Acca F9 Key Point Notes

ACCA F9 Financial Management Key Point Notes June 2011 ------------------------------------------------------------------------------------------------------------

________________________________________________________________________ Sunil Bhandari – IAT Ltd 1

Key Point Notes

June 2011

ACCA F9

Financial Management

Tutor: Sunil Bhandari

Tutor Contact Details

Mobile: +44 (0)7833 438771 E-mail: via www.IntelligentAccountancyTutorsLtd.co.uk

These notes are not intended to cover the whole syllabus, but target key examinable areas.

Copyright to Intelligent Accountancy Tutors Ltd



Use of these Key Point Notes These notes have been written as an aid to assist students preparing for the ACCA F9 June 2011 Exam. They accrue for the topics tested in the past exams. It is of paramount importance that they are used with an up to date Revision Kit. A combination of using the notes and question practice is the best way to prepare for the forthcoming exams.



Index Chapter Number Chapter Name Page Numbers Preliminaries 4-12

Chapter One Financial Objectives 13-20

Chapter Two

Dividend policy 21-24

Chapter Three Cost of Capital 25-30

Chapter Four

Bonds-Yields & Market Value

31-32

Chapter Five

Risk Adjusted WACC 33-36

Chapter Six

CAPM 37-46

Chapter Seven

Capital Structure 47-50

Chapter Eight

Project Appraisal 51-66

Chapter Nine

Business Valuations 67-70

Chapter Ten Sources of Finance 71-78

Chapter Eleven

Ratios 79-82

Chapter Twelve

Working Capital 83-84

Chapter Thirteen Inventory Control 85-88

Chapter Fourteen Receivables& Payables 89-92

Chapter Fifteen

Cash Management 93-98

Chapter Sixteen Foreign Currency Risk 99-106

Chapter Seventeen Interest Rate Risk 107-112

Appendix

Islamic Finance 113-116













Exam Technique

First 15 minutes

Read the questions carefully Recognise the topic being tested (eg NPV, Rights Issue

etc)

Rank the questions according to your ‘strongest’ to ‘weakest’

Next 180 minutes

Attempt the questions in your ranked order. Stay within your time allocation both on each part of

the question and on the question itself. If the written elements are unrelated to the

computations-try front load as they represent ‘easier’ marks.

Try to attempt all parts to all the questions. If in doubt about how to compute a value-make a

reasonable estimate and move on.



General

Numerical Questions

State formula Show method

Explain as you go

Make assumptions if in doubt

Written Questions

Check format – report / essay/ listed points Headings / subheadings / columnar

Simple short paragraphs-essays and reports

Use ‘numbered’ points for most questions-simple

sentence approach.



Tips These will be available via my website. Please download from there.





Chapter One Financial Objectives 1 Primary Financial Objective 1.1 For profit making business “Maximise Shareholder(S/H)

Wealth”

1.2 To Measure S/H wealth Value of Equity (Ve) =Number of issued Equity/Ordinary Shares X Current Market Price (Po)

1.3 To find Po:

Given in the Question if it is a listed company(see below)

Compute Using:-

• Dividend Valuation Model(DVM) • Earnings Based Models(PE)

1.4 Check the question very carefully for the size of the

company is it:-

Listed Private Company

Make your comments relevant to the size and nature of the company stated within the question.



2 Indicators 2.1 Financial indicators pointing towards maximising S/H

wealth include:-

Earning per share(EPS) Dividend per share(DPS) Return on Capital Employed(ROCE) Return on Shareholder Capital(ROSC) Profit after tax Revenue

2.2 Non-Financial Indicators include:

Market Share Customer Satisfaction Quality Measures

The above are all Key Performance Indicators (KPI’s) that need to be measured and reviewed on a regular basis by the board of directors. (Board)

3. External Factor Affecting Ve & Po 3.1 The Board cannot control all aspects that effect Ve and/or Po. One of the major factors is macroeconomic variables.

3.2 Economic Variables -what are they and how may directional changes effect the share price? 3.2.1 Interest Rates- If they fall:-

Stimulate demand and revenue Lower the cost of debt and improve profits Investors switch to share market for better

returns



3.2.2 Inflation Rates- If it rises:-

Costs rise causing a drop in profits Cause interest rates to rise. Devalues the home currency

3.2.3 Foreign Exchange Rate(FOREX)- If it rises:-

Reduce cash receipts for exporters Lowers the cost for importers Discourage exporting

3.2.4 Gross Domestic Product- If it falls:-

Reduce demand and revenue Cause interest rates to fall to stimulate demand

3.2.5 General Taxation –If it rises:-

Damage company profits Not encourage investment by companies More savings from tax effect of tax allowable

depreciation. Important to relate your comments to the effect upon Po & Ve.

3.3 Agency Problem

3.3.1 S/H are the owners of the company and expect their directors (agents) to take decisions to maximise S/H wealth. The agency problem occurs when directors take decisions that DO NOT lead to maximising S/H wealth.



3.3.2 Examples of decisions that ‘may’ damage S/H wealth:

Directors pay Taking high risk business decisions Non-payment of dividends Using debt finance (against the wishes of the

S/H) 3.3.3 Solutions to this problem include:

Company Law Corporate Governance (eg UK Combined Code) Share Options (ESOPS)

3.3.4 ESOPS This provides a way of rewarding Directors by

granting them options to buy shares in their company at a fixed price. They can buy the shares in future (normally 1 year) at the fixed price which usually is today’s price. Hence, directors are encouraged to take decisions to maximise future share prices. This benefits both the directors and the shareholders.



4 The Three Key Decisions

4.1 To maximize S/H wealth the board must take

Investment Finance Dividend

4.2 Investment 4.2.1 Allocate cash for:-

Organic Growth (Projects) Acquisitions

4.2.2 Must always consider how investments

impact upon:- Company Liquidity Future Profits and Asset values Business Risk Profile i.e. effect upon

variability of the cash flows and profits. 4.3 Finance 4.3.1 To finance investments the board have to

decide the best balance of equity and debt.

4.3.2 They will consider:-

Cash available within the company Access to new sources of finance Impact on KPI’s like gearing

ratio(Debt:Equity) Cost of Finance (WACC)



4.4 Dividends

4.4.1 The Board needs to establish a dividend policy – see Chapter 2

4.5 The three decisions are interlinked.

Example: New projects need new finance but must generate cash to service the finance providers including paying dividends to the shareholders.

5 Objectives of Not-For-Profit- Organisations (NFP)

5.1 These include:

government funded functions(“Public Sector”) charities trade unions

5.2 With no shareholders it is important to ascertain.

a) who are the main stakeholders? b) what are there objectives?

5.3 It is widely recognised that NFP entities should

demonstrate the principles of “Value for money”(VFM)

The indicators are:-

1) Economy - lowest cost of input resources 2) Efficiency - ratio of input to output measures 3) Effectiveness - how outputs are measured.



5.4 For example, in a government funded school measures could be:-

Economy - cost of teachers

- cost of admin Efficiency - cost/pupil - Number of pupils/teacher Effectiveness - pass rates

- number of pupils moving to higher education





Chapter Two Dividend Policy 1 Introduction To maximise S/H wealth the Board should establish a dividend policy-the payment pattern to the equity investors. 2 Theories Several theories have been put forward to assist:- 2.1 Residual – If spare cash exists at the end of the year pay dividend. 2.2 Pattern – Be consistent with dividend payments. Either a) Pay the same dividend per share (DPS) each year. b) Maintain the payout ratio (DPS/EPS) c) Maintain the same year-on-year growth rate in dividends. The latter links into the Po via the dividend valuation model (DVM) Po= Do (1+g)

(re-g)



2.3 Irrelevancy In a perfect capital market providing the directors can invest in projects with a positive NPV no dividends are required. The Ve will rise and the S/H can sell shares to create the cash the need(Manufacture Dividends). 3 Practical Considerations There are many to consider:

Availability of Cash What dividends to S/H want (clientele effect)? Signalling effect –payment of dividends indicates a

healthy company Retaining cash is a key source of Finance. Dividend growth should be greater than inflation Tax impact upon S/H Effect the dividend will have on dividend

cover(EPS/DPS) Number of investment opportunities will restrict

dividend payments. Risk-paying now is safer than promising to pay next

year Is the dividend within the company law regulations?

4 Alternatives to Cash Dividends 4.1 Scrip Dividends 4.1.1 The S/H will receive extra shares instead of cash on a pro rata basis. 4.1.2 This will allow the S/H to sell extra shares for cash and the gain will be subject to CGT.



4.1.3 The effect will:- a) Increase the issued equity capital b) Dilute EPS and Po values c) Create pressure for the board to pay more total dividends in the future as more shares are in issue 4.2 Share Buy Back 4.2.1 If the board has “one off” period of excess cash, they could consider a share buy back. i.e. Buy back shares at Po and cancel them. 4.2.2 Considerations:-

a) Allowable under company law. b) Increase gearing as Ve may fall. c) Tax implications for the S/H(CGT) d) Reduced number of shares will cut supply for

trading purposes and may cause Po to rise. e) Less dividend pressure on the board in future. f) Criticism-is this the best use of company cash.





Chapter Three Cost of Capital 1 Weighted Average Cost of Capital (WACC)

Ke=Cost of Equity Kd=Should be “Kd(1-t)”=Cost of Debt Ve=Market Value of Equity Vd=Market Value of Debt 2 Market Values 2.1 Ve=Total Number of Issued Shares X Po 2.2 Vd=Total Book value of the Debt X Po

$100 2.3 Alternative Presentations

a) Ratio (Vd:Ve) e.g. 1:4 b) Gearing Percentage e.g. 35% hence, Vd=35,Ve=65

for WACC equation



3 Cost of Equity (Ke) 3.1 The minimum return required by the S/H to compensate for the risks they face from the equity investment. 3.2 CAPM Ke=Rf+ (Rm-Rf)βe

where Rf=Risk free return Rm=Return on the market portfolio (Rm-Rf)=Equity Risk Premium βe=Measure of the risks being faced by the S/H 3.3 DVM

Where Po=Ex Dividend Share Price d1=The DPS at Time 1 do=The DPS at Time 0 g =Constant annual future growth rate in the DPS 4 Cost of Debt (Kd (1-t)) Depends upon the type of Debt Also note:-

a) Kd=Called Yield(the minimum return of the lender)or pre tax cost of debt

b) “Kd (1-t)”=Cost of Debt* or post tax cost of debt * This is part of the cost of capital computation.



4.1 Non traded debt (Bank Loans)

Kd is the Interest rate on the loan “Kd (1-t)”=Interest Rate X (1-t)

4.2 Traded Bonds 4.2.1 These are issued and traded in blocks of $100 or £100.Do all computations per block of “100”. 4.2.2 Undated Bonds-the process is:-

a) Kd (1-t) = Ints x (1-t) PO b) Exam Tricks :

i. If there is no taxation Kd (1-t) = Ints

PO ii. If the Kd is given by the examiner in the question Kd (1-t)=Given Kd% x (1-t) 4.3.3 Redeemable Bonds-the process is via IRR computation Time $ To Po (X) Take two guesses at the Kd(1-t) like T1-Tn Ints x (1-t) X 10% & 1% and Perform IRR computation Tn Capital Repayment* X * can be replaced by equity value for convertible bonds if higher than capital repayment.



5 Uses of the WACC 5.1 The WACC is the money or nominal cost of capital to use in project DCF approaches. It can be used:-

a. To compute the NPV as the discount rate. b. Compare with the project IRR. IRR>WACC-Accept

5.2 The WACC is useable if the new project under consideration:-

a) Is a core activity –same as the company’s normal activities b) Does not alter the capital structure of the company (Vd:Ve)

5.3 In all the past F9 exam questions, it has been very clear within the question details that the conditions exist to use the WACC. If the WACC can’t be used then the Risk Adjusted Cost of Equity per Chapter 5 may be used.

6 What if’s? 6.1 Extend the WACC formula for all extra methods of company finance. So you could have a WACC with:-

Equity Preference Capital Bank loans Traded Bonds



6.2 For Preference Capital > Kp=D.P.S Po > Vp= No of issued X Market price per Preference shares share (PO)





Chapter Four Bonds –Yields and Market Values 1 Bonds Debt which is issued in blocks of “100” and trades on the stock exchange. 2 Market Value 2.1 The market value is Po/$100 and can be established via the DVM “The present value of future cash flows received by the investor and discounted at the yield(Kd)” 2.2 Undated Debt Po= Ints Yield 2.3 Redeemable Bonds Time $ Yield% PV Ti-Tn Ints X X X Tn Capital X X X Repayment* Po = XX



2.4 Convertible Bonds Replace the * Capital repayment with the share value if higher than the cash repayment. 2.5 Bank loans market value is the book value. 3 Yield (the minimum return required by the lender) OR Pre-tax cost of Debt 3.1 Yield is the minimum return of a lender. Practically we would expect:- RF<Inter-Bank rate(LIBOR)<Yield required by the lender 3.2 Undated Bonds Yield = Ints Po 3.3 Redeemable Bonds Time $ To Po (X) Take two guesses at the yield say 10% & T1-Tn Ints X 1% and perform IRR computation Tn Capital Repayment X 3.4 Bank Loans

Yield=Interest Rate on the loan



Chapter Five Risk Adjusted Cost of Equity 1 Uses When the company wants to assess a project that is non-core. 2 Process

a. Take the Proxy Company Beta equity and degear via

b. Repeat the above for other Proxy Company Betas. Then average all the βa

c. Re-gear βa to find the project βe

d. Put the Project βe into CAPM Project Ke =Rf + (Rm-Rf) Project βe Note:(Rm-Rf) is the Equity Risk Premium.



3 Concerns

Will the project finance truly have no effect upon the company’s gearing?

Proxy company βe:-

a) Does it exist? b) Does the proxy company specialise in the non-

core field or does it have many different business activities

c) If we are not listed-how do we gear up the βa



4 Examiners Article





Chapter Six CAPM 1 CAPM Equation Minimum return = Rf+ (Rm-Rf) β There are several uses of the CAPM equation:-

To find the company’s Ke(Chapter 3) Risk Adjusted Ke (Chapter 5) Assist a stock market investor to buy or sell equities

2 CAPM & Buy/Sell Equities 2.1 Single Equity

Take/Find βe Put into CAPM

Minimum Return = Rf+(Rm-Rf)βe Forecast a return for the investment (could use

past returns) Forecast exceeds/equals

minimum return-Buy or Keep the share



2.2 Combining Equities (portfolio) a) Created a weighted average portfolio Beta i.e (Cash in Share (1)/Total Cash in Equities X β1) + (Cash In Share (2)/Total Cash in Equities X β2 )

b) Put into CAPM

Minimum Return = Rf+(Rm-Rf)Weighted Average β

c) Forecast exceeds/equals minimum return-Buy or keep the portfolio.

3 Meaning of a βe

3.1 A βe is the measure of risk being faced by equity shareholders 3.2 βe can be split into:-

Systematic Business Risk-measured by βasset Financial Risk(βe-βa)

3.3 Systematic risk is how market factors effect that investment. Market factors are:-

Macroeconomic variables Political factors

The measure is relative to the benchmark of the market portfolio which has a βeta factor of 1.



3.4 CAPM assumes that the investor has eliminated the unsystematic risk.

TOTAL RISK Unsystematic risk Systematic risk Company specific factors General economic factors Can be eliminated by Cannot be eliminated diversification By holding a portfolio, the unsystematic risk is diversified away but the systematic risk is not and will be present in all portfolios. If we were to enlarge our portfolio to include approximately 25 shares we would expect the unsystematic risk to be reduced to close to zero, the implication being that we may eliminate the unsystematic portion of overall risk by spreading investment over a sufficiently diversified portfolio. Total Risk

Unsystematic Risk ……………………………………………………………………………. Systematic Risk 0 No of different business Approx 25

Shares in the portfolio



4 Criticisms of CAPM

1) CAPM is a single period model. This means that the values calculated are only valid for a finite period of time and will need to be recalculated or updated at regular intervals.

2) CAPM assumes no transaction costs associated

with trading securities. 3) Any beta value calculated will be based on

historic data which may be not appropriate currently. This is particularly so if the company has changed the capital structure of the business or the type of business it is trading in.

4) The market return may change considerably over

short periods of time. 5) CAPM assumes an efficient investment market

where it is possible to diversify away risk. This is not necessarily the case, meaning that some unsystematic risk may remain.

6) Additionally, the idea that all unsystematic risk is

diversified away will not hold true if stocks change in terms of volatility. As stocks change over time it is very likely that the portfolio becomes less than optimal.

7) CAPM assumes all stocks relate to going

concerns, this may not be the case.



5 Examiners Articles













Chapter Seven Capital Structure 1 Introduction How should the company decide the mix of equity and debt capital? 2 Practical Issues If the company uses Debt capital funding it should consider:-

Credit Rating of the company Rate of interest it will pay Market conditions- access to Debt capital Forecast Cash Flows-to service and repay the debt. Level of Tangible Assets on which secure the loans. Interest will lead to tax savings i.e Tax Shield Constraints on the level of debt from

a) Articles Of Association b) Loan Agreements.

Effect upon the company gearing ratio

Debt/Equity+Debt OR Debt/Equity

Will the debt providers exercise influence over the company?

The chance of bankruptcy.



5 Theories of Optimal Capital Structure

3.1 Common Ground-both major views accept two facts:-

a) Yield<Ke b) Gearing causes Ke to rise

3.2 Traditional View

% Ke Cost Of capital

WACC Kd 0 X Gearing

Key Points:-

1) Ke rises due to financial risk caused by gearing. 2) Kd is initially uneffected by gearing but rises at “high”

gearing levels due to the perception of the possibility of bankruptcy.

3) WACC-trade off of Ke and Kd. Point X is the optimum gearing level where WACC is lowest.

4) Once point X is reached via trial and error it must be maintained.



3.3 MM and Tax % Ke Cost of Capital WACC Kd 0 Gearing Key points:-

1) Assumption behind the model:-

All debt is risk free Only corporation tax exists Debt is issued to replace Equity All types of debt carry one yield, the risk free

rate Full distribution of profits Perfect Capital Market

2) MM concluded companies should gear up to the

maximum levels.



4 Pecking Order Theory In this approach, there is no search for an optimal capital structure through a theorised process. Instead it is argued that firms will raise new funds as follows:-

Internally-generated funds Debt New issue of equity

Firms simply use all their internally –generated funds first then move down the pecking order to debt and the finally to issuing new equity. Firms follow a line of least resistance that establishes the capital structure. Internally –generated funds-i.e. retained earnings.

Already have funds. Do not have to spend any time persuading outside

investors of the merits of the project. No issue costs.

Debt

The degree of questioning and publicity associated with debt is usually significantly less than that associated with a share issue.

Moderate issue costs. New issue of equity

Perception by stock markets that it is possible sign of problems. Extensive questioning and publicity associated with a share issue.

Expensive issue costs.



Chapter Eight Project Appraisal 1 Accounting Rate of Return (ARR) 1.1 Average Annual Post Depreciation Profit X 100 Investment 1.2 Investment is:-

a) Initial Investment b) (Initial Investment +Scrap Value)

2 1.3 Decision rule is:- ARR> Target return-accept the project OR Take the project with the highest ARR 1.4 Limitations and Strengths Limitations

Figures are easily manipulated e.g. by changing the method of depreciation or the estimate of disposal value.

Ignores the actual/incremental cash flows associated

with the project, and the effect of the timing of those cash flows on the real return.



Double counting-depreciation is deducted from the profit figure in full, but the use of the average assets means that part of this is also included in the denominator. The effect is to depress the calculated return.

Strengths

Expressed in terms familiar to managers-profit and capital employed.

Easy to calculate the likely effect of the project on the

reported profit and loss account / balance sheet. Managers are frequently rewarded in relation to performance against these variables.

Business is judged by ROI by financial markets.

2 Payback 2.1 Time it takes the project to payback it’s initial investment. 2.2 General Approach:- Time Cash Flows Cumulative Cash flows To (X) (X) T1 X (X) T2 X (X) T3 X X T4 X - T5 X -



2.3 Annuity and Perpetuity cash flows Payback period=Initial Outflow Annual Inflows 3 Net Present Value (NPV) 3.1 NPV is the increase in S/H wealth arising from the project. 3.2 Two formats to consider Format (A)

Year 0 1 2 3 4 5 $000 $000 $000 $000 $000 $000

Receipts X X X X Payments:

Wages (X) (X) (X) (X) Materials (X) (X) (X) (X)

Variables/Fixed Overheads (X) (X) (X) (X) Administration/Distribution

Expenses (X) (X) (X) (X)

Taxable Operating Cash Flows

X X X X

Tax: Corporation Tax on operating cash flows

(X) (X) (X) (X)

X X X X Initial Outlay (X)

Net Realisable Value X Tax saved on TAD X X X X X Working Capital (X) (X) (X) (X) X Net Cash Flows (X) (X) X X X (X)

Discount Rate (e.g. 12%) 1 X X X X X Present Value (X) X X X X (X)

Net Present Value(NPV) $XXX



Format B Time CF 12% (SAY) PV$’000 To (X) 1.0 (X) T1-Tn X X X T2-Tn X X X NPV $XXX 3.3 Incremental Cash Flows

Result from/caused by the project Include opportunity cash flows Ignore:-

Non-Cash Flows Sunk Costs Interest /Dividend payments

3.4 Financial Maths Required:- 1) Compounding Eg: Inflation is 5% pa Real cash flow at time 7 is $250 Money cash flow =$250 x 1.057= $352 2) Discounting (tables) Eg: Cash flow at T5 is $390. r=10%pa PV=$390 x 0.621 =$242 3) Annuity (tables) Eg: Cash flow from T1-T9 is $400 pa r=5% PV =$400 x 7.108 = $2843



4) Delayed Annuity Eg: Cash flow T3-T5 =$300 pa r=10% PV=$300 x (AF1-5 –AF1-2) =$300 x (3.791-1.736) =$617 5) Perpetuity Eg:Cash flow is $500 pa from T1 each year forever. r= 4% PV= $500 x 1 r =$500 x 1 = $12,500 0.04 6) Delayed Perpetuity Eg: Cash flow is $600 from T4-Tperp r= 5% PV=$600 x (1/r –AF1-3) =$600 x (1/0.05-2.723)= $10,366 7) Perpetuity with Growth Eg: Cash Flow at time 1 will be $120 and then it will grow at 3% pa. r=12% PV= $120 x 1 (r-g) PV=$120 x 1 = $1,333 (0.12-0.03)



8) Delayed Perpetuity with Growth Eg: As for (7) above but $120 is cash flow at T5. PV= $120 x Effective Discount Rate. Effective Discount Rate= 1 x DF4 at 12% (r-g) 1 x 0.636 (0.12-0.03) = 7.067 PV =$120 x 7.067 = $848 3.5 Inflation- Factors to consider:

a) ‘h’ is symbol for inflation b) ‘r’ is symbol for real –excludes inflation c) ‘i’ is symbol for money/nominal –includes inflation d) Two approaches are possible

3.6 Include Inflation

Money cash flows can be:-

Given in the question Computed via Real CF x (1+h)n

Money cost of Capital can be

Given in the question WACC (see earlier chapter) Computed via

(1+i)= (1+r) (1+h)



Exclude Inflation

Not yet tested by the examiner at F9 Cash flows are REAL i.e. exclude inflation Discounted at REAL Cost of Capital i.e. exclude

inflation

3.7 Working capital-think of as a project bank account:-

i. Invest at To ii. Adjust each year iii. Close at end of the project.

Eg: Project needs WC at end of each year as follows:

T0 T1 T2 T3 - 300 350 375 Relevant CF’s

(300) (50) (25) 375

3.8 Taxation-relevant cash flows to be included in the NPV computation. (RTQ re timings of tax flows!!!)

1) Operating Flows x Tax rate 2) Tax saved on Capital allowances or Tax Allowable

Depreciation(TAD):-

a) TAD-straight line. eg: CAPEX is $1m.Scrap value at T4=$200K.TAD is 4 years and tax rate is 30% (No delay) Tax saved= [($1000-$200)] x 30% =$60 pa T1-T4 4



b) TAD-Reducing Balance eg: Asset is bought at T0 (1/1/10)cost $1m.Sold at T4 for $200k.TAD is 25% reducing balance. Tax is 30% (1 year delay).

Time Tax saved $’000

T2 $1000 x 25% x 30% 75 T3 75 x (100% -25%) 56 T4 56 x75% 42 T5 Bal Figure 67 30% x (1000-200) 240



4 Internal Rate of Return (IRR) 4.1 The cost of capital that gives an NPV=Nil 4.2 Approach-Take the following example: NPV@ 10% =$200K NPV@ 20% = ($15K) IRR= 10+ (200/200-(-15)) x (20-10) =19.30% 4.3 Decision Rule IRR>Project Cost of Capital-Accept 4.4 PROS CONS

*Easier to explain *Will mislead if comparing *Simple decision rule projects

* If cash flows are non- regular (-, +, +, +,-) IRR computed above is incorrect as there will be multiple IRR’s



5 Capital Rationing 5.1 A restriction of cash preventing the company from accepting all projects with a positive NPV 5.2 Causes: Hard Soft External constraint on Internal within the Raising cash.Eg:- Credit Company Crunch Crisis Eg:- Capex Budget 5.3 Period –only single period is examinable i.e. cash may Be restricted at T0 or T1. 5.4 Divisible projects –can invest in proportions of a project from 0% to 100% maximum. Approach:-

1) Compute Project NPV’s 2) Compute Profitability Index(PI) = NPV

Cash Invested at critical period 3) Rank-High to Low PI



5.5 Non-Divisible –take all or none of any project. Approach:-

1) Compute Project NPV’S 2) Take best combination of projects that

maximise the total NPV but spend less than or equal to cash available in the critical period.

6 Asset Replacement 6.1 If assets have to be replaced on a periodic basis, Equivalent Annual NPV is the method to use. 6.2 Process a) Compute the NPV for each replacement cycle. b) E.A.NPV = NPV Annuity Factor for life of the project @cost of capital c) As (b) will give negative values, take the least expensive.



7 Accruing for Risk or Uncertainty within NPV Several methods, the best are:- 7.1 Probabilities –One project cash flow may be uncertain. Example Sales in year 1 $’000 P 2000 0.70 1000 0.30 1.0 Sales in T1 for NPV= (2000 X 0.70)+ (1000 X 0.30) =$1700K 7.2 Decision Trees Used when dependent probabilities exist. This can best be demonstrated by an example. Year 1 Sales Year 2 Sales $10,000 0.3 $15,000 0.6 $ 5,000 0.4 $20,000 0.7 $30,000 0.8 $ 15,000 0.2



As a decision tree:- P P 15,000 0.3 x 0.6 = 0.18 0.3 10,000 5,000 0.3 x 0.4 = 0.12 20,000 30,000 0.7 x 0.80 =0.56 0.7 15,000 0.7 x 0.20 = 0.14 1.00 1.00 7.3 Risk adjusted Cost of Equity –See Chapter 5 7.4 Sensitivity Analysis-What if? Change one variable that will cause the NPV to go nil. Quickest way is to:-

NPV X 100% For Cash flows PV of the cash flow

that is uncertain

IRR-Cost of Capital X 100% For the Cost of capital Cost of Capital

Lower the sensitivity % the higher the risk



7.5 Discounted Payback

Payback using discounted cash flows

Format

Time D.C.F Cumulative D.C.F T0 (X) (X) T1 X (X) T2 X (X) T3 X X T4 X - T5 X -

8 Post Completion Audit (PCA) During the life of a project, an investigation should be undertaken to examine its profitability and compare it with the plan. There are three reasons for undertaking these post-mortems:

To discourage managers from spending money on doubtful projects, because they may be called to account at a later date.

It may be possible over a period of years to discern a

trend of reliability in the estimates of various managers.

A similar project may be undertaken in the future, and

then the recently completed project will provide a useful basis for estimation.



9 NPV and S/H wealth 9.1 As stated earlier, NPV represents the change in S/H wealth arising from the project. It is the only method that can be directly related to the primary objective of financial management. 9.2 The NPV is effectively the change in the market capitalisation of the company and the movement in its share price. It relies upon markets being efficient (see chapter 9) to reflect the project data within the new market price.





Chapter Nine Business Valuations 1 Equity 1.1 To value equity /ordinary shares on a per share basis two primary methods exists. 1.2 DGM/DVM Po is the present value of future dividends discounted at the cost of equity(re or Ke) Po= Do (1+g)

(re-g)

1.3 P/E Model PO =EPS X P/E Ratio P/E Ratio may have to come from a proxy company. 2 Others 2.1 Preference shares

PO = D rp



2.2 Traded Debt-Undated PO per $100 = Ints rd

2.3 Traded debt –Redeemable PO per $100:-

Time $ rd PV T1-Tn Ints X X X Tn Capital Repayment * X X X PO X *For convertibles, use higher of capital repayment or share value if converted into equity.



3 Efficient Market Hypothesis (EMH) 3.1 EMH explains how stock market prices change to reflect data /information. The market can be efficient at 3 levels:-

Weak Semi-Strong Strong

3.2 Weak –the prices reflect only historic/past data. 3.3 Semi-Strong-prices include past data +public announcements. 3.4 Strong-prices reflect past, public and insider (secret) data. 3.5 Most of the world’s stock markets are closer to semi strong.





Chapter Ten Sources of Finance 1 Introduction Where and how do companies raise long term capital. 2 Equity –General Factors 2.1 Ordinary shares of the company with voting rights. 2.2 Carry the greatest risk but also the best possible returns. 2.3 Could be traded on the stock exchange if company is listed. 2.4 “A Stock Exchange Listing” Advantages of a listing on the stock exchange To existing shareholders:

they can sell some of their shares; greater marketability raises value; no valuation problems e.g. for IHT



To the company

new funds can be obtained; takeovers can be financed by equity issues; easier to raise future finance perceived risk reduction –fall in cost of equity; extra status may generate new business.

Disadvantages of a listing

costs borne by company; company must comply with SE regulations; dilution of control; public scrutiny of profits/results.

3 Equity- Raising New Capital 3.1 Retained Earnings-First source of cash. Hold back the payment of dividends. Will effect the dividend policy and can raise a small amount of cash. 3.2 Rights Issue-Pro Rata issue to existing S/H. 3.2.3 From the exam questions will need to obtain or compute:-

a) Po just before the rights issue (Cum Rights price)

b) Issue Price

c) Ex Rights Price-price directly after the share

issue (TERP)



For Example: 1 for 3 rights issue at 550p and cum rights is 600p No £

3 at 600p 18.00 1 at 550p 5.50 4 £ 23.50 TERP =£ 23.50/4 =£5.88 d) Value of the right £ 5.88- £5.50 =38p 3.2.4 Shareholder can sell the rights to another shareholder at the value of the rights. 3.3 Placing- Sell a large batch of new shares to institutions. 3.4 Prospectus- Sell shares to investors at a fixed price after issuing a prospectus. 3.5 Tender- Request investors to tender for the shares at a price they would want to pay. The board then establishes final price.



4 DEBT 4.1 Loans provided to the company on a long term basis. Debt holders will:-

a) Interest paid from pre-tax profits b) Security via

• Fixed charged • Floating charge • Securitisation of future income.

c) Covenants-restrict company activity in areas such as:

• Dividend payments • Issues of further debt

4.2 Bank Loans 4.2.1 Funds come from one bank or group of banks. 4.2.2 Terms & Conditions depend upon market conditions and credit rating. 4.3 Traded Bonds 4.3.1 Loan is split into blocks of $100 and issue on the market. 4.3.2 Can be undated or redeemable. 4.3.3 Bond has a yield and market value (Chapter 4)



4.4 Other Types of Debt

a) Convertible Bonds-Debt that can be converted to shares, normally at redemption.

b) Eurobonds-Rare large foreign currency loan in the home country. Used by MNC’s and minimum values normally $1m. c) Mezzanine Loan Loan Finance that has elements of equity as part of it. For example

a) Convertible Bonds b) Loan plus a warrant –right to buy a share

in the future at a fixed price. d) Grants-Free government finance providing conditions are met.



5 Leases Leasing is an alternative way of obtaining the use of items of equipment for companies which for varying reasons may wish to avoid acquiring them outright. Terminology

a) Operating lease Usually for a short period, where substantially all the risks and rewards of ownership remain with the lessor.

b) Finance Lease Usually for long period, where substantially all the risks and rewards of ownership pass to the lessee. The type of lease that we need to consider in more detail is a finance lease because this is an alternative to borrowing some money in the long term in order to purchase an asset. Reasons for leasing

The full lease rental is allowable against tax. Interest on debt financing is allowable against tax but the capital repayment is not.

It is readily available form of finance, especially

for plant and equipment or motor vehicles. It is therefore very convenient for companies to enter into such arrangements.



It removes the need for a significant capital outlay at the beginning of a project’s life i.e. it avoids the need to find the capital at the outset.

It may be cheaper in financial terms that

conventional debt financing i.e. the effective interest rate on leasing may be less than the interest payable on a loan.

5.2 Lease Vs Buy Evaluation 3 Step approach

1. Ascertain the post tax cost of debt i.e Pretax % X (1-t) 2. NPV of the lease cash flows using (1) Lease cash flows are:

• Payments/Rental • Tax savings caused by rentals.

3. NPV of buy cash flows using (1) Relevant flows are:-

• Capital Cost • Scrap value • Tax saved on Capital allowances or Tax

allowable depreciation.



6 The role of Treasury Function 6.1 Treasury functions mainly exist in Large MNC. 6.2 Roles include:-

Managing the groups cash resources Liaise with the banks. Advising on Heading strategies for:-

• Forex Risk • Interest Rate Risk

Establishing source of Finance and cost of capital for the group.

Deciding upon investment policy.



Chapter Eleven

Ratios 1. Ratios-You must Learn!!!! 1.1 Investor EPS = PAT less Preference Dividends No of ordinary shares in issue P/E = Po EPS Dividend Cover= EPS DPS Payout Ratio = DPS EPS Dividend Yield = DPS Po Total Shareholder = Dividend for + Capital Gain Return(TSR) the year for the year Share Price at start of the year



1.2 Gearing Capital Gearing= Debt or Debt X 100 Equity Debt+Equity NB Preference shares are generally treated as debt. Interest Cover = Operating Profit Interest 1.3 Profitability ROCE = Operating Profit X 100 Equity +Debt ROE = PAT X 100 Equity Margin = Operating Profit X 100 Turnover 1.4 Liquidity Current Ratio= C.Assets C.Liabilities Quick/Acid Test = (C.Assets-Inventory) Ratio C.Liabilities Inventory Days= Inventory x 365 COS or purchases Receivables Days= Trade Receivables x 365 Sales Payables Days = Trade Payables x 365 COS or Purchases



2 Important

Learn the ratios State on answer book, substitute the relevant

figures from the question and compute the ratio. Comment on each ration in a sensible manner. Be ready to change the ratios around

Eg: C.Ratio is 1.25:1.C.Assets are $260K and C.Liabilities are made up of bank overdraft and payables. Payables are $108K.What is the value of the bank overdraft? Solution

CA=1.25($260K) CL=1.00(?) CL=$260K=$208K $1.25 Bank O/D=$208K-$108K =$100K





Chapter Twelve Working Capital Management & Financing 1 General The level and nature of working capital within any organisation depends on a variety of factors, such as:

the industry within which the firm operates the type of products sold whether products are manufactured or brought in the level of sales inventory and receivables policies the efficiency with which working capital is managed

Ultimately it is the balance of:-

liquidity profitability

2 Cash Operating Cycle Length of cycle =Average inventory + Average - Period holding receivables credit period collection period taken



3 Financing of Working Capital 3.1 Current assets can be simply financed by using current

liabilities .The latter is made up of:-

Trade payables Bank Overdraft

The latter carries an interest cost while the former does not. 3.2 However, there is a view that some elements of the

current assets are “permanent”. Hence they are a kin to non-current assets. There are financed by long term sources of funding-WACC.

3.3 For example $’000 Current Assets 4,500 Trade payables 2,000 Bank overdraft 1,000 Bank overdraft Interest = 8% pa WACC =12% What is the cost of financing the current assets? Solution Short term cost 8% x 1000 = $80 Long term cost 12% x (4500-2000-1000)= $180 $260



Chapter Thirteen Inventory Control 1 INVENTORY MANAGEMENT Economic Order Qty(EOQ) Just In Time(JIT) -Optimise stock order quantity -Nil/minimum and Re-order level stock -Minimises stock associated costs No discounts With discounts



EOQ

Assumptions • Demand is known • Purchase price is

constant (No discounts)

• Lead time is

constant (No Stock outs)

• Re-order level =

demand in lead time

• All costs are known

and constant

Graphs Q Q/2

ROL 0 TIME

£ Total relevant Variable costs holding costs Fixed order costs EOQ Q

Co=Fixed cost per order D=Annual Demand CH=Variable holding cost per unit.

EOQ + DISCOUNTS

Method 1) Calculate the EOQ

using the formula, ignoring any potential discounts. This is the starting point.

2) If, and only if, the

EOQ calculated in 1) would result in a discounted purchase price, recalculate the EOQ using the formula taking into account the relevant discount.

3) Finally, calculate

the total annual cost using the EOQ calculated in 2) AND the total annual cost ordering in quantities higher than the EOQ but where greater discounts are available.



Forecast Sales qtys (2) Demand Driven

(1) No Finished (3) Goods inventory

Close Link with suppliers

(7) No or Ltd JIT Raw material Production (4) Inventory(6) NO WIP(5)

JIT (Factors)





Chapter Fourteen

Receivables and Payables 1 Receivables 1.1 Receivables management is the balance between:-

liquidity (hold a lower balance) profitability(offer more credit)

1.2 Factors to consider when offering credit.

Do competitors offer credit? Industry norms Check the credit rating of both new and existing customers Set realistic credit limits

1.3 To collect cash from receivables efficiently:-

Invoice promptly State terms on the invoice Send out monthly statements Call customers to chase payment Consider legal proceedings as a last resort.

1.4 Factoring companies offer “contracted out” receivables management.

Receivables administration/collection of cash. Advances of cash Insurance cover for “bad” debts.

All the above have costs & fees attached.



1.5 Recourse- Services can be offered with or without recourse. If without recourse, the factoring company will suffer any bad debts should they arise. 1.6 Invoice discounting-this is where cash can be raised using certain receivables balances as security. Customers are not aware of the transaction. The debt is paid off when the receivables settle their debt. 1.7 Offering early settlement discounts to customers. Eg Receivables normally pay in 45 days a settlement discount of 1.0% is offered for payment within 30 days. Bank overdraft rate is 20%pa Solution

Assume sale of $100

Discount is $ 1.00 = 0.01 $99.00

Effectively, annual value is:-

365 = 24.33 (45-30) (1+0.01)24.33-1 x 100 =27.4%

Discounts costs the company 27.4 % but save 20%.Hence, don’t offer these terms.



1.8 Changes of Policy

Prepare all computations on an annual basis Show incremental relevant cash costs and savings

when changing from old to new policy. Proforma –Changing Receivables Policy

Annual $’000 Bad debts saved xxx Admin costs saved xxx Discount given (xxx) $’000 Finance cost of xxx Original receivables Finance cost of New receivables xxx xxx /(xxx) NET SAVINGS xxx 2 Payables 2.1 Again balancing act:-

Maximise use of free credit Not to over extend and lead to:-

a) Costs/Charges b) Supplier withdrawing supply c) Supplier going out of business.

2.2 Taking early settlement discount offered by suppliers – same approach as receivables as per 1.7.





Chapter Fifteen

Cash Management 1 GENERAL

Motives to hold cash • Transactions-Day to Day payments • Precautionary-To cover “rainy day” • Speculative-Possible investment

opportunities

Business may have • Surpluses • Deficits

Surpluses Consider: -

• Amount • Time • Access • Return • Risk

Investments

• Deposits • Building society

a/c’s • Inter bank

market • Gilts • AIM • London SE • Futures

Deficits Uses: -

1. Extend trade payables finance.

2. Bank facils.

3. Factoring

companies.



2 CASH BUDGETS-SHORT TERM MANAGEMENT LAYOUT January February March

Receipts

Cash sales

Receipts from debtors

Sale of assets

Payments

Cash purchases

Payments to creditors

Expenses

Purchase of assets

Tax

Dividends

Interest

Net cash inflow/(outflow)

Balance b/f

Balance c/f



Exam Technique

• Proforma (as above)

• Copy in easy figures.

• Workings for others e.g. receivables receipts, payables payments.

• Total & tidy!!

3 Cash Flow Forecasts 3.1 Two ways /possible exam questions covering this area:-

Balancing figure Cash Flow Statement

3.2 Balancing Figure Prepare a Forecast statement of Financial position and use “CASH AT BANK” as the balancing figure.



3.3 Cash Flow Statement Prepare a cash flow statement but not strictly to “P7” standards as follows:-

$’000 Operating Profit xxx Add: Depreciation xxx Change in Inventory xxx Change in Receivables xxx Change in payables xxx Cash from operations xxx Sale of NCA xxx Issue of Shares xxx New Loans xxx Tax paid (xxx) Interest paid (xxx) Dividends paid (xxx) Purchase of NCA (xxx) Loans repaid (xxx) Share buyback (xxx) Cash generated this year xxx Balance b/f xxx Cash Balance C/F $xxx



4 CASH MODELS Aim is to optimise the amount of cash held in the longterm. 4.1 Baumol Model The “inventory control” model of cash. £ Max Bal Spread Min Bal Time

4.2 Spread comes from EOQ formula:



4.3 Miller Orr A model to cope with the daily variances in the use of cash. £ Max Bal SPREAD Return Point One third of spread Min Bal Time Sell Investments and Replenish cash

Formulae are:



Chapter Sixteen

Foreign Currency Risk 1. Translation Exposure This is a Financial Reporting risk. The change in the value of an asset /liability caused by a change in the spot exchange rate. 1.1 Example-ABC plc has a US subsidiary worth $10m. 2008 - at $1.50 £6.67m 2009 - at $1.75 £5.71m Loss to equity (£0.96m) Funded by a $10m loan. 2008 - at $1.50 £6.67m 2009 - at $1.75 £5.71m Gain to equity £0.96m 1.2 Not a cash risk, only due to financial reporting!!!! 2. Transaction Exposure Change in the value of the spot rate over the short term (less than a year) causing a cash gain or loss. 2.2 Must hedge!!



3. Economic Exposure Longterm change in the spot rates effecting project cash flows .Risk can be reduced by Global Diversification. 4. SPOT and Forward Rates 4.1 Typical presentation of SPOT and Forward Rates. (Bid) (Offer) $1.5000 - $1.5555 / £ £0.6429 - £0.6667 / $ (Bid) (Offer) 4.2 Picking the correct rate –Good Method

Spot and Forward rates presented as FX/Home currency

If “we” are Receiving Forex

Use the right hand rate

5. Internal Hedges for Transaction Risk 5.1 Invoice in home currency

All transactions in home currency

Transfer risk to the other party

Only useable rarely-if “we” have monopoly power.

Reciprocal and cross over!!!!!



5.2 Foreign currency bank account

Held in the main currencies ($, Euro)

Pool all transactions in same FX

Liking have 3 bank accounts with 3 cheque books!! 5.3 Leading and Lagging

Watcher / predictor of spot rate changes

Leading – accelerate exchange

Lagging – delay the exchange

Used a lot by Importers who have to sell their home currency

5.4 Netting

Match all FX transactions in the same FX occurring on the same day Eg: 30 June we expect Receive $200K Pay ($50k) Net Rec $150k



6. External Hedges for Transaction Risk 6.1 Forward Market “Fix the rate today that will apply on a set future date” Technique: -

1. Net the future transactions in same FX and same date. Ascertain if “buying” or “selling” the £.

2. Forward contract, X months, at Given as a ‘spread’

3. Exchange FX at the forward rate(Remember if

receiving FX use the right hand rate) 6.2 Money Market Hedge “The exchange will take place today at the known spot rate”. Technique Home Abroad

Today Today’s Spot £Answer FX X

1+ints home

Future Date

£ Answer FX FX

÷ 1+ ints foreign



7. Pros & Cons Pros Cons Forward Market • Fixed Rate, certainty • Easy • Cheap • Tailored(Any size of

transaction)

• Inflexible/contract • Lose out on the

upside potential or gain

• Must ensure FX receipts arrive

MMH • Convert today • Cheap • Tailored • Flexible

• Complicated • May not apply for FX receipt as borrowing may not be possible abroad

8. Predicting Future Exchange Rates

Best long term prediction model is PPPT

S0=Spot Today S1=Spot 1 years time hc=annual inflation rate foreign hb=annual inflation rate base/home country

In the short term use IRPT

F0=Forward/future spot rate i=interest rate



Practical Factors influencing the Spot Rate

1. Political stability-strengthens home currency value 2. Economic growth-strengthens home currency

value 3. Commodity pricing-oil is priced in dollars 4. Trader activity-buying & selling of currencies 5. Central bank action acting as a trader in FX 6. Changing interest rates-protect the value of the

home currency. 9 Derivatives (written questions only at F9) 9.1 Futures

This is a method of hedging which is trying to fix the future spot rate at a value approximately equal to the current spot rate.

“Futures exchange rates” are always similar to spot rates and this is a key factor.

Hedge is based upon:-

1) Find the direction of the change in the spot rate that

would cause a transaction loss. 2) Use the Futures market and effectively “spread bet” on

the futures rate moving in directions that cause a loss. 3) If:-

a) Spot rate moves in the direction to cause a transaction loss, a profit will be made on the futures market, hence two will cancel out.

b) Spot rate moves in the direction to cause a transaction profit, a loss will be made on the futures market, hence two will cancel out.



It’s not a perfect hedge due to basis risk and “odd” contract sizes. 9.2 Options

If “we” could take the current spot rate and use it in the future, there would be no transaction risk.

With an option:-

1) Take a contract to give us the option (right)to exchange in the future at approx current spot rate. 2) Pay a non-refundable premium 3) Future-use the option rate if spot rate has move unfavourably. Otherwise the option lapses.

Think of an insurance policy-very similar





Chapter Seventeen Interest Rate Risk 1 ISSUES There are two issues / type of F9 questions:-

Term Structure of Interest rates Risk Management.

2 Term Structure of Interest Rates 2.1 Interest rates on the market generally follow this relationship: Return on LIBOR Lenders Gov’t Bonds < (Interbank < Rates (RF) Rate) 2.2 Hence if the RF was to change it has a direct impact on all other rates. 2.3 To “predict” the change in the RF, we use the “Theory of the Yield curve”



% Years until maturity The curve is upward due to:-

a) Liquidity Preference Theory- the longer there is to maturity the greater the return wanted by the lender.

b) Expectations theory-the yield reflects the expectation of

higher future inflation rates 2.4 Some research has indicated it may not be a curve but a kinked function.

%

5 years Years to Maturity

The standard of the yield curve



2.5 If inflation expectations are in “reverse” ie deflation, it is feasible to get a reverse yield curve.

3 Risk Management 3.1 Normally, this occurs when a company has produced a short term budget and believe that in the near future they will run up a cash deficit (possibly a surplus). They want to hedge against interest change that could damage their profits. 3.2 For example 1 Jan 31 Mar 31 May Now (Deficit) Return to Pay old interest surplus for 2 months

No of years of maturity

%



3.4 To hedge this risk a company has two basic choices:-

Lock the Rate Ceiling/ cap the rate

4 Lock The Rate 4.1 FRA A company can purchase a FRA that would lock the rate for a set period in the future. No fees are payable but minimum size is $1m. 4.3 Futures

This will effectively lock the rate to a value equivalent to the borrowers current rate. It involves effectively spread betting on the movement of the interest rate on the market. Contract sizes and deposits (margins) complicate this process.

5 Ceiling Rate 5.1 IRG

An IRG can be purchased at fees that can cap the rate payable. The company only uses the cap if the borrowing rate exceeds this value. Fees effectively increase the value of the cap offered by the banks.



5.2 Option

Achieves the same as above but uses the futures market. The purchase of a PUT Option sets a capped rate.





Appendix – New Topic Islamic Finance 1.Introduction

The Islamic economic model has developed over time based on the rulings of Sharia on commercial and financial transactions. The Islamic finance framework is based upon:

• Equity, such that all parties involved in a transaction can make informed decisions without being misled or cheated.

•

To pursue personal economic gain but without entering into those transactions which are forbidden.(eg, transactions involving alcohol, pork related products, armaments, gambling and other socially detrimental activities). Also, speculation is also prohibited (so options and futures are ruled out).

• The strict prohibition of interest (riba = excess).

2.How can returns are earned?

As stated above, earning interest (riba) is not allowed.

In an Islamic bank, the money provided by depositers is not lent, but is instead channeled into an underlying investment activity, which will earn profit. The depositer is rewarded by a share in that profit, after a management fee is deducted by the bank.

A typical illustration would be how an Islamic bank may purchase a property from a seller and re sell it to a buyer at



a profit. The buyer will be allowed to pay in installments. Compare this to a typical mortgage where the bank lends money to the buyer and charges interest.

Hence returns are made from cash returns from a productive source eg profits from selling assets or allowing the use of an asset (rent).

3.Islamic Sources of Finance

In Islamic Banking there are broadly 2 categories of financing techniques:

• “Fixed Income” modes of finance – murabaha, ijara, sukuk • Equity modes of finance – mudaraba, musharaka FIXED INCOME MODES a) Murabaha

Murabaha is a form of trade credit or loan. The key distinction between a murabaha and a loan is that with a murabaha, the bank will take actual constructive or physical ownership of the asset. The asset is then sold onto the 'borrower' or 'buyer' for a profit but they are allowed to pay the bank over a set number of installments.

The period of the repayments could be extended but no penalities or additional mark up may be added by the bank. Early payment discounts are not within the contract.

b) Ijara

Ijara is the equivalent of lease finance; it is defined as when the use of the underlying asset or service is transferred for consideration. Under this concept, the Bank makes available to the customer the use of assets or equipment such as



plant or motor vehicles for a fixed period and price. Some of the specifications of an Ijara contact include:

• The use of the leased asset must be specified in the contract.

• The lessor (the bank) is responsible for the major maintenance of the underlying assets (ownership costs)

• The lessee is held for maintaining the asset in proper order.

An Islamic lease is more like an operating lease but the redemption features may be structured to make it similar to a finance lease.

c) Sukuk Companies often issue bonds to enable them to raise debt finance. The bond holder receives interest and this is paid before dividends. This is prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked to an underlying asset, such that a sukukholder is a partial owner in the underlying assets and profit is linked to the performance of the underlying asset. So for example a sukukholder will participate in the ownership of the company issuing the sukuk and has a right to profits (but will equally bear their share of any losses).



EQUITY MODES

a) Mudaraba

Mudaraba is a special kind of partnership where one partner gives money to another for investing it in a commercial enterpirse. The investment comes from the first partner (who is called 'rab ul mal'), while the management and work is an exclusive responsibility of the other (who is called 'mudarib').

The Mudaraba (profit sharing) is a contract, with one party providing 100% of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. In a Mudaraba only the lender of the money has to take losses.

This arrangement is therefore most closely aligned with equity finance.

b) Musharaka

Musharaka is a relationship between two or more parties, who contribute capital to a business, and divide the net profit and loss pro rata. It is most closely aligned with the concept of venture capital. All providers of capital are entitled to participate in management, but are not required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to their respective capital

Documents

Acca F9 Key Point Notes