BA1 Course notes

Syllabus A: Macroeconomic and Institutional Context of Business ......................2

Syllabus A1: Factors Affecting National Income .............................................................................. 2
Syllabus A2: The Balance of Payments .......................................................................................40
Syllabus A3: Globalisation ..........................................................................................................54

Syllabus B: Microeconomic and Organisational Context of Business ................63

Syllabus B1: Economic Goals of Various Stakeholders and Organisations .......................................63
Syllabus B2: Determination of prices by market forces and the impact of price changes ...................99
Syllabus B3. Economic And Social Considerations And The Regulation Of Markets .......................110

Syllabus C: Informational Context of Business ................................................136

Syllabus C1: Techniques to communicate data as information to stakeholders ..............................136
Syllabus C2: Uses of big data and analytics for understanding the business context ...................... 156

Syllabus D: The Financial Context of Business ............................................... 185

Syllabus D1: Functions of the main financial markets and institutions .............................................185
Syllabus D2: Financial mathematical techniques in a business decision-making context ..................206
Syllabus D3: Impact of changes in interest and exchange rates ...................................................218

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 Syllabus A: Macroeconomic and Institutional Context of
Business

Syllabus A1: Factors Affecting National Income

Syllabus A1a) Explain determination of macroeconomic phenomena, including equilibrium national

income, growth in national income, price inflation, unemployment, and trade deficits and surpluses

The study of economics can be divided into:

Macroeconomics 

Looks at "aggregate" behaviour, basically the sum of individual economic decisions.

Microeconomics

is the study of the individual's (and firms) economic behaviour

Macro-economic policy / macroeconomics

covers the following issues:

1. Unemployment

2. Inflation

3. Productivity

4. Interest rates

5. Government budget

6. Foreign trade (Imports v Exports)

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 Syllabus A1a) Explain determination of macroeconomic phenomena, including equilibrium national
income, growth in national income, price inflation, unemployment, and trade deficits and surpluses

National Income

National Income 

is basically total Income earned.

In other words, the value of goods and services produced in a year.

• In the Exam!

The terms National Income, GDP and GNP are used interchangeably.

Growth in National Income

National Income can increase due to:

1. An increase in Aggregate Demand (AD) - the Demand curve moves to the

right

2. An increase in Aggregate Supply (AS) - the Supply curve moves to the right

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How can AD be increased?

• Increase in government spending/investment

• Increase in investment

• Increase in exports

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How can AS be increased?

• Increased investment in technology

• Improvements in training

• Increased incentive for firms to employ workers

• Decrease in costs of goods to supply

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 Syllabus A1a) Explain determination of macroeconomic phenomena, including equilibrium national
income, growth in national income, price inflation, unemployment, and trade deficits and surpluses

The circular flow of income

Firms pay workers -so people get INCOME

Firms make goods and people SPEND on those goods

This is the CIRCULAR FLOW of income / expenditure

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INJECTIONS increase the Circular Flow

These are:

1. Exports (More money coming from abroad) (X)

2. Government Spending (helps firms and people spend more) (G)

3. Investments (I)

WITHDRAWALS decrease the Circular Flow

These are:

1. Imports (Money leaving for abroad) (M)

2. Savings (money not being spent) (S)

3. Tax (Money not being spent) (T)

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 Syllabus A1a) Explain determination of macroeconomic phenomena, including equilibrium national
income, growth in national income, price inflation, unemployment, and trade deficits and surpluses

Aggregate Demand

Aggregate Demand (AD) is made up of 

1. Consumer Spending (C) - (See below)

2. Injections:

- Government spending (G)

- Investments (I)
- Exports (E)
3. LESS:

Imports (M)

Remember!

AD = C + G + I + E - M

Consumer Spending

Households (people) purchase goods and services using income from e.g.
employment or rent of land or profits from running companies.

The amount households plan to spend is called Consumer spending

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It has 2 elements:

1. Income induced
= we spend more as income rises

Marginal prosperity to consume (MPC) is a measure of the proportion of extra

income that is spent on consumer goods.

2. Autonomous consumption (a)

Formula for Consumer Spending

C = a + bY

Where:

a = autonomous consumption

b = the marginal propensity to consume

Y = national Income

Example
Autonomous consumer spending = $300

Marginal propensity to consume = 0.3

National Income = $1,000

Required:
Calculate the Consumer Spending

Solution
C = a + bY

C = $300 + 0.3 x $1,000

C = $600

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 Syllabus A1a) Explain determination of macroeconomic phenomena, including equilibrium national
income, growth in national income, price inflation, unemployment, and trade deficits and surpluses

Equilibrium condition

The economy will be stable where national income (Y) shows no tendency to
change through time = Equilibrium

This is when planned expenditure (ie demand) equals national income (ie supply).

Therefore, where:

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Exam Style question

Autonomous consumer spending = $100m

Marginal propensity to consume (MPC) = 0.4

Required:
Using the Formula C = a + bY for consumer spending and E = Y for equilibrium,
calculate the equilibrium level of national income.

Solution
Y = E at equilibrium

So, National Income (Y) = Consumer spending (C)

Y = C (which is a + bY)

So Y = a + bY

Y = $100 + 0.4Y

0.6Y = $100

Y = $167m

Now don't forget C + Injections - Withdrawals = Y

Exam Style question

Autonomous consumer spending = $100m

Marginal propensity to consume = 0.4

Injections = $300m

Required:
Using the Formula C = a + bY for consumer spending and E = Y for equilibrium,
calculate the equilibrium level of national income.

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Solution

Y = E at equilibrium

So, National Income (Y) = Consumer spending (C) + Injections

Y = C (which is a + bY)

So Y = a + bY + Injection

Y = $100 + 0.4Y + $300

0.6Y = $400

Y = $433m

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 Syllabus A1a) Explain determination of macroeconomic phenomena, including equilibrium national
income, growth in national income, price inflation, unemployment, and trade deficits and surpluses

The Multiplier

Imagine a consumer receives $100 more income - this will probably mean he/she
spends more.

This means the firms get more income and supply more and thus pay more wages

So the consumer gets more wages and spend more again.

This is the multiplier effect

So for example a 100m initial increase could result in a final increase in national
income of $140m.

The effect of a $100m injection is to increase national income by a multiplicative

effect of $140m / 100m = 1.4.

This 1.4 is called a multiplier.

A short cut to calculating the multiplier is to use this formula:

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Exam Style question

Change in Injections = 100

MPC = 0.7

Required:

Calculate the following figures:

1) Value of Multiplier

2) Change in National Income

3) Change in Consumption

Solution

Value of Multiplier = 1 / (1 - 0.7) = 3.33

Change in National Income = 100 x 3.33 = 333

Change in Consumption = 333 - 100 = 233

Marginal Propensity to Withdraw (MPW)

This is easy

So if the MPC is 0.3 then the MPW is 0.7

Simple.

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Syllabus A1b) Explain the stages of the trade cycle and the consequences of each stage for the policy
choices of government

Objectives of government economic policy

Imagine a consumer receives $100 more income - this will probably mean he/she
spends more.

This means the firms get more income and supply more and thus pay more wages

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Governments have a number of economic objectives:

1. Economic growth
This means an increase in National Income

2. Low unemployment
The unemployment rate is normally defined as the percentage of the population
(of working age) and who are actively seeking work (ie not full-time students,
unpaid home makers, pensioners etc) who are unemployed.

3. Balance of trade stability (to achieve a balance between exports and

imports)
If imports are higher than exports, this may cause financing problems.

4. Low inflation
Inflation = A price increase

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Syllabus A1b) Explain the stages of the trade cycle and the consequences of each stage for the policy
choices of government

Tools of government economic policy

In order to achieve its objectives, a government has several types of

macroeconomic policy instruments:

1. Fiscal policy

2. Monetary policy

3. Supply-side policy

Fiscal policy

relates to

1. Taxation

2. Public Borrowing and Spending

Monetary policy

relates to:

1. Money Supply

2. Interest rates

3. Exchange rates

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Fiscal & monetary policies

• Fiscal and monetary policy attempt to influence Aggregate demand

• Fiscal policy is more directly under the control of government.

Monetary policy is normally controlled by independent Central Banks.

• Changes to monetary policy can be implemented more quickly, eg interest rates

can be changed every month, while tax and spending decisions (fiscal policy)
are normally only changed annually.

Supply-side policy

Supply-side policies, on the other hand, attempt to increase the level of Aggregate
supply by increasing efficiency, motivation or productive capacity.

Examples include deregulation, re-training, privatisation and cutting corporation tax.

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Syllabus A1b) Explain the stages of the trade cycle and the consequences of each stage for the policy
choices of government

The Trade Cycle

A trade cycle is a repeated pattern of changes in economic growth.

Phases of the trade (or business) cycle

• Recession (At point A)

• Depression (At point B)

• Recovery (At point C)

- modest growth and improved consumer confidence

• Boom (At point D)

- capacity and labour will be fully utilised.

• And then back to Recession again

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Syllabus A1d) Describe the impacts on business of potential policy responses of government, to each
stage of the trade cycle

Government action

1. In recession?
Boost demand by:

- Increasing Money Supply

- Reducing Interest Rates

- Lowering tax

2. In a Boom?
Reduce demand by:

- Increasing Tax

- Increasing Interest Rates

- Reducing Public spending

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Syllabus A1d) Describe the impacts on business of potential policy responses of government, to each
stage of the trade cycle

Types of Unemployment

1. Cyclical unemployment
Caused by a decline in the general level of economic activity

2. Structural unemployment (Long Term)

May be due to a lack of skills, or wages being set artificially high

3. Frictional unemployment (Short term)

This is due to the time it takes workers to find jobs, or due to seasonal factors.

The amount of STRUCTURAL and FRICTIONAL unemployment is sometimes called

the 'natural rate of unemployment'.

The Deflationary Gap and cyclical unemployment

The economy is currently in equilibrium at Ye (with aggregate demand AD) but it

would need to be at Yf (with aggregate demand AD2) to achieve full employment.

A deflationary gap can be described as the extent to which the aggregate demand
function will have to shift upward to produce the full employment level of national
income.

If the level of aggregate demand is below the level need to sustain full employment,
there is said to be a deflationary gap


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Syllabus A1d) Describe the impacts on business of potential policy responses of government, to each
stage of the trade cycle

Inflation

Demand-Pull Inflation

Caused by an increase in the general level of economic activity

• The trade cycle is at its boom phase

• Aggregate demand may rise above aggregate supply

• Labour is at full employment, and factories are at full capacity

• So higher demand can't be met by more supply - so firms put the prices up on
those they can supply i.e Inflation

Cost-Push Inflation

Caused by a general increase in costs of production

This can come from:

• Higher wages demanded by workers

• Commodity prices (eg oil) increase

• Home currency weakens - so imports become more expensive

Inflationary gap
If demand exceeds capacity (full employment) there is what we call... an inflationary
gap

This type of Inflation can be reduced by shifting the demand curve left

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Syllabus A1d) Describe the impacts on business of potential policy responses of government, to each
stage of the trade cycle

Balance of Trade and The Trade Cycle

In a boom we probably have a Trade Deficit (Imports > Exports)

In a recession we probably have a Trade Surplus (Imports < Exports)

• Boom Phase

Imports will be high as consumers have more money

(Exports level depends on foreign consumers trade cycle)

• Recession Phase

Imports will be low as consumers have little money

(Exports level depends on foreign consumers trade cycle)

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 Syllabus A1e) Calculate indices for price inflation and national income growth using either base or
current weights and use indices to deflate a series

Index Numbers

Basic Index Numbers

Index numbers help us compare values over time.....

1. A base year is given an index number of 100

2. Future years are given index numbers by comparing the values over two periods
and multiplying by 100.

Illustration 1
A cup of milk was $2.00 in 20X0

A cup of milk was $3.40 in 20X9

Index Numbers

20X0 = 100

20X9 = 100 x 3.40 / 2.00 = 170

You can now easily see prices have increased by 70% by looking at the index
number rise from 100 to 170

Fixed Base And Chain Base Methods

There are 2 ways in which index numbers can be compared:

1. Fixed Bases
As above, a base year is selected (index 100), and all subsequent changes are
measured against this base

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2. Chain base
Here changes are measured against the period immediately before

Illustration 2 - Chain Base and Fixed Base

Cup of Coffee

$2.50 in 20X0

$3.00 in 20X1

$3.30 in 20X2

Chain Index

20X0 100

20X1 120 (3.00/2.50 x 100)

20X2 110 (3.30/3.00 x 100)

Fixed Index:

20X0 100

20X1 120 (3.00/2.50 x 100)

20X2 132 (3.30/2.50 x 100)

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Price and Quantity Indices

• Price Indices

Measures changes in the monetary value of a group of items over time.

Eg Consumer Prices Index (CPI) for inflation

• Quantity Indices

Measures changes in the Non-monetary value of a group of items over time

Eg. Production volumes

Illustration 3
Using the CPI data below calculate the annual rate of inflation in 20X9 (to one
decimal place).

Year 20X7 20X8 20X9

CPI 100 115 111

Solution
111 / 115 x 100 = 96.5

100 - 96.5 = - 3.5%

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Base & Current Weighted Price Indices

Here we look at 2 ways of working out the change in price at a basket of goods

We take into account the quantity of the items in the baskets though too

So we use either:

1) The Base (start) Quantities

2) The Current (latest) Quantities

• Using the base quantities is called the Base Weighted price index

• Using the current quantities is called the Current Weighted price index

Illustration 4
2 products are in our basket, milk and butter

We show you their quantities at the start (Base) and their quantities now (Current)

We also show you the prices at the start (Base) and their quantities now (Current)

Item Quantity (Base) Price in 20X0 Quantity Price in 20X1

(Base) (Current) (Current)

Q0 P0 Q1 P1

Milk 10 $12 9 $18

Butter 5 $8 6 $10

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a) What is the overall price index For this 'basket' of goods, using a Base weighted
approach?

b) What is the overall price index for this 'basket' of goods, using a Current
weightings approach?

a) Base weighted approach

For this approach, we are using the base year quantity

Item Quantity Price in Base-year Change Base year value x

(Base) 20X0 (Base) value in Price Change in Price

Q0 P0 P0 x Q0 P1 / P0

Milk 10 12 120 18/12 = 180

1.5

Butter 5 8 40 10/8 = 50
1.25

∑ = 160 ∑ = 230

Price Index in 20X1 = 230 / 160 x 100 = 143.8

The price rise is 43.8% using Base weighted approach

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b) Current weightings approach

Item Quantity Price in Value Change Value x Change

(Current) 20X0 (Base) in Price in Price

Q1 P0 P0 x Q1 P1 / P0
(currently
purchased)

Milk 9 12 108 18/12 = 162

1.5

Butter 6 8 48 10/8 = 60
1.25

∑ = 156 ∑ = 222

Price Index in 20X1 = 222 / 156 x 100 = 142.3

The price rise is 42.3% using current weightings approach

Using price indices to deflate a time series

Here, we will remove the effect of inflation on data (e.g Wage expenses)

One of the uses of a price index is to deflate data that includes inflation, often called
’nominal’ data, by stripping out the effect of inflation so that the data becomes ’real’
(ie not distorted by inflation).

Illustration 5
Average wages have increased between 20X5 and 20X9 from $10,000 per head to
$19,000 in nominal terms.

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CPI data is given below as a fixed index.

Year 20X5 20X6 20X7 20X8 20X9

CPI 100 104 110 115 121

How much better off are workers in real terms?

This can be addressed by expressing wages in terms at base year (ie 20X5) prices.

• 20X5 wages are already in terms at 20X5 prices.

• 20X9 wages of $19,000 can be adjusted by dividing by 121/100

therefore: $19,000 / 1.21 = $15,702.

• So ‘real’ wages have risen by (15,702 / 10,000) - 1 = 57%

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 Syllabus A1c) Explain the main principles of public finance (i.e. deficit financing)

Government Spending

The amount of money that a government plans to spend will depend on the attitude
to government involvement in the economy and other factors such as the stage of
the trade cycle.

The table below shows an example of government spending.

Country Government expenditure (% of GDP)

Finland 57

France 57

Sweden 50

Italy 50

Spain 44

Germany 44

United Kingdom 43

Czech Republic 42

United States 39

(OECD, 2015)

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A government spends money on:

1. Pensions

2. Health Care

3. Education

4. Debt interest

5. Defence

Military defence

Civil defence

6. Welfare

Family and children

Unemployment

Housing

Social protection

7. Protection

Police services

Fire-protection services

Law courts

Prisons

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 Syllabus A1c) Explain the main principles of public finance (i.e. forms of taxation)

Financing central government spending

Taxation is the main method of financing government spending.

Types of taxation

• Direct taxes
A direct tax is paid directly by the person or business on whom the tax is
imposed

Examples:

- income tax,

- capital gains tax,

- corporation tax,

- inheritance tax.

• Indirect taxes
An indirect tax is collected by an intermediary from the person who ultimately
bears the economic burden of the tax

Examples:

- VAT,

- tax on cigarettes, alcohol

A retailer would be responsible for collecting and paying these taxes to the
government (ie the retailer is the intermediary), but the Consumer bears the
burden through higher prices.

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Direct taxation can be:

• Proportional tax
- average rate of tax is the same at all income levels,

eg 20% income tax for all levels of income.

• Progressive tax
- the rate of tax increases as income increases so that a higher proportion of
total income is paid as tax by the better-off.

Indirect taxation is likely to be a regressive tax

It is a tax that takes a higher proportion of a poor person's salary than of a rich
person's.

For example, in the UK the television licence fee (the annual licence fee people have
to pay in the UK to watch television) is an example of regressive tax since the fee is
the same for all people.

Sales taxes (such as VAT in the UK) are also regressive because they take a greater
proportion of the income of low income workers.

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 Syllabus A1c) Explain the main principles of public finance (i.e. deficit financing)

Financing the central government budget — borrowing

• Budget deficits
A budget deficit arises when the government spends more than it receives from
taxes

This will need to be financed by government borrowing.

• Cyclical deficits
A cyclical budget deficit arises as a consequence of the trade cycle.

During a recession, governments will receive less tax but will spend more

• Structural deficits
Structural deficits are long-term deficits not associated with the trade cycle

They can be caused by.

Increased role of government

eg increased spending on government-provided services such as health and
education.

Past government spending

- if the deficit is caused by interest on past borrowing.

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Policies to deal With structural deficits

1. Emergency loans from other national governments and international institutions

at low interest rates to finance the present deficit.

2. Austerity measures adopted, often as a condition of receiving the emergency

loans, to cut public spending and increase taxation.

This includes seeking efficiency savings in government spending and even

reductions to pension benefits.

3. Sale of state assets governments may be required to sell nationalised

industries, mines, land rights and public buildings to private investors to raise
the funds needed to repay some of their past borrowings.

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 Syllabus A2: The Balance of Payments

Syllabus A2a) Explain the concept of the balance of payments and its implications for government
policy

The Balance of Payments

= all international trade and financial transactions made between a country and the
rest of the world

The balance of payments accounts have three parts:

1. Current account

2. Capital account

3. Financial account

Current account

The current account mainly records:

• Trade in goods
- relates to exports and imports of tangible (visible) goods

- such as oil, electrical goods, cars, clothing etc.

• Trade in services
- relates to exports and imports of services (invisibles)

- such things as international travel, financial and other services.

• Income earned or paid out on international investments

- Income relates to income from employment of overseas residents

- Income from capital investment overseas (eg dividends and interest).

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The overall balance of exports and imports is referred to as the current
account balance

In the UK in 2018, the Current account Deficit was £92bn or 4.3% of GDP

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Balance of trade

The surplus or deficit on trade in goods & services Only is also known as the
Balance of trade (BOT)

Calculating a Country's BOT

For example, if the UK imported £1.50 trillion in goods and services, but exported
only £1.12 trillion to other countries.

Then the UK had a trade balance of -£38 billion, or a £38 billion trade deficit.

The UK has a trade deficit

• Meaning the value of imports (M) exceeded the value of exports (X)

M > X

• In 2018, the UK’s trade deficit was -£38 billion, equal to -1.8% of GDP.

Capital account

- is made up of public sector flows of capital into and out of the country

- such as government loans to other countries.

Financial account

- is made up of flows of capital to and from the non-government sector

- such as direct investment in overseas facilities, shares, bonds.

- movements on government foreign currency reserves

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Overall balance

The sum of the balance of payments accounts (current, capital and financial
accounts) will be zero.

The reason is that every credit appearing in the current account has a
corresponding debit in the capital account, and vice-versa.

If a country exports an item (a current account credit), it effectively imports foreign

capital when that item is paid for (a capital account debit).

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 Syllabus A2a) The causes and effects of fundamental imbalances in the balance of payments.

Causes and effects of an imbalance

Reasons for deficits

There are many factors that can cause a country to suffer a current account deficit.

Meaning Import (M) > Export (X)

Cause Explanation

High production costs This may be due to out dated machinery or labour
costs being too high

Unable to compete Domestic firms may be too small to compete with

larger international rivals.

High exchange rate This makes exports more expensive and imports
cheaper.

High levels of If aggregate demand is high then imports will rise

aggregate demand (more foreign goods are purchased as well as local
goods) but exports will not rise (and may even fall if
local firms divert production from overseas markets to
the local market)

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 Syllabus A2a) Identify the main elements of national policy with respect to trade

Free trade

Practical reasons for overseas trade

1. Choice

The diversity of goods available in a domestic economy is increased through the

import of goods that could be uneconomic or impossible to produce at home (e.g.
oil).

2. Competition

International trade will increase competition in domestic markets, which is likely to

lead to both a reduction in price, together with increasing pressure for new products
and innovation.

3. Economies of scale

By producing both for the home and international markets companies can produce
at a larger scale and therefore take advantage of economies of scale.

4. Specialisation

If a country specialises in producing the goods and services at which it is most

efficient, it can maximise its economic output.

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Trade barriers (Protectionism)

There are a number of ways that a country can seek to restrict imports.

Trade barriers include:

• Quotas
– a restriction on the number of items that are allowed to be imported

e.g. quotas on the number of cars manufactured outside of Europe that can be
imported into the EU.

• Tariffs
– imposition of an import tax on goods being imported

– making imported goods relatively more expensive compared to domestically

produced goods

• Exchange controls
– domestic companies wishing to buy foreign goods will have to pay in the
currency of the exporter’s country.

To do this they will need to buy the currency involved by selling sterling.

If the government controls the sale of sterling it can control the level of imports
purchased.

• Administrative controls
– a domestic government can subject imports to excessive levels of
administration, paperwork and red tape to slow down and increase the cost of
importing goods into the home economy.

eg increasing the safety standards that imported goods must comply with

• Embargoes
– the prohibition of commerce and trade with a certain country.

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• Ban on Import
An outright ban on imports (or on imports of certain products)

• Subsidies
Offering subsidies to domestic producers

Multinational companies have to find ways of overcoming these barriers.

For example by investing directly and manufacturing within a country rather than
importing into it.

Free trade - problems

In reality, many countries try to protect local companies and to improve their
balance of payments by reducing imports.

Sometimes there is an argument that foreign competition is not appropriate

because:

• Imported products are being sold below production cost to destroy domestic
firms (this is called dumping)

• Domestic firms are new and are too small to be able to compete against larger
foreign rivals yet, and so need protecting from them (sometimes called the infant
industry argument)

• Some industries must not be allowed to be driven out of existence by foreign

rivals because they have a long-term strategic importance to the country

eg shipbuilding

• Some countries have an unfair advantage because they don't pay the social
costs of production (eg decent wages and working conditions)

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Trade agreements and common markets

In many parts of the world, governments have created trade agreements and
common markets to encourage free trade.

However, the World Trade Organisation (WTO) is opposed to these trading blocs
and customs unions (e.g. the European Union) because they encourage trade
between members but often have high trade barriers for non-members.

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 Syllabus A2c) Explain the impacts of exchange rate policies on business

Exchange rates

An exchange rate is the price of one currency in terms of another, and is determined
by the demand for and supply of the currency on the foreign exchange market.

Demand

Demand for the local currency (£) is created when:

1. We Export goods or services

Then demand for the local currency will increase as foreign currency revenue
from export sales are converted into the local currency (eg from $ to £)

2. Overseas investors invest in the local economy (UK).

Exports

Demand for the local currency (£) will rise as its exchange rate (its price) falls.

In other words, demand for £ rises when you get more £ for $1, then you want to
buy more £, therefore the Demand for £ rises.

And local currency is cheap and therefore Exports are cheaper (eg. US can buy
more for $1 in the UK) and therefore Exports increase.

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Illustration 1
A UK car maker EXPORTS cars to the USA.

The required revenue per car is £10,000.

If the exchange rate is $1.2 per £1 (as it was in 2018) then a price of 10,000 x 1.2 =
$12,000 is charged.

However, if the value of the pounds falls to $1.1 per £1 (in 2019) then a price of a
car falls to $11,000 (10,000 x 1.1).

The price in dollars has fallen (from $12,000 to $11,000)

So demand from US customers will increase, and

more cars will be exported to the USA as a result of a fall in the exchange rate.

Supply

Supply of the local currency (£) arises when:

• Imports (here goods bought from the USA) are purchased.

The pounds used to pay for these will be supplied to the Foreign exchange
market and will be converted from pounds to dollars

• Local investors invest in overseas businesses.

Imports

Supply of the local currency (£) will fall as its exchange rate (its price) falls.

In other words, supply of £ falls when you get less $ for £1, then you want to SELL
less £, therefore the SUPPLY of £ falls.

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And local currency is EXPENSIVE and therefore Imports are expensive (eg. You can
buy LESS for £1 in the US) and therefore Imports decrease.

Illustration 2

Imagine an American car maker is trying to sell cars in the UK. (Import cars)

The required revenue per car is $10,000.

If the exchange rate is $1.2 per £1 then a price of 10,000 / 1.2 = £8,333 is charged.

However, if the value of the pounds falls to $1.1 then the price of a car rises to
£9,091 (10,000 / 1.1).

The price in pounds has risen (from £8,333 to £9,091)

So, fewer US cars will be imported by UK consumers, because its more expensive
and therefore the imports into the UK from USA will fall

So, because the UK consumers won't need $ now, they will sell /offer LESS £. (to
buy $)

Therefore, the Supply of £ will FALL.

Therefore, the level of imports into the UK from USA will fall as a result.

Exchange rates and the balance of payments

A lower exchange rate will cause an increase in exports and reduce imports

A potential solution to a balance of payments deficit is to reduce the exchange rate.

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Exchange rates and interest rates

Interest rates will affect the demand for a currency

eg lower interest rates will cause a fall in demand from overseas investors (eg US)
looking to put money on deposit in the local economy (eg in the UK).

If interest rates fall the demand for the currency will also Fall (because people are
not interested in it because in £), leading to a fall in the exchange rate.

Exchange rates and inflation rates

If a country experiences a rise in inflation rate (increase in prices) so that its rate is
higher than that abroad this means that the country's products are more expensive
relative to the goods produced abroad.

This will lead the demand for its exports to fall, and therefore the demand for its
currency to fall.

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 Syllabus A2c) Explain the impacts of exchange rate 2 policies on business

Government policies on exchange rates

Free floating exchange rates

Free floating or flexible exchange rates occur when exchange rates are left to the
interaction of market forces (supply and demand for a currency).

A problem with allowing exchange rates to be determined by market forces is that if

exchange rates change too much, the uncertainty surrounding fluctuations in
exchange rates could deter trade and investment.

So, in practice, governments may prefer to intervene in the market to buy or sell
currency in order to achieve a degree of exchange rate stability.

This is sometimes called a managed (or dirty) floating exchange rate policy.

Fixed exchange rates

A government policy of buying and selling currency to fixed exchange rates by

using its official currency reserves to create an exact match between supply and
demand for its currency in the foreign exchange markets, in order to keep the
exchange rate unchanged.

A fixed exchange rate system removes exchange rate uncertainty and so

encourages international trade.

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 Syllabus A3: Globalisation

Syllabus A3a) Explain the concept of globalisation and the consequences for businesses and national
economies

Globalisation

Globalisation 

is the integration of national cultures, economies and political systems.

Features of globalisation include:

• The ability of individuals to enter into transactions with individuals and

organisations who are in other countries

• The increased importance of global economic policy to domestic policy

• The increase of globally linked and dependent financial markets

• The reduction in importance of local manufacturing.

• Reduced transaction costs

• The rise of emerging, newly industrialised nations

Factors encouraging the globalisation of world trade

• Country/continent alliances

• Legal factors such as patents and trade marks

• Markets trading in international commodities

• Lower international freight costs for businesses

• Lower barriers to the international movement of factors of production

• Reductions in the tariff levels imposed by governments

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International trade

The political environment is very important in international trade.

It is governed by an extra layer of legislation which includes treaties and

agreements.

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 Syllabus A3b) Explain the role of major institutions promoting global trade and development

Types of trade agreement

Free trade area

• There is no restriction on the movement of goods and services between countries

• Individual countries can impose their own restrictions on non-member countries

For example, the North American Free Trade Agreement (NAFTA) is a free trade area

that includes Canada, the USA and Mexico

Customs union

= Free trade area + the following features:

• There are common external tariffs applying to imports from non-member countries

into the union.

For example, Mercosur is a customs union comprising Argentina, Brazil, Paraguay,

Uruguay and Venezuela.

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Common and single markets

= Customs union + the following features:

• There are free markets in each of the factors of production and a move to

standardise market regulations (eg safety and packaging rules).

• Where there are common policies on product regulation this is sometimes called a

'single market'.

• Eventually a common market becomes a single market with no restriction of

movement or regulatory differences.

For example a citizen in the European Union (EU) has the freedom to work in any

other country of the EU.

Economic union

= Common markets + the following features:

• Will involve a common Central Bank and a common interest rate and a single

currency.

For example, within the EU, most member countries are part of the eurozone; they

share a single currency and co-ordinate economic policies.

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 Syllabus A3b) Principal institutions encouraging international trade.

The World Trade Organisation (WTO)

Aims are: 

1. to reduce the barriers to international trade

It does this by seeking to prevent protectionist measures such as tariffs, quotas

and other import restrictions.

2. resolving trade disputes

it acts as a forum for negotiation and offering settlement processes to resolve

disputes between countries.

The WTO will impose fines, if members are in breach of their rules.

Members of the WTO cannot offer selective free trade deals with another country

without offering it to all other members of the WTO (the most favoured nation

principle).

The benefits of reducing protectionist measures are:

1. increased trade and economic growth

2. allow to specialise and gain competitive advantage in certain products and

services, and compete more effectively globally

3. gain political capital and more influence worldwide

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The drawbacks of reducing protectionist measures are:

1. the need to protect certain industries.

It may be that these industries are developing and in time would be competitive

on a global scale.

They may fail too quickly due to international competition, and would create

large scale unemployment

2. dumping’ of goods at a very cheap price, which hurt local producers.

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 Syllabus A3b) Principal institutions encouraging international trade.

Central banks

Central banks normally have control over interest rates and support the stability of
the financial system.

Collaboration between central banks is supported by the Bank of International

Settlements (BICS).

In the context of international trade, a key role of the central bank is to guarantee
the convertibility of a currency (eg from £s to $s).

The International Monetary Fund (IMF)

The IMF's main purpose is to support the stability of the international monetary
system by providing support to countries with balance of payments problems; most
countries are members.

Where a member is having difficulties overcoming balance of payments

problems the IMF will:

1. offer advice on economic policy

2. lend money, at subsidised rates to finance short-term exchange rate intervention

IMF loans are conditional on action being taken to reduce domestic demand, and
are normally repayable over a five-year period.

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The IMF has been criticised as being controlled by those who don’t need funds, for
failing to control its own costs and for holding on to its substantial gold reserves.

The World Bank

The World Bank, partially funded by the IMF, exists to fund reconstruction and
redevelopment.

Loans are normally made directly to governments, for periods of 10-20 years and
tied to specific projects.

The International Bank for Reconstruction and Development (IBRD)

Popularly known as the World Bank, it was also created at Bretton Woods in 1944,
with the aim of financing the reconstruction of Europe after the Second World War.

The World Bank is now an important source of long-term low interest funds for
developing countries.

The Bank for International Settlements (BIS)

Established in Basle, Switzerland in 1930, it acts as a supervisory body for central

banks assisting them in the investment of monetary assets.

It acts as a trustee for the IMF in loans to developing countries and provides
bridging finance for members pending their securing longer term finance for balance
of payments deficits.

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 Syllabus A3c) Identify the impacts of economic and institutional factors using the PESTEL framework

PESTEL Analysis

PESTEL is useful tool for analysing opportunities and threats in the external
environment of a business.

PESTEL covers six areas that would often be analysed before key decisions are
made

eg whether to locate in a new market.

1. Political

Tax policy; Foreign trade regs; Government stability

2. Economic

Business cycles; GNP trend; Interest rates; Money supply; Inflation;

Unemployment; Disposable Income

3. Sociocultural

Demographics; Income distribution; Social mobility; Lifestyles; Consumerism;

Education levels

4. Technological

Research spending; Government focus; New discoveries; Obsolescence rates

5. Ecological

Environmental protection laws; Using up of raw materials; cutting edge e.g.

genetically modified goods

6. Legal

Monopoly laws; Employment law

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 Syllabus B: Microeconomic and Organisational Context
of Business

Syllabus B1: Economic Goals of Various Stakeholders and

Organisations

Syllabus B1a) Distinguish between the goals of profit seeking organisations, not-for- profit organisations
and governmental organisations

The organisation can be:

1. Private
Owned and operated by private individual

2. Public
Owned by state

PRIVATE SECTOR

Motive of Private organisations can be:

• For - Profit

• Not-for-profit

For - Profit organisation

Business organisations engage in commercial and industrial activities, with the

purpose of making a profit.

Profit-seeking organisations typically exist to maximise their owners' wealth.

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Types of For - Profit organisation:

1. Sole Trader
An individual sets up business on his own

Sole traders are people who work for themselves.

Examples include a hairdresser, the local stationer, a plumber.

The owner has UNLIMITED LIABILITY for the debts of his business.

It means that the law will not distinguish between the private assets and
liabilities of the owner to those of the organisation.

In case of bankruptcy the owner can lose his personal assets.

e.g. if the business has debts that it is unable to pay, the sole trader will become
personally liable for the unpaid debts and would be required, if necessary, to sell
his private possessions (e.g. his car or house) to repay them.

2. Partnership
Partnerships occur when two or more people decide to run a business together.

Examples include an accountancy practice, a legal practice and a medical

practice.

The owners have UNLIMITED LIABILITY for the debts of their business.

In general, the partners have unlimited liability although there may be

circumstances when one or more partners have limited liability

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3. Corporations (Companies)
These companies have a LIMITED LIABILITY

This means that the maximum amount that an owner stands to lose in the event
that the company becomes insolvent and cannot pay off its debts, is his share of
the capital in the business.

In all cases, we apply the separate entity concept, i.e. the business is regarded
as being separate from the owner (or owners) and the accounts are prepared for
the business itself.

The shareholders cannot normally be sued for the debts of the business.

Their risk is generally restricted to the amount that they have invested in the
company when buying the shares (limited liability).

Examples:
- Private Limited Company (LTD) - Shares in private companies cannot be
offered to the general public

- Public Limited Company (PLC) - Shares in a public company can be freely sold
and traded to the general public and their shares can be listed on a stock
exchange.

Not-for-profit organisations

A non-profit organisation (NFP) works with a prime intention (primary goal) of

providing a good or a service to different sectors of society for which they are set up
to provide a benefit.

NFP has to be efficiently managed so that their resources are used effectively to
meet the objectives of the organisation while not making a financial loss

For example, a school is set up to provide education.

Charities, such as, the Red Cross is set up to provide a medical service.

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Mutual Associations

are a special type of NFP organisation in the Private sector.

• A mutual association exists with the purpose of raising funds from its
membership or customers, which can then be used to provide common services
to all members of the organisation

There are therefore owned by, and run for the benefit of, its members - it has no
external shareholders to pay in the form of dividends, and as such does not
usually seek to maximise and make large profits or capital gains.

They exist for the members to benefit from the services they provide.

Profits made will usually be re-invested in the mutual for the benefit of the
members.

• Generally mutual organisations deal with intangible products such as financial

services, example, ACCA

Co-operative

can a NFP or a for-profit organisation in the Private sector.

• - are people-centred enterprises owned, controlled and run by and for their
members to realise their common economic, social, and cultural needs.

• - they are not owned by shareholders, the economic and social benefits of their
activity stay in the communities where they are established.

• - profits generated are either reinvested in the enterprise or returned to the

members.

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Types of Cooperatives

1. Retail Cooperatives
Examples: hardware, food, agriculture products, and even movie theaters.

2. Worker Cooperatives
Examples: bakeries, retail stores, software development groups.

3. Producer Cooperatives
Examples: agricultural products, carpentry and crafts.

4. Service Cooperatives
Examples: service co-ops such as child care, health care clinics, and funeral
services

5. Housing Cooperatives
Examples: rentals or single family homes

Multinational Corporations (MNCs)

These organisations have the capacity to produce in more than one country

They are often large, well-known organisations such as PepsiCo, Proctor & Gamble,
Nestle

PUBLIC SECTOR

Public Sector organisations are owned or run by the government

They are funded by and accountable to the government.

A major challenge that any government faces is that of balancing their limited
resources with a huge demand for public services.

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Examples of a public sector organisation are:

1. Hospitals

2. Armed Forces

3. Centrally funded agencies

4. Most schools & Universities

5. Government Departments

Non-governmental organisations (NGO's)

A non-governmental organisation is an independent voluntary association of people

acting together for some common purposes.

These organisations often support such things as: conservation issues,

environmental change etc.

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 Syllabus B1a) Types of not-for-profit organisations and their objectives.

Primary goal is NOT shareholder wealth

• A not-for-profit organisation’s primary goal is to provide some socially desirable

need on an ongoing basis.

• A not-for-profit generally lacks the financial flexibility of a commercial enterprise

because it depends on resource providers who often gain no tangible benefit
themselves.

Charities

Charities, unlike companies, do not have shareholders.

• Charities could not operate without the work of employees and volunteers, or
without donations from their donors, so these are both important stakeholder
groups.

• The objective of a charity is to provide help or support for its beneficiaries, so

beneficiaries are also an important stakeholder group.

Objectives hard to quantify

• The non financial objectives are often more important in not for profit
organisations.

However, they are harder to quantify

eg Quality of care

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Value for money as an NFP objective

• Economy – Buy goods at minimum cost (still paying attention to quality)

Efficiency – Use these goods to maximise output

Effectiveness – Use these goods to achieves objectives

• Another way of looking at these is:

Economy - ‘doing things at a low price’

Efficiency - ‘doing things the right way’

Effectiveness - ‘doing the right things’

• A final way of looking at these is as input - process - output

Inputs - Economy - get as cheap as possible given quality

Process - Efficiency - perform the process as efficiently as possible

Outputs - Effectiveness - These match the objectives set

Input driven - Try to get as much out given limited inputs e.g. library

Output driven - Maintaining standards even when output changes eg Prison

service

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Syllabus B1b) Explain shareholder wealth, the variables affecting shareholder wealth, and its application
in management decision making

Increasing shareholder wealth

The value of the company's shares influences shareholder wealth.

Future cash flows will depend on:

• the state of the economy

• management

- they have the ability to affect cash flows and therefore to increase the share
price.

Measuring changes in shareholder wealth

Shareholder wealth can be monitored by measuring:

• Dividends paid to ordinary shareholders

• Plus

• Changes in the value of their shares

- if it is an increase (capital gain)

- if it is a fall (capital loss)

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This measure is called Total shareholder return

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 Syllabus B1b) Concepts of returns to shareholder investment in the short run and long run (and the
cost of capital).

Short-term measures of return

A profit-seeking company can use ratio analysis to give a snapshot of its short-term
financial performance.

For example:

1. Return on capital employed (ROCE)

2. Earnings per share (EPS)

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 Syllabus B1b) Concepts of returns to shareholder investment in the short run and long run (and the
cost of capital).

Return on capital employed (ROCE)

Measuring profit does not give a good measure of how well a firm is performing
because it doesn't consider the amount of long-term finance (capital) that has been
invested in the firm.

Illustration 1
If a company earns a profit of $100,000

• this would be a good performance if $500,000 had been invested in the

company (100,000 / 500,000 x 100 = 20% return)

• but not if $10 million had been invested (100,000 / 10 million x 100 = 1% return).

Measuring capital employed (Capital invested)

Capital is the total amount of long-term finance:

• Long-term debt finance

- a long-term loan

• Preference Shares
- shares that pay a fixed dividend

• Ordinary shares (equity finance)

- are the owners of the Company

- these shares do not pay a fixed dividend

- the dividend they pay can vary from year to year.

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Return on capital employed (ROCE)

shows how well a business has generated profit from its long-term financing.

It is expressed in the form of a percentage, and the higher the percentage, the
better.

Note:
Profit before interest and tax is called 'Operating profit'.

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Illustration

Operating Profit (PBIT) $10,000

LT Liabilities $50,000

Equity $20,000

Required
Calculate ROCE

Solution

ROCE = PBIT / Capital Employed

ROCE = 10,000 / (20,000 + 50,000)

ROCE = 0.14 = 14%

Average Capital employed

The figure for Capital employed is normally averaged out between the beginning
and the end of the year.

So, if you are asked to calculate ROCE and you are given 2 years' worth of capital
employed figures, you should use an Average Capital employed.

However, the ROCE calculation can also be based solely on the value of capital
employed at the end of the year, so you will have to read the question to see how to
perform the calculation.

Example
Company's financial statements for the years ending 31 December 20X0 and 20X1:

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 20X1 20X0

$ $

Operating profit 200,000 180,000

Interest payable 20,000 20,000

_______________ _______________

Profit before tax 180,000 160,000

Tax charges 36,000 32,000

Profit after tax 144,000 128,000

_______________ _______________

Capital employed 500,000 465,000

_______________ _______________

What is the company's return on capital employed (ROCE) for 20X1?

Solution
Average Capital employed is: (500,000 + 465,000) / 2 = 482,500

ROCE = PBIT / Capital employed.

so, for 20X1, this is: 200,000 / 482,500 = 0.41 = 41%

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Syllabus B1b) Explain shareholder wealth, the variables affecting shareholder wealth, and its application
in management decision making

Earnings per share (EPS)

EPS shows the maximum dividend that could be paid to the owners of the business
(ie the ordinary or equity shareholders) out of that year's profit after all payments
have been made to other providers of finance (eg banks and preference
shareholders).

EPS shows the return earned by the ordinary shareholders only, unlike ROCE which
considers the return generated to all the investors including those who have just
lent money to the company (eg banks).

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Illustration
Cow Co has the following results.

$000

Operating profit 200.000

Interest paid (finance charges) (20,000)

-----------------

180,000

Taxation (54,000)

-----------------

Profits after tax 126,000

Dividends payable * (26,000)

-----------------

Retained earnings 100,000

Issued share capital (shares of $1) 100 million

* Includes preference dividend of $ 6 million

Required
Calculate earnings per share (EPS).

Solution
EPS = (126,000 - 6,000) / 100,000

EPS = 120c per share

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 Syllabus B1b) Concepts of returns to shareholder investment in the short run and long run (and the
cost of capital).

Returns To Shareholder Investment

Assessing if return is acceptable

The return expected by shareholders is referred to as the Cost of equity

This can be used to assess whether the profit that has been achieved is acceptable
to shareholders.

Illustration

Cow Co has the following results

$000

Operating profit 200.000

Interest paid (finance charges) (20,000)

-----------------

180,000

Taxation (54,000)

-----------------

Profits after tax 126,000

Dividends payable * (26,000)

-----------------

Retained earnings 100,000

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Cow Co has $ 100 million of equity capital and $ 200 million of retained earnings
(including the $100 million from the current year as shown above).

Cow Co's shareholders expect a return of 10% (Cost of Equity).

Required
Assess whether Cow Co is producing an adequate short-term return to
shareholders.

Solution
Profit after tax of $126m less $20m preference dividend leaves $106m for ordinary
shareholders.

Cow Co's shareholders expect a return of 10% on their equity investment of $300
million (share capital 100 + retained earnings 200) ie 300 x 0.1 — $30 million.

Profits after tax are greater than $30 million so Cow Co is producing an adequate
short-term return to its shareholders.

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 Syllabus B1b) Concepts of returns to shareholder investment in the short run and long run (and the
cost of capital).

Long-run measures of return

Companies are trying to maximise the wealth of their shareholders by making a

profit.

However, for a company whose shares are traded on a stock market, the movement
in the share price is important.

The value of shares depends on a company's future cash flow potential.

When valuing a share on the basis of future cash flows

Remember that ... money to be received in the future is worth less than money
received today. 

This is because investors prefer to receive money sooner rather than later.

So, the value of a company's future cash Flows will need to be adjusted to reflect
this time value of money

This process is called Discounting.

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Discounting free cash flows to equity

Free cash flows to equity

The cash flows generated by a business in a particular year after interest and tax
and investment spending.

Free cash flows to equity are available either to pay as a dividend or to keep within
a business — either way this cash is a benefit to ordinary (equity) shareholders.

Illustration

Cow Co is predicted to generate the following free cash flows to equity.

Year 1 $150 million Year 2 $170 million Year 3 $200 million

There are 50 million shares and shareholder's required rate of return is 10%

This is to reflect the time value of money and indicates the rate at which future cash
flows are to be discounted.

The discounted, or present, value of the cash flows is:

In year 1:  

$150m / 1.1 = $136.4m.

In year 2:

$170m /1.1 / 1.1 = $140.5m

In year 3:

$200m /1.1 / 1.1 / 1.1 = $150.3m

Total value = $136.4m + $140.5m + $150.3m = $427.2m

Price per share = $427.2m / 50m = $8.54

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Discounting free cash flows to the firm

Free cash flows to the firm

The cash flows generated by a business in a particular year after tax and investment
spending (but before interest).

The value of debt needs to be subtracted to obtain the value of equity.

Free cash flows to the firm are available to pay to all investors, whether
shareholders or providers of debt finance.

Illustration

Cow Co (above) has a $30m three-year loan costing 10%.

Repayments on this loan are:

$3m in year I,

$3m in year 2 and

$33m (capital plus interest) in year 3.

Cow is predicted to make the following free cash flows to the firm.

Year 1 $153 million Year 2 $173 million Year 3 $233 million

There are 50 million shares and the overall cost of capital is 10%.

The discounted, or present, value of the cash flows is:

In year 1:  

$153m / 1.1 = $139.1m.

In year 2: 

$173m /1.1 / 1.1 = $143m

In year 3: 

$233m /1.1 / 1.1 / 1.1 = $175.1m

Total value = $139.1m + $143m + $175.1m = $457.2m

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This is the value of the cash flows to all investors (debt or equity); the value of debt
therefore needs to be subtracted to obtain the value of equity.

Value of equity = $457.2m - $30m = $427.2m

Price per share = $427.2m / 50m = $8.54 (the same as above)

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 Syllabus B1c) Distinguish between the potential objectives of management, shareholders, and other
stakeholders and the effects of these on the behaviour of the firm

Stakeholders

DEFINE STAKEHOLDERS

A stakeholder is a group or individual who has an interest in what the organisation

does, or an expectation of the organisation.

It is important that an organisation understands the needs of the different

stakeholders.

Stakeholders may be categorized as follows:

• Internal stakeholders

• External stakeholders

• Connected stakeholders

The diagram below lists some of the most important stakeholders of an

organisation.

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 Syllabus B1c) Distinguish between the potential objectives of management, shareholders, and other
stakeholders and the effects of these on the behaviour of the firm

Stakeholders

STAKEHOLDERS

A stakeholder is a group or individual who has an interest in what the organisation

does, or an expectation of the organisation.

Internal Stakeholders

Internal stakeholders are intimately associated to the organisation and their

objectives are likely to have a strong influence on how it is run.

The main two examples of internal stakeholders are:

• Employees

• Management

Their interests to defend are

jobs / careers, money, promotion prospects and benefits.

Response risk if interests are not recognised

Pursuit of individual goals rather than shareholder interests

Resignation

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Connected Stakeholders

Connected stakeholders can be viewed as having a contractual relationship with the

organisation.

The objective of satisfying the shareholders needs to be fulfilled, however,

customers and finance objectives must be met if the company is to succeed.

Some examples of connected stakeholders may include:

• Shareholders – interested in shareholders’ wealth measured by profitability, P/E

ratios, market capitalisation

Response risk if interests are not recognised

Sell shares (e.g. to predator) or vote against management (e.g. at AGM)

• Customers – interested in the company’s products

Response risk if interests are not recognised

Buy elsewhere

Damage reputation (e.g. bad publicity)

Legal action

• Suppliers – interested in building long term relationship, on time payment of

goods and profitable sales

Response risk if interests are not recognised

Refusal of credit

Stop supplying

Legal action (e.g. for unpaid debts)

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• Finance providers - like banks interested in loan security

Response risk if interests are not recognised

Denial of credit

Higher interest charges

External Stakeholders

External stakeholders have quite diverse objectives and have varying ability to
ensure that the organisation meets its objectives.

Some examples of external stakeholders may include:

• Non-governmental organisations

Interests to defend

Human rights

Response risk if interests are not recognised

Legal action

• Environmental pressure groups

Interests to defend

Protecting the environment

Human rights

Response risk if interests are not recognised

Publicity

Direct action

Sabotage

Pressure on government

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• Government and regulatory agencies – interested in tax, compliance with
legislation and employment opportunities

Response risk if interests are not recognised

Tax increases

Regulation

Legal action

Tariffs

• Trade unions – interested in protecting their members.

Response risk if interests are not recognised

Legal action

Direct action

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 Syllabus B1c) Distinguish between the potential objectives of management, shareholders, and other
stakeholders and the effects of these on the behaviour of the firm

Understanding the Influence of each Stakeholder

(MENDELOW)

This framework is used to attempt to understand the influence that each

stakeholder has over an organisation’s strategy.

The idea is to establish which stakeholders have the most influence by estimating
each stakeholder’s individual power over – and interest in – the organisation’s
affairs.

The stakeholders with the highest combination of power and interest are likely to be
those with the most actual influence over objectives.

The Mendelow Framework

• Power
Is the stakeholder’s ability to influence objectives

• Interest
Is how much the stakeholders care

• Influence
= Power x Interest

However, it is very hard to effectively measure each stakeholder’s power and

interest.

The ‘map’ is not static; changing events can mean that stakeholders can move
around the map

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Mendelow Framework - explanation

• A) Low power, low Interest - Minimal effort

These can be largely ignored, although this does not take into account any moral
or ethical considerations.

It is simply the stance to take if strategic positioning is the most important

objective.

• B) Low power, high interest - Keep informed

Can increase their overall influence by forming coalitions with other stakeholders
in order to exert a greater pressure and thereby make themselves more
powerful.

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 The management strategy for dealing with these stakeholders is to ‘keep
informed’.

• C) High power, low interest - Keep satisfied

All these stakeholders need to do to become influential is to re-awaken their

interest.

This will move them across to the right and into the high influence sector, and so
the management strategy for these stakeholders is to ‘keep satisfied’.

• D) High power, high interest - Key players

Those with the highest influence.

The question here is how many competing stakeholders reside in that quadrant
of the map.

If there is only one (eg management) then there is unlikely to be any conflict in a
given decision-making situation.

If there are several and they disagree on the way forward, there are likely to be
difficulties in decision making and strategic direction.

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 Syllabus B1c) The principal-agent problem, its impact on the decisions of organisations.

Agency

Agency is defined in relation to a principal. What?! Well all this means is an owner
(principal) lets somebody run her business (manager).

The agent is doing this job on behalf of someone else.

Footballers, film stars etc all have agents. They work on behalf of the star. The star
hopes that the agent is working in their best interest and not just for their own
commission…

Principals and Agents

A principal appoints an agent to act on his or her behalf.

In the case of corporate governance, the principal is a shareholder and the agents
are the directors.

The directors are accountable to the principals

Examples of Agents:

1. The Chief Executive (CEO)

2. Non-executive directors (NEDs)

3. The Chairman

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 Syllabus B1c) The principal-agent problem, its impact on the decisions of organisations.

Stakeholders and impact on corporate objectives

We have just seen that the primary objective of a company is the maximisation of
shareholder wealth.

However, there is an alternative known as the stakeholder view.

This means balancing shareholder wealth with the objectives of other stakeholders.

Let’s have a look at some stakeholders and their objectives:

Stakeholder Objective

Staff High salaries; safe job

Managers High bonuses

Shareholders High share price; dividend growth

Banks Minimise company risk

Customer Quality service

Suppliers Good liquidity

Government Good accounting records; Training

initiatives

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Clearly meeting all stakeholders objectives entirely is impossible.

Often they are in conflict with each other. Therefore a degree of compromise is
reached.

For example, Performance related pay for example is a means of satisfying both
staff and shareholders.

So how can the owners ensure that the agents are working for the owners
objectives and not just their own?

1. Fixed wages
Not always the optimal way to organise relationships between principals and
agents.

A fixed wage might create an incentive for the agent to shirk since his
compensation will be the same regardless of the quality of his work or his effort
level.

2. Performance related Pay

When agents have incentive to shirk, it is often more efficient to replace fixed
wages with compensation based on the profits of the firm, since it makes their
compensation dependent on their performance.

However this can lead to individuals not working for the team as a whole by
inflating budgets required etc.

Output may also be encouraged rather than quality. It disregards job satisfaction
also

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3. Share options
Seems like a great idea as if the share price goes up then both the managers
and the owners benefit.

However often shares go up and down in line with market movements

regardless of how well the managers have performed so many managers would
not like to be measured and paid solely this way.

Some element of share options within their pay though would be a good thing
and acceptable by all

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 Syllabus B2: Determination of prices by market forces and the
impact of price changes

Syllabus B2a) Identify the equilibrium price in product or factor markets

THE CONCEPT OF DEMAND AND SUPPLY FOR

GOODS AND SERVICES

Microeconomics

Microeconomics looks into the individual people and firms within the economy. 

The competition also has a key influence on the micro environment.

The 5 M’s refer to inputs that an organisation requires in order to function.

They are:
1. Materials

2. Money

3. Men (human resources)

4. Machines

5. Management

Utility

Utility describes the benefit of consuming goods.

Total utility is the total benefit people get from spending their income on consuming
goods.

Marginal utility is the satisfaction gained from consuming one additional unit of a
good

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Demand for goods and services

Five main variables influence the quantity of each product that is demanded by
each individual consumer:

1. The price of the product

2. The prices of other products
3. The consumer’s income and wealth
4. Various sociological factors
5. The consumer’s tastes

All of those create a shift in the demand curve

Generally the higher the price the less is demanded. Hence a downward sloping
curve (see diagram)

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Supply for goods and services

Four major determinants of the quantity supplied in a particular market are:

1. The price of the product

2. The prices of factors of production

3. The goals of producing firms

4. The state of technology

All of those create a shift in the supply curve.

Supply is basically what producing firms are willing to supply.

They will normally supply more for a higher price (received)

Hence the curve is normally upward sloping (see diagram)

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Equilibrium

Where demand and supply intersect the economy is said to be at equilibrium.  

This is the most efficient point/price because supply is exactly matched with
demand. So everybody is happy

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 Syllabus B2bcd) b) Calculate the price elasticity of demand and the price elasticity of supply
c) Explain the determinants of the price elasticities of demand and supply
d) Calculate the effects of price elasticity of demand on a firm’s total revenue curve

Price Elasticity of Demand

If Pizza Express raises its prices by ten percent, what will happen to its revenues?

The answer depends on how consumers will respond. Will they cut back purchases
a little or a lot?

This question of how responsive consumers are to price changes involves the
economic concept of elasticity.

• The most common elasticity measurement is price elasticity of demand.

It measures how much consumers respond in their buying decisions to a change

in price.

The coefficient of PED is measured as:

Since demand usually increases when the price falls, and decreases when the price
rises, elasticity has a negative value.

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However it is usual to ignore the minus sign and just describe the absolute value of
the coefficient.

Interpreting price elasticity of demand

Value greater than 1: Elastic demand

Demand is said to be price elastic = responsive to price changes.

When demand is elastic, companies will experience:

• A rise in revenue if prices are cut, and

• A fall in revenue if prices are increased.

Value less than 1: Inelastic demand

Demand is said to be price inelastic =  unresponsive to price changes.

When demand is price inelastic, companies will experience:

• A fall in revenue if prices are cut, and

• A rise in revenue if prices are increased.

Goods whose income elasticity of demand is positive are said to be NORMAL

GOODS, meaning that demand for them will rise when household income rises.

If income elasticity is negative, the commodity is called an INFERIOR GOOD since

demand for it falls as income rises.

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Methods - Price elasticity of demand

1) Simple method (also known as the non-average arc method).

This measures the responsiveness of demand compared to the starting or initial

demand and price.

Example 1 - Simple method

Initial demand at €1.10 per unit is 700,000 units. 

New demand at €1.20 per unit is 650,000 units.

% change in demand:

(650,000 - 700,000) / 700,000 x 100% = - 7.1%

% change in price:

1.20 - 1.10 / 1.10 x 100% = 9.09%

Price elasticity of demand = -7.1 / 9.09 = -0.78

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2) Average (midpoint) method
- measures the responsiveness of demand compared to the average demand and
price.

Example
Initial demand at €1.10 per unit is 700,000 units. 

New demand at €1.20 per unit is 650,000 units.

Average demand = (650,000 + 700,000) / 2 = 675,000

% change in demand:

(650,000 - 700,000) / 675,000 x 100% =7.4%

Average price = (1.20 + 1.10) / 2 = 1.15

% change in price:

1.20 - 1.10 / 1.15 x 100% =  8.7%

Price elasticity of demand = -7.4 / 8.7 = -0.85

In the Exam
Use the midpoint (average arc) method ONLY if asked in an exam question

but if no method is stated use the Simple method

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Factors that determine the value of price elasticity of demand

1. Number of close substitutes within the market

The more (and closer) substitutes available in the market the more elastic
demand will be in response to a change in price.

In this case, the substitution effect will be quite strong

2. Luxuries and necessities

Necessities tend to have a more inelastic demand, whereas luxury goods and
services tend to be more elastic.

3. Percentage of income spent on a good

It may be the case that the smaller the proportion of income spent, taken up with
purchasing the good or service, the more inelastic demand will be.

4. Habit forming goods

Goods such as cigarettes and drugs tend to be inelastic in demand.

Preferences are such that habitual consumers of certain products become

desensitised to price changes.

5. Time period under consideration

Demand tends to be more elastic in the long run rather than in the short run.

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 Syllabus B2b) The price elasticity of demand and supply.

Price elasticity of supply

= A measure of the responsiveness of quantity supplied to a change in price.

Price elasticity of supply reflects the ability of firms to increase output when
demand rises.

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Influences on price elasticity of supply

If the market price of a product rises, producers will want to increase supply.

Their ability or willingness to do this (ie the price elasticity of supply) will be greater
if:

• The time period since the price changed is longer (allowing a firm more time to
organise extra production)

• The cost of attracting more factors of production (eg labour, capital) is lower

• Excess inventories are available which can be used to supply the market

• There is spare capacity (meaning that it is easy for a Firm to increase production
levels)

Illustration

Required
Below you can see how the supply of Pizza has changed following changes to their
prices.

Calculate price elasticity of supply for Pizza, to two decimal place.

Price Quantity supplied

Before US$10 200

After US$12 250

[(250 - 200) / 200] / [(12 - 10) / 10] = 1.25

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 Syllabus B3. Economic And Social Considerations And The
Regulation Of Markets

Syllabus B3a) Sources of internal and external economies of scale and their influence on market
concentration.

Economies of scale

Internal economies of scale

Internal economies of scale arise from the firm, either through its own growth or
potentially from growth by acquisition.

This is the type of economy of scale that is under the control of management.

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Trading economies of scale (internal)

1. Buying economies
- reducing the cost of material purchases through bulk purchase discounts

2. Bulk selling
- will enable a large firm to make relative savings in distribution costs and
advertising costs

3. Economies of scope
- refer to the cost savings available by offering a wider range of products,

Financial economies of scale (internal)

It may be cheaper and easier for large firms to raise finance.

Investors accept lower returns if risk is lower.

Larger firms are perceived to be less risky because they often have:

• Valuable assets to use as security

• High levels of market power

• Less reliance on a single product or market

Technical economies of scale (internal)

A high proportion of costs are fixed costs

eg aircraft manufacture, car manufacture, logistics companies.

In these industries, larger firms may have a significant cost advantage because the
fixed costs can be spread over a larger number of units.

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Illustration 1

Cow Co and Calves Co produce Bottles of milk.

Storage cost is $10 million for both companies.

The average variable cost for both companies, is $0.1 per bottle.

Average costs per unit will be:

Cow Co Calves Co

Number of parcels per 12m 3m

year

Total variable costs 12m x 0.1 = $1.2m 3m x 0.1 = $0.3m

Fixed costs $10m $10m

Total costs $11.2m $10.3m

Average cost / unit $11.2m / 12m = $0.9 per $10.3m / 3 = $3.4

unit per unit

Cow Co will therefore have a significant cost advantage over Calves Co.

Managerial economies of scale (internal)

The number of management and supervisory staff does not increase at the same
rate as output

For example a hotel with 10 bedrooms and a hotel with 100 bedrooms would
each have a single General Manger and Head Chef.

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External economies of scale

It is also possible for costs per unit to fall because of a growth in the size of the
industry (not the firm).

Here are some examples:

• To support a growing industry, the government may provide educational services

that are geared towards training new entrants.

This saves firms in the industry from having to incur the costs of training.

• Government assistance may be granted to industries that promise large

amounts of jobs or export earnings.

In recent years, information technology, green energy and biotechnology

industries have benefited from this.

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 Syllabus B3a) Identify the influence of costs on the size and structure of the organisation

Diseconomies of scale

= rising cost per unit

Reasons for Internal diseconomies of scale are:

• Chains of command may become too long, and management will become too
remote and lose control over operations.

• Morale and motivation amongst staff may deteriorate in large firms and there
may be conflicts between different departments.

• There may be increased levels of bureaucracy.

External diseconomies of scale

There may also be external diseconomies of scale which affect all firms in an
industry as the industry grows.

For example, if a shortage of materials or labour occurs (due to high levels of

demand across the industry) then this might lead to higher raw material and labour
costs.

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 Syllabus B3a) Identify the influence of costs on the size and structure of the organisation

Impact of long run costs on industry structure

Minimum efficient scale (MES)

Minimum efficient scale is the lowest level of output at which a firm can achieve its
minimum average cost.

If a firm is producing at quantities below the MES, its unit costs of production may
be higher than those of its bigger rivals.

This means it will be at a competitive disadvantage.

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If Company 1 is producing at Q1 it will have unit costs of C1.

It has not reached minimum efficient scale.

Company 2 is producing at Q2 and has unit costs of C2, the minimum feasible cost
in the industry.

Company 2 might seek to set market price at PO to cause losses of C1 — PO per

unit on Company 1 whilst making profits per unit of PO - C2 itself.

This could have the effect of driving Company 1 from the industry.

MES in different sectors

The level of the MES will vary in different industries.

In industries where:

• Fixed costs are low

- then the MES will be low

eg software, apps

• Fixed costs are higher as a percentage of total costs

- then MES will be high

eg aircraft manufacture, mining

Concentration ratios

= The percentage of market share taken up by the largest firms.

It could be a 3 firm concentration ratio (market share of 3 biggest) or a 5 firm

concentration ratio.

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Concentration ratios are used to determine the market structure and
competitiveness of the market.

eg the five-firm concentration ratio for UK supermarkets is approximately 66%

Tesco – 24%

Asda 13%

Sainsbury’s 13%

Morrisons 12%

Co-op 5%

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Methods of growth

Companies can increase the scale of their operations by:

• Internal (organic) growth

— investing to build the company's own capacity to enable higher production
levels so that internal economies of scale can be generated.

• Acquiring other companies

— a strategy of buying another company may be referred to either as an

acquisition, merger or as an integration strategy.

Types of integration

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Horizontal integration

Involves the acquisition of a rival firm in the same line of business

eg Volkswagen acquired Skoda

Horizontal integration is likely to create internal economies of scale and to reduce

competition.

Vertical integration

The acquisition of a firm that operate at different stages of production.

Backward vertical integration is where a firm merges with a supplier.

Forward vertical integration is where a firm merges with a customer

eg Booker, a food supplier, acquired Budgens and Londis (food retailers).

Conglomerate integration

Also called diversification, this involves the acquisition of a firm in a different line of
business.

Sometimes there may be a link between the two businesses

eg Lenovo (computers) acquisition of Motorola (mobile phones).

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 Syllabus B3b) Impacts of changing transactions costs on the decision to outsource aspects of a
business (including network organisations, shared service centres, and flexible staffing).

Impact of long run costs on industry structure

Alternative strategies for firms

Although economies of scale encourage firms to get bigger, small firms can still
survive and be competitive.

Strategies such as outsourcing of high-cost activities, or off shoring, often enable

smaller firms to survive.

1. Outsourcing
- refers to transferring an activity previously conducted by the firm itself to an
outside contractor.

eg a small internet-based retail company can use an external logistics company

to deliver goods to its customers, rather than running its own delivery service
(employing its own delivery staff, purchasing delivery vehicles etc).

2. Off shoring
The costs of operation vary widely from country to country, due to factors such
as:

(a) Lower general pay rates

(b) Better skills available

(c) Better support services such as transportation, information systems or

education and training

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 (d) More favourable regulatory environment such as lower taxation, less costs of
complying with government regulations.

A firm may decide to locate some its in-house operations offshore or may
outsource some of its activities to off-shore locations in order to gain cost
efficiencies needed to compete in its market.

3. Network organisations

Outsourcing means a firm will rely on several other firms to supply a product.

So, the supply of a good involves several firms in partnership.

If a firm has outsourced most of its activities, it is called a network organisation.

4. Shared service centre

eg using a central Finance team, rather than the different divisions in a company
each having their own finance team.

5. Flexible staffing

This involves the use of a variety of flexible working arrangements

For example the use of temporary staff, or full time staff on zero-hours contracts.

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Syllabus B3b) Positive and negative externalities in goods markets and government responses to them
including indirect taxes, subsidies, polluter pays policies, regulation and direct provision.

Market failure - externalities

Externalities

A positive or negative impact of a transaction on people who are external to that

transaction (ie not a buyer or seller).

Positive and negative externalities

• Positive externalities
Benefits from production or consumption of a good or service that extend
beyond the trading parties (ie the buyer and seller)

• Negative externalities
Costs from production or consumption of a good or service that extend beyond
those paid for by the trading parties

Merit and demerit goods

Sometimes a product generates such a high impact in terms of externalities that it is

generally agreed that this product is either good or bad for society as a whole.

• Merit good
Generates positive externalities to society as a whole (social benefits).

For example, vaccinations, education

• Demerit good
Generates negative externalities to society as a whole (social costs).

For example, smoking.

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Dealing with externalities

Merit goods Demerit goods

Subsidies to reduce the price. Indirect taxation to raise price.

Public information campaign to Public information campaign to raise

stress benefits. awareness of risks.

Public provision of the product. Legislation/ ban on product, eg smoking

in public buildings.

Price regulation (maximum price). Price regulation (minimum price).

Public goods

Public goods have two characteristics:

1. Non-diminishability
-the good or service can serve a small or large number of people at exactly the
same cost

E.g. the good or service does not diminish in supply as more people enjoy it.

2. Non-exclusivity
- providers of the good or service cannot exclude non-payers, which makes it
unlikely that it will be provided by profit-seeking providers.

Note that not all goods provided by the public sector are public goods,

e.g.

healthcare is a merit good, not a public good, because it is diminishable (ie there is
less healthcare available for others as more people use healthcare resources).

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Syllabus B3b) Positive and negative externalities in goods markets and government responses to them
including indirect taxes.

Government intervention - indirect taxes

Indirect tax

An indirect tax is a tax levied on spending.

The Supplier is responsible for collecting and paying the tax to the government, but
much of the tax is passed on to the consumer (due to a higher price being charged).

A key purpose of an indirect tax is to reflect social costs by adding them as a cost
to be paid by the Supplier.

This will result in less of the product being consumed, which is especially desirable
in the case of demerit goods such as alcohol.

Consumer's & Supplier's Portion Tax

Step 1: Price increases (due to an Indirect tax)

• Supplier is prepared to sell MORE

• Supply Curve moves LEFT S -> S1

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Step 2:

• What is the new price when D = S? A

• What is the old price when D = S? C

• What is the difference in Price? A -> C

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Step 3:
Consumer Pays the difference in Price (AC)

Supplier Pays the rest (CB)

Illustration 1
The price of a bottle of rum is $10.

At this price, the amount consumed is Q0.

If the government imposes an indirect tax of $5 per bottle, this is paid to the
government by the supplier.

The supplier will now only be prepared to sell the same quantity when the price is
$15 per bottle (rather than $10).

Therefore, the supply curve moves up by $5 from S0 to S1.

However, at this new price of $15, demand for rum will be lower.

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There is now a surplus of rum (Q1 — Q0), so rum producers will cut their price until
the surplus is removed at B, where price is $13.

As a result of the tax, price rises by $3 (from 10 to 13) — so $3 of the tax is passed
on to the consumer.

The rest of the burden of the tax ($2) is borne by the supplier.

Price elasticity and the impact of indirect taxes

The impact of an indirect tax will be that the price of the good rises, and that the
quantity produced and sold falls.

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The extent to which a price rise causes a fall in quantity depends on the price
elasticity of demand and supply.

• If the price elasticity of demand is very low (inelastic) then the quantity
demanded will not fall significantly as a result of a price rise.

• If the price elasticity of supply is very low (inelastic) then the quantity supplied
will not fall significantly, and in some cases supply may be fixed in the short term
regardless of price

eg output of gas from a tracking site.

So the imposition of an indirect tax may not achieve a significant reduction in the
consumption of a demerit good.

However, it can still raise useful income to finance government spending and to
force producers to bear some of the costs of managing the negative externalities
resulting from production.

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Syllabus B3b) Positive and negative externalities in goods markets and government responses to them
including subsidies, polluter pays policies

Government intervention - subsidies, polluter pays

policies

‘Polluters pay’ policies

Demerit goods often cause negative externalities, such as pollution.

Other 'polluters pay' policies include:

• Tradable permits

A firm is allowed to produce a certain level of pollution.

If it produces more it will have to pay for additional permits.

If it produces less, it can sell its unused permits for a profit to other companies.

• Charges for dumping waste products,

eg landfill tax

• Fines for breaching regulations

Subsidy

A subsidy is a financial contribution from government to reduce the costs of

production.

It can have a number of aims:

• To reduce cost of living by making essential goods affordable.

• To encourage production or consumption of merit goods.

• To stabilise incomes of producers (eg farm subsidies).

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Impact of a subsidy

A per-unit subsidy shifts the supply schedule downwards (rightwards) by the

amount of the subsidy per unit.

Illustration

The equilibrium is initially at A, where the price is $10 and the quantity is QO.

The government grants a subsidy of $5 per item.

This encourages producers to make more of the product, so the supply curve shifts
to S1 and the amount supplied increases to QS.

There is now excess supply of QS - QO.

So suppliers reduce their price until a new equilibrium is reached at B.

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At B the price is $8, so consumers benefit from $2 of the subsidy ($10 — $8) and
suppliers take the rest of the benefit ($3).

Price elasticity and the impact of subsidies

The impact of a subsidy will be that the price of the good falls, and that the quantity
produced and sold rises

(ie from QO to QE in Illustration above).

The extent to which a price fall causes a rise in quantity depends on the price
elasticity of demand and supply.

• If the price elasticity of demand is very law then the quantity demanded will not
rise significantly as a result of the lower price.

• If the price elasticity of supply is very low then the quantity supplied will not rise
significantly, because supply may be fixed in the short term regardless of price
eg subsidies for nuclear fuel.

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Syllabus B3b) Positive and negative externalities in goods markets and government responses to them
including regulation and direct provision

Regulation & Direct provision

Direct provision

Where the free market is producing too few merit goods, or where the market power
at private firms is seen to be too high, the government may decide to act as a
provider of goods and services

eg provision of healthcare in the UK through the National Health Service (NHS).

There are potential problems with this approach, for example:

• Government organisations do not need to make a profit so there is less incentive

for them to control costs.

• State ownership leads to large organisations which are difficult to control.

• Some international trade treaties Forbid state ownership.

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 Syllabus B3b) Impact of minimum price (minimum wages) and maximum price policies in goods and
factor markets.

Minimum Price And Maximum Price

Price regulation

The government can manipulate the market by setting a maximum or minimum

price for goods or services.

Minimum pricing policies

A minimum price is a price level below which the market price will not be permitted
to fall = a price floor.

An example of this is minimum wage.

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Effects of a minimum price

• Increases welfare of producers

A higher price to suppliers of goods will result if the minimum price is above the
current market price.

• Create a surplus (excess supply)

In the diagram above, there is an overall excess supply represented by Qd to
Qs.

This may lead to informal arrangements whereby suppliers agree to supply the
good for less than the minimum price.

Effects of a minimum wage

• Increases pay of workers

A higher price to suppliers of labour will result if the minimum wage is above the
current market price.

• Create a surplus (unemployment)

In the diagram above, there is an overall excess supply of labour represented by
Qd to Qs.

However, the unemployment caused by the minimum wage itself is only the
distance Qd to Qo (because the equilibrium point prior to the minimum wage
was Qo).

This may lead to informal arrangements whereby workers agree to work for less
than the minimum wage.

Maximum pricing

A maximum price is a price level above which price will not be permitted to rise ie a
price ceiling.

An example of this is the imposition of a maximum price for household rents.

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Effects of maximum price (price ceiling)

• Consumers are protected from the effects of high prices

eg rent controls are used in many cities (eg New York, Berlin) for this reason.

• A shortage is created, and the market will not be able to ration the good
between customers.

So the government will have to perform the rationing function by:

(i) Formal rationing — eg by issuing coupons or deciding allocation (in New York
priority for apartments is given to long-term New York residents).

(ii) Implementing waiting lists.

• Shortages may lead to illegal trading on the parallel (or black) market.

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 Syllabus C: Informational Context of Business

Syllabus C1: Techniques to communicate data as information

to stakeholders

Syllabus C1a) Explain the difference between data and information and the characteristics of good
information

Data vs information

Data is the raw material for data processing.

Data relate to numbers, raw facts, events and transactions which have been
recorded but not yet processed into a form suitable for use.

Data on its own is meaningless.

Information is data that has been processed in such a way as to be meaningful to

the person who receives it.

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Quantitative Or Qualitative

Data can be either quantitative or qualitative, as can information.

• If data can be measured, it is quantitative

eg value of sales per day

• If it cannot be measured, then it is qualitative

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 Syllabus C1a) Explain the difference between data and information and the characteristics of good
information.

Good Information

Attributes of good information

Good information should be ACCURATE

• Accurate

Information should be accurate because using incorrect information could have

serious and damaging consequences.

• Complete

A user should have all the information he needs but it should not be excessive.

• Cost-effective

The benefits obtainable from the information must exceed the costs of acquiring
it.

• Understandable

Information must be clear to the user.

If the user does not understand it properly he cannot use it properly.

• Relevant

Information must be relevant to the purpose for which a manager wants to use it.

• Accessible

Information should be accessible via the appropriate channels of communication

and to the right people.

For example, emails should be used if the person who needs the information is
not physically present.

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• Timely

Information should be made available before a decision needs to be made to be

considered useful

If it is made available after a decision is made, it will be useful only for

comparisons

• Easy to Use

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 Syllabus C1b) Graphs, charts and diagrams: scatter diagrams, histograms, bar charts and ogives.

Charts and Graphs

Charts or graphs (diagrams) make data clearer and more understandable.

Types of diagrams:

1. Bar charts

2. Histograms

3. Scatter diagrams

4. Ogives

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 Syllabus C1b) Identify relevant data from graphs, charts and diagrams

Bar Charts

A bar chart is a widely used method of illustrating quantitative data.

Quantities are shown in the form of bars on a chart, the length of the bars being
proportional to the quantities.

1. Simple bar charts

A simple bar chart consists of one or more bars, in which the length of each bar
indicates the size of the corresponding information.

ABC Ltd: Sales Figures

Year Total Sales ($)

2009 1,200,000

2010 1,500,000

2011 1,300,000

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2. Component bar chart

A simple bar chart consists of one or more bars, in which the length of each bar
indicates the size of the corresponding information.

ABC Ltd: Sales Figures

Product A ($) Product B ($) Product C ($) Total($)

2009 300,000 400,000 500,000 1,200,000

2010 400,000 500,000 600,000 1,500,000

2011 300,000 600,000 400,000 1,300,000

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3. Percentage component bar chart

A percentage component bar chart is a component bar chart which does not show total
magnitudes.

The total length of each bar is the same — the size of the sections within the bar shows the
relative sizes of the components

(ie the size of the section indicates the percentage of the total that each component
accounts for).

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ABC Ltd: Sales Figures

Product A Product B Product C Total

2009 $300,000 $400,000 $500,000 $1,200,000

25% 33.33% 41.67%

2010 $400,000 $500,000 $600,000 $1,500,000

27% 33% 40%

2011 $300,000 $600,000 $400,000 $1,300,000

23% 46% 31%

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 Syllabus C1b) Identify relevant data from graphs, charts and diagrams

Histograms and frequency distributions

Frequency distribution

A frequency distribution shows how often each different value occurs.

A histogram is the most commonly used graph to show frequency distributions.

Illustration: A histogram with EQUAL intervals

The table below shows how many hours students study per week.

Hours Spent to study Number of Students (Frequency)

0-1 10

1 - 1.99 15

2 - 2.99 4

3 - 3.99 3

4 - 4.99 1

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Interpreting a histogram with unequal class intervals

If a distribution has unequal intervals, the heights of the bars have to be adjusted for the

fact that the bars do not have the same width.

With a histogram we look at the whole area (not just a height), also a width.

Illustration: A histogram with UNEQUAL intervals

The table below shows how many hours students study per week.

Number of Hours Number of students

>3≤5 8

>5≤6 6

>6 ≤ 8 6

>8 ≤ 10 10

>10 ≤ 13 6

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Note the symbol:

≤ means 'less than or equal to'.

> means 'greater than'

Here the class intervals for hours are not all the same

1 (eg 5 - 6)

2 (eg 6 - 8)

3 (eg 10 - 13)

So a bar chart would be misleading because there will naturally be more students in

the bigger intervals than the smaller intervals.

That's why we use a Histogram.

A histogram is drawn as follows:

1. Choose a standard width of bar

This will be the most frequently occurring interval

in Our Illustration this is an interval of 2.

2. The width of each bar on the chart reflects the size of the interval

eg > 6 ≤ 8 , a range of 2, will be twice as wide as the bar representing > 5 ≤ 6,

a range of 1.

3. Calculate the height of the bar

Check the adjustment in the following table:

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 Number of
Number of Size of Height of
students Adjustment
Hours interval bar
(Frequency)

>3≤5 2 8 x 2/2 8

>5≤6 1 6 x 2/1 12

>6 ≤ 8 2 6 x 2/2 6

>8 ≤ 10 2 10 x 2/2 10

>10 ≤ 13 3 6 x 2/3 4

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 Syllabus C1b) Identify relevant data from graphs, charts and diagrams

Cumulative frequency distributions

Cumulative frequencies are obtained by adding the individual frequencies together.

Ogive

An ogive is a graph of the cumulative number of items with a value less than or
equal to, or alternatively greater than or equal to, a certain amount.

It is drawn by plotting a diagram of a cumulative frequency distribution.

Notice:
• a frequency distribution can be graphed as a histogram

• a cumulative frequency distribution can be graphed as an ogive.

Illustration
Here, we have a number of students (Frequency) and how many hours they study
per week.

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See how A Cumulative frequency distribution is calculated:

Hours Spent to Number of Students

Cumulative Frequency
study (Frequency)

<1 10 10

<3 15 10 + 15 = 25

<4 4 10 + 15 + 4 = 29

<6 3 10 + 15 + 4 + 3 = 32

<10 1 10 + 15 + 4 + 3 + 1 = 33

The cumulative frequency distribution shows that, of the total of 33 students:

10 students study less than 1 hour per week,

25 students study less than 3 hours per week,

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29 students study less than 4 hours per week,

32 students study less than 6 hours per week and

33 students study less than 10 hours per week.

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 Syllabus C1b) Identify relevant data from graphs, charts and diagrams

Scatter Diagram

Information about two variables that are considered to be related in some way can
be represented on a form of graph known as a ‘scatter diagram’, each axis
representing one variable.

For example, the level of advertising expenditure and sales revenue of a product, or
the level of electricity cost and the number of units produced can be plotted against
each other.

The values of the two variables are plotted together to show a number of points on
the graph.

The way in which these are scattered or dispersed indicates if any relationship is
likely to exist between the variables.

The following scatter graph shows the relationship between 2 variables:

- the independent variable can be the units

- the dependent variable can be production cost.

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Line of Best Fit

The "best-fit" line (trend line) is the straight line which passes as near to as many of
the points as possible. By drawing such a line, we are attempting to minimise the
effects of random errors in the measurements.

For example, if our points look like this

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The line of best fit would be drawn as follows

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When we have our line of best fit drawn on the scatter diagram, we can use it to
read off values for the variables at any points on the axes.

In doing this, we have to assume that the line of best fit is accurately drawn and that
the relationship established, based on past data, will also apply in the future - this is
known as extrapolating the trend.

Using scatter diagrams with lines of best fit is useful as a forecasting technique and
has the advantage of relative simplicity.

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Syllabus C2: Uses of big data and analytics for understanding the business context

Syllabus C2a) Describe the principal business applications of big data and analytics

Big Data

is an emerging technology that has implications across all business departments.

It involves the collection and analysis of a large amount of data to find trends,
understand customer needs and help organisations to focus resources more
effectively.

The 3 V's

Big data has a role to play in information management

Gartner’s 3Vs definition of "Big Data":

1. Volume
You have more volume of data now

For example, data captured from social media.

2. Velocity
You have quicker data (You can get data much quicker)

3. Variety
Modern data takes many different forms.

Structured data may take the form of numerical data whereas unstructured data
may be in the format of email or video.

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 Syllabus C2a) Use of big data and analytics to identify customer value, customer behaviour, cost
behaviour and to assist with logistics decisions.

Big Data

Data comes from different sources:

• Processed data
- data that already exists

- e.g. from another database

• Open data
- government statistics

• Human sourced
- blogs, emails, social media

• Machine sourced
- fixed and mobile sensors (they pick things up as they happen)

- traffic sensors in traffic lights (showing congestion hotspots)

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Big data analytics

Analyse 'big data' and give them meaning.

Advantages of big data analytics:

• Better understanding of customer behaviour

For example, identifying what customers are saying in social media about an
organisation's customer service could help the organisation identify how well it is
meeting customers' needs.

• Targeted marketing messages

Big data could facilitate targeted promotions and advertising — for example,
advertising on FB based on location

• Improved logistics

Delivery companies can optimise package delivery routes taking into account
the order of delivery, the traffic situation and the availability of the recipient.

• New products and services

Big data could also enable organisations to introduce new products or services.

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 Syllabus C2bcd) b) Demonstrate the relationship between data variables
c) Demonstrate trends and patterns using an appropriate technique
d) Prepare a trend equation using either graphical means or regression analysis

Time Series

A time series

is a series of figures or values recorded over time.

e.g. monthly sales over the last 3 years.

The data often conforms to a certain pattern over time.

This pattern can be extrapolated into the future and hence forecasts are possible.

Time periods may be any measure of time including days, weeks, months and
quarters.

A graph of a time series is called a Histogram

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A time series has 4 components:

1. Trend
a trend is the underlying long-term movement over time in values of data
recorded

2. Seasonal variations or fluctuations

are short-term fluctuations in recorded values, due to different circumstances

e.g. sales of ice creams will tend to be highest in the summer months

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3. Cycles or cyclical variations
are medium-term changes in results caused by circumstances which repeat in
cycles

e.g. booms and slumps in the economy.

4. Residual variantions
no-recurring, random variations.

These may be caused by unforseen circumstances such as a change in

government, a war, technological change or a fire.

Hence these are non-repetitive and non-predictable variations.

The actual time series is:

Y = T + S + C + R

Where:

Y = the actual time series

T = the trend series

S = the seasonal component

C = the cyclical component

R = the random component

In the exam, it is unlikely that you will be expected to carry out any calculation of
‘C’.

Therefore, ‘C’ will be ignored.

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 Syllabus C2d) Trends in time series – graphs, moving averages and linear regressions

Methods of finding the Trend:

These are Methods of finding the Trend:

1. Moving averages

2. A line of best fit

this can be drawn by eye on a graph

3. Linear regression analysis

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 Syllabus C2d) Trends in time series – graphs, moving averages and linear regressions.

Moving Averages

It is common for a moving average to be measured over an even number of time

periods

By analysing the four-quarter moving average of sales, seasonal variations will be

smoothed out and it will be possible to identify the Trend = the long-term movement

over time.

For example, the four-quarter moving average of 4 quarters of sales is shown

below:

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This average relates to the mid-point of the period ie between summer and autumn.

However, the moving average needs to relate to a particular quarter, otherwise

seasonal variations cannot be calculated.

The illustration below shows how to deal with this:

Illustration: Moving averages

Calculate a four-quarter moving average trend of the following results.

Sales in
$'000

Spring Summer Autumn Winter

20X0 100 150 180 90

20X1 120 160 190 110

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To align these moving averages to a specific quarter, we need to average the

moving averages to create a 'Centred moving average':

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The centred moving average now relates to a specific quarter

eg 132.5 relates to Autumn 20X0

This is the TREND, ie the long-term movement over time.

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 Syllabus C2c) Seasonal factors for both additive and multiplicative models.

Trend and Seasonal Variations

Seasonal variations arise in the short-term

It is very important to distinguish between trend and seasonal variation.

Seasonal variations must be taken out, to leave a figure which is indicating the

Trend.

Methods of calculating Seasonal variation:

• Additive model

• Proportional (multiplicative) model

Additive model

This is based upon the idea that each actual result is made up of two influences.

Time series = Trend (T) + Seasonal Variation (SV)

Additive model - Steps

Step 1

Identify the trend

using Centred moving averages

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Step 2

Deduct the Trend from the time series data to obtain the Seasonal variation

the logic here is that if Time series = Trend + Seasonal variation then re-arranging

this gives:

Seasonal variation = Time series (Y) - Trend (T)

Illustration

Calculate the average seasonal variations from the following data.

Sales in $'000

Actual data Spring Summer Autumn Winter

20X0 100 150 180 90

20X1 120 160 190 110

Trend data

20X0 132.5 136.25

20X1 138.75 142.5

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The multiplicative model

The additive model assumes that seasonal variation does not increase over time.

This is unlikely — for example, companies that are growing rapidly will have

increasing sales figures and therefore higher seasonal variations too.

This drawback of the additive model is picked up by the Multiplicative model.

The multiplicative model is generally considered to be better as it assumes forecast

seasonal components are a constant proportion of sales.

Time series = Trend x Seasonal Variation (SV)

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Multiplicative model - Steps

Step 1

Identify the trend

using centred moving averages

Step 2

Divide the time series by the trend data to obtain the seasonal variation

the logic here is that if time series = trend x seasonal variation then re-arranging this

gives:

Seasonal variation = Time series (Y) / Trend (T)

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Illustration - Multiplicative model

Forcasting

Illustration - Additive model

The trend for train passengers at Paddington station is given by the relationship:

y = 5.2 + 0.24x

y = number of passengers per annum

x = time period (2010 = 1)

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What is the trend in 2019?

Solution

If x = time period (2010 = 1), then 2019 will be 9.

y = 5.2 + 0.24 x 9 = 7.36

Illustration - Multiplicative model

A company uses a multiplicative time series model.

Trend = 500 + 30T

T1 = First quarter of 2010.

Average seasonal variation:

1st Q = -20

2nd Q = +7

3rd Q = +16

4th Q = -1

What is the sales forecast of the 3rd Q of 2012?

Solution

If T1 = First quarter of 2010, then 3rd Quarter of 2012 will be 11.

T = (500 + (30 x 11)) x 116% = 963

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 Syllabus C2e) Identify the limitations of forecasting models

Advantages & Disadvantages

Advantages of Time Series Analysis

• it is useful when forecasting data which has a regular seasonal pattern as may

be the case with sales of certain products

• it is a rather simplistic approach

Disadvantages of Time Series Analysis

• it assumes that past trends will continue indefinitely and that extrapolating data

based on historic information will give valid conclusions.

• In reality, the sales of products may be influenced by the actions of competitors,

particularly in relation to new products becoming available on the market.

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 Syllabus C2d) The regression equation to predict the dependent variable, given a value of the
independent variable.

Linear Regression Analysis

Advantages of Time Series Analysis

Linear regression analysis is based on working out an equation for the line of best

fit.

The line of best fit will be of the form

y = a + bx

where

y is the value of the dependent variable (on vertical axis)

a is the intercept - fixed costs

b is the slope of the line - variable costs

x is the value of the independent variable (on horizontal axis)

i. How do we calculate 'a' and 'b'?

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How do we calculate ‘a’ and ‘b’?

‘a’ is the fixed cost per period

‘b’ is the variable cost per unit

‘x’ is the activity level (independent variable)’

‘y’ is the total cost = fixed cost + variable cost

‘n’ is the sample size – number of pairs of data

These formulae are given in the exam. Remember always start working ‘b’,

then move to ‘a’.

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Correlation

Correlation measures the strength of the relationship between two variables.

One way of measuring ‘how correlated’ two variables are, is by drawing the ‘line of
best fit’ on a scatter graph. When correlation is strong, the estimated line of best fit
should be more reliable.

Another way of measuring ‘how correlated’ two variables are, is to calculate a

correlation coefficient, r.

Different degrees of correlation

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177 aCOWtancy.com


The correlation coefficient (r)

The correlation coefficient measures the strength of a linear relationship between two

variables. It can only take on values between -1 and +1.

r = +1 indicates perfect positive correlation

r = 0 indicates no correlation

r = -1 indicates perfect negative correlation

The correlation coefficient is calculated as follows

This formula is also given in the exam

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Coefficient of determination (r2)

The coefficient of determination is the square of the correlation coefficient.

It measures how much of the variation in the dependent variable is ‘explained’ by

the variation of the independent variable.

The value of r2 can be between 0 and 1.

For example, if r = 0.97, r2 = 0.94 or 94%.

94% of the variation in the dependent variable (y) is due to variations in the

independent variable (x). 6% of the variation is due to random fluctuations.

Therefore, there is high correlation between the two variables.


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 Syllabus C2e) Identify the limitations of forecasting models

Advantages & Disadvantages

Advantages of Linear Regression

• It provides a more reliable approach to forecasting, as it arrives at the equation

of the regression line from the use of mathematical principles, known as the
least squares method.

• Unlike the high-low method, which uses only two past observations, regression
analysis can build into the regression line a large number of observations - this is
likely to make the relationship derived more accurate.

Disadvantages of Linear Regression

• It is only valid where the relationships involved are linear.

• It still uses past data to forecast future values of the variables - if the relationship
which existed in the past is not valid for the future, the forecast will be
inaccurate.

• It is a more complex technique to apply, requiring the mathematical derivation of

values for a and b in the regression equation.

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 Syllabus C2b) Correlation coefficient: Spearman’s rank correlation coefficient and Pearson’s
correlation coefficient.

Spearman's rank correlation coefficient

If you are given ranking rather than actual values.

Use Spearman's rank correlation coefficient to evaluate correlation.

n = number of pairs of data

d = the difference between the rankings

The coefficient of rank correlation can be interpreted in exactly the same way as the
ordinary correlation coefficient.

Its value can range from —1 to +1 .

Illustration
The following data relates to 5 students:

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 Ranking by how
Students Ranking by exam result
many hours studied

A 2 1

B 1 3

C 4 7

D 6 5

E 5 6

Required

Judge whether the performance of students correlates with their performance.

Solution

Correlation must be measured by Spearman's coefficient because we are given the

data as rankings.

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 Difference in
Difference2
rankings

A 1 1

B 2 4

C 3 9

D 1 1

E 1 1

Total 8 16

where d is the difference between the rank in hours studied and exam performance
for each Student.

R = 1 - {(6 x 16) / [5 x (25 - 1)]}

R = 1 - (96 / 120)
R = 1 - 0.8
R = 0.2

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The correlation is positive, 0.2, but the correlation is not strong.

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 Syllabus D: The Financial Context of Business

Syllabus D1: Functions of the main financial markets and

institutions

Syllabus D1a) Explain the role of various financial assets, markets and institutions in assisting
organisations to manage their liquidity position and to provide an economic return to providers of liquidity

Direct Finance

Direct Finance

• This is where borrowers borrow funds directly from lenders (people who saved
money) in financial markets by selling them securities (financial instruments).

• Typically a borrower issues a receipt to the lender promising to pay back the
capital.

These receipts are securities which may be freely bought or sold.

In return for lending money to the borrower, the lender will expect some
compensation in the form of interest or dividends

• As the financial markets are normally direct and no financial intermediaries

used, this is called financial disintermediation

Indirect Finance

Borrowers obtain funds through financial intermediaries (banks, stock

exchanges).

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So, Financial markets facilitate

1. The raising of capital (in the capital markets)

2. The transfer of risk (in the derivatives markets)

3. International trade (in the currency markets)

4. Match those who want capital to those who have it

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 Syllabus D1a) Role and functions of financial intermediaries.

A financial intermediary is an entity who performs

intermediation between two parties

This means that the lender gives money to the borrower indirectly as the financial
intermediary sits in between

It is typically an institution that allows funds to be moved between lenders and

borrowers.

It works as follows:
1. Savers (lenders) give funds to
2. An intermediary institution (such as a bank), who then gives those funds to
3. Spenders (borrowers)
This may be in the form of loans or mortgages.

The Roles include

1. Aggregating investments to meet needs of borrowers
To provide a link between many investors who may have small amounts of
surplus cash and fewer borrowers who may need large amounts of cash

2. Risk transformation
Intermediaries offer low-risk securities to primary investors to attract funds,
which are then used to purchase higher-risk securities issued by the ultimate
borrowers

3. Maturity transformation
Investors can deposit funds for a long period of time while borrowers may
require funds on a short-term basis only, and vice versa. In this way the needs
of both borrowers and lenders can be satisfied

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 Syllabus D1a) Explain the role of various financial assets, markets and institutions in assisting
organisations to manage their liquidity position and to provide an economic return to providers of liquidity

Short term finance

The following are short terms forms of finance

- in the exam always remember to think about these when asked about possible
ways of raising finance

1. Overdraft

This is the riskiest type of finance as the bank can call it in at any time.

The bank has the right to be repaid overdrawn balances on demand, except
where the overdraft terms require a period of notice.

The bank can use the customers’ money in any legally or morally acceptable
way that it chooses

2. Short term Loan

Less risky than an overdraft but it will possibly need replacing and there’s a
risk that it would be on worse terms - if the economy changes

Unlike an overdraft, a bank loan cannot be withdrawn by the bank after the
loan has been granted (assuming the loan terms
have been met) so this is a more secure source of finance.

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3. Trade payables

Often seen as free finance - although you may actually be missing out on early
settlement discounts.

Be careful also not to annoy your creditors by taking too long to pay

4. Debt Factoring

The sale of a business' invoices to a third party.

The business selling will pay a fee for this service

The third party is charged with processing the invoices, and the business
lending the invoices is able to receive loans based on the expected payments
on the invoices.

5. Short -Term Leases

Some assets (eg vehicles, printers) can be financed by short-term rental

agreements which remove the risk of owning the asset (eg technological
change, equipment failure) but are expensive.

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 Syllabus D1a) Explain the role of various financial assets, markets and institutions in assisting
organisations to manage their liquidity position and to provide an economic return to providers of liquidity

Long term finance

1. Equity
2. Debt

Equity

1. Ordinary shares
via a placing - does not need to be redeemed, since ordinary shares are truly
permanent finance.
The return to shareholders in the form of dividends depends on the dividend
decision made by the directors of a company, and so these returns can increase,
decrease or be passed.
Dividends are not tax-deductible like interest payments, and so equity finance is
not tax-efficient like debt finance.

2. Preference Share
These are seen as a form of debt

3. Venture Capital
For companies with high growth and returns potential
This is provided to early/start up companies with high-potential.
The venture capitalist makes money by taking an equity share and then realising
this in an IPO (Initial Public Offering) or trade sale of the company

4. Business angels
are wealthy individuals who invest in start-up and growth businesses in return for
an equity stake.
These individuals are prepared to take high risks in the hope of high returns.

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5. Private equity
consists of equity securities in companies that are not publicly traded on a stock
exchange.

Private equity funds might require a 20 – 30% shareholding or/and Rights to

appoint directors

Debt

1. Finance Lease
You will notice we have included finance leases as potential sources of finance
- don’t forget too to mention the possibility of selling your assets and leasing
them back as a way of getting cash.

Be careful though - make sure there are enough assets on the SFP to actually
do this - or your recommendation may look a little silly ;)

2. Bank loans and bonds/debentures

Bonds securities which can be traded in the capital markets.
Bond holders are lenders of debt finance.
Bond holders will be paid a fixed return known as the coupon.
Traded bonds raise cash which must be repaid usually between 5 and 15
years after issue.
Bonds are usually secured on non-current assets thus reducing risk to the
lender.
Interest paid on the bonds is tax-deductible, thus reducing the cost of debt to
the issuing company

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 Syllabus D1a) Explain the role of various financial assets, markets and institutions in assisting
organisations to manage their liquidity position and to provide an economic return to providers of liquidity

Financial Markets are

1. Money Markets
For short-term finance (up to 12 months)

- treasury bills, forwards and futures

- issued by governments, financial institutions and large corporations
- are very liquid and considered extraordinarily safe (therefore LOW Return)

2. Capital Markets
For long-term finance (bonds and equity)

- is an ideal environment for the creation of strategies that can result in raising
long-term funds for bond issues or even mortgages.

In London, the money markets are active in all the major currencies, and the term
'eurocurrency market' is used for the money market for wholesale lending and
deposits of currencies outside their country of origin.

The money market's products:

1. Bills of exchange
When a business has made a large sale (eg more than £75,000) a legal
document can be drawn up and signed by the customer confirming their
obligation to pay in the near future (up to 180 days ahead) - this is called a bill
of exchange.

This document can then be sold by a business to a bank or a discount house if

the business needs to raise short-term finance.

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2. Commercial paper
Similar to a bill of exchange except that commercial paper is signed by the
company confirming its obligation to pay the buyers of the 'bill' in the near
future (up to 270 days ahead).

Commercial paper is unsecured and can only be issued by companies with a

good credit rating.

3. Bank Bills
Similar to commercial paper/bill of exchange, except that bill is signed by the
company's bank, guaranteeing (accepting) payment to the buyers of the 'bill' in
the near future.

This can be sold to banks or discount houses at a higher price because of the
bank's guarantee to pay.

This is also called an acceptance credit.

Note. If a government issues bills, these are called Treasury Bills; like other
bills these are bought at a discount to their face value; they do not pay interest.

Illustration (Bills of exchange)

A bill of exchange confirms that a customer owes £100,000 and is due to pay in 90
days.

If this is sold to a discount house for £95,000, a firm has raised this Finance 90 days
early, at a cost of £5,000.

Assuming 360 days in a year, this is an annual interest cost in percentage terms of:

5,000 / 100,000 x 360 / 90 = 20%

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The Capital market's products:

1. Shares
Share capital might be in the form of ordinary shares (equity) or preference
shares.

Bear in mind that only the ordinary shareholders are owners of the company,
and preference shares are comparatively rare.

Shares are bought (and sold) on organised stock markets, such as the London
Stock Exchange.

2. Bonds (Debentures, loan stock)

Bonds are (normally) fixed interest securities issued by companies that are
listed on the stock market.

3. Commodities
- such as precious metals

Other types of bond

• Eurobonds
Bonds sold outside the jurisdiction of the country in whose currency the bond
is denominated and are often used by large companies to raise debt finance in
a range of different currencies.

• Convertible bonds
The bond holder has the right to convert the bond into shares in the future.
This type of bond, which combines aspects of both debt and equity finance, is
sometimes referred to as mezzanine finance

• Gilts
Bonds issued by the government are called gilt-edged securities or gilts (being
very low risk) or Treasury Bonds.

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Syllabus D1b) Explain the role of commercial banks in the process of credit creation and in determining
the structure of interest rates and the roles of the ‘central bank’ in ensuring liquidity

Types of banks

These are:

1. Retail Banks (Commercial banks)

- traditional 'High Street' banks.

2. Wholesale Banks (Investment Banks or merchant banks)

- specialise in providing financial services to large organisations.

Types of banks

• Retail Banks:
Retail banks provide basic banking services to individual consumers.
Examples include savings banks, savings and loan associations.

Products and services include:

- safe deposit boxes,
- checking and savings accounting,
- certificates of deposit (CDs),
- mortgages,
- personal, consumer and car loans.

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• Commercial Banks:

Accept deposits of money from the public for the purpose of lending or
investment.

Commercial Banks provide financial services to businesses, including credit

and debit cards, bank accounts, deposits and loans, and secured and
unsecured loans.

Commercial banks in modern capitalist societies act as financial

intermediaries, raising funds from depositors and lending the same funds to
borrowers.

• Investment Banks:

An investment bank is a financial institution that assists individuals,

corporations and governments in raising capital by underwriting and/or acting
as the client's agent in the issuance of securities.

An investment bank may also assist companies involved in mergers and

acquisitions, and provide services such as trading of derivatives, fixed income
instruments, foreign exchange, commodities, and equity securities.

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Syllabus D1b) Explain the role of commercial banks in the process of credit creation and in determining
the structure of interest rates and the roles of the ‘central bank’ in ensuring liquidity

Credit Creation

In the process of trying to maximise profits, while maintaining sufficient liquidity,

banks will aim to lend a proportion of any money which is deposited with them.

They can do this because they know that not all of the money that has been
deposited will be withdrawn at the same time.

This is commonly referred to as fractional reserve banking because it involves the

bank keeping only a fraction of customers' deposits as cash reserves, and lending
out the remainder.

When this loan is spent, it will flow into another bank account as a deposit and will
again be lent out by the bank.

In this way, banks 'create' extra deposits of a much greater magnitude than the
amount of money originally deposited.

This process is called 'credit creation'.

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Illustration of credit creation

We shall assume for simplicity that there is only one bank in the banking system.

Step 1

Let us assume a customer deposits $1,000 in cash in the bank.

This $1,000 is an asset for the customer but, for the bank, it is a liability.

Bank's liabilities (deposits)

$1,000 deposit

Bank's assets
$1,000 cash

Step 2

Let us assume that the bank has decided (on the basis of past experience and
observation) to keep 20 cents in cash for every $1 deposited, and then lend out the
other 80 cents.

In other words, the bank in this example is operating a 20% cash reserve ratio.

On the basis of the 20% cash ratio, the bank manager decides to keep $200 cash,
and make a loan of $800 to Company A.

Bank's liabilities (deposits)

$1,000 deposit

Bank's assets (cash and loans)

$200 cash and $800 loans

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Step 3

Company A spends the money on goods that it purchases from Company B.

Company B pays the $800 into their bank account.

So the bank is now holding $1,000 in cash, but has total deposits of $1,800.

Bank's liabilities (deposits)

$1,000 deposit
$800 extra deposit

Bank's assets (cash and loans)

$200 cash and $800 loans
$800 extra cash

On the basis of the 20% cash ratio, the bank only needs to be holding $360 (20% x
total deposits of $1,800) as cash.

However, the bank is currently holding $1,000 of cash.

So there is surplus cash of $1,000 - $360 = $640 available for further lending.

Step 4

Accordingly the bank lends $640 to another customer seeking a loan.

Bank's liabilities (deposits)

$1,000 deposit
$800 deposit

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Bank's assets (= cash and loans)
$200 cash and $800 loan
$160 cash
$640 loan

The bank can continue with this process of depositing and lending as long as the
cash reserve ratio is maintained.

However, even by the end of step (4) in our simple example, we can see that,
through the process of credit creation, the bank now has deposits of $1,800
compared to the initial deposit of $1,000. So, it has 'created' extra deposits of $800.

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Syllabus D1b) Explain the role of commercial banks in the process of credit creation and in determining
the structure of interest rates and the roles of the ‘central bank’ in ensuring liquidity

The Credit Multiplier

Helps you calculate the increase in deposits:

Illustration 1

• If a bank decides to keep a cash reserve ratio of 20%, the credit multiplier = 1 /
0.2 = 5.

If the bank receives additional deposits of $1,000, the increase in bank

deposits will be $1,000 x 5 = $5,000.

• If a bank decides to keep a cash reserve ratio of 30%, the credit multiplier = 1 /
0.30 = 3.333.

If the bank receives additional deposits of $1,000, the increase in bank

deposits will be $1,000 x 3.33 = $3,333.

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Illustration 2
If all the commercial banks have cash reserve ratio of 40%, how much cash would
have to flow into the banks initially for the money supply to increase by $100 million
in total?

Solution

• Initial cash deposited x credit multiplier = increase in deposits

The credit multiplier here is 1 / 0.4 = 2.5
Call the extra cash C.

• Then:
C x 2.5 = 100
So C = 100 / 2.5 = 40
If an extra $40 million is deposited, the total money supply will rise by $100
million.
This includes the initial $40 million deposited.
So there is a further increase of $60 million after the initial deposit.

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Syllabus D1b) Role and common functions of central banks including their influence on yield rates and
policies of quantitative easing

Central Banks

Central banks are bankers’ banks.

They guarantee stable monetary and financial policy from country to country and
play an important role in the economy of the country.

Typical functions include:

• Implementing monetary policy

• Managing foreign exchange and gold reserves
• Making decisions regarding official interest rates
• Acting as banker to the government and other banks
• Regulating and supervising the banking industry.

Role of central banks

A central bank is a bank which acts on behalf of the government.

The central bank for the UK is the Bank of England, and in Europe it is the European
Central Bank (ECB).

The main functions of a central bank are:

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1) Setting interest rates

The level of interest rates can be influenced by the central bank

To support interest rate policy, the central bank may use open market operations.

This involves the central bank supplying cash to the banking system on days when
the banks have a cash shortage by buying (for example) 'bills' in exchange for cash.

When bills are sold, they are traded at a discount to their face value, and there is an
implied interest rate in the rate of discount obtained.

Illustration
A 170-day Treasury Bill is sold for an average price of $9,800 per $10,000 face
value.

Assuming a 360-day year, this creates a yield of:

(10,000 - 9,800) / 9,800] x 360 / 170 x 100 = 4.3%

2) Regulating the banking sector

Central banks will monitor the general stability of the financial system and, where
necessary, introduce regulations to reduce the risk of financial crisis.

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3) Maintaining financial stability

Apart from regulation, the central bank will also act as a 'lender of last resort' when
the banking system is short of money, ie the central bank will provide the money the
banks need — at a suitable rate of interest.

Even if the banking system is not short of money the central bank may inject liquidity
(ie cash) into the banking system by buying assets from commercial banks.

The surplus cash that commercial banks will then be holding will be lent out to firms
and will hopefully stimulate the economy through the process of credit creation
covered earlier.

This is sometimes called 'quantitative easing', and has been used by central banks in
Europe, the UK, the USA and Japan in the aftermath of the economic crisis of 2008.

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 Syllabus D2: Financial mathematical techniques in a business
decision-making context

Syllabus D2a) Calculate future values of an investment using both simple and compound
interest

The Difference Between:

Simple interest

Simple interest is calculated on the original principal only.

Illustration

You invest $100 for 3 years and you receive a simple interest rate of 10% a year on
the $100.

This would be $10 each year.

Simply $100 x 10% = $10.

Compound interest

The important thing to remember is that you get interest on top of the previous
interest.

This is called compound interest.

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Illustration

Suppose that a business has $100 to invest and wants to earn a return of 10%.

What is the future value at the end of each year using compound interest?

Solution

Yr 1 - 100 x 1.10 = $110

Yr 2 - 110 x 1.10 = $121 or 100 x (1.10) ^ 2
Yr 3 - 121 x 1.10 = $133 or 100 x (1.10) ^ 3

This future value can be calculated as:

FV = PV (1+r) ^ n

Where

FV is the future value of the investment with interest

PV is the initial or ‘present’ value of the investment
r is the compound annual rate of return or rate of interest expressed as a proportion
n is the number of years
e.g. $100 x 1.1 ^3 = $133

Nominal interest rate = Real interest rate + Inflation

The nominal interest rate is given as a percentage.

A compounding period is also given. In the above example, the 10% is the nominal
rate and the compounding period is a year.

The compounding period is important when comparing two nominal interest rates, for
example 10% compounded semi-annually is better than 10% compounded annually.

In the exam, unless told otherwise, presume the compounding period is a year.

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Effective annual rate of interest (annual percentage rate – APR)

The effective interest rate, on the other hand, can be compared with another
effective rate as it takes into account the compounding period automatically, and
expresses the percentage as an annual figure.

In fact, when interest is compounded annually the nominal interest rate equals the
effective interest rate.

To convert a nominal interest rate to an effective interest rate, you apply the formula:

= (1 + i/m) ^ m – 1

Where ‘m’ is the number of compound periods

‘i’ is the interest rate

Illustration
What is the effective rate of return of a 15% p.a. monthly compounding investment?

Solution
Effective rate = (1 + (0.15/12)) ^ 12 - 1 = (1 + 0.0125) ^ 12 - 1 = 0.1608 = 16.08%

Illustration
What effective rate will a stated annual rate of 6% p.a. yield when compounded
semi-annually?

Solution
Effective Rate = (1 + (0.06/2)) ^ 2 - 1 = 0.0609 = 6.09%

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 Syllabus D2a) Calculate future values of an investment using both simple and compound
interest

Compounding & Discounting

Compounding

We have already looked at compounding in previous section.

Just a reminder that the formula for compounding is:

FV = PV (1+r) ^ n

Discounting

Discounting is compounding in reverse.

It starts with a future amount of cash and converts it into a present value.

A present value is the amount that would need to be invested now to earn the future
cash flow, if the money is invested at the ‘cost of capital’.

Hence, when looking at whether we should invest in something we will be looking at

future cash flows coming in.

We want to know what these future cash flows are worth now, in today’s money
ideally.

PV = FV
---------
(1 + r) ^ n

r - rate of interest
n - number of time periods

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Illustration
A business is to receive $100 in one year’s time and the interest rate/discount rate is
10%.

What is the PV of that money?

Solution

PV = 100 /1.10 ^ 1
PV = $90.9

Example
A business is to receive $100 in two years’ time and the interest rate/discount rate is
10%.

What is the PV of that money?

Solution

PV = $100 /1.10 ^ 2
PV = $82.6

Discount Rate
The present value can also be calculated using a discount factor (saving all the
dividing by 1.1 etc.)

The discount factor can be calculated as:

1/ (1+r) ^ n

r - rate of interest
n - number of time periods

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So, the discount factor for 10% in 3 years is:

1/1.1 ^ 3 = 0.751

There are also tables that give you a list of these ‘discount factors’ – a copy of these
tables is included at the end of these notes.

Hence, to calculate a present value for a future cash flow, you simply multiply the
future cash flow by the appropriate discount factor.

Illustration
What is the present value of $133 received at the end of 3 years, using a cost of
capital of 10%

Solution
$133 x 0.751 = $100

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 Syllabus D2b) Calculate the present value of a future cash sum, an annuity and a perpetuity

Discounted Cash Flow

Discounted cash flow, or DCF, is an investment appraisal technique that takes into
account both the timing of cash flows and also the total cash flows over a project’s
life.

Net Present Value

The NPV is the value obtained by discounting all the cash outflows and inflows for
the project capital at the cost of capital and adding them up.

Hence, it is the sum of the present value of all the cash inflows from a project minus
the PV of all the cash outflows.

NPV is positive – the cash inflows from a capital investment will yield a return in
excess of the cost of capital.

The project is financially attractive

NPV is negative – the cash inflows from a capital investment will yield a return below
the cost of capital.

From a financial perspective, the project is therefore unattractive.

NPV is exactly zero - the cash inflows from a capital investment will yield a return
exactly equal to the cost of capital.

The project is therefore just about financially attractive.

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If a company has 2 projects under consideration it should choose the one with the
highest NPV.

Illustration
Initial investment ($1,000)

Inflows:
Year 1 $900
Year 2 $800
Year 3 $700

The cost of capital is 10%.

What is the net present value?

Solution
Year 1 $900 x 0.909 = $818
+ Year 2 $800 x 0.826 = $661
+ Year 3 $700 x 0.751 = $526

($1,000)

= $1,005 is the NPV

Internal Rate of Return

The internal rate of return (IRR) is essentially the discount rate where the initial cash
out (the investment) is equal to the PV of the cash in.

So, it is the discount rate where the NPV = 0.

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If the IRR is higher than a target rate of return, the project is financially worth
undertaking.

Consequently, to work out the IRR we need to do trial and error NPV calculations,
using different discount rates, to try and find the discount rate where the NPV = 0.

This is known as the interpolation method.

The steps in this method are:

Step 1: Calculate two NPV for the project at two different costs of capital. It is
important to fi nd two costs of capital for which the NPV is close to 0, because the
IRR will be a value close to them.

Step 2: Having found two costs of capital where the NPV is close to 0, we can then
estimate the cost of capital at which the NPV is 0, i.e. the IRR.

A formula is used:

IRR formulae

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Illustration

At 12% cost of capital, the NPV was $10,000

At 18% cost of capital, the NPV was ($1,000)

What is the IRR?

Solution

12%+(10,000/10,000- - 1,000)(18%-12%)

= 17.5% is the IRR

Mutually Exclusive Investments

The rule for deciding between mutually exclusive projects is to accept the project
with the higher NPV.

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 Syllabus D2b) Calculate the present value of a future cash sum, an annuity and a perpetuity

Annuities and Perpetuities

Annuity
An annuity is a fixed (constant) periodic payment or receipt which continues either
for a specified time or until the occurrence of a specified event, e.g. ground rent.

Illustration
$100 will be received at the end of every year for the next 3 years.

If cost of capital is 10%, what is the PV of these amounts together?

Solution
Strictly speaking it is:
Yr 1 $100 / 1.1 = $91
Yr 2 $100/1.1 ^ 2 = $83
Yr 3 $100/1.1 ^ 3 = $75

All added together = $249

This is easier is to calculate using an annuity discount factor - this is simply the 3
different discount factors above added together

So using normal discount factors:

Yr 1 0.909
Yr 2 0.826
Yr 3 0.751

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All added together 2.486 = Annuity factor (or get from annuity table)

So $100 x 2.486 = $248.6 = $249

Perpetuity
Perpetuity is a periodic payment or receipt continuing for a limitless period.

Calculating the PV of a perpetuity:

Cash flow
---------------
Interest rate

Illustration
What is the present value of an annual income of $50,000 for the foreseeable future,
given an interest rate of 5%?

Solution
50,000 / 0.05 = $1,000,000

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Syllabus D3: Impact of changes in interest and exchange rates

Syllabus D3a) Describe the impact of interest rate changes on market demand and the costs of
finance

Impact of interest rates changes

Direct impact on business performance

The net present value of a project and the value of a company are affected by the
cost of capital being used as a discount factor

The relationship between the present value of future cash flows and the cost of
capital is shown below.

If interest rates rise (for example due to government policy)

then investors will expect a higher return and the cost of capital will rise.

So the impact of higher interest rates will often be to:

• Decrease the present value of cash inflows from planned investments

(investment means spending on new asset creation, eg new factories), leading to
a fall in investment.

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• Decrease the share price of a company

Share price is influenced by the present value of a company's forecast cash

inflows.

• A company will have to pay a higher rate of interest on its debt if interest rates
rise

Therefore, will see a rise in costs and a fall in profits.

These effects will have an adverse impact on business performance and they are
likely to lead to significant falls in a company's share price.

Example
Calculate the impact on the present value of a future cash flow of $10,000 per year
receivable into perpetuity, if the cost of capital rises from 2% to 4%.

Solution

The present value of a constant cash flow in perpetuity is calculated by multiplying

the cash flow by 1 / r.

If r = 2% the present value is $10,000 x 1 / 0.02 = $500,000

If r = 4% the present value is $10,000 x 1 / 0.04 = $250,000

This is a decline of $250,000 (ie 50% fall from the original value of $500,000)

Indirect impact on business performance

Where the trade cycle is at its boom phase, and resources are already fully
employed there may be an inflationary gap.

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If demand is too high the central bank may increase interest rates to shift the
aggregate demand (AD) curve to the left, from AD1 to AD2.

As we know, AD consists of:

• Consumer spending on domestically produced goods (C)

• Investment spending (l)

• Government spending (G)

• Exports (X)

This is sometimes expressed as AD = C + I + G + X

This fall in demand will indirectly impact on business performance because the
general level of demand in the economy will fall.

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Impact of interest rate changes on exchange rates

The exchange rate is determined by the forces of demand and supply (ie demand
for a currency in relation to supply of that currency).

• Interest rates will affect the demand for a currency

eg higher interest rates will cause a rise in demand from overseas investors
looking to put money on deposit in the local economy

ie demand will rise.

• Interest rates will also affect the supply of a currency

eg higher interest rates cause a fall in consumer demand and therefore a fall in
demand for imported goods (as well as locally produced goods)

ie supply will fall.

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• A rise in demand for a currency and a fall in the supply of currency will both lead
to a rise in the exchange rate.

Therefore, an increase in interest rates in a country would be expected to lead to

an increase in the exchange rate for its currency.

A change in the exchange rate will have an impact on business performance.

This impact is summarised below and is developed in the next section.

Export sales revenue will rise if: Costs of imported goods will fall if:

The exchange rate falls The exchange rate rises

A business will receive more of its A business will pay less in its domestic
domestic currency (eg €s) when it sells currency (eg €s) when it buys a unit
a unit overseas (eg in $s). from an overseas supplier (eg in $s).

This may allow prices (in $s) to be So a high exchange rate can result in
reduced, and sales to rise. lower costs and higher profits.

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 Syllabus D3b) Calculate the impact of exchange rate changes on export and import prices and the
value of the assets and liabilities of the business

Understanding Exchange Rates

£ : $1.5

Here £ = Base Currency; $ = Counter Currency

£0.67:$

Here $ = Base Currency; £ = Counter currency

Normally the “foreign” currency is the counter currency

Banks BUY HIGH and SELL LOW

Here we are referring to the foreign / counter currency

If a company needs to make a foreign currency payment

Banks SELL the foreign currency at the LOWER rate

If a company needs to make a foreign currency receipt

Banks will BUY that foreign currency from them at the HIGHER rate

Translating Currencies

1. If you are given the counter currency:

DIVIDE the amount by the exchange rate

Eg A UK company has to pay $1,500.

£ : $1.5

Solution = $1,500 / 1.5 = £1,000


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2. If you are given the Base currency:
MULTIPLY the amount by the exchange rate

Eg A UK company has to pay £1,000 in $.

£ : $1.5

Solution = £1,000 x 1.5 = $1,500

If £ is strong (strengthening, appreciate)

• UK exporters suffers because the $ is weak and their revenues is in $s.

• If the £ appreciates relative to the $, the exchange rate falls:

it takes fewer £ to purchase $1.

($1 = £1.5 → $1= £1.4).

If £ is weak (weakening, depreciate, devalue)

• UK importers suffer because the $ is strong and their costs are in $s.

Translation risk

- NCA and CA value - decrease

- NCL and CL value - increase.

• For instance, if the £ depreciates relative to the $, the exchange rate rises:

it takes more £ to purchase $1.

($1= £1.5 → $1= £1.7).

224 aCOWtancy.com
 Syllabus D3b) Calculate the impact of exchange rate changes on export and import prices and the
value of the assets and liabilities of the business

Impact of exchange rate changes

The impact of exchange rate movements can be beneficial or adverse for an

organisation.

Impact on measures of economic performance (sales, costs, profits)

If the exchange rate moves AFTER a transaction (an export or an import) has been
agreed, this risk is referred to as transaction risk.

Any losses incurred by a company due to transaction risk will be recorded in an

exchange losses account and will reduce the company's profit.

Illustration 1

In July 20X1 Company A (whose local currency is the A$) agreed a contract with an
export customer for €100,000.

The exchange rate at that time (the spot rate) was A$1: €1.6.

When the invoice was paid the exchange rate was A$1 : €1 .9

• At the time the sale was recorded in the accounts of Company A, the expected
revenue was €100,000 / 1.6 = A$ 62,500.

• However the revenue that is received will be €100,000 / 1.9 = A$ 52,632.

• The exchange loss (caused by the strengthening of the A$) will be A$62,500 -
A$52,632 = A$9,868.

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Impact on assets and liabilities denominated in a foreign currency
Many companies will hold foreign assets (eg factory, land) and/or foreign liabilities
(eg a bank loan).

Movements in the exchange rate will affect the value in the domestic currency of
foreign assets and foreign liabilities.

This is called translation risk.

Foreign asset value will rise if: Foreign liability value will fall if:

The exchange rate falls The exchange rate rises

Foreign assets will be worth more in the A business will pay less in its domestic
domestic currency. currency to repay foreign loans.

Illustration 2

It is approaching the year end, and Company A (whose local currency is the A$) has
assets in euros worth €10 million.

These will be translated into A$ at the year-end exchange rate.

If the year-end exchange rate is $1: €1.6 these assets will be worth €10m / 1.6 —
A$6.25m.

However, if the year-end exchange rate is $1 : €1.9 then these assets will be worth
much less, €10m / 1.9 = A$5.3m.

Managing translation risk

To manage translation risk a company that has assets in a foreign currency will
often match them with foreign liabilities (eg by borrowing in a foreign currency).

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Syllabus D3c) Explain the role of hedging and derivative contracts in managing the impact of changes
in interest and exchange rates

Forward Rates

Forward contracts are typically signed between a business and bank.

They are a binding contract.

So we have agreed a sale now in a foreign currency, but the cash won’t be paid (or
received) until a future date

With a forward rate we are simply agreeing a future rate now.

Therefore fixing yourself in against any possible future losses caused by movements
in the real exchange rate

However - you also lose out if the actual exchange rate moves in your favour as you
have fixed yourself in at a forward rate already

Illustration
A UK Company has to pay $100m in 3 months.

So you enter into a forward agreement to exchange £90 using exchange rate £:
$0.90 in 3 months.

Like that you dont need to worry about the movement in the exchange rates.

So, in 3 months time you'll have:

£90 / 0.9 = $100

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Advantages of forward rate

1. Flexible

2. Straightforward

3. By fixing the rate, forward contracts remove risk, and they are cheap (normally
free) to arrange.

Disadvantages of forward rate

1. Contracted commitment (even if you haven’t received money)

2. Cannot benefit from favourable movements

3. The bank is unlikely to offer an attractive interest or exchange forward rate,

because it is looking to make a profit on the transaction.

4. The forward contract is for a fixed date, so a company needs to be certain about
the timing of transactions before entering into a forward contract.

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What is this little baby all about then?

• It’s a standard contract for set amount of currency at a set date

• It is a market traded forward rate basically

Explanation

When a currency futures contract is bought or sold, the buyer or seller is required to
deposit a sum of money with the exchange, called initial margin.

If losses are incurred as exchange rates and hence the prices of currency futures
contracts change, the buyer or seller may be called on to deposit additional funds
(variation margin) with the exchange

Equally, profits are credited to the margin account on a daily basis as the contract is
‘marked to market’.

Most currency futures contracts are closed out before their settlement dates by
undertaking the opposite transaction to the initial futures transaction

ie if buying currency futures was the initial transaction, it is closed out by selling
currency futures.

A gain made on the futures transactions will offset a loss made on the currency
markets and vice versa.

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Advantages

1. Lower transaction costs than money market

2. They are tradeable and so do not need to always be closed out

Disadvantages

1. Cannot be tailored as they are standard contracts

2. Only available in a limited number of currencies

3. Still cannot take advantage of favourable movements in actual exchange rates

(unlike in options…next!)

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Currency Options

Features of currency options

A currency option gives its holder the right to buy (call option) or sell (put option) a
quantity of one currency in exchange for another, on or before a specified date, at a
fixed rate of exchange (the strike rate for the option).

Currency options can be purchased over-the-counter or on an exchange.

In practice, companies buying call or put currency options do so in over-the-

counter deals with a bank.

They protect against adverse movements in the actual exchange rate but allow
favourable ones!

Clearly, because of this, the option involves buying at a premium.

Disadvantages

1. The premium

2. Must be paid up immediately

3. Not available in every currency

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Advantages

1. Currency options do not need to be exercised if it is disadvantageous for the

holder to do so.

2. Holders of currency options can take advantage of favourable exchange rate

movements in the cash market and allow their options to lapse. The initial fee
paid for the options will still have been incurred, however.

Example
A company is expecting receipt from a foreign currency sale (in $s) in three months’
time and is concerned about the potential impact exchange rate movements could
have on the money it receives.

Required
Which of the following statements is correct?

A A call option in $s would allow the company to fix the rate.

B A futures contract would allow the company to hedge the exact size of the
transaction.

C A forward contract would remove risk but may be prohibitively expensive.

D A put option in $s would remove downside risk but would also allow the
company to benefit if the value of the $ was significantly higher in three months'
time.

Solution
Correct answer: D

A put option is an option to sell $s, which is what is needed.

After taking out the contract, the optional exchange rate does not have to be used
and if the value of the $ was significantly higher in three months' time then this
means that the receipts will be worth more when they are converted at the spot
rate.

So the option is unlikely to be used.

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Interest Rate - Forwards & Futures

Forward rate

This locks the company into one rate (no adverse or favourable movement) for a
future loan

If actual borrowing rate is higher than the forward rate then the bank pays the
company the difference and vice versa

They are usually only available on loans of at least £500,000

Procedure

1. Get loan as normal

2. Get forward rate agreement

3. Difference between 2 rates is paid/received from the bank

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Illustration
Company gets 6% 600,000 FRA

Actual rate was 10%

Solution

FRA receipt from bank (10%-6%) x 600k 24,000

Payment made (10% x 600,000) (60,000)

Net payment 36,000

Interest Futures

Standard contract for set interest rate at a set date

It is a market traded forward rate basically

As interest rates rise - bond prices fall

Let’s say you are expecting interest rates to rise.

You would sell a bond futures contract, and when the interest rate rises, the value of
the bond futures contract will fall.

You would then buy the return of the contract at a normal price, making a profit.

As interest rates fall - bond prices increase

Let’s say you are expecting interest rates to decline in the near future.

You would buy a futures contract for bonds.

When interest rates fall, the price of bonds increase, and so does the bonds futures
contract.

You then sell the bond futures contract at a higher price.

Borrowers sell futures to hedge against rises

Lenders buy futures to hedge against falls

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