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ACCA F9 Financial management notes

Exam

A total of 4 questions, each worth 25 marks = 100 marks.

About this note

This note is created by focusing on the study guide of F9 found in ACCA website, satisfying the

requirements in study guide as much as possible and covering what you need to know to pass this

exam. The notes only covered main ideas, make sure you practice past year questions to be fully

prepared. It is good if you can bring forward your knowledge from previous studies to understand

better, especially F5 and it gives you advantage if you have FFM knowledge.

Syllabus areas Page numbers

A: Financial management function 2-4

B: Financial management environment 5-7

C: Working capital management 8-19

D: Investment appraisal 20-34

E: Business finance 35-45

F: Cost of capital 46-56

G: Business valuations 57-63

H: Risk management 64-75

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Financial management function

1. Nature and purpose of financial management

Financial management is the management of activities associated with the efficient acquisition and use

of short and long-term financial resources, to ensure the objectives of the company are achieved.

There are three key decisions in financial management:

1. Investment – this includes investment in projects (long-term) and working capital (short-term).

2. Financing – company will decide the best balance of equity and debt.

3. Dividend – how much and how frequently dividend will be paid.

Relationship between financial management and financial and management accounting

Financial management relies on financial accounting and management accounting. For example, the

information in financial statement and other past information generated from financial accounting

could assist in future financial planning. Financial planning is further assisted by management

accounting, for example relevant cash flows are identified. Also, management accounting plays a role

in financial control, ensuring objectives are being met or assets being used efficiently.

2. Financial objectives and the relationship with corporate strategy

Corporate objectives and strategy

Corporate objectives are relevant for the organisation as a whole, relating to key factors for business

success (critical success factors or CSFs). The primary financial objective of profit making organisation is

to maximise shareholder wealth, other financial objectives include profit maximisation, earnings per

share (EPS) growth, market share growth etc. Strategy is a course of action to achieve an objective so

corporate strategy depends on corporate objectives.

3. Stakeholders and impact on corporate objectives

Stakeholders and their objectives

Stakeholders are groups or individuals having a legitimate interest in the activities of an entity. There

are three types of stakeholders and each having their specific objectives:

1. Internal stakeholders – employees and management.

2. Connected stakeholders – shareholders, customers, suppliers and lenders.

3. External stakeholders – community, government and pressure groups.

Examples of stakeholders’ objectives:

1. Shareholders want to maximise their wealth.

2. Trade payables want to be paid full amount at due date.

3. Management wants to maximise their rewards.

4. Government wants sustained economic growth and high levels of employment.

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Conflict between stakeholder objectives and agency theory

Sometime conflict will arise between stakeholder objectives, for example shareholders may encourage

management to pursue risky strategies in order to maximise returns (high risk, high return), but finance

providers prefer lower risk policies. Management has to try and balance the interest of different

stakeholders.

According to agency theory, directors/managers are agents of the shareholders being tasked to run the

entity in the best interest of shareholders. However conflict may also arise between directors’ personal

objectives (eg. increase personal remuneration) and stakeholder’s objectives. If directors fail to act in

the best interests of shareholders, this leads to sub-optimal returns to shareholders. This potential lost

of wealth for shareholders is known as “agency costs”. Agency costs can also be defined as costs

incurred by the principal to monitor the agent.

Measuring achievement of corporate objectives

Ratio analysis

1. Return on capital employed (ROCE) = profit before interest and tax (PBIT)/(equity + debt) x 100%.

2. Return on equity = profit available to ordinary shareholders/equity x 100%.

3. EPS = profit available to ordinary shareholders/number of shares.

4. Dividend yield = Dividend per share/market price per share x 100% (indicates the return on capital

investment relative to price).

5. Dividend cover = EPS/dividend per share (measures the ability to maintain existing level of dividend).

6. Price earnings ratio (P/E ratio) = market price per share/EPS (reflect shareholders’ expectation of

company’s future performance).

It is useful to bring forward your knowledge of ratio analysis to this paper (if you studied F5 or F7).

Total shareholder return (TSR)

TSR = (Year-end share price – share price at start of the year + dividend per share)/share price at start

of the year x 100% (total return to shareholders through dividend and capital gains).

Ways to encourage the achievement of stakeholder objectives

Firstly, we have to make sure that goal congruence (managers’ goals = organizations’ goals) is achieved,

probably by managerial reward schemes including performance-related pay, rewarding managers with

shares and share options schemes (this enables managers to buy an amount shares at fixed price which

is usually today’s price, therefore managers are encouraged to take decisions that maximise future

share prices), these can be given to managers if target is achieved.

Regulatory requirements can also help:

1. Corporate governance (system by which companies are directed and controlled) – the elements

include risk management, internal controls, accountability to stakeholders, conducting business in an

ethical and effective way.

2. Stock exchange listing regulations (rules and regulations to ensure stock market operates fairly and

efficiently).

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4. Financial and other objectives in not-for-profit organisations

Not-for-profit organisations (NFPOs) are those organisations that are not formed primarily to make

profit but probably to serve public interest.

Objectives of NFPOs

Their objectives are mainly non-financial, which may relate to a level of service and difficult to quantify.

NFPOs have multiple objectives which are difficult to define. Therefore, it is later identified that value

for money (VFM) concept is very relevant to them, this means providing a service in a way which is

economical, efficient and effective.

VFM as objectives

NFPOs can take VFM as their objectives, this means achieving economy, efficiency and effectiveness,

the 3Es.

1. Economy can be achieved if company is able to obtain appropriate quantity and quality of inputs at

lowest cost. In other word, comparing inputs with money spent.

2. Efficiency can be achieved if company is able to get as much outputs as possible from the inputs. In

other word, comparing outputs with inputs.

3. Effectiveness can be achieved if company’s outputs are in line with the objectives set. In other word,

comparing objectives with outputs.

Taking a school as an example, let say the objective is to increase the overall passing rate, the school is

said to be economical if teachers are trained with lowest possible cost, the school is said to be efficient

if the number of students passing the exam have increased with the trained teachers, the school is said

to be effective if there are 95% of students passing the exam which achieved the objective to increase

overall passing rate.

We can also say that economy + efficiency = effectiveness.

Measuring achievement of NFPO objectives

Other than looking at the VFM, customer satisfaction, competitive position, market share, resource

utilisation measures, benchmarking and so on could be useful as indicators of whether the company is

achieving the objectives.

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Financial management environment

1. The economic environment for business

Macroeconomic policy targets

Macroeconomic policy is a government policy aimed to manage the economy by influencing the

performance and behaviour of the economy as a whole. The main targets include:

1. Full employment.

2. Price stability – control inflation.

3. Balance of payments – balance between imports and exports.

4. Economic growth – improve living standards.

5. Acceptable distribution of income and wealth.

Components of macroeconomic policy

1. Fiscal policy – action by government to spend money or collect money in taxes, to influence the

condition of the national economy. It can be used to manage aggregate demand (eg. raise tax to

reduce demand in the economy, spend more to increase demand in the economy).

2. Monetary policy – aim to influence quantity of money, price of money (interest rate) and money

supply (total stock of money) in the economy.

3. Exchange rate policy – control the value of the currency to change the prices of imports and exports.

Effects of government economic policy

If tax rises, it damages the company’s profits and company may be reluctant to invest.

If interest rate rises, demand for money will reduce and inflation will fell, company’s profits will

also fell.

If exchange rate rises (ie. own country’s currency strengthen), it increases export prices (higher

revenue) and lower cost of imports (cheaper purchase).

Government intervention in the economy

Government may intervene in the operation of free market when monopolies, mergers or restrictive

practices operate against public interest, when the free market fails to the amount of capital required

etc. Government will intervene through:

1. Competition policy – to reduce a company’s domination of a market (ie. monopoly) and to increase

the efficiency of the economy by stimulating competition.

2. Government assistance for business – through official aid schemes (eg. giving grants, tax incentives)

or enterprise initiatives to encourage the formation of new businesses.

3. Green policies – increase production costs as companies are required by legislation to reduce

environmental impact of their business operations. Green policies can be seen as leading to fairer

prices in particular product markets since these prices reflect more completely the economic resources

consumed in the production of the products offered for sale.

4. Corporate governance regulation.

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2. The nature and role of financial markets and institutions

Financial intermediaries

Financial intermediaries bring together lenders and borrowers of money, either as broker (an agent

handling a transaction on behalf of others) or as principal (holding money balances of lenders for

lending on to borrowers). Examples of financial intermediaries are:

(i) Bank.

(ii) Building societies – give loans to borrowers for house purchase.

(iii) Finance houses – provide hire purchase service.

(iv) Insurance companies – use policyholders’ premiums to invest.

(v) Pension funds – collect contributions to invest for pensions.

(vi) Unit trusts – raise funds by trading in shares and bonds.

(vii) Investment trust companies – similar to unit trusts but trade in larger amount.

Benefits of financial intermediation are:

(i) Aggregation – bank can aggregate the amount of money from lenders and then lend to borrowers

who need the money, this makes things easier for lenders and borrowers to lend or obtain money.

(ii) Risk reduction – bank should be better at assessing credit risk.

(iii) Maturity transformation – lenders may want to keep money for liquidity while borrowers may need

loan (long-term borrowing), financial intermediary can facilitate short-term and long-term needs of

lenders and borrowers, this is called maturity transformation.

Financial markets

These are the places where those requiring finance (Deficit Units) can meet those who are able to

supply finance (Surplus Units). There are two types of financial markets:

1. Money markets – markets for short-term borrowing and lending, in wholesale amount. Money

markets include a primary market and a secondary market. The primary market is used by the central

bank and other approved banks and securities firms. The central bank uses it to balance shortages and

surpluses of cash. Main money market’s financial instruments are:

(i) Deposits – deposits of money in financial intermediaries.

(ii) Bills – short-term financial assets which can be converted into cash at very short notice, by selling

them in the discount market.

(iii) Commercial paper – short-term IOUs issued by large companies which can be held until maturity or

sold to others. It is issued when company wants to raise short-term money.

(iv) Certificates of deposits (CDs) – fixed terms deposit, customer can obtain cash before the term is up

by selling CD in CD market.

Other secondary UK markets include:

(i) Local authority markets – provide local authority bonds and bills.

(ii) Inter bank market – unsecured loans between banks.

(iii) CDs market

(iv) Inter company market – companies with surplus funds lend directly (through a broker) to those

which need to borrow. They do not involve financial intermediation and this is called disintermediation.

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(v) Commercial paper market

(vi) Eurocurrency markets – eurocurrency deposit is a foreign currency deposit, a deposit of own

country’s funds in other countries which have different currency, eg. deposit of US dollars with a bank

in London. This is an international money market and only suitable for larger companies.

2. Capital markets – markets for trading in longer-dated securities such as shares and bonds. Examples

of capital markets include Stock Exchange (or stock market, for buying and selling of shares) and bond

market (for trading of debt securities). There is also an international capital market which trades

Eurobond (bond issued in foreign currency) which is also suitable for larger companies only.

Functions of stock market

In UK, the stock market is known as the London Stock Exchange. There are actually two markets within

this stock exchange. The first of these is the Official List. This is the top tier (level) of the market and is

only available for large companies who can meet the strict listing requirements. The second tier is the

Alternative Investment Market (AIM). The listing requirements for this market are less strict, hence it is

used by new and smaller companies. There are two main functions:

1. As primary markets they enable companies to raise new finance by issuing shares or bonds.

2. As secondary markets they enable existing investors to sell their investments.

Apart from these two, stock markets have two other important functions:

1. The owners of the company can sell some of their shares to new investors when the company comes

to the stock market for the first time, eg. just became public company.

2. Company can take over another company by issuing shares to finance the takeover, ie. share

exchange.

Risk/return trade-off

The concept of this is that investors in riskier assets expect to be compensated higher return. The risk

level of different securities can be ranked as follow, first being least risky:

1. Government bonds.

2. Company bonds/loan note – usually secured against company’s assets.

3. Preference shares – rank behind debt in the event of liquidation.

4. Ordinary shares – in the event of liquidation, ordinary shareholders are the last to be paid.

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Working capital management

1. The nature, elements and importance of working capital

Working capital is the capital available for conducting the day-to-day operations of an organisation.

Net working capital can be calculated as current assets less current liabilities. Company needs working

capital to keep the trading activities on-going. Inventory, receivables, payables and cash are the major

elements of working capital.

Objectives of working capital management

Working capital management has two main objectives:

1. To ensure company has sufficient liquid resources to continue in business (minimise risk of

insolvency).

2. To increase profitability (maximise return on assets).

These two objectives often conflict as liquid assets give the lowest returns. For example, holding high

level of cash will improve liquidity position but will also harm profits because if the cash was used more

profits could be made.

Role of working capital management

Working capital management aims to balance not having too much or too less working capital.

Working capital management involves:

Controlling the liquidity position.

Controlling the working capital elements which are inventory, receivables and payables.

Cash is the most liquid asset, inventory is considered non-cash and so it is least liquid asset.

Receivables fall in the middle of cash and inventory.

2. Management of inventories, accounts receivable, accounts payable and cash

Cash operating cycle

Cash operating cycle/working capital cycle is the period between the suppliers being paid and the cash

being received from the customers. Working capital cycle in a manufacturing business equals:

The average time that raw materials remain in stock (inventory days)

- period of credit taken from suppliers (payables days)

+ time taken to produce the goods (inventory days)

+ time finished goods remain in stock after production is completed (inventory days)

+ time taken by customers to pay for the goods (receivables days)

In brief, working capital cycle = inventory days + receivables days – payable days.

Liquidity ratios

Liquidity ratios may help to indicate whether a company is over-capitalised, with excessive working

capital, or if a business is likely to fail. A business which is trying to do too much too quickly with too

little long-term capital is overtrading.

1. Current ratio = current assets/current liabilities, ideal is 2:1.

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2. Quick or acid test ratio = (current assets – inventories)/current liabilities, ideally should be at least

1:1.

3. Average collection period/receivables days = receivables/credit sales x 365 days, this shows the

length of time it takes for company’s customers to pay. This formula can be changed to receivables

days/365 days x credit sales to get receivables.

4. Average payable period/payables days = payables/credit purchases x 365 days, this shows the time

taken for company to pay suppliers. This formula can be changed to payables days/365 days x credit

purchases to get payables.

5. Inventory turnover period (finished goods) = inventory/cost of sales x 365 days.

6. Raw materials days = raw materials inventory/purchases x 365 days.

7. Work-in-progress (WIP) period = (WIP inventory/cost of sales x % of completion) x 365 days.

8. Inventory turnover ratio = cost of sales/average inventory.

9. Sales revenue/net working capital ratio = sales/(current assets – current liabilities), this shows the

level of working capital supporting sales and working capital must increase in line with sales to avoid

liquidity problems.

Symptoms of overtrading are increased revenue, increased current/non-current assets, current

liabilities more than current assets, assets financed by credit and not share capital, reduced current

and quick ratios, inventory and receivables are more than sales.

Managing inventory

Important techniques include economic order quantity (EOQ) and just-in-time (JIT). It is very useful to

bring forward your knowledge from previous studies.

EOQ is the optimal ordering quantity for an item of inventory that will minimise costs, at the same time

balancing the need to meet customer demand. Inventory costs include:

(i) Holding costs – eg. rental of warehouse, theft of stock.

(ii) Ordering costs – eg. telephone charges, delivery costs.

(iii) Shortage costs – eg. loss of sale

(iv) Purchase costs – price of the goods

EOQ or Q = 2cd/h, c = cost of per order for one year, d = annual demand, h = holding cost per unit

of inventory for one year, Q = reorder quantity. (EOQ formula is given in exam).

Holding cost = Qh/2, ordering cost = cd/Q

Total annual cost = holding cost + ordering cost + purchase cost

Assumptions of EOQ formula are purchase costs are constant, lead time is constant, demand is

constant and no inflation.

When there are bulk discounts from other supplier and you have to decide whether to order based on

EOQ or take the bulk discounts, compare the total annual cost if used EOQ and the total annual cost if

takes the bulk discounts (company may order more to get the discount), the lower costs will be chosen.

Other formulas include:

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Reorder level = maximum usage x maximum lead time, measure the inventory level at which

replenishment order should be placed.

Maximum level = reorder level + reorder quantity – (minimum usage x minimum lead time), inventory

level should not exceed this level.

Minimum level/buffer inventory = reorder level – (average usage x average lead time), inventory level

should not fall under this level.

Average inventory = reorder quantity/2 + minimum level

Just-in-time (JIT) aims to hold as little inventory as possible and production systems need to be very

efficient to achieve this. Deliveries will be small and frequent rather than in bulk. Company needs to

have a reliable supplier as that supplier will guarantee to deliver raw materials components of

appropriate quality always on time. Unit purchasing prices may be higher as supplier guarantees the

quality and also on time delivery. Workforce must also be flexible and multi-skilled in order to minimize

delay and eliminate poor quality production. Reduced inventory levels mean that a lower level of

investment in working capital will be required.

Managing receivables

Managing accounts receivable involves many aspects, mainly relating to offering credit and collecting

back the money. Credit control policies are guideline on giving credit, can be set based on before

offering credit (assess creditworthiness, check past record of customers), during credit period (monitor

the receivables) and after credit period (chase slow payers, aged receivables analysis). The amount of

total credit that a business offers depends on:

(i) The firm’s working capital needs and the investment in receivables.

(ii) Management responsibility for carrying out the credit control policy.

An important aspect of the credit control policy is to devise suitable payment terms, covering when

and how should payment be made.

Assessing creditworthiness

A credit assessment is a judgement about the creditworthiness of a customer. It provides a basis for a

decision as to whether credit should be granted. If the credit risk (possibility that the debt goes bad) is

high, the customers need to be managed carefully. The methods include:

1. Bank reference – banks are cautious as they owe duties of care to customer and enquirer, therefore

the information about customers are limited.

2. Trade reference - get information from customers’ suppliers, useful but careful as customers will

give name of suppliers that they have good history with.

3. Check the credit ratings from the credit rating agency.

4. Ratio analysis.

5. Customer visits.

6. Press comments.

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Monitoring accounts receivables

Aged receivables analysis and credit utilisation report can be used to monitor accounts receivable.

Example of aged receivables analysis is as follow:

Customer name 0-30 days 31-60 days 61-90 days >90 days

Balance

ABC 1000 300 700 0 0

DEF 2000 0 900 200 900

Total 3000 300 1600 200 900

Example of credit utilisation report is as follow:

Customer name Limit Utilisation %

ABC 300 280 93

DEF 100 50 50

This shows that ABC needs more credit and DEF does not.

The decision to extend credit given to customers will depend on factors such as:

1. Profits from extra sales.

2. Extra length of average debt collection period.

3. Required rate of return (cost of capital) on the investment in additional accounts receivable.

Example: Ice Co currently expects sales of $50000 per month and variable cost of sales is $40000 per

month (all payable in the month of sale). It is estimated that if credit period increased from 30 days to

60 days, sales volume will increase by 20%. If cost of capital is 10% per annum, decide whether to

extend credit period.

Solution: Remember that when sales volume increases, the variable cost of sales will also increase.

Contribution per month = 50000 – 40000 = $10000, new contribution = 10000 x 1.2 = $12000.

Extra contribution per month = 12000 – 10000 = $2000.

Accounts receivable for 60 days credit period (2 month) = $60000 (new sales) x 2 = $120000.

Accounts receivable for 30 days credit period (1 month) = $50000 x 1 = $50000.

Extra receivables = $120000 - $50000 = $70000.

Annual benefit from extending credit period = $2000 x 12 months – $70000 x 10% = $17000.

Therefore, financially it is worthwhile to extend the credit period.

Collecting amounts owing

The benefits of action to collect debts must be greater than the costs incurred. To encourage

customers to pay on time, make sure that:

Customer is fully aware of the payment terms.

Invoice is correctly drawn up and issued promptly.

Awareness of customer’s system – understand the payment system of customer’s business.

Queries are resolved quickly.

Monthly statements are issued promptly.

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There should be efficiently organised procedures for ensuring that overdue debts and slow payers are

dealt with effectively, some examples are:

Issuing reminder letters

Chasing payment by telephone

Charge interest for late settlement

Employ services of debt collection agency (pay commission)

Send authorized person to visit and request payment

Take legal action

Offering early settlement discounts

Early settlement discounts may be offered to reduce average credit periods and investment in

accounts receivable which will also reduce interest costs. To decide whether to offer the discount,

compare cost of discount allowed and benefits from reduced accounts receivable.

Example: Fire Co has annual credit sales of $12000000 and three months are allowed for payment. The

company decides to offer 2% discount for payments made within ten days of invoice being sent and to

reduce the time allowed for payment to two months. It is estimated that 50% of customers will take

the discount. Company requires 20% return on investments and assume sales volume remain, decide

whether or not to offer the discount.

Solution: New accounts receivable = 10/365 x 50% x $12000000 + 2/12 x 50% x $12000000 = $1164384.

Current accounts receivable = 3/12 x $12000000 = $3000000.

Reduction in accounts receivable = 3000000 – 1164384 = $1835616.

Benefits of the reduced accounts receivable = $1835616 x 20% = $367123.

Cost of discount allowed = $12000000 x 50% x 2% = $120000.

Net benefit = 367123 – 120000 = $247123.

It is therefore financially beneficial to offer the early settlement discount.

The compound annual cost of early settlement discount can be calculated by (100/100 – d) ^ (365/t) –

1, d = discount, t = time difference between cash discount date and the credit term.

Example: A company offers its goods to customers on 30 days’ credit. It also offers a 2% discount if

payment is made within 10 days of the date of invoice, calculate compound annual cost of offering the

early settlement discount.

Solution: Compound annual cost = (100/98) ^ (365/20) – 1 = 44.6%.

Alternatively, 2/98 is the cost of discount and to convert it to annual percentage:

(1 + 2/98) ^ (365/20) – 1 = 44.6%.

Using factoring and invoice discounting

Some businesses might have difficulties in financing amounts owed by customers, they can employ the

service of factoring. Factoring is an arrangement to have debts collected by a factor company which

advances a proportion of the money that it is due to collect.

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An easier way to understand factoring is through steps:

1. Company asks for factoring service from factor.

2. Factor will administer the sales ledger (control the receivables of the company) and give money in

advance to company (about 80%).

3. After factor received money from receivables, factor will pay back the company an amount which

has been deducted for interest.

There are two types of factoring:

(i) With recourse – if debt cannot be collected, factor can claim back the advance from company

(ii) Without recourse – if debt cannot be collected, factor cannot claim back the advance from

company.

To determine whether it is financially viable to use factoring service, compare cost of factoring and cost

of not factoring.

1. The cost of not factoring – this means that the costs if company uses own system of managing

receivables. Examples include credit controller salaries, administration costs and interest charged on

overdraft.

2. The cost of factoring – examples of costs are interest charged for advance of money, interest

charged for financing remaining receivables and administration fees.

Example: Rock Co makes annual credit sales of $1500000. Credit terms are 30 days, average collection

period has been 45 days with 0.5% of sales resulting in bad debts, administration costs are $30000. A

factor would charge annual fee of 2.5% of credit sales and payment period would be 30 days. The

factor would also provide an advance of 80% of invoiced debts at an interest rate of 14%. Interest on

overdraft is 13.5%. Decide whether to accept the factor’s service.

Solution: Accounts receivable without factoring = 45/365 x 1500000 = $184932.

Accounts receivable with factoring = 30/365 x 1500000 = $123288.

Cost of not factoring

Admin cost = $30000

Interest on overdraft = 13.5% x 184932 = $24966

Bad debt = 0.5% x 1500000 = $7500

Total cost = $62466

Cost of factoring (80% financed by factor and 20% financed by overdraft)

Interest on advance = $123288 x 80% x 14% = $13808

Interest on overdraft = $123288 x 20% x 13.5% = $3329

Admin fee = $1500000 x 2.5% = $37500

Total cost = $54637

It is financially viable for the company to use factoring service as the cost is lower. The net benefit of

using factor = $62466 - $54637 = $7829.

Invoice discounting is the purchase of trade debts at a discount. Invoice discounting enables company

to raise working capital. It is similar to factoring, but invoice discounter does not administer sales

ledger, with this, customers will not know that the company is employing this service.

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Managing foreign accounts receivable

Company with foreign accounts receivable or exporters might have problems of larger inventories and

accounts receivable, and an increased risk of bad debts due to the transportation time and additional

paperwork involved in sending goods abroad. There are several ways for exporters to overcome these

problems:

1. Reduce investment in foreign accounts receivable.

2. Reducing the bad debt risk – assessing creditworthiness is essential.

3. Export factoring – the functions of overseas factor are the same as the factor discussed.

4. Documentary credits – customer requests the bank of his country to issue letter of credit in favour of

exporter, then the issuing bank will guarantee payment to the beneficiary (exporter).

5. Countertrade – goods are exchanged for other goods, it is a form of barter.

6. Export credit insurance – insurance against the risk of non-payment by foreign customers.

Summary of accounts receivable management

There are four key areas of accounts receivable management told by examiner in the pilot paper:

1. Policy formulation – establishing a framework within which management of accounts receivable in

an individual company takes place. The elements to be considered include establishing terms of trade,

such as period of credit offered and early settlement discounts: deciding whether to charge interest on

overdue accounts; determining procedures to be followed when granting credit to new customers;

establishing procedures to be followed when accounts become overdue, and so on.

2. Credit analysis – assessment of creditworthiness depends on the analysis of information relating to

the new customer. This information is often generated by a third party and includes bank references,

trade references and credit reference agency reports. The depth of credit analysis depends on the

amount of credit being granted, as well as the possibility of repeat business.

3. Credit control – once credit has been granted, it is important to review outstanding accounts on a

regular basis so overdue accounts can be identified. This can be done, for example, by an aged

receivables analysis. It is also important to ensure that administrative procedures are timely and

robust, for example sending out invoices and statements of account, communicating with customers

by telephone or e-mail, and maintaining account records.

4. Collection of amount due - Ideally, all customers will settle within the agreed terms of trade. If this

does not happen, a company needs to have in place agreed procedures for dealing with overdue

accounts. These could cover logged telephone calls, personal visits, charging interest on outstanding

amounts, refusing to grant further credit and, as a last resort, legal action. With any action, potential

benefit should always exceed expected cost.

Managing accounts payable

Effective management of payables involves seeking satisfactory credit terms from suppliers, getting

credit extended during periods of cash shortage, and maintaining good relations with suppliers.

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Using trade credit effectively

Trade credit is a source of short-term finance because it helps to keep working capital down. It is

usually cheap as suppliers rarely charge interest. However, if the company attempts to make maximum

use of trade credit, potential cost might include loss of suppliers’ goodwill and loss of available early

settlement discount.

Evaluating the benefits of discounts for early settlement and bulk purchase

The percentage compound annual cost of not taking discount can be calculated by (100/100 – d) ^

(365/t) – 1, ie. same as the one used in accounts receivable. Now an example is taken from June 2011

question 4.

Example: ZPS Co places monthly orders with a supplier for 10,000 components that are used in its

manufacturing processes. Annual demand is 120,000 components. The current terms are payment in

full within 90 days, which ZPS Co meets, and the cost per component is $7·50. The cost of ordering is

$200 per order, while the cost of holding components in inventory is $1·00 per component per year.

The supplier has offered either a discount of 0·5% for payment in full within 30 days, or a discount of

3·6% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of

holding components in inventory would increase to $2·20 per component per year due to the need for

a larger storage facility.

Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 4·5% per year,

calculate if ZPS Co will benefit financially by accepting the offer of early settlement discount or bulk

purchase discount.

Solution:

Early settlement discount

Since we are given the interest rate, we can calculate the value of discount in % and compare.

Value of the discount expressed in annual percentage = (100/99.5)^(365/60) – 1 = 3.1%.

Since the value of the discount is lower than the short-term borrowing rate, it is not financially

beneficial to accept the discount. (Note: Another way is to compare the value of discount in $ and the

cost, that is the increase in finance cost due to reduction in payables).

Bulk purchase discount

Compare the annual inventory cost of order at 10000 and at 30000 components.

Cost of order at 10000 components

Holding cost = 10000/2 x $1 = $5000

Ordering cost = 120000/10000 x $200 = $2400

Purchase cost = 120000 x $7.50 = $900000

Total cost = $907400

Cost of order at 30000 components

Purchase cost = 120000 x $7.50 x 96.4% = $867600

Holding cost = 30000/2 x $2.2 = $33000

Ordering cost = 120000/30000 x $200 = $800

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Total cost = $901400

It is financially beneficial for ZPS Co to accept the bulk purchase discount as it saves $6000 (907400 –

901400) per year.

Managing foreign accounts payable

Foreign accounts payable are subject to exchange rate risk. Depreciation of a domestic currency will

cause the cost of supplies more expensive. The management of exchange rate risk will be discussed in

last syllabus area.

Managing cash

Reasons of holding cash

Keynes had identified three reasons why company should hold the surplus cash rather than investing it:

(i) Transaction motive – hold cash to meet regular commitments.

(ii) Precautionary motive – hold cash in case of emergency purpose.

(iii) Speculative motive – hold cash to wait for good opportunity to invest (eg. when interest rates rise).

Preparing cash flow forecasts

A cash flow forecast is a detailed forecast of cash inflows and outflows. The timing is important, for

example a new delivery vehicle was brought in June and the cost of $8000 is to be paid in August, then

you should record $8000 in August. Remember, we include the item only when cash is receipt or paid.

A good step to prepare cash flow forecast is to set out the pro-forma first and include amount which

does not or just require easy calculation, then only do workings and include the rest of the amount.

Example of cash flow forecast format is as follow:

Cash flow forecast for six months ending 31 December 2011

Jul Aug Sep Oct Nov Dec

Receipts $ $ $ $ $ $

Credit sales 100

100

Payments

Corporation tax 50

Materials 10

60

Surplus/ (Deficit) 40

Balance b/f 10 50

Balance c/f 50

Treasury management

Treasury management in a modern enterprise covers various areas, and in larger business may be a

centralised function. The role of treasurer includes liquidity management, funding management,

currency management, formulating corporate financial objectives, handling corporate finance and risk

management. Advantages of centralised treasury management are: better short-term investment

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opportunities, improved foreign exchange risk management, able to employ experts (cash is pooled)

and easier to manage cash.

Cash management models

Optimal cash holding levels can be calculated using Baumol model and Miller-Orr model.

Baumol model is based on the idea that deciding on optimum cash balances is similar to deciding on

optimum inventory levels. It is similar to EOQ, it is based on the formula Q =

, Q is cash to be

raised, F is fixed cost of obtaining new funds, S is amount of cash to be used, I is interest cost of holding

cash.

Example: Fire Co faces a fixed cost of $4000 to obtain new funds. There is a requirement for $24000 of

cash over each period of one year for the foreseeable future. The interest cost of new funds is 12% per

annum, interest rate earned on short-term securities is 9% per annum. How much finance should Fire

Co raise at a time?

Solution: Interest cost of holding cash = 12% - 9% = 3%.

Q =

= $80000. Q is like reorder quantity, so this means to raise $80000 every time.

The limitations of Baumol cash management model are as follow:

(i) In reality, amounts required over future periods will be difficult to predict with much certainty.

(ii) The model works satisfactorily for a firm which uses cash at steady rate but not if there are larger

inflows and outflows of cash over time.

(iii) There may be difficulty in predicting future interest rates.

Miller-Orr model is based on the idea that variance of cash flows, transaction costs and interest rates

will affect the return point (normal level of cash balance). Lower limit will be set, then upper limit and

return point depend on lower limit. The following formulas are given in exam:

Return point = Lower limit + (1/3 x spread)

Spread = 3 (3/4 x transaction cost x variance of cash flows/interest rate)^1/3

The upper limit is calculated as lower limit + spread as spread shows the fluctuation between lower

limit and upper limit. Note that if standard deviation is given instead of variance, remember to square

it to get variance. This model is applied to manage daily cash.

Example: Ice Co has the following data, formulate a decision rule using Miller-Orr Model:

1. Minimum cash balance is $8000. (This is the lower limit)

2. Variance of daily cash flows is 4000000, equivalent to standard deviation of $2000 per day.

3. Transaction cost for buying and selling securities is $50. Interest rate is 0.025% per day.

Solution: Spread = 3 x (3/4 x 50 x 4000000/0.00025)^1/3 = $25303, let’s take $25300.

Upper limit = Lower limit + $25300 = $8000 + $25300 = $33300.

Return point = $8000 + 1/3 x 25300 = $16433, let’s take $16400.

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The decision rule is if cash balance reaches $33300, buy $16900 (33300 – 16400) of marketable

securities (reduce the cash balance to return point). If cash balance falls to $8000, sell $8400

marketable securities (increase the cash balance to return point).

Short-term investment of surplus funds

Before investing surplus funds, key factors to consider are as follow:

(i) Risk – the higher the risk, the higher the return. There are two types of risks, systematic risk (risk

that affects the whole market and cannot be diversified away) and unsystematic risk (risks that affects

only specific market, can be reduce by diversification, means to hold more than one/portfolio of

investment).

(ii) Liquidity – the ease of converting into cash, high liquid low return.

(iii) Maturity – the duration of investment, long maturity high return.

(iv) Return – after considered risk, liquidity and maturity, company is in position of considering how

much return they want.

The investment options available include:

1. Certificate of deposit (CD) – a certificate indicating that a sum of money has been deposited with a

bank and will be repaid at a later date. As CDs can be bought and sold in the CD market any time, they

are liquid type of investment.

2. Treasury bills – IOUs issued by government, promising to pay a certain amount to their holder on

maturity.

3. Shares.

4. Deposit in bank or similar financial institution.

5. Bonds.

3. Determining working capital needs and funding strategies

Working capital requirements

The amount of current assets and current liabilities can be determined by looking at the working

capital cycle components. You can change the formula of receivable, inventory and payable days to

find the amount.

Example: The annual cost of purchasing direct materials is $450000 and raw materials are in inventory

for three months.

Solution: Raw material days = raw material/purchases x 365 so raw material = raw material days/365 x

purchases. In this case, raw material in inventory = 3/12 x $450000 = $112500. Of course there will be

other elements such as WIP and finished goods in reality, you will need to calculate the total current

assets then minus current liabilities to get working capital.

Permanent and fluctuating current assets

1. Permanent current assets are the amount required to meet long-term minimum needs and maintain

normal trading activity. For example, inventory and accounts receivable.

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2. Fluctuating current assets vary due to the unpredictability of business activity.

Working capital policy

Working capital policies can cover the level of investment in current assets, the way in which current

assets are financed, and the procedures to follow in managing elements of working capital such as

inventory, trade receivables, cash and trade payables. The twin objectives of working capital

management are liquidity and profitability, and working capital policies support the achievement of

these objectives.

Working capital financing

Working capital can be financed by a mixture of short (riskier but cheaper) and long-term finance

(more expensive but less risk). It depends on the working capital policy adopted by the company which

is set based on the risk attitude:

1. Conservative policy – holding high levels of working capital. This approach to financing working

capital will be that all non-current assets and permanent current assets, as well as part of fluctuating

current assets are financed by long-term finance. This is safer but less profitable due to higher interest

rates.

2. Aggressive policy – holding low levels of working capital to reduce finance cost and increase

profitability. This approach to financing working capital will be that fluctuating and some of the

permanent current assets are financed by short-term finance. This increases liquidity risk but cheaper.

3. Moderate policy – This is a middle way between the aggressive and conservative policy, balancing

between risk and return, and follow matching principle. Long-term finance is matched with non-

current assets and permanent current assets.

Other factors to consider

1. The industry in which the organisation operates. This is particularly important for the management

of receivables as it will be difficult to offer a shorter credit than competitors.

2. Management attitudes to risk will determine the working capital policy.

3. Previous funding decisions. If previous way was proven to be very suitable for the organisation, then

manager may follow it.

4. Organisation size. The larger size organisation will probably require more working capital.

5. Terms of trade. The terms of trade must be comparable with those of competitors and the level of

receivables will be determined by the credit period offered and the average credit period taken by

customers.

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Investment appraisal

1. The nature of investment decisions and the appraisal process

Firstly, the distinction must be made between capital and revenue expenditure. Capital expenditure is

expenditure which results in the acquisition of non-current assets or an improvement in their earning

capacity. Revenue expenditure is incurred for the purpose of the trade of the business or to maintain

the existing earning capacity of non-current assets.

Secondly, we should differentiate between non-current assets and working capital investment.

Investment in non-current assets involved large amount of money and it takes some time for the

benefit to cover the investment cost. Non-current assets will be used on a continuing basis within the

organisation.

Investment in working capital involved a smaller amount of money and arises from the need to pay out

money for resources such as raw materials before it can be recovered from sales of the finished

product or service. It is therefore needed to maintain the operational trade cycle.

Capital budget

Capital budget is essentially a non-current asset purchase budget, and it will form part of longer term

plan of a business. Regular and minor non-current asset purchases may be covered by an annual

allowance provided for in the capital budget. Major projects will need to be considered individually and

will need to be fully appraised. Therefore, investment appraisal holds an important role in capital

budgeting.

Stages of capital investment decision-making process

1. Identifying investment opportunities – Investment opportunities or proposals could arise from

analysis of strategic choices, analysis of the business environment, research and development, or legal

requirements. The key requirement is that investment proposals should support the achievement of

organisational objectives.

2. Screening investment proposals – In the real world, capital markets are imperfect, so it is usual for

companies to be restricted in the amount of finance available for capital investment. Companies

therefore need to choose between competing investment proposals and select those with the best

strategic fit and the most appropriate use of economic resources.

3. Analysing and evaluating investment proposals – Candidate investment proposals need to be

analysed in depth and evaluated to determine which offer the most attractive opportunities to achieve

organisational objectives, for example to increase shareholder wealth. This is the stage where

investment appraisal plays a key role, indicating for example which investment proposals has the

highest net present value.

4. Approving investment proposals – The most suitable investment proposals are passed to the

relevant level of authority for consideration and approval. Very large proposals may require approval

by the board of directors, while smaller proposals may be approved at divisional level, and so on. Once

approval has been given, implementation can begin.

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5. Implementing, monitoring and reviewing investments – The time required to implement the

investment proposal or project will depend on its size and complexity, and is likely to be several

months. Following implementation, the investment project must be monitored to ensure that the

expected results are being achieved and the performance is as expected. The whole of the investment

decision-making process should also be reviewed in order to facilitate organisational learning and to

improve future investment decisions.

2. Non-discounted cash flow techniques

Relevant cash flows

The skill of identifying relevant cash flows is essential in investment appraisal, we only take into

account the relevant cash flows. Relevant cash flows are always future, incremental cash flows.

Variable cost is normally relevant and fixed cost (or unavoidable) is normally irrelevant (incremental

fixed cost is relevant). Opportunity cost (contribution loss from not taking another option) is relevant

but sometime it may be difficult to identify. The extra or reduced tax is also relevant. Interest will not

be relevant here because it is allowed in discount rate (discount rate discussed later). We will now look

at non-discounted cash flow techniques to investment appraisal, payback method and return on capital

employed (ROCE) are covered.

Payback method

The payback period is the time taken for the initial investment to be recovered by cash inflows (time

for cash inflows = cash outflows). When there are two projects, project with the least payback period is

favoured.

Example: An investment would costs $10000 and generate cash inflows of $3000 per annum, what is

the payback period?

Solution: Year cash flows ($) accumulated cash flows ($)

0 ($10000) ($10000)

1 $3000 ($7000)

2 $3000 ($4000)

3 $3000 ($1000)

4 $3000 $2000

Payback period = 3 years + 1000/3000 x 12 months = 3 years 4 months.

Advantages of payback period are:

(i) It is easy to calculate and understand

(ii) Widely used in practice as a first screening method (fast check).

(iii) Identify quick cash generating projects.

Disadvantages of payback period are:

(i) Total profitability is ignored.

(ii) Time value of money is ignored.

(iii) Does not take into account positive cash inflows occurring after the end of the payback period.

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Return on capital employed (ROCE) or accounting rate of return (ARR) or ROI

ROCE calculates estimated average annual profits/estimated average investment x 100% to evaluate

an investment. If it exceeds target rate of return, the project will be accepted. When there are two

acceptable projects, the one with highest ROCE will be favoured.

Average profit can be calculated as total profits for x year/x year (eg. Total profits for 5 years/ 5).

Average investment can be calculated as (initial investment costs + residual value)/2.

Advantages of ROCE are:

(i) A widely understood and used method, it is in percentage as well.

(ii) Use readily available accounting data.

(iii) Look at the entire project life.

Disadvantages of ROCE are:

(i) Based on accounting profits (accrual concept) rather than cash flows, it included costs like

depreciation, therefore may not be relevant to the project performance.

(ii) Does not take into account the timing of cash inflows and outflows.

(iii) Ignore time value of money.

3. Discounted cash flows (DCF) techniques, ie. net present value (NPV), internal rate of return (IRR)

Before looking at NPV and IRR, the concept of compounding, discounting and time value of money

should be understood.

Compounding

Compounding is a method of converting present value to future value by using the formula:

F = P (1 + r) ^ n, F is future value with interest, P is amount invested now (present value), r is rate of

interest in decimal, n is number of years.

Example: The cost of investment is $2000 now at 10%, what would the investment be worth after 5

years?

Solution: F = $2000 (1 + 0.10) ^ 5 = $3222.

Discounting

Discounting is a method of converting future cash flows into present value (the value now), therefore

the formula is the reverse of compounding, ie. F/[(1 + r)^n] or F x (1 + r)^(-n) but you can just use the

present value table in exam. The cost of capital (required rate of return by investors) can be used as

the discount factor.

Example: The company’s cost of capital is 10% and a cash flow is expected to occur at year 2, what is

the present value rate to be used to convert this cash flow to present value?

Solution: Referring to the present value table, it is 0.826, this can be calculated:

(1 + 0.1)^(-2) = 0.826.

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If the annual cash flows are constant from year to year, this is called annuities. When this occurs, a

short-cut will be to use annuity factors to convert the future cash flows to present values.

Example: The company’s cost of capital is 10% and a constant annual cash flows of $5000 is expected

to occur from year 2 to year 5, what is the present value of the cash flows?

Solution: Referring to the annuity table, at annuity factor of 10% period 5, the present value rate is

3.791, this includes period 1’s rate, so present value rate for year 2 to year 5 = present value rate of

year 5 – present value rate of year 1 = 3.791 – 0.909 = 2.882. This can also be calculated by adding the

present value rate of year 2 to year 5 from the present value table.

Present value = $5000 x 2.882 = $14410.

In the case of perpetuity, this means that annual cash flows are constant and occur in infinite time. The

present value rate is calculated as 1/r.

Example: The company’s cost of capital is 10% and cash inflows are expected to be $20000 per annum

in perpetuity, what is the present value of the cash flows?

Solution: Present value rate = 1/0.1 = 10. Present value = $20000 x 10 = $200000.

Time value of money

This is an important consideration in decision-making. Most people would prefer $100 today rather

than $100 in 10 years' time. Because $100 will probably buy you less in 10 years' time than it will today.

NPV and IRR recognise this and therefore discount the future cash flows to present value in project

appraisal.

Net present value

NPV method calculates the present value of all cash flows, and sums them to give the NPV. If this is

positive, then the project is acceptable. When performing NPV calculations, the following approach

should be taken:

1. Identify the relevant cash inflows and outflows of the project, not forgetting the initial investment.

The timing of cash flows is very important. In NPV all cash flows are assumed to occur at year ends only:

(i) If cash flows occur at the beginning of investment project, then include in time 0.

(ii) If cash flows occur during the time period, then include in this time.

(iii) If cash flows occur at the beginning of time period, then include in previous time.

2. Add up the cash inflows and outflows for each year, then discount each of the cash flows to its

present value, using the company's cost of capital.

3. Calculate the net present value of the project by adding all present values for each year.

4. Decide whether or not the project should be accepted (accept if positive NPV).

Advantages of NPV are:

(i) Positive NPV project will maximise shareholder wealth.

(ii) Takes into account the time value of money.

(iii) Based on cash flows which are less subjective than profit.

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Disadvantages of NPV are:

(i) Can be difficult to identify an appropriate discount rate (this depends on cost of capital).

(ii) Cash flows are assumed to occur at year ends only.

(iii) Some managers are unfamiliar with the concept of NPV.

Internal rate of return

IRR tells us the rate at which the NPV of a project is zero. There are four steps to an IRR calculation:

1. Calculate the project's NPV at cost of capital (required rate of return).

2. If the above NPV is positive, choose a higher discount rate and calculate the NPV again. If the above

NPV was negative, choose a lower discount rate. This is because you need a positive and a negative

NPV to get accurate IRR (don’t worry if you get two positive or negative NPV).

3. You must now calculate the IRR by using the following formula:

IRR = A + [(a/a – b) x (B – A)]

Where A is the lower discount rate and B is the higher rate, a is the NPV at the lower rate and b is the

NPV at the higher rate.

4. The IRR must then be compared to the company's cost of capital (required rate of return). If IRR is

higher than the required rate of return, the project should be accepted. If it is lower than the required

rate of return, the project should be rejected.

Example: Company’s cost of capital is 10% and considering a project. NPV using 10% rate of return is

$1000, after calculating NPV at rate of return of 15%, NPV = ($3000). Calculate IRR.

Solution: IRR = 10 + [(1000/(1000 + 3000) x (15 – 10)] = 11.25%, it is higher than cost of capital of

company and therefore the project is acceptable.

Advantages of IRR are:

(i) Take into account the time value of money.

(ii) Results are expressed as simple percentage, easier to understand.

(iii) Indicates how sensitive calculations are to changes in interest rates.

Disadvantages of IRR are:

(i) May be confused with ROCE.

(ii) Problems occur if there are mutually exclusive projects (discussed below).

(iii) Some managers are not familiar with IRR method.

Other issues about NPV and IRR

1. Sometimes there are mutually exclusive projects where for example NPV is positive but IRR is lower

than cost of capital. In this case, we will take NPV as priority and accept the project.

2. An investment project may have multiple internal rates of return if it has unconventional cash

flows (ie. the pattern of cash flows that are not like starting with initial cash outflow followed by a

series of cash inflows). One solution is to use the NPV instead of IRR, since the non-conventional cash

flows are easily accommodated by NPV.

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3. Both method uses reinvestment assumption (an assumption about the rate of return of the project

when reinvested). NPV assumes that net cash inflows generated during the life of the project can be

reinvested in the same project to earn rate of return equals to cost of capital (discount rate). IRR

assumes that net cash inflows can be reinvested in the same project to earn rate of return equals to

IRR.

Discounted payback

The approach will be similar to payback method, we are still calculating the time where investment

cost will be covered by cash inflows, but this time the cash flows will be discounted to present values.

Advantages of discounted payback method

1. Take into account time value of money.

2. Easy to calculate and understand.

3. Identify quick cash generating projects.

4. Payback can be adjusted for risk by discounting future cash flows with a risk-adjusted discount rate.

Disadvantages of discounted payback method

1. Require cost of capital to be estimated first.

2. Ignore cash flows beyond discounted payback period.

3. No decision criteria to indicate whether the investment increases company’s value, unlike NPV and

IRR, eg. positive NPV means increase value, IRR more than cost of capital means acceptable.

Superiority of discounted cash flow (DCF) methods over non-DCF methods

It is the obvious point that DCF methods take into account time value of money which makes the

assessment of project more accurate. They also take into account all cash flows of the project, unlike

payback method which only looks at when investment cost is paid back.

Timing of cash flows is taken into account as opposed to ROCE method. In addition, they use relevant

cash flows in investment appraisal, ROCE used profit which includes non-cash items.

Finally, there are universally accepted methods of calculating NPV and IRR, unlike ROCE which people

can have different formula and therefore different percentage leading to different decision. Both NPV

and IRR are widely used in practice, payback and ROCE were mostly used for initial project screening

only (quick look through of how fast to pay back or profitability).

4. Allowing for inflation and taxation in DCF

Relationship between interest rates and inflation

This can seen from Fisher formula which is given in exam, (1 + i) = (1 + r)(1 + h), i = nominal or money

rate of interest, r = real rate of interest, h = inflation rate. Real rate of interest is the interest that is

adjusted for inflation while nominal rate of interest covers inflation as well. In this formula, we can see

that if inflation rises, the nominal rate of interest will also rise and this can be taken as the discount

factor to use.

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The rule to decide whether to use real rate or nominal rate in NPV computation is as follow:

1. If cash flows are expressed in actual number of dollars that will be received or paid on the various

future dates, use nominal rate for discounting.

2. If cash flows are expressed in value of dollar at time 0 (ie. current price level), use real rate for

discounting.

Example: Inflation rate is 10% a year and company requires a minimum return of 20% on the project.

The cash flows of the project are as follow, calculate NPV.

Time Cash flows ($)

0 (15000)

1 9000

2 8000

3 7000

Solution: Using fisher formula:

(1 + 0.2) = (1 + r)(1 + 0.1)

1 + r = 1.2/1.1, r = 9.1%

In this question, we are given cash flows are various future dates, so use nominal rate.

Time Cash flows ($) Discount factor (20%) Present value ($)

0 (15000) 1 (15000)

1 9000 0.833 7497

2 8000 0.694 5552

3 7000 0.579 4053

NPV 2102

We can also use real rate to discount but we have to convert the future cash flows to value at time 0

first by discounting the future cash flows using the inflation rate as discount factor (as inflation is

related to general price level).

Time Cash flows ($) Discount factor (10%) Cash flows at time 0 price

0 (15000) 1 (15000)

1 9000 0.909 8181

2 8000 0.826 6608

3 7000 0.751 5257

With this information available we can now discount the cash flows using real rate.

Time Cash flows ($) Discount factor (9.1%) Present value ($)

0 (15000) 1 (15000)

1 8181 (1.091)^(-1) 7502

2 6608 (1.091)^(-2) 5553

3 5257 (1.091)^(-3) 4047

NPV 2102

You will get the same or nearly same (due to rounding difference) answer, but in exam you should

know which rate is most suitable to use in the given cash flows.

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If the inflation rate of some cash flows is different than the general level of inflation, you just need to

inflate those cash flows specifically for each year and finally discount at nominal rate. Note that you

should not inflate those cash flows which are affected by general level of inflation as the nominal rate

has taken into account about it.

Taxation effects of relevant cash flows

In investment appraisal, tax is often assumed to be payable one year in arrears (this year tax is paid

next year). You have learnt in taxation that capital allowance (tax-allowable depreciation/writing down

allowance) can reduce the amount of tax payable, the tax benefit of the capital allowance is a relevant

cash flow (not the tax-allowable depreciation!). This tax savings can be calculated by capital allowance

x tax rate. You also know that when you sell an asset, there is either balancing charge (sale price > tax

written down value, this will be taxable profit) or balancing allowance (tax written down value > sale

price, this will be tax allowable loss), again the tax effect (eg. taxable profit x tax rate) on the sale of

asset is a relevant cash flow. In the year of disposal, capital allowance cannot be claimed. If you have

some cost savings, this will subject to extra tax payable.

Example: Psychic Co is considering whether or not to purchase an item of machinery costing $40000

payable immediately. It would have a life of 4 years, after which it would be sold for $5000. The

machinery would create annual cost savings of $14000.

The company pays tax one year in arrears at an annual rate of 30% and can claim capital allowance on

a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation. The

company’s cost of capital is 8%. Should the machinery be purchased?

Solution: You must be careful about the taxation effects, company pays tax one year in arrears, so for

example year 1 tax is paid at year 2 and therefore tax benefit of capital allowance is earned at year 2.

Also note that the annual cost savings will increase tax payable and for example, cost savings in year 1

mean that extra tax is paid in year 2.

Capital allowance Tax benefits

Year $ Year $

1 40000 x 0.25 10000 2 10000 x 0.3 3000

2 (40000 – 10000) x 0.25 7500 3 7500 x 0.3 2250

3 (30000 – 7500) x 0.25 5625 4 5625 x 0.3 1688

23125

In year 4 (disposal), the reducing balance is $16875 (40000 – 23125) and the machinery is sold for only

$5000, which mean there is a tax allowable loss of $11875 (16875 – 5000). The tax benefit of this is in

year 5, ie. $11875 x 0.3 = $3563.

The extra tax payable for annual cost savings is 14000 x 0.3 = $4200.

Time 0 1 2 3 4 5

$ $ $ $ $ $

Machine costs (40000) 5000

Cost savings 14000 14000 14000 14000

Extra tax on cost savings (4200) (4200) (4200) (4200)

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Tax benefit on capital allowance 3000 2250 1688 3563

After-tax cash flows (40000) 14000 12800 12050 16488 (637)

Discount factor @ 8% 1.000 0.926 0.857 0.794 0.735 0.681

Present values (40000) 12964 10970 9568 12119 (434)

The NPV is $5187 so the purchase appears to be worthwhile.

When taxation is ignored in DCF calculations, the discount factor will reflect the pre-tax rate of return

required on capital investments. When tax is included then post-tax required rate of return should be

used. For example, if tax rate is 20% and the pre-tax rate of return is 10%, the post-tax rate of return is

0.1 x 0.8 = 0.08, ie. 8%.

Working capital

This is relatively simple. Increases in working capital would mean more investment in working capital,

so there will be a cash outflow. Remember, only the changes in working capital investment are cash

flows. Working capital is assumed to be recovered at the end of the project.

Example: A project lasts for 5 years with a $20000 working capital requirement at the end of year 1,

rising to $30000 at the end of year 2. State the effect of this.

Solution: $20000 cash outflow will be shown in year 1 and $10000 (30000 – 20000) cash outflow in

year 2. $30000 cash flow will be shown in year 5 (end of project).

5. Adjusting for risk and uncertainty in investment appraisal

There is a difference between risk and uncertainty. Risk is refers to the variability of returns and

probabilities can be estimated for the possible outcomes. Uncertainty is where probabilities cannot be

estimated objectively and will increase as the project life increases. There are a number of techniques

to deal with risk and uncertainty.

Main techniques of adjusting for risk and uncertainty in investment appraisal

An overview of the techniques is shown here, the application of sensitivity analysis and probability

analysis are shown later (examinable on calculations).

1. Sensitivity analysis – this assesses the sensitivity of project NPV to changes in project variables. It

calculates the relative change in a project variable (eg. sales volume) required to make the NPV zero, or

the relative change in NPV for a fixed change in a project variable. Only one variable is considered at a

time. When the sensitivities for each variable have been calculated, the key or critical variables can be

identified. These show where assumptions may need to be checked and where managers could focus

their attention in order to increase the likelihood that the project will deliver its calculated benefits.

However, since sensitivity analysis does not incorporate probabilities, it cannot be described as a way

of incorporating risk into investment appraisal, although it is often described as such.

2. Probability analysis – this approach involves assigning probabilities to each outcome of an

investment project, or assigning probabilities to different values of project variables. The range of net

present values that can result from an investment project is then calculated, together with the joint

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probability of each outcome. The net present values and their joint probabilities can be used to

calculate the mean or average NPV (the expected NPV or ENPV) which would arise if the investment

project could be repeated a large number of times. Other useful information that could be provided by

the probability analysis includes the worst outcome and its probability, the probability of a negative

NPV, the best outcome and its probability, and the most likely outcome. Managers could then make a

decision on the investment that took account more explicitly of its risk profile.

3. Simulation – this will overcome the problems of having large number of possible outcomes. A

simulation model could be constructed by assigning random numbers to each uncertain variable and

the random numbers must match their probabilities. Random numbers would be generated by

computer program and these would be used to assign values to each uncertain variable.

4. Risk-adjusted discount rate – the greater the risk, the greater the risk premium required and

therefore, the discount rate should be higher. In theory, capital asset pricing model (CAPM) will be

useful in this case (CAPM discussed in cost of capital area).

5. Adjusted payback - Payback can be adjusted for uncertainty by shortening the payback period. The

logic here is that as uncertainty increases with the life of the investment project, shortening the

payback period for a project that is relatively risky will require it to pay back sooner, putting the focus

on cash flows that are more certain (less risky) because they are nearer in time. Payback can also be

adjusted for risk by discounting future cash flows with a risk-adjusted discount rate, i.e. by using the

discounted payback method. The normal payback period target can be applied to the discounted cash

flows, which will have decreased in value due to discounting, so that the overall effect is similar to

reducing the payback period with undiscounted cash flows.

Sensitivity analysis

Sensitivity of each variable = NPV/present value of project variable x 100%. The lower the percentage,

the more sensitive is NPV to that project variable, this means that small changes in that project

variable will influence NPV significantly (it might be useful to think sensitivity as margin of safety).

Management should pay attention to this project variable.

Example: Fire Co has a cost of capital of 8% and is considering a project with the following “most likely”

cash flows. Measure the sensitivity (%) of the project to changes in the levels of expected costs and

savings.

Year Purchase of plant Running costs Savings

$ $ $

0 (7000)

1 2000 6000

2 2500 7000

Solution: Make sure you calculate the present values of each variable.

Year Discount factor (8%) PV of plant cost PV of RC PV of S PV of net cash flow

$ $ $ $

0 1.000 (7000) (7000)

1 0.926 (1852) 5556 3704

30

2 0.857 (2143) 5999 3856

(7000) (3995) 11555 560

Plant cost sensitivity = 560/7000 x 100% = 8%

Running cost sensitivity = 560/3995 x 100% = 14%

Savings sensitivity = 560/11555 x 100% = 4.8%. (Most sensitive)

If you are required to calculate the sensitivity of cost of capital, you have to estimate one IRR (it is

better not to use cost of capital as discount factor) and then compare IRR and cost of capital, the

differences in percentage is the sensitivity.

Example: IRR has been estimated to be 18.52% and cost of capital is 8%. Measure the sensitivity of cost

of capital.

Solution: Cost of capital sensitivity = (18.52 – 8)/8 x 100% = 132%. This means that cost of capital can

increase by 132% before NPV becomes negative.

Also one more thing to note is that when calculating sensitivity of sales volume, NPV should be divided

by present value of contribution because changes in sales volume will affect sales and also variable

costs, ultimately affecting contribution.

Probability analysis

You have learnt that expected value = possible outcome x probability. However in F9 level, joint

probabilities might need to be used when calculating year 2 expected cash flows as year 1 cash flows

are affected by probabilities as well. Joint probabilities are calculated by multiplying both probabilities.

The following example is an extract from June 2010 question 1 with modification.

Example: Water Co has prepared the following forecasts of net cash flows for the next two periods,

together with their associated probabilities.

Period 1 cash flow Probability Period 2 cash flow Probability

$000 $000

8000 10% 7000 30%

4000 60% 3000 50%

(2000) 30% (9000) 20%

Water Co expects to be overdrawn at the start of the period 1 by $500000. Calculate:

(i) Expected value of the period 1 closing balance.

(ii) Expected value of the period 2 closing balance.

(iii) Probability of negative cash balance at the end of period 2.

(iv) Probability of exceeding the overdraft limit at the end of period 2.

Solution:

(i) It is good that you show the closing balance for each of the different cash flows because this will be

used in (ii) to add with period 2 cash flows.

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Opening balance Cash flow Closing balance Probability Expected value

$000 $000 $000 $000

(500) 8000 7500 0.1 750

(500) 4000 3500 0.6 2100

(500) (2000) (2500) 0.3 (750)

2100

Expected value of period 1 closing balance = $2100000.

(ii) Be careful here, for example when the opening balance of period 2 is $7500000, there are three

possible cash flows for it. In this case, joint probabilities must be used to calculate the expected value

of period 2 closing balance.

Opening balance Cash flow Closing balance Joint probability Expected value

$000 $000 $000 $000

7500 7000 14500 0.1 x 0.3 = 0.03 435

7500 3000 10500 0.1 x 0.5 = 0.05 525

7500 (9000) (1500) 0.1 x 0.2 = 0.02 (30)

3500 7000 10500 0.6 x 0.3 = 0.18 1890

3500 3000 6500 0.6 x 0.5 = 0.3 1950

3500 (9000) (5500) 0.6 x 0.2 = 0.12 (660)

(2500) 7000 4500 0.3 x 0.3 = 0.09 405

(2500) 3000 500 0.3 x 0.5 = 0.15 75

(2500) (9000) (11500) 0.3 x 0.2 = 0.06 (690)

3900

The expected value of period 2 closing balance is $3900000.

(iii) With the information in (ii), you can solve (iii) and (iv) without any problem. The probability of

negative cash balance at the end of period 2 is 0.02 + 0.12 + 0.06 = 20%, ie. Just take those

probabilities that result in negative expected value.

(iv) Probability of exceeding the overdraft limits (ie. -$500000) = 0.12 + 0.06 = 18%.

6. Specific investment decisions (Lease or buy; asset replacement; capital rationing)

Leasing

Leasing is a commonly used source of finance. You should know that lessee can use the asset but the

ownership of the asset belongs to lessor. Therefore, lessor can claim capital allowance and lessee can

claim tax deduction for lease payment. There are three types of leasing:

1. Operating lease – lessor is responsible for maintaining the asset and it is for shorter term.

2. Finance lease – lessee is responsible for maintaining the asset.

3. Sale and leaseback – lessee sells the asset and later lease back.

However in F9 we are not concerned with this, this is just for your knowledge. Also, we are normally in

the position of lessee who wants to make decision whether to lease or buy.

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Lease or buy decisions

Lease or buy an asset is actually a financing decision as the decision whether to have the asset is an

investment decision. When we lease the asset, we can claim tax deduction on lease payment and if we

buy, we can claim capital allowance as we own the asset. To keep things simple, we should compare

the cash flows of purchasing and leasing to evaluate decision. The cash flows are discounted at an

after-tax cost of borrowing as tax is included in the cash flows. Remember the cash flows of purchasing

do not include the interest payments on the loan (if any) as cost of capital has dealt with it. However,

do not forget that there are other issues such as liquidity, flexibility, alternative use of funds etc to

consider before making the decision.

Example: Thunder Co has decided to install a new milling machine (investment decision is made). The

machine costs $20000 and it would have a useful life of five years with a trade-in value of $4000 at the

end of the 5th year. The company has two choices:

1. Purchase the machine for cash, using bank loan facilities, current rate of interest is 13% before tax.

2. Lease the machine under an agreement which would entail payment of $4800 at the end of each

year for the next five years.

The rate of tax is 30%. Capital allowance (CA) is given at 100% in year 1 if machine is purchased. Tax is

payable with a year’s delay. Decide whether to lease or buy the machine.

Solution: We will use after-tax cost of borrowing to discount, it is calculated as 13% x 70% = 9%. Now

we should compare the NPV of leasing and borrowing to purchase.

Borrow to purchase:

Year Item Cash flow Discount factor (9%) Present value

$ $

0 Machine cost (20000) 1.000 (20000)

5 Trade-in value 4000 0.650 2600

2 Tax savings on CA (20000 x 30%) 6000 0.842 5052

6 Balancing charge (4000 x 30%) (1200) 0.596 (715)

NPV of purchase (13063)

Note: Interest payment should not be included as it has been taken into account in the discount factor.

In year 5, the machine is traded for $4000 cash inflow, therefore creating a balancing charge of $4000,

there is an extra tax payment which is paid in year 6.

Lease

Year Item Cash flow Discount factor (9%) Present value

$ $

1-5 Lease payment (4800) 3.890 (18672)

2-6 Tax savings (4800 x 30%) 1440 3.569 5139

NPV of leasing (13533)

Note: There will be tax deduction given for lease payment and it is saved in the next year in this case.

You should use annuity factor to save time, to get 3.569, use year 6 present value rate at annuity factor

of 9%, ie. 4.486 minus year 1 present value rate, ie. 0.917.

By comparing the NPV, purchasing the machine will be the cheaper option.

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The above example is for the lessee, if you are a lessor, lease payment will be your income which is

also taxable. You will buy the asset to lease to the lessee so the cost of asset becomes your cash

outflow but you might be able to claim capital allowance since you are the owner of the asset.

Therefore, if you are the lessor, the evaluation of whether to lease or not depends on the NPV of

leasing to the lessee.

Asset replacement decisions

The decision is to decide how frequently an asset should be replaced with an identical asset. The

equivalent annual cost method can be used to calculate an optimum replacement cycle. Equivalent

annual cost is the average cost of owning an asset over its entire life. We have to first calculate the

present value of cost over one replacement cycle and then convert it to equivalent annual cost by

dividing a suitable present value rate, ie. PV of cost/annuity factor (annuity table is useful).

Example: Megatron Co operates a machine purchased at $25000 which has the following costs and

resale values over its three year life.

Year 1 Year 2 Year 3

$ $ $

Running costs (cash expenses) 7500 11000 12500

Resale value (end of year) 15000 10000 7500

The organisation’s cost of capital is 10%. Assess how frequently the asset should be replaced.

Solution: Replace every year Replace every 2 years Replace every 3 years

Year Discount factors Cash flow PV Cash flow PV Cash flow PV

$ $ $ $ $ $

0 1.000 (25000) (25000) (25000) (25000) (25000) (25000)

1 0.909 (7500) (6818) (7500) (6818) (7500) (6818)

15000 13635

2 0.826 (11000) (9086) (11000) (9086)

10000 8260

3 0.751 (12500) (9388)

7500 5633

PV of cost over one

replacement cycle (18183) (32644) (44659)

Replacement every year:

Equivalent annual cost = (18183)/0.909 = $(20003)

Replacement every 2 years:

Equivalent annual cost = (32644)/1.736 = $(18804), note 1.736 = 0.909 + 0.826 or you can get this from

annuity table.

Replacement every 3 years:

Equivalent annual cost = (44659)/2.487 = $(17957)

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From these we can see that the equivalent annual cost of replacement every 3 years is the least and

this would mean that optimum replacement policy is to replace the machine every 3 years.

Single period capital rationing

Capital rationing is where a company has a limited amount of money to invest and investments have to

be compared in order to allocate monies most effectively. Capital rationing may occur due to internal

factors (soft capital rationing, eg. reluctant to issue additional share capital, reluctant to raise

additional debt capital, wish only to use retained earnings, reserve capital for projects to be taken in

another period, capital may be needed for other necessary expenditures such as replacement of non-

current assets) or external factors (hard capital rationing, eg. depressed stock market, restrictions on

bank lending, issue costs, financial position does not attract investors).

Profitability index (PI)

When capital rationing occurs in a single period, projects are ranked in terms of PI to determine the

mix of projects. PI can only be applied to divisible projects (possible to undertake a fraction of a

project), if the projects are non-divisible (discussed later) then do not apply PI. PI = NPV/present value

of capital investment. Therefore, this compares the NPV per investment cost of each project and those

with high PI will be ranked first. However you should exclude the investment cost from NPV, generally

PI of 1.0 is the lowest acceptable index.

Example: There are three projects, A, B and C with investment cost of $20000, $30000 and $40000

respectively and present value of cash inflows of $30000, $35000 and $41000 respectively. The

company has only $55000 available for investment. The projects are divisible. Evaluate how the

projects are to be undertaken.

Solution: Firstly we calculate the PI for each of the projects.

PI for A = 30000/20000 = 1.5

PI for B = 35000/30000 = 1.17

PI for C = 41000/40000 = 1.025

The ranking is first given to A, then B and finally C. After investing for A and B, company still has $5000

to invest for C, which is 12.5% of the investment cost. The decision is therefore to invest fully in A and

B and 12.5% of C.

However note that this method ignores the size of the projects, strategic value and the cash flow

patterns.

Trial and error

For non-divisible projects (impossible to undertake a fraction of a project, eg. building ship), trial and

error would have to be used to test the NPV available from different combinations of projects. For

example, when there are three projects, A, B and C, we will have to calculate the NPV of A + B, A + C

and B + C, the combination with the highest NPV will be undertaken.

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Business finance

1. Sources of and raising short-term finance

The common sources of short-term finance include overdraft, short-term loan, trade credit and lease

finance.

Overdraft

Overdrafts are subject to an agreed limit and must be paid if bank demand for repayment (repayable

on demand). Overdraft is commonly used as a support for normal working capital, eg. to increase the

current assets or to reduce other current liabilities. The customers only pay interest when they are

overdrawn (credit balance of bank account). The advantage of this is that it won’t affect financial

gearing of the company and is cheap.

Short-term loan

It is drawn in full at the beginning of the loan period and repaid at a specified time or in installments.

Loan is actually more suitable for medium term purpose. Interest must be paid unlike overdraft. Once

the loan is agreed, the term of the loan must be adhered to. The advantage of this is that it helps in

better planning since the amount of interest and repayments is known. But note that it will affect the

gearing calculation.

Trade credit

This is one of the main sources of short-term finance as it is like an interest-free borrowing. However,

there will be a risk of losing supplier goodwill and also cost of not accepting early settlement discounts.

Lease finance

Leasing is a good source of finance to acquire an asset through finance lease (long-term finance) or

renting an asset for a while through operating lease (short-term finance). Company can also sell an

asset to a lessor and lease back (sale and leaseback) to get immediate cash (short or long-term finance).

Types of leases are covered earlier.

2. Sources of and raising, long-term finance

The common sources of long-term finance include equity finance, debt finance and venture capital.

Equity finance

This is raised through the issue of ordinary shares to investors. The ordinary shareholders will then able

to attend company general meetings and vote. This means that they have some control of the business.

Debt finance

In simplest meaning, debt financing means borrowing money on credit with a promise to repay the

amount borrowed, plus interest. It is usually in the form of bonds or debentures. It is useful to

differentiate equity and debt finance first before looking at types of debt finance:

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(i) Cost – the cost of equity is higher than the cost of debt. This is because an equity investor takes a

greater risk. If the company goes into liquidation, an equity investor is the last person to be paid any

money. Therefore, an equity investor expects a higher return to reflect the risk he is taking. Debt

finance is cheaper as interest payments are tax deductible but dividends (for equity finance) are not.

Debt finance also has lower risk.

(ii) Control of the business – equity is normally invested into the business through the issue of ordinary

shares. Shareholders will share the ownership of the business and carry voting rights. Hence, a

shareholder can participate in business decisions. Debt finance avoids the share of control (company

will still have full control).

(iii) A significant difference between debt and equity is that debt has to be repaid, whereas equity does

not.

(v) Effect on gearing – The more debt finance is raised, the higher is the gearing level. The higher equity

finance is raised, the lesser is the gearing level. Gearing = debt/equity or debt/(equity + debt).

Now let’s consider different types of debt finance.

Deep discount bonds

These are issued at a price which is at a large discount to the nominal/face value of the loan notes.

They will be redeemable (repaid) at par (or above par) when they eventually mature. This would mean

that investors can get a large capital gain (redemption value – issue price) when redeemed. However,

the interest rate is much lower than other types of bonds.

Zero coupon bonds

These are similar to deep discount bonds. They are issued at large discount to their face value and no

interest is payable. Investors gain from the difference between redemption value on maturity and the

issue price. These are also known as zero interest bonds.

Convertible bonds

These give the holder the right to convert to other securities (normally ordinary shares) at a pre-

determined price and time. The smarter investors will determine whether the conversion rights are

attractive or not by estimating a conversion premium. Conversion premium = current market value –

current conversion value.

Example: Leaf Co quoted 10% convertible bonds at $142 per $100 nominal (this means it has a nominal

value of $100 which we normally assumed). The earliest date for conversion is in four years time, at

the rate of 30 ordinary shares per $100 nominal bond. The share price is currently $4.15. Decide

whether the conversion rights are attractive or not.

Solution: We should first calculate the conversion value which is 30 x $4.15 = $124.50. This is the value

of the converted shares if conversion is done.

Conversion premium = $142 - $124.50 = $17.50.

This would mean that if the conversion rights have to be attractive, the share price would have to rise

by $17.50 or 14% (17.50/124.50).

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We can also estimate the market value of convertible bond by discounting the future cash flows of it.

Example: Rock Co quoted 10% convertible bonds with nominal value of $100, interest is payable yearly.

Each $100 of convertible bonds may be converted into 40 ordinary shares in three years time or

redeemed at $110 per $100 nominal value of bond. Assume the required pre-tax rate of return is 8%

and investors will redeem at maturity, estimate the likely current market price for $100 of the bonds.

Solution: Cash flow Discount factor (8%) Present value

Year $ $ $

1 Interest (10% x 100) 10 0.926 9.26

2 Interest 10 0.857 8.57

3 Interest 10 0.794 7.94

Redemption value 110 0.794 87.34

Estimated market value of $100 debt 113.11

Venture capital

Venture capital is risk capital, normally provided in return for an equity stake. Venture capitalists are

prepared to invest in new businesses, small businesses, specific expansion projects or management

buyouts (managers purchase all or parts of a business). They will be less interested in providing the

money required to finance running expenditure and working capital requirements. Also, venture

capitalists will want to involve in running the business because of their need to protect their

investment. Venture capitalists will take into account certain factors in deciding whether or not to

invest:

(i) The nature of company’s product – the selling potential of products.

(ii) Expertise in production – technical ability to produce efficiently.

(iii) Expertise in management – commitment, skills and experience.

(iv) Market and competition – threat from current competitors and also future new competitors.

(v) Future profits – they will want to see the detailed business plan.

(vi) Board membership – they will ensure that they are part of representatives of the board of directors

and have say in future strategy.

(vii) Exit routes – they will consider potential exit routes in order to realise the investment.

Methods of raising equity finance

To be able to issue shares to the public, company has to go for stock market listing which allows

company to access to wider pool of finance and improve marketability of shares. The unquoted

company can obtain a listing on stock market through initial public offer (IPO) or placing.

Initial public offer

When companies “go public” for the first time, a large issue will probably takes the form of an IPO. This

is known as flotation. Subsequent issues are likely to be placing or rights issue (discussed later).

However the costs of share issue include underwriting cost, stock market listing fee, professional fees

and advertising cost.

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Underwriting cost is the cost incurred to get an underwriter who will subscribe those shares which are

not taken-up by the public. Therefore, underwriter is a risk taker.

Placing

Placing means arranging for most of an issue to be brought by a small number of institutional investors

and this is cheaper than IPO.

Setting a share issue price

This will depend on a number of factors such as price of similar quoted companies, current market

conditions, future trading prospects and whether there is a desire for immediate premium. Company

should avoid over-pricing (to avoid undersubscribed) or under-pricing an issue (avoid oversubscribed).

Rights issues

Rights issue is an offer to existing shareholders enabling them to buy more shares, usually at a price

lower than current market price. With this, company does not have to issue to public which is more

costly and can dilute voting rights of existing shareholders. Rights issue can affect EPS as it affects the

number of ordinary shares.

Example: Shock Co’s profit after tax is always 20% of capital employed. Directors propose to raise an

additional $126000 from a rights issue. Current market price is $1.80 so it is decided that the rights

price is $1.60. Before the rights issue, the capital employed is $300000 (with 200000 ordinary shares of

$1 each). Calculate the dilution in EPS with the rights issue.

Solution: Earnings before rights issue = 20% x $300000 = $60000. EPS before rights issue =

60000/200000 x 100 = 30c.

Capital employed after rights issue = $426000. Therefore, earnings after rights issue = 20% x 426000 =

$85200.

Number of new shares from rights issue = $126000/$1.60 = 78750.

EPS after rights issue = $85200/278750 x 100 = 30.6c

Dilution of EPS = 30.6 – 30 = 0.6 cents.

For the shareholders to take up the rights issue, they may consider the value of the rights. Theoretical

ex rights price (TERP, market price after the rights issue in theory) is an important consideration. Value

of rights can be determined by TERP – issue price.

Example: Thunder Co decides to make a rights issue of one new share at $1.50 each for every four

shares already held. After announcement of the use, the share price fell to $1.95, but by the time just

prior to the issue being made, it had recovered to $2 per share (actual cum rights price). Calculate TERP

and discuss whether shareholder would exercise the rights.

Solution: As TERP is in theory, the calculation will seem theoretical.

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4 shares @ $2 $8.00

1 share @ $1.50 $1.50

5 $9.50

It is estimated that 5 shares are worth $9.50, so TERP = 9.5/5 = $1.90. The value of rights = $1.90 -

$1.50 = $0.40. This means that shareholder can expect to gain $0.40 for each new share he buys so he

might exercise the rights.

The actual ex rights price (actual market price after rights issue) may differ from TERP. The market will

take a view of how profitable the new funds will be invested and will value the shares accordingly.

1. If new funds are expected to generate earnings at the same rate as existing funds, actual ex rights

price will probably be the same as TERP.

2. If new funds are expected to generate earnings at a lower rate, actual ex rights price < TERP.

3. If new funds are expected to generate earnings at higher rate than current funds, actual ex rights

price should rise above the TERP.

Shareholders’ actions with regard to rights issues

1. Do nothing – % of ownership will reduce as others subscribe the shares.

2. Sell the rights - % of ownership will reduce.

3. Fully subscribe - % of ownership will be maintained.

4. Any combination of the above actions.

Example: King, an owner of 1000 shares in Queen Co, has been offered rights issue of 1 for 5 with issue

price of $3.40 and current market price of company’s shares is $4 per share. Theoretical ex-rights price

(TERP) is determined as $3.90. Value of rights is $0.50 ($3.90 - $3.40). Identify the actions that King

could take and the effect of these actions on the wealth of King.

Solution: Number of shares from rights issue = 1000/5 = 200.

Value of 1,200 shares after rights issue = 1,200 x 3·90 = $4680

Value of 1,000 shares before rights issue = 1,000 x 4·00 = $4000

Value of 1,000 shares after rights issue = 1,000 x 3·90 = $3900

Cash subscribed for new shares = 200 x 3·40 = $680

Cash raised from sale of rights = 200 x 0.50 = $100

1. Do nothing

It is obvious that King will lose $100 (4000 – 3900) in wealth if he ignores the rights issue.

2. Sell the rights

In this case, the wealth of King = $3900 + $100 = $4000. Therefore, part of the wealth has changed

from shares to cash, but there is neutral effect on King’s wealth (original is $4000).

3. Fully subscribe

By subscribing in full, King’s wealth becomes $4680 (4000 + 680). This is the same as the value of 1200

shares after rights issue, so there is neutral effect on King’s wealth.

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3. Raising short and long-term finance through Islamic financing

Islamic finance is based on Islamic law, ie. Shariah. The main principles include:

1. Wealth must be generated from legitimate trade and asset-based investment. (The use of money for

the purposes of making money is expressly forbidden.)

2. Investment should also have a social and an ethical benefit to wider society beyond pure return.

3. Risk should be shared.

4. All harmful activities (haram) should be avoided. (eg. investing in drug business)

Concept of interest (riba)

Charging and receiving interest is prohibited in Islamic finance because it represents the money itself

being used to make money (Not in accordance to first principle above). Therefore, when Islamic banks

provide finance they must earn their profits by other means. This can be through a profit-share relating

to the assets in which the finance is invested, or can be via a fee earned by the bank for services

provided. The essential feature of Shariah is that when commercial loans are made, the lender must

share in the risk. If this is not so then any amount received over the principal of the loan will be

regarded as interest.

Islamic financial instruments

1. Murabaha is a form of trade credit/loan for asset acquisition that avoids the payment of interest.

Instead, the bank buys the item and then sells it on to the customer on a deferred basis at a price that

includes an agreed mark-up for profit. The mark-up is fixed in advance and cannot be increased, even if

the client does not take the goods within the time agreed in the contract. Payment can be made by

instalments. The bank is thus exposed to business risk because if its customer does not take the goods,

no increase in the mark-up is allowed and the goods, belonging to the bank, might fall in value.

2. Ijara is a lease finance agreement whereby the bank buys an item for a customer and then leases it

over a specific period at an agreed amount. Ownership of the asset remains with the lessor (bank)

regardless of operating or finance transaction, which will seek to recover the capital cost of the

equipment plus a profit margin out of the rentals payable.

3. Mudaraba is essentially like equity finance in which the bank and the customer share any profits.

The bank will provide the capital, and the borrower, using their expertise and knowledge, will invest

the capital. Profits will be shared according to the finance agreement (no dividends are paid), but as

with equity finance there is no certainty that there will ever be any profits, nor is there certainty that

the capital will ever be recovered. This exposes the bank to considerable investment risk as losses are

solely attributable to the provider of capital. In practice, most Islamic banks use this is as a form of

investment product on the liability side of their statement of financial position, whereby the investor

or customer (as provider of capital) deposits funds with the bank, and it is the bank that acts as an

investment manager (managing the funds).

4. Sukuk (Islamic bonds) is debt finance which cannot bear interest. Typically, an issuer of the Sukuk

would acquire property and the property will generally be leased to tenants to generate income. The

sukuk are issued by the issuer to the Sukuk holders, who thereby acquire a proprietary interest in the

assets of the issuer. The issuer collects the income and distributes it to the Sukuk holders. This entitles

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to a share of the income generated by the assets. Most Sukuk give Sukuk holders ownership of the

cash flows but not of the assets themselves.

5. Musharaka is a joint venture or investment partnership between two parties. Both parties provide

capital towards the financing of projects and both parties share the profits in agreed proportions. This

allows both parties to be rewarded for their supply of capital and managerial skills. Losses would

normally be shared on the basis of the equity originally contributed to the venture. Because both

parties are closely involved with the ongoing project management, banks do not often use Musharaka

transactions as they prefer to be more ‘hands off’.

4. Internal sources of finance and dividend policy

Internal sources of finance

Internal sources of finance include retained earnings and increasing working capital management

efficiency:

1. Retained earnings – company can choose to retain the earnings or paid out as dividends. Retained

earnings belong to shareholders and are classed as equity financing. Retained earnings are a flexible

source of finance, enabling directors to invest without asking for approval by financial providers. There

is no new share issue so no issue cost and no dilution of control. However, shareholders may be

sensitive to the loss of dividends and there is an opportunity cost of retaining the earnings (cash can be

invested to earn more rather than keeping them idle). Retained earnings are no doubt, the most

important single source of finance for companies.

2. Increasing working capital management efficiency – there will be savings that can be generated from

more efficient management of trade receivables, inventory, cash and trade payables.

Relationship between dividend policy and financing decision

When deciding how much dividends to be paid out to shareholders, one of the main considerations is

the amount of earnings to retain to meet financing needs. A company must restrict its self-financing

through retained earnings because shareholders should be paid a reasonable dividend.

Factors influencing dividend policy

Legal constraints

The law on distributable profits could require company to pay dividends solely out of accumulated net

realised profits or restrict the amount of dividends payable.

Profitability

A company cannot consistently pay dividends higher than its profit after tax as a healthy level of

retained earnings is needed to finance the continuing business needs of the company.

Liquidity

The company must have enough cash to pay the dividends it declares and the desire to hold cash

would mean lower dividend payout.

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Shareholder expectations

Shareholders usually expect a consistent dividend policy from the company, with stable dividends each

year or a steady dividend growth. Stable dividends or steady dividend growth are usually needed for

share price stability.

Signaling effect

Dividend declared can be interpreted as a signal from directors to shareholders about the strength of

underlying project cash flows or the future prospects of the company. For example, a cut in dividends

may be treated by shareholders as signaling that the future prospects of the company are weak.

Therefore, companies tend to adopt a stable dividend policy.

Theories of dividend policy

Residual theory

Company should invest any project with positive NPV and dividends should be paid only when these

investment opportunities are exhausted.

Traditional view

Shareholders prefer large dividends to smaller dividends because the dividend is sure but future capital

gains are uncertain.

Irrelevancy theory by Modigliani and Miller (MM)

Shareholders are not concerned with the dividend policy since they can sell a portion of their portfolio

of equities if they want cash. This indicates that an issue of dividend should have little or no impact on

share price, perfect capital market is assumed. MM proposed that in a tax-free world, shareholders are

indifferent between dividends and capital gains, and the value of a company is determined solely by

the ‘earning power’ of its assets and investments.

Other basic terms

1. Scrip dividends – dividend is paid in the form of new shares rather than by cash.

2. Scrip issue/bonus issue – issue of new ‘free’ shares to existing shareholders, by converting equity

reserves to share capital.

3. Stock split – for example, each ordinary share of $1 each is split into two shares of 50c each. This

creates cheaper shares with greater marketability.

4. Share repurchase – company could purchase its own shares when there is surplus cash or to increase

EPS (reduce number of shares). This could also prevent a takeover or enable a quoted company to

withdraw from the stock market.

5. Gearing and capital structure considerations

Problem of high levels of gearing

Gearing is the amount of debt finance a company uses relative to its equity finance. The greater the

level of debt, the more is the financial risk. Financial risk can be seen from different points of view:

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1. Company – when the debts are too high that company cannot pay back, it will be forced into

liquidation. Therefore, gearing can measure the company’s ability to remain in business.

2. Lenders – lenders will want higher interest yield to compensate the higher financial risk faced.

3. Ordinary shareholders – similar to lenders. They would want a higher expected return from their

shares to compensate for higher financial risk faced. Market value of shares will therefore depend on

gearing.

In short, gearing increases variability of shareholder earnings and risk of financial failure.

Ratio analysis

Ratios can be used to assess the impact of sources of finance on financial position and financial risk.

The relevant ratios include:

1. Financial gearing = long-term debt/capital employed x 100% or market value of long-term

debt/(market value of equity + market value of long-term debt) x 100%. This will indicate the financial

risk. Long-term debt/equity is also a method to calculate financial gearing.

2. Operational gearing = contribution/profit before interest and tax (PBIT). This will indicate the

business risk. For example, if contribution is high but PBIT is low, fixed costs will be high so business

risk will be high. Other ways to calculate include fixed cost/total cost or fixed cost/variable cost.

3. Interest coverage ratio = PBIT/interest. Generally, an interest coverage ratio of less than three times

is considered low, indicating that profitability is too low given the gearing of the company.

4. Debt ratio = total long-term debts/total assets. This indicates the financial risk as well.

Note for financial and business risk

1. Business risk/operating risk – possibility of changes in level of profit before interest as a result of

changes in turnover or operating costs. Business risk relates to the nature of business operations.

2. Financial risk/gearing risk – possibility of changes in level of distributable earnings as a result of the

need to make interest payments on debt finance or prior charge capital.

Cash flow forecasting

A change in sources of finance can be taken into account in cash flow forecast. If the change in sources

of finance results in significant cash deficit, then company might need to consider other, more

appropriate source of finance.

Effect of gearing on shareholder wealth

A company will only be able to raise finance if shareholders think the returns they can expect are

satisfactory in view of the risks they are taking. If a company can generate returns on capital in excess

of the interest payable on debt, financial gearing will raise the EPS and this affects two ratios:

1. Price earnings ratio (P/E ratio) = market price per share/EPS. This reflects the market’s appraisal of

the share’s future prospects.

2. Dividend cover = EPS/dividend per share.

Another important ratio is dividend yield which is dividend per share/market price per share x 100%.

With this, we look at the effect of gearing on market price of shares. The changes in dividend yield

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required by shareholders (required rate of return) can impact the market price of the shares (discussed

more in business valuation topic).

6. Finance for small and medium sized entities (SMEs)

SMEs can be defined as having three characteristics:

1. Firms are likely to be unquoted.

2. Owned by s small number of individuals, typically a family group.

3. They are not micro-businesses (very small businesses that exist to employ just owner).

They are always in need of finance to run or expand the business. However, they have some problems

in obtaining finance.

Financing problems of SMEs

SMEs may not know about the sources of finance available or difficult to obtain finance because of the

risks faced. More specific problems are:

1. Funding gap – there is a high failure rate so hard to raise external finance and there are few

shareholders so hard to raise internal finance.

2. Maturity gap – it is difficult for SMEs to obtain medium-term loans due to mismatching of the

maturity of assets and liabilities. Longer-term loans are easier to obtain than medium-term loans as

longer loans are easily secured with mortgages against property.

3. Inadequate security – banks will be unwilling to increase loan funding without an increase in security

given (which the owners may be unwilling or unable to give).

Government aids to ease financing problems of SMEs

UK government aid includes:

1. Loan guarantee scheme – help businesses to get a loan from the bank because bank would be

unwilling to lend as SMEs cannot offer the security that the bank would want.

2. Grants – sum of money given to an individual or business for a specific project or purpose. A grant

usually covers only part of the total costs involved.

3. Enterprise capital funds (ECFs) – designed to be commercial funds, investing a combination of

private and public money in small high-growth businesses. Each ECF will be able to make equity

investments of up to £2m into eligible SMEs.

Appropriate sources of finance for SMEs

1. Equity – owner’s personal resources or those of family connections are generally the initial sources

of finance. Since the business will have few tangible assets at this stage, it will be difficult to obtain

equity from elsewhere. The external investors would not like to invest because of the inability of SMEs

to offer an exit route.

2. Overdraft financing – interest may be more expensive as bank takes the high risk.

3. Bank loans – likely to be available only for projects or assets which are in long-term.

4. Trade credit – taking extended credit from suppliers is a source of finance for many SMEs. However

this might cause loss of early settlement discounts and loss of supplier goodwill.

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5. Business angel financing – business angels are wealthy individuals who invest directly in small

businesses. However the amount of money available from individual angels may be limited. Business

angels generally have prior knowledge of the industry. As business angel financing occurs in informal

market, it is difficult to arrange with the business angels.

6. Leasing.

7. Factoring.

8. Venture capital – venture capitalists are prepared to invest in new businesses and specific expansion

projects. However, venture capitalists will want to involve in running the business because of their

need to protect their investment.

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Cost of capital

1. Sources of finance and their relative costs

Now, you should understand that every sources of finance have costs, because by raising capital using

these sources, company is required to return an amount to satisfy the providers of funds. Therefore,

cost of capital can be interpreted as the required rate of return (%) by the providers of funds.

Remember that cost of capital can be used in investment appraisal.

Cost of equity and debt

We can split cost of capital into cost of equity and cost of debt. Cost of debt is likely to be lower than

the cost of equity because debt is less risky. Let’s look at the creditor hierarchy, the first one will mean

least risky and the last one is the most risky one:

1. Creditors with a fixed charge (secured by specific asset such as land).

2. Creditors with a floating charge (secured by fluctuating class of assets such as receivables account).

3. Unsecured creditors.

4. Preference shareholders (being paid fixed dividend and get paid first in the event of liquidation

compared to ordinary shareholders).

5. Ordinary shareholders.

The cheapest type of finance is debt and the most expensive type of finance is equity. This determines

the differences in cost of equity and cost of debt.

2. Estimating the cost of equity

There are two ways to estimate cost of equity, dividend valuation/growth model and capital asset

pricing model (CAPM).

Dividend valuation/growth model

Dividend valuation model will be used if future dividend per share is expected to be constant, the cost

of equity is therefore the dividend yield, ie. Dividend per share/market price per share.

However, dividend normally increases year by year, so dividend growth model is needed. With this the

dividend yield formula takes into account the growth rate of the dividend, ie. cost of equity = [dividend

per share x (1 + g)/market price per share] + g, g is the growth rate.

Example: A share has a current market value of 96c, and the last dividend was 12c. If the expected

annual growth rate of dividends is 4%, calculate the cost of equity.

Solution: Cost of equity = [12 x (1 + 0.04)/96] + 0.04 = 0.17 = 17%.

Estimating growth rate

There are two ways, either through analysis of the growth in dividends over the past few years (trend)

or Gordon’s growth model.

By looking at the trend, we can say that dividend in year 1 x (1 + g)^4 = dividend in year 5, ie. 4 years

growth.

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Example: Dividend in 20X1 is $150000 and dividend in year 5 is $262350, calculate the growth rate.

Solution: $150000 x (1 + g)^4 = $262350

(1 + g)^4 = 1.749

1 + g = 1.15

Growth rate = 15%. Every year dividend will increase by 15%.

Gordon’s growth model gives a formula g = br where b is the proportion of profits retained and r is the

rate of return on new investments. This formula is given in exam.

Example: Leaf Co retains 65% of its earnings for capital investment projects it has identified and these

projects are expected to have an average return of 8%. The current dividend per share is 15c and

market value per share is $1, calculate the cost of equity and use Gordon’s growth model is estimate

the growth rate in dividend.

Solution: g = 65% x 8 = 5.2%.

Cost of equity = (0.15 x 1.052/1) + 0.052 = 0.2098 = 21%.

Weaknesses of dividend growth model

1. Does not consider risk.

2. The growth rate is only an approximation, dividend do not grow smoothly in reality.

3. Assume there are no issue costs for new shares.

Capital asset pricing model

This model incorporates risk. It assumes that all investors hold diversified portfolios and as a result only

seek compensation (return) for the systematic/market risk (risk that cannot be diversified away) of an

investment. Beta factor measures a share’s volatility and systematic risk is measured through this. If a

share price were to risk or fall at double the market rate, it would have a beta factor of 2.0.

The individual components of CAPM are risk-free rate of return, equity/market risk premium and

equity beta. CAPM is the cost of equity as the sum of risk-free rate of return and a risk premium

reflecting the systematic risk of an individual company relative to the systematic risk of the stock

market. This risk premium is the product of the company’s equity beta and equity risk premium.

CAPM formula is therefore created as = where is cost of equity, is

the risk-free rate of return, is the equity beta of the individual security (eg. shares), is the rate

of return on a market portfolio. Equity risk premium is therefore represented by and the

risk premium is represented by . CAPM formula is given in exam.

Example: Shares in Fire Co has a beta of 0.9. The expected returns to the market are 10% and the risk-

free rate of return is 4%. What is the cost of equity?

Solution: Cost of equity = 4 + 0.9 (10 – 4) = 9.4%.

Remember that total risk is divided into systematic and unsystematic risk, beta only measures the

systematic risk.

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Disadvantages of CAPM

1. Unrealistic assumptions.

2. Beta can change over time.

3. Need to determine the equity premium (historical returns are often used in practice).

4. Need to determine the risk-free rate (risk-free investment might be a government security).

Summary of CAPM

Since investors will expect the risk they took to be compensated with more return, CAPM takes this

into account by adding an amount of risk premium to the risk-free rate of return to increase the cost of

equity. It is usually suggested that the CAPM offers a better estimate of the cost of equity than the

dividend growth model.

3. Estimating cost of debt and other capital instruments

When company uses debt to finance capital, there will be cost of debt. We will focus on calculating

cost of debt for irredeemable debt, redeemable debt, convertible debt and preference shares, cost of

bank debt is just the current interest rate. Since interest is tax deductible, we will always take after-tax

cost of debt. Note that we normally assume the nominal value of bond is $100.

Irredeemable debt

Since the debt is irredeemable, interest is paid in perpetuity, interest yield represents the cost of

irredeemable debt, ie. Interest/market price of bond.

Example: Water Co issued bonds of $100 nominal value with annual interest of 9% based on the

nominal value. The current market price of the bonds is $90. What is the cost of the bonds?

Solution: Cost of debt = 9/90 = 10%.

If interest is not paid annually, there would be a need to express the interest yield to annual

percentage.

Example: Rock Co has 12% irredeemable bonds in issue with a nominal value of $100. The market price

is $95 ex interest. Calculate the cost of debt if interest is paid half-yearly.

Solution: 6% is payable half-yearly, so 6/95 is the cost of debt for 6 months, to express it in annual cost:

Cost of debt = (1 + 6/95)^(12/6) – 1 = 13%.

Remember that interest can be allowable for tax purpose, so when there is tax (which is normally the

case), the cost of debt should be after-tax, calculated by updating interest yield formula as [interest x

(1 – tax rate)]/market price of bond.

Example: Using the first example, when the tax rate is 30%, calculate cost of the bonds.

Solution: Cost of debt = (9 x 0.7)/90 = 7%.

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Redeemable debt

The debt will be redeemed in the year of redemption and interest (allowable for tax) plus capital (not

allowable for tax, this is the nominal value of the bond) will be paid to the debt holder. In this case,

internal rate of return (IRR) of the redeemable debt represents the cost of debt. Remember that IRR is

the rate at which NPV of the cash flows will be zero.

Example: Fire Co has outstanding $660000 of 8% bonds on which the interest is payable annually on 31

December. The debt is due for redemption at par on 1 January 20X6. The market price of the bonds at

28 December 20X2 was $95. Effective tax rate was 30% and tax is paid each 31 December. Calculate

the after-tax cost of debt.

Solution: Firstly, let’s try 5% as the discount factor first.

Year Item Cash flows Discount factor (5%) Present value

0 Market value (95) 1.000 (95)

1-3 Interest (8 x 0.7) (until 31/12/X5) 5.6 2.723 15.2

3 Redemption 100 0.864 86.4

NPV 6.6

Since this NPV is positive, another rate to choose must be higher in order to result in negative NPV.

Let’s take 10% as the discount factor.

Year Item Cash flows Discount factor (10%) Present value

0 Market value (95) 1.000 (95)

1-3 Interest (8 x 0.7) (until 31/12/X5) 5.6 2.487 14

3 Redemption 100 0.751 75.1

NPV (5.9)

After-tax cost of debt = 5 + [(6.6/(6.6 + 5.9) x (10 – 5)] = 7.6%.

The market value of the bond can also be estimated by calculating the NPV of the cash flows

discounted at cost of debt.

Example: Using the above example, if cost of debt would rise to 12% during 20X3 and 20X4, estimate

the market value of the bonds at 28 December 20X2.

Solution: It is probable that the market value in December 20X2 will reflect the new rates in future, so

we can take 12% as the discount factor.

Year Item Cash flows Discount factor (12%) Present value

0 Interest (31/12/X2) 5.6 1.000 5.6

1-3 Interest (until 31/12/X5) 5.6 2.402 13.5

3 Redemption 100 0.712 71.2

NPV 90.3

The estimated market value of the bonds would be $90.3.

From the above two examples, the calculation is based on the view of the debt holder, who lends to

the company at first (so market value of the bond is included in year 0) and later receive interest and

finally capital repayment at the year of redemption.

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Convertible debt

The cost of debt calculation will depend on whether or not conversion is likely to happen.

1. If conversion is not expected, the bond is treated as redeemable debt so use IRR to calculate cost of

debt.

2. If conversion is expected, IRR will still be used, but follow the number of years to conversion and the

redemption value is replaced by the conversion value (market value of the shares converted from

debt). Conversion value will also take growth in share price into account and can be calculated as

current share price x (1 + growth rate)^n x shares received on conversion, n is the number of years to

conversion.

Example: Fire Co issued 8% convertible bonds which are due to be redeemed in five years’ time. They

are currently quoted at $82 per $100 nominal. The bonds can be converted into 25 shares in five years’

time. The share price is currently $3.50 and is expected to grow at a rate of 3% per annum. Assume tax

rate is 30%, calculate the cost of debt.

Conversion value = future share price x number of shares received = [$3.50 x (1.03)^5] x 25 = $101.44.

Since redemption value is $100, it is likely that investors will convert as conversion value is higher.

Year Item Cash flows Discount factor (8%) Present value

0 Market value (82) 1.000 (82)

1-5 Interest (8 x 0.7) 5.6 3.993 22.36

5 Conversion value 101.44 0.681 69.08

NPV 9.44

A higher rate will be chosen to discount, let’s take 12%.

Year Item Cash flows Discount factor (12%) Present value

0 Market value (82) 1.000 (82)

1-5 Interest (8 x 0.7) 5.6 3.605 20.19

5 Conversion value 101.44 0.567 57.52

NPV (4.29)

Cost of debt = 8 + [(9.44/(9.44 + 4.29) x (12 – 8)] = 10.75%.

Preference shares

For irredeemable preference shares, future cash flows are the dividend payments in perpetuity.

Therefore, we can use dividend yield to calculate the cost of debt, ie. dividend/market price of

preference share capital. Remember that dividend does not attract tax relief.

For redeemable preference shares, cost of debt is calculated using IRR.

4. Estimating the overall cost of capital

Weighted average cost of capital (WACC)

WACC is the average cost of company’s finance weighted by the total market value or book value of

each source of finance. There are two methods to weight the source of finance, ie. market value and

book value weightings. Market values should always be used unless unavailable (unquoted company)

because book value is based on historical costs.

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The formula for WACC is given in exam as

, V is the market value, T is

tax rate, e is equity, d is debt, k is cost. Since the formula includes (1 – T) which means after-tax, the

cost of debt to be included, ie. must be before-tax cost of debt.

Example: The following information relates to Rock Co’s cost of finance and corporate tax rate is

currently 30%.

Source Cost of finance Market value ($m)

Equity 17% 23

Preference shares 18.6% 5

Debt 8.6% 14

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The above cost of finance is before-tax. Calculate the WACC for Rock Co.

Solution: Do not combine cost of preference shares with the cost of debt, we will modify the formula.

WACC =

9.31% + 1.55% + 2% = 12.86%.

You don’t actually need to refer to the formula, let’s use the above example again but with different

approach and more in line with the definition of WACC.

Example: The following information relates to Rock Co’s cost of finance and corporate tax rate is

currently 30%.

Source Cost of finance Market value ($m)

Equity 17% 23

Preference shares 18.6% 5

Debt 8.6% 14

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The above cost of finance is before-tax. Calculate the WACC for Rock Co.

Solution: Make the cost of finance after-tax and do the following.

Source Cost of finance Market value ($m) Cost x market value

Equity 17% 23 3.91

Preference shares 13% 5 0.65

Debt 6% 14 0.84

42 5.40

WACC = 5.4/42 x 100% = 12.86%. The weighting is done at cost of finance x market value.

Marginal cost of capital

The word “marginal” tells you about variable. It is calculated when there are changes to the cost of

finance and market value of the source of finance. It is argued that WACC should be used to evaluate

projects. However where gearing levels fluctuate significantly or finance for new project carries a

significant different level of risks, it is good to use marginal cost of capital to evaluate new project. The

following example is an extension of the above example.

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Example: Rock Co decided to invest in a new project which will increase the cost of equity to 18% and

cost of debt to 10%. The market value of equity will then be $24m and market value of debt will be

$20m. Calculate new WACC and marginal cost of capital.

Solution:

Source Cost of finance Market value ($m) Cost x market value

Equity 18% 24 4.32

Preference shares 13% 5 0.65

Debt 10% 20 2.00

49 6.97

New WACC = 6.97/49 x 100% = 14.2%.

Marginal cost of capital = (6.97 – 5.4)/(49 – 42) x 100% = 22.4%.

WACC for investment appraisal

WACC can be used as discount rate in investment appraisal when:

1. Project has the similar business risk as the existing operations of the company.

2. Project has the similar financial risk as the existing operations of the company.

3. Project should be small in comparison with the size of the company.

Be prepared to face question where cost of equity, cost of debt and WACC come together. Theoretical

aspect must not be ignored.

5. Capital structure theories and practical considerations

Traditional view of capital structure and its assumptions

Some believe that optimal capital structure (mix of equity and debt finance) will be the point at which

WACC is lowest. Cost of equity will rise when financial risk increases. As the level of gearing increases,

cost of debt remains unchanged up to a certain level of gearing, after this level the cost of debt will

increase. The assumptions used in this theory include:

1. Company pays out all its earnings as dividends.

2. Taxation is ignored.

3. Earnings and business risk are constant in perpetuity.

4. No issue cost of issuing debt or shares.

Ko = WACC. X = Optimal capital structure.

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Miller and Modigliani (MM) view on capital structure

MM however says that WACC is not influenced by changes in capital structure. MM made various

assumptions in arriving at this conclusion, including:

1. Debt is risk-free and freely available at the same cost to investors and companies.

2. No tax or issue costs.

3. A perfect capital market exists.

MM’s no tax model (assume no tax)

No optimum capital structure exists. WACC will remain constant at all levels of gearing. Therefore,

company cannot reduce its WACC by altering its gearing. In short, we can say that benefits of cheaper

debt are counterbalanced by increased cost of equity (due to increased financial risk).

MM’s with tax model

MM admitted corporate tax into their analysis and conclusion changed. As debt became even cheaper

(due to tax relief on interest payments), cost of debt falls significantly from Kd to Kd (1 – T). WACC will

fall when gearing increases. Therefore, if company wishes to reduce its WACC, it should borrow as

much as possible. In short, we can say that benefits of cheaper debt now exceeds the increased cost of

equity. Optimum capital structure is 99.99% debt finance.

Market imperfections

Companies are discouraged from following MM’s with tax model approach to capital structure as MM

does not take into account factors such as bankruptcy costs, agency costs and tax exhaustion.

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Bankruptcy costs

MM’s theory assumes perfect capital markets so a company can always raise finance and avoid

bankruptcy. In reality, the higher the gearing level, bankruptcy risk increases. Shareholders and debt

holders will then require a higher rate of return as compensation which increase cost of equity and

debt.

Agency costs

As gearing increases, debt holders would want to impose more constrains on the management to

safeguard their increased investment. They might impose restrictive covenants in the loan agreement

which for example set the minimum level of liquidity of the company to restrict company’s freedom.

Debt holders who are concerned about the increased gearing level will incur more agency costs (cost to

monitor the agent).

Tax exhaustion

Companies become tax exhausted when interest payments are no longer tax deductible as additional

interest payments exceed profits made. In this case, cost of debt will rise from Kd (1 – T) to Kd.

Pecking order theory

This theory states that firms will prefer retained earnings to any other source of finance, and then will

choose debt, and last of all equity. The order of preference will be:

1. Retained earnings.

2. Straight debt.

3. Convertible debt.

4. Preference shares.

5. Equity shares.

Company follows pecking order theory because:

1. Minimise issue costs – retained earnings have no issue costs, issuing debt is cheaper than issuing

equity.

2. Minimise time and expense involved in persuading outside investors.

3. Some managers believe that debt issues have a better signaling effect than equity issues. There is an

information asymmetry where managers (insiders) know more about companies’ prospects than the

outsiders. Therefore, market depends on the signal shown by the company to interpret about the

company. For example, market will interpret debt issues as a sign of confidence, that businesses are

confident of making sufficient profits to fulfill their obligations on debt and that they believe that the

shares are undervalued.

6. Impact of cost of capital on investments

Company value and cost of capital

The market value of a company depends on its cost of capital. The lower a company’s WACC, the

higher the NPV of its future cash flows and therefore the higher will be the company value.

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Using WACC in investment appraisal

This is covered before, WACC is suitable when:

1. Project being appraised is small relative to the company.

2. The existing capital structure will be maintained so that project has the same financial risk as the

company.

3. The project has the same business risk as the company. Therefore, WACC can be used to evaluate an

expansion of existing business.

Using CAPM in determining project-specific cost of capital

The capital asset pricing model (CAPM) can be used to calculate a project-specific discount rate in

circumstances where the business risk of an investment project is different from the business risk of

the existing operations of the investing company.

The first step in using the CAPM to calculate a project-specific discount rate is to find a proxy

(representative) company that undertake operations whose business risk is similar to that of the

proposed investment. The equity beta of the proxy company will represent both the business risk and

the financial risk of the proxy company. The effect of the financial risk of the proxy company must be

removed (ungearing) to give a proxy beta representing the business risk alone of the proposed

investment. This beta is called an asset beta.

The asset beta representing the business risk of a proposed investment must be adjusted to reflect the

financial risk of the investing company, a process called ‘regearing’. This process produces an equity

beta that can be placed in the CAPM in order to calculate a required rate of return (a cost of equity).

This can be used as the project-specific discount rate for the proposed investment if it is financed

entirely by equity. If debt finance forms part of the financing for the proposed investment, a project-

specific weighted average cost of capital can be calculated.

Ungearing and regearing of beta

As discussed above, ungearing beta means from a equity beta of the proxy company to an asset beta

and regearing beta means from asset beta to equity beta of the investing company. Formula for asset

beta is given in exam as

. We often assume debt is risk-free

(which follow MM’s view) and its beta ( ) is then taken as zero, so the formula is reduced to

, if without tax then remove the (1 – T). To convert the ungeared beta (asset

beta) to geared beta (equity beta), simply modify the formula of asset beta to

.

Example: Two companies are identical in every respect except for their capital structure. Water Co has

a debt to equity ratio of 1:3 and its equity has a β value of 1.20. Fire Co has a debt to equity ratio of 2:3.

Currently Fire Co is considering a project with risk-free rate of return of 4% and equity risk premium of

6%. Calculate the specific-project cost of equity for Fire Co’s project.

Solution: We will start with ungearing the equity beta of Water Co. Note that it is not necessary to put

market value of equity or debt in $ inside the formula.

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Next we regear this to equity beta for Fire Co.

We can now apply this to the CAPM formula to determine specific-project cost of equity.

Cost of equity = = 4 + 1.427 x 6 = 12.6%.

Limitations of beta formula

1. Difficult to identify a proxy company with identical operating characteristics.

2. Estimates of beta values from share price information are not wholly accurate as they are based on

statistical analysis of historical data.

3. There may be differences in beta values between firms caused by different size of the organization

and debt capital not being risk-free.

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Business valuations

1. Nature and purpose of the valuation of business and financial assets

There are a number of different ways of putting a value on a business or on shares of unquoted

company. A share valuation will be necessary when (examples):

1. In a takeover bid (another company (A) wishes to acquire this company (B)), offer price might be

estimated at fair value which is in excess of current market price of B’s shares in Stock Exchange.

2. Unquoted company wishes to ‘go public’, issue price of the shares have to be decided.

3. Holding company wishes to sell subsidiary and is negotiating the price.

4. Company is in a liquidation situation.

Information required for valuation

There are many, some are listed below:

1. Past financial statements information.

2. Aged accounts receivable summary.

3. List of marketable securities.

4. Inventory summary.

5. Budgets for a minimum of five years.

6. List of major customers.

However there are limitations to some of the information. For example, some information may be out

of date or subjective.

Market capitalisation

This is an important term representing an estimation of the value of business obtained by current price

per share x number of ordinary shares.

2. Models for the valuation of shares

Three models to look into, ie. asset-based, income-based and cash flow-based valuation models.

Asset-based valuation models

Net assets valuation method provides a lower limit for the value of a company. By itself it is unlikely to

produce the most realistic value. In this model, value of share = (total assets – total liabilities)/number

of ordinary shares, ie. net assets per share. Intangible assets are excluded as they do not represent the

worth of company’s physical assets, but if they have a market value (eg. license which could be sold),

then they can be included.

The choice of asset values to use includes:

1. Net book value (statement of financial position basis) – unlikely to be realistic.

2. Net realisable value – suitable if assets are to be sold or business as a whole broken up.

3. Net replacement cost – suitable if assets are to be used on an on-going basis.

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Use of net asset valuation

1. As a measure of the ‘security’ (safety) in a share value as it provides a lower limit of share value.

2. As a measure of comparison in a scheme of merger (business combination which nonce obtains

control over any other) – company can compare this value with another company in a merger to

determine whether it is necessary to adjust the value of the company to allow for difference.

3. As a ‘floor value’ (minimum value) for a business that is up for sale.

Advantages of net asset valuation

1. Information is readily available.

2. Indicate a minimum value of the company.

Disadvantages of net asset valuation

1. Ignore future profitability expectations.

2. Statement of financial position valuations depend on accounting conventions, which might be very

different from market valuations.

Income-based valuation models

We can use either price-earnings ratio (P/E ratio) method (commonly asked) or earnings yield method.

It mainly involves playing with the formula.

P/E ratio method

P/E ratio = market value of share/earnings per share, therefore the market value per share can be

determined as P/E ratio x EPS. However it may not be suitable to use P/E ratios of quoted companies to

value unquoted companies, in exam you should normally take a figure around one half to two thirds of

the industry average when valuing an unquoted company. Factors to consider in deciding suitable P/E

ratio include:

1. General economic and financial conditions.

2. Industry – eg. if P/E ratio is affected by lack of confidence in the industry, the valuation will be

unrealistically low.

3. Financial status of any principal shareholders.

4. Reliability of profit estimates and the past profit record.

5. Asset backing (net asset value) and liquidity.

Earnings yield method

Earnings yield = EPS/market value per share, therefore the market value per share = EPS/earnings yield.

We can also incorporate earnings growth, then earnings yield = ([EPS x (1 + g)]/market value per share)

+ g, and market value per share = [EPS x (1 + g)/(earnings yield – g).

Cash flow-based valuation models

We can use either dividend valuation model/dividend growth model (commonly asked) or discounted

cash flow basis. It involves playing with the formula for dividend valuation/growth model.

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Dividend valuation model/dividend growth model

It is covered before in cost of equity topic that when dividend growth model is used, cost of equity =

cost of equity = [dividend per share x (1 + g)/market price per share] + g, therefore market price per

share = [dividend per share x (1 + g)]/(cost of equity – g). Cost of equity can be determined using

capital asset pricing model (CAPM). Now it is good to look at December 2007 question 1 (a).

Example: Phobis Co is considering a bid for Danoca Co. Both companies are stock-market listed and are

in the same business sector. Financial information on Danoca Co, which is shortly to pay its annual

dividend, is as follows:

Number of ordinary shares 5 million

Ordinary share price (ex div basis) $3.30

Earnings per share 40.0c

Proposed payout ratio 60%

Dividend per share one year ago 23·3c

Dividend per share two years ago 22·0c

Equity beta 1·4

Other relevant financial information:

Average sector price/earnings ratio 10

Risk-free rate of return 4·6%

Return on the market 10·6%

Required:

Calculate the value of Danoca Co using the following methods:

(i) price/earnings ratio method;

(ii) dividend growth model;

and discuss the significance, to Phobis Co, of the values you have calculated, in comparison to the

current market value of Danoca Co.

Solution: (i) Market value per share = P/E ratio x EPS = 10 x 40 = 400c = $4.

Value of Danoca = $4 x 5m = $20m.

(ii) Market value per share = [dividend per share x (1 + g)]/(cost of equity – g), therefore we need to

find the missing figures.

Dividend per share = 40c x 60% = 24c.

We can estimate the growth by finding out the average geometric dividend growth rate, 22c x (1 + g)^2

= 24c, (1 + g)^2 = 24/22, so g = (24/22)^1/2 – 1 = 4.5%.

We are given enough information to use CAPM to find cost of equity.

Cost of equity = 4.6 + 1.4 x (10.6 – 4.6) = 13%.

Market value per share = [24 x (1 + 0.045)]/(0.13 – 0.045) = $2.95.

Value of Danoca = $2.95 x 5m = $14.75m.

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Current market capitalisation of Danoca Co is $16.5m ($3.3 x 5m). The P/E ratio value of Danoca Co is

$20m, higher than the current market capitalisation due to the difference in P/E ratio of the average

sector and Danoca Co. This indicates that there is a need to improve financial performance of Danoca

Co after acquisition so that Phobis Co and its shareholders will benefit from the acquisition.

Dividend growth model value is less than current market capitalisation of Danoca Co. Dividend growth

model value represents the minimum value that Danoca shareholders will accept if Phobis Co makes an

offer to buy their shares. This difference may reflect the belief of stock market that a takeover bid is

imminent as shareholders are prepared to accept a value lower than market capitalisation but it could

also be due to inaccuracy of cost of equity or expected dividend growth rate. (Referred to answer)

The dividend models made a number of assumptions:

1. Investors act rationally and homogeneously – failed to take into account that expectations of

shareholders may be different.

2. Other influences on share prices are ignored.

3. Company’s earnings will increase sufficiently to maintain dividend growth levels.

4. Dividends either show no growth or constant growth.

5. No increase in cost of capital.

One obvious problem is when valuing company that doesn’t pay dividends.

Discounted cash flow basis

Appropriate when one company intends to buy the assets of another company and to make further

investments in order to improve cash flows in the future. Value of investment = expected after-tax

cash flows discounted to present values at appropriate cost of capital. This value of investment will be

the maximum price that company is willing to pay for the shares of another company.

3. The valuation of debt and other financial assets

Again we will play with the formulas of the cost of debt here. We always assume that debt is quoted

with $100 nominal value.

Irredeemable debt

The cost of irredeemable debt, as mentioned before, is the same as interest yield. When there is tax,

cost of debt = [interest x (1 – T)]/market price of bond ex interest, so market price of bond = [interest x

(1 – T)]/cost of debt. Remember that ex interest means excluding any interest payment that might

soon be due.

Redeemable debt

Valuation of redeemable debt depends on future expected receipts (interest and redemption).

Therefore, the market price of bond = NPV of the cash flows.

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Example: Fire Co issued some 9% bonds, which are now redeemable at par in three years time.

Investors now require a redemption yield of 10%. What will be the current market value of each $100

of bond?

Solution:

Year Items Cash flows ($) Discount factor (10%) Present value ($)

1-3 Interest 9 2.487 22.38

3 Redemption 100 0.751 75.10

NPV 97.48

Each $100 of bond has a current market value of $97.48.

Convertible debt

If conversion is not expected, then market value of bond = NPV of cash flows. If conversion is expected,

then market value of bond is still the NPV of cash flows, but follow the number of years to conversion

and also redemption value is replaced with conversion value (refer back to cost of debt topic if you are

confused).

Example: Water Co issued 9% convertible bond which can be converted in five years time into 35

ordinary shares or redeemed at par on the same date. An investor’s required return is 10% and the

current market price of the underlying share is $2.50 which is expected to grow by 4% per annum.

Estimate the current market value of convertible bond assuming that conversion will occur.

Solution: Conversion value = 35 x $2.5 x (1.04)^5 = $106.46.

Year Items Cash flows ($) Discount factor (10%) Present value ($)

1-5 Interest (9% x $100) 9 3.791 34.12

5 Conversion 106.46 0.621 66.11

Current market price of convertible bond 100.23

Preference shares

Remember that tax is not allowed for the fixed dividend payment. Cost of preference shares = dividend

payment/market price of bond so market price of bond = dividend/cost of preference shares.

4. Efficient Market Hypothesis (EMH) and practical considerations in the valuation of shares

Efficient Market Hypothesis (EMH)

EMH is the hypothesis that the stock market reacts immediately to all the information that is available.

Stock market efficiency usually refers to the way in which the prices of traded financial securities

reflect relevant information. Types of efficiency include:

1. Operational efficiency requires that transaction costs are low and do not hinder investors in the sale

or purchase of securities.

2. Informational efficiency means that relevant information is widely available at low cost.

3. Pricing efficiency refers to the ability of capital markets to process information quickly and

accurately, and arises as a consequence of operational efficiency and informational efficiency.

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4. Allocative efficiency means that capital markets are able to allocate available funds to their most

productive use and arises as a result of pricing efficiency.

Most of the research into market efficiency has been into pricing efficiency.

There are three forms of efficiency: weak, semi-strong and strong-form efficiency.

Weak-form efficiency

This is when research indicates that share prices fully and fairly reflect past information. Since new

information arrives unexpectedly, share price movements should follow a “random walk”. Investors

cannot predict share prices by analysing past information because of the “random walking” share price.

Semi-strong form efficiency

This is when research indicates that share prices fully and fairly reflect public information (published)

as well as past information. Investors cannot generate abnormal returns by analysing either public

information, such as published company reports, or past information, since research shows that share

prices respond quickly and accurately to new information as it becomes publicly available. Therefore,

individuals cannot ‘beat the market’ by reading the newspapers or annual reports, since the

information contained in these will be reflected in the share price. Evidence suggests that most leading

stock markets are semi-strong efficient.

Strong-form efficiency

This is when research indicates that share prices fully and fairly reflect all information, which includes

private information. Even investors with access to insider information cannot generate abnormal

returns in such a market. Stock markets are not held to be strong form efficient. It is unlikely that

strong-form exists in reality.

Consequences of market efficiency

1. There is no right or wrong time to issue new shares since share prices are always fair (in theory).

2. Managers will not be able to deceive the market by the timing or presentation of new information,

such as annual reports or analysts’ briefings, since the market processes the information quickly and

accurately to produce fair prices. Managers should therefore simply concentrate on making financial

decisions which increase the wealth of shareholders.

3. There are no bargains to be found in capital markets (in theory).

Practical considerations in the valuation of shares and businesses

A number of factors to consider in relation to shares valuation.

Fundamental analysis theory of share values

It states that the realistic market price of a share can be derived from a valuation of estimated future

dividends. Value of share will be the present value of all future expected dividends discounted at the

shareholders’ cost of capital.

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Marketability and liquidity of shares

In financial markets, liquidity is the ease of buying and selling the shares without significantly moving

the price. Large companies have better liquidity and greater marketability than small companies. In

such case, the small companies may try to improve the marketability of their shares with stock split.

Availability and sources of information

This depends on the efficiency of the financial market. Efficient market is one where the prices of

securities bought and sold reflect all the relevant information available. Efficiency relates to how

quickly and accurately prices adjust to new information.

Market imperfections and pricing anomalies

Various types of anomaly appear to support the views that irrationality often drives the stock market,

including:

1. Seasonal effects may cause share prices to rise or fall.

2. A short-run overreaction to recent events, for example, stock market crash in 1987 (Black Monday)

causes huge loss in value in a very short time.

Market capitalisation

Market capitalisation or size of a company has also produced some pricing anomalies. The return from

investing in smaller companies is greater than average return from all companies in the long run,

probably due to greater risk associated with smaller companies.

Investor speculation and behavioural finance

Investor speculation means that the investor buys the shares when he expects the share price will go

up in future (now low) and sells shares when he expects the share price is at peak already (so

speculator is like a gambler). Speculators can affect the share price through these buying and selling

activities.

Behavioural finance is a psychology-based theory. It states that the characteristics of market

participants can influence the market outcomes, so the irrational investor behaviour may significantly

affect share price movement.

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Risk management

1. The nature and types of risk and approaches to risk management

In F9, we deal with foreign currency risk and interest rate risk. We start with some introductions.

Types of foreign currency risk

1. Translation risk – this risk occurs when company has a foreign branch or subsidiary and the currency

of foreign subsidiary’s country weaken. It is the risk that when company consolidates accounts, there

will be exchange losses when the accounting results of foreign subsidiary are translated into home

currency. (IAS 21 requires holding company to translate the account of foreign subsidiary to home

currency in consolidation).

2. Transaction risk – this arises when company is importing or exporting. It is the risk of adverse

exchange rate movements between the date the price is agreed and the date cash is received/paid,

arising during normal international trade. For example, in June a UK company agrees to sell an export

to Australia for 100,000 Australian $ (A$), payable in three months. The exchange rate at the date of

the contract is A$/£1.80 so the company is expecting to receive 100,000/1.8 = £55,556. If, however,

the A$ weakened over the three months to become worth only A$/£2.00, then the amount received

would be worth only £50,000.

3. Economic risk – this refers to the effect of exchange rate movements on the international

competitiveness of a company and refers to the effect on the present value of future cash flows. For

example, if a company is exporting (let’s say from the UK to a eurozone country) and the euro weakens

from say €/£1.1 to €/£1.3 (getting more euros per pound sterling implies that the euro is less valuable,

so weaker) any exports from the UK will be more expensive when priced in euros. So goods where the

UK price is £100 will cost €130 instead of €110, making those goods less competitive in the European

market.

Types of interest rate risk

1. Gap exposure – this arises from the risk of adverse changes in interest rates between the time

interest is paid for debt and the time interest is earned from investments. Company’s exposure to

interest rate risk can be identified using gap analysis (grouping together assets and liabilities which are

sensitive to interest rate changes according to their maturing dates). A negative gap occurs when

company has larger amount of interest-sensitive liabilities maturing than it has interest-sensitive assets

maturing at the same time while positive gap is the opposite of this. Therefore, with a negative gap,

company faces exposure if interest rates rise by the time of maturity. With positive gap, company faces

exposure if interest rates fall by maturity.

2. Basis risk – this is the risk when yields (interest receivable) on assets and costs (interest payable) of

liabilities are based on different bases, such as LIBOR (London Inter-Bank Offered Rate, this is the rate

of interest applied to wholesale money market lending between London banks) versus U.S. prime rate.

Different bases may move at different rates or in different directions, affecting the amount receivable

or payable (not applicable for fixed interest rate debt, only apply to floating rate).

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2. Causes of exchange rate differences and interest rate fluctuations

Before starting, there are some terms to introduce here:

1. Exchange rate – rate at which one country’s currency can be traded in exchange for another

country’s currency. For example, A$ per £2.00 means that every A$1 can be exchanged for £2.00.

2. Spot rate – rate of exchange agreed for immediate transactions.

3. Forward rate – rate agreed NOW for currencies to be exchanged at a future date.

4. Forward contract – agreement to exchange different currencies at a specified future date and at a

specified rate. These are traded privately.

Causes of exchange rate fluctuations

In general, exchange rate can be influenced by inflation, interest rates, balance of payments,

speculation and government policy on managing or fixing exchange rates. The following headings are

the causes of exchange rate fluctuations in detailed (can be confusing).

Balance of payments

Balance of payments are surplus if source of funds (eg. export goods sold) exceed uses of funds (eg.

paying for imported goods) and deficit if the other way round. As government is able to influence

exchange rate through exchange rate policy, when there is trade deficit, government will rectify by

trying to bring about a fall in the exchange rate. Similarly to prevent a balance of trade surplus from

getting too large, government will try to bring about a limited rise in the exchange rate. Government

will try to maintain a stable balance of payments.

Purchasing power parity (PPP) theory (relationship between exchange rates and inflation rates)

This suggests that changes in exchange rates over time must reflect relative changes in inflation

between two countries. PPP is based on the of law of one price which suggests that, in equilibrium,

identical goods should sell at the same price in different countries, and that exchange rates relate

these identical values. For example, if a basket of goods costs £100 in the UK and $150 for an

equivalent in the US, for equilibrium to exist, the exchange rate would be expected to be £1 = $1.50.

PPP holds in the longer term rather than the shorter term and so is often used to provide long-term

forecasts of exchange rate movements, for example for use in investment appraisal.

Interest rate parity (IRP) theory (relationship between exchange rates and interest rates)

This states that the difference between the nominal interest rates in two countries is the difference

between forward rate and the spot rate of their currencies. When one makes two fixed investments in

two different currencies, the return from both investments will be the same even though interest

rates may be different in absolute terms. This applies if there is no arbitrage (activity of buying

currency in one financial market and selling it at a profit in another). Both the spot rate and the

forward rate are available in the current foreign exchange market, and the forward rate can be

guaranteed by using a forward contract.

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Fisher effect

This has been covered earlier that the relationship between inflation rate and interest rate are:

(1 + i) = (1 + r)(1 + h) where i is nominal/money interest rate, r is the real interest rate and h is the

inflation rate.

International Fisher effect

This states that differences in nominal interest rate between countries provide an unbiased predictor

of future changes in spot exchange rates. The international Fisher effect can be expressed as:

where is the nominal interest rate in country a, is the inflation rate in country a.

Four-way equivalence

This model states that in equilibrium, differences between forward and spot rates, differences in

interest rates, expected differences in inflation rates and expected change in sport rates are equal to

one another (don’t worry about the formula first).

Revision

To refresh your mind, maybe it is a good idea to look back at the relationship between interest rate,

inflation rate and exchange rate.

1. When inflation rate increases, interest rate will be increased so that demand for money will fall (this

discourages people to spend). Inflation is generally caused by people spending more.

2. When exchange rate is low, interest rate can be increased to attract foreign investors to invest which

might help to improve the currency values and therefore the exchange rate.

Forecasting exchange rates

We will use PPP and IRP to forecast exchange rates.

Purchasing power parity

Expected spot rate is forecast from the current spot rate by multiplying the ratio of expected inflation

rates in the two countries being considered. Therefore, the formula is:

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, this formula is given in exam. Country c is the foreign country.

Example: The spot exchange rate between UK sterling and Danish krone is £1 = 8.00 kroner. Assuming

there is now purchasing parity, an amount of a commodity costing £110 in the UK will cost 880 kroner

in Denmark. Over the next year, price inflation in Denmark is expected to be 5% while inflation in UK is

expected to be 8%. Calculate the expected spot exchange rate at the end of the year.

Solution: We take 8 kroner as spot rate, we are UK so country c will be Denmark.

Expected spot exchange rate = 8 x 1.05/1.08 = 7.78. This amount can also be found by:

UK price = £110 x 1.08 = £118.80, Denmark price = Kr880 x 1.05 = Kr924

New spot exchange rate = 924/118.80 = 7.78.

Interest rate parity

Forward rate is forecast from the current spot rate by multiplying the ratio of interest rates in the two

countries being considered. Therefore, the formula is:

, this formula is given in exam as well. Country c is the foreign country.

Example: Exchange rates between two currencies, the Northland florin (NF) and Southland dollar ($S)

are as follow:

Spot rates $S1 = NF4.7250

NF1 = $S0.21164

90 days forward rates NF4.7506 per $S1

$S0.21050 per NF1

Money market interest rate for 90 day deposits in Northland florins is 7.5% annualised. Estimate the

interest rates in Southland.

Solution: Since we are given the 90 days forward rates, the interest rate of 7.5% should be adjusted to

90 days.

Northland interest rate on 90 day deposit = 0.075 x 90/365 = 1.85%.

There is a need to adjust the formula so that forward rate/spot rate = ratio of interest rates. If we take

$S0.21164 as spot rate, we are Northland so country c is Southland.

0.21050/0.21164 = 1 + /1.0185, 1 + = 0.21050/0.21164 x 1.0185, 1 + = 1.013, so = 1.3% OR

4.7506/4.7250 = 1.0185/1 + , 1 + = 1.0185 x 4.7250/4.7506, 1 + = 1.013 so = 1.3%.

In annual rate, 0.013 x 365/90 = 5.3%.

Causes of interest rate fluctuations

The causes of interest rate fluctuations include the structure of interest rates and yield curves and

changing economic factors. The following headings are the causes in detailed.

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Structure of interest rates and yield curves

It is quite common sense that higher risk borrowers must pay higher rates to compensate the risk that

lenders are taking. Also, larger deposits with the bank might attract higher rates than smaller deposits.

Furthermore, different types of financial asset attract different rates of interest.

Duration of the lending can affect the interest rates as well, we refer to the term structure of interest

rates, ie. yield on a security varies according to the term of the borrowing, this is shown by the yield

curve below:

Yield can mean interest rate/market price (running yield) or the discount rate that makes present value

of future interest payments and redemption value equal to current market price, ie. IRR (redemption

yield or cost of debt). Long-term debt is usually expected to be more expensive than short-term debt

(ie. yield curve slopes upward, meaning the lender can yield more for longer-term debt). This is

because lender faces greater risk that borrower may not be able to repay interest payments or

principal amount.

Expectations theory

Forward interest rate is due only to expectations of interest rate movements. If interest rates are

expected to fall, short-term rates might be higher than long-term rates (so that lender maintains

sufficient yield %) and yield curve would be downward sloping.

Liquidity preference theory

Liquidity preference means investors/lenders prefer cash now and want compensation in the form of

higher return for being unable to use their cash now. Therefore, the long-term interest rates do not

only reflect investors’ assumptions about future interest rates but also include a premium to

compensate investors for added risk.

Market segmentation theory (segmented market theory)

This theory states that most investors have set preferences regarding the length of maturities that they

will invest in (investors are interested in bonds of only one maturity). For example, bank prefers short-

term debt and pension funds prefer long-term debt. Slope of the yield curve will reflect conditions in

different segments of the market. Even if short term rate increases in any period of time, this theory

implies that investors will not shift from long term bonds to short term bonds in order to enjoy higher

rate in the short run.

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3. Hedging techniques for foreign currency risk

Hedging is a risk management strategy to limit or offset probability of loss from fluctuations in eg.

currencies and securities. Remember, hedging is not about maximising income, it is about providing

certainty about the cost of a transaction in your own currency.

Foreign currency risk management methods (managing transaction risks)

Currency of invoice

Arrange for the contract and the invoice to be in your own currency. This will shift all exchange risk

from you onto the other party.

Netting

Netting is a process where credit balances are netted off against debit balances so that only the

reduced net amounts remain due to be paid by actual currency flows. If you owe your US supplier

US$1m, and another US company owes your US subsidiary US$1.1m, then by netting off group

currency flows your net exposure is only for US$0.1m. Bilateral netting is where two companies in the

same group cooperate as explained above; multilateral netting is where many companies in the group

liaise with the group’s treasury department to achieve netting where possible.

Matching

Company can reduce or eliminate foreign exchange transaction exposure by matching receipts and

payments. Wherever possible, company that expects to make payments and have receipts in same

foreign currency should plan to offset its payments against its receipts in the same currency, opening a

foreign currency bank account will help. For example:

1 November: should receive US$2m from US customer

15 November: must pay US$1.9m to US supplier.

Deposit the US$2m in a US$ bank account and simply pay the supplier from that. That leaves only

US$0.1m of exposure to currency fluctuations.

Leading and lagging

Company can try to lead payments (payments in advance) when expect foreign currency will

strengthen against own currency and lag payments (delaying payments) when expect that foreign

currency will weaken against own currency.

Forward exchange contracts

This is a binding agreement to sell or buy an agreed amount of currency at a specified time in the

future at an agreed exchange rate (the forward rate). Each spot and forward there is always a pair of

rates given. For example:

Spot €/£ 1.2025 ± 0.03 (ie. 1.2028 and 1.2022)

Three-month forward rate €/£ 1.2020 ± 0.06 (ie. 1.2026 and 1.2014)

Bank will always give you the rate that is more favourable to them, ie. 1.2022 if changing £ to euros

now, or 1.2014 if using a forward contract.

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Example: A UK importer imports from a foreign seller on 1 April for 26500 Swiss francs and has to pay

in one month’s time, on 1 May. He can arrange a forward exchange contract with his bank on 1 April,

whereby the bank undertakes to sell the importer 26500 Swiss francs on 1 May, let say forward rate of

SFr2.6400 = £1. With this, the UK importer must pay at this forward rate on 1 May, amount payable is

26500/2.6400 = £10037.88.

1. If spot rate on 1 May is lower than 2.6400, the importer would have successfully protected himself

against the weakening of sterling.

2. If spot rate on 1 may is higher than 2.6400, importer would have to pay more. The extra cost is

unavoidable because forward contract is binding.

Let say later the seller fails to deliver the goods as specified, the forward exchange contract must still

be satisfy. With this, bank will sell the customer 26500 Swiss Francs at £10037.88 and buy back the

unwanted currency at the spot rate. Importer could win or lose depending on the spot rate at the time.

This process is called ‘closing out’ where bank arranges for customer to perform his part of the foreign

exchange contract by either selling or buying the ‘missing’ currency at spot rate.

Money market hedging

Money market hedging is the use of borrowing and lending transactions in foreign currencies to lock in

the home currency value of a foreign currency transaction. This involves borrowing in one currency,

converting the money borrowed into another currency and putting the money on deposit until the

time the transaction is completed, hoping to take advantage of favourable exchange rate movements.

Example will be required to understand how it works.

1. Foreign currency receipt (aim to create a foreign currency liability and use the foreign currency

receipt to pay it).

Example: A UK manufacturer exported to a US company and in 3 months’ time he will receive US$2m.

To face no currency risk, this US$2m can be used to settle a US$2m liability. UK manufacturer can

create a US$2m liability by borrowing US$2m now and repaying that in 3 months’ time with the

US$ receipt. Interest rates information is important, let say US$ 3 months interest rate is 0.54% - 0.66%

(this amount is always annualised). Same rule, UK manufacturer will be charged at higher rate, ie. 0.66%

per annum. The amount that UK manufacturer actually need to borrow now is:

X (1 + 0.66%/4) = 2000000, X = US$1996705. This can be changed now from US$ to £ at the current

spot rate, say US$/£ 1.4701, to give £1358210 (1996705/1.4701). This £1,358,210 is certain, UK

manufacturer can deposit it into the bank or use it elsewhere.

Finally, when US$2m is received from US company, it will be used to repay the loan which should have

increased to US$2m from US$1996705.

2. Foreign currency payment (aim to create a foreign currency asset and use this to pay the foreign

currency payment, cost involved is the borrowings to create the foreign currency asset).

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Example: A UK company owes a Danish creditor Kr3500000 in three months’ time. Spot exchange rate

is Kr7.5509 – Kr7.5548 per £1. The company can borrow in Sterling for 3 months at 8.6% per annum

and can deposit Kroner for 3 months at 10% per annum. What is the cost in pounds with a money

market hedge?

Solution: Interest rates for 3 months are 2.15% (8.6%/4) to borrow in pounds and 2.5% (10%/4) to

deposit in kroner. Amount to borrow = amount to deposit = X (1 + 2.5%) = 3500000, X = Kr3414634.

Convert this to £ will be 3414634/7.5509 = £452215 (spot rate given will always be the bad one).

Company has to borrow £452215 and with 3 months interest will have to repay:

£452215 x 1.0215 = £461938.

In 3 months, deposit (Kr3414634 should have increased to Kr3500000) will be taken out to pay the

Danish creditor and company will pay £461938 to the bank.

The choice between forward exchange contract (forward market) and money markets is generally

made on the basis of which method is cheaper, with other factors being of limited significance. We

shall take a look at June 2011 question 4 as example.

Example: ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several

years ago when peso interest rates were relatively cheap compared to dollar interest rates. Economic

difficulties have now increased peso interest rates while dollar interest rates have remained relatively

stable. ZPS Co must pay interest of 5,000,000 pesos in six months’ time. The following information is

available.

Per $

Spot rate: pesos 12·500 – pesos 12·582

Six-month forward rate: pesos 12·805 – pesos 12·889

Interest rates that can be used by ZPS Co:

Borrow Deposit

Peso interest rates: 10·0% per year 7·5% per year

Dollar interest rates: 4·5% per year 3·5% per year

Calculate whether a forward market hedge or a money market hedge should be used to hedge the

interest payment of 5 million pesos in six months’ time. Assume that ZPS Co would need to borrow any

cash it uses in hedging exchange rate risk.

Solution: The cost of both methods has to be compared.

Forward market hedge

Cost = 5000000/12.805 = $390472 (always take the rate that is bad).

Money market hedge

The aim is to create a 5000000 peso asset in 6 months’ time. The amount of pesos required to deposit

is X (1 + 7.5%/2) = 5000000, X = 4819277 pesos. Therefore, the $ to borrow this amount will be

4819277/12.500 = $385542. This is the cost now, we have to include the interest cost for 6 months, ie.

385542 x (1 + 4.5%/2) = $394217.

Comparing the cost, forward market hedge is cheaper by $3745 and should be used to hedge.

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Asset and liability management

A company which has a long-term foreign investment, for example an overseas subsidiary, can try to

match its foreign assets by a long-term loan in the foreign currency.

Evaluating the foreign currency risk management methods

1. Currency of invoice – If the foreign customer wants you to invoice in their currency and you are very

keen to sale to this customer, then you might have to invoice in their currency.

2. Netting - This will really only work effectively when there are many sales and purchases in the

foreign currency. It would not be feasible if the transactions were separated by many months.

3. Matching - For matching to work well, either specific matches are spotted or there have to be many

import and export transactions to give opportunities for matching. Matching would not be feasible if

you received US$2m in November, but didn’t have to pay US$1.9m until the following May.

4. Leading and lagging – The currency movement may be different from expected.

5. Forward exchange contracts – It is cheap and available for many currencies but it is binding and rates

may be unattractive.

6. Money market hedging – more time consuming compared to forward exchange contracts.

Foreign currency derivatives

These can be used to hedge foreign currency risk as well. A derivative is a financial instrument whose

value changes in response to the change in an underlying variable. No calculation will be required in

exam.

Currency futures

These can be found in futures market. Currency futures are standardised contracts that oblige the

buyer (seller) to purchase (sell) the specified quantity of foreign currency at a pre-determined price at

the expiration of the contract. Currency futures provide a hedge that theoretically eliminates both

upside (opportunities) and downside (threats) risk by effectively locking the holder into a given

exchange rate, since any gains in the currency futures market are offset by exchange rate losses in the

cash market, and vice versa.

In practice however, movements in the two markets are not perfectly correlated and basis risk exists if

maturities are not perfectly matched. Imperfect hedges can also arise if the standardised size of

currency futures does not match the exchange rate exposure of the hedging company. Initial margin

subsequently required. Futures are generally settled through an offsetting (reversing) trade.

Example: A US exporter is expecting to receive €5m in three months’ time and that the current

exchange rate is US$/€1.24. Assume that this rate is also the price of US$/€ futures. The US exporter

will fear that the exchange rate will weaken over the three months, say to US$/€1.10 (that is fewer

dollars for a euro). If that happened, then the market price of the future would decline too, to around

1.1. The exporter could arrange to make a compensating profit on buying and selling futures: sell now

at 1.24 and buy later at 1.10. Therefore, any loss made on the main currency transaction is offset by

the profit made on the futures contract.

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Currency options

This gives holders the right, but not the obligation, to buy (call option) or sell (put option) foreign

currency at specific date at a specific rate. An advantage of currency options over currency futures is

that currency options do not need to be exercised if it is disadvantageous for the holder to do so.

Holders of currency options can take advantage of favourable exchange rate movements in the cash

market and allow their options to lapse. The initial fee (non-returnable premium) paid for the options

will still have been incurred and it depends on the strike price (exercise price of call or put option),

maturity, liquidity in the market and so on.

Example: A UK exporter is expecting to be paid US$1m for a piece of machinery to be delivered in 90

days. If the £ strengthens against the US$ the UK firm will lose money, as it will receive fewer £ for the

US$1m. However, if the £ weakens against the US$, then the UK company will gain additional money.

Say that the current rate is US$/£1.40 and that the exporter will get particularly concerned if the rate

moved beyond US$/£1.50. The company can buy £ call options at an exercise price of US$/£ = 1.50,

giving it the right to buy £ at US$1.50/£. If the dollar weakens beyond US$/£1.50, the company can

exercise the option thereby guaranteeing at least £666,667. If the US$ stays stronger – or even

strengthens to, say, US$/£1.20, the company can let the option lapse (ignore it) and convert at 1.20, to

give £833,333.

Currency swaps

This is appropriate for hedging exchange rate risk over a longer period of time. It involves exchange of

principal and interest of a loan in one currency for the same in another currency. It begins with an

exchange of principal, although this may be a notional exchange rather than a physical exchange.

During the life of the swap agreement, the counterparties undertake to service each others’ foreign

currency interest payments. At the end of the swap, the initial exchange of principal is reversed.

4. Hedging techniques for interest rate risk

Interest rate risk can be managed using internal hedging in the form of asset and liability management,

matching and smoothing or using external hedging instruments such as forward rate agreements and

derivatives.

Interest rate risk management methods

Matching and smoothing

Matching (commonly used by banks) is where assets and liabilities with a common interest rate are

matched. For example, one subsidiary could invest in money market at LIBOR and another subsidiary

could borrow through the same market at LIBOR. When LIBOR increases, one’s borrowing cost and

another’s returns will increase, therefore matched.

Smoothing is where company keeps a balance between its fixed rate and floating rate borrowing.

Therefore, when the interest rates increase, floating rate loan will be more expensive but this will be

compensated by the less expensive fixed rate loan.

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Forward rate agreements (FRAs)

This hedges interest rate risk by fixing the interest rate on future borrowing. This protects the

borrower from adverse market interest rates movements to the levels above the rate negotiated for

the FRA. However it is likely to be difficult to obtain FRA for periods of over one year. Something to

note of is the terminology of FRA:

1. 4.00 - 3.80 means that you can fix a borrowing rate at 4.00% (favourable to the bank).

2. A ‘3 - 6’ FRA is one that starts in three months and lasts for three months.

3. A basis point is 0.01%.

Example: It is 30 June. Water Co needs a $10m 6 months fixed rate loan from 1 October. Water Co

wants to hedge using an FRA and the relevant FRA rate is 6% on 30 June. What if the FRA benchmark

rate has moved to 9% later?

Solution: FRA required is ‘3 - 9’. Since the rate increased, Water Co will receive the 3% (9 – 6) from

bank.

Net payment on loan = 9% x $10m x 6/12 – 3% x $10m x 6/12 = $300000. Therefore, with FRA the

effective interest rate on loan will be fixed at 6%, in this case Water Co will not lose when the rate

becomes 9%.

Interest rate derivatives

No calculation will be required for these in exam. In considering which instrument to use, consider cost,

flexibility, expectations and ability to benefit from favourable interest rate movements.

Interest rate futures

This is similar to FRAs, except that the terms, amounts and periods are standardised. Because of this,

they cannot always be matched with specific interest rate exposures. With interest rate futures, what

we buy is the entitlement to interest receipts and what we sell is the promise to make interest

payments. Therefore, if a lender buys one 3 month sterling contract, he has the right to receive

interest for three months in pounds.

1. Borrowers will wish to hedge against interest rate rise by selling futures now and buying futures (if

interest rate did rise) on the day that the interest rate is fixed.

2. Lenders will wish to hedge against falling of interest rate by buying futures now and selling futures

(if interest rate did fell) on the date that the actual lending starts.

We can see that borrowers sell futures to hedge against interest rate rises and lenders buy futures to

hedge against interest rate falls.

Normally, futures price is likely to vary with changes in interest rates and outlay to buy futures is much

less than buying a financial instrument itself.

Interest rate swaps

Interest rate swaps are where two parties agree to exchange interest rate commitments. The exchange

could be fixed rate to floating rate or vice versa (plain vanilla or generic swap). For example, party A

agrees to pay the interest on party B’s loan (fixed rate) and party B agrees to pay interest on party A’s

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loan (floating rate). If both parties are in different countries, a fixed to floating rate currency swap

(combination of currency and interest rate swap) can be done.

Arranging a swap is cheaper than terminating original loan (termination fee is high) and taking out a

new loan (involve issue costs), therefore companies (normally banks and other types of institution)

swap interest payments with another companies.

Interest rate options

This grants the buyer the right, but not the obligation, to deal at an agreed interest rate (strike rate) at

a future maturity date. On the date of expiry of the option, buyer must decide whether or not to

exercise the right. If a company needs to hedge borrowing, it will purchase a put option to obtain the

right to pay interest at strike rate, so if the interest rate rises at the future date, company will exercise

this option. Similarly, if a company needs to hedge lending, it will purchase a call option.

Interest rate caps, collars and floors

Caps set a ceiling to the interest rate, floor sets a lower limit and collar is the simultaneous purchase of

a cap and sale of floor.

An interest rate cap will compensate the purchaser of the cap if interest rates rise above a

predetermined rate (strike rate) while an interest rate floor will compensate the purchaser if rates fall

below a predetermined rate. Both are also interest rate options.

Interest rate collar is a combination of a purchase of an interest rate cap and a sale of an interest rate

floor to create a range for interest rate fluctuations between the cap and floor strike prices to

minimise the risk of a significant rise in the floating rate. This limits the cost for the company as it

receives a premium for the option (floor) sold.