F9 Revision Kit

SESSION 03 – INVESTMENT DECISIONS
OVERVIEW
Objective
¾ To understand the type of investment decisions that will be made by organisations.
¾ To assess an investment using the payback period and the ARR methods.
INVESTMENTS
TYPES OF
EVALUATION
EXPENDITURE
¾ Capital
¾ Revenue
¾ Investment decisions
PAYBACK ACCOUNTING
PERIOD RATE OF RETURN
¾ Definition ¾ Definition
¾ Possible Improvements ¾ Calculation
¾ Advantages ¾ Advantages
¾ Disadvantages ¾ Disadvantages
0301
1 TYPES OF EXPENDITURE
1.1 Capital
¾ Capital expenditure (CAPEX) refers to the purchase of non-current (fixed) assets or their
improvement;
1.2 Revenue
¾ Revenue expenditure is incurred to maintain non-current assets e.g. repairs
1.3 Investment decisions
¾ Decisions about which non-current assets should be acquired.
¾ Also referred to as project appraisal, investment appraisal or CAPEX analysis.
2 PAYBACK PERIOD
2.1 Definition
The time it takes for the operating cash flows from a project to pay back the
initial investment.
Decision rule
If payback period < target ACCEPT

If payback period > target REJECT
Illustration 1
Investment $1.4m
Annual cash flows (before depreciation but after tax) $0.3m
Project life 10 yrs
Solution
1.4
Payback period = = 4.7 years
0.3
(or five years if cash flows are assumed to arise at year ends.)
0302
2.2 Possible Improvements
2.2.1 Discounted payback period
¾ First discount the cash flows to present value and then calculate the payback period
¾ This takes into account the time value of money.
2.2.2 Bail-out factor
¾ This takes into account the estimated scrap/disposal value of the asset if the project is
abandoned early
2.3 Advantages of payback
9 Simple to calculate.
9 Easy to understand.
9 Concentrates on earlier flows:
more certain;
more important if firm has liquidity concerns.
2.4 Disadvantages of payback
8 Ignores cash flows after payback period;

8 Target period is subjective;
8 Gives little information about change in shareholder wealth.
8 Unless flows are discounted, time value of money is ignored
3 ACCOUNTING RATE OF RETURN (ARR)
3.1 Definition
The earnings of a project expressed as a percentage of the capital outlay or

average investment.
¾ Also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI).
3.2 Calculation
¾ This is a financial accounting measure based on the income statement and balance sheet.
¾ It includes:
Sunk costs (money already spent);

Net book values of assets;
Depreciation and amortisation ;
Allocated fixed overheads.
0303
¾ Calculated as
Average annual operating profit

× 100
Initial investment
OR Average annual operating profit

× 100
Average investment
Decision rule
If ARR > target ACCEPT

If ARR < target REJECT
Example 1
Initial investment $200m

Scrap value at end $20m
Cash flows Year 1 $100m

Year 2 $50m
Year 3 $50m
Year 4 $50m
Required:
Calculate ARR on
(i) Initial investment
(ii) Average investment
0304
3.3 Advantages
9 Uses readily available accounting information;

9 Simple to calculate and understand;
9 Often used by financial analysts to appraise performance.
3.4 Disadvantages
8 Different methods of calculation may cause confusion;
8 Based on profits rather than cash. Profits are easily manipulated by accounting policy.
8 Ignores time value of money;
8 Target rate is subjective;
8 A relative measure (%) – gives little information about the absolute change in
shareholders’ wealth.
Example 2
A project being considered would require a machine costing $80,000. Market

research of $8,000 has already been carried out and has been capitalised. The
result is that the project is expected to last for six years and produce net cash
earnings of $20,000 for each of the first three years and then $15,000 for each of
the last three years. The anticipated scrap proceeds of the machine at various
stages in its life are as follows:
After year 1 $40,000
After year 6 $4,000
Required:
Evaluate the project using
(a) ARR
(b) ARR using the average investment approach
(c) payback period
(d) payback period incorporating the bail-out factor.
You may assume that cash flows arise evenly during the year.
0305
Solution
(a)
(b)
(c)/ (d)
Time Flow Cumulative Scrap Net cumulative

flow flow
0 (88,000)
1 20,000 40,000
2 20,000 30,000
3 20,000 20,000
4 15,000 13,000
5 15,000 10,000
6 15,000 4,000
Payback period =
Payback period with bail-out =
0306
Key points
³ Payback and ARR are commonly used in practice. However neither

method informs management of the absolute change in shareholders’
wealth due to a particular project
³ As well as being able to calculate payback and ARR it is therefore vital that
you can also explain why they are not acceptable methods of project
appraisal
FOCUS
You should now be able to:
¾ define and distinguish between capital and revenue expenditure;
¾ calculate payback and assess its usefulness as a measure of investment worth;
¾ calculate ARR and assess its usefulness as a measure of investment worth.
EXAMPLE SOLUTIONS
Solution 1
Average annual profit
Total cash flows − Total depreciation 250 − 180

= = 17.5
No of project years 4
Average investment
Initial investment + Scrap value 200 + 20

= = 110
2 2
17.5
ARR on initial investment × 100 = 8.75%
200
17.5
ARR on average investment × 100 = 15.91%
110
0307
Solution 2 — ARR and Payback
(a) ARR
Average annual earnings = (3 × 20,000 + 3 × 15,000)
= $17,500
6
Average annual depreciation = 80,000 + 8,000 − 4 ,000

= $14,000
6
ARR = 17,500 − 14 ,000

= 4%
88 ,000
(b) Average investment = 88,000 + 4 ,000

= $46,000
2
ARR = 17,500 − 14 ,000

= 7.6%
46 ,000
(c)/ (d)
Time Flow Cumulative Scrap Net cumulative

flow flow
0 (88,000) (88,000) (88,000)
1 20,000 (68,000) 40,000 (28,000)
2 20,000 (48,000) 30,000 (18,000)
3 20,000 (28,000) 20,000 (8,000)
4 15,000 (13,000) 13,000 −
5 15,000 2,000 10,000 12,000
6 15,000 17,000 4,000 21,000
Payback period = 4 15
13
years
Payback period with bail-out = 4 years
0308
SESSION 04 – DISCOUNTED CASH FLOW TECHNIQUES
OVERVIEW
Objective
¾ To apply the time value of money to investment decisions.
INTEREST
SIMPLE COMPOUND DISCOUNTING
¾ Single sum ¾ “Compounding in

¾ Annuities reverse”
¾ Effective Annual Interest Rates ¾ Points to note
(EAIR)
DISCOUNTED
CASH FLOW (DCF)
TECHNIQUES
¾ Time value of money
¾ Procedure ¾ DCF techniques
¾ Meaning
¾ Cash budget pro forma NET PRESENT
¾ Tabular layout VALUE (NPV)
¾ Annuities
¾ Perpetuities
¾ Definition and decision

rule INTERNAL RATE
¾ Perpetuities OF RETURN (IRR)
¾ Annuities
¾ Uneven cash flows
¾ Unconventional cash
flows
NPV vs. IRR
¾ Comparison
0401
1 SIMPLE INTEREST
¾ Interest accrues only on the initial amount invested.
Illustration 1
If $100 is invested at 10% per annum (pa) simple interest:
Year Amount on deposit Interest Amount on deposit

(year beginning) (year end)
1 $100 0.1 × 100 = 10 $110
2 $110 0.1 × 100 = 10 $120
3 $120 0.1 × 100 = 10 $130
¾ A single principal sum, P invested for n years at an annual rate of interest, r (as a
decimal) will amount to a future value FV.
Where FV = P (1 + nr)
2 COMPOUND INTEREST
¾ Interest is reinvested alongside the principal.
2.1 Single sum
Illustration 2
If Zarosa placed $100 in the bank today (t0) earning 10% interest per annum,
what would this sum amount to in three years time?
Solution
In 1 year’s time, $100 would have increased by 10% to $110

In 2 years’ time, $110 would have grown by 10% to $121
In 3 years’ time, $121 would have grown by 10% to $133.10
Or
FV = P (1 + r) n
where
P = initial principal
r = annual rate of interest (as a decimal)
n = number of years for which the principal is invested
0402
Example 1
$500 is invested in a fund on 1.1.X1. Calculate the amount on deposit by

31.12.X4 if the interest rate is
(a) 7% per annum simple
(b) 7% per annum compound.
Solution
The $500 is invested for a total of 4 years
(a) Simple interest FV = P (1 + nr)
FV =
(b) Compound interest FV = P (1 + r)n
FV =
Example 2
$1,000 is invested in a fund earning 5% per annum on 1.1.X0. $500 is added to

this fund on 1.1.X1 and a further $700 is added on 1.1.X2. How much will be
on deposit by 31.12.X2?
Solution
Date Amount × Compound = Compounded

invested interest factor cashflow
$ $
1.1.X0 1,000
1.1.X1 500
1.1.X2 700
_________
Amount on deposit =
_________
0403
2.2 Annuities
¾ Many saving schemes involve the same amount being invested annually.
¾ There are two formulae for the future value of an annuity. Which to use depends on
whether the investment is made at the end of each year or at the start of each year.
(i) first sum paid/received at the end of each year

(ii) first sum paid/received at the beginning of each year
 (1 + r )n − 1    (1 + r )n + 1 − 1  
(i) FV = a  
 (ii) FV = a    − 1
r  r  
    
where a = annuity (i.e. annual sum)

r = interest rate (interest payable annually in arrears)
n = number of years annuity is paid/invested
Commentary
These formula will not be provided in the examination
Illustration 3
Andrew invests $3,000 at the start of each year in a high interest account
offering 7% pa. How much will he have to spend after a fixed 5 year term?
Solution
  (1.07 )6 − 1  
FV = $3,000 ×    − 1  = $3,000 × 6.153 = $18,460

 0.07 
  
2.3 Effective Annual Interest Rates (EAIR)
¾ Where interest is charged on a non-annual basis it is useful to know the effective annual
rate.
¾ Foe example interest on bank overdrafts (and credit cards) is often charged on a
monthly basis. To compare the cost of finance to other sources it is necessary to know
the EAIR.
Formula
1 + R = (1 + r) n
R = annual rate
r = rate per period (month/quarter)
n = number of periods in year
0404
Illustration 4
Borrow $100 at a cost of 2% per month. How much (principal + interest) will
be owed after a year?
Using FV = P (1 + r)n
⇒ = £100 × (1.02)12
= £100 × 1.2682 * = £126.82
EAIR is 26.82%
3 DISCOUNTING
3.1 “Compounding in reverse”
¾ Discounting calculates the sum which must be invested now (at a fixed interest rate) in
order to receive a given sum in the future.
Illustration 5
If Zarosa needed to receive $251.94 in three years time (t3), what sum would
she have to invest today (t0) at an interest rate of 8% per annum?
Solution
The formula for compounding is:

FV = P (1 + r) n
Rearranging this:
1
P = FV ×
(1 + r ) n
1
or alternatively PV = CF ×
(1 + r ) n
where PV = the present value of a future cash flow (CF)

r = annual rate of interest/discount rate.
n = number of years before the cash flow arises
1
In this case PV = $251.94 × = $200
(1.08) 3
The present value of $251.94 receivable in three years time is $200.
0405
3.2 Points to note
1
¾ is known as the “simple discount factor” and gives the present value of $1
(1 + r) n
receivable in n years at a discount rate, r.
¾ A present value table is provided in the exam
¾ The formula for simple discount factors is provided at the top of the present value
table.
¾ For a cash flow arising now (at t0) the discount factor will always be 1.
¾ t1 is defined as a point in time exactly one year after t0.
¾ Always assume that cash flows arise at the end of the year to which they relate (unless
told otherwise).
Example 3
Find the present value of
(a) 250 received or paid in 5 years time, r = 6% pa
(b) 30,000 received or paid in 15 years time, r = 9% pa.
Solution
(a) From the tables: r = 6%, n = 5, discount factor =
Present value =
(b) From the tables: r = 9%, n = 15, discount factor =
Present value =
0406
4 DISCOUNTED CASH FLOW (DCF) TECHNIQUES

4.1 Time value of money
¾ Investors prefer to receive $1 today rather than $1 in one year.
¾ This concept is referred to as the “time value of money”
¾ There are several possible causes:
Liquidity preference – if money is received today it can either be spent or

reinvested to earn more in future. Hence investors have a preference for having
cash/liquidity today.
Risk – cash received today is safe, future cash receipts may be uncertain.
Inflation – cash today can be spent at today’s prices but the value of future cash
flows may be eroded by inflation
DCF techniques take account of the time value of money by restating each
future cash flow in terms of its equivalent value today.
4.2 DCF techniques
¾ DCF techniques can be used to evaluate business projects i.e. for investment appraisal.
¾ Two methods are available:
NET PRESENT INTERNAL RATE

VALUE OF RETURN
0407
5 NET PRESENT VALUE (NPV)

5.1 Procedure
¾ Forecast the relevant cash flows from the project
¾ Estimate the required return of investors i.e. the discount rate. The required return of
investors represents the company’s cost of finance, also referred to as its cost of capital.
¾ Discount each cash flow (receipt or payment) to its present value (PV).
¾ Sum present values to give the NPV of the project.
¾ If NPV is positive then accept the project as it provides a higher return than required by
investors.
5.2 Meaning
¾ NPV shows the theoretical change in the $ value of the company due to the project.
¾ It therefore shows the change in shareholders’ wealth due to the project.
¾ The assumed key objective of financial management is to maximise shareholder wealth.
¾ Therefore NPV must be considered the key technique in business decision making.
5.3 Cash budget pro forma
Time 0 1 2 3
$000 $000 $000 $000
Capital expenditure (X) – – X
Cash from sales – X X X
Materials (X) (X) (X) –
Labour – (X) (X) (X)
Overheads – (X) (X) (X)
Advertising (X) – (X) –
Grant – X – –
___ ___ ___ ___
Net cash flow (X) X X X
___ ___ ___ ___
r% discount factor 1 1 1 1
1+ r (1 + r ) 2 (1 + r )3
Present value (X) X X X
NPV = X
0408
5.4 Tabular layout
Discount Present
Time Cash flow factor value
$000 @ r% $000
0 CAPEX (X) 1 (X)
1–10 Cash from sales X x X
0–9 Materials (X) x (X)
1–10 Labour and overheads (X) x (X)
0 Advertising (X) x (X)
2 Advertising (X) x (X)
1 Grant X x X
10 Scrap value X x X
___
Net present value X
___
Example 4
Elgar has $10,000 to invest for a five-year period. He could deposit it in a bank
earning 8% pa compound interest.
He has been offered an alternative: investment in a low-risk project that is

expected to produce net cash inflows of $3,000 for each of the first three years,
$5,000 in the fourth year and $1,000 in the fifth.
Required:
Calculate the net present value of the project.
Solution
Time Description Cash flow 8% DF PV

$ $
0 Investment (10,000)
1 Net inflow 3,000
2 Net inflow 3,000
3 Net inflow 3,000
4 Net inflow 5,000
5 Net inflow 1,000
_____
NPV =
_____
0409
5.5 Annuities
¾ An annuity is a stream of identical cash flows arising each year for a finite period of
time.
¾ The present value of an annuity is given as
1 1 
CF × 1 − 
r  (1 + r) n 
where CF is the cash flow received each year commencing at t1.
1 1 
¾ 1 −  is known as the “annuity factor” or “cumulative discount factor”. It is
r  (1 + r) n 
simply the sum of a geometric progression.
1 - (1 + r) −n
¾ The formula is given in the exam as
r
¾ Annuity factor tables are also provided in the exam
¾ Remember that the formula and tables are based on the assumption that the cash flow
starts after one year.
Illustration 6
Calculate the present value of $1,000 receivable each year for 3 years if interest
rates are 10%.
Time Description Cash flow 10% Annuity factor PV

$ $
1  1 
t1–3 Annuity 1,000 1− = 2.486 2,486
0.1  1.1 3 
Note: An annuity received for the next three years is written as t1–3.
Example 5
Calculate the present value of $2,000 receivable for each of 10 years

commencing three years from now. Assume interest at 7%.
0410
Solution
5.6 Perpetuities
¾ A perpetuity is a stream of identical cash flows arising each year to infinity.
¾ As n → ∞
(1 + r)n → ∞
1
→0
(1 + r) n
1 1  1
1 − →

r (1 + r ) n  r

1
¾ is known as the “perpetuity factor”.
r
1
The present value of a perpetuity is given as CF ×
r
where CF is the cash flow received each year.
¾ The formula is based on the assumption that the cash flow starts after one year.
Illustration 7
Calculate the present value of $1,000 receivable each year in perpetuity if

interest rates are 10%.
Solution

$ $
1
t1–∞ Perpetuity 1,000 = 10 10,000
01
.
0411
Example 6
Calculate the present value of $2,000 receivable in perpetuity commencing in

10 years time. Assume interest at 7%.
Solution
6 INTERNAL RATE OF RETURN (IRR)

6.1 Definition and decision rule
¾ IRR is the discount rate where NPV = 0
¾ IRR represents the average annual % return from a project.
¾ It therefore shows the highest finance cost that can be accepted for the project.
¾ If IRR > cost of capital, accept project.
¾ If IRR < cost of capital, reject project.
6.2 Perpetuities
¾ If a project has equal annual cash flows receivable in perpetuity then
Annual cash inflows

IRR = × 100%
Initial investment
Illustration 8
An investment of $1,000 gives income of $140 per annum indefinitely, the

return on the investment is given by
IRR = 140/1000 × 100% = 14%
0412
Example 7
An investment of $15,000 now will provide $2,400 each year to perpetuity.
Required:
Calculate the return inherent in the investment.
Solution
6.3 Annuities
¾ To give an NPV of zero, the present value of the cash inflows must equal the initial cash
outflow.
¾ i.e. annual ash inflow × Annuity factor = Cash outflow
Cash outflow
Annuity factor =
Cash inflow
¾ Once the annuity factor is known the discount rate can be established from the
appropriate table.
Illustration 9
An investment of $6,340 will yield an income of $2,000 for four years.
Calculate the internal rate of return of the investment.
Solution
Year Description CF DF PV
0 Initial investment (6,340) 1 (6,340)
1-4 Annuity 2,000 AF1-4 years 6,340
_____
NPV Nil
_____
6 ,340
AF1-4 years = = 3.17
2 ,000
From the annuity table, the rate with a four year annuity factor closest to 3.17 is 10% and this
is therefore the approximate IRR for this investment.
0413
Example 8
An immediate investment of $10,000 will give an annuity of $1,000 for the next
15 years.
Required:
Calculate the internal rate of return of the investment.
Solution
Time Description Cash flow Discount factor PV

$ $
0 Investment (10,000)
1-15 Annuity 1,000
______
______
6.4 Uneven cash flows
Method
¾ Calculate the NPV of the project at a chosen discount rate.
¾ If NPV is positive, recalculate NPV at a higher discount rate (i.e. to get closer to IRR).
¾ If NPV is negative, recalculate at a lower discount rate.
¾ The IRR can be estimated using the formula:
NA
IRR ~ A + (B − A)
NA − NB
Where A = Lower discount rate

B = Higher discount rate
NA = NPV at rate A
NB = NPV at rate B
¾ This method is known as “linear interpolation”.
0414
Illustration 10
The NPVs of a project with uneven cash flows are as follows.
Discount rate NPV

£
10% 64,237
20% (5,213)
Estimate the IRR of the investment.
Solution
NA
IRR ~ A + (B – A)
NA − NB
64 ,237
IRR ~ 10% + (20 – 10)%
64 ,237 − ( −5,213)
IRR ~ 19%
Graphically
NPV
IRR using formula

(interpolated)
NA
Discount rate
A B
NB Actual NPV as
discount rate varies
Actual IRR
0415
Example 9
An investment opportunity with uneven cash flows has the following net
present values
$
At 10% 71,530
At 15% 4,370
Required:
Estimate the IRR of the investment.
Solution
Formula
NA
IRR ~ A + (B – A)
NA − NB
IRR ~
Graphically
0416
6.5 Unconventional cash flows
¾ If there are cash outflows, followed by inflows are then more outflows (e.g. suppose at the
end of the project a site had to be decontaminated), the situation of “multiple yields”
may arise – i.e. more than one IRR.
NPV
Actual NPV as
discount rate varies
IRR1 IRR2 Discount rate
Actual IRR
¾ The project appears to have two different IRR’s – in this case IRR is not a reliable
method of decision making.
¾ However NPV is reliable, even for unconventional projects.
7 NPV vs. IRR

7.1 Comparison
NPV IRR
¾ An absolute measure ($) ¾ A relative measure (%)
¾ If NPV ≥ 0 ,accept ¾ If IRR ≥ target %, accept
¾ If NPV ≤ 0, reject ¾ If IRR ≤ target %, reject
¾ Shows $ change in value of ¾ Does not show absolute change in

company/wealth of shareholders wealth
¾ A unique solution i.e. a project has only ¾ May be a multiple solution

one NPV
¾ Always reliable for decision making ¾ Not always reliable
0417
Key points
³ Discounted cash flow techniques are arguably the most important

methods used in financial management.
³ DCF techniques have two major advantages (i) they focus on cash flow,
which is more relevant than the accounting concept of profit (ii) they take
into account the time value of money.
³ NPV must be considered a superior decision-making technique to IRR as it

is an absolute measure which tells management the change in
shareholders’ wealth expected from a project.
FOCUS
¾ explain the difference between simple and compound interest rate and
calculate future values;
¾ calculate future values including the application of annuity formulae;
¾ calculate effective interest rates;
¾ explain what is meant by discounting and calculate present values;
¾ apply discounting principles to calculate the net present value of an investment project
and interpret the results;
¾ calculate present values including the application of annuity and perpetuity formulae;
¾ explain what is meant by, and estimate the internal rate of return, using a graphical and
interpolation approach, and interpret the results;
¾ identify and discuss the situation where there is conflict between these two methods of
investment appraisal;
¾ Compare NPV and IRR as decision making tools.
0418
EXAMPLE SOLUTION
Solution 1 — 7% simple and compound interest
The $500 is invested for a total of 4 years
(a) Simple interest FV = P (1 + nr)
FV = 500 (1 + 4 × 0.07) = 500 × 1.28 = $640
(b) Compound interest FV = P (1 + r)n
FV = 500 (1 + 0.07)4 = 500 × 1.3108 = $655.40
Solution 2 — 5% compound interest
Date Amount Compound Compounded

invested × interest factor = cashflow
$ $
1.1.X0 1,000 (1 + 0.05)3 1,157.63
1.1.X1 500 (1 + 0.05)2 551.25
1.1.X2 700 (1 + 0.05)1 735.00
_________
Amount on deposit = 2,443.88
_________
Solution 3 — Present value
(a) From the tables: r = 6%, n = 5, discount factor = 0.747
Present value = 250 × 0.747 = $186.75
(b) From the tables: r = 9%, n = 15, discount factor = 0.275
Present value = 30,000 × 0.275 = $8,250
0419
Solution 4 — Net present value

$ $
0 Investment (10,000) 1 (10,000)

1 Net inflow 3,000 1 2,778
(1.08)
2 Net inflow 3,000 1 2,572
(1.08) 2
3 Net inflow 3,000 1 2,381

(1.08) 3
4 Net inflow 5,000 1 3,675

(1.08) 4
5 Net inflow 1,000 1 681

(1.08) 5
_____
NPV = 2,087
_____
Solution 5 — Annuity

$ $
t3-12 Annuity 2,000 6.135 (W) 12,270
WORKING
Cdf3-12 @ 7% = CDF1-12 @ 7% – CDF1-2 @ 7%

= 7.943 – 1.808 (per tables)
= 6.135
Solution 6 — Perpetuity

$ $
t10-∞ Perpetuity 2,000 7.771 (W) 15,542
0420
WORKING
Cdf10-∞ @ 7% = CDF1-∞ @ 7% - CDF1-9 @ 7%

= 1
– 6.515 (per tables)
0.07
= 14.286 – 6.515
= 7.771
Solution 7 — IRR (perpetuity)
2,400
IRR = × 100 = 16%
15,000
Solution 8 — IRR (annuity)
Time Description Cash flow Discount factor PV

$ $
0 Investment (10,000) 1 (10,000)
1-15 Annuity 1,000 Cdf1-15 = 10 (βal) 10,000
______
Nil
______
From the annuity table the rate with a 15 year annuity factor of 10 lies between 5% and 6%.
Thus if $10,000 could be otherwise invested for a return of 6% or more, this annuity is not
worthwhile.
Solution 9 — IRR (uneven cash flows)
Formula
Commentary
The formula always works but take care with + and – signs.
NA
IRR ~ A + (B – A)
NA − NB
 71,530 
IRR ~ 10 +   (15 – 10)
 71,530 − 4 ,370 
IRR ~ 10 + 5.325
say 15.4% (rounded up)
0421
Graphically
NPV
£
Actual
NPV
71,530
Actual
IRR
4,370
Discount rate
10 15 (%)
IRR using
formula
(extrapolated)
0422
SESSION 05 – RELEVANT CASH FLOWS FOR DCF
OVERVIEW
Objective
¾ To recognise the costs that are relevant to a discounted cash flow analysis.
¾ To be able to determine the taxation effects of a new investment.
¾ To be able to deal with inflation using either the money method, real method or
effective method.
¾ To do able to deal with cash flows relating to working capital.
RELEVANT ¾ General rule

COSTS ¾ Layout of cash flows
WORKING
TAXATION INFLATION
CAPITAL
¾ Basic effect of the UK tax ¾ Why inflation is a problem

system ¾ Real and money interest rates
¾ Timing ¾ General and specific inflation
¾ Other assumptions rates
¾ Dealing with taxation ¾ Cash flow forecasts
¾ Discounting
0501
1 RELEVANT COSTS FOR DISCOUNTING

1.1 General rule
Include only those costs and revenues which are affected by the decision. This means using
only:
¾ future;
¾ Incremental;
¾ operating cash flows.
Operating cash flows means the cash flows generated from operating the project e.g. cash
from sales, less operating costs such as materials and labour.
Do not include financing cash flows because the cost of finance is measured in the cost of
capital/discount rate - finance costs are taken into account by the discounting process itself.
Specifically, exclude:
¾ sunk costs – money already spent;
¾ non-cash costs – e.g. depreciation;
¾ book values – e.g. FIFO/LIFO inventory values;
¾ unavoidable costs – money already committed e.g. apportioned fixed costs;
¾ finance costs – e.g. interest (discounting the operating cash flows already deals with this).
However, include:
¾ all opportunity costs and revenues e.g. ‘cannibalisation’; where the launch of a new
product will reduce the sales if an exiting product. The lost contribution is an
opportunity cost and should be shown as a cash outflow.
0502
Example 1
A research project, which to date has cost the company $150,000, is under
review.
If the project is allowed to proceed, it will be completed in approximately one

year, when the results would be sold to a government agency for $300,000.
Shown below are the additional expenses which the managing director
estimates will be necessary to complete the work.
Materials
This material has just been purchased at a cost of $60,000. It is toxic and, if not
used in this project, must be disposed of at a cost of $5,000.
Labour
Skilled labour is hard to recruit. The workers concerned were transferred to

the project from a production department, and at a recent meeting the
production manager claimed that if the men were returned to him they could
generate sales of $150,000 in the next year. The prime cost of these sales would
be $100,000, including $40,000 for the labour cost itself. The overhead
absorbed into this production would amount to $20,000.
Research staff
It has already been decided that, when work on this project ceases, the research
department will be closed. Research wages for the year are $60,000, and
redundancy and severance pay has been estimated at $15,000 now or $35,000 in
one year’s time.
Equipment
The project utilises a special microscope which cost $18,000 three years ago. It
has a residual value of $3,000 in another two years, and a current disposal
value of $8,000. If used in the project it is estimated that the disposal value in a
year’s time will be $6,000.
Share of general building services
The project is charged with $35,000 per annum to cover general building
expenses. Immediately the project is discontinued, the space occupied could
be sub-let for an annual rental of $7,000.
Required:
Advise the managing director as to whether the project should be allowed to

proceed, explaining the reasons for the treatment of each item.
(Ignore the time value of money.)
0503
Solution
Costs and revenues of proceeding with the project.
$
(1) Costs to date –
(2) Materials –
(3) Labour cost –
Absorption of overheads –
(4) Research staff costs

Wages
Redundancy pay
(5) Equipment
(6) General building services

Apportioned costs
Opportunity costs
_______
Sales value of project

_______
Increased contribution from project
_______
Advice:
0504
1.2 Layout of cash flows
A company invests $10,000 today in a machine. It expects to earn $7,000 per year for two
years as a result. Discount rate = 15%.
Calculate the net present value of the investment.
(i) Time Narrative Cash flow 15% Present

Discount factor/
annuity factor
0 Machine (10,000) 1 (10,000)
1−2 Project
income 7,000 1.626 11,382
______
NPV $1,382
______
or
(ii) 0 1 2
Machine (10,000)
Income 7,000 7,000
______ ______ ______
(10,000) 7,000 7,000
15% factor 1 0.870 0.756
______ ______ ______
Present
value (10,000) 6,090 5,292
NPV
= $1,382
______
Commentary
In complex exam questions it is usually better to present your answer using the
second format i.e. with columns for years.
0505
2 TAXATION
2.1 Basic effect of the UK tax system
Taxation has two effects in investment appraisal
NEGATIVE POSITIVE
EFFECT EFFECT
Tax relief given

Tax charged on non-current assets
on operating via
results
WRITING DOWN
ALLOWANCES
¾ Operating results = revenues – ¾ Depreciation expense from the financial

operating costs statements is not a tax allowable
deduction in the UK
¾ Any tax relief on finance costs is
taken into account in the ¾ Instead companies can claim Writing
discount rate/cost of capital. Down Allowances (WDA’s), also called
Capital Allowances (CA’s)
¾ Details:
Often given at 25% reducing balance

– but exam question will tell you the
policy.
no WDA in year of sale; balancing

allowance/charge given instead,
representing a tax loss/gain on
disposal.
0506
2.2 Timing
The timing of tax cash flows is complex. Some exam questions will tell you that tax is paid
in the year of taxable profits, other questions will tell you tax is paid "one year in arrears” i.e.
in the following year,
T0 Year 1 T1 T2
¾ Assume net revenues (revenues minus operating costs) are received at the end of year 1
(T1)
Tax assessed at T1
Tax paid T2 (assuming tax is paid one year in arrears)
¾ If asset bought at start of year 1

First WDA received at T1 (date of next tax assessment)
Reduces tax payment at T2
¾ However if the asset is bought on the last day of the previous year i.e. on the date of a tax
assessment, the first WDA would be received immediately i.e. at T0 , which reduces the
tax payment at T1
Illustration 1
An asset is bought for $5,000 at the start of an accounting period. It is sold at

the end of the third accounting period for $1,000.
Corporation tax is 30% and paid one year in arrears. Writing down allowances
are available at 25% reducing balance.
What are the tax savings available and when do they arise?
Solution
Tax saving Timing

@ 30%
$ $ $
Cost 5,000
Year 1 WDA 25% (1,250) 375 T2
______
WDV c/f 3,750
Year 2 WDA 25% (938) 281 T3
______
WDV c/f 2,812
Year 3 Disposal (1,000)
______
Balancing allowance 1,812 544 T4
______
0507
2.3 Other assumptions
¾ Tax rate is constant.
¾ Sufficient taxable profits are available to use all tax deductions in full
¾ Working capital flows have no tax effects e.g. if the level of accounts receivable rises this
does not change the tax situation as tax is charged when revenues are recorded rather
than when the cash is received (see additional notes on working capital in the last
section of this chapter)
2.4 Dealing with taxation
Step 1 Set up table

T0 T1 T2 T3
REVENUE
Step 2 (a) Put in revenues Revenue x x
and operating costs
Operating costs (x) (x)
— — — —
(b) Total columns for net Net revenue x x

revenues
(c) Calculate tax payable on net Tax @ 30% (x) (x)

revenues
CAPITAL
Step 3 Put in capital outlay and any Investment (x)
disposal value Scrap proceeds x
Step 4 Calculate tax saving on WDAs WDA tax savings x x

— — — —
(x) x x (x)
Step 5 Total columns for net cash flows

and discount Discount factor r% x x x x
— — — —
Present value (x) x x x
— — — —
0508
Example 2
1 A company buys an asset for $10,000 at the beginning of an accounting

period (1 January 19.01) to undertake a two year project.
2 Net cash inflows received at the end of year 1 and year 2 are $5,000.
3 The company sells the asset on the last day of the second year for $6,000.
4 Corporation tax = 33% (paid one year in arrears)

Writing down allowance = 25% reducing balance
5 Cost of capital = 10%
Required:
Calculate the project’s NPV.
Solution
T0 T1 T2 T3
Net cash inflows

Tax @ 33%
Asset
Scrap proceeds
Tax savings on WDAs (W)
_______ _______ _______ _______
Net cash flow
Discount factor
Present value
WORKING
T0 PROFITS T1 T2
IN
YEAR 1
¾ Asset purchased 1 Jan 19.01 ¾ Asset sold 31 Dec 19.02

¾ First WDA will be set off ¾ No WDA in year of sale
against profits earned in year ¾ Balancing
1 (T1) allowance/charge
¾ First tax saving at T2
0509
$ Tax relief at Timing

33%
T0 Investment in asset
Year 1 WDA @ 25%
_______
Year 2 Proceeds
_______
Balancing allowance
Example 3
1 A company buys an asset for $10,000 at the end of the previous accounting
period (31 December 19.00) to undertake a two year project.
2 Net cash inflows received at the end of year 1 and year 2 are $5,000.
3 The asset has zero scrap value when it is disposed of at the end of year 2.
4 CT = 33% (paid one year in arrears)

WDA = 25% reducing balance
5 Cost of capital = 10%
Required:
Calculate the project’s NPV.
Solution
T0 T1 T2 T3
Net cash inflows 5,000 5,000
Tax @ 33% (1,650) (1,650)
Asset (10,000)
Tax saving on WDA (W)
_______ _______ _______ _______
Net cash flow
Discount factor
Present value
NPV =
0510
WORKING
Tax computation
PROFITS T0 T1 T2
IN
YEAR 0
¾ Asset purchased 31 Dec 19.00 ¾ Asset scrapped 31 Dec 19.02

against profits earned in prior
year
¾ First tax relief at T1
Tax relief at Timing

$ 33%
T0 Investment in asset 10,000
Year 0 WDA @ 25% (2,500) 825
_______
7,500
Year 1 WDA @ 25%
_______
Year 2 Proceeds –
_______
Balancing allowance
3 INFLATION
3.1 Why inflation is a problem for project appraisal
¾ It is hard to estimate, especially when rates are high.
¾ It causes governments to take actions which may impact on business e.g. raising interest
rates, cutting state spending.
¾ Differential inflation rates will occur; different costs and revenues will inflate at
different rates.
¾ It alters the cost of capital (in nominal terms).
¾ It makes historic costs irrelevant and therefore causes ROCE to be overstated.
¾ It creates uncertainty for customers, which may lead to lower demand.
¾ It encourages managers to become short-term in outlook.
0511
3.2 Real and money (or nominal) interest rates
¾ Real rate of interest reflects the rate of interest that would be required in the absence of
inflation.
¾ Money (or nominal) rate of interest reflects the real rate of interest adjusted for the effect
of general inflation (measured by the CPI – the Consumer Price Index).
Illustration 2
Suppose you invest $100 today for one year and, in the absence of inflation,
you require a return of 5%. The CPI is expected to rise by 10% over the coming
year.
In one year, in the absence of inflation, you require
$100 × 1.05 = $105
To maintain the purchasing power of your investment, i.e. to cover inflation

you require
$105 × 1.1 = $115.50
15.50
You therefore require a money return of = 15.5% over the year.
100
¾ Money rates, real rates and general inflation (CPI) are linked by the Fisher formula:
(1+money rate) = (1+real rate) (1+general inflation rate)
(1+i) = (1+r) (1+h)
i = nominal/money interest rate

r = real interest rate
h = general inflation rate
In the example above
(1 + i) = (1.05) (1.1) = 1.155
i = 15.5%
0512
3.3 General and specific inflation rates
¾ A specific inflation rate is the rate of inflation on an individual item e.g. wage inflation,
materials price inflation.
¾ The general inflation rate is a weighted average of many specific inflation rates, e.g. CPI
3.4 Cash flow forecasts
If there is inflation in the economy there are three ways in which the cash flow forecast for
project appraisal can be performed:
3.4.1 Current cash flows
¾ Cash flows expressed at today’s prices i.e. before the effects of inflation.
3.4.2 Money (or nominal) cash flows
¾ Cash flows are inflated to future price levels using the specific inflation rate for each type
of revenue/cost.
¾ This produces a forecast of the physical amount of money that will move in/out of the
company
3.4.3 Real cash flows
¾ Money cash flows with the effect of general inflation removed.
3.5 Discounting
There are three methods of discounting if there is inflation. Each method results in the same
NPV.
3.5.1 Money method
¾ Adjust each cash flow for specific inflation to convert to nominal/money cash flows.
¾ Discount using the nominal/money cost of capital.
3.5.2 Real method
¾ Remove the effects of general inflation from money cash flows to generate real cash
flows.
¾ Discount using the real cost of capital.
3.5.3 Effective method
¾ Express each type of cash flow in current terms i.e. at t0 prices
¾ Discount at the effective rate for that cash flow
(1+money rate) = (1+effective rate) (1+specific inflation rate)
0513
Illustration 3
One year project
Outlay at T0 = $5m
Sales for the year are expected to be $10m in current terms, with an expected
specific inflation rate of 5%
Costs for the year are expected to be $3m in current terms, with an expected
specific inflation rate of 3%
CPI expected to rise by 4%
Nominal cost of capital = 6%
Solutions
Money method
T0 T1
Outlay (5)
Sales 10 × 1.05 = 10.5
Costs (3) × 1.03 = (3.09)
___ _____
Money flows (5) 7.41
7.41
NPV = (5) + 1.06 = $1.99m
Real method
T0 T1
Money cash flow (5) 7.41
7.41
RPI 4%
1.04
Real cash flow (5) 7.125
(1 + i) = (1 + r) (1 + h)
(1.06) = (1 + r) (1.04)
r = 1.92307%
7.125
NPV = (5) + = $1.99m
1.0192307
0514
Commentary
⇒ As money flows are needed to do this, the money method might just as well be
used – it gives the same result.
⇒ Net cash flow expressed in current terms ($7m) is not the same as real cash flow
($7.125m), because sales and costs are not changing at CPI.
Effective method
¾ Effective discount rates:
for sales:
(1.06) = (1 + e) (1.05)
e = 0.95238%
for costs (1.06) = (1 + e) (1.03)

e = 2.91262%
¾ Technique
Discount cash flows expressed in current terms at effective rates
10 ( 3)
NPV = (5) + + = $1.99m
1.0095238 1.0921262
as before
¾ Effective method can be useful where an annuity is given in today’s prices.
Example 4
A project produces a cash inflow at the end of years 1–3 of $10,000 (at t0 prices).
Real cost of capital = 10%
CPI = 5%
Inflation of project cash flows = 8%
Required:
Calculate NPV using:
(i) money method

(ii) real method
(iii) effective method.
0515
Solution
(i) Money method
(1 + i) = (1 + r) (1 +h)
=
i=
t $ DF PV
$
1
2
3
______
______
(ii) Real method
t $ DF PV
$
1 (W)
2
3
______
______
WORKING
(iii) Effective method
e=
t $ DF PV
$
1–3 (W)
______
WORKING
0516
Example 5
1 A company buys a machine today for $10,000
2 Material costs at current prices will be $1,500 pa for three years

Material costs inflate at 8% pa
3 Labour savings at current prices will be $4,000 pa for three years

Labour costs inflate at 5% pa
4 Overhead savings at current prices will be $2,000 pa for three years

Overhead costs inflate at 10% pa
5 Money cost of capital = 15.5%
6 General inflation = 7%
Required:
Calculate the NPV of the project, using:
(i) the money method;

(ii) the effective method;
(iii) the real method.
Ignore taxation.
Solution
(i) Money method
T0 T1 T2 T3
$ $ $ $
Investment (10,000)
Materials
Labour savings
Overhead savings
______ _____ _____ _____
Net cash flow
Discount factor
______ _____ _____ _____
Present value
______ _____ _____ _____
NPV =
0517
(ii) Effective method
(a) Calculation of effective rates
Materials =
e =
Labour =
e =
Overheads =
e =
(b) Discount flows at effective rates
Time Cash flow Discount/ Present

annuity value
factor
0 Investment (10,000) 1 (10,000)
1−3 Material cost (W)
1−3 Labour saving †
Overhead saving †
1−3
_____
Net present value
_____
† from tables
(iii) Real method
T0 T1 T2 T3
Money cash flows (10,000) 4,780 5,080 5,403
÷
Real cash flows
Discount factor
Present value
NPV =
Real rate: (1+i) = (1+r)(1+h)

=
r =
0518
Example 6
A company is considering a project which requires the purchase of a machine

costing $250,000 on 1 January 19.04. Net inflows from the project are expected
to be $80,000 per annum in current terms for the next four years. At the end of
the project it is estimated that the machine will be sold for cash proceeds of
$50,000.
The company has a December year end and pays tax at 33%, 12 months after
the end of the accounting period. The project flows are expected to inflate at
5%, and the company’s money cost of capital is 15%. Writing Down
Allowances are given at 25% reducing balance.
Required:
Determine whether the company should proceed with the project.
Solution
WDA’s
$ Tax @ 33% Time

y/e 31 December 19.04
Purchase 250,000
WDA @ 25%
______

WDA @ 25%
______

WDA @ 25%
______

Sales proceeds
______
Balancing allowance
______
0519
Project appraisal
T0 T1 T2 T3 T4 T5
Inflows
Tax @ 33%
Initial investment
Scrap
Tax saving on
WDA’s
_______ _______ _______ _______ _______ _______
DF
_______ _______ _______ _______ _______ _______
PV
_______ _______ _______ _______ _______ _______
NPV =
Therefore,
4 WORKING CAPITAL
At the start of a project we usually see a cash outflow for the investment in non-current
assets e.g. plant and equipment. However many projects will also require an investment in
net current assets i.e. working capital. For project appraisal working capital is defined as
inventory + accounts receivable – accounts payable. Note that this definition excludes cash –
the cash flow is found as the change in the level of inventory + accounts receivable –
accounts payable.
For example at the start of the project inventory must be purchased, causing a cash outflow.
Over the life of the project the level of accounts receivable may rise, with the result that cash
inflows are less than the sales revenues. On the other hand the level of accounts payable
may also rise, reducing the required investment in working capital and improving the cash
flows because payments to suppliers are below the level of purchases. At the end of the
project the inventory levels may be reduced to zero, all receivables may be collected,
creating a cash inflow.
0520
Movements in working capital need to be incorporated into investment appraisals. Cash

flows are derived as follows:
¾ Increase in net working capital = cash outflow;
¾ Decrease in net working capital = cash inflow.
¾ Unless the question tells you otherwise assume that working capital is “released” at the
end of a project i.e. the investment in working capital falls to zero, creating a cash
inflow.
¾ Assume that changes in the level of working capital have no tax effects. This is a
realistic assumption because tax will be charged when net revenues accrue rather than
when the cash is received.
Example 7
A company plans to make sales of $100,000 at T1, increasing by 10% per annum
until T4. Working capital equal to 15% of annual sales is required at the start of
each year.
Required:
What is the total cash flow for each year?
Solution
T0 T1 T2 T3 T4
$ $ $ $ $
Sales
Cash re working capital (W)
Total cash flow
(W)
Sales
Level of working capital
Cash re working capital
0521
Key points
³ The golden rule – only discount future, incremental, operating cash flows.
³ Never discount depreciation – it is not a cash flow.
³ Do not discount finance costs – the cost of finance is measured in the
discount rate and is therefore already taken into account.
³ Exam questions will be in the environment o the UK tax system.

Depreciation expense is not a tax allowable deduction in the UK – instead
companies can claim Writing Down Allowances/Capital Allowances.
³ Discounting with inflation is a difficult area. The key here is consistency

i.e. if inflation is included in the cash flow forecast then make sure you
include it in the discount rate.
³ Adjusting for changes in working capital is relevant if you are given

accruals-based accounting information which needs to be converted to a
cash flow basis.
FOCUS
¾ distinguish relevant from non-relevant costs for investment appraisal;
¾ calculate the effect of Writing Down allowances and corporation tax on project cash
flows;
¾ explain the relationship between inflation and interest rates, distinguishing between
real and nominal rates;
¾ distinguish general inflation from specific price increases and assess their impact on
cash flows;
¾ evaluate capital investment projects on a real terms basis;
¾ evaluate capital investment projects on a nominal terms basis;
¾ evaluate capital investment projects on a current/effective terms basis;
¾ incorporate cash flows relating to changes in the level of working capital.
0522
EXAMPLE SOLUTIONS
Solution 1 — Relevant costs
Costs and revenues of proceeding with the project.
$
(1) Costs to date of $150,000 sunk – ∴ ignore. –
(2) Materials – purchase price of $60,000 is also sunk.
Opportunity benefit is disposal costs saved. 5,000
(3) Labour cost – direct cost of $40,000 will be incurred
regardless of whether or not the project is undertaken–
and so is not relevant. Opportunity cost of lost
contribution = 150,000 – (100,000 – 40,000) (90,000)
Absorption of overheads – irrelevant as it is merely an –
apportionment of existing costs
(4) Research staff costs
Wages for the year (60,000)
Redundancy pay increase (35,000 – 15,000) (20,000)
(5) Equipment
Deprival value if used in the project = disposal value (8,000)
Disposal proceeds in one year 6,000

(6) General building services
Apportioned costs irrelevant –
Opportunity costs rental forgone (7,000)
________
(174,000)
Sales value of project 300,000
________
Increased contribution from project 126,000
________
Advice. Proceed with the project.
0523
Solution 2 — Tax cash flows
T0 T1 T2 T3
Tax @ 33% (1,650) (1,650)
Asset (10,000)
Scrap proceeds 6,000
Tax savings on WDAs (W) 825 495
_______ _______ _______ _______
Net cash flow (10,000) 5,000 10,175 (1,155)
10% discount factor 1 0.909 0.826 0.751
Present Value (10,000) 4,545 8, 405 (867)
NPV = $2, 083

Accept project
WORKING
Tax computation
T0 PROFITS T1 T2
IN
YEAR 1
¾ Asset purchased 1 Jan 19.01 ¾ Asset sold 31 Dec 19.02

against profits earned in year
1 (T1)
$ Tax relief at Timing

33%
Year 1 WDA @ 25% (2,500) 825 T2
_______
7,500
Year 2 Proceeds (6,000)
_______
Balancing allowance (1,500) 495 T3
0524
Solution 3 — Tax cash flows
T0 T1 T2 T3
Tax @ 33% (1,650) (1,650)
Asset (10,000)
Tax saving on WDA (W) 825 619 1,856
_______ _______ _______ _______
Net cash flow (10,000) 5,825 3,969 206
10% discount factor 1 0.909 0.826 0.751
Present value (10,000) 5,295 3, 278 155
NPV = $(1, 272)

Reject project
WORKING
Tax computation
PROFITS T0 T1 T2
IN
YEAR 0
¾ Asset purchased 31 Dec 19.00 ¾ Asset scrapped 31 Dec 19.02

against profits earned in prior
year
Tax relief at Timing

$ 33%
Year 0 WDA @ 25% (2,500) 825 T1
_______
7,500
Year 1 WDA @ 25% (1,875) 619 T2
_______
5,625
Year 2 Proceeds –
_______
Balancing allowance 5,625 1,856 T3
0525
Solution 4 — Money, real and effective methods
(i) Money method
(1 + i) = (1 + r) (1 + h)
= 1.1 × 1.05
= 1.155
m = 15.5%
T $ DF (15.5%) PV
$
1 10,800 0.866 9,353
2 11,664 0.75 8,748
3 12,597 0.649 8,175
______
26,276
______
(ii) Real method
T $ DF (10%) PV
$
1 10,286 (W) 0.909 9,350
2 10,580 0.826 8,739
3 10,882 0.751 8,172
______
26,261
______
WORKING
10 ,800
1.05
(iii) Effective method
1.155 = (1 + e) 1.08
e = 6.94
T $ DF PV
$
1–3 10,000 2.627 (W) 26,270
______
WORKING
1  1 
1 −  = 2.627
0.0694  1.0694 3 
0526
Solution 5 — Money, real and effective methods
(i) Money method
T0 T1 T2 T3
$ $ $ $
Investment (10,000)
Materials (8%) (1,620) (1,750) (1,890)
Labour savings (5%) 4,200 4,410 4,631
Overhead savings (10%) 2,200 2,240 2,662
______ _____ _____ _____
Net cash flow (10,000) 4,780 5,080 5,403
Discount factor @ 15.5% 1 1 1 1
2 3
1155
. .
1155 .
1155
______ _____ _____ _____
Present value (10,000) 4,139 3,808 3,507
______ _____ _____ _____
NPV = $1,454
(ii) Effective method
(a) Calculation of effective rates
Materials (1.155) = (1 + e)(1.08)

e = 6.94%
Labour (1.155) = (1 + e)(1.05)

e = 10%
Overheads (1.155) = (1 + e)(1.05)

e = 5%
(b) Discount flows at effective rates
Time Cash flow Discount/ Present

annuity value
factor
0 Investment (10,000) 1 (10,000)
1−3 Material cost (1,500) 2.627(W) (3,941)
1−3 Labour saving 4,000 2.487† 9,948
1−3 Overhead saving 2,000 2.723† 5,446
_____
Net present value 1,453
_____
† from tables
WORKING
1  1 
3 year 6.94% annuity factor =  1− 3 
= 2.627
0.0694  1.0694 
0527
(iii) Real method
T0 T1 T2 T3
Money cash flows (10,000) 4,780 5,080 5,403
÷ 1 1.07 1.072 1.073
Real cash flows (10,000) 4,467 4,437 4,410
Discount factor @ 7.944% 1 0.926 0.858 0.795
Present value (10,000) 4,136 3,807 3,506
NPV = $1,449
Real rate : (1+i) = (1+r)(1+h)

1.155 = (1+r)(1.07)
r = 7.944%
Solution 6 — Tax and inflation
WDA’s
Tax @ 33% Time

Purchase 250,000
WDA @ 25% (62,500) 20,625 T2
______
187,500
WDA @ 25% (46,875) 15,469 T3
______
140,625
WDA @ 25% (35,156) 11,602 T4
______
105,469
Sales proceeds (50,000)
______
Balancing allowance 55,469 18,305 T5
______
0528
Project appraisal
T0 T1 T2 T3 T4 T5
Inflows 84,000 88,200 92,610 97,241
Tax @ 33% (27,720) (29,106) (30,561) (32,090)
Initial investment (250,000)
Scrap 50,000
WDA’s 20,625 15,469 11,602 18,305
_______ _______ _______ _______ _______ _______
(250,000) 84,000 81,105 78,973 128,282 (13,785)
DF @ 15% 1 0.870 0.756 0.658 0.572 0.497
_______ _______ _______ _______ _______ _______
PV (250,000) 73,080 61,315 51,964 73,377 (6,851)
_______ _______ _______ _______ _______ _______
NPV = $2,885
Therefore, accept the project
Solution 7 — Working capital
T0 T1 T2 T3 T4
$ $ $ $ $
Sales 100,000 110,000 121.000 131,100
Cash re working capital (W) (15,000) (1,500) (1,650) (1,815) 19,965
_______ _______ _______ _______ _______
Total cash flow
(15,000) 98,500 108,350 119,185 151,065
_______ _______ _______ _______ _______
(W)
Sales 100,000 110,000 121,000 131,100
Level of working capital 15,000 16,500 18,150 19,965 0
Cash re working capital (15,000) (1,500) (1,650) (1,815) 19,965
_______ _______ _______ _______ _______
0529
0530
SESSION 06 – APPLICATIONS OF DCF
OVERVIEW
Objective
¾ To apply discounted cash flow techniques to specific areas.
DCF
APPLICATIONS
ASSET
CAPITAL
REPLACEMENT LEASE v BUY
RATIONING
DECISIONS
¾ Definition ¾ The issue ¾ The issue
¾ Methods ¾ Limitations of replacement ¾ Decision-making
analysis ¾ The investment decision
¾ The financing decision
¾ The final decision
0601
1 CAPITAL RATIONING
1.1 Definition
A situation where there is not enough finance available to undertake all

available positive NPV projects.
¾ Hard capital rationing – where the capital markets impose limits on the amount of
finance available e.g. due to high perceived risk of the company.
¾ Soft rationing – where the company itself sets internal limits on finance availability e.g.
to encourage divisions to compete for funds.
¾ Single-period capital rationing – where capital is in short supply in only one period.
¾ Multi-period – where capital is rationed in two or more periods.
1.2 Methods
1.2.1 Divisible projects
A divisible project is where the company can undertake between 0-100% of the project -
infinite divisibility. However a project cannot be repeated.
¾ Calculate a “profitability index” for each project = NPV/Initial Investment
¾ Rank projects according to their index
¾ Allocate funds to the most effective projects in order to maximise NPV.
0602
Illustration 1
Projects A B C D
$000 $000 $000 $000
NPV 100 (50) 84 45
Cash flow at t0 (50) (10) (10) (15)
Cash rationed to $50,000 at t0

NPV 100 ( 50 ) 84 45
Investment 50 10 10 15
Cost benefit ratio =2 Reject = 8.4 =3
Rank 3 1 2
Plan: CASH NPV

___ ___
AVAILABLE 50
C (10) 84
___
40
D (15) 45
___
25
50% A (25) 50
___ _____
– $179
_____
1.2.2 Non-divisible projects
A non-divisible/indivisible project must be done 100% or not at all.
¾ Do not calculate a profitability index;
¾ Simply list all possible combinations of projects
¾ Choose combination with highest NPV.
Example 1
Detail as for Illustration 1 but assume that projects are non-divisible.
Solution
0603
1.2.3 Mutually-exclusive projects
Mutually exclusive projects is where two or more particular projects cannot be undertaken
at the same time e.g. because they use the same land.
¾ Divide projects into groups; with one of the mutually-exclusive projects in each group.
¾ Calculate the highest NPV available from each group (assume projects are divisible
unless told otherwise)
¾ Choose the group with the highest NPV
Example 2
As for Illustration 1 but C and D are mutually exclusive.
Solution
1.2.4 Multi-period capital rationing
¾ If finance is limited in several periods then a linear programming model would have to
be set up and solved in order to find the optimal investment strategy.
¾ This is outside of the scope of the syllabus
2 ASSET REPLACEMENT DECISIONS

2.1 The issue
¾ Assume that the company has already decided it requires a particular non-current asset.
¾ A secondary decision is about how often to replace the asset.
¾ For example how often should the company replace its fleet of motor vehicles or its
computer equipment?
¾ This is referred to as an asset replacement decision.
0604
Method:
1 Calculate the NPV of each possible replacement cycle.
2 Calculate the Annual Equivalent Cost (AEC) of each cycle
AEC = NPV/Annuity factor
3 Choose the cycle with the lowest AEC.
Example 3
A machine costs $20,000.
Running costs Scrap proceeds

Year 1 5,000 16,000
Year 2 5,500 13,000
Company’s cost of capital = 10%
Required:
Should the machine be replaced every one or every two years?
Replace every year
Time Cash flow Discount factor PV

0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909 (4,545)
1 Scrap proceeds 16,000 0.909 14,544
______
NPV = (10,001)
______
NPV 10,001
Annual equivalent cost = = = $11,002
1 year 0.909
annuity factor
Now repeat the above procedure, assuming the machine is replaced every two years.
0605
Replace after two years
Time Narrative Cash flow Discount factor Present

@ 10% value
0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909
2 Running costs (5,500) 0.826
2 Scrap proceeds 13,000 0.826
______
NPV =
______
Annual equivalent cost =
Conclusion:
2.2 Limitations of replacement analysis
¾ Changing technology e.g. it may be advisable to replace IT equipment more often than
suggested by the above analysis.
¾ Asset requirements may change over time.
¾ Non-financial factors e.g. employees may be more satisfied if their company cars are
replaced more often.
3 LEASE v BUY
3.1 The issue
¾ Should the company acquire an asset through:
A straight purchase i.e. borrowing to buy, or

A lease.
¾ There are two main types of lease:
Operating lease; where the asset is simply rented for a relatively short part of its
useful economic life;
Financial/capital lease; where the asset is leased for most of its life.
¾ Although the distinction between operating and finance lease is very important in
financial reporting, it is not so relevant in financial management.
¾ The important issue for financial management is the cash flows created by a lease, as
compared to a straight purchase of the asset.
0606
3.2 Decision-making
TWO DECISIONS
INVESTMENT DECISIONS FINANCING DECISIONS
Does the asset give operational benefits? Is it cheaper to buy or lease?
Focus on the relative beefits of

Focus on the NPV of the operating cash
WDA’s from buying and the tax
flows
relief on the lease payments.
Discount these cash flows using a rate Discount these cash flows using
which reflects operating risk of after-tax cost of borrowing
investment e.g average cost of capital
Commentary
¾ The issue here is stripping financing cash flows from operating cash flows and
using separate discount rates for each.
¾ Examination questions may focus merely on the financing decisions.
3.3 The investment decision
Discount the cash flows from using the asset (sales, materials, labour, overheads, tax on net
cash flows, etc) at the firm’s weighted average cost of capital (WACC).
3.4 The financing decision
Discount the cash flows specific to each financing option at the after-tax cost of debt. The
assumption is that shareholders view borrowing and leasing as equivalent in terms of
financial risk, so the after-tax cost of debt is an appropriate discount rate for both options.
The preferred financing option will be that with the lowest NPV of cost.
The relevant cash flows for each possible method of financing are as follows.
Buy asset – Purchase cost, tax saving on WDA’s, scrap

proceeds
Lease asset (operating – Lease payments, tax saving on lease payments

or finance lease)
Under UK tax law all lease payments are tax allowable deductions – both for finance leases
and operating leases.
0607
3.5 The final decision
If the NPV of the cost of the best finance source is less than the NPV of the operating cash
flows, then the project should be undertaken.
Example 4
New project
Asset costs $200,000 on the first day of a new accounting period.
Scrap value $25,000 on the last day of the next accounting period.
Operating inflows $150,000 for two years.
Tax at 33% and paid one year in arrears.
Weighted average cost of capital 10%.
Capital allowances at 25% reducing balance.
Finance options:
(1) borrowing at a post-tax cost of 7%;

(2) lease for $92,500 per year in advance for two years (lease payments
are tax allowable).
Required:
(a) Determine whether the project is operationally acceptable.

(b) Determine how the project should be financed.
(c) Decide whether it is worth undertaking.
0608
Solution
(a) Investment decision
Project appraisal
Time Cash flow Narrative DF @ 10% PV

$ $
1–2 150,000 Project returns
2–3 (49,500) Tax on profits
________
Present value
________
(b) Financing decision
(1) Borrow and buy flows

$ $
0 (200,000) Purchase cost
2 25,000 Sale proceeds
2 16,500 (W)
3 41,250 (W)
________
________
(W) WDA’s
Time Tax effect Time

at 33%
$ $
0 Purchase 200,000
1 WDA at 25%
________
WDV b/f
Sale 25,000
________
2 Balancing allowance
________
0609
(2) Leasing flows

$ $
0–1 (92,500) Lease payments
2–3 30,525 Tax relief
________
PV of leasing
________
flows
(c) Final decision
$
PV of operating flows
PV of leasing flows (cheapest finance – see (b))
________
NPV
________
Key points
³ With capital rationing it is essential to identify the nature of the projects

i.e. divisible or non-divisible, mutually exclusive or not.
³ With asset replacement decisions, the key is the use of Annual Equivalent
Cost to compare cycles of different lengths.
³ With lease vs. buy decisions, the key is to separate the financing decision
from the investment decision and analyse each at a discount rate reflecting
the risk of the cash flows. Also remember all lease payments are tax
deductible expenses in the UK.
FOCUS
¾ distinguish between hard and soft capital rationing;
¾ apply profitability index techniques for single period divisible projects;
¾ use DCF to analyse asset replacement decisions;
¾ apply DCF methods to projects involving lease or buy problems.
0610
EXAMPLE SOLUTION
Solution 1 — Non-divisible
Combinations NPV
$000
A only 100
C+D 129
... Choose C + D.
Solution 2 — Mutually exclusive
Group 1 Group 2
$000 $000
A B C A B D
NPV 100 (50) 84 100 (50) 45
$ 50 10 10 50 10 15
___ ___ ___ ___ ___ ___
Index 2 (5) 8.4 2 (5) 3
___ ___ ___ ___ ___ ___
Rank 2 Reject 1 2 Reject 1
Plan
NPV Capital NPV Capital
50 50
Accept C 84 (10) Accept D 45 (15)
___ ___
Accept 0.8 A 80 (40) Accept 0.7 A 70 (35)
___ ___ ___ ___
164 115
___ ___
... Accept C and 0.8A.
Solution 3 — Machine replacement
Replace after two years
Time Narrative Cash flow Discount factor Present

@ 10% value
0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909 (4,545)
2 Running costs (5,500) 0.826 (4,543)
2 Scrap proceeds 13,000 0.826 10,738
______
NPV = (18,350)
18,350 18,350
Annual equivalent = = = $10 ,570
2 year 10% AF 1.736
Conclusion. Replace every two years.
0611
Solution 4 — Financing decision
Project appraisal

$ $
1–2 150,000 Project returns 1.736 260,400
2–3 (49,500) Tax on above 1.578 (78,111)
_______
Present value 182,289
_______
∴ Project operationally acceptable.
(b) Financing decision
(1) Borrow and buy flows

$ $
0 (200,000) Purchase cost 1 (200,000)
2 25,000 Sale proceeds 0.873 21,825
2 16,500 (W) 0.873 14,405
3 41,250 (W) 0.816 33,660
________
(130,110)
________
(W) WDA’s
Time Tax effect Time

at 33%
$ $
0 Purchase 200,000
1 WDA at 25% (50,000) 16,500 2
________
WDV b/f 150,000
Sale 25,000
________
2 Balancing allowance 125,000 41,250 3
________
(2) Leasing flows

$ $
0–1 (92,500) Lease payments 1.935 (178,988)
2–3 30,525 Tax relief thereon 0.873 + 0.816 51,557
= 1.689
________
PV of leasing flows (127,431)
________
Conclusion: The cheapest method of finance is to lease.
0612
(c) Final decision
$
PV of operating flows 182,289
PV of leasing flows (cheapest finance – see (b)) (127,431)
________
NPV 54,858
________
The asset should be acquired using a lease.
0613
0614
SESSION 07 – PROJECT APPRAISAL UNDER RISK
OVERVIEW
Objective
¾ To appraise investment projects where the outcome is not certain.
¾ Definitions
RISK AND REDUCTION OF
¾ Sources of risk
UNCERTAINTY RISK
SENSITIVITY STATISTICAL
SIMULATION
ANALYSIS MEASURES
¾ Definition ¾ Use ¾ Expected values

¾ Method ¾ Stages ¾ Standard deviation
¾ Advantages ¾ Advantages
¾ Limitations ¾ Limitations
0701
1 RISK AND UNCERTAINTY
1.1 Definition
1.1.1 Risk
A condition in which several possible outcomes exist, the probabilities of

which can be quantified from historical data.
1.1.2 Uncertainty
The inability to predict possible outcomes due to a lack of historical data

being available for quantification.
1.2 Sources of risk in projects
The major risks to the success of an investment project will be the variability of the future
cash flows. This could be the variability of income streams or the variability of cost cash
flows or a combination of both.
2 SENSITIVITY ANALYSIS
Definition
The analysis of changes made to significant variables in order to determine

their effect on a planned course of action.
The cash flows, probabilities, or cost of capital are varied until the decision changes, i.e. the
NPV becomes zero. This will show the sensitivity of the decision to changes in those
elements.
Therefore the estimation of IRR is an example if sensitivity analysis, in this case on the cost
of capital.
Sensitivity analysis can also be referred to as “what if?” analysis.
2.1 Method
Step 1 Calculate the NPV of the project on the basis of best estimates.
Step 2 For each element of the decision (cash flows, cost of capital)
calculate the change necessary for the NPV to fall to zero.
The sensitivity can be expressed as a % change.
For an individual cash flow in the computation
0702
NPV
Sensitivity = × 100%
PV of flow considered
Commentary
For change in sales volume, the factor to consider is contribution. This may involve
combining a number of flows.
Example 1
Williams has just set up a company, JPR Manufacturing Ltd, and estimates its cost of
capital to be 15%. His first project involves investing in $150,000 of equipment with a
life of 15 years and a final scrap value of $15,000.
The equipment will be used to produce 15,000 deluxe pairs of rugby boots per annum
generating a contribution of $2.75 per pair. He estimates that annual fixed costs will be
$15,000 per annum.
Required:
(a) Determine, on the basis of the above figures, whether the project is
worthwhile.
(b) Calculate what percentage changes in the factors would cause your
decision in (a) change.
(i) initial investment

(ii) volume
(iii) fixed costs
(iv) scrap value
(v) cost of capital
Comment on your results.
Ignore tax.
703
Solution
(a) Time Cash flow DF @ 15% PV

$ $
0 Initial cost
1 − 15 Contribution
1 − 15 Fixed costs
15 Scrap value
_______
_______
(b) The sensitivity of the decision in (a) can be calculated by expressing the
NPV as a percentage of the various factors.
Sensitivity =
(ii) Volume
The PV figure of contribution is directly proportional to volume.
Sensitivity =
(iii) Fixed costs
Sensitivity =
(iv) Scrap value
Sensitivity =
(v) Sensitivity to cost of capital
This can be found by calculating the project’s IRR:
Year Cash flow factor Present value

$ $
0 (150,000) 1
1-15 26,250
15 15,000
_______
NPV
_______
0704
IRR NPV1
= r1 + (r2 − r1 )
NPV1 − NPV2
2.2 Advantages of sensitivity analysis
9 It gives an idea of how sensitive the project is to changes in any of the original estimates.
9 It directs management attention to checking the quality of data for the most sensitive
variables.
9 It identifies the Critical Success Factors for the project and directs project management.
9 It can be easily adapted for use in spreadsheet packages.
2.3 Limitations
8 Although it can be adapted to deal with multi-variable changes, sensitivity is normally

only used to examine what happens when one variable changes and others remain
constant.
8 Assumes data for all other variables is accurate.
8 Without a computer it can be time-consuming.
8 Probability of changes is not considered.
3 SIMULATION
3.1 Use of simulation
Simulation is a technique which allows more than one variable to change at the same time.
One example of simulation is the “Monte Carlo” method. Calculations will not be required
in the exam, an awareness of the stages is sufficient.
3.2 Stages in a Monte Carlo simulation
(1) Specify the major variables.
(2) Specify the relationship between the variables.
(3) Attach probability distributions to each variable and assign random numbers to reflect
the distribution.
(4) Simulate the environment by generating random numbers.
705
(5) Record the outcome of each simulation.
(6) Repeat simulation many times to obtain a probability distribution of the likely outcomes.
3.3 Advantages
9 It gives more information about the possible outcomes and their relative probabilities.
9 It is useful for problems which cannot be solved analytically.
3.4 Limitations
8 It is not a technique for making a decision, only for obtaining more information about
the possible outcomes.
8 It can be very time-consuming without a computer.
8 It could prove expensive in designing and running the simulation, even on a computer.
8 Simulations are only as good as the probabilities, assumptions and estimates made.
4 STATISTICAL MEASURES
4.1 Expected values
The quantitative result of weighting uncertain events by the probability of their occurrence.
4.1.1 Calculation
Expected value = weighted arithmetic mean of possible outcomes.

∑
= x p(x)
Where x = value of an outcome, p(x) = probability of that outcome , ∑ = sum
Example 2
State of market Diminishing Static Expanding

Probability 0.4 0.3 0.3
Project 1 100 200 1,000
Project 2 0 500 600
Figures represent the net present value of projects under each market state in
$m.
Required:
Determine which is the best project based on expected values.
0706
Solution
Project 1 Expected value =

The best project based on expected values is
4.1.2 Advantages
9 It reduces the information to one number for each choice.
9 The idea of an average is readily understood.
4.1.3 Limitations
8 The probabilities of the different possible outcomes may be difficult to estimate.
8 The average may not correspond to any of the possible outcomes.
8 Unless the same decision has to be made many times, the average will not be achieved;
it is therefore not a valid way of making a decision in “one-off” situations.
8 The average gives no indication of the spread of possible results, i.e. it ignores risk.
4.2 Standard deviation
A measure of variation of numerical values from a mean value.
A measure of spread i.e. it indicates the likely level of variation from an expected value.
Exam questions are more likely to provide standard deviation for interpretation, rather than
to require its calculation.
4.2.1 Calculation
σ = standard deviation =
∑ (x − x ) 2
prob ( x )
x = each observation
x = mean of observations
Prob (x) = probability of each observation
Note that variance = σ2
707
Example 3
Using the information from Example 2, calculate the standard deviation for
each project.
Solution
Strategy 1
Strategy 2
Strategy 3
4.2.2 Advantages
9 It gives an idea of the spread of possible results around the average.
9 It can be used in further mathematical analysis, in particularly using Normal

Distributions.”
4.2.3 Limitations
8 The calculation of standard deviation can be difficult.
8 The exact meaning is not widely understood by non-financial managers.
5 REDUCTION OF RISK
Ways of reducing project risk:
¾ Setting a maximum payback period.
¾ Use of a higher discount rate − therefore reducing the influence of distant cash flows.
¾ Select projects with a combination of low standard deviation and acceptable average
predicted outcome.
¾ More effort directed to Critical Success Factors indicated by sensitivity analysis.
0708
Key points
³ Exam calculations on project risk are likely to focus on sensitivity analysis

i.e. finding the value of key variables at which NPV = 0.
³ Adjusting the discount rate to reflect a project’s risk is dealt with later in
the session on the Capital Asset Pricing Model (CAPM).
FOCUS
¾ distinguish between risk and uncertainty;
¾ evaluate the sensitivity of project NPV to changes in key variables;
¾ explain the role of simulation in generating a probability distribution for the NPV of a
project;
¾ apply the probability approach to calculating expected NPV of a project and the
associated standard deviation.
709
EXAMPLE SOLUTION
Solution 1 — Sensitivity analysis
(a) Time Cash flow DF @ 15% PV

$ $
0 Initial cost (150,000) 1 (150,000)
1 − 15 Contribution 41,250 5.847 241,189
1 − 15 Fixed costs (15,000) 5.847 (87,705)
15 Scrap value 15,000 0.123 1,845
_______
5,329
_______
The project is worthwhile as NPV is positive
(b) The sensitivity of the decision in (a) can be calculated by expressing

the NPV as a percentage of the various factors.
If the initial investment rises by more than $5,329, the project would be
rejected.
5,329
Sensitivity = × 100 = 3.6%
150 ,000
(ii) Volume
The PV figure of contribution $241,189 is directly proportional to

volume. If this PV is reduced by more than $5,329, the project would
be rejected.
5 ,329
241,189
(iii) Fixed costs
5,329
87 ,705
0710
(iv) Scrap value
5 ,329
Sensitivity = × 100 = 289%
1,845
From the above calculations the decision to accept the project is

extremely sensitive to most of the figures given in the question. The
project will be rejected in the event of small rises in the initial
investment or fixed cost figures or falls in contribution or volume. It
could be seen, for instance, that the project just breaks even if fixed
costs become $15,000 × 1.06 = $15,900.
The scrap value is relatively irrelevant to the investment decision – we

would have to pay to have the plant taken away before the project
would be rejected.
(v) Sensitivity to cost of capital
This can be found by calculating the project’s IRR, which is probably

only marginally above 15%.
Year Cash flow 16% factor Present value

$ $
0 (150,000) 1 (150,000)
1-15 26,250 5.575 146,344
15 15,000 0.108 1,620
_______
NPV at 16% (2,036)
_______
IRR NPV1
= r1 + (r − r )
NPV1 − NPV2 2 1
5,329
= 15% + (16% − 15%)
5,329 + 2,036
= 15.7%
If the cost of capital rises from 15% to more than 15.7% the project
would be rejected.
Solution 2 — Expected values
Project 1 Expected value = 100 × 0.4 + 200 × 0.3 + 1,000 × 0.3 = 400
Project 2 Expected value = 0 × 0.4 + 500 × 0.3 + 600 × 0.3 = 330
Project 3 Expected value = 180 × 0.4 + 190 × 0.3 + 200 × 0.3 = 189
Therefore, based on expected values, Project 1 should be adopted.
711
Solution 3 — Standard deviation
Strategy 1 ( 100 − 400 ) 2 × 0.4 + (200 − 400) 2 × 0.3 + (1,000 − 400) 2 × 3

= 156,000 = 395
Strategy 2 ( 0 − 330 )2 × 0.4 + (500 − 330)2 × 0.3 + (600 − 330) 2 × 0.2

= 74 ,100 = 272
Strategy 3 ( 180 − 189 ) 2 × 0.4 + (190 − 189) 2 × 0.3 + (200 − 189)2 × 0.3
= 69 = 8.3
0712
SESSION 08 – EQUITY FINANCE
OVERVIEW
Objective
¾ To understand the options available to a company considering an issue of equity funds.
EQUITY
FINANCE DIVIDENDS
METHODS OF INTERNAL DIVIDEND

SHARE ISSUE EQUITY FINANCE POLICY
¾ Quoted ¾ Stable
¾ Unquoted ¾ Constant payout ratio
¾ Considerations ¾ Residual dividend policy
¾ Official Listing ¾ Clientele theory
¾ AIM Listing ¾ Bird in the Hand Theory
¾ Rights issue ¾ Dividend Irrelevance Theory
¾ Enterprise Investment Scheme ¾ Share Buy Back Programmes
¾ Venture capital ¾ Special Dividends
¾ Practical considerations
OTHER TYPES OF
SHARE ISSUE
¾ Bonus issue
¾ Stock splits
¾ Scrip dividends
0801
1 METHODS OF SHARE ISSUE

1.1 New shares — quoted companies
If a company is already listed the following methods are available for the issue of new
shares.
Method Explanation
Offer for subscription A sale direct to the general public. This is generally the most
(public issue) expensive method of issuing new shares.
Offer for sale A sale indirect to the public via selling shares directly to an issuing
house (merchant/investment bank) which then sells them to the
public.
Placing In a placing the sponsor (normally a merchant bank) places the

shares with its clients. At least 25% of shares placed must,
however, be made available to the general public. This is
generally the least expensive method of issuing new shares.
Rights issue An offer to existing shareholders to buy shares in proportion to

their existing holdings.
Offer for sale or Like an auction – the public is invited to bid for shares. Useful
subscription by tender where setting a price for the shares is difficult.
Vendor placing Sometimes used in takeovers when a predator company buys a

target company by offering its own shares but pre-arranges third
party buyers for those shares. The result is that the target
company shareholders are confident that they will be able to sell
the shares they receive in the predator company.
1.2 Options for unquoted companies
¾ Become quoted, i.e. raise new equity finance at the same time as becoming listed –
known as an IPO (Initial Public Offering) The method could be an offer for
subscription or sale, tender, or placing.
¾ Stay unquoted. Use rights issue or private placing. However there may be a limited
source of funds from either existing owners or new private investors.
¾ Introduction. Existing shares are given permission to be traded/”floated” on the Stock

Exchange. No new finance is raised. Public must already hold at least 25% of the shares
in the company.
Commentary
The terms “quoted”, “floated” and “listed” all refer to the same thing i.e. shares which
are traded on a stock exchange.
0802
Many small or medium sized enterprises (SME’s) find that raising equity is difficult. This is
an acknowledged problem and has been addressed by both government and commerce.
Attempted solutions include the AIM, Enterprise Investment Schemes, Venture Capital and
Venture Capital Trusts (discussed later).
1.3 Considerations when considering a share issue
¾ Legal restrictions;
¾ Cost e.g. fees must be paid to an investment bank to underwrite/guarantee the share
issue
¾ Pricing problems;
¾ Stock Exchange rules as contained in the Yellow Book;
¾ Timing.
1.4 The requirements for an Official Listing
Before the shares of a company can receive an Official Listing i.e. become traded on the full
London Stock Exchange, the following requirements must be met:
¾ The market capitalisation (value) is at least £700,000;

¾ There is a three year trading record;
¾ At least 25% of the shares are made available to the general public;
¾ Detailed disclosure requirements are met;
¾ Any new issue of shares is accompanied by a detailed prospectus.
The costs of acquiring and maintaining an Official Listing mean that it is not really a
possibility for Small or Medium-sized Enterprises (SME’s). These companies may find the
AIM market more attractive.
1.5 The requirements for an Alternative Investment Market (AIM) Listing
The AIM market has fewer regulations and in this way is attractive to smaller companies.
Investors recognise that due to the more limited regulation, investment in AIM companies
carries additional risk.
The requirements include:
¾ Companies must have plc or equivalent (if non-UK) status;
¾ The accounts must conform to UK or US accounting practice;
¾ A prospectus must be published prior to the initial quotation and any following issue of
securities;
¾ The company must appoint a “nominated advisor” which may be an investment bank,
accountancy or law firm to ensure that it understands and obeys the rules of the market.
0803
1.6 Rights issue
In a rights issue existing shareholders are offered more shares (usually at a discount to the
current market price) in proportion to their existing holding.
UK company law guarantees shareholders “pre-emptive rights” i.e. the right to purchase
new shares before they can be offered to other investors. This is to protect shareholders from
dilution of their control
The result of issuing these shares at a discount is to reduce the market value of all the shares
in issue.
Calculation of a theoretical ex-rights price.
Example 1
A company has 100,000 shares with a current market price of $2 each.
It then announces that it is to take on a project with a NPV of $25,000.
The project will be financed by a rights issue of one new share for every two
existing shares. The rights price is $1 per new share.
Required:
What is the theoretical ex-rights price of the company’s shares?
Shareholder wealth and rights issues
Example 2
Assume in Example 1 above that Mr X owns 1,000 shares in the company.
Required:
Show Mr X’s position if:
(i) he takes up his rights;

(ii) he sells his rights;
(iii) he does nothing.
0804
1.7 Enterprise Investment Scheme (EIS)
¾ A UK scheme designed to encourage private investors to buy shares in unlisted trading

companies.
¾ Tax relief, at an income tax rate of 20%, is available for investors.
¾ Maximum investment is £100,000 per annum
¾ Shares must be held for five years.
1.8 Venture capital
¾ What is it?
“Venture capital” simply means equity capital for small and growing businesses. It
includes funds provided for management buy-outs. Typically $1m minimum is
involved.
¾ Who provides it?
Specialist venture capital providers, e.g. “Investors In Industry” (the 3i Group);

Banks, insurance companies, pension funds;
Local authorities and development agencies.
¾ What do they look for?
Product with strong potential e.g. a new innovation ;

Solid management;
High returns.
¾ What conditions are normally attached?
Providers of funds would normally expect:
a business plan with medium-term cash flow and profit projections ;

board representation;
a dividend policy which promotes growth i.e. high reinvestment of profits;
an “exit route” e.g. proposed time-scale for seeking a market quotation;
provision of regular management accounting information.
¾ Venture Capital Trusts (VCTs)
VCTs are listed investment trust companies which invest at least 70% of their funds
in a spread of small unquoted trading companies.
An investment trust company one is which invests in other companies.
The UK government gives tax incentives to individual investors in VCTs
0805
2 INTERNAL EQUITY FINANCE

As an alternative to issuing new shares (or debt) a company can finance its investment
projects using retained earnings i.e. using internal finance rather than external finance.
¾ The amount of internal finance available = cash generated from operations – dividend
payments.
¾ Creating accounting profits is not enough – the company must be converting profits
into positive cash flows.
¾ Note that Microsoft did not pay any dividends for many years - it reinvested all cash to
produce growth of the company and its share price. Any shareholder that required a
dividend could simply sell some shares to take a capital gain and create a “home- made
dividend”.
¾ Company managers may prefer to use internal finance rather than external finance for
the following reasons:
a belief that using internal finance costs nothing – in fact this is not true as retained
earnings belong to the shareholders who expect significant returns.
“asymmetry of information” – external investors do not have as much knowledge

of the business as the management and are therefore often reluctant to provide
finance or will only provide it at high cost. This is particularly significant for SME’s
which often have problems attracting new investors due to little public knowledge
of the business. Using internal finance avoids the problem.
no issue costs on internal finance
internal finance avoids possible change in control due to issue of new shares
taxation position of shareholders: - they may prefer to make a capital gain than
receive current income via dividends e.g. in the UK individuals are given a large
tax-free limit on capital gains.
¾ This preference for internal finance has been refereed to as “Pecking Order Theory”
3 DIVIDEND POLICY
3.1 Stable
¾ Stable level of dividends or constant level of growth to avoid sharp movements in share
price.
¾ Maintains the level of dividends in the face of fluctuating earnings.
¾ Very common approach for quoted companies.
0806
3.2 Constant payout ratio
¾ Constant proportion of earnings paid out as dividend;
¾ Not particularly suitable as dividends will fluctuate.
3.3 Residual dividend policy
¾ Remaining earnings, after funding all attractive projects, are paid out as dividend i.e.
dividend = cash generated from operations – capital expenditure.
¾ Links to Pecking Order Theory i.e. a dividend is only paid if more cash is available than
required for reinvestment back into the business.
¾ However it is likely to lead to fluctuating dividends and may not particularly suitable
for quoted companies.
3.4 Clientele theory
¾ The company’s historical dividend policy may have attracted particular investors to
whom the policy is suited in terms of tax, need for current income, etc
¾ The company should then maintain a stable dividend policy or risk losing key investors.
¾ Management should view shareholders as their “clientele”
3.5 Bird in the Hand Theory
¾ Shareholders may prefer higher dividends (and therefore lower potential capital gains)
as a cash dividend today is without risk whereas future share price growth is uncertain.
3.6 Dividend Irrelevance Theory
¾ Modigliani and Miller (finance theorists) argue that shareholders are indifferent to
dividend policy.
¾ If a company pays no dividend then the share price should rise due to reinvestment of
earnings. Any shareholder that requires a dividend can sell part of their holding to
create a capital gain i.e. to manufacture a “home made” dividend.
3.7 Share Buy Back Programmes
¾ In recent years there has been a trend for traditional dividend payments to be replaced
by share repurchase schemes.
¾ With approval from shareholders the company uses surplus cash to buy back part of its
share capital, on the assumption that shareholders can reinvest this cash more
effectively than the company.
¾ The buy back can be performed either by writing directly to all shareholders with an
offer to buy shares at a fixed price (a “tender offer”) or by purchasing shares via the
stock market at the prevailing price.
0807
¾ The shares are either cancelled as held by the company as Treasury Shares for possible
future reissue. If held by the company the shares carry no voting rights or dividend.
¾ The result of a buy back programme is that there will be fewer shares in issue, and
hence the share price should rise.
¾ Ratios such as Earnings Per Share (EPS) and Return on Equity (ROE) should also
improve.
3.8 Special Dividends
¾ If a quoted company announces a larger than expected dividend this may raise market
expectations of at least the same in future.
¾ To avoid raising expectations to an unsustainable level the dividend may be announced

as a “special” dividend – basically a bonus dividend.
¾ The company is telling the markets that, from time to time, any exceptional cash surplus
will be returned in this way, but that this should not be built into dividend per share
forecasts.
3.9 Practical considerations
¾ Company law - a dividend can only be legally paid if there is a credit balance on
retained earnings in the balance sheet.
¾ Level of inflation.
¾ Liquidity position.
¾ Stability of earnings – if earnings are stable, a larger dividend can be more easily
maintained.
¾ “Signalling” – dividend announcements are seen by the financial markets as a sign of

company strength/weakness.
4 OTHER TYPES OF SHARE ISSUE

4.1 Bonus issue
¾ Reserves e.g. revaluation reserve is converted into share capital which is distributed as
new shares to existing shareholders in proportion to their existing holdings.
¾ No finance is raised
¾ Purpose − Increases the marketability of the shares, as it increases the number in

existence and reduces their price.
¾ Bonus issues can also be referred to as Scrip Issues or a Capitalisation of Reserves.
0808
4.2 Stock splits
¾ Where ordinary shares are split in value, e.g. $1 shares converted into two 50 cent
shares.
¾ This reduces the market price per share, increasing their marketability.
4.3 Scrip dividends
¾ Shareholders are offered extra shares instead of a cash dividend.
¾ This preserves corporate liquidity and releases cash for reinvestment back into the
business - linking to Pecking Order Theory
Key points
³ Ordinary shareholders take more risk than any other type of investor in a
company.
³ This is because (i) ordinary dividends are discretionary i.e. the company has
no legal obligation to pay an ordinary dividend (ii) ordinary shareholders
rank last in the event of bankruptcy/liquidation.
³ Shareholders require high returns to compensate for this risk and therefore
issuing new shares is an expensive source of finance.
³ However sometimes a new share issue is the only available source of

finance and therefore you need to be familiar with the methods of issue
available to both listed and unlisted companies.
0809
FOCUS
¾ describe the methods available for issuing new shares;
¾ describe ways in which a company may obtain a stock market listing;
¾ calculate the theoretical ex-rights price of a share;
¾ explain the importance of internally generated funds;
¾ discuss the main dividend policies followed by companies;
¾ explain the purpose and impact of a bonus issue, scrip dividends and stock splits;
¾ discuss the financing problems of small and medium sized enterprises (SME’s);
¾ suggest appropriate sources of equity finance for SME’s e.g. AIM, venture capital, EIS.
0810
EXAMPLE SOLUTIONS
Solution 1
Ex-rights price
MV of old shares pre - rights issue + Proceeds of rights issue + NPV

=
No. of shares ex - rights
(100 ,000 × $2 ) + ( 50 ,000 × $1) + $25,000

= = $1.83
100 ,000 + 50 ,000
Value of a right per new share
= Ex-rights price – Subscription price

= $1.83 – $1 = 83c
Value of a right per existing share
= 83c ÷ 2 = 41c
Note - If the market price of the existing shares had been given post the announcement of the
project, then the NPV of $25,000 would already be included in the MV of the old shares.
This is the more usual circumstance.
Solution 2
(i) Takes up rights
$
Wealth prior to rights issue 1,000 × $2 2,000
______
Wealth post rights issue 1,500 × $1.831/3 2,750

Less Rights cost 500 × $1 (500)
______
2,250
______
∴ $250 better off
0811
(ii) Sells rights
$
Wealth prior to rights issue 1,000 × $2 2,000
______
Wealth post rights issue
Shares 1,000 × $1.831/3 1,8331/3
Sale of rights 500 × $0.831/3 4162/3
______
2,250
______
∴ $250 better off
(iii) Does nothing
$
Wealth prior to rights issue 2,000
______
Wealth post rights issue 1,8331/3

______
∴ Loss of $166
0812
SESSION 09 – DEBT FINANCE
OVERVIEW
Objective
¾ To appreciate the options available to a company for long, medium and short-term debt
finance.
DEBT
FINANCE
LONG-TERM MEDIUM-TERM SHORT-TERM

OTHER SOURCES
FINANCE FINANCE FINANCE
¾ Preference shares ¾ Bank loans ¾ Bank overdraft ¾ Grants

¾ Debentures ¾ Leasing ¾ Trade credit ¾ Loan guarantee
¾ Deep discount bonds ¾ Sale and leaseback ¾ Bills of exchange scheme
¾ Zero coupon bonds ¾ Mortgage loans ¾ Commercial paper ¾ Business angels
¾ Tax relief on interest
CONVERTIBLES
AND WARRANTS
¾ Convertibles
¾ Effect on EPS of convertible debt
¾ Warrants
0901
1 LONG-TERM FINANCE
1.1 Preference shares
Definition
Shares with a fixed rate of dividend having a prior claim on profits available
for distribution.
Whilst legally equity, they are often treated as debt as they are similar in nature to debt.
1.1.1 Features
¾ Shares which have a fixed percentage dividend payable before ordinary dividend.
¾ The dividend is only payable if there are sufficient distributable profits. However if the
shares are cumulative preference shares the right of dividend is carried forward. Any
arrears of dividend are then payable before ordinary dividends.
¾ As with ordinary dividends, preference dividends are not deductible for corporate tax
purposes – they are a distribution of profit rather than an expense.
¾ On liquidation of the company, preference shareholders rank before ordinary

shareholders.
1.1.2 Advantages
9 No voting rights; therefore no dilution of control.
9 Compared to the issue of debt:
Dividends do not have to be paid if profits are poor;

Not secured on company assets;
Non-payment of dividend does not give holders the right to appoint a liquidator.
1.1.3 Disadvantages
8 Dividends are not tax deductible (unlike interest on debt).
8 To attract investors the company needs to pay a higher return to compensate for
additional risk compared to debt.
0902
1.2 Debentures
Definition
A written acknowledgement of a debt, usually given under the company’s seal,

containing provisions for payment of interest and repayment of principal. The
debt may be secured on some or all of the company’s assets
Type Secured debentures Unsecured debentures
Security and ¾ Can be secured on one or more ¾ No security.

voting rights specific assets - a “fixed charge” e.g.
over property ¾ Holders have the same rights as
ordinary creditors.
¾ Or a “floating charge” can be offered
over a class of assets e.g. over net ¾ No voting rights.
current assets (working capital)
¾ On default the assets are sold and

debt repaid
¾ No voting rights.
Income ¾ A fixed annual amount, usually ¾ A fixed annual amount, usually

expressed as a % of nominal value. expressed as a % of nominal value.
Amount of ¾ A fixed amount per unit of loan stock ¾ A fixed amount per unit of loan
capital or debenture. stock or debenture.
In the UK debentures are usually issued with a face value of £100. They can then be traded
on the bond market and reach a market price. Hence, if a debenture is said to be selling at a
premium of £15%, this means that a debenture with a face value of £100 is currently selling
for £115. This indicates that the rate of interest on this debenture is attractive when
compared with current market rates, creating demand for the debenture and a rise in price.
In the US the face value of each debenture is usually $1000.
Note – the terms “debenture”, “loan stock” and “bond” all basically refer to the same thing
i.e. a written acknowledgement of a company’s debt which can then be traded. Also “face
value” can also be referred to as “par value” of “nominal value”.
0903
1.3 Deep discount bonds
Definition
Loan stock issued at a large discount to nominal value − redeemable at par on

maturity
¾ Investors receive large capital gain on redemption, but low rate of interest during term
of the loan.
¾ Cash flow advantage to the borrower – useful for financing projects which produce
weak cash flows in early years.
Illustration 1
A five year $1000 3% Bond issued at $800 would generate the following cash
inflows/(outflows) for the issuing company:
t0 t1 t2 t3 t4 t5
Issue price 800
Interest (30) (30) (30) (30) (30)
Redemption (1000)
1.4 Zero coupon bonds
Definition
Bonds issued at a discount to face value and which pay zero annual interest
¾ No interest is paid.
¾ Investors gain from the difference between issue and redemption price.
¾ Advantages to borrowers:
No cash payout until maturity;

Cost of redemption known at time of issue.
1.5 Tax relief on debt interest
¾ Interest expense is tax deductible and therefore reduces corporate tax payments.
¾ Regarding the tax system the Issue of debt is preferable to the issue of shares as
dividends are not allowable for tax.
0904
Illustration 2
CoA CoB
Profit before tax 100 100
Interest − (10)
___ ___
100 90
Corporation tax 30% (30) (27)
___ ___
70 63
$7 difference
Effective cost of debt in CoB
Interest 10
Less Tax relief (3)
___
$7
___
¾ After-tax cost of debt = Pre-tax cost of debt × (1 – Tax rate)
¾ The fact that interest on debt is tax allowable is referred to as the “tax shield”
2 CONVERTIBLES AND WARRANTS

2.1 Convertibles
Definition
Bonds or preference shares that can be converted into ordinary shares.
¾ Pay fixed interest or dividend until converted.
¾ They may be:
converted into ordinary shares;

on a pre-determined date;
at a pre-determined rate;
at the option of the holder.
¾ Conversion ratio may change during the period of convertibility − to stimulate early
conversion.
0905
¾ Advantages to investors − a relatively low risk investment with the opportunity to make
high returns upon converting to ordinary shares.
¾ Advantages to issuing company − can offer a lower rate of interest than on “straight”
debentures.
2.2 Effect on EPS (Earnings Per Share) of convertible debt
Convertible debentures require a “fully diluted” EPS to be calculated to indicate what EPS
might be if debt is converted into equity.
Method
¾ Increase earnings by the loan interest saved, net of tax.
¾ Increase the number of shares due to conversion.
¾ Recalculate EPS
2.3 Warrants
Definition
A right given to an investor to subscribe cash for new shares at a future date at
a fixed price − the exercise price.
¾ Warrants are sometimes attached to loan stock, to make the loan stock more attractive.
¾ Warrants are basically share options
¾ The holder of the warrants may sell them rather than keep them.
Advantages to issuing company
9 The warrants themselves do not involve the payment of any interest or dividends.
9 When they are initially attached to loan stock, the interest rate on the loan stock will be
lower than for comparable straight debt. This due to the additional benefit for the
investor of potential equity shares at an attractive price.
9 May make an issue of unsecured loan stock possible where no adequate security exists.
0906
3 MEDIUM-TERM FINANCE
3.1 Bank loans
3.1.1 Advantages
9 The loan will be for a fixed term: no risk of early recall;

9 Interest rate may be fixed.
3.1.2 Disadvantages
8 Inflexible;
8 May require security,
8 May require “covenants” – restrictions on the company e.g. limits on dividend
payments, limits on further borrowing.
3.2 Leasing
3.2.1 Advantages
9 Many willing providers;

9 Remains off-balance sheet if an operating lease;
9 Matches finance to the asset ;
9 Very flexible packages available, some of which include maintenance.
3.2.2 Disadvantage
8 Can be costly.
3.3 Sale and leaseback
Property is sold to an institution, such as a pension fund, and then leased back to the
company.
3.3.1 Advantages
9 Releases significant funds;

9 May improve ratios such as ROCE (Return on Capital Employed).
3.3.2 Disadvantages
8 No longer own property and hence cannot participate in any future increase in value;
8 Risk of lease payments increasing.
0907
3.4 Mortgage loan — a loan secured on property.
3.4.1 Advantages
9 Given the security, the loan will attract a lower interest rate than other debt;
9 Institutions will be willing to lend over a longer term;
9 Still participate in the growth in value of the property.
3.4.2 Disadvantage
8 Default may result in a key asset being liquidated
4 SHORT-TERM FINANCE
4.1 Bank overdraft
4.1.1 Advantages
9 Flexible;
9 Provides instant finance.
4.1.2 Disadvantages
8 Repayable on call, unless the bank offers a “revolving line of credit”

8 High and variable interest rate.
4.2 Trade credit
4.2.1 Advantages
9 Generally cheap;
9 Flexible.
4.2.2 Disadvantages
8 May lose settlement (quick payment) discounts;

8 May lose suppliers’ goodwill.
0908
4.3 Bills of exchange
Definition
An acknowledgement of a debt to be paid at some time in the future e.g. by a

customer. Such a bill may then be ”discounted” i.e. sold to a third party for a %
of face value
4.3.1 Advantages
9 Improves cash flow.

9 Flexible.
4.3.2 Disadvantages
8 Fees.
Illustration 3
X sells $2m worth of goods to Y. X writes out (“draws”) a bill of exchange for
$2m payable in 2 months (say) which it sends to Y. Y signs the bill to
acknowledge the debt and returns it to X.
X can hold on to the bill for 2 months until Y pays the debtor sell it at a
discount e.g. at 98%of face value. The buyer of the bill then receives the $2m
and makes a gain.
4.4 Commercial Paper
Definition
Commercial paper is short-term (usually less than 270 days) unsecured debt
issued by high quality companies. The paper can then be traded by investors
on the bond markets.
4.4.1 Advantages
9 Large sums can be raised and relatively cheaply

9 No security required
4.4.2 Disadvantages
8 Only available to large companies with very good credit ratings
0909
5 OTHER SOURCES
Commentary
The following are particularly suitable for small and medium sized enterprises (SME’s)
which are of particular interest to the examiner as they often have difficulty finding
debt finance. Such difficulties may be caused by”asymmetry of information” – where
banks fear making loans to companies which are not well known and without published
credit ratings.
5.1 Grants
Depending upon the location and nature of the business local, regional, national or
European grant assistance may be available.
5.2 Loan guarantee scheme
Just as small/medium sized companies find it hard to raise equity, they can also find it hard
to raise debt, due to their high perceived risk. The Loan Guarantee Scheme is a UK
government-backed scheme where, for a fee, a substantial proportion of the loan may be
guaranteed. Hence potential providers of that loan are willing to lend, as most of their risk
has been eliminated.
5.3 Business angels
Business angels are rich individuals who are prepared to invest money in small companies if
they see high potential for growth
Such angels are often retired businesspeople who became wealthy as entrepreneurs in the
high-tech sector.
They may also give useful advice as well as finance and may even be able to use their
contacts to obtain new business for the companies they invest in.
0910
Key points
³ Preference shares are in substance debt as they pay a fixed committed

dividend in priority to any ordinary dividend. They also rank ahead of
ordinary shareholders upon liquidation (although after “real” debt such as
bank loans and debentures)
³ Preference shareholders therefore face lower risk than ordinary

shareholders and require lower returns
³ However banks and bondholders take even lower risks, as they rank
ahead of preference shareholders upon bankruptcy, and their debts may
be secured by fixed or floating charge over assets. Providers of loans
therefore require lower returns than other providers of finance.
³ Hence loans are the least expensive source of finance for a company,
particularly if the effect of the tax system is introduced (loan interest is a
tax allowable expense, unlike dividends.)
³ Unfortunately debt also has a dark side – too much debt may increase the
risks faced by shareholders to unacceptable levels.
FOCUS
¾ explain the features of preference shares and the reasons for their issue;
¾ explain the features of different types of long-term straight debt and the reasons for
their issue;
¾ explain the features of convertible debt and warrants and the reasons for their issue;
¾ assess the effect on EPS of conversion and option rights;
¾ suggest appropriate sources of debt finance for SME’s e.g. leasing, loan guarantee
scheme, and business angels.
0911
0912
SESSION 10 – SECURITY VALUATION AND THE COST OF CAPITAL
OVERVIEW
Objective
¾ To develop a model for the valuation of shares and bonds.
¾ To use this model to estimate the cost of equity and the cost of debt.
¾ To consider further practical influences on the valuation of securities.
SECURITY
VALUATION AND THE
COST OF CAPITAL
EQUITY DEBT
ANALYSIS ANALYSIS
¾ Dividend Valuation Model ¾ Irredeemable debentures

¾ Cost of equity ¾ Redeemable debentures
¾ Semi-annual interest
¾ Convertible debentures
1001
1 DIVIDEND VALUATION MODEL

1.1 The general model
¾ The dividend valuation model states that:
“the market value of a share or other security is equal to the present value of the
future expected cash flows from the security discounted at the investor’s required
rate of return”.
¾ A security is any traded investment e.g. shares and bonds.
1.2 Constant Dividend
¾ The formula for share valuation can be developed as follows:
Ex-div market value at time 0 = Present value of the future dividends

discounted at the shareholders’
required rate of return
¾ Ex-div market value is the market value assuming that a dividend has just been
paid.
¾ Let:
Po = Current ex-div market value

Dn = Dividend at time n
ke = Shareholders’ required rate of return/company’s cost of equity
¾ The model then becomes:
D1 D2 D3 Dn
Po = + + .....
(1 + ke) 2 3 n
(1 + ke) (1 + ke) (1 + ke)
¾ If the dividend is assumed to be constant to infinity this becomes the present

value of a perpetuity which simplifies to:
D
Po =
ke
¾ This version of the model can be used to determine the theoretical value of a share
which pays a constant dividend e.g. a preference share or an ordinary share in a zero
growth company.
1002
1.3 Constant growth in dividends
¾ If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate
D0(1 + g) D1
Po = =
ke − g ke − g
where Do = most recent dividend

D1 = dividend in one year
The formula is published in the exam in the following format:
D O (1 + g )
PO =
(re − g )
Where re = required return of equity investors = ke
1.4 Assumptions behind the dividend valuation model
¾ rational investors
¾ all investors have the same expectations and therefore the same required rate of return
¾ perfect capital market assumptions, e.g.,
no transactions costs
large number of buyers and sellers of shares
no individual can affect the share price
all investors have all available information
¾ dividends are paid just once a year and one year apart
¾ dividends are either constant or are growing at a constant rate.
1.5 Uses of the dividend valuation model
¾ The model can be used to estimate the theoretical fair value of shares in unlisted
companies where a quoted market price is not known. .
¾ However if the company is listed, and the share price is therefore known, the model can
be used to estimate the required return of shareholders i.e. the company’s cost of equity
finance.
1003
Illustration 1
Suppose that a share has a current ex-div market value of 80 cents and
investors expect a dividend of 10 cents per share to be paid each year as has
been the case for the past few years.
Using the dividend valuation model the required return of the investors for
this share can be determined:
D
Po =
ke
10c
80c =
ke
10c
ke =
80c
ke = 12.5%
Investors will all require this return from the share as the model assumes they
all have the same information about the risk of this share and they are all
rational.
If investors think that the dividend is due to increase to 15 cents each year then
at a price of 80 cents the share is giving a higher return than 12.5%. Investors
will therefore buy the share and the price will increase until, according to the
model, the value will be:
15c
Po = = 120 cents
0.125
Alternatively suppose that the investors' perception is that the dividend will
remain at 10 cents per share but that the risk of the share has increased thereby
requiring a return of 15%. If the share only gives a return of 12.5% (on an 80
cents share price) then investors will sell and the price will fall. The fair value
of the share according to the model will be:
10c
Po = = 66.7 cents
0.15
1004
1.6 Practical factors affecting share prices
¾ The dividend valuation model gives a theoretical value, under the assumptions of the
model, for any security.
¾ In practice there will be many factors other than the present value of cash flows from a
security that play a part in its valuation. These are likely to include:
interest rates
market sentiment
expectation of future events
inflation
press comment
speculation and rumour
currency movements
takeover and merger activity
political issues.
The dividend valuation model helps us to understand how a change in these

variables should affect the market value of the security.
¾ Share prices change, often dramatically, on a daily basis. The dividend valuation model
will not predict this, but will give an estimate of the underlying fair value of the shares.
2 COST OF EQUITY
2.1 Shareholders required rate of return
¾ The basic dividend valuation model is:
D
Po =
ke
¾ This can be rearranged to find ke:
D
ke =
Po
¾ If ke is the return required by the shareholders in order for the share value to remain
constant then ke is also the return that the company must pay to its shareholders.
Therefore ke also equates to the cost of equity of the company.
¾ Therefore the cost of equity for a company with a constant annual dividend can be
estimated as the dividend divided into the ex-div share price i.e. the dividend yield.
¾ The ex-div market value is the market value of the share assuming that the current
dividend has just been paid. A cum-div market value is one which includes the value of
the dividend just about to be paid. If a cum-div market value is given then this must be
adjusted to an ex div market value by taking out the current dividend.
1005
Example 1
A company’s shares have a market value of $2.20 each. The company is just
about to pay a dividend of 20c per share as it has every year for the last ten
years.
What is the company’s cost of equity?
Solution
2.2 Dividend with constant growth
¾ The model can also deal with a dividend that is growing at a constant annual rate of g.
¾ The formula for valuing the share is as seen earlier:
D 0 (1 + g) D1
Po = =
ke − g ke − g

¾ Rearranged this becomes
D0(1 + g)
ke = +g
Po
where g = growth rate (assumed constant in perpetuity).
where Po = ex div market value
¾ Therefore the cost of equity = dividend yield + estimated growth rate
1006
Illustration 2
Do = 12c, Po (ex div) = $1.75, g = 5%.
What is the value of ke?
0.12 (1.05)
ke = + 0.05
1.75
= 12.2%
¾ The growth rate of dividends can be estimated using either of two methods.
Two methods
Extrapolation of Gordon’s growth model

past dividends
2.3 Growth from past dividends
¾ Look at historical growth and use this to predict future growth. If you have specific
information about future growth, use that.
If dividends have grown at 5% in each of the last 20 years, predicted future growth
= 5%.
Uneven but steady growth – take an average overall growth rate.
Discontinuity in growth rate – take the most recent evidence.
New company with very high growth rates – take care! It is unlikely to produce
such high growth in perpetuity.
No pattern – do not use this method (i.e. dividends up one year, down the next).
1007
Example 2
A company has paid the following dividends over the last five years.
Cents per share

19X0 100
19X1 110
19X2 125
19X3 136
19X4 145
Estimate the growth rate and the cost of equity if the current (19X4) ex div
market value is $10.50 per share.
Solution
2.4 Gordon’s growth model
¾ Gordon’s growth model states that growth is achieved by retention and reinvestment of
profits.
g = bre
b = proportion of profits retained
re = return on equity
¾ Take an average of r and b over the preceding years to estimate future growth.
Profit after tax Profit after tax

re = =
Shareholders' funds Net assets
Retained profit
b =
Profit after tax
¾ These figures can be obtained from the balance sheet and profit and loss account.
1008
Example 3
A company has 300,000 ordinary shares in issue with an ex-div market value of
$2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits
of $100,000.
Net assets at the year end were valued at $1.06m.
Estimate the cost of equity.
Solution
1009
2.5 Cost of equity and project appraisal
Illustration 3
A plc is all equity financed and has 1m shares quoted at $2 each ex div. It pays
constant annual dividends of 30c per share.
It is considering adopting a project which will cost $500,000 and which is of the
same risk as its existing activities. The cost will be met by a rights issue. The
project will produce inflows of $90,000 pa in perpetuity. All inflows will be
distributed as dividends.
What is the new value of the equity in A plc and what is the gain to the
shareholders? Ignore tax.
0.30
¾ ke = = 15%
2.00
¾ New dividend
$
Existing total dividend 300,000
Dividends from the project 90,000
New total dividend 390,000
390 ,000
Value of equity =
0.15
= $2,600,000
Shareholders’ gain = $(2,600,000 – 2,000,000) – $500,000
= $100,000
90 ,000
Project NPV = ($500,000) + = $100,000
0.15
Therefore, new value of equity = Existing value + Equity outlay + NPV
= Existing value + Present value of

additional dividends
¾ Therefore the NPV of a project serves to increase the value of the company’s shares i.e.
the NPV of a project shows the increase in shareholders’ wealth.
¾ This proves that NPV is the correct method of project appraisal – it is the only method
consistent with the assumed objective of maximising shareholders’ wealth.
1010
2.6 Cost of preference shares
¾ By definition preference shares have a constant dividend
D
¾ Ke =
Po
¾ where D = constant annual dividend
¾ Preference dividends are normally quoted as a percentage, e.g. 10% preference shares.
This means that the annual dividend will be 10% of the nominal value, not the market
value.
Example 4
A company has 100,000 12% preference shares in issue (nominal value $1).
The current ex-div market value is $1.15 per share.
What is the cost of the preference shares?
Solution
3 COST OF DEBT
3.1 Terminology of debentures
A debenture is a written acknowledgement of a company’s debt. A debenture usually pays a

fixed rate of interest and it may be secured or unsecured. It may be traded on the bond
market and will reach a market price. The terms debenture, bond and loan stock all basically
refer to the same thing i.e. traded corporate debt (unlike bank loans which are not traded).
¾ The coupon rate is the interest rate printed on the debenture certificate.
Annual interest = coupon rate × nominal value
Nominal value is also known as par or face value. In the exam the nominal value of one
debenture is usually $100.
¾ Market value (MV) is normally quoted as the MV of a block of $100 nominal value.
e.g. 10% debentures quoted at $95 means that a $100 block is selling for $95 and annual
interest is $10 per $100 block.
1011
3.2 Irredeemable debentures
Irredeemable debentures are a type of debt finance where the company will never repay the
principal but will pay interest each year until infinity. They are also referred to as undated
debentures.
¾ Using the same logic as for dividends and looking at the cash flows from the investor’s
point of view:
¾ MV (ex interest) = present value of future interest payments discounted at the

debenture-holder’s required rate of return
¾ For irredeemable debentures the interest is perpetuity.
I
¾ MV (ex int) =
r
where I = annual interest received

r = return required by debenture holder
I
¾ r = = Interest yield
MV (ex int)
¾ The company gets tax relief on the debenture interest it pays, which reduces the cost of
debentures to the company – known as the “tax shield” on debt.
Illustration 4
Consider two companies with the same earnings before interest and tax (EBIT).
The first company uses some debt finance, the second uses no debt.
$ $
EBIT 100 100
Debt interest (10)
___ ___
Profits before tax 90 100
Tax @ 33% 29.70 33
$3.30 difference
Therefore
Effective cost of debt
$
Debt interest 10.00
Less Tax shield (3.30)
_____
Effective cost of debt 6.70
_____
1012
¾ Because of tax relief, the cost to the company is not equal to the required return of the
debenture holders.
Unless told otherwise, we assume that tax relief is instant (in practice, there will be a
minimum time lag of nine months under the UK tax system
¾ Note that if debt is irredeemable then:
Cost of debt to the company (also = Return required by the debenture

known as the post tax cost of debt) holders × (1–Tc)
= Interest yield × (1–Tc)
Where Tc = corporate tax rate as a decimal
¾ Kd can be used to denote the cost of debt – but care is needed as to whether it is stated
pre-tax or post-tax.
Example 5
12% undated debentures with a nominal value of $100 are quoted at $92 cum
interest. The rate of corporation tax is 33%.
Find
(a) the return required by the debenture-holders
(b) the cost to the company.
Solution
1013
3.3 Redeemable debentures/dated debentures
¾ The cash flows are not a perpetuity because the principal will be repaid. However from
the dividend valuation model we can derive the following rule:
The cost of any source of funds is the IRR of the cash flows associated with that source.
¾ If we are looking at the return from an investor’s point of view, interest payments are
included gross.
¾ If we are looking at the cost to the company, we take the interest payments net of
corporation tax. Assume instant tax relief.
¾ Assume that the final redemption payment does not have any tax effects.
¾ To find the cost of debt for a company find the IRR of the following cash flows:
Time $
0 Ex int MV (x)
1−n Interest net of corporation tax x
n Redemption value x
The IRR is found as usual using linear interpolation.
Example 6
A company has in issue $200,000 7% debentures redeemable at a premium of

5% on 31 December 19X6. Interest is paid annually on the debentures on 31
December. It is currently 1 January 19X3 and the debentures are trading at $98
ex interest. Corporation tax is 33%.
What is the cost of debt for this company?
Solution
1014
¾ Care should be taken not to confuse the required return of the debenture holders with
the cost of debt of the company.
Required return of the = IRR of pre-tax cash = Gross redemption

redeemable debenture flows from the yield
holder debenture
¾ Gross Redemption Yield is also referred to as the Yield To Maturity (YTM)
¾ The cost of debt of the company is then determined by finding the IRR of the market
value, net of tax interest payments and redemption value.
Example 7
A company has 8% debentures redeemable at a 5% premium in ten years.

Debenture-holders require a return of 10%.
What is the cost to the company? Corporation tax is 33%.
Solution
1015
3.4 Semi-annual interest payments
¾ In practice debenture interest is usually paid every six months rather than annually.
This practical aspect can be built into our calculations for the cost of debt.
¾ If interest payments are being made every 6 months then when the IRR of the debenture
cash flows is calculated it should be done on the basis of each time period being 6
months.
¾ The IRR, or cost of debt, will then be a 6 monthly cost of debt and must be adjusted to
determine the annual cost of debt.
¾ Effective annual cost = (1+semi annual cost)2 -1
Example 8
A company has in issue 6% debentures the interest on which is paid on 30 June

and 31 December each year. The debentures are redeemable at par on 31
December 19X9. It is now 1 January 19X7 and the debentures are quoted at
96% ex interest.
What is the effective annual cost of debt for the company? Ignore corporation
tax.
Solution
1016
3.5 Convertible debentures
¾ Convertible debentures allow the investor to choose between redeeming the debentures
at some future date or converting them into a pre-determined number of ordinary
shares in the company.
¾ In order to find the cost of convertibles it is necessary to be able to determine which

option the investor will exercise and at what date.
¾ This will normally involve the following stages:
Step 1 Estimate the value of the conversion option

Step 2 Compare the conversion option with the redemption option. As investors are
rational it can be assumed that they will all choose the option with the higher
value.
Step 3 Calculate the IRR of the cash flows as for redeemable debentures using either
the conversion value or redemption value as determined in Step 2.
Example 9
A company has in issue some 8% convertible loan stock currently quoted at $85
ex interest. The loan stock is redeemable at a 5% premium in five years time, or
can be converted into 40 ordinary shares at that date. The current ex-div
market value of the shares is $2 per share and dividend growth is expected at
7% per annum. Corporation tax is 33%.
What is the cost to the company of the convertible loan stock?
Solution
1017
Key points
³ If capital markets are perfect the sale/purchase of any security must be a

zero NPV transaction i.e. market price = present value of future cash flows
discounted at investors’ required return.
³ This general rule can be specifically applied to shares to develop the

dividend valuation model (DVM) and also to bond valuation.
³ If the market price of a security is already known then the model can be re-
arranged to find the required return of investors’ i.e. the company’s cost of
equity/debt finance.
³ Care must be taken with the cost of debt as interest, unlike dividends, is a
tax allowable expense form the side of the company.
FOCUS
¾ understand and use the dividend valuation model;
¾ estimate the cost of equity and cost of debt for a company;
¾ understand the practical factors that affect share prices.
1018
EXAMPLE SOLUTION
Solution 1
Po (cum div) = $2.20
Po (ex div) = $2.00
D
Ke =
Po
20
= × 100%
200
= 10%
Solution 2
19X0–19X4 − four changes in dividend
100 (1 + g)4 = 145
145
(1 + g)4 =
100
145
1+g = 4
100
= 1.097
g = 9.7%
D1
ke = +g
P0
145 (1.097 )
= + 0.097
1,050
= 24.8%
1019
Solution 3
Growth rate g = bre
b = % profit retained
60 ,000
=
100 ,000
= 60%
re = Return on equity
Profit after tax

=
Opening net assets
100,000
= × 100%
1,060,000 − 60,000
= 10%
Note – return on average equity could be used rather than return on opening equity.
g = 0.6 × 0.1
= 0.06
= 6%
D1
ke = +g
P0
40 ,000 (1.06)
= + 0.06
300 ,000 × 2.70
= 11.2%
Solution 4
12% preference shares: dividend is 12% × nominal value
D
Ke =
Po
12
= × 100%
115
= 10.4%
1020
Solution 5
Int
r =
MV ex int
12
= × 100%
92 − 12
= 15%
Return required by debenture-holders is 15%.
Cost to the company
Int (1 − Tc )
Kd =
MV ex int
12 (1 − 0.33)
=
92 − 12
= 10.05%
Solution 6
Time Cash PV @ 10% PV @ 5%

flow
0 (98) (98) (98)
7 × 0.67
1−4 = 4.69 14.87 16.63
4 105 71.72 86.42
_______ _______
(11.41) 5.05
_______ _______
5.05
IRR = 5 + × (10 − 5)
5.05 + 11.41
Kd = 6.5%
1021
Solution 7
To find the cost to the company, we need to know the market value of the debentures.
We do this by discounting the future flows at the debenture-holder’s required return.
MV = (8 × 6.145) + (105 × 0.386)
= $89.69
To find the cost to the company we do an IRR calculation, bringing in the effects of tax relief.
DF @ 10% PV DF @ 5% PV
$ $
t0 (89.69) 1 (89.69) 1 (89.69)
t1–10 8 (1 – 0.33) 6.145 32.94 7.722 41.39
t10 105 0.386 40.53 0.614 64.47
______ ______
(16.22) 16.17
______ ______
NA
IRR = A+ (B − A)
NA − NB
16.17
= 5+ × (10 – 5)
16.17 + 16.22
= 7.5%
Therefore Kd = 7.5%
Solution 8
Time 0 is 1 January 19X7
Interest payments due
30 June X7 Time 1
31 Dec X7 Time 2
30 June X8 Time 3
31 Dec X8 Time 4
30 June X9 Time 5
31 Dec X9 Time 6
1022
Each interest payment will be just half of the coupon rate, $3 each 6 months.
Time Cash flow PV @ 3% PV @ 5%

0 (96) (96) (96)
1−6 3 16.25 15.23
6 100 83.70 74.60
______ ______
3.95 (6.17)
______ ______
3.95
IRR = 3+ × ( 5 − 3)
3.95 + 6.17
= 3.78%
This is the 6 monthly cost of debt.
The effective annual cost of debt is (1.03782) -1 = 7.7%
Solution 9
First we need to decide whether the loan stock will be converted or not in five years. To do
this we compare the expected value of 40 shares in five years’ time with the cash alternative.
We assume that the MV of shares will grow at the same rate as the dividends.
MV/share in five years = 2(1.07)5 = $2.81
MV of 40 shares × $2.81 = $112.40
Cash alternative = $105
Therefore all loan stock-holders will choose the share conversion.
To find the cost to the company, find the IRR of the post-tax flows.
DF @ 5% PV DF @ 10% PV
$ $
t0 (85) 1 (85.00) 1 (85.00)
t1−5 8(1 – 0.33) 4.329 23.20 3.791 20.32
t5 112.4 0.784 88.12 0.621 69.80
______ ______
26.32 5.12
______ ______
26.32
IRR = 5+ × (10 – 5)
26.32 − 5.12
= 11.2%
Therefore cost to the company = 11.2%.
1023
1024
SESSION 11 – WEIGHTED AVERAGE COST OF CAPITAL AND GEARING
OVERVIEW
Objective
¾ To understand the weighted average cost of capital (WACC) of a company and how it is
estimated.
¾ To understand the effect of gearing on the WACC of a company.
¾ To discuss the theories of Modigliani and Miller.
WEIGHTED AVERAGE
COST OF CAPITAL
AND GEARING
WEIGHTED
AVERAGE COST GEARING
OF CAPITAL
¾ Calculation of WACC ¾ The effects of gearing
¾ Limitations of WACC ¾ Traditional view of capital structure
¾ Modigliani and Miller’s theories
1101
1 WEIGHTED AVERAGE COST OF CAPITAL

1.1 Calculation of WACC
¾ Companies are usually financed by both debt and equity, i.e. they use some degree of
financial/capital gearing. We must therefore calculate a weighted average cost of
capital (WACC) which represents a company’s average cost of long-term finance. This
will give us a potential discount rate for project appraisal using NPV.
¾ In the previous session we saw how to estimate the cost of equity and the cost of
various types of debt.
¾ We weight the various costs of debt and equity using their respective market values.
KegE + Kd1D1 + Kd2D2 + ... +

WACC =
E + D1 + D2 + ... +
Written as
KegE + KdD E D
WACC = OR WACC = Keg + Kd
E+ D E+D E+D
Where:
E = Total market value of equity

D = Total market value of debt
Keg= Cost of equity of a geared company
Kd = Cost of debt to the company (i.e. the post tax cost of debt)
In the exam the formula is given as follows:
 Ve   Vd 
WACC =  ke +  kd(1 − T )

 Ve + Vd   Ve + Vd 
Where:
Ve = Total market value of equity Vd = Total market value of debt
Ke = Cost of equity geared
Kd = Pre-tax cost of debt T = corporation tax rate
Note that the post tax cost of debt = Kd (1 – T) for irredeemable debentures or bank loans.
If you are given a redeemable bond then you should calculate the IRR of its post-tax cash
flows which directly gives you the post-tax cost of debt.
1102
A company’s current WACC is used as the discount rate only if
Proportion of
debt to equity
does not change
Project is financed Project has same

by existing pool of funds business risk as
existing operations
i.e. a company’s existing WACC can only be used as the discount rate for a potential project
if that project does not change the company’s:
¾ Gearing level i.e. Financial Risk
¾ Business Risk
¾ More detail on the important concepts of Financial Risk and Business Risk is found in
the next section.
Example 1
A company has in issue:

45 million $1 ordinary shares
10% irredeemable loan stock with a book value of $55million
The loan stock is trading at par.
Share price $1.50
Dividend 15c (just paid)
Dividend growth 5% pa
Corporation tax 33%
Estimate the WACC.
Solution
1103
1.2 Limitations of WACC
LIMITATIONS
THEORETICAL PRACTICAL
Assumes perfect capital market
Assumes CALCULATION
− market value of shares OF Ke
Estimation of “g”
= present value of dividend stream
− market value of debt
− historical data used to
= present value of interest/principal
estimate future growth rates
− Gordon’s model assumes all
Current WACC can only be used to
growth is financed by retained
assess projects
earnings
which
Share price may not be in
− have similar operating risk to equilibrium
that of the company
− are financed by the company’s pool Ignores impact of personal
of funds, ie have same financial risk taxation
A h
CALCULATION OF Kd
Assumes constant tax rates
Bond price may not be in equilibrium
Difficulty in incorporating all

forms of long term finance, eg
BANK OVERDRAFT CONVERTIBLE FOREIGN LOANS

LOAN STOCK
Current liability but often Final cash flow is uncertain Exchange rates will
has permanent core affect the value of
Investor has option of the loans to be
Must be aplit between fixed and included and
variable element (i) taking the redemption interest payments
value, or
Put fixed element in calculation (ii) converting into shares
Assume it will be redeemed

unless data is available to
suggest conversion
1104
¾ These problems are particularly difficult for unquoted companies which have no share
price available and possibly irregular dividend payments.
¾ In this case it may be advisable to estimate the WACC of a quoted company in the same
industry and with similar gearing and then add a (subjective) premium to reflect the
(perceived) higher risk and lower marketability of unquoted shares.
2 THE EFFECTS OF GEARING

¾ The current WACC reflects the current risk profile of the company: both
Business risk – The variability in the operating earnings of the company i.e. the
volatility of EBIT due to the nature of the industry
and
Financial risk – The additional variability in the return to equity as a result of

introducing debt i.e. using financial gearing. Interest on debt is a committed fixed cost
which creates more volatile bottom line profits for shareholders.
¾ As a company gears up two things happen.
WACC = Ke E + Kd D
E+D
Ke increases due to The proportion of

the increased financial debt relative to equity
risk. in the capital
structure increases.
All else equal, this
pushes up the value Since Kd < Ke this
of WACC pushes the value of
WACC down, all else
equal
¾ The effect of increased gearing on the WACC depends on the relative sizes of these two
opposing effects.
¾ There are two main schools of thought
Traditional view
Modigliani and Miller’s theories
1105
3 TRADITIONAL VIEW OF CAPITAL STRUCTURE

3.1 Reasoning
¾ The traditional view has no theoretical foundation – often described as the “intuitive
approach”. It is based upon the trade-off caused by gearing i.e. using more (relatively
cheap) debt results in a rising cost of equity. The model can also be referred to as the
“static trade-off model”.
¾ It is believed that Ke rises only slowly at low levels of gearing and therefore the benefit
of using lower cost debt finance outweighs the rising Ke.
¾ At higher levels of gearing the increased financial risk outweighs this benefit and
WACC rises.
Cost of
capital Ke
WACC
Kd
D/E
Optimal
gearing
¾ Note that at very high levels of gearing the cost of debt rises. This is due to the risk of
default on debt payments i.e. credit risk.
¾ This is referred to as financial distress risk – not to be confused with financial risk which
occurs even at relatively safe levels of debt.
3.2 Conclusions
¾ There is an optimal gearing level (minimum WACC).
¾ However there is no straightforward method of calculating Ke or WACC or indeed the

optimal capital structure. The latter can only be found by trial and error.
1106
3.3 Project finance — implications
¾ If the company is optimally geared
Raise finance so as to maintain the existing gearing ratio
¾ If the company is sub-optimally geared
Raise debt finance so as to increase the gearing ratio towards the optimal
¾ If the company is supra-optimally geared
Raise equity finance so as to reduce the gearing ratio back to the optimal
3.4 Approach
¾ Appraise the project at the existing WACC
If the NPV of the project is positive the project is worthwhile
¾ Appraise the finance
If marginal cost of the finance > WACC the finance is not appropriate and should
be rejected.
If this was the case the company could raise finance in the existing gearing ratio
and the WACC would not rise
1107
4 MODIGLIANI AND MILLER’S THEORIES

4.1 Introduction
¾ Modigliani and Miller (MM) constructed a mathematical model to provide a basis for
company managers to make financing decisions.
¾ Mathematical models predict outcomes that would occur based on simplifying

assumptions.
¾ Comparison of the model’s conclusions to real world observations then allows

researchers to understand the impact of the simplifying assumptions. By relaxing these
assumptions the model can be moved towards real life.
¾ MM’s assumptions include:
Rational investors
Perfect capital market
No tax (either corporate or personal) – although they later relaxed the assumption
of no corporate tax.
Investors are indifferent between personal and corporate borrowing
No financial distress risk i.e. no risk of default even at very high levels of debt.
There is a single risk-free rate of borrowing
Corporate debt is irredeemable.
4.2 Theory without tax
¾ MM expressed their theory as two propositions.
¾ MM considered two companies - both with the same size and with the same level of
business risk.
One company was ungeared − Co U
One company was geared − Co G
¾ MM’s basic theory was that in the absence of corporation tax the market values (V) and
WACC’s of these two companies would be the same. (proposition 1)
Vg = Vu
WACCg = WACCu
1108
¾ MM argued that the costs of capital would change as gearing changed in the following
manner:
kd would remain constant whatever the level of gearing
ke would increase at a constant rate as gearing increased due to the perceived

increased financial risk (proposition 2)
the rising ke would exactly offset the benefit of the additional cheaper debt in order
for the WACC to remain constant.
This can be shown as a graph:
Cost of
capital
Ke
WACC
Kd
D/E
¾ Conclusion
There is no optimal gearing level;
The value of the company is independent of the financing decision
Only investment decisions affect the value of the company.
¾ This is not true in practice because the assumptions are too simplistic. There are
differences between the real world and the model
¾ Note that MM never claimed that gearing does not matter in the real world. They said
that it would not matter in a world where their assumptions hold. They were then in a
position to relax the assumptions to see how the model’s predictions would change.
¾ The first assumption they relaxed was the no corporate tax assumption.
4.3 Theory with tax
¾ When MM considered corporation tax then their conclusions regarding capital structure
were altered. This is due to the tax relief available on debt interest – the “tax shield”.
1109
Illustration 1
Consider two companies, one ungeared, Co U, and one geared, Co G, both of

the same size and level of business risk.
Co U Co G
$m $m
EBIT 100 100
Interest − 20
____ ____
PBT 100 80
Tax @ 35% 35 28
____ ____
Dividends 65 52
____ ____
Returns to the investors:

Equity 65 52
Debt − 20
____ ____
65 72
____ ____
The investors in G receive in total each year $7m more than the investors in U.
This is due to the tax relief on debt interest and is known as the tax shield.
Tax shield = kd × D × t
where kd = pre-tax cost of debt
D = current market value of the debt
t = tax rate
MM assume that the tax shield will be in place each year to perpetuity and
therefore has a present value, which can be found by discounting at the rate
applicable to the debt, kd.
Kd × D × t
PV of tax shield =
kd
= D×t
The difference in market value between G and U should therefore be that G

has a higher market value due to the tax shield and this extra value is made up
of the present value of the tax shield.
MM expressed this as:
MVg = MVu + Dt
1110
¾ When corporation tax is introduced MM argue that the costs of capital will change as
follows:
Kd (the required return of the debt holders) remains constant at all levels of gearing
Ke increases as gearing levels increase to reflect additional perceived financial risk
WACC falls as gearing increases due to the additional tax relief on the debt interest.
Cost of Ke
capital
WACC
Kd
D/E
¾ The relationship between the WACC of a geared company, according to MM, and the
WACC (Ke) of an ungeared company is:
 Dt 
WACCg = Keu  1 − 
 E+D
where Keu = cost of equity in an ungeared company

D = market value of debt in the geared company
E = market value of equity in the geared company
t = corporate tax rate
¾ The formula for the cost of equity is:
D
Keg = Keu + (1 – T) (Keu – kd)
E
1111
Illustration 1 — continued
Returning to the previous illustration these MM formulae can now be

illustrated.
Suppose that the business risk of the two companies requires a return of 10%
and the return required by the debt holders in Co G is 5%.
Co U
Market value of Co U will be the market value of the equity. This will be the
dividend capitalised at the equity holders’ required rate of return
65
MVu = = $650m
0 .1
Keu = 10% i.e. required rate of return for business risk (U has no financial
risk)
Co G
Market value of the equity of Co G is determined by the equity shareholders’

analysis of their net operating income into its constituent parts and the
capitalisation of those elements at appropriate rates:
EBIT Tax @ 35%  Interest tax relief @ 35% 

MVe = − − − 
0.1 0.1  0.05 0.05 
100 35  20 7 
= − − − 
0.1 0.1  0.05 0.05 
= 1,000 − 350 − (400 - 140) = $390m
Market value of debt is determined by the debt holders capitalising their

interest at their required rate of return:
20
MVd = = $400m
0.05
∴ Total market value of Co G = MVg = $390m + $400m = $790m
The MM formula that describes the relationship between the market values
of equivalent companies at various gearing levels can be illustrated here:
MVg = MVu + Dt
$790m = $650m + ($400m×35%)
1112
MM’s WACC relationship can also be illustrated
Firstly, WACC by the usual approach:
Dividend 52
Keg = = = 13.33%
Market value 390
(assumes no growth in dividends)
Kd = 5% × (1 − 35%) = 3.25%
390 400
WACC = 13.33% × + 3.25% × = 8.23%
790 790
Dt
Then by using MM/s formula: WACC = Keu (1− )
E+D
Keu = 10%
400 × 35%
= 10% (1− )
390 + 400
= 8.23%
MM’s equation for the cost of equity can also be checked
D
Keg = Keu + (1 – T) (Keu – kd)
E
400
= 10 + (1-0.35)(10-5)
390
= 13.33%, (as per the dividend valuation model above)
1113
¾ Conclusion
The logical conclusions to be drawn from MM’s theory with tax is that there is an
optimal gearing level and that this is at 99.9% debt in the capital structure.
This implies that the financing decision for a company is vital to its overall market
value and that companies should gear up as far as possible.
¾ This is not true in practice; companies do not gear up to 99.9%. Why not?
In practice there are obviously many other factors that will limit this conclusion
¾ These factors include
the risk of financial distress;
the existence of not only corporate tax but also personal taxes;
¾ Thus in practice there are a series of factors that a company will need to consider in
deciding how to raise finance.
4.4 Practical considerations in choosing a gearing level
¾ These will include:
business risk of the project;

existing level of financial gearing:
level of operational gearing – the proportion of fixed to variable operating costs. If
this is high then the company may not wish to use debt as this increases the level
of fixed costs even further;
type and quality of the assets;
expected growth;
personal tax position of the shareholders and debt holders.
internal and external limits to debt availability;
tax exhaustion (not enough profit to fully utilise the tax shield)
agency costs (increasingly restrictive debt covenants e.g. restricting dividends)
issue costs
asymmetry of information – potential providers of finance may over-estimate the
risk of the company and refuse to provide capital at reasonable cost. Therefore the
managers may have a preference for using internal finance i.e. retained earnings,
limiting the level of gearing;
market sentiment.
1114
Key points
³ WACC estimates the company’s average cost of long-term finance.

³ It is therefore a potential discount rate to use for the calculation of the
NPV of possible projects. However the existing WACC should only be
used if the project would not change the company’s business risk or level
of gearing i.e. financial risk.
³ There are various, and conflicting, models of how financial gearing affects
the WACC – traditional trade-off theory, Modigliani and Miller without
tax and MM with corporate tax. Each model has useful elements even if
the conclusions of such models lack practical relevance.
FOCUS
¾ understand the weighted average cost of capital, how it is estimated and

when it should be used;
¾ discuss the theories of Modigliani and Miller, their assumptions, implications and
limitations;
¾ evaluate the impact of varying capital structures on the cost of capital.
1115
EXAMPLE SOLUTION
Solution 1
Do(1 + g)
Ke = +g
Po
0.15 × 1.05
= + 0.05 = 15.5%
1.50
Kd = 10% × (1 − 0.33) = 6.67%
45 × 1.50 55
WACC = 15.5% × + 6.67% × = 11.54%
( 45 × 1.50) + 55 ( 45 × 1.50) + 55
1116
SESSION 12 – CAPITAL ASSET PRICING MODEL
OVERVIEW
Objective
¾ To understand the Capital Asset Pricing Model and its uses in financial management.
SYSTEMATIC AND ¾ Definitions

UNSYSTEMATIC ¾ Measurement of systematic risk
RISK
¾ Measurement
BETA FACTORS ¾ Calculation
¾ Interpretation
¾ Formula
CAPITAL ASSET
¾ Security Market Line
PRICING MODEL
ASSUMPTIONS
USES OF THE DEGEARING AND
AND
CAPM REGEARING BETA
LIMITATIONS
¾ Well-diversified investor ¾ Project appraisal in a new ¾ Assumptions
¾ Companies industry ¾ Limitations
¾ Asset betas ¾ MM and betas
¾ Equity betas
¾ Use of the equity beta
1201
1 SYSTEMATIC AND UNSYSTEMATIC RISK

1.1 Definitions
¾ Risk, the variability of returns, can be split into two elements:
unsystematic risk − These are the risks that are unique to each company’s shares;
− It is the element of risk that can be potentially eliminated by

shareholders building a diversified portfolio.
− It is also known as unique or industry-specific risk
systematic risk − These are the risks that affect the market as a whole rather than
specific company shares;
− This cannot be diversified away;
− Therefore systematic risk still remains even in a well-diversified

portfolio;
− This is also known as market risk.
1.2 Measurement of systematic risk
¾ A well-diversified portfolio of shares still has some degree of risk or variability. This is
due to the fact that all shares are affected by systematic risk i.e. to macro-economic
changes.
¾ Systematic risk will affect the shares of all companies although some will be affected to
a greater or lesser degree than others.
¾ This sensitivity to systematic risk is measured by a beta factor.
2 BETA FACTORS
2.1 Measurement
¾ Beta factors for quoted shares are measured using historic data and published in”beta
books”. They are determined by comparing changes in a share’s returns to changes in
the stock market returns over a period of many years (5 years data should be used at
least)
¾ This can be illustrated by the Security Characteristic Line which gives an indication of
the share’s sensitivity to market changes.
¾ The beta factor is estimated from these observations by determining the gradient or
slope of the “line of best fit” through the observed points. The steeper the slope the
more volatile the share and the higher the beta factor.
1202
(Ri - Rf) Security characteristic line
Slope = β
Intercept = α
(Rm - Rf)
Where (Ri − Rf) = the excess return of the share over the risk free return
(Rm − Rf) = the excess return of the stock market over the risk free return
Rf = the return on a risk-free investment
¾ The Security Characteristic Line should in the long run pass through the point where
the two axes meet.
¾ However in the short run this may not always be the case and any short term difference,
or abnormal return, is known as the alpha factor.
2.2 Calculation
¾ A beta factor for a share “i” can also be calculated using linear regression:
Covariance of i with the market

Bi =
Variance of the market' s returns
Or
Correlation of the share with the market × standard deviation of the share‘s returns
Standard deviation of the market’s returns
Example 1
A share has a standard deviation of 15% and a correlation coefficient with the
market returns of 0.72. The standard deviation of the market is 21%.
What is the share’s beta factor?
Solution
1203
2.3 Interpretation
¾ A beta factor therefore simply describes a share’s degree of sensitivity to changes in the
market’s returns, caused by systematic risk.
Beta factor of 1 − this indicates that the share is as sensitive as the market to
systematic risk
Beta factor > 1 − this means that the share is more sensitive than the market.
Therefore if the market in general rises by 10% then the returns
from this share are likely to be more than 10%.
Beta factor < 1 − the share is less sensitive than the market and is likely to rise and
fall in value less than the market in general.
3 CAPITAL ASSET PRICING MODEL

3.1 Formula
¾ If the shareholders of a company hold well-diversified portfolios then they are

concerned only with systematic risk.
¾ The return these shareholders require therefore is only a return to cover the systematic
risk of an investment.
¾ Systematic risk is measured by a beta factor - therefore the required return from an
investment must be related to the beta factor of that investment.
¾ This is brought together in the Capital Asset Pricing Model which is a formula that
relates required returns to beta factors as measures of systematic risk.
¾ The CAPM formula is :
E(ri) = Rf + βi(E(rm)–Rf)
E(ri) = expected/required return from an investment

Rf = risk free return
E(rm) = expected return from the “market portfolio”
βι = beta of the investment
The Market Portfolio is a portfolio containing every share on the stock market.
¾ CAPM is the equation of the Security Market Line
1204
3.2 Security Market Line
¾ The Security Market Line is a graph that indicates the required return from any
investment given its beta factor. Forecast returns from investments can be compared to
the figure from the security market line to indicate whether that investment is under or
over valued.
Return
Security market line
x Rb
Rm
x Ra
Rf
Beta
0 Ba 1 Bb
Where Ra = the forecast return from investment A
¾ The required return of an investment with a beta of zero (risk free) will be the risk free
return.
¾ The required return of an investment with a beta of 1 will be the market return.
¾ Consider investment A - it is forecast to earn higher returns than the CAPM would
predict given its beta. It is therefore temporarily under-priced. This is referred to as a
“positive alpha” investment.
¾ Consider investment B - it would appear to be temporarily over priced – a “negative

alpha” investment.
¾ In the long run market forces should ensure that all investments do give the returns
predicted by the Security Market Line.
1205
4 USES OF THE CAPM

4.1 Well-diversified investors
¾ If an investor already holds a well-diversified portfolio then that investor will be

concerned only with systematic risk. The CAPM is therefore relevant.
¾ The investor will be satisfied only if a potential investment gives a high enough return
given its sensitivity to market risk as measured by its beta factor.
Example 2
An investment has an forecast return over the next year of 12%. The beta of the
investment is estimated at 0.9. The risk free rate is 5% and the market return is
15%.
Should a well-diversified investor buy this investment?
Solution
4.2 Companies
¾ Companies should not diversify their activities simply to reduce the risk of their
shareholders. Shareholders can diversify their shareholdings much more easily than a
company can diversify its activities.
¾ If shareholders are already well-diversified then the company should concern itself, on
behalf of the shareholders, simply with the systematic risk of potential projects.
¾ Therefore the aim of a company, with well-diversified shareholders, should be to

determine the required return from its investment projects and then compare this to the
forecast return.
¾ If the project is the same risk as that of the existing activities of the company then the
existing WACC can be used.
¾ However if the project is of a different risk type to the existing activities then the
existing WACC will not be appropriate. In these instances a tailor-made discount rate
for that type of project must be determined using the CAPM.
1206
4.3 Asset betas
¾ Any company is made up of its assets or activities. These assets will have a certain
amount of risk depending upon their nature. These assets will have a beta factor that
recognises the sensitivity of such assets to systematic risk.
¾ This beta factor is the asset beta and measures the systematic business risk of the
company.
¾ It can also be referred to as an ungeared beta factor
4.4 Equity betas
¾ The equity beta measures the sensitivity to systematic risk of the returns to the equity
shareholders in a company.
¾ In an all-equity financed company, or ungeared company, the only risk that is incurred
is business risk.
¾ Therefore in an ungeared company the asset beta and the equity beta are the same.
¾ However in a geared company the equity shareholders face not only business risk,
measured by the asset beta, but also a degree of financial risk.
¾ Therefore in a geared company the equity beta > the asset beta.
¾ Equity betas can also be called geared betas.
4.5 Use of the equity beta
¾ The equity beta measures the sensitivity to market risks of the equity shareholders’
returns. If the equity beta is used in the CAPM this gives the required return for the
equity shareholders.
¾ The required return of shareholders = the cost of equity geared (Keg)
¾ The CAPM can therefore be used as an alternative to the Dividend Valuation Model for
estimating the cost of equity of a company.
Example 3
The equity beta of a company is estimated to be 1.2. The risk free return is 7%
and the return from the market is 15%.
Estimate the cost of equity of the company?
Solution
1207
5 DEGEARING AND REGEARING BETA

5.1 Project appraisal in a new industry
¾ It has already been noted that a company’s existing WACC is only a relevant discount
rate for a project with the same level of business risk as existing activities..
¾ If the project is in a different industry (or country) then a discount rate to reflect the
business risk of that industry is required.
¾ A company in a similar industry can be found and its beta discovered. If that company
is geared then its equity beta will contain both business risk and financial risk.
However that company will probably have a different level of gearing compared to our
company.
¾ This requires us to first “degear” the beta to find the asset beta, and then “regear” to
reflect our company’s level of financial risk
5.2 MM and betas
¾ The following formula (based on Modigliani and Miller’s models) can be used to
convert an equity beta to an asset beta (and vice-versa):
 Ve   Vd(1 − T ) 
βa =  βe  +  βd
 (Ve + Vd(1 − T ))   (Ve + Vd(1 − T )) 
where βa = asset beta

βe = equity beta
βd = beta of corporate debt
Ve = market value of equity
Vd= market value of debt
T = corporation tax rate
¾ If the exam question does not give a beta factor for debt then assume that debt is risk
free i.e. βd = 0
1208
Example 4
A plc produces electronic components but is considering venturing into the

manufacture of computers. A plc is ungeared with an equity beta of 0.8.
The average equity beta of computer manufacturers is 1.4 and the average
gearing ratio is 1:4.
The risk free return is 5%, the market return 12% and the rate of Corporation
Tax 33%.
If A plc is to remain an equity financed company what discount rate should it

use to appraise a computer manufacture project?
Solution
Example 5
Suppose that A plc from the previous example has a gearing ratio of 1:2. It still
wishes to enter into the same computer manufacturing project.
What is the discount rate that should be used for A plc for a computer
manufacturing project?
Solution
1209
6 ASSUMPTIONS AND LIMITATIONS OF THE CAPM

6.1 Assumptions
¾ total risk can be split between systematic risk and unsystematic risk;
¾ unsystematic risk can be completely diversified away;
¾ all of a company’s shareholders hold well-diversified portfolios
¾ a risk-free security exists;
¾ perfect capital markets.
6.2 Limitations
¾ it is a single period model;
¾ it is a single index model - beta being the only variable to explain different required
returns on different investments.
¾ Lack of data for the model – particularly in developing markets
¾ CAPM tends to over-state the required return on very high risk companies and under-
state the returns on very low risk companies.
¾ Many of the assumptions do not hold in real life
Key points
³ CAPM is an alternative to the Dividend Valuation Model (DVM) for

estimating a company’s cost of equity.
³ Beta factors measure systematic risk and therefore CAPM should only be
used if the company’s shareholders have themselves used portfolio theory
to diversify way unsystematic risk
³ Despite its assumptions and limitations CAPM is a more flexible model

than DVM as it allows the estimation of project-specific discount rates
FOCUS
¾ understand the meaning and significance of systematic and unsystematic risk;
¾ appreciate the uses of the CAPM for financial management;
¾ discuss the assumptions and limitations of CAPM;
1210
EXAMPLE SOLUTION
Solution 1
0.72 × 15
Beta factor =
21
= 0.51
Solution 2
Required return = 5 + 0.9 × (15 − 5)
= 14%
Expected return = 12%
Therefore the investor should not invest.
Solution 3
Ke = 7 + 1.2 × (15 − 7)
= 16.6%
Solution 4
Using MM formula find the asset beta of the computer industry:
 Ve   Vd(1 − T ) 
βa =  βe  +  βd
 (Ve + Vd(1 − T ))   (Ve + Vd(1 − T )) 
4
Ba = 1.4
4 + (1 × 0.67)
Asset beta = 1.2
As A plc is ungeared then this asset beta is the appropriate beta for use in the CAPM in
order to determine the discount rate that A plc should use for a computer manufacture
project:
Required return = 5 + 1.2(12 − 5)
= 13.4%
1211
Solution 5
Using MM formula find the asset beta of the computer industry:
 Ve   Vd(1 − T ) 
βa =  βe  +  βd
 (Ve + Vd(1 − T ))   (Ve + Vd(1 − T )) 
4
Ba = 1.4
4 + (1 × 0.67)
Asset beta = 1.2
In order to find the discount rate for A plc this asset beta must be converted into an equity
beta appropriate to A plc:
2
1.2 = Be
2 + (1 × 0.67)
1.2 = 0.749 × Be
Be = 1.6
Ke of A plc if in computer manufacture = 5 + 1.6 (12 – 5)
= 16.2%
The discount rate that A plc must use is the WACC that it would have if its Ke were 16.2%.
In the absence of any other information assume Kd is 5% (risk free rate).
Discount rate = 16.2% × ⅔ + 5 (1 – 0.33) × ⅓
= 11.92%
1212
SESSION 13 – WORKING CAPITAL MANAGEMENT
OVERVIEW
Objective
¾ To appreciate the importance of working capital and therefore its effective management.
WORKING
CAPITAL
MANAGEMENT
¾ What is “working capital”?
¾ Investment in working capital
¾ Financing working capital
ASSESSING THE
LIQUIDITY
POSITION
¾ Ratios
¾ Cash operating cycle
¾ Calculating the cash operating cycle
¾ Overtrading
¾ Solutions to liquidity problems
1301
1 WORKING CAPITAL MANAGEMENT

1.1 What is “working capital”?
Definition
The capital represented by net current assets which is available for day-to-day
operating activities. It normally includes inventories, trade receivables, cash
and cash equivalents, less trade payables.
¾ Net working capital is made up of
Accounts receivable + Inventory + Cash – Accounts payable
¾ Each of these components needs a control system, but it is also essential to consider
working capital as a whole and how these components fit together.
¾ Working capital management is concerned with the liquidity position of the company,
so the main aim is to generate cash as quickly as possible.
¾ Working capital management is crucial to the effective management of a business

because:
(i) Current assets comprise over half the assets of some companies
(ii) A failure to control working capital, and therefore liquidity, is a major
cause of business failure.
¾ Two questions must be considered:
How much to invest in working capital?
How to finance it?
1.2 Investment in working capital
¾ The firm faces a trade-off
LIQUIDITY v PROFITABILITY
High investment Low investment

in working in working
capital capital
⇒ more liquid ⇒ less liquid

But may not be using But may be using
working capital efficently working capital efficiently
⇒ less profitable ⇒ more profitable
⇒ Is there an OPTIMAL level of working capital?
1302
¾ For each company there will be an optimal level of working capital. However this can
only be found by trial and error, and in any case it is constantly changing.
¾ Businesses must avoid the extremes:
overtrading – an insufficient working capital base to support the level of activity.

This can also be described as under-capitalisation.
over-capitalisation – too much working capital, leading to inefficiency
1.3 Financing working capital
Whatever level of current assts the business decides to hold, they must be matched by
liabilities i.e. current assets must be financed.
The business must decide whether to use short-term or long-term finance.
It is generally true that short-term interest rates are lower than long-term rates as short-term
finance is less risky for the provider/lender.
However short-term finance is not always cheaper and must be renegotiated when it expires.
The four principal sources of finance for current assets are:
1.3.1 Long-term
¾ Equity – new share issues

– retained profits
¾ Debt – debentures
– long-term bank loans
1.3.2 Short-term
¾ Overdraft – expensive as it is flexible

– risky as repayable on demand
¾ Accounts payable – appears cheap but refusing quick settlement discounts can be
expensive
1303
2 ASSESSING THE LIQUIDITY POSITION

¾ Liquidity is a company’s ability to meet its financial obligations as they fall due.
¾ A secure liquidity position is desirable. The firm’s liquidity position can be assessed in
two ways.
2.1 Ratios
2.1.1 Liquidity ratios
Current assets
Current ratio =
Current liabilities
Quick assets Current assets − inventory

Quick ratio = =
Current liabilities Current liabilities
2.1.2 Efficiency ratios
Cost of goods sold

Inventory turnover =
Average stock
¾ shows how quickly inventory is sold
Credit sales
Accounts receivable’ turnover =
Average accounts receivable
¾ shows how quickly debts are collected
Credit purchases
Accounts payable’ turnover =
Average accounts payable
¾ shows how quickly accounts payable for supplies received on credit are paid.
2.1.3 Problems with ratios
(i) Seasonal and other factors may mean that the balance sheet values may not be typical
(ii) There may be “window-dressing” e.g. the finance director may make a large payment to
suppliers at the year-end in order to reduce the reported payables days.
(iii) Concern the past and not the future
(iv) They are of little value unless used in comparison to industry average data.
1304
2.2 Cash operating cycle
¾ The length of time between a firm paying out cash for raw materials and/or inputs and
receiving cash for goods sold
¾ The number of days between paying suppliers and receiving cash from customers.
¾ Can also be referred to as the working capital cycle or the cash conversion cycle
THE CASH OPERATING CYCLE
Cash payment
CASH SUPPLIERS
Cash
collection
Purchases
CUSTOMER RAW MATERIALS
Sales
Production
FINISHED GOODS
WORK-IN-PROGRESS
Production
¾ The length of the operating cycle is affected by various factors e.g.
type of industry, e.g. retailing v house building;
liquidity v profitability trade-off;
efficiency of management e.g. accounts receivable and accounts payable control.
Whilst it is desirable to have as short a cycle as possible, it is often difficult to differ

significantly from competitors in the same trade.
1305
2.3 Calculating the cash operating cycle
Accounts receivable days Average accaounts receivable

= × 365 = x
Annual credit sales
Accounts payable days Average accounts payable
= × 365 = (x)
Annual credit purchases
Finished goods days Average stock of finished goods
= × 365 = x
Annual cost of sales
Average stock of work in progress
WIP holding period = × 365 = x
Annual cost of sales × Degree
of completion of WIP
Raw materials days Average stock of raw materials
= × 365 = x
Annual purchases
__
Length of cycle x
__
Commentary
¾ Use year-end figures if averages not available.
Example 1
Tipple plc has the following estimated figures for the coming year:
Sales $3,600,000
Accounts receivable $306,000
Gross profit margin 25%
Finished goods inventory $200,000
Work in Progress Inventory $350,000
Raw Materials Inventory $150,000
Accounts payable $130,000
WIP is 80% complete. Purchases represent 60% of production cost.
Required:
Calculate the length of the cash operating cycle.
1306
Solution
Cost of sales =
WORKINGS Days
__
___
Number of days between payment and receipt
___
2.4 Overtrading
¾ Overtrading occurs when a company tries to support a large volume of trade from a
small working capital base.
¾ It can also be referred to as under-capitalisation and often occurs when a business

grows very rapidly without increasing its level of long-term finance.
¾ The result can be a liquidity crisis.
This can often happen at the start of a new business, since
¾ there is no reputation to attract customers, so a long credit period is likely to be

extended in order to break into the market;
¾ if the business has found a “niche market”, rapid sales expansion may occur;
¾ smaller companies which are growing quickly will often lack the management skills to
maintain adequate control of the debt collection period and the production period.
For the above reasons the amount of cash required will increase. However, companies in
this position will often find it hard to raise long-term finance and hence overtrading and
business failure may result.
1307
2.4.1 Indicators of overtrading
¾ Decline in liquidity;
¾ Rapid increase in turnover;
¾ Increase in inventory days;
¾ Increase in accounts receivable days;
¾ Increase in short-term borrowing and a decline in cash holdings;
¾ Large and rising overdraft
¾ Reduction in profit margin;
¾ Increase in ratio of sales to fixed assets.
2.5 Solutions to liquidity problems
If a business is suffering from liquidity problems, then the aim will be to reduce the length
of the cash operating cycle. Possibilities to consider include:
¾ reducing the inventory-holding period for both finished goods and raw materials ;
¾ reducing the production period – not easy to do but it might be worth investigating
different machinery or working methods;
¾ reducing the credit period extended to accounts receivable, and tightening up on cash
collection;
¾ increasing the period of credit taken from suppliers;
¾ an increase in the level of long-term finance i.e. an equity or debt issue. A new share
issue is probably preferable to increasing debts in a risky company;
¾ reducing the level of sales growth to a more sustainable level.
1308
Key points
³ The key issues are (i) what level of current assets should a business hold
and (ii) how should current assets be financed?
³ There are not always unique answers to these questions; it is a matter of

opinion. Therefore you need (i) an appreciation of the
advantages/disadvantages of holding cash, inventory and receivables (ii)
the relative advantages of using short vs. long-term finance
³ Good knowledge of ratio analysis is essential in many exam questions on

working capital management e.g. estimating the length of the operating
cycle.
³ There is no official definition of overtrading but it refers to a situation

where a business is growing at an unsustainable rate compared to its level
of long-term finance .It is also associated with poor working capital
management.
FOCUS
¾ explain the nature and scope of working capital management;
¾ calculate appropriate ratios to analyse the liquidity and working capital management of
a business;
¾ calculate the length of the operating cycle of a business;
¾ explain the relationship between working capital management and business solvency;
1309
EXAMPLE SOLUTION
Solution 1 — Cash operating cycle
Cost of sales = 75% × 3,600,000 = 2,700,000
WORKINGS Days
Raw materials days 150,000 34
× 365
2,700,000 × 60%
Credit taken from suppliers 130,000 (29)
× 365
2,700,000 × 60%
__
5
WIP days 350,000 59
× 365
2,700,000 × 80%
Finished goods days 200,000 27
× 365
2,700,000
Credit given to customers 306,000 31
× 365
3,600,000
___
Number of days between payment and receipt 122
___
1310
SESSION 14 – INVENTORY MANAGEMENT
OVERVIEW
Objective
¾ To understand the costs and benefits of holding inventory and determine the Economic
Order Quantity (EOQ) which minimises costs.
¾ To appreciate other possible inventory control systems.
INVENTORY ¾ Definition
CONTROL ¾ Reasons for holding inventory
¾ Costs associated with inventory
OTHER
EOQ MODEL RE-ORDER LEVEL INVENTORY
SYSTEMS
¾ Definition ¾ Definitions ¾ Periodic review system
¾ Determination of EOQ ¾ Constant demand ¾ ABC system
¾ Complications during lead time ¾ Just-in-time (JIT)
¾ Quantity discounts ¾ Uncertain demand ¾ Perpetual inventory
during lead time ¾ MRP
¾ Service levels
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1 INVENTORY CONTROL
1.1 Definition
The systematic regulation of inventory levels.
¾ If inventory is too high
Inefficient ⇒ profit reduced
¾ If inventory is too low
Insufficient to satisfy customers ⇒ profit reduced.
1.2 Reasons for holding inventory
¾ To meet demand by acting as a buffer in times of unusually high consumption, i.e. to

reduce the risk of stockouts.
¾ To ensure continuous production.
¾ To take advantage of quantity discounts.
¾ To buy in ahead of a shortage or ahead of a price rise.
¾ For technical reasons (e.g. maturing whisky in casks or keeping oil in pipelines).
¾ To reduce ordering costs.
1.3 Costs associated with inventory
¾ Purchase price;
¾ Holding costs:
cost of capital tied up;

insurance;
deterioration, obsolescence and theft;
warehousing;
stores administration.
¾ Re-order costs:
transport costs;
clerical and administrative expenses;
batch set-up costs for goods produced internally.
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¾ Shortage costs:
production stoppages caused by lack of raw materials;

stockout costs for finished goods – anything from a delayed sale to a lost customer;
emergency re-order costs.
¾ Systems costs – people and computers.
The benefits of holding inventory must outweigh the costs.
2 EOQ MODEL
2.1 Definition
¾ The Economic Order Quantity (EOQ) is the quantity of inventory that should be ordered
each time a purchase order is made.
¾ EOQ aims to minimise the costs which are relevant to ordering and holding inventory.
2.2 Determination of EOQ
x = order quantity
CH = cost of holding one unit for one year
D = annual demand
CO = cost of placing an order
¾ The total annual relevant cost to be minimised
= annual holding cost + annual order cost
= the cost of holding one + the cost of an order × the

unit in inventory for one number of orders in a year
year × the average number
of units held
= x + Co
CH D
2 x
The total cost is minimized when:
2C 0 D
x=
CH
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¾ EOQ graph
$
Cost
Total cost
holding cost
ordering cost
EOQ Order quantity

x
¾ Assumption of EOQ:
purchase price per unit is constant;

constant demand;
no risk of stockouts.
Example 1
¾ Using the following data calculate the EOQ
D = 40,000 units
CO = $2
CH = $1
Solution
EOQ =
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2.3 Complications
2.3.1 Warehouse rental
¾ The EOQ model assumes that holding costs vary with the average inventory level.
¾ However if a warehouse is rented on a long-term contract (rather than daily) then it

needs to be large enough to hold the maximum level of stock, rather than the average.
x
must rent sufficient floor space to meet this quantity rather than
2
x
(x/2)
¾ deal with this by doubling the floor space used by one unit when calculating holding cost,
and then use the normal EOQ formula
Example 2
Annual demand = 3,000 units

Reorder cost = $5
Holding cost = $3.33 per unit + rental of warehouse
Each unit occupies 3m2 rented on annual contracts for $5 per m2
Solution
D = 3,000
CO = 5
CH =
EOQ =
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2.3.2 Cost of capital
¾ Inventory, like any other asset, must be matched by a liability. Therefore there must be a
cost of financing inventory.
¾ This is a type of holding cost.
Illustration 1
Cost of Capital = 10%
Price per unit = $100
∴ Holding cost = $100 × 0.1 = $10
This is in addition to any other holding costs you are given.
2.4 Quantity discounts
¾ The supplier may offer a “bulk-buying” discount on each unit purchased for specified
quantities above the EOQ
¾ In this case the purchase price obviously becomes a relevant factor in the decision
¾ To deal with this, calculate

Annual holding Annual order Annual
Total annual cost = + +
cost cost purchase cost
for each order quantity where discounts are available and at the order level calculated
by the EOQ.
¾ Choose the order quantity with the lowest total cost.
1406
Example 3
Annual demand = 5,000

Holding cost = $7.50
Reorder cost = $30
Purchase price = $1.10
A discount of 3% is available on orders of 300 units or more.
Required:
Determine whether or not the discount is worthwhile.
Solution
EOQ =
Total cost at EOQ $

x
Holding CH =
2
D
Reorder CO =
x
Purchase cost
_____
Total
–––––
Total cost at order quantity = 300 units
x
Holding CH =
2
D
Reorder CO =
x
Purchase cost
_____
–––––
Conclusion:
1407
3 RE-ORDER LEVEL
3.1 Definitions
¾ Re-order level (ROL) is the level to which inventory should fall before a purchase order
is made.
¾ Lead time is the time between placing and receiving an order.
¾ There are two possible situations to be dealt with:
(1) Constant demand in lead time

(2) Uncertain demand in lead time
3.2 Constant demand during lead time
¾ Re-order level (ROL) = lead time (days) × demand per day
¾ For example if demand is 40 units per day and lead time is two days - when inventory
levels fall to 80 units then inventory would be re-ordered. This can be shown
graphically:
INVENTORY
LEVEL
ROL
{
TIME
Lead
time
3.3 Uncertain demand during lead time
¾ There will be an expected level of demand, not a known level of demand.
¾ A “buffer” or “safety” inventory will need to be held to reduce the risk of a stockout.
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Method
(1) Calculate expected demand in the lead time.
Expected lead time demand = ∑xi p(xi)
where
xi = level of demand
p (xi) = probability of level of demand
(2) Take each level of demand ≥ expected lead time demand as a possible
reorder level and calculate the expected annual stockout cost.
(3) For each possible ROL calculate the expected annual buffer holding
cost.
(4) Choose the ROL with the lowest sum of stock out and holding cost.
Example 4
The following information relates to inventory levels of component XL5:

Holding cost = $8
Stockout cost = $3
Lead time = 1 week
EOQ = 150
The company operates for 50 weeks per annum and weekly demand is given
by:
xi p(xi)
Demand Probability
40 0.1
50 0.2
60 0.4
70 0.2
80 0.1
Required:
Calculate the optimum reorder level.
1409
Solution
Average demand in the lead time =
Average annual demand =
orders per annum =
ROL Buffer Demand Units Probability Ave Exp annual Exp Total
short units stock-out annual annual
short cost buffer cost
holding $
cost
60 0 70 0
80
__ ___ ___
Average =
__ ___ ___
––––
70 10
___ ___
––
Average =
___ ___
–– ––––
80 20
___ ___
––
___ ___
––––
The optimum ROL is therefore
3.4 Service levels
¾ Setting a “service level” of 98% implies that the firm accepts a 2% chance of a stock-out
Example 5
Average weekly demand for an item of inventory is 300 units with a standard
deviation of 40 units. The lead time is one week.
Required:
What ROL is needed to provide a service level of 95%? Normal distribution

tables show that 5% of observations lie 1.645 standard deviations above the
mean.
Solution
1410
4 OTHER INVENTORY SYSTEMS

4.1 Periodic review system
The inventory levels are reviewed at fixed time intervals, and variable quantities will be ordered
as appropriate.
The order size made is sufficient to return inventory levels to a pre-determined level.
A very simple method of inventory control – ideal where inventory control is only one of a
person’s responsibilities.
4.2 ABC system of inventory control
The aim is to reduce the work involved in inventory control in a business which may have
several thousand types of inventory items.
The inventory is categorised into class A, B or C according to the annual cost of the usage of
that inventory item, or the difficulty of obtaining replacements, or the importance to the
production process.
Class A will then take most of the inventory control effort, Class B less and Class C less still.
Commentary
Whilst this seems acceptable for inventory of finished goods, it may cause problems for
raw materials. There may be an item which has a very small cost but which is vital for
the manufacture of the finished product. Such an item would have to be included in
with the Class A items because of its inherent importance, rather than its cost.
4.3 Just-in-time (JIT)
In a JIT system production and purchasing are linked closely to sales demand on a week-to-
week basis. The aim is to create a continuous flow of raw materials inventory into work in
progress, which becomes finished goods to go immediately to the customer. This means
that negligible inventory needs to be held.
Conditions necessary include the following:
¾ Flexibility of both suppliers and internal workforce to expand and contract output at
short notice.
¾ Raw material inventory must be of guaranteed quality – indeed, quality must be

maintained at every stage.
¾ Close working relationship with suppliers and, if possible, geographically proximity in

order to make immediate deliveries.
¾ A low inventory level normally requires short production runs. This is only
appropriate, therefore, where set-up costs are low. High-technology production
methods have made this easier to achieve.
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¾ The workforce must be willing to increase or decrease its working hours from one
period to another. This could be done by having a core workforce with a group of part-
time or freelance workers.
¾ The design of the factory must be such that JIT deliveries to all areas are possible.
¾ Total reliance on suppliers for quality and delivery, and therefore very tight contracts
with penalty clauses.
¾ Significant investment by suppliers, and therefore long-term contracts.
4.4 Perpetual inventory methods
Where a firm keeps perpetual inventory records, there will frequently be a replenishment
point that triggers an order. Such a system relies upon the accuracy of the records, not on
physical counts.
It is possible to use point of sale (POS) terminals that automatically update inventory
records as each successive sale is made.
One advantage of such a system is the data it provides to management to determine which
product lines are moving rapidly. Sales managers may also use the data to make tactical
decisions on special prices to sell slow-moving items.
4.5 Material requirements planning (MRP)
A system that uses the production schedule to decide what is needed and when. This is then
linked in with suppliers’ discounts, lead times, etc to devise an optimal inventory holding
and ordering policy.
Key points
³ They formula for the Economic order Quantity is provided in the exam –
the key is to identify the relevant data.
³ Do not confuse the Economic Order Quantity (EOQ) with the Re –Order
Level (ROL). EOQ tells us how large each order should be, ROL tells us
when we should place on order for inventory
³ Just-In-Time (JIT) is the other main inventory system to be familiar with
FOCUS
¾ apply the tools and techniques of inventory management.
1412
EXAMPLE SOLUTION
Solution 1 — EOQ
2 × $2 × 40 ,000
EOQ =
$1
x = 400 units
Solution 2 — Floor space
D = 3,000
CO = 5
CH = $3.33 + (2 × 3 × 5) = $33.33
2 × 5 × 3 ,000
EOQ = = 30 units
33.33
Solution 3 — Quantity discount
2 × 30 × 7 ,000
EOQ = = 200 units
7.50
Total cost at EOQ $

x 200 750
Holding CH = × 7.50
2 2
D 5,000 750
Reorder CO = × 30
x 200
Purchase cost 5,000 × 1.10 5,500

_____
Total 7,000
_____
Total cost at order quantity = 300 units
x 300 1,125
Holding CH = × 7.50
2 2
D 5,000 500
Reorder CO = × 30
x 300
Purchase cost 5,000 × 1.10 × 0.97 5,335

_____
6,960
_____
The discount is therefore worthwhile.
1413
Solution 4 — Re-order level
Average demand in the lead time = 60 units
Average annual demand = 60 × 50 = 3,000 units
Since the EOQ = 150, there will be 3 ,000 = 20 orders per annum.
150
ROL Buffer Demand Units Prob Ave Exp Exp Total

short units annual annual annual
short inventory out buffer cost
cost holding $
cost
60 0 70 10 0.2 2 2 × $3 × 20 0
80 20 0.1 2 2 × $3 × 20
__ ___ ___
Average 4 240 0 240
__ ___ ___
––––
70 10 80 10 0.1 1 1 × $3 × 20 10 × $8
___ ___
––
Average 1 60 80 140
___ ___
–– ––––
80 20 80 – – – 0 20 × $8
___ ___
––
0 160 160
___ ___
–– ––––
The optimum ROL is therefore 70 units.
Solution 5 — Service level
SD = 40
45%
5%
300
ROL
z = 1.645 (using normal distribution tables)
ROL = 300 + (1.645 × 40) = 300 + 65.8 = 366
1414
SESSION 15 – CASH MANAGEMENT
OVERVIEW
Objective
¾ To understand the importance of cash flow and methods of controlling cash flows, the
theoretical models relating to optimal cash balances and the importance of treasury
management.
¾ Reasons for holding cash

CASH
¾ Cash and profits
MANAGEMENT
¾ Advantages of centralised treasury

TREASURY management
MANAGEMENT ¾ The role of the treasurer
¾ Cash flow budgeting
¾ Sensitivity analysis in cash budgeting
BORROWING IN INVESTING IN OPTIMAL CASH

THE SHORT-TERM THE SHORT-TERM BALANCES
¾ Sources ¾ Why do surplus funds arise? ¾ EOQ (Baumol) model

¾ Investing surplus funds – ¾ Miller-Orr model
factors to consider
¾ Short-term investments
1501
1 CASH MANAGEMENT
1.1 Reasons for holding cash
¾ Transactions motive – to provide sufficient liquidity to meet current day-to-day

financial obligations, e.g. payroll, the purchase of raw materials, etc.
¾ Precautionary motive – a cash reserve to give a cushion against unplanned expenditure,

rather like buffer/safety level of inventory. This reserve may be held in the form of
“cash equivalents” - short-term, low risk, highly liquid investments e.g. treasury bills.
¾ Speculative motive – to quickly take advantage of investment opportunities that may

arise e.g. some firms build a “war chest’ of cash ready to use if a suitable takeover target
appears.
However it is important that a firm does not hold excessive levels of cash as this leads to
inefficiency. Cash balances belong to the shareholders who are expecting to receive
significant return on their investment in the firm.
Any long-term surplus of cash should therefore be either reinvested into positive NPV
projects or returned to shareholders via:
¾ Dividends – possibly as a “special” dividend, or
¾ Share buy-back programme
1.2 Cash and profits
Profits are accounted for on an accruals basis and a company must be profitable to continue
in existence. However, profitability is not enough; companies must also have enough cash
flow available to meet all their day to day payments and longer-term commitments in order
to survive.
2 TREASURY MANAGEMENT
Definition
The efficient management of liquidity and risk in a business including the

management of funds (generated from internal and external sources),
currencies and cash flow.
As companies and financial markets have become larger, more sophisticated and
increasingly international, there has been a trend towards the establishment of separate
treasury departments where the control of cash is centralised in order to ensure its efficient
use.
1502
2.1 Advantages of centralised treasury management
These include:
9 Management by specialised staff;
9 Economies of scale e.g. less staff required in total ;
9 “Pooling” - netting cash deficits against surpluses in order to save interest expense.
9 Increased negotiating power with banks;
9 More efficient foreign exchange risk management - the treasury department at head
office can find the group’s net position on each currency and then consider an external
hedge on this balance.
Within a treasury department of a large company there may still be a degree of

decentralisation in order to ensure that the decisions taken are appropriate to local
circumstances.
2.2 The role of the treasurer
To have the right amount of cash available at the right time the treasurer will be involved in:
¾ accurate cash flow forecasting, so that shortfalls and surpluses can be anticipated;
¾ planning short-term borrowing when necessary;
¾ planning investments of surpluses when necessary;
¾ cost efficient cash transmission;
¾ dealing with foreign currency issues;
¾ optimising banking arrangements;
¾ planning major finance-raising exercises;
¾ accounts receivable/accounts payable policies.
In addition, the treasurer is often involved in risk assessment and insurance.
2.3 Cash flow budgeting
A major task of the treasurer is cash flow budgeting. A simple pro-forma is given below:
¾ Forecast:
– Sales volume;
– Revenue;
– Costs;
– One-off expenses (e.g. capital expenditure).
¾ Typical format
1503
Q1 Q2 Q3 Q4 Total
Cash inflows $ $ $ $ $
Cash sales x x x x x
Cash from receivables x x x x x
Fixed asset disposals x x x x x
Share/debt issues x x x x x
___ ___ ___ ___ ___
Total inflow x x x x x
___ ___ ___ ___ ___
Cash outflows
Materials x x x x x
Labour x x x x x
Variable overhead x x x x x
Fixed overhead x x x x x
Dividends x x
Capital expenditure/leases x x
Interest/principal on debt x x x x x
___ ___ ___ ___ ___
x x x x x
___ ___ ___ ___ ___
Net cash flow x x x x x

Opening balance x x x x x
___ ___ ___ ___ ___
Closing balance x x x x x
___ ___ ___ ___ ___
2.4 Sensitivity analysis in cash budgeting
¾ Sensitivity analysis answers the question “What if?” and can be used to deal with
uncertainty in cash budgeting.
¾ The effect on net cash flows per month or quarter could be examined in the following
ways:
Considering changes in payment patterns by credit customers. Best-case and

worst- case scenarios should be examined.
Allowing for changes in the timing of other receipts, e.g. sale of fixed assets, rights
issues, debt issues, etc.
Considering changes in materials costs. If prices are uncertain, a worst-case

scenario should be examined.
Allowing for changes in other costs (e.g. labour, overheads) or timings of outflows
(e.g. fixed overhead payments, dividends, capital expenditure).
Considering changes in interest rates where borrowings are at variable rates. A

worst- case scenario should be forecast.
1504
3 BORROWING IN THE SHORT-TERM

Having completed a cash flow forecast the treasurer may identify a requirement to borrow
funds in the short term.
3.1 Sources of short-term borrowing
¾ Debt factoring and invoice discounting;
¾ Bank overdraft - however:
technically repayable on demand (although the bank may offer a “revolving line of
credit”);
normally carries a flat charge for the facility and high variable interest rate on the
balance.
¾ Short-term loans:
may require security
can have fixed or variable rates of interest.
4 INVESTING IN THE SHORT-TERM

Alternatively a treasurer may discover that the company has a cash surplus for a short-term
period.
4.1 Why do surplus funds arise?
¾ Over funding – proceeds which are not yet fully required may have already been
received from a share/debt issue;
¾ Disposal of surplus assets or divisions;
¾ Operating surpluses.
4.2 Investing surplus funds — factors to consider
¾ Amount of funds available.
¾ Liquidity – how quickly can the investment be converted back into cash?
¾ Risk – the treasurer should not gamble with the shareholders’’ funds
¾ Return on the proposed investment – obviously this will be limited by the requirement
to select low risk investments.
The general rule is to select short-term, low risk, highly liquid investments e.g. treasury bills.
1505
4.3 Short-term investments
¾ Money market deposits i.e.-bank deposits. There may be a notice period for
withdrawals and therefore should only be used if there is high certainty of cash flows.
¾ Certificate of deposit - negotiable deposits issued by banks and building societies,

maturities from 28 days to 5 years. The holder can sell the certificate before its maturity
date, hence more liquid than money market deposits but lower returns.
¾ Treasury bills – 2, 3, and 6 month UK government debt, very low risk and very liquid,
but even lower returns.
¾ Gilt-edged government securities (“gilts”) – the long term version of Treasury Bills with
maturities usually greater than 5 years. It is not recommended that short-term cash
surpluses are invested in newly issued gilts as their market prices are very sensitive to
interest rate changes. It would be more sensible to invest in gilts which are close to
maturity
¾ Other government bonds – for example UK local authority bonds, rates tied to money
markets, good liquidity.
¾ Certificates of tax deposit – deposits with UK Inland Revenue that may be surrendered
for cash or used in settlement of tax liabilities.
¾ Commercial paper – short term (7 days - 3 months) unsecured debts issued by high
quality companies, good liquidity
¾ Corporate bonds - longer maturity fixed interest securities issued by the corporate
sector. Liquidity can be poor and risk higher than on government bonds or commercial
paper.
¾ Equities – investing short term cash surpluses on the stock market is not recommended
as high risk.
¾ Non-sterling instruments - most of the above have non-sterling counterparts, e.g. US

Treasury bills, etc; beware exchange risk.
Commentary
Most businesses will be looking for a variety of investments in order to minimise the
risks involved, and also to ensure that some cash is available at short notice and that
some is invested longer term to obtain higher interest rates.
1506
5 OPTIMAL CASH BALANCES

Is there an optimal cash balance?
Two theoretical models will now be considered.
5.1 EOQ (Baumol) model
5.1.1 Assumptions
¾ This model applies the EOQ model to cash. It assumes that that cash requirements are
funded by the sale of “parcels” of securities e.g. Treasury Bills.
¾ The model calculates the optimal size for the “parcel” of securities. This is known as the
“economic transfer”.
5.1.2 Formula
s = cash needs for the period
f = transaction costs (brokerage, commission etc) of

selling a “parcel” of securities
h = Opportunity cost of holding cash (interest forgone

on securities)
2fs
¾ Economic transfer =
h
5.1.3 Weaknesses
¾ Uncertainty - demand for cash is not constant.
¾ The model assumes that the business is constantly using cash and must finance this by
selling investments. However any worthwhile business must at some point generate cash
rather than “burn” it.
Illustration 1
A firm has large deposits which currently attract interest of 15%.
It has cash needs of $300,000 in the next year.
Transaction costs are $120.
Required:
What is the economic transfer and the average cash balance?
1507
Solution
s = 300,000
f = 120
h = 0.15
Economic transfer 2 × 120 × 300,000

= = $21,909
0.15
Average balance $21,909

= = $10,954
2
5.2 Miller-Orr model
Cash Upper limit

balance
make investments
Return point
convert investments
back into cash
Lower limit
Time
¾ Lower limit - represents the “safety” level of cash and is set by management. If cash falls
to this level then sell short-term investments to return the cash balance to the Return
Point.
¾ Upper limit - the maximum level of cash to hold. Once the cash balance reaches the
upper limit, short-term investments should be bought in order to bring the cash balance
back down to the Return Point.
¾ Return Point – the level to which cash balances should be brought if they reach the
upper or lower limit.
¾ The model is particularly useful when cash flows are uncertain.
¾ The return point is set to minimise the sum of transaction costs and lost interest on
investments
1508
¾ The following formulae are provided in the examination :
Return point = Lower limit + (⅓ × spread)
1
3 3
 4 × transaction cost × variance of cash flows 
Spread = 3  
 interest rate 
 
Where:
Spread = the difference between the upper limit and lower limit
Transaction costs = the fixed cost of buying or selling marketable securities
Variance = variance of the net daily cash flows
Interest rate = daily interest rate on marketable securities i.e. the daily opportunity
cost of holding cash
Example 1
A company requires a minimum cash balance of $6000 and the variance of

daily cash flows is estimated to be $2,250, 000. The interest rate on securities is
0.025% per day and the transaction cost for each sale or purchase of securities
is $20.
Required:
Calculate:
– the spread
– the upper limit
– the return point
and interpret the results.
Solution
1509
Key points
³ The only reason for a business to exist is if it can generate positive cash
flows from operations.
³ However cash surpluses should not simply be left in the company’s bank
account as this produces a very low return. Long term surpluses should be
invested into positive NPV projects, or used to pay a dividend.
³ Short –term surpluses should be invested in low risk, highly liquid

investments such as Treasury Bills. The Baumol and Miller-Orr models
provide detailed models on how to manage transactions between cash and
short-term investments.
FOCUS
¾ explain the role of cash in the working capital cycle;
¾ describe the functions of and evaluate the benefits from centralised cash control and
treasury management;
¾ apply the tools and techniques of cash management;
¾ calculate optimal cash balances.
1510
EXAMPLE SOLUTION
Solution 1
1
3 3
Spread = 3  
 
1
3 3
 4 × 20 × 2 ,250 ,000 
= 3  
 0.00025 
 
= 15,390
Upper limit = lower limit + spread
= 6,000 + 15,390
= 21, 390
Return point = Lower limit + (⅓ × spread)
= 6,000 + (15, 390/3)
= 11, 130
Interpretation:
¾ if cash balance rises to $21,390 then invest $10,260 ($21, 390 – $11, 130) in securities. This
reduces the cash balance to $11, 130
¾ if cash balance falls to $6, 000, sell $5,130 of securities to replenish cash.
1511
1512
SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE
OVERVIEW
Objective
¾ To consider the factors involved in the granting and accepting of trade credit.
¾ Granting credit
CREDIT ¾ Credit periods and settlement discounts
CONTROL ¾ Credit rating
¾ Collection procedures
¾ Charging interest on overdue invoices
INVOICE MANAGEMENT OF
SETTLEMENT
DISCOUNTING ACCOUNTS
DISCOUNTS
AND FACTORING PAYABLE
¾ Invoice discounting ¾ Credit as a source of finance
¾ Debt factoring ¾ Advantages of trade credit as
a source of finance
1601
1 CREDIT CONTROL
1.1 Granting credit
¾ Should credit be granted at all? Consider normal trade practice, but also consider
leading a change. Providing credit may stimulate sales.
¾ What is the true cost to the business of customer credit? This will be influenced by the
risk of bad debts and the cost of financing accounts receivable.
1.2 Credit periods and settlement discounts
¾ Credit periods can be changed to respond to competition but will be largely influenced
by trade custom.
¾ Settlement discounts – again influenced largely by accepted practice within the

industry. The company must ensure the discounts allowed expense does not exceed the
benefit in terms of reduced finance costs.
¾ Having defined the credit periods and settlement discounts, the company must make
sure that customers are aware of them by stating the terms:
on orders;
on invoices;
on statements.
¾ The settlement discount policy must be enforced, since some customers will attempt to
take the settlement discount whether they pay on time or not.
1.3 Credit rating
This is a crucial policy area. The company must balance the risk inherent in granting credit
against the necessity to allow enough credit to support the level of business.
Credit limits should be set for all accounts, based upon:
¾ an assessment of the customer’s financial statements;
¾ the use of credit rating agencies (e.g. Dun and Bradstreet);
¾ contacting credit managers in other firms to exchange information;
¾ references from the customer’s bank or accountant, although these may be of limited
value;
¾ the impression of credit-worthiness gained when visiting customers’ premises and

meeting the management;
¾ review of the aged accounts receivables ledger to identify customers who have
significant debts outstanding for long periods.
1602
1.4 Collection procedures
¾ Establish timings for issuing letters of demand, making chasing telephone calls, and the
point when further deliveries should stop.
¾ Ensure credit controllers liaise with sales management to avoid insensitive collection
procedures that may damage customer relations.
¾ Consider using a “stop list” i.e. suspending supplies.
¾ Decide when outside assistance is needed to collect overdue debts. Lawyers, trade
associations and debt collection agencies may be considered.
1.5 Charging interest on overdue invoices
Some powerful companies have a reputation for paying their small suppliers very slowly.
Therefore in November 1998 the UK government introduced the Late Payment Act.
This legislation allows small suppliers to charge large companies 8% above central bank
interest rate on invoices unpaid after 30 days.
2 INVOICE DISCOUNTING AND FACTORING

2.1 Invoice discounting
Definition
Selling selected sales invoices to a third party for a discounted cash sum.
The process is as follows:
¾ A company issues an invoice to a customer and sends a copy to the discounter.
¾ The discounter pays the company a percentage of the invoice value e.g. 90%, and takes
responsibility for collecting the debt from the customer.
¾ The customer pays the discounter.
¾ The discounter then pays the company the 10% balance due minus fees. Fees include
finance charges (linked to base rate) on the cash advance and often an administration
fee of 0.2% - 0.5% of invoice value.
¾ The process operates “with recourse”i.e. the company keeps the risk of bad debts. Even
so companies will often find that they are only able to discount the invoices of
customers with high credit ratings.
¾ Therefore discounting is most advantageous for companies which are selling to

customers with high credit ratings and a good payment record.
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2.2 Debt factoring
Definition
A range of services in the area of sales administration and the collection of

amounts due from customers
Debt factors may offer three closely integrated elements:
¾ Accounting and collection – the company is paid by the factor as customers settle their
invoices or after an agreed settlement period. The factor will maintain the sales ledger
accounting function.
¾ Credit control – the factor is responsible for chasing the customers and speeding up the
collection of debts.
¾ Finance against sales – the factor advances, e.g., 80% of the value of sales immediately
on invoicing.
Accounting and collection is often carried out together with credit control. The finance that
the factor then makes available is only taken if required, as it is typically slightly more
expensive than a bank overdraft.
Factoring is becoming increasingly competitive; generally, factors will act for customers with
turnover in excess of $100,000 and invoices over $100.
The usual fees are between 0.5%- 2.5% of invoice value, plus a charge for cash advances.
2.2.1 Advantages
9 Administrative savings;
9 Provides a flexible source of finance;
9 Obtain benefits from the factor’s economies of scale;
9 Obtain benefits from the factor’s expertise.
2.2.2 Disadvantage
8 Cost;
8 Loss of customer contact/goodwill;
8 Possible damage to company reputation.
2.2.3 Recourse vs. Non-recourse
¾ Factoring with recourse – bad debts remain the company’s problem.
¾ Non-recourse factoring – bad debts are the factor’s problem – in effect the company is
insured against bad debts. Fees are higher.
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Example 1— Factoring (service basis/admin only)
A plc makes annual credit sales of $2m. Customers take 60 days to pay and
bad debts are 1% of sales.
Factoring is being considered. The factor would charge a service fee of 2% of

sales per annum, reduce the accounts receivable collection period to 40 days,
and it would be a non-recourse agreement. Administration savings of $10,000
per annum would be made.
Required:
Assuming a cost of working capital of 15% per annum, what is the impact on
annual profit of the factoring option that is being considered?
Solution
Example 2 — Factoring (with finance)
Tipsy Ltd has annual sales of $500,000 and accounts receivable days of 60. It
pays overdraft interest at 17%.
It is approached by a factor who offers:

Immediate finance of 80% of sales at 18% interest
A guaranteed collection period of 45 days
$8,000 of administration savings
A service fee of 2% of turnover
Required:
Calculate the impact on annual profit of using the factor.
Solution
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3 SETTLEMENT DISCOUNTS
In the UK it is common to offer credit customers a discount if they pay within a certain
number of days.
To decide if this is a good policy the cost of the discount must be compared to the cost of
financing accounts receivable e.g. overdraft rate.
To allow a fair comparison the cost of the discount must be expressed as an annual effective
cost.
Example 3
Customers normally take 60 days credit. A quick payment discount of 1.5% is

offered for payment within 20 days.
Required:
Calculate the annual effective cost of the discount and conclude whether the
discount should be offered if the overdraft rate is 15%.
Solution
Example 4
Dodgy Ltd has sales of $100,000 and accounts receivable days of 60. It pays
overdraft interest at 18%.
It is considering a discount of 2% to customers who pay within 10 days. It is

estimated that 50% of customers will take the discount.
Required:
Calculate the impact on annual profit of the discount.
Solution
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4 MANAGEMENT OF TRADE ACCOUNTS PAYABLE

4.1 Credit as a source of finance
¾ Firms can use trade credit as a flexible source of short-term finance. The firm may even
decide to pay suppliers late.
Trade credit is not, however, without cost. For example:
possible loss of credit status such that the supplier might give low priority to the
firm’s future orders, with consequent disruption of activities;
the supplier may raise prices in order to compensate for the finance which he is
involuntarily supplying;
¾ the firm may lose any discounts for prompt payment;
¾ the annual effective cost of refusing a discount should be calculated. This should be
compared to the cost of financing working capital e.g. overdraft rate;
¾ if the cost of refusing discount > overdraft rate then the discount should be accepted.
Example 5
A supplier offers a 2% discount if the invoice is paid within 10 days of receipt,

but offers no discount if the payment is delayed for a further 20 days.
Required:
Calculate the annual effective cost of refusing the discount.
Solution
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Example 6
A company currently takes 40 days credit from its suppliers, believing this to
be “free” finance.
Annual purchases are $100,000 and the company pays overdraft interest at
13%.
Payment within 15 days would attract a 1½ % quick settlement discount.
Required:
Calculate the effect on the profit and loss account of accepting the discount.
Solution
4.2 Advantages of trade credit as a source of finance
9 Convenient and informal.
9 Can be used if unable to obtain credit from financial institutions.
9 If settlement discount s are taken, it can result in a cheap source of financing − as a

period of time is still allowed before payment.
9 Can be used on a short-term basis to overcome unexpected cash flow crises.
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Key points
³ Many exam questions on this area require candidates to use working

capital management ratios “in reverse” e.g. to re-arrange the formula for
accounts receivable days and then use it to move from the sales figure to
the estimated level of receivables.
³ The other key technique is to calculate the Annual Effective Cost of

settlement discounts. Use compound interest, not simple and bring a
scientific calculator to the exam.
FOCUS
¾ explain the role of accounts receivable in the working capital cycle;
¾ explain how the credit-worthiness of customers may be assessed;
¾ explain the role of factoring and invoice discounting;
¾ explain the role of settlement discounts.
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EXAMPLE SOLUTIONS
Solution 1 — Factoring (admin. only)
Annual (costs)/
savings
$
Administration savings 10,000
Bad debt reduction 20,000
Factor’s fee (40,000)
Reduction in financing cost (W) 16,438
______
Net annual saving 6,438
______
WORKING
Reduction in cost of financing working capital

$
60 328,767
Current average accounts receivable 2,000,000 ×
365
40 (219,178)
Revised average accounts receivable 2,000,000 ×
365
_______
One-off cash flow improvement 109,589
Annual saving thereon at 15% 16,438

_______
Solution 2 — Factoring (with finance)
 60 
Current accounts receivable  × 500 ,000  = 82,192
 365 
Finance cost (82,192 × 17%) = 13,973
 45 
New accounts receivable  × 500 ,000  = 61,644
 365 
$
Finance by factor = 61,644 × 80% × 18% 8,877
Finance by overdraft = 61,644 × 20% × 17% 2,096
______
10,973
______
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P & L impact:
$
Reduced interest expense (13,973 – 10,973) 3,000
Saved admin expense 8,000
Service fee (500,000 × 2%) (10,000)
______
Increased profits 1,000
______
Solution 3 — Settlement discount
It costs 1.5% to receive 98.5% of accounts receivable 40 days sooner.
40 day interest rate = 1.5

= 1.52%
98.5
Annual effective rate = 365

1.0152 40 – 1 = 1.0152 9.125 – 1 = 14.8%
Conclusion: This is below the overdraft rate and therefore the discount should be offered.
Note – the annual effective rate has been calculated above using compound interest to compare to the
cost of overdraft where interest is also charged on a compound basis. However the examiner has
said that he would also accept the use of simple interest i.e. 1.52% × 9.125 = 13.87%
Solution 4 — Settlement discount
Current accounts = 60
100,000 × = 16,438
receivable 365
New accounts = 10 60
(100,000 × 50% × ) + (100,000 × 50% × )
receivable 365 365
= 1,370 + 8,219
= 9,589
$
Reduced interest expense (16,438 – 9,589) × 18% 1,233
Discounts allowed expense 100,000 × 50% × 2% (1,000)
_____
Increased profit 233
_____
Note - This solution follows the examiner’s approach as shown in the Pilot Paper and in his
book “Corporate Finance Principles and Practice” (Denzil Watson and Antony Head)
However there is a strong argument that the new level of accounts receivable should be
stated net of discounts allowed i.e.
10 60
(100,000 × 50% × 98% × ) + (100,000 × 50% × ) = 9, 561.
365 365
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The examiner has stated that he would accept this variation.
Solution 5 — Supplier finance
If a company receives an invoice of $1,000 under the terms in the example, and decides to
pay after 30 days it will:
-lose the 2% discount.

-effectively have the use of $980 ($1,000 – $20) for the additional 20 days.
365 / 20
 20 
This is an equivalent compound rate of 1 +   − 1 = 44.6%pa
 980 
This should be compared with the cost of financing working capital. Trade credit can
therefore be a very expensive form of financing when a cash discount is offered but refused.
Solution 6 — Discount
40
Current accounts payable = 100,000 × = 10,959
365
15
New accounts payable = 100,000 × = 4,110
365
$
Increased interest expense (4,110 – 10,959) × 13% (890)
Discounts received (100,000 × 1½%) 1,500
_____
Increase in profit 610
_____
Conclusion: The discount should therefore be accepted.
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SESSION 17 – RISK MANAGEMENT
OVERVIEW
Objective
¾ To explain the causes of exchange rate fluctuations.
¾ To apply hedging techniques for foreign currency risk.
¾ To apply hedging techniques for interest rate risk.
RISK
MANAGEMENT
CURRENCY INTEREST RATE

RISK RISK
¾ Forecasting exchange rates ¾ Types of interest rate risk

¾ Types of exchange rate risk ¾ External hedging of interest
¾ External hedging of rate risk
transaction risk
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1 FORECASTING EXCHANGE RATES

¾ The key models for forecasting future exchange rates focus either on inflation rate
differences, or interest rate differences.
¾ The relationships between these macro-economic variables can be summarised in the

“four-way equivalence model” shown below
Differences in Fisher Expected difference

interest rates effect in inflation rates
Interest rate International Purchasing power

parity Fisher effect party
Difference between spot Expectations Expected change

and forward exchange theory in spot exchange rate
rate
¾ Spot exchange rate - the market exchange rate for buying/selling the currency for
immediate delivery.
¾ Forward exchange rate – the exchange rate for buying or selling the currency at a
specific date in the future.
1.1 Purchasing Power Parity (PPP)
¾ Absolute PPP states that the exchange rate simply reflects the different cost of living in
two countries. For example if a representative basket of goods and services costs $1, 700
in the US and £1,000 in the UK, the exchange rate should be $1.70 to £1.
¾ While absolute PPP exchange rates may represent the long-run equilibrium rate
between two currencies, they are of limited practical use in financial management.
¾ Financial managers are more interested in market exchange rates than theoretical rates.
This is where relative PPP is useful.
¾ Relative PPP claims that changes in market exchange rates are caused by the rate of
inflation in different countries.
¾ For example if the rate of inflation is higher in the US than in the UK, relative PPP
predicts that the value of the dollar will fall.
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¾ The formula for relative PPP is as follows:
(1 + h c )
s1 = s0 x
(1 + h b )
where:
s1 = expected spot exchange rate after one year
s0 = today’s spot exchange rate
hc = foreign inflation rate (as a decimal)
hb = domestic inflation rate
¾ Spot rates should be put into the formula is the format:
Units of foreign currency/units of domestic currency
Example 1
Spot rate 1 January 19X6 = $1.90 to £1
Predicted inflation rates for 19X6:
US 2%
UK 3%
Required:
What is the predicted exchange rate at 31 December 19X6?
Solution
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1.2 Interest Rate Parity (IRP)
¾ IRP states that the forward exchange rate is based upon the spot rate and .the interest
rate differential between the two currencies:
Forward rate = spot rate × (1+overseas interest rate/1+ domestic interest rate)
(1 + i c )
¾ f0 = s0 x
(1 + i b )
where:
f0 = forward exchange rate
s0 = spot exchange rate
ic = overseas interest rate
ib = domestic interest rate
Example 2
If spot $/£ = 1.78 and the dollar and sterling one year interest rates are 3.25%
and 4.5% respectively, what is the one year forward exchange rate?
Solution
¾ If this theory did not hold it would be possible for investors to make a risk-free profit
using a process referred to as covered interest rate arbitrage.
¾ Covered interest rate arbitrage = simultaneously borrowing domestic currency,

transferring it into foreign currency at the spot exchange rate, lending it, and buying a
forward exchange contract to repatriate the foreign currency into domestic currency at a
known forward exchange rate.
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1.3 Fisher effect
¾ Countries with a higher rate of inflation have higher nominal interest rates in order to
offer the same real return as countries with low inflation
(1+i) = (1+r) (1+h)
Where i = nominal interest rate

r = real interest rate
h = inflation rate
1.4 International Fisher effect
¾ States that the spot exchange rate will change to offset interest rate differences between
countries.
¾ The calculations are basically as per Interest Rate Parity theory.
1.5 Expectations theory
¾ Differences between forward and spot rates reflect the expected change in spot rates.
1.6 Other factors influencing exchange rates
¾ Current and prospective government policies.
¾ Balance of payments surpluses/deficits.
¾ Actions of speculators.
2 TYPES OF EXCHANGE RATE RISK

There are three types of exchange rate risk to consider – translation risk, economic risk and
transaction risk.
2.1 Translation risk
¾ This occurs where a parent company holds an overseas subsidiary.
¾ In order to consolidate the subsidiary’s financial statements into the group accounts,
they must first be translated into the reporting currency of the parent company. The
exact method for doing this depends on the relevant financial reporting standards.
¾ In particular translating the balance sheet of overseas subsidiaries can lead to significant
translation gains/losses.
¾ If the home currency has appreciated against the foreign currency, it is likely to produce a
translation loss when converting the value of overseas net assets.
¾ If the home currency has depreciated against the foreign currency, it is likely to produce
a translation gain when converting the value of overseas net assets.
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¾ Although such gains/losses can be significant in size, they do not represent actual cash
gains/losses for the group – they are simply caused by financial accounting methods for
consolidating overseas subsidiaries.
¾ As long as users of financial statements understand that translation differences do not

represent cash flows, they should not affect the value of the group.
¾ Therefore the financial manager should ensure that the nature of translation
gains/losses is clearly explained e.g. in the annual report, at shareholder meetings.
¾ However the financial manager does not need to hedge translation risk, because it is not
a cash flow.
2.2 Economic risk
¾ Economic risk is the risk that cash flows will be affected by long-term exchange rate
movements.
¾ As the value of a firm is the present value of its future cash flows, economic risk is a
significant issue for the financial manager. Unfortunately it is difficult to hedge against.
¾ For example, take a UK company which exports to the US and therefore has dollar
export earnings. Suppose that, over time, sterling becomes stronger against the dollar.
The sterling value of export earnings will fall, damaging the cash flow and the value of
the company. What can the company do to reduce this risk?
Increase the dollar price of the exports – however this may not be practical,
particularly when exporting to a competitive market.
Diversify exports into other markets – in the hope that sterling will fall against
some currencies while rising against the dollar.
Use hedging techniques such as forward contracts – however, in the long run this
will not give effective protection. As sterling rises over time in the spot markets it
also rises in the forward markets – and the value of exports still falls.
Attempt to convert the cost base into dollars - for example by importing materials
from the US or setting up operations in the US. However these may not be practical
options for many companies.
¾ Note that economic risk can affect a company even if it does not export or import.
Domestic producers may face tougher competition from overseas firms if the home
currency appreciates. Again there is no easy method of protecting against this.
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2.3 Transaction Risk
¾ Transaction risk is the short-term version of economic risk.
¾ It is the risk that the exchange rate changes between the date of a specific export/import
and the related receipt/payment of foreign currency.
¾ Like economic risk this affects cash flows and hence affects the value of the firm. It is
therefore a significant issue for financial management.
¾ Transaction risk can be effectively managed using both internal and external techniques.
2.4 Internal management of exchange rate risk:
¾ Invoicing in the domestic currency – an exporter could denominate sales invoices in its
domestic currency, effectively transferring the transaction risk to the customer.
However this may lead to lost sales.
¾ “Leading and lagging” - paying overseas suppliers earlier (“leading”) if the home
currency is expected to fall, or later (“lagging”) if the home currency is expected to
appreciate.
¾ Netting - where there are both sales and purchases in a foreign currency offset the
receivables and payables and only consider an external hedge on the net difference.
¾ Matching - consider using foreign currency loans to finance overseas subsidiaries.

Overseas earnings can be used to pay the loan interest and repay principal, reducing the
net foreign currency cash flow exposed to risk upon repatriation to the parent company.
This may be effective as a longer-term hedge against economic risk.
¾ Asset and Liability Management – if overseas subsidiaries borrow locally rather than
receiving finance from the parent company this reduces the net assets of the subsidiary.
This can also be referred to as a “balance sheet hedge” and reduces exposure to
translation risk upon consolidation of the subsidiaries’ net assets into the group
accounts (although, as mentioned above, translation risk should not affect the value of
the group).
3 EXTERNAL HEDGING OF TRANSACTION RISK

3.1 Forward exchange contracts
¾ Forward contract – a legally binding agreement to buy or sell:
a specified quantity
of a specified currency
on an agreed future date (“delivery date”)
at an exchange rate fixed today
¾ Forward contracts are not traded but agreed between a company and a bank. This
means they are customised agreements which can match the exact requirements of the
company regarding quantity and delivery date.
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¾ Forward contracts are not bought, they are entered into. Therefore no premium needs to
be paid to set up a forward hedge (unlike options).
¾ Forward contracts do not require any margin to be posted i.e. no deposit of cash is
required when setting up a forward hedge (unlike futures contracts). However there
will usually be a small arrangement fee to set up a forward contract.
¾ The major disadvantage of forward contracts is that physical delivery must occur i.e. if a
company signs a forward contract to buy/sell foreign currency then it must physically
exchange currency on the agreed date at the agreed rate, even if that rate has become
unattractive compared to the spot rate.
¾ Therefore forward contracts are not a flexible method of hedging.
Example 3
Today is 1 January 19X1. A UK-based company is expecting dividend income

of $200,000 to be received from its US subsidiary on 31 March 19X1.
$/£ spot rate 1 January 19X1 = 1.5123–1.5245
Three month forward = 2.00–2.14 cents discount (c dis)
Required:
(a) How much sterling will be received if forward cover is taken out?
(b) How much sterling would be received if no forward cover is taken out and
the actual spot rate on 31 March 19X1 = 1.5247–1.5361?
Solution
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3.2 Money Market Hedges
¾ Money market hedges involve either borrowing or investing foreign currency in order
to protect against transaction risk. Whether to borrow or invest depends on whether the
company is exporting or importing.
¾ Suppose a UK company has dollar export earnings. A money market hedge could be set
up as follows:
1. Today borrow dollars.
2. Exchange these dollars into sterling, which can then be invested.
3. Use the dollar export earnings to repay the dollar loan.
Example 4
A UK-based company expects to receive $300,000 in 3 months.
Spot rate ($ per £): 1.7820 ± 0.0002
One year sterling interest rates: 4.9%(borrowing) 4.6% (investing)

One year dollar interest rate: 5.4% (borrowing) 5.1% (investing)
Required:
Set up a money market hedge.
Solution
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3.3 Currency Options
¾ If a company wants a more flexible hedge it may consider buying a currency option.
¾ Options are an example of derivatives – a financial instrument based upon an underlying

asset. In the case of currency options the underlying asset is a currency.
¾ The purchaser of a currency option has the right, but not the obligation, to buy or sell:
a specified quantity
of a specified currency
on or before a specified date (expiry date)
at an exchange rate agreed today (exercise price/strike price)
¾ The owner of the option can either:
exercise their right or

allow it to lapse i.e. not exercise it.
¾ However the owner of an option must pay for this flexibility. The cost of an option is
known as its premium
¾ Premiums are paid at the date the option is bought and are non-refundable.
¾ A company may buy options on:
a derivatives market, or
directly from a bank – known as OTC (Over The Counter)
¾ A call option gives its owner the right to buy the underlying asset.
¾ A put option gives its owner the right to sell the underlying asset.
¾ European style options can only be exercised on the expiry date.
¾ American style options can be exercised at any time until the expiry date.
3.4 Currency Futures Contracts
¾ Futures are simply traded forward contracts.
¾ Currency futures contracts are standardised contracts for the buying or selling of a
specified quantity of a specified currency. They are traded on a futures exchange and
have various “delivery dates” e.g. March, June, September and December.
¾ A company can choose whether to buy or sell futures and can choose which delivery
date to use.
¾ The price of a currency futures contract represents the forward exchange rate for the
currencies specified in the contract.
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¾ When a currency futures contract is bought or sold, the buyer or seller is required to
deposit a sum of money with the exchange, called initial margin. If losses are incurred
(as exchange rates and hence the prices of currency futures contracts change), the buyer
or seller may be called on to deposit additional funds (variation margin) with the
exchange.
¾ Any profits are credited to the margin account on a daily basis as the contract is
“marked to market”.
¾ Although the definition of a futures contract is basically the same as a forward contact,
there is a significant practical difference between hedging with forwards and futures:
With forward contracts there is always physical delivery i.e. a company that signs a
forward contract will physically buy or sell the underlying currency when the
contract reaches its delivery date.
However most currency futures contracts are “closed out” before their delivery
dates. The company simply executes the opposite transaction to the initial futures
position e.g. if buying currency futures was the initial transaction, it is later closed
out by selling currency futures.
¾ If a futures hedge is correctly performed any gain made on the futures transactions will
offset a loss made on the spot currency markets (and vice versa).
Illustration 1
Today is 1 February. A UK exporter expects to receive $300,000 in three

months’ time and is considering the use of sterling futures to protect against
transaction risk.
The company is worried that sterling will appreciate, leading to a loss on the
spot market sale of dollars in 3 months.
It therefore needs to set up a futures position that would produce a gain on a

rise in sterling.
On 1 February it should buy sterling futures contracts. It needs to hedge until 1

May and hence June contracts should be used (March contacts would only
hedge until the end of March)
On 1 May the company should:
¾ sell June sterling futures
¾ sell the $300,000 export receipts on the spot market
If sterling has risen against the dollar, there will be a gain on sterling futures
(bought sterling low, sold sterling high) to offset the loss on the spot market.
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3.5 Currency Swaps
¾ A currency swap is a formal agreement between two parties to exchange principal and
interest payments in different currencies over a stated time period.
¾ Currency swaps can be used to eliminate transaction risk on foreign currency loans.
¾ The steps are as follows:
On commencement of the swap; an exchange of agreed principal amounts, usually

at the prevailing spot rate.
Over the life of the swap; an exchange of interest payments.
At the end of the swap; a re-exchange of principals, usually at the original spot rate
(thereby removing foreign currency risk).
4 INTEREST RATE RISK

4.1 Types of interest rate risk
¾ Exposure to rising interest rates – there are two main situations where a company may
fear rising interest rates:
If a company has a significant proportion of floating interest rate debt it will fear a
rise in interest rates as this obviously leads to lower profits. However higher
interest expense also leads to higher financial risk i.e. more volatile future profits due
to a larger block of committed interest expense to be covered. An extreme interest
rate rise could even cause financial distress risk i.e. bankruptcy.
If a company has a significant amount of surplus cash invested in fixed interest rate
securities e.g. government bonds.
¾ Exposure to falling interest rates – there are two main situations where a company may
fear falling interest rates:
a company which has a significant proportion of fixed interest rate debt and
therefore does not participate in the benefits of falling rates (unlike its competitors
for example).
a company with significant floating rate investments e.g. money market investments.
¾ Basis Risk – even if a company has floating rate assets and floating rate liabilities of
similar size, they may be linked to different reference rates which may change at
different times and/or by different amounts.
¾ Gap Exposure - if a company has floating rate assets and floating rate liabilities of
similar size that are all linked to the same reference rate e.g. LIBOR (London Interbank
Offered Rate), it can still face risk. It is possible that the interest rate is reset at different
intervals on assets and liabilities e.g. every 6 months on assets but every 3 months on
liabilities.
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4.2 Internal Management of Interest Rate Risk
¾ Smoothing – maintaining a balance between fixed rate and floating rate borrowing.
¾ Matching – attempting to have a common interest rate for both assets and liabilities.
This is more practical for financial institutions than for industrial companies.
5 EXTERNAL HEDGING OF INTEREST RATE RISK

5.1 Forward rate Agreements (FRAs)
¾ FRAs allow companies to fix, in advance, either a future borrowing rate or a future
deposit rate, based on a notional principal amount, over a given period.
¾ FRAs are cash settled in advance, based upon the present value of the difference on
settlement date between:
The fixed contract rate

The reference interest rate e.g. LIBOR
¾ The maximum maturity period for an FRA is usually around two years.
¾ Customised agreement with a bank i.e. OTC
¾ No premium is paid for the FRA and no margin needs to be posted.
Illustration 2
A company plans to borrow $20 million in 3 months time for a period of 6

months and wishes to pay 7% interest no matter what happens to interest rates
during the next 3 months.
It can enter into an FRA with a bank at an agreed rate of 7% on a notional

principal amount of $20 million, starting in 3 months and lasting for 6 months.
This is known as a 3v9 FRA.
¾ if actual interest rates are higher than 7% in 3 month’s time then the bank
pays the company the difference between 7% and the actual rate i.e. cash
settlement is made at the start of the FRA period. The compensation
would be calculated as the present value of the interest rate difference on a
$20m 6 month loan (discounted a the actual interest rate)
¾ if actual interest rates are lower than 7% then the company pays the bank
the difference.
No matter what the actual interest rate the company will pay interest at a rate
of 7% on the underlying $20 million loan.
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5.2 Interest Rate Options
Various OTC interest rate options can be purchased from financial institutions and tailor-
made to meet company requirements. The major types are:
¾ Cap - if the reference interest rate rises above a pre-determined level, the financial
institution pays the difference to the company, based upon an agreed notional principal
and time period. This puts a cap or ceiling on the interest rate paid by the company. If
the reference rate stays below the pre-determined rate the cap will not be exercised.
¾ Floor - if the reference interest rate falls below a pre-determined level, the financial
institution pays the difference to the company. This would be relevant for a company
with floating rate investment income that wishes to guarantee a minimum return.
¾ Collar – combination of a cap and a floor and therefore keeps an interest rate between
an upper and lower limit. This is a cheaper hedge than just using a cap or floor.
5.3 Interest Rate Futures
¾ The most common futures contract to use for interest rate hedging is a “three-month”
contract. This contract is referenced to short-term interest rates e.g. three month LIBOR.
¾ Interest rate futures contacts are priced at 100 minus the implied interest rate. Therefore
if interest rates rise, the price of interest rate futures falls.
¾ If a company wishes to hedge against rising interest rates it should use futures as
follows:
Today sell interest rate futures
Wait for interest rates to rise
If interest rates rise, the price of futures must fall
“Close out” the futures position by buying the same contracts that were originally
sold.
There should be a gain on futures (as we sold high and bought low) to offset higher
interest expense on company debts.
¾ Note above that we sold futures and later bought them. This is called taking a “short
position” and is absolutely possible in futures markets because of the ability to close out
positions before contracts reach their delivery date i.e. physical delivery does not occur.
1714
5.4 Interest Rate Swaps
¾ Interest rate swap - an exchange between two parties of interest obligations or receipts
in the same currency on an agreed amount of notional principal for an agreed period of
time.
¾ Interest rate swaps are a flexible method for companies to change the interest rate
profile of their underlying loans or investments.
¾ The most common is a plain vanilla swap where fixed interest payments based on a
notional principal are wapped for floating interest payments based upon the same
notional principal.
Key points
³ Risk management is a topic that is introduced in this paper and taken to a

higher level in the Advanced Financial Management syllabus.
³ It is important to understand the various types of foreign exchange and

interest rate risk.
³ Calculations will focus on forecasting exchange rates and performing

relatively simple hedges such as forward contracts, money market hedges
or FRA’s for interest rate management.
³ An appreciation of more complex derivatives such as futures, options and

swaps should be sufficient.
FOCUS
¾ Forecast exchange rates using purchasing power parity and interest rate parity;
¾ Discuss the various types of exchange rate risk and interest rate risk;
¾ Discuss and apply both internal and external methods of hedging against currency or
interest rate risk.
1715
EXAMPLE SOLUTIONS
Solution 1
(1 + h c )
s1 = s0 x
(1 + h b )
(1 + 0.02 )
s1 = 1.90 x
(1 + 0.03)
= $/£ 1.88
This is a predicted fall in the value of sterling.
Solution 2
(1 + i c )
f0 = S 0 x
(1 + i b )
(1 + 0.0325)
f0 = 1.78 x
(1 + 0.045)
=$/£ 1.76
Sterling is weaker in the forward market than the spot market
Solution 3
(a) Forward rate = 1.5245 + 0.0214
= 1.5459
$200,000
= £129,374
1.5459
$200,000
(b) = £130,200
1.5361
Solution 4
Expected receipt after 3 months = $300,000

Dollar interest rate over three months = 5.4/ 4 = 1.35%
Dollars to borrow now to have $300,000 liability after 3 months = 300,000/ 1.0135 = $296,004
Spot rate for selling dollars = 1.7820 + 0.0002 = $1.7822 per £
Sterling deposit from borrowed dollars = 296,004/ 1.7822 = £166,089
Sterling interest rate over three months = 4.6/ 4 = 1.15%
Value in 3 months of sterling deposit = 166,089 x 1.0115 = £167,999
1716
SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS
OVERVIEW
Objective
¾ To estimate the value of one share or of a company’s equity in total.
¾ To be familiar with all ratios commonly used in business analysis.
BUSINESS
VALUATIONAND
RATIO ANALYSIS
BUSINESS RATIO
VALUATION ANALYSIS
¾ Reasons for business valuation ¾ Profitability

¾ Nature of valuation ¾ Liquidity
¾ Asset based valuations ¾ Efficiency
¾ Earnings based valuations ¾ Gearing
¾ Dividend based valuation ¾ Investor ratios
1801
1 REASONS FOR BUSINESS VALUATION

¾ To determine the value of a private company e.g. for a Management Buy Out (MBO)
team;
¾ To determine the maximum price to pay when acquiring a listed company e.g. in a
merger or takeover - note that the quoted share price is only relevant for taking a
minority shareholding;
¾ To aid in decisions on buying/selling shares in private companies;
¾ To place a value on companies entering the stock market i.e. Initial Public Offerings –
IPO’s;
¾ To value shares in a private company for tax/legal purposes;
¾ To value subsidiaries/divisions for possible disposal.
2 NATURE OF BUSINESS VALUATION

¾ When a business is valued it is not a precise exercise and there is often no unique
answer to the question of what it is worth e.g. the value to the existing owner may be
significantly different to the value to a potential buyer.
¾ There are a variety of different methods of valuing businesses which may produce
different overall values. These can be used to determine a range of prices.
¾ The relevant range of values is:
the minimum price the current owner is likely to accept;

the maximum price the bidder is likely to pay.
¾ The final price will result from negotiations between the parties.
¾ In the following sections the following methods of valuation will be considered:
asset based valuations

earnings based valuations
dividend based valuations
1802
3 ASSET BASED VALUATION METHODS

3.1 Net Book Value (NBV)
¾ Simply uses the balance sheet equation i.e.
Equity = assets - liabilities
¾ Problems:
balance sheet values are often based upon historical cost rather than market values;
net book value of assets depends on depreciation policy;
many key assets are not recorded on the balance sheet e.g. internally generated
goodwill.
¾ For the above reasons a valuation based upon balance sheet net assets is not likely to be
reliable.
3.2 Net Realisable Value (NRV)
¾ This estimates the liquidation value of the business
Equity = estimated net realisable value of assets - liabilities
¾ This may represent the minimum price that might be acceptable to the present owner of
the business.
¾ Problems:
estimating the NRV of assets for which there is no active market e.g. a specialist
item of equipment ;
ignores unrecorded assets such as internally generated goodwill;
3.3 Replacement cost
¾ This can be viewed as the cost of setting up an identical business from nothing
Equity = estimated depreciated replacement cost of net assets
¾ This may represent the maximum price a buyer might be prepared to pay.
¾ Problems:
technological change means it is often difficult to find comparable assets for the
purposes of valuation ;
ignores unrecorded assets;
1803
4 EARNINGS BASED VALUATION METHODS

4.1 Price/Earnings Ratios
The published P/E ratio of a quoted company takes into account the expected growth rate of
that company i.e. it reflects the market’s expectations for the business.
Using published P/E ratios as a basis for valuing unquoted companies may indicate an
acceptable price to the seller of the shares.
Market price per ordinary share

Price/Earnings (P/E) ratio =
Earnings Per Share
Profit after tax and preference dividends

Earnings per Share (EPS) =
Number of issued ordinary shares
Therefore:
Ordinary share price = P/E ratio × EPS
This can be used for valuing the shares in an unquoted company.
Step 1 Select the P/E ratio of a similar quoted company.
Step 2 Adjust downwards to reflect the additional risk of an unquoted company and the
non-marketability of unquoted shares.
Step 3 Determine the maintainable earnings to use for EPS.
4.2 Earnings Yield
¾ Earnings yield is simply the reciprocal of the P/E ratio.
EPS
Earnings Yield = × 100
Market price per share
Therefore:
EPS
Ordinary share price =
Earnings Yield
1804
Example 1
You are given the following information regarding Accrington Ltd, an

unquoted company.
(a) Issued ordinary share capital is 400,000 25c shares.
(b) Extract from income statement for the year ended 31 July 19X4.
$ $
Profit before taxation 260,000
Less Corporation tax (120,000)
________
Profit after taxation 140,000
Less Preference dividend 20,000
Ordinary dividend 36,000
______
(56,000)
________
Retained profit for year 84,000
________
(c) The P/E ratio applicable to a similar type of business (suitable for an
unquoted company) is 12.5.
Value 200,000 ordinary shares in Accrington Ltd on an earnings basis.
Solution
1805
5 DIVIDEND BASED METHODS OF VALUATION

5.1 Dividend yield
Dividend per share

Dividend yield = × 100
Market price pre share
Dividend per share

Therefore share price =
Dividend yield
Step 1 Determine the dividend for the unquoted company
Step 2 Choose a published dividend yield for a similar quoted company
Step 3 Adjust this dividend yield upwards to reflect the greater risk of an unquoted
company and the non-marketability of unquoted company shares.
¾ This method fails to take growth in to account and therefore can lead to an under-
valuation
¾ It also has little relevance for valuing a majority shareholding as such an investor has the
ability to change the dividend policy.
Example 2
An individual is considering the purchase of 2,000 shares in G Ltd.
G Ltd has 50,000 shares in issue and the latest dividend payment was 12 cents
per share.
G Ltd is similar in type of business, size and gearing to H plc. H plc has a
published dividend yield of 10%.
Suggest a price that the individual might pay for the 2,000 shares in G Ltd.
Solution
1806
5.2 Dividend Valuation Model
¾ If dividends are expected to remain constant e.g. on preference shares:
D
Po =
re
Where P0 = today’s share price
D = dividend per share
re = required return of equity investors
¾ If dividends are forecast to grow at a constant rate in perpetuity
D0(1 + g) D1
Po = =
re − g re − g

g = growth rate
Step 1 Determine current dividend and estimated growth rate
Step 2 Determine the required return − for example by using the Capital Asset Pricing
Model (CAPM) on a similar quoted company and then adjusting upwards to reflect
greater risk/lack of marketability of unquoted shares
¾ Problems:
determining growth rate of dividends;

determining appropriate required return for unquoted company;
little relevance for valuing a majority shareholding as such an investor has the
ability to change the dividend policy.
1807
Example 3
Claygrow Ltd is a company which manufactures flower pots. The following

data are available.
Current dividend 25c per share

Required return on equities in this risk class 20%
Value one share in Claygrow Ltd under the following circumstances.
(i) No growth in dividends
(ii) Constant dividend growth of 5% per annum
(iii) Constant dividends for five years and then growth of 5% per annum to
perpetuity
(iv) Constant dividends for five years and then sale of the share for $2.00.
Solution
1808
6 RATIO ANALYSIS
6.1 Profitability ratios
Gross profit
Gross profit margin = × 100
Sales
Profit before interest and tax

Operating profit margin = × 100
Sales

Return on Capital Employed (ROCE) = × 100
Shareholders' funds + non - current liabilities
Profit after tax - preference dividends

Return on Equity (ROE) = × 100
Ordinary shareholders' funds
6.2 Liquidity ratios

Current assets
Current ratio =
Current liabilities
Current assets − inventory

Quick or acid test ratio =
Current liabilities
6.3 Efficiency/activity ratios
Average accounts receivable

Accounts receivable days = × 365
Annual credit sales
Average accounts payable
Accounts payable days = × 365
Annual credit purchases
Average inventory
Inventory days = × 365
Annual cost of sales
Cash conversion cycle = inventory days + receivables days – payables days
Sales
Total asset turnover =
Total assets
Sales
Fixed asset turnover =
Fixed assets
1809
6.4 Gearing/Risk ratios
Financial gearing:
Non - current liabilities

Debt to equity = × 100
Capital + reserves
Non - current liabilitie s

Debt to total capital = × 100
Capital employed
¾ gearing can also be referred to as leverage
Operational gearing:
Fixed operating costs Fixed operating costs

× 100 or × 100
Variable operating costs Total operating costs

Interest cover =
Interest expense
Cash generated from operations

Cash flow coverage =
Interest expense
6.5 Investor ratios
Earnings per ordinary share (EPS)
Profit after tax - preference dividends

=
Weighted average number of ordinary shares in issue
Diluted EPS should also be calculated where a company has a complex capital structure that
includes Potentially Dilutive Securities (PDS’s). These are securities in issue which involve
an obligation to issue shares in the future e.g. convertible debt, warrants.
Profit after tax - preference dividends + PDS adjustments

Diluted EPS =
Weighted average ordinary shares + PDS' s outstanding
Profit ater tax - preference dividend

Dividend cover =
Ordinary dividend
Ordinary dividend
Dividend payout ratio =
Profit after tax - preference dividend
Dividend per ordinary share

Dividend yield = × 100
Ordinary share price

Price earnings ratio (P/E ratio) =
EPS
1810
EPS
Earnings yield = × 100
Year - end share price + dividends

Total Shareholder Return (TSR) = × 100
Share price at start of year
Example 4
Cathcart Inc
Summarised balance sheet at 31 December 200X
$000 $000
Non - current assets
Cost less depreciation 2,200
Current assets
Inventory 400
Receivables 500
Cash 100
_____
1,000
_____
3,200
_____
Equity
Ordinary shares ($1 par) 1,000
Retained earnings 800
Non-current liabilities
10% bond 600
Preferred shares (10%) ($1 par) 200
Current liabilities
Payables 400
Income tax 200
_____
600
_____
3,200
_____
1811
Cathcart Inc
Summarised income statement for the year ended 31 December 200X
$000 $000
Turnover 3,000
Cost of sales (2,400)
_____
Gross profit 600
Operating expenses (200)
_____
Profit before interest and tax 400
Interest (60)
_____
Profit before tax 340
Income tax (180)
_____
Profit after tax 160
_____
Dividends
Ordinary 125
Preference 20
Current quoted price of $1 ordinary shares in Cathcart Inc $1.40

_____
Required:
Calculate each of the following ratios for Cathcart Inc:
(a) Gross profit margin
(b) Operating profit margin
(c) Return on capital employed
1812
(d) Return on equity
(e) Current ratio
(f) Acid test ratio
(g) Receivables days
(h) Total asset turnover
(i) Fixed asset turnover
(j) Proportion of debt finance
(k) Interest cover
(l) Earnings per ordinary share
1813
(m) Dividend cover
(n) Dividend yield
(o) Price earnings ratio
Key points
³ Business valuation is not a science – different analysts use different

techniques.
³ You need to enter the exam with a range of methods at your disposal and
choose the most relevant depending what data is available and whether
you are required to value a minority stake or a business in total.
³ Ratio analysis is also a subjective area – different analysts calculate ratios

in slightly different ways. If the exam question does not define exactly
how a certain ratio should be calculated then state your definition, show
your workings and be consistent between companies/years. Often it is the
change in ratios which is more relevant than their absolute level.
FOCUS
¾ prepare and justify a range of prices for valuing a business in a variety of

different circumstances;
¾ calculate and interpret all key ratios for a business.
1814
EXAMPLE SOLUTIONS
Solution 1
Valuation of 200,000 shares = 200,000 × P/E ratio × EPS
(140,000 − 20,000)
= 200,000 × 12.5 ×
400,000
= $750,000
Solution 2
Dividend
Share price =
Dividend yield
Dividend yield to be adjusted upwards to reflect greater risk and non-marketability of

unquoted company - say 13% (subjective)
12
Share value =
0.13
= 92 cents per share.
Estimated value of 2,000 shares = $1840
Solution 3
0.25
(i) Constant dividend Po = = $1.25
0.2
0.25 (1.05)
(ii) Constant growth in dividend Po = = $1.75
(0.2 − 0.05)
(iii) Present value of five years’ dividend of $0.25 pa = $0.25 × 2.991 =

$0.748
plus
Present value of growing dividend from year 6 onwards
0.25 (1.05) 1
× = $0.703
(0.20 − 0.05) 1.2 5
_______
$1.451
_______
(iv) Present value of five years’ dividend of $0.25 pa = $0.25 × 2.991 $0.748
1
Present value of $2.00 in five years’ time = $2.00 × $0.804
1.2 5
_______
$1.552
_______
1815
Solution 4
(a) Gross profit margin
600
= × 100 = 20%
3 ,000
(b) Operating profit margin
400
= × 100 = 13.3%
3 ,000
(c) Return on capital employed
400
= × 100 = 15.4%
1,000 + 200 + 800 + 600
(d) Return on equity
160 - 20
= × 100 = 7.8%
1800
(e) Current ratio
1,000
= = 1.67: 1
600
(f) Acid test ratio
600
= = 1: 1
600
(g) Receivables days
500
= × 365 = 61 days
3,000
(h) Total asset turnover
3,000
= = 0.94
3,200
(i) Fixed asset turnover
3,000
= = 1.4
2,200
1816
(j) Proportion of debt finance
800
= × 100 = 44.4%
1800
OR
800
= × 100 = 30.8%
800 + 1800

(k) Interest cover =
Interest charge
400
= = 6.67
60
(l) Earnings per ordinary share
160 − 20
= = 14 cents
1,000
(m) Dividend cover
160 - 20
= = 1.1
125
Dividend per ordinary share

(n) Dividend yield = × 100
12.5 cents
= = 8.9%
$1.40
Share price
(o) Price earnings ratio =
EPS
140
= = 10
14
1817
1818
SESSION 19 – GLOSSARY
Accounting Rate of Return (ARR) – the average annual operating profit generated by a project
Agency Costs – the reduction in shareholders’ returns below the maximum possible level due
to company managers following personal objectives not in the best interests of shareholders
Alpha – a measure of abnormal return from a security i.e. where the forecast return is higher
or lower than expected by CAPM
Asymmetry of information – the fact that potential investors know less about a company than
its managers and may therefore over-estimate the risk of providing finance. This can be a
particular problem for SME’s
Basis risk – the risk that interest rates on assets and liabilities are referenced to a different
benchmark
Beta factors – a measure of the sensitivity of a security’s returns to systematic risk
Bird in the Hand theory – suggest that shareholders may prefer the certainty of a cash
dividend today rather than reinvestment of profits to create an uncertain capital gain in the
future
Bonus issue – issue of new shares to existing shareholders, without any subscription of new
funds. Also referred to as a scrip issue
Business Risk – the volatility of operating profits, caused by the volatility of revenues and the
level of operational gearing
CAPM – Capital Asset Pricing Model. A model that relates the systematic risk of an
investment to the required return
Cap – an agreement that fixes a maximum rate of interest
Capital Rationing – where insufficient finance is available to undertake all available positive
NPV projects
Cash conversion cycle – time period between paying suppliers and receiving cash from
customers. Also known as the cash operating cycle or working capital cycle
Certificate of deposit – a tradable security issued by banks to investors who deposit a fixed
amount for a fixed period
Clientele Theory – suggest that a company’s historical dividend pattern may have attracted
particular investors. Changing the pattern in future may cause this “clientele” to sell their
holdings and lead to a fall in share price
Collar – an agreement that keeps either a borrowing or lending rate between specified upper
and lower limits
Corporate governance – controls and procedures implemented to reduce agency costs to an

acceptable level
1901
Corporate Social Responsibility (CSR) – a model which suggests that company managers
should take into account the objectives of a wide range of stakeholders and not just the
shareholders
Dividend Valuation Model – states that the value of a share is the present value of future
expected dividends, discounted at the investors’ required return
Economic risk – the risk that long-term changes in exchange rates affects a company’s
profitability
Efficient Markets Hypothesis (EHM) – a theory which asks what information is reflected in
share prices
Environmental Management Accounting (EMA) – attempts to measure the full environmental

impact of a company’s operations e.g. the cost of inefficient energy usage due to poor
insulation of buildings
Financial gearing – the proportion of debt in the capital structure
Financial risk – the increased volatility of returns to ordinary shareholders due to interest on
debt being a fixed committed cost
Financial distress risk – the risk of bankruptcy caused by dangerously high levels of financial
gearing
Floor – an agreement that fixes a minimum rate of interest
Forward contract – a legally binding contract between a company and a bank to buy or sell a
fixed amount of foreign currency at a fixed exchange rate on a fixed date in the future
Forward Rate Agreements – contracts which allow companies in advance to fix future
borrowing or lending rates, based on a notional principal over a given period.
Futures contract – a traded forward contract
Gap exposure – the risk that interest rates on assets and liabilities are reset at different
intervals
Gordon’s growth model – states that the forecast growth rate of a company’s dividend =
proportion of profits retained × return on equity
Gross Redemption Yield – see Yield to Maturity
IRR – Internal Rate of Return; the discount rate where NPV equals zero
NPV – Net Present Value; the change in shareholders’ wealth due to an investment project
Operational gearing – the proportion of fixed operating costs to variable operating costs
Payback – the period of time required for the operating cash flows from a project to equal the
cost of investment
1902
Pecking Order theory – a theory which suggests that company managers have a preference for
using internal finance i.e. retained earnings, rather than external finance. A key cause may
be asymmetry of information
Pre-emptive rights – the right of existing shareholders to be offered new shares before they
can be offered to new investors. Also known as pre-emption rights
Rights Issue – an offer of new shares to existing shareholders who hold pre-emptive rights
Scrip dividend – issue of new shares to existing shareholders in lieu of a cash dividend
Scrip Issue – see bonus issue
Securities – financial instruments that can be traded e.g. shares, bonds and derivatives.
SME’s – Small and Medium-sized Enterprises. No official definition exists but generally
these are unlisted companies
Special dividend – a substantial dividend payment that is not expected to be repeated in the
near future
Stakeholders – groups of people who have some type of interest in an organization.

Shareholders are the key stakeholder but other groups include employees, customers,
suppliers and, arguably, even society as a whole.
Systematic risk – the relative effect on the returns of an individual security of changes in the
market as a whole. Also known as market risk. It cannot be removed by diversification but
can be measured using beta factors
Tax Shield – interest on debt is a tax allowable expense for a company and leads to lower
corporate tax payments
Term Structure of Interest Rates – the relationship between short and long term interest rates
Total Shareholder Returns (TSR) – the total return to shareholders via dividend and capital
gain, usually measured over a one year period
Transaction Risk – the risk that exchange rates change between the date of an import/export
and the related payment/receipt of foreign currency
Translation risk – gains/losses caused by translating the financial statements of overseas

subsidiaries into the reporting currency of the parent upon consolidation
Treasury Bills – virtually risk-free short-dated debt securities issued by governments
Unsystematic risk – the risk that is specific to a company and hence can be diversified away
by building a portfolio of investments
1903
WACC – Weighted Average Cost of Capital; the average cost of long-term finance
Warrants – share options attached to debt to make the debt more attractive to investors
Yield to Maturity (YTM) – the average annualized return on a debt security, taking into
account both income and capital gains
1904
SESSION 20 – INDEX
A D
ABC system of stock control 1411 Debentures 903
Accounting rate of return (ARR) 303 Debt factoring 1505, 1604
AIM Listing 803 Decision-making 607
Annual equivalents 605 Direct control 203
Annuities 410, 413 Discounted cash flow techniques 407
Asset betas 1207 Discounting 405
Dividend growth 1006
B Dividend policy 806
Dividend valuation model 1002
Bank loans 907, 1303
Bank overdraft 908, 1505
Baumol model 1507
E
Beta factors 1202 Economic order quantity (EOQ) 1403
Bill of exchange 212, 909 Efficiency ratios 1304, 1809
Bonus issue 808 Efficient Market Hypothesis 218
Borrowing 1505 Enterprise Investment Scheme (EIS) 805
Business angels 910 Equity betas 1207
Business risk 1105 EURO 211
Eurobond market 215
C European Regional Development Fund211
Expectations theory 1705
Capital asset pricing model 1201
Expected values 706
Capital expenditure 302
Capital markets 215
Capital rationing 602
F
Capital structure 1106 Finance leases 606
Capitalisation issue 808 Financial distress risk 1108
Cash management 1502 Financial intermediaries 212, 220
Cash operating cycle 1305 Financial management 102
Clearing banks 213 Financial risk 1105, 1207
Collection procedures 1603 Financing ratios 1810
Competition policy 210 Fiscal policy 205, 207
Compound interest 403 Fisher effect 1705
Conflicts of interest 104
Convertible debentures 1017 G
Convertibles 905
Gearing 1105
Corporate objectives 102
Goal congruence 105
Cost of capital 1406
Gordon’s growth model 1008
Cost of debt 1011
Government intervention 210
Cost of equity 1005
Grants 910
Credit control 204, 1602
Credit creation 214
Credit rating 1602
Credit terms 1602
Cumulative preference dividends 902
Currency risk 1706
2001
I O
Inflation 207, 511 Offer for sale 802
Interest rate parity 1704 Offer for subscription 802
Interest rates 220 Official Listing 803
Internally-generated funds 806 Organisational objectives 102
International Fisher effect 1705 Overdue invoices 1603
Investment decisions 301 Overheads 408
Invoice discounting 1603 Overtrading 1307
Irredeemable debt 1012
P
J Payback period 302
Just-in-time system 1411 Periodic review system 1411
Perpetual inventory methods 1412
K Perpetuities 411
Placing 802
Keynesian approach 205
Preference shares 902, 1011
Private companies 103
L
Privatisation 211
Lagging 1707 Profitability ratios 1809
Lead time 1408 Project appraisal 407
Leading 1707 Public limited companies 103
Lease v buy 606 Public sector organisations 103
Leasing 907 Purchasing power parity 1702
Liquidity 1302
Loan guarantee scheme 910, 911 Q
Quantity discounts 1406
M
Macroeconomic policy 202 R
Management of trade creditors 1607
Real rates 512
Material requirements planning (MRP)
Redeemable debentures 1014
1412
Relevant costs 502
Matching 1707
Re-order level 1408
Miller-Orr model 1508
Replacement analysis 604, 606
Modigliani and Miller’s 1108
Retail Price Index 207
Monetarists 208
Revenue expenditure 302
Monetary policy 203, 206, 207
Rights issue 802, 804
Money markets 215
Risk 702
Money rates 512
Money supply 203, 204
Monte Carlo method 705
Mortgage loan 908
Multiplier effect 214
N
Net present value 408, 409
Netting 1707
Nominal rates 512
2002
S U
Sale and leaseback 907, 908 Uncertainty 702
Scrip dividends 809, 810 Unsystematic risk 1202
Scrip issue 808
Security Market Line 1205 V
Sensitivity analysis 702, 1504
Valuations 1801
Settlement discounts 1602, 1606
Vendor placings 802
Share issue 802, 808
Venture capital 805
Shareholders 105
Venture Capital Trusts (VCTs) 805
Shares 216
Short-term investments 1506
W
Simple interest 402
Simulation 705 Warrants 905
Single-period capital rationing 602 Wealth maximisation 103
Source of finance 1607 Weighted average cost of capital 1102
Standard deviation 707 Working capital management 1302
Stock control 1402
Stock Exchange 216 Y
Stock market ratios 1810 Yield curves 221
Stock splits 809
Supply side policies 206 Z
Surplus funds 1505
Systematic risk 1202 Zero coupon bonds 904
T
Tax relief 904
Taxation 506
Tender 802
Time value 407
Trade credit 1608
Transaction exposure 1707
Treasury management 1502
2003
2004
STUDY QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Answer 1 PRIVATE V PUBLIC SECTOR OBJECTIVES
(a) Financial objectives
(i) State owned enterprise
(1) The overall objective is commonly to fulfil a social need.
(2) Because of problems of measuring attainment of social needs the

government usually sets specific targets in accounting terms.
(3) Examples include target returns on capital employed, requirement to be

self financing, cash or budget limits.
(ii) Private sector
(1) The firm has more freedom to determine its own objectives.
(2) A capital market quotation will mean that return to shareholders becomes
an important objective.
(3) Traditionally financial management sees firms as attempting to maximise

shareholder wealth. Note that other objectives may exist, e.g. social
responsibilities, and the concept of satisficing various parties are
important.
(b) Strategic and operational decisions
The major change in emphasis will be that decisions will now have to be made on a largely
commercial basis. Profit and share price considerations will become paramount. The
following are examples of where significant changes might occur.
Financing decisions. The firm will have to compete for a wide range of sources of
finance. Choices between various types of finance will now have to be made, e.g.
debt versus equity.
Dividend decision. The firm will now have to consider its policy on dividend
payout to shareholders.
Investment decision. Commercial rather than social considerations will become of

major importance. Diversifications into other products and markets will now be
possible. Expansion by merger and takeover can also be considered.
Threat of takeover. If the government completely relinquishes its ownership it is

possible that the firm could be subject to takeover bids.
Other areas. Pricing, marketing, staffing etc will now be largely free of
government constraints.
1001
FINANCIAL MANAGEMENT (F9) – STUDY QUESTION BANK
Answer 2 CAPITAL MARKET EFFICIENCY
The efficient market hypothesis is often considered in terms of three levels of market efficiency.
(a) Weak-form efficiency

(b) Semi-strong form efficiency
(c) Strong-form efficiency.
The accuracy of the statement in the question depends in part upon which form of market efficiency is
being considered. The first sentence states that all shares prices are correct at all times. If “correct”
means that prices reflect true values (the true value being an equilibrium price which incorporates all
relevant information that exists at a particular point in time), then strong-form efficiency does suggest
that prices are always correct. Weak and semi-strong prices are not likely to be correct as they do not
fully consider all information (e.g. semi-strong efficiency does not include inside information). It might
be argued that even strong-form efficiency does not lead to correct prices at all times as, although an
efficient market will react quickly to new relevant information, the reaction is not instant and there will
be a short period of time when prices are not correct.
The second sentence in the statement suggests that prices move randomly when new information is
publicly announced. Share prices do not move randomly when new information is announced. Prices
may follow a random walk in that successive price changes are independent of each other. However,
prices will move to reflect accurately any new relevant information that is announced, moving up when
favourable information is announced, and down with unfavourable information. If strong-form
efficiency exists, prices might not move at all when new information is publicly announced, as the
market will already be aware of the information prior to public announcement and will have already
reacted to the information.
Information from published accounts is only one possible determinant of share price movement. Others
include the announcement of investment plans, dividend announcements, government changes in
monetary and fiscal policies, inflation levels, exchange rates, and many more.
Fundamental and technical analysts play an important role in producing market efficiency. An efficient
market requires competition among a large numb of analysts to achieve “correct” share prices, and the
information disseminated by analysts (through their companies) helps to fulfil one of the requirements
of market efficiency, i.e. that information is widely and cheaply available.
An efficient market implies that there is no way for investors or analysts to achieve consistently
superior rates of return. This does not say that analysts cannot accurately predict future share prices.
By pure chance some analysts will accurately predict share prices. However, the implication is that
analysts will not be able to do so consistently. The same argument may be used for corporate financial
managers. If, however, the market is only semi-strong efficient, then it is possible that financial
managers, having inside information, would be able to produce a superior estimate of the future share
price of their own companies and that, if analysts have access to inside information, they could earn
superior returns.
1002
Answer 3 BASIC DISCOUNTING
(a) (i)
(30 × 0.909) + (40 × 0.826) + (50 × 0.751)

= $182
+ (60 × 0.683) + (70 × 0.621)
(ii)(30 × 1.736) + (50 × (3.791 – 1.736)) = $155
(iii)((50 + 60) × 0.909) + (70 × 0.826) + (80 × 0.751) = $222
(b) (i) $500 × 5.019 = $2,510
(ii)$500 × (5.019 × 0.870) = $2,183
(iii)$500 × (4.772 + 1) = $2,886
(c) (i) $15,000 ÷ 4.329 = $3,465
(ii)$15,000 ÷ (4.329 × 0.952) = $3,640
(iii)$15,000 ÷ (3.546 + 1) = $3,300
(d) (i) $1,500 ÷ 0.10 = $15,000
(ii)($1,500 ÷ 0.10) × 0.683 = $10,245
(e) $500 ÷ 0.482 = $1037
(f) ($8 × 3.791) + ($100 × 0.621) = $92.43
1003
Answer 4 ELVIRA CO PLC
(a) Payback period
A $100,000/$40,000 = 2.5 years (or 3 years, if cash flows arise at year end)
B After 4 years net position is $120,000-$40,000 = $80,000 negative.

Payback = 4 years + $80,000/$200,000 = 4.4 years
C After one year cash $50,000 negative. Payback = 1 + $50,000/$80,000 = 1.6 years
(b) Accounting rate of return
A Total profit = total inflow – total depreciation = 160 - (100-10) = 70

Average profit = 70/4 = 17.5
Average investment = (cost + residual value)/2 = (100+10)/2 = 55
ARR = 17.5/55 = 31.8%
B 40.0%
C 27.3%
(c) Net present value at 15%
A – $100,000 + ($40,000 × 2.855) + ($10,000 × 0.572) = $19,920

B – $120,000 + ($10,000 × 2.855) + ($212,000 × 0.497) = $13,914
C – $150,000 + ($100,000 × 0.870) + ($95,000 × 0.756) = $8,820
(d) Internal rate of return
NPV at 20%
A – $100,000 + $40,000 × 2.589 + $10,000 × 0.482 = $8,380

B – $120,000 + $10,000 × 2.589 + $212,000 × 0.402 = – $8,886
C – $150,000 + $100,000 × 0.833 + $95,000 × 0.694 = – $770
IRR
19,920
A 15 + × (20 – 15) = 24%
(19,920 − 8,380)
13,914
B 15 + × (20 – 15) = 18%
(13,914 + 8,886)
8,820
C 15 + × (20 – 15) = 20%
(8,820 + 770)
Summary
A B C Preferred
Payback (years) 3 5 2 C
ARR (%) 32 40 27 B
NPV ($000) 20 14 9 A
IRR (%) 24 18 20 A
1004
Answer 5 KHAN LTD
(a) NPV and IRR calculations
Promotion method NPV IRR

$ %
Alternative 1 + 3,100 5 or 50
Alternative 2 + 3,470 23
WORKINGS
Alternative 1
(i) Net present value
Cash 20% Present

flow discount value
$000 factor $000
Year 0 (100.0) 1.000 (100.00)
Year 1 255.0 0.833 212.41
Year 2 (157.5) 0.694 (109.31)
———
Net present value 3.10
———
(ii) Internal rate of return
NPV = – 100 + 255 (1 + r)-1 – 157.5 (1 + r)-2 = 0
Solving this quadratic equation for “r” to find the internal rate of return (note –
it is not likely that you will be required to solve quadratic equations under
exam conditions)
Multiply each side of the equation by – (1 + r)2
100 (1 + r)2 – 255 (1 + r) + 157.5 = 0
− b ± (b 2 − 4ac)
Using the quadratic formula: x =
2a
255 ± (255 2 − (4 × 100 × 157.5) 255 ± 45

(1 + r) = =
2 × 100 200
∴ (1 + r) = + 1.05 r = 0.05 or 5%
or (1 + r) = + 1.50 r = 0.50 or 50%
Thus Alternative 1 has two internal rates of return: 5% and 50%.
1005
Alternative 2
(i) Net present value
Cash 20% Present

flow discount value
$000 factor $000
Year 0 (50) 1.000 (50.00)
Year 1 0 0.833 0
Year 2 42 0.694 29.15
Year 3 42 0.579 24.32
———
Net present value 3.47
———
The internal rate of return is estimated using linear interpolation.
Using a 20% discount rate (see above), the cash flow has an NPV of $3,470.
Using a 25% discount rate, the NPV of the cash flow is as follows.
Cash 25% Present

flow discount value
$000 factor $000
Year 0 (50) 1.000 (50.00)
Year 1 0 0.800 0
Year 2 42 0.640 26.88
Year 3 42 0.512 21.50
———
Net present value (1.62)
———
Therefore, the IRR (the discount rate that reduces net present value to zero) lies
between 20% and 25%.
3,470
IRR ≈ 0. 20 + × (0.25 – 0.2) = 0.234
(3,470 + 1,620)
The internal rate of return is approximately 23%.
(b) Choice of project
The net present value calculations indicate that Alternative 2 is more favourable and
should be undertaken. It has the larger positive net present value and should therefore add
the greater extra amount to shareholders’ wealth; although it should be noted that there is
relatively little difference between the NPV of the two alternatives.
1006
However, it would be unwise to make the final decision solely on the basis of these
calculations without investigating the risk attached to each alternative and the marketing
and manpower factors that may be involved. For example, the heavy advertising
characteristic of Alternative 1 may have a beneficial spin-off for the company’s other
products, or the widespread use of agents with this alternative may again benefit the
promotion of other products imported by Khan Ltd. In terms of the risk aspects, it may be
judged that novelty products generally are high risk short-lived undertakings and that
Alternative 1, which promotes the product for only a single year, may be a less risky
approach than Alternative 2, which appears to extend the life by a further one or two years.
In addition, there are innumerable other considerations which may be relevant to the
decision, such as whether the promotion of this particular novelty product will adversely
affect other products sold by the company.
The internal rates of return of the two alternatives have been ignored in formulating the
decision advice for two main reasons. The first is that Alternative 1 has two internal rates
of return, one above, the other below, the required rate. This conflicting investment advice
clearly indicates that the use of internal rates of return is an unreliable (and unhelpful)
investment decision guide.
The second reason for rejecting the IRR approach is more theoretical, but still valid for
practical decision-making. It is that the decision rule selects between mutually-exclusive
alternatives on the assumption that the opportunity cost of any investment’s cash flow is
equal to the internal rate of return of that investment.
This can easily be demonstrated to be a fallacious assumption, as the opportunity cost of

cash generated by a project is (or should be) reflected by the firm’s cost of capital at the
time of generation, certainly not (except by chance) by the internal rate of return of the
generating project.
In these terms the internal rate of return of a project can be seen as little more than an
arithmetic artefact that has little economic rationale behind it, and is therefore an unreliable
decision-making guide. Mr Court’s views are important and are commented upon in part
(c) below, including reasons why the payback method was not used to help to reach a
decision.
(c) Comments on Mr Court’s views
Mr Court makes two points of note – one concerns the payback method of investment
appraisal, whilst the other concerns the relationship between reported profits and
investment decision-making. These two points will be commented upon separately.
(i) The payback method
The payback method of investment appraisal is relatively quick and simple to operate and
understand. It calculates how quickly a project’s outlay is recovered from its generated
earnings, usually cash flows, though alternatives are possible.
A number of fairly minor criticisms of the use of payback period can be made, some of which
can be illustrated by the two alternatives under evaluation. On the basis of Mr Court’s
remarks, it would appear that Khan Ltd already uses the payback method and therefore has
already set a maximum acceptable payback criterion. Ignoring the problems surrounding the
setting of this criterion, Alternative 1 illustrates two of the method’s possible ambiguities: the
definition of outlay (e.g. is it $100,000 or $257,700?) and identifying the start of the payback
period. However, assuming that some sort of discounted payback is used which takes into
account the time value of money, the major fault of the method concerns its failure to
consider the project cash flow that lies outside the payback time period.
1007
Notwithstanding these comments, payback can act as a useful guide to project desirability
when liquidity is a problem for a company and the speed of a project’s return is of prime
importance. This may be particularly true where, in addition, the investment opportunities are
relatively small and where it may be felt that a full scale discounted cash flow evaluation is
unnecessary.
However, in the situation given, there is no indication as to the relative size of the two
promotion alternatives to the company as a whole but, on the basis that cash is not in short
supply over the next three years, the firm does not appear to have any liquidity problem.
Thus there would seem to be little evidence to support Mr Court’s preference for the payback
method.
One final point is that the supporters of payback claim that the method does attempt to allow
for uncertainty in that it prefers fast payback projects. Such a claim is really unjustified as it
is based on the belief that uncertainty is concerned with the timing of a project’s return. This
is somewhat naive.
(ii) Investment appraisal and reported profits
Mr Court’s second comment highlights a real problem in that a different approach is used for
investment decision-making (discounted cash flows) from that used for reporting the success
or otherwise of the decisions made (reported profits). Most investment opportunities
undertaken by firms have returns whose generation covers a relatively long time period
(several years). It is one of the tasks of published accounts (and particularly the profit and
loss account) to cut up this continuous stream of wealth generation into a series of time
periods: the accounting year.
It is certainly a powerful argument that, as well as undertaking NPV calculations,

management should also consider the implications for the published accounts of any
investment opportunity – especially if the projects are of a substantial size. For instance, if a
particular project had a healthy positive NPV but its acceptance would have an adverse effect
on the published financial accounts, although it would be unwise for the project to be rejected
on these grounds alone, management should make strenuous efforts to ensure that its
investment plans are fully communicated to and understood by the shareholders and the bonds
market in general.
In this case the comment has been made earlier that, although Alternative 2 is the more
favoured on the basis of its net present value, there is really little difference between the
NPVs of the two alternatives. If the acceptance of Alternative 2 would have a substantial and
adverse effect on the company’s reported profits, this may well be a legitimate reason in these
circumstances to review the NPV decision.
1008
Answer 6 FIORDILIGI PLC
t0 t1 t2 t3 t4 t5
$000 $000 $000 $000 $000 $000
Labour
Skilled 10,000 × 0.5 × Nil –
10,000 × 0.5 × $4.00 20.0 20.0
8,000 × 0.5 × $4.00 16.0 16.0
Unskilled 10,000 × 2 × $2.50 50.0 50.0 50.0
8,000 × 2 × $2.50 40.0 40.0
Materials
Ping 10,000 × 2 × $1.40 28.0 28.0 28.0
8,000 × 2 × $1.40 22.4 22.4
Pang 46,000 × 0.5 × $1.80 41.4
Pong 10,000 × 1.5 × $0.80 12.0 12.0 12.0
8,000 × 1.5 × $0.80 9.6 9.6
Overheads
Variable 10,000 × 0.5 × $1.40 7.0 7.0 7.0
8,000 × 0.5 × $1.40 5.6 5.6
Fixed Rent 2.0 2.0 2.0 2.0 2.0
Rates 1.0 1.0 1.0 1.0 1.0
——— ——– ——– ——– ——– ——–
83.4 100.0 120.0 112.0 96.6 62.6
——— ——– ——– ——– ——– ——–
Revenue 10,000 × $18 180.0 180.0 180.0

8,000 × $14 112.0 112.0
Costs (as above) (83.4) (100.0) (120.0) (112.0) (96.6) (62.6)
Purchase of plant (60.0)
Resale 6.0
——— ——– ——– ——– ——– ——–
Net cash flow (143.4) 80.0 60.0 68.0 15.4 55.4
——— ——– ——– ——– ——– ——–
Discount factors at 15% 1.000 0.870 0.756 0.658 0.572 0.497
Present values ($000) (143.0) 70.0 45.0 45.0 9.0 28.0
NPV = + $54,000
————
Therefore, accept.
1009
Answer 7 HULME LTD
(a) Cash flows resulting from manufacture and sale of Champs
Ref to Time 1 Time 2 Time 3 Time 4

workings $000 $000 $000 $000
Machine (150) – – –
Labour (1) – (75) (210) (252)
Materials
Alpha (2) (100) (110) (121) –
Beta (3) (90) (121) (133) –
Overheads (4) – (50) (55) (61)
——– ——– ——– ——–
Total outflows (340) (356) (519) (313)
Sales (5) – 600 660 726
——– ——– ——– ——–
Net inflow/(outflow) (340) 244 141 413
——– ——– ——– ——–
20% discount factor 1.000 0.833 0.694 0.579
Present value (340) 203 98 239
Net present value = $200,000

————
On the basis of the estimates given, production of Champs is worthwhile.
Note Time 0 is taken to be the date on which manufacture would commence, i.e.
1 January 19.00; time 1 is 31 December 19.00, etc.
WORKINGS
For explanations of the figures used, see part (b).
(1) Labour cost

$
Year 1 Skilled 25,000 hours @ $3 75,000
Unskilled No cost incurred –
———–
75,000
———–
Year 2 Skilled 25,000 × ($3 × 1.2) 90,000

Unskilled 50,000 × ($2 × 1.2) 120,000
———–
210,000
———–
Year 3 Year 2 cost × 1.2 252,000
1010
(2) Material Alpha
Current buying price is 50c per kg, rising at 10% per annum.
Time 0 cost 50c × 200,000 = $100,000

Time 1 cost $100,000 × 1.1 = $110,000
Time 2 cost $110,000 × 1.1 = $121,000
(3) Material Beta
Quantity held is enough for one year.
Time 0 realisable value 100,000 × 90c = $90,000

Time 1 buying price 100,000 × $1.10 × 1.1 = $121,000
Time 2 buying price 121,000 × 1.1 = $133,100
(4) Overheads
The only relevant costs are variable overheads, which rise at 10% per annum.
Year 1 cost 100,000 × 50c = $50,000

Year 2 cost $50,000 × 1.1 = $55,000
Year 3 cost $55,000 × 1.1 = $60,500
(5) Sales
The selling price rises at 10% per annum.
Year 1 100,000 × $6 = $600,000

Year 2 $600,000 × 1.1 = $660,000
Year 3 $660,000 × 1.1 = $726,000
(b) Brief explanations of the figures used
(1) Machine
Although the machine is owned already, it has an opportunity cost if used on

this project, which is the revenue forgone if it is not sold now for $150,000.
(2) Labour
In the first year of the project the company will have to pay for extra skilled
labour only, as there is enough surplus unskilled labour to cover the necessary
50,000 hours on the project. As this unskilled labour is paid whether or not the
Champs are produced, there is no relevant unskilled labour cost in year 1 of the
project.
In years 2 and 3 of the project the company will have to pay for extra skilled
and unskilled labour.
1011
(3) Material Alpha
Alpha is used regularly by the company on many projects. If existing inventory

are used to manufacture Champs, the company will have to buy in more
inventory of Alpha for its other projects. The relevant cost of Alpha is thus
always its buying price, which is expected to rise by 10% per annum.
(4) Material Beta
Present inventory of Beta are sufficient for the first year’s production of
Champs. Since there is no alternative use for Beta within the company, the
opportunity cost of existing inventory is the realisable value of 90c per kg.
After one year present inventory will be exhausted, and the relevant cost of
further supplies of Beta will be the buying price.
(5) Overheads
Fixed costs allocated from head office will be irrelevant to this decision as they
will be incurred whether or not Champs are produced.
Depreciation is irrelevant to a project appraisal based on cash flows.
The only relevant cost is, therefore, the variable overhead.
(c) Factors not included in the calculations which may affect the decision
(i) Availability of more profitable projects
The project has been appraised in its own right, but it should be compared with
alternative uses for the funds employed, particularly if there are constraints on
capital or other resources.
(ii) Scarcity of resources
The calculations assume that there is no scarcity in supply of the resources used on
the project, e.g. that sufficient supplies of Alpha or skilled labour are available at
the prices stated and that the use of them will not affect the quantities available for
the company’s normal operations. If there is a scarcity in supply, the opportunity
cost of these resources will include the lost contribution through not using the
resources on alternative projects.
(iii) Risk and uncertainty of estimates
Most of the figures used in the project appraisal are subject to uncertainty. The
decisions might be affected by revised estimates of the following.
(1) The sales price/sales volume relationship. Marketing of the Champ

may encourage others to compete with the new product, leading to
reduced sales, or to reduced selling price, or to a combination of the
two.
(2) The rate of inflation, which could lead to revised forecasts for costs and
the cost of capital.
(3) The length of the project.
1012
(4) Whether head office fixed costs would be unaltered by the new project.
In practice, the addition of a new line is likely to increase fixed costs.
Additional staff may be employed in accounts, despatch or stores, for
example, not directly connected with the new product line, but
ultimately resulting from the increased turnover. The need for
additional storage area may require the utilisation of space which could
otherwise have been sub-let. If so, the rental income forgone would be
treated as a relevant cash outflow.
Other more general possibilities, such as a change of government or a change in

fiscal policy, may affect the profitability of the project.
(iv) Management and labour skills
The calculation assumes that the necessary skills exist for this new project or that
they can be quickly acquired without any teething problems. In practice, this would
be a major factor in the decision.
(v) Technological change
Changing technology may render the Champ obsolete before the end of three years.
Answer 8 BAILEY PLC
(a) Investment appraisal of production of Oakmans
Year 1 2 3 4 5 6 7
$ $ $ $ $ $ $
Contribution before labour costs 139,150 153,065 168,371 92,604 101,865
Labour cost (39,675) (45,626) (52,470) (30,171) (34,696)
Redundancy payments (15,741)
Redundancy payments avoided 20,700
Machine overhaul (79,860)
———– ———– ———– ———– ——— ——— ———
20,700 99,475 27,579 100,160 62,433 67,169
Tax at 35% (7,245) (34,816) (9,653) (35,056) (21,852) (23,509)
Cost of machine (209,000)
WDAs 18,288 13,716 10,287 7,715 5,786 17,359
———– ———– ———– ———– ——— ——— ———
Net cash flows (188,300) 110,518 6,479 100,794 35,092 51,103 (6,150)
———– ———– ———– ———– ——— ——— ———
20% factors 0.833 0.694 0.579 0.482 0.402 0.335 0.279
Present value (156,854) 76,699 3,751 48,583 14,107 17,120 (1,716)
Net present value = $1,690

———
Conclusion
Bailey plc should, on the basis of the positive net present value, undertake production of
the Oakman. However, the decision is fairly marginal, and the estimate of all variables
should be carefully reviewed to ensure that the decision to produce is correct.
1013
Explanatory notes
(1) Contribution from sales before labour cost
These cash flows have been grouped as they all inflate at 10% per annum. At
current values the cash flow per unit is as follows.
$
Sales price 35
Material and other consumables (8) It is assumed that there is no
Variable overheads (4) change in head office fixed
—— costs if Oakman is produced
Net contribution before labour cost 23
——
(2) Labour cost
At current prices the labour cost per unit of 2 hours × $3 is included, as the six
employees would not be paid if the Oakman were not produced.
(3) Redundancy payment
This is the payment to the three redundant employees in four years’ time.
(4) Redundancy payments avoided
If the Oakman were not produced, there would be a payment of 6,000 hours ×
$3 × 1.15 to the six employees who would be made redundant. This is avoided
and hence is an incremental cash flow.
(5) Purchase and maintenance of machine
These are the cash flows that will be incurred.
(6) Overhead costs
It is assumed that the overhead costs will be allowed for tax in the year in
which they are incurred.
(7) Taxation
All tax paid on accounting profits is based on the previous year’s cash flow at
35%.
1014
(8) Writing down allowances

WDA Tax saved Timing
$ $ $
Cost – paid at end of first year (t1) 209,000
WDA year 1 (52,250) 52,250 18,288 t2
———–
156,750
WDA year 2 (39,188) 39,188 13,716 t3
———–
117,563
WDA year 3 (29,391) 29,391 10,287 t4
———–
88,172
WDA year 4 (22,043) 22,043 7,715 t5
———–
66,129
WDA year 5 (16,532) 16,532 5,786 t6
———–
49,597
Proceeds – end of year 6 –
———–
Balancing allowance 49,597 49,597 17,359 t7
———–
(9) General comments
The production of Oakman has been evaluated by considering the incremental

change in the company’s cash flows caused by a decision to produce. These
have been valued at the actual cash flow in each year, after allowing for the
differing effects of inflation on each item. These money cash flows have then
been discounted at the money cost of capital (net of corporation tax).
An alternative would have been to calculate a “real” discount rate for each cash
stream and discount the un-inflated cash flows at that rate.
(b) Discussion of investment appraisal problems caused by high inflation rates
The existence of high rates of inflation creates problems in investment appraisal by

contributing to the uncertainty attached both to the cash flows themselves and the
appropriate discount rate. It is unlikely that in any investment appraisal situation each cash
flow stream will be affected in the same way by inflation. The budget must predict as
accurately as possible the anticipated level of inflation.
Higher rates of inflation will tend to be more volatile than lower rates, especially as
government action will be directed to reducing them. With different inflation rates
applying to each item (e.g. materials and labour) the value of an investment could be
highly sensitive to changes in those rates. The extent to which the effect of inflation can be
passed on by income increases (e.g. raising product selling price) must also become less
certain as government controls, competitors’ reactions and the elasticity of demand become
more important.
1015
The conventional treatment of inflation is to discount the anticipated money cash flows at a
money discount rate. This money rate would normally be derived from the so-called
“dividend valuation model”, to give the shareholders’ required rate of return and the
required rate of return for other suppliers of capital such as debenture holders. Such a
required rate of return will consist of both a real rate reflecting the “time value of money”
to the providers of funds, plus an additional return to compensate for the decrease in
purchasing power caused by inflation.
Clearly, with higher anticipated inflation rates, such a money rate will be higher than with
lower rates. However, the company must anticipate such a required rate of return when
evaluating capital projects. With high inflation rates this anticipation becomes more
difficult, as again the expectations of the shareholders as to the effect of inflation on them
will become more diverse. Moreover, with the increased probability of changes in
inflation in the future, the required rate of return is unlikely to be constant over the life of
the project. The company will be faced with increasing uncertainty as to whether it is
acting in the best interests of shareholders by accepting or rejecting a particular project.
Finally, it should be noted that the above comments refer to the problems presented to
investment appraisal by expected or anticipated inflation. The correct treatment in capital
budgeting of unanticipated inflation has so far defied a workable solution, and this
represents a serious gap in the theory of financial decision-making.
Answer 9 STAN BELDARK
(a) Optimal replacement period
The effects of increasing running costs and decreasing resale value have to be weighed up
against capital cost. Road fund licence etc can be ignored, since Stan will always pay $300
per year per car.
The following table is one of the quickest ways to reach an answer.
Running PV Cum PV Resale PV of NPV of Cum EAC

cost of RC of RC value RV car discount
$ $ $ $ $ $ factor $
Life 1 3,000 2,727 2,727 3,500 3,182 5,045 0.909 5,550
Life 2 3,500 2,891 5,618 2,100 1,735 9,383 1.736 5,405
Life 3 4,300 3,229 8,847 900 676 13,671 2.487 5,497
From the above table it can be seen that the optimal replacement period is every two years.
(b) Discussion of investment appraisal and high inflation rates
The existence of high inflation creates problems in investment appraisal by contributing to

the uncertainty attached both to the cash flows and to the appropriate discount rate. It is
unlikely that in any investment appraisal each cash flow stream will be affected in the
same way by inflation. Higher rates of inflation will tend to be more volatile than lower
rates, especially as government action will be directed to reducing them.
With different inflation rates applying to each item (e.g. materials and labour), the value of
an investment could be highly sensitive to changes in those rates. The extent to which the
effect of inflation can be passed on by raising selling prices must also become less certain
as government controls, competitors’ reactions and the elasticity of demand become more
important. The appraisal procedures must therefore focus more attention on predicting the
effect of inflation on each type of cash flow.
1016
The existence of high rates of inflation will also affect the discount rate used. The
conventional treatment is to discount the anticipated money cash flows at a money
discount rate. This money rate would normally be the yield for shareholders and the
required rate of return for other suppliers of capital such as debenture holders. Such a
required rate of return will be a rate reflecting the time value of money to the provider of
funds, plus an additional return to compensate for the decrease in purchasing power caused
by inflation.
Clearly, with higher anticipated inflation rates such a money rate will be higher than with
lower rates. However, the company must anticipate such a required rate of return when
evaluating capital projects. With high inflation rates this anticipation becomes more
difficult, as again the expectations of the shareholders as to the effect of inflation on them
will become more diverse. Moreover, with the increased probability of changes in
inflation in the future the required rate of return is unlikely to be constant over the life of
the project. The company will be faced with increasing uncertainty as to whether it is
acting in the best interests of shareholders by accepting/rejecting a particular project.
Answer 10 TALEB LTD
Summary showing the optimal replacement policy for Taleb’s Dot machines
Replacement cycle Annual equivalent net revenue

$000
1 year 8.0
2 years 11.1 * * optimal policy
3 years 9.8
4 years 10.3
Replacement of the Dot machine every two years results in the greatest annual equivalent net
revenue for the company (i.e. $11,100) and therefore is the recommended replacement policy.
WORKINGS
Annual production/sales (units) 500,000 400,000
$ $
Annual revenue ($0.12 per unit) 60,000 48,000
Less Annual variable costs ($0.04 per unit) (20,000) (16,000)
——— ———
40,000 32,000
——— ———
1017
(i) One year replacement

Year 0 Year 1
$000 $000
Machine outlay (60)
Scrap value 40
Running costs (6)
Contribution 40
—— ——
Net cash flow (60) 74
—— ——
Net present values = – 60 + (74 × 0.909)
= 7.266
Annual equivalent = 7.266 ÷ 0.909
≡ $7,993
———
(ii) Two year replacement
Year 0 Year 1 Year 2
$000 $000 $000
Machine outlay (60.0)
Scrap value 25.0
Running costs (6.0) (6.5)
Contribution 40.0 40.0
——— ——— ———
Net cash flow (60.0) 34.0 58.5
——— ——— ———
Net present values = – 60 + (34 × 0.909) + (58.5 × 0.826)
= 19.227
≡ $11,075
———–
(iii) Three year replacement

Year 0 Year 1 Year 2 Year 3
$000 $000 $000 $000
Scrap value 10.0
Running costs (6.0) (6.5) (7.5)
Contribution 40.0 40.0 32.0
——— ——— ——— ———
Net cash flow (60.0) 34.0 33.5 34.5
——— ——— ——— ———
Net present values = – 60 + (34 × 0.909) + (33.5 × 0.826) + (34.5 × 0.751) = 24.4865
Annual equivalent = 24.4865 ÷ 2.487 ≡ $9,846

———
1018
(iv) Four year replacement
Year 0 Year 1 Year 2 Year 3 Year 4

$000 $000 $000 $000 $000
Scrap value 0
Running costs (6.0) (6.5) (7.5) (9.0)
Contribution 40.0 40.0 32.0 32.0
——— ——— ——— ——— ———
Net cash flow (60.0) 34.0 33.5 24.5 23.0
——— ——— ——— ——— ———
Net present values = – 60 + (34 × 0.909) + (33.5 × 0.826) + (24.5 × 0.751) + (23 ×
0.683)
= 32.6855
≡ $10,311
———–
Answer 11 STICKY FINGERS PLC
(a) No rationing
Present values
Year 0 1 2 3 4
Time t0 t1 t2 t3 t4
Discount factor 1 0.870 0.756 0.658 0.572
$000 $000 $000 $000 $000

Project A (1,500) (435) 907 395 172
Project B (2,000) (870) 1,890 1,645 1,430
Project C (1,750) 435 832 921 572
Project D (2,500) 609 680 855 172
Project E (1,600) (435) 151 1,842 1,316
NPV
$000
Project A (461)
Project B 2,095 Therefore, accept all projects with a
Project C 1,010 positive NPV - projects B, C and E
Project D (184)
Project E 1,274
1019
(b) Single-period capital rationing
Project A B C D E
NPV ($000) (461) 2,095 1,010 (184) 1,274
Investment, t0 ($000) 1,500 2,000 1,750 2,500 1,600
NPV/$ – $1.05 $0.58 – $0.80

Rank – 1st 3rd – 2nd
10
Therefore, accept B and 16
E.
(c) Single-period capital rationing – inflows and outflows, negative NPVs
NPV
Using benefit cost ratios
Rationed investment
Benefit/cost NPV per Ranking

$1 invested
Project A *
Project B $2,095/$1,000 $2.10 2
Project C *
Project D $184/$700 $0.26 **
Project E $1,274/$500 $2.55 1
Notes
* Project A would never be accepted because it has a negative NPV and uses up
funds in the restricted year.
Project C would always be accepted since it has a positive NPV and releases
funds in the restricted year. A total of $700,000 is then available.
** Project D has a negative NPV but releases funds at t1.
If project D is accepted, this makes an extra $700,000 available at t1. However, in doing
so a negative NPV (– $184,000) is incurred. Thus, it is necessary to examine whether the
extra positive NPV generated by the additional investment finance outweighs this cost.
(1) Available capital = $200,000. Accept projects C, E and 20% B. Total NPV =
$2,703,000.
(2) If D is accepted the available capital becomes $1,400,000 [$200,000 +
$500,000 (from project C) + $700,000 (from project D)]. Accept projects C, D,
E and 90% B. Total NPV = $3,985,500. This is the optimal solution.
(d) Indivisible projects
Possible investment “portfolios” are

B or C or E or (C and E)
The portfolio which has the highest NPV is C and E requiring an investment of $3.35
million and generating $2.3 million.
1020
(e) Multi-period capital rationing
Note – it is not likely that you will be required to solve a multi period capital rationing
situation in exam conditions. It is enough to be aware of the technique that would be used
i.e. linear programming
Let a = the proportion of project A undertaken etc.

Let z = NPV
Sticky Fingers should aim to maximise an objective function
z = – 461a + 2,095b + 1,010c – 184d + 1,274e
subject to constraints
1,500a +2,000b +1,750c +2,500d +1,600e ≤ 3,000

500a +1,000b +500e ≤ 200 + 500c + 700d
a, b, c, d, e ≤ 1
Non-negativity conditions
a, b, c, d, e ≥ 0
Answer 12 ARMSTRONG PLC
t0 t1 t2 t3 t4 t5 t6
$ $ $ $ $ $ $
Contribution from
new product 30,000 50,000 60,000 122,500 122,500
Contribution forgone
from old product (30,000) (22,500) (4,500) (1,500) –
Advertising (14,200)
———– ——— ——— ——— ——— —–—— ———
– 27,500 41,300 121,000 122,500
Tax at 35% (9,625) (14,455) (42,350) (42,875)
Land (120,000) 160,000
New building (30,000) 25,000
CAs (W1) 420 420 420 420 420 (350)
———– ——— ——— ——— ———– ———– ———
(150,000) 420 27,920 32,095 106,965 265,570 (43,225)
———– ——— ——— ——— ———– ———– ———
Discount factor
at 15% 1 0.870 0.756 0.658 0.572 0.497 0.432
Present value
$(150,000) 365 21,108 21,119 61,184 131,988 (18,673)
NPV = $67,091
–––––––
1021
This NPV does not include cash flows relating to the acquisition of the burnishing machine.
Of the two options for the acquisition, leasing has the lower present value of costs, at $61,981
(see part (b)). Since this is lower than the present value of the benefits from the project
($67,091 above), the project is worthwhile, and should be undertaken.
(b) Financing options (burnishing machine)
(i) Purchase
Present value
$
Purchase price 100,000
Tax saved (W2) (25,996)
———–
74,004
———–
(ii) Leasing
Present value
$
Lease rentals $21,800 × (1 + 3.170) 90,206
Tax relief $21,800 × 0.35 × 3.791 (28,925)
———
61,981
———
The above calculations demonstrate that, at a discount rate of 10%, leasing is the preferred
method of financing the machine. This does not mean, however, that the project is worth
undertaking. As shown in (a) above, the decision must be taken after comparison of the
present value of the cheaper option with the present value of the benefits to be obtained
from acquiring the machine and undertaking the project.
The calculations above have been made at a discount rate of 10%, the after-tax cost of
borrowing from the bank to finance the purchase. This rate is taken to be risk-free and is
the appropriate rate to use for risk-less flows such as those in the two financing options.
WORKINGS
Capital allowances
(1) Building
$
Years 0 to 4 WDA 4% × $30,000 1,200
———
Tax saved 35% × $1,200 420
———
Timing t1 to t5
Year 5 Sale proceeds 25,000

Written down value $30,000 – 5 × $1,200 (24,000)
———
Balancing charge 1,000
———
Tax effect at 35% 350
———
1022
(2) Burnishing plant
Tax CAs Tax saved Time Discount PV

WDV at 35% factor
at 10%
$ $ $ $
Cost (t0) 100,000
WDA (year 0) (25,000) 25,000 8,750 t1 0.909 7,954
———
75,000
WDA (year 1) (18,750) 18,750 6,563 t2 0.826 5,421
———
56,250
WDA (year 2) (14,062) 14,062 4,922 t3 0.751 3,696
———
42,188
WDA (year 3) (10,547) 10,547 3,691 t4 0.683 2,521
———
31,641
WDA (year 4) (7,911) 7,911 2,769 t5 0.621 1,720
———
23,730
SV (year 5) –
———
Balancing allowance
(year 5) 23,730 23,730 8,305 t6 0.564 4,684
——— ———– ——— ———
100,000 35,000 25,996
———– ——— ———
Answer 13 COMPOUNDING AND DISCOUNTING
(a) T = p (1 + r)n
p = present value
r = interest rate
n = number of times compounded
T = terminal value
(i) T = 1 (1 + 0.1)1 = $1.10

(ii) T = 1 (1 + 0.1)2 = $1.21
(iii) T = 1 (1 + 0.1)3 = $1.33
(iv) T = 1 (1 + 0.1)10 = $2.59
(b) The present value of $T in n years time at r% per annum ⇒
T
p= or T (1 +r)-n
(1 + r) n
(i) r = 10%, n = 1, discount factor = 0.909
p = 1 × 0.909 = $0.91
1023
(ii) r = 10% n = 2 discount factor = 0.826
p = 1 × 0.826 = $0.83
(iii) r = 10% n = 3 discount factor = 0.751
p = 1 × 0.751 = $0.75
(iv) r = 10% n = 10 discount factor = 0.386
p = 1 × 0.386 = $0.39
(c) Year end Cash flow Discount factor Discounted

(r = 10%) cash flow
$ $
1 2,000 0.909 1,818
2 1,500 0.826 1,239
3 3,000 0.751 2,253
4 1,000 0.683 683
——–
NPV = 5,993
——–
(d) Year end Cash flow Discount factor Discounted

(r = 10%) cash flow
$ $
1 1,000 0.909 909
2 1,000 0.826 826
3 1,000 0.751 751
4 4,000 0.683 2,732
——–
NPV = 5,218
——–
(e) Year end Investment Compound interest Compounded

Cash flows factor cash flow
$ $
1 1.00 (1.1)3 = 1.331 1.33
2 1.00 (1.1)2 = 1.210 1.21
3 1.00 (1.1)1 = 1.100 1.10
4 1.00 (1.1)0 = 1.000 1.00
——
4.64
——
Alternatively, using formula:
 (1 + r )n − 1  4 
  =  1.1 − 1  = 4.641
 r   0.1 
   
1024
(f) Year beginning Investment Compound interest Compounded

Cash flows factor cash flow
$ $
1 1.00 (1.1)4 = 1.4641 1.46
2 1.00 (1.1)3 = 1.3310 1.33
3 1.00 (1.1)2 = 1.2100 1.21
4 1.00 (1.1)1 = 1.1000 1.10
——
5.10
——
Alternatively, using formula:
  1 + r n +1 − 1 
 ( )  5  
 − 1 =   1.1 − 1  − 1 = 5.105
 r     0 .1  
     
(g) Year beginning Investment Compound interest Compounded

factor cash flow
$ $
1 450 (1.08)4 = 1.3605 612.23
2 525 (1.08)3 = 1.2597 661.34
3 500 (1.08)2 = 1.1664 583.20
4 425 (1.08)1 = 1.0800 459.00
5 350 (1.08)0 = 1.0000 350.00
————
Terminal value = 2,665.77
————
(h) (i) 12% per annum nominal ≡ 6% per 6 months
Imagine investing $1.00 for 1 year
T = 1 (1 + 0.06)2 = 1.1236
APR = 12.36%
(ii) 12% per annum nominal ≡ 3% per quarter
Invest $1.00 for 1 year
T = 1 (1 + 0.03)4 = 1.1255
APR = 12.55%
(iii) 24% per annum nominal ≡ 2% per month
Invest $1.00 for 1 year
T = 1 (1 + 0.02)12 = 1.2682
APR = 26.82%
1025
(i) 8% per annum nominal ≡ 4% per 6 months
Date Deposit Compound interest Compounded

factor cash flow
$ $
30.06.X1 600 (1.04)5 = 1.2167 730.02
31.12.X1 600 (1.04)4 = 1.1699 701.94
30.06.X2 600 (1.04)3 = 1.1249 674.94
31.12.X2 600 (1.04)2 = 1.0816 648.96
30.06.X3 600 (1.04)1 = 1.0400 624.00
31.12.X3 600 (1.04)0 = 1.0000 600.00
–———
Amount on deposit = 3,979.86
–———
(i) (ii)
(j) Year end Cash flow Discount factor PV Discount PV
$000 10% $000 factor 20% $000
0 (23) 1.000 (23.000) 1.000 (23.000)
1 10 0.909 9.090 0.833 8.330
2 15 0.826 12.390 0.694 10.410
3 5 0.751 3.755 0.579 2.895
——— ———
NPV = 2.235 NPV = (1.365)
——— ———
(iii) IRR
 NA 
Formula IRR ~ A +   (B – A)
 N A − NB 
 2.235 
IRR ~ 10 +   × 10 ~ 16% rounded down (see graph)
 2.235 + 1365
. 
Graph (for illustration only)
NPV
£000
3
NA
2
1 approx IRR
A
0
10 12 14 16 18 20
Discount
-1 actual IRR rate %
N
B
-2
1026
Alternatively: Using equal triangles
NPV
£000
3
A
2
1 X,IRR
B
0
10 12 14 16 18 20
Discount
-1 rate %
C D
-2
AB BX
= AB = 2.235
AC CD
AC = 2.235 + 1.365 = 3.6
CD = 20 – 10 = 10
Substituting:
2.235 BX
=
3.6 10
2.235 × 10
BX = = 6.208
3.6
IRR = 10 + 6.208 ~ 16% (rounded down)
(k) Year end Cash flows Discount factors PV

$000 10% $000
0 (50) 1.000 (50.00)
1 10 0.909 9.09
2 20 0.826 16.52
3 30 0.751 22.53
——–
(1.86)
——–
(l) The balance outstanding would be $1,860. In present value terms $50,000 now is worth
$1,860 more than the sum of $10,000 in one year’s time, $20,000 in two years’ time and
$30,000 in three years’ time.
1027
(m)
Year end Cash flow Discount PV Discount PV

$000 factor 8% $000 factor 12% $000
0 (33) 1.000 (33.00) 1.000 (33.00)
1 10 0.926 9.26 0.893 8.93
2 20 0.857 17.14 0.797 15.94
3 10 0.794 7.94 0.712 7.12
——– ——–
NPV = 1.34 NPV = (1.01)
——– ——–
Formula
 NA 
Using IRR ~ A +   (B – A)
 NA − NB 
 134 . 
IRR ~ 8 +   × 4 ~ 10.2% (rounded down)
 134 . 
. + 101
Graph (as visual aid)
NPV
£000
1.5
0.5
approx IRR
0
8 9 10 11 12
-0.5 Discount rate %
-1
-1.5
Alternatively
AB BX
= AB = 1.34
AC CD
AC = 1.34 + 1.01 = 2.35

CD = 12 – 8 = 4
Substituting:
1.34 BX
=
2.35 4
. ×4
134
BX = = 2.28
2.35
∴ IRR = 8 + 2.28 ~ 10.2% (rounded down)
1028
(n) Year end Cash flows Discount factors PV

$ $
0 (1,440) 1.000 (1,440)
1 1
1 700 700 ×
(1 + r ) (1 + r )
1 1
2 900 900 ×
(1 + r ) 2 (1 + r ) 2
——
0
——
Let x = (1 + r)
700 900
Then – 1,440 + + = 0
x x2
Multiply by x2
– 1,440x2 + 700x + 900 = 0
Compare with ax2 + bx + c = 0 and use equation for roots of a quadratic
(note – it is not likely that you will be required to solve quadratic equations under exam
conditions)
a = – 1,440 b = 700 c = 900
−b ± b2 − 4 ac − 700 ± (700) 2 − 4( −1,440) × 900 − 700 ± 2,382

x = = =
2a 2 × ( −1,440) − 2,880
− 700 + 2 ,382 − 700 − 2,382

= or
− 2 ,880 − 2,880
= – 0.584 or 1.07
The value x = 1.07 gives a realistic (i.e. positive) answer
x = 1 + r = 1.07
r = 0.07 i.e. IRR = 7%
(o) Calculate the expected cash flows for each year
Year 1 (0.75 × 12) + (0.25 × 10) = $11.50

Year 2 (0.75 × 13) + (0.25 × 10) = $12.25
Year 3 (0.75 × 13) + (0.25 × 9) = $12.00
Year 4 (0.75 × 14) + (0.25 × 8) = $12.50
1029
Year end Expected Discount factors PV

cash flow 14%
$000 $000
0 (30.00) 1.000 (30.00)
1 11.50 0.877 10.09
2 12.25 0.769 9.42
3 12.00 0.675 8.10
4 12.50 + 2 = 14.50 0.592 8.58
——
NPV = 6.19
——
NPV @ 14% = $6,190,000
Answer 14 DESPATCH CO
Time Cash 14% factor PV

$ $
0 (12,000) 1 (12,000)
1 – 10 2,000 5.216 10,432
10 500 0.27 135
———
(1,433)
———
As the NPV is negative at 14% the company should not undertake this project.
Answer 15 DISCOUNTED CASH FLOW
(a) (i) Alternative machines
Year 8% Factor Machine 1 PV Machine 2 PV

$ $ $ $
0 1 (10,000) (10,000) (9,000) (9,000)
1 0.926 1,000 926 1,200 1,111
2 0.857 1,600 1,371 1,500 1,286
3 0.794 2,500 1,985 3,500 2,779
4 0.735 2,500 1,838 2,000 1,470
5 0.681 2,500 1,702 2,000 1,362
6 0.630 1,500 945 2,000 1,260
7 0.583 2,500 1,458
——— ———
225 268
——— ———
Since both projects have positive NPVs either machine is a good investment. However, the
NPV for machine 2 is slightly higher and this machine should therefore be preferred.
1030
(ii) Comment
Since the difference between the two figures is marginal it may be prudent to carry out a
“sensitivity analysis” on the result.
The cash flow figures are estimates for several years ahead. A small change in any of these
figures could affect the result to such an extent that machine 1 might be the better investment.
Changes could even lead to the projects having negative NPVs since the values are only small
positive figures. Investments with negative NPVs should be rejected.
(b) Device

$ $
1 (40,000) 0.935 (37,400)
2 – 29 2,000 12.278 (W) – 0.935 22,686
———
Negative NPV (14,714)
———
∴ Firm should not produce the device.
WORKING
1  1 
0.07 1– 1.0729 = 12.278
(c) Crusher

$ $
0 (6,000) 1 (6,000)
3–∞ 1,200 1/0.12 – 1.690 = 6.643 7,972
———
Positive NPV 1,972
———
∴ The crusher should be purchased.
Alternatively
Time Cash Time Cash

$ $
1
3–∞ 1,200 is the same as 1–∞ 1,200 ×
1.12 2
1 1
Therefore PV of perpetuity = $1,200 × 2
× = $7,972
1.12 0.12
Therefore NPV of project = – $6,000 + $7,972 = $1,972
1031
(d) IRR
Equal annual inflow 475

IRR of perpetuity = × 100 = × 100 = 9.5%
Initial investment 5,000
Since the internal rate of return is greater than the return which J can obtain elsewhere, he
would be advised to invest in the scheme.
(e) (i) IRR
Time Cash flow 10% Factor 10% NPV 7% Factor 7% NPV

$ $ $
0 (10,000) 1 (10,000) 1 (10,000)
1 (10,000) 0.909 (9,090) 0.935 (9,350)
2&3 4,000 1.577 6,308 1.689 6,756
4 – 11 3,000 4.008 (W1) 12,024 4.875 (W2) 14,625
——— ———
(758) 2,031
——— ———
WORKINGS
(1) @10% DF1–11 – DF1–3 = 6.495 – 2.487

= 4.008
(2) @7% = 7.499 – 2.624

= 4.875
 2,031 
IRR = 7% +   × (10 – 7)%
 2,031 + 758 
= 7% + 2.18% ~ 9%
Since the IRR of this project is less than the required rate of return, it should not be
undertaken. Therefore, the ball and crane should not be bought.
(ii) An alternative approach to this problem would be to discount the cash flows at 10%.
Since the project has a negative NPV at 10% (the desired rate of return), the project
would not be accepted.
Answer 16 GERRARD
Net
Year end Machinery Receipts Paper Salary cash flow
$000
0 (50) + (8) = (58.0)
1 (25) + 30 + (8) + (0.5) = (3.5)
2 30 + (8) + (0.5) = 21.5
3 30 + (8) + (0.5) = 21.5
4 30 + (8) + (0.5) = 21.5
5 30 + (0.5) = 29.5
1032
(a) and (b)
Year end Net Discount PV Discount PV

cash flow factors 12% factors 14%
$000 $000 $000
0 (58.0) 1.000 (58.00) 1.000 (58.00)
1 (3.5) 0.893 (3.13) 0.877 (3.07)
2 21.5 0.797 17.14 0.769 16.53
3 21.5 0.712 15.31 0.675 14.51
4 21.5 0.636 13.67 0.592 12.73
5 29.5 0.567 16.73 0.519 15.31
–—— –——
NPV = 1.72 NPV = (1.99)
–—— –——
(c) In view of the project’s positive NPV at 12%, expansion is (just) worthwhile.
The IRR of the project is approximately 13% (i.e. half way between 12 & 14%) or
172
.
IRR = 12% + (14 – 12)% = 12.9%
. + 199
172 .
This gain indicates that the project is worthwhile.
Answer 17 CARTER LTD
(a) (i) Net present value
Time Cash flow 10% factor Present value

$ $
0 (32,000) 1 (32,000)
1 – 15 5,000 7.606 38,030
———
Positive NPV 6,030
———
In view of the positive NPV the project should be undertaken.
The internal rate of return is calculated by finding a 15 year cumulative discount

factor as follows.
Investment 32,000
15 year factor @ IRR = = = 6.4
Annual cash flow 5,000
IRR = 13%
The project should be undertaken as the IRR exceeds the cost of borrowing (10%).
1033
(b) (i) Book value of $2,000
This information does not affect the NPV as a book value is not a cash flow.
(ii) Reduced project duration to ten years
Revised NPV calculation
10% Present
Time Cash flow factor value
$ $
0 Net investments (32,000) 1 (32,000)
1 – 10 Net savings 5,000 6.145 30,725
———
Negative NPV (1,275)
———
The reduction in the project duration means that it is no longer worthwhile.
(iii) Changes in allocation and apportionment
This information does not affect the NPV as allocation and apportionment are
arbitrary. The cash flows are unchanged.
(iv) Revised scrap values
With the existing equipment having a scrap value of $2,000 in 15 years’ time, if the
project is undertaken this $2,000 in year 15 will be forgone.
The NPV will therefore be reduced be reduced by the present value of $2,000
discounted for 15 years.
NPV = $6,030 – ($2,000 × 0.239) = $5,552

The project will still be accepted though the NPV is reduced.
Answer 18 ABC
Project A
Cash flows
Time 0 1 2 3 4 5
$ $ $ $ $ $
Equipment – cost (95,000) (95,000) (95,000)
Deluxe – net cash inflow (W1) 80,000 80,000 88,000 96,800 106,480
Existing – lost cash contribution
(W2) (7,500) (7,500) (8,250) (9,075) (9,985)
——— ——— ——— ——— ——— ———–
Net cash flow (95,000) (22,500) (22,500) 79,750 87,725 96,495
DF @ 17% 1 0.855 0.731 0.624 0.534 0.456
PV (95,000) (19,237) (16,448) 49,794 46,845 44,002
NPV = $9,956
1034
Project B

$ $
0 Patent rights (320,000) 1 (320,000)
1–5 Reduction in labour 70,000 3.199 223,930
Expected increase in sales (W3) 27,600 3.199 88,292
———–
NPV = (7,778)
———–
Project C

$ $
0–4 Rental (50,000) 1 + 2.743 = 3.743 (187,150)
2–5 IT bureau costs saved 90,000 3.199 – 0.855 210,960
1 Training (10,000) 0.855 (8,550)
½ Consultant (5,000) 0.925 (W4) (4,625)
1 Consultant (5,000) 0.855 (4,275)
———–
NPV = 6,360
———–
Projects A and C are worth considering further as they show a positive NPV at the company’s required
rate of return.
WORKINGS
Project A
(1) De-luxe net cash inflow
Year 1 2 3 4 5
Demand (units) 10,000 10,000 11,000 12,100 13,310
Net cash inflow (@ $8) 80,000 80,000 88,000 96,800 106,480
(2) Loss of cash contribution on existing project
Year 1 2 3 4 5
Reduction in demand (units)
(15% of demand in W1) 1,500 1,500 1,650 1,815 1,997
Contribution lost (@ $5) 7,500 7,500 8,250 9,075 9,985
Project B
(3) Expected increase in contribution from increased sales
0.8 × 5,000 + 0.2 × 3,000 = 4,600 units
Extra contribution = 4,600 × $(12 – 6)

= $27,600 pa
1035
Project C
(4) Discount factor for a flow taking place in six months’ time
1
=
1.17
= 0.925
Answer 19 MOORGATE COMPANY
(a) Ex-rights price
$
4 existing shares × $3.00 12.00
1 rights share × $2.00 2.00
–––––
14.00
–––––
The theoretical value of Moorgate’s shares ex-rights is
14.00
= $2.80
5
(b) Value of right
Value of right = $(2.80 – 2.00)

= $0.80
One right enables a holder to buy for $2.00 a share which will eventually sell for $2.80.
The value of the right to buy one share is, therefore, $0.80. Four existing shares are
needed to buy one additional share. Thus, the value of the rights attaching to each existing
share is $0.20.
(c) Chairman’s views
The chairman is correct. The shareholder should either exercise his rights or sell them
(subject to (d) below).
(i) If he sells all rights
$
Wealth before rights issue
Value of shares 1,000 × $3.00 3,000
––––––
Wealth after rights issue
Value of shares 1,000 × $2.80 2,800
Plus Cash from sale of rights 1,000 × $0.20 200
––––––
3,000
––––––
1036
(ii) If he exercises one half of his rights and sells the other half
$
Value of shares 1,000 × $3.00 3,000
––––––
Value of old shares 1,000 × $2.80 2,800
500
Value of new shares × $2.80 350
4
Cash from sale of rights 500 × $0.20 100
––––––
3,250
Less Cost of purchasing new shares 125 × $2 (250)
––––––
3,000
––––––
(iii) If he does nothing
$
Value of shares 1,000 × $3.00 3,000
Value of shares 1,000 × $2.80 (2,800)
––––––
Reduction in wealth 200
––––––
(d) Shareholder wealth
It is possible that the shareholder, whether exercising the rights or selling them, will suffer
a reduction in wealth.
The above analysis is based on the assumption that the funds to be raised by the new issue
of shares will be invested in the business to earn a rate of return comparable to the return
on the existing funds. The capital market, in valuing the share of Moorgate after the rights
issue, has to make some assumption as to how profitably the new funds are to be used. For
example, if the new funds were squandered the overall return on equity funds would fall,
and the price would drop below the $2.80 calculated above.
Alternatively, if the sales are to be used to finance a highly profitable investment and the
capital market does not initially appreciate this point, then the market in arriving at a price
of $2.80 ex-rights would be undervaluing the share. When the true earning potential of the
company were realised, the share price would rise. However, by then it might be too late
for the shareholder referred to in the question.
If the shareholder exercises the rights in the circumstances just described, he will not lose.
When the shares rise in price he will benefit. However, if at the time of the right issue he
decides to sell the shares, he will lose. The value of his right in the circumstances
described is based on the assumption that the new funds will earn as much as the old.
Later the person who exercises the rights will benefit, when the shares rise in price above
that expected at the time of issue.
1037
Answer 20 GREINER LTD
REPORT
To Mr and Mrs Greiner

From XYZ Ltd
Date Today
Subject Proposed entry onto the Stock Exchange
With reference to your recent enquiry, we set out below information regarding
(a) the necessary steps to be taken prior to obtaining a quotation, and

(b) the methods of raising finance from the market and advice as to which should be used.
(a) Steps prior to obtaining a quotation
(i) Review of current situation
Before approaching the sponsoring brokers, a detailed review of the company’s current
situation should be made. This will include consideration of the following areas.
(i) Management. Is there sufficient financial expertise within the company to cope
with the demands of being a public company? The meetings and information-
gathering involved with obtaining a quotation will take up an excessive amount of
your time. It is possible that further staff may be required to aid with the running of
the business during this period.
(ii) Contractual relationships. It may be necessary to formalise trading relationships

with the company’s major suppliers and customers, and to review the debt
collection procedure if this has caused problems in the past.
(iii) Directors’ contracts. The terms of your appointments as directors should be clearly
laid out in the form of service contracts. Prospective shareholders will want to be
sure that remuneration and other benefits are of a reasonable level.
(iv) Accounting systems. These must be in good order to enable management to be

confident of their ability to supply sufficiently accurate information at the required
time.
(ii) Appointment of professional team
The full professional team required to take a company to the market comprises a sponsoring
broker, a reporting accountant and a solicitor. The broker will take overall responsibility for
the co-ordination of the various stages leading up to the quotation. It is important that you
feel confident in the broker’s ability to handle the work and that good working relationships
can be maintained before, during and after the flotation.
(iii) Information-gathering and presentation
The sponsor will generally require a long-form report to be prepared by the reporting
accountant. This will provide information to the sponsor about the company and its
prospects. The sponsor will use this report as a guide to the suitability of the company for
flotation, and for the provision of details to be included in the prospectus.
1038
The reporting accountant will thus be obliged to carry out a detailed review of the financial
records of the company and will solicit any other information he may require from yourselves
or your employees.
Once the long-form report has been drafted and agreed upon by all parties, the sponsor will
prepare the prospectus, and preliminary clearance for the quotation will be obtained from the
Stock Exchange.
The finalisation of the prospectus may take several meetings between yourselves and the
professionals; it is essential that all legal requirements are met and that the document is
carefully and accurately worded.
Appended to the prospectus will be the accountant’s short-form report, containing a profits
record of the company, a balance sheet, and other statements similar in content to those
contained in the annual accounts.
(iv) The final stages
Once the prospectus and other necessary documentation have been completed, they will be
submitted by the sponsor to the Stock Exchange for approval.
(b) Methods of raising equity on the Stock Exchange
There are two main methods.
(i) Placing
This is the most favoured method for small issues, in part because the costs are likely to be
lower than those of an offer for sale.
In a placing the shares are not offered generally to the public but are placed in the hands of a
group of large investing institutions, possibly via an issuing house.
As a placing involves only a limited number of prospective investors, substantial savings may
be made in printing of the prospectus, allotment letters, application forms, etc, as well as in
advertising.
The general cost of a placing of the size being considered will be in the range $50,000 –
$120,000.
(ii) Offer for sale
This involves the issuing house or broker buying the shares from the directors and selling
them on to the public at a predetermined price.
The offer for sale has to be advertised, under Stock Exchange rules, in a leading newspaper.
Just before the prospectus is made available to prospective investors, the documentation will
be filed with the Registrar of Companies and the company re-registered as a public company.
A press conference will be arranged to promote the company and the flotation and hopefully
gain some favourable press comment which will assist a successful launch of the shares.
Shortly after the prospectus has been made available, permission to deal will be sought from
the Stock Exchange. As soon as this is received, dealings will begin.
1039
You will then be able to realise part of your investment in the company as well as raising the
additional amount of finance required.
The costs of an offer for sale typically range between $200,000 and $500,000.
Where the sale of shares to be issued is in excess of $3 million, an offer for sale is the
method encouraged by the Stock Exchange. This is because an offer for sale gives as large
a number of investors as possible the chance to invest in the security being offered. It
therefore helps to ensure that there is a wide distribution of shareholders and a good
trading market once they have been issued.
For the size of issue involved with Greiner Ltd, however, a placing is strongly
recommended, principally due to the lower costs involved.
Answer 21 MR FIDELIO
All sources of finance to a business fall into one of two categories. The first is equity, the second debt.
The essential difference between the two is that the providers of equity capital become owners of the
business: they participate in running the business, share in the profits and bear the risk. The providers
of debt finance have merely lent money to the firm, they usually have a fixed return and some form of
security over the company’s assets. Mr Fidelio and Aida Ltd will have to consider both categories in
their search for the required finance.
There are three significant differences between Mr Fidelio and Aida with respect to their ability to raise
long-term finance. Firstly, Mr Fidelio has no “track record” to support his request for funds.
Secondly, he does not have very much in the way of “mortgageable assets” to offer as security for his
loan. Finally, Mr Fidelio wishes to raise a very high proportion of the total funds required. Of the
$250,000 he needs he is only able to provide 20% from his personal resources. No investor would be
prepared to bear so much of the risk of the enterprise without an opportunity to share in the potential
return, i.e. some form of equity would be required. It is equally likely that the providers of such funds
would require some say in the running of the business.
Possible sources of finance for Mr Fidelio are as follows.
(a) Enterprise Investment Scheme
Tax relief is given to individual investors in new equity in unquoted trading companies.
Obviously Mr Fidelio would lose some control of the business and would need to form a
company. In order to retain at least half of the shares Mr Fidelio would probably also need
debt finance.
(b) Venture capital trusts
Tax relief is given to investors in listed investment trust companies who invest at least 70% of
their funds in unquoted trading companies. Hence investment trust companies may provide
equity and debt finances. Again, Mr Fidelio would have to set up a company.
(c) Loan guarantee scheme
In view of the lack of security Mr Fidelio is unlikely to be able to borrow on normal

commercial terms. The loan guarantee scheme provides banks and other lenders with
increased security (the majority of the loan is guaranteed by the government) in return for the
borrower paying an interest premium to the government.
1040
(d) Venture capital funds
$200,000 is probably too small an amount for venture capitalists such as 3i to be interested.
(e) Leasing
Leasing provides an alternative to borrowing to fund the acquisition of fixed assets like plant
and machinery.
(f) Government grants/EU grants
Various grants are available from the above, particularly for high-tech industries (into which
category electronic components may fall). Mr Fidelio should contact the DTI (Department of
Trade and Industry) to see what is available.
Aida Ltd has a major advantage over Fidelio in raising debt finance and that is that it
presumably owns a considerable amount of mortgageable assets. It could raise a fixed
interest loan from an institutional investor such as an insurance company or a pension fund by
giving a mortgage on its property. It is unlikely that such an investor would be prepared to
advance more than 60-70% of the valuation so, if Aida wishes to raise the whole $2 million
this way, it would have to mortgage some of its existing properties as well as the new site.
Alternatively, if Aida were prepared to give up the freehold interest on the site, it could
negotiate a sale and leaseback arrangement with an institutional investor. The ease with
which this sort of arrangement could be set up would depend on the quality of the new site.
However, this type of arrangement is very popular at this time, particularly for the retail
warehouse type of development that Aida is considering.
As far as equity is concerned Aida has a number of options.
(a) Private placing of shares if its articles so allow.
(b) Rights issue to existing shareholders, if they have sufficient funds.
(c) (a) and (b) above maintain the existing limited status of Aida. If neither source of equity
funds is available, Aida could consider becoming a plc and obtaining a listing. Much depends
on the company’s size but assuming it is a relatively small (in terms of value), then a listing
on the Alternative Investment Market at the same time as a new issue of shares (e.g. via a
placing) would provide it with the necessary funds. The downside is the cost of listing and
increased scrutiny of the company’s activities by external investors and the Stock Exchange.
Answer 22 COST OF CAPITAL
(a) Cost of debt (pre-corporation tax)
Annual interest payment 10

(i) = = 10%
Issue proceeds (or market price) 100
10
(ii) = 11.76%
85
1041
(iii) We need to find the IRR by the following cash flows.
t0 t1 t2 t3
$(74) $10 $10 $110
By trial and error, NPV of the four cash flows at
25% NPV = – $74 + 1.440 × $10 + 0.512 × $110 = – $3.28
20% NPV = – $74 + 1.528 × $10 + 0.579 × $110 = $4.97
4.97
∴ kd = 20% + × (25% – 20%)
4.97 + 3.28
= 23%
(iv) As redeemable at current market price, then
10
= 10%
100
(v) Irredeemable
5
= 7.7%
65
(b) Cost of debt (post-corporation tax)
(i) 10% (1 – 0.35) = 6.5%
(ii) 11.76% (1 – 0.35) = 7.64%
(iii) We need to find the IRR by the following cash flows.
t0 t1 t2 t3
$(74) $6.5 $6.5 $106.5
(Note This assumes no lag in corporation tax payment.)
By trial and error,
15% NPV = – $74 + 1.626 × $6.5 + 0.658 × $106.5 = $6.646
20% NPV = – $74 + 1.528 × $6.5 + 0.579 × $106.5 = – $2.405
6.646
∴ kb = 15% + × (20% – 15%)
6.646 + 2.405
= 19%
(iv) 10% × (1 – 0.35) = 6.5%
(v) 7.7% (no corporation tax relief on preference share dividend).
1042
(c) Cost of equity
7.5
(i) ke = × 100
150
= 5%
15
(ii) ke = × 100
165 − 15
= 10%
24 × (1 + 0.05)
(iii) ke = × 100 + 5
120
= 26%
1 .5
(iv) ke = × 100
10
= 15%
(d) Dividend valuation model
D
(i) No growth, hence Po =
ke
0.10 × 50,000
=
0.1
= $50,000
10
Per share Po =
0.10
= $1.00
500
(ii) No growth, hence Po =
0.15
= $3,333
3,333
Per share Po =
1,000
= $3.33
1043
D 0 (1 + g )
(iii) Constant growth Po =
(ke − g)
.10 × 1m × (1.05)
=
(0.15 − 0.05)
= $1.05m
Per share S = $1.05
(iv) Po = PV of future dividends
0.10 × 10,000 × (1.05)

= $0.10 × (10,000 × 3.352) + × 0.497
(0.15 − 0.05)
= $8,570
Per share ≈ 0.86
Answer 23 KELLY PLC
(a) Six-monthly gross redemption yield
This is found as the IRR of the following cash flows.
Initial capital cost Market value $110.43

Interest Nine payments of $7 due half-yearly
Redemption One payment of $100 in nine half-years’ time
Cash 10% PV 5% PV
flows factor at 10% factor at 5%
$ $ $
Time 0 (110.43) 1 (110.43) 1 (110.43)
Time 1–9 7.00 5.759 40.31 7.108 49.76
Time 9 100.00 0.424 42.40 0.645 64.50
——— ———
Net present values (27.72) 3.83
——— ———
3.83 × 5
IRR, i.e. six monthly yield ≈ 5+
31.55
≈ 5.6%
1044
(b) Redemption date and effective annual gross redemption yield
Kelly plc will presumably choose the option which minimises the effective cost (based on
similar IRR calculations) of the bond
(i) Redeem 19X8
PV at 10% PV at 5%
$ $
Market value (110.15) (110.15)
Six interest payments of $7 30.49 35.53
One payment of $100 56.40 74.60
——— ———
Net present values (23.26) (0.02)
——— ———
IRR = 5%
(ii) Redeem 19X10
PV at 10% PV at 5%
$ $
Market value (110.15) (110.15)
Ten interest payments of $7 43.02 54.05
One payment of $100 38.60 61.40
——— ———
Net present values (28.53) 5.30
——— ———
5.30 × 5
IRR ≈ 5+
33.83
= 5.8%
Therefore Kelly will redeem the bond in July 19X8. The effective annual gross redemption
yield is (1.05)2 – 1 = 10.25%.
(c) Price of debentures on 1 July 19X5
The value at 1 October 19X5 is the present value, at 6%, of two cash flows.
(i) Interest Nine interest payments of $3
plus $3 due on 1 October 19X5.
(ii) Redemption payment $100 in nine half years’ time.
3  1 
PV of interest = 1 −  + $3.00
0.06  1.06 9 
= $(20.41 + 3.00)
= $23.41
1045
100
PV of capital =
(1.06) 9
= $59.19
(23.41 + 59.19)
Value at 1 July =
1.0296
= $80.23
(d) Factors influencing the market price of issued corporate debentures
The market price of a corporate debenture will be equal to the present value of the expected
future interest payments plus the present value of the amount due on redemption. Since the
coupon rate of the bond and the terms for redemption will be known with certainty, the price
is largely a function of the discount rate applied to the future cash flows.
Generally it is agreed that the discount rate used to capitalise an anticipated cash flow stream
is a function of the risk-free rate and a premium for risk. The risk-free rate is often taken to
be the return on government debt. Strictly speaking, government debt is not risk-free; it is
default-free. Whist there is no realistic possibility that the government will not meet its
obligations to pay interest and redemption of capital, there is a risk for the holders of
government debt, since their returns, in real terms, are influenced by the rate of inflation.
Therefore, the required return from a corporate debenture, and hence its market value, is a
function of
the true “risk-free” rate

a premium for inflation
a premium for risk.
Each of these will now be considered in turn.
(i) The “risk-free” rate
Even in the absence of risk and inflation, all investors require a return to persuade them to
forgo current consumption in return for future consumption. It is felt that if investors are
prepared to forgo a certain amount of current consumption at a given interest rate, in order to
persuade them to make more funds available it will be necessary to offer a higher “risk-free”
rate. Therefore it seems likely that the “risk-free” rate will, in part at least, be a function of
the demand and supply of investment funds. An increase in the demand for funds, e.g.
resulting from a rise in the government’s budget deficit, is likely to result in an increase in the
risk-free rate.
(ii) A premium for inflation
The rate of interest which is necessary to persuade investors to forgo current consumption in a
risk-less, inflation-less environment will have to be increased to compensate investors for the
existence of inflation. Therefore the default-free rate (the return on Government bonds) will
be a function of the demand for investment funds and the rate of inflation.
1046
(iii) A premium for risk
For most established companies there is little likelihood of default on either interest payments
or redemption of capital. However, corporate bankruptcy is a possibility and it is likely that
investors will require a premium over the default-free rate to persuade them to invest in
corporate bonds.
The required return from the bond and hence its market value may also be influenced by the
maturity date. Although interest rates vary from time to time, short-term rates are normally
lower than long-term rates (although the reverse may be true if short-term rates are very high
and generally expected to fall in the near future). Therefore the market value of a short-dated
bond would normally be expected to be higher than that of a comparable longer-dated bond.
The coupon rate can also affect the required return. A company may issue bonds with a
coupon rate equal to the current market rate in which case it will issue the bonds at par.
Alternatively, it may reduce the coupon rate and issue the bonds at a discount. The advantage
of the second alternative is that part of the returns to the investor are in the form of capital
gains. This may have tax advantages and could result in low coupon rate, deep discounted
bonds being relatively attractive and hence having a higher market value than equivalent high
coupon rate bonds.
There is one further factor that is likely to influence the required return from, and therefore
the value of, corporate bonds. As has been noted above, the required return from bond is a
function of the return on Government bonds (the default-free rate) and a premium for risk.
There is little doubt that in recent years governments have influenced the default-free rate
through various agencies (notably the Bank of England) as an instrument of macroeconomic
policy. Therefore a final variable is added to the mix in determining the price of corporate
bond. Ultimately the relevant factors are the demand for investment funds, the rate of
inflation, the perceived risk of the corporate borrower and government policy.
Answer 24 REDSKINS PLC
(a) Post-tax weighted average cost of capital
The following calculations are based on the capital structure of the Redskins group which is
deemed to be more appropriate for determining a discount rate to evaluate the projects
available to Redskins plc and its subsidiaries.
(i) Cost of debt
Interest (1 - T)
For irredeemable bonds kd =
Ex − interest market value
3.00 × (1 - 0.30)
Cost of 3% irredeemable bond=
(31.60 - 3.00)
= 7.34%
1047
For redeemable bonds, to calculate kd it is necessary to compute the internal rate of return of
the after-tax cash flows.
Cash PV PV
flows at 5% at 10%
$ $ $
Time 0 Ex-interest market price (94.26) (94.26) (94.26)
Time 1–10 Interest (post-tax) 6.30 48.65 38.71
Time 10 Repayment of capital 100.00 61.40 38.60
——— ———
Net present values 15.79 (16.95)
——— ———
 15.79 
Cost of redeemable debt = 5% +   × 5%
 (15.79 + 16.95) 
= 7.41%
After-tax cost of bank loan = (11% + 2%) × (1 – 0.30)
= 9.10%
Cost of 6% unquoted bonds
The value of the bonds is the present value of the pre-tax cash flows discounted at 10%, i.e.
($6.00 × 6.145) + ($100 × 0.386) = $75.47
The after-tax cost is the discount rate which equates the after-tax cash flows to a present value
of $75.47, i.e.
Cash PV PV
flows at 5% at 10%
$ $ $
Time 0 Current value (75.47) (75.47) (75.47)
Time 1–10 Post-tax interest 4.20 32.43 25.81
Time 10 Repayment 100.00 61.40 38.60
——— ———
Net present values 18.36 (11.06)
——— ———
18.36
By linear interpolation IRR = 5% + × 5%
29.42
= 8.12%
Cost of equity = 18% (given)
1048
The market values of the various sources of finance are as follows.
$000 $000
Equity 8,000 × 1.1 8,800
3% debt 1,400 × 0.286 400
9% debt 1,500 × 0.9426 1,414
6% debt 2,000 × 0.7547 1,509
Bank loan 1,540
WACC =
(0.18 × 8,800) + (0.0734 × 400) + (0.0741 × 1,414) + (0.0812 × 1,509) + (0.0910 × 1,540)
8,800 + 400 + 1,414 + 1,509 + 1,540
1,981
=
13,663
= 14.5%
(b) Problems in estimating WACC
(i) Where bank overdrafts are used as sources of long-term finance
Theoretically bank overdrafts are repayable on demand and therefore are current liabilities.
However, it is undoubtedly true that many firms run more or less permanent overdrafts and
effectively use them as a source of long-term finance. Where this is true, a case can be made
for incorporating the cost of the overdraft into the calculation of the weighted average cost of
capital. In order to do this it is necessary to know the interest rate and the size of the
overdraft.
The first of these variables, the interest rate, presents no special problems. Overdraft rates are
known and the quoted rate is the “true” rate. As with other interest payments, overdraft
interest is an allowable expense for tax purposes and this must be incorporated in the
calculation. Interest on overdrafts fluctuates through time and this presents a problem.
However, it is not a problem unique to overdrafts as other interest rates are also likely to vary.
The particular problem in incorporating the cost of an overdraft into the WACC is
determining its magnitude for weighting purposes. By their very nature overdrafts vary in
size on a daily basis. It would be necessary to separate the overdraft into two components.
The first is the underlying permanent amount which should be incorporated into the WACC.
The second component is that part which fluctuates on a daily basis with the level of activity.
(ii) Where convertible bonds are used as sources of long-term finance
The formula for determining the cost of a convertible bond derives from the basic valuation
model for convertibles which is as follows.
n
I(1 - T) MV
Vc = ∑ (1 + kc) + (1 + kc)n
t =1
where I = Interest payable

T = Rate of corporation tax
n = Years to conversion
MV = Market value of shares at the time of conversion
kc = Cost of convertible bond
Vc = Market value of convertibles
1049
In principle the calculation of kc is a simple IRR computation. In practice the difficulty is in

knowing whether the investor will exercise his conversion right, which will depend upon the
market value of the shares at the time of conversion. Therefore, to compute kc requires a
prediction of future share prices which obviously poses severe problems.
(c) Fundamental problems underlying the use of WACC as a discount rate
It can be shown that, in a perfect capital market in which the market value of an ordinary
share is the discounted present value of the future dividend stream, acceptance of a project
which has a positive NPV when discounted at the WACC will result in the share price
increasing by the amount of the NPV. It is this relationship between the NPV and the market
value which is the basis of the rationale for using the WACC in conjunction with the NPV
rule. However, the use of the WACC in this way depends upon a number of assumptions.
(i)
The objective of the firm is to maximise the current market value of the ordinary shares. If
the firm is pursuing other objectives, some other discount rate may be more appropriate.
(ii)
The market is perfect and the share price is the discounted present value of the dividend
stream. Market imperfections may undermine the relationship between NPV and the market
value, and cast doubt upon the usefulness of WACC as a discount rate. Furthermore, if the
market values shares in some other way (earnings multiplied by a P/E ratio), then the link will
also be broken.
(iii)
The current capital structure will be maintained and the existing capital structure is optimal.
(iv)
The risk of projects to be evaluated is the same as the average risk of the company as a whole.
The discount rate has two components, namely the risk-free rate and a premium for risk. The
weighted average cost of capital incorporates a risk premium which is appropriate to the risk
of the company as a whole, i.e. the average risk of all its existing assets and projects. Where a
project is to be considered which has a different level of risk, then the WACC is not the
appropriate rate.
1050
Answer 25 BERLAN
(a) Berlan plc – Calculation of cost of capital using traditional approach
(i) Cost of equity
$000
Earnings before interest and tax 15,000
Interest 23,697 × 16% (3,791)
Profit before tax 11,209
——–
Corporation tax @ 35% (3,923)
Available for dividend to equity 7,286
——–
7,286 × 100
Dividend per share = 14.57
12,500 × 4
D
Ke =
P0
14.57
= = 18.2%
86 − 6
(ii) Cost of debt
31 Dec 19X1 31 Dec 19X2 31 Dec 19X3 31 Dec19X4

Year 0 1 2 3
(105.50) 16(1 – 0.35) 16(1 – 0.35) 16(1–0.35) + 100
The cost of debt is found by discounting the above cash flows, using trial discount rates.
Try 6%
– 105.5 + (10.4 × 2.673) + (1 00 × 0. 84) = 6.3
Try 10%
– 105.5 + (10.4 × 2.487) + (100 × 0.751) = (4.5)
6 .3
Cost of debt =6+ × (10% – 6%) (by interpolation)
6.3 + 4.5
= 8.3%
(iii) Cost of capital
$000
Market value of equity = E = 12,500 × 4 × (0.86 – 0.06) 40,000
Market value of debt = D = 23,697 × 105.5 25,000
100 65,000
Cost of capital = WACC = (0.182×40/65) + (0.083×25/65) = 14.4%
1051
(b) Canalot plc
Effect of change in capital structure
Market value
Vg = Vu + Dt
= 32.5 + (5 × 0.35)
= $34.25m i.e. an increase of $ 1.75m
Tax relief is available on the interest on debt. Hence introduction of debt instead of equity
reduces the company’s tax liability. The present value of tax relief to perpetuity is Dt and this
increase in value accrues to the equity shareholders.
Cost of equity
D(I - t)
Keg = Keu + (Keu – Kd)
E
5(1 − 0.35)
= 0.18 + (0.18 – 0.13) ×
32.5 − 5 + 1.75
0.05 × 3.25
= 0.18 +
29.25
= 0.1856 i.e. 18.56 an increase 0.56%
The introduction of debt increases the risk faced by the equity shareholders – this increase in
risk is referred to as financial risk. This increase in risk results in the equity holders
demanding a higher return on their investment. Hence the cost of equity rises which,
according to Modigliani and Miller (M&M) is at a linear rate.
Cost of capital
WACC = (0.1856×29.25/34.25) + (0.13×0.65×5/34.25)
= 0.171 i.e. 17.1%
a decrease of (1 8 – 17. 1) = 0.9%
The introduction of debt has three effects:
it increases the cost of equity;
the cost of debt is less than the cost of equity which results in a saving;
tax relief is available on debt interest.
M&M argue that the first two effects cancel out. The net effect of introducing debt is the
benefit of tax relief which reduces the company’s overall cost of capital.
1052
(c)
The traditional theory suggests that at “low” levels of gearing the benefits (i.e. cost of debt <
cost of equity and tax relief) from increasing debt outweigh the disadvantages (i.e. the
increase in financial risk to the equity shareholders) and therefore the average cost of capital
decreases. However, at “high” levels of gearing the costs start to outweigh the benefits
causing the cost of capital to increase. Hence a “U” shaped cost of capital curve and an
optimum’ level of gearing i.e. the level of gearing can directly affect the value of the firm.
This is not based on a theoretical model and no guidance is given as to how to identify this
optimum. Therefore, the theory is of limited practical use although it does suggest that
managers should attempt to achieve a balance between the amount of debt and equity finance
used.
The M&M theory with corporation tax suggests that a company should gear up as much as
possible since the benefits of debt always exceed the cost. This implies a gearing level
approaching 100% which is clearly unrealistic.
The reasons for the model being unrealistic are the assumptions on which it is based and the
costs which are excluded from the model.
(i) The model assumes that:
(1) individuals and companies borrow at the same interest rate for all levels of debt;
(2) personal gearing is viewed by shareholders as equivalent in risk terms to corporate

borrowing;
(3) there are no transaction costs and that information is freely available.
(ii) The model does not take account of..
(1) Bankruptcy costs. At high levels of gearing the probability of bankruptcy occurring
increases and with it the expected cost of bankruptcy which can be a very
significant amount from the shareholders’ point of view.
(2) Debt capacity. There is a restriction on the amount of debt that a company is able to
raise. Lenders will not be prepared to lend beyond certain levels – often determined
by the level of security required for a loan. This capacity will vary from company
to company.
(iii) Personal tax.
In a more recent article Miller argued that when personal tax is taken into account the
introduction of debt has no effect on the value of the firm.
(iv) Tax relief
At high levels of debt the firm may reach a stage where it has insufficient taxable profits
against which to set off debt interest i.e. it would not be able to utilise the tax relief and hence
no cash benefit from introducing more debt. This is sometimes referred to as “tax
exhaustion”.
1053
(v) Agency costs.
The managers of the company may impose limits on the level of debt in order to suit their
requirements rather than the best interests of shareholders. Similarly providers of debt may
restrict the actions of management.
These costs/restrictions will tend to counteract the beneficial effect (tax relief) of introducing
more debt. The impact of these various costs is to restrict the level of gearing below the 1
00% suggested by the M&M model, indicating again that an optimal level of gearing may
exist.
Answer 26 WEMERE
(a)
The first error made is to suggest using the cost of equity, whether estimated via the dividend
valuation model or the capital asset pricing model (CAPM), as the discount rate. The
company should use its overall cost of capital, which would normally be a weighted average
of the cost of equity and the cost of debt.
Errors specific to CAPM
The formula is wrong. It wrongly includes the market return twice. It should be:
rj = rf + (rm. – rf) ßj
The equity beta of Folten reflects the financial risk resulting from the level of
gearing in Folten. It must be adjusted to reflect the level of gearing specific to
Wemere. It is also likely that the beta of an unlisted company is higher than the
beta of an equivalent listed company.
The return required by equity holders i.e. the cost of equity, is inclusive of a return
to allow for inflation.
Errors specific to the dividend valuation model
The formula is wrong. It should be:
D1
+g
P0
Treatment of inflation – as for CAPM.
Again the impact of the difference in the level of gearing of Wemere and Folten on
the cost of equity has not been taken into account.
Revised estimates of cost of capital
CAPM: required return = rf + (rm – rf) Bj
1054
For Folten
 Ve   Vd(1 − T ) 
βa =  βe +  βd 
 (Ve + Vd(1 − T ))   (Ve + Vd(1 − T )) 
assume βd = 0, D = 4,400 E= 1.38 × 1,800 × 4 (share price × no. of equity shares)
= 9,936
9,936
Ba = 1.4 ×
9,936 + 4,400(1 − 0.35)
= 1.087
For Wemere
D = 2,400, Equity value of $10.6 million,
10,600
1.087 = × βe
10,600 + 2,400 (1 - 0.35)
1.087 = 0.872 βe
βe = 1.25
Cost of equity = 12 + (18 –12) × 1.25
= 19.5%
10,600 2,400
WACC = 19.5% × + 13(1–0.35) ×
10,600 + 2,400 10,600 + 2,400
= 17.5%
Dividend valuation model
Folten
D1
Ke = +q
P0
Calculate dividend growth rate:
9.23 (1+g)4 = 13.03

(1+g)4 = 1.412
1+g = 1.09
g = 9%
D1 = 13.03 (1 + 0.09)
= 14.20c
14.20
ke = + 0.09
138
= 0.193 i.e. 19.3%
Now use Modigliani and Miller’s theory with tax:
D(I - t)
Keg = Keu + (Keu – Kd)
E
1055
Folten
4,400(1 - 0.35)
19.3 = Keu + (Keu – 13)
9,936
Keu = 17.9%
Wemere
2,400(1 - 0.35)
Keg = 17.9 + (17.9 – 13)
10,600
= 18.6%
10,600 2,400
WACC = 18.6% × + 13(1 – 0.35) ×
10,600 + 2,400 10,600 + 2,400
= 16.7%
(b)
Both methods result in a discount rate of approximately 17%. They are both based on
estimates from another company which has, for example, a different level of gearing. The
cost of equity derived using the dividend valuation model is based on Folten’s dividend
policy and share price and not that of Wemere. The dividend policy of Wemere (e.g. the
dividend growth rate) is likely to be different.
CAPM involves estimating the systematic risk of Wemere using Folten. The beta of Folten is
likely to be a reasonable estimate, subject to gearing, of the beta of Wemere.
CAPM is therefore likely to produce the better estimate of the discount rate to use. However,
this will be incorrect if the projects being appraised have a different level of systematic risk to
the average systematic risk of Folten’s existing projects or if the finance used for the project
significantly changes the capital structure of Wemere.
(c)
Discounted cash flow techniques allow for the time value of money and should therefore be
used for all investment appraisals including that carried out by small unlisted companies. It is
important for all managers to recognise that money received now is worth more than money
received in the future. Discounting enables future cash flows to be expressed in terms of
present value and for net present value to be calculated. A positive net present value indicates
that the return provided by the project is greater than the discount rate.
One non-discounting method – accounting rate of return – is used because it employs data
consistent with financial accounts, but it is not theoretically sound and is not recommended.
However it does show the impact of a new project on the financial statements and thus likely
impact on users of these statements.
Discounted payback measures how long it takes to recover the initial investment after taking
account of the time value of money. It is a useful initial screening method but should not be
used alone since it ignores cash flows outside the payback period.
A problem for all companies, not only small unlisted companies, is estimation of the discount
rate. This can be partly overcome by calculating the internal rate of return (IRR) i.e. the
discount rate at which the NPV is zero. This provides a “break-even” cost of capital – i.e. a
yield which is then acceptable provided the capital cost of the business “could not be lower”.
1056
Answer 27 CRESTLEE
(a) The discount rate should reflect the systematic risk of the individual project being undertaken.
Unless the risk of the textile expansion and the diversification into the packaging industry are
the same, their cash flows should not be discounted at the same.
The discount rate to be used should not be the cost of the actual source of funds for a project,
but a weighted average of the costs of debt and equity which is weighted by the market values
of debt and equity. It is possible to estimate an existing weighted average cost of capital for
Crestlee, but the rate cannot be applied to new projects unless the following assumptions are
complied with:
(i) The project should be financed in a way that does not alter the company’s existing
capital structure. The net present value investment appraisal method cannot handle a
significant change in capital structure (if such a change occurs the adjusted present
value method (APV) should be used – outside of the syllabus.)
Crestlee’s existing capital structure using market values is:
$m %
30 million ordinary shares at 380 cents 114.00 66
$56 million debentures at $104 58.24 34
_____
172.24
_____
If the two investments are considered as a “package”:
$m %
New finance being raised 9.275 equity 66
$56 million debentures at $104 4.725 debt 34
_____
14.000 m
_____
The company’s capital structure does not change as a result of these two
investments.
(iv) The project should have the same level of systematic risk as the company’s existing
operations. As the textile investment is an existing operation it is reasonable to
assume that it has the same systematic risk. The diversification into packaging could
have very different risk characteristics. The company’s existing weighted average
cost of capital should not be used as a discount rate for the diversification.
Textile expansion
The discount rate may be based upon the company’s weighted average cost of
capital (given that assumptions (i) and (ii) are not violated).
E D
WACC = Ke + Kd (1 – t)
E+D E+D
1057
Using the capital asset pricing model Ke may be estimated by
RF + (RM – RF)βe
Ke = 6% + (14% – 6%) 1.2 = 15.6%
Kd is taken as the current cost of bond, 11% (alternatively a rate could have been
estimated using the redemption yield of the debenture).
WACC = 15.6% × 66/100 + 11% (1 – 0.33) 34/100= 12.8%
This is the suggested discounted rate for the expansion.
Packaging diversification
The systematic risk of diversifying into the packaging industry may be estimated by
referring to the systematic risk of companies within that industry. However, the
equity beta is influenced by the level of financial risk (gearing). Unless the market
weighted gearing of Canall and Sealalot is the same as Crestlee, it is necessary to
“ungear” the equity beta of these companies (to remove the effect of financial risk)
and “regear” to take account of Crestlee’s financial risk.
Gearing Canall ($m) % Sealalot ($m) %

Equity 72.0 81 138 91
Debt 16.8 19 13 9
____ ___
88.8 151
____ ___
These are both significantly different from Crestlee.
Ungearing Canall (assuming debt is risk free and βd = 0)
E 72
βa = βe × = 1.3 × = 1.124
E + D(1- t) 72 + 16.8(1 − 0.33)
Ungearing Sealalot
138
βa = 1.2 × = 1.129
138 + 13(1 − 0.33)
These are very similar. The ungeared equity beta of the packaging industry will be
assumed to be 1.125.
Regearing for Crestlee’s capital structure
E + D(1 - t) 114 + 58.24(1 − 0.33)

βe = βa × = 1.125 × = 1.51
E 114
Ke is estimated to be:
6% + (14% – 6%) 1.51 = 18.08%
WACC = 18.08% × 66/100 + 11% (1 – 0.33) 34/100 = 14.4%
1058
15% is not an appropriate discount rate for either of these projects. The less risky
textile expansion has an estimated discount rate of 12.8%, and the diversification
14.4%.
(b) The marketing director might be correct. If there is initially a high level of systematic risk in
the packaging investment before it is certain whether the investment will succeed or fail, it is
logical to discount cash flows for this high risk period at a rate reflecting this risk. Once it has
been determined whether the project will be successful, risk may return to a more normal
level, and the discount rate reduced commensurate with the lower risk.
The other board member is incorrect. If the same discount rate is used throughout a project’s
life the discount factor becomes smaller and effectively allows a greater deduction for risk for
more distant cash flows. The total risk adjustment is greater the further into the future cash
flows are considered. It is not necessary to discount more distant cash flows at a higher rate.
Answer 28 MUGWUMP LTD
(a) Costs incurred
$
Direct materials 30% of $1,500,000 450,000
Direct labour 25% of $1,500,000 375,000
Variable overheads 10% of $1,500,000 150,000
Fixed overheads 15% of $1,500,000 225,000
Selling and distribution 5% of $1,500,000 75,000
(b) Average value of current assets
$ $
Raw materials 3
12
× $450,000 112,500
Work in progress
Materials 2
12
× $450,000 75,000
Labour 1
12
× $375,000 31,250
Variable overheads 1
12
× $150,000 12,500
——–– 118,750
Finished goods
Materials 1
12
× $450,000 37,500
Labour 1
12
× $375,000 31,250
12
× $150,000 12,500
——— 81,250
2 12
Accounts receivable 12
× $1,500,000 312,500
————
625,000
1059
(c) Average value of current liabilities
Materials 2
12
× $450,000 75,000
Labour 1
50
× $375,000 7,500
12
× $150,000 12,500
Fixed overheads 1
12
× $225,000 18,750
Selling and distribution 1
24
× $75,000 3,125
——–– (116,875)
————
(d) Working capital required 508,125
————
Note It has been assumed that all the direct materials are allocated to work in progress when
production is commenced.
Answer 29 DYER LTD
(a) Long-term effects of policy
(i) Annual profit increase
Old New Increase

position position
$000 $000 $000
Sales (note 1) 2,400 3,960 1,560
——— ——— ———
Raw materials (note 2) 720 1,080 360

Other variable costs (note 2) 960 1,440 480
Fixed costs (note 3) 600 600 –
——— ——— ———
Total costs (2,280) (3,120) (840)
——— ——— ———
Profit $120 $840 $720

——— ——— ———
Notes
(1) Increase in sales volume 50%

Increase in sales price 10%
Total revised sales
$2.4m × 1.5 × 1.1 = $3.96m.
(2) Increase caused by volume increase of 50%.
(3) Unchanged.
1060
(ii) Working capital requirement
$000 $000
(1) Raw materials
One month’s supply 1,080 ÷ 12 90
(2) Work in progress
One month (1,080 + 1,440) ÷ 12 210
(3) Finished goods
One month’s supply (1,080 + 1,440) ÷ 12 210
——
420
(4) Accounts receivable
70 days’ credit 3,960 × 70/360 770
———
1,280
(5) Accounts payable
One month’s purchases (90)
––––––
Total working capital requirements 1,190
———
(b) Monthly cash forecast
Basic data
(i) Sales
$200,000 up to July
$220,000 August and September
$330,000 October onwards
(ii) Production
Materials Other
used variable
costs
$ $
June 60,000 80,000
July onwards 90,000 120,000
(iii) Cash costs
Per month
$
Fixed costs 50,000
Less Depreciation (10,000)
———
Cash costs 40,000
———
1061
Cash forecast – June to December
Month Jun Jul Aug Sep Oct Nov Dec

$000 $000 $000 $000 $000 $000 $000
Sales receipts
Old credit terms 200 200
New credit terms
60% 2 months’ credit 120 132 132 198
40% 3 months’ credit 80 88 88
—— —— —— —— —— —— ——
Total receipts 200 200 – 120 212 220 286
—— —— —— —— —— —— ——
Expenditure
Raw materials 60 90 90 90 90 90 90
Other variable costs 80 120 120 120 120 120 120
Fixed costs 40 40 40 40 40 40 40
—— —— —— —— —— —— ——
Total expenditure (180) (250) (250) (250) (250) (250) (250)
—— —— —— —— —— —— ——
Net inflow/(outflow) $20 $(50) $(250) $(130) $(38) $(30) $36

—— —— —— —— —— —— ——
Opening cash balance 80 100 50 (200) (330) (368) (398)

Closing cash balance 100 50 (200) (330) (368) (398) (362)
(c) Concerning the expansion
Tutorial note: The three important points of examination technique to make here are:
(i) Do not be afraid to state the obvious.

(ii) Think practically about the problem.
(iii) Plan your answer before writing in full.
The main comments could include reference to the following points.
(i) The long-term expansion will increase annual profits by 600% before
considering the cost of financing the increase in working capital required. This
profit increase will be reduced after financing costs are considered.
(ii) During the transitional period there are considerable cash outflows in individual
months and, in spite of a positive cash balance anticipated at the end of May, a
large negative balance is expected at the end of December. Had there been no
change in activity levels or credit terms, etc, the cash balance would be
expected to increase by $20,000 in each month so that at the end of December it
would have reached $220,000. The revised cash balance of a negative
$362,000 is therefore $582,000 lower, and it is this latter figure which is the
true indication of the short-term reduction in liquidity caused by the expansion.
(iii) Therefore, although the expansion is highly profitable, it requires heavy cash
resources to finance the extra working capital. This is especially true over the
first seven months when the new activities produce a substantial increase in
reported profits, but also require additional financing of $582,000.
1062
Answer 30 PUNTER BOOKMAKERS LTD
(a) The reasons for holding cash within the business are primarily the transactions and
precautionary motives. This should enable day-to-day business payments to be met
(primarily the winning customers), and allow for a margin of safety to cope with
unexpected cash needs.
If the finance director carries too high a cash balance, there is an inherent opportunity cost
in the loss of interest, or equivalent return, through its non-investment.
In theory a cash control model could be formulated which is similar to that used in
inventory control. This model would be based on the two basic costs of
(i) holding cash (the opportunity cost)

(ii) procurement of cash (transaction costs incurred in liquidating securities, and the
loss of customer good will if customers cannot be paid promptly).
The model would determine the optimum average cash balance to be held.
The Miller-Orr model is perhaps the derivative most commonly used.
Alternatively, the required cash balances could be determined by the establishment of

required ranges for the values of various cash ratios, e.g. cash to value of bets placed.
The problem with the models outlined above is that they may be of restricted practical
relevance to Punter Bookmakers Ltd, because the cash flows are continuously changing.
Just as with the EOQ inventory control model under uncertainty, one can try to deal with
the problem by estimating the likelihood of abnormally large daily demands for cash where
bets have not been reinsured by referring to the mean and standard deviation of past cash
flows. This presupposes that the cash flows follow a clearly defined statistical pattern,
such as a normal distribution. The finance director could therefore strive to prepare a more
detailed simulation of future periodic cash requirements.
The finance director must also forecast the timing of other payments, such as any capital
investments, renewal of licences, taxation, proposed dividends, loan repayments and
wages.
A computerised model could then be set up (obviously with the necessary help), which
would incorporate the forecast operating cash requirements and interest rates applicable to
financing and investments.
The model could then be used to highlight any long-term deficiencies, but also to allow the
advanced planning of the investment of any surpluses in either short-term or long-term
investments, depending upon the degree of permanency of the surplus envisaged.
The above has adopted a somewhat theoretical approach. Certain practical steps that the
finance director should consider are as follows.
(i) The company should specify that winning bets cannot be collected until a
certain time (perhaps the next day) which would allow cash inflows from other
bets to offset the payments, and would also give more time to consider the
liquidation of securities.
(ii) The operation of a credit system for major clients may smooth out fluctuations,
since any wins could be credited to the account rather than immediately being
paid out in cash.
1063
(iii) The finance director should consider a range of investments for the surplus cash
– such that some investments can be liquidated with minimum delay and with
little or no transaction costs. Where there is a lower probability of access to the
funds being needed, longer-term investments can be made.
(iv) The finance director should ensure that he has a safety net available to meet
unexpected demand – perhaps through an overdraft facility which can be drawn
upon as a last resort. This means that a good working relationship with the
company’s bankers should be developed.
(v) Investments should be managed so that they mature at times where cash
requirements may be high. Thus, large cash balances may be needed around
Grand National time, so perhaps investments should be at a comparatively low
level then, with funds held on deposit to either pay out or to be ready for
reinvestment.
(vi) The risks borne by individual branches can be pooled by operating a centralised
cash account. This should prove helpful unless there is a strong systematic
correlation in bets placed, e.g. where a large number of bets are placed on the
same horse at many branches and there is inadequate reinsurance, the business
would be severely exposed if that horse were to win.
(vii) It is also worth noting that reinsurance may protect profitability, but does not in
itself cover the immediate cash requirements, unless the other bookmakers
settle immediately. Thus the settlement terms when bets are laid off with other
bookmakers must be carefully negotiated.
In summary, a theoretical cash planning model may not be practical because of the
inherent uncertainties within the business. Hence, a flexible approach must be taken to
investment policy, ensuring that sufficient cash is available on short-term deposit to meet
unexpectedly high demand.
(b) The following is a brief summary of the types of securities that the finance director might
choose.
(i) Various types of bank deposits. These will range from high interest cheque
accounts to money market deposits. The differences are largely related to the
minimum deposit, length of deposit required, and conditions attaching to early
recall. If the finance director chooses bank deposits, he may be restricted
substantially by the amount of cash available (for example, money market
deposits at call usually require a minimum of £50,000). The likelihood of early
redemption points towards the use of investment accounts offered by clearing
banks where early redemption is possible, but subject to an interest penalty.
(ii) Negotiable instruments. Most dealing in bills and certificates of deposit takes
place on the secondary market (i.e. the transfer of an existing instrument as
opposed to the purchase of a new, or prime, bill).
Negotiable instruments offer the finance director two distinct advantages,

having regard to the uncertainty surrounding the time for which funds are
available.
(1) An instrument with a first class name, such as a major bank, can be
resold on the market at any time without notice.
1064
(2) The yield will reflect the term for which the instrument is issued.
The main disadvantage is that the price on resale will fluctuate with
interest rates.
(iii) Treasury bills, bank bills and trade bills. These have a nominal value of
£5,000 upwards. Bills could be purchased from banks or discount houses, and
the major cost is likely to be the turn between the buying and selling prices
quoted. Most bills can be resold without difficulty but, again, incurring
transaction costs.
(iv) Sterling Certificates of Deposit (CDs). These are negotiable instruments that
entitle the bearer to repayment of the capital deposited, plus the stated interest,
when presented to the issuing bank on maturity. Normally issued for lengthy
periods up to five years, they can be bought and sold on secondary markets
which make them a shorter-term investment. However, the minimum face
value of a CD is £50,000, so these investments may be beyond the scope of the
finance director.
(v) Stock Exchange investments in listed companies. Investment in securities

issued by public companies could be considered. However, this involves a
larger risk and could be considered over-speculative. If this type of investment
were made, care should be taken to mix a well-diversified portfolio in order to
reduce the random risk associated with each individual investment.
In summary, the finance director must consider the trade-off between higher returns
yielded by longer-term investments against the flexibility given by bank deposits and
negotiable instruments. The overall portfolio of investments should comprise
comparatively liquid assets, including some overnight money if the funds at stake are
sufficiently large.
Answer 31 MR COLORADO
(a) Cash forecast to 31 March 19.02
Existing policy
WORKINGS
Current sales $14,500 per month 50% cash $7,250

50% credit $7,250
Purchases (60%) $8,700 – takes 2.5% discount. Therefore cash $8,483
Overhead $4,000 per month – variable with sales
Budgeted profit and loss items

Nov Dec Jan Feb Mar Apr
$ $ $ $ $ $
Sales 14,500 14,500 14,790 15,086 15,387
Purchases 8,700 8,700 8,874 9,051 9,233 9,418
Overhead 4,000 4,000 4,080 4,162 4,245
1065
Budgeted cash flows under existing policy

Jan Feb Mar
$ $ $
Income
Cash sales 7,395 7,543 7,694
Credit sales
November 7,250
December 7,250
January 7,395
——— ——— ———
14,645 14,793 15,089
——— ——— ———
Payments
Accounts payable
December 8,483
January 8,652
February 8,825
Overhead 4,080 4,162 4,245
——— ——— ———
12,563 12,814 13,070
——— ——— ———
Net cash flow 2,082 1,979 2,019

Balance brought forward (14,800) (13,088) (11,436)
Add Interest at 2.5% (370) (327) (286)
——— ——— ———
Balance carried forward (13,088) (11,436) (9,703)
——— ——— ———
Hence estimated overdraft at 31 March 19.02 = $9,703
Proposed policy
Sales 50% on credit × 0.975

Purchases Two months later at 100%
Inventory
Assume the opening balance each month = next three months’ cost of sales (COS).
∴ Target inventory 1 January = COS (January + February + March).

= $(8,874 + 9,051 + 9,233)
= $27,158
Actual inventory = $18,500
∴ Special purchase = $8,658 paid two months later
∴ January purchases = Special + April COS
= $(8,658 + 9,418)
= $18,076
1066
Budgeted cash flows under proposed policy

Jan Feb Mar
$ $ $
Income
Cash sales 7,395 7,543 7,694

Credit sales
November 7,250
December 7,250
January 7,210
February 7,354
——— ——— ———
14,645 22,003 15,048
——— ——— ———
Payments
Accounts payable
December 8,483
January 18,076
Overheads 4,080 4,162 4,245
——— ——— ———
12,563 4,162 22,321
——— ——— ———
Net cash flow 2,082 17,841 (7,273)

Balance brought forward (14,800) (13,088) 4,426
Interest at 2.5% (370) (327)
——— ——— ———
(13,088) 4,426 (2,847)
——— ——— ———
Hence, estimated overdraft at 31 March 19.12 = $2,847
(b) Comment on figures and method of long-term evaluation of policy
Under the existing policy Mr Colorado has a steadily improving cash position in the next
three months. This must be the case as he makes a gradually increasing profit month by
month. His working capital also increases but this is a linear function of the increase in
activity as far as accounts receivable and accounts payable are concerned, and inventory
remains constant. Thus the steadily increasing cash flow from accounts receivable is more
than sufficient to cover the increased working capital. The net cash flow each month will
steadily increase, with the exception of the one-off reduction in February, caused by the
initial increase in activity and the fact that the higher creditor and overhead costs are paid
earlier than the receipt for the higher credit sales. Nevertheless the net cash flow is
positive. Overdraft interest costs will steadily decline.
Under the proposed policy there is a substantial once-only change in the working capital.
The substantial increase in inventory is paid for in March, which reduced the net cash flow
in that month. More specifically the increase in accounts payable , by not taking the
discount, means no payment at all in February. This, combined with the earlier receipt of
the January credit sales, gives a much improved cash flow in February.
1067
Once the adjustments due to the change in policy have taken place, cash flow will become
positive from April onwards and then steadily increase. However, the April cash flow will
be lower under the new policy as the creditor payment will be higher. Despite the delay in
payment by a further month, it is now without discount and is for purchases required two
months further ahead than the current policy and thus at a higher level.
Both policies give month-end cash balances that are within the bank overdraft limit.
The evaluation of the long-term effect of the alternative credit policies must be made by
considering the net cash flow effect in terms of Mr Colorado’s cost of capital (finding the
NPV of each policy). This exercise is justified as consistent with the objective of the firm
to maximise shareholder wealth. The change in working capital is a cash flow effect on
the firm. The change in receipts from accounts receivable and payment to accounts
payable is similarly an annual cash flow. The policies can thus be regarded as any other
decision, and evaluated by discounting the cash flows they produce.
Answer 32 WORRAL LTD
(a)
(i) Increase long-term loans by $300,000
Cost of loan = Grandus’ cost of debt
12
=
82.75
= 14.5%
Cost of bank overdraft = 11 + 2
= 13%
4,874
Effect on current ratio =
3,293 − 300
= 1.63
(ii) Offer cash discount
$
New accounts receivable level
No discounts (2,684 × 0.5) 1,342,000
Cash discount (2,684 × 0.5 × 14
107
) 175,589
–––––––––
1,517,589
Old accounts receivable level 2,684,000
–––––––––
Reduction in accounts receivable 1,166,411
–––––––––
There will be a corresponding reduction in the overdraft adjusted by the amount

of cash discounts given.
1068
Total reduction in overdraft will be 2,684 × 0.5 × 93

107
× 0.97
= $1,131,419
4,874,000 − 1,166,411
The effect on the current ratio =
3,293,000 − 1,131,419
= 1.72
Annual cost of discount scheme = $30,000
Saving in overdraft interest = 13% × 1,131,419
= $147,084
(iii) Non-recourse factoring company
$ $
Reduction in accounts receivable 2,684,000
Reduction in current liabilities

Advances 2,684,000
Less Commission (2½% × 9,182,000) (229,550)
–––––––––
2,454,450
–––––––––
4,874,000 − 2,684,000
Effect on current ratio =
3,293,000 − 2,454,400
= 2.61
Annual cost of factoring

$000
Commission (9,182 × 2½%) (229.55)
Interest (2,684 × 14%) (375.76)
Saving in overdraft interest (1,650 × 13%) 214.50
Saving in bad debts (9,182 × 1½%) 137.73
Saving in credit management 135.00
–––––––
(118.08)
–––––––
Recommendation
Each of the three suggestions will increase the current ratio to above the average of 1.6.
However, increasing long-term loans achieves this aim by only a small margin. Factoring
increases the ratio to well over 2 and is the most beneficial in this respect.
Considering the annual cost of each alternative, the long-term loan option substitutes a cost
of 14½% for one of only 13% and is obviously not beneficial.
1069
The factoring arrangement has a net cost of $118,080 per annum and therefore is unlikely
to be as attractive as the cash discount option. Not only does the latter achieve the desired
current ratio but also an annual net saving of $117,000.
(b) Other ways of obtaining finance using accounts receivable as security would include the
following.
(i) A short-term loan or overdraft on the back of trade accounts receivable .
(ii) Selected invoices could be sold, or discounted, to a factoring company or

finance house. The company will receive a percentage (usually up to 90%) of
the invoice value. When the debt is collected the money is paid back to the
factor or finance house.
(iii) On the sale of goods a bill of exchange may be drawn up and accepted by the
buyer as his means of payment. The seller can then discount the bill (i.e.
receive a percentage in cash) with a third party.
Answer 33 DIRE PLC
Existing level New level Difference

$ $ $
3
Accounts receivable 12
× 5m × 0.9 2
12
× 5m × 0.9
= 1,125,000 = 750,000 375,000
3
Inventory 4
12
× 3m 12
× 3m
= 1,000,000 = 750,000 250,000
2 12
Accounts payable 2
12
× 3m × 0.8 12
× 3m
= 400,000 = 625,000 225,000
––––––––
Total reduction in working capital 850,000
––––––––
Interest saved
$
Working capital 850,000 × 0.1 85,000
Reduced interest payable on loan 200,000 × (0.1 – 0.07) 6,000
––––––
91,000
––––––
1070
Answer 34 MOORE LTD
(a) DCF appraisal
Assume that the new policy is implemented at t = 0. This affects anything invoiced at t = 1
onwards.
Existing scheme
1 2 3→∞
$ $ $
Accounts receivable
1 month 2,000 2,000
2 months 7,800
Accounts payable (6,000) (6,000)
Administration (1,000) (1,000) (1,000)
––––– ––––– –––––
(1,000) (5,000) 2,800
––––– ––––– –––––
New scheme
1 2 3→∞
Accounts receivable $ $ $
1 month 98% × 60% × 11,000 6,468 6,468
2 months 37% × 11,000 4,070
Accounts payable
To cover sales (6,600) (6,600)
Extra to boost inventory (1,200)
Administration (1,150) (1,150) (1,150)
––––– ––––– –––––
(1,150) (2,482) 2,788
––––– ––––– –––––
Incremental CF (150) 2,518 (12)
DF @ 1% pcm 0.99 0.98 98
PV (149) 2,468 (1,176)
NPV $1,143
–––––
NPV > 0. Therefore, new scheme better.
(b) Profits
Old scheme New scheme

$ $
Sales 120,000 132,000
Cost of sales (72,000) (79,200)
––––––– –––––––
Gross profit 48,000 52,800
Administration (12,000) (13,800)
Bad debts (2,400) (3,960)
Discounts – (1,584)
––––––– –––––––
Profit before interest and tax 33,600 33,456
––––––– –––––––
1071
This would indicate that the old scheme is better, in contradiction of the result in (a). The
reason for this discrepancy is that the P&L approach ignores the timing of the cash flows
and the change in working capital. The difference in profit of $144 (or $12 pcm) reflects
the cash flows from month 3 onwards but not the transition to get there.
(c) Cash operating cycle
Before After
months months
Accounts receivable period
(0.2 × 1 + 0.78 × 2) 1.76
(0.6 × 1 + 0.37 × 2) 1.34
Inventory period 2.00 2.00
Accounts payable period (1.00) (1.00)
–––– ––––
Length of cycle 2.76 2.34
–––– ––––
New scheme will reduce the length of the cycle.
(d) Working capital in one year
Old scheme
$
Accounts receivable = 0.2 + 10,000 + 0.78 × 100,000 × 2 = 17,600
Accounts payable = 1 × 6,000 = 6,000
Inventory = 2 × 6,000 = 12,000
Cash balance = 20,000
17,600 + 12,000 + 20,000

Current ratio = = 8.27
6 ,000
17,600 + 20,000
Quick ratio = == 6.27
6,000
New scheme
Accounts receivable = 0.6 × 11,000 + 0.37 × 11,000 × 2 = 14,740

Accounts payable = 1 × 6,600 = 6,600
Inventory = 2 × 6,600 = 13,200
Cash (W1) = 22,248
14,740 + 13,200 + 22,248

Current ratio = = 7.6
6,600
14 ,740 + 22 ,248
Quick ratio = = 5.6
6 ,600
Both current and quick ratios are lower under the new scheme.
1072
WORKINGS
Either
(1) Use figures from (a)
Cash balance = 20,000 – 150 + 2,518 – (10 × 12)
= $22,248
or
(2) Do a basic CF statement

$
Cash balance under old scheme 20,000
Difference in profit (144)
Movement in accounts receivable 2,860
Movement in accounts payable 600
Movement in inventory (1,200)
Adjustments for discounts for last month of sales that should not
have gone through P&L a/c for first year 2% × 60% × 11,000 132
––––––
22,248
––––––
Answer 35 WAGTAIL LTD
(a) Optimal batch size
s = 4,000
h = $15
f = $30 + 5 × $9* = $75
* The opportunity cost of the employee’s time is the revenue forgone, i.e. $(5 + 4) =
$9, not merely the contribution. If the employee were producing, revenue would be $9,
i.e. enough to cover his $5 wages and also to provide a contribution of $4.
2fs
Optimal batch size =
h
2 × 75 × 4,000
=
15
= 200 units
1073
(b) Quantity discount decision
The annual cost of B becomes relevant. To take the discount, the batch size would be
increased to only 400. Any larger figure would increase the total of holding and order
costs, since the formula gives 200 regardless of price.
(i) Order size = 200; Price = $24

$
Q 200
Holding cost h = $15 × 1,500
2 2
s
Ordering cost f = $75 × 20 1,500
Q
———
3,000
Cost of B 4,000 × $24 96,000
———
Total cost 99,000
———
(ii) Order size = 400; Price = $(24 – 0.24) = $23.76

$
Q
Holding cost h = $15 × 200 3,000
2
s
Ordering cost f = $75 × 10 750
Q
———
3,750
Cost of B 4,000 × $23.76 95,040
———
Total cost 98,790
———
(iii) Conclusion
Wagtail Ltd should take up the discount by adopting a batch size of 400 as this
results in a net saving.
Answer 36 TIPEX LTD
(a) Reorder quantity
Mean monthly demand = 7 (from symmetry of distribution)

Mean annual demand = 7 × 12 = 84
2fs 2 × 15 × 84
EOQ = = = 45 = 7 (to nearest whole number)
h 280 × 0.2
This implies 12 orders per annum.
1074
(b) Reorder level
Lead time is one month. Therefore average demand in lead time is 7 units. A reorder level
of 7 corresponds to no buffer inventory. Reorder levels of 7 and upwards will be
considered.
ROL B No of units Prob- Expected Annual Total

short ability annual holding annual
stock-out cost cost cost
7 0 1 0.20 0.53 × 12
2 0.10 × $40
3 0.03
4 0.01
——————— ———— ———
0.53 $254.40 $0 $254.40
——————— ———— ——— ————
8 1 1 0.10 0.19 × 12 1
2 0.03 × $40 × $56
3 0.01
——————— ———— ———
0.19 $91.20 $56 $147.20
——————— ———— ——— ————
9 2 1 0.03 0.05 × 12 2
2 0.01 × $40 × $56
——————— ———— ———
0.05 $24.00 $112 $136,00
——————— ———— ——— ————
10 3 1 0.01 0.01 × 12 3
× $40 × $56
——————— ———— ———
0.01 $4.80 $168 $172.80
——————— ———— ——— ————
The total expected cost is minimised for a reorder level of 9 units.
Answer 37 ORION PLC
(a) Optimal order size
Annual demand s = 2,800 × 250
= 700,000 items
Holding costs per unit per annum h = $0.1715 + 0.15 × $1.19 = $0.35
Fixed costs per order f = $12.25
1075
2fs
Optimal order size x =
h
2 × 12.25 × 700,000
= = 7,000 items
0.35
(Orders should be placed every 21/2 days, 100 times a year)
(b) Discounts
(i) Total annual costs with orders of 7,000
$
Purchase price 700,000 × $1.19 833,000
Holding costs 3,500 × $0.35 1,225
Reorder costs 100 × $12.25 1,225
————
Total 835,450
————
(ii) With orders of 20,000
$
Purchase price 700,000 × $1.18 826,000.00
Holding costs 10,000 × ($0.1715 + 0.15 × $1.18) 3,485.00
Reorder costs 35 × $12.25 428.75
—————
Total 829,913.75
—————
The optimal order size is therefore 20,000 items.
(c) Minimum discount acceptable
Let the reduced price be P.
The annual costs if inventory is ordered in batches of 20,000
= $428.75 + 10,000 × ($0.1715 + 0.15P) + 700,000P
= $2,143.75 + 701,500P
For the discount to be acceptable
$2,143.75 + 701,500P < $835,450
701,500P < $833,306.25
P < $1.187892
This is a discount of 0.2c or 0.18%.
1076
(d) Reorder level
Lead time = 2 days

Average demand in lead time = 2 × 2,800 = 5,600
Standard deviation = 400 2 + 400 2 = 2 × 400 2 = 565.685
σ = 565.685
2%
µ = 5,600 R
z
From tables z = 2.05
Buffer inventory = 565.685 × 2.05 = 1,160
Reorder level = 5,600 + 1,160 = 6,760 items
Answer 38 THREE SMALL UK COMPANIES
There is some evidence that foreign exchange markets are efficient (in the context of the efficient
markets hypothesis) when foreign exchange rates are allowed to float freely. However, there are very
few examples of currencies that are allowed to float freely in response to economic forces; where a
floating exchange rate exists it is normally in the form of a managed float (or dirty float) where a
government intervenes in the foreign exchange market to influence the price of its currency. Even if an
efficient foreign exchange market exists the manager of company one would be engaging in a risky
strategy. The effect of changes in the exchange rate on the company’s export transactions depends
upon the strength of sterling relative to the currencies in the countries to which company one exports. It
is possible that sterling could rise in value against all of these currencies simultaneously, and losses be
made on the export sales due to exchange rate changes. The company might not be able to sustain such
losses until more favourable exchange rate movements occur. Hedging, although it involves costs, can
limit foreign exchange losses (if any) to a known amount.
Company two only trades within Europe. It might be thought that, as imports are contracted to be paid
for in sterling, there is no foreign exchange risk with such transactions. Risk, however, does still exist,
as is explained for company three.
The answer with respect to company two’s exports will depend upon whether or not the UK uses the
Euro or continues to use $. At the time of writing the UK is choosing to remain outside “Euroland”.
Alternative answers are:
(i) If the UK joins the European single currency
The company will not face exchange risk in dealing with other countries participating in the
Euro. However the Euro itself of course floats against all other world currencies. Hence if the
company exports outside Euroland, it will face foreign exchange risk.
1077
(ii) If the UK does not join the Euro
The value of sterling can fluctuate against the Euro. Substantial foreign exchange gains or
losses could occur on the company’s export transactions.
Although company three is not engaged in foreign trade, exchange rate changes are still likely
to be relevant to the company. One form of foreign exchange risk is economic exposure,
which relates to the effects of unexpected changes in exchange rate on future cash flows.
Changes in exchange rates might affect the company’s competitive position. If exchange rate
movements make foreign competitors’ products cheaper, company three could lose sales to
such foreign competitors. Additionally, although the company is not directly engaged in
foreign trade, if it purchases components from other UK companies such components might
contain imported materials. If exchange rates change, this could directly affect the price
company three has to pay for components, even though these are purchased from UK
suppliers. There are several other ways in which exchange rate change could affect company
three. Exchange rate changes are not irrelevant to this company.
Answer 39 FOURX LTD
(a) Buying and selling rates
(i) Buying francs
Francs will be bought at 9.725 Ff/$. Ff 2,000 will cost
2,000
= £205.66
9.725
(ii) Selling francs
francs will be sold at 9.735 Ff/$. Ff 100 will provide
100
= £10.27
9.735
(b) Spot and forward rates
Note Remember ADDIS (Add discount; therefore subtract premiums).
Forward buying rate = 9.725 – 0.015
= 9.710
Francs received = £200 × 9.710
= Ff 1,942
1078
(c) Forward market cover
Forward buying rate (as in (b)) = 9.710 Ff/$
150,000
Cost of machine =
9.710
= £15,448
(d) Money market cover
Note This involves
(i) investing that amount of foreign currency to accumulate to the required

sum to be paid at the required date
(ii) buying that amount of foreign currency in (i) in the spot market, and
(iii) borrowing sufficient funds in the UK to buy the foreign currency in (ii).
Ff 150,000
Invest = Ff 146,341
1.025
Buy Ff 146,341 in the spot market for
146,341
= £15,048
9.725
Borrow £15,048 and repay in three months’ time
£15,048 × 1.0275 = £15,462
The cost using money market cover (£15,462) is very similar to that using forward market
cover (£15,448). These hedges eliminate the uncertainty of what is to be paid.
1079
Answer 40 STORACE PLC
(a) Sterling receipts
(i) Price in sterling = £100,000
(ii) Invoice price in dollars = 100,000 × 1.11
= $111,000
Exchange rate in three months’ time (spot rate)
= 1.20 – 1.09
Therefore, £ received is between £92,500 and £101,835
(iii) Invoice in dollars $111,000
Forward rates
Spot 1.1100 – 1.1100

Three months pm (0.0120) – (0.0115)
______ ______
Three months forward 1.0980 – 1.0985
______ ______
Sell dollars forward at $1.0985 to £1
Receive £101,047
(b) Report comparing methods of invoicing
To Storace plc
From Gluck & Co, Chartered Accountants
Date 3 January 19X0
Re Methods of invoicing export order
You have asked us to advise on the best method of invoicing one of your foreign clients,
Jacquin Inc. Three methods are under consideration.
(1) Invoice in sterling.
(2) Convert the sterling price into dollars at the current spot rate, invoice in dollars and
convert the dollars into sterling at the spot rate prevailing on receipt of the dollars
three months hence.
(3) Invoice in dollars and sell the dollars forward at the three month forward exchange
rate.
Our calculations in Appendix 1 show the expected sterling receipts resulting from each of the
three options. In summary they are as follows.
(1) £100,000
(2) Between £92,500 and £101,835
(3) £101,047
1080
In general, the objective in deciding on the method of invoicing foreign clients should be to
minimise exchange rate risk, i.e. the potential losses suffered by the company as a result of
movements in the exchange rate between the date of invoice and the date of payment. Stated
simply, if your company wishes to speculate on the foreign currency exchanges, there are
easier ways of doing it than exporting goods to foreign customers.
Given this objective the obvious answer is to invoice in sterling which completely eliminates
any exchange rate risk from the view point of the selling company. By invoicing in sterling
and thereby guaranteeing the sterling receipt three months hence, Storace plc will pass on the
exchange risk to the foreign customer, Jacquin Inc. The management of Jacquin Inc will
then have to decide whether to buy the £100,000 needed to meet the invoice in the forward
market or wait until the payment date and buy in the spot market. However, it may not be
prepared to accept the risk. Therefore it is possible that your client may not be prepared to
accept a sterling invoice. If you wish to keep the business you may have to invoice in the
currency of your foreign client. In these circumstances the choice is between options (2) and
(3).
Option (3), to cover your position in the forward market, is also riskless provided your client
pays on the due date. Indeed, since the dollar is trading at a premium in the forward market,
i.e. the market expects the value of the dollar to rise, it is possible for your client to make a
“profit” of £1,047 by using this method of invoicing as compared with invoicing in sterling.
However, if your client defaults on payment for whatever reason, you will still have to honour
your contract to deliver $111,000 three months hence.
Another option is to invoice in dollars and convert the dollars at the spot rate prevailing in
three months’ time. Depending on the strength of the dollar at that time, you could receive
between £92,500 and £101,835. Compared with option (3) this gives a potential gain of 788
if the exchange rate moves to $1.09, and a potential loss of £8,547 if the rate moves to $1.20.
These figures assume that management expectations of the future spot rate are correct.
Conclusions
Ultimately the choice must depend on the commercial considerations affecting your company.
Although invoicing in sterling is the simplest solution, it is unlikely to lead to a sale. The
choice is therefore between options (2) and (3). Under option (2) there is a chance that only
£92,500 will be received, which could mean that a loss is made on the sale of the machine.
Therefore, you will probably prefer the certain £101,047 given by a forward contract. To
protect yourself against the possibility of a delay in payment by Jacquin Inc, I would suggest
that you consider using an option date forward contract where delivery can take place
between two dates rather than on a single date. You will receive less than £101,047 because
the contract rate will be less favourable from your point of view, but the difference will not be
great.
(c) Implications of a major export drive
If the company decides to engage in a major exports sales drive, there are four decisions to be
made in which corporate financial management will have a major role to play.
(i) Choice of organisation
A company can sell its product in a variety of ways abroad, e.g. direct to customers or agents,
via a branch or department established in that country or via a subsidiary company established
in that country.
1081
(ii) Financing branches/subsidiaries
Overseas branches/subsidiaries will require financing. Financial managers will need to

consider both the cost of funds and exchange risk (e.g. whether a loan to finance a subsidiary
should be taken in sterling or a foreign currency).
(iii) Protecting against exchange risk on receipts
This is the subject of part (a) of the question and can be covered by dealing in the forward
markets as explained in part (b).
(iv) Assessing creditworthiness of overseas customers
A company may experience more problems in assessing the creditworthiness of overseas

customers than of domestic customers. The risk of default by an overseas customer can be
insured against via the Export Credits Guarantee Department. The ECGD also gives banks
guarantees on cash advanced against such insurance policies, thus providing a company with
the means to finance increased working capital requirements resulting from overseas sales.
Answer 41 OMNIOWN PLC
(a)
A forward rate agreement (FRA) involves fixing the future interest rate now for the
$5m. It involves an agreement tailor-made to the company’s requirement in terms of
amount and dates. Once an FRA has been entered into Omniown must pay interest
at the agreed rate. The rate offered will depend on the market’s current perception
of future interest rates. The FRA is based on a notional principal i.e. it is
independent from the underlying loan which should be arranged separately. It would
protect the firm from rate increases but if the actual rate fell below the forward rate
the company would not benefit from this decrease i.e. it would still have to pay the
rate per the forward rate agreement.
The mechanics of an FRA are that if actual rates are in excess of the rate per the
FRA, the bank will compensate the company by the amount of the excess. Similarly,
if actual rates are below the agreed rate the company pays the difference to the bank.
There is no initial premium payable on an FRA. FRAs can normally be arranged for
up to two years into the future.
Interest rate futures are contracts of standard amounts and for standard periods of
time running from a limited number of dates. They are therefore less flexible than
an FRA but are similarly binding on both parties. For Omniown protection against
interest rate increases could be achieved by selling futures contracts now. As
interest rates rise the value of futures contracts will fall. Hence Omniown can buy
back the contracts at a lower price and make a profit. This profit should compensate
the company for the increase in interest rates though this profit is unlikely to match
perfectly the additional interest costs incurred. Interest rate futures involve payment
of a small initial margin.
1082
An interest rate guarantee (or cap) is an option which enables the treasurer to fix a
maximum interest rate for a period in the future but if the rate falls the treasurer can
choose not to use the option and take advantage of the lower rate. Because of this
additional benefit – of taking advantage of lower rates – options tend to be more
expensive: they involve payment of a premium in advance at the time the contract is
entered into.
In this case the option would be to guarantee rates at their existing level and because
it is a short-term option, the premium is likely to be fairly high unless the market
expects rates to fall.
(Tutorial note: the premium would be lower if the guaranteed rate were higher than
existing rates e.g. 16%.)
Answer 42 BRITISH INDUSTRIAL GROUP
Report front page
To Directors of BIG plc

From Anne Analyst
Date Today
Subject Valuation of Bertram Ltd
Contents
1 Terms of reference
2 Dividend valuation
3 Price earnings valuation
4 Asset valuation
5 Conclusion
Appendices
1 Terms of reference
This report makes three estimates of the value of Bertram Ltd. The usefulness of these
valuations depends upon the size of stake you intend to take in the company, and the
relevance of each valuation will be discussed.
It is vital to appreciate that valuation is not an exact science and the final price paid will be a
matter of negotiation. These figures simply provide boundaries for discussion.
Also included are details of further information required to increase confidence in the figures
provided.
2 Dividend valuation
(i) Valuation
This approach works on the basis that the value of the share is equal to the present value of
future dividends calculated at a rate of return which reflects the risk of the share returns.
As detailed in Appendix 1 this gives a valuation of $2.29 per share. This figure falls
considerably if we make an adjustment to the cost of equity to reflect the non-marketability of
the private company’s shares. The size of this adjustment is debatable but some reduction has
to be made.
1083
(ii) Suitability
This technique is suitable if you believe that the value of a share is equal to the present value
of future dividends. It is particularly appropriate if you intend to take a minority interest as it
bases value on the cash returns you could expect to earn.
It is not as appropriate for a controlling interest as you would then be in a position to

influence future dividend policy. However, it could be argued that as this approach
“simulates” a market value for Bertram if it were a listed company, then it gives a guide to
what you would have to pay to acquire the firm. If you did use these figures for a controlling
interest, you could adjust upwards the price you would be prepared to pay for the net of tax
gain you could generate on the surplus warehouse. This figure is detailed in Appendix 4 as
$4.34m.
(iii) Further information
Further information would be useful to substantiate the estimates of future dividends and the
cost of equity.
To verify a growth rate of 10% in dividends it would be useful to have details of past
dividends, more detailed sets of accounts to explain the nature of the extraordinary items, and
details of the company’s future strategy to maintain this growth rate in current economic
circumstances. As earnings growth has reduced over the last two years, forecasts of future
earnings would be useful.
General economic data on interest rates, forecast inflation, the prospects of the domestic
appliances industry and the results of other firms in this sector would also be helpful.
Growth in dividend over the last two years has actually averaged 12% and this could cast
doubt on the 10% figure. A Gordon growth rate estimate, return on shareholders’ funds
multiplied by the retention rate
20.3m 10.3m
×
103.12m 15.3m
also gives a slightly more optimistic estimate of 13.25%.
To verify the suitability of the cost of equity employed, further details of the size, operating
gearing, products and markets of the listed companies from which the 16% has been derived
would be helpful. The basis of calculation (dividend valuation or CAPM) would also be of
interest.
3 Price earnings valuation
(i) Valuation
This approach works on the basis that the value of a business depends on its future earnings
potential. Current earnings are taken as an indicator of earnings potential and anticipated
growth rates and risks are embodied in the PE multiple.
As detailed in Appendix 2 this gives a valuation of $4.06 per share. This figure is
substantially reduced to $3.045 following adjustments for non-marketability. Once again the
size of this adjustment is debatable, but some reduction must be made.
1084
(ii) Suitability
This technique is suitable if you believe that the value of a business depends upon its future
earnings potential. It is most suitable for a majority interest as with a controlling interest you
would have control of the assets and therefore earnings.
If you were to take a controlling interest it could give a rough indication of value as once
again it could be considered as a “simulated” market price. It is probably more suitable than a
dividend-based estimate in these circumstances as earnings are less easy to manipulate. If it
were used to estimate the price for a controlling interest, the net of tax gain on the surplus
warehouse could be added to the above figures.
In using this approach it is essential that the earnings figure and the PE multiple adopted are
realistic.
To verify the earnings figure most of the information already requested to support the
dividend valuation approach would be helpful.
In addition, more detail on the extraordinary items is essential. As significant and growing
amounts are involved for three consecutive years, it is legitimate to question if they are truly
extraordinary, or if they are simply being used to massage reported earnings. It could well be
prudent to base our valuation on earnings after extraordinary items, resulting in a total value
of $91.8m on a PE ratio of 6. Directors’ salaries may also need to be classified as
distributions rather than expenses.
Further information on the size, operating gearing, products and markets of the listed
companies from which the PE ratio has been derived would be helpful. It would also be
useful to know how extraordinary items have been dealt with in calculating their multiples.
4 Asset valuation
(i) Valuation
The above approaches value the company by attempting to assess the value of its future
earnings stream. An asset valuation approach takes the view that a collection of assets is
being bought and that this needs to be managed to achieve future earnings. There is no
guarantee that existing managers will stay and therefore future earnings could be in doubt,
whereas asset value is relatively certain.
As detailed in Appendix 3 this gives a valuation of $1.59 per share. Note that this is after
deducting the present value of the debenture obligations that the firm is carrying.
(ii) Suitability
Asset valuation is usually regarded as most suitable for a controlling interest as minority
holders would not be in a position to realise asset values. The figure presented could be
viewed as a break-up value of the business (net realisable value) and the minimum the owners
are likely to accept, or a cost of setting up the business from scratch (replacement cost) by
buying individual assets.
1085
Whichever view is taken it must be remembered that goodwill is excluded from these figures.
Much here will depend upon the company’s past trading record, its market position, the
quality of its management and the likelihood of their remaining after the takeover as well as
your own managerial skills in the domestic appliances business. Although various procedures
are available to value goodwill (e.g. a super profits approach), they are very subjective and the
price you are prepared to pay on top of asset value is a matter of judgment and negotiation. It
is worth noting, however, that asset value is considerably below the PE ratio valuation.
Asset values are subjective and further independent verifications of the fixed asset figures
would be welcome, particularly in the light of the current state of the property market. Details
of any disposal costs would also be helpful.
The figure included for net current assets is very much a guess and a detailed breakdown of
their composition would be useful. Details of raw materials, work in progress and finished
goods would be particularly helpful, especially when taking a net realisable value view of the
business, as inventory is often of little value on disposal.
5 Conclusion
(a) Valuation
As stated in the introduction, the figures provided are estimates and should be considered a
framework for negotiation.
If you are able to take a majority stake, asset value will most likely form the minimum
valuation. Even so, the existing owners of Bertram are unlikely to sell without considering
future earnings potential.
For a minority interest the PE ratio approach applied to the earnings after extraordinary items
would probably give the most realistic valuation as it avoids the problems of estimating future
dividend growth.
It should be appreciated that you are likely to pay a higher price per share for a controlling
interest than for a minority stake.
(b) Further information
Much of the necessary further information has already been requested. However, several
other items also need to be considered.
(i) Is the acquisition of Bertram for strategic reasons or is it purely an “asset-stripping”

investment? In the former case synergistic effects would need to be considered in
more detail; in the latter case, asset values are more pertinent.
(ii) Are the directors of Bertram likely to defend the acquisition? This could lead to a
higher price.
(iii) What is the quality of the management team of Bertram and how easily could they
be replaced by BIG’s existing staff? It is only through the management team that
you can secure future earnings.
1086
Appendix 1
Dividend valuation
Using the constant growth approach
Do = $5m
ks = 16%
g = 10%
D 0 (1 + g)
Po =
ks − g
5m(1 + 0.10)
=
0.16 − 0.10
= $91.67m
91.67m
Price per share =
40m shares
= $2.29 per share
If the cost of equity were increased by (say) 25% to reflect the non-marketability of the private
company’s shares, these figures would reduce to
5m(1.10)
Po =
0.20 − 0.10
= $55m in total and $1.375 per share
Appendix 2
Price earnings ratio valuation
PE ratio = 8.00
Earnings before extraordinary items = $20.30m
“Market value” = 20.30m × 8.00 = $162.40m
162.40m
Price per share = = $4.06
40m shares
If the PE ratio were reduced by (say) 25% to reflect the non-marketability of the private company’s
shares, these figures would reduce to
$20.30m × 6 = $121.8m in total and $3.045 per share
1087
Appendix 3
Asset based valuation
$m $m
Market value
Land and buildings 25.000
Plant and equipment 31.000
Estimated market value net current assets 46.375 (note 1)
———–
102.375
Less Market value of debt 33.804 (note 2)
Value of warehouse not required 5.000 (note 3)
———
(38.804)
———–
63.571
———–
63.571
Net value per share = $1.59 per share
40m
Notes
(1) Net current assets valued at 50% of book value. This is very much a guess and much will
depend upon their make-up.
(2) Present value of debenture holders’ claim is the present value of future interest and principal
payments at market interest rates
$m
Interest payments $30m × 0.14 × 3.170 13.314
Principal payment $30m × 0.683 20.490
———–
33.804
———–
(3) You will not require the warehouse. Therefore, it should not be purchased but left for the
existing owners to dispose of. Alternatively, you could pay $5m more which could be
recouped by a subsequent sale.
Appendix 4
Value of surplus warehouse
$m
Proceeds from sale 5.00
Less Tax 0.33 $(5m– 3m) (0.66)
—–—
4.34
—–—
1088
Answer 43 TWELLO PLC
(a)
(Tutorial note: a wide range of ratios can be calculated, but time will restrict the number
which can be done. Major ratios should be calculated, and presented in logical groupings.)
19X5 19X6 19X7 19X8

Profitability:
ROCE 22/118 25/165 40/149 54/171
18.6% 15.2% 26.9% 31.6%
Operating profit margin 22/742 25/859 40/961 54/1,028
2.96% 2.91% 4.16% 5.25%
Total asset turnover 742/222 859/268 961/299 1,028/334
3.34 3.21 3.21 3.08
Liquidity:
Current ratio: 76/104 94/103 1031/50 101/163
0.73 0.91 0.69 0.62
Acid Test: 33/104 48/103 54/150 49/163
0.32 0.47 0.36 0.30
Payables days 32 days 25 days 32 days 32 days
Financial Gearing: debt/equity 25/118 25/165 67/149 65/171
21% 15% 43% 38%
Earnings per share 26.0c 28.3c 38.3c 51.7c
P/E Ratio 11.5 12.4 11.5 10.1
With such limited information, a complete analysis is not possible. However, the following
observations can be made.
Profitability: this would have to be compared with other companies in a similar

business. However, ROCE does appear to be high and rising.
Profit/sales appears low, but one would need to compare this with Twello’s competitors.
Again, it is improving, which reduces any concern.
Asset turnover has fallen from 3.34 to 3.08 which is not encouraging. Without knowing the
industry it is not possible to determine how serious this is, but if the business only produces
3% – 5% return on sales, it requires a much higher asset turnover.
Liquidity: both Current ratio and Acid test appear to be low. Nevertheless, Twello has lived
with these figures for four years without the share price suffering. The slight deterioration in
both these ratios should not be allowed to continue. The trade accounts payable were further
studied because of the low ratios, but accounts payable appear to be being paid promptly.
Financial gearing appears not to be excessive although it has increased. EPS has risen in each
of the last three years, quite substantially in the last two. This is encouraging. The share
price has risen steadily, but it would have to be compared with the market generally, and the
segment in particular, before any opinions could be expressed. The P/E ratio has fallen over
the period.
The interest payable exceeds the interest receivable by $5m and $6m in the last two years.
Comparing the amounts invested with the amounts borrowed, it would be worth investigating
further to see if the policy of having both borrowings and investments is sound.
1089
Overall it is difficult to draw any firm conclusions as to Twello’s financial health. Whilst its
liquidity and return on sales ratios might appear weak for a manufacturing company, they
could be normal for a retailer.
(b) Other information
(1) Twello’s business.
(2) Comparable figures for similar companies.
(3) Share price movements in company sector for 19X5–8.
(4) Price level changes for 19X5–8.
(5) Cash flow statements.
(6) Current cost accounts.
(7) Chairman’s statement regarding future plans.
(8) Directors’ shareholdings and details of any management share option scheme.
(9) Details of any developments since the last accounts.
(10) Details of labour relations in Twello.
(11) Age and experience of management team.
(12) Information regarding the market in which Twello operates.
(c)
Deep discount bonds are bonds offered at a substantial discount to their nominal value.
Advantages accrue to both the company and the investor.
Company advantages
(1) Low interest rate is paid.
Investor advantages
(1) They are likely to remain in issue for their full life, an early call being unlikely.
(2) Gain on redemption may be treated as a capital gain, with tax advantages. Some tax
authorities amortise the discount and treat this amount as taxable income.
(3) Yield to redemption can be calculated more accurately, as the annual interest
received is less (therefore the uncertainties of reinvestment returns are less).
Zero coupon bonds are the extreme deep discount bond.
1090
The redemption yield of a 4% bond issued at $50 and redeemed in 17 years’ time is found by
solving for r in the following:
$50 = 4 4 4 ............. 4+100

—— + —— + —— + ———
1+r (l+r)2 (l+r)3 (1 + r)17
Try 11 % discount rate:
PV of an annuity of $4 for 17 years is $4 × 7.549 $30.20
PV of $ 100 in 17 years’ time is $1 00 × 0. 170 $17.00
——
Total $47.20
Issue ($50.00)
——
NPV (2.80)
Try 8 % discount rate:

PV of an annuity of $4 for 17 years is $4 × 9.122 $36.49
PV of $ 100 in 17 years’ time is $100 × 0.270 $27.00
——
Total $63.49
Issue ($50.00)
——
NPV 13.49
Redemption yield = 8% + 13.49
————— ×3% = 10.5 %
13.49 + 2.80
1091
1092
ATC
INTERNATIONAL
ACCA
FINANCIAL MANAGEMENT (F9)
STUDY QUESTION BANK
(i)
No responsibility for loss occasioned to any person acting or refraining from action as a result of
any material in this publication can be accepted by the author, editor or publisher.
This training material has been published and prepared by Accountancy Tuition Centre Limited
16 Elmtree Road
Teddington
TW11 8ST
United Kingdom.
Editorial material Copyright  Accountancy Tuition Centre (International Holdings) Limited, 2007.
All rights reserved. No part of this training material may be translated, reprinted or reproduced or utilised in
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permission in writing from the Accountancy Tuition Centre Limited.
Acknowledgement
Past ACCA examination questions are the copyright of the Association of Chartered
Certified Accountants and have been reproduced by kind permission.
(ii)
STUDY QUESTION BANK
CONTENTS
Question Name or subject Page Answer Marks
THE FINANCIAL MANAGEMENT FUNCTION
1 Private v public sector objectives 1 1001 10
THE FINANCIAL MANAGEMENT ENVIRONMENT
2 Capital market efficiency 1 1002 10
INVESTMENT DECISIONS
3 Basic discounting 1 1003 15

4 Elvira Co plc 2 1004 12
5 Khan Ltd 3 1005 18
6 Fiordiligi plc 3 1009 15
7 Hulme Ltd 5 1010 20
8 Bailey plc 6 1013 20
9 Stan Beldark 8 1016 10
10 Taleb Ltd 9 1017 10
11 Sticky Fingers plc 9 1019 20
12 Armstrong plc 10 1021 20
13 Compounding and discounting 12 1023 45
14 Despatch Co 14 1030 4
15 Discounted cash flow 14 1030 30
16 Gerrard 15 1032 12
17 Carter Ltd 15 1033 13
18 ABC 16 1034 20
EQUITY AND DEBT FINANCE
19 Moorgate company 17 1036 25

20 Greiner Ltd 17 1038 12
21 Mr Fidelio 18 1040 10
SECURITY VALUATION AND THE COST OF CAPITAL
22 Cost of capital 18 1041 15

23 Kelly plc 19 1044 20
WEIGHTED AVERAGE COST OF CAPITAL AND GEARING
24 Redskins plc 20 1047 20

25 Berlan 21 1051 15
CAPITAL ASSET PRICING MODEL
26 Wemere (ACCA J90) 22 1054 25

27 Crestlee (ACCA D92) 23 1057 25
(iii)
STUDY QUESTION BANK
CONTENTS
Question Name or subject Page Answer Marks
WORKING CAPITAL MANAGEMENT
28 Mugwump Ltd 24 1059 10

29 Dyer Ltd 25 1060 20
30 Punter Bookmakers Ltd 27 1063 16
31 Mr Colorado 28 1065 20
32 Worral Ltd 29 1068 20
33 Dire plc 30 1070 6
34 Moore Ltd 31 1071 17
35 Wagtail Ltd 32 1073 10
36 Tipex Ltd 33 1074 10
37 Orion plc 33 1075 15
RISK MANAGEMENT
38 3 small companies (ACCA J93) 34 1077 12

39 Fourx Ltd 35 1078 10
40 Storace plc 35 1080 16
41 Omniown (ACCA D91) 36 1082 10
BUSINESS VALUATION AND RATIO ANALYSIS
42 British Industrial Group 36 1083 30

43 Twello 38 1089 25
(iv)
Formula Sheet
Economic order quantity
2Co D
=
Ch
Miller – Orr Model
Return point = Lower limit + (1/3 × spread)
1
3 3
Spread = 3  
 
The Capital Asset Pricing Model
E(ri) = Rf + βi(E(rm)–Rf)
The asset beta formula
 Ve   Vd(1 − T ) 
βa =  βe +  βd 
 (Ve + Vd(1 − T ))   (Ve + Vd(1 − T )) 
The Growth Model
D O (1 + g )
PO =
(re − g )
Gordon’s growth approximation
g = bre
The weighted average cost of capital
 Ve   Vd 
WACC =  Ke +  Kd(1 − T )
 Ve + Vd   Ve + Vd 
The Fisher formula
(1+i) = (1+r) (1+h)
Purchasing power parity and interest rate parity
(1 + h c ) (1 + i c )
s1 = s0 x f0 = S0 x
(1 + h b ) (1 + i b )
(v)
Present Value Table
Present value of 1 i.e. (1 + r)–n

where r = discount rate
n = number of periods until payment
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.667 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
(vi)
Annuity Table
1 − (1 + r ) − n
Present value of an annuity of 1 i.e.
r
where r = discount rate
n = number of periods
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.586 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
(vii)
(viii)

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SESSION 03 – INVESTMENT DECISIONS

¾ To understand the type of investment decisions that will be made by organisations.

¾ Revenue expenditure is incurred to maintain non-current assets e.g. repairs

1.3 Investment decisions

¾ Decisions about which non-current assets should be acquired.

¾ Also referred to as project appraisal, investment appraisal or CAPEX analysis.

If payback period < target ACCEPT

Annual cash flows (before depreciation but after tax) $0.3m

Project life 10 yrs

2.2 Possible Improvements

2.2.1 Discounted payback period

¾ This takes into account the time value of money.

2.2.2 Bail-out factor

2.3 Advantages of payback

2.4 Disadvantages of payback

8 Ignores cash flows after payback period;

3 ACCOUNTING RATE OF RETURN (ARR)

The earnings of a project expressed as a percentage of the capital outlay or

¾ Also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI).

 Sunk costs (money already spent);

Average annual operating profit

OR Average annual operating profit

If ARR > target ACCEPT

Initial investment $200m

Cash flows Year 1 $100m

(i) Initial investment

(ii) Average investment

9 Uses readily available accounting information;

8 Different methods of calculation may cause confusion;

8 Ignores time value of money;

8 Target rate is subjective;

A project being considered would require a machine costing $80,000. Market

Evaluate the project using

Time Flow Cumulative Scrap Net cumulative

Payback period with bail-out =

³ Payback and ARR are commonly used in practice. However neither

¾ define and distinguish between capital and revenue expenditure;

¾ calculate payback and assess its usefulness as a measure of investment worth;

¾ calculate ARR and assess its usefulness as a measure of investment worth.

Average annual profit

Total cash flows − Total depreciation 250 − 180

Initial investment + Scrap value 200 + 20

Solution 2 — ARR and Payback

Average annual depreciation = 80,000 + 8,000 − 4 ,000

ARR = 17,500 − 14 ,000

(b) Average investment = 88,000 + 4 ,000

ARR = 17,500 − 14 ,000

Time Flow Cumulative Scrap Net cumulative

Payback period with bail-out = 4 years

¾ To apply the time value of money to investment decisions.

SIMPLE COMPOUND DISCOUNTING

¾ Single sum ¾ “Compounding in

¾ Definition and decision

If $100 is invested at 10% per annum (pa) simple interest:

Year Amount on deposit Interest Amount on deposit

2.1 Single sum

In 1 year’s time, $100 would have increased by 10% to $110

$500 is invested in a fund on 1.1.X1. Calculate the amount on deposit by

(a) 7% per annum simple

(b) 7% per annum compound.

Sunk costs (money already spent);

Liquidity preference – if money is received today it can either be spent or