FINANCIAL

MANAGEMENT
WEEK 1
Introduction
of module

Lec 01
 What is
financial management
Can be defined as the management of the finances
of an organisation in order to achieve the financial Be awa
objectives of the organisation. The usual assumption
re
in financial management for the private sector is that
the objective of the company is to maximise
shareholders' wealth.
About the module
What are we going to discuss on?
● Financial environment;
● Measuring of corporate performance;
● Investment appraisals;
● Working capital management;
● Capital structure & the cost of finance.
About the module

How’s it different to Financial accounting and Management

accounting?
 Financial accounting Management accounting

Keeps track of a company's financial Managers use the provisions of

transactions. Using standardized accounting information in order to
guidelines, the transactions are better inform themselves before they
recorded, summarized, and presented decide matters within their
in financial reporting organizations, which aids their
management and performance of
control functions.
Financial accounting Management accounting
Detail the performance over the Aid management to record, plan and
period and Financial position at the control activities and to help the
end of the period decision – making process

By law, accounting standard No legal requirement, no strict rules

Concentrate on the business as a Focus on specific areas

whole
Monetary information Non – monetary measures
Both historical record and a future
Past operations
planning tool
Financial Management
Refers to the strategic planning, organising,
directing, and controlling of financial
undertakings in an organisation or an
institute. It also includes applying
management principles to the financial
assets of an organisation, while also playing
an important part in fiscal management.
About the module
What do we expect from you?
After completion of the module, the Student will be able to:
1. Demonstrate an awareness of the financial context in which
business operate.
2. Understand and explain key concepts and models, including net
present value, arbitrage and efficient markets.
3. Apply relevant knowledge and skills in making decisions relating to
investment, financing & working capital management.
4. Demonstrate a high level of ability to interpret and use financial
data.
5. Evaluate capital projects/investments using a range of recognized
techniques.
6. Understand costs of various sources of medium & long term.
 About the module
Required Reading
Arnold, Glen and Deborah Lewis, 2019, Corporate Financial Management, 6th
Edition, Pearson.
Recommended Reading
1. ACCA Paper F9 Financial Management (UK) Study Text for exams in 2019,
Published by BPP Learning Media.
2. McLaney, E.J., 2017, Business Finance – Theory and Practice, 11th Edition,
Pearson.
Assessments
1. Exam (May 2022) (100%)
 Thing to be
hightlighted

● The importance of attending classes

● Prepare for your classes – use of handbook
● Reading is essential
● Sufficient practice
● Have your revision planned in advance – do not wait until the last minute!
QUESTION
and
ANSWER
 QUESTION 1

● Explain the differences between Financial

accounting, Management accounting and
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 QUESTION 2
Identify which accounting concept involves which task by ticking the box.

Tasks Management Financial Financial

accounting management accounting
Review of overtime spending

Depreciation of non-current assets

Establishing dividend policy

Evaluating proposed expansion plans

Identifying accrual and prepayments

Introduction
of module

Lec 02
 Financial management
definition

Financial management can be defined as the

management of the finances of an organization in Be awa
re
order to achieve the financial objectives of the
organization
What are the financial objectives of companies
● Primary target – maximizing shareholders’ wealth
● Financial objectives - financial ratio analysis
● Non-financial objectives
ü Welfare of employees
ü Welfare of local community
ü Provision of a service/quality control
ü Growth of an organization
ü Ethical issues
ü Environmental issues
Examples: Objectives of organizations
● Implement of Just-In-Time inventory system.
● Increase EPS by 5% on prior year.
● Acquire a rival in a share-for-share purchase.
● Buy four new cutting machines for £250,000 each.
● Achieve returns of 15% on new manufacturing investment.
● Improve liquidity ratio from 1.7 to 1.85.
● Reduce unsold inventory items by 12%.
● Update manufacturing capacity to incorporate new technology.
● Improve brand awareness within the UK.
Not – for – profit organizations

Not for profit and public sector organisations have their own
objective, generally concerned with efficient use of resources in
the light of specified targets.
○ Possible objectives for a NFP organisation
■ Surplus maximisation
■ Revenue maximisation
■ Usage maximisation
■ …
Not – for – profit organizations

Value For Money: getting the best possible combination of services

from the least resources.
● Economy- Obtaining the right quality and quantity of inputs at

lowest cost (being frugal)

● Efficiency – Relationship between inputs and outputs (getting out

as much as possible for what goes in)

● Effectiveness- Relationship between outputs and objectives

(getting done what was supposed to be done)

Example: Economy, efficiency, effectiveness
(a) Economy. The economy with which a school purchases equipment can
be measured by comparing actual costs with budgets, with costs in
previous years, with government/local authority guidelines or with
amounts spent by other schools.
(b) Efficiency. The efficiency with which a school's IT laboratory is used
might be measured in terms of the proportion of the school week for
which it is used.
(c) Effectiveness. The effectiveness of a school's objective to produce
quality teaching could be measured by the proportion of students going on
to higher or further education
Influence of stakeholders
● Stakeholders can affect or be affected by the organization's
actions, objectives and policies. Some examples of key
stakeholders are creditors, directors, employees, government
(and its agencies), owners (shareholders), suppliers, unions, and
the community from which the business draws its resources.
● For corporations with shareholders who differ from their
managers, a conflict of goals can exist - the ‘agency problem’.
● Dealing with agency problem: Corporate governance; Reward
scheme; Regulation.
 Financial statements of three kinds are
produced by the typical UK business
● Income statement (Profit & loss account) – summarizes operating
performance for a period. It compares
Ø the revenues (wealth generated by the business through trading), with
Ø the expenses (wealth used up in generating those revenues)
● Statement of financial position(Balance sheet) – summarizes the position at
a point in time. It lists
Ø the business’s assets (things of value to the business), and
Ø the claims (liabilities and equity) against those assets
● Statement of cash flows – summarizes cash movements during a period,
analyzed into appropriate categories.
 Jackson plc
Income statement for the year ended 31 December 2018

£ million £ million £ million

Revenue 837
Cost of sales (478)
Gross profit 359
Distribution costs
Salaries and wages (37)
Motor expenses (43)
Depreciation of motor vehicles (16)
Sundry distribution expenses (15) (111)
 Jackson plc
Statement of financial position as at 31 December 2018
Cost Depreciation
£ million £ million £ million
Assets
Non-current assets
Freehold land 550 – 550
Plant and machinery 253 (226) 27
Motor vehicles 102 (56) 46
905 (282) 623
Current assets
Inventories 43
Trade receivables (debtors) 96
Prepaid expenses 12
Cash 25
176
Total assets 799
 Jackson plc
Statement of financial position as at 31 December 2018 (Continued)
Cost Depreciation
£ million £ million £ million
Equity and liabilities
Equity
Ordinary share capital – 200 200
million shares of £1 each
Retained earnings 209
409
Non-current liabilities
10% secured loan notes 300
Current liabilities
Trade payables (creditors) 45
Accrued expenses 18
Taxation 27
90
Total equity and liabilities 799
 Jackson plc
Statement of cash flows for the year ended 31 December 2018
£ million £ million
Cash flows from operating activities
Cash generated from operations 212
Interest paid (30)
Taxation paid (18)
Dividend paid (20) 144
Cash flows from investing activities
Payments to acquire non-current assets (33)
Cash flows from financing activities –
Net increase in cash and cash equivalents 111
Cash and cash equivalents at 1 January 2016 (overdraft) (86)

Cash and cash equivalents at 31 December 2016 25

Measuring Achievement of
Corporate Objectives
• How did Jackson perform in 2018 financially?
• Good or bad?
• From which aspect?
• Any evidence?
• Any potential issues?
• What could be the solution?
QUESTION
and
ANSWER
 QUESTION 1

● Discuss how the different types of non-financial,

ethical and environmental issues might influence
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 QUESTION 2

Suggest the potential conflicts in objectives which could arise between the
following groups of shareholders in a company.

Shareholders Potential conflict

Employees – Shareholders
Customers - Community at large
Shareholders - Finance providers
Customers - Shareholders/managers
Government - Shareholders
Shareholders - Managers
 FINANCIAL
MANAGEMENT
WEEK 2
 MEASURING
ACHIEVEMENT OF
CORPORATE OBJECTIVES

Financial Ratio analysis

Part 01: Formulas
 Why use ratio?
1. Compare two related figures, usually both from the
same set of financial statements.
ü Inter year comparisons - to establish a trend from past years,
to provide a standard of comparison;

ü Intra firm comparisons - to compare against a similar

business in the same industry;
ü Benchmark - compare against industry averages.
 Why use ratio?

2. An aid to understanding what the financial statements are

saying.

3. An inexact science, so results must be interpreted cautiously.

4. One ratio may indicate something but other ratios and data
are needed to support and interpret it in order for a
meaningful evaluation
Financial Ratio Analysis
Common questions require knowledge of:
● Calculations of ratios
● Explanation of the ratio
● Comment on the performance of the company, based on
your calculations
● Overall comment on changes
1. Profitability ratios
Concerned with effectiveness at generating profit
1. Return on capital employed

PBIT
ROCE =
Capital employed

● PBIT: Profit before interest and tax

● Capital employed = Shareholder’s funds + Long-term liabilities
= Total assets - current liabilities
1. Profitability ratios
Concerned with effectiveness at generating profit
2. Profit margin
Gross profit
Gross profit margin =
Sales revenues

PBIT
Operating profit margin =
Sales revenues

PAIT
Net profit margin =
Sales revenues
2. Liquidity ratios
Concerned with the ability to meet short – term debts

Current Assets
Current Ratio =
Current Liabilities

Current assets - inventories

Quik ratio (Acid ratio) =
Current liabilities
3. Gearing (Debt) ratios
Concerned with the relationship between equity and debt financing

Long – term debt

Gearing Ratio =
Equity

Total debt
Debt ratio =
Total assets

FBIT
Interest coverage ratio =
Interest
4. Efficiency (Activity) ratios
Concerned with efficiency of using assets
Average stock * 365 days
Stock turnover =
Cost of sale

Average receivables * 365 days

Trade receivables collection period =
Credit sales

Average payables * 365 days

Trade payables payment period =
Cost of sales

Cash operating cycle = ST + RCP - PPP

 5. Investors’ ratios
Concerned with returns to shareholders

Earnings distributable to OSHs

EPS (Earnings per share) =
No. of OSHs

Share price
P/E ratio =
EPS

Dividend
DPS (Dividend per share) =
No. of OSHs
 5. Investors’ ratios
Concerned with returns to shareholders

DPS
Dividend yield =
Share price

EPS
Dividend cover =
DPS

PAIT
ROE =
Equity
Example
Hedge plc
Calculate Hedge plc’s EPS, P/E ratio, dividend yield & dividend
cover from the following:
● Issued & paid up share capital consists of 500,000 £1
ordinary shares;
● Current share price is £3.50;
● The most recent reported profit after tax was £70,000;
● Proposed dividend is 6.3 pence per share (net) for the year.
 Example
A & B Ltd.
The following information is provided relating to the financial position of two companies which are similar in
terms of size & trading activities:
A Ltd B Ltd
Ordinary shares @ £1 £800,000 £500,000
15% Debentures £200,000 £500,000
PBIT – Year 1 £110,000 £110,000
PBIT – Year 2 £190,000 £190,000
Assume that both companies pay tax at 50% (on profit after interest charges). Both companies pay out all profits
after tax as dividends.
Required:
(a) Calculate (for both companies): (i)debt/equity ratio;(ii)dividend per share for both years.
(b) Discuss the returns earned by the two sets of shareholders over the two years in the context of each
company’s capital structure.
QUESTION
and
ANSWER
 QUESTION 1
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Ordinary dividend 150,000
Retained profit 450,000
The market price per share is currently 80 pence ex div. Calculate
the following ratios:
1. EPS
2. P/E
3. Dividend yield
4. Dividend cover
Briefly explain the meaning of each ratio.
 QUESTION 2
Summary financial information for Company ABS is given below, covering the last two years.

Curren Previou Required

t year s year
£'000 £'000 1. Using profitability, debt, and
Revenue 74,521 68,000 shareholders’ investment ratios,
Cost of sales 28,256 25,772
Salaries and wages 20,027 19,562 to discuss the performance of
Other costs 11,489 9,160 ABS over the last two years.
Profit before interest and tax 14,749 13,506
Interest 1,553 1,863 2. Explain why accounting profits
Tax 4,347 3,726 may not be the best measure of a
Profit after Interest and tax 8,849 7,917
Dividends payable 4,800 3,100 company’s achievements.
Shareholders' funds 39,900 35,087 3. Discuss how good corporate
Long term debt 14,000 17,500
Number of share in issue 14,000 14,000 governance procedures can help
P/E ratio (average for year) to manage under-performance in
ABS 14 13
Industry 15.2 15.0 private sector companies.
 QUESTION 3

Based on the Balance sheet and Profit loss account, calculate the
following liquidity ratios for ABC Ltd and Sage Ltd:
1. Current ratio
2. Quick ratio
3. Receivables payment period
4. Inventory turnover period
5. Payables’ payment period
6. Cash operating cycle.
Comment on the working capital management of the company using
relevant ratios.
 FINANCIAL
MANAGEMENT
WEEK 3
 MEASURING
ACHIEVEMENT OF
CORPORATE OBJECTIVES

Ratio analysis 02
Comments on the performance
of the company
BASED ON CALCULATIONS CARRIED OUT
1. Firstly, state whether the ratio has increased/decreased or improved/deteriorated from
• Last year
• Industry average
• Another company.
2. Explain reasons for the change: Profitability, liquidity, use of resources and Gearing.
• Your focus should be on any changes i.e. if Gross profit margin stays the same over
the past two years you do not need to restate this;
• Only give comments on changes that have occurred and any reasons you anticipate
for these changes.
 1. Profitability ratios
PBIT PBIT Sale revenues
ROCE = ROCE = X
Capital employed Sales revenues Capital employed

Earning atributable to OSHs

ROE = ROCE = Profit margin X Asset turnover
Shareholderequity

Gross profit
Gross profit margin =
Sales revenues

PBIT
Operating profit margin =
Sales revenues

PAIT
Net profit margin =
Sales revenues
 Profitability ratios
Ratio Increase/Improved Decrease/Deteriorated
Less profits generated from investment in
Return on Shareholder’s Funds/ More profits generated from investment in the company than from other
Equity the company than from other means/investments e.g. an ISA. This can
ROE means/investments e.g. an ISA. affect the amount shareholders may want to
invest in the future

More profit generated per £1 of capital Less profit generated per £1 of capital
Return on Capital Employed employed. Therefore capital employed is employed. Therefore capital employed is
ROCE efficient. Compare to other investments e.g. not efficient. Compare to other investments
ISA/other companies e.g. ISA/other companies

Generating more net profit from sales. Due Generating less net profit from sales. Due
to increased sales margins or decrease in to decreased sales margins or increase in
Operating (Net) Profit margin
expenses. Compare to gross profit to see expenses. Compare to gross profit to see
where the increase has occurred. where the decrease has occurred.

Decreased sales margins or increase in

Increased sales margins or reduction in cost
Gross Profit margin cost of sales e.g new supplier, poor buying,
of sales. Examples same as opposite
competition
 2. Liquidity ratios

Concerned with the ability to meet short – term debts

Current Assets
Current Ratio =
Current Liabilities

Current assets - inventories

Quik ratio (Acid ratio) =
Current liabilities
 2. Liquidity ratios
Ratio Increase/Improved Decrease/Deteriorated
More current assets to meet
Working capital/
liabilities. Decreased liquidity
Current ratio
Better liquidity

Better liquidity however, should

Acid Test/ Compare to Working capital, receivable collection
compare to working capital,
and payables days. Decreased Liquidity therefore
Quick ratio receivable collection and payables
perhaps not able to meet liabilities as they fall due
days
 3. Gearing (Debt) ratios
Concerned with the relationship between equity and debt financing

Long – term debt

Gearing Ratio =
Equity

Total debt
Debt ratio =
Total assets

FBIT
Interest coverage ratio =
Interest
 3. Gearing (Debt) ratios
Ratio Increase/Improved Decrease/Deteriorated

Depends on culture of the industry

Depends on the culture of the industry.
High debt/gearing – risk of not being able to pay
Gearing interest charges from profits. After these
Lenders like to see 50% or less payments there is a risk that dividends cannot
be afforded and therefore returns to
shareholders could be volatile

The higher the better – looking for 2:1. Low ratio – company may get into difficulties if
the interest rates increase. Affect whether
Company is likely to be able to meet
Companies will lend you money and
Interest Cover changing demands in interest rates. shareholders unlikely to invest as less profits to
Lenders will like to invest and
pay in dividends.
shareholders are likely to receive
dividends and will also invest Could end up in liquidation
 4. Efficiency (Activity) ratios
Concerned with efficiency of using assets
Average stock * 365 days
Stock turnover =
Cost of sale

Average receivables * 365 days

Trade receivables collection period =
Credit sales

Average payables * 365 days

Trade payables payment period =
Cost of sales

Cash operating cycle = ST + RCP - PPP

 4. Efficiency (Activity) ratios
Ratio Increase/Improved Decrease/Deteriorated

Takes longer to sell stock or Co. is holding too

much inventory.
Depends on business but usually shows good
Inventory turnover Poor stock control
stock control
(days) Problems with overstocking
Getting rid of old stock quickly
Increased amounts of older stock, perhaps
obsolete

Should be less than payables days. Takes more days to collect money owed.
Receivables
Receivables may have liquidity problems and
collection Quicker in collecting money owed. Due to good could lead to an increase in bad debts.
internal debt control procedures i.e. checking
(days)
credit-worthiness before giving credit Poor debt collection procedures

Paying debts slower, keeping money within the

Payables Payment Paying debts too quickly – inefficiency of
business. However, Co. should ensure they are
management to make use of credit terms or
(days) still within credit arrangements. Also could
pressure from suppliers
indicate problems with liquidity
5. Investors’ ratios

Earnings distributable DPS

EPS = to OSHs Dividend yield =
(Earnings per share) Share price
No. of OSHs

Share price EPS

P/E ratio = Dividend cover =
EPS DPS

Dividend PAIT
DPS =
ROE =
(Dividend per share)
No. of OSHs Equity
5. Investors’ ratios
Ratio Increase/Improved Decrease/Deteriorated

More earnings attributable to each share than Less earnings attributable to each share
EPS from other means, than from other means,
e.g. an ISA e.g. an ISA
Low confidence in the company, could be
P/E ratio High confidence and expectations for the due to poor performance or even a high
company profile legal case affecting perception of
company

Dividend per share

Increase in profits or change in company Could be a drop in profits, or a result of a
and Dividend
dividend policy new share issue
Cover

Dividend yield Similar to above Similar to above

 Comments on the performance from different aspects

Performance in Choices of ratio(s) Comments Overall

Profitability Profit margin(s), ROCE Concerned with effectiveness at Compare
generating profit. to?
Liquidity Current ratio, Acid ratio Concerned with the ability to Better or
meet short-term debts. worse?
Any
Debt controlling Gearing, debt ratio, Concerned with the relationship concern?
Interest cover between equity and debt Any
financing. solution?
Efficiency Stock turnover, Concerned with efficiency of
Receivable (Payable) using assets.
collection days, Cash
operating cycle
Investment EPS, P/E, DPS, Dividend Concerned with returns to
yield, ROE shareholders.
QUESTION
and
ANSWER
QUESTION 1
QUESTION 1
QUESTION 1
QUESTION 3
 Required
Compare and contrasting the financial performance of Fama Plc and Brass
Plc using following ratios:
1. ROCE, GPM, OPM, NPM;
2. Gearing, Interest cover;
3. Current ratio, Acid ratio;
4. ROE, EPS, DPS, P/E, Dividend yield.
Based on the results, identifying any issues that you consider should be
brought to the attention for your managing director.
QUESTION 2
QUESTION 2
Encouraging the achievement of
stakeholder objectives
• It is argued that management will only make optimal decision if they are
monitored and appropriate incentives are given.
• Remuneration incentives are:
- Performance related pay.
- Rewarding managers with shares.
- Executives share options plans (ESOPs).
Encouraging the achievement
of stakeholder objectives
Corporate governance (code of best practice). The system by which organizations
are directed and controlled such as:
– Risk reduction.
– Enhance performance.

– Code of ethics.

– Accountability.

Stock Exchange listing rules and regulations to ensure that the stock market operates
both efficiently and fairly For all parties (Issuers, investors and brokers).
 Summary

• Have a good read of financial statements.

• Choose the correct ratios.
• Analysis has to be backed by the results.
• Address the significant issues, providing possible causes/solution
 QUESTION 3

● Summer plc is a medium-sized

manufacturing company. The following are
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 QUESTION 3
Profit and Loss Accounts for years ending 31 December

2019 2018
£000 £000
Sales 5,000 5,000
Cost of Sales 3,100 3,000
Gross Profit 1,900 2,000
Administration and Distribution Expenses 400 250
Profit before Tax 1,100 1,370

Tax 330 400

Profit after Tax 770 970
Dividents 390 390
Retained Earning 380 580
 QUESTION 3 Balance Sheets as at 31 December
2019 2018
£000 £000
Fixed Assets 6,500 6,400
Current Assets 2,150 2,000
Stock 1,170 1,000
Debtors 850 900
Cash 130 100
Creditors: Amounts due in less than one year 1,150 1,280
Creditors: Amounts due beyond one year
10% debentures 2015 3,500 3,500
Capital and Reserves 4,000 3,620
£0.50 Ordinary shares 3,040 3,040
Reserves – P&L a/c 960 580
Share price at 31 December £1.35 £1.80
 QUESTION 3

Average data for the business sector in which Summer operates is as follows:
Return before Interest and Tax/Capital Employed 25%
P/E ratio 12 times
Dividend cover 3 times
Gearing (book value of debt/book value of equity) 100%
Interest Cover 4 times
Current Ratio 2:1
Stock Days 90 days
 QUESTION 3

Required:
1. Calculate five ratios for both years that would be helpful in assessing the recent financial
performance of the company from a shareholder perspective.
2. Analyse the company’s performance in the year ended 31st December 2019 using the
information derived in (a) above, clearly identifying any issues that you consider should be
brought to the attention of the ordinary shareholders. You are not expected to discuss
working capital management as part of your answer here.
 QUESTION 3
2019 2018
1 ROCE
2 Operating profit margin
3 Current ratio
4 Quick ratio
5 Debt / Equity
6 Interest cover
7 EPS
8 P/E ratio
9 DPS
10 Divident cover
11 Divident yield
 FINANCIAL
MANAGEMENT
WEEK 4
MACROECONOMIC
POLICY

Lec 1
 Overview – economic environment

Maximisation of shareholder wealth

Investment decision Financing decision Dividend decision

Economic environment
Slide 3
 The economic environment for business

Part (1) Part (2)

The economic environment for business Financial markets and institutions
Outline of macroeconomic policy • Financial intermediaries.
• Fiscal Policy. • Money markets & capital markets.
• Monetary & interest rate policy. • International monetary &
• Exchange rates. capital markets.
• Competition policy. • Rates of interest and rate of return
• Government assistance for business.
• Green policies.
• Corporate governance regulation.

Slide 4
 Outline of macroeconomic policy
Macroeconomic policy involves

Policy objectives Policy targets Policy instruments

Set for: Set for:

• Economic growth • Economic growth • Monetary policy (rate of interest & money supply).
• Low inflation • The rate of inflation
• Fiscal policy (using government spending &Taxation).
• Full employment
• Exchange rate policy (value of £).
• Balance of payments stability
• External trade policy (export & domestic
(country wealth relative to other
manufacturing).
countries).
• Green policy (polluter pay policy).
• Corporate governance regulation.
Slide 5
 Fiscal policy
• Fiscal policy ‘‘It is the governmental action to spend money or to collect
money in taxes, with the purpose of influencing the condition of the national
economy’’.
• The government might:
– Spending more money & finance expenditure by borrowing.
– Collecting more in taxes without increasing public spending.
– Collecting more in taxes in order to increase public spending.
• The fiscal policy affects business enterprises in:
– The level of aggregate demand for goods and affect the environment for
business .
– Tax changes by fiscal policy affect businesses.

Slide 6
 Monetary and interest rate policy

• Monetary policy ‘‘It aims to influence monetary variables such as the rate of interest and
the money supply in order to achieve targets set’’.
• The effectiveness of the monetary policy will depend on:
– Whether the targets of monetary policy are achieved successfully.
– Whether the success of monetary policy leads to intermediate target (lower inflation rate).
– Whether the successful achievement of the intermediate target and leads on successful
achievement of the overall objectives.

•The interest rate policy affects business enterprises in:

– The borrowing costs of business (increases in interest rates will mean fewer investments) .
– Increases in interest rates will also exert a down ward pressure on share prices.

Slide 7
 Exchange rates
• An exchange rate ‘‘is the rate at which one country’s currency can be traded in exchange for another country’s
currency’’.
• Exchange rates are determined by supply and demand even under fixed exchange rate system.
• Factors influencing the exchange rate for currency:
– The rate of inflation.
– speculation.
– Interest rates.
– The balance of payments.
– Government policy on intervention to influence the EX rate.
– Total income and expenditure.
– Output capacity and the level of employment.
– The growth in the money supply.
• The EX rates affects business enterprises and can be managed (reduced by):
– Currencies forward contracts.
– Dealing in a hard currency (that is not likely to depreciate suddenly in value).
– Operation (sales & purchases) management.
– Out sources activities (local suppliers).
Slide 9
 Exchange rates policy

• The exchange rate of an economy affects aggregate demand through its effect on
exports and imports, and policy makers can exploit this connection.

• Exchange rates can be manipulated so that they deviate from their natural rate. Many
economists regard exchange rate manipulation as a type of monetary policy.

ALTERNATIVE EXCHANGE RATE SYSTEMS

• Floating Rate System - Market forces of supply and demand determine rates.

• Fixed Rate System - Rate is determined by the government and maintained through
central bank’s activities.

WHAT IS CURRENT EXCHANGE RATE BETWEEN VND AND OTHER CURRENCIES?

Slide
 Competition policy
• The government influences markets in various ways one of which is through regulations.
• Market failure is said to occur when the market mechanism fails to result in economic efficiency.
Cases where regulations can often be the most appropriate policy response:
– Imperfect competition (large market share).
– Imperfect information (informational inadequacies).
– Social costs or externalities (controls on emissions or pollutants).
– Equity (improve social justice)
• Advantages of monopoly (one firm being the sole producer of a good):
– Benefits of economies of scale.
– Maximize profits.
• Disadvantages of monopoly:
– Companies can impose high prices.
– The lack of competition.
– No pressure to improve the efficiency. Slide
 Competition policy
• Deregulation ‘’The removal of any form of statutory‘’ i.e. free market forces.
• Privatization ‘’Is the policy of introducing private enterprise into industries which were previously
stated owned or operated’’.
• Privatisation forms are:
– Deregulation of industries.
– Contracting out work to private sector.
– Transferring the ownership.
• Advantages of privatisation:
– Provide immediate source of money.
– Reduce bureaucratic & political meddling.
– Encourage wider share ownership.

Slide 12
 Green policy

Pollution policy ‘‘are positive or negative effect on third party resulting from production and
consumption activities ‘’.
Numbers of policy approaches to pollution:
– Polluter pays policies.
– Subsidies.
– Legislation.
Advantages of environmental friendly policies:
– Attract new potential customers .
– Enhance the relationships with public.
– Attract ethical investment funds.
– Attract highly qualified people to work in.

Slide 13
 Corporate governance regulation

Corporate governance:
‘‘It used to enforce the achievement of shareholder objectives‘’.
The impact of corporate governance on:
– Decision making process.
– The financial organisation.
– The relationships with investors and auditors.
• The impact of corporate governance on business enterprises:
– The consequences of failure to obey corporate governance regulations should run
the risk of financial penalties .

Slide 14
QUESTION
and
ANSWER
 QUESTION 1 – Give your answer

● What are likely to be the main aims of a goverment’s economy policy?

● What is the difference between fiscal policy ad monetary policy?

● What effect does a high interest rate have on the exchange rate?

● Name five factors that can influence the level of exchang rate?

● Give four reasons for government intervention in markets?

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 QUESTION 1 – Give your answer

What are likely to be the main aims of a goverment’s economy policy?

● Economic growth

● Control of price inflation

● Full employment

● Balance between imports and exports

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 QUESTION 1 – Give your answer

What is the difference between fiscal policy ad monetary policy?

● Fiscal policy: Concerned with taxation, borrowing, spending and their effects

upon the economy.

● Monetary policy: Concerned with money and interest rate

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 QUESTION 1 – Give your answer

What effect does a high interest rate have on the exchange rate?

● It attracts foreign investment, thus increasing the demand for the currency.

The exchange rate rises as a result.

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 QUESTION 1 – Give your answer
Name five factors that can influence the level of exchang rate?

● Comparative inflation rates

● Comparative interest rates

● Balance of payment

● Speculation

● Government policy Becaus

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 QUESTION 1 – Give your answer

Give four reasons for government intervention in markets?

● Imperfect competition

● Social costs/externalities

● Imperfect information

● Equity
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 QUESTION 2 –Choose the best answer

What is the situation called when there is only one firm, the sole producer

of a good, which has no closely competing substitutes?

A. Duopoly

B. Oligopoly

C. Monopoly

D. Totopoly

C. Monopoly
 QUESTION 3 – Fill in the blank

1. …………….are positive or negative effects on third parties resulting

from production and consumption activities.

2. Corporate governance is …………………

1. Externalities

2. The system by which companies are directed and controlled

FINANCIAL MARKET AND
INSTITURION

Lec 2
 Financial markets and institution

• Financial intermediaries.
• Money markets and capital markets.
• International money and capital markets
• Rates of interest and rates of return.
 Financial markets and institution

Maximisation of
shareholder wealth

Investment decision Financing decision Dividend decision

Financial Financial
markets institutions
 Financial intermediaries

Financial
intermediaries

Merchant banks
Investors Pension funds Company
Insurance companies

Financial intermediaries:
Links those with surplus funds (e.g. Lenders) to those with funds deficits (e.g.
Borrowers) thus providing aggregation and economies of scale, risk pooling and
maturity transformation.
 Financial intermediaries

The benefits of Financial intermediaries:

• Provide convenient ways for lenders to save money (sort of return & maturity).
• Provide a ready source of funds for borrowers.
• They can package the amounts lent by savers.
• Reduce risk for individual lenders (by pooling).
• Give investors access to diversified portfolios covering a varied range of different securities.
• Provide maturity transformation between lenders (Liquidity) and borrowers (Loans).
 Money markets and capital markets

disintermediation

Investors Financial intermediary Company

 Money markets and capital markets

Financial markets

Money markets Capital markets

For short capital for long term capital
(financial instruments and
ST lending and borrowing)

Primary Markets
(Official market) Parallel or Wholesale Markets
• Interbank market.
• Eurocurrency market.
• Certificate of deposit market.
Slide 30 • Local authority market.
• Finance house market.
• Inter-company market.
 Money markets and capital markets

Primary Markets (Official market): Approved institution deal in financial instruments with
central banks.
Interbank market: Banks lend short term funds to each other.
Eurocurrency market: Banks lend and borrow in foreign currencies.
Certificate of deposit market: Market for trading in certificate of deposits.
Local authority market: Borrow short term funds by issuing and selling short term debts.
Finance house market: Dealing in short term loans raised from money markets by financial
houses.
Inter - company market: Direct short term lending between treasury departments of large
companies.
 Money markets and capital markets

Capital market (long term finance): A stock market (the main market plus Alternative
Investment Market AIM in UK) acts as primary market and as a secondary market for trading
in securities (shares and bonds).
The purposes of stock markets:
• As a primary markets: enable companies to raise new finance.
• As secondary markets: enable existing investors to sell their investments.

Capital markets
Demand for funds Intermediaries Suppliers of funds
• Individuals
• Banks. • Individuals (savers).
(consumer good finance).
• Building societies. • Firms
• Firms
• Insurance companies. (funds to invest).
(share capital loans).
• Turt companies. • Government
• Government
• Venture capital org. (budget surplus).
(budget deficit).
 International money and capital markets
International money: Are available for larger companies wishing to raise larger amount of
money (Eurocurrency markets).
International capital markets : Are available for larger companies wishing to borrow
larger amount of money (Eurobonds: is a bond denominated in currency which often differs
from that of the country of issue).
Factors should be considered in bond investments:
• Security.
• Marketability.
• Anonymity.
• The return on investment.
 Rates of interest and rates of return

The pattern of interest rate on financial asset influenced by:

• Risk.
• Need to make a profit on relending.
• Duration of the lending.
• Size of the loan.
• Different types of financial asset.
LIBOR (London inter-bank offered rate) :
is the rate of interest applying to wholesale money market lending between London banks.
The risk-return trade-off:
Investors in riskier assets expect to be compensated for the risk.
 Rates of interest and rates of return

Forms of investments are listed in ascending order of risk:

• Governmental bonds.
• Company bonds.
• Preference shares.
• Ordinary shares.
The reverse yield gap:
Because debt in lower risk than equity investment, we expect to receive yield on debt lower than
yields on shares. If the yield on shares are lower than yield on debts this called (reverse yield
gap).
MARKET EFFICIENCY
QUESTION
and
ANSWER
 QUESTION 1 – Give your answer

● Indentify five types of financial intermediaries

● Is the Stock Exchang a money market?

● Indentify five types of financial intermediaries: Banks, Insurance companies;

Pension funds; Stock exchanges; Venture capital organisations.

● Is the Stock Exchang a money market? Money market

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 QUESTION 1 – Choose the best answer
● For short term borrowing, a company will go to the money markets/capital

markets Money markets

Which of following types of investment carries the highest level of risk?

● Company bonds

● Preference shares Ordinary shares

● Government bonds
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 QUESTION 1 – Choose the best answer
● From which does the demand for capital markets funds come:

Individuals/Firms/Government

● From which does the supply of capital market funds come:

Individuals/Firms/Government

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 FINANCIAL
MANAGEMENT
WEEK 5
Investment decision and
investment appraisal
Methods

Part 01
Investment Appraisal (Investment decision)

We will discuss the following topics

Investment

The capital budgeting process

Relevant cash flows

The payback period

The return on capital employed

Slide
3
 Investment decision

Investment can be divided into

Capital expenditure Revenue expenditure

• Acquisition of non current assets • It is charged in income statement.

• An improvement in their earning capacity. • Incurred for the purpose of trade in business.

• It is not charged in income statement • Incurred to maintain the earning capacity

(stated in statement of financial position) of non current assets.

 Investment decision

Investment can be made in

Non current assets Working capital

• Money paid to acquire resources to be • Money paid to acquire resources for
used on a continuing business (machinery). a short period and can be recovered
from sales (raw materials).
6

The nature of investment decisions

Example – Identify the type of expenditure:

v Annual rental payment for the warehouse
v A new fork-lift truck to replace one damaged in an accident
v Increased inventory to fulfil a new-won contract
v An automatic moulding machine to streamline a production process
 The capital budgeting process

Capital budgeting

• Is the process of identifying, analysing and selecting investment projects whose

returns are expected to extend beyond one year (than sales).

• Budget limits or constraints might be imposed

• internally (limited managerial resources ‘‘soft capital rationing’’)

• or externally (scarcity financing or high financing cost ‘‘hard capital rationing’’).

 The investment decision - making process

A typical model for investment decision making has a number of distinct stages:

v Origination of proposals.

v Project Screening.

v Analysis and acceptance.

v Monitoring and review.

The investment decision - making process
1. Origination of proposals (investment opportunities)

• An organization must set up a mechanism to scan investment

opportunities from the business environment (internally or externally).

• The investment proposal should be consistent with the company’s

strategy.

2. Project screening (qualitative evaluation)

• Only if the project passes the initial screening process the detailed
financial analysis will begin.
The investment decision - making process
3. Analysis and acceptance (steps)

1. Complete and submit financial information standards.

2. Classify project by type (more or less financial rigorous).

3. Carry out financial analysis (investment appraisal techniques).

4. Compare the outcomes with the predetermined criteria.

5. Choose the project in the light of capital budget.

6. Make a decision (go or no go) depend on (type of investment, risk & required money).

7. Monitor the progress of the project.

The investment decision - making process

4. Monitor the progress of the project (project control)

To ensure:

• The capital spending does not exceed the amount authorised.

• The implementation of the project is not delayed.

• The anticipated benefits are eventually obtained.

 Relevant cash flows

The cash outflows or inflows which occur as a result of a decision to invest in a

project.

• The cost which arise as a consequence of the investment decision

under evaluation.

• The annual profits from a project can be calculated as the incremental

contribution earned minus any incremental fixed costs.
 Relevant cash flow
In capital investment appraisal, the ‘Relevant cash flows’ are:
§ Future
§ Incremental
§ Cash-based
Ignore:
§ Sunk costs – the cost already incurred and cannot be recovered
§ Non-cash items – e.g. depreciation
§ Committed costs – the cost will incur anyway no matter the project runs or not
 Relevant cash flow
Other costs should be considered

• Opportunity cost:
that can be lost if a specific investment project is undertaken.
• The extra tax cost:
that should be paid on the extra profit.
• Residual value:
at the end of the project life.
• Working capital cost:
during the life of the project.
• Other relevant cost:
(i.e. infrastructure cost, marketing cost and human resource costs).
 Relevant cash flow
Relevant benefits of investment

• Savings because assets used currently must also be evaluated.

• Extra savings or revenue benefits because of improvement caused.
• Revenue benefits from sale of assets.
• Intangible benefits i.e.
• customer satisfaction,
• improved staff morale and
• better decision making.
16

Investment appraisal method used in practice

Multiple appraisal methods:

○ Payback period
○ Accounting rate of return
○ Discount cash flow
○ International experience
 Investment decision

Investment appraisal techniques

ROCE ARR
Payback period Return on capital employed Accounting rate of return
 The payback period

• Is the amount of time it takes for cash inflows = cash outflows (from
a capital investment project) usually expressed in years.

Decision rule
Projects with a PBP up to defined maximum
period are acceptable; the shorter the PBP, the more desirable.
 The payback period

Advantages of the payback period

• Simple to calculate and to understand.

• It use cash flows not accounting profits.

• It can used as a screening tool as a first stage.

• Bias to short term projects (business risk).

 The payback period
Disadvantages of the payback period

• It ignores the timing of cash flow.

• It ignores the cash flows after the payback period.

• It ignores the time value of money.

• It can not be used to distinguish between projects with the same payback period.

• It Ignores the variability of cash flows.

 The payback period

● Constant annual cash flows:

Payback period = (Initial investment)/(Annual cash flow)
Example: An expenditure of £2m is expected to generate net cash flows of
£500,000 each year for the next seven years. What is the payback period for the
project? What if the annual cash flow is £600,000 for the project life? Not an
exact number of years.
 PBP = 3 years + 4 months
Year Cash Flow Cumulative
n CF Cash Flow

0 (2.000.000) (2,000,000)

1 600,000 (1,400,000)

2 600,000 (800,000)

3 600,000 (200,000)

4 600,000 400,000

5 600,000

6 600,000

Year 0 Year 1 Year 2

 Discounted PBP

Example: An expenditure of £2m is expected to generate net cash flows of

£500,000 each year for the next seven years. What is the payback period for the
project? What if the annual cash flow is £600,000 for the project life? Not an
exact number of years. (Interest rate: 11%)
 Discounted PBP

● PBP ignores the time value of money.

● Solution – Accounts for time value of money by discounting the cash
inflows of the project – DPBP.
Step 1: Calculate the DCFs using the formula
Step 2: Same as PBP.

Actual Cash Inflow

Discounted Cash Inflow =
(1 + i)n
Discounted PBP = 5 years + 4 months

Discounted Cash Cumulative

Year Cash Flow
Flow Discounted
n CF
Cash Flow

0 (2,324,000) (2,324,000) (2,324,000)

1 600,000 540,541 (1,783,459)

2 600,000 486,973 (1,296,486)

3 600,000 438,715 (857,771)

4 600,000 395,239 (462,533)

5 600,000 356,071 (106,462)

6 600,000 320,785 214,323

 Discounted PBP
● Discounted Payback Period = 5Ys+ (106,462)/ 320,785 x 12 Ms = 5Ys 4Ms
Advantages
• It accounts for time value of money.
• If a project has negative net present value it won't pay back the initial
investment.
• It ignores the cash inflows from project after the payback period.
 The Return on capital employed
The return on capital employed (ROCE) = Accounting rate of return (ARR)
= Return on investment (ROI)

It is an investment appraisal technique by estimating the accounting rate of return

that the project should yield. If it exceeds the expected target rate of return, the
project will be accepted.

• Can be used to rank projects taking place over a number of years (using
average profits and investment).
• Can also rank mutually exclusive projects.
• Decision rule - project with an ARR above a defined minimum are acceptable;
the greater the ARR, the more desirable.
 The Return on capital employed
Estimated average annual accounting profits
ROEC = ´ 100%
Estimated average investment
Capital cost + diposal value
Average investment =
2
Estimated average profits
ROCE = ´ 100%
Estimated intial investment

Estimated total profits

ROCE = ´ 100%
Estimated intial investment
 The Return on capital employed
Advantages of ROCE

• Simple to calculate and to understand.

• It use percentage return.
• It focus on the entire project life.

Disadvantages of ROCE

• It based on accounting profits not cash flow.

• It is a relative measure rather than absolute measure.
• It ignores the time value of money.
• It takes no account of the length of the project.
30

The Return on capital employed

Accounting profits VS. cash flows In capital investment appraisal it is more

appropriate to evaluate future cash flows than accounting profits, because:

• Profits cannot be spent: profits are only a guide to cash availability;

• Profits are subjective: the time period in which income and expenses are

recorded, and so on, are a matter of judgement;

• Cash is required to pay dividends: dividends are the ultimate method of

transferring wealth to equity shareholders.

 Comparing PBP with ROCE
The cash flows for project Z and S are as follow and there is no residual value for both:
Z S
£ £
Year 0 (20,000) (25,000)
1 4,000 8,000
2 6,000 8,000
3 6,000 6,000
4 7,000 6,000
5 6,000 5,000

Anticipated PBP 3 years 7months 3 years 6month

 Comparing PBP with ROCE
Using ROCE
Project Z:
[(4000+6000+6000+7000+6000)-20000]/5 = 18.0%
10,000
Project S:
[(8000+6000+5000+6000+8000)-25000]/5 = 12.8%
12,500
Conflicting – which one to choose?
QUESTION
and
ANSWER
34

Trial question 1
A company is evaluating a proposed expenditure on an item of equipment that would cost

£160,000. A technical feasibility study has been carried out by consultants, at a cost of

£150,000, into benefits from investing in the equipment. It has been estimated that the

equipment would have a life of four years, and annual profits would be £8,000, after

deducting annual depreciation of £40,000 and an annual charge of £25,000 for a share of

the existing fixed cost of the company. What are the relevant cash inflows?
What if £25,000 is the amount of working capital required by the project?
Profit = Cash inflows – Working capital – Non expense cash
8,000 = Cash inflows – (40,000 + 25,000) – 25,000
35

Trial question 1

Cash inflow = 8 +40 + 25 + 25 = 98

Net cash flow = 98 - 25

36

Trial question 2
Example: A project involves the immediate purchase of an item of plant costing £110,000.

It would generate annual cash flows of £24,400 for five years, staring in Year 1. The plant

purchased would have a scrap value of £10,000 in five years, when the project

terminates, Depreciation is on a straight-line basis. Calculate the ROCE.

Estimated average investment = (110,000 + 10,000)/2 = 60,000

Estimated average annual accounting profits = (24,400 – (110,000-10,00)/5) = 4,400

ROCE = 4,400/60,000 = 7,3%

 FINANCIAL
MANAGEMENT
WEEK 6
 INVESTMENT
APPRAISAL METHODS

Part 02
3

Discounted Cash Flow

DCF is the process of discounting future cash flow back to their present value. It is an
investment appraisal technique which takes into account both:
• The timings of cash flows and
• Total profitability over a project life.
v Two methods to evaluate capital investment:

• Net present value (NPV)

• Internal Rate of Return (IRR)
4
7.1

Discounted Cash Flow

£1,000 now ¹ £1,000 later Rate: 5%

Present Value x (1+ 0.05) = Terminal Value

$1000 $1050
Compounding

Discounting

x 1
(1+ 0.05)
5

Conventions used in DCF

● Cash flows incurred at the beginning of project occur in year 0.
● Cash flows occurring during time period assumed to occur at
period-end.
● Cash flows occurring at beginning of period assumed to occur at
end of previous period.
6

Discounted Cash Flow

• Compounding
FV = PV (1 + r ) n
• Discounting
1
PV = FV
(1 + r ) n
 NPV
● NPV is the sum of the discounted values of the cash flows from the investment.
○ Represent the change in wealth of the investor as a result of investing in the
project.
○ Money has a time value.
● Decision rule:
○ All positive NPV investments enhance shareholders’ wealth- Accept.
○ the greater the NPV, the greater the enhancement and the more desirable.
 NPV
Example – Company Saga estimates the relevant cash flow of project A as following:
Year Cash flow £
0 (100,000)
1 60,000
2 80,000
3 40,000
4 30,000
If Discount rate = 15% , is project A acceptable for the company?
What if the discount rate is not constant over the years?
 NPV
Example – Company Saga estimates the relevant cash flow of project A as following:
Year Cash flow £
0 (500,000)
1 90,000
2 80,000
3 40,000
4 70,000
If Discount rate = 12% , is project A acceptable for the company?
 Annuity
• Annuity - A constant cash flow for a number of years.
• A project that is involved with equal annual cash flows (or annuities) can be
discounted separately back to present value or the use of a single discount factor
called an annuity factor or cumulative factor.
Cumulative PV of £1 per annum in n years
=£
1 - (1 + r ) - n
r
 Example
● A project has an outlay of £40,000 today and provided a definite return of £16,000 per
year for three years. Will you recommend such project? Assume that the return on similar
investment risk is 6%.

● PV of £16,000 per year for three years = 16,000 * 2.673 = 42,768

● NPV = PV inflow – PV outflow = 42,768 – 40,000 = 2,768 à Accept
 Perpetuity
● Annuity that occurs for the foreseeable future.
● Cumulative PV of £1 per annum in perpetuity = £ 1/ r
● Example: A project involved an outlay of £40,000 today and provided a definite return
of £6,000 per year for the foreseeable future. Would you accept the project? Assume
that you could get a return of 6% on investments of a similar risk.
● PV £6,000 per year for three years = 6.000*1/0.06 = 100.000
● NPV A project = 100.000 – 40.000 = 60.000 à Accept
 Internal Rate of return (IRR)

● IRR is the discount rate that causes a project to have a zero NPV.
● It represents the average percentage return on the investment, taking account
of the fact that cash may be flowing in and out of the project at various points
in its life.
● Decision rule:
○ projects that have an IRR greater than the cost of capital are acceptable;
○ the greater the IRR, the more desirable.
 IRR
Interpolation Method – Uneven cash flows
1. NPV of the project at a%
2. NPV of the project at b%
3. Use the formula

IRR = a + NPVa x (b - a)
NPVa - NPVb

Where a is the lower discount rate giving NPVa and b is the higher discount
rate giving NPVb
 IRR
Interpolation Method – Uneven cash flows
1. NPV of the project at 12% = -32,870
2. NPV of the project at 15% = -44,860
3. Use the formula

IRR = 12% + -32,870 x (15%-12%)

-32.870 + 44,860

à IRR = 3.98% < Cost of capital 5% -

 IRR
Example – Uneven cash flows

Time CF 10% Discount factor PV 12% Discount factor PV

£ £ £
Y0 (80,000) 1.000 (80,000) 1.000 (80,000)
Y1-5 20,000 3.791 75,820 3.605 72,100
Y5 10,000 0.621 6,210 0.567 5,670
NPV= 2,030 NPV=(2,230)

2,030
IRR = 10 + [ X (12 - 10)]% = 10.95%
(2,030 + 2,230)
 NPV and IRR compared

NPV & IRR:

● Takes account of the timing of cash flows.
● Takes all relevant information into account.
● Provides clear signals and practical to use.
 NPV and IRR compared
NPV
● Simple to calculate
● Better for ranking mutually exclusive projects
● Easy to incorporate different discount rates
● Relates directly to shareholders’ wealth objective
IRR
● More easily understood
● Can be confused with ROCE
● Ignores relative size of investments
● May be several IRRs if cash flows not conventional
 NPV

Example: What is the PV of £1,000 earned each year from year 1-10
when the required earning rate of money is 11%
Example: What if the annuity is perpetuity?
PV of £1,000 earned each year from year 1-10 = 1,000*5.889 =5,889
PV of £1,000 foreseeable future = 1,000 *1/0,11 = 9,091
QUESTION
and
ANSWER
 QUESTION 1
Growfast Ltd. is evaluating six possible capital investments. Details of relevant cash flows are given below
(all £000’s).
Project
Y0 Y1 Y2 Y3 Y4 Y5
£'000
A -330 120 120 120 120
B -250 75 160 160
C -140 48 48 48 48
D -520 140 140 140 140 140
E -240 75 100 120 75 2
F -310 150 150 100

The company's cost of capital is 9% per annum.

Evaluate each of the proposed investments, using PBP, ARR and NPV.
 QUESTION 2
Turners Ltd is considering the purchase of a new machine that is expected to save labor on an
exiting project. The estimated data for the two machines available on the market are as follows:
Machine A Machine B
£000 £000
Initial cost (Year 0) 120 120
Residual value of machines (Year 5) 20 30
Annual labor cost savings:
Year 1 40 20
2 40 30
3 40 50
4 20 70
5 20 20
Which machine will be selected under the following criteria:
(a) ARR?
(b) PBP?
(c) NPV? And the cost of finance is 10%.
Ignore taxation throughout, and treat the savings as if they will occur at the end of the relevant year.
 QUESTION 3
For project A, the NPV at a discount rate of 5% is calculated as follows.

Year Expected Cash DCF Present value

flows (£) factors (£000)
0 (220,000) (220,000)
1 38,000 0.952 36,176
2 42,000 0.907 38,094
3 57,000 0.864 49,248
4 65,000 0.823 53,495
5 36,000 0.784 28,224
6 40,000 0.747 29,880
NPV 15,117

If the cost of capital is 10% and the NPV at a discount rate of 10% is -£18,608.
What is the IRR? Is the project acceptable?
 QUESTION 4

The research and development department of ABC plc has produced two designs of product
XYZ: model One and model Two. The development costs incurred, and already paid; in
getting the models to design stage are £100,000 for model One and £120,000 for model Two.
However, management has decided that the company has the facilities to support production
and sales of only one of the two models in the foreseeable future.
For model One, it requires an investment in machinery with an estimated useful life of five
years. The machinery will cost £3,000,000 and possess a disposal value of £200,000 if resold
during the first three years of ownership, and £80,000 thereafter.
For model Two, the machinery would cost £2,200,000, have a useful economic life of five
years and a disposable value of £150,000 at any time after initial installation.
 QUESTION 4

The marketing department has estimated the annual demand for each model for the five years
commencing 1 January 2013, which is the expected time period over which either model would be
sold. The financial planning department has produced the following estimated annual operating
cash flows:

Model One Model Two

£000 £000
2013 420 800
2014 420 1,000
2015 1,000 450
2016 2,400 450
2017 1,200 450
 QUESTION 4

It may be assumed that the annual operating cash flows will arise on the 31 of
December in each year. The company’s money cost of capital is 12%.
Required: Utilising the above information, numerically assess the projects using:
1. PBP & DPBP
2. ARR
3. NPV
4. IRR
On the basis of your evaluation, what is your recommendations regarding which
project should be undertaken?
 FINANCIAL
MANAGEMENT
WEEK 7
 ASSET INVESTMENT
DECISIONS AND
CAPTITAL RATIONING
 Specific investment decisions

Lease VS. Buy Asset Replacement

decisions Capital rationing

Divisible projects Indivisible projects

 Lease or Buy

Leasing – a contract between a lessor and a lessee for hire of a specific

asset selected.

● Lessor – has ownership of the asset;

● Lessee – has possession and use of the asset on payment of specific rentals over a period.

start end
Operating Finance
lease lease
 Types of Lease

● 1. Leases that minimize risk to the lease

Operating ○ Short term rental

lease ○ Lessor is responsible for servicing and maintaining

○ Risk is minimized

● 2. Leases that are purely a source of finance

○ Long term
Finance
lease ○ Rented for most of its life

○ Lessee is responsible
Benefits of any type of lease

● Availability

● Avoiding tax exhaustion

● Avoiding loan covenants

Slide 6
 Asset replacement

Issues

How frequently Is it worth paying more

should an asset for an asset which has
be replaced? a longer expected life?

Slide 7
● Shorter replacement cycle

○ Lower operating cost

○ Higher residual value when the asset is disposed of

○ Increased capital expenditure

● Longer replacement

○ Reduce capital expenditure

○ But as the asset get older, it may cost more to operate, and residual value will be lower
 Asset Replacement
Equivalent annual cost method
● When an asset is being replaced with an identical asset, the equivalent annual cost
method can be used to calculate an optimum replace cycle.
● Steps to do:
1. Calculate PV of costs for each replacement cycle
2. Turn PV of costs for each replacement cycle into

PV over one replacement cycle

Equivalent annual Cost (EAC) =

Annuity factor (AF)

● The optimum replacement policy is the one with the lowest equivalent annual cost.
 Asset Replacement

Example 1: A company uses machinery which has the following cost and resale values
over three-year life. Purchase cost = £25,000, cost of capital = 10%.
Year1 Year2 Year3
Running cost (7,500) (11,000) (12,500)
Resale value 15,000 10,000 7,500
Organization's cost of capital is 10%
Required: Identify how frequently the asset should be replaced
 Asset Replacement

● Step 1:Calculate PV of costs for each replacement cycle

Replace every year Replace every 2 years Replace every 3 years

Discount
Y CF PV CF PV CF PV
factor@10%
0 1 (25,000) (25,000) (25,000) (25,000)
(7,500) (6,818) (7,500) (7,500)
1 0.909
15,000 13,635
(11,000) (11,000)
2 0.826
10,000
(12,500)
3 0.751
7,500
PV (18,183)
 Asset Replacement

● Step 1:Calculate PV of costs for each replacement cycle

Replace every year Replace every 2 years Replace every 3 years

Discount
Y CF PV CF PV CF PV
factor@10%
0 1 (25,000) (25,000) (25,000) (25,000) (25,000) (25,000)
1 0.909 (7,500) (6,818) (7,500) (6,818) (7,500) (6,818)
15,000 13,635
2 0.826 (11,000) (9,086) (11,000) (9,086)
10,000 8,260
3 0.751 (12,500) (9,388)
7,500 5,633
PV (18,183) (32,644) (44,659)
 Asset Replacement
Step 2: Calculate the equivalent annual cost (EAC)
PV over one replacement cycle

Equivalent annual Cost (EAC) =

Annuity factor (AF)

a) Replace every year: EAC= £(18,183)/0.909 = (£20,003)

b) Replace every 2 years: EAC = £(32,644)/1.736 = (£18,804)
c) Replace every 3years: EAC = £(44,659)/2.487 = (£17,957)
Therefore, replacing every 3 years offers the lowest EAC.
Asset Replacement

● Equivalent annual benefit (EAB)

● EAB expresses the NPV from a project as an annuity, i.e.
a constant cash flow per year.

NPV of project

Equivalent annual Benefit (EAB) =

Annuity factor
 Example
Project A has an NPV of £8.22m and an expected life of six years. With a Discount rate of
12%, the Annuity factor for six years at 12% is 4.111, what will be the Equivalent annual
benefit of Project A?
EAB = 8.22/4.111=2.00
Project B has an NPV of £8.90m and and expected life of seven years. With annuity factor of
12% (4.564) what is the equivalent annual benefit of the project?
EAB = 8.90/4.564=1.95
● Project A will be accepted despite the fact that it has a lower NPV
 Capital rationing

Techniques

Indivisible
Divisible - examine NPV of
- use NPV / $ invested affordable combinations
 Reasons for Capital Rationing

● Is where a company has a limited amount of money to invest and

investments have to be compared in order to allocate monies most
effectively.
1. Soft capital rationing (Internal factors)
○ Reluctance to cede control
○ Wish only to use retain earnings
○ Reluctance to dilute EPS
○ Reluctance to pay more interest
○ Capital expenditure budgets
2. Hard capital rationing (External factors)

• Depressed stock market

• Restrictions on bank lending
• Conservative lending policies
• Issue costs
 Techniques of Capital rationing

(1) Divisible – use NPV/ £ invested (profitability index)

(2) Indivisible – examine NPV of affordable combinations

 Assumptions of Profitability Index

● Opportunity to undertake project lost if not taken during capital

rationing period
● Compare uncertainty about project outcomes
● Projects are divisible
● Ignore strategic value
● Ignore cash flow patterns
● Ignore project sizes
Suppose that HTC plc is considering four projects, W, X, Y and Z. the following are the
relevant details:

Capital PV of NPV PI
Project NPV PI
outlay Cashflows Ranking Ranking

W (10,000) 11,240

X (20,000) 20,991

Y (30.000) 32,230

Z (40,000) 43,801

Required:
Calculate the NPV from investing in the optimal combination of projects if only £60,000
was available for capital investment.
Suppose that HTC plc is considering four projects, W, X, Y and Z. the following are the
relevant details:

Project Capital outlay PV of Cashflows NPV PI PI Ranking

W (10,000) 11,240 1,240 0.124 1

X (20,000) 20,991 991 0.049 4

Y (30.000) 32,230 2,230 0.074 3

Z (40,000) 43,801 3,801 0.095 2

Required:
Calculate the NPV from investing in the optimal combination of projects if only £60,000
was available for capital investment.
 Profitability Index approach

Project Project Outlay £

W 1st 10,000

Z 2nd 40,000
(1/3 of
Y(balance) 3rd 10,000
£30,000)
60,000

Total NPV
Choosing projects according to PI with
W. 1,240
Z 3,801 £60,000, the NPV is £5784
Y(balance) 743
5,784
 Non-divisible projects

● These are projects that can be undertaken completely or not at all.

● This cannot be scaled down.
● Here examine NPV of affordable combinations
● Select the project combination with the highest NPV
 Example
● STC plc has capital of £95,000 available for investment in the forthcoming
period. The directors are considering P, Q, and R only. They wish to invest only
in whole projects.
Project Investment required PV of Cash inflows
P 40,000 56,500
Q 50,000 67,000
R 30,000 48,800

Required
Which combination of projects will produce the highest NPV at a cost of capital of 20%
 Capital Rationing

● The key in the examination is to ascertain whether or not the project

are divisible – projects can be ranked using the PI.

● Mutually-exclusive projects – find out which combination offers the

highest level of return.

QUESTION
and
ANSWER
 QUESTION 1
A decision has to be made on replacement policy for vans. A van costs £12,000 and the
following additional information applies:

Asset sold at end Trade-in Asset kept for Maintenance cost

of year allowance at end of year

£ £
Y1 9,000 1 year 0
Y2 7,500 2 years 1,500
Y3 7,000 3 years 2,700

Calculate the optimal replacement policy at a cost of capital of 15%. Note that the asset is only
maintained at the end of the year if it is to be kept for a further year. Ignore taxation and inflation.
 QUESTION 2
PQ Co has £50,000 available to invest. Its cost of capital is 10%. The following projects are
available:

Project Initial outlay PV

1 £20,000 £15,000

2 £10,000 £15,000

3 £15,000 £30,000

4 £30,000 £54,000

5 £25,000 £48,000

Identify the optimal selection of project(s) for the time to undertake under the following circumstances:
1. The projects are indivisible.
2. The projects are divisible.
 FINANCIAL
MANAGEMENT
WEEK 8
 WORKING CAPITAL
MANAGEMENT

Part 1: Cash and Inventory

 WORKING CAPITAL MANAGEMENT

The nature of working capital

Objectives of working capital

Role of working capital Management

Working capital management

 THE NATURAL OF WORKING CAPITAL

Current assets Current liabilities

Cash Trade accounts
Inventory of raw materials Taxation payable
Inventory of work in progress Dividend payments due
Inventory of finished goods Short term loans
Accounts receivable Salaries and wage payable
Marketable securities Lease rentals due within one year

Working capital = Current assets - Current liabilities

 THE NATURAL OF WORKING CAPITAL

• Different business will have different working capital as follows:

– Holding inventory
– Taking time to pay suppliers.
– Allowing customers time to pay.
 OBJECTIVE OF WORKING CAPITAL

• The two main objectives of working capital management:

– To ensure sufficient liquid resources to continue in
business.
– To increase the overall profitability.
• These two objectives determine the level of working capital.
 ROLE OF WORKING CAPITAL

• Business needs to have clear policies for the management of each component
of working capital.
• Working capital management is a key factor in an organization’s long term
success.
• The management of cash, marketing securities, accounts receivables, accruals
and all short term financing is the direct responsibility of the financial manager.
 OVERCAPITALIZATION

• It means the company has excessive in cash, account receivable

and inventories
• A situation where market value of a company is less than the long
term capitalisation of the company.
• There will be an over investment in working capital or over
capitalised.
• Indicators of over capitalisation:
 THE NATURAL OF WORKING CAPITAL

• It happens when a business tries to do too much too quickly with too little long
term capital, So that it is trying to support too large a volume of trade with
capital resources at its disposal. It may cause liquidity troubles because of
short of money.
• Symptoms of over trading are as follows:
o Rapid increase in turnover.
o Rapid increase of current assets.

o Small increase in proprietors’ capital (through retained profits).

o Increase in asset financed by credit.

o Increase in bank overdrafts.
WORKING CAPITAL MANAGEMENT

Cash operating cycle

Managing inventory

Managing receivable

Managing payable
 CASH OPERATING CYCLE

• The period of time which elapses between the point at which cash begins to be
expended on the production of product and the collection of cash from a
purchaser
• The period of time which elapses between the point at which cash begins to be
expended on the production of product and the collection of cash from a
purchaser

Goods Suppliers Goods sold Cash received

Purchased Paid to customers from customers
 OPERATING CYCLE CASH OPERATING CYCLE

The average time that raw Raw material inventory holding period
material remain in inventory

Accounts payable payment period

The period of credit taken
from supplies

Average production period

The average time taken to
produce the goods
Inventory turnover (Finish goods)

The time taken by customer to

pay the goods Account receivable payment period
 CASH OPERATING CYCLE

Average stock * 365 days

Stock turnover =
Cost of sale

Average receivables * 365 days

Trade receivables collection period =
Credit sales

Average payables * 365 days

Trade payables payment period =
Purchase or Cost of sales

Cash operating cycle = ST + RCP - PPP

 QUESTION and ANSWER
Example – Marlboro Co estimates the following figures for the coming year.
• Sales – all on credit £3,600,000
• Receivables £306,000
• Gross profit margin 25% on sales
• Finished goods £200,000
• Work in progress £350,000
• Raw materials £150,000
• Trade payables £130,000
Inventory levels are constant. The purchase of raw materials are 80% of cost of sales
– all on credit.
Required: Calculate the cash operating cycle.
MANAGING INVENTORY
 MANAGING INVENTORY

To simplify:
Inventory costs = holding cost + ordering cost

Order quantity * Holding cost per unit of inventory for one period
Holding cost =
2

Annual demand * Cost per order

Ordering cost =
Order quantity
 MANAGING INVENTORY

Example 1 – A company requires 1,000 units of material X per month for

£10 per unit. The cost per order is £30 regardless of the size of the
order. The holding costs are £2.88 per unit.
Required: Investigate the total cost of buying the material in quantities of
400, 500, 600 or 700 units at one time. What is the cheapest option?
 MANAGING INVENTORY

Almost every company carries inventories of some sort, event if they

are only inventories of consumables such as stationery. For a
manufacturing business, inventories in the form of raw materials, work
in progress and finish good, may amount to a substantial proportion of
the total assets of the business.
Businesses attempt to control inventories on a scientific basis by
balancing the costs of inventory shortage against those of inventory
holding.
 MANAGING INVENTORY

The economic order quantity (EOQ): Is the optimal ordering quantity for
an item of inventory which will minimise costs.

Q ´ C H C O ´D
Total annual cost of having inventory = +
2 Q

D= usage in units for one period (the demand)

C0= cost of placing one order
CH=Holding cost per unit for one period
Q= re-order quantity
 MANAGING INVENTORY

Formula to calculate economic order quantity (EOQ)

2C 0 D
EOQ =
CH
 Example

W Co is a retailer of barrels. The company has an annual demand of 30,000 barrels. The

barrels cost £2 each. Fresh supplies can be obtained immediately, with ordering and

transport costs amounting to £200 per order. The annual cost of holding one barrel in

stock is estimated to be £1.2. A 2% discount is available on orders of at least 5,000

barrels and a 2.5% discount is available if the order quantity is 7,500 barrels or above.

Required: Calculate the EOQ ignoring the discount and determine if it would change

once the discount is taken into account

 MANAGING INVENTORY

Uncertainties in demand and lead times taken to fulfil orders mean

that inventory will be ordered once it reaches a re order level

Re – Order Maximum Maximum

level
= usage
x lead time
 MANAGING INVENTORY

Maximum and buffer safety inventory levels

 EXAMPLE

A company has an inventory management policy which involves ordering

50,000 units when the inventory level falls to 15,000 units. Forecast demand
to meet production requirements during the next year is 310,000 units. You
should assume a 50-week year and that demand is constant throughout the
year. Orders are received two weeks after being placed with the supplier.
Required: What is the average inventory level?
 INVENTORY MANAGEMENT SYSTEM

1) Two-Bin system
The first bin has a minimum of working stock and the second bin keeps reserve
stock or remaining material.
• Mainly used for small or low-value items.
2) Periodic review (constant order cycle system)
• Inventory level are reviewed at a fixed internals.
• Orders are more evenly spread and easier to plan.
3) JIT (just–in–time)
• To minimize inventory level.
 JUST IN TIME PROCUREMENT

• It means you will reduce the inventory level to as low a level as possible .
• It means obtaining goods from suppliers at latest possible time (as needed).
• The benefits of JIT policy (It will not be suitable for some cases ‘‘restaurants’’):
o Reduce inventory holding cost.
o Reduce manufacturing lead times.
o Improved labour productivity.
o Reduced scrap/ rework/ warranty cost.
 JUST IN TIME STOCKHOLDING

Describes a policy of obtaining goods from

suppliers at the latest possible time, avoiding the
need to carry materials/component inventory.

inventory

suppliers staff quality lead times

0
 JUST IN TIME STOCKHOLDING

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.

Q: Any potential issues with JIT?

QUESTION
and
ANSWER
 QUESTION 1
D Co uses component V22 in its construction process. The company has a
demand of 45,000 components. 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. Calculate the optimal order quantity.
b. A 0.5% discount is available on order of at least 3,000 components and a
0.75% discount is available if the order quantity is 6,000 components or
above. Will the company increase the order number to 6,000?
 QUESTION 1

Ignoring discounts, assume that the company adopts the EOQ as its order
quantity and that is now takes three weeks for an order to be delivered.
c. How frequently with the company place an order?
d. How much inventory will it have on hand when the order is placed?
 QUESTION 2

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?
 QUESTION 3
TT Co expects annual demand for product X to be 127,690 units. Product X
has a selling price of £18 per unit and is purchased for £6 per unit from a
supplier, MM Co. TT places an order for 25,000 units of product X at regular
intervals throughout the year. Because the demand for product X is to some
degree uncertain, TT maintains a safety (buffer) stock of product X which is
sufficient to meet demand for 28 working days. The cost of placing an order
is £25 and the storage cost for Product X is 10 pennies per unit per year.
 QUESTION 3
TT normally pays trade suppliers after 60 days, but MM has offered a
discount of 1% for cash settlement within 20 days.
TT Co has a short-term cost of debt of 10% and uses a working year
consisting of 365 days.
Required
(a) Calculate the annual cost of the current ordering policy (ignore financing
costs in this part of the question).
 QUESTION 3
(b)
i. Calculate the annual savings if the economic order quantity (EOQ) model is
used to determine an optimal ordering policy (ignore financing costs in this
part of the question).
ii. Critically discuss the limitations of the EOQ model as a way of managing
inventory.
(c) Determine whether the discount offered by the supplier is financially
acceptable to TT Co.
 FINANCIAL
MANAGEMENT
WEEK 9
 WORKING CAPITAL
MANAGEMENT

Part 2: Receivable and Payable

 The objectives of managing receivables

The optimum level of trade credit extended represents a balance between

two factors:

1. Profit improvement from sales obtained by allowing credit;

2. The cost of credit allowed.

 Managing Accounts Receivables

Establishing a credit policy

○ The amount of credit?
○ For how long?
○ Which customers?
○ Any protection of payment?
 Managing Accounts Receivables

Four key aspects:

1. Assess creditworthiness.
2. Credit limits.
3. Invoice promptly and collect overdue debts.
4. Monitor the credit system.
 MANAGING ACCOUNTS RECEIVABLE

Cost of offering credit = Value of interest charged on an overdraft to fund the

period of credit or Interest lost on cash not received

• Cost of financing receivables = receivable balance x interest (overdraft) rate

!"#"$%&'(" )&*+
• Receivable balance = sales x
,-. )&*+
 MANAGING ACCOUNTS RECEIVABLE

Example 1: P Co has sales of £20m for the previous year, receivables at the year end
were £4m, and the cost of financing receivables is covered by an overdraft at
the interest rate of 12% pa.
Required
a) Calculate the receivables days for P Co.
b) Calculate the annual cost of financing receivables.
 MANAGING ACCOUNTS RECEIVABLES

Discounts for early settlement

Calculate:
ü Profits foregone by offering discount
ü Interest charge changes because customer paid at different times and
sales change
100 365 / t
ü Annual cost of discount = ( ) -1
100 - d
d = the discount offered
t = the reduction in the payment period in days to obtain the discount
 MANAGING ACCOUNTS RECEIVABLE

Example 2: Continuing the case of P Co.

It is now considering offering a cash discount of 2% for payment of debts
within 10 days.
Required:
(a) What’s the cost of discount for P co.?
(b) Should it be introduced if 40% of customers will take up the discount?
 Factoring
Factoring – the outsourcing of the credit control department to a third party.
v Advantages
• Saving in staff time/admin costs
• New source of finance to help liquidity
• Frees up management time
• Supports a business when sales are rising
v Disadvantages
• Can be expensive
• Loss of direct customer contact goodwill
 Factoring

Example – Cost of factoring (Continuing of P Co case)

A factor has offered a debt collection service which should shorten the receivables collection
period on average to 50 days. It charges 1.5% of turnover but should reduce administration costs
to the company by £150,000.
Required:
a) Should P Co hire the factoring facility?
b) In addition, the factor has offered a finance provision of 80% of the debt immediately. They
charge 14% but this is expected to save an additional £50,000. What is the overall cost of this
service?
 MANAGING ACCOUNTS PAYABLE

• Under trade credit a firm is able to obtain goods (or services) from a supplier

without immediate payment, the supplier accepting that the firm will pay at

a later date.

• Again there is a balancing act between liquidity and profitability.

• A delay of payment to suppliers could cause problems.

• Suppliers will normally offer early settlement discounts which ensures

prompt payment.
 MANAGING ACCOUNTS PAYABLE

● Costs of taking credit:

• Higher price than purchases for immediate cash settlement.
• Administrative costs.
• Restrictions imposed by seller.
• Foreign exchange losses.
● Costs of not taking credit:
• Financing cost.
• Lost purchasing power.
• Inconvenience – paying at the time of purchase can be inconvenient.
 MANAGING ACCOUNTS PAYABLE

Example – Account payable with early settlement discount

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. If Box’s overdraft rate

is 10% pa, is it financially worthwhile for them to accept the

discount and pay early?

 RECEIVABLES & PAYABLES

Managing foreign trades

Export credit risk
1. Insolvent customers
2. Bank failure
3. Unconvertible currencies
4. Political risk
Foreign exchange risk
1. Buying from abroad in a foreign currency
2. Denominating sales to export customers in a foreign currency.
QUESTION
and
ANSWER
 QUESTION 1

KXP Co is an e-business which trades solely over the internet. In the last year the company
had sales of £15 million. All sales were on 60 days’ credit to commercial customers.
Extracts from the company’s most recent statement of financial position relating to working
capital are as follows:
£000
Trade receivables 2,466
Trade payables 2,220
Overdraft 3,000
 QUESTION 1
In order to encourage customers to pay on time, KXP Co proposes introducing an early settlement
discount of 1% for payment within 30 days, while increasing its normal credit period to 45 days. It is
expected that, on average, 50% of customers will take the discount and pay within 30 days, 30% of
customers will pay after 45 days, and 20% of customers will not change their current paying
behaviour.

KXP Co currently orders 15,000 units per month of Product Z, demand for which is constant. There is
only one supplier of Product Z and the cost of Product Z purchases over the last year was £540,000.
The supplier has offered a 2% discount for orders of Product Z of 30,000 units or more. Each order
costs KXP Co £150 to place and the holding cost is 24 pence per unit per year.
 QUESTION 1

KXP Co has an overdraft facility charging interest of 6% per year.

Required:
a. Should KXP adopt the new policy? Calculate the net benefit and comment on your
findings.
b. Should KXP accept the bulk purchase discount offered by the supplier? Calculate the
different costs of inventory (including cost of material, annual ordering cost and annual
holding cost before and after taking the discount) and comment on your findings.
c. Identify and evaluate the key factors of formulating a trade receivables management
policy by businesses.
 QUESTION 2
International Electric plc at present offers its customers 30 days’ credit. Half the
customers, by value, pay on time. The other half take an average of 70 days to
pay. The business is considering offering a cash discount of 2 per cent to its
customers for payment within 30 days.
The credit controller anticipates that half of the customers who now taken an
average of 70 days to pay (that is, a quarter of all customers) will pay in 30 days.
The other half (the final quarter) will still take an average of 70 days to pay. The
scheme will also reduce bad debts by £300,000 a year.
Annual sales revenue of £365m is made evenly throughout the year. At present
the business has a large overdraft (£60m) with its bank at an interest cost of 12
per cent a year.
 QUESTION 2
Required
1. Calculate the appropriate equivalent annual percentage cost of a discount of 2
per cent, which reduces the time taken by credit customers to pay from 70
days to 30 days.
2. Calculate the value of trade receivables outstanding under both the old and
new schemes.
3. How much will the scheme cost the business in discounts?
4. Should the business go ahead with the scheme? State what other factors, if
any, should be taken into account.
5. Outline the controls and procedures that a business should adopt to manage
the level of its trade receivables.
 FINANCIAL
MANAGEMENT
WEEK 10
BUDGETING CASH AND
FUNDING STRATEGIES
The Basic Framework of Budgeting

A budget is a detailed quantitative plan for acquiring and

using financial and other resources over a specified
forthcoming time period.
1. The act of preparing a budget is called budgeting.
2. The use of budgets to control an organization’s
activities is known as budgetary control.

3
The Master Budget: An Overview
Sales budget

Selling and
Ending inventory administrative
Production budget
budget budget

Direct materials Direct labor Manufacturing

budget budget overhead budget

Cash Budget

Budgeted
Budgeted
income
balance sheet
statement
Preparing the Master Budget
§ The Sale Budget

§ The Production Budget

§ The Direct Material Budget

§ The Direct Labor Budget

§ The Manufacturing Overhead Budget

§ The Ending Finished Goods Inventory Budget

§ The Selling and Admin Expense Budget

§ The Cash Budget

§ The Budget Income Statement

§ The Budgeted Balance Sheet

5
Budgeting Example
1. Royal Company is preparing budgets for the
quarter ending June 30.
2. Budgeted sales for the next five months are:
April 20,000 units
May 50,000 units
June 30,000 units
July 25,000 units
August 15,000 units.

3. The selling price is $10 per unit.

6
 The Sales Budget
The individual months of April, May, and June are summed to
obtain the total budgeted sales in units and dollars for the quarter
ended June 30th

7
 Expected Cash Collections

• All sales are on account.

• Royal’s collection pattern is:

70% collected in the month of sale,

25% collected in the month following sale,

5% uncollectible.

• The March 31 accounts receivable balance of $30,000 will

be collected in full.

8
Quick Check ü
What will be the total cash collections for the
quarter?
a. $700,000

b. $220,000

c. $190,000

d. $905,000

9
The Production Budget
e d
let
p
m Sales
C o Production
Budget Budget
and
Expected
Cash
Collections

The production budget must be adequate to

meet budgeted sales and to provide for
the desired ending inventory.
10
 The Production Budget

• The management at Royal Company wants ending

inventory to be equal to 20% of the following
month’s budgeted sales in units.
• On March 31, 4,000 units were on hand.
• Let’s prepare the production budget.

11
Quick Check ü

What is the required production for May?

a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units

12
 The Direct Materials Budget
• At Royal Company, five pounds of material are required
per unit of product.
• Management wants materials on hand at the end of
each month equal to 10% of the following month’s
production.
• On March 31, 13,000 pounds of material are on hand.
Material cost is $0.40 per pound.
Let’s prepare the direct materials budget.

13
Quick Check ü
How much materials should be purchased in
May?
a. 221,500 pounds

b. 240,000 pounds
c. 230,000 pounds
d. 211,500 pounds

14
Expected Cash Disbursement for Materials

• Royal pays $0.40 per pound for its materials.

• One-half of a month’s purchases is paid for in the month
of purchase; the other half is paid in the following
month.
• The March 31 accounts payable balance is $12,000.
Let’s calculate expected cash disbursements.

15
Quick Check ü

What are the total cash disbursements

for the quarter?
a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400

16
 The Direct Labor Budget
• At Royal, each unit of product requires 0.05 hours (3 minutes) of direct
labor.
• The Company has a “no layoff” policy so all employees will be paid for
40 hours of work each week.
• For purposes of our illustration assume that Royal has a “no layoff”
policy, workers are pay at the rate of $10 per hour regardless of the
hours worked.
• For the next three months, the direct labor workforce will be paid for a
minimum of 1,500 hours per month.
Let’s prepare the direct labor budget.

17
Quick Check ü
What would be the total direct labor cost for the quarter if
the company follows its no lay-off policy, but pays $15
(time-and-a-half) for every hour worked in excess of 1,500
hours in a month?

a. $79,500

b. $64,500

c. $61,000

d. $57,000
18
 Manufacturing Overhead Budget
• At Royal, manufacturing overhead is applied to units of
product on the basis of direct labor hours.
• The variable manufacturing overhead rate is $20 per direct
labor hour.
• Fixed manufacturing overhead is $50,000 per month,
which includes $20,000 of noncash costs (primarily
depreciation of plant assets).
Let’s prepare the manufacturing overhead budget.

19
Selling and Administrative Expense Budget

• At Royal, the selling and administrative expense budget is divided into

variable and fixed components.
• The variable selling and administrative expenses are $0.50 per unit
sold.
• Fixed selling and administrative expenses are $70,000 per month.
• The fixed selling and administrative expenses include $10,000 in costs
– primarily depreciation – that are not cash outflows of the current
month.
Let’s prepare the company’s selling and administrative expense
budget.

20
Quick Check ü

What are the total cash disbursements for selling

and administrative expenses for the quarter?
a. $180,000
b. $230,000
c. $110,000
d. $ 70,000

21
PREPARE A BUDGET
CASH

22
 CASH
Reasons for holding cash
• Transactions motive to meet regular commitments
• Precautionary motive to maintain a buffer for unforeseen
contingencies
• Speculative motive to make money from a rise in interest
rates
• Failure to carry sufficient cash levels can lead to?
• A balance between profitability and liquidity.
 Format of the Cash Budget
The cash budget is divided into four sections:
1. Cash receipts section lists all cash inflows excluding cash received
from financing;
2. Cash disbursements section consists of all cash payments excluding
repayments of principal and interest;
3. Cash excess or deficiency section determines if the company will
need to borrow money or if it will be able to repay funds previously
borrowed; and
4. Financing section details the borrowings and repayments projected to
take place during the budget period.

24
 The Cash Budget
Assume the following information for Royal:
• Maintains a 16% open line of credit for $75,000
• Maintains a minimum cash balance of $30,000
• Borrows on the first day of the month and repays loans on
the last day of the month
• Pays a cash dividend of $49,000 in April
• Purchases $143,700 of equipment in May and $48,300 in
June (both purchases paid in cash)
• Has an April 1 cash balance of $40,000
25
TREASURY MANAGEMENT

The role of treasury management:

• Banking and exchange
• Cash and currency management
• Investment in short0term assets
• Risk and insurance
• Raising finance
 TREASURY MANAGEMENT
A company must choose between having its treasury management

between:

• Centralised – each operating company holds only the minimum

cash balance required for day-to-day operations, remitting the

surplus to the centre for overall management.

• Decentralised – each operating company must appoint an

officer responsible for that company’s own treasury operations.

Q: Should treasury activities in a large international group be

centralised or decentralised?
CASH MANAGEMENT MODELS

• Aim at minimizing the total costs associated

with movements between a current account
and short-term investments.
• At what point should funds be moved?
• How much should be moved in one go?
• Two models – Baumol & Miller-Orr
 CASH MANAGEMENT MODELS

!"#
Baumol model Q=
$

Where:
• S = amount of cash to be used in each time period
• C = cost per sale of securities
• i = interest cost of holding cash
• Q = total amount to be raised to provide for S
 CASH MANAGEMENT MODELS

Example - Baumol model

A company faces a constant demand for cash totally £200,000 pa. It
replenishes its current account (which pays no interest) by selling constant
amounts of gilts which are held as an investment earning 6% pa. The cost
per sale of gilts is a fixed £15 per sale.
Required:
1. What is the optimum amount of gilts to be sold each time an injection
of cash is needed in the current account?
2. How many transfers will be needed and what will the overall transaction
cost be?
Miller-Orr Model
£

Upper Limit
Invest
cash
<----Spread---->

Return
Point
Borrow cash
Lower Limit

Time
 CASH MANAGEMENT MODELS
This model recognizes that cash inflow and outflows vary considerably on a day-to
day basis. More realistic than the Baumol model’s assumption of constant usage
of cash during a period.
1. Set lower limit for cash balance
2. Estimate variance of cash flow
3. Ascertain interest rate and transaction cost
4. Compute upper limit and return point
• Upper limit= lower limit + lower limit
• Return point = lower limit + (1/3 x spread)
• Spread = Upper limit - lower limit
3 transaction cos t ´ cashflow var iance 1/ 3
• Spread = 3´[ ´ ( )]
4 int erestrate
a) The daily interest rate should be adopted.
var ianceofcashflow = ( s tan darddeviationofcashflow) 2
 CASH MANAGEMENT MODELS
Example: Miller - Orr Model
The minimum cash balance of £20,000 is required at M 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 £9m. The interest rate is 0.03% per day.
Calculate:
a. The spread between the upper and lower limit.
b. The upper limit.
c. The return point.
d. Explain the relevance of these value for the cash management of the company.
 FINANCIAL
MANAGEMENT
WEEK 11
SOURCES OF FINANCE
Overdraft Selecting sources of finance

Short-term Short-term Long-term

loan

Credit Venture capital

Leasing

Leasing

Equity Debt Hybrids

Raising equity Choosing between

Debt
sources

Rights issues
 Introduction
Criteria for choosing between sources of finance
— Cost
— Duration
— Term structure of interest rates
— gearing
— Accessibility

Q: Besides all the external financial sources mentioned, what could be internal
financial sources?
 Short-term sources of finance

Types of short-term finance – working capital is usually funded using STF

— Overdraft
— Short-term loan
— Trade credit
— Leasing (operating or finance leasing?)
 Short-term sources of finance
Finance leases
— Lessee bears most of risk and rewards
— Lessee responsible for servicing and maintenance
— Primary period of lease for asset’s useful economic life, secondary (low-rent) period
afterwards
— Asset shown on lessee’s balance sheet
Operating leases
— Lessor bears most of risk and rewards
— Lessor responsible for servicing and maintenance
— Period of lesses short, less than useful economic life of asset
— Asset not shown on lessee’s balance sheet
 Long-term Finance

Types of long-term finance

— Leasing
— Debt
— Equity
— Venture capital
 Long-term Finance - Equity

Equity finance - is raised thought the sale of ordinary shares to

investors via a new issue or a right issue - is an offer to existing
shareholders enabling them to buy new shares.
• Offer price will be lower than current market price of existing shares.
• Value of rights = ‘Theoretical ex-rights price’ – ‘Issue price’
 Long-term Finance - Equity
Example - Polecat plc has 18m £0.50 ordinary shares in issue. The current
stock exchange value of these is £1.70 per share. The directors have
decided to make a one for three rights issue at £1.25 each. Julie owns
3000 Polecat ordinary shares.
Assuming that the right issue will be the only influence on the share price:
a. What, in theory, will be the ex-rights price of the shares?
b. For how much, in theory, could Julie sell the ‘right’ to buy one
share?
c. Will it matter to Julie if she allows the rights to lapse?
d. What are the advantages of rights issue?
 Solution
a. Pre-rights value of the business = 18m £1.70 = £30.60m
Cash to be raised from the rights issue = 6m £1.25 = 7.50
Ex-rights price per share £38.10m/24m = £1.5875
b. From (a) it would appear that Julie could sell her rights for £0.3375
each, because a buyer could pay Julie this amount for the right to
pay the business a further £1.25 and obtain a share worth £1.5875.
 Solution
c. Yes, it will matter greatly to Julie if she neither takes up the shares nor
sells the rights.
Before the rights issue, Julie owns shares worth £5,100 (i.e. 3,000
£1.70).
Assuming that she does nothing, after the rights issue, she will have
shares worth £4,762.50 (i.e. 3,000 £1.5875). She must either sell
the rights or take up the shares in order to maintain her wealth.
 Long-term Finance - Debt

Loan notes are known as corporate bonds or loan stock:

● Duration of loan?
● Fixed or floating rate?
● Secured or unsecured?
● Redeemable or irredeemable?
● The impact of tax relief.
Example of the description of long-term finance debt in reality - “5% 2025 loan
notes redeemable at par, quoted at £95 ex-int”
 Long-term Finance - Debt

• Deep discount bonds – are issued at a large discount to the nominal

value of the loan notes.
• Zero coupon bonds – are issued at a discount with no interest paid
on them.
 Hybrids - convertibles
Convertible loan notes – give the holder the right to convert to other
securities, normally ordinary shares, at a predetermined price rate and
time.
• Have elements of both debt and equity
• Conversion premium occurs if
Market value of convertible stock > Market value of shares the stock is
to be converted into
QUESTION
and
ANSWER