Accounting

Financial management func on
1. Nature and purpose of nancial management

Financial management is the management of ac vi es associated with the ecient acquisi on and use
of short and long-term nancial resources, to ensure the objec ves of the company are achieved.
There are three key decisions in nancial management:
1. Investment this includes investment in projects (long-term) and working capital (short-term).
2. Financing company will decide the best balance of equity and debt.
3. Dividend how much and how frequently dividend will be paid.
Rela onship between nancial management and nancial and management accoun ng
Financial management relies on nancial accoun ng and management accoun ng. For example, the
informa on in nancial statement and other past informa on generated from nancial accoun ng
could assist in future nancial planning. Financial planning is further assisted by management
accoun ng, for example relevant cash ows are iden ed. Also, management accoun ng plays a role
in nancial control, ensuring objec ves are being met or assets being used eciently.
2. Financial objec ves and the rela onship with corporate strategy
Corporate objec ves and strategy
Corporate objec ves are relevant for the organisa on as a whole, rela ng to key factors for business
success (cri cal success factors or CSFs). The primary nancial objec ve of prot making organisa on is
to maximise shareholder wealth, other nancial objec ves include prot maximisa on, earnings per
share (EPS) growth, market share growth etc. Strategy is a course of ac on to achieve an objec ve so
corporate strategy depends on corporate objec ves.
3. Stakeholders and impact on corporate objec ves
Stakeholders and their objec ves
Stakeholders are groups or individuals having a legi mate interest in the ac vi es of an en ty. There
are three types of stakeholders and each having their specic objec ves:
1. Internal stakeholders employees and management.
2. Connected stakeholders shareholders, customers, suppliers and lenders.
3. External stakeholders community, government and pressure groups.
ec ves:
1. Shareholders want to maximise their wealth.
2. Trade payables want to be paid full amount at due date.
3. Management wants to maximise their rewards.
4. Government wants sustained economic growth and high levels of employment.
Conict between stakeholder objec ves and agency theory

Some me conict will arise between stakeholder objec ves, for example shareholders may encourage
management to pursue risky strategies in order to maximise returns (high risk, high return), but nance
providers prefer lower risk policies. Management has to try and balance the interest of dierent
stakeholders.
According to agency theory, directors/managers are agents of the shareholders being tasked to run the
en ty in the best interest of shareholders. However conict may also
the best interests of shareholders, this leads to sub-op mal returns to shareholders. This poten al lost
Agency costs can also be dened as costs
incurred by the principal to monitor the agent.
Measuring achievement of corporate objec ves
Ra o analysis
1. Return on capital employed (ROCE) = prot before interest and tax (PBIT)/(equity + debt) x 100%.
2. Return on equity = prot available to ordinary shareholders/equity x 100%.
3. EPS = prot available to ordinary shareholders/number of shares.
4. Dividend yield = Dividend per share/market price per share x 100% (indicates the return on capital
investment rela ve to price).
5. Dividend cover = EPS/dividend per share (measures the ability to maintain exis ng level of dividend).
6. Price earnings ra o (P/E ra o) = market price per share/EPS (
It is useful to bring forward your knowledge of ra o analysis to this paper (if you studied F5 or F7).
Total shareholder return (TSR)
TSR = (Year-end share price share price at start of the year + dividend per share)/share price at start
of the year x 100% (total return to shareholders through dividend and capital gains).
Ways to encourage the achievement of stakeholder objec ves
Firstly, we have to make sure that goal congruence
probably by managerial reward schemes including performance-related pay, rewarding managers with
shares and share op ons schemes (this enables managers to buy an amount shares at xed price which
i
share prices), these can be given to managers if target is achieved.
Regulatory requirements can also help:
1. Corporate governance (system by which companies are directed and controlled) the elements
include risk management, internal controls, accountability to stakeholders, conduc ng business in an
ethical and eec ve way.
2. Stock exchange lis ng regula ons (rules and regula ons to ensure stock market operates fairly and
eciently).
4. Financial and other objec ves in not-for-prot organisa ons

Not-for-prot organisa ons (NFPOs) are those organisa ons that are not formed primarily to make
prot but probably to serve public interest.
Objec ves of NFPOs
Their objec ves are mainly non-nancial, which may relate to a level of service and dicult to quan fy.
NFPOs have mul ple objec ves which are dicult to dene. Therefore, it is later iden ed that value
for money (VFM) concept is very relevant to them, this means providing a service in a way which is
economical, ecient and eec ve.
VFM as objec ves
NFPOs can take VFM as their objec ves, this means achieving economy, eciency and eec veness,
the 3Es.
1. Economy can be achieved if company is able to obtain appropriate quan ty and quality of inputs at
lowest cost. In other word, comparing inputs with money spent.
2. Eciency can be achieved if company is able to get as much outputs as possible from the inputs. In
other word, comparing outputs with inputs.
3. Eec veness
comparing objec ves with outputs.
Taking a school as an example, let say the objec ve is to increase the overall passing rate, the school is
said to be economical if teachers are trained with lowest possible cost, the school is said to be ecient
if the number of students passing the exam have increased with the trained teachers, the school is said
to be effec ve if there are 95% of students passing the exam which achieved the objec ve to increase
overall passing rate.
We can also say that economy + eciency = eec veness.
Measuring achievement of NFPO objec ves
Other than looking at the VFM, customer sa sfac on, compe ve posi on, market share, resource
u lisa on measures, benchmarking and so on could be useful as indicators of whether the company is
achieving the objec ves.
Financial management environment

1. The economic environment for business
Macroeconomic policy targets
Macroeconomic policy is a government policy aimed to manage the economy by inuencing the
performance and behaviour of the economy as a whole. The main targets include:
1. Full employment.
2. Price stability control ina on.
3. Balance of payments balance between imports and exports.
4. Economic growth improve living standards.
5. Acceptable distribu on of income and wealth.
Components of macroeconomic policy
1. Fiscal policy ac on by government to spend money or collect money in taxes, to inuence the
condi on of the na onal economy. It can be used to manage aggregate demand (eg. raise tax to
reduce demand in the economy, spend more to increase demand in the economy).
2. Monetary policy aim to inuence quan ty of money, price of money (interest rate) and money
supply (total stock of money) in the economy.
3. Exchange rate policy control the value of the currency to change the prices of imports and exports.
Eects of government economic policy
If interest rate rises, demand for money will reduce and ina on will fell
also fell.
If exchange rate rises
strengthen), it increases export prices (higher
revenue) and lower cost of imports (cheaper purchase).
Government interven on in the economy
Government may intervene in the opera on of free market when monopolies, mergers or restric ve
prac ces operate against public interest, when the free market fails to the amount of capital required
etc. Government will intervene through:
1. Compe on policy
the eciency of the economy by s mula ng compe on.
2. Government assistance for business through ocial aid schemes (eg. giving grants, tax incen ves)
or enterprise ini a ves to encourage the forma on of new businesses.
3. Green policies increase produc on costs as companies are required by legisla on to reduce
environmental impact of their business opera ons. Green policies can be seen as leading to fairer
prices in par cular product markets since these prices reect more completely the economic resources
consumed in the produc on of the products oered for sale.
4. Corporate governance regula on.
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2. The nature and role of nancial markets and ins tu ons

Financial intermediaries
Financial intermediaries bring together lenders and borrowers of money, either as broker (an agent
handling a transac on on behalf of others) or as principal (holding money balances of lenders for
lending on to borrowers). Examples of nancial intermediaries are:
(i) Bank.
(ii) Building socie es give loans to borrowers for house purchase.
(iii) Finance houses provide hire purchase service.
(iv) Insurance companies
(v) Pension funds collect contribu ons to invest for pensions.
(vi) Unit trusts raise funds by trading in shares and bonds.
(vii) Investment trust companies similar to unit trusts but trade in larger amount.
Benets of nancial intermedia on are:
(i) Aggrega on bank can aggregate the amount of money from lenders and then lend to borrowers
who need the money, this makes things easier for lenders and borrowers to lend or obtain money.
(ii) Risk reduc on bank should be be er at assessing credit risk.
(iii) Maturity transforma on lenders may want to keep money for liquidity while borrowers may need
loan (long-term borrowing), nancial intermediary can facilitate short-term and long-term needs of
lenders and borrowers, this is called maturity transforma on.
Financial markets
These are the places where those requiring nance (Decit Units) can meet those who are able to
supply nance (Surplus Units). There are two types of nancial markets:
1. Money markets markets for short-term borrowing and lending, in wholesale amount. Money
markets include a primary market and a secondary market. The primary market is used by the central
bank and other approved banks and securi es rms. The central bank uses it to balance shortages and
surpluses of cash.
are:
(i) Deposits deposits of money in nancial intermediaries.
(ii) Bills short-term nancial assets which can be converted into cash at very short no ce, by selling
them in the discount market.
(iii) Commercial paper short-term IOUs issued by large companies which can be held un l maturity or
sold to others. It is issued when company wants to raise short-term money.
(iv) Cer cates of deposits (CDs) xed terms deposit, customer can obtain cash before the term is up
by selling CD in CD market.
(v) Commercial paper market

(vi) Eurocurrency markets eurocurrency deposit is a foreign currency deposit, a deposit of own
deposit of US dollars with a bank
in London. This is an interna onal money market and only suitable for larger companies.
2. Capital markets markets for trading in longer-dated securi es such as shares and bonds. Examples
of capital markets include Stock Exchange (or stock market, for buying and selling of shares) and bond
market (for trading of debt securi es). There is also an interna onal capital market which trades
Eurobond (bond issued in foreign currency) which is also suitable for larger companies only.
Func ons of stock market
In UK, the stock market is known as the London Stock Exchange. There are actually two markets within
this stock exchange. The rst of these is the Ocial List. This is the top er (level) of the market and is
only available for large companies who can meet the strict lis ng requirements. The second er is the
Alterna ve Investment Market (AIM). The lis ng requirements for this market are less strict, hence it is
used by new and smaller companies. There are two main func ons:
1. As primary markets they enable companies to raise new nance by issuing shares or bonds.
2. As secondary markets they enable exis ng investors to sell their investments.
Apart from these two, stock markets have two other important functions:
1. The owners of the company can sell some of their shares to new investors when the company comes
to the stock market for the rst me, eg. just became public company.
2. Company can take over another company by issuing shares to nance the takeover, ie. share
exchange.
Risk/return trade-o
The concept of this is that investors in riskier assets expect to be compensated higher return. The risk
level of dierent securi es can be ranked as follow, rst being least risky:
1. Government bonds.
2. Company bonds/loan note
3. Preference shares rank behind debt in the event of liquida on.
4. Ordinary shares in the event of liquida on, ordinary shareholders are the last to be paid.
Other secondary UK markets include:

(i) Local authority markets provide local authority bonds and bills.
(ii) Inter bank market unsecured loans between banks.
(iii) CDs market
(iv) Inter company market companies with surplus funds lend directly (through a broker) to those
which need to borrow. They do not involve nancial intermedia on and this is called disintermedia on.
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Working capital management

1. The nature, elements and importance of working capital
Working capital is the capital available for conduc ng the day-to-day opera ons of an organisa on.
Net working capital can be calculated as current assets less current liabili es. Company needs working
capital to keep the trading ac vi es on-going. Inventory, receivables, payables and cash are the major
elements of working capital.
Objec ves of working capital management
Working capital management has two main objec ves:
1. To ensure company has sucient liquid resources to con nue in business (minimise risk of
insolvency).
2. To increase protability (maximise return on assets).
These two objec ves o en conict as liquid assets give the lowest returns. For example, holding high
level of cash will improve liquidity posi on but will also harm prots because if the cash was used more
prots could be made.
Role of working capital management
Working capital management aims to balance not having too much or too less working capital.
Working capital management involves:
Controlling the liquidity posi on.
Controlling the working capital elements which are inventory, receivables and payables.
Cash is the most liquid asset, inventory is considered non-cash and so it is least liquid asset.
Receivables fall in the middle of cash and inventory.
2. Management of inventories, accounts receivable, accounts payable and cash
Cash opera ng cycle
Cash opera ng cycle/working capital cycle is the period between the suppliers being paid and the cash
being received from the customers. Working capital cycle in a manufacturing business equals:
The average me that raw materials remain in stock (inventory days)
- period of credit taken from suppliers (payables days)
+ me taken to produce the goods (inventory days)
+ me nished goods remain in stock a er produc on is completed (inventory days)
+ me taken by customers to pay for the goods (receivables days)
In brief, working capital cycle = inventory days + receivables days payable days.
Liquidity ra os
Liquidity ra os may help to indicate whether a company is over-capitalised, with excessive working
capital, or if a business is likely to fail. A business which is trying to do too much too quickly with too
li le long-term capital is overtrading.
1. Current ra o = current assets/current liabili es, ideal is 2:1.
2. Quick or acid test ra o = (current assets inventories)/current liabili es, ideally should be at least
1:1.
3. Average collec on period/receivables days = receivables/credit sales x 365 days, this shows the
days/365 days x credit sales to get receivables.
4. Average payable period/payables days = payables/credit purchases x 365 days, this shows the me
taken for company to pay suppliers. This formula can be changed to payables days/365 days x credit
purchases to get payables.
5. Inventory turnover period (nished goods) = inventory/cost of sales x 365 days.
6. Raw materials days = raw materials inventory/purchases x 365 days.
7. Work-in-progress (WIP) period = (WIP inventory/cost of sales x % of comple on) x 365 days.
8. Inventory turnover ra o = cost of sales/average inventory.
9. Sales revenue/net working capital ra o = sales/(current assets current liabili es), this shows the
level of working capital suppor ng sales and working capital must increase in line with sales to avoid
liquidity problems.
Symptoms of overtrading are increased revenue, increased current/non-current assets, current
liabili es more than current assets, assets nanced by credit and not share capital, reduced current
and quick ra os, inventory and receivables are more than sales.
Managing inventory
Important techniques include economic order quan ty (EOQ) and just-in- me (JIT). It is very useful to
bring forward your knowledge from previous studies.
EOQ is the op mal ordering quan ty for an item of inventory that will minimise costs, at the same me
balancing the need to meet customer demand. Inventory costs include:
(i) Holding costs eg. rental of warehouse, the of stock.
(ii) Ordering costs eg. telephone charges, delivery costs.
(iii) Shortage costs eg. loss of sale
(iv) Purchase costs price of the goods
EOQ or Q =
2cd/h, c = cost of per order for one year, d = annual demand, h = holding cost per unit
of inventory for one year, Q = reorder quan ty. (EOQ formula is given in exam).
Holding cost = Qh/2, ordering cost = cd/Q
Total annual cost = holding cost + ordering cost + purchase cost
Assump ons of EOQ formula are purchase costs are constant, lead me is constant, demand is
constant and no ina on.
When there are bulk discounts from other supplier and you have to decide whether to order based on
EOQ or take the bulk discounts, compare the total annual cost if used EOQ and the total annual cost if
takes the bulk discounts (company may order more to get the discount), the lower costs will be chosen.
Other formulas include:
Reorder level = maximum usage x maximum lead me, measure the inventory level at which
replenishment order should be placed.
Maximum level = reorder level + reorder quan ty (minimum usage x minimum lead me), inventory
level should not exceed this level.
Minimum level/buer inventory = reorder level (average usage x average lead me), inventory level
should not fall under this level.
Average inventory = reorder quan ty/2 + minimum level
Just-in- me (JIT) aims to hold as li le inventory as possible and produc on systems need to be very
ecient to achieve this. Deliveries will be small and frequent rather than in bulk. Company needs to
have a reliable supplier as that supplier will guarantee to deliver raw materials components of
appropriate quality always on me. Unit purchasing prices may be higher as supplier guarantees the
quality and also on me delivery. Workforce must also be exible and mul -skilled in order to minimize
delay and eliminate poor quality produc on. Reduced inventory levels mean that a lower level of
investment in working capital will be required.
Managing receivables
Managing accounts receivable involves many aspects, mainly rela ng to oering credit and collec ng
back the money. Credit control policies are guideline on giving credit, can be set based on before
oering credit (assess creditworthiness, check past record of customers), during credit period (monitor
the receivables) and a er credit period (chase slow payers, aged receivables analysis). The amount of
total credit that a business oers depends on:
(ii) Management responsibility for carrying out the credit control policy.
An important aspect of the credit control policy is to devise suitable payment terms, covering when
and how should payment be made.
Assessing creditworthiness
A credit assessment is a judgement about the creditworthiness of a customer. It provides a basis for a
decision as to whether credit should be granted. If the credit risk (possibility that the debt goes bad) is
high, the customers need to be managed carefully. The methods include:
1. Bank reference banks are cau ous as they owe du es of care to customer and enquirer, therefore
the informa on about customers are limited.
2. Trade reference give name of suppliers that they have good history with.
3. Check the credit ra ngs from the credit ra ng agency.
4. Ra o analysis.
5. Customer visits.
6. Press comments.
Monitoring accounts receivables

Aged receivables analysis and credit u lisa on report can be used to monitor accounts receivable.
Example of aged receivables analysis is as follow:
Customer name
0-30 days
31-60 days
61-90 days
>90 days
Balance
ABC
1000
300
700
0
0
DEF
2000
0
900
200
900
Total
3000
300
1600
200
900
Example of credit u lisa on report is as follow:
Customer name
Limit
U lisa on
%
ABC
300
280
93
DEF
100
50
50
This shows that ABC needs more credit and DEF does not.
The decision to extend credit given to customers will depend on factors such as:
1. Prots from extra sales.
2. Extra length of average debt collec on period.
3. Required rate of return (cost of capital) on the investment in addi onal accounts receivable.
Example: Ice Co currently expects sales of $50000 per month and variable cost of sales is $40000 per
month (all payable in the month of sale). It is es mated that if credit period increased from 30 days to
60 days, sales volume will increase by 20%. If cost of capital is 10% per annum, decide whether to
extend credit period.
Solu on: Remember that when sales volume increases, the variable cost of sales will also increase.
Contribu on per month = 50000 40000 = $10000, new contribu on = 10000 x 1.2 = $12000.
Extra contribu on per month = 12000 10000 = $2000.
Accounts receivable for 60 days credit period (2 month) = $60000 (new sales) x 2 = $120000.
Accounts receivable for 30 days credit period (1 month) = $50000 x 1 = $50000.
Extra receivables = $120000 - $50000 = $70000.
Annual benet from extending credit period = $2000 x 12 months $70000 x 10% = $17000.
Therefore, nancially it is worthwhile to extend the credit period.
Collec ng amounts owing
The benets of ac on to collect debts must be greater than the costs incurred. To encourage
customers to pay on me, make sure that:
Customer is fully aware of the payment terms.
Invoice is correctly drawn up and issued promptly.
Awaren
Queries are resolved quickly.
Monthly statements are issued promptly.
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There should be eciently organised procedures for ensuring that overdue debts and slow payers are
dealt with eec vely, some examples are:
Issuing reminder le ers
Chasing payment by telephone
Charge interest for late se lement
Employ services of debt collec on agency (pay commission)
Send authorized person to visit and request payment
Take legal ac on
Oering early se lement discounts
Early se lement discounts may be oered to reduce average credit periods and investment in
accounts receivable which will also reduce interest costs. To decide whether to oer the discount,
compare cost of discount allowed and benets from reduced accounts receivable.
Example: Fire Co has annual credit sales of $12000000 and three months are allowed for payment. The
company decides to oer 2% discount for payments made within ten days of invoice being sent and to
reduce the me allowed for payment to two months. It is es mated that 50% of customers will take
the discount. Company requires 20% return on investments and assume sales volume remain, decide
whether or not to oer the discount.
Solu on: New accounts receivable = 10/365 x 50% x $12000000 + 2/12 x 50% x $12000000 = $1164384.
Current accounts receivable = 3/12 x $12000000 = $3000000.
Reduc on in accounts receivable = 3000000 1164384 = $1835616.
Benets of the reduced accounts receivable = $1835616 x 20% = $367123.
Cost of discount allowed = $12000000 x 50% x 2% = $120000.
Net benet = 367123 120000 = $247123.
It is therefore nancially benecial to oer the early se lement discount.
The compound annual cost of early se lement discount can be calculated by (100/100 d) ^ (365/t)
1, d = discount, t = me dierence between cash discount date and the credit term.
payment is made within 10 days of the date of invoice, calculate compound annual cost of oering the
early se lement discount.
Solu on: Compound annual cost = (100/98) ^ (365/20) 1 = 44.6%.
Alterna vely, 2/98 is the cost of discount and to convert it to annual percentage:
(1 + 2/98) ^ (365/20) 1 = 44.6%.
Using factoring and invoice discoun ng
Some businesses might have dicul es in nancing amounts owed by customers, they can employ the
service of factoring. Factoring is an arrangement to have debts collected by a factor company which
advances a propor on of the money that it is due to collect.
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An easier way to understand factoring is through steps:

1. Company asks for factoring service from factor.
2. Factor will administer the sales ledger (control the receivables of the company) and give money in
advance to company (about 80%).
3. A er factor received money from receivables, factor will pay back the company an amount which
has been deducted for interest.
There are two types of factoring:
(i) With recourse if debt cannot be collected, factor can claim back the advance from company
(ii) Without recourse if debt cannot be collected, factor cannot claim back the advance from
company.
To determine whether it is nancially viable to use factoring service, compare cost of factoring and cost
of not factoring.
1. The cost of not factoring this means that the costs if company uses own system of managing
receivables. Examples include credit controller salaries, administra on costs and interest charged on
overdra .
2. The cost of factoring examples of costs are interest charged for advance of money, interest
charged for nancing remaining receivables and administra on fees.
Example: Rock Co makes annual credit sales of $1500000. Credit terms are 30 days, average collec on
period has been 45 days with 0.5% of sales resul ng in bad debts, administra on costs are $30000. A
factor would charge annual fee of 2.5% of credit sales and payment period would be 30 days. The
factor would also provide an advance of 80% of invoiced debts at an interest rate of 14%. Interest on
overdra is 13.5
Solu on: Accounts receivable without factoring = 45/365 x 1500000 = $184932.
Accounts receivable with factoring = 30/365 x 1500000 = $123288.
Cost of not factoring
Admin cost = $30000
Interest on overdra = 13.5% x 184932 = $24966
Bad debt = 0.5% x 1500000 = $7500
Total cost = $62466
Cost of factoring (80% nanced by factor and 20% nanced by overdra )
Interest on advance = $123288 x 80% x 14% = $13808
Interest on overdra = $123288 x 20% x 13.5% = $3329
Admin fee = $1500000 x 2.5% = $37500
Total cost = $54637
It is nancially viable for the company to use factoring service as the cost is lower. The net benet of
using factor = $62466 - $54637 = $7829.
Invoice discoun ng is the purchase of trade debts at a discount. Invoice discoun ng enables company
to raise working capital. It is similar to factoring, but invoice discounter does not administer sales
ledger, with this, customers will not know that the company is employing this service.
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13
Managing foreign accounts receivable

Company with foreign accounts receivable or exporters might have problems of larger inventories and
accounts receivable, and an increased risk of bad debts due to the transporta on me and addi onal
paperwork involved in sending goods abroad. There are several ways for exporters to overcome these
problems:
1. Reduce investment in foreign accounts receivable.
2. Reducing the bad debt risk assessing creditworthiness is essen al.
3. Export factoring the func ons of overseas factor are the same as the factor discussed.
4. Documentary credits customer requests the bank of his country to issue le er of credit in favour of
exporter, then the issuing bank will guarantee payment to the beneciary (exporter).
5. Countertrade goods are exchanged for other goods, it is a form of barter.
6. Export credit insurance insurance against the risk of non-payment by foreign customers.
Summary of accounts receivable management
There are four key areas of accounts receivable management told by examiner in the pilot paper:
1. Policy formula on establishing a framework within which management of accounts receivable in
an individual company takes place. The elements to be considered include establishing terms of trade,
such as period of credit oered and early se lement discounts: deciding whether to charge interest on
overdue accounts; determining procedures to be followed when gran ng credit to new customers;
establishing procedures to be followed when accounts become overdue, and so on.
2. Credit analysis assessment of creditworthiness depends on the analysis of informa on rela ng to
the new customer. This informa on is o en generated by a third party and includes bank references,
trade references and credit reference agency reports. The depth of credit analysis depends on the
amount of credit being granted, as well as the possibility of repeat business.
3. Credit control once credit has been granted, it is important to review outstanding accounts on a
regular basis so overdue accounts can be iden ed. This can be done, for example, by an aged
receivables analysis. It is also important to ensure that administra ve procedures are mely and
robust, for example sending out invoices and statements of account, communica ng with customers
by telephone or e-mail, and maintaining account records.
4. Collec on of amount due - Ideally, all customers will se le within the agreed terms of trade. If this
does not happen, a company needs to have in place agreed procedures for dealing with overdue
accounts. These could cover logged telephone calls, personal visits, charging interest on outstanding
amounts, refusing to grant further credit and, as a last resort, legal ac on. With any ac on, poten al
benet should always exceed expected cost.
Managing accounts payable
Eec ve management of payables involves seeking sa sfactory credit terms from suppliers, ge ng
credit extended during periods of cash shortage, and maintaining good rela ons with suppliers.
Using trade credit eec vely

Trade credit is a source of short-term nance because it helps to keep working capital down. It is
usually cheap as suppliers rarely charge interest. However, if the company a empts to make maximum
se lement discount.
Evalua ng the benets of discounts for early se lement and bulk purchase
The percentage compound annual cost of not taking discount can be calculated by (100/100 d) ^
(365/t) 1, ie. same as the one used in accounts receivable. Now an example is taken from June 2011
ques on 4.
Example: ZPS Co places monthly orders with a supplier for 10,000 components that are used in its
manufacturing processes. Annual demand is 120,000 components. The current terms are payment in
full within 90 days, which ZPS Co meets, and the cost per component is $750. The cost of ordering is
$200 per order, while the cost of holding components in inventory is $100 per component per year.
The supplier has offered either a discount of 05% for payment in full within 30 days, or a discount of
36% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of
holding components in inventory would increase to $220 per component per year due to the need for
a larger storage facility.
Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 45% per year,
calculate if ZPS Co will benet nancially by accep ng the oer of early se lement discount or bulk
purchase discount.
Solu on:
Early se lement discount
Since we are given the interest rate, we can calculate the value of discount in % and compare.
Value of the discount expressed in annual percentage = (100/99.5)^(365/60) 1 = 3.1%.
Since the value of the discount is lower than the short-term borrowing rate, it is not nancially
benecial to accept the discount. (Note: Another way is to compare the value of discount in $ and the
cost, that is the increase in nance cost due to reduc on in payables).
Bulk purchase discount
Compare the annual inventory cost of order at 10000 and at 30000 components.
Cost of order at 10000 components
Holding cost = 10000/2 x $1 = $5000
Ordering cost = 120000/10000 x $200 = $2400
Purchase cost = 120000 x $7.50 = $900000
Total cost = $907400
Cost of order at 30000 components
Purchase cost = 120000 x $7.50 x 96.4% = $867600
Holding cost = 30000/2 x $2.2 = $33000
Ordering cost = 120000/30000 x $200 = $800
14
Total cost = $901400

It is nancially benecial for ZPS Co to accept the bulk purchase discount as it saves $6000 (907400
901400) per year.
Managing foreign accounts payable
Foreign accounts payable are subject to exchange rate risk. Deprecia on of a domes c currency will
cause the cost of supplies more expensive. The management of exchange rate risk will be discussed in
last syllabus area.
Managing cash
Reasons of holding cash
Keynes had iden ed three reasons why company should hold the surplus cash rather than inves ng it:
(i) Transac on mo ve hold cash to meet regular commitments.
(ii) Precau onary mo ve hold cash in case of emergency purpose.
(iii) Specula ve mo ve hold cash to wait for good opportunity to invest (eg. when interest rates rise).
Preparing cash ow forecasts
A cash ow forecast is a detailed forecast of cash inows and ou lows. The ming is important, for
example a new delivery vehicle was brought in June and the cost of $8000 is to be paid in August, then
you should record $8000 in August. Remember, we include the item only when cash is receipt or paid.
A good step to prepare cash ow forecast is to set out the pro-forma rst and include amount which
does not or just require easy calcula on, then only do workings and include the rest of the amount.
Example of cash ow forecast format is as follow:
Cash ow forecast for six months ending 31 December 2011
Jul
Aug
Sep Oct
Nov Dec
Receipts
$
$
$
$
$
$
Credit sales
100
100
Payments
Corpora on tax
50
Materials
10
60
Surplus/ (Decit)
40
Balance b/f
10
50
Balance c/f
50
Treasury management
Treasury management in a modern enterprise covers various areas, and in larger business may be a
centralised func on. The role of treasurer includes liquidity management, funding management,
currency management, formula ng corporate nancial objec ves, handling corporate nance and risk
management. Advantages of centralised treasury management are: be er short-term investment
15
opportuni es, improved foreign exchange risk management, able to employ experts (cash is pooled)
and easier to manage cash.
Cash management models
Op mal cash holding levels can be calculated using Baumol model and Miller-Orr model.
Baumol model is based on the idea that deciding on op mum cash balances is similar to deciding on
op mum inventory levels. It is similar to EOQ, it is based on the formula Q =
, Q is cash to be
raised, F is xed cost of obtaining new funds, S is amount of cash to be used, I is interest cost of holding
cash.
Example: Fire Co faces a xed cost of $4000 to obtain new funds. There is a requirement for $24000 of
cash over each period of one year for the foreseeable future. The interest cost of new funds is 12% per
annum, interest rate earned on short-term securi es is 9% per annum. How much nance should Fire
Co raise at a me?
Solu on: Interest cost of holding cash = 12% - 9% = 3%.
Q=
= $80000. Q is like reorder quan ty, so this means to raise $80000 every me.
The limita ons of Baumol cash management model are as follow:

(i) In reality, amounts required over future periods will be dicult to predict with much certainty.
(ii) The model works sa sfactorily for a rm which uses cash at steady rate but not if there are larger
inows and ou lows of cash over me.
(iii) There may be diculty in predic ng future interest rates.
Miller-Orr model is based on the idea that variance of cash ows, transac on costs and interest rates
will aect the return point (normal level of cash balance). Lower limit will be set, then upper limit and
return point depend on lower limit. The following formulas are given in exam:
Return point = Lower limit + (1/3 x spread)
Spread = 3 (3/4 x transac on cost x variance of cash ows/interest rate)^1/3
The upper limit is calculated as lower limit + spread as spread shows the uctua on between lower
limit and upper limit. Note that if standard devia on is given instead of variance, remember to square
it to get variance. This model is applied to manage daily cash.
Example: Ice Co has the following data, formulate a decision rule using Miller-Orr Model:
1. Minimum cash balance is $8000. (This is the lower limit)
2. Variance of daily cash ows is 4000000, equivalent to standard devia on of $2000 per day.
3. Transac on cost for buying and selling securi es is $50. Interest rate is 0.025% per day.
Solu on: Spread = 3 x (3/
Upper limit = Lower limit + $25300 = $8000 + $25300 = $33300.
16
17
The decision rule is if cash balance reaches $33300, buy $16900 (33300 16400) of marketable
securi es (reduce the cash balance to return point). If cash balance falls to $8000, sell $8400
marketable securi es (increase the cash balance to return point).
Short-term investment of surplus funds
Before inves ng surplus funds, key factors to consider are as follow:
(i) Risk the higher the risk, the higher the return. There are two types of risks, systema c risk (risk
that aects the whole market and cannot be diversied away) and unsystema c risk (risks that aects
only specic market, can be reduce by diversica on, means to hold more than one/por olio of
investment).
(ii) Liquidity the ease of conver ng into cash, high liquid low return.
(iii) Maturity the dura on of investment, long maturity high return.
(iv) Return a er considered risk, liquidity and maturity, company is in posi on of considering how
much return they want.
The investment op ons available include:
1. Cer cate of deposit (CD) a cer cate indica ng that a sum of money has been deposited with a
bank and will be repaid at a later date. As CDs can be bought and sold in the CD market any me, they
are liquid type of investment.
2. Treasury bills IOUs issued by government, promising to pay a certain amount to their holder on
maturity.
3. Shares.
4. Deposit in bank or similar nancial ins tu on.
5. Bonds.
3. Determining working capital needs and funding strategies
Working capital requirements
The amount of current assets and current liabili es can be determined by looking at the working
capital cycle components. You can change the formula of receivable, inventory and payable days to
nd the amount.
Example: The annual cost of purchasing direct materials is $450000 and raw materials are in inventory
for three months.
Solu on: Raw material days = raw material/purchases x 365 so raw material = raw material days/365 x
purchases. In this case, raw material in inventory = 3/12 x $450000 = $112500. Of course there will be
other elements such as WIP and nished goods in reality, you will need to calculate the total current
assets then minus current liabili es to get working capital.
2. Fluctua ng current assets vary due to the unpredictability of business ac vity.

Working capital policy
Working capital policies can cover the level of investment in current assets, the way in which current
assets are nanced, and the procedures to follow in managing elements of working capital such as
inventory, trade receivables, cash and trade payables. The twin objec ves of working capital
management are liquidity and protability, and working capital policies support the achievement of
these objec ves.
Working capital nancing
Working capital can be nanced by a mixture of short (riskier but cheaper) and long-term nance
(more expensive but less risk). It depends on the working capital policy adopted by the company which
is set based on the risk a tude:
1. Conserva ve policy holding high levels of working capital. This approach to nancing working
capital will be that all non-current assets and permanent current assets, as well as part of uctua ng
current assets are nanced by long-term nance. This is safer but less protable due to higher interest
rates.
2. Aggressive policy holding low levels of working capital to reduce nance cost and increase
protability. This approach to nancing working capital will be that uctua ng and some of the
permanent current assets are nanced by short-term nance. This increases liquidity risk but cheaper.
3. Moderate policy This is a middle way between the aggressive and conserva ve policy, balancing
between risk and return, and follow matching principle. Long-term nance is matched with noncurrent assets and permanent current assets.
Other factors to consider
1. The industry in which the organisa on operates. This is particularly important for the management
of receivables as it will be dicult to oer a shorter credit than compe tors.
2. Management a tudes to risk will determine the working capital policy.
3. Previous funding decisions. If previous way was proven to be very suitable for the organisa on, then
manager may follow it.
4. Organisa on size. The larger size organisa on will probably require more working capital.
5. Terms of trade. The terms of trade must be comparable with those of compe tors and the level of
receivables will be determined by the credit period oered and the average credit period taken by
customers.
Permanent and uctua ng current assets

1. Permanent current assets are the amount required to meet long-term minimum needs and maintain
normal trading ac vity. For example, inventory and accounts receivable.
18
Investment appraisal
1. The nature of investment decisions and the appraisal process
Firstly, the dis nc on must be made between capital and revenue expenditure. Capital expenditure is
expenditure which results in the acquisi on of non-current assets or an improvement in their earning
capacity. Revenue expenditure is incurred for the purpose of the trade of the business or to maintain
the exis ng earning capacity of non-current assets.
Secondly, we should dieren ate between non-current assets and working capital investment.
Investment in non-current assets involved large amount of money and it takes some me for the
benet to cover the investment cost. Non-current assets will be used on a con nuing basis within the
organisa on.
Investment in working capital involved a smaller amount of money and arises from the need to pay out
money for resources such as raw materials before it can be recovered from sales of the nished
product or service. It is therefore needed to maintain the opera onal trade cycle.
Capital budget
Capital budget is essen ally a non-current asset purchase budget, and it will form part of longer term
plan of a business. Regular and minor non-current asset purchases may be covered by an annual
allowance provided for in the capital budget. Major projects will need to be considered individually and
will need to be fully appraised. Therefore, investment appraisal holds an important role in capital
budge ng.
Stages of capital investment decision-making process
1. Iden fying investment opportuni es Investment opportuni es or proposals could arise from
analysis of strategic choices, analysis of the business environment, research and development, or legal
requirements. The key requirement is that investment proposals should support the achievement of
organisa onal objec ves.
2. Screening investment proposals In the real world, capital markets are imperfect, so it is usual for
companies to be restricted in the amount of nance available for capital investment. Companies
therefore need to choose between compe ng investment proposals and select those with the best
strategic t and the most appropriate use of economic resources.
3. Analysing and evalua ng investment proposals Candidate investment proposals need to be
analysed in depth and evaluated to determine which oer the most a rac ve opportuni es to achieve
organisa onal objec ves, for example to increase shareholder wealth. This is the stage where
investment appraisal plays a key role, indica ng for example which investment proposals has the
highest net present value.
4. Approving investment proposals The most suitable investment proposals are passed to the
relevant level of authority for considera on and approval. Very large proposals may require approval
by the board of directors, while smaller proposals may be approved at divisional level, and so on. Once
approval has been given, implementa on can begin.
19
5. Implemen ng, monitoring and reviewing investments The me required to implement the
investment proposal or project will depend on its size and complexity, and is likely to be several
months. Following implementa on, the investment project must be monitored to ensure that the
expected results are being achieved and the performance is as expected. The whole of the investment
decision-making process should also be reviewed in order to facilitate organisa onal learning and to
improve future investment decisions.
2. Non-discounted cash ow techniques
Relevant cash ows
The skill of iden fying relevant cash ows is essen al in investment appraisal, we only take into
account the relevant cash ows. Relevant cash ows are always future, incremental cash ows.
Variable cost is normally relevant and xed cost (or unavoidable) is normally irrelevant (incremental
xed cost is relevant). Opportunity cost (contribu on loss from not taking another op on) is relevant
but some me it may be dicult to iden fy. The extra or reduced tax is also relevant. Interest will not
be relevant here because it is allowed in discount rate (discount rate discussed later). We will now look
at non-discounted cash ow techniques to investment appraisal, payback method and return on capital
employed (ROCE) are covered.
Payback method
The payback period is the me taken for the ini al investment to be recovered by cash inows ( me
for cash inows = cash ou lows). When there are two projects, project with the least payback period is
favoured.
Example: An investment would costs $10000 and generate cash inows of $3000 per annum, what is
the payback period?
Solu on:
Year
cash ows ($)
accumulated cash ows ($)
0
($10000)
($10000)
1
$3000
($7000)
2
$3000
($4000)
3
$3000
($1000)
4
$3000
$2000
Payback period = 3 years + 1000/3000 x 12 months = 3 years 4 months.
Advantages of payback period are:
(i) It is easy to calculate and understand
(ii) Widely used in prac ce as a rst screening method (fast check).
(iii) Iden fy quick cash genera ng projects.
Disadvantages of payback period are:
(i) Total protability is ignored.
(ii) Time value of money is ignored.
(iii) Does not take into account posi ve cash inows occurring a er the end of the payback period.
20
21
Return on capital employed (ROCE) or accoun ng rate of return (ARR) or ROI

ROCE calculates es mated average annual prots/es mated average investment x 100% to evaluate
an investment. If it exceeds target rate of return, the project will be accepted. When there are two
acceptable projects, the one with highest ROCE will be favoured.
Average prot can be calculated as total prots for x year/x year (eg. Total prots for 5 years/ 5).
Average investment can be calculated as (ini al investment costs + residual value)/2.
Advantages of ROCE are:
(i) A widely understood and used method, it is in percentage as well.
(ii) Use readily available accoun ng data.
(iii) Look at the en re project life.
Disadvantages of ROCE are:
(i) Based on accoun ng prots (accrual concept) rather than cash ows, it included costs like
deprecia on, therefore may not be relevant to the project performance.
(ii) Does not take into account the ming of cash inows and ou lows.
(iii) Ignore me value of money.
3. Discounted cash ows (DCF) techniques, ie. net present value (NPV), internal rate of return (IRR)
Before looking at NPV and IRR, the concept of compounding, discoun ng and me value of money
should be understood.
Compounding
Compounding is a method of conver ng present value to future value by using the formula:
F = P (1 + r) ^ n, F is future value with interest, P is amount invested now (present value), r is rate of
interest in decimal, n is number of years.
Example: The cost of investment is $2000 now at 10%, what would the investment be worth a er 5
years?
Solu on: F = $2000 (1 + 0.10) ^ 5 = $3222.
Discoun ng
Discoun ng is a method of conver ng future cash ows into present value (the value now), therefore
the formula is the reverse of compounding, ie. F/[(1 + r)^n] or F x (1 + r)^(-n) but you can just use the
present value table in exam. The cost of capital (required rate of return by investors) can be used as
the discount factor.
the present value rate to be used to convert this cash ow to present value?
Solu on: Referring to the present value table, it is 0.826, this can be calculated:
(1 + 0.1)^(-2) = 0.826.
If the annual cash ows are constant from year to year, this is called annui es. When this occurs, a
short-cut will be to use annuity factors to convert the future cash ows to present values.
Example:
cost of capital is 10% and a constant annual cash ows of $5000 is expected
to occur from year 2 to year 5, what is the present value of the cash ows?
Solu on: Referring to the annuity table, at annuity factor of 10% period 5, the present value rate is
present value rate for year 2 to year 5 = present value rate of
year 5 present value rate of year 1 = 3.791 0.909 = 2.882. This can also be calculated by adding the
present value rate of year 2 to year 5 from the present value table.
Present value = $5000 x 2.882 = $14410.
In the case of perpetuity, this means that annual cash ows are constant and occur in innite me. The
present value rate is calculated as 1/r.
10% and cash inows are expected to be $20000 per annum
in perpetuity, what is the present value of the cash ows?
Solu on: Present value rate = 1/0.1 = 10. Present value = $20000 x 10 = $200000.
Time value of money
This is an important considera on in decision-making. Most people would prefer $100 today rather
than $100 in 10 years' me. Because $100 will probably buy you less in 10 years' me than it will today.
NPV and IRR recognise this and therefore discount the future cash ows to present value in project
appraisal.
Net present value
NPV method calculates the present value of all cash ows, and sums them to give the NPV. If this is
posi ve, then the project is acceptable. When performing NPV calcula ons, the following approach
should be taken:
1. Iden fy the relevant cash inows and ou lows of the project, not forge ng the ini al investment.
The ming of cash ows is very important. In NPV all cash ows are assumed to occur at year ends only:
(i) If cash ows occur at the beginning of investment project, then include in me 0.
(ii) If cash ows occur during the me period, then include in this me.
(iii) If cash ows occur at the beginning of me period, then include in previous me.
2. Add up the cash inows and ou lows for each year, then discount each of the cash ows to its
present value, using the company's cost of capital.
3. Calculate the net present value of the project by adding all present values for each year.
4. Decide whether or not the project should be accepted (accept if posi ve NPV).
Advantages of NPV are:
(i) Posi ve NPV project will maximise shareholder wealth.
(ii) Takes into account the me value of money.
(iii) Based on cash ows which are less subjec ve than prot.
22
Disadvantages of NPV are:

(i) Can be dicult to iden fy an appropriate discount rate (this depends on cost of capital).
(ii) Cash ows are assumed to occur at year ends only.
(iii) Some managers are unfamiliar with the concept of NPV.
23
3. Both method uses reinvestment assump on (an assump on about the rate of return of the project
when reinvested). NPV assumes that net cash inows generated during the life of the project can be
reinvested in the same project to earn rate of return equals to cost of capital (discount rate). IRR
assumes that net cash inows can be reinvested in the same project to earn rate of return equals to
IRR.
Internal rate of return

IRR tells us the rate at which the NPV of a project is zero. There are four steps to an IRR calcula on:
1. Calculate the project's NPV at cost of capital (required rate of return).
2. If the above NPV is posi ve, choose a higher discount rate and calculate the NPV again. If the above
NPV was nega ve, choose a lower discount rate. This is because you need a posi ve and a nega ve
NPV
3. You must now calculate the IRR by using the following formula:
IRR = A + [(a/a b) x (B A)]
Where A is the lower discount rate and B is the higher rate, a is the NPV at the lower rate and b is the
NPV at the higher rate.
4. The IRR must then be compared to the company's cost of capital (required rate of return). If IRR is
higher than the required rate of return, the project should be accepted. If it is lower than the required
rate of return, the project should be rejected.
rn is
$1000, a er calcula ng NPV at rate of return of 15%, NPV = ($3000). Calculate IRR.
Solu on: IRR = 10 + [(1000/(1000 + 3000) x (15 10)] = 11.25%, it is higher than cost of capital of
company and therefore the project is acceptable.
Discounted payback
The approach will be similar to payback method, we are s ll calcula ng the me where investment
cost will be covered by cash inows, but this me the cash ows will be discounted to present values.
Advantages of discounted payback method
1. Take into account me value of money.
2. Easy to calculate and understand.
3. Identify quick cash generating projects.
4. Payback can be adjusted for risk by discoun ng future cash ows with a risk-adjusted discount rate.
Disadvantages of discounted payback method
1. Require cost of capital to be estimated first.
2. Ignore cash flows beyond discounted payback period.
3. No decision criteria to indicate whether the investment increases company s value, unlike NPV and
IRR, eg. positive NPV means increase value, IRR more than cost of capital means acceptable.
Advantages of IRR are:

(i) Take into account the me value of money.
(ii) Results are expressed as simple percentage, easier to understand.
(iii) Indicates how sensi ve calcula ons are to changes in interest rates.
Disadvantages of IRR are:
(i) May be confused with ROCE.
(ii) Problems occur if there are mutually exclusive projects (discussed below).
(iii) Some managers are not familiar with IRR method.
Superiority of discounted cash ow (DCF) methods over non-DCF methods

It is the obvious point that DCF methods take into account me value of money which makes the
assessment of project more accurate. They also take into account all cash ows of the project, unlike
payback method which only looks at when investment cost is paid back.
Timing of cash ows is taken into account as opposed to ROCE method. In addi on, they use relevant
cash ows in investment appraisal, ROCE used prot which includes non-cash items.
Finally, there are universally accepted methods of calcula ng NPV and IRR, unlike ROCE which people
can have dierent formula and therefore dierent percentage leading to dierent decision. Both NPV
and IRR are widely used in prac ce, payback and ROCE were mostly used for ini al project screening
only (quick look through of how fast to pay back or protability).
Other issues about NPV and IRR

1. Some mes there are mutually exclusive projects where for example NPV is posi ve but IRR is lower
than cost of capital. In this case, we will take NPV as priority and accept the project.
2. An investment project may have mul ple internal rates of return if it has unconven onal cash
ows (ie. the pa ern of cash ows that are not like star ng with ini al cash ou low followed by a
series of cash inows). One solu on is to use the NPV instead of IRR, since the non-conven onal cash
ows are easily accommodated by NPV.
4. Allowing for ina on and taxa on in DCF

Rela onship between interest rates and ina on
This can seen from Fisher formula which is given in exam, (1 + i) = (1 + r)(1 + h), i = nominal or money
rate of interest, r = real rate of interest, h = ina on rate. Real rate of interest is the interest that is
adjusted for ina on while nominal rate of interest covers ina on as well. In this formula, we can see
that if ina on rises, the nominal rate of interest will also rise and this can be taken as the discount
factor to use.
24
25
The rule to decide whether to use real rate or nominal rate in NPV computa on is as follow:
1. If cash ows are expressed in actual number of dollars that will be received or paid on the various
future dates, use nominal rate for discoun ng.
2. If cash ows are expressed in value of dollar at me 0 (ie. current price level), use real rate for
discoun ng.
Example: Ina on rate is 10% a year and company requires a minimum return of 20% on the project.
The cash ows of the project are as follow, calculate NPV.
Time
Cash ows ($)
0
(15000)
1
9000
2
8000
3
7000
Solu on: Using sher formula:
(1 + 0.2) = (1 + r)(1 + 0.1)
1 + r = 1.2/1.1, r = 9.1%
In this ques on, we are given cash ows are various future dates, so use nominal rate.
Time
Cash ows ($)
Discount factor (20%)
Present value ($)
0
(15000)
1
(15000)
1
9000
0.833
7497
2
8000
0.694
5552
3
7000
0.579
4053
NPV
2102
We can also use real rate to discount but we have to convert the future cash ows to value at me 0
rst by discoun ng the future cash ows using the ina on rate as discount factor (as ina on is
related to general price level).
Time
Cash ows ($)
Discount factor (10%)
Cash ows at me 0 price
0
(15000)
1
(15000)
1
9000
0.909
8181
2
8000
0.826
6608
3
7000
0.751
5257
With this informa on available we can now discount the cash ows using real rate.
Time
Cash ows ($)
Discount factor (9.1%)
Present value ($)
0
(15000)
1
(15000)
1
8181
(1.091)^(-1)
7502
2
6608
(1.091)^(-2)
5553
3
5257
(1.091)^(-3)
4047
NPV
2102
You will get the same or nearly same (due to rounding dierence) answer, but in exam you should
know which rate is most suitable to use in the given cash ows.
If the ina on rate of some cash ows is dierent than the general level of ina on, you just need to
inate those cash ows specically for each year and nally discount at nominal rate. Note that you
should not inate those cash ows which are aected by general level of ina on as the nominal rate
has taken into account about it.
Taxa on eects of relevant cash ows
In investment appraisal, tax is o en assumed to be payable one year in arrears (this year tax is paid
next year). You have learnt in taxa on that capital allowance (tax-allowable deprecia on/wri ng down
allowance) can reduce the amount of tax payable, the tax benet of the capital allowance is a relevant
cash ow (not the tax-allowable deprecia on!). This tax savings can be calculated by capital allowance
x tax rate. You also know that when you sell an asset, there is either balancing charge (sale price > tax
wri en down value, this will be taxable prot) or balancing allowance (tax wri en down value > sale
price, this will be tax allowable loss), again the tax eect (eg. taxable prot x tax rate) on the sale of
asset is a relevant cash ow. In the year of disposal, capital allowance cannot be claimed. If you have
some cost savings, this will subject to extra tax payable.
Example: Psychic Co is considering whether or not to purchase an item of machinery cos ng $40000
payable immediately. It would have a life of 4 years, a er which it would be sold for $5000. The
machinery would create annual cost savings of $14000.
The company pays tax one year in arrears at an annual rate of 30% and can claim capital allowance on
a 25% reducing balance basis. A balancing allowance is claimed in the nal year of opera on. The
d the machinery be purchased?
Solu on: You must be careful about the taxa on eects, company pays tax one year in arrears, so for
example year 1 tax is paid at year 2 and therefore tax benet of capital allowance is earned at year 2.
Also note that the annual cost savings will increase tax payable and for example, cost savings in year 1
mean that extra tax is paid in year 2.
Capital allowance
Tax benets
Year
$
Year
$
1
40000 x 0.25
10000
2
10000 x 0.3
3000
2
(40000 10000) x 0.25 7500
3
7500 x 0.3
2250
3
(30000 7500) x 0.25 5625
4
5625 x 0.3
1688
23125
In year 4 (disposal), the reducing balance is $16875 (40000 23125) and the machinery is sold for only
$5000, which mean there is a tax allowable loss of $11875 (16875 5000). The tax benet of this is in
year 5, ie. $11875 x 0.3 = $3563.
The extra tax payable for annual cost savings is 14000 x 0.3 = $4200.
Time
0
1
2
3
4
5
$
$
$
$
$
$
Machine costs
(40000)
5000
Cost savings
14000
14000
14000
14000
Extra tax on cost savings
(4200) (4200) (4200) (4200)
26
Tax benet on capital allowance

3000
2250
A er-tax cash ows
(40000)
14000
12800
12050
Discount factor @ 8%
1.000
0.926
0.857
0.794
Present values
(40000)
12964
10970
9568
The NPV is $5187 so the purchase appears to be worthwhile.
1688
16488
0.735
12119
3563
(637)
0.681
(434)
When taxa on is ignored in DCF calcula ons, the discount factor will reect the pre-tax rate of return
required on capital investments. When tax is included then post-tax required rate of return should be
used. For example, if tax rate is 20% and the pre-tax rate of return is 10%, the post-tax rate of return is
0.1 x 0.8 = 0.08, ie. 8%.
Working capital
This is rela vely simple. Increases in working capital would mean more investment in working capital,
so there will be a cash ou low. Remember, only the changes in working capital investment are cash
ows. Working capital is assumed to be recovered at the end of the project.
Example: A project lasts for 5 years with a $20000 working capital requirement at the end of year 1,
rising to $30000 at the end of year 2. State the eect of this.
Solu on: $20000 cash ou low will be shown in year 1 and $10000 (30000 20000) cash ou low in
year 2. $30000 cash ow will be shown in year 5 (end of project).
5. Adjus ng for risk and uncertainty in investment appraisal
There is a dierence between risk and uncertainty. Risk is refers to the variability of returns and
probabili es can be es mated for the possible outcomes. Uncertainty is where probabilities cannot be
es mated objec vely and will increase as the project life increases. There are a number of techniques
to deal with risk and uncertainty.
Main techniques of adjus ng for risk and uncertainty in investment appraisal
An overview of the techniques is shown here, the applica on of sensi vity analysis and probability
analysis are shown later (examinable on calcula ons).
1. Sensi vity analysis this assesses the sensi vity of project NPV to changes in project variables. It
calculates the rela ve change in a project variable (eg. sales volume) required to make the NPV zero, or
the rela ve change in NPV for a xed change in a project variable. Only one variable is considered at a
me. When the sensi vi es for each variable have been calculated, the key or cri cal variables can be
iden ed. These show where assump ons may need to be checked and where managers could focus
their a en on in order to increase the likelihood that the project will deliver its calculated benets.
However, since sensi vity analysis does not incorporate probabili es, it cannot be described as a way
of incorpora ng risk into investment appraisal, although it is o en described as such.
2. Probability analysis this approach involves assigning probabili es to each outcome of an
investment project, or assigning probabili es to dierent values of project variables. The range of net
present values that can result from an investment project is then calculated, together with the joint
27
probability of each outcome. The net present values and their joint probabili es can be used to
calculate the mean or average NPV (the expected NPV or ENPV) which would arise if the investment
project could be repeated a large number of mes. Other useful informa on that could be provided by
the probability analysis includes the worst outcome and its probability, the probability of a nega ve
NPV, the best outcome and its probability, and the most likely outcome. Managers could then make a
decision on the investment that took account more explicitly of its risk prole.
3. Simula on this will overcome the problems of having large number of possible outcomes. A
simula on model could be constructed by assigning random numbers to each uncertain variable and
the random numbers must match their probabili es. Random numbers would be generated by
computer program and these would be used to assign values to each uncertain variable.
4. Risk-adjusted discount rate the greater the risk, the greater the risk premium required and
therefore, the discount rate should be higher. In theory, capital asset pricing model (CAPM) will be
useful in this case (CAPM discussed in cost of capital area).
5. Adjusted payback - Payback can be adjusted for uncertainty by shortening the payback period. The
logic here is that as uncertainty increases with the life of the investment project, shortening the
payback period for a project that is rela vely risky will require it to pay back sooner, pu ng the focus
on cash ows that are more certain (less risky) because they are nearer in me. Payback can also be
adjusted for risk by discoun ng future cash ows with a risk-adjusted discount rate, i.e. by using the
discounted payback method. The normal payback period target can be applied to the discounted cash
ows, which will have decreased in value due to discoun ng, so that the overall eect is similar to
reducing the payback period with undiscounted cash ows.
Sensi vity analysis
Sensi vity of each variable = NPV/present value of project variable x 100%. The lower the percentage,
the more sensi ve is NPV to that project variable, this means that small changes in that project
variable will inuence NPV significantly (it might be useful to think sensi vity as margin of safety).
Management should pay a en on to this project variable.
Example:
cash ows. Measure the sensi vity (%) of the project to changes in the levels of expected costs and
savings.
Year
Purchase of plant
Running costs
Savings
$
$
$
0
(7000)
1
2000
6000
2
2500
7000
Solu on: Make sure you calculate the present values of each variable.
Year
Discount factor (8%) PV of plant cost PV of RC PV of S PV of net cash ow
$
$
$
$
0
1.000
(7000)
(7000)
1
0.926
(1852)
5556
3704
28
29
0.857
(2143)
(7000)
(3995)
Plant cost sensi vity = 560/7000 x 100% = 8%
Running cost sensi vity = 560/3995 x 100% = 14%
Savings sensi vity = 560/11555 x 100% = 4.8%. (Most sensi ve)
5999
11555
3856
560
Opening balance
$000
(500)
(500)
(500)
If you are required to calculate the sensi vity of cost of capital, you have to es mate one IRR (it is
be er not to use cost of capital as discount factor) and then compare IRR and cost of capital, the
dierences in percentage is the sensi vity.
Example: IRR has been es mated to be 18.52% and cost of capital is 8%. Measure the sensi vity of cost
of capital.
Solu on: Cost of capital sensi vity = (18.52 8)/8 x 100% = 132%. This means that cost of capital can
increase by 132% before NPV becomes nega ve.
Also one more thing to note is that when calcula ng sensi vity of sales volume, NPV should be divided
by present value of contribu on because changes in sales volume will aect sales and also variable
costs, ul mately aec ng contribu on.
Probability analysis
You have learnt that expected value = possible outcome x probability. However in F9 level, joint
probabili es might need to be used when calcula ng year 2 expected cash ows as year 1 cash ows
are aected by probabili es as well. Joint probabili es are calculated by mul plying both probabili es.
The following example is an extract from June 2010 ques on 1 with modica on.
Example: Water Co has prepared the following forecasts of net cash ows for the next two periods,
together with their associated probabili es.
Period 1 cash ow
Probability
Period 2 cash ow
Probability
$000
$000
8000
10%
7000
30%
4000
60%
3000
50%
(2000)
30%
(9000)
20%
Water Co expects to be overdrawn at the start of the period 1 by $500000. Calculate:
(i) Expected value of the period 1 closing balance.
(ii) Expected value of the period 2 closing balance.
(iii) Probability of nega ve cash balance at the end of period 2.
(iv) Probability of exceeding the overdra limit at the end of period 2.
Solu on:
(i) It is good that you show the closing balance for each of the dierent cash ows because this will be
used in (ii) to add with period 2 cash ows.
Cash ow
$000
8000
4000
(2000)
Closing balance
$000
7500
3500
(2500)
Probability
0.1
0.6
0.3
Expected value
$000
750
2100
(750)
2100
Expected value of period 1 closing balance = $2100000.

(ii) Be careful here, for example when the opening balance of period 2 is $7500000, there are three
possible cash ows for it. In this case, joint probabili es must be used to calculate the expected value
of period 2 closing balance.
Opening balance Cash ow Closing balance
Joint probability
Expected value
$000
$000
$000
$000
7500
7000
14500
0.1 x 0.3 = 0.03
435
7500
3000
10500
0.1 x 0.5 = 0.05
525
7500
(9000)
(1500)
0.1 x 0.2 = 0.02
(30)
3500
7000
10500
0.6 x 0.3 = 0.18
1890
3500
3000
6500
0.6 x 0.5 = 0.3
1950
3500
(9000)
(5500)
0.6 x 0.2 = 0.12
(660)
(2500)
7000
4500
0.3 x 0.3 = 0.09
405
(2500)
3000
500
0.3 x 0.5 = 0.15
75
(2500)
(9000)
(11500)
0.3 x 0.2 = 0.06
(690)
3900
The expected value of period 2 closing balance is $3900000.
(iii) With the informa on in (ii), you can solve (iii) and (iv) without any problem. The probability of
nega ve cash balance at the end of period 2 is 0.02 + 0.12 + 0.06 = 20%, ie. Just take those
probabili es that result in nega ve expected value.
(iv) Probability of exceeding the overdra limits (ie. -$500000) = 0.12 + 0.06 = 18%.
6. Specic investment decisions (Lease or buy; asset replacement; capital ra oning)
Leasing
Leasing is a commonly used source of nance. You should know that lessee can use the asset but the
ownership of the asset belongs to lessor. Therefore, lessor can claim capital allowance and lessee can
claim tax deduc on for lease payment. There are three types of leasing:
1. Opera ng lease lessor is responsible for maintaining the asset and it is for shorter term.
2. Finance lease lessee is responsible for maintaining the asset.
3. Sale and leaseback lessee sells the asset and later lease back.
However in F9 we are not concerned with this, this is just for your knowledge. Also, we are normally in
the posi on of lessee who wants to make decision whether to lease or buy.
30
Lease or buy decisions

Lease or buy an asset is actually a nancing decision as the decision whether to have the asset is an
investment decision. When we lease the asset, we can claim tax deduc on on lease payment and if we
buy, we can claim capital allowance as we own the asset. To keep things simple, we should compare
the cash ows of purchasing and leasing to evaluate decision. The cash ows are discounted at an
a er-tax cost of borrowing as tax is included in the cash ows. Remember the cash ows of purchasing
do not include the interest payments on the loan (if any) as cost of capital has dealt with it. However,
do not forget that there are other issues such as liquidity, exibility, alterna ve use of funds etc to
consider before making the decision.
Example: Thunder Co has decided to install a new milling machine (investment decision is made). The
machine costs $20000 and it would have a useful life of ve years with a trade-in value of $4000 at the
end of the 5th year. The company has two choices:
1. Purchase the machine for cash, using bank loan facili es, current rate of interest is 13% before tax.
2. Lease the machine under an agreement which would entail payment of $4800 at the end of each
year for the next ve years.
The rate of tax is 30%. Capital allowance (CA) is given at 100% in year 1 if machine is purchased. Tax is
Solu on: We will use a er-tax cost of borrowing to discount, it is calculated as 13% x 70% = 9%. Now
we should compare the NPV of leasing and borrowing to purchase.
Borrow to purchase:
Year Item
Cash ow Discount factor (9%) Present value
$
$
0
Machine cost
(20000)
1.000
(20000)
5
Trade-in value
4000
0.650
2600
2
Tax savings on CA (20000 x 30%)
6000
0.842
5052
6
Balancing charge (4000 x 30%)
(1200)
0.596
(715)
NPV of purchase
(13063)
Note: Interest payment should not be included as it has been taken into account in the discount factor.
In year 5, the machine is traded for $4000 cash inow, therefore crea ng a balancing charge of $4000,
there is an extra tax payment which is paid in year 6.
Lease
Year Item
Cash ow Discount factor (9%) Present value
$
$
1-5
Lease payment
(4800)
3.890
(18672)
2-6
Tax savings (4800 x 30%)
1440
3.569
5139
NPV of leasing (13533)
Note: There will be tax deduc on given for lease payment and it is saved in the next year in this case.
You should use annuity factor to save me, to get 3.569, use year 6 present value rate at annuity factor
of 9%, ie. 4.486 minus year 1 present value rate, ie. 0.917.
By comparing the NPV, purchasing the machine will be the cheaper op on.
31
The above example is for the lessee, if you are a lessor, lease payment will be your income which is
also taxable. You will buy the asset to lease to the lessee so the cost of asset becomes your cash
ou low but you might be able to claim capital allowance since you are the owner of the asset.
Therefore, if you are the lessor, the evalua on of whether to lease or not depends on the NPV of
leasing to the lessee.
Asset replacement decisions
The decision is to decide how frequently an asset should be replaced with an iden cal asset. The
equivalent annual cost method can be used to calculate an op mum replacement cycle. Equivalent
annual cost is the average cost of owning an asset over its en re life. We have to rst calculate the
present value of cost over one replacement cycle and then convert it to equivalent annual cost by
dividing a suitable present value rate, ie. PV of cost/annuity factor (annuity table is useful).
Example: Megatron Co operates a machine purchased at $25000 which has the following costs and
resale values over its three year life.
Running costs (cash expenses)

Resale value (end of year)
Solu on:
Year Discount factors
0
1
1.000
0.909
0.826
0.751
Year 1
$
7500
15000
Year 2
$
11000
10000
Year 3
$
12500
7500
Replace every year Replace every 2 years

Cash ow
PV
Cash ow
PV
$
$
$
$
(25000) (25000)
(25000) (25000)
(7500)
(6818)
(7500) (6818)
15000
13635
(11000) (9086)
10000
8260
Replace every 3 years

Cash ow
PV
$
$
(25000) (25000)
(7500) (6818)
(11000) (9086)
(12500) (9388)
7500
5633
PV of cost over one

replacement cycle
(18183)
(32644)
(44659)
Replacement every year:
Equivalent annual cost = (18183)/0.909 = $(20003)
Replacement every 2 years:
Equivalent annual cost = (32644)/1.736 = $(18804), note 1.736 = 0.909 + 0.826 or you can get this from
annuity table.
Replacement every 3 years:
Equivalent annual cost = (44659)/2.487 = $(17957)
32
33
From these we can see that the equivalent annual cost of replacement every 3 years is the least and
this would mean that op mum replacement policy is to replace the machine every 3 years.
Single period capital ra oning
Capital ra oning is where a company has a limited amount of money to invest and investments have to
be compared in order to allocate monies most eec vely. Capital ra oning may occur due to internal
factors (so capital ra oning, eg. reluctant to issue addi onal share capital, reluctant to raise
addi onal debt capital, wish only to use retained earnings, reserve capital for projects to be taken in
another period, capital may be needed for other necessary expenditures such as replacement of noncurrent assets) or external factors (hard capital ra oning, eg. depressed stock market, restric ons on
bank lending, issue costs, nancial posi on does not a ract investors).
Protability index (PI)
When capital ra oning occurs in a single period, projects are ranked in terms of PI to determine the
mix of projects. PI can only be applied to divisible projects (possible to undertake a frac on of a
project), if the projects are non-divisible (discussed later) then do not apply PI. PI = NPV/present value
of capital investment. Therefore, this compares the NPV per investment cost of each project and those
with high PI will be ranked rst. However you should exclude the investment cost from NPV, generally
PI of 1.0 is the lowest acceptable index.
Example: There are three projects, A, B and C with investment cost of $20000, $30000 and $40000
respec vely and present value of cash inows of $30000, $35000 and $41000 respec vely. The
company has only $55000 available for investment. The projects are divisible. Evaluate how the
projects are to be undertaken.
Solu on: Firstly we calculate the PI for each of the projects.
PI for A = 30000/20000 = 1.5
PI for B = 35000/30000 = 1.17
PI for C = 41000/40000 = 1.025
The ranking is rst given to A, then B and nally C. A er inves ng for A and B, company s ll has $5000
to invest for C, which is 12.5% of the investment cost. The decision is therefore to invest fully in A and
B and 12.5% of C.
However note that this method ignores the size of the projects, strategic value and the cash ow
pa erns.
Trial and error
For non-divisible projects (impossible to undertake a frac on of a project, eg. building ship), trial and
error would have to be used to test the NPV available from dierent combina ons of projects. For
example, when there are three projects, A, B and C, we will have to calculate the NPV of A + B, A + C
and B + C, the combina on with the highest NPV will be undertaken.
Business nance
1. Sources of and raising short-term nance
The common sources of short-term nance include overdra , short-term loan, trade credit and lease
nance.
Overdra
Overdra s are subject to an agreed limit and must be paid if bank demand for repayment (repayable
on demand). Overdra is commonly used as a support for normal working capital, eg. to increase the
current assets or to reduce other current liabili es. The customers only pay interest when they are
overdrawn (credit balance of bank account).
gearing of the company and is cheap.
Short-term loan
It is drawn in full at the beginning of the loan period and repaid at a specied me or in installments.
Loan is actually more suitable for medium term purpose. Interest must be paid unlike overdra . Once
the loan is agreed, the term of the loan must be adhered to. The advantage of this is that it helps in
be er planning since the amount of interest and repayments is known. But note that it will aect the
gearing calcula on.
Trade credit
This is one of the main sources of short-term nance as it is like an interest-free borrowing. However,
there will be a risk of losing supplier goodwill and also cost of not accep ng early se lement discounts.
Lease nance
Leasing is a good source of nance to acquire an asset through nance lease (long-term nance) or
ren ng an asset for a while through opera ng lease (short-term nance). Company can also sell an
asset to a lessor and lease back (sale and leaseback) to get immediate cash (short or long-term nance).
Types of leases are covered earlier.
2. Sources of and raising, long-term nance
The common sources of long-term nance include equity nance, debt nance and venture capital.
Equity nance
This is raised through the issue of ordinary shares to investors. The ordinary shareholders will then able
to a end company general mee ngs and vote. This means that they have some control of the business.
Debt nance
In simplest meaning, debt nancing means borrowing money on credit with a promise to repay the
amount borrowed, plus interest. It is usually in the form of bonds or debentures. It is useful to
dieren ate equity and debt nance rst before looking at types of debt nance:
34
(i) Cost the cost of equity is higher than the cost of debt. This is because an equity investor takes a
greater risk. If the company goes into liquida on, an equity investor is the last person to be paid any
money. Therefore, an equity investor expects a higher return to reect the risk he is taking. Debt
nance is cheaper as interest payments are tax deduc ble but dividends (for equity nance) are not.
Debt nance also has lower risk.
(ii) Control of the business equity is normally invested into the business through the issue of ordinary
shares. Shareholders will share the ownership of the business and carry vo ng rights. Hence, a
shareholder can par cipate in business decisions. Debt nance avoids the share of control (company
will s ll have full control).
(iii) A signicant dierence between debt and equity is that debt has to be repaid, whereas equity does
not.
(v) Eect on gearing The more debt nance is raised, the higher is the gearing level. The higher equity
nance is raised, the lesser is the gearing level. Gearing = debt/equity or debt/(equity + debt).
Deep discount bonds

These are issued at a price which is at a large discount to the nominal/face value of the loan notes.
They will be redeemable (repaid) at par (or above par) when they eventually mature. This would mean
that investors can get a large capital gain (redemp on value issue price) when redeemed. However,
the interest rate is much lower than other types of bonds.
Zero coupon bonds
These are similar to deep discount bonds. They are issued at large discount to their face value and no
interest is payable. Investors gain from the dierence between redemp on value on maturity and the
issue price. These are also known as zero interest bonds.
Conver ble bonds
These give the holder the right to convert to other securi es (normally ordinary shares) at a predetermined price and me. The smarter investors will determine whether the conversion rights are
a rac ve or not by es ma ng a conversion premium. Conversion premium = current market value
current conversion value.
Example: Leaf Co quoted 10% conver ble bonds at $142 per $100 nominal (this means it has a nominal
value of $100 which we normally assumed). The earliest date for conversion is in four years me, at
the rate of 30 ordinary shares per $100 nominal bond. The share price is currently $4.15. Decide
whether the conversion rights are a rac ve or not.
Solu on: We should rst calculate the conversion value which is 30 x $4.15 = $124.50. This is the value
of the converted shares if conversion is done.
Conversion premium = $142 - $124.50 = $17.50.
This would mean that if the conversion rights have to be a rac ve, the share price would have to rise
by $17.50 or 14% (17.50/124.50).
35
We can also es mate the market value of conver ble bond by discoun ng the future cash ows of it.
Example: Rock Co quoted 10% conver ble bonds with nominal value of $100, interest is payable yearly.
Each $100 of conver ble bonds may be converted into 40 ordinary shares in three years me or
redeemed at $110 per $100 nominal value of bond. Assume the required pre-tax rate of return is 8%
and investors will redeem at maturity, es mate the likely current market price for $100 of the bonds.
Solu on:
Cash ow
Discount factor (8%) Present value
Year
$
$
$
1
Interest (10% x 100)
10
0.926
9.26
2
Interest
10
0.857
8.57
3
Interest
10
0.794
7.94
Redemp on value
110
0.794
87.34
Es mated market value of $100 debt
113.11
Venture capital
Venture capital is risk capital, normally provided in return for an equity stake. Venture capitalists are
prepared to invest in new businesses, small businesses, specic expansion projects or management
buyouts (managers purchase all or parts of a business). They will be less interested in providing the
money required to nance running expenditure and working capital requirements. Also, venture
capitalists will want to involve in running the business because of their need to protect their
investment. Venture capitalists will take into account certain factors in deciding whether or not to
invest:
the selling poten al of products.
(ii) Exper se in produc on technical ability to produce eciently.
(iii) Exper se in management commitment, skills and experience.
(iv) Market and compe on threat from current compe tors and also future new compe tors.
(v) Future prots they will want to see the detailed business plan.
(vi) Board membership they will ensure that they are part of representa ves of the board of directors
and have say in future strategy.
(vii) Exit routes they will consider poten al exit routes in order to realise the investment.
Methods of raising equity nance
To be able to issue shares to the public, company has to go for stock market lis ng which allows
company to access to wider pool of nance and improve marketability of shares. The unquoted
company can obtain a lis ng on stock market through ini al public oer (IPO) or placing.
Ini al public oer
is known as ota on. Subsequent issues are likely to be placing or rights issue (discussed later).
However the costs of share issue include underwri ng cost, stock market lis ng fee, professional fees
and adver sing cost.
36
37
Underwri ng cost is the cost incurred to get an underwriter who will subscribe those shares which are
not taken-up by the public. Therefore, underwriter is a risk taker.
Placing
Placing means arranging for most of an issue to be brought by a small number of ins tu onal investors
and this is cheaper than IPO.
Se ng a share issue price
This will depend on a number of factors such as price of similar quoted companies, current market
condi ons, future trading prospects and whether there is a desire for immediate premium. Company
should avoid over-pricing (to avoid undersubscribed) or under-pricing an issue (avoid oversubscribed).
Rights issues
Rights issue is an oer to exis ng shareholders enabling them to buy more shares, usually at a price
lower than current market price. With this, company does not have to issue to public which is more
costly and can dilute vo ng rights of exis ng shareholders. Rights issue can aect EPS as it aects the
number of ordinary shares.
additional $126000 from a rights issue. Current market price is $1.80 so it is decided that the rights
price is $1.60. Before the rights issue, the capital employed is $300000 (with 200000 ordinary shares of
$1 each). Calculate the dilu on in EPS with the rights issue.
Solu on: Earnings before rights issue = 20% x $300000 = $60000. EPS before rights issue =
60000/200000 x 100 = 30c.
Capital employed a er rights issue = $426000. Therefore, earnings a er rights issue = 20% x 426000 =
$85200.
Number of new shares from rights issue = $126000/$1.60 = 78750.
EPS a er rights issue = $85200/278750 x 100 = 30.6c
Dilu on of EPS = 30.6 30 = 0.6 cents.
For the shareholders to take up the rights issue, they may consider the value of the rights. Theore cal
ex rights price (TERP, market price a er the rights issue in theory) is an important considera on. Value
of rights can be determined by TERP issue price.
Example: Thunder Co decides to make a rights issue of one new share at $1.50 each for every four
shares already held. A er announcement of the use, the share price fell to $1.95, but by the me just
prior to the issue being made, it had recovered to $2 per share (actual cum rights price). Calculate TERP
and discuss whether shareholder would exercise the rights.
Solu on: As TERP is in theory, the calcula on will seem theore cal.
4 shares @ $2
$8.00
1 share @ $1.50
$1.50
5
$9.50
It is es mated that 5 shares are worth $9.50, so TERP = 9.5/5 = $1.90. The value of rights = $1.90 $1.50 = $0.40. This means that shareholder can expect to gain $0.40 for each new share he buys so he
might exercise the rights.
The actual ex rights price (actual market price a er rights issue) may dier from TERP. The market will
take a view of how protable the new funds will be invested and will value the shares accordingly.
1. If new funds are expected to generate earnings at the same rate as exis ng funds, actual ex rights
price will probably be the same as TERP.
2. If new funds are expected to generate earnings at a lower rate, actual ex rights price < TERP.
3. If new funds are expected to generate earnings at higher rate than current funds, actual ex rights
price should rise above the TERP.
1. Do nothing % of ownership will reduce as others subscribe the shares.

2. Sell the rights - % of ownership will reduce.
3. Fully subscribe - % of ownership will be maintained.
4. Any combina on of the above ac ons.
Example: King, an owner of 1000 shares in Queen Co, has been oered rights issue of 1 for 5 with issue
-rights price
(TERP) is determined as $3.90. Value of rights is $0.50 ($3.90 - $3.40). Iden fy the ac ons that King
could take and the eect of these ac ons on the wealth of King.
Solu on: Number of shares from rights issue = 1000/5 = 200.
Value of 1,200 shares after rights issue = 1,200 x 390 = $4680
Value of 1,000 shares before rights issue = 1,000 x 400 = $4000
Value of 1,000 shares after rights issue = 1,000 x 390 = $3900
Cash subscribed for new shares = 200 x 340 = $680
Cash raised from sale of rights = 200 x 0.50 = $100
1. Do nothing
It is obvious that King will lose $100 (4000 3900) in wealth if he ignores the rights issue.
2. Sell the rights
In this case, the wealth of King = $3900 + $100 = $4000. Therefore, part of the wealth has changed
s wealth (original is $4000).
3. Fully subscribe
By subscribing in full,
38
3. Raising short and long-term nance through Islamic nancing

Islamic nance is based on Islamic law, ie. Shariah. The main principles include:
1. Wealth must be generated from legi mate trade and asset-based investment. (The use of money for
the purposes of making money is expressly forbidden.)
2. Investment should also have a social and an ethical benet to wider society beyond pure return.
3. Risk should be shared.
4. All harmful ac vi es (haram) should be avoided. (eg. inves ng in drug business)
Concept of interest (riba)
Charging and receiving interest is prohibited in Islamic nance because it represents the money itself
being used to make money (Not in accordance to rst principle above). Therefore, when Islamic banks
provide nance they must earn their prots by other means. This can be through a prot-share rela ng
to the assets in which the nance is invested, or can be via a fee earned by the bank for services
provided. The essen al feature of Shariah is that when commercial loans are made, the lender must
share in the risk. If this is not so then any amount received over the principal of the loan will be
regarded as interest.
Islamic nancial instruments
1. Murabaha is a form of trade credit/loan for asset acquisi on that avoids the payment of interest.
Instead, the bank buys the item and then sells it on to the customer on a deferred basis at a price that
includes an agreed mark-up for prot. The mark-up is xed in advance and cannot be increased, even if
the client does not take the goods within the me agreed in the contract. Payment can be made by
instalments. The bank is thus exposed to business risk because if its customer does not take the goods,
no increase in the mark-up is allowed and the goods, belonging to the bank, might fall in value.
2. Ijara is a lease nance agreement whereby the bank buys an item for a customer and then leases it
over a specic period at an agreed amount. Ownership of the asset remains with the lessor (bank)
regardless of opera ng or nance transac on, which will seek to recover the capital cost of the
equipment plus a prot margin out of the rentals payable.
3. Mudaraba is essen ally like equity nance in which the bank and the customer share any prots.
The bank will provide the capital, and the borrower, using their exper se and knowledge, will invest
the capital. Prots will be shared according to the nance agreement (no dividends are paid), but as
with equity nance there is no certainty that there will ever be any prots, nor is there certainty that
the capital will ever be recovered. This exposes the bank to considerable investment risk as losses are
solely a ributable to the provider of capital. In prac ce, most Islamic banks use this is as a form of
investment product on the liability side of their statement of nancial posi on, whereby the investor
or customer (as provider of capital) deposits funds with the bank, and it is the bank that acts as an
investment manager (managing the funds).
4. Sukuk (Islamic bonds) is debt nance which cannot bear interest. Typically, an issuer of the Sukuk
would acquire property and the property will generally be leased to tenants to generate income. The
sukuk are issued by the issuer to the Sukuk holders, who thereby acquire a proprietary interest in the
assets of the issuer. The issuer collects the income and distributes it to the Sukuk holders. This en tles
39
to a share of the income generated by the assets. Most Sukuk give Sukuk holders ownership of the
cash ows but not of the assets themselves.
5. Musharaka is a joint venture or investment partnership between two par es. Both par es provide
capital towards the nancing of projects and both par es share the prots in agreed propor ons. This
allows both par es to be rewarded for their supply of capital and managerial skills. Losses would
normally be shared on the basis of the equity originally contributed to the venture. Because both
par es are closely involved with the ongoing project management, banks do not o en use Musharaka
transac ons as they prefer to
4. Internal sources of nance and dividend policy
Internal sources of nance
Internal sources of nance include retained earnings and increasing working capital management
eciency:
1. Retained earnings company can choose to retain the earnings or paid out as dividends. Retained
earnings belong to shareholders and are classed as equity nancing. Retained earnings are a exible
source of nance, enabling directors to invest without asking for approval by nancial providers. There
is no new share issue so no issue cost and no dilu on of control. However, shareholders may be
sensi ve to the loss of dividends and there is an opportunity cost of retaining the earnings (cash can be
invested to earn more rather than keeping them idle). Retained earnings are no doubt, the most
important single source of nance for companies.
2. Increasing working capital management eciency there will be savings that can be generated from
more ecient management of trade receivables, inventory, cash and trade payables.
Rela onship between dividend policy and nancing decision
When deciding how much dividends to be paid out to shareholders, one of the main considera ons is
the amount of earnings to retain to meet nancing needs. A company must restrict its self-nancing
through retained earnings because shareholders should be paid a reasonable dividend.
Factors inuencing dividend policy
Legal constraints
The law on distributable prots could require company to pay dividends solely out of accumulated net
realised prots or restrict the amount of dividends payable.
Protability
A company cannot consistently pay dividends higher than its prot a er tax as a healthy level of
retained earnings is needed to nance the con nuing business needs of the company.
Liquidity
The company must have enough cash to pay the dividends it declares and the desire to hold cash
would mean lower dividend payout.
40
41
Shareholder expecta ons

Shareholders usually expect a consistent dividend policy from the company, with stable dividends each
year or a steady dividend growth. Stable dividends or steady dividend growth are usually needed for
share price stability.
Signaling eect
Dividend declared can be interpreted as a signal from directors to shareholders about the strength of
underlying project cash ows or the future prospects of the company. For example, a cut in dividends
may be treated by shareholders as signaling that the future prospects of the company are weak.
Therefore, companies tend to adopt a stable dividend policy.
Theories of dividend policy
Residual theory
Company should invest any project with posi ve NPV and dividends should be paid only when these
investment opportuni es are exhausted.
Tradi onal view
Shareholders prefer large dividends to smaller dividends because the dividend is sure but future capital
gains are uncertain.
Irrelevancy theory by Modigliani and Miller (MM)
Shareholders are not concerned with the dividend policy since they can sell a por on of their por olio
of equi es if they want cash. This indicates that an issue of dividend should have li le or no impact on
share price, perfect capital market is assumed. MM proposed that in a tax-free world, shareholders are
indierent between dividends and capital gains, and the value of a company is determined solely by
Other basic terms

1. Scrip dividends dividend is paid in the form of new shares rather than by cash.
2. Scrip issue/bonus issue
reserves to share capital.
3. Stock split for example, each ordinary share of $1 each is split into two shares of 50c each. This
creates cheaper shares with greater marketability.
4. Share repurchase company could purchase its own shares when there is surplus cash or to increase
EPS (reduce number of shares). This could also prevent a takeover or enable a quoted company to
withdraw from the stock market.
5. Gearing and capital structure considera ons
Problem of high levels of gearing
Gearing is the amount of debt nance a company uses rela ve to its equity nance. The greater the
level of debt, the more is the nancial risk. Financial risk can be seen from dierent points of view:
1. Company when the debts are too high that company cannot pay back, it will be forced into
2. Lenders lenders will want higher interest yield to compensate the higher nancial risk faced.
3. Ordinary shareholders similar to lenders. They would want a higher expected return from their
shares to compensate for higher nancial risk faced. Market value of shares will therefore depend on
gearing.
In short, gearing increases variability of shareholder earnings and risk of nancial failure.
Ra o analysis
Ra os can be used to assess the impact of sources of nance on nancial posi on and nancial risk.
The relevant ra os include:
1. Financial gearing = long-term debt/capital employed x 100% or market value of long-term
debt/(market value of equity + market value of long-term debt) x 100%. This will indicate the nancial
risk. Long-term debt/equity is also a method to calculate nancial gearing.
2. Opera onal gearing = contribu on/prot before interest and tax (PBIT). This will indicate the
business risk. For example, if contribu on is high but PBIT is low, xed costs will be high so business
risk will be high. Other ways to calculate include xed cost/total cost or xed cost/variable cost.
3. Interest coverage ra o = PBIT/interest. Generally, an interest coverage ra o of less than three mes
is considered low, indica ng that protability is too low given the gearing of the company.
4. Debt ra o = total long-term debts/total assets. This indicates the nancial risk as well.
Note for nancial and business risk
1. Business risk/opera ng risk possibility of changes in level of prot before interest as a result of
changes in turnover or opera ng costs. Business risk relates to the nature of business opera ons.
2. Financial risk/gearing risk possibility of changes in level of distributable earnings as a result of the
need to make interest payments on debt nance or prior charge capital.
Cash ow forecas ng
A change in sources of nance can be taken into account in cash ow forecast. If the change in sources
of nance results in signicant cash decit, then company might need to consider other, more
appropriate source of nance.
Eect of gearing on shareholder wealth
A company will only be able to raise nance if shareholders think the returns they can expect are
sa sfactory in view of the risks they are taking. If a company can generate returns on capital in excess
of the interest payable on debt, nancial gearing will raise the EPS and this aects two ra os:
2. Dividend cover = EPS/dividend per share.

Another important ra o is dividend yield which is dividend per share/market price per share x 100%.
With this, we look at the eect of gearing on market price of shares. The changes in dividend yield
42
required by shareholders (required rate of return) can impact the market price of the shares (discussed
more in business valua on topic).
6. Finance for small and medium sized en es (SMEs)
SMEs can be dened as having three characteris cs:
1. Firms are likely to be unquoted.
2. Owned by s small number of individuals, typically a family group.
3. They are not micro-businesses (very small businesses that exist to employ just owner).
They are always in need of nance to run or expand the business. However, they have some problems
in obtaining nance.
43
5. Business angel nancing business angels are wealthy individuals who invest directly in small
businesses. However the amount of money available from individual angels may be limited. Business
angels generally have prior knowledge of the industry. As business angel nancing occurs in informal
market, it is dicult to arrange with the business angels.
6. Leasing.
7. Factoring.
8. Venture capital venture capitalists are prepared to invest in new businesses and specic expansion
projects. However, venture capitalists will want to involve in running the business because of their
need to protect their investment.
Financing problems of SMEs

SMEs may not know about the sources of nance available or dicult to obtain nance because of the
risks faced. More specic problems are:
1. Funding gap there is a high failure rate so hard to raise external nance and there are few
shareholders so hard to raise internal nance.
2. Maturity gap it is dicult for SMEs to obtain medium-term loans due to mismatching of the
maturity of assets and liabili es. Longer-term loans are easier to obtain than medium-term loans as
longer loans are easily secured with mortgages against property.
3. Inadequate security banks will be unwilling to increase loan funding without an increase in security
given (which the owners may be unwilling or unable to give).
Government aids to ease nancing problems of SMEs
UK government aid includes:
1. Loan guarantee scheme help businesses to get a loan from the bank because bank would be
unwilling to lend as SMEs cannot oer the security that the bank would want.
2. Grants sum of money given to an individual or business for a specic project or purpose. A grant
usually covers only part of the total costs involved.
3. Enterprise capital funds (ECFs) designed to be commercial funds, inves ng a combina on of
private and public money in small high-growth businesses. Each ECF will be able to make equity
investments of up to 2m into eligible SMEs.
Appropriate sources of nance for SMEs
1. Equity
of nance. Since the business will have few tangible assets at this stage, it will be dicult to obtain
equity from elsewhere. The external investors would not like to invest because of the inability of SMEs
to oer an exit route.
2. Overdra nancing interest may be more expensive as bank takes the high risk.
3. Bank loans likely to be available only for projects or assets which are in long-term.
4. Trade credit taking extended credit from suppliers is a source of nance for many SMEs. However
this might cause loss of early se lement discounts and loss of supplier goodwill.
44
45
Cost of capital
1. Sources of nance and their rela ve costs
Now, you should understand that every sources of nance have costs, because by raising capital using
these sources, company is required to return an amount to sa sfy the providers of funds. Therefore,
cost of capital can be interpreted as the required rate of return (%) by the providers of funds.
Remember that cost of capital can be used in investment appraisal.
Cost of equity and debt
We can split cost of capital into cost of equity and cost of debt. Cost of debt is likely to be lower than
the cost of equity because debt is less risky
creditor hierarchy, the rst one will mean
least risky and the last one is the most risky one:
1. Creditors with a xed charge (secured by specic asset such as land).
2. Creditors with a oa ng charge (secured by uctua ng class of assets such as receivables account).
3. Unsecured creditors.
4. Preference shareholders (being paid xed dividend and get paid rst in the event of liquida on
compared to ordinary shareholders).
5. Ordinary shareholders.
The cheapest type of nance is debt and the most expensive type of nance is equity. This determines
the dierences in cost of equity and cost of debt.
2. Es ma ng the cost of equity
There are two ways to es mate cost of equity, dividend valua on/growth model and capital asset
pricing model (CAPM).
Dividend valua on/growth model
Dividend valua on model will be used if future dividend per share is expected to be constant, the cost
of equity is therefore the dividend yield, ie. Dividend per share/market price per share.
However, dividend normally increases year by year, so dividend growth model is needed. With this the
dividend yield formula takes into account the growth rate of the dividend, ie. cost of equity = [dividend
per share x (1 + g)/market price per share] + g, g is the growth rate.
Example: A share has a current market value of 96c, and the last dividend was 12c. If the expected
annual growth rate of dividends is 4%, calculate the cost of equity.
Solu on: Cost of equity = [12 x (1 + 0.04)/96] + 0.04 = 0.17 = 17%.
Example: Dividend in 20X1 is $150000 and dividend in year 5 is $262350, calculate the growth rate.
Solu on: $150000 x (1 + g)^4 = $262350
(1 + g)^4 = 1.749
1 + g = 1.15
Growth rate = 15%. Every year dividend will increase by 15%.
owth model gives a formula g = br where b is the propor on of prots retained and r is the
rate of return on new investments. This formula is given in exam.
Example: Leaf Co retains 65% of its earnings for capital investment projects it has iden ed and these
projects are expected to have an average return of 8%. The current dividend per share is 15c and
the growth rate in dividend.
Solu on: g = 65% x 8 = 5.2%.
Cost of equity = (0.15 x 1.052/1) + 0.052 = 0.2098 = 21%.
Weaknesses of dividend growth model
1. Does not consider risk.
2. The growth rate is only an approxima on, dividend do not grow smoothly in reality.
3. Assume there are no issue costs for new shares.
Capital asset pricing model
This model incorporates risk. It assumes that all investors hold diversied por olios and as a result only
seek compensa on (return) for the systema c/market risk (risk that cannot be diversied away) of an
investment.
and systema c risk is measured through this. If a
share price were to risk or fall at double the market rate, it would have a beta factor of 2.0.
The individual components of CAPM are risk-free rate of return, equity/market risk premium and
equity beta. CAPM is the cost of equity as the sum of risk-free rate of return and a risk premium
reec ng the systema c risk of an individual company rela ve to the systema c risk of the stock
market. This risk
CAPM formula is therefore created as
=
where
is cost of equity, is
the risk-free rate of return, is the equity beta of the individual security (eg. shares),
is the rate
of return on a market por olio. Equity risk premium is therefore represented by
and the
risk premium is represented by
. CAPM formula is given in exam.
Es ma ng growth rate
There are two ways, either through analysis of the growth in dividends over the past few years (trend)
Example: Shares in Fire Co has a beta of 0.9. The expected returns to the market are 10% and the riskfree rate of return is 4%. What is the cost of equity?
Solu on: Cost of equity = 4 + 0.9 (10 4) = 9.4%.
By looking at the trend, we can say that dividend in year 1 x (1 + g)^4 = dividend in year 5, ie. 4 years
growth.
Remember that total risk is divided into systema c and unsystema c risk, beta only measures the
systema c risk.
46
47
Disadvantages of CAPM
1. Unrealis c assump ons.
2. Beta can change over me.
3. Need to determine the equity premium (historical returns are o en used in prac ce).
4. Need to determine the risk-free rate (risk-free investment might be a government security).
Redeemable debt
The debt will be redeemed in the year of redemp on and interest (allowable for tax) plus capital (not
allowable for tax, this is the nominal value of the bond) will be paid to the debt holder. In this case,
internal rate of return (IRR) of the redeemable debt represents the cost of debt. Remember that IRR is
the rate at which NPV of the cash ows will be zero.
Summary of CAPM
Since investors will expect the risk they took to be compensated with more return, CAPM takes this
into account by adding an amount of risk premium to the risk-free rate of return to increase the cost of
equity. It is usually suggested that the CAPM oers a be er es mate of the cost of equity than the
dividend growth model.
Example: Fire Co has outstanding $660000 of 8% bonds on which the interest is payable annually on 31
December. The debt is due for redemp on at par on 1 January 20X6. The market price of the bonds at
28 December 20X2 was $95. Eec ve tax rate was 30% and tax is paid each 31 December. Calculate
the a er-tax cost of debt.
3. Es ma ng cost of debt and other capital instruments

When company uses debt to nance capital, there will be cost of debt. We will focus on calcula ng
cost of debt for irredeemable debt, redeemable debt, conver ble debt and preference shares, cost of
bank debt is just the current interest rate. Since interest is tax deduc ble, we will always take a er-tax
cost of debt. Note that we normally assume the nominal value of bond is $100.
Irredeemable debt
Since the debt is irredeemable, interest is paid in perpetuity, interest yield represents the cost of
irredeemable debt, ie. Interest/market price of bond.
Example: Water Co issued bonds of $100 nominal value with annual interest of 9% based on the
nominal value. The current market price of the bonds is $90. What is the cost of the bonds?
Solu on: Cost of debt = 9/90 = 10%.
Year
0
1-3
3
Item
Cash ows
Market value
(95)
1.000
(95)
Interest (8 x 0.7) (un l 31/12/X5) 5.6
2.723
15.2
Redemp on
100
0.864
86.4
NPV
6.6
Since this NPV is posi ve, another rate to choose must be higher in order to result in nega ve NPV.
Year
0
1-3
3
Item
Cash ows
Market value
(95)
1.000
(95)
Interest (8 x 0.7) (un l 31/12/X5) 5.6
2.487
14
Redemp on
100
0.751
75.1
NPV
(5.9)
A er-tax cost of debt = 5 + [(6.6/(6.6 + 5.9) x (10 5)] = 7.6%.
The market value of the bond can also be es mated by calcula ng the NPV of the cash ows
discounted at cost of debt.
If interest is not paid annually, there would be a need to express the interest yield to annual
percentage.
Example: Rock Co has 12% irredeemable bonds in issue with a nominal value of $100. The market price
is $95 ex interest. Calculate the cost of debt if interest is paid half-yearly.
Solu on: 6% is payable half-yearly, so 6/95 is the cost of debt for 6 months, to express it in annual cost:
Cost of debt = (1 + 6/95)^(12/6) 1 = 13%.
Remember that interest can be allowable for tax purpose, so when there is tax (which is normally the
case), the cost of debt should be a er-tax, calculated by upda ng interest yield formula as [interest x
(1 tax rate)]/market price of bond.
Example: Using the rst example, when the tax rate is 30%, calculate cost of the bonds.
Solu on: Cost of debt = (9 x 0.7)/90 = 7%.
Example: Using the above example, if cost of debt would rise to 12% during 20X3 and 20X4, es mate
the market value of the bonds at 28 December 20X2.
Solu on: It is probable that the market value in December 20X2 will reect the new rates in future, so
we can take 12% as the discount factor.
Year
Item
Cash ows
0
Interest (31/12/X2)
5.6
1.000
5.6
1-3
Interest (un l 31/12/X5)
5.6
2.402
13.5
3
Redemp on
100
0.712
71.2
NPV
90.3
The es mated market value of the bonds would be $90.3.
From the above two examples, the calcula on is based on the view of the debt holder, who lends to
the company at rst (so market value of the bond is included in year 0) and later receive interest and
nally capital repayment at the year of redemp on.
48
49
Conver ble debt

The cost of debt calcula on will depend on whether or not conversion is likely to happen.
1. If conversion is not expected, the bond is treated as redeemable debt so use IRR to calculate cost of
debt.
2. If conversion is expected, IRR will s ll be used, but follow the number of years to conversion and the
redemp on value is replaced by the conversion value (market value of the shares converted from
debt). Conversion value will also take growth in share price into account and can be calculated as
current share price x (1 + growth rate)^n x shares received on conversion, n is the number of years to
conversion.
ar
me. The share price is currently $3.50 and is expected to grow at a rate of 3% per annum. Assume tax
rate is 30%, calculate the cost of debt.
Conversion value = future share price x number of shares received = [$3.50 x (1.03)^5] x 25 = $101.44.
Since redemp on value is $100, it is likely that investors will convert as conversion value is higher.
Year
Item
Cash ows
0
Market value
(82)
1.000
(82)
1-5
Interest (8 x 0.7)
5.6
3.993
22.36
5
Conversion value
101.44
0.681
69.08
NPV
9.44
Year
0
1-5
5
Item
Cash ows
Market value
(82)
1.000
(82)
Interest (8 x 0.7)
5.6
3.605
20.19
Conversion value
101.44
0.567
57.52
NPV
(4.29)
Cost of debt = 8 + [(9.44/(9.44 + 4.29) x (12 8)] = 10.75%.
Preference shares
For irredeemable preference shares, future cash ows are the dividend payments in perpetuity.
Therefore, we can use dividend yield to calculate the cost of debt, ie. dividend/market price of
preference share capital. Remember that dividend does not a ract tax relief.
For redeemable preference shares, cost of debt is calculated using IRR.
The formula for WACC is given in exam as
, V is the market value, T is
tax rate, e is equity, d is debt, k is cost. Since the formula includes (1 T) which means a er-tax, the
cost of debt to be included, ie. must be before-tax cost of debt.
Example: The following informa on relates to
currently 30%.
Source
Cost of nance
Equity
17%
Preference shares
18.6%
Debt
8.6%
Market value ($m)

23
5
14
42
The above cost of nance is before-tax. Calculate the WACC for Rock Co.
Solu on: Do not combine cost of preference shares with the cost of debt, we will modify the formula.
WACC =
9.31% + 1.55% + 2% = 12.86%.

ain but with dierent
approach and more in line with the deni on of WACC.

Example: The following informa o
currently 30%.
Source
Cost of nance
Equity
17%
Preference shares
18.6%
Debt
8.6%
Market value ($m)

23
5
14
42
The above cost of nance is before-tax. Calculate the WACC for Rock Co.
Solu on: Make the cost of nance a er-tax and do the following.
Source
Cost of nance
Market value ($m)
Cost x market value
Equity
17%
23
3.91
Preference shares
13%
5
0.65
Debt
6%
14
0.84
42
5.40
WACC = 5.4/42 x 100% = 12.86%. The weigh ng is done at cost of nance x market value.
4. Es ma ng the overall cost of capital

Weighted average cost of capital (WACC)
Marginal cost of capital
or book value of
each source of nance. There are two methods to weight the source of nance, ie. market value and
book value weigh ngs. Market values should always be used unless unavailable (unquoted company)
because book value is based on historical costs.
nance and market value of the source of nance. It is argued that WACC should be used to evaluate
projects. However where gearing levels uctuate signicantly or nance for new project carries a
signicant dierent level of risks, it is good to use marginal cost of capital to evaluate new project. The
following example is an extension of the above example.
50
Example: Rock Co decided to invest in a new project which will increase the cost of equity to 18% and
cost of debt to 10%. The market value of equity will then be $24m and market value of debt will be
$20m. Calculate new WACC and marginal cost of capital.
Solu on:
Source
Cost of nance
Market value ($m)
Cost x market value
Equity
18%
24
4.32
Preference shares
13%
5
0.65
Debt
10%
20
2.00
49
6.97
New WACC = 6.97/49 x 100% = 14.2%.
Marginal cost of capital = (6.97 5.4)/(49 42) x 100% = 22.4%.
51
Miller and Modigliani (MM) view on capital structure

MM however says that WACC is not inuenced by changes in capital structure. MM made various
assump ons in arriving at this conclusion, including:
1. Debt is risk-free and freely available at the same cost to investors and companies.
2. No tax or issue costs.
3. A perfect capital market exists.
(assume no tax)
No op mum capital structure exists. WACC will remain constant at all levels of gearing. Therefore,
company cannot reduce its WACC by altering its gearing. In short, we can say that benets of cheaper
debt are counterbalanced by increased cost of equity (due to increased nancial risk).
WACC for investment appraisal

WACC can be used as discount rate in investment appraisal when:
1. Project has the similar business risk as the exis ng opera ons of the company.
2. Project has the similar nancial risk as the exis ng opera ons of the company.
3. Project should be small in comparison with the size of the company.
Be prepared to face ques on where cost of equity, cost of debt and WACC come together. Theore cal
aspect must not be ignored.
5. Capital structure theories and prac cal considera ons
Tradi onal view of capital structure and its assump ons
Some believe that op mal capital structure (mix of equity and debt nance) will be the point at which
WACC is lowest. Cost of equity will rise when nancial risk increases. As the level of gearing increases,
cost of debt remains unchanged up to a certain level of gearing, a er this level the cost of debt will
increase. The assump ons used in this theory include:
1. Company pays out all its earnings as dividends.
2. Taxa on is ignored.
3. Earnings and business risk are constant in perpetuity.
4. No issue cost of issuing debt or shares.
MM admi ed corporate tax into their analysis and conclusion changed. As debt became even cheaper
(due to tax relief on interest payments), cost of debt falls signicantly from Kd to Kd (1 T). WACC will
fall when gearing increases. Therefore, if company wishes to reduce its WACC, it should borrow as
much as possible. In short, we can say that benets of cheaper debt now exceeds the increased cost of
equity. Op mum capital structure is 99.99% debt nance.
Market imperfec ons

does not take into account factors such as bankruptcy costs, agency costs and tax exhaus on.
Ko = WACC. X = Op mal capital structure.
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Bankruptcy costs
avoid
bankruptcy. In reality, the higher the gearing level, bankruptcy risk increases. Shareholders and debt
holders will then require a higher rate of return as compensa on which increase cost of equity and
debt.
Agency costs
As gearing increases, debt holders would want to impose more constrains on the management to
safeguard their increased investment. They might impose restric ve covenants in the loan agreement
Debt holders who are concerned about the increased gearing level will incur more agency costs (cost to
monitor the agent).
Tax exhaus on
Companies become tax exhausted when interest payments are no longer tax deduc ble as addi onal
interest payments exceed prots made. In this case, cost of debt will rise from Kd (1 T) to Kd.
Pecking order theory
This theory states that rms will prefer retained earnings to any other source of nance, and then will
choose debt, and last of all equity. The order of preference will be:
1. Retained earnings.
2. Straight debt.
3. Conver ble debt.
4. Preference shares.
5. Equity shares.
Company follows pecking order theory because:
1. Minimise issue costs retained earnings have no issue costs, issuing debt is cheaper than issuing
equity.
2. Minimise me and expense involved in persuading outside investors.
3. Some managers believe that debt issues have a be er signaling eect than equity issues. There is an
informa on asymmetry
outsiders. Therefore, market depends on the signal shown by the company to interpret about the
company. For example, market will interpret debt issues as a sign of condence, that businesses are
condent of making sucient prots to fulll their obliga ons on debt and that they believe that the
shares are undervalued.
Using WACC in investment appraisal

This is covered before, WACC is suitable when:
1. Project being appraised is small rela ve to the company.
2. The exis ng capital structure will be maintained so that project has the same nancial risk as the
company.
3. The project has the same business risk as the company. Therefore, WACC can be used to evaluate an
expansion of exis ng business.
Using CAPM in determining project-specic cost of capital
The capital asset pricing model (CAPM) can be used to calculate a project-specic discount rate in
circumstances where the business risk of an investment project is dierent from the business risk of
the exis ng opera ons of the inves ng company.
The rst step in using the CAPM to calculate a project-specic discount rate is to nd a proxy
(representa ve) company that undertake opera ons whose business risk is similar to that of the
proposed investment. The equity beta of the proxy company will represent both the business risk and
the nancial risk of the proxy company. The eect of the nancial risk of the proxy company must be
removed (ungearing) to give a proxy beta represen ng the business risk alone of the proposed
investment. This beta is called an asset beta.
The asset beta represen ng the business risk of a proposed investment must be adjusted to reect the
nancial risk of the inves ng company
regearing
beta that can be placed in the CAPM in order to calculate a required rate of return (a cost of equity).
This can be used as the project-specic discount rate for the proposed investment if it is nanced
en rely by equity. If debt nance forms part of the nancing for the proposed investment, a projectspecic weighted average cost of capital can be calculated.
Ungearing and regearing of beta
As discussed above, ungearing beta means from a equity beta of the proxy company to an asset beta
and regearing beta means from asset beta to equity beta of the inves ng company. Formula for asset
beta is given in exam as
. We o en assume debt is risk-free

and its beta (
) is then taken as zero, so the formula is reduced to
, if without tax then remove the (1 T). To convert the ungeared beta (asset
beta) to geared beta (equity beta), simply modify the formula of asset beta to
Example: Two companies are iden cal in every respect except for their capital structure. Water Co has
6. Impact of cost of capital on investments
Company value and cost of capital
Currently Fire Co is considering a project with risk-free rate of return of 4% and equity risk premium of
6%. Calculate the specicSolu on: We will start with ungearing the equity beta of Water Co. Note that it is not necessary to put
market value of equity or debt in $ inside the formula.
higher the NPV of its future cash ows and therefore the higher will be the company value.
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Business valua ons

Next we regear this to equity beta for Fire Co.
1. Nature and purpose of the valua on of business and nancial assets

There are a number of dierent ways of pu ng a value on a business or on shares of unquoted
company. A share valua on will be necessary when (examples):
1. In a takeover bid (another company (A) wishes to acquire this company (B)), oer price might be
We can now apply this to the CAPM formula to determine specic-project cost of equity.
Cost of equity =
= 4 + 1.427 x 6 = 12.6%.
Limita ons of beta formula
1. Dicult to iden fy a proxy company with iden cal opera ng characteris cs.
2. Es mates of beta values from share price informa on are not wholly accurate as they are based on
sta s cal analysis of historical data.
3. There may be dierences in beta values between rms caused by dierent size of the organiza on
and debt capital not being risk-free.
2. Unquoted company
3. Holding company wishes to sell subsidiary and is nego a ng the price.
4. Company is in a liquida on situa on.
Informa on required for valua on
There are many, some are listed below:
1. Past nancial statements informa on.
2. Aged accounts receivable summary.
3. List of marketable securi es.
4. Inventory summary.
5. Budgets for a minimum of ve years.
6. List of major customers.
However there are limita ons to some of the informa on. For example, some informa on may be out
of date or subjec ve.
Market capitalisa on
This is an important term represen ng an es ma on of the value of business obtained by current price
per share x number of ordinary shares.
2. Models for the valua on of shares
Three models to look into, ie. asset-based, income-based and cash ow-based valua on models.
Asset-based valua on models
Net assets valua on method provides a lower limit for the value of a company. By itself it is unlikely to
produce the most realis c value. In this model, value of share = (total assets total liabili es)/number
of ordinary shares, ie. net assets per share. Intangible assets are excluded as they do not represent the
then they can be included.
The choice of asset values to use includes:
1. Net book value (statement of nancial posi on basis) unlikely to be realis c.
2. Net realisable value suitable if assets are to be sold or business as a whole broken up.
3. Net replacement cost suitable if assets are to be used on an on-going basis.
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Use of net asset valua on

(safety) in a share value as it provides a lower limit of share value.
2. As a measure of comparison in a scheme of merger (business combina on which nonce obtains
control over any other) company can compare this value with another company in a merger to
determine whether it is necessary to adjust the value of the company to allow for dierence.
value) for a business that is up for sale.
Advantages of net asset valua on
1. Informa on is readily available.
2. Indicate a minimum value of the company.
Disadvantages of net asset valua on
1. Ignore future protability expecta ons.
2. Statement of nancial posi on valua ons depend on accoun ng conven ons, which might be very
dierent from market valua ons.
Income-based valua on models
We can use either price-earnings ra o (P/E ra o) method (commonly asked) or earnings yield method.
It mainly involves playing with the formula.
P/E ra o method
P/E ra o = market value of share/earnings per share, therefore the market value per share can be
determined as P/E ra o x EPS. However it may not be suitable to use P/E ra os of quoted companies to
value unquoted companies, in exam you should normally take a gure around one half to two thirds of
the industry average when valuing an unquoted company. Factors to consider in deciding suitable P/E
ra o include:
1. General economic and nancial condi ons.
2. Industry eg. if P/E ra o is aected by lack of condence in the industry, the valua on will be
unrealis cally low.
3. Financial status of any principal shareholders.
4. Reliability of prot es mates and the past prot record.
5. Asset backing (net asset value) and liquidity.
Earnings yield method
Earnings yield = EPS/market value per share, therefore the market value per share = EPS/earnings yield.
We can also incorporate earnings growth, then earnings yield = ([EPS x (1 + g)]/market value per share)
+ g, and market value per share = [EPS x (1 + g)/(earnings yield g).
Cash ow-based valua on models
We can use either dividend valua on model/dividend growth model (commonly asked) or discounted
cash ow basis. It involves playing with the formula for dividend valua on/growth model.
Dividend valua on model/dividend growth model

It is covered before in cost of equity topic that when dividend growth model is used, cost of equity =
cost of equity = [dividend per share x (1 + g)/market price per share] + g, therefore market price per
share = [dividend per share x (1 + g)]/(cost of equity g). Cost of equity can be determined using
capital asset pricing model (CAPM). Now it is good to look at December 2007 ques on 1 (a).
Example: Phobis Co is considering a bid for Danoca Co. Both companies are stock-market listed and are
in the same business sector. Financial informa on on Danoca Co, which is shortly to pay its annual
dividend, is as follows:
Number of ordinary shares
5 million
Ordinary share price (ex div basis)
$3.30
Earnings per share
40.0c
Proposed payout ra o
60%
Dividend per share one year ago
233c
Dividend per share two years ago
220c
Equity beta
14
Other relevant nancial informa on:
Average sector price/earnings ra o
10
Risk-free rate of return
46%
Return on the market
106%
Required:
Calculate the value of Danoca Co using the following methods:
(i) price/earnings ra o method;
(ii) dividend growth model;
and discuss the signicance, to Phobis Co, of the values you have calculated, in comparison to the
current market value of Danoca Co.
Solu on: (i) Market value per share = P/E ra o x EPS = 10 x 40 = 400c = $4.
Value of Danoca = $4 x 5m = $20m.
(ii) Market value per share = [dividend per share x (1 + g)]/(cost of equity g), therefore we need to
nd the missing gures.
Dividend per share = 40c x 60% = 24c.
We can es mate the growth by nding out the average geometric dividend growth rate, 22c x (1 + g)^2
= 24c, (1 + g)^2 = 24/22, so g = (24/22)^1/2 1 = 4.5%.
We are given enough informa on to use CAPM to nd cost of equity.
Cost of equity = 4.6 + 1.4 x (10.6 4.6) = 13%.
Market value per share = [24 x (1 + 0.045)]/(0.13 0.045) = $2.95.
Value of Danoca = $2.95 x 5m = $14.75m.
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Current market capitalisa on of Danoca Co is $16.5m ($3.3 x 5m). The P/E ra o value of Danoca Co is
$20m, higher than the current market capitalisa on due to the dierence in P/E ra o of the average
sector and Danoca Co. This indicates that there is a need to improve financial performance of Danoca
Co a er acquisi on so that Phobis Co and its shareholders will benet from the acquisi on.
Dividend growth model value is less than current market capitalisa on of Danoca Co. Dividend growth
model value represents the minimum value that Danoca shareholders will accept if Phobis Co makes an
oer to buy their shares. This dierence may reect the belief of stock market that a takeover bid is
imminent as shareholders are prepared to accept a value lower than market capitalisa on but it could
also be due to inaccuracy of cost of equity or expected dividend growth rate. (Referred to answer)
Example: Fire Co issued some 9% bonds, which are now redeemable at par in three years me.
Investors now require a redemp on yield of 10%. What will be the current market value of each $100
of bond?
Solu on:
Year
Items
Cash ows ($) Discount factor (10%) Present value ($)
1-3
Interest
9
2.487
22.38
3
Redemp on
100
0.751
75.10
NPV
97.48
Each $100 of bond has a current market value of $97.48.
The dividend models made a number of assump ons:

1. Investors act ra onally and homogeneously failed to take into account that expecta ons of
shareholders may be dierent.
2. Other inuences on share prices are ignored.
3.
4. Dividends either show no growth or constant growth.
5. No increase in cost of capital.
Conver ble debt

If conversion is not expected, then market value of bond = NPV of cash ows. If conversion is expected,
then market value of bond is s ll the NPV of cash ows, but follow the number of years to conversion
and also redemp on value is replaced with conversion value (refer back to cost of debt topic if you are
confused).
Discounted cash ow basis

Appropriate when one company intends to buy the assets of another company and to make further
investments in order to improve cash ows in the future. Value of investment = expected a er-tax
cash ows discounted to present values at appropriate cost of capital. This value of investment will be
the maximum price that company is willing to pay for the shares of another company.
3. The valua on of debt and other nancial assets
Again we will play with the formulas of the cost of debt here. We always assume that debt is quoted
with $100 nominal value.
Irredeemable debt
The cost of irredeemable debt, as men oned before, is the same as interest yield. When there is tax,
cost of debt = [interest x (1 T)]/market price of bond ex interest, so market price of bond = [interest x
(1 T)]/cost of debt. Remember that ex interest means excluding any interest payment that might
soon be due.
Redeemable debt
Valua on of redeemable debt depends on future expected receipts (interest and redemp on).
Therefore, the market price of bond = NPV of the cash ows.
Example: Water Co issued 9% conver ble bond which can be converted in ve years me into 35
ordinary shares or
current market price of the underlying share is $2.50 which is expected to grow by 4% per annum.
Es mate the current market value of conver ble bond assuming that conversion will occur.
Solu on: Conversion value = 35 x $2.5 x (1.04)^5 = $106.46.
Year
Items
Cash ows ($) Discount factor (10%) Present value ($)
1-5
Interest (9% x $100)
9
3.791
34.12
5
Conversion
106.46
0.621
66.11
Current market price of conver ble bond
100.23
Preference shares
Remember that tax is not allowed for the xed dividend payment. Cost of preference shares = dividend
payment/market price of bond so market price of bond = dividend/cost of preference shares.
4. Ecient Market Hypothesis (EMH) and prac cal considera ons in the valua on of shares
Ecient Market Hypothesis (EMH)
EMH is the hypothesis that the stock market reacts immediately to all the informa on that is available.
Stock market eciency usually refers to the way in which the prices of traded nancial securi es
reect relevant informa on. Types of eciency include:
1. Opera onal eciency requires that transac on costs are low and do not hinder investors in the sale
or purchase of securi es.
2. Informa onal eciency means that relevant informa on is widely available at low cost.
3. Pricing eciency refers to the ability of capital markets to process informa on quickly and
accurately, and arises as a consequence of opera onal eciency and informa onal eciency.
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4. Alloca ve eciency means that capital markets are able to allocate available funds to their most
produc ve use and arises as a result of pricing eciency.
Most of the research into market eciency has been into pricing eciency.
There are three forms of eciency: weak, semi-strong and strong-form eciency.
Weak-form eciency
This is when research indicates that share prices fully and fairly reect past informa on. Since new
informa on arrives unexpectedly, share price movement
cannot predict share prices b
Semi-strong form eciency
This is when research indicates that share prices fully and fairly reect public informa on (published)
as well as past informa on. Investors cannot generate abnormal returns by analysing either public
informa on, such as published company reports, or past informa on, since research shows that share
prices respond quickly and accurately to new informa on as it becomes publicly available. Therefore,
informa on contained in these will be reected in the share price. Evidence suggests that most leading
stock markets are semi-strong ecient.
Strong-form eciency
This is when research indicates that share prices fully and fairly reect all informa on, which includes
private informa on. Even investors with access to insider informa on cannot generate abnormal
returns in such a market. Stock markets are not held to be strong form ecient. It is unlikely that
strong-form exists in reality.
Consequences of market eciency
1. There is no right or wrong me to issue new shares since share prices are always fair (in theory).
2. Managers will not be able to deceive the market by the ming or presenta on of new informa on,
briengs, since the market processes the informa on quickly and
accurately to produce fair prices. Managers should therefore simply concentrate on making nancial
decisions which increase the wealth of shareholders.
3. There are no bargains to be found in capital markets (in theory).
Marketability and liquidity of shares

In nancial markets, liquidity is the ease of buying and selling the shares without signicantly moving
the price. Large companies have be er liquidity and greater marketability than small companies. In
such case, the small companies may try to improve the marketability of their shares with stock split.
Availability and sources of informa on
This depends on the eciency of the nancial market. Ecient market is one where the prices of
securi es bought and sold reect all the relevant informa on available. Eciency relates to how
quickly and accurately prices adjust to new informa on.
Market imperfec ons and pricing anomalies
Various types of anomaly appear to support the views that irra onality o en drives the stock market,
including:
1. Seasonal eects may cause share prices to rise or fall.
2. A short-run overreac on to recent events, for example, stock market crash in 1987 (Black Monday)
causes huge loss in value in a very short me.
Market capitalisa on
Market capitalisa on or size of a company has also produced some pricing anomalies. The return from
inves ng in smaller companies is greater than average return from all companies in the long run,
probably due to greater risk associated with smaller companies.
Investor specula on and behavioural nance
Investor specula on means that the investor buys the shares when he expects the share price will go
up in future (now low) and sells shares when he expects the share price is at peak already (so
speculator is like a gambler). Speculators can aect the share price through these buying and selling
ac vi es.
Behavioural nance is a psychology-based theory. It states that the characteris cs of market
par cipants can inuence the market outcomes, so the irra onal investor behaviour may signicantly
aect share price movement.
Prac cal considera ons in the valua on of shares and businesses

A number of factors to consider in rela on to shares valua on.
Fundamental analysis theory of share values
It states that the realis c market price of a share can be derived from a valua on of es mated future
dividends. Value of share will be the present value of all future expected dividends discounted at the
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Risk management
1. The nature and types of risk and approaches to risk management
In F9, we deal with foreign currency risk and interest rate risk. We start with some introduc ons.
Types of foreign currency risk
1. Transla on risk this risk occurs when company has a foreign branch or subsidiary and the currency
risk that when company consolidates accounts, there
will be exchange losses when the accoun ng results of foreign subsidiary are translated into home
currency. (IAS 21 requires holding company to translate the account of foreign subsidiary to home
currency in consolida on).
2. Transac on risk this arises when company is impor ng or expor ng. It is the risk of adverse
exchange rate movements between the date the price is agreed and the date cash is received/paid,
arising during normal interna onal trade. For example, in June a UK company agrees to sell an export
to Australia for 100,000 Australian $ (A$), payable in three months. The exchange rate at the date of
the contract is A$/1.80 so the company is expecting to receive 100,000/1.8 = 55,556. If, however,
the A$ weakened over the three months to become worth only A$/2.00, then the amount received
would be worth only 50,000.
3. Economic risk this refers to the eect of exchange rate movements on the interna onal
compe veness of a company and refers to the eect on the present value of future cash ows. For
s say from the UK to a eurozone country) and the euro weakens
/1.1
per pound sterling implies that the euro is less valuable,
so weaker) any exports from the UK will be more expensive when priced in euros. So goods where the
110, making those goods less compe ve in the European
market.
Types of interest rate risk
1. Gap exposure this arises from the risk of adverse changes in interest rates between the me
interest is paid for debt and the me interest is earned from investments. Compan
interest rate risk can be iden ed using gap analysis (grouping together assets and liabili es which are
sensi ve to interest rate changes according to their maturing dates). A nega ve gap occurs when
company has larger amount of interest-sensi ve liabili es maturing than it has interest-sensi ve assets
maturing at the same me while posi ve gap is the opposite of this. Therefore, with a nega ve gap,
company faces exposure if interest rates rise by the me of maturity. With positive gap, company faces
exposure if interest rates fall by maturity.
2. Basis risk this is the risk when yields (interest receivable) on assets and costs (interest payable) of
liabili es are based on dierent bases, such as LIBOR (London Inter-Bank Oered Rate, this is the rate
of interest applied to wholesale money market lending between London banks) versus U.S. prime rate.
Dierent bases may move at dierent rates or in dierent direc ons, aec ng the amount receivable
or payable (not applicable for xed interest rate debt, only apply to oa ng rate).
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2. Causes of exchange rate dierences and interest rate uctua ons

Before star ng, there are some terms to introduce here:
1. Exchange rate
ded in exchange for another
2.00 means that every A$1 can be exchanged for 2.00.
2. Spot rate rate of exchange agreed for immediate transac ons.
3. Forward rate rate agreed NOW for currencies to be exchanged at a future date.
4. Forward contract agreement to exchange dierent currencies at a specied future date and at a
specied rate. These are traded privately.
Causes of exchange rate uctua ons
In general, exchange rate can be inuenced by ina on, interest rates, balance of payments,
specula on and government policy on managing or xing exchange rates. The following headings are
the causes of exchange rate uctua ons in detailed (can be confusing).
Balance of payments
Balance of payments are surplus if source of funds (eg. export goods sold) exceed uses of funds (eg.
paying for imported goods) and decit if the other way round. As government is able to inuence
exchange rate through exchange rate policy, when there is trade decit, government will rec fy by
trying to bring about a fall in the exchange rate. Similarly to prevent a balance of trade surplus from
ge ng too large, government will try to bring about a limited rise in the exchange rate. Government
will try to maintain a stable balance of payments.
Purchasing power parity (PPP) theory (rela onship between exchange rates and ina on rates)
This suggests that changes in exchange rates over me must reect rela ve changes in ina on
between two countries. PPP is based on the of law of one price which suggests that, in equilibrium,
iden cal goods should sell at the same price in dierent countries, and that exchange rates relate
these iden cal values. For example, if a basket of goods costs 100 in the UK and $150 for an
equivalent in the US, for equilibrium to exist, the exchange rate would be expected to be 1 = $1.50.
PPP holds in the longer term rather than the shorter term and so is o en used to provide long-term
forecasts of exchange rate movements, for example for use in investment appraisal.
Interest rate parity (IRP) theory (rela onship between exchange rates and interest rates)
This states that the dierence between the nominal interest rates in two countries is the dierence
between forward rate and the spot rate of their currencies. When one makes two xed investments in
two dierent currencies, the return from both investments will be the same even though interest
rates may be dierent in absolute terms. This applies if there is no arbitrage (ac vity of buying
currency in one nancial market and selling it at a prot in another). Both the spot rate and the
forward rate are available in the current foreign exchange market, and the forward rate can be
guaranteed by using a forward contract.
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Fisher eect
This has been covered earlier that the rela onship between ina on rate and interest rate are:
(1 + i) = (1 + r)(1 + h) where i is nominal/money interest rate, r is the real interest rate and h is the
ina on rate.
Interna onal Fisher eect
This states that dierences in nominal interest rate between countries provide an unbiased predictor
of future changes in spot exchange rates. The interna onal Fisher eect can be expressed as:
where
is the nominal interest rate in country a,
is the ina on rate in country a.
Four-way equivalence
This model states that in equilibrium, dierences between forward and spot rates, dierences in
interest rates, expected dierences in ina on rates and expected change in sport rates are equal to
, this formula is given in exam. Country c is the foreign country.

Example: The spot exchange rate between UK sterling and Danish krone is 1 = 8.00 kroner. Assuming
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 ina on in Denmark is expected to be 5% while ina on in UK is
expected to be 8%. Calculate the expected spot exchange rate at the end of the year.
Solu on: We take 8 kroner as spot rate, we are UK so country c will be Denmark.
Expected spot exchange rate = 8 x 1.05/1.08 = 7.78. This amount can also be found by:
UK price = 110 x 1.08 = 118.80, Denmark price = Kr880 x 1.05 = Kr924
New spot exchange rate = 924/118.80 = 7.78.
Interest rate parity
Forward rate is forecast from the current spot rate by mul plying the ra o of interest rates in the two
countries being considered. Therefore, the formula is:
, this formula is given in exam as well. Country c is the foreign country.
Revision
To refresh your mind, maybe it is a good idea to look back at the rela onship between interest rate,
ina on rate and exchange rate.
1. When ina on rate increases, interest rate will be increased so that demand for money will fall (this
discourages people to spend). Ina on is generally caused by people spending more.
2. When exchange rate is low, interest rate can be increased to a ract foreign investors to invest which
might help to improve the currency values and therefore the exchange rate.
Example: Exchange rates between two currencies, the Northland orin (NF) and Southland dollar ($S)
are as follow:
Spot rates
$S1 = NF4.7250
NF1 = $S0.21164
90 days forward rates
NF4.7506 per $S1
$S0.21050 per NF1
Money market interest rate for 90 day deposits in Northland orins is 7.5% annualised. Es mate the
interest rates in Southland.
Solu on: Since we are given the 90 days forward rates, the interest rate of 7.5% should be adjusted to
90 days.
Northland interest rate on 90 day deposit = 0.075 x 90/365 = 1.85%.
There is a need to adjust the formula so that forward rate/spot rate = ra o of interest rates. If we take
$S0.21164 as spot rate, we are Northland so country c is Southland.
0.21050/0.21164 = 1 + /1.0185, 1 + = 0.21050/0.21164 x 1.0185, 1 + = 1.013, so = 1.3% OR
4.7506/4.7250 = 1.0185/1 + , 1 + = 1.0185 x 4.7250/4.7506, 1 + = 1.013 so = 1.3%.
In annual rate, 0.013 x 365/90 = 5.3%.
Causes of interest rate uctua ons
The causes of interest rate uctua ons include the structure of interest rates and yield curves and
changing economic factors. The following headings are the causes in detailed.
Forecas ng exchange rates

We will use PPP and IRP to forecast exchange rates.
Purchasing power parity
Expected spot rate is forecast from the current spot rate by mul plying the ra o of expected ina on
rates in the two countries being considered. Therefore, the formula is:
66
Structure of interest rates and yield curves

It is quite common sense that higher risk borrowers must pay higher rates to compensate the risk that
lenders are taking. Also, larger deposits with the bank might a ract higher rates than smaller deposits.
Furthermore, dierent types of nancial asset a ract dierent rates of interest.
Dura on of the lending can aect the interest rates as well, we refer to the term structure of interest
rates, ie. yield on a security varies according to the term of the borrowing, this is shown by the yield
curve below:
Yield can mean interest rate/market price (running yield) or the discount rate that makes present value
of future interest payments and redemp on value equal to current market price, ie. IRR (redemp on
yield or cost of debt). Long-term debt is usually expected to be more expensive than short-term debt
(ie. yield curve slopes upward, meaning the lender can yield more for longer-term debt). This is
because lender faces greater risk that borrower may not be able to repay interest payments or
principal amount.
Expecta ons theory
Forward interest rate is due only to expecta ons of interest rate movements. If interest rates are
expected to fall, short-term rates might be higher than long-term rates (so that lender maintains
sucient yield %) and yield curve would be downward sloping.
Liquidity preference theory
Liquidity preference means investors/lenders prefer cash now and want compensa on in the form of
higher return for being unable to use their cash now. Therefore, the long-term interest rates do not
compensate investors for added risk.
Market segmenta on theory (segmented market theory)
This theory states that most investors have set preferences regarding the length of maturi es that they
will invest in (investors are interested in bonds of only one maturity). For example, bank prefers shortterm debt and pension funds prefer long-term debt. Slope of the yield curve will reect condi ons in
dierent segments of the market. Even if short term rate increases in any period of me, this theory
implies that investors will not shi from long term bonds to short term bonds in order to enjoy higher
rate in the short run.
67
3. Hedging techniques for foreign currency risk

Hedging is a risk management strategy to limit or oset probability of loss from uctua ons in eg.
currencies and securi es. Remember, hedging is not about maximising income, it is about providing
certainty about the cost of a transac on in your own currency.
Foreign currency risk management methods (managing transac on risks)
Currency of invoice
Arrange for the contract and the invoice to be in your own currency. This will shi all exchange risk
from you onto the other party.
Ne ng
Ne ng is a process where credit balances are ne ed o against debit balances so that only the
reduced net amounts remain due to be paid by actual currency ows. If you owe your US supplier
US$1m, and another US company owes your US subsidiary US$1.1m, then by ne ng o group
currency ows your net exposure is only for US$0.1m. Bilateral ne ng is where two companies in the
same group cooperate as explained above; mul lateral ne ng is where many companies in the group
Matching
Company can reduce or eliminate foreign exchange transac on exposure by matching receipts and
payments. Wherever possible, company that expects to make payments and have receipts in same
foreign currency should plan to oset its payments against its receipts in the same currency, opening a
foreign currency bank account will help. For example:
1 November: should receive US$2m from US customer
15 November: must pay US$1.9m to US supplier.
Deposit the US$2m in a US$ bank account and simply pay the supplier from that. That leaves only
US$0.1m of exposure to currency uctua ons.
Leading and lagging
Company can try to lead payments (payments in advance) when expect foreign currency will
strengthen against own currency and lag payments (delaying payments) when expect that foreign
currency will weaken against own currency.
Forward exchange contracts
This is a binding agreement to sell or buy an agreed amount of currency at a specied me in the
future at an agreed exchange rate (the forward rate). Each spot and forward there is always a pair of
rates given. For example:
Spot
Three-month forward rate
Bank will always give you the rate that is more favourable to them, ie. 1.2022 if changing to euros
now, or 1.2014 if using a forward contract.
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69
Example: A UK importer imports from a foreign seller on 1 April for 26500 Swiss francs and has to pay
whereby the bank undertakes to sell the importer 26500 Swiss francs on 1 May, let say forward rate of
SFr2.6400 = 1. With this, the UK importer must pay at this forward rate on 1 May, amount payable is
26500/2.6400 = 10037.88.
1. If spot rate on 1 May is lower than 2.6400, the importer would have successfully protected himself
against the weakening of sterling.
2. If spot rate on 1 may is higher than 2.6400, importer would have to pay more. The extra cost is
unavoidable because forward contract is binding.
Let say later the seller fails to deliver the goods as specied, the forward exchange contract must s ll
be sa sfy. With this, bank will sell the customer 26500 Swiss Francs at 10037.88 and buy back the
unwanted currency at the spot rate. Importer could win or lose depending on the spot rate at the me.
closing out
Money market hedging

Money market hedging is the use of borrowing and lending transac ons in foreign currencies to lock in
the home currency value of a foreign currency transac on. This involves borrowing in one currency,
conver ng the money borrowed into another currency and pu ng the money on deposit un l the
me the transac on is completed, hoping to take advantage of favourable exchange rate movements.
Example will be required to understand how it works.
1. Foreign currency receipt (aim to create a foreign currency liability and use the foreign currency
receipt to pay it).
To face no currency risk, this US$2m can be used to se le a US$2m liability. UK manufacturer can
create a US$2m liability by borrowin
US$ receipt. Interest rates informa on is important, let say US$ 3 months interest rate is 0.54% - 0.66%
(this amount is always annualised). Same rule, UK manufacturer will be charged at higher rate, ie. 0.66%
per annum. The amount that UK manufacturer actually need to borrow now is:
X (1 + 0.66%/4) = 2000000, X = US$1996705. This can be changed now from US$ to at the current
spot rate, say US$/ 1.4701, to give 1358210 (1996705/1.4701). This 1,358,210 is certain, UK
manufacturer can deposit it into the bank or use it elsewhere.
Finally, when US$2m is received from US company, it will be used to repay the loan which should have
increased to US$2m from US$1996705.
2. Foreign currency payment (aim to create a foreign currency asset and use this to pay the foreign
currency payment, cost involved is the borrowings to create the foreign currency asset).
Example: A UK company
is Kr7.5509 Kr7.5548 per 1. The company can borrow in Sterling for 3 months at 8.6% per annum
and can deposit Kroner for 3 months at 10% per annum. What is the cost in pounds with a money
market hedge?
Solu on: Interest rates for 3 months are 2.15% (8.6%/4) to borrow in pounds and 2.5% (10%/4) to
deposit in kroner. Amount to borrow = amount to deposit = X (1 + 2.5%) = 3500000, X = Kr3414634.
Convert this to will be 3414634/7.5509 = 452215 (spot rate given will always be the bad one).
Company has to borrow 452215 and with 3 months interest will have to repay:
452215 x 1.0215 = 461938.
In 3 months, deposit (Kr3414634 should have increased to Kr3500000) will be taken out to pay the
Danish creditor and company will pay 461938 to the bank.
The choice between forward exchange contract (forward market) and money markets is generally
made on the basis of which method is cheaper, with other factors being of limited signicance. We
shall take a look at June 2011 ques on 4 as example.
Example: ZPS Co, whose home currency is the dollar, took out a xed-interest peso bank loan several
years ago when peso interest rates were rela vely cheap compared to dollar interest rates. Economic
dicul es have now increased peso interest rates while dollar interest rates have remained rela vely
available.
Per $
Spot rate: pesos
12500 pesos 12582
Six-month forward rate: pesos
12805 pesos 12889
Interest rates that can be used by ZPS Co:
Borrow
Deposit
Peso interest rates:
100% per year
75% per year
Dollar interest rates:
45% per year
35% per year
Calculate whether a forward market hedge or a money market hedge should be used to hedge the
interest
cash it uses in hedging exchange rate risk.
Solu on: The cost of both methods has to be compared.
Forward market hedge
Cost = 5000000/12.805 = $390472 (always take the rate that is bad).
Money market hedge
is X (1 + 7.5%/2) = 5000000, X = 4819277 pesos. Therefore, the $ to borrow this amount will be
4819277/12.500 = $385542. This is the cost now, we have to include the interest cost for 6 months, ie.
385542 x (1 + 4.5%/2) = $394217.
Comparing the cost, forward market hedge is cheaper by $3745 and should be used to hedge.
70
Asset and liability management

A company which has a long-term foreign investment, for example an overseas subsidiary, can try to
match its foreign assets by a long-term loan in the foreign currency.
Evalua ng the foreign currency risk management methods
1. Currency of invoice If the foreign customer wants you to invoice in their currency and you are very
keen to sale to this customer, then you might have to invoice in their currency.
2. Ne ng - This will really only work eec vely when there are many sales and purchases in the
foreign currency. It would not be feasible if the transac ons were separated by many months.
3. Matching - For matching to work well, either specic matches are spo ed or there have to be many
import and export transac ons to give opportuni es for matching. Matching would not be feasible if
you received
the following May.
4. Leading and lagging The currency movement may be dierent from expected.
5. Forward exchange contracts It is cheap and available for many currencies but it is binding and rates
may be una rac ve.
6. Money market hedging more me consuming compared to forward exchange contracts.
Foreign currency deriva ves
These can be used to hedge foreign currency risk as well. A deriva ve is a nancial instrument whose
value changes in response to the change in an underlying variable. No calcula on will be required in
exam.
Currency futures
These can be found in futures market. Currency futures are standardised contracts that oblige the
buyer (seller) to purchase (sell) the specied quan ty of foreign currency at a pre-determined price at
the expira on of the contract. Currency futures provide a hedge that theore cally eliminates both
upside (opportuni es) and downside (threats) risk by eec vely locking the holder into a given
exchange rate, since any gains in the currency futures market are oset by exchange rate losses in the
cash market, and vice versa.
In prac ce however, movements in the two markets are not perfectly correlated and basis risk exists if
maturi es are not perfectly matched. Imperfect hedges can also arise if the standardised size of
currency futures does not match the exchange rate exposure of the hedging company. Ini al margin
subsequently required. Futures are generally se led through an ose ng (reversing) trade.
Example:
will fear that the exchange rate will weaken over the three months, s
dollars for a euro). If that happened, then the market price of the future would decline too, to around
1.1. The exporter could arrange to make a compensa ng prot on buying and selling futures: sell now
at 1.24 and buy later at 1.10. Therefore, any loss made on the main currency transac on is oset by
the prot made on the futures contract.
71
Currency op ons
This gives holders the right, but not the obliga on, to buy (call op on) or sell (put op on) foreign
currency at specic date at a specic rate. An advantage of currency op ons over currency futures is
that currency op ons do not need to be exercised if it is disadvantageous for the holder to do so.
Holders of currency op ons can take advantage of favourable exchange rate movements in the cash
market and allow their op ons to lapse. The ini al fee (non-returnable premium) paid for the op ons
will still have been incurred and it depends on the strike price (exercise price of call or put op on),
maturity, liquidity in the market and so on.
Example: A UK exporter is expec ng to be paid US$1m for a piece of machinery to be delivered in 90
days. If the strengthens against the US$ the UK firm will lose money, as it will receive fewer for the
US$1m. However, if the weakens against the US$, then the UK company will gain additional money.
Say that the current rate is US$/1.40 and that the exporter will get particularly concerned if the rate
moved beyond US$/1.50. The company can buy call options at an exercise price of US$/ = 1.50,
giving it the right to buy at US$1.50/. If the dollar weakens beyond US$/1.50, the company can
exercise the op on thereby guaranteeing at least 666,667. If the US$ stays stronger or even
strengthens to, say, US$/1.20, the company can let the op on lapse (ignore it) and convert at 1.20, to
give 833,333.
Currency swaps
This is appropriate for hedging exchange rate risk over a longer period of me. It involves exchange of
principal and interest of a loan in one currency for the same in another currency. It begins with an
exchange of principal, although this may be a no onal exchange rather than a physical exchange.
During the life of the swap agreement, the counterpar es undertake
currency interest payments. At the end of the swap, the ini al exchange of principal is reversed.
4. Hedging techniques for interest rate risk
Interest rate risk can be managed using internal hedging in the form of asset and liability management,
matching and smoothing or using external hedging instruments such as forward rate agreements and
deriva ves.
Interest rate risk management methods
Matching and smoothing
Matching (commonly used by banks) is where assets and liabili es with a common interest rate are
matched. For example, one subsidiary could invest in money market at LIBOR and another subsidiary
, therefore matched.
Smoothing is where company keeps a balance between its xed rate and oa ng rate borrowing.
Therefore, when the interest rates increase, oa ng rate loan will be more expensive but this will be
compensated by the less expensive xed rate loan.
72
73
Forward rate agreements (FRAs)

This hedges interest rate risk by xing the interest rate on future borrowing. This protects the
borrower from adverse market interest rates movements to the levels above the rate nego ated for
the FRA. However it is likely to be dicult to obtain FRA for periods of over one year. Something to
note of is the terminology of FRA:
1. 4.00 - 3.80 means that you can x a borrowing rate at 4.00% (favourable to the bank).
ree months and lasts for three months.
3. A basis point is 0.01%.
Example: It is 30 June. Water Co needs a $10m 6 months xed rate loan from 1 October. Water Co
wants to hedge using an FRA and the relevant FRA rate is 6% on 30 June. What if the FRA benchmark
rate has moved to 9% later?
6) from
bank.
Net payment on loan = 9% x $10m x 6/12 3% x $10m x 6/12 = $300000. Therefore, with FRA the
eec ve interest rate on loan will be xed at 6%, in this case Water Co will not lose when the rate
becomes 9%.
Interest rate deriva ves
No calcula on will be required for these in exam. In considering which instrument to use, consider cost,
exibility, expecta ons and ability to benet from favourable interest rate movements.
Interest rate futures
This is similar to FRAs, except that the terms, amounts and periods are standardised. Because of this,
they cannot always be matched with specic interest rate exposures. With interest rate futures, what
we buy is the en tlement to interest receipts and what we sell is the promise to make interest
payments. Therefore, if a lender buys one 3 month sterling contract, he has the right to receive
interest for three months in pounds.
1. Borrowers will wish to hedge against interest rate rise by selling futures now and buying futures (if
interest rate did rise) on the day that the interest rate is xed.
2. Lenders will wish to hedge against falling of interest rate by buying futures now and selling futures
(if interest rate did fell) on the date that the actual lending starts.
We can see that borrowers sell futures to hedge against interest rate rises and lenders buy futures to
hedge against interest rate falls.
Normally, futures price is likely to vary with changes in interest rates and outlay to buy futures is much
less than buying a nancial instrument itself.
loan (oa ng rate). If both par es are in dierent countries, a xed to oa ng rate currency swap
(combina on of currency and interest rate swap) can be done.
Arranging a swap is cheaper than termina ng original loan (termina on fee is high) and taking out a
new loan (involve issue costs), therefore companies (normally banks and other types of ins tu on)
swap interest payments with another companies.
Interest rate op ons
This grants the buyer the right, but not the obliga on, to deal at an agreed interest rate (strike rate) at
a future maturity date. On the date of expiry of the op on, buyer must decide whether or not to
exercise the right. If a company needs to hedge borrowing, it will purchase a put op on to obtain the
right to pay interest at strike rate, so if the interest rate rises at the future date, company will exercise
this op on. Similarly, if a company needs to hedge lending, it will purchase a call op on.
Interest rate caps, collars and oors
Caps set a ceiling to the interest rate, oor sets a lower limit and collar is the simultaneous purchase of
a cap and sale of oor.
An interest rate cap will compensate the purchaser of the cap if interest rates rise above a
predetermined rate (strike rate) while an interest rate oor will compensate the purchaser if rates fall
below a predetermined rate. Both are also interest rate op ons.
Interest rate collar is a combina on of a purchase of an interest rate cap and a sale of an interest rate
oor to create a range for interest rate uctua ons between the cap and oor strike prices to
minimise the risk of a signicant rise in the oa ng rate. This limits the cost for the company as it
receives a premium for the op on (oor) sold.
Interest rate swaps

Interest rate swaps are where two par es agree to exchange interest rate commitments. The exchange
could be xed rate to oa ng rate or vice versa (plain vanilla or generic swap). For example, party A
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Financial management func on

1. Nature and purpose of nancial management

Conict between stakeholder objec ves and agency theory

4. Financial and other objec ves in not-for-prot organisa ons

Financial management environment

2. The nature and role of nancial markets and ins tu ons

(v) Commercial paper market

Other secondary UK markets include:

Working capital management

Monitoring accounts receivables

An easier way to understand factoring is through steps:

Managing foreign accounts receivable

Using trade credit eec vely

Total cost = $901400

The limita ons of Baumol cash management model are as follow:

2. Fluctua ng current assets vary due to the unpredictability of business ac vity.

Permanent and uctua ng current assets

Return on capital employed (ROCE) or accoun ng rate of return (ARR) or ROI

Disadvantages of NPV are:

Internal rate of return

Advantages of IRR are:

Superiority of discounted cash ow (DCF) methods over non-DCF methods

Other issues about NPV and IRR

4. Allowing for ina on and taxa on in DCF

Tax benet on capital allowance

Expected value of period 1 closing balance = $2100000.

Lease or buy decisions

Running costs (cash expenses)

Replace every year Replace every 2 years

Replace every 3 years

PV of cost over one

Deep discount bonds

1. Do nothing % of ownership will reduce as others subscribe the shares.

3. Raising short and long-term nance through Islamic nancing

Shareholder expecta ons

Other basic terms

2. Dividend cover = EPS/dividend per share.

Financing problems of SMEs

3. Es ma ng cost of debt and other capital instruments

Conver ble debt

The formula for WACC is given in exam as

, V is the market value, T is

Market value ($m)

9.31% + 1.55% + 2% = 12.86%.

approach and more in line with the deni on of WACC.

Market value ($m)

4. Es ma ng the overall cost of capital

Marginal cost of capital

Miller and Modigliani (MM) view on capital structure

WACC for investment appraisal

Market imperfec ons

Using WACC in investment appraisal

. We o en assume debt is risk-free

) is then taken as zero, so the formula is reduced to

Business valua ons

1. Nature and purpose of the valua on of business and nancial assets

Use of net asset valua on

Dividend valua on model/dividend growth model

The dividend models made a number of assump ons:

Conver ble debt

Discounted cash ow basis

Marketability and liquidity of shares

Prac cal considera ons in the valua on of shares and businesses

2. Causes of exchange rate dierences and interest rate uctua ons