WORKING CAPITAL MANAGEMENT

The Nature, Elements and Importance of Working Capital:

The Nature of Working Capital and its Elements

Working capital is the capital available for conducting day-to-day operations of an organization,
normally the excess of current assets over current liabilities.

Working capital management is the management of all aspects of both current assets and current
liabilities, to minimise the risk of insolvency while maximising the return on assets.

Investing in working capital has a cost, which can be expressed either as:
● The cost of funding it
● The opportunity cost of lost investment opportunities because cash is tied up and
unavailable for other uses.

The elements of working capital can be broken down into three categories:
● Current assets: These are assets that can be converted into cash within one year, such as
cash and cash equivalents, accounts receivable, and inventory.
● Current liabilities: These are obligations that are due within one year, such as accounts
payable, short-term loans, and taxes owed.
● Net working capital: This is the difference between a company's current assets and its
current liabilities, and it represents the funds available to a company to meet its short-term
obligations.

Objectives of Working Capital Management and the Conflict between Them

The objectives of working capital management are twofold:
● Liquidity: The primary objective of working capital management is to ensure that a company
has sufficient funds available to meet its short-term obligations and to maintain its day-to-day
operations. This is known as liquidity management, and it aims to ensure that the company
is able to pay its bills on time and avoid defaulting on its loans.
● Profitability: The second objective of working capital management is to optimize the level of
working capital in order to improve the company's profitability. This is known as profitability
management, and it aims to balance the need for liquidity with the desire to minimize the
amount of capital tied up in working capital.

However, these objectives can be in conflict with each other. On one hand, a company may want to
minimize its working capital in order to maximize profitability, but this could lead to a lack of liquidity
and the inability to meet short-term obligations. On the other hand, a company may want to
maximize its working capital in order to ensure liquidity, but this could lead to an excessive amount
of capital being tied up in working capital and reduced profitability.
Therefore, working capital management requires a balance between liquidity and profitability. A
company must aim to maintain sufficient liquidity to meet its short-term obligations, while also
minimizing the amount of capital tied up in working capital in order to maximize profitability.

The Central Role of Working Capital Management in Financial Management

Working capital management plays a central role in financial management because it helps a
company to ensure that it has sufficient funds available to meet its short-term obligations and to
maintain its day-to-day operations. This is crucial for the overall financial health of a company, as a
lack of working capital can lead to default on loans, inability to pay bills on time, and even
bankruptcy.

Working capital management also helps a company to optimize the level of working capital in order
to improve its profitability. By minimizing the amount of capital tied up in working capital, a company
can increase its return on investment and improve its overall financial performance.

Additionally, working capital management is closely linked to other areas of financial management,
such as budgeting, forecasting, and investment analysis. For example, working capital management
can help a company to make informed decisions about its budget and forecast future cash flow
needs. It can also assist in evaluating the financial viability of potential investments and help the
company to decide whether or not to invest in a particular project.

Management of Inventories, Accounts Receivable, Accounts

Payable and Cash:

The Cash Operating Cycle

The cash operating cycle is the length of time between the company’s outlay on raw materials,
wages and other expenditures and the inflow of cash from the sale of goods.

The faster a firm can ‘push’ items around the cycle the lower its investment in working capital will
be.

For a manufacturing business, the cash operating cycle is calculated as:

Raw materials holding period X

Payables’ payment period (X)
WIP holding period X
Finished goods holding period X
Receivables collection period X

X
For a wholesale or retail business, there will be no raw materials or WIP holding periods, and the
cycle simplifies to:

Inventory holding period X

Payables’ payment period (X)
Receivables collection period X

Working Capital Ratios

Current Ratio:
The current ratio measures how much of the total current assets are financed by current liabilities.
An idea current ratio is 2:1, however this depends on the nature of the business too.

Quick Ratio:
The quick or acid test ratio measures how well current liabilities are covered by liquid assets. It is
particularly useful where inventory holding periods are long and therefore distort the current ratio.
A measure of 1:1 is considered to be an ideal figure, and means that the company is able to meet
existing liabilities if they all fall due at once.

Receivables’ Collection Period:

The receivables’ collection period is the length of time credit is extended to customers.
Generally, shorter credit periods are seen as financially sensible but the length will also depend
upon the nature of the business.

Payables’ Payment Period:

The payables’ payment period is the average period of credit extended by suppliers.
Generally, increasing payables days suggests advantage is being taken of available credit but there
are risks:
● Losing supplier goodwill
● Losing prompt payment discounts
● Suppliers increasing the price to compensate
Inventory Holding Period:
The inventory holding period is the length of time inventory is held between purchase and sale.
● Raw material holding period is the length of time raw materials are held between purchase
and being used in production. It is calculated by dividing raw material inventory by material
usage and then multiplying with the total number of days in a year (if expressed in days).
● WIP holding period is the length of time goods spend in production. It is calculated by
dividing work-in-progress inventory by production cost and then multiplying with the total
number of days in a year (if expressed in days).
● Finished goods holding period is the length of time finished goods are held between
completion or purchase and sale. It is calculated by dividing finished goods inventory held by
cost of goods sold and then multiplying with the total number of days in a year (if expressed
in days).
For all inventory period ratios, a low ratio is usually seen as a sign of good working capital
management. It is very expensive to hold inventory and thus minimum inventory holding usually
points to good practice.

Working Capital Turnover:

The working capital turnover ratio measures how efficiently management is utilising its investment in
working capital to generate sales and can be useful when assessing whether a company is
overtrading.

Relevant Techniques in Managing Inventory

Economic Order Quantity (EOQ):

The Economic Order Quantity (EOQ) model is a method used to determine the optimal quantity of
inventory to order in order to minimize the total cost of ordering and holding inventory. The EOQ
takes into account the fixed cost of placing an order, the variable cost of holding inventory, and the
annual demand for the product.
The EOQ is the point at which the cost of ordering is equal to the cost of holding inventory, and it
represents the most cost-effective balance between these two costs.
It's important to note that the EOQ model assumes that the demand and lead time are constant, the
purchase price is constant, and that buffer inventory is not needed and therefore is not held. In real-
world situations, these assumptions may not be accurate, and other factors such as uncertainty of
demand, variability of lead time, and safety stock needs to be considered.

Periodic Review System:

The periodic review system of inventory management is a method used to manage inventory levels
by regularly reviewing and adjusting the inventory levels at set intervals.
In a periodic review system, the inventory level of each item is reviewed at set intervals, such as
weekly or monthly. Based on the review, a decision is made to either place an order for more
inventory or to not place an order. The order quantity is then determined using the Economic Order
Quantity (EOQ) model, or another inventory management model.

Just-in-Time (JIT) System:

The Just-in-Time (JIT) system of inventory management is a method used to minimize inventory
levels by only ordering and receiving goods as they are needed for production or for sale. The goal
of JIT is to reduce the cost of holding inventory and to increase efficiency by eliminating waste and
unnecessary steps in the production process.
JIT is based on the principles of pull production, in which production is driven by actual customer
demand rather than by forecasts or schedules. This means that inventory is only ordered and
received when it is needed, reducing the amount of inventory that must be stored and managed.
One of the main advantages of JIT is that it allows for minimal inventory levels, which reduces the
costs of holding and managing inventory. It also helps to increase efficiency by eliminating waste
and unnecessary steps in the production process.
However, JIT also has some drawbacks. One of the main disadvantages is that it requires a high
level of coordination and communication between suppliers, manufacturers, and customers. It also
requires a high level of reliability and responsiveness from suppliers, as well as a good forecasting
system.
Another disadvantage is that it can be risky, since it relies heavily on the timely delivery of goods
and materials. If a supplier is late or if there is an unexpected increase in demand, it can lead to
stockouts and production delays.

Management of Accounts Receivable

Credit Analysis / Assessing Creditworthiness:
Offering credit to customers exposes a company to the risk of bad debts and this should be
minimised through credit analysis or assessing creditworthiness. This can be done through
collecting and analysing information about potential credit customers. Relevant information includes
bank references, trade references, reports from credit reference agencies, records of previous
transactions with potential customers, annual reports, and so on.
A company might set up its own credit scoring system in order to assess the creditworthiness of
potential customers. Where the expected volume of trade justifies it, a visit to a company can be
made to gain a better understanding of its business and prospects.

Credit Control:
The accounts of customers who have been granted credit must be monitored regularly to ensure
that agreed trade terms are being followed and that accounts are not getting into arrears.
An important monitoring device here is an aged trade receivables analysis, identifying accounts and
amounts in arrears, and the extent to which amounts are overdue.
A credit utilisation report can assist management in understanding the extent to which credit is being
used, identifying customers who may benefit from increased credit, and assessing the extent and
nature of a company’s exposure to trade receivables.

Collection of Amounts Owed:

A company should ensure that its trade receivables are kept informed about their accounts,
amounts outstanding and amounts becoming due, and the terms of trade they have accepted. An
invoice should be raised when a sale is made. Regular statements should be sent, for example, on
a monthly basis. Customers should be encouraged to settle their accounts on time.
Overdue accounts should be chased using procedures contained within a company’s trade
receivables management policy. Reminders of payment due should be sent, or phone calls could be
made. Taking legal action or employing a specialised debt collection agency could be considered as
a last resort. A clear understanding of the costs involved is important here, as the costs incurred
should never exceed the benefit of collecting the overdue amount.

Offering Early Settlement Discounts:

Offering early settlement discounts is a method of encouraging customers to pay their bills early.
This can include offering a discount for payment within a certain time period, or offering a discount
for paying the full amount due. By offering early settlement discounts, a company can encourage
customers to pay their bills early, which can help to improve cash flow and reduce the risk of bad
debt.

Factoring:
Factoring is the outsourcing of the credit control department to a third party. The debts of the
company are effectively sold to a factor. The factor takes on the responsibility of collecting the debt
for a fee. The factor will assess the creditworthiness of new customers, record sales, send out
statements and reminders, collect payment, identify late payers and chase them for settlement, and
take appropriate legal action to recover debts where necessary.
The factor will also offer finance to a company based on invoices raised for goods sold or services
provided. This is usually up to 80% of the face value of invoices raised. The finance is repaid from
the settled invoices, with the balance being passed to the issuing company after deduction of a fee
equivalent to an interest charge on cash advanced.
If factoring is without recourse, the factor rather than the company will carry the cost of any bad
debts that arise on overdue accounts. Factoring without recourse therefore offers credit protection to
the selling company, although the factor’s fee will be quite high, to reflect the cost of the insurance
offered.

Invoice Discounting:
Invoice discounting is a method of raising finance against the security of receivables without using
the sales ledger administration services of a factor. With invoice discounting, the business retains
control over its sales ledger, and confidentiality in its dealings with customers.
Invoice discounting can help a business that is trying to improve its cash flows, but does not want a
factor to administer its sales ledger and collect its debts. It is therefore equivalent to the financing
service provided by a factor, without the control of credit passing to the lender.

Managing Foreign Accounts Receivable:

Foreign accounts receivable present some additional challenges to a business that are not present
with domestic-based customers.
It is harder for a business to pursue any overdue amounts from a business in another country with a
different legal system. One option for a business is to simply trust the foreign customer to pay within
the stated credit period without demanding additional security, a method known as ‘open account’.
This option means the business faces a level of non-payment risk that some businesses may find
unacceptable.
Exporters can protect themselves against export credit risk by the following means:
● Reducing investment in foreign accounts receivable
A company can reduce its investment in foreign accounts receivable by asking for full or part
payment in advance of supplying goods. However, this may be resisted by consumers,
particularly if competitors do not ask for payment up front.
Another approach is for the seller (exporter) to arrange for a bank to give cash for foreign
accounts receivable, sooner than the seller would normally receive payment.
● Forfaiting
Forfaiting involves the purchase of foreign accounts receivable from the seller by a forfaiter.
The forfaiter takes on all of the credit risk from the transaction (without recourse) and
therefore the forfaiter purchases the receivables from the seller at a discount. The purchased
receivables become a form of debt instrument which can be sold on the money market.
The non-recourse side of the transaction makes this an attractive arrangement for
businesses, but as a result the cost of forfaiting is relatively high.
● Letter of credit
Documentary letters of credit are a payment guarantee backed by one or more banks. They
carry almost no risk, provided the exporter complies with the terms and conditions contained
in the letter of credit. The exporter must present the documents stated in the letter, such as
bills of lading, shipping documents, bills of exchange, and so on, when seeking payment. As
each supporting document relates to a key aspect of the overall transaction, letters of credit
give security to the importer as well as the exporter.
● Countertrading
In a countertrade arrangement, goods or services are exchanged for other goods or services
instead of for cash.
The benefits of countertrading include the fact that it facilitates conservation of foreign
currency and can help a business enter foreign markets that it may not otherwise be able to.
The main disadvantage of countertrading is that the value of the goods or services received
in exchange may be uncertain, especially if the goods being exchanged experience price
volatility. Other disadvantages of countertrade include complex negotiations and logistical
issues, particularly if a countertrade deal involves more than two parties.
● Export credit insurance
Export credit insurance protects a business against the risk of non-payment by a foreign
customer. Exporters can protect their foreign accounts receivable against a number of risks
which could result in non-payment. Export credit insurance usually insures the seller against
commercial risks, such as insolvency of the purchaser or slow payment, and also insures
against certain political risks, for example war, riots, and revolution which could result in non-
payment. It can also protect against currency inconvertibility and changes in import or export
regulations.
However, its disadvantages include the relatively high cost of premiums and the fact that the
insurance does not typically cover 100% of the value of the foreign sales.
● Export factoring
An export factor provides the same functions in relation to foreign accounts receivable as a
factor covering domestic accounts receivable and therefore can help with the cash flow of a
business.
However, export factoring can be more costly than export credit insurance and it may not be
available for all countries, particularly developing countries.

Management of Accounts Payable

Trade credit is the simplest and most important source of short-term finance for many companies.

Whilst trade credit may be seen as a source of free credit, there will be costs associated with
extending credit taken beyond the norm – lost discounts, loss of supplier goodwill, more stringent
terms for future sales.
In order to encourage early payments, the supplier may offer early settlement discounts. The benefit
of this discount in terms of less cash paid to the supplier should be compared with the cost of this
discount in terms of the increased working capital funding cost.

Management of Cash
Although cash needs to be invested to earn returns, businesses need to keep a certain amount
readily available. The reasons include:
● Transactions Motive: The transactions motive refers to the need for cash to meet day-to-
day operating expenses, such as paying for goods and services, making payroll, and paying
bills. Cash is needed to pay for these expenses as they arise, and companies must have
enough cash on hand to meet these needs.
● Precautionary Motive: The precautionary motive refers to the need for cash to be available
in case of unexpected events, such as an economic downturn, changes in consumer
demand, or a natural disaster. Companies hold cash as a buffer against these unexpected
events to ensure they can meet their financial obligations and continue operations.
● Speculative Motive: The speculative motive refers to the need for cash to be available for
future investment opportunities. Companies may hold cash in anticipation of future
opportunities, such as purchasing new equipment, acquiring another company or investing in
a new product line. By holding cash, companies are able to take advantage of these
opportunities without needing to raise additional funding.

However, holding cash has a cost: the loss of profits which would otherwise have been obtained by
using funds in another way. So, as ever, the financial manager must try to balance liquidity with
profitability.

Cash Budgets and Cash Flow Forecasts:

A cash forecast is an estimate of cash receipts and payments for a future period under existing
conditions.
Cash forecasts can be prepared based on:
● Receipts and payments forecast
● Statement of financial position forecast
● Working capital ratios
A cash budget is a commitment to a plan for cash receipts and payments for a future period after
taking any action necessary to bring the forecast into line with the overall business plan.
Cash budgets are used to:
● Assess and integrate operating budgets
● Plan for cash shortages and surpluses
● Compare with actual spending.

Cash Management Models:

Cash management models are aimed at minimising the total costs associated with movements
between:
● A current account (very liquid but not earning interest)
 ● Short-term investments (less liquid but earning interest)
The models are devised to answer the questions:
● At what point should funds be moved?
● How much should be moved in one go?
There are two main cash management models:
i. The Baumol Cash Management Model
The Baumol model is based on the idea that deciding on optimum cash balances is like
deciding on optimum inventory levels. Thus, the optimum cash balance is the balance at
which transaction costs and costs of holding cash are minimum (and equal).
This model assumes that cash use is steady and predictable and that cash inflows are
known and regular. Day-to-day cash needs are funded from current account and buffer cash
is held in short-term investments.
The formula calculates the amount of funds to inject into the current account or to transfer
into short-term investments at one time.

The model suggests that when interest rates are high, the cash balance held in non-interest-
bearing current accounts should be low. However, its weakness is the unrealistic nature of
the assumptions on which it is based.
ii. The Miller-Orr Cash Management Model
The Miller-Orr model controls irregular movements of cash by the setting of upper and lower
control limits on cash balances. It is used for setting the target cash balance.
It has the advantage (over the Baumol model) of incorporating uncertainty in the cash
inflows and outflows and so may be more appropriate than the Baumol model when cash
flows are erratic.
The lower limit has to be specified by the firm and the upper limit is calculated by the model.
The cash balance of the firm is allowed to vary freely between the two limits but if the cash
balance on any day goes outside these limits, action must be taken.
If the cash balance reaches the lower limit, it must be replenished in some way, e.g., by the
sale of marketable securities or withdrawal from a deposit account. The size of this
withdrawal is the amount required to take the balance back to the return point. It is the
distance between the return point and the lower limit.
If the cash balance reaches the upper limit, an amount must be invested in marketable
securities or placed in a deposit account, sufficient to reduce the balance back to the return
point. Again, this is calculated by the model as the distance between the upper limit and the
return point.

Dealing with Cash Flow Surpluses:

Companies and other organisations sometimes have a surplus of cash and become ‘cash rich’. A
cash surplus is likely to be temporary, but while it exists the company should invest or deposit the
cash bearing the following considerations in mind:
● Liquidity: Money should be available to take advantage of favourable short-term interest
rates on bank deposits, or to grasp a strategic opportunity, for example, paying cash to take
over another company.
● Profitability: The company should seek to obtain a good return for the risk incurred.
● Safety: The company should avoid the risk of a capital loss.
Other factors that organisations need to consider include:
● Whether to invest at fixed or floating rates. Floating rate investments are likely to be chosen
if interest rates are expected to rise.
● Terms to maturity. The terms chosen will be affected by the business’s desire for liquidity
and expectations about future rates of interest – if there are major uncertainties about future
interest rate levels, it will be better to choose short-term investments. There may also be
penalties for early liquidation.
● How easy it will be to realise the investment.
● Whether a minimum amount has to be invested in certain investments.
● Whether to invest on international markets.
If a company has no plans to grow or to invest, then surplus cash not required for transactions or
precautionary purposes should normally be returned to shareholders. Surplus cash may be returned
to shareholders by:
● Increasing the usual level of annual dividends which are paid.
● Making a one-off special dividend payment.
● Using the money to buy back its own shares from some of its shareholders. This will reduce
the total number of shares in issue and should therefore raise the level of earnings per
share.

Determining Working Capital Needs and Funding Strategies:

Working Capital Investment Levels

The working capital ratios can be used to predict the future levels of investment required. This is
done by re-arranging the formulas.

There are a number of factors that determine the level of investment in current assets:
● Length of the working capital cycle: The working capital cycle or operating cycle is the
period of time between when a company settles its accounts payable and when it receives
cash from its accounts receivable. Operating activities during this period need to be financed
and as the operating period lengthens, the amount of finance needed increases. Companies
with comparatively longer operating cycles than others in the same industry sector, will
therefore require comparatively higher levels of investment in current assets.
● Terms of trade: These determine the period of credit extended to customers, any discounts
offered for early settlement or bulk purchases, and any penalties for late payment. A
company whose terms of trade are more generous than another company in the same
industry sector will therefore need a comparatively higher investment in current assets.
 ● Organisation’s policy on the level of investment in current assets: Even within the
same industry sector, companies will have different policies regarding the level of investment
in current assets, depending on their attitude to risk. A company with a comparatively
conservative approach to the level of investment in current assets would maintain higher
levels of inventory, offer more generous credit terms and have higher levels of cash in
reserve than a company with a comparatively aggressive approach. While the more
aggressive approach would be more profitable because of the lower level of investment in
current assets, it would also be riskier, for example, in terms of running out of inventory in
periods of fluctuating demand.
● Industry in which the organisation operates: Another factor that influences the level of
investment in current assets is the industry within which an organisation operates. Some
industries, such as aircraft construction, will have long operating cycles due to the length of
time needed to manufacture finished goods and so will have comparatively higher levels of
investment in current assets than industries such as supermarket chains, where goods are
bought in for resale with minimal additional processing and where many goods have short
shelf lives.

Strategies for Funding Working Capital

A firm must make a decision about what source of finance is best used for the funding of working
capital requirements.

The decision about whether to choose short- or long-term options depends upon a number of
factors. Some of the key factors in determining working capital funding strategies are:
● Permanent and fluctuating current assets: One key factor when discussing working
capital funding strategies is to distinguish between permanent and fluctuating current assets.
Permanent current assets represent the core level of current assets needed to support
normal levels of business activity, for example, the level of trade receivables associated with
the normal level of credit sales and existing terms of trade. Business activity will be subject
to unexpected variations, however, such as some customers being late in settling their
accounts, leading to unexpected variations in current assets. These can be termed
fluctuating current assets.
● Relative cost and risk of short-term and long-term finance: A second key factor is the
relative cost of short‐term and long‐term finance. Long‐term debt finance is more expensive
than short‐term debt finance, for example, because of investor liquidity preference or default
risk. Provided the terms of loan agreements are adhered to and interest is paid when due,
however, long‐term debt finance is a secure form of finance and hence low risk. On the
other hand, while short‐term debt finance is lower cost than long‐term debt finance, it is
higher risk. For example, an overdraft is technically repayable on demand, while a short‐term
loan is subject to the risk that it may be renewed on less favourable terms than those
currently enjoyed.
● Matching principle: A third key factor is the matching principle, which states that the
maturity of assets should be reflected in the maturity of the finance used to support them.
Short‐term finance should be used for fluctuating current assets, while long‐term finance
should be used for permanent current assets and non‐current assets.
● Relative costs and benefits of different funding policies: A matching funding policy
would use long‐term finance for permanent current assets and non‐current assets, and
short‐term finance for fluctuating current assets. A conservative funding policy would use
long‐term finance for permanent current assets, non‐current assets and some of the
 fluctuating current assets, with short‐term finance being used for the remaining fluctuating
current assets. An aggressive funding policy would use long‐term finance for the non‐current
assets and part of the permanent current assets, and short‐term finance for fluctuating
current assets and the balance of the permanent current assets.
A conservative funding policy, using relatively more long‐term finance, would be lower in risk
but lower in profitability. An aggressive funding policy, using relatively more short‐term
finance, would be higher in risk but higher in profitability. A matching funding policy would
balance risk and profitability, avoiding the extremes of a conservative or an aggressive
funding policy.

● Other key factors: Other key factors in working capital funding strategies include
managerial attitudes to risk, previous funding decisions and organisation size. Managerial
attitudes to risk can lead to a company preferring one working capital funding policy over
another, for example, a risk‐averse managerial team might prefer a conservative working
capital funding policy. Previous funding decisions dictate the current short‐term / long‐term
financing mix of a company. Organisational size can be an important factor in relation to, for
example, access to different forms of finance in support of a favoured working capital
funding policy.

Other Important Concepts under Working Capital Management:

Working Capital Investment vs Working Capital Financing

Working capital investment policy is concerned with the level of investment in current assets, with
one company being compared with another. Working capital financing policy is concerned with the
relative proportions of short‐term and long‐term finance used by a company. While working capital
investment policy is therefore assessed on an inter‐company comparative basis, assessment of
working capital financing policy involves analysis of financial information for one company alone.

Working capital financing policy uses an analysis of current assets into permanent current assets
and fluctuating current assets. Working capital investment policy does not require this analysis.
Permanent current assets represent the core level of investment in current assets that supports a
given level of business activity. Fluctuating current assets represent the changes in the level of
current assets that arise through, for example, the unpredictability of business operations, such as
the level of trade receivables increasing due to some customers paying late or the level of inventory
increasing due to demand being less than predicted.

Working capital financing policy relies on the matching principle, which is not used by working
capital investment policy. The matching principle holds that long‐term assets should be financed
from a long‐term source of finance. Non‐current assets and permanent current assets should
therefore be financed from a long‐term source, such as equity finance or loan note finance, while
fluctuating current assets should be financed from a short‐term source, such as an overdraft or a
short‐term bank loan.

Both working capital investment policy and working capital financing policy use the terms
conservative, moderate and aggressive.
In investment policy, the terms are used to indicate the comparative level of investment in current
assets on an inter-company basis. One company has a more aggressive approach compared to
another company if it has a lower level of investment in current assets, and vice versa for a
conservative approach to working capital investment policy.
In working capital financing policy, the terms are used to indicate the way in which fluctuating
current assets and permanent current assets are matched to short-term and long-term finance
sources. An aggressive financing policy means that fluctuating current assets and a portion of
permanent current assets are financed from a short‐term finance source. A conservative financing
policy means that permanent current assets and a portion of fluctuating current assets are financed
from a long‐term source.

Overall, therefore, it can be said that while working capital investment policy and working capital
financing policy use similar terminology, the two policies are very different in terms of their meaning
and application. It is even possible, for example, for a company to have a conservative working
capital investment policy while following an aggressive working capital financing policy.

Centralisation of Treasury Management

Within a centralised treasury department, the treasury department is normally based at Head Office
and acts as an in-house bank serving the interests of the group.

This has a number of advantages compared to the alternative of allowing each division to organise
their own (decentralised) treasury operations:
● Economies of scale: Borrowing required for a number of subsidiaries can be arranged in
bulk (meaning lower administration costs and possibly a better loan rate) and combined cash
surpluses can be invested in bulk.
● Improved risk management: Foreign exchange risk management is likely to be improved
because a central treasury department can match foreign currency income earned by one
subsidiary with expenditure in the same currency by another subsidiary. In this way, the risk
of losses on adverse exchange rate movements can be avoided without incurring the time
and expense in managing foreign exchange risk.
● Reduced borrowing: Cash surpluses in one area can be used to match to the cash needs
in another, so an organisation avoids having a mix of overdrafts and cash surpluses in
different localised bank accounts.
● Lower cash balances: The centralised pool of funds required for precautionary purposes
will be smaller than the sum of separate precautionary balances which would need to be
held under decentralised treasury arrangements.
● Expertise: Experts can be employed with knowledge of the latest developments in treasury
management.

However, some companies prefer to decentralise treasury management because:

● Sources of finance can be diversified and can match local assets.
● Greater autonomy can be given to subsidiaries and divisions because of the closer
relationships they will have with the decentralised cash management function.
● A decentralised treasury function may be more responsive to the needs of individual
operating units.
 INVESTMENT APPRAISAL

Investment Appraisal Techniques:

Relevant Cash Flows

In investment appraisal, relevant costs are future costs that will be incurred or saved as a direct
consequence of undertaking the investment.

The only cash flows that should be taken into consideration in capital investment appraisal are:
● Cash flows that will happen in the future
● Cash flows that will arise only if the capital project goes ahead.

Thus, the relevant cash flows are:

● Future
● Incremental
● Cash-based
● Opportunity costs

The following cash flows are not relevant and should be ignored:
● Sunk costs (costs that have already been incurred)
● Committed costs (costs that will be incurred anyway, whether or not a capital project goes
ahead)
● Non-cash items
● Allocated costs

Payback Method of Appraisal

The payback period is the time a project will take to pay back the money spent on it. It is based on
expected cash flows and provides a measure of liquidity.

The projects that pay back within the specified time period should be selected.
The choice between options is made on the basis of the fastest payback.

The above formula is used when the annual cash flows are constant. In cases of uneven annual
cash flows, payback is calculated by working out the cumulative cash flow over the life of the
project.

The advantages of the payback method of appraisal are:

● Simplicity: It is easy to understand and calculate, making it suitable for use by people with
little financial expertise. Moreover, it provides a quick and simple way to assess the
feasibility of an investment.
● Useful in certain situations: The payback method of appraisal is useful in certain
situations, such as those involving rapidly changing technology or improving investment
 conditions. For example, if a new plant is likely to be scrapped in a short period because of
obsolescence, a quick payback is essential.
● Favours quick return: Payback favours projects with a quick return. These are to be
preferred for three reasons:
i. Rapid project payback leads to rapid company growth.
ii. Rapid payback minimises time risks.
iii. Rapid payback maximises liquidity.
● Uses cash flows, not accounting profits: Unlike ROCE, it uses cash flows rather than
accounting profits. These are preferred because:
i. Profits cannot be spent
ii. Profits are subjective
iii. Cash is required to pay dividends

The disadvantages of this method of investment appraisal include:

● Ignores returns after the payback period: Cash flows arising after the payback period are
totally ignored.
● Ignores project profitability: Payback takes no account of the effects on business profits
and periodic performance of the project, as evidenced in the financial statements. This is
critical if the business is to be reasonably viewed by uses of the accounts.
● Ignores the timing of cash flows: It does not consider the time value of money, which
means that it does not account for the fact that a dollar received in the future is worth less
than a dollar received today.
● Ignores the risk associated with an investment: Although payback is able to provide a
useful means of assessing time risks, it does not consider other important risks associated
with an investment.
● No definitive investment signal (lack of objectivity): There is no objective measure as to
what length of time should be set as the target payback period. Investment decisions are
therefore subjective.

Overall, the payback period method can be a useful tool for evaluating investments, but it should not
be used in isolation. It is important to consider other factors, such as the time value of money, the
potential profitability of the investment, and the risk associated with the investment, when making
investment decisions.

Discounted Payback Method of Appraisal

The discounted payback method is a variation of the payback method, except it takes into account
the time value of money. The cash flows are first discounted using an appropriate discount rate that
reflects the risk profile of the project. The cumulative discounted cash flow can then be calculated in
the same manner as the cumulative cash flow is for the standard payback calculation.

It has the same advantages and disadvantages as for the traditional payback method except that
the shortcoming of failing to account for the time value of money has been overcome.

Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE) is a financial performance measure that is used to evaluate
the efficiency and profitability of a company's investment in its capital assets. It is also known as
Accounting Rate of Return (ARR).

OR

If the expected ROCE for the investment is greater than the target or hurdle rate (as decided by
management), then the project should be accepted.

The advantages of ROCE include:

● Simplicity: Being based on widely reported measures of profits and assets, it is easily
understood and easily calculated.
● Links with other accounting measures: Annual ROCE, calculated to assess a business or
sector of a business is a widely used measure. It is expressed in percentage terms with
which managers and accountants are familiar.

The disadvantages of ROCE include:

● No account is taken of project life: ROCE does include numbers from the whole life of the
project, but doesn’t take account of the timings within it and would not differentiate between
projects of different lengths as long as the same average profits were earned.
● No account is taken of timing of cash flows: It does not consider the time value of money,
which means that it does not account for the fact that a dollar received in the future is worth
less than a dollar received today.
● Varies depending on accounting policies: ROCE varies with specific accounting policies,
and the extent to which project costs are capitalised. For example, different methods of
depreciation produce different profit figures and hence different rates of return.
● Can be expressed in a variety of ways: ROCE can be expressed in many variants, such
as average profit to initial capital or average profit to average capital investment. Thus, it is
susceptible to manipulation.
● Ignores working capital: It may ignore working capital requirements.
● Does not measure absolute gain: Like all rate of return measures, it is not a measurement
of absolute gain in wealth for the business owners.
● No definitive investment signal: The decision to invest or not remains subjective in view of
the lack of an objectively set target ROCE.
● Uses accounting profits, not cash flows: ROCE uses accounting profits, which are
subjective and open to manipulation. Furthermore, only cash flows are capable of adding to
the wealth of shareholders in the form of increased dividends.
● Ignores the risk associated with an investment: ROCE does not consider the risk
associated with the investment, which is an important factor in investment decision-making.

Overall, ROCE is a useful investment appraisal technique that can help investors and analysts to
understand the efficiency and profitability of a company's capital investments. However, it is
important to consider other factors, such as risk and the time value of money, when making
investment decisions.

Net Present Value (NPV)

The Net Present Value (NPV) represents the surplus finds, after funding the investment, earned on
the project. Therefore, it gives the impact of the project on shareholder wealth.

It is calculated by taking the sum of the present values of the expected cash flows from the
investment, minus the initial cost of the investment.

● If the NPV is positive, the project is financially viable.

● If the NPV is zero, the project breaks-even.
● If the NPV is negative, the project is not financially viable.

If the company has two or more mutually-exclusive projects under consideration, it should choose
the one with the highest NPV.

There are two assumptions used in discounting:

● All cash flows occur at the start or end of a year.
● Initial investments occur at once (T0); other cash flows start in one year’s time (T1).

NPV is considered to be superior to other investment appraisal methods. Some of the reasons for
this are:
● NPV considers cash flows: This is the reason why NPV is preferred to return on capital
employed (ROCE), since ROCE compares average annual accounting profit with initial or
average capital invested. Financial management always prefers cash flows to accounting
profit, since profit is seen as being open to manipulation. Furthermore, only cash flows are
capable of adding to the wealth of shareholders in the form of increased dividends.
● NPV considers the whole of an investment project: In this respect NPV is superior to
Payback, which considers cash flows within the payback period and ignores cash flows
outside of the payback period. If Payback is used as an investment appraisal method,
projects yielding high returns outside of the payback period will be wrongly rejected.
● NPV considers the time value of money: NPV and IRR are both discounted cash flow
models that consider the time value of money, whereas ROCE and Payback do not.
Although Discounted Payback can be used to appraise investment projects, this method still
suffers from the criticism that it ignores cash flows outside of the payback period.
● NPV considers the risk associated with the investment: Unlike the ROCE and Payback
methods of investment appraisal, NPV considers the risk associated with the investment, as
the discount rate used to calculate the present value of the expected cash flows reflects the
perceived risk of the investment.
● NPV is an absolute measure of return: NPV is seen as being superior to investment
appraisal methods that offer a relative measure of return, such as IRR and ROCE, and which
therefore fail to reflect the amount of the initial investment or the absolute increase in
corporate value.
● NPV links directly to the objective of maximizing shareholders’ wealth: The NPV of an
investment project represents the change in total market value that will occur if the
investment project is accepted. The increase in wealth of each shareholder can therefore be
measured by the increase in the value of their shareholding as a percentage of the overall
 issued share capital of the company. Other investment appraisal methods do not have this
direct link with the primary financial management objective of the company.
● NPV always offers the correct investment advice: With respect to mutually exclusive
projects, NPV always indicates which projects should be selected in order to achieve the
maximum increase in corporate value. This is not true of IRR, which offers incorrect advice
at discount rates that are less than the internal rate of return of the incremental cash flows.
● NPV can accommodate changes in the discount rate: While NPV can easily
accommodate changes in the discount rate, IRR simply ignores them, since the calculated
internal rate of return is independent of the cost of capital in all time periods.
● NPV has a sensible re-investment assumption: NPV assumes that intermediate cash
flows are re‐invested at the company’s cost of capital, which is a reasonable assumption as
the company’s cost of capital represents the average opportunity cost of the company’s
providers of finance, i.e., it represents a rate of return that exists in the real world. By
contrast, IRR assumes that intermediate cash flows are re-invested at the internal rate of
return, which is not an investment rate available in practice.

● NPV can accommodate non-conventional cash flows: Non‐conventional cash flows exist
when negative cash flows arise during the life of the project. For each change in sign, there
is potentially one additional internal rate of return. With non‐conventional cash flows,
therefore, IRR can suffer from the technical problem of giving multiple internal rates of return.

However, despite its superiority over other investment appraisal techniques, NPV is subject to a
number of limitations. These are listed below:
● NPV assumes that firms pursue an objective of maximising the wealth of their shareholders.
This is questionable given the wider range of stakeholders who might have conflicting
interests to those of the shareholders. NPV is largely redundant if organisations are not
wealth maximising. For example, public sector organisations may wish to invest in capital
assets but will use non‐profit objectives as part of their assessment.
● NPV is potentially a difficult method to apply in the context of having to estimate what is the
correct discount rate to use.
● NPV can most easily cope with cash flows arising at period ends and is not a technique that
is used easily when complicated, mid‐period cash flows are present.
● NPV is not universally employed. The available evidence suggests that businesses assess
projects in a variety of ways (payback, IRR, return on capital employed). The fact that such
methods are used, which are theoretically inferior to NPV, calls into question the practical
benefits of NPV, and therefore hints at certain practical limitations.
● The conclusion from NPV analysis is the present value of the surplus cash generated from a
project. If reported profits are important to businesses, then it is possible that there may be a
conflict between undertaking a positive NPV project and potentially adverse consequences
on reported profits. This will particularly be the case for projects with long time horizons,
large initial investment and very delayed cash inflows. In such circumstances, businesses
may prefer to use accounting measures of investment appraisal.
● Managerial incentive schemes may not be consistent with NPV, particularly when long time
horizons are involved. Thus, managers may be rewarded on the basis of accounting profits
in the short term and may be incentivised to act in accordance with these objectives, and
thus ignore positive NPV projects.
 ● NPV is of limited use when there are non‐quantifiable benefits or costs. NPV does not take
account of non‐financial information, which may even be relevant to shareholders who want
their wealth maximised. For example, issues of strategic or environmental benefit may arise
against which it is difficult to immediately quantify the benefits but for which there are
immediate costs. NPV would treat such a situation as an additional cost since it could not
incorporate the indiscernible benefit.
● NPV requires accurate estimates of the expected cash flows from the investment, which can
be difficult to predict with certainty.
● NPV may be less suitable for evaluating investments with long lifetimes, as the accuracy of
the cash flow estimates may decrease over time.

Internal Rate of Return (IRR)

The IRR represents the discount rate at which the NPV of an investment is zero. As such, it
represents a breakeven cost of capital.

Projects should be accepted if their IRR is greater than the cost of capital.

IRR can be calculated using linear interpolation.

The advantages of IRR include:

● It takes into account the time value of money, which means that it accounts for the fact that a
dollar received in the future is worth less than a dollar received today.
● It considers the risk associated with the investment, as the discount rate used to calculate
the present value of the expected cash flows reflects the perceived risk of the investment.
● It is easy to understand and communicate, as it is expressed as a single percentage value.
● IRR uses cash flows, not profits. These are less subjective and capable of adding to the
wealth of the shareholders in the form of dividends.
● IRR considers the whole life of the project rather than ignoring later flows, as in the case of
Payback.
● It has a clear-cut decision rule which should lead to the maximisation of shareholder wealth.
Projects with IRRs bigger than the company’s cost of capital should be adopted, and if they
are, shareholder wealth will increase.

The disadvantages of IRR include:

● It is not a measure of absolute profitability. Unlike NPV, which tells us the absolute increase
in shareholder wealth as a result of accepting the project at the current cost of capital, the
 IRR simply tells us how far the cost of capital could increase before the project would not be
worth accepting.
● Interpolation only provides an estimate and an accurate estimate requires the use of a
spreadsheet programme.
● It is fairly complicated to calculate.
● Non-conventional cash flows may give rise to multiple IRRs, which means the interpolation
method can't be used.
● Contains an inherent assumption that cash returned from the project will be re-invested at
the project’s IRR, which may be unrealistic.
● Since IRR only considers cash flows, it does not consider the impact of the investment on
the company's overall financial performance, which may be an important factor in investment
decision-making.

Allowing for Inflation and Taxation in Discounted Cash Flow:

Real-terms and Nominal-terms Approaches to Investment Appraisal

The real-terms approach to investment appraisal is a method of evaluating the profitability of an
investment without taking into account the effects of inflation. This means that the expected cash
flows from the investment are not adjusted for inflation, and the discount rate used to calculate the
present value of the cash flows is also not adjusted for inflation.
Thus, a real discount rate would be used, which represents the investors’ base level of return for
risk before inflation is taken into account.

The nominal-terms (or money-terms) approach to investment appraisal is a method of evaluating

the profitability of an investment by taking into account the effects of inflation. This means that the
expected cash flows from the investment are adjusted for inflation, and the discount rate used to
calculate the present value of the cash flows is also adjusted for inflation.

The real and money returns are linked by the above formula.

The Impact of Taxation on Cash Flows

Corporation tax charged on a company’s profits is a relevant cash flow for NPV purposes. It is
assumed, unless otherwise stated in the question, that:
● Operating cash inflows will be taxed at the corporation tax rate.
● Operating cash outflows will be tax-deductible and attract tax relief at the corporation tax
rate.
 ● Investment spending attracts tax-allowable depreciation (or writing-down allowance):
o Tax-allowable depreciation is calculated based on the written-down value of the
assets.
o The total amount of tax-allowable depreciation given over the life of the asset will
equate to its fall in value over the period.
o Tax-allowable depreciation is given for every year of ownership except the year of
disposal.
o In the year of sale, a balancing allowance or balancing charge arises.

● The company is earning net taxable profits overall.

● Tax is paid one year after the related operating cash flow is earned.

Adjusting for Risk and Uncertainty in Investment Appraisal:

The Difference between Risk and Uncertainty

The terms, Risk and Uncertainty, are often used interchangeably in financial management, but the
distinction between them is a useful one.

Risk refers to the situation where an investment project has several outcomes, all of which are
known and to which probabilities can be attached, for example, on the basis of past
experience. Risk can therefore be quantified and measured by the variability of returns of an
investment project.

Uncertainty, on the other hand, refers to a lack of knowledge or understanding about the potential
outcomes of an investment or project. Uncertainty can be caused by a lack of information or by the
complexity of the investment or project. Uncertainty is often difficult to quantify, as it is not possible
to assign probabilities to the potential outcomes.

The difference between risk and uncertainty, therefore, is that risk can be quantified whereas
uncertainty cannot be quantified. Risk increases with the variability of returns, while uncertainty
increases with project life.

Sensitivity Analysis

Sensitivity analysis is a financial analysis tool that shows the maximum possible change in a
variable that would bring the NPV to zero. It is expressed in percentage terms and shows where
management should focus in order to make an investment project successful.

The sensitivity of an investment project to a change in a given project variable can be calculated as
the ratio of the NPV to the present value of the project variable.

Higher the sensitivity margin, lower is the sensitivity of the decision to the particular parameter being
considered.

The strengths of sensitivity analysis include:

 ● No complicated theory to understand.
● Information will be presented to management in a form that facilitates subjective judgement
to decide the likelihood of the various possible outcomes considered.
● Identifies areas that are crucial to the success of the project. If the project is chosen, those
areas can be carefully monitored.
● Indicates just how critical are some of the forecasts which are considered to be uncertain.

The weaknesses of sensitivity analysis include:

● It assumes that variables change independently of each other. This is unlikely.
● It only identifies how far a variable needs to change. It does not look at the probability of
such a change.
● It is not an optimising technique. It provides information on the basis of which decisions can
be made and therefore does not point directly to the correct decision.

Probability Analysis

When there are several possible outcomes for a decision and probabilities can be assigned to each,
a probability distribution of expected cash flows can often be estimated, recognising there are
several possible outcomes, not just one.

Probabilities for different values of project variables can be assessed and assigned. A range of
project NPVs can then be calculated, as well as the mean NPV (the expected NPV or ENPV)
associated with repeating the investment project many times. The worst and best outcomes and
their probabilities, the most likely outcome and its probability and the probability of a negative NPV
can also be calculated. Investment decisions could then be based on the risk profile of the
investment project, rather than simply on the NPV decision rule.

Other Techniques of Adjusting for Risk and Uncertainty in Investment Appraisal

Simulation:
Sensitivity analysis considers the effect of changing one variable at a time. Simulation improves on
this by looking at the impact of many variables changing at the same time.
Simulation is a computer-based method used to evaluate an investment project by considering the
probability distributions associated with various variables and interdependencies between those
variables. To do this, random numbers are used to represent the probability distribution of each
variable. The mean (expected) NPV is calculated for each simulation run, and the probability
distribution of the mean NPV is created using the results of multiple simulation runs. The risk of the
project can be assessed using the standard deviation of the expected returns, as well as the most
likely outcome and the probability of a negative NPV.

Adjusted Payback:
If risk and uncertainty are considered to be the same, payback can be used to adjust for risk and
uncertainty in investment appraisal
As uncertainty (risk) increases, the payback period can be shortened to focus more on cash flows
that are closer to the present time and hence less uncertain. Conversely, as uncertainty (risk)
decreases, the payback period can be lengthened to focus less on cash flows that are closer to the
present time.
Discounted payback adjusts for risk by using a discount rate, and can therefore be seen as an
adjusted payback method.

Risk-Adjusted Discount Rate:

It is often said that ‘the higher the risk, the higher the return’. Investment projects with higher risk
should therefore be discounted with a higher discount rate than lower risk investment projects.
Better still, the discount rate should reflect the risk of the investment project.

Theoretically, the capital asset pricing model (CAPM) can be used to determine a project‐specific
discount rate that reflects an investment project’s systematic risk. This means selecting a proxy
company with similar business activities to a proposed investment project, ungearing the proxy
company equity beta to give an asset beta which does not reflect the proxy company financial risk,
regearing the asset beta to give an equity beta which reflects the financial risk of the investing
company, and using the CAPM to calculate a project‐specific cost of equity for the investment
project.

Specific Investment Decisions:

Lease versus Buy

Once the decision has been made to acquire an asset for an investment project, a decision still
needs to be made as to how to finance it. The choices that we will consider are:
● Lease
● Buy

The NPVs of the financing cash flows for both options are found and compared and the lowest cost
option selected.

Only the relevant cash flows arising as a result of the type of finance are included in the NPV
calculation.

In case of lease, the relevant cash flows for the user would be:
● The lease payments
● Tax relief on the lease payments

If a decision is made to buy the asset, then the relevant cash flows would be:
● The purchase cost
● Any residual value
● Any associated tax implications due to tax-allowable depreciation

The assumption here is that buying requires the use of a bank loan.

Since the interest payments attract tax relief, we must use the post-tax cost of borrowing as our
discount rate.
Asset Replacement Decisions using Equivalent Annual Cost

Once the decision has been made to acquire an asset for a long-term project, it is quite likely that
the asset will need to be replaced periodically throughout the life of the project.

A problem arises where:

● Equivalent assets available are likely to last for different lengths of time.
● An asset, once bought, must be replaced at regular intervals.

In order to deal with the different timescales, the NPV of each option is converted into an annuity or
an EAC.
The EAC is the equal annual cash flow (annuity) to which a series of uneven cash flows is
equivalent in PV terms.

The optimum replacement period (cycle) will be the period that has the lowest EAC, although in
practice other factors may influence the final decision.

One of the limitations of the replacement analysis is that it assumes that when an asset is replaced,
the replacement is in all practical respects identical to the last one and that this process will continue
for the foreseeable future. However, in practice this will not hold true owing to:
● Changing technology
● Inflation
● Changes in production plans

Capital Rationing

Shareholder wealth is maximised if a company undertakes all possible positive NPV projects.
Capital rationing is where there are insufficient funds to do so. This implies that where investment
capital is rationed, shareholder wealth is not being maximised.

Hard Capital Rationing:

If investment finance is limited for reasons outside a company, it is called hard capital rationing.
Some of the reasons for hard capital rationing include:
● Industry-wide factors limiting funds. For example, the availability of new finance may be
limited because share prices are depressed on the stock market or because of government-
imposed restrictions on bank lending.
● If a company only requires a small amount of finance, issue costs may be so high that using
external sources of finance is not practical.
● Hard capital rationing could also arise due to company-specific factors. For example, a
company may not be able to raise new debt finance if banks or investors see the company
as being too risky to lend to. The company may have high gearing or low interest cover, or a
poor track record. Companies in the service sector may not be able to offer assets as
security for new loans.

Soft Capital Rationing:

If investment finance is limited for reasons within a company, it is called soft capital rationing.
Reasons for soft capital rationing include:
● Reluctance to issuing new equity, in order to avoid diluting EPS or becoming a takeover
target. Alternatively, managers may be reluctant to issue new debt in order to avoid paying
fixed interest payments every year.
● Soft capital rationing might also arise because managers wish to finance new investment
from retained earnings, for example, as part of a policy of controlled organisational growth,
rather than a sudden increase in size which might result from undertaking all investments
with a positive NPV.
● Managers may want investment projects to compete for funds, in the belief that this will
result in the acceptance of stronger, more robust investment projects.
● Another reason could be due to limited management skills available. For example, a
company may be subject to soft capital rationing if it lacks the expertise or capacity to pursue
all of the investment opportunities that are available to it.
 BUSINESS FINANCE

Sources of, and Raising, Business Finance:

Short-Term Sources of Finance

Short-term finance is usually needed for businesses to run their day-to-day operations including
payment of wages to employees, inventory ordering and supplies. Businesses with several peaks
and troughs and those engaged in international trade are likely to be heavy users of short-term
finance.

Overdrafts:
The bank grants an overdraft facility, usually for a fee. This facility can be used by the borrower (up
to an agreed limit) but does not have to be.
Overdrafts are the most important source of short-term finance available to businesses. They can
be arranged relatively quickly and offer a level of flexibility with regard to the amount borrowed at
any time, while interest is only paid when the account is overdrawn.
Overdrafts are repayable on demand.

Short-Term Loan:
This is drawn in full at the beginning of the loan period and repaid at a specified time or in defined
instalments.
Once the loan is agreed, the term of the loan must be adhered to, provided that the customer does
not fall behind with their repayments.
It is not repayable on demand by the bank.

Trade Credit:
Trade credit is a major source of short-term finance for a business. Current assets such as raw
materials may be purchased on credit, with payment terms normally varying from between 30 days
and 90 days. Trade credit therefore represents an interest-free short-term loan. In a period of high
inflation, purchasing via trade credit will be very helpful in keeping costs down. However, it is
important to take into account the loss of discounts suppliers offer for early payment.
Unacceptable delays in payment will worsen a company’s credit rating and additional credit may
become difficult to obtain.

Lease Finance:
Rather than buying an asset outright, using either available cash resources or borrowed funds, a
business may lease an asset. Leasing is a popular source of finance.
Leasing can be defined as a contract between lessor and lessee for hire of a specific asset selected
from a manufacturer or vendor of such assets by the lessee. The lessor retains ownership of the
asset. The lessee has possession and use of the asset on payment of specified rentals over a
period. Short-term leases are a source of short-term finance for non-current assets.

Long-Term Sources of Finance

Where finance is required over a longer time period, it is possible to rely on short-term finance and
to renew it so that it provides finance over a longer time period. However, this exposes the borrower
to the risk that this short-term finance may not be available (or may be expensive) at the point that it
is being renewed. For this reason, it is more likely that a source of long-term finance will be
appropriate where finance is required over a longer time period.

Equity Finance:
Equity finance is the investment in a company by the ordinary shareholders, represented by the
issued ordinary share capital plus reserves. This can include issuing new shares to the public,
issuing shares to existing shareholders, or issuing shares to private equity investors.
Equity finance allows a business to raise capital without incurring debt, but it also means giving up a
portion of ownership in the company.

Debt Finance:
Debt finance refers to the process of raising capital by borrowing money. This can include borrowing
from banks, issuing bonds, or taking out a loan from other financial institutions.
Debt finance allows a business to raise capital without giving up ownership in the company, but it
also means incurring debt that must be repaid with interest.

Lease Finance:
Lease finance, also known as capital leases or finance leases, is a long-term form of leasing in
which the lessee (the user of the asset) is responsible for the majority of the risks and rewards
associated with owning the asset. This means that the lessee is considered to have an "effective
ownership". Capital leases also tend to have longer terms than operating leases, often spanning
several years or even decades.

Venture Capital:
Venture capital is a form of equity finance provided by a venture capital firm or individual venture
capitalist to start-up or early-stage companies with high growth potential. Venture capital firms
provide funding in exchange for an equity stake in the company and also provide strategic guidance
and mentorship to the management team. They seek a high return, which is often realised through a
stock market listing, and accept that this will mean that the investments are often high risk.

Methods of Raising Equity Finance

Rights Issue:
A rights issue involves issuing shares to the existing shareholders in proportion to their existing
holding. Rights issues are often successful, easier to price and are cheaper to arrange than a public
issue but the amount of finance raised is limited as there is a finite amount that shareholders will be
willing to invest. A rights issue would be mandatory if shareholders have not elected to waive their
pre‐emptive rights.

Private Placing:
A private placing is when a company, usually with the assistance of an intermediary, seeks out new
investors on a one‐to‐one basis. Shares are normally issued to financial institutions when
performing a placing rather than to individuals. This can be a useful source of new equity for an
unlisted company but control of the company will be diluted as a result. A placing is also cheaper to
arrange than a public issue but only useful for relatively small issues.

Public Offer:
If the company is listed, it may undertake a public offer whereby shares are offered for sale to the
public at large. This is an expensive way of issuing shares as there are significant regulatory costs
involved and like the placing, control of the existing shareholders will be diluted. A public issue will,
however, allow very large amounts of equity finance to be raised, and will also give a wide spread of
ownership.

Initial Public Offering (IPO):

If the company is not listed, it can list through the process of an IPO which will raise equity at the
same time. An IPO will be more expensive than a public offer as there are further regulations having
to be complied with, increasing costs. Consequently, only a large company wishing to raise a
significant amount of finance would consider this option.

Islamic Finance

Islamic finance is a financial system based on the principles of Islamic law (Sharia) and guided by
the principles of risk-sharing, fairness, and ethical investing.

Islamic finance differs from other conventional forms of business finance in a number of ways:
● Prohibition of interest: Interest (riba) is absolutely forbidden in Islamic finance and is seen
as immoral. This can be contrasted with debt in conventional finance, where interest is seen
as the main form of return to the debt holder, and with the attention paid to interest rates in
the conventional financial system, where interest is the reward for depositing funds and the
cost of borrowing funds.
● Prohibition of Gharar and Maysir: Islamic finance also prohibits practices that are
considered speculative or uncertain, such as gharar (excessive uncertainty) and maysir
(gambling). This means that Islamic finance prohibits investments in speculative or high-risk
ventures, such as derivatives, options, and futures.
● Ethical investing: Islamic finance also places a strong emphasis on ethical investing, and
prohibits investments in certain industries such as tobacco, alcohol, gambling, and weapons.
It also encourages investments in socially responsible and environmentally friendly projects.
● Profit and loss sharing: Another major difference between Islamic finance and other forms
of business finance is the use of profit and loss sharing structures. For example, Islamic
finance uses structures such as Mudaraba, where the investor provides capital, and the
entrepreneur manages the business, with profits shared in accordance with an agreed ratio,
and losses borne by the investor.

In Islamic finance, the concept of riba refers to the charging and paying of interest, which is
considered to be prohibited under Islamic law. The prohibition of riba is based on the belief that
charging interest on a loan is unjust, as it allows the lender to gain a financial benefit without
contributing to the underlying business or investment.
Instead of charging interest, Islamic finance relies on profit and loss sharing structures, where the
lender and borrower share the risks and rewards of the investment. This is in line with the principles
of risk-sharing and fairness in Islamic finance.

Returns are made by Islamic financial securities in a number of ways. In a Mudaraba contract, for
example, profits are shared between the partners in the proportions agreed in the contract, while
losses are borne by the provider of finance. In a Musharaka contract, profits are shared between the
partners in the proportions agreed in the contract, while losses are shared between the partners
according to their capital contributions. With Sukuk, certificates are issued which are linked to an
underlying tangible asset and which also transfer the risk and rewards of ownership. The underlying
asset is managed on behalf of the Sukuk holders.
In a Murabaha contract, payment by the buyer is made on a deferred or instalment basis. Returns
are made by the supplier as a mark‐up is paid by the buyer in exchange for the right to pay after the
delivery date. In an Ijara contract, which is equivalent to a lease agreement, returns are made
through the payment of fixed or variable lease rental payments.

Murabaha:
Murabaha is a form of trade credit for asset acquisition that avoids the payment of interest. Instead,
the bank buys the item and then sells it on to the customer on a deferred basis at a price that
includes an agreed mark-up for profit. The mark-up is fixed in advance and cannot be increased,
even if the client does not take the goods within the time agreed in the contract. Payment can be
made by instalments. The bank is thus exposed to business risk because if its customer does not
take the goods, no increase in the mark- up is allowed and the goods, belonging to the bank, might
fall in value.

Ijara:
In this form of Islamic finance, the lessee uses a tangible asset in exchange for a regular rental
payment to the lessor, who retains ownership throughout the period of the lease contract. The
contract may allow for ownership to be transferred from the lessor to the lessee at the end of the
lease period.
Major maintenance and insurance are the responsibility of the lessor, while minor day-to-day
maintenance is the responsibility of the lessee. The lessor may choose to appoint the lessee as
their agent to undertake all maintenance, both major and minor.

Mudaraba:
A mudaraba contract is between a capital partner (rab al mal) and an expertise partner (mudarab)
for the undertaking of business operations. The business operations must be compliant with the
Sharia law and are run on a day-to-day basis by the mudarab. The rab al mal has no role in relation
to the day‐to‐day operations of the business.
Profits from the business operations are shared between the partners in a proportion agreed in the
contract. Losses are borne by the rab al mal alone, as provider of the finance, up to the limit of the
capital provided.

Sukuk:
Sukuk is debt finance. A conventional, non-Islamic loan note is a simple debt, and the debt holder's
return for providing capital to the bond issuer takes the form of interest. Islamic bonds, or sukuk,
cannot bear interest. So that the sukuk are Shariah-compliant, the sukuk holders must have a
proprietary interest in the assets which are being financed. The sukuk holders’ return for providing
finance is a share of the income generated by the assets. Most sukuk, are ‘asset-based’, not ‘asset-
backed’, giving investors ownership of the cash flows but not of the assets themselves. Asset-based
is obviously risker than asset backed in the event of a default.

Musharaka:
Musharaka is a relationship between two or more parties, who contribute capital to a business, and
divide the net profit and loss pro rata. It is most closely aligned with the concept of venture capital.
All providers of capital are entitled to participate in management, but are not required to do so.
The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each
partner strictly in proportion to their respective capital contributions.

Internal Sources of Finance

Internal sources of finance refer to the funds that a business generates from its own operations,
rather than from external sources such as banks or investors.
Retained Earnings:
Retained earnings are the portion of a company's profits that are kept by the company rather than
being distributed as dividends to shareholders. Retained earnings can be used to finance a variety
of business activities, including investments in new equipment, expansion of the business, or the
repayment of debt.
Retained earnings are a reliable source of internal financing because they are generated by the
company's own operations. However, relying too heavily on retained earnings can limit the
company's ability to invest in growth opportunities and may not be sufficient to cover all the
financing needs of the business.

Increasing Working Capital Management Efficiency:

Working capital management refers to the management of a company's short-term assets and
liabilities. By improving the efficiency of working capital management, a company can free up cash
that can be used to finance business activities. This can be done through actions such as reducing
inventory levels, extending payment terms with suppliers, or collecting receivables more quickly. By
increasing working capital management efficiency, a company can improve its cash flow and reduce
the need to borrow from external sources of finance.

Dividend Policy
The Relationship between Dividend Policy and the Financing Decision:
Dividend policy and financing decisions are closely related because they both affect a company's
cash flow and capital structure. Dividend policy refers to the decision of how much of a company's
profits will be distributed to shareholders as dividends, and how much will be retained to finance the
company's future growth. Financing decisions, on the other hand, refer to the decisions a company
makes about how to raise capital to finance its operations and growth.
A company that chooses to pay a high dividend may have less cash available to invest in growth
opportunities, so it may have to rely more heavily on external sources of financing such as debt or
equity. On the other hand, a company that chooses to retain more of its earnings will have more
cash available to invest in growth opportunities and may be able to finance those opportunities
through internal sources of financing such as retained earnings.
Additionally, a company's dividend policy can also affect its capital structure and creditworthiness. A
company that pays a high dividend may be viewed as more stable and financially sound by
investors and creditors, which can make it easier for the company to access external sources of
financing.
Furthermore, a company's dividend policy can also affect its stock price. A company that pays a
high dividend may attract income-oriented investors, which can increase demand for the stock and
drive up the stock price. On the other hand, a company that chooses to retain more of its earnings
may attract growth-oriented investors, which can also drive up the stock price.
In summary, the relationship between dividend policy and financing decision is complex and
intertwined. A company's dividend policy can affect its ability to raise capital and finance growth, as
well as its creditworthiness, stock price, and the type of investors it attracts. A company should
carefully consider its dividend policy in the context of its overall financial and strategic objectives.

Theories of Dividend Policy:

There are three main theories concerning what impact a cut in the dividend will have on a company
and its shareholders:
i. Dividend Irrelevancy Theory
 The dividend irrelevancy theory put forward by Modigliani & Miller (M&M) argues that in a
perfect capital market (no taxation, no transaction costs, no market imperfections), existing
shareholders will only be concerned about increasing their wealth, but will be indifferent as to
whether that increase comes in the form of a dividend or through capital growth.
Thus, provided a company is investing in positive NPV projects, it will make no difference to
the shareholder (and share price) whether the projects are funded via a cut in dividends or
by obtaining additional funds from outside sources.
As a result of obtaining outside finance instead of using retained earnings, there would be a
reduction in the value of each share. However, M&M argued that this reduction would equal
the amount of the dividend paid, thereby meaning shareholder wealth was unaffected by the
financing decision.
Any investor requiring a dividend could ‘manufacture’ their own by selling part of their
shareholding. Equally, any shareholder wanting retentions when a dividend is paid can buy
more shares with the dividend received.
Most of the criticism of M&M's theory surrounds the assumption of a perfect capital market.
ii. Residual Theory
This theory is closely related to M&Ms but recognises the costs involved in raising new
finance.
It argues that dividends themselves are important but the pattern of them is not. Thus, the
timing of the dividend payments is irrelevant.
It follows that only after a firm has invested in all positive NPV projects (thereby increasing
the potential for higher dividends in the future) should a dividend be paid if there are any
funds remaining. Retentions should be used for project finance with dividends as a residual.
In this way, the cost of raising new finance is kept to a minimum.
However, this theory still takes some assumptions that may not be deemed realistic. This
includes no taxation and no market imperfections.
iii. Dividend Relevance Theory
Practical influences, including market imperfections, mean that changes in dividend policy,
particularly reductions in dividends paid, can have an adverse effect on shareholder wealth:
● Reductions in dividend can convey ‘bad news’ to shareholders (dividend signalling)
● Changes in dividend policy, particularly reductions, may conflict with investor liquidity
requirements
● Changes in dividend policy may upset investor tax planning (clientele effect)
As a result, companies tend to adopt a stable dividend policy and keep shareholders
informed of any changes.

Practical Influences on the Dividend Decision:

There are several practical influences on a company's dividend decision that go beyond the
theoretical considerations of the dividend irrelevancy theory. Some of the key factors include:
● Legal restrictions: Companies are subject to legal requirements that can affect their
dividend decisions. For example, some jurisdictions require companies to maintain a certain
level of retained earnings in order to meet the capital requirements of the company.
Additionally, some jurisdictions prohibit companies from paying dividends if they are not
profitable or if they have insufficient cash or assets.
● Liquidity: A company's liquidity position, or its ability to meet its short-term obligations, can
also affect its dividend decision. A company that is facing liquidity constraints may be unable
to pay dividends, or may need to reduce the amount of dividends it pays, in order to
conserve cash.
● The signalling effect of dividends: In a less than perfectly efficient market, directors have
access to more information about a company than the shareholders do. Given this
information asymmetry, dividend decisions convey new information to the market and can
therefore provide signals around the current position of the company and its future
prospects. The signalling effect also depends on the dividend expectations in the market. A
 company should therefore consider the likely effect on share prices of the announcement of
a proposed dividend.
● The need for finance: There is a close relationship between investment, financing and
dividend decisions, and the dividend decision must consider the investment plans and
financing needs of the company. If a company is looking at additional investment, say, then
the need for external finance can be reduced if the dividend payment is reduced.
● The level of financial risk: If financial risk is high due to a high level of debt finance within
the capital mix, maintaining a low level of dividend payments will result in a higher level of
retained earnings, which will reduce gearing by increasing the level of reserves. Over time,
this will help to reduce the level of financial risk to a more acceptable level.

Alternatives to Cash Dividends:

Scrip dividends and share repurchases are alternative ways for companies to return value to
shareholders in lieu of cash dividends.
i. Scrip Dividends
A scrip dividend is a dividend paid by the issue of additional company shares, rather than by
cash.
The advantage to the shareholder of a scrip dividend is that they can painlessly increase
their shareholding in the company without having to pay broker’s commissions or stamp duty
on a share purchase.
The advantage of scrip dividend to the company is that it will conserve cash. This is useful
when liquidity is a problem, or when cash is needed for investment. Furthermore, due to an
increase in issued shares, it could lead to a decrease in gearing, thereby increasing the debt
capacity.
There are two main disadvantages of scrip dividends. Assuming that dividend per share is
maintained or increased, the total cash paid as a dividend will increase. Scrip dividends may
be seen as a negative signal by the market, i.e., the company is experiencing cash flow
issues.
ii. Share Repurchases
As an alternative to a cash dividend, a company can choose to return significant amounts of
cash to shareholders by means of a share repurchase (or share buy-back).
Share repurchase may be appropriate in the following circumstances:
● If there is a one-off cash surplus generated from asset sales (higher dividends would
increase expectations of further increases)
● The company wants to give an exit route to disaffected shareholders; in this sense it
is a defence against a takeover.

Estimating the Cost of Capital:

Estimating the Cost of Equity

Dividend Growth Model:
The dividend growth model calculates the apparent cost of equity in the capital market, provided
that the current market price of the share, the current dividend and the future dividend growth rate
are known.
While the current market price and the current dividend are readily available, it is very difficult to find
an accurate value for the future dividend growth rate. There are two common ways of estimating the
likely growth rate of dividends. The first method involves extrapolating based on past dividend
patterns. This method assumes that the past pattern of dividends is a fair indicator of the future. The
second method of estimating the growth rate of dividends is by assuming growth is dependent on
the level of earnings retained in the business. There is no reason why these assumptions should be
true.

The above formula can be used to find the share price.

To find the cost of equity, the formula can be rearranged to:

The Dividend Growth Model has several assumptions that are important to understand when
applying the concept:
● Dividends will be paid in perpetuity.
● The dividends will grow at a constant rate.
● The company's dividends are stable, and will not be affected by the economic cycle.
The advantages of the Dividend Growth Model include:
● It is relatively simple and easy to use.
● It focuses on the dividends, which are a tangible measure of a company's financial
performance.
● It can be used to compare the intrinsic value of a share to its current market price, which can
help identify undervalued or overvalued shares.
The disadvantages of the Dividend Growth Model include:
● It requires accurate forecasting of future dividends, which can be difficult to do accurately.
● It assumes that dividends will grow at a constant rate, which may not be the case in the real
world.
● The growth in earnings of the company is ignored.

Systematic and Unsystematic Risk:

With any investment, there is a risk that the actual outcome may be different from the expected or
predicted outcome. This risk can be reduced by holding several different investments, since different
investments are affected to differing extents by changes in economic variables such as interest
rates and inflation rates. The return from one investment may increase, for example, when the
return from a different investment decreases. Holding a range of different investments is known as
portfolio diversification.
However, there is a limit to the reduction in total risk that can be achieved as a result of portfolio
diversification. The risk that cannot be removed by portfolio diversification is called systematic risk
or market risk. It is the risk that is inherent in the market as a whole, and affects all investments in
the market to a certain extent. This type of risk is caused by factors such as changes in interest
rates, economic recessions, natural disasters, and geopolitical events.
The risk that can be removed through portfolio diversification is called unsystematic risk or specific
risk. It is the risk that is specific to a particular company in which investment is made. This type of
risk is caused by factors such as poor management, competition, changes in technology, and
fluctuations in commodity prices.
Experience has shown that investing in the shares of between 20 and 30 companies is sufficient to
eliminate almost all of the unsystematic risk from an investment portfolio.
Systematic risk contains both business risk and financial risk. A company with no debt finance faces
business risk alone, while a company with both equity and debt finance faces both business risk and
financial risk.

Capital Asset Pricing Model (CAPM):

The Capital Asset Pricing Model (CAPM) is a model that helps investors understand the relationship
between the expected return on an investment and its systematic risk, which is the risk that cannot
be diversified away.
This model is based on the portfolio theory, which assumes that investors diversify their investments
across a wide portfolio to reduce their exposure to risk.
The CAPM assumes that the only relevant factor that affects the expected return of a security is its
systematic risk, which is measured by its beta (β). The beta of a security represents its sensitivity to
market risk, and the model assumes that a security with a higher beta will have a higher expected
return than a security with a lower beta.
According to the CAPM, the expected return on an investment can be calculated as the risk-free
rate plus the product of the security's beta and the market risk premium. The market risk premium is
the difference between the expected return on the market and the risk-free rate.

The basic assumptions of the CAPM include:

● Investors hold diversified portfolios: While portfolio theory considers total risk, the CAPM
considers only systematic risk, as it makes the assumption that all investors hold diversified
portfolios. Investors will therefore only require compensation for the systematic risk in their
portfolios.
● Single‐period transaction horizon: In order to compare the returns on different assets
such as shareholdings, the CAPM assumes that all returns are over a standard single‐period
transaction horizon, usually taken to be one year.
 ● Perfect capital market: The CAPM assumes a perfect capital market, with no taxes, no
transaction costs and perfect information freely available to all participants.
● Borrowing and lending at the risk‐free rate: The CAPM assumes that all investors can
borrow and lend at the risk‐free rate of return. This represents a minimum rate of return
required by all investors and is one of the variables in the CAPM equation.

The CAPM has several advantages over other methods of calculating required return:
● It considers only systematic risk, reflecting a reality in which most investors have diversified
portfolios from which unsystematic risk has been essentially eliminated.
● It is a theoretically-derived relationship between required return and systematic risk which
has been subject to frequent empirical research and testing.
● It is generally seen as a much better method of calculating the cost of equity than the
dividend growth model (DGM) in that it explicitly considers a company’s level of systematic
risk relative to the stock market as a whole.
● It is clearly superior to the WACC in providing discount rates for use in investment appraisal.

The disadvantages of the CAPM include:

● By concentrating only on systematic risk, other aspects of risk are excluded; these
unsystematic elements of risk will be of major importance to those shareholders who do not
hold well-diversified portfolios.
● The model considers only the level of return as being important to investors and not the way
in which that return is received. Hence, dividends and capital gains are deemed equally
desirable. With differential tax rates, the ‘packaging’ of return between dividends and capital
gain may be important.
● It is strictly a one-period model and should be used with caution, if at all, in the appraisal of
multi-period projects.
● There are difficulties associated with finding the information needed. This applies not only to
the equity risk premium and the risk-free rate of return, but also to locating appropriate proxy
companies with business operations similar to the proposed investment project. Most
companies have a range of business operations they undertake and so their equity betas do
not reflect only the desired level and type of business risk.
● The CAPM assumes a perfect capital market, when in reality capital markets are only semi-
strong form efficient at best.

Estimating the Cost of Debt

A distinction must be made between the required return of debt holders and the company’s cost of
debt. Although in the context of equity the company’s cost is equal to the investor’s required return,
the same is not true of debt. This is because of the impact of tax relief.

Cost of Irredeemable Debt:

The company does not intend to repay the principal but to pay interest forever.
The market price is equal to the future expected income stream from the debt (in the form of the
interest paid in perpetuity) discounted at the investor’s required return.
The required return (pre-tax cost of debt) can be found by rearranging the formula.
The post-tax cost of debt to the company is found by adjusting the formula to take account of the tax
relief on the interest.

Cost of Redeemable Debt:

The company will pay interest for a number of years and then repay the principal (sometimes at a
premium or a discount to the original loan amount).
The market price is equal to the future expected income stream from the loan notes discounted at
the investor’s required return. The expected income stream will be the interest paid to redemption
and the repayment of the principal.
Hence, the market value of redeemable loan notes is the sum of the PVs of the interest and the
redemption payment.
The return an investor requires (pre-tax cost of debt) can therefore be found by calculating the IRR
of the investment flows:

If it is the post-tax cost of debt to the company that is required, an IRR is still calculated but as the
interest payments are tax-deductible, the IRR calculation is based on the following cash flows:

Cost of Convertible Debt:

A convertible debt is a form of loan note that allows the investor to choose between taking the
redemption proceeds or converting the loan note into a pre-set number of shares.
To calculate the cost of convertible debt:
● Calculate the value of the conversion option using available data.
● Compare the conversion option with the cash option. Assume all investors will choose the
option with the higher value.
● Calculate the IRR of the flows as for redeemable debt.

Cost of Preference Shares:

Preference shares usually have a constant dividend. So, the same approach can be used as we
saw with estimating the cost of equity with no growth in dividends.
Cost of Non-Tradeable Debt:
Bank and other non-tradeable fixed interest loans simply need to be adjusted for tax relief.

Estimating the Overall Cost of Capital

Average and Marginal Cost of Capital:

The average cost of capital is the weighted average of the costs of all the sources of financing used
by a company, while the marginal cost of capital is the cost of raising additional funds through either
debt or equity.
The average cost of capital is calculated by dividing the total cost of capital by the total amount of
capital. This cost is then used as a benchmark for evaluating investment opportunities.
On the other hand, the marginal cost of capital is the incremental cost of raising an additional dollar
of capital. It takes into account the cost of each source of financing, including the interest rate on
debt and the expected rate of return on equity.
In practice, a company's marginal cost of capital will often be higher than its average cost of capital,
since it is more expensive to raise additional funds than it is to maintain existing funding sources.

Weighted Average Cost of Capital (WACC):

The Weighted Average Cost of Capital (WACC) is a measure of the average cost of all sources of
financing (debt and equity) used by a company to finance its investments.
The calculation of WACC requires the determination of the costs of each source of financing and the
allocation of those costs based on the relative weight of each source.
There are two methods of weighting the cost of each source of financing: the book value weighting
and the market value weighting.
The book value weighting method uses the book value of debt and equity as the weights in the
calculation. The book value of debt is the face value of outstanding bonds, while the book value of
equity is the shareholder's equity shown on the statement of financial position.
The market value weighting method uses the current market value of debt and equity as the weights
in the calculation. The market value of debt is the current market value of outstanding bonds, while
the market value of equity is the current market value of the company's shares.
It is important to note that the market value weighting method is considered to be more accurate
than the book value weighting method, as it takes into account the current market conditions, while
the book value weighting method only considers the historical cost of financing. However, the
market value weighting method is more difficult to determine and is subject to more fluctuations in
the short term.
Sources of Finance and their Relative Costs:

The Relative Risk-Return Relationship and the Relative Costs of Equity and Debt

The risk‐return relationship explains why different sources of finance have different costs. An
investor’s required rate of return will be determined primarily by the level of risk the investment has.
If an investment carries a high level of risk, the investor will require a high rate of return to
compensate for that risk. Investing in a low‐risk investment will mean a lower level of return will be
required.
A rational investor would not invest in a high‐risk investment offering a low return as they could
obtain the same return from a lower‐risk investment. A low‐risk investment offering high returns
would not exist as it would be undervalued and the high demand for that investment would increase
the price and therefore reduce the return.

When considering the relative costs of equity and debt, it's important to note that equity is
considered a riskier source of financing than debt. Equity financing is considered riskier because the
owners of equity (i.e., shareholders) are entitled to the last claim on a company's assets and
earnings in the event of bankruptcy or liquidation. Debt, on the other hand, is considered less risky
because the lenders (i.e., bondholders) are entitled to a specific payment regardless of the
company's performance. Because of this difference in risk, equity financing is generally more
expensive than debt financing.
The cost of equity reflects the expected return that equity investors require in order to compensate
for the risk they are taking. The cost of debt, on the other hand, reflects the interest payments that
the company must make to its bondholders (less the tax savings).

The Creditor Hierarchy and its Connection with the Relative Costs of Sources of
Finance
The creditor hierarchy refers to the order in which financial claims against a company are settled
when the company is liquidated. The hierarchy, in order of decreasing priority, is secured creditors,
unsecured creditors, preference shareholders and ordinary shareholders. The risk of not receiving
any cash in a liquidation increases as priority decreases. Secured creditors (secured debt) therefore
face the lowest risk as providers of finance and ordinary shareholders face the highest risk.

The return required by a provider of finance is related to the risk faced by that provider of finance.
Secured creditors therefore have the lowest required rate of return and ordinary shareholders have
the highest required rate of return. The cost of debt should be less than the cost of preference
shares, which should be less than the cost of equity.
Operating and Financial Gearing

Operating Gearing:
Operating gearing is a measure of the extent to which a firm’s operating costs are fixed rather than
variable. This affects the level of business risk in the firm.
Operating gearing can be measured in a number of different ways, including:

Financial Gearing:
Financial gearing is a measure of the extent to which debt is used in the capital structure.
It can be measured in a number of ways:

Interest gearing considers the percentage of the operating profit absorbed by interest payments on
borrowings and as a result measures the impact of gearing on profits.

The Problems of High Gearing

The use of high levels of gearing, or borrowing, can present several problems for a company:
● Bankruptcy risk: When a company has high levels of debt, it becomes more vulnerable to
bankruptcy. In the event of a financial downturn, the company may not have the cash flow to
service its debt obligations, which could lead to bankruptcy.
● Agency costs: In order to safeguard their investments, lenders / debenture holders often
impose restrictive conditions in the loan agreements that constrain management’s freedom
of action. For example, there could be restrictions on the level of dividends, or on
management from disposing of any major non-current assets without the debenture holders’
agreement.
● Tax exhaustion: High levels of debt can lead to tax exhaustion, meaning that a company
may not have enough taxable profits to offset the interest payments on its debt.
 ● Impact on borrowing/debt capacity: High levels of gearing can limit a company's
borrowing capacity, making it more difficult for the company to secure additional financing in
the future.
● Differences in risk tolerance levels: There can be differences in risk tolerance levels
between shareholders and directors. Shareholders may be more willing to accept high levels
of debt, as it can increase returns in the short term, while directors may be more risk-averse
and concerned about the long-term impact of high levels of debt on the company's stability.
● Restrictions in the articles of association: The articles of association of a company may
place restrictions on the level of debt the company can incur.
● Increases in the cost of borrowing: High levels of gearing can also increase the cost of
borrowing, as lenders may view the company as a higher credit risk due to its high debt
levels.

Impact of Cost of Capital on Investments

The Circumstances under which WACC can be used in Investment Appraisal:

The weighted average cost of capital (WACC) of a company reflects the required returns of existing
providers of finance, such as the cost of equity of shareholders and the cost of debt of providers of
debt finance, for example, banks and loan note holders.
The cost of equity and the cost of debt depend on particular elements of the existing risk profile of
the company, such as business risk and financial risk. Providing the business risk and financial risk
of a company remain unchanged, the cost of equity and the cost of debt, and hence the WACC,
should remain unchanged.
Turning to investment appraisal, the WACC could be used as the discount rate in calculating the
present values of investment project cash flows. Since the discount rate used should reflect the risk
of investment project cash flows, using the WACC as the discount rate will only be appropriate if the
investment project does not result in a change in the business risk and financial risk of the investing
company.
One of the circumstances which is likely to leave business risk unchanged is if the investment
project were an expansion of existing business activities. WACC could therefore be used as the
discount rate in appraising an investment project that looked to expand existing business
operations.
However, business risk depends on the size and scope of business operations as well as on their
nature, and so an investment project that expands existing business operations should be small in
relation to the size of the existing business.
Financial risk will remain unchanged if the investment project is financed in such a way that the
relative weighting of existing sources of finance is unchanged, leaving the existing capital structure
of the investing company unchanged.
If business risk changes as a result of an investment project, so that using the WACC of a company
in investment appraisal is not appropriate, a project‐specific discount rate should be calculated. The
capital asset pricing model (CAPM) can be used to calculate a project‐specific cost of equity and
this can be used in calculating a project‐specific WACC.

The Application of CAPM in Calculating a Project-Specific Discount Rate:

The capital asset pricing model (CAPM) assumes that investors hold diversified portfolios, so that
unsystematic risk has been diversified away. Companies using the CAPM to calculate a project‐
specific discount rate are therefore concerned only with determining the minimum return that must
be generated by an investment project as compensation for its systematic risk.
The CAPM is useful where the business risk of an investment project is different from the business
risk of the investing company’s existing business operations. In such a situation, one or more proxy
companies are identified that have similar business risk to the investment project. The equity beta of
the proxy company represents the systematic risk of the proxy company, and reflects both the
business risk of the proxy company’s business operations and the financial risk arising from the
proxy company’s capital structure.
Since the investing company is only interested in the business risk of the proxy company, the proxy
company’s equity beta is degeared to remove the effect of its capital structure. Degearing converts
the proxy company’s equity beta into an asset beta, which represents business risk alone. The
asset betas of several proxy companies can be averaged in order to remove any small differences
in business operations.
The asset beta can then be regeared, giving an equity beta whose systematic risk takes account of
the financial risk of the investing company as well as the business risk of an investment project.
Both degearing and regearing use the weighted average beta formula, which equates the asset beta
with the weighted average of the equity beta and the debt beta.

The project‐specific equity beta resulting from the regearing process can then be used to calculate a
project‐specific cost of equity using the CAPM. This can be used as the discount rate when
evaluating the investment project with a discounted cash (DCF) flow investment appraisal method
such as net present value or internal rate of return. Alternatively, the project‐specific cost of equity
can be used in calculating a project‐specific weighted average cost of capital, which can also be
used in a DCF evaluation.

Capital Structure Theories and Practical Considerations:

The Traditional View of Capital Structure

Also known as the intuitive view, the traditional view has no theoretical basis but common sense.
Taxation is ignored in the traditional view.

This theory suggests that the WACC decreases as debt is introduced at low levels of gearing,
before reaching a minimum and then increasing as the cost of equity responds to a higher degree to
increasing financial risk.

As an organisation introduces debt into its capital structure, the WACC will fall because initially the
benefit of cheap debt finance outweighs any increases in the cost of equity required to compensate
equity holders for higher financial risk.
As gearing continues to increase, the equity holders will ask for increasingly higher returns to
compensate for the ever-increasing risk they face. Eventually, this increase will start to outweigh the
benefit of cheap debt finance and the WACC will rise.
At extreme levels of gearing the cost of debt will also start to rise (as debt holders become worried
about the security of their loans and the company’s ability to make any payments, even of interest),
shareholders will continue to increase their required return and this will contribute to a sharply
increasing WACC.

The traditional view therefore claims that there is an optimal capital structure where WACC is at a
minimum. This means that the company should gear up until it reaches the optimal point and then
raise a mix of finance to maintain this level of gearing in the future.
The problem with this theory is that there is no method, apart from trial and error, available to locate
the optimal point. Moreover, this theory completely ignores the impact of taxation.

Modigliani and Miller’s Views on Capital Structure

1958 Theory with No Tax:

In 1958, Modigliani and Miller stated that, assuming a perfect capital market and ignoring taxation,
the WACC remains constant at all levels of gearing. As a company gears up, the decrease in the
WACC caused by having a greater amount of cheaper debt is exactly offset by the increase in the
WACC caused by the increase in the cost of equity due to financial risk.
The WACC remains constant at all levels of gearing, and thus the market value of the company is
also constant. Therefore, a company cannot reduce its WACC by altering its gearing.
Since the WACC, the total value of the company and shareholder wealth are constant and
unaffected by gearing levels, no optimal capital structure exists.

1963 Theory with Tax:

In 1963, when Modigliani and Miller admitted corporate tax into their analysis, their conclusion
altered dramatically. Since debt interest is tax-deductible, debt becomes even cheaper. This lower
cost of debt results in less volatility in returns for the same level of gearing, which leads to lower
increases in the cost of equity. The increase in the cost of equity does not offset the benefit of the
cheaper debt finance and therefore the WACC falls as gearing increases.
Therefore, gearing up reduces the WACC and increases the value of the company. The company
should thus use as much debt as possible. The optimal capital structure is 99.9% gearing.

Pecking Order Theory

In this approach, there is no search for an optimal capital structure through a theorised process.
Instead, it is argued that firms will raise new funds as follows:
● Internally-generated funds
● Debt
● New issue of equity.

Firms simply use all their internally-generated funds first then move down the pecking order to debt
and then finally to issuing new equity. Firms follow a line of least resistance that establishes the
capital structure.

The justifications that underpin the pecking order are threefold:

● Companies will want to minimise issue costs.
● Companies will want to minimise the time and expense involved in persuading outside
investors of the merits of the project.
● The existence of asymmetrical information and the presumed information transfer that result
from management actions.
Finance for Small and Medium-Sized Entities (SMEs):

The Financing Needs of Small Businesses

Small and medium-sized entities (SMEs) tend to be unquoted with ownership of the business
usually being restricted to a small number of individuals. Often the financing needs are beyond the
levels of initial seed capital invested by the owner when the business is formed. Capital will be
required to invest in non-current assets as well as financing the working capital requirements of the
business.

The Nature of the Financing Problem for SMEs

Small businesses often face challenges in obtaining the financing they need to grow and operate
effectively. This can be due to a variety of factors, including the funding gap, the maturity gap, and
inadequate security.

The funding gap refers to the difference between the amount of capital a small business requires
and the amount it can actually obtain from traditional sources of finance, such as loans or equity
investments. This gap can be particularly pronounced for early-stage businesses with limited
operating history, as well as for businesses in industries that are perceived as high-risk by lenders.

The maturity gap refers to the mismatch between the long-term nature of many small business
assets and the short-term nature of the financing they are able to obtain. For example, a small
business may need to invest in new equipment to support growth, but the financing it can secure
may only be available for a period of a year or less. This can create a significant burden for small
businesses, as they must constantly refinance their assets or face the prospect of losing them.

Inadequate security is another issue faced by small businesses seeking financing. Small businesses
often lack the assets or collateral that lenders typically require as security for loans. This can make it
difficult for small businesses to obtain the financing they need, as lenders are reluctant to take on
the risk of lending to businesses that lack the means to repay their debts.

These factors collectively contribute to the financing problem faced by small businesses, making it
challenging for them to obtain the financing they need to grow and succeed.

Measures to Ease the Financing Problems of SMEs

Small and medium-sized enterprises (SMEs) often face a number of financing challenges, such as
the funding gap, the maturity gap, and inadequate security. To help address these issues, various
solutions have been developed.

Financial investors:
● Business angels: Business angel financing is an informal source of finance from wealthy
individuals or groups of investors who invest directly in the company and who are prepared
to take higher risks in the hope of higher returns. Information requirements for this form of
finance may be less demanding than those associated with more common sources of
finance.
● Venture capitalists: Venture capitalists are professional investors who provide equity
financing to high-growth potential companies. They usually take a more hands-on approach
than business angels and offer significant resources, including experience and networks, to
help the companies they invest in achieve their goals.
Government solutions:
● Increasing the marketability of shares: Governments can encourage the growth of equity
markets by removing barriers to listing and improving the efficiency of the regulatory
framework. This can help SMEs access capital from a wider pool of investors, which in turn
can help them overcome the funding gap.
● Providing tax incentives: Governments can provide tax incentives for investment in SMEs
to encourage capital formation. This can help bridge the funding gap and reduce the cost of
capital for SMEs.
● Other specific forms of assistance: Governments can also provide other specific forms of
assistance to SMEs, such as grants, loans, and guarantees, to help them overcome the
challenges they face in accessing finance.

Other practices:
● Supply chain financing: Supply chain financing is a method that optimizes cash flow by
allowing businesses to lengthen their payment terms to their suppliers while providing the
option for suppliers to get paid early through the use of financial institutions. This results in a
win-win situation for the buyer and supplier. The buyer optimizes working capital, and the
supplier generates additional operating cash flow, thus minimizing risk across the supply
chain.
● Crowdfunding: Crowdfunding is a form of financing where a large number of people invest
small amounts of money in a company, typically through an online platform. This type of
financing can help SMEs access capital from a large number of investors, many of whom
they would not have been able to reach through traditional channels.
● Peer-to-peer funding: Peer-to-peer financing is the practice of borrowing and lending
money between unrelated individuals, or 'peers', without going through a traditional financial
intermediary such as a bank or other traditional financial institution. There is no necessary
common bond or prior relationship between borrowers and lenders. Intermediation takes
place by a peer-to-peer lending company and all transactions take place online, with a view
to the lender making a profit. Lenders may choose which borrowers to invest in and the
loans are unsecured.

These measures can help SMEs overcome some of the financing challenges they face and enable
them to access the capital they need to grow and succeed.