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STUDYNOTES
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 Syllabus Area A:Foreword 3

Table of Contents
Exam formulae .............................................................................................................................. 4
Foreword....................................................................................................................................... 7
Syllabus Area A: ............................................................................................................................... 17
Financial Management Function ...................................................................................................... 17
Syllabus Area D:............................................................................................................................... 24
Investment Appraisal....................................................................................................................... 24
Syllabus Area B: ............................................................................................................................... 52
Financial Management Environment ............................................................................................... 52
Syllabus Area E: ............................................................................................................................... 58
Sources of Finance........................................................................................................................... 58
Syllabus Area F: ............................................................................................................................... 98
Business Valuation .......................................................................................................................... 98
Syllabus Area C: ............................................................................................................................. 114
Working Capital Management ....................................................................................................... 114
Syllabus Area G:............................................................................................................................. 136
Risk Management.......................................................................................................................... 136
Dividend Policy .............................................................................................................................. 155
Ratio Analysis ................................................................................................................................ 158
 Syllabus Area A:Foreword 4

Exam formulae
Economic order quantity

2C D
= 0

Ch

Miller–Orr Model

Return point = Lower limit + ( 1 × spread)

3
1
3 × transaction cost × variance of cash flows 3
Spread = 3 4
interest rate

The Capital Asset Pricing Model

E ( ri ) = R f + βi (E (rm ) – Rf )
The asset beta formula

β =
Ve
β +
( )
Vd 1– T
β
(e d ( )) (
e d ( ))
a V +V 1–T e V + V 1–T d

The Growth Model

P = D0 (1 + g ) r = D 0 (1 + g ) + g
(r e – g )
0 e
P0

Gordon’s growth approximation

g = bre

The weighted average cost of capital

V
Ve d
WACC = k + k 1–T
V +V e V +V d ( )
e d e d
 Syllabus Area A:Foreword 5

Present Value Table

Present value of 1 i.e. (1 + r)–n

Where r = discount rate
n = number of periods until payment

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
 Syllabus Area A:Foreword 6

Annuity Table

1 – (1 + r)–n
Present value of an annuity of 1 i.e.
————––
r

Where r = discount rate

n = number of periods

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
 Syllabus Area A:Foreword 7

Foreword
‘By the ACCA, for the ACCA’

These notes are designed with a simple mission, to fill the gap for Indian students who don’t find
comfort in studying from notes that are framed in a complex manner. Our priority at Zell is to improve
the results our students achieve by providing all that they need, be it quality education, state of the
art infrastructure and techniques or the next step, the content that perfectly fits in making the trifecta
or the winning formula.

Here at Zell, we don’t worry about the background, prior knowledge or preferences someone has. The
aim is simple, by the time a student is done with a paper, they are on the same page as anyone else
and that for us, should be enough knowledge to be able to call them a professional truly.

Keeping all this in mind, we bring to you these notes, created by us, for you, to truly help make the
difference and turn your journey of ACCA into an even better one. This is just the beginning; there is
more in store.

Thank you

Credits

Authored by:

Naethan Dsouza

Satyamedh Nandedkar

Designed by:

Vrushali Shah

Geeta Shewani

Last updated: August 2022

 Syllabus Area A:Foreword 8

Planning how to study

Before starting the preparation for any paper, you should always make a macro level plan on how to
go about preparing for the exam. Understand what is expected of you to be able to clear the exam
with high scores. It is important to set targets and stick to them, to ensure that you stay on track and
progress in your ACCA journey.

Have a plan from the beginning about where you want to be at the end of the month or two months,
then work backwards and understand what you must do to stay on track. Then, at the start of every
week, make a brief plan about how much needs to be covered every day, resulting in the timely
completion of the exam.

Break your macro plan intro studying along with the professor/recordings, examination month and
final revision. Plan how many hours can you give every day and make a schedule accordingly. Ensure
that you can give quality hours without distractions. The quantity of hours doesn’t matter.

How to approach the exam

Knowing how much importance ACCA places on application-based learning is important. You must
understand that rote learning in any exam for any concept will mostly amount to zero marks being
scored.

Students leave minimal time to their core exam preparation and directly jump into mock exams
without finishing the exam kit. Leave the exam month for core practice of questions available to you,
ensure you finish the conceptual understanding before starting to do so.

The ideal approach is to watch/attend lectures and keep up with the pace, practising 40% of the
question bank alongside, to cement conceptual understanding. Once classes conclude, ensure the
remaining 60% of the question bank is solved, followed by at least three mock examinations before
attempting the main exam.

Exam month

• In the exam month, ensure that you finish the portion as soon as possible and shift all focus
to completing the question bank. Remember, completing the textbook alone is not enough,
whereas completing the question bank gives you a higher chance of clearing the exam.
• If you are done with your question bank, repeat the question bank or key questions you
marked before the exam. Only 40% of your total time should be allocated to building a
conceptual understanding, the remaining 60% to solve questions.
• You must practice newly launched past exam questions available on the ACCA website at the
end to ensure you can solve questions of the rigour expected from you.
• Ensure you do not get into the habit of reading a question and then reading the answer. This
approach will make you seek answers in the exam and not seek solutions on your own. Read
a question, solve it on your own, check the answer. If it is incorrect, solve the question again
to get another answer, rather than reading the explanation to understand what you did
wrong. That should always be the last resort.
 Syllabus Area A:Foreword 9

• For subjective questions, do not simply read the answer and make notes. Type the answer or
solve it on a spreadsheet before checking the solution. Practising on a computer for a
computer-based exam can make the difference for you in finishing the exam.
• Familiarise yourself with the scientific calculator, the CBE exam platform and other tools to
ensure you are comfortable with the same in the actual exam.
• Ensure you complete 100% of the portion. Do not skip anything as the exam will test you on
a range of interconnected topics, and leaving parts of the portion will guarantee you are
losing certain marks.

Exam strategy

There are certain things to be kept in mind before attempting the main exam.

1. Remain calm before the exam. Do not study at the last moment, as going into the exam with
a fresh mind will allow you to tackle the questions more easily.
2. There is no negative marketing in the exams. Ensure that you attempt 100% of the paper to
ensure that some of your educated guesses score some marks even in the worst case.
3. The examination is 3 hours 15 minutes long, which means you have 195 minutes for 100
marks, or simply 1.95 minutes per mark. Ensure you don’t get overboard with the time you
take to solve a question at hand.
4. Ensure you read the question very carefully. Don’t assume that you faced a similar question
in the past and jump to solving it as the requirements can vary even in small concepts
causing you to lose easy marks.
5. Read the requirements carefully. Pay attention to the verb used, Define, explain, calculate,
evaluate etc., to understand what the examiner is seeking to ensure you answer on those
lines.
6. Do not go for quantity when you are answering subjective questions. The examiner will
award one mark per valid statement and one mark only per valid point. Do not elaborate on
points to simply write more.
7. The options are set up so that even answers derived using the wrong steps are available as
options. Do not jump to the conclusion that your answer has to be correct because it is
available as an option.
8. If there is a tricky question that you can’t solve, make an educated guess by eliminating the
one’s you definitely know are wrong, flag the question and move ahead. If you finish the
paper and have remaining time, revisit the flag questions to score full marks.
9. Do not sit and recalculate the answer you got more than twice, as you are likely to calculate
it in the same way you did previously, by repeating the same mistake if any. This is a massive
waste of your crucial time. Rather move faster and revisit key questions at the end,
recalculating your answers at that point will possibly reveal mistakes and allow you to rectify
them, thus scoring more marks.
 Syllabus Area A:Foreword 10

Elements

Syllabus wise study material

The study material is curated in a manner where the syllabus provided by ACCA has been covered in
vast depth, and the order is set in a way that the flow of concepts within the material suits a
student.

Apply Your Knowledge

Various AYK style questions test the student on their ability to remember and understand concepts
thoroughly before moving to analytical questions.

Quiz

Further, there are primarily application-based quiz questions, introducing the student to analytical
and evaluative questions to bring the student one step closer to actual exam-style questions.

Recap

After the end of every main chapter, there is a recap page summarising all the important topics,
formulae etc., to enable ease of revision for the student.

Mind Maps

Mind maps are flowcharts that summarise the information visually, making it more likely for a
student to retain the knowledge and build upon it. These are present at the end of the book to
enable last-minute revision by simply spending time on those pages.
 Syllabus Area A:Foreword 11

Nimbus™ Preparation tools

Interactive notes with gamification

The articulated version of the notes is available on the platform, allowing students to get fully
immersed in their learning and complete more in less or equivalent time they spend reading the
book.

Case studies

Case studies are specifically tailored to address the audience commonly using these notes. Having
interesting case studies based on current affairs, covering key organisations etc., contribute to
further professional development.

Technical articles

ACCA’s technical articles are placed strategically in the material, allowing students to understand
when to go through these all-important technical articles.

Exam experience

The system mimics the exam experience to ensure that the student has conceptually and technically
mastered the paper before appearing for the exam. This includes various objective questions, live
spreadsheets and word processors to practice typing, presentation and most importantly, time
management.

Question Bank & Test Series

The students have access to unit tests, half portion tests, progressive tests, mock tests and unlimited
practice tests with all performance data allowing them to know where they stand, the
improvements required before the exam day arrives.

Flashcards and Interactive mind maps for revision

Flashcards help students quiz themselves, which is more effective as a revision technique than
simply reading through pages. Interactive mind maps allow the student the power to take a detailed
glance through a whole chapter or large concept in minutes while revising at the same time.

Check the last page of this book for more information on Nimbus™ LMS by Zell
 Syllabus Area A:Foreword 12

ACCA support

Examining team guidance/Exam technique & reports

The examiners’ reports are an essential study resource. Read them to learn about mistakes that
students commonly make in exams and how to avoid them.

Practice tests

Practice Tests are an interactive study support resource that will replicate the format of all the
exams available as on-demand computer-based exams (CBEs). They will help you to identify your
strengths and weaknesses before you take an exam.

As well as giving you an insight into a live exam experience, Practice Tests will also provide feedback
on your performance. Once you complete the test, you will receive a personalised feedback diagram
showing how you have performed across the different areas of the syllabus.

Specimen exams

The specimen exam indicates how the exam will be assessed, structured and the likely style and
range of questions that could be asked. Any student preparing to take this exam should familiarise
themselves with the exam style.

Technical articles

There is a range of technical articles available on ACCAs website under ‘Study support resources’.
These include a range of simplified articles on complex topics, study support videos, articles on exam
technique etc. making it an important tool to be practised when nearing the exam.

FAQs

Various commonly asked questions about the style of the examination, the coverage, computer-based
exam setup etc., are covered here to allow a student to stay up to date and ensure their understanding
is aligned with that of the ACCA body.

Question practice – ACCA practice platform

Question practice is a vital part of exam preparation. Practising in the CBE environment provides a
fantastic opportunity to get fully prepared for the real exam.

The ACCA Practice Platform contains a range of content that allows you to attempt questions to time
and then mark and debrief your answers. It also contains a blank workspace that allows you to
answer constructed response questions from other sources in the CBE environment.

Past Exam library

Past exams are made available to view and become familiar with the styles of questions that you
may face in your exam.

Make sure you log into the ACCA Practice Platform early in your studies - completing your practice in
the CBE environment is the only way to prepare for your exam fully.
 Syllabus Area A:Foreword 13

CBE Support

Getting ready for your CBE includes getting familiar with the CBE functionality and how to use it to
your advantage in the exam. You should be thinking about your exam approach well before exam
day itself.

There are series of videos that will help you get ready for your exam. It includes what to think about
before your exam day, exam strategy, how to manage your CBE workspace effectively and
techniques you could use to plan and complete your answers.
 Syllabus Area A:Foreword 14

Syllabus

Introduction to the syllabus

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

The syllabus for Financial Management is designed to equip candidates with the skills that would be
expected from a finance manager responsible for the finance function of a business. It prepares
candidates for more advanced and specialist study in Advanced Financial Management.

The syllabus, therefore, starts by introducing the role and purpose of the financial management
function within a business. Before looking at the three key financial management decisions of
investing, financing, and dividend policy, the syllabus explores the economic environment in which
such decisions are made.

The next section of the syllabus is the introduction of investing decisions. This is done in two stages -
investment in (and the management of) working capital and the appraisal of long-term investments.

The next area introduced is financing decisions. This section of the syllabus starts by examining the
various sources of business finance, including dividend policy and how much finance can be raised
from within the business. It also looks at the cost of capital and other factors that influence the
choice of the type of capital a business will raise. The principles underlying the valuation of business
and financial assets, including the impact of cost of capital on the value of business, is covered next.

The syllabus then covers an introduction to, and examination of, risk and the main techniques
employed in managing such risk.

Section H of the syllabus contains outcomes relating to the demonstration of appropriate digital and
employability skills in preparing for and taking the FM examination. This includes being able to
interact with different question item types, manage information presented in digital format and
being able to use the relevant functionality and technology to prepare and present response options
in a professional manner. These skills are specifically developed by practicing and preparing for the
FM exam, using the learning support content for computer-based exams available via the practice
platform and the ACCA website and will need to be demonstrated during the live exam.
 Syllabus Area A:Foreword 15

Main capabilities

A. On successful completion of this exam, candidates should be able to:

B. Discuss the role and purpose of the financial management function
C. Assess and discuss the impact of the economic environment on financial management
D. Discuss and apply working capital management techniques
E. Carry out an effective investment appraisal
F. Identify and evaluate alternative sources of business finance
G. Discuss and apply principles of business and asset valuations
H. Explain and apply risk management techniques in business
I. Apply employability and technology skills

Performance Objectives

Objective Chapter in Text

PO1 Ethics and professionalism Financial Management Environment

PO9 Evaluate investment and financing decisions Investment Appraisal

PO10 Manage and control working capital Working Capital Management

PO11 Identify and manage financial risk Risk Management

PO22 Data analysis and decision support Business Valuation

 Syllabus Area A:Foreword 16

Exam Structure

The syllabus is assessed by a three-hour computer based examination. All questions are compulsory.
The exam will contain both computational and discursive elements. Some questions will adopt a
scenario/case study approach.

Prior to the start of the exam candidates are given an extra 10 minutes to read the exam
instructions.

Candidates are provided with a formulae sheet and tables of discount and annuity factors.

Section A of the computer-based exam comprises 15 objective test questions of 2 marks each.

Section B of the computer-based exam comprises three questions, each containing five objective
test questions.

Section C of the exam comprises two 20-mark constructed response questions. The two 20-mark
questions will mainly come from the working capital management, investment appraisal and
business finance areas of the syllabus. The section A and section B questions can cover any areas of
the syllabus.

Total 100 marks

 Syllabus Area A: 17

Syllabus Area A:

Financial Management Function

 Financial Management Function 18

The nature and purpose of financial management

Syllabus area A1a-b

- Explain the relationship between financial management and financial and management
accounting.
- Explain the nature and function and purpose of financial management.

Introduction to Financial Management F9

First and foremost, we need to understand that financial management will have to be studied in a
rather different approach as compared to an accounting paper. This is a decision-making exam, and
you will be expected to be thorough with the underlying concepts of each decision-making
technique. You will be expected to think and make decisions from the perspective of a financial
manager.

But bear in mind that everything has its genesis in the basics you learnt at the Knowledge Level.
Every question that you will face will ask you to pick and choose between two or more alternatives.
You must pick the one which gives the highest benefit or the one that minimizes the loss. (Greater of
the two goods or lesser of the two evils)

Nature and purpose of financial management

We learn financial management in order to decide the best method to acquire financial resources
and then where to effectively utilize them to meet the company’s pre-determined objectives.

From a company perspective, the core purpose of financial management is the maximization of
shareholder wealth. This basically means, growing capital that has currently been invested in the
company by the shareholders.

The following are the three critical areas that form the foundation of this subject and to making any
financial management decision:

1) Financing decision
A company will need to know from where to source money from in the first place, the
financing decision is basically choosing the most optimum method to acquire funding. It is
vital that the shareholder demands are well understood before making the financing
decision.

2) Investment decision
The investment decision is figuring where to effectively deploy/invest the funds to yield
results that fit the company’s objectives and goals.

3) Dividend decision
For a profit seeking company, the financial objective will be to make profitable investments.
Thus, after making a profitable investment decision, shareholders usually expect returns in
the form of dividends. The important decision, as a financial manager here, is to what extent
must the profits earned be distributed among the shareholders as dividends, because a
 Financial Management Function 19

certain amount of the profits earned could be re-invested into the business, which would
work towards the common objective of maximization of shareholder wealth.

As you can see that each of these elements work together, and each decision taken will affect the
other, therefore it is essential that the entire company’s objectives and demands of shareholders are
thoroughly understood before making any of the above decisions.

Relationship between financial management and financial and management accounting

In previous subjects, we have studied the difference between financial and management accounting,
the one thing that accounting has in common is the fact that it is the presentation of past or current
data. Financial management on the other hand deals with forecasting future outcomes and using
these forecasts as a basis to take critical decisions to meet the business requirements.

Management accounting is concerned with providing information about the day-to-day operations
of the business, this involves, budgeting, control reports, variance analysis, cost accounting etc.

Financial accounting is mainly concerned with reporting the historical Information and past
decisions. While financial management deals with the long-term raising of finance and efficient
allocation of the funds, it involves targets that are long term in nature.

Only when your historical information is accurate will your forecasts be accurate and your analysis
meaningful. The subjects might appear diverse but are more linked and connected than they appear
to be.
 Financial Management Function 20

Syllabus area A2a A3b

- Relationship between financial objectives, corporate objectives and corporate strategy
- Identify and describe a variety of financial objectives, including:
i. Shareholder wealth maximization
ii. Profit maximisation
iii. Earnings per share growth

Relationship between financial objectives, corporate objectives and corporate strategy

Corporate objectives

Every company will have a mission statement, this basically states what the company is set out to
achieve, the company goals are then set to meet the company’s core purpose. These are broad
targets and are further broken down into corporate objectives, these objectives will have
measurable targets and are monitored frequently. After these objectives are set, the company will
work towards achieving these objectives by setting appropriate corporate strategies.

Corporate strategy

Corporate strategy is set at the top most level by senior management, it is concerned with matters
like, whether to acquire or merge with a company, whether to enter new markets or not, whether to
develop a new product, etc. These strategies are further broken down and then passed down to the
strategic business units of the company.

Financial objectives

The main concept to remember here is that the wealth of shareholders grows in line with the growth
of the value of the company and that mainly happens when the profit for the company is maximized.
The growth of shareholders can take place through various ways, one of which is through increasing
the earnings per share. The earnings per share is calculated as follows: profit after tax/total number
of shares. Thus, on increasing the company’s overall profits, the shareholders wealth will eventually
be maximized.

An important point to remember is that profits are subjective and can be manipulated, thus the
company should ideally be focusing on cash flows which we will be studying later.
 Financial Management Function 21

Syllabus area A3a-A3e(ii)

- Identify the range of stakeholders and their objectives.

- Discuss the possible conflict between stakeholder objectives.
- Discuss the role of management in meeting stakeholder objectives, including the application
of agency theory
- Explain ways to encourage the achievement of stakeholder objectives, including:
i. managerial reward schemes such as share options and performance related pay.
ii. regulatory requirements such as corporate governance codes of best practice and
stock exchange listing regulations.

It is vital to understand the different types of stakeholders to the company and the underlying
conflicts in the objectives among each stakeholder that exists.

Stakeholder and stakeholder objectives

Stakeholders include any individual or entity that interacts with the company in one way or another,
it could be as remotely related as being neighbours to a company factory or have as big a role of
being the company director.

The following are some examples of stakeholders and their objectives:

Internal Stakeholders Stakeholder Objective

Staff Salary, job safety
Management High bonuses

External Stakeholders Stakeholder Objective

Shareholders High share price; dividend growth
Customers Quality products/services
Suppliers Prompt payments
Governments Timely tax payments and registrations

Stakeholder conflicts

As you can see in the above table, shareholders have the objective of receiving a higher dividend
while staff and management have the goal of increasing their salary. It is highly likely that directors
will work just to ensure short term profits for their bonuses while jeopardizing the long-term
prospects of the business, this becomes a problem as increasing management salary, or bonuses will
cut into profits which in turn end up cutting into the dividend that shareholders receive. This forms a
very serious issue known as the agency problem.

Agency theory

Shareholders are the owners of the company thus, they are the “principal”, and the directors that
are employed to run the company are known as “agents” to the company. As they both have
conflicting objectives, the issue forms the agency problem.
 Financial Management Function 22

Managerial reward schemes

One way to manage the agency problem is to put into place reward or bonus schemes that are
linked to an increase in shareholder wealth. For example, linked to an increase in revenue, specific
performance measures and employee stock option schemes. Managerial reward schemes should be
clearly identifiable, easy to monitor and be matching the time horizon of the managers.

Employee stock option schemes (ESOPs) is a popular scheme that is included in the payment
package of managers, it includes a specific number of company shares that can be purchased at a
certain future date for a pre-determined price. This ensures that the directors will work towards the
long-term growth of the share value and not just towards ensuring short term profits.

Regulatory requirements

As we saw with agency theory, there are conflicts of interest that arise when it comes to running a
public company, that is the reason corporate governance exists. Thus, regulatory requirements are
imposed on companies with the help of corporate governance and stock exchange listing
requirements. (Read about Arthur Anderson and Enron to understand the importance of corporate
governance)

*everything explained below are all frameworks to Corporate governance codes and stock exchange
listing requirements, as the actual law varies from country to country*

Corporate governance codes of best practice

When trying to study corporate governance codes, all you need to remember is that they are
specifically designed to align the interests and objectives of shareholders and directors. Corporate
governance is practiced to increase the level of corporate accountability. In simple words, Corporate
Governance keeps the managers in check. The following are some of the corporate governance
codes that are practiced:

• Ensuring that there are an equal number of non-executive directors on the board
• Having two different people as the chairman and CEO of the company
• The chairman should be independent at the time of appointment
• The executive directors should ideally all be re-elected every 3 years

Stock exchange listing requirements

We all are familiar with the fact that getting a company listed on the stock exchange is quite a
tedious process, the reason for that is again simply because the level of accountability increases. If
the company is successfully listed on the stock exchange, the directors will now be responsible in
handling the capital investments made by the public (as a public stock exchange is open to everyone)
and will be accountable to every single shareholder.

Here are some of the obligations that the directors are tied to if the company goes public.

• Publishing the company’s financial statements every year.

• Making available to the public all the payment packages of the top directors of the company.
• Publishing detailed reports of corporate governance and corporate social responsibility.
 Financial Management Function 23

Syllabus area A4 a-c.

- Discuss the impact of not-for-profit status on financial and other objectives.

- Discuss the nature and importance of Value for Money as an objective in not for-profit
organisations
- Discuss ways of measuring the achievement of objectives in not-for profit organisations.

The key concept to remember in this syllabus area is that not-for-profit organizations have a
different core objective and mission as compared to profit seeking companies. Their primary
objective is to provide some social benefit or need and not to maximize their shareholder value.
Thus, NFPs will have different methods to assess their effectiveness, and that’s what we will be
studying here.

Value for Money

NFPs usually do not have the benefit of having the financial resources that they desire, thus cash
management and budgeting are two of the main areas where financial management will have a lot
of importance. Hence, one of the objectives for every NFP organization will be to get as much value
from the resources that they have available.
This concept is tested quite often, it is known as Value for Money, which can be broken down into
the Three E’s:

• Economy – Getting the best quality for the cheapest available price (It is important that the
organization does not skimp on quality here)
• Efficiency – Getting the best achievable results with the available resources.
• Effectiveness – Achieving the desired results and objectives that were initially set.

Measuring performance of NFP’s

Since NFP’s have significantly different objectives as compared to profit seeking companies, it
becomes a problem to assess their performance. NFP’s cannot be simply assessed based on financial
measures such as net profit or ROCE, they will need to be assessed based on the social objective that
they set out to achieve, thus they will need to have non-financial measures set into place.

Setting non-financial performance measures can be much more tedious than financial measures as
they are subjective to the organization. Value for money is a good framework to assess the
performance of NFP’s.
 Syllabus Area D: 24

Syllabus Area D:

Investment Appraisal
 Investment Appraisal 25

Investment Appraisal

Syllabus area D1 a-b

- Identify and calculate relevant cash flows for investment projects.

- Calculate payback period and discuss the usefulness of payback as an investment appraisal
method.

Introduction to Investment Appraisal and Capital Budgeting

This includes one of the most important conceptual areas, not only for F9 but also to get a solid
foundation in finance. The entire purpose of studying capital budgeting is to ensure that the
company’s funds are allocated efficiently in projects while generating the returns that they desire.
You will be put in the position of a financial manager and asked whether to take the critical decision
to invest in a specific long-term project or not.

The concept of the time value of money that will be covered here will form the base for your entire
journey as a financial manager.
Capital Budgeting

Capital budgets are plans for expenditure for long term projects, and these projects usually involve a
significant amount of capital for investment. Capital budgeting is the process of identifying a suitable
project, evaluating them and then making the most appropriate investment decision.

Key stages in capital investment and investment decision making

The following are the typical steps taken to come to the most beneficial investment decision.

• Identifying an investment opportunity: As studied earlier, businesses need to make strategic

choices to achieve the business objectives set. Thus, this step involves critically analyzing the
company objectives and further identifying what kind of investment opportunities it should look
to undertake. The key here is that the investment proposal chosen should support the
achievement of organizational objectives.

• Shortlisting investment proposals: In this step, the company will need to choose between
competing investment opportunities and select those that serve the best strategic fit, along with
the most efficient use of resources. This is a screening stage where projects that cannot be
pursued are discarded.

• Analyzing and evaluating the investment project: This step is tedious and involves in depth
analysis of investment projects to determine which proposal will benefit the company the most.
This is the step where the various investment appraisal techniques that we are about to study
will be used. Net present value (NPV), Internal Rate of Return (IRR), Payback period, Accounting
rate of return (ARR)/ROCE are the important investment appraisal techniques that will be
further studied.

• Approving investment proposals: After selecting the most appropriate investment proposal, it is
sent for consideration and final approval to the relevant authority. Proposals that require
 Investment Appraisal 26

significant capital outlay are presented to the board of directors. After approval, the next
obvious step is implementation.

• Implementing, monitoring and reviewing investments: Implementation of such projects usually

take months, but it all depends on the type and size of the project. Monitoring is an important
step as this deals with comparing actual results with planned objectives, it is important to
monitor these projects at regular intervals to ensure that everything is going as planned. The
final step is reviewing the entire investment appraisal project for organizational learning and to
improve future investment decisions.

Investment Appraisal Techniques

Investment appraisal techniques

Profit Based Cash flow based

1) Net present value(NPV)

1) Accounting Rate of Return(ARR)
2) Internal Rate of Return(IRR)
3) Payback Period

Profit Based

While studying profit-based investment appraisal techniques, it is important to keep in mind that
profits can be manipulated with various accounting loopholes, when that is done, we do not get the
accurate cash value created from the investment, this could lead to sub-optimal decisions being
made. Thus, cash flow-based techniques should always be preferred over profit based techniques.

Accounting Rate of Return (ARR) / Return on capital employed (ROCE)

ARR is calculated as, ARR = PBIT post depreciation x 100

Initial Investment

OR

ARR = PBIT post depreciation x 100

Average Investment

Note: In the F9 exam, you will have to simply use the initial investment unless told otherwise. In
addition, the initial investment could also be termed differently, such as initial capital cost, but you
need to simply use what conceptually comes under the initial investment.
 Investment Appraisal 27

Decision rule: If ARR is greater than target ARR then the company should accept the project.

To come to the final average annual post depreciation profit, you will have to use the profits before
interest and tax and then subtract depreciation from it. The initial investment includes only capital
investments that occur at the start of the project. Thus, from the formula we can see that ARR
basically gives you the return (based on profits) from the capital invested.
 Investment Appraisal 28

Apply Your Knowledge:

Marati, a car company is launching a new car with brand new features, and they have already spent
$40,000 on market research, Marati capitalizes market research. The new project will require an
investment of $400,000 for machinery and manufacturing equipment. The machinery and
equipment will have a scrap value of $10,000. The project is for 4 years and will generate cash flows
as follows:

Year 1 2 3 4
Cash flows $140,000 $142,000 $165,000 $110,000

1. Calculate and comment on the ARR if the company has a target ARR of 15% based on average
investment.
2. Calculate and comment on the ARR if the company has a target ARR of 20% based on initial
investment.

Solution:

Total Initial Investment = Cost of Market Research + Purchase Price of Machinery & Manufacturing
Equipment

Since, question is silent about depreciation, we shall assume straight-line method of depreciation
over four years, i.e., (400,000-10,000)/4 = $97,500

Year 1- 2 3 4

NPBIT (post $42,500 $44,500 $67,500 $12,500

depreciation)

1. Average profits over the 4 years = (42,500+44,500+67,500+12,500)/4 = $41,750

Average Investment = (440,000 + 10,000)/2 = $225,000
ARR = 41,750/225,000 = 18.56%
Since, this rate of accounting return (or ROCE) is greater than the organisation’s target ARR
of 10%, this project will be approved in terms of investment appraising decision techniques.

2. Average profits over the 4 years = $41,750

Initial Investment = $440,000
ARR = 41,750/440,000 = 9.49%
Since, this rate of accounting return (or ROCE) is lower than the organisation’s target ARR of
20%, this project will NOT be approved in terms of investment appraising decision
techniques.

Market Research Costs are sunk costs.

 Investment Appraisal 29

The following are the advantages to using ARR as an investment appraisal technique.

• Easy to calculate.
• Linked to accounting measures.

The following are some of the disadvantages to using ARR. (you will have to further study till
syllabus area D3 to properly understand this)

• Does not take account of the time value of money.

• Includes irrelevant cash flows (sunk cost as seen in the above example)
• Needs a target ARR to make a decision, thus not giving a definitive sign to investment.
• It is based on profits which can be manipulated.
• Does not calculate actual value created/absolute gain, as it is a rate of return measure.
• Profits vary according to the company’s accounting policy.

RELEVANT CASH FLOWS

One of the main issues faced in investment appraisal questions is selecting the appropriate cash
flows to be used in the various investment appraisal techniques that are about to be studied. We will
learn how to establish relevant cash flows that should be considered when making an investment
appraisal decision.

The general rule of thumb is that all future incremental cash flows arising as a result of the
investment will be considered as relevant cash flows.

Any cash flow other than a relevant cash flow will have to be ignored when undertaking an
investment appraisal. Cash flows such as committed costs, sunk costs, allocated fixed overheads,
historic costs, non-cash items such as depreciation will all have to be ignored. Basically, any cash
flow which will not change, regardless of the decision to undertake the investment project. For
example, opportunity cost will be regarded as a relevant cost.

In simple terms, if a cash flow has already occurred and will not have a bearing on the future
decision making, it is not relevant.
For example, Company ABC has incurred $150,000 in the last month, to gather data for the
investment project that is under review. This cost should be ignored and treated as irrelevant as the
amount has already been incurred and will not be recovered regardless of the decision to undertake
the project.

Let us take another example. I am an ACCA student. I have to decide whether I should move to
Mumbai or Delhi for ACCA coaching and internship. The amount I will pay to ACCA as annual fees
etc., will be the same regardless of which city I shift to. So that is not a relevant cash flow. But rent
paid, living expenses will be different in the two cities, and that will drive my decision making. These
cash flows will be relevant to decision making.
The following is a list of cash flows that are not relevant and need to be ignored:

• Committed costs
• Sunk costs
• Interest (as it is included in the discount factor)
 Investment Appraisal 30

• Non-cash items (depreciation)

• Allocated fixed overheads
• Historic costs

A simple way to determine relevant cash flows are by seeing whether they occur in the future, are
incremental and include cash items.

Apply Your Knowledge:

A development project is under review. Materials necessary for the project costs $50,000.

The company will need trained staff for 2 months, already employed on a fixed yearly salary of
$40,000. The company will have to invest $4,000,000 in machinery for the project. The company’s
total depreciation for the year will amount to $90,000.
The company’s finance cost for the year totals to $2,000.This project will last for 4 years and
generate revenue of $100,000 per annum.
Establish the relevant cash flows.
Solution:
Firstly, we need to identify all the costs occurring to the company and then decide it’s relevancy.

1. Materials Cost = $50,000 – Relevant Cashflow

2. Trained Staff for 2 months – Irrelevant Cashflow (already employed staff; no incremental
cost)
3. Investment in Machinery - $4,000,000 – Relevant Cashflow
4. Depreciation - $90,000 – Irrelevant Cost (not a cashflow)
5. Company’s finance cost - $2,000 – Irrelevant Cashflow (we need project specific costs, not of
company as a whole)
6. Revenue - $100,000 – Relevant Cashflow
 Investment Appraisal 31

Cash Flow Based Investment Appraisal Techniques

Cash flow-based techniques uses the actual cash generated and excludes non-cash items and
irrelevant cash flows, plus it does not suffer from the risk of it being manipulated, unlike profit. That
is why cash flow-based techniques are superior as compared to profit based.
Payback Period

Payback period is the time (usually expressed in years) a company takes to make back the initial
investment spent on a particular project. Payback uses cash flows and not profits, plus it excludes all
irrelevant cash flows.

Payback period is useful as a parameter for liquidity, the faster the initial investment is recovered,
the more liquid the investment is. In addition to this, it is also used to measure risk, uncertainty
increases with time, which means that risk will also increase with a longer payback period.

When the cash flows are constant, the cumulative method is used. It can be calculated as:

Payback period = Initial Investment

Annual cash inflow

When the cash flows are not constant, you will have to manually keep reducing the cash inflows
from the Initial Investment.
 Investment Appraisal 32

Apply Your Knowledge:

Sasung is planning to launch a new phone, the company has already paid $45,000 on market
research. The company will need an investment of $500,000 in machinery to manufacture the new
product. The project life is for 5 years, and after that, the machinery can be scrapped for $7,000.
The company has a policy of capitalizing on market research. The company has a target payback
period of 4 years.

Calculate and comment on the payback period for the project.

Year Cash flows

1 $70,000
2 $50,000
3 $100,000
4 $150,000
5 $200,000
6 $250,000

Solution:

Total Initial Investment = Market Research Cost + Purchase price of Machinery

= 45,000 + 500,000 = $545,000

Year Cash flows Cumulative Cash Payback Status

flows
0 ($545,000) - No
1 $70,000 ($475,000) No
2 $50,000 ($425,000) No
3 $100,000 ($325,000) No
4 $150,000 ($175,000) No
5 $200,000 $25,000 Yes
6 $250,000 $275,000

As we can see from the table above, the cumulative cashflows are positive only in the 5th year, i.e.,
between 4th and 5th year.

To be precise, we assume that the entire cashflow of year 5 occurs evenly thoughout the year.

To get the fraction of the year 5, during which the payback is completed, we calculate:

Profit left to be recovered/Profit in the forth coming year * No. of periods

175,000/200,000*12 [if we calculate in months] = 10.5 months

Therefore, payback period = 4 years and 10.5 months

 Investment Appraisal 33

This is beyond the company policy of target payback period of 4 years. Thus, this project will NOT be
approved.

Apply Your Knowledge:

Year Cash flows

0 (current year) (2100)
1 400
2 500
3 1000
4 500
5 200
6 1000

The method to calculate the payback period here is as follows:

Year Cash flows Cumulative cash flows

0 (current year) (2100) (2100)
1 400 (1700) [2100-400] *
2 500 (1200) [1700-800] *
3 1000 (200) [1200-1000] *
4 500 0 [note below] *
5 200
6 1000

*As we can see above, the entire initial investment is recovered when cumulative cash flows become
0, that is in year 4. But we have to assume that cash flows occur evenly throughout the year hence to
get an absolute figure, we divide the amount remaining to be recovered (i.e., 200) by the next years
cash inflow (i.e. 500), which is (200/500) =0.4.

Therefore, the payback period is (3+0.4) 3.4 years.

 Investment Appraisal 34

Syllabus area D1 c-d-e-f-g-h

- Calculate discounted payback and discuss its usefulness as an investment appraisal method.
- Calculate return on capital employed (accounting rate of return) and discuss its usefulness as
an investment appraisal method.
- Calculate net present value and discuss its usefulness as an investment appraisal method.
- Calculate internal rate of return and discuss its usefulness as an investment appraisal method.
- Discuss the superiority of discounted cash flow (DCF) methods over non-DCF methods.
- Discuss the relative merits of NPV and IRR.

Time Value of Money

This is a critical concept to understand. The basic idea is that money received in the future will be
worth less than the money received today. This is mainly because of the lost opportunity of earning
interest if kept in a fixed deposit, along with the effect of inflation. Thus, to get the accurate value of
the cash received, we need to discount the future cash receipts to current value terms.

Note: Unless mentioned otherwise, it is always assumed that cash flows occur at the end of the year,
and year 1 means the end of the current year. Year 2 means end of year 2 and so on. T0 means the
present day, i.e. beginning of the year.
Compounding

Money invested today will earn interest on the principal. Compounding is earning interest on the
principal along with the interest accumulated until that day. Compounding is essentially earning
interest on interest.

P.S: Albert Einstein called ‘Compounding’ the eighth wonder of the world.
Future value

To calculate the future value of a sum invested now is as follows:

FV = PV(1+r)^n

FV = Future Value
PV = Present value
r = Rate of interest per period
n = Number of periods (usually years)
(This formula will be provided to you in the exam so you need not remember it)
 Investment Appraisal 35

Apply Your Knowledge:

$7,500 is invested now for four years at an interest rate of 6% p.a.
Calculate the amount received after 4 years
Solution: FV = 7500 x (1+0.06)^4 = $9467
This means that $7500 invested today will be worth $9467 at the end of 4 years.

Present Value
To get to the present value of money, we discount that amount with a certain discount factor. Now
this discount factor basically relates to the time value of money explained earlier, where you are
simply reversing the effect of earning interest to get to the current value of a future receipt. Thus,
over here, r could be the rate of interest, the discount rate or even the required rate of return, it is
basically the rate at which the company would have earned interest.
Present Value (PV) = Future Value (FV)
(1+r)^n
OR
Present value (PV) = Future value x Discount Factor
Discount factor = 1/(1+r)^n
Note: A table of discount factors will be provided to you in the exam (which is also behind this study
text) as it becomes much faster to find the present values rather than using the formula.

Apply Your Knowledge:

$5,000 is to be received in 3 years, the current discount rate is at 10% p.a.
Calculate the present value of money
Solution: PV= $5000 x 0.751 (using discount factor table)

PV= $3,755
This means that the receipt of $5000 that is to be received in 3 years is worth $3755 today.
In simple words, if 5,000 is the future value of 3,755 at 10% after 3 years, then 3,755 is the present
value of 5,000 to be received after 3 years.
 Investment Appraisal 36

Discounting annuities
An annuity is a repetitive cash flow, i.e., a constant cash flow for a certain number of years. The
above method of discounting is viable when there are uneven cash flows, E.g.
Year 1 2 3 4
Cash flow $6000 $5,000 $4,000 $5,500

However, when there is a constant cash flow like $4000 for all 3 years, it is much easier to use
annuity factors rather than repeatedly calculating the present value for each year.
PV of an annuity = Constant cash flow x Annuity Factor
Note: This is not the same as compounding. (Again, the annuity factor table, along with the formula
will be provided to you in the exam and is also at the end of the notes)

Apply Your Knowledge:

$5,000 is to be received at the end of every year for the next 3 years, the current discount rate is at
10% p.a.
Calculate the present value
Solution: PV= $5000 x 1.331 (using annuity factor table)
PV= $6,655
This means that the receipt of $5000 every year for the next 3 years is worth $6,655.

Discounting advanced annuities

If a constant cash flow starts from year 0, which is the end of the current year, then it is an advanced
annuity. Since the annuity formula, along with the annuity tables assumes all cash flows start at the
end of year 1, we need to take a different approach. Here, the year 0 cash flow will not be
discounted as it is received in the current year itself, so we take that separately and add it to the
cash flows multiplied by the annuity factor using the final year.
PV of an annuity = (Annual cash flows x Annuity factor [final year]) + Cash flow

Apply Your Knowledge:

Starting from this year, $5,000 is invested at the end of every year for 5 years at the rate of 9%.
Calculate the present value.
Solution: PV= ($5,000 x 3.8897) + $5,000 = $24,449
 Investment Appraisal 37

Discounting delayed annuities

A similar issue is faced here, when constant cash flows start after year 1, then it is a delayed annuity.
In this case, we first find the annuity of the constant cash flows (using a number of repetitions as the
year) and further multiplying it with the discount factor of the year preceding the first cash flow (to
get it in present value terms).
PV of annuity = Annual cash flow x Annuity factor [number of repetitions] x Discount factor [year
before the first cash flow]

Apply Your Knowledge:

$5,000 is invested at the end of every year for 5 years, starting 3 years from now at the rate of 9%.
Calculate the present value
Solution: PV= ($5,000 x 3.8897) x 0.8417 = $16,370

Perpetuity
A perpetuity is a constant cash flow that occurs for infinity. Many forget the concept of discounting
and assume that the present value would be an infinite amount as well, but because of discounting,
the present value is an absolute amount. The farther you go from the present date, the lower will be
the present value of the amount you will receive in the future.
The present value of a perpetuity is calculated as follows:
Present value of a perpetuity = Constant Annual Cash Flow
r
Where r = discount rate

Apply Your Knowledge:

$200,000 is received at the end of every year for the foreseeable future at a discount rate of 6%.
Calculate the present value.
Solution: PV= 200000/6% = $3,333,333
 Investment Appraisal 38

Discounting advanced perpetuities

The same logic in discounting advanced annuities applies here, if perpetuity starts from year 0, it is
known as an advanced perpetuity. Advanced perpetuities are calculated as follows:
Present value of an advanced perpetuity = Constant Annual Cash Flow + Constant annual cash flow
r
Where r = discount rate

Apply Your Knowledge:

$200,000 is received at the end of every year, starting from today for the foreseeable future at a
discount rate of 6%.
Calculate the present value.
Solution: PV= (200000/6%) + 200000
PV= $3,533,333

Discounting delayed perpetuities

The same logic in discounting delayed annuities applies here, if a perpetuity starts after year 1 it is
known as a delayed perpetuity. Delayed perpetuities are calculated as follows:
Present value of an advanced perpetuity = Constant Annual Cash Flow x D.F. [of year before the start
of first cash flow] r
Where r = discount rate and D.F = Discount factor

Apply Your Knowledge:

$200,000 is received at the end of every year, starting at the end of year 3, for the foreseeable
future at a discount rate of 6%.
Calculate the present value.
Solution: PV= (200000/6%) x 0.89
PV= $296,667
 Investment Appraisal 39

Net Present Value

Net present value (NPV) is regarded as one of the most reliable techniques to determine the
feasibility of a project. This is because, it is a discounted cash flow technique, which means it
incorporates cash flows as well as the time value of money.
NPV is the value of surplus funds generated from investing in a certain project. To get to the NPV,
you need to consider the entire timeline of the project and then compute the surplus funds
generated each year from the project. Surplus funds are computed by using all the relevant cash
flows and then discounting them to get their present value.
Assumptions
Since we are forecasting cash flows, the following are some of the assumptions:
• All cash flows occur at the end of the year.
• Only initial investment and initial working capital occur at year 0.

Decision Rule (Based solely on financially viability)

In the exam, you will be given information pertaining to a specific project and further asked for a
decision on acceptance of the project. Thus, the decision can be subjective, but when it comes to
financial viability, the following are standard decisions that are taken:

• If the NPV is a positive figure, that means the company has made an overall gain in value,
and the project is financially viable for the company to accept.
• If the NPV is zero, that means the company has neither gained nor lost any value, and the
project would still be financially viable to accept.
• If the NPV is a negative figure, that means the company has made an overall loss in value,
and the project is not financially viable to accept.

Solving an NPV Question

In the exam, there is a significant chance that an NPV question will be asked for 20 marks in section
C. There will be two aspects to the sum, one is the practical bit where you need to compute the NPV,
and the other is commenting upon your calculations.
While attempting any question on NPV, we need three things:-
a) Amount of cash flow
b) Timing of cash flow
c) Discount rate to be used
Our endeavour should be towards locking in the above three aspects.
 Investment Appraisal 40

NPV proforma (sample figures)

The following is the standard proforma you should use while solving any NPV sum, as it includes
Year 0 ($) 1 ($000) 2 ($000) 3 ($000) 4 ($000)

Sales revenue 2000 2500 3,100

Variable cost (300) (650) (1100)
Maintenance cost (100) (150) (200)
Fixed cost (1000) (1000) (1000)
Net operating cash flow 600 700 800
Taxation *(working below) 30 98 (60)
Initial Investment (2000)
Scrap proceeds 125
Incremental working capital (200) (50) (60) 310
*(working below)
Free cash flows (2200) 550 670 1333 (60)
Discount factor @ 10% 1 0.909 0.826 0.751 0.683
Present Value -2,200 500 553 1001 (41)
NPV -187

every form of cash flow that can be asked in the exam.

[NPV = (2200)+500+553+1001+(41)] *workings to tax and working capital are provided below

The important elements are further explained below:

Cost of capital
If you noticed, interest is not included in the proforma even though it is an expense to the company,
that is because it is included in the discount factor, which in this case, is the cost of capital to the
company.
The cost of capital, as the name suggests, is the company’s expense for borrowing capital. It is
essentially the average rate at which the company can borrow funds. Two main sources of
borrowing capital are debt finance and equity.
The cost of capital is the weighted average cost of debt and equity of the company. It is also known
as WACC (weighted average cost of capital), which in the case of NPV projects is the most
appropriate rate to use as the discount factor.

Discount factor
The discount factor to be used will be given to you in the question, but it could be termed as any of
the following:
• Required rate of return
 Investment Appraisal 41

• Discount factor
• Weighted average cost of capital
• Cost of capital
For discounting cash flows, you will have to use the after-tax discount rate. It is calculated as [after
tax discount rate = before tax discount rate x (1-Tax rate)]. The reason behind this is explained in the
next section

Tax
Tax is a relevant expense to the company and is charged on the operating profits of the company.
The following are some points to keep in mind while charging tax:
• Capital investment (E.g. Machinery, equipment etc.) gets the benefit of tax-allowable
depreciation.
• Net operating profits will be charged tax, and net operating losses will receive a tax
benefit.
• Tax is paid in arrears unless mentioned otherwise, i.e. if income is earned in year 1, the
tax on the said income is paid in year 2. Similarly, if there is an expense or loss sustained
in year 1, the impact of tax saving should be incorporated in year 2.
 Investment Appraisal 42

Tax allowable depreciation

If you recall, depreciation is not included in the proforma as it is a non-cash item, thus it is an
irrelevant cash flow. Tax-allowable depreciation is not traditional depreciation, but just an
adjustment to claim an allowance (reduction) provided by the government for the total tax payable.
Tax payable is calculated as follows:
(continued)
[extract from question] If Tax-allowable depreciation is charged at 25% on a reducing balance
method.

Years 0 1 2 3 4
Step 1 Net operating cash flow 600 700 800
Step 2 Tax allowable depreciation (500) (375) (1000)
[25% x 2000] [25% x (2000-500) [1,125-125]
[net book value-scrap]
Step 3 Taxable profit 100 325 (200)
Step 4 Tax @30% paid/benefit (in (30) (97.5) 60
arrears)

i. Step 1: Take this from the proforma, it is the net operating cash flow.

ii. Step 2: Depreciation can either be charged using the straight-line method or the reducing-
balance method. Tax allowable depreciation will be charged on the initial investment. At the
end of the life of the project, you will need to deduct the scrap value from the net book
value (initial investment-accumulated depreciation), this will give you a balancing allowance
(loss on sale of asset) or a balancing charge (profit on the sale of asset). This basically means
that you will be charged tax if you make a profit on selling the asset, and if you make a loss,
you will be given a tax benefit.

iii. Step 3: This is the “profit” figure upon which you can charge tax. It is basically the net
operating cash flows minus tax-allowable depreciation. If there is a loss, you will be asked to
carry forward the loss to the next year, this is simply done by deducting the next years
taxable profit with the current year loss. (losses are not taxed, they are given a benefit)

iv. Step 4: Tax is charged in arrears (after one year), the tax rate will be provided to you in the
exam. Tax charged is calculated as (Tax% x taxable profit). In situations, where the final
taxable profit figure is negative, you will be given a benefit, thus you need to calculate tax
the same way but put it as a receipt instead of an expense.
 Investment Appraisal 43

Working Capital
Just the initial investment might not be enough to fund the project, that is why companies usually
require an additional investment in working capital as safety. To better understand, think of working
capital as an investment kept aside as safety, thus only the incremental amounts will be relevant.
Plus, the entire amount will be recovered at the end of the project.
(Continued)
[extract from question] Working capital is required each year at 10% of sales, the entire amount
will be released at the end of the project.
Years 0 1 2 3 4
Step 1 Working capital -200 -250 -310
Step 2 Incremental working capital -200 -50 -60 310
[250-200] [310-250] [200+50+60]

Step 1: The question could only give you the absolute working capital amount required each year.
The working capital required each year is not a relevant cash flow, only the incremental amount is
relevant. Working capital is treated as an inflow and occurs at the start of each year. Thus, working
capital always begins from year 0 (if you remember the assumptions discussed above, the start of
year 1 = year 0, the start of year 2= year 1).

Step 2: Calculate the incremental amounts required each year as shown in the Apply Your
Knowledge above. The cumulative amount of working capital is then released and treated as an
inflow in the final year of the project.
 Investment Appraisal 44

Example 4
Dagobah Plc has purchased a patent for developing a gaming console. They have already paid
$50,000 for initial market research. The investment for the manufacturing of the console will be
$400,000. The product will have an expected life of 4 years, and Dagobah PLC expects the scrap
proceeds to be $75,000 at the end of the project. It is estimated that the demand for the project will
be as follows;
Year 1 2 3 4
Demand (units) 3000 4000 5000 6000

The selling price per unit is $60, and the variable cost per unit is $20. The annual fixed cost is
estimated at $75,000, which includes $50,000 of depreciation and $5,000 of allocated overhead
costs.
Corporation tax is paid at 30% and is payable in the same year. Working capital required is equal to
10% of sales each year. Tax-allowable depreciation is allowed at 25% on a reducing balance basis.
The company has a pre-tax cost of capital at 13.4%.
Calculate the NPV of the project and comment on the acceptability of the project.
Solution:

Year 0 1 2 3 4
Revenue 180,000 240,000 300,000 360,000
Cost of sales (60,000) (80,000) (100,000) (120,000)
Fixed cost (20,000) (20,000) (20,000) (20,000)
Net operating cash 100,000 140,000 180,000 220,000
flows
Taxation (working 0 (19,500) (37,125) (37,875)
note 1)
Working capital (18,000) (6,000) (6,000) (6,000) 36,000
(WN 2)
Initial Investment (400,000)
Scrap 75,000
Total Cash flow (418,000) 94,000 114,500 136,875 293,125
Discount factor @ 1 0.919 0.826 0.751 0.683
10%
Present value (418,000) 86,386 94,577 102,793 200,204
NPV 65,960

The project has a positive NPV thus, it is financially viable. However, acceptability depends on the risk
attitude of managers.
 Investment Appraisal 45

Working note 1: Tax-allowable depreciation

Year 0 1 2 3 4
Net operating cash 100,000 140,000 180,000 220,000
flows
Tax-allowable (100,000) (75,000) (56,250) (93,750)
depreciation [25% of 400,000] [25% of 300,000] [25% of 225,000] [168,750-75,000]
Taxable profit 0 65,000 123,750 126,250
Taxation @ 30% 0 (19,500) (37,125) (37,875)

Working note 2: Working capital

Year 0 1 2 3 4
Net operating cash 18000 24000 30000 36000
flows
[10% OF ANNUAL
SALES]
Incremental working (18000) (6000) (6000) (6000) 36000
capital [24000 -18000] [30000 -24000] [36000 - 30000] [18000 + 6000 + 6000
+ 6000]
 Investment Appraisal 46

Advantages of NPV
• NPV is based on cash flows and not profits, thus it does not suffer from the limitations of
profit-based techniques.
• NPV incorporates the time value of money.
• It measures the gain on an investment in absolute value.
• It is in line with the primary objective of maximizing shareholder wealth.
• NPV considers the whole life of the project

Disadvantages of NPV
• It can be misleading when evaluating projects with two different lives
• It is complex and can be challenging to explaining to managers.
• Knowledge of the cost of capital is a prerequisite.

IRR (Internal Rate of Return)

IRR is basically the discount rate at which the NPV would be zero. The cost of capital represents the
rate at which the free cash flows are discounted, thus if the NPV is zero, it means that the project is
earning at the same rate as the cost of capital.
Using that logic, the internal rate of return will be the cost of capital at which the NPV is zero. It is
used as a tool for decision making as if the IRR is more than the cost of capital, the project is
financially viable.
Computing IRR
IRR = L+[{NPVL/(NPVL-NPVH)}]+(H-L) *get used to solving this on a scientific calculator and Excel.
L = Lower discount rate as %
H = Higher discount rate as %
NPVL = NPV calculated at lower discount rate
NPVH = NPV calculated at higher discount rate
For computing IRR, you have to make an assumption for the second discount rate. For the sake of
the formula, it is ideal for NPVL to be positive and NPVL to be negative. In the exam, you will most
likely need to calculate the IRR as an additional requirement after a regular NPV question.
• If the NPV is positive that will be NPVL and you will have to make an assumption and take a
higher discount rate (H) such that NPVH will be a negative figure.
• If the NPV is negative that will be NPVH and you will have to make an assumption and take a
lower discount rate (L) such that NPVL will be a positive figure.
 Investment Appraisal 47

Apply Your Knowledge:

The following are the free cash flows from a project by REX plc
Year 0 1 2 3
Free cash flows ($50,000) $17,000 $20,000 $22,000

REX plc has a cost of capital of 10%

Calculate the NPV for this project, also compute the IRR.
Solution:
Calculation of NPV
Year 0 1 2 3
Free cash flows ($50,000) $17,000 $20,000 $22,000
Discount factor @ 10% 1 0.909 0.826 0.751
Present value of free (50,000) 15453 16520 16522
cash flows
NPV (1505)

Calculation of IRR:

Taking 5% as an assumption for the lower discount rate

Year 0 1 2 3
Free cash flows ($50,000) $17,000 $20,000 $22,000
Discount factor @ 5% 1 0.952 0.907 0.864
Present value of free (50,000) 16184 18140 19008
cash flows
NPV 3332

IRR= 5% + [{3332/(3332-(-1505))} * (10%-5%)]

IRR= 8.45% ( can be rounded to 8.5%)
 Investment Appraisal 48

Decision rule
• If the internal rate of return is higher than the cost of capital, the project should ideally be
accepted.
• If the internal rate of return is higher than the cost of capital, the project is not financially
viable and should be rejected.
• At times the NPV and IRR may give conflicting decisions, but you should always use NPV as
the first preference. (It is explained why below)

Advantages of IRR

• It considers the time value of money.

• It is not based on profits and based on cash flows.
• It considers the entire life of the project.

Disadvantages of IRR
• It is complex to calculate
• Non-conventional cash flows (a mix of positive and negative cash flows after year 0) can lead
to multiple IRR’s.
• Does not measure gain in absolute value, unlike NPV.
• Actual IRR might differ as a second rate is assumed.
• IRR makes an unrealistic assumption that cash flows are reinvested at IRR, when it is much
safer to assume that they are reinvested at the cost of capital.
• It also includes all the disadvantages of NPV.
 Investment Appraisal 49

NPV versus IRR

As IRR suffers from more limitations as compared to NPV, so the decision provided by NPV should
always be given first preference. From this diagram, we can understand why NPV is superior under
normal circumstances.

Discounted payback period

This is similar to the payback period, except we incorporate the time value of money over here. This
is simply done by discounting the cash flows with the respective discount factor and then computing
 Investment Appraisal 50

the payback period as studied earlier. It serves the same purpose and overcomes the limitation of
not considering the time value of money, thus becoming a better technique to use.

Apply Your Knowledge:

The following are the free cash flows of company BDAA plc:
Year 0 1 2 3 4 5
Free cash flows (1700) 400 500 1000 500 200

Company BDAA plc uses a cost of capital of 10%.

Calculate the discounted payback period.
Solution:

Year Cash flows Discount factor Present value Cumulative cash flows
0 (current year) (1700) 1 (1700) (1700)
1 400 0.909 364 (1336)
2 500 0.826 413 (923)
3 1000 0.751 751 (172)
4 500 0.683 342 0 [172/342]
5 200 0.621 124

Thus the discounted payback period is 3.5 years

The decision rule is the same as that of the payback period.
 Investment Appraisal 51

Syllabus area D2 a-c

- Apply and discuss the real-terms and nominal-terms approaches to investment appraisal.
- Calculate the taxation effects of relevant cash flows, including the tax benefits of tax-
allowable depreciation and the tax liabilities of taxable profit.
- Calculate and apply before- and after-tax discount rates.

Inflation

Inflation is the decline in purchasing power or a general increase in prices. This leads to the decline
in the real value of money over time.

Investors need to be compensated for inflation. Thus, we incorporate inflation with the required rate
of return to get what is called the ‘nominal’ or ‘money’ rate of return. In the exam, either a general
rate of inflation or specific inflation rates will be given.

The two terms you need to be familiar with while dealing with inflation is as follows:
• Real terms: When the cash flow and/or discount rate is not adjusted for inflation, then they
are said to be in ‘real terms’.
• Nominal/Money terms: When the cash flow and/or discount rate is already adjusted for
inflation, then they are said to be in ‘nominal/money terms’.
• Current price terms: When cash flows are given in their current price terms, it means that
Year 0 price terms are given, and you will have to inflate the cash flows from year 1. If not
mentioned, it means that cash flows are already inflated for year 1, thus you will have to
start inflating cash flows from year 2.

Apply Your Knowledge:

Company Albacore has a project that generates revenue of $50,000 per annum, has a total variable
cost of $10,000 per annum and incurs incremental fixed costs of $30,000 every year. All the cash
flows are given in current price terms. Revenue has an inflation rate of 5%, while fixed and variable
costs have an inflation rate of 4%.

Calculate the net operating cash flows, if the project has a 4 year life.
 Investment Appraisal 52

Solution:

Year 0 1 2 3 4
Revenue 51,500 54,075 56,779 59618
[50000 x 1.05] [51500 x 1.05] [54075 x 1.05] [56779 x 1.05]

Variable (10400) (10816) 11249 11699

cost [10000 x 1.04] [10400 x 1.04] [10816 x 1.04] [11249 x 1.04]

Fixed cost (31200) (32448) (33746) (35096)

[30000 x 1.04] [31200 x 1.04] [32448 x 1.04] [33746 x 1.04]

Net 9900 10811 11784 12823

operating
cash flows

Specific rates of inflation (multiple rates inflation)

In reality, every single cash-flow is not affected by inflation to the same extent. In the exam, you
could get various cash-flow specific inflation rates. In this case, you will have to use the
‘nominal/money method’ to solve the question, which is done as follows:

• All cash flows are adjusted for inflation using the cash flow specific inflation rates and
expressed in their nominal/money terms.
• The discount rate is also adjusted for inflation and expressed in nominal/money terms. You
need to use the nominal discount rate.

You can find the nominal discount rate using the following formula:

Fishers’ formula: (1+i) = (1+r) (1+h)

i = money rate
r = real rate
h = general inflation

General rate of inflation (single rate of inflation)

This is when a single rate of inflation is given to you in the exam. You can solve the question using
the real method, the money method is also applicable here but not recommended as it leads to a
waste of time during the exam. The result of using either method will be the same. The real method
is used as follows:

• The cash flows are not adjusted for inflation and are instead expressed in their real terms
itself.
• The discount rate is not adjusted for inflation either and is expressed in real terms. Thus,
you will have to use the real cost of capital.
 Investment Appraisal 53

Example 5

Archer Co is a company that manufactures android robots. The Managing Director of Archer Co is
considering a proposal to increase the production capacity by purchasing machinery which has a
maximum capacity of 60,000 units. This machine will last for 5 years and cost $215,000, at the end of
the machine’s life, it will have a scrap value of $0. The company will incur a maintenance cost of
$10,000 in the first year of operation.

Archer Co has estimated demand to be 30,000 units per year from the first year of operation and for
it to increase by a further 10,000 units per year in each subsequent year. Selling price is expected to
be $10 per unit, and the marginal cost of production is expected to be $7.8 per unit. Incremental
fixed production overheads of $10,000 per year will be incurred. Selling price and costs are in
current price terms.

Annual inflation rates are expected to be as follows:

Selling price of Product: 4% per year
Marginal cost of production: 4% per year
Maintenance cost: 5% per year
Fixed production overheads: 6% per year
General inflation rate: 2.78%

Archer Co has a real cost of capital of 8%. The company pays tax one year in arrears at an annual
rate of 30% and can claim capital allowances on a 25% reducing balance basis, with a balancing
allowance at the end of the life of the machines. The company depreciates fixed assets on a straight-
line basis.

Calculate and comment on the NPV of the investment in the new machine

Solution:

0 1 2 3 4 5 6
A Revenue 3,12,000.00 4,32,640. 5,62,500. 7,02,000. 8,51,900.00
00 00 00
B Total Variable (2,43,360.0 (3,38,000. (4,38,500. (5,47,800. (6,64,300.0
Costs 0) 00) 00) 00) 0)
C Total Fixed Costs (10,600.00) (11,236.0 (11,910.1 (12,624.7 (13,382.26)
0) 6) 7)
D Maintenance Costs (10,500.00) (11,025.0 (11,576.2 (12,155.0 (12,762.82)
0) 5) 6)
E Net Operating Cash 47,540.00 72,379.00 1,00,513. 1,29,420. 1,61,454.93
Flow (A+B+C+D) 59 17

F Initial Investment (2,15,000.

00)
G Tax Paid 1,863.00 (9,619.95) (21,083.7 (32,023.32) (28,028.28
6) )
H Net Cash Flows (2,15,000. 47,540.00 74,242.00 90,893.64 1,08,336. 1,29,431.61 (28,028.28
00) 40 )
 Investment Appraisal 54

I Discounting Factor 1 0.901 0.812 0.731 0.659 0.593 0.535

@ 11%
J Adjusted Cash (2,15,000. 42,833.54 60,284.50 66,443.25 71,393.69 76,752.95 (14,995.13
Flows 00) )
NPV 87,712.80

Working Notes:

WN 1: Units in Demand

Current 1 2 3 4 5
Terms (0)
Demand (increases by 30000 40,000 50,000 60,000 70,000
10,000 units every [Given in [30,000 + [40,000 + [50,000 + [60,000 +
subsequenct year) question] 10,000] 10,000] 10,000] 10,000]

WN 2: Revenue

Current 1 2 3 4 5
Terms (0)
Demand Units (WN 1) 30,000 40,000 50,000 60,000 70,000
SP/unit [Inflation 4%] 10 10.4 [10 + 10.816 [10 + 11.25 [10 + 11.7 [10 + 12.17 [10 +
(1+4%)^1] (1+4%)^2] (1+4%)^3] (1+4%)^4] (1+4%)^5]
Total Revenue 3,12,000.00 4,32,640.00 5,62,500.00 7,02,000.00 8,51,900.00

WN 3: Variable Costs

Current 1 2 3 4 5
Terms (0)
Demand Units (WN 1) 30,000 40,000 50,000 60,000 70,000
VC/unit [Inflation 4%] 7.8 8.112 8.45 8.77 9.13 9.49
Total Variable Costs 2,43,360.00 3,38,000.00 4,38,500.00 5,47,800.00 6,64,300.00

WN 4: Fixed Costs

Current Terms 1 2 3 4 5
(0)
Fixed Cost 10,000 10,600 11,236 11,910.16 12,624.77 13,382.36
[Inflation 6%] [10,000 * (1 [10,000 * (1 [10,000 * (1 [10,000 * (1 [10,000 * (1
+ 6%)^1] + 6%)^2] + 6%)^3] + 6%)^4] + 6%)^5]
 Investment Appraisal 55

WN 5: Maintenance Costs

Current Terms 1 2 3 4 5
(0)
Maintenance 10,000 10,500 11,025 11,576.25 12,155.06 12.762.82
Costs [Inflation [10,000 * (1 [10,000 * (1 [10,000 * (1 [10,000 * (1 [10,000 * (1
5%] + 5%)^1] + 5%)^2] + 5%)^3] + 5%)^4] + 5%)^5]

WN 6: Taxation

Current 1 2 3 4 5 6
Terms
(0)
Net Operating 47,540.00 72,379.00 1,00,513.59 1,29,420.17 1,61,454.93
Cashflows
Tax Allowable 53,750 40,312.50 30,234.38 22,675.78 68,027.34
Depreciation [25% [25% of [25% of [25% of [25% of [215,000 -
reducing balance 215,000] (215,000 - (215,000 - (215,000 - 146,972.66]
method] 53750)] 94,062.50)] 124,296.88)]
Taxable Profits (6,210.00) 32,066.50 70,279.21 1,06,744.39 93,427.59
Tax Paid @ 30% in 1,863.00 (9,619.95) (21,083.76) (32,023.32) (28,028.28)
arrears

Comment: The project is financially viable as it has a positive NPV, however, the final decision
depends on the risk appetite of the company
 Investment Appraisal 56

Syllabus D3 a-b-c-d (i-iii)

- Describe and discuss the difference between risk and uncertainty in relation to probabilities
and increasing project life.
- Apply sensitivity analysis to investment projects and discuss the usefulness of sensitivity
analysis in assisting investment decisions.
- Apply probability analysis to investment projects and discuss the usefulness of probability
analysis in assisting investment decisions.
- Apply and discuss other techniques of adjusting for risk and uncertainty in investment
appraisal, including: (i) simulation, (ii) adjusted payback, (iii) risk-adjusted discount rates.

In common language, risk and uncertainty are quite similar, but that is not the case when it comes to
finance, and you need to be able to distinctly differentiate between the two.

Most of the investment appraisal deals with predicting the future, and the future is uncertain, thus
we need to incorporate this uncertainty into the investment appraisal process.

Risk

Risk is generally referred to as the chance of a bad situation happening. However, in finance, risk
arises when there are several outcomes, and the probability of each outcome occurring is available.
Risk is quantifiable and increases with the variability of outcomes.

Uncertainty

Uncertainty refers to the situation where probabilities cannot be assigned to the various outcomes.
Uncertainty is not quantifiable and increases with the life of the project.

Risk can be incorporated in the investment appraisal process with the help of techniques like
probability analysis, sensitivity analysis, discounted payback period and simulation. We shall now
further study these techniques:
 Investment Appraisal 57

Probability analysis

Probability analysis is essentially assigning weights (probabilities) across a range of outcomes and
then taking the average of them to come to the expected value. The expected value is the weighted
average of all the possible outcomes based on probabilities.

The expected value is calculated as follows: EV = ∑px

P= probability and;

X = the value of an outcome

 Investment Appraisal 58

Apply Your Knowledge:

The following are a set of possible annual cash flows that company WLR Plc might receive, below are
a set of probabilities assigned to each outcome:

Annual Cash flow ($) Probability

80,000 0.2
90,000 0.4
60,000 0.4

EV = (80,000 x 0.2)+(90,000 x 0.4)+(60,000 x 0.4)

EV = $76,000. This means that on an average WLR plc will receive an annual cash flow of $76,000.

Example 6

Stigmak plc is considering an investment of $400,000 in a non-current asset. The investment is

expected to generate surplus funds over the 5 year life of the project. Unfortunately, the annual
cash flows from the investment cannot be accurately determined, but the following probability
distribution has been established:

Annual cash flow ($) Probability

60,000 0.4
90,000 0.5
165,000 0.1

At the end of its five-year life, the asset is expected to have a scrap value of $49,000. Stigmak plc has
a cost of capital of 4%.

Advice Stigmak plc should go ahead with the investment.

Solution:

Expected value = (60,000 x 0.4) +(90,000 x 0.5) + (165,000 x 0.1) = 85,500

NPV based on expected value:

Cash flow Amount ($) Discount factor @ 4% Present Value

Year 1-5: Annual cash 85,500 4.452 [AF @ 4% for 5 380,646
flow years]
Year 0: Investment (400,000) 1 (400,000)
Year 5 scrap 49,000 0.784 [DF @ 4% for 5th 38,416
year]
NPV 19,062

Comment: The project is financially viable as it has a positive NPV, however, the final decision
depends on the risk appetite of the company.
 Investment Appraisal 59

Advantages of using expected values:

• Easy to compute.
• Includes all possible outcomes.
• Weights are assigned to their respective outcomes, thus highly probable outcomes are given
more importance.
• Provides managers with the best possible outcome and the worst possible outcome, along
with the probability of each outcome occurring.

Limitations of using expected values:

• Probabilities derived are forecasts based on historic information and are usually subjective.
As the future is different and might differ from the past.
• Expected value does not give the actual outcome but just the average of the actual outcome.
• Does not consider the investors risk attitude.
• Does not lead directly to a correct decision.

Sensitivity analysis

Sensitivity analysis basically measures how much a project variable needs to change for the NPV to
become 0 (or how far can a specific variable change until the project looses its financial viability).
Thus, this basically measures how sensitive a project variable is to the overall investment decision.

Sensitivity analysis is carried out by first selecting a project variable (Eg. Sales) then calculating the
change required to make the NPV zero. This analysis helps managers assess the critical project
variables that need to be closely monitored while implementing an investment project. Sensitivity
analysis is not considered as a method of incorporating risk, as it does not take the probability of a
project variable changing into consideration.

Calculation of sensitivity to a variable:

Sensitivity to a variable = NPV x 100

Post-tax PV of cash flow affected

NPV is adjusted for tax, thus for a fair comparison, the cash flows are also adjusted for tax, this is
calculated as: Cash flow x (1-Tax rate). As studied earlier, tax is charged on cash inflows and benefits
are given for cash outflows, therefore we adjust every cash flow for the tax to get an accurate value.
 Investment Appraisal 60

Apply Your Knowledge:

A project is expected to earn $40,000 annually as sales revenue over the project’s four year life. The
project has an NPV of $7,000. The relevant discount rate and the tax rate is 10% and 25%,
respectively.

Calculate the sensitivity of the selling price to the investment.

Solution:

Sensitivity of selling price = [7000/(3.16987x40,000x(1-0.25))]

= 7.36%

This means that only a 7.36% change in the selling price estimate could lead to the project yielding a
negative NPV.

Decision Rule

The lower the sensitivity margin, the more sensitive that specific project variable is to the
investment decision. A lower sensitivity margin basically means that a small change in the forecast
could potentially reverse the decision to invest in a project. So the close to 0% the sensitivity of a
variable is, the more critical it is to the project.

Example 7

Investing $35,000 today will potentially lead to receiving $22,000 yearly as a contribution. This
estimate is based on selling a volume of 11,000 units at a selling price of $11. Annual variable and
fixed costs are expected to be $9 per unit and $5,000, respectively. The project is expected to run for
4 years, with a discount rate of 10% and corporation tax at the rate of 30%.

Calculate the NPV of the project.

Calculated the sensitivity of the calculation for the following:

A. Initial Investment
B. Sales volume
C. Selling price per unit
D. Rate of discount

Solution:

Cash flow Amount $ Discount factor PV

@10%
Year 1-4: revenue 121,000 3.17 [AF for 4 years] 383,570
Year 1-4: Variable cost (99,000) 3.17 (313,830)
Year 1-4: contribution 22,000 3.17 69,740
Year 1-4: Fixed cost (5,000) 3.17 (15,850)
 Investment Appraisal 61

Net operating c/f 17,000 3.17 53,890

Year 1-4: Tax @ 30% (5,100) [17,000 3.17 (16,167)
x 0.3]
Year 0: Investment (35,000) 1 35,000
NPV 2,723

The project is financially viable as it has a positive NPV, however, the final decision depends on
the risk appetite of the company.

Calculation of sensitivity:

(i) Initial investment sensitivity = 2,723/35,000 = 7.78%

(ii) Sales price sensitivity = (NPV/PV of revenue post tax)
= [2,723/ (383,570x0.7)]
= 1.01%
(iii) Sales volume sensitivity = NPV/PV of contribution post-tax
= [2,723/ (69,740x0.7)]
= 5.58%
(iv) Discount factor sensitivity (calculation of IRR):

Calculating second NPV with a discount factor of 15%

Cash flow Amount $ Discount factor @ 15% PV

Year 1-4: revenue 121,000 2.855 345,455
Year 1-4: Variable cost (99,000) 2.855 (282,645)
Year 1-4: contribution 22,000 2.855 62,810
Year 1-4: Fixed cost (5,000) 2.855 (14,275)
Net operating c/f 17,000 2.855 48,535
Year 1-4: Tax @ 30% (5,100) [17000 x 0.3] 2.855 (14,561)
Year 0: Investment (35,000) 1 (35,000)
NPV (1,026)

IRR = 10% + [2723/ (2723+1026)] x (15%-10%) = 13.63%

Sensitivity to discount factor = (13.36%-10%)/10% = 33.6%

 Investment Appraisal 62

Advantages of using sensitivity analysis:

• Provides additional information that assists managers in making a better investment
decision.
• Easy to calculate.
Disadvantages of sensitivity analysis
• Does not directly point to a correct decision.
• Cannot process more than one variable changing at the same time.
• Does not take the probability of a variable changing into consideration.

Simulation
Simulation overcomes the limitation of sensitivity analysis by assessing the effect of changing
multiple variables at the same time. It is a complex process and is usually a computer aided
technique. It is carried out by varying the input variables to assess the various possible outcomes.
This process helps an entity process various outcomes and assess the potential impact of each
variable changing. (Only theory questions will be asked from this topic)
Advantages of simulation

• Easy to interpret.
• Includes all possible outcomes.
• Provides additional information that assists managers in making a better investment
decision.
Disadvantages of simulation
• Simulation tends to be expensive, and the potential benefits might not outweigh the cost.
• Complex and hard to calculate.

Payback and Discounted payback period: Explained earlier in this study text.

Risk adjusted cost of capital: Explained in the cost of capital.

 Investment Appraisal 63

Syllabus Area D4 a-b-c (i-iii)

- Evaluate leasing and borrowing to buy using the before- and after-tax costs of debt.
- Evaluate asset replacement decisions using equivalent annual cost and equivalent annual
benefit.
- Evaluate investment decisions under single-period capital rationing, including:
i. the calculation of profitability indexes for divisible investment projects
ii. the calculation of the NPV of combinations of non-divisible investment projects
iii. a discussion of the reasons for capital rationing.

While purchasing machinery for an investment project, it is essential to choose the most economic
source. In practice, you will get different options to finance that machinery, such as leasing or
borrowing to buy, so it is important to choose the cheapest option.

The best option is assessed by calculating the NPV of both options, as operating line items like
revenue remain constant while only the cash flows relating to each financing decision will be
different.

Leasing

Leasing is essentially renting out an asset for fixed lease payments. Leasing is explained in detail in
another syllabus area, for this section, you need to know the relevant cash-flows included in the NPV
calculation. The user of the asset does not legally own the asset.

The following are the points to remember while evaluating an option to lease:

• From the perspective of the government, the company taking the lease does not own the
asset, so the company will not receive tax-allowable depreciation. However, the lease
payments attract tax relief which is a relevant cash flow and should be included in the NPV
calculation.
• The lease payments made to the lessor is included in the NPV calculation as this obviously is
a relevant cash-flow.

Buying

Buying involves borrowing capital to buy the asset, in this case, it is assumed that the company uses
a bank loan to borrow money. The company that uses the asset is the owner.

The following are the points to remember while evaluating an option to buy:

• The company takes ownership of the asset, thus attracting tax-allowable depreciation. Tax-
allowable depreciation is relevant and must be included in the NPV calculation.
• The cost of buying the asset should be included.
• Again, as the company owns the asset, scrap value at the end of the asset’s life must be
included.
• Interest on borrowing money should not be included as it is already included in the discount
factor, which was discussed earlier.
 Investment Appraisal 64

Cost of capital in relation to leasing and borrowing

Interest payment is a cash outflow and attracts tax relief, that is the reason we use the post-tax rate
of borrowing as the discount rate. This is applicable to both leasing and borrowing.
Post-tax cost of borrowing = cost of borrowing x (1-Tax rate)

Example 8

Arkham plc is considering to invest in a machine to manufacture bottle packages. The machine
would have a five-year economic life and cost $5 million. Arkham plc pays corporation tax at 30% on
operating cash flows, one year in arrears. Tax-allowable depreciation is available at 20% per year on
a reducing balance basis. The company is planning to finance the machine over a five year lease at
$1 million p.a., which is payable in advance. Alternatively, the company could also finance the
machine by a five year fixed interest loan at a pre-tax cost of 13% p.a., with the principal amount
payable in five years. It is projected that the machine will have a scrap value of $100,000 after its five
year life.

Evaluate both the financing options available to Arkham plc and advise the better alternative.

Solution:

Post-tax discount rate = 13% x 0.7 = 9% (rounded down)

Calculation to find NPV of leasing

Year Particular Amount $000 Discount factor @ 9% PV

Year 0-4 Lease payment (1000) (1000*3.24)+1000 (4240)
Year 2-6 Tax benefit on lease 300 3.56 [3.89 x 0.917] 1068

[Advance and delayed annuities have been used for the discount factor here]

NPV of leasing = ($3172)

Calculation to find NPV of buying

Year 0 1 2 3 4 5 6
Net operating cash flows [irrelevant] 0 0 0 0 0 0
Taxation (WN1) 300 240 192 154 585
Initial Investment (5000)
Scrap proceeds 100
Net cash flows (5000) 300 240 192 254 585
Discount factor 1 0.917 0.842 0.772 0.708 0.650 0.596
Free cash flows (5000) 253 185 136 165 349
NPV (3,912)

Comment: As the lease option is the cheapest or least negative, it is the recommended option

WN1: Taxation
 Investment Appraisal 65

Year 0 1 2 3 4 5 6
Net operating cash 0 0 0 0 0 0
flows [irrelevant]
Tax allowable (1,000) (800) (640) (512) (1,948)
depreciation [20% x [20% x [3,200 x [2,560 x [NBV-
5,000] 4,000] 20%] 20%] scrap]
Taxation @ 30% 300 240 192 154 585

Asset replacement

After assessing which financing decision is most suitable to the company, it is important to know
how often the asset should be replaced, i.e. the most optimal frequency at which an asset should be
replaced.
It is difficult selecting a replacement cycle for an asset due to the following reasons:
• An asset, once bought must be regularly replaced for it to function at optimal levels.
• Assets with a similar functionality might have different economic lives, thus it becomes
difficult comparing equivalent assets.

The EAC (Equivalent Annual Cost) and EAB (Equivalent Annual benefit) is calculated to help solve the
problem of choosing an optimal replacement cycle.

Equivalent Annual Cost

EAC helps deal with the problem of differing time scales. The EAC is essentially just converting the
NPV of a replacement cycle into a yearly cash-flow (with the help of annuity), so that projects with
different lives can be fairly compared. You can only compare like with like, apples with apples.
Hence, when project lives are different, it is unfair to compare such projects. Calculating EAC thus
enables us to compare such projects.
EAC is calculated as follows:

EAC = NPV of replacement cycle

Annuity factor
While computing the NPV, all operational cash-flows such as revenue, variable cost can be ignored
as they remain constant irrespective of the decision. However, the relevant cash-flows are as
follows:
• Maintenance cost.
• Initial investment.
• Scrap value.
Decision rule
The replacement cycle with the lowest EAC is the most optimal and should be chosen.
 Investment Appraisal 66

Example 9

Jindal Co is an international shipping company that is currently preparing its budgets. Their delivery
trucks need to be replaced at regular intervals, management is deciding how frequently they should
replace these trucks. The following is information regarding the replacement:
It costs $50,000 to invest in a new truck.
Replacement cycle Maintenance cost (per year) Resale value
Every 1 year $2,000 $20,000
Every 2 years $2,100 $21,000
Every 3 years $5,100 $15,000

Maintenance costs are respective to each year end. For example, if the trucks are replaced every
two years, there will be a maintenance cost of $2,000 at the end of year one, and the maintenance
cost at the end of year two will be $2,100. Each truck can make 690 trips per year and generate a
revenue of $969 per trip. The fuel costs are equal to $696 per trip. The discount rate applicable s
10% p.a.
Select the optimum replacement cycle.
Solution:
If replaced every three years

Year 0 1 2 3
Maintenance (2,000) (2,100) (5,100)
Investment (50,000)
Scrap 15,000
Net cash flows (50,000) (2,000) (2,100) 9,900
Discount factor 1 0.909 0.826 0.751
Free cash flows (50,000) (1,818) (1,735) 7,435
NPV (46,118)

If replaced every two years

Year 0 1 2
 Investment Appraisal 67

Maintenance (2,000) (2,100)

Investment (50,000)
Scrap 21,000
Net cash flows (50,000) (2,000) 18,900
Discount factor 1 0.909 0.826
Free cash flows (50,000) (1,818) 15,611
NPV (36,206)

If replaced every one year

Year 0 1
Maintenance (2,000)
Investment (50,000)
Scrap 20,000
Net cash flows (50,000) 18,000
Discount factor 1 0.909
Free cash flows (50,000) 16,362
NPV (33,638)

Replacement NPV Annuity @ 10% EAC

1 year (46,118) 0.909 50,735
2 year (36,206) 1.736 20,856
3 year (33,638) 2.487 13,525

As the EAC for the 3 year replacement cycle is the least, Jindal Co is advised to replace their trucks
on a 3-yearly basis.
 Investment Appraisal 68

EAB (Equivalent annual benefit)

As explained earlier, a company cannot use NPV to assess projects with different time horizons. In
addition, if two mutually exclusive projects could be repeated in perpetuity then it is tough to decide
which project to choose. EAB is calculated by expanding the:
EAB = NPV of project
Annuity factor

Decision rule

Project with the highest EAB should be selected.

Capital Rationing

The primary objective of financial management is to maximize shareholder wealth, this is done by
undertaking all positive NPV projects. Capital rationing is when there are insufficient funds to do so.

The following are some of the important capital rationing terms you need to be familiar with:
• Soft capital rationing (Internal): This is when the company itself imposes limitations on
capital availability.
• Hard capital rationing (External): The finance available to invest is limited by external factors.
For example, limited lending by the bank.
• Single period rationing: Shortage of capital for one period only.
• Mutli-period rationing: Shortage of capital for more than one period. (outside syllabus)

Hard rationing Soft rationing

Low credit rating Risk attitude of directors

Limited assets to use as security Poor management skills

Economic factors (recession) Departments may be given limited capital

within the organisation, to encourage internal
competition

Limiting factors due to the industry Sometimes, equity might be the only source
from where a company could raise funds. Thus,
 Investment Appraisal 69

funds could be limited to prevent dilution of

control.

Banks refusing to lend over a certain limit, due

to the company having poor performance in
the past

There are a couple of project terminologies you need to be familiar with:

Divisible projects

The primary objective to keep in mind while capital rationing, is to maximize the NPV per $1 invested
in a project.
Projects are said to be divisible when you can invest in portions and not necessarily the entire
project. For example: You are given an acre of land in which you can plant 100 trees. With 2 acres,
you can plant 200. However, if you are given only a quarter of an acre, you can still plant 25. You can
take up the project in parts, and you do not necessarily need the entire 1 acre.
The above objective can be fulfilled by following these steps:

• Step 1: Calculate the profitability index (PI) for each project, PI is calculated as follows:
Profitability Index = NPV
Investment

• Step 2: Rank the projects based on the PI.

• Step 3: Allocate funds according to the ranking until the capital is used up.

In-divisible projects
These projects cannot be done in portions, the entire project needs to be undertaken. The optimal
allocation of funds can be found by trial and error.
Mutually exclusive projects
When two or more projects cannot be invested together at the same time, they are said to be
mutually exclusive projects.
 Investment Appraisal 70

Example 10
Bhargavi plc currently has 4 investments under consideration, and the company has $130,000
available to invest. Investments must commence from year 0.
Project Initial Investment (Year 0) NPV $
A 45,000 23,000
B 101,000 34,000
C 55,000 23,000
D 60,000 (5,000)

Determine which projects should be taken up, with a view to maximize shareholder wealth:
A. If all projects are divisible
B. If the projects are indivisible
C. If projects are indivisible and project A and B are mutually exclusive
D. If project D must be accepted under any circumstance and all projects are divisible

Solution:

Project NPV Initial Investment $ Profitability Index Ranking

A 23,000 45,000 0.5 1
B 34,000 101,000 0.34 3
C 23,000 55,000 0.4 2
D (5,000) 60,000 -0.083 4

Based on the PI with the available funds of $130,000

i) If projects are divisible

According to the ranking, we can invest in project A, C and 33% of B (34,000/101,000)

Giving us a total NPV of $57,220 (23,000 + 23,000 + (33% of 34,000))

ii) If projects are indivisible using trial and error method

Possible contribution NPV

A+C 46,000
B alone 34,000
C+D 18,000
D+A 18,000

Since A+C gives the highest NPV, it should be the project that should be undertaken.

iii) If projects A and B are mutually exclusive, we select the next best option from above,
which is A+C
 Investment Appraisal 71

iv) D must be invested in; thus, $60,000 worth of capital is tied, which leaves us with
$70,000.

We then allocate $80000 the same way as i).

Therefore, we can invest in D, A and 45.5% of C (25,000/55,000)
The NPV would result to $28,000 [23,000+(45.5%x22,000)-5000]
 Investment Appraisal 72

PO9 – EVALUATE INVESTMENT AND FINANCING DECISIONS

Description

You advise on alternative sources of finance. And you evaluate and review the financial viability of
investment decisions.

Elements

a. Advise on the appropriateness and cost of different sources of finance.

b. Identify and raise an appropriate source of finance for a specific business need.
c. Review the financial and strategic consequences of undertaking a particular investment
decision.
d. Select investment or merger and acquisition opportunities using appropriate appraisal
techniques.

Evaluate projects, financial securities and instruments – and advise on their costs and benefits to the
organisation.
 Syllabus Area B:

Financial Management Environment

 Financial Management Environment 53

The economic environment for business

Syllabus area B1 a-b-c-d (i-iv):

- Identify and explain the main macroeconomic policy targets

- Define and discuss the role of fiscal, monetary, interest rate and exchange rate policies in
achieving macroeconomic policy targets
- Explain how government economic policy interacts with planning and decision-making in
business
- Explain the need for, and the interaction with, planning and decision-making in business of:
i. competition policy
ii. government assistance for business
iii. green policies
iv. corporate governance regulations

This is an important part of the syllabus when it comes to understanding the circumstances under
which a company functions in. It is critical to understand the economic environment because almost
every strategic decision that financial managers have to take will depend on economic factors. It is
essential for mangers to be proactive and assess the economic environment to make decisions
beneficial to the company.

Macroeconomic policy targets

Macroeconomic policy targets are set by the government in order to influence the economy so that
everyone gets a fair environment to function in. This is much easier said than done, here are some of
the major objectives set by the government:

• Full employment: This is self-explanatory, unemployment especially in regions with a high

population such as India, can be an incredible problem to solve. Thus, ensuring everyone has an
income stream is important.
• Economic growth and low inflation (Price stability): Here, growth means improving the
standard of living for people. With high inflation, it becomes difficult for growth thus, it is
essential to have high growth with sustainable inflation.
• Balance of payments: This basically deals with balancing the imports with the exports of a
country. It is calculated by subtracting the total of all the money coming into a country (from
abroad), from all of the money going out of the country during the same period.

We will now further breakdown the macroeconomic policy and study other policies that are used to
influence the objectives discussed above.

Fiscal policy

A fiscal policy deals with achieving the above macroeconomic targets and controlling the overall
activity in the economy. Under the fiscal policy, the government uses taxation and government
spending as tools to influence macro-economic conditions. It is important to understand how fiscal
policies can affect a business:
 Financial Management Environment 54

• Taxation can affect public spending and disposable income.

• Government spending can directly influence specific industries.

Monetary policy

Monetary policy is controlled by the government/central bank with a view to influence the monetary
conditions of a country. Interest rates and money supply are the two key factors that are impacted
by the monetary policy. A good monetary policy is important to control inflation and stabilize the
currency. This could affect a business in the following ways:

• The cost for borrowing money for a business is affected by the change in interest rate. An
increase in the interest rate will lead to an increase in the overall expense for the company,
which hinders growth.
• Increasing the interest rate will most likely apply downward pressure on the share price of a
company.

The following are ways the fiscal and monetary policy can influence certain macroeconomic targets:

FISCAL POLICY

To reduce balance of
For economic growth For low inflation
payment deficit

• Higher government • Lower government • Lower government

spending spending spending
•Lower taxes • Higher taxes • Higher taxes

MONETARY POLICY

To reduce balance of
For economic growth For low inflation
payment deficit

• Increase money supply • Reduce money supply

• Reduce interest rates • Increase Interest rate • Increase interest rates
 Financial Management Environment 55

Example 1

1. The government will reduce spending in a contractionary fiscal policy.

2. In an expansionary monetary policy, the business will most likely see its variable rate
debt interest increase.

Which of the statements are false?

A. (a) only
B. (a) and (b)
C. (b) only
D. Not either

Market failure

Market failure occurs when a specific system fails, this poses to be a hindrance to every
macroeconomic policy discussed in the previous syllabus area. Markets can fail due to various
reasons however, to understand this syllabus area, we are concerned with imperfect competition.
Imperfect competition is essentially one company dominating the entire market, which leads to
unfair opportunities for smaller businesses and excessive profits. We will now study how market
failure can be prevented.

Competition policy

Competition policies primarily exist to counter the problems that come with a monopoly or an
oligopoly. In situations of a monopoly or an oligopoly, the price could be solely controlled by a single
entity or group to earn excessive profits at the expense of their buyers. Thus authorities such as
(Competition and markets authority in the UK) regulates the market to ensure these situations do
not occur. They control competition by making sure a single company or group does not own a
significant portion of the market share, one way of doing this is to regulate large mergers and
acquisitions.

This benefits the entire economy in the following ways:

• Consumer will have a wider variety to choose from.

• Businesses will be motivated to compete, as there is a fair market.
• Healthy competition will promote fair pricing.

Other policies:

• Government assistance: The government is responsible for the fulfilment of certain

economic and social needs. Thus, they provide grants to companies in areas such as health,
medical care, education, innovation, technology, etc.
• Green policies: Majority of the large enterprises fail to consider the effect of their
operations on the society and environment, therefore the government has policies that
ensure companies do not directly or indirectly destroy the environment they function in. For
example, higher taxes for owning cars that emit higher levels of C02.
• Corporate governance codes: This is thoroughly explained in syllabus area A.
 Financial Management Environment 56

Example 2

In which situation would a single company most likely have sole control over setting prices.

Which of the statements are false?

A. Monopoly
B. Oligopoly
C. Perfect Market
D. Totopoly

Solutions:

Example 1 - C

Example 2 – A
 Financial Management Environment 57

PO1 – ETHICS AND PROFESSIONALISM

Description

The fundamental principles of ethical behaviour mean you should always act in the wider public
interest. You need to take into account all relevant information and use professional judgement, your
personal values and scepticism to evaluate data and make decisions. You should identify right from
wrong and escalate anything of concern. You also need to make sure that your skills, knowledge and
behaviour are up-to-date and allow you to be effective in your role.

Elements

a. Act diligently and honestly, following codes of conduct, taking into account – and keeping up-
to-date with – legislation.
b. Act with integrity, objectivity, professional competence and due care and confidentiality. You
should raise concerns about non-compliance.
c. Develop a commitment to your personal and professional knowledge and development. You
should become a life-long learner and continuous improver, seeking feedback and reflect on
your contribution and skills.
d. Identify, extract, interrogate and evaluate complex data to make reliable, informed decisions.
e. Interrogate, critically analyse and assess data and other information with professional
scepticism. You should challenge opinion and facts through corroboration and robust testing.

Example activities

• Applying legislation appropriately to client needs.

• Continually reviewing legislation and regulation that affects your working environment.
• Briefing a team on a new standard and how to apply it.
• Keeping sensitive information confidential and disclosing only to those who need it or when
disclosure is legally required.
• Recognising unethical behaviour and telling your line manager about what you have seen.
• Avoiding situations where there may be any threat to your professional independence.
• Deciding what information is important and reliable, using it to support your decision making.
• Completing all the code of conduct and/or professional ethics training provided by your
organisation.
• Checking transactions and supporting documents to verify the accuracy of accounting records.

Use digital technology responsibly to analyse and evaluate data from a variety of sources, ensuring
the integrity and security of this data.
 Syllabus Area E: 58

Syllabus Area E:

Sources of Finance
 Sources of Finance 59

Syllabus area: E1 a (i-iv)-b (i-iv)-c (i-iv)-d (i-iii)-e (i-iv)

- Identify and discuss the range of short-term sources of finance available to businesses, including:
(i) overdraft, (ii) short term loan, (iii) trade credit, (iv) lease finance
- Identify and discuss the range of long-term sources of finance available to businesses, including:
(i) equity finance, (ii) debt finance, (iii) lease finance, (iv) venture capital
- Identify and discuss methods of raising equity finance, including: (i) rights issue, (ii) placing, (iii)
public offer, (iv) stock exchange listing
- Identify and discuss methods of raising short- and long-term Islamic finance
- Identify and discuss internal sources of finance, including: (i) retained earnings, (ii) increasing
working capital management efficiency, (iii) the relationship between dividend policy and the
financing decision, (iv) the theoretical approaches to, and the practical influences on, the
dividend decision, including legal constraints, liquidity, shareholder expectations and
alternatives to cash dividends.

Sources of finance

Sources of
finance

Equity Debt &

other

Retained (Long term) Government

( medium grants
earnings Debentures, (short term)
Ordinary term)
loan notes, trade credit, Leasing, Hire
shares preference overdraft purchase
shares

Money Market
Capital Market

Short term: Within 1 year

Medium term: 1-7 years
Long term: More than or equal to 7 years

We are all familiar with equity and debt, financial markets are further divided into money markets
and capital markets.
 Sources of Finance 60

Capital Markets

These markets basically deal with long term securities and company shares. Here are the main types
of securities you should be familiar with:

• Company shares: Ownership of a company in the form of security. Shares are traded on the
public stock market.
• Loan notes/Bonds: Buying a bond is like the opposite of taking a loan. When a company
issues a bond, it is basically issuing a document that is given to the buyer, which legally binds
the company to pay the buyer back over fixed instalments along with interest. The way the
payment is done varies and gets more complicated, we will learn the different types of
bonds in business valuation.
• Eurobonds: Eurobonds do not have anything to do with Europe or the Euro currency in
specific, they are basically bonds that are denoted in a currency other than that of the
national currency.

International financial markets exist where entities can acquire funds in a currency other than that
of their national currency. International financial markets is a place where funds in the home
currency can be lent to foreign borrowers, or foreign currency is lent to local borrowers. Note that
the funds transferred must be either of the borrowers or lenders currency. International financial
markets are also known as Euromarkets.
 Sources of Finance 61

Money Markets

Money markets deal with short to medium term securities. The types of securities traded here are
classified as follows:

• Coupon/Interest bearing securities: These are the securities that pay interest, here the
investor receives the face value along with interest on maturity (the last date of any
transaction for a security).
• Discount securities: These do not pay any interest, instead they are issued and traded at a
discount to the face value and redeemed at their par value at maturity. This basically means
the investor will receive less than the face value of the instrument initially, but will have to
pay the entire face value back on redemption.
• Derivative security: This is explained in-depth in Risk Management.

Coupon/Interest
Discount securities Derivative security
bearing securities
•Repo •Treasury bills •Forward rate agreements
•Certificate of deposit •Commercial paper •Cap & floors
•Commercial bills •Interest rate futures
•Banker's acceptance •Option
•Interest rate swap

Other sources of short-term finance:

• Bank overdraft
• Bank loan
• Trade credit
• Leasing
• Sale and leaseback
 Sources of Finance 62

Selecting the source of finance

The relationship between risk and return

This is an important concept and applies to every single chapter and even everyday life. The basic
concept is that risk and return are directly related, i.e., the higher the risk, the greater the return. In
finance, there is always a certain degree of risk for an investor, as he is relying on agents to carry out
an activity and generate returns which will always have a certain degree of uncertainty attached to
it. Thus, if you noticed fixed deposits have really low returns as there is close to no risk involved in
the investment. However, investing in the stock market could potentially make you a millionaire
overnight as it involves high amounts of risk (you could lose everything as well).

Therefore, the higher the risk involved, the higher the lender will expect the returns to be.
Government securities will always be the safest.

Example 1
Which of the following type of investments carries the lowest level of risk?
A. Preference shares
B. Government bonds
C. Bonds
D. Ordinary shares
Solution: B

Criteria for choosing a source of finance

As seen above, there are several ways for a firm to acquire funding, thus it is important that the firm
choses a source that suits its requirements the most. The following are some of the key points that
must be taken into consideration while selecting a source of finance:

• Cost: As discussed earlier the higher the cost of funding the worse it is for the firm as their
profits will reduce. A general rule of thumb is that debt is cheaper than equity, this is because
equity holders receive returns in the form of dividends which are uncertain and depend on
company profits, while debt gives guaranteed fixed returns in the form of interest. In addition,
interest is tax deductible, whereas equity finance is not.

• Matching duration: This means that companies usually tend to match the duration of assets
with that of their liabilities. Higher risk is associated with a longer duration while investing or
borrowing this is because the future is uncertain. Thus, longer term loans tend to be more
expensive than shorter term loans. Plus, unlike short term loans, long term loans cannot be
withdrawn with short notice. Normally, short term funds should finance short term assets, and
long term assets should be financed by long term loans.

• Term structure of interest rates: It is always assumed that interest rates follow an upward
sloping yield curve, this is explained in the next chapter.
 Sources of Finance 63

• Gearing: Gearing refers to the ratio of debt to equity. High gearing means that the company is
using more (cheaper)debt than equity. A company with high gearing is perceived to be risky,
thus from the perspective of the investor, gearing is directly related to risk. This is because, debt
is associated with fixed interest payments, while dividend payments are not fixed. So higher
debt would mean that the company is obliged to pay several fixed payments, which increases
the chance of the company going bankrupt. That is why it is important for any company to
maintain their gearing level to an industry-accepted level, otherwise, it will be difficult for them
to get investors.

• Accessibility: Companies do not always have access to unlimited sources of funding. In addition,
as discussed earlier, some companies have their capital rationed.

• Security: It is much easier for a company to be granted longer term loans if they have assets
which can be used as collateral for the loan.

Example 2

Which of the following is the most likely to not be a reason for seeking a stock market floatation?
A. Enhancement of the company’s image
B. Transfer of capital to other uses
C. Access to wider pool of finance
D. Improving existing owners control over the business
Solution: D

Leasing

A lease is a contract between two parties for the hire of a specific asset. The party providing the
asset is called as the lessor, while the party taking it on hire is known as the lessee. The following are
some different types of leases.

Operating lease

Under Operating Lease, the lessee has the right to use the asset for the short term, but the lessor
retains the rights and ownership of the asset. The running costs and administration is usually in the
lease payments. For example, car rentals. Ownership is not transferred to the lessee, thus risks and
rewards associated with the asset stays with the lessor.

Finance lease

Under finance lease, the lessor provides funds to the lessee to buy a specific asset, the lessee pays
the lessor a fixed lease payment for a specific period of time. Initially, the ownership of the asset lies
in the hands of the lessor but after the repayments are over the ownership is transferred to the
lessee. The running and admin costs are usually not included in the lease payments and will have to
 Sources of Finance 64

be borne by the lessee. Ownership is transferred to the lessee, thus risks and rewards associated
with the asset stays with the lessor. For example, car loans.

Sale and lease back

A company if in need of a lump sum amount of cash but at the same time requires its assets, can sell
an asset and rent it back from the acquirer, this is known as a sale and lease back. The acquirer is
usually a pension fund or an insurance company.

We will now look at long term finance in detail.

Long term finance

1) Ordinary shares

• Equity shareholders are the owners of the business and exercise ultimate control.
• Shareholders have voting rights in general meetings.
• When a company goes bankrupt, equity shareholders can claim the assets that remain after
paying back creditors and preference shareholders. Thus, they are ranked last.
• Equity shareholders receive dividends from the remaining profits but at the discretion of the
company.
• They have the right to surplus funds after prior claims have been met.

2) Preference shares

• Unlike equity shareholders, Preference shareholders receive fixed dividend per annum
regardless of what the company profits are for that year. Payment of preference dividend is
not compulsory. But, if the company decides to pay, then preference dividend has to be paid
at the fixed rates.
• Therefore, preference shares are not considered as equity but as debt as they have
characteristics closer to debt.
• During liquidation, they are usually ranked before the equity shareholders when it comes to
claiming assets.
• Preference shares are further divided into the following two categories:
- Cumulative preference shares: If the company does not pay dividends, they can be
accumulated over the years. In this case, the preference shareholders would receive
voting rights, but will need to be paid their dividends before equity shareholders are
paid.
- Non-cumulative preference shares: If there are dividends in arrears, they cannot be
accumulated here, but instead, the shareholders will receive voting rights if
dividends are accumulated for over three years.
 Sources of Finance 65

Raising equity

We will now learn how a company can raise finance:

1) Retained earnings

These are basically funds that are retained from the annual profits of the company. It is the
cheapest source of finance for a company.

2) Issuing shares to new shareholders

A company can issue shares the following ways:

• Placing: A placing is where the company places or sells its shares to a financial institution,
and if the public wishes to buy these shares, they can buy from the financial institution. It is
the sale of shares to a small number of private investors that are usually exempted from
registration with securities exchange authorities.

• Public offer: The newly issued shares are directly offered to the public to purchase. These
are further divided into the following:
- Fixed price: Shares are offered at a fixed price to the public.
- Tender: The potential investors need to bid for shares here, and the highest bidder
will get to purchase the share of their choosing. This is kind of an auction for shares.

• Offer for sale: Companies wishing to raise capital by an offer for sale will sell a block of
shares to an issuing house or an underwriting institution which then will an offer to the
general public.

• IPO (Initial Public Offering): This is where a company sells its shares to the public via a public
stock exchange, it is a tedious process where a company will have to first register and
further adhere to every requirement put forward by the stock exchange. This is where a
company ‘goes public.’

3) Issuing shares to existing shareholders

Existing shareholders have a pre-emptive right to subscribe for newly issued shares. A rights
issue is an offer to existing shareholders to subscribe for new shares at a discount to the
 Sources of Finance 66

current market value of a share, but in proportion to their current shareholding. Pre-emptive
essentially means, a certain party having access to purchase shares before the general
public.

It is important that you understand the effect of a rights issue on the shareholding. The
following are key elements to a rights issue:
a) Offer price: This is the price at which a company issues the rights offer.

b) Issue quantity: The number of new shares that are going to be issued.

c) Terms of issue: The shares will be offered in a specific ratio, this is in proportion to their
current shareholding. For example, “company ABC will offer a 1 for 3 rights issue at a
discount of 20%”, which means that the company is going make a rights issue of one
new share for every for every two existing shares held at a discount of 20%.

d) TERP (Theoretical ex-rights price): A rights issue will usually have an effect on the
market price of all the shares that are trading. Thus TERP is the theoretical price a stock
should have after a rights issue has taken place.

e) Value of a right: This is the difference between the TERP and offers price, it is essentially
the value gained to a shareholder for taking up a rights issue.

We shall now see how to calculate the TERP for a rights issue.

Ex-rights price = (Portion of existing shares x issue price) + (Portion of new shares x offer price)
Total number of shares
Value of a right = TERP – offer price

Apply Your Knowledge:

Crackle Ltd has a current market price of $16 per share and wishes to raise $2,560,000 via rights
issue at a discount of 40% to market price. There are currently 1,200,000 shares in issue.

Calculate the following:

1. Offer price
2. Issue quantity
3. Terms of issue
4. TERP
5. Value of a right

Solution:

1. Offer price = (1-0.4) x 16 = $9.6

2. Issue quantity = $2,560,000/$6.4 = 266,667 shares
3. Terms of issue = 266,667/1,200,000 = 2/9 i.e. 2 shares issued for every 9 shares owned
 Sources of Finance 67

4. TERP = ((2 x 9.6) + (9 x 16))/11 = $14.84

5. Value of a right = 14.84 – 9.6 = $5.24

Thus, from the above Apply Your Knowledge, we can see that the share price post the rights issue
(ex-right price) tends to fall in value after a rights issue. However, we shall see how this affects
shareholders in the next part.

Shareholders options with a rights issue

It is important to understand the effect of a rights issue on the shareholders. When there is a rights
issue, a shareholder will have the following options:

1) Take up his right by buying the specified proportion at the price offered
2) Take up his rights and sell them in the market
3) Take up his rights and sell part of it in the market
4) Do nothing

Apply Your Knowledge:

Xenophage Co has a share capital of 50 million shares with a current market value of $0.43 each. It
announces a 2 for 4 rights issue at a price of 20c per share. Thus, Xenophage Co would like to raise
$5 million in new funds by issuing 25 million new shares.

Calculate the TERP and for a shareholder Ramu, holding 500 shares in Xenophage Co, consider his
wealth If he;

1. Takes up his right

2. Sells his right
3. Takes up his right and sells 150 shares
4. Takes no action
Solution:

Current Holding:
No of shares 5,00,00,000.00
MV per share 0.43
Total MV 2,15,00,000.00
Rights Issue:
2 for every 4 shares
Total Shares issued 2,50,00,000.00
Price of Rights share 0.2
Total Equity raised 50,00,000.00
TERP (4*.43 + 2*.2)/6 0.35333333
 Sources of Finance 68

1. Takes up his right

Existing shares with RAMU 500

Shares Issued 250
Total Shares 750
Value of Shares:
Existing (before taking the right) 215
Post taking the right 265
Difference 50
Paid for the right 50
Ramu will be indifferent with the choice of taking up or not taking up the right

Since, he takes up the right here, there is no gain or loss

2. Sells his right

Existing Value of shares 215

Value of 500 shares after taking up the right 176.6666667

Net Capital Loss in share valuation 38.33333333

Cash received on sale of rights 88.33333333
Cash paid to purchase the right 50
Net Gain 38.33333333

Since the net gain on sale is the same as net capital loss in share valuation,

There is no gain or loss to Ramu

3. Takes the right and sells 150 shares

Existing Value of shares 215

Net share value post rights issue 265
Cash paid for rights issue -50
Net Value 215
Selling off 150 shares
Left with 600 shares
Share Value of 600 shares 212
Cash paid for rights -50
Cash received on sale of 150 shares 53
Net Value of 600 shares & sale 215

Since the net gain on sale is the same as net capital loss in share valuation,
 Sources of Finance 69

There is no gain or loss to Ramu

4. Takes no Action

Value of existing 500 share:

Pre Rights issue 215
Post Rights issue 176.6666667

Net Loss 38.33333333

If Ramu takes no action, he faces a loss of $38.33

Scrip issue / Bonus issue

A bonus issue is when shares are offered for free to current shareholders in proportion of their
existing shareholding.

From a company perspective, this is advantageous as:

• If taken up, it will reduce the actual cash outflow from a company as compared to a cash
dividend. This is useful when liquidity is a problem or when capital is needed for investment
or financing needs.
• An important point is that scrip dividends increase the amount of equity of a company, thus
this will bring down the gearing of a company. As discussed earlier, a low gearing will assist
the company in being perceived as a low-risk investment.

It is disadvantageous as:

• It will be a problem to the company if it decides to give out a cash dividend as a total
number of shares has increased, and the total dividend payable will also have increased.

Scrip dividend vs. Bonus issue – With a scrip dividend, the shareholder has the option of receiving
the dividend in the form of cash or additional shares. With a Bonus issue, there is no option, the
shareholder just receives additional shares.

Long term finance (Debt)

We shall learn in detail about the different types of long-term debt

Bonds

• Bonds are also known as loan notes, loan stock or debentures.

• They are securities that are traded on the stock market
• They may be further divided as secured or unsecured
 Sources of Finance 70

• They may be redeemable or irredeemable

Redeemable debt

This is where the principal as well as the interest is repayable at a future date. Thus the word
‘redeemable’ as the principal amount is paid back.

Irredeemable debt

In this case, as the word ‘irredeemable’ suggests, the principal is not paid back at any specified date
in the future. Instead, interest is payable in perpetuity.

Advantages and disadvantages of bonds or other kind of long-term debt.

It is important that you understand the advantages and disadvantages from the view of either party.

From the investor’s point of view

Advantages

• Low risk: A bond will give a fixed yearly return irrespective of the profits of the company,
thus it is considered as low risk. This is also a reason why the investor will expect low
returns.
• Predictable income: Investing in traditional long term debt securities like bonds, will give
returns in the form of fixed interest. Thus, bond income is predictable.

Disadvantages

• Has no voting rights: Unlike equity shareholders, investing in a traditional bond will not give
you voting rights.
• Fixed returns: Fixed returns protects your downside risk, but also prevent the potential of
gaining a higher return.

From the point of view of the company

Advantages
 Sources of Finance 71

• Cheap: As mentioned earlier, the lower the risk, the lower will the investor expect the
return. Thus, debt having lower risk as compared to equity debt is a cheaper source of
finance.
• Has predictable cash flows: Again, debt gives fixed returns, thus a company can forecast
how much the expense is going to be.
• Does not dilute control: Investors do not get any shareholding of the company; thus, control
will not be diluted.

Disadvantages

• Inflexible: The company will have to make sure they can pay the amount of pre-determined
interest on the bond.
• Increase risk at high level of gearing: As mentioned earlier, a company with high gearing will
be perceived as high risk.
• Must be repaid: Unlike equity, interest payments must be made irrespective of the profits.

Types of bonds

1) Deep discount bonds: Similar to discount securities studied earlier, deep discount bonds are
basically bonds that are issued at a large discount to its nominal value and will be
redeemable at or above its par value on maturity. Companies with a low credit rating will
usually issue deep discount bonds.
For example, an original issue bond may be issued at $97 with a $100 par value, and a deep-
discount bond may be issued at 60 with a $100 par value.

2) Zero coupon bond: These bonds are issued at a discount to their redemption value, but no
interest is paid on them. The discount on the bond is the return for the company that issues
the bond.
For example, an investor who purchases a bond at a discount for $90 will receive $100. The
$10 return, plus coupon payments received on the bond, is the investor's earnings or return
for holding the bond

3) Convertible loan notes: These are essentially loan notes that give the investor the right (not
obligation) to convert the redemption value into ordinary shares at a predetermined ratio
or price. You will learn about convertible loan notes in detail in the next syllabus area.

4) Loan notes with warrants: Warrants give the holder the right to subscribe to a specified
number of ordinary shares at a pre-determined price at a certain fixed future date. If
warrants are issued with loan notes, the bond holder will not be able to convert to equity,
but will have to make a cash payment for the shares and will retain the loan notes till
redemption. For companies, an advantage of warrants is that, the loans can be issued at a
lower-than-normal interest rate because of the conversion option. Thus, it is a form of
getting finance at a low cost.
 Sources of Finance 72

Factors that affect the interest rate on the new issue of bonds

As it is a competitive environment, companies are not exactly free to issue bonds at any interest
rate, it depends on various factors. The following are some of the factors that can affect the interest
rate on a new issue bond:

• General economic conditions: From the company’s perspective, during a poor economy,
funding is scarce, thus the interest rate (return to investors) will tend to rise.
• Risk profile of the company: As mentioned repeatedly, a company that is perceived as high
risk will be charged a higher interest rate by investors.
• Availability of security: If there are not enough assets for security, the investment will
obviously be perceived as high risk. Thus interest rates demanded by investors will tend to
rise.
• Duration of the bond: Uncertainty increases with time, thus as the risk is increased the
longer the duration of the bond, the higher will be the interest charged on it.
• Conversion clause: Like discussed in the types of bonds, if the bond has any form of a
conversion clause, it is possible to keep investors satisfied with lower interest rates.
 Sources of Finance 73

Finance for SME’s (Small and medium enterprises)

As the name suggests, SME’s are small unestablished, or even unquoted companies, thus it would be
harder for them to get access to all the forms of finance. As these companies might not have
adequate financial and other controls, no established track record, lack of security or a market
standing, investors will find it difficult to invest in these companies.

This gives rise to a funding gap, because SME’s are, for the most part in need of finance, and it is
hard for them to get this finance.

The funding gap can be bridged through the following ways:

Financial investors

- Business angels: If you are familiar with the show Shark Tank, the investors there are essentially
business angels. These are private individuals that are established and have experience as
business professionals. So these individuals use their expertise and invest in these SME’s in
exchange for an equity stake in the company. Business angels can use their skills to manage the
business as well, which can prove to be beneficial to the SME.

- Venture capitalists: Venture capitalists are distinct from business angels as they are institutions
or companies and not an individual that provides funding to SMEs.

Government solutions

- Alternative investment market: Despite having a good idea and decent growth, SME’s can find it
difficult to get a listing on a public stock exchange as there are several requirements that need to
be fulfilled to get a listing. Thus, the government has introduced an Alternative Investment
Market whereby these SME’s can basically get a listing.

- Governments tend to provide SMEs with grants to help them establish themselves.

Islamic finance
Islamic finance is different to the traditional system of finance even though it serves the same
purpose. Islamic finance is based on the rulings of Sharia Law on financial and commercial
transactions. Islamic finance is based on the following principles:
• Finance cannot be sourced to or from activities that are not accepted in Islam. For example,
gambling, alcohol, etc.
• All parties involved must be fairly treated and should be able to make informed decisions
without being cheated.
• Interest (known as Riba) is forbidden in Islamic finance. Interest is replaced by earnings
generated through an underlying investment activity. It is further explained below.
 Sources of Finance 74

How returns are earned

The traditional banks get funds by allowing investors to deposit their money in exchange for interest.
Banks make a profit by lending those funds at a higher interest rate than the interest they pay out to
the depositors. This process is forbidden in Islam.
In an Islamic bank, the funds received by depositors is channelled to an underlying investment
activity which will earn profit. The depositor will earn a share in profit after a management fee is
deducted by the bank.
Thus, interest is replaced with cash flows from productive sources, such as activities that generate
wealth.

Sources of Islamic finance

These are critical to remember as the Islamic finance is broadly classified into 2 categories of finance
techniques:

Islamic sources of finance

Fixed income
Equity finance
1) Murabah
1) Mudaraba
2) Ijara
2) Musharaka
3) Sukuk

Fixed income
1) Murabaha

You can remember this as a form of trade credit. The main difference is that with a
Mubaraha, the bank will actually take physical ownership of the asset. This asset will then
be sold to the borrower for a profit, but the payment is made over a fixed number of
instalments. The period of the repayments could be extended, but no additional mark-up,
nor any penalties can be added by the bank.

2) Ijara
 Sources of Finance 75

You can remember this as a form of lease finance. The way an Ijara contract works is, the
bank will provide the asset or equipment such as motor vehicles or machinery to the
customer in exchange for a fixed price over a specified period. The following are the
specifications of an Ijara contract:
- The use of the leased asset must be specified in the contract.
- The lessee is not responsible for the major maintenance of the underlying asset,
the responsibility lies with the lessor (bank).
- Although, the lessee is responsible for the general maintenance of the asset.
An Islamic lease is like an operating lease but shows the redemption features that are similar
to that of a finance lease.

3) Sukuk

This can becalled as an Islamic bond. Traditionally investors will invest in a company’s bond
that will pay out a fixed amount of interest before the company pays out its dividends. This
again, is forbidden in Islamic finance. Instead, investment in Sukuk will be linked to an
underlying asset, thus the Sukuk holder becomes a partial owner in that asset and profit
(returns) is linked to the performance of the underlying asset. A Sukuk holder will have a
right to profits but will also equally bear any losses.
 Sources of Finance 76

Equity finance

1) Mudaraba

This is similar to equity finance. A Mudaraba forms a type of partnership where one partner gives
money to another partner for investing in a commercial enterprise. The first partner is called ‘rab-ul-
mal,’ this partner provides funds for investment. the second partner is known as ‘mudarib,’ this
partner provides investment and management expertise.
Mudaraba is a contract where one party provides all the capital, and the other uses their knowledge
to manage the investment. The profits generated are shared in a pre-determined ratio, but the
losses are solely borne by the ‘rab-ul-mal.’ Thus, it is similar to equity finance.

2) Musharaka

This is similar to a joint venture or partnership. Musharaka is a relationship where two or more
parties form an agreement to contribute capital to a business and share both profits and losses pro
rata. All providers of capital are entitled to participate in management but are not required to do so.
Losses are borne by every partner in proportion to their respective capital contributions, while profit
is distributed in accordance to a pre-determined ratio.
 Sources of Finance 77

Example 3
Which of the following statements are false about money market instruments?
1. Discount instruments trade at less than twice face value
2. A negotiable security can be sold before maturity
3. The yield on commercial paper is usually lower than on treasury bills

A. 1 and 3 only
B. 2 only
C. 1, 2 and 3
D. 1 only
Solution: B

Example 4

Which of the following is/are true about a rights issue?

1. Relative voting rights are unaffected if shareholders exercise their rights
2. If shareholders do not take up the rights, the rights lapse
3. Rights issue do not require a prospectus
4. The rights issue price can be at a discount to the market price

A. A, C and D
B. A, B, C, and D
C. B only
D. A only
Solution: A
Syllabus area E2a (i-iv)-b (i-v)-c (ii):

- Estimate the cost of equity

- Estimating the cost of debt

Introduction

We have briefly learnt about the cost of capital in syllabus area D, this section focuses on how we
get to that cost of capital. The cost of capital is an essential element for valuation, valuation of
investment projects (NPV discount factor), valuation of company shares, valuation of debt. This is
because the company needs to incorporate the cost that it owes to the lenders of finance.

Another important concept to remember is the relationship of risk and return that was discussed in
the previous syllabus area. You also have to keep in mind the two perspectives involved here, the
investors’ perspective and the company’s perspective. Basically, based on the source of finance, we
will have to evaluate the return expected from the equity shareholder, preference shareholder and
debt holders separately.

We shall be using the market values of each security to calculate the cost of that security. Further,
we shall calculate the cost of each security and take their weighted average to calculate the cost of
capital.

We will learn how to establish the cost of:

• equity
• preference shares
• bonds
• convertible loan notes

Cost of equity – dividend valuation model (DVM)

The cost of equity is the return expected by the equity shareholder

As we are trying to estimate the cost of equity, we need to use the following assumptions:
(Important)

• Dividends will be paid in perpetuity

• Future income is by the dividends paid out by the company
• Dividends will be constant or will grow at a fixed rate.
 Sources of Finance 75

Formula for DVM:

DVM without dividend growth: Ke = d0

ExP0

Where,

Ke = Cost of equity

d0 = Annual dividend

P0 = Current share price (Ex Div/after dividend is paid)

When the dividend is expected to grow at a constant rate then:

DVM with constant dividend growth: Ke = d1 + g

ExP0
D1 = D0(1+g)

Where,

P0 = Current share price(Ex Div)

D0 = Current dividend

d1 = Dividend in one year’s time

g = Annual growth in dividends

Generally, once a company pays out dividends, its share price tends to reduce by the amount of
dividend paid. Thus,

cum div/cum P0 = share price before dividend is paid

Ex-div/ExP0 = Cum P0 – d0 (share price immediately after dividend is paid)

The examiner will trick you with the dividend and give you the share price before dividends have
been announced, but you always need to convert it to an ExP0 share price, if the company pays out
dividends.

If you observe carefully, this is nothing but the formula for calculating the present value of a
perpetuity.

Think of it this way – What does the current market price of any security reflect? It tells me how
much I am willing to pay to buy that instrument,

The next question you must ask is – How do I know how much am I willing to pay? I will pay no more
than the present value of all future cash flows I will get from this security. Hence the formula.
 Sources of Finance 76

Estimating growth

Sometimes, you will be given information pertaining to certain years, you will have to use your
judgement here and estimate a growth rate. In addition, as mentioned above, you will have to
assume that the growth rate is going to be fixed for the future, unless mentioned otherwise. The
growth rate is estimated as follows:

Geometric Historic growth approximation (leaps method): g = ( Latest year ) 1/n - 1

Oldest year
Where,

n = number of leaps

For example, if the information is given as: Leap 1 Leap 2

Year 2010 (current year) 2011 2012

Dividend paid $0.65 $0.77 $0.88

Here, n = 2 as there are just 2 leaps

Another method to estimate growth is by using the gordon’s growth model, which is calculated as
follows:

Gordons growth model: g = bre

Where,

b = proportion of retained earnings (1-dividend payout ratio)

re = returns on the re invested funds

In the exam, you might not directly get the growth figure given to you, you will have to assess the
data given to you and apply growth wherever data pertaining to either of the above models is given.
Another important tip to remember is that ordinary share dividends depends on the profit
generated by the company, thus dividend growth also represents sales or company profit growth
and vice versa.
 Sources of Finance 77

Apply Your Knowledge:

a) The market value of Salman plc shares is $9.6. It is due to pay a dividend next week of 80
cents. The company expects to pay a similar dividend every year in the near future.
b) The market value of Joji plc shares is $6.40. It is due to pay a dividend one year from now of
$0.72. The expected growth in dividends is 10%.
c) Lucky plc’s shares are currently valued at $7.0 per share. Lucky paid a dividend a week ago of
$0.48, which represents a 4% increase on the previous year. This rate of growth has been
maintained for the past five years.
d) Clank plc has an ordinary share price of $4.0, 0.4 cents dividend has just been announced
which is in line with the company’s objective of 5% per annum growth in dividends.
e) An Ignite plc share has a current market price of $9.58 and has paid the following annual
dividends over the past 5 years:

Year Dividends payable

20X9 (current year) 48 cents (Payable soon )
20X8 42 cents
20X7 38 cents
20X6 30 cents
20X5 28 Cents

f) Ariana plc has a current share price of $10 and has recently paid out a dividend of $0.5 per
share which represents a dividend payout ratio of 40%. The company makes an average
return of 16% on re-invested funds.

Compute the cost of equity for each of the above companies.

Solution:

a) ExP0 = 9.6-0.8 =8.8

Ke= 0.8/8.8 = 9.09%
 Sources of Finance 78

b) d1 = 0.72
ExP0 = 6.4

Ke = (0.72/6.4) + 0.1
Ke = 21.25%

c) d0 = 0.48
g = 4%
d1 = 0.48 x 1.04
= 0.5
ExP0 = 7.0

Ke = (0.5/7) + 0.04
Ke = 11.14%

d) d1 = 0.4 X 1.05 = 0.42

g = 5%
ExP0 = 4-0.4 = 3.6

Ke = (0.42/3.6) +0.05
Ke = 16.67%

e) g = ((0.48/0.28)1/4)-1 = 9%
ExP0 = 9.58-0.48 = 9.1
D1 = 0.48 x 1.09 = 0.5232

Ke = (0.52/9.1) +0.09
Ke = 14.7%

f) g = 0.16 x 0.6 = 9.6%

d1 = 0.5 x 1.096 = 0.548
Ke = (0.548/10) + 0.096
Ke = 15%
 Sources of Finance 79

Cost of preference shares

This is basically the return expected by the preference shareholders. As the dividend payable with
preference shares is fixed regardless of the company’s profit, there is not growth involved here.

Kp = d0 x Face value/Nominal value per share

ExP0

Where,

D0 = constant annual preference dividend

ExP0 = Current preference share price (ex-div)

Remember that d0 is based on the nominal/face value of the preference share, which may vary
according to the question, it is not an assumption that the face value is always $1.

Apply Your Knowledge:

The current ex-div value of Miles Co preference shares is 25 cents. These shares pay a 6% coupon
rate and have a face value of $0.7 each.

Calculate the cost of preference shares.

Solution:

Kp = [0.06*0.7]/0.25 = 16.8%

Cost of debt (Net of tax)

As mentioned earlier, debt is tax deductible thus, the cost of any debt will always net of tax, i.e.
incorporating the tax benefit in the cost
 Sources of Finance 80

Cost of debt

Traded debt Non-traded debt

1) Irredeemable debt 1) Bank loans
2) Redeemable debt
3) Convertible debt

1. Irredeemable debt

As mentioned in the previous section, irredeemable debt is where the company does not
pay the principal, but pays interest in perpetuity.

Cost of irredeemable debt (net of tax): Kd = i(1-T)

ExP0

Where,

Kd net = cost of debt (net of tax)

i = Annual interest (not in decimal)
t = Marginal tax rate (as a decimal)
P0 = Current market price of debt (ex-interest)

Debt is always quoted in a $100 nominal value block, thus 1 bond will have a nominal value
of $100. Interest paid on debt is stated as a percentage of the nominal value. Cum interest
and Ex-div is used the same way as was used in the cost of equity calculations.

2. Redeemable debt

As studied in the previous syllabus area, redeemable debt is where interest is paid for a
certain number of years, and then the principal is paid on maturity.
For calculation, the best way to find a rate of return(which is cost, from the company’s
perspective) of a bond we can basically use the same concept used while computing IRR.
Thus, we assume two discount rates to find a mean which will be the cost of redeemable
debt.

The relevant cash flows are as follows

 Sources of Finance 81

Year Description Cash Discount rate PV Discount rate PV low

flows high (assumed) high low
(assumed)
Year 0 Current market price (x) X (X) X (X)
(ExP0)
Year 1-n Coupon interest (1-t) X X X X X
Year n Redemption value X X X X X
NPVH NPVL

Now use the same IRR formula as used in investment appraisal, with the discount rates and
NPV’s above. Thus, Kd net of tax= IRR of the investment

Apply Your Knowledge:

a) Zavala Inc currently has an issue of 4% irredeemable bonds quoted at $100 cum int.
Corporation tax is at 25%. Compute the cost of debt.

b) Cayde plc has issued 9% bonds redeemable at an 11% premium in six years. If the bonds is
presently trading at $100, compute the cost of debt (Tax rate is 30%)

c) Compute the cost of debt when Ikora plc has 10% bonds in issue quoted at $96 excluding
interest. The bonds will be redeemed at a premium of 11% compared to a nominal value of
$100 in 3 years. The corporation tax rate is 30%

Calculate the cost of debt for each of the above companies.

Solution:

a) Kd = [4*0.75]/96 = 3.125%

b) We need to compute the IRR

C/F D.F.@ 10% PV D.F. @ 5% PV

(100) 1 (100) 1 (100)

6.3 [9*0.7] 4.355 27.44 5.076 31.98

110 0.564 62.04 0.746 82.06

(10.52) 14.04

IRR = 0.05+ [(14.04/(14.04+10.52))*(0.1-0.05)]

IRR = 7.8%

c)
 Sources of Finance 82

C/F D.F.@ 10% PV D.F. @ 5% PV

(86) 1 (96) 1 (96)

7 [10*0.7] 4.355 30.485 5.076 35.532

111 0.564 62.6 0.746 82.8

(2.915) 22.338

IRR = 0.05+[(22.338/(22.338+2.915))*(0.1-0.05)]
IRR = 9.42%

Convertible debt

Convertible debt is essentially a loan note which has the option to either redeem the bond and
receive its redemption proceeds or convert the loan note into ordinary equity shares at a certain
date.

The calculation for the cost of convertible debt is similar to that of redeemable debt, except you will
have to perform a few more steps here. We assume that the investor will take the option with the
highest redemption value, thus we calculate the redemption value of the bond and the estimated
value of the equity shares on the redemption date.

Note that there is no tax effect irrespective of the option chosen on the redemption date.

The following are the steps to calculating the cost of convertible debt:

1. Calculate the conversion value (estimated value of ordinary shares on redemption date).
Conversion value = no. of shares x value per share x (1 + growth%) number of years
 Sources of Finance 83

2. Compare the conversion value with the cash redemption value. Choose the higher value and
use it in the computation.
3. Calculate the IRR of the cash flows the same way it was done in redeemable debt

Example 5

a) Omega plc has issued convertible loan notes, which are due to be redeemed at a 10% premium
in 5 years. The coupon rate is 9% and the current MV is $95. Alternatively, the investor can
choose to convert each loan note into 22 shares in five year’s time. The company pays a tax at
30% per annum.
Omega’s shares are currently worth $3, and their value is expected to grow at a rate of 9%
p.a.

b) Offset co has a 7% loan note in an issue that’s currently trading at $95. The loan stock is
redeemable at a 5% premium to face value in 5 years, or can be converted into 35 ordinary
shares at that date. The current market price of one share of the company is $2, but this is
expected to grow at the rate of 10%. The corporation tax rate is 30%

c) Quavo Co has 5% convertible loan notes in the issue. Interest is paid annually, and the tax is
50%. On the conversion date in two years’ time, the investor can choose between redemption
at a 15% premium or ordinary shares, which are expected to be worth $90 on that day. The
nominal value of a loan note is $100, which is currently trading at $114.

Compute the post-tax cost of the convertible debt for each of the above companies.

Solution:

a) Choices are to be decided on which option yields the higher return after 5 years

Value of Converting the bond into shares:

Current MV 3
g 9%
time 5 years
MV at the time of conversion 4.615871865
Total number of shares 22
Value 101.549181
Value of Redemption:
Redemption at 10% Premium 110

Since the value of redemption is higher, we assume all investors will redeem their debts.

Now, we need to calculate the IRR

CF DF @ 10% DCF DF @ 5% DCF

-95 1 -95 1 -95
6.3 3.791 23.8833 4.329 27.2727
 Sources of Finance 84

110 0.621 68.31 0.784 86.24

-2.8067 18.5127

IRR 9.34%

b) Choices are to be decided on which option yields the higher return after 5 years

Value of Converting the bond into shares:

Current MV 2
g 10%
time 5 years
MV at the time of conversion 3.22102
Total number of shares 35
Value 112.7357
Value of Redemption:
Redemption at 10% Premium 105

Since the value of redemption is higher, we assume all investors will convert their debts.

Now, we need to calculate the IRR

CF DF @ 10% DCF DF @ 5% DCF

-95 1 -95 1 -95
4.9 3.791 18.5759 4.329 21.2121
112.7357 0.621 70.0088697 0.784 88.3847888
-6.4152303 14.5968888

IRR 8.47%

c) Choices are to be decided on which option yields the higher return after 5 years

Value of Converting the bond into shares:

MV at the time of conversion 90
Value of Redemption:
Redemption at 15% Premium 115

Since the value of redemption is higher, we assume all investors will redeem their debts.

Now, we need to calculate the IRR

CF DF @ 10% DCF DF @ 5% DCF

-114 1 -114 1 -114
2.5 1.736 4.34 1.86 4.65
 Sources of Finance 85

115 0.826 94.99 0.952 109.48

-14.67 0.13

IRR 5.04%

Non-tradable debt

This basically includes personalized bank loans, which obviously will not be traded on a financial
market. The only calculation necessary is to include the tax benefit by making the interest rate a
post-tax interest rate. Note, there is no market value for non-traded debt.

Kd net = interest rate x (1-T)

Weighted average cost of capital (WACC)

This is the ‘cost of capital’ which you might have repeatedly come across while solving investment
appraisal questions. As the name suggests, it is the weighted average cost of all the sources of
finances for a company. The term ‘weighted’ is used as the costs that need to be allocated in
proportion to the market value of each source of finance.

The WACC is computed as follows:

Type Market value Proportion (a) Cost of capital (b) WACC (a x b)

Equity X X (MV of Ke X
equity/total MV)
Debt X X (MV of debt/total Kd net X
MV)
Preference shares X X (MV of pref. Kp X
shares /total MV)
Total MV WACC
 Sources of Finance 86

Example 6

Otenga plc has the below capital structure (as at year end 20X9)

5 million $1 equity shares: $5 million

Reserves: $2 million
13% loan stock 2024: $4 million

The loan stock may be redeemed at par in 2024. The current market value for an Otenga share is
$2.80, and the 13% loan stock is trading at $100.

The company is to pay a corporation tax at a rate of 30%. The cost of the company’s equity share
capital is estimated at 11%.

Calculate the cost of capital for Otenga plc.

Solution:

Cost of Equity 11%

Total Market Cap of Equity 1,40,00,000.00

Cost of Redeemable Shares Calculate IRR

CF DF @ 10% DCF DF @ 5% DCF
-100 1 -100 1 -100
9.1 3.791 34.4981 4.329 39.3939
100 0.621 62.1 0.784 78.4
-3.4019 17.7939
IRR 9.20%
Total Market Cap of Loan Notes 40,00,000.00

Calculation of WACC

Source Market Cap Proportion Cost of Cap Wt Avg

Equity 1,40,00,000.00 77.78% 11% 8.56%
Loan Notes 40,00,000.00 22.22% 9.20% 2.04%
1,80,00,000.00 10.60%
WACC = 10.6%

Apply Your Knowledge:

TUPAC Co has 10 million 50c ordinary shares in issue with a current price of 150c cum div. An annual
dividend of 10c has just been proposed. The company earns an accounting rate of return to equity
(ROE) of 10% and pays out 30% of the return as dividends. The company also has 12% redeemable
loan notes with a nominal value of $8 million, trading at $100. They are due to be redeemed at par
in five years’ time.

If the rate of corporation tax is 30%, what is the company’s WACC?

 Sources of Finance 87

Solution:

Calculation of cost of equity

g = ROE*Retention Rate

= 0.7*0.1 = 7%

Ke = (d0(1+g)/P0)+g

= (0.1(1.07)/1.4)+0.07 = 14.6%

Calculation of redeemable debt

C/F D.F.@ 10% PV D.F. @ 5% PV

(100) 1 (100) 1 (100)

8.4 [12*0.7] 3.791 31.84 4.329 36.36

100 0.621 62.1 0.784 78.4

(6.06) 14.76

IRR = 0.05+[(14.76/(14.76+6.06))*(0.1-0.05)]
IRR = 8.55%

Calculation of WACC

Source MV (in millions) Weightage Cost Cost x weightage

Equity 14 [10*1.4] 63.63% (14/22) 14.6% 9.29%

Loan notes 8 36.36% (7.76/22) 8.55% 3.1%

Total 21.76 12.39%

WACC = 12.39%
 Sources of Finance 88

When can WACC be used?

It was mentioned earlier that WACC is essentially the discount factor that is used to calculate the
NPV for projects. However, WACC is only applicable when all of the following 3 conditions are met:
• The new investment does not have a similar risk profile to the entity as a whole.
• The capital structure of the company is unaffected after the investment.
• The new investment is marginal, so any changes are insignificant.
The first point basically states that, the investment should be of a similar activity/operation that the
business is already undertaking. This is because if the business decides to invest in a different
activity, the risk profile of the business will change and if the business risk changes, so will the return
expected from the investors, thus having an effect on the cost of capital.

When the business does decide to invest in a different type of activity, it can adjust the cost of
capital for risk using the Capital Asset Pricing Model (CAPM), which we will learn next.
The second point talks about the financial risk faced by the company. Financial risk is essentially the
gearing ratio and depends on the proportion in which the company raises capital. If the company
raises capital in the debt to equity ratio, then the financial risk of that project will be unchanged, and
the WACC can then be used in investment appraisal. Where the capital structure is changed, i.e.
finance is raised in a different debt-to-equity ratio, then the marginal cost of capital should be used.
However, the marginal cost of capital is out of the F9 syllabus.
How useful is the dividend growth model?
The dividend growth model suffers from many flaws. The DGM assumes that the investors current
required return will remain unchanged for future projects while calculating Ke and WACC. This may
not hold true for projects with different risk profiles.
Limitations of dividend growth model for estimating Ke
• The current market price may be inaccurate as the market price is subject to short term
influences.
• The future dividend growth is estimated based on the historic growth trend. It is not certain
that the growth is going to remain constant for the future.
• The growth in earnings is ignored. Dividends are directly linked to the company’s earnings;
thus, earnings cannot be ignored.
• DGM does not consider the risk associated with an investment while predicting the return
required.
• Cannot be used for companies that have a zero-dividend policy.
CAPM can be used to estimate Ke, in order to overcome the limitations faced in the DGM.

Introduction to CAPM
There is an old English saying that says, “never put all your eggs in a single basket”. The logic is
because if something happens to that basket, you risk losing all your eggs.
The same logic applies to finance as well, if an investor decides to invest all his capital in one
company, they will face high risk because they could lose everything if that company fails. However,
if an investor decides to spread the investment across different companies, they have the benefit of
reducing overall risk as, if one company yields losses, another company’s earnings will compensate
for those losses. Thus, spreading your investment across different entities significantly reduces risk.
 Sources of Finance 89

But as mentioned repeatedly, a lower risk means lower potential with earnings. Thus, in other
words, the risk is reduced as variability in returns compensate for each other to a certain extent.
Total risk undertaken by an investor can be divided into systematic and unsystematic risk:
Systematic risk
Systematic risk includes market wide risk factors that affect all the companies. Factors such as
economic downturn, change in taxation policy, etc. Thus, no matter how well diversified a portfolio
might be, they will always be exposed to systematic risk. It is also known as market risk.
Unsystematic risk
Unsystematic risk includes the risk that affects specific companies. For example, the entry of Jio in
the telecom market mainly affected Idea and Vodafone, while other sectors of the market were not
affected at all. Thus, unsystematic risk can be hedged (reduced) by diversifying the portfolio, i.e. by
buying shares in companies in different industries.

Having understood the difference between systematic and unsystematic risk, we can move ahead
and study CAPM. In CAPM, we assume that all the investors are rational and have diversified their
unsystematic risk away, leaving them only with systematic/market risk.

Capital Asset Pricing Model (CAPM)

As mentioned earlier, the risk is more or less directly related to return, thus the capital asset pricing
model states that the return required by the shareholders will be in proportion to the systematic
risks faced by that company. This basically means that the investor will expect returns that are in
proportion to the market risk faced by the company they are investing in at that time.

(CAPM assumes that systematic risk is eliminated and that investors already have diversified
portfolios)

Using CAPM, we can estimate Ke as below:

Ke = Rf+B(Rm-Rf)

Where,
 Sources of Finance 90

Ke = cost of equity

Rf = Risk free rate

Rm = Market return

B = Beta (measures the systematic risk)

(Rm-Rf) = Risk premium

The Rf can be represented as treasury bills/risk free rate

Beta is basically a measure of risk. If beta is 1.2, it means that if the market moves by 100 (in any
direction), this security will move 1.2 times the market.

B represents the asset’s risk profile, thus if:

• B = 1, the asset is as risky as the market

• B > 1, the asset is riskier than the market
• B < 1, the asset is less risky than the market

Apply Your Knowledge:

The current market return being paid on risky investments is 10%, compared with 4% on treasury
bills. Plum Co has a beta of 1.2.

What is the required return on equity of an investor in Plum Co?

Calculate the required return of an equity investor in companies with the following values for
beta:
 Sources of Finance 91

a) Beta = 0.5
b) Beta = 0
c) Beta = 1

Solution:

If beta is 1.2 then Ke = 0.04 + 1.2 (0.1-0.04) = 11.2%

If beta is 0.5 then Ke = 0.04 + 0.5 (0.1-0.04) = 7%
If beta is 0 then Ke = 0.04 + 0 (0.1-0.04) = 4%
If beta is 1 then Ke = 0.04 + 1 (0.1-0.04) = 10%

As with any tool used for estimation, we have to take various assumptions:

Assumptions of CAPM

• Assumes perfect capital markets.

• There is unrestricted lending or borrowing at the risk-free rate of interest.
• Unsystematic risk is eliminated. i.e. investors have diversified portfolios.
• Investors are rational
• Uniformity of investor expectations with equal availability of information.

Advantages of using CAPM

• Considers risk
• Relates return to risk
• Considers only systematic risk.
• Provides a more rational basis for arriving at the return required by equity shareholders.
• Facilitates calculation of risk adjusted weighted average cost of capital. (discussed later)

Limitations of using CAPM

• Cannot be used if investors have not diversified their portfolio.

• Does not consider the tax situation of the investor
• Actual data (ex. Beta) inputs are estimates and may be hard to obtain
• Calculations are valid for only one period.

Risk adjusted weighted average cost of capital

As mentioned earlier, WACC cannot be used to appraise an investment that has a different risk
profile than the company’s current operations. In such circumstances, the risk adjusted weighted
average cost of capital can be to compute a suitable cost of capital.
Risk adjusted WACC can be used as a discount rate to appraise an investment if:
1. The business risk (operational risk) of the investment is different from the risk of the
company’s current operations.
2. The capital structure (debt-to-equity ratio) of the business is unchanged. In other words, if
the financial risk of the business remains unchanged.
 Sources of Finance 92

3. No systematic risk remains as it is assumed that the investors maintain a diversified

portfolio.
In order to calculate the risk adjusted WACC, we need to understand that risk is bifurcated as
follows:

Risk

Unsystematic
Systematic (assumed to be
eliminated)

Business risk Financial risk

Business risk relates to the risk that a company will have to face due to its operations. For example,
Vodafone Idea and Jio will have a similar business risk or TATA motors, and Maruti will have a similar
business risk.
Financial risk represents the proportion of debt-to-equity that a company maintains. It is very rare
for companies to have the same financial risk as companies will raise finance in order to specifically
match their needs.

Calculation for Risk Adjusted WACC

You will need to understand the following terms to compute risk adjusted WACC:
• Asset beta (Ba/Bu): Measures the business risk faced by a company. This is also known as
ungeared beta, because the term ‘geared’ means including financial risk.
• Equity beta (Be/Bg): Measures the business risk and the financial risk of a company. This is
also known as geared beta, as the equity beta is multiple that includes the business risk
combined with the financial risk of a company.

Formula for Risk Adjusted WACC:

Where,
Ba = Asset Beta
Be = Equity Beta
Ve = market value of company’s shares
Vd = Market value of company’s debt
T = Tax rate
 Sources of Finance 93

The whole idea in the exam is to be able to estimate the cost for equity for a company. For example,
you will be given a company, ABC, that manufactures cars, but it is deciding to invest in
manufacturing soap. Thus, you will be given data of a ‘proxy’ company that also manufactures soap
(to represent a similar risk profile). Thus you will have to perform the following steps to compute the
risk adjusted WACC:
1. De-gear the proxy company: In most questions, you will be given the equity beta of the proxy
company (which represents both financial and business risk). The goal is to get the asset beta of
the proxy company as we only need the business risk from that entity. Thus, we will enter the
proxy company’s market values of debt and equity in the above formula to compute the asset
beta.

2. Re-gear: In the previous step, we basically separated the proxy company’s financial risk from the
business risk, in this step we are combining the business risk with our company’s financial risk
thus re-gearing the asset beta with the suitable financial risk. Therefore, we enter our company’s
market values of debt and equity in the above formula along with the asset beta found in the
previous step.

3. Compute Ke: In this step, we basically take the Equity beta that was computed in the previous
step and use it in the CAPM formula to compute the cost of equity that is suitable for our
company.

4. Compute WACC: Calculate WACC using the normal method.

Apply Your Knowledge:

YEEZUS Co is a shoe manufacturer whose D/E ratio is 60:40. The pre-tax cost of debt may be
assumed to be 10%, and this represents the risk free rate of return. The beta value of the company’s
equity is 1.2. The average return on stocks in the market is 14%. The corporation tax rate is 30%
The company is considering a furniture manufacturing project. Hemis Co is a furniture
manufacturing company. It has an equity beta of 1.60 and a D/E ratio of 20:80. YEEZUS Co maintains
its existing capital structure after the implementation of the new project.
Calculate the suitable cost of capital for the project
Solution:

Step 1 – De-gearing the proxy

Ba = Be [Ve/Ve+Vd(1-T)]

Ba = 1.6 [0.8/(0.8+0.2*(0.7)]

Ba = 1.36

Step 2 =Regearing Beta to YEEZUS gearing level

2.36 = Be [0.4/0.4+(0.6*0.7)]
 Sources of Finance 94

Be = 2.7

Step 3: Calculate Ke & Kd

Ke = 0.1 + 2.7(0.14-0.1)
Ke = 20.8%
Kd = 0.1*0.7 = 7%

Step 4: Appropriate rate for the project

Discount rate = Ke x proportion of equity + Kd x proportion of debt

= [0.208 x 0.4] + [0.07*0.6]

= 12.52%

Impact of financing decision on the value of the firm and the WACC
This section explains how the capital structure of a company can affect its value. The value of a firm
is assumed to be the present value of the total estimated future cash flows discounted at the firm’s
WACC. Therefore, in order to increase the estimated value of a firm, the managers should try to
have such a capital structure where WACC is minimized. We will now study the various theories on
capital structure (gearing). The dilemma faced here is that, debt is the cheapest source of finance
thus, taking more debt than equity would lead to a lower WACC, however taking more debt will also
increase gearing, which increases risk, which in turn will increase the expected return required by
equity shareholders. The theories below, aim to solve this problem.

Traditional theory of gearing

Explanation
The traditional view is based on logic and not on any theory, you should note that taxation is ignored
in the traditional view.
The traditional theory states that at low levels of gearing equity shareholders perceive risk as low
thus, the increase in the proportion of debt compared to equity, will lower the WACC.
However, taking a larger proportion of debt will increase the level of gearing, and at high levels of
gearing, equity holders will perceive the company as high risk as there will be increased volatility
with company profits because debt interest will have to be paid first.
Therefore, after a certain point increasing the portion of debt further, will lead to the WACC rising as
the expected increase in shareholder returns (Ke) will outweigh the cheaper debt finance.
 Sources of Finance 95

Conclusion

Point X is the optimal level of gearing. At point X, the WACC will be minimized, thus the combined
value of the firm will be maximised here.
Implication of finance
Companies should gear up (taking advantage of cheaper debt) until it reaches optimal point X and
then raise a mix of debt to equity to maintain this level of gearing. We can even see from the
diagram, as soon as the debt is raised beyond point X, the WACC starts to rise.
Flaw
Companies can only find optimal point X by trial and error.

Modigliani and Miller’s theory without tax (1958)

Note: This theory was formed a long time ago, and is almost never followed by any company.
Nevertheless, it is important for you to know, especially from an exam stand point.
Explanation
M&M proposed that investors are rational, and thus, the required return of equity (ke) is directly
proportional to the increase in gearing. Thus, according to M&M there is a linear relationship
between Ke and gearing (D/E).
They are basically contradicting the traditional theory and saying that, companies should take
advantage of cheaper debt as it exactly offsets the increase in Ke (that occurs due to an increase in
gearing). Therefore stating that the offset will keep the WACC constant, regardless of any increase or
decrease in gearing.
 Sources of Finance 96

Conclusion
The WACC and the value of the firm is unaffected by changes in gearing levels, and gearing is
irrelevant.
Implication of finance
Choice of finance is irrelevant to shareholder wealth as the company can use any mix of funds, and
the value of the firm will be unaffected.
Assumption

• No taxation
• Perfect capital markets, where investors have the same information and act rationally on
receiving that information
• No transaction cost
• Debt is risk free

Modigliani and Miller’s theory with tax (1963)

This is an improved version of the earlier model proposed by M&M.
Explanation
The major difference here is, M&M includes the tax benefit received for paying interest on debt.
Basically, in addition to debt being cheaper than equity, it will also receive a tax benefit making it
even more cheap. Thus, according to M&M, taking on debt over equity is the most beneficial option
regardless of the current capital structure of the company, as its total benefits outweigh the increase
in Ke due to increased gearing.
 Sources of Finance 97

Conclusion
Companies should gear up completely, i.e. only source debt finance in order to minimize WACC/
increase the MV of the company. The optimal capital structure is 99.9% gearing.
Implication of finance
The company should use as much debt as possible and maintain a high level of gearing.
Flaws

High levels of gearing will lead to the following problems:

• Taking on many obligatory interest payments will increase the risk of the company becoming
bankrupt.
• It will have an impact on borrowing and debt capacity.
• The cost of borrowing will increase as gearing increases.
• If the company keeps taking on debt (increasing its finance cost), the tax benefit will eventually
be exhausted.
• Difference in risk attitude between the directors and the shareholders.

The problem all the above theories are trying to solve:

MAIN GOAL = reduce WACC
Increasing debt in more proportion to equity -> reduces WACC
But
Increasing debt -> Increases gearing -> Increases risk -> Increases Ke -> (could increase overall
WACC)
Thus all the above theories are trying to find that sweet spot where the WACC is minimized.
 Sources of Finance 98

Example 7

Which of the following statements concerning the capital structure theory is incorrect?

A. In the traditional view, there is a linear relationship between the cost of equity and financial
risk
B. Modigliani and Miller said that, in the absence of tax, the cost of equity will remain constant.
C. Pecking order theory indicates that preference shares are preferred to convertible debt as a
source of finance.
D. Business risk is assumed to be constant.

i. A and B
ii. A only
iii. A, B and C
iv. B and C only

Solution: C

Example 8

Which of the following can be eliminated by diversification?

A. Unsystematic risk
B. Inherent risk
C. Market risk
D. Systematic risk

Solution: A

Example 9

When calculating WACC, which of the following is the preferred method of weighting?

A. Current market values of debt and equity, including reserves.

B. Current market values of debt and equity excluding reserves.
C. Book values of debt and equity.
D. Average levels of market values of debt and equity.

Solution: B
 Syllabus Area F:

Business Valuation
 Business Valuation 99

Syllabus area F1 a-F4 c

▪ Nature and purpose of the valuation of business and financial assets

▪ Models for the valuation of shares
▪ The valuation of debt and other financial assets
▪ Efficient Market Hypothesis (EMH) and practical considerations in the valuation of shares

Introduction

This area of the syllabus will test your understanding on valuing companies. This is basically done by
valuing the securities that are traded on the market, issued by the company. Companies mainly
value their business to give an accurate estimate and establish terms during a takeover or merger.
Companies entering the stock market are also valued to estimate the appropriate market value of
the stock. This chapter has all the same concepts from previous chapters combined, but slightly
tweaked. Thus, it is relatively one of the easier syllabus areas.

Merger and acquisition

A merger is where two companies come together and believe there is going to be financial gain with
the help of sharing each other’s resources (assets). An acquisition is similar, however, it is the
takeover of one entity by another. Basically, a merger is where two companies fuse together, but an
acquisition includes one company completely subsuming the other.

Business valuation

Predator: The entity that plans to buy another company.

Target: The company whose shares are proposed to be bought.

Before the terms of an acquisition are established, the predator company must place a value on the
target company. However, after valuation is completed, this may not be the actual price that is paid
in the transaction. Thus, the valuation is used to estimate a fair value at which the company can be
bought. The term ‘value a company’ basically means the market value of equity of the company.

Synergy

Firms come together and share resources mainly because they believe there is a financial gain in
doing so. This financial gain is known as synergy. In layman terms, synergy can be described as 2+2 =
5 and not 4. The additional benefit of 1 (5 and not 4) is because of the reasons mentioned below.

• Elimination of competitors
• Sharing of knowledge
• Cross selling of products
• Economies of scale
 Business Valuation 100

Valuation of equity shares (same as valuing a company)

Valuing a company

Asset based methods Income/cash flow based methods

1)Net book Value 1) P/E method

2) Net realizable value 2) Dividend valuation (DVM)
3) Replacement cost 3) PV of future cash flows

Asset Based Techniques

This method is the least preferred as it does not consider the earning capacity of the company.
Value of equity = Total Assets – Total Liabilities

1) Net Book Value: The net book value is the book value of the assets – book value of its liabilities

2) Net Realizable Value: The net realizable value calculates the value of a company as the realizable
value of its assets minus the amount for which its liabilities could be settled. The realizable value
is basically the estimated value at which the asset can be sold in the market.

3) Replacement cost: This is similar to NRV, except the replacement cost of assets is used instead of
NRV.

Advantages of using asset-based techniques

• It is useful during asset stripping. Asset stripping is where a company in financial difficulties
is taken over by selling each of its assets at a profit. (not to be confused with a distress sale)
• Good technique to use if a minimum value for a company needs to be quoted.
• It is simple and easy to calculate
• Suitable in asset-intensive/manufacturing industry.

Disadvantages of using asset-based techniques

• Historic and outdated (if book values are used)

• It does not consider the earning capacity of the company.
• Ignores goodwill
• It is difficult to estimate an accurate NRV or replacement cost.
 Business Valuation 101

Income/Cash flow Based Methods

Price/Earnings (P/E) Method

The P/E ratio essentially indicates the number of times investors are willing to pay for a share when
compared to its earnings. For example, if the P/E ratio is 10/1, this means investors are willing to pay
10 times the earnings of that share.

Thus, to value a company using this method, an industry average P/E ratio is used, or a proxy
company’s PE ratio is used and then multiplied with the earnings of the company that is to be
valued. (This is the same concept used in the cost of the capital where a proxy company was used to
value the cost of equity.)

Value of a company = P/E ratio (of proxy) x Total earnings

Value of a share = P/E ratio (of proxy) x Earnings per share

Where,

P/E = Price per share/ Earnings per share (EPS). In case a private company is being valued,
the P/E ratio should be multiplied by 80% as there is a change in risk profile from public to
private companies. The 80% is just an average number used to adjust for a private company.
Also, the shares of a private company are not listed and hence are not easily traded. So, this
multiplication by 80%, factors in for that as well.

Total earnings = Profit after tax, including any additional earnings like positive or negative
synergies net of tax. For example, if there is a synergy benefit, total earnings will be = profit
after tax + synergy benefit*(1-T). The additional earning must be net of tax because the
profit is also ‘after tax.’

EPS = Total earnings/Total number of shares

 Business Valuation 102

Think of the P/E ratio as a multiplier for the value of the company. This basically means that
all you have to do is multiply the P/E ratio with any earnings net of tax in order to get the
value (amount investors will be willing to pay).

Advantages of using P/E ratio

• It considers the earning capacity of the company

• Takes the combined synergy benefit into account
• Easy to calculate

Disadvantages of using P/E ratio

• The proxy P/E ratio may require adjustments in order for it to be suitable for the
target company.
• It is difficult to value unlisted companies as it is tough to get basic financial
information from private companies.
• The total earnings can be manipulated. Thus, it is subjective to accounting policy.
• P/E ratio is based on historic earnings and may not reflect the future earning
capacity of the company.
• Appropriate adjustments need to be made to get the profit after tax.

Earnings yield method

Earnings yield method is basically the inverse of P/E ratio.

Earnings yield method: Value of company = total earnings x 1/earnings yield

Value of a share = EPS x 1/earnings yield

Earnings yield = EPS/Price per share

The advantages and disadvantages are the same as P/E ratio.

Dividend valuation model

This model uses the dividend paid to compute the market value of a company’s share. DVM
essentially uses the same formula used to calculate Ke except for P0, is now on the left-hand side.

DVM formula: P0 = D0(1+g)

Ke – g

Advantages of using DVM

• It uses cash flows and not accounting profits (dividends paid is actual cash flow)
• It is theoretically sound.

Disadvantages of using DVM

• It uses historic growth rates, which might not necessarily predict an accurate estimate.
• The model is based on estimated discount and growth rates which will be accurate.
 Business Valuation 103

• Unlisted companies do not publicly display their financial data. Thus, it is difficult to value
them.
• Assumes growth rate to be constant, which is not realistic.
• DVM fails to consider any changes in the earnings stream or dividend policy post-merger.

Example 1

Hanzo plc is considering making an offer for Genji Ltd. It is believed that upon acquisition, the
current management team of DEF will retire and be replaced. This will generate salary cost savings
before tax of $60,000.

As Genji is not a quoted company, there is not a published P/E ratio available. However, Tracer Ltd.
is a similar company to Genji Ltd. and has a P/E ratio of 9.

The balance sheet for Genji Ltd, as at 31st December 2006, was as follows:

$ $

Non-current assets 300,000

Current asset:
Inventories 70000
Receivables 40000
Cash at bank 4000
Total Assets 414,000
Equity and Liabilities
Capital and reserves
Ordinary share capital ($0.5 shares) 50000
Reserves 168000
Non-current liabilities
10% debentures 160000
Current Liabilities 36000
Total equity and liabilities 414,000

Other information for Genji Ltd.

• The non-current assets have not been revalued for several years, and it is believed that their
current replacement value is $600,000.
• $20,000 of the inventory is obsolete and, if not used, could be sold for $2000.
• The earnings per share for 2006 were $1.7, and the dividend per share was 90 cents. The
dividend is expected to grow by 4% per annum.
• A suitable cost of equity for Genji Ltd. is 11%
• The corporation tax rate is 30%
 Business Valuation 104

Reqiured:

Calculate suitable valuations for Genji Ltd based on;

A. Net book value and Net realizable value

B. DVM (Dividend valuation model
C. P/E ratio method

Present Value of Future Cash Flows (Also known as discounted cash flow technique)

This is the most optimum method used from all the above methods of valuing a company, as this
method uses cash flows and not accounting profits. The value of a company is arrived at by
discounting all the future cash flows the company estimates, using the appropriate WACC. However,
it is next to impossible to accurately forecast the future cash flows, plus various assumptions are
used to get to the WACC.

The computation is similar to NPV calculations done in Investment Appraisal. It is a concept that is
frequently used in practice and in the AFM exam. The only key difference here is that usually, the
estimates of cash-flows for the foreseeable future will be given to you. Thus, you will have to
assume they occur in perpetuity, hence you will need to use the perpetuity formula taught in the
time value of money. However, perpetuity with growth is calculated as follows:

PV of the company = Net cash flows (1+g)

Ke-g

(similar to DVM)

This will give you the present value of the company and further, to get to the ‘equity value’, you will
need to use the following formula. Basically, if you multiply any value with (1+g)/ke-g, it will give you
its present perpetuity value at a constant growth.

PV of equity = PV of the company – total debt of the company

Advantages of using Discounted cash-flow technique

• Theoretically, this is the best method to use as it uses cash flows and not accounting profits.
• Based on cash flows and it can include any synergistic gains into the computations post-merger.

Disadvantages of using Discounted cash-flow technique

• It relies on accurate estimates of future cash flows and discount rates.

• It is complex and difficult to explain to managers.
• It is tough to choose an appropriate time period for computation.

Another simple formula to keep in mind is Market capitalization

 Business Valuation 105

You might have heard the term ‘market cap’ frequently in the stock market, it is basically the total
value of all the stocks trading in issue multiplied by the current market value of the share.

Market capitalization: Current share price x number of shares in issue.

Example 2

Tracer plc’s current revenues and cost are as follows:

Description $ million
Sales 400
Cost of sales 220
Distribution and admin 40
Annual capital spending 100
Capital allowances 80
Value of Debt 34

Tracers WACC is 14.4%, and the corporation tax rate is 30%. The above cash-flows is expected to
continue every year for the foreseeable future.

Required:

A. Calculate the value of the company’s equity share.

B. Calculate the value of the company’s equity share if cash flows are expected to grow at 5%
per annum for the foreseeable future.
 Business Valuation 106

Valuation of preference shares and debentures

Preference shares

The same formula as cost of preference shares is used, but P0 is on the left-hand side.

Market value of preference share: P0 = (d0 /Kp) x face value

Example 3

ECHO Ltd. has in issue 10% preference shares with a face value of $100. The return required by
shareholders equal 11%.

Required: Calculate the value of one preference share of the company.

Irredeemable debentures

Irredeemable debentures are valued using the same formula as the cost of irredeemable, except P0 is
on the left hand side.

Value of irredeemable debentures: P0 = Interest

kd

It is important to remember that interest is not net of tax in business valuation as you are on the
investor’s side, thus you will have to think form that perspective. And obviously, an investor will not
get tax benefits on interest as the company is paying the interest and not the investor.

Example 4

Zarya plc has issued irredeemable debentures with a coupon rate of 8%. If the required return of the
investors is 7%, value the debenture.
 Business Valuation 107

Required: Calculate the value of debt of Zarya plc

Redeemable debentures

The value of redeemable debentures is basically the present value of the total coupon interest
earned throughout the term, in addition to the redemption value on maturity, discounted at the
required rate of return.

Year Description Cash flows Discount @ Kd PV

Y1-n Coupon interest X X (annuity factor) X
Yn Redemption value X X (discount factor) X
NPV
(Value)

(The same rule as irredeemable debt for tax applies here)

Example 5

Zenyatta Plc has in issue 10% redeemable debt with a par value of $11 and 10 years to redemption.
Redemption will be at a premium of 11%. The return required by investors is 5%. What is the market
value of debt? You may assume the tax rate to be 30%.

Required: Calculate the value of debt of the company.

Convertible debentures, conversion premium and floor value

Computing the value of convertible debentures is again, similar to calculating the cost of convertible
debentures. You have to use the same proforma as used above in redeemable debt, except you will
need to choose between the redemption value and conversion value (always choose the highest).
Conversion value is calculated the same as in the cost of capital.

In the exam, you will have to compute the following:

Floor value
Defined as market value without the conversion option. It is essentially exactly the same as
calculating redeemable debt. You only have to completely ignore the conversion value. Think of floor
as a minimum value you can get from a convertible loan note.

Conversion premium

Market value of debenture minus value of equity shares if converted now.

Example 6

Winston plc has in issue 9% bonds which are redeemable at their par value of $100 in five year’s
time. Alternatively, each bond may be converted on that date into 22 ordinary shares of the
 Business Valuation 108

company. The current ordinary share price of Winston is $4.20, and this is expected to grow at a rate
of 6% per year for the foreseeable future. Winston pls has a cost of debt of 8% per year.

Required:

Calculate the following current values for each $100 convertible bond.

A. Market value
B. Floor value
C. Conversion premium

Example 7

Ana plc is considering a bid for Pharah Co. Both companies are listed and are in the same business
sector. Financial information on Pharah Co, which is shortly to pay its annual dividend, is as follows:

Number of ordinary shares 10 million

Ordinary share price (ex-div basis) $6.6
Earnings per share 80.0c
Proposed payout ratio 60%
Dividend per share a year ago 46.6c
Dividend per share two years ago 44.0c
Equity beta 1.4

Other relevant information:

The average sector P/E ratio is 10, the risk-free rate of return is 4.7%, and the return on the market
is 10.7%.

Required: Calculate the value of Pharah Co using the following methods:

A. Price/earnings ratio method

B. Dividend growth model
C. Discuss the significance to Pharah Co, of the values you have calculated, in comparison to
the current market values.

Efficient Market Hypothesis (EMH)

People make money in the stock market by predicting whether a certain stock is going to grow
before the stock market actually reflects the growth of that stock. As we all know, this is incredibly
difficult as the market is quick to react to any information that is made available to it. The price of a
share is arrived at, after people react to information or ‘news’ regarding the stock. The people’s
reaction will affect the demand level of the stock thus, affecting its price. EMH is concerned with
how efficiently the stock markets are pricing shares; it basically measures how much information is
incorporated in the share price. The following are the various levels of efficiency:

No efficiency
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A market with no efficiency reflects no information. This means that the stock markets are far from
reflecting real time information, nor does it reflect past trends of the stock.

Implication: Thus, people can make above average returns just by analyzing the past history of the
stock and predicting its growth.

Weak form efficiency

A market is said to have a weak form efficiency when it is said to only reflect historic information, i.e.
by analyzing past trends and charts. (Analyzing past trends and studying historic chart patterns of
shares is known as technical analysis)

Implication: It is possible to earn above average returns by anyone analyzing publicly available
information. For example, the latest news.

Semi-Strong form efficiency

A market is said to have a semi-strong form efficiency when it is said to reflect historic information
as well as current publicly available information. This means that the share price will move as soon
as information is made available to the public. For example, the share price of Reliance moved as
soon as the news of its acquisitions were released.

Implication: It is possible to earn above-average returns by anyone getting private information. (This
is basically insider trading) In reality, almost all stock markets are aimed at being semi-strong
efficient.

Strong form efficiency

In a strong form efficient market, the share prices are said to reflect all; past, public and private
information.

Implications: It is impossible to earn above-average returns. As not matter how well you analyze
real-time information, you will not have access to private information thus, your predictions could
go wrong. The only way to earn returns here will be illegally.

Summary

Information reflected Can make above average return by

analysing
No efficiency No information Historic information
Weak form efficiency Historic information Current publicly available
information
Semi-strong form efficiency Historic information; Private information
Current publicly available
information.
Strong form efficiency Historic information; Impossible
Current publicly available
information;
Private information.

In a strong form efficient market, presentation and timing of results are irrelevant, and managers
 Business Valuation 110

should concentrate on investing in projects that yield positive net present value projects. Private
information.

Solutions:

Example 1

a) Net book value = Total Assets – Total Liabilities = 414,000 - 196,000 = 218,000
Net realizable value = $414,000 – 160,000 – 36,000 + 300,000 (non-current asset
revaluation) – 18,000 (obsolete inventory elimination) = $500,000
b) DVM
Using formula P0 = D0*(1+g) / (ke-g)
Value of Genji Ltd. share = 0.9*(1 + 0.04) / (0.11 - 0.04) = $13.4
Total value of Genji Ltd. = 13.4*100,000 = $1,337,143
c) P/E ratio method

There will be a saving of $60,000 salary cost. Thus, after tax saving is 60,000*(1 - 0.3) = 42,000.

Proxy P/E ratio = 9

Value of Genji Ltd = Proxy P/E x Earnings of Genji Ltd. = 9*(1.7*100,000 shares + 42,000) =
$1,908,000

Example 2

Yearly cash flows are estimated as follows (In $million):

 Business Valuation 111

Sales 400
Cost of sales (220)
Distribution cost (40)
Operating cash flow 140
Tax @ 30% (W1) (18)
Annual capital spending (100)
Net cash flows 22

W1

Operating cash flow 140

TAD (80)
Operating profit 60
Tax @30% (18)

a) These cash flows are expected to continue in perpetuity, and hence to get the value of the
firm, we discount these as a perpetuity at the cost of capital
PV of the company = 22/0.144 = $152.7 million
To get value of equity we deduct value of debt = $152.7 – $34 = $118.7 million

b) The net cash flow is now estimated to have a constant growth rate of 5% in perpetuity, and
thus, to get the value of the company, we discount these as a growing perpetuity at the cost
of capital. (similar to DVM)
PV of the company = [22(1 + 0.05)] / (0.144 - 0.05) = $245.74 million
To get the value of equity we deduct total debt = 245.74 - 34 = $211.74 million

Example 3

Value of a preference share = PV of dividends in perpetuity = 0.1*$100/0.11 = $90.9

Example 4

Value of an irredeemable debenture = PV of interest in perpetuity = 0.08*100/0.07 = $114.3

Example 5

Value of a redeemable debenture = PV of interest and redemption amount

Year Description Cash flows Discount @ 5% PV

Year 1-10 Interest (10%*$11) 1.1 7.722 8.49
Year 10 Redemption value 12.21 0.614 7.5
$15.99
 Business Valuation 112

Value of bond = $15.99

Example 6

Market value of a bond is PV of interest and higher of redemption or conversion amount.

If converted bond holder gets 22*4.20*(1.06)5 = $123.65, while redemption value is at $100, thus the
conversion option is chosen.

Year Description Cash flows Discount @ 8% PV

Year 1-5 Interest (9%*$100) 9 3.993 35.937
Year 5 Redemption value 123.65 0.681 84.2
$120.14

Market value of bond = $120.14

Floor value = (9*3.993) + (100*0.681) = $104 …. basically, just ignore conversion option

Redemption premium = 123.65 – (4.2*22) = $31.25/bond

Example 7

a) P/E ratio method valuation

EPS of Pharah Co = 80c

Average sector P/E ratio = 10
Imputed value of Pharah Co. = 0.8*10 = $8
Number of ordinary shares = 10 million
Value of Pharah Co = 8*10 million = $80 million

b) Dividend valuation model

EPS Pharah Co. = 80c

Proposed payout ratio = 60%
Proposed dividend = 80c*60% = $0.48 per share
It is now assumed that the historic growth rate for dividends is going to continue for the foreseeable
future.
Geometric growth rate over the last two years = [(46.6/44) ^ (1/2)] – 1
= 1.029 - 1 = 3%

c) Calculation of Ke using CAPM

Ke = 0.047 + [1.4*(10.7% - 4.7%)]

Ke = 13%
Value or ordinary share from dividend model = 0.466*(1.03) / (0.13-0.03) = $4.8
Value of Pharah Co. = 4.8*10 million = $48 million
 Business Valuation 113

The current market capitalisation of Pharah Co is $66 million (6.6*10 million). The P/E ratio value of
Pharah Co. is higher than this at $80 million, using the average price/earnings ratio used for the
sector. Pharah’s own P/E ratio is 8.25 (6.6/0.8). The difference between the two P/E ratios may
indicate that there is scope for improving the financial performance of Pharah Co following the
acquisition. If Pharah Co has the managerial skills to affect the environment, the company and its
shareholders may be able to benefit as a result of the acquisition.

The dividend growth model value is lower than the current market capitalisation at $48 million. This
represents a minimum value that Pharah Co. shareholders will accept if Ana Co makes an offer to
buy their shares. In reality, they would want more than this as an inducement to sell. The current
market capitalisation of Pharah Co. of $66 million may reflect the belief of the stock market that a
takeover bid for the company is imminent and, depending on its efficiency, may indicate a fair price
for Pharah Co shares. Alternatively, Either the cost of equity or the expected dividend growth rate
used in the dividend growth model calculation could be inaccurate, or the difference between the
two values may be due to a degree of inefficiency in the stock market.
 Business Valuation 114

PO22 – DATA ANALYSIS AND DECISION SUPPORT

Description

You use commercial acumen to articulate business questions to resolve problems, exploit
opportunities and identify and manipulate relevant data requirements; deeply analysing data by
applying appropriate techniques. You draw clear conclusions and present your findings to enable
relevant stakeholders to make sound business decisions.

Elements

a. Identify any relevant financial and non-financial data and use it to provide insights to answer
important business questions and provide solutions for your organisation.
b. Use appropriate analytical tools to process, manipulate and analyse data. These tools could
include spreadsheet applications or more technical statistical analysis software.
c. Apply modelling techniques to deliver specific types of analysis, which may include: scenario
analysis, forecasting, optimisation problems or cost-benefit analysis.
d. Use data and resulting information ethically and responsibly, analysing and interpreting data
sceptically to draw appropriate conclusions and make recommendations to support effective
decision-making.
e. Communicate the recommendations to relevant stakeholders in a way they can easily visualise
and understand, to exploit business opportunities, manage risk and evaluate performance.
 Syllabus Area C:

Working Capital Management

 Working Capital Management 115

Syllabus area C1 a-C3 b

▪ The nature, elements and importance of working capital

▪ Management of inventories, accounts receivable, accounts payable and cash
▪ Determining working capital needs and funding strategies

Introduction

Theoretically, working capital is defined as the excess of current assets over current liabilities. It is
basically the capital available for conducting the day-to-day business of an organization. The funds
you need for your day-to-day working are basically ‘Working Capital’.
The main objective of working capital management is to find the right balance between profitability
and liquidity.

Inventory, receivables and cash are current assets, and they all require funding. What does that
mean? Say you need to buy material for production and you are a new business. How do you buy
this material? You go to a supplier and purchase, with a promise to pay him after a set time period.
Now, because you did not have the resources for your day to day operations, you financed your
purchase of material by taking credit. Think of the accounting entry here. It will be purchases (stock)
debit to suppliers account credit. Your current asset, i.e. stock, is financed by your creditors.
Trade payables and overdraft are current liabilities that are the short-term sources of funding
available.
The following are the two decisions that a business needs to make with regards to working capital;

• The level of investment required in current assets.

• The type of finance used to fund these assets.

The level of investment required in current assets

Naturally, it would be preferred to hold a high level of current assets as the organization will be able
to respond to any changes in the business promptly. However, a high level of investment in current
assets will result in an increase in the costs for holding cash/inventory/management.

On the other hand, if current assets are underinvested, the company may be unable to respond to
changes in demand and business conditions, even if it is a less expensive option.

Factors that must be considered when determining the level of investment in current assets

• Industry in which organization operates: Certain industries require considerable investment

in working capital and have long operating cycles, others have shorter operating cycles and
therefore require significantly lower investment in working capital.
• Working capital policy: The company's working capital policy (funding policy) will also affect
investment levels. The company chooses between a conservative (less risky but expensive)
approach, an aggressive (risky but cheap) route and a moderate (middle of the road)
approach. These are discussed below in detail.
 Working Capital Management 116

• Terms of trade: The terms provided to consumers and collected from vendors for receipts
and payments of dues also influence the degree of investment in current assets such as
receivables. The investment level will vary depending on the terms given to the company.

The type of finance used to fund current assets

Funding is required for both forms of current assets.

• Permanent current assets: a constant level of current assets, such as a buffer inventory or a
minimum amount of cash in the bank
• Fluctuation current assets: The part of current assets that is constantly changing, such as
receivables and payables.

We'll look at three different financing mechanisms that could be used to finance current asset
investments. To better understand the three strategies, we'll divide current assets into three
categories:

a) Conservative strategy

Mostly long-term finance is used. All permanent and most fluctuating current assets are funded
using long term finance.

If too much of long term funds are devoted to funding current assets. It results in over-investments,
and this is referred to as over-capitalization, which can have a negative impact on profitability.

b) Aggressive strategy

The majority of the time, short-term financing is used. Short-term finance is used to cover all
volatility as well as a portion of the permanent current assets. We can also call it the balanced
approach.

A conservative approach will result in lower profitability (more cost) but lower risk, while an
aggressive approach will result in higher profitability but lower risk.

c) Moderate strategy

Long-term financing is used to fund permanent current assets. Short-term financing is used to fund
fluctuating current assets. We can also call it the balanced approach.
 Working Capital Management 117

Short-term finance is usually cheaper than long-term finance

This is largely due to the risks taken by creditors.

For example, if a bank were considering two loan applications, one for one year and the other for 20
years, all other things being equal it would demand a higher interest rate on the 20-year loan.
This is because it feels more exposed to risk on long-term loans, as more could go wrong
with the borrower over a period of twenty years than a period of one year

The risks of short-term finance

Renewal problems – short-term finance may need to be continually renegotiated as various facilities
expire and renewal may not always be guaranteed.

Unstable interest rates – if the company constantly has to renew its funding arrangements, it will be
at the mercy of fluctuations in short-term interest rates
 Working Capital Management 118

Overtrading

“Overtrading" is the term to use in this context if a company's ability to meet working capital
requirements is dependent on its liquidity needs from short-funding, and poses a significant threat
to the organisation. Overtrading indicators include:

a. A rapid rise in turnover

b. A rapid decrease in the current and quick ratios.
c. A large portion of short-term debt (current liabilities) is used to fund current assets.

What happens in overtrading is that the company extends the credit limit it offers to its customers,
offers them a higher time limit for making the payment, keeps a higher level of stock than is
necessary to meet the current level of sales.

Working capital ratios

These ratios may be used to analyse the effectiveness and efficiency of the working capital
management process within an organization:

These can be separated into two area:

• Liquidity
• Efficiency (forming the operating cycle)
 Working Capital Management 119

Liquidity ratios

Current ratio
Measures whether the company has sufficient current assets to meet its current liabilities.

Current ratio = Current assets

Current liabilities

Quick ratio
Measures how well current liabilities are covered by liquid assets (excluding inventory, which is
considered not as liquid as the other current assets).

Current ratio = Current assets - Inventory

Current liabilities

Working capital efficiency ratios

Inventory holding days

The amount of time which a stock is held in the business entity

Inventory holding days = Inventory x365

Cost of sales

Receivables turnover or debtor days

The of time takes to recover cash from customers (those who would have availed credit)

Receivables turnover days = Receivables x 365

Credit Sales

Payables turnover or credit days

This is the length of time required to pay suppliers' invoices.

Receivables turnover days = Payables x365

Credit Purchases

Working capital cycle (cash conversion cycle or operating cycle)

This is known as the length of time it's been since you've bought a good and will have received the
money.

Operating cycle = Inventory days + Receivable days – Payable days

Working Capital Management 120
 Working Capital Management 121

Example 1

The following financial information relates to Roadhog Co.

Income statement extracts

2013 2012
$000 $000
Revenue 29050 20750
Cost of sales 20916 13280
Profit before interest and tax 8134 7470
Interest 718 584
Profit before tax 7424 6886
Taxation 2970 2556
Distributed profit 4454 4330

Statement of financial position

2013 2012
$000 $000 $000 $000

Non-current assets 30568 29204

Current assets:

Inventory 4298 2184

Trade receivables 6400 3468
10698 5652
Total assets 41266 34856
Current liabilities

Trade payables 5730 3274

Overdraft 3000 500

8730 3774

Equity

Ordinary shares 16000 16000

Reserves 8536 7082

24536 23082

Long-term liabilities

7% loan notes 8000 8000

Total equity and liabilities 41266 34856

 Working Capital Management 122

Average ratios for the last two years for companies with similar business operations to
Roadhog Co are as follows:

Current ratio 1.7 times

Quick ratio 1.1 times
Inventory days 55 days
Trade receivable days 60 days
Trade payable days 85 days
Revenue/Net working capital 10 times

Required: Using suitable working capital ratios and analysis of the financial information provided,
evaluate whether Roadhog Co can be described as overtrading (undercapitalised)

Inventory management

Inventory is one of the most significant line items on the balance sheet for many businesses. It is a
significant investment that must be properly handled. It is important for a company to have enough
inventory on hand to satisfy consumer demand. Having too much stock, on the other hand, can be
costly. The following are the various categories of inventory costs:

• Purchase costs
• Holding costs (for e.g., Storage, Insurance)
• Ordering costs (for e.g., Order entry, Documentation and tender costs.)

Good inventory management entails keeping track of the above costs and ensuring that the quantity
ordered minimises the amount of all of them. It has been observed that a business that orders a
specific quantity (referred to as EOQ) reduces the above-mentioned costs. As a result, every business
striving for maximum profits should place orders at the EOQ on a regular basis.

Economic order quantity

The EOQ is the order quantity that minimises the total expense of holding and ordering a product.

The EOQ can be found using the following formula:

 Working Capital Management 123

Where,
C0 = Cost of placing one order
D = Annual demand
Ch = Cost of holding one unit for one year

Total annual holding cost

Total annual holding cost = Ch x (average inventory)

Or
Total annual holding cost = Ch (Q + Buffer stock)
2
Where Q = re-ordering quantity

Total annual ordering cost

Total annual ordering cost (AOC) = Co x Number of orders in year

Or
AOC = Co x D
Q
Where Q = re-ordering quantity

Total annual purchasing cost

Total annual purchasing cost (APC) = Purchase price per unit x Annual Demand
Or
APC = P x D

Average Inventory = Order size / 2

The total annual holding cost equals the total annual ordering cost at EOQ. If a quantity greater than
EOQ is ordered every time, the number of orders decreases and therefore, the ordering cost
decreases, but the annual ordering cost rises (as more quantity is ordered each time). When a
quantity less than the EOQ is ordered, the opposite is true.

Total annual cost

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

TAC = Ch (Q + Buffer stock) + AOC = Co x D + APC = P x D

2 Q
 Working Capital Management 124

Assumptions for EOQ

• Demand is known and remains constant
• Lead time is known and constant
• Purchase price is constant
• No buffer inventory

Costs of high inventory levels

1. Foregone interest from tying up capital in inventory (Opportunity Cost)

2. Holding costs:
• Storage
• Stores administration
• Risk of theft/ damage/ obsolescence

3. Costs of low inventory levels

4. Stockouts:
• Lost contribution
• Production halt
• Emergency order

5. High re-order/setup costs

6. Lost quantity discounts.

 Working Capital Management 125

Example 2
Quantity required per year 64,000 items;
Order costs are $30 per order;
Inventory holding costs are estimated at 3% of inventory value per year;
Each unit currently costs $80.

Required:

A. Calculate EOQ from the above information

B. Compute the total annual holding and ordering costs for the company if it adopts EOQ as
its re-order quantity.

Bulk discounts and decision to move away from the EOQ model

Occasionally, retailers will give a discount on large orders. Although this quantity may not be the
EOQ, the discount offered may make a larger order worthwhile. We've skipped the material
purchase costs so far because they were the same with all order sizes. When bulk discounts are
present, calculate the Total annual cost but include the purchase price too.
 Working Capital Management 126

Example 3

Mcree Co manufactures a range of domestic appliances. Due to past delays in suppliers

providing goods, Mcree has had to hold an inventory of raw materials in order that the
production could continue to operate smoothly. Due to recent improvements in supplier
reliability, Mcree is re-examining its inventory holding policies and recalculating economic
order quantities (EOQ). Item "L" costs Mcree $2000 per unit. Expected annual production
usage is 130,000 units

Procurement costs (costs of placing and processing one order) are $5000.The cost of holding one
unit for one year has been calculated as 30% of inventory value. The supplier of item "L" has
informed Mcree that if the order was 4000 units or more at one time, a 2% discount would be given
on the price of the goods.

Required:

A. Calculate the EOQ for item "L" before the quantity discount.
B. Advise Mcree if it should increase the order size of item "L" so as to quantity for
the 2% discount.

Just in time system

System of Just in Time is a collection of manufacturing and supply chain strategies aimed at
reducing inventory levels and improving customer service by producing not only at the
precise time and quantity required by consumers, but also at competitive prices.

The following are some of the characteristics of a JIT system:

• Nil/negligible stock levels

• Nil/negligible stock costs
• Items are only produced after an order has been placed
• Little room for error
• Higher quality
• Good supplier relations
• Frequent deliveries of small orders
 Working Capital Management 127

Inventory is reduced to an absolute minimum or eliminated altogether.

Aims of JIT are:

• A smooth flow of work through the manufacturing plant
• A flexible production process which is responsive to the customer’s requirements
• Reduction in capital tied up in inventory.

A JIT manufacturer looks for a single supplier who can provide high quality, frequent and reliable
deliveries, rather than the lowest price. In return, the supplier can expect more business under long-
term purchase orders, thus providing greater certainty in forecasting activity levels. Very often the
suppliers will be located close to the company.

JIT attempts to eliminate waste at every stage of the manufacturing process, notably by the
elimination of:
• WIP, by reducing batch sizes (often to one)
• Raw materials inventory, by the suppliers delivering direct to the shop floor JIT for use
• Scrap and rework, by an emphasis on total quality control of the design, of the process, and of
the materials
• Finished goods inventory, by reducing lead times so that all products are made to order
• Material handling costs, by re-design of the shop floor so that goods move directly between
adjacent work centres.

The combination of these concepts in JIT results in:

• A smooth flow of work through the manufacturing plant
• A flexible production process which is responsive to the customer’s requirements
• Reduction in capital tied up in inventory.

Benefits of Just in time system

• Less spending in working capital because inventory levels have been reduced.
• Inventory storage costs are reduced.
• Lower material processing costs as a result of increased material movement during the
manufacturing process.
• A better relationship with suppliers, since JIT procurement needs close collaboration
between suppliers and customers.
• Greater operational efficiency as a result of the need to streamline production processes in
order to reduce inventory between stages of the manufacturing process.
• Lower reworking costs as a result of a greater focus on supply efficiency, as output hold-ups
must be avoided as inventory between stages is removed.

Periodic Review System

Inventory levels are reviewed at fixed intervals, e.g. every four weeks. The inventory in hand is then
made up to a predetermined level, which takes account of:
- Likely demand before the next review
- Likely demand during the lead time.
 Working Capital Management 128

Managing trade receivables

Credit control department

Some of the important areas of receivables management that need to be planned and tackled are
described below.

▪ Policy formulation: Creating the process in which receivables management can occur. It involves
deciding the conditions of trade for a fixed period of credit, available settlement discounts, and
so on.
▪ Credit analysis: This entails determining a customer's creditworthiness by means of third-party
and bank references. An analysis of the customer's financials can also show how much credit
may be extended to the customer.
▪ Credit control: Based on credit analysis, credit limits for each customer can be defined. No more
items are sold to the consumer until the cap has been reached. Receivables ageing reports are
often produced on a regular basis to keep track of long-overdue accounts.
▪ Follow-up and collection: There must be a formal and well-defined set of procedures in place for
receivables follow-up and collection. This can include phone reminders, personal visits, daily
statements of accounts being sent through, and, as a last resort, legal action.

Factoring

Factoring is when a credit management department is outsourced to a third party. A debt factor is a
specialised company that can:-

• Help companies handle their trade receivables ledger.

• Provide companies with short-term funding backed by their trade receivables.
• Have cover against bad debts.

Advantages of factoring

▪ Administration costs are reduced.

▪ The need for management control is reduced.
▪ Credit management departments in small and fast-growing companies cannot keep up with
volume growth.

Disadvantages of factoring

▪ Using a factor is likely to be more costly than an efficiently managed internal credit management
department, and it may mean that the business is experiencing financial difficulties.
▪ Customers do not want to deal with a factor.
▪ It's difficult to go back to an internal credit management scheme after you've started factoring.
The organisation can relinquish its right to choose who receives credit (non-recourse factoring).

Foreign Exchange Risk

Export credit risk is the risk of failure or delay in collecting payments due from foreign customers.
 Working Capital Management 129

Foreign exchange risk is the risk that the value of the currency will change between the date of contract
and the date of settlement.

Reducing investment in foreign accounts receivable

A company can reduce its investment in foreign accounts receivable by asking for full or part payment in
advance of supplying goods.
However this may be resisted by consumers, particularly if competitors do not ask for payment up front.

Another approach is for the seller (exporter) to arrange for a bank to give cash for foreign accounts
receivable sooner than the seller would normally receive payment.

Forfaiting
One method of doing this is forfaiting. Forfaiting involves the purchase of foreign accounts receivable
from the seller by a forfeiter. The forfaiter takes on all of the credit risk from the transaction (without
recourse) and therefore the forfaiter purchases the receivables from the seller at a discount. The
purchased receivables become a form of debt instrument such as bills of exchange) which can be sold on
the money market.
The non-recourse side of the transaction makes this an attractive arrangement for businesses, but as a
result the cost of forfaiting is relatively high.
Forfaiting is usually available for large receivable amounts (over $250,000) and also is only for major
convertible currencies. It is usually only available for medium-term or longer transactions.

Letter of Credit
This is a further way of reducing the investment in foreign accounts receivable and can give a business a
risk-free method of securing payment for goods or services.

There are a number of steps in arranging a letter of credit:

▪ Both parties set the terms for the sale of goods or services
▪ The purchaser (importer) requests their bank to issue a letter of credit in favour of the seller
(exporter)
▪ The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once the
conditions specified in the letter have been complied with.

Typically the conditions relate to presenting shipping documentation and dispatching the goods before a
certain date
▪ The goods are dispatched to the customer and the shipping documentation is sent to the
purchaser’s bank
▪ The bank then issues a banker’s acceptance
▪ The seller can either hold the banker’s acceptance until maturity or sell it on the money market
at a discounted value.

Factoring
Factoring is the outsourcing of the credit control department to a third party.
The debts of the company are effectively sold to a factor (normally owned by a bank). The factor takes
on the responsibility of collecting the debt for a fee. The company can choose some or all of the
following three services offered by the factor:
1. Debt collection and administration – recourse or non-recourse
2. Financing
3. Credit insurance
 Working Capital Management 130

Without Recourse Factoring

When factoring is without recourse or ‘non-recourse’, the factor provides protection for the client
against irrecoverable debts. The factor has no ‘comeback’ or recourse to the client if a customer
defaults. When a customer of the client fails to pay a debt, the factor bears the loss and the client
receives the money from the debt.

With Recourse Factoring

When the service is with recourse (‘recourse factoring’), the client must bear the loss from any
irrecoverable debt, and so has to reimburse the factor for any money it has already received for the
debt.

Benefits of Factoring
A business improves its cash flow, because the factor provides finance for up to 80% or more of debts
within 24 hours of the invoices being issued. A bank providing an overdraft facility secured against a
company’s unpaid invoices will normally only lend up to 50% of the invoice value. (Factors will provide
80% or so because they set credit limits and are responsible for collecting the debts.)
A factor saves the company the administration costs of keeping the sales ledger up to date and the
costs of debt collection.
A business can use the factor’s credit control system to assess the creditworthiness of both new and
existing customers.
Non-recourse factoring is a convenient way of obtaining insurance against irrecoverable debts.

Problems with Factoring

Although factors provide valuable services, companies are sometimes wary about using them.
A possible problem with factoring is that the intervention of the factor between the factor’s client and
the debtor company could endanger trading relationships and damage goodwill.
Customers might prefer to deal with the business, not a factor.
When a non-recourse factoring service is used, the client loses control over decisions about granting
credit to its customers. For this reason, some clients prefer to retain the risk of irrecoverable debts,
and opt for a ‘with recourse’ factoring service.
With this type of service, the client and not the factor decides whether extreme action should be
taken against a non-payer.
On top of this, when suppliers and customers of the client find out that the client is using a factor to
collect debts, it may arouse fears that the company is beset by cash flow problems, raising fears about
its viability. If so, its suppliers may impose more stringent payment terms, thus negating the benefits
provided by the factor.
Using a factor can create problems with customers who may resent being chased for payment by a
third party and may question the supplier’s financial stability.

Evaluating factoring deals

When assessing factoring transactions, we must take into account the expense of administration,
any interest savings from reduced receivables (assuming receivables are funded by overdraft), and
any reduction in bad debts. Additional costs, such as a factoring fee and additional interest charged
on advanced funds (which may be included in the deal!), must also be weighed.
 Working Capital Management 131

Example 4
Echo Co currently has a turnover of $50m. Receivables turnover is currently 40 days.
Interest is charged on the overdraft at 12%. A factoring company has offered its services
for an annual fee of 1% of turnover. The factoring company can reduce receivables
turnover to 15 days.
The factor will also generate an admin saving for the company of $30,000.

Required: Advise whether Echo Co Limited should accept the factors offer.

Change in credit policy (offering early settlement discounts)

A company's credit and discount policies can change from time to time, and you will be asked to
assess the effect on the organisation. In this situation, you must weigh the costs and benefits of the
shift and make recommendations accordingly.

Example 5
Nuketown plc is a specialist manufacturer of designer kitchen appliances and its sales are all on
credit only.
Extracts from NUketowns plc's most recent accounts are given below:
$000
Sales 40,000
COS 34,000
Operating profit 18,000
Inventory 5,000
Receivables 9.000

The company is now devising a new credit policy wherein customers would be offered a 1.5%
discount if payments are made within 20 days and 3% if payments are made in 10 days. 20% and
30% of the customers are expected to pay up within 10 days and 20 days respectively. Nuketown
plc currently borrows from its lead bank at 13%.
 Working Capital Management 132

Required: Evaluate whether the change in policy is to be implemented or not by

Nuketwon plc.

Early settlement discounts: % method

Customers are granted cash bonuses if they pay their bills on time. The cost of the discount is offset
by the savings achieved by the company as a result of having less money invested due to a lower
receivables balance and a shorter average collection period. Discounts can also help to cut down on
the amount of uncollectible debts. The formulae assist the company in determining whether or not
to give an early settlement discount by evaluating the annual expense.

This formulae help the company to evaluate the annual cost and reach a decision on whether to
offer an early settlement discount.
n
Annual cost of the discount % = Gross invoice value
Discounted invoice value

Where n = 365
Days money is received early

OR

n= 52
Weeks money is received early

OR

n= 12
Months money is received early

Decision rule: If the cost of offering the discount exceeds the annual interest rate on overdraft, then
the discount should not be offered.
 Working Capital Management 133

Example 6
A company is offering a cash discount of 2.6% to receivables if they agree to pay debts within one
month. The usual credit period taken is three months.
Required: Compute the effective annualized cost of offering the discount and determine whether
should it be offered, if the bank would loan the company at 18% pa.

Invoice discounting

• Invoice discounting is a way of raising funds against the protection of receivables that does
not require the use of a factor's sales ledger administration services.
• Selected invoices are used as collateral for the company to borrow money. It is a short-term
loan that will be repaid until the debt is paid off.
• The main benefit of invoice discounting is that it is a private service that does not need the
customer's knowledge.
• If the customer defaults, we still need to repay the bank.

Process Flow Understanding

At the beginning of August, Leron plc sells goods for a total value of $300,000 to regular customers but
decides that it requires payment earlier than the agreed 30-day credit period for these invoices.
A discounter agrees to finance 80% of their face value, i.e. $240,000, at an interest cost of 9% pa.
The invoices were due for payment in early September, but were subsequently settled in mid-September,
exactly 45 days after the initial transactions. The invoice discounter’s service charge is 1% of invoice
value. A special account is set up with a bank, into which all payments are made.

Sequence
 Working Capital Management 134

Beginning of August - Sale

Debtors A/c Dr 3,00,000

To Sales A/c 3,00,000

Customers will pay in 30 days, i.e. by beginning of September

Go to the discounter - he gives an advance of 240000

Mid September
Customers pay 300000 in the designated bank account

Service charges @ 1% of invoice value 3,000

Interest cost on 240000 for 45 days 2,663
(240000 * 9% * 45/365)

The service provider deducts his charges of 5663 from the total. He also collects his 240000 which he had
given as advance to Leron PLC

Balance amount transferred to Leron PLC. 54,337

This will happen Mid September,

Leron Plc will receive

2,40,000 Start of August
54,337 Mid September
2,94,337

Charges incurred 5,663

Debtors

Very high balance - Means I have very lenient credit terms

Lenient credit terms - It means sales are high as more customers will be attracted to me. But there will
always be an increased risk of bad debts. My funds will remain locked in debtors. I won’t have enough cash
to pay all the dues like salaries, rent, suppliers etc. So, I will have to borrow.

Very Low Balance - Strict credit terms and low balance on receivables
Sales will be low and consequently, profits will be lower. But the amount will not remain locked in
debtors, better availability of cash.

Credit worthiness
• Ability of an individual to repay the funds borrowed.
• Ability to provide collateral
• Past track records
• Published data - Stock Market reports
• Credit rating agencies report - CRISIL, ICRA, CIBIL
 Working Capital Management 135

• Competitors
• Company sales records

Credit Limits
- Amount of credit
- Length of time

Invoicing and follow up

Monitoring

- Ageing Analysis of Debtors Outstanding for 0 - 30 Days 100,000 Least risk

Medium
Outstanding for 30 - 60 Days 150,000 Risk
Outstanding for 60 Days or
above 200,000 High Risk
- Ratios

Assessing Creditworthiness
• Bank References
• Trade References
• Competitors
• Published Information
• Credit reference agencies
• Company’s own sales records
• Credit scoring

Credit Limits
Credit limits should be set to reflect both the:
• Amount of credit available
• Length of time allowed before payment is due.

Invoicing and collecting overdue debts

• Reminder letters
• Telephone calls
• Witholding supplies
• Debt collectors
• Legal action

Monitoring Receivables
• Age Analysis
• Ratios
• Statistical analysis
 Working Capital Management 136

Managing trade payables

The money owed to suppliers for goods and services is known as trade payables. Excessive
dependence on creditors (trade) is often regarded as a free source of finance - but it can be fatal!
Through delaying payment, the company would be able to increase its trade payables. Without
jeopardising your relationship with your supplier

Taking a discount – Policy decision

Some suppliers can give you a discount if you pay your invoices on time. The annualised value of the
discount must be weighed against the additional finance expense. Our computations are identical to
the ones we used to measure the average annual discount rate for discount given to debtors.

Example 7

One supplier has offered a discount to Ignite Co of 2% on an invoice for $15,000. if payment is made
within one month, rather than the three months normally taken to pay. Ignite Co’s overdraft rate is
10% pa.

Required: Compute if its financially worthwhile for Ignite Co to accept the discount and pay early.

Cash management

Cash, like inventory and receivables, is a current asset. As a result, it necessitates careful
consideration in its management. Businesses must have ample cash on hand to fulfil their short-term
commitments. Surplus currency, on the other hand, should not be kept if it can be put to better use
elsewhere.

The transaction need for cash

A cash budget, which nets expected receipts against expected payments, can be used to estimate
the amount of cash necessary for the next cycle. This will assess the need for cash in purchases,
which is one of the three reasons for keeping cash on hand.

The precautionary need for cash

While a cash budget will include an estimation of the transactions' cash needs, it will be based on
potential expectations and thus be subject to risk. The actual cash requirement will exceed the
anticipated requirement. A business should have some extra liquidity (a cash buffer) in its cash
balance to cover any unforeseen cash needs.

The speculative need for cash

In the business world, there is always the possibility of an unexpected opportunity, and a company
may wish to be prepared to take advantage of such an opportunity if it occurs. As a consequence, it
may wish to have some cash on hand for this reason. This is the speculative cash requirement.

The availability of finance

 Working Capital Management 137

If a business has trouble getting cash when it needs it, it can decide to keep more cash on hand. If a
company's bank finds it impossible to obtain overdraft financing, or if an overdraft facility is denied,
the company's precautionary cash requirement would rise, and its optimum cash amount will rise as
well.

Cash management models

There are two cash models that you should be familiar with

• The Baumol model

• The Miller Orr Model

Baumol Model

This is similar to the EOQ formula and calculates the amount of funds to inject into the current
account or transfer into short-term investments at one time:

C0 = transactions cost (brokerage, commission, etc)

D = demand for cash over the period

Ch = cost of holding one $ of cash

It tells me the amount of funds I need to inject into my current account for transaction purpose
(When there is a shortage of funds in my current account and I need to redeem the short term
investments)
OR
How much should I transfer from my current account into investments
(This will happen when I have excess funds in my current account and they are lying idle)

Q (Amount) = Square Root of (2* Demand for cash over period * Transaction cost / Cost of holding
cash)

The demand for cash over the period relates to cash needs for daytoday transactions

CO = transaction costs are the costs of making a trade in securities or moving funds in and out of
interest-bearing deposit accounts.

Cost of holding cash is the opportunity cost of investing the funds in short term investment
In questions, you should simply pick up the rate of interest and use it for holding cost of cash

Assumptions
• Cash use is steady and predictable
• Cash inflows are known and regular
 Working Capital Management 138

• Day to day needs for cash are funded from current account
• Buffer cash is held in short term investments

Example 8

Seta Co faces a constant demand for cash totalling $400,000. It replenishes its current account
(which pays no interest) by selling constant amounts of treasury bills which are held as an
investment earning 6% pa. The cost per sale of treasury bills is a fixed $30 per sale.

Required: Compute the optimum amount of treasury bills to be sold each time an injection of cash
is needed in the current account.

The Miller Orr Model

Miller and Orr did not take into account the fact that cash is consumed at a constant rate. Instead,
they thought that cash flows were completely random. They calculated a company's higher and
lower cash limits.

When the company reaches its upper cap, it can purchase short-term assets in order to maximise
cash on hand. When the business reaches the lower cap, these assets will be sold to raise cash in the
bank.

The aim is to always get the cash balance back to the return point, whether you're buying or selling
investments.

The following are the important formulae (given in exam) regarding the Miller-Orr model are:
 Working Capital Management 139

Upper limit = lower limit + spread …[this formula is not given in the exam, the above two are]

Minimum Level 45,000

Return Point 70,000 Most convenient point
Maximum Level 1,00,000

The moment my cash balance hits 100000, I invest 30000 in FD and return to my 70000
balance.
The moment my cash balance hits 45000, I go to the bank and break my FD for the
difference so that my cash balance is again 70000
 Working Capital Management 140

Cashflow forecast

Method - I : Forecasting receipts and payments

Jan Feb Mar

Receipts
Sales
Interest income

Payments
Purchases
Salaries
Rent
Misc Exp

Net cash generated / (used)

Opening balance
Closing (Opening + Impact of
monthly)

Method - II: Prepare Balance sheet

Write down forecast of all balance sheet values

Equity
Share Capital XX
Reserves

Long term debt XX

Current Liabilities XX

Non Current Asset XX

Current Asset
- Inventory XX
- Debtors XX
- Cash Cash will be balancing figure
 Working Capital Management 141

Apply your knowledge

The minimum cash balance of $20,000 is required at Miller-Orr Co, and transferring money to or
from the bank costs $50 per transaction. Inspection of daily cash flows over the past year suggests
that the standard deviation is $3,000 per day, and hence the variance (standard deviation squared)
is $9 million. The interest rate is 0.03% per day.

Calculate the spread between the upper, lower limits and return point

Solution

Standard Deviation of cash flow 3,000

Variance (Square of SD) 9,000,000

Interest rate per day 0.03%

Transaction cost per transaction 50

(3/4*Transaction cost*Variance of cash flow)

(3/4*50*9,000,000) 337,500,000
(3/4*Transaction cost*Variance of cash flow) / Interest Rate
(335,500,000/0.03%) 1,125,000,000,000

[(3/4*Transaction cost*Variance of cash flow) / Interest Rate]^1/3

1,125,000,000,000^0.33333
10,400
3 * [(3/4*Transaction cost*Variance of cash flow) / Interest Rate]^1/3
10,400*3 31,201

Lower Limit 20,000

Return Point = Lower Limit + 1/3 * Spread

20,000 +(31,201*3) 30,400

Upper Limit = Lower Limit + Spread

(20,000 + 31,201) 51,201
 Working Capital Management 142

Apply your knowledge

A company sets its minimum cash balance at $5,000 and has estimated the following:
Transaction cost = $15 per sale or purchase of gilts
Standard deviation of cash flows = $1,200 per day (i.e. Variance = $1.44 million per day)
Interest rate = 7.3% pa = 0.02% per day.

What is the spread between the upper and lower limits?

What is the upper limit?
What is the return point?

Solution

Standard Deviation of cash flow 1,200

Variance (Square of SD) 1,440,000

Interest rate per

day 0.02%

Transaction cost per transaction 15

Lower Limit 5000

Spread = 3*{[(3/4*Transaction cost*Variance of cash flow)/Interest Rate ]^1/3}

(3/4*Transaction cost*Variance of cash flow)

3/4*15*1,440,000
16,200,000
(3/4*Transaction cost*Variance of cash flow) / Interest Rate
16,200,000*0.02% 81,000,000,000

[(3/4*Transaction cost*Variance of cash flow) / Interest Rate]^1/3

81,000,000,000^0.3333 4,327
3 * [(3/4*Transaction cost*Variance of cash flow) / Interest Rate]^1/3
4,327*3 12,980

Return Point = Lower Limit + 1/3*Spread

5000 + (12980/3) 9,327

Upper Limit = Lower Limit + Spread

(5000 + 12980) 17,980
 Working Capital Management 143

Example 9

Miller-Orr Co needs a minimum cash balance of $40,000, and money transfers to and from the bank
cost $100 per transaction. According to a study of actual cash flows over the past year, the standard
deviation is $6,000 per day. The regular interest rate is 3% percent.

Requirements:

Calculate:

A. The spread between the upper and lower limits

B. The upper limit.
C. The return point.

Example 10

Which of the following does not determine the amount of credit offered by a supplier?

a) The credit terms the supplier obtains from its own suppliers
b) The ease with which buyer can go elsewhere
c) The suppliers total risk exposure
d) The number of purchases made by the buyer each year.

Choose from the following:

A. A only
B. A,B and C
C. C only
D. C and A

Example 11
A company requires 1,000 units of material X per month. The cost per order is $30 regardless of the size of the
order. The holding costs are $2.88 per unit pa. Calculate EOQ

Example 12
A company has estimated that for the coming season weekly demand for components will be 80
units. Suppliers take three weeks on average to deliver goods once they have been ordered and a
buffer inventory of 35 units is held.
If the inventory levels are reviewed every six weeks, how many units will be ordered at a review
where the count shows 250 units in inventory?

Example 13. Select the following

The Economic Order Quantity (EOQ):
A - is a formula that calculates a realistic purchase price for an item
 Working Capital Management 144

B - determines the lowest order quantity by balancing the cost of ordering against the cost of holding
inventory
C - is used to calculate how much safety inventory should be carried
D - should be calculated once a year

Example 14
Roshan Co is a European company that sells goods solely within Europe. The recently appointed
financial manager of Roshan Co has been investigating the working capital management of the
company and has gathered the following information:
Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units.
Forecast demand to meet production requirements during the next year is 625,000 units.
The cost of placing and processing an order is €250, while the cost of holding a unit in stores is €0.50
per unit per year. Both costs are expected to be constant during the next year. Orders are received
two weeks after being placed with the supplier. You should assume a 50-week year and that demand
is constant throughout the year.
Calculate the cost of the current ordering policy and determine the saving that could be made by
using the economic order quantity model.

Example 15
Monthly demand for a product is 10,000 units. The purchase price is $10/unit and the company’s
cost of finance is 15% pa. Warehouse storage costs per unit pa are $2/unit. The supplier charges
$200 per order for delivery.
Calculate EOQ

Example 16
Samkit Co uses component Anime22 in its construction process. The company has a demand of
45,000 components pa. They cost $4.50 each. There is no lead time between order and delivery, and
ordering costs amount to $100 per order. The annual cost of holding one component in inventory is
estimated to be $0.65.
A 0.5% discount is available on orders of at least 3,000 components and a 0.75% discount is available
if the order quantity is 6,000 components or above.
Calculate the optimal order quantity.
Using the data above, and ignoring discounts, assume that the company adopts the EOQ as its order
quantity and that it now takes three weeks for an order to be delivered.
How frequently will the company place an order?
How much inventory will it have on hand when the order is placed?

Example 17
One supplier has offered a discount to Box Co of 2% on an invoice for $7,500. If payment is made
within one month, rather than the three months normally taken to pay, Box’s overdraft rate is 10%
pa. Compute if it is financially worthwhile for them to accept the discount and pay early.

Example 18
 Working Capital Management 145

Clare Co has sales of $20 million for the previous year. Receivables at the year-end were $4 million
and the cost of financing receivables is covered by an overdraft at the interest rate of 12% pa.
Calculate the receivables days for Clare. Calculate the annual cost of financing receivables.

Example 19
A company is offering a cash discount of 2.5% to receivables I they agree to pay debts within one
month. The usual credit period taken is three months. What is the effective annualised cost of
offering the discount and should it be offered, if the bank would loan the company at 18% pa?

Example 20
Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although
customers on average take ten days more than this to pay. Contribution represents 60% of sales
and the company currently has no bad debts. Accounts Receivable are financed by an overdraft at
an annual interest rate of 7%.
Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and to
extend the maximum credit offered to 60 days. The company expects that these changes will
increase annual credit sales by 5%, while also leading to additional incremental costs equal to
0.5% of sales revenue. The discount is expected to be taken by 30% of customers, with the
remaining customers taking an average of 60 days to pay.
Evaluate whether the proposed changes in credit policy will increase the profitability of Ulnad
Co.

Example 21
A company faces a constant demand for cash totalling $200,000 pa. It replenishes its current account
(which pays no interest) by selling constant amounts of treasury bills which are held as an
investment earning 6% pa. The cost per sale of treasury bills is a fixed $15 per sale.
What is the optimum amount of treasury bills to be sold each time an injection of cash is needed
in the current account, how many transfers will be needed and what will the overall transaction
cost be?

Example 22

Crag Co has sales of $200m per year and the gross profit margin is 40%. Finished goods inventory
days vary throughout the year within the following range:

Maximum Minimum
Inventory Days 120 90

All purchases and sales are made on a cash basis and no inventory of raw materials or work in
progress is carried. Crag Co intends to finance permanent current assets with equity and fluctuating
current assets with its overdraft.
In relation to finished goods inventory and assuming a 360-day year, how much finance will be
needed from the overdraft?
 Working Capital Management 146

Example 23
Mile Co is looking to change its working capital policy to match the rest of the industry. The following
results are expected for the coming year:

Revenue 20,500
Cost of sales -12,800
Gross Profit 7,700

Revenue and cost of sales can be assumed to be spread evenly throughout the year.

The working capital ratios of Mile Co, compared with the industry, are as follows:

Mile Co Industry
Receivable Days 50 42
Payable Days 45 35
Inventory Holding Period 40 35

Assume there are 365 days in each year

If Mile Co matches its working capital cycle with the industry, what will be the decrease in its net
working capital?

Apply your knowledge: When only some of the customers take up the discount

Pratham Co has sales of $20 million for the previous year, receivables at the year-end of $4 million
and the cost of financing receivables is covered by an overdraft at the interest rate of 12% pa. It is
now considering offering a cash discount of 2% for payment of debts within 10 days.

Should it be introduced if 40% of customers will take up the discount?

Solution

Existing Scenario

Receivable Days = (Debtors / Credit Sales ) * 365

(4/20)*365 = 73

Cost of financing the debtors = Total debtors * Rate of interest

4000000*12% = 480,000

Proposed Scenario
Average
Description Proportion Sales Receivable Debtor Balance
Days
Category A: Who take up
discount 40% 8,000,000 10 219,178
 Working Capital Management 147

Category B: Do NOT take up

discount 60% 12,000,000 73 2,400,000
Total 20,000,000 2,619,178

Cost of financing debtors

(Revised) 314,301 [ 26,19,178 * 12% ] Total debtors * Rate of interest

Saving in cost of financing 165,699 [ 480000 - 314301 ]

Cost of discount 160,000 [ 80,00,000 * 2% ]

Net Benefit 5,699

Accept the proposal as there is a NET BENEFIT

Apply your knowledge

Leron is a medium-sized company producing a range of engineering products, which it sells to

wholesale distributors. Recently, its sales have begun to rise rapidly due to economic recovery.
However, it is concerned about its liquidity position and is looking at ways of improving cash flow.

Its sales are $16 million pa, and average receivables are $3.3 million (representing about 75 days of
sales). One way of speeding up collection from receivables is to use a factor.

Requirement

Determine the relative costs and benefits of using the factor in each of the following scenarios.

Option A:

The factor will operate on a service-only basis, administering and collecting payment from Leron’s
customers. This is expected to generate administrative savings of $100,000 each year.

The factor has undertaken to pay outstanding debts after 45 days, regardless of whether the
customers have actually paid or not. The factor will make a service charge of 1.75% of Leron’s
revenue. Leron can borrow at an interest rate of 8% pa.

Option B:

It is now considering a factoring arrangement with a different factor where 80% of the book value of
invoices is paid immediately, with finance costs charged on the advance at 10% pa.

Suppose that this factor will charge 1 % of sales as their fee for managing the sales ledger that there
will be administrative savings of $100,000 as before, but that outstanding balances will be paid after
75 days (i.e. there is no change in the typical payment pattern by customers this time).
 Working Capital Management 148

Solution

Existing Scenario

Sales 16,000,000

Debtors 3,300,000
Receivable Days 75

Current cost of financing debtors 264,000

[ Debtors * 8% ]

Situation A

Saving in admin cost 100,000 Saving

Because Leron is availing factor services, instead of the regular 75 days waiting time for collection.
The factor will pay him after 45 days. So, Receivable Days are 45.

Updated Receivable Days 45

Updated Balance of Debtors 1,972,603 [ Sales * 45 / 365 ]

Revised cost of financing debtors 157,808

Saving in cost of financing 106,192 [ 264000 Original - 157808 Revised ]

Service charge - 1.75% of Revenue 280,000

Cost benefit analysis

Saving in admin cost 100,000
Saving in cost of financing 106,192
Service charge cost -280,000
Net Benefit / (Cost) -73,808

So, proposal will be rejected

Existing Scenario
Sales 16,000,000
Debtors 3,300,000
Receivable Days 75
Current cost of financing debtors 264,000
[ Debtors * 8% ]

Situation B
Current Balance of Debtors 3,300,000
Any advance that the factor provides will be against this amount
 Working Capital Management 149

Advance from factor is 80% 2,640,000

Factor charges interest @ 10%
Interest payable to factor 264,000

Remaining 20% of the debtor balance is not Financed by the Factor.

For this remaining 20%, I will have to go to the bank and take an OD.
Bank will charge 8% interest on the OD amount.
OD will be 20% of debtor value.

Cost of financing via OD 52,800 [ 3300000 * 20% * 8% ]

Total cost of financing under [ Interest payable to Factor for 80% + Interest to
Factoring option 316,800 Bank for 20% ]
Additional cost of financing
debtors -52,800 [ 264000 Original - 316800 under factoring ]

Cost Benefit Analysis

Saving in admin cost 100,000
Sales ledger admin cost - 1% of sales -160,000
Additional cost of financing debtors -52,800
Net Benefit / (Cost) -112,800

Reject the offer

Apply your knowledge

Pop Co is switching from using mainly long-term fixed rate finance to fund its working capital to
using mainly short-term variable rate finance.

Indicate, by clicking in the relevant boxes, whether each of the following items will increase,
decrease or see no change with this change in working capital financing policy?

Finance Cost Decrease

Re-financing risk Increase
Interest rate risk No change
Overcapitalization risk No change

Overcapitalization risk refers to a level of investment in working capital. This is an investment

decision. Hence, no change.
 Working Capital Management 150

Apply your knowledge

A company generates $10,000 per month excess cash, which it intends to invest in short-term
securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs
associated with each separate investment of funds is constant at $50.

Requirement
What is the optimum amount of cash to be invested in each transaction?
How many transactions will arise each year?
What is the cost of making those transactions pa?
What is the opportunity cost of holding cash pa?

Solution

Q (Amount) = Square Root of (2* Demand for cash over period * Transaction cost / Cost of holding
cash)

=SQRT(2*120000*50/5%) = 15,492

Monthly excess cash = 10000

Annual Cash = 10000* 12 = 120000
Transaction cost = 50
Cost of holding cash = 5%

This 15492 indicates that if I want to invest the surplus cash, I must invest 15492 each time

In the year, you are generating 120000 excess cash, how many times will you invest (Annual Demand
/ Amount calculated) = 120,000/15,492 = 7.75

Cost of these transactions (Number of transactions * Transaction cost per transaction) = 7.75*50 =
387.30

Holding cost [ Average balance * Holding cost ] = [ 15492 / 2 * 5% ] = 387.30

Jan 10,000 (This is generated evenly throughout the month)

(Daily, I am generating 10000/31 = 323 $ excess cash) =10000/31 = 322.5806

Feb 10,000

Mar 10,000

You generate 10000 in Jan

Then you generater additional 5492 in Feb
The moment excess cash in your account is 15492, you invest the amount in Securities

Solutions:
 Working Capital Management 151

Example 1

2013 2012
Net profit margin =100*8134/209050 =100*7470/20750
=28% =36%

Current ratio =10698/8730 =5652/3774

=1.2 times =1.5 times

Quick ratio =6400/8730 =3468/3774

=0.7 times =0.9 times

Inventory days =365*4298/20916 =365*2184/1328

=75 days =60 days

Receivable days =365*6400/29050 =365*3468/20750

=80 days =61 days

Payable days =365*5730/20916 =365*3274/13280

=100 days =90 days

Net working capital ratios =10,698,000 - 8,730,000 =5,652,000 - 3,774,000

=$1,968,000 =$1,878,000

Sales/net working capital =29050/1968 =20746/1878

=15 times =11 times

❖ The current ratio and quick ratio have drastically fallen in 2013 as compared to 2012 and
are below the industry averages, clearly indicating deteriorating liquidity of Roadhog.
❖ The inventory turnover days have increased by 25% and are far in excess of the industry
average, indicating Roadhog is taking longer to sell off inventory. It may indicate that
Roadhog is holding excessive inventory.
❖ Receivables turnover days have increased and could be the reason for the fall in liquidity as
the company may not be collecting money from customers on time. The increase in sales
by around 40% may be attributed to less stringent credit terms and follow up.
❖ Payables turnover days have also increased by 10 days from 90 to 100, and Roadhog is
paying supplier much later than industry standards. This could be a result of poor liquidity
and cash-crunch, as evidenced by the increase in overdraft.
❖ In 2012, the current assets of 5652, 67% seems to be funded from short term liabilities,
whereas in 2013, out of the current assets of 10698, 81% is funded by short term funds,
which means the company's reliance on short term finance has increased.
❖ Since the turnover of the company is rapidly increasing, the current ratio and liquidity
deteriorating, and the reliance on short term finance is rising, the company may be said to
be over-trading.
 Working Capital Management 152

Example 2

EOQ = V (2*30*64000/3% x 80) =1265 units

Annual Cost of ordering = (1265/2) x(3% x 80) = $1518
Annual cost of Holding = 64000/1265 x 30 =$1518

Example 3

EOQ = V(2x 5000 x 130,000/600) =1,472 units

Ch = 30% of $2000 = $600
Annual cost of ordering at EOQ = 130,000/1,472 x 5,000 =$441,576
Annual cost of holding at EOQ = 1,472/2 x 600 = $441,576 (rounded
down!)
Purchase cost = 130000 x 2,000 = 260,000,000 Total cost = $260,883,152

If the company orders at 4000 units,

Ch = 30% of $1960 (discount) = $588
Annual cost of ordering = 130,000/4,000 x 5,000 =$162,500
Annual cost of holding = 4,000/2 x 588 = $11,76,000
Purchase cost = 130,000 x 98% x 2000 = 254,800,000
Total cost = $256,138,500
Since ordering at 2000 units is cheaper, order bulk.

Example 4
(All calculations in $000)

Cost of factoring:
Factoring fee = 1%*50,000 = 500

Benefit from choosing factoring

Admin savings = $30
Interest savings (W1) = $389
Total = $419
Since the benefit is less than the cost reject the offer.

(Working 1)

Current receivables = 50,000*40/365 = $5479

Revised receivables = 50,000*15/365 = $2055
Reduction in receivables = $3245 (5479-2055)
Interest savings there on = $3245*12%= $389
 Working Capital Management 153

Example 5

(All calculations in $000)

Cost of change:
Discount = (3%*40,000*0.2) + (1.5%*40,000*30%) = $420

Benefit of change
Interest savings (W1) = $436
Since the benefit is greater than cost change to new policy

W1
Current receivables = $9000
Current receivables turnover days = 365*9000/40,000 = 82 days
Current receivables turnover days = (20%*10 days) + (30%*2 days) + (50%*82 days) = 49 days
Revised receivables = 40,000*49/365 = $5370
Reduction in receivables = $3630 (9000-5370)
Interest savings there on = $3630*12%= $436

Example 6
Annual cost of discount = (100/97.4)6-1 = 17%
n =12/(3-1) = 6
Bank overdraft = 18%
Hence if money is paid earlier discount benefit is more than the additional interest cost. Hence, take
discount.

Example 7
Annual benefit of discount = (15,000/14700)6-1 = 12.9%
n = 12/(3-1)
Bank overdraft = 10%
Hence if money is paid earlier discount benefit is more than the additional interest cost. Hence, take
discount.

Example 8
Optimum cash to inject/transfer = V(2*30*400000/0.06) = $20,000

Example 9

Spread = 3*3V(3/4*100*36000000/0.0003) = $62402

Upper limit = 40,000+62402 = $102402
Return point = (40,000+62402)/3 = $60,800

Example 10 – b
 Working Capital Management 154

Example 11
EOQ = Square Root of ( 2*Annual Demand *Order cost per order/Holding cost per unit per annum)
= SQRT(2*12000*30/2.88) = 500

Example 12
Weekly Demand 80
Lead Time 3 weeks
Buffer Stock 35

Re-order level 240 Demand in Lead Time

Review happens every six weeks

So, if I check it today, the next review will happen after 6 weeks and there will be no review at any
point of time in between.
When I check today, I must ensure that I have enough stock to last for six weeks because no one will
go and check on stock levels in between.
Does that mean I need to have 6*80 = 480 units in stock today so that these will last me six weeks.
After I do a review after six weeks and I want to place an order, it will be delivered after 3 weeks.
So, I must also have additional 3 weeks of stock with me to handle the requirement in lead time.
So, in addition to 480 units, I must have 3*80 = 240 units to handle my requirement in Lead Time.

So, total units I must have when I conduct a review today = 480 + 240 = 720 units
The question says, I need to have a Buffer stock of 35 units
So, total stock I should have = 480 + 240 + 35 = 755
And when I did my review, I had 250 units in stock
So, I must order = 755 - 250 = 505 units when I place an order

Example 13 B

Example 14
Current Inventory Management Policy

Re-order level 35,000

Annual Demand 6,25,000

Order size 1,00,000

Number of orders 6.25

Order cost per order 250

Total order cost 1,563

 Working Capital Management 155

Lead time 2 weeks

Which means I should have 2 weeks worth of stock on hand while placing an order

2 weeks worth of stock 25,000

Re-order level 35,000

Can I Say that 10000 units are for safety purpose?

Ideally, re-order level should be equal to demand in lead time

My supplier is going to deliver in 2 weeks. So ideally, I should hold only 25000 units to manage lead time
But I hold 35000 units as re-order level
This means 10000 is to take care of contingency - Buffer stock

Average stock = Order size / 2

But in our case, in addition to this value, I always hold 10000 units for the sake of safety
So, 10000 will always have to be carried by the business

Average stock = Safety stock + 100000/2 60,000

Holding cost per unit per annum 0.50

Total Holding cost 30,000

Total Cost 31,563

EOQ Model

EOQ = Square Root of ( 2* Annual Demand * Order cost per order / Holding cost per unit per annum)

EOQ = 25000

Order cost per order = 250

Number of orders = 25

Order cost (Total) = 6,250

Buffer stock + (Order size / 2)

Average Inventory = Here, order size is 25000
= 22500

Holding cost per unit per annum = 0.50

Total Holding cost = 11,250

Total Cost = 17,500

How much will I save if I use EOQ = 14,063

 Working Capital Management 156

Example 15

Monthly Demand 10,000

Annual Demand 1,20,000

EOQ = Square Root of ( 2* Annual Demand * Order cost per order / Holding cost per unit per annum)
= 3,703 units

Order cost per order 200

Holding cost per unit per annum
Storage cost 2.00
Purchase cost 10.00
Interest cost - 15% 1.50

Total Holding cost per unit 3.50

If I do not borrow funds, I will not be able to purchase the material

So, borrowing is essential for buying material and holding it in my warehouse
So, borrowing cosr is an essential element of holding cost

Example 16
Part A

EOQ = Square Root of ( 2* Annual Demand * Order cost per order / Holding cost per unit per annum)
= SQRT(2*45000*100/0.65) = 3,721

Particulars Proposal I Proposal II EOQ

Annual Demand 45,000 45,000 45,000

Order size 3,000 6,000 3,721

Number of orders (45000 / Order Size) 15 7.50 12.09

Order cost per order 100 100 100

Total Order Cost - ( A ) 1,500 750 1,209

Order size 3,000 6,000 3,721

Average Inventory (Order size / 2) 1,500 3,000 1,861

Holding cost per unit per annum 0.65 0.65 0.65

 Working Capital Management 157

Total Holding Cost - ( B ) 975 1,950 1,209

Purchase cost per unit (without discount) 4.5 4.5 4.5

Total Purchase cost (without discount) -
45000 * cost p.u 202,500 202,500 202,500
Discount offered by supplier 0.50% 0.75% 0.50%
Total purchase cost after discount - ( C ) 201,488 200,981 201,488

Total Cost ( A + B + C ) 203,963 203,681 203,906

Out of I and II, your total cost is lower in case you order 6000 units in one go
So, out of I and II, you should go in for 6000 units, avail the discount and save cost
Even if EOQ is considered, ordering 6000 units in one go is cheaper
Prefer proposal II as cost is lowest

Part B
EOQ = 3721 units
Lead time is 3 weeks means after placing an order, it will be delivered after 3 weeks
So, you should have 3 weeks worth of stock with you when you place an order

Annual Demand 45,000 (52 weeks)

Inventory level desired while placing an order 2,596 (Re-order level) [ 45000 * 3 / 52 ]

Order size (EOQ) 3721

Number of orders 12

If I am placing 12 orders in a year, that means I am placing orders on a MONTHLY frequency.

Example 17
Annual Cost of Discount = [(1 + Discount / Amount left to pay)^ Number of periods ] – 1
= ((1+2/98)^6)-1 = 12.89%

Number of periods = 12 / Number of months cash is paid in advance = 12/2 = 6

Current payment period 3

If discount is accepted within 1

Cash is paid 2 months in advance

OD Rate 10%

If I accept to pay within 1 month, I will have to borrow from the bank
This borrowing will be at the rate of 10% - This is my cost
When I borrow from the bank and pay my supplier with 1 month, the annual benefir of discount
comes to 12.89%
Benefit (12.89%) is more than cost (10%)
 Working Capital Management 158

So, it makes sense to borrow from bank and pay the creditor within 1 month

Example 18
Receivable Days = ( Debtors / Credit Sales ) * 365 = 73 days
Rate of interest = 12%
Cost of financing = Amount of debtors outstanding * Interest Rate
= 4*1000000*12% = 4,80,000

Example 19
Annual Cost of Discount = ([1 + (Discount / Amount left to pay)] ^ Number of periods) – 1 = 16.41%
Discount 2.5
Amount left to pay 97.5 [ 100 - 2.5 ]

Usual credit period 3

Early settlement after 1
Cash is received 2 months in advance

Number of periods 6 [ 12 / 2 ]

If you give a discount, then the cost you would incur is 16.41%
Cost of taking an OD from bank is 18%
Cost of discount is lower than cost of interest on OD
So, offer the discount and collect the cash early

Example 20
Current Policy
Sales 6,000,000
Receivable Days 40
Debtors Balance 657,534 [ 6 mn * 40/365 ]

Cost of financing debtors 46,027

Proposed Policy
Sales increase by 5%
Revised Sales 6,300,000
Additional Sales 300,000
Additional Contribution - 60% of sales 180,000

% of Receivable
Category of debtors Sales Debtors
customers Days
Category A: Take the
discount 30% 1,890,000 15 77,671
 Working Capital Management 159

Category B: Do NOT take

the discount 70% 4,410,000 60 724,932
802,603

Updated Balance of debtors 802,603

Cost of financing these debtors 56,182

Additional cost of financing debtors -10,155 [ 56182 New - 46027 old ]

Additional Cost due to increased sales 31,500

[ Total Sales * 0.5% ]

Cost of discount [ 1890000 * 1.5% ] 28,350

Cost Benefit Analysis

Additional contribution due to increased sales 1,80,000

Additional cost of financing debtors -10,155
Additional Cost due to increased sales -31,500
Cost of discount -28,350

Net Benefit / (Cost) 1,09,995

Accept the proposal

Example 21
Annual Demand 200,000
Transaction cost 15
Interest (Holding cost) 6%

Q (Amount) = Square Root of (2* Demand for cash over period * Transaction cost / Cost of holding
cash) = 10,000
2*200,000*15/6% = 100,000,000
100,000,000 ^ (1/2) = 10,000

Optimum amount to be invested / withdrawn = 10000

Number of trasnactions (Annual Demand / Optimum Cash calculated) = 200,000/10,000 = 20 Transactions
during the year
Total Transaction Cost [ Number of transactions * Cost per transaction ] = 15*20 = 300
 Working Capital Management 160

Example 22
Minimum Inventory Days - 90: This means at any given point of time, I have 90 days worth of stock.
This is my permanent stock - Permanent / Fixed Working Capital

Maximum Inventory Days - 120: This means that at any point, my stock level does not exceed 120
days worth of stock

The stock value fluctuates over 90 but never exceeds 120

So 120 - 90 = 30 is my fluctuating working capital

Sales 200
Gross Profit (40%) 80
Cost of sales 120

90 days stock: Permanent Current Asset 30

120 days stock 40

Fluctuating working capital [ Max - Permanent] 10

You are going to finance only fluctuating current asset using OD.
So, OD needed will be 10

Example 23

Current level of working capital If I shift to industry average

Receivables 2,808 Receivables 2,359

Payables -1,578 Payables -1,227
Inventory 1,403 Inventory 1,227

Net working capital 2,633 Net working capital 2,359

Decrease in net working capital 274

 Working Capital Management 161

PO10 – MANAGE AND CONTROL WORKING CAPITAL

Description

You manage cash and working capital effectively using appropriate technology, planning for any
shortfall or surplus including receivables, payables and inventories.

Elements

A. Source short-term finance to improve organisational liquidity.

B. Analyse and plan appropriate levels of cash and working capital.
C. Prepare and monitor organisational cash flow, credit facilities and advise on appropriate
actions.
D. Contribute to the way current systems for managing cash, short-term liquidity and working
capital operate.
Operate and comply with controls and safeguards over working capital management.
Syllabus Area G:

Risk Management
 Risk Management 137

Syllabus area G1 a-G4 b

- The nature and types of risk and approaches to risk management

- Causes of exchange rate differences and interest rate fluctuations
- Hedging techniques for foreign currency risk
- Hedging techniques for interest rate risk

Introduction

We all are familiar with the fact that currency exchange rates and interest rates are volatile (change
rapidly) thus, this becomes a problem to corporations that deal with different countries and
corporations that deals with debt. There are MNCs that deal with large values of debt, and foreign
exchange (MNCs), small movements in currency can cause disproportionate losses to a business.

Thus, in this syllabus area, we will learn how to mitigate these risks, namely;

1. Interest rate risk

2. Foreign exchange risk

Interest rate risk

This refers to the risk of an adverse impact on a company’s assets as a result of interest rate
changes. Interest rate risk affects both the borrowers and investors, several organisations and
capital-intensive industries.

As studied before, risk increases with uncertainty, and uncertainty rises with a longer duration. Thus,
interest rate risk arises when capital is borrowed over long periods of time. Capital can be borrowed
at a fixed or a floating rate (fixed interest rates remain static for the duration of the loan while
floating charges change periodically with the market.)

For example, If ABC Co wants to borrow $8 billion in 3 months time and the current interest rate is
7%, however, the company is uncertain whether the interest rate might increase in the next three
months. This gives rise for a need to quantify the risk faced by the company and further mitigating it.
The risk is quantified by the difference in the rate of interest that has to be paid by the organization
and the estimated movement of market interest rates.

Interest rates on newly issued bonds may be influenced by either company specific factors such as
availability of security, duration of borrowing or other general economic factors such as the term
structure of interest rates, which is discussed below.

The yield curve

The yield curve basically indicates future interest rate changes, the slope will give an idea of what
future interest rates are going to look like. The yield(return) of debt security varies with respect to
the to the term structure(duration) of the security. This is because the risk is related to return, and
term structure is a factor that varies the risk profile (same concept of risk and return). Term
structure of interest rates refers to the way in which the yield (return) of a debt security or bond
varies according to the term structure of the security.
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Above is a normal upward sloping yield curve, this suggests that interest rates will rise in the future,
it also indicates that there is going to be ac. A manager would therefore have to:

• Avoid borrowing long-term on variable rates, since interest payments may increase considerably
over the long term of the loan.
• Rather choose short-term variable rate loans or long-term fixed rate loans instead.

The yield curve will not always necessarily be upward sloping (other types of the yield curve is not
tested in F9), however, the slope of the yield curve at any point is the result of the following three
theories acting together.

1) Expectations theory

Expectations theory states that an investor would earn the same amount of interest by
investing in a one year bond today and rolling that investment into a new one-year bond a
year later, as compared to buying a two year bond today itself. The implication is that long-
term interest rates contain a prediction of future short-term interest rates.
For example, a twenty-year bond is equal to buying two ten year bonds in succession. But,
investors attach a higher risk to longer maturities due to some intrinsic factors not explained
or predicted. The liquidity preference theory explains why.

2) Liquidity preference theory

An investor would naturally prefer to have more liquid (shorter maturity) investments over
locking in its capital for a longer period of time. Thus investors will expect a higher return if
their investment is for a longer duration.

3) Market segmentation theory

The market segmentation theory states that there are different players in the short-term end
of the market and the long-term end of the market.
This theory states that the bond market is completely different and segmented for bonds
with different maturities.
The interest rate for a bond with a given maturity is determined by the supply and demand
for bonds in that segment with no effect from the returns on bonds in other segments. This
theory explains the ‘kink’ seen in the middle of the curve where the short end of the curve
meets the long end – it is a natural disturbance where two different curves are joining, and
the influence of both the short-term factors and long-term factors are weakest.
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Hedging interest rate risk

The term hedging refers to the process of protecting oneself from the risk of financial loss.
The following are some methods of hedging interest rate risk:

• Forward rate agreements (FRA)

• Interest rate futures
• Interest rate guarantee (IRG)
• Interest rate option
• Interest rate swap

It is important to think from both the perspective of a borrower and depositor while studying these
concepts.
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Forward rate agreements (FRAs)

FRAs are used to lock the interest rate on a loan or a deposit that will commence on a future date. It
is an agreement to fix the effective interest rate at which the company will be able to borrow at a
future date. Effective interest rate is the actual interest rate applied to the investment or loan.
These are called as over the counter agreements (OTC), which are tailor made to the company’s
needs.

In market terminology, an FRA on a notional four-month loan/deposit starting in six months time is
called a ‘6v10 FRA/6-10 FRA.’ The first digit represents the number of months remaining for the
loan/deposit to commence and the digit to the right represents the number of months from today to
the end of the loan/deposit’s term.

The aim of FRA is to:

• Lock the company to a target interest rate.

• Protect the company from any adverse movements, but preventing the company to
gain from any favorable movements too.

For example, if GYNA Co needs to borrow money and enters into an FRA with its bank to lock in the
interest rate at 6%. If the market interest rate turns out to be higher when the loan commences,
GYNA Co will be protected, however, if the interest rate falls to say 5%, GYNA will not benefit from
this as they are locked into paying 6% interest.

However, in practice, this transaction is done in a slightly different manner. The company enters into
a normal loan with an entity but independently organizes a forward rate agreement with a bank. An
FRA for a loan is carried out in the following manner:

1) Interest is paid on the loan as usual.

2) If the interest is less than the agreed forward rate, the bank pays the difference to the
borrower.
3) If the interest rate is more than the agreed forward rate, the borrower pays the bank the
difference.

It is crucial to remember this table.

FRA > Market interest rate FRA < Market interest rate

Borrowing Holder pays the bank the Bank pays the holder the
difference between FRA and difference between FRA and
market interest. market interest.

Depositing Bank pays the holder the Holder pays the bank the
difference between FRA and difference between FRA and
market interest. market interest.

LIBOR is a term that will show up in almost every sum, and it is nothing but the base market interest
rate. It stands for London Inter-Bank Offer rate.
 Risk Management 141

Banks quote interest rates as, for example, 5%-5.5%, the lower rate will always be the interest
receivable for depositing with the bank, and the higher rate will be for borrowing from the bank.
Because banks will always intend to make a profit.

Apply Your Knowledge:

A company wishes to borrow $20 million in seven months time for a four-month period. It can
normally borrow from its bank at LIBOR + 0.5%. The company is worried about the risk of a sharp
rise in interest rates in the near future.

A bank quotes FRA rates of:

4 v 11: 5.4%-5.5%

7 v 11: 5.3%-5.25%

The LIBOR will be 6% in of 6 months time.

Required: Compute the gain/loss on FRA and who will need to make the compensation payment.

Solution:

The FRA borrowing rate relevant to the company is 5.3%. The company will pay LIBOR+0.5% which is
6%+0.5% = 6.5%. FRA > interest rate thus, the company will get compensated by 1.2% (6.5%-5.3%)
Interest compensation will be = 1.2%*(4/12) *$20 million = $80,000

Interest rate futures (IRFs) Only theoretical questions relating to this will come on the exam

❖ IRFs is a derivative and works on a different market (futures market).

❖ IRFs work on the same principle of forward agreements, except interest rate futures are not
tailor made for the company, they are traded contracts on a public market and is sold in blocks,
these contracts expire at the end of every three months (March, June, September and
December).
❖ The futures market works inversely to the money market, this means that if interest rates in the
money market rise, then the value of futures will fall. Thus, a company can hedge themselves by
having positions in both the money market and the futures market, as if there are losses in the
money market, they will be set off by gains in the futures market and vice versa.

Interest Rate Guarantees (IRGS).

FRAs did not allow the company to avail of any gains due to a favorable interest rate movement (if
any). However, IRGs allow for this flexibility at the cost of an upfront fee, making this more
expensive than FRAs as this allows the company to benefit from any favorable movements in the
market.
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The way an IRG works is, a company will get into a contract with the bank and fix a
maximum/(minimum) borrowing/lending rate on a notional loan for a fixed period starting from a
fixed future date.

For example, if ABC Co wants to borrow money, they will fix a maximum payable interest rate,
protecting them from any adverse movement. However, the benefit with an IRG is that the company
has the benefit of lapsing the contract if there is any favorable movement in the interest rate. For
example, if ABC Co has fixed a maximum interest rate of 5% and the market rate turns out to be 4%
when the loan commences, ABC Co can pay interest at the market rate instead of the maximum cap
fixed in the contract.

The following are some terms you need to be familiar with:

❖ Cap: This is an IRG where the maximum interest rate on borrowings is restricted, with the
company getting the full benefit of any rise in interest rates (like in the example above).
❖ Floor: Floor is an IRG where the company sets a minimum interest rate payable by the bank on
deposits, with the company getting the full benefit of any decrease in rates.
❖ Collar: Collar is basically a combination of Cap and Floor. From a borrowing company’s point of
view, this means that while the company’s maximum interest rate payable is restricted, the
minimum interest it must pay is also fixed. The company faces the lowest risk in a collar as
compared to other IRGs. Thus, it has a lower premium and is generally cheaper.

Exchange traded interest rate options

This again is similar in principle to IRGs, except options are market traded instruments and are sold
in blocks, not over the counter, unlike IRGs. Here, instead of taking an IRG with the bank, the
company transacts in the options market and obtains the same benefit through these market traded
instruments. The mechanics and calculations of options are not in the F9 syllabus.

Interest rate swaps

Interest rate swaps are generally long term and over the counter (OTC). This is an agreement
whereby the parties agree to swap a floating stream of interest payments for a fixed stream of
interest payments and vice versa. However, there is no exchange of principal.

The above might be complicated to understand, but the mechanics and calculations are beyond F9.
Swaps may be used by firms that desire a type of interest rate structure that another firm can
provide less expensively.

Foreign exchange risk

Foreign exchange (Forex) risk is basically the risk of adverse currency exchange rate movements
causing financial losses to company’s that trade internationally and/or MNCs.

A company may owe or be owed money by various entities across national borders. The company
can then create a cash forecast of the inflows and outflows from different countries, this facilitates
in identifying the extent to which the company is exposed to foreign exchange risk.

Exchange rate risk can arise through:

• Transaction risk
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• Translation risk
• Economic exposures

Transaction risk

In practice, transactions for payments are completed before the payments are actually settled. This
basically means that an invoice will be generated, and the goods will be received however, the
actual payment will be completed on another date. Thus, transaction risk refers to the risk of an
exchange rate moving adversely between the transaction date and the settlement date of an
invoice.

Managing transaction risk: There are various techniques used to manage this and will be studied
later in the chapter.

Translation risk

This is a risk that is mainly faced by MNCs and groups that have entities in various countries. For
example, a company in the US has a subsidiary in the EU, and the value of the $ has depreciated
against the Euro. Thus the value of assets converted from Euro to $ will have also declined.
Translation exposure results whenever assets, liabilities or profits are translated from operating
currency into reporting currency.

Managing translation risk: Translation risk is notional and is not a real risk that needs to be managed
in an organized manner.

Economic risk

Economic risk refers to the risks accruing to a company due to the long-term fluctuations in the
exchange rate. This leads to certain companies suffer in international markets.

For example, if a company’s domestic currency appreciates in value significantly over time, their
products will naturally be more expensive on international markets. Thus, this leads to the company
having a disadvantage internationally as no matter how much they try to control their costs, they
will not be cheaper than domestic products available in other countries.

Managing economic risk: Global diversification, is a solution to economic risk exposures. This means
that the parent company should try to have head offices or subsidiaries in different countries.
 Risk Management 144

Foreign exchange rate hedging calculations

The following are some terminology you should be aware of:

❖ Spot rate: The exchange rate for transactions that are going to take place immediately. Basically,
this is the rate at which currency can be exchanged today. For example, $3/1£.
❖ Forward rate: It is the rate at which the settlement price for a transaction that will take place on
a predetermined future date.

For example, Current spot rate $3/1£. 2-month forward rate $3.04/£1

❖ Bid/offer spread: This is a common area students get confused. This is the difference between
the buying and the selling prices offered at the close of each business day. The bid rate is the
rate at which the bank is willing to buy currency from a customer, the offer rate is the rate at
which the bank will sell currency to the customer. It is presented as follows:

E.g. £ is the home currency. The US $/£ at the close of business was: 1.888-2.404. This means that
the bank will buy 1£ for 1.888$ and will be willing to sell 1£ in exchange for $2.404. A simple way to
remember which is the buy rate and offer rate, is to remember that the bank will always make a
profit. Thus, the bank will always sell home currency at a rate higher than at which it will buy the
same currency.

Predicting future exchange rates

This section will help you understand how banks come up with the forward rate. There are two
theories that help with this, they are as follows:

1. Interest rate parity theory (IRPT)

The IRPT claims that the difference between the interest rate between two countries is equal to the
difference between the forward exchange rate and the spot exchange rate.
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IRPT predicts that exchange rates will vary to eliminate price differences between countries.

(Assume US is the foreign currency and UK is the home currency)

Forward rate US$/£ = Spot US$/£ x (1 + US interest rate) number of years
(1 + UK interest rate) number of years

Forward rate = Spot x (1 + foreign interest rate) number of years

(1 + home interest rate) number of years

IRPT predicts that the country with the higher interest rate will see the forward rate for its currency
depreciate in value.

2. Purchasing [power parity theory (PPPT)

This theory is based on the idea that the exchange rate between two countries depends on the
relative inflation rates within the respective countries.

The forward rate can be estimated using PPPT using the following formula:

(Assume US is the foreign currency and UK is the home currency)

Forward rate US$/£ = Spot US$/£ x (1 + US inflation rate)number of years
(1 + UK inflation rate) number of years

Forward rate = Spot x (1 + foreign inflation rate) number of years

(1 + home inflation rate) number of years

PPPT predicts that the country with the higher inflation rate will have its exchange rate
depreciate in value.
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Example 1

US $ is the home currency. If the spot rate is INR 50/$ and the expected interest rate in India is
10%, and the expected interest rate is 4% in the US.

Required:

a) What will be the expected forward rate in one year?

b) What will be the expected forward rate in four years?
c) What will be the expected forward rate in 5 months?

Managing foreign exchange transaction risk – Internal methods

The following are some methods a firm can use within the company to manage its foreign exchange
risk.

• Dealing in the home currency: This method insists that all customers of the firm pay in
the domestic currency, this includes all imports for the firm as well. Thus, this method is
not widely accepted as all the risk is transferred to the counter party while the company
will not face any risk.
• Leading: Leading is making the payment before it is due. This is used if the firm that is
importing goods expects that the currency it is due to pay (foreign) will appreciate in
value and should settle the payment immediately. However, this will result in the loss of
working capital.
• Lagging: Lagging is making the payment after it is due, basically delaying the payment.
This is used if the firm that is importing goods expects that the currency it is due to pay
(foreign) will depreciate in value, it should try to delay the payment. However, it is rare
that exporters will accept this.
• Matching or netting off payments with receipts: When a company is owed receipts and
is due to make payments at the same time in the same foreign currency, it can simply
net the payments off. This will result in the company being exposed by forex risk only to
the extent of the unmatched portion of the company’s total transactions.
• Foreign currency with bank accounts: When a firm has several transactions in a foreign
country it, would be ideal for that firm to open a bank account in that country itself. This
essentially operates as a permanent matching process. However, only the net balance of
the bank account will be exposed to foreign currency risk.
• Do nothing: If the probability of the risk occurring is high, as well as if the impact (loss) if
it occurs is high. Then the company could just exit the transaction.
 Risk Management 147

Managing foreign exchange transaction risk – External methods

These are external techniques established by banks and financial markets to help firms hedge
foreign exchange risk.

• Forward exchange contracts

• Money market hedge
• Future contracts
• Options

Forward exchange contracts

This is similar in principle to FRAs. A forward exchange contract is over the counter and is an
agreement whereby a company fixes today the rate at which currency will be exchanged for on a
specific future date. Thus, it locks itself into a particular exchange rate.

Example 2

Ashe plc, a UK based company, is due to pay $100,000 in 4 months’ time. The spot rate is currently
($ per £) 1.998-2.002, but this has been volatile over the recent month. The 4-month forward rate is
($ per £) 1.97-2.01.

Required: Calculate the expected sterling payments in 4 months’ time, if a forward market hedge
is used.
 Risk Management 148

Money Market Hedge (MMH)

This concept is frequently tested in the exam. The whole idea of an MMH is to lock in the company’s
future cash flows at a certain exchange rate, thus providing certainty at a point in the future. The
result is similar to that of a forward contract and thus is used whenever a forward contract is not
available to be used.

A money market hedge is not a special type of contract or anything, but just smartly uses a foreign
bank and interest rates to hedge its position. The working is slightly complicated but keeps these
points in mind, and it is hard to go wrong

If the company needs to make payments in the future in a foreign currency

• Borrow in the domestic currency

• Convert it into the overseas currency
• Invest the money borrowed in an overseas bank (make a deposit)
• At the end of the term, that money can be used to make the overseas payment.

If the company has a receipt in the future in a foreign currency

• Borrow in the overseas currency. (this is what will be used to make the foreign payment)
• Convert into domestic currency
• Invest the money in a domestic bank
• Withdraw domestic investment and use the receipt to pay off the overseas loan.

Apply Your Knowledge:

Reaper plc is a UK based company and is expected to pay $300,000 in 4 months’ time, but is now
considering a money market hedge. The following details are available:

Spot rate: $3/£ ± 0.002

4-month forward rate: $2.99/£ ± 0.04$

Borrow Deposit
UK 6% 5.6%
USA 4.3% 4%

Required:

a) Construct an MMH for the future payment in 4 month’ time

b) If Reaper were to now sell goods to a customer and expects to receive $400,000 in four month’
time, how would you now use MMH.

Solution:

a) This is a receipt transaction thus, an MMH would require to create an asset (deposit) overseas and
a(borrow) domestically.

The loan will not be for an entire year. Thus, we first calculate the effective interest rate, which is:
 Risk Management 149

Domestic borrow rate = 6%*4/12 = 2%

Overseas deposit rate = 4%*4/12 = 1.33%

The company is going to convert the domestic loan into a foreign currency

Step 2: Home borrow 98,751 x (1.02) Step 3: Pay domestic loan

£98,751 £100,726

Convert @ spot $296,054/(3.002)

$296,054 $300,000 payment

Step 1: foreign invest 300000 / (1.0133)

(To get an idea of what exactly is happening refer to the points on MMH in case overseas payments
above)

Important Explanation of steps: (not necessary to write during exam, this is just for understanding)

Step 1: The payment amount is discounted by the foreign investment interest rate to the date where
the payment needs to be made. [The whole idea of this is to borrow exactly how much you should
invest overseas in order for the total yield to equal the overseas payment amount by the due date.]

Step 2: The foreign investment amount is converted to the home currency, as this is the amount that
needs to be borrowed.

Step 3: The payment to the supplier is made with the amount that was invested in the foreign bank,
while all the company has to do is pay off the domestic loan at the effective interest rate.

b) This is a receipt transaction thus, an MMH would require to create a liability (borrow) overseas
and an asset (deposit) domestically.

The payment will not be for an entire year. Thus, we first calculate the effective interest rate, which
is:

Overseas borrow rate = 4.3%*4/12 = 1.43%

Domestic deposit rate = 5.6%*4/12 = 1.86%

Step 2: Home deposit 98,751 x (1.0186) Step 3: Receive yield from investment

£131,366 £133,809

Convert @ spot $394,361/(3.002)

$394,361 $400,000 receipt

Step 1: foreign borrow 300000 / (1.0143)

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(To get an idea of what exactly is happening refer to the points on MMH in case overseas payments
above)

Important Explanation of steps: (not necessary to write during exam, this is just for understanding)

Step 1: The payment amount is discounted by the foreign investment interest rate to the date where
the payment needs to be made. [The whole idea of this is to borrow exactly how much will end up
being equal to the receipt amount on the due date]

Step 2: The foreign borrowed amount is converted to the home currency, as this is the amount that
needs to be invested.

Step 3: The overseas receipt is used to pay off the overseas loan, and the investment domestically is
withdrawn, and that is treated as the receipt.

Future contracts

The exact mechanics and calculations are not a part of the f9 syllabus, however, there are certain
points you need to be familiar with.

Futures contracts are similar in principle to Forward rate agreements, in the sense that it is an
agreement between the buyer and seller to exchange something at a certain point in the future,
except they are not over the counter and trade in standard sizes only. These are market traded
derivatives and operate in the futures market.

A future is more flexible as it can be traded at any time. It is not literally a contract, but more of a
form of bet that is placed, based on the exchange rates and only the actual gain or loss made on the
bet is what is exchanged.

Similar to interest rate futures, the forex futures market works inversely to the money market,
where any gains or losses made in the money market will be set off by the gains or losses made in
the futures market.

This is what you need to remember when trying to hedge using futures:

• If you are due to receive foreign currency in the future, you need to sell foreign currency
futures today.
• If you are due to pay foreign currency in the future, you would buy foreign currency
futures today.

Basis risk: The way the futures market works is that, on the expiry date of the contract, the futures
prices will match the prices in the money market. Futures are called derivatives because the values
are derived from the actual prices in the money market and are thus highly correlated to them.
However, the correlation is not perfect until the expiry of the contract. Thus, basis risk is the risk that
these prices don’t exactly correlate, and it could result in an imperfect hedge.
 Risk Management 151

Options

An option is like a futures contract, where it is an agreement to buy or sell currency at some at a
predetermined date in the future. However, an option gives the holder the right but not an
obligation to buy or sell the currency. Thus the holder has more flexibility as they can lapse the
agreement if the market movement of the exchange rate is favorable itself. These, too are traded in
fixed sizes on the derivative market.

The following is the terminology for options:

• Put: The holder has the right to sell a currency at a predetermined date in the future.
• Call: The holder has the right to buy foreign currency at a predetermined date in the
future

As the holder has more flexibility with options, thus it is more expensive than futures. A premium
must be paid on the option regardless of whether it is exercised or not.

Example 4

Sombra Co is a UK-based company which has the following expected transactions:

Two months: Expected receipt of $340,000

Two months: Expected payment of $240,000
Four months: Expected receipts of $400,000

The following is relevant financial information:

Spot rate ($ per £): 1.8820±0.0003

Two months forward rate ($ per £): 1.8829±0.0004
Four months forward rate ($ per £): 1.8846±0.0005

Money market rates for Sombra Co:

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Borrowing Deposit
One year sterling interest rate 5.9% 5.6%

One year dollar interest rate 6.4% 6.1%

Assume that it is now 1 April

Required:

a) Calculate the expected sterling receipts in two months and in four months using the
forward market.
b) Calculate the expected sterling receipts in three months using a money market hedge and
recommend whether a forward market hedge or a money market hedge should be used.

Example 5

What is the impact of a fall in a country’s exchange rate

1) Exports will be given a stimulus.

2) The rate of domestic inflation will rise.

Which of the above are false?

a) Neither 1) nor 2)
b) 1) only
c) 2) only
d) Both 1) and 2)

Example 6

Which of the following is exhibited by the yield curve?

a) The relationship between interest rates and the time to maturity.

b) The relationship between maturity and inflation rates.
c) The relationship between interest rates and the risk to the investor.
d) The relationship between interest rates due to supply and demand.
 Risk Management 153

Solutions

Example 1

Forward rate = Spot x (1 + foreign interest rate) number of years

(1 + home interest rate) number of years

a) One year Forward rate = 50 x (1 + 0.1) = 48.55/$

(1 + 0.04)

b) Four year Forward rate = 50 x (1 + 0.1)4 = 44.45/$

(1 + 0.04)4

c) The p.a interest rates are 10% and 4% thus, the 5 month interest rates are 10%*5/12 = 4.16% and
4%*5/12= 1.6%.

Four year Forward rate = 50 x (1 + 0.0416) = 48.77/$

(1 + 0. 016)

Example 2

Forward Rate = $1.97/£ (If you are making a payment, you will need to buy dollars from the bank
thus, use the bid rate.)

Expected sterling payments = £50,761

Example 3

a) Net receipt in 2 months = 340,000 – 240,000 = $100,000

Sombra Co. needs to dollars at an exchange rate of exchange rate of 1.8829+0.004 = $1.8869 per £
Sterling value of net receipt = 100,000/1.8869 = $52,997

Receipt in 3 months = $400,000

Sombra Co needs to dell dollars at an exchange rate of 1.8846+0.005 = 1.8896 per £
Sterling value of net receipt in 4 months = 300,000/1.8896 = $52,997

b) Home deposit rate: 5.6%*4/12=1.866%

Foreign borrow rate: 6.4%*4/12=2.133%
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Example 4

Step 2: Home deposit 98,751 x (1.0187) Step 3: Receive yield from investment
£208,074 £211,965

Convert @ spot $391,658/(1.8823)

$391,658 $400,000 receipt

Step 1: foreign borrow 300000/ (1.02133)

Example 5 - A

Example 6 – A
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PO11 – IDENTIFY AND MANAGE FINANCIAL RISK

Description
You identify, measure, and advise on the financial risks to the organisation.

Elements
a. Identify key sources of financial risk to the organisation and how they might arise.
b. Assess the likelihood and impact of financial risks to specific business activities.
c. Assess whether to transfer, avoid, reduce or accept financial risk.
d. Advise on using instruments or techniques to manage financial risk.
e. Monitor financial risks, reviewing their status and advising on how they should be managed.
Dividend Policy
 Dividend Policy 156

Syllabus area E1 e (iii)-E1 e (iv)

- Identify and discuss internal sources of finance, including:

i. the relationship between dividend policy and the financing decision.

ii. the theoretical approaches to, and the practical influences on, the dividend
decision, including legal constraints, liquidity, shareholder expectations and
alternatives to cash dividends.

Introduction

Another significant factor for a financial manager is the dividend decision. This relates to the amount
of money paid out to investors versus the amount held in the company. There are a number of
appropriate dividend theories, several of which claim that dividends have an effect on stock prices,
whereas others, such as M&M's theory, assume that stock prices are unaffected by dividends
announced by the business.

In this sense, it's critical to comprehend the considerations that should be considered when deciding
on a dividend. While some factors promote dividend declaration, others prevent dividends from
being declared.

Dividend policies in practice

1. Consistent pattern: This approach to dividend payment necessitates a consistent dividend

payment pattern, which may include:
• Paying a constant (same) dividend every year.
• Maintaining a steady increase in dividends year after year.
• Maintaining a constant payout ratio, i.e., the same percent of profit.

2. Policy on Residual Dividends: The dividends paid are equal to the funds remaining after all
investments in positive NPV ventures have been produced. However, this can lead to a lot of
dividend volatility.

3. Zero dividend policy: A zero dividend policy is one under which no dividends are paid to
investors, but any surplus cash-flow assets created are reinvested in other ventures with a
positive net present value (Re-invested).

4. Scrip dividends: This is a form of a dividend that differs from cash dividends in that shareholders
are given additional shares for free. As a result, investors will be able to sell these shares and
generate the required profits. Scrip dividends have the benefit of allowing the company to keep
excess cash for future investment without hurting the shareholders.

5. Share-buyback: While not a type of dividends in and of itself, share-buyback is viewed as an

alternative to dividends in which a company with excess cash buys back shares at the current
market price and cancels them. Restriction covenants, tax consequences, and legal limitations
are all obvious considerations.
 157

Factors to consider when formulating the dividend policy of companies

1. Profitability: Businesses must continue to be profitable, and dividends are a transfer of profit
after taxes. A business cannot pay dividends that are greater than its profit after taxes on a
regular basis. To fund the company's ongoing business needs, a healthy level of retained
earnings is needed.

2. Liquidity - A dividend is a benefit transfer made by a corporation to its shareholders in the form
of cash. As a result, a corporation must ensure that it has enough cash to pay a planned dividend
and that doing so would not jeopardize its day-to-day cash funding needs.

3. Legal and other covenant limitations - A dividend can only be paid out if it complies with the
law. It must also abide by all covenants.

4. Availability and need for further finance - Another consideration in assessing how much
dividends must be paid is the availability of funds for further investment and the presence of
investment opportunities.

5. Level of financial risk: if the financial risk is high, for example, due to a high level of gearing
resulting from a large amount of debt financing, maintaining a low level of dividend payments
will result in a high level of retained earnings, which would minimize gearing by raising the level
of reserves, The cash flow created by a higher level of retained earnings can also be used to
minimize a company's debt load.

Other factors, such as investor tax consequences and market factors, can have an effect on
dividends.

Dividend Irrelevancy Theory by M&M

❖ According to Modigliani and Miller, in a perfect capital market, shareholders benefit are
unconcerned with dividends as long as the directors invest in projects that have a reasonable
chance of succeeding. Instead of paying dividends, make a positive NPV.

❖ In other words, investors would not be worried with whether or not they would make a profit,
receive dividends or future capital growth in the form of dividends. As a result, changes in
dividend streams have no impact on the share price.

❖ However, the dividend irrelevancy principle is questioned in practice for the following reasons:
- Signalling impact - Failure to pay dividends can be perceived negatively by investors
as an alarm sign for investors and as a sign of financial distress.
- Clientele effect – A sudden change in the company's dividend policies based on the
availability of projects for investment can cause investors' liquidity needs and tax
plans to be disrupted.
 Ratio Analysis 158

Ratio Analysis
 Ratio Analysis 159

Syllabus area E2 a (i)

Estimate the cost of equity including:

- Ratio analysis using statement of financial position gearing, operational and

financial gearing, interest coverage ratio and other relevant ratios.

Introduction

In assessing the effectiveness of investment and financing by managers, you may sometimes be
asked to calculate and adjust the ratios. Before and after a main business purpose, candidates can
be asked to calculate and comment on interest cover, gearing, and so on.

A bond/share issue or buyback plan, for example. The following is a list of ratios for your reference.
These are in addition to the working management ratios. It is crucial that you know how to interpret
each ratio thoroughly.

Ratios

Other
Profitability Risk Liquidity
ratios

1) ROCE 1) Gearing ratio 1) Current ratio 1) P/E ratio

2) ROE 2) Interest cover 2) Quick ratio 2) Dividennd per share
3) Gross proit margin 3) Dividend 3) Dividend yield
cover
4) Operating margin 4) Total shareholder returns
5) EPS

Profitability ratios

Return on capital employed

Where,

Capital employed = Total Assets – Current Liabilities

Or
Equity + Long term debt

It shows the net profit generated by every $1 of the assets employed. A high level of ROCE is
desirable. It can be increased by increasing profits by increasing sales or lowering costs, or by
reducing the capital employed by holding old assets or repaying long-term debt.
 Ratio Analysis 160

Return on equity

ROE = Profit after tax and preference shares x 100

Ordinary share capital and reserves

It shows the net profit generated by every $1 of the capital stock and reserves employed. The higher
the ROE the better. It can be increased by increasing profits by increasing sales or lowering costs, by
reducing equity or by holding back old assets.

Gross profit margin

Gross profit margin = Gross Profit x 100
Revenue

High margins are attractive because they reflect high sales revenue and/or low cost of products
produced (production cost).

Operating profit margin

Operating profit margin = Operating profit x 100
Revenue

A high margin is advantageous because it means that revenue is high or that operating costs are kept
low. Cost of goods sold (production cost) and other non-production costs incurred in operations are
included in operating costs.

Earnings per share (EPS)

EPS = profit after tax (net profit) x 100

Number of ordinary equity shares in issue

The sum of returns attributable to each outstanding share is represented by this ratio. High EPS is
beneficial because it means that either sales rates are high or all costs are under control and that the
number of shares in question can be decreased to increase the EPS.

Risk ratios

Gearing ratios

Gearing = debt
Equity
Or

Gearing = debt
Debt+equity

High gearing ratio means the company is heavily reliant on debt to meet its financial obligations.
Since interest and capital repayments must be paid on debt, there is no requirement to pay a
 Ratio Analysis 161

dividend on equity, this raises the risk for a company. Reduce your debt and increase your equity to
boost your debt-to-equity ratio.

Interest cover ratio

Interest cover = profit before interest and tax x 100

Debt interest

This metric indicates the company's ability to service its debt costs from operating profit. It's
preferable to have a high ratio (this ratio is not a percentage)
A drop in interest cover means that the company is at risk of not being able to mee its finance
payments on time.
This can be enhanced by rising operating profit and decreasing finance costs by reducing debt levels.

Dividend cover

Dividend cover ratio = profit after tax x 100

Dividend for the year

Dividend reductions indicates that the company is not in a position to make dividend payments to
shareholders on the basis of the current net profit.
This can be strengthened by rising profit by increased sales, decreasing prices or financing costs, or
lowering the year's dividend.

Liquidity ratios

Current ratio
Current ratio = Current assets
Current liabilities

This shows the ability of the company to meet its short-term liabilities as they fall due. Decreasing
the ratio below the industry average indicates liquidity problems. It can be improved by paying
creditors as they fall due and better debt management
If the current ratio falls below 1, this may indicate problems with the fulfilment of obligations as they
are due. Even if the current ratio is above 1, this does not guarantee liquidity, especially if the
inventory is moving slowly. On the other hand, a very high current ratio cannot be encouraged, as it
may indicate an inefficient use of resources (for example, excessive cash balances).

Quick ratio
Quick ratio = Current assets – inventory
Current liability

Similar to the current ratio, but excluding inventory as it is the least liquid asset (All the inventory
cant be sold quickly without loss of value). Ratio greater than 1 is desirable. The quick ratio is
particularly relevant where inventory is moving slowly.
 Ratio Analysis 162

Other key ratios

P/E ratios (explained in business valuations chapter)

Dividend per share

Dividend per share = dividend

Number of share in issue

Dividend per share (DPS) is the sum of the declared dividends issued by the company for each
outstanding ordinary share. Dividend per share (DPS) is the total dividend paid by the company,
including interim dividends, divided by the number of outstanding ordinary shares issued by the
company.

Dividend yield
Dividend yield = dividend per share
Market price per share

The dividend yield or the dividend-price ratio of the share is divided by the price of the share. It is
also the total annual dividend payments of a company divided by its market capitalization, assuming
that the number of shares is constant. It is often expressed as a percentage of the amount.

Total shareholder returns (TSR)

TSR = dividend per share + change in share price

Share price at the start of the period

Or

D0 + P1 – P0
P0

Where,
D0 is dividend Paid during the year
P0 is the share price at the start of the year
P1 is the share price at the end of the year

Total shareholder return (TSR) (or simply total return) is a measure of the performance of the shares
of the company over time. It combines the increase of the share price and the dividends paid to
show the shareholder's total return expressed as an annualised percentage.
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