Course Notes

ACCA F9
Financial Management
Exams from September 2017

Tutor details

JUNE 2017 RELEASE

ii Introduction AC C A F9

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F i No part of this publication may be reproduced, stored in a retrieval system
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© First Intuition Ltd, 2017

AC C A F 9 Introduction iii

Contents
Page

Introduction i

1 Links to other papers v

2 Paper based or computer based exam? vii
3 Study planner viii

1: Financial management function 1

1 The nature and purpose of financial management 1

2 Financial objectives and the relationship with corporate strategy 2
3 Stakeholders and impact on corporate objectives 3
4 Financial and other objectives in not-for-profit organisations 6

2: Financial management environment 7

1 The economic environment for business 7

2 The nature and role of financial markets and institutions 9

3: Working capital management

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1 The nature, elements and importance of working capital 13

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2 Techniques for managing inventory 17
3 Techniques for managing accounts receivable 19

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4 Techniques for managing accounts payable 22
5 Techniques for managing cash balances 23

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6 Determining working capital needs and funding strategies 28

4: Investment appraisal

1 Investment appraisal techniques

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33
2 Allowing for inflation and taxation in discounted cash flows 42
3 Adjusting for risk and uncertainty in investment appraisal 49
4 Specific investment decisions 53

5: Business finance 59

1 Sources of and raising business finance 59

2 The relationship between dividend policy and the financing decision 65
3 Estimating the cost of equity 67
4 Estimating the cost of debt 71
5 The weighted average cost of capital (WACC) 75
6 Sources of finance and their relative costs 76
7 Capital structure theories and practical considerations 77
8 Changes to a company and their impact on the WACC 80
9 Finance for small and medium sized entities (SMEs) 83
iv Introduction AC C A F9

6: Business valuations 87

1 Nature and purpose of the valuation of business and financial assets 87

2 Models for the valuation of shares 88
3 The valuation of debt and other financial assets 96
4 Efficient Market Hypothesis (EMH) and practical considerations in the valuation of shares 99

7: Risk management 101

1 Managing interest rate risk 101

2 Managing foreign exchange risk 105

Solutions to Class lecture examples 117

Chapter 1 117
Chapter 2 118
Chapter 3 118
Chapter 4 121
Chapter 5 126
Chapter 6 129
Chapter 7 130

Formulae sheets 133

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AC C A F 9 Introduction v

1 Links to other papers

AFM (P4)

FM (F9)

MA (F2)

1.1 Paper aim

To develop the knowledge and skills expected of a finance manager, in relation to investment,
financing, and dividend policy decisions.

Main capabilities
On successful completion of this paper, candidates should be able to:
A

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Discuss the role and purpose of the financial management function

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B Assess and discuss the impact of the economic environment on financial management
C Discuss and apply working capital management techniques

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D Carry out effective investment appraisal
E Identify and evaluate alternative sources of business finance

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F Discuss and apply principles of business and asset valuations
G Explain and apply risk management techniques in business

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vi Introduction AC C A F9

Relational diagram of main capabilities

Financial
management function
(A)

Financial management environment (B)

Working capital
management (C)

Investment appraisal
(D)

Business Business
valuations (F)
finance (E)

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Risk

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management (G)

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Rationale

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The syllabus for Paper F9, Financial Management, is designed to equip candidates with the skills that

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would be expected from a finance manager responsible for the finance function of a business. The

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paper, therefore, starts by introducing the role and purpose of the financial management function

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within a business. Before looking at the three key financial management decisions of investing,

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financing, and dividend policy, the syllabus explores the economic environment in which such

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decisions are made.
The next section of the syllabus is the introduction of investing decisions. This is done in two stages -
investment in (and the management of) working capital and the appraisal of long-term investments.
The next area introduced is financing decisions. This section of the syllabus starts by examining the
various sources of business finance, including dividend policy and how much finance can be raised
from within the business. It also looks at the cost of capital and other factors that influence the choice
of the type of capital a business will raise. The principles underlying the valuation of business and
financial assets, including the impact of cost of capital on the value of business is covered next.
The syllabus finishes with an introduction to, and examination of, risk and the main techniques
employed in the management of such risk.

Approach to examining the syllabus

The syllabus for Paper F9 aims to develop the knowledge and skills expected of a finance manager who
is responsible for the finance function of a business.
The paper also prepares candidates for more advanced and specialist study in Paper P4, Advanced
Financial Management.
The syllabus is assessed by a three-hour 15 minutes paper-based examination. All questions are
compulsory. It will contain both computational and discursive elements. Some questions will adopt a
scenario/case study approach.
AC C A F 9 Introduction vii

Section A of the exam comprises 15 multiple choice questions of 2 marks each.

Section B of the exam comprises three scenarios consisting of 15 multiple choice questions of 2 marks
each.
Section C contains two 20 mark questions.
The two 20 mark questions will come from working capital management, investment appraisal and
business finance areas of the syllabus. The section A and section B questions can cover any areas of
the syllabus.
Candidates are provided with a formulae sheet and tables of discount and annuity factors.

2 Paper based or computer based exam?

Sessional computer based exams are available for papers F5 to F9. Until December 2017 these run
alongside the traditional paper based exams and you may sit either. At the time of printing these
Course Notes the ACCA had announced that they are hoping to phase out the paper exams from
March 2018. If this happens you will then have to sit the CBE. If you are taking your exam from March
2018 onwards, please check the ACCA website for further detail www.accaglobal.com
The technical content of paper based and computer based exams is identical, but there is a slightly
wider variety of question styles in the computer based exam.

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You will find a variety of question styles in the companion Question Ban, so that you are prepared for

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the computer based exam as well as the paper one.

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For more information on the computer based exam please see the ACCA website:

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http://www.accaglobal.com/gb/en/student/exam-entry-and-administration/computer-based-
exams.html
and
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http://www.accaglobal.com/content/dam/ACCA_Global/Students/exam/Guide-to-CBEs-v3.pdf

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The ACCA has produced a specimen exam which is available as both a paper specimen and as a
computer based specimen. The paper version of the specimen exam is included at the back of this
question bank. If you are sitting the computer based exam, it is VITAL that you work through the
computer based specimen, which can be found at the following:
https://sampletds1.pearsonvue.com/Minerva/startDelivery?sessionUUID=1c817140-1132-4b98-9c2c-
3954bf26fd2f
In addition, it is VITAL that you look at the extra constructed response questions and the constructed
response workspace information provided at:
https://sampletds1.pearsonvue.com/Minerva/startDelivery?sessionUUID=5602afd4-1b9b-45be-9ea4-
accb3dd39284

2.1 Examination technique

Time management
The paper is very time pressured. Students should keep track of their time carefully, and not ‘over-
run’ on one question to the detriment of another.

Question requirements
Always read the question carefully.
viii Introduction AC C A F9

3 Study planner
PER Questions from the First
Chapter Subject relevance Time (min) Intuition Question Bank
Introduction This sets the background to the 10
paper
Formulae In this paper you are supplied with 10
Sheet formulae sheets, a copy of which is
provided at the back of these Notes
so that you can familiarise yourself
in preparation for the real exam.
1 Financial Management Function 60 reading SFQs: 1-8
This is an introduction to the paper, 110 Scenario Qs: Q9-13 YNM
but make sure you learn the ratios. questions Co
2 Financial Management PO11 40 reading SFQs: 1-11
Environment 85 questions
This is a brief written chapter
showing the link between the
outside world and financial
management.

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3 Working Capital Management PO10 160 reading SFQs: 1-12

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This is an important chapter as it

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360 Scenario Qs: 13-17 FLG Co

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has appeared in every single real questions

2
LFQs: 1 Plot Co, 2 Ulnad Co,

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exam so far. It is not difficult, but it 3 Ginboa Co, 4 HGR Co, 5

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is worth going through it slowly to ZSE co

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ensure that you understand it fully.

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4 Investment Appraisal PO09 220 reading SFQs: 1-13

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This is another important chapter 450 Scenario Qs: 14-18 Socan,

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as it has also appeared in every questions 19-23 Trecor

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single real exam so far. It is slightly

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LFQs: 1 Darn Co, 2 HDW Co,

F
more technical in places. The NPV 3 Riddulph Co, 4 BRT Co
calculation is the central idea you
MUST be happy with and the IRR is
also important both here and in
Chapter 6.
5 Business Finance PO09, PO11 220 reading SFQs: 1-12
Sources of finance is a mostly 500 Scenario Qs: 13-17 Amah Co
written part of the syllabus, though questions LFQs: 1 Card Co, 2 Rochie
the Examiner does like you to be Co, 3 Burse Co, 4 Spot Co,
able to calculate the theoretical ex 5 Nugfer Co, 6 Maratona Co,
rights price. Cost of capital is 7 Zigto Co, 8 Clozer Co
another important part of the
syllabus, having been examined in
all but one of the real exams so far.
The whole chapter is important and
if you are happy with it the
following chapter is much easier.
AC C A F 9 Introduction ix

PER Questions from the First

Chapter Subject relevance Time (min) Intuition Question Bank
6 Business Valuations PO09 80 reading SFQs: 1-9
In this chapter we are given the cost 250 Scenario Qs: 10-14 Close Co,
of capital and have to calculate the questions 15-19 Gemlo Co
value, which is the reverse of the LFQs: 1 Quasa Co, 2 THP Co
previous chapter.
7 Risk Management PO11 80 reading SFQs: 1-11
This final chapter is a mix of 240 Scenario Qs: 12-16 PZK Co
discussion and calculation covering questions LFQs: 1 Birne Co
the two main risks faced by most
businesses; namely foreign
currency and interest rates.

The chapter number refers to the chapter of these Course Notes. The time is a guide as to how long
you should spend reading the relevant chapter and how long it will take to attempt and review the
solutions for the recommended questions.

3.1 Practical Experience Requirements (PER) and Performance Objectives

ACCA requires students to have 36 months’ practical experience in order to become members. Part of

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the practical experience requirements is achieving performance objectives that demonstrate that you

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can apply what you’ve learnt when studying to real-life, work activities.

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ACCA has set out 20 performance objectives in 9 areas. You are required to achieve 9 performance
objectives – all 5 Essentials performance objectives and any 4 Technical performance objectives. ACCA

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has provided guidance on which objectives are strongly linked to which exam. The relevant objectives

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for F9, which are 1 Essential and 3 Technical objectives, are:
(1) Professionalism and ethics (relevant for all exams)
(9)
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Evaluate investment and financing decisions (relevant for F9, P3 and P4)
(10)
(11)
Manage and control working capital (relevant for F9 only)
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Identify and manage financial risk (relevant for F9, P1 and P4)
You can find further guidance on Practical Experience Requirements and performance objectives at:
http://www.accaglobal.com/uk/en/student/practical-experience.html
Further guidance and resources to support your studies from the ACCA may be found at:
http://www.accaglobal.com/us/en/student/exam-support-resources.html
x Introduction AC C A F9

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 1

Financial management
function

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1 The nature and purpose of financial management
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1.1 Financial management

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Financial management involves identifying the financial objectives of an organisation and then
ensuring that these are achieved.
In order to achieve the financial objectives set out by an organisation the financial managers within
the organisation have to make effective decisions in three key areas:
 Investment (covered in Chapters 3 and 4)
 Financing (covered in Chapter 5)
 Dividend (covered in Chapter 6)
These decisions form the Financial Strategy of the organisation).
Examples of interdependence of the three key decision areas:
– Companies raise capital either in the form of equity or debt (the financing decision) which
they invest in different projects (the investment decision) in order to generate returns
which are either reinvested or paid out to the shareholders (the dividend decision).
– If a company increases its dividends (the dividend decision), this will reduce the level of
retained cash and increase the need for external finance (the financing decision) in order
to fund capital investment projects (the investment decision).
– An increase in capital investment expenditure (the investment decision) would also
increase the need for finance (the financing decision) which may be internally generated
by reducing dividends (the dividend decision).
 2 1: Financial management function AC C A F9

1.2 Financial and management accounting

Financial accounting is used to report on the past performance of an organisation and so allows
stakeholders to see how successful the financial management has been historically.
Management accounting provides both current and forecast information which is used by financial
managers to help them achieve the financial objectives. Management accountants are involved in
three different activities:
 Planning: Identifying where the business would like to be, at some future point, by
setting objectives or targets (financial targets are known as budgets).
 Decision-making: Making decisions to get the business from where it is now, to where it
wants to be i.e. deciding how to achieve the plan. Decisions on products and markets are
key in this respect.
 Control: Ensuring the decisions are implemented correctly and that the plan is actually
fulfilled.

2 Financial objectives and the relationship with corporate strategy

2.1 Financial objectives, corporate objectives and corporate strategy

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Corporate objectives are the targets that need to be met in order for the business to be successful in

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achieving its overall mission and goal(s). These objectives cover the whole organisation and include:
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Commercial objectives (e.g. market share, growth, customer satisfaction)

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Financial objectives (objectives which can be expressed in financial terms - see below).

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Corporate strategy is the course of action required to achieve the corporate objectives and includes
key business decisions such as how the business will grow (organic vs. acquisition) and in which

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markets to operate.

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2.2 Identify and describe a variety of financial objectives
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F i2.2.1 Shareholder wealth maximisation
As a general rule the prime financial objective of profit making organisations is to maximise
shareholder wealth. Wealth is delivered to shareholders through the payment of dividends and the
increase in share price. So this combination needs to be maximised.

2.2.2 Profit maximisation

Applying shareholder wealth maximisation to internal decisions can be difficult and consequently it is
not uncommon for organisations to follow an objective of profit maximisation. As long as this is long
term profit maximisation, it should be consistent with shareholder wealth maximisation.

2.2.3 Earnings per share growth

It can be very difficult to judge whether a company has maximised its shareholders’ wealth or
maximised its long-term profitability, so the word ‘maximised’ will often be replaced with the word
‘increased’. One way of judging whether there has been an increase is to see if earnings per share have
grown. These earnings can either be used to pay a dividend or to reinvest to create capital growth.
AC C A F 9 1 : Fi n a n c i a l m a n a g e m e n t f u n c t i o n 3

3 Stakeholders and impact on corporate objectives

3.1 Measuring achievement of corporate objectives (ratio analysis)
The achievement of financial objectives can be judged using ratio analysis. Ideally the calculated ratios
for the business in question should be compared to either historic ratios or industry averages.
Definitions:
 PBIT = Profit before interest & tax, PAT = Profit after tax and preference dividends (also known
as ‘earnings’)
 TALCL = Total assets less current liabilities
 Shareholder funds = Ordinary share capital + Share premium + Reserves

3.1.1 Financial performance ratios

Ratio Calculation Description & Notes
Return on Capital PBIT Measures efficiency in generating profits from all
Employed (ROCE) TALCL capital employed (by both lenders + shareholders)
Return on PAT Measures efficiency in generating earnings for
Shareholder Funds Shareholder Funds shareholders from capital they have contributed
Gross Profit Margin Gross Profit Measures our ability to sell goods for more than
Revenue they cost to make
Net Profit Margin PBIT

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Measures our ability to make an overall profit on

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Revenue goods sold
Growth in Revenue, Year on year, or geometric To what extent is turnover growth leading to profit

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PBIT, PAT growth growth? How good is cost control?

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3.1.2 Shareholder ratios

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Ratio Calculation Description & Notes

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Total Shareholder Divi + change in price Measures the total return on investment (based on
Return Price at start of year income and capital growth) for shareholders
Dividend Yield Dividends per share If you purchased a share today, what % income
Share Price return would you expect on your investment?
Earnings per share PAT The amount of earnings the company has generated
(EPS) Number of shares for the shareholders on each share they hold.
P/E Ratio Share Price What is the market’s view of our future growth? A
EPS high P/E ratio suggests high predicted growth
Growth in EPS, DPS, Year on year, or geometric To what extent is earnings growth leading to dividend
share price growth growth? How does this compare to share price moves?

3.1.3 Financial position ratios

Ratio Calculation Description & Notes
Debt:Equity Ratio Long term debt What proportion of assets are funded by lenders vs
Equity shareholders (use market values if available)
Gearing Long term debt What proportion of assets are funded by lenders vs
Equity + long term debt shareholders (use market values if available)
Interest Cover PBIT How many times could the annual interest bill be
Interest payable paid with profits before interest and tax
Operational Gearing Contribution Fixed Costs To what extent are our costs fixed vs. variable?
or
PBIT Total Costs
 4 1: Financial management function AC C A F9

LECTURE EXAMPLE 1.1

The following financial data is available for Diamond Co which has issued 2.1 million shares which are
currently priced at $7.20 per share (they were priced at $7 at the end of the prior year).
Extracts from the financial statements:
$000
Income statement
Revenue 14,687
Profit from operations before interest and tax 2,159
Profit from operations after interest and tax 1,260
Dividends 525

Statement of financial position

Non-current assets 7,340
Current assets 3,562
Current liabilities 3,070
Long-term liabilities 2,876
Shareholders’ funds 4,956

Industry average figures

ROCE 27.5%

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Return on Equity 25.5%

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EPS $0.42

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Dividend per share $0.15

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Calculate the ROCE, Return on Equity, EPS, Dividend per Share, P/E ratio and total shareholder return

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for Diamond Co and comment on your figures.

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SOLUTION

ROCE

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F iReturn on
Equity

EPS

Dividend
per share

P/E ratio
AC C A F 9 1 : Fi n a n c i a l m a n a g e m e n t f u n c t i o n 5

TSR

3.2 Stakeholders and their objectives

A stakeholder is an individual or group of individuals with an interest in the organisation.
Stakeholder Objectives
Shareholder Share price maximisation, dividend maximisation, earnings growth,
maintenance of control
Lenders Certainty of payment, security of capital, further loans
Directors/Senior managers Maximise remuneration, Security of tenure, maximisation of power and
influence
Employees Maximise remuneration, security of tenure, career development , training
Customers VFM, high quality, reliable service, innovation

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Suppliers Certainty of payment, further business

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Government Creation of employment, payment of taxes
Community Environmental improvements, creation of wealth

3.3 Possible conflicts between stakeholder objectives

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As can be seen in in the table above, different stakeholders will have different objectives and some of

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these may not be consistent, for example:

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 Maximising the dividend and maximising directors’ remuneration; the more the directors
are paid, the less that is left to pay out a dividend

3.4 Discuss the role of management in meeting stakeholder objectives,

including the application of agency theory
It is the manager’s role to balance the objectives of the different stakeholders and where there are
conflicts, deciding upon which objective should take priority.
 The shareholders are the owners of a company, however the owners do not also have to
be the managers and so they appoint directors (who can also be shareholders) to manage
the company for them.
 In legal terms the directors are the shareholders’ agents and an agent should always act
in the best interests of their principals i.e. the shareholders.
Agency theory says the directors will always put the shareholders’ objectives first. That is not to say
the directors will ignore all other stakeholders’ objectives as if the remaining stakeholders are
unhappy, then it will be difficult to maximise shareholder wealth.
The Agency Problem refers to the situation where the directors may be tempted to act in their own
best interests rather than the shareholders.
The agency problem may be addressed by using a mixture of appropriate managerial reward schemes
corporate governance.
 6 1: Financial management function AC C A F9

3.5 How to encourage the achievement of stakeholder objectives

3.5.1 Managerial reward schemes such as share options and performance-related pay
Directors can be encouraged to act in the best interests of shareholders if their objectives are aligned
with those of the shareholders.
This can be achieved by rewarding them partly in share options in the company. Hence, if the share
price of the company rises over the long term, the value of the options will increase (and this should
encourage the directors to target long term growth and performance).
Alternatively, the director’s remuneration can be linked to the increase in the company’s share price,
profits or earnings.
However, both of these approaches may still lead to poor performance being rewarded (as the move
in share price may not be due to the actions of the directors).

3.5.2 Regulatory requirements such as corporate governance codes of best practice and
stock exchange listing regulations
In the UK the UK Corporate Governance Code (September 2012) sets out what is accepted as best
practice as to the ways in which directors should behave in running a company. All listed companies
must make a statement on the appliance and compliance of the Code when they publish their financial
statements.

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The Code recommends certain measures to curb the power of the executive directors, such as the

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appointment of non-executive directors and nomination and remuneration committees.

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The Stock Exchange Listing Regulations contain the eligibility criteria for listing, the duties of sponsors

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and continuing obligations of listed companies. These regulations apply to all companies listed on the

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Main Market, but are particularly pertinent to those obtaining a listing for the first time.

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uobjectives in not-for-profit organisations
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4.1 The impact of not-for-profit status on financial and other objectives
Not-for-profit organisations (e.g. government departments, schools, charities) tend not to have
shareholders and consequently lose the objective of maximising shareholder wealth. As a result,
financial objectives change and become less important, with non-financial objectives becoming key.

4.2 The importance of Value for Money in not-for-profit organisations

The most common way of measuring performance in not-for-profit organisations is to identify whether
they are offering value for money (VFM). The National Audit Office (NAO) assesses VFM according to
three criteria:
(a) Economy – cost of resources used
(b) Efficiency – outputs vs. inputs
(c) Effectiveness – achieving targets

4.3 Measuring the achievement of objectives in not-for-profit organisations

The achievement of objectives in not-for-profit organisations can be measured by:
 Comparing actual performance to non-financial targets
 Questioning users
 Appointing regulators/experts to monitor performance
 Comparing actual performance to appropriate financial targets
 7

Financial management
environment

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1 The economic environment for business
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1.1 The main macroeconomic policy targets

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Different governments will put a different emphasis on individual policies and use different measures
to achieve these policies, but in general governments try to achieve the following macroeconomic
targets:
 Strengthening business to make the economy more competitive
 Protecting the environment
 Increasing employment opportunities
 Ensuring fairness for families and communities
 Delivering macroeconomic stability to encourage long term planning and investment

1.2 Fiscal, monetary, interest rate and exchange rate policies

Fiscal policy determines how Governments raise and spend money:
 Taxation and Government spending affect the amount that companies and individuals
have available for spending and hence impact on demand and output
 Hence increasing taxation levels or decreasing public expenditure should decrease
demand and output.
Monetary policy is used by Governments to regulate the supply of money:
 The broad aim of monetary policy is to achieve price stability by influencing the level of
demand in the economy
 One aspect of monetary policy is interest rate policy, where central banks change
interest rates to change the price of and hence demand for money
8 2: Financial management envir onment AC C A F9

 Central banks can also increase the supply of money by repurchasing Government debt
from banks (known as quantitative easing)
 Increasing the supply of money (by reducing interest rates or quantitative easing) should
make borrowing cheaper and hence increase demand
Exchange rate policy describes Government’s attempts to influence exchange rates:
 Current policy in the UK is to allow a free or floating exchange rate (where demand and
supply is allowed to set the exchange rate)
 Alternatives include managed and fixed exchange rate policies.
 However, exchange rates are one of the factors taken into account by the Bank of
England when setting interest rates.
 A higher exchange rate (1 unit of domestic currency buys a large quantity of a foreign
currency) will make imports and costs of production cheaper (hence leading to a
reduction in inflation) and make exports more expensive (reducing demand for exports)

1.3 Interaction between government policies and planning and decision-

making in business
1.3.1 Economic policy

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When a business plans and makes decisions it may need to take into account the following factors:


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Demand levels

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

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Cost of capital

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 Inflation of costs and revenues

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 Exchange rates if importing or exporting or competing with those that do

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Government economic policy affects all of the above and so interacts with planning and decision-

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making in business.

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1.3.2 Competition policy

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 Without a competition policy which prevents anti-competitive behaviour such as price fixing,
and market dominance; business could abuse its power and consumers would suffer.
 Thus when business is making plans especially for things such as mergers and takeovers, but
also with regards to general competition it will be influenced by relevant competition policy.

1.3.3 Government assistance for business

 Governments may wish to encourage certain behaviour such as organic food production or the
provision of social housing. Without some sort of assistance it may not be economical for
business to change behaviour.
 Thus by offering assistance government (e.g. tax breaks or grants) can make the business
decision attractive.

1.3.4 Green policies

 Green policies benefit society as a whole and are only effective if followed by virtually everyone;
however they tend to also have an economic cost. Therefore, unless encouraged by
government, individual businesses are unlikely to follow such policies.
 The Carbon Trading Scheme encourages businesses to plan ways of reducing their CO2
emissions.
AC C A F 9 2 : Fi n a n c i a l m a n a g e m e n t e n v i r o n m e n t 9

1.3.5 Corporate governance regulation

 Without corporate governance regulation, it would be left to the personal morality of each
director to decide on what is and what is not acceptable. As a result of competition this would
in turn lead to the lowest standard being adopted by everyone.
 The Companies Act dictates that directors must, for example, promote the success of the
company for the benefit of its members, act within their powers and exercise independence,
reasonable care, skill and diligence.
 If directors do not follow the Companies Act they can be barred from being a director or even
sent to prison. Consequently, most directors abide by the Act when planning and making
decisions.

2 The nature and role of financial markets and institutions

2.1 Identify the nature and role of money and capital markets, both
nationally and internationally
 The money markets are short term (less than 12 months) interest rate markets for investing
and borrowing. Such markets exist all around the world e.g. London, New York and Tokyo.
These markets enable borrowers and lenders to manage their working capital efficiently.

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The capital markets are long term (more than 12 months) debt and equity markets. Such

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markets also exist all around the world e.g. London, New York and Tokyo. These markets enable
companies to manage their capital structure efficiently.

ntu ght
Both Money and Capital markets consist of a primary market through which initial issues take

itio
place and a secondary market where the securities are traded once they have been issued.

n2
2.1.1 Money market instruments

017
Instrument Description Term Return
Money Market Accounts A deposit account at a bank where the Overnight - 12 Variable
balance is invested in the money months
markets (short-term inter-bank
borrowing markets).
Certificates of Deposit A time deposit with a bank (≥$100k) 3 months - 5 years Fixed rate
Repo (sale & repurchase Short term loan secured on specific Usually < 1 year Fixed rate
agreement) assets (lender actually takes possession
of secured assets)
Treasury Bills Short-term securities issued by 1 / 3 / 6 month Redeem at par, so
Governments at a discount (sold in effectively a fixed
denominations of $1k) rate
Commercial Paper Short-term debt issued by companies / Usually < 270 days Redeem at par, so
banks (usually issued at a discount) effectively a fixed
rate
Eurocurrency Market Short - medium term deposits / loans (often bank - bank) in currencies of
(International Money countries other than that of the bank (e.g. USD deposit at bank in London)
Market) Most money market instruments are available on the Eurocurrency market
(though typically only in major currencies)
10 2: Financial management envir onment AC C A F9

2.1.2 Describe the role of the money markets

Providing short-term liquidity to industry and the public sector

The money market consists of financial institutions and dealers in money or credit who wish to either
borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months.
Thus the money markets are a source of short-term finance.

Providing short-term trade finance

Short-term trade finance can take the form of loans which normally can be sourced from a bank, but
an organisation can also use the money markets.

Allowing an organisation to manage its exposure to foreign currency risk and interest rate risk
One way an organisation can manage its exposure to foreign currency risk is by using a money market
hedge (Chapter 7), which involves short term lending and borrowing which is facilitated by the money
markets. An organisation can also manage its exposure to foreign currency risk and interest rate risk is
by using derivatives (Chapter 7), which also involves short term lending and borrowing which is
facilitated by the money markets.

2.1.3 Capital market instruments

Instrument Description Term Return
Corporate Bonds

ht 7
Longer-term debt issued by companies Any (but often 3-10 Fixed rate coupon,

i g 1
/ banks (usually issued at par) years) with redemption at

y r 20
maturity

p ion
Government Bonds Longer-term debt issued by Any Fixed rate coupon,

o
C uit
governments (usually issued at par) with redemption at
maturity

n t
Ordinary Shares Shares issued by companies with no term.

t I
Returns for shareholders comprise:

r s
Dividends (dependent on the performance of the company, not guaranteed).

F i
Capital growth (shares may rise in value based on performance of the company)
Eurobond Market Longer term debt (bonds) issued to investors (probably international) and
denominated in a currency other than the domestic currency of the issuer
Often issued via investment banks, normally in the major currencies (USD, EUR,
CHF, GBP)

2.2 The functions of a stock market and a corporate bond market

The functions of a stock market are as follows:
 To enable companies to raise new finance
 To enable existing investors to sell their investments
 To aid takeovers by issuing shares to finance the takeover
 To enable private company shareholders to realise part/all of their investment by floating the
company
The functions of a corporate bond market are as follows:
 To enable companies to disintermediate i.e. to deal directly with lenders
 To enable companies to raise new debt finance
 To enable existing debt investors to sell their debt
 To aid takeovers by issuing debt to finance the takeover
AC C A F 9 2 : Fi n a n c i a l m a n a g e m e n t e n v i r o n m e n t 11

2.3 Nature of different securities and risk vs. return

Investors require compensation for the risks they are exposed to by their investment. Hence, the
greater the risks run by the investor, the greater the return they require.
This is demonstrated by the most common types of securities:
 Ordinary shares – these are the owners of the company, however they stand last in the queue
and are only paid (a dividend) once all other debts have been settled and so they face the
highest risk and would consequently expect the highest return in the long term.
 Preference shares – these tend not to have any voting rights despite being shareholders. Their
dividend is normally fixed and has to be paid as long as the company has the money to do so.
Thus they do not face as much risk as the ordinary shareholders and so their dividend is lower
on average.
 Unsecured debt – this is paid interest and if the company is unable to pay, then the unsecured
debt holders can have the company wound up, however there is no guarantee that they will
recover all of their capital as they rank equally with all other creditors.
 Secured debt – this is also paid interest and if the company is unable to pay, then the secured
debt holders can realise their security and if they are still owed money can have the company
wound up, thus they are all but certain to recover all of their capital. Hence they face the least
risk and receive the lowest return of all securities.

Fir Co
2.4 Explain the role of banks and other financial institutions in the

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operation of the money markets

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Banks and other financial institutions form the core of the money market as the vast majority of
transactions consist of interbank lending where banks borrow and lend to each other.

2.5 Explain the role of financial intermediaries itio

n2
Financial intermediaries such as banks and city institutions, link lenders with borrowers. There are a

017
number of advantages of using financial intermediaries compared to lenders and borrowers dealing
directly with one another. These are:
 Security. Intermediaries will generally be able to guarantee the security of the lenders’ and
borrowers’ positions.
 Convenience. The lender does not need to directly find an appropriate borrower.
 Aggregation. An intermediary can take small amounts from investors and lend on in larger
packages. This is a significant benefit as lenders and borrowers do not need to find people who
want to deal with exactly the same amounts as them.
 Maturity transformation. The intermediary can provide investors and borrowers with
instruments that match their desired timescales. For example, investors may want to invest for
the short term but borrowers may wish for a longer term source of finance.
 Source of funds. A borrower will normally be able to find an intermediary who is prepared to
provide them with some funds even if the general market conditions are not that favourable.
Disintermediation arises where borrowers deal directly with lending individuals.
12 2: Financial management envir onment AC C A F9

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 13

Working capital management

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1 The nature, elements and importance of working capital
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1.1 The nature of working capital and its elements
ntu ght
itio
Working capital is the cash invested in current assets less current liabilities. Current assets will consist

n2
of inventories (raw materials, work in progress and finished goods), receivables and cash. Current
liabilities will consist of trade and other payables, short term loans and overdrafts.

1.2 The objectives of working capital management (liquidity vs.

profitability)
017
 The liquidity objective of working capital management is to ensure that the organisation
always has sufficient cash to pay its liabilities as they become due.
 The profitability objective of working capital management is to ensure that the organisation is
as efficient as possible by, amongst other things, ensuring all capital is invested to earn the
maximum return.
 The greater the liquidity of an organisation, the more cash it will have which is not invested and
thus the profitability will be lower. The greater the profitability of an organisation, the more
cash it will have which is invested and thus the liquidity will be reduced.
Aggressive WC Policy Conservative WC Policy
Policy Maintain a low level of working capital Maintain a high level of working capital
Result Higher profit (due to greater investment of Lower profit (due to more cash being tied up in
cash), but lower liquidity and higher risk due to working capital, earning no return), but higher
lower cash and inventory balances (hence more liquidity and lower risk due to higher cash and
chance of running out of cash / inventory). inventory balances.
14 3: Working capital management AC C A F9

1.3 Discuss the central role of working capital management in financial

management
 If working capital is not managed correctly the outcome is terminal.
 If an organisation is too liquid, it will have large amounts of cash which are not invested in
business assets and thus the profitability will suffer. An inefficient business will eventually fail or
be taken over at a low price.
 If an organisation is illiquid, it will be unable to meet its liabilities and will fail. When a business
is growing its profits will increase, but it will also require more capital to pay for the increased
levels of working capital. If this extra capital is not raised in time, the business will become
illiquid.
 This situation is commonly referred to as ‘overtrading’ as the growth in trade is what
necessitated the extra capital, which if not raised leads to the business failing.
 It is also appropriate to describe this situation as ‘undercapitalisation’ as it is the lack of capital
which causes the business to be unable to meet its liabilities as they fall due.
 Overtrading could thus be indicated by:
– A rapid increase in turnover
– An increase in inventory days
– An increase in receivables days

t
– An over reliance on short-term sources of finance, including overdraft, trade payables

i g h 1 7
and leasing

r 0
– A decreases in the current ratio

y 2
– A decrease in the quick ratio

o p ion– A decrease in profit caused by selling more at low prices

C uit
Note: The measures (e.g. receivables days) mentioned above are covered in section 2 below.

t
Both ‘overtrading’ and ‘undercapitalisation’ are opposite sides of the same coin and the financial

I n
manager should always ensure that any project undertaken by an organisation (such as a growth in

t
s
sales) is beneficial to the shareholders and that the appropriate funding is also available.

F ir
Thus the successful management of working capital is central to a company achieving its financial
objectives.

1.4 The cash operating cycle and the role of accounts payable / receivable
The cash operating cycle is the time difference between cash being paid out for production costs and
cash being received for goods sold. This can be calculated as follows:
Days
Average time raw materials are in stock X
Average time work in progress is in production X
Average time finished goods are in stock X
Average collection period X
Less: (Average payable period) (X)
Cash operating cycle X

Thus the cash operating cycle will become smaller either as accounts payable increase and/or as
accounts receivable reduce.
AC C A F 9 3: Working capital management 15

1.5 Explain and apply relevant accounting ratios

1.5.1 Current ratio and quick ratio
Current assets
Current ratio =
Current liabilities
 This ratio looks at the liquidity of the organisation and assesses its ability to meet its short term
debts. There is no correct minimum or maximum level for this ratio and you need to consider
the type of business, its historic position and the ratio of its competitors.
Current assets − inventory
Quick ratio (acid test) =
Current liabilities
 This is sometimes considered a better measure of an organisations liquidity especially where
inventory cannot be turned into cash very quickly.

1.5.2 Inventory turnover ratio, average collection period and average payable period
Cost of sales
Inventory turnover ratio =
Average inventory

 This ratio looks at how many times the inventory is used each year. Year-end inventory can also
be used to measure this ratio.
 A higher ratio indicates a more efficient management of inventory, however the relatively low

Fir Co
levels of inventory could also increase the risk of stock-outs, which could damage an

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organisations reputation. It may also discourage customers from trading with the organisation
as there could be a lack of choice or a delay in receiving delivery.

ntu ght
 By inverting this ratio and multiplying by 365 it is possible to calculate the inventory days as
follows

Average inventory period =

Average inventory
× 365 days
itio
n2
Cost of sales
 This ratio looks at the average time inventory stays in the warehouse. Again year-end inventory

017
can also be used. A short period has the same implications as a high inventory turnover ratio.
Average trade receivables
Average collection period = × 365 days
Credit sales turnover
 This ratio looks at the average time it takes to collect money from customers. Again year end
trade receivables can also be used. A short period is good for liquidity but may discourage
customers from trading with the organisation.
Average trade payables
Average payable period = × 365 days
Credit purchases or cost of sales

 This ratio looks at the average time it takes to pay money to suppliers. Again year end trade
payables can also be used. A long period is good for liquidity but may discourage suppliers from
trading with the organisation.

1.5.3 Sales revenue/net working capital ratio

Sales revenue
Sales revenue/net working capital ratio =
Net working capital

 This ratio looks at the overall working capital of the organisation compared to its sales. It is very
difficult to compare absolute levels of working capital as even organisations involved in the
same business will vary in size.
 This ratio allows the overall working capital efficiency management to be compared, both over
time and against competitors. If this ratio is low, this would suggest inefficiency, however if it is
high the organisation may be losing business due to being too tough with customers.
16 3: Working capital management AC C A F9

LECTURE EXAMPLE 3.1

The following financial data is available for Diamond Co.

Extracts from the financial statements:
$000
Income statement
Revenue 14,687
Gross profit 4,386
Profit from operations 2,159

Statement of Financial Position

Non-current assets 7,340
Inventory 936
Trade receivables 2,626
Trade payables 1,296
Other payables 537
Overdraft 1,237
Net current assets 492
Calculate the current ratio, quick ratio, inventory turnover ratio, average collection period, average
payable period and sales revenue/net working capital ratio for Diamond Co.

t
SOLUTION

Current ratio

i g h 1 7
y r 20
o p ion
C uit
Quick ratio

I n t
t
Inventory turnover ratio

ir s
F Average collection period

Average payable period

Sales revenue/net working capital ratio

AC C A F 9 3: Working capital management 17

2 Techniques for managing inventory

2.1 Economic order quantity (EOQ)
 The Economic Order Quantity (EOQ) model identifies the optimal order quantity in order to
minimise the total annual inventory costs.
 This model assumes:
– A constant demand
– A zero or constant lead (delivery) time.
 The EOQ can be calculated by using the following formula:

FORMULA GIVEN IN EXAM

2CoD
EOQ =
Ch

Where
Co = Cost of placing one order
D = Demand per annum

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Ch = Cost of holding one unit for one year

ntu ght
And the total annual cost (TAC) is:
Annual order cost + Annual holding cost

TAC = C o
D
+ Ch
Q
itio
n2
Q 2

017
Where
Q = Reorder quantity (EOQ)

LECTURE EXAMPLE 3.2

Paton Co uses components at the rate of 500 units per month, which are bought in at a cost of $1.20
each from the supplier. It costs $20 each time an order is placed, regardless of the quantity ordered.
The total holding cost is 20% per annum of the value of stock held.
What are the EOQ and TAC?
SOLUTION
18 3: Working capital management AC C A F9

 The EOQ model assumes both constant known levels of demand and lead times, which are
unlikely in practice.
 One way of overcoming this issue is to hold a buffer stock (so if the level of demand is higher
than expected or the lead time longer, the buffer can be used and stock-outs will be avoided)
 On average the buffer stock will not be used and so the inventory levels are simply increased by
the quantity of buffer stock and so are the holding costs. The level of buffer stock needs to be
balanced against the cost of stock-outs.
 If a buffer stock of B units is held, the total annual inventory cost will be
D 
+ Ch  B 
Q
TAC = C o 
Q  2

2.1.1 EOQ and bulk discounts

Sometimes a supplier will offer a bulk discount if a certain quantity of inventory is ordered.
To calculate the best order quantity if a discount is offered:
(1) Calculate the EOQ ignoring the discounts.
(2) If the EOQ is above the first discount point recalculate the EOQ allowing for the discount
(3) Then calculate the total annual cost (including the total purchase cost) at the new EOQ and all

t
discount points above the EOQ: TAC = C o D + C h Q  DP (where each unit costs $P)

g h 7
Q

1
2

(4)

y r i 20
The point at which the total annual cost is lowest is the best order quantity.

o p ion
LECTURE EXAMPLE 3.2 REVISITED

C uit
t
Paton Co has now been offered a 0.5% discount if it orders at least 1,500 units at a time.

t I n
How many units should Paton order?

ir s
SOLUTION

The EOQ model uses relevant costing principles and so ignores committed costs such as the fixed costs
associated with the warehouse. However, if inventory is removed completely, then these costs also
become relevant and so there is potential for significant savings.
AC C A F 9 3: Working capital management 19

2.2 Just-In-Time purchasing & production

 Just-in-Time (JIT) production helps to reduce inventory levels to their absolute minimum by
only producing an item when a customer requires it (hence eliminating finished goods stocks
and minimising work-in-progress stocks).
 JIT Purchasing helps to reduce inventory levels to their absolute minimum by only taking
delivery of raw materials when required for production (hence eliminating raw material stocks).
 This requires a close working relationship with (local) suppliers, a quick production process and
flexible staff.
Advantages of JIT Disadvantages of JIT
Reduced holding costs Increased risk of stock-out
Increased flexibility Less opportunity for bulk discounts
Increased quality and efficiency Low staff morale due to unpredictable production
Closer relationships with suppliers and increased schedule
price transparency Not appropriate for all organisations (e.g. NHS!)

3 Techniques for managing accounts receivable

The main advantage of offering credit is that you may sell more and hence make more profit.

Fir Co
However, this also worsens the liquidity of the organisation and if the debt went bad, could result in

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no benefit what so ever from the sale. This is a significant drawback and can be dealt with as follows.

ntu ght
3.1 Assessing creditworthiness
Before credit is offered to a new customer their creditworthiness needs to be assessed to give

itio
confidence that they will meet their debts as and when they fall due. There is no single correct way of

n2
assessing credit worthiness, but common elements include obtaining:
 A bank reference



At least one trade references
A credit rating agency report
Financial statements
017
 Any media coverage
 Views of a member of staff who has visited the potential customer

3.2 Managing accounts receivable

Accounts receivable need to be managed by ensuring:
 Invoices and statements are issued on time
 The credit limit is not exceeded and is reviewed regularly
 The on-going financial performance is kept under review

3.3 Collecting amounts owing

It is essential to ensure that amounts owing are collected when due. This will include the following:
 Ensuring any queries are investigated promptly
 The account is put on hold if any amounts are overdue
 Legal action is taken (when necessary) to recover the funds
20 3: Working capital management AC C A F9

3.4 Offering early settlement discounts

One way of encouraging credit customers to pay earlier is to offer early settlement discounts. It is
important to ensure that the benefits of such schemes outweigh the costs.

To determine whether the discount will be financially beneficial:

 Consider the cost of financing accounts receivable before and after the discount
 Treat the accounts receivable balance like a permanently overdrawn balance

LECTURE EXAMPLE 3.3

Early Bird Co currently has annual credit sales of $4,450,000. On average trade receivables take
55 days to pay and 8% of credit sales go bad. Early Bird is considering introducing an early settlement
discount whereby all customers who pay in less than 30 days will receive a 5% discount. It is expected
that 80% of customers will take advantage of the scheme and that bad debts will fall to 5%. The
average trade receivables are expected to fall to 30 days. Early Bird currently pays 12% pa on its
overdraft.
Is the proposed early settlement discount scheme economically viable for Early Bird Co?
SOLUTION

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F i
AC C A F 9 3: Working capital management 21

3.5 Factoring and invoice discounting

Factoring is an arrangement to have debts collected by a factor company, which advances a
proportion of the money it is due to collect.
 This is usually up to 80% of the face value of invoices raised - the finance is repaid once
the invoices have been settled and the balance is passed to the issuing company after
deduction of a fee. This fee is equivalent to an interest charge on the cash advanced.
 Factoring usually involves administration of the client's invoicing, sales accounting and
debt collection service and credit protection for the client's debts, whereby the factor
takes over the risk of loss from bad debts and so 'insures' the client against such losses.
This is known as a non-recourse service.
 However, if a non-recourse service is provided the factor, not the firm, will decide what
action to take against non-payers.
Invoice discounting is the purchase of trade debts at a discount (effectively a loan to the company
secured on specific receivables).
 Invoice discounting enables the company from which the debts are purchased to raise
working capital.
 The invoice discounter does not take over the administration of the client's sales ledger.
A client should only want to have some invoices discounted when he has a temporary

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cash shortage, and so invoice discounting tends to consist of one-off deals.

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3.6 Managing foreign accounts receivable

ntu ght
Managing foreign accounts receivable is the same as managing home accounts receivable but three
points in particular need to be borne in mind:
(1)
itio
Credit periods tend to be longer due to the extra time taken for goods to be physically

n2
transported and the extra associated paperwork. These delays in foreign trade mean that
exporters often build up large investments in inventories and accounts receivable. These

017
working capital investments have to be financed somehow.
(2) The bad debt risk is generally higher and so the credit worthiness checks become even more
important. If a foreign customer refuses to pay a debt, the exporter must pursue the debt in the
debtor's own country, where procedures will be subject to the laws of that country.
(3) If the debts are denoted in a foreign currency, their value will vary as the exchange rates vary.
Potential solutions to this problem are covered in Chapter 7.
The first two issues above can be managed and reduced as follows:

Reduced credit terms

 A company can reduce its investment in foreign accounts receivable by insisting on earlier
payment for goods.

Advances on / discounting of Bills of Exchange

 Another approach is for an exporter to get a bank to give cash up front for a foreign debt by:
– Agreeing for a bank to take collection of the payment and make an advance against it
(the advance might be 80% to 90% of the value of the collection)
– Selling the bill to a bank before it is due for a discounted amount
22 3: Working capital management AC C A F9

Export factoring
 The exporter pays for the specialist expertise of the factor in order to reduce bad debts and the
amount of investment in foreign accounts receivable.

Documentary credits / Letters of credit

 A method of payment in international trade, which gives the exporter a secure risk-free method
of obtaining payment.
 The buyer (importer) and the seller (exporter) first of all agree a contract for the sale of the
goods, which provides for payment through a letter of credit (a guarantee of payment).
 The buyer then requests a bank in his country to issue a letter of credit in favour of the exporter
(through the letter, the bank guarantees payment to the beneficiary).

Countertrade
 A means of financing trade in which goods are exchanged for other goods.

Export credit insurance

 Insurance against the risk of non-payment by foreign customers for export debts.
 Premiums for export credit insurance are however very high and the benefits are sometimes
not fully appreciated.

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4 Techniques for managing accounts payable
2
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o
4.1 Using trade credit effectively

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Trade credit helps to reduce the cash operating cycle and so the amount should be maximised,

n t
however care must be taken not to abuse suppliers as this can result in future credit being stopped.

I
t
As relationships with suppliers develop, the amount of credit should be extended

ir s
4.2 Evaluating the benefits of discounts for early settlement and bulk
F purchase
In exactly the same way organisations offer their customers early settlement discounts (as discussed
above), they may be offered early settlement discounts themselves. Before taking such discounts it is
important to ensure that the benefits outweigh the costs (calculations very similar to lecture example
3.3 above).

4.3 Managing foreign accounts payable

Foreign accounts payable should be managed in exactly the same way as home accounts payable but if
the amount due is denoted in a foreign currency, then the exchange rate will also need to be
monitored and possibly hedged (see Chapter 7).
AC C A F 9 3: Working capital management 23

5 Techniques for managing cash balances

Cash will be held for three reasons:
(1) The transactions motive – to enable the organisation to meet foreseeable cash requirements
e.g. paying suppliers and staff
(2) The precautionary motive – to enable the organisation to meet unforeseeable cash
requirements e.g. paying an unexpected fine
(3) The speculative motive – to enable the organisation to benefit from one off opportunities e.g.
taking advantage of an unexpected early settlement discount offer

5.1 Preparing cashflow forecasts

Cash is a critical resource for all businesses and the most common reason for business failure is
running out of cash. Most businesses will be able to raise more cash as long as they have sufficient
time to do so. It is thus essential to plan ahead by preparing cash flow forecasts to determine future
cash flows and cash balances.

LECTURE EXAMPLE 3.4

Flow Co started in business in June, making children’s ride on toy Jeeps. The following information is

Fir Co
available for the first few months of trading. $50,000 of capital was put into the business at the start of

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June.
Forecast sales volumes for the first four months are as follows:
Month
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Sales (Jeeps)

itio
June 500
July 1,200

n2
August 1,500
September 1,900
An initial selling price of $90 has been set
017
Normal trading terms are for customers to pay within one month of end of month of sale but a more
realistic pattern of receipts is as follows:

Month of payment % of customers

month of sale 30 (a 1% discount is given for paying in month of sale)
1 month later 50
2 months later 15

The remainder of customers are expected to never pay!

Closing inventory at the end of each month will be sufficient to meet one quarter of the following
months’ sales volumes. There was no inventory at the start of June.
Unit cost information is given as:
$
Direct materials 15
Direct labour 20
Variable production overheads 5
Fixed production overheads 10
Total production cost 50
24 3: Working capital management AC C A F9

Supporting notes:
(1) Direct materials. All materials needed in the production process will be purchased in the month
of production and paid for one month later. It is policy not to hold any inventory for materials.
(2) Direct labour. All paid for in the month production occurs.
(3) Variable production overheads. 50% is paid in the month of production and 50% a month later.
(4) Fixed production overheads. The absorption rate used has been based on expected annual
overheads of $180,000 and expected annual sales of 18,000 units. Fixed overheads are
expected to be paid in equal instalments each month.
Prepare a detailed monthly cash budget for June, July and August.
SOLUTION
June July August
$ $ $
Receipts
From customers (W1)
Capital

Payments

ht
Materials (W3)
Labour (W4)

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Variable overheads (W5)

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Fixed overheads (W6)

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Net cash flow

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Opening balance

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Closing balance

F iWorkings
(W1) Cash receipts from customers
June July August
Sales

Received in month of sale

Received 1 month later
Received 2 months later
TOTAL
AC C A F 9 3: Working capital management 25

(W2) Production
In order to work out our costs we need to establish the production volumes each month. This
can be done by taking the sales volumes for a month, adding closing inventory and deducting
opening inventory.
June July August
Sales volume
Add: closing inventory
Less: opening inventory
Production

Now we know this we can calculate the cash flows for the variable costs:
(W3) Materials
June July August
Production (W2)
Material cost (@ $15 each)
Cash payment

(W4) Labour

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June July August

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Production (W2)
Labour cost (@ $20 each)
Cash payment
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(W5) Variable overheads

n2
June July August

017
Production (W2)
Variable overhead cost (@ $5 each)
Cash payment
Cash payment
TOTAL

(W6) Fixed overheads

Monthly cost =
26 3: Working capital management AC C A F9

5.2 Centralised treasury management and cash control

Cash can be managed and controlled either at a local level or it can be centralised. Most organisations
follow a centralised treasury management and cash control approach due to the benefits this brings:
 Allows the internal netting off of local surpluses and deficits which is cheaper
 Lower bank charges due to increased volumes through a single point
 Better interest rates on borrowing and lending due to increased volumes
 Reduced external foreign exchange due to internal netting off
 Allows the employment of experts due to the volume of work required

5.3 Cash management models

5.3.1 Baumol model
This model is based on the same principles as the inventory EOQ model and identifies the optimal cash
holding level. When obtaining cash there are two relevant costs which need to be minimised:
(1) The cost of obtaining new funds (F)
(2) The cost of holding cash for a year (I)
The amount of cash to be raised (Q) can be calculated by using the following formula:

2FS

t
Q=

h 7
I
F

r i g 01
= Cost of obtaining funds

2
y
S = Amount of cash required per annum

o p ion
I = Cost of holding $1 for one year

C uit
And the total annual cost (TAC) is:

t
Annual order cost + Annual holding cost

t I n S Q

s
TAC = F +I

ir
Q 2

F
ILLUSTRATION 3.1

Reddies Co uses cash at the rate of $500 per month. It costs $20 each time cash is raised. The interest
rate is 24% per annum.
What are the amounts of cash to be raised and the total annual cost?
SOLUTION
F = $20
S = $500 × 12months = $6,000
I = $1.00 @ 24% = $0.24
2×20×6,000
Q = √ 0.24
= $1,000

6,000 1,000
TAC = 20 × 1,000 + 0.24 × 2
= $120 + $120 = 240

By raising $1,000 of cash whenever Reddies needs cash, the total annual variable costs are minimised
at $240.
AC C A F 9 3: Working capital management 27

5.3.2 Miller-Orr model

 The Baumol model assumes a constant use of cash which is unlikely in the real world.
 The Miller-Orr model is more realistic and allows for a varying cash balance and sets lower and
upper limits between which the amount of cash should be kept.
 If the upper limit is breached, then cash is invested (in e.g. T-Bills) to reduce the amount of cash
held and if the lower limit is breached, then cash is raised (by liquidating investments) to
increase the amount of cash held, to take the cash balance to the return point:

Cash
balance

Upper limit

The firm
buys securities

Spread
Return point

Co
Lower limit

Fir
The firm

st I pyri
sells securities

Time

ntu ght
itio
These three points are found as follows:
(1) Lower limit: this is set by the organisation and will normally be either nil or the overdraft limit

n2
017
FORMULAE GIVEN IN EXAM
(2) Return point = Lower limit + (⅓ × spread)
3/4 × transaction cost × variance of cash flows 1/3
(3) Spread = 3 ( Interest rate
)

(4) Upper limit = Lower limit + spread

28 3: Working capital management AC C A F9

LECTURE EXAMPLE 3.5

Oscillate Co has an overdraft limit of $40,000 which it does not want to exceed. The variance of its
daily cash flows is $400,000,000. The transaction cost of investing and raising funds is $575 and the
interest rate is 0.03% per day.
What are the spread, return point and upper limit for Oscillate Co using the Miller-Orr model?
SOLUTION

h t 7
i g 1
Investing short-term

y r 2 0
If an organisation has a short-term surplus, this can be used to:

o p ion
Offer more generous credit terms to customers

C uitReduce short term borrowing (e.g. overdrafts)

t
 Put on deposit on the money markets

t I n
r s
6 Determining working
i
capital needs and funding strategies

F 6.1 The level of working capital investment and key factors determining
this level
The level of working capital investment in current assets is the monetary value of inventories and
receivables. You may, for instance, be provided with the average receivables collection period and
thus have to calculate the trade receivables by rearranging the average collection formula (from
section 1.5)
The level of working capital investment in current assets will be determined by the following key
factors:

6.1.1 The length of the working capital cycle and terms of trade
 The working capital (or cash operating) cycle depends in part upon the level of current assets;
the higher the current assets, the longer the cash operating cycle and so the more cash there
will be invested in working capital.
 The more generous the terms of trade offered to customers, the higher receivables will be and
so once again the more cash there will be invested in working capital.
AC C A F 9 3: Working capital management 29

6.1.2 An organisation’s policy on the level of investment in current assets

 There is no such thing as a correct level of investment in current assets and so this is a
management decision based upon experience and the overall strategy of the organisation. This
will be reflected in the organisation’s policy on the level of investment in current assets.
 This will be driven by the organisation’s attitudes to risk, liquidity and profitability (aggressive or
conservative, per section 1.2)

6.1.3 The industry in which the organisation operates

 The level of current assets will be affected by the levels held by competitors. If competitors
have high inventory levels to allow customers a wide selection with immediate delivery, it will
be difficult not to match this.
 If competitors offer 90-day credit terms, again it will be difficult not to match this. So industry
norms will have a significant influence on the level of current assets.
 For example, supermarkets will have shorter operating cycles (due to high power over suppliers,
cash sales and low inventory (due to the perishable nature of their stock)), whereas
manufacturers whose customers are businesses may need to hold greater stocks of inventory
and offer trade credit (leading to increased operating cycles and investment in working capital).

6.2 Key factors in determining working capital funding strategies

Fir Co
st I pyri
6.2.1 The distinction between permanent and fluctuating current assets
 The overall level of current assets is likely to vary over time; this is particularly obvious if we

ntu ght
think of a seasonal business. The level of current assets will fluctuate between a minimum and
maximum level.

itio
The minimum level represents a permanent long-term requirement from a funding point of

n2
view; whereas the range between the minimum and maximum represent a temporary short-
term requirement.

017
6.2.2 The relative cost and risk of short-term and long-term finance and the matching
principle
 Long term funding is relatively expensive but is lower risk, as once it is raised, assuming there is
no breach of any terms, it may be kept for the long term whether or not it is required.
 Short-term funding is relatively cheap (due to liquidity preference theory, see Chapter 7) but is
higher risk, as once it is repaid there is no guarantee that it will be replaced even if it is required.
 The matching principle states that long term investments should be financed with long term
finance e.g. people buy their homes with 25-year mortgages; and short term investments
should be financed with short term finance e.g. if you don’t have enough money to last until
your next pay day, you use an overdraft.
30 3: Working capital management AC C A F9

The aggressive approach

As short-term funding is the cheapest source of finance, the most cost effective approach is to finance
all of your current assets with short term finance. However, as there is no guarantee that this finance
will be available when required, this is a very high risk strategy which should only be used if the
organisation is confident of always being able to raise the required short-term finance. This strategy is
called the aggressive funding policy.

Fluctuating current assets

Short-
term
funds
Total
assets Short-
term
funds
Permanent current assets

Long-
Non-current assets term
funds

ht 7
Time

r i g 201
y
p ion
o
C uit
The conservative approach

n t
Alternatively, long-term finance could be used to fund all of your current assets, this would be more

I
t
expensive, but the organisation will know that it will not run out of funding and so is safe.

s
Consequently, this is referred to as the conservative funding policy.

F ir Fluctuating current assets Long-

term
funds

Total
assets
Long-
term
Permanent current assets funds

Long-
Non-current assets term
funds
AC C A F 9 3: Working capital management 31

The matching approach

The matching funding policy uses long term funding for the minimum permanent current assets and
uses short term finance for the range between the minimum and maximum. However there is still a
risk that the required short term finance cannot be found.

Fluctuating current assets

Short-
term
funds
Total
Assets Long-
term
funds
Permanent current assets

Long-
Non-current assets term
funds

Fir Co
st I pyri
ntu ght
6.2.3 Management attitudes to risk, previous funding decisions and organisation size


itio
If management are high risk takers they are likely to adopt the aggressive funding policy and if
they are risk averse they are likely to adopt the conservative funding policy. In practice most

n2
managers will be somewhere in between these two extremes and so the matching funding
policy is very popular.



017
Previous funding decisions for current assets will also influence the current decision as if these
are seen as having been successful they are more likely to be repeated.
Finally, larger organisations are able to raise funds relatively easily and so the risks of the
aggressive funding policy may not in fact be that high.
 Smaller organisations find fund raising significantly harder and find raising long-term finance
even harder than short term-finance and so, ironically, may be forced into the aggressive
funding policy despite the high risks involved.
32 3: Working capital management AC C A F9

ht 7
r i g 201
y
p ion
o
C uit
I n t
r s t
F i
 33

Investment appraisal

Fir Co
1 Investment appraisal techniques
st I pyri
1.1 Relevant cash flows
ntu ght
itio
In investment projects it is important that the appraisal is based upon the correct information.

n2
The correct financial figures are the relevant costs. A relevant cost is defined as a future incremental
cash flow. In other words for a figure to be relevant it must pass three tests:
(1) Future
–
017
A decision being made today cannot change the past and so only future costs are
considered.
– Past costs are sometimes referred to as sunk costs and are not relevant and so are
ignored e.g. the price paid for something which is already owned.
(2) Incremental
– Only those costs that are affected by the decision are incremental and therefore
relevant.
– Costs that are sometimes referred to as committed costs and are not relevant and so are
ignored e.g. unavoidable fixed costs.
– Businesses need to consider lost opportunity costs (revenue / contribution lost from
diverting resources away from an alternative use), which are also relevant.
– Businesses also need to consider the deprival value (the relevant cost of using capital
items on a new project instead of continuing with their current use). A useful diagram for
determining the deprival value for capital items is shown below:
34 4: Investment appraisal AC C A F9

Lower of

Higher of

Replacement cost
Net Realisable Value Value in Use

(3) Cash flows

– These are factual and not based upon accounting conventions. Also organisations live or
die due to their cash position. So non-cash flows are not relevant e.g. depreciation.

LECTURE EXAMPLE 4.1

Proposal Co is considering investing in a new project. The following details have been obtained:
The project requires 1,200 kg of raw material. Proposal Co has 2,000 kg in inventory, bought two years
ago for $1.50 per kg, but no longer used for any of the firms' products. The current market price for
the material is $2.00 per kg, but Proposal Co could only sell it for $0.80 per kg.
100 hours of labour will be used on this project. There are 300 hours’ worth of spare labour capacity.

t
There is a union agreement that staff cannot be laid-off. The workers are paid $6.50 per hour.

g h 1 7
The variable overheads will total $34,564 and the fixed overhead rent $42,500.

i
y r 20
The project will require a machine which was bought four years ago for $20,000. This machine could

p ion
be scrapped now for $12,000. If it is kept it will generate $15,000. An identical machine can currently

o
C uit
be purchased for $14,000.
What are the relevant costs of this project?

I
SOLUTION
n t
r s t
F i
AC C A F 9 4: Investment appraisal 35

1.2 Payback period

The payback period is the time it takes for the net cash flow of a project to equal zero i.e. cash inflows
= cash outflows.

LECTURE EXAMPLE 4.2

Horizon Co is considering a project that will require an investment in machinery of $80,000 and which
will generate a net income of $15,000 in the first year, increasing by $5,000 each subsequent year. The
project is expected to last for five years and the machinery is not expected to have any residual value.
Calculate the payback period of this project.
SOLUTION
Annual cash flow Cumulative cash flow
$ $
Investment
First year
Second year
Third year

Co
Fourth year

Fir
st I pyri
ntu ght
itio
n2
The usefulness of payback as an investment appraisal method is: 017
 It is simple to calculate
 It is easy to understand, especially for non-accountants
 It uses relevant cash flows
 It can be used as an initial screening tool on projects before undertaking a more detailed review
 It (rather crudely) allows for risk

1.3 Return on capital employed (accounting rate of return)

The Return On Capital Employed (ROCE), or Accounting Rate of Return (ARR) as it is also known, is
calculated as follows:
Average annual profit of the project
ROCE = Average investment
× 100

Where:
(Total net cash flows – Total depreciation)
Average annual profit of the project =
Length of project
(Initial investment + Scrap value)
Average investment = 2

This measures the return made by the project from the amount of capital invested and so gives an
indication as to how efficient the project is at generating profits from its capital investment.
36 4: Investment appraisal AC C A F9

LECTURE EXAMPLE 4.2 CONTINUED (PART 2)

Calculate the ROCE for Horizon Co.

SOLUTION

ht 7
The ROCE usefulness as an investment appraisal method is:


r i g 01
It is simple to calculate

2
y


p ion
As a percentage the measure is familiar to non-accountants

o
 It looks at the entire project

C uit
 It reflects the way external investors judge the organisation

n t
1.4 Present Valuing

I
s t
When money is borrowed or invested, the amounts grow larger over time as interest is added,

r
i
however when appraising investments we want to know what they are worth to the organisation now,

F
so that we can directly compare different potential investments. Thus we need to calculate present
values.
To calculate the present value of a future value we can use the following formula:

FORMULA GIVEN IN EXAM

PV = FV × (1 + r)–n

Where:
FV = future value
r = period interest rate expressed as a decimal
n = number of periods
As the present value is lower than the future value, the multiplier is called the discount factor.
AC C A F 9 4: Investment appraisal 37

LECTURE EXAMPLE 4.3

Money Bags is expecting to receive $16,751 in six years. Interest rates will be 5% for the whole six
years.
Calculate the present value of Money Bags’ receipt.
SOLUTION

1.4.1 Annuities
Some investments generate a constant return, this is called an annuity. The present value of an
annuity can be calculated by using the following formula:

FORMULA GIVEN IN EXAM

Fir Co
st I pyri
1−(1+r)−n
PV = A ×
r

ntu ght
Where:

itio
PV = present value
A = constant return (starting in one year’s time)

n2
r = period interest rate expressed as a decimal
n = number of periods

LECTURE EXAMPLE 4.4 017

Henry Stanley is going to receive $150 every year for 12 years. The annual interest rate is 6%.
Calculate the present value of Henry Stanley’s annuity.
SOLUTION

FORMULA GIVEN IN EXAM

In the exam you are given Present Value and Annuity Tables where the discount factors for
individual cash flows and annuities have already been calculated for whole percentages from
1% to 20% for periods 1 to 15.
38 4: Investment appraisal AC C A F9

LECTURE EXAMPLE 4.3 REVISITED

Money Bags is expecting to receive $16,751 in six years. Interest rates will be 5% for the whole six
years.
Calculate the present value of Money Bags’ receipt using the discount tables.
SOLUTION

LECTURE EXAMPLE 4.4 REVISITED

Henry Stanley is going to receive $150 every year for 12 years, starting in one year’s time. The annual
interest rate is 6%.
Calculate the present value of Henry Stanley’s annuity using the discount tables.

t
SOLUTION

i g h 1 7
y r 20
o p ion
C uit
I n t
r s t
i
1.4.2 Delayed Annuities

F The annuity formula and annuity factors from the annuity table assume that the first cashflow will
occur in one year’s time.
If that is not the case, then the annuity formula / annuity factors should be used to calculate the value
as at one year before the start of the annuity. Then a discount factor may be used to find the present
value.

LECTURE EXAMPLE 4.5

Henry Stanley is going to receive $150 every year for 12 years, starting in four years’ time. The annual
interest rate is 6%.
Calculate the present value of Henry Stanley’s annuity.
SOLUTION
AC C A F 9 4: Investment appraisal 39

1.4.3 Perpetuities
Some annuities last forever, these are called a perpetuities. The present value of a perpetuity can be
calculated by using the following formula:
1
PV = A × r
Where:
PV = present value
A = constant return (starting in one year’s time)
r = period interest rate expressed as a decimal

LECTURE EXAMPLE 4.6

Victoria is expecting to receive $2,000 a year for ever, starting in one year’s time. Interest rates are
expected to remain constant at 5%.
Calculate the present value of Victoria’s perpetuity.
SOLUTION

Fir Co
st I pyri
1.4.4 Net Present Value

ntu ght
 Most investments will involve a series of cash outflows and inflows at different points in time.
 If we calculate the present value of each cash flow and then add all the present values together,

itio
we can calculate the Net Present Value (NPV) of the investment.

n2
 A positive NPV represents the present value of the excess return of the project over and above
the cost of capital, hence investments with a positive NPV should be undertaken (as the return


on the project beats the cost of financing the project)
Projects with a negative NPV should not be undertaken 017
LECTURE EXAMPLE 4.2 CONTINUED (PART 3)

The funding used by Horizon Co costs 10%.

Calculate the NPV for Horizon Co.
SOLUTION
Timing Cash flow Discount Factor Present Value
$ 10% $
0
1
2
3
4
5
NPV =
40 4: Investment appraisal AC C A F9

The net present value’s usefulness as an investment appraisal method is:

 It allows for the time value of money
 It shows the change in shareholders’ wealth
 It can allow for risk via the cost of capital
 It looks at the entire project

1.5 Internal Rate of Return

The Internal Rate of Return (IRR) is the discount factor which gives a zero NPV. As the discount factor
increases, the NPV reduces. As can be seen on the following diagram, this forms a curved relationship:

NPV

0 %

ht 7
g 1
_–
y r i 20
IRR

o p ion
C uit
I n t
Due to this curved relationship, finding the precise IRR would be very time consuming, so instead we

t
find an approximate IRR by finding two points on the curve and then assuming that there is a straight

ir s
line between them:

F NPV

NPV L ≈IRR

H
0 %
L
NPV H

_– IRR
AC C A F 9 4: Investment appraisal 41

We can then use the following formula to find this approximate IRR:
NPV
L
IRR ≈ L + NPV −NPV × (H – L)
L H

Where:
L = lower discount factor
H = higher discount factor

LECTURE EXAMPLE 4.2 (PART 4)

Calculate the approximate IRR for Horizon Co.

SOLUTION
Discount Discount
Timing Cash flow Factor Present Value Factor Present Value
$ 10% $ $
0 (80,000) 1.000 (80,000)
1 15,000 0.909 13,635
2 20,000 0.826 16,520
3 25,000 0.751 18,775

Fir Co
4 30,000 0.683 20,490

st I pyri
5 35,000 0.621 21,735
$11,155

ntu ght
itio
n2
017
The internal rate of return’s usefulness as an investment appraisal method is:
 It does not require the exact cost of funds to be known
 As a percentage the measure is familiar to non-accountants
 It looks at the entire project
 It provides a relative measure of performance

1.6 Advantages of discounted cash flow (DCF) methods over non-DCF

methods
DCF methods are superior to non-DCF methods because they:
 Allow for the timing of the cash flows
 Use the relevant costs and revenues
 Look at the impact of the entire project
42 4: Investment appraisal AC C A F9

1.7 The relative merits of NPV and IRR

The relative merits of NPV over IRR are:
 It provides a clear decision i.e. accept if positive, reject if negative
 It always gives the correct decision (when evaluating single projects, or mutually exclusive
projects)
 It always gives a single answer (some projects have more than one IRR)
 It maximises the shareholders’ wealth
The relative merit of IRR over NPV is:
 It is much easier for non-accountants to accept
 It does not require the exact cost of funds to be known

2 Allowing for inflation and taxation in discounted cash flows

2.1 Real vs. Nominal terms
 The interest rate set by the Bank of England allows for the current level of inflation and is called
the nominal interest rate (sometimes called the ‘money rate’).
 As inflation causes prices to rise, if you were to invest money at the nominal interest rate, you

t
would only benefit by the nominal interest after adjusting for the inflation rate. This net or

h 7
ignoring inflation return is called the real interest rate, as it shows how much better off you

r i g 01
really are.

y
p ion 2
The relationship between real and nominal interest rates is:

F
o
C uit
ORMULA GIVEN IN EXAM

I n t
(1 + i) = (1 + r) × (1 + h)

r s t
Where:

F ii
r
h
= nominal interest rate
= real rate
= general inflation rate
So there are two different rates;
 Real rate (excludes inflation, compensates the lender for the time value of money)
 Nominal rate (includes inflation, compensates the lender for TVM and inflation)
In choosing which rate to use we must be consistent:
 If the cash flows exclude inflation (‘real’ cashflows) then so must the discount factor
(‘real’ rate)
 If the cash flows include inflation (‘nominal’ or ‘money’ cashflows) then so must the
discount factor (‘nominal’ rate)
AC C A F 9 4: Investment appraisal 43

ILLUSTRATION 4.1

Rise Co is considering a project that will require an investment in machinery of $50,000 and which will
generate net income of $18,000 in the first year, $24,000 in the second year and $33,000 in the third
and final year. The cost of funds is 12%. None of these figures include inflation.
Calculate the NPV for Rise Co.
SOLUTION
Timing Cash flow Discount Factor Present Value
$ 12% $
0 (50,000) 1.000 (50,000)
1 18,000 0.893 16,074
2 24,000 0.797 19,128
3 33,000 0.712 23,496
NPV = $8,698

ILLUSTRATION 4.1 REVISITED

Fir Co
st I pyri
Inflation is currently 7% and is expected to remain at this level for at least the next three years in the
country where Rise Co operates.

ntu ght
Calculate the NPV for Rise Co including inflation.

itio
SOLUTION
To include inflation in the cost of funds we use the formula:

n2
017
(1 + i) = (1 + r) × (1 + h)

(1 + i) = (1 + 0.12) × (1 + 0.07)
(1 + i) = 1.1984
i = 0.1984 or 19.84%
Real cash Nominal Discount Present
Timing flow Inflation cash flow Factor Value
$ 7% $ 19.84% $
0 (50,000) 1.00 (50,000) 1.000 (50,000)
1 18,000 1.07 19,260 0.834 16,063
2
2 24,000 1.07 27,478 0.696 19,125
3
3 33,000 1.07 40,426 0.581 23,488
NPV = $8,676

Note. The small differences are due to rounding of discount factors to 3 d.p.
44 4: Investment appraisal AC C A F9

2.2 The impact of tax

 Businesses pay tax on their profits and hence, if a project makes a profit or loss then the
organisation will have to pay more or less tax.
 We will assume that tax is calculated on the net operating cash flows unless the Examiner
specifically tells us otherwise.
 If any equipment has been purchased, there will be a tax saving as a result of capital allowances
(sometimes referred to tax allowable depreciation).
 The best approach is to calculate the tax on the operating cash flows and the saving on capital
allowances as two separate figures.

ILLUSTRATION 4.2

Penalty Co is considering a project that will require an investment in machinery of $40,000 and which
will generate revenue of $27,000 in the first year, $37,000 in the second year and $49,000 in the third
and final year. The direct costs will equal 35% of the revenue and relevant overheads will be $9,000
each year. It is thought that the machinery will be sold for $19,000 at the end of the project.
Penalty Co pays 30% corporation tax on its net operating cash flows and can claim capital allowances
on the machinery at 25% on a reducing balance basis, with a balancing allowance or charge in the final
year. All tax is paid or saved at the end of year in which the cash flows arise. The cost of funds is 9%.

ht 7
Calculate the NPV for Penalty Co.
SOLUTION

r i g 201
Time
y
p ion
0 1 2 3

o
$ $ $ $

C uit
Revenue 27,000 37,000 49,000

t
Direct costs @ 35% (9,450) (12,950) (17,150)

I n
Overheads (9,000) (9,000) (9,000)

t
Net operating cash flows 8,550 15,050 22,850

ir s
Tax @ 30% (2,565) (4,515) (6,855)

F
Machinery (40,000) 19,000
Capital allowance savings (W1) 3,000 2,250 1,050
Net cash flow (40,000) 8,985 12,785 36,045
Discount Factor @ 9% 1.000 0.917 0.842 0.772
Present Value (40,000) 8,239 10,765 27,827

NPV = $6,831
Workings:

Capital Allowances (W1)

Time 1 2 3
Opening value of equipment 40,000 30,000 22,500
Closing value of equipment 30,000 22,500 19,000
Capital Allowances 25% reducing balance 10,000 7,500 3,500
Tax Saving at 30% 3,000 2,250 1,050
AC C A F 9 4: Investment appraisal 45

2.3 Working capital

When a company invests in a new project it may need to increase its investment in working capital
(e.g. increase the value of receivables and inventory held).
Any increase in working capital investment ties up cash, hence we need to treat this as a cash outflow
in our NPV calculation, with any decrease in working capital treated as a cash inflow.
Notes:
 The working capital investment for a new project will usually need to be in place at the start of
the project and released in full at the end of the project.
 If the level of working capital investment is increased at the end of a year, the incremental
change will be a cash outflow in that year (for any reduction in working capital investment the
incremental change will be a cash inflow)
 There is no tax payable or receivable on the working capital cash flows.

ILLUSTRATION 4.3
A company plans to make sales of £100,000 in year 1, increasing by 5% per annum until year 3 when
the project ends. Working capital equal to 15% of annual sales is required at the start of each year.

Fir Co
What are the working capital cash flows for the NPV calculation?

st I pyri
SOLUTION

ntu ght
Time 0 1 2 3
$ $ $ $

itio
Sales 100,000 105,000 110,250

n2
Working capital required (15% x sales) 15,000 15,750 16,538 0
Working capital CF (15,000) (750) (788) 16,538

017
46 4: Investment appraisal AC C A F9

2.4 Standard NPV calculation layout

2.4.1 Lead schedule ($000s)

Time 0 1 2 3 4 5
Revenue 0 250 220 200 190 170
Operating cashflows

Variable Costs 0 (100) (88) (80) (76) (68)

Contribution 0 150 132 120 114 102
Incremental Fixed Costs 0 (20) (20) (20) (20) (20)
Net Operating Cashflow 0 130 112 100 94 82
Tax @ 30% (if same year) 0 (39) (34) (30) (28) (25)
Capital cashflows

Capital Expenditure (400)

Scrap Value 100
Tax saving on Cap Allowances (W) 30 23 17 13 8
Working Capital (25) 3 2 1 2 17
Net Cashflow (425) 124 103 88 81 182

DCF @10% 1 0.909 0.826 0.751 0.683 0.621

t
(425) 113 85 66 55 113

h
Present Value

r i g 01 7
2
$7k

y
Net Present Value

o p ion
C uit
2.4.2 Capital allowance workings

I n t Capital Allowances (W)

t
Time 1 2 3 4 5

ir s Opening value of equipment 400 300 225 169 127

F
Closing value of equipment 300 225 169 127 100
Capital Allowances 25% reducing balance 100 75 56 42 27
Tax Saving at 30% (included in lead schedule) 30 23 17 13 8

2.5 Comprehensive example

 The Examiner likes to ask investment appraisal questions that bring together several of the
elements of the syllabus that have been covered so far.
 This can be seen in the following exam standard example.
AC C A F 9 4: Investment appraisal 47

LECTURE EXAMPLE 4.7

Funtime Co, a toy company, has developed a new game, ‘Zoom’, which it plans to launch in time for
the school summer holidays. Sales of the new game are expected to be very strong, following a
favourable review by a national newspaper. Sales and production volumes and selling prices for ‘Zoom’
over its four-year life are expected to be as follows:
Year 1 2 3 4
Sales and production (no. of games) 150,000 70,000 60,000 60,000
Selling price (per game) $25 $24 $23 $22
Financial information on ‘Zoom’ in current prices is as follows:
Direct material cost $5.40 per game
Other variable production cost $6.00 per game
Apportioned fixed costs $4.00 per game
Advertising costs to stimulate demand are expected to be $650,000 in the first year of production and
$100,000 in the second year of production. No advertising costs are expected in the third and fourth
years’ of production. ‘Zoom’ will be produced on a new production machine costing $800,000. Capital
allowances can be claimed at 20% on a straight-line basis, with a balancing allowance or balancing
charge in the final year. It is expected that the machine will be sold for $150,000 at the end of the
project.

Fir Co
Funtime Co pays tax on cash flows at the rate of 30% per year and tax liabilities are settled at the end

st I pyri
of the year in which they arise. Inflation at 3% pa is expected to apply to the production costs for the
duration of the project.

ntu ght
If the new game is launched then sales of another game ‘Skip’ would be reduced due to lack of
resources to devote to this other game. This reduction in sales would amount to 10,000 units per year.

itio
‘Skip’ currently earns a contribution of $15 per game and this would be expected to remain constant

n2
over the next four years.
Working capital equal to 10% of the annual sales revenue is needed at the start of each year. All
working capital will be released at the end of the project.
Required 017
Calculate the net present value of the proposed investment using an after tax nominal discount rate of
15%.
SOLUTION
48 4: Investment appraisal AC C A F9

ht 7
r i g 201
y
p ion
o
C uit
I n t
r s t
F i
AC C A F 9 4: Investment appraisal 49

3 Adjusting for risk and uncertainty in investment appraisal

3.1 Risk and uncertainty
 It is impossible to be sure as to what will happen in the future; there will always be a range of
possible outcomes.
 Risk is when there is a range of possible outcomes and the likelihood of those outcomes can be
quantified in the form of probabilities.
 Uncertainty is when there is a range of possible outcomes, but the likelihood of the outcomes
cannot be quantified
 As a project’s life increases it becomes harder to quantify the likelihood and so the outcomes
are more likely to be uncertain. There are a range of techniques to deal with both risk and
uncertainty in project appraisal:

3.2 Sensitivity Analysis (uncertainty)

Sensitivity analysis involves seeing how much the estimates used to make the original decision can
change before the decision becomes incorrect. The less they can change, the more sensitive the
decision.

Co
When calculating the sensitivity for a particular cash flow the following formula is used:

Fir
NPV

st I pyri
× 100%
PV of required variable

When calculating the sensitivity to the cost of capital, the following formula is used:
IRR - Cost of capital
× 100%
ntu ght
itio
Cost of capital

n2
ILLUSTRATION 4.2 (PART 2)

017
How sensitive is Penalty Co’s decision to invest in new machinery to changes in the sales volume,
overheads and cost of capital?
50 4: Investment appraisal AC C A F9

ht 7
r i g 201
y
p ion
o
C uit
The usefulness of sensitivity analysis in assisting investment decisions is:

t
 It gives an indication of how likely the project is to be successful

I n
 It indicates which forecasts should be researched further

t
 It also indicates which variables require the closest control once the project starts

ir s
F
3.3 Probability analysis and expected values (risk)
 If it is possible to identify the possible outcomes (x) and their associated probabilities (p). By
multiplying each outcome by its probability and adding all of the results together (∑px), an
expected value (probability-weighted average result) can be calculated.
 This expected value can then be used in investment appraisal.

LECTURE EXAMPLE 4.8

Possibly Co is considering a project which requires equipment costing $300,000.

In the first year the sales revenue will be $480,000. In the second year the sales figures will either be
high (probability 0.55) $650,000 or low (probability 0.45) $350,000. In the third and final year the sales
figures will either be high (probability 0.25) $600,000, medium (probability 0.6) $500,000 or low
(probability 0.15) $400,000. The direct costs will equal 60% of the revenue and relevant overheads will
be $54,000 each year.
It is thought that the equipment could be sold for either $160,000 (probability 0.4) or $110,000
(probability 0.6) at the end of the project, though it will not be eligible for capital allowances.
Corporation tax will be 35% of the net operating cash flows for the next three years. All tax is paid or
saved at the end of year in which the cash flows arise. The cost of funds is 13%.
AC C A F 9 4: Investment appraisal 51

(a) Calculate the expected net present value of the project being considered by Possibly Co.
(b) What is the probability that the total revenue exceeds $1,600,000?
SOLUTION
(a)
Time 0 1 2 3
$ $ $ $
Expected revenue (W1)
Direct costs @ 60%
Overheads
Net operating cash flows
Tax @ 35%
Equipment (W2)
Net cash flow
Discount Factor @ 13%
Present Value

Fir Co Expected NPV = $

st I pyri
Workings:

ntu ght
itio
n2
017
52 4: Investment appraisal AC C A F9

The usefulness of probability analysis in assisting investment decisions is:

 It allows us to evaluate risky investments
 It allows us to quantify the risk
The limitations of using probability analysis are:
 Expected values are not meaningful in one off decision making situations since they represent a
long run average value. Take the example above, achieving sales of $510k will not happen (it
will either be $600k, $500k or $400k) in an individual year. Hence, expected values are more
appropriate for assessing decisions or cashflows which will be repeated.
 Expected values ignores the spread of possible returns (i.e. risk), as they average the outcomes.
A separate measure is needed to show the spread of possible returns (such as the standard
deviation or simulation).
 Expected values rely on the accuracy of the probabilities used.

3.4 Other techniques to cope with risk and uncertainty

3.4.1 Simulation
 In real life investment appraisal situations there will often be a very large number of variables
with a large range of possible values.

t
 In such situations, expected value analysis alone may not be appropriate and hence simulation

h 7
is used.


r i g 01
Simulation involves identifying each of the different variables, the range of the different values

2
y
p ion
of those variables and the probabilities of those values.

o
 Hundreds, thousands or more simulations are then run to record the NPVs of the project for

C uitdifferent combinations of values for the different variables (using random numbers and

t
computers to select values for each of the variables).


t I n
The results then show the expected NPV and the distribution of possible NPV values.

ir s
3.4.2 Risk-adjusted discount rates

F  As we have already seen the discount factor reduces the future cash flows to allow for the time
value of money.
 As the future cash flows also contain risk, the discount factor can be adjusted to reflect this risk.
So a project with more risk would have a higher discount factor applied to it and so the NPV
would be reduced to reflect this risk.

3.4.3 Adjusted payback

 The adjusted payback (also known as discounted payback) involves adjusting the cash flows in
the payback calculation to take account of the risk.
 In practice this means reducing the future cash flows to reflect the risk in the estimated figures.
As forecasting is generally harder the further into the future you predict, the reduction needs to
be greater for more distant figures.
AC C A F 9 4: Investment appraisal 53

LECTURE EXAMPLE 4.2 REVISITED (PART 5)

Horizon Co now realises that the payback period it has already calculated is too simplistic and so it is
considering using an adjusted payback by discounting the cash flows to reflect the risk in these
forecasts, using its cost of funds.
Calculate the adjusted payback period of this project.
SOLUTION
Time Cash flow Discount factor Present value Cumulative PV
$ 10% $ $
0 (80,000) 1.000 (80,000)
1 15,000 0.909 13,635
2 20,000 0.826 16,520
3 25,000 0.751 18,775
4 30,000 0.683 20,490
5 35,000 0.621 21,735
 This is more appropriate than using undiscounted cashflows, as it factors in the time value of
money and uncertainty surrounding later cashflows.


Fir Co
However, the adjusted payback method still suffers from the same shortcomings as the

st I pyri
standard payback period (e.g. no consideration of cashflows later than the payback date, the
need for a target payback period to compare to).

ntu ght
4 Specific investment decisions itio
n2
017
4.1 Lease vs. buy
 Once an organisation has decided to acquire an asset it then needs to decide how it is going to
finance this acquisition. The two alternatives we are going to compare here are leasing the asset
or borrowing the required funds and buying the asset.
 The most significant difference between these two alternatives is that with a lease, the
organisation (lessee) is not the legal owner; whereas if the asset is purchased then the
organisation is the legal owner.
 Legal ownership is particularly important when considering taxation. Only the legal owner can
claim capital allowances, however the lease payments are assumed to be fully tax allowable.
 Any disposal proceeds are also only received by the legal owner and so are also a relevant cash
flow.
 To evaluate these two alternatives we discount the relevant cash flows and see which option is
cheapest. We can discount the cash flows using any discount factor, however it is
recommended to use the cost of borrowing.
 The reason for this is that we can then avoid calculating and including the loan repayments and
interest and instead just put in the amount borrowed e.g. If you borrow $1,000 for one year at
10% interest, in one year you will have to repay $1,100. If you discount this at 10%, the present
value is $1,000 i.e. the amount borrowed.
54 4: Investment appraisal AC C A F9

4.1.1 Before- and after-tax discount rates

If in cash flows we allow for the impact of tax; to be consistent we should also allow for the impact of
tax on the discount rate.
Let us compare two companies both earning the same amount, however one has borrowed $1,000
and pays 10% interest and the other has not:
No Interest Co Interest Co
$ $
Earnings 800 800
Interest nil (100)
800 700
Tax @ 30% (240) (210)
After tax earnings 560 490

So despite paying $100 of interest, Interest Co after tax earnings are only $70 lower than No Interest
Co. Hence the after-tax cost is:
10% (1 – 0.30) = 7%
Or in more general terms:
Before-tax rate (1 – tax rate) = After-tax rate
 If we are discounting post-tax cashflows, then we need to use a post-tax discount rate.


ht 7
Therefore, if tax is included in the cash flows in a lease vs buy calculation the cash flows

i g 1
should be discounted at an after- tax cost of borrowing.


y r 20
The examiner may provide you with a discount rate which is already post tax – hence it’s

p ion
very important to read the question

o
C uit
ILLUSTRATION 4.2 (PART 3)

I n t
t
Penalty Co has decided that it would like a machine costing $40,000. It can either borrow the money

r s
from its bank at an interest rate of 13% or a leasing company has offered to lease the machine to

F i
Penalty Co for three years at an annual cost of $11,300. It is thought that the machine can be sold in
three years’ time for $19,000.
Would it be better for Penalty to lease or borrow and buy this machine?
SOLUTION
Lease:
Timing Cash flow Discount Factor Present Value
$ 13% $
1–3 (11,300) 2.361 (26,679)
Borrowing and buy:
Timing Cash flow Discount Factor Present Value
$ 13% $
0 (40,000) 1.000 (40,000)
3 19,000 0.693 13,167
$(26,833)

The two alternatives are very close, but the lease is marginally cheaper.
In the previous example we ignored tax. As we earlier, tax reduces the cost of debt and brings in tax on
the operating cash flows and capital allowances.
AC C A F 9 4: Investment appraisal 55

ILLUSTRATION 4.2 (PART 4)

Would it be better for Penalty to lease or borrow and buy this machine after allowing for tax?
SOLUTION
The after tax cost of borrowing = 13% (1 – 0.30) = 9%
Lease:
Time 0 1 2 3
$ $ $ $
Payments (11,300) (11,300) (11,300)
Net operating cash flows (11,300) (11,300) (11,300)
Tax saved @ 30% 3,390 3,390 3,390
Net cash flow (7,910) (7,910) (7,910)
Discount Factor @ 9% 0.917 0.842 0.772
Present Value (7,253) (6,660) (6,107)

NPV = $(20,020)
Borrow and buy:

Fir Cop
Time 0 1 2 3

st I yri
$ $ $ $
Borrow (40,000)

ntu ght
Machinery 19,000
Capital allowance savings (W1 from 3,000 2,250 1,050

itio
illustration 4.2 part 1)
Net cash flow (40,000) 3,000 2,250 20,050

n2
Discount Factor @ 9% 1.000 0.917 0.842 0.772
Present Value (40,000) 2,751 1,894 15,479

017
NPV = $(19,876)
The two alternatives are still very close, but now borrow and buy is marginally cheaper.

4.2 Asset replacement decisions using equivalent annual cost

Sometimes an investment decision will involve choosing between two alternatives where the benefits
are unequal e.g. comparing renting one property for five years and an alternative for seven years.
In such situations comparing the NPV’s would not necessarily give the correct decision and so instead
we calculate the equivalent annual cost (EAC):
NPV
EAC = Annuity factor for the project life

 The EAC represents a constant annual cashflow that has the same present value as the actual
cashflows arising under each proposal. The proposal with the lowest EAC should be chosen.
 We are assuming that the replacement will keep happening forever.
56 4: Investment appraisal AC C A F9

LECTURE EXAMPLE 4.9

Mobile Co is trying to decide whether to replace its grinding machines every one, two or three years.
Each machine costs $7,000. Mobile Ltd has a cost of capital of 12%. Costs and scrap value data is as
follows:
Year 1 2 3
$ $ $
Maintenance costs 500 1,000 1,500
Running costs 2,500 3,000 3,250
Year-end scrap value 5,000 3,500 2,500
What is the optimum replacement cycle for the machines?

ht 7
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y
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o
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I n t
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F i
AC C A F 9 4: Investment appraisal 57

4.3 Investment decisions under single period capital rationing

Single period capital rationing describes the situation where an organisation does not have sufficient
funds to undertake all positive NPV projects at one particular point in time.

4.3.1 The calculation of profitability indexes for divisible investment projects

 If the investment projects are divisible, this means that part of a project could be undertaken
and a comparable part of the positive NPV generated.
 In such situations we need to rank the projects by identifying the net present value generated
from the current investment or in other words, how much NPV do we generate from each $1 of
investment. This measure is known as the Profitability Index (PI):
Net Present Value
PI = Initial investment

ILLUSTRATION 4.4
Short Co is trying to choose between four projects, all of which have positive NPV’s, however Short
only has $1,000,000 to invest. Details of the four projects are as follows:
Project: A B C D
$ $ $ $

Fir Co
Initial investment (300,000) (370,000) (143,000) (1,000,000)
PV of future cash flows

st I pyri
445,000 500,000 200,000 1,340,000
NPV 145,000 130,000 57,000 340,000

ntu ght
All four of the projects are divisible.

itio
What is the optimum investment policy for Short Co?
SOLUTION
Project: A
n2 B C D

017
$ $ $ $
NPV 145,000 130,000 57,000 340,000
Initial investment 300,000 370,000 143,000 1,000,000
Profitability Index 0.48 0.35 0.40 0.34
st rd nd th
Ranking 1 3 2 4

Project Proportion NPV Funds available/required

% $ $
1,000,000
A 100 145,000 (300,000)
700,000
C 100 57,000 (143,000)
557,000
B 100 130,000 (370,000)
187,000
D 18.7 63,580 (187,000)
$395,580 Nil

So Short Co should do all of projects A, C, and B and 18.7% of D.

58 4: Investment appraisal AC C A F9

4.3.2 The calculation of the NPV of combinations of non-divisible investment projects

If the investment projects are non-divisible, this means that either the whole project is undertaken or
none of it is undertaken.
In such situations we need to identify all possible combinations of whole projects that can be
undertaken and then select the combination with the greatest total NPV.

ILLUSTRATION 4.4 CONTINUED

Short Co now realises that the four projects are non-divisible.

What is the optimum investment policy for Short Co?
SOLUTION
Possible combinations Required investment Total NPV
$ $
A, B & C 813,000 332,000
D 1,000,000 340,000
So Short Co should undertake project D

t
4.3.3 A discussion of the reasons for capital rationing

g h 1 7
Capital rationing can be caused by two different reasons:

i
(1)

y r 20
The organisation would like to raise more funds, but no stakeholder is prepared to invest. This is

p ion
known as hard capital rationing and may result from the potential returns not being high

o
enough to compensate for the perceived risks involved.

C uit
(2) The organisation could raise more funds, but has internally decided not to. This is known as soft

t
capital rationing and may result from a concern that the available finance is too expensive or

t I n
may result in a loss of control.

ir s
F
 59

Business finance

Fir Co
1 Sources of and raising business finance
st I pyri
ntu ght
1.1 Identify and discuss the range of short-term sources of finance
available to businesses
itio
1.1.1 Overdraft
n2
017
An overdraft is an overdrawn balance on a current account and is the most common form of bank
funding. This is due to their flexibility and ease of operation; a facility letter is all that is required to
initiate this facility. In the UK overdrafts are strictly repayable on demand. Interest which is variable
and calculated daily tends to be at a higher rate than other short-term sources of finance.

1.1.2 Short-term loan

A short-term loan is where a fixed amount of funds are borrowed for a fixed period (of less than one
year) of time at the end of which the full amount has to be repaid. Interest is charged on the total
amount borrowed either at a fixed or variable rate.

1.1.3 Trade credit

Trade credit refers to the provision of credit by trade suppliers. This is an important source of
financing for current assets. Trade credit is often described as a ‘free’ source of finance as interest is
not charged, however delayed payment could result in the loss of a settlement discount, interest being
charged on the overdue amount (Late Payment of Commercial Debts (Interest) Act 1998) or the loss of
future credit.

1.1.4 Lease finance

Short-term lease finance is in the form of an operating lease where finance is provided specifically to
access the use of a particular asset e.g. a photocopier. The legal ownership of the asset remains with
the lessor, however the lessee has physical use of the asset and makes (normally monthly) payments
60 5: Business finance AC C A F9

for doing so. This is consequently very similar to renting an asset and due to the security provided by
the asset, operating leases are often available to organisations that may find it difficult to obtain other
sources of finance because of their poor credit rating.

1.2 Identify and discuss the range of long-term sources of finance available
to businesses
1.2.1 Equity finance
Equity finance normally takes the form of ordinary shares and these denote ownership of the
business. This is the primary risk capital as if the business fails, it is the last to be paid, conversely
however if the business is a success it will receive the greatest benefit in the form of increasing
dividends and share prices.
Preference shares also exist, but these tend not to denote ownership and receive a fixed return in the
form of a set dividend. As the Preference dividend is paid before the Ordinary dividend, Preference
shares are also sometimes referred to as prior charge capital.
Issuing equity finance will reduce the level of gearing and assuming the business expansion results in
increased profits, interest coverage would also improve and financial risk would fall.

1.2.2 Debt finance

t
Debt finance takes the form of a long term loan which is normally secured on some of the

h 7
organisations assets and receives regular interest payments. Thus compared to equity finance, debt

r i g 01
finance is relatively low risk and so receives a commensurately low return. Debt is also referred to as

y 2
debentures, bonds, loan stock and loan notes.

o p ion
C uit
1.2.3 Lease finance

t
Long-term lease finance is in the form of a finance lease where a lessee selects an asset which the

n
lessor purchases and then leases to the lessee. Substantially all of the risks and rewards of ownership

t I
are transferred to lessee. Thus this is very similar to debt finance however the finance is provided for a

s
r
specific (long term) asset.

F i 1.2.4 Venture capital

Venture capital refers to higher risk finance provided by venture capitalist companies. This will
normally take the form of an investment in ordinary shares and unsecured debt in an unlisted
company for a period of around five years at the end of which time the venture capitalist will look for
an exit route either by listing or selling the company. In this way they can realise their investment. The
venture capitalist will normally insist on Board representation.

1.3 Identify and discuss methods of raising equity finance

1.3.1 Rights issue
 A rights issue is where a company offers further shares, at a fixed price which is normally below
the current market price, to existing shareholders in proportion to their existing holding.
 This will reduce the level of gearing (as for any issuance of ordinary shares).
 It is possible to calculate what the share price will theoretically be immediately after the rights
issue using a weighted average approach; this is known as the theoretical ex rights price (TERP).
 The TERP is calculated before taking into account what use the proceeds will be put to.
Total share value before+proceeds from issuance−issue costs
 TERP = Total shares before+new shares issued
AC C A F 9 5: Business finance 61

The value of a right

Shareholders may wish to sell their rights, instead of taking up their rights. The value of a right to a
new share (which they could charge) = TERP – rights issue price.
If asked for the value of the right per existing shares divide the above answer by the number of
existing shares that need to be held in order to be able to get a new share under the rights issue.

Evaluating the use of the proceeds of a rights issue

A common question that the examiner may pose is to evaluate the proposed use of the proceeds of a
rights issue.
In order to do this, we need to:
(i) Calculate the TERP
(ii) Calculate the expected share price after the proceeds have been put to use (this may be
via a P/E ratio given in the question).
(iii) Compare the TERP to the expected new share price.
(iv) If the expected new share price < the TERP, then shareholders will make a loss
(v) If the expected new share price > the TERP, then shareholders will make a gain

Co
LECTURE EXAMPLE 5.1

Fir
st I pyri
White Spirit Co currently has 10m shares in issue (valued at a current share price of $2.40) and
generated profits after tax of $2m in the last year.

ntu ght
White Spirit intends to raise $4.288m for a new investment opportunity via a rights issuance at a

itio
discount of 25% to the current share price. The issue costs are expected to be $212,000.

n2
The board member proposing the project insists that the project will increase White Spirit’s profits
after tax by 15% and will not affect the price-earnings ratio of White Spirit (which is expected to

017
remain constant).
(a) What is the theoretical ex rights price?
(b) What is the value of one right?
(c) Calculate whether the proposed use of the rights issuance funds will be financially acceptable to
the shareholders of White Spirit Co
SOLUTION
62 5: Business finance AC C A F9

1.3.2 Private placing

A placing is where the shares are sold privately to clients of an issuing house at a fixed issue price. This
is a relatively simple and cheap method of raising equity finance.
This will however dilute the ownership and control of existing shareholders but will not require
security (unlike most debt) and will also reduce the level of gearing.

1.3.3 Public offers

A public offer is where shares are offered directly to the public either at a fixed price or by tender.

t
 Fixed price offer: This is where shares are offered directly to the public at a fixed price. The

h 7
issuance may be underwritten (by an investment bank) in order to reduce the risk to the

r i g 01
company of less than full subscription.

2

y
p ion
Offer for sale by tender: This is where shares are offered to the public, but no fixed price is set.

o
Instead, potential investors bid for shares with a striking price set based on demand. These

C uit
issuances are often via an issuing house (investment bank) which will also underwrite the

t
issuance and are rarer than fixed price offers.

t I n
1.3.4 Stock exchange listing

ir s
A stock exchange listing is where a company has its shares listed on a recognised stock exchange by

F
fulfilling certain criteria:
In the UK in order to obtain a listing on the main market a company must have at least a three year
trading history, be worth at least £700,000 and at least 25% of the shares must be in the hands of the
public.
Such shares have a secondary market i.e. they can be traded between individual shareholders, and this
makes it considerably easier to issue further shares. It is common for companies to simultaneously
obtain a listing and issue more shares – this is called an initial public offer (IPO)

1.4 Factors to consider when raising finance

Having identified the different sources of finance, the Examiner sometimes asks what practical factors
should be considered before deciding on the source of finance to be used. Here it is worth considering
matching, cost and capital providers.

1.4.1 Matching
A fundamental principle of financing is that the type/source of funds used should match the use of
those funds. Matching can cover the following variables:
AC C A F 9 5: Business finance 63

Duration – long term funds (e.g. mortgage) used to fund long term acquisitions (e.g. house purchase)
and shorter term funds (e.g. three-year loan) used to finance shorter term items (e.g. car). A short
term shortfall in day to day spending could be financed with an overdraft.
Currency – An investment in a foreign asset could be funded with a foreign source (e.g. currency loan,
Eurobond issue, equity issue in foreign currency), which will reduce exposure to foreign exchange rate
movements (covered in Chapter 7).
Pattern of cash flows – try to mirror the pattern of receipts from projects with the pattern of
payments made on the finance. High risk projects where the potential returns are high but by no
means certain, may be more suited to being financed with equity where returns are not obligatory.
Projects with regular steady income may be able to support the use of debt finance.

1.4.2 Cost
Cost covers many areas and is an important factor when looking into raising finance. It is sensible to
split this into issue costs and on-going servicing costs.
Issue costs will include the following:
 Arrangement fees
 Underwriting fees
 Prospectus printing costs
 Advisers’ fees (e.g. merchant bankers, accountants, lawyers)

Fir Co
In general it is much cheaper to issue debt than shares in terms of the above issue costs.

st I pyri
The on-going servicing costs will include dividends with equity and interest payments with debt.
Generally, required returns on equity will be higher than those on debt due to equity being the highest

ntu ght
risk form of finance from the provider’s point of view (see later in this chapter). Other on-going cost
factors to consider include:

itio
Tax (interest is tax deductible for the company whereas dividends are not). This makes debt

n2
finance attractive.


017
Reporting/Information provision required. If raising debt finance the banks/investors may well
require regular information (e.g. monthly detailed accounts).

1.4.3 Capital providers

Any existing or potential future capital provider’s positions need to be assessed in terms of areas such
as:
 Impact on gearing? (debt covenants, future borrowing capacity etc.)
 Impact on control? (new share issue will dilute control unless it’s a fully subscribed rights issue)
 Impact on EPS?
 How much is needed?
As well as these factors you need to look at the current state of the market (is it a good time to be
issuing shares? What about the “credit crunch”?) and the type of company; is it private or listed.

1.5 Islamic finance

Major difference between Islamic finance and the other forms of business finance
Islamic finance is consistent with the principles of Islamic (Shariah) law which prohibits the payment or
acceptance of interest for loans.
64 5: Business finance AC C A F9

The concept of “Riba” (interest) and how returns are made by Islamic financial securities
(calculations are not required)
 The word “Riba” means excess, increase or addition and in the form of interest is forbidden by
the Qur’an.
 Conventional banks aim to profit by accepting money deposits in return for the payment of
interest and then lending money out in return for the payment of a higher level of interest.
 Islamic finance does not allow the use of interest - returns are made by sharing the profits and
losses of the business with the finance providers. Islamic financial instruments include:

1.5.1 Trade credit (Murabaha)

 A Murabaha transaction involves a bank buying an asset and then selling on to a business for a
marked-up price (agreed when purchase is made). The business will then pay the amount due in
instalments.
 The overall idea here is that goods can be bought and then sold at a higher price to make a
profit. These goods are then paid for with the mark-up element being paid for out of the profits.

1.5.2 Lease finance (Ijara)

 An Ijara transaction is the Islamic equivalent of a lease and works in exactly the same way as
conventional leases except if it is a finance lease the lessor remains responsible for major

t
maintenance and insurance costs. The use of the asset will be specified in the contract.


i g h 1 7
The reason such leases are allowed is because the payments being made by lessee, are rental

y r 20
payments not interest payments i.e. the asset is being rented from its owner.

o p ion
1.5.3 Debt finance (Sukuk)

C uitA Sukuk transaction is where a business asset with a life of three to five years is bought and paid

n t
for by a third party or parties. The business then uses this asset to earn profits which it then

t I
shares with the third party or parties (i.e. there is no interest).

ir

s If the asset makes a loss, this is also shared with the third party or parties.

F 1.5.4 Equity finance (Mudaraba)

 A Mudaraba transaction is a partnership between a partner who provides the capital and
another partner who provides the time, skill and expertise required by the business. The
partners share in any profits made by the business and the capital provider suffers any losses.
 Interest cannot be charged for the capital invested.

1.5.5 Venture capital (Musharaka)

 A Musharaka transaction is where two or more partners provide both the capital and the time,
skill and expertise required by the business.
 These partners all share in the profits in a ratio agreed in their original contract. Losses are
always shared in proportion to the capital contributions.

1.6 Identify and discuss internal sources of finance

Retained earnings
A company ultimately exists for the benefit of its shareholders and so when it makes money, it is the
shareholders’ money. However a company does not have to hand this money over to its shareholders;
it can instead keep and invest these funds.
AC C A F 9 5: Business finance 65

Such funds are described as retained earnings. These should not be confused with retained profits, as
you can only invest the cash that retained profits generate!

Increasing working capital management efficiency

We saw in Chapter 3, that working capital requires an investment of funds, however if the amount of
working capital can be reduced then the corresponding level of investment will also be reduced and
the cash released can be used to invest elsewhere in the business.

2 The relationship between dividend policy and the financing decision

The dividend policy is the decision over how much of the money that the company has made should
be paid out to its shareholders. Paying a bigger dividend has two impacts on the financing decision:
 The company will have less money left and is thus more likely to face capital rationing or to
have to raise more finance;
 The shareholders will have received more income from their investment and are thus more
likely to be prepared to invest further.
Having said this, the issuing of more shares will incur issue costs and so most companies that require
further funding tend to pay lower dividends.

Co
2.1 Theoretical considerations for dividend policy
Fir
st I pyri
There are two main theories with regards to the dividend decision:
(1) Residual theory

ntu ght
Dividends are paid out only after all projects with a positive NPV have been financed. Whatever

itio
cash is left (i.e. the residual amounts) is returned to shareholders as a dividend. This would
seem to be consistent with the concept of trying to maximise shareholder wealth but can lead

n2
to an erratic dividend.

017
(2) Irrelevancy theory
American economists Modigliani & Miller stated that the pattern of dividends paid by a
company is irrelevant in a tax-free world, based on the following logic:
 A company will always invest in positive NPV projects.
 If the company can’t invest in a certain project out of its retained earnings (due to a
dividend having been paid out), then it will need to raise funds from other sources (which
M&M assume will always be possible for positive NPV projects).
 This will potentially lead to existing shareholders receiving proportionately less of the
returns from the new project, but this loss will be offset by the dividend they are
receiving now.
 Hence, the ultimate pattern of dividend payments is irrelevant.
Modigliani and Miller stated that if a firm’s dividend policy was not to the taste of shareholders,
the shareholders could take action:
 If the dividend is lower than desired, simply sell a few shares to create some extra
income to replicate an increased dividend (a ‘manufactured dividend’)
 If the dividend is higher than desired, simply use the ‘excess’ dividend to buy some
additional shares.
In reality, tax and transaction cost implications means this logic is flawed.
66 5: Business finance AC C A F9

2.2 Practical considerations for dividend policy

In practice, there are other influences which need to be considered.

2.2.1 Shareholder expectations (Clientele Effect)

The directors propose the level of dividend; the shareholders either accept it and are paid or reject it
and receive nothing. Having said this, the shareholders select the directors and so the directors will
generally try to fulfil their shareholders expectations. These expectations will be significantly
influenced by historic dividends.
 Companies attract shareholder because of their historic dividends on the expectation that these
patterns will continue in the future (shareholders may favour the existing policy due to tax
preferences for income vs. capital gains, or the need for cashflow).
 This is known as the clientele effect.
 If a company changes its dividend policy, then existing shareholders may seek to sell their
shares (causing the share price to fall) and reinvest in companies whose dividend policies meet
their needs.

2.2.2 Signalling
In Chapter 6 you will see how investors do not have perfect information and capital markets are, at
best, semi-strong efficient. Hence, investors will look for information contained in dividend

ht 7
announcements and react to it, causing share price movements:


r i g 01
If a company cuts its dividend, investors may interpret this as a sign of bad news and seek to sell

2
y
their shares, leading to a reduction in share price


o p ion
If a company increases its dividend, investors may interpret this as a sign of improved future

C uit
prospects and purchase shares in the company, increasing the share price.

n t
2.2.3 Legal constraints

I
r s t
Legally a dividend can only be paid from accumulated profits. A dividend can exceed this year’s profit

i
only if the company has sufficient retained profit from previous years.

F 2.2.4 Liquidity
The dividend is an optional cash outflow, which by definition reduces the liquidity of the company. Thus a
dividend should only be paid if the company is left with or has access to sufficient cash to remain solvent.

2.3 Alternatives to cash dividends

As the dividend is proposed by the directors who are viewed as being the most knowledgeable about
their company’s present and future prospects; the dividend also sends a signal to the market which
will influence the share price.
If a company does not want to pay a cash dividend, the following alternatives are available:
(a) Scrip dividend
A scrip dividend is a dividend paid by the issue of additional company shares, rather than by
cash. It is offered pro rata to existing shareholdings.
From a company point of view this has the advantage of preserving a company's cash position if
a substantial number of shareholders take up the offer and will decrease the company's gearing
(due to retained profits remaining higher), and may therefore enhance its borrowing capacity.
AC C A F 9 5: Business finance 67

There are also disadvantages of scrip dividends. Assuming that dividend per share is maintained
or increased, the total cash paid as a dividend will increase in the future. Scrip dividends may
also be seen as a negative signal by the market i.e. the company is experiencing cash flow
issues.
(b) Share repurchase
The company pays cash to the shareholders in return for a proportion of their shares. This could
be used to change the capital structure of the company (see later in this chapter).
(c) Concessions
Shareholders are given concessions if they use the company’s products or services e.g. Original
Eurotunnel shareholders could travel at reduced fares.

3 Estimating the cost of equity

After having raised finance, a company must decide what to invest in.
When appraising potential investments, directors will need to determine a cost of capital (the
minimum return required when using the company’s funds).
An important component of this is the company’s cost of equity – the minimum return that
shareholders require from the funds they have invested in the company.


Fir Co
There are two ways of estimating the cost of equity that we will see – the dividend growth

st I pyri
model and the capital asset pricing model.

ntu ght
3.1 The dividend growth model

itio
The dividend growth model is a formula which calculates the current price of a share as the present
value of a stream of constantly growing dividends (valuing them as a growing perpetuity discounted at

n2
the cost of equity).

017
FORMULA GIVEN IN EXAM
Do (1+g)
Po =
(re −g)

Where:
Po = Current ex-div share price
Do = Current dividend
g = Constant growth in dividends
re = Return on equity or the cost of equity
We can then rearrange this formula to calculate the cost of equity:
Do (1+g)
re = Po
+g

 Share prices can be quoted Cum div, meaning the current price includes the right to the
upcoming dividend i.e. the dividend is about to be paid, and Ex div, meaning the current price
excludes the right to the upcoming dividend i.e. the dividend has just been paid.
68 5: Business finance AC C A F9

LECTURE EXAMPLE 5.2

Lano Co has just paid a dividend of 25 cents on its ordinary shares which have a market value of $3.75.
The constant dividend growth rate is 9%.
What is the cost of equity for Lano Co?
SOLUTION

The weaknesses of the dividend growth model are as follows:

 It is too simplistic as most companies do not pay a constantly growing dividend
 Identifying an ex-div share price is difficult for listed companies and very difficult for unlisted
companies and so the model is based on estimates

Estimating growth
Often, the growth rate (g) is not provided so we can use one of two methods to estimate this:

ht
(1) Annualising growth as a geometric average of the historical dividend stream
(2)

i g 01 7
The earnings retention method

r
F
y
p ion
ORMULA GIVEN IN EXAM
2
o
C uit
g = bre

I
Where:
n t
s t
b = The proportion of earnings retained and reinvested

ir
re = The % return earned on those investments

F
ILLUSTRATION 5.1

Growth Co has just paid a dividend of 25c per share from earnings per share of $1.00. The dividend has
grown from 18c four years ago. The company has a target return on capital of 12%. Its share price is
currently $2.50. Calculate the Cost of Equity (Ke) using both methods.
SOLUTION
(a) We assume that there has been compound growth over the four-year period:
18 × (1+g)4 = 25  g =8.56%
25 (1.0856)
ke = + 0.0856 = 19.4%
250
(b) If a dividend of 25c has been paid from earnings of $1.00, then b = 0.75/1.00 = 75% and r = 12%
growth = 75% × 12% = 9% p.a.
25 (1.09 )
ke = + 0.09 = 19.9%
250
AC C A F 9 5: Business finance 69

3.2 The capital asset pricing model (CAPM)

If a share price is not observable, an alternative way to calculate the cost of equity is by using the
Capital Asset Pricing Model (CAPM).
CAPM uses the principle that the return required by an investor is in proportion to the riskiness of the
investment.
Hence, when determining the return required, we must consider the business risk of a the company
(the variability of the PBIT of the company due to the nature of its operations)
Business risk is composed of two elements:
 Specific business risk (also called unsystematic risk)
– These are risks specific to the company which affect it uniquely and may be
diversified away.
– These include e.g. equipment failure, labour strikes, and product faults.
 Systematic business risk
– This is the exposure of the company to macro-economic factors which impact all
businesses to some degree and cannot be diversified away (e.g. exposure to
changes in gross domestic product, interest rates, inflation, FX rates and
commodities prices).
–

Fir Co
Exposure to these risks is driven by the business sector of the company and is

st I pyri
increased by e.g. operational gearing and is measured by β (see later).
The main assumption of CAPM is that shareholders in a company own a portfolio of shares in

ntu ght
uncorrelated companies and that due to this their exposure to specific risk has been diversified away
(as if one of their shareholdings performs worse than expected due to specific risk factors, it will be

itio
offset by another shareholding performing better than expected).

n2
Because of this, the shareholders are only concerned by the impact of a new investment on their
exposure to systematic risk, as measured by a β factor (calculated by comparing the change in the

017
return on an individual share to the change in return on a stock market index in the same period).
This β factor for a company, individual investment or project is then used in the CAPM formula to give
a measure of the shareholders’ required return (the cost of equity) to compensate them only for the
systematic risk they are facing.

FORMULA GIVEN IN EXAM

E(ri) = Rf + βi (E(rm) – Rf)

Where:
E (ri) = Expected return on a share called ‘i’ or the cost of equity of share ‘i’
Rf = Risk free rate of return, often taken as the return on short term Government Bonds
βi = Beta, which is a measure of the systematic risk in share ’i’
E(rm) = Expected return on the market portfolio (e.g. the return on stock indices like FTSE100)
(E(rm) – Rf) = Equity risk premium
 CAPM calculates the required return by starting with the risk free return which can be obtained
without being exposed to any risk at all.
 This is then increased by the systematic risk premium based upon the excess of the market
return over the risk free return. In other words:
Required return = Risk free return + Premium for the risk being taken
70 5: Business finance AC C A F9

LECTURE EXAMPLE 5.3

Drewboy Co has a beta value of 1.5. The average return on the market is currently 17% and risk free
investments are paying a return of 5%.
What is the cost of equity for Drewboy Co?
SOLUTION

ht 7
r i g 201
y
p ion
o
Advantages and disadvantages of the CAPM

C uit
The advantages of CAPM are:


I n t
It directly links risk and return

r


s t It can be used to calculate the cost of equity when the dividends are not growing constantly

F i The disadvantages of CAPM are:

 It can only be used when the investors are diversified
 It assumes that all of the components will remain constant and the same as they have been
historically
 It assumes that investors can invest and borrow at the risk free rate
 It assumes that the capital markets are perfect i.e. no transaction costs, no tax and no dominant
investor
 It assumes that the risk of all macroeconomic variables can be grouped into one measure
We will see later on that the β factor used will need to be adjusted if there are changes in:
 Business risk
 Gearing (financial risk)
AC C A F 9 5: Business finance 71

4 Estimating the cost of debt

If a company is geared, then its directors will need to also need to consider the cost of their debt
finance when determining their overall cost of capital.
If the future cashflows on a debt instrument are discounted at the cost of debt, then the resulting
present value will be the current market value of the debt. This is the technique that will be used to
find the cost of debt where we have been given the market value of the debt.
This process will vary depending on the type of debt.

4.1 Irredeemable debt

Because irredeemable debt doesn’t redeem, the only future cashflows are the interest payments on
the debt (which, per chapter 4, need to be evaluated post-tax).
Hence, irredeemable debt represents a perpetuity of interest payments and can be valued as such:
I(1–T)
 Po = Kd

If we are given the market value of the debt, then we can re-arrange the formula to solve for the cost
of debt:
I(1–T)
 Kd =

Co
Po

Fir
st I pyri
Where:
Kd = Cost of debt

ntu ght
I = Interest
T = Corporation tax rate

itio
Po = Current ex-interest debt price

LECTURE EXAMPLE 5.4

n2
017
Hammered Co has some $100 nominal value 6% irredeemable debt which currently has a market value
of 84% ex-interest. The corporation tax rate is 30%.
What is the cost of debt for Hammered Co?
SOLUTION
72 5: Business finance AC C A F9

4.2 Redeemable debt

The cost of redeemable debt capital is more complex, as the future cashflows will include both interest
and redemption payments.
 It is still the case that we will be given a market value for the debt and then we will be required
to find the discount rate at which the present value of the future cashflows = the market value.
 This is achieved by calculating the IRR (see Chapter 4) of the redeemable debt cash flows
Timing Cash flow
$
0 (Po)
1–n I(1 –T)
n Rv
Where:
Rv = Redemption value at time n

LECTURE EXAMPLE 5.5

Plastered Co has some $100 nominal value 4% redeemable debt which currently has a market value of
75% ex-interest. This debt will be redeemed in seven years’ time at a 12% premium and the

t
corporation tax rate is 35%.

g h 1 7
What is the cost of redeemable debt for Plastered Co?
SOLUTION

y r i 20
o p ion
C uit
I n t
r s t
F i
AC C A F 9 5: Business finance 73

4.3 Convertible debt

Convertible debt is similar to redeemable debt however at the end of the debt’s life it can either be
redeemed or converted into a certain number of ordinary shares.
This is the debt holder’s decision and will depend upon the value of the shares compared to the
redemption value.
 If you are not told the expected market value of the ordinary shares at the time of conversion, it
can be estimated as follows, using the expected dividend growth rate:
– MV now × (1+g)n = MV in n years’ time
 The redemption cashflow will then be included as the higher of redemption at par and the value
of the conversion
 The cost of debt is then the IRR of the future cashflows and the current market value (as for
redeemable debt).

ILLUSTRATION 5.2
Sozzled Co has some $100 nominal value 6% convertible debt which currently has a market value of
88% ex-interest. This debt will be redeemed in four years’ time at par or converted into 20 ordinary
shares. A financial expert has forecast that Sozzled’s shares will be worth $5.10 in four years’ time.

Fir Co
The corporation tax rate is 40%.

st I pyri
What is the cost of the convertible debt for Sozzled Co?
SOLUTION

ntu ght
So in four years’ time the debt can either be redeemed for $100 or converted into shares which will be

itio
worth 20 × $5.10 = $102 and so the debt will be converted.

n2
I = $6
T = 0.40

017
Po = $88
Rv = $102
Timing Cash flow Discount factor Present value Discount factor Present value
$ 10% $ 5% $
0 (88) 1.000 (88) 1.000 (88)
1–4 6(1 – 0.40) 3.170 11.41 3.546 12.77
4 102 0.683 69.67 0.823 83.95
$(6.92) $8.72
8.72
IRR ≈ 0.05 + 8.72−(6.92) × (0.10 − 0.05)

= 0.08
So the cost of convertible debt for Sozzled Co is 8%.
74 5: Business finance AC C A F9

4.4 Preference shares

Preference shares are similar to ordinary shares except the dividend is constant and so there is no
growth. Thus the cost of preference share capital can be calculated by using the following formula:
Do
Kp = Po

LECTURE EXAMPLE 5.6

Razzled Co has just paid a dividend of 20 cents on its preference shares which have a market value of
$1.90.
What is the cost of preference share capital for Razzled Co?
SOLUTION

ht 7
r i g 201
y
p ion
o
C uit
t
4.5 Bank debt

t I n
Unlike other forms of debt finance, bank loans have a variable rate of interest, which means that the

r s
market value always equals the nominal value and the cost of bank debt capital can be calculated by

F i
using the following formula:
I(1–T)
Kb = Po

LECTURE EXAMPLE 5.7

Blotto Co has a bank loan that is currently charging 8% interest and the corporation tax rate is 25%.
What is the cost of bank debt capital for Blotto Co?
SOLUTION
AC C A F 9 5: Business finance 75

5 The weighted average cost of capital (WACC)

As we have seen, the different sources of finance in a company have different costs.
 Hence, when appraising new projects/investments to be funded out of the overall pool of funds,
we need to use a weighted average cost of capital (WACC) that takes into account the required
return of all of the different investors in the company.

FORMULA GIVEN IN EXAM

eV d V
WACC = (V +V ) K e + (V +V ) K d (1–T)
e d e d

Where:
Ve = Total value of the equity
Vd = Total value of the debt
Ke = Equity cost of capital
Kd = Debt cost of capital
T = Corporation tax rate
Note. The total equity and debt values can either be calculated using book values or market values,
though market values give a better indication of the current cost of capital.

Fir Co
Note. This formula assumes that tax has been ignored in calculating Kd, however as tax has to be

st I pyri
included when calculating the cost of redeemable debt, it is much easier to always include tax when
calculating the cost of debt and then ignoring it when using this formula.

ntu ght
This formula also assumes that the organisation only has two sources of finance; if it has more the
formula can be extended by adding the extra source and its market value. So if an organisation was

itio
financed with ordinary shares, preference shares and debt; the formula would look as follows:

n2
Ve Vp Vd
WACC = (V ) Ke + (V ) Kp + (V ) Kd (1–T)
e +Vp +Vd e +Vp +Vd e +Vp +Vd

LECTURE EXAMPLE 5.8 017

SCS Co is financed with a mixture of equity and debt. It has just paid a dividend of 45 cents on its
4.5 million ordinary shares which have a market value of $5.25. The constant dividend growth rate is
6%. The 7% irredeemable debt currently has a market value of 83% cum-interest. The corporation tax
rate is 35%. An extract from SCS’s statement of financial position shows the following:
$
Debt 10,000,000
Shareholders’ funds 19,450,000
What is the WACC using book value and market value weightings for SCS Co?
SOLUTION
76 5: Business finance AC C A F9

6 Sources of finance and their relative costs

t
6.1 The relative costs of equity and debt (risk vs. return)

g h 1 7
Risk and return are connected; as the risk rises so the required return increases and so the relative

i
r 0
costs rise.

y
p ion 2
Equity is the primary risk capital and, hence, the most expensive source of capital, as:

o
C uit
If the business fails, it is the last to be paid

t
 The returns it receives (dividends) are also uncertain (as they are discretionary).

t I n
Debt is a less risky and hence cheaper source of capital, as:

ir

s It is generally secured

F
 The returns it receives are more certain (interest is not discretionary)
 It may be redeemable
 Debtholders are the first to be paid should the business fail
 Finally, tax makes the debt even cheaper from the businesses point of view (per Chapter 4)

6.2 The creditor hierarchy (and its impact on risk and return)
The creditor hierarchy refers to the order creditors are paid when a business becomes insolvent and is
as follows:
(1) Secured Creditors e.g. fixed charge over a non-current asset
(2) Preferential Creditors e.g. pension schemes and employees
(3) Floating Charge Holders e.g. charge over the current assets
(4) Unsecured Creditors e.g. trade payables and the Crown
(5) Preference Shareholders
(6) Ordinary Shareholders
 As a creditor moves down the above list they are exposed to greater risk and so require a
commensurately greater return. Hence the cost of the source of finance increases.
AC C A F 9 5: Business finance 77

6.3 Gearing and financial risk

Gearing refers to the level of debt used to finance a business and can be measured using the ratios
seen in Chapter 1 (Financial Position).
High levels of gearing mean the organisation has high levels of debt and so is committed to high levels
of interest payments which must be made regardless of how the business is actually performing.
Hence, increased gearing leads to increased financial risk (the variability in PAT due to the level of
fixed interest payments on debt in the company), which is concerning for shareholders, as there will
be a greater amount of fixed payments that will need to be made before a dividend can be paid.
Hence, as gearing increases, so does the risk for shareholders and hence the cost of equity increases.

7 Capital structure theories and practical considerations

7.1 Explain the relationship between company value and cost of capital
A company’s value is the present value of all of its future cash flows discounted at its cost of capital
(WACC). Hence, companies can maximise their value by attempting to minimise their WACC.
Theories as to how to minimise the WACC are presented below:

Fir
7.2 The traditional view of capital structure
Co
st I pyri
We have just seen that debt is cheaper than equity and that introducing debt increases the risk for
shareholders and so the cost of equity. So is having cheaper debt and more expensive equity a good or

ntu ght
bad idea overall? The traditional view of capital structure states that:

itio
 Introducing debt starts off by being a good thing as the WACC falls because the increase in the
cost of equity is relatively small compared to the benefit of the increase in cheap debt.

n2
However as the level of debt increases further, the cost of equity starts to rise faster,

017
outweighing the benefit of the extra cheap debt, resulting in the WACC also rising.
Note: At very high levels of gearing, even the cost of debt starts to rise.
The traditional view can be depicted graphically as follows:

Cost of Ke
Capital

WACC

Kd

Gearing
Optimum Vd
Ve + Vd
78 5: Business finance AC C A F9

It can be seen from the above graph that the traditional view suggests that there is an optimum capital
structure where the WACC is at a minimum.
The traditional view makes the following assumptions:
 Operating profits are constant
 There are no transaction costs on issuing finance
 Business risk is constant
 All earnings are paid out as dividends
Unfortunately, the traditional theory doesn’t tell us where the optimum WACC is reached. Hence trial
and error must be used to find the this point

7.3 Modigliani & Miller’s view of capital structure 1958 (no tax)
The economists Modigliani & Miller made the following assumptions in their initial view of capital
structure:
 Capital markets are perfect
 Investors are rational and risk averse
 There are no transaction costs
 Debt is always risk free
 There is no taxation
The no taxation assumption is particularly important as this removes the tax benefit of paying interest

t
and means that the total payments to investors will be the same for equivalent companies with and
without debt:

i g h 1 7
y r 20 No Interest Co Interest Co

p ion
Year 1 2 3 1 2 3

o
$ $ $ $ $ $

C uit
Earnings 800 1,600 400 800 1,600 400

t
Interest nil nil nil (100) (100) (100)

I n
After tax earnings 800 1,600 400 700 1,500 300

r s t
Debt holders’ return nil nil nil 100 100 100

F i Equity holders’ return

Total investors’ return
800
800
1,600
1,600
400
400
700
800
1,500
1,600
300
400

This in turn means that these comparable companies must also have the same total market value and
hence the same WACC.
M&M’s initial views can be summarised as:
 As debt is introduced, the cost of equity rises
 Without any tax saving on interest payments, the benefit of the extra cheap debt is only enough
to offset the increased cost of equity
 Hence the WACC remains unchanged and there is no optimal capital structure
AC C A F 9 5: Business finance 79

The Miller and Modigliani view without corporate taxation can be depicted graphically as follows:

Cost of Ke
Capital

WACC

Kd

Gearing
Vd

Co
Ve + Vd

Fir
st I pyri
This view was criticised because the no taxation assumption is unrealistic.

ntu ght
7.4 Modigliani & Miller’s view of capital structure 1963 (with tax)

itio
If the no taxation assumption is removed then the tax benefit of paying interest is reintroduced and

n2
this means that the total payments to investors will be higher for the equivalent company with debt:

017
No Interest Co Interest Co
Year 1 2 3 1 2 3
$ $ $ $ $ $
Earnings 800 1,600 400 800 1,600 400
Interest nil nil nil (100) (100) (100)
800 1,600 400 700 1,500 300
Tax @ 30% (240) (480) (120) (210) (450) (90)
After tax earnings 560 1,120 280 490 1,050 210

Debt holders’ return nil nil nil 100 100 100

Equity holders’ return 560 1,120 280 490 1,050 210
Total investors’ return 560 1,120 280 590 1,150 310

This in turn means that the company with debt must also have a higher total market value and hence a
lower WACC.
80 5: Business finance AC C A F9

The Miller and Modigliani view with corporate taxation can be depicted graphically as follows:

Cost of Ke
Capital

WACC

Kd

Gearing
Vd
Ve + Vd

ht 7
r i g 01
7.5 Capital market imperfections and their impact on M&M

2
y
p ion
In the real world capital markets are not perfect and suffer from the following imperfections:

o
C uit
Companies cannot always raise finance when required (hard capital rationing) and so there is a
risk of bankruptcy. This risk increases as the level of gearing increases and so this deters

I n t
companies from having high levels of debt.

t


s
Debt is not always risk free, especially at high gearing levels and so the cost of debt will rise as

ir
debt increases and so the WACC will stop falling and start to rise at some point. (Traditional

F
view!)
 The tax saving on interest payments only exists while the company has sufficient pre-interest
profits. Once the interest payment exceeds pre-interest profit (known as tax exhaustion), there
is no longer any benefit from increasing the level of debt finance.

8 Changes to a company and their impact on the WACC

8.1 When we should use the WACC
The WACC reflects the company’s existing business risks and capital structure (financial risks), hence we
may use the current WACC to appraise new projects so as long as:
 The new project has the same business risk as our existing operations
 There will be no change in the long term capital structure of the company
 The project is relatively small (so its NPV won’t have a significant effect on MV of equity)
 We are not using project specific finance (e.g. a government grant which is tied to this specific
project).
AC C A F 9 5: Business finance 81

8.2 What to do if the situation changes?

As discussed above, if the capital structure or business risk changes, then the old WACC will no longer
be appropriate to use to appraise new projects, hence a new WACC will need to be calculated.

8.2.1 A change in capital structure

If the long term gearing of the company changes, then so will its cost of equity (and hence its WACC).
In order to calculate the revised cost of equity, we will need to use the CAPM formula with a revised β
(to reflect the change in financial risk in the company).
 If a company was previously ungeared, its previous β is referred to as an ‘asset beta’ or ‘βa’.
 We now need to find a new β for the same company (whose business risk has not changed) that
reflects the increased financial risk of the increased gearing; this is called the ‘equity beta’ or
‘βe’.
 You will find that βe is greater than βa as financial risk increases a company’s exposure to
systematic risk
 The equity and asset betas are linked by the following formula:

FORMULA GIVEN IN EXAM

βa = (
Ve
βe ) + (
Vd (1 − T)
β )
Fir Co
st I pyri
(Ve + Vd (1– T)) (Ve + Vd (1– T)) d

ntu ght
Where:
βa = Asset beta or the ungeared beta

itio
βe = Equity beta or the geared beta
βd = Debt beta

n2
Note: The debt beta measures the risk of the company’s debt, which we assume is zero unless the

017
question specifically says otherwise (this means that the company can borrow at the risk free rate of
return).
If we assume βd = 0, then the formula can be simplified and presented as follows:
Ve
 βa = ((V +V
βe )
e d (1–T))

Ve +Vd (1-T)
 βe = βa ( Ve
)

Hence, the steps to follow are:

(1) Un-gear the company’s equity beta to obtain an asset beta;
Ve
βa = ((V βe )
e +Vd (1–T))

(2) Calculate the new βe for the company (based on the new debt to equity ratio given)
Ve +Vd (1-T)
βe = βa ( Ve
)

(3) Use the CAPM formula with the new βe to calculate the new cost of equity
(4) Use the new cost of equity and new debt to equity ratio to find a new WACC
(5) Use this new WACC to evaluate new projects
82 5: Business finance AC C A F9

8.2.2 A change in business risk

If a company invests in a new project in a new business sector, it will be exposed to new business risks.
Hence both a new cost of equity and WACC will need to be calculated to appraise the project.
The steps in calculating a new project specific cost of equity using CAPM are as follows:
(1) Locate a suitable proxy company (operating in the new industrial sector);
(2) Find the equity beta of the proxy company alongside its gearing and tax rate;
(3) Un-gear the proxy company’s equity beta to obtain an asset beta for the new industrial sector
Ve
βa = ( β )
(Ve + Vd (1– T)) e
(4) Re-gear the asset beta using our company’s gearing;
Ve +Vd (1-T)
βe = βa ( Ve
)

(5) Use the new equity beta and the CAPM formula to calculate a project specific cost of equity.
(6) Use this cost of equity to calculate a new project-specific WACC.

LECTURE EXAMPLE 5.9

ht 7
Millie Mo Co produces bread and is financed with 43% debt. It is now appraising a new project which

r i g 01
will involve producing cakes and will be financed from its existing capital. It has obtained beta factors

2
y
for a number of different companies as follows:
Name

o p ion Business Debt finance Beta

C uit
Millie Mo Co Bread 43% 1.34
Huckleberry Co Jam 28% 1.30

I n
Fletch Co
t Cakes 32% 1.36

t
Jo Jo Co Bread 28% 1.12

s
Sally Co Currents 43% 1.52

ir
Thumb Co Jam 35% 1.40

F The average return on the market is currently 18% and risk free investments are paying a return of 4%.
Tax is 30%.
What is the cost of equity that should be used in a WACC calculation to identify a project specific
discount rate for Millie Mo’s new project?
SOLUTION
AC C A F 9 5: Business finance 83

8.2.3 Marginal cost of capital approach

An alternative approach to take if business risk and the capital structure change as a result of a new
project is to consider the marginal cost of capital when appraising the new project.
The marginal cost of capital represents the incremental cost of raising the new finance, factoring in the
cost of the new finance and the change in the return required by the existing investors on the existing
finance as the risks they face are changed by the project.
For example:
 If a company funds a new project by issuing new equity finance (and permanently changing its
capital structure) then its WACC will likely increase (as equity is more expensive than debt).
 Previous projects will have been appraised using the old WACC (which was lower)
 Considering the marginal cost of capital in appraising the new project will factor in both the
risks presented by the new project and the increased return required on the previous projects.

8.3 Pecking order theory and the selection of sources of finance

Pecking order theory states that firms will select finance in a particular order, only moving down the
list if there is insufficient finance at the earlier level; rather than considering the overall cost of capital.
The pecking order is as follows:

Co
(1) Retained earnings: this is the easiest, quickest and cheapest (in terms of issue costs) way to

Fir
raise finance.

st I pyri
(2) Debt: this is relatively cheap to service and issue and can be interpreted as a sign of
management confidence.
(3)
ntu ght
Convertible debt: this offers investors the potential to benefit, at the expense of the

itio
shareholders, if the company does well.

n2
(4) Preference shares; this offers an equity stake without the uncertainty of dividend levels.
(5) Ordinary shares: this is time consuming to arrange and expensive to service and if unsuccessful

017
leads to a general loss of confidence and accompanying fall in share price of the company.

9 Finance for small and medium sized entities (SMEs)

9.1 Financing needs of small businesses
The financing needs of small businesses are no different from larger businesses but the absolute
amounts required will be less. Small businesses will also often be offered less credit from suppliers.
Thus small businesses will need a mix of short, medium and long term finance.

9.2 Financing problems for small businesses

The nature of the financing problem for small businesses is as follows:
(1) The funding gap results from the difficulties small businesses face in raising the finance they
require. This is because such businesses are higher risk due to their limited track record and
dependency on a very small number of key employees
(2) The maturity gap results from the fact that most of the finance that small businesses are able to
raise will be short term in nature and this will not match with the investments being made.
(3) The inadequate security results from most small businesses having very little in the way of
traditional non-current assets to offer as security to potential lenders to help reduce their risk
84 5: Business finance AC C A F9

9.3 Appropriate sources of finance for SMEs

Sources of finance Financial impact
Owners investment – equity This tends to form the initial source of finance and in the short term
and/or debt requires very little return, however in the longer term the original owners
will wish to realise their investment.
Overdraft This is designed as a short term source of finance, though many SMEs find
it becomes increasingly permanent. As a result the bank may insist on
converting part of the overdraft into a loan. Due to the fact that overdrafts
are repayable on demand; this puts the bank in a very influential position.
Bank loans This offers greater certainty but the repayments must be met.
Supplier credit This is an extremely important part of working capital funding and tends to
grow over time as the SME becomes more established and builds its
relationship with its suppliers.
Debt factoring This uses the receivable current assets as security to raise short term
finance.
Leases This helps with acquiring the use of particular assets
Business Angel funding This is funding from individuals who have already made a lot of money
normally in the same industry. Thus they tend to be well informed and are
often prepared to invest for the longer term.

ht
Venture capital These provide medium term funding where they believe the business will

g 1 7
be successful and grow significantly. They will normally want significant

y r i 20
influence over the business and a potential exit route in around five years,

p ion
Supply chain financing Introduced in 2012, this scheme allows SME’s to potentially access finance

o
(usually in the form of an advance by a bank) when a large organisation

C uit
which is a customer of the SME has vouched for the income of the SME.

t
The bank accepts the credit rating of the large organisation as evidence

n
that the SME’s sales invoice will be paid.

t I
Crowdfunding

s
This involves raising finance from a large number of investors who each

ir
only have to provide a small portion of the finance. This has become

F
popular as websites and social media make it possible to access many
potential investors quickly.
Peer-to-peer financing This involves borrowing and lending between unrelated individuals (peers)
without using a traditional financial intermediary. This is usually organised
via a peer-to-peer company’s website.
AC C A F 9 5: Business finance 85

Sources of finance Financial impact

Government assistance Governments tend to provide varying forms of assistance to SME’s ranging
from tax incentives through to specialist schemes such as:

 The Loan Guarantee Scheme offers a guarantee by the Government

for the bulk (80% to 85% maximum) of the loan. The SME pays an
annual premium but as result the risk is greatly reduced from the
lenders point of view (70-85% of loan amounts up to £100,000) and
so funding is far more forthcoming. There is a large amount of
administration involved in this scheme.
 Regional Selective assistance (In the UK assistance may be available
for projects involving up to £0.5m capital expenditure),
 Enterprise grants (Selective scheme for firms employing fewer than
250 people),
 Regional innovation grants (grants for developing new
products/processes in certain geographical locations up to a
maximum of £25,000),
 Training loans (loans with deferred repayment for vocational courses
up to a maximum of £125,000)
 The Enterprise Investment Scheme (EIS) offers tax incentives to
outsiders who invest in the ordinary shares of unquoted companies.

Fir Co
 Venture Capital Trusts (VCT) offers tax relief’s to investors when the

st I pyri
trusts invest a large proportion of their assets in unquoted
companies.

ntu ght
These are just some of the features of a select number of schemes.

itio
n2
017
86 5: Business finance AC C A F9

ht 7
r i g 201
y
p ion
o
C uit
I n t
r s t
F i
 87

Business valuations

Fir Co
st I pyri
1 Nature and purpose of the valuation of business and financial assets
1.1 Reasons for valuing businesses and financial assets
ntu ght
itio
There are several reasons for valuing businesses and financial assets as follows:

n2
For tax reasons – inheritance, capital gains and income taxes can all require business and

017
financial asset values.
 For legal purposes – if business and financial asset are being used as loan collateral or as part of
an estate valuation in matrimonial disputes
 For commercial reasons – if business and financial asset are being bought or sold or if a business
is being floated on a stock market. This is the mostly likely reason for performing a valuation in
this paper.

1.2 Information requirements for valuation

Information requirement Limitations
Size of holding: the more significant the The size of the holding on its own does not give the full picture. If
holding the greater the value per share you own 10% of a company and the remaining 90% is all owned
by one individual; your 10% is not significant. However if you own
10% and the next biggest shareholder owns 1%, your 10% is very
significant.
Details of the parties involved and the The parties and circumstances are likely to be unique for each
circumstances of the transaction such transaction and so this information will not necessarily be
that helpful.
Copies of the Articles of Association, The Articles of Association can be changed by the shareholders
specifically any clauses related to such and so may not be relevant.
transactions
88 6: Business valuations AC C A F9

Information requirement Limitations

Details of past transactions Many factors change over time and so past transactions do not
necessarily reflect current circumstances.
Recent published accounts These could both be out of date and could have been prepared
with this transaction in mind.
Financial projections and market These will always be partly based on subjective judgements and
outlook opinions and may not be that realistic.
Valuations of similar listed companies Identifying similar listed companies can be difficult and even
when successful, listing increases the value of a company.

2 Models for the valuation of shares

2.1 Methods of valuation
There are generally considered to be three main groups of valuation techniques, these are as follows.

Asset based Income based Cash flow based

• Use of historic cost, • P/E ratios • DCF

ht
replacement cost or

7
• Earnings yield • Dividend yield

i g 1
realisable value? • Dividend growth

y r 20 model

o p ion
In addition, the quickest way to value a business is if given a share price for a company and then its

C uit
market capitalisation can be calculated as share price × no of shares (often overlooked by students

t
making them look rather foolish!).

I n
The following illustration will be used throughout this section to demonstrate the above valuation

t
s
techniques. A typical exam question may require you to do a valuation of a company or demonstrate a

ir
detailed understanding of the benefits and drawbacks of all of the valuation techniques.

F
AC C A F 9 6: Business valuations 89

LECTURE EXAMPLE 6.1

AJB is an IT consultancy based in Asia that trades globally. It was established 10 years ago. The four
founding shareholders own 25% of the issued share capital each and are also executive directors of the
entity. The shareholders are considering a flotation of AJB on an Asian stock exchange and have
started discussing the process and a value for the entity with financial advisors. The four founding
shareholders, and many of the entity’s employees, are technical experts in their field; however they
are not financial experts.
Assume you are one of AJB’s financial advisors. You have been asked to estimate a value for the entity
and explain your calculations and approach to the directors. You have obtained the following
information.
Summary financial data for the past three years and forecast revenue and costs for the next two years
is as follows.
Statement of profit or loss for the years ended 31 December
Actual Forecast
20X1 20X2 20X3 20X4 20X5
$m $m $m $m $m
Revenue 85.0 92.5 102.0 115.0 130.0
Less:

Fir Co
Cash costs 29.8 32.4 35.7 40.3 45.5

st I pyri
Depreciation 22.5 35.0 35.0 35.0 35.0
Pre-tax profits 32.7 25.1 31.3 39.7 49.5
Tax 9.8 7.5 9.4 11.9 14.9
PAT 22.9
ntu ght
17.6 21.9 27.8 34.6

itio
Dividends 10.0 10.6 11.2 11.9 12.6
Retained profits 12.9 7.0 10.7 15.9 22.0

Statement of financial position at 31 December

n2
017
20X1 20X2 20X3
$m $m $m
ASSETS
Non-current assets
Property & Equipment 100 115 125
Current assets 35 40 45
135 155 170

EQUITY & LIABILITIES

Share capital (50c shares) 20 20 20
Retained profits 95 102 113
115 122 133
Current liabilities 20 33 37
135 155 170

Note: The book valuations of non-current assets are considered to reflect current realisable values.

Other information/assumptions
Growth in after tax cash flows for 20X6 and beyond (assume indefinitely) is expected to be 2% per
annum.
Cash operating costs can be assumed to remain at the same percentage of revenue as in previous
years.
90 6: Business valuations AC C A F9

Depreciation can be assumed to equal capital allowances and to remain constant from 20X6 onwards
at the 20X5 level. Capital expenditure can be assumed to equal depreciation.
Tax has been payable at 30% per annum for the last three years. This rate is expected to continue for
the foreseeable future and tax will be payable in the year in which the liability arises.
A comparable company to AJB which is already listed has a current share price of $7.50 based on
earnings per share of $0.50 for the year ended 31st December 20X3.
An estimated cost of equity capital for the industry is 11% after tax.
Required:
Calculate a range of values for AJB, in total and per share, using methods of valuation that you
consider appropriate.

2.2 Asset based valuations

Net Assets

ht 7
Minimum Cost of starting

g 1
acceptable price up like for like

r i 0
to sell business

y
p ion 2
o
C uit Book value Realisable value
Replacement

t
cost

t I n
s
To get an estimate of the minimum potential valuation, the net asset value as it appears on the

F irstatement of financial position can be a quick and easy starting point. Care needs to be taken to
identify the correct net assets figure (strictly this is non-current assets plus net current assets less any
long-term liabilities).
Important points to note:
 Statement of financial position book values are likely to be stated at historic cost and therefore
not representative of current market values (important if there is a large property/land element
that has not been revalued).
 A realisable value would give a better indication of price if there was a sell off or asset stripping
intention. However, realisable values would need to be given in the question and would
generally be lower than market values since the reason for sale would probably be known (e.g.
football clubs in financial trouble selling off key players for less than their true worth).
 Using the replacement cost of the assets may be more appropriate if you are trying to duplicate
an existing business. You would need to be given the replacement cost of the assets in the
question.
AC C A F 9 6: Business valuations 91

LECTURE EXAMPLE 6.1 (a)

Calculate the asset based valuation for AJB and briefly comment on your answer.

Advantages and disadvantages

Advantages Disadvantages
Quick and simple to estimate. Not as good at valuing the on-going earnings/profit
potential of the business.

Co
Gives a starting point/benchmark. Does not consider valuation of assets not shown on

Fir
the statement of financial position such as intangible

st I pyri
assets.

ntu ght
2.3 Income based valuations

itio
These methods are useful if valuing an on-going earnings stream with a view to the business carrying
on. For example, if considering an acquisition where a controlling stake in being considered (since the

n2
acquirer will be in control of the potential earnings).

017
2.3.1 P/E valuation
Share price
Per Chapter 1, the PE ratio of a company = Earnings per share

A P/E ratio gives an indication of the market’s perception of the future growth potential of a business.
By applying a suitable P/E ratio to the current earnings the valuation of a business can be estimated as:
𝑃
 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑙𝑙 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 = 𝐸 𝑟𝑎𝑡𝑖𝑜 × 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝑃𝐴𝑇 𝑢𝑠𝑢𝑎𝑙𝑙𝑦)

Or if trying to value an individual share:

𝑃
 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 = 𝐸 𝑟𝑎𝑡𝑖𝑜 × 𝐸𝑃𝑆

Important points to note:

The P/E ratio used should reflect as closely as possible the potential growth of the business in the
question. This may require a P/E ratio of a similar business to be used and then adjusted to reflect
any differences in likely growth (e.g. expected growth, strength of team, quoted or unquoted status,
R&D capability…).
The earnings figure used should be the sustainable earnings available to the ordinary shareholders,
typically this is the profit after tax (PAT) but some adjustments may be necessary if the current
earnings figure is distorted by any one-off factors (e.g. restructuring costs, salaries).
P/E ratios are only available for quoted (listed) companies so if valuing an unquoted (non-listed)
business a P/E ratio for a similar quoted business must be used (& adjusted if necessary).
92 6: Business valuations AC C A F9

LECTURE EXAMPLE 6.1 (b)

Calculate a valuation on a P/E basis for AJB and briefly comment on your answer.
SOLUTION

ht 7
r i g 01
Advantages and disadvantages

2
y
p ion
o
Advantages Disadvantages

C uit
Quick to calculate. Adjustments may be necessary to both the P/E and

t
Considers future potential. earnings figure.

I n
Useful for valuing unquoted companies. Which P/E to use in a takeover situation (target co’s,

t
predator co’s or an average)?

ir s
F
2.3.2 Earnings yield
This is a much less common method of valuing a business but should give essentially the same
valuation as the P/E method.
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐸𝑃𝑆
The Earnings Yield ratio is calculated as 𝑀𝑉 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑟 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒
(i.e. the inverse of the P/E ratio).

This can then be used to value a company (often by using a listed company’s earnings yield:
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝑃𝐴𝑇)
 𝑀𝑉 𝑜𝑓 𝑎𝑙𝑙 𝑠ℎ𝑎𝑟𝑒𝑠 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑦𝑖𝑒𝑙𝑑
𝐸𝑃𝑆
 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑦𝑖𝑒𝑙𝑑
AC C A F 9 6: Business valuations 93

2.4 Cash flow based valuations

Cash based methods are also useful for valuing the on-going business, with DCF appropriate for
controlling interests and dividend based methods more suitable for smaller (i.e. minority)
shareholdings since they are only valuing the entitlement to a future stream of dividends.

2.4.1 Discounted cash flow

COMPANY
VALUE

Future Cost of
cashflows capital

If the valuation is being done as part of an

acquisition exercise the cash flows will need to Usually use the WACC of the company that
include any synergies likely to be available to the is being valued
new owners

Sundry points to note:


Fir Co
The calculation approach is the same as for typical DCF project appraisal (see Chapter 4)

st I pyri
 Strictly speaking, if you want to find the MV of the shares in a business you should take the cash

ntu ght
flows attributable to the shareholders (after interest and tax) and discount using a
shareholders required return (the cost of equity, Ke).

itio
 If cash flows (before interest but after tax) are discounted at the WACC the result will give the
total value (debt + equity) of the business, so to get the value of the shares only you need to

n2
deduct the market value of any debt.

017
Cashflows Cashflow after interest and tax Cashflow before interest, but after tax
Discount rate to use Cost of equity WACC
Result MV of equity MV of equity + MV of debt

LECTURE EXAMPLE 6.1 (c)

Calculate the discounted cash flow valuation of AJB and briefly comment on your answer.
SOLUTION
94 6: Business valuations AC C A F9

Advantages and disadvantages

Advantages Disadvantages
Considers future potential. Future cash flows will be estimates only.
Can be used to value any business. Requires a cost of capital to be estimated.

ht
Determining the time horizon for future cashflows is

r i g 01 7 problematic. If constant growth is assumed after a

point, then a large part of the valuation will be based

y
p ion 2
on a very simplified estimate.

o
C uit
2.4.2 Dividend yield

t
Dividend per share

n
As discussed in Chapter 1, the dividend yield of a company =

I
Share Price

s t
This can be used to value a company:

ir
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

F
 𝑀𝑉 𝑜𝑓 𝑎𝑙𝑙 𝑠ℎ𝑎𝑟𝑒𝑠 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑

Important points to note:

 Dividend yields are only available for quoted companies, so if valuing a non-listed company you
will have to use the dividend yield of a similar listed company and make some adjustments to
your valuation (similar idea to P/E adjustments in the P/E valuation in that for a non-listed
company the valuation needs to be scaled down potentially).

2.4.3 Dividend growth model

We have already seen the dividend growth model used to estimate a company’s cost of equity.
A rearranged version of that formula can be used to estimate the value of the equity in the business
(providing a figure for ke can be identified).
This views the cash flows that the shareholder actually might receive rather than the overall cash flows
the company generates and as such it is better suited to valuing minority shareholdings.
AC C A F 9 6: Business valuations 95

FORMULA GIVEN IN EXAM

Do (1+g)
Po = (re −g)

Po = Current ex-div share price

Do = Current dividend
re = Return on equity or the cost of equity
g = Constant growth in dividends

Important points to note:

 The toughest challenge is to identify a relevant cost of equity figure (ke). The normal rule would
be to try to use the cost of equity for the business you are trying to value. If this is not available
then you may need to use a cost of equity of a similar business and make any necessary
adjustments to reflect differences in their capital structure (gearing).
 The formula assumes dividends are going to grow at a constant rate forever.
 As per Chapter 5, growth can be estimated either by using historic figures, or the earnings
retention method.

LECTURE 6.1 (d)

Fir Co
st I pyri
Calculate a dividend valuation for AJB and briefly comment on your answer.
SOLUTION

ntu ght
itio
n2
017

Advantages and disadvantages

Advantages Disadvantages
Considers future cash flows to shareholder. Assumes dividends grow at a constant rate forever.
Relevant for minority interests. Requires a cost of equity to be estimated.
Spurious results arise for businesses that don’t pay
dividends (zero value) or where growth (g) > cost of
equity (ke) (negative value).
96 6: Business valuations AC C A F9

3 The valuation of debt and other financial assets

When valuing the debt in a company we will use essentially the same approaches as in Chapter 5,
although this time we will be given the cost of debt and will be asked to find the market value of debt.
Note: Because we will not know the tax position of the owners of the debt, we will be using a pre-tax
cost of debt to value pre-tax cashflow when calculating the market values.

3.1 Irredeemable debt

The valuation of irredeemable debt can be calculated by using the following formula:
𝐼
Po = r
d

Where:
Po = Current ex-interest debt value
I = Interest
rd = Required return of the debt holders

ILLUSTRATION 6.1

t
Hammered Co has some $100 nominal value 6% irredeemable debt. Hammered’s debt holders have a

h 7
required return of 7%.

r i g 01
What is the value of Hammered Co debt?

2
y
p ion
SOLUTION
I
rd o
C uit
= $6
= 0.07

n t
6

I
So Po = 0.07 = $86

r s t
So the value of Hammered Co debt is $86.

F i
AC C A F 9 6: Business valuations 97

3.2 Redeemable debt

The valuation of redeemable debt capital can be calculated by discounting the future cash flows that
will be received by the redeemable debt holders (interest and the redemption value) at their required
rate of return (rd).

ILLUSTRATION 6.2

Plastered Co has some $100 nominal value 4% redeemable debt. This debt will be redeemed in seven
years’ time at a 12% premium. The debt holders’ required return is 10%. What is the value of Plastered
Co redeemable debt?
SOLUTION
I = $4
Rv = $112
rd = 10%
Timing Cash flow Discount Factor Present Value
$ 10% $
1–7 4 4.868 19.47
7 112 0.513 57.46
76.93

Fir Co
So the value of Plastered Co redeemable debt is $76.93.

st I pyri
3.3 Convertible debt
ntu ght
itio
Convertible debt is similar to redeemable debt however at the end of the debts life it can either be

n2
redeemed or converted into a certain number of ordinary shares. This is the debt holder’s decision and
will depend upon the value of the shares compared to the redemption value.

ILLUSTRATION 6.3 017

Sozzled Co has some $100 nominal value 6% convertible debt. This debt will be redeemed in four
years’ time at par or converted into 20 ordinary shares. A financial expert has forecast that Sozzled’s
shares, which are currently valued at $3.48, will be worth $5.10 in four years’ time. The convertible
debt holders required return is 10%. What is the market value of Sozzled Co convertible debt?
SOLUTION
So in four years’ time the debt can either be redeemed for $100 or converted into shares which will be
worth 20 × $5.10 = $102 and so the debt will be converted.
I = $6
Rv = $102
rd = 10%
Timing Cash flow Discount Factor Present Value
$ 10% $
1–4 6 3.170 19.02
4 102 0.683 69.67
$88.69

So the value of Sozzled Co convertible debt is $88.69.

98 6: Business valuations AC C A F9

Rather than calculating the market value, we could calculate the floor value which assumes that the
debt will not be converted but redeemed.

ILLUSTRATION 6.3 CONTINUED (PART 2)

What is the floor value of Sozzled Co convertible debt?

SOLUTION
Timing Cash flow Discount Factor Present Value
$ 10% $
1–4 6 3.170 19.02
4 100 0.683 68.30
$87.32

So the floor value of Sozzled Co convertible debt is $87.32.

Finally we can also calculate the conversion premium, which is the difference between the current
market value of the convertible debt and the current conversion value of the shares. This is the extra
value in holding the convertible debt rather than the equivalent shares.

t
ILLUSTRATION 6.3 CONTINUED (PART 3)

i g h 1 7
r 0
What is the conversion premium of Sozzled Co convertible debt?

y
p ion
SOLUTION
2
o
C uit
The current conversion value is 20 × $3.48 = $69.60.

t
So the conversion premium of Sozzled Co convertible debt is $88.69 – $69.60 = $19.09 or $19.09/20 =

I n
$0.95 per share.

r s t
F i 3.4 Preference shares
Preference shares are similar to ordinary shares except the dividend is constant and so there is no
growth. Thus the value of preference share capital can be calculated by using the following formula:
D
Po = K o
p

ILLUSTRATION 6.4
Razzled Co has just paid a dividend of 20 cents on its preference shares. The preference shareholders
required return is 11%. What is the value of Razzled Co preference share capital?
SOLUTION
Do = $0.20
Kp = 0.11
0.20
So Po =
0.11

So Po = $1.82
So the value of Razzled Co preference share capital is $1.82.
AC C A F 9 6: Business valuations 99

4 Efficient Market Hypothesis (EMH) and practical considerations in the

valuation of shares
4.1 Market Efficiency
An efficient market is one where:
 No individual dominates the market
 Transaction costs are not significant
 Share prices change ‘quickly’ to reflect information about a company
There are different degrees of efficiency which reflect different interpretations of the word ‘quickly’:

4.1.1 Weak form efficiency

 Share prices reflect all information available from past changes in the price i.e. all past
information which has now become a fact (e.g. past share price movements, results from
audited sets of accounts).
 Hence, the market cannot be beaten by technical analysis (the study of past share price
movements), as share prices already reflect the information that technical analysis uses to
predict share prices.

4.1.2 Semi-strong form efficiency

Fir Co
st I pyri
 Share prices reflect all information available from past changes in the price and any publicly
available current information i.e. all past and present publicly available information.

ntu ght
Hence, the market cannot be beaten by reading the news or published accounts, as all publically

itio
available information is already reflected in share prices.


n2
Major stock markets are close to semi-strong efficiency. This is tested by monitoring the speed
with which markets react to new publically available information.

4.1.3 Strong form efficiency


017
Share prices reflect all information available from past changes in the price and any publicly
available current information and any inside information i.e. all information.
 Hence the market cannot be beaten, even using insider information.

4.2 Practical considerations in the valuation of shares and businesses

4.2.1 Marketability and liquidity of shares
The main difference between private and listed company shares is that listed company shares are far
more marketable and hence the shares are more liquid. This feature makes listed company shares
more valuable.

4.2.2 Availability and sources of information

The more information that is available and the more reliable and independent the source of that
information, the less risk there will be. Reducing the risks increases the value.
100 6: Business valuations AC C A F9

4.2.3 Market imperfections and pricing anomalies

Markets are not perfect and as a result the actual value put on a business will not necessarily equal its
theoretical value. Markets are often higher at particular times in the day, particular days of the week
and particular times of the year. ‘Speculation bubbles’ are also rarely based on rational thinking.

4.2.4 Market capitalisation

Market capitalisation is the total market value of a company’s ordinary shares or the size of a
company. The larger a company, the more stable its overall earnings tend to be and so the lower risk it
is seen to have and consequently, the lower the long-term return. This will enhance its value in bad
times but reduce it in good times.

4.3 Behavioural Finance

Behavioural finance proposes psychology-based theories to explain stock market anomalies. Within
behavioural finance, it is assumed that the information structure and the characteristics of market
participants systematically influence individuals' investment decisions as well as market outcomes.
Behavioural finance uses the psychological factors behind investor decisions such as sentiment and
speculation to explain why irrational investor behaviour is likely to have a significant impact on share
prices.
Examples of these factors include:


ht 7
Investor over-confidence


r i g 01
Cognitive dissonance (clinging onto long-held beliefs and ignoring evidence to the contrary)

2

y
p ion
Availability bias (placing too much significance on the latest piece of available information and

o
losing sight of the bigger picture).

C uit
I n t
r s t
F i
 101

Risk management

Fir Co
1 Managing interest rate risk
st I pyri
1.1 Causes of interest rate risk
ntu ght
itio
Interest rate risk refers to the sensitivity of a company’s profits and cashflows to changes in interest

n2
rates.

017
For example, a company with variable rate debt will face increases in interest payments if interest
rates rise.

1.1.1 Gap risk / exposure

Gap exposure arises where the principle of matching the maturity of funding to maturity of assets
(discussed in Chapter 3) has not been followed.
 For example, a company may have initially secured an interest rate on 5-year borrowing and
used this borrowing to fund the purchase of a 10-year income generating asset (we can assume
that the income from the asset exceeded the interest rate on the borrowing at the start).
 When the debt matures after 5 years, the company will have to refinance and will be exposed to
any increases in interest rates over the course of the 5-year period – i.e. the ‘spot’ rate (current
interest rate) in 5 years’ time may be higher than today.
 This may mean that interest rate secured on the funding for the second 5-year period may
exceed the income from the asset.
In other words there is a gap between the earnings and the required interest payments. The earnings
and interest rate risks can vary over time and so the gap exposure will not necessarily be constant.
102 7: Risk management AC C A F9

1.2 Structure of interest rates and yield curves

The yield curve shows the relationship between the interest rates (yields) on debt instruments (traded
in the money markets and bond markets) and their maturities.
There are several theories that attempt to explain the relationship between interest rates and the time
to maturity:

Rate
% Normal yield curve
(upward sloping)

Inverted yield curve

(downward sloping)
Time to
maturity

ht 7
g 1
1.2.1 Liquidity preference theory


y r i 20
Liquidity preference theory states that as investors prefer instant access to their funds, the

p ion
longer the funds are borrowed for, the higher the cost will be.

o
C uit
This would result in the normal yield curve shown above.

n t
1.2.2 Expectations theory

I
t


s
Expectations theory states that the shape of the yield curve reflects investors’ expectations of

ir
future interest rates.

F  Hence, if lenders expected interest rates to fall in the future, then they would be prepared to
accept lower interest rates on borrowing spanning future periods. This would result in short
term interest rates being higher than long term interest rates, resulting in the inverted yield
curve shown above.

1.2.3 Market segmentation

 Market segmentation explains that the yield curve may not in fact be a perfect curve as is it is
made up of different segments of investors, some investing for the short term, some the
medium term and some the long term.
 Hence the shape of the yield curve would be based on the supply of money to lend and the
demand to borrow at each maturity date, leading to ‘humps’ at maturity dates where there is
greater demand to borrow.
AC C A F 9 7: Risk management 103

1.3 Techniques for hedging interest rate risk

1.3.1 Basic / traditional methods of interest rate risk management

Matching
This is where a company has investments and loans of the same value earning and paying the same
rate of interest at the same dates. Thus if interest rates change the effects self-cancel. This technique
is most commonly used by financial institutions and for the majority of institutions is a noble long-term
goal that is practically very difficult to achieve.

Smoothing
This is where a company maintains a balance between fixed rate and variable rate borrowing to
reduce the impact of any interest rate rises.

Asset and liability management

This involves matching the term of assets and liabilities (i.e. the matching approach from Chapter 3), in
order to avoid gap exposure.

Forward rate agreements (FRAs)

Co
FRAs are contracts that help companies to fix the rate of interest to pay on borrowing that will start at

Fir
a future date:

st I pyri
 Borrowers wanting to fix an interest rate on some future borrowing will need to buy a FRA

ntu ght
 A borrower buying a FRA will pay the FRA fixed rate and receive the spot (benchmark) rate in
one net settlement at the start of the borrowing period.

itio
 FRAs settle on the start date of the underlying loan as one net payment or receipt (but no

n2
amounts are actually lent as part of the FRA).
 The net impact (across the FRA and the actual borrowing) is that the borrower will pay the FRA

017
fixed rate.
Terminology:
– A spot interest rate of 5.65-5.61 means that you can borrow at 5.65% and deposit at
5.61% (remember, you always get the worst rate!).
– A 3-6 FRA starts in 3 months’ time and lasts for 3 months
– A FRA fixed rate of 5.75-5.70 means you can fix a rate to borrow at 5.75%, and to deposit
at 5.70%
Advantages of FRAs
 They fix an interest rate, hedging away any downside risk
 They are tailored to the investor (so they won’t be under/over hedged)
Disadvantages of FRAs
 They are usually only available on loans > £500k & < 1yr maturity
 They remove any upside potential (i.e. if interest rates were to fall)
 They cannot be cancelled (e.g. if the borrowing requirement changes)
104 7: Risk management AC C A F9

ILLUSTRATION 7.1

In 3 months’ time Paton Co will be borrowing $2.5m for 3 months from a bank and wants to hedge
uncertainty over its borrowing costs using a forward rate agreement. The quote for a 3-6 forward rate
agreement is currently 2.60-1.35.
Show the effect if in 3 months’ time the spot rate of interest is 3%.
Answer:
 As our borrowing period will start in 3 months’ time and last for 3 months, we will need to buy a
3-6 FRA with notional value $2.5m
 In 3 months’ time we will pay the FRA fixed rate (2.6%) and receive the spot rate
 The cashflow on the FRA = (3% - 2.6%) × $2.5m × 3/12 = $2,500 receipt
 We will then borrow $2.5m at spot and pay interest = $2.5m × 3% × 3/12 = $18,750
 Net payment = $18,750 - $2,500 = $16,250
 Hence, the effective interest rate = ($16,250/$2,500,000) × 12/3 = 2.6% (= the FRA rate)

1.3.2 Hedging interest rate risk with derivatives

ht 7
A derivative is something which derives its value from something else; in this context it will be interest

r i g 01
rates. There are three main types of interest rate derivative:

2
y
p ion
o
Interest Rate Futures

C uit
These are similar to forward rate agreements, but futures are of a standardised contract size,

t
standardised maturity date and are traded on organised exchanges.

I n
 Settlements take place in three-monthly cycles ending in March, June, September and December.


r s t Borrowers will sell futures now and buy the same number of futures contracts when their

F i
borrowing starts. This will lead to a net cash payment or receipt based on the difference
between the price sold at and the price purchased at.
 However, the futures do not facilitate the borrowing – we will still have to borrow at spot.
 Being traded on an exchange means that they can be closed out i.e. by purchasing an equal and
opposite investment in the same underlying currency, prior to maturity. This makes futures
more flexible than forward contracts.
 The futures price will change as the spot price changes and this allows any gain or loss on the
actual borrowing (due to interest rate movements) to be offset by losses/ gains on the futures.
Advantages of futures
 They fix an interest rate, hedging away any downside risk
 They may be closed out early (and are hence more flexible than FRAs)
Disadvantages of futures
 They are standardised and hence may lead to over / under hedging (if maturity dates and
contract sizes don’t fit with borrowing requirements)
 They remove any upside potential (i.e. if interest rates were to fall)
 Futures prices will differ to the spot rate until you reach the maturity date of the future
and this will lead to the hedge not being 100% effective if the borrowing date doesn’t
equal the futures maturity date (this is known as ‘basis risk’)
AC C A F 9 7: Risk management 105

Options
Over the counter (OTC) interest rate options can be purchased from major banks and allow the
borrower to have the right, but not the obligation to borrow at a set fixed rate (strike price) in the
future.
 The borrower would have to pay a premium now to buy the option contract and would then
wait to see how interest rates move before deciding whether to exercise the option or not.
 If interest rate rise between now and the borrowing date, the borrower would exercise the
option and borrow at the pre-determined fixed rate specified in the option
 If interest rates fall between now and the borrowing date, the borrower would let the option
lapse and borrow at the spot rate.
Advantage of options
 They only hedge away the downside risk, leaving the borrower the ability to benefit from
the upside (rates falling) – this is in contrast to FRAs and futures.
Disadvantage of options
 They are expensive and the premium must be paid up front.

Swaps

Co
Interest rate swaps involve two counterparties swapping interest rate payments on a set notional

Fir
borrowing amount for a set period of time.

st I pyri
The swap would be based on one party having fixed rate debt, but actually desiring variable rate
interest payments and another party wanting fixed rate interest payments but having variable rate

ntu ght
debt.

itio
By swapping interest payments, the two parties get the type of interest rate exposure that they desire,
without having to renegotiate the terms of their debt / refinance.

n2
2 Managing foreign exchange risk
2.1 Different types of foreign currency risk
017
2.1.1 Transaction risk
 Transaction risk refers to the risk a business is exposed to when it enters into a short term
transaction involving credit in a non-native currency - e.g. a UK based exporter making a sale on
1-month credit with payment in Euros.
 By the time the transaction is actually settled the exchange rate may have moved adversely
(e.g. Euros weakening against the Pound) and the value of the receipt will have reduced.

2.1.2 Economic risk

 Economic risk refers to the longer term risk a business is exposed to by trading in a particular
foreign country – e.g. a UK exporter (whose costs are in Pounds) making sales to the US
 If the Dollar weakens vs. the Pound, then the value of Dollar denominated sales to the US will
reduce, but costs in Pounds will not, leading to the exporter becoming less competitive than US
rivals (whose costs and revenues are both denominated in Dollars).
106 7: Risk management AC C A F9

2.1.3 Translation risk

 Translation risk refers to the danger of a business generating accounting losses when translating
the results of overseas subsidiaries (denominated in a foreign currency) into their group
reporting currency
 E.g. a UK parent company may generate paper losses when translating accumulated Dollar
profits from a US subsidiary into Pounds if the Dollar weakens against the Pound.

2.2 Causes of exchange rate fluctuations

2.2.1 Balance of payments
The balance of payments is the difference between a country’s overseas earnings and spending. If a
country earns more than it spends it will have a surplus and if it spends more than it earns it will have
a deficit.
A surplus implies the country is doing well and so its exchange rate will strengthen and a deficit implies
it is doing badly and so the exchange rate will weaken.

2.2.2 Interest rate parity theory (IRPT)

Interest rate parity theory states that the difference between the current spot exchange rate (S0) and
current forward rate (F0) reflects the difference between nominal interest rates in each country.


h t 7
This needs to hold for there to be no arbitrage (risk-free profits) available


r i g 01
I.e. an investor should be indifferent between buying Dollars using a forward contract OR

2
y
borrowing Pounds to buy Dollars at spot and investing Dollars in a deposit account.

o p i o n
Assumptions: spot price represents equilibrium price (demand = supply)

C uit
t
F
ORMULA GIVEN IN EXAM

t I n (1 + ic )

s
F0 = S0 ×

ir
(1 + ib )

F Where:
F0 = Current forward exchange rate
S0 = Current spot exchange rate
ic = interest rate in foreign country
ib = interest rate in home country
AC C A F 9 7: Risk management 107

ILLUSTRATION 7.2

The current exchange rate between the USA and the UK is $1.9854:£1. Interest rates in the USA are
forecast to be 8% for the next year and UK interest rates are forecast to be 6%.
What should the current one year forward rate be (using interest rate parity)?
SOLUTION
S0 = 1.9854
ic = 0.08
ib = 0.06
(1+0.08)
So the forward rate for the first year is: F0 = 1.9854 × (1+0.06)
F0 = 2.0229

2.2.3 Purchasing power parity theory (PPPT)

Purchasing power parity theory states that the difference between the current spot rate (S0) and
expected future spot rate (S1) is equal to the difference between inflation rates in each country
 I.e. an investor should be indifferent between buying goods in Pounds OR converting money to

Fir
Dollars and buying the same goods in Dollars
Co
st I pyri
 If it is cheaper to buy goods in the US (due to higher inflation in the UK), the exchange rate will
adjust to make Dollars more expensive as more people buy Dollars - bringing the equivalent

ntu ght
future Pound and Dollar prices back in line.

itio
 I.e. the country with higher inflation will see its currency weaken (depreciate).
Problems: inflation rates are estimates; PPPT works better in the long run as it is hampered by
government intervention (monetary policy).
n2
FORMULA GIVEN IN EXAM
(1 + hc )
017
S1 = S0 ×
(1 + hb )

Where:
S1 = Expected future spot rate
S0 = Current spot exchange rate
hc = inflation rate in foreign country
hb = inflation rate in home country
108 7: Risk management AC C A F9

LECTURE EXAMPLE 7.1

The current exchange rate between the USA and the UK is $1.9854:£1. Inflation in the USA is forecast
to be 5% for the next year and UK inflation is forecast to be 3%.
What is the forecast exchange rate in one year’s time using purchasing power parity?
SOLUTION

2.2.4 Four-way equivalence

International Fisher Effect
 Assuming that real interest rates are the same in both countries, the only difference between
the nominal rates in the two countries is caused by differences in the inflation rates in the two
countries (per the Fisher effect in Chapter 4).

ht 7
Hence nominal interest rate differences should be an unbiased predictor of future changes in

r i g
the spot rate

201
y
p ion
Expectations theory

o
C uit
Following on, the current forward rate should therefore be an unbiased predictor of the future
spot rate

I n t
These theories are summarised in the diagram below:

r s t Difference in (nominal) Fisher Effect Expected difference in

i
interest rates inflation rates

F
(1 + 𝑖𝑐 ) (1 + ℎ𝑐 )
(1 + 𝑖𝑏 ) (1 + ℎ𝑏 )

International
Fisher Effect PPPT
IRPT

Difference between forward Expected change in spot

and spot rates
𝐹0 𝑆1
𝑆0 Expectations 𝑆0
Theory
AC C A F 9 7: Risk management 109

2.3 Quotation conventions for foreign exchange rates

In the real world exchange rates are quoted as a spread e.g. Spot rate ($ per £): 1.9854 ± 0.0003 or
1.9851 to 1.9857.
The correct rate to select depends upon whether you are translating a cost or revenue figure.
Remember the bank always wins and so if it is a cost you use the rate that gives the highest domestic
currency figure and if it is revenue you use the rate that gives the lowest domestic currency figure.
The spread is normally presented in the form:
Spot rate £/$1.9730 – 1.9738

This is the rate This is the rate

that we buy the that we sell the
foreign currency foreign currency
at at

2.4 Hedging techniques for foreign currency risk

2.4.1 Basic / traditional methods of foreign currency risk management

Currency of invoice

Fir Co
By ensuring that the currency of invoice is the same as the domestic currency, the transaction risk is

st I pyri
removed entirely in a cheap and effective way. The risk is in fact transferred to the other party
involved in the transaction and so this will not always be a viable solution.

Netting and matching

ntu ght
itio
Netting and matching can be used where foreign currency is both being earned and spent so that

n2
receipts and payments can be netted (just leaving the risk on the net balance). This approach is
facilitated by having a bank account denoted in relevant currency.

017
However this only works where there is a two way flow in the currency concerned and so unless the
organisation is both earning and spending the currency in question, this approach will not be available.

Leading and lagging

Leading: e.g. bringing forward a foreign currency payment if you think that the foreign currency will
strengthen before the payment due date
 Remember that if you lead on a payment, then you will incur borrowing costs in making the
payment early!
Lagging: e.g. trying to push back a foreign currency payment if you think that the foreign currency will
weaken after the current expected payment date
 This is not strictly hedging, rather speculation – if you lag on a payment then you remain
exposed to FX movements.

Asset and liability management

Asset and liability management involves matching the assets and liabilities held in a particular
currency. In this way any change in value is automatically off set between the asset and liability. This
technique also eliminates the translation risk.
However, in practice, it will not always be economical to raise funds in the same currency as they are
to be invested.
110 7: Risk management AC C A F9

Forward exchange contracts

A forward exchange contract is a contract, normally with a bank, which fixes the exchange rate that
will be used on the future transaction today, thus the transaction risk is being taken, for a fee, by the
bank (the fee is usually factored into the rate offered).
These share the same advantages (a tailor made hedge) and disadvantages (hedges upside and
downside risk, can’t be cancelled or exited early) as FRAs. Not being cancellable is problematic if the
future receipt / payment date changes (delivery will still be expected).

LECTURE EXAMPLE 7.2

Exportit Co is a UK based organisation which sells some goods on three months’ credit to a US
customer for $90,000. The current exchange rate is $1.9851-$1.9857:£1 and the bank has offered
Exportit a forward contract at a rate of $2.0117-$2.0123.
Using a forward contract, how much sterling will Exportit receive in three months’ time?
SOLUTION

ht 7
Calculating a forward rate


r i g 01
Instead of being given the forward rate, you may be asked to calculate it. For example, you may

2
y
p ion
be given the spot rate spread and the necessary adjustments to the spot rate to calculate the

o
forward rate.

C uit
The forward rate adjustment is quoted as a premium or discount on the spot rate.

t
 If the forward rate is at a discount, it means the foreign currency is expected to depreciate in

t I n
relation to the home currency. Thus the home currency will be worth more under the forward

s
rate than it is currently.

F ir
 It may seem illogical but therefore you need to ADD a discount, but DEDUCT a premium as the
exchange rate tells us what the home currency is worth.

ILLUSTRATION 7.3

Spot rate £/$1.9730 – 1.9738 (i.e. £1 = 1.973 dollars). The 2 month forward adjustment is given as
0.9 to 0.58 cents premium for £/$.
To calculate the 2 month forward rate spread :
£/$ Spread
Spot (£/$) 1.9730 – 1.9738 0.0008
2 month adjt (premium) 0.0090 – 0.0058
2 month forward rate 1.9640 – 1.9680 0.0040
Three things to note here:
(1) A “premium” will ALWAYS mean that you DEDUCT the adjustment
(2) The forward adjustment is usually quoted in the smallest unit of currency, so 0.9 cents =
$0.0090
(3) The spread for a forward contract is ALWAYS greater than the spread for the spot
AC C A F 9 7: Risk management 111

LECTURE EXAMPLE 7.3

Spot rate £/$ 1.9730 – 1.9738

The 3 month forward adjustment is given as 0.06 to 0.14 cents discount for £/$.
Calculate the 3-month forward rate spread.
SOLUTION

Money market hedging

Money market hedging involves borrowing or lending money in the money markets to match the
overseas transaction and eliminate the transaction risk by fixing an effective forward exchange rate.
 So if a company is expecting an overseas receipt, it borrows money now such that at
termination the receipt and borrowing match and cancel each other out.
 The borrowings can then be translated into the home currency at the current known exchange
rate and then invested to create a certain home currency receipt in the future.

Fir Co
If a company is expecting to make an overseas payment, then the reverse process is followed

st I pyri
(borrowing now in the home currency and depositing in the foreign currency).

ntu ght
MM hedges are effectively do-it-yourself forward contracts, however the interest rates obtained by
companies in the money markets are unlikely to be as good as those obtained by banks and so these

itio
are not that widely used (and may prove more difficult to arrange and expensive than forward
contracts).

MM Hedge step-by-step guide:

n2
To hedge future payment in Euros:
Borrow in $ now 017
To hedge future receipt in Euros:
Borrow in € now
Convert to € at spot Convert to $ at spot
Deposit €, earn interest Deposit $, earn interest
On payment date, settle payment out of € deposit account On receipt date, use receipt to pay back € loan
Pay back $ loan + interest. Withdraw $ from deposit
112 7: Risk management AC C A F9

LECTURE EXAMPLE 7.4: MM HEDGE – FOREIGN CURRENCY PAYMENT

Importit Co is a UK based organisation which buys some goods on three months credit from a US
supplier for $90,000. The current exchange rate is $1.9851-$1.9857:£1 and the money market interest
rates are as follows:
Borrowing Depositing
One year sterling interest rate: 6.0% 5.7%
One year dollar interest rate: 8.3% 8.0%
Using a money market hedge, how much sterling will Importit pay in three months’ time?
SOLUTION

ht 7
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y
p ion
o
C uit
I n t
r s t
F i
AC C A F 9 7: Risk management 113

LECTURE EXAMPLE 7.5: MM HEDGE – FOREIGN CURRENCY RECEIPT

Trading Co is a UK based organisation which sells some goods on six months credit to a European
customer for €120,000. The current exchange rate is €1.1446-€1.1452:£1 and the money market
interest rates are as follows:
Borrowing Depositing
One year sterling interest rate: 6.0% 5.7%
One year euro interest rate: 4.0% 3.7%
Using a money market hedge, how much sterling will Trading receive in six months’ time?
SOLUTION

Fir Co
st I pyri
ntu ght
itio
n2
017
114 7: Risk management AC C A F9

2.4.2 Hedging foreign exchange risk with derivatives

A derivative is something which derives its value from something else; in this context it will be foreign
exchange rates. There are three main types of FX derivative:

FX Futures
These are similar to forward contracts, but FX futures are of a standardised contract size, standardised
maturity date and are traded on organised exchanges.
 Settlements take place in three-monthly cycles ending in March, June, September and
December.
 E.g. a US company expecting to receive Euros in 3 months’ time will sell Euro futures now (to
lock in a Dollar price at which they can sell the Euros).
 They will then buy the same number of Euro futures contracts when on the date they receive
the Euros.
 This will lead to a net cash payment or receipt in Dollars based on the difference between the
price sold at and the price purchased at.
 However, the futures do not facilitate the sale of the Euros – we will still have to sell our Euros
at the spot rate to a buyer.
 Being traded on an exchange means that they can be closed out i.e. by purchasing an equal and

t
opposite investment in the same underlying currency, prior to maturity. This makes futures

g h 7
more flexible than forward contracts.


y r i 201
The futures price will change as the spot price changes and this allows any gain or loss on the

p ion
actual business transaction to be offset by losses or gains on the futures.

o
C uit
Advantages of futures


t
They fix an exchange rate, hedging away any downside risk

n


I
They may be closed out early (and are hence more flexible than forwards)

s t
Disadvantages of futures

F ir 


They are standardised and hence may lead to over / under hedging (if maturity dates and
contract sizes don’t fit with the user’s requirements)
They remove any upside potential (i.e. in the above example if the Euro strengthens vs
the Dollar)
 Futures prices will differ to the spot rate until you reach the maturity date of the future
and this will lead to the hedge not being 100% effective if the transaction date doesn’t
equal the futures maturity date (this is known as ‘basis risk’)
AC C A F 9 7: Risk management 115

FX Options
Over the counter (OTC) currency options can be purchased from major banks and allow the user to
have the right, but not the obligation to e.g. sell Euros at a set Dollar price (strike price) in the future
(this would be a ‘put’ option – the right to sell, ‘call’ options are the right to buy).
 We would have to pay a premium now to buy the option contract and would then wait to see
how exchange rates move before deciding whether to exercise the option or not.
 If Euros weaken vs. the Dollar between now and the receipt date, we would exercise the option
and sell the Euros at the pre-determined fixed Dollar price specified in the option
 If Euros strengthen vs. the Dollar between now and the receipt date, we would would let the
option lapse and sell the Euros at the spot rate.
Advantage of options
 They only hedge away the downside risk, leaving the borrower the ability to benefit from
the upside (rates falling) – this is in contrast to forwards and futures.
Disadvantage of options
 They are expensive and the premium must be paid upfront.

Currency Swaps

Co
Currency swaps involve two counterparties swapping principal and interest rate payments on

Fir
borrowings in two different currencies.

st I pyri
 For example, a US based company might have arranged existing debt finance in Dollars but are
using the debt to finance an investment in operations in the Eurozone.

ntu ght
Meanwhile, a French company has existing debt in Euros which it is using to finance operations

itio
in the US.


n2
A currency swap would allow the two parties to swap interest payments and notionals on their
debt to better facilitate asset and liability management (see earlier), without the pain of having

017
to refinance (especially useful if either of the two companies are unable to borrow in their
desired currency).
116 7: Risk management AC C A F9

ht 7
r i g 201
y
p ion
o
C uit
I n t
r s t
F i
 117

Solutions to
Class lecture examples

Fir Co
st I pyri
Chapter 1
ntu ght
Lecture example 1.1 itio
2,159
n2
017
ROCE 28%
× 100 =
7,340 + 3,562 – 3,070
Return on Equity 1,260 25%
× 100 =
4,956
EPS 1,260 $0.60
=
2,100
Dividend per share 525 $0.25
=
2,100
P/E ratio 7.20 12
=
0.60
TSR 0.25 + (7.20 − 7) 6.4%
=
7
These figures give us very little indication as to whether or not Diamond Co is achieving its own
corporate objectives, however if we knew what its corporate objectives were and what ROCE, Return
on Equity, EPS and Dividend per Share had been achieved in previous years, we would then be better
placed to reach a conclusion.
118 Solutions to Class lecture examples AC C A F9

However we are able to compare these figures with the industry averages, though care needs to be taken:
(1) ROCE: Diamond is marginally outperforming the industry average.
(2) Return on Equity: The fact that this slightly lower than the industry average, but the ROCE is
higher, suggests that the debt holders are doing relatively well.
(3) EPS: The industry average comparison is almost certainly meaningless as this figure depends
upon the nominal value of the shares and this can be any figure the company chooses. If
Diamond had twice as many shares with half their current nominal value, the total nominal
value of the shares would be the same, but the EPS would be halved to $0.30.
(4) Dividend per share: Again comparing with the industry average is dangerous as the significance
of the absolute dividend depends upon what was paid for the shares and the risks being faced
by shareholders.
(5) Total shareholder return: to conclude on whether this is a sufficient return for shareholders we
would need to compare it to either an industry average or an estimated cost of equity for
Diamond Co (see chapter 5).

Chapter 2
No lecture examples

Chapter 3
ht 7
r i g 201
y
Lecture example 3.1

o p ion 936 + 2,626

C uit
Current ratio 1.2
=
1,296 + 537 + 1,237

I n t
Quick ratio 2,626
=
0.9

t
1,296 + 537 + 1,237

ir s
Inventory turnover ratio 14,687– 4,386 11 times

F
=
936
Average collection period 2,626 65 days
× 365 =
14,687
Average payable period 1,296 46 days
× 365 =
14,687– 4,386
Sales revenue/net working capital ratio 14,687 29.9
=
492

Lecture example 3.2

Co = $20
D = 500 units × 12months = 6,000 units per annum
Ch = $1.20 @ 20% = $0.24
2×20×6,000
EOQ = √ 0.24
= 1,000 units

6,000 1,000
TAC = (20 × 1,000) + (0.24 × 2
) = $120 + $120 = $240

By ordering 1,000 units of inventory whenever Paton places an order, the total annual variable
inventory costs are minimised at $240.
AC C A F 9 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 119

Lecture example 3.2 revisited

The total annual cost of ordering at the EOQ including the purchase price is:
6,000 1,000
(20 × 1,000) + (0.24 × 2
) + (6,000 × 1.20) = $120 + $120 + $7,200 = $7,440

The total annual cost of ordering 1,500 units including the purchase price is:
6,000 1,500
(20 × 1,500) + (0.24 × 0.995 × 2
) + (6,000 × 1.20 × 0.995) = $80 + $179 + $7,164 = $7,423

Thus it is financially worth Paton Co taking advantage of the bulk discount.

Lecture example 3.3

The cost of this scheme is the discount:
$4,450,000 × 80% × 5% = $178,000
The benefits of this scheme are:
Reduction in bad debts (8% – 5%) × $4,450,000 = $133,500
Reduction in overdraft interest:
Old receivables $4,450,000 × 55/365 = $670,548
New receivables $4,450,000 × 30/365 = $365,753
Reduction in receivables $304,795

Fir Co
Interest saved × 12% = $36,575

st I pyri
Total benefit $170,075

So as the costs are greater than the benefits this particular scheme is not economically worthwhile.

Lecture example 3.4 ntu ght

itio June July August

n2
$ $ $
Receipts
From customers (W1)
Capital
017
13,365
50,000
63,365
54,576

54,576
100,845

100,845
Payments
Materials (W3) 12,000 19,125
Labour (W4) 16,000 25,500 32,000
Variable overheads (W5) 2,000 5,188 7,187
Fixed overheads (W6) 15,000 15,000 15,000
33,000 57,688 73,312
Net cash flow 30,365 (3,112) 27,533
Opening balance 0 30,365 27,253
Closing balance $30,365 $27,253 $54,786

Workings
(W1) Cash receipts from customers
June July August
Sales $45,000 $108,000 $135,000

Received in month of sale (30% × 99% × sales in mth) $13,365 $32,076 $40,095
Received 1 mth later (50% × previous mth sales) – $22,500 $54,000
Received 2 mths later (15% × sales 2 mths ago) – – $6,750
TOTAL $13,365 $54,576 $100,845
120 Solutions to Class lecture examples AC C A F9

(W2) Production
In order to work out our costs we need to establish the production volumes each month. This
can be done by taking the sales volumes for a month, adding closing inventory and deducting
opening inventory.
June July August September
Sales volume 500 1,200 1,500 1,900
Add: closing inventory (25% of next
month’s sales) 300 375 475
Less: opening inventory nil 300 375
Production 800 1,275 1,600

Now we know this we can calculate the cash flows for the variable costs:
(W3) Materials
June July August
Production (W2) 800 1,275
Material cost (@ $15 each) $12,000 $19,125
Cash payment (1 month later) nil $12,000 $19,125

(W4) Labour
June July August
Production (W2) 800 1,275 1,600

t
Labour cost (@ $20 each) $16,000 $25,500 $32,000

h 7
Cash payment (same month) $16,000 $25,500 $32,000

r i g 201
y
(W5) Variable overheads

p ion
June July August

o
Production (W2) 800 1,275 1,600

C uit
Variable overhead cost (@ $5 each) $4,000 $6,375 $8,000

t
Cash payment ( 50% same month) $2,000 $3,188 $4,000

I n
Cash payment (50% month later) nil $2,000 $3,187

t
TOTAL $2,000 $5,188 $7,187

ir s
(W6) Fixed overheads

F Monthly cost = $180,000 ÷ 12 months = $15,000

Lecture example 3.5

3/4 ×575×400,000,000 1/3
Spread = 3 ( 0.0003
) = $249,466

Return point = –40,000 + (⅓ × 249,466) = $43,155

Upper limit = –40,000 + 249,466 = $209,466
AC C A F 9 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 121

Chapter 4
Lecture example 4.1
Materials: The relevant cost is $0.80 × 1,200kg = $960, which is the benefit forgone from the
next best alternative use of the material.
Labour: The relevant cost is nil as there is no incremental cost.
Overheads: The relevant cost is $34,564. The fixed overhead will not change and so is not
incremental.
Machine: The original purchase price of $20,000 is not relevant as this is a sunk cost. Ignoring
the new opportunity, Proposal Co would keep the machine as it will earn more
money ($15,000) than its scrap value ($12,000).
If the machine is used on the new project, the final question to ask is, will Proposal
Co replace it? The answer is yes as the replacement cost ($14,000) is less than the
money it will earn ($15,000).
So the relevant cost is $14,000.

Lecture example 4.2

Co
Annual cash flow Cumulative cash flow

Fir
$ $

st I pyri
Investment (80,000) (80,000)
First year 15,000 (65,000)

ntu ght
Second year 20,000 (45,000)
Third year 25,000 (20,000)

itio
Fourth year 30,000 10,000
So the payback period is 4 years or if we assume that the cash flows come in evenly throughout each
year:
n2
017
20,000
3 + 30,000 = 323 years

Lecture example 4.2 (part 2)

(($15,000 + $20,000 + $25,000 + $30,000 + $35,000) − $80,000)
Average profit = 5
= $9,000
$9,000
ROCE = $40,000 × 100 = 22.5%

Lecture example 4.3

FV = $16,751
r = 0.05
n =6
So PV = 16,751 × (1 + 0.05)−6 = $12,500

Lecture example 4.4

A = $150
r = 0.06
n = 12
1−(1+0.06)−12
So PV = $150 × 0.06
= $1,258
122 Solutions to Class lecture examples AC C A F9

Lecture example 4.3 revisited

FV = $16,751
r = 0.05
n =6
So PV = 16,751 × 0.746 = $12,496

Lecture example 4.4 revisited

A = $150
r = 0.06
n = 12
So PV = $150 × 8.384 = $1,258

Lecture example 4.5

A = $150
r = 0.06
n = 12
So value as at t3 (one year before the cashflows start) = $150 × 8.384 = $1,258
PV = $1,258 x DF (3 years, 6%) = $1,258 x 0.84 = $1,057

ht 7
i g 1
Lecture example 4.6
A
y r
= $2,000
20
r

o p ion
= 0.05

C uit
1
So PV = 2,000 × 0.05 = $40,000

I n t
Lecture example 4.2 (part 3)

r s t
i
Timing Cash flow Discount Factor Present Value

F
$ 10% $
0 (80,000) 1.000 (80,000)
1 15,000 0.909 13,635
2 20,000 0.826 16,520
3 25,000 0.751 18,775
4 30,000 0.683 20,490
5 35,000 0.621 21,735
NPV = $11,155

Lecture example 4.2 (part 4)

Discount Discount
Timing Cash flow Factor Present Value Factor Present Value
$ 10% $ 20% $
0 (80,000) 1.000 (80,000) 1.000 (80,000)
1 15,000 0.909 13,635 0.833 12,495
2 20,000 0.826 16,520 0.694 13,880
3 25,000 0.751 18,775 0.579 14,475
4 30,000 0.683 20,490 0.482 14,460
5 35,000 0.621 21,735 0.402 14,070
$11,155 $(10,620)
AC C A F 9 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 123

11,155
IRR ≈ 0.10 + 11,155−(10,620) × (0.20 − 0.10)

= 0.15 or 15%

Lecture example 4.7

The net present value of the proposed investment:
Time 0 1 2 3 4
$000 $000 $000 $000 $000
Sales (no. of games × selling price) 3,750 1,680 1,380 1,320
Direct materials ($5.40 × no of games × (1 + h)n ) (834) (401) (354) (365)
Variable production costs (927) (446) (393) (405)
($6.00 × no of games × (1 + h)n )
Advertising (650) (100) – –
Lost contribution on existing game (10,000 × $15) (150) (150) (150) (150)
Net operating cash flow 1,189 583 483 400
Tax @ 30% (357) (175) (145) (120)
New machine (800) 150
Tax saved on Capital Allowances (W1) 48 48 48 51
Working capital (W2) (375) 207 30 6 132
Net cash flow (1,175) 1,087 486 392 613
Discount Factor @ 15% 1.000 0.870 0.756 0.658 0.572

Fir Co
Present Value (1,175) 946 367 258 351

st I pyri
Net Present Value $747

ntu ght
As the net present value is positive, the proposed investment should be accepted as it will increase the
shareholders’ wealth by $747k.
(W1) Tax saved on Capital Allowances
itio
n2
Time Tax Tax Saved Cash Flow

017
$000 $000
0 Purchase 800
1 CA @ 20% (160) @30% 48
640
2 CA @ 20% (160) @30% 48
480
3 CA @ 20% (160) @30% 48
320
4 Sale Proceeds (150)
170
Balancing Allowance (170) @30% 51
Nil 195

(W2) Working capital

Time 0 1 2 3 4
$000 $000 $000 $000 $000
Sales (no. of games × selling price) 3,750 1,680 1,380 1,320
Working capital needed (10% × sales) 375 168 138 132 0
Working capital cash flows (375) 207 30 6 132
124 Solutions to Class lecture examples AC C A F9

Illustration 4.2 (part 2)

If the present value falls by more than $6,831, the NPV will no longer be positive.
If the sales volume falls then so will the direct costs and the tax. So, a $1 fall in revenue will cause the
net operating cash flow to fall by $1 × (1 – 0.35) = $0.65 and the net cash flow after tax to fall by $0.65
× (1 – 0.30) = $0.455 or 45.5%. So the present value impact of the revenue is:
Revenue Direct costs and Net cash flow Discount Present
Timing cash flow tax reduction after tax Factor Value
$ 45.5% $ 9% $
1 27,000 0.455 12,285 0.917 11,265
2 37,000 0.455 16,835 0.842 14,175
3 49,000 0.455 22,295 0.772 17,212
PV = 42,652
$6,831
× 100 = 16%
$42,652
A rise in overheads will also cause the tax to fall. So the present value impact of the overheads is:
Overhead Net cash flow Discount Present
Timing cash flow Tax reduction after tax Factor Value
$ 70% $ 9% $
1–3 9,000 0.70 6,300 2.531 15,945

t
$6,831

h 7
× 100 = 42.8%

i g 1
$15,945

y r 20
For the NPV of the project to hit zero, the cost of capital would have to increase to equal the internal

p ion
rate of return (the actual % return on the project). For instance, the NPV at 20% =
Time
o
C uit
0
$
1
$
2
$
3
$

I n t
Net cash flow (40,000) 8,985 12,785 36,045

t
Discount Factor @ 20% 1.000 0.833 0.694 0.579

r s
Present Value (40,000) 7,485 8,873 20,870

F i NPV = $(2,772)
6,831
IRR ≈ 0.09 + × (0.20 − 0.09)
6,831−(2,772)
= 16.8%
16.8%−9%
× 100 = 87%
9%
Thus the new machine is most sensitive to the revenue estimate.
AC C A F 9 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 125

Lecture example 4.8

(a)
Time 0 1 2 3
$ $ $ $
Expected revenue (W1) 480,000 515,000 510,000
Direct costs @ 60% (288,000) (309,000) (306,000)
Overheads (54,000) (54,000) (54,000)
Net operating cash flows 138,000 152,000 150,000
Tax @ 35% (48,300) (53,200) (52,500)
Equipment (W2) (300,000) 130,000
Net cash flow (300,000) 89,700 98,800 227,500
Discount Factor @ 13% 1.000 0.885 0.783 0.693
Present Value (300,000) 79,385 77,360 157,657

Expected NPV = $14,402

Workings 1: Expected Sales Values
Second Year Probability Forecast Sales
High 0.55 $650,000 $357,500
Low 0.45 $350,000 $157,500

Co
Expected Sales Value = $515,000

Fir
st I pyri
Third Year Probability Forecast Sales
High 0.25 $600,000 $150,000

ntu ght
Medium 0.60 $500,000 $300,000
Low 0.15 $400,000 $60,000

itio
Expected Sales Value = $510,000

n2
Workings 2: Expected Disposal Value

017
Probability Forecast Sales
High 0.4 $160,000 $64,000
Low 0.6 $110,000 $66,000
Expected Disposal Value = $130,000

(b) For the revenue to exceed $1,600,000, as the first year’s sales are $480,00, the second year’s
sales would need to be high ($650,000) and the third year’s sales would need to be either high
or medium ($600,000 or $500,000). So the probability of this is:
(0.55 × 0.25) + (0.55 × 0.60) = 0.1375 + 0.33 = 0.4675

Lecture example 4.2 (part 5)

Time Cash flow Discount factor Present value Cumulative cash flow
$ 10% $ $
0 (80,000) 1.000 (80,000) (80,000)
1 15,000 0.909 13,635 (66,365)
2 20,000 0.826 16,520 (49,845)
3 25,000 0.751 18,775 (31,070)
4 30,000 0.683 20,490 (10,580)
5 35,000 0.621 21,735 11,155
So the adjusted payback period is 5 years.
126 Solutions to Class lecture examples AC C A F9

Lecture example 4.9

Replace every year:
Time Cash flow 12% DF PV Annuity factor EAC
0 (7,000) 1.000 (7,000)
1 (3,000) 0.893 (2,679)
1 5,000 0.893 4,465
(5,214) 0.893 (5,839)

Replace every 2 years:

Time Cash flow 12% DF PV Annuity factor EAC
0 (7,000) 1.000 (7,000)
1 (3,000) 0.893 (2,679)
2 (4,000) 0.797 (3,188)
2 3,500 0.797 2,790
(10,077) 1.690 (5,962)

Replace every 3 years:

Time Cash flow 12% DF PV Annuity factor EAC
0 (7,000) 1.000 (7,000)
1 (3,000) 0.893 (2,679)
2 (4,000) 0.797 (3,188)

ht
3 (4,750) 0.712 (3,382)
3

r i g 1 7
2,500

0
0.712 1,780

2
(14,469) 2.402 (6,024)

y
p ion
o
So Mobile Co should replace their grinding machines every year.

Chapter 5 C i t
n t u
s t I
r
Lecture example 5.1

F i (a) White Spirit Co needs to raise enough funds for the new investment opportunity and the issue
costs: $4,288,000 + $212,000 = $4,500,000
Rights issue price $2.40 × 75% = $ 1.80
So the number of shares that will need to be issued is $4,500,000/$1.80 = 2.5m shares. As the
company already has 10m shares, this will be a 1 for 4 rights issue.
The current value of Spirit’s shares = $2.40 x 10m = $24m
$24m+$4.5m−$212k
Hence the TERP = = $2.26
10m+2.5m
(b) The value of one right = TERP – issue price = $2.26 - $1.80 = $0.46
(c) Before the rights issuance, White Spirit has:
 PAT = $2m
 Market value of equity = 10m x £2.40 = $24m
 Hence, it’s P/E ratio = $24m / $2m = 12
After the rights issuance, White Spirit has:
 PAT = $2m x 1.15 = $2.3m
 Market value of equity = $2.3m x 12 = $27.6m
AC C A F 9 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 127

Hence the new share price = $27.6m / 12.5m shares = $2.21

This is lower than the TERP of $2.26, hence the proposed use of the funds is unacceptable for
the shareholders (as it will lead to them making a loss).

Lecture example 5.2

Do = $0.25
g = 0.09
Po = $3.75
0.25(1+0.09)
So re = 3.75
+ 0.09

re = 0.16 or 16%

Lecture example 5.3

Rf = 0.05
βi = 1.5
E(rm) = 0.17
So E(ri) = 0.05 + 1.5(0.17 – 0.05) = 0.23
So the cost of equity for Drewboy Co is 23%.

Lecture example 5.4

Fir Co
I = $6
st I pyri
ntu ght
T = 0.30
Po = $84

itio
6(1−0.30)
So Kd = 84
= 0.05

So the cost of debt for Hammered Co is 5%.

n2
Lecture example 5.5
I = $4
017
T = 0.35
Po = $75
Rv = $112
Discount Present Discount Present
Timing Cash flow Factor Value Factor Value
$ 10% $ 5% $
0 (75) 1.000 (75) 1.000 (75)
1–7 4(1 – 0.35) 4.868 12.66 5.786 15.04
7 112 0.513 57.46 0.711 79.63
$(4.88) $19.67
19.67
IRR ≈ 0.05 + 19.67−(4.88) × (0.10 − 0.05)

= 0.09
So the cost of redeemable debt for Plastered Co is 9%.
128 Solutions to Class lecture examples AC C A F9

Lecture example 5.6

Do = $0.20
Po = $1.90
0.20
So Kp = 1.90

So the cost of preference share capital for Razzled Co is 11%.

Lecture example 5.7

I =8
T = 0.25
Po = 100
8(1−0.25)
So Kb = 100

Kb = 0.06
So the cost of bank debt capital for Blotto Co is 6%.

Lecture example 5.8

Do = $0.45

t
g = 0.06

h 7
Po = $5.25

r i g 01
0.45(1+0.06)
So re = + 0.06

y 2
5.25

o p ion
re = 0.15

C uit
I = $7

t
T = 0.35

I n
Po = $83 – $7 = $76

t
7(1−0.35)

s
So Kd = = 0.06

ir
76

F
So the WACC using book values is:
19,450,000 10,000,000
WACC = (19,450,000+10,000,000) 0.15 + (19,450,000+10,000,000) 0.06

= 0.12 or 12%
To calculate the WACC using market values we first need to calculate the total market value of the
equity and debt:
Total market value of equity = 4,500,000 shares @ $5.25 = $23,625,000
Total market value of debt = $10,000,000 @ 76% = $7,600,000
So the WACC using market values is:
23,625,000 7,600,000
WACC = (23,625,000+7,600,000) 0.15 + (23,625,000+7,600,000) 0.06

= 0.13 or 13%
AC C A F 9 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 129

Lecture example 5.9

Fletch Co is in the correct business, but has the wrong gearing level. So we will need to ungear Fletch
Co’s beta, taking out 32% gearing and then add in Millie Mo’s 43% gearing.
68
βa = 68+32(1−0.30) × 1.36

βa = 1.02
57
1.02 = 57+43(1−0.30) × βe

1.02 = 0.654 × βe
1.02
βe = = 1.56
0.654

Rf = 0.04
E(rm) = 0.18
So the project specific discount rate for Millie Mo’s new project is 25.8%.

Chapter 6

Co
Lecture example 6.1

Fir
st I pyri
(a) Calculate the asset based valuation for AJB
The most recent net asset value from the statement of financial position is $133m. This could be

ntu ght
expressed as a value per share of $133m/40m shares = $3.325. The limitations of this value here
are that:

itio
No account is taken of any intangible value which in an IT consultancy might be assumed to be a

n2
significant amount (see later valuation of intangibles/intellectual property).

017
Whilst we are told that book values reflect realisable values there is no indication as to when
things like the non-current assets were last revalued.
(b) Earnings based valuation for AJB
The P/E ratio for the similar listed company = $7.5/$0.5 = 15
Applying a P/E valuation to the most recent (i.e. 2013) earnings (PAT) gives:
15 x $21.9m = $328.5m = MVe
Hence, the value of one share = $328.5m / 40m = $8.21
However, adjustments would have to be made for differences between the two companies:
 AJB is not listed, hence it might have a lower P/E ratio (due to investors paying a
premium for shares in a listed company due to increased liquidity / marketability 
hence we may need to revise the valuation down (say by 25-30%?)
 What are the growth projections in each company?
 How does the gearing of each company compare?
All of these differences could cause the P/E valuation to be inaccurate.
130 Solutions to Class lecture examples AC C A F9

(c) Cash flow valuation of AJB

The free cash flow can be estimated as follows for the future cash flows starting in one year’s
time
1 2 3 Thereafter
PAT 27.8 34.6
Add: depreciation 35.0 35.0
Less: CAPEX 35.0 35.0
Free cash flow 27.8 34.6 35.3 Growing at 2%pa
A PV calculation can then be performed on the future cash flows.
Step 1 – Work out the value as at 2015 of the growing perpetuity from 2016 onwards:
1 1
𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 20𝑋5 = 20𝑋6 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 × 𝑟−𝑔
= 35.3 × 0.11−0.02 = $𝟑𝟗𝟐𝒎

Step 2 – The PV of all future cash flows can now be calculated:

Time Cash flow 11% DF PV
$m $’m
1 27.8 0.901 25.0
2 34.6 0.812 28.1
3 392.0 0.812 318.3
Valuation 371.4

t
or a value per share of $9.29

g h 1 7
But, how realistic is constant growth after X5 and a constant cost of equity?

i
(d)

y r 20
Dividend valuation for AJB

o p ion
Using historic growth to predict future growth:

C uit$10𝑚 × (1 + 𝑔)2 = $11.2m

n t
Hence,

s t I√
$11.2𝑚
− 1 = 𝑔 = 5.8%

ir
$10𝑚

F
Using the DGM formula;
𝑑1 $11.9𝑚
𝑃0 = 𝐾 = 0.11−0.058 = $𝟐𝟐𝟖. 𝟖𝒎 (𝑜𝑟 $5.72 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒)
𝑒 −𝑔

Remember to question the assumptions about constant growth and a constant cost of equity

Chapter 7
Lecture example 7.1
S0 = 1.9854
hc = 0.05
hb = 0.03
(1+0.05)
S1 = 1.9854 ×
(1+0.03)

S1 = 2.0240
AC C A F 9 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 131

Lecture example 7.2

By taking out a forward contract with its bank, Exportit knows that the exchange rate on this
transaction is fixed at $2.0123:£1. So in three months’ time Exportit will receive:
$90,000
$2.0123
= £44,725

Lecture example 7.3

£/$ Spread
Spot (£/$) 1.9730 – 1.9738 0.0008
3 month adjt (discount) 0.0006 – 0.0014
3 month forward rate 1.9736 – 1.9752 0.0016
(1) A “discount” will ALWAYS mean that you ADD the adjustment (Remember ADDIS)
(2) The spread for a forward contract is again greater than the spread for the spot

Lecture example 7.4

$90,000
To match the $90,000 payment in three months’ time, Importit will need to invest 1+(0.08 / 4) = $88,235
today.
$88,235
To make this investment it will need to borrow $1.9851 = £44,449 today.

Fir Co
st I pyri
So in three months’ time Importit will owe £44,449 × {1 + (0.06/4)} = £45,116.

Lecture example 7.5

ntu ght $120,000

itio
To match the €120,000 receipt in six months’ time, Trading will need to borrow 1+(0.04 / 2) = €117,647
today.

n2
€117,647
This loan can be translated into €1.1452
= £102,731 today.

017
So in six months’ time Trading will receive £102,731 × {1 + (0.057/2)} = £105,658.
132 Solutions to Class lecture examples AC C A F9

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