1

WELCOME TO
FINANCIAL MANAGEMENT (FM)
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Some notes for learning FM

FM main capabilities

Financial management function (A)

Financial management environment (B)

Working capital
management (C)

Investment appraisal (D)

Business finance (E) Business valuations (F)

Risk management (G)

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Some notes for learning FM

Table of contents
Page

FINANCIAL MANAGEMENT FUNCTION

Part A 5 - 68
Chapter 1: Financial management and financial objectives

FINANCIAL MANAGEMENT ENVIRONMENT

Part B Chapter 2: The economic environment for business 69 - 89
Chapter 3: Financial markets and institutions 90 - 113

WORKING CAPITAL MANAGEMENT

Part C Chapter 4: Working capital investment 114 - 131
Chapter 5: Managing working capital 132 - 169
Chapter 6: Cash management and working capital finance 170 - 198

INVESTMENT APPRAISAL
Part D 199 - 217
Chapter 7: Investment decision
Chapter 8: Investment appraisal using DCF methods 218 - 274
Chapter 9: Project appraisal under risk and uncertainty 275 - 298
Chapter 10: Specific investment decision 299 - 326
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Some notes for learning FM

Table of contents
Page

BUSINESS FINANCE
Part E Chapter 11: Source of finance 327 - 358
Chapter 12: Dividend policy 359 - 372
Chapter 13: The cost of capital 373 - 415
Chapter 14: Capital structure 416 - 455

BUSINESS VALUATIONS
Part F Chapter 15: Business valuation 456 - 513
Chapter 16: Market efficiency and influences on valuation 514 - 533
of share and business

RISK MANAGEMENT
Part G Chapter 17: Foreign currency risk 534 - 596
Chapter 18: Interest rate risk 597 - 649
5

CHAPTER 1: FINANCIAL
MANAGEMENT AND FINANCIAL
OBJECTIVES
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Chapter 1: Financial Management

and Financial Objectives
Overview graph

Financial management
Nature and purpose of
financial management
Framework of financial management

Relationship between corporate strategy

and financial objectives

Financial objectives

Non-financial objectives
Financial
Financial objectives and
management
the relationship with Stakeholders
and financial
corporate strategy
objectives
Encouraging shareholder wealth
maximisation

Measuring the achievement of corporate

objectives

Definition

Not-for-profit
Objectives
organisations

Value for money and the 3Es

 7

I. Nature and purpose of financial management

1. What is Financial Management?

Financial management is the management of the finances of an organisation in order to

achieve the financial objectives of the organisation.

Financial management is concerned with the efficient acquisition and deployment of financial
resources.

Acquisition of financial réources

The financing decision
Equity • Source of finance
Debt
• Cost of capital
• Risk

Finance

Company

Using resources effectively

Investment in
Working capital Dividend
non-current assets

The investment decision The dividend

• Investment appraisal decision
• Working capital management • Business valuation
• Risk • Efficient markets

Financial objectives
 8

I. Nature and purpose of financial management

2. Framework of financial management

2.1 Financial planning

The financial manager will need to plan to ensure that enough funding is available at the right
time to meet the needs of the organisation for short, medium and long-term capital.

Short-term Medium-term Long-term

Funding needs: • Pay for purchases of inventory • Purchases of non-

• Smooth out changes in current assets
receivables, payables and cash

Planning has to • Working capital requirements are • Funding is available

ensure that: met
 9

I. Nature and purpose of financial management

2. Framework of financial management

2.2 Financial control

Financial controls are the procedures, policies, and means by which an organization monitors
and controls the direction, allocation, and usage of its financial resources. Financial controls are
at the very core of resource management and operational efficiency in any organization.

Example:
Cash inflow control
Finance • Reconciliation of bank
statements with the
company’s general ledger
• Credit checks on all potential
customers
Company

• Clear and comprehensive

expense management
policies
Working Investment in • Comprehensive vendor
Dividend management
capital non-current assets
Cash outflow control
 10

II. Financial objectives and the relationship with

corporate strategy
1. Relationship between corporate strategy and financial objectives

Strategy may be defined as a course of action, including the specification of resources required,
to achieve a specific objective.

Overall mission

Broad-based goals
1

Detailed objectives/Targets Strategy

2
Non-financial
See details in Financial objectives
next slide objectives

Organic or
3 Corporate Expand market share Increase share price
Acquisition?

Acquire and equip new

3 Business Maximize profits Lease or buy?
premises

Credit or cash on
3 Operational Maintain liquidity levels Low receivable days
delivery
 11

II. Financial objectives and the relationship with

corporate strategy
1. Relationship between corporate strategy and financial objectives

Overall goal is broken down into detailed objectives, each of which should have
1 appropriate identifiable, measurable targets so that progress towards them can be
monitored.

Objectives have been commonly divided to two main components:

2 • Financial objectives
• Non-financial objectives

Once objectives and targets are set, the enterprise must then work to achieve them by
3 developing and implementing appropriate strategies. Strategies will be developed at all
levels of the business.

Corporate strategy concerns the decisions made by senior management about matters
such as the particular business the company is in, whether new markets should be
entered or whether to withdraw from current markets.

Business strategy concerns the decisions to be made by the separate strategic business
units within the group. Each unit will try to maximise its competitive position within its
chosen market.

Operational strategy concerns how the different functional areas within a strategic
business unit plan their operations to satisfy the corporate and business strategies
being followed.
 12

II. Financial objectives and the relationship with

corporate strategy
2. Financial objectives

Broad-based goals
1

Detailed objectives/Targets Strategy

2
Non-financial
See details in Financial objectives
objectives
next slide

Organic or
3 Corporate Expand market share Increase share price
Acquisition?

Business Acquire and equip new

3 Maximize profits Lease or buy?
premises

Operational Credit or cash on

3 Maintain liquidity levels Low receivable days
delivery

Earnings per share growth

Shareholder
wealth
Profit maximization maximization Other financial targets
 13

II. Financial objectives and the relationship with

corporate strategy
2. Financial objectives

2.1 Shareholder wealth maximization

• Shareholder wealth maximisation is a fundamental principle of financial management, and it

is therefore the primary financial objective of most companies.
• The wealth of the shareholders in a company comes from:
o Dividends received
o Market value of the shares
• In order to achieve high market value of the shares or high dividend payout, generally a
company has to make attractive profit and/or potential future profit growth.

Shareholder wealth maximization – measurement

The wealth of the shareholders

Market value of the shares

Capital gains from

Dividends received
increases in share price
(D1)
(P1 – P0)

Total shareholder’s return (TSR)

P − P0 + D1
Total shareholder’s return (TSR) = 1
P0
• P0 , P1 are the share prices at the beginning and at the end of the period.
• D1 is the dividend paid
 14

II. Financial objectives and the relationship with

corporate strategy
2. Financial objectives

2.1 Shareholder wealth maximization

Shareholder wealth maximization – measurement

Example:

A shareholder purchased 1,000 shares in SJG Co on 1 January at a market price of $2.50 per
share. On 31 December the shares had an ex-div market value of $2.82 per share. The
dividend paid during the period was $0.27 per share.

Required: What is the total shareholder return?

Answer:
The total shareholder return is:
$2.82 – $2.5 + $0.27
= 0.24 or 24%
$2.5
 15

II. Financial objectives and the relationship with

corporate strategy
2. Financial objectives

2.2 Profit maximization

• It is assumed in much economic theory that the firm behaves in such a way as to maximise
profits.
• A company’s profit can be measured by its net income, its profit margins or other profit
figures on income statement.
• There are a number of potential problems with adopting an objective of profit maximization.

Long-run vs short-run: Profitability are measures of short-term performance,

a company's performance should be judged over the longer term.

Manipulation and fraudulent: Accounting

profits can be manipulated.

Risk: Profit does not take account of risk. Maximizing profits may be achieved by
increasing risk to unacceptable levels.

Profit, unlike share price/dividends, does not

represent the income of shareholders
 16

II. Financial objectives and the relationship with

corporate strategy
2. Financial objectives

2.3 Earnings per share growth

• EPS (Earnings per share) growth is a commonly pursued objective, because it provides a
measure of return to equity (= EPS/Share price).
• It is a measure of profitability, and is therefore open to the same criticisms as profit
maximisation.

Earnings per share – measurement

Earnings per share is calculated by dividing the net profit or loss attributable to ordinary
shareholders by the weighted average number of ordinary shares.

Net profit or loss attributable to ordinary shareholders

Earning per share (EPS) =
The weighted average number of ordinary shares.
 17

II. Financial objectives and the relationship with

corporate strategy
2. Financial objectives

2.3 Earnings per share growth

Earnings per share – measurement

Example:

Walter Wall Carpets made profits before tax in 20X8 of $9,320,000. Tax amounted to
$2,800,000.
The company's share capital is as follows.
Ordinary shares (10,000,000 shares of $1) 10,000,000
8% preference shares 2,000,000
12,000,000

Calculate the EPS for 20X8.

Profit before tax 9,320,000

Less tax 2,800,000
Profits after tax 6,520,000
Less preference dividend 160,000
Earnings attributable to ordinary shareholders 6,360,000
Divided by the number of ordinary shares 10,000,000
EPS 63.6
 18

II. Financial objectives and the relationship with

corporate strategy
2. Financial objectives

2.4 Other financial targets

In addition to targets for earnings, EPS and dividend per share, a company might set other
financial targets:

• A restriction on the company's level of

gearing, or debt.
ie. a company's management might decide: the
ratio of long-term debt capital to equity capital
should never exceed, say, 1:1.

• A target for profit retentions.

ie. management might set a target that dividend
cover (the ratio of distributable profits to
dividends actually distributed) should not be less
than, say, 2.5 times.

• A target for operating profitability.

Ie. management might set a target for the
profit/sales ratio (say, a minimum of 10%) or for
a return on capital employed (say, a minimum
ROCE of 20%).
 19

II. Financial objectives and the relationship with

corporate strategy
3. Non-financial objectives
A company may have important non-financial objectives which must be satisfied in order to
ensure the continuing participation of all stakeholders, that help the company in maximizing
shareholder wealth may be compromised in the future.

Example: Some examples of non-financial objectives are as follows:

A company might try to provide good wages and salaries,

The welfare of
comfortable and safe working conditions for its
employees
employees.
The major objectives of some companies will include
The provision of a
fulfillment of a responsibility to provide a service to the
service
public.

Responsibilities towards suppliers are expressed mainly

The fulfilment of in terms of trading relationships;
responsibilities Responsibilities towards customers include providing in
good time a product or service.

The welfare of The Company has to play in exercising corporate social

society as a responsibility (this includes compliance with applicable
whole laws and regulations).

Non-financial objectives do not negate financial objectives, but they do suggest that the simple
theory of company finance, that the objective of a firm is to maximise the wealth of ordinary
shareholders, is too narrow.

Financial objectives may have to be compromised in order to satisfy non-financial objectives.

 20

II. Financial objectives and the relationship with

corporate strategy
4. Stakeholders – Additional reading

4.1 Types of stakeholders

A stakeholder group is one with a vested interest in the company.

Typical stakeholders for an organisation would include:
 21

II. Financial objectives and the relationship with

corporate strategy
4. Stakeholders – Additional reading

4.2 Stakeholder objectives and conflicts

Management must balance the needs and objectives of all stakeholders to avoid conflict as
each group is focused on furthering their own interests.

INTERNAL CONNECTED EXTERNAL

Company
employees & Finance providers/ Bankers The government
Managers/Directors
Impinge on the
Interested in the ability of the
Maximize rewards, firm’s activities to
organization to repay the finance
salaries and benefits achieve the political
including interest
and financial terms
Customers The community
The provision of value-for-money Maximizing public
products and services interest

Shareholder

Maximize their wealth

Suppliers
Prompt payment terms alongside
long-term requirements including
contracts and regular business
 22

II. Financial objectives and the relationship with

corporate strategy
4. Stakeholders – Additional reading

4.3 The role of management and goal congruence

Agency theory is a description of the relationships between the various interested parties in a
firm and can help to explain the various duties and conflicts that occur:
• Agency relationships occur when one party, the principal, employs another party, the
agent, to perform a task on their behalf. In particular, directors (agents) act on behalf of
shareholders (principals).

Agency theory can help to explain the actions of the various interest groups in the corporate
governance debate.

Principal
Employs

Performs task or activities with

Agent Third party

For example:
• Managers can be seen as the agents of shareholders;
• Employees as the agents of managers;
• Managers and shareholders as the agents of long- and short-term creditors.
 23

II. Financial objectives and the relationship with

corporate strategy
4. Stakeholders – Additional reading

4.3 The role of management and goal congruence

Appointing to manage company

Shareholder Manager/ Director
Maximizing shareholder wealth

However, managers may not behave in a way that is likely to maximize shareholder wealth. The
danger that managers may not act in the best interest of owners is referred to as the agency
problem.

Neglect risk management

Maximization of short-term profits at

Agency
the expense of long-term profits
problems
(short-termism)

Boost their own pay and perks

Besides, there are many conflicts between stakeholders such as Employees – Shareholders,
Shareholders – Finance providers, Customers – Shareholders/managers,…
 Agency problems can be addressed by monitoring the actions of management (corporate
governance) or by the use of incentive schemes.
 24

II. Financial objectives and the relationship with

corporate strategy
5. Encouraging shareholder wealth maximization

5.1 Managerial reward schemes

One way to help ensure that managers take decisions that are consistent with the objectives of
shareholders is to introduce carefully designed remuneration packages. The schemes should:
• be clearly defined, impossible to manipulate and easy to monitor
• link rewards to changes in shareholder wealth
• match managers’ time horizons to shareholders’ time horizons
• encourage managers to adopt the same attitudes to risk as shareholders.

Common types of reward schemes include:

Performance-related pay (PRP)

Remuneration linked to profits or performance indicators:

• Minimum profit levels
• Economic value added (EVA)
• Revenue growth

Executive share option plans (ESOPs)

In a share option scheme, selected employees are given a

number of share options, each of which gives the holder
the right after a certain date to subscribe for shares in the
company at a fixed price
 25

II. Financial objectives and the relationship with

corporate strategy
5. Encouraging shareholder wealth maximization

5.1 Managerial reward schemes

There are some benefits and some problems that would be faced with of reward scheme:

Benefits Problems

A serious problem that can arise is

Performance-related pay may
that performance-related pay and
give individuals an incentive to
performance evaluation systems can
achieve a good performance level.
encourage dysfunctional behaviors

Effective schemes also succeed in

They undervalue intrinsic rewards
attracting and keeping employees
given that they promote extrinsic
that are valuable to the
rewards
organization.

Schemes based on shares can Self-interested performance may be

motivate employees/managers to encouraged at the expense of
act in the long-term interests of teamwork.
the organization by doing things to To make bonuses more accessible,
increase the organization’s market standards and targets may have to be
value. lowered, with knock-on effects on
quality.
 26

II. Financial objectives and the relationship with

corporate strategy
5. Encouraging shareholder wealth maximization

5.2 Regulatory requirements

The achievement of stakeholder objectives can be enforced using regulatory requirements such
as corporate governance codes of best practice and stock exchange listing regulations.

5.2.1. Corporate governance codes

Corporate governance is the system by which organizations are directed and controlled.

The director/shareholder conflict has also been addressed by the requirements of several
corporate governance codes. The solution presented in the code is as follows:

Segregation
of roles
Non-executive directors (NEDs) Executive directors (EDs)
• Important presence on the • Separation of chairman and chief
board executive officer (CEO)
• Must give obligation to spend • Submit for re-election
sufficient time with the • Clear disclosure of financial
company rewards
• Should be independent.
• At least half the board should be
NEDs
 27

II. Financial objectives and the relationship with

corporate strategy
5. Encouraging shareholder wealth maximization

5.2 Regulatory requirements

5.2.1. Corporate governance codes

A recommended corporate governance structure is given below:

GENERAL MEETING OF SHAREHOLDERS

Apppointment Apppointment

BOARD OF DIRECTOR

Implement
Establish
Nomination
committee

Executive
Report for
Non-executive
directors (NED) X directors
Audit and supervisory board/Committee

monitoring Direct
Chairman CEO
purpose supervision
Set up

Internal control
Execute &
monitor
Remuneration

Strategies &
committee

Design
objectives
To achieve

Audit &
BUSINESS OPERATION
monitor
CFO CMO COO

Research and
development
committee
Audit

Internal audit

implementation
Monitoring
Supervise

Departments Departments Departments

Report to
 28

II. Financial objectives and the relationship with

corporate strategy
5. Encouraging shareholder wealth maximization

5.2 Regulatory requirements

5.2.2. Stock exchange listing requirements and other regulations

A stock exchange is an organization that provides a marketplace in which to trade shares. It

also sets rules and regulations to ensure that the stock market operates both efficiently and
fairly for all parties involved.

To be listed on a stock exchange, a stock must meet the listing requirements laid down in the
listing rules in its approval process.
 29

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives
Ratios analysis is used for managers, shareholders and other stakeholders to measure the
progress of the company towards its objectives. Ratios analysis is concerned with comparing and
quantifying relationships between financial variables.

Ratio ananlysis can be grouped into 04 main categories:

Ratio analysis

Profitability and Debt and

Liquidity Investor
return gearing

Note:

The key to obtaining meaningful information from ratio analysis is the comparison:
comparing ratios over several periods within the same business to establish whether the
business is improving or declining and comparing ratios between similar businesses to see
whether the company you are analyzing is better or worse than average within its business
sector.
 30

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

A company ought of course to be profitable if it is to maximize shareholder wealth, and obvious

checks on profitability are:
• Whether the company has made a profit or a loss on its ordinary activities
• By how much this year's profit or loss is bigger or smaller than last year's profit or loss
⇨ Therefore, profitability and return ratios are probably the most widely used. They are
key to assessing performance against objectives as well as being crucial to the
investment decision.

Common
ratios used

Return on Capital
Profit margins Return on Asset Return on Equity
employed (ROCE)
 31

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

6.1.1. Profit margins

 Profit margins show the percentages of profit left after all payments of production
expense, to cover operation expense and other liabilities

Formula:
Gross profit
Gross profit margin = Revenue × 100

Operating profit
Operating profit margin = Revenue × 100

Where:
• Gross profit = Revenue – Cost of goods sold
• Operating profit = Gross profit – Operating expense

Evaluating the profit margins:

A comparison of the changes in the two ratios can often reveal more information about cost
control and the changes in operating gearing.

Note:

Operating profit can also be expressed as profit before interest and taxation (PBIT).
 32

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

6.1.2. Return on Capital Employed (ROCE)

 Return on Capital Employed (ROCE) is a profitability ratio that helps determine the profit
that a company earns for the capital it employs.

 ROCE gives a measure of how efficiently a business is using the funds available. It
measures how much is earned per $1 invested.

Formula:
EBIT EBIT
ROCE = Capital employed = Total asset – Current liabilities
EBIT
= Equity+Long−term liabilities

Where:
• Earnings before interest and tax (EBIT) is the company’s profit, including all expenses
except interest and tax expenses.
• Capital employed (CE) is the total amount of equity invested in a business. Capital employed
is commonly calculated as either total assets less current liabilities or fixed assets plus
working capital.
 33

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

6.1.2. Return on Capital Employed (ROCE)

Evaluating the ROCE

The change in ROCE from one year to the

next

Three
comparisons can
The ROCE being earned by other companies,
be made to
evaluate the if this information is available
ROCE:

A comparison of the ROCE with current

market borrowing rates
 34

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

6.1.2. Return on Capital Employed (ROCE)

Secondary ratios

When assessing company performance, return on capital employed (ROCE) is often broken
down as follows:

ROCE

Operating profit margin Asset turnover

Gross profit Operating

margin expense ratio

 Profit margin and asset turnover together explain the change in ROCE, by using both
secondary ratios, we may interpret the reason why ROCE has an adverse fluctuation.
 35

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

6.1.3. Return on asset

 Return on assets (ROA) is a profitability ratio that helps determine how efficiently a
company uses its assets.

 It is the ratio of net income after tax to total assets. In other words, ROA is an efficiency
metric explaining how efficiently and effectively a company is using its assets to generate
profits.

Formula:
Profit after tax (PAT)
ROA =
Total asset

ROA is closely similar to ROCE, instead of using capital employed, we use Total assets to assess
the profitability of a company based on its assets.

Note:

• ROA could be broken down into secondary ratios in the same as ROCE
• In some cases, based on particular circumstances, we can use ROCE, also called return on
investment (ROI), to be an alternative ratio for ROA to assess the profitability of a
company or a project.
 36

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

6.1.4. Return on equity

 Return on equity (ROE) is a profitability ratio that helps determine how efficiently a
company uses its shareholders’ equity.

 ROE measures how much profit a company generates for its ordinary shareholders with
the money they have invested in the company.
Formula:
Profit after tax and preference dividends
ROE =
Shareholder ′s equity

Where there are no preference shares this is simplified to:

Profit after tax (PAT)
ROE =
Shareholder ′s equity

Where:
• Profit after tax and preference share dividends is also referred to as earnings (or net
income).
• Shareholder’s equity is the figure ‘equity share’ on the SOFP.
Evaluating the ROE

• This ratio shows the earning power of the shareholders' book investment and can be used
to compare two firms in the same industry.
• A high return on equity could reflect the firm's good management of expenses and ability
to invest in profitable projects.
 37

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

6.1.5. Relationship between profitability ratios – Ratios pyramids

The Dupont system of ratio analysis involves constructing a pyramid of interrelated ratios as
shown below:
Return on equity (ROE)

Return on Total assets

investment (ROA) ÷ equity

Return on sales Asset

(profit margin) turnover

Net Total
income Sales Sales
assets

Non-current Current
Sales Total cost
assets assets

Such ratio pyramids help in providing for an overall management plan to achieve profitability
and allow the interrelationships between ratios to be checked.
 38

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.2 Debt and gearing

Debt and gearing

Short-term ratios Long-term ratios

Current Quick Interest

Gearing Leverage
ratio ratio cover
 39

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.2 Debt and gearing

6.2.1. Current ratio

 The current ratio, also known as the working capital ratio, measures the capability of a
business to meet its short-term obligations that are due within a year.

 It indicates the financial health of a company whether current assets are enough to cover
the current liabilities and how it can maximize the liquidity of its current assets to settle
debt and payables.

Formula:
Current assets
Current ratio =
Current liabilities

Example:

A measure of 2:1 means that current liabilities can be paid twice over out of existing current
assets.
 40

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.2 Debt and gearing

6.2.1. Current ratio

Evaluating the Current ratio

Conventional wisdom has it that an ideal

current ratio is 2

Acceptable level could be over 1

Evaluating the
Current ratio Current ratio below 1, which means the
business has a liquidity problem.

Using current ratio to compare with

competitors, market trend or budget to
assess the liquidity of the company
 41

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.2 Debt and gearing

6.2.2. Quick ratio

 The quick ratio, also known as the acid-test ratio, is a liquidity ratio that measures the
ability of a business to pay its short-term liabilities by having assets that are readily
convertible into cash.

 These assets are, namely, cash, marketable securities, and accounts receivable. These
assets are known as “quick” assets since they can quickly be converted into cash.

Formula:
Current assets − Inventory
Quick ratio (acid-test ratio) =
Current liabilities

It is similar to the current ratio. However, in current assets, illiquid assets like inventory are not
considered. Inventory can only be liquidated when there are buyers for the same. In an
economic downturn or emergencies, it will be difficult to sell inventory.
 42

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.1 Profitability and return

6.2.2. Quick ratio

Evaluating the Quick ratio

Generally, the acid-test ratio should be 1:1

or higher

This ratio varies widely by industry

Evaluating the
Quick ratio In general, the higher the ratio, the greater
the company's liquidity

Using quick ratio to compare with

competitors, market trend or budget to
assess liquidity
 43

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.2 Debt and gearing

6.2.3. Financial gearing and leverage

 Financial gearing measures the degree to which an organization's activities are funded by
borrowed funds, as opposed to shareholder's funds.

 Leverage ratio are financial ratio used to measure a company’s capital structure, financial
obligations, and its ability to clear those obligations.

 A leverage ratio or gearing ratio is a financial ratio that can be defined as a financial metric
to measure the capability of the company to pay off its dues or how much asset is put to
use with the loan taken along with being a good indicator of capital structure.

Formula:
Interest−bearing debt
Financial gearing=
Equity + Interest−bearing debt
Equity
Financial leverage=
Equity + Interest−bearing debt

Note:

In some cases, Interest-bearing debt can be replaced by total debt or non-current liabilities.
 44

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.2 Debt and gearing

6.2.4. Interest cover

 The Interest Cover Ratio (ICR) is a financial ratio that is used to determine how well a
company can pay the interest on its outstanding debts

 Interest cover is a measure of the adequacy of a company’s profits relative to its interest
payments on its debt.

Formula:
EBIT
Interest cover ratio =
Interest expense

Where:
• EBIT is the company’s operating profit (Earnings Before Interest and Taxes)
• Interest expense represents the interest payable on any borrowings such as bonds, loans,
lines of credit, etc.
 45

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.2 Debt and gearing

6.2.4. Interest cover

Evaluating the Interest cover

An interest cover ratio of less than three

times is considered low, indicating that
profitability is too low given the gearing of
the company.

Evaluating the
Interest cover

In general, a high level of interest cover is

‘good’ but may also be interpreted as a
company failing to exploit gearing
opportunities to fund projects at a lower
cost than from equity finance.
 46

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.3 Working capital efficiency

Working capital efficiency

Receivables ratios Inventory ratios Payables ratios

Receivable Receivable Inventory Inventory Paybles Payables

period turnover days turnover period turnover

Cash operating cycle

 47

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.3 Working capital efficiency

The cash operating cycle (also known as the working capital cycle or the cash conversion cycle)
is the number of days between paying suppliers and receiving cash from sales.

Purchases Sales Receipt cash

Inventory days Receivable days

Payable days Cash operating cycles

Pay cash
Formula:

Cash operating cycle = Inventory days + Receivables days – Payables days.

 48

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.3 Working capital efficiency

Formula: Receivable ratios

Receivable
Receivable days = Credit sale × 365

Credit sale
Receivable turnover=
Receivable

Where:
• Receivable days ratio represents the average number of days it takes credit sales to be
converted into cash or how long it takes a company to collect its account receivables.
• Receivable turnover ratio measures the number of times over a given period that a
company collects its average accounts receivable.
 49

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.3 Working capital efficiency

Formula: Inventory ratios

Inventory
Inventory days =
COGS × 365

COGS
Inventory turnover = Inventory

Where:
• Inventory days is the average number of days that a company holds its inventory before
selling it.
• Inventory turnover is the number of times a business sells and replaces its stock of goods
during a given period.

Note:

In the manufacturing sector inventory days has three components:

• Raw materials days
• Work-in-progress days (the length of the production process)
• Finished goods days
 50

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.3 Working capital efficiency

Formula: Payables ratio

Trade payable
Payable days = Credit purchase× 365

Credit purchase
Payable turnover = Trade payable

Where:
• Payable days ratio refers to the average number of days it takes a company to pay back its
accounts payable.
• Payable turnover ratio measures the average number of times a company pays its
creditors over an accounting period.

Note:

In some cases, cost of goods sold (COGS) is used in the numerator in place of credit purchases.
 51

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

Shareholder’s
investment

Earning Dividend

Earning Price Dividend

Total Dividend
per earning per Dividend
shareholder cover
share ratio share yield
return ratio
(EPS) (P/E) (DPS)
 52

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.1. Earning per share

 Earnings per share (EPS) is a key metric used to determine the common shareholder’s
portion of the company’s profit.

 EPS is a financial ratio, which divides net earnings available to common shareholders by
the average outstanding shares over a certain period. The EPS formula indicates a
company’s ability to produce net profits for common shareholders.

Formula: EPS
Net income − Preference dividend
Earning per share EPS =
Weighted Average Shares Outstanding

Where:
• Net income could be profit after interest and tax
• Weighted average shares outstanding refers to the number of shares of a company
calculated after adjusting for changes in the share capital over a reporting period.
 53

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.1. Earning per share

Evaluating the EPS

EPS can be analyzed by studying the growth rate over

time – trend analysis.

A company’s real earning capability cannot be assessed

by the EPS figure for one accounting period. Investors
Evaluating the should compute the company’s EPS for several years
EPS and compare them with the EPS figures of other similar
companies to select the most appropriate investment
option.

A company with a constant increase in its EPS figure is

usually regarded to be a reliable option for investment.

Note:
EPS does not represent the income of the shareholder. Rather, it represents the investor’s
share of profit after tax generated by the company according to an accounting formula.
 54

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.2. Price earning ratio

 Price earnings ratio (P/E Ratio) is the relationship between a company’s stock price and
earnings per share (EPS)

 This is the basic measure of a company’s performance from the market’s point of view.
Investors estimate a share’s value as the amount they are willing to pay for each unit of
earnings. It expresses the current share price as a multiple of the most recent EPS.

Formula: P/E ratio

Market share price Total share value
Price earning ratio (P/E) = =
EPS Total earnings

Where:
• Market share price must be ex-div price, which means it excludes dividend in share price.
• Earnings per Share (EPS) are the total earnings of a company for the year divided by the
total number of shares outstanding at the end of the year.
 55

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.2. Price earning ratio

Evaluating the P/E ratio

High P/E: Companies with a high Price

earnings ratio are often considered to be
growth stocks, indicating positive future
performance, and investors have higher
expectation for future earnings growth and
are willing to pay more for them.

Evaluating the
P/E ratio

Low P/E: Companies with a low Price

earnings ratio are often considered to be
value stocks – undervalued because the
stock prices trade lower relative to their
fundamentals.

6.4.3. Total shareholder’s return

This ratio has been mentioned in Section 2.1. Shareholder wealth maximization
 56

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.4. Dividend per share

 Dividend Per Share (DPS) is the total amount of dividends attributed to each share
outstanding of a company.

 Calculating the dividend per share allows an investor to determine how much income from
the company he or she will receive on a per-share basis.

Formula:
Total ordinary dividend
Dividend per share (DPS) =
Weighted Average Shares Outstanding

Where:
• Dividends only include interim dividends to be distributed to common shareholders for a
specific fiscal year. Preference dividends and special dividends are not included here.
• Weighted average shares outstanding refers to the number of shares of a company
calculated after adjusting for changes in the share capital over a reporting period. It also
could be the total number of shares issued.
 57

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.4. Dividend per share

Evaluating the Dividend per share ratio

DPS provides better comparability between

two companies as it is on a per-share basis

Evaluating the
Dividend per
share ratio

Increasing the level of DPS is considered to

be a positive signal as it shows that the
company has more confidence in its future
earnings. Similarly, reducing that level would
send a negative signal.

Note:

DPS may be affected by dividend and/or retentions policy of the management.

 58

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.5. Dividend cover

 The dividend cover, also known as the Dividend Coverage Ratio, is a financial metric that
measures the number of times that a company can pay dividends to its shareholders

 Dividend cover is an important number for income-oriented investors because buyers of

high-yield shares tend to want a stable income.

Formula:
Net income EPS
Dividend cover = =
Dividend for the year DPS

Where:
• Net income could be profit after interest and tax
• Dividend for the year is the amount of dividend entitled to shareholders
• EPS is earning per share
• DPS is the dividend per share
 59

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.5. Dividend cover

Evaluating the Dividend cover

If the dividend coverage ratio (DCR) is greater than 1, it

indicates that the earnings generated by the company are
enough to serve shareholders with their dividends.

A dividend cover above 2 is considered good.

Evaluating the
Dividend cover A deteriorating DCR or a dividend cover that is consistently
below 1.5 may be a cause for concern for shareholders.

A consistently low or a deteriorating dividend cover may

signal poor company profitability in the future, which may
mean the company will be unable to sustain its current
level of dividend payouts.
 60

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.6. Dividend yield

 Dividend yield is a financial ratio that measures the annual value of dividends received
relative to the market value per share of a security.

 The dividend yield formula is used to determine the cash flows attributed to an investor
from owning stocks or shares in a company. Therefore, the ratio shows the percentage of
dividends for every dollar of stock.

Formula:
DPS
Dividend yield =
Market share price

Where:
• DPS has been mentioned above
• Market share price must be ex-div price, which means it excludes dividend in share price.
 61

II. Financial objectives and the relationship with

corporate strategy
6. Measuring the achievement of corporate objectives

6.4 Shareholder’s investment

6.4.6. Dividend yield

Evaluating the Dividend yield

Shareholders look for both dividend yield

and capital growth. The dividend yield is
therefore an important aspect of a share's
performance.

Evaluating the
Dividend yield

A high or low yield depends on factors such

as the industry and the business life cycle of
the company.
 62

III. Not-for-profit organisations

1. Not-for-profit organisations

Not-for-profit organisations are types of organizations that do not earn profits for their owners.

All of the money earned by or donated to a not-for-profit organization (NPOs) is used in

pursuing the organization's objectives and keeping it running.

Example:

Some examples for NPOs:

• Central government departments and agencies
• Local or federal government departments
• Publicly funded bodies providing healthcare (in the UK this would be the NHS) and
social housing
• Further and higher education institutions
• Charitable bodies
 63

III. Not-for-profit organisations

2. Objective setting in not-for-profit organizations

The primary objective of not for profit organisations (NFPs or NPOs) is not to make money but
to benefit prescribed groups of people.

NFPs will use a mix of financial and non-financial objectives.

However, unlike companies, the non-financial objectives are often more important for NFPs:

• Key objectives may be difficult to quantify, especially financial terms.

• Multiple and conflicting objectives are common in NFPs.

 64

III. Not-for-profit organisations

3. Value for money (VFM) and the three Es

Value for money (VFM) can be defined as ‘achieving the desired level and quality of service at
the most economical cost’.

The lack of clear financial performance measures.

The needs of
evaluating VFM
in public sector
organizations
The complex mix of objectives with no absolute
priority had led to concern that the money may
be being directed towards the wrong ends.
 65

III. Not-for-profit organisations

3. Value for money (VFM) and the three Es

A more detailed analysis of what is meant by VFM can be achieved by viewing the organization
as a system set up to achieve its objectives using processing inputs into outputs:

The organisation as a system

Resources Outcome

Input Process Output

The three Es
 66

III. Not-for-profit organisations

3. Value for money (VFM) and the three Es

Economy: Effectiveness:
Minimising the costs of inputs required to Whether outputs are achieved that match
achieve a defined level of output. the predetermined objectives.

Achieving
the three Es

Efficiency:
Ratio of outputs to inputs – achieving a
high level of output in relation to the
resources put in (input-driven) or
providing a particular level of service at
reasonable input cost (output-driven)

Note:

Using 3 Es as performance measurement and a way to assess VFM is a key issue for
examination questions that relate to NFPs and public sector organizations.
 67

III. Not-for-profit organisations

3. Value for money (VFM) and the three Es

An organization achieving economy, efficiency and effectiveness in each part of the system is
considered to be providing good VFM.

Economy: Effectiveness:
Acquiring resources of appropriate quality Ensuring that the output from any given
and quantity at the lowest cost. activity is achieving the desired result.

Achieving
the three Es

Efficiency:
Maximizing the useful output from a
given level of resources, or minimizing
the inputs required to produce the
required level of output.

‘input-driven’ efficiency ‘output-driven’ efficiency

Try to provide as much of a service as provide the service at a reasonable cost
possible with strictly limited resources (In case providing a particular standard of
and few opportunities to generate further service, which cannot be significantly
income sources reduced or withdrawn)
 68

III. Not-for-profit organisations

3. Value for money (VFM) and the three Es

Example:

In the context of managing performance in 'not-for-profit‘ organisations, which of the

following definitions is incorrect?
A. Value for money means providing a service in a way which is economical, efficient and
effective
B. Economy means doing things cheaply: not spending $2 when the same thing can be
bought for $1
C. Efficiency means doing things quickly: minimising the amount of time that is spent on a
given activity
D. Effectiveness means doing the right things: spending funds so as to achieve the
organisation's objectives

Answer: C
Efficiency means doing things well: getting the best use out of what money is spent on.
69

CHAPTER 2: THE ECONOMIC

ENVIRONMENT FOR BUSINESS
 70

Chapter 2: The economic environment for business

Overview graph

Economic environment
for business

Macroeconomic
policies

Other
Competition Supply side
economic
policies policies
policies
 71

I. Macroeconomic policy
1. Target of macroeconomic policy
The macroeconomic policies aim to achieve four main targets for the economy as a whole.

Economic growth
'Growth' implies an increase in national income in
'real' terms. It is usually interpreted as a rising
standard of living.

Control inflation
This means managing price inflation to a low,
stable level. If a country has a relatively high rate
of inflation, then companies in this country can
become less competitive relative (Eg. Its goods are
more expensive) to their international trading
Targets rivals.

Full employment
Unemployment levels are low, and involuntary
unemployment is short term.

Balance of payments stability

It is very difficult for a country to spend more on
imports than it earns from exports for a sustained
period.
Where imports exceed exports, this is often called
a balance of payments deficit, and governments
will often act to correct this situation by
manipulating the exchange rate to switch spending
away from imports and towards exports.
 72

I. Macroeconomic policy
1. Target of macroeconomic policy

1.1 Fiscal policy

1.1.1. Definition

Fiscal policy: Involves using government spending and taxation to manage demand to achieve
macroeconomic targets.

Government spending

A government
might influence
macroeconomic Taxation
conditions by:

Government borrowing

which are linked as follows:

Public expenditure = Taxes raised + Government borrowing (+ Sundry other income)
 73

I. Macroeconomic policy
1. Target of macroeconomic policy

1.1 Fiscal policy

1.1.2. Impacts on business of fiscal policy

Each of these may have a direct impact on a business (e.g. changing the rate of tax on
corporate income), or an indirect impact due to changes to the level of overall demand within
an economy (e.g. increased government spending or lower taxes will boost aggregate demand
and is likely to increase sales).

Terms Contractionary fiscal policy Expansionary fiscal policy

The government either cuts tax

The government either cuts
Activities rates or increases government
spending or raises taxes.
spending.

To slow growth to a healthy

To boost growth and reduce
Targets economic level with stable
unemployment.
inflation.

Impacts Reduce aggregate demand Increase aggregate demand

 74

I. Macroeconomic policy
1. Target of macroeconomic policy

1.1 Fiscal policy

1.1.2. Impacts on business of fiscal policy

Example: Impact on business of fiscal policy

A government has adopted a contractionary fiscal policy.

How would this typically affect market in general?
A. Higher interest rates and higher inflation
B. Lower taxes and higher government subsidies
C. Higher taxes and lower government subsidies
D. Lower inflation and lower interest rates

Solution:
C. Higher taxes and lower government subsidies.
A contractionary fiscal policy implies a government budget surplus – the Government is
reducing demand by withdrawing higher amounts from the economy by way of higher
taxation and/or spending less.
(B) would be the result of an expansionary fiscal policy.
Fiscal policy is the balance of government taxation and spending. (A) and (D) are
connected with monetary policy.
 75

I. Macroeconomic policy
1. Target of macroeconomic policy

1.1 Fiscal policy

1.1.3. Problem with fiscal policy

The problem of ‘crowding out’

Government borrowing leads to a fall in
private investment. This occurs because
increased borrowing leads to higher interest
rates by creating a greater demand for
money and loanable funds and hence a
higher ‘price’.
Two difficulties
associated with
fiscal policy:
The incentive effects of taxation.
Taxes have undesirable side effects on the
economy, notably on incentives.
Eg. High taxes, especially when they are
steeply progressive, act as a disincentive to
work.
 76

I. Macroeconomic policy
1. Target of macroeconomic policy

1.2 Monetary policy

1.2.1. Definition

Monetary policy aims to influence monetary variables such as the interest rate and the money
supply to achieve macroeconomic targets, such as targets for the rate of inflation.

Open market operation: buy or sell bonds

A government
might influence
macroeconomic Changing the interest rate
conditions by:

Changing the reserve requirement

 77

I. Macroeconomic policy
1. Target of macroeconomic policy

1.2 Monetary policy

1.2.2. Impact on business of monetary policy

Interest rate changes brought about by government policy affect the borrowing costs of
businesses:

Increases in interest rates will mean that fewer investments

show positive returns, deterring companies from borrowing
to finance expansion.

Increases in interest rates will also exert downward

Affect the borrowing pressure on share prices, making it more difficult for
costs companies to raise monies from new share issues.

Businesses will also be indirectly affected by decreases in

consumer demand that result from increases in interest
rates.
 78

I. Macroeconomic policy
1. Target of macroeconomic policy

1.2 Monetary policy

1.2.2. Impact on business of monetary policy

Terms Contractionary monetary policy Expansionary monetary policy

The government either sells The government either buys

Activities bonds or increases interest rate bonds or decreases interest
or increases reserve rate or decreases reserve
requirements. requirements.

To slow economic growth and To boost economic growth

Targets
prevent inflation. and more inflation.
 79

I. Macroeconomic policy
1. Target of macroeconomic policy

1.2 Monetary policy

1.2.2. Impact on business of monetary policy

Example: Impact of monetary policy on business

A government follows an expansionary monetary policy. How would this typically affect
market in general?
A. Higher demand from customers, lower interest rates on loans and increased
availability of credit
B. A contraction in demand from customers, higher interest rates and less
available credit
C. Lower taxes, higher demand from customers but less government
subsidies/available contracts
D. Lower interest rates, lower exchange rates and higher tax rates

Solution: A
Monetary policy manages demand by influencing the supply of money and interest
rates. An expansionary policy implies low-interest rates to encourage borrowing and
investment, and to discourage saving. It also implies an increased availability of credit to
encourage spending and the stimulation of demand in an economy.
Tax rates are a tool of fiscal policy, so the (C) and (D) are incorrect.
(B) would be the result of a contractionary monetary policy.
 80

I. Macroeconomic policy
1. Target of macroeconomic policy

1.3 Comparison between fiscal and monetary policy

Terms Fiscal Policy Monetary Policy

Government spending /Tax Interest rates /Open market

Tool
rates operation (buy/sell bonds)

Set by independent Central

Politics Set by Government
Bank

Impact to Demand side Supply side

 81

I. Macroeconomic policy
1. Target of macroeconomic policy

1.4 Exchange rate policy

1.4.1. Definition

An exchange rate is the rate at which one country's currency can be traded in exchange for
another country's currency.

Reasons for a policy of controlling the exchange rate are as follows:

To adjust the balance of the trade deficit, by
1
trying to reduce the exchange rate.

Reasons for a
policy of To prevent a large balance of trade surplus, by
Title 2 trying to bring a limited rise in the exchange rate.
controlling the
exchange rate

3 To stabilize the exchange rate of the

currency, exporters and importers will then
face less risk of exchange rate fluctuations
and lose their profits; a stable currency
increases confidence in the currency and
promotes international trade.
 82

I. Macroeconomic policy
1. Target of macroeconomic policy

1.4 Exchange rate policy

1.4.2. A lower and higher exchange rate

Domestic goods Domestic goods

are cheaper in are more
foreign markets expensive in
so demand for foreign markets
exports so demand for
increases. exports fall.

Foreign goods Foreign goods

are more Low High are cheaper so
Exchange
expensive so demand for
rate
demand for imports rises.
imports falls.

Imported raw Imported raw

materials are materials are
more expensive cheaper so costs
which increases of production
production fall.
costs.
 83

I. Macroeconomic policy
1. Target of macroeconomic policy

1.4 Exchange rate policy

1.4.3. Floating and fixed exchange rates

Terms Floating exchange rates Fixed exchange rates

The exchange rates fluctuate The exchange rate would be kept

Definition according to demand and supply at a fixed level against a major
conditions in the foreign currency or kept within a
exchange markets. specified value range.

Create uncertainties for

Pressure on the country's
Impact businesses involved in
exchange rate to change.
international trade.
 84

I. Macroeconomic policy
1. Target of macroeconomic policy

1.4 Exchange rate policy

1.4.4. Changes in exchange rates

Factors influencing the exchange rate for a currency:

The rate of inflation

A country with a lower inflation rate will see an appreciation in the value of its
currency as its purchasing power increases relative to other currencies, and vice
versa.

Interest rates
Higher interest rates offer lenders a higher return which results in more foreign
capital further leading to an increase in the exchange rate.

The balance of payments

If the price of a country’s exports is greater than their imports, there will be greater
demand for that country’s exports, and in turn, greater demand for the currency.
Then, the value of that country’s exports and currency increase in value, and vice
versa.

Speculation
If speculators believe a currency will rise in the future, they will demand more now
to be able to make a profit. This increase in demand will cause the value of a
currency to rise.

Political
If there is a politically unstable nation, foreign investors will tend to avoid investing
there. As a result, the former country’s economy will experience depreciation in its
currency rate.
 85

II. Additional reading

1. Competition policy

The main targets of competition policy are:

To promote competition.

To make markets work better.

To contribute towards improved efficiency in

individual markets.
 86

II. Additional reading

1. Competition policy

1.1 Market failure

Markets that are not perfectly competitive are considered as the “Market failure”.

Market failure

Imperfect Imperfect
Social costs Equity
competition information

One company’s The impacts on a False The government

large market third party of an information is may also resort to
share is leading economic transaction being put into regulation to
to inefficiency effect society the public improve social
or excessive negative externality. domain and justice.
profit. distorting
These costs may consumer Eg: Concerns about
The state may require regulation. choice. the fairness of
intervene to expensive housing
stimulate Eg: Controls on Eg. Ads making
competition emissions of falso claims
pollutants
 87

II. Additional reading

1. Competition policy

1.2 Competition policy

Government regulatory authorities can be asked to investigate what could be called ‘oligopoly
situations’ involving explicit or implicit collusion between firms, who together control the
market. If a potential merger is investigated, the Government again must determine whether
the merger would be against the public interest.

The Authority must decide whether the monopoly is acting ‘against

the public interest’, including:

The breaking
Price and
Price cuts up of the firm
profit controls
(rarely)
 88

II. Additional reading

2. Supply-side policies

Supply-side policies aim to improve efficiency, motivation, or productive capacity.

Deregulation
Re-training
Allow new firms to
Government schemes to
enter the market –
provide new skill to those
open monopolies to
who lose jobs – productive
competition
capacity

Cutting income tax Privatisation

Greater incentive to work Sell state-owned assets
longer hours – improve to the private sector –
motivation. improve motivation.

Competition policy is another example of a supply-side policies.

 89

II. Additional reading

3. Other economic policies

Corporate governance regulation: Tighter regulation

imposes costs on a business but increases the confidence of
investors and may benefit businesses by making it easier to
attract finance.

Other economic Government assistance for business: Grants may be

policies available to attract firms to invest in depressed areas.

Green policies: The failure of the free market to recognize

positive and negative externalities (e.g. pollution) may lead
to government action; this may either threaten a business
(e.g. tax on petrol so ‘the polluter pays’) or create
opportunities (e.g. subsidies for loft insulation).
90

CHAPTER 3: FINANCIAL
MARKETS AND INSTITUTIONS
 91

Chapter 3: Financial markets and institutions

Overview graph

Financial markets
and institutions

Financial Financial
institutions market

Financial Maturity Purpose of Organisational International

intermediary of claim claim structure financial
markets

Money Primary Exchange-

market market traded Eurocurrency
market
Over the
Capital Secondary
Counter
market market
Market
Eurobonds
 92

I. Financial intermediaries
1. Definition

Financial intermediary: An institution bringing together providers of finance and users of

finance. A financial intermediary links lenders (surplus unit) with borrowers, by obtaining
deposits from lenders and then re-lending them to borrowers (deficit unit).

Investor Deposit Financial Deposit Borrower

(Surplus unit) intermediary (Deficit unit)

Example:

• Retail banks – offer services to general public.

• Investment banks – offer finance, services and advice to large corporate clients.
• Mutual societies – offer banking facilities to its members and those owned by its
members (e.g building societies).
• Institutional investors – such as pension funds, insurance companies, and
investment trusts and unit trusts.
 93

I. Financial intermediaries
2. Roles of financial intermediaries

Financial intermediaries can borrow money

on shorter timeframes than they lend out.
Maturity
They shorten the gap between the wish of
transformation
most investors/lenders for liquidity and of
most borrowers for loans over longer
periods.

As the amount required by borrowers is

usually much larger than an individual
Aggregation of
Functions lender can provide, financial intermediaries
funds
can aggregate smaller deposits into a
larger amount.

Risk for individual lenders is reduced by

spreading funds across a diverse range of
investments and loans.

As financial intermediaries lend to many

individuals and organizations, any losses
Pooling losses
suffered through default by borrowers or
capital losses are effectively pooled and
borne as costs by the intermediary.

Therefore, risky investments may be

reduced for individual investors.
 94

II. Financial markets

Definition

Financial markets: The markets where individuals and organizations with surplus funds lend
funds to other individuals and organizations that want to borrow.

Indirect finance

Funds Funds
Financial
intermediaries

Funds
Lender-savers Borrower-spenders
• Households • Firms
• Firms • Government
• Government Funds • Households
Funds Financial
• Overseas • Overseas
markets

Direct finance

Financial markets can be classified in several ways. We will look at the main classifications
below in turn:
• Capital and money markets – By Maturity of claim;
• Primary and secondary markets – By Purpose of claim; and
• Exchange-traded and over the counter markets – By Organizational structure.
 95

II. Financial markets

1. Capital markets and money markets

There are two types of market-based on the maturity of claim:

• Capital markets are markets for medium-term and long-term capital.

• Money markets are markets for short-term capital.

Year 1 Year 5 Year 10

Short-term Money
markets
Medium-term Capital
markets
Long-term
 96

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

Money markets: Markets for trading short-term financial instruments and short-term lending
and borrowing.

Interest-bearing Derivatives
Discount instruments
instruments

Money market deposits Treasury Bills Futures and Forwards

Certificates of deposit Swaps

Commercial paper
(CD)

Repurchase Agreements
Banker’s acceptance Options
(Repos)

Where an instrument is said to be a negotiable instrument, it means that the instrument is

tradeable and therefore can be sold before maturity.

Money markets play a key role in:

• Providing short-term liquidity to companies, banks and the public sector.
• Providing short-term trade finance.
• Allowing an organisation to manage its exposure to foreign currency risk and interest rate
risk.
 97

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

1.1.1. Interest-bearing instruments

Interest-bearing instruments pay interest and the investor receives face value plus interest at
maturity.

Money market deposits Very short-term loans normally between banks

A certificate of receipt for funds deposited at a financial

institution
Certificate of deposit
Specified term and specified rate on a specified date
(CD)

A negotiable instrument

An agreement between two parties (Repos dealer and

lender)
Repo dealer agrees to sell a financial instrument to the
Repurchase agreements lender on an agreed date at an agreed price
(Repos) Repo dealer will buy back the instrument at a later date
for a higher price

The typical term is up to 180 days

An attractive instrument (it can accommodate a wide

spectrum of short-term maturities)
 98

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

1.1.1. Interest-bearing instruments

Example 1: Repos

A company enters into a repo agreement with a bank and it sells $10,000,000 of
government bonds with an obligation to repurchase the security in 60 days.

Required: If the repo rate is 8.2% what is the repurchase price of the bond?

Solution:

The repurchase price of the bonds is the sale price plus the interest on the cash
received.
60
Interest = $10,000,000 x 0.082 x 365 = $134,794.52

Repurchase price = $10,000,000 + $134,794.52 = $10,134,794.52

 99

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

1.1.2. Discount instrument

Do not pay interest

Discount
They are issued and traded at a discount to
instrument
the face value

They are redeemed at their par value at maturity.

Note:

The discount is equivalent to interest and is the difference between the issue price of the
instrument and the redemption price at maturity.
 100

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

1.1.2. Discount instrument

The debt instruments issued by the Government.
Maturities ranging from one month to one year.
Most are issued with a maturity of 91 days.
Treasury bill To finance short-term cash deficiencies in the
government's expenditure programme.

A negotiable instrument.

Issued by large organisations with good

credit ratings.
Maturity up to 270 days. The typical
term of this debt is 30 or 60 days.
Commercial paper
Short-term unsecured corporate debt, normally
to fund short-term expenditure.

A negotiable instrument.

Sold by and guaranteed by a bank on behalf of a

company.
Maturity of up to 180 days.
Bank bills or banker’s
acceptance (BAs) To finance commercial transactions, such as
imports or the purchase of goods.

A negotiable instrument.
 101

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

1.1.2. Discount instrument

Example 2: Discount instrument

A bill with a face value of $100 is issued at a price of $98.50 and redeemed at maturity
at the face value of $100.00 in one years’ time (assume 360 days).

Required:
(a) Calculate the annualized yield on this bill.
(b) Calculate the annualized yield if this bill was due to mature in 120 days’ time.

Solution:
(a) The discount of $1.50 ($100 – $98.5) represents interest on the investment of $98.50.
This is an interest rate of 1.5 ÷ 98.5 × 100 = 1.52% per year (assuming that the bill is
redeemed in one years’ time).
(b) If the bill was redeemable in 120 days’ time, and assuming a 360-day year,
The annual implied interest rate is calculated as: 1.52% × 360/120 = 4.56%.
 102

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

1.1.3. Derivatives

These instruments derive their value from the value of another asset or variable such as
exchange rates and interest rates. Examples of derivatives include forward futures, options
and swaps. A summary of the derivatives is given in the following mind map (derivatives
instruments are discussed in Chapter 17 and Chapter 18).

Derivatives

Forward Future Option Swap

• Fix date • Fix date

Buyer Seller • Exchange
• Fix price • Fix price
the cash
• Transaction • Transaction
Have flows or
on Over the on Exchange Independent
right liabilities.
count (OTC) trade with buyer
and no • From two
• Buyer, seller • Buyer, seller
obligati different
have both have both
on to financial
right & right &
exercise instruments
obligation obligation
 103

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

1.1.4. Risk and return

Higher risk investments require a higher return to be paid and instruments that are non-
negotiable require a higher return because they cannot be sold on.

Treasury bills (issued by governments)

Increasing of risk

Certificates of deposit (shows an entitlement to a deposit)

Commercial paper (issued by companies with a high credit rating)

Banker’s acceptance (higher risk unless guaranteed or ‘accepted’ by a

bank).
 104

II. Financial markets

1. Capital markets and money markets

1.1 Money markets

1.1.4. Risk and return

Example 3: Hoddor Co is a large company and frequently participates in the money

markets as both a lender and borrower.

Required: Indicate which of the following instruments are described in the box below.

Repurchase agreement Money market deposit Commercial paper

Instruments
1 Hoddor Co makes a short-term deposit to a bank. The interest rate has been
agreed in advance along with the maturity date
2 Hoddor Co sells an unsecured debt instrument that matures in 180 days, after
which it redeems the instrument at face value.
3 Hoddor Co sells some shares to Cersei Co for $1m on 1 May 20X6 and agrees to
buy the shares back from Cersei Co for $1.05m on 1 November 20X6.

Solution:
1: Money market deposit
2: Commercial paper
3: Repurchase agreement
 105

II. Financial markets

1. Capital markets and money markets

1.2 Capital markets

Capital markets: Markets for raising medium or long-term finance, in the form of medium or
long-term financial instruments such as equities and corporate bonds or loan notes.

1.2.1. Types of capital market instruments

Firms obtain capital in one of the following ways:

By issuing debt capital.

By issuing share capital. Debt capital might be
Most new issues of raised in the form of loan
share capital are in the notes which commit to
form of ordinary share paying interest over a
capital. E.g. ordinary significant period,
share, preference share, normally 5 years or more.
etc. E.g. long-term loan,
bonds, convertible bonds,
junk bonds, etc.

We will look at sources of long-term finance in more detail in Chapter 11 Source of finance.
 106

II. Financial markets

1. Capital markets and money markets

1.2 Capital markets

1.2.2. Risk and return

Not all capital market instruments offer the same return to investors, higher-risk investments
require a higher return to be paid.

Bonds/loan notes (secured on an asset or by

covenants)
Increasing of risk

Junk bonds (unsecured)

Preference share

Ordinary share
 107

II. Financial markets

2. Primary and secondary markets

Primary markets are where the company issues new shares or new bonds to the investors.

Secondary markets are where those securities are traded by investors.

Terms Primary markets Secondary markets

Enable organizations to raise Enable investors to buy and sell

Purpose existing investments to each
new finance
other

Parties Companies and the investors Investors and investors

Decided by the demand and

Price Decided by companies
supply of securities
 108

II. Financial markets

3. Exchange-traded and over the counter markets
Based on organizational structure, financial markets may be divided into exchange–traded
market and over the counter (OTC) market.

Terms Over the counter Exchange-traded market

Wherein trading of stocks takes place

Wherein brokers and dealers
Meaning between buyers and sellers in a safe,
transact directly
transparent and systematic manner

A decentralized dealer A regulated market

Market
market

Used by Small companies Well established companies

Contract Customized Standardized

Secondary markets can operate as over the counter (OTC) markets, where transactions do not
involve buying and selling through an exchange, but customers negotiate individual
transactions, usually with a financial intermediary such as a bank.
 109

II. Financial markets

4. Securitization

Securitization: the process of converting illiquid assets into marketable securities.

These securities are backed by specific assets and are normally called asset-backed securities
(ABS). The oldest and historically most common type of asset securitization is the mortgage-
backed bond or security (MBS). Very simplistically, the process is as follows:

A financial entity can purchase a number of mortgage loans from banks.

The entity pools the mortgage loans together.

The entity issues bonds to institutional investors. The money raised from issuing the bonds
is used to pay for the mortgage loans.

The institutional investors now have the right to receive the principal and interest payments
made on the mortgage.
 110

II. Financial markets

4. Securitization

Today, virtually anything that has a cash flow (for example, a loan, a public works project, or a
receivable balance) is a candidate for securitization.

The development of securitization has led to disintermediation and a reduction in the role of
financial intermediaries, as borrowers can reach lenders directly.

Disintermediation describes a decline in the traditional deposit and lending relationship

between banks and their customers and an increase in direct relationships between the
ultimate suppliers and users of financing.

Example:

Once banks have securitized mortgages and sold them on, they have been removed from
the link between lender and borrower.
 111

III. International financial markets

1. Eurocurrency market

1.1 Definition

Eurocurrency is the currency that is held by individuals and institutions outside the country of
issue of that currency.

Example:

If a UK company borrows US$50,000 from its UK bank, the loan will be a ‘eurodollar’
loan.

Note:

The term “eurocurrency” is a generalization of the eurodollar and should not be confused with
the EU currency, the euro. The eurocurrency market functions in many financial centers around
the world, not just in Europe.
 112

III. International financial markets

1. Eurocurrency market

1.2 Types of eurocurrency

Eurodollars were the first eurocurrency, they still have the

Eurodollar
most influence.

The offshore Euroyen market was established in the 1980s

Euroyen
and expanded with Japan's economic influence.

There is an active bond market for countries, companies, and

Eurobond financial institutions to borrow in currencies outside of their
domestic markets.
 113

III. International financial markets

2. Eurobond

Eurobond: A bond denominated in a currency which often differs from that of the country of
issue.

Eurobond market

Borrowing of funds

Depositing funds

Long-term, typically between 10 and 20 years

114

CHAPTER 4: WORKING CAPITAL

INVESTMENT
 115

Chapter 4: Working capital investment

Overview graph

Working capital investment

Nature of Working capital Working capital

working capital planning investment policy

Over
Working capital Influences
capitalization

Objectives Ratios Overtrading

Cash operating
cycle
 116

I. The nature of working capital

1. Definition

Working capital: The working capital of a business is its current assets less its current liabilities.

Net working capital = Current assets - Current liabilities

Example: Common components of working capitals

Current assets Current liabilities

Cash Overdraft
Inventory Short-term loans
Amounts receivable from customers Amounts payable to suppliers
 117

I. The nature of working capital

2. Objectives of working capital management

Working capital management has two main objectives:

Profitability: Liquidity:
to increase the To ensure sufficient
profits of a business liquidity to meet
short-term obligations
as they fall due
 118

I. The nature of working capital

2. Objectives of working capital management

2.1 Profitability

If a business operates with excessively low levels of working capital, then this may lead to
trading problems and lower profits.

Example: Examples of problems of operating with excessively low working capital

Low inventory A business does not have enough inventory to meet peaks in
demand, leading to increase in lead time and lost sales.
Low receivables If this means that a business’s credit terms are quite strict and its
customers are not enjoyed long credit periods, this may lead to
lost sales.

2.2 Liquidity

Every business needs adequate liquid resources to maintain day-to-day cash flow such as wages
and payments to suppliers.

Example:
If money is tied up in short-term assets such as inventory and receivables, this may cause
liquidity problems. Liquidity can be maintained by ensuring that the amounts of cash tied
up in inventory and receivables is not excessive.
 119

I. The nature of working capital

2. Objectives of working capital management

2.3 Conflict between objectives of liquidity and profitability

The objectives of liquidity and profitability may conflict (not always).

Profitability Liquidity

Decrease Inventory level Increase

Receivable balances
Decrease Increase

Investment in working capital

Decrease Increase

Example:

If the levels of inventory and receivables are high because working capital is not being
managed well, then improved management of the warehouse (to keep inventory lower)
and credit control (to keep receivables lower) may allow both higher liquidity and higher
profitability.
 120

II. Working capital planning

1. Influences on the level of investment in working capital

Influences on working capital investment

General factors Specific factors

Nature of the Seasonal Aggressive Conservative

Competitors
industry factors strategy strategy

Eg: A company There may This Reduce

Supermarket will be be a need of prioritizes trading
will receive unwilling to higher liquidity but problems
lots of cash lose inventory as may create (eg stock-
sales; business to a a season of trading outs) but
It will operate rival offering peak sales problems may
with minimal its approaches compromise
receivables. customers liquidity.
more
favorable
credit
terms.
 121

II. Working capital planning

2. Planning overall working capital needs

2.1 Working capital ratios

2.1.1. Liquidity ratio

Refer to II.6.2. Debt and gearing Chapter 1

Current ratio: The current ratio is the standard test of liquidity.

Current assets
Current ratio =
Current liabilities

Current ratio in excess of 1 implies that the organisation has enough cash and near-cash assets
to satisfy its immediate liabilities.

The quick ratio:

We calculate an additional liquidity ratio, known as the quick ratio or acid test ratio.

Current assets − Inventory

Quick ratio or Acid test ratio =
Current liabilities

For companies with a fast inventory turnover, a quick ratio can be less than 1 without
suggesting that the company is in cash flow difficulties.
 122

II. Working capital planning

2. Planning overall working capital needs

2.1 Working capital ratios

2.1.2. Turnover

Refer to II.6.3. Working capital efficiency Chapter 1

The accounts receivable payment period:

• This ratio measures the length of time taken to collect receivables from customers.
• The trade accounts receivable are not the total figure for accounts receivable in the
statement of financial position, which includes prepayments and non-trade accounts
receivable. The trade accounts receivable figure will be itemized in an analysis of the total
accounts receivable, in a note to the accounts.

Therefore, the estimate of accounts receivable days is only approximate.

Trade receivables
Accounts receivable days = × 365 days
Credit sales revenue
 123

II. Working capital planning

2. Planning overall working capital needs

2.1 Working capital ratios

2.1.2. Turnover

Refer to II.6.3. Working capital efficiency Chapter 1

The inventory turnover period

These indicate the average number of days that items of inventory are held for. As with the
average accounts receivable collection period, these are only approximate figures.

Average inventory
Inventory turnover period = ×365 days
COS

The inventory turnover period can also be calculated:

Average inventory
Inventory turnover period (finished goods) = ×365 days
COS
Average raw materials inventory
Raw materials inventory holding period = ×365 days
Annual purchase
Average WIP
Average production (work−in−progress) = ×365 days
COS
 124

II. Working capital planning

2. Planning overall working capital needs

2.1 Working capital ratios

2.1.2. Turnover

Refer to II.6.3. Working capital efficiency Chapter 1

The accounts payable payment period

This ratio often helps to assess a company's liquidity; an increase in accounts payable days is
often a sign of lack of long-term finance or poor management of current assets, resulting in the
use of extended credit from suppliers, increased bank overdraft, and so on.
Average trade payables
Accounts payable days = ×365 days
Purchases or Cost of sales

Note:

All the ratios calculated above will vary by industry; hence comparisons of ratios calculated
with other similar companies in the same industry are important.

2.1.3. Sales to net working capital ratio

This shows the level of working capital (excluding cash) required to support sales.

Sales revenue
Sales/net working capital =
Receivables + Inventory − Payables
 125

II. Working capital planning

2. Planning overall working capital needs

2.1 Working capital ratios

Example: Working capital ratios

Calculate working capital ratios from the following accounts of a manufacturer of products
for the construction industry, and comment on the ratios. 20X3 20X2
$m $m
Sales revenue 2,065.0 1,788.7
Cost of sales 1,478.6 1,304.0
Gross profit 586.4 484.7
Current assets
Inventories 119.0 109.0
Accounts receivable (note 1) 400.9 347.4
Short-term investments 4.2 18.8
Cash at bank and in hand 48.2 48.0
572.3 523.2
Accounts payable: amounts falling due within one year
Loans and overdrafts 49.1 35.3
Corporation taxes 62.0 46.7
Dividend 19.2 14.3
Accounts payable (note 2) 370.7 324.0
501.0 420.3
Net current assets 71.3 102.9
Notes
1. Trade accounts receivable 329.8 285.4
2. Trade accounts payable 236.2 210.8
 126

II. Working capital planning

2. Planning overall working capital needs

2.1 Working capital ratios

Solution:

20X3 20X2
Current ratio 572.3/501 = 1.14 523.2/420.3 = 1.24

Quick ratio (572.3-119)/501 = 0.9 (523.2-109)/420.3 = 0.99

Accounts receivable days 329.8/2,065 x 365 = 58 days 285.4/1,788.7 x 365 = 58 days

Inventory turnover period 119/1,478.6 x 365 = 29 days 109/1,304 x 365 = 31 days

Accounts payable days 236.2/1,478.6 x 365 = 58 days 210.8/1,304 x 365 = 59 days

Sales/net working capital 2,065/(572.3 – 501) = 28.96 1,788.7/(523.2 - 420.3) = 17.38

 127

II. Working capital planning

2. Planning overall working capital needs

2.2 The cash operating cycle

Cash operating cycle = Inventory days + Receivable days − Payable days

Purchases Sales Receipt cash

Inventory days Receivable days

Payable days Cash operating cycles

Pay cash

The cash operating cycle measures the length of time (in days, weeks or months), following the
receipt of a customer order for:

• Cash to be received: measured as inventory days plus receivables days.

• Cash to be paid out to suppliers: measured as payables days.
 128

III. Working capital investment policy

1. Over capitalization

Over capitalization: A situation where there are excessive stocks, debtors and cash, and very
few creditors, there will be an over investment in current assets.

Sales/working Compare with previous years or similar

capital companies. A low or falling ratio may
indicate over-capitalization.

Indicators of Compare with previous years or similar

over Liquidity ratios companies. A high or rising ratio may
capitalization indicate over-capitalization.

Long turnover periods for inventory and

Turnover
accounts receivable or; Short credit
periods
period from suppliers may be unnecessary.
 129

III. Working capital investment policy

2. Overtrading

Overtrading: A situation where a business has inadequate cash to support its level of sales (also
known as undercapitalization)

The indicators of overtrading:

Sales revenue and profit margins Receivables and inventory

Compare with previous
Compare with previous
years or similar companies.
years or similar companies.
A rapid increase in
A rapid increase in sales
receivables and inventory
revenue and falling in
may indicate overtrading.
profit margins may
indicate overtrading.

Liquidity ratios Trade payables and overdraft

Worsening liquidity Compare with previous years
ratios causing a or similar companies.
significant increase A rapid increase in trade
in the operating payables and a rising
cycle. overdraft may indicate
liquidity problems.
 130

III. Working capital investment policy

2. Overtrading

Example 3: Overtrading

Emily's business is three years old. Her annual turnover is $200,000 and her annual profit is
$18,000. She operates with a bank overdraft of up to $25,000. Her working capital is
sufficient to steadily expand the business.
Emily succeeds in winning a contract to supply Business A. The order is for $40,000 a
month for two years. She will be paid 75 days after delivery.
She rings her suppliers. She orders everything that she will need to fulfil the contract in the
first few months. She tells them all to deliver everything as soon as possible.

The first month

Things go very well. All the suppliers start delivering as promised. The only problem is that
she is short of space.

The second month

Things still look good. She has made the first delivery to Business A. She increases her
overdraft.
 131

III. Working capital investment policy

2. Overtrading

Example 3: Overtrading

The third month

Emily has problems. She has made more deliveries to Business A but her overdraft is at the
limit. She is getting calls from unpaid suppliers.

The fourth month

Emily has a crisis. She cannot pay all her suppliers. Some have stopped delivering and are
threatening legal action. She thinks that she will be fine because she is still supplying
Business A.

The fifth month

Her overdraft is $4,000 over the limit. Three suppliers start legal action. The bank refuses
to pay any more cheques. But her first payment from Business A arrives on time.

The sixth month

The next Business A payment does not arrive on the due day. She cannot fulfill any more
orders. The bank demands that the overdraft be repaid within seven days.
Emily closes the business and blames the bank. However, if timings and payments of
deliveries from suppliers and to customers had been negotiated and regulated more
successfully beforehand and at the start, the closure may have been avoided.
132

CHAPTER 5: MANAGING
WORKING CAPITAL
133

Chapter 5: Managing working capital

Overview graph

Managing working
capital

Managing Managing accounts Managing

inventory receivable accounts payables

Objectives of Objectives of Objectives of

inventory account receivables account payables
management management management

Economic order Evaluating

Credit policy
quantity (EOQ) discounts

Calculating the Managing foreign

Related calculations
reorder level (ROL) account payables

JIT inventory
Invoice discounting
management
and factoring
system

Managing foreign
account receivables
 134

I. Managing inventory
1. The objectives of inventory management

It is essential for companies, especially manufacturing ones carrying inventory equivalent to

between 50% - 100% of the revenue, to reduce the levels of inventory held to the necessary
minimum for the efficiency of managing working capital.

Cost of carrying inventory

At high inventory level At low inventory level

Once goods are Interruptions to the

Purchase purchased, capital is tied Stockout production, idle time,
costs up in them until sold on, stockpiling of WIPs, possibly
capital earns no return. miss orders…
New supplies must be
Opportunity cost
acquired when inventory
associated with the
Storage and runs out. If the goods are
alternative uses the Reorder
stores bought in, the costs arise are
space could be put to / setup
administration associated with
Additional requirements costs
administration (purchase
for storage requires extra
requisition, authorisation
funds. order…)

Staff required to manage the

If only small amounts are
warehouse and protect
bought at one time in order
Extra costs against theft Opportunity
to keep inventory levels low,
incurred Significant investment may cost
the quantity discounts will
require sophisticated
not be available.
inventory control systems.
 135

I. Managing inventory
1. The objectives of inventory management
Objective of good inventory management is:

Liquidity
Reducing inventory to the lowest possible
amount to minimise the level of capital
employed to be funded.

Profitability
Ensuring that sufficient inventory is held so
that it does not run out and disrupt business.

The optimum re-order quantity – how

many items should be ordered when
the order is placed (Refer to 2.
The objective of Economic order quantity (EOQ)).
good inventory
management is
therefore to
determine: The optimum re-order level – how
many items are left in inventory when
the next order is placed (Refer to 3.
Calculating the re-order level (ROL)).
 136

I. Managing inventory
2. Economic order quantity (EOQ)

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

The EOQ model links the order quantity placed with a supplier to inventory related costs.

2.1 Inventory related costs

Holding costs increase

The order size increases Ordering costs decrease

Purchasing costs may decrease if bulk

discounts are offered (although discounts are
ignored by the simple EOQ model)

Example:
Holding costs: Warehousing, insurance, obsolescence, and opportunity cost of capital.
Ordering costs: Costs of administering orders, and delivery costs.
Purchasing costs: The amount paid for purchases from suppliers.
 137

I. Managing inventory
2. Economic order quantity (EOQ)

2.1 Inventory related costs

2.1.1. Holding costs

Holding cost can be calculated as:

Holding cost per unit × Average inventory
q
Annual holding cost = CH ×
2

Where:
• CH – holding cost of a unit for a year
• q – re-ordered quantity

The model assumes that it costs a certain amount to hold a unit of inventory for a year (referred
to as CH in the formula).
 138

I. Managing inventory
2. Economic order quantity (EOQ)

2.1 Inventory related costs

2.1.1. Holding costs

Specifically, the formula above can be illustrated as graph 1 and graph 2 below:

Graph 1: What is q/2?

Inventory
(units)

Order q
quantity

Average
quantity

0
Time
• If a firm orders an amount (q) from a supplier, holds zero opening inventory and receives
the order immediately then the level of inventory at the start of the period is q.
• By the end of the period, we can assume that the inventory level has been run down to
zero.
 The average inventory level with the above assumptions is (starting inventory + closing
inventory)/2 which can be expressed as q/2
 139

I. Managing inventory
2. Economic order quantity (EOQ)

2.1 Inventory related costs

2.1.1. Holding costs

Graph 2: Linear holding costs

Annual cost

Holding
costs

Re-order quantity

As the average level of inventory increases, so too will the total annual holding costs incurred.
We, therefore, see an upward sloping, linear relationship between the reorder quantity and
total annual holding costs.
 140

I. Managing inventory
2. Economic order quantity (EOQ)

2.1 Inventory related costs

2.1.2. Ordering costs

Annual cost

Ordering costs

Re-order quantity

The model assumes that a fixed cost is incurred every time an order is placed (referred to as CO
in the formula in next slide). Therefore, as the order quantity increases, there is a fall in the
number of orders required, which reduces the total ordering cost.
However, the fixed nature of the cost results in a downward sloping, curved relationship.
 141

I. Managing inventory
2. Economic order quantity (EOQ)

2.1 Inventory related costs

2.1.2. Ordering costs

If D is the annual expected sales demand, the annual order cost is calculated as:

Order cost per order × no. of orders per annum.

D
Annual ordering cost = C0 ×
q

Where:
• D – the annual expected sales demand
• q – re-ordered quantity
• CO – Order cost per order

2.1.3. Purchasing costs

If order size affects the purchase price, purchasing costs will need to be considered.

Purchasing costs are calculated as:

Annual demand × purchase price of one unit

Annual purchasing cost = D x P

Where:
• D – the annual expected sales demand
• P – Purchase price per unit
 142

I. Managing inventory
2. Economic order quantity (EOQ)

2.2 EOQ formula

In EOQ model, we are trying to minimise inventory related costs, in which:

Increase as re-order quantity

Holding costs
increases (Refer to 2.1.1).

Decreases as re-order quantity

Related costs Ordering costs
increases (Refer to 2.1.2).

is neglected as EOQ based on

assumptions that “purchase price is
Related costs
constant” ie. Order size does not
affect purchase price.

⇨ We have to try to balance between “holding costs” and “ordering costs”. Total cost will
always be minimised at the point where the total holding costs equals the total ordering
costs. When the re-order quantity chosen minimises the total cost of holding and ordering,
it is known as the EOQ.
 143

I. Managing inventory
2. Economic order quantity (EOQ)

2.2 EOQ formula

Annual
cost Total
Holding
costs
costs

Ordering costs

EOQ Re-order quantity

 144

I. Managing inventory
2. Economic order quantity (EOQ)

2.2 EOQ formula

The EOQ can be more quickly found using a formula (given in the examination):

2C0 D
EOQ =
CH

Where:
• C0 – cost per order
• D – annual demand
• CH – cost of holding one unit for one year

1 Demand and lead-time are constant and known

EOQ
Title 2 Purchase price is constant
assumptions

3 No buffer inventory held (not needed)

 145

I. Managing inventory
2. Economic order quantity (EOQ)

2.3 Bulk purchases discount

If bulk purchase discounts are available, the simple EOQ formula cannot be used and we need
to adjust our approach as follows:
Step 1

Calculate EOQ, ignoring discounts

Step 2

If the EOQ is below the quantity qualifying for a discount, calculate the total annual inventory
cost arising from using the EOQ

Total annual inventory cost =

purchase costs (D × P) + ordering costs ( CO× D/q) + holding costs ( CH × q/2)

Step 3

Recalculate total annual inventory costs using the order size required to just obtain each
discount. Take the available discount into account within the purchase costs

Step 4

Compare the totals from steps 2 and 3 and select the lowest cost option.
 146

I. Managing inventory
2. Economic order quantity (EOQ)

2.4 Drawbacks of EOQ model

Assumes zero lead times, and no bulk purchase discounts.

1

Ignores the need to increase order sizes if there is a

2 possibility of supplier shortages or price rises.

Ignores the possibility of fluctuations in

Drawbacks 3
demand (the order quantity is constant).

4 Ignores the benefit of holding inventory to

customers.
5 Ignores the hidden costs of holding inventory.
 147

I. Managing inventory
3. Calculating the re-order level (ROL)

Having decided how much inventory to re-order, the next problem is when to re-order.
To discuss further into ROL, we need to recap some key terms with inventory management.

How many items are left in inventory when the next order is
Re-order level placed?

How many items should be ordered when the order is

Re-order level placed?

The lag between when an order is placed and the item is

Lead time
delivered

Buffer inventory The basic level of inventory kept for emergencies.

 148

I. Managing inventory
3. Calculating the re-order level (ROL)

The re-order level can be decided based on:

Certainty about
demand and lead ROL = Demand in the lead time
time
Re-order
level (ROL)

Uncertainty about ROL = Maximum usage x

demand or lead time Maximum lead time

Optimum level of buffer

inventory must be found
 149

I. Managing inventory
3. Calculating the re-order level (ROL)

3.1 Maximum and buffer safety inventory level

Maximum = Re-order + Re-order – (Minimum usage x minimum lead time)

inventory level level quantity

The maximum level acts as a warning signal to management that inventories are reaching a
potentially wasteful level.

Minimum inventory/ Re-order

= – (Average usage x average lead time)
buffer safety inventory level

The buffer safety level acts as a warning to management that inventories are approaching a
dangerously low level and that stock-outs are possible.

Average inventory (*) = Buffer safety inventory + (Re-order quantity/2)

This formula assumes that inventory levels fluctuate evenly between the buffer safety (or
minimum) inventory level and the highest possible inventory level.
(*) Average inventory here is different from “the average inventory level” mentioned in 2.1.1.
Average inventory level in 2.1.1 is based on assumption for calculating holding costs only.
 150

I. Managing inventory
4. Just-in-time (JIT) inventory management system

Just-in-time (JIT) is a philosophy which involves the elimination of inventory

JIT procurement JIT production

Obtaining goods from suppliers at the Manufacturing to orders

latest possible time (i.e. when they As orders are received, manufacturing
are in need). is triggered to fulfil those orders.

Better product customisation

Avoiding the need to carry any
No risk of obsolescence
materials or components as inventory
Few holding costs

It allows a firm to JIT will not be

compensate for appropriate if
inefficient processes Benefit Drawback production processes
by holding buffer and suppliers are
inventory unreliable
 151

II. Managing accounts receivables

1. The objectives of account receivables management

Account receivables management is the key trade-off between two main following factors:

Account receivables
management

Collects sales receipts as

Extends the credit period
quickly as possible to
to customers to encourage
reduce the cost of financing
additional sales.
the receivables balance.

Liquidity Profitability
 152

II. Managing accounts receivables

2. Credit policy

A firm must establish a policy for credit terms given to its customers. A lenient credit policy may
well attract additional customers but at a disproportionate increase in cost.

A credit policy has four key aspects:

Assess creditworthiness

Credit limits

4 key aspects

Invoice promptly and collect overdue debts

Monitor the credit system

 153

II. Managing accounts receivables

2. Credit policy

2.1 Assess creditworthiness

To minimize the risk of irrecoverable debts occurring, a company should:

Investigate the creditworthiness of all new

01
customers (credit risk)

Review that of existing customers from

02 time to time, especially if they request
that their credit limit should be raised
 154

II. Managing accounts receivables

2. Credit policy

2.1 Assess creditworthiness

Information about a customer’s credit rating can be obtained from a variety of sources. These
include:

Bank references Trade references

A customer’s permission Suppliers already giving credit to
must be sought the customer can give useful
information about how good the
customer is at paying bills on time

Competitors Published information

In some industries such The customer’s annual
as insurance, Assess accounts and reports will
competitors share creditworthiness give some idea of the
information on general financial position of
customers, including the company and its
creditworthiness liquidity

Company’s sales records Credit scoring

For an existing customer, the Indicators such as family
sales ledgers will show how circumstances, home
prompt a payer the company is ownership, occupation and age
can be used to predict likely
creditworthiness
 155

II. Managing accounts receivables

2. Credit policy

2.2 Credit limits

Credit limits should be set to reflect

Length of time allowed before

Amount of credit available
payment is due

The ledger account should be monitored to take account of orders in the pipeline as well as
invoiced sales, before further credit is given, to ensure that limits are not breached.
 156

II. Managing accounts receivables

2. Credit policy

2.3 Invoice promptly and collect overdue debts

A credit period only begins once an invoice is received so prompt invoicing is essential.

If debts go overdue, the risk of default increases, therefore a system of follow-up procedures is
required.

Reminder These are often regarded as being a relatively poor way of obtaining
letter payment, as many customers simply ignore them.

These are more expensive than reminder letters but where large
Telephone
sums are involved, they can be an efficient way of speeding up
calls
payment.

Withholding Putting customers on the ‘stop list’ for further orders or spare parts
supplies can encourage rapid settlement of debts.

These offer debt collection services on a fixed fee basis or on ‘no

Debt
collection no charge’ terms. The quality of service provided varies
collectors
considerably and care should be taken in selecting an agent

This is often seen as a last resort. A solicitor’s letter often prompts

payment and many cases do not go to court. Court action is usually
Legal action
not cost effective but it can discourage other customers from
delaying payment.
 157

II. Managing accounts receivables

2. Credit policy

2.4 Monitoring the credit system

Management will require regular information to take corrective action and to measure the
impact of giving credit on working capital investment.

Age
Age analysis of oustanding debts
analysis

Methods Compared with the previous period or target,

of Ratio to indicate trends in credit levels and the
monitoring incidence of overdue and irrecoverable debts

To identify causes of default and the incidence of

Statistical irrecoverable debts among different classes of
data customer and types of trade
 158

II. Managing accounts receivables

3. Calculations related to managing accounts receivables

3.1 Costs of financing receivables

Finance cost = Receivable balance x Interest (overdraft) rate

Where:
Receivable balance = Credit sales x (Receivable days/365)
 159

II. Managing accounts receivables

3. Calculations related to managing accounts receivables

3.2 Early settlement discounts

Cash discounts are given to encourage early payment by customers. The cost of the discount is
balanced against the savings the company receives from having less capital tied up due to a
lower receivables balance and a shorter average collection period.

3.2.1. Approach 1

The percentage cost of an early settlement discount to the company giving it can be estimated by
the formula:
365
100 t
−1 %
(100 − d)

Where:
• d = the discount offered
• t = the reduction in the payment period in days that is necessary to obtain the early payment
discount

Note:

• The annual cost calculation is always based on the amount left to pay, i.e. the amount net
of discount.
• If the cost of offering the discount exceeds the rate of overdraft interest then the discount
should not be offered.
 160

II. Managing accounts receivables

3. Calculations related to managing accounts receivables

3.2 Early settlement discounts

3.2.2. Approach 2

In many scenarios, you may be provided with more in-depth information. In these situations, it
is necessary to perform a longer calculation. The calculation involves comparing the monetary
cost of offering the discount with the benefit that will be received.

The benefit is a reduction in the receivables balance, which will result in a higher cash balance,
thereby reducing interest payable (say, on an overdraft balance). The value can be found by
following steps:

• Calculate the current level of receivables & receivables days

Step 1 • Calculate the cost of financing current level of receivables and receivables
days

• Calculate the new level of receivables & receivables days

Step 2
• Calculate the cost of financing this new level

• Compare the old cost (step 1) with the new cost (step 2) to determine the
Step 3
benefit
 161

II. Managing accounts receivables

4. Invoice discounting and factoring
Invoice discounting and factoring are both ways of speeding up the receipt of funds from
accounts receivable.

4.1 Invoice discounting

Invoice discounting is the purchase (by the provider of the discounting service) of trade debts
at a discount. Invoice discounting enables the company from which the debts are purchased to
raise working capital.

The typical arrangement can be illustrated as below:

(1) The company sells goods

to the customer payable in
30 days
Company Customer
(3) The company receives
payment
(4) The company pays (2) The company
the invoice borrows up to 80% of
discounter the the value of the debt
amount borrowed
plus interest Invoice
discounter

With invoice discounting, the business retains control over its sales ledger, and confidentiality
in its dealings with customers. Firms of factors will also provide invoice discounting to clients.
 162

II. Managing accounts receivables

4. Invoice discounting and factoring

4.2 Factoring

Factoring is an arrangement to have debts collected by a factor company, which advances a

proportion of the money it is due to collect.

The main aspects of factoring include the following:

Credit protection for the

client's debts, whereby
Administration of the the factor takes over the
client's invoicing, sales risk of loss from bad
accounting and debt debts and so 'insures'
collection service the client against such
losses (*). This is non-
recourse service.

Making payments to the client

in advance of collecting the
debts.

Note:
Please be sure to differentiate two types of factor services:
Non-recourse: The factor takes all the risk ≠ Recourse: The client, not the factor, still
of loss from bad debts bears the risk of loss from bad debts
 163

II. Managing accounts receivables

4. Invoice discounting and factoring

4.2 Factoring

Typical factoring arrangements are:

• Administration and debt collection

• Administration and debt collection include financing

Administration and debt collection

(1) The company sells goods to

the customer payable in 30 days
Company Customer

(2) The company

factors the debt
(3) The customer
(4) The factor pays pays the factor
the company after after 30 days
deducting the
amount of Factor
administration fee
 164

II. Managing accounts receivables

4. Invoice discounting and factoring

4.2 Factoring

Including financing

(1) The company sells goods to the

customer payable in 30 days

Company Customer

(3) Up to 80% of the

(2) The debt is paid to the
company company in advance
sells the debt (4) The customer
to the factor pays the factor
after 30 days

(5) The factor pays the

company the balance Factor
less an administration
fee and finance fee
165

II. Managing accounts receivables

5. Managing foreign accounts receivables

Foreign debts raise the following special problems:

It may be harder to build an accurate credit analysis of a company in a distant

country

It may be harder to chase foreign customers for payments (different time zones
and languages)

If a foreign debtor refuses to pay a debt, the exporter must pursue the debt in the
debtor’s own country and may lack an understanding of the procedures and laws
of that country
 166

II. Managing accounts receivables

5. Managing foreign accounts receivables

However, there are several measures available to exporters to help overcome the risks of non-
payment or late payment on larger transactions.

Bill of exchange
An IOU is signed by the customer. Until it is
paid, shipping documents that transfer
ownership to the customer are withheld.
Letter of credit
The customer’s bank guarantees it
will pay the invoice after delivery of
the goods.
Methods of
reducing risks
Invoice discounting
Sale of selected invoices to a debt factor,
at a discount to their face value.

Debt factoring
A local debt factor based in the export market can be
especially useful in performing credit analysis and
chasing for payment.
 167

III. Managing accounts payables

1. The objectives of account payables management

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

Again, it is a balancing act between liquidity and profitability.

Account payables
management act

Delaying payments to suppliers Delaying too long may cause

to obtain a “free” source of difficulties for the company in
finance the long- term

Liquidity Profitability
 168

III. Managing accounts payables

2. Evaluating discounts

Accepting early settlement discounts from a supplier will result in a benefit (the discount) but
will result in lower payables which will incur a cost to the company by increasing the cost of
the interest charged on an overdraft since money is being paid to suppliers earlier.

This can be assessed by:

Benefit of the
discount

Comparing

The cost of higher finance costs

associated with lower payables.

It can be done using the same techniques we saw under accounts receivable. Refer to II.3.2.2
 169

III. Managing accounts payables

2. Evaluating discounts

In other ways, the cost of lost cash discounts can be calculated by comparing the saving from
the discount with the opportunity cost of investing the cash used.

The cost of lost cash discounts can also be estimated by the formula:

365
100 t
−1 %
(100 − d)

Where:
• d is the % discount, d = 5 for 5%
• t is the reduction in the payment p eriod in days which would be necessary to obtain the
early payment discount, final date to obtain discount – final date for payment

3. Managing foreign accounts payables

To avoid the risk of an adverse exchange rate movement by the time a foreign currency
invoice is due to be paid, companies sometimes pay the invoice early. This is sometimes called
leading.

The management of exchange rate risk is covered in Chapter 17 – Foreign currency risk.
170

CHAPTER 6:
CASH MANAGEMENT AND
WORKING CAPITAL FINANCE
171

Chapter 6: Cash management

and working capital finance
Overview graph

Motivation of holding cash

Technique for cash management

Cash management
Treasury management

Cash management models

Long-term and short-term finance

Working capital finance

Working capital finance strategies

 172

I. Cash management
1. Motives of holding cash
There are three main motives for holding cash.

Example:
Transaction motive
Payment to suppliers, employees, ...

A business primarily
needs to plan to maintain
sufficient cash to meet its
forecast transactions.

Precautionary motive

Example:
Cash may also be needed
An unforeseen downturn in sales, or to meet unexpected
disruption to production. occurrences.

Speculation motive
Example:
An opportunity to take over another company
Some businesses hold
at an attractive price.
surplus cash to take
advantage of attractive
investment opportunities if
these arise.
 173

I. Cash management
1. Motives of holding cash

However, holding cash (or near equivalents to cash) has a cost: the loss of profits that would
otherwise have been obtained by using the funds in another way.

Failure to carry sufficient cash levels can lead to:

Loss of settlement Loss of supplier

discounts goodwill

Potential
liquidation. Poor industrial relations

Once again, therefore the firm faces a balancing act between liquidity and profitability.
 174

I. Cash management
2. Technique for cash management

2.1 Cash flow forecast and cash flow budget

Technique for cash flow management

Cash flow forecast Cash flow budget

An estimate of cash receipts and

A commitment to a plan for cash
payments for a future period
receipts and payments for a
under existing conditions before
future period after taking any
taking account of possible
action necessary to bring the
actions to modify cash flows,
forecast into line with the overall
raise new capital, or invest surplus
business plan.
funds.

Cash budgets are likely prepared as part of the annual master budget.

Cash flow forecasts will be prepared continuously during the year and will allow a business to
plan how to deal with expected cash flow surpluses or shortages.
 175

I. Cash management
2. Technique for cash management

2.1 Cash flow forecast and cash flow budget

Predictions of sales and cost

Receipts and of sales and the timings of
payments forecast the cash flows relating to
these items.

Predictions are made of all

Cash forecasts can be Statement of financial items except cash, which is
prepared based on: position forecast then derived as a balancing
figure.

Future cash and funding

requirements can be
Working capital ratios determined from the
working capital ratios seen
in the previous chapter.
 176

I. Cash management
2. Technique for cash management

2.1 Cash flow forecast and cash flow budget

Here is an example of a cash forecast, illustrating a sensible format.

CASH FORECAST FOR THE THREE MONTHS ENDED

31 MARCH 20X1
January February March
Cash receipts
Sales receipts (W1) X X X
Issue of shares X
Cash payments
Purchase payments (W2) X X X
Dividends/Taxes X
Purchase of non-current assets X
Wages X X X
Cash surplus/deficit for the month X (X) X
Cash balance, beginning X X (X)
Interest on opening cash balance (X) X X
Cash balance, ending X (X) X

Working:
1. Timing of sales receipts January February March
Revenue from sales 1 month ago (assuming 1- From Dec From Jan From Feb
month credit period) sales sales sales

2. Timing of supplier payments

Supplier invoices from 2 months ago (assuming 2- From Nov From Dec From Jan
month credit period) purchases purchases purchases
 177

I. Cash management
2. Technique for cash management

2.1 Cash flow forecast and cash flow budget

If a question provides you with operating cash flows and working capital movements, you may
be required to adjust the operating cash flows for the cash flow impact of working capital
movements to calculate monthly cash flows.

Example 1: Cash forecast

A company is preparing its cash flow forecast for the next financial period.
Which THREE of the following items should be included in the calculations?
A. A corporation tax payment
B. A dividend receipt from a short term investment
C. The loss made on the disposal of an item of machinery
D. A bad debt written off
E. An increase in a provision
F. The receipt of funding for the purchase of a new vehicle
Answer: A, B and F
Bad debt write offs, changes in provisions and losses on disposal are non-cash items.
 178

I. Cash management
2. Technique for cash management

2.2 Method of easing cash shortages

Methods Examples
However, it may
be impossible to
(a) Delaying non-essential If a company’s policy is to replace
delay some
capital expenditure. company cars every 2 years, but the
capital
company is facing a cash shortage, it
expenditures
might decide to replace cars every 3
without serious
years.
consequences.
(b) Accelerating cash inflows It might be possible to encourage credit
that would otherwise be customers to pay more quickly by
expected in a later period. offering discounts for earlier payments.
(c) Reversing past investment Selling investments or property might
decisions by selling assets have to be considered.
previously acquired. Sale and leaseback of the property could
also be considered.
(d) Negotiating a reduction in There are several ways in which this
cash outflows to postpone or could be done: There would be
reduce payments. • Longer credit might be taken from a risk of having
suppliers further supplies
• Loan repayments could be refused.
rescheduled by agreement with a
bank
Dividend payments could be reduced.

Dividend payments are discretionary cash outflows. However, cutting the dividend is likely
to be interpreted as sign of weakness by the financial markets so this could be considered
as a last resort.
 179

I. Cash management
2. Technique for cash management

2.3 Managing cash surpluses

2.3.1. Short-term

It is important to invest short-term cash surpluses in a way that minimizes risk (because the
funds will be needed soon).

Desirable investments would generally be low risk and liquid (easy to turn into cash). These
could include:

Short-term government
IOUs, can be sold when
needed.

Fixed period deposits. Term deposits

Issued by banks, entitle

the holder to interest
plus principal, can be
sold when needed.

Short-term IOUs issued

Commercial
by companies,
paper
unsecured.
 180

I. Cash management
2. Technique for cash management

2.3 Managing cash surpluses

2.3.2. Long-term

If cash surpluses are forecast for the long-term (Eg: due to seasonal factors) then a different
perspective can be taken. Long-term cash surpluses may be used to fund:
• Investments
• Financing
• Dividends

These areas are covered in the later chapters.

 181

I. Cash management
3. Treasury management

3.1 Functions of treasury management

The responsibility for arranging short- and long-term finance is part of the responsibility of the
Treasury department.

Treasury management normally has four functions:

Liquidity management
Funding management

Risk management Corporate finance

advisory
 182

I. Cash management
3. Treasury management

3.2 Centralization and decentralization of the treasury department

Centralization Decentralization

Reduced risk when the Sources of finance can be

company’s process is diversified and can match
centralized and consistent. local assets.

Greater autonomy given to

Expert participant.
subsidiaries.

More responsive to the

Concentration of financial
needs of individual
resources.
operating units.

More limited opportunities

More investment
to invest such balances on
opportunities.
a short-term basis.
 183

I. Cash management
4. Cash management models
Several different cash management models indicate the optimum amount of cash that a
company should hold.

4.1 Baumol model

4.1.1. Formula

Baumol noted that cash balances are very similar to inventory levels, and developed a model
based on the economic order quantity (EOQ).

1 cash use is steady and predictable.

2 cash inflows are known and regular.

Assumptions
Title
day-to-day cash needs are funded from the
3 current account.

buffer cash is held in short-term

4
investments.
 184

I. Cash management
4. Cash management models

4.1 Baumol model

4.1.1. Formula

The formula calculates the amount of funds to inject into the current account or to transfer
into short-term investments at one time:

2C0 D
Economic order quantity =
CH
Where:
• C0 = transaction costs (brokerage, commission,…)
• D = demand for cash over the period
• CH = cost of holding cash (the net interest forgone from not investing the cash…)

4.1.2. Drawbacks of the Baumol model

It is unlikely that cash

will be used at a
constant rate over
In reality, it is difficult
any given period
to predict amounts Drawbacks (there will points in
required over future
time when cash
periods with much
outflows will spike as
accuracy.
machinery is bought
or interest payment
on a loan is made…)
 185

I. Cash management
4. Cash management models

4.1 Baumol model

Example 2: Baumol model

A division requires $1.5m per year; cash use is constant throughout the year. Transaction
costs are $150 per transaction and deposit interest is generated at 7.5% and interest on
short-term financial securities is 12%.

Required: What is the optimal economic quantity of cash transfer into this division’s sub-
account and how frequently?
A. $1,500,000 once a year
B. $77,500, 19 times a year
C. $61,200, 25 times a year
D. $100,000, 15 times a year

Answer: D
$100,000, 15 times a year

2 x 150 x 1,500,000 2 x 150 x 1,500,000

𝐸𝑂𝑄 = = = $100,000
12% − 7.5% 0.045

ie 15 (1,500,000/100,000) transfers of $100,000 are needed.

 186

I. Cash management
4. Cash management models

4.2 Miller-Orr model

4.2.1. Formula

The Miller-Orr model controls irregular movements of cash by the setting of upper and lower
control limits on cash balances.

The Miller-Orr model 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.

The diagram below shows how the model works overtime:

Amount

H
Maximum level (H)
Z
Return point (Z)

L
Minimum level (L)

Time
 187

I. Cash management
4. Cash management models

4.2 Miller-Orr model

4.2.1. Formula

• The model sets higher and lower control limits, H and L, respectively, and a target cash
balance, Z

• When the cash balance reaches H, then (H-Z) dollars are transferred from cash to
marketable securities, i.e. the firm buys (H-Z) dollars of securities.

• Similarly, when the cash balance hits L, then (Z-L) dollars are transferred from marketable
securities to cash.

• The lower limit, L is set by management depending upon how much risk of a cash shortfall
the firm is willing to accept, and this, in turn, depends both on access to borrowings and on
the consequences of a cash shortfall.
 188

I. Cash management
4. Cash management models

4.2 Miller-Orr model

4.2.1. Formula
The formulae (given in the examination) for the Miller-Orr model are:

1
Return point = Lower limit + 3 x Spread
3 Transaction cost x Variance of cash flows 1
Spread = 3 x ( 4 x Interest rate )3

Note:

Variance and interest rates should be expressed in daily terms. If the question provides you
with the standard deviation of daily cash flows, you will need to square this number to obtain
the variance.

4.2.2. Drawbacks of the Miller-Orr model

The estimates used The model does not

are likely to be based incorporate the
on historic Drawbacks impact of seasonality:
information which for example, for a
may unreliable as a retailer, seasonal
predictor of future factors are likely to
variability. affect cash inflows.
 189

I. Cash management
4. Cash management models

4.2 Miller-Orr model

Example 3: Miller-Orr model

The treasury department in TB Co has calculated, using the Miller-Orr model, that the
lowest cash balance they should have is $1m, and the highest is $10m. If the cash balance
goes above $10m they transfer the cash into money market securities.
Are the following true or false?
True False
1. When the balance reaches $10m they would buy $6m of
securities.
2. When the cash balance falls to $1m they will sell $3m of
securities.
3. If the variance of daily cash flows increases the spread between
upper and lower limit will be increased.
 190

I. Cash management
4. Cash management models

4.2 Miller-Orr model

Example 3: Miller-Orr model

Answer: They are all true
Miller Orr defines the difference between the upper limit and lower limit as the ‘spread’.
TB Co's spread is: $10m – $1m = $9m.
Miller Orr also defines the return point as the lower limit plus a third of the spread. In this
case: 1 + [(1/3) x 9] = $4m
When the upper limit is reached, sufficient securities are purchased to reduce the cash
balance back to the return point. In this case $10m – $4m = $6m. Therefore statement 1 is
correct.

When the lower limit is reached, sufficient securities are sold to increase the cash balance
back to the return point. In this case $4m – $1 = $3m. Therefore statement 2 is correct.

The spread is calculated as:

1
3 3
x transaction cost x variance of cash flows
3 4
interest rate

An increase in variance will therefore increase the spread. Therefore statement 3 is

correct.
 191

II. Working capital finance

Overview

In the same way as for long-term investments, a firm must decide on what source of finance is
best used for the funding of working capital requirements.

To understand working capital financing decisions, assets will be divided into 3 different types:

Long-term assets from which an

Non-current Example:
organisation expects to benefit
(fixed) assets Buildings, machinery
over periods.

The minimum current asset base

Permanent Example: Inventory,
required to sustain normal trading
current assets cash, receivables
activity.

Example:
Fluctuating Current asset which vary
Seasonal inventory
current assets following business activity.
items
 192

II. Working capital finance

1. Long-term finance and short-term finance

There are different ways in which long- and short-term sources of funding can be used to
finance current and non-current assets.

Chapter 11 Sources of finance will examine specific types of short- and long-term finance in
more detail, here we discuss some of the general characteristics of short- and long-term
finance.

Short-term finance Long-term finance

More expensive (investors

Cheaper (due to the risk
require a higher return for
taken by creditors)
longer periods)

More flexible in term of Higher guarantee

maturity

More risky (Renewal

problems and unstable
interest rates)
 193

II. Working capital finance

2. Working capital finance strategies

2.1 Choice of working capital finance strategy

The working capital finance strategy that is most appropriate to a company depends on:

Attitude of management to risk

Depends on whether the management is risk-
seeker, risk-adverse, or risk-neutral.

Strength of relationship with the

bank providing an overdraft
Factors If this is strong, it will encourage the
use of short-term finance as it a bank
overdraft will be more likely
available for short-term finance.

Ability to raise long-term finance

If this is weak (perhaps because the
organisation is small), this will mean long-term
finance is hard to access so the entity need to
use more short-term finance.
 194

II. Working capital finance

2. Working capital finance strategies

2.2 Aggressive, conservative and matching financing strategies

There is no ideal funding package, but three approaches may be identified.

Aggressive – finance most current assets,

including ‘permanent’ ones, with short-term
finance. Risky but profitable (as the finance is
cheaper).

Matching (or Moderate) – the duration

Approaches of the finance is matched to the
duration of the investment.

Conservative – long-term finance is used for

most current assets, including a proportion of
fluctuating current assets. Stable but expensive.
 195

II. Working capital finance

2. Working capital finance strategies

2.2 Aggressive, conservative and matching financing strategies

The following graphs will illustrate each type of these financing strategies:

Aggressive strategy
Amount

Short Fluctuating
term current
assets

Permanent
current
assets

Long Non-
term current
assets

Time
 196

II. Working capital finance

2. Working capital finance strategies

2.2 Aggressive, conservative and matching financing strategies

Conservative strategy
Amount

Short Fluctuating
term current
assets

Permanent
current
assets
Long
term

Non-
current
assets

Time
 197

II. Working capital finance

2. Working capital finance strategies

2.2 Aggressive, conservative and matching financing strategies

Matching strategy
Amount

Short
term
Fluctuating
current
assets

Permanent
current
assets
Long
term
Non-
current
assets

Time
 198

II. Working capital finance

2. Working capital finance strategies

2.2 Aggressive, conservative and matching financing strategies

We can compare these three strategies on 5 factors: liquidity, profitability, risk, asset
utilization, and working capital.

Factors Aggressive Conservative Matching

Liquidity Low High Balanced

Profitability More Comparatively less Balanced

(Because of too much
idle and costly funds)
Risk High Low Balanced

Asset utilization Low High Balanced

Working capital Less More Balanced

199

CHAPTER 7: INVESTMENT
DECISIONS
200

Chapter 7: Investment decisions

Overview graph

Investment Decisions

The capital budgeting

Investment appraisal

Relevant
cash flow Benefits of Investment
in investment appraisal
investment appraisal techniques
appraisal
 201

I. The capital budgeting

What is capital budget?

A capital budget:
• is a program of the capital expenditure covering several years.
• includes authorized future projects and projects currently under consideration.

Budget limits or constraints might be imposed internally or externally.

Hard capital rationing

Soft capital rationing is occurs when external
the imposition of limits are set, perhaps
internal constraints,
because of the scarcity of
which are often
imposed when financing, high financing
managerial resources costs, or restrictions on
are limited, is known as. the amount of external
financing an organization
can seek.

Note:

Techniques to deal with capital rationing are mentioned in more detail in Chapter 10.
 202

I. The capital budgeting

Phases of capital budgeting
Capital budgeting process that is familiar with the investment decision-making process includes
the following phases:

• Arise from analysis of strategic choice, business

Identifying
environment, R&D or legal environment, etc.
1 investments
• Key requirement is to achieve the
oppotunities
organizational objectives.

Screening • Select those proposals with best strategic fit and

2 investment the most appropriate use of economic
proposals resources.

Analyzing and • Analyze and evaluate which proposal(s) offer

evaluating the most attractive opportunities to achieve
3
investment company objectives.
proposals • Investment appraisal plays a key role here.

• Resources will be available and specific target

should be set.
Implementation
4 • Progress must be monitored to check whether
and monitoring
there are any big variances and unforeseen
events.

• A post-completion review (or audit) aims to

5 Review learn from mistakes that have arisen in the
project appraisal process.
 203

II. Investment appraisal

1. Relevant cash flows in investment appraisals

Stage 3 in the capital budgeting process is investment appraisal.

Features of investment appraisal

Assessment of the level of expected

Estimates of future costs and benefits
returns earned for the level of
over the project’s life.
expenditure made.

The relevant cash flows that should be considered in investment appraisals are those which
arise as a consequence of the investment decision under evaluation.

Will be future Relevant cash

incremental cash flows flow
Cost

Benefit
Will be incurred
regardless of whether Non-relevant
or not an investment is costs
undertaken
 204

II. Investment appraisal

1. Relevant cash flows in investment appraisals

Example :

Some examples of non-relevant costs:

• Centrally allocated overheads that are not a consequence of undertaking the project
• Sunk costs (Management costs and marketing research expenditure already incurred)
• Committed costs – they are future cash flow but will be incurred anyway, regardless
of what decision will be taken.
• Non-cash items (Depreciation, provision…)
• Interest costs – they have already been included in the discount rate, if counted, it will
be double-counted.

There are some relevant cash flows to consider. These might include the following.

Relevant cost

Working capital Opportunity cost Wider costs

Cash Tax
Inventory Residual value
Trade receivable Infrastructure costs
Trade payable Human resource
costs
Additional specific
fixed costs
 205

II. Investment appraisal

1. Relevant cash flows in investment appraisals

1.1 Opportunity costs

Opportunity costs are the costs incurred or revenues lost from diverting existing resources
from their best use and equal to the value of a benefit foregone as a result of choosing a
particular course of action.

Example :

If a salesman, who is paid an annual salary of $30,000, is diverted to work on a new project
and as a result, existing sales of $50,000 are lost, the opportunity cost to the new project
will be the $50,000 of lost sales.

The salesman's salary of $30,000 is not an opportunity cost since it will be incurred
however their time is spent.
 206

II. Investment appraisal

1. Relevant cash flows in investment appraisals

1.2 Working capital

Increase in Working capital Decrease in Working capital

Cash outflow Cash inflow

Working capital will be released again at the end of a project's life, and so there will be a cash
inflow arising out of the eventual realization into cash of the project's inventory and receivables
in the final year of the project.
$
Cash flow from profits in the period X
Less: working capital increase (X)
or Add: working capital reduction X
Equals adjusted cash flow for the period X

In investment appraisal:
• An investment in working capital at the beginning of the investment period is treated as an
outflow of cash.
• A reduction in working capital to $0 at the end of the investment period is treated as an
inflow of cash.
 207

II. Investment appraisal

1. Relevant cash flows in investment appraisals

1.3 Wider costs

Tax Residual value

This refers to the extra This refers to the residual
tax that will be payable value or disposal value of
on extra profits, or the the equipment at the end
reductions in tax arising of its life, or its disposal
from tax allowable cost.
depreciation or
operating losses in any
year. Wider
costs Infrastructure costs
Additional specific
Infrastructure costs means
fixed costs
the costs of designing,
Specific fixed costs acquiring, constructing,
include additional improving, or expanding
electricity costs the infrastructure serving
incurred by the use of the Project.
new machines. Human resource
costs
Training costs and the costs of
reorganization arising from
investments.
 208

II. Investment appraisal

2. Relevant benefits of investments

Relevant benefits from investments include not only increased cash flows but also savings and
better relationships with customers and employees.

Savings because assets used currently will no longer be

used.
(i) Savings in staff costs .
(ii) Savings in other operating costs, such as consumable
materials .

Extra savings or revenue benefits

(i) More sales revenue and so additional contribution
Types of benefit (ii) More efficient system operation.
(iii) Further savings in staff time, resulting perhaps in
reduced future staff growth.

Possibly, some one-off revenue benefits from the sale of

assets that are currently in use, but which will no longer be
required.

Some benefits might be intangible, or impossible to give a monetary value to.

(a) Greater customer satisfaction, arising from a more prompt service (eg because of a
computerized sales and delivery service).
(b) Improved staff morale from working with higher-quality assets.
(c) Better decision-making may result from better information systems.
 209

II. Investment appraisal

3. Investment appraisal techniques

Investment appraisal
techniques

Discounted cash
Simple techniques flow method (*)

Return on capital
Net present Internal rate of
Payback period employed
value (NPV) return (IRR)
(ROCE)

(*) Investment appraisal techniques using discounted cash flow method will be considered
and mentioned in Chapter 8.

Now we will find out about some simple techniques.

 210

II. Investment appraisal

3. Investment appraisal techniques

3.1 Payback period

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.

When faced with a choice, the project with the shortest payback period is preferred.

Example 2: Payback period

The payback period is the number of years that it takes a business to recover its original
investment from net returns.
Which of the following statements is true?
A. It is calculated before both depreciation and taxation
B. It is calculated before depreciation but after taxation
C. It is calculated after depreciation but before taxation
D. It is calculated after both depreciation and taxation
Answer: B
The payback is most likely to take post-tax relevant cash flows.
 211

II. Investment appraisal

3. Investment appraisal techniques

3.1 Payback period

Note:

If cash flow is Constant annual cash flow, the payback period is calculated by the following
formula:

Initial investment
Payback period =
Annual cash flow

Drawbacks The payback period is not able

to assess two mutually
exclusive projects.

Therefore, a project should not be evaluated based on payback alone.

⇨ If a project gets through the payback test, it ought then to be evaluated with a more
sophisticated investment appraisal technique that takes into consideration the total return
over the full investment period.
 212

II. Investment appraisal

3. Investment appraisal techniques

3.1 Payback period

There are some benefits and drawbacks of using a payback period to appraising a project:

Benefits Drawbacks

It is simple to calculate and It ignores the timing of cash flows

simple to understand. within the payback period.

It uses cash flows rather than It ignores the time value of money.
accounting profits.

It can be used when there is a Payback is unable to distinguish

capital rationing situation to between projects with the same
identify those projects which payback period.
generate additional cash for
It may lead to excessive investment
investment quickly.
in short-term projects.
The fact that it tends to bias in
favor of short-term projects The choice of any cut-off payback
means that it tends to minimize period by an organisation is arbitrary.
both financial and business risk.
It takes account of the risk of the
It can be used as a screening timing of cash flows but not the
device as a first stage in variability of those cash flows.
eliminating obviously
It ignores the cash flows after the
inappropriate projects prior to
end of the payback period and
more detailed evaluation.
therefore the total project return.
 213

II. Investment appraisal

3. Investment appraisal techniques

3.2 Return on capital employed

3.2.1. Introducing to Return on capital employed

Note:

ROCE used to appraise investment projects has some differences from the ROCE ratio given in
Chapter 1 to measure corporate efficiency.

The return on the capital employed method (ROCE) (also called the accounting rate of return
method or the return on investment (ROI) method) of appraising a capital project is to estimate
the accounting rate of return that the project should yield.
Formula:
Average annual profits
ROCE = Initial investment (%)
or
Average annual profit
ROCE = Average investment (%)

Where:
Initial investment + Disposal value
Average investment =
2

If we have annual cash flow instead of accounting profit, we must eliminate depreciation from
cash flow to obtain accounting profit.
 214

II. Investment appraisal

3. Investment appraisal techniques

3.2 Return on capital employed

3.2.1. Introducing to Return on capital employed

Example 3: ROCE
Brenda and Eddie are considering expanding their restaurant business through the
purchase of the Parkway Diner, which will cost $350,000 to take over the business and a
further $150,000 to refurbish the premises with new equipment. Cash flow projections for
this project is 540,000.
The equipment will be depreciated to a zero resale value over the same period and, after
the sixth year, Brenda and Eddie confidently expect that they could sell the business for
$350,000.
Required: What is the ROCE of this investment (using the average investment method)?
A. 13.0%
B. 15.3%
C. 18.0%
D. 21.2%
 215

II. Investment appraisal

3. Investment appraisal techniques

3.2 Return on capital employed

3.2.1. Introducing to Return on capital employed

Example 3: ROCE

Answer: B
$

Total cash flows from operations 540,000

Total depreciation (500,000 - 350,000) (150,000)

Total profits 390,000

Average profits (390,000/6) 65,000

Investment calculation (500,000 + 350,000)/2 425,000

ROCE (65,000/425,000) 15.3%

 216

II. Investment appraisal

3. Investment appraisal techniques

3.2 Return on capital employed

3.2.2. ROCE and the comparison of mutually exclusive projects

The ROCE method of capital investment appraisal can also be used to compare two or more
projects which are mutually exclusive. The project with the highest ROCE would be selected
(provided that the expected ROCE is higher than the company's target ROCE).
There are some benefits and drawbacks of using ROCE to appraising project:

Benefits Drawbacks

It is simple to calculate and It is based on accounting profits

simple to understand. and not cash flows.

It is a relative measure rather

It links with other accounting than an absolute measure and
measures. therefore takes no account of the
size of the investment.
It gives a percentage measure
means that ROCE makes it easy
It takes no account of the length
to compare two investment
of the project.
options even if they are of
different sizes.

It looks at the entire project life. It ignores the time value of

money.
 217

II. Investment appraisal

3. Investment appraisal techniques

3.2 Return on capital employed

3.2.2. ROCE and the comparison of mutually exclusive projects

Example 4:
Which TWO of the following are benefits of the ROCE method of investment appraisal?
A. It considers the whole project
B. It is a cash flow based
C. It is a percentage that, being meaningful to non-finance professionals, helps
communicate the benefits of investment decisions
D. It will not be impacted by a company’s accounting policies
Answer: A, C
It considers the whole project – this is true as there is no 'cut-off' point (unlike the
payback period calculation).

It is a percentage that, being meaningful to non-finance professionals, helps

communicate the benefits of investment decisions – this is a benefit of ROCE and may
well help explain ROCE's use in the real world.

ROCE is profit based. Therefore it is not based on cash flow and will be impacted by a
company’s accounting policies.
218

CHAPTER 8: INVESTMENT
APPRAISAL USING DISCOUNTED
CASH FLOW METHODS
 219

Chapter 8: Investment appraisal using discounted

cash flow methods
Overview graph

Time value of money

Time value of money
and discounting
Discounted cash flow

Net present value

Discounted cash flow

techniques in Internal rate of return
investment appraisal

Using NPV and IRR compared

discounted
cash flow
methods Allowing for inflation
Allowing for inflation
and taxation
Allowing for taxation

Impact of working capital

Allowing for working
movement on project
capital
appraisal

Net present value

layout
 220

I. Time value of money and discount

1. Time value of money

The time value of money is a basic financial concept that holding money in the present is worth
more than the same sum of money to be received in the future.

The time value of money occurs for three reasons:

Potential for earning interest/cost of finance 1

Time value of
Impact of inflation 2 Title
money

Effect of risk 3
 221

I. Time value of money and discount

2. Discounted cash flow

Discounted cash flow (DCF) is an investment appraisal technique that takes into account both
the timings of cash flows and also total profitability over a project's life. Discounted cash flow
(DCF) analysis is the process of discounting future cash flows back to their present value.

It is important in project appraisal because many projects involve investing money now and
receiving returns in many different periods in the future.

Three important points about DCF are as follows:

DCF looks at the cash flows of a project, not the

accounting profits.

Only future incremental cash inflows

DCF and outflows are considered.

The timing of cash flows is taken into account

by discounting them.
 222

I. Time value of money and discount

2. Discounted cash flow

2.1 Compounding

Compounding calculates the future or terminal value of a given sum invested today for several
years.

Compounding tells us how much an investment will be worth at the end, and can be used to
compare two projects with the same duration.
The formula for the future value of investment plus accumulated interest after n periods is:

FV = PV × (1+r)n
Where:
• FV is the future value of the investment with interest
• PV is the initial or present value of the investment
• r is the compound rate of return per time period, expressed as a proportion (10% = 0.10,
5% = 0.05, and so on)
• n is the number of periods
 223

I. Time value of money and discount

2. Discounted cash flow

2.2 Discounting

Discounting starts with the future value and converts a future value to a present value.
Discounting tells us how much an investment will be worth in today's terms. This method can
be used to compare two investments with different durations.

Timeline

Discounting
Present value (PV) Future value (FV)

Present value is the cash equivalent now of a sum of money receivable or payable at a stated
future date, discounted at a specified rate of return.

Formula:

FV
PV = = FV × (1+r)−n
(1+r)n

Where:
• FV is the future value of the investment with interest
• PV is the initial or present value of the investment
• r is the compound rate of return per time period, expressed as a proportion (so 10% =
0.10, 5% = 0.05, and so on)
• n is the number of periods
• (𝟏 + 𝒓)−𝒏 is called the discount factor (DF)
 224

I. Time value of money and discount

2. Discounted cash flow

2.3 Discount factors

In the compounding and discounting, we used the company's required rate of return as the
discount factor. This discount factor reflects the investor’s required return (also referred to as a
cost of capital) and the timing of the future cash flow (in one year’s time).

Formula:
The discount factor (DF) = (1+r)-n

The cost of capital is often used to derive a discount rate for DCF analysis and investment
appraisal.

The return that

Cost of funds that a investors expect to
company raises and Cost of capital be paid for putting
uses. funds into the
company.

Note:
The cost of capital is not the cost of borrowing, although the cost of borrowing may be an
element in the cost of capital.
 225

I. Time value of money and discount

2. Discounted cash flow

2.3 Discount factors

Conventions used in DCF

 226

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

An annuity is a constant annual cash flow for a number of years.

If a project involves equal annual cash flows (or annuities) then each future cash flow can be
discounted separately back to a present value, but it is quicker to use a single discount factor,
it’s called an annuity factor or a cumulative discount factor.

The annuity factor (AF) is the name given to the sum of the individual DF. The PV of an
annuity can therefore be quickly found using the formula:

PV = Annual cash flow × AF

Like with calculating a discount factor, the AF can be found using a formula (1) as below:
1 − (1 + 𝑟)− 𝑛
𝐴𝐹 =
𝑟

(n: number of years; r: interest rate)

 227

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

Example 1:
A lease agreement has an NPV of ($26,496) at a rate of 8%. The lease involves an
immediate down payment of $10,000 followed by 4 equal annual payments.
Require: What is the amount of the annual payment?
A $11,020
B $4,981
C $11,513
D $14,039
Answer: B

1 − (1 + 𝑟)− 𝑛 1 − (1 + 0.08)− 4
𝐴𝐹 = = = 3.312
𝑟 0.08

Time 0 1 to 4
Cash flow (10,000) a
Annuity factor 3.312
Present value (10,000) a x 3.312
Net present value 26,496
 228

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

Example 1:
$26,496 = ($a x 3.312) + 10,000
$16,496 = $a x 3.312
$a = $16,496/3.312
= $4,981
 229

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

2.4.1. Perpetuities

Perpetuity: is a constant annual cash flow that will last forever.

If the series of cash flows does not have an end date (i.e. it is expected for the foreseeable
future) then this is called a perpetuity.

The PV of perpetuity is found using the formula (2): PV = Cash flow × 1/r
1/r is known as the perpetuity factor.

Notes:
An annuity becomes a perpetuity when a constant cash flow last forever, meaning that n
increases leading to (1 + 𝑟)−𝑛 falls to zero.
 230

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

2.4.1. Perpetuities

Example 2:
Assuming a discount rate of 10%, $3,000 received in one year's time and for ever
Required: Calculate the present value
A. $30,000
B. $37,500
C. $35,000
D. 31,500
Answer: A

$3,000
PV = = $30,000
0.1
 231

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

2.4.2. Delayed annuities and perpetuities

Ordinary annuity/ Delayed annuities/

perpetuities perpetuities

Begin of cash flows Time 1 (T1) Not time 1 (T1)

Time of valuing Time 0 (present) Time 0 (present)

An annuity of $1,000 per An annuity of $1,000 per

Example annum for five years starts at annum for five years starts at
the end of the first year. the end of the third year.
 232

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

2.4.2. Delayed annuities and perpetuities

Method: The valuing of delayed annuities/ perpetuities are dealt with by:

Step 1. Applying the appropriate factor to the

cash flow as normal.

Step 2. Discounting back to T0.

Cash flows begin

a a a a a
Step 2:
Discounting
Step 1: Applying the appropriate
back to T0.
factor to the cash flow as normal.
 233

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

2.4.2. Delayed annuities and perpetuities

Example 3:
A newspaper reader has won first prize in a national competition and they have a choice as
to how they take the prize:
Option 1 Take $90,000 per year indefinitely starting in 3 years' time (and bequeath this
right to their children and so on); or
Option 2 Take a lump sum of $910,000 in 1 year's time.
Require: Assuming a cost of capital of 10%, which would you advise and why?
A. Option 1 because $90,000 p.a. indefinitely is an infinite amount of money compared
to a one-off payment
B. Option 1 because it is worth more in present value terms
C. Option 2 because it is worth more in present value terms

D. Option 2 because the lump sum has the flexibility to be invested and earn a larger

return than $90,000 p.a.

 234

I. Time value of money and discount

2. Discounted cash flow

2.4 Annuities

2.4.2. Delayed annuities and perpetuities

Example 3:
Answer: C
Option 1:
Step 1: Calculate the future value of the perpetuity using the cost of capital
$90,000/0.1 = $900,000
Step 2: Discount it back to today using a discount factor of 10% at the end of year 2
PV = $900,000 x 0.826 = $743,400

Option 2:

The present value of the lump sum = $910,000 x DF1

Where DF1 is the 1 year 10% discount factor from tables = 0.909
So present value of lump sum = $910,000 x 0.909 = $827,180
The lump sum should be chosen because it has a higher net present value.
 235

I. Time value of money and discount

2. Discounted cash flow

2.5 Time-saving in exam

Present Value Tables

(1 + 𝑟)−𝑛 is called the discount factor (DF).

In the exam, you will be provided with a Present Value table that gives the discount factors for
different discount rates over the various time periods.
A part of the present value table:
 236

I. Time value of money and discount

2. Discounted cash flow

2.5 Time-saving in exam

Annuity Tables

Annuity Table (sometimes referred to as a Cumulative Present Value Table), which provides
pre-calculated annuity factors for different discount rates over various periods.
A part of the annuity table:

Note:
• There might be a small difference due to roundings.
• DF and AF tables are preferred to be used in the exam.
• The tables only cover a small range of discount rates and time periods and you may be
required to calculate a discount factor or annuity factor for variables outside of this range.
 237

II. Discounted cash flow techniques in investment

appraisal
Overview

Discounted cash flow techniques

Net present value Internal rate of return

(NPV) (IRR)
 238

II. Discounted cash flow techniques in

investment appraisal
1. Net present value

The Net present value (NPV) method compares the present value (PV) of all the cash inflows
from an investment with the present value of all the cash outflows from an investment.

The NPV is thus calculated as the PV of cash inflows minus the PV of cash outflows. The
difference, the NPV, represents the change in wealth of the investor as a result of investing in
the project.

Using NPV to appraising:

NPV negative 0 NPV positive

One The project is not The project breaks The project is

project financially viable, the even should consider financially
entity should not other factors for viable.
undertake the project. decision-making.

Two or
more The entity should It should choose the
mutually reject projects which one with the highest
exclusive have negative NPV. NPV.
projects
 239

II. Discounted cash flow techniques in

investment appraisal
1. Net present value

The following assumptions are made about cash flows when calculating the net present value:

1 All cash flows occur at the start or end of a year.

Assumptions
Title 2 Initial investments occur at T0.

3 Other cash flows start one year after that (T1).

Note:
You should never include interest payments as cash flows within an NPV calculation as these
are taken into account by the cost of capital.
 240

II. Discounted cash flow techniques in

investment appraisal
1. Net present value

Example 4:
In a review of a project with a large initial cash outflow followed by a few years of cash
inflows that has a positive NPV, the cash inflows are shifted to 1 year later than originally
predicted and the cost of capital used for discounting the project is reduced by 1%.
Require: What are the effects of these changes on the project NPV?
A. Cash flows – lower NPV, cost of capital – lower NPV
B. Cash flows – lower NPV, cost of capital – higher NPV
C. Cash flows – higher NPV, cost of capital – lower NPV
D. Cash flows – higher NPV, cost of capital – higher NPV
Answer: B
Cash flows occurring at a later date will be more heavily discounted, giving a lower present
value. As the cash flows are inflows, this will lower the overall NPV.

A lower cost of capital will mean that all cash flows after T0 will be less heavily discounted.
This will have the effect of raising the NPV.
 241

II. Discounted cash flow techniques in

investment appraisal
1. Net present value

Advantages and disadvantages of using NPV:

Considering the time

1
value of money.

An absolute
2 It is difficult to explain
measure of return. 1
to managers.
Based on cash flows,
3 It requires knowledge
not profits.
2
of the cost of capital.

Considering the Advantage Disadvantage

whole life of the 4 3 It is relatively complex.
project.

Should lead to the 5

maximization of
shareholder wealth.
 242

II. Discounted cash flow techniques in

investment appraisal
2. Internal rate of return

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

IRR method is to calculate the exact DCF rate of return which the project is expected to
achieve. This method is to accept investment projects whose IRR exceeds a target rate of
return.

Calculation: The IRR is calculated approximately using a technique called interpolation.

Step 1 Calculate the net present value using the company's cost of capital.

Step 2 Calculate the NPV using a second discount rate.

If the NPV at STEP 1 is use a second rate that is greater

positive. than the first.

If the NPV at STEP 1 is use a second rate that is less than

negative. the first rate.

Step 3 Use the two NPV values to estimate the IRR using interpolation.
 243

II. Discounted cash flow techniques in

investment appraisal
2. Internal rate of return

The formula to apply is as follows:

NPVa
IRR ≈ a + b−a %
NPVa – NPVb
Where:
• a is the lower of the two rates of return used
• b is the higher of the two rates of return used
• NPVa = the NPV obtained using rate a
• NPVb = the NPV obtained using rate b

Note:

• Ideally NPVa will be a positive value and NPVb will be negative, but do not worry if you
have two positive or two negative values, since the above formula will extrapolate as
well as interpolate.
• IRR only can be calculated when all future cash flow is positive, if a forecasted cash flow
is negative, there are more than two values of IRR, which means the interpolation
method can't be used.
 244

II. Discounted cash flow techniques in

investment appraisal
2. Internal rate of return

The diagram below shows the IRR as estimated by the formula.

NPV

Estimated IRR found using

interpolation

Discount rate
0 a b

True IRR

Actual NPV graph

NPV linear graph

We can estimate the IRR by drawing a straight line between the two points on the graph that
we have calculated.
 245

II. Discounted cash flow techniques in

investment appraisal
2. Internal rate of return

NPV

A B Discount rate
0

True IRR

Actual NPV graph

Consider the graph above:

• If we establish the NPVs straight-line created by the two points 𝑄1 and 𝑄2 , we would
estimate the IRR to be at point B.
• If we establish the NPVs straight-line created by the two points 𝑃1 and 𝑃2 , we would
estimate the IRR to be at point A.

⇨ The closer our NPVs are to zero, the closer our estimate will be to the true IRR.
 246

II. Discounted cash flow techniques in

investment appraisal
2. Internal rate of return

Example 5:
Arbury plc has made an investment with a net present value (NPV) of $42,000 at 10% and
an NPV of ($22,000) at 20%.
Require: What is the internal rate of return of the project?
A. 31.0%
B. 16.6%
C. 15.0%
D. 13.4%
Answer: B
The IRR can be calculated using the following formula.
42,000
IRR ≈ 10% + 20 − 10 % = 16.6%
42,000 – (–22,000)
 247

II. Discounted cash flow techniques in

investment appraisal
2. Internal rate of return

Advantages and disadvantages of IRR

Considering the time

1
value of money.
It is not a measure of
1
It is a percentage absolute profitability.
and easy to 2
understand. Interpolation only
2
provides an estimate.
Based on cash flows,
3
not profits.
Non-conventional cash
3
flows may give rise to
Means a firm multiple IRRs*
Advantage Disadvantage
selecting projects
where the IRR Contains an inherent
4 4
exceeds the cost of assumption that cash
capital should returned from the
increase project will be
shareholders' wealth. reinvested at the
project’s IRR, which
Considering the may be unrealistic.
whole life of the 5
project.

(*) This statement is mentioned below. (refer to II.3.1)

 248

II. Discounted cash flow techniques in

investment appraisal
3. NPV and IRR compared

3.1 Non-conventional cash flows

The projects we have considered so far have had conventional cash flows. When flows vary
from this, they are termed non-conventional. The following project has non-conventional cash
flows.
Year Project X
$'000
Non- conventional cash
0 (1,900)
flow (negative cash
1 4,590
flow)
2 (2,735)

Project X would have an NPV diagram as below:

NPV

a b Discount rate
0

NPV graph
IRR

In this case, there are two IRR values. Lack of knowledge of multiple IRRs could therefore lead
to serious errors in the decision of whether to accept or reject a project.
⇨ In general, if the sign of the net cash flow changes in successive periods, the
calculations may produce as many IRRs as there are significant changes. IRR should
not normally be used when there are non-conventional cash flows.
 249

II. Discounted cash flow techniques in

investment appraisal
3. NPV and IRR compared

3.2 Mutually exclusive projects

Only NPV can be used to distinguish between two mutually exclusive projects, because IRR is a
percentage measure that can lead to incorrect choices being made when choosing between
mutually exclusive projects.

NPV

Discount rate
Firm cost of
capital Project B

Project A

The profile of project A is such that it has a lower IRR and applying the IRR rule would prefer
project B. However, in absolute terms, A has the higher NPV at the company’s cost of capital
and should therefore be preferred.

⇨ NPV is therefore the preferable technique for choosing between projects.

 250

III. Allowing for inflation and taxation

1. Allowing for inflation

1.1 General theory about inflation

Inflation is a general increase in prices leading to a general decline in the real value of money.

Real: The term ‘real’ when applied to cash flows or to the cost of capital, means based on
current price levels.

Nominal: The term ‘nominal’, when applied to cash flows or to the cost of capital, means after
adjusting for the impact of expected inflation.

Nominal discount rate is a rate relating to current market rates of return.

Real discount rate is based on a nominal cost of capital that has been deflated by the general
rate of inflation.
 251

III. Allowing for inflation and taxation

1. Allowing for inflation

1.2 The impact of inflation on interest rates

In times of inflation, the fund providers will require a return made up of 2 elements:
• Real return for the use of their funds (i.e. the return they would want if there were no
inflation in the economy) (also called real rate).
• Additional return to compensate for inflation.

The overall required return is called the money or nominal rate of return.
The relationship between real and nominal rates of interest is given by the Fisher formula.

Fisher formula:
(1 + i) = (1 + r)(1 + h)
Where:
• h is rate of inflation
• r is real rate of interest
• i is nominal (money) rate of interest
 252

III. Allowing for inflation and taxation

1. Allowing for inflation

1.3 The impact of inflation on cash flows

In a business environment with inflation, future cash flows will have decreasing purchasing
power in current value terms as time passes.

Example:

If inflation is expected to be 5% per year and a cash amount of $100.00 is received at the
end of each year for three years, the deflated values of these future cash receipts are as
follows:
Year Cash received Deflation factor Deflated value
1 $100 1/1.05 = 0.952 $95.20
2 $100 1/1.052 = 0.907 $90.7
3 $100 1/1.053 = 0.864 $86.40

In order to maintain the purchasing power of future cash receipts, the cash received must
be inflated.
Year Cash received Inflation factor Inflated value
1 $100 1.05 $105
2 $100 1.052 = 1.1025 $110.25
3
3 $100 1.05 = 1.1576 $115.76
The inflated values in this table are also called nominal values.
Ref: ACCA FM Technical article: Inflation and investment appraisal
 253

III. Allowing for inflation and taxation

1. Allowing for inflation

1.3 The impact of inflation on cash flows

The impact of inflation can be dealt with in two different ways – both methods give the same
NPV.

Methods of dealing with inflation

Real cash flows Nominal cash flows

Inflate each cash flow by

DO NOT inflate the cash
the inflation rate i.e.,
flows – leave them in real
convert it to a nominal
terms – real cash flows
cash flow

Discount using the nominal

Discount using the real rate
rate
Real/real Nominal/Nominal

Be consistent
 254

III. Allowing for inflation and taxation

1. Allowing for inflation

1.3 The impact of inflation on cash flows

Note:

You can assume that cash flows you are given in the exam are the money cash flows unless told
otherwise. Make sure you read the question carefully. Sometimes you will be given the cash
flows in Year 1 terms with subsequent inflation.

For example, if the question tells you that For example, if the question says "Sales will
sales for the next 3 years are $100 in current be $100 in the first year, but are they going to
terms but are expected to inflate by 10%, inflate by 10% for the next two years", then
then what is actually meant is that the sales the sales will be:
will be:
Inflated
Year 1: $110 Year 1: $100
from the
first year Inflated
from the
Year 2: $121 Year 2: $110
second
year
Year 3: $133.10 Year 3: $121

The impact of inflation can be dealt with in two different ways – both methods give the same
NPV.
 255

III. Allowing for inflation and taxation

1. Allowing for inflation

1.3 The impact of inflation on cash flows

Example 6:
A company has a 'money' cost of capital of 16.55% per annum. The 'real' cost of capital is
11% per annum.
Require: What is the inflation rate?
A. 5%
B. 5.55%
C. 11%
D. 16.55
Answer A
(1 + Money rate) = (1 + Real rate) × (1 + Inflation rate)
1.1655 = (1.11) × (1 + Inflation rate)
Inflation rate = 5%
 256

III. Allowing for inflation and taxation

1. Allowing for inflation

1.4 Inflation rates in exam

Types of inflation

Specific inflation rate General rate of inflation

Impact all the individual cash

Impact the investor’s overall
flow items – each cash flow is
required rate of return.
affected by a specific rate.
 257

III. Allowing for inflation and taxation

1. Allowing for inflation

1.4 Inflation rates in exam

Number of rates of inflation

1 rate given More than one rate given

Inflation has no net impact on a project’s Inflation will have an impact on profit
NPV because the impact of an increase in margins (as revenue and costs are changing
prices on project cash inflows is exactly at different rates) and therefore inflation
offset by the impact of inflation on needs to be included in project appraisal.
increasing the cost of capital.
⇨ In this case it is normally quicker to In this case, cash flows must be inflated,
ignore inflation in the cash flows and and inflation must also be incorporated
to use a real cost of capital – real- into the cost of capital.
term approach.
 258

III. Allowing for inflation and taxation

1. Allowing for inflation

1.4 Inflation rates in exam

Example 7:
NCW Co is considering investing $10,000 immediately in a 1-year project with the
following cash flows.
Income $100,000
Expenses $35,000
The cash flows will arise at the end of the year. The above are stated in current terms.
Income is subject to 10% inflation; expenses will not vary. The real cost of capital is 8% and
general inflation is 2%.

Require: Using the money cost of capital to the nearest whole percentage, what is the net
present value of the project?
A. $68,175
B. $60,190
C. $58,175
D. $78,175
 259

III. Allowing for inflation and taxation

1. Allowing for inflation

1.4 Inflation rates in exam

Example 7:
Answer is: C
As not all cash flows will inflate at the same rate, cash flows will be inflated where
necessary and discounted using the money rate.
(1 + money rate) = (1.08) x (1.02) = 1.1016 so m = 10% to the nearest whole percentage
Nominal income = $100,000 x (1 + income inflation) = $100,000 x 1.1 = $110,000
Nominal expenses = $35,000 (zero inflation)
Therefore NPV = [(110,000 - 35,000) x 1/(1+0.1)] - 10,000
= (75,000 x 0.909) - 10,000 = $58,175
 260

III. Allowing for inflation and taxation

1. Allowing for inflation

1.4 Inflation rates in exam

Notes:
It is advisable to always use money method when:
• Inflating the cash flows at their specific inflation rates (more than one inflation rates).
• Discounting using the money rate because using real approach involves complex
calculations.
• Deflate nominal cash flows using the general rate of inflation so that they become real
cash flows.
• Discount the real cash flows at the real cost of capital.
 261

III. Allowing for inflation and taxation

2. Allowing for taxation
Why taxation has to be considered in DCF analysis?

So far, in looking at project appraisal, we have ignored taxation. However, payments of tax, or
reductions in tax payments, are relevant cash flows and ought to be considered in DCF analysis.

Which cash flows must be considered?

The existence of tax on corporate profits gives rise to two cash flows.

Impact of corporation tax

Tax payments Tax benefits

Additional Additional Tax-allowable depreciation allowed

income expense as an expense against profits.

Additional tax
Less tax paid
paid
 262

III. Allowing for inflation and taxation

2. Allowing for taxation

2.1 Tax payment

In dealing with these tax effects, it is always assumed that:

Where a tax loss arises from the project,

1 there are sufficient taxable profits elsewhere
in the organisation to allow the loss to
reduce any relevant tax payment.

Assumptions
Title

The company has sufficient taxable profits to

2 obtain full benefit from tax-allowable
depreciation.

Note:
Check any question involving tax carefully to see what assumptions about the timing of tax
payments should be made (paid in the current year or paid in one year arrears).

Tax-allowable depreciation (TAD) is not a cash flow and to calculate the tax impact we have to
multiply each year’s tax-allowable depreciation by the corporation tax rate.
Tax-allowable depreciation is used to reduce taxable profits, and the consequent reduction in a
tax payment should be treated as a cash saving arising from the acceptance of a project. Cash
saving from TAD is also called tax benefit.
 263

III. Allowing for inflation and taxation

2. Allowing for taxation

2.2 Tax benefit - tax allowable depreciation

For example, suppose that a company have a profit for the year of $100 and corporate tax rate
is 20%:

If no tax-allowable depreciation, total $100 profit is transferred to taxable income, so the tax
payable is 20$.

No tax-allowable depreciation

100
Profit for the year

100 Taxable income

20 Tax payable
 264

III. Allowing for inflation and taxation

2. Allowing for taxation

2.2 Tax benefit - tax allowable depreciation

If tax-allowable depreciation occurred, an $20 TAD.

Not all of the profit for the year is transferred to taxable income because of TAD’s impact, so it
reduces taxable income to $80. Thus, the consequent tax payable deteriorates to only $16, the
saving of $4 is known as Tax benefit.

Tax-allowable depreciation

100 Profit for the year

Taxable income
80

Tax payable
16
Tax-allowable
depreciation Tax benefit
 265

III. Allowing for inflation and taxation

2. Allowing for taxation

2.2 Tax benefit - tax allowable depreciation

Note:
Tax-allowable depreciation is not the same as the depreciation charge for the purpose of
reporting profit in the financial statements.

Determining relevant cash flow relating to TAD

TAD may be applied as straight-line depreciation (the same amount each year) or on a reducing
balance basis based on the written down value (WDV) of the asset at the start of year.

Suggested format to determine relevant cash flow of TAD

Year WDV b/f Depreciation WDV c/f Tax benefit Time to record TAD
(1) (2) (1) – (2) (2)*t%
1 X Y X–Y Y × t% n
…
Tax rate
…
n Disposal
value Tax rate Based on given
timing of tax
payments
 266

III. Allowing for inflation and taxation

2. Allowing for taxation

2.2 Tax benefit - tax allowable depreciation

Example 8:
A company has 31 December as its accounting year end. On 1 January 20X5 a new
machine costing $2,000,000 is purchased. The company expects to sell the machine on 31
December 20X6 for $350,000.
The rate of corporation tax for the company is 30%. Tax-allowable depreciation is obtained
at 25% on the reducing balance basis, and a balancing allowance is available on disposal of
the asset. The company makes sufficient profits to obtain relief for tax-allowable
depreciation as soon as they arise.
Require: If the company’s cost of capital is 15% per annum, what is the present value of
the tax savings from the tax-allowable depreciation at 1 January 20X5 (to the nearest
thousand dollars)?
A. $391,000
B. $248,000
C. $263,000
D. $719,000
 267

III. Allowing for inflation and taxation

2. Allowing for taxation

2.2 Tax benefit - tax allowable depreciation

Example 8:
Answer: A
The investment is made on 1 January 20X5, so tax-allowable depreciation can first be set
off against profits for the accounting period ended 31 December 20X5. The tax cash saving
will therefore be at 31 December 20X5. i.e. year 1.

Year WDV b/f Depreciation WDV c/f Tax benefit Time to

(1) (2) (1) – (2) (2)*30% record TAD
1 2,000,000 500,000 1,500,000 150,000 1
2 1,500,000 350,000 1,150,000 345,000 2

Present value = ($150,000 × 0.870) + ($345,000 × 0.756) = $391,320

 268

IV. Allowing for working capital

Overview

The relevant cash flow associated with working capital is the change in working capital.

An increase in working A decrease in working capital

capital required required
Cash outflow Cash inflow

Impact of working capital movement on project appraisal

An increase in A decrease in
working capital working capital
Cash outflow Cash inflow

Each year

Beginning of project End of project

An investment in working capital Working capital will be released,

is treated as a cash outflow. there will be a cash inflow.
 269

IV. Allowing for working capital

Example

Example 9:
A project has the following projected cash inflows.
Year 1 100,000
Year 2 125,000
Year 3 105,000
Working capital is required to be in place at the start of each year equal to 10% of the cash
flow for that year. The cost of capital is 10%.
Require: What is the present value of the working capital?
A. $Nil
B. $(30,036)
C. $(2,735)
D. $33,000
 270

IV. Allowing for working capital

Example

Example 9:
Answer: C
Year 1 2 3 4
Working capital demand
10,000 12,500 10,500 0
(10% x cash inflow)
Change in working capital 10,000 2,500 (2,000) (10,500)
Change in cash flow (10,000) (2,500) 2000 10,500
Discount factor 10% 1 0.909 0.826 0.751
Present value (10,000.00) (2,272.50) 1,652.00 7,885.50
Present value of the working capital = (-10,000.00) + (-2,272.50) + 1,652.00 + 7,885.50
= 2,735.00
 271

V. Net present value layout

Layout
For the majority of investment appraisal questions, the following pro-forma is recommended:
Year 0 1 2 3 4 …
Sales X X X X
Costs (X) (X) (X) (X)
Operating cash flow X X X X
Tax paid (X) (X) (X) (X) (X)
Tax benefit of TAD X X X X X
Working capital changes (X) (X) (X) X
Initial outlay (X)
Scrap value X
Net cash flow (X) X X X X X
Discount factors X X X X X X
Present value X X X X X X
NPV X

Note:
Dealing with questions with both tax and inflation
• Inflate costs and revenues, where necessary, before determining their tax implications.
• Ensure that the cost and disposal values have been inflated (if necessary) before
calculating tax-allowable depreciation.
• Always calculate working capital on these inflated figures, unless given.
• Use a post-tax money discount rate.
 272

V. Net present value layout

Layout
Extended pro-forma recommended: Add an extra year if
tax is delayed

Year 0 1 2 3 4 …
Sales [W1] X X X X
Variable cost [W2] (X) (X) (X) (X)
Fixed Costs [W3] (X) (X) (X) (X)
Operating cash flow X X X X
Tax paid (X) (X) (X) (X) (X)
Tax benefit of TAD [W4] X X X X X
Working capital
(X) (X) (X) X
changes
Initial outlay (X)
Scrap value X
Net cash flow (X) X X X X X
Discount factors X X X X X X
Present value (X) X X X X X
NPV X
 273

V. Net present value layout

Layout

Working 1: Sales
Selling price
inflation
Year 0 1 2 3 4 …
Selling price X X X X …
Specific inflation rate (1+a%) 1+a% 2 1+a% 3 1+a% 4 …
Inflated selling price X X X X …
Sale volume X X X X …
Total sale annually X X X X …

Working 2: Variable cost

Year 0 1 2 3 4 …
Variable cost per unit X X X X …
Specific inflation rate (1+b%) 1+b% 2 1+b% 3 1+b% 4 …
Inflated variable cost per unit X X X X …
Sale volume X X X X …
Total variable cost annually X X X X …
 274

V. Net present value layout

Layout

Working 3: Fixed cost

Year 0 1 2 3 4 …
Fix cost X X X X …
Specific inflation rate (1+c%) 1+c% 2 1+c% 3 1+c% 4 …
Inflated fixed cost annually X X X X …

Working 4: Tax benefit from TAD

Year 0 1 2 3 4 …
WDV b/f X … … … …
Depreciation (Y) … … … … Depend
WDV c/f X-Y … … … … on given
Tax benefit Y*t% … … … scenario
275

CHAPTER 9: PROJECT
APPRAISAL UNDER RISK AND
UNCERTAINTY
 276

Chapter 9: Project appraisal under risk and

uncertainty
Overview graph

Risk & Uncertainty

Expected value

Project appraisal
Risk analysis
under Probability analysis
techniques
risk & uncertainty

Other methods

Sensitivity analysis
Uncertainty analysis
techniques
Other methods
 277

I. Risk and uncertainty

1. Difference between risk and uncertainty

Investment decisions are based on predictions of what will probably happen in the future,
which means unpredictability.

This unpredictability could be described as risk and uncertainty, which could be differentiated
as below:

Risk Uncertainty

Several possible Several possible

outcomes outcomes

Based on past relevant

Little past experience
experience
⇒ Difficult to assign
⇒ Easy to assign
probabilities to
probabilities to
outcomes
outcomes

Increases as variability Increases as project

of returns increase life increases

Can be quantified Cannot be quantified

 278

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

The expected value (EV) is the weighted average of the outcomes, with the weightings based
on the probability estimates.

1.1.1. Application of EV

a. Basic application of EV

Example 1:

Sales Probability
500,000 0.1
700,000 0.2
1,000,000 0.4
1,250,000 0.2
1,500,000 0.1
Here you can see that the most probable outcome is sales of 1,000,000 as this has the
highest probability
Require: What is the expected value of the sales for year one ?
A. $950,000
B. $990,000
C. $930,000
 279

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

1.1.1. Application of EV

a. Basic application of EV

Example 1:
Answer: B
EV = 500,000 x 0.1 + 700,000 x 0.2 + 1,000,000 x 0.4 + 1,250,000 x 0.2 + 1,500,000 x 0.1
= 990,000
 280

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

1.1.1. Application of EV

b. EV in NPV analysis

The EV technique can be used to simplify the available data in a larger investment appraisal
question.

Example 2:
Harry Co is choosing between two mutually exclusive projects. The NPV of these projects in
$m depends on the rate of growth of the economy over the next five years. Forecast NPV is
shown under scenarios of low, medium and high growth:
Low growth Medium growth High growth
Probability 0.25 0.5 0.25
NPV NPV NPV
($’000) ($’000) ($’000)
Project A 1,000 2,500 4,00
Project B (8,000) 4,000 16,000

Required: Calculate each project’s expected NPV and consider which project would be
chosen.
 281

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

1.1.1. Application of EV

b. EV in NPV analysis

Example 2:
A. EV of project A = 2,500, EV of project B = 4,000 and choose project B
B. EV of project A = 4,000, EV of project B = 2,500 and choose project A
C. EV of project A = 2,500, EV of project B = 4,000 and choose project A
D. EV of project A = 4,000, EV of project B = 2,500 and choose project B

Answer: A
Expected values can be calculated as follows:
EV of project A = (1,000 x 0.25) + (2,500 x 0.50) + (4,000 x 0.25) = 2,500
EV of project B = (-8,000 x 0.25) + (4,000 x 0.50) + (16,000 x 0.25) = 4,000
Project B has a higher expected value and would therefore be chosen on the basis of this
technique.
 282

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

1.1.1. Application of EV

c. EV with decision matrices

EVs are also used to deal with situations where the same conditions are faced many times.

Example 3:

EV with decision matrices

A newsagent sells weekly magazine, which advertises local second-hand goods. The owner
can buy the magazines for $15 each and sell them at the retail price of $25. At the end of
each week, unsold magazines are obsolete and have no value:
Weekly demand in units Probability
10 0.20
15 0.55
25 0.25

Required:
a) What is the EV of demand?
b) If the owner is to order a fixed quantity of magazines per week how many should that
be (the optimum quantity ordered)? Assume no seasonal variations in demand.
 283

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

1.1.1. Application of EV

c. EV with decision matrices

Example 3:

Guidance:
a) The EV of demand = (10 x 0.2) + (15 x 0.55) + (25 x 0.25) = 16.5 units per week.
b) The optimum quantity ordered will give the highest expected value of returns (revenue
– costs).
Step 1: Draw up a decision matrix for decisions of number bought and number demanded
Step 2: Calculate returns for all combination of action and outcome
Step 3: Calculate the total EV for each combination of action and outcome
Total EV = Total of returns for each ordering scenario x probability in demand
Step 4: Compare and choose the ordered amount with the highest EV.

Solution:
Step 1: Draw up a decision matrix for decisions of number bought and number
demanded
Probability 0.20 0.55 0.25 EV ($)
Demand 10 15 25
Quantity
10 (W) (W) (W)
15 (W) (W) (W)
25 (W) (W) (W)
 284

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

1.1.1. Application of EV

c. EV with decision matrices

Example 3:
Step 2: Calculate returns for all combination of action and outcome
Probability 0.20 0.55 0.25 EV ($)
Demand 10 15 25
Order
10 100 (W) 100 100
15 25 150 150(W)
25 (125) 0 250
Workings (W): We take 2 examples to demonstrate for all other calculations
(Order/Demand: 10/10 and 15/25)
Order Cost per Cost Demand Selling Revenue Revenue
unit ($) ($’000) price – cost ($)
10 15 150 10 25 250 100
[10x15] [10x25]
15 15 225 25 25 375 (*) 150
[15x15] [15x25]
(*) Ordered amount = 15 units ⇒ Maximum demand could be fulfilled is 15 units.
Calculate the other workings using the same mindset.
 285

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

1.1.1. Application of EV

c. EV with decision matrices

Example 3:

Step 3: Calculate the total EV for each combination of action and outcome

Probability 0.20 0.55 0.25 EV ($)

Demand 10 15 25
Order
10 100 100 100 100
15 25 150 150 125
25 (125) 0 250 37.5

From this matrix, the best option is to order 15 magazines each week.
The EV means that if the strategy is followed for many weeks, the average profit will be
$125.
 286

II. Risk analysis techniques

1. Probability analysis

1.1 Expected values

1.1.2. Discussion about EV

Advantages Disadvantages

Recognize several possible Requires complicated

outcomes forecasting process and
subjective probabilities

Quantify probability of different Only applies if the project is

outcomes repeated many times

Ignore dispersion of probability

Directly leads to simple
distribution. The more widely
optimizing decision rule by
spread out the possible results
reducing a range of possible
are, the riskier the investment is
outcomes into one number
usually seen to be.

Ignore investor’s attitude to

Simple calculation
risk.
From the discussion above, it could be concluded that the EV decision rule is appropriate if:
• There is a reasonable basis for making the forecasts and estimating the probability
of different outcomes
• The decision is relatively small with business
• The decision is often made (repeated)
 287

II. Risk analysis techniques

1. Probability analysis

1.2 Joint probabilities

Joint probabilities: The probability of two risky outcomes occurring at the same time and is
calculated as the probability of one outcome multiplied by the probability of the other.

Example 4:
An investment project has a cost of $12,000, payable at the start of the first year of
operation. The possible future cash flows arising from the investment project have the
following present values and associated probabilities:
PV of Year 1 cash flow Probability PV of Year 1 cash flow Probability
($) ($)
16,000 0.15 20,000 0.75
12,000 0.60 (2,000) 0.25
(4,000) 0.25
Required: What is the expected value (EV) of the net present value of the investment
project?
A. $11,850
B. $28,700
C. $11,100
D. $76,300
 288

II. Risk analysis techniques

1. Probability analysis

1.2 Joint probabilities

Example 4:
Answer: C
EV of PV of year 1 cash flow: $16,000 × 0.15 + $12,000 × 0.6 – $4,000 × 0.25 = $8,600
EV of PV of year 2 cash flow: $20,000 × 0.75 – $2,000 × 0.25 = $14,500
EV of NPV = ($12,000) + $8,600 + $14,500 = $11,100
 289

II. Risk analysis techniques

2. Other techniques

2.1 Certainty-equivalent approach (Conservative forecasting)

By this method, the expected cash flows of the projects are converted to riskless equivalent
amounts and they should be discounted at a risk-free rate.

Example 5:

Certainty-equivalent approach
Dark Ages Co, whose cost of capital is 10%, is considering a project with the following
expected cash flows
Year Cash flow ($) DF at 10% Present value (PV)
0 (10,000) 1.000 (10,000)
1 7,000 0.909 6,363
2 5,000 0.826 4,130
3 5,000 0.751 3,755
NPV = 4,248

The project seems to be worthwhile. However, because of the uncertainty about the
future cash receipts, the management decides to reduce them to ‘certainty-equivalents’ by
taking only 70%, 60% and 50% of the years 1, 2 and 3 cash flows respectively. The risk-free
rate is 5%.

Required: On the basis of the information set out above, assess whether the project is
worthwhile.
 290

II. Risk analysis techniques

2. Other techniques

2.1 Certainty-equivalent approach (Conservative forecasting)

Example 5:

Solution:
Year Cash flow: certainty- DF at 5% Present value
equivalent ($) (PV)

0 (10,000) 1.000 (10,000)

1 (7,000 x 0.7) 4,900 0.952 4,665
2 (5,000 x 0,6) 3,000 0.907 2,721
3 (5,000 x 0.5) 2,500 0.864 2,160
NPV = (454)

The project’s certainty-equivalent NPV is negative. This means that the project is too risky
and should be rejected.
The disadvantage of the ‘certainty-equivalent’ approach is that the amount of the
adjustment to each cash flow is decided subjectively.
 291

II. Risk analysis techniques

2. Other techniques

2.2 Simulation

Simulation considers the effect of changing many variables at the same time. Using
mathematical models, it produces a distribution of the possible outcomes from the projects to
calculate the probability of different outcomes.

Notes:
You may not be expected to carry out a simulation exercise in the FM exam!

2.2.1 Stages involved in simulation

1 Specify major variables (e.g. market details, operating costs, …)

2 Specify relationships between variables to calculate an NPV

(e.g. Sales revenue = Market size × Market share × Selling price)

3 Simulate the environment

• Select different values of each variable within the parameters set and compute
an NPV
• Repeat the process many times to create a probability distribution of returns

4 The results of a simulation exercise will be a probability distribution of NPVs

 292

II. Risk analysis techniques

2. Other techniques

2.2 Simulation

2.2.2 Discussion about simulation

Advantages Disadvantages

Includes all possible

outcomes for decision Complex model, costly and
making process time-consuming

Wide variety of applications

(inventory control, component Probability distribution may be
replacement, corporate difficult to formulate
models, etc.)
 293

III. Uncertainty analysis techniques

1. Sensitivity analysis

1.1 Application of sensitivity analysis

Sensitivity analysis: Analyze the uncertainty surrounding a capital expenditure project and
enables an assessment to be made of how responsive the project’s NPV is to changes in a
single variable that affects a project’s NPV.

Sensitivity is calculated as:

Project NPV
Sensitivity % = Present value PV of project variable × 100

Meaning:
Calculate the value of a single variable would have to change by, to change project’s NPV to 0.
The lower the percentage, the more sensitive the NPV is to that variable.
 294

III. Uncertainty analysis techniques

1. Sensitivity analysis

1.1 Application of sensitivity analysis

Example 6:
A company has calculated the NPV of a new project as follows:

PV ($’000)
Sales revenue 4,000
Variable costs (2,000)
Fixed costs (500)
Corporation tax at 20% (300)
Initial outlay (1,000)
NPV 200

Require: What is the sensitivity of the project decision to a change in sales volume?
A. 12.5%
B. 6.3%
C. 10.0%
D. 5.0%
 295

III. Uncertainty analysis techniques

1. Sensitivity analysis

1.1 Application of sensitivity analysis

Example 6:
Answer: A
A change in sales volume affects sales revenue and variable costs, but not fixed costs. The
sensitivity of the NPV to a change in contribution must therefore be calculated. However,
a change in contribution will cause a change in the corporation tax liability, so it is
essential that the after-tax contribution be considered.

Contribution = 4,000,000 – 2,000,000 = $2,000,000

After-tax contribution = 2,000,000 x 0.8 = $1,600,000
Sensitivity = NPV/PV of project variable = 200,000/1,600,000 x 100 = 12.5%

In exam, the calculation of sensitivity will be required, for example:

Sales revenue

Variable costs

Fixed costs
296

III. Uncertainty analysis techniques

1. Sensitivity analysis

Advantages Disadvantages

No complicated theory to The unreasonable assumption

understand; that changes to variables can
be made independently

Information will be presented

to management in a form that
It only identifies how far, not
facilitates subjective judgment
the probability, a variable
to decide the likelihood of the
needs to change;
various possible outcomes
considered;
It may be that sales volume
appears to be the most crucial
Identifies areas that are
variable, but if the firm were
crucial to the success of the
facing volatile raw material
project. If the project is
markets a large change in raw
chosen, those areas can be
material prices may be far
carefully monitored;
more likely than a small
change in sales volume;
It is not an optimizing
technique. It provides
This indicates just how critical
are some of the forecasts information based on which
which are considered to be decisions can be made, not
uncertain. point directly to the correct
decision.
 297

III. Uncertainty analysis techniques

2. Other techniques

2.1 Discounted payback (Adjusted payback)

Discounted payback method takes into account the time value of money, hence overcomes that
shortcoming of traditional payback

Example 7:
SAC Co has a cost of capital of 8% and is appraising project Gamma. It has the following
cash flows.
T0 Investment 100,000
T1–5 Net cash inflow 40,000
Required: What is the adjusted payback period for this project?
A. 2.5 years
B. Just under 3 years
C. 2 years
D. Just over 4 years
Answer: B
Adjusted payback period is payback period based on discounted cash flows:
Year Working Discounted CF Cumulative discounted CF
0 (100,000) (100,000)
1 40,000 × (1.08)−1 37,040 (62,960)
2 40,000 × (1.08)−2 34,280 (28,680)
3 40,000 x (1.08)-3 31,760 3.080
 298

III. Uncertainty analysis techniques

2. Other techniques

2.2 Risk-adjusted discount rates

Applying the existing discount rate or cost of capital to an investor assumes that the existing
business and gearing risk of the company will remain unchanged.

If the project is significant in size and likely to result in additional risks then project-specific or
risk-adjusted discount rate should be used.

⇨ This method will be discussed further in Chapter Cost of capital.

299

CHAPTER 10: SPECIFIC

INVESTMENT DECISION
 300

Chapter 10: Specific investment decision

Overview graph

Specific investment
decisions

Asset replacement decision Lease vs buy Capital rationing

Equivalent Equivalent Approach 1:

annual annual Two Approach 2: Divisible Indivisible
cost benefit separate Single NPV projects projects
method method NPVs
 301

I. Asset replacement decision

Overview

DCF techniques can be useful in asset replacement decisions to assess how frequently a non-
current asset that is in continual use in a business (e.g. delivery vehicles) should be replaced.

For making asset replacement decision, there are two types of DCF techniques that we may
discuss as followed:

1 Equivalent annual cost method (EAC)

2 types of DCF
Title
techniques
2 Equivalent annual benefit method (EAB)
 302

I. Asset replacement decision

1. Equivalent annual cost method (EAC)

1.1 Asset replacement cycle

The asset replacement cycle is the length of time between an asset being purchased and the
asset being replaced. If the asset is replaced less frequently, then it has a longer replacement
cycle.

There are several aspects to consider about the replacement cycle:

Shorter replacement cycle Longer replacement cycle

Operating costs higher when the

Lower operating costs
asset gets older

A higher residual value when the

Residual value will be lower
asset is disposed of

Increased capital expenditure (as Reduced capital expenditure (as

the asset is bought more the asset is bought less
frequently) frequently)

The ideal replacement cycle will minimize the costs per year over the replacement cycle. The
ideal replacement cycle can be calculated by equivalent annual cost (EAC).
 303

I. Asset replacement decision

1. Equivalent annual cost method (EAC)

1.2 Equivalent annual cost method

1.2.1. Definition

Equivalent annual cost (EAC) is the equal annual cash flow (annuity) to which a series of
uneven cash flows is equivalent in present value terms.

With this method, the NPV of the cost of buying and using the asset over its life cycle is
converted into an equivalent annual cost or annuity.

⇨ The least-cost replacement cycle is the one with the lowest equivalent annual cost.

Example 1:

A machine has a cost of $2,500. The annual maintenance costs of the machine are forecast
to be $900 in the first year, $1,000 in the second year. The residual value of the machine is
expected to be $500 after two years. The cost of capital of the company is 11% per year.

Required: Calculate the equivalent annual cost (EAC) of the asset.

 304

I. Asset replacement decision

1. Equivalent annual cost method (EAC)

1.2 Equivalent annual cost method

1.2.1. Definition

Example 1:

Solution:

With this example, we have the NPV of the three-year replacement cycle is calculated
as below:

Year 0 1 2
Initial cost (2,500)
Maintenance cost (900) (1,000)
Resale value 500
Net cash flow (2,500) (900) (500)
11% Discount factors 1 0.901 0.812
Present values (2,500) (811) (406)
Net present value (3,717)
 305

I. Asset replacement decision

1. Equivalent annual cost method (EAC)

1.2 Equivalent annual cost method

1.2.1. Definition

Example :

As from the calculation above, we see that in different years, cash flows have different
present values, so that different life cycles of an asset cannot be compared. We use the
formula of EAC to convert the different cash flows among years into the equivalent annual
cost. Therefore we can make a comparison.

NPV of cost over the replacement cycle $(3,717)

EAC = = = $(2,170)
Annuity factor for the life of the asset 1.713

EAC of $(2,170) means that this is the equivalent annual cost at year 1, 2 equates to an
NPV cost of $(3,717).
Year 1 2 Total
EAC (2,170) (2,170)
Discount factor 11% 0.901 0.812
NPV (1,955) (1,762) (3,717)

As we can see from the calculation above, the NPV of EAC is equal to the NPV of
discounted cash flows. Hence, the formula EAC is proved to be true.
 306

I. Asset replacement decision

1. Equivalent annual cost method (EAC)

1.2 Equivalent annual cost method

1.2.2. Calculation
EAC is calculated following these steps below:

STEP Calculate the present value of costs for each replacement cycle over one
1 cycle only

Note:
These costs are not comparable because they refer to different time periods
(Ref: Example 1 – STEP 1).

STEP Turn the present value of costs for each replacement cycle into equivalent
2 annual cost (EAC)

NPV of cost over the replacement cycle

EAC =
Annuity factor for the life of the asset
 307

I. Asset replacement decision

1. Equivalent annual cost method (EAC)

1.2 Equivalent annual cost method

1.2.2. Calculation

Example 2:
PD Co is deciding whether to replace its delivery vans every year or every other year. The
initial cost of a van is $20,000. Maintenance costs would be nil in the first year, and $5,000
at the end of the second year. Secondhand value would fall from $10,000 to $8,000 if it
held onto the van for 2 years instead of just 1. PD Co's cost of capital is 10%.
Require: How often should PD Co replace its vans, and what is the equivalent annual cost
(EAC) of that option?
Replace every EAC
Year $
A. 1 10,910
B. 1 12,002
C. 2 10,093
D. 2 8,761

Answer: C
Net present cost of 1-year cycle = 20,000 – (10,000/1.11) = $10,910 cost
Net present cost of 2-year cycle = 20,000 – [(8,000 – 5,000)/1.12] = $17,522 cost
EAC 1-year cycle = $10,910/0.909 = 12,002
EAC 2-year cycle = $17,522/1.736 = 10,093
The 2-year cycle should be chosen with an equivalent annual cost of $10,093
 308

I. Asset replacement decision

2. Equivalent annual benefits (EAB)
Equivalent annual benefit (EAB) is the annual annuity with the same value as the net present
value of an investment project.

NPV of project
EAB =
Annuity factor

Note:

EAC and EAB are both annual annuity measurements and they have the same technique of
discounted cash flows. However, EAC and EAB have differences in their usages.

• If the company makes a decision based on the cost it pays out, EAC will be used.

• Otherwise, if the company considers the benefits it may receive when making decisions,
EAB is used instead.
 309

I. Asset replacement decision

2. Equivalent annual benefits (EAB)

Example 3:
A professional kitchen is attempting to choose between gas and electricity for its main
heat source. Once a choice is made, the kitchen intends to keep to that source indefinitely.
Each gas oven has an NPV of $50,000 over its useful life of 5 years. Each electric oven has
an NPV of $68,000 over its useful life of 7 years. The cost of capital is 8%.
Require: Which should the kitchen choose and why?
A. Gas because its average NPV per year is higher than electric
B. Electric because its NPV is higher than gas
C. Electric because its equivalent annual benefit is higher
D. Electric because it lasts longer than gas

Answer: C
The NPVs cannot be directly compared as they relate to different time periods. Equivalent
annual benefits (EAB) should be compared. This is similar in principle to equivalent annual
cost.
EAB gas = $50,000/AF1-5 = 50,000/3.993 = $12,522 pa
EAB electric = $68,000/AF1-7 = 68,000/5.206 = $13,062 pa
Therefore electric should be chosen as its EAB is higher.
 310

I. Asset replacement decision

3. Limitations of replacement analysis
The replacement analysis model assumes that the firm replaces like with like each time it
needs to replace an existing asset.
Changing technology
Impact of taxation
Machines fast become
Both buying an asset and
obsolete and can only be
incurring a maintenance cost
replaced with a more up-to-
will cause tax cash flows.
date model, which will be
While these cash flows could
more efficient and perhaps
be included, they would add
perform different functions.
to the complexity of the
calculation.

This assumption
ignores

Changes in production plans Inflation

Firms cannot predict with The increase in prices over
accuracy the market time alters the cost
environment they will be structure of the different
facing in the future and assets, meaning that the
whether they will even need optimal replacement cycle
to make use of the asset at can vary over time.
that time.
 311

II. Lease and buy

1. The nature of leasing

Rather than buying an asset outright, using either available cash resources or borrowed funds,
a business may lease an asset.

Leasing

a contract between a lessor and lessee for hire a specific asset by the lessee from a
manufacturer or vendor of such assets

Lessor Lessee

has ownership of the asset and so has possession and use of the
provides the initial finance for the asset on payment of specified
asset rentals over a period

Types of leasing

Sale and
Operating leasing Financial leasing
leaseback
 312

II. Lease and buy

2. Types of leases

2.1 Leases that minimize risk to the lessee

Some leases, often short-term leases, are rental arrangements between a lessor and lessee that
the lessor retains most of the risks of ownership. (Operating leasing)

The lessor is responsible for servicing and maintaining the leased equipment.

The lessor endures with a higher risk of ownership when the asset is out of date.
Because, the lessee can exit from the rental arrangement at the end of the lease term
and not be tied into using outdated assets.

2.2 Leases that are purely a source of finance

Some leases are long-term arrangements that transfer the risks and rewards of ownership of an
asset to the lessee. (Financial leasing)

The lessee is responsible for the upkeep, servicing and maintenance of the asset.

This can be a cheaper source of finance than a bank loan when the lessor obtains bulk
purchase discounts and lower rental payments for the lessee.
 313

II. Lease and buy

2. Types of leases

2.3 Sale and leaseback

Sale and leaseback is when a business that owns the asset agrees to sell the asset to a financial
institution and lease it back on terms specified in the sale and leaseback agreement.

The business retains the use of the asset but has the funds from the sale while having to pay
rent.

Example:
A common form of sale and leaseback arrangement has involved commercial property.
A company might sell its premises to a bank or finance company (to raise cash) (1). After
that, it signs a long-term lease arrangement to use the premises (2). Periodically, it pays
lease payments and interests to bank/finance company (3). It is described as below:

1 Sell premises

Receive cash
Bank/ Finance
Company A 2 Long-term leasing arrangements company

3 Lease payments and interests

 314

II. Lease and buy

3. Benefits of leasing

There are several benefits of leasing for lessee and lessor can be listed in the graph below:

Benefits of leasing

For lessee For lessor

Reduce risk
Availability
If the lessee defaults in payments, the
Getting a lease is
lessor can take back the possession of
easier than getting a bank loan
the asset.

Returns on finance
Avoiding loan covenants
The lessor purchase assets and making a
Loan covenants may be a restriction for
return out of the lease payments from
a company to borrow in the future
lessee
 315

II. Lease and buy

4. Lease or buy decisions

4.1 Approach 1: Two separate NPVs

This approach evaluates the NPV of the cost of the loan and the NPV of the cost of the lease
separately and simply chooses the cheapest option.

STEP 1:
Calculate the costs of leasing using the post-tax cost of debt as the discount factor

STEP 2:
Calculate the costs of the loan using the post-tax cost of debt as the discount factor

STEP 3:
Compare and choose the cheaper cost of finance
 316

II. Lease and buy

4. Lease or buy decisions

4.1 Approach 1: Two separate NPVs

Example 4:
AB Co is considering either leasing an asset or borrowing to buy it, and is attempting to
analyse the options by calculating the NPV of each. When comparing the two, AB Co is
uncertain whether it should include interest payments in its option to 'borrow and buy' as
it is a future, incremental cash flow associated with that option. AB Co is also uncertain
which discount rate to use in the NPV calculation for the lease option.
Require: How should AB Co treat the interest payments and what discount rate should it
use?
Include interest? Discount rate
A. Yes After tax cost of the loan if they borrow and buy
B. Yes AB Co’s weighted average cost of capital
C. No After-tax cost of the loan if they borrow and buy
D. No AB Co’s weighted average cost of capital

Answer: C
Interest should not be included as a cash flow as it is part of the discount rate.
As a financing decision the alternatives should be assessed at the after-tax cost of
borrowing – the risk associated with each is the risk of borrowing (or not), and not related
to what is done with the asset.
 317

II. Lease and buy

4. Lease or buy decisions

4.2 Approach 2: Single NPV

An alternative method is to evaluate the NPV of the cost and benefits of using a lease in one
calculation.

The benefits of leasing

The costs of leasing
saved money as not have to pay for the
may include lease payments and
initial outlay and savings on maintenance
opportunity costs of not buying the asset
cost (if provided by lessor)

Discount the net cash flows

i.e. the costs net of the benefits
Accept lease if NPV is positive
 318

II. Lease and buy

4. Lease or buy decisions

4.2 Approach 2: Single NPV

Example 5:
A lease versus buy evaluation has been performed. The management accountant
performed the calculation by taking the saved initial outlay and deducting the tax-adjusted
lease payments and the lost capital allowances. The accountant discounted the net cash
flows at the post-tax cost of borrowing. The resultant net present value (NPV) was positive.
Require: Assuming the calculation is free from arithmetical errors, what would the
conclusion for this decision be?
A. Lease is better than buy
B. Buy is better than lease
C. A further calculation is needed
D. The discount rate was wrong so a conclusion cannot be drawn

Answer: A
The saved outlay is a benefit of the lease so if it outweighs the present value of the costs
relevant to the lease then the lease is financially worthwhile
 319

III. Capital rationing

1. Reasons of capital rationing

Capital rationing: Arises when there is insufficient capital to invest in all available projects
which have positive NPVs – capital is a limiting factor.

Hard capital rationing (external factors) is

1 brought about by external factors, such as
the limited availability of new external
finance.

Capital
rationing
Title
arises for two
main reasons:

Soft capital rationing (internal factors) is

2 brought about by internal factors and
decisions made by management.
320

III. Capital rationing

1. Reasons of capital rationing

Hard capital rationing Soft capital rationing

(external factors) (internal factors)

Management may be
Investors are unwilling or reluctant to issue additional
unable to invest more in share capital for fear of losing
equity finance. control and dilutive impact on
earnings per share.

Management may not want to

Lending institutions consider an raise additional debt capital
organization to be too risky to as they do not want to be
be granted funds. committed to large fixed
interest payments and want to
keep gearing under control.

Capital markets are Creating competition for a

depressed and reluctant to limited pool of funds
lend businesses because of encourages divisions to search
fear of an economic for the very best possible
downturn. projects.
 321

III. Capital rationing

2. Capital rationing techniques

Note:
In this exam, you only need to be able to analyse situations where this is a problem in a single
year.

2.1 Divisible projects

Divisible projects: A project that can be scaled down and done in part.

Where the projects are divisible, investment funds are a limiting factor and management should
follow the decision rule of maximizing the use of limiting factor by selecting the projects whose
cash inflows have the highest return per $1 of capital invested. This is measured by the
Profitability Index (PI).

Present value of cash inflows

Profitability Index (PI) =
Initial cash outflow
 322

III. Capital rationing

2. Capital rationing techniques

2.1 Divisible projects

The process of selecting projects is achieved by the following steps:

Step 1
Calculate PI for each project

Step 2
Rank projects according to their PI from highest PI to lowest PI

Step 3
Allocate funds according to the projects’ rankings until they are used up
 323

III. Capital rationing

2. Capital rationing techniques

2.1 Divisible projects

Example 6:
A company has four independent projects available:
Capital needed at time 0 NPV
$ $
Project 1 10,000 30,000
Project 2 8,000 25,000
Project 3 12,000 30,000
Project 4 16,000 36,000
Require: If the company has $32,000 to invest at time 0, and each project is infinitely
divisible, but none can be delayed, what is the maximum NPV that can be earned?
A. $85,000
B. $89,500
C. $102,250
D. $103,000
 324

III. Capital rationing

2. Capital rationing techniques

2.1 Divisible projects

Example 6:
Answer: B
Project Capital needed at time NPV P. Index
0
$ $
1 10,000 30,000 30,000/10,000 = 3.0
2 8,000 25,000 25,000/8,000 = 3.125
3 12,000 30,000 30,000/12,000 = 2.5
4 16,000 36,000 36,000/16,000 = 2.25
Project Rank Invested NPV
$'000 $
1 2 10,000 30,000
2 1 8,000 25,000
3 3 12,000 30,000
4 4 2,000 4,500
Total = 32,000 89,500
 325

III. Capital rationing

2. Capital rationing techniques

2.2 Non-divisible projects

Non-divisible project: A project that must be undertaken completely or not at all; i.e. it is not
possible to scale down the project and do it in a part.

Where a project cannot be done in part, the choice facing a company is not how to spend each
$1 so the PI should not be used.

The appropriate technique here is to:

Step 1
Identify which project combinations are affordable

Step 2
Select the project combination with the highest NPV

Note:
For this combination, there is a problem however relating to the unused funds. The assumption
is that the un-utilized funds will earn a return equivalent to the cost of capital and hence will
generate an NPV of 0. This may or may not be the case.
 326

III. Capital rationing

2. Capital rationing techniques

2.2 Non-divisible projects

Example 7:
Hard up Ltd can spend $1,000. They have identified the following 3 projects
Project Investment NPV
1 600 300
2 200 180
3 400 210
Require: Calculate the optimal combination of projects if they are - Non divisible
A. 1 and 2
B. 1 and 3
C. 2 and 3
Answer: B
Projects 1 and 3 give the highest NPV without breaking the $1,000 constraint.
327

CHAPTER 11:
SOURCES OF FINANCE
 328

Chapter 11: Sources of finance

Overview graph

Sources of finance Islamic finance

Short-term Long-term Principles of Islamic Islamic finance

finance finance finance instruments

Long-term debt Ethical and

Overdraft Murabaha
finance moral investing

Short-term
Equity finance Musharaka
loan

Preference Mudaraba
Trade credit
shares

Short-term Venture Ijara

lease capital
Sukuk
 329

I. Sources of finance
Overview

Firms need funds to:

Provide working capital Invest in non-current assets

Among sources of finance, a firm may need to consider the following factors to borrow for funds.

Factors Issues to consider

Cost Debt usually cheaper than equity

Duration Long-term finance more expensive but secure (In case of purchasing
assets, firms usually match duration to assets purchased)

Term structure of Relationship between interest and loan duration

interest rates

Gearing Using mainly debt is cheaper but high gearing is risky

Accessibility Not all sources are available to all firms

 330

I. Sources of finance
1. Short-term finance
Generally, short-term finance is less risky than long-term finance because its duration is only
for a shorter period of time. Hence, short-term finance investors require a lower rate of
return.

Short-term finance is usually needed for businesses to run their day-to-day operations which
are payments of wages to employees, inventory ordering, and supplies.

We briefly review the main types of short-term finance in the following table:

Short-term
Definition Characteristics Purposes
finance
Overdraft The bank grants  The interest rate is usually higher Overdraft is
an overdraft than the rate for a short-term generally to
facility (usually bank loan. cover short-
for a fee). This  Depends on the size of the facility. term deficits in
facility can be The bank may ask for security cash flows from
used by the (collateral) but often does not. normal business
borrower up to  This can be arranged quickly and operations.
an agreed limit. offer a level of flexibility.

Short-term A loan of a fixed  It is drawn in full at the beginning The loan may
loan amount for a of the loan period and repaid at a have a specific
specified period, specified time or in defined purpose, often
usually from a installments. for a stable
bank.  Once the loan is agreed upon, the short-term
term of loan must be adhered to, capital needed.
provided that the customer does
not fall behind with their
repayments.
 331

I. Sources of finance
1. Short-term finance

Short-term
Definition Characteristics Purposes
finance
Trade credit Current assets such  The credit period is Suitable for suppliers
as raw materials may agreed and clearly stated having purposes to
be purchased on before the purchase. enhancing its goods
credit, and this  It is important to take consumption while
therefore represents into account the loss of buyers do not have
an interest-free discounts suppliers may enough money.
short-term loan. offer for early payment.
 Unacceptable delays in
payment will worsen a
company’s credit rating
and additional credit may
become difficult to
obtain.
Short-term Leasing can be  The lessor retains Suitable for
lease defined as a contract ownership of the asset. companies that need
between lessor and  The lessee has possession assets to use but not
lessee for hire a and use of the asset on have finance to
specific asset. payment or specified purchase one.
rentals over a period.
 332

I. Sources of finance
1. Short-term finance
Comparison between Overdraft and Short-term loan

Among types of short-term finance, Overdraft and Short-term loan have the most similarities
and can be comparable.

An overdraft A loan

Variable amount of borrowing up Fixed amount of borrowing

Amount
to a agreed limit

Higher interest rate than short- Lower interest rate than

Interest
term loan as overdraft is more overdraft as loan is fixed amount
rate
flexible and available and time of repayment

Interest Customer only pays interest Interest is paid periodically or at

payments when they are overdrawn specified time in the future

Repayment Repayment on demand Timing and amount of repayment

schedules are exactly set

Often do not require Required loan covenants or

Security
collateral

Often for deficiency of cash flows For a specific purpose or when a

Purpose
in day-to-day business operations stable short-term capital needed
 333

I. Sources of finance
2. Long-term finance

Long-term finance is used for major investments, which require finance over a long-time
period. As the duration of finance is longer, long-term finance investors expose more risks.
Therefore, long-term finance is usually more expensive and less flexible than short-term one.

2.1 Long-term debt finance

The choice of debt finance that a company can make depends on various factors:

• Listed company: a public issue loan note

Availability
• Smaller company: bank loan only

Credit rating given to a loan note issue affects the interest yield
Credit rating
that investors will acquire

• Large amount: loan notes

Amount
• Small amount: a bank loan

If loan finance is sought to buy an asset to generate revenues,

Duration the length of loan should match the length of time that asset will
be generating revenues

Fixed or • Fixed-rate: more expensive

floating rate • Floating rate: run the risks of upward rate movements

The choice of finance maybe determined by:

Security and
• The assets that the business is able to offer as security; and
covenants
• The restrictions in covenants lenders wish to impose
 334

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.1. Bank loans

a. Requirements to obtain a bank loan

To obtain a bank loan a firm may need to:

Present a convincing Provide security by either

business plan (including a fixed or floating charge
information on cash against a firm’s assets or
flow forecasts, the provide personal
management team and collateral, eg. the
investment proposals) Director’s home.
 335

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.1. Bank loans

b. Loan covenants

Loan covenant: A condition that the borrower must comply with. If the borrower does not act
in accordance with the covenants, the loan can be considered in default and the bank can
demand payment.

Example 1: Loan covenants

Positive covenants Negative covenants

Maintaining certain levels of particular Limit a borrower’s behaviour
financial ratios

Eg: Maintaining levels of the Eg: Prevent borrowing from another

debt/equity ratio, interest cover ratio... lender, disposal of key assets...
 336

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.2. Loan notes

Loan notes are long-term debt capital raised by a company for which interest is paid, usually
half-yearly and at a fixed rate. Holders of loan notes are therefore long-term payables for the
company.

The coupon rate is fixed at the time of issue and

will be set according to prevailing market
Coupon rate
conditions given the credit rating of the
company issuing the debt.

The ability to sell the debt can mean that

Marketable investors accept a lower return compared to the
cost of a bank loan.
Features of
loan notes
Loan notes are normally redeemable. Some loan
notes are ‘irredeemable’ or ‘undated’. These are
Redeemable
often called perpetual bonds and are normally
issued by banks.

Loan notes are normally secured – if unsecured,

they are likely to carry debt covenants (see
Secured earlier). Investors are likely to expect a higher
yield with unsecured bonds to compensate for
the extra risk.
 337

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.2. Loan notes

a. Convertible loan notes

Convertible loan notes are loan notes that can give the holder the right to convert to normally
ordinary shares at either:
• Predetermined price (Eg: notes may be converted into shares at a value of 400c per share)
• Predetermined ratio (Eg: $100 of stock may be converted into 25 ordinary shares)

Convertible loan notes

Loan note holders Loan note holders

do not convert convert loan into shares
loan into shares

Conversion value
Conversion ratio
The current
number of
market value of
shares a single Market price
ordinary shares
convertible loan per share
Loan notes will be into which a loan
note can be
redeemed at note may be
converted to
maturity converted

Current
Current
Conversion conversion
market value
premium value of
of loan note
share
 338

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.2. Loan notes

a. Convertible loan notes

Example 2:

Convertible loan notes

Cleethorpe Co has a 3% convertible bond in issue, with a nominal value of $100. Each bond
can be converted into 25 ordinary shares at any time over the next 3 years. The bond is
currently trading at $120 (ex-interest), and the share price is currently $3.80.

Required:
(a) Calculate the conversion value.
(b) Calculate the conversion premium, and comment on its meaning.

Solution:
As requirements mentioned to calculate conversion value and conversion premium so
that in this case the investors choose option to convert convertible loan notes into shares
 339

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.2. Loan notes

a. Convertible loan notes

Example 2: Loan notes holders

convert loan into notes

Conversion Market price per

Conversion ratio
value share

1 x 25 $3.80
$95 (1 bond can be converted (share price is currently
into 25 shares) $3.80)

Conversion Current market value Current conversion

premium of loan note value of shares

$120 $95
$26.3* (The bond is currently (Conversion value of share
trading at $120 ex-interest) – calculated above)

*Meaning: The share price would have to rise by 26.3% before the conversion rights
became attractive; if this premium is set too high then the convertible bond may not be
popular with investors.
 340

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.2. Loan notes

b. Deep discount loan note

Deep discount loan notes are issued at a large discount to the nominal value of the notes, and
will be redeemable at nominal value (or above nominal value) when they eventually mature.

The low initial price paid by the investor is balanced against a lower rate of return (coupon
rate) offered on the bond. Much of the return gained by the investor comes from the capital
gain when the bond is redeemed.

Example 3:

Deep discount loan note

A company might issue $1,000,000 of loan notes in 20X1, at a price of $50 per $100
nominal value. The coupon rate of interest will be very low compared with yields on
conventional loan notes with the same maturity. These are deep discount loan notes.

These loan notes are redeemable at nominal value in the year 20X9.
 341

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.2. Loan notes

c. Zero coupon loan notes

Zero coupon loan notes are issued at a discount to their redemption value, but no interest is
paid on them.

Zero coupon loan notes are an extreme form of deep discount bond.

Example 4:

Zero coupon loan notes

A company may issue zero coupon discount loan notes at 75.00, pay no interest at all, but
at maturity redeem the loan notes at 100.00.

The investor gains from the difference between the issue price and the redemption value
($25 per $75 invested).
 342

I. Sources of finance
2. Long-term finance

2.1 Long-term debt finance

2.1.3. Long-term lease

Long-term lease arrangements would be used as debt finance for assets that have a useful life
over the medium to long-term period.

The main conditions of long-term lease can be discussed as below:

Lease period One lease exists for the whole useful life of the asset

Lessor’s
The lessor does not usually deal directly in this type of asset
business

Risk and The lessor does not retain the risks or rewards of ownership.
rewards Lessee responsible for repairs and maintenance

The lease agreement cannot be canceled. The lessee has

Cancellation
liability for all payments
 343

I. Sources of finance
2. Long-term finance

2.2 Equity finance

Equity finance refers to finance provided by the owners of the business, and as such normally
refers to the capital invested by ordinary shareholders.

Ordinary shareholders have voting rights in general meetings, rank after all creditors and
preference shares in rights to assets on liquidation.

Companies often decide to retain cash within the business to finance their investment needs
(instead of paying this cash to shareholders as a dividend). For larger projects, it may be
necessary to raise new equity by issuing new ordinary shares.

There are four main ways of issuing new shares:

Right issues A placing

Stock exchange
Public offer
listing
 344

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.1. Right issues

Right issues provide a way of raising new share capital by means of an offer to existing
shareholders, inviting them to subscribe cash for new shares in proportion to their existing
holdings.

Example 5:

Right issues
A rights issue on a one for four basis at 280c per share would mean that a company is
inviting its existing shareholders to subscribe for one new share for every four shares they
hold, at a price of 280c per new share.
 345

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.1. Right issues

A ‘cum rights’ price means that the purchaser of existing shares has the right to participate in
the rights issue (ie the price prior to the rights issue).

Issue price is the price at which the new shares are being offered for sale.

Theoretical ex-rights price (TERP) is the theoretical price after the rights issue.

Market value of shares already in issue

TERP = + Proceeds from new shares issue
Number of shares in issue after the rights issue

Value of a right (*) is the price at which a right can be sold (calculate as TERP – issue price).

Value of a right per existing share is the value of a right divided by the number of shares that
need to be possessed in order to own a right.
 346

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.1. Right issues

(*) Value of a right:
To clearly definite “value of the right”, we have the below demonstration:
To make the offer relatively attractive to shareholders, new shares are generally issued at a
discount on the current market price.

Market price Theoretical ex-rights

Issue price
price
(value afterwards)

Discount Value of
to encourage a right
take up

Therefore, we have:
• Value of a right = theoretical ex-rights price – issue price
• Value of a right per existing share = (theoretical ex-rights price – issue price)/no. of shares
needed to obtain a right
Since rights have a value, they can be sold on the stock market.
 347

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.1. Right issues

Example 6:

TERP & Value of a right

ABC Co announces a 2 for 5 rights issue at $2 per share. There are currently 10 million
shares in issue, and the current market price of the shares is $2.70.

Required:
(a) Calculate the TERP
(b) What is the value of a right in ABC Co and the value of the right per existing share?
 348

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.1. Right issues

Example 6:

Solution:

a) Calculate the TERP

Market value of shares already in issue

+ proceeds from new shares issue
TERP =
Number of shares in issue after the rights issue

Number of shares in
Market value of shares Proceeds from new
issue after the rights
already in issue shares issue
issue

10mil shares +
10mil shares (10 mil shares/5) x 2
(10 mil shares/5 x 2)
x $2.70/share = $27mil x $2/share = $8mil
= 14mil shares

TERP = ($27mil + $8mil) / 14mil shares = $2.50/share

 349

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.1. Right issues

Example 6:

Solution:

(b) Value of a right and the value of the right per existing share
• Value of a right
= Theoretical ex-rights price – Issue price
= $2.50 - $2 = $0.50 per new share issued

• Value of a right per existing share

= (Theoretical ex-rights price – Issue price)/Number of shares needed to obtain a right
= ($2.50 - $2) / (5/2) = $0.20 per existing share
 350

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.2. A placing

A placing is an arrangement whereby, instead of offering the shares to the general public, the
sponsoring investment bank arranges for most of the issue to be bought by a small number of
investors.

This method may be favorable by unquoted companies. There are several advantages of ‘a
placing’ that support unquoted companies.

1 Placings are likely to be quicker

2 Placings are likely to involve less disclosure of information

3 Placings are much cheaper than public offers.

 351

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.3. Public offer

A public offer is an invitation to apply for shares in a company based upon information
contained in a prospectus, either at a fixed price or by tender.

Public offer

Offer for sale by tender

Fixed price offer
Shares are offered to the general public
Shares are offered at a fixed price to the
(including institutions) but no fixed price is
general public (including institutions).
specified.

Details of the offer document are Potential investors bid for shares at a
published in a prospectus. This contains price of their choosing. The shares are
information about the company’s past sold at a price determined by the demand
performance and future prospects. for shares.
 352

I. Sources of finance
2. Long-term finance

2.2 Equity finance

2.2.4. Stock exchange introduction

A company may wish to become listed on the stock exchange to increase its pool of potential
investors.

Introduction is a process that allows a company to join a stock exchange without raising capital.
A company does not issue any fresh shares; it merely introduces its existing shares in the
market.

Pricing shares for a stock market launch depends on different factors:

Price of similar quoted Current market

companies conditions

Future trading Desire for immediate

prospects premium
 353

I. Sources of finance
2. Long-term finance

2.3 Preference shares

Preference shares are shares that give the right to receive dividends (typically a fixed amount)
before any dividends can be paid to ordinary shareholders

Types of preference shares

Cumulative preference shares Non-cumulative preference shares

• Limited right to vote at a general • Typically acquire some voting

meeting rights if dividend has not been
• Arrears accumulate and must be paid for three years
paid before a dividend on ordinary • Arrears do not accumulate
shares may be paid
 354

I. Sources of finance
2. Long-term finance

2.3 Preference shares

As a source of finance, preference shares have several advantages and disadvantages over debt
and ordinary shares, which can be detailed as below:

Compared to debt Compared to ordinary shares

No dilution of control
More flexible than debt
(preference shares carry no
finance (if losses are made,
voting rights except in
the dividend is not paid).
exceptional circumstances).

Creates extra risk for ordinary

No tax relief is received on shareholders because the
dividend payments preference dividend has to be
paid before the ordinary
dividend.
 355

I. Sources of finance
2. Long-term finance

2.4 Venture capital

Venture capital is risk capital, normally provided by a venture capital firm or individual venture
capitalist, in return for an equity stake.

The types of venture that a venture capitalist might invest in

Business start-ups Business development Management buyouts

To provide finance to To provide development To purchase of all parts

enable it to get off the capital for a company of a business from its
ground which wants to invest in owners by its managers
new project
 356

II. Islamic finance

1. Principles of Islamic finance

Islamic finance transactions are based on the concept of sharing risk and reward between the
investor and the user of funds.

Islamic finance has the same purpose as other forms of business finance except that it
operates in accordance with the principles of Islamic law (Sharia).

Sharing of profits and losses

Basic principles of
No interest allowed
Islamic finance

Finance is restricted to Islamically

accepted transaction

Therefore, ethical and moral investing is encouraged.

Islamic finance is arranged in such a way that the bank’s profitability is closely tied to that of
the client. The bank stands to take profit or make a loss in line with the projects they are
financing and as such must be more involved in the investment decision-making.
 357

II. Islamic finance

2. Islamic financial instruments

This is a form of trade credit for asset acquisition that avoids the
payment of interest:
Murabaha • The bank buys the item and then sells it on to the customer on a
(trade deferred basis at a price that includes an agreed mark-up for
credit) 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

This is a partnership agreement whereby all partners provide capital

Musharaka and know-how.
(venture • Profits are shared according to a pre-agreed contract in an agreed
capital) proportion
• Losses are shared according to capital contribution.

A contract in which one of the partners (investor) contributes capital

and the other (manager) contributes skills and expertise.
Mudaraba • The partner who contributes capital has no or little involvement in
(equity) operational decisions
• Profits are shared in a pre-agreed ratio and losses are solely
attributable to the investor
 358

II. Islamic finance

2. Islamic financial instruments

This is a lease finance agreement whereby the bank buys an item for a
customer and then leases it back over a specific period at an agreed
amount:
Ijara • The lessor is still the owner of the asset and incurs the risk of
(leasing) ownership. This means that the lessor will be responsible for
major maintenance and insurance
• The lessee must take responsibility for day-to-day maintenance,
wear and tear and damage

This is a debt finance. Islamic bonds, or sukuk, cannot bear interest.

• Sukuk holders must have a proprietary interest in the assets which
Sukuk
are being financed
(bonds)
• The sukuk holders’ return for providing finance is a share of the
income generated by the assets
359

CHAPTER 12:
DIVIDEND POLICY
 360

Chapter 12: Dividend policy

Overview graph

Dividend policy

Alternatives to cash
The dividend decision Dividend policies
dividends

Theories of dividend
policy Scrip dividend
The amount of
dividend paid
depends on the
Practical constraints of
amount of retained
dividend policy
cash company want
to retained
Share repurchase
Types of policies
 361

I. The dividend decision

Content
For many companies, the decision to use retained cash as a source of finance will have a direct
impact on the amount of dividends it will pay to shareholders. If the company wants to retain
more cash, the amount of dividends paid out would be cut.

Retained cash is surplus cash that has not been needed for operating costs, interest payments,
tax liabilities, asset replacement or cash dividends.

Specifically, using retained cash as an internal source of finance has the following advantages
and disadvantages:

Advantages Disadvantages

Shareholders may be sensitive

Flexible source of finance
to the loss of dividends

No change in pattern of
shareholdings and no dilution Expensive source of finance
of control

No issue costs
 362

I. The dividend decision

Content
Besides retained cash, the amount of savings from more efficient working capital
management is an internal source of finance, and also have an influence on the amount of
dividends paid out.

When deciding on the amount of dividend to pay out to shareholders, two of the main
considerations of the directors will be:

Investment decision
1 If the company is going through a growth
phase, dividend may be expected to be
low or zero
Dividend
amount
Title
affected by
Financing decision
2 If a company can finance its investments
by borrowing, it can still pay dividends
as long as it has profits

Note:

If the level of dividend is not at the level expected by shareholders, it will generally cause the
share price to fall. Because shareholders do not have the same information as directors
about the future prospects of company.
 363

II. Dividend policies

1. Theories of dividend policy

Theories of dividend
policy

Dividend irrelevancy
Residual theory Dividend relevance
theory
 364

II. Dividend policies

1. Theories of dividend policy

1.1 Dividend irrelevancy theory

The dividend irrelevancy theory put forward by Modigliani & Miller (M&M) argues that in a
perfect capital market, 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.

The M&M perfect capital market underlies the following assumptions:

No taxes exist
1
Capital markets are perfectly efficient: funds will
2 always be made available to finance attractive
investments

Assumptions

No transactions costs: in issuing new shares, or

3
taking out a bank loan, or selling shares.

4 Information is fully and freely available to

shareholders
 365

II. Dividend policies

1. Theories of dividend policy

1.1 Dividend irrelevancy theory

Thereby, shareholder wealth was unaffected by the financing decision. This method can be
demonstrated as below.

X X = Amount of
dividend paid
Value of
shares Value of
shares

No dividend Dividend
payment payment
Case 1 Case 2

In M&M point of view, there is no difference to shareholder’s wealth whether they receive
dividends now or in the future.

Case 1: No dividend payment Case 2: Dividend payment

Company would use the amount of not Although shareholders will have the benefit of
paying dividend (X) for finance receiving the dividend, the shortfall in funds
purposes. Therefore, shareholders will lead to the decrease in the value of
would expect the increase of wealth in shares. The loss in the value is equal to the
the future growth of the company. amount of dividends paid (X).

In this case, funds for finance purposes can be obtained from outside sources.
 366

II. Dividend policies

1. Theories of dividend policy

1.2 Residual theory

The residual theory argues that provided the present value of the dividend stream remains the
same, 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.

Residual theory of dividend policy can be summarized as follows.

If a company can identify project with

1 positive NPVs, it should invest in them

Residual
Title
theory

Only when these investment opportunities

2
are exhausted should dividends be paid
 367

II. Dividend policies

1. Theories of dividend policy

1.3 Dividend relevance

Practical influences, including market imperfections, mean that changes in dividend policy,
particularly reductions in dividends paid, can have an adverse effect on shareholder’s wealth.
There are several practical influences that should be considered for dividend payment.

Dividend relevance

Dividend signaling Preference for current income Taxation

Investors do not have Many investors require Income from dividends is

perfect information about cash dividends to finance generally taxed in a
future prospects of the current consumption. different way from
company. income from capital gains.
E.g.: Insurance companies This can have impact on
→ Dividend payments is a require regular cash investor’s preferences.
key consideration of inflows to meet day-to-day
estimating future insurance claims. E.g.: Higher rate tax payers
performance. may prefer capital gains to
dividend income as they
can choose the timing of
the gain to minimize the
tax burden.
368

II. Dividend policies

2. Practical constraints of dividend policy

Constraints

Rules as to distributable profits that prevent excess cash

Legal distributions.
restrictions on
dividend
payments Bond and loan agreements may contain covenants that restrict the
amount of dividends a firm can pay.

Consider availability of cash, not just to fund the dividend but also
Liquidity cash needed for the continuing working capital requirements of the
company.
 369

II. Dividend policies

3. Types of dividend payment policies

Policy

Constant Payment of a constant % of profit as a dividend is logical but can

payout ratio create volatile dividend movements if profits are unstable.

Dividends are increased at a level that directors think is sustainable.

Stable growth
This signals the growth prospects of the company.

A dividend is paid only if all +NPV projects have been funded. This is
Residual policy
often used by companies which have difficulty raising debt finance.

Companies at different life stages may vary in the choices of dividend policy to apply. For
example, this can be seen clearly with young companies and mature ones.

Young companies Mature companies

(or companies with volatile cash flows) often follow a stable growth or constant
often follow a residual policy payout policy

These companies often prefer These companies often prefer

to avoid debt finance to use debt finance
 370

III. Alternatives to cash dividends

1. Scrip dividend

Scrip dividend: A dividend paid by the issue of additional company shares, rather than by cash.

Advantages Disadvantages

Assuming that dividend per

If taken up, it can preserve share is maintained or
a company cash position increased, the total cash paid
will increase

Investors may be able to obtain Scrip dividends may be seen as

tax advantages if dividends are a negative signal by the
in form of shares market (ie company is
experiencing cash flow issues)

Investors looking to expand

their holding can do so
without incurring transaction
costs

A share issue will decrease

the company’s gearing, hence
enhance its borrowing
capacity
 371

III. Alternatives to cash dividends

2. Share repurchase

In many countries, companies have the right to buy back shares from shareholders who are
willing to sell them, subject to certain conditions.

Share repurchase may be appropriate in the following

circumstances:

Smaller company with

Public company
few shareholders

There is no immediate
willing purchaser at a Share repurchase
time when a could provide a way of
shareholder wishes to withdrawing from the
sell shares, so the share market and
company buys back its ‘going private’.
own shares
372

III. Alternatives to cash dividends

2. Share repurchase

Advantages Disadvantages

Can be hard to arrive at a

Finding use for surplus
price that fair both vendors
cash
and shareholders

Increase in earnings per share Can be seen as admission that

through finding use for surplus the company cannot make
cash better use of the funds

Increase in gearing which Some shareholders may suffer

may be interest to several from being taxed on a capital
companies gain

Readjustment of the
company’s equity base

Possibly preventing a
takeover
373

CHAPTER 13:
THE COST OF CAPITAL
 374

Chapter 13: The cost of capital

Overview graph

The cost of capital

Weighted
Overall about The cost of The cost of
average cost
cost of capital equity debt
of capital

Cost of capital and Dividend growth Cost of irredeemable Weightings used in

risk model debt WACC

Capital asset
Risk return Cost of redeemable
pricing model WACC formula
relationship debt
(CAPM)

CAPM versus Cost of convertible Use of WACC in

Overall approach Dividend growth debt project evaluation
model

Cost of preference
shares

Cost of bank loan

 375

I. Overall about cost of capital

1. The cost of capital and risk

Cost of capital is the return that investors expect to be paid for putting funds into the
company.

The total return demanded by an investor can be analyzed into three elements.

Cost of
capital

Risk-free rate This is return which would be required from an investment if it were
of return completely free from risk

Premium for This is an increase in the required rate of return due to the existence of
business risk uncertainty about the future and about a firm’s business prospects

This relates to the danger of high debts levels. The higher the gearing of
Premium for
the company’s capital structure, the greater will be financial risk to
financial risk
ordinary shareholders.
 376

I. Overall about cost of capital

2. Risk-return relationship
The cost of finance will depend on the level of risk that an investor is taking when they provide
funds to a company. The higher the risk faced, the higher the return that will be expected.

In reality, different types of investors will face different levels of risk.

Ordinary
shareholders

Preference * Debt finance includes:

shareholders (from high to low risk)
1. Unsecured creditors
2. Creditors with a floating charge
3. Creditors with a fixed charged
Debt finance *

Creditor hierarchy
 377

I. Overall about cost of capital

2. Risk-return relationship

Types of investors Payment order Case of liquidation

Ordinary shareholders After the providers of Receive after debt

(highest risk) debt and preference holders and preference
shareholders have been shareholders have been
paid paid

Preference Receive after debt Receive after debt

shareholders holders holders

Debt finance Obligatory to make Debt holders are paid

(lowest risk) interest payments off before providers of
(unlike dividend share capital
payments) each year

From the discussion above, we could come to conclusion that:

• Since debt is a relatively low risk source of finance then the return expected by
providers of debt will be relatively low, so debt is a relatively cheap source of finance.
• Since equity is the finance with highest risk, equity is a relatively expensive source of
finance.
 378

I. Overall about cost of capital

3. Overall approach

This session will be looking at how a firm can identify their overall cost of finance using the
technique below:

Identify source of finance

Equity finance Debt finance

Identify types of debt

Calculate the cost of equity Calculate the cost of each type

Using all the costs together, find a

weighted average cost
 379

II. The cost of equity

1. The dividend growth model

1.1 Fomulas

1.1.1. Constant dividend

If the future dividend per share is expected to be constant in amount, the present value of
future dividends is a perpetuity, the ex-dividend share price* (no expectation of dividend) is
calculated as:

d d d d d
P0 = + + +…= → ke =
(1 + k e ) (1 + k e )2 (1 + k e )3 ke P0

Where:
• k e is the cost of equity capital
• d is the annual dividend per share, annually in perpetuity
• P0 is the ex-dividend share price (the price of a share where the share's new owner is not
entitled to the dividend that is soon to be paid)

(*) the price of share where the share’s new owner is not entitled to the dividend that is soon
to be paid.
 380

II. The cost of equity

1. The dividend growth model

1.1 Fomulas

1.1.1. Constant dividend

Example 1:

A company has paid a dividend of 30c for many years. The company expects to continue
paying dividends at this level in the future. The company’s current share price is $1.50.

Required: Calculate the cost of equity.

A. 20%
B. 15%
C. 25%
D. 19%

Answer: A
re = 30/150 = 0.2 or 20%
 381

II. The cost of equity

1. The dividend growth model

1.1 Fomulas

1.1.2. Growth dividend

Shareholders will normally expect dividends to increase year by year. Although in reality a
firm’s dividends will vary year on year, a practical assumption is to assume a constant growth
rate in perpetuity.

d (1 + g) d (1 + g)
P0 = 0 → ke = 0 +g
(k e − g) P0

Where:

• P0 is the current market price (ex-dividend share price)

• d0 is the current net dividend
• k e is the cost of equity capital
• g is the expected annual growth in dividend payments
 382

II. The cost of equity

1. The dividend growth model

1.1 Fomulas

1.1.2. Growth dividend

Example 2:
Wright Co has just paid a dividend of 60c and has a market value of $5.50. The dividend
growth rate is 8%.
Required: What is Wright Co’s cost of equity?
A. 11.8%
B. 21.2%
C. 18.9%
D.19.8%

Answer: D
Cost of the equity capital is:
d (1+g) 60 x (1+0.08)
ke = 0 +g= + 0.08 = 0.198 (19.8%)
P0 550
Hence, the cost of equity capital is 19.8%.
 383

II. The cost of equity

1. The dividend growth model

1.1 Fomulas

1.1.2. Growth dividend

Note:
 As we can see from the discussion above, the case of “constant dividend” is “growth
dividend” when the growth rate is zero.

 Cum-dividend share price vs Ex-dividend share price:

o If there is a dividend about to be paid, the share price is said to be cum
div. (the holder of shares expects to receive dividends shortly)
o If there is no imminent dividend, the share price is said to be ex-div. (the
holder of shares not entitled to the dividend that soon be paid)

Thus, when a share is quoted cum div, the price includes both the underlying ex div value of the
share and the dividend due shortly. According to the model, we might need to adjust cum div to
ex div share price (which better reflex the actual share price).
 384

II. The cost of equity

1. The dividend growth model

1.2 Estimating the dividend growth rate (g)

In the exam context, if the dividend growth rate is not given in the question, we may need to
calculate it. There are two methods of estimating dividend growth that you need to know.

Estimating future dividend growth

Using historic growth Using current reinvestment levels

Assumption:
Assumption:
The higher level of retentions in a
The past pattern of dividends is a fair
business, the higher the potential
indicator of the future
growth rate

n latest dividend g = b x re
1 + g= b = balance (%) of profits reinvested
earliest dividend
re = return on reinvested funds
n = the number of growth periods
 385

II. The cost of equity

1. The dividend growth model

1.2 Estimating the dividend growth rate (g)

Example 3: Using historic growth (Past exam – June 2015)

The following information relates to a company:
Year 0 1 2 3
Earnings per
30.0 31.8 33.9 35.7
share (cents)
Dividends per
13.0 13.2 13.3 15.0
share (cents)
Share price at
1.95 1.98 2.01 2.25
start of year ($)

Required: Which of the following statements is correct?

A. The dividend payout ratio is greater than 40% in every year in the period
B. Mean growth in dividends per share over the period is 4%
C. Total shareholder return for the third year is 26%
D. Mean growth in earnings per share over the period is 6% per year
 386

II. The cost of equity

1. The dividend growth model

1.2 Estimating the dividend growth rate (g)

Example 3: Using historic growth (Past exam – June 2015)

Answer: D
Using the formula above, we have the growth rate (g) is calculated as:

n latest dividend 3 35.7

1+g= = = 1.0596
earliest dividend 30.0

 g = 1.0596 – 1 = 0.0596 (5.97%)

The growth rate can be used in the company cost of equity calculation is 5.97% or 6%.
 387

II. The cost of equity

1. The dividend growth model

1.2 Estimating the dividend growth rate (g)

Example 4: Using current reinvestment level (Past exam December 2016)

Carp Co has announced that it will pay an annual dividend equal to 55% of earnings. Its
earnings per share is $0.80, and it has ten million shares in issue. The return on equity of
Carp Co is 20% and its current cum dividend share price is $4.60
Required: What is the cost of equity of Carp Co?
A. 19.4%
B. 20.5%
C. 28.0%
D. 22.7%
 388

II. The cost of equity

1. The dividend growth model

1.2 Estimating the dividend growth rate (g)

Example 4: Using current reinvestment level (Past exam December 2016)

Answer: B
The annual growth in this case is calculated by using the current reinvestment level. We
have formula:
g = b x re
in which:
• b – balance of profits reinvested = 45% (100% - dividend payout ratio = 100% - 55%)
• re − return on reinvestment funds = 20%
 g = b x re = 20% x 45% = 9%
The growth rate can be used in the company cost of equity calculation is 9%

Ex div share price = 4.60 - 0.44 = 4.16

0.44 x (1 + 9%)
Ke = + 9% = 20.5%
4.16
 389

II. The cost of equity

1. The dividend growth model

1.3 Weaknesses of the dividend growth model

1 The model does not explicitly incorporate risk

Dividends do not grow smoothly in reality, g is only an

2
approximation

3 No allowance is made for the effects of taxation

The model fails to take capital gains into account; however, it is

4 argued that a change of share ownership does not affect the
present value of the dividend stream

5 It assumes there are no issue costs for new shares

It does not produce meaningful results where no dividend is

6
paid (if d is zero, ke is 0)
 390

II. The cost of equity

2. The capital asset pricing model (CAPM)
In part I.1, we have mentioned that the required return was equaled to the risk-free rate of
return plus a risk premium (premium for business risk and premium for financial risk). The
Capital asset pricing model (CAPM) will look into how to quantify the risk premium.

2.1 Portfolio theory

Portfolio theory suggests that investors can reduce the total risk on their investments by
diversifying their portfolio of investments.

An investor can reduce risk by diversifying to hold a portfolio of shareholdings, since shares in
different industries will, at least to some degree, offer differing returns over time.
 391

II. The cost of equity

2. The capital asset pricing model (CAPM)

2.1 Portfolio theory

Example 5:

Portfolio theory

An investor could combine investment A (for example shares in a company making

sunglasses) with investment B, (perhaps shares in a company making raincoats).
The fortunes of both firms are affected by the weather, but whilst A benefits from the
sunshine, B losses out and vice versa for the rain.
Our investor has therefore smoother overall returns – i.e. faces less overall volatility/risk.

Return

Investment A

Average return

Investment B

Time
 392

II. The cost of equity

2. The capital asset pricing model (CAPM)

2.2 Systematic risk and unsystematic risk

Risk is the risk of variability in the investment returns. The total risk involved in holding
securities (shares) divides into systematic risk and unsystematic risk.

Systematic (or market) risk: The component of risk that will still remain even if a diversified
portfolio has been created.

Unsystematic (or specific) risk: The component of risk that is associated with investing in a
particular company.

The presence of unsystematic and systematic risk is illustrated below:

Risk

Unsystematic risk
(the risk specified
to a share)

Systematic
risk
No. of investments
 393

II. The cost of equity

2. The capital asset pricing model (CAPM)

2.2 Systematic risk and unsystematic risk

Systematic risk will affect all companies in the same way (although to varying degrees).

Example:

The vast majority of companies suffer in a recession but not necessarily to the same extent
– e.g. house-builders typically suffer more than bakers.

Unsystematic risk doesn’t affect everyone; indeed, their impact may be unique to an individual
company or restricted to a small number of companies.

Example:

The weather – if we have a wet summer then raincoat manufacturers will benefit but
sunglasses manufacturers will suffer. However, for the majority of businesses, it won't
make any difference.
 394

II. The cost of equity

2. The capital asset pricing model (CAPM)

2.3 The CAPM formula

2.3.1. Beta factors

Beta factor (β) is the measure of the systematic risk of a security relative to the average market
portfolio. The higher the beta factor, the more sensitive the security is to systematic risk (the
more volatile its returns in response to factors that affect market returns generally).

Range of beta factor has the meaning that can be discussed below:
Increasing risk

β<1 β=1 β>1

Below average risk Average risk Above average risk

Moves in the same Moves in the same direction

Moves in line with the
direction as the market, but as the market, but by more
market
not by as much

E.g. a stock with a β of 0.2 E.g. if the market rises by

E.g. a stock with a β of 1.5
would increase by only 1% then that security is
would fall by 1.5% if the
0.2% if market increase by expected to rise by the
market suffer a drop by 1%
1% same amount

Return/loss expected by Return/loss expected by Return/loss expected by

shareholders will be less shareholders will be the shareholders will be more
than market average same as market average than market average
 395

II. The cost of equity

2. The capital asset pricing model (CAPM)

2.3 The CAPM formula

2.3.2. The equity risk premium

Market risk premium or equity risk premium is the difference between the expected rate of
return on a market portfolio and the risk-free rate of return over the same period

Equity risk premium = E(rm )− Rf

The equity risk premium represents the extra return required for investing in equity rather than
investing in risk-free assets.

Example:

For example, if the return on British government stock is 9% and market returns are 13%,
the excess return on the market’s shares as a whole is 4%. The equity risk premium of
investing in market shares (not investing on government stock) is 4%.

For an individual security, equity risk premium can be measured as the excess return for the
market as a whole multiplied by the security’s beta factor. {β x [E(rm )− Rf]}. β measures the
impact of changes of the market shares to individual securities.
 396

II. The cost of equity

2. The capital asset pricing model (CAPM)

2.3 The CAPM formula

2.3.3. The CAPM formula

The capital asset pricing model is a statement of the principles explained above. It can be stated
as follows.

E ri = Rf + βi [E(rm ) − Rf ]

Where:
• E ri is the cost of equity capital
• Rf is the risk-free rate of return
• E(rm ) is the return from the market as a whole
• βi is the beta factor of the individual security
 397

II. The cost of equity

2. The capital asset pricing model (CAPM)

2.3 The CAPM formula

2.3.3. The CAPM formula

Example 6:
If a geared company’s asset beta is used in the CAPM formula (rj = rf + ßj (rm – rf)) what
will rj represent?
A. The WACC of the company
B. The ungeared cost of equity
C. The geared cost of equity
D. The market premium

Answer: B
CAPM can be used to predict the cost of equity. Using an asset beta will predict the
ungeared cost of equity. Using the equity beta (geared beta) will predict the geared cost of
equity.
 398

II. The cost of equity

2. The capital asset pricing model (CAPM)

2.4 Weaknesses of CAPM

The need to determine the excess return (E(rm) – Rf). Expected, rather
1 than historical, returns should be used, although historical returns are
used in practice, since beta factors are derived from statistical analysis
of historical returns

The need to determine the risk-free rate. A risk-free investment might

2 be a government security.However, interest rates vary with the term of
the lending

3 Errors in the statistical analysis used to calculate values are an issue.

Betas may also change over time and changes may not be identified
4
quickly through historical statistical analysis.

The CAPM is also unable to forecast returns accurately for companies

5 with low price/earnings ratios and to take account of seasonal 'month
of the year' effects and 'day of the week' effects that appear to
influence returns on shares
 399

II. The cost of equity

3. CAPM versus Dividend growth model

From the discussion above, we have a brief summary about the CAPM and dividend growth
model.

Dividend growth model CAPM

d (1 + g)
ke = 0 +g E ri = R f + βi(E(rm ) − R f )
P0
Cost of equity is estimated based on the Cost of equity is based on its risk
dividend growth rate

CAPM is generally perceived as being a more robust and stable method for calculating the
cost of equity, compared to the dividend growth model for two main reasons:

• CAPM gives a clear link between risk and expected return.

• CAPM does not rely on potentially inaccurate estimates of the future dividend growth
rate.
400

III. The cost of debt

Overview

Irredeemable
debt

Redeemable
debt

Traded debt
Convertible
debt

Types of debt Preference

shares

Non-traded
Bank loans
debt
 401

III. The cost of debt

1. Cost of irredeemable debt

Irredeemable debt - The company does not intend to repay the principal but to pay interest
over an indefinite period.

Assumption:

Market value = Future expected income stream from the debt discounted at the investor’s
required return (in which: expected income stream will be the interest paid in perpetuity)

This can be clearly seen as dividend growth model with growth rate is zero.

Specifically, it can be detailed as below:

Cost of irredeemable debt

Pre-tax cost of debt Post-tax cost of debt

I I I × (1 − t)
P0 = → Kd (pre−tax) = P0 =
Kd (pre−tax) P0 Kd (post−tax)
I × (1 − t)
→ Kd (post−tax) =
P0

Where:
• I = interest paid
• P0 = market value of the debt ex-interest
• t = tax rate
 402

III. The cost of debt

1. Cost of irredeemable debt

Example 7:
In relation to an irredeemable security paying a fixed rate of interest, which of the
following statements is correct?
A. As risk rises, the market value of the security will fall to ensure that investors receive
an increased yield
B. As risk rises, the market value of the security will fall to ensure that investors receive
a reduced yield
C. As risk rises, the market value of the security will rise to ensure that investors receive
an increased yield
D. As risk rises, the market value of the security will rise to ensure that investors receive
a reduced yield

Answer: A
 403

III. The cost of debt

2. Cost of redeemable debt

Redeemable debt – The company will pay interest for a number of years and then repay the
principal.

Assumption:

Market value = Future expected income stream from the loan notes discounted at the
investor’s required return (pre-tax cost of debt). In which, expected income stream will be:
• interest paid to redemption
• the repayment of the principal

For the investors, the purchase of redeemable loan notes is effectively a zero NPV project as
the present value of the income they receive in the future is exactly equivalent to the market
value (the amount they invest today).
I I I + pn
P0 = + +…+
(1 + kd )1 (1 + kd )2 (1 + kd )n
Where:
• P0 = market value of the debt ex-interest
• pn = the amount payable on redemption in year n

The investor’s required return is therefore the internal rate of return (IRR) (breakeven discount
rate) for the investment in the loan notes. The rate will have to be calculated by trial and error.
 404

III. The cost of debt

2. Cost of redeemable debt

Example 8:
Now is 1 January 20X5. Willco plc has $100,000 5% 20X8 redeemable loan notes in issue.
Interest is paid annually on 31 December. The ex–interest market value of a loan note on 1
January 20X5 is $90 and the loan notes are redeemable at a 5% premium. Tax on profits is
20%.
Required: What is the cost of debt?
A. 8.5%
B. 8.15%
C. 8.05%
D. 8.3%
 405

III. The cost of debt

2. Cost of redeemable debt

Example 8:
Answer: B
Post-tax cost of interest = (100 x 5%) × (1-0.2) = $4
Redemption value = $100 + $100 x 5% = $105
There are four years between 1 Jan 20X5 and 31 Dec 20X8.
Choosing the rate of return a = 7%, we calculate NPV of debt from the view of creditor as
below:
Time Year 0 Year 1 to Year 4 Year 4
Cash flow (90) 4 105
Df 7% 1.0 3.387 0.763
PV (90) 13.55 80.12
NPV(a) = (90) + 13.55 + 80.12 = 3.67
As we have NPV > 0, the other rate of return "b" should be higher than "a" . With "b =
9%", we calculate NPV of debt from the view of creditor as below:
Time Year 0 Year 1 to Year 4 Year 4
Cash flow (90) 4 105
Df 9% 1.0 (3.240) (0.763)
PV (90) 12.96 74.34

NPV(b) = (90) + 12.96 +74.34 = (2.70)

Using the formula to calculate IRR we have:
NPVa
IRR = a% + x (b% − a%)
NPVa − NPVb
3.67
→ IRR = 7% + x 9% − 7% = 8.15%
3.67 + 2.70
 406

III. The cost of debt

3. Cost of convertible debt

Convertible debt - 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 you should:

Step 1 Calculate the value of the conversion option and cash option using available data

Conversion value = P0 × (1+g)n × R

Where P0 is the current ex-dividend ordinary share price
g is the expected annual growth of the ordinary share price
n is the number of years to conversion
R is the number of shares received on conversion

Compare the conversion option with the cash option.

Step 2
Assume all investors will choose the option with the higher value

Step 3 Calculate the IRR of the flows as for redeemable debt to get the cost of debt
 407

III. The cost of debt

3. Cost of convertible debt

Example 9:
BRW Co has 10% redeemable loan notes in issue trading at $90. The loan notes are
redeemable at a 10% premium in 5 years' time, or convertible at that point into 20
ordinary shares. The current share price is $2.50 and is expected to grow at 10% per year
for the foreseeable future. BRW Co pays 30% corporation tax.
Required: What is the best estimate of the cost of these loan notes (to one decimal place)?
A. 14.1%
B. 12.6%
C. 11.5%
D. 13.2%
 408

III. The cost of debt

3. Cost of convertible debt

Example 9:
Answer: B
Conversion value = 20 x $2.50 x (1.1)5 = $80.60
The cash alternative = 100 x 1.1 = $110
Therefore investors would not convert and redemption value = $110
Post-tax cost of interest = ($100 x 10%) × (1-0.3) = $7
Kd = IRR of the after-tax cash flows as follows:

Time Year 0 Year 1 to Year 5 Year 5

Cash flow (90) 7 110
Df 10% 1.0 3.791 0.621
PV (90) 26.54 68.31
NPV(a) = (90) + 26.54 + 68.31 = 4.85
Time Year 0 Year 1 to Year 5 Year 5
Cash flow (90) 7 110
Df 15% 1.0 3.352 0.497
PV (90) 23.46 54.67
NPV(b) = (90) + 23.46 + 54.67 = (11.87)
NPVa
IRR = a% + x (b% − a%)
NPVa − NPVb

4.85
= 10% + x 15% − 10% = 11.5%
4.85 + 11.87
 409

III. The cost of debt

4. Cost of preference shares

Preference shares - A preference shareholder will receive a fixed income based upon the
nominal value of the shares held (not the market value)

For preference shares, the future cash flows are the dividend payments in perpetuity. The
relationship between the market price of the preference shares and the annual dividend is
expressed as:
d d d
P0 = + + +…(in perpetuity)
(1 + k d )1 (1 + k d )2 (1 + k d )3

Where
• P0 = the current market price of preference shares after payment of current dividend
• d = the dividend received
• k d = the cost of preference share capital

In this case, we can calculate the cost of preference shares using the dividend growth model
when the growth rate is zero (constant dividend – Refer to II.1.1.1).
 410

III. The cost of debt

5. Cost of bank loan

Cost of a bank loan is often a rate which has already been decided before whether a floating
rate or fixed rate. Moreover, interest payment will attract tax relief. Therefore, in order to
calculate the cost of bank loan, what we need to do is to adjust the pre-tax cost of a bank loan
to the post-tax cost.

Cost of bank loan = Interest rate x (1 – t)

Where t = tax rate

Example 10:

If the interest rate on a bank loan is 8% and the rate of tax is 20%
Required: What is the post-tax cost of the loan?
A. 6.4%
B. 7.5%
C. 5.6%
D. 8.1%

Answer: A
The cost of the bank loan to the company is calculated by:
Cost of bank loan = Interest rate x (1 – t)
We have:
• Interest rate = 8%
• t – tax rate = 20%
Therefore, cost of bank loan = 8% x (1 – 20%) = 6.4%.
 411

IV. Weighted average cost of capital (WACC)

What is WACC?

In practical business situation, cost of capital is more complex to calculate as there is a

continuous raising of funds from various sources and funds are not always used in separation
for specific project.

Therefore, we need to calculate the cost of each individual source of medium-long term finance
and then weight it according to its importance in the financing mix. This average is known as
the weighted average cost of capital (WACC).

Weighted average cost of capital is the average cost of the company’s finance (equity, loan
notes, bank loans) weighted according to the proportion each element bears to the total pool
of capital
 412

IV. Weighted average cost of capital (WACC)

1. Weightings used in WACC
To find an average cost, the various sources of finance must be weighted according to the
amount of each held by the company.

Two methods of weighting could be used.

The weights for the sources

of finance could be

Market values Book values

• Easier to obtain but based

on historical costs
• Equity value is often below
Should always be used if data the market value which will
is available seriously understate the
impact of cost of equity in
WACC

When using market values to weigh the sources of finance, you should use the following
calculations:
• Equity = Market value of each share x number of shares in issue
• Debt = (Total nominal value/$100) x current market value
 413

IV. Weighted average cost of capital (WACC)

2. WACC formula

Ve Vd
WACC = × Ke+ × K d (1 − t)
Ve + Vd Ve + Vd

Where
• Ve = total market value (ex-div) of shares
• Vd = total market value (ex-interest) of debt
• K e = the cost of equity
• K d (1 − t) = the post-tax cost of debt
In another ways, the formula can be detailed as following steps:

Step 1 Calculate weights for each source of capital

Step 2 Estimate cost of each source of capital

Multiply proportion of total of each source of capital by cost of

Step 3
that source of capital

Step 4 Sum the results of Step 3 to give the WACC

 414

IV. Weighted average cost of capital (WACC)

2. WACC formula

Example 11: (Past exam – June 2015)

On a market value basis, GFV Co is financed 70% by equity and 30% by debt. The company
has an after-tax cost of debt of 6% and an equity beta of 1·2. The risk-free rate of return is
4% and the equity risk premium is 5%.
Required: What is the after-tax weighted average cost of capital of GFV Co?

A. 5·4%
B. 7·2%
C. 8·3%
D. 8·8%

Answer: D
Cost of equity = 4% + (1.2 x 5%) = 4% + 6% = 10%
WACC = (10% x 70%) + (6% x 30%) = 7% + 1.8% = 8.8%
 415

IV. Weighted average cost of capital (WACC)

3. Use of the WACC in project evaluation

The WACC calculation is based upon the firm’s current costs of equity and debt. It is therefore
appropriate for use in project evaluation if it meets the following criteria.

In the long term the company will maintain its

existing capital structure i.e. same financial risk

WACC can
only be used The project has the same risk as the
for project company i.e. same business risk
evaluation if:

The project is marginal in size; major projects

are likely to have a material effect on risk, so the
WACC is not normally used for major projects

If these conditions do not hold, a marginal cost of capital may be needed.

Note:
Marginal cost of capital is the cost of raising the next increment of capital. The firm’s
marginal cost of capital is the additional cost the firm will pay to raise an additional dollar of
capital.
416

CHAPTER 14:
CAPITAL STRUCTURE
 417

Chapter 14: Capital structure

Overview graph

Gearing
Practical capital
structure issues
Practical capital structure considerations

Traditional theory

Capital structure
Modigliani and Miller (M&M) theory
theories

Pecking order theory

Capital
structure
Use of the WACC in investment appraisal
Project specific
cost of capital
Use of CAPM in project appraisal

Definitions

Finance for SMEs Problems of financing SMEs

Sources of financing for SMEs

 418

Chapter 14: Capital structure

What is capital structure?

Capital structure: The capital structure of a company refers to the mixture of equity and debt
finance used by a company

An optimal mix of finance exists at which the company's cost of capital will be minimized. By
doing so, it minimises its cost of funds.

The traditional view concludes that there is an optimal capital mix of equity and debt at which
the weighted average cost of capital is minimised.

However, the alternative view of Modigliani and Miller (assuming no tax) is that the firm's
overall weighted average cost of capital is not influenced by changes in its capital structure.

Both views agree that:

• The cost of equity is higher than the cost of debt.
• As the level of gearing increases, the larger proportion of debt in the capital structure
means that there is a larger proportion of lower-cost finance.
• However, as the level of gearing rises, the cost of equity also rises to compensate
shareholders for the higher risk.
• As gearing increases, the higher proportion of low-cost debt but the rising cost of equity
pull the WACC in opposite directions.
 419

I. Practical capital structure issues

1. Gearing

Gearing

Operational gearing
Financial gearing
measures the relationship between
a measure of the extent to which
contribution and profit before
debt is used in the capital structure
interest and tax (PBIT)

It indicates the degree to which the It indicates the degree to which the
organisation’s activities are funded by organisation’s profits are made up of
borrowed funds variable costs

Formula*: Formula:
Debt Contribution
Financial gearing = Operational gearing =
Equity PBIT

Related to Financial risk Related to Business risk

(*) There are several formulas to calculate the financial gearing (Refer to Chapter 1).
However, the formula mentioned above is the one most common in ACCA FM exam.
 420

I. Practical capital structure issues

1. Gearing

1.1 Financial gearing

Financial risk can be resulted from a high level of debt. Financial gearing can be an effective
way to measure the financial risk of the business.

Financial risk can be seen from different points of view:

Points of view Financial risk

Higher levels of financial gearing increase the variability of

Ordinary after-tax profits and earnings per share.
shareholders
 Greater variability in returns means greater financial risk

The company If a company builds up debt that it cannot pay when they fall
as a whole due, it will be forced into liquidation.

If a company cannot pay its debt and go liquidation, suppliers

Suppliers/ may not recover in full.
lenders
 Lenders want higher interest yield to compensate them
for higher financial risk and gearing
 421

I. Practical capital structure issues

1. Gearing

1.2 Operational gearing

Operational gearing measures the effect of fixed costs on the relationship between sales and
operating profits.

The significance of operational gearing is as follows.

High
High High business
proportion of PBIT is low
contribution risk
fixed costs

Low
Low Low business
proportion of PBIT is high
contribution risk
fixed costs

Note:
• The objective of management is to maximise shareholder wealth.
• In reality, there is little that a financial manager can do to alter the business risk and there
may only be limited opportunities for altering operating gearing (e.g. a service organisation
may have mostly fixed costs by nature).
• It is therefore the risk associated with how the company is financed that is most easily
controlled.
 422

I. Practical capital structure issues

2. Practical capital structure considerations

Each company will need to evaluate the importance of the relative advantages of debt and
equity, and to consider practical, company-specific, factors to determine their appropriate
capital structure.

Practical issues Explanation

Life cycle A new, growing business will find it difficult to forecast cash flows
with any certainty so high levels of gearing are unwise.

If fixed costs are high, then contribution (ie before fixed costs) will be
Operational
high relative to profits (after fixed costs). High fixed costs mean future
gearing
cash flows may be volatile, so high gearing is not sensible.

Stability of If operating in a highly dynamic business environment, then high

revenue gearing is not sensible.

Security If a company is unable to offer security, then debt will be difficult and
expensive to obtain.
 423

II. Capital structure theories

1. Traditional theory

Capital structure theories mainly examine the impact of using debt finance on the WACC and
whether debt can be used to lower the WACC - in which case shareholders will benefit since
the market value of a company depends on its cost of capital.

Also known as the intuitive view, the traditional view has no theoretical basis but common
sense. Taxation is ignored in the traditional view. The traditional approach suggests that debt
brings benefits, up to a certain level of gearing. This is illustrated below:
 424

II. Capital structure theories

1. Traditional theory

Cost of
capital
A WACC

B Gearing increasing

From A to B WACC is falling, as gearing rises

As an organisation introduces debt into its capital structure, WACC will fall
because benefit of cheap debt finance outweighs any increases in the cost of
equity.
Point B Optimal level of gearing, since the WACC is lowest at this point
This point shows the optimum level of debt: cheap debt finance minimises the
cost of capital.
From this point, as gearing continues to increase, the equity holders will ask for
increasingly higher returns to compensate for the ever increasing risk they face.
From B to C The WACC is rising, as gearing rises
(and over) 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.
 425

II. Capital structure theories

1. Traditional theory
Implication for finance

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.

Drawbacks of traditional theory

It fails to consider the Drawbacks The traditional view

impact of tax on the does not identify the
cost of debt finance optimal level of gearing
 426

II. Capital structure theories

2. Modigliani and Miller theory (no tax)

This theory, also known as the net operating income approach, takes a different view of the
effect of gearing on WACC.

M&M concluded that the capital structure of a company would have no effect on its overall
value or WACC.

Assumptions underpinning M&M’s theory

1 No taxation

Perfect capital markets where investors have the

2 same information, upon which they react rationally

Assumptions
Title

3 No transaction costs

4 Debt is risk free

 427

II. Capital structure theories

2. Modigliani and Miller theory (no tax)
Modigliani and Miller (M&M) proposed that the total market value of a company, in the
absence of tax relief on debt interest, will be determined only by 2 factors:

The total earnings The level of business

of the company risk attached to those
earnings

Market value would be computed by discounting the total earnings at a rate appropriate to
the level of business risk. This rate represents WACC of the company.
 428

II. Capital structure theories

2. Modigliani and Miller theory (no tax)

The theory of M&M can be proved as follows:

$ Value of the
company

WACC

Gearing D/E

1 Graph 1: Value of the company will not change with gearing

The M&M view is that:

Companies which have the same type of business and similar operating risks must have the
same total value, irrespective of their capital structures.

Their view is based on the belief that the value of a company depends upon the future
operating income generated by its assets.
 The way in which this income is split between returns to debt holders and returns to
equity should make no difference to the total value of the firm (equity plus debt).
 The total value of the firm will not change with gearing, and therefore neither will its
WACC.
WACC is constant with changes in gearing (1).
 429

II. Capital structure theories

2. Modigliani and Miller theory (no tax)
Graph 2: Ke increases as gearing increase Cost of capital
To understand the M&M view, we go back with
WACC formula: K
Ve Ke + Vd Kd (1 − t) e
WACC =
Ve + Vd
In M&M view without tax, we ignore the impact of WACC
tax, so t = 0
M&M also give theory on the assumption that: K
o There is no financial distress and agency costs
d
o Ability to borrow and lend at the risk-free rate
So, Kd is constant (2)
2 Gearing D/E
Proofing WACC > Kd (3)
Vd Ve
WACC = ( )K + ( )K
Ve + V d d Ve + Vd e

Ve Ve
⇒ WACC = (1 − )K + ( )K
Ve + Vd d Ve + V d e

Ve
⇒ WACC= Kd + Ke − Kd
Ve + Vd

Ve
⇒ WACC − Kd = Ke − Kd
Ve + Vd
As in case of liquidation, the shareholders of the company would face higher risk of not
recovering their investment, Ke > Kd . Hence, Ke − Kd >0
The proportion of Ve /(Ve + Vd ) > 0.
 WACC − Kd > 0
 WACC > Kd
 430

II. Capital structure theories

2. Modigliani and Miller theory (no tax)

Proofing Ke increases with gearing (4)

Vd Ve
WACC = ( )K + ( )K
Ve + V d d Ve + Vd e
⇒ WACC x (Ve + Vd) = Vd Kd + Ve Ke
WACC x (Ve + Vd ) − Vd Kd
⇒ Ke =
Ve
V
⇒ Ke = WACC + d (WACC − Kd )
Ve
As WACC - Kd > 0 (proved in (3)), Ke will increase as Vd increase or Vd /Ve increase, meaning
higher gearing.

From the (1), (2), (3) and (4) we can understand the graph.
Conclusion:
• The WACC and therefore the value of the firm are unaffected by changes in gearing
levels and gearing is irrelevant.
• Implication for finance: Choice of finance is irrelevant to shareholder wealth: company
can use any mix of funds.
 431

II. Capital structure theories

3. Modigliani and Miller theory (with tax)

A number of practical criticisms were leveled at M&M’s no tax theory, but the most significant
was the assumption that there were no taxes.

M&M therefore revised their theory (perfect capital market assumptions still apply).

M&M (with tax) conclude that:

Geared companies have an advantage over ungeared companies, i.e. they pay less tax and
will, therefore, have a greater MV and a lower WACC.
This is demonstrated in the following diagrams:

$ Value of the Graph 1: Value of the company increases as

company gearing increases

The value of the company is calculated based on

expected future cash flow and the level of business
risk represented WACC.

Expected future cash flow

Value of the company =
(1 + WACC)n
1 Gearing D/E As gearing up reduces the WACC, it increases the
MV of the company.
 432

II. Capital structure theories

3. Modigliani and Miller theory (with tax)

Cost of capital
Graph 2: WACC falls as gearing increases
Ke
• Debt interest is tax deductible so the
overall cost of debt (Kd (1 − t)) to the
company is lower than cost of debt Kd in
WACC M&M – no tax (Kd ).
Kd (1 − t)
• Lower debt costs result in less volatility in
returns for the same level of gearing
which leads to lower increases in Ke .
2 Gearing D/E
 The increase in Ke does not offset the
benefit of the cheaper debt finance and
therefore the WACC falls as gearing
increases.

Implication for finance

The company should use as much debt as possible.

 433

II. Capital structure theories

3. Modigliani and Miller theory (with tax)
Drawbacks of M&M theory with tax

Example:
M&M’s theory assumes perfect capital markets so a company
Direct financial would always be able to raise finance and avoid bankruptcy.
distress cost However, at higher levels of gearing.
 there is an increasing risk of the company being unable to
meet its interest payments and being declared bankrupt.
 shareholders and providers of debt will require a far higher
rate of return as compensation for risk of bankruptcy.

Example:
Indirect As gearing rises, the risk of bankruptcy may also damage:
financial  sales as customers may not want to buy from a company
distress costs that looks financially unstable.
 supplies as suppliers may not want to supply a potentially
unstable firm.

Example:
This emerges from the action of debt holders.
Agency cost
At high levels of gearing, debt holders also increase their
level of monitoring and require more financial information.
 434

II. Capital structure theories

4. Pecking order theory

Pecking order theory states that firms will prefer retained cash to any other source of finance,
and then will choose debt, and last of all equity.

Pecking order theory is based on what companies do, not what they necessarily should do. This
theory is based on the view that companies will not seek to minimise their WACC, but they will
seek additional finance in an order of preference.

The order of preference (from most favorable to less favorable) will be as below:

• Immediately available funds.

Internally generated funds
• Do not have to spend time persuading outside investors
• Retained cash
• No issue costs.

Debt
• Debt issues have a better signaling effect than equity
• Straight debt (bank loans
issues i.e. the market will interpret debt issues as a sign
or loan notes)
of confidence.
• Convertible debt
• Moderate issue costs.
• Preference shares

• Perception by stock markets that it is a possible sign of

New issue of equity problems.
• Expensive issue costs.
 435

II. Capital structure theories

4. Pecking order theory

Drawbacks of pecking order theory

It fails to take into

account taxation,
Pecking order theory is
financial distress,
an explanation of what
agency costs or how the
Drawbacks businesses actually do,
investment rather than what they
opportunities that are should do
available may influence
the choice of finance
 436

II. Capital structure theories

4. Pecking order theory

After discussion above, we have a summary of gearing theories:

Net effect as gearing Impact on

Theory Optimal finance method
increases WACC
At optimal
Find and maintain optimum
Traditional theory The WACC is U-shape point, WACC
gearing ratio
is minimised
Choice of finance is irrelevant
Cheaper debt = Increase WACC is
M&M (no tax) – use any (debt finance or
in K e constant
equity finance)
Cheaper debt > Increase
M&M (with tax) WACC falls As much debt as possible
in K e
First internally generated
No theorised
The pecking order No theorised process funds, then debt and finally
process
new issue of equity
 437

III. Project specific cost of capital

1. Use of the WACC in investment appraisal

Note:
In chapter 14, we have learnt how to calculate WACC. It was based upon the firm’s current
costs of equity and debt.
Ve Vd
WACC = K + K (1 − t)
Ve + Vd e Ve + Vd d

WACC is appropriate for use in investment appraisal provided:

The project is small in relation to the company, so any

changes are insignificant

WACC is The historic proportions of debt and equity are not to be

appropriate changed
for
investment Otherwise the weightings in the WACC will change and the
appraisal WACC would need to be recalculated
provided
that The operating risk (business risk) of the firm will not be
changed

Otherwise Ke will change and so will the WACC

 438

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.1 Equity betas and asset betas

The risk resulting

from its business
activities (business
risk)
Firms must provide a return to
compensate for the risk faced by
investors, and even for a well-
diversified investor, this
systematic risk will have two
causes: The finance risk
caused by its level of
gearing (financial risk)

Therefore, there are two types of betas:

Business Business
risk risk
Asset beta Equity beta
(βa ) Financial
(βe )
risk

Ungeared beta Geared beta

Asset beta: An ungeared beta – a measure of business risk

Equity beta: A measure of the systematic risk of a share, including its business and financial
risk
 439

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

Where a company is moving into a different business area, it cannot use its current WACC to
assess the project because its risk is changing. A marginal cost of capital is therefore needed.
This can be calculated by using betas for project appraisal.

The process to calculate betas for project appraisal includes the following 3 steps:

Step 1 Find the asset beta of a company in the same business as the new project

Step 2 Re-gear the asset beta* to reflect the project’s gearing

(*) Re-gear the asset beta is to convert it to an equity beta based on the gearing
levels of the company undertaking the project

Step 3 Use the re-geared beta (equity beta) to calculate an appropriate cost of equity
 440

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

2.2.1. Step 1: Find the asset beta of a company in the same business as the new project

First, find the beta of a company in the same business (a proxy company) as the
proposed project; this is an equity beta

This equity beta gives an indication of the business risk of the project but will be
distorted by the gearing

To understand business risk, the equity beta needs to be adjusted by stripping out
the effect of gearing to create an asset beta

Ve
βa (∗)= βe
Ve + Vd 1 − t
Where:
Ve = market value of equity
Vd = market value of debt
t = corporation tax rate

(*): The beta formula above is the simplified of below formula:

Ve Vd 1 − t
βa = βe + βd
Ve + Vd 1 − t Ve + Vd 1 − t

Within the FM exam, βd will always be assumed to be zero.

 441

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

2.2.2. Step 2: Re-gear the asset beta to reflect the project’s gearing

An asset beta is ungeared and so does not include any allowance for financial risk

If a project is financed using some debt finance then it will create financial risk as well as
business risk

Then, we need to adjust the asset beta by including the impact of the gearing of the project
(re-gearing the asset beta to equity beta)
 442

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

2.2.3. Step 3: Use the re-geared asset beta (equity beta) to calculate an appropriate cost of equity

The equity beta shows the risk of the project (including both financial and business risk) and is
used to calculate a project-specific cost of equity.

This is done using the standard CAPM formula (Refer to Chapter 14).

CAPM formula:
K e = R f + β(R m − Rf )

Where:
• R f = risk-free rate
• R m = average return on market
• R m − R f = equity risk premium (sometimes referred to as average market risk premium)
• β = the beta factor calculated in Step 2 (equity beta which reflects both business risk and
financial risk)
 443

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

The following graph illustrates the measure used to calculate the equity beta of a company
from equity beta of a company in the same business:

Company A Company B
Same

Asset
Business risk beta Business risk
(Same)

Financial risk Financial risk

Difference

Equity beta Equity beta

A B
 444

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

Example 1:

Using CAPM in project appraisal

Train Co is a company experienced in the provision of training courses. Shares in Train have
a beta value of 1.2. Train Co has a debt: equity ratio of 1:10 which will not change as a
result of the project.

The directors of Train plan to expand their business by building hotels which are located
near their training centres.

Thirtes Co is a listed hotel company with a debt: equity ratio of 1:1, its shares have a beta
of 1.5.

The market premium for risk is 8% and the risk-free rate is 4%. The corporation tax rate is
30%.

Required: Calculate Train’s cost of equity for this project (assume debt has a beta of zero)
 445

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

Example 1:

Solution:

Find the asset beta of a company in the same business as the new
Step 1
project

Step 2 Re-gear the asset beta to reflect the project’s gearing

Use the re-geared beta (equity beta) to calculate an appropriate cost of

Step 3
equity

Following the steps mentioned above we have:

Step 1: Find the asset beta of a company in the same business as the new project

The beta of Thirtes Co is relevant as it is in the same business as the proposed project,
however it is distorted by the relatively high level of gearing.
Ve Vd 1 − t
βa = × βe + × βd
Ve + Vd 1 − t Ve + Vd 1 − t
 446

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

Example 1:

As assumed debt has a beta of zero.

We have:
Ve 1
βa = × βe = × 1.5 = 0.882
Ve + Vd 1 − t 1 + 1 1 − 0.3
The asset beta = 0.882 reflects the risk of Thirtes’s business.

Step 2: Re-gear the asset beta to reflect the project’s gearing

Using formula from Step 1 we have:
Ve Vd 1 − t
βa = × βe + × βd
Ve + Vd 1 − t Ve + Vd 1 − t
As assumed debt has a beta of zero. The asset beta calculated in Step 1 is 0.882.
Ve
βa = × βe
Ve + Vd 1 − t
10
⇔ 0.882= × βe ⇒ βe = 0.944
10 + 1 1 − 0.3

So the equity beta of Train Co is 0.944

 447

III. Project specific cost of capital

2. Use CAPM in project appraisal

2.2 Using betas in project appraisal

Example 1:

Step 3: Use the re-geared beta (equity beta) to calculate an appropriate cost of equity

Cost of equity can be calculated using CAPM formula:

Ke = Rf + β(Rm − Rf)
In which:
• Rf = 0.04 (4% - risk free rate)
• β = 0.944 (equity beta – calculated in Step 2)
• Rm − Rf = 0.08 (market risk premium – 8%)

So, we have:
K e = R f + β(R m − Rf ) = 0.04 + 0.944 × 0.08 = 0.1155 (11.55%)

Train’s cost of equity for this project is 11.55%

Note:
A key problem with this approach is finding a similar company’s beta; this is very difficult in
reality.
 448

IV. Finance for small and medium sized enterprises

(SMEs)
1. Definitions

1 Firms are likely to be unquoted private company

The business is owned by a few individuals,

SMEs 2
typically a family group

They are not micro businesses – very small businesses

3 that act as the owners’ medium for self-employment
 449

IV. Finance for small and medium sized enterprises

(SMEs)
2. Problems of financing SMEs

2.1 Funding gap

The inability of SMEs to raise adequate finance is sometimes referred to as the funding gap.

Funding gap is often the result of the following features of a SME

The business is owned by a relatively small pool

of investors and is likely to be unquoted

There is a greater failure rate among

small companies
Reasons
The companies are less likely to have a
discernible track record and generally
undergo much less regulatory and public
scrutiny

Knowledge of sources of finance may be limited

 450

IV. Finance for small and medium sized enterprises

(SMEs)
2. Problems of financing SMEs

2.2 Maturity gap

Even medium-sized companies will sometimes find that they cannot obtain more debt finance,
due to inadequate security (in the form of assets).

This is a particular problem for medium-term projects (eg a new advertising campaign) which
often do not have the security offered by long-term investments that land and buildings create.

The difficulty in obtaining medium-term financing is called the maturity gap.

 451

IV. Finance for small and medium sized enterprises

(SMEs)
3. Sources of finance for SMEs

Potential sources of financing for small and medium-sized companies include the following:

• Owner financing
• Overdraft financing (cover in Chapter 12)
• Bank loans (cover in Chapter 12)
• Trade credit (cover in Chapter 5)
• Equity finance
• Business angel financing
• Venture capital (cover in Chapter 12)
• Leasing (cover in Chapter 12)
• Factoring (cover in Chapter 5)
• Government assistance (cover in Chapter 2)
• Supply chain finance
• Crowdfunding/peer to peer funding

As several sources of finance have been discussed before, in this chapter we will discuss the
remaining ones.
 452

IV. Finance for small and medium sized enterprises

(SMEs)
3. Sources of finance for SMEs

3.1 Owner financing

The finance from the owner(s)’s personal resources or those of family connections is generally
the initial source of finance.

At this stage, because many assets are intangible, external funding may be difficult to obtain.

3.2 Equity finance

Other than investments by owners or business angels, business with few tangible assets will
probably have difficulty in obtaining equity finance when they are formed (a problem known as
equity gap).

Once small firms have become established, they do not necessarily need to seek a market
listing to obtain equity financing; shares can be placed privately.

3.3 Business angel financing

Business angels are wealthy individuals or groups of individuals who invest directly in small
businesses. They are prepared to take high risks in the hope of high returns.
• The main problem with business angel financing is that it is informal in terms of a market
and can be difficult to set up.
• However, there may be less needed to provide business angels with detailed information
about company, since business angels generally have prior knowledge of the industry.
 453

IV. Finance for small and medium sized enterprises

(SMEs)
3. Sources of finance for SMEs

3.4 Supply chain finance (SCF)

SMEs are likely to make use of electronic platforms ie. Supply chain finance, usually provided by
banks or financial institutions, which facilitates the factoring of outstanding trade debts.

Supplier sends invoice to

buyer

Buyer approves invoice and

uploads the invoice data
onto the SCF platform

Supplier can see approved

invoices on the platform
Either Or
Supplier can sell invoice to a
Supplier can wait for payments funding provider on the
(60 days, say) platform for advanced cash
with discount

Supplier receives payment Buyer pay the fund provider in

from buyer when due full
 454

IV. Finance for small and medium sized enterprises

(SMEs)
3. Sources of finance for SMEs

3.4 Supply chain finance (SCF)

Example 2:
Company A buys $50,000 of goods from B on
60-day credit

Company A approves the invoice for

payment and uploads it to a SCF platform

Company B can see the invoice has been

approved for payment and either

Either Or

Receives the cash within five days from C

Waits 60 days to receive cash
(the SCF platform provider (the bank) in
from A
return for a discount)

Payment received from A when due Company A pays the full amount to C

Company A has the benefit of paying in 60 days as planned but Company B has the cash
early and C has earned the discount.
 455

IV. Finance for small and medium sized enterprises

(SMEs)
3. Sources of finance for SMEs

3.5 Crowdfunding/peer to peer funding

Crowdfunding is a means of raising funds from large numbers of people. This uses internet
technology to a large pool of potential investors who may believe in the project on which their
funds will be used.

Crowdfunding (also known as peer-to-peer funding) has been used to fund start-up businesses,
rock band and theatrical tours, art projects and other projects.
456

CHAPTER 15:
BUSINESS VALUATION
457

Chapter 15: Business valuation

Overview graph

Market capitalization

Asset valuation bases

Equity valuation

Income-based
methods

Cash flow-based
Business valuation methods

Debt
The nature and Debt
purpose of valuation
business valuations
Preference shares
 458

I. The nature and purpose of business valuations

1. When are business valuations required?

A business valuation will be necessary when:

Quoted companies When there is a takeover bid

Unquoted companies When:

• The company wishes to 'go public’;
• There is a scheme of merger with another
company;
• Shares need to sold;
• Shares are pledged as collateral for a loan and
the bank wants to put a value to the collateral.

When the group's holding company is negotiating the

Subsidiary companies
sale of the subsidiary

When a shareholder wishes to dispose of

Other company
their holding
 459

II. Business valuation determination methods

2. Business valuation methods

Each of the methods give different values and are suitable in different situations.

Max

Value the cash flows or earnings under new ownership

Valuation

Value the dividends under the existing management

Value the assets

Min
 460

I. The nature and purpose of business valuations

3. Information requirements for valuation

Financial statements

• Statements of financial position, For the

• Statements of profit or loss and other comprehensive income
past few
• Statements of changes in equity,
years
• Statements of cash flow.

Supporting listings
Source of information

• Summary of non-current assets and depreciation schedule

• Aged accounts-receivable summary
• Aged accounts-payable summary
• Inventory summary

Details of existing contracts

Leasing contract, supplier agreements,…

Budgets or projections for the future

For a minimum of five years

Background information on the industry and key personnel

 461

II. Business valuation determination methods

Overview

Business valuation is not merely the equity value of a business, it is the total value of all assets
used in the course of running the business of that enterprise to benefit its owners and capital
providers.

Debt
Business valuation Equity valuation
valuation

 To determine business valuation, we ought to specify both equity valuation and debt
valuation
 462

II. Business valuation determination methods

1. Equity valuation

There are four types of equity valuation technique:

Equity valuation

Market Asset-based Income-based Cash flow-

capitalization methods methods based methods
(section 1.1) (section 1.2.) (section 1.3.) (section 1.4)

Dividend
Net book value
P/E method valuation
(historic) basis
method

Realizable asset Earnings yield Discounted

values method cash flow basis

Replacement
cost
 463

II. Business valuation determination methods

1. Equity valuation

1.1 Market capitalisation

Market capitalisation is the market value of a company's shares. This is the share price
multiplied by the number of issued shares.

Market Number of issued

Market share price
capitalization shares

For quoted companies, calculating the market capitalisation of its shares is therefore a
straightforward process.

Note:
If the shares of the company do not have a liquid secondary market, its quoted market price
may not be a fair reflection of value  Other methods of valuation are required.
 464

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

The asset-based method, also called net asset value (NAV) approach, normally represents the
value of an equity valuation is equal to the net tangible assets

For asset stripping

Net asset valuation models are useful in the
unusual situation that a company is going to be
purchased to be broken up and its assets sold off

When asset- To identify a minimum price in a takeover

Shareholders will be reluctant to sell at a price
based valuations
less than the NAV even if the prospect for
are useful?
income growth is poor

To value property investment companies

The market value of investment property has a
close link to future cash flows and share values
 465

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

Problems with asset-based valuations

1 2
Investors do not normally buy a The asset approach also ignores non-
company for its statement of financial statement of financial position intangible
position assets, but for the assets (e.g., highly-skilled workforce,
earnings/cash flows that all of its assets competitive positioning of the company’s
can produce in the future products,…)
We should value what is being
purchased, i.e., the future
income/cash flows must be taken into
account.
 466

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

Applying ‘Asset-based methods’:

The NAV approach can involve the valuation of assets in three different ways:

Net book value

Net realizable value Net asset value Equity valuation

Replacement value
 467

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.1. Net book value

Using this method of valuation, the net value of net tangible assets is the value in the statement
of financial position of the tangible non-current assets (net of depreciation) plus current assets,
minus all liabilities.

Net
Non-current assets*
assets Current assets All liabilities
(net of depreciation)
value

(*) Intangible non-current assets are ignored by this method.

 468

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.1. Net book value

Example 1:
The following financial information relates to QK Co, whose ordinary shares have a
nominal value of $0.50 per share:
$m $m
Non-current assets 120
Current assets
Inventory 8
Trade receivables 12 20
Total assets 140
Equity
Ordinary shares 25
Reserves 80 105
Non-current liabilities 20
Current liabilities 15
Total equity and liabilities 140

Require: On an historic basis, what is the net asset value per share of QK Co?
 469

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.1. Net book value

Example 1:
A. $2.10 per share
B. $2.50 per share
C. $2.80 per share
D. $4.20 per share

Answer: A
Net asset value (NAV) = 140m – 15m – 20m = $105m
Number of ordinary shares = 25m/0.5 = 50m shares
NAV per share = 105m/50m = $2.10 per share
 470

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.2. Net realizable values

Net realizable values represent what should be left for shareholders if the assets were sold off
and the liabilities settled

This method adjusts the book value of the assets to reflect their market value and is therefore a
more accurate way of assessing the net asset value in the event of a liquidation.

Under
Net
net book Non-current Current
assets All liabilities.
value assets assets
value
method

Revaluate to realizable value

Under
Realizable
net Net Realizable
Realizable value of value of
realizable assets value of All
Non-current assets current
value value liabilities
asset
method
 471

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.2. Net realizable values

Example 2: (Past exam – September/2016)

The owners of a private company wish to dispose of their entire investment in the
company. The company has an issued share capital of $1m of $0.50 nominal value
ordinary shares. The owners have made the following valuations of the company's assets
and liabilities:
Assets $m
Non-current assets 30
Current assets 18
Non-current liabilities 12
Curent liabilities 10

The net realisable value of the non-current assets exceeds their book value by $4m. The
current assets include $2m of accounts receivable which are thought to be irrecoverable.

Required: What is the minimum price per share that the owners should accept for the
company (to the nearest $)?
A. $14
B. $25
C. $28
D. $13
 472

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.2. Net realizable values

Example 2: (Past exam – September/2016)

Answer: A
Number of share capital = $1m/$0.5 = 2m
They should not accept less than NRV = [(30m + 4m) + (18m– 2m) – 12m – 10m]/2m
= $14 per share
 473

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.3. Replacement value

This takes a different perspective to the previous two methods, representing the total cost of
forming the business from scratch.

If a potential buyer of a company can estimate the replacement cost of the assets of the target
company (ie the cost of acquiring its separate assets on the open market)

 Estimate the maximum it should pay for the target company.

 474

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.3. Replacement value

Example 3:

The summary statement of financial position of Cactus is as follows.

Assets $ Equity and liabilities $

Non-current assets Ordinary shares of $1 80,000
Land and buildings 160,000 Reserves 140,000
Plant and machinery 80,000
Motor vehicles 20,000 Total equity 220,000
Goodwill 20,000
Non-current liabilities 120,000
Current assets 160,000 Current liabilities 100,000

Total assets 440,000 Total liabilities 220,000

Assume that some further information: Included in non-current assets is specialist

machinery that has a NBV of $20,000, would cost $100,000 to replace but would only be
able to be sold for scrap of $15,000 if disposed of.

Required: What is the value of equity valuation using the replacement value basis?
 475

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.3. Replacement value

Example 3:
Solution:
Step 1: Adjust the value of specialist machinery which is attributable to total assets
value
Assets Book values Replacement cost Attributable to total
assets value
Specialist machinery $20,000 $100,000 +$80,000

Step 2: Calculate equity valuation under net replacement value method

Equity valuation is calculated by: $
Total assets 440,000
Added value of specialist 80,000
machinery
Less goodwill (20,000)
Less total liabilities (220,000)
Net asset value 280,000  Equity valuation = net asset value
= 280,000
 476

II. Business valuation determination methods

1. Equity valuation

1.2 Asset-based methods

1.2.4. Summarizing strengths and weakness of asset-based methods

Book values are relatively easy to obtain

Net book value

• Historic cost value (instead of fair value);
• Ignores goodwill

• Minimum price that should be accepted for

the sale of a business;
• Asset stripping
Net realizable value
• Asset valuation problems (only suitable in
quick sale cases);
• Ignores goodwill

Maximum to be paid for assets by buyer

Replacement value
• Asset valuation problems (No similar assets
for comparison);
• Ignores goodwill
 477

II. Business valuation determination methods

1. Equity valuation

1.3 Income-based methods

Income-based methods use the current earnings or the prospective earnings of a business
under new ownership as the basis for valuing a business.

Income-based methods may be used to value equity valuation when a large block of shares, or
a whole business, is being valued.

When income-based valuations are useful?

Income-based methods of valuation are of particular use when valuing a majority

shareholding:

Ownership bestows additional benefits of control not reflected in the dividend

valuation model;

Majority shareholders can influence dividend policy and therefore are more
interested in earnings.

There are two income-based valuation methods:

Income-based Earnings yield

P/E method
methods method
 478

II. Business valuation determination methods

1. Equity valuation

1.3 Income-based methods

1.3.1. P/E method

Note:
The P/E ratio, meaning price/earning ratio (introduced in Chapter 1), indicates the market’s
assessment of a company’s future cash flows and risk.

How to use P/E ratio to value equity share

P/E ratios are quoted for all listed companies and calculated as:

Price per share

P/E =
Earnings per share (EPS)

This can then be used to value shares in unquoted companies as:

Value of company = Total earnings × P/E ratio

Price per share = EPS × P/E ratio

Note:
Using an adjusted P/E multiple from a similar quoted company (or industry average);
The EPS/earning could be a historical EPS/earning or a prospective future EPS/earning.
 479

II. Business valuation determination methods

1. Equity valuation

1.3 Income-based methods

1.3.1. P/E method Earnings calculation

• The latest earnings figures
Problems with the P/E ratio method might have been manipulated
upwards by the target company;
• Historic earnings will not
reflect the potential future
Choice of which P/E ratio synergies.
to use
Finding a quoted
company with a similar
range of activities may be
difficult. Quoted
companies are often
diversified.

Imprecise evaluation for

unquoted entity
The unquoted company
Stock market efficiency may have a different
Stock market prices may not be capital structure to the
efficient because they are affected quoted company.
by psychological factors
 480

II. Business valuation determination methods

1. Equity valuation

1.3 Income-based methods

1.3.1. P/E method

Example 4:
Company A's latest accounts show earnings of $150k and the company has a P/E ratio of 8.

Company B's latest accounts show earnings of $75k and the company has a P/E ratio of 10.
Company A is considering making a bid for company B. It expects synergies of $10k pa as a
result of the merger and expects the market to apply a P/E ratio of 9 to the combined
entity.
Require: What is the minimum that Company B's shareholders are likely to accept?
A $915k
B $750k
C $600k
D $1,500k

Answer: B
Value of Company B alone: Company B earnings × Company B P/E ratio
= $75,000 × 10 = $750k
Company B's shareholders are likely to accept anything above $750k
 481

II. Business valuation determination methods

1. Equity valuation

1.3 Income-based methods

1.3.2. Earnings yield

The earnings yield is simply the inverse ratio of the P/E ratio:

Earnings per share (EPS)

Earnings yield =
Price per share

This can then be used to value shares in unquoted companies as:

Total earnings
Value of company =
Earnings yield

EPS
Price per share =
Earnings yield

Note:
We can incorporate earnings growth into this method as follows:
Earning × (1 + g)
(Earning yield − g)
Where: g is growth rate per year

Some notes for application of P/E ratio can also be applied to earnings yield.
 482

II. Business valuation determination methods

1. Equity valuation

1.3 Income-based methods

1.3.2. Earnings yield

Example 5:
Company A has earnings of $300,000, growing at 3% pa. A similar listed company has an
earnings yield of 12.5%.
Require: Estimate the value of company A
A. $3,252,632
B. $2,943,500
C. $3,520,700
D. $2,856,252

Answer: A
Company A: ($300,000 × 1.03) / (0.125 – 0.03) = $3,252,632
 483

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

Cash flow based methods use a discounted cash flow approach to establish the present value
of a business or per share.

When Cash flow based method are useful?

1 Valuing minority shareholdings in a company,

When Cash
flow based The model is theoretically sound and good for
Title 2
method are valuing a non-controlling interest
useful?

Acquiring a majority shareholding since any

3 buyer of a business is obtaining a stream of
future operating cash flows.
Problems with cash flow-based valuations
Must have assumptions
Rely on estimates of
Problems that the discount rate,
both cash flows and
tax and inflation rates
discount rates – may be
are constant through
unavailable
the period.
 484

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

There are two cash flow-based valuation methods:

Cash flow-based methods

Dividend valuation method Discounted cash flow basis

(DVM) (DCF)
 485

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

Assumptions in the dividend valuation model

The estimates of future Dividends either show no

dividends and prices used growth or constant
and also the cost of capital growth;
are reasonable;

The discount rate used Other influences on share

exceeds the dividend prices are ignored;
growth rate

The company's earnings will increase

sufficiently to maintain dividend growth
levels;
 486

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

The dividend valuation model is based on the theory that an equilibrium price for any share on
a stock market is:

• The future expected stream of income from the security

• Discounted at a suitable cost of capital

Hence, equilibrium market price is a present value of a future expected income stream.
Besides, the annual income stream for a share is the expected dividend every year in
perpetuity.

 The basic dividend-based formula for the market value of shares is expressed in the dividend
valuation model as follows:
D D D D
P0 (ex div) = + + +... =
1+k e 1+k e 2 1+k e 3 ke

Where:
• P0 = Ex-dividend market value per share;
• D = Constant annual dividend;
• k e = Shareholders' required rate of return/cost of capital.
 487

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

In addition, if company has a constantly growing future dividend, The formula calculates the
value of a share as follows:

D0 (1 + g) D0 (1 + g)2 D0 (1 + g)3 D ( 1+ g)
P0 (ex div) = + + +... = 0
1 + ke 1 + ke 2 1 + ke 3 ke – g

Where:
• P0 = Ex-dividend market value per share;
• D0 = Current year's dividend;
• ke = Shareholders' required rate of return/cost of capital;
• g = Growth rate in earnings and dividends

Note:
In Chapter 13, Cost of capital, we used this model to calculate a cost of equity, given the share
price, the current annual dividend and expectations of future dividend growth.
Here, we calculate a market value per share, given the current annual dividend, expectations of
future dividend growth and a cost of equity.
 488

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

a. Estimating dividend growth

Estimating future dividend growth*

Use historical growth Use current re-investment levels

g=b×r
Where:
n newest dividend
1 + 𝑔 =
oldest dividend b = balance of earning reinvested
r = expected return on reinvested
earnings

(*) This section is introduced exhaustively in Chapter 13 Cost of capital

 489

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

a. Estimating dividend growth

Example 6:
Ring Co has in issue ordinary shares with a nominal value of $0.25 per share. These shares
are traded on an efficient capital market. It is now 20X6 and the company has just paid a
dividend of $0.450 per share. Recent dividends of the company are as follows:
Year 20X6 20X5 20X4 20X3 20X2
Dividend per share $0.45 $0.43 $0.41 $0.39 $0.37
Ring Co also has in issue loan notes which are redeemable in seven years’ time at their
nominal value of $100 per loan note and which pay interest of 6% per year.
The finance director of Ring Co wishes to determine the value of the company.
Ring Co has a cost of equity of 10% per year and a before-tax cost of debt of 4% per year.
The company pays corporation tax of 25% per year.
Require: Using the dividend growth model, what is the market value of each ordinary
share (to two decimal places)?
 490

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

a. Estimating dividend growth

Example 6:

A. $8.59
B. $9.00
C. $9.45
D. $7.77

Answer: C
Historical dividend growth rate = 100 x ((0·450/0·370)0·25– 1) = 5%
Share price = (0·450 x 1·05)/(0·1 – 0·05) = $9·45
 491

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

b. Disadvantages of the simple dividend valuation model

It is difficult to estimate
future dividend growth;
It creates negative values
for high growth
companies (if g > ke ).

It is inaccurate to assume
that growth will be
constant;
It creates zero values for
zero dividend
companies;
 492

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

c. Non-constant growth

The DVM formula can be adapted to value dividends that are forecast to go through two
phases:

Phase 1 Phase 2
(e.g., next three years) (e.g., Year 4 onwards)

Growth is forecast at an unusually high (or Growth returns to a constant rate

low ) rate
Use a normal NPV approach to calculate the • Use the formula to assess the NPV of the
present value of the dividends in this phase. constant growth phase; however the time
periods need to be adapted
D ( 1+ g) D ( 1+ g)
P0 = 0 ⟹ P3 = 3
ke – g ke – g
• Then adjust the value given above by
discounting back to a present value (here
using a T3 discount rate because the first
cash flow being assessed is in time 4).).
 493

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

c. Non-constant growth

Example 7:
Cant Co has a cost of equity of 10% and has forecast its future dividends as follows:
Current year: No dividend
Year 1: No dividend
Year 2: $0.25 per share
Year 3: $0.50 per share and increasing by 3% per year in subsequent years
Require: What is the current share price of Cant Co using the dividend valuation model?
A. $7.35
B. $5.57
C. $6.11
D. $6.28

Answer: C
The dividend valuation model states that the ex dividend market value of an ordinary share
is equal to the present value of the future dividends paid to the owner of the share. No
dividends are to be paid in the current year and in Year 1, so the value of the share does
not depend on dividends from these years.
 494

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

c. Non-constant growth

Example 7:
The first dividend to be paid is in Year 2 and this dividend is different from the dividend
paid in Year 3 and in subsequent years. The present value of the Year 2 dividend,
discounted at 10% per year, is (0.25 x 0.826) = $0.2065.
The dividends paid in Year 3 can subsequently be valued using the dividend growth model.
By using the formula P0 = D1/(re – g) we can calculate the present value of the future
dividend stream beginning with $0.50 per share paid in Year 3. This present value will be a
Year 2 value and will need discounting for two years to make it a Year 0 present value.
P0 = (0.826 x 0.5)/(0.1 – 0.03) = 0.826 x 7.1429 = $5.90
Share price = $5.90 + 0.2065 = $6.11 per share
 495

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.1. Dividend valuation method

c. Non-constant growth

Note:
The techniques that have been covered for estimating dividend growth (historic method and
current reinvestment method) can also be used to evaluate forecasts of a company’s earnings
growth.

1.4.2. Discounted cash flow method

By using discounted cash flow (DCF) method, the value of a share is calculated as the present
value of the future cash flows that will be generated by the new management team.

This method presents the maximum value of the business because it takes account of
including forecast synergies.
 496

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.2. Discounted cash flow method

The steps in this method of valuation are:
Approach 2
Approach 1
Free cash flow to equity
Free cash flow method
method
Free cash flow (FCF): the Free cash flow to equity
cash available for payment (FCFE): the cash available for
to investors (shareholders payment to shareholders,
and debt holders), also also called dividend capacity
Step 1: called free cash flow to firm (after interest)
(before interest)

Estimate
FCF FCFE
the cash
flows that
This is the
will be difference
obtained PBIT PBIT
between
each year two
from the Interest, tax, approaches
acquired Tax, investment in
investment in
business. assets
assets

Depreciation, any Depreciation, any

new capital raised new capital raised
 497

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.2. Discounted cash flow method

Approach 2
Approach 1
Free cash flow to equity
Free cash flow method
method

Discount at the overall Discount at the cost of equity

weighted average cost of (ke ) to calculate the present
capital (WACC) to calculate value of the equity
the present value of the This value will be
Step 2: company only used if for a
valuation of
This value will be
Discount equity.
used if for a
these cash valuation of the
flows at an whole company
appropriate
cost of If only the equity needs to be
capital. valued then the value of debt
will then need to be
deducted to calculate the
value of equity
 498

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.2. Discounted cash flow method

Example 8:
A company’s current revenues and costs are as follows: sales $200 million, cost of sales
$110 million, distribution and administrative expenses are $20 million, tax allowable
depreciation $40 million and annual capital spending is $50 million. Corporation tax is 30%.
The current value of debt is $17 million.
The WACC is 14.4%. Inflation is 4%.
These cash flows are expected to continue every year for the foreseeable future.
Require: Calculate the value of equity.
A. $93m
B. $94m
C. $95m
D. $96m

Answer: A
Operating profits = $200m – $110m – $20m = $70m
Tax on operating profits = $70m × 0.3 = $21m
Allowable depreciation = $40m
Tax relief on depreciation = $40m × 0.3 = $12
Therefore net cash flow = $70 – $21 + $12 – $50 = $11
 499

II. Business valuation determination methods

1. Equity valuation

1.4 Cash flow based methods

1.4.2. Discounted cash flow method

Example 8:
1 + r = (1 + i)/(1 + h) = 1.144/1.04 = 1.10
The real discount rate is: 1.10 - 1 = 10%
The corporate is: $11m/0.10 = $110m
Equity = $110m - $17m = $93m
 500

II. Business valuation determination methods

1. Equity valuation

1.5 The range of valuations for equity

Example 9: The range of valuations for equity

ASAP Co provides a tuition service for professional students. This includes courses of
lectures provided on their own premises and provision of study material for home study.
Most of the lecturers are qualified professionals with many years' experience in both their
profession and tuition. Study materials are written and word processed in-house, but sent
out to an external printers.
The shareholders of ASAP Co mainly comprise the original founders of the business who
would now like to realise their investment. In order to arrive at an estimate of what they
believe the business to be worth, they have identified a long-established quoted company,
City Tutors, who have a similar business, although they also publish texts for external sale
to universities, colleges, etc.
Summary financial statistics for the two companies for the most recent financial year are
as follows.
ASAP Co City tutors
Issued shares (million) 4 10
Net asset values ($m) 7.2 15
Earnings per share (cents) 35 20
Dividend per share (cents) 20 18
Debt: equity ratio 1:7 1:65
Share price (cents) 362
Expected rate of growth in earnings/dividends 9% per annual 7.5% per annual
 501

II. Business valuation determination methods

1. Equity valuation

1.5 The range of valuations for equity

Example 9:

Notes:
• The net assets of ASAP Co are the net book values of tangible non-current assets plus
net working capital. However:
o A recent valuation of the buildings was $1.5m above book value.
o Inventory includes past editions of textbooks which have a realisable value of
$100,000 below their cost.
o Due to a dispute with one of their clients, an additional allowance for bad
debts of $750,000 could prudently be made.
• Growth rates should be assumed to be constant per annum; ASAP Co's earnings
growth rate estimate was provided by the marketing manager, based on expected
growth in sales adjusted by normal profit margins. City Tutors' growth rates were
gleaned from press reports.

Required:
Compute a range of valuations for the business of ASAP Co, using the information
available.
 502

II. Business valuation determination methods

1. Equity valuation

1.5 The range of valuations for equity

Example 9:

Solution

The information provided allows us to value ASAP Co on three bases: net assets, P/E ratio
and dividend valuation.

Asset-based method – Using net realizable value:

$’000
Net assets at book value 7,200
Add increased valuation of buildings 1,500
Less decreased value of inventory and receivables (850)
Net asset value of equity 7,850

 Value per share = $1.96 (7,850,000/4,000,000)

 503

II. Business valuation determination methods

1. Equity valuation

1.5 The range of valuations for equity

Example 9:

Dividend valuation method

The dividend valuation method (DVM) gives the share price as:
D ( 1+ g)
P0 = 0k – g
e
We can use the information for City Tutors to estimate a cost of equity for ASAP Co. This is
assuming the business risks to be similar and ignoring the small difference in their gearing
ratio.

Again, from the DVM, cost of equity (City tutors):

D (1 + g) 0.18 × (1 + 7.5%)
ke = 0 +g= + 7.5% = 12.84%
P0 3.62
D0( 1+ g) 0.2(1+9%)
 Share price: P0 = = = $5.45
ke – g 12.84% – 9%
 This values the whole of the share capital at $21.8m.
 504

II. Business valuation determination methods

1. Equity valuation

1.5 The range of valuations for equity

Example 9:

Income-based method – Using P/E ratio

ASAP Co City tutors
Issued shares (million) 4 10
Share price ($) 3.62
Market value ($m) 36.2
Earnings per share ($) 0.35 0.20
P/E ratio (share price/EPS) 18.1

This approach will value ASAP Co at 18.1 × $0.35 = $6.34 per share
 A total valuation of $25.4m.

Range for valuation

The three methods used have thus come up with a range of value of ASAP Co, as follows:
Value per share Total valuation
$ $m
Net assets 1.96 7.9
Dividend valuation model 5.45 21.8
P/E ratio 6.34 25.4
 505

II. Business valuation determination methods

2. Debt valuation

Note:
Discounted cash flow techniques can be used to value debt.

Debt calculations – a few notes:

Debt is always quoted Debt can be quoted as

in $100 nominal units, a percentage or as a
or blocks; always use value, e.g. 97% or $97.
$100 nominal values Both mean that $100
as the basis to your nominal value of debt
calculations; is worth $97 market
value;

Corporate
Governance Interest on debt is
Always use ex- Code stated as a
interest prices in any percentage of
calculations. nominal value. This
is known as the
coupon rate. It is not
the same as the
redemption yield on
debt or the cost of
The ACCA examining team debt;
sometimes quotes an
interest yield, defined as
coupon/market price;
 506

II. Business valuation determination methods

2. Debt valuation
There are four types of debt:

Redeemable debt

Irredeemable debt

Convertible debt

Preference shares.
 507

II. Business valuation determination methods

2. Debt valuation

2.1 Irredeemable debt valuation

For irredeemable loan notes where the company will go on paying interest every year in
perpetuity, without ever having to redeem the loan.

Irredeemable (undated) debt Irredeemable (undated) debt

without taxation with taxation
i i(1 − T)
P0 = P0 =
Kd k ∗d

Where:
• P0 = is the market price of debt ex interest;
• i = the annual interest payment on the bond
• Kd = is the return required by the bond investors
• i(1−T) = paying annual after-tax interest
• k∗d = is cost of debt after tax (interest less taxation)
 508

II. Business valuation determination methods

2. Debt valuation

2.1 Irredeemable debt valuation

Example 10:
Black Co has in issue 5% irredeemable loan notes, nominal value of $100 per loan note, on
which interest is shortly to be paid. Black Co has a before-tax cost of debt of 10% and
corporation tax is 30%
Require: What is the current market value of one loan note?
A. $55
B. $50
C. $76
D. $40

Answer: A
Discounting the interest of $5 per year at a required return of 10% to perpetuity
= $5 x 1/0.1 = present value $50.
In addition a payment of $5 is about to be received
So total present value = $50 + $5 = $55.
 509

II. Business valuation determination methods

2. Debt valuation

2.2 Redeemable debt valuation

Redeemable debt valuation is the discounted present value of future interest receivable, up to
the year of redemption, plus the discounted present value of the redemption payment.

Example 11: (Past exam-September/2016)

Ring Co has in issue ordinary shares with a nominal value of $0·25 per share. These shares
are traded on an efficient capital market. It is now 20X6 and the company has just paid a
dividend of $0·450 per share. Recent dividends of the company are as follows:

Year 20X6 20X5 20X4 20X3 20X2

Dividend per share $0·450 $0·428 $0·408 $0·389 $0·370

Ring Co also has in issue loan notes which are redeemable in seven years’ time at their
nominal value of $100 per loan note and which pay interest of 6% per year.
The finance director of Ring Co wishes to determine the value of the company.
Ring Co has a cost of equity of 10% per year and a before-tax cost of debt of 4% per year.
The company pays corporation tax of 25% per year.

Require: What is the market value of each loan note?

 510

II. Business valuation determination methods

2. Debt valuation

2.2 Redeemable debt valuation

Redeemable debt valuation is the discounted present value of future interest receivable, up to
the year of redemption, plus the discounted present value of the redemption payment.

Example 11: (Past exam-September/2016)

A. $109·34
B. $112·01
C. $116·57
D. $118·68

Answer: B
Market value = (6 x 6·002) + (100 x 0·760) = 36·01 + 76·0 = $112·01
 511

II. Business valuation determination methods

2. Debt valuation

2.3 Convertible debt valuation

Determining convertible debt valuation is same as treatment for redeemable debt except for
redemption value is replaced by higher of conversion value and redeemed amount.

Redemption value

Converted value Redeemed amount

is the sum of the present values of the This is the money which is received
future interest payments and the present when the loan note is redeemed
value of the loan note's conversion value.

Converted value = P0 × (1+g)n × R

Where:
• P0 = the current ex-dividend
ordinary share price
• g = the expected annual growth of
the ordinary share price
• n = the number of years to
conversion
• R = the number of shares received
on conversion
 512

II. Business valuation determination methods

2. Debt valuation

2.3 Convertible debt valuation

Example 12: (Past exam – September/2016)

Lane Co has in issue 3% convertible loan notes which are redeemable in five years’ time at
their nominal value of $100 per loan note. Alternatively, each loan note can be converted
in five years’ time into 25 Lane Co ordinary shares.
The current share price of Lane Co is $3·60 per share and future share price growth is
expected to be 5% per year.
The before-tax cost of debt of these loan notes is 10% and corporation tax is 30%.
Required: What is the current market value of a Lane Co convertible loan note?
A. $82.71
B. $73.47
C. $67.26
D. $94.20

Answer: A
Conversion value = 3·60 x 1·055 x 25 = $114·87
Discounting at 10%, loan note value = (3 x 3·791) + (114·87 x 0·621) = $82·71
 513

II. Business valuation determination methods

2. Debt valuation

2.4 Preference share

Preference shares pay a fixed-rate dividend which is not tax deductible for the company.

Formula:
d
P0 =
Kpref

Where:
• P0 = the market price of the preference share;
• d = the annual dividend payment on the preference share
• K pref = the return required by the preference shareholders
514

CHAPTER 16: MARKET EFFICIENCY

AND INFLUENCES ON VALUATION
OF SHARE AND BUSINESS
 515

Chapter 16: Market efficiency and influences on

valuation of share and business
Overview graph

Types of market efficiency

The efficient market

hypothesis
The market efficiency
Features of efficient
markets

Market efficiency The market paradox

and influences
on valuation of
share and Marketability and liquidity
business of shares

Availability and sources of

information
Practical considerations in
Market imperfections and
the valuation of shares and
market pricing anomalies
business

Market capitalization

Behavioural finance
 516

I. The market efficiency

1. Types of market efficiency

Different types of efficiency can be distinguished in the context of the operation of

financial markets.

Financial markets allow funds to be directed towards

Allocative efficiency
firms which make the most productive use of them.

Operational Describes the ability of a financial market to operate

efficiency with transaction costs are kept as low as possible.

The market price for securities reflects all the relevant

Information
and available information relating to the securities and
processing efficiency
the company which issued them.

The efficient markets hypothesis is concerned with the

information processing efficiency of stock markets.
 517

I. The market efficiency

2. The efficient market hypothesis

The efficient market hypothesis (EMH) states that security prices fully and fairly reflect all
relevant information.

The idea is that new information is quickly and efficiently incorporated into asset prices at any
point in time, so that old information cannot be used to forecast future price movements.

Capital markets can potentially display three varying levels of information processing
efficiency.

LEVELS OF
EFFICIENCY

Weak form Semi-strong form Strong form

All information
Historical All publicly available
(Both public and
information information
private)

Share price
reflects
 518

I. The market efficiency

2. The efficient market hypothesis

Forms Market price reflects Evidence Conclusion

Past Public Private
info info info
Share prices follow a random
• Future price movement
walk:
cannot be predicted from
• There are no patterns or
past price movements.
Weak × trends.
• Technical analysis cannot
• Prices rise or fall depending on
help make a consistent
whether the next piece of
gain on the market.
news is good or bad.
Share prices react very quickly to • Fundamental analysis-
any new information being examining publicly-
released and: available information -
• Rise in response to breaking will not provide
good news opportunities to
Semi-strong × × • Fall in response to breaking consistently beat the
bad news. market.
• Only those trading in the
first few minutes after the
news breaks can beat the
market.
 519

I. The market efficiency

2. The efficient market hypothesis

Forms Market price reflects Evidence Conclusion

Past Public Private

info info info
Share price incorporates all The market is not strong form
information, including information efficient:
that is as yet unpublished. • Insider dealers have been
Then, if the market was strong fined and imprisoned
form: • The stock exchange
• Share price wouldn’t move (e.g. encourages quick release of
news broke about a takeover) – new information to prevent
Strong × × ×
in practice, they do! insider trading
• There would be no need to an opportunities
‘insider dealing’ as insider • Insiders are forbidden from
couldn’t make money by trading trading in their shares at
before news become public – in crucial times
practice, it is banned because
they do!
 520

I. The market efficiency

2. The efficient market hypothesis

Example 1:

Strong form of market efficiency

Mr. X who is the CFO of a major pharmaceutical company. The company is in the final
stages of research and development of introducing a new cancer drug in the market. The
drug should be a grand success in all probabilities and take the company to new heights.

Based on this inside information and before the launch of the drug, Mr. X through his
relatives makes a purchase of the Company’s stock in big volumes at the currently
prevailing market prices. He has the notion that the price of the stock will shoot up once
the drug is brought into the market.

After the successful launch of the drug, he is astonished to see that the price of the stock
has not shot up as per his expectations. This is so because the market had already taken
into account this piece of insider information. The effect of the launch is already
calculated in the current stock price of the company. Characteristic of strong form

⇨ The launch does not provide an opportunity for making windfall gains to an
individual investor.
Evidence of a strong form
 521

I. The market efficiency

2. The efficient market hypothesis

Example 1:

The semi-strong form of market efficiency

Mr. X is having an investment in a retail-chain company. He finds out by thorough research

that a bigger retail chain is showing interest in the above company. Mr. X immediately
increases his stock holding. As the acquisition happened, the stock prices shot up by over
35%.

Mr. X decides to hold the stock with the hope of further appreciation of the stock value of
the company. But the market has a semi-strong form of efficiency. There is a limit to an
increase in the market price of the stock and it is non-sustainable. The overall market
immediately absorbs the news of the company’s acquisition. The price of the stock again
falls back to its average levels and any chances of making extraordinary gains are over.
(Share prices react very quickly to any new information being released).
Share prices
reflect all publicly
available
knowledge.
⇨ Therefore, even a thorough technical and fundamental analysis of the likely
acquisition could not help Mr. X to reap extraordinary profits. Evidence of a
semi-strong
form
 522

I. The market efficiency

2. The efficient market hypothesis

Example 1:

Weak form of market efficiency Using technical analysis

to gain profit

Suppose Mr. X, a swing trader, sees Alphabet continuously decline on Mondays and
increase in value on Fridays. He may assume he can profit if he buys the stock at the
beginning of the week and sells at the end of the week.

However, Alphabet’s price declines on Monday but does not increase on Friday, the
market is considered weak form efficient.

⇨ The theory states that the market is weakly efficient because it doesn’t allow Mr. X to
earn an excess return by selecting the stock based on historical earnings data.
Evidence of a
weak form

Note:
The forms of efficiency are cumulative, so that if the market is semi-strong form, it also
includes weak-form’s characteristics.
 523

I. The market efficiency

3. Features of efficient markets

Stock markets that are efficient (or semi-efficient) are therefore markets in which:

The prices of securities reflect all the

relevant information available;

There are low, or no, Share prices change

costs of acquiring quickly to reflect all
information. new information about
future prospects;

Opinion
Investors are rational and No individual dominates
so make rational buying the market;
and selling decisions, and
value shares in a rational
way;

Transaction costs are not so high

as to discourage trading
significantly;
 524

I. The market efficiency

4. The market paradox

The market paradox is that an efficient market requires people to believe that the market is
inefficient, so that they trade securities in an attempt to outperform the market.

In order for the market to remain efficient, investors must believe there is value in assessing
information. Because they assess it continuously, the information is reflected in the share price
as soon as it is released and an investor cannot beat the market.

The paradox of the efficient market

hypothesis (EMH)

Investors disbelieve the Perform the continuous collective

efficient market hypothesis actions of fundamental analysts

want to beat the market

It helps
Self-defeating

the market reacts instantaneously to

Maintain market efficiency
new information.
 525

I. The market efficiency

5. Impacts of efficiency on share prices

If the stock market is efficient, share prices should vary in a rational way.

If a company makes an investment with a positive net Market share prices will
present value (NPV) rise

Market share prices will

If a company makes a bad investment
fall

If interest rates rise, shareholders will want a higher

Market share prices will
return from their investments
fall
 526

II. Practical considerations in the valuation of

shares and business
Overview graph

Marketability Availability and

and liquidity of sources of
shares information

Factors to
consider
Behavioral Market
finance imperfections and
pricing anomalies

Market
capitalisation
 527

II. Practical considerations in the valuation of

shares and business
1. Marketability and liquidity of shares
This factor shows how marketability and liquidity will influence the value of a share:

Marketability and liquidity of shares

Marketability Liquidity

A measure of the ability of a A ease of dealing in the shares; how

Definition security to be bought and sold. easily the shares can be bought and
sold without significantly moving the
price

In general, shares in large It may be difficult to sell shares in a

companies are relatively easy to private company, particularly a
Influences sell, which has a positive impact minority shareholding, which will
on their share value compared to have the effect of lowering the share
small companies. value.

Note:

Marketability is similar to liquidity, except that liquidity implies that the value of the security is
maintained, whereas marketability simply indicates that the security can be bought and sold
easily.
 528

II. Practical considerations in the valuation of

shares and business
2. Availability and sources of information
An efficient market is one where the prices of securities bought and sold reflect all the
relevant information available. Efficiency relates to how quickly and how accurately prices
adjust to new information.

⇨ If investors are unable to obtain accurate information, this is likely to lead to a drop in the
value of a share as they react adversely to uncertainty.

Example:

In unlisted companies, information may be less readily available for a number of reasons
such as:

∙ a weaker control environment

∙ unaudited financial statements

∙ fewer compliance regulations apply

∙ no tradition of sharing information so channels of communication not set up

∙ less detailed record keeping.

⇨ The relative shortage of information in unlisted companies may also cause the value of
share to be downgraded.
 529

II. Practical considerations in the valuation of

shares and business
2. Availability and sources of information
Dividend information

It has been argued that shareholders see dividend decisions as passing on new information
about the company and its prospects.

Example:

Market share
A dividend increase* Good news
prices will rise

Market share
A dividend decrease* Bad news
prices will fall

(*) increase or decrease is based on market's expectations of the level of dividend.

 530

II. Practical considerations in the valuation of

shares and business
3. Market imperfections and market pricing anomalies

Various types of anomaly appear to support the views that irrationality often drives the stock
market, including the following:

Calendar anomalies: seasonal month of the year effects, day of the week effects
and also hour of the day effects seem to occur, so that share prices might tend to
rise or fall at a particular time of the year, week or day.

Momentum and Overreaction Anomalies: there may be a short-run overreaction

to recent events.

Cross-Sectional Anomalies: two of the most researched cross-sectional

anomalies in financial markets are the size effect and the value effect.

The size effect refers to initial findings that

small-cap stocks outperform large-cap stocks;

The value effect refers to the finding that

value stocks (which have lower P/E and higher
dividend yields) have outperformed growth
stocks (with higher P/E and lower dividend
yields).
 531

II. Practical considerations in the valuation of

shares and business
4. Market capitalisation

The market capitalisation is the market value of a company's shares multiplied by the number
of issued shares.

Example:

The return from investing (%) in smaller companies has been shown to be greater than
the average return from all companies in the long run.

>

Explanation: This increased return may:

∙ Compensate for the greater risk associated with smaller companies; and
∙ Be due to a start from a lower base reflecting that they are often undervalued.
 532

II. Practical considerations in the valuation of

shares and business
5. Behavioural finance

Behavioural finance is an alternative view to the efficient market hypothesis. It attempts to

explain the market implications of the psychological factors behind investor decisions and
suggests that irrational investor behaviours may significantly affect share price movements.

Behavioural finance terms including the follow:

Terms Explanation

This is when investors choose to buy or sell particular shares

because many other investors have already done so.
Explanations for investors following a herd instinct include social
Herding conformity, the desire not to act differently from others. Individual
investors lacking the confidence to make their own judgments,
believing that a large group of other investors cannot be wrong.

Stock market Where a herd instinct has led to a sharp rise in the value of shares in a
bubble certain sector that is unsustainable.

They are stock market traders who do not base their decisions on
Noise traders professional analysis, who make poorly timed decisions and follow
trends.
 533

II. Practical considerations in the valuation of

shares and business
5. Behavioural finance

Behavioural finance terms including the follow:

Terms Explanation

Where investors avoid investments that have the risk of making

losses even though long-term analysis would suggest significant
Loss aversion capital gains may be made. This can lead to choosing investments
that are safe but low earning and away from investments that have
high gain potential.

Once a trend is seen in share prices, the market may become

optimistic (if prices are rising) or pessimistic (if prices are falling) and
Momentum effect this will stimulate or stifle further investment and lead to the trend
continuing.
If a momentum effect exists, then it is likely to lengthen periods of
stock market boom or bust.
534

CHAPTER 17:
FOREIGN CURRENCY RISK
 535

Chapter 17: Foreign currency risk

Overview graph

Exchange rates Foreign exchange demand

Transaction risk

Foreign currency
Translation risk
risk

Economic risk

Currency supply and demand

Foreign The causes of
currency exchange rate
risk fluctuations Exchange rate fluctuation prediction
theory

Foreign currency Techniques for Foreign currency risk

risk management management

Future

Foreign currency
Option
derivatives

Swap
 536

I. Introduction of exchange rate

1. Definitions and terminologies
Terms Definition

is the rate at which one country's currency can be traded in

Exchange rate
exchange for another country's currency.

Spot rate is the exchange rate currently offered on a particular currency for
immediate delivery.

Future spot rate is an exchange rate for currencies to be exchanged at a future date.

is an exchange rate set now for currencies to be exchanged at a

Forward rate
future date.

Ask (offer) price is the rate at which a dealer (bank) will sell a foreign currency

Bid price is what the dealer (bank) is willing to pay for a foreign currency

Currency
is the decline of a currency’s value relative to another currency.
depreciation

Strengthening A strengthening means that it now buys more of the other currency
currency than it did before

Weakening A strengthening means that it now buys more of the other currency
currency than it did before
 537

I. Introduction of exchange rate

2. Foreign exchange demand

Every traded currency in fact that has many

exchange rates.

Characteristics of Rates change continuously, because there is

foreign currency a huge volume of transactions daily in the
transactions foreign exchange markets globally.

Symbol: Foreign currency (FC)/ Base

currency (BC) = exchange rate OR bid price –
ask price per 1 foreign currency

Note:
• When we need foreign currency, we borrow or buy it from the bank by base currency.
The rate which is used in this case is ask price or offer price.
• When we have foreign currency and want to translate to base currency, we lend or sell it
to the bank. The rate which is used in this case is bid price.
Ask (offer) price > bid price
 538

I. Introduction of exchange rate

2. Foreign exchange demand

Example 1: Ask price

A USA bank's customer, a trading company, has imported goods, from Germany, for which
it must now pay €10,000. we have exchange rate is EUR/USD = 1.2357(bid price)/1.2367
(ask price). To settle payment, the company will buy €10,000 from the bank.

Note: Base currency is USD and Foreign currency is EUR;

When the bank agrees to sell €10,000 to the company, it will tell the company the
exchange rate will be for the transaction is Ask price. With ask price is $1.2367 per €1 for
the currency, the bank will charge the company: 10,000 x $1.2367 = $12,367.

Example 2: Bid price

An USA’s exporter is paid €10,000 by a foreign customer in the Europe, they may wish to
exchange the Euro to obtain Dollar. They will therefore ask the bank to buy the Euro from
them. Since the exporter is selling currency to the bank, the bank is buying the currency.
we have exchange rate is USD/EUR = 1.2357(bid price)/1.2367 (ask price).

In this case, the exchange rate that the bank used to determine spot rate is Bid price
 The bank quotes a bid price of $1.2357 per €1, exporter will receive 10,000 x $1.2357 =
$12,357.
 539

II. Foreign currency risks

Overview

Foreign exchange risk, also called currency risk or FX risk, is the risk arising from unforeseen
changes in an exchange rate or the value of a currency.

Foreign currency risk is a two-way risk. This means that exchange rate movements may be
favorable as well as adverse, so the term 'risk' can be misleading.

Transaction risk

Foreign
currency risks Translation risk

Economic risk
 540

II. Foreign currency risks

1. Transaction risk

Transaction risk is the risk of an exchange rate changing between the transaction date and the
subsequent settlement date.

It arises on any future transaction involving conversion between two currencies. The most
common area where transaction risk is experienced relates to imports and exports.

Transaction risk

The price of transactions (imports The agreed price at the transaction

or exports) is recognized at a spot date is different from the amount at
rate at the transaction date. the settlement date

Transaction Movement in exchange rate Settlement date

date
 541

II. Foreign currency risks

1. Transaction risk

Example 3: Transaction risks

A Britain company buys goods from a US supplier costing $336,000, for settlement in three
months' time. If the current spot rate of exchange is $1.50 = £1, the expected cost of the
goods for the UK buyer will be £224,000 (= $336,000/$1.50)

Buy goods from US supplier

Cost: $336,000

Current spot rate is

Present $1.50 per £1

Expected payable for Sterling

£224,000

If spot rate is If spot rate is

$1.40 per £1 $1.60 per £1
After
Outstanding payable Outstanding payable
three
£240,000 £210,000
months
£16,000 more than expected £14,000 less than expected
(loss) (gain)
 542

II. Foreign currency risks

1. Transaction risk

Example 4: Transaction risk

Bulldog Ltd, a UK company, buys goods from Redland which cost 100,000 Reds (the local
currency). The goods are resold in the UK for £32,000. At the time of the import purchase,
the exchange rate for Reds against Sterling is £0.2793 - £0.2805 per Red

Required:
(a) What is the expected profit on the resale in Sterling?
(b) What would the actual profit be if the spot rate at the time when the currency is
received has moved to:
(i) £0.3231 - £0.3247 per Red?
(ii) 0.2451 - £0.2460 per Red?
Ignore bank commission charges.

Solution:
(a) Bulldog must buy Reds to pay the supplier, and so the bank is selling Reds. We use ask
price: £0.2805 per Red.
 543

II. Foreign currency risks

1. Transaction risk

Example 4:

The expected profit is as follows:

£
Revenue from resale of goods 32,000.00
Less cost of 100,000 Reds in sterling (× 0.2805) 28,050.00
Expected profit 3,950.00
(b) (i) If the actual spot rate for Bulldog to buy and the bank to sell the Reds is £0.3247 per
Red (Ask price) the result is as follows:
£
Revenue from resale 32,000.00
Less cost (100,000 × 0.3247) 32,467.00
Loss (467.00)
(ii) If the actual spot rate for Bulldog to buy and the bank to sell the Reds is £0.2460 per
Red, the result is as follows:
£
Revenue from resale 32,000.00
Less cost (100,000 × 0.2460) 24,600.00
Profit 7,400.00
This variation in the final sterling cost of the goods (and thus the profit) illustrates the
concept of transaction risk.
 544

II. Foreign currency risks

2. Translation risk
Translation risk is the risk that the organization will make exchange losses when the
accounting results of its foreign branches or subsidiaries are translated into the home
currency.

Translation losses can result, for example, from re-stating the book value of a foreign
subsidiary's assets at the exchange rate on the statement of financial position date.

Translation risk

At the end of accounting period

Consolidation the result of foreign

Re-stating account balance
branches or subsidiaries

Cash on hand

Account receivable

Account payable

The effect of translation risk is to create gains or losses in the reported financial results of the
parent group, but they do not create cash flow gains or losses (unrealised gain/loss).
 545

II. Foreign currency risks

2. Translation risk

Example 5:

Translation risk

Butterfly Ltd, a UK company, buys goods from Redalert which cost 100,000 Reds (the local
currency). At the time of the import purchase the exchange rate for Reds against sterling is
Red3.5650 – Red3.5800 per £1. At the end of accounting period, Butterfly has not carried
out any payment to Redalert and exchange rate is Reds/pound = 3.5600/3.5780. Butterfly
must be retranslating this payable at the end of period.

At import date At year end Gain/loss

Record a payable: £28,050.50 Restate payable: £28,090 Loss: £39.5
(=100,000/3.5650) (=100,000/3.5600)
 546

II. Foreign currency risks

3. Economic risk

Economic risk is the variation in the value of the business (i.e. the present value of future cash
flows) due to unexpected changes in exchange rates.

It is the long-term version of transaction risk. This refers to the effect of exchange rate
movements on the international competitiveness of a company and refers to the effect on the
present value of longer-term cash flows.

For an export company it could occur because:

• The home currency strengthens against the currency in which it trades; or
• A competitor’s home currency weakens against the currency in which it trades.

Economic exposure can be difficult to avoid, although diversification of the supplier and
customer base across different countries will reduce this kind of exposure to risk.
 547

III. The causes of exchange rate fluctuations

1. Currency supply and demand

The exchange rate between two currencies is determined primarily by supply and demand in
the foreign exchange markets.

Inflation rate Interest rates

Supply and
demand for
currencies are
in turn mainly
influenced by:

Government The balance of

policy payments
 548

III. The causes of exchange rate fluctuations

1. Currency supply and demand

1.1 Inflation rate

Purchasing Power Parity Theory (PPPT)

PPPT is based on: 'the law of one price', it states that the same good cannot sell for different
prices in different locations at the same time, regardless of the currency in which they are sold.

PPPT claims that the rate of exchange between two currencies depends on the relative inflation
rates within the respective countries. When consider an exchange rate between two countries,
A (A dollar) and B (B dollar), A have a higher inflation rate than B. According to “Purchasing
power parity theory”, the A currency is devalued, so for one B dollar may translate to more A
dollar.

1.2 Interest rate

The higher interest rate

Interest rate affects exchange rate
in the same way that inflation does
to exchange rate.
The lower of value the currency will have
 549

III. The causes of exchange rate fluctuations

1. Currency supply and demand

1.3 Balance of payment

Whenever the Balance of payment (BoP) registers a purchase of a foreign asset or a sale of a
domestic commodity abroad, this implicitly indicates that there is a change in the demand for
or in the supply of the foreign currency (FC).

Therefore changes in any of the components of the BoP affect the supply of and demand for
foreign currency:

• When a country export, the FC demand will decrease by payment purpose in domestic
currency by customers, exchange rate between two currency witnesses a decrease, that
means less BC is needed to exchange to a FC, so its value of exporter currency will grow in
comparison with other currency.

Exchange
rate (%)

Decrease in
exchange rate

0
Net export (NX)
Decrease in FC
demand
 550

III. The causes of exchange rate fluctuations

1. Currency supply and demand

1.3 Balance of payment

• When a country import, FC demand will increase by payment purpose in foreign

currency, exchange rate between two currency witnesses an increase, that means more
BC is needed to exchange to obtain a FC, so its value of exporter currency will depreciate
in comparison with other currency.

Exchange
rate (%)

Increase in
exchange rate

0 Net export
Increase in FC (NX)
demand
 551

III. The causes of exchange rate fluctuations

1. Currency supply and demand

1.3 Balance of payment

Example 6:

Balance of payment
Suppose a consumer in France wants to purchase goods from an American company. The
American company is not likely to accept euros as payment, it wants U.S. dollars.
Somehow the French consumer needs to purchase U.S. dollars (ostensibly by selling Euros
in the forex market) and exchange them for the American product. As more U.S. dollars are
demanded to satisfy the needs of foreign investors or consumers, upward pressure is
placed on the price of U.S. dollars.
 552

III. The causes of exchange rate fluctuations

1. Currency supply and demand

1.4 Government policy

Policy of government towards the level of the exchange rate of its currency, it may want to
influence the exchange rate by using its gold and foreign currency reserves held by its central
bank to buy and sell its currency.

Example:

Exchange rates can be manipulated by buying or selling currencies on the foreign exchange
market. To raise the value of the pound the Bank of England buys pounds, and to lower the
value, it sells pounds (E.g. via the issuance/repurchase of Treasury bonds).
553

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

Exchange rate
fluctuation prediction
theory

Purchasing
Interest The Fisher Expectation
power
rate parity effect theory
parity
 554

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.1 Interest rate parity

The interest rate parity (IRP) is a method of predicting foreign exchange rates based on the
hypothesis that the difference between the interest rates in the two countries should offset the
difference between the spot rates and the forward foreign exchange rates over the same
period. Interest rate parity is being used to determine the forward rate.

The principle can be stated as follows:

1+ic
F0 = S 0 x
1+ib
Where:
• F0 = forward rate
• S0 = current spot rate
• ic = interest rate in country c (the overseas country) up to the future date
• ib = interest rate in country b (the base country) up to the future date
 555

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.1 Interest rate parity

Example 7:

Exchange rates between two currencies, the Northland florin (NF) and the Southland dollar
($S), are listed in the financial press as follows.

Spot rates: 90-day forward rates:

$S1 = NF4.7250 NF4.7506 per $S1
NF1 = $S0.21164 $S0.21050 per NF1

The money market interest rate for 90-day deposits in Northland florins is 7.5% annualized.

Required:
What is interest rates in Southland?
Assume a 365-day year. (Note. In practice, foreign currency interest rates are often
calculated on an alternative 360-day basis, one month being treated as 30 days.)
 556

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.1 Interest rate parity

Example 7:

Solution:

Applying the formula given earlier

1 + is
F0 = S 0 x
1 + in
we have the following:
Northland interest rate on 90-day deposit = in = 7.5% x 90/365 = 1.85%
Southland interest rate on 90-day deposit = is
90-day forward exchange rate = F0 = 0.21050
Spot exchange rate = S0 = 0.21164
1+is
0.2150 = 0.21164 x
1+0.0185

1 + is 0.21050
=
1+0.0185 0.21164

 is = 0.013, or 1.3%
Annualized, this is 0.013 × 365/90 = 5.3%
 557

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.2 Purchasing power parity

Purchasing power parity (PPP) theory states that the exchange rate between two currencies is
the same in equilibrium when the purchasing power of currency is the same in each country.
Purchasing power parity is being used to determine the future (expected) spot rate.

Formally, purchasing power parity can be expressed in the following formula.

1+hc
S1 = S0 x
1+hb

Where:
• S1 = future spot rate (expected spot rate)
• S0 = current spot rate
• hc = expected inflation rate in country c (a foreign country)
• hb = expected inflation rate in country b (the investor's country)

Note:
• This formula is given in the exam.
• Try to remember that purchasing power parity predicts the future spot rate and interest
rate parity predicts the forward rate.

In the real world, exchange rates move towards purchasing power parity only over the long
term.
However, the theory is sometimes used to predict future exchange rates in investment
appraisal problems where forecasts of relative inflation rates are available.
 558

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.2 Purchasing power parity

Example 8:

The spot exchange rate between UK sterling and the Danish krone is £1 = 8.00 kroner.
Assuming that there is now purchasing parity, an amount of a commodity costing £110 in
the UK will cost 880 kroner in Denmark. Over the next year, price inflation in Denmark is
expected to be 5% while inflation in the UK is expected to be 8%.

Required:
What is the ‘expected spot exchange rate’ at the end of the year?

Solution:

Using the formula above:

1+hc
S1 = S0 x
1+hb
we have the following:
• Price inflation in Denmark = hc = 5%
• inflation in the UK = hb = 8%
• Spot exchange rate = S0 = 8.00

Future (forward) rate:

1.05
S1 = 8 x 1.08 = 7.78
 559

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.3 The Fisher effect

According to the international Fisher effect, nominal interest rate differentials between
countries provide an unbiased predictor of future changes in spot exchange rates. The currency
of countries with relatively high interest rates is expected to depreciate against currencies with
lower interest rates, because the higher interest rates are considered necessary to compensate
for the anticipated currency depreciation.

Fisher formula:

1 + nominal interest rate = (1 + real interest rate) × (1 + inflation rate)

We have two formula:

• For country a: 1 + ia = (1 + ha ) × (1 + ra )
• For country b: 1 + ib = (1 + hb ) × (1 + rb )

Given free movement of capital internationally, this idea suggests that the real rate of return in
different countries will equalize as a result of adjustments to spot exchange rates.

 1 + ra = 1 + rb
 560

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.3 The Fisher effect

The international Fisher effect can be expressed as:

1 + ia 1 + ha
1 + ib = 1 + hb

Where:
• ia is the nominal interest rate in country a
• ib is the nominal interest rate in country b
• ha is the inflation rate in country a
• hb is the inflation rate in country b
 561

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.4 Four-way equivalence

The four-way equivalence model states that in equilibrium, differences between forward and
spot rates, differences in interest rates, expected differences in inflation rates and expected
changes in spot rates are equal to one another.

Difference in interest Expected difference in

2
rates interest rates
(1 + ia ) (1 + ha )
International Fisher
(1 + ib ) effects (1 + hb )

Purchasing power parity

Interest rate parity

1 3

Difference between Expected change in

forward and spot rates Expectation theory spot rates
F0 S1
S0 S0
 562

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.4 Four-way equivalence

1+ic F 1+ic
1 Following interest rate parity (IRP) theory: F0 = S 0 x  0 =
1+ib S0 1+ib

1 + ia 1 + ha
Following international Fisher effect
2 1 + ib = 1 + hb
1+hc S 1+ic
3
Following Purchasing power parity (PPP) S1 = S 0 x  1 =
theory: 1+hb S0 1+ib

Example 9: Four-way equivalence

Country X uses the dollar as its currency and country Y uses the dinar. Country X’s expected
inflation rate is 5% per year, compared to 2% per year in country Y. Country Y’s nominal
interest rate is 4% per year and the current spot exchange rate between the two countries
is 1.5000 dinar per $1.
According to the four-way equivalence model,
1. Country X’s nominal interest rate should be 7.06% per year
2. Forward rate after one year should be 1.4571 dinar per $1
3. Country X’s real interest rate should be higher than that of country Y
Required:
Which of the following statements is/are true?
A. 1 only
B. 1 and 2 only
C. 2 and 3 only
 563

III. The causes of exchange rate fluctuations

2. Exchange rate fluctuation prediction theory

2.4 Four-way equivalence

Example 9:

Solution:
B. 1 and 2 only

1. Using the formula above:

1 + ix 1 + hx
1 + iy = 1 + hy
We have the following:
i𝑥 is the nominal interest rate in country X
i𝑦 is the nominal interest rate in country Y = 4%
h𝑥 is the inflation rate in country X = 5%
h𝑦 is the inflation rate in country Y = 2%
 ix = 7.06%  True

2. According to four-way equivalence model:

1.02
Forward rate = The future spot rate = 1.5 × = 1.4571 (dinar/$)  True
1.05

3. According to Fisher effect: real rate of return in different countries will equalize  False
 564

IV. Foreign currency risk management

Overview

Foreign risk management describes the policies which a firm may adopt and the techniques it
may use to manage the risks it faces, in order to reduce the risk to acceptable level. Measures
to reduce currency risk are known as 'hedging'.

Foreign currency risks

Invoicing Matching Leading Forward Money

of own assets and and Netting exchange market
currency liabilities lagging contract hedge
 565

IV. Foreign currency risk management

1. Invoicing of own currency

Company issues commercial invoice to customers or requires foreign supplier to accept

payment under own currency.

This method:
• Transfers foreign exchange risk to the other party.
• May not be commercially acceptable.

2. Matching assets and liabilities

A company that expects to receive a significant amount of income in a foreign currency will
want to hedge against the risk of this currency weakening.

It can do this by borrowing in the foreign currency and using the foreign receipts to repay the
loan.
 566

IV. Foreign currency risk management

3. Matching payments and receipts

When a company has receipts and payments in the same foreign currency due at the same
time, it can simply match them against each other.

Example 10:

Matching payments and receipts

Suppose that ABC plc has the following receipts and payments in three months’ time
(Sterling is not base currency of ABC plc):

Receives £16mil
UK customers
ABC plc Pays £10mil
UK supplier

Only face with the FX risk of

unmatched exposure £6mil
 567

IV. Foreign currency risk management

4. Leading and lagging

In order to take advantage of foreign exchange rate movements, companies might try to use:

For buyer:

Leading Lagging

Money paid Money due Money due Money paid

If an buyer expects that the currency it is If an buyer expects that the currency it is
due to pay will appreciate over the next due to pay will depreciate, it may attempt
few months it may try to pay immediately to delay payment beyond their due date for
or pay in advance. goods purchased in a foreign currency
 568

IV. Foreign currency risk management

4. Leading and lagging

For seller:

Leading Lagging

Money receipt Money due Money due Money receipt

If an seller expects that the currency it is If an seller expects that the currency it is
due to receive will depreciate over the due to receipt will appreciate, it will not
next few months it may try to obtain attempt to collect this receivable until the
payment immediately. due date or occurring an unforeseeable
adverse exchange rate movement. If an
seller expects that the currency it is due to
receipt will appreciate, it may attempt to
delay payment.
 569

IV. Foreign currency risk management

5. Netting

Netting is a process in which credit balances are netted off against debit balances so that only
the reduced net amounts remain due to be paid by actual currency flows.

The objective is simply to save transactions costs by netting off inter-company balances before
arranging payment. Netting is applied widely to multinational groups of companies due to large
of intra-group trading transactions.

Netting has the following advantages:

Save transaction costs by netting off intercompany balances

1 before arranging payment between group companies.

Foreign exchange purchase costs, including commission and the

2 spread between selling and buying rates, and money transmission
costs are reduced.

3 There is less loss in interest from having money in transit.

 570

IV. Foreign currency risk management

5. Netting

Example 11:

Netting
A and B are respectively UK- and US-base subsidiaries of a Swiss-base holding company
(CHF is base currency of Swiss). At 31 March 20X5, A owed B CHF 300,000 and B owed A
CHF 220,000.
Netting can reduce the value of the inter-company debts: the two inter-company balances
are set against each other, leaving a net debt owed by A to B of CHF 80,000 (CHF 300,000 -
220,000).

Group
(Swiss-base)
A owed B
CHF 300,000
Subsidiary A Subsidiary B
(UK-base) (US-base)
B owed A
CHF 220,000

Only face with foreign exchange

risk of CHF 80,000
 571

IV. Foreign currency risk management

6. Forward exchange contract

A forward exchange contract is defined as:

• An immediately firm and binding contract (e.g. between a bank and its customer)
• For the purchase or sale of a specified quantity of a stated foreign currency
• Fix an exchange rate now for the settlement of a transaction at a future date.

A forward exchange contract hedges against transaction exposure by allowing the importer or
exporter to arrange for a bank to sell or buy a quantity of foreign currency at a future date, at a
rate of exchange determined when the contract is signed.

Example 12:

Forward exchange contract

A UK importer knows on 1 April that they must pay a foreign seller 26,500 Swiss francs in
one month's time, on 1 May. They can arrange a one-month forward exchange contract
with the bank on 1 April, whereby the bank undertakes to sell the importer 26,500 Swiss
francs. The bank's forward rates for one month are: CHF/ £: 1.4396 – 1.4504

The UK importer can be certain that whatever the spot rate is on 1 May, they will have to
pay at this forward rate. The cost in sterling will be: £18,407.89 (26,500/1.4396).

If the spot rate is lower than 1.4396 If the spot rate is higher than 1.4396
on 1 May on 1 May
The importer would have successfully The importer would pay more at the
protected themselves against a fall in forward rate than if they had obtained
the value of sterling, and would have the francs at the spot rate on 1 May. They
avoided paying more sterling at the spot cannot avoid this extra cost because a
rate to obtain the Swiss francs. forward contract is binding.
 572

IV. Foreign currency risk management

7. Money market hedging
Money market hedging involves some acts to translate a foreign currency receipt or payment
in the future to base currency now, hoping to take advantage of favourable exchange rate
movements.

Hedging a payment Hedging a receipt

Method: Deposit of foreign currency by base Method: Borrow a foreign currency term and
currency at present and after few months, after few months, total principle and interest
total principle and interest of that deposit is of its are equal to receivable amount
used to net off with foreign payable.
573

IV. Foreign currency risk management

7. Money market hedging
Hedging a payment
 574

IV. Foreign currency risk management

7. Money market hedging
Hedging a payment
ACTUAL HEDGING PROCESS
1. Borrow the appropriate amount in pounds now.
2. Convert the pounds to Yen immediately at the spot rate.
3. Put the Yen on deposit in Yen bank account
4. When the time comes to pay the company:
• Pay the supplier out of the Yen bank account.
• Repay the pounds loan.
CALCULATION PROCESS
Lending (depositing): The company needs to deposit enough Foreign currency now
so that the total including interest will be paid amount in the future. This means
Step 1 depositing:
foreign currency paid amount
1 + interest rate

Converting: Translate the principal of deposit to the home currency at the spot
Step 2 rate
foreign currency amount × bid spot rate
Borrowing: To have enough foreign money to deposit, the company must borrow
amount of base currency money, which is translated to foreign money to be used
to deposit. The interest of debt is included in hedging amount of base currency
Step 3
money. Hedging amount is:
Based currency amount × (1+borrowing rate)

Conclusion: instead of paying a foreign currency payable by base currency after a few
months, the company can calculate accurately which amount of payable must be paid at
present, with its base currency.
 575

IV. Foreign currency risk management

7. Money market hedging

Example 13:

Hedging a payment
A UK company owes a Danish supplier Kr 3,500,000 which is payable in three months'
time. The spot exchange rate is Kr7.5509 – Kr7.5548 per £1. The company can borrow in
sterling for three months at 8.60% per annum and can deposit kroner for three months at
10% per annum. What is the cost in pounds with a money market hedge?
Lending: The interest rates for three months is 2.5% (= 10%/4) to deposit in
kroner. The company needs to deposit enough kroner now so that the total
including interest will be Kr 3,500,000 in three months' time. This means
Step 1
depositing:
foreign currency paid amount 3,500,000
1+interest rate = 1 + 0.025 =Kr3,414,634
Converting: Spot rate Kr7.5509 = £1, these kroner will cost:
Step 2 foreign currency amount x bid spot rate
3,414,634
7.5509 =£452,215
Borrowing: The company must borrow this amount and, with three months'
interest at 2.15%, will have to repay:
Step 3
Base 1+borrowing rate
=£452,215 x (1+0.0215) = £461,938

Thus, in three months, the Danish supplier will be paid out of the Danish bank account and
the company will effectively be paying $461,938 to satisfy this debt. The effective forward
rate which the company has 'manufactured' is 3,500,000/461,938 = Kr7.5768 = $1. This
effective forward rate shows the krone at a discount to the dollar because the krone
interest rate is higher than the dollar interest rate.
576

IV. Foreign currency risk management

7. Money market hedging
Hedging a receipt
 577

IV. Foreign currency risk management

7. Money market hedging
Hedging a receipt
ACTUAL HEDGING PROCESS
1. Borrow an appropriate amount in the foreign currency today.
2. Convert it immediately to base currency at the spot rate
3. Place a deposit of above money in a home bank account
4. When the receivable's cash is received:
• Repay the foreign currency loan.
• Take the cash from the home currency deposit account.
CALCULATION PROCESS
Borrowing: Company determined that which amount of foreign money will be
received in the future, then now it can borrow foreign amount so that in the future
Step 1 principal and interest of this loan is equal to receipt amount.
foreign currency receipt amount
1+interest rate
Converting: Translate the borrowing amount to the home currency at the spot rate
Step 2
foreign currency amount × ask spot rate
Lending (depositing): Deposit the money which is borrowed from the loan in step
1, in a home bank to gain interest benefit. Total principal and interest is hedging
Step 3
amount of this foreign receipt:
Base currency amount × (1 + deposit rate)

Conclusion: company can receive earlier that receivable regardless of fluctuation of exchange
rate

Note: The deposit and borrowing rates will normally be given as annual rates and will have to
be adjusted for the time period in the question. Assume that simple interest applies so, for
example, divide the annual rate by 4 for a 3- month time period.
 578

IV. Foreign currency risk management

7. Money market hedging

Example 14:
Hedging a receipt
A US company is owed CHF 2,500,000 receivable in three monthes’ time from a Swiss
company. The spot exchange rate is CHF1.4498 – CHF1.4510 per $1. The company can
deposit in dollars for three months at 8.00% per annum and can borrow Swiss francs for
three months at 7.00% per annum. What is the receipt in dollars with a money market
hedge?
Borrowing: The interest rates for three months are 2% to deposit in dollars
and 1.75% to borrow in Swiss francs. The company should borrow:
Step 1 foreign currency paid amount 2,500,000
1+interest rate = 1 + 0.0175=2,457,002(CHF)
After three months, CHF 2,500,000 will be repayable, including interest.
Converting: Spot rate CHF1.4510 = $1, these CHF will cost:
foreign currency amount x ask spot rate
Step 2 2,457,002
= =$1,693,316
1.4510
Lending: The company must deposit this amount for three months, when
it will have increased in value with interest (2% for the three months) to:
Step 3
Base 1 + deposit rate
=$1,693,316 x (1+0.02) =$1,727,182

Thus, in three months, the loan will be repaid out of the proceeds from the trade
receivable and the company will receive $1,727,182. The effective forward rate which the
company has 'manufactured' is 2,500,000/1,727,182 = CHF1.4474 = $1. This effective
forward rate shows the Swiss franc at a premium to the dollar because the Swiss franc
interest rate is lower than the dollar rate.
 579

IV. Foreign currency risk management

8. Choosing the hedging method

Method: The choice is generally made on the basis of which method is cheaper, with other
factors being of limited significance.

When a company expects to receive or pay a sum of foreign currency in the next few months, it
can choose between using the forward exchange market and the money market to hedge
against the foreign exchange risk. Other methods may also be possible, such as making lead
payments. The cheapest method available is the one that ought to be chosen.
 580

IV. Foreign currency risk management

8. Choosing the hedging method

Example 15:

Choosing hedging method

Trumpton, a US company, has bought goods from a foreign supplier, and must pay
4,000,000 pesos for them in three months' time. The company's finance director wishes to
hedge against the foreign exchange risk, and the three methods which the company
usually considers are:
• Using forward exchange contracts
• Using money market borrowing or lending
• Making lead payments
The following annual interest rates and exchange rates are currently available.

Dollar Peso
Deposit rate Borrowing rate Deposit rate Borrowing rate
% % % %
1 month 4.2% 6.6% 2.4 3.6
3 months 5.4% 7.2% 2.8 4.8

Exchange rate peso per $1

Spot rate 1.8625 – 1.8635
1-month forward rate 1.8560 – 1.8626
3-months forward rate 1.8424 – 1.8607

Required: Which is the cheapest method for Trumpton?

 581

IV. Foreign currency risk management

8. Choosing the hedging method

Example 15:

Solution:
The three choices must be compared on a similar basis, which means working out the cost
of each to Trumpton either now or in three months' time. In the following paragraphs, the
cost to Trumpton now will be determined.

Choice 1: The forward exchange market

Trumpton must buy pesos in order to pay the foreign supplier. The exchange rate in a
forward exchange contract to buy 4,000,000 peso in 3 months' time (bank sells) is 1.8424 =
$1.

The cost of the 4,000,000 peso to Trumpton in three months' time will be:

4,000,000
=$2,171,081
1.8424

The cost in three months is $2,171,081

Choice 2: The money markets

It would invest enough pesos for three months, so that the principal repaid in three
months' time plus interest will amount to the payment due of 4,000,000 pesos.
 582

IV. Foreign currency risk management

8. Choosing the hedging method

Example 15:
Borrowing: The interest rates for three months is 0.70% (2.80%/4) to borrow
in Peso. The company should borrow:
Step 1 Foreign currency paid amount 4,000,000
= = 3,972,195 (Peso)
1 + interest rate 1 + 0.7%
After three months, Peso 4,000,000 will be repayable, including interest.

Converting: Spot rate: Peso1.8625 = $1., these Peso will cost:

3,972,195
Step 2 Foreign currency amount × bid spot rate = = $2,132,722
1.8625
Lending: The company must deposit this amount for three months, when
it will have increased in value with interest (1.8% for the three months
Step 3 (7.2 × 3/12)) to:
Base currency amount × 1 + borrowing rate
= $2,132,722 × 1.018 = $2,171,111
Choice 3: Lead payments
Lead payments should be considered when the currency of payment is expected to
strengthen over time, and is quoted forward at a premium on the foreign exchange
market.
Here, the cost of a lead payment (paying 4,000,000 pesos now) would be 4,000,000 ÷
1.8625 = $2,147,651
Again, assuming that Trumpton starts with a zero cash flow position, then this would need
to be borrowed. This would incur interest costs in the US of 7.2% per annum so
approximately:
7.2 × 3/12 = 1.80% over three months.
 The cost in three months' time is therefore $2,147,651 × (1+1.8%) = $2,186,309.
 583

IV. Foreign currency risk management

8. Choosing the hedging method

Example 15:

Summary
$
Forward exchange contract 2,171,081 (cheapest)
Money market hedging 2,171,111
Lead payment 2,186,309

(*) It is closely similar to a foreign currency receipt

584

V. Foreign currency derivatives

Overview

Foreign currency
derivatives

Currency future Currency option Currency swap

 585

V. Foreign currency derivatives

1. Currency future

A currency future is a standardised, market-traded contract to buy or sell a specified quantity

of foreign currency in the future.

Futures are like a forward

contract in which:

The company’s position is fixed by

the rate of exchange in the futures
contract

It is a binding contract.
 586

V. Foreign currency derivatives

1. Currency future
The following table summarizes the differences between currency futures and forward
contracts:

Currency Forward
futures contracts

Standardized contracts Bespoke contracts

Traded on the open market (futures Traded over the counter

exchange)

Contract price in any strong currency Contract price in any currency offered
by the bank

Agreed (fixed) close-out dates Fixed date of settlement

Underlying transactions take place at the Underlying transactions take place at the
spot rate; the difference between the forward rate
spot rate and future rate is settled
between two parties

Cheaper than forwards Relatively high premium required

 587

V. Foreign currency derivatives

1. Currency future

Now we will consider some advantages and disadvantages of currency future contract:

Advantages Disadvantages

Transaction costs should The contracts cannot be

be lower than other tailored to the user's exact
hedging methods. requirements.

Futures are tradeable and can Hedge inefficiencies are

be bought and sold on a caused by having to deal in a
secondary market so there is large number of foreign
pricing transparency. contracts and by basis risk.

The exact date of receipt or

Only a limited number of
payment of the currency does
currencies are the subject of
not have to be known 
futures contracts.
more flexible.

They do not allow a company

to take advantage of favorable
currency movements.
 588

V. Foreign currency derivatives

2. Currency option

A currency option is a right of an option holder to buy (call) or sell (put) a quantity of one
currency in exchange for another, at a specific exchange rate on or before a future expiry date.

• If a buyer exercises the option, the option seller must sell or buy at this rate.
• If an option is not exercised, it lapses at the expiry date.

Note:
• Options are similar to forwards but with one key difference: they give the right but not the
obligation to buy or sell currency at some point in the future at a predetermined rate.

• Owner can let it lapse if:

o the spot rate is more favourable
othere is no longer a need to exchange currency.
 589

V. Foreign currency derivatives

2. Currency option

Options are most useful when there is uncertainty about the timing of the transaction or when
exchange rates are very volatile. Because of the flexibility offered by currency options – the
holder can exercise the option at any point or choose to sell the option – it allows the holder to
enjoy the upside without a risk of adverse exchange rate fluctuation.

A tailor-made currency option A standard option

Be issued from a bank, suited to the Be in certain currencies only, from an options
company's specific needs. These are over the exchange. Such options are traded or
counter (OTC) or negotiated options exchange-traded options.
 590

V. Foreign currency derivatives

2. Currency option

Example 16: Currency option

Method: currency options will be exercised by the option holder only if the exercise rate in
the option is more favorable than the spot rate at the exercise date for the option.

A company may buy a currency call option, giving it the right to buy US$6,000,000 in 2
months' time in exchange for sterling at an exercise rate of $1.50. Buying the dollars at
this rate would cost £4,000,000.
(a) If the spot exchange rate at the exercise (b) If the spot exchange rate at the exercise
date is $1.60: date is $1.40,
OPTION NO OPTION OPTION NO OPTION

Spot rate is Spot rate is Spot rate is Spot rate is

$1.5 per £1 $1.6 per £1 $1.5 per £1 $1.4 per £1

Amount would Amount would Amount would Amount would

be paid be paid be paid be paid
£4,000,000 > £3,750,000 £4,000,000 < £4,285,714
(6,000,000/1.5) (6,000,000/1.6) (6,000,000/1.5) (6,000,000/1.4)

Let the option Choose Exercise option Ignore

lapse fluctuation
591

V. Foreign currency derivatives

2. Currency option

Advantages Disadvantages

It is extremely useful
where there is uncertainty
They have a cost (the 'option
about foreign currency
premium');
receipts or payments,
either in timing or amount;

To support the tender for an

overseas contract by a Options must be paid for as
company, priced in a foreign soon as they are bought;
currency;

To allow the publication of Tailor-made options (arranged

price lists for its goods in a over the counter with a bank)
foreign currency lack negotiability;

Traded options are not

available in every currency.
 592

V. Foreign currency derivatives

3. Currency swap

A currency swap is an agreement in which two parties exchange the principal amount of a loan
and the interest in one currency for the principal and interest in another currency.

1. The equivalent principal 3. The principal amounts are swapped

amounts are exchanged at back at either the prevailing spot rate, or a
the spot rate pre-agreed rate

Inception of The end of

the swap the swap
2. Each party pays the
interest on the swapped
principal loan amount
 593

V. Foreign currency derivatives

3. Currency swap

Restructuring the currency base of the company’s liabilities

Currency swaps are used to obtain foreign currency loans at a better interest rate than a
company could obtain by borrowing directly in a foreign market or as a method of hedging
transaction risk on foreign currency loans which it has already taken out.

 This may be important where the company is trading overseas and receiving revenues in
foreign currencies, but its borrowings are denominated in the currency of its home country.
 594

V. Foreign currency derivatives

3. Currency swap

Example 17: Currency swap

Company A is a US-based company that is planning to expand its operations in Europe.

Company A requires €850,000 to finance its European expansion.

On the other hand, Company B is a German company that operates in the United States.
Company B wants to acquire a company in the United States to diversify its business. The
acquisition deal requires US$1 million in financing.

Neither Company A nor Company B holds enough cash to finance their respective projects.
Thus, both companies will seek to obtain the necessary funds through debt financing.
Company A and Company B will prefer to borrow in their domestic currencies (that can be
borrowed at a lower interest rate) and then enter into the currency swap agreement with
each other.

The currency swap between Company A and Company B can be designed in the following
manner.

Company A Company B
Company A obtains a credit line of $1 At the same time, Company B borrows
million from US Bank with a fixed interest €850,000 from UK Bank with the floating
rate of 3.5%. interest rate of 6-month LIBOR.
The companies decide to create a swap agreement with each other.
595

V. Foreign currency derivatives

3. Currency swap

Example 17: $1 million + interest

payment (€)
COMPANY A COMPANY B
€850,000 +
interest payment

€850,000
payment
$1 million

Interest
payment
Interest

($)

(€)
($)

US Bank EURO Bank

After Swap

COMPANY A COMPANY B

€850,000 + interest $1 million + interest

payment ($) payment (€)

US Bank EURO Bank

 596

V. Foreign currency derivatives

3. Currency swap

Example 17:

According to the agreement, Company A and Company B must exchange the principal
amounts ($1 million and €850,000) at the beginning of the transaction. In addition, the
parties must exchange the interest payments semi-annually.

Company A must pay Company B the floating rate interest payments denominated in
euros, while Company B will pay Company A the fixed interest rate payments in US dollars.
On the maturity date, the companies will exchange back the principal amounts at the same
rate ($1 = €0.85).
597

CHAPTER 18:
INTEREST RATE RISK
 598

Chapter 18: Interest rate risk

Overview graph

Interest rate management

The cause of
Introduction of Interest rate risk
interest rate
interest risk management
fluctuation

Structure Yield
Forward Interest
Interest Basis of curve of Other
rate rate
rate risk interest interest techniques
agreements derivatives
rate rate

Future

Option

Collar

Swap
 599

I. Introduction of interest rate risk

1. Definitions and terminologies

Interest rates are effectively the 'prices' governing lending and borrowing

Interest rate risk is faced by companies with risk arising from changes in interest rates, lack of
certainty about the amounts or timings of cash payments and receipts

London Interbank Offered Rate (LIBOR) is the rate of interest applying to wholesale money
market lending between London banks.

There are mainly 2 types of interest rates:

Floating interest rate Fixed interest rate

is an interest rate that rise or fall is an unchanging rate charged on a

in line with changes in a liability, such as a loan or mortgage
Definition
benchmark interest rate (such as
the bank's base rate or LIBOR)

If interest rates rise, more In case the interest rate of a

interest will be payable on loans company's liability is fixed but market
and other liabilities, but this will interest rates fall sharply, the
be compensated for by higher company will suffer from a loss of
Risk
interest received on assets, such competitive advantage compared
as money market deposits. with companies using floating rate
borrowing whose interest costs and
cost of capital will fall.
 600

I. Introduction of interest rate risk

2. Interest rate risk

Interest rate risk is fluctuations in interest rate impacting on the organization’s profitability

Borrowings: higher interest rates will Investments: lower interest rates will
increase financing costs reduce the return on cash investments
 601

I. Introduction of interest rate risk

2. Interest rate risk

2.1 Gap Exposure

The degree to which a firm is exposed to interest rate risk can be identified through gap
analysis. This uses the principle of grouping together assets and liabilities that are affected by
interest rate changes according to their maturity dates. Two different types of gap may occur:

Gap exposure

A negative gap A positive gap

Interest-sensitive > Interest-sensitive Interest-sensitive < Interest-sensitive

liabilities assets liabilities assets

Maturing at a same certain time. Maturing at a same certain time.

This results in a net exposure if interest The firm will lose out if interest rates fall by
rates rise by the time of maturity maturity.
 602

I. Introduction of interest rate risk

2. Interest rate risk

2.2 Basis risk

Basis risk is that the gain or loss on the futures contracts may not exactly offset the cash effect
of the change in interest rates.

It may appear that a company which has size-matched assets and liabilities, and is both
receiving and paying interest, may not have any interest rate exposure. However, the two
floating rates may not be determined using the same basis or benchmark.

Example 1:

One loan may be linked to one-month

Maturity
LIBOR and the other to six-month LIBOR.
 Different interest rate
Interest One might be linked to the central bank
base base rate, and the other to LIBOR

Note:
• Basis risk is caused by different basis or benchmark
• Gap exposure is caused by the variable rate which is revised at different points in time
 603

II. The cause of interest rate fluctuation

1. Structure of interest rate

The term structure of interest rates refers to the way in which the yield (return) of a debt
security or bond varies according to the term of the security, i.e. to the length of time before
the borrowing will be repaid.

Risk
Higher risk borrowers must pay higher rates
on their borrowing, to compensate lenders
for the greater risk involved.

The need to make a

The duration profit on re-lending
Long duration, Financial intermediaries
higher interest rate make their profits from
(conventionally) re-lending at a higher
Structure of rate of interest than the
interest rate cost of their borrowing.

Different types of The size

financial asset A large deposit may
Different types of attract higher rates of
financial asset attract interest than smaller
different rates of deposits.
interest.
 604

II. The cause of interest rate fluctuation

2. Yield curve of interest rate

2.1 Yield curve shapes

The interest rate for different maturities of a debt security can be shown graphically in a yield
curve. On the other way, the yield curve is an analysis of the relationship between the yields
on debt (rate of interest) with different periods to maturity.

A yield curve can have any shape, and can fluctuate up and down for different maturities. There
are three main types of yield curve shapes:

Yield curve shapes

Normal yield curve Inverted yield curve Flat yield curve

Longer maturity bonds The shorter-term yields are The shorter- and longer-
have a higher yield higher than the longer- term yields are very close
compared with shorter- term yields, which can be a to each other
term bonds due to the sign of upcoming recession
risks associated with term
of maturity
 605

II. The cause of interest rate fluctuation

2. Yield curve of interest rate

2.1 Yield curve shapes

Rate of
interest
Normal yield curve
(%)

Flat yield curve

Inverted yield curve

0 Term of maturity (year)

The slope of the yield curve is also seen as important: the greater the slope, the greater the gap
between short- and long-term rates. Yield curves are usually drawn for ‘benchmark’
investments that are either risk free or low risk.
 606

II. The cause of interest rate fluctuation

2. Yield curve of interest rate

2.2 Factors affecting the shape of the yield curve

The shape of the yield curve at any point in time is the result of the three following theories
acting together:

Liquidity preference theory

Expectations theory

Market segmentation theory

2.2.1. Liquidity preference theory

Investors have a natural preference for holding cash rather than other investments, even low-
risk ones such as government securities. They also prefer having cash sooner to having cash
later.
Therefore, they want compensation in the form of a higher return for being unable to use their
cash now.
 The interest rates in long-term loan (deposit) will higher than short-term, it explains that the
normal shape of the curve as being upwards sloping.
 607

II. The cause of interest rate fluctuation

2. Yield curve of interest rate

2.2 Factors affecting the shape of the yield curve

2.2.2. Expectations theory

Expectations theory states that the shape of the yield curve varies according to investors'
expectations of future interest rates.

interest rates are expected Short-term rate < long-term The yield curve
to rise in the future rate upward sloping

interest rates are expected Short-term rate > long-term The yield curve
to fall in the future rate downward sloping

 The shape of the yield curve gives an indication about how interest rates are expected to
move in the future and vice versa.
 608

II. The cause of interest rate fluctuation

2. Yield curve of interest rate

2.2 Factors affecting the shape of the yield curve

2.2.3. Market segmentation theory

The market segmentation theory suggests that

there are different players in the short-term
end of the market and the long-term end of the
market. The slope of the yield curve will reflect
conditions in different segments of the market

Market
segmentation
theory

This theory describes that the major investors

are confined to a particular segment of the
market and will not switch segment even if the
forecast of likely future interest rates changes.
 609

II. The cause of interest rate fluctuation

2. Yield curve of interest rate

2.2 Factors affecting the shape of the yield curve

2.2.3. Market segmentation theory

As a result of this theory, the two ends of the curve may have different shapes, as they are
influenced independently by different factors:

Investors are assumed to be

risk adverse and to invest in
segments of the market that
match their liability
commitments.

The supply and demand

forces in various segments of
the market in part influence
the shape of the yield curve.
 610

II. The cause of interest rate fluctuation

3. The significance of the yield curve

Expectations of future interest rate movements are monitored closely by the financial markets,
and are important for any organisation that intends to borrow heavily or invest heavily in
interest-bearing instruments.

Use a ‘forward yield curve’ to predict future interest

rates

Significance of yield
curve

Support to decide on the term of borrowings or

deposits
 611

II. The cause of interest rate fluctuation

4. Potential factors impact on level of interest rate

Interest rates on any one type of financial asset will vary over time. The general level of
interest rates is affected by several factors:

Inflation
Need for a real return
Nominal rates of interest
Investors normally want to
should be sufficient to cover
earn a 'real' rate of return
expected rates of inflation over
on their investment.
the term of the investment and
to provide a real return.

Monetary policy Uncertainty about

control the rate of future rates of inflation
inflation through Investors are likely to
Potential factors require higher interest
management of
short-term interest yields to persuade them
rates. to take the risk of
investing.

Balance of payments Liquidity preference of investors

interest rates may have to and the demand for borrowing
be raised to attract capital Higher interest rates have to be
into the country offered to persuade savers to
invest their surplus money. When
the demand to borrow interest
rates will rise
 612

III. Interest rate risk management

Overview

Risk management describes the policies which a firm may adopt and the techniques it may use
to manage the interest rate risks it faces.

Interest rate risks

Internal hedging External hedging instruments

Asset and Interest rate

Matching and Forward rate
liability derivatives
smoothing agreements
management (section IV)
 613

III. Interest rate risk management

1. Asset and liability management

Asset and liability management method relates to the periods or durations for which loans
(liabilities) and deposits (assets) last.

Asset and liability management aims to achieve similar durations for payments and earnings
because the fixed interest rates for payments or earnings may have different maturity time
scales.

Example 2:

Asset and liability management

A company borrows using a ten-year mortgage on a new property at a fixed rate of 6% per
year. The property is then let for five years at a rent that yields 8% per year. All is well for
five years but then a new rent has to be arranged. If rental yields have fallen to 4% per
year, the company will start to lose money.
 614

III. Interest rate risk management

1. Asset and liability management

Example 2:

Borrowing
Fixed rate of 6% per year

0 5 10

Matching period Unmatched period

(yield < interest rate)

0 Gain from renting 5 Gain from renting 10

yield rate of 8% per year yield rate of 4% per year

Lose money

 In general, a safer option would have been to match the loan period to the rental
period. Therefore, it would have been wiser to match the loan period to the rent period so
that the company could benefit from lower interest rates (convert from 6% per year for
ten-year mortgage to 4% per year for 5 years mortgage)
615

III. Interest rate risk management

1. Asset and liability management

Example 2:

Borrowing
0 Fixed rate of 4% per year 5 10

Matching period

0 Gain from renting 5 10

yield rate of 8% per year
 616

III. Interest rate risk management

2. Matching and smoothing

Matching is where liabilities and assets with a common interest rate are matched. This involves
creating assets that are based on the same interest rates (e.g. LIBOR) as their liabilities.

Smoothing is where a company keeps a balance between its fixed rate and floating rate
borrowing. Some loans or deposits have fixed rates of interest and some have variable rates.

2.1 Matching (Cash flow matching)

By using matching method, borrowing and depositing must have the same kind of interest rate
(floating or fixed rate), so the interest rates on the assets and liabilities are matched.

Group

Company A Company B

Deposit Borrow
Matching kind
of interest rate

Method: Every future cash inflow is balanced with an offsetting cash outflow on the same date
and vice versa.
 617

III. Interest rate risk management

2. Matching and smoothing

2.1 Matching (Cash flow matching)

Example 3:

Cash flow matching

Scenario 1: Subsidiary A of a company might be investing $500,000 in the money markets

at LIBOR + 1% and subsidiary B is borrowing $520,000 through the same market at LIBOR +
4%. Assume that LIBOR is currently 3%.
If LIBOR increases to 5%, subsidiary A's borrowing cost increases and subsidiary B's returns
increase, it may result in interest rate being matched between interest expense and
return.
Group

CompanyAA
Subsidiary Company
SubsidiaryB B

Deposit (6 months) Borrow (6 months)

Interest rate: LIBOR + 1% Interest rate: LIBOR + 4%

Matching
 618

III. Interest rate risk management

2. Matching and smoothing

2.1 Matching (Cash flow matching)

Example 3:

Currently:

Subsidiary A Subsidiary B Group

Annual interest received Annual interest paid

Net cost
$20,000 $(36,400)
$(16,400)
(= $500,000 x (3 + 1)%) (= $520,000 x (3 + 4)%)

Now assume that LIBOR rises by 2% to 5%.

Annual interest received Annual interest paid

Net cost
$30,000 $(46,800)
$(16,800)
(= $500,000 x (5 + 1)%) (= $520,000 x (5 + 4)%)

The increase in interest paid has been almost exactly offset by the increase in interest
received. The extra $400 ($20,000 x 2%) relates to the mismatch of the borrowing and
deposit of $20,000 x increase in LIBOR of 2%.

Scenario 2: While subsidiary B is borrowing $520,000 through the same market at LIBOR +
4%, Subsidiary A of a company might be investing $500,000 in the money markets at a
fixed rate of 4%.
If LIBOR increases to 5%, subsidiary A's borrowing cost increases but subsidiary B's returns
remain unchanged, which may result in the company having to face with increase in
interest expense because of the change in LIBOR.
 619

III. Interest rate risk management

2. Matching and smoothing

2.1 Matching (Cash flow matching)

Example 3:

Currently:

Subsidiary A Subsidiary B Group

Annual interest received Annual interest paid

Net cost
$20,000 $(36,400)
$(16,400)
(= $500,000 x 4%) (= $520,000 x (3 + 4)%)

Now assume that LIBOR rises by 2% to 5%.

Annual interest received Annual interest paid

Net cost
$20,000 $(46,800)
$(26,800)
(= $500,000 x 4%) (= $520,000 x (5 + 4)/100)

The increase in interest paid makes an increase in interest expense because the interest
received is fixed while interest paid increase. An extra expense occurred is $10,400
 620

III. Interest rate risk management

2. Matching and smoothing

2.2 Smoothing

This involves using a prudent mix of fixed and floating rate finance to mitigate the impact of
interest rate changes. A rise in interest rates will make the variable rate loan more expensive
but this will be compensated for by the less expensive fixed rate loan.

Interest
rate (%) Floating
rate
Average rate
after Smoothing

Fixed rate

0 Time

In this simple approach to interest rate risk management the loans or deposits are simply
divided so that some are fixed rate and some are variable rate.
 621

III. Interest rate risk management

2. Matching and smoothing

2.2 Smoothing

Floating rate

Reduce the fluctuation of

High fluctuation
Smoothing interest rate.

High proportion of Fixed rate

loan, low interest rate
Fixed rate
fluctuation.

No Fluctuation

Deficiencies: It will not allow the business to benefit from interest rates decreases.
 622

III. Interest rate risk management

3. Forward rate agreements

Forward rate agreement (FRA) is a contract with a bank covering a specific amount of money
to be borrowed over a specific time period in the future at an interest rate agreed now.

A forward rate agreement (FRA) for interest rates is similar in many respects to a forward
exchange contract for currencies:

FRAs are arranged with a bank as an over-the-counter transaction.

An FRA is a binding contract that fixes an interest rate for short-term lending/investing
or short-term borrowing, for an interest rate period that begins at a future date.

A company can enter an FRA with a bank that fixes the rate of interest for short-term
borrowing for a certain time in the future.

What if:
The actual The actual
The rate in the The rate in the
interest rate at > FRA
interest rate at < FRA
that date that date
 The bank supplying the FRA pays the  The company pays the bank supplying
company the difference. the FRA the difference.
 623

III. Interest rate risk management

3. Forward rate agreements

Note:
• The FRA does not need to be arrange with the exact bank offering loan, as the FRA is a
hedging method independent of any loan agreement. This allows a company to take out
the loan in future at the best rate available.
• Student must distinguish the differences between Forward rate agreements (FRA) and
Forward exchange contract (FEC), while FRA is applied to hedge interest rate risk, FEC is
used to hedge exchange rate risk.

Advantages Disadvantages

Simple: Easy to organize Fixed date: The forward

for the exact amount of contract must be exercised on
money required and the a specific date, and the bank
exact timing of the that has provided the forward
transaction contract can enforce this

Low or zero up-front costs: Unattractive rate: The fixed

Unlike interest rate options rate that is offered may not be
attractive

Counter-party risk: The

Fix the interest rate: This
agreement is between two
protects the borrower from
parties, there is a risk of
higher interest rates in future
default on either side
 624

III. Interest rate risk management

3. Forward rate agreements
Quotation of FRAs:

Start and
end month

$5m 3–9 FRA at 5.75 – 5.70%

Base rate
Size of loan
guaranteed

• Base rate guaranteed ‘5.75 - 5.70%’ means that you can fix a borrowing rate at 5.75% (and
a deposit rate at 5.70%). The interest rate in the FRA will be compared with a reference
rate or benchmark rate of interest

• Start and end month '3 – 9' FRA is an agreement that fixes an interest rate for a period
starting in 3 months' time, and lasting for six months to the end of month 9.
 625

III. Interest rate risk management

3. Forward rate agreements

Example 4:

Forward rate agreements

Lynn plc is a UK listed company. It is 30 June, Lynn determines that it will need a £10m six-
month fixed rate loan from 1 October. Lynn wants to hedge its exposure to the risk of a
rise in the six-month interest rate between 30 June - 1 October, using an FRA.
The relevant FRA rate is 6% on 30 June and the reference rate for the FRA is the six-month
LIBOR rate which currently is 6.25%.

Required: What is the result of the FRA and the effective loan rate if the spot six-month
LIBOR rate (the benchmark or reference rate for the FRA) is:
(i) 5%
(ii) 9%

Guidance:
Step 1: Determining receipt or payment from FRA
Step 2: Calculating net cost and determining the effective annual interest rate
 626

III. Interest rate risk management

3. Forward rate agreements

Example 4:

Solution
(i) If the six-month LIBOR rate on 1 October is 5%
Step 1: Determining receipt or payment from FRA
Interest paid to bank without FRA: £10m × 5% × 6/12 = 250,000
Interest payment with FRA: £10m × 6% × 6/12 = 300,000
Payment 50,000

Lynn makes a payment for the difference between interest for six months at the FRA rate
of 6% and the spot rate of 5%.

Step 2: Calculating net cost and determining effective annual interest rate
Lynn is able to borrow for 6 months at the LIBOR rate. It will borrow £10m on 1 October
for six months at an interest rate of 5%.
FRA payment (50,000) ( = £10m × (6% - 5%) × 6/12 )
Interest payment on actual loan 5% (250,000) ( = £10m × 5% × 6/12 )
Net cost (300,000)
300,000
Effective interest rate on loan: 10,000,000 = 3% (per 6-months)

 Effective annual interest rate: 6% per year, This is the rate in the FRA.
 627

III. Interest rate risk management

3. Forward rate agreements

Example 4:

(ii) If the six-month LIBOR rate on 1 October is 9%

Step 1: Determining receipt or payment from FRA
Interest paid to bank if no FRA: £10m × 9% × 6/12 = 450,000
Interest payment with FRA: £10m × 6% × 6/12 = 300,000
Receipt 150,000
Lynn takes a receipt for the difference between interest for six months at the FRA rate of
6% and the spot rate of 9%.
Step 2: Calculating net cost and determining effective annual interest rate
Lynn is able to borrow for 6 months at the LIBOR rate. It will borrow £10m on 1 October
for six months at an interest rate of 9%.
FRA receipt 150,000 ( = £10m × (9% - 6%) × 6/12 )
Interest payment on actual loan 9% (450,000) ( = £10m × 9% × 6/12 )
Net cost (300,000)
300,000
The effective interest rate on loan: 10,000,000 = 3% (per 6-months)
 Effective annual interest rate: 6% per year, this is the rate in the FRA.
 628

IV. Interest rate derivatives

Overview

Interest rate
derivatives

Interest rate Interest rate Interest rate Interest rate

future option collars swap
 629

IV. Interest rate derivatives

1. Interest rate future

1.1 Introduction

Interest rate futures: A contract to receive or pay interest on a notional standard quantity of
money at an agreed future date and at a specified interest rate.

Interest rate futures work in much the same way as currency futures. The result of a future is
to:

Lock the company into the effective interest rate

Hedge both adverse and favorable interest rate

movements

Futures can be used to fix the rate on loans and

investments
 630

IV. Interest rate derivatives

1. Interest rate future

1.1 Introduction

The following table summarizes the differences between interest rate futures and forward rate
agreement:

Interest rate futures Forward rate agreement

Standard Bespoke
contracts contracts

Traded on the Traded over the

open market counter

Flexible closeout dates Fixed date of settlement

 631

IV. Interest rate derivatives

1. Interest rate future

1.1 Introduction

Some advantages and disadvantages of interest rate future:

Advantages Disadvantages

Futures are valid for a Interest rate futures are only

period of time. This is more available in large, standard,
flexible than a forward contract sizes

Counterparty risk is lower since A company using futures will

the futures exchange be required to place a deposit
guarantees the transaction to cover potential losses

This hedge is not effective for

basis risk because there is a
risk that futures interest rates
do not move exactly in line
with spot interest rates.
 632

IV. Interest rate derivatives

1. Interest rate future

1.1 Introduction

Types of interest rate futures contract

Contract to buy Contract to sell

With interest rate futures what is With interest rate futures what is
being bought is the entitlement being sold is the promise to make
to interest receipts. interest payments.

A contract to receive interest at a A contract to pay interest at a

fixed rate would be appropriate fixed rate would be appropriate
for an investor; this is called a for a borrower investor; this is
contract to buy. called a contract to sell.
 633

IV. Interest rate derivatives

1. Interest rate future

1.2 How it works?

Futures contracts are of fixed sizes and forgiven durations. They give their owners the right to
earn interest at a given rate, or the obligation to pay interest at a given rate.

Buying a future Selling a future

The obligation to The right to The obligation to The right to pay

deposit money receive interest borrow money interest

The price of futures contracts depends on the prevailing rate of interest and it is crucial to
understand that as interest rates rise, the market price of futures contracts falls and interest
rates fall, the market price of futures contracts grows.
 634

IV. Interest rate derivatives

1. Interest rate future

1.2 How it works?

Explanation: Why interest rates rise, the market price of futures contracts falls?

Futures
Allows borrowers and lenders to pay or receive interest at 5%
contract

The 5% futures contract has become less attractive to

If the market rate of
buy because depositors can earn 6% at the market
interest rises to 6%
rate but only 5% under the futures contract

The price of the

futures contract fall

Note:

In practice, futures price movements do not move perfectly with interest rates so there are
some imperfections in the mechanism. This is known as basis risk.
 635

IV. Interest rate derivatives

1. Interest rate future

1.2 How it works?

Explanation: Why interest rates rise, the market price of futures contracts falls?

Hedging: The approach used with futures to hedge interest rates depends on two parallel
transactions:

1 Borrow/deposit at the market rates

2 parallel
Title
transactions

Buy and sell futures in such a way that any gain that
2 the profit or loss on the futures deals compensates
for the loss or gain on the interest payments.
 636

IV. Interest rate derivatives

1. Interest rate future

1.2 How it works?

Depositing and earning interest Borrowing and paying interest

If interest rates fall, this will reduce If interest rates rise, this will increase
income expense

Hedging Hedging

Futures prices will rise Futures prices will fall

Buy futures contracts now (at the Sell futures contracts now (at the
relatively low price) and sell later (at relatively high price) and buy later (at
the higher price) the lower price)

The gain on futures can be used to The gain on futures can be used to
offset the lower interest earned offset the higher interest paid

Note:
Students are often puzzled by how you can sell something before you have bought it. Simply
remember that you don’t have to deliver the contract when you sell it: it is a contract to be
fulfilled in the future and it can be completed by buying in the future. Of course, if interest
rates fall the loan will cost less, but a loss will be made on the futures contracts.
 637

IV. Interest rate derivatives

2. Interest rate option

2.1 Introduction

Interest rate options: Give the option holder the right to pay or receive interest on an agreed
amount of money, at a specific interest rate on or before a future expiry date.

An interest rate option is a right of an option holder to call (receive) or put (pay) at a pre-
determined rate on a standard notional amount over a fixed period in the future.
• Call option – a right to buy (receive interest)
• Put option – a right to sell (Pay interest)

On the date of expiry of the option, the buyer must decide whether or not to exercise the right.

Note:
• An interest rate option grants the buyer of it the right, but not the obligation, to deal at
an agreed interest rate (also called strike rate) at a future maturity date (the expiry date
for the option).
• Options are taken on interest rate futures contracts and they give the holder the right,
but not the obligation, either to buy the futures or sell the futures at an agreed price at an
agreed date.
 638

IV. Interest rate derivatives

2. Interest rate option

2.1 Introduction

Options are most useful when there is uncertainty about the timing of the transaction or when
Interest rates are very volatile. Because of the flexibility offered by interest rate options – the
holder can exercise the option at any point, or choose to sell the option – it allows the holder to
enjoy the upside without a risk of suffering the downside

2 types of option

A tailor-made interest rate option A standard interest rate option

from a bank, suited to the from an options exchange. Such

company’s specific needs. These options are traded or exchange-
are over the counter (OTC) or traded options.
negotiated options
 639

IV. Interest rate derivatives

2. Interest rate option

2.1 Introduction

Some advantages and disadvantages of interest rate option:

Advantages Disadvantages

Flexible dates (like a Only available in large contract

future) sizes

Allow a company to take Can be expensive due to the

advantage of favorable requirement to pay an up-
movements in interest rates. front premium.

Useful for uncertain

transactions, can be sold if not
needed
 640

IV. Interest rate derivatives

2. Interest rate option

2.2 How it works?

They are also known as interest rate guarantees. Options are like insurance policies: You pay a
premium to take out the protection, this is non-returnable whether or not you make use of the
protection.

Interest rates

Unfavorable direction Unfavorable direction

Call on the insurance Ignore the insurance

Method: interest rate options will be exercised by the option holder only if the exercise rate in
the option is more favorable than the spot rate at the exercise date for the option.
 641

IV. Interest rate derivatives

2. Interest rate option
2.2 How it works?

Example 5:
A company may take an interest-rate put option, giving it the right to sell futures
contracts at today’s price. Suppose that price is 95.
(a) If interest rates rise the futures (b) If interest rates fall the futures
contract price will fall to 93: contract price will increase to 97

The borrower The borrower

The put The put
Buy at 93 < option right
to sell at 95.
Buy at 97 > option right
to sell at 95.

Choose to exercise the option Not exercise the option

The gain on the options is used to

The business will simply benefit
offset the extra interest that must
from the lower interest rate
be paid

Note:
• It is closely similar to a currency put option
• The buyer pays the writer a sum of money called the option premium or just the
“premium.” It represents a fair price of the option, and in a well-functioning market, it
would be the value of the option.
 642

IV. Interest rate derivatives

3. Interest rate collars

An interest rate cap is where an option is used to set a maximum rate (useful for borrowers).

An interest rate floor is where an option is used to set a minimum rate (useful for investors).

An interest rate collar is where options are used to set both a maximum and a minimum range
for the interest paid or earned.
 643

IV. Interest rate derivatives

3. Interest rate collars
How it works?

For a borrower a collar will buy a put option to cap the cost of borrowing and selling a call
option at a lower rate to establish a floor (the borrower will not benefit if interest rates fall
below this level):

• If interest rates rise the borrower is protected by the cap.

• If interest rates fall the borrower will benefit until the interest rate falls to the level of the
floor.
• If interest rates fall below this then the borrower will have to pay compensation to the
purchaser of the call option.
 644

IV. Interest rate derivatives

3. Interest rate collars
How it works?

For an investor a collar will involve buying a call option to establish a floor for the interest rate
and selling a put option at a higher rate to establish a cap (the investor will not benefit if
interest rates rise above this level):

• If interest rates fall the investor is protected by the floor.

• If interest rates rise the investor will benefit until the interest rate rises to the level of the
cap.
• If interest rates rise above this then the investor will have to pay compensation to the
purchaser of the put option.
 645

IV. Interest rate derivatives

3. Interest rate collars

Example 6:
Interest rate collar for borrower
A company wishes to borrow $10m on the 1st of March for three months. The company
can borrow at LIBOR + a fixed margin of 2%. LIBOR is currently 8%.
It is keen to hedge using options, to prevent an increase in LIBOR rate causing the
borrowing rate to rise above the existing level. However, having made initial enquiries, it
has been discouraged by the cost of the option premium.
A member of its treasury team has suggested the use of a collar to reduce the premium
cost of the purchased option.

Market data: Interest rate options

Exercise price CALLS PUTS
March June March June
92.00 0.80 0.77 0.20 0.22
93.00 0.15 0.12 0.60 0.70

Required: Calculate the effective interest rate the company will pay using a collar if:
(a) LIBOR rises to 9.5% and futures prices move to 90.20.
(b) LIBOR falls to 4.5% and futures prices move to 96.10.
 646

IV. Interest rate derivatives

3. Interest rate collars

Example 6:
Solution:
When borrowing money, the standard option strategy is to buy PUT options. To prevent
the interest cost rising above the current level, put options at 92.00 should be used.
Therefore, the collar will involve both buying PUT options and selling CALL options to
reduce the overall premium cost. March options will be used, since they expire sooner
after the transaction date of 1st March.
Therefore, the company should buy March 92.00 put options for a cost of 0.20%, and sell
March 93.00 call options for a cost of 0.15%.
A net premium of 0.2% – 0.15% = 0.05% is paid.
(a) Interest rates exceed the cap so the company will exercise its put option:

Open market interest (9.5% + 2%)

Net premium gain (0.05)%
Closeout the options (*) 1.8%
Effective rate (9.75%)
(*) 1 March put options to pay interest at 92 The price is in fact an
Futures prices move to 90.20 interest rate if it is
Difference 1.8 subtracted from 100

The easiest way of interpreting interest rate futures is to convert them into percentages
 647

IV. Interest rate derivatives

3. Interest rate collars

Example 6:
Solution:
(b) Interest rates exceed the cap so the company will exercise its put option:

Open market interest (4.5% + 2%)

Net premium gain (0.05)%
Closeout the options (*) (3.10)%
Effective rate (9.65%)

(*) 1 March call options to pay interest at 93

Futures prices move to 96.10
Difference (3.10)
 648

IV. Interest rate derivatives

4. Interest rate swap

Interest rate swap: An agreement whereby the parties to the agreement exchange interest
rate commitments.

Interest rate swaps allow companies to exchange interest payments on an agreed notional
amount for an agreed period of time. Swaps may be used to hedge against adverse interest
rate movements or to achieve a desired balanced between fixed and variable rate debt.

Manage interest rate risk

Taking out a loan in a market where they have
a comparative interest rate advantage.
Hedging against adverse interest rate
movements

Swaps

Reduce borrowing costs

Swapping some of its existing variable rate
finance into fixed rate finance a company can
protect itself against interest rate rises; this
may be cheaper than refinancing the original
debt

The most common type of swap involves exchanging fixed interest payments for variable
interest payments on the same notional amount. This is known as a plain vanilla swap.
 649

IV. Interest rate derivatives

4. Interest rate swap

Example 7:

Illustration of a common Swap

Say a company has a $200 million floating loan and the treasurer believes that interest
rates are likely to rise over the next five years. They could enter into a five-year swap with
a counter-party to swap into a fixed rate of interest for the next five years. From year six
onwards, the company will once again pay a floating rate of interest. This may be cheaper
than repaying the floating rate loan early (and incurring early payment charges) and taking
out a new fixed rate loan.