (124)
The=IRRapproach showsthatthecostofconvertible
debtisnow11.5% comparedtoitsprevious
8.1%whenthedebtwassimply redeemable.
Thisillustrates
thehidden costofconvertibledebt,becauseifitisconverted
intoshares(because
thesharepriceishigh)thecompany willhavetopurchase
theseshares andsupplythemto
convertibledebtholders,
andthiswillcostmorethansimplyredeeming thedebt.
So,despite theinterest
costonconvertibledebtnormally
beinglower thanonredeemable debt,
theultimate costtothecompany ofusingconvertibledebtmayturnouttobehigh.
4.4 Cost of preference shares

Apreferenceshareholderwillreceive
a fixedincome(ieitdoesnotgrow),baseduponthenominal
valueoftheshares held(notthemarket value).
G H
Thesedividends,whilst
fixedandhenceshowing debtcharacteristics,
arepaidoutofpost-tax
profits
andthereforedonotreceive taxrelief.
Thecostofpreferencesharecapitalcanbecalculated adapting
thedividendvaluation
model
(whichisgivenintheexam).
re = Do(1+ g) + g
P0
Setting
thedividend
growth ratetozero(because
preference
dividends
arefixed)thedividend
growthformulasimplifies
to:
Do
P0
Activity7: Cost of preferenceshares
Acompanyhas$100,000
12%preference
shares inissue.Thenominal
valueoftheseshares
is$1.
Themarket
valuetodayoftheshares
is$1.25.Adividend
hasrecently
beenpaid.
Required
Calculate
thecostofpreference
sharecapital(toonedecimal
place).
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Solution
4.5 Cost of bank loan

Thecost of a bank loanwillbe giveninthe exam.Rememberthat interestpaymentswillattract
tax reliefand thereforewillneed to be multipliedby (1– t) to obtainthe post-taxcost.
Real life example: Interest rates

Ifthe interestrate on a bank loanis 8%and the rate of tax is 20%then the post-taxcost of the
loanis 8%×(1- 0.2)=6.4%.
5 Weighted average cost of capital (WACC)

Inthe exam,you may be requiredto calculatethe weightedaveragecost of two or moreof the
types of capital coveredin the previoussection.
Thiswillshowthe overallcost of capital of a businessand is calleda weightedaveragecost of
G
capital or WACC.Thiswilloftenbe used as the cost of capital inmany investmentappraisal H
calculations(whereNPVis beingused).
Aswithany cost, managementwilltry to findwaysof keepingthiscost to a minimum(thisis
discussedinthe nextchapter).
5.1 WACC formula
Formula provided
Ve Vd( Ve Vd+
)
= Ve ) Ke + ( Vd Kd(1−t)WACC
+
Where:
Ve=total marketvalue(ex-div)of shares ie marketcapitalisation
Vd=total marketvalue(ex-interest)of debt
Ke=cost of equityina geared company
Kd=cost of debt
234 Financial
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Illustration5: WACC
Thecurrent
dateistheendof20X5.
Relevant
data
Bookvalues Market
values
$m $m
Equity(50mshares) 140 214
Debt:10%loannotes20X9 80 90
Pershare Annual
growth
rates
Current
dividend 24c 6%
Required
Iftaxation
is30%,calculate
theWACC.
Solution
(1) Costofequity
Asthereare50million
sharesthesharepricecanbecalculated as$214m / 50m=$4.28
Thecostofequitycanbecalculated usingeither
theCAPMmodel orthedividendvaluation
model.Withtheinformation
provided hereonlythedividendvaluation
model canbeused.
Dividend
valuationmodel:D1/Po+ g =[24(1.06)
/428]+ 0.06=0.1194or11.94%
(2) Costofdebt
G
ThedebtisredeemablesotheIRRapproach mustbeused.Thetotalmarket valueofdebtis12.5% H
higher
thanthebookvalue(calculated bycomparing thetotalmarketvalueof$90mtothetotal
bookvalueof$80mie90m/ 80m=1.125). So,themarket valueofa $100blockofdebt(orone
loannote)is$112.5
Thepost-taxcostofdebtona $100nominal valueblockofdebtis10%x(1minus thetaxrateof
0.3)=7%.
Thecashflowsfora $100nominalvalueblockofdebtare:
Time 0 1 2 3 4
Cashflows(aftertax) 112.5 (7) (7) (7) 107)
Usingthe=IRRfunctionthisgives3.6%.
(3) Marketvalueofequity(Ve)
Givenas$214m
(4) Marketvalueofdebt(Vd)
Givenas$90m
(5) Weightedaveragecostofcapital
Ve+
( Ve Vd) ( Ve+ Vd)
= Ke + Vd Kd(1−t)WACC
Nowthatallthevariableshavebeenidentified,
theWACCcanbecalculated.
Note.Notethatthecostofdebtof3.6%isalready posttaxandtherefore
doesnotneedtobe
multiplied
by(1-t)again.
So,theWACCis:
WACC=[(214/304) ×11.94+ (90/304)]×3.6=9.5%
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Activity 8: WACC
DCo is financedby 10million$1ordinaryshares and $8,000,0008%redeemableloannotes

havingmarketvaluesof $1.90cum-divand $90%ex-interestrespectively.
Theloannotes are redeemableat par infouryears’time
Adividendof 30c is about to be paid and futuredividendsare expectedto growby 5%.
Required
Iftaxationis 20%,calculatethe WACC.
Solution
G H
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5.2 More than two types of finance

TheWACCformulaprovidedinthe examassumesthat onlytwosourcesof financeare being
used.
Inthe examyou may need to adapt the formulato accommodatemorethan twosourcesof
finance.
Thisis not difficultas the formulais simplycalculatinga weightedaverageof twovariablesand
can easilybe adapted to includemorethan twovariables.
Real life example: WACC – more than two types of finance

Fromthe previousactivitywehavethe following:
Cost of equity=24.69%
Cost of debt (posttax)=9.5%
Valueof equity=$16m
Valueof debt =$7.2m
Ifwewerenowtoldthat the companyalso had a bank loanof $1.8mcosting10%post-tax,then
the total capital becomes$16m+$7.2m+$1.8m=$25mand the WACCformulabecomes:
WACC=(16/25)×24.69+(7.2/25)×9.5+(1.8/25)×10%
Sothe WACCis now19.3%.
G H
5.3 Weightings used in WACC

Twomethodsof weightingcouldbe used.
Market Book
values values
Marketvaluesshouldalwaysbe used if data is available.

Althoughbookvaluesare ofteneasierto obtain,they are based on historicalvaluesand theiruse
willseriouslyunderstate the impactof the cost of equityfinanceon the weightedaveragecost of
capital.
Thisis because the bookvalueof equityis likelyto be wellbelowthe marketvalueof equityand
thereforeequity(the moreexpensivesourceof finance)willhavea lowerweightinginthe WACC
calculationleadingto the WACCbeingunderestimated.
Ifthe WACCis underestimated,projectsmay be accepted that do not infact delivera high
enoughreturnto satisfythe providersof finance.
5.4 Use of the WACC
TheWACCcan be used as a discountrate at whichto appraise projects;ifthe projecthas a
positiveNPVwhendiscountedusingthe WACC,it shouldbe accepted.
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However,wherethe riskof an extraprojectis differentfromnormal,then the returnexpectedby
providersof financewillchange.
Therefore,the WACCcan onlybe used for projectevaluationif:
(a) Inthe longtermthe companywillmaintainits existingcapital structureie same financialrisk
(b) Theprojecthas the same riskas the companyie same businessrisk
(c) Theprojectis marginalin size;majorprojectsare likelyto havea materialeffect on risk,so
the WACCis not normallyused formajorprojects
Ifthere isa change inrisk,then there is an argumentfora cost of capital to be calculatedforthat
particularproject;thisis calleda marginalcost of capital and is coveredin the next chapter.
G H
238 Financial
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Chapter summary
Cost of capital
Risk Costofequity: Costofequity:

andreturn dividend
growth
model CAPM
Creditor
hierarchy D(
01+g) Beta
measures
systematic
risk
• Higherrisk
meansthatahigher re= P0 +g
return
isrequired • Growthestimated
byusing
• Forthisreason
thecost
of historic
data Disadvantages
equity
willbehigher
thanthe • Alternatively
growth
estimated • Single
period
model
costofdebt byg=br • Beta
may beoutofdate
• Ignores
size
ofcompany
• Assumes
adiversified
portfolio
Disadvantages • Better
thanthedividend
• Assumes
constant
growth growth
model
• Assumes
dividends
arepaid
• Only
works
forlisted
companies
Costofdebt WACC
G
Irredeemable
loannotes ( Ve ) ( Vd ) H
• Adaptthedividend
growth WACC = Ve+Vd Ke+ Ve+Vd Kd(1–t)
modelandassume zero
growth • UsemarketvaluesforVeandVd
• Multiply
by(1-t)
toreflect
tax • May needtoadapt forthree
sources
of
relief
oninterest
payments finance
• Onlyappropriateasacostofcapital
to
appraise
project
which:
Redeemable loannotes –Donotchange financial
risk
• Use=IRRfunction –Donotchange business
risk
• Alternatively
useformulaiftwo –Arenotlargeinsize
NPVsaregiven • Ifthese
conditions
donothold,a
marginal
costofcapitalmaybeneeded
Convertible
loannotes
• Assess
ifloannoteswillbe
converted
intoshares
• Use=IRRfunction
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1.Riskandreturn
Thecreditor
hierarchy
establishes
therelationship
between
riskandreturn.
2. Dividend
growth model
Thismodelforestimating
thecostofequityisnotasstableastheCAPMbutneedstobeusedto
estimate
thecostofequityifa betafactorisnotgiven.
3. CAPM
Assuming thatshareholders
diversify
theirinvestments,
thismodelestablishes
thereturn
thatis
neededtocompensate shareholders
forthesystematic
riskofa company(asmeasurebyitsbeta
factor).
4. Costofdebt
Ifdebtisredeemable
orconvertible
thiswillrequire
theuseoftheIRRapproach.
5. WACC
Thisisappropriate
forcalculatingthecostofcapitalforuseinNPVanalysis
unless
a project
represents
a different
levelofrisktothatnormally
facedbyshareholders.
G H
240 Financial
Management
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Question practice
the Workbook):
SectionAquestions
Q27,Q29
SectionC questions
Q55 Cry
Further reading
Thereis a usefulTechnicalArticlewrittenby a memberof the FMexaminingteam that is available
on ACCA’swebsite;it is called‘CAPM – theory, advantages and disadvantages’.Werecommend
that you read thisarticleas part of yourpreparationforthe FMexam.
G H
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Activity answers
Activity1:Dividend growth model

Thecost of equityis
= 60(1.08)+ 0.08 = 0.198 or 19.8%
550
Activity2: Historic growth

0.30 ×(1+g)=0.3925
4
∴
( ) (1/4)
g = 0.3925 −1 = 0.0695
0.3
∴ g =6.95%thisis the geometricaveragegrowthrate
Note.Ifthe questionhad askedforthe cost of equity, usingthisgrowthrate the answerwouldbe:
ke=[0.3925(1.0695)/(8.31)]
+(0.0695)=12%
Activity3: Exam standard

Growth=40%×30%=12%p.a.
Thedifferencebetweenthe cumdivand exdivshare priceis 20c, so thisis the dividendthat is
G about to be paid. H
ke=((20×1.12)/125)+0.12=29.92%
Activity4: CAPMTechnique demonstration

1 15.8%
Usethe beta of the company;1.6
Donot mistakethe riskpremiumforthe marketreturn.Theriskpremiumis Rm-Rf.
Ke=3 +(8 ×1.6)=15.8%
2 0.875
Ifthe cost of equityis 10%,Ke=3%+(8%×β ) =10%
So10%- 3%=8%×β
So7%÷8%=β =0.875
Activity5: Technique demonstration

Cost of debt to the company=[8(1- 0.20)/82]=7.8%
Activity6: Redeemable debt

CBEexamapproach
Post-taxcost of interest=$5 ×(1- 0.2)=$4
Redemptionvalue=$105
Thereare fouryears between1Jan 20X5and 31Dec20X8.
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A B C D F
1 Time 0 1 2 3 4
2 Per$100 90 -4 -4 4 -109
3 IRR =IRR(B2:F2)
Thespreadsheet
solution
incellB3is8.1%
Usingtheapproach
oftwoNPVswould beslower
buttheworkings
areshown
below:
Discounting
at7%
Time 0 1to4 4
Per$100 90 -4 -105
Df7% 1.0 3.387 0.763
Present
value 90 -13.55 -80.12
NPVa=-3.67
Discounting
at9%
Time 0 1to4 4
Per$100 90 -4 -105
Df10% 1.0 3.240 0.708
Present
value 90 -12.96 -74.34
NPVb=+2.70
G IRR=7+(-3.67/(-3.67
- 2.70)× (9- 7)) H
IRR=7+(-3.67/(-6.37)
×2)=8.15%
TheCBEmethod ismoreaccurate
Activity7: Costofpreferenceshares
9.6%
Dividend=12%ofnominalvalue=$0.12
Costofpreferenceshares
= 0.12/1.25
=9.6%
Activity8: WACC
Thecorrect answeris:20.0%
(1) Costofequity
Because thedividendisabouttobepaidandthesharepriceiscumdiv,theex-divshareprice
needstobecalculated as$1.90- $0.30=$1.60
Ke=[Do(1+g)/P]+g
0 =[30(1.05)/160] +0.05
=24.69%
(2) Costofdebt
CBEexamapproach
Posttaxcostofinterest=$8×(1- 0.2)=$6.4
Redemption value=$100
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A B C D E F
1 Time 0 1 2 3 4
2 Per$100 90 6.4 -6.4 -6.4 -106.4
3 IRR =IRR(B2:F2)
ThespreadsheetsolutionincellB3is 9.5%
(3) Valueof equity
Ve=10m×1.6=£16m
(4) Valueof debt
Vd=8,000,000 ×90%=£7,200,000
(5) WACC
WACC=[16/(16+7.2)]×24.69%+[7.2/(16+7.2)×9.5%=20.0%
G H
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12
Capital structure
12
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
• Estimating
theoverall
costofcapitalincluding
distinguishing
between E2(c)
average
&marginal
costofcapital
• Identify
anddiscuss theproblem ofhighlevelsofgearing E3(c)
• Assesstheimpact ofsourcesoffinanceonfinancial financial E3(d)
position,
riskandshareholder wealthusingappropriate measures, including
ratioanalysis(usingstatement
offinancialpositiongearing,
operationalandfinancialgearing,interest
coverage ratioandother
relevantratios),
cashflowforecastingandleasing orborrowing tobuy
(Chapter 8)
G H
• Impact ofcostofcapitaloninvestments includingtheadvantages of E3(e)

theCAPMoverWACCindetermining a project-specific
costof
capital,application
ofCAPMincalculating a project-specific
discount
rate
• Describethetraditional
viewofcapitalstructure
anditsassumptionsE4(a)
• DescribetheviewsofMiller
andModigliani both E4(b)
oncapitalstructure,
without
andwithcorporate taxation,
andtheirassumptions
• Identify
a rangeofcapitalmarket
imperfections
anddescribetheir E4(c)
impactontheviews ofMiller
andModiglianioncapitalstructure
• Explain
therelevanceofpeckingorder
theory toselection
ofsources E4(d)
offinance
• Describethefinancingneedsofsmallbusinesses E5(a)
• Describethenature ofthefinancingproblemforsmallbusinessesin E5(b)
termsofthefunding gap,thematurity gapandinadequate security
• Explain
measures thatmaybetakentoeasethefinancing problems E5(c)
ofSMEs,includingtheresponses ofgovernment departmentsand
financial
institutions
• Identify
&evaluate thefinancial
impactofsources offinancefor E5(d)
SMEs,includingsources fromsyllabus
sectionE1andbusiness angel
financing,
government assistance,supplychainfinancing,
crowdfunding/peer-to-peerfunding
12
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Exam context
Thischaptermainlycovers ‘capitalstructure
issues’ whichispartofSection
E ofthesyllabus
(Business
Finance).Having described a varietyofsourcesoffinance inChapters9-10,this
chapterdiscussestheappropriatebalance ofdifferenttypesoffinance,orcapitalstructure.
The
theories
coveringcapitalstructure
arealsouseful forcalculating
a marginalcostofcapitalwhich
shouldbeusedtoevaluate investments where riskischangingandsotheuseoftheWACC
(Chapter11)isnotappropriate.
G H
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12
Chapter overview
Capital structure
issues Capital structure theoriesPractical
Disadvantages
ofdebt Traditional
theory
Advantages
ofdebt Netoperating
incometheory
Practical
capitalstructureissues M&M
withtax
Pecking
ordertheory
Marginalcost of capital Financefor SMEs
Step1– ungeara proxycompany

beta Funding
gap
G
Step2– regearthebeta Maturity
gap H
Step3– calculatethecostofequity Business

angels,supply-chain
finance,
crowdfunding
Capitalstructure
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1 Practical capital structure issues
PER alert
Performanceobjective11requiresyou to ‘identifykeysourcesof financialriskto the
organisationand howthey mightarise’and to ‘monitorfinancialrisks,reviewingtheirstatus
and howthey shouldbe managed’.Youcan apply the knowledgeyou obtainfromthis
chapter of the textto helpto demonstratethiscompetence.
Capital structure:Thecapital structureof a companyrefersto the mixtureof equityand debt

KEY financeused by a company.
TERM
Havinglookedat a varietyof sourcesof financeinChapter 9,wenowconsiderthe issueof capital
structure.Wehaveseen inChapter 1that thisis measuredby the gearing ratio.
Westart by consideringthe relativeadvantages and disadvantagesof debt and equity.
1.1 Disadvantages of debt finance compared to equity
Disadvantages of debt Discussion

Debtcreates highervariabilityin Ifthere is a downturninbusiness,there willbe a dramatic
dividendsie higherfinancialrisk. cut inthe fundsavailableto pay a dividendbecause of
the need to pay interestfirst.
Theuse of debt worsensinterest Debtcreates higherdefaultriskwhichcan lead to
coverand gearing ratios financialdistresscosts such as lowersales or higher
suppliercosts (thisis exploredlater inthischapter).
G H
Debtpayments must be made, Akeyadvantage of equityis that dividendpaymentsare

evenif a businessis not making at the discretionof the Board.
profits.
Activity 1: Financial risk
BadtimesCo’slatest forecastfinancialdata forthe currentyear is as follows:

Lastyear Forecast
$m $m
Profitsbeforeinterestand tax (PBIT) 12,000 6,000
Tax 2,700 900
Profitsafter interestand tax 6,300 2,100
Dividends(assumingno change individendpayout ratio) 2,100 700
Required
Comparethe %change inPBITto the %change individendsand explainthe difference.
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Solution
1.2 Advantages of debt finance compared to equity
Advantagesof debt Discussion

Debtisa cheaper
source
offinance Thishasbeendiscussed
inChapter
11inthesection
on
thecreditor
hierarchy.
Debthasa better
impactonearnings Issuingnewsharescanbeexpected tohavea more
pershare(EPS) dilutive
effectonEPSthantheissueofdebt.
Debtisquicker
andcheaper toissue Onlytrueifcomparing
toa shareissue,butequity
comparedtoa shareissue mayalsobesourced
frominternalfinance.
Interest
repayments attracttaxrelief Thisisoneofthekeyreasons
whydebtisa cheaper
(iereducetaxable
profit) sourceoffinance.
Theuseofdebtisa discipline
on Careful
cashflowmanagementisneeded
eggood
G management management ofworking
capital. H
Usingdebtcanbeinterpreted
asa Canbeinterpreted
asa signalthatmanagementare
signalofconfidence
inthe confident
inthestability
ofthecompany’s
cashflows.
company’s cashflows
Activity2: Gearing & EPS
GoodtimesCoplanstospend$5monexpanding itsexisting
business.
Itisconsidering
raising
the
finance
byissuing
5%loannotes.Theexpansion
ofbusiness isexpected
toincrease
profitbefore
interest
andtaxby10%inthefirstyear.
Anordinary
dividend
of$425,000hasjustbeenpaidanddividendsareexpectedtoincreaseby
4%peryearfortheforeseeable
future.
Summarisedfinancial
information
onGoodtimesCoforthelastfinancial
yearisasfollows.
$’000
Profit
before
interest
andtax 3,500
Interest (250)
Profit
before
tax 3,250
Tax(30%) (975)
Profit
aftertax 2,275
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$’000 $’000
Ordinaryshares, par value$1 2,500
Retainedearnings 11,250
Totalequity 13,750
10%loannotes 2,500
6%preferenceshares, par value$1 1,250
Priorcharge capital 3,750
Other information
Averagesectorfinancialgearing(priorcharge capital dividedby equityshare capital)is 55%.
Required
Evaluatethe effect,after one year, of the debt issueand the businessexpansionon:
(a) Profitafter tax
(b) Financialgearingusingbookvalues(currently=3,750/13,750×100=27.3%)
(c) Earningsper share (currentlyEPS=[2,275- (6%×1,250)]/2,500=0.88)
Solution
G H
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1.3 Practical capital structure considerations

Eachcompanywillneed to evaluatethe importanceof the relativeadvantages of debt and
equity, and to considerpractical,company-specific,factorsto determinetheirappropriate
capital structure.
Practical issues Explanation
Lifecycle Anew,growingbusinesswillfindit difficultto forecastcash flows
withany certaintyso highlevelsof gearingare unwise.
Operationalgearing Iffixedcosts are high,then contribution(iebeforefixedcosts)will
(iecontribution/PBIT) be highrelativeto profits(afterfixedcosts).Highfixedcosts mean
G futurecash flowsmay be volatile,so highgearingis not sensible. H
Stabilityof revenue Ifoperatingina highlydynamicbusinessenvironment,then high

gearingis not sensible.
Security Ifa companyis unableto offersecurity,then debt willbe difficult
and expensiveto obtain.
Essential reading
SeeChapter 12Section1of the Essentialreading,availableinthe digitaleditionof the Workbook,

formorebackgroundinformationon thisarea. TheIllustrationcalled‘Impactof alternativetypes
of finance’is especiallyimportant.
2 Capital structure theories
Capitalstructuretheoriesmainlyexaminethe impactof usingdebt financeon the WACCand

whetherdebt can be used to lowerthe WACC- in whichcase shareholderswillbenefitsincethe
marketvalueof a companydepends on its cost of capital.Thelowera company’sWACC,the
higherthe net presentvalueof its futurecash flowsand thereforethe higherits marketvalue.
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2.1 Traditional theory
Atraditionalapproach to gearingsuggeststhat debt bringsbenefits,up to a certain levelof
gearing. Thisis illustratedbelow.
Costof
capital
WACC
1 2
3 Gearing
increasing
Atpoint1inthe diagram,the weightedaveragecost of capital (WACC)is falling,as gearingrises.
Thisreflectsthe impactof usingmoredebt, and that debt is a relativelycheap sourceof finance.
Atpoint2 inthe diagram,the WACCis rising,as gearingrises.Thisreflectsthat the use of high
levelsof debt makesequityriskier(eghigherbankruptcyrisk)whichcauses the cost of equityto
riseexponentiallyand so the WACCincreases.
Point3 representsthe optimallevelof gearing,sincethe WACCis lowestat thispoint.
2.1.1 Drawbacks of traditional theory
Thetraditionalviewdoes not identifythe optimallevelof gearing.
Anotherdrawbackisthat it failsto considerthe impactof tax on the cost of debt finance.
G
2.2 Modigliani and Miller (no tax) H
Thistheory, also knownas the net operatingincomeapproach, takes a differentviewof the effect
of gearingon WACC.Intheir1958theory, Modiglianiand Miller(M&M) proposedthat the total
marketvalueof a company, inthe absence of tax reliefon debt interest,willbe determinedonly
by twofactors:
(a) Thetotal earningsof the company
(b) Thelevelof businessriskattached to those earnings
Thetotal marketvaluewouldbe computedby discountingthe total earningsat a rate that is
appropriateto the levelof businessrisk.Thisrate wouldrepresentthe WACCof the company.
ThusM&Mconcludedthat the capital structureof a companywouldhave no effect on its overall
valueor WACC(quotedin:Watsonand Head,2013,p.299).
Thistheorycan be illustratedas follows:
Costof
capital
WACC
Gearing
increasing
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Liketraditionaltheory,
netoperating
incometheoryacknowledges thatdebtischeaper than
equityandthattheuseofhighlevels ofdebtmakes equityriskier
sothecostofequitywillriseas
gearing rises.However,
thetheorysuggests
thattheseeffectsexactlyoffseteachothersothe
WACCremains constant.
Thisisillustrated
inthefollowing
diagram whichshows thecostofequityrisingina linear
manner,
exactly offsetting
theimpactofusing(cheaper)
debtfinance.
Cost
of Ke
capital
WACC
Kd
Gearing
increasing
2.2.1 Arbitrage
M&M justified
netoperatingincome theory
bysuggesting thatiftwocompanies,
thatwere
identical
toeachotherasidefromtheircapitalstructure,
haddifferentvalues
theninvestors
could
makea riskfreegainbysellingsharesincompany witha highervalueandbuyingshares
from
thecompany witha lower
value.Thiswouldmeanthatveryquickly themarketvalues
ofthetwo
companies wouldmove intolinewitheachother.
Arbitrage:
Whena purchaseandsaleofa security takesplacesimultaneously
indifferent
KEY markets,
withtheaimofmakinga risk-free
profit
throughtheexploitation
ofanyprice
G H
TERM difference
between themarkets.
Examfocus point
TheproofofM&M’s
theory
byarbitrage
isnotexaminable.
2.2.2 Drawbacksofnetoperatingincometheory
M&M madevarious assumptions
inarrivingatthisconclusion,
including:
(a) Aperfectcapitalmarketexists,inwhichinvestors
havethesameinformation,
onwhichthey
actrationally,
toarrive
atthesameexpectations aboutfutureearnings
andrisks.
(b) Therearenotaxortransaction costs.
(c) Debtisriskfreeandisfreelyavailable
atthesamecosttoinvestors
andcompanies alike.
2.3 Modigliani and Miller (with tax)
In1963Modigliani
andMillermodified
theirtheorytorecognise
thattaxreliefoninterest
paymentsdoeslower theweighted
average costofcapital.
Thesavingsarisingfromtaxreliefon
debtinterest
arethetaxshield.
Havingshown thatdebtbrought
nobenefit ina zerotaxworld,
M&M werethenabletoarguethat
thetaxshield
istakenintoaccount,
thendebtbringsanextrabenefit (notaccounted forinnet
operating
income theory).
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Thismeansthata company shoulduseasmuchdebtfinanceasitcananditsweighted
average
costofcapitalcontinues
tofallasgearing
rises(Watson
andHead,2013,p.301).
Cost
of
capital Ke
K0
Kdafter
tax
Gearing
upto100%
2.3.1 DrawbacksofM&Mtheorywithtax
Inreality
companies
donotmaximisetheirgearing
duetotheexistence
ofmarket
imperfections
andotherpractical
issueswhichmitigate
thetaxadvantages
ofdebtfinance.
Capital market Examples
imperfections
Directfinancial
distress M&M’stheoryassumes perfect
capitalmarkets
soa company would
costs alwaysbeabletoraisefinanceandavoidbankruptcy.
However,athigherlevels
ofgearingthereisanincreasing
riskofthe
company beingunable tomeetitsinterest
payments andbeing
declared
bankrupt.
G Atthesehigherlevels
ofgearing,thebankruptcyriskmeansthat H
shareholders
andprovidersofdebtwillrequire
a farhigher
rateof
return
ascompensation.
Indirect
financial Asgearingrises,theriskofbankruptcy
mayalsodamage sales
distress
costs (customers
maynotwanttobuyfroma company thatlooks
financially
unstable).
Suppliers
maynotwanttosupplya potentiallyunstable
firm,or
mayputuppricestocompensate fortheriskofnon-payment.
Agencycosts Athigherlevels
ofgearingtherearealsoagencycostsasa result
of
actiontakenbyconcerned debtholders.
Providers
ofdebtfinancearelikelytoimpose
restrictive
covenants,
suchasrestriction
offuturedividends.Theymayalsoincreasetheir
levelofmonitoring
andrequiremorefinancial
information.
M&M theorywithtaxalsofailstorecognisethat:
• ascompanies increasetheirgearing,theymayreacha pointwhere
therearenotenough
profits
fromwhichtoobtain allavailable
taxbenefits
(taxexhaustion).
Theywillstillbesubject
toincreasedbankruptcyandagencycostsbutwillnotbeabletobenefitfromtheincreased
taxshield.
• theimpactofpersonal tax,whichoftenincentivises
shareownership.
Activity3: M&M
Haridoy
Corecently issuedsomedebenturestoraisenewfinance.
Before theissueHaridoy
Co
hada costofequityof12%anda weighted averagecostofcapitalof9%.Thecompany paystax
at20%.Aftertheissuethecostofequityroseto12.5%andtheweighted averagecostofcapital
(WACC)fellto8.6%.
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Required
Withwhichtheoryor theoriesare these movementsincost of capital (Keand WACC)potentially
consistent?
 Traditionaltheoryonly
 Traditionaltheoryand Modiglianiand Miller(withtax)
 Traditionaltheoryand Modiglianiand Miller(bothwithand withouttax)
 Modigilaniand Miller(withtax)
2.4 Pecking order theory

Peckingordertheorysees the financingdecisioninpracticaltermsand suggeststhat firmswill
financeprojectsinthe followingorder:
1.Useinternalfundsifavailable
2.Usedebt
3.Convertible
debt
4.Preferenceshares
5.Issuenewequity
• Issuecosts (theseare zeroifretainedcash is used, and the issuecosts of debt are lowerthan
those of equity).
• Investorpreferenceforsafer securities;that is,debt withits guaranteed incomeand priorityon
liquidation.
• Debtissueshavea better signallingeffect than equityissuesie the marketwillinterpretdebt
G
issuesas a signof confidence. H
• Themarketwillinterpretequityissuesas an indicationthat managersbelievethat equityis

currentlyovervaluedand hence are tryingto achievehighproceedswhilethey can.
Essential reading

3 Project specific (marginal) cost of capital

Inthe previouschapter wesaw that a marginalcost of capital willbe needed if a project
changes the riskfaced by shareholders.Herewewillapply the CAPMand M&Mtheory(withtax)
to estimatea marginalcost of capital.
3.1 Equity betas and asset betas
3.1.1 Equity (geared) beta
Thebeta of a company’sshares reflectsboth its businessriskand its financialrisk(the riskof
usingdebt financeinthe capital structure).
Sincemostcompanieshavesomelevelof debt finance,an equitybeta can be assumedto be a
‘geared’beta ie the beta of a companythat employssomedebt finance.
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3.1.2 Asset (ungeared) beta
M&Mtheorycan be used to adjust an equitybeta to showits valueifthe companywas ungeared.
Thisis calledan asset beta. Anungearedbeta measuresonlybusinessrisk,not financialrisk.
Equitybeta Assetbeta
Anequitybeta willbe largerthan an asset beta because an asset beta onlymeasuresbusiness

risk,whereasan equitybeta measuresbusinessriskand financialrisk.
Assetbeta: Anungearedbeta ie onlymeasuresbusinessrisk.

KEY
TERM Equitybeta: Ameasureof the systematicriskof a share, includingits businessand financial
risk.
Formula provided
[ (Ve+ Vd(1−T))
Ve
] (Ve+ Vd(1−T))[]
Vd(1−T) βd
βa = βe +
Exam focus point

Oftenno debt beta is giveninthe examand thereforeonlythe firstpart of the formulais used.
G 3.2 Calculating a marginal (or project-specific cost of capital) H
Wherea companyis movingintoa differentbusinessarea, it cannot use its currentWACCto

assess the projectbecause its riskis changing.Amarginalcost of capital is thereforeneeded.
Thiscan be calculatedby following3 steps.
Step 1:Findthe asset beta of a companyin the same businessas the newproject
First,findthe beta of a companyinthe same business(a proxycompany)as the proposed
project;thisis an equitybeta.
Thisequitybeta givesan indicationof the businessriskof the projectbut willbe distorted by the
gearing of the proxycompany(ifa companyhas a highequitybeta thismay be because it has
highgearing,not because it is a highriskbusiness).
Illustration 1: Beta factors
TrainCo is a companyexperiencedinthe provisionof trainingcourses.SharesinTrainhavea

beta valueof 1.2.
TrainCo has a debt: equityratio of 1:10whichwillnot change as a resultof the project.
Thedirectorsof Trainplan to expandtheirbusinessby buildinghotelswhichare locatednear their
trainingcentres.
ThirtéCo is a listedhotelcompanywitha debt: equityratio of 1:1,its shares havea beta of 1.5.
Themarketpremiumfor riskis 8%and the risk-freerate is 4%.
Required
Whichbeta factor is a better measureof the riskof the newproject?
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Solution
ThebetaofThirtéCoismorerelevant
asitisinthesamebusinessastheproposed
project,
howeveritisdistorted
bytherelatively
highlevelofgearing
ofThirté
Co.
Tounderstand
thelevelofbusiness
risk,theequitybetaoftheproxycompanyneedstobe
adjusted
bystripping
outtheeffectofgearingtocreateanungeared oranassetbeta– this
measures
thebusinessriskoftheproject.
Activity4: Calculating an asset beta
Usethedetails
fromtheprevious
illustration
andassume
thetaxrateis30%.
Required
Calculate
theassetbetaofThirté
(assume
debthasa betaofzero).Workto3 decimal
places.
Solution
G
Step2:Re-geartheassetbetatoreflecttheproject’sgearing H
Anassetbetaisungeared andsodoesnotinclude anyallowance forfinancialrisk.However,

ifa
project
isfinanced usingsomedebtfinance thenitwillcreatefinancial
riskaswellasbusiness
risk.
Therefore,
wenowneedtoadjust theassetbetabyincluding theimpact ofthegearingofthe
project;
thisiscalledre-gearing
thebeta.
Thisusesthesameformula thatweusedforungearing theequitybeta.
Formulaprovided
[ (Ve+ Vd(1−T))
Ve
] (Ve+ Vd(1−T))[]
Vd(1−T) βd
βa = βe +
Activity5: Re-gearing the asset beta
TrainCo(fromthepreviousactivity)
hasa debt:equityratioof1:10andThirté
plcisa listed
hotel
company withanassetbetaof0.882.
Themarket premiumforriskis8%andtherisk-free
rateis4%.Taxis30%.
Required
Calculate
theequitybetaoftheproject
tobuildhotels
(assume
debthasa betaofzero).Workto
3 decimal
places.
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Solution
Step3:Usethere-geared betatocalculate
anappropriatecostofequity
Theregearedbetashows theriskoftheproject
(including
bothfinancial
andbusiness
risk)andis
usedtocalculate
a project-specific
costofequity.
ThisusestheCAPMwhichwascovered inthepreviouschapter:
) =Rf+β(E(Rm)- Rf)E(r
i
Activity6: Calculating a projectspecific cost of equity
Usetheequitybetaof0.944tocalculate
Train’s
costofequityforthisproject
(iethemarginal
cost
ofequity).
Workto2 decimal places.
Solution
G H
Inreality,
thiscostofequity
wouldbeincluded
ina project-specific
WACCifa combination
of
debtandequityisusedtofinance
theinvestment.
However,thiswillnotbetestednumerically
in
theexam.
Examfocus point
Calculation
ofa project
specific
WACCisnotexaminable,
onlya project
specific
costof
equity
Asummaryofthethree-step
approach tocalculating
a project
specific
costofequityis:
Step1 Findtheassetbetaofa company inthesamebusinessasthenewproject
Step2 Re-geartheassetbetatoreflect
theproject’s
gearing
Step3 Usethere-gearedbetatocalculateanappropriate
costofequity
Activity7: Calculating a projectspecific cost of equity
Company B,a training

company, hasa debt:equityratioof1:2.Itwishes
toexpandinto
recruitment
consultancy.Ithasidentified
thatthebetaofa highlygeared recruitment
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consultancy company (companyX)is1.8.Thisisitsequitybetaandisinfluenced
byitshigh
levelofgearingof1:1debttoequity.
Assume thatdebthasa betaof0.
Risk-freerate=4%
Market rate=12%
Tax=30%
Required
Calculate
thecostofequitythatCompany
Bshould
usetoappraise
thisinvestment.
Solution
3.3 Problem with a CAPM based marginal cost of capital

Akeyproblem
withthisapproach
isfinding
a similar
company’s
beta;thisisverydifficult
in
reality.
G
Essentialreading H
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
4 Finance for small and medium sized enterprises (SMEs)
4.1 Funding gap

Smallandmedium-sized enterprises
(SMEs)faceparticularproblemsinraisingexternal
finance
whichwillimpactontheircapitalstructure.
Theinability
ofSMEstoraiseadequate financeissometimesreferred
toasthefunding gap.
Thefunding gapisoftentheresult ofthefollowingfeatures
ofa SME:
• Thebusiness isowned bya relativelysmallpoolofinvestors
(veryoftena family)
andislikelyto
beunquoted
• Thereisa greaterfailurerateamong smallcompanies
• Thecompanies arelesslikelytohavea discernible
trackrecordandgenerallyundergo much
lessregulatoryandpublicscrutiny
• Knowledge ofsources offinance maybelimited
4.2 Maturity gap
Evenmedium-sized
companies willsometimes
findthattheycannot obtain
moredebtfinance,
duetoinadequate
security
(intheformofassets).
Thisisa particular
problem
formedium-term
12:Capital
structure
259
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projects(ega newadvertisingcampaign)whichoftendo not havethe securityofferedby long-
terminvestmentsthat land and buildingscreate.
Thedifficultyinobtainingmedium-termfinancingis calledthe maturitygap.
Governmenthas recognisedthese difficultiesand has triedto encourageinvestmentinSMEsby
underwriting(guaranteeing)a proportionof the valueof loansmade to SMEsand by direct
assistancesuch as grants.
4.3 Business angel financing
Wealthyindividualsor groupsof individualswhoinvestdirectlyinan SME.Theyare prepared to
take large risksinthe expectationof large returnson theirinvestment.Thisfinanceisalso
relativelyinformalwhichmeans that the raisingof the fundscan be speeded up.
4.4 Supply chain finance (SCF)
SMEsare likelyto makeuse of electronicplatforms,usuallyprovidedby banksor financial
institutions,whichfacilitatesthe factoringof outstandingtrade debts.
Real life example: SCF

(a) CompanyAbuys $50,000 of goodsfromBon 60-day credit.
(b) CompanyAapprovesthe invoiceforpaymentand uploadsit to a SCFplatform.
(c) CompanyBcan see the invoicehas been approvedforpaymentand either:
(i) Waits60 days to receivecash fromA;or
(ii) Receivesthe cash withinfivedays fromC (the SCFplatformprovider(the bank))in
returnfora discount.
(d) CompanyApays the fullamountto C.
CompanyAhas the benefitof payingin60 days as plannedbut CompanyBhas the cash early
and C has earned the discount.
G H
4.5 Crowdfunding
Crowdfundingis a means of raisingfundsfromlarge numbersof people.Thisuses internet
technologyto reach a large poolof potentialinvestorswhomay believeinthe projecton which
theirfundswillbe used.
Crowdfunding(alsoknownas peer-to-peerfunding)has been used to fundstart-up businesses,
rockband and theatricaltours,art projectsand otherprojects.
4.6 Capital structure
SMEsare restrictedintheirsourcesof newequityfinance.Theyare privatecompanies,witha
limitednumberof shareholders.Unlessthe shareholdersare wealthy,there is a limitto the amount
of extracapital they may be able to investinthe company.
SMEsthereforerelyheavilyon retainedprofitsfornewequityfinance,but there is a limitto the
amountof equitythat can be obtainedfromthissource,especiallywhenprofitsare low.
Itis not easy forSMEsto attract venturecapital.Theymustbe able to demonstratestrong
opportunitiesforprofitgrowth.
So,ifSMEsare restrictedinthe amountof newequitythey can obtain,they may be forcedto rely
on borrowingto supplementtheir finances.
Essential reading

formorebackgroundinformationon thisarea, includingexamplesof governmentschemes.
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Chapter summary
Capital structure
Practical issues Capital structure theories
Disadvantagesofdebt Traditional
theory
• Createsfinancial
risk • Optimal
capitalstructure
• Worsensliquidity
andriskratios –Debtgivesa benefituptothislevel
Advantages ofdebt Netoperating

incometheory
• Cheapersourceoffinance • WACCissameat anygearinglevel
• ImpactonEPS –M&Mtheorywithouttax
• Quickerandcheaperto issue
• Taxrelief
• Discipline M&M withtax
• Signalofconfidence • WACC fallsconsistently
asgearingrises
• Ignores:
– Directfinancial
distresscosts
Practical
capitalstructureissues – Indirectfinancial
distresscosts
• Lifecycle – Agency costs
• Operationalgearing – Taxexhaustionandpersonal tax
• Stability
ofrevenue
• Security
Peckingordertheory
• Newequityisthelastsourceoffinanceto
beconsidered
G
• Duetoissuecosts,investor
preference
for H
security,andsignalling
issues
Marginalcost of capital Financefor SMEs
Step1– ungeara proxycompany

beta Fundinggap
Calculate
theassetbeta Inability
toraisesufficient
finance
Step2– regearthebeta Maturitygap

Toreflectthegearingoftheproject Inability
toraisemedium
termfinance
Step3– calculatethecostofequity Business

angels,supply-chain
finance,
UsingCAPM crowdfunding
Important
sourcesoffinanceforSMEs
Capitalstructure
Inability
toaccesssufficient
equitymayleadto
highgearing
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1.Practicalcapital structureissues
Aswellas beingaware of the generaladvantages of debt and equity, you shouldappreciate that
capital structurewillbe influencedby company-specificfactorssuch as: stage inthe life-cycle,
operatinggearing,stabilityof cash flowsand abilityto offersecurity.
2. Basicratio analysis
Itis vitalthat you can use basic ratiossuch as EPS,interestcoverand gearingto evaluatea
potentialcapital structure.
3. Capital structuretheories
Modiglianiand Millertheorywithtax suggeststhat gearingshouldbe maximised,but makesure
you understandthe limitationsof thistheory- forexamplethe assumptionthat financialdistress
costs (directand indirect)do not exist.
4. Marginalcost of capital
Wherean investmentcauses a change inriskit willrequirea projectspecificcost of capital (as
opposedto usingthe existingWACC).Thisis calculatedby adjustinga proxycompany’sbeta to
reflectthe gearingof the project.
5. SMEfinance
SMEswilloftenexperienceproblemsinaccessingequityfinanceand are oftenexposedto
problemsinraisingfinanceoverthe mediumand longterm.
G H
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Question practice
the Workbook):
SectionAquestions
Q28
SectionC questions
Q56 Katash
Further reading
Thereare three usefulTechnicalArticlesavailableon ACCA’swebsite,called:
• ‘BusinessfinanceforSMEs’
• ‘Thecapital asset pricingmodel’– parts 1and 2 (writtenby a memberof the FMexamining
team).
Werecommendthat you read these articlesas part of yourpreparationforthe FMexam.
G H
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Activity answers
Activity1:Financial risk
PBITchange
$m Lastyear Forecast
Profitsbeforeinterestand tax 12,000 6,000
%change =6,000/12,000×100=50%
Dividendsfallby 1,400/2,100×100=67%
Dividendsfallby morethan PBITbecause interesthas to be paid – thisis calledfinancialrisk.
Activity2: Gearing &EPS

(a) Profitsafter tax
Interestpaid on newdebt =0.05 ×$5m=$250,000
$000s
RevisedPBIT(3,500×1.1) 3,850
Revisedinterest(250+250) 500
RevisedPBT 3,350
Tax(30%) 1,005
RevisedPAT 2,345
G
(b) Financialgearing H
Financialgearing=Priorcharge capital/Equityshare capital

$000s
RevisedPAT 2,345
Preferencedividend(0.06×1,250) 75
Revisedearnings 2,270
Ordinarydividend(425×1.04) 442
Retainedearnings(2,270– 442) 1,828
Revisedequity(13,750+1,828) 5,578
Revisedpriorcharge capital (3,750+5,000) 8,750
Newgearing=8,750/15,578=56.2%
Thecurrentfinancialgearingof GoodtimesCo is around 50%((55– 27.3)/55)lessthan the
sectoraverage.Afterthe bond issue,it ispredictedto be only2%((56.2- 55)/55)morethan
the sectoraverage.Thisincreasein,and levelof,financialgearingis unlikelyto be of concern
to investorsand the stockmarketespeciallyas ifthe companycontinuesto growat 10%per
annum,financialgearingwillgraduallyreduceas the proportionof debt to equityfalls.
(c) Earningsper share (EPS)
EPS=Profitattributableto ordinaryshareholders/Numberof ordinaryshares
EPSafter one year =[2345- (6%×1,250)]/2,500=0.908=90.8cents per share
EPShas risenwhichis likelyto be welcomedby investors,especiallyas the increasedriskdue
to extradebt beingtakenon appears to be manageable.
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Inconclusion,the plan is likelyto havea positiveimpact on the company’sfinancialposition.
Activity3: M&M
Thecorrectansweris:Traditionaltheoryand Modiglianiand Miller(withtax)
Withthe increaseingearingthe traditionaltheoryand allof M&M’stheoriessuggestedthat the
cost of equitywouldrise.Onlythe traditionaltheoryand M&M(withtax)suggestedthat the
WACCwouldpotentiallyfallifgearingwas increased.
Activity4: Calculating an asset beta

0.882
[ Ve [ (Ve+ Vd(1−T))]
Vd(1−T) βd ]
βa = βe +
(Ve+ Vd(1−T))
Assetbeta =1.5×(1/1.7)= 0.882
Thisreflectsthe riskof Thirté’sbusiness.
Activity5: Re-gearing the asset beta

0.944
] Vd[
(1−T))+ ](Ve
[(VeVd(1−T)
βa = Ve βe + βd
+ Vd(1−T))
0.882=equitybeta ×(10/10.7)
Sothe equitybeta =0.882/0.9346=0.944
Activity6: Calculating a project specific cost of equity

G 11.55% H
E(ri) =Rf+β(E(Rm)- Rf)

Ke=4 +(0.944×8) =11.55%
Activity7: Calculating a project specific cost of equity

Calculationas follows:
Step 1 Betaof recruitmentcompany=1.8
Ungear
Ba=1.8×(1/1.7)= 1.059
Step 2 Regear
Be=1.059/(2/2.7)= 1.430
Step 3 Ke=4 +(8)1.43=15.44%.Thisreflectsthe newscenario– that CompanyBdoes have
debt financeand that it is investingina newbusinessarea. Inotherwords,it reflectsthe
financialriskand businessriskof the investment.
Note.TheWACC=(15.44%×2/3) +(4%×0.7×1/3)=11.23%(but thisis not examinable).
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G H
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Skills checkpoint 3
Sources of finance and
WACC – handling
complex calculations
Chapter overview
msuccess
Exa skills
werplanning
Ans
Co
ion Specific
FM skills r
m
r
at ofrerect
fo qu inte
gin Technique
to forinvestment em
Approach
ir rp
gn
i objective
test appraisal enreta
a (OT)
questions calculations ts tio
an
M n
How
to Handling
G approach
oo your
FM complex sis
d exam calculations lny
a
tim Effective a
em discussion al
c
i
G H
an ofkey mer
ag financial
topics u
em n
ent nt
ie
c
Effi
Effectiv ting
ewri
andpresentation
Introduction
Thefinancingdecision(sectionEof the syllabus)isa keypart of FinancialManagement.In
sectionC of the examyou may be askedto adviseon the appropriatenessand cost of different
sourcesof finance.
Calculatingthe weightedaveragecost of capital (WACC)is a popularquestioninsectionC of the
FMexam.Itcan be challengingat first,but mostof the formulaeyou’llneed willbe giveninthe
exam.
Youcouldalso be askedto calculatea marginalcost of capital whichshouldbe used to evaluate
investmentswhereriskis changingand so the use of the WACCis not appropriate.Thiscould
involveungearingand re-gearingbeta factorswhichis a technicalarea of the syllabusand
involvessomecomplexcalculations.
Giventhe complexnature of these calculationit is importantthat you approach the questionina
practicaland time-efficientway. Usinga standard layoutand makinggood use of the
spreadsheetformulaeavailableinthe examis criticalto successfullytacklingthese calculations.
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Skills checkpoint 3: Handling complex calculations
FM Skill: Sources of finance and WACC – handling complex

calculations
Thekeystepsinapplying
thisskillareoutlinedbelow
andwillbeexplained
inmoredetailinthe
following
sections
asthepastexamquestion ‘NNCo’isanswered.
STEP1:Understanding thedatainthequestion
Where aquestionincludesasignificant
amount ofdata, readtherequirements
carefully
tomake sure thatyouunderstand clearly
whatthequestion isasking
youtodo.Youcanusethehighlighting functiontopulloutimportantdatafrom
thequestion.
Usethedataprovided tothink aboutwhat formula
youwillneedto
use.Forexampleifyouaregiven abetafactor youwilluseCAPMtocalculate the
costofequity;
ifyouaregiven adividendgrowth rateitwillbethedividend
growthmodel.Ifthequestionstatesthatthedebtisredeemable, youwillneedto
usetheIRRformula tocalculate
thecostofdebt.
STEP2:Useastandard proformaworking.
Forexample,
ifyouareaskedtocalculate
theWACC,useyour
standard
proforma
orapproach
forcalculating
WACCandseparatelyworkthrough
theindividual
parts
ofthecalculation
(Ke,Kd,Ve,Vd).
STEP3:Usespreadsheet
formulae
toperform
basiccalculations.
Donotwrite
outyour
workings;
thiswastes
Use
G
thespreadsheet
formulae
instead! H
Exam success skills

Thefollowing
question isanextract froma pastexamquestion; thisextractwasworth 10marks.
Forthisquestion,
wewillalsofocusonthefollowing examsuccess skills:
• Managing information.Itiseasyfortheamount ofinformationcontained ina sectionC
questiontofeelover-whelming. Activereading isa useful
technique tousetoavoidthis.This
involves
focusing ontherequirement first,onthebasisthatuntilyouhavedonethisthedetail
inthequestion willhavelittlemeaning.Thisisespecially
important incostofcapitalquestions
where thereislikelytobea highlevelofnumerical content.
• Correctinterpretationofrequirements. Therequirements clearlyaskfortwoseparate
calculations.Theafter-tax costofdebtandtheaftertaxWACC.Thecostofdebtwillbe
needed tocomplete theWACCcalculation.
• Efficient
numerical analysis. Thekeytosuccess hereisapplying a sensible
proforma for
typicalWACCcalculations, backed upbyclear,referenced, workings whereverneeded.
Working through thenumerical dataina logicalmanner willensure thatyoustayfocused.
• Goodtimemanagement. Complete alltasksinthetimeavailable.
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Skill activity
1 Where
STEP aquestion
includes
asignificant
amountofdata,readtherequirements
carefully
tomakesurethat
youunderstandclearly
whatthequestion
isasking
youtodo.
Inthisquestion,
therequirement
istocalculate
acostofdebtandaweighted average
costofcapital,
so
youknow thatyouwillneed
tocalculate
thecostof,andmarketvalue
of,various
typesoffinance;
thiswill
helpyoutounderstandwhycertain
information
hasbeenprovided.
Youcanusethehighlighting
function
topulloutimportant
datafromthequestion.
$m $m $m
Assets
Non-current
assets 101
Current
assets
Inventory 11
Trade
receivables 21
Cash 10
42
Totalassets 143
Ordinarysharecapital 50
Preference
sharecapital 25
Retained
earnings 19
G H
Totalequity 94
Non-current
liabilities
Long-term
borrowings 20
Current
liabilities
Trade
payables 22
Otherpayables 7
Totalcurrent
liabilities 29
Totalliabilities 49
Totalequityandliabilities 143
Skills
Checkpoint
3:Sources
offinance
andWACC
– handling
complex
calculations
269
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NNCo has a cost of equityof 12%.7 7Thecostofequity(Ke)
isgiven.
Theordinaryshares of the companyhavea nominal
valueof $0.50per share8 and an exdivmarketvalueof 8There
are100million
ordinary
shares
$8.30per share.9 ($50m/$0.50)
Thelong-termborrowingsof NNCo consistof 7%10 9Themarket

valueofequity(Ve)=100m
bonds that are redeemable11in6 years’timeat their x$8.30=$830m
nominalvalueof $100per bond. Thecurrentexinterest
marketpriceof the bonds is $103.50.12 10Interestononebondis$7
Thepreference13shares of NNCo havea nominalvalue 11UsetheIRRfunction

tocalculate
the
costofdebt(kd)
of14$0.50per share and pay an annual dividendof
8%.15Theexdivmarketvalueof the preferenceshares is 12TheMVofdebt(Vd)=
$20m/$100
x
$0.6716per share. $103.50
=$20.7m
NNCo pays profittax at an annual rate of 25%per
13There
isa thirdsourceoffinance!
year.
14There
are50million
preference
Required shares($25m/$0.50)
(a)Calculatethe after-tax cost of debt of NNCo.
(4 marks) 15Dividend
=8%x$0.50=$0.04
Required 16Themarket
valueofpreference
shares
G
(Vp)
=0.67x50=33.5 H
(b)Calculatethe weightedaverageafter-tax cost of

capital of NNCo.
(6 marks)
2 Usea standardproformaworking.
STEP Forexample,ifyouareaskedtocalculatetheWACCuseyourstandard
proformaforcalculatingWACCandseparatelyworkthroughtheindividualpartsofthecalculation(Ke,Kd,
Ve,Vd).
Thereare three sourcesof financeinthisquestionso the basic WACCformulaprovidedinthe
examcannot be used (althoughit couldbe adapted).
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Insteadit wouldmakesense to use the followingproforma/approachto calculateWACC.
C6 fx =100*8.3
A B C D E
1
2 WACC CalculaƟon Cost Marketvalue Weightedcost
3 Typeoffinance % $m % (BxD)
4 Ordinaryshares 12 830 0.94 11.3
5 Preferenceshares(W1) 6 33.5 0.04 0.2
6 Redeemable bonds(parta) 4.6 20.7 0.02 0.1
7 884.2 11.6
8
9
10
11 W1- Preferenceshares
12
13 Do 0.04
14 Po 0.67
15 Kpref 6%
16
3 Usespreadsheetformulaetoperformbasiccalculations.
STEP Donotwriteoutyourworkings,
thiswastestime
andyoumaymakea mistake.Usethespreadsheetthespreadsheetformulaeinstead!
Simplespreadsheetformulaeare used to calculatethe MVof each sourceof financeand to
weightthose valuesagainst the cost of each type of finance.
D6 fx =C4/C7
G H
A B C D E
1
2 WACC CalculaƟon Cost Marketvalue Weightedcost
3 Typeoffinance % $m % (BxD)
4 Ordinaryshares 12 830 0.94 11.3
5 Preferenceshares(W1) 6 33.5 0.04 0.2
6 Redeemable bonds(parta) 4.6 20.7 0.02 0.1
7 884.2 11.6
8
9
10
TheIRRspreadsheetfunctioncan be used to calculatethe cost of debt.
Skills
Checkpoint
3:SourcesoffinanceandWACC
– handling
complex
calculations271
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B26 fx =IRR(B19:B25)
A B C D
16
17 Costof debt calculaƟon
18
19 0 -103.5
20 1 5.25
21 2 5.25
22 3 5.25
23 4 5.25
24 5 5.25
25 6 105.25
26 ofdebt 4.6%Cost
27
28
Everytimeyou completea question,use the diagnosticbelowto assess howeffectivelyyou

demonstratedthe examsuccessskillsinansweringthe question.Thetable has been completed
belowforthe ‘NN’activityto giveyou an idea of howto completethe diagnostic.
Exam success skills Your reflections/observations
Managinginformation Thereis a significantamountof numericaldata providedin
thisquestion.
G H
Didyou note that there are 3 sourcesof financeand therefore

the basic WACCformulaprovidedinthe examcannot be
used?
Didyou identifythe correctnumberof shares?
Didyou note the marketvalueof each instrument?
Correct interpretationof Youneed to calculatethe post-taxcost of debt and the post-
requirements tax WACC.
Didyou rememberto account fortax?
Efficientnumericalanalysis Didyouranswerpresenta neat WACCcalculationina format
that wouldhavebeen easy fora markerto follow?
Good timemanagement Didyou manage yourtimeto ensureyou tackledallworkings
and completedboth requirementsinthe timeavailable?
Mostimportantaction pointsto apply to yournext question
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Summary
SectionC of the FMexamcouldcontaina questionthat focuseson businessfinanceand asks you

to performan WACCcalculation.
Thisis an importantarea to reviseand to ensurethat you understanddata presentedinthe
questionand use it to prepare a WACCcalculation.
Itis also importantto be aware that inthe examyou are dealingwithdetailedcalculationsunder
timedexamconditionsand timemanagementis absolutelycrucial.Youthereforeneed to ensure
that you:
• Interpretthe data giveninthe questioncorrectly
• Usea clear,standard WACClayout.
• Usespreadsheetformulato performbasic calculations.
• Showclearworkings
Rememberthat there are no optionalquestionsinthe FMexamand that thissyllabussection
(sectionE:BusinessFinance)willdefinitelybe tested!
G H
Skills
Checkpoint
3:SourcesoffinanceandWACC
– handling
complex
calculations273
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G H
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13
Business valuations
13
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
• Natureandpurpose ofthevaluationofbusiness
and
financial
assets
- Identifyanddiscuss reasonsforvaluing
business
and F1(a)
financial
assets
- Identifyinformation
requirementsforvaluation
and F1(b)
discuss
thelimitationsofdifferent
typesofinformation
Modelsforthevaluationofshares
G
• Discussandapplyasset-based valuation
modelsincluding: F2(a) H
- Netbookvalue(statement offinancial
position)
basis
- Netrealisablevaluebasis
- Netreplacement costbasis
• Discussandapplyincome-based valuation
models
including:
- Price/earningsratiomethod F2(b)
- Earnings yieldmethod
• Discussandapplycashflow-based valuation
models
including:
- Dividend valuationmodelandthedividend growthmodel F2(c)
- Discounted cashflowbasis
• Thevaluation
ofdebtandotherfinancial
assets.
Discuss
and F3(a)
applyappropriate
valuation
methodsto:irredeemable
debt,
redeemable
debt,convertible
debt,preferenceshares
• EMHandpractical considerations
inthevaluationofshares
- Distinguishbetween weak,semi-strongandstrongform
efficiency
- Discuss practical
considerations,
including:
marketabilityF4(a)
&liquidityofshares,availability
&sourcesofinformation,
market imperfections&pricing
anomalies andmarket F4(b)
capitalisation.
- Describe thesignificance
ofinvestor speculation
andthe
explanationsofinvestor
decisions offered
bybehavioural
finance. F4(c)
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13
Exam context
Thischapter coversSectionF of the syllabus(BusinessValuations).Thissyllabusarea is
examinableinthe OTQsectionsof the exam(sectionsAand B)and commonlyformsthe central
themeof one of the (10mark)SectionBquestions.
Itis also possibleforthissyllabusarea to be touchedon as a part of a SectionC question.
G H
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13
Chapter overview
Businessvaluations
Reasonsfor Assets
basis
business
valuations
Net
book
value Replacement
cost
Realisable
value Drawbacks
Income Cashflow Valuing

other Market
basis basis securities efficiency
Earnings Dividend
valuation Valuing
debt
and Types
ofmarket
method preference
shares efficiency
P/Emethod
DCFmethod Levels
ofmarket
G
efficiency H
Drawbacks
Behavioural
finance
Earnings
yield
13:Business
valuations
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1 Reasons for business valuations
1.1 When share valuations are required

Anestimateof the valuationof a share willtypicallybe requiredifan investoris consideringthe
purchase or sale of a share, or inotherscenariossuch as wherea share isbeingused as
collateralfor a loan.
Sharesare valuedby stockexchanges,so an independentshare valuationwillnot alwaysbe
required,but may be necessary if:
(a) Ifthe companyis unquoted.
(b) Ifthe stockmarketdoes not valueshares accurately (ieit is not efficientintermsof the
efficientmarketshypothesis,coveredlater inthischapter).
(c) Ifthere is a takeoverbid and the valueof the companybeingbought willchange underthe
managementof the newowner.
Takeover:Theacquisitionby a companyof a controllinginterestinthe votingshare capital of

KEY another company, usuallyachievedby the purchaseof a majorityof the votingshares.
TERM
Marketcapitalisation:Thetotal valueof allthe shares ina company.
1.1.1 Other reasons for valuations

Inaddition,a part of a businessmay need to be valuedbecause a companyis negotiatingthe
sale of a part of its businessto a managementbuyoutteam or to an externalbuyer.
1.2 Methods of business valuation
Ifan independentvaluationis needed, it willoftenbe helpfulto use a range of techniquesinorder
to create a range of valueswithinwhicha buyer(orseller)willbe prepared to negotiate.
G
Thereare severaldifferentmethodsof valuinga business.Eachof the methodsgivedifferent H
values,and are suitableindifferentsituations.

Max Valuethecashflowsorearnings(oftenundernewownership)
Valuethedividends(oftenundertheexistingmanagement)
Min Valuetheassetsusingthenetbookvalueorrealisablevalueapproaches
Essential reading
SeeChapter 13Section1of the Essentialreading,availableinthe digitaleditionof the Workbook,

2 Assets basis (also called net asset value basis)
Asan alternativeto sellinga businessas a goingconcernits ownerscouldsellthe assets and use

the fundsto repay its creditors;any surplus(iethe net asset value)wouldthen belongto the
shareholders.
Thenet asset valueapproach normallyrepresentsthe minimumamount that shareholderswill
accept ifthey are sellingthe business.
Assetvaluationmethodsare mostusefulifa businessderivesmostits valuefromits assets (egits
mainbusinessis investinginproperty),or ifit is tryingto establishthe lowestpricethat it would
findacceptable forits shares.
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Thenet asset valuation(NAV)approach can involvethe valuationof assets inthree differentways:
net bookvalue,realisablevalueor replacementvalue.
2.1 Net book value (historic) basis
Usingthe net bookvaluemethodof valuation,the valueof a share is calculatedas the valueof
net assets dividedby the numberof shares.
Netassets are the valueinthe statementof financialpositionof:
non-currentassets (net of depreciation)
+currentassets
– all liabilities.
Intangibleassets that are not recognisedin the statement of financialpositionare ignoredby
thismethod(includingworkforceskills,customerrelationships).
Activity 1: Assets basis
GroadyCo wantsto buy another company, BergerboCo, whichoperates inthe same industry.
BergerboCo has non-currentassets inits statementof financialpositionof $50.5mand net
currentassets of $12.3m.Theequityand liabilitiesof BergerboCo are as follows.
$m
Ordinaryshares ($100par value) 10.4
Reserves 19.3
Medium-and long-termbank loans 33.1
62.8
G H
Required
Whatis the net asset valueof Bergerbo?
 $10.4m
 $62.8m
 $29.7m
 $50.5m
Solution
2.2 Realisable asset values

Thismethodworksinthe same wayexceptthat it adjusts the bookvalueof the assets to reflect
theirmarketvalueand is thereforea moreaccurate wayof assessingthe net asset valueinthe
eventof a liquidation.
Anyadjustmentsthat are requiredwouldbe stated in an examquestion.
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Forexample:
• youmaybeaskedtoadjustforinventory
beingovervalued
byx%
• orthemarket
valueofnon-current
assetsmaybegiven.
2.3 Replacement cost
Thistakesa different
perspective
totheprevious twomethods.
Ifa potential
buyerofa company canestimate thereplacement costoftheassetsofthetarget
company (iethecostofacquiringitsseparateassetsontheopenmarket), thenitcanestimate
themaximum itshouldpayforthetargetcompany.
Inreality,
replacement costsaredifficult
toestimate andthisbasisalsoignores
thedifficulty
and
costofcreating theintangible
assetsofa targetcompany (egitsbrandname).
Again,anyadjustments thatarerequiredwould bestatedinanexamquestion.
2.4 Disadvantages of the asset-based approach
Asset-based
methodsignoresthevalueofintangible
assetsandthevalueoffuture
profits.
Asset-based
methodsareespecially
limited
intheiruseinvaluing
service
companies,whichoften
operate
witha lowtangible
assetbase(eganaccountancy practice).
3 Income (or earnings) bases
These
approachesusethecurrentearnings
ortheprospective
earnings
ofa business
under
new
ownership
asthebasisforvaluing
a business.
There
aretwoincome-based valuation
methods:theP/Emethod,
andtheearnings
yieldmethod.
3.1 P/E method
G TheP/Eratio(introduced
inChapter 1)indicates
themarket’s
assessment
ofa company’s
(ora H
sector’s)
futurecashflowsandrisk.
Expectations
ofhighfuture
growth Lowrisk
ahighprice
isbeing
paidfor alowriskcompany(lowbusiness
orfinancial
risk)
future
profit
prospects would bevaluedonahigher
P/Eratio
HighP/E
ratio
TheP/Eratioproduces
anearnings-based
valuation
ofshares
bytakingthelatestearnings
ofthe
targetandmultiplying
byanappropriate
P/Eratio.
Income-based
value
= earnings
oftarget
× appropriate
P/Eratio
Shows
thecurrent
profitability Reflects
thegrowth
prospects/risk
ofthecompany ofacompany
Note.IfEPSisusedinthiscalculation
thisgivesthevalueofanindividual
share.
Examfocus point
TheACCAexamining teamhascommented inthepastthatstudents
oftencalculate
earnings
pershareincorrectly.
Remember thatearnings
arecalculated
asprofits
afterinterest
andtax
andanypreferencedividends
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Activity2: P/E method
GroadyCo(fromactivity
1)wantstobuyanother company, Bergerbo
Co,whichoperates
inthe
sameindustry.
Thestatement
ofprofit
orlossforBergerbo
fortheyearjustendedisasfollows.
$m
PBIT 5.8
Interest
expense 2.3
Taxable
profit 3.5
Taxation
(25%) 0.9
Profit
aftertax 2.6
Ordinarydividend 2.0
Groady’s
P/Eiscurrently
21.2,whilst
theindustry
average
is19.5.
Required
Whatistheearnings
valuation
forBergerbo
basedontheassumption
thatitwillperform
aswell
asGroadyintermsofearnings?
 $55.1m
 $50.7m
 $74.2m
 $66.5m
G
Solution H
3.2 Problems with P/E method

• ChoiceofwhichP/Eratiotouse
TheP/Eratiousedshould reflect
thebusiness andfinancialrisk(iecapitalstructure)ofthe
company thatisbeingvalued. Thisisquitedifficult
toestimate inpractice.
Also,theP/Eratiowillnormallybereduced ifthecompany thatisbeingvalued isunlisted.
Listedcompanieshavea higher value,mainly duetothegreater easeinselling
shares ina listed
company. TheP/Eratioofanunlisted company’s shares
willbe30%–50% lower compared tothe
P/Eratioofa similar
publiccompany.
• Earnings calculation
Theearnings ofthetargetcompany mayneedtobeadjusted ifitincludes
one-off items thatwill
tendnottorecur.
Historic
earningswillnotreflect
thepotentialfuture synergies
(iecostsavingsorrevenue
increases)
thatmayarisefromanacquisition. Earnings mayneedtobeadjusted toreflectsuch
synergies.
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Finally,the latest earningsfiguresmighthavebeen manipulatedupwardsby the target company
ifit has been lookingto be boughtby another company.
• Stockmarketefficiency
Stockmarketpricesmay not be efficientbecause they are affected by psychologicalfactors(see
behaviouralfinancelater inthischapter),so P/Eratiosmay be distortedby swingsinmarket
sentiment.
3.3 Earnings yield method
Theearningsyieldmethodproducesan income-basedvaluationof shares by takingthe latest
earningsof the target and dividingby earningsyield(definedas earnings/ share price).
Thisis the same approach as the P/Emethodbut uses differentterminology.
Income-basedvalue=earningsof target ÷earningsyield
Inthe previousactivity,the P/Eratioof 21.2was used, so the earningsyieldwouldbe 1÷21.2 =
0.0472or 4.72%.
Themarketvalueof Bergerbo’sshares can thereforebe calculatedas earningsdividedby
earningsyieldie 2.6 / 0.0472=$55.1m.Thisis the same valueobtained by the P/Emethod.
4 Cash flow basis
Theseapproaches use a discountedcash flowapproach to establishthe presentvalueof a

companyeitherin$mor per share. Thereare twocash flow-basedvaluationmethods:the
dividendvaluationmethod,and the DCFmethod.
4.1 Dividend valuation method (DVM)
Thevalueof a share is calculatedas the presentvalueof the futuredividendsthat are being
generated by the currentmanagementteam. Thismethodis suitableforvaluinga minority
G
interestinthe shares of a company, because it ignoresforecastsynergiesarisingfroma takeover. H
Formula provided
Valueper share =
Po = D0(1+ g)
(re−g)
d0=dividendpaid now
re=cost of equityof the target
g =annual growthrate individends
InChapter 11wedemonstratedhowto estimate‘g’,usinghistoricgrowthor the reinvestment
approach, inthe contextof the dividendgrowthmodelforestimatingthe cost of equity.
Activity 3: Dividend valuation model
GroadyCo (fromactivities1and 2) wantsto buy another company, BergerboCo, whichoperates

inthe same industry.
Bergerbo’sstatementof profitor lossforthe year justended is as follows:
$m
PBIT 5.8
Interestexpense 2.3
Taxableprofit 3.5
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$m
Taxation
(25%) 0.9
Profit
aftertax 2.6
Ordinarydividend 2.0
Thereareconflicting
views onBergerbo’s
futuredividend
growth
potential;
someanalyststhink
thatthedividendwillnotgrowfortheforeseeable
future,
others
estimate
thatthedividend
growth
ratewillbebetween3%and5%p.a.
Bergerbo’scostofequityisestimated
at7.6%.
Required
1 Whatisthedividend
valuation
forBergerbo
assuming
zerodividend
growth
fortheforeseeable
future?
 $26.3m
 $0.152m
 $34.2m
 $7.9m
2 Whatisthedividend
valuation
forBergerbo
assuming
3%dividend
growth
fortheforeseeable
future?
 $43.48m
 $44.78m
 $0.092m
 $13.43m
G H
Solution
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4.1.1 Disadvantages ofthesimpledividendvaluationmodel
(a) Itisdifficult
toestimatefuturedividend
growth.
(b) Itisinaccurate toassume thatgrowthwillbeconstant
(butseesection
4.1.2)
(c) Itcreates zerovaluesforzerodividend
companies.
(d) Itcreates negativevaluesforhighgrowthcompaniesieifg > re
4.1.2 Non-constant
growth
TheDVMformula
canbeadapted
tovaluedividends
thatareforecast
togothrough
twophases:
Phase1(eg next3 years) Phase2 (eg year 4 onwards)
• Growth
isforecastatan • Growth
returns
toa constant
rate
unusually
high(orlow)rate
Usea normalNPVapproach to 1. Usetheformula
toassesstheNPVoftheconstant
calculate
thepresent
valueofthe growthphase,however
thetimeperiods
needtobe
dividends
inthisphase. adaptedeg:
Po = D0(1+ g)
(re−g)
isadapted
to
P3 = D3(1+ g)
(re−g)
2. Thenadjust thevaluegivenabovebydiscounting
backtoa present value(hereusinga T3discountrate
becausethefirstcashflowbeingassessed isintime4).
G
Illustration1:Dividendvaluationmodeland non-constantgrowth H
Usingtheinformation
fromtheprevious
activity,
calculatethedividend
valuation
tothenearest
$mforBergerboassuming5%dividend
growthfor3 yearsand3%thereafter.
Solution
Time 1 2 3 4 onwards
Expected
dividend
($2m) 2.1 2.205 2.315 2.384
Perpetuity
factor(1/(0.076
– 0.03)) 21.739
DF@7.6% 0.929 0.864 0.803 0.803
Present
value 1.951 1.905 1.859 41.616
Dividend
valuation 47.29ie$47mtothenearest
$m.
4.2 Discounted cash flow (DCF) method

Thevalueofa shareiscalculated
asthepresentvalueofthefuture
cashflowsthatwillbe
generatedbythenewmanagement team.Itincludes
forecastsynergies.
Thismethodissuitable
forvaluing
a controlling
interest
inthesharesofa company,where the
ownercanacttochangetheprofitability
ofa company.
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Thestepsinthismethodofvaluation
are:
Step1 Estimate thecashflowsthatwillbeobtained
eachyearfromtheacquired business.
Step2 Discount thesecashflowsatanappropriatecostofcapital.Thecostofcapitalthatis
usedshould beconsistent
withthecashflowestimates;
thismeans thatoneoftwo
approaches mayberequired:
Approach1 Approach2
Cashflowsareafterinterest
payments Cashflowsarebeforeinterest
andaftertax
andaftertax(representing
returns
to (representing
returns
toordinaryshareholders
ordinary
shareholders) andalsodebtholders)
Discount
atthecostofequitytocalculate Discountattheoverallweightedaveragecostof
thepresent
valueoftheequity(ie capitaltocalculate
thepresentvalueofthe
ordinary)
shares company (ieordinary
sharesplusdebt)
• Thisvaluewillbeusediffora valuation
ofthe
whole company (egiftheproposal
istobuy
theentire business,
including
thedebt)
• Ifonlytheequityneedstobevalued thenthe
valueofdebtwillthenneedtobededucted to
calculate thevalueofequity
Activity4: DCF method
Diversification
wishestomakea bidforTadpole.
Tadpole
makes after-tax
profits
of$40,000a
year.Diversification
believes
thatiffurther
money
isspentonadditional
investments,
theafter-tax
(andinterest)
cashflows(ignoring
thepurchase
consideration)
couldbeasfollows.
Time Cashflow(netoftaxandinterest)
in$
G H
0 (100,000)
1 (80,000)
2 60,000
3 100,000
4 150,000
5 150,000
ThecostofequityofDiversification
is15%,andtheWACCis10%;thecompany
expects
allits
investments
topayback,indiscountedterms,
within
fiveyears.
Required
1 Whatisthemaximum
pricethatDiversification
should
bewilling
topayfortheshares
of
Tadpole?
2 Whatisthemaximum pricethatDiversification
should
bewilling
topayforthesharesof
Tadpoleifitdecides
tovaluethebusinessonthebasisofitscashflowsinperpetuity,
and
annualcashflowsfromYear6 onwards areexpectedtobe$120,000?
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Solution
Activity5: Furtherpractice: SectionB example
Thefollowing
scenario relates
toquestionsa-e
MathildaCoisa listed
company whichisseenasa potential
targetforacquisition
byfinancial
analysts.
Thevalueofthecompany hasthereforebeena matter
ofpublicdebate inrecent
weeks
andthefollowingfinancial
information
isavailable:
Year 20X4 20X3 20X2 20X1
Profit
aftertax($m) 25.3 24.3 22.3 21.3
Totaldividends
($m) 15.0 14.0 13.0 2.5
Statement
offinancial
position
information
for20X4:
$m $m
G H
Non-current
assets 227.5
Current
assets
Inventory 9.5
Trade
receivables 11.3 20.8
Totalassets 248.3
Equityfinance
Ordinary shares 50.0
Reserves 118.0 168.0
Non-current
liabilities
8%loannotes 62.5
Current
liabilities 17.8
Totalfinancing 248.3
ThesharesofMathildaCohavea nominal valueof50cpershareanda marketvalueof$10.00
pershare.
ThebusinesssectorofMathildaCohasanaverage price/earnings
ratioof16times.
Theexpectednetrealisable
valuesofthenon-currentassetsandtheinventory
are$215.0m and
$10.5m,
respectively.
Intheeventofliquidation,
only90%ofthetradereceivables
areexpected
to
becollectible.
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Required
1 Whatis the valueof MathildaCo usingmarketcapitalisation?
 $50m
 $250m
 $500m
 $1,000m
2 Whatis the valueof MathildaCo usingthe net asset valueon a liquidationbasis?
 $147.20m
 $155.37m
 $217.87m
 $248.30m
3 Whatis the valueof MathildaCo usingthe price/earningsratiomethod(businesssector
averageprice/earningsratio)?
 $269.87m
 $404.8m
 $155.37m
 $240m
4 Whatis the geometricaveragehistoricdividendgrowthrate forMathildaCo?
 4.66%
 5.90%
 6.27%
G
 35.72% H
5 Whichof the followingstatementsare problemsinusingthe price/earningsratioto valuea

company?
(1) Itcan be difficultto finda quoted companywitha similarrange of activities.
(2) Asingleyear’sP/Eratiomay not be representative
(3) Itis the reciprocalof the earningsyield
(4) Itcombinesstockmarketinformationwithcorporateinformation
 (1)and (2)only
 (3)and (4)only
 (1),(3)and (4)only
 (1),(2),(3)and (4)
Solution
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G H
5 Valuation of other securities

Discountedcashflowtechniquescanbeusedtovalueothersecurities including
irredeemable
debt,redeemabledebt,convertible
debtandpreference shares.
Because wearevaluingthesesecurities
fromtheviewpoint ofinvestors
anytaxreliefdueon
interest
paymentsisignoredsothecashflowsandtherequired yieldshouldbothbepre-tax.
Forconvertible
debtandredeemable debt,theDCFshould includetheinterest
receivedduring
thetermofthedebtplustheamount receivedatredemption.
Forirredeemable
debtandpreference sharesthecashflowscanbetreated asbeingreceived
into
perpetuity.
Inthecasethepresent valueiscalculated
as:
Cashreceived×(1/required
return)
Activity6: Valuingothersecurities
Groadyhas7%loannoteswhichareredeemable
attheirparvalueof$100in3 years’time.
Alternatively,
eachloannotecanbeconverted
into25sharesin3 years’time.Thesharepriceis
currently
$4.50andisexpected
togrowat5%p.a.
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Groady’sbond has a yieldof 6%.
Required
1 Calculatethe marketvalueof thisconvertibleloannote.
2 Calculatethe floorvalue(ieits valueifthe loannote was not convertedintoshares).
3 Calculatethe valueof the 7%loannote ifit had been irredeemable.
Solution
G H
Essential reading
SeeChapter 13Section2 of the EssentialReading,availableinthe digitaleditionof the Workbook,

6 The efficient market hypothesis
Theefficientmarkethypothesis:Arationaleforexplaininghowshare pricesreact to new

KEY informationabout a company, and whenany such change inshare priceoccurs.Stockmarket
TERM reactionto newinformationdepends on the strengthof the stockmarket’sefficiency.
6.1 Types of market efficiency

Threedifferenttypes of efficiencycan be distinguishedinthe contextof the operationof financial
markets.
6.1.1 Allocative efficiency
Thisrefersto the abilityof a financialmarketto direct funds to those organisations(borrowers)
whichcan use themmostprofitably.
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6.1.2 Operational efficiency
Operationalefficiencydescribesthe abilityof a financialmarketto operate withminimal
transaction costs.
6.1.3 Information processing (or pricing) efficiency
Themarketpriceforsecuritiesreflectsall the relevantand availableinformationrelatingto the
securitiesand the companywhichissuedthem.
6.2 Levels of market efficiency
Capitalmarketscan potentiallydisplaythree varyinglevelsof informationprocessingefficiency.
Levels of Definition / Implication(s)
efficiency explanation
Zeroefficiency Sharepricesfailto Sharepriceswillregularlybe mis-pricedand
reflecta widerange of investorscan makeexcessprofitsoverthe long-
factorsthat should termby studyingthe marketto spot over-or
impacton the share under-pricedshares
price. eg by analysingpast share pricemovements
(thisis calledChartism,or technicalanalysis).
Weakform Sharepricesreflect Iftrue, investorscan’t makeexcessprofitsover
historicalinformation the long-termby studyingpast share price
includinginformation movements.
about past share price Sharepricesmovedue to the unpredictable
movements. arrivalof favourableand unfavourable
information,because thisinformationcannot
be predictedshare pricesare said to followa
‘randomwalk’.Thisis calledrandomwalk
theory.
G H
However,investorscan makeexcessprofitsby
analysingany newinformationand reactingto
it quickerthan the stockmarketdoes.Thisis
because a weak-formefficientmarketis not
quickat respondingto newinformationcoming
intothe publicdomainthat shouldaffect share
prices.
Semi-strongform Inadditionto historical Here,professionalinvestorscan’tbeat the
information,share price marketinthe longterm eitherby analysing
movementsalso reflect past pricepatterns (as forweakform
all publiclyavailable efficiency)or by analysingthe implicationsof
informationquicklyand newpubliclyavailableinformation.
accurately. Overthe long-terminvestorswillnot be able to
makeaboveaverageprofitsby consistently
identifyingshares that havea fundamental
valuethat is materiallydifferentfromtheir
marketvalue.
Strongform Sharepricesreflectall Inthiscase, share priceswillrespondto new
information,whether developmentsand eventsbeforethey even
publiclyavailableor becomepublicknowledge.
not: Thishappens usinginformationheldprivately
by the directors;in theory directorsare not
allowedto trade shares usingthis information
(thiswouldbe insidertradingand is not legal).
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Moststudiessupport theviewthatthesophisticated markets liketheLondon StockExchange are
semi-strongformefficient.Ifthisisthecase,thentheimplications arethat:
(a) Thesharepriceofa company isthebestbasisfora takeoverbid;a company should
only
paymorethanthemarket priceiftherearesynergies (egextracashflows)arising
froma
takeover.
(b) Thedirectorsshouldtakethecorrect investment/financing/risk
management decisionsand
makethisinformation public(pressrelease,
annual accounts).
Thecentralparadox ofefficient
markets isthatanefficientmarketrequires
people tobelieve
that
themarketisinefficient,
sothattheytradesecurities inanattempt tooutperformthemarket. This
issometimes calledthemarket paradox.
Activity7: EMH
1 Givena strongformefficient
marketwhichofthefollowing
actionsbythedirectors
ofa
company listedonthemarket wouldimpacttheshareprice?
 Window dressing
theaccounts tomakefinancialperformanceappearmoreimpressive
 Releasinginformationrelevant
totheriskiness
oftheorganisation
 Making a decision
tolaunch a newproductwithinnovative
technology
 Increasingthedividendinthecurrent
yeartomakeshareholders moresatisfied
withtheir
investment
2 Sergeyhasdevised aninvestment
strategywherebyshares
willbebought
andsoldbasedon
patterns
discernedfroma graphofpastsharepricemovements.
Whichlevelofefficiency
doesSergeythinkthemarket
has?
 Notefficient
onanylevel
G
 Weakformefficient H
 Semi-strongformefficient
 Strongformefficient
6.3 Practical considerations in the valuation of shares
Marketabilityand Howeasyitistofinda buyerfora share(marketability) andhow

liquidityof shares liquida shareis(howeasyitistoconvert intocashata fairvalue)
will
influence thevalueofa share.
Ingeneral, sharesinlargecompanies arerelatively
easytosell,which
hasa positive impactontheirsharevaluecompared tosmall
companies. Itmaybedifficult
tosellsharesina private
company,
particularlya minority
shareholding,
whichwillhavetheeffectof
lowering thesharevalue.
Availabilityand Ifinvestors
areunable toobtainaccurateinformation
(egifthereare
sourcesof doubts overtheaccuracyofa company’sfinancial
statements)thisis
information likelytoleadtoa dropinthevalueofa shareastheyreactadversely
touncertainty.
Market Varioustypesofanomaly appear tosupporttheviewsthat
imperfectionsand irrationality
oftendrives
thestockmarket, including
calendar
effects
pricinganomalies suchassharepricesoftenfallingatparticular
times
oftheweek(eg
Monday mornings)
andhighreturns oftenoccurring
inparticular
months.
Market Sharesinsmallcompanies
maybeneglected.
Thereturn
from
capitalisation investing
insmaller
companies
hasbeenshown
tobegreater
thanthe
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averagereturnfromallcompaniesinthe longrun.Thisincreased
returnmay compensateforthe greater riskassociatedwithsmaller
companies,or it may be due to a start froma lowerbase reflecting
that they are oftenundervalued.
6.4 Behavioural finance

Behaviouralfinanceis an alternativeviewto the efficientmarkethypothesis.Itattempts to
explainthe marketimplicationsof the psychologicalfactorsbehindinvestordecisionsand
suggeststhat irrationalinvestorbehaviourmay significantlyaffect share pricemovements.
6.4.1 Herding
Anexampleof irrationalbehaviouris the tendencyforinvestorsto followtrends,thiscan lead to
stockmarketbubblesinparticularsectors,or inthe stockmarketas a whole.
6.4.2 Loss-aversion
Someinvestorswillplace undueemphasison avoidingshort-termlosseseveniflong-term
performancelooksstrong.
Essential reading

G H
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Chapter summary
Business valuations
Reasonsfor Assetsbasis
businessvaluations
• Company isunquoted General

aimtoestablish
a Replacement cost
• Stockmarketsdonotvalue minimum
value • Adjust
assetvaluestocostof
sharesaccurately acquiring
ontheopenmarket
• Takeoverbid • Ignoresvalueofintangible
• Saleofa partofa business Netbookvalue assets
Onlyinclude
tangible
asset
values
Drawbacks
Realisable
value • Assetbasedmethods ignore
intangibleassetvaluesand
Adjust
bookvalueofassetsto futureprofits
marketvalues • Especiallylimited
intheir
abilitytovalueservice
companies
Income Cash flow Valuingother Market

basis basis securities efficiency
G
Earnings Dividend
valuation Valuingdebtand Typesofmarket H
Profits
afterinterest,
tax method preferenceshares efficiency
andpreference • Formula
given • Usesa DCFapproach Allocative,
operational
dividends • Dependentongrowth • Ensurecashflows andinformation
estimate anddiscountrateare processing
• Assumesconstant pretax
P/Emethod growth
Earnings
×P/Eratio • Assumesdividends
are Levelsofmarket
paid efficiency
• Canadapttoinclude • Weakform(historic)
Drawbacks twophasesofgrowth • Semi-strong(allpublic
• ChoiceofwhichP/Eto information)
use • Strong(allprivateand
• Calculation
of DCFmethod publicinformation)
earnings • Suitableformajority
• Assumptionofstock shareholders
marketefficiency • Valueequityby Behaviouralfinance
discountingcashflows Irrational
behaviour
aftertaxandinterest (herding,
lossaversion)
Earningsyield atKe
• Earnings/earnings • Valuethewhole
yield company by
• Sameapproach as discountingposttax
P/Ebutdifferent operating
terminology • CashflowsatWACC
(thendeductdebtto
findthevalueof
equity)
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1.Assetbasedmodels
Themainmethods
(netbookvalueandrealisable
value)
establish
a minimum
pricefora share.
2. Income
basedmodels
Mainmodel
istheP/Emodel,
theP/Eratioreflects
theriskandgrowth
potential
ofa business.
3. Dividendgrowthmodel
Thisisbasedona company’s
existing
growth
rateanddividend
policyandistherefore
mainly
usedtovalueminority
stakes.
4. DCFmodel
BecarefultousetheWACCifcashflowsarepre-interest
andthecostofequityifthecashflows
arepostinterest.
5. Stockmarketefficiency
Moststudies
suggest theLondon
Stockmarket
isa semi-strong
formefficient.
G H
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Question practice
the Workbook):
SectionAquestions
Q26,Q30
SectionBquestions
Q34,Q35,Q36(alsorecaps on earlierchapters)
SectionC questions
Q57Basesof valuation(thislongerquestionisto allowfurtherstudy of thisarea, but thischapter
isnot directlyexaminableinSectionC of the real exam).
Further reading
Thereis a usefulTechnicalArticlewrittenby a memberof the FMexaminingteam that is available
on ACCA’swebsite;it is called‘Behaviouralfinance’.Werecommendthat you read thisshort
articleto improveyourunderstandingof thisarea.
G H
13:Business
valuations 295
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q
Activity answers
Activity1:Assets basis
Thecorrectansweris:$29.7m
$62.8m– debt of $33.1m=$29.7m
Butwehaveno informationabout the industry,the nature of the assets or any intangiblevalues.
Activity2: P/E method

Thecorrectansweris:$55.1m
P/Evaluation:21.2×2.6 =$55.1m
Thisuses the P/Eof 21.2on the assumptionthat Bergerboshares Groady’sgrowthprospects.
Activity3: Dividend valuation model

1 Thecorrectansweris:$26.3m
P =2/0.076=26.3m
2 Thecorrectansweris:$44.78m
P =2.06/(0.076- 0.03)=44.78m
Activity4: DCF method

1 $101,910
Themaximumpriceis one whichwouldmakethe returnfromthe total investmentexactly15%
overfiveyears, so that the NPVat 15%wouldbe 0. Itis suitableto use the cost of equity
G
because the cash flowsare after interest. H
Time Cash flows DF(15%) PV

$ $
0 (100,000) 1.000 (100,000)
1 (80,000) 0.870 (69,600)
2 60,000 0.756 45,360
3 100,000 0.658 65,800
4 150,000 0.572 85,800
5 150,000 0.497 74,550
Maximumpurchaseprice:101,910
2 $499,510
Ifthe shares are valuedon the basis of cash flowsinperpetuity,weneed to add the PVof
annual cash flowsfromYear6 onwards.
Thevalueof the cash flowsfromTime6 onwards,inperpetuity,at a Time5 presentvalue=
$120,000/0.15=$800,000.
Discountingthisto a Time0 PV:$800,000 ×0.497=$397,600.
Thisincreasesthe valuationfrom$101,910 to $499,510($101,910
+$397,600).
Thedifferencebetweenthisvaluationand the valuationin(a)is huge.Itmay illustratethat
businessvaluationsdepend cruciallyon the assumptionsthat are used to reach the valuation.
296 Financial
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Activity5: Furtherpractice:SectionB example
1 Thecorrect
answeris:$1,000m
Market
capitalisation
=number ofshares
× market
value.
=($50m/ $0.5)×$10.00=$1,000m
2 Thecorrect
answeris:$155.37m
Thenetrealisable
valueofassetsatliquidation=non-current
assets+ inventory
+trade
receivables
– current
liabilities
– loannotes
=$215m +$10.5m+($11.3m × 90%)– $17.8m– $62.5m
=$155.37m
3 Thecorrectanswer is:$404.8m
Historic
earningsbasedon20X4profit areaftertax=$25.3m
AverageP/Eratioinindustry=16times
Assuming noadjustment required
toP/Eratio(Mathilda
isa listed
company
sononeedto
adjust
fortransferability)
andusinghistoric
earnings:
P/Eratiovalue=16×$25.3m =$404.8m
4 Thecorrect
answer
is:6.27%
Ageometric
averageisthecompoundaverage
growthrate.
Historic
growth
dividendrate=[(15m/12.5m)
1/3
–1]=0.0627=6.27%
5 Thecorrect
answer is:(1)and(2)only
Itcanbedifficult
tofinda quoted company witha similar
rangeofactivities.
Quoted companies areoftendiversified.
G Asingleyear’sP/Eratiomaynotbea goodbasisifearnings arevolatile
orthequoted H
company’ssharepriceisatanabnormal level.
TheP/Eratioisthereciprocal ofearnings
yield(whichisE/P),butthisisnota probleminusing
theP/Eratio.
TheP/Eratiodoescombine stockmarket
information(e.g.thegeneral stateofthemarket)
and
company specificfactors (egforecast
growth),butbotharerelevant forvaluinga business
so
thesearenotproblems.
Activity6: Valuingothersecurities
1 $128.1
Sharepricein3 years’time=4.50×1.05×1.05×1.05=$5.21
25shares× $5.21=$130.25 soconversion
willbepreferred
AssumeinYear3 $7interestisreceived
aswell.
Time 2 3
Cashflow 7 7 137.25
DF@6% 0.943 0.890 0.840
PV 6.6 6.2 115.3
Total$128.1
13:Business
valuations
297
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q
2 $102.7
Time 1 2 3
Cash flow 7 7 107
DF@6% 0.943 0.890 0.840
PV 6.6 6.2 89.9
Total$102.7
3 $116.7
$7×1/r=$7×1/0.06=$116.7
Activity7: EMH
1 Thecorrectansweris:Makinga decisionto launcha newproductwithinnovativetechnology
Ina strongformefficientmarket,the releaseof insiderinformationor informationdesignedto
manipulateshareholdersentimentwillhaveno effect on the share priceas the share pricewill
already reflectthe directors’viewof the company’strue value.
However,makinga decisionon a newproductwillchange the presentvalueof futurecash
flowsand willthereforechange the fundamentalvalueof the company.
2 Thecorrectansweris:Notefficienton any level
Ifthe marketwas efficient(evenweakformefficient)share priceswouldbe based on the
availableinformationrelevantto the individualcompanieslisted.Ifshare pricesare expected
to continueto followpast trends then the marketis not reactingto availableinformation.On a
weakformefficientmarket,those past share pricemovementswouldalready be reflectedin
the share price.
G H
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Skills checkpoint 4
Effective discussion of key
financial topics
Chapter overview
msuccess
Exa skills
sw
An erplanni
ng
n ecific
FM skills Co
tio Sp o rre
a
o
frm freqctin
in u te
n
i
g
Approach
to
objective
a (OT)
questions appraisal
n
a
How
to Handling
G approach complex
o
o
d
your
FM
a
tim Effective an
l
G
em discussion ca H
an
ag
ofkey
financial
topics meri
u
em
ent ntn
ie
c
Effi
Eff
ectiv g
tin
ewri
andpresentati
on
Introduction
Section C oftheFMexamwillcontain twoquestionswhichwillbescenario-based andwillcontain

bothdiscursiveandcomputationalelements.
AkeyskillinSectionC, andonethatcandidates areoftenweakon,isthatofdiscussing and
explainingFinancialManagement conceptsasapplied toa givenscenario.
Thismaybea weakness becausecandidates
preparing forthisexamfocusonpractising
numerical questions,
astheyareeasytomarkbecause theanswer isrightorwrong, whereas
written questions
aremoresubjective.
Evenwhenattempting writtenquestions,
itistempting to
writea briefanswerplanandthenlookattheanswer rather thanwritinga fullanswer toplan.
However, unlessyoupractisewritten
questionsinfulltotime,youwillnotacquire thenecessary
skillstotacklediscussion
questions.
TheFMexamining teamprovidethefollowing
useful feedback onanswering discursivequestion
responses:
Question requirementsmustbereadcarefully
andanswered directly.
Candidates writing
‘allthat
theyknowaboutthetopic’without addressing
thequestion requirementwillinvariably
scorefew
marks. Instead,
thefocusmustbeonthequestion requirement andrelating thistothescenario
provided.
Page 321 of 641

q
Question requirementswilloftenrefertothecompany inthescenario, eg‘DiscussTHREEwaysin
whichKCocan...’.Thismeans thatcandidates mustrefertothecompany’s circumstancesin
ordertoscorethemarks onoffer.
Asinprevious diets,somecandidates failedtoscoremarks where a recommendation and/ora
comment wasrequired oncalculated figures. Forinstance,ifaskedwhether a company should
undertake aninvestment project,itisnotenough fora candidate tosimplysay‘Goodproject so
invest’,
without justifying
thedecision. Saying‘theproject isfinanciallyacceptableasithasa
positive
NPV’offers a suitable
justification.
Finally,interms ofgeneralcomments aboutSection C, itmustbeemphasised thatifaskedto
discussfactors/benefits/reasons/merits,itisnotenough tosimplylista fewwords.ACCA’s
guidance isthat‘Discuss’means ‘Consider anddebate/argue abouttheprosandconsofan
issue.Examine indetailbyusingarguments infavouroragainst’.
Effective discussion of key financial topics.
FM Skill: Effective discussion of key financial topics.

Thekeystepsinapplying
thisskillareoutlined
below
andwillbeexplained
inmoredetailinthe
following
sections
asanextractofthepastexamquestion‘CorfeCo’isanswered.
STEP1:Readandanalysetherequirement.
Theactive
verbusedoften
dictates
theapproach
thatwritten
answers
should
take.
Forexample,
'discuss'
meanstoexamine
indetail
byusing
arguments
in
favour
oragainst.
Workouthowmany minutesyouhavetoanswer
eachsubrequirement.
G
STEP2:Readandanalyse thescenario. H
Identify
thetypeofcompanyyouaredealing
withandhowthefinancial
topics
in
therequirement
relate
tothattypeofcompany.
Asyougothroughthescenario
youshouldbehighlighting
importantinformation
whichyouthink
willplayakey
roleinanswering
thespecific
requirements.
STEP3:Planyouranswer
Ensure
youranswerisbalanced
intermsofidentifying
thepotential
benefits
and
limitations
oftopics
thatarebeingdiscussed
orrecommended.
Step4:Writeyouranswer
Asyouwriteyouranswer,
trywherever possible
toapplyyouranalysis
tothe
scenario,
instead
ofsimply
writing
aboutthefinancial
topicingeneric,
technical
terms.
explainwhatyoumean – inone(ortwo)sentence(s)
–
andthenexplain
whythismattersinthegivenscenario.
Thisshould
result
ina
series
ofshortparagraphs
thataddress
thespecific
context
ofthescenario.
300 Financial
Management
(FM)
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q
Exam success skills
Thefollowingquestionis an extractfroma past examquestion;thisextractwas worth9 marks.

Forthisquestion,wewillalso focuson the followingexamsuccess skills:
• Managinginformation.Thereis a lotof informationto absorb inthisquestionand the best
approach is activereading.Thisinvolvesfocusingon the requirementfirst,on the basis that
untilyou havedone thisthe detailinthe questionwillhavelittlemeaning.
• Correct interpretationof requirements.Therequirementsclearlyask you to discussthe views
of three directors,it may thereforebe helpfulto thinkof thisas three sub-requirementsworth
three markseach. Rememberthat the verb‘discuss’means that you shoulddebate/argue
about the prosand cons of each director’sview.
• Answerplanning.Everyonewillhavea preferredstyleforan answerplan. Forexample,it may
be a mindmap, bullet-pointedlistsor simplyannotatingthe questionpaper. Choosethe
approach that you feelmostcomfortablewithor, ifyou are not sure,try out different
approaches fordifferentquestionsuntilyou havefoundyourpreferredstyle.Youwilltypically
be awarded1markper relevant,wellexplainedpointso you shouldaimto generate sufficient
pointsto scorea comfortablepass.
• Effectivewritingand presentation.Thisisparticularlyimportantindiscussionquestions.Use
headingsand sub-headingsinyouranswer,and writeinfullsentences,ensuringyourstyleis
professional.Toachievethe necessarydepth of discussionand to explainyourpoints,it is
recommendedthat you includeillustrativeexamplesinyouranswer.
• Good timemanagement.Theexamwillbe time-pressured,and you willneed to manage it
carefullyto ensurethat you can makea good attempt at everypart of everyquestion.Itis
temptingto spend moretimeon numericalrequirementsand then rushthroughthe discursive
elements. Pleasetry to avoidthis.Youwillhave1.8minutesper markinthe exam.Thefollowing
questionis worth9 marksso you shouldallow16minutesinthe exam.
G
Skill activity H
1 Readandanalysetherequirement.
STEP
Theactiveverbusedoftendictatestheapproachthatwrittenanswersshouldtake.Forexample,discuss
meansexamineindetailbyusingargumentsinfavouroragainst.Workouthowmanyminutesyouhaveto
answereachsubrequirement.Heretherequirementwas:
Discuss17the viewsexpressedby the three18directorson 17Youmustprovidea reasonedapproach
howthe investmentshouldbe financed. toyouranswer discussing
theprosand
conofeachdirectors’view
9 marks
183markswillbeallocatedtotheviewof
2 Readandanalysethescenario.
STEP eachdirector,
youwillscoreonemarkfor
Identifythetypeofcompanyyouaredealingwithandhowthe eachrelevant,
wellexplained point
financialtopicsintherequirement
relatetothattypeofcompany.As
yougothroughthescenarioyoushouldbehighlighting keyinformation
whichyouthinkwillplaya keyrole
inansweringthespecificrequirements.
CorfeCo isa listed19company, the board is lookingto 19CorfeCoisa listedco;therefore
any
financeinvestmentsinfacilitiesoverthe nextthree adviceonhowtofinance thenew
investment
mustfocusonthekey
years20, forecastto cost up to21$25m.Theboard does objective
ofmaximising shareholder
wealth
not wishto obtainfurtherlong-termdebt financeand is
also unwillingto makean equityissue.Thismeans that 20Thesuggested
sourceoffinancewill
needtobeavailable
overthenextthree
investmentshaveto be financedfromcash whichcan years
be made availableinternally.22 21Amounttoberaised
Boardmembershavemade a numberof suggestions 22Makesureyoudonotdiscussraising
about howthiscan be done: newexternal
debtorequityasthisisnot
relevant
tothescenario
SkillsCheckpoint
4:Effective
discussion
ofkeyfinancialtopics 301
Page 323 of 641

q
Director
Ahassuggested
thatthecompany
doesnot
havea problemwithfunding
newinvestments,
asithas
cashavailable 23of$29m.Ifextracashis
inthereserves 23Reserves
donotrepresent
cash
required
soon,CorfeCocouldreduceitsinvestment
in
working 24
capital. 24What would
bethepros
andconsof
reducingworking
capital
torelease
extra
Director
Bhassuggested selling 25
thebuildingwhich cash?
contains
thecompany’s headquartersinthecapitalcity 25Istheproperty
usedassecurity
fora
for$20m.26Thiswillraisea largeone-off
sumandalso loan?
saveonongoing property
managementcosts.Head
26Insufficient
amount.
officesupport 27would
functions bemoved toa number
ofdifferent
locations
rented
outside
thecapitalcity. 27What
arethepros
andcons
ofmoving
thehead
office
function?
Director
C hascommented thatalthougha high
dividend
hasjustbeenpaid,dividends
couldbe
28 thenextthreeyears,allowing
reducedover sparecash 28Whataretheexpectations
of
forinvestment. shareholders?
Whatarethepros
and
cons
ofcutting
thedividend
payment?
3 Planyouranswer
STEP
Ensureyouranswer
isbalancedinterms
ofidentifying
thepotentialbenefits
andlimitations
oftopics
that
arebeingdiscussed
orrecommended.
Typeupyouranswer planusingtheword-processingfunctionavailable
intheconstructive
responseworkspace.Abriefanswerplancouldlooklikethis:
G
Pros Cons H
Director
A Better
management
ofWC Mustmaintain
liquidity
Risksassociated
withreducing
WC
Director
B Savings
incosts Usedassecurity?
Additional
costs– Restructuring
costs?
Losefuture
increase
invalue
Director
C Capitalgrowth
inshareprice Negative
signaltomarket
Shareholders
expectations
4 Write
STEP youranswer
Asyouwriteyouranswer,trywherever
possible
toapplyyouranalysis
tothescenario,
instead
ofsimply
writing
aboutthefinancial
topic
ingeneric,
technical
terms.
explain
what you
mean – inone(ortwo)
sentence(s)
– andthenexplain
whythismatter
inthegiven
scenario.
Thisshould
result
inaseries ofshort
paragraphsthataddress
thespecific
context
ofthescenario.
Awell-structured
answer
would
address
eachdirector’s
comments (3marks
wereavailable
foreach)andwould
looklikethis:
302 Financial
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q
Director
A29 29Use
headings
and
subheadings
to
provide
good
structure.
Reserves
arenotcash
DirectorAisincorrect
insayingthat$29mofcash
reservesareavailable.
Reserves are$29m,butthis
figurerepresents
backingforallCorfeCo’sassetsand
notjustcash.
Mustmaintain
liquidity
Someofthiscouldbeusedforinvestment,although
the
company willneeda minimum balanceofcashto
maintain
liquidity
foritsday-to-day
operations.
Corfe
Co’scurrent
ratiois(20/7)=2:86.Thismaybea high
figure(depending
ontheindustry
CorfeCoisin),so
CorfeComayhavescopetogenerate
someextracash
byreducing
working
capital.
Risksassociated
withreducing
WC
Inventory
levels
couldbereduced
byjust-in-time
policies,
30tradereceivables
reduced bytightercredit 30Illustrate
your
point
with
anexample
controlandpayments delayedtosuppliers.
Allofthese
G havepossibledrawbacks.
Just-in-time
policies
may H
result
inrunningoutofinventory,
andtighter
policies
for
tradereceivables
andpayables
mayworsen relations
withcustomers
andsuppliers.
Againalso,CorfeCo
would
havetomaintain
minimum
levels
ofeachelement
ofworkingcapital,soitseemsunlikely
thatitcould
raisethemaximum $25msolelybydoingwhatDirector
Asuggests.
31 31Provide
aconclusion
Director
B
Losefuture
increase
invalue
Selling
theheadquarters
would
raisemostofthesum
required
forinvestment,
assumingthatDirectorB’s
assessmentofsalespriceisaccurate.
However,Corfe
Cowould losethebenefitofthevalueofthesite
increasing
infuture,
whichmayhappen ifthe
headquarters
isina prime
location
inthecapitalcity.
Skills
Checkpoint
4:Effective
discussion
ofkeyfinancial
topics303
Page 325 of 641

q
Security
Beingabletoselltheheadquarters wouldbesubjectto
theagreement oflendersifthepropertyhadbeenused
assecurityfora loan.Evenifithasnotbeenusedas
security,
thesalecouldreduce theborrowingcapacity
ofthecompany byreducing theavailability
ofassetsto
offerassecurity.
Additional
costs
Anongoingcommitment topropertymanagement
costs
ofanowned sitewouldbereplacedbya commitment
to
payrent,whichmightalsoinclude
someresponsibility
forproperty
costsforthelocations
rented.
Itispossible
thatgooddealsforrenting
areavailable
outsidethe
capitalcity.However,
inthelonger
term,therentmay
becomemoreexpensive
iftherearefrequent
rent
reviews.
There
mayalsobevisible
andinvisible
costs
attachedtomovingandsplitting
upthefunctions.
There
willbeone-off
costsofmovinganddisruption
towork
aroundthetimeofthemove. Staffreplacement
costs
G
mayincreaseifstaffaremovedtoa location
whichis H
notconvenient
forthem 32andthenleave.Senior 32Illustrate
your
point
with
anexample
managersmayfinditmoredifficult
tomanage
functions
whichareindifferent
locations
rather
than
thesameplace.There
maybea lossofsynergies
through
staffindifferent
functionsnotbeingableto
communicate easilyface-to-face
anymore.
Director
C
Capitalgrowth
inshareprice
Ifthefundsareinvestedina projectwitha positive
NPV
thiswillleadtoa capitalgrowthintheshareprice.
Shareholders33maybehappytoforego theirdividend 33Provide
abalanced
discussion
knowing thattheyachievea growthintheshareprice. illustrating
thepros
andcons
ofthe
director’s
view
Shareholder
expectations
304 Financial
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Shareholders
maywellexpect
a consistent
orsteadily
growing dividend.Acutindividendmayrepresent a
significant
lossofincome forthem.Ifthisisso,
shareholdersmaybeunhappy aboutseeing dividends
cutornotpaid,particularlyiftheyhavedoubts about
thedirector’s
futureinvestmentplans.
Negative
signaltomarket
Theymayseethisasa signalthatthecompany
has
poorprospects,
particularly
iftheyareunsureabout
whythedirectors
arenotseekingfinancefromexternal
sources.
Thedirector’s
dividendpolicymayalsobe
questioned
ifthedividend
justpaidwasa one-off,
high
payment.
Sucha payment isnormallymadeifa
company hassurplus
cashanddoesnothaveplansto
useit.However,
thedirectors
areplanninginvestments,
andshareholders
maywonder whya highdividend
was
paidwhenthedirectors
needmoneyforinvestments.

G Everytimeyoucompletea question,usethediagnostic
belowtoassesshoweffectively
you H
demonstratedtheexamsuccess skillsinanswering
thequestion.
Thetablehasbeencompleted
belowforthe‘CorfeCo’activity
togiveyouanideaofhowtocomplete thediagnostic.
Examsuccessskills Yourreflections/observations
Managing
information Didyouidentify
thatCorfeCoisa listed
Co?
Didyouidentify
thatinternal
financingwastobeusedforthis
investment?
Correctinterpretation
of Didyoupresent
a reasonedargument
oftheprosandconsof
requirements eachofthethreedirector’s
views?
Answer
planning Didyoutaketimetoprepareananswer
planandnotethree
relevant
pointsforeachdirector?
Effective
writing
and Didyouuseheadings andsubheadings?
presentation. Didyouwriteinclear,concise
paragraphs?
Didyouexplainyourpointsinenough
detailusingillustrative
examples?
Goodtimemanagement Didyoumanage yourtimetoensure
youdiscussed
allthree
director’s
views
inthetimeavailable?
Mostimportant
actionpoints
toapplytoyournextquestion
Skills
Checkpoint
4:Effective
discussion
ofkeyfinancial
topics305
Page 327 of 641

q
Summary
SectionC of the FMexamwillcontaintwoquestionswhichwillbe scenario-basedand willcontain

both discursiveand computationalelements.ThisSkillsCheckpointshouldhelpwithyour
approach to allnarrativerequirements.Makesureyou practicediscussionquestionsinfull,to
time. Themostimportantaspects to take away are:
• Preparea briefanswerplan to gather yourthoughtsand makesureyou address allparts of
the requirement.
• Structureyouranswerwithheadings,sub-headingsand conciseand clearparagraphs.
• Providea balanced discussion.
• Donot overlookthe scenariointhe question– it is likelyto provideyou withsomeideas for
youranswer.
G H
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14
Foreign currency risk
14
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
Thenature
andtypesofriskandapproachestorisk
management
• Describe
anddiscussdifferent
typesofforeign risk: G1(a)
currency
- Translation
risk
- Transaction
risk
- Economicrisk
Causesofexchangeratedifferences
G2(a)
G H
• Describe
thecausesofexchange ratefluctuations,
including:
- Balance ofpayments
- Purchasingpower paritytheory
- Interest
rateparitytheory
- Four-way equivalence
• Forecast
exchangeratesusing: G2(b)
- Purchasingpower paritytheory
- Interest
rateparitytheory
Hedgingtechniquesforforeigncurrencyrisk
• Discuss andapplytraditionalandbasicmethods offoreign G3(a)
currency riskmanagement, including:
currencyofinvoice,
netting andmatching,leading andlagging,forward
exchange contracts,
money markethedging, assetand
liability
management
• Compare andevaluatetraditional
methods offoreign G3(b)
currency riskmanagement
• Identifythemaintypesofforeign currencyderivatives
used G3(c)
tohedgeforeign currencyriskandexplain howtheyare
usedinhedging (nonumerical questions
willbesetonthis
topic)
14
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q
Exam context
Thischapter,
andthenext,coverSection G ofthesyllabus
(RiskManagement).Thissyllabus
section
isexaminable
intheOTsections oftheexam(SectionsAandB)andcommonly formsthe
central
theme ofoneofthe(10mark) Section
B questions.
Itispossible
foranaspectofriskmanagement tobetestedasa partofa SectionC question,
mainlybecauseexchange rateriskcanariseduetoforeigncurrencyreceivables
andpayables,
andtheseworkingcapitalissuesareexaminableinSection
C oftheexam. However,itisrarefor
thischapter
tobetestedinSection C oftheexam.
G H
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Management
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14
Chapter overview
Basics Basichedgingmethods Forwardcontracts
Transaction
risk Internal
methods Advantages
Spotrates Disadvantages
Spreads
Moneymarket Derivatives
hedging
Receipts Currency
futures Currency
options
G
Payments Advantages Advantages H
Disadvantages Disadvantages
Currency
swaps
Forecastingexchange Managing
rate movements other risks
Balance
ofpayments Translation
risk
Inflation Economic
risk
Interest
rates
Fourwayequivalence
14:Foreigncurrencyrisk 309
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1 Exchange rate risk management basics
PER alert
Performanceobjective11requiresyou to ‘adviseon usinginstrumentsor techniquesto manage
financialrisk’.Thischapter coversthe managementof foreigncurrencyrisk.
Exchangerate: Therate at whichone country’scurrencycan be traded inexchangefor

KEY
TERM another country’scurrency.
Thischapter focuseson exchangerate riskmanagement,whichis sometimesreferredto as

hedging.
Thereare three categoriesof exchangerate risk:transactionrisk,translationriskand economic
risk.Themainfocusof thischapter, and of the exam,is the managementof transaction risk;the
othertypes of riskare brieflycoveredinthe finalsectionof the chapter.
Exam focus point

Inthe exam,the domesticcurrencyis normallydollars.Theuse of dollarsas the domestic
currencydoes not mean that weare dealingwiththe USdollar– it is simplybeingconsistent
withthe fact that cash flowsinthe ACCAexamsare usuallyexpressedindollars.Inthis
chapter the domesticcurrencyis normallyin dollarsand the foreigncurrencyis in pesos.
1.1 Transaction risk
G
Transactionrisk:Theriskthat a transactionina foreigncurrencyis recordedat one rate and H
KEY then settledat a differentrate because of a change inthe exchangerate.

TERM
Transactionriskarisesdue to the timingbetweenenteringintothe transaction (agreeingthe
price)and the timethat the actual cash flowswillmaterialise.Itcan arisefora numberof
reasons,forexample:
• a companyexportsto foreigncountriesand has foreigncurrencyreceivables
• a companyimportsfromforeigncountriesand has foreigncurrencypayables
• a companyis makinginterestpayments on a foreigncurrencyloan(oris receivinginterest
froma foreigninvestment)
$ strong $ weak
Exportersloseifthe $ isstrong Importersloseifthe $ isweak

becausethepeso(theforeign becausethepeso(theforeign
currency)isweakandtheir currency)
isstrongandtheir
revenueisinpesos costsareinpesos
Illustration 1: Transaction risk
CompanyAis based inCountryZwherethe currencyis the dollar.

CompanyAexportsto CountryC wherethe currencyis the peso and has receivablesof 154,000
pesos due in1month.
Duringthe monththe valueof the dollarincreasedby 10%against the peso;from2 pesos to the
dollarto 2.2 pesos to the dollar.
310 Financial
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Required
Calculate
theimpact
ofthisexchange
ratemovement
onCompany
A.
Solution
154,000peso/ 2 =$77,000 revenue
expected
1month later:
154,000peso/ 2.2=$70,000revenue received
Foreign
currency loss=$7,000
ExportersinCountry Z losewhenthe$getsstronger
Activity1:Transactionrisk
Company BisbasedinCountryZ wherethecurrency

isthedollar.
Company BimportsfromCountryC wherethecurrencyisthepesoandhaspayables of180,000
pesosduein1month.
During themonththevalueofthedollardecreased
by10%against thepeso;from2 pesostothe
dollarto1.8pesostothedollar.
Required
Calculate
theimpact
ofthisexchange
ratemovement
onCompany
B.
Solution
G H
Youshould
notethatforeign
currency
riskisa two-wayrisk.Thismeansthatexchange
rate
movements
maybefavourable aswellasadverse,sotheterm‘risk’canbemisleading.
1.2 Spot rate
Spotrate:Theexchange ratecurrently
offered
ona currencyforimmediatedelivery.
KEY
TERM
1.2.1 Exports
Export
salescreaterevenueina foreign
currency(egpesos),
thiswillnormally
beconverted bya
company intodollars
(thedomesticcurrency)
atthespotrateavailablewhenthemoney is
received.
Exporter
Receives
pesos
Sellspesos
tobuydollars
14:Foreign
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1.2.2 Imports
Coststhatarepayableina foreign
currencywillrequirea company
toselldollars
(thedomestic
currency)
tobuytheforeign currency
requiredforthetransaction,
atthespotratethatis
available.
Thiswillmeanthatanimporterwillselldollars
andbuytheforeign
currency.
Importer
Paysinvoices
inpesos
Sellsdollars
tobuypesos
1.3 Spreads
Sometimes anexamquestion willsimply
provideyouwitha singlespotratetouseeg1.7800 peso
perdollar.
However, examquestions mayalsoprovide thespotrateasa spread eg1.7600 – 1.8000pesosper
dollar.
Thisismorerealistic
sincea bankwould notoffera rateof1.7800 pesosperdollartoboth
exporters(selling
pesos) andimporters (buyingpesos);instead,itwillchargethemdifferent
rates
andmakea profit onthespread.
Aspread shows thedifferentratesatwhicha bankwilltransact withanexporter andanimporter.
Inordertomakea profit, a banksellsdollars
(thedomestic currency) toanexporterata high
price(1.8000pesos)andbuysdollars fromanimporter ata lowprice(1.7600pesos) andmakea
profitonthespread (iethedifferencebetween 1.8000and1.7600).
Lowerrate1.7600 Higherrate1.8000
G
– a bankbuysdollarsat thisrate – a banksellsdollarsat thisrate H
Animportersellsdollars
toa bankin Anexporterbuysdollars
froma bankin
exchangeforforeigncurrency,
andso exchange
forforeign
currencyandsopays
receives
thelowerratewhensellingdollars
to thehigher
ratewhenbuyingdollarsfroma
a bank. bank.
Spreadscanbeshown indifferent
ways;youdonothavetoremember
thesedifferent
methods,
justmakesureyoucaninterpret
them.
Spotrate1.7600
– 1.8000pesosperdollar
Spotrate1.7800
+/-0.0200pesosperdollar
Examfocus point
Ifindoubtastowhichpartofthespreadtouse,remember
thata company willalwaysbe
offered
theworserateinorderthatthebankgenerates
a profitonthetransaction.
Activity2: Spreads
Thespotrateatthetimethata company
wishes
toconvertitsexport
revenue
of360,000peso
intodollars
isquoted
as1.4000-1.5000
pesosperdollar.
Required
Calculate
thereceipts
indollars.
312 Financial
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q
Solution
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
2 Managing transaction risk – basic methods
Basictechniques
canbeusedbya company toeliminate
transaction
riskortoreduce
ittoan
acceptable
level.These
areillustrated
belowfora companywithdollars
asitsdomestic
currency
andwithrevenue inpesos(aforeign
currency).
Real life example:Illustrationof basic methods

G
Theriskisthatthevalueofthepesowillfallsothatthepesorevenue
isworth
fewer
dollars. H
Matching
Wherepossible
creating
costs
inpesos
Invoice
indomestic Leading
currency
(dollars) Peso Taking
stepstoencourage
early
Passes
exchangerateriskto revenue paymentbycustomers
(canbe
customers
(canresult
inlostsales) expensive
ifdiscounts
offered)
Netting Lagging
Savetransactions
costs
bynetting Delay
conversion
intodollars
to
offreceipts
andpaymentsduetobe allow
matching
against
pesocosts
incurred
bydifferent
divisions
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
14:Foreign
currency
risk 313
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3 Managing transaction risk – forward contracts
Forward
contract:Acontract
witha bank(sometimes
calledanoverthecounter
orOTC
KEY contract)
TERM payable
fixingtheexchange
rateona specificamount
offoreign
currency
(FX)receivable
or
ata futuredateatanexchangerateagreednow.
Thepurpose ofa forwardcontract istofixanexchange ratenowforthesettlement

ofa
transactionata futuredate.Thisremoves uncertainty
aboutwhattheexchange ratewillbeat
thatfuture date.
Currency riskisa two-way risk.Byarranginga forwardcontract,
a company canhedgeagainst
theriskofanadverse movement inthespotexchange rateuptothedateofsettlement,
butatthe
sametimeitlosestheopportunity togainfroma favourablemovementinthespotrate.
Forward contracts canbearranged forsettlement
uptoseveralmonths ahead,orpossiblyas
muchasoneyearahead(orevenslightly longer)
butcannotbeusedasa hedgeagainst
currency riskinthelongterm.
Forward contracts arearranged directly
witha bankandaresometimes referred
toasover-the-
counterorOTCtransactions.
3.1 Quotation of forward rates
Aswithspotrates,a forward
ratemaybegivenasa singlefigureorasa spread,
thesamerules
applyforinterpreting
thespread.
Activity3: Forwardrates
Thespotexchange
rateis1.2500-1.3500pesostothedollarandthethree-month
forward
rateis
1.3000-1.5000
pesostothedollar.
Required
G H
1 Calculate
thereceipts
froma 1,400,000
pesosale,duetobereceived
in3 months’
timeif
forward
ratesareused.
2 Calculate
thecostofpayinganinvoice
of1,500,000
pesosin3 months’
time,ifforward
rates
areused.
Solution
3.2 Advantages of forward rates

Forward
contracts
arethemostpopular
method
ofhedging
currency
risk.
Advantages Discussion
• Simple Easytoorganisefortheexactamount
of
money required
andtheexacttiming
ofthe
transaction
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• Loworzeroup-front
costs Unlike
currency
options
(seelater)
• Available
formanycurrencies Likelytobeavailable
intherequired
currency.
3.3 Disadvantages of forward rates
Disadvantages Discussion
• Fixeddate Theforwardcontract
mustbeexercised ona
specific
date,andthebankthathasprovided
theforwardcontract
canenforcethis.
• Unattractive
rate Thefixedratethatisoffered
maynotbe
attractive.
• Counter-party
risk Theagreement isbetween
twoparties,
thereis
therefore
a riskofdefault
oneither
side.
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
4 Managing transaction risk – money market hedging

G H
4.1 Foreign currency receipt (eg an export)

Because ofthecloserelationship between forward exchange ratesandtheinterestratesin
currencies,
itispossible to‘manufacture’a forwardratebyusingthespotexchange rateand
money market lending orborrowing.
Where foreigncurrency revenueisexpected, exchange rateriskcanbeeliminated by:
(a) borrowing intheforeign currencytoday,converting thesefundsintodollars (thedomestic
currency)attoday’sspotrate(sothereisnoexchange raterisk)
(b) usingthefuture revenue(inforeigncurrency)torepaytheforeign currencyloan.
Because thisinvolvesa short-termloanina foreigncurrency itiscalledmoney-market hedging.
Tocreatea money markethedgefora receipt,followthestepsbelow.
Step1 Identify theloanrepayment required inthefuture(thisshould matchtheexpected
revenue)
Step2 Usingtheinterest rateprovided,calculatetheamount thatneedstobeborrowed today
intheforeign currency(adjusting
theinterestrate,ifgiveninannual terms,toreflectthe
period oftheloan).
Step3 Convert thisimmediatelytodomestic (home) currency atthespotrate.Placethison
deposit inthehome currency.
Step4 Include theinterestearnedonthedeposit inthehome currency,usingtheinterestrate
provided (adjusting
theinterest
rate,ifgiveninannual terms,toreflect
theperiod ofthe
deposit).
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Thesesamestepscanbeeasier
toremember
asa table,thefollowing
tableassumes
thatthe
transaction
isin3 months’
time:
Receipts
Domesticcurrency$ Foreigncurrency(peso)
Now (3)Paypesoloanintoyourbank (2)Takeoutloaninpesos:thiswillbe
accounttodayatthespotrate theamount instep1dividedby(1+
borrowing
rate)
(1+deposit
rate)* (1+borrowing
rate)*
Threemonths (4)Adjust
step3 bymultiplying
by(1 (1)Receivepesosfromexport.
Thisis
+depositrate),toallowcomparison theamountofloanrepayment
toa forward
contract required
*Youwillneedtotaketheinterest
ratequoted
andmultiply
by3/12ifa three-month
loan,if
interest
ratesaregiveninannualterms.
Illustration2: Moneymarkethedge
Acompany whose domestic

currencyisthedollarisowed2,500,000pesos,
receivable
inthree
months’time.Thespotexchangerateis1.4498
– 1.4513pesosper$1.Thecompanycandeposit
in
dollars
forthreemonthsat2.00%perannum andcanborrow pesosforthreemonths
at1.5%per
annum.
Required
Whatisthereceipt
indollars
witha money
market
hedge?
G
Solution H
Theinterest
ratesforthreemonths arecalculated
byadjustingtheannualratesgivenby
multiplying
themby3/12.Thisgivesa 0.5%ratetodeposit indollars
and0.375% toborrowin
pesos.
(1) Thecompany shouldaimtorepay2,500,000pesosin3 months’ time.
(2) Thecompany shouldaimtoborrow 2,500,000/1.00375=2,490,660pesostoday(afterthree
months,2,500,000pesoswillberepayable, including
interest).
(3) Thesepesoswillbeconverted to$ at2,490,660/1.4513
=$1,716,158.
Thisisplacedondeposit
intheUS.
(4) Thecompany willdeposit
thisamount forthreemonths,whenitwillhaveincreased
invalue
withinterest
(2%forthethreemonths) to:$1,716,158
×1.005=$1,724,739
Inthreemonths,theloanwillberepaid outofthepesosproceeds fromthetradereceivable.
Thecompany has‘manufactured’ a forwardrateof1.4495
(2,500,000/$1,724,739)
Activity4: Moneymarkethedging:receipts
Three-month
interest
ratesarecurrently
asfollows:
US Country
P
Borrowing
rates 5.59%peryear 5.38%peryear
Deposit
rates 5.50%peryear 5.31%
peryear
Thespotrateis1.9612-1.9618
pesostothedollar.
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q
Required
Calculatethereceipts
froma 1mpesosale,duetobereceived
in3 months’
timeifmoney
market
hedgingisusedbya UScompany.
Solution
4.2 Foreign currency payable (eg an import)

Where foreigncurrency expenses aredue,money market hedgingcaneliminate exchange rate
riskby:
(a) Withdrawing fundsfromyourlocalbankaccount inthedomestic currency(egdollars)and
puttingthemondeposit ina foreigncurrency bankaccount today(sothereisnoexchange
raterisk)
(b) Usingthesefunds(plusinterest)topaytheforeign currencyexpense infuture.
Because thisinvolves
a short-terminvestmentina foreigncurrencyitisa money-market hedge.
Tocreatea money market hedgeforanexpense, followthestepsbelow.
Step1 Identify thecashrequired topaytheforeign currency expense
Step2 Usingtheinterest rateprovided,calculatetheamount thatneedstobeinvested todayin
G H
theforeigncurrency.
Step3 Convert thisimmediatelytohome currencyatthespotrate.Thisistheamount of$sthat
needstobeborrowed todayfromyourdomestic bankaccount.
Step4 Include thecostofborrowing inthedomestic countrytocompare toa forward contract.
Again,thesesamestepscanbepictured asa table,hereassuming a transactionisin3 months’
time:
Expenses
Domesticcurrency$ Foreigncurrency(peso)
Now (3)Withdraw
fundsfrom$ bank (2)Putmoney
intoa foreign
accounttoday currency
bankaccount(inpesos)
(1+borrowing
rate)* (1+deposit)
*
Threemonths (4)Include
thecostofborrowing
(to (1)Paypesoinvoice
fromsupplier
compare toa forward) Payoffinvoice
withpesosinforeign
currency
bankaccount
*Remember
totaketheinterest
ratequoted
andmultiply
by3/12,ifinterest
ratesaregivenin
annual
terms.
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currency
risk 317
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Illustration3: Moneymarkethedge
Acompany whoselocalcurrencyisthedollarowesa Danishsupplier

Kr3,500,000
whichis
payable
inthreemonths’time.Thespotexchange rateisKr7.5509
– Kr7.5548
per$1.The
companycanborrow indollars
forthreemonths at8.60%perannum andcandepositkroner
for
threemonths
at4.92%perannum.
Required
Whatisthecostindollars
usinga money
market
hedge?
Solution
Theinterest
ratesforthreemonths arecalculatedbyadjustingtheannual ratesgivenby
multiplying
themby3/12.Thisgives2.15% toborrow indollars
and1.23% todeposit inkroner.
(1) Thecompany needstodeposit enough kronernowsothatthetotalincluding interest
willbe
Kr3,500,000inthreemonths’ time.
(2) Thismeans depositing:
Kr3,500,000/ 1.0123=Kr3,457,473today.
(3) Thesekroner willbeconvertedto$ atthespotrateofKr7.5509 givinga cost$457,889today.
(4) Thecompany mustborrow thisamount nowandwillhavetorepay:$457,889 ×(1+0.0215)=
$467,734in3 months’time.
So,inthreemonths, theDanish supplier
willbepaidoutoftheDanish bankaccount andthe
company willeffectively
bepaying$467,734 tosatisfythisdebt.Thecompany has
‘manufactured’a forwardrateof7.4829 (3,500,000/$467,734).
G Activity5: Moneymarkethedging:expenses H
Current
three-month
interest
ratesareasfollows:
US Country
P
Borrowing
rates 5.59%peryear 5.38%peryear
Deposit
rates 5.50%peryear 5.31%
peryear
Thespotrateis1.9612-1.9618
pesotothe$.
Required
Calculatethedollarcostofaninvoice
for1mpesospayable
inthreemonths’
timeifmoney
market
hedgingisused.
Solution
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4.3 Money market hedging compared to forward contracts
Aswewillseelaterinthischapter, interestrateparitytheory explainsthatforward
contractsare
determined byinterestratedifferences betweentwocountries. Thismeans thatmoneymarket
hedging isunlikely
todeliver a significantlydifferent
outcome fromthatdeliveredbya forward
contract.
Money market hedging maydeliver a slightly
betteroutcome ifusedbyanexporter witha cash
flowdeficit,(sothatstep4 inthemethod bringsa greaterbenefit
intheformofsavedoverdraft
interest).
Alternatively,
ifusedbyanimporter witha cashflowsurplus (sothatstep4 inthemethod brings
a lowercostasinterestlostona cashflowsurplus willbelower thanthecostofborrowing).
Money market hedging islikelytobemoretimeconsuming thana forward contract
andcould
involve
issuecostsasborrowing isinvolved.
Activity6: Mini-casepractice1
Fiddenisa medium-sized
company ina countrywhosecurrency isthedollar,
withexport
and
importtradewithcountryP,whosecurrencyisthepeso.Thefollowingtransactions
areduewithin
thenextninemonths:
(1) Saleoffinished
goods,cashreceipt
dueinthreemonths: 197,000pesos
(2) Purchaseoffinished
goodsforresale,
cashpayment dueinsixmonths: 293,000pesos
(3) Saleoffinished
goods,cashreceipt
dueinninemonths: 154,000 pesos
Exchange
rates Pesoper$
Spot .9612-1.9618
Three
months’
forward .9598-1.9612
Sixmonths’
forward .9585-1.9607
G H
Ninemonths’
forward 1.9477-1.9621
Annual
interest
rates(3,6 or9months) Borrowing Lending
Dollars 5.59% 5.5%
Country
P 5.38% 5.31%
Required
1 Whatisthevalueindollars
ofthereceipt
inthreemonths
ifa forward
contract
isused?
 389,356dollars
 386,475dollars
 100,417
dollars
 100,449dollars
ofthepayment
insixmonths
ifa money
market
hedgeisused?
 149,556
dollars
 149,502
dollars
 149,602
dollars
 145,534dollars
ofthepayment
insixmonths
ifa forward
contract
isused?
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currency
risk 319
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4 Ifthereceipt
inninemonthswashedged
usinga money
market
hedgehowwould
thehedge
beinitiated?
 Depositinpesosnow
 Depositindollarsnow
 Borrowing inpesosnow
 Borrowing indollars
now
Solution
G H
5 Managing transaction risk – derivatives
Examfocus point
Thissection
willnotbetestednumerically
intheexam.
5.1 Currency futures
Currency
futures:
Acontracttopurchaseorsella standard
quantity
ofa currency
byan
KEY
TERM agreed
future
d ateata specified
e xchange
rate.
Currency futureshavea similarimpact toforwardcontracts

inthattheyfixtheexchange rateto
useinthefuture.
Currency futuresaretraded ona market andaremainly availablefromtheUSmarkets. Each
contract
fixestheexchange rateona large,standardamount ofcurrencyandcontracts expire
at
theendofeachquarter (March, June,September andDecember) butcanbeusedonanydate
uptotheexpirydate.
However,unlikea forward,a futurescontractisseparate
fromtheactualtransaction andis
designedinsucha waythat:
• Ifa company makes anexchange lossona transaction,
thenitwillmakea profitinthefutures
market tocompensate forthis.
• Ifa company makes anexchange profit
ona transaction,
thenitwillmakea lossinthefutures
market.
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So,theoutcome
isfixedwhatever
happens
totheexchange
rate.
5.1.1 Settingupa futurestransaction
Therearethreestepstoa futures transaction.
Fora foreigncurrency (peso)receipt,
thestepsareasfollows:
Step1 Today:Enterintoa futures contract
tosellpesosata fixedrate
Contracts should beduetobefulfilledona standardised dateafterthetransaction
date.
Step2 Complete theactualtransaction onthespotmarket.
Step3 Closeoutthefutures contractbydoingtheopposite ofwhatyoudidinStep1ieby
enteringintocontracts tobuypesos.
Anyprofitsorlosses thatariseasfuturesaresettledwilloffsettheimpact ofexchange rate
movements ontheactualtransaction thatisbeinghedged.So,theoutcome isfixedwhatever
happens totheexchange rate.
• Ifthepesodevalues
- There willbea gainonthefuture asitwillbebought backata lower pricethanitwassold
instep1.
- However, ontheactualtransaction therewillbeanexchange lossbecause thepeso
receipts
fromtheactualtransaction would beworth lessindollars.
• Ifthepesoincreases invalue
- There willbea lossonthefuture asitwillbebought backata higher pricethanitwassold
instep1.
- However, ontheactualtransaction therewillbeanexchange gainbecause thepeso
receipts
fromtheactualtransaction would beworth moreindollars.
5.1.2 Advantagesofcurrencyfutures
Futuresarevalidfora period
oftime.Ega September
futurecanbeusedonanydaybetween
G H
thedayitwasentered intouptotheendofSeptember.
Thisismoreflexible
thana forward,
which
isonlyvalidona specific
day.
Counterpartyriskislowersincethefutures
exchange
guaranteesthetransaction.
5.1.3 Disadvantages ofcurrencyfutures
Currency futuresareonlyavailable inlarge,standard,contract sizes,andfora narrow rangeof
currencies(compared toforward contracts).Thismakes currency futureslesssuitable
forsmall
transactions.
Tocoverpotentiallossesa company usingfutureswillberequired toplacea deposit(calleda
margin)withthefutures exchange, whichmayneedtobetopped upona dailybasisifthe
contractisincurring
losses.
Thereisa riskthatfuturesexchange ratesdonotmove exactly
inlinewithspotexchange ratesso
thatthehedgeisnoteffective (thisisanexample ofbasisrisk).
5.2 Currency options
Currencyoptions:
Arightofanoptionholder
tobuy(call)orsell(put)a quantity
ofone
KEY currency
inexchangeforanother,
ata specific
e xchange
rateonorbefore a future
expiry
TERM
date.
Companies canchoosewhether
tobuy:
(a) Atailor-made
currency
option
froma bank,suited
tothecompany’sspecific
needs.
These
are
overthecounter
(OTC)ornegotiated
options;
or
(b) Astandardexchange-
tradedoption,
incertain
currencies
only,fromanoptions
exchange.
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currency
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Witheithertypeofoption,
theholdercanchoose whether ornottoexercise
theoption – this
allowstheholdertoenjoytheupsidewithouta riskofsuffering
thedownside ofexchange rate
movements.
Obtaininga currencyoption
involves
payinga premium upfronttotheoptionseller.
Theoptionactsasaninsurance policyandcanbeusedbythepurchaser tocompensate for
adverseexchange ratemovements.
Iftheexchangeratemoves favourably
thentheoption willnotbeexercised.
5.2.1 Advantagesofcurrencyoptions
Exchange-traded
options(butnotOTCoptions) arevalidfora period
oftime.Thisismoreflexible
thana forward,
whichisonlyvalidona specific
day.
Exchange traded
optionscanbesoldonifnotneeded.
Anytypeofoptionallowsa company tobenefitfromfavourableexchangeratemovements.
5.2.2 Disadvantagesofcurrencyoptions
Exchange-traded
optionsareonlyavailable
inlarge,standard,
contract
sizes,andfora narrow
rangeofcurrencies
(compared toforwardcontracts).
Anytypeofoptionwillneedtobepurchased,andthepremium canbeexpensive.
5.3 Currency swaps
Swap:A formalagreement
whereby
twoorganisations
contractually
agreetoexchange
KEY
TERM payments ondifferent
terms,
egindifferent
currencies.
Ina currencyswap,thepartiesagreetoswapequivalent amounts ofcurrency fora period.This

effectively
involvestheexchangeofdebtfromonecurrency toanother.Liability
onthemaindebt
G (theprincipal)
istransferred
andtheparties areliabletocounterparty
risk:iftheotherparty H
defaults
ontheagreement topayinterest,
theoriginalborrower
remains liabletothelender.
Currencyswapsmaybeusedtorestructure thecurrency baseofthecompany’s liabilities.
This
maybeimportant where
thecompany istradingoverseasandreceivingrevenues inforeign
currencies,
butitsborrowings
aredenominated inthecurrency ofitshome country.
Currencyswapsthereforeprovidea means ofreducing exchangerateexposure overthelong-
term.
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
6 Forecasting exchange rate movements

There
areseveral
factors
thatinfluence
exchangeratesoverthelongterm,theseinclude
the
balance
ofpayments,
inflation
andinterest
rates.
6.1 Balance of payments
Ifaneconomy isimportingmorethanitisexporting,
thenthismeansthatovertimemoreofthe
domestic
currency isbeingsold(topayforimports)
thanisbeingbought (asexport
revenue
is
converted
intothedomestic currency).
Abalanceofpayments deficit
cantherefore
weakenthe
domestic
currency overthelong-term.
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6.2 Inflation
Highratesofinflation ina foreigncountryerodethepurchasing power ofthatcurrencyiewhata
unitofthecurrency canbuyinterms ofgoodsandservices.
Overtimethisfallinpurchasing powerwillaffectwhata unitofthecurrency canbuyonthe
currency markets andleadstoa fallinthevalueofitscurrency.
Purchasingpower paritytheory predicts
thattheexchange valueofforeign currency
depends on
therelative
purchasing power ofeachcurrency initsowncountry andthatspotexchange rates
willvaryovertimeaccording torelative
pricechanges.
So,ifinflationisrelatively
highinonecountry, thenthatcountrywill,overthelong-term,
experiencea fallinthevalueofitscurrency.
S1 = S0 × (1+ hc)
(1+ hb)
Where S1=expectedspotrate
S0=currentspotrate
hb=basecountry inflation
hc=inflation
inforeign
country
Real life example:Purchasingpowerparity theory

Thespotexchange ratebetween CountryA (wherethecurrencyisthedollar)
andCountry B
(wherethecurrency isthekroner)
is$1=8.00kroner.
Assuming thatthereisnowpurchasingparity,anamountofa commodity costing
$110inCountry
Awillcost880kroner inCountryB.
Overthenextyear,priceinflation
inCountryB isexpected
tobe5%whileinflation
inCountryA is
G
expectedtobe8%.Whatisthe‘expected spotexchangerate’attheendoftheyear? H
Forecast
rate,S1
= 8 × 1.05
1.08
=7.7778
Thisisthesamefigureaswegetifwecompare theinflated
pricesforthecommodity.Attheend
oftheyear:
Country A price=$110× 1.08=$118.80
Country B price=Kr880×1.05=Kr924
Forecastrate,S1=924÷118.80 = 7.7778
Intherealworld,exchange ratesmovetowards
purchasing
powerparityonlyoverthelongterm.
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
Thecurrency
ofCountry
A isthedollar($).
Thecurrency
ofCountry
B istheeuro(€).
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Thevalueofonedollariscurrently
€1.5000.
Inflation
inCountry
A is2.7%,andinCountryB is2.1%.
Inflation
inCountry
C, wherethecurrency
isthepeso.isexpected
toremain
constant
at2.5%for
theforeseeable
future.
Required
1 Whatisthevalueofa dollarexpected
tobeinoneyear?
 €0.6628
 €0.6706
 €1.5088
 €1.4912
tobeinsixyears?
 €0.6436
 €1.4482
 €0.6905
 €1.5537
tobeinsixmonths?
 €0.6647
 €1.4956
 €1.5044
 €0.6686
4 According
tothepurchasingpowerparitytheory
whatisthemostlikelyeffectonthevalueof
G Country
C’scurrency,thepeso,overthecomingyears? H
 Thepesowillweakenagainst
the$ andthe€
 Thepesowillstrengthen
against
the$ andthe€
 Thepesowillweakenagainst
the$ butstrengthen
against
the€
 Thepesowillstrengthen
against
the$ butweakenagainst
the€
Solution
324 Financial
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6.3 Interest rates
6.3.1 Long-term
Inthelongtermtwocountries ofsimilar
riskshouldoffersimilarratesofreturn
tointernational
investors
soanydifferences ininterest
ratesshould reflectdifferences
ininflation.
Highratesofinflation
ina foreigncountry weakenitsexchange ratesohighinterest
ratesare
associatedwithweakening currencies,inthelong-term.
ThisissometimescalledtheinternationalFisher
effect.
6.3.2 Short-run
Intheshort-runbanksuseinterest
ratestocalculate
forward
exchange
rates;thisisinterest
rate
paritytheory.
F0 = S0 × (1+ ic)
(1+ ib)
Where F0=forward
rate
S =current
spotrate
0
b=basecountryandc =foreign
country
Activity8: IRP theory
Acompanybasedincountry A,where thecurrency

isthe$,isexpecting
toreceive
Kuwaiti
dinars
insixmonths’
time.Thespotrateis5.4670dinars
per$.Annual interest
ratesare8%incountry
A
and6%inKuwait.
Required
Calculate
theforward
exchange
ratein6 months’
time.
G H
Solution
6.4 Four-way equivalence

Thefour-way equivalencemodel states
thetheories
thatwehavebeenexamining arelinked.
Ifinterestratesareonlydifferentbetweentwocountries
duetoinflation
(ierealinterest
ratesare
thesameinbothcountries) then:
(a) Inflationratescanbeusedtopredict thefuture
spotrate(purchasing
power paritytheory),
and
(b) Long-term interest
ratescanalsobeusedtopredict thefuture
spotrate(international
fisher
effect).
Itisalsologicaltoassume thatifshort-term
interest
ratedifferences
explainthedifferences
between theforwardrateandthespotratethenoverthelong-termthiscanalsobeseenasan
unbiased indicator
ofexpected changesinthespotrate.
Inotherwords, thetheoriesthatwehavebeenexamining arelinked.
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Purchasing
power parity
theory
Inflation
rate High
inflation
=fallinexchange
rate Forecast
changes
differences inexchange
rates
High
interest
rates High
long-term
interest
rates
predicts
due
tohigh
inflation adecline
intheexchange
rate
Forwardrate–
Interest
rate unbiased
indicator
differences Interest
rate
parity
theory ofspot
rate
Forward
rates
arecalculated
byinterest
rate
differences
7 Managing other risks

Thischapterhasfocussed
ontransaction
risk,butyoualsoneedtobeawareofotherexchange
raterisks.
7.1 Translation risk
Translation
risk:Theriskthatthedomestic currency
valueofforeign
currency
assetsfalls,or
KEY thevalueofforeigncurrencyliabilities
rises.
TERM
Ifa changeintheexchange ratecausesanadverse changeinthedomestic currencyvalueof
foreigncurrencyassetsandliabilitiesthenthedifferencemaybewritten offasa loss.
G H
Unliketransactionrisk,thisisnota cashflow,butitisstilla worry

forsomecompanies because
of
itspotential
profit
impact.
Tomanage translationrisk,a company thathasassetsina foreign currency
canmatchthese
assetswithliabilities
(egdebtfinance) inthesameforeign currency.
Onewayofobtaining foreign currency debtfinanceistousea currency swap(notexaminable
withnumbers).
7.2 Economic risk
Economic
risk:Duetolong-term
movements
intheexchangeratethatdamage thevalueofa
KEY company
because
TERM exchange t henet
present
value
ofthebusiness’s
cash flowsi sdiminished
byexpected
ratetrends.
Companies should carefullyanalyse potential

exchange ratefluctuations
sothattheyminimise
theriskofexport revenue beingdamaged overthelonger-term duetosustained exchange rate
movements (orthecostofimported goodsrising).
However,evencompanies thatdonotexport orimport canbeexposed toeconomicriskifa
sustainedmovement intheexchange ratebenefitsanoverseas rival.
Economic riskisdifficult
tomanage effectively,
buta recognisedstrategyistodiversify
its
international
operations sothatitisnotoverlyexposed toa changeina singleexchange rate.
326 Financial
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Chapter summary
Foreigncurrencyrisk
Basics Basichedging
methods Forward
contracts
Transaction
risk Internal
methods Fixedrate,
arranged
Risk
ofexisting
foreign
currency Matching,
leading
andlagging, now forasetdate
in
transactions
having
avariable netting,
invoice
inlocal
currency thefuture
value
inthedomestic
currency
becauseofachange
inthe
exchangerate Advantages
• Simple
• Lowsetupcosts
Spot
rates • Available
Quotedtothedollar
(assumed
to
bethedomestic
currency)
Disadvantages
• Fixed
date
Spreads • Unattractive
rate
Always
usetheleast
favourable • Counterparty
risk
rate
Money
market Derivatives
G
hedging H
Receipts Currency futures Currencyoptions

Setupforeign
currency
loan • Fixed
rate,standard
amount • Exchange
traded orOTC
foruseinthefuture • Premiumpaid upfront
• Marginpaidupfront • Call=optiontobuy,
Payments • Separatefromactual put=optiontosell
Setupforeign
currency transaction • Operates
likeaninsurance
investment • Createsafixedoutcome policy
Advantages Advantages
• Foraperiod
oftime,
nota Allow
favourable
exchange
rates
fixed
date tobeused
• Lower
counterparty
risk
Disadvantages
Disadvantages Expensive
• Standard
contract
sizes
• Narrow
range
ofcurrencies
• Basis
risk Currency
swaps
• Used
torestructure
the
currency
base ofthe
company's
liabilities
• Ameansofreducingexchange
rate
exposure
overthe
long-term
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Forecasting
exchange
ratemovements Managing
otherrisks
Balance
ofpayments Translation
risk
Deficit
causes
aweaker
exchange
rate
inthe • Riskofchangesinthedomesticvalue
of
long-term foreign
assetsandliabilities
• Useforeigncurrency
liabilities
tomatch
to
foreign
currencyassets
Inflation • Foreigncurrency
liabilities
may beobtained
• PPPtheory
suggests
relatively
highinflation viaacurrencyswap
causesaweakening
oftheexchange
rate
• Onlytrue
over
thelonger
term
Economic
risk
• Change
incompany
value
duetolong-term
Interest
rates exchange
rate
movements
• Long-term:
international
fisher
effect • Manage
bydiversifying
operations
• Short-term:
interest
rateparity
(IRP)
theory
• IRPused
tocalculate
forwardrates
Four-way
equivalence
Links
together
interest
rateandinflation
rate
theories
G H
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1.Basichedgingmethods
Internal
methods
suchasleading
&lagging,netting,
matchingandinvoicing
inowncurrency
are
simpletechniques
thatcanbeconsidered
independently
bya company.
2. Forward
contracts
Themostpopular
formofhedgingbecause
oftheabilitytousea rangeofcurrencies
andtotailor
theamountandthetiming
toa company’s
specific
circumstances.
3. Money markethedging
Matchestothetransaction:
anexport
willrequire
a foreign
currency
loan;animport
willrequire
a
foreign
currency
investment.
4. Derivatives
Derivatives
include
futures,
options
andswaps.
5. Causesoffluctuationsinexchangesrates
Primary explanations
centreoninflation
(PPPtheory)
andinterest
rates.Four-way
equivalence
linksthesetheories.
G H
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q
Question practice
NowtrythefollowingfromtheFurther question
practice
bank(availableinthedigitaledition
of
theWorkbook):
Section
A questions
Q31,Q32
Section
B questions
Q37(a),(b),and(c)
Section
C questions
Q58Expo(thislongerquestionistoallowfurther
studyofthisarea,butthischapterisnotdirectly
examinableinSectionC oftherealexam).
Further reading
Thereisa useful
Technical
Article
thatisavailable
onACCA’swebsite; itiscalled‘Foreign
currency
riskanditsmanagement’.
Werecommend thatyoureadthisarticleaspartofyourpreparation
fortheFMexam.
G H
330 Financial
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Activity answers
Activity1:Transactionrisk
$10,000loss
180,000peso/2= $90,000costexpected
180,000peso/1.8
=$100,000 costincurred
Losses= $10,000
ImportersinCountryZ losewhenthe$getsweaker
Activity2: Spreads
$240,000
Anexporter buysdollars
froma bankinexchangeforforeign
currency
andsopaysthehigher
ratewhenbuyingdollars froma bank.
360,000peso/1.5=$240,000revenue received
Activity3: Forwardrates
1 $933,333
Anexporterbuysdollars
froma bankinexchange forforeign
currency
andsopaysthehigher
ratewhenbuyingdollarsfroma bank.Usingtheforwardspread
therateistherefore
1.5pesos
tothedollar.
1,400,000
peso/1.5=$933,333revenuereceived
2 $1,153,846
G
Animporter sellsdollars
toa bankinexchangeforforeign
currencyandsoreceivesthelower H
rate.Usingtheforward spreadtherateistherefore
1.3pesostothedollar.1,500,000
peso/1.3
=$1,153,846costincurred
Activity4: Moneymarkethedging:receipts
$509,887
Theinterestratesforthreemonths arecalculatedbyadjustingtheannual ratesgivenby
multiplyingthemby3/12.Thisgivesa 1.375% rate(5.5%×3/12)todepositindollarsand1.345% to
borrowinpesos(5.38%×3/12).
(1) Thecompany shouldaimtorepay1,000,000 pesosin3 months’time.
(2) Thecompany shouldaimtoborrow 1,000,000/1.01345=986,729 pesostoday(afterthree
months, 1,000,000 pesoswillberepayable,includinginterest).
(3) Thesepesoswillbeconverted to$ at986,729/1.9618
=$502,971.Thisisplacedondeposit in
theUS.
(4) Thecompany willdeposit
thisamount forthreemonths, whenitwillhaveincreasedinvalue
withinterest
(5.5%forthethreemonths) to:$502,971×1.01375=$509,887
Inthreemonths, theloanwillberepaid outofthepesosproceeds fromthetradereceivable.
Thecompany has‘manufactured’ a forwardrateof1.9612(1,000,000/$509,887).
14:Foreign
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q
Solution
presented
asa table:
$ Peso
Now (3) 986,729/1.9618=
$502,971 (2)1000000/1.013245
=986,729
pesos
(1+interest
rate)= 1.01375 1.01345
Threemonths (4)$502,971
×1.01375
=$509,887 (1)–1,000,000
pesostopay
+1,000,000
pesosrequired
0
Activity5: Moneymarkethedging:expenses
$510,224
Theinterestratesforthreemonthsarecalculatedbyadjustingtheannual ratesgivenby
multiplyingthemby3/12.Thisgives1.3975% toborrowindollars
and1.3275% todepositinpesos
(1) Thecompany needstodepositenough pesosnowsothatthetotalincluding interest
willbe
1,000,000 pesosinthreemonths’time.
(2) Thismeans depositing:
1,000,000/ 1.013275
=986,899 pesostoday.
(3) Thesepesoswillbeconverted to$ atthespotrateof1.9612givinga cost$503,212today.
(4) Thecompany mustborrowthisamount nowandwillhavetorepay:$503,212 ×(1+0.013975)
=$510,244 inthreemonths’
time.
So,inthreemonths, thesupplier
willbepaidoutofthepesobankaccount andthecompany will
effectively
bepaying$510,244 tosatisfythisdebt.Thecompany has‘manufactured’ a forward
rateof1.9598 (1,000,000/$510,244)
Again,thesesamestepscanbepictured asa table
G H
IMPORTER– threemonths
Now (3)986,899/1.9612
=$503,212 (2)1,000,000/1.013275
=986,899
pesos
5.59%×3/12=1.3975% 5.31%×3/12=1.3275%
ie1.013975 ie1.013275
6 months (4)503,212
× 1.013975
=$510,244 (1)–1,000,000
pesos
+1,000,000
pesos
1 Thecorrect
answer
is:100,449
dollars
Value
Three
months
Nettransactions +197,000
pesos
Forward
rate 1.9612
Forward
outcome +$100,449
2 Thecorrect
answer
is:149,602
dollars
Financial
Management
(FM)332
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q
Theinterest
ratesforsixmonthsarecalculated byadjusting
theannual ratesgivenby
multiplying
themby6/12.Thisgives2.795% toborrow indollars
and2.655%todeposit in
pesos.
(1) Thecompany needstodeposit enough pesosnowsothatthetotalincluding interestwill
be293,000pesosinsixmonths’ time.
(2) Thismeansdepositing:
293,000/1.02655 = 285,422pesostoday.
(3) Thesepesoswillbeconvertedto$ atthespotrateof1.9612 givinga cost$145,534today.
(4) Thecompany mustborrow thisamount nowandwillhavetorepay:$145,534 ×(1+
0.02795)=$149,602in6 months’ time.
So,insixmonths,thesupplier
willbepaidoutofthepesobankaccount andthecompany will
effectively
bepaying$149,602 tosatisfythisdebt.Thecompany has‘manufactured’ a
forwardrateof1.9585(293,000/$149,602).
Again,thesesamestepscanbepictured asa table
IMPORTER– Sixmonths
Now (3)285,422/1.9612
=$145,534 (2)293,000/1.02655
=285,422
pesos
5.59%×6/12=2.795% 5.31%×6/12=2.655%
ie1.02795 ie1.02655
6 months (4)145,534
× 1.02795
=$149,602 (1)–293,000pesos
+293,000pesos
0
3 $149,604
G H
Sixmonths
Nettransactions -293,000pesos
Forward
rate 1.9585
Forward
outcome $149,604
Thisis$2worse
thanthemoneymarkethedge(animmaterial
difference
aswould
normally
be
expectedbecause
forward
ratesaredetermined
byinterest
ratedifferences)
4 Thecorrect
answeris:Borrowing
inpesosnow
Theunderlying
transaction
isanassetinpesostherefore
thehedgemustbeginwiththe
creation
ofanequivalent
pesoliability
(some
borrowings)
whichareturned
immediately
into
dollars.
1 Thecorrect
answeris:€1.4912
€1.5000
× 1.021/1.027
=€1.4912
in1year
2 Thecorrect
answeris:€1.4482
€1.5000
× (1.021/1.027)
6=€1.4482
in6 years
3 Thecorrectanswer is:€1.4956
Inflation
rateover6 months =2.1%x6/12=1.05%and2.7%x6/12=1.35%sotheexchange
ratein½yearisestimated as1.5000×1.0105/1.0135
=1.4956
or€1.5000× (1.021/1.027)
1/2
4 Thecorrect
answer
is:Thepesowillstrengthen
against
the$ butweaken
against
the€
14:Foreign
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q
Thecurrency whoseinflation
rateishigher
willweaken.
HeretheCountryC (peso)hasa lower
inflation
ratethanCountryA ($)andsowillstrengthen
against
the$,thereverse
istruefor
Country B.
Activity8: IRPtheory
5.4144
Usinginterestrateparity,thedinaristhenumerator
andthe$ isthedenominator.
Interest
ratesneedtobemultiplied by6/12tocreatea ratefora 6 month
period.
So,theforward rateisgivenby:
5.4670× 1.03/1.04= 5.4144
G H
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15
Interest rate risk
15
Learning objectives
Oncompletion
ofthischapter,
youshould
beableto:
Syllabus
reference
Thenatureandtypesofriskandapproachestoriskmanagement
• Describe&discuss raterisk:gapexposure, G1(b)
typesofinterest
basisrisk
Causesofinterest
ratefluctuations
• Describethecausesofinterest
ratefluctuations,
including: G2(c)
- Structureofinterest
ratesandyieldcurves
G
- Expectationstheory H
- Liquidity
preferencetheory
- Market segmentation
Hedgingtechniquesforinterest
raterisk
• Discussandapplytraditional
andbasicmethods ofinterest G4(a)
rateriskmanagement, including:
matchingandsmoothing,
assetandliability
management, forwardrateagreements
• Identify
themaintypesofinterestratederivatives
usedto G4(b)
hedgeinterest
rateriskandexplainhowtheyareusedin
hedging (nonumericalquestions
willbesetonthistopic)
15
Exam context
Thischapter,
andtheprevious chapter,
coverSectionG ofthesyllabus
(RiskManagement).
SyllabussectionG, riskmanagement, isexaminableintheOTsectionsoftheexam(sections
A
andB)andcommonly formsa theme ofoneofthe(10mark) Section
B questions.
Itisalsopossible
foranaspectofthischapter tobetestedasa partofa Section
C question,
mainly becauseinterestrateriskcanimpactoninvestment appraisal
andthefinancing
decision;
butthisisrare.
Page 357 of 641

q
15
Chapter overview
Interestraterisk
Basics FRAs
Basis
risk Advantages
Gapexposure Disadvantages
Basic
hedging
methods
Derivatives Yield
curve
Interest
ratefutures Interest
rateoptions Expectations
theory
G
Advantages Advantages Liquidity
preference H
Disadvantages Disadvantages Market

segmentation
Strategies
Interest
rateswaps
336 Financial
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1 Introduction to interest rate risk
PER alert
Performanceobjective11requires
youto‘advise
onusinginstruments
ortechniques
tomanage
financial
risk’.Thischaptercovers
themanagementofinterest
raterisk.
1.1 Types of interest rate risk

Acompany
mayfaceinterest
rateriskon:
Borrowings:
higher
interest
rates
willincrease
financing
costs
Investments:
lowerinterest
rates
will
reduce
thereturn
oncash investments
Evenifa company hasbothborrowings andinvestments ofsimilar

sizes,theremaystillbea risk
if:
(a) Interest
isearnedata fixedrateoninvestments butinterest
ispaidata variablerateon
borrowings
(sothereisa riskifinterest
ratesrise).
G H
(b) Interest
isearnedata variable rateoninvestments butinterest
ispaidata fixedrateon
borrowings
(sothereisa riskifinterest
ratesfall).
1.1.1 Basisriskandgapexposure
Evenifa company hasbothcashassetsandliabilities ofsimilar
sizes,andbothinvestments and
borrowings areata variable rateofinterest,
theremaystillbea riskif:
(a) Thevariable interest
ratesarenotdetermined bythesamebasisegonemightbelinked to
thecentralbankbaserate,andtheothertoLIBOR(theLondon inter-bank offerrate).
Thisisanexample ofbasisrisk.
(b) There isa timegap thatgivesrisetorisk.
Thisiscalledgapexposure.
Gapexposure mayarisebecause:
• theinterest ratesoninvestments andborrowings arerevised
atdifferent points intimeeg
assetsmightbeata variable ratebasedonLIBORthatisrevised everythreemonths and
liabilities
mightbevariable ratebasedonLIBORbutrevised everysixmonths
• ata givenpointintimethereisa difference between thevalueofthe(interest-sensitive)
assetsmaturing atthattimeandthevalueofthe(interest sensitive)
liabilities
maturingatthat
time.Ifliabilities
aregreaterthanassets, thereisa riskofinterest
ratesrising(anegative gap).
Ifassetsaregreater thanliabilities,
thereisa riskofinterest
ratesfalling(apositivegap).
15:Interest
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q
1.2 Basic methods of managing risk
Fromtheperspective ofa company borrowingmoney, interest
rateriskcanbemanaged by:
• Smoothing
Thisinvolvesusinga prudent mixoffixedandfloating
ratefinancetomitigate
theimpactof
interestratechanges.
• Matching
Thisinvolvescreatingassetsthatarebasedonthesameinterest rates(egLIBOR)astheir
liabilities
(mainly
usedbybanks).
1.3 Protecting against future interest rate exposure
Ifthecompany isriskaverse
orexpectsinterest
ratestorise,thentheemphasis willbeonusing
fixedratefinance.
If,however,a loan(orinvestment)
isbeingplannedinthefuture,thentheriskisharderto
manage.
Acompany isplanning
totake Inonemonths'
time,whentheloanis
outaloaninonemonths'
time taken
out,interest
ratesmayhaverisen.
Thisriskcanbemanaged bythetechniques
coveredinthefollowing
sections,
whicheither
aimto
fixtheinterest
rate(FRAs,futures,
swaps)
orcaptheinterest
rate(options).
2 Forward rate agreements (FRAs)
FRA:A contract
witha bankcovering
a specificamount
ofmoney tobeborrowed
overa
KEY specific
timeperiod
inthefuture
ataninterestrateagreednow.
G H
TERM
Aforward rateagreement (FRA)forinterestratesissimilarinmanyrespects toa forward
exchange contractforcurrencies.
• FRAsarearranged witha bankasanoverthecounter transaction.
• AnFRAisa binding contract thatfixesaninterestrateforshort-term lending/investing
or
shorttermborrowing, foraninterest rateperiodthatbegins ata futuredate.
However, anFRAisnotidentical toa currency
forward because itisnotanagreement thatis
directly
linked toa transaction (egtolendorborrow). Instead,
itisa derivative
agreement that
fixesaninterestrateona notional amount ofmoney (theprincipal).
Acompany canenter intoanFRAwitha bankthatfixestherateofinterest forshort-term
borrowing froma certain timeinthefuture.
• Iftheactualinterest rateatthatdateproves tobehigher thantherateintheFRA,thebank
supplying theFRApaysthecompany thedifference.
• Iftheactualinterest rateislower thantheFRArate,thecompany paysthebanksupplying the
FRAthedifference.
TheFRAdoesnotneedtobewiththesamebankastheloan,astheFRAisa hedging method
independent ofanyloanagreement.
Thisallows a company totakeouttheloaninfuture atthebestrateavailable.
338 Financial
Management
(FM)
Page 360 of 641

q
2.1 Quotation of FRAs
$5m3–9FRAat5%
Sizeofloan Start
and Baserateguaranteed
endmonth
Activity1:FRA
Frantic
plcisplanning
totakeouta 6-monthloanof£5min3 months’
time.Itisconcerned
about
thebaserate(LIBOR)
risingaboveitscurrent
levelof4.75%.
Frantic
hasbeenoffereda threetonineFRAat5%.
Frantic
canborrowatapproximately 1%abovethebaserate.
Required
1 Advise
Frantic
ofthelikelyoutcome
ifin3 months’
timethebaserateis5.5%.
2 Advise
Frantic
ofthelikelyoutcome
ifin3 months’
timethebaserateis4.5%.
Solution
G H
2.2 Advantages of FRAs

FRAshavesimilar
advantages
tocurrency
forwards.
• Simple Easytoorganise
fortheexactamountofmoney
required
and
theexacttiming
ofthetransaction
• Loworzeroup-front
costs Unlike
interest
rateoptions
(seelater)
• Fixtheinterest
rate Thisprotects
theborrower
fromhigher
interest
ratesinfuture
2.3 Disadvantages of FRAs
Disadvantages Discussion
• Fixeddate Theoutcome oftheFRAwillbedeterminedona specified
date,
eveniftheactualborrowing
isona different
date.
• Unattractive
rate Thefixedratethatisoffered
maynotbeattractive
• Counter-party
risk Theagreement
isbetween
twoparties,
thereistherefore
a risk
ofdefault
oneither
side
15:Interest
raterisk 339
Page 361 of 641

q
FRAsareusually
onlyavailable
onlargeloansandarelikelytobedifficult
toobtainforperiods
of
overoneyear.
Activity2: FRA discussion
Todayis1January20X6.Deverosity
Ltdwillborrow
$6million
on31March20X6andwillrepay
thisdebton31December 20X6.
LIBORiscurrently
at1.0%andDeverosity
Ltdcanborrowshort-term
debtat8%aboveLIBOR.
Aforward rateagreement
isavailable
forDeverosity
Ltdat1.25%.
On31March20X6,LIBORis0.75%.
Required
Statewhetherthefollowing
statements
aretrueorfalse.
(1) Theappropriate
typeofforward
rateagreementinthiscasewouldbea 3–9FRA
(2) TheFRAratewould be9.25%
(3) IfLIBORwasactually
0.75%on31March20X6thiswould result
inanobligation
onDeverosity
LtdtomakeanFRApayment
(4) IfLIBORwasactually
0.75%on31March20X6thiswould result
inanFRApayment orreceipt
of$22,500
Solution
1
G H
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
3 Interest rate derivatives
Examfocus point
Thissection
willnotbetestednumerically
intheexam.
3.1 Interest rate futures
Interest
ratefutures:
Aninterest
ratefutures
contract
isa contract
toreceive
orpayinterest
KEY
TERM ona notional
standardquantity
ofmoneya tanagreedfuture
d ateata specified
interest
rate.
340 Financial
Management
(FM)
Page 362 of 641

q
LikeanFRA,a futurescontractisintendedtofixtheoutcome ofa hedge.However,
a futures
contract
isfora standardamount ofmoney andistradedonanexchange.
LikeanFRA,aninterestratefutureshedgeisdesigned sothat:
• Ifa company makesa lossona transaction(borrowing
orinvesting)
duetointerest rate
movements,thenitwillmakea profitinthefuturesmarket
tocompensate forthis.
• Ifa company makesa profitona transaction(borrowing
orinvesting)
duetointerest rate
movements,thenitwillmakea lossinthefutures market.
So,theoutcome isfixedwhatever happens totheexchangerate.
Typesofinterestratefuturescontract
Contracttobuy Contracttosell
Withinterest
ratefutures
whatisbeing Withinterest
ratefutures
whatisbeingsoldis
boughtistheentitlement
tointerest
receipts. thepromise
tomakeinterest
payments.
Acontract toreceive
interest
ata fixedrate Acontract
topayinterestata fixedratewould
would beappropriateforaninvestor;
thisis beappropriate
fora borrower;
thisiscalleda
calleda contract
tobuy. contract
tosell.
3.1.1 Settingupa futurestransaction

Therearethreestepstoa futures transaction.Fora borrower,theseareasfollows:
Step1 Today:Enterintoa futures contract tosell(payinterest)
ata fixedrate
Contracts shouldbeduetobefulfilled ona standardised
dateafterthetransaction
date.
Step2 Complete theactualtransaction onthespotmarket.
Step3 Closeoutthefutures contract bydoingtheopposite ofwhatyoudidinStep1ieby
G
enteringintocontractstobuy(receive interest). H
Aprofitorlosswillariseasfuturesaresettled.
• Ifinterestratesrisethentherewillbea gainonthefuture astheinterestreceived
instep3 will
behigher thantheinterestpaidinstep1.
However,therewillalsobeaninterest ratelossbecausetheinterest
rate(ierepayments)onthe
actualloanwillbehigher.
• Ifinterestratesfallthentherewillbea lossonthefuture astheinterestreceived
instep3 will
belower thantheinterestpaidinstep1.
However,therewillalsobeaninterest rategainbecause theinterest
rate(ierepayments)onthe
actualloanwillbelower.
3.1.2 Advantagesofinterestratefutures
Asforcurrency
futures.
• Futuresarevalidfora period
oftimeega September
futurecanbeusedonanydaybetween
thedayitwasentered intouptotheendofSeptember.
Thisismoreflexible
thana forward,
day.
• Counterpartyriskislowersincethefutures
exchange
guarantees
thetransaction.
3.1.3 Disadvantages ofinterestratefutures
Asforcurrencyfutures.
• Interest
ratefuturesareonlyavailable
inlarge,standard,contractsizes(compared
toforward
contracts).
Thismakes interest
ratefutureslesssuitable
forsmalltransactions.
• Tocoverpotentiallossesa companyusingfutureswillberequiredtoplacea deposit
(calleda
margin)withthefutures exchange,
whichmayneedtobetopped upona dailybasisifthe
contractisincurring
losses.
15:Interest
raterisk 341
Page 363 of 641

q
• Thereisa riskthatfutures
interest
ratesdonotmoveexactlyinlinewithspotinterest
ratesso
thatthehedgeisnoteffective(thisisanexample
ofbasisrisk).
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
3.2 Interest rate options
Interest
rateoptions:
Givesanoption holder
therighttopayorreceiveinterest
onanagreed
KEY
TERM quantity
ofmoney,ata specific
i nterest
rateonorbeforea future
e xpiry
d ate.
Asforcurrency options,
companies canchoose whether tobuy:
(a) Atailor-madeinterest
rateoption froma bank,suitedtothecompany’s specific
needs.These
areoverthecounter (OTC)ornegotiated options;
or
(b) Astandard interest
rateoption, fromanoptions exchange. Suchoptions aretradedor
exchange-tradedoptions.
Optionsoffertheflexibility
totheholder ofenjoyingtheupside withouta riskofsuffering
the
downside ofadverseinterestratemovements.
However,buyinganoption involves
payinga premium totheoptionseller.Theoption premiumis
a costofusinganoption.
Theoption actsasaninsurance policyandwillbeusedbythepurchaser tocompensate for
adverseinterest
ratemovements. Iftheinterest
ratemoves favourably
thentheoption willnotbe
G
exercised. H
3.2.1 Advantagesofoptions
• Exchange-tradedoptions(notOTCoptions)
are,likefutures,
validfora period
oftime.Thisis
moreflexible
thana forward,
day.
• Exchangetradedoptionscanbesoldonifnotneeded.
• Anytypeofoptionallowsthecompany tobenefitfromfavourable interest
ratemovements.
3.2.2 Disadvantages
ofoptions
• Exchange-traded
optionsareonlyavailable
inlarge,standard,
contract
sizes
• Anytypeofoption
willneedtopurchasedandthepremium canbeexpensive.
Putoption:Anoption topayinterestata pre-determined

rateona standard
notional
amount
KEY overa fixedperiodinthefuture.
TERM
Calloption:Anoption toreceiveinterest
ata pre-determined
rateona standard
notional
amount overa fixedperiodinthefuture.
342 Financial
Management
(FM)
Page 364 of 641

q
3.2.3 Option strategies
Aninterestrate cap protectsagainst interestrate risesfora borrower.
Loan
rate Cap–buyaputoption
%
%Market
interest
rate
Aninterestrate floorprotectsagainst interestrate fallsforan investor.
Deposit
rate
%
Floor–buyacalloption
%Market
interest
rate
Aninterestrate collaris cheaper than a cap or a floor.Fora borrower,a collarwouldbe as
follows:
Loan
G H
rate Cap–buyaputoption,
payapremium
%
Collar
Floor–sella call,receive
a premium
%Market
interest
rate
Thecost of a collaris lowerthan forbuyingan optionalone.However,the borrowingcompany
forgoesthe benefitof movementsininterestrates belowthe floorlimitinexchangeforthiscost
reduction.
Foran investora collarinvolvesbuyinga calloption(a floor)and sellinga put option(at a higher
interestrate than the floor).Theinvestorthereforeforgoesthe benefitof movementsininterest
rates abovethe put optionrate.
Activity 3: Interest rate collar
Acompanywishesto arrange a collarto fixa futureinterestrate on a variablerate five-yearloan

it has obtainedfromits bank.
Required
Whichof the followingtransactionswillenable the companyto arrange an appropriatecollar?
 Buyinga cap and buyinga floor
 Buyinga cap and sellinga floor
15:Interestraterisk 343
Page 365 of 641

q
 Selling
a capandselling
a floor
 Selling
a capandbuyinga floor
Solution
3.3 Interest rate swaps
Interest
rateswap:Anagreement
whereby
theparties
totheagreement
exchange
interest
KEY
TERM ratecommitments.
Finally,a company maybeabletoswapvariable ratedebtforfixedratedebtifitisworried

about
interest
raterises.Thistypeofswapissometimesknownasa ‘plainvanilla’swap.
Aswapallows a company toorganise
a newloanwithout
incurringredemptionpenalties
forearly
repayment ofanexistingloan.
3.3.1 Whybothertoswap?
G Obviousquestionstoaskare: H
• Whydothecompanies botherswapping interest

payments
witheachother?
• Whydon’ttheyjustterminate theiroriginal
loanandtakeouta newone?
Theanswer isthattransactioncostsmaybetoohigh.Terminating anoriginal
loanearlymay
involve
a significant
termination
feeandtakingouta newloanwillinvolve
issuecosts.Arranging
a
swapcanbesignificantly cheaper,evenifa bankerisusedasanintermediary.
Because the
bankerissimply actingasanagentontheswaparrangement anddoesnothavetobearany
default
risk,thearrangement feecanbekeptlow.
4 Yield curve
Thetermstructure
ofinterest
ratesrefers
tohowtheyieldonbondsofa certain
typeeg
government bondsvaries
accordingtothetermoftheborrowing.
Normally,thelonger
thetermofanassettomaturity,thehigher
therateofinterest
paidonthe
asset.Thiscanbeshown asa yieldcurve.
%yield
Normal
yield
curve
5 10 Years
tomaturity
344 Financial
Management
(FM)
Page 366 of 641

q
4.1 Explanations of the yield curve
There area number ofexplanations oftheyieldcurve;thesearenotcompeting explanations,
and
atanyonetimeallmaybeinfluencing theshapeoftheyieldcurve.
(a) Expectationstheory– thecurvemayreflect expectations
thatinterest
rateswillriseinthe
future,sotheGovernment hastoofferhigher returnsonlong-termdebt.
(b) Liquidity
preferencetheory – thecurvereflects
thecompensation thatinvestors
require
higherreturnsforsacrificing
liquidity
onlong-dated bonds.
(c) Market segmentationtheory – short-datedbondstendtobemorepopular withbanks, and
long-datedbondsaremorepopular withpensionfunds,ietherearedifferent
markets.This
theorysuggests thattheslopeoftheyieldcurvewillreflectconditions
indifferentsegments
ofthemarket.
4.1.1 Thesignificanceofyieldcurvestofinancialmanagers
Financial
managers caninspecttheshapeoftheyieldcurvewhendeciding thetermofborrowing
ordeposits.
Thecurveisinfluenced bythemarket’s
expectations
offuture interest
rate
movements.
Forinstance,
a yieldcurvethatissloping
steeply
upwardssuggestsa riseininterest
ratesinthe
future;
inthiscasea company willbemoreconcerned aboutmanaging interestraterisk.
Essentialreading
reading,
available
inthedigitaledition
oftheWorkbook,
formorebackground
TheEssential
readingisavailable
oftheWorkbook.
G H
4.2 Comprehensive example on risk management

Section
B oftheexamwilloftenhavea 10-mark
questionfocusing
onriskmanagement. Thistype
ofquestion
cancombineelements ofbothcurrency
riskandinterest
rateriskasillustrated
inthe
following
comprehensive
activity.
Activity4: Risk management:SectionB style OTQ
RobinCoexpectstoreceive€800,000froma creditcustomer
intheEuropeanUnion
insixmonths’
time.Thespotexchangerateis€2.413
per$1andthesixmonth forward
rateis€2.476
per$1.The
following
commercial
interest
ratesareavailable
toRobinCo:
Deposit
rate Borrow
rate
Euros 3.0%peryear 7.0%peryear
Dollars 1.0%peryear 2.5%peryear
RobinCodoesnothaveanysurplus
cashtouseinhedging
thefuture
euroreceipt.
Required
1 WhatcouldRobinCodotoreduce theriskoftheeurovaluedropping
relative
tothedollar
beforethe€800,000isreceived?
(1) Deposit€800,000immediatelyaspartofa money markethedge
(2) Enterintoa forward
contract
tosell€800,000insixmonths
(3) Enterintoaninterest
rateswapforsixmonths
 (1)or(2)only
15:Interest
raterisk 345
Page 367 of 641

q
 (2)only
 (3)only
 (1),(2)or(3)
2 Whatisthedollarvalueofa forward
market
hedge?
 $323,102
 $331,538
 $1,930,400
 $1,980,800
3 IfRobinCouseda money
market
hedge,whatwould
bethepercentage
borrowing
rateforthe
period?
 1.25%
 2.5%
 3.5%
 7%
4 Whichofthefollowing statementsaboutforward
rateagreements
(FRAs)aretrue?
(1) Theyfixtheborrowing rateona sumofmoney foranagreedperiod
(2) Theyarearranged witha bankasanover-the-counter
transaction
(3) Theallowcompanies tobenefitfromfavourable
interest
ratemovements
(4) Theycanbeusedtohedgeagainst foreign
exchangerisk
 (1),(2),(3)and(4)
 (1)and(2)only
G
 (3)and(4)only H
 (2),(3)and(4)only
5 Whichofthefollowing statements
aboutinterestratetheories
aretrue?
(1) Expectationstheoryprovides
a reasonwhytheinterestyieldcurveisnormally
upward
sloping
(2) Marketsegmentation theory
statesthatinterest
ratesreflect
expectations
offuture
changesininterestrates
 Statement (1)istrueandstatement(2)isfalse
 Statement (2)istrueandstatement(1)isfalse
 Bothstatements aretrue
 Bothstatements arefalse
Solution
346 Financial
Management
(FM)
Page 368 of 641

q
Chapter summary
Interestraterisk
Basics FRAs
Basisrisk • Basedonanotional
loan
Riskofinterest
rates
onassets
andliabilities • Fixed
rate,
arranged
nowforasetdate
in
notmoving inline
with
eachother
because thefuture
influenced
bydifferent
basis
Advantages
Gapexposure • Simple
Risk
ofinterest
rates
onassets
andliabilities • Lowsetupcosts
notmoving
inline
with
eachother
because • Available
revised
atdifferent
times
Disadvantages
Basic
hedging
methods • Fixed
date
Smoothing
andmatching • Unattractive
rate
• Counterparty
risk
Derivatives Yield
curve
Interest
rate futures Interestrateoptions Expectations
theory
G H
• Fixed
rate,standardamount • Exchange traded orOTC Steeper
curve
ifinterest
raterises
foruseinthefuture • Premium paid upfront areexpected
• Marginpaidupfront • Putoption =topayinterest
• Separatefromactual (borrower),calloption
=receive
transaction interest
(investor) Liquidity
preference
• Createsafixedoutcome • Operates like
aninsurance Investors
require
ahigherreturn
• Contracttosell=topay policy tocompensate
forless
liquidity
interest
(borrower),
contract
to
buy=receiveinterest
(investor)
Advantages Market
segmentation
Allowfavourableinterest
rates
to Interest
rates
reflect
different
Advantages beused
• Foraperiodoftime,nota market
conditions
indifferent
fixed
date market
segments
• Lowercounterpartyrisk Disadvantages
Expensive
Disadvantages
• Standardcontractsizes Strategies
• Basis
risk Caps, floors,collars
Interest
rate
swaps
• Ameansofreducing
interest
rate
exposure
over
the
long-term
15:Interest
raterisk 347
Page 369 of 641

q
1.Basichedging
methods
Internal
methodssuchassmoothing
andmatching
aresimple
techniques
thatcanbeconsidered
independently
bya company.
2. FRAs
FRAsfixtheinterest
rateonborrowingthatisplanned
forthefuture
butunlike
currency
forwards
arebasedona notionalloan(separate
fromtheactualloan).
3. Interest
ratefutures
LikeFRAsbutbasedona standard
amountofmoney.
Acontract
tosellisrequired
bya borrower,
anda contract
tobuyisrequired
byaninvestor.
4. Interest
rateoptions
Aputoptionisrequired
bya borrower,
anda calloption
isrequired
byaninvestor.
5. Yieldcurve
Theshapeoftheyieldcurvegivesanindication
ofthelikelytrendininterest
rates(expectations
theory)butisalsoinfluenced
byliquidity
preference
andmarket segmentation.
G H
348 Financial
Management
(FM)
Page 370 of 641

q
Question practice
Nowtrythefollowing
fromtheFurther
question
practice
bank(available
inthedigitaledition
of
theWorkbook):
Section
B questions
Q37(d)and(e)
Further reading
There
isa usefulTechnical
Articlethatisavailable
onACCA’swebsite;itiscalled‘Hedging
techniques
forinterest
raterisk’.Werecommend thatyoureadthisarticleaspartofyour
preparation
fortheFMexam.
G H
15:Interest
raterisk 349
Page 371 of 641

q
Activity answers
Activity1:FRA
1 Netcost=6%
Bankpayscompensation of0.5%toFrantic
Frantic
borrows
atthebestrateavailable
eg5.5+1=6.5%
Netcosts=6%in£sthisis0.06×£5m×6/12=£0.15m
2 Netcost=6%
Frantic
paysbankcompensationof0.5%
Frantic
borrows
atthebestrateavailable
eg4.5+1=5.5%
Netcosts=6%
Activity2: FRAdiscussion
Answerasfollows:
(1) False– thecontract
startsin3 months
andlastsfor9monthsandthereforeisa 3-12FRA
(2) False– theFRArateis1.25%
(3) True– LIBORhasfallensothecompany mustpayextraastheyhaveentered anFRAata
higherrate.
(4) True– asLIBORis0.5%below theFRArate,Deverosity
willpay0.5/100× $6m×9months /12
months = $22,500.
Activity3: Interestratecollar
Thecorrect answeris:Buyinga capandselling
a floor
G H
Buyinga cap(iea putoption) setsthemaximumrateforborrowing.

Selling
a floor(iea call
option)
reduces thecostofthehedge,butalsosetsa minimumeffective
rate.
Activity4: Riskmanagement:
SectionB styleOTQ
1 Thecorrect
answeris:(2)only
Statement
1isincorrect.
RobinCocouldusea money markethedgebut€800,000would have
tobeborrowed,thenconverted intodollars
andthenplacedondeposit.
Statement3 isalso
incorrect.
Aninterest
rateswapswapsonetypeofinterest payment(suchasfixedinterest)
for
another
(suchasfloatingrateinterest).
Therefore,
itwould
notbesuitable.
2 Thecorrect
answer
is:$323,102
Future
value=€800,000/2.476
=$323,102.
3 Thecorrect
answer
is:3.5%
RobinCoisexpecting
a euroreceipt
insixmonths’
timeanditcanhedgethisreceipt
inthe
money markets
byborrowing euros
tocreatea euroliability.
Euroborrowing
rateforsixmonths=7.0%/2 = 3.5%.
4 Thecorrectanswer is:(1)and(2)only
Statement3 isfalse.Acompany islocked
intotheFRAborrowing rateandsoitcannotbenefit
fromfavourableratemovements. Statement
4 isfalse.FRAshedgeagainst
interest
raterisk
(although
theyaresimilar toa forwardexchange contractforcurrencies).
5 Thecorrect
answer
is:Bothstatements
arefalse
350 Financial
Management
(FM)
Page 372 of 641

q
Statement1is false.Itis liquiditytheorywhichprovidesa reason whythe interestyieldcurveis
normallyupwardsloping.Expectationstheorystates that interestrates reflectexpectationsof
futurechanges ininterestrates. Thereforestatement2 is also false.
G H
15:Interestraterisk 351
Page 373 of 641

q
G H
352 Financial
Management
(FM)
Page 374 of 641

q
Skills checkpoint 5
How to approach your FM
exam
Chapter overview
msuccess
Exa skills
sw
An erplanni
ng
n ecific
FM skills Co
tio Sp o rre
a
o
frm freqctin
in u te
n
i
g
Approach
to
objective
a (OT)
questions appraisal
n
a
How
to Handling
G approach complex
o
o
d
your
FM
a
tim Effective an
l
G
em discussion ca H
an
ag
ofkey
financial
topics meri
u
em
ent ntn
ie
c
Effi
Eff
ectiv g
tin
ewri
andpresentati
on
Introduction
Youcananswer yourFMexaminwhatever orderyouprefer.Itisimportantthatyouadopta

strategy
thatworksbestforyou.Wewould suggestthatyoudecide onyourpreferred approach
andpracticeitbydoinga timed mockexambefore yourrealexam.
Remember youFMexamwillbestructured asfollows:
SectionA– 15individual
OTquestions worth2 marks each.QuestionsinSection A cancomefrom
anysyllabusarea.There willbeanequalmixofnumerical anddiscursivestylequestions.
SectionB– ThreeOTcasequestions worth10marks each.Eachcasequestion willconsist
offive
individual
OTquestionsworth twomarks each.Therewillnormallybetwonumerical questions
followed
bythreediscussionstylequestions.
Again,questions
inSectionB cancomefromany
syllabus
area.Eachindividual casedoeshowevertendtofocusona particular syllabusareafor
example,workingcapitalmanagement, investment
appraisal,riskmanagement orbusiness
finance.
Page 375 of 641

q
SectionC – SectionC willcontaintwo,20markquestions
whichwillbescenariobasedandwill
containbothdiscursiveandcomputational elements.
Section
C questionswillmainly
focusonthe
followingsyllabus
areas,buta minority ofmarks
canbedrawn fromanyotherareaofthe
syllabus.
• Working capitalmanagement (syllabus
areaC)
• Investment appraisal(syllabusareaD)
• Business finance(syllabusareaE)
ThisSkillsCheckpointwillprovide
youwithonesuggested
approach fortackling
yourFMexam.
Goodluck!
How to approach your FM exam
FM Skill: How to approach your FM exam

Wewould suggest thefollowing approach fortacklingyourFMexam.Itisimportant thatyou
adoptanapproach thatworks bestforyouandpractice itbycompleting a mockexamtotime
priortoyourrealexam.
Complete Section A first– allocated time54minutes
• Tackle anyeasier OTquestions first.Oftendiscursive stylequestions canbeanswered quickly,
savingmoretimeforcalculations. Donotleaveanyquestions unanswered. Evenifyouare
unsure makea reasoned guess.SkillsCheckpoint 1covers howtoapproach OTquestions in
moredetail.
• Ifyoudonotfeelthatyouneedthefull54minutes tocomplete SectionA youcancarrythis
timeforward toyourSection C questions whichtendtobemoretimepressured. Withpractice,
itmaybepossible foryoutocomplete section A upto10minutes quickerthantheallocated
timeof54minutes.
G
Complete Section B next– allocated time54minutes H
• Youwillhave18minsofexamtimetoallocate toeachofthethreeOTcasequestions inSection

B.Usethesameapproach toOTquestions asdiscussed forSection A.
• Eachindividual casetendstofocusona specific syllabus area.StartwiththeOTcase
question youfeelmostconfident with.
• There willnormally bethreediscussion typeandtwonumerical questionswithineachcase.
Again,itisbetter totacklethediscussion typequestions firstastheytendtobelesstime
consuming.
• Ifyoudonotfeelthatyouneedthefull54minutes tocomplete section
B youcancarrythis
timeforward toyourSection C questions whichtendtobemoretimepressured. Withpractice,
itmaybepossible foryoutocomplete Section A approximately 5 minutes quickerthanthe
allocated timeof54minutes.
Finally,complete Section C – allocated time72minutes
• Section C willcontain two,20-mark questions whichwillbescenario basedandwillcontain
bothdiscursive andcomputational elements. Allocate atleast36minutes toeachquestion
(remembering tosplityourtimebetween eachofthesubrequirements) butyoumayhaveup
to15minutes ofextratimeifyouhavecompleted Sections AandBoftheexaminlessthanthe
allotted time.
• Startwiththequestion youfeelmostconfident with.Thefirstsubrequirement willnormally
involve somedetailed calculations,thesetendtobeverytimepressured. Ensure thatyoudon’t
spendtoomuchtimeonthecalculations andthenloseoutontheeasier discursivemarks.
Makeitcleartoyourmarker whichsubrequirement youareanswering.
• SkillsCheckpoints 2 and3 lookspecifically atthetechniques youshould useforinvestment
appraisal andcomplex costofcapitalcalculations. NPVandWACCarepopular areas
examined inSection C somakesureyouareconfident usingthetechniques coveredinthese
skillscheckpoints
Setsometimeasidetopractice thisapproach through thecompletion ofa mockexamtotime.
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function
Essential reading
G H
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1 Aspects of financial management
1.1 Financial planning and control

1.1.1 Financialplanning
Thefinancial
manager willneedtoplantoensurethatenoughfundingisavailable
attheright
timetomeettheneedsoftheorganisationforshort-,medium-andlong-term capital.
Inthemedium orlongterm,theorganisation
mayhaveplanned purchasesofnon-current assets,
suchasplantandequipment, forwhichthefinancial
manager mustensurethatfunding is
available.
Thefinancial
manager contributes
todecisions
ontheusesoffundsraisedbyanalysing financial
datatodetermineuseswhichmeettheorganisation’sfinancial
objectives.
Isproject
Atobe
preferred
overproject
B?Should a newassetbebought orleased?
1.1.2 Financialcontrol
Thecontrol functionofthefinancial
manager becomes relevantforfunding
whichhasbeen
raised.Arethevarious activities
oftheorganisationmeetingitsobjectives?
Areassetsbeingused
efficiently?
Toanswer thesequestions,
thefinancialmanager maycompare dataonactual
performance withforecastperformance.
Forecast datawillhavebeenprepared inthelightof
pastperformance (historical
data)modifiedtoreflect
expected futurechanges.
Futurechanges
mayinclude theeffectsofeconomic development,forexample, aneconomicrecoveryleadingto
a forecast
upturn inrevenues.
1.2 Profit measures
Inmucheconomic theory, itisassumed thatthefirmbehaves insucha wayastomaximise
profits,where profit isviewed inaneconomist’s sense. Unliketheaccountant’s concept ofcost,
totalcostsbythiseconomist’s definitionincludeanelement ofreward fortherisk-taking ofthe
G entrepreneur, called‘normal profit’. H
Where theentrepreneur isinfullmanagerial control ofthefirm,asinthecaseofa smallowner-

managed company orpartnership, theeconomist’s assumption ofprofitmaximisation would
seemtobeveryreasonable. Remember thoughthattheeconomist’s concept ofprofitsisbroadly
interms ofcash,whereas accounting profitsmaynotequate tocashflows.
Evenincompanies owned byshareholders butrunbynon-shareholding managers, ifthe
manager isserving thecompany’s (ietheshareholders’) interests,wemightexpect thattheprofit
maximisation assumption shouldbeclosetothetruth.
Although profitsdomatter, theyarenotthebestmeasure ofa company’s achievements.
(a) Accounting profitsarenotthesameas‘economic’ profits.
Accounting profitscanbe
smoothed tosomeextent bychoices ofaccounting policies.Forexample:
(i) Provisions, suchasprovisions fordepreciation oranticipated losses
(ii) Thecapitalisation ofvarious expenses, suchasdevelopment costs.
(b) Profit doesnottakeaccount ofrisk.Shareholders willbeveryinterested inthelevelofrisk,
andmaximising profits
maybeachieved byincreasing risktounacceptable levels.
(c) Profits ontheirowntakenoaccount ofthevolume ofinvestment thatithastakentoearnthe
profit. Profits
mustberelated tothevolume ofinvestment tohaveanyrealmeaning.
(d) Profits arereported everyyear(withhalf-year interimresults forquoted companies). They
aremeasures ofshort-term historic performance, whereas a company’s valuation is
commonly judged byconsidering itsfuture
performance potential.
1.2.1 Earningspersharegrowth
Earnings
pershare(EPS)iswidelyusedasa measure ofa company’sperformance
andisof
particular
importanceincomparing results
overa periodofseveral
years.Acompanymustbe
abletosustain
itsearnings
inordertopaydividendsandreinvest
inthebusiness
soastoachieve
future
growth.
Investors
alsolookforgrowthintheEPSfromoneyeartothenext.
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Illustration2: EPS
Walter
WallCarpets
madeprofits before
taxin20X8of$9,320,000.
Taxamounted
to$2,800,000.
Thecompany’s
sharecapitalisasfollows:
$
Ordinary
shares
(10,000,000
shares
of$1) 10,000,000
8%preference
shares 2,000,000
12,000,000
Required
Calculate
theEPSfor20X8
Solution
$
Profit
before
tax 9,320,000
Lesstax (2,800,000)
Profits
aftertax 6,520,000
Lesspreference
dividend
(8%of$2,000,000) (160,000)
Earnings
attributable
toordinary
shareholders 6,360,000
Number
ofordinary
shares 10,000,000
G
EPS 0.636 H
1.2.2 Otherfinancialtargets
Inaddition totargets forearnings, EPSanddividend pershare,a company mightsetother
financialtargets, suchas:
(a) Arestriction onthecompany’s levelofgearing, ordebt.Forexample, a company’s
management mightdecide:
(i) Theratiooflong-term debtcapitaltoequitycapitalshould never exceed,say,1:1.
(ii) Thecostofinterest payments should neverbehigher than,say,25%oftotalprofits
beforeinterestandtax.
(b) Atargetforprofitretentions. Forexample, management mightseta targetthatdividend
cover(theratioofdistributable profits
todividends actuallydistributed)
shouldnotbeless
than,say,2.5times.
(c) Atargetforoperating profitability.
Forexample, management mightseta targetforthe
profit/salesratio(say,a minimum of10%)orfora return oncapitalemployed (say,a
minimum ROCEof20%).
These financialtargets arenotprimary financialobjectives,
buttheycanactassubsidiary targets
orconstraints whichshould helpa company toachieve itsmainfinancialobjective
without
incurringexcessive risks.
Theyareusually measured overa yearrather thanoverthelongterm.
Remember, however, thatshort-term measures ofreturncanencourage a company topursue
short-term objectives attheexpense oflong-term ones,forexample bydeferringnewcapital
investments, orspending onlysmallamounts onresearch anddevelopment andontraining. A
major problem withsettinga number ofdifferentfinancialtargets,
eitherprimarytargetsor
supporting secondary targets,isthattheymightnotallbeconsistent witheachother.Whenthis
happens, somecompromises willhavetobeaccepted.
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2 Stakeholders
2.1 Objectives of stakeholder groups

Thevarious groups ofstakeholders ina firmwillhavedifferent goalswhichwilldepend inparton
theparticular situation oftheenterprise. Someofthemoreimportant aspectsofthesedifferent
goalsareasfollows.
(a) Ordinary (equity) shareholders
Ordinary (equity) shareholders aretheproviders oftheriskcapitalofa company. Usuallytheir
goalwillbetomaximise thewealth whichtheyhaveasa result oftheownership oftheshares in
thecompany.
(b) Tradepayables (creditors)

Trade payables havesupplied goodsorservices tothefirm.Trade payables willgenerallybe
profitmaximising firmsthemselves andhavetheobjective ofbeingpaidthefullamount dueby
thedateagreed. Ontheotherhand,theyusually wishtoensure thattheycontinue theirtrading
relationshipwiththefirmandmaysometimes beprepared toacceptlaterpayment toavoid
jeopardising thatrelationship.
(c) Long-term payables (creditors)
Long-term payables, whichwilloftenbebanks, havetheobjective ofreceivingpayments of
interestandcapitalontheloanbytheduedatefortherepayments. Where theloanissecured on
assetsofthecompany, thelender willbeabletoappoint a receivertodispose ofthecompany’s
assetsifthecompany defaults ontherepayments. Toavoidthepossibility thatthismayresult in
a losstothelender iftheassetsarenotsufficient tocovertheloan,thelender willwishtominimise
theriskofdefault andwillnotwishtolendmorethanisprudent.
(d) Employees
Employees willusually wanttomaximise theirrewardspaidtotheminsalaries andbenefits,
according totheparticular skillsandtherewards availableinalternative
employment. Most
G
employees willalsowantcontinuity ofemployment. H
(e) Government
Government hasobjectives whichcanbeformulated inpolitical
terms. Government agencies
impinge onthefirm’s activities
indifferent waysincluding through taxationofthefirm’sprofits,
theprovision ofgrants, health andsafetylegislation, traininginitiatives,
andsoon.Government
policieswilloftenberelated tomacroeconomic objectives,
suchassustained economic growth
andhighlevels ofemployment.
(f) Management
Management has,likeotheremployees (andmanagers whoarenotdirectors willnormally be
employees), theobjective ofmaximising itsownrewards. Directors, andthemanagers towhom
theydelegate responsibilities,mustmanage thecompany forthebenefit ofshareholders.The
objectiveofreward maximisation mightconflict withtheexercise ofthisduty.
2.2 Stakeholder groups, strategy and objectives
Theactions
ofstakeholder
groups inpursuit
oftheirvariousgoalscanexertinfluence
onstrategy
andobjectives.
Thegreaterthepower ofthestakeholder,
thegreatertheirinfluence
willbe.Each
stakeholder
groupwillhavedifferent
expectations
aboutwhatitwants, andtheexpectations of
thevarious
groupsmayconflict.Eachgroup,however,willinfluence
strategicdecision
making.
2.3 Ratio analysis
Thekeytoobtaining
meaningful
information
fromratioanalysis
iscomparison:comparing
ratios
overa numberofperiods
within
thesamebusiness
toestablish
whetherthebusinessisimproving
ordeclining,
andcomparingratiosbetween
similar
businesses
toseewhether thecompanyyou
areanalysing
isbetter
orworse
thanaveragewithin
itsownbusinesssector.
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2.4 Ratio pyramids
TheDuPontsystem
ofratioanalysis
involves
constructing
a pyramid
ofinterrelated
ratiosas
shownbelow:
Return
onequity
Return
oninvestment × Total
assets
÷ equity
Return
onsales
(profit
margin) × Asset
turnover
Netincome ÷ Sales Sales ÷ Total

assets
Sales Total
costs– Non-current+ Current
assets assets
Suchratiopyramidshelpinproviding
foranoverall
management
plantoachieve
profitability
and
allowtheinterrelationships
between
ratiostobechecked.
2.5 Profitability
Acompany ought,ofcourse,tobeprofitable ifitistomaximise shareholderwealth,
andobvious
checks onprofitability
are:
(a) Whether thecompany hasmadea profit ora lossonitsordinaryactivities
(b) Byhowmuchthisyear’sprofit orlossisbiggerorsmaller thanlastyear’sprofit
orloss.
Profitbeforetaxationisgenerallythought tobea better figuretousethanprofitaftertaxation,
G H
because theremightbeunusualvariations inthetaxchargefromyeartoyearwhichwould not

affecttheunderlying profitability
ofthecompany’s operations.
Another profit
figurethatshouldbeconsidered isprofitbeforeinterestandtax(PBIT).Thisisthe
amount ofprofit
whichthecompany earned before havingtopayinteresttotheprovidersofloan
capital.
Thisisalsoa goodmeasure ofoperating profit,
theprofitthatthecompany ismaking
fromitsbusiness operations.
Byproviders ofloancapital,weusually meanlonger-term loan
capital,suchasloannotesandmedium-term bankloans.
2.5.1 Profitabilityandreturn:thereturnoncapitalemployed
Youcannot assessprofits
orprofit
growthproperlywithout
relating
themtotheamount offunds
(thecapital)
employedinmaking theprofits.
Themostimportant profitability
ratioistherefore
returnoncapitalemployed (ROCE),alsocalledreturn
oninvestment(ROI).
Formulato learn
Return
oncapitalemployed=PBIT/Capitalemployed
Capitalemployed
=Shareholders’fundspluslong-term liabilities
Or
Capitalemployed
=Totalassetslesscurrent
liabilities
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2.5.2 EvaluatingtheROCE
Whatdoesa company’s ROCEtellus?Whatshould webelooking for?There arethree
comparisons thatcanbemade:
(a) ThechangeinROCEfromoneyeartothenext
(b) TheROCEbeingearned byothercompanies,ifthisinformation isavailable
(c) Acomparison oftheROCEwithcurrent marketborrowing rates(warning: thisneedstobe
interpretedwithcare,asROCEwilloftenreflect
higher riskthanborrowing rates)
(i) Whatwould bethecostofextraborrowingtothecompany ifitneeded moreloans,and
isitearning
a ROCEthatsuggests itcouldmakehighenough profits
tomakesuch
borrowingworthwhile?
(ii) Isthecompany makinga ROCEwhichsuggests thatitismaking profitableuseofits
currentborrowing?
2.5.3 Secondaryratios
Wemayanalyse changesinROCEbybreaking itdownintotwosub-ratios
(orsecondary
ratios):
profit
marginandassetturnover.
Profitmargin andassetturnovertogether
explain
theROCE.
Therelationship
betweenthethreeratiosisasfollows.
Profit
margin× assetturnover
=ROCE
PBIT × Salesrevenue= PBIT
Salesrevenue Capitalemployed Capitalemployed
Itisalsoworth
commenting onthechangeinrevenue
(turnover)
fromoneyeartothenext.Strong
salesgrowthwillusually
indicate
volumegrowth
aswellasrevenueincreases
duetopricerises,
andvolume growth isonesignofa prosperous
company.
Examfocus point
G H
Remember thatcapitalemployed
isnotjustshareholders’
funds.
Itisshareholders’
fundsplus
long-term
liabilities.
2.5.4 Returnonequity
Anothermeasure ofthefirm’s
overall
performance
isreturn
onequity.Thiscompares
netprofit
aftertaxwiththeequitythatshareholders
haveinvested
inthefirm.
Formulato learn
Returnonequity = Earnings
Shareholders'equity
Thisratioshows theearning
power oftheshareholders’
bookinvestment andcanbeusedto
compare twofirmsinthesameindustry. Ahighreturn
onequitycouldreflectthefirm’s
good
management ofexpenses andabilitytoinvest
inprofitable
projects.However,
itcouldalsoreflect
a higherlevelofdebtfinance
(gearing)withassociated
higherrisk(seeSection4.5).
Notethatshareholders’equityincludesreserves.
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2.5.5 Grossprofitmargin,thenetprofitmarginandprofitanalysis
Dependingontheformatofthestatement
ofprofit
orloss,youmaybeabletocalculate
thegross
profitmargin
andalsothenetprofitmargin.
Lookingatthetwotogether
canbequite
informative.
Real life example:Profitmargins

Acompany
hasthefollowing
summarised
statements
ofprofit
orlossfortwoconsecutive
years.
Year1 Year2
$ $
Salesrevenue 70,000 00,000
Lesscostofsales 42,000 55,000
Grossprofit 28,000 45,000
Lessexpenses 21,000 35,000
Netprofit 7,000 0,000
Althoughthenetprofit
marginisthesameforbothyearsat10%,thegrossprofit margin
isnot.
Inyear1itis:28,000/70,000
=40%andinyear2 itis45,000/100,000 =45%
Isthisgoodorbadforthebusiness? Anincreasedprofit
marginmustbegoodbecause this
indicates
a widergapbetween selling
priceandcostofsales.However,
giventhatthenetprofit
ratiohasstayedthesameinthesecond year,expensesmustberising.Inyear1,expenses
were
30%ofrevenue, whereasinyear2 theywere35%ofrevenue. Thisindicatesthatadministration
or
selling
anddistribution
expenses mayrequiretighter
control.
Apercentage analysis
ofprofit
between year1andyear2 isasfollows.
Year1 Year2
G H
% %
Costofsalesasa %ofsales 60 55
Grossprofit
asa %ofsales 40 45
100 100
Expenses
asa %ofsales 30 35
Netprofit
asa %ofsales 10 10
Grossprofit
asa %ofsales 40 45
2.6 Debt and gearing ratios

Debtratiosareconcernedwithhowmuchthecompany owesinrelationtoitssizeandwhetherit
isgetting
intoheavier
debtorimproving itssituation.
Financialgearing(oftensimplyreferred
to
as‘gearing’)
istheamountofdebtfinance a company usesrelative
toitsequityfinance.
(a) Whena company isheavilyindebt,andseems tobegetting evenmoreheavily intodebt,
banksandotherwould-be lendersareverysoonlikelytorefuse furtherborrowing.
(b) Whena company isearning onlya modest profit
beforeinterest
andtax,andhasa heavy
debtburden,therewillbeverylittleprofitleftoverforshareholdersaftertheinterest
charges
havebeenpaid.
Themaindebtandgearing ratiosarecovered inChapter 12.
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2.7 Liquidity ratios: cash and working capital
Profitability
isofcourseanimportantaspectofa company’sperformance, anddebtorgearing is
another.Neither,
however,
directly
addresses
thekeyissueofliquidity.
Acompany needsliquid
assetssothatitcanmeetitsdebtswhentheyfalldue.Themainliquidityratioswillbedescribed
inChapter3 (intheEssential
reading).
2.8 Shareholders’ investment ratios
Returnstoshareholdersareobtained intheformofdividendsreceivedand/or
capitalgainsfrom
increases
inmarket value.
Acompany willonlybeabletoraisefinanceifinvestors
thinkthatthereturns
theycanexpect are
satisfactory
inviewoftheriskstheyaretaking. Wemustthereforeconsiderhowinvestors
appraisecompanies.Wewillconcentrate onquotedcompanies.
Information
thatisrelevant
tomarket pricesandreturnsisavailable
frompublished
stockmarket
information,
andinparticular
fromcertain stockmarketratios.
Cumdividend: Cumdividendorcumdivmeans thepurchaser

ofshares
isentitled
toreceive
KEY
TERM thenextd ividend
payment.
Exdividend:Exdividend
orexdivmeansthatthepurchaser
ofshares
isnotentitled
toreceive
thenextdividendpayment.
Therelationship
between thecum-divpriceandtheex-divpriceis:
Marketpricepershare(exdiv)= Market
pricepershare(cumdiv)– forthcoming
dividendper
share.
Whenstockmarket sharepricesarequoted,shares
gofrombeingcumdivtoexdivona given
day,andshareholdersbuyingthesharesfromthetimetheygoexdivarenotentitled
tothenext
dividend
pay-out,whichwillhappensoon.
G H
Thedividendyield2.8.1
Formulato learn
Dividend
yield=Dividend
pershare/Ex-div
market
pricepershare
Thedividendyieldisthereturn
a shareholderiscurrently
expectingontheshares
ofa company.
(a) Thedividendpershareistakenasthedividend forthepreviousyear.
(b) Exdivmeans thatthesharepricedoesnotinclude therighttothemostrecent
dividend.
Shareholders
lookforbothdividend yieldandcapitalgrowth.Obviously,
dividend
yieldis
therefore
animportant aspectofa share’sperformance.
Illustration3: Dividendyield
Intheyearto30September 20X8,anadvertising
agencydeclaresaninterim
ordinary
dividend
of
7.4centspershareanda finalordinary
dividend
of8.6centspershare.
Required
Assuming
anex-divsharepriceof315cents,whatisthedividend
yield?
Solution
Thetotaldividend
pershareis(7.4+8.6)=16cents
16/315
×100=5.1%
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Illustration4: Ratios
Thedirectors
ofXarecomparing someofthecompany’s year-end
statistics
withthoseofY,the
company’s maincompetitor.
Xhashada fairlynormal yearintermsofprofit,
butY’slatestprofits
havebeenseverelyreduced
byanexceptional lossarising
fromtheclosure
ofanunsuccessful
division.
Yhasa considerably
higher
leveloffinancial
gearingthanX.
Theboardisfocusingonthefigures
givenbelow.
X Y
Shareprice 450c 525c
Nominal
valueofshares 50c 00c
Dividend
yield 5% 4%
Price/earnings
ratio 15 25
Proportion
ofprofits
earned
overseas 60% 0%
Inthecourse
ofthediscussion
a number
ofcomments
aremade,including
thosegivenbelow.
Required
Discusscomments (1)to(4),makinguseoftheabovedatawhere appropriate.
(1) ‘Thereissomething oddabouttheP/Eratios. Yhashada particularlybadyear.ItsP/E
should surely
belower thanours.’
(2) ‘Oneofthefactors whichmayexplain Y’shighP/Eisthehighfinancial
gearing.’
(3) ‘Thecomparison ofourownP/Eratioanddividend yieldwiththoseofYisnotreallyvalid.The
G
shares ofthetwocompanies havedifferentnominalvalues.’ H
(4) ‘Thesefigureswillnotplease
ourshareholders.Thedividendyieldisbelow
thereturn an
investorcouldcurrentlyobtain
onrisk-freegovernmentbonds.’
Solution
(1) P/Eratio
TheP/Eratiomeasures therelationship between themarket priceofa shareandtheearnings
pershare.Itscalculation involves
theuseoftheshareprice,whichisa reflection ofthemarket’s
expectations ofthefuture earningsperformance, andthehistoric levelofearnings.
IfYhasjustsuffered anabnormally badyear’sprofit performance whichisnotexpected tobe
repeated, themarket willpricetheshareonthebasisofitsexpected future
earnings. Theearnings
figureusedtocalculate theratiowillbethehistorical figure,whichislower thanthatforecast for
thefuture, andthustheP/Eratiowillappear high.
(2) Financial gearing
Thefinancial gearing ofthefirmexpresses therelationshipbetween debtandequityinthe
capitalstructure.Ahighlevelofgearing means thatthereisa highratioofdebttoequity. This
means thatthecompany carries
a highfixedinterest charge, andthustheamount ofearnings
availabletoequitywillbemorevariable fromyeartoyearthanina company witha lower
gearing level.Thustheshareholders willcarrya higher levelofriskthanina company withlower
gearing. Allotherthingsbeingequal,itistherefore likelythatthesharepriceina highlygeared
company willbelowerthanthatina lowgeared firm.
ThehistoricalP/Eratioisdependent onthecurrent sharepriceandthehistorical levelof
earnings. AhighP/Eratioistherefore morelikelytobefoundina company withlowgearing than
inonewithhighgearing. InthecaseofY,thehighP/Eratioismoreprobably attributabletothe
depressed levelofearningsthantothefinancial structure ofthecompany.
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(3) Comparison ofratios
Theratiosarecalculated asfollows.
P/Eratio=Market shareprice/Earningspershare
Dividend yield=Dividend pershare/Market shareprice
Eveniftheshares havea nominal value(which isn’tthecaseineverycountry) thisnominal value
isirrelevantincalculatingtheratios.
Thiscanbeproved bycalculatingtheeffectontheratiosof
a sharesplit– theratioswillbeunchanged. Thus,ifallotherfactors (suchasaccounting
conventions usedinthetwofirms) areequal,a directcomparison oftheratiosisvalid.
(4) Comparison withrisk-free
securities
Asoutlined in(c)above, thedividendyieldistherelationship between thedividend pershareand
thecurrent market priceoftheshare.Themarket priceofthesharereflects investorexpectations
aboutthefuture levelofearningsandgrowth. Iftheshareistrading witha lowdividend yield,this
means thatinvestorshavepositivegrowth expectations aftertakingthelevelofriskintoaccount.
Although government bondscarrylittlerisk,theyareunlikely tooffersignificant
growth potential
either,
andthismeans thatthesharewillstillbemoreattractive evenafterthelowdividend yield
hasbeentakenintoaccount.
3 Not-for-profit organisations
3.1 Not-for-profit sectors

Although
mostpeople wouldknowoneiftheysawit,thereisa surprising
probleminclearly
defining
whatcountsasa not-for-profit
(NFP)organisation.
Localauthority
services,
forexample,
wouldnotbesetting
objectives
inordertoarrive
ata profit
forshareholders,
butnowadays they
arebeingincreasingly
required
toapplythesamedisciplinesandprocessesascompanieswhich
G areoriented
towardsstraightforward
profit
goals. H
Real life example

Oxfamoperatesaround750shopsinBritain,
andtheseoperate
ata profit.
TheRoyalSocietyfor
theProtection
ofBirdsownsandoperatesaninternet
andmailordertradingcompanywhich
operates
profitably
andeffectively.
Thenot-for-profit
sector mayinvolve
a number ofdifferentkindsoforganisationswith,for
example, differing
legalstatus
– charities,
statutory
bodies offering
publictransport
orthe
provisionofservicessuchasleisure,
health orpublicutilities.
Thetasksofsetting objectives
anddevelopingstrategiesandcontrols fortheirimplementation
can
allhelpinimproving theperformanceofcharities
andNFPorganisations.
3.2 Objectives
Theprimary objective
ofmanyNFPorganisations willbetheeffective
provision
ofa service,not
thecreationofprofit.
Thishasimplications
forthereportingofresults.
Theorganisationwillneed
tobeopenandhonest inshowing howithasmanaged itsbudgetandallocated fundsraised.
Efficiency
andeffectiveness areparticularly
important intheuseofdonated funds,butthereisa
danger thatresourceefficiencybecomesmoreimportant thanserviceeffectiveness.
Herearesomepossible objectives
fora NFPorganisation:
(a) Surplusmaximisation(equivalent
toprofit
maximisation,ega charityshop)
(b) Revenue maximisation(asfora commercialbusiness,ega charity
shop)
(c) Usagemaximisation (egleisurecentre
swimming poolusage)
(d) Usagetargeting(matching thecapacityavailable,
egina government-funded hospital)
(e) Full/partial
costrecovery (minimising
subsidy)
(f) Budgetmaximisation (maximisingwhatisoffered)
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(g) Producersatisfaction
maximisation
(satisfying
thewants
ofstaffandvolunteers)
(h) Clientsatisfaction
maximisation
(egthepolicegenerating
thesupportofthepublic).
3.3 Value for money
Itisreasonable toarguethatnot-for-profit
organisations
bestservesociety’s
interests
whenthe
gapbetween thebenefits theyprovideandthecostofproviding thosebenefitsisgreatest.
Thisis
commonly termed valueformoney andisnotdissimilarfromtheconcept ofprofitmaximisation,
apartfromthefactthatsociety’s interests
arebeingmaximised ratherthanprofit.
Thisisusuallyaccepted asrequiringtheapplicationofeconomy, effectiveness
andefficiency
(sometimes known asthe3Es).
(a) Economy (spending money frugally)
(b) Efficiency(getting
outasmuchaspossible forwhatgoesin)
(c) Effectiveness(gettingdone,bymeans of(a)and(b),whatwassupposed tobedone.
Moreformally, thesecriteria
canbedefined asfollows.
Economy: Attaining
theappropriatequantity
andquality
ofinputs
atthelowest
costto
KEY achievea certain
levelofoutputs.
TERM
Efficiency:
Therelationship
betweeninputs
andoutputs.
Effectiveness:
Theextent towhichdeclared
objectives/goals
aremet.
Real life example:Economy,efficiency, effectiveness

(a) Economy: Thisdimensionrelates
tothecostofinputs.
Economy within
a schoolcouldbe
measured, forexample,
bycomparing average salaries
perteacherwithearlier
yearsand
budgets.
(b) Efficiency:
Theefficiency
withwhicha school’s
ITlaboratory
isusedmightbemeasured in
terms oftheproportion
oftheschoolweekforwhichitisused.
G H
(c) Effectiveness:
Theeffectiveness
ofa school’s
objective
toproducequalityteachingcouldbe
measured bytheproportionofstudentsgoingontohigherorfurthereducation.
3.4 Performance measures

Valueformoney asa concept assumes thatthereisa yardstick againstwhichtomeasure the
overall
performance ofanorganisation. Itcanbedifficult todetermine where thereisvaluefor
money, however.
(a) Not-for-profitorganisationstendtohavemultiple objectives,sothateveniftheycanallbe
clearlyidentifieditisimpossible
tosaywhichistheoverriding objective.
(b) Outputs canseldom bemeasured ina waythatisgenerally agreed tobemeaningful. (Are
goodexamresults aloneanadequate measure ofthequality ofteaching?Howdoesone
quantify theeasingofpainfollowing a successfuloperation?)Forexample, ina publicly
funded healthcare system,success maybemeasured interms offewerpatientdeaths per
hospitaladmission, shorter
waiting listsforoperations,average speedofpatient recovery,
andsoon.
Herearea number ofpossible solutionstotheseproblems.
(a) Performance canbejudged interms ofinputs.Thisisverycommon ineveryday life.If
somebody tellsyouthattheirsuitcost$750,forexample, youwould generallyconclude that
itwasanextremely well-designed
andgoodquality suit,evenifyoudidnotthinksowhen
youfirstsawit.Thedrawback, ofcourse, isthatyoumightalsoconclude thattheperson
wearing thesuithadbeencheated orwasa fool,oryoumaythinkthatnopieceofclothing is
worth$750.Itissimilar withtheinputs andoutputs ofa non-profit-seekingorganisation.
(b) Acceptthatperformance measurement musttosomeextent besubjective.
Judgements can
bemadebyexperts.
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(c) Mostnot-for-profit
organisations donotfacecompetitionbutthisdoesnotmeanthatthey
areallunique.
Bodies likelocalgovernments,
healthservices,
andsooncancompare their
performanceagainsteachotherandagainstthehistorical resultsoftheirpredecessors.
Unit
costmeasurements like‘costperpatientday’or‘costofborrowingonelibrary
book’canbe
established
toalloworganisations toassesswhethertheyaredoingbetterorworsethantheir
counterparts.
Caremustbetakennottoreadtoomuchintolimited information,
however.
Real life example:Performancemeasures

Althoughoutput
ofnot-for-profit
organisations
isdifficult
tomeasureina waythatisgenerally
agreedtobemeaningful,
itisnotimpossible.
Outputs ofa university
mightbemeasuredinterms
ofthefollowing:
Broader
performance measures
• Proportion
oftotalundergraduate
population
attending
theuniversity
(bysubject)
• Proportion
ofstudentsgraduating,
andclassesofdegrees
obtained
• Amountofprivate
sectorresearch
fundsattracted
• Numberofstudentsfinding
employmentaftergraduation
• Numberofpublications/articles
producedbyteachingstaff.
Operationalperformancemeasures
• Unitcostsforeachoperating
‘unit’
• Staff-student
ratios;
staffworkloads
• Classsizes
• Coursesoffered.
G H
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1 Fiscal policy
1.1 Fiscal policy and demand management
Fiscalpolicy:Action
bythegovernment tospendmoney,
ortocollect
money
intaxes,withthe
KEY
TERM purposeofinfluencingthecondition
ofthenational
economy.
Agovernment mightintervene intheeconomy by:

(a) Spending moremoney andfinancing thisexpenditurebyborrowing
(b) Collecting moreintaxeswithout increasingpublicspending
(c) Collecting moreintaxesinorder toincreasepublicspending, thusdivertingincome fromone
partoftheeconomy toanother
Government spending isan‘injection’intotheeconomy, addingtototaldemand forgoodsand
servicesintheeconomy (known asaggregate demand) andtherefore national
income, whereas
taxesarea ‘withdrawal’ fromtheeconomy. Fiscalpolicycanthusbeusedasaninstrument of
demand management iedeliberatepoliciestostimulateandcontrol thelevelofaggregate
demand inaneconomy. Toolittledemand createsunemployment, toomuchcreates inflation.
Fiscalpolicyappears tooffera method ofmanaging aggregate demand intheeconomy.
(a) Ifthegovernment spends more– forexample, onpublicworks suchashospitals, roadsand
sewers – withoutraisingmoremoney intaxation(iebyborrowing more)itwillincrease
expenditure intheeconomy, andsoraisedemand.
(b) Ifthegovernment keptitsownspending atthesamelevelbutreduced thelevelsoftaxation,
itwould alsostimulate demand intheeconomy because firmsandhouseholds would have
moreoftheirownmoney aftertaxforconsumption orsaving/investing.
Thisisan
expansionary policy.
(c) Inthesameway,a government canreduce demand intheeconomy byraisingtaxesor
G
reducing itsexpenditure.Thisisa contractionary policy. H
1.2 Fiscal policy and business

Fiscalpolicyaffectsbusinessenterprises
inbothserviceandmanufacturing industries
invarious
ways.Forexample:
(a) Byinfluencingthelevelofaggregate demand (AD)forgoodsandservices intheeconomy,
macroeconomic policyaffectstheenvironment forbusiness.
Business
planning shouldtake
account ofthelikelyeffectofchanges inADforsalesgrowth ega dropinADmightmean
lowerdemand fromcustomers fora business’s
products andservices.
Businessplanningwill
beeasier ifgovernment policyisrelatively
stable.
(b) Taxchanges brought aboutbyfiscalpolicyaffectbusinesses.Forexample,labourcostswill
beaffected bychanges inemployment taxes.Forexample,ifindirect
taxessuchassalestax
orexcisedutyrise,eithertheadditionalcostwillhavetobeabsorbed ortherisewillhaveto
bepassed ontoconsumers intheformofhigher prices.
2 Monetary policy
Money isimportant because:

(a) It‘oilsthewheels’ ofeconomic activity,providing
aneasymethod forexchanging
goodsand
services (iebuyingandselling).
(b) Thetotalamount ofmoney ina nationaleconomy mayhavea significant
influence
on
economic activityandinflation.
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2.1 The role and aims/targets of monetary policy
Monetary policy:Theregulation
oftheeconomythrough control
ofthemonetary system
by
KEY
TERM operatingonsuch variables
asthemoneys upply,
thelevel
ofinterest
rates
a ndtheconditions
foravailability
ofcredit.
Theeffectiveness
ofmonetary policywilldependon:
(a) Whetherthetargets ofmonetarypolicyareachievedsuccessfully
(b) Whetherthesuccess ofmonetary policyleadsontothesuccessfulachievementofthe
intermediate
target(eglower
inflation)
(c) Whetherthesuccessfulachievement oftheintermediate
target(eglower
inflation)
leadson
tothesuccessful
achievement oftheoverallobjective
(egstronger
economicgrowth)
2.2 Targets of monetary policy
Targets
ofmonetary policyarelikelytorelate
tothevolume ofnational
income andexpenditure.
• Growth inthesizeofthemoney supply
• Thelevelofinterestrates
• Thevolume ofcredit,
orgrowth inthevolume ofcredit
• Thevolume ofexpenditureintheeconomy (ienational
incomeorgrossnational
product
(GNP)
itself)
2.3 The money supply as a target of monetary policy
Tomonetarist
economists,themoney supplyisa possible
intermediate
targetofeconomic
policy.
Thisisbecause
theyclaimthatanincrease inthemoney supplywillraisepricesandmoney
incomes,andthisinturnwillraisethedemand formoneytospend.
G 2.4 Interest rates as a target for monetary policy H
Theauthorities maydecidethatinterest ratesthemselves shouldbea targetofmonetary policy.

Thiswould beappropriate ifitisconsidered thatthereisa directrelationshipbetween interest
ratesandthelevelofexpenditure intheeconomy.
Itcertainlyseems logicalthatinterest ratesshouldhavea strong influence oneconomic activity.
However, although empirical evidence suggests thereissomeconnection between interestrates
andinvestment (bycompanies) andconsumer expenditure,theconnection isnota stableand
predictable one.Someeconomists arguethatthekeyelement affectinginvestment isbusiness
confidence ratherthanthelevelofinterest rates.Interest
ratechanges areonlylikelytoaffectthe
levelofexpenditure aftera considerable timelag.
In1997theBritish government gaveresponsibilityforsettingshort-term interest
ratestothe
centralbank,theBankofEngland. TheBanksetsratesata levelwhichitconsiders appropriate,
giventheinflationratetargetsetbythegovernment. Forexample, ifinflation
isforecasttobe
excessive,increasinginterestratesshould increase saving,reduceborrowing andreduce
investment, thusreducing aggregate demand intheeconomy. Withlower aggregate demand,
thereislesspressure forsuppliers toincreasepricesastheystruggle tohitsalestargets, so
inflationarypressureisreduced. Thepurpose ofhaving thecentralbanksetting interest
ratesisto
remove theriskofpoliticalinfluence overthedecisions.IntheEuropean Monetary Union (where
theeuroisthecommon currency), theinterest
ratesthatprevailareeffectively setatthe
European level.
2.5 Interest rate policy and business
Interest
ratechangesbroughtaboutbygovernment policyaffecttheborrowingcostsof
business.
Increases
ininterest
rateswillmeanthatfewerinvestments showpositive
returns,
deterring
companiesfromborrowingtofinanceexpansion.
Increases ininterest
rateswillalso
exerta downwardpressureonshareprices,makingitmoredifficult
forcompaniestoraise
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monies
fromnewshareissues.
Businesses
willalsobesqueezed
bydecreases
inconsumer
demandthatresult
fromincreases
ininterest
rates.
3 Exchange rates
Exchangerate:Therateatwhichonecountry’s
currency
canbetraded
inexchange
for
KEY
TERM another
country’s currency.
Dealersinforeignexchangemaketheirprofit
bybuyingcurrency atoneexchangerateand
selling
itata different
rate.Thismeans
thatthereisa sellingrateanda buyingratefora
currency.
3.1 Factors influencing the exchange rate for a currency
Theexchange ratebetween twocurrencies isdetermined primarilybysupplyanddemand inthe
foreignexchange markets. Demand comes fromindividuals,firmsandgovernments whowantto
buya currency andsupplycomes fromthosewhowanttosellit.
Supplyanddemand inturnaresubject toa number ofinfluences.
• Therateofinflation, compared withtherateofinflation inothercountries
• Interestrates,compared withinterestratesinothercountries
• Thebalance ofpayments
• Speculation
• Government policyonintervention toinfluence theexchange rate
Otherfactorsinfluencetheexchange ratethrough theirrelationship
withtheitems identified
above.
(a) Totalincome andexpenditure (demand) inthedomestic economy determines thedemand
G
forgoods.Thisincludes imported goodsanddemand forgoodsproduced inthecountry H
whichwould otherwisebeexported ifdemand forthemdidnotexistinthehome markets.

(b) Output capacityandthelevelofemployment inthedomestic economy mightinfluence the
balance ofpayments because, ifthedomestic economy hasfullemployment already,itwill
beunable toincrease itsvolume ofproduction forexports.
(c) Thegrowth inthemoney supplyinfluences interest
ratesanddomestic inflation.
Wewilllookatthecauseofexchange ratefluctuationsinmoredetailinChapter 14.
3.2 Consequences of an exchange rate policy
Reasons fora policyofcontrolling
theexchange rateareasfollows.
(a) Torectifya balanceoftradedeficit,bytryingtobringabouta fallintheexchange rate
(b) Toprevent a balanceoftradesurplus fromgettingtoolarge,bytryingtobringabouta
limited
riseintheexchange rate
(c) Tostabilisetheexchange rateofthecurrency,asexporters andimporterswillthenfaceless
riskofexchange ratemovements wiping outtheirprofits;
a stablecurrency
increases
confidenceinthecurrency andpromotes international
trade.
3.3 Fixed exchange rates
Agovernment maytrytokeeptheexchange rateata fixedlevelagainst a majorcurrency suchas
theUSdollarormaytrytokeepitwithin a specifiedvaluerange.However, ifa government cannot
controlinflation,
therealvalueofitscurrency would notremain fixed.Ifonecountry’s rateof
inflation
ishigherthanothers, itsexportpriceswillbecome uncompetitive inoverseas markets and
thecountry’stradedeficitwillgrow(oritstradesurplus willdiminish).
Devaluation ofthecurrency
would benecessary fora recovery.Forexample, a government mayworktomove theexchange
ratefrom$2:£1to$1:£1 sothatexports become lessexpensive.
Ifexchange ratesarefixed,anychanges in(real)interest
ratesinonecountry willcreatepressure
forthemovement ofcapitalintooroutofthecountry. Capitalmovements would putpressure on
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thecountry’s
exchange ratetochange.Itfollows
thatifexchange
ratesarefixedandcapitalis
allowed
tomove freelybetween countries
(ietherearenoexchange
controls)allcountries
must
haveconsistent
policies
oninterest
rates.
3.4 Floating and managed exchange rates
Floatingexchange ratesareattheopposite endofthespectrum tofixedrates.Atthisextreme,
exchange ratesarecompletelylefttothefreeplayofdemand andsupplymarket forces,and
thereisnoofficialintervention
atall.Therulingexchange rateis,therefore,
atequilibriumby
definition.
Inpractice,manygovernments seektocombine theadvantages ofexchange ratestability
with
flexibility
andtoavoidthedisadvantages ofbothrigidlyfixedexchange ratesandfreefloating.
Managed (ordirty)floating
refers
toa system whereby exchange ratesareallowed tofloat,but
fromtimetotimetheauthorities willintervene
intheforeign exchange market:
• Tousetheirofficial reserves
offoreign currenciestobuytheirowndomestic currency
• Toselltheirdomestic currencytobuymoreforeign currency fortheofficial
reserves
Buying andselling inthiswaywould beintended toinfluencetheexchange rateofthedomestic
currency. Governments donothaveofficialreserveslargeenough todictateexchange ratesto
themarket, andcanonlytryto‘influence’ market rateswithintervention.
Speculation inthecapitalmarkets oftenhasa muchbiggershort-term impact thanchanges in
fundamental supplyanddemand.
3.5 European Economic and Monetary Union
There arethreemainaspects totheEuropean Monetary Union.
(a) Acommon currency(theeuro)
(b) AEuropean CentralBank.TheEuropean CentralBankhasseveralroles:
(i) Issuing thecommon currency
G
(ii) Conducting monetary policyonbehalfofthecentralgovernmentauthorities H
(iii) ActingaslenderoflastresorttoallEuropeanbanks
(iv) Managing theexchange rateforthecommon currency
(c) Acentralised monetary policyapplies
acrossallthecountries
intheunion.Thisinvolves
the
surrender ofcontroloveraspects ofeconomic policyandtherefore
surrender
ofsomepolitical
sovereignty bythegovernment ofeachmember statetothecentralgoverning
bodyofthe
union.
3.6 Exchange rates and business
Achangeintheexchange
ratewillaffecttherelative
pricesofdomestic
andforeign
produced
goodsandservices.
A lowerexchangerate A higherexchangerate
Domestic
goodsarecheaperinforeign Domestic
inforeign
markets
sodemand forexports
increases. markets
sodemand forexports
falls.
Foreign
sodemand Foreign
goodsarecheaper
sodemand
for
forimports
falls. imports
rises.
Importedrawmaterials
aremoreexpensive
so Imported
rawmaterials
arecheaper
socosts
costsofproduction
rise. ofproduction
fall.
Fluctuating
exchangeratescreateuncertainties
forbusinesses involvedininternational
trade.A
service
industry
islesslikelytobeaffected
becauseitislesslikelytobeinvolved
insubstantial
international
trade.
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Internationaltradingcompaniescan do a numberof thingsto reducetheirriskof sufferinglosses
on foreignexchangetransactions,includingthe following.
(a) Manycompaniesbuy currencies‘forward’at a fixedand knownprice.
(b) Dealingin a ‘hard’currencymay lessenthe risksattached to volatilecurrencies.
(c) Operationscan be managed so that the proportionof sales inone currencyare matched by
an equal proportionof purchasesinthat currency.
(d) Invoicingcan be in the domesticcurrency.Thismeans that the customerbears allthe foreign
exchangerisk,however,and, inindustrieswherecustomershavehighbargainingpower,this
may be an unacceptablearrangement.Furthermore,there is the riskthat sales willbe
adverselyaffected by highprices,reducingdemand.
(e) Activitiescan be outsourcedto the localmarket.Manyof the Japanese car firmswhichhave
investedinthe UKinrecentyears havemade effortsto obtainmany of theirinputs,subjectto
qualitylimits,fromlocalsuppliers.Promotionalactivitiescan also be sourcedlocally.
(f) Firmscan aimat segmentsinthe marketwhichare not particularlypricesensitive.For
example,many Germancar marquessuch as Mercedeshavebeen marketedinthe USon the
basis of qualityand exclusivity.Thisis a type of strategy based on differentiationfocus.
Foreigncurrencyriskwillbe coveredinmoredetailinChapter 14.
4 Supply side policy
4.1 Deregulation
Deregulationor ‘liberalisation’
is,ingeneral,the oppositeof regulation.Deregulationcan be
definedas the removalor weakeningof any formof statutory (orvoluntary)regulationof free
marketactivity.Deregulationallowsfree marketforcesmorescope to determinethe outcome.
Deregulation,whosemainaimis to introducemorecompetitionintoan industryby removing
statutory or otherentry barriers,has the followingpotentialbenefits.
G H
(a) Improvedincentivesfor internal/costefficiency– Greater competitioncompelsmanagersto

try harder to keepdowncosts.
(b) Improvedallocativeefficiency– Competitionkeepsdownpricescloserto marginalcost, and
firmsthereforeproducecloserto the sociallyoptimaloutput level.
Insomeindustriesit couldhavecertaindisadvantages,includingthe following.
• Lossof economiesof scale – Ifincreasedcompetitionmeans that each firmproducesless
output on a smallerscale,unitcosts willbe higher.
• Lowerqualityor quantity of service– Theneed to reducecosts may lead firmsto reduce
qualityor eliminateunprofitablebut sociallyvaluableservices.
• Needto protect competition– Itmay be necessaryto implementa regulatoryregimeto
protectcompetitionwhereinherentforceshavea tendencyto eliminateit, forexampleifthere
is a dominantfirmalready inthe industry,as inthe case of BritishTelecom.Inthistype of
situation,effective‘regulationforcompetition’willbe required,ie regulatorymeasuresaimed
at maintainingcompetitivepressures,whetherexistingor potential.
4.2 Privatisation
Privatisationtakes three broad forms.
(a) Thederegulationof industries,to allowprivatefirmsto competeagainst state-owned
businesseswherethey werenot allowedto competebefore(forexample,deregulationof bus
and coach services;deregulationof postalservices)
(b) Contractingout workto privatefirms,wherethe workwas previouslydone by government
employees– forexample,refusecollectionor hospitallaundrywork
(c) Transferringthe ownershipof assets fromthe state to privateshareholders
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Privatisation
canimprove efficiencyinoneoftwoways.
(a) Iftheeffectofprivatisation
istoincreasecompetition,theeffectmightbetoreduce or
eliminateallocative
inefficiency.
(b) Theeffectofprivatisationmightbetomaketheindustries morecost-conscious,because
theywillbedirectlyanswerable toshareholders,andunder scrutiny
fromstockmarket
investors.
There areotherpossibleadvantages ofprivatisation.
• Itprovidesanimmediate source ofmoney forthegovernment.
• Itreduces bureaucraticandpolitical meddling intheindustries
concerned.
• Itencourages widershareownership. Denationalisation
isonemethod ofcreating
wider share
ownership,asthesaleofBT,British Gasandsomeothernationalised industries
haveshown in
theUK.
There arearguments againstprivatisation
too.
• State-owned industries
aremorelikelytorespond tothepublicinterest,
aheadoftheprofit
motive.Forexample, state-owned industries
aremorelikelytocross-subsidise
unprofitable
operationsfromprofitableones.
• Encouraging private
competition tostate-runindustries
mightbeinadvisablewhere significant
economies ofscalecanbeachieved bymonopoly operations.
• There isalsoanargument thatprivatisedbusinessestrytousetheirmarketpower tocreate
monopolies andtodriveupprices.
5 Money market instruments
5.1 Money market deposits

Money marketdeposits
areveryshort-termloansbetweenbanks.
These
deposits
caneither
be
G fixeddeposits,
where therateofinterest
andmaturity
datesareagreed
atthetimeofthe H
transaction,
orcalldeposits
where theinterest
isvariable
andthedeposit
canbeterminated
if
noticeisgiven.Thetablebelowshowsexamplesofmarketrate.
Over 7 days’ 1month 3 months 6 months 1year
night notice
Interbank 53/32
–5 6 – 53/4 615/16
– 61/16 63/16
– 61/16 65/16
– 63/1663/8– 61/4
Sterling
Thetablequotestworates.Thehigher rateineachcolumn shows theinterestrateatwhicha

bankwilllendmoney. Thisiscalledtheofferprice.Thelowernumber istherateatwhichthe
bankwillpaytoborrow money. Thisiscalledthebidprice.
Therateatwhichbanksborrow fromeachotherintheLondon marketisofparticular
importance
forthemoney market.ThisiscalledLIBORandisthemostwidely usedreferencerateforshort-
terminterest
ratesgloballyforthesettlementofmoney market derivatives.
LIBORisnotonlyquoted forBritishpounds, itisalsoquotedforothermajor currencies
including
theUSdollar,Swissfranc,EuroandYen.
Thefollowing
tableshows examples ofLIBORratesforthreecurrencies fordifferent
maturities.
EUR USD GBP
Overnight 3.413 5.289 5.141
1week 3.592 5.305 5.150
1month 3.653 5.350 5.241
3 months 3.672 5.360 5.279
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EUR USD GBP
9months 3.851 5.313 5.420
12months 3.898 5.250 5.459
5.2 Certificates of deposit (CDs)

Thespecified
interest
rateona CDisexpressed asanannual percentage rateandneedstobe
adjusted
toreflect
thefactthatitsmaturity
islessthana year.Sterling
CDsassume thereare365
daysintheyear,whileUSCDsassume 360days.
Illustration2: SterlingCD
Consider
a Sterling
CDwitha facevalueof£1,000,000
issued
on1March20X0maturing
on1
September20X0(184dayslater).Thecouponis7%p.a.
Required
Calculate
thematurity
valueoftheCD.
Solution
£1,035,288
Valueatmaturity
=£1,000,000
×[1+(0.07×184÷365)]
=£1,035,288
G H
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Working capital
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1 Working capital characteristics of different businesses
Differentbusinesseswillhavedifferentworkingcapital characteristics.Thereare three main

aspects to these differences:
(a) Holdinginventory(fromtheirpurchasefromexternalsuppliers,throughthe productionand
warehousingof finishedgoods,up to the timeof sale)
(b) Takingtimeto pay suppliersand otheraccounts payable (creditors)
(c) Allowing customers(accountsreceivable)timeto pay.
Hereare someexamples:
(a) Supermarketsand otherretailersreceivemuchof theirsales incash or by creditcard or debit
card. However,they typicallybuy fromsupplierson credit.Theymay thereforehavethe
advantage of significantcash holdings,whichthey may chooseto invest.
(b) Acompanywhichsuppliesto othercompanies,such as a wholesaler,is likelyto be sellingand
buyingmainlyon credit.Co-ordinatingthe flowof cash may be quitea problem.Sucha
companymay makeuse of short-termborrowings(suchas an overdraft)to manage its cash.
(c) Smallercompanieswitha limitedtradingrecordmay face particularlysevereproblems.
Lackinga longtrack record,such companiesmay findit difficultto obtaincreditfrom
suppliers.Atthe same time,customerswillexpectto receivethe lengthof creditperiodthat is
normalforthe particularbusinessconcerned.Thefirmmay finditselfsqueezedinits
managementof cash.
Exam focus point

Someaspect of workingcapital managementis likelyto be includedineveryexam.
2 Liquidity ratios
G H
2.1 The current ratio

Thecurrentratio is the standard test of liquidity.
Formula to learn
Currentratio=Currentassets/Currentliabilities
Acompanyshouldhaveenoughcurrentassets that givea promiseof ‘cashto come’to meet its

commitmentsto pay its currentliabilities.Superficially,a ratioinexcessof 1impliesthat the
organisationhas enoughcash and near-cash assets to satisfyits immediateliabilities.However,
interpretationneeds to be conductedwithcare. Toohigha ratioimpliesthat too muchcash may
be tied up inreceivablesand inventories.Whatis ‘comfortable’variesbetweendifferenttypes of
business.
2.2 The quick ratio
Formula to learn
Quickratio or acid test ratio =(Currentassets lessinventories)/Current
liabilities
Companiesare unableto convertalltheircurrentassets intocash veryquickly.Insome

businesseswhereinventoryturnoveris slow,mostinventoriesare not veryliquidassets, and the
cash cycleis long.Forthese reasons,wecalculatean additionalliquidityratio,knownas the
quickratioor acid test ratio.
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Thisratioshouldideallybeatleast1forcompanies witha slowinventory
turnover.
Forcompanies
witha fastinventory
turnover,a quickratiocanbelessthan1withoutsuggesting
thatthe
company isincashflowdifficulties.
2.3 The accounts receivable payment period
Formulato learn
Accounts
receivable
daysoraccountsreceivable
payment
period,
oraverage
collection
period
=
(Trade
receivables/Credit
salesrevenue)
×365days
Thisformula
measures theaverage lengthoftimeittakesfora company’s accountsreceivable
to
paywhattheyowe.
Thetradeaccounts receivable arenotthetotalfigureforaccounts receivable
inthestatementof
financial
position,whichincludes prepayments andnon-tradeaccounts receivable.
Thetrade
accountsreceivable figurewillbeitemisedinananalysis ofthetotalaccounts receivable,
ina
notetotheaccounts.
Theestimateofaccounts receivable
daysisonlyapproximate.
(a) Thestatement offinancial position
valueofaccounts receivablemightbeabnormally high
orlowcompared withthe‘normal’ levelthecompany usuallyhas.Thismayapplyespecially
tosmallercompanies, wherethesizeofyear-end accounts receivable
maylargelydepend on
whethera feworevena singlelargecustomer payjustbefore orjustaftertheyearend.
(b) Revenue(turnover) inthestatementofprofitorlossexcludessalestax,buttheaccounts
receivable
figureinthestatement offinancialposition
includessalestax.Wearenotstrictly
comparing likewithlike.
G 2.4 The inventory turnover period H
Formulato learn
Inventory
turnover
=Costofsales/Averageinventory
Theinventory
turnover
periodcanalsobecalculated:
Inventory
turnover
period
(finished
goods)= (Averageinventory/Cost
ofsales)× 365days
Rawmaterials
inventory
holdingperiod= (Averagerawmaterials
inventory/Annual
purchases)
×365days
Average
production
(work-in-progress)
period= (Average
WIP/Cost
ofproduction)×365days
Theseindicate theaverage number ofdaysthatitemsofinventoryareheldfor.Aswiththe

averageaccounts receivable
collectionperiod,
theseareonlyapproximate figures,butoneswhich
shouldbereliable enough forfindingchangesovertime.Average inventoryisoftencalculatedas
(opening+closing balance)/2althoughothermethodsofestimating a typicalvaluemaybeused.
Alengthening inventoryturnoverperiodindicates:
(a) Aslowdown intrading;
or
(b) Abuild-up ininventory
levels,perhapssuggestingthattheinvestment ininventories
is
becoming excessive.
Ifweaddtogether theinventorydaysandtheaccounts receivabledays,thisshouldgiveusan
indication
ofhowsooninventory isconvertible
intocash,therebygivinga furtherindicationofthe
company’s liquidity.
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2.5 The accounts payable payment period
Accounts payablepayment period:Accounts payable paymentperiod

= (Averagetrade
KEY
TERM payables/Purchases orCostofsales) × 365days

Theaccounts payablepayment periodoftenhelpstoassessa company’sliquidity;
anincreasein
accountspayable daysisoftena signoflackoflongtermfinanceorpoormanagement of
currentassets,resulting
intheuseofextended creditfromsuppliers,
increasedbankoverdraft,
andsoon.
Alltheratioscalculated
abovewillvarybyindustry;hencecomparisons ofratioscalculated
with
othersimilarcompaniesinthesameindustry areimportant.
2.6 The need for funds for investment in current assets
Theseliquidity
ratiosarea guidetotheriskofcashflowproblems andinsolvency. Ifa company
suddenly findsthatitisunable torenew itsshort-term
liabilities
(forexample,ifthebank
suspends itsoverdraftfacilities),
therewillbea dangerofinsolvency unlessthecompany isable
toturnenough ofitscurrent assetsintocashquickly.
Currentliabilities
areoftena cheapmethod offinance(tradeaccounts payable donotusually
carryaninterest cost).Companies maythereforeconsiderthat,intheinterestofhigher profits,
it
isworthaccepting someriskofinsolvency byincreasingcurrentliabilities,
takingthemaximum
creditpossible
fromsuppliers.
2.7 Over-capitalisation and working capital
Ifthereareexcessive
inventories,
accountsreceivable
andcash,andveryfewaccounts payable,
therewillbeanoverinvestment
bythecompany innetcurrent
assets.
Working
capitalwillbe
excessiveandthecompanyinthisrespect
willbeover-capitalised.
G
Indicatorsof over-capitalisation H
Sales/working
capital Compare withprevious
yearsorsimilar
companies.Alowor
fallingratiomayindicate
over-capitalisation.
Liquidity
ratios Compare
withprevious
yearsorsimilar
companies.
Turnover
periods Longturnover
periods forinventory
andaccounts
receivable
orshortcreditperiod
fromsuppliers
maybeunnecessary.
Workingcapitalrequirements
canbereduced
byimproving
theseturnovertimes.
Illustration6: Workingcapital ratios
20X3 20X2
$m $m
Salesrevenue 2,065.0 1,788.7
Costofsales 1,478.6 1,304.0
Grossprofit 586.4 484.7
Current
assets
Inventories 119.0 109.0
receivable
Accounts (note1) 400.9 347.4
Shortterminvestments 4.2 18.8
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20X3 20X2
$m $m
Cashatbankandinhand 48.2 48.0
572.3 523.2
Accounts
payable:
amounts
fallingduewithin
one
year
Loansandoverdrafts 49.1 35.3
Corporation
taxes 62.0 46.7
Dividend 19.2 14.3
Accounts
payable
(note2) 370.7 324.0
501.0 420.3
current
assets 71.3 102.9Net
Notes
20X3 20X2
$m $m
Trade
accounts
receivable 329.8 285.4
Trade
accounts
payable 236.2 210.8
Required
G
Calculate
liquidity
andworkingcapitalratiosfromtheaboveaccounts
ofa manufacturer
of H
products
fortheconstruction
industry,
andcomment ontheratios.
Solution
20X3 20X2
Current
ratio 572.3/501.0
=1.14 523.2/420.3
=1.24
Quickratio 453.3/501.0
=0.90 414.2/420.3
=0.99
Receivables
days (329.8/2,065.0)
×365=58days (285.4/1,788.7)
×365=58days
Inventory
days (119.0/1,478.6)
×365=29days (109.0/1,304.0)
×365=31days
Accountspayable
days (236.2/1,478.6)
×365=58days (210.8/1,304.0)
×365=59days
Salesrevenue/net
workingcapital 2,065.0/(572.3
– 501.0)=28.96 1,788.7/(523.2
– 420.3)= 17.38
(1) Thecompany isa manufacturing groupservingtheconstruction
industry,
andsowould be
expectedtohavea comparatively lengthyaccounts receivable
turnover
period,
because of
therelatively
poorcashflowintheconstruction industry.
(2) Thecompany compensates forthisbyensuring thatitdoesnotpayforrawmaterialsand
othercostsbeforeithassolditsinventories
offinished goods(hencethesimilarity
of
receivables
daysandaccounts payabledays).
(3) Thecompany’s current
andquickratioshavefallenbutarestillreasonable,
andthequick
ratioisnotmuchlessthanthecurrent ratio.Thissuggests
thatinventory
levels
arestrictly
controlled,
whichisreinforced
bythelowinventory turnover
period.
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(4) Theratioofsalesrevenue/networking capitalindicatesthatworkingcapitalhasnot
increasedinlinewithsales.Thismayforecastfuture liquidity
problems.
Itwouldseemthatworking capitalistightlymanaged toavoidthepoorliquiditywhichcouldbe
caused bya highaccounts receivableturnover
period andcomparatively highaccounts
payable.
However,revenue hasincreased butnetworkingcapitalhasdeclined dueinparttothefallin
short-terminvestments
andtheincrease inloansandoverdrafts.
Note.TheACCAexamining teammaygiveyouindustry averages forratiosandexpect
youto
compare performance againstwhatcouldbeexpected usingfinancialanalysis,
including
ratio
analysis.
3 Overtrading
Real life example:Overtrading

GreatAmbition Coappoints a newmanaging director whohasgreatplanstoexpand the
company. ThisnewMDwanttoincrease revenue by100%within twoyears,andtodothisthey
employ extrasalesstaff.Theyrecognise thatcustomers donotwanttohavetowaitfordeliveries,
andsotheydecide thatthecompany mustbuildupitsinventory levels.
There isa substantial
increaseinthecompany’s inventories.Theseareheldinadditional warehouse spacewhichisnow
rented.Thecompany alsobuysnewcarsforitsextrasalesrepresentatives.
Themanaging director’spolicies
areimmediately successful inboosting sales,whichdouble injust
overoneyear.Inventory levelsarenowmuchhigher butthecompany takeslonger creditfromits
suppliers,
eventhough somesuppliers haveexpressed theirannoyance atthelength oftimethey
mustwaitforpayment. Creditterms foraccounts receivable areunchanged, andsothevolume
ofaccounts receivable,likethevolume ofsales,risesby100%.
Inspiteoftakinglonger credit,thecompany stillneedstoincrease itsoverdraftfacilities
withthe
G
bank,whichareraised froma limitof$40,000tooneof$80,000.Thecompany isprofitableand H
retains
someprofits inthebusiness, butprofit
margins havefallen.Grossprofitmargins arelower
because somepriceshavebeenreduced toobtain extrasales.Netprofitmargins arelower
because overhead costsarehigher. These include salesrepresentatives’wages,carexpenses and
depreciationoncars,warehouse rentandadditional lossesfromhaving towriteoffoutofdate
andslow-moving inventory items.
Thestatement offinancial position ofthecompany mightchangeovertimefrom(A)to(B).
Statement
offinancial
position Statement
offinancial
position
(A) (B)
$ $ $ $
assets 160,000 210,000Non-current
Current
assets
Inventory 60,000 150,000
Accounts
receivable 64,000 135,000
Cash 1,000 –
Current
assets 125,000 285,000
Totalassets 285,000 495,000
Sharecapital 10,000 10,000

Retained
profits 200,000 205,000
Totalequity 210,000 215,000
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Statement
offinancial
position Statement
offinancial
position
(A) (B)
$ $ $$
Current
liabilities
Bank 25,000 80,000
Accounts
payable 50,000 200,000
Totalliabilities 75,000 280,000
Totalequityand
liabilities 285,000 495,000
Statement
ofprofit
orloss(A) Statement
ofprofit
orloss(B)
$ $
Sales 1,000,000 2,000,000
Grossprofit 200,000 300,000
Netprofit 50,000 20,000
Insituation
(B),thecompany hasreached itsoverdraftlimitandhasfourtimesasmany
accountspayableasinsituation (A)butwithonlytwicethesalesrevenue. Inventory levelsare
muchhigher, andinventoryturnover islower.
Thecompany isovertrading.
Ifithadtopayitsnexttradeaccount, orsalaries andwages,before
itreceived
anyincome, itcouldnotdosowithout thebankallowing ittoexceed itsoverdraftlimit.
Thecompany isprofitable,
although profit
margins havefallen,anditoughttoexpect a
prosperousfuture.Butifitdoesnotsortoutitscashflowandliquidity, itwillnotsurvivetoenjoy
G
futureprofits. H
Suitable
solutionstotheproblem wouldbeimplementing measures toreduce thedegree of
overtrading.
(a) Newcapitalfromtheshareholders couldbeinjected.
(b) Better
control couldbeapplied toinventoriesandaccounts receivable. Thecompany could
abandon ambitiousplansforincreased salesandmorenon-current assetpurchases untilthe
businesshashadtimetoconsolidate itspositionandbuildupitscapitalbasewithretained
profits.
Abusinessseeking toincrease itsrevenuetoorapidly without anadequate capitalbaseisnotthe
onlycauseofovertrading. Othercausesareasfollows:
(a) Whena business repaysa loan,itoftenreplaces theoldloanwitha newone(refinancing).
However, a businessmightrepaya loanwithout replacingit,withtheconsequence thatit
haslesslong-term capitaltofinance itscurrentlevelofoperations.
(b) Abusiness mightbeprofitable, butina period ofinflation,
itsretained profits mightbe
insufficient
topayforreplacement non-currentassetsandinventories, whichnowcostmore
because ofinflation.
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4 Discounts
Illustration7: Bulkdiscounts
Acompany
usesanitemofinventory
asfollows:
Purchase
price: $96perunit
Annual
demand: 4,000units
Ordering
cost: $300
10%ofpurchase
Annual
holding
cost: price
Economic
order
quantity: 500units
Required
Should
thecompany
order
1,000unitsata timeinorder
tosecure
an8%discount?
Solution
Thetotalannual
costattheeconomic
order
quantity
of500unitsisasfollows:
$
Purchases
4,000×$96 384,000
Ordering
costs$300×(4,000/500) 2,400
Holding
costs$96×10%×(500/2) 2,400
G
388,800 H
Thetotalannual
costatanorder
quantity
of1,000unitswould
beasfollows:
$
Purchases
$384,000× 92% 353,280
Ordering
costs$300×(4,000/1,000) 1,200
Holding
costs$96×92%×10%×(1,000/2) 4,416
358,896
Thecompany
should
order
theitem1,000unitsata time,saving$(388,800
– 358,896)
=$29,904
a year.
5 Inventory and lead times
5.1 Uncertainties in demand and lead times: a re-order level system
Re-order
level:Re-order
level=maximum
usage×maximum
leadtime
KEY
TERM
There-orderlevelisthemeasure ofinventoryatwhicha replenishment
order
shouldbemade.
(a) Ifanorder isplacedtoolate,theorganisation
mayrunoutofinventory,
a stock-out,
resulting
ina lossofsalesand/ora lossofproduction.
(b) Ifanorder isplacedtoosoon,theorganisation
willholdtoomuchinventory,
andinventory
holdingcostswillbeexcessive.
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Useofa re-order levelbuildsina measure ofsafetyinventory andminimises theriskofthe
organisationrunning outofinventory. Thisisparticularly
importantwhenthevolume ofdemand
orthesupplyleadtimeisuncertain.
Theaverage annual costofsucha safetyinventory would be:
Quantity ofsafetyinventory (inunits)×Inventory holdingcostperunitperannum
Thediagram below shows howtheinventory levelsmightfluctuate
withthissystem. Points
marked
‘X’ showthere-order levelatwhicha neworder isplaced.Thenumber ofunitsordered eachtime
istheEOQ.Actualinventory levelssometimes fallbelowthesafetyinventorylevel,andsometimes
theresupply arrives
before inventorieshavefallentothesafetylevel.Onaverage, however,extra
inventoryholding willapproximate thesafetyinventory. Thesizeofthesafetyinventory will
depend onwhether stock-outs (runningoutofinventory) areallowed.
Inventory
level
x x x x x
x
Safety
inventory
0 Time
5.2 Maximum and buffer safety inventory levels
G
Maximuminventory
level:Maximum inventory
level=re-order
level+re-order
quantity
– H
KEY
TERM (minimum
usage×minimum leadtime)
Themaximum levelactsasa warning

signaltomanagement
thatinventories
arereaching
a
potentially
wasteful level.
Minimuminventory
orbuffersafetyinventory:
Minimum
inventory
orbuffer
safetyinventory
=
KEY
TERM re-order
level
– (average
usage ×averagel eadtime)
Thebuffer
safetylevelactsasa warning
tomanagement thatinventories
areapproaching
a
dangerously
lowlevelandthatstock-outs
arepossible.
Average
inventory:
Average
inventory
=buffer
safetyinventory
+(re-order/2)
KEY
TERM
Thisformula
assumes thatinventorylevels
fluctuate
evenly
between thebuffer
safety(or
minimum)inventory
levelandthehighest possible
inventory
level(theamountofinventory
immediately
afteranorder isreceived,
safetyinventory
andre-order quantity).
Illustration8: Maximumand buffersafety inventory
Acompany hasaninventory management policywhichinvolves

ordering
50,000unitswhenthe
inventory
levelfallsto15,000units.
Forecast
demand tomeetproductionrequirementsduring
the
nextyearis310,000 units.
Youshouldassumea 50-week yearandthatdemand isconstant
throughouttheyear.Orders arereceived
twoweeksafterbeingplacedwiththesupplier.
Required
Whatistheaverage
inventory
level?
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Solution
Average
usageperweek =310,000
units/50
weeks
=6,200units
Average
leadtime =2 weeks
Re-order
level =15,000units
Buffer
safetyinventory =re-order
level- (average
usage×average
leadtime)
=15,000- (6,200×2)=2,600units
Average
inventory =buffer
safetyinventory
+(re-order/2)
=2,600+(50,000/2)=27,600units
Thisapproach assumesthata business

wants tominimisetheriskofstock-outsatallcosts.Inthe
modern manufacturingenvironmentstock-outs
canhavea disastrouseffectontheproduction
process.
If,however,
youaregivena questionwheretheriskofstock-outsisassumedtobeworth taking,
andthecostsofstock-outs
arequantified,
there-order levelmaynotbecalculated intheway
describedabove.Foreachpossiblere-order
level,andthereforeeachpossiblelevelofbuffer
inventory,
calculate:
• Thecostsofholding bufferinventory
perannum
• Thecostsofstock-outs(Costofonestock-out ×expected number ofstock-outsperorder ×
number oforders
peryear)
Theexpected numberofstock-outs
perorder reflects
thevariouslevels
bywhichdemand during
theleadtimecouldexceedthere-orderlevel.
G H
Real life example:Possibilityof stock-outs

Ifre-order
levelis4
units,butthereisa probability
of0.2thatdemandduringtheleadtimewould
be5 units,and0.05thatdemand during theleadtimewouldbe6 units.
Thentheexpected
number ofstockouts=((5– 4)×0.2)+((6– 4)×0.05)=0.3.
Note.Stock-outs aredefined
asthenumber ofunitsnotavailable
ininventory
whenrequired.
Real life example:Toyota

Japanese carmanufacturer Toyotawasthefirstcompany todevelopJIT (JITwasoriginally
called
theToyota ProductionSystem). AftertheendoftheSecond World Warin1945,Toyota recognised
thatithadmuchtodotocatchupwiththeUSautomobile manufacturing industry.Thecompany
wasmaking losses.
InJapan,however, consumer demand forcarswasweak,andconsumers were
veryresistant
topriceincreases.Japanalsohada badrecord forindustrialdisputes.
Toyotaitself
suffered
frommajor strikeactionin1950.
Theindividualcredited
withdevising JIT atToyota fromthe1940swasTaiichi Ohno,andJIT
techniquesweredeveloped graduallyovertime.
Ohnoidentifiedsevenwastes andworked toeliminate themfromoperations inToyota.Measures
thatweretakenbythecompany included thefollowing:
(a) Theaimofreducing costswasofparamount importance inthelate1940s. Toyotawaslosing
money andmarket demand wasweak,preventing pricerises.Theonlywaytomove from
losses
intoprofits
wastocutcosts,andcostreduction wasprobably essentialforthesurvival
ofthecompany.
(b) Thecompany aimed toleveltheflowofproduction andeliminate unevenness intheworkflow.
Productionlevelling
shouldhelptominimise idletimewhileatthesametimeallowing the
company toachieve itsobjective
ofminimum inventories.
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(c) Thefactorylayoutwaschanged. Previously
allmachines,
suchaspresses, werelocated in
thesameareaofthefactory. Under thenewsystem,different typesofmachines were
clustered
together inproduction
cells.
(d) Machineoperators wereretrained.
(e) Employeeinvolvementinthechanges wasseenasbeingparticularly important.
Teamwork
waspromoted.
(f) Thekanban system waseventually introduced,
buta major problem withitsintroductionwas
theelimination
ofdefectsinproduction.Thekanban system isa ‘pull’systemofproduction
scheduling.
Itemsareonlyproduced whentheyareneeded. Ifa partisfaultywhenitis
produced,theproductionlinewillbeheldupuntilthefaultiscorrected.
6 Receivables
6.1 Credit analysis

Creditcontrolinvolvestheinitial
investigation
ofpotential creditcustomers
andthecontinuing
control
ofoutstanding accounts. Additional
controlscouldinclude:
(a) Thecompany couldsenda member ofstafftovisitthecompany concerned,
togeta first-
handimpression ofthecompany anditsprospects. Thiswould beadvisable
inthecaseofa
prospective majorcustomer.
(b) Anorganisation mightdevise a credit-rating
system fornewindividual
customers
thatis
basedoncharacteristicsofthecustomer (suchaswhether thecustomerisa homeowner, and
thecustomer’s ageandoccupation). Pointsorratings would beawardedaccording
tothe
characteristics
ofthecustomer, andtheamount ofcreditthatisofferedwoulddepend on
theircreditscore.
G
6.2 Percentage cost of an early settlement discount H
Thepercentagecostofanearlysettlement
discount
tothecompany
givingcanbeestimated
usingthefollowing
approach.
Illustration9: Percentagecost of discount
Acompany offers
itsgoodstocustomers
on30days’credit,
subject
tosatisfactory
trade
references.
Italsooffers
a 2%discount
ifpayment
ismadewithin
tendaysofthedateofthe
invoice.
Assumea 365-dayyear.
Required
Calculate
thecosttothecompany
ofoffering
thediscount.
Solution
No$ amounts aregivenhere,sowehavetolookatthisinpercentage terms.
Ifthediscount isacceptedandthemoney wasreceived
20daysearly,thecostofthediscount
canbecalculated as:
Discountpaid/Amount receivedifdiscount
taken
Herethisis2%/98% =0.0204or2.04%,where 2%isthediscount
and98%isthepercentage ofthe
amount duethatispaid(afterthe2%discount).
Thisisthebenefit ofacceptingtheofferexpressed
overa 20-dayperiod(sincethecompanyis
paying20daysearly).Thiscanbeconverted intoanannualequivalent
rateusingthefollowing
formula.(Thisformula isnotgivenintheexam.)
(1+R)=(1+r)
n
R=annual rate
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r=period rate(here20days)
n=no.ofperiods ina year(here365/20=18.25)
Inannual termsthisis1.0204^ 18.25=1.4456
soR=44.6%.
Thiscostlooksveryhighandifthecompany canaccessfinance (eganoverdraft)
ata lower
cost
than44.6%thenthiswould bepreferabletooffering
thisdiscount.
6.3 Managing foreign accounts receivable

6.3.1 Reducingtheinvestment inforeignaccountsreceivable
Acompany canreduce itsinvestmentinforeignaccounts receivable
byinsisting
onearlier
payment forgoods.Another approach isforanexportertoarrange fora banktogivecashfora
foreigndebtsooner thantheexporter wouldreceivepayment inthenormal course ofevents.
Thereareseveralwaysinwhichthismightbedone.
(a) Advances againstcollections. Where theexporteraskstheirbanktohandle thecollectionof
payment (ofa billofexchange ora cheque) ontheirbehalf,
thebankmaybeprepared to
makeanadvance totheexporter against thecollection.
Theamount oftheadvance mightbe
80%to90%ofthevalueofthecollection.
(b) Negotiationofbillsorcheques. Thisissimilar
toanadvance againstcollection
butwould be
usedwhere thebillorcheque ispayable outside
theexporter’s
country (forexampleinthe
foreign
buyer’s country).
(c) Discountingbillsofexchange. Thisiswhere thecustomeragreestoaccepta billofexchange
drawn onthecustomer bytheexporter.Theexporter’sbankmaybuythebillbefore itisdue
forpayment (ata discount tofacevalue) andcredittheproceedsfromthissaletothe
company’s account.
(d) Documentary credits. Thesearedescribed below.
G
(e) Forfaiting.
Thisisalsodescribed below. H
6.3.2 Reducingthebaddebtrisk
Methods
ofminimising
baddebtrisksarebroadly
similar
tothosefordomestic
trade.Anexporting
companyshould
vetthecreditworthiness
ofeachcustomer,
andgrantcreditterms
accordingly.
6.3.3 Exportfactoring
Thefunctionsperformed
byanoverseas factororexport
factorareessentially
thesameaswith
thefactoring
ofdomestictradedebts,whichwasdescribed
earlier
inthischapter.
Factoringcanbemoreexpensivethancreditinsurance
(explained
below) andmaynotbe
available
inallcountries.
6.3.4 Documentary credits
Documentary credits(‘letters
ofcredit’)providea method ofpayment ininternational
trade,
whichgivestheexporter a secure risk-free
method ofobtaining payment.
Theprocess works asfollows:
(a) Thebuyer(aforeign buyerordomestic importer)andtheseller (adomestic exporteror
foreignsupplier)
firstofallagreea contract forthesaleofthegoods,whichprovides for
payment through a documentary credit.
(b) Thebuyerthenrequests a bankintheircountry toissuea letterofcreditinfavourofthe
exporter.
Thebankwhichissues theletter
ofcreditisknown astheissuing bank.
(c) Theissuing bank,byissuing itsletter
ofcredit,
guarantees payment totheexporteron
conditionthattheexporter complies withcertainspecifiedconditionsintheletter
ofcredit
(relating
tosuchmatters aspresenting documentation fortheexport shipmentandshipping
thegoodsbefore a latestshipment date).
(d) Thegoodsaredespatched andtheshipping documentation issenttothepurchaser’s bank.
(e) Thebankissues a banker’s acceptance.
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(f) Theseller
either
keeps thebanker’sacceptance untilmaturityorsellsitata discountonthe
money market.
Adocumentary creditarrangementmustbemadebetween theexporter,
thebuyerand
participating
banksbefore theexportsaletakesplace.Documentary creditsareslowtoarrange,
administratively
cumbersome andinflexible.
Forexample, theexactconditions oftheletter
of
creditmustbemet.Iftheletterofcreditstatesthatshipping documentsarerequired, thenthe
seller
wouldbeunable toclaimpayment ifthegoodsweresentbyair.Despite thesedrawbacks,
letters
ofcreditmightbeconsideredessentialwhere theriskofnon-payment ishigh.
6.3.5 Forfaiting
Forfaiting
isthemostcommon method ofproviding
medium-term (say,threetofiveyears)export
finance.
Ithasnormally beenusedforexport
salesinvolving
capitalgoods(suchasmachinery),
where payments willbemadeovera numberofyears.Itisusuallyavailable
forlargeamounts
(over$250,000), butonlyinthemajorconvertible
currencies.
Theforfaiterbuystheforeignaccountsreceivable
froma sellerata discount
andtakesonallof
thecreditriskfromthetransaction
(without
recourse).Thereceivablesthenbecome a formof
debtinstrument whichcanbesoldonthemoney market.
Forfaiting
canbeanexpensive choice,
andarranging ittakestime.However,itcanbea useful
wayofenabling tradetooccurincaseswhere othermethods ofensuring payment andsmooth
cashflowarenotcertain, andincaseswhere trademaynotbepossible byothermeans.
6.3.6 Countertrade
Countertrade
isa meansoffinancingtradeinwhichgoodsareexchanged forothergoods.Three
parties
mightbeinvolved
ina ‘triangular’
deal.Countertrade
isthusa formofbarterandcan
involve
complexnegotiations
andlogistics.
Oneofthemainproblems withcountertrade
isthatthe
valueofthegoodsreceived
inexchange maybeuncertain.
6.3.7 Exportcreditinsurance
G
Youmightbewondering whyexport creditinsuranceshould benecessary,whenexporters can H
pursue non-paying customers through thecourtsinorder toobtainpayment. Theanswer isthat:

(a) Ifa creditcustomer defaults
onpayment, thetaskofpursuing thecasethrough thecourts
willbelengthy,anditmightbea longtimebefore payment iseventually
obtained.
(b) There arevarious reasonswhynon-payment mighthappen. Forexample,theseller
canbe
insured againstslowpayment, insolvency, certain
political
risksandchanges inimport or
export regulations.
Notallexporters takeoutexport creditinsurancebecause premiums areveryhigh,andthe
benefitsaresometimes notfullyappreciated.Iftheydo,theywillobtain aninsurancepolicyfrom
a privateinsurancecompany thatdealsinexport creditinsurance.
Notethatinsurance doesnot
usuallycover100%ofthevalueoftheforeign sales.
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Cash management
and working capital
finance
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1 Cash flow forecasting
Illustration3: Forecasting
Youarepresented
withthefollowing
forecasted
cashflowdataforyourorganisation
forthe
period
November20X1toJune20X2.Ithasbeenextracted
fromfunctional
flowforecasts
that
havealready
beenprepared.
NovX1 DecX1 Jan X2 FebX2 MarX2 AprX2 MayX2 JunX2
$ $ $ $ $ $ $ $
Sales 80,000 100,000 110,000130,000 140,000 150,000 160,000 180,000
Purchases 40,000 60,000 80,000 90,000 110,000130,000 140,000 150,000
Wages 10,000 12,000 16,000 20,000 24,000 28,000 32,000 26,000
Overhead 10,000 10,000 15,000 15,000 15,000 20,000 20,000 20,000
Dividends 20,000 40,000
Capitalexpenditure 30,000 40,000
Youarealsotoldthefollowing.
(1) Salesare40%cash,60%credit. Creditsalesarepaidtwomonths afterthemonth ofsale.
(2) Purchasesarepaidthemonth followingpurchase.
(3) 75%ofwagesarepaidinthecurrent month and25%thefollowing month.
(4) Overheads arepaidthemonth aftertheyareincurred.
G
(5) Dividends
arepaidthreemonths aftertheyaredeclared. H
(6) Capitalexpenditureispaidtwomonths afteritisincurred.

(7) Theopening cashbalance on1January20X2is$15,000.
Themanaging director
ispleasedwiththeabovefigures, astheyshowsaleswillhaveincreased
bymorethan100%intheperiod underreview.
Inorder toachievethistheyhavearranged a bank
overdraft
witha ceiling
of$50,000toaccommodate theincreasedinventory levels
andwagebill
forovertimeworked.
Required
1 Prepare
a cashflowforecast
forthesix-month
period
JanuarytoJune20X2.
2 Comment
onyourresults
inthelightofthemanaging
director’s
comments
andofferadvice
Solution
1 Cashflowforecast
Jan Feb March April May June
$ $ $ $ $ $
Cashreceipts
Cashsales(40%
ofinvoiced 44,000
sales) (0.4×110,000 52,000 56,000 60,000 64,000 72,000
Creditsales(60%
ofsales2
months 48,000
previous) (0.6×80,000) 60,000 66,000 78,000 84,000 90,000
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Jan Feb March April May June
$ $ $ $ $ $
92,000 112,000 122,000 138,000 148,000 162,000
Cash payments
Purchases 60,000 80,000 90,000 110,000 130,000 140,000
Wages:75% 12,000 15,000 18,000 21,000 24,000 27,000
Wages:25% 3,000 4,000 5,000 6,000 7,000 8,000
Overheads 10,000 15,000 15,000 15,000 20,000 20,000
Dividends 20,000
Capital
expenditure 30,000 40,000
85,000 114,000 178,000 152,000 181,000 235,000
b/f 15,000 22,000 20,000 (36,000) (50,000) (83,000)
Netcash flow 7,000 (2,000) (56,000) (14,000) (33,000) (73,000)
c/f 22,000 20,000 (36,000) (50,000) (83,000) (156,000)

2 Theoverdraftarrangementsare quiteinadequate to servicethe cash needs of the business
overthe sixmonthperiod.Ifthe figuresare realisticthen actionshouldbe takennowto avoid
difficultiesinthe near future.Thefollowingare possiblecoursesof action.

(1) Activitiescouldbe curtailed.
(2) Other sourcesof cash couldbe explored,forexamplea long termloanto financethe
G
capital expenditureand a factoringarrangementto providecash due fromaccounts H
receivablemorequickly.
(3) Effortsto increasethe speed of debt collectioncouldbe made.
(4) Paymentsto accounts payable couldbe delayed.
(5) Thedividendpayments couldbe postponed(the figuresindicatethat thisis a small
company, possiblyownermanaged).

(6) Staff mightbe persuadedto workat a lowerrate inreturnfor,say, an annual bonusor a
profitsharingagreement.
(7) Extrastaff mightbe takenon to reducethe amountof overtimepaid.
(8) Theinventoryholdingpolicyshouldbe reviewed;it may be possibleto meet demand from
currentproductionand minimisecash tied up ininventories.
2 Investing cash flow surpluses
Companiesand otherorganisationssometimeshavea surplusof cash and become‘cashrich’.A

cash surplusis likelyto be temporary, but whileit existsthe companyshouldinvestor depositthe
cash bearingthe followingconsiderationsinmind:
(a) Liquidity– moneyshouldbe availableto take advantage of favourableshort-terminterest
rates on bank deposits,or to grasp a strategicopportunity,forexamplepayingcash to take
overanother company.
(b) Profitability– the companyshouldseekto obtaina good return forthe riskincurred.
(c) Safety – the companyshouldavoidthe riskof a capital loss.
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Otherfactorsthat organisationsneed to considerinclude:
(a) Whetherto investat fixedor floatingrates. Floatingrate investmentsare likelyto be chosenif
interestrates are expectedto rise.
(b) Termto maturity. Thetermschosenwillbe affected by the business’sdesireforliquidityand
expectationsabout futurerates of interest– ifthere are majoruncertaintiesabout future
interestrate levelsit willbe better to chooseshort-terminvestments.Theremay also be
penaltiesforearly liquidation.
(c) Howeasy it willbe to realisethe investment.
(d) Whethera minimumamount has to be investedincertaininvestments.
(e) Whetherto investon internationalmarkets.
Ifa companyhas no plans to growor to invest,then surpluscash not requiredfortransactionsor
precautionarypurposesshouldnormallybe returnedto shareholders.
Surpluscash may be returnedto shareholdersby:
(a) Increasingthe usuallevelof the annual dividendswhichare paid
(b) Makinga one-offspecialdividendpayment (forexample,Nextplchas made such payments
inrecentyears)
(c) Usingthe moneyto buy back its ownshares fromsomeof its shareholders.Thiswillreduce
the total numberof shares inissueand shouldthereforeraisethe levelof earningsper share.
Ifsurpluscash is to be investedon a regularbasis,organisationsshouldhaveinvestment
guidelinesinplace coveringthe followingissues.
(a) Surplusfundscan onlybe investedinspecifiedtypes of investment(egno equityshares).
(b) Allinvestmentsmustbe convertibleintocash withina set numberof days.
(c) Investmentsshouldbe ranked:surplusfundsare to be investedinhigherriskinstrumentsonly
whena sufficiencyhas been investedinlowerriskitems(sothat there is alwaysa cushionof
safety).
G
(d) Ifa firminvestsincertainfinancialinstruments,a credit rating shouldbe obtained.Credit H
ratingagencies,discussedearlier,issuegradingsaccordingto risk.
2.1 Short-term investments
Temporarycash surplusesare likelyto be:
(a) Depositedwitha bank or similarfinancialinstitution
(b) Investedinshort-termdebt instruments,such as Treasurybillsor CDs(debt instrumentsare
debt securitieswhichcan be traded)
(c) Investedinlonger-termdebt instrumentssuch as governmentbonds,whichcan be soldwhen
the companyeventuallyneeds the cash
(d) Possiblyinvestedinshares of listedcompanies,whichcan be soldon the stockmarketwhen
the companyeventuallyneeds the cash. However,investinginequitiesis fairlyhighrisk,since
share pricescan fallsubstantially,resultinginlarge losseson investmentso thisis lesslikely
to be appropriate.
2.2 Short-term deposits
Cash can of coursebe put intoa bank deposit to earn interest.Therate of interestobtainable
depends on the sizeof the depositand variesfrombank to bank.
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Thereareothertypesofdeposit.
(a) Money marketlending
Thereisa verylargemoney marketintheUKforinterbanklending.
Theinterest
ratesinthemarket
arerelatedtotheLondon InterbankOfferRate(LIBOR)andtheLondonInterbankBidRate(LIBID).
(b) Localauthoritydeposits
Localauthorities
oftenneedshort-termcash,andinvestors
candepositfundswiththemfor
periodsrangingfromovernightuptooneyearormore.
(c) Financehouse deposits
These aretimedepositswithfinancehouses(usually
subsidiaries
ofbanks).
2.3 Short-term debt instruments
There area number
ofshort-term
debtinstruments
whichaninvestorcanresell
before
thedebt
matures andisrepaid.
These
debtinstruments
include
certificates
ofdeposit
(CDs)andTreasury
bills.
These havealready
beendescribed
inthecontextofmoneymarket instruments.
2.3.1 Certificatesofdeposit(CDs)
ACDisa securitythatisissued bya bank,acknowledgingthata certainamountofmoney has
beendepositedwithitfora certain
periodoftime(usually
a shortterm).TheCDisissuedtothe
depositorandattractsa statedamount ofinterest.
CDsarenegotiableandtraded ontheCDmarket (amoney market),
soifa CDholderwishesto
obtainimmediatecashtheycanselltheCDonthemarket atanytime.Thissecond-hand market
inCDsmakes themattractive,
flexible
investments
fororganisations
withexcess
cash.A company
witha temporarycashsurplusmaytherefore buya CDasaninvestment.
2.3.2 Treasurybills
G Treasury
billsareissued
weekly bythegovernment tofinanceshort-termcashdeficiencies
inthe H
government’sexpenditure
programme. TheyareIOUsissued bythegovernment, givinga promise
topaya certainamounttotheirholder onmaturity. Treasury
billhavea termofbetween 1and
364days,afterwhichtheholder ispaidthefullvalueofthebill.
ThemarketforTreasurybillsisveryliquid,
andbillscanbebought orsoldatanytime.
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Investment decision
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1 Investment
1.1 Investment
Expenditure
canbedivided intotwocategories:capitalexpenditureandrevenueexpenditure.
Supposethata business
purchases a building
for$30,000.Itthenaddsanextensiontothe
building
ata costof$10,000.Thebuilding needstohavea fewbroken windows mended,itsfloors
polished
andsomemissing rooftilesreplaced.
Thesecleaning andmaintenancejobscost$900.
Theoriginal
purchase($30,000)andthecostoftheextension ($10,000)
arecapitalexpenditure
becausetheyareincurredtoacquire andthenimprove a non-current
asset.Theothercostsof
$900arerevenue expenditurebecause theymerely maintainthebuildingandthustheearning
capacityofthebuilding.
Capitalexpenditure:Expenditurewhichresults
intheacquisitionofnon-currentassetsoran
KEY improvement intheirearningcapacity.
Itisnotcharged asanexpense inthestatementof
TERM profit
orloss;theexpenditureappearsasa non-current assetinthestatementoffinancial
position.
Revenue expenditure:Charged tothestatementofprofitorlossandisexpenditure whichis
incurred:
• Forthepurpose ofthetradeofthebusiness – thisincludesexpenditure
classified
asselling
anddistribution
expenses,administration
expenses andfinancecharges
• Tomaintain theexisting
earningcapacityofnon-currentassets
1.1.1 Non-current assetinvestmentandworkingcapitalinvestment

Investmentcanbemadeinnon-current assetsorworking capital.
(a) Investment
innon-current
assetsinvolves a significant
amountoftimebetweenthe
G commitmentoffundsandrecovering theinvestment.Money ispaidouttoacquire
resources H
whicharegoingtobeusedona continuing basiswithin theorganisation.

(b) Investment
inworkingcapitalarisesfromtheneedtopayoutmoney forresources
(suchas
rawmaterials)
beforeitcanberecovered fromsalesofthefinishedproductorservice.
The
fundsaretherefore
onlycommitted fora shortperiod oftime.
1.1.2 Investment by thecommercial sector
Investment
bycommercial organisations
mightinclude
investment in:
• Plantandmachinery
• Researchanddevelopment
• Advertising
• Warehouse facilities
Theoverriding
feature ofa commercial
sectorinvestment
isthatitisgenerally
basedonfinancial
considerationsalone.Thevarious
capitalexpenditure
appraisaltechniques
thatwewillbelooking
atassessthefinancial aspects
ofcapitalinvestment.
1.1.3 Investment by notforprofitorganisations
Investmentbynotforprofit
organisations
differsfrominvestmentbycommercialorganisations
for
severalreasons.
(a) Relatively
fewnotforprofit
organisations’
capitalinvestments
aremadewiththeintentionof
earninga financial
return.
(b) Whentherearetwoormorewaysofachieving thesameobjective(mutually
exclusive
investmentopportunities),
a commercialorganisation
mightprefertheoptionwiththelowest
presentvalueofcost.Not-for-profit
organisations,however,
ratherthanjustconsidering
financial
costandfinancial
benefits,
willoftenhaveregardtothesocialcostsandsocial
benefits
ofinvestments
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(c) Thecostofcapitalthatisapplied
toproject
cashflowsbythepublicsector
willnotbea
‘commercial’
rateofreturn,
butonethatisdetermined
bythegovernment.Anytargets thata
publicsector
investmenthastomeetbeforebeingaccepted
willtherefore
notbebasedon
thesamecriteria
asthoseinthecommercialsector.
2 Discounted cash flow (brought forward knowledge)

Discounted cashflow,orDCFforshort,isaninvestment appraisaltechnique
whichtakesinto
account boththetimings ofcashflowsandalsototalprofitability
overa project’s
life.
Three importantpoints
aboutDCFareasfollows.
(a) DCFlooksatthecashflowsofa project, nottheaccounting profits.
Cashflowsare
considered becausetheyshowthecostsandbenefits ofa project
whentheyactually occur
andignore notionalcostssuchasdepreciation.
(b) Onlyfutureincrementalcashinflowsandoutflows areconsidered.Thismeans thatcosts
incurredinthepast(sunkcosts)shouldbeignored. Costswhichwould needtobeincurred
regardlessofwhether ornottheprojectisundertakenshouldalsobeignored.
(c) Thetiming ofcashflowsistakenintoaccount bydiscounting them.$1earned todaywillbe
worthmorethan$1earned aftertwoyears.Thisispartlyduetotheeffectofinflation,
and
partlyduetothegreater certaintyinhaving$1inhandtodaycompared withthepromise of
$1ina year’stime.Inaddition,
cashwehaveinhandtodaycanbespentorinvested
elsewhere:forexample,putintoa savingsaccount toearnannual interest.
2.1 Compounding
Suppose thata company has$10,000 toinvestandwants toearna return of10%(compound
interest)
onitsinvestments.Thismeans thatifthe$10,000 couldbeinvested at10%,thevalueof
theinvestmentwithinterest
would buildupasfollows.
(a) After1year$10,000×(1.10) =$11,000
G
(b) After2 years$10,000× (1.10)=
2 $12,100 H
(c) After3 years$10,000× (1.10)=

3 $13,310 andsoon.
Thisiscompounding. Compounding tellsushowmuchaninvestment willbeworth attheendand
canbeusedtocompare twoprojects withthesameduration. Theformula forthefuture
valueof
aninvestment plusaccumulated interestaftern timeperiods
is:
FV=PV(1+r)n
Where FVisthefuturevalueoftheinvestment withinterest
PVistheinitial
or‘present’
valueoftheinvestment
risthecompound rateofreturn pertimeperiod, expressed
asa proportion(so10%=0.10,5%=
0.05,andsoon)
nisthenumber oftimeperiods
2.2 Discounting
Discounting
startswiththefuture
valueandconverts a futurevaluetoa present
value.
Discounting
tellsushowmuchaninvestment willbeworthintoday’sterms.Thismethodcanbe
usedtocompare twoinvestments
withdifferent
durations.
Forexample,ifa company expectstoearna (compound) rateofreturnof10%onitsinvestments,
howmuchwould itneedtoinvest
nowtohavethefollowing investments?
(a) $11,000
after1year
(b) $12,100
after2 years
(c) $13,310
after3 years
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Theanswer is$10,000ineachcase,andwecancalculate itbydiscounting.Thediscounting
formulatocalculatethepresent valueofa futuresumofmoney attheendofntimeperiods is:
PV=FV1/(1+r)nor,alternatively:
PV=FV(1+r)-n
Soheretheanswers are:
(a) After1year,$11,000 ×1/1.10
=$10,000
(b) After2 years,$12,100×1/1.10
2= $10,000
(c) After3 years,$13,310×1/1.10
3=$10,000
Discounting canbeapplied tobothmoney receivable
andalsotomoney payable ata future
date.Bydiscounting allpayments andreceiptsfroma capitalinvestment
toa present
value,they
canbecompared ona common basisata valuewhichtakesaccount ofwhenthevarious cash
flowswilltakeplace.
Illustration7: Presentvalue
Spenderexpectsthecashinflow fromaninvestment tobe$40,000aftertwoyearsandanother

$30,000afterthreeyears.Itstargetrateofreturn
is12%.
Required
Calculate
thepresent
valueofthesefuture
returns
andexplain
whatthispresent
valuesignifies.
Solution
(1)
Year Cashflow Discount
factor12% Present
value
$ $
2 40,000 1/(1.120)
2=0.797 31,880
G H
3 30,000 1/(1.120)
3=0.712 21,360
TotalPV53,240
(2) Thepresent
valueofthefuture
returns,
discountedat12%,is$53,240.Thismeans thatif
Spendercaninvest
nowtoearna return
of12%onitsinvestments,itwouldhavetoinvest
$53,240nowtoearn$40,000aftertwoyearsplus$30,000afterthreeyears.
2.3 The discount factor

Inthecompounding anddiscounting
examples above, weusedthecompany’s requiredrateof
returnasthediscount factor.
Howdocompanies decide therateofreturnthattheyrequire?
Imagine Company Ahasa bankaccount, earning
5%interest.Whenconsidering whether ornot
toinvestina project,
thecompany’s directorsmayusethebankinterest rateasa benchmark. If
theinvestment’srateofreturnis3%,would Company Ainvest? Probablynot,because a higher
levelofreturncanbeearned bysimply depositing
thesameamount ofmoney inthebank
account. However,iftheinvestment’s
rateofreturn is8%,thenthecompany willprobably choose
toinvest.
Ontheotherhand,consider Company B,whichhasnocashinhand.Itwillberequired toborrow
froma bankshould itdecidetoinvest
ina project.
Company B’sdirectors
mayusetheloan
interest
asa benchmark whenevaluating investmentstoensure thattheyonlyacceptprojects
whichsufficiently
reward thecompany fortheadditionalcoststhecompany hastobearin
making theinvestment.Ifthecompany borrowsat6%,itwillmostlikelyrejecta projectwhich
yieldsa rateofreturnof3%.However, itmayconsider a projectthatisexpected toyielda rateof
returnof8%.
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These examples aretwosimplisticwaysofthinking aboutthecostofcapital,oftenusedtoderive
a discountrateforDCFanalysis andinvestment appraisal.
Thecostofcapitalhastwoaspects toit.
(a) Itisthecostoffundsthata company raises
anduses.
(b) Thereturn thatinvestors
expect tobepaidforputting fundsintothecompany. Itistherefore
theminimum returnthata company shouldmakefromitsowninvestments, toearnthecash
flowsoutofwhichinvestors canbepaidtheirreturn.
Thecostofcapitalisnotthecostofborrowing, although
thecostofborrowing maybeanelement
inthecostofcapital.WewillstudythecostofcapitalindetailinPartE ofthisStudyText.Forthe
purpose ofthischapter,
weshallassume thatthecostofcapitalisa knownrequiredpercentage
annual rateofreturnoninvestments.
2.4 Annual cash flows growing in perpetuity
Youalsoneedtoknowhowtocalculate
thecumulative present
valueof$1perannum
growing
at
a constant
rateeveryyearinperpetuity
(thatis,forever).
Formulato learn
Whenthecostofcapitalisr,thecumulative
PVof$1perannum
growing
ata constant
ratein
perpetuity
is:
1
r−g
Forexample,thePVof$1perannum inperpetuity,
growing ata constant
rateof6%and
discounted
ata rateof10%would
be$1×1/(0.10-0.06)
=$25.
Iftherewasnogrowththepresent
valuewouldbelower ie$1×1/(0.10)
=$10.
G H
Illustration8: Perpetuities
Anorganisation
witha costofcapitalof14%isconsidering
investing
ina project
costing
$500,000.Theproject
would yieldnothinginYear1,butfromYear2 wouldyieldcashinflows
of
$100,000
perannum growing at4%peryearinperpetuity.
Required
Assess
whether
theproject
should
beundertaken.
Solution
factor14% Present
value
$ $
0 (500,000) 1.000 500,000)
1 0 0.877 0
1/(0.14
- 0.04)×0.877=8.770(for
2 100,000 time2 onwards) 877,000
NPV=377,000
Thepresentvalueoftheperpetuity
of$100,000 perannum iscalculated
bymultiplying $100,000
by1/(0.14-0.04).
Thisgivesa cumulative
present
valueofcashinflows
fromYear2 onwards of
$1,000,000.
However,
because thecashinflows
startonlyatYear2,weneedtodiscount thecashinflowsback
totoday’svalue.Thisisdonebyusingthepresent
valuefactorof0.877(or1/(1+0.14)).
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TheNPVispositive
andsotheproject
should
beundertaken.
3 The internal rate of return method

UsingtheNPVmethod ofdiscounted cashflow,present values arecalculatedbydiscountingata
targetrateofreturn,orcostofcapital,andthedifference between thePVofcostsandthePVof
benefits
istheNPV.Incontrast, theinternal rateofreturn (IRR)method istocalculatetheexact
DCFrateofreturn whichtheproject isexpected toachieve;inotherwords, therateatwhichthe
NPViszero.Iftheexpected rateofreturn (theIRRorDCFyield)exceeds a targetrateofreturn,
theprojectwould beworth undertaking (ignoring riskanduncertainty factors).
Ina sectionC question,youcancalculate theIRRusingtheexcelfunction =IRR
InanOTquestion, thecalculationoftheinternal rateofreturn isapproximated usingthe
interpolation
method.
Step1 Calculate thenetpresentvalueusingthecompany’s costofcapital.
Step2 Having calculatedtheNPVusingthecompany’s costofcapital,calculatetheNPVusing
a second discountrate.
(a) IftheNPVispositive,usea second ratethatisgreater thanthefirstrate.
(b) IftheNPVisnegative, usea second ratethatislessthanthefirstrate.
Step3 UsethetwoNPVvalues toestimate theIRR.Theformula toapplyisasfollows.
Formulato learn
IRR = a% + NPVa (b%−a%)

NPVa−NPVb
G H
Where a =thelowerofthetworatesofreturnused
b=thehigher ofthetworatesofreturnused
NPV=the
a NPVobtained usingratea
NPV=the
b NPVobtained usingrateb
Note.Ideally
NPVwill
a bea positive valueandNPVwill
b benegative. (IfNPVisnegative,
b thenin
theequationaboveyouwillbesubtractinga negative,
ietreating
itasanaddedpositive.)
3.1 Illustration
Illustration9: TheIRR method
Acompany istryingtodecide whether

tobuya machine for$80,000whichwillsavecostsof
$20,000perannum forfiveyearsandwhichwillhavea resale
valueof$10,000attheendofyear
5.
Required
Ifitisthecompany’s
policytoundertake
projects
onlyiftheyareexpected
toyielda DCFreturn
of10%ormore,ascertain
whether
thisproject
should
beundertaken.
Solution
(1) Calculate
thefirstNPV,usingthecompany’s
costofcapitalof10%.
Time Cashflow PVfactor10% PVofcashflow
$ $
(80,000) 1.000 (80,000)0
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Time Cashflow PVfactor10% PVofcashflow
$ $
1–5 20,000 3.791 75,820
5 10,000 0.621 6,210
NPV=2,030
(2) Calculatethesecond
NPV,usinga ratethatisgreater
thanthefirstrate,asthefirstrategave
a positive
answer.
Suppose
wetry12%.
Year Cashflow PVfactor12% PVofcashflow
$ $
0 (80,000) 1.000 (80,000)
1–5 20,000 3.605 72,100
5 10,000 0.567 5,670
NPV=(2,230)
Thisisfairlyclosetozeroandnegative.
TheIRRisthereforegreater
than10%(positive
NPVof
$2,030)butlessthan12%(negative NPVof$2,230).
UsethetwoNPVvalues toestimate
theIRR.
Theinterpolationmethod assumes
thattheNPVrisesinlinearfashion
betweenthetwoNPVsclose
to0.TheIRRistherefore assumedtobeona straightlinebetween
NPV=$2,030at10%andNPV=
–$2,230at12%.
Usingtheformula:
G
IRR = 10 + 2,030 (12 - 10) = 10.95 say 11%. H
2,030+ 2,230
Ifitiscompanypolicytoundertakeinvestmentswhichareexpectedtoyield10%ormore, this
projectwouldbeundertaken.
Ifweweretodrawa graphofa ‘typical’capitalproject,
witha negativecashflowatthestartof
theproject,
andpositivenetcashflowsafterwardsuptotheendoftheproject, wecoulddrawa
graphoftheproject’s
NPVatdifferentcostsofcapital.
Itwouldlooklikethesolidcurved
lineinthe
following
diagram.
• Ifweestablish
theNPVsatthetwopoints P,wewould estimate
theIRRtobeatpointA.
• Ifweestablish
theNPVsatthetwopoints Q,wewould estimatetheIRRtobeatpointB.
ThecloserourNPVsaretozero,thecloserourestimatewillbetothetrueIRR.
NPV
Q
PPositive
A B
0
True
IRR Cost
ofcapital
%
Negative
P
Q
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3.2 Advantages and disadvantages of IRR method

Themainadvantage oftheIRRmethod isthattheinformationitprovides
ismoreeasily
understood bymanagers, especially
nonfinancial managers. Forexample,itisfairlyeasyto
understandthemeaning ofthefollowingstatement.
‘Theprojectwillbeexpectedtohaveaninitial capitaloutlayof$100,000,
andtoearna yieldof
25%.Thisisinexcess ofthetargetyieldof15%forinvestments.’
Itisnotsoeasytounderstand themeaning ofthisstatement.
‘Theprojectwillcost$100,000andhaveanNPVof$30,000whendiscounted attheminimum
requiredrateof15%.’
However, managers mayconfuse IRRandaccounting returnoncapitalemployed, ROCE.
TheIRRmethod ignores
therelative
sizeofinvestments.BoththefollowingprojectshaveanIRRof
18%.
Project
A Project
B
$ $
Cost,year0 350,000 35,000
Annualsavings,
years1–6 100,000 10,000
Clearly,project
Aisbigger(tentimesasbig)andsomore‘profitable’
butiftheonlyinformation
onwhichtheprojectswerejudged weretobetheirIRRof18%,project
Bwouldbemadetoseem
justasbeneficial
asprojectA,whichisnotthecase.
3.3 Non-conventional cash flows
Theprojects
wehaveconsideredsofarhavehadconventional
cashflows(aninitial
cashoutflow
followed
bya series
ofinflows).
Whenflowsvaryfromthistheyaretermednon-conventional.
The
G
following
project
hasnon-conventional
cashflows. H
Year Project
X
$’000
0 (1,900)
1 4,590
2 (2,735)
Project
Xwould
havetwoIRRsasshown
bythisdiagram.
NPV
30
Positive
20
10
0
5 10 20 30 40 Cost
ofcapital
%
-10
-20
Negative
-30
-40
-50
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TheNPVrulesuggests thattheprojectisacceptablebetween costsofcapitalof7%and35%.
Suppose thattherequiredrateonproject Xis10%andthattheIRRof7%isusedindeciding
whethertoacceptorrejecttheproject. Theprojectwould berejectedsinceitappearsthatitcan
onlyyield7%.
Thediagram shows,however,thatbetween ratesof7%and35%theproject shouldbeaccepted.
UsingtheIRRof35%would produce thecorrectdecisiontoaccepttheproject.Lackofknowledge
ofmultipleIRRscouldthereforeleadtoseriouserrorsinthedecisionofwhether toacceptorreject
a project.
Ingeneral,ifthesignofthenetcashflowchanges insuccessiveperiods,thecalculations
may
produceasmanyIRRsastherearesignchanges. IRRshould notnormally beusedwhenthereare
non-conventionalcashflows.
Examfocus point
Youneedtobeawareofthepossibility
ofmultiple
IRRs,buttheareaisnotexaminable
ata
computational
level.
3.4 Mutually exclusive projects

Mutually
exclusiveprojects
aretwoormoreprojects fromwhichonlyonecanbechosen.
Examplesincludethechoiceofa factorylocation
orthechoiceofjustoneofa numberof
machines.TheIRRandNPVmethods can,however,giveconflicting
rankings
astowhichproject
shouldbegivenpriority.
Letussuppose thata company isconsidering
twomutuallyexclusive
options,
option
A andoption
B.Thecashflowsforeachwould beasfollows.
Year Option
A Option
B
G
$ $ H
0 Capitaloutlay (10,200) (35,250)

1 Netcashinflow 6,000 18,000
Thecompany’s
costofcapitalis16%.
TheNPVofeachproject
iscalculated
below.
Option
A Option
B
Discount
Year factor Cashflow Present
value Cashflow Present
value
$ $ $ $
0 1.000 (10,200) (10,200) (35,250) 35,250)
1 0.862 6,000 5,172 18,000 5,516
2 0.743 5,000 3,715 15,000 1,145
3 0.641 3,000 1,923 15,000 9,615
NPV=+610 NPV=+1,026
TheIRRofoption
A is20%andtheIRRofoption
B isonly18%(workings
notshown).Ona
comparison
ofNPVs, option
B would
bepreferred,
butona comparison
ofIRRs,option
A would
be
preferred.
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Iftheprojects
wereindependent thiswouldbeirrelevant
sinceundertheNPVrulebothwould
be
accepted.Withmutually exclusive
projects,
however,onlyoneproject
canbeaccepted.Therefore,
therankingiscrucialandwecannot beindifferent
totheoutcomesoftheNPVandIRRappraisal
methods.TheNPVmethod ispreferable.
3.5 Reinvestment assumptions
Anassumptionunderlying theNPVmethod isthatanynetcashinflows generated during thelife
oftheproject
willbereinvestedatthecostofcapital(thatis,thediscountrate).TheIRRmethod,
ontheotherhand,assumes thesecashflowscanbereinvested toearna return equaltotheIRR
oftheoriginal
project.
Intheexampleabove,theNPVmethod assumes thatthecashinflows of$6,000,$5,000and
$3,000foroptionA willbereinvested
atthecostofcapitalof16%whereas theIRRmethod
assumestheywillbereinvestedat20%.Intheory, a firmwillhaveaccepted allprojects
which
provide
a returninexcessofthecostofcapital.Anyotherfundswhichbecome available
canonly
bereinvested
atthecostofcapital.Thisistheassumption impliedintheNPVrulebutisunlikely to
bethecaseinpractice.
4 Assessment of DCF methods of project appraisal
4.1 Advantages of DCF methods

DCFisa capitalappraisal techniquethatisbasedona concept known asthetimevalueof
money: theconcept that$1receivedtodayisnotequalto$1received inthefuture.Giventhe
choicebetween receiving
$100todayand$100inoneyear’stime,mostpeople would optto
receive$100todaybecause theycouldspenditorinvestittoearninterest.Iftheinterest
ratewas
10%,youcouldinvest $100todayanditwould beworth ($100×1.10) =$110inoneyear’stime.
There are,however,otherreasonswhya present $1isworth morethana future $1.
G (a) Uncertainty.Although theremightbea promise ofmoney tocomeinthefuture, itcannever H
becertain thatthemoney willbereceived

untilithasactuallybeenpaid.
(b) Inflation.
Inflation
alsomeans $1nowisworth morethan$1inthefuture because ofinflation.
Thetimevalueofmoney conceptapplies
evenifthereiszeroinflationbutinflationobviously
increasesthediscrepancy invaluebetweenmonies received atdifferenttimes.
Taking account ofthetimevalueofmoney (bydiscounting)isoneoftheprincipal advantages of
theDCFappraisal method. Otheradvantages areasfollows.
• Themethod usesallrelevantcashflowsrelating
totheproject.
• Itallows forthetiming ofthecashflows
• There areuniversally
accepted methods ofcalculatingtheNPVandtheIRR.
4.2 Problems with DCF methods
Although DCFmethods aretheoretically
thebestmethodsofinvestment appraisal,
youshould
be
awareoftheirlimitations.
(a) DCFmethods usefuture cashflowsthatmaybedifficulttoforecast.
Althoughothermethods
usetheseaswell,arguably theproblemisgreater
withDCFmethods thattakecashflows
intothelongerterm.
(b) Thebasicdecisionrule,acceptallprojects
witha positive
NPV,willnotapplywhenthecapital
available
forinvestmentisrationed.
(c) ThecostofcapitalusedinDCFcalculations maybedifficult
toestimate.
(d) Thecostofcapitalmaychangeoverthelifeoftheinvestment.
4.3 The use of appraisal methods in practice
Onereasonforthefailure
ofmanybusinesses
touseNPVisthatits(sometimes
long-term)
nature
mayconflict
withjudgements
ona business
thatareconcerned
withits(short-term)
profits.
Managers’
remunerationmaydependonthelevelofannual
profits,
andtheymaythusbe
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unwillingtorisklargeinitial
expenditure
ona project
thatonlyoffersgoodreturnsinthe
significantly
uncertainlongterm.
Inaddition,theNPVmethod isbasedontheassumption thatbusinesses
seektomaximise the
wealth oftheirshareholders. Asdiscussed
previously,
thismayconflict
withtheinterests
ofother
stakeholders.Publicsectororganisations
willbeconcernedwiththesocialopportunity
costs.
Evenwhenwealth maximisation isthekeyobjective,
theremaybefactors thathelpmaximise
wealthbutcannot bequantified forNPVpurposes,forexample investment
ina loss-making
projectforstrategicreasons suchasobtaininganinitial
shareinanimportantmarket.
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Allowing for tax,
working capital and
inflation
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1 Taxation
Illustration3: Depreciationand tax
Acompany isconsidering
whether ornottopurchase anitemofmachinery costing
$40,000
payable
immediately.Itwouldhavea lifeoffouryears,afterwhichitwould besoldfor$5,000.
Themachinery wouldcreateannualcostsavingsof$14,000.
Thecompany paystaxoneyearinarrears atanannual rateof30%andcanclaimtax-allowable
depreciation
ona 25%reducing balance basis.Abalancing allowanceisclaimedinthefinalyear
ofoperation.
Thecompany’s posttaxcostofcapitalis8%.
Required
Should
themachinery
bepurchased?
Solution
Calculations
asfollows.
Workings
1 Taxpaidoncostsavings
Theextrataxpayments
onannual
costsavings
of$14,000
= 0.3×14,000=$4,200
2 Taxsavedontaxallowable
depreciation
Time 1 2 3 4
WDVb/f $40,000 $30,000 $22,500 $16,875
Scrap $5,000
$10,000 $7,500 $5,625 $11,875
G H
TAD (25%of$40,000) (25%of$30,000) (25%of$22,500)

WDVc/f $30,000 $22,500 $16,875 $0
Time 2* 3 4 5
$3,000 $2,250 $1,688 $3,563
Taxsaved (30%of$10,000) (30%of$7,500) (30%of$5,625) (30%of$11,875)
*(1yearafterTADclaimed)
Calculation
ofNPV
0 1 2 3 4 5
$ $ $ $ $ $
Costsavings 14,000 14,000 14,000 14,000
Taxoncostsaving (4,200) (4,200) (4,200) (4,200)
Taxbenefits
from
tax-allowable
depreciation – – 3,000 2,250 1,688 3,563
Machinecosts (40,000) 5,000
After-tax
cashflow (40,000) 14,000 12,800 12,050 16,488 (637)
Discount
factor@
8% 1.000 0.926 0.857 0.794 0.735 0.681
Present
values (40,000) 12,964 10,970 9,568 12,119 (434)
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Thenetpresent
valueis$5,187
andsothepurchase
appears
tobeworthwhile.
Examfocus point
Itispossibletocalculate
a singletaxcashflow(insteadofthetwoshown) bycalculating
the
taxtobepaidonprofits aftertaxandafterdeducting taxallowable
depreciation.However,
thiswillthenrequiretaxallowabledepreciation
tobeaddedbacksinceitisnotinitselfa cash
flow,andstudents oftenforgettodothis.Thisiswhyitisbetter
tosplitthetaxcashflowsinto
theirtwoelements (taxpaidandtaxsaved)atthisstageinyourstudies.
2 Inflation
Anexamquestion mayaskyoutostripinflationoutofa costofcapital(perhaps

because
thereis
onerateofinflationandyouareaskedtodiscountuninflated
cashflows).Youcandeflate
a cost
ofcapitalusingtheFisher
formula provided:
(1+i)=(1+r)(1+h)
Whereh=general rateofinflation
r=realrateofinterest
i =nominal(money)rateofinterest
Illustration4: Deflatinga cost of capital
Acompany’s
money
costofcapitalis11%.
Theexpected
annual
rateofinflation
is5%.
Required
G H
Whatistherealcostofcapital?
 16.6%
 6.0%
 16.0%
 5.7%
Solution
Thecorrectanswer is:5.7%
(1+r)(1+i)=(1+m)
(1+r)(1+0.05)=(1+0.11)
(1+r)(1.05)= (1.11)
(1+r)=1.11/1.05
1+r=1.057
r=1.057– 1=0.057or5.7%
2.1 Further illustration of more than one rate of inflation
Illustration5: Projects
Riceisconsideringa project
whichwouldcost$5,000now.Theannual benefits,
forfouryears,
would bea fixedincome of$2,500a year,plusothersavings
of$500a yearinyear1,risingby
5%eachyearbecause ofinflation.
Runningcostswillbe$1,000inthefirstyearbutwould
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increase
at10%eachyearbecause
ofinflating
labour
costs.Thegeneral
rateofinflation
is
expected
tobe7½%andthecompany’s requirednominal
rateofreturn
is16%.
Required
Istheproject
worthwhile?
Ignore
taxation
Solution
Thecashflowsatinflated
values
areasfollows.
Year Fixedincome Othersavings Running
costs Netcashflow
$ $ $ $
1 2,500 500 1,000 2,000
2 2,500 525 1,100 1,925
3 2,500 551 1,210 1,841
4 2,500 579 1,331 1,748
TheNPVoftheproject
isasfollows.
factor16% PV
$ $
0 (5,000) 1.000 (5,000)
1 2,000 0.862 1,724
2 1,925 0.743 1,430
3 1,841 0.641 1,180
G H
4 1,748 0.552 965

+299
TheNPVispositive
andtheproject
would
therefore
seemtobeworthwhile.
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Project appraisal and
risk
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1 Techniques for managing risk (further discussion)
1.1 Conservative forecasting (certainty-equivalent approach)

Bythismethod, theexpected cashflowsoftheproject areconverted toriskless
equivalent
amounts. Thegreatertheriskofanexpected cashflow,thesmaller thecertainty-equivalent
value
(forreceipts)
orthelargerthecertainty-equivalent
value(forpayments).
Asthecashflowsarereduced tosupposedly certainamounts, theyshould bediscounted ata
risk-free
rate.Thisconceptwillbecoveredindetaillaterinthistext(inChapter11),buttherisk-
freerateiseffectively
thelevelofreturn
thatcanbeobtained fromundertaking norisk.
Because thisapproachreduces theestimatedprojectcashflowstoanultra-safe level(iethecash
flowscouldbenoworse thanthislevel),
thiscanbethought ofasa ‘conservativeapproach’ to
projectappraisal.
Illustration3: Certainty-equivalentapproach
DarkAgesCo,whose
costofcapitalis10%,isconsidering
a project
withthefollowing
expected
cashflows.
factor10% Present
value
$ $
0 (10,000) 1.000 (10,000)
1 7,000 0.909 6,363
2 5,000 0.826 4,130
3 5,000 0.751 3,755
G
NPV=+4,248 H
Theprojectseems
tobeworthwhile.
However,because oftheuncertainty
aboutthefuturecash
receipts,
themanagement
decidestoreduce themto‘certainty-equivalents’
bytakingonly70%,
60%and50%oftheyears1,2 and3 cashflowsrespectively.
Therisk-free
rateis5%.
Required
Onthebasisoftheinformation
setoutabove,
assesswhether
theproject
isworthwhile.
Solution
Therisk-adjusted
NPVoftheproject
isasfollows.
Cashflow: Discount factorat
certainty riskfree
rateofreturn
equivalents 5%Year Present
value
$ $
0 (10,000) 1.000 (10,000)
1 (7,000×0.70) 4,900 0.952 4,665
2 (5,000×0.60) 3,000 0.907 2,721
3 (5,000×0.50) 2,500 0.864 2,160
NPV=(454)
Theproject’s
certainty-equivalent
NPVisnegative.
Thismeans
thattheproject
istooriskyand
should
berejected.
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Thedisadvantageofthe‘certainty-equivalent’
approach
isthattheamount
oftheadjustment
to
eachcashflowisdecided subjectively.
1.2 Simulation
Simulation
willovercomeproblemsofhaving
a verylargenumberofuncertain outcomes,
aswell
asthecorrelation
ofcashflows(aproject
whichissuccessful
initsearlyyearsismorelikelytobe
successful
initslateryears).
Illustration4: Simulationmodel
Thefollowing
probability
estimates
havebeenprepared
fora proposed
project.
Year Probability $
Costofequipment 0 1.00 (40,000)
Revenue
eachyear 1–5 0.15 40,000
0.40 50,000
0.30 55,000
0.15 60,000
Running
costseachyear 1–5 0.10 25,000
0.25 30,000
0.35 35,000
0.30 40,000
G H
Required
Thecostofcapitalis12%.Assess
howa simulation
model
mightbeusedtoassesstheproject’s
NPV.
Solution
Asimulation
model couldbeconstructedbyassigning
a rangeofrandom numberdigitstoeach
possible
valueforeachoftheuncertainvariables.
Therandom numbers
mustexactlymatchtheir
respective
probabilities.
Thisisachieved
byworkingupwards cumulatively
fromthelowest tothe
highest
cashflowvaluesandassigningnumbers thatwillcorrespond
toprobability
groupings,as
follows.
Revenue Running
costs
Random Random
$ Prob numbers $ Prob numbers
40,000 0.15 00– 14 * 25,000 0.10 00– 09
50,000 0.40 15– 54 ** 30,000 0.25 10– 34
55,000 0.30 55– 84 *** 40,000 0.35 35– 69
60,000 0.15 85– 99 40,000 0.30 70– 99
*Probability
is0.15(15%).
Random numbersare15%ofrange00– 99.
**Probability
is0.40(40%).Randomnumbersare40%ofrange00– 99butstarting
at15.
***Probability
is0.30(30%).Randomnumbersare30%ofrange00– 99butstarting
at55.
Forrevenue,
theselectionofa randomnumberintherange00and14hasa probability
of0.15.
Thisprobability
represents
revenue
of$40,000.Numbershavebeenassigned
tocashflowsso
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thatwhennumbers areselected
atrandom, thecashflowshaveexactly thesameprobability
of
beingselectedasisindicated
intheirrespective
probability
distribution
above.
Random numbers would begenerated,forexamplebya computer program, andthesewould
be
usedtoassignvalues toeachoftheuncertainvariables.
Forexample,ifrandom numbers 37,84,20,01,56and89weregenerated, thevalues
assigned
to
thevariables
would beasfollows.
Revenue Costs
Calculation Random
number Value Random
number Value
$ $
1 37 50,000 84 40,000
2 20 50,000 01 25,000
3 56 55,000 89 40,000
Acomputer would calculate
theNPVmanytimes overusingthevalues
established
inthiswaywith
morerandom numbers,andtheresultswouldbeanalysedtoprovide
thefollowing.
(1) Anexpected NPVfortheproject
(2) Astatistical
distribution
pattern
forthepossible
variation
intheNPVaboveorbelow this
average
Thedecisionwhethertogoaheadwiththeprojectwouldthenbemadeonthebasisofexpected
return
andrisk.
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Specific investment
decisions
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1 Lease or buy decisions
1.1 The nature of leasing

Rather
thanbuyinganassetoutright,
usingeither
available
cashresources
orborrowed
funds,a
business
mayleaseanasset.
Leasing:
Acontract
betweena lessor
anda lessee
forhireofa specific
assetbythelessee
KEY froma manufacturer
orvendorofsuchassets.
TERM
1.1.1 Examplesoflessors
• Banks
• Insurance
companies
1.1.2 Typesofassetleased
• Officeequipment
• Computers
• Cars
• Commercialvehicles
• Aircraft
• Ships
• Buildings
1.2 Leases that minimise risk to the lessee
Someleases,oftenshort-termleases,
arerental
agreements between a lessoranda lessee,
that
arestructuredsothatthelessorretains
mostoftherisksofownership,iethelessorisresponsible
G
forservicing
andmaintaining theleasedequipment.
Theriskofownership isalsominimised
for H
thelesseebecauseifthereisa changeintechnologythenthelesseecanexitfromtherental
agreement attheendoftheleasetermandistherefore nottiedintousingassetsthatare
technologically
outofdate.
1.3 Leases that are purely a source of finance
Someleases arelong-term arrangements thattransfer
therisksandrewards ofownership
ofan
assettothelessee.
These areagreements between thelesseeandthelessorformostorallofthe
asset’s
expectedusefullife.Thelesseeisresponsible
fortheupkeep,servicing andmaintenance
oftheasset.
Thiscanbea cheaper source offinance thana bankloanifthelessor buysa largequantity
of
assets(egaircraft)
andobtains bulkpurchase discountsasa result;
someofthesavings from
suchdiscountscanbeshared withthelesseeintheformoflower rentalpayments.
1.4 Sale and leaseback
Saleandleaseback:Whena business
thatownsanassetagreestoselltheassettoa financial
KEY
TERM institution
andlease
itbackontermss pecified
inthesaleandleaseback
agreement.
Thebusiness
retainsuseoftheassetbuthasthefundsfromthesale,whilehaving
topayrent.
Acommon formofsaleandleaseback arrangement
hasinvolvedcommercialproperty.
A
companymightsellitspremises
toa bankorfinance
company (toraisecash)andthenlease
backthepremises
under a long-term
leasing
arrangement.
1.5 Lease or buy decisions
Thedecision
ofwhether
tobuyorleaseanassetismadeoncethedecision
toinvest
intheasset
hasbeenmade.
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Discounted cashflowtechniques areusedtoevaluate theleaseorbuydecision sothattheleast-
costfinancingoption canbechosen.
Thecostofcapitalthatshould beappliedtothecashflowsforthefinancing decisionisthecost
ofborrowing. Assuming thatthelessee
isina taxpayingposition thenthecostofborrowing
should beaftertax.Thiscanbecalculated asthepost-tax costofborrowing. Thiscanbe
calculatedasthepre-tax costofborrowing multiplied
by(1– taxrate).Ifthecompany isnotina
taxpayingpositionoranexamquestion saysthattaxshould beignored, thenthepre-tax costof
borrowing canbeused.Weassume thatiftheorganisationdecidedtopurchase theequipment,it
would financethepurchase byborrowing funds(ratherthanoutofretained funds). Wetherefore
compare thecostofpurchasing withthecashflowsofleasingbyapplying thiscostofborrowing
tothefinancing cashflows.
Thecashflowsofpurchasing donotinclude theinterestrepayments ontheloan,astheseare
dealtwithviathecostofcapital.
Animportant cashflowdifference between leasing
andbuyingisthat:
• Withbuyingtheasset,thecompany receivesthetaxallowances (tax-allowable depreciation).
• Withleasing, thelessorandnotthelessee receives
theseallowances.
Withleasing,theleaserentalisallowablefortaxpurposes, andthereareconsequently savings
in
taxcashflows.
Real life example:An examplewithtaxation

MallenandMullinshasdecided toinstall
a newmilling machine.Themachine costs$20,000and
itwouldhavea useful
lifeoffiveyearswitha trade-invalueof$4,000attheendofthefifthyear.
Adecisionnowhastobetakenonthemethod offinancingtheproject.
(a) Thecompany couldpurchase themachine forcash,usingbankloanfacilities
onwhichthe
current
rateofinterest
is13%before tax.
(b) Thecompany couldleasethemachine under anagreement whichwould entailpaymentof
G $4,800attheendofeachyearforthenextfiveyears. H
Therateoftaxis30%.Ifthemachine ispurchased, thecompany willbeabletoclaima tax

depreciation
allowanceof100%inyear1.Taxispayable witha year’sdelay.
Cashflowsarediscounted attheafter-tax costofborrowing,
whichisat13%×70%=9.1%, say
9%.
Thepresentvalue(PV)ofpurchase costs
Year Item Cashflow Discount
factor PV
$ 9% $
0 Equipmentcost (20,000) 1.000 (20,000)
5 Trade-in
value 4,000 0.650 2,600
2 Taxsavings,
fromallowances
30%×$20,000 6,000 0.842 5,052
6 Balancing
charge
6 30%×$4,000 (1,200) 0.596 (715)
NPVofpurchase (13,063)
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ThePVofleasingcosts
Itisassumed
thattheleasepayments
arefullytaxallowable.
Year LeasepaymentSavings
intax(30%) Discount
factor PV
$ $ 9% $
(4,800)p.a.1–5 3.890 (18,672)
2–6 1,440p.a. 3.569(W) 5,139
NPVofleasing (13,533)
Working
Six-year
cumulative
present
valuefactor9% 4.486
One-year
present
valuefactor9% (0.917)
3.569
Thecheapest option
wouldbetopurchasethemachine.
Analternativemethodofmaking
leaseorbuydecisions
istocarryouta singlefinancing
calculation
withthepayments
foronemethod beingnegative
andthereceiptsbeingpositive,
and
viceversafortheothermethod.
Year 0 1 2 3 4 5 6
$ $ $ $ $ $ $
Savedequipment
cost 20,000
Losttrade-in
value (4,000)
G H
Balancing
charge
fromallowances (6,000) 1,200
Leasepayments (4,800) (4,800) (4,800) (4,800) (4,800)
Taxallowances 1,440 1,440 1,440 1,440 1,440
Netcashflow 20,000 (4,800) (9,360) (3,360) (3,360) (7,360) 2,640
Discount
factor9% 1.000 0.917 0.842 0.772 0.708 0.650 0.596
PV 20,000 (4,402) (7,881) (2,594) (2,379) (4,784) 1,573
NPV (467)
Thenegative
NPVindicates
thattheleaseisunattractive
andthepurchasing
decision
isbetter,
as
thenetsavings
fromnotleasing
outweighthenetcostsofpurchasing.
Examfocus point
Remember thatthedecisions
madebycompanies arenotsolelymadeaccordingtotheresults
ofcalculations
likethese.
Otherfactors
(short-term
cashflowadvantages,
flexibility,
risk)may
besignificant.
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1.6 The position of the lessor
Examfocus point
Sofar,wehavelooked atexamples ofleasing
decisions
fromtheviewpoint
ofthelessee.
You
maybeaskedtoevaluate a leasing
arrangement
fromtheposition
ofthelessor.
Thisisrather
likea mirror
imageofthelessee’s
position.
Thelessor
willreceive
tax-allowable
depreciation
ontheexpenditure,
andtheleasepayments
will
betaxable
income.
Real life example:Lessor’sposition

ContinuingthesamecaseofMallen andMullins,
supposethatthelessor’s
requiredrateofreturn
is12%aftertax.Thelessor
canclaim25%reducingbalance
taxdepreciation.
Thelessor’s
cash
flowswillbeasfollows.
Discount
flow factor12%Cash PV
$ $
Purchase
costs
Year0 (20,000) .000 (20,000)
Year5 trade-in 4,000 0.567 2,268
Taxsavings
(seeworking
below)
Year2 1,500 0.797 ,196
G
Year3 1,125 0.712 801 H
Year4 844 0.636 537

Year5 633 0.567 359
Year6 698 0.507 354
Leasepayments:
years1–5 4,800 3.605 7,304
Taxonleasepayments:
years2–6 (1,440) 3.218 4,634)
NPV (1,815)
Conclusion
Theproposedlevelofleasing
payments
arenotjustifiable
forthelessor
ifitseeks
a required
rate
ofreturn
of12%,sincetheresulting
NPVisnegative.
Working
Timebenefit
Year Depreciation
25% Taxsaved30% receivedBalance
$ $ $
1 Cost 20,000 5,000 1,500 2
2 15,000 3,750 1,125 3
3 11,250 2,813 844 4
4 8,437 2,109 633 5
5 Balancing
allowance
* 2,328 698 6
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*$20,000
– $4,000scrap– totalclaims
inYears
1–4
Activity4: Leaseor buy
Themanagement ofa company hasdecidedtoacquireMachine

Xwhichcosts$63,000andhas
anoperational
lifeoffouryears.Theexpected
scrapvaluewould
bezero.Taxispayable
at30%
onoperating
cashflowsoneyearinarrears.
Tax-allowable
depreciation
isavailable
at25%a year
ona reducing
balancebasis.
Required
Supposethatthecompany hastheopportunityeither
topurchase
themachine ortoleaseitat
anannual rentof$20,000forfouryears,payableattheendofeachyear.Thecompany can
borrowtofinancetheacquisition
ata pre-taxcostofborrowing
of10%.Shouldthecompany
leaseorbuythemachine?
Solution
G H
2 Capital rationing
2.1 Supplementary example on the profitability index
Activity5: Profitabilityindexpractice
Acompany isexperiencing
capitalrationing
inyear0,whenonly$60,000ofinvestment
finance
willbeavailable.
Nocapitalrationing
isexpectedinfuture
periods,
butnoneofthethreeprojects
under consideration
bythecompany canbepostponed. Theexpected
cashflowsofthethree
projects
areasfollows.
Project Year0 Year1 Year2 Year3 Year4
$ $ $ $ $
A (50,000) (20,000) 20,000 40,000 40,000
B (28,000) (50,000) 40,000 40,000 20,000
Required
Thecostofcapitalis10%.Youarerequired
todecidewhichprojects
should
beundertaken
inyear
0,inviewofthecapitalrationing,
giventhatprojects
aredivisible.
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Solution
G H
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G H
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Activity answers
Activity4: Leaseorbuy
Answerasfollows:
Working
Tax-allowable
depreciation
Year $
1 (25%of$63,000) 15,750
2 (75%of$15,750) 11,813
3 (75%of$11,813) 8,859
36,422
4 ($63,000– $36,422) 26,578
Note.75%of$15,750isalso25%(63,000– 15,750).
Thefinancing
decisionwillbeappraised
bydiscounting
therelevant
cashflowsattheafter-tax
costofborrowing,
whichis10%of70%=7%.
(1) Purchase
option
Cash Discount Present
Year Item flow factor7% value
$ $
G
0 Costofmachine (63,000) 1.000 (63,000) H
Taxsavedfromtax-allowable
depreciation
2 30%×$15,750 4,725 0.873 4,125
3 30%×$11,813 3,544 0.816 2,892
4 30%×$8,859 2,658 0.763 2,028
5 30%×$26,578 7,973 0.713 5,685
(48,270)
(2) Leasing
option
Itisassumed
thattheleasepayments
aretaxallowable
infull.
Cash Discount Present
Year flow factor7%Item value
$ $
1–4 Leasecosts (20,000) 3.387 (67,740)
2–5 Taxsavings
onleasecosts(30%) 6,000 3.165 18,990
(48,750)
Thepurchase
option
ischeaper,usinga costofcapitalbasedontheafter-tax
costofborrowing.
Ontheassumption
thatinvestors
would regardborrowingandleasing
asequallyriskyfinance
options,
thepurchase
optionisrecommended.
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Activity5: Profitability index practice
Theratioof the PVof cash inflowsat 10%to outlayinyear 0 (the year of capital rationing)isas
follows:
Project OutlayinYear0 PV NPV Ratio Ranking
$ $ $
A 50,000 55,700 5,700 1.114 3rd
B 28,000 31,290 3,290 1.118 2nd
C 30,000 34,380 4,380 1.146 1st
Working
PresentvalueA
Year Discountfactor 10% Presentvalue
$ $
1 Cash flow (20,000) 0.909 (18,180)
2 Cash flow 20,000 0.826 16,520
3 Cash flow 40,000 0.751 30,040
4 Cash flow 40,000 0.683 27,320
55,700
PresentvalueB
G H
$ $
1 Cash flow (50,000) 0.909 (45,450)
2 Cash flow 40,000 0.826 33,040
3 Cash flow 40,000 0.751 30,040
4 Cash flow 20,000 0.683 13,660
31,290
PresentvalueC
$ $
1 Cash flow (30,000) 0.909 (27,270)
2 Cash flow 30,000 0.826 24,780
3 Cash flow 40,000 0.751 30,040
4 Cash flow 10,000 0.683 6,830
34,380
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Theoptimal
investment
policyisasfollows:
Ranking Project Year0 outlay NPV
$ $
1st C 30,000 4,380
2nd B 28,000 3,290
3rd A(balance) 2,000(*4%of5,700) 228
NPVfromtotalinvestment
=7,898
*4%=(2,000/50,000)
G H
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G H
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Sources of finance
Essential reading
G H
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1 Sources of short-term finance
Short-termfinanceis usuallyneeded forbusinessesto run theirday to day operationsincluding

paymentof wagesto employees,inventoryorderingand supplies.Businesseswithseasonalpeaks
and troughsand those engaged ininternationaltrade are likelyto be heavyusersof short-term
finance.
1.1 Overdrafts
Wherepaymentsfroma currentaccount exceedincometo the account fora temporaryperiod,
the bank may agree to financea deficitbalance on the account by means of an overdraft.
Overdraftsare the mostimportantsourceof short-termfinanceavailableto businesses.Theycan
be arranged relativelyquicklyand offera levelof flexibilitywithregard to the amountborrowed
at any time,whileinterestis onlypaid whenthe account is overdrawn.
Overdrafts
Amount Thebank specifiesan overdraftlimit.Theoverdrawn(negative)balance on
the account cannot exceedthislimit.Thebank usuallydecidesthe limit
withreferenceto the borrower’sknownincome.Overdraftborrowingis
throughthe borrower’snormalbusinessbank account.
Margin Interestcharged at the bank’sadministrativebase rate plusa margin.This
rate is usuallyhigherthan the rate fora short-termbank loan.
Interestis calculateddailyon the amountoverdrawnand is charged to the
borrower’saccount quarterly(ormonthly).Anadditionalfee may be
charged forarranginga large-sizeoverdraftfacility.
Purpose Generallyto covershort-termdeficitsincash flowsfromnormalbusiness
operations.Theborrowermay not wantto retainlarge amountsof cash in
a bank account, earningno interest;thereforesomenegativecash
balances may occur.
G H
Repayment Technicallyrepayableon demand.Ifa bank ends an overdraftfacility

withoutwarning,the borrowercouldface a riskof insolvency.
Security Dependson sizeof facility.Thebank may ask forsecurity(collateral)but
oftendoes not.
Benefits Thecustomerhas flexiblemeans of short-termborrowing;the bank has to
accept fluctuationsinthe amountof lending.
Byprovidingan overdraftfacilityto a customer,the bank is committingitselfto providingan

overdraftto the customerwheneverthe customerwantsit, up to the agreed limit.Thebank will
earn intereston the lending,but onlyto the extentthat the customeruses the facilityand goes
intotheiroverdraft.Ifthe customerdoes not go intotheiroverdraft,the bank cannot charge
interest.
Thebank willgenerallycharge a commitmentfee whena customeris granted an overdraft
facilityor an increaseintheiroverdraftfacility.Thisis a fee forgrantingan overdraftfacilityand
agreeingto providethe customerwithfundsifand wheneverthey need them.
1.1.1 Overdrafts and the operating cycle
Manybusinessesrequiretheirbank to providefinancialassistancefornormaltradingoverthe
operatingcycle.
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Forexample,
suppose
thata business
hasthefollowing
working
capitalposition.
$ $
andtradereceivables 10,000Inventorie
Bankoverdraft 1,000
Trade
payables 3,000
4,000
Working
capital 6,000
Itnowbuysinventory
costing
$2,500forcash,usingitsoverdraft.
Workingcapitalremains
the
same,$6,000,although
thebank’sfinancial
stakehasrisenfrom$1,000to$3,500.
$ $
andtradereceivables 12,500Inventorie
Bankoverdraft 3,500
Trade
payables 3,000
6,500
Working
capital 6,000
Abankoverdraft provides
support fornormaltrading
finance.Inthisexample,
finance
fornormal
tradingrisesfrom$(10,000
- 3,000)= $7,000to$(12,500
- 3,000)= $9,500andthebank’s
contribution
risesfrom$1,000outof$7,000to$3,500outof$9,500.
Afeature ofbanklendingtosupport normaltrading
financeisthattheamount oftheoverdraft
requiredatanytimewilldepend onthecashflowsofthebusiness – thetiming
ofreceipts
and
payments, seasonalvariations
intradepatterns,
andsoon.Thepurpose oftheoverdraft
isto
G H
bridgethegapbetween cashpayments andcashreceipts.

1.1.2 Solidcoreoverdrafts
Whena business customerhasanoverdraft
facility,andtheaccount
isalwaysinoverdraft,
then
ithasa solidcore(orhardcore)overdraft.
Forexample, suppose
thattheaccountofa company
hasthefollowingrecordfortheprevious
year.
Average Debit
balance Range revenue
Quarterto $ $ $ $
31March20X5 40,000debit 70,000debit – 20,000debit 600,000
30June20X5 50,000debit 80,000debit – 25,000debit 500,000
30September
20X5 75,000debit 105,000debit – 50,000debit 700,000
31December
20X5 80,000debit 110,000
debit – 60,000debit 550,000
Thesefiguresshowthattheaccount hasbeenpermanentlyinoverdraft,
andthehardcoreofthe
overdraft
hasbeenrisingsteeply overthecourse
oftheyear.
Ifthehardcoreelement oftheoverdraftappears
tobebecoming a longtermfeature
ofthe
business,
thebankmightwish,afterdiscussionswiththecustomer,toconvert
thehardcoreofthe
overdraft
intoa loan,thusgivingformalrecognition
toitsmorepermanent nature.
Otherwise
annualreductionsinthehardcoreofanoverdraftwould typically
bea requirement
ofthebank.
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1.2 Short-term loans
Atermloanisa loanfora fixedamount fora specifiedperiod,usually froma bank.Theloanmay
havea specificpurpose, suchasthepurchase ofanasset.Itisdrawn infullatthebeginning of
theloanperiod andrepaid ata specifiedtimeorindefined instalments. Term loansareoffered
witha varietyofrepayment schedules.Often,theinterest andcapitalrepayments are
predetermined.
Thebankestablishes a separate loanaccount fortheloan,charging interest totheaccount and
setting
offloanpayments against thebalance ontheaccount.
Themainadvantage oflending ona loanaccount forthebankisthatitmakes monitoring
and
controloftheadvance mucheasier, because theloancashflowsarerecorded ina separate
account.Thebankcanseeimmediately whenthecustomer isfallingbehind withtheir
repayments orstruggling tomakethepayments. Withoverdraft lending, a customer’sdifficulties
mightbeobscured forsometimebythevariety oftransactions ontheircurrent account.
(a) Thecustomer knows whattheywillbeexpected topaybackatregular intervals
andthe
bankcanalsopredict itsfutureincome withmorecertainty (depending onwhether the
interest
rateisfixedorfloating).
(b) Oncetheloanisagreed, thetermoftheloanmustbeadhered to,provided thatthecustomer
doesnotfallbehind withtheirrepayments. Itisnotrepayable ondemand bythebank.
(c) Because thebankwillbecommitting itsfundstoa customer fora number ofyears,itmay
wishtoinsistonbuilding certainwritten safeguards intotheloanagreement, topreventthe
customer frombecoming overextended withtheirborrowing during thecourse oftheloan.A
loancovenant isa condition thattheborrower mustcomply with.Iftheborrower doesnotact
inaccordance withthecovenants, theloancanbeconsidered indefault andthebankcan
demand payment.
1.3 Overdrafts and short-term loans compared
Acustomer mightaskthebankforanoverdraft facilitywhenthebankwould wishtosuggesta
G
loaninstead;alternatively,
a customermightaskfora loanwhenanoverdraft wouldbemore H
appropriate.
(a) Inmostcases,whena customer wantsfinancetohelpwith‘daytoday‘trading andcash
flowneeds,anoverdraftwould betheappropriate methodoffinancing.
Thecustomer should
notbeshortofcashallthetimeandshould expect tobeincreditonsomedays,butinneed
ofanoverdraftonothers.
(b) Whena customer wants toborrow froma bankforonlya shortperiod oftime,evenforthe
purchase ofa major
fixedasset,suchasanitemofplantormachinery, anoverdraft
facility
mightbemoresuitable thana loan,because thecustomer willstoppayinginterest
assoon
astheiraccountgoesintocredit.
1.3.1 Advantagesofanoverdraftovera loan
(a) Thecustomer
onlypaysinterestwhentheyareoverdrawn.
(b) Thebankhastheflexibility
toreview thecustomer’s overdraft
facilityperiodically,
and
perhaps
agreetoadditionalfacilities,
orinsistona reduction
inthefacility.
(c) Anoverdraft
candothesamejobasa loan:a facilitycansimply berenewed everytimeit
comesupforreview.
Bearinmind,however,
thatoverdraftsarenormally repayable
ondemand.
1.3.2 Advantagesofa loanforlonger-term lending
(a) Boththecustomer andthebankknowexactly whattherepayments oftheloanwillbeand
howmuchinterest ispayable,
andwhen. Thismakes planning (budgeting)simpler.
(b) Theinterestrateontheloanbalance islikelytobelower thantheinterest
chargedon
overdrawnbalances. Thecomparative costthereforedepends onthesizeanddurationof
borrowingrequirements.
(c) Thecustomer doesnothavetoworryaboutthebankdeciding toreduce orwithdrawan
overdraft
facilitybefore
theyareina position torepaywhatisowed. There isanelementof
‘security’
or‘peaceofmind’inbeingabletoarrange a loanforanagreed term.
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(d) Loansnormally carrya facilitylettersetting
outtheprecise
termsoftheagreement.
However,a mixofoverdrafts andloansmightbesuggested insomecases.Consider
a casewhere
a businessasksfora loan,perhaps topurchase a shopwithinventory.
Thebankermightwishto
suggesta loantohelpwiththepurchase oftheshop,butthatinventory
oughttobefinancedby
anoverdraftfacility.
Theofferofpartloanpartoverdraft isanoptionthatmightbewellworth
considering.
1.3.3 Calculationofrepayments ona loan
Wecanuseanannuity tabletocalculate
therepaymentsona loan.
Forexample,a $30,000loanistakenoutbya businessata rateof12%overfiveyears.Whatwill
betheannual payment, assumingthatpayments aremadeevery12months andtheloan
provides
forgradualrepayment overthetermoftheloan?
Theannuityfactorfor12%overfiveyearsis3.605.Therefore
$30,000=3.605×annual payment.
Annualpayment =30,000/3.605
=$8,321.78
1.3.4 Thesplitbetweeninterestandcapitalrepayment
Aloanof$100,000
istoberepaidtothebank,overfiveyears,inequalannualyear-end
instalments
madeupofcapitalrepaymentsandinterestat9%p.a.
Theannualpayment=$100,000/3.890
=$25,707
Eachpaymentcanthenbesplitbetweentherepayment ofcapitalandinterest.
Year Balance
b/f Interest
@9% Annual
payment Balance
c/f
$ $ $ $
1 100,000 9,000 (25,707) 83,293
G 2 83,293 7,496 (25,707) 65,082 H
3 65,082 5,857 (25,707) 45,232

4 45,232 4,071 (25,707) 23,596
5 23,596 2,111* (25,707)
*Rounding
difference
1.4 Trade credit
Tradecreditisa major sourceofshort-termfinancefora business.
Current assetssuchasraw
materialsmaybepurchased oncredit,withpayment terms normally varyingfrombetween 30
and90days.Trade credittherefore
representsaninterest-free
short-term
loan.Ina periodofhigh
inflation,
purchasingviatradecreditwillbeveryhelpfulinkeepingcostsdown. However,
itis
important totakeintoaccount thelossofdiscountssuppliersofferforearlypayment.
Unacceptable delaysinpayment willworsena company’s creditratingandadditional
creditmay
become difficult
toobtain.
1.5 Leasing
Rather thanbuyinganassetoutright,usingeither
availablecashresourcesorborrowed funds,a
business mayleaseanasset.Leasing isa popular
source offinance.
Leasing canbedefined asa contractbetweenlessorandlesseeforhireofa specific
asset
selectedfroma manufacturerorvendor ofsuchassetsbythelessee.Thelessorretainsownership
oftheasset.Thelessee haspossessionanduseoftheassetonpayment ofspecifiedrentals
over
a period.Short-term
leasesarea sourceofshort-termfinancefornon-current
assets.
Manylessors arefinancial
intermediaries,
suchasbanksandinsurance companies.Therangeof
assetsleasediswide,including
officeequipmentandcomputers, carsandcommercial vehicles,
aircraft,
shipsandbuildings.
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2 Sources of long-term finance
2.1 Factors influencing choice of debt finance

(a) Availability
Onlylistedcompanies areabletomakea publicissueofloannotes. Witha ‘publicissue’theloan
notesarelistedona stockmarket. Mostinvestors willnotinvest
inloannotesissued bysmall
companies. Smaller companies areonlyabletoobtain significant
amounts ofdebtfinance froma
bank.
(b) Creditrating
Largecompanies mayprefer toissueloannotesiftheyhavea strong creditrating.Creditratings
aregiventoloannoteissues bycreditratingagencies. Thecreditratinggiventoa loannoteissue
affectstheinterestyieldthatinvestorswillrequire.Ifa company’s loannoteswould onlybegiven
a sub-investmentgraderating(‘junkbond’rating), thecompany mayprefer toseekdebtfinance
froma bankloan.
(c) Amount
Loannoteissues areusuallyforlargeamounts. Ifa company wants toborrow onlya small
amount ofmoney, a bankloanwould beappropriate.
(d) Duration
Ifloanfinanceissought tobuya particular assettogenerate revenuesforthebusiness, the
lengthoftheloanshould matchthelength oftimethattheassetwillbegenerating revenues.
(e) Fixedorfloating rate
Expectationsofinterest ratemovements willdetermine whethera company wants toborrow ata
fixedorfloatingrate.Fixed-rate
finance maybemoreexpensive, butthebusiness runstheriskof
adverse upward ratemovements ifitchooses floatingratefinance.Banksmayrefuse tolendata
fixedrateformorethana givenperiod oftime.
G
(f) Securityandcovenants H
Thechoiceoffinance maybedetermined bytheassetsthatthebusiness iswillingorabletooffer

assecurity,andbytherestrictions incovenants thatthelenders wishtoimpose.
2.2 Loan notes
2.2.1 Conventional loannotes
Conventional loannotesarefixed-rate redeemable securities.
Loannoteshavea nominal value,whichisthedebtowedbythecompany, andinterestispaidat
a stated‘coupon‘ onthisamount. Forexample, ifa company issues10%loannotes, thecoupon
willbe10%ofthenominal valueoftheloannotes, sothat$100ofloannoteswillreceive $10
interest
eachyear.Theratequoted isthegrossrate,before tax.
Unlikeshares, debtisoftenissuedatnominal value,iewith$100payable per$100nominal value,
orclosetonominal value.Loannotepricesarequoted per$100nominal valueofloannotes, soa
priceof$98.65means a market priceof$98.65per$100nominal value.
Where thecoupon rateisfixedatthetimeofissue,itwillbesetaccording toprevailingmarket
conditions giventhecreditratingofthecompany issuing
thedebt.Subsequent changes in
market (andcompany) conditionswillcausethemarket valueoftheloannotetofluctuate,
although thecoupon willstayatthefixedpercentage ofthenominal value.
Loannotesissued bylargecompanies aremarketable, butbondmarkets aresmall.Whena
company issuesnewequityshares, thenewshares rankequally withallexisting
equityshares
andcanbebought andsoldinthesamemarket. Incontrast,
eachloannoteissueisdifferent,
withitsowninterest rateandredemption date;themarket fordifferent
loannoteissues bythe
samecompany cannot becombined. Thisiswhyequities maybeextensively tradedona stock
market, butloannotesarenot.
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2.2.2 Deepdiscountloannotes
Deepdiscountloannotes:These
areissuedata pricethatisata largediscount
tothe
KEY nominal
TERM value) value
ofthenotes,andwhichwill
b eredeemableatnominal value(orabove
nominal
whentheyeventuallymature.
Forexample, a company mightissue$1,000,000ofloannotesin20X1,ata priceof$50per$100

nominal value,andredeemableatnominal valueintheyear20X9.Thecoupon rateofinterest
will
beverylowcompared withyieldsonconventionalloannoteswiththesamematurity. Fora
company withspecific
cashflowrequirements,thelowservicingcostsduring
thecurrency ofthe
loannotemaybeanattraction, coupledwitha highcostofredemption atmaturity.
Investors
mightbeattracted bythelargecapitalgainoffered bytheloannotes,whichisthe
differencebetweentheissuepriceandtheredemption value.However, deepdiscountloannotes
willcarrya muchlowerrateofinterestthanothertypesofloannote.Theonlytaxadvantage is
thatthegaingetstaxed(asincome) inonelumponmaturity orsale,notasamounts ofinterest
eachyear.Theborrower can,however,deductnotionalinteresteachyearincomputing profits.
Themainbenefit ofdeepdiscount loannotesfora company isthattheinterest
yieldontheloan
notesislower thanonconventionalloannotes.
However, itwillhavetopaya muchlargeramount
atmaturity thanitborrowedwhentheloannoteswereissued. Deepdiscount
loannotesdefer
muchofthecostofthedebt.
2.2.3 Zero-coupon
loannotes
Zero-coupon
loannotes:Issued
ata discount
totheirredemption
value,butnointerest
ispaid
KEY
TERM onthem.
Zero-coupon loannotesareanextreme formofdeepdiscount bond.Forexample, a company

mayissuezero-coupon discountloannotesat$75.00(per$100nominal value),
paynointerest at
all,butatmaturity (say,fiveyearslater)redeem theloannotesat$100.00. Theinvestorgains
G H
fromthedifference between theissuepriceandtheredemption value($25per$75invested).

There isanimplied interest
rateintheamount ofdiscount atwhichtheloannotesareissued (or
subsequently resoldonthemarket).
(a) Theadvantage forborrowersisthatzero-coupon loannotescanbeusedtoraisecash
immediately, andthereisnocashrepayment untiltheredemptiondate.Thecostof
redemption isknown atthetimeofissue.Theborrower canplantohavefundsavailable to
redeem theloannotesatmaturity.
(b) Theadvantage forlendersisrestricted,unless
therateofdiscount ontheloannotesoffers a
highyield.Theonlywayofobtaining cashfromtheloannotesbefore maturityistosellthem.
Theirmarket valuewilldepend ontheremaining termtomaturity andcurrentmarket
interest
rates.
Thetaxadvantage ofzero-coupon loannotesisthesameasthatofdeepdiscount loannotes(see
above).
Deepdiscount loannotesandzero-coupon loannotesarenotcommon. Companies mustwantto
paylittleornointerest andincurthemaincostatredemption. Investors
musthavereasons for
wanting toinvestintheseloannotes, rather thaninconventionalloannotes.
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3 Stock market listing
3.1 Advantages of a stock market listing

Acompany
canobtain
a stockmarket
listingforitsshares
through
a publicofferora placing.
Accesstoawider Improved
marketability
pooloffinance ofshares
Easier
toseek Whyseeka stock Enhanced
growthby market
listing? public
image
acquisition
Original
owners
selling Original
owners
holding
toobtain
funds realising
holding
forother
projects
3.2 Disadvantages of a stock market listing

Theowners ofa company seekinga stockmarket
listing
musttakethefollowing disadvantages
intoaccount:
(a) Therewillbesignificantly
greaterpublicregulation,
accountabilityandscrutiny.Thelegal
requirementsthecompany faceswillbegreater,andthecompany willalsobesubject
tothe
rulesofthestockexchangeonwhichitsshares arelisted.
(b) Awidercircleofinvestors
withmoreexacting requirementswillholdshares.
(c) Therewillbeadditional
costsinvolvedinmakingshareissues,
including brokerage
G H
commissions andunderwritingfees.
3.3 Methods of obtaining a listing
Anunquoted company thatisbecoming
listed
forthefirsttimecanissueshares
onthestock
market
bymeans of:
• Aninitialpublicoffer(IPO)
• Aplacing
• Anintroduction
3.3.1 Initialpublicoffer
Initialpublicoffer(IPO):Aninvitation
toapplyforshares
ina company
basedoninformation
KEY
TERM contained ina prospectus.
Aninitialpublicoffer(IPO)isa meansofselling theshares ofa company tothepublicatlargefor

thefirsttime.Whencompanies ‘gopublic’forthefirsttime,a largeissuewillprobablytakethe
formofanIPO.Thisisknown asflotation.
Subsequent issuesarelikelytobeplacings orrights
issues,
described later.
AnIPOentails theacquisition byanissuing house (aninvestment bankactingforthecompany)
ofa largeblockofshares ofa company, witha viewtooffering themforsaletothepublicand
investinginstitutions.
Anissuing houseisusuallyaninvestmentbank.Itmayacquire theshareseitherasa direct
allotment fromthecompany orbypurchase fromexisting shareholders.Ineithercase,theissuing
house publishesaninvitationtothepublictoapplyforshares, eitherata fixedpriceorona
tenderbasis.Theissuing houseacceptsresponsibility tothepublicandgivestotheissuethe
support ofitsownstanding.
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InanIPO,thecompany’s shareholders
maytaketheopportunity
tosellsomeoftheirshares.
They
receive
themoney fromthesesharesales.Inaddition,
thecompany
willissuenewsharesinthe
IPOtoraiseequityfinance
forinvestment.
3.3.2 A placing
Aplacingisanarrangement whereby,instead
ofoffering
thesharestothegeneral
public,
the
sponsoringinvestment
bankarrangesformostoftheissuetobebought bya smallnumber
of
investors,
usuallyinstitutional
investors
suchaspensionfundsandinsurance
companies.
3.3.3 ThechoicebetweenanIPOanda placing
Isa company likelytoprefer anIPOofitsshares,ora placing?
(a) Placingsaremuchcheaper. Approachinginstitutional
investors
privately
isa muchcheaper
wayofobtaining finance,andthusplacings areoftenusedforsmaller
issues.
(b) Placingsarelikelytobequicker.
(c) Placingsarelikelytoinvolvelessdisclosure
ofinformation.
(d) However,mostoftheshares willbeplacedwitha relatively
smallnumberof(institutional)
shareholders,whichmeans thatmostoftheshares areunlikely
tobeavailablefortrading
aftertheflotation,andthatinstitutional
shareholders
willhavecontrol
ofthecompany.
(e) Whena company firstcomes tothemarket,theremaybea restriction
ontheproportion of
sharesthatcanbeplaced,ora minimum proportion
thatmustbeofferedtothegeneral
public.
3.3.4 A stockexchangeintroduction
Bythismethodofobtaining a quotation,
nosharesaremadeavailable
tothemarket,neither
existing
nornewlycreatedshares;nevertheless,
thestockmarket
grantsa quotation.
Thiswillonly
happen wheresharesina largeprivatecompanyarealreadywidely
held,sothata market
can
beseentoexist.Acompany mightwantanintroductiontoobtain
greatermarketability
forthe
shares,
a known sharevaluationforinheritance
taxpurposes
andeasieraccessinthefutureto
G
additional
capital. H
3.4 Costs of share issues on the stock market

Companiesmayincurthefollowing costswhenissuing shares.
• Underwriting
costs(seebelow)
• Stockmarketlisting
fee(theinitial
charge)
forthenewsecurities
• Feesoftheissuinghouse (investment
bank),solicitors,
auditors
andpublicrelations
consultants
• Chargesforprintinganddistributing
theprospectus:(theprospectus
isthedocument inwhich
thecompany offersitssharesforsale)
• Advertising
innational newspapers
3.4.1 Underwriting
Acompany abouttoissuenewsecurities inordertoraisefinance
maydecidetohavetheissue
underwritten.Underwritersarefinancialinstitutions
whichagree(inexchangefora fixedfee,
perhaps 2.25%ofthefinance toberaised) tobuyattheissuepriceanysecurities
whicharenot
subscribed forbytheinvesting public.
Underwritersremove theriskofa shareissuebeingundersubscribed,butata costtothe
company issuingtheshares.Itisnotcompulsory tohaveanissueunderwritten.
Ordinary offers
forsale(IPOs)arelikelytobeunderwritten, although
rightsissues
maybeaswell.
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3.5 Pricing shares for a stock market launch
Price
ofsimilar Current
market
quoted
companies conditions
Whatprice
toset?
Desire
forimmediate Future
trading
premium prospects
Companies willbekeentoavoidoverpricing
anissue,whichcouldresultintheissuebeing
undersubscribed,leaving
underwriters
withtheunwelcome taskofhavingtobuyuptheunsold
shares.
Ontheotherhand,iftheissuepriceistoolowthentheissuewillbeoversubscribed and
thecompany would havebeenabletoraisetherequired
capitalbyissuingfewershares.
Thesharepriceofanissueisusuallyadvertised
asbeingbasedona certain P/Eratio,theratioof
thepricetothecompany’s mostrecentearningspersharefigureinitsaudited
accounts.The
issuer’s
P/Eratiocanthenbecompared byinvestorswiththeP/Eratiosofsimilar
quoted
companies.
3.6 Rights issues
Arightsissueprovides a wayofraising newsharecapitalbymeans ofanoffertoexisting
shareholders, invitingthemtosubscribe cashfornewshares inproportion totheirexisting
holdings.
Forexample, a rightsissueona oneforfourbasisat280centspersharewould meanthata
company isinvitingitsexisting
shareholders tosubscribeforonenewshareforeveryfourshares
theyhold,ata priceof280centspernewshare. Arightsissuemaybemadebyanytypeof
company. Theanalysis below,however, appliesprimarily
tolisted
companies.
G H
Themajor advantages ofa rightsissueareasfollows:

(a) Rightsissues arecheaper thanIPOstothegeneral public.Thisispartlybecause no
prospectus isnormally required,partlybecause theadministration issimpler
andpartly
because thecostofunderwriting willbeless.
(b) Rightsissues aremorebeneficial toexistingshareholdersthanissues tothegeneral public.
Newshares areissued ata discount tothecurrentmarket pricetomakethemattractive to
investors.Arightsissuesecures thediscount onthemarket priceforexisting
shareholders,
whomayeither keeptheshares orsellthemiftheywish.
(c) Relative votingrightsareunaffected ifshareholders
alltakeuptheirrights.
(d) Thefinance raisedmaybeusedtoreduce gearinginbookvalueterms byincreasingshare
capitaland/or topayofflong-term debtwhichwillreduce gearing inmarketvalueterms. We
willlookatgearing inmoredetailinChapter 15.
3.6.1 Decidingtheissuepricefora rightsissue
Theofferpriceina rightsissuewillbelowerthanthecurrent marketpriceofexisting
shares.
The
sizeofthediscountwillvaryandwillbelargerfordifficult
issues.
IntheUK,however, theoffer
pricemustbeatorabovethenominal valueoftheshares,soasnottocontravene company law.
Acompany making a rightsissuemustseta pricewhichislowenough tosecuretheacceptance
ofshareholders,
whoarebeingaskedtoprovide extrafunds,butnottoolow,soastoavoid
excessive
dilution
oftheearnings pershare.
Examfocus point
Aquestioncouldaskfordiscussion
oftheeffectofa rightsissue,aswellascalculations,
egof
theeffectonEPS.
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Illustration2: Rightsissue(1)
Seagull
canachieve a profit
aftertaxof20%onthecapitalemployed.
Atpresent
itscapital
structure
isasfollows.
$
200,000ordinary
shares
of$1each 200,000
Retained
earnings 100,000
300,000
Thedirectors
propose
toraiseanadditional
$126,000
froma rightsissue.Thecurrent
market
price
is$1.80.
Required
(1) Calculate
thenumber ofshares
thatmustbeissuediftherightspriceis:$1.60;$1.50;$1.40;
$1.20.
(2) Calculate
thedilution
inearnings
pershareineachcase.
Solution
Theearningsatpresent
are20%of$300,000=$60,000.Thisgivesearnings pershareof30
cents.Theearnings
aftertherightsissuewillbe20%of$426,000= $85,200.
Noofnewshares
($126,000 EPS($85,200totalnoof
Rightsprice rightsprice) shares) Dilution
$ Cents Cents
G
1.60 78,750 30.6 +0.6 H
1.50 84,000 30.0 –

1.40 90,000 29.4 -0.6
1.20 105,000 27.9 -2.1
Notethatata highrightspricetheearnings
pershareareincreased,notdiluted.
Thebreakeven
point(zerodilution)
occurswhentherightspriceisequaltothecapitalemployed
pershare:
$300,000/200,000 =$1.50.
3.6.2 Themarketpriceofsharesaftera rightsissue:thetheoreticalex-rightsprice

Whena rightsissueisannounced, allexistingshareholders
havetherighttosubscribe fornew
shares, andsotherearerightsattached totheexistingshares.
Theshares aretherefore described
asbeing‘cumrights‘(withrightsattached) andaretraded cumrights. Onthefirstdayof
dealings inthenewlyissued shares therightsnolongerexistandtheoldshares arenow‘ex-
rights‘(without
rightsattached).
Aftertheannouncement ofa rightsissue,sharepricesnormallyfall.Theextentandduration of
thefallmaydepend onthenumber ofshareholdersandthesizeoftheirholdings.Thistemporary
fallisduetouncertainty inthemarket abouttheconsequences oftheissue,withrespect tofuture
profits,earnings
anddividends.
Aftertheissuehasactually beenmade,themarket pricepersharewillnormallyfall,because
therearemoreshares inissueandthenewshares wereissuedata discountprice.
Intheory, thenewmarket pricewillbetheconsequence ofanadjustment toallowforthediscount
priceofthenewissue,anda theoretical ex-rights
pricecanbecalculated.
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4 Islamic finance
Thissectiondevelops thediscussion
ofIslamicfinancetoinclude themostcommonly used
financial
arrangements whichoffersuitable
Shariacompliant financial
services.
Forms ofcontract
include:
• Mudaraba – a partnership
contract
• Musharaka – a formofequitywhere a partnership
exists,
andprofitsandlosses areshared
• Murabaha – a formofcreditsale
• Ijara– a formoflease
• Sukuk – similar toa bond
Unlike
conventional bankingwherea division
mayexistbetween thelenderoffundsandtherisks
andactions ofthepartyusingthefunds,Islamic finance
willrequirethatanactiveroleisplayed
intheuseoftheassetbythefundprovider andthatrisksandrewards beshared. Instruments
suchasthoselisted abovehavevariedforms andmaybeapplied carefully
toofferservices
comparable tothoseoffered byconventionalbanks.
4.1 Mudaraba contract
Amudaraba transactionisa partnership
transactioninwhichonlyoneofthepartners (therabal
mal)contributes
capital,andtheother(themudarib) contributes
skillandexpertise.
The
contributor
ofcapitalhasnorighttointerfere
inthedaytodayoperations ofthebusiness.Dueto
thefactthatoneofthepartners isrunning
thebusinessandtheotherissolelyproviding capital,
theinvestor
hastorelyheavily onthemudarib, theirabilitytomanage thebusinessandtheir
honestywhenitcomes toprofitsharepayments.
Mudaraba transactionsareparticularly
suitedtoprivateequityinvestmentsorforclients
depositing
money witha bank.
Investing
Partner Business
Partner
G
(RabalMal) (Mudarib) H
Capital 1.Expertise1.
1.Profit 1.Profit
andLoss andLoss
Project
or
Enterprise
4.1.1 Therolesofandthereturnsreceivedby therabal malandmudaribundera

mudarabacontract
• Capitalinjection
Theinvestorprovidescapitalfortheproject orcompany. Generally, aninvestor willnotprovide
anycapitalunlessa clearlydefinedbusiness planispresented tothem. Inthisstructure,the
investor
provides100%ofthecapital.
• Skillandexpertise
Thebusiness manager’s contributiontothepartnership istheirskillandexpertise inthechosen
industryorarea.
• Profitandloss
Anyprofitswillbeshared between thepartners according totheratiosagreed intheoriginal
contract.Anylossesaresolelyattributable totheinvestor duetothefactthattheyarethesole
providerofallcapitaltotheproject.Intheevent ofa loss,thebusiness manager doesnotreceive
anycompensation (mudarib share)fortheirefforts.Theonlyexception tothisiswhenthe
businessmanager hasbeennegligent, inwhichcasetheybecome liableforthetotalloss.
Theinvestorina mudaraba transaction isonlyliabletotheextent ofthecapitaltheyhave
provided.Asa result,
thebusiness manager cannot commit thebusiness foranysumwhichis
overandabovethecapitalprovided.
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Themudaraba contractcanusually
beterminatedatanytimebyeither ofthepartiesgivinga
reasonablenotice.
Typically,
conditions
governing
termination
areincludedinthecontractsothat
anydamage tothebusinessorproject
iseliminated
intheevent
thattheinvestor
would liketo
taketheirequityoutoftheventure.
Therabalmalhasnorighttointerferewiththeoperations
ofthebusiness,
meaning thissituation
issimilar
toanequityinvestment
ona stockexchange.
4.2 Musharaka partnership contract
Musharaka transactions
aretypically
suitable
forinvestments
inbusiness
ventures
orspecific
business
projects,
andneedtoconsistofatleasttwoparties,
eachofwhichisknownasmusharik.
Itiswidely
usedinequityfinancing.
General
Partner General
Partner
(Musharik) (Musharik)
1.Capital 1.Capital
andExpertiseandExpertise
2.Profit 2.Profit
andLoss andLoss
Project
or
Enterprise
Oncethecontract hasbeenagreed between thepartners,

theprocess canbebroken downinto
thefollowing
twomaincomponents.
(a) Allpartners
bringa shareofthecapitalaswellasexpertise tothebusinessorproject.The
partners
donothavetoprovide equalamounts ofcapitalorequalamounts ofexpertise.
(b) Anyprofits
willbeshared betweenthepartnersaccordingtotheratiosagreed intheoriginal
contract.
Tothecontrary, anylossesthattheproject
mightincuraredistributed tothe
G
partners
strictlyinproportiontocapitalcontributions.
Althoughprofits
canbedistributedin H
anyproportionbymutual consent,itisnotpermissible
tofixa lumpsumprofit foranysingle
partner.
Thistransaction
issimilartoventurecapital,forexample
a management buyout,
where both
partiescontribute
bothcapitalandexpertise. Theventure
capitalistwillwantboard
representation
andtherefore provides
expertiseandtheywillalsowantmanagement toprovide
capitaltodemonstrate theircommitment.
4.3 Murabaha contract
Instruments
withpredictablereturns
aretypically
favoured
bybanksandtheirregulators
since
thereliance
onthird-partyprofit
calculations
iseliminated.
Amurabaha transaction
isa deferred
payment saleoraninstalment
creditsaleandismostly
usedforthepurchase ofgoodsforimmediate delivery
ondeferred
payment terms.
Initsmost
basicform,thistransaction
involves
theseller
andbuyerofa good,ascanbeseenbelow.
1.Deliver
goodstoday
Seller Buyer
2.Pay
forgoods
later
Aspartofthecontract betweenthebuyerandtheseller,
thepriceofthegoods,themark-up,the
deliverydateandpayment dateareagreed.
Thesaleofthegoodsisimmediate, against
future
payment. Thebuyerhasfullknowledgeofthepriceandquality
ofgoodstheybuy.Inaddition,
thebuyerisalsoawareoftheexactamount ofmark-up theypayfortheconvenienceofpaying
later.Inthecontextoftrading,
theadvantagetothebuyeristhattheycanusethegoodsto
generate a profit
intheirbusiness
andsubsequently
usetheprofittorepaytheoriginal
seller.
Theunderlying assetcanvaryandcaninclude rawmaterials
andgoodsforresale.
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Shariaprescribes thatcertainconditions
arerequired fora salescontract(whichinclude
murabaha contracts) toexist.
• Theobjectinthecontract mustactually existandbeowned bytheseller.
• Theobjectisoffered fora priceandbothobjectandpriceareaccepted (thepriceshould be
withinfairmarket range).
• Theobjectmusthavea value.
• Theobjectinquestion anditsexchange maynotbeprohibited bySharia.
• Thebuyerinthecontract hastherighttodemand thattheobjectisofsuitable qualityandis
notdefective.
Abankcanprovide financetoa business ina murabaha transactionasfollows:
• Themanager ofthebusiness identifies
anassetthatthebusiness wants tobuy.
• Thebankagreestobuytheasset,andtoresell ittothebusinessatanagreed (fixed)
price,
higherthantheoriginal purchase priceoftheasset.
• Thebankwillpayfortheassetimmediately butagreestopayment fromthebusiness under a
deferredpayment arrangement (murabaha).
• Thebusiness thereforeobtains theasset‘now’andpaysforitlater.Thisissimilar ineffectto
arranging a bankloantopurchase theasset,butitiscompliant withSharialaw.
4.3.1 Thedifferencesbetweena murabahasaleanda loanofmoney
Murabahaisinmanywayssimilar
initsnaturetoa loan;however,
therearekeycharacteristics
whichmustbepresent
ina murabaha contract
whichdistinguish
it.
• Thegoodsforwhichthefinancing
isbeingarrangedmusteffectively
beowned bythe
financing
company.
• Penalties
should
notbecharged forlatepayment whichwouldprofit
thelender.
(Extensions
arepermissible
butnotforadditional
feesorcharges.)
G
4.4 Ijara contract H
Anijaratransaction
istheIslamic equivalentofa leasewhere oneparty(lessor)
allowsanother
party(lessee)
tousetheirassetagainst thepayment ofa rentalfee.
Noteveryassetissuitable forleasing.
Theassetneedstobetangible, non-perishable,
valuable,
identifiable
andquantifiable.
Withanijarathelessor istheowner oftheassetandincurs allriskassociated
withownership.
Whilethelesseebearstheresponsibilityforwearandtear,day-to-day maintenanceand
damage, thelessor
isresponsible formajor maintenance andinsurance. Duetothefactthatthe
lessee
isusingtheassetona dailybasis,theyareoftenina better position
todetermine
maintenancerequirements andaregenerally appointed bythelessor asanagenttoensure all
maintenanceiscarried out.Inaddition,thelesseeis,insomecases,similarly
appointedasagent
forthelessor
toinsure theasset.
Intheeventofa totallossoftheasset,thelesseeisnolonger obliged topaythefutureperiodic
rentals.
4.5 Islamic bond market – sukuk
Fromtheviewpoint ofIslam,conventionalbondshavetwomajor drawbacksandasa resultare
prohibited.
Firstly,
theypayinterest, andsecondly thereisgenerally
nounderlyingasset.
Unlike
conventional bonds,sukuk arenormally linked
toanunderlying tangible
asset.The
ownershipoftheunderlying assetistransferred totheholderofthesukukcertificates
together
withallownershipbenefitsandrisks. Thisgivessukukcharacteristics
ofbothequityandbonds.
Sukukcurrentlyissued havea shorter termthanconventionalbondsandaretypically threetofive
years.
Thesukuk holderownsa proportional shareoftheunderlyingassetandtheincome thatit
generatesandhasa financial righttotherevenues generatedbytheasset.However,as
mentionedbefore, theholder isalsosubjecttoownership risk,whichmeansthattheyare
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exposed toanyriskandpotential lossesassociated
withtheshareoftheunderlying asset.
Conventional bonds,ontheotherhand,remain partoftheissuer’s financial
liability.
Theposition ofa manager ina sukukisfundamentally different
tothatofa manager ina
company issuingbonds.Whena sukuk manager sellstheassetstoinvestorstoraisecapital,the
management oftheassetsremains themanager’sresponsibility.
Thesukuk manager is
responsibleformanaging theassetsonbehalfofthesukuk holders.Theresult
ofthisrelationship
isthatholderswillhavetherighttodismissthemanager iftheyfeelthatthisisappropriate.
Thisisdifferent
totherelationshipbetweentheholders ofconventional bondsandbondissuers. In
thissituation
theissuingcompany isresponsible
forfulfilling
theterms ofthebond,suchas
payinginterest,butholdersofthebondshavelittlepower toinfluencetheactions
oftheissuing
companies.
4.6 Summary of Islamic finance transactions
Thetablethatfollows
summarises
theIslamic
finance
transactions
already
covered
andhowthey
differfromotherforms
ofbusiness
financing.
Islamic
finance
transaction Similarto Differences
Murabaha Tradecredit/ Thereisa pre-agreed
mark-uptobepaidinrecognition
of
loan theconvenienceofpayinglaterforanassetthatis
transferred
immediately.
There isnointerest
charged.
Musharaka Venture Profits
areshared
according
toa pre-agreed
contract.
There
capital arenodividends
paid.Losses
aresharedaccording
tocapital
contribution.
Mudaraba Equity Profits
aresharedaccording
toa pre-agreed contract.
There
G
arenodividendspaid.Losses
aresolelyattributable
tothe H
providerofcapital.
Ijara Leasing Inijarathelessor
isstilltheowner
oftheassetandincurs
the
riskofownership.Thismeans thatthelessor
willbe
responsibleformajormaintenance andinsurance.
Sukuk Bonds There
isanunderlyingtangibleassetthatthesukuk holder
shares
intheriskandrewards ofownership.Thisgivesthe
sukuk
propertiesofequityfinance
aswellasdebtfinance.
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Dividend policy
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1 Internal sources of finance
1.1 Retained cash

Retainedcashissurplus cashthathasnotbeenneeded foroperatingcosts,interest
payments,
taxliabilities,
assetreplacementorcashdividends.Formanybusinesses, thecashneeded to
financeinvestments willbeavailable
because thecashthebusiness hasmadehavebeenretained
withinthebusiness ratherthanpaidoutasdividends.Weemphasised inChapter 1thatthis
interactionofinvestment,financing
anddividend policyisthemostimportant issuefacingmany
businesses.
Retainedcashbelongs toshareholdersandisclassed asequityfinancing.
Notethata company mayhavesubstantial retained
profitsinitsstatement
offinancial position
butnocashinthebankandtherefore willnotbeabletofinance investmentfromretained cash.
2 Dividend policies
Whendeciding onthedividends topayouttoshareholders, oneofthemainconsiderations ofthe
directors
willbetheamount ofcashtheywishtoretain tomeetfinancing needs.
Aswellasfuture financing requirements, thedecisiononhowmuchofa company’s profits
should
beretained,andhowmuchpaidouttoshareholders, willbeinfluencedby:
(a) Theneedtoremain profitable. Dividends
arepaidoutofprofits, andanunprofitable
company cannot goonindefinitely payingdividends outofretained profits
madeinthepast.
(b) Thelawondistributable profits.Companies legislation
maymakecompanies bound topay
dividends solelyoutofaccumulated netrealisedprofits,
asintheUK.
(c) Thegovernment mayimpose directrestrictionsontheamount ofdividendsthatcompanies
canpay.
(d) Anydividend restraintsthatmightbeimposed byloanagreements andcovenants.Aloan
G
covenant mayrestrict theamount ofdividendsthatthecompany canpay,because thiswill H
provideprotection forthelender.
(e) Theeffectofinflation. Thereisalsotheneedtoretain someprofitwithinthebusinessjustto
maintain itsoperating capability unchanged.
(f) Thecompany’s gearing level.Ifthecompany wantsextrafinance, thesourcesoffundsused
shouldstrike a balance between equityanddebtfinance.
(g) Thecompany’s liquidityposition.Dividends
area cashpayment, anda company musthave
enough cashtopaythedividends itdeclares.
(h) Theneedtorepaydebtinthenearfuture. Thecompany musthaveenough cashtopay
debtsastheyfalldue.
(i) Theeasewithwhichthecompany couldraiseextrafinance fromsources otherthanretained
cash.Smallcompanies whichfindithardtoraisefinance mighthavetorelymoreheavily on
retainedcashthanlargecompanies.
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The cost of capital
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1 Risk and return
Thecostofcapitalhastwoaspects toit.
(a) Thecostoffundsthata company raisesanduses
(b) Thereturnthatinvestorsexpecttobepaidforputting fundsintothecompany
Itistherefore
theminimum returnthata company shouldmakeonitsowninvestments,
toearn
thecashflowsoutofwhichinvestors canbepaidtheirreturn.
Thecostofcapitalcantherefore bemeasured bystudyingthereturns
required
byinvestors.
The
costofcapitalcanthenbeusedtoderive a discount
rateforDCFanalysis andinvestment
appraisal.
Eachformofcapitalhasitsowncost.Forexample, equityhasa costandeachbankloanorbond
issuehasa different
cost.A company mustmakesufficient returns
fromitsinvestments
tosatisfy
therequirementsforreturnofallthedifferentfinance
providers.
1.1 The cost of capital as an opportunity cost of finance
Thecostofcapitalisanopportunity costoffinance,because itistheminimum return
that
investorsrequire.
Iftheydonotgetthisreturn, theywilltransfer someoralloftheirinvestment
somewhere else.Herearetwoexamples.
(a) Ifa bankoffers tolendmoney toa company, theinterestrateitcharges istheyieldthatthe
bankwants toreceive frominvesting
inthecompany, because itcangetjustasgooda return
fromlending themoney tosomeone else.Inotherwords, theinterest rateistheopportunity
costoflending forthebank.
(b) Whenshareholders invest
ina company, thereturns thattheycanexpect mustbesufficient
topersuade themnottosellsomeoralloftheirshares andinvest themoney somewhereelse.
Theyieldontheshares istherefore
theopportunity costtotheshareholders ofnotinvesting
somewhere else.
G
1.2 The cost of capital and risk H
Thecostofcapitalcanbeanalysed
intothreeelements.
Risk-free
rateofreturn
+
Premium
forbusiness
risk+
Premium
forfinancial
risk=
COSTOFCAPITAL
(a) Risk-free rateofreturn
Thisisthereturn whichwould berequiredfromaninvestment ifitwerecompletelyfreefromrisk.
Typically,a risk-freeyieldistheyieldongovernment securities.
(b) Premium forbusiness risk
Thisisanincrease intherequired rateofreturnduetotheexistence ofuncertainty
aboutthe
future andabouta firm’sbusiness prospects.Theactualreturns fromaninvestmentmaynotbe
ashighastheyareexpected tobe.Businessriskwillbehigher forsomefirmsthanforothers,and
sometypesofproject undertaken bya firmmaybemoreriskythanothertypesofproject thatit
undertakes.
(c) Premium forfinancial risk
Thisisanincrease intherequired rateofreturnduetotheexistence ofuncertainty
thecash
available forshareholders duetotheneedtopayinterest ondebtfinance.
Because different companies areindifferent
typesofbusiness (varying business
risk)andhave
differentcapitalstructures (varying financial
risk)thecostofcapitalappliedtoonecompany may
differradicallyfromthecostofcapitalofanother.
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2 Dividend growth model
Shareholderswillnormallyexpectdividends toincrease
yearbyyearandnottoremain constant
inperpetuity.
Thefundamental theory ofsharevaluesstatesthatthemarket priceofa shareis
thepresentvalueofthediscounted future cashflowsofrevenues
fromtheshare,sothemarket
valuegivenanexpected constantannual growth individends
wouldbe:
P0=[d(1+g)/(1
0 +k)]+[d(1+g)
e 0 2/(1+ke)2] +…
where P0isthecurrentmarket price(exdiv)
d0isthecurrentnetdividend
keisthecostofequitycapital
andbothkeandg areexpressed asproportions.
Itisoftenconvenienttoassume a constant expecteddividend
growthrateinperpetuity.
The
formula abovethensimplifies
to:
P0=[d(1+g)/(k-
0 e g)]=[d/(k
1 e- g)]
Rearrangingthis,wegeta formula forthecostofequity:
re=[d(1+g)/(p)
0 0 +g]
3 CAPM
TheCAPMismainly concerned
withhowsystematic
riskismeasured,
andhowsystematic risk
affectsrequired
returns
andshareprices.
Systematic
riskismeasured
usingbetafactors.
Betafactors
Thisisthemeasurement
ofsystematic
riskforthestockmarket
asa whole.
G 0 Thisisthesystematic
riskforrisk-free
investments.
Returns
onrisk-free H
investments
areunaffectedbymarket riskandvariations
inmarketreturns.
Lessthan1 Systematic
riskislower
thanforthemarket
onaverage.
Morethan1 Systematic
riskishigher
thanforthemarket
onaverage.
Thebetafactorreflects thefactthatdifferent marketsectors, andindividualcompanies within

eachmarket sector,areexposed todifferent degrees
ofsystematic risk.Supermarketsare
relatively
unaffected bysystematic risk,forexample,soarelikelytohavea lowbetafactor. On
theotherhand,thebanking andtourism industries
areimpacted toa muchgreater degreeby
systematicrisk.Theywillhavea highbetafactor.

CAPMtheory includes thefollowing propositions.
(a) Investorsinshares requirea return inexcessoftheriskfreerate,tocompensate themfor
systematic risk.
(b) Investorsshould notrequire a premium forunsystematic risk,becausethiscanbediversified
awaybyholding a wideportfolio ofinvestments.Inthis,CAPMbuilds onportfoliotheory.
(c) Because systematic riskvariesbetween companies, investorswillrequire
a higherreturn
from
sharesinthosecompanies where thesystematic riskisbigger.

Thesamepropositions canbeapplied tocapitalinvestments bycompanies.
(a) Companies willwanta return ona project toexceed theriskfreerate,tocompensate them
forsystematic risk.
(b) Unsystematic riskcanbediversified away,andsoa premium forunsystematicriskshould
notberequired.
(c) Companies should wanta biggerreturn onprojectswhere systematicriskisgreater.
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Illustration6: Beta factor
1 Whatdoesbetameasure,
andwhatdobetasof0.5,1and1.5mean?
2 Whatfactors
determine
thelevelofbetawhicha company
mayhave?
Solution
1 Betameasures thesystematicriskofa riskyinvestment,suchasa shareina company. The
totalriskofthesharecanbesubdivided intotwoparts,known assystematic (ormarket)risk
andunsystematic (orunique)risk.Thesystematic riskdepends onthesensitivity
ofthereturn
ofthesharetogeneral economic andmarket factors,
suchasperiods ofboomandrecession.
Thecapitalassetpricingmodel shows howthereturn whichinvestorsexpectfromshares
should depend onlyonsystematic risk,notonunsystematic risk,whichcanbeeliminated by
holding a well-diversified
portfolio.
Betaiscalibratedsuchthattheaverage riskofstockmarket investmentshasa betaof1.Thus
shares withbetasof0.5or1.5would havehalfor1½times theaverage sensitivity
tomarket
variationsrespectively.
Thisisreflectedbyhighervolatility
ofsharepricesforshares witha betaof1.5thanforthose
witha betaof0.5.Forexample, a 10%increase ingeneral
stockmarket priceswould be
expected tobereflectedasa 5%increase fora sharewitha betaof0.5anda 15%increase for
a sharewitha betaof1.5,witha similareffectforpricereductions.
2 Thebetaofa company willbetheweightedaverageofthebetaofitsshares andthebetaof
itsdebt.Thebetaofdebtisverylow,butnotzero,because corporate
debtbearsdefault risk,
whichinturnisdependent onthevolatility
ofthecompany’s cashflows.
G
Factorsdetermining thebetaofa company’s equityshares include: H
• Sensitivityofthecompany’s cashflowstoeconomic factors,

asstatedabove. Forexample,
salesofnewcarsaremoresensitive thansalesofbasicfoodsandnecessities.
• Thecompany’s operating gearing.
Ahighleveloffixedcostsinthecompany’s cost
structure
willcausehighvariations inoperatingprofitcompared withvariations
insales.
• Thecompany’s financialgearing.
Highborrowing andinterestcostswillcausehigh
variations
inequityearnings compared withvariationsinoperating
profit,increasing
the
equitybetaasequityreturns become morevariableinrelation
tothemarket asa whole.
Thiseffectwillbecountered bythelowbetaofdebtwhencomputing theweighted average
betaofthewhole company.
3.1 Dividend growth model and CAPM

Thedividendgrowthmodel andCAPMwillnotnecessarilygivethesamecostofequity,
andin
yourexamyoumayhavetocalculate thecostofequityusingeither,
orboth,models.
WherethisisthecaseitislikelythattheCAPMwillgivea morestableandreliable
answer,
dueto
thedrawbacks ofthedividendgrowth model.
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Capital structure
Essential reading
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1 Practical issues - financial ratios
Exam focus point

Youneed to be able to explainand calculate the levelof financialgearingusingalternative
measures.
Financialgearing measuresthe degree to whichan organisation’sactivitiesare fundedby
borrowedfunds,as opposedto shareholder’sfunds.
Commonlyused measuresof financialgearingare based on the statement of financialposition
valuesof the fixedinterestand equitycapital.Theyinclude:
Formula to learn
Financialgearing=Priorcharge capital/Equitycapital (includingreserves)
or
Financialgearing=Priorcharge capital/Totalcapital employed
Priorcharge capital is capital whichhas a rightto the receiptof interestor of preferreddividends

inprecedenceto any claimon distributableearningson the part of the ordinaryshareholders.On
windingup, the claimsof holdersof priorcharge also rankbeforethose of ordinaryshareholders.
Withthe firstdefinitionabove,a companyis lowgeared ifthe gearingratiois lessthan 100%
(meaningit isfundedlessby priorcharge capital than by equitycapital),highlygeared ifthe
ratiois over100%and neutrallygeared ifit is exactly100%.Withthe seconddefinition,a
companyis neutrallygeared ifthe ratiois 50%,lowgeared belowthat, and highlygeared above
that.
G H
Exam focus point

Ifthe questionspecifiesa gearingformula,forexampleby definingan industryaveragefor
comparison,you mustuse that formula.
Illustration 2: Gearing
Fromthe followingstatementof financialposition,computethe company’sfinancialgearingratio.

$’000
Non-currentassets 12,400
Currentassets 1,000
13,400
Financing
Loannotes 4,700
Bankloans 500
Provisionsforliabilitiesand charges:deferredtaxation 300
Deferredincome 250
Ordinaryshares 1,500
Preferenceshares 500
Sharepremiumaccount 760
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$’000
Revaluation
reserve 1,200
Statement
ofprofit
orloss 2,810
12,520
Current
liabilities
Loans 120
Bankoverdraft 260
Trade
payables 500
13,400
Solution
Priorchargecapital
$’000
Preference
shares 500
Loannotes 4,700
Long-termbankloans 500
Priorchargecapital,ignoring
short-term
debt 5,700
Short-term
loans 120
Overdraft 260
Priorchargecapital,including
short-term
interest-bearing
debt 6,080
G H
Eitherfigure,$6,080,000or$5,700,000, couldbeused.Ifgearing iscalculated

withcapital
employed inthedenominator, andcapitalemployed isnetnon-currentassetsplusnetcurrent
assets,itwould seemmorereasonable toexclude short-term
interest-bearing
debtfromprior
chargecapital. Thisisbecause short-termdebtissetoffagainst
current assetsinarriving
atthe
figurefornetcurrent assets.
Equity= 1,500+760+1,200+2,810=$6,270,000
Thegearing ratiocanbecalculated inanyofthefollowing ways.
(1) Priorchargecapital/Equity ×100%=6,080/6,270 ×100%=97%
(2) Priorchargecapital/Equity pluspriorchargecapital×100%=[6,080/(6,080 +6,270)]×100%
=49.2%
(3) Priorchargecapital/Totalcapitalemployed ×100%=5,700/12,520 ×100%=45.5%
1.1 Gearing ratios based on market values

Analternative
method
ofcalculating
a gearing
ratioisonebasedonmarket
values.
Formulato learn
Financial
gearing= Marketvalueofpriorchargecapital/ (Market
valueofequity+ Market
valueofpriorchargecapital)
Theadvantageofthismethod isthatpotential
investors
ina company
areabletojudgethe
further
debtcapacityofthecompany moreclearlybyreference
tomarket
valuesthantheycould
bylooking
atstatement offinancial
position
values.
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Thedisadvantage ofa gearing
ratiobasedonmarketvaluesisthatitdisregardsthevalueofthe
company’s assets,whichmightbeusedtosecurefurtherloans.Agearingratiobasedon
statementoffinancial
position
valuesarguably
givesa better
indication
ofthesecurityforlenders
offixedinterest
capital.
1.1.1 Changingfinancialgearing
Financial
gearing isanattempt toquantifythedegree ofriskinvolved inholding equitysharesin
a company, bothinterms ofthecompany’s abilitytoremain inbusiness andinterms ofexpected
ordinarydividends fromthecompany.
Themoregeared thecompany is,thegreater theriskthatlittle(ifanything)willbeavailable
to
distribute
bywayofdividend totheordinary shareholders.Interest andpreference dividends
on
debtmustcontinue tobepaidregardless ofthecompany’s profits. Ahighfinancialgearing
therefore
means thecompany ismorevulnerable topoortrading conditions.
Thereisthereforegreater volatilityofamount ofearningsavailable forordinaryshareholders,
and
greatervolatility
individends paidtothoseshareholders where a company ishighlygeared.
That
isthemainfinancial riskwithhighgearing. Youmaydoextremely wellorextremelybadly,without
a particularly
largemovement intheprofitfromoperations ofthecompany.
Gearing ultimately measures thecompany’s abilitytoremain inbusiness. Ahigh-geared
company hasa largeamount ofinterest
topayannually. Ifthoseborrowings are‘secured’
inany
way,thentheholders ofthedebtareperfectly entitled
toforcethecompany torealise
assetsto
paytheirinterestiffundsarenotavailable fromothersources. Clearly,themorehighlygeared a
company, themorelikelythisistooccurifandwhenprofits fall.
Real life example:Gearing

Suppose thattwocompanies
areidenticalineveryrespect
except fortheirgearing.
Bothhave
assetsof$20,000andmakethesameoperating profits
(profit
beforeinterest
andtax:PBIT).The
onlydifference
between
thetwocompanies isthatNon-lever
isall-equity
financedandLever is
G
partlyfinanced
bydebtcapital,asfollows. H
Non-lever Lever
$ $
Assets 20,000 20,000
10%loannotes 0 (10,000)
20,000 10,000
Ordinary
shares
of$1 20,000 10,000
Because Leverhas$10,000 of10%loannotesitmustmakea profitbeforeinterest
ofatleast
$1,000inorder topaytheinterestcharges.Non-lever,
ontheotherhand,doesnothaveany
minimum PBITrequirementbecause ithasnodebtcapital.
Acompany whichislower geared is
consideredlessriskythana highergearedcompany becauseofthegreaterlikelihood
thatitsPBIT
willbehighenough tocoverinterest
chargesandmakea profit
forequityshareholders.
1.1.2 Operational gearing

Financial
risk,aswehaveseen,canbemeasured byfinancial
gearing.Business
riskrefers
tothe
riskofmaking onlylowprofits,
orevenlosses,
duetothenature ofthebusiness
thatthecompany
isinvolved
in.Onewayofmeasuring businessriskisbycalculating
a company’s
operational
gearing.
Formulato learn
Operational
gearing= Contribution/Profit
beforeinterest
andtax(PBIT)
Contribution
issalesminus
variable
costofsales.
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Operationalgearing indicates thedegree towhichanorganisation’s profitsaremadeupof
variable(asopposed tofixed)costs.
Thesignificanceofoperational gearingisasfollows.
(a) Ifcontribution
ishighbutPBITislow,thecompany hasa highproportion offixedcosts,which
areonlyjustcovered bycontribution. Businessrisk,asmeasured byoperational gearing,will
behigh.
(b) IfcontributionisnotmuchbiggerthanPBIT,thecompany hasa lowproportion offixed
costs,whicharefairlyeasilycovered bycontribution. Business
risk,asmeasured by
operationalgearing, willbelow.
Operationalgearing, likefinancialgearing,affectsthevolatility
ofearnings.Ifa company has
highoperationalgearing, a smallpercentage changeinsalesrevenue willhavea muchgreater
percentage changeinoperating profits.
Theproportional sizeofthechangeishigher thanfora
company withlowoperational gearing.
Acompany withbothhighoperational gearing andhighfinancial gearing islikelytohavehighly
volatile
earningsandearnings pershare.
1.2 Interest coverage ratio
Theinterest
coverage(orinterest
cover)ratioisa measure
offinancialriskwhichisdesigned
to
showtherisksintermsofprofit
rather
thaninterms ofcapitalvalues.
Formulato learn
Interest
coverage
ratio=Profit
before
interest
andtax/Interest
Thereciprocal
ofthis,theinterest
toprofit
ratio,isalsosometimesused.Asa general
guide,an
interest
coverageratiooflessthanthreetimesisconsideredlow,indicating
thatprofitability
istoo
lowgiventhegearingofthecompany. Aninterest coverage
ratioofmorethanseven isusually
seenassafe.
G H
1.3 The debt ratio

Anothermeasureoffinancialriskisthedebtratio.
Debtratio=Totaldebts: Totalassets
Debtdoesnotincludelong-term provisions
andliabilities
suchasdeferred
taxation.
Thereisnofirmruleonthemaximum safedebtratiobut,asa general
guide,youmightregard
50%asa safelimittodebt.
Illustration3: Impactof alternativetypes of finance
Asummarised
statement
offinancial
position
ofRufusisasfollows.
$m
Assets
lesscurrent
liabilities 150
Debtcapital (70)
80
Sharecapital(20million
shares
of$1) 20
Reserves 60
80
Thecompany’s
profits
intheyearjustended
areasfollow.
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$m
Profit
fromoperations 21.0
Interest 6.0
Profit
before
tax 15.0
Taxationat30% 4.5
Profit
aftertax(earnings) 10.5
Dividends 6.5
Retained
profits 4.0
Thecompany isnowconsidering aninvestmentof$25m.Thiswilladd$5meachyeartoprofits

beforeinterest
andtax.
Therearetwowaysoffinancing thisinvestment.
Onewould betoborrow $25mata costof8%perannum ininterest.
Theotherwould betoraisethemoney bymeans ofa oneforfourrightsissue.
Whicheverfinancingmethod isused,thecompany willincrease
dividendspersharenextyear
from$0.325to$0.35.
Thecompany doesnotintend toallowitsgearing
level,measured asdebtfinanceasa proportion
ofequitycapitalplusdebtfinance,
toexceed 55%asattheendofanyfinancial year.Inaddition,
thecompany willnotacceptanydilutioninearnings
pershare.
Assume thattherateoftaxationwillremainat30%andthatdebtinterest costswillbe$6mplus
theinterest
costofanynewdebtcapital.
Required
1 Producea profit
forecast
fornextyear,assuming thatthenewproject
isundertaken
andis
G H
financed
(i)bydebtcapitalor(ii)bya rightsissue.Calculate
theearnings
persharenextyear,
witheachfinancingmethod.
2 Calculate
theeffectongearing
asattheendofnextyear,witheachfinancing
method.
3 Explain
whether
either
orbothmethods
offunding
would
beacceptable.
Solution
1 Currentearningspershareare$10.5m/20millionshares= $0.525
Iftheproject
isfinanced
by$25mofdebtat8%,interest chargeswillriseby$2m.Ifthe
project
isfinancedbya oneforfourrightsissue,therewillbe25million
shares
inissue.
Finance
withdebt Finance
withrightsissue
$m $m
Profit
before
interest
andtax(+5.0) 26.00 26.00
Interest 8.00 6.00
18.00 20.00
Taxation
(30%) 5.40 6.00
Profit
aftertax 12.60 14.00
Dividends
($0.35pershare) 7.00 8.75
Retained
profits 5.60 5.25
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Finance
withdebt Finance
withrightsissue
$m $m
Earnings
(profits
aftertax) $12.6m $14.0m
Numberofshares 20million 25million
Earnings
pershare $0.63 $0.56
*Therightsissueraises
$25m,ofwhich$5misrepresented
inthestatement
offinancial
position
bysharecapitalandtheremaining$20mbysharepremium.Thereserves
are
therefore
thecurrent amount
($60m)plusthesharepremium
of$20mplusaccumulated
profits
of$5.25m.
2 Effectongearing
Finance
withdebt Finance
withrightsissue
Debtcapital 95.0 70.0
Debtcapitalplusequityfinance (95.0+85.6) (70.0+110.25)
Gearing 53% 39%
3 Either
financingmethodwouldbeacceptable, sincethecompany’s requirements
forno
dilution
inEPSwould bemetwitha rightsissueaswellasbyborrowing,andthecompany’s
requirementforthegearing
leveltoremain below55%is(just)metevenifthecompanywere
toborrow themoney.
G H
Examfocus point
Achangeinsources
offinance
couldbeexamined
bythepreparation
ofa cashflowforecast
whichwecovered
inChapter4.
2 Capital structure theories
Real life example:Netoperatingincomeapproach

Acompany has$5,000ofdebtat10%interest
andearns$5,000a yearbefore interest
ispaid.
There
are2,250issued
shares,
andtheweightedaveragecostofcapitalofthecompany is20%.
Themarket
valueofthecompany should
beasfollows.
Earnings $5,000
Weighted
average
costofcapital 0.2
$
Market
valueofthecompany
($5,000/ 0.2) 25,000
Lessmarket
valueofdebt 5,000
Market
valueofequity 20,000
Thecostofequityistherefore
(5,000- 500)/20,000= 4,500/20,000=22.5%
andthemarketvaluepershareis[(4,500/2,250)×(1/0.225)]
=$8.89
Supposethatthelevelofgearingisincreasedbyissuing$5,000moreofdebtat10%interestto
repurchase
562shares (ata market valueof$8.89pershare)leaving
1,688shares
inissue.
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Theweighted
average
costofcapitalwill,according
tothenetoperatingincomeapproach,
remain
unchangedat20%.Themarket valueofthecompany should
stilltherefore
be$25,000.
Earnings $5,000
Weighted
average
costofcapital 0.2
$
Market
valueofthecompany 25,000
Lessmarket
valueofdebt 10,000
Market
valueofequity 15,000
Annualdividendswillnowbe$5,000– $1,000interest
=$4,000.
Thecostofequityhasrisento4,000/15,000=26.667% andthemarket valuepershareisstill:
[(4,000/1,688)
×(1/0.2667)]
=$8.89
Theconclusion
ofthenetoperatingincome approach isthatthelevelofgearingisa matter
of
indifference
toaninvestor,becauseitdoesnotaffectthemarket valueofthecompany, norofan
individual
share.Thisisbecauseasthelevelofgearingrises,sodoesthecostofequityinsucha
wayastokeepboththeweighted averagecostofcapitalandthemarket valueoftheshares
constant.
Although,inourexample,thedividend
persharerisesfrom$2to$2.37,theincrease in
thecostofequityissuchthatthemarketvaluepershareremains at$8.89.
2.1 Limitations of pecking order theory

(a) Itfailstotakeintoaccount taxation,
financial
distress,
agencycostsorhowtheinvestment
opportunities thatareavailable
mayinfluencethechoiceoffinance.
(b) Pecking ordertheoryisanexplanationofwhatbusinessesactuallydo,rather
thanwhatthey
G
should do. H
Studiessuggest thatthebusinesses
thataremostlikelytofollowpeckingordertheory arethose
thatareoperating profitably
inmarkets wheregrowthprospects arepoor.Therewillthusbe
limitedopportunitiestoinvestfunds,andthesebusinesses
willbecontenttorelyonretained cash
forthelimited resourcesthattheyneed.
3 Project specific cost of capital
Illustration4: ExtraIllustration
Acompany’s debt:equity
ratio,bymarket values,
is2:5.Thecorporatedebt,whichisassumed to
beriskfree,yields11%
before tax.Thebetavalueofthecompany’s equityiscurrently
1.1.The
average returnsonstockmarket equityare16%.
Thecompany isnowproposing toinvest
ina projectwhichwould involve
diversification
intoa new
industry,andthefollowinginformation
isavailableaboutthisindustry.
(1) Average betacoefficient
ofequitycapital=1.59
(2) Average debt:equity
ratiointheindustry
=1:2(bymarket value)
Required
Therateofcorporation
taxis30%.Whatwould
bea suitable
costofcapitaltoapplytothe
project?
Solution
Thecompany should
notuseitsexisting
WACCasthediscount
ratefortheplannedproject,
becausetheinvestment
willbeina different
industry
ormarket
sector wherethesystematic
riskis
different.
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Insteaditcanusetheaverage systematic riskinthe‘new’industrytodeterminea costofcapital.
Aproblem isthatthebetafactorforlisted companies thatarealready intheindustryisdifferent
tosomeextent because ofthedifferentgearing level.
Togetaround thisproblem, wecalculate a geared betaforthecompany basedontheaverage
geared betasofcompanies alreadyintheindustry, adjusted
toallowforthedifference ingearing.
Thisisessentially a three-step
process.
(1) Convert thegeared betaforthenewindustry intoanungeared beta.
(2) Usetheungeared betatocalculate a geared betathatreflects
thecompany’s owncapital
structure.
(3) Usethisgeared betatocalculateanappropriate costofequityfortheinvestment.Thiscost
ofequityshould beusedtodetermine anappropriate weighted costofcapitaltouseasthe
discount rate.
Thebetavaluefortheindustry is1.59.
Step1 Convert thegeared betavaluefortheindustry toanungeared beta(assetbeta)forthe
industry.
[ Ve [ (VeVd(1−T)
+ Vd(1−T))]]
βa = βe + βd
(Ve+ Vd(1−T))
Ungeared β=
a
[ 2 ]
× 1.59 = 1.18
(2+ 1(1−0.3))
Step2 Convertthisungearedindustry betabackintoa geared
beta,whichreflects
the
company’s owngearing levelof2:5.
[ (5+ 2(1−0.3))
5
]
1.18 = βe
Sogeared
β=
G H
1.18×
(1) [5+
Thisisa2(1−0.3)]
project= 1.51
specific
betaforthefirm’s
equitycapitalandso,usingtheCAPM,-
5
canestimatetheproject
w
specific
e costofequityas:
Step3
K =11% +(16%– 11%) 1.51= 18.55%

eg
(2) Theproject
willpresumably befinanced ina gearing
ratioof2:5debttoequity,
and
sotheproject specific
costofcapitaloughttobe:
[5/7×18.55%]
+[2/7×70%×11%] =15.45%
4 Finance for SMEs

Themainhandicap thatSMEsfaceinaccessing fundsistheproblem ofuncertaintyandriskfor
lenders.
(a) Whateverthedetailsprovided
topotential
investors,SMEshaveneither thebusiness
historynor
thelongertrackrecordthatlargerorganisationspossess.
(b) Larger
enterprises
aresubjectbylawtomorepublicscrutiny: theirfinancial
statementshave
tocontain
moredetailandbeaudited, theyreceive morepresscoverage, andsoon.
(c) Becauseoftheuncertainties
involved,
banksusecreditscoring systems andcontroltheir
exposure
totheSMEbusiness sector.
SMEswillhavetoprovide extensive
information
abouttheirbusiness toa bankwhentheyseek
loanfinance.
Theywillneedtogivea businessplan,a listofthefirm’s
assets,details
ofthe
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experience ofdirectorsandmanagers andshowhowtheyintend toprovide security
forsums
advanced.
Prospectivelenders,usually banks,willthenmakea decisionbasedontheinformation provided.
Theterms oftheloan(interest rate,term,security,
repayment details)
willdepend ontherisk
involved,
andthelender willalsowanttomonitor theirinvestment.
Acommon problem isoftenthatthebankswillbeunwilling toincreaseloanfunding without
an
increaseinsecurity givenintheformofassets(which theowners maybeunwilling orunableto
give),oranincrease inequityfunding (whichmaybedifficulttoobtain).
Afurther problem forSMEsisthematurity gap.Itisparticularly
difficult
forSMEstoobtain
medium-term loansduetoa mismatching ofthematurityofassetsandliabilities.
Longer-term
loansareeasier toobtain thanmedium-term loans,aslongerloanscanbesecured with
mortgages againstproperty.
4.1 Crowdfunding/peer to peer funding
SMEsarefinding itincreasingly
difficult
toobtainfunding inthetraditional
way,iefroma bank.
Atthesametime,investorsarefindingthatbanksareofferingverylowreturnsfortheirmoney.
Thissituation
hasledtothedevelopment ofcrowdfunding.
Crowdfunding isthefundingofa projectbyraising
money froma largenumber ofpeople.
Itis
usuallycarried
outviatheinternetandinvolvestheinitiator,
thepeoplewilling
tosupportthe
projectanda platformtobringthemtogether.Variousplatformsarenowinexistence,
suchas
www.crowdcube.com andwww.seedrs.com.
Real life example:Crowdfunding

Kickstarter,
oneoftheworld’s leading crowdfundingwebsites,haslaunched inbothHongKong
(SAR)andSingapore, itsfirstsitesinAsia.
Thecrowdfunding concept allowspeople topresent
innovations orbusinessideasonlinetoaskfor
G
funding. H
Untilnow,Kickstarter hasoperated inNorthAmerica,

AustraliaandEurope.
Asa result,entrepreneurs inSingapore orHongKonghadtoco-operate withoverseaspartnersif
theywanted theirideasonthewebsite.
WithKickstarter nowlaunching inHongKongandSingapore, people canpresent theirprojects
froma localbaseandwiththeirfundraising goalssetinHongKongorSingapore dollars.
Kickstarterwillhavetocompete withlocalcrowdfundingplatformssuchasSingapore’s
MoolahSense andOurCrowd orHongKong’s FringeBacker.
Crowdfunding sitesoffera platform topresent
a projectorbusinessideaandaskforfinancial
support.
Inordertowinfinancial pledges, theprojectsneedstospellouttheexactfinancial goalandby
whenitaimstoreachit.
Kickstartermakes money bytakinga cutfromtheamount theprojectsreceive.
Prominent examples ofproducts startedonKickstarter
includetheOculus Riftheadset, which
receiveditsfirstfunding viaKickstarterin2012,andthePebble smartwatch. (BBC,2016)
4.2 Government aid for SMEs

Somegovernments
provide
assistance
schemestohelpbusinesses.
Someschemes maybe
designed
toencourage
lenders
andinvestors
tomakefinanceavailable
tosmallandunquoted
businesses.
4.2.1 Loanschemes
Somegovernments
mayprovide
loanschemes
tofacilitate
lending
toviablebusinesses
thathave
beenturned
downfora normal
commercial
loanduetoa lackofsecurity
ora proventrack
record.
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4.2.2 Grants
Agrantisa sumofmoney giventoanindividualorbusinessfora specific
project
orpurpose.
A
grantusuallycovers
onlypartofthetotalcostsinvolved.
Grantstohelpwithbusinessdevelopment areavailable
froma varietyofsources,suchasthe
government,localauthorities
andsomecharitable organisations.
Thesegrantsmaybelinked tobusinessactivity
ora specific
industry
sector.Somegrantsare
linked
tospecific
geographicalareas,egthoseinneedofeconomic regeneration.
G H
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Business valuations
Essential reading
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1 Information for valuing a business
There isa widerangeofinformation thatcanbeusedtovaluea business.

• Financial statements:
statements offinancialposition
andcomprehensiveincome,statements
ofchanges infinancial
positionandstatements ofshareholders’
equity.
• Details ofanyexistingcontracts:eglong-term customercontracts
• Listofshareholders withnumber ofsharesowned byeach(tounderstand thelevelofcontrol
associated withthesharesbeingbought orsold)
• Budgets orprojections,
tobuildanunderstanding offuture
cashflows.
• Information aboutthecompany’s industry
andeconomic environment
(egindustryreports)
• Report totheAccounts givinginformationabouta company’sstructure
andstrategy.
Thislistisnotexhaustive
andtherearelimitations tosomeoftheinformation.Forexample,
statement offinancial
positionvalues ofassetsmaybeoutofdate(egtheymayhavebeen
published uptoa yearinthepast)andunrealistic, projections
maybeunduly optimistic
or
pessimisticandmuchoftheinformation usedinbusinessvaluation
issubjective.
1.1 Market capitalisation
Forquotedcompanies,calculating
themarketcapitalisation
ofitsshares
istherefore
a
straightforward
process.
However,
iftheshares
ofthecompany donothavea liquidsecondarymarket,itsquoted
market
pricemaynotbea fairreflection
ofvalue.Inthesecases,wherea valuation
ofthebusiness
is
required,
othermethods ofvaluation
inaddition
tomarket capitalisation
maybeworth makingto
assesswhether
themarket capitalisation
seemsreasonable.
2 Valuation of debt
G
2.1 Debt calculations – a few notes H
(a) Debtisalwaysquoted in$100nominalunits,orblocks;

alwaysuse$100nominal values
as
thebasistoyourcalculations.
(b) Debtcanbequoted asa percentage orasa value,eg97%or$97.Bothmeanthat$100
nominal valueofdebtisworth $97marketvalue.
(c) Interest
ondebtisstated asa percentageofnominalvalue.Thisisknown asthecouponrate.
Itisnotthesameastheredemption yieldondebtorthecostofdebt.
(d) TheACCAexamining teamsometimes quotesaninterestyield,defined
ascoupon/market
price.
(e) Always useex-interest
pricesinanycalculations.
Real life example:Redeemabledebt

Thevaluation
ofredeemabledebtdependsonfuture
expected
receipts.
Themarket
valueisthe
discounted
presentvalueoffuture
interest
receivable,
uptotheyearofredemption,
plusthe
discounted
presentvalueoftheredemption
payment.
Formulato learn
Valueofdebt= (Interest
earnings
×Annuity
factor)+(Redemption
value×Discounted
cash
flowfactor)
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Illustration2: Valuationof debt (1)
Furryhasinissue12%loannoteswithparvalue$100,000
andredemption
value$110,000,
with
interest
payable quarterly.
Thecostofdebtontheloannotesis8%annually
and2%quarterly.
Theloannotesareredeemableon30June20X4anditisnow31December 20X0.
Required
Calculate
themarket
valueoftheloannotes.
Solution
Youneedtousethecostofdebtasthediscount
rateandremembertouseanannuity
factorfor
theinterest.
Wearediscounting
over14periods
(quarters)
usingthequarterly
discount
rate
(8%/4).
Period Cashflow Discount
factor2% Present
value
$ $
1–14 Interest 3,000 12.11 36,330
14 Redemption 110,000 0.758 83,380
19,710
Themarket
valueis$119,710.
Illustration3: Valuationof debt (2)

G H
Acompany hasissued
some9%loannotes,whicharenowredeemable
atparinthreeyears’time.
Investors
nowrequire
a redemption
yieldof10%.
Required
Whatwillthecurrent
market
valueofeach$100ofloannotebe?
Solution
Marketvalue
factor10% Present
value
$ $
1 Interest 9 0.909 8.18
2 Interest 9 0.826 7.43
3 Interest 9 0.751 6.76
3 Redemption
value 100 0.751 75.10
97.47
Each$100ofloannotewillhavea market
valueof$97.47.
2.2 Convertible debt

Convertible
loannoteswerediscussed
inChapter
9.Asa reminder,
whenconvertibleloannotes
aretraded
ona stockmarket,
itsminimummarket
pricewillbethepriceofstraight
loannotes
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withthesamecoupon rateofinterest.
Ifthemarketvaluefallstothisminimum,itfollowsthatthe
marketattaches
novaluetotheconversionrights.
Theactualmarketpriceofconvertible
loannoteswilldepend on:
• Thepriceofstraight
debt
• Thecurrentconversionvalue
• Thelengthoftimebefore conversion
maytakeplace
• Themarket’sexpectationastofuture
equityreturns
andtheassociated risk
Iftheconversion
valuerisesabovethestraight
debtvaluethenthepriceofconvertible loannotes
willnormally
reflect
thisincrease.
Formulato learn
Conversion value= P0(1+g)n×R
where P0isthecurrentex-dividend
ordinary
shareprice
g istheexpectedannual growthoftheordinary
shareprice
nisthenumber ofyearstoconversion
Risthenumber ofshares received
onconversion
Thecurrentmarketvalueofa convertible
loannotewhere
conversion
isexpectedisthesumofthe
presentvalues
ofthefutureinterest
paymentsandthepresent
valueoftheloannote’s
conversion
value.
Illustration4: Valuationof convertibledebt
Whatisthevalueofa 9%convertible
loannoteifitcanbeconverted
in5 years’timeinto35
G ordinary
shares
orredeemedatparonthesamedate?Aninvestor’s
required
return is10%andthe H
current
market
priceoftheunderlying
shareis$2.50whichisexpected
togrowby4%perannum.
Solution
Conversion
value= P0(1+g)nR=2.50×1.04×35=$106.46
5
Present
valueof$9interest
perannum for5 yearsat10%=9×3.791 = $34.12
Present
valueoftheconversion
value=106.46× 0.621=$66.11
Currentmarket
valueofconvertible
loannote=34.12+ 66.11
= $100.23
3 Market efficiency
3.1 Features of efficient markets

Stockmarkets thatareefficient
(orsemi-efficient)
arethereforemarketsinwhich:
(a) Thepricesofsecurities
bought andsoldreflectalltherelevant
information
available
tothe
buyers andsellers,
andsharepriceschangequickly toreflect
allnewinformation
about
futureprospects.
(b) Noindividualdominatesthemarket.
(c) Transactioncostsofbuyingandsellingarenotsohighastodiscourage trading
significantly.
(d) Investors
arerationalandsomakerational buyingandsellingdecisions,
andvaluesharesin
a rational
way.
(e) There arelow,orno,costsofacquiring
information.
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3.2 Impact of efficiency on share prices
Ifthestockmarket isefficient,
sharepricesshouldvaryina rationalway.
(a) Ifa company makes aninvestment
witha positivenetpresent value(NPV),shareholders
will
gettoknowaboutitandthemarket priceofitsshares
willriseinanticipation
offuture
dividendincreases.
(b) Ifa company makes a badinvestment,shareholders
willfindoutandsothepriceofits
shareswillfall.
(c) Ifinterest
ratesrise,shareholders
willwanta higherreturn fromtheirinvestments,
somarket
priceswillfall.
3.3 Implications of efficient market hypothesis for the financial manager
Ifthemarkets arequitestrongly efficient,themainconsequence forfinancialmanagers willbe
thattheysimply needtoconcentrate onmaximising thenetpresent valueofthecompany’s
investments inorder tomaximise thewealth ofshareholders. Managers neednotworry, for
example, abouttheeffectonsharepricesoffinancial resultsinthepublished accounts because
investors
willmakeallowances forlowprofits ordividends inthecurrent yearifhigher profitsor
dividendsareexpected inthefuture.
Ifthemarket isstrongly efficient,thereislittlepointinfinancial managers attempting strategies
thatwillattempt tomislead themarkets.
(a) There isnopointforexample intryingtoidentify a correctdatewhenshares shouldbe
issued, sincesharepriceswillalwaysreflect thetrueworth ofthecompany.
(b) Themarket willidentify anyattempts towindow dresstheaccounts andputanoptimistic
spinonthefigures.
(c) Themarket willdecidewhatlevelofreturn itrequires fortheriskinvolved inmaking an
investment inthecompany. Itispointless forthecompany totrytochangethemarket’s view
byissuing differenttypesofcapitalinstruments.
G
Similarly,
ifthecompany islooking toexpand, thedirectors willbewasting theirtimeiftheyseek H
astakeover targets companies whose shares areundervalued, sincethemarket willfairlyvalueall

companies’ shares.
Onlyifthemarket issemi-strongly efficient,
andthefinancial managers possess inside
information thatwould significantly alterthepriceofthecompany’s sharesifreleasedtothe
market,couldtheyperhaps gainanadvantage. However, attempts totakeaccount ofthisinside
information maybreach insiderdealing laws.
Thedifferent characteristics ofa semi-strong formanda strong formefficient marketthusaffect
thetiming ofsharepricemovements, incaseswhere therelevant informationbecomes available
tothemarket eventually. Thedifference between thetwoforms ofmarket efficiencyconcerns
whenthesharepriceschange, notbyhowmuchpriceseventually change.
3.4 The fundamental theory of share values
Thisisbasedonthetheory thattherealistic
market priceofa sharecanbederivedfroma
valuation
ofestimatedfuturedividends.
Thevalueofa sharewillbethediscounted presentvalue
ofallfuture
expecteddividendsontheshares, discounted attheshareholders’
costofcapital.
The
theorytherefore
supportstheviewthat‘realistic’
sharepricescanbedetermined byvaluation
models,suchasthedividend growthmodel.
Ifthefundamentalanalysistheoryofsharevaluesiscorrect,thepriceofanysharewillbe
predictable,
provided
thatallinvestors
havethesameinformation abouta company’s expected
futureprofits
anddividends,anda known costofcapital.
3.5 Charting or technical analysis
Chartists
or‘technical
analysts’
attempt topredict
sharepricemovements byassumingthatpast
pricepatterns
willberepeated.
Thereisnorealtheoretical
justification
forthisapproach,
butit
canattimesbespectacularly
successful.
Studies
havesuggested thatthedegreeofsuccess
is
greater
thancouldbeexpectedmerely fromchance.
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Chartistsdonotattempt topredicteverypricechange. Theyareprimarilyinterested
intrend
reversals,
forexamplewhenthepriceofa sharehasbeenrisingforseveral months butsuddenly
startstofall.
Moving averages
helpthechartisttoexamineoveralltrends.Forexample, theymaycalculate and
plotmoving averagesofsharepricesfor20days,60daysand240days.The20dayfigures will
givea reasonablerepresentation
oftheactualmovement insharepricesaftereliminating
dayto
dayfluctuations.
Theothertwomoving averages givea goodideaoflonger-term trends.
Oneofthemainproblems withchartismisthatitisoftendifficulttoseea newtrenduntilafterit
hashappened. Bythetimethechartisthasdetected a signal,otherchartists
willhaveaswell,
andtheresultingmassmovement tobuyorsellwillpushthepricesoastoeliminate any
advantage.
Withtheuseofsophisticatedcomputer programs tosimulatetheworkofa chartist,academic
studies havefoundthattheresultsobtainedwerenobetter orworse thanthoseobtainedfroma
simple ‘buyandhold’strategyofa well-diversified
portfolioofshares.
Thismaybeexplained byresearch thathasfoundthattherearenoregular patternsorcyclesin
sharepricemovements overtime– theyfollowa random walk.
3.6 Random walk theory
Random walktheory isconsistentwiththefundamentaltheory ofsharevalues.Itaccepts thata
shareshouldhaveanintrinsic pricedependent onthefortunesofthecompany andthe
expectations
ofinvestors.Oneofitsunderlying assumptionsisthatallrelevant
information about
a company isavailable toallpotential
investorswhowillactontheinformation ina rational
manner.
Thekeyfeature ofrandom walktheory isthat,although
sharepriceswillhaveanintrinsicor
fundamental value,thisvaluewillbealteredasnewinformation becomes available,
andthatthe
behaviourofinvestorsissuchthattheactualsharepricewillfluctuatefromdaytodayaround
theintrinsic
value.
G H
3.7 Marketability and liquidity of shares

Infinancialmarkets,liquidityistheeaseofdealing intheshares; howeasilytheshares canbe
bought andsoldwithout significantly
moving theprice.
Ingeneral,largecompanies, withhundreds ofmillions
ofshares inissue,andhighnumbers of
shareschanging handseveryday,havegoodliquidity. Incontrast,smallcompanies withfew
sharesinissueandthintrading volumes canhaveverypoorliquidity.
Themarketabilityofshares ina privatecompany, particularly
a minority shareholding,
is
generallyverylimited,a consequence beingthatthepricecanbedifficult todetermine.
Shareswithrestricted marketabilitymaybesubject tosudden andlargefallsinvalueand
companies mayacttoimprove themarketability
oftheirshareswitha stocksplit.A stocksplit
occurswhere, forexample, eachordinary shareof$1eachissplitintotwoshares of50ceach,
thuscreatingcheaper shares withgreatermarketability.There
ispossibly anadded
psychologicaladvantage inthatinvestorsmayexpect a company whichsplitsitssharesinthis
waytobeplanning forsubstantial earnings
growth anddividend growth inthefuture.
Asa consequence, themarket priceofsharesmaybenefit. Forexample, ifoneexistingshareof$1
hasa market valueof$6,andisthensplitintotwoshares of50ceach,themarket valueofthe
newshares mightsettleat,say,$3.10instead oftheexpected $3,inanticipation ofstrong future
growth inearningsanddividends.
3.8 Market imperfections and pricing anomalies
Various
typesofanomaly appeartosupporttheviewsthatirrationality
oftendrives
thestock
market,including
thefollowing.
(a) Seasonalmonth oftheyeareffects,dayoftheweekeffects andalsohourofthedayeffects
seemtooccur,sothatsharepricesmighttendtoriseorfallata particular
timeoftheyear,
weekorday.
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(b) Theremaybea short-run overreaction
torecentevents. Forexample,during thestock
market crashin1987,
themarket wentintofreefall,losing20%ina fewhours.
(c) Individual
sharesorsharesinsmallcompanies maybeneglected. Thereturn frominvestingin
smallercompanies hasbeenshown tobegreater thantheaverage returnfromallcompanies
inthelongrun.Thisincreasedreturnmaycompensate forthegreaterriskassociatedwith
smallercompanies,oritmaybeduetoa startfroma lower basereflectingthattheyare
oftenundervalued.
Thecentralparadox ofefficient
markets
isthatanefficient marketrequirespeople tobelieve
that
themarket isinefficient
sothattheytradesecurities
inanattempt tooutperform themarket.This
sometimes calledthemarket paradox.Anoisetraderisa trader whobuysandsellsirrationally
anderratically;
forexample,overreacting
togoodorbadnews. Noise
traders cancauseprices
andrisklevelstochangefromexpected levels.
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1 Basics
Ifanimporter hastopaya foreign supplier

ina foreigncurrency,theymightasktheirbanktosell
themtherequired amount ofthecurrency, sothattheycanmakethepayment. Forexample,
suppose thata USbank’scustomer, a tradingcompany, hasimported goodsforwhichitmust
nowpay10,000pesos.
(a) Thecompany willaskthebanktosellit10,000pesos. Ifthecompany isbuyingcurrency,
the
bankisselling it.
(b) Whenthebankagreestosell10,000pesostothecompany, itwilltellthecompany whatthe
spotrateofexchange willbeforthetransaction.Ifthebank’ssellingrate(known asthe
‘offer’,or‘ask’price)is,say,1.5135 pesoper$1forthecurrency, thebankwillchargethe
company: 10,000/1.5135 =$6,607.20
Similarly,
ifa USexporter ispaid,say,10,000pesosbya foreign customer, theymaywishto
exchange thepesostoobtain dollars.
Theywillthereforeaskthebanktobuythepesosfrom
them. Sincetheexporter issellingcurrencytothebank,thebankisbuyingthecurrency.
Ifthebankquotes a buyingrate(known asthebidprice)of,say,1.5195 pesosper$1,forthe
currency thebankwillpaytheexporter: 10,000/1.5195
=$6,581.11
Abankexpects tomakea profit fromsellingandbuyingcurrency, anditdoessobyoffering a
rateforselling a currency whichisdifferentfromtherateforbuyingthecurrency.
Illustration4: Sterlingreceipts
Calculate
howmuchexporters wouldreceive
orhowmuchimporterswouldpay,ignoring
the
bank’scommission,ineachofthefollowing
situations.
(a) Anexporter
receivesa paymentfroma Danishcustomer
of150,000kroner.
(b) Animporterbuysgoodsfroma Japanese supplier
andpays1million
yen.
G
Note.Spotratesareasfollows. H
Banksells(offer) Bankbuys(bid)
Danish
Krper$ 9.4340 9.5380
JapanYenper$ 168.650 170.781
Solution
(a) ThebankisbeingaskedtobuytheDanish kroner
andwillgivetheexporter:
150,000/9.5380
=$15,726.57
inexchange
(b) Thebankisbeingaskedtoselltheyentotheimporter
andwillchargeforthecurrency:
1,000,000/168.650
=$5,929.44
1.1 Currency of invoice

Onewayofavoiding exchange riskisforexporters
toinvoice theirforeign customerintheir
domesticcurrency,orforimporters toarrangewiththeirforeign suppliertobeinvoiced intheir
domesticcurrency.However, although eithertheexporterortheimporter canavoidthe
transaction
riskthrough invoicing
indomestic currency,
onlyoneofthemcandoit.Theother
mustdealina foreigncurrency andmustaccepttheexchange risk.Thisistheriskofadverse
movement intheexchange rateuptothedateofsettlement oftheinvoice.
Forexample,ifa UKexporter isabletoquoteandinvoice anoverseas buyerinsterling,thenthe
foreign
exchange riskisineffecttransferredtotheoverseas buyer.
Analternative
method ofachieving thesameresultistonegotiate contractsexpressedinthe
foreign
currency butspecifyinga fixedrateofexchange asa condition ofthecontract.
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Therearecertain advantages ininvoicing
ina foreign
currencywhichmightpersuadeanexporter
totakeontheexchange risk.
(a) Thereisthepossible marketing advantage byproposingtoinvoice
inthebuyer’s
own
currency,whenthereiscompetition forthesalescontract.
(b) Theexporter mayalsobeabletooffsetpayments totheirownsuppliers
ina particular
foreigncurrency againstreceipts
inthatcurrency.
(c) Byarranging tosellgoodstocustomers ina foreign
currency,
anexportermightbeableto
obtaina loaninthatcurrency, andatthesametimeobtain coveragainst
exchangerisksby
arranging torepaytheloanoutoftheproceeds fromthesalesinthatcurrency.
1.2 Matching receipts and payments
Acompany maybeabletoreduce oreliminateitsforeignexchangetransaction
exposureby
matching receipts
andpayments ina foreigncurrency. Whereverpossible,
a company that
expectstomakepayments andhavereceipts inthesameforeign currency
shouldplantooffset
itspayments againstitsreceipts
inthecurrency.
Sincethecompany willbesettingoffforeigncurrency receipts
againstforeign
currency
payments, itdoesnotmatterwhether thecurrency strengthens
orweakens against
the
company’s ‘domestic’
currencybecause therewillbenopurchase orsaleofthecurrency.
Theprocess ofmatching receipts
andpayments ismadepossiblebyhavingoneormoreforeign
currencyaccounts witha bank.Receipts oftheforeign currency
canbepaidintotheaccount,
andpayments madefromtheaccount.
1.3 Leading and lagging
Inordertotakeadvantage offoreignexchange ratemovements, companies mighttrytouse:
• Leadpayments (paymentsinadvance forgoodspurchased ina foreign
currency)
• Laggedpayments (delaying
payments beyond theirduedateforgoodspurchased ina
G
foreign
currency) H
Payments ina foreign

currencymaybemadeinadvance whenthecompany expectstheforeign
currencytoincreaseinvalueuptothesettlement dateforthetransaction.
Witha leadpayment, payinginadvance oftheduedate,thereisa finance costtoconsider.
This
istheinterest
costonthemoney usedtomakethepayment, butearlysettlement
discountsmay
beavailable.
Payments ina foreign
currencymaybedelayed untilaftertheduesettlementdatewhenitis
expectedthatthecurrencywillsoonfallinvalue.However,delayingpayments andtakingmore
thantheagreed amountofcreditisquestionable
business practice.
1.4 Netting
Atitssimplest
thiswillinvolve
netting
theforeign
currency
receipts
fromonedivision
totheforeign
currencypayments duetobemadebyanother. Forexample,
ifonedivision
isduetoreceive
100,000pesoandanother isduetopaythesameamount thennopesosneedtobeconverted
intodollars
becausethereceiptsfromonedivisioncanbeusedtopaythecostsoftheother.
Netting:
Aprocess
inwhichcreditbalances
arenetted
offagainst
debitbalances
sothatonly
KEY
TERM thereduced
net
amountsremaind uetobepaidbyactual
currencyflows.
Nettingreduces
foreign
exchange
purchase
costs,including
commission
andthespread
between
selling
andbuyingrates,andmoney
transmission
costsarereduced.
2 Forward contracts
Forwardexchangecontractsarelegallybinding
contracts.
Theyhedgeagainsttransaction
exposurebyallowingtheimporter
orexportertoarrange
fora banktosellorbuya quantity
of
foreign
currencyata future
date,ata rateofexchangedetermined
whentheforward contractis
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made.Thetrader willknowinadvance eitherhowmuchlocalcurrency theywillreceive(ifthey
areselling foreigncurrency tothebank)orhowmuchlocalcurrency theymustpay(iftheyare
buyingforeign currency fromthebank).
Forward contracts
areverypopular withsmallcompanies asa method ofhedging currency risk
andtakingawayuncertainty abouttheexchange rate.Thecurrentspotpriceisirrelevanttothe
outcome ofa forward contract.
Acompany mayarrange a forward contract
andthensubsequently discoverthatitdoesnotneed
tobuyorsellthecurrency.
(a) Animporter mightfindthat:
(i) Theirsupplier failstodeliverthegoodsasspecified,sotheimporter willnotacceptthe
goodsdelivered andwillnotagreetopayforthem.
(ii) Thesupplier sendsfewergoodsthanexpected, perhapsbecause ofsupplyshortages,
andsotheimporter haslesstopayfor.
(iii) Thesupplier islatewiththedelivery, andsotheimporter doesnothavetopayforthe
goodsuntillaterthanexpected.
(b) Anexporter mightexperience thesametypesofsituation, butinreverse,sothattheydonot
receive anypayment atall,ortheyreceive moreorlessthanoriginallyexpected,orthey
receive theexpected amount, butonlyaftersomedelay.
Ifa customer cannot satisfya forward exchange contract,
thebankwillmakethecustomer fulfil
thecontract.
(c) Ifthecustomer hasarranged forthebanktobuycurrency butthencannot deliverthe
currency forthebanktobuy,thebankwill:
(i) Sellcurrency tothecustomer atthespotrate(when thecontractfallsduefor
performance)
(ii) Buythecurrency back,under thetermsoftheforward exchange contract
(d) Ifthecustomer hascontracted forthebanktosellthemcurrency, thebankwill:
G
(i) Sellthecustomer thespecified amountofcurrency attheforward exchange rate H
(ii) Buybacktheunwanted currency atthespotrate

Thus,thebankarranges forthecustomer toperformtheirpartoftheforward exchange contract
byeither selling
orbuyingthe‘missing’ currency atthespotrate.These arrangements areknown
asclosingouta forward exchange contract.
3 Derivatives
3.1 Currency futures

Currencyfutures
canbeusedtohedgecurrencyriskinthesamewayasforward contracts.
Futuresareexchange-traded
instrumentswhereas
forwardcontracts
areoverthecounter
transactions.
Forwardcontracts
areusedmuchmoreextensively
thancurrencyfutures.
Thefollowing
tablesummarises
thedifferences
between currency
futures
andforwardcontracts.
Currencyfutures Forwardcontracts
Standard
contracts Bespoke
contracts
Exchange
traded Traded
overthecounter
Flexible
closeoutdates Fixeddateofsettlement
Underlyingtransactions
takeplaceatthespot Underlying
transactions
takeplaceatthe
rate;thedifferencebetween
thespotrateand forward
rate
futuresrateissettled
betweentwoparties
Cheaper
thanforwards Relatively
highpremium
required
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Afutures market isanexchange-traded marketforthepurchaseorsaleofa standardquantity of
anunderlying item,suchascurrencies,commoditiesorshares,
forsettlementata future
date
andatanagreed price.
Thecontract sizeisthefixedminimum quantityofcommodity whichcanbebought orsoldusing
a futurescontract.Ingeneral,
dealingonfuturesmarketsmustbeina wholenumber ofcontracts.
Thesettlement date(ordeliverydate,orexpiry
date)isthedatewhentrading ona particular
futurescontractstopsandallaccounts aresettled.
OntheInternational
Monetary Market(IMM),
thesettlementdatesforallcurrencyfuturesareattheendofMarch, June,Septemberand
December.
Afuture’spricemaybedifferent fromthespotprice,andthisdifference
isthebasis.
Basis=Futures price– Spotprice
Onetickisthesmallest measured movement inthecontractprice.Forcurrency
futuresthisisa
movement inthefourth decimalplace.
Market traderswillcomputegainsorlossesontheirfutures
positionsbyreference
tothenumber
ofticksbywhichthecontract pricehasmoved.
Examfocus point
Youwillnotbeexpected
todofutures
calculations
intheexam,butthefollowing
example
will
helpyoutounderstand
howtheywork.
Illustration5: Futurescontract
AUScompany buysgoodsworth €720,000 froma German company payablein30days.TheUS

company wants tohedgeagainstthe€ strengtheningagainstthedollar.
G Currentspotis$0.9215 – $0.9221
per€1andthe€ futures rateis$0.9245per€1. H
Thestandard sizeofa three-month€ futures

contractis€125,000.
In30days’timethespotis$0.9345 – $0.9351per€1.
Closingfuturespricewillbe$0.9367per€1.
Required
Evaluate
thehedge.
Solution
Step1 Setup
(1) Whichcontract?
Weassume thatthethreemonth contract
isthebestavailable.
(2) Typeofcontract
Weneedtobuy€ orsell$.
Asthefutures contractisin€,weneedtobuyfutures.
(3) Number ofcontracts
720,000/125,000 =5.76,say6 contracts
(4) Ticksize
Minimum pricemovement ×contract
size=0.0001×125,000 = $12.50
Step2 Closingfutures price
We’retolditwillbe0.9367.
Step3 Hedgeoutcome
(1) Outcome infuturesmarket
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Opening
futures
price 0.9245 Buyatlowprice
Closingfutures
price 0.9367 Sellathighprice
Movementinticks 122ticks Profit
Futures
profit/loss 122×$12.50× 6 contracts
=$9,150
(2) Netoutcome
$
Spotmarket
payment
(720,000× 0.9351) 673,272
Futures
market
profit (9,150)
664,122
3.2 Currency options

Theexercise
pricefortheoption
maybethesameasthecurrentspotrate,oritmaybemore
favourable
orlessfavourable
totheoption
holder
thanthecurrent
spotrate.
Real life example:Currency options

Currency optionswillbeexercised bytheoptionholder onlyiftheexerciserateintheoption is
morefavourable thanthespotrateattheexercise datefortheoption.
Forexample, a company maybuya currency calloption,givingittherighttobuy€6,000,000 in
2 months’ timeinexchange fordollars
atanexerciserateof€1.5000per$.Buying theeuros at
thisratewould cost$4,000,000.
(a) Ifthespotexchange rateattheexercisedateis€1.60,theoption holderwilllettheoption
lapseandwillbuytheeuros atthespotratefor$3,750,000.
G H
(b) Ifthespotexchange rateattheexercisedateis€1.40,theoption holderwillexercise

the
option andwillbuytheeuros attheexerciserateof€1.50.(Buying atthespotratewould cost
$4,285,714.)
Similarly,
a company maybuya currency putoption, givingittherighttosell€2,800,000 in2
months’ timeinexchange fordollarsatanexerciserateof€1.4000. Theeuros couldbesoldatthis
ratefor$2,000,000.
(a) Ifthespotexchange rateattheexercisedateis€1.35,theoption holderwilllettheoption
lapseandwillselltheeuros atthespotratefor$2,074,074.
(b) Ifthespotexchange rateattheexercisedateis€1.45,theoption holderwillexercise
the
option andwillselltheeuros attheexercise
rateof€1.40.(Sellingatthespotratewould earn
$1,931,034.)
4 Purchasing power parity theory
Thistheory argues thatthechangeintheexchange rateensuresthatthepriceofgoodsinone

country willbeequaltothepriceofthesamegoodsinanother country.
Forexample, ifa basketofgoodscost$100inCountry A.Thecurrent exchangerate(thespot
rate)is1.40pesotothe$.Thesamebasket ofgoodscurrently costs140pesoinCountry B.
Inflation
inCountry A tobe5%,andinCountry B inflation
isforecasttobe2%.
Inoneyears’timethebasket ofgoodswould cost$105inCountry A,and142.8inCountry B.The
exchange ratewould therefore
beforecast
tomove to142.8/ 105=1.36pesotothe$.
Iftheexchange ratehadnotchanged thenitwould becheaper tobuythegoodsinCountry B for
142.8/ 1.40=$102.Theexchange ratetherefore
changes duetomarket forces.
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Interest rate risk
Essential reading
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1 FRA
Illustration1:Forwardrateagreement
Lynnplcisa UKlisted
company. Itis30June.Lynnwillneeda £10m six-monthfixedrateloan
from1October.Lynnwants tohedgeitsexposuretotheriskofa riseinthesix-month interest
rate
betweentheendofJuneand1October, usinganFRA.Therelevant FRArateis6%on30Juneand
thereference
ratefortheFRAisthesix-monthLIBORrate.Thecurrent six-month LIBORrateis
6.25%
Required
1 StatewhatFRAisrequired.
2 Whatistheresult
oftheFRAandtheeffectiveloanrateifthespotsix-month
LIBORrate(the
benchmarkorreference
ratefortheFRA)is:
(a) 5%
(b) 9%
Solution
1 TheFRArequired is‘3 – 9’.Itisfora period beginningafterthreemonths andlasting forsix
months. TheFRAisforLynntoborrow a notionalsumof£10m forsixmonths ata fixedrateof
6%,startingon1October. Lynnhasfixedtheeffective borrowing ratewiththeFRA,even
though itmaynotbeborrowing the£10m fromthebankthathasarranged theFRA.
22 (a) Ifthesix-monthLIBORrateon1October is5%,theLIBORratewillhavefallensince30
June.TheFRAisa binding contract, soLynnmustborrow thenotional
sumof£10m for
sixmonths at6%.Inpractice, thereisnoactuallending.Instead,Lynnmakes a payment
G forthedifferencebetween interest
forsixmonths attheFRArateof6%andthespotrate H
of5%.
Thepayment is£10m ×(6%– 5%)×6/12=£50,000.
Let’ssupposethatLynnisabletoborrow for6 months attheLIBORrate.Itwillborrow
£10m on1October forsixmonths ataninterestrateof5%.Taking thecostoftheactual
loaninterest
withthecostoftheFRApayment, theeffectivecostofborrowing forthe six
months isanannual rateof6%.ThisistherateintheFRA.
£
FRApayment
£10m
×(6%– 5%)× 6/12 (50,000)
Interest
payment
onactualloan5%×£10m
× 6/12 250,000)
Totalcost 300,000)
Effective
annual
interest
rateonloan 6%
(b) Ifthesix-monthLIBORrateon1October is9%,theLIBORratewillhaverisensince30
June.TosettletheFRAcontract, thebankmustpayLynn:£10m ×(9%– 6%)×6/12=
£150,000.
Let’ssupposeagainthatLynnisabletoborrow forsixmonthsattheLIBORrate.Itwill
borrow £10mon1October forsixmonths ataninterest
rateof9%.Takingthecostofthe
actualloaninterest
withtherevenue fromtheFRAcontract,theeffective
costof
borrowingforthesixmonths isanannual rateof6%.ThisistherateintheFRA.
£
FRAreceipt
£10m
×(9%– 6%)× 6/12 150,000
Payment
onactualloanatmarket
rate9%×£10m
× 6/12 (450,000)
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£
Netpayment (300,000)
Effective
interest
rateonloan 6%
NotethattheFRAandloanneednotbewiththesamebank.
2 Interest rate futures

Withinterestratefutureswhatwebuyistheentitlement tointerest receiptsandwhatwesellis
thepromise tomakeinterest payments. Sowhena lender buysonethree-month sterling
contract
(anotherwayofputting thisisthatthelender entersintoa contract tobuy)theyhavetherightto
receive
interestforthreemonths insterling.
Whena borrower sellsa three-monthsterlingcontract
(again,another wayofputting thisisthatthelenderenters intoa contract tosell)theyincuran
obligation
tomakeinterest payments forthreemonths.
(a) Sellinga futurecreatestheobligationtoborrow money andtheobligation topayinterest.
Borrowers willwishtohedgeagainst aninterestraterisebysellingfutures nowandbuying
futuresonthedaythattheinterest rateisfixed.
(b) Buyinga future createstheobligation todepositmoney andtherighttoreceive interest.
Lenders willwishtohedgeagainst thepossibility
offallinginterestratesbybuying
futuresnow andsellingfutures onthedatethattheactuallending starts.
2.1 Other factors to consider
(a) Short-terminterestratefutures contractsnormallyrepresent
interest
receivable
orpayable
onnotionallending orborrowing fora three-monthperiodbeginning
ona standardfuture
date.Thecontract sizedepends onthecurrency inwhichthelendingorborrowingtakes
G place.Forexample, thethree-month sterling
interest
ratefutures
Marchcontract
represents H
theinterest
onnotional lending orborrowing of£500,000forthreemonths,starting
atthe
endofMarch. £500,000isthecontract size.
(b) Aswithallfutures,a wholenumber ofcontractsmustbedealtwith.Notethatthenotional
periodoflendingorborrowing startswhenthecontract expires,
attheendofMarch.
(c) OnLIFFE(London InternationalFinancialFuturesandOptions Exchange),
futures
contracts
areavailablewithmaturity datesattheendofMarch, June,SeptemberandDecember.The
threemonth dollarinterestratefutures contract
isfornotional
lending
orborrowinginUS
dollars.
Thecontract sizeis$1m.
3 Yield curve
3.1 The structure of interest rates

There areseveralreasons whyinterest ratesdifferindifferentmarkets
andmarket segments.
(a) Risk– higher riskborrowers mustpayhigher ratesontheirborrowing,
tocompensate lenders
forthegreater riskinvolved.Forexample, governments canborrowatlower ratesthan
companies, because lending togovernment isgenerallyconsidered
a muchlower risk.
Similarly,
lending toa largelistedcompany islessriskythanlendingtoa smallstart-up
business,andlargecompanies cantherefore borrow ata muchlower cost.
(b) Theneedtomakea profitonre-lending – financialintermediaries
maketheirprofits fromre-
lendingata higher rateofinterestthanthecostoftheirborrowing.
(c) Thesizeoftheloan– deposits abovea certain amount witha bankorbuildingsociety may
attracthigher ratesofinterest thansmaller deposits.
(d) Differenttypesoffinancial asset– different typesoffinancial
assetattractdifferentratesof
interest.
Thisislargelybecause ofthecompetition fordeposits
between different
typesof
financial
institution.
(e) Theduration ofthelending - Thisisdiscussed below.
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3.1.1 The term structure of interest rates
Theterm structure of interestrates refersto the wayinwhichthe yieldon a securityvaries
accordingto the termof the borrowing.Theinterestrate fordifferentmaturitiesof a debt security
can be showngraphicallyina yieldcurve.
(a) Normally,the longerthe termto maturity,the higherthe rate of interest.Thisis shownby the
normalyieldcurveinthe diagrambelow.
(b) Occasionally,interestrates may be higherforshort-termmaturitiesthan longer-term
maturities.Whenthishappens, there is a negativeyieldcurve,whichis also illustratedinthe
diagrambelow.
%rate
ofinterest Normal
yieldcurve
(upward
sloping)
Downward sloping
yieldcurve
0 Termtomaturity
ofsecurity
Thereare severaldifferentreasonswhyinterestrates on a debt securityor loanmay differfor
differentmaturities.
(a) Liquiditypreferencetheory providesa reason why,intheory, the yieldcurveis normally
upwardsloping,so that long-termfinancialassets offera higheryieldthan short-term
G
assets. Liquiditypreferencemeans that investorspreferhavingcash nowto deferringthe use H
of the cash by lendingor investingit. Investorsalso preferhavingcash soonerto havingcash

later. Theythereforewantcompensationinthe formof a higherreturn forbeingunableto
use theircash now.Therequiredreturnincreaseswiththe lengthof timeforwhichthe cash is
unavailable.Becauseof this,long-terminterestrates, such as bond yields,tend to be higher
than short-termyields,and the yieldcurveslopesupward.
(b) Expectationstheory states that interestrates reflectexpectationsof futurechanges in
interestrates. Ifinterestrates are expectedto riseinthe future,the yieldcurvewillslope
upwards.Wheninterestrates are expectedto fall,short-termrates may be higherthan long-
termrates, and the yieldcurvedownwardsloping.Thus,the shape of the yieldcurvegivesan
indicationabout howinterestrates are expectedto moveinthe future.
(c) Themarketsegmentationtheory of interestrates suggeststhat the slopeof the yieldcurve
willreflectconditionsindifferentsegmentsof the market.Thistheoryholdsthat the major
investorsare confinedto a particularsegmentof the marketand willnot switchsegmenteven
ifthe forecastof likelyfutureinterestrates changes.
(d) Governmentpolicyon interestrates may be significanttoo. Agovernmentpolicyof keeping
interestrates relativelyhighmay havethe effect of forcingshort-terminterestrates higher
than long-termrates. Similarly,a governmentmay havea policyof verylowshort-term
interestrates. Inthe US,the eurozoneand the UK,the centralbanksare responsiblefor
managingshort-terminterestrates, throughthe rates at whichthe centralbank lendsto
banks.
3.1.2 The general level of interest rates
Interestrates on any one type of financialasset willvaryovertime.Inotherwords,the general
levelof interestrates mightgo up or down.Thegenerallevelof interestrates is affected by several
factors.
(a) Needfor a real return– investorsnormallywantto earn a ‘real’rate of return on their
investment.Theappropriate‘real’rate of returnwilldepend on such factorsas investment
risk.
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(b) Inflation
– nominal ratesofinterestshould besufficienttocoverexpected ratesofinflation
overthetermoftheinvestment andtoprovide a realreturn.
(c) Uncertainty aboutfuture ratesofinflation– wheninvestors areuncertain aboutinflation
andtherefore aboutwhatfuture nominal andrealinterest rateswillbe,theyarelikelyto
requirehigher interest
yieldstopersuade themtotaketheriskofinvesting, especially
inthe
longerterm.
(d) Liquiditypreferenceofinvestors andthedemand forborrowing – higherinterestrateshave
tobeoffered topersuade saverstoinvest theirsurplusmoney. Whenthedemand toborrow
increases,interest
rateswillrise.
(e) Balance ofpayments – whena country hasa continuing deficitonthecurrent account ofits
balance ofpayments, andtheauthorities areunwillingtoallowtheexchange rateto
depreciate bymorethana certain amount, interest
ratesmayhavetoberaised toattract
capitalintothecountry. Thecountry canthenfinance thedeficit byborrowing fromabroad.
(f) Monetary policy– asexplained above,themonetary policyofa government maybetotryto
controltherateofinflationthrough management ofshort-term interest
rates.Thisisdoneby
thecentral bank,whichcancontrol veryshort-term interestratesthrough theratesatwhich
itlendstobanks. However, although thecentral bankcanacttochangejustshort-term
interest
rates,itmayexpect thatincreases orreductions inshort-term rateswilleventually
workthrough toincreasesorreductions inlonger-term interestrates.
G H
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Further question
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Section A questions (Q1-Q32) – 2 marks each
1 Thefollowing
statements
relate
tovarious
functions
within
a business.
Arethestatements
trueorfalse?
True/False
1. Thefinancial
management
function
makes
decisions
relating
to
finance.
2. Financial
accounts
areusedasa future
planning
tool.
2 Whichofthefollowing
istrue?
 Mostmanagement accountinginformation
isofa monetarynature
 Financial
accountsactasa futureplanningtool
 Financial
management decisions
include
dividenddecisions
 Management accounting
isthemanagement offinance
isNOTa connected
stakeholder?
 Shareholders
 Customers
 Competitors
 Localcommunity
G 4 Thefollowing
statements
relate
tofiscalpolicyanddemand
management. H
Arethestatements
trueorfalse?
True/False
1. Ifa government
spends
morebyborrowing
more,
itwillraise
demand intheeconomy.
2. Agovernment
canreduce
demand
inaneconomy
byraising
taxes.
5 Thefollowing
statements
relate
tobusiness
andtheeconomic
environment.
Arethestatements
trueorfalse?
True/False
1. Tocreatejobsandgrowth,
theremustbeanincrease
in
aggregatedemand.
2. Highinterest
ratesencourage
companies
tomakeinvestments.
6 Thefollowing
statements
relate
tobusiness
andtheeconomic
environment.
Arethestatements
trueorfalse?
True/False
1. Raising
taxesorreducing
government
spending
isa contractionary
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True/False
policy.
2. Fiscalpolicyseeks
toinfluence
theeconomy
bymanaging
government spendingandtaxation.
statementsisNOTcorrect?
 Money markets aremarketsforshort-termcapital
 Money markets areoperatedbybanksandotherfinancial institutions
 Money market instruments
includeinterest-bearing
instruments,
discount
instruments
and
derivatives
 Money market derivatives
includecertificates
ofdepositsandmoney marketdeposits
isNOTa financial
intermediary?
 Commercial bank
 Pensionfund
 Shareholder
 Financehouse
9 WhichTWOofthefollowingarederivatives?
 Treasurybill
 Swap
G
 Forward contract H
 Certificate
ofdeposit
10 Whichoneofthefollowingwould lengthen
theworking
capitalcycle?
 Delaying
payments madetosuppliers
 Reducingrawmaterial inventory
 Increasing
theturnover offinished
goodsinventory
 Increasing
creditgiventocustomers
11 Thefollowing
statements
relate
toovertrading.
Arethestatements
trueorfalse?
True/False
1. Arapidincrease
insalesrevenue
isa signofovertrading.
2. Adecrease
inthevolume
ofcurrent
assetsisa signof
overtrading.
12 Thefollowing
statements
relate
toworking
capital.
Arethestatements
trueorfalse?
True/False
1. Workingcapitalisexcessive
ina company
thatisover-
capitalised.
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True/False
2. Aconservative
approach
toworking
capitalresults
inlargelevels
ofinventory.
13 Acompany isoffering
itscustomers
a choiceofa cashdiscountof2%forpayment
within
10days
oftheinvoice
dateorpayinginfullwithin
40days.
Whatistheeffective
annualinterest
rateofcashdiscount(tothenearest
whole
%)?
%
14 SubCoisa subsidiaryofDubCo.SubCorequires $5millioninfinancetobeeasilyspread

over
thecoming yearwhichDubCowillsupply. Researchshows:
Thereisa standingbankfeeof$250foreachdrawdown.
Theinterestcostofholding
cash(iefinance
costlessdeposit
interest)
is6%p.a.
Howmuchshould SubCodrawdownata time(giveyouranswer tothenearest$’000)?
$
15 Indecision
making,costswhichneedtobeconsidered
arecalledrelevant
costs.
WhichTWOofthefollowingarerelevant
costs?
 Future costs
 Unavoidable costs
 Incrementalcosts
G
 Sunkcosts H
16 Identify
whether
eachofthefollowing
arerelevant
ornon-relevant
costsforinvestment
appraisal
ofa newmachine?
Relevant/ Non-relevant
1. Depreciation
ofthemachine
2. Pastresearch
intodifferent
typesofmachine
3. Annual
maintenance
costsforthemachine
17 Whichofthefollowing is/aretrueofthepayback method ofinvestment

appraisal?
(1) Ittendstomaximise financial
andbusiness risk.
(2) It’sa fairlycomplex
techniqueandnoteasytounderstand.
(3) Itcannot beusedwhenthereisa capitalrationing
situation.
 (1)only
 (2)and(3)only
 Noneofthese
 Allofthese
18 Usinga discount
rateof10%peryear,thenetpresent value(NPV)ofa project
hasbeencorrectly
calculated
as$50.Ifthediscount
rateisincreased
by1%,theNPVoftheproject fallsby$20.
Whatistheinternal
rateofreturn
(IRR)oftheproject
(giveyouranswerto1decimal place)?
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%
19 Thedetailsof an investmentprojectare as follows.

Investment project details
Lifeof the project 0 years
Cost of asset boughtat the start of the project $100,000
Annualcash inflow $20,000
Cost of capital,after tax 8%each year
Corporationtax is 30%and is paid inthe followingyear after the profitshavebeen earned.

Tax-allowabledepreciationof 25%reducingbalance willbe claimedeach year.
(Assumethe asset is boughton the firstday of the tax year and that the company’sotherprojects
generate healthyprofits.)
(Roundallcash flowsto the nearest $ and discountend of year cash flows.)
Required
Whatis the presentvalueof the cash flowsthat occurinthe secondyear of the project(giveyour
answerto the nearest $100)?
$
20 Acompanyhas a cost of capital of 10%.ProjectAhas the followingpresentvalues:

G $ H
Initialinvestment 300,000
Cash inflows 600,000
Cash outflows 100,000
Required
Whatis the sensitivityof ProjectAto changes inthe cash inflows(giveyouranswerto the nearest
wholenumber)?
%
21 RCo is decidingwhetherto launcha newproduct.Theinitialoutlayforthe productis $20,000.

Theforecastpossibleannual cash inflowsand theirassociatedprobabilitiesare shownbelow.
Probability Year1 Year2 Year3
$ $ $
Optimistic 0.20 10,000 12,000 9,000
Mostlikely 0.50 7,000 8,000 7,600
Pessimistic 0.30 6,400 7,200 6,200
Thecompany’scost of capital is 10%per annum.
Assumethe cash inflowsare receivedat the end of the year and that the cash inflowsforeach
year are independent.
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Required
Whatistheexpected
netpresent
valuefortheproduct?
 $(582)
 $582
 $(19,418)
 $19,418
22 TSoperatesa fleetofvehicles
andisconsidering
whethertoreplace
thevehicles
ona 1,2 or3
yearcycle.Eachvehiclecosts$25,000.Theoperating
costspervehicle
foreachyearandthe
resale
valueattheendofeachyearareasfollows:
Year1 Year2 Year3
$ $ $
Operating
costs 5,000 8,000 1,000
Resale
value 18,000 15,000 5,000
Thecostofcapitalis6%perannum.
Youshould assume thattheinitial
investment
isincurred
atthebeginning
ofYear1andthatall
othercashflowsariseattheendoftheyear.
Ignoretheimpactoftaxation.
Required
Whatistheequivalent
netannual
costofreplacing
thevehicles
everytwoyears?
 $23,485
G
 $12,812 H
 $43,048
 $20,095
23 ADCoannounced itsintention
tomakea rightsissueofoneshareat$1.45foreveryfourexisting
shares.
Aftertheannouncement oftheissue,thesharepricefellby40cto$2.20.Thepriceper
sharejustpriortotherightsissueis$2.45exdividend.
Whatisthetheoretical ex-rights
pricepershare(totwodecimal places)?
$
24 Thefollowing
statements
refertoIslamic
financial
instruments.
Arethestatements
trueorfalse?
True/False
1. Sukuk
(debtfinance)
holders
havelittleinfluence
overtheactions
of
theSukukmanager.
2. Under
a Musharaka
contract
(venturecapital),
profits
areshared
between
partners
according
toratiosinthecontract.
3. AnIjaratransaction
istheIslamic
equivalent
ofa lease.
25 Thefollowing
statements
relate
todividend
policy.
Arethestatements
trueorfalse?
514 Financial
Management
(FM)
Page 536 of 641

q
True/False
1. According
toModigliani
andMiller,
ina perfect
capitalmarket,
shareholders
areindifferent
betweendividends
andcapitalgains.
2. Residual
theorystates
thatdividends
should
bepaidaheadof
investing
inpositive
NPVprojects.
26 CTFCohasthefollowing
information
relating
toitsordinary
shares:
Dividend
cover 5
Earnings
pershare $1.50
Published
dividend
yield 3.75%
Required
WhatisthepriceofCTFCo’sordinary
shares
(giveyouranswer
totwodecimal
places)?
$
27 Theequityshares
ofHFCohavea betavalueof0.90.Thisrisk-free
rateofreturn
is6%andthe
marketriskpremium
is7%.Taxis30%.
Whatistheexpectedreturn
onequityforHFCo?
 8.6%
 6.9%
 6.3%
 12.3%
G H
28 Thefollowing
statements
relatetocapitalstructure
theory.
Arethesestatements
trueorfalse?
True/False
1. Thetraditional
viewisthat,intheabsenceoftax,a company’s
capitalstructure
would havenoimpact onitsweighted costofcapital
(WACC).
2. Thenetoperating
income
approach
(MM)assumes
thatdebtisrisk
free.
29 SparrowCohasjustpaidanordinary
dividend
of30cpershare.
Theshares
arenowtradingat
480c.
Ifdividend
growth
isexpected
tobe3%perannum,whatisthecompany’s
costofequityasa %,
tothenearest
wholenumber?
%
30 Thefollowing
statements
relatetothevaluation
ofshares
andmarket
efficiency.
Arethesestatements
trueorfalse?
16:Practice
Questions
515
Page 537 of 641

q
True/False
1. Technical
analysis
isbasedonthetheory
thatsharepricescanbe
derived
fromananalysisoffuture
dividends.
2. Underthestrong formhypothesis
ofmarket
efficiency,
share
pricesreflect
allavailable
information
aboutpastchanges
inthe
shareprice.
31 Thespotrateis3.4670Krone perdollar.TheborrowratesinCountry
A (currency=dollar)
areat
8%andinCountry K (currency=Krone) theyareat13%.
There isnoforwardrateforoneyear’stime.
Whatwould interest
rateparitypredict
theforwardexchangerateperdollartobeinoneyear
(giveyouranswertotwodecimal places)?
Krone
32 Thefollowing
statements
relatetocurrency
risk.
Arethesestatements
trueorfalse?
True/False
1. Transaction
riskistheriskthattheorganisation
willmakeexchange
losseswhentheaccounting results
ofitsforeign
branchesareshownin
thehome currency.
2. Economic
riskistheeffectonthepresent
valueoflonger-term
cash
G
flows. H
516 Financial
Management
(FM)
Page 538 of 641

q
Section B questions (2 marks each)
3333
Thefollowing scenario
relates
toquestionsa– e
Acompany isconsideringtwocapitalexpenditure
proposals.
Bothproposals
areforsimilar
productsandbothareexpected tooperateforfouryears.Onlyoneproposal
canbeaccepted.
Thefollowinginformation
isavailable:
Profit/(loss)
Proposal
A ProposalB
$ $
Initial
investment 46,000 46,000
Year1 6,500 4,500
Year2 3,500 2,500
Year3 3,500 4,500
Year4 (1,500) 14,500
Estimated
scrapvalueattheendofYear4 4,000 4,000
Depreciation
ischarged
onthestraight
linebasis.
Required
(a) Whatistheannual
cashflowforYear4 forProposal
A?
 $2,500
 $14,000
 $13,000
G H
 $9,000
(b) Whatisthepaybackperiod
forProposalB(inyears,toonedecimal
place)?
years
(c) Whatisthereturn
oncapitalemployed
onaverage
investment
forProposal
A(tothenearest
whole
%)?
%
(d) WhichTWOofthefollowing aretrueoftheuseofpayback period?
 Itisa measureusedbyexternal analysts
 Itreducesuncertainty
 Itlooksattheentire
project
life
 Itmayleadtoexcessiveinvestmentinshort-term
projects
(e) Arethefollowing
statements
aboutROCEtrueorfalse?
True/False
(1)Itcanbeusedtocompare
twoinvestment
options.
(2) Ittakesaccount
ofthelength
ofa project.
(3) Itignores
thetimevalueofmoney.
(4) Itissubject
tothecompany’s
accounting
treatment.
16:Practice
Questions
517
Page 539 of 641

q
3434
Thefollowing
scenario
relates
toquestions
a– e
Florrie
Cocurrently
hasthefollowing
long-term
capitalstructure:
$m $m
Equityfinance 75
Ordinary
shares 96
Reserves 171
Non-current
liabilities
Bankloans 37.5
7%convertible
loannotes 40.0
5%redeemable
preference
shares 37.5
115
Totalequityandliabilities 286
The7%loannotesareconvertibleinto10ordinarysharesperloannoteinsixyears’time.Ifnot
converted,
theloannotescanberedeemed onthesamefuture dateattheirnominal valueof
$100.Florrie
Cohasa costofdebtof8%peryear.
TheordinarysharesofFlorrie
Cohavea nominal valueof$1pershare.Thecurrentexdividend
sharepriceofthecompany is$11.20pershareandsharepricesareexpected togrowby5%per
yearfortheforeseeable
future.TheequitybetaofFlorrie
Cois0.98.Therisk-free
rateis4%.
Required
(a) Whatarethecheapestandmostexpensive sources
offinance?
G H
 Cheapest:Debtwitha fixedcharge,
Mostexpensive:
Ordinaryshares
 Cheapest:Debtwitha floating
charge,
Mostexpensive:Ordinary
shares
 Cheapest:Debtwitha fixedcharge,
Mostexpensive:
Preference
shares
 Cheapest:Debtwitha floating
charge,
Mostexpensive:Preference
shares
(b) Whatistheconversion
valueofa 7%loannoteofFlorrie
Coaftersixyears(to2 decimal
places)?
$
(c) Assumingthattheconversion
valueaftersixyearsis$192.36,
whatisthecurrent
market
valueofa 7%loannoteofFlorrie
Co(to2 decimalplaces)?
$
(d) Whichofthefollowingstatementsrelatingtothecapitalassetpricingmodel
iscorrect?
 TheequitybetaofFlorrie Coreflects
systematicandfinancial risk
 ThedebtbetaofFlorrie Coiszero
 Itisassumed thatsystematicriskcanbediversified
away
 SystematicriskforFlorrie
Coishigher thanforthemarket onaverage
(e) WhichTWOofthefollowing statementsrelating
totheweighted average
costofcapital
(WACC)aretrue?
 IfWACCisunderestimated, projects
maybeaccepted thatdonotdeliver
a positive
NPV
 Bookvalues shouldalwaysbeusedifthedataisavailable
 WACCassumes thelong-termgearing ofthecompany willchange
518 Financial
Management
(FM)
Page 540 of 641

q
 WACCassumes
newinvestments
havethesameriskascurrent
ones
3535
Thefollowing
scenario relates
toquestionsa– e
MathildaCoisa listed
company whichisseenasa potential
targetforacquisition
byfinancial
analysts.
Thevalueofthecompany hasthereforebeena matter
ofpublicdebate inrecent
weeks
andthefollowingfinancial
information
isavailable:
Year 20X4 20X3 20X2 20X1
Profit
aftertax($m) 25.3 24.3 22.3 21.3
Totaldividends
($m) 15.0 14.0 13.0 2.5
Statement
offinancial
position
information
for20X4
$m $m
Non-current
assets 227.5
Current
assets
Inventory 9.5
Trade
receivables 11.3 20.8
Totalassets 248.3
Equityfinance
Ordinary shares 50.0
Reserves 118.0 168.0
G
Non-current
liabilities H
8%loannotes 62.5
Current
liabilities 17.8
Totalliabilities 248.3
Theshares
ofMathildaCohavea nominal valueof50cpershareanda marketvalueof$10.00
pershare.
Thebusiness
sectorofMathildaCohasanaverage price/earnings
ratioof16times.
Theexpected
netrealisable
valuesofthenon-current
assetsandtheinventory
are$2.15million
and$10.5million,
respectively.
Intheeventofliquidation,
only90%ofthetradereceivables
are
expected
tobecollectible.
Required
(a) WhatisthevalueofMathilda
Co’smarket
capitalisation
(in$mtothenearest
million)?
$ million
(b) WhatisthevalueofMathilda
Cousingthenetassetvalue(liquidation
basis)?
 $168.00million
 $155.37million
 $248.30million
 $235.67million
(c) WhatisthevalueofMathilda
Cousingtheprice/earnings
ratiomethod (business
sector
average
price/earnings
ratio)(in$mtoonedecimal
place)?
$ million
16:Practice
Questions
519
Page 541 of 641

q
(d) Whatisthegeometric
average
historic
dividend
growth
rateforMathilda
Co(totwodecimal
places)?
%
(e) WhichTWOofthefollowing statements
areproblemsinusingtheprice/earnings
ratioto
valuea company?
 Itcanbedifficult
tofinda quotedcompanywitha similar
rangeofactivities
 Asingleyear’sP/Eratiomaynotberepresentative
 Itisthereciprocal
oftheearnings
yield
 Itcombinesstockmarket information
withcorporateinformation
3636
Thefollowingscenario
relates
toquestionsa– e
DaisyCoislistedonthestockmarketandhasincreasedearnings overthelastyear.Asa result,
theboardofdirectors
hasincreasedthedividendpayoutratiofrom36%fortheyeartoJune
20X4to37.1% fortheyeartoJune20X5.DaisyCohasa costofequityof13%.
Thefollowing
information
isalsoavailable:
YeartoJune 20X4 20X5
$’000 $’000
Earnings 12,100 2,700
Ordinary
shares 7,000 7,000
Thenominal
valueoftheordinary
shares ofDaisyCois$0.50pershare.
Listed
companies
similar
toDaisyCohaveanearningsyieldof9.2%.
G
Required H
(a) Whatistheequitymarket
valueofDaisyCousingthedividend
growth
model
(in$millions
to
onedecimalplace)?
$ million
(b) Whatistheequitymarket
valueofDaisyCousingtheearnings
yieldmethod
(in$millions
to
onedecimal
place)?
$ million
(c) Thefollowing
statements
relatetothedividend
growth
model
(DGM)andtheearnings
yield
method (EYM).
Arethesestatements
trueorfalse?
True/False
1. TheEYMusesprofit(rather
thancash)soisthepreferable
method forDaisyCo.
2. Inanacquisition
context,
theEYMisusedtovaluea minority
shareholding
ina targetcompany.
(d) Howisthenetassetsmethod ofsharevaluationcalculated?

 Netcurrentassets/numberofshares
 Nettangibleassets/numberofshares
 Totalnetassets/numberofshares
 Tangibleassetslesscurrent
liabilities/number
ofshares
520 Financial
Management
(FM)
Page 542 of 641

q
(e) Inwhichofthefollowingcircumstances
mightnetassetsbeusedasa basisforvaluing
a
company?
(1) Asa floorvalue
(2) Asa measure ofassetbacking
forshares
(3) Ina merger
 (1)and(2)only
 (2)only
 (3)only
 (1),(2)and(3)
3737
Thefollowing
scenariorelates
toquestions
a– e
RobinCoexpectstoreceive€800,000froma creditcustomer
intheEuropean Union
insixmonths’
time.Thespotexchangerateis€2.413
per$1andthesix-month forward
rateis€2.476
per$1.The
following
commercial
interest
ratesareavailable
toRobinCo:
Depositrate Borrowrate
Euros 3.0%peryear 7.0%peryear
Dollars 1.0%peryear 2.5%peryear
RobinCodoesnothaveanysurplus
cashtouseinhedging
thefuture
euroreceipt.
Required
(a) WhatcouldRobinCodotoreduce theriskoftheeurovaluedropping
relative
tothedollar
beforethe€ 800,000isreceived?
G
(1) Deposit€800,000immediately H
(2) Enterintoa forward

contract
tosell€800,000insixmonths
(3) Enterintoaninterest
rateswapforsixmonths
 (1)or(2)only
 (2)only
 (3)only
 (1),(2)or(3)
(b) Whatisthedollarvalueofa forwardmarkethedge(tothenearest
$100)?
$
(c) IfRobinCouseda money
markethedge,whatwould
bethepercentage
borrowing
ratefor
theperiod
(asa %working
toonedecimal
place)?
%
(d) WhichTWOofthefollowingstatements
aboutforward rateagreements(FRAs)aretrue?
 Theyfixtheborrowing
rateona sumofmoney foranagreed period
 Theyarearrangedwitha bankasanover-the-countertransaction
 Theyallowcompanies
tobenefitfromfavourableinterest
ratemovements
 Theycanbeusedtohedgeagainst foreignexchange risk
(e) Arethefollowing
statements
aboutinterest
ratetheoriestrueorfalse?
16:Practice
Questions
521
Page 543 of 641

q
True/False
1. Expectations
theory
provides
a reason
whytheinterest
yield
curveisnormally
upwardsloping.
2. Market
segmentationtheory
statesthatinterest
ratesreflect
expectations
offuture
changesininterest
rates
G H
522 Financial
Management
(FM)
Page 544 of 641

q
Section C style questions
38 Gustaffson (39 mins)

(a) Briefly
explain
whatismeant
bytheterm‘overtrading’ (3marks)
(b) Gustaffsonisa toymanufacturing
company.
Itmanufactures
PollyPlaytime,
thelatestdoll
crazeamong younggirls.Thecompany
isnowatfullproduction
ofthedoll.Thefinal
accountsfor20X9havejustbeenpublished
andareasfollows
(20X8’saccounts arealso
shown forcomparisonpurposes).
STATEMENT OFPROFIT ORLOSSY/E31DECEMBER
20X9 20X8
$’000 $’000
Sales 30,000 20,000
Costofsales 20,000 11,000
Operating
profit 10,000 9,000
Interest 450 400
Profit
before
tax 9,550 8,600
Tax 2,000 1,200
Profit
aftertax 7,550 7,400
Dividends
paidwere$2.5million
inbothyears.
STATEMENT
OFFINANCIAL POSITIONASAT31DECEMBER
G H
20X9 20X8
$’000 $’000 $’000 $’000
assets 1,500 1,400Non-curre
Current
assets
Inventory 7,350 3,000
Accounts
receivable 10,000 6,000
Cash 2,500 4,500
19,850 13,500
21,350 14,900
Ordinary
shares
(25c) 5,000 5,000
Reserves 6,450 1,400
8%loannotes 1,200 3,500
Current
liabilities
Overdraft 2,000 –
Dividends
owing 2,500 2,500
Trade
accounts
payable 4,200 2,500
8,700 5,000
21,350 14,900
16:Practice
Questions
523
Page 545 of 641

q
Required
(i) Bystudying
theaboveaccounts
andusingratioanalysis,
identify
themainproblems
facingGustaffson. (12marks)
(ii) Provide
possible
solutions
totheproblems
identified
in(i). (5marks)
(Total= 20marks)
39 H Finance
HFinance Coisprepared toadvance
80%ofDCo’ssalesinvoicing,
provideditsspecialist
collection
services
areusedbyDCo.HFinance Cowould chargeanadditional0.5%ofDCo’s
revenueforthisservice.
DCowould avoidadministration
costsitcurrently
incurs amounting to
$80,000perannum.
ThehistoryofDCo’saccounts receivable
ledgers
maybesummarised asfollows:
20X8 20X9 20Y0
Revenue
($’000) 78,147 81,941 98,714
%accounts
receivable
atyearend 17 20 22
%accounts
receivable
of90+days(ofrevenue) 1.5 2 2.5
Baddebts($’000) 340 497 615
DCoestimates thattheaggressive
collection
procedures
adoptedbythefinancecompany
are
likelytoresult
inlostrevenueofsome10%ofotherwiseexpected
levels.
Currently,each$1ofrevenue generates
18centsadditional
profit
beforetaxation.
DCoturnsits
capitalover,onaverage, threetimes
eachyear.OnreceiptbyHFinance Coofamountsduefrom
DCo’scustomers, a further
15%oftheamounts aretoberemitted
toDCo.DCohasanoverdraft
costing 20%.
G H
Required
(a) Calculate
whether
thefactoring
ofDCo’saccounts
receivable
ledger
would
beworthwhile.
(b) Explain
howthefactoring
ofsalesinvoicing
mayassista firm’s
financial
performance.
40 Victory
Victory
isa retailer,
specialising
invitaminsupplements andhealthfoodsclaimed toenhance
performance. Oneoftheproducts purchased byVictoryforresale
isa performanceenhancing
vitamindrinkcalled‘Buzz’.
Victory
sellsa fixedquantityof200bottles ofBuzzperweek. Theestimatedstoragecostsfora
bottle
ofBuzzare$2.00perannum perbottle.
Delivery
fromVictory’sexistingsuppliertakestwoweeks andthepurchase priceperbottle
delivered
is$20.Thecurrent supplierchargesa fixed$75orderprocessingchargeforeachorder,
regardless
oftheorder size.
Victory
hasrecently beenapproached byanother supplier
ofBuzzwiththefollowingoffer:
(1) ThecosttoVictory perbottle willbe$19each.
(2) Therewillbea fixedorderprocessing chargeof$250regardless ofordersize.
(3) Deliverytimewillbeoneweek.
(4) Victoryestimatesthatduetopackaging differences,
thestoragecostperbottlewillbe$1.80
perannum perbottle.
524 Financial
Management
(FM)
Page 546 of 641

q
Theeconomic
order
quantity
Q,whichwillminimise
costs,is:
EOQ = 2C0D
Ch
Where
C0=Thecostofmaking oneorder
D=Annual
demand
Ch=Theholding
costperunitperannum
Required
(a) Assuming Victorycontinuestopurchasefromtheexistingsupplier,calculate:
(1) Economic orderquantity
(2) Reorderlevel
(3) Totalcostofstocking
Buzzforoneyeartothenearest $
(b) Nowanswer thefollowing
questions.
(1) Calculatetheeconomic order
quantityifVictorychanges tothenewsupplier
and
determine
ifitwouldb efinancially
viablet ochanget othis newsupplier.
(2) DiscussTWOlimitations oftheabovecalculationsandbriefly describeTHREEother
nonfinancialfactors
tobetaken intoaccount beforea finaldecision
ismade.
(c) Explain
whatismeant bya just-in-time
(JIT)system andbriefly describe
FOURofitsmain
features.
(Introductory
question)
41 ZX (39 mins)
ZXisa relatively
smallcompany intheagricultural
industry.
Itishighlymechanisedanduses
G
modern techniquesandequipment. Inthepast,ithasoperated a veryconservative
policyin H
respectofthemanagement ofitsworking capital.

Assumethatyouarea newlyrecruited
management accountant.
Thefinance director,
whoisresponsibleforbothfinancial
controland
treasuryfunctions,
hasaskedyoutoreview thispolicy.
Youassemble thefollowing
informationaboutthecompany’s forecastend-of-year
financial
outcomes. Thecompany’syear-end isinsixmonths’ time.
$’000
Receivables 2,500
Inventory 2,000
Cashatbank 500
Current
assets 5,000
Non-current
assets 1,250
Current
liabilities 1,850
Forecast
salesforthefullyear 8,000
Forecast
operatingprofit
(18%ofsales) 1,440
Youwishtoevaluate
thelikelyeffectonthecompany
ifitintroduced
oneortwoalternative
approachestoworking
capitalmanagement.
16:Practice
Questions
525
Page 547 of 641

q
Thefinance
director
suggests
youadjust
thefigures
inaccordance
withthefollowing
parameters:
‘Moderate’
policy ‘Aggressive’
policy
Receivables
andinventory –20% –30%
Cash Reduce
to$250,000 Reduce
to$100,000
Non-current
assets Nochange Nochange
Current
liabilities +10% +20%
Forecast
sales +2% +4%
Forecast
profit Nochangeinpercentage
profit/sales
Required
(a) Writea report
tothefinancedirector
thatincludes
anexplanation
ofa conservative
and
aggressive
workingcapitalpolicy. (5marks)
(b) Showcalculationsofthereturn onnetassetsandthecurrentratioundereachofthe
followingthreescenarios:
(1) Thecompany continues
withitspresentpolicy.
(2) Thecompany adoptsthe‘moderate’
policy.
(3) Thecompany adoptsthe‘aggressive’
policy.
(8marks)
(c) Recommend a proposedcourseofaction.Yourrecommendationshouldbebasedonyour
evaluationasdiscussedaboveandonyouropinion ofwhatfurther
actionisnecessary
before
a finaldecision
canbetaken. (7marks)
(Total= 20marks)
G H
42 Velm Co
VelmCosellsstationery
andofficesuppliesona wholesale basisandhasanannual revenue
of$4
million.
Thecompany employsfourpeople initssalesledgerandcreditcontrol
department atan
annualsalaryof$12,000each.Allsalesareon40days’creditwithnodiscount forearly
payment. Baddebtsrepresent
3%ofrevenue andVelmCopaysannual interest
of9%onits
overdraft.
Themostrecentaccountsofthecompany offerthefollowing
financial
information:
VelmCo:Statement offinancial
positionasat31December 20X2
$’000 $’000
Non-current
assets
Tangible
non-current
assets 17,500
Current
assets
Inventory
ofgoodsforresale 900
Receivables 550
Cash 120
1,570
assets 19,070Total
Ordinaryshares 3,500
526 Financial
Management
(FM)
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q
$’000 $’000
11,640Reserves
15,140
Non-current
liabilities
12%Loannotesdue20Y0 2,400
Current
liabilities
Trade
payables 330
Overdraft 1,200
1,530
Totalequityandliabilities 19,070
VelmCoisconsidering offeringa discount
of1%tocustomers payingwithin
14days,whichit
believeswillreducebaddebtsto2.4%ofrevenue. Thecompany alsoexpects
thatoffering
a
discount forearlypayment willreducetheaveragecreditperiod
takenbyitscustomersto26
days.Theconsequent reduction inthetimespentchasingcustomerswherepayments areoverdue
willallowonemember ofthecreditcontrolteamtotakeearlyretirement.
2/3ofcustomersare
expected totakeadvantageofthediscount.
Required
(a) Usingtheinformation
provided,
determinewhether
a discount
forearlypayment
of1%will
leadtoanincrease
inprofitability
forVelmCo. (5marks)
(b) Discuss
therelative
merits
ofshort-term
andlong-term
debtsources
forthefinancing
of
working
capital. (8marks)
(c) Discuss
thedifferent
policies
thatmaybeadopted bya companytowards
thefinancing
of
G H
working
capitalneedsandindicate
whichpolicyhasbeenadopted
byVelmCo. (7marks)
(Total= 20marks)
43 Knuckle Down
Themanagement ofKnuckle
Downarereviewing thecompany’s
capitalinvestment
options
forthe
comingyearandareconsidering
sixprojects.
Project
Awouldcost$29,000nowandwould earnthefollowing
cashprofits:
1styear $8,000 3rdyear $10,000
2ndyear $12,000 4thyear $6,000
Thecapitalequipmentpurchased
atthestartoftheproject
couldberesold
for$5,000atthestart
ofthefifthyear.
Project
Bwould involve
a current
outlayof$44,000oncapitalequipment
and$20,000onworking
capital.
Theprofits
fromtheproject
wouldbeasfollows:
Year Sales Variable
costs Contribution Fixedcosts Profit
$ $ $ $ $
1 75,000 50,000 25,000 10,000 15,000
2 90,000 60,000 30,000 10,000 20,000
3 42,000 28,000 14,000 8,000 6,000
16:Practice
Questions
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q
Fixedcostsincludeanannual chargeof$4,000fordepreciation. Attheendofthethirdyear,the
workingcapitalinvestmentwouldberecovered andtheequipment would besoldfor$5,000.
Project
C would involve
a current
outlayof$50,000onequipment and$15,000 onworking
capital.
Theinvestment inworkingcapitalwould beincreasedto$21,000 attheendofthefirst
year.Annual cashprofitswouldbe$18,000 forfiveyears,attheendofwhichtheinvestment in
workingcapitalwould berecovered.
Project
Dwould involveanoutlayof$20,000nowanda further outlayof$20,000afteroneyear.
Cashprofitsthereafterwouldbeasfollows:
1stto5thyears $5,000
6thto10thyears $4,000
11th
yearonwards
forever $3,000

Project
E isa longtermproject,
involving
animmediate
outlayof$32,000andannualcashprofits
of$4,500inperpetuity.
Project
F isanotherlongtermproject,
involving
animmediate
outlayof$20,000andannualcash
profits
asfollows.
1stto5thyears $5,000
6thto10thyears $4,000
11th
yearonwards
forever $3,000
Thecompany discounts
allprojects
of10yearsduration
orlessata costofcapitalof12%,andall
otherprojects
ata costof15%.
G
Ignoretaxation. H
Required
(a) Calculate
theNPVofeachproject
anddetermine
whichshould
beundertaken
bythe
company onfinancial
grounds.
(b) Calculate
theIRRofProjects
A,C andE.
(Introductory
question)
44 Mezen (39 mins)

Mezeniscurrently considering
thelaunchofa newProduct.
Amarket survey
wasrecently
commissioned toassessthelikelydemand fortheproduct
andthisshowed thattheproducthas
anexpected lifeoffouryears.Thesurveycost$30,000andthisisdueforpayment infour
months’time.Onthebasisofthesurvey information
aswellasinternal
management accounting
information
relatingtocosts,theassistant
accountant
prepared thefollowing
profit
forecasts
for
theproduct.
Year 1 2 3 4
$’000 $’000 $’000 $’000
Sales 180 200 160 120
Costofsales (115) (140) (110) (85)
Grossprofit 65 60 50 35
Variable
overheads (27) (30) (24) (18)
Fixedoverheads (25) (25) (25) (25)
528 Financial
Management
(FM)
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q
Year 1 2 3 4
$’000 $’000 $’000 $’000
Market
survey
written
off (30) – – –
Netprofit/(loss) (17) 5 8)
Theseprofitforecastswereviewed withdisappointment
bythedirectors andtherewasa general
feeling
thatthenewproduct should notbelaunched.TheChiefExecutive pointedoutthatthe
productachieved profits
inonlytwoyearsofitsfour-year lifeandthatoverthefour-year period
asa whole,a netlosswasexpected. However,before
a meeting thathadbeenarranged todecide
formallythefuture oftheproduct, thefollowing
additional information
became available:
(1) Thenewproduct willrequire theuseofanexisting machine. Thishasa written
downvalueof
$80,000butcouldbesoldfor$70,000immediately ifthenewproduct isnotlaunched.Ifthe
product islaunched, itwillbesoldattheendofthefour-year periodfor$10,000.
(2) Additionalworkingcapitalof$20,000willberequired immediatelyandwillbeneeded over
thefour-year period. Itwillbereleased attheendoftheperiod.
(3) Thefixedoverheads include a figureof$15,000
peryearfordepreciation ofthemachine and
$5,000peryearforthere-allocation ofexisting
overheads ofthebusiness.
(4) Thecompany hasa costofcapitalof10%.
Ignoretaxation.
Required
(a) Calculate
thenetpresent
valueofthenewproduct. (10marks)
(b) Calculate
theapproximate
internal
rateofreturn
oftheproduct. (5marks)
(c) Explain,
withreasons,
whether
ornottheproduct
should
belaunched. (5marks)
(Total= 20marks)
G H
45 Auriga
Auriga(Healthcare) hasinvested$220,000overthepasttwoyearsinthedevelopment ofa
personalstress-monitoringdevice(PSMD). Thedeviceisdesignedforbusyindividualswishing
to
checktheirstresslevels.
Market research thatwascommissioned earlier
intheyearata costof
$45,000suggests thatthepriceforthePSMDshould be$22perunitandthattheexpected
productlifecycleofthedevice isfouryears.
Inordertoproduce thedevice,thebusiness mustpurchase immediatelyspecialist
machineryand
equipment ata costof$300,000.Thismachinery andequipment hasanexpected lifeoffour
yearsandwillhavenoresidual valueattheendofthisperiod. Themachinery andequipment can
produce a maximum of15,000PSMDs peryearoverfouryears.Toensure thatthemaximum
outputisachieved, thebusiness willspend$50,000a yearinadvertisingthedeviceoverthenext
fouryears.
Basedonthemaximum outputof15,000unitsperyear,thePSMDhasthefollowing expected
costsperunit(excluding theadvertisingcostsabove):
Notes $
Materials (1) 6.50
Labour (2) 5.50
Overheads (3) 8.50
20.50
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Notes.
1 Thematerials figureaboveincludesa chargeof$2fora polymer thatiscurrently
instockand
canbeusedforthisproject.EachPSMDrequires 200gramsofthepolymer andthechargeis
basedontheoriginal costof$1per100gramsforthepolymer. Itisa materialthatiscurrently
usedinotherareasofthebusiness andthecostofreplacingthepolymer is$1.50per100
grams.Thepolymer couldeasilybesoldata priceof$1.25per100grams.
2 Thelabour costsrelate
topayments madetoemployees thatwillbedirectlyinvolved
in
producingthePSMD.These employees havenoworkatpresent and,ifthePSMDisnot
produced,theywillbemaderedundant immediatelyata costof$230,000. If,however,the
PSMDisproduced, theemployees arelikelytobefoundotherworkattheendofthefour-year
periodandsonoredundancy costswillbeincurred.
3 Thefigureincludes a depreciation
chargeforthenewmachinery andequipment. Thepolicyof
thebusinessistodepreciatenon-currentassetsinequalinstalmentsovertheirexpected life.
Allotheroverheadsincludedintheabovefigureareincurredinproduction ofthenewdevice.
4 Auriga usesa costofcapitalof10%toassessprojects.
Ignoretaxation.
Required
(a) Calculate
thenetpresent
valueoftheproject.
(b) Calculate
therequired
reduction
inannual
netcashflowsfromoperations
before
theproject
becomesunattractive.
(Introductory
question)
46 Bridgeford
Bridgeford
isconsideringwhether ornottoinvestinthedevelopment
ofa newproduct,
which
G
wouldhaveanexpected marketlifeoffiveyears. H
Themanaging director
isinfavour oftheproject,
becauseitsestimated
accounting
rateofreturn
(ARR)wouldbeover15%.
Hisestimates
fortheprojectareasfollows:
Year 0 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000 $’000
Costofequipment 2,000
Totalinvestment
inworking
capital 200 250 300 350 350
Sales 2,500 3,000 3,500 3,500 3,000
Materials
costs 500 600 700 700 600
Labour
costs 750 900 1,100 1,100 1,000
Overhead
costs 300 350 350 350 350
Interest 240 240 240 240 240
Depreciation 400 400 400 400 400
Totalcosts 2,190 2,490 2,790 2,790 2,590
Profit 310 510 710 710 410
Theaverage
annual profit
before
taxis$530,000andwithcorporation
taxat35%,theaverage
annual
profit
aftertaxis$344,500.
ThisgivesanARRof15.7%
ontheinitial
investment
of
$2,200,000.
530 Financial
Management
(FM)
Page 552 of 641

q
Asfinance director,
youhavesomecriticisms ofthemanaging director’sestimates. Hisfigures
ignore bothinflation
andcapitalallowances ontheequipment, andyoudecidetoprepare an
amended assessment oftheprojectwiththefollowing data.
(1) Selling
pricesandoverhead expenses willincreasewithinflationby5%pa.
(2) Materialscosts,labourcostsandtheworking capitalrequirements,willincreaseby10%pa.
(3) Fortaxation purposes,capitalallowances willbeavailable
against thetaxable profits
ofthe
project,at25%paona reducing balance basis.
(4) Therateofcorporation taxontaxable profits
is35%andtaxispaidoneyearinarrears.
(5) Theequipment will
havea zerosalvage valueattheendoftheproject’s life.
(6) Thecompany’s realaftertaxweighted average costofcapitalisestimated tobe7%paand
itsnominal aftertaxweightedaverage costofcapitalis12%.
Required
(a) Estimate
thenetpresentvalueoftheproject,
andrecommend,onthebasisoftheNPV,
whetherornottheproject
shouldbeundertaken.
(b) Outline
thestrengths
andweaknesses oftheinternal
rateofreturn
methodasa basisfor
investment
appraisal.
(Introductory
question)
47 Dinard
(a) Explain
thedifference
between
realratesofreturn
andnominal
ratesofreturn.
(b) Dinard Cohasjustdeveloped a newproducttobecalledRanceandisnowconsidering
whether toputitintoproduction.Thefollowing
information
isavailable:
(1) Costsincurred inthedevelopmentofRanceamount to$480,000.
(2) Production ofRancewillrequire
thepurchase ofnewmachinery ata costof$2.4million,
G H
payable immediately.Thismachineryisspecific
totheproduction
ofRanceandwillbe
obsoleteandvaluelesswhenthatproduction ceases.Themachineryhasa production
lifeoffouryearsanda productioncapacityof30,000unitsperannum.
(ProductioncostsofRance(atYear1prices)areestimatedasfollows:(3)
$
Variable
materials 8.00
Variable
labour 2.00
Variable
overheads 2.00
Inaddition,
fixedproduction costs(atYear1prices),
including
straight
linedepreciation
on
plantandmachinery, willamountto$800,000perannum.
(4) ThesellingpriceofRancewillbe$80.00perunit(atYear1prices). Demand isexpected
tobe25,000unitsperannum forthenextfouryears.
(5) Theretailpriceindexisexpected toincreaseat5%perannum forthenextfouryearsand
thesellingpriceofRanceisexpected toincrease
atthesamerate.Annual inflation
rates
forproductioncostsareexpected tobeasfollows:
%
Variable
materials 4
Variable
labour 10
Variable
overheads 4
Fixedcosts 5
16:Practice
Questions
531
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q
(6) Thecompany’s
weighted
average
costofcapitalinnominal
terms
isexpected
tobe15%.
Required
Advisethedirectors
ofDinardCowhether itshould
produce
Ranceonthebasisofthe
information
above.
Note.Unlessotherwise
specified,
allcostsandrevenues
should
beassumedtoriseattheend
ofeachyear.Ignoretaxation.
(Introductory
question)
48 Muggins
Mugginsisevaluating
a project
toproducea newproduct.
Theproducthasanexpected
lifeof
fouryears.Costsassociated
withtheproductareexpected
tobeasfollows:
Variable costsperunit
Labour: $30
Materials:
6kgofmaterial Xat$1.64perkg
3 unitsofComponent Yat$4.20perunit
Othervariablecosts:$4.40
Indirectcosteachyear
Apportionment ofheadofficesalaries$118,000
Apportionment ofgeneralbuildingoccupancy $168,000
Otheroverheads are$80,000,ofwhich$60,000represent additional
cashexpenditures
(includingrentofmachinery)
Tomanufacture theproduct,
a product manager willhavetoberecruitedatanannual grosscost
G H
of$34,000,andoneassistant manager, whose currentannual salaryis$30,000,willbe

transferredfromanotherdepartment, wheretheywillbereplaced bya newappointee ata costof
$27,000 a year.
Thenecessary machinerywillberented.Itwillbeinstalledinthecompany’s factory.Thiswilltake
upspacethatwould otherwiseberented toanother localcompany for$135,000a year.Thisrent
(forthefactoryspace)isnotsubject toanyuncertainty, asa bindingfour-year
leasewould be
created.
60,000kgofMaterial Xarealready ininventory,ata purchase valueof$98,400.Theyhaveno
useotherthanthemanufacture ofthenewproduct. Theirdisposalvalueis$50,000.
Expected salesvolumesoftheproduct, attheproposed selling
priceof$125a unit,areasfollows:
Year Expectedsales
Units
1 10,000
2 18,000
3 18,000
4 19,000
Allsalesandcostswillbeona cashbasisandshouldbeassumed tooccurattheendoftheyear.

Ignoretaxation.
Thecompany requiresthatcertainty-equivalent
cashflowshavea positive
NPVata discount
rate
of5%.Adjustment factors
toarriveatcertainty-equivalent
amounts areasfollows:
532 Financial
Management
(FM)
Page 554 of 641

q
Year Costs Benefits
1 1.1 0.9
2 1.3 0.8
3 1.4 0.7
4 1.5 0.6
Required
Assessonfinancial
grounds
whether
theproject
isacceptable.
(Introductory
question)
49 Banden (39 mins)

Banden isa highlygeared
company thatwishes
toexpand itsoperations.
Sixpossible
capital
investmentshavebeenidentified,
butthecompany onlyhasaccesstoa totalof$620,000.The
projects
arenotdivisible
andmaynotbepostponed untila future
period.
Aftertheproject’s
endit
isunlikely
thatsimilar
investment
opportunities
willoccur.
Expected netcashinflows
(including
salvage
value):
Initial
Project Year1 Year2 Year3 Year4 Year5 outlay
$ $ $ $ $ $
A 70,000 70,000 70,000 70,000 70,000 246,000
G
B 75,000 87,000 64,000 80,000 H
C 48,000 48,000 63,000 73,000 75,000

D 62,000 62,000 62,000 62,000 80,000
E 40,000 50,000 60,000 70,000 40,000 80,000
F 35,000 82,000 82,000 50,000
Projects
AandE aremutually exclusive.
Allprojects
arebelieved
tobeofsimilar
risktothe
company’sexisting
capitalinvestments.
Anysurplus
fundsmaybeinvested inthemoney markettoearna return
of9%peryear.The
moneymarket maybeassumed tobeanefficient
market.
Banden’s
costofcapitalis12%a year.
Required
(a) Answerthefollowing
questions.
(1) Calculate
theexpected
netpresentvalueforeachofthesixprojects.
(2) Calculate
theexpected
profitability
indexassociated
witheachofthesixprojects.
(3) Ranktheprojects
according
tobothoftheseinvestment
appraisalmethods.
Explain
briefly
whytheserankings
differ.
(12marks)
(b) GivereasonedadvicetoBandenrecommending whichprojects
shouldbeselected.(8marks)
(Total= 20marks)
16:Practice
Questions
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q
50 ANT (39 mins)
ANT,a multi-product
company,
isconsidering
fourinvestment
projects,
details
ofwhicharegiven
below:
Developmentcostsalready
incurred
ontheprojects
areasfollows:
A B C D
$ $ $ $
100,000 75,000 80,000 60,000
Eachproject
willrequire
animmediate
outlayonplantandmachinery,
thecostofwhichis
estimated
asfollows:
A B C D
$ $ $ $
2,100,000 1,400,000 2,400,000 600,000
Inallfourcases,theplantandmachineryhasa useful
lifeoffiveyearsattheendofwhichitwill
bevalueless.
Unitsalesperannum, foreachproject,
areexpectedtobeasfollows:
A B C D
150,000 75,000 80,000 120,000
Selling
priceandvariable
costsperunitforeachproject
areestimated
asfollows:
A B C D
$ $ $ $
G H
Selling
price 30.00 40.00 25.00 50.00
Materials 7.60 12.00 4.50 25.00
Labour 9.80 12.00 5.00 10.00
Variable
overheads 6.00 7.00 2.50 10.50
Thecompany charges depreciation

onplantandmachinery ona straight
linebasisoverthe
useful
lifeoftheplantandmachinery. Developmentcostsofprojectsarewritten
offintheyear
thattheyareincurred.Thecompany apportions
generaladministration
coststoprojectsata rate
of5%ofsellingprice.Noneoftheaboveprojectswillleadtoanyactualincrease inthecompany’s
administration
costs.
Working capitalrequirements
foreachprojectwillamount to20%oftheexpected annual sales
value.Ineachcase,thisinvestment
willbemadeimmediately andwillberecoveredinfullwhen
theprojectsendinfive-years’
time.
Fundsavailableforinvestment
arelimitedto$5,200,000.Thecompany’s costofcapitalis
estimatedtobe18%.
Required
(a) Calculate
theNPVofeachproject. (12marks)
(b) Calculate
theprofitability
indexforeachproject
andadvisethecompany whichofthenew
projects,
ifany,toundertake.
Youmayassume thateachoftheprojectscanbeundertaken ona reduced scalefora
proportionate
reduction
incashflows.Youradviceshould
stateclearlyyourorderof
preference
forthefourprojects,
whatproportion
youwould takeofanyproject thatisscaled
down,andthetotalNPVgenerated byyourchoice. (4marks)
534 Financial
Management
(FM)
Page 556 of 641

q
(c) Brieflydiscussthe limitationsof the profitabilityindexas a means of dealingwithcapital
rationingproblems.
Ignoretaxation. (4 marks)
(Total=20 marks)
51 Sagitta
Sagitta is a large fashionretailerthat openedstoresinIndiaand Chinathree years ago. Thishas
provedto be lesssuccessfulthan expected,so the directorsof the companyhavedecidedto
withdrawfromthe overseasmarketand to concentrateon the homemarket.Toraisethe finance
necessaryto closethe overseasstores,the directorshavealso decidedto makea one-for-five
rightsissueat a discountof 30%on the currentmarketvalue.Themostrecentstatementof profit
or lossof the businessis as follows.
STATEMENT OFPROFIT ORLOSSFORTHEYEAR ENDED 31MAY20X4
$m
Sales 1,400.00
Netprofitbeforeinterestand taxation 52.0
Interestpayable 24.0
Netprofitbeforetaxation 28.0
Companytax 7.0
Netprofitafter taxation 21.0
Dividendspaid are $14million.
G H
Thecapital and reservesof the businessas at 31May20X4are as follows:

$m
$0.25ordinaryshares 60.0
Accumulatedprofits 320.0
380.0
Theshares of the businessare currentlytraded on the StockExchangeat a P/Eratioof 16times.

Aninvestorowning10,000ordinaryshares inthe businesshas receivedinformationof the
forthcomingrightsissuebut cannot decidewhetherto take up the rightsissue,sellthe rightsor
allowthe rightsofferto lapse.
Required
(a) Calculatethe theoreticalex-rightspriceof an ordinaryshare inSagitta.
(b) Calculatethe priceat whichthe rightsinSagitta are likelyto be traded.
(c) Evaluateeach of the optionsavailableto the investorwith10,000ordinaryshares.
(d) Discuss,fromthe viewpointof the business,howcriticalthe pricingof a rightsissueis likelyto
be.
(e) Sagitta’sfinancedirectorhas lookedintoalternativesourcesof finance,particularlyIslamic
finance.Sheknowsthat there is a transactiontype calledMurabaha,howevershe is unsure
howit differsfroma conventionalloan.
Explainhowa simpleMurabahatransactionworksand discussthe differencesfroma
conventionalloan.
(Introductoryquestion)
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q
52 Headwater
ItisnowAugust 20X6.In20X0,thecurrentmanagementteamofHeadwater,
a manufacturer of
carandmotorcycle parts,bought
thecompany fromitsconglomerate
parent
company ina
management buyout
deal.Sixyearson,themanagersareconsidering
thepossibility
ofobtaining
a listing
forthecompany’sshares
onthestockmarket.Thefollowing
information
isavailable.
HEADWATER STATEMENTOFPROFIT ORLOSSFORTHEYEARENDED 30JUNE20X6
$m
Revenue 36.5
Costofsales (31.6)
Profit
before
interest
andtaxation 4.9
Interest (1.3)
Profit
before
taxation 3.6
Taxation (0.5)
Profit
attributable
toordinary
shareholders 3.1
Dividends
paidwere$300,000.
STATEMENT
OFFINANCIALPOSITION
ASAT30JUNE20X6
$m $m
Non-current
assets(atcostlessaccumulated
depreciation)
Landandbuildings 3.6
G
Plantandmachinery 9.9 H
13.5
Current
assets
Inventories 4.4
Accounts
receivable 4.7
Cashatbank 1.0
10.1
23.6
Ordinary
$1shares
Voting 1.8
‘A’shares
(non-voting) 0.9
Reserves 9.7
Accountspayable dueaftermorethanoneyear:12%Debenture
20X8 2.2
Current
liabilities
Trade
accounts
payable 7.0
Bankoverdraft 2.0
9.0
23.6
Average
performance
ratiosfortheindustry
sector
inwhichHeadwater
operates
areasfollows:
536 Financial
Management
(FM)
Page 558 of 641

q
Industry
sector
ratios
Return
before
interest
andtaxonlong-term
capitalemployed 24%
Return
aftertaxonequity 6%
Operating
profit
aspercentage
ofsales 11%
Current
ratio .6:1
Quick(acidtest)ratio .0:1
Totaldebt:equity(gearing) 24%
Dividend
cover 4.0
Interest
cover 4.5
Price/earnings
ratio 0.0
Required
(a) Evaluate
thefinancial
stateandperformance
ofHeadwater
bycomparing
itwiththatofits
industry
sector.
(b) Discuss
theprobablereasonswhythemanagement
ofHeadwater
isconsidering
a Stock
Exchangelisting.
(Introductory
question)
53 ABC
Themanaging directors
ofthreeprofitable
listed
companies discussed
theircompany’sdividend
policies
ata business
lunch.
G
Company Ahasdeliberately
paidnodividends forthelastfiveyears. H
Company Balwayspaysa dividend of50%ofearnings aftertaxation.

Company C maintains
a lowbutconstant dividendpershare(afteradjusting
forthegeneralprice
index)
andoffersregularscripissues
andshareholderconcessions.
Eachmanaging director
isconvinced thathiscompany’spolicyismaximisingshareholder
wealth.
Required
Discusstheadvantagesanddisadvantages
ofthealternative
dividendpolicies
ofthethree,and
thecircumstancesunderwhicheachmanagingdirector
mightbecorrectinhisbeliefthathis
company’s dividend
policyismaximising
shareholder
wealth.
Stateclearlyanyassumptions that
youmake.
(Introductory
question)
54 DF (39 mins)
DFisa manufacturer ofsports
equipment.AllofthesharesofDFareheldbytheWongfamily.
Thecompany hasrecently wona majorthree-yearcontracttosupplyFFwitha rangeofsports
equipment.
FFisa largecompany withover100sports shops.Thecontract mayberenewed after
threeyears.
Thenewcontract isexpectedtodoubleDF’sexisting
totalannualsales,butdemand fromFFwill
varyconsiderably frommonth tomonth.
Thecontractwill,however,meana significant
additional
investmentinbothnon-currentand
current
assets.Aloanfromthebankistobeusedtofinance theadditionalnon-current
assets,
as
theWongfamilyiscurrently unabletosupplyanyfurther sharecapital.Also,theWongfamily
doesnotwishtoraisenewcapitalbyissuing shares tonon-familymembers.
16:Practice
Questions
537
Page 559 of 641

q
Thefinancing oftheadditionalcurrentassetsisyettobedecided. Inparticular,
thecontract
with
FFwillrequireorderstobedeliveredwithintwodays.ThisdeliveryperiodgivesDFinsufficient
time
tomanufacture items,
thussignificant
inventoriesneedtobeheldatalltimes. Also,FFrequires
90
days’creditfromitssuppliers.
Thiswillresult
ina significant
additional
investment inaccounts
receivable
byDF.
Ifthecompany borrowsfromthebanktofinance currentassets,
eitherusinga loanoran
overdraft,
itexpectstobecharged annual interest
at12%.Consequently,DFisconsidering
alternative
methods offinancingcurrent assets.
Theseincludedebtfactoring,invoicediscounting
andoffering a 3%cashdiscount toFFforsettlement within10daysratherthanthenormal 90
days.
Required
(a) Calculate
theannual equivalent
rateofinterestimplicit
inoffering
a 3%discount
toFFfor
settlement
ofdebtswithin
10daysrather than90days.
Briefly
explain
thefactors,
otherthantherateofinterest,thatDFwouldneedtoconsider
beforedeciding
onwhether tooffera cashdiscount. (6marks)
(b) Writea reporttotheWongfamilyshareholders
explaining
thevariousmethods
offinancing
available
toDFtofinance theadditional
current
assetsarising
fromthenewFFcontract.
The
reportshouldinclude
thefollowing
headings:
• Bankloan
• Overdraft
• Debtfactoring
• Invoicediscounting
(14marks)
(Total= 20marks)
G H
55 CRY
Thefollowing
figures
havebeenextracted
fromthemostrecent
accounts
ofCRY.
STATEMENTOFFINANCIALPOSITIONASON30JUNE20X9
$’000 $’000
Non-current
assets 10,936
Current
assets 3,658
14,594
3,000,000ordinary
shares
of$1 3,000
Reserves 7,125
Totalequity 10,125
7%Loannotes 1,300
Current
liabilities 1,735
Corporation
taxpayable 1,434
4,469
14,594
Summary
ofprofits
anddividends
538 Financial
Management
(FM)
Page 560 of 641

q
Yearended
30June: 20X5 20X6 20X7 20X8 20X9
$’000 $’000 $’000 $’000 $’000
Profit
before
tax 1,737 2,090 1,940 1,866 2,179
Lesstax 573 690 640 616 719
Profit
aftertax 1,164 1,400 1,300 1,250 1,460
Lessdividends 620 680 740 740 810
Retained
earnings 544 720 560 510 650
Thecurrent(1July20X9)marketvalueofCRY’sordinarysharesis$3.00pershareexdiv.Theloan
notesareredeemableatparinfouryears’time.Theircurrent
market valueis$88.00per$100
nominal.Annualinterest
hasjustbeenpaidontheloannotes. Therehavebeennoissues or
redemptionsofordinary
sharesorloannotesduringthepastfiveyears.
Thecurrentrateofcorporation
taxis30%.Assume thattherehavebeennochanges inthesystem
orratesoftaxation
duringthelastfiveyears.
Required
(a) Calculate
thecostofcapitalwhichCRYshould
useasa discount
ratewhenappraising
new
investment
opportunities.
(b) Discuss
anydifficulties
anduncertainties
inyourestimates.
(Introductory
question)
56 Katash (39 mins)

Katashisa majorinternational
company withitsheadofficeintheUK.Itsshares
andloannotes
G
arequoted ona majorinternational
stockexchange. H
Katashisevaluating
thepotentialforinvestment inanareainwhichithasnotpreviouslybeen
involved.
Thisinvestment
willrequire
$900million topurchasepremises,
equipmentandprovide
workingcapital.
Extracts
fromthemostrecent (20X1)statement offinancial
position
ofKatash areasfollows:
$m
Non-current
assets 2,880
Current
assets 3,760
6,640
Equity
Sharecapital(Shares
of$1) 450
Retained
earnings 2,290
2,740
Non-current
liabilities
10%Secured
loannotesrepayable
atpar20X6 1,800
Current
liabilities 2,100
6,640
Current
shareprice(pence) 500
Loannoteprice($100) 105
Equitybeta 1.2
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Questions
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Katashproposes tofinancethe$900million investment witha combination ofdebtandequityas
follows:
• $390million indebtpayinginterestat9.5%perannum, secured onthenewpremises and
repayablein20X8.
• $510millioninequityviaa rightsissue.Adiscount of15%onthecurrent sharepriceislikely.
AmarginallypositiveNPVoftheproposed investment hasbeencalculated usinga discount rateof
15%.Thisistheentity’s
costofequityplusa smallpremium, a ratejudged toreflecttheriskofthis
venture.
TheChiefExecutive ofKatash thinks thisistoomarginal andisdoubtful whether the
investmentshouldgoahead.However, thereissomedisagreement among theDirectorsabout
howthisproject wasevaluated,inparticularaboutthediscount ratethathasbeenused.
Director
A:Suggests theentity’scurrentWACCismoreappropriate
Director
B:Suggests calculatinga discountrateusingdatafromChlopop, a quoted entity,the
maincompetitor inthenewbusiness area.Relevant dataforthisentityisasfollows:
• Shares inissue:600million
currently quoted at560centseach
• Debtoutstanding: $525million variable
ratebankloan
• Equitybeta:1.6
Otherrelevantinformation
• Therisk-freerateisestimated at5%perannum andthereturn onthemarket 12%perannum.
Theseratesarenotexpected tochangeintheforeseeable future.
• Katash payscorporate taxat30%andthisrateisnotexpected tochangeintheforeseeable
future.
• Issuecostsshould beignored.
Required
(a) Calculate
thecurrent
WACCforKatash. (7marks)
G H
(b) Calculate
a project
specific
costofequityforthenewinvestment. (5marks)
(c) Discuss
whether
financial
management
theory
suggests
thatKatash
canreduce
itsWACCto
a minimum
level. (8marks)
(Total= 20marks)
57 Bases of valuation
Thedirectors
ofCarmen, a largeconglomerate,areconsideringtheacquisition
oftheentire
share
capitalofManon, whichmanufacturesa rangeofengineering machinery.
Neithercompany has
anylongtermdebtcapital.ThedirectorsofCarmen believe
thatifManonistakenover,the
businessriskofCarmen willnotbeaffected.
Theaccounting reference
dateofManon is31July.Itsstatementoffinancial
positionason31
July20X4isexpected tobeasfollows:
$ $
assets(netofdepreciation) 651,600Non-current
Current
assets
Inventory
andWIP 515,900
Receivables 745,000
Bankbalances 158,100
1,419,000
2,070,600
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$ $
Capitalandreserves
Issuedordinary
shares
of$1each 50,000
Distributable
reserves 404,100
Current
liabilities
Payables 753,600
Bankoverdraft 862,900
1,616,500
2,070,600
Manon’s
summarised
financial
record
forthefiveyearsto31July20X4isasfollows:
Yearended
31July 20X0 20X1 20X2 20X3 20X4(estimated)
$ $ $ $ $
Profit
aftertax 33,300 66,800 43,300 38,400 52,200
Lessdividends 20,500 22,600 25,000 25,000 25,000
Added
toreserves 12,800 44,200 18,300 13,400 27,200
Thefollowing
additional
information
isavailable:
(1) There
havebeennochangesintheissuedsharecapitalofManonduring
thepastfiveyears.
(2) Theestimated
values
ofManon’snon-current
assetsandinventory
andWIPason31July
G
20X4areasfollows: H
Replacement
cost Realisable
value
$ $
Non-current
assets 725,000 450,000
Inventory
andworkinprogress 550,000 570,000
(3) Itisexpectedthat2%ofManon’s receivables
at31July20X4willbeuncollectableifthe
company isliquidated.
(4) ThecostofcapitalofCarmen plcis9%.Thedirectors
ofManon estimate
thatthe
shareholdersofManon require
a minimum return
of12%perannum fromtheirinvestment
in
thecompany.
(5) ThecurrentP/EratioofCarmen is12.Quotedcompanies withbusiness
activities
and
profitability
similartothoseofManon haveP/Eratiosofapproximately
10,althoughthese
companiestendtobemuchlargerthanManon.
Required
(a) Estimate thevalueofthetotalequityofManon
ason31July20X4usingeachofthefollowing
bases:
(i) Statement offinancial
position
value
(ii) Replacement costoftheassets
(iii) Realisable
valueoftheassets
(iv) Thedividendvaluationmodel
(v) TheP/Eratiomodel
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Questions
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(b) Explain
theroleandlimitations
ofeachoftheabovefivevaluation
basesintheprocess by
whicha pricemightbeagreedforthepurchase
byCarmen ofthetotalequitycapitalof
Manon (ignoretaxation).
(Introductory
question)
58 Expo Co
ExpoCoisanimporter/exporter oftextilesandtextile
machinery. ItisbasedintheUSbuttrades
extensively
withcountriesthroughout Europe. Thecompany isabouttoinvoice a European
customerfor€750,000, payable inthreemonths’ time.Expo’s treasurerisconsidering
two
methodsofhedging theexchange risk.Theseare:
Method1:Borrow Eurosnow,converting theloanintodollarsandrepaying theEuroloanfromthe
expectedreceiptinthreemonths’ time.
Method2:Enterintoa three-month forward exchange contract withthecompany’s banktosell
€750,000.
Thespotrateofexchange is€0.7834 = $1.Thethree-monthforward rateofexchange is€0.7688
=
$1.Annualinterestratesforthreemonths’ borrowingin:Eurosis3%forinvesting indollars,
5%.
Required
(a) Advisethetreasurer
on:
(1) Whichofthetwomethods themostfinancially
advantageousforExpois;and
(2) Thefactors
toconsiderbeforedeciding
whethertohedgetheriskusingtheforeign
currencymarkets
Includerelevant
calculations
inyouradvice.
(b) Advisethetreasurer
onothermethodstohedgeexchange raterisk.
G
(Introductory
question) H
59 Yields (39 mins)

(a) Describewhata yieldcurveis.
(b) Explain
theextenttowhichtheshapeoftheyieldcurvedepends
onexpectations
aboutthe
future.
(Introductory
question)
542 Financial
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Further question
solutions
G H
Page 565 of 641

q
Section A questions (Q1-Q32) – 2 marks each
1 Thecorrect
answers
are:
True/False
1. Thefinancial
management
function
makes
decisions
relating
to True
finance.
2. Financial
accounts
areusedasa future
planning
tool. False
Statement
1istrueandStatement
2 isfalse.
Managementaccounts
areusedasa futureplanning
tool(notfinancial
accounts).
2 Thecorrect
answeris:Financial
management
decisions
include
dividend
decisions
Theotheroptions
areallincorrect.
3 Thecorrect
answeris:Localcommunity
Theotheroptions
areallconnected
stakeholders
because
theyhavea financial
connection
tothe
company.
4 Thecorrect
answers
are:
True/False
1. Ifa government
spends
morebyborrowing
more,
itwillraise True
2. Agovernment
canreduce
demand
inaneconomy
byraising True
G H
taxes.
Bothstatements
aretrue.
Ifa government
spendsmore,forexample,onpublicservices,
suchashospitals,
without
raising
moremoney intaxation,
itwillincreaseexpenditure
intheeconomy andraisedemand.
Agovernmentcanreducedemand intheeconomybyraisingtaxesorreducing
itsexpenditure.
5 Thecorrect
answers
are:
True/False
1. Tocreatejobsandgrowth,
theremustbeanincrease
in True
aggregatedemand.
2. Highinterest
ratesencourage
companies
tomakeinvestments. False
Statement
1istrueandStatement 2 isfalse.
Aggregate
demand isthetotalamount ofgoodsandservices
demanded intheeconomy
ata
givenoverall
pricelevelandina giventimeperiod.
Asitincreases,
morejobsarecreated
and
growthoccurs.
Statement
2 isfalse.Highinterest
ratesappear todetercompanies
frominvesting.
6 Thecorrect
answers
are:
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q
True/False
1. Raising
taxesorreducing
government
spending
isa contractionary
True
policy.
2. Fiscalpolicyseeks
toinfluence
theeconomy
bymanaging True
government spendingandtaxation.
Bothstatements aretrue.
Raising taxesorreducing governmentspendingaremethods
thatthegovernment
usestoreduce
‘Fiscalpolicy’isa termforthewaysinwhicha government
willattempt
tomanagetheeconomy
through taxation,spending,
andborrowing.
7 Thecorrect
answer
is:Moneymarket
derivatives
include
certificates
ofdeposits
andmoney
market
deposits
These
areinterest-bearing
instruments,
notderivatives.
8 Thecorrect
answeris:Shareholder
Ashareholder
isnota financial
intermediary
astheydonotactasa middleperson
connecting
borrowers
andsavers.Commercialbanks,
pensionfundsandfinance
housesareallfinancial
intermediaries.
9 Thecorrectanswersare:
• Swap
• Forward contract
Derivatives
include
forwards,
swaps,futures
andoptions.
Treasury
billsarediscount
instruments.
G H
Certificates
ofdeposit
areinterest-bearing
instruments.
10 Thecorrect
answer is:Increasing
creditgiventocustomers
Increasing
creditgiventocustomerswillincrease
thelevelofreceivables
andthiswilllengthen
the
working
capitalcycle.
11 Thecorrect
answers
are:
True/False
1. Arapidincrease
insalesrevenue
isa signofovertrading. True
2. Adecrease
inthevolume
ofcurrent
assetsisa signof False
overtrading.
Statement1istrue,Statement2 isfalse.
Symptoms ofovertradingincludea rapidincrease
insalesrevenue
andanincrease
(notdecrease)
inthevolume ofcurrent
assets.
12 Thecorrect
answers
are:
True/False
Working capitalisexcessive
ina company
thatisover- True1.
capitalised.
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Questions
545
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q
True/False
2. Aconservative
approach
toworking
capitalresults
inlargelevels True
ofinventory.
Bothstatementsaretrue.
Ifthereareexcessive
inventories,
receivables
andcash,andfewpayables, therewillbeanover
investmentbythecompany incurrent
assets.
Aconservative
approach results
inhighlevels
of
cashtiedupinexcessiveinventories
andreceivables,
andharms profits.
13 28%
Payment
willbemade30daysearly.
Number
ofcompounding periods
=365/30=12.167
( 1.00) 12.167
1+ r = = 1.279
0.98
∴r =27.9%
(28%tothenearest
whole
%)
14 $204,000
TheBaumolmodelapplies
here.Thisiseffectively
economic
order
quantity
applied
tocashdraw-
downs,
asfollows:
EOQ = 2 × Co× D = 2 × 250× 5,000,000
Ch 0.06
=$204,124
=$204,000tothenearest
$’000
G 15 Thecorrectanswers are: H
• Future costs
• Incrementalcosts
Adecisionisaboutthefuture,
therefore
relevant
costsarefuture
coststhatchangeasa resultofa
decision.
Coststhatchangeastheresult
ofa decision
areknown asincremental
costs.
Unavoidablecostsarenotaffected
bydecisions
andarethereforenot‘relevant’.
Sunkcostsarecoststhathavealready
beenincurredinthepastandaretherefore notrelevant
to
a future
decision.
16 Thecorrect
answers
are:
Relevant/ Non-relevant
1. Depreciation
ofthemachine Non-relevant
2. Pastresearch
intodifferent
typesofmachine Non-relevant
3. Annual
maintenance
costsforthemachine Relevant
Depreciation
isnota cashflowandsoisnotrelevant.
Pastresearch
intodifferent
typesofmachine isa sunkcostandtherefore
notrelevant.
Annualmaintenancecostswillbea future
incrementalcashflowandsoarerelevant.
17 Thecorrectansweris:Noneofthese
Statement1isnottrue.Paybacktendstofavour
short-term
projects
andtherefore
minimises
financial
andbusiness risk.
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Statement2 is not true. Itis simpleto understand.
Statement3 is not true. Paybackhelpsto identifythose projectswhichgenerate additionalcash
forinvestmentquickly.
18 12.5%
IRR=A+[(a/a - b) ×(B- A)]
=0.10+[(50/50- 30)×(0.01)]
=0.125
=12.5%
19 $16,800
Tax-allowabledepreciationinYear1=$100,000×25%=$25,000
TaxsavedinYear2 =$25,000×30%=$7,500
Reducingbalance of asset at beginningof Year2 =$100,000– $25,000=$75,000
∴ tax-allowabledepreciationinYear2 =$75,000×25%=$18,750
TaxsavedinYear2 =$18,750×30%=$5,625
Cash flows
$
Annualcash inflow 20,000
Taxon inflowat 30%* (6,000)
Taxsaved(Year1) 5,625
G H
Cash flowsafter tax 19,625

×8%discountfactor forYear2 ×0.857
PV 16,819
Or $16,800,to the nearest $100.
20 33%
NPV=-300,000 +600,000 – 100,000=200,000
Sensitivity=(NPV/PV
of projectvariable)%
=200/600 ×100%
=33%
21 Thecorrectansweris:$(582)
EVof Year1cash flow=0.2 ×$10,000+0.5 ×$7,000+0.3 ×$6,400=$7,420
EVof Year2 cash flow=0.2 ×$12,000+0.5 ×$8,000 +0.3 ×$7,200=$8,560
EVof Year3 cash flow=0.2 ×$9,000+0.5 ×$7,600+0.3 ×$6,200=$7,460
Year Cash flow Discountfactor PV
$ 10% $
0 (20,000) .000 (20,000.00)
1 7,420 0.909 6,744.78
2 8,560 0.826 7,070.56
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q
factor PV
$ 10% $
3 7,460 0.751 5,602.46
(582.20)
22 Thecorrect
answer
is:$12,812
Equivalent
netannualcost
Year Replace
everytwoyears
Cashflow PVat6%
$ $
0 (25,000) (25,000)
1 (5,000) (4,715)
2 7,000* 6,230
PVofcost (23,485)
÷CDF 1.833
Annualised
equivalent
cost (12,812)
*Resale
value– running
costs
Notesonincorrect
answers:
$23,485isthepresent
valueofthetwo-year
replacement
decision.
$43,048incorrectly
multiplies
thepresent
valuebytheannuity
factor.
G H
$20,095ignores
theresale
value.
23 $2.25
$
Fourcurrent
shareshaveanex-divvalueof(×$2.45) 9.80
Onenewshare– subscription
price$1.45 1.45
Theoretical
ex-rights
valueoffiveshares 11.25
Theoretical
ex-rights
pricepershare(/5) 2.25
24 Thecorrect
answers
are:
True/False
1. Sukuk
(debtfinance)
holders
havelittleinfluence
overtheactions
of False
theSukukmanager.
2. Under
a Musharaka
contract
(venturecapital),
profits
areshared True
between
partners
according
toratiosinthecontract.
3. AnIjaratransaction
istheIslamic
equivalent
ofa lease. True
OnlyStatements
2 and3 aretrue.
548 Financial
Management
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q
Statement (1)isfalse.TheSukuk
manager isresponsible
formanagingtheassetsonbehalfofthe
Sukuk holders andtheholdershavetherighttodismiss
themanageriftheyfeelitisappropriate.
Thisisdifferentfromtherelationship
between theholderofconventional
bondsandbondissuers.
25 Thecorrect
answers
are:
True/False
1. According
toModigliani
andMiller,
ina perfect
capitalmarket, True
shareholders
areindifferent
betweendividends
andcapitalgains.
2. Residual
theorystates
thatdividends
should
bepaidaheadof False
investing
inpositive
NPVprojects.
Statement1istrueandStatement2 isfalse.
M&M proposed thatthevalueofthecompany isdeterminedsolelybytheearning
powerofits
assetsandinvestmentsandthatshareholdersareindifferent
between dividends
andcapital
gains.
Residual
theory states
thata company should invest
inprojects
witha positive
NPV.Onlywhen
theseinvestmentopportunities
areexhausted shoulddividends
bepaid.
26 $8.00
Step1 Calculate
thedividendamount usingdividend
cover.
Dividend
cover= EPS/dividendpershare
∴ Dividend
pershare=EPS/dividend cover
=$1.50/5
G
=$0.30pershare H
Step2 Calculate
themarket pricepershareusingdividend
yield.
Dividend
yield=dividend pershare/ex-div
marketpricepershare
∴ Marketpricepershare=dividend pershare/dividend
yield
=$0.30/0.0375
=$8.00pershare
27 Thecorrect answeris:12.3%
E(r)=R +B(E(r) – R)
i f i m f
E(rm) – Rf=marketriskpremium= 7%
∴ E(r)=0.06+(0.9×0.07)
i
=0.123
=12.3%
Notes onincorrect
answers:
8.6%isobtained bymultiplying
12.3%by(1– t):rememberthereisnotaxreliefonequityfinance.
6.9%isobtained bymis-readingthemarket
premium of7%asbeingthemarket return.
6.3%isobtained byforgetting
toaddtherisk-freerate.
28 Thecorrect
answers
are:
True/False
Thetraditional
viewisthat,intheabsenceoftax,a company’s False1.
capitalstructure
would havenoimpact onitsweighted costofcapital
16:Practice
Questions
549
Page 571 of 641

q
True/False
(WACC).
2. Thenet operatingincomeapproach (MM)assumesthat debt is risk True
free.
Statement1is false.Statement2 is true.

Thetraditionalviewis that there is an optimalmixat whichthe averagecost of capital,weighted
accordingto the differentformsof capital employed,is minimised.
One of the assumptionsof the net operatingincomeapproach is that debt is risk-freeand freely
availableat the same cost to investorsand companiesalike.
29 9%
Thecost of equityis
d0(1+ g) + g
P0
∴ Cost of equity=[(30×1.03)/480]+0.03 =0.094=9%
True/False
1. Technicalanalysisis based on the theorythat share pricescan be False
derivedfroman analysisof futuredividends.
2. Underthe strongformhypothesisof marketefficiency,share False
G pricesreflectallavailableinformationabout past changes inthe H
share price.
Bothstatementsare false.
Technicalanalysisassumesthat past pricepatterns willbe repeated.
Underthe weakform(ratherthan strongform)hypothesisof marketefficiency,share prices
reflectallavailableinformationabout past changes inthe share price.
31 3.63Krone
Usinginterestrate parity, the expectedfutureexchangerate is givenby:
3.4670×(1.13/1.08)=3.6275(3.63to twodecimalplaces)
True/False
Transactionriskis the riskthat the organisationwillmakeexchange False1.
losseswhenthe accountingresultsof its foreignbranchesare shownin
the homecurrency.
2. Economicriskis the effect on the presentvalueof longer-termcash True
flows.
Statement1is falseand Statement2 is true.

Theriskthat the organisationwillmakeexchangelosseswhenthe accountingresultsof its foreign
branchesare showninthe homecurrencyis knownas translationrisk(nottransactionrisk).
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Section B questions (2 marks each)
33
33 (a) Thecorrectansweris:$13,000
Depreciationmustfirstbe added back to the annual profitfiguresto arriveat the annual
cash flows.
Depreciation=initialinvestment$46,000– scrap value$4,000/4 years =$10,500
Cash flowinYear4 =$4,000– $1,500+$10,500=$13,000
Noteson incorrectanswer:
$2,500ignoresthe need to add back depreciation.
$14,000resultsfroman incorrectdepreciationcalculation(ignoringscrap value).
$9,000ignoresthe scrap value(whichweare toldisreceivedat the end of year 4 ).
(b) 3.1 years
Depreciationmustfirstbe added back to the annual profitfiguresto arriveat the annual
cash flows.
Depreciation=initialinvestment$46,000– scrap value$4,000/4 years =$10,500
Adding$10,500per annumto the profitfiguresproducesthe cash flowsforthe proposal.
ProposalB
Annual Cumulative
Year cash flow cash flow
$ $
0 (46,000) 46,000)
G H
1 15,000 31,000
2 13,000 18,000)
3 15,000 (3,000)
4 25,000 22,000
4 4,000 26,000
ProposalB
Paybackperiod=3 +[(3,000/25,000)×1year]=3.1years
(c) 22.0 %
Thereturnon capital employed(ROCE)is calculatedusingthe accountingprofitsgiveninthe
question.
Averageinvestment= [(46,000+4,000)/2]=25,000
ProposalA
Averageprofit={$(6,500+3,500 +13,500– 1,500)/4]=$22,000/4 =$5,500
ROCEon averageinvestment= ($5,500/$25,000×100%=22%
(d) Thecorrectanswersare:
• Itreducesuncertainty
• Itmay lead to excessiveinvestmentinshort-termprojects
Becausepayback favoursshort-termprojects,it tends to minimisethe uncertaintyassociated
withprojects.Ifpayback is used, it may lead to excessiveinvestmentinshort-termprojectsas
it willfavourthose that payback the initialinvestmentquickly.
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q
Incorrect
answers:
Itisa measureusedbyexternal analysts.
ROCE(notpayback) isusedbyanalysts.
Itlooksattheentire
project
life.Paybackonlylooksattheperioduptothepaybackand
ignoresthecashflowsafterpayback.
(e) Thecorrectanswersare:
True/False
(1)Itcanbeusedtocompare
twoinvestment
options. True
(2) Ittakesaccount
ofthelength
ofa project. False
(3) Itignores
thetimevalueofmoney. True
(4) Itissubject
tothecompany’s
accounting
treatment. True
ROCEcanbeusedtocompare twoormoreinvestment
options.
Unlike
payback,ROCEtakes
noaccountofthelength
oftheproject.
BothpaybackandROCEignore thetimevalueof
money.ROCEisbasedonaccounting profits
andnotcashflows.
Accountingprofits
are
subject
toa numberofdifferent
accounting
treatments.
34
34(a) Thecorrect
34 answer
is:Debtwitha fixedcharge,
Mostexpensive:
Ordinary
shares
Inthecreditorhierarchy,
debtwitha fixedcharge(assecurity
ona specific
assetminimises
risk)isthecheapest
andordinary
shares arethemostexpensive (asthereturns
arethemost
uncertain).
(b) $ 150.10
G
Future
sharepriceaftersixyears=$11.20
× 1.05=$15.01
6 pershare. H
Conversion
valueofeachloannote=$15.01 ×10=$150.10perloannote.
(c) $ 153.55
Market
valueofeachloannote
=($7×8%annuity factorforsixyears)+($192.36
×8%timesixdiscount
factor)
=($7×4.623)+ ($192.36
×0.630)
=$32.36+$121.19
=$153.55
(d) Thecorrectanswer is:TheequitybetaofFlorrie
Coreflects systematic
andfinancial risk
Thecostofdebtisabovetherisk-freerate,sothedebtbetaisnotzero.
Theequitybetaof0.98means thatsystematicriskislower(nothigher)
thanforthemarket on
average.
Itisassumed thatunsystematic
risk(notsystematicrisk)canbediversified
away.
(e) Thecorrectanswers are:
• IfWACCisunderestimated, projectsmaybeaccepted thatdonotdelivera positive
NPV
• WACCassumes newinvestments
havethesameriskascurrent ones
Marketvalues (rather
thanbookvalues)shouldbeused.WACCassumes thelong-term
gearingwillnotchange.
35
35 (a) $ 1,000 million
Market
capitalisation
=number
ofshares
× market
value.
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=($50m/$0.5)
×$10.00=$1,000m
(b) Thecorrectanswer is:$155.37 million
Thenetrealisablevalueofassetsatliquidation=non-currentassets+ inventory
+trade
receivables
– currentliabilities
– loannotes.
=$215m +$10m+($11.3m × 90%)– $17.8m– $62.5m
=$155.37m
$168millionisbasedonthecurrent bookvalueofnetassetsandhasnotadjusted for
liquidation
value.
$248.3millionisbasedonthecurrent bookvalueofassets(ignoring
liabilities)
andhasnot
adjustedforliquidationvalue.
$235.67millionisbasedonthecurrent bookvalueofassetsadjustedforliquidation
valuebut
hasfailedtodeduct liabilities.
(c) $ 404.8 million
Historic
earningsbasedon20X4profitareaftertax=$25.3m
AverageP/Eratioinindustry
=16times
P/Eratiovalue=16×$25.3m =$404.8m
(d) 6.27 %
Historic
growthdividendrate=(15m/ 1/3
12.5m) - 1=0.0627=6.27%
(e) Thecorrectanswers are:
• Itcanbedifficulttofinda quotedcompany witha similar
rangeofactivities
G
• Asingleyear’sP/Eratiomaynotberepresentative H
Itcanbedifficult
tofinda quotedcompany witha similar
rangeofactivities
asquoted
companies areoftendiversified
acrossmanysectors.Asingleyear’sP/Eratiomaynotbea
goodbasisifearningsarevolatile
orthequoted company’ssharepriceisatanabnormal
level.
Notesonincorrectanswers:
TheP/Eratioisthereciprocalofearnings
yield,however
thisisnota problem withthe
method; thesamepointistrueabouttheP/Eratiocombining stockmarketinformationwith
corporateinformation.
36
36 (a) $ 105.5 million
Totaldividend
hasincreasedfrom$12,100,000
×0.36=$4,356,000to$12,700,000
×0.371=
$4,711,700.
Thisrepresents
a growth
of$4,711,700/$4,356,000
×100%=8.17%
Equitymarketvalueusingthedividend
growthmodelistherefore:
($4,711,700
×1.0817)/(0.13
– 0.0817)=$105,520,619
or$105.5m
(b) $ 138.0 million
Market
value=earnings/earnings
yield=$12,700,000/0.092
=$138.0m
(c) Thecorrect
answers
are:
True/False
1. TheEYMusesprofit
(rather
thancash)soisthepreferable False
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True/False
method
forDaisyCo.
2. Inanacquisition
context,
theEYMisusedtovaluea minority False
shareholding
ina targetcompany.
Bothstatements
arefalse.
Cash-flow
valuationmodels tendtobepreferred toprofit-based valuation
methods andso
theDGMwould bepreferred asitusescash.
Inanacquisition
context,theDGMvalues a minorityshareholdingina targetcompany,while
theearnings
yieldvaluationgivesa valuefromtheperspective oftheacquirer,provided
the
earnings
yieldusedisappropriate.
(d) Thecorrect
answer is:Tangibleassetslesscurrentliabilities/number
ofshares
Intangible
assetsshould beexcluded unless theyhavea market value(forexample,
copyrights,
whichcouldbesold).
(e) Thecorrect answer is:(1),(2)and(3)
Thenetassetbasiscanbeusedasa floorvaluefora business thatisupforsale.
Shareholders willbereluctant tosellforlessthanthenetassetvalue.
Asharemightbevalued usinganearnings basis.Thisvaluationmightbehigherorlower than
thenetassetvaluepershare. Iftheearnings basisishigher andthecompany wentinto
liquidation,
theinvestor couldnotexpect toreceive thefullvalueoftheirshares
whenthe
underlying assetswererealised. Theassetbacking thusprovidesa measureofthepossible
lossifthecompany failstomaketheexpected earnings ordividend payments.
Thenetassetbasiscanalsobeusedasa measure ofcomparison ina schemeofmerger. For
example, iftwocompanies havedifferent assetbackings thenonemightconsider thattheir
G
shares’valueshould reflectthis. H
37
37 (a) Thecorrect answeris:(2)only
RobinCoshould enterintoa forwardcontracttosell€800,000insixmonths.Thiswould
reduce theriskoftheeurovaluedropping relative
tothedollarbeforethe€800,000is
received.
Statement (1)isincorrect.
RobinCocouldusea money market
hedgebut€800,000would
havetobeborrowed, thenconverted intodollarsandthenplacedondeposit.
Statement (3)isincorrect.Aninterest
rateswap,swapsonetypeofinterest payment (suchas
fixedinterest)
foranother (suchasfloatingrateinterest).
Therefore,
itwouldnotbesuitable.
(b) $ 323,100
Future
value=€800,000/2.476
=$323,102
($323,100
tothenearest
$100)
(c) 3.5 %
RobinCoisexpecting a euroreceiptinsixmonths’
timeanditcanhedgethisreceipt inthe
money marketsbyborrowing eurostocreatea euroliability.
Euroborrowing
rateforsix
months=7.0%/2 = 3.5%.
(d) Thecorrect
answers are:
• Theyfixtheborrowing rateona sumofmoney foranagreed period
• Theyarearranged witha bankasanover-the-counter transaction
Incorrect
answers:
Theyallowcompanies tobenefitfromfavourableinterest
ratemovements.Acompany is
locked
intotheFRAborrowing rateandsoitcannot benefit fromfavourable
ratemovements.
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Theycanbeusedtohedgeagainst foreign
exchange
risk.FRAshedgeagainst
interest
rate
risk(although
theyaresimilar
toa forwardexchange
contractforcurrencies).
(e) Thecorrectanswersare:
True/False
1. Expectations
theory
provides
a reason
whytheinterest
yield False
curveisnormally
upwardsloping.
2. Market
segmentationtheory
statesthatinterest
ratesreflect False
expectations
offuture
changesininterest
rates
Bothstatements arefalse.
Itisliquidity
theory(notexpectations
theory)
whichprovides
a reason
whytheinterestyield
curveisnormallyupward sloping.
Expectationstheory(notmarketsegmentation
theory)
states
thatinterest
ratesreflect
expectationsoffuturechangesininterest
rates.
G H
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Section C style questions
38 Gustaffson
TopTips
Part (a)shouldbe fairlystraightforward.Part (b)shouldbe approached by usingyour
calculationsto determinewhetherovertradingexistsrather than justcalculatingrandom
ratios.Thismeans examiningthe short-termratiosincompanyfinance,as wellas sales
growth,profitmargins,liquidityratiosand workingcapital ratios.Donot be surprised,
however,ifnot allthe ratiosshowthe same results;here the companyis keepingup its
paymentscheduleto accounts payable despiteits otherproblems.
Part (b)concludesby highlightingthe mostimportantindicatorsof overtrading.Itis important
to do thisinan answerwhereyou havegivena lotof detail,as you need to pickout wherethe
greatest threats to the businesslie.Inthisquestion,the threats highlightedat the end of (b)will
be those forwhichremediesare identifiedin(c).
(a) ‘Overtrading’commonlyoccurswhena companyis expandingrapidly,and the termrefersto

the situationwherethe companybecomesover-relianton short-termfinanceto supportits
growingoperations.Thisis riskybecause short-termfinancemay be withdrawnrelatively
quicklyifaccounts payable loseconfidenceinthe business,or ifthere is a generaltightening
of creditinthe economy,and thismay resultina liquiditycrisisand evenbankruptcy,even
thoughthe firmis profitable.Thefundamentalsolutionto overtradingis to replaceshort-term
financewithlonger-termfinancesuch as termloansor equityfunds.
(b) (b) (i) Thecompanyhas becomesignificantlymorerelianton short-termliabilitiesto financeits
operationsas shownby the followinganalysis:
(b) 20X9 (b) 20X8
G
(b) (b) (b) H
(b) (b)
$’000 (b) (b)$
’000
(b)
(b) Totalassets (b) (b)
21,350 (b) (b)
14,900
(b) Short-termliabilities (b) (b)
8,700 (b)
40.7% (b)
5,000 33.6%
(b) Long-termfunds(equityan(b)d
debt) 12,650
(b) (b)
59.3% 9,900
(b) 66.4%
(b) (b) (b)
21,350 (b) (b)
14,900
Overtrading
Amajorreason forthisis classicovertrading:sales increasedby 50%inone year, but the
operatingprofitmarginfellfrom9,000/20,000=45%in20X8to 10,000/30,000=33%in
20X9.
Refinancing
However,the effect is compoundedby the repaymentof $2.3million(66%)of the 8%
loannotes and replacementwitha $2 millionbank overdraftand increasedtrade
creditorfinance.Althoughthismay be because the interestrate on the overdraftis
cheaper than on the loannotes,it is generallynot advisableinthe contextof the riskof
short-termdebt.
However,ifit is feltthat the currentsales volumeis abnormaland that, whenthe Polly
Playtimedollreaches the end of its productlifecycle,sales willstabiliseat a lowerlevel,
the use of shorter-termdebt is justified.
Liquidityratios
Asa resultof overtrading,the company’scurrentratio has deterioratedfrom
13,500/5000=2.7in20X8to 19,850/8700=2.28in20X9.Thequickassets ratio (or‘acid
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test’)hasdeteriorated from10,500/5,000 =2.1to12,500/8,700 =1.44.However, these
figures areacceptable andonlyiftheycontinue todeteriorate istherelikelytobea
liquidityproblem. Inthe20X9accounts, thecompany continues tohavea healthy bank
balance, although thishasbeenachieved partlybyhalting dividend growth.
Investment innon-current assets
Thecompany hasnotmaintained aninvestment innon-current assetstomatchitssales
growth. Sales/non-current assetshaveincreased from20,000/1,400 =14.3times to
30,000/1,500 =20times. Thismaybeputting thequality ofproduction atrisk,butmay
bejustified, however, ifsalesareexpected todecline whenthedolllosespopularity.
Working capitalratios
Aninvestigation ofworking capitalratiosshows that:
(1) Inventory turnover hasdecreased from11,000/3,000 =3.67times to20,000/7,350 =
2.72times. Thisindicates thattherehasbeena largeinvestment ininventory. The
question ofwhether thisisjustified
againdepends onexpected future sales,butthe
strategy appears tobetheopposite ofthatadopted fornon-current assets.
(2) Theaverage accounts receivablepayment period hasincreased from
6,000/20,000 × 365=110daysto10,000/30,000 ×365=122days,indicating a lack
ofcreditcontrol. Thishascontributed toa weakening ofthecashposition. There
appears tobenoevidence ofprompt payment discountstoaccounts receivable.
(3) Thepayment period toaccounts payable(roughly estimated)hasdecreased from
2,500/11,000 ×365=83daysto4,200/20,000 ×365=77days.Thisresult is
unexpected, indicating thattherehasbeennoincrease indelaying payment to
accounts payable overtheyear.Suppliers arebeingpaidina significantly shorter
period thantheperiod ofcredittaken bycustomers.
(4) Thesales/net working capitalratiohasincreased from20,000/8,500 = 2.35times to
30,000/11,150 =2.69times. Thisindicates thatworking capitalhasnotincreased in
G
linewithsalesandthismayindicate future liquidityproblems. H
Conclusion
Insummary, themainproblem facingGustaffson isitsincreasingoverdependence on
short-term finance, caused inthemainby:
• Amajor investment ininventory tosatisfya rapidincrease insalesvolumes
• Deteriorating profit margins
• Poorcreditcontrol ofaccounts receivable
• Repayment ofbondcapital
(ii) Future sales
Possible solutions totheaboveproblems depend onfuture salesandproduct
projections. Iftherapidincrease insaleshasbeena one-product phenomenon, thereis
littlepointinover-capitalising byborrowing long-term andinvesting ina major expansion
ofnon-current assets.If,however, salesofthisandfuture products areexpected to
continue increasing, andfurther investment isneeded, thecompany’s growth should be
underpinned byaninjection ofequitycapitalandanissueoflonger-term debt.
Better working capitalmanagement
Regardless oftheabove, various working capitalstrategies couldbeimproved. Credit
customers should beencouraged topaymorepromptly. Thisisbestdonebyinstituting
proper creditcontrol procedures. Longer creditperiods couldprobably benegotiated
withaccounts payable andquantity discounts should beinvestigated.
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39 H Finance
TopTips
Whenanalysinga working capitalpolicy,itissensible
tolayoutthecostsandbenefitsclearly
andtostateanyassumptions thatyouhavemade.
Toadequately
answer (b),youneeded tobringoutbenefits indifferent
areas(factoring
asa
source
offinance,useoffactorsasmeans ofimproving
working capitalmanagementand
decreasing
administration
timeandcosts.) Asfarastheeffectontheaccounts isconcerned,
thegearing
pointissignificant
butnotetheuncertain effectonreturn
oncapitalemployed.
(a) Assumingthatthehistorical
datapresented
isa reasonable
guidetowhatwillhappeninthe
future,
wecanusesomeapproximate calculations
toassesswhether
thefactoring
ofthe
debtswouldbeworthwhileasfollows.
The20Y0figuresareassumed belowtobetypical.
Cost $000s Benefit $000s
(1)Costoffundsadvanced 4,442 (2)Savedadministration
costs 80
(2)Administration
costs 444 (3)Possible
savings
inbaddebts 615
(3)Lostprofits 1,777 (1)Savedfinance
costs 3,909
Total 6,663 Total 4,604
Costexceeds benefit
sousingthefactorwould notbeworthwhile.
(1) Costoffinance
Thecostofthefinance providedbythefactoris5%ofsales,since80%andthena further
15%isremitted bythefactor.Ifsalesare10%lower duetotheaggressive collection
procedures,thisis0.05×98,714 × 0.9=4,442.
Assuming that80%ofreceivables willbefactored, andthatthesewillbelower inthefuture
G H
because ofthelostsalesof0.22×98,714 × 0.9=19,545,thiswillsavethefinance cost

associatedwiththesereceivables of19,545 × 0.2=3,909.
Note.IfDCowasusinganoverdraft, therewould alsobeaninterest savingonthereduction
intheoverdraftfromusingthereduced receivablestoreduce theoverdraft.
(2) Administrationcosts
Inaddition,therewould beadministration costsof0.5%×98.7m ×0.9=444.Thisamounts to
considerably morethantheamount of$80,000savedinDCo’sownadministration costs.
(3) Baddebts
There maybesomesavingthrough a reduction inbaddebts,whichin20Y0amounted to615
whichis0.6%ofrevenue. However, thereisagainst thisa lossofcontribution
amounting to
18%×10%×98,714 = 1,777asa resultofthefactor’s aggressivecollection
procedures.
(b) Aspects offactoring
Thethreemainaspects offactoring areasfollows.
(1) Administrationoftheclient’s
invoicing, salesaccounting anddebtcollectionservice
(2) Creditprotectionfortheclient’sdebts,whereby thefactortakesovertheriskoflossfrom
baddebtsandso‘insures’ theclientagainst suchlosses. Thisservice
isalsoreferredtoas
‘debtunderwriting’orthe‘purchase ofa client’sdebts’.
Thefactorusuallypurchases
thesedebts‘without recourse’totheclient,whichmeans thatintheeventthatthe
client’s
accountsreceivableunable topaywhattheyowe,thefactorwillnotaskforhis
money backfromtheclient.
(3) Making payments totheclientinadvance ofcollectingthedebts.Thismightbereferred
toas‘factorfinance’because thefactorisproviding cashtotheclientagainst
outstanding debts.
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Benefits
offactoring
Thebenefits offactoring fora business customer includethefollowing.
(1) Thebusiness canpayitssuppliers promptly, andsocantakeadvantage ofanyearly
payment discounts thatareavailable.
(2) Optimum inventory levelscanbemaintained, because thebusiness willhaveenough
cashtopayfortheinventories itneeds.
(3) Growth canbefinanced through salesrather thanbyinjecting freshexternal capital.
(4) Thebusiness getsfinance linkedtoitsvolume ofsales.Incontrast, overdraftlimitstend
tobedetermined byhistorical statements offinancialposition.
(5) Themanagers ofthebusiness donothavetospendtheirtimeontheproblems ofslow-
payingaccounts receivable.
(6) Thebusiness doesnotincurthecostsofrunning itsownsalesledgerdepartment.
Effectonaccounts
Factoringofsalesinvoicing leadstoa reduction ofaccounts receivable andtherefore of
assetsemployed inthebusiness, accompanied bya reduction inprofitasa result ofthecosts
involved.
Partofthese‘costs’aregenerally reflected inthefactthatlessthan100%ofthe
debtispaidtothecompany bythefactor. Theeffectonthereturn oncapitalemployed will
depend uponthecostoffactoring andthelevelofprofits withoutfactoring relative toassets
employed.
Sincetheyreduce assets,thefundsadvanced bythefactordonotshowupasborrowings in
thestatement offinancial position.
Theapparent gearing willtherefore improve. Factoringis
attractive
tosomecompanies asa method ofavoiding borrowing limitsorcovenants being
breached.Itprovides a means offinancingaccounts receivable,whichareotherwise
unsuitableforsecured lending because oftheirvolatility.
Disadvantages offactoring
G
Themaindisadvantage offactoring isthatitisa relativelyexpensive formoffinance H
compared toloanfinance. Somebusinesses willalsofinditundesirable forcustomer relations

iftheadministration ofdebtcollection ispassed toa thirdparty.
40 Victory
(a) Usingtheeconomic
order
quantity
(EOQ)model:
EOQ = 2CoD
Ch
Where: C0=costofmaking oneorder= $75
D=annual demand = 200×52=10,400
Ch=holding costperunitperannum =$2
Q=883.2units
Theeconomic orderquantity
istherefore
883units(tothenearest
unit).
(1) Demand isfixedat200bottlesperweek,
anddeliveryfromthesupplier
takestwoweeks.
Victory
mustthereforereorder
wheninventoryfallsto400units(twoweeks
demand).
(2) ThetotalcostofstockingBuzzforoneyearwillbe:
$
Purchase
cost
10,400units$20each 208,000
Ordering
cost
Annual
demand
(units) 10,400
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$
Ordersize(units) 883
Numberof ordersper year 11.78
Cost of placingone order $75
Annualorderingcost 883
Holdingcost
Averageinventory(883/2) 441.5
Holdingcost per unitp.a. $2
Annualholdingcost 883
Totalannual cost 209,766
(b) Thefactorsforthe newsupplierare as follows:
C0=$250
D= 10,400
Ch=$1.80
EOQ = 2 × 250× 10,400
1.80
=1,699.7
Theeconomicorderquantityis therefore1,700units(tothe nearest unit).
Todeterminewhetherit isfinanciallyviableto change supplierwemustcalculatethe total
annual cost of orderingfromthissupplierand to comparethiswiththe existingannual cost.
G H
$
Purchasecost
10,400units$19each 197,600
Orderingcost
Annualdemand (units) 10,400
Ordersize(units) 1,700
Numberof ordersper year 6.12
Cost of placingone order $250
Annualorderingcost 1,530
Holdingcost
Averageinventory(1,700/2) 850
Holdingcost per unitp.a. $1.80
Annualholdingcost 1,530
Totalannual cost 200,660
Thisis $9,106lessthan the existingannual purchasingcost, and thereforeit wouldbe
financiallybeneficialto switchsuppliers.
Limitationsof the calculationsincludethe following:
(1) Demandis assumed to be the same throughoutthe year. Inpractice,there are likelyto
be variations.
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(2) It is assumed that the lead-timeis constant and that the suppliersare both completely
dependable.
(3) It is assumed that purchase costs are constant. Inpractice,it is necessaryto allowfor
the effectsof differingdiscountand creditpolicies.
Non-financialfactorsto be consideredinclude:
(1) Qualitymustbe consistentand reliablefromboth suppliers.
(2) Packagingdifferencesmustbe acceptable, and the productfromboth suppliersmustbe
equallyattractiveto consumers.
(3) Flexibility.Bothsuppliersmustbe able to respondquicklyand efficientlyto variationsin
the levelof demand.
(4) Environmentaleffects. Victorymustensurethat the suppliers’productionfacilitiesmeet
any agreed environmentalstandards that the companyrequires.
(c) Just-in-time(JIT)manufacturinginvolvesobtaininggoodsfromsuppliersat the latest
possibletime(iewhenthey are needed on the productionline),therebyavoidingthe need to
carry any materialsor componentsinventory.Reducedinventorylevelsmean that a lower
levelof investmentin workingcapital willbe required.Incertainenvironmentswherethe cost
of a stock-outis high,JITis inappropriate,eg ina hospital,the cost of a stock-outforcertain
itemscouldbe fatal.
Themainfeaturesof a JITsystemincludethe following:
(1) Deliverieswillbe smalland frequent,rather than inbulk.Productionruns willalso be
shorter.
(2) Supplierrelationshipsmustbe close,sincehighdemandswillbe placed on suppliersto
deliveron timeand with100%quality.
(3) Unitpurchasingpricesmay need to be higherthan ina conventionalsystemto
compensatesuppliersfortheirneed to holdhigherinventoriesand to meet morerigorous
G
qualityand deliveryrequirements.However,savingsinproductioncosts and reductions H
inworkingcapital shouldoffsetthese costs.

(4) Improvedlabourproductivityshouldresultfroma smootherflowof materialsthrough
the process.
(5) Productionprocess improvementsmay be requiredfora JITsystemto functionto full
effectiveness.Inparticular,set-up timeformachinerymay haveto be reduced,
workforceteams reorganised,and movementof materialswithinthe productionprocess
minimised.
41 ZX
TopTips
Thekeypointto
emphasiseisthat holdingtoo muchworkingcapital is expensivewhereas
holdingtoo littlecan resultinsystembreakdown.However,modernmanufacturingtechniques
and re engineeringof businessprocessescan helpachievethe best of both worlds:low
workingcapital and efficientproductionand sales systems.
In(b),you need to showthe effectson assets and liabilities,sales and profits,and current
ratiosand returnon assets to scoremaximummarks.In(c),a coupleof marksare available
specificallyfora recommendation,withthe remainingmarksbeingavailableforthe effect on
variousstakeholders(staff,customersand suppliers)and possibledisadvantages.
(a) Reportas follows:

To: FinanceDirector
From: FinancialManager
Date: 4 December20X1
Page 583 of 641

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Subject:Working capitalpolicy
Conservative working capitalpolicy
Aconservative policy,suchasweadoptatpresent, aimstoreduce theriskofsystem
breakdown byholding highlevels ofworking capital.Thus,customers areallowed
generous payment terms tostimulate demand, inventory offinished goodsishighto
ensureavailability
forcustomers, andrawmaterials andWIParehightominimise therisk
ofrunning outofinventory andconsequent downtime inthemanufacturing process.
Suppliersarepaidpromptly toensure theirgoodwill,
againtominimise thechanceof
stock-outs.
Aggressiveworking capitalpolicy
Anaggressive working capitalinvestment policyaimstoreduce thisfinancingcostand
increase
profitabilitybycuttinginventory, speedingupcollections fromcustomers, and
delayingpayments tosuppliers. Thepotentialdisadvantage ofthispolicyisanincrease in
thechances ofsystem breakdown through running
outofinventory orlossofgoodwill
withcustomers andsuppliers. However, modern manufacturing techniquesencourage
inventoryandworkinprogress reductionsthroughJIT policies,flexibleproduction
facilities
andimproved qualitymanagement. Improvedcustomer satisfactionthroughqualityand
effective
responsetocustomer demand canalsoenable theshortening ofcreditperiods.
Ourmodern production facilitygivesthecompany thepotential toimplement radical
new
management techniques,including thosementioned above, andtomove alongthe
workingcapitalpolicyspectrum towards a moreaggressive stance.
(b) Ratioanalysis
Conservative
Policy: (present) Change Moderate Change Aggressive
$’000 % $’000 % $’000
Receivables 2,500 –20 2,000 –30 ,750
G H
Inventory 2,000 –20 1,600 –30 ,400

Cashatbank 500 250 00
Current
assets 5,000 3,850 3,250
Current
liabilities (1,850) 10 (2,035) 20 2,220)
Netcurrent
assets 3,150 1,815 1,030
Non-current
assets 1,250 1,250 ,250
Netassets 4,400 3,065 2,280
Forecast
sales 8,000 2 8,160 4 8,320
Operatingprofit
margin 18% 18% 18%
Forecast
operating
profit 1,440 1,469 1,498
Return
onnetassets 33% 48% 66%
Current
ratio 2.70 1.89 1.46
Return on net assets = operating

profit
netassets
Note.There
isnologicalreason whysalesshouldincrease
asa result
ofa moreaggressive
workingcapitalpolicy.Thereasoning
behindthisassumption
isunclear.
(c) Recommended course ofaction
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Theconclusion tobedrawn fromthefigures in(b)isthatsubstantialfundscanbereleased
bymoving froma conservative toanaggressive working capitalposition($4.40m – $2.28m =
$2.12m).These fundscouldberepaidtoshareholders, invested orusedtoreduce borrowings
depending onthecompany’s situation.
Moderate working capitalposition
Myfirstrecommendation isthatthecompany shouldattempt tomove towards a moderate
workingcapitalposition bytightening upitsdebtcollectionprocedures, buyinginventory in
smallerbatches andnegotiating longercreditperiods fromsuppliers.Oursmallsizedoesnot
helpusinthisrespect but,ifachievable,thiswould resultina significant
increase inreturnon
netassetsandanacceptable currentratio.
Useofmodern techniques
However,further moves towards moreaggressiveworking capitalarrangements should bethe
outcome rather thanthedriver ofpolicychanges. Thekeychanges thatneedtobemadein
ourfirmareconcerned withtheadoption ofmodern supplychainandmanufacturing
techniques.These willenable usnotonlytoreduce working capitalwhileavoiding system
breakdown butalsotoimprove qualityandflexibility
andtoincrease customer demand. At
themoment, wehavemodern equipment butarenottakingfulladvantage ofitspotential.It
is,therefore,
recommend thata comprehensive studyofourkeybusiness processes is
undertaken.I willbehappytoevaluate thefinancialeffectsofthepossible scenarios.
42 Velm Co
TopTips
There
isnotmuchtocalculateheresojustmakesureyouknowyourreceivabledaysformula,
andthinkabouttherelationship
between receivables
andcashflow.
Mostofthemarks onthisquestion
arefora discussion
ofworking
capitalinoneformor
another.
So,thinkaboutsources
offinanceandpolicies
formanagingworkingcapital.
G H
(a) Receivablesarecurrently
takingonaverage ($550,000/$4,000,000)×365=50daystopay.
ThisisinexcessofVelm’s
statedterms.Thediscount,tobetakenupby2/3ofcustomers, will
costthecompany $4,000,000× 1%×2/3=$26,667. Itisstatedthatthiswillbringthe
receivables’
payment perioddownto26days,whichisrepresented bya newreceivables level
of$4,000,000 × 26/365=$284,932.Thisisa reduction
inreceivables
of$265,068. Atcurrent
overdraftcostsof9%,thiswouldbea savingof$265,068 × 0.09=$23,856.
Baddebtswould decreasefrom3%to2.4%ofrevenue, whichsavesa totalof$4,000,000 ×
0.006=$24,000.There would alsobea salarysavingfromearlyretirement of$12,000.
Assuch,theneteffectonVelm’s profitability
isasfollows:
$
Savingonoverdraft
costs 23,856
Decreasedbaddebts 24,000
Salarysaving 12,000
Less:costofdiscount (26,667)
Netsaving 33,189
(b) Short-term
sources
offinanceinclude
overdraftsandshort-termloans.Long-term
sourcesof
financeincludeloannotesandlong-term loans.Thechoiceisbetweencheaperbutriskier
shorttermfinance andmoreexpensivebutlessriskylong-termdebt.A customer
mightask
thebankfora short-term overdraft
facilitywhenthebankwould wishtosuggesta loan
instead;alternatively,
a customermightaskfora loanwhenanoverdraft wouldbemore
appropriate.
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q
Inmostcases,whena customer wants finance tohelpwith‘day-to-day’ trading andcash
flowneeds, anoverdraft would betheappropriate method offinancing. Thecustomer should
notbeshortofcashallthetime,andshould expect tobeincreditonsomedays,butinneed
ofanoverdraft onothers.
Whena customer wants toborrow froma bankforonlya shortperiod oftime,evenforthe
purchase ofa major non-current assetsuchasanitemofplantormachinery, anoverdraft
facilitymightbemoresuitable thana loan,because thecustomer willstoppayinginterest as
soonashisaccount goesintocredit.
However, whena customer wants toborrow froma bank,butcannot seehiswaytorepaying
thebankexcept overthecourse ofa fewyears,therequired financing isbestcatered forby
theprovision ofa loanrather thananoverdraft facility.
Advantages ofanoverdraft overa loan
(1) Thecustomer onlypaysinterest whentheyareoverdrawn.
(2) Thebankhastheflexibility toreview thecustomer’s overdraft facilityperiodically, and
perhaps agreetoadditional facilities,
orinsistona reduction inthefacility.
(3) Anoverdraft candothesamejobasa loan:a facilitycansimply berenewed everytime
itcomes upforreview.
(4) Beingshort-term debt,anoverdraft willnotaffectthecalculation ofa company’s
gearing.
Bearinmind,however, thatoverdrafts aretechnically repayable ondemand, soeventhough
theyarecheaper thanlonger-term sources ofdebtfinance, theyareriskier.
Advantages ofa long-term loan
(1) Boththecustomer andthebankknowexactly whattherepayments oftheloanwillbe
andhowmuchinterest ispayable, andwhen. Thismakes planning (budgeting) simpler.
(2) Thecustomer doesnothavetoworry aboutthebankdeciding toreduce orwithdraw an
G overdraft facilitybefore theyareina position torepaywhatisowed. There isanelement H
of‘security’or‘peaceofmind’inbeingabletoarrange a loanforanagreed term.

However, long-term finance isgenerally moreexpensive thanshort-term finance.
(3) Loansnormally carrya facilityletter settingouttheprecise terms oftheagreement.
Working capitalpolicies canbecharacterised asconservative, moderate andaggressive. A
conservative policywould finance working capitalneedsprimarily fromlong-term sources of
finance, soalllong-term assetsandsomefluctuating currentassets. However, VelmCois
following anaggressive financing policyaslong-term debtonlymakes up2.75%(40/1,450) of
non-cash currentassetsandmostfinance isprovided byshort-term debt($1,530k).

(c) Asa general rule,assetswhichyieldprofits overa longperiod oftimeshould befinanced by
longtermfunds. Thisisanapplication ofthematching principle.
Inthisway,thereturns madebytheassetwillbesufficient topayeither theinterest costof
theloansraised tobuyit,ordividends onitsequityfunding.
If,however a long-term assetisfinanced byshort-term funds,thecompany cannot be
certain thatwhentheloanbecomes repayable, itwillhaveenough cash(fromprofits) to
repayit.
Under a moderate ormatching approach, a company would normally finance short-term
assetspartlywithshort-term funding andpartlywithlong-term funding. However, Velm
appears tobeconducting anaggressive financing policy,asshort-term finance isbeingused
formostofitscurrent assets. Thisisa higher risksource offinance.
43 Knuckle Down
TopTips
Anexamquestionwould
notconsist
purely
ofcalculations.
Itwould
alsomostlikelyinclude
discussion
ofthebenefits
anddrawbacksoftheNPVandIRRmethods.
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q
Thisquestion neverthelessdoesgiveyoulotsofpractice inthetechniques andhighlights
common traps.Depreciationisnota cashflowandshould beeliminated. Ifyouhavetodeal
withworking capital,youneedtoreadthequestion verycarefully.InC theincrease inworking
capitalfrom$15,000 to$21,000 attheendofYear1isanincrease ofthedifferencebetween
thefigures ($6,000)attheendofYear1.Thequestion alsotellsyouthattheworking capital
investment willberecovered,sothatfigureultimatelyhastobeincluded asa receipt.
Thequestion alsorequiresyoutocalculateannuitiesandperpetuities,anddealwithcash
flowsthatareconstant overa number ofyearsbutdonotstartatYear1.Thetreatment ofthe
discount ratemayhavecaughtyououtifyoudidnotreadthequestion carefully.
Thediscount
rateof15%should beusedthroughout thedurationofallprojectslastingmorethantenyears,
andnotjustfromyear10onwards.
YoucanusetheNPVcalculations forAandC asthefirstratesintheIRRestimation process.
ThefactthattheNPVforC wasrather largerthanAindicates thatyoushould trya different
second rate.Themainthingistopicktwohigher ratesastheNPVswerepositive; youwould
getequalcreditifyouhadchosen anyrateinthe15%– 20%bandforyoursecond IRR
calculation.(Below15%would probably bea bittooneartothe12%,however youwould be
unlikelytobepenalised veryheavily
forusing13%or14%.)
(a) Project
comparison
(1) Project
A
factor12% Present
value
$ $
0 (29,000) 1.000 (29,000)
1 8,000 0.893 7,144
2 12,000 0.797 9,564
3 10,000 0.712 7,120
G H
4 11,000 0.636 6,996

Netpresent
value=1,824
(2) Project
B
Discount
Working Cash Netcash factor Present
capital profit flow 12% value
$ $ $ $ $
(44,000)0 (20,000) (64,000) 1.000 (64,000)
1 19,000 19,000 0.893 16,967
2 24,000 24,000 0.797 19,128
3 5,000 20,000 10,000 35,000 0.712 24,920
Netpresent
value=(2,985)
(3) Project
C
Working Cash Netcash Discount Present
capital profit flow factor12% value
$ $ $ $ $
(50,000)0 (15,000) (65,000) 1.000 (65,000)
1 (6,000) (6,000) 0.893 (5,358)
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Working Cash Netcash Discount Present
capital profit flow factor12% value
1– 5 18,000 18,000 3.605 64,890
5 21,000 21,000 0.567 11,907
Netpresent
value=6,439
(4) Project
D
factor12% Present
value
$ $
0 (20,000) 1.000 (20,000)
1 (20,000) 0.893 (17,860)
2 15,000 0.797 11,955
3 12,000 0.712 8,544
4– 8 8,000 2.566 20,528
Netpresent
value=3,167
Discount
factorat12%,Years
1to8 4.968
Lessdiscount
factorat12%,Years
1to3 2.402
Discount
factorat12%,Years
4 to8 2.566
(5) Project
E
G
Thecumulative
discount
factorfora perpetuity
at15%is1/0.15
= 6.667. H

factor15% Present
value
$ $
0 (32,000) 1.000 (32,000)
1– 4,500 6.667
Netpresent
value=(2,000)
(6) Project
F
$
1 Present
value(at15%)of$3,000a yearfromYear1inperpetuity 20,000
Lesspresent
valueof$3,000a yearforYears
1to10(×5.019) 15,057
Present
valueof$3,000a yearfromYear11inperpetuity 4,943
2 Discount
factorat15%,Years
1to10 5.019
Lessdiscount
factorat15%,Years
1to5 3.352
Discount
factorat15%,Years
6 to10 1.667
3 Year Netcashflow Discount

factor15% Present
value
$ $
0 (20,000) .000 (20,000)
1– 5 5,000 3.352 16,760
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3 Year Netcashflow Discount
factor15% Present
value
$ $
6 – 10 4,000 1.667 6,668
11– 3,000 Seeabove 4,943
Netpresent
value=8,371
(7) Projects
A,C, DandF havepositive
netpresent
valuesandshould
beundertaken.
Projects
BandE shouldnotbeundertaken.
(b) IRRofprojects
(1) CBEexamapproach tocalculate
theIRRofProject
A
A B C D E F
Time 0 1 2 3 4
2 CF -90 33 25 21 42
3 IRR =IRR(B2:F2)
Thespreadsheet
solution
incellB3is14.8%
(2) CBEexamapproachtocalculatetheIRRofProject
C
A B C D E F G
Time 0 1 2 3 4 5
2 CF -65 12 18 18 8 39
3 IRR =IRR(B2:G2)
G H
Thespreadsheetsolution
incellB3is15.3%
(3) TheIRR,r,ofProject
E isfoundasfollows:
PVofcost = PVofbenefits
(32,000) = 4,500
r
r=0.141
IRR=14.1%
44 Mezen
TopTips
In(a),ifyoufailedtoidentify
whichcostswererelevant
correctly,
makesureyouunderstand
why.Part(c)makes theimportantpointaboutsensitivity
ofcashflows.
Evenifa project
hasa
positiveNPV,oranacceptable IRR,a companymaynotgoaheadiftheprofitsarefelttobe
toomarginal,andtheriskoflosstoogreat.
(a) Incremental
cashflows
Thesurvey
hasbeenundertaken already,eventhoughithasnotyetbeenpaidfor,and
therefore
the$30,000isa sunkcost.
Thedepreciation
chargeof$15,000 isnota cash-flow.
There-allocated
fixedoverheads
will
beincurred
whetherorMezengoesaheadwiththeproduct. Bothoftheseamountsmaybe
subtracted
fromthe$25,000offixedoverheads intheoriginal
calculations.
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Thecompany
forgoes
$70,000ofimmediate
income
fromthesaleofthemachine.
Time0 Time1 Time2 Time3 Time4 NPV
$’000 $’000 $’000 $’000 $’000 $’000
Sales 180 200 160 20
Costofsales (115) (140) (110) 85)
Variable
overheads (27) (30) (24) 18)
Fixedoverheads (5) (5) (5) (5)
Machine (70) 10
Working
capital (20) – – – 20
Incremental
cashflows (90) 33 25 21 42
×10%discount
factor 1.00 0.909 0.826 0.751 0.683
Present
value (90.00) 30.00 20.65 15.77 28.69 5.11
(b) CBEexamapproach
tocalculate
theIRR
A B C D E F
Time 0 1 2 3 4
2 CF -90 33 25 21 42
3 IRR =IRR(B2:F2)
Thespreadsheet solution
incellB3is12.5%
(c) Theproduct hasa positivenetpresent
valueandanIRRthatexceeds thecompany’s costof
G H
capital,andthissuggeststhatitshouldbelaunched.
Thedecisionisverymarginal, however.
Itwould
certainly
notbeworthwhile ifthemarket
surveyhadnotyetbeencommissioned, inwhichcasethecostof$30,000would needtobe
included.Arelatively
smalldropinsalesora smallincreaseincostswouldresult
ina negative
NPV.Thecompany maywellbeabletofindbetter usesforthe$20,000thatwillbespent
now,andfortheimmediate incomeof$70,000onthesaleofthemachine.
45 Auriga
(a) Netpresent
value
Time
0 1 2 3 4
$’000 $’000 $’000 $’000 $’000
Machinery (300.00)
Advertising (50.00) (50.00) (50.00) (50.00)
Sales($22×15,000) 330.00 330.00 330.00 330.00
Materials
(W1) (112.50) (112.50) (112.50) (112.50)
Labour
($5.50×15,000) (82.50) (82.50) (82.50) (82.50)
Redundancy
costsaving 230.00
Overheads
(W2) – (52.50) (52.50) (52.50) (52.50)
Netcashflow (70.00) 32.50 32.50 32.50 32.50
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Time
0 1 2 3 4
$’000 $’000 $’000 $’000 $’000
Discount
factor@ 10% 1.00 0.91 0.83 0.75 0.68
Present
value (70.00) 29.60 27.00 24.40 22.10
Netpresent
value 33.10
Workings
1 Asfollows:
$
Costperunit
Without
polymer
(6.50– 2.0) 4.50
Replacement
cost(2×$1.50) 3.00
7.50
2 Asfollows:
$
Totaloverheads
($8.50×15,000) 127,500
Depreciation
(300,000/4) (75,000)
Cashflow (52,500)
G H
(b) X=annual netcashflowfromoperations

Projectbecomesunattractive
whenNPViszero,iewhere netpresent
valueofannual
cash
flowsisequaltotheinitial
cashoutflow of$70,000.
(X×4 yearannuityfactor)=$70,000
X×(0.91+0.83+0.75+0.68)=$70,000
3.17X
= $70,000
X=$22,082
Therefore,
ifthenetcashflowsreduce from$32,500perannum to$22,082perannumthe
netpresentvaluewillbezero.Thisisa reduction
of$10,418.
46 Bridgeford
(a) NPVcalculations
Itisassumedthattheaftertaxnominalweighted average
costofcapitalistheappropriate
costofcapitaltouse,althoughthemethodoffinancing
impliedinthemanaging director’s
estimates
ofinterest
charges fortheproject
raises
questions
aboutwhatthemost
appropriate
costofcapitalshouldbe.
Year 0 1 2 3 4 5 6
$’000 $’000 $’000 $’000 $’000 $’000 $’000
Sales(W1) 2,625 3,308 4,052 4,254 3,829
Operating
costs
(W2) – (1,690) (2,201) (2,801) (3,061) (3,024) –
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Year 0 1 2 3 4 5 6
$’000 $’000 $’000 $’000 $’000 $’000 $’000
Contribution 935 1,107 1,251 1,193 805
Tax@35% (327) (387) (438) 418) (282)
Capitalexpenditure(2,000)
Working
capital(W3) (200) (75) (88) (103) (46) 512
Taxbenefit
oftax
depreciation
(W4) – – 175 131 98 74 222
Netcashflow (2,200) 860 867 892 807 973 (60)
Discount
factor@
1.000 0.893 0.797 0.712 0.636 0.567 0.50712%
Present
value (2,200) 768 691 635 513 552 30)
NPV 929
Itisassumedthatworking
capitalasattheendofYear5 willallberecovered,
givinga total
netcashinflowof$512,000.
TheNPVispositive,
+$929,000,
andsotheprojectshouldbeundertaken.
Workings
1 Sales
Salesintime1are2500butthisneedstobeadjusted
by1yearofinflationso2500×1.05
=2,625
Salesintime2 are3000butthisneedstobeadjusted
by2 yearsofinflation
so3000×
1.05×1.05=3,308
G H
Theothertimeperiodsareadjusted
inthesameway.
2 Operatingcosts
Asfollows:
Year 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000
Materials
costs 550 726 932 1,025 966
Labour
costs 825 1,089 1,464 1,611 1,611
Overhead
costs 315 386 405 425 447
Totaloperating
costs 1,690 2,201 2,801 3,061 3,024
3 Workingcapital
Asfollows:
Year 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000
Totalinvestment
inworking
capital* 275 363 466 512
Cashfloweffectofworking
capitalchanges (75) (88) (103) (46)
Sales 2,625 3,308 4,052 4,254 3,829
Materials
costs 550 726 932 1,025 966
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Year 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000
Labour
costs 825 1,089 1,464 ,611 1,611
Overhead
costs** 315 386 405 425 447
*Working capitalinYear1=250×1.1,inYear2 =300×1.1etc
2
**Allareassumed toinvolve
cashoutflows.
4 Taxdepreciation
Itisassumedthatthecapitalallowanceswillbeclaimed
fromYear1andwillhavean
effectoncashflowsoneyearlater.
Yearofclaim Allowance Taxbenefit
$’000 $’000
1(25%of$2,000) 500 175
2 (75%of$500) 375 31
3 (75%of$375) 281 98
4 (75%of$281) 211 74
1,367
5 (2,000– 1,367) 633 222
(b) Theinternal rateofreturn (IRR)istherateofreturn thatresultsina NPVofzero.Therulewith
theinternal rateofreturn (IRR)method ofproject evaluation
isthata projectshould be
undertaken ifitisexpected toachieve a returninexcessofthecompany’s costofcapital.A
projectthathasanIRRinexcess ofthecostofcapitalmusthavea positive NPV.
G H
Strengths
Themainadvantage oftheIRRmethod isthattheinformation itprovides
maybemoreeasily
understood bymanagers, especiallynonfinancialmanagers.
Itissometimes saidthatIRRisdifficult
tocalculate,butbothNPVandIRRareactually very
easytocalculate witha spreadsheet.
Weaknesses
However, itmightbetempting forsomemanagers toconfuse IRRandaccounting return on
capitalemployed (ROCE).Theaccounting ROCEandtheIRRaretwocompletely different
measures. Ifmanagers weregiveninformation aboutbothROCE(orROI)andIRR,itmightbe
easytogettheirrelative meaning andsignificancemixed up.
TheIRRmethod alsoignorestherelativesizeofinvestments:forexample, a projectwithan
annual return of$50onaninitial investmentof$100would havethesameIRRasa project
withanannual returnof$5,000onaninitial investmentof$10,000, although thelatteris
clearlypreferable.
IRRfavours projects thatarelesssensitive toincreasesinthediscount rateand,therefore,
theIRRmethod maysometimes indicate thata project
thatyieldsa smallerincreasein
shareholder wealth should bepreferredtoonethatyieldsa largerincrease, whereas the
oppositeisthecase.NPVshould thereforebeusedtodecidebetween mutually exclusive
projects.
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Questions
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q
47 Dinard
TopTips
Allowsyou to demonstratethat you understandthe topicof real and nominalreturnsby
explainingthe differencebetweenthem.
Introducesthe complicationof what you shoulddo ifyou are toldwhat current(orYear1)
pricesare but are also giveninformationabout priceincreasesoverthe periodof investment.
Becausethe costs are increasingat differentrates, the nominalrate (whichyou are given)has
to be used, and the revenuesand costs inflatedeach year. Ifthe rate of increaseforeverything
had been the same, you couldeitherhaveused the nominalrate (and inflatedcosts and
revenues),or calculatedthe real rate (and used uninflatedcosts and revenues).Since
calculatingthe real rate onlyinvolvesone calculation,you shouldreallyhavechosenthat
option.
Again,do not forgetto excludedepreciationas it is not a cash flow.Developmentcosts of
$480,000are sunkcosts and shouldalso be excludedfromthe calculation.Becauseyou are
toldto confineyouranswerto the informationgiven,you shouldnot discussany widerissues
that mightbe involvedinthe investment.
(a) Thereal rate of returnis the rate of returnwhichan investmentwouldshowinthe absence of

inflation.Forexample,ifa companyinvests$100,inflationis0%,and the investmentat the
end of the year isworth$110,then the real rate of returnis10%.
Inrealityhowever,there islikelyto be an elementof inflationinthe returnsdue to the change
inthe purchasingpowerof moneyoverthe period.Inthe exampleabove,ifinflationwas
runningat 5%,to showa real rate of returnof 10%,the investmentwouldneed to be worth
$115.50at the end of the year. Inthiscase, the nominalrate of returnis 15.5%whichis made
up of the real returnof 10%and inflationat 5%.
Therelationshipbetweenthe nominal(‘money’)rate of returnand the real rate of returncan
be expressedas follows:
G H
(1+nominalrate) =(1+real rate) ×(1+inflationrate)

(b) Shouldthe directorsof DinardCo produceRance:
Workings
1 Calculationsas follows:
Year1 Year2 Year3 Year4
Salesvolume 25,000 25,000 25,000 25,000
Unitprice($) 80 84 88 93
Variablematerialcost ($) 8.00 8.32 8.65 9.00

Variablelabourcost ($) 12.00 13.20 14.52 15.97
Variableoverhead($) 12.00 12.48 12.98 13.50
Note.Evaluationof investment
2 Asfollows:
Year0 Year1 Year2 Year3 Year4
Capital outlay (2,400)
Sales 2,000 2,100 2,205 2,315
Directcosts
Materials (200) (208) (216) (225)
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Year0 Year1 Year2 Year3 Year4
Labour (300) (330) (363) (399)
Overhead (300) (312) (324) (337)
Fixedoverheads – (200) (210) (221) (232)
Grosscashflow (2,400) 1,000 1,040 1,081 1,122
Discount
at15% 1.000 0.870 0.756 0.658 0.572
Present
value (2,400) 870 786 711 642
Cumulative
PV (2,400) (1,530) (744) (33) 608
Theinvestment
yieldsa netpresent
valueattheendoffouryearsof$608,000.Inthe
absenceofotherfactors,
suchasa capitalrationing
situation,
production
oftheRance
should
beundertaken.
48 Muggins
TopTips
Amethodical setofworkings iskeytoanswering thisquestion
well(alsonotconfusing
the
adjustmentfactorsforcostsandbenefits).
Apartfromtestingyourabilitytousethecertainty-equivalent approach,thequestion
isa
goodtestofyourunderstanding ofrelevantcostsandopportunitycosts.
• Apportioned costsarenotincurred bytheproject andshould notbeincluded.
• Onlytheadditional element ofotheroverheads shouldbeincluded.
G
• Thecurrent assistantmanager’s salaryof$30,000willbeincurred anywayandshould not H
beincluded; the$27,000 salaryofthenewmanager should howeverbeincluded

sinceit
hasbeenincurred because thecurrent assistant
manager isneeded ontheproject.
• Thecompany willnotbeabletoobtain therentalof$135,000onthefactoryspaceifit
undertakes theproject;thus,therental isanopportunity
costwhichshould beincluded.
• The60,000kgofMaterial Xcurrently ininventoryshould
notbeincluded atpurchase price
sincethisisa sunkcost.However, byundertaking theproject,
thecompany forgoesthe
opportunity toselltherawmaterials ininventory,andtheyshould thusbeincludedat
selling
price.
Financial
acceptability
$’000 $’000 $’000 $’000
Sales(W1) 1,125 1,800 1,575 1,425
Material
X(W2) 50 230 248 280
Othervariable
costs(W3) 517 1,100 1,184 1,340
Management
salaries
(W4) 67 79 85 92
Rental:
opportunity
cost 135 135 135 135
Otheroverheads
(1.1,1.3,1.4,1.5) 66 78 84 90
835 1,622 1,736 1,937
Saleslesscashcosts 290 178 (161) (512)
Discount
factorat5% 0.952 0.907 0.864 0.823
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Questions
573
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q
$’000 $’000 $’000 $’000
Present
value 276 161 (139) (421)
Thenetpresent
valueis–$123,000,
sotheproject
isnotacceptable.
Workings
1 Sales
Year1 10,000×$125×0.9
Year2 18,000×$125×0.8
Year3 18,000×$125×0.7
Year4 19,000
× $125×0.6
2 Material
X
Year1 $50,000opportunity
cost
Year2 18,000×6 ×$1.64×1.3
Year3 18,000×6 ×$1.64×1.4
Year4 19,000
× 6 ×$1.64×1.5
3 Othervariable
costs
Perunit:$30+(3×$4.20)+ $4.40=$47
Year1 10,000×$47×1.1
G H
Year2 18,000×$47×1.3
Year3 18,000×$47×1.4
Year4 19,000
× $47×1.
4 Management
salaries
Year1 $34,000+$27,000
= $61,000
× 1.1
Year2 $61,000
× 1.3
Year3 $61,000
× 1.4
Year4 $61,000
× 1.5
49 Banden
TopTips
Thisquestion givesyoupractice indoingNPVcalculations
rapidly.
NotehowtheNPV
calculationsarelaidoutina waythatenables youtoshowclearlyhowtheprofitability
indexis
calculated.
Itwould belesstimeconsuming tousetheproformawehaveusedthantodothe
NPVcalculations, andthenseparately todotheprofitability
indexcalculations.
Whatthis
emphasises istheusefulness oftakinga fewmoments toplanthemostefficient
wayof
carryingoutcalculations.
In(b),because oftheconstraints,
youhavetocalculatethecombined NPVofvarious possible
combinations. Itisobvious
looking atthefigures
thatthecompany willbeundertaking
some
combination ofthreeoftheprojects. However,youwouldbepenalised(andwaste time)ifyou
calculated
theNPVofallcombinations ofthreeofthesix.Anycombinationsincluding
C should
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q
beexcludedastheprojectmakesa loss.Itisalsonotpossible
fora combinationtoinclude
A
andE astheyaremutuallyexclusive.
Ouranswer showsonlythosepossible
combinations ofprojects
thatcostlessthan$620,000.
It
wouldalsobefineifyoushowedthecostofcombinations thatcostmorethan$620,000;
however,
youshould havethenstatedthattheycouldnotbeundertaken, andshouldnothave
calculated
theirNPV.
(a) Theprofitability
indexwillbecalculated
astheratioofthePVofnetcashinflows
totheYear0
capitaloutlay.
Discount Profitability
Year Cashflow factor12% Present
value index
$ $
Project
A 1– 5 70,000 3.605 252,350 252,350
0 (246,000) 1.000 (246,000) 246,000
NPV=6,350 =1.026
Project
B 1 75,000 0.893 66,975
2 87,000 0.797 69,339
3 64,000 0.712 45,568
181,882 181,882
0 (180,000) 1.000 (180,000) 180,000
NPV=1,882 =1.010
G H
Project
C 1 48,000 0.893 42,864
2 48,000 0.797 38,256
3 63,000 0.712 44,856
4 73,000 0.636 46,428
172,404 172,404
0 (175,000) 1.000 (175,000) 175,000
NPV=(2,596) =0.985
Project
D 1– 4 62,000 3.037 188,294 188,294
0 (180,000) 1.000 (180,000) 180,000
NPV=8,294 =1.046
Project
E 1 40,000 0.893 35,720
2 50,000 0.797 39,850
3 60,000 0.712 42,720
4 70,000 0.636 44,520
5 40,000 0.567 22,680
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Discount Profitability
Cashflow factor12% Present
value indexYear
$ $
185,490 185,490
0 (180,000) 1 (180,000) 180,000
NPV=5,490 =1.031
Project
F 1 35,000 0.893 31,255
2 82,000 0.797 65,354
3 82,000 0.712 58,384
154,993 154,993
0 (150,000) 1 (150,000) 150,000
4,993 =1.033
Ranking NPV Profitability

index
1st D D
2nd A
3rd E
4th F A
5th B B
G H
6th C C
Therankings
differbecause
theproject’s
capitaloutlays
differ.
NPVshows theabsolute
benefit
froma project,
whileprofitability
indexscalesthatbenefit
according
totheproject’s
size.
(b) Project
C comes sixthandlastintheranking
accordingtobothNPVandprofitability
index.
It
hasa negative
NPVandshould notbeundertaken.
Banden cannotaffordtoundertakemorethanthreeprojects,
giventhemaximum
available
capitalof$620,000.
Itshould notundertake
Project
C, anditcannotundertake
AandE
simultaneously.
Thevarious feasible
options
areasfollows:
Capitaloutlay
Projects ntotal NPVintotal
$ $
D,F,E 510,000 8,777
D,F,A 576,000 9,637
D,F,B 510,000 5,169
D,E,B 540,000 5,666
D,A,B 606,000 6,526
F,A,B 576,000 3,225
F,E,B 510,000 2,365
Banden
should
notinvest
anyfundsinthemoney markets,
because
thereturn
would
onlybe
9%paandthecostofcapitalforBanden
ishigher,
at12%pa.
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Itisassumed thatthecompany
doesnothavetousemorefundsthanitneedsto,andso
therewillnotbeanysurplus
fundswhichhavetobeinvested
somewhere.
Recommendation. Thecompany
shoulduse$576,000andinvest
inProjects
D,F andA.
50 ANT
(a) Thefirststepistocalculatetheannual contribution
fromeachproject, together
withthe
working capitalcashflows.Thesecashflows,togetherwiththeinitial
outlay,canthenbe
discounted atthecostofcapitaltoarriveattheNPVofeachproject. Developmentcosts
already incurredareirrelevant.
Therearenoadditionaladministrationcostsassociated
with
theprojects,anddepreciationisalsoirrelevant
sinceithasnocasheffect.
First,calculate
annual contribution.
A B C D
150,000 75,000 80,000 20,000
Unitsales $ $ $ $
Selling
priceperunit 30.00 40.00 25.00 50.00
Materialcostperunit 7.60 12.00 4.50 25.00
Labourcostperunit 9.80 12.00 5.00 0.00
Variable
overheads
perunit 6.00 7.00 2.50 0.50
$’000 $’000 $’000 $’000

Salesperannum 4,500 3,000 2,000 6,000
Materials 1,140 900 360 3,000
G H
Labour 1,470 900 400 1,200

Variable
overheads 900 525 200 1,260
Annual
contribution 990 675 ,040 540
Working
capitalrequirement
(20%annual
salesvalue) 900 600 400 ,200
Itisassumed
thatworking
capitalwillberecovered
attheendofYear5.Theinitial
outlaywill
bemadeinYear0.
TheNPVofeachproject
cannowbecalculated.
Cashflow
A B CYear D
Gross Gross Gross Gross Discount
pa Net pa Net pa Net pa Net factor18%
$’000 $’000 $’000 $’000 $’000 $’000 $’000 $’000
0 (3,000) (2,000) (2,000) (2,800) (2,800) (1,800) (1,800) 1
1- 4 990 2,663 675 1,816 1,040 2,798 540 1,453 2.690
5 1,890 826 1,275 557 1,440 629 1,740 760 0.437
489 373 627 413
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(b) Theprofitability
indexprovides
a means ofoptimising
theNPVwhentherearemoreprojects
available
whichyielda positive
NPVthanfundstoinvest inthem.Theprofitability
index
measurestheratioofthepresentvalueofcashinflowstotheinitialoutlayandrepresents
thenetpresent
valueper$1invested.
Project PVofinflows Outlay Ratio Ranking
$’000 $’000
A 3,489 3,000 .163 4
B 2,373 2,000 .187 3
C 3,427 2,800 1.224 2
D 2,213 1,800 1.229
Project
DhasthehighestPIranking
andistherefore
thefirstchoiceforinvestment.
Onthis
basisthefundsavailable
should
beinvested
asfollows:
Cumulative
Project Initial
outlay TotalNPV %taken outlay ActualNPV
$’000 $’000 $’000 $’000
D 1,800 413 100 1,800 413
C 2,800 627 100 4,600 627
B 2,000 373 30 5,200 112
A 3,000 491 0 5,200 0
TotalNPVgenerated 1,152
G
(c) Theprofitability index(PI)approach canbeapplied onlyiftheprojectsunderconsideration H
fulfilcertaincriteria,
suchas:
(1) There isonlyoneconstraint oninvestment, inthiscasecapital.ThePIensuresthat
maximum returnperunitofscarceresource (capital)
isobtained.
(2) Eachinvestment canbeaccepted orrejected initsentirety
oralternatively
acceptedon
a partial basis.
(3) TheNPVgenerated bya givenproject isdirectlyproportionaltothepercentageofthe
investment undertaken.
Ifadditional fundsareavailable butata higher cost,thenthesimple PIapproachcannotbe
usedsinceitisnotpossible tocalculateunambiguous individual
NPVs.
Ifparticular projects
thatmaybeundertaken aremutually exclusive
thensub-problemsmust
bedefined andcalculations madefordifferentcombinations ofprojects.
Possibly a moreserious constraint
istheassumption thatthecompany’s onlyconcernisto
maximise NPV.Itispossible thattheremaybelong-term strategic
reasonswhichmeanthat
aninvestment witha lower NPVshould beundertaken insteadofonewitha higherNPV,and
theratioapproach takesnoaccount oftherelative degreesofriskassociated
withmaking
thedifferent investments.
51 Sagitta
TopTips
Remember in(b)thatthevalueofrightsisnotthecostoftherightsshare.
(c)emphasises
that
takingupandselling
therightsshouldhaveidentical
effects.
(a) Current
totalmarket
value=$21m
×16
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=$336m
Marketvalueper share =$336m/(60m×4)
=$1.40
Rightsissueprice=$1.40×0.70
=$0.98
Theoreticalex-rightsprice
$
5 shares @$1.40 7.00
1share @$0.98 0.98
6 shares 7.98
Theoreticalex-rightsprice=$7.98/6
=$1.33
(b) Rightsprice
$
Theoreticalex-rightsprice 1.33
Cost of rightsshare 0.98
Valueof rights 0.35
(c) Takeup rightsissue
$
G
Valueof shares after rightsissue(10,000×6/5 ×$1.33) 15,960 H
Cost of rights(2,000×$0.98) (1,960)

14,000
Sellrights
$
Valueof shares (10,000×$1.33) 13,300
Saleof rights(2,000×$0.35) 700
14,000
Allowrightsofferto lapse
$
Valueof shares (10,000×$1.33) 13,300
Ifthe investoreithertakes up the rightsissueor sellstheirrights,theirwealthwillremainthe
same. Thedifferenceis that, ifthey take up the rightsissue,they willmaintaintheirrelative
shareholdingbut, ifthey selltheirrights,theirpercentage shareholdingwillfall,although
they willgain $700incash.
However,ifthe investorallowsthe rightsto lapse theirwealthwilldecrease by $700.
(d) Sagitta clearlyneeds to raise$47.04millionwhichis whyit was decidedto makea one-for-
fiverightsissueof 48 millionadditionalshares at a priceof $0.98.Providedthat thisamount
is raised,it couldhavebeen done (forexample)by issuing96 millionnewshares as a two-for-
fiverightsissuewiththe issuepriceat $0.49per share.
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Thepriceof the issueand the numberof shares shouldnot be importantina competitive
marketas the valueof the businesswillnot change and nor willthe shareholders’percentage
shareholding.
However,the criticalfactor about the priceof the rightsissueis that it must be belowthe
marketvalueat the timeof the rightsissue.Ifthe rightsissuepriceis higherthan the market
value,there is no incentiveto shareholdersto purchasethe additionalshares and the rights
issuewillfail.Asfar as the businessisconcerned,the detailsof the rightsissueincludingthe
pricemustbe determineda considerabletimebeforethe rightsissueactuallytakes place,
thereforethere is alwaysthe riskthat the share pricemightfallinthe interveningperiod.
(e) AMurabahatransactionis a formof creditsale. Thereis an immediatetransferof an asset,
withthe buyermakingpaymentinthe future(possiblyininstalments).Thetotal paymentwill
includea mark-upon the valueof the asset inrecognitionof the convenienceof payinglater.
Theasset can be soldto raisefundsforthe futurepayment.Thereis a contract betweenthe
buyerand the sellerstating the valueof the asset transferredand the mark-upamount.
Aconventionalloanhas capital borrowedand then interestis to be repaidon top and there is
no transferof an asset to the borrower.Fora Murabahatransaction,there mustbe an
underlyingasset that existsand has a valuewithina fairmarketrange. Althoughthe asset
can varyfortransactionsit must not be prohibitedby Sharia’a.Anotherdifferenceis that in
Murabahatransactionspenaltiesforlate paymentsthat wouldprofitthe sellerare not
allowed.
InIslamicfinance,riba (orinterest)is not permitted,thereforeunderMurabahathere is an
agreed uponmark-up,whichshouldallowboth parties to share inthe profitfromthe sale of
the asset.
52 Headwater
(a) Theperformanceand financialhealth of Headwaterinrelationto that of the industrysector
G as a wholecan be evaluatedby comparingits financialratioswiththe industryaverages,as H
follows:
Headwater ndustryaverage
Returnon (long-term)capital employed
Operatingprofit(PBIT):
Equity+long-termdebt
$4.9m:($12.4m+$2.2m)=33.6% 24%
Returnon equity
Profitattributableto equityshareholders
$3.1m:$12.4m=25% 6%
Operatingprofitmargin
Operatingprofit:Sales
$4.9m:$36.5m=13.4% 1%
Currentratio
Currentassets: Currentliabilities
$10.1m:$9.0m=1.12:1 1.6:1
Acidtest
Currentassets excludinginventory:Currentliabilities
$5.7m:$9.0m=0.63:1 1.0:1
Gearing
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Headwater Industry
average
Debt:Equity
($2m+$2.2m):
$12.4m
=33.9% 24%
Dividend
cover
Profit
attributable
toequityshareholders
$3.1m:
$0.3m=10.3times 4.0
Interest
cover
Profit
before
interest
andtax(PBIT):Interest
$4.9m:$1.3m=3.77times 4.5
These ratioscanbeusedtoevaluate performance interms ofprofitability, liquidity
and
financial
security.
Profitability
Headwater’s returnoncapitalemployed, return onequityandoperating profit margin areall
significantly
abovetheindustry averages. Although thefirsttwomeasures couldbeinflated
duetoassetsbeingshown atlowbookvalues, theprofit margin indicatesthatHeadwater is
managing tomakegoodprofits, whichcouldbeduetosuccessful marketing, a lowcostbase
ortoitsoccupation ofa particularly profitable
nicheinthemarket.
Liquidity
Boththecurrent andthequick(acidtest)ratiosarewellbelow theindustry averages.This
suggests thatHeadwater iseither shortofliquidresources orismanaging itsworking capital
poorly.However, thethreekeyworking capitalratiosmodify thisimpression.
Receivablesdays:365×4.7/36.5 = 47days
Inventoryturnover:365×4.4/31.6 =51days
G H
Payment period:365×7.0/31.6 =81days

Although theindustry averages arenotknown, theseratiosappear tobeverygoodby
generalstandards. Ittherefore appears thatHeadwater hasbecome under-capitalised,
perhaps through theuseofworking capitaltofinance growth.
Financialsecurity
Gearingishighincomparison withtherestoftheindustry, and48%ofthedebtisintheform
ofoverdraftwhichisgenerally repayable ondemand. Thisistherefore a riskyformofdebtto
useinlargeamounts. Thedebenture isrepayable intwoyearsandwillneedtoberefinanced
sinceHeadwater cannot redeem itoutofexisting resources. Interest coverisalsopoor,and
thistogether withthepoorliquidity probably account forthelowpayoutratio(theinverse of
thedividend cover).
Insummary, profitperformance isstrong, buttherearesignificant weaknesses inboththe
liquidity
andthefinancial structure.These problems needtobeaddressed ifHeadwater isto
beabletomaintain itsrecord ofstrong andconsistent growth.
(b) Acompany suchasHeadwater mayseeka stockmarket listingforthefollowing reasons:
(1) Toallowaccesstoa widerpooloffinance: companies thataregrowing fastmayneed
toraiselargersumsthanispossible privately.
Obtaining a listing
widens thepotential
number ofequityinvestors, andmayalsoresult inanimproved creditrating,thus
reducing thecostofadditional debtfinance.
(2) Toimprove themarketability oftheshares: shares thataretraded onthestockmarket
canbebought andsoldinrelatively smallquantities atanytime.Thismeans thatitis
easierforexisting investorstorealise a partoftheirholding.
(3) Toallowcapitaltobetransferred tootherventures: founder owners maywishto
liquidatethemajor partoftheirholding eitherforpersonal reasons orforinvestment in
othernewbusiness opportunities.
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(4) Toimprove thecompany image:quoted companies arecommonlybelievedtobemore
financially
stable,andthismayimprove theimageofthecompany withitscustomers
andsuppliers,allowingittogainadditional
businessandtoimprove itsbuyingpower.
(5) Growth byacquisitioniseasier:a listed
company isina better
position
tomakea paper
offerfora targetcompany thananunlistedone.
53 ABC
TopTips
Thewisdom ofthedividend policyeachcompany adopts issomewhat dependentuponits
current
andfuture plans– whether infactitcanmake‘better’useoftheprofitsbyre-investing
them.Theanswer stressestheimportance ofstability
individend
payments, whichisa very
important
‘real-world’
issue.ThescripissuesandotherconcessionsbyC areunlikelytobe
harmful,
although theirpositive
effectmaynotbeverygreat.
Thekeyelement inthesecond partofthequestion istheclientele
effect.Youneedtostressthe
importanceoftheshareholders’taxpositionhere.
A’spolicy
Company A,whichhasdeliberately avoided payinganydividends inthelastfiveyears,is
pursuing a sensiblepolicyfora rapidly growing company. Allitsposttaxprofits arebeing
reinvested inthecompany’s business. Byadopting thisstrategy,Company Areduces toa
minimum itsneedtoraisenewcapitalfromthemarket. Issuecostsarereduced oreliminated and
thecompany hasgreater flexibility
initsinvestment programme sincedecision making isnot
dependent ongaining market approval. Furthermore, sincethecompany isprobably investing
heavily itstaxation liability
maywellbesmall.
B’spolicy
Atfirstsightthepolicypursued byCompany B,ofdistributing 50%ofposttaxprofits, appears to
G H

offertheshareholders predictability.Infact,however, withchanges inthecompany’s operating
profitsandinthetaxregime, theposttaxearnings mayfluctuate considerably. Reducing the
dividend ofa quoted company normally causesitssharepricetofallsharply, sincethemarket
takesthisascasting considerable doubtonitsfuture earningspotential. But,themoremature
andpredictable thatCompany B’sbusiness is,thegreater themeritinitsdividend policy.A
mature business usually needslessnewcapitalinvestment thana growing oneandsoa higher
levelofdividend isjustified.Distributing profitsallows shareholderstomakesomeadjustment to
theriskandreturn profile oftheirportfolios without incurringthetransaction costsofbuyingand
selling.
C’spolicy
Company C’spolicyfallsbetween thoseofAandBinthata dividend ispaid,albeita smallone.
Thepredictability ofthedividend willbewelcomed byshareholders, sinceitallows themtomake
theirfinancial planswithmorecertainty thanwould otherwisebepossible. ItalsogivesC partof
A’sadvantage; retained earnings canbeusedastheprincipal source ofinvestment capital.Tothe
extent thattheyarerelevant atall,scripissuesarelikelytoincrease a company’s market value,
sincetheyareoftenmadetoincrease themarketability oftheshares. Shareholderconcessions
aresimply a means ofattracting the‘small’shareholder whocanbenefit fromthempersonally,
andhavenoimpact ondividend policy.
Effectonshareholders
Inaddition tolooking atthecashflowsofeachcompany, wemustalsoconsider theimpact of
thesedividend policies ontheaftertaxwealth ofshareholders. Shareholders canbedivided into
groups or‘clienteles’.Differentclienteles maybeattracted toinvestineachofthethreefirms,
depending ontheirtaxsituation. Itisworth noting thatoneclientele isasgoodasanother in
terms ofthevaluation itimplies
forthefirm.
Company Awould beparticularly attractive toindividuals whodonotrequire anincome stream
fromtheirinvestment andprefer toobtain a return through capitalgrowth. Company B’sclientele
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prefer a muchhigher proportion oftheirreturn
tobeintheformofincome, although itwouldnot
beincome onwhichtheyrelysinceitmaybeveryvariable fromyeartoyear.Taxexempt funds,
suchaspension funds,areindifferentbetween returnsintheformofincome orcapitalandmight
wellinvestinBsincetheyneeda flowofincome tomeettheirdaytodayobligations. Alarge,
diversified
portfoliowouldreduce theeffectofvariability
inthedividend.Company C ismore
likelytoappealtotheprivate investor sincemostofthereturn isintheformofcapitalgrowth and
thereareshareholder concessions too.
Assuch,eachcompany maymaximise thewealth ofitsshareholders.
Ifthetheorists
areright,A,
BandC allmaximise shareholder wealthbecause thevalueofthecompanies isunaffectedby
dividend policy.Alternatively,
eachcompany’s
groupofshareholders mayfavour theircompany’s
policy(andsotheirwealth ismaximised) because thedividendpolicyisappropriatetotheirtax
position andsomaximises theirposttaxreturns.
54 DF
TopTips
Thenature ofthecalculationin(a)should havesuggested toyouthatthemajority ofmarks
would beavailableforthediscussion.Theanswer lookswellbeyond therelationshipwithFF,
considering theeffectonrelationswithothercustomers, theeffectonDFitself,andwhether
therearealternative sourcesoffinance forDF.
(b)goesontocoverthosealternative sourcesoffinance.Variouscriteria
canbeusedto
consider them:
• Costs(including costssaved);
• Flexibility(acompany knows whenandhowmuchinterest andprincipal ithastopayona
loanbutstillhastopayit;bycontrast, anoverdraft
facilityonlyhasinterestcharged onit
ifitisused,butitisrepayable ondemand);
• Commitment (security
thathastobegiven,howmuchthecompany istiedintothe
G H
arrangement); and
• Appearances (effectongearing, effectonaccounts receivable
iffactororganisationis
employed).
Although thequestion directsyoutowards discussing
certainsourcesoffinance, itdoesnot
confine youtothosesources. Therefore,althoughthebulkofyouranswer to(b)shoulddiscuss
thesources listed,
a sectionbriefly
mentioning othersources shouldalsobeincluded.
Donotforgetalsoin(b)tobearinmindthelikelyleveloffinancial knowledge oftherecipients
ofyourreport; don’tassume a highlevelofunderstanding.
(a) Costofdiscount
Thepercentage costofanearlysettlement
discount,
tothecompany
givingit,canbe
estimated bytheformula:
[ 100-
100
d]365
1- t
Where d isthesizeofdiscount
(%),t isthereduction
inpayment
period
indaysnecessary
to
achieve discount
d=3%
t =90– 10=80
%cost=
[ 100−3]365
1− 100 80= 14.9%
Theannual
equivalent
rateofinterest
inoffering
a 3%cashdiscount
istherefore
14.9%.
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Offerofdiscount
Otherfactors thatDFshould takeintoaccount beforedeciding onwhether tooffera
discount include:
(1) Theattractiveness ofthediscount toFF,andtheprobability thatitwillbetaken up
(2) Whether thediscount willencourage FFtopurchase largervolumes thanitwould ifthe
discount wasnotavailable
(3) Therelative effectofthedifferent financing alternatives ontheadministration costsof
DF
(4) TheeasewithwhichDFwillbeabletoraisealternative sources offinance, theeffecton
gearing ofthesesources andtheneedforsecurity
(5) Theinterest othercustomers mightshowintakinga discount
(6) Thepossibility ofwithdrawing fromthediscount arrangement without lossofFF’s
goodwill inthefuture
(b) ToShareholders inDF
FromManagement Accountant
Date11December 20X1
Subject Alternative methods offinancing currentassets
Introduction
Thecontract tosupplyFFmeans thatDFwillneedtomakea significant additional
permanent investment incurrent assets(intheformofadditional inventoriesandhigher
accounts receivable). There willalsobeanadditional temporary element whichfluctuates
withthelevelofsales.Thiswillincrease theamount ofmoney needed bythecompany to
finance theseassets. There area number ofdifferentsources offinance thatcouldbe
considered.
G Bankloan H
Abankloanwould normally befora fixedamount ofmoney fora fixedtermandata fixed

rateofinterest. Itisnotclearwhether ornotthecompany hasanyexisting debtfinance.
However, ithasalready beendecided tousea bankloantofundthepurchase ofthe
additional non-current assets. Thesizeofthisloanandthequalityofsecurity availablewill
bekeyfactors indetermining whether thebankiswilling tomakea further advance tocover
theinvestment incurrent assets. Assuming thata furtherloanisforthcoming, thecompany
willneedtoevaluate theeffectofthisinterms ofcostandtheeffectonthecapitalstructure.
Advantages ofbankloan
(1) Bankfinance ischeaper thanthecostofallowing a 3%settlement discount andisalso
likelytobecheaper thanusingdebtfactoring orinvoice discounting.
(2) Theloancanbenegotiated fora fixedtermanda fixedamount, andthisislessrisky
thanforexample usinganoverdraft, whichisrepayable ondemand.
Disadvantages ofbankloan
(1) Thecompany willhavetopayinterest onthefullamount oftheloanfortheentire
period. Thiscouldmakeitmoreexpensive inabsolute terms thanusinganalternative
source offinance where interestisonlypayable ontheamount outstanding.
(2) Theloanwillincrease thelevelofthecompany’s financial gearing.Thismeans thatthere
couldbegreater volatility
inthereturns attributabletotheordinary shareholders.
(3) Thebankislikelytorequire security.Iftherearequestions astothequality oftheasset
base,thebankmayalsorequire personal guarantees oradditional security fromthe
directors orshareholders.
Overdraft
Anoverdraft isa formoflending thatisrepayable ondemand. Thebankgrantsthecustomer
a facilityuptoa certain limit,andthecustomer cantakeadvantage ofthisasnecessary.
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Overdraftsare essentiallyshort-termfinance,but are renewableand may becomea near-
permanentsource.
Advantagesof overdraft
Theattraction of usingan overdraftto financecurrentassets is that interestis onlypayable
on the amountof the facilityactually in use at any one time.Thismeans that the effective
cost of the overdraftwillbe lowerthan that of the bank loan. Thisis particularlyattractive
fora companysuch as DF,wheredemand is expectedto fluctuatesignificantlyfrommonth
to month,and consequentlythere are likelyto be large variationsinthe levelof working
capital.Itis also likelyto be cheaper than the otheralternativesbeingconsidered.
Disadvantagesof overdraft
Themaindrawbackto usingan overdraftis that it willbe repayable on demand, and
thereforethe companyis ina morevulnerablepositionthan it wouldbe ifa bank loanwere
used instead.Along-termoverdraftmay be includedinthe gearing calculations,and the
bank may requiresecurity.
Debtfactoring
Factoringis an arrangementto havedebts collectedby a factor company, whichadvances
a proportionof the moneyit is due to collect.Servicesofferedby the factor wouldnormally
includethe following:
(1) Administrationof the client’sinvoicing,sales accountingand debt collectionservice
(2) Creditprotectionforthe client’sdebts, wherebythe factor takes overthe riskof lossfrom
bad debts and so ‘insures’the clientagainst such losses
(3) Makingadvance payments to the clientbeforethe debts are collected
Advantagesof factoring
(1) Growthis effectivelyfinancedthroughsales, whichprovidethe securityto the factor.DF
wouldnot haveto providethe additionalsecuritythat mightbe requiredby the bank.
G (2) Themanagers of the businesswillnot haveto spend timeon the problemof slowpaying H
accounts receivable.
(3) Administrationcosts willbe reduced sincethe companywillnot haveto run its ownsales
ledgerdepartment.
Disadvantagesof factoring
(1) Thelevelof financeisgeared to the levelof sales; inotherwords,financelags sales.In
practice,DFwillneed financeahead of sales inorderto buildup sufficientinventoriesto
meet demand.
(2) Factoringmay be moreexpensivethan bank finance.Servicecharges are generally
around 2%of total invoicevalue,inadditionto financecharges at levelscomparableto
bank overdraftrates.
(3) Thefact that accounts receivablewillbe makingpaymentsdirectto the factor may
presenta negativepictureof the firm.
Invoicediscounting
Invoicediscountingis relatedto factoringand many factorswillprovidean invoice
discountingservice.Invoicediscountingisthe purchase of a selectionof invoices,at a
discount.Thediscounterdoes not take overthe administrationof the client’ssales ledger,
and the arrangementis purelyforthe advance of cash.
Advantagesof discounting
Thearrangementis thus a purelyfinancialtransaction that can be used to releaseworking
capital,and thereforeshares someof the benefitsof factoringinthat furthersecurityis not
required.Thediscounterwillmakean assessmentof the riskinvolved,and onlygood quality
invoiceswillbe purchased,but thisshouldnot be a problemto DFsinceFFis a large well-
establishedcompany.
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Disadvantages ofdiscounting
Themaindisadvantage isthatinvoicediscountingislikelytobemoreexpensive thananyof
theotheralternatives.
Itisnormally onlyusedtocovera temporary cashshortage, andnot
fortheroutineprovisionofworking capital.
Otheroptions
(1) Financecanbeobtained bydelaying payment toaccounts payable. Intheory, thisis
potentially
a cheapsource offinance.Themaindisadvantage maybea lossofsupplier
goodwill,
ata timewhenthecompany needssupplier co-operation tofulfilthenew
order.
(2) Othermethods ofloanfinance, notably debenture issue,arenotappropriate astheyare
essentially
long-term, andthedebenture holdersmayrequire security thatthe
company isunable togive.
(3) Althoughwearetoldthatincreased inventorylevelswillbeneeded tofulfilFF’s
requirements,theremaybescopeforreducing theinventory levelsnecessary tofulfil
othercustomers’requirements.
Conclusions
Oftheoptions considered, factoringorsomeformofbankfinance islikelytobethemost
appropriate.
Thefinaldecision musttakeintoaccount thefullcostimplications, andnotjust
therelative
ratesofinterest onthefinance.DFmustalsoconsider theeffectofthetypeof
financeselectedonthestatement offinancialposition,andthetypeofsecurity thatwillbe
required.
Thiscouldalsoimpact ontheabilityofthecompany toraisefurther finance inthe
future.
55 CRY
G
TopTips H
Thisquestion:
(a) Demonstrates thecomplications
thatmayoccurinweighted average costofcapital
calculations
Withloannotes,themostserious mistake youcanmakeistotreatredeemable loannotesas
irredeemable.
Because theloannotesareredeemable,youneedtocarryoutanIRRanalysis.
Lastlydonotforgetthattheweightings intheWACCcalculationarebasedonmarket values,
notbookvalues.
(b) Demonstrates thatthecalculation
oftheweightedaveragecostofcapitalisnota purely
mechanicalprocess. Itmakesassumptionsabouttheshareholders,
theproposed
investment
andthecompany’s capitalstructure
andfuturedividendprospects.
Givenall
theassumptions involved,
theresultofthecalculations
mayneedtobetakenwitha large
pinchofsalt!
(a) Thepost-taxweighted
averagecostofcapitalshould
firstbecalculated.
(1) Ordinaryshares
Theformulaforcalculating
thecostofequitywhenthereisdividendgrowthis:
re = d0(1+ g) + g
po
where
re=costofequity
d0=currentdividend
g =rateofgrowth
p0=currentexdivmarket
value.
586 Financial
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Inthiscase,weshallestimatethefuturerateofgrowth(g)fromtheaveragegrowth
in
dividendsoverthepastfouryears.
810=620(1+g)4
(1+g)4 = 810/620= 1.3065
(1+g)= 1.069
g = 0.069=6.9%
ke=(0.27×1.069/3)
+0.069=16.5%
(2) 7%Loannotes
Therelevantcashflowsfora singleloannotewitha nominalvalueof$100are:
• Annual interest
payments, netoftax,whichare$100×7%×70%=$4.90(forfouryears)
• Acapitalrepayment of$100(infouryears’time)
CBEexamapproach tocalculatetheIRR
Posttaxcostofinterest
=$7×(1-0.3)= $4.9
Redemption value=$100
A B C D E F
1 Time 0 1 2 3 4
2 Per$100 88.00 -4.9 -4.9 -4.9 104.9
3 IRR =IRR(B2:F2)
Thespreadsheet
solution
incellB3is8.6%
(3) Theweighted
average costofcapital
G
Market
value Cost H
$’000 %
Equity 9,000 16.5
7%Loannotes 1,144 8.6
10,144
( 9000) ( )
WACC = × 16.5 + 1144 × 8.6
10144 10144
(Thecostofdebtisalready post-tax soitisnotmultiplied
by1– T)
=14.64+0.97=15.61%
Theabovecalculations suggestthata discountrateintheregion of16%mightbeappropriate
fortheappraisal ofnewinvestment opportunities.
(b) Difficulties
anduncertainties intheaboveestimates ariseina number ofareas.
(1) Thecostofequity.Theabovecalculation assumes thatallshareholdershavethesame
marginal costofcapitalandthesamedividend expectations,whichisunrealistic.
In
addition,itisassumed thatdividend growth hasbeenandwillbeata constant rateof
6.9%.Infact,actualgrowth intheyears20X5/6and20X8/9wasinexcess of9%,whilein
theyear20X7/X8 therewasnodividend growth.6.9%ismerely theaverage rateof
growth forthepastfouryears.Therateoffuture growth willdepend moreonthereturn
fromfuture projects
undertaken thanonthepastdividend record.
(2) Theuseoftheweighted average costofcapital.Useoftheweighted averagecostof
capitalasa discount rateisonlyjustified
wherethecompany inquestionhasachieved
whatitbelieves tobetheoptimal capitalstructure
(themixofdebtandequity) and
where itintendstomaintain thisstructure
inthelongterm.
16:Practice
Questions
587
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(3) Theprojects
themselves.Theweighted average costofcapitalmakes noallowance for
thebusiness
riskofindividual
projects.Inpractice,somecompanies, having calculated
theWACC,adda premium forrisk.Inthiscase,forexample, ifoneuseda riskpremium
of5%thefinaldiscountratewould be21%.Ideally, theriskpremium shouldvaryfrom
project
toproject,
sincenotallprojectsareequally risky.Ingeneral,
theriskier
the
project
thehigherthediscountratewhichshould beused.
56 Katash
TopTips
Useclearworkings
anda logicalapproach
tothecalculations
inparts(a)and(b).Theyshould
bestraightforward
ifyouhavedoneenough practice
butmakesureyoudonotspendtoolong
onthem.
Thediscussion
inpart(c)covers
a veryimportant
andhighlyexaminablearea.Youmustbe
familiar
withboththetraditional
viewandthatofModigliani
andMiller.
Easymarks
There
areplenty
ofmarks
available
forsomestraightforward
calculations.
(a) CurrentWACC
CBEexamapproach tocostofdebt
Posttaxcostofinterest
=$10×(1-0.3)= $7
Redemptionvalue=$100
A B C D E F G
G
1 Time 0 1 2 3 4 5 H
2 Per$100 105.00 -7 -7 -7 -7 -107

3 IRR =IRR(B2:G2)
Thespreadsheet solution
incellB3is5.8%
Costofequity
ke=Rf+(Rm– R)B
f
Rf =5%
Rm=12%
ke=5%+(12%– 5%)×1.2
=13.40%
Weighted average costofcapital
VE=450×5 =$2,250million
VD=1,800×1.05=$1,890million
WACC
=(13.4×2,250/4,140) +(5.8×1,890/4,140)
=7.28% +2.65%
=9.93%
(b) Projectspecificcostofequity
Ungear Chlopop beta
ForChlopop:
VE=600×5.60=$3,360m
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V =$525m
D
bu=1.6×(3,360)/3,360 +(525×0.7))
=1.44
Re-gearing
VE=$510m
VD=$390m
bg=1.44×(510+(390×0.7))/510 =2.211
Costofequity
ke=Rf+(Rm– Rf) B
=5%+(12%– 5%)2.211
=20.48%
(c) Sources offinance
Thesources oflong-term finance forKatash areordinary shares andloannotesandtherate
ofreturnexpected byinvestors depends ontherelative risksofeachtypeoffinance. Equityis
riskier
and,therefore, hasthehighest costofcapital.Theloannotesaretheleastriskywith
thelowest costofcapital.
Therefore,ifweignore taxation, theweighted average costofcapitalwould beexpected to
decrease ifequityisreplaced bydebt.
Traditionalview
Inthetraditional viewofcapitalstructure, ordinary shareholders arerelativelyindifferent to
theaddition ofsmallamounts ofdebtsotheWACCfallsasa company gearsup.
However, asequityisreplaced bydebtandgearing increases, financialriskwillincrease so
thecostofequityrisesandoffsets theeffectofcheaper debt.
G
Thebefore-tax costofdebtwillalsoincrease athighlevels ofgearing duetotheriskof H
bankruptcy. Thisbankruptcy riskwillfurther increase thecostofequity.

Acompany cantherefore gearupusingdebtandreduce itsWACCtoa minimum. Whenthe
WACCisminimised, themarket valueofthecompany, equaltothepresent valueofitscash
flows,
willbemaximised.
Beyond thisminimum point,theWACCwillincrease duetotheeffectofincreasing financial
andbankruptcy risk.
Modigliani andMiller
Incontrast tothistraditionalview,Modigliani andMiller, assuming a perfect market and
ignoringtax,demonstrated thattheWACCremained constant asa company increased its
gearing.Theyargued thattheincrease inthecostofequityduetofinancial riskexactly
balanced thedecrease inWACCcaused bythelower before-tax costofdebt.
Ina perfect capitalmarket, thereisnobankruptcy risksotheWACCandtherefore the
market valueofthecompany isconstant atallgearing levels.
Themarket valueofa company
depends onitsbusiness riskonly.Thismeans thatKatash cannot changeitsWACC.
However, corporate taxdoesexistandinterest payments ondebtreduce taxliability.
Itcould
thusbeargued thatWACCfallsasgearing increases. Katash couldtherefore reduce its
WACCtoa minimum bytakingonasmuchdebtaspossible.
Theassumption ofa perfect capitalmarket isunrealistic. Bankruptcy riskandothercostsof
servicingdebtwillincrease asgearing increases andthiswilloffsetthevalueofthetaxshield.
Conclusion
Inconclusion, Katash should beabletoreduce itsWACCbygearing up,buttheminimum
WACCachievable maybehardtodetermine.
16:Practice
Questions
589
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57 Bases of valuation
TopTips
Itisimportant
thatyouhavea goodunderstandingofthistopicareainorder
topasstheFM
exam. Theideaofthisquestion
istogetyouthinking
aboutsomeofthekeyissues.However,
SectionC questions
intherealexamwillmainly
focusonothersyllabusareas:working
capital,investment
appraisal
andbusinessfinance.
(a) (a) (i) Statement offinancialpositionvalue=($2,070,600 – $1,616,500)
=$454,100.
(ii) Replacement costvalue=$454,100 +$(725,000 – 651,600)+$(550,000– 515,900)=
$561,600.
(iii) Realisablevalue=$454,100 +$(450,000– 651,600) +(570,000– 515,900)– $14,900=
$291,700.Baddebtsare2%×$745,000 = $14,900.
Baddebtsareassumed nottobe
relevanttostatement offinancialpositionandreplacement costvalues.
(iv) Thedividend growthmodel valuedepends onanestimate ofgrowth,whichisfarfrom
cleargiventhewidevariations inearnings overthefiveyears.
(1) Thelowest possible
value,assuming zerogrowth,isasfollows.
Valueexdiv=15,000/0.12 =$208,333
Itisnotlikelythatthiswillbethebasistaken.
(2) Looking atdividendgrowth overthepastfiveyearswehave:
20X4dividend =$25,000
20X0dividend =$20,500.
Iftheannual growth rateindividends isg
(1+g)4=25,000/20,500 =1.2195
1+g =1.0508
G H
g =0.0508,say5.1%
Then,MVexdiv=
dividendin1year
0.12−g
=25,000(1.051)/0.069
=$380,797
(3) Usingtherbmodel,
wehave:
Averageproportion
retained
=
12800+ 44200+ 18300+ 13400+ 27200
33300+ 66800+ 43300+ 38400+ 52200
=0.495(sayb=0.5)
Returnoninvestmentthisyear=52,200/average investment
Averageinvestment
=[454,100 +(454,100- 27,200)]/2
=440,500
Returnoninvestmentthisyear=52,200/440,500
=0.1185(sayr=12%).
Theng =0.5×12%=6%
soMVexdiv=25,000×1.06/0.06 = $441,667
(v) P/Eratiomodel
Comparable quotedcompanies toManon haveP/Eratiosofabout10.Manon
ismuch
smaller
and,beingunquoted, itsP/Eratiowouldbelessthan10,buthowmuchless?
Ifwetakea P/Eratioof5,wehaveMV=$52,200×5 =$261,000.
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Ifwetakea P/Eratioof10×2/3,wehaveMV=$52,200×10×2/3=$348,000.
Ifwetakea P/Eratioof10,wehaveMV=$522,000.
(b) Foreachofthevaluation bases:
(1) Thestatement offinancialposition value
Thestatement offinancialpositionvalueshouldnotplaya partinthenegotiation
process.
Historicalcostsarenotrelevant toa decision
onthefuture valueofthe
company.
(2) Thereplacement cost
Thisgivesthecostofsetting upa similarbusiness.
Sincethisgivesa higher
figurethan
anyothervaluation inthiscase,itcouldshowthemaximum priceforCarmen tooffer.
Thereisclearlynogoodwill tovalue.
(3) Therealisablevalue
Thisshows thecashwhichtheshareholders inManon couldgetbyliquidating the
business.Itistherefore theminimum pricewhichtheywould accept.
Allthemethods (i)to(iii)sufferfromthelimitation thattheydonotlookatthegoing
concern valueofthebusiness asa whole. Methods (iv)and(v)doconsider thisvalue.
However, therealisable valueisofuseinassessing theriskattached tothebusiness asa
goingconcern, asitgivesthebasevalueifthingsgowrong andthebusiness hastobe
abandoned.
(4) Thedividend model
Thefigures havebeencalculated usingManon’s Ke(12%). If(2)or(3)werefollowed, the
valuewould betheminimum thatManon’s shareholders would accept,asthevaluein
useexceeds scrapvaluein(iii).Therelevance ofa dividend valuationtoCarmen will
depend onwhether thecurrent retentionandreinvestment policies
would becontinued.
Certainly, thevaluetoCarmen should bebasedon9%rather than12%.Bothcompanies
G
areungeared andinthesameriskclasssothedifferent required returns
mustbedueto H
theirrelativesizesandthefactthatCarmen’s shares aremoremarketable.

Oneofthemainlimitations onthedividend growth model istheproblem ofestimating
thefuture valueofg.
(5) TheP/Eratiomodel
TheP/Eratiomodel isanattempt togetatthevaluewhichthemarket wouldputona
company likeManon. Itdoesprovide anexternal yardstick,
butisa verycrude measure.
Asalready stated, theP/Eratiowhichapplies tolargerquoted companies mustbe
lowered toallowforthesizeofManon andthenonmarketability ofitsshares.Another
limitation
ofP/Eratiosisthattheratioisverydependent ontheexpected futuregrowth
ofthefirm.Itistherefore noteasytofinda P/Eratioofa ‘similar firm’.However,in
practicetheP/Emodel maywellfeature inthenegotiations overpricesimplybecause it
isaneasilyunderstood yardstick.
58 Expo Co
TopTips
Itisimportant
thatyouhavea goodunderstandingofthistopicareainorder
topasstheFM
exam. Theideaofthisquestion
istogetyouthinking
aboutsomeofthekeyissues.However,
SectionC questions
intherealexamwillmainly
focusonothersyllabusareas:working
capital,investment
appraisal
andbusinessfinance.
(a) ToTheTreasurer
FromAssistant
Date12November20X7
16:Practice
Questions
591
Page 613 of 641

q
(1) Comparison oftwomethods ofhedging exchange risk
Method 1
3-month borrowing rate=3 ×3/12=0.75%
750,000/1.0075 =744,417 Euros
Dollarsatspotrate=744,417/0.7834 =$950,239
3-month dollardeposit rate=5 ×3/12=1.25%
Dollarvalueofdeposit in3 months =$950,239 × 1.0125 =$962,117
Method 2
Theexchange rateisagreed inadvance. Cashreceived inthreemonths isconverted to
produce 750,000/0.7688 =$975,546.
Conclusion
Onthebasisoftheabovecalculations, Method 2 givesa slightly betterreceipt. Banker’s
commission hasbeenomitted fromthefigures.
(2) Factors toconsider before deciding whether tohedgeforeign exchange riskusingthe
foreign currency markets
Risk-averse strategy
Thecompany should havea clearstrategy concerning howmuchforeign exchange riskitis
prepared tobear.Ahighlyrisk-averse or‘defensive’ strategy ofhedging alltransactions is
expensive interms ofcommission costsbutrecognises thatfloating exchange ratesarevery
unpredictable andcancauselosses highenough tobankrupt thecompany.
Predictivestrategy
Analternative ‘predictive’ strategy recognises thatifalltransactions arehedged, thenthe
chanceofcurrency gainsislost.Thecompany couldtherefore attempt toforecast foreign
exchange movements andonlyhedgethosetransactions where currency lossesare
G
predicted. Thefactisthatsomecurrencies arerelatively predictable (forexample, ifinflation H
ishighthecurrency willdevalue andthereislittletobegainedbyhedging payments inthat

currency).
Thisis,ofcourse, a muchriskier strategy but,inthelongrun,ifpredictions aremade
sensibly,thestrategy should leadtoa higher expected valuethanthatofhedging everything
andwillincurlower commission costsaswell.Theriskremains, though, thata singlelarge
uncovered transaction couldcausesevere problems ifthecurrency moves intheopposite
directiontothatpredicted.
Beststrategy
Asensible strategy forourcompany couldbetoseta cashsizefora foreign currency
exposure abovewhichallamounts mustbehedged, butbelow thislimita predictive approach
istakenoreven,possibly, allamounts areleftunhedged.
(b) Theothermethods usedtohedgeexchange rateriskinclude thefollowing.
Currency ofinvoice whichiswhere anexporter invoices hisforeign customer inhisdomestic
currency, oranimporter arranges withhisforeign supplier tobeinvoiced inhisdomestic
currency. However, although either theexporter ortheimporter canavoidanyexchange risk
inthisway,onlyoneofthemcandealinhisdomestic currency. Theothermustacceptthe
exchange risk,sincetherewillbea period oftimeelapsing between agreeing a contract and
payingforthegoods(unless payment ismadewiththeorder).
Matching receipts andpayments iswhere a company thatexpects tomakepayments and
havereceipts inthesameforeign currency offsets itspayments againstitsreceipts inthe
currency. Sincethecompany willbesetting offforeign currency receipts against foreign
currency payments, itdoesnotmatter whether thecurrency strengthens orweakens against
thecompany’s ‘domestic’ currency because therewillbenopurchase orsaleofthecurrency.
Matching assetsandliabilities iswhere a company whichexpects toreceive a substantial
amount ofincome ina foreign currency hedges against a weakening ofthecurrency by
borrowing intheforeign currency andusingtheforeign receiptstorepaytheloan.For
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example, USdollarreceivables
canbehedged bytakingouta USdollaroverdraft.Inthe
sameway,USdollartradepayables canbematched againsta USdollarbankaccount which
isusedtopaythecreditors.
Leading andlaggingiswhere a company makespayments inadvance ordelayspayments
beyond theirduedateinorder totakeadvantageofforeign exchangemovements.
Nettingiswhere inter-company balancesarenettedoffbeforearrangingpayment. It
reducesforeignexchange purchase costsandthereislesslossininterest
fromhaving money
intransit.
Foreigncurrency derivatives
suchasfuturescontracts,
options andswapscanbeusedto
hedgeforeign currencyrisk.
59 Yields
(a) Ayieldcurveisa curvethatcanbedrawn showing therelationship
betweentheyieldonan
asset(usually
long-termgovernment stocks)
andthetermtomaturity ofthatsameasset.It
shows howtherateofinterest
(yield)varies
withdifferent
maturities.
Toconstruct
a yield
curve,youneedtogatherinformation abouttheinterest
ratesonshort-term
stocks,medium-
termstocksandlongtermstocks. These ratescanthenbeplotted ona diagramagainstthe
maturitydatesofthosesamestocks.
Anormal yieldcurvelookslikeFigure1.
Yield
Normal
yield
curve
G H
Term
tomaturity
Figure1
(b) Importance ofexpectations
Theshapeoftheyieldcurvedepends verymuchonexpectations aboutthefuture. Reward
forlossofliquidityislikelytoremain fairlyconstant. Reward forpossibledefaultislikelyto
remain constant also.Reward fortheriskofhaving tocashinbefore maturity andsuffering a
lossarealsolikelytostayfairlyconstant. Theonlyfactorwhichwillvarywidely is
expectations;inparticular, expectationsaboutfuture short-terminterest
rates.
Expectationsaboutthefuture levelofshort-term interest
ratesarethemostimportant
factorindetermining theshapeoftheyieldcurve.Although thenormal yieldcurveisupward
sloping,withhigher yieldsbeingexpected forlonger maturityperiods,expectations ofrisesin
futureinterestratescancausethe yieldcurvetobesteeper thanthenormal curve.
Expectationsoffallsininterest ratescancausetheyieldtoflatten or,ifsubstantialfallsare
expected,tobecome downward sloping
(Figure 2).
16:Practice
Questions
593
Page 615 of 641

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Yield
Steep
upward–sloping
yield
curve
Normal
yield
curve
Downward
–sloping
yield
curve
Term
tomaturity
Figure2
Risinginterestrates
Ifinterest
ratesarenowexpected torise,investorswillnotwishtolockintolower interest
ratesandwilltherefore sellshort.Borrowerswillwishtoborrow atlower long-term ratesto
avoidexposure tothehigher ratesexpected inthefuture. These
demand andsupplyfactors
willresult
ina shortage oflong-term funds,whichwillpushuplong-term money market rates,
andtoanexcess supplyofshort-term funds,whichwillleadtoa reduction inshort-term
rates.Theresulting yieldcurvewillbemoresteeply upward-slopingthanthenormal curve.
Fallinginterestrates
Iftherearenewexpectations thatinterestrateswillfall,investors
willprefer tolockinat
higher longrates,whileborrowers willnotwishtobecommitted tohigher long-term ratesand
willprefertoborrow short.Therewillbeanexcess supplyoffundsatlongmaturities anda
shortage offundsatshortmaturities. Thiswilltendtolower theyieldcurve,possibly resulting
G
ina flatcurveorevenina downward-sloping curve. H
Inflation
Short-term interestratesareinturndetermined partlybyexpectations ofinflation ratesin
thenearfuture. Ifhighinflation
isexpected, investorswillseekhighernominal ratesofinterest
inorder toachieve a realreturn.
Ifpeople believethatinflation
isfalling,theywillnotrequire
sucha highreturn.
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Appendix 1:
Formulae, ratios and
mathematical tables
G H
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G H
596 Financial
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Appendices
Appendix A: Formulae and ratios that you need to learn

Profitabilityratios:
ROCE = Profitfromoperations(beforeinterestandtax)
Capitalemployed
Debtratios include:
Gearing = Valueofdebt
Valueofequity(ordebt + equity)
Interest cover = Profitfromoperations

Interest
Liquidityratios:
Currentratio = Currentassets
Currentliabilities
G Shareholderinvestorratios include: H
Dividendyield = Dividendpershare× 100

Shareprice
Earningspershare(EPS) = Profitsaftertax - preferencedividend

Numberofordinaryshares
Pricetoearningsratio(P/E) = Shareprice
EPS
Workingcapital ratios
Operatingcycle=inventorydays +receivabledays – payables days
Inventorydays =inventory/costof sales ×365
Receivablesdays =trade receivables/(credit)sales ×365
Payablesdays =trade payables/(credit)purchases×365
Salesto net workingcapital ratio=sales/networkingcapital (exclcash)
Appendix597
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Costofcapitalformulae:
Kd = I(1- t)
P0
Kp = d
p
Otheruseful
formulae
tolearn:
NPVa-NPVb
[ NPVa ]
IRR = a% + × (b% - a%)
Totalshareholderreturn = dividendgain
+ capital
sharepriceatstart
year
EAC = NPVofcosts
Annuityfactorfor
lifeoftheproject
Profitabilityindex = Present
valueofcashinflows
(orNPVof
theproject)
Present
valueofcashoutflows
G H
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AppendixB: Mathematicaltables
Present
ValueTable
valueof$1,thatis(1+r)−nwhere
Present r =interest
rate;n =number
ofperiods
untilpayment
orreceipt.
Periods Interest
rates
(r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 0%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
Periods Interest
rates
(r)
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
G
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 H
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
Appendix
599
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q
Annuity
Table
Present
valueofanannuity +r)−n
of1ie 1−(1
r
Wherer=discount
rate;n=number ofperiods
Periods Discount
rate(r)
(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
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 .783 .759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
G
(n) 11% 12% 13% 4% 15% 16% 17% 18% 19% 20%
H
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
600 Financial
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q
FormulaSheet
EconomicOrderQuantity
= 2COD
CH
Miller-OrrModel
Return point = Lower limit + ( 1 × spread)
3
Interestrate[ ]
3 × transactioncost × varianceofcashflows13
Spread = 3 4
TheCapital AssetPricingModel
E(n) = Rf + βi(E(rm) - Rf)
Theasset beta formula

[ ] (Ve+Vd(1−T))[]
βa = Ve βe + Vd(1−T) βd
(Ve+Vd(1−T))
G H
TheGrowthModel
PO = DO(1+ g) re = DO(1+ g) +g
(re- g) PO
Gordon’sGrowthApproximation
g =br
Theweightedaverage cost of capital

[ veve ] [ ve+vd]
vd kd(1 - T)WACC
= ke +
+vd
TheFisherformula
(1 + i) = (1 + r)(1
+ h)
PurchasingPowerParityand InterestRate Parity

S1 = S0 × (1 + hc) F0 = S0 × (1 + ic)
(1 + hb) (1 + ib)
Appendix601
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q
G H
602 Financial
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q
Glossary
G H
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q
Chapter 1:Financialmanagementfunction
Agencyrelationship:Adescriptionoftherelationship
between businessowners (egshareholders)
andthoseactingasagentsontheirbehalf(egmanagers), expressingtheideathatmanagers act
asagentsfortheowners, usingdelegatedpowers torunthecompany intheowners’ best
interests.
Corporate governance:Therulesandprocesses bywhichthebehaviour ofa firmisdirected.
Cumdividend: Cumdividend orcumdivmeans thepurchaserofshares isentitled
toreceivethe
nextdividend payment.
Exdividend: Exdividendorexdivmeans thatthepurchaser ofsharesisnotentitledtoreceivethe
nextdividend payment.
Earnings pershare(EPS):Profits
distributable
toshareholders/Numberofordinary shares
Economy: Attaining
theappropriatequantityandqualityofinputsatthelowest costtoachievea
certainlevelofoutputs.
Efficiency:
Therelationshipbetweeninputs andoutputs.
Effectiveness:Theextenttowhichdeclared objectives/goals
aremet.
Financialmanagement: Theacquisition
anddeployment offinancial
resources toachievekey
objectives.
Goalcongruence: Thealignmentbetween theobjectivesofagentsactingwithin anorganisation
andtheobjectives oftheorganisationasa whole.
Stakeholders:Groups orindividuals
whose interests
areaffectedbytheactivitiesofa firm.
Totalshareholderreturn:Dividend+changeinshareprice/Share priceatthestartoftheyear
Valueformoney: Thiscanbedefined asgetting thebestpossible
combination ofservices
from
theleastresources,whichmeans maximising thebenefits
forthelowest possiblecost.
G H
Chapter 2: Financialmanagementenvironment
Disintermediation:Describes a declineinthetraditional
deposit andlending relationship
between
banksandtheircustomers andanincrease indirectrelationships
between theultimate suppliers
andusersoffinancing.
Eurobond: Abonddenominated ina currencywhichoftendiffers fromthatofthecountry of
issue.
Exchange rate:Therateatwhichonecountry’s currencycanbetraded inexchange foranother
country’scurrency.
Financialintermediary : Aninstitution
bringingtogetherproviders offinanceandusersoffinance.
Fiscalpolicy:Actionbythegovernment tospendmoney, ortocollect money intaxes,withthe
purpose ofinfluencingthecondition ofthenational economy.
Macroeconomics: Concerned withissues affectingtheeconomy asa whole egeconomic growth,
inflation,
unemployment.
Market failure:
Saidtooccurwhenthemarket mechanism failstoworkefficientlyandtherefore
theoutcome issub-optimal.
Monetary policy:Theregulation oftheeconomy throughcontrol ofthemonetary systemby
operating onsuchvariables asthemoney supply,thelevelofinterestratesandtheconditions for
availability
ofcredit.
Chapter 3: Workingcapital investment

Accounts
payablepaymentperiod:
Accountspayable paymentperiod
= (Average
trade
payables/Purchases
orCostofsales)× 365days
Average
inventory:
Average
inventory=buffersafetyinventory
+(re-order/2)
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Cash operatingcycle:Theperiodof timethat elapsesbetweenthe pointat whichcash beginsto
be expendedon the productionof a productor serviceand the collectionof cash froma
customer.
Factoring:Anarrangementto havedebts collectedby a factor company, whichadvances a
proportionof the moneyit is due to collect.
Maximuminventorylevel:Maximuminventorylevel=re-orderlevel+re-orderquantity–
(minimumusage ×minimumlead time)
Minimuminventoryor buffersafety inventory:Minimuminventoryor buffersafety inventory=re-
orderlevel– (averageusage ×averagelead time)
Networkingcapital: Thenet workingcapital of a businessis its currentassets lessits current
liabilities.
Non-recoursefactoring:Thedebt factor has no recourseto the clientinthe eventof non-
payment,ie bad debts insuranceis beingprovidedby the debt factor.
Overtrading:Asituationwherea businesshas inadequate cash to supportits levelof sales (also
knownas undercapitalisation).
Re-orderlevel:Re-orderlevel=maximumusage ×maximumlead time
Theeconomicorderquantity (EOQ):Theoptimalorderingquantityforan itemof inventorywhich
willminimiseinventoryrelatedcosts.
Workingcapital finance:Theapproach takento financingthe level,and fluctuationsinthe level,
of net workingcapital.
Chapter 4: Cash management and working capital finance

Cash flowforecast: Adetailedforecastof cash inflowsand outflowsincorporatingboth revenue
and capital items.
G Workingcapital finance:Theapproach takento financingthe level,and fluctuationsinthe level, H
of net workingcapital.
Chapter 5: Investment decision

Annuity:Aseriesof equal cash flows.
Capital expenditure:Expenditurewhichresultsinthe acquisitionof non-currentassets or an
improvementintheirearningcapacity. Itis not charged as an expenseinthe statementof profit
or loss;the expenditureappears as a non-currentasset inthe statementof financialposition.
Revenueexpenditure:Charged to the statementof profitor lossand is expenditurewhichis
incurred:
• Forthe purposeof the trade of the business– thisincludesexpenditureclassifiedas selling
and distributionexpenses,administrationexpensesand financecharges
• Tomaintainthe existingearningcapacity of non-currentassets
Internalrate of return(IRR):Adiscountedcash flowtechniquethat calculatesthe percentage
returngivenby a project.Ifthisreturnisused to discounta project’scash flows,it woulddeliver
an NPVof zero.
Opportunitycost: Acost incurredfromdivertingexistingresourcesfromtheirbest use.
Payback period:Ameasureof howlongit takes forthe cash flowsaffected by the decisionto
investto repay the cost of the originalinvestment.
Perpetuity:Anannuitythat occursforthe foreseeablefuture.
Presentvalue:Thecash equivalentnowof moneyreceived(orpaid)inthe future.
Relevantcash flow:Afutureincrementalcash flowcaused by a decision(egto investina project).
Glossary 605
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q
Chapter 6: Allowingfor tax, workingcapital and inflation
Real:Theterm‘real’whenapplied
tocashflowsortothecostofcapital,means
basedoncurrent
pricelevels.
Nominal:Theterm‘nominal’,
whenappliedtocashflowsortothecostofcapital,means
after
adjusting
fortheimpactofexpectedinflation.
Chapter 7: Projectappraisaland risk

Jointprobability:
Theprobability oftworiskyoutcomes occurring
atthesametimeandis
calculated
astheprobability ofoneoutcome multiplied
bytheprobability
oftheother.
Risk:Arises
where thereareseveralpossible
outcomes and,basedonpastrelevantexperience,
probabilities
canbeassigned tothepossible outcomes.
Sensitivity
analysis: Akeymethod ofanalysing theuncertainty
surrounding
a capital
expenditure
project andenables anassessment tobemadeofhowresponsive theproject’s
NPV
istochanges ina singlevariablethataffectsa project’s
NPV.
Uncertainty:Ariseswhere thereareseveralpossibleoutcomesandnoinformation(egexperience)
uponwhichtocreateprobabilities sothedegree ofuncertainty
cannotbequantified.
Chapter 8: Specific investmentdecisions

Capitalrationing:
Ariseswhenthereisinsufficientcapitaltoinvest
inallavailableprojects
which
havepositiveNPVs,iecapitalisa limiting
factor.
Divisible
projects:
Aprojectthatcanbescaleddownanddoneinpart.
Equivalentannualbenefit:
Expresses theNPVfroma project asanannuity,iea constant cash
flowperyear.
Equivalentannualcost:Expresses thepresentvalueofthecostsofanassetreplacement cycleas
G H
a costperyear.
Leasing:Acontractbetween a lessoranda lesseeforhireofa specific
assetbythelessee froma
manufacturerorvendor ofsuchassets.
Lessor:Alessor
receivesleasepayments.
Lessee:Alesseemakes leasepayments.
Non-divisible
project:
Aproject thatmustbeundertaken completely ornotatall;ieitisnot
possibletoscaledowntheproject anddoitinpart.
Saleandleaseback: Whena business thatownsanassetagreestoselltheassettoa financial
institution
andleaseitbackonterms specified
inthesaleandleaseback agreement.
Chapter 9: Sourcesof finance

Conversion premium:Conversion premium = Currentmarket valueofloannote– current
conversionvalueofshares
Convertible loannotes:Givetheloannoteholders theright(butnotanobligation)toconvert
theirloannotesata specifiedfuturedateintonewequityshares ofthecompany, ata conversion
ratethatisalsospecifiedwhentheloannotesareissued.
Cumrightsprice:A ‘cumrights’ pricemeans thatthepurchaser ofexistingshares
hastherightto
participateintherightsissue(iethepricepriortotherightsissue).
Issueprice:Thepriceatwhichthenewshares arebeingoffered forsale.
Theoreticalex-rights
price(TERP):Thetheoretical priceaftertherightsissue.
Valueofa right:Thepriceatwhicha rightcanbesold(calculate asTERP– issueprice).
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q
Valueofa rightperexisting share:Thevalueofa rightdivided bythenumber ofshares thatneed
tobepossessed inordertoowna right.
Deepdiscount loannotes:These areissued ata pricethatisata largediscount tothenominal
valueofthenotes, andwhichwillberedeemable atnominalvalue(orabovenominal value)when
theyeventually mature.
Initialpublicoffer(IPO):Aninvitationtoapplyforshares ina company basedoninformation
contained ina prospectus.
Loancovenant: Acondition thattheborrower mustcomply with.Iftheborrower doesnotactin
accordance withthecovenants, theloancanbeconsidered indefault andthebankcandemand
payment.
Rightsissue:Ina rightsissue,ordinary shareholders areinvited
toapplyforshares inproportion
totheirexisting shareholdings.Ina rightsissue,shareholders
havea number ofchoices;theycan:
• Buythenewshares
• Selltheir‘right’tobuyshares
• Doa mixoftheaboveA rightsissuewillnormally beata significantdiscount(eg20%)tothe
existingshareprice,sothesharepriceaftertherightsissuewillbebelow thepre-rightsshare
price.However, thisdoesnotinitselfdamage shareholder
wealth because shareholdersalso
benefitfrombuyingtheshares ata discount (orbysellingtherights).
Venture capital:Riskcapital,normally provided bya venturecapitalfirmorindividualventure
capitalist,
inreturn foranequitystake.
Zero-coupon loannotes:Issued ata discount totheirredemption value,butnointerestispaidon
them.
Chapter 10: Dividendpolicy
G
Scripdividend:
Adividend
paidbytheissueofadditional
company
shares,
rather
thanbycash. H
Chapter 11:Thecost of capital

Betafactors:Measures
theaverage changeinthereturn ona shareeachtimethereisa change
inthestockmarketasa whole.
Marketriskpremium/equity riskpremium:Thisisthedifference betweentheexpectedaverage
marketreturnandtherisk-free rateofreturn
overthesameperiod.
Systematic(ormarket)
risk:Thecomponent ofriskthatwillstillremain
evenifa diversified
portfolio
hasbeencreated.
Unsystematic(orspecific)
risk:Thecomponent ofriskthatisassociatedwithinvesting
ina
particular
company.
Chapter 12: Capital structure

Arbitrage:
Whena purchase andsaleofa security takesplacesimultaneously
indifferent
markets,withtheaimofmaking a risk-free
profitthrough theexploitation
ofanypricedifference
between themarkets.
Assetbeta:Anungeared betaieonlymeasures businessrisk.
Equitybeta:A measureofthesystematic riskofa share,including
itsbusiness
andfinancial
risk.
Capitalstructure:
Thecapitalstructureofa company referstothemixtureofequityanddebt
financeusedbya company.
Glossary607
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q
Chapter 13:Businessvaluations
Takeover:
Theacquisition
bya company ofa controlling
interest
inthevotingsharecapitalof
anothercompany,usuallyachievedbythepurchase ofa majority
ofthevotingshares.
Marketcapitalisation:
Thetotalvalueofallthesharesina company.
Theefficient
markethypothesis:Arationaleforexplaining
howsharepricesreacttonew
information
abouta company,andwhenanysuchchangeinsharepriceoccurs. Stockmarket
reaction
tonewinformationdepends onthestrength ofthestockmarket’s
efficiency.
Chapter 14: Foreigncurrencyrisk

Currency futures: Acontract topurchase orsella standardquantity ofa currencybyanagreed
futuredateata specified exchange rate.
Currency options: Arightofanoption holder tobuy(call)orsell(put)a quantityofonecurrency
inexchange foranother,ata specific exchange rateonorbefore a futureexpirydate.
Economic risk:Duetolong-term movements intheexchange ratethatdamage thevalueofa
company because thenetpresent valueofthebusiness’s cashflowsisdiminished byexpected
exchange ratetrends.
Exchange rate:Therateatwhichonecountry’s currencycanbetraded inexchange foranother
country’scurrency.
Forward contract: Acontract witha bank(sometimes calledanoverthecounter orOTCcontract)
fixingtheexchange rateona specificamount offoreigncurrency (FX)receivableorpayable ata
futuredateatanexchange rateagreednow.
Netting:Aprocess inwhichcreditbalances arenetted offagainst debitbalances sothatonlythe
reduced netamounts remain duetobepaidbyactualcurrency flows.
Spotrate:Theexchange ratecurrently offered ona currency forimmediate delivery.
Swap:A formal agreement whereby twoorganisations contractuallyagreetoexchange payments
G H
ondifferentterms, egindifferent currencies.

Transaction risk:Theriskthata transaction ina foreigncurrency isrecorded atonerateandthen
settledata differentratebecause ofa changeintheexchange rate.
Translationrisk:Theriskthatthedomestic currency valueofforeign currency assetsfalls,orthe
valueofforeign currency liabilities
rises.
Chapter 15: Interestraterisk

FRA:A contractwitha bankcovering a specificamount ofmoney tobeborrowed overa specific
timeperiod inthefutureataninterest rateagreednow.
Interestratefutures:
Aninterestratefutures contractisa contract toreceive
orpayinterest ona
notionalstandard quantity
ofmoney atanagreedfuture dateata specifiedinterestrate.
Interestrateoptions:
Givesanoption holder therighttopayorreceive interest
onanagreed
quantity ofmoney, ata specific
interestrateonorbefore a futureexpirydate.
Interestrateswap:Anagreement whereby theparties totheagreement exchange interest
rate
commitments.
Putoption: Anoptiontopayinterest ata pre-determined rateona standard notionalamount
overa fixedperiodinthefuture.
Calloption: Anoptiontoreceive interestata pre-determined rateona standardnotionalamount
overa fixedperiodinthefuture.
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q
Index
G H
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q
G H
610 Financial
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q
A Costofdebt,230
Acceptancecredits,31 Costofirredeemableloannotes,
230
Accountingrateofreturn,
105 Costofpreferenceshares,233
Adjusted
payback, 105 Costofredeemable debt,231
Agencyproblem, 8 Creditperiod,
54
Agencytheory,8 Creditor
hierarchy,
221
Aggregation,
29 Cumdiv,223
Annuities,
108 Currencyfutures,
320
Arbitrage,
253 Currencyoptions,
321
Assetbeta,256 Currencyswaps,322
Assetreplacementdecisions,
161 D
Auditcommittee,8 Debtbeta,232
B Debtratios,11
Bankbills,31 Delayedannuities,110
Basisrisk,337 Discountfactors,
107
Baumol model, 78 Discountedpayback period,
105
Behaviouralfinance,
292 Discounting,106
Betafactor,227 Disintermediation,
29
Billofexchange,31 Dividendgrowthmodel, 221
Dividendirrelevance
theory,
208
C
Dividendpolicies,
207
Capitalassetpricingmodel(CAPM),
226
G Dividendvaluationmethod,282 H
Capitalrationing,
167 Divisible
projects,168
Capitalstructure,
248
Cashflowforecast, 73 E
Cashoperating cycle,45 Earlysettlementdiscount,55
Cashshortages, 76 Earningspershare,4
Cashsurpluses,77 Earningsyieldmethod, 282
Certainty-equivalent
method,150 Economic risk,326
Certificates
ofdeposit,31 Efficient
market hypothesis,
289
Clientele
effect,208 EOQmodel, 49
Commercial paper,31 Equitybeta,255
Competitionpolicy,27 Equityfinance,191
Conservativeforecasting,
150 Equivalentannual benefit,
163
Contractionarymacroeconomicpolicies,
24 Equivalentannual cost,161
ConventionsusedinDCF,108 Eurobond, 33
Conversionpremium, 190 Eurocurrency,33
Conversionratio,190 Exdiv,223
Conversionvalue,190 Exchange ratepolicy,25
Convertible
loannote,190 Expansionary macroeconomic policies,
24
Corporategovernance, 8 Expectationstheory,345
Costofbankloan,234 Expected values,147
Costofconvertibledebt,232
Index 611
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q
F Loancovenants,
188
Factoring,58 Loannotes,
189
Financialaccounting,
14 Long-term
finance,
188
Financialintermediary,
28 Loss-aversion,
292
Financialmanagement, 4 M
Financialrisk,248 Macroeconomic policytargets,
24
Fiscalpolicy,25 Management accounting, 14
Foreignaccounts payable,62 Marginalcostofcapital,256
Foreignaccounts receivable,
59 Marketcapitalisation,
278,484
Forward contract,314 Marketfailure,
27
Forward rateagreement (FRA),338 Marketriskpremium, 228
Framework formanaging receivables,
57 Marketsegmentation theory,345
Framework formaximisingshareholder
wealth, Matching,338
7
Maturitytransformation,29
G Methods ofraisingequityfinance,192
Gapexposure,
337 Miller-Orr
model, 79
H ModiglianiandMiller(notax),252
Hardcapitalrationing,
167 ModiglianiandMiller(withtax),253
Herding,
292 Monetary policy,25
Money market,30
I Money market deposits,30
G
Ijara,196 Monopoly, 27 H
Incentiveschemes, 9 Mudaraba, 196

Inflation,
133 Murabaha, 196
Interestratecap,343 Musharaka, 196
Interestratefloor,343
N
Interestratefutures,340
Interestrateoptions, 342 Negative
externalities,
27
Interestrateswaps, 344 Negotiable
instrument,30
Internalfinance,207 Netassetvaluation,
279
Internalrateofreturn, 114 Netoperatingincome approach,
252
InternationalFishereffect,325 Netpresentvalue,112
Inventory,49 Networkingcapital,42
Islamicfinance,196 Nominationcommittee, 8
Non-divisible
projects,
169
J Non-relevant
costs,102
Jointprobability,
148 Not-for-profit
organisations,
13
Just-in-time,
53
O
L Objectives
ofworking capitalmanagement,
42
LeasevsBuy,164 Offerforsale– fixedprice,195
Lessor,
166 Offerforsale– tender,196
Liquidity
preference
theory,
345 Oligopoly,
27
Liquidity
ratios,
11 Overcapitalisation,
49
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q
Overdraft,
187 Simulation,
150
Overtrading,
49 Smoothing,338
P Softcapitalrationing,
167
Speculationmotive,
73
P/Emethod, 280
Stakeholders,
10
Payback period,
103
Sukuk,197
Peckingordertheory,255
Synergies,
281
Performance-related
pay,9
Systematic
risk,226
Perpetuities,
110
Placing,
195 T
Pooling
losses,29 Tax-allowable depreciation,
127
Portfolio
theory,226 Taxation,127
Precautionarymotive,
73 Timevalueofmoney, 106
Preference
shares,191 Totalshareholder return,
5
Probability
analysis,
147 Trade credit,
187
Profitability
index,168 Trade payables, 60
Profitability
ratios,
11 Traditional
theory, 252
Purchasingpower paritytheory,
323 Transactionrisk,310
R Transactions motive,
73
Translation
risk,326
Random walktheory,
290
Treasurybill,30
Receivables,54
Treasurymanagement, 83
Relevant cashflows,
101
G
Remuneration committee,
8 U H
Repurchase agreements,
31 Uncertainty,
147
Return oncapitalemployed,105 Unsystematic
risk,226
Return oninvestment,105 V
Reverse yieldgap,33,221
Valuation
ofothersecurities,
288
Rightsissues,193
Valueformoney, 13
Risk,147
Venturecapital,192
Risktransformation,
29
Risk-returnrelationship,
220 W
S Weighted
average costofcapital,234
Working
capital,130
Salestonetworking capitalratio,47
Working
capitalfinance,42,80
Scenariobuilding,
153
Working
capitalfinancing,
81
Scripdividend,
211
Working
capitalfinancingstrategies,
81
Securitisation,
29
Working
capitalplanning,43
Sensitivity
analysis,
151
Working
capitalratios,
44
Shareoptions,9
Sharerepurchases,211 Y
Shareholderinvestorratios,
11 Yieldcurve,344
Short-termfinance,187
Short-termlease,187
Short-termloan,187
Index613
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Bibliography
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616 Financial
Management
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Arnold,G. (2015)CorporateFinancialManagement.5th edn. Harlow,PearsonEducationLimited.
Chisolm,A.(2007)Derivativesdemystified.Chichester,WileyFinance.
Pike,R.,Neale,B.and Linsley,P. (2016)CorporateFinance&Investment.8th edn. Harlow,
PearsonEducationLimited.
Watson,D.and Head,A.(2013)CorporateFinanceprinciplesand practice. 6thedn. London,
PearsonEducationLimited.
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Bibliography617
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Financial Management (FM)

For exams in September 2021,

December 2021, March 2022

Free access to eBook & additional digital content

For exams in September

2021, December 2021, March

2022 and June 2022

1 Financial management function 1

7 Project appraisal and risk 145

Further question practice 509

BPP Learning Media – ACCA Approved Content Provider

Studyingcan be a dauntingprospect,particularlywhenyou havelotsof othercommitments.This

Activitiesgiveyou essentialpracticeof techniquescoveredinthe chapter.

Theelectronicversionof the Workbookcontainsadditionalcontent,selectedto enhance your

Overall aim of the syllabus

• Explainand apply riskmanagementtechniquesinbusiness

Strategic Business Advanced Financial

A1 Thenature and purposeof financialmanagement Chapter 1

C1 Thenature, elementsand importanceof workingcapital Chapter 3

E1 Sourcesof and raisingbusinessfinance Chapter 9, 10

Theresponsestoeachquestion aremarked automatically

General guidanceforapproaching OTquestions

Thebalance oftheFMexamwillbeapproximately 50:50interms ofthenumber ofmarks

STEP1: Readandanalysethe requirement.

STEP2: Readandanalysethe scenario.

SkillsCheckpoint4 coversthistechniqueindetailthroughapplicationto an exam-standard

Thischapter coversSectionA ofthesyllabus

Other Not-for-profit Financial

1.1 Definition of financial management

Activity2: Calculation of financialobjectives

2 A framework for maximising shareholder wealth

2.1 Investment decision

3.1 Agency theory

G 3.3 Incentive schemes H

5.1 Value for money

 Theagencyproblem isnotimportant fora publicsector

6 Financial management compared to management and

Financial management function

Definition Frameworkfor maximising Encouragingshareholder

Other Not-for-profit Financialmanagement

Activity2: Calculation of financial objectives

Activity3: Corporate governance

Soundcorporategovernancedoes not includebreakingthe lawand a non-executivedirectorcan

Activity4: Calculation of financial objectives

• Thedebt leveldoes not appear to be a problem,as interestcoveris high.

Money Capital International

1.1 Macroeconomic policy targets

(a) Economic growth – ‘Growth’ implies anincrease innational income, whichisusually

reason thatinflationisviewed asa problem isthatifa country hasa relativelyhighrateof

Real life example

SeeChapter 2 Section4 of the EssentialReading,availableinthe digitaleditionof the Workbook,

1.5 Other economic policies

2 Financial markets and institutions

Whena firmis makingits financingdecisionit has tworoutesto obtainingfinance:

Financialintermediary: Aninstitutionbringingtogetherprovidersof financeand usersof

Investor(surplusunit) Financialintermediary Borrower(deficitunit)

Afinancialintermediarylinkslenderswithborrowersby obtainingdepositsfromlendersand then

2.2 Financial markets

3.1 Types of money market instruments