ACCA – FM

FINANCIAL MANAGEMENT

STUDY NOTES
 Contents

Sr. # TOPIC Page #

1. Investment Appraisal 01

2. Inflation 20

3. Risk & Uncertainty 32

4. Cost of Capital 39

5. Cost of Irredeemable Debt 46

6. Capital Structure and WACC 51

7. Business Valuation 57

8. Sources of Finance 64

9. Cost of Convertible Debt 70

10. 77
Islamic Financing
11. Small and Medium Enterprises (SME) 80

12. Working Capital Management 94

13. Inventory Management 99

 Investment Appraisal

Decision making

Short term Long term

(Single period effect) (Having multi period effects)

Investment Appraisal:-
A detailed evaluation of projects/investments to assess the viability, its effects on shareholders wealth is called
investment appraisal,

What is Appraisal:-
Any expenditure in the expectation of future benefits. There are two types of investment:

Capital expenditure:
Capital expenditure is an expenditure which results in the acquisition of non-current assets or an improvement in
their earning capacity. It is not charged as an expense in the income statement; this expenditure appears as a non-
current asset in the balance sheet.

Revenue expenditure:
Charged to the income statement and is expenditure which is incurred.
(i) For the purpose of the trade of the business this includes expenditure classified as selling and distribution,
administration expenses and finance charges.
(ii) To maintain the existing earning capacity of non-current asset.

The capital budgeting process:

The process of identifying, analyzing and selecting investments projects whose returns are expected to extend
beyond one year.

These steps are being followed in capital budgeting process.

I. Creation of capital budgets
This steps involves assessing the time required by projects, when they are anticipated to start, how they
will be financed, how they would effect the current production budget, expected levels of production and
long term development of organization.
II. Investment Decision making process

It involves the following steps

Origination of Proposals Project screening Analysis Monitoring

and Acceptance and Review

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 i. Origination:-
A good understanding of market demand, market conditions and customer perceptions are always needed in
order to avail the opportunities.

There should be a proper mechanism which identifies the potential opportunities available in the market for
investment, and if technology is obsoleting, organization should know beforehand that new investment is
required.

ii. Project Screening:-

Each proposal should be screened before doing financial analysis on it. This screening would involve the
following questions:
 What is the purpose of the project?
 Does it align with organizations long term objectives? There should not be a single conflict between the
organization objectives and projects objectives.
 Are sufficient resources available?
 Necessary management skills are present?
 What kind of risk is involved in the project?

iii. Analysis and acceptance:-

It involves the following steps
 Standard format of financial information as a formal investment proposal should be submitted.
 Project should be classified e.g. what kind of financial appraisal is required, what % of return should be
achieved.
 Financial analysis should be done.
 Outcome of financial analysis should be compared with predetermined criteria
 Consider the project in the light of capital budget for the current and future operating periods
 Make the decision (accept or reject).
 Monitor the progress of the project.

a) Financial Analysis:-
This step would involve the application of organization’s preferred investment appraisal techniques e.g. IRR,
NPV etc.

Some projects e.g. marketing investment decisions have intangible returns in this case more weight may be
given to the consideration and qualitative issues.

b) Qualitative Issues:-
Qualitative Issues are those issues which are difficult or impossible to quantify but decisions should be made
after considering these issues e.g.
(i) How the project will affect the company’s image
(ii) Would the project help the organization in satisfying the customer needs

c) Accept or Reject:-
Acceptance depends on three factors
(i) Type of investment

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 (ii) Risk of the investment
(iii) Amount of expenditure required

iv. Monitoring the progress:-

A project progress should be monitored regularly, to ensure that capital spending is not exceeding from the
budget, implementation is not delayed and the anticipated benefits are eventually obtained.

Financial Evaluation Methods

Basic Methods Advanced Methods
 Accounting Rate of Return (ARR)  Net Present Value NPV
 Payback Period  Internal Rate of Return (IRR)
 Discounted Payback Period
In the above methods, ARR method is based on profits whereas all other methods are based on cash flows.
The Advanced Methods Includes Time Value of money

Basic Methods
1. Accounting Rate of Return (ARR)

Definition:-
The earnings of a project expressed as a percentage of the capital outlay or average investment
Or
Average return as a percentage of average investment.
Formula:-
ARR = Average Annual profit x 100
Initial investment

Alternative Version of ARR is:

ARR = Average Annual profit x 100
Average Investment

Where “Average Investment” is

= Initial Investment + Scrap value
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Decision Rule:-
Feasibility Decision:
If ARR of the project > Target ARR, Accept the project
If ARR of the project < Target ARR, Reject the project

Comparison Decision:
Project with higher ARR shall be preferred.

Advantages of Accounting Rate of Return:-

 It considers the readily available accounting information, that’s why eliminating the need of any other
additional reporting.
 ARR is simple to calculate and easy to understand, there is no technical knowledge required for its calculations.

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  It takes into account the whole life of the project, as it takes the average of all profits available in the project
life.
 It can be used as a relative measure in case of mutually exclusive projects.
 The expected profitability of a project can be compared with the present profitability of business.

Disadvantages of Accounting Rate of Return:-

 ARR does not consider the time value of money. It ignores the timing, relevancy of cash inflows.
 It includes:
 Sunk costs (money already spent)
 Net Book Values of Assets
 Depreciation and amortization of intangibles
 Allocated Fixed Overheads.
 ARR calculations are based on accounting profits and they can be easily manipulated by applying different
accounting policies.
 It ignores the size of investment and length of the project.
 It gives no absolute measure to reach at some conclusion, we need to do comparison that’s why it is a relative
measure only.
 Calculation of target ARR is a subjective approach.
 ARR does not take into account the risk and uncertainty related to the profits of the project.
 It is an average measure, so does not consider relative life of the project.
 The average annual profit used to calculate ARR, is unlikely to be the profit earned in any year of the project life.

Relevant Cash flows in Investment Appraisal:-

Relevant cash flows are those cash flows which are:
(i) Directly related with the project
(ii) Incremental
(iii) Future cash flows

Any cash flows or cost incurred in the past, or any committed costs which will be incurred regardless of whether the
investment is undertaken or not are non-relevant cash flows e.g. sunk lost, allocated overheads etc.

The all other cash flows, which should be considered, are as follows:
i. Opportunity Cost:-
Cost incurred or revenues lost from diverting enlisting resources from their best use are called opportunity cost.
As this will happen because of new project that’s why it is relevant.

ii. Tax:-
Relevant costs include the extra taxation that will be payable on extra profits, or the reductions in tax arising
from capital allowances or operating losses in any year.

iii. Residual value:

The residual value or disposal value of equipment at the end of its life or its disposal date are relevant to the
appraisal.
iv. Infrastructure Costs
v. Marketing Costs:

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 May be substantial, particularly if the investment is in a new product or service, but if the market research has
been done in the past and no further investment in marketing is required then this will be non-relevant cost.

vi. Human resource costs:

It includes training costs and the costs of reorganization arising from investment.

vii. Finance Related Cash flows:-

Finance related cash flows (e.g. Interest on Bank Loan) are normally excluded from project appraisal exercises
because the discounting process takes account of the time value of money, that is opportunity cost of investing
the money in the project.

Finance Related cash flows are only relevant if the incur a different rate of interest from the rate which is being
used as the discount rate.

viii. Relevant Benefits of Investment:-

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

These might consist of benefits of several types;

o Savings because assets used currently will no longer be used. The savings should include savings in staff
costs, or savings in other operating costs, such as consumable materials.
o Extra savings or benefits because of the improvements or enhancement that the investment might bring.
These include more sales revenue, greater contribution, more efficient systems operation and savings in
staff time.
o Possibly some off revenue benefits from the sales of assets that are currently in use, but which will no longer
be required.
o Greater customer satisfaction, arising from a more prompt service (e.g. because of a computerized sales
and delivery service).
o Improved staff morale from working with high quality assets.
o Better decision making may result from better information systems.

Assumptions of Timing of Cash flows

 If Cash flows arise during the period, then it is assumed as it arises at the end of that period.
 If cash flow arises at the start of the period then it is assumed as if it arises at the end of the preceding period
 Period ‘0’ is not a period, instead it represents start of period ‘1’.

2. PAYBACK PERIOD METHOD:

Definition:-
The time period in which initial investment gets recovered, known as payback period.

The number of years for the cash out lay to be matched by cash inflows.

Formula:-
a. For constant(Even) cash flows:

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 Payback period = Initial investment
Annual inflows

b. For Uneven cash flows:

Draw a cumulative cash flow column, then calculate project payback period.

Answer should be compared with the target payback period of the business.

Decision rule:-
i. Feasibility Decision:
If payback period is less than target payback period then ACCEPT the project.

If payback period is more than target payback period then REJECT the project.

ii. Comparison Decision:

Project with minimum payback period should be preferred.

Advantages of payback period:-

 It is simple to calculate and easy to understand, as it does not involve complex calculations.
 Payback period method can also be used as a basic screening device at the first stage for short listed projects.
 It considers cash flows rather than accounting profits, that’s why chances of manipulation are very low.
 Payback period method indirectly avoids risk as it gives favor to those investments which have short payback
periods. This method helps the company to grow, minimize risk and maximize liquidity.
 In the situation of capital rationing, it can be used to identify the projects which generate additional cash for re-
investment quickly.

Disadvantages of payback period:-

 It does not consider the time value of money.
 It does not consider the whole life of project. It might be possible that it will favor the projects, giving high cash
inflows in the starting years only and giving very low cash inflows in the remaining years.
 There are no specific criteria or rule which can justify that company’s target payback period is measured
accurately that’s why it is difficult to measure target payback period.
 It may lead to excessive investment in short term projects.
 It does not consider the risk and uncertainty in the projects. Uncertainty of cash inflows can deteriorate the
results.
 It does not focus on shareholders wealth maximization.
 Life expectancy of a project is ignored.
 Projects with same payback period may have different cash flows.

Lecture Examples on Payback Period:

Example.1
Initial investment in project A is $80,000. Life of the project is six years and project generating equal cash inflows of
$20,000. If target payback period of the company is 5 year whether the project should be feasible or not.

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Required: Calculate payback period using non discounting payback period method and comment whether to
accept or reject.

Example.2
Initial investment in project Z is $5,000. Project life is five years. For the year cash flows from project Z are $2,000,
$1,500, $1,000, $500 and $250 respectively. If target payback period of company is 7 year whether the project should
be feasible or not.

Required: Calculate how much time is required to regain its investment and comment of it acceptability.

Example.3
Initial investment in project HMZ is $10,000. Project life is five years. For the year cash flows from the project HMZ
are $5,000, $1,000, $1,500, $1,250 and $2000 respectively. If target payback period of the company is 4 year whether
the project should be feasible or not.
Required: Calculate time Compute payback period by using non discounting payback period method and comment
of it acceptability.
Solutions
Ex #1
Initial investment
Payback period =
Constant cash inflow
80,000
=
20,000
= 4yrs < targeted 5y.
So accept the project.

Ex #2
Yr Cash flow Cumulative cash flow
T0 (5,000) (5,000)
T1 2,000 (3,000)
T2 1,500 (1,500)
T3 1,000 (500)
T4 500 -
T5

Payback period is 4 yrs.

Ex #3
Yr Cash flow Cumulative cash flow
T0 (10,000) (10,000)
T1 5,000 (5,000)
T2 1,000 (4,000)
T3 1,500 (2,500)
T4 1,250 (1,250)
T5 2,000 750
𝑅𝑒𝑞
Payback period = 4𝑦𝑟𝑠 +
𝑅𝑒𝑐
1,250 1,250
= 4𝑦𝑟𝑠 + 4𝑦𝑟𝑠 & [ ] 𝑋12
2,000 2,000

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 = 4 + 0.625 4 years & 7.5 months
= 4.625 yrs.

Advanced Methods

Time Value of Money

Sum of money received today has more worth than same sum of money received in future because of these
reasons.
• Inflation
• Opportunity to reinvest
• Risk and uncertainty

Simple interest
1. 1000 x 10% = $100
2. 1000 x 10% = $100
3. 1000 x 10% = $100

Cash flows are not reinvested each year

Compound interest
1. 1000 x 10% = 100 + 1000 = 1100
2. 1100 x 10% = 110 + 1100 = 1210
3. 1210 x 10% = 121 + 1210 = 1331

Cash flows are reinvested each year resulting in higher principal that increases the interest amount.

We can also calculate the future amounts using this formula

FV = PV (1+r)n
FV= future value= 1331
PV= Present Value= 1000
1331 = 1000 x (1+10%)3

Discounting
Where r = cost of capital = WACC = required rate of return
PV = FV (1+r)-n

Assumption:
All cash flows are reinvested in the same project or any other at a given rate of return (cost of capital).

Year Cash flows Df@12% PV

1 1000 0.893 892.9
2 2000 0.797 1594.39
3 3000 0.712 2135

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Consistent Cashflows
If Cashflows arises in a series of equal cashflows then it is called Consistent Cashflows. These are of two Types:
Annuity: If Consistent cashflow for a certain Period. e.g Y1-5 or Y3-7
Perpetuity: If Consistent cashflow for infinite period e.g. Y1-∞ or Y3-∞
Present Values of Consistent Cashflows
𝟏−(1 + r)-n
The Annuity Factor =
𝒓
𝟏
The Perpetuity Factor =
𝒓

Annuity Perpetuity

If Cash flows Start from Period 1.

Annual Cash flow X Annuity Factor Annual Cash flow X Perpetuity Factor
e.g. Y1-5 $10,000 at Disc. Rate of 10% e.g. Y1-∞ $10,000 at Disc. Rate of 10%
$10,000 X 3.791(from annuity table) =$37,910 $10,000 X (1/10%) = $100,000

If Cashflows Start from Period 0.

NET PRESENT VALUE (NPV):

Definition:-
The term NPV means absolute savings from a project today.

Formula to calculate NPV:-

NPV= P.V of cash inflows minus P.V of cash outflows.

Decision Rule:-
If NPV of the project, discounted at cost of capital, is positive, Accept the project
If NPV of the project, discounted at cost of capital, is negative, Reject the project.

Advantages of Net Present Value:

 Net Present Value method takes into account the time value of money and this is giving a better picture of the
projects viability.
 It considers the timing of cash flows.
 It considers the whole life of the project because all cash flows relating to the project life are incorporated in its
calculations.
 It gives an indication about the increase or decrease in the wealth of shareholders. Its decisions rule is consistent
with the objective of maximization of shareholders wealth.
 It focuses on cash flows rather than accounting profit, so it takes into account the relevancy and irrelevancy of
cash flows.
 Net Present Value is technically a strong method as compared to others as it is an absolute measure. Resultantly
it can be used in isolation.
 Change in cost of capital can be incorporated in it.
 It can also be used for projects with non-conventional cash flows.
 It gives a better ranking of mutually exclusive projects.

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 It assumes that cash flows are reinvested at the company’s cost of capital.
 NPV is technically more superior method to IRR because of its less rigid assumptions.

Disadvantages of Net Present Value:

 It involves complex calculations as compared to other techniques. Resultantly, it is difficult to calculate and
difficult to understand.
 Managers feel it difficult to explain the calculations of Net Present Value method.
 It does not take into account the risk and uncertainty of estimates and scarcity of resources.
 Cost of capital used in NPV calculation is difficult to calculate and gets subjective when we incorporate risk and
uncertainty within companies cost of capital.
 Changing technology may render the product obsolete before the natural end of the project life.
 It fails to relate the return of the project to the size of the cash outlay.

Lecture Examples on Net Present Value:

Example.5
Mr. Omar have $50,000 in his old age, he wants to invest into ASA. Project life is 5 years and Mr. Omar will get the
cash benefit in following manner.
Year Cash flow ($)
1 16,000
2 14,000
3 12,000
4 10,000
5 8,000

Rate of interest is 10% per annum.

Required: Calculate net present value & comment on its acceptability.

Example.6
Initial investment in a project is $80,000. Project life is 6 years.
Yr Cash flow ($)
1 24,000
2 22,000
3 20,000
4 26,000
5 20,000
6 2000

Cost of capital 5% P(a).

Required :
i. Calculate NPV of the project
ii. Decide whether the project should be accepted or not.

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Example.7
An Organization is considering a capital investment in new equipment the estimated cash flows are as follows.
Yr Cash flow ($)
0 (240,000)
1 80,000
2 120,000
3 70,000
4 40,000
5 20,000

The company cost of capital is 9%

Required : Calculate Net Present Value (NPV) of the project to access whether it should be undertaken or not.

Example.8
Wheel Ltd. has the opportunity to invest in investment with the following initial cost & returns (cash profit).

Year A B
$ $
0 (90,000) (20,000)
1 40,000 10,000
2 30,000 8,000
3 20,000 6,000
4 20,000 4,000
5 20,000 4,000

Residual value in case of A $4,000 and in case of B $2,000. Cost of Capital in both situations are 10%.

Required: Calculate NPV of A & B.

Example.9
Initial investment in a project is $100,000. Net cash inflows from year 1 to 10 are $60,000, $30,000, $25,000, $20,000,
$18,000, $15,000, $12,000 and $10,000.

Cost of capital is 10% p.a

Required: calculate NPV of the project.

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 Solutions
Ex #5
Year Cash flow D.F. PV
T0 (50,000) 1 (50,000)
T1 16,000 0.909 14,545
T2 14,000 0.826 11,564
T3 12,000 0.751 9,012
T4 10,000 0.683 6,830
T5 8,000 0.621 4,968
NPV = - 3,082
Reject the Project

Ex #6
Yr Cash flow D.F. PV
T0 (80,000) 1 (80,000)
T1 24,000 0.952 22,848
T2 22,000 0.907 19,954
T3 20,000 0.863 17,280
T4 26,000 0.823 21,398
T5 20,000 0.784 15,680
T6 2,000 0.746 1,492
NPV = - 18,652

NPV of project = PV of cash inflow – PV of cash outflow

= 98,652 – 80,000
= 18,652
It should be accepted

Ex #7
Yr Cash flow D.F. PV
T0 (240,000) 1 (240,000)
T1 80,000 0.917 73,360
T2 120,000 0.842 101,040
T3 70,000 0.772 54,040
T4 40,000 0.708 28,320
T5 20,000 0.650 1,304
29,760

Ex #8
Project A
Yr Cash flow D.F. PV
T0 (90,000) 1 (90,000)
T1 40,000 0.909 36,360
T2 30,000 0.826 24,780
T3 20,000 0.751 15,020
T4 20,000 0.683 13,660

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 T5 24,000 0.621 14,904
NPV = 14,724

Project B
Yr Cash flow D.F. PV
T0 (20,000) 1 (20,000)
T1 40,000 0.909 9,090
T2 8,000 0.826 6,608
T3 6,000 0.751 4,506
T4 4,000 0.683 2,732
T5 6,000 0.621 3,725
NPV = +6,662

Ex #9
Yr Cash flow D.F. PV
T0 (60,000) 1 (60,000)
T1 22,500 0.943 21,218
T2 22,500 0.890 20,025
T3 22,500 0.840 18,900
T4 22,500 0.792 17,820
T5 22,500 0.747 16,808
NPV = +33,771

4. Internal Rate of Return (IRR):

Definition:-
IRR is the total rate of return offered by an investment over its life.

Formula to calculate IRR:-

𝐴
IRR =a% +[ (b-a)]%
𝐴−𝐵
Where
a = Lower discount rate
b = Higher discount rate
A = NPV at lower discount rate and
B = NPV at higher discount rate

Decision Rule:-
a) Feasibility Decision:
 If IRR of the project > Cost of Capital, Accept the project because the project is adding value to the owner’s
wealth resulting in positive NPV.
 If IRR of the project < Cost of Capital, Reject the project because the project is destroying value in shape
of negative NPV.

b) Comparison Decision:
Project with higher IRR shall be preferred.

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Advantages of IRR:
 IRR takes into account the time value of money and thus giving a better picture of the projects viability.
 It considers the timing and life of the project.
 It can be calculated by assuming any discount rate in its calculation.
 IRR is easier to understand as compared to NPV.
 Risk can be incorporated into decision making by adjusting the company’s target discount rate.

Disadvantages of IRR:
 It ignores the size of investment and length of the project.
 It gives no absolute measure to reach at some conclusion.
 It is fairly complicated to calculate.
 It can be confused with accounting ROCE.
 Interpolation technique used in IRR calculation does not give exact answer. It only provides an estimate and if
the margin between required rate of return and IRR is fairly small, this lack of accuracy could result in wrong
decision being taken.
 In case of non-conventional cash flows, there may be several IRRs which can mislead the decision makers.
 IRR does not give indication about the increase or decrease in the wealth of shareholders.
 It considers the long term viability of the project, losses may be made in the short term.
 It requires assumption of reinvestment at IRR which may not be fulfilled in case of higher IRR.

Lecture Example of IRR

Example 1:
Initial investment in a project is $100,000. Net cash flows in year1 are $32,000, year 2 $28,000 and from year 3 to
year 6 $852,000 p.a. cost of capital is 10% p.a.

Required: Calculate IRR of project.

Example 2:
Initial investment in a project is $50,000. Net cash inflows from year 1 to 8 are $30,000, $15,000, $15,000, $20,000,
$18,000, $15,000, $12,000 and $10,000.

Cost of capital is 10% p.a

Required: calculate IRR of the project.

Solutions

Ex # 1
Yr Cash flow D.F. PV D.F. PV
0 (100) 1 (100) 1 (100)
1 32 0.909 29.088 0.833 26.656
2 28 0.826 23.128 0.694 23.128
3 852 0.751 639.852 0.578 492.456

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 4 852 0.683 581.916 0.482 410.664
5 852 0.621 529.092 0.402 342.504
6 852 0.576 490.752 0.334 284.568
NPV 2194 NPV 1480

2194
IRR = 10% + (20 − 10)
2194−1480
IRR = 40%

Ex # 2
Yr Cash flow D.F. PV D.F PV
T0 (50) 1 (50) 1 (50)
T1 30 0.909 27.27 0.833 24.99
T2 15 0.826 12.39 0.694 10.41
T3 15 0.751 11.26 0.578 8.76
T4 20 0.683 13.66 0.482 9.64
T5 18 0.621 11.17 0.402 7.23
T6 15 0.576 8.64 0.334 5.01
T7 12 0.513 6.156 0.279 3.34
T8 10 0.466 4.66 0.232 2.32
45.236 21.7

45.236
IRR = 10% + (20 − 10)
45.236−21.7
IRR = 29%

Discounted Payback period method:

Definition:
The time period in which initial investment is recovered in terms of present value, known as payback period
or
The number of years for the present value of the cash out lay to be matched by present value of cash inflows.

It is similar to simple payback period. The only difference is that the discounted cash flows are used instead of simple
cash flows for calculation.

Decision Rule
 Feasibility Decision:
If discounted payback period is less than target discounted payback period then ACCEPT the project.
If discounted payback period is more than target discounted payback period then REJECT the project.

 Comparison Decision :
Project with minimum discounted payback period should be preferred.

Advantages of Discounted payback period:-

 It takes into account the time value of money and timings of cash flows.
 Payback period method can also be used as a basic screening device at the first stage for short listed projects.

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 It considers cash flows rather than accounting profits, that’s why chances of manipulation are very low.
 Risk and uncertainty can be incorporated with the help of risk adjusted cost of capital.
 In the situation of capital rationing, it can be used to identify the projects which generate additional cash for
reinvestment quickly.
 Short payback period result in increased liquidity and enable business to grow more quickly, so used in rapidly
changing technologies and industries.

Disadvantages of Discounted payback period:-

 It does not consider the whole life of project.
 Calculation of discounted target payback period is difficult to measure.
 Disadvantages of Discounted payback period does not give indication about the increase or decrease in the
wealth of shareholders.
 It may lead to excessive investment in short term project.
 It requires knowledge of cost of capital which is difficult to calculate.
 Life expectancy of a project is ignored.
 It takes into account the Risk of timing of cash flows but not the variability of those cash flows.

Lecture Examples on Discounted Payback period

Example.1
Initial investment in a project A is $60,000. Net cash inflows during project life of 7 years are $25,000, $20,000,
$18,000, $16,000, $15,000, $13,000 & $10,000.

Required:
i) Calculate payback period
ii) Calculate discounted payback period. (If cost of capital is 10% p.a.)

Example.2
Initial investment in a project $500,000. Initial investment includes investment in working capital of 10%. Scrap value
of initial investment is 10%. Project life is 5 years. Net cash flows from the project are $200,000, $180,000, $160,000,
$(20,000) and $67,000.

Working will be recovered evenly throughout the project life.

Required:
If cost of capital is 15% p.a. calculates the NPV.

Example.3
Initial investment in a project $50,000.Project life 8 years .Net cash flows are as below:
Years Cash flows ($)
1 24,000
2 20,000
3 16,000
4 12,000
5 10,000

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 6 68,000
7 6,000
8 4,000

Cost of capital is 15% p.a.

Required:
i. Calculate the simple payback period.
ii. Calculate discounted payback period.

Solutions

Ex #1 (a)
Yr Cash flow Cumulative cash flow
T0 (60,000) (60,000)
T1 25,000 (35,000)
T2 20,000 (15,000)
T3 18,000 3,000
T4
T5

15,000
Pay period = 2 + 𝑦𝑟
18,000
= 2.83y
(b)
Yr Cash flow D.F. PV Cum PV
T0 (60,000) 1 (60,000) (60,000)
T1 25,000 0.909 22,725 (37,275)
T2 20,000 0.826 16,520 (20,755)
T3 18,000 0.751 13,518 (7,237)
T4 16,000 0.683 10,928 3691
T5 15,000 0.621 93,159

7237
= 3yr +
10928
= 3.66Yr

Ex #2

Yr Cash flow Cum cash

flow
T0 50,000 (50,000)
T1 24,000 (26,000)
T2 20,000 (6,000)
T3 16,000 (10,000)

= 2.4 yr

17
 Yr Cash flow D.F. PV Cum PV
T0 50,000 1 (50,000) (50,000)
T1 24,000 0.867 20,856 (29,144)
T2 20,000 0.756 15,120 (104,029)
T3 16,000 0.650 10,512 (3,512)
T4 12,000 0.572 6,864 (3,352)
3,512
=3 +
6,864
= 3.511 yrs.

Yr
D.F. PV Cum PV
T0 (550) 1 (550) (550)
T1 200 0.909 181.8 (368.2)
T2 180 0.826 148.68 219.52
T3 160 0.751 120.16 99.36
T4 (20) 0.683 (13.660) (113.02)
T5 167 0.621 103.707 (10.02)
The initial investment’s recovers so, reject the project

Effect of Taxation in investment appraisal

Taxation is a major practical consideration for business. It is vital to take it into account in making decisions.
i. Basic Assumption
Taxation has two effects in investment appraisal
a) Negative effect:- Tax charged on net revenue cash flows.
b) Positive effect:- Tax relief on assets purchased via writing down allowances (capital allowances)

ii. Corporation tax on profits

Calculate the taxable profits (before capital allowances) and calculate tax at the rate given.
1. Tax on Operating Cashflows: Operational Cashflows X Rate of Tax
2. Tax Savings on Capital Allowances: Calculate the capital Allowances/ Balancing Allowances and
then multiply with Tax Rate.

 The effect of taxation will not necessarily occur in the same year as the relevant cash flow that comes in.

18
Follow the instructions given in exam question
Example
Initial Investment = 2000
Capital Allowances = 25% reducing balance
Useful life = 4 years, Tax rate = 30% payable in arrears, Scrap Value = 500
Years Written Capital Tax Timing
Down Value Allowances Savings
@ 25% @ 30%

1 2000 500 150 2

2 1500 375 113 3

3 1125 281 84 4

4 844 344 103 5

Effect of Inflation in investment appraisal:

19
 Inflation
Definition:-
Inflation may be defined as a general increase in prices, leading to general decline in the real value of money.
(Decrease in purchasing power)
Inflation

Real rate of General Money rate

Return Inflation rate of return

i. Real rate of return/cost of capital

Real rate of interest reflects the rate of return that would be required in the absence of inflation.

ii. Money rate of return/cost of capital

Money or nominal rate of return is rate that will be required in presence of inflation.

Relationship between real and nominal rates of interest (Fisher formula)

(1 + i) = (1 + r) (1 + h)

Where h= rate of inflation/RPI

r = real rate of interest
i = nominal (money rate of interest)

Types of Cash Flows

i. Money cash flows are those cash flows in which the effect of specific inflation has been adjusted.
ii. Real cash flows are those cash flows which have not been adjusted for inflation.

Nominal Cashflow = Real cashflows ( 1+ i)n

Sometimes Examiners gives the value in year 1 terms instead of current prices terms then

Nominal Cashflow = Real cashflows ( 1+ i)n-1

Why Inflation is a problem

 It is hard to estimate, especially when rates are high
 It has economic impacts which cause governments to take into account its impacts on business
 Different inflation rates will occur, different costs and revenues will inflate at different rates
 It alters the cost of capital
 It makes historic costs irrelevant and therefore causes ROCE to be overstated
 It creates uncertainty
 It encourages business to be short term in looking
 Inflation may not be constant
 The longer a project, the more significant the impact of inflation

20
Effect of inflation on the discount rate:-
The discount rate used in investment appraisal reflects the finance providers required rate of return (e.g the rate of
interest on a loan raised, or shareholders required return if financed by equity.

In times of inflation, the fund providers will require a return made up of two elements.
i. A return to compensate for inflation (to maintain purchasing power).
ii. A real return on top of this for the use of their funds.
The required return that incorporates both of these elements is known as a money return.

Methods to be used in Investment Appraisal

i. Money method
 Adjust individual cash flows for specific inflation to convert to money cash flows
 Discount using money rate

ii. Real method

 No need to adjust any individual cash flows for inflation to convert to money cash flows
 Discount using Real rate
 This is the simplest technique
 Remove the effects of general inflation from money cash flows to generate real cash flows.
 Achieves the same result as money method

Note:
 In case of general inflation, either of the two methods can be used.
 In case of specific inflation, only applicable method is Money method

Working Capital Change

Every business requires working capital for its operations.

Calculate working capital change in two steps:

1. Calculate working capital requirement one year in advance e.g. working capital is 10% of sales at the start
of each year
2. Calculate incremental working capital by taking change of each year working capital
3. In last year, there will be an assumption that all working capital will be recovered (Only for project and not
for ongoing business)

ILUSTRATION 6
A company is considering to invest in a project with its life of 4 years. Total working capital required at the
beginning of each year is as follows:
Year Cashflows
$’000
1 500
2 700
3 1000
4 600

21
 Required:
Calculate the working capital cashflows of each year to be included in NPV calculation?

Solution

Total Working Capital Incremental Working capital

$'000 $'000
Y0 500 (500)
Y1 700 (200)
Y2 1000 (300)
Y3 600 400
Y4 0 600

The Finance Cost

The Finance Cost will be a relevant cashflow however it will NOT become the part of cashflows. This is because
it is part of cost of capital.

Performa for Net Present Value

Years 0 1 2 3 4
Sales X X X X
Variable Cost (X) (X) (X) (X)

Incremental Fixed Cost (X) (X) (X) (X)

Operating Cashflows X X X X

Tax Expense (X) (X) (X) (X)

Tax Savings on Capital X X X X
Allowances

Change in Working Capital (X) (X) (X) (X) X

Initial Investment (X)

Scrap Value X
Net Cash flows (X) X X X X

X Discount Factor X X X X X
Present Values (X) X X X X
Net Present Value X

Investment appraisal in Capital Rationing situation

Capital rationing:
Where the finance available for capital expenditure is limited to an amount which prevents acceptance of all new
projects with a positive NPV, the company is said to experience “capital rationing”.

22
 There are two types of capital rationing.
I. Hard capital rationing:
This applies when a company is restricted from undertaking all worthwhile investment opportunities due to
external factors over which it has no control. These factors may include government monetary restrictions and
the general economic and financial climate (e.g., a depressed stock market, which precludes a rights issue of
ordinary shares).

II. Soft capital rationing:

This applies when a company decides to limit the amount of capital expenditure which it is prepared to
authorize. Segments of divisionalised companies often have their capital budgets imposed by the main board of
directors. A company may purposely curtail its capital expenditure for a number of reasons e.g., it may consider
that it has insufficient depth of management expertise to exploit all available opportunities without jeopardizing
the success of both new and ongoing operations.

Capital rationing may exist in a:

Single period capital rationing :

Available finance is only in short supply during the current period, but will become freely available in subsequent
periods.

Projects may be:

i. Divisible – An entire project or any fraction of that project may be undertaken. In this event projects may be
ranked by means of a profitability index, which can be calculated by dividing the present value (or NPV) of each
project by the capital outlay required during the period of restriction. Projects displaying the highest profitability
indices will be preferred. Use of the profitability index assumes that project returns increase in direct proportion
to the amount invested in each project.
ii. Indivisible – An entire project must be undertaken, since it is impossible to accept part of a project only. In this
event the NPV of all available projects must be calculated. These projects must then be combined on a trial and
error basis in order to select that combination which provides the highest total NPV within the constraints of
the capital available. This approach will sometimes result in some funds being unused.

Lecture example
A company has four projects under consideration.

Project A Initial investment $60,000 .project life 3 years. Net cash inflows per year are $30,000, $45,000 &
$27,000 respectively.

Project B Initial investment is $80,000. Project life is 4 yrs. Net cash inflows from the project in yr 1 $50,000,
yr 2 $30,000, yr 3 $28,000 and yr 4 $25,000.

Project C Initial investment $100,000.Project life 7 yrs

Net cash inflows per Annum for whole life of project are $21,000.

Project D Initial investment $120,000. Project life is 5 yrs.

Net cash inflow from yr 1-5 is $60,000, $50,000, $30,000, $28,000 and $35,000 respectively.

23
The company has only $335,000 currently available. Additional funds will be freely available in future years. If cost
of capital is 10% p.a.

Required:
a) Calculate Net present value of each project.
b) Assuming no capital rationing situation, decide which projects to be accepted and also calculate their
total net present value.
c) Assuming capital rationing situation, calculate profitability index for each project.
d) If projects are divisible determine the optimal investment plan.
e) Using the above investment plan calculate the associated NPV.
f) Assuming that the projects are indivisible find out the optimal investment plan.
g) Using the above investment plan, find out the relevant NPV.

Solutions

Ex # 1
Project A:
NPV = PV of inflow – PV of outflow
= 30,000 x 0.909 x 45,000 x 0.826 + 27,000 x 0.751 – 60,0000 x 1
= 84,717 – 60,000
= 24,717

Project B
NPV = 50,000 x 0.909 + 30,000 x 0.826 + 28,000 x 0.751 + 25,000 x 0.683 – 80,000 x 1
= 45,450 + 24,780 + 21,028 + 17,075 – 80,000
= 28,333

Project C
NPV = 21,000 x 4.865 – 100,000
= 102,288 – 100,000
= 2,228

Project D
NPV = 60,000 x 0.909 + 50,000 x 0.826 + 30,000 x 0.751 + 28,000 x 0.680 + 35,000 x 0.621 – 120,000 x 1
NPV = 39,229

In case of divisibility:
NPV P.I.
A 24,717 1.4119 (1)
B 28,333 1.354 (2)
C 2,228 1.0222 (4)
D 39,229 1.3269 (3)

24
(C)
$ NPV
335,000
A (100%) (60,000) 24,717
275,000
B (100%) 80,000 28,333
19,5000
C (100%) 120,000 1,671
75,000
Total NPV 93,950

Indivisible
Req. NPV
A+B+C 24,000 55,278
A+ B + D 260,000 92,279
B+C+D 300,000 69,790
A+C+D 280,000 66,174

Asset replacement decisions

Once the decision has been made to replace the asset,
The decision how to replace an asset. The asset will be replaced but we aim to adopt the most cost effective
replacement strategy. The key in all questions of this type is the lifecycle of the asset in years.

Asset Replacement issues:

1. How frequently an asset be replaced?
2. Is it worth paying more for an asset that has a longer expected life?
 In both of these scenarios, the ideal approach is to keep the costs per annum (in NPV terms) to a minimum. This
is calculated as an equivalent annual cost (EAC).
NPV of costs
 EAC =
annuity factor for the life of the project

 The best decision is to choose the option with the lowest EAC.

Key ideas/assumptions:
 Cash inflows from trading (revenues) are not normally considered in this type of question. The assumption being
that they will be similar regardless of the replacement decision.
 The operating efficiency of machines will be similar with differing machines or with machines of differing ages.
 The assets will be replaced in perpetuity.

25
Lecture Examples on Asset Replacement Decision:

Lecture example.1
A company operates a machine which has the following costs and resale values over its four year life. purchase cost:
$25,000.
Year1 Year2 Year3 Year4
$ $ $ $
Running costs (cash expenses) 7,500 11,000 12,500 15,000
Resale value (end of year) 15,000 10,000 7,500 2,500

The organizations cost of capital is 10%.

Required: You are required to assess how frequently the asset should be replaced.

Lecture example.2
Naurfold regularly buys new delivery vans. Each van costs £30,000, has running costs of £3,000 and a scrap value of
£10,000 in its 1st year. In its 2nd year the van has higher running costs (£4,000) & a lower scrap value (£7,000).
Vehicles are not kept for > 2 years for reliability reasons.

Required: Using Naurfold’s cost of capital of 15%, identify how often the van should be replaced. Ignore tax.

Lecture example.3
A company operates a machine which has the following costs and resale values over its three year life .purchase
cost: $30,000.
Year1 Year2 Year3 Year4
$ $ $ $

Running costs (cash expenses) 7,000 12,500 13,000 17,500

Resale value (end of year) 12,000 9,250 8,200 1,000

The organization’s cost of capital is 25%.specific inflation in running cost and residual value is 6% & 7.5% respectively.

Required : You are required to assess how frequently the asset should be replaced.

Solutions
Ex # 1
Everyone Yr
T0 T1
$000) $(000)
Purchase cost (25
Running cost (7.5)
Residual value 15
Cash flow (25) 7.5
D.F. 10% 1 0.909

26
 (25) 6.818

NPV = (18.181
18.181
Annual Equivalent Cost (AEC) =
0.909
= (2.001)

Every two Yr
T0 T1 T2
$(000) $(000) $(000)
Purchase cost (25)
Running cost (7.5) (11)
Residual value 10
(25) (7.5) (1)
D.F. 10% 1 0.909 0.826
(25) 6.818 (0.826)

NPT = - 32.644
−32.664
EAC =
1.736
EAC = (18.804)

Every three yr
T0 T1 T2 T3
$(000) $(000) $(000) $(000)
Purchase cost (25)
Running cost (7.5) (11) (12.5)
Residual value 7.5
(25) (7.5) (11) (5)
1 0.909 0.826 0.751

NPV = (44.659)
44.659
EAC =
2.486
EAC = (17,964)

Every four yr
T0 T1 T2 T3 T4
$(000) $(000) $(000) $(000)
Purchase cost (25)
Running cost (7.5) (11) (12.5) (15)
Residual value 2.5
(25) (7.5) (11) 12.5 (12.5)
D.F. 10% 1 0.909 0.826 0.751 0.683
(25) (6.818) (9.086) (9.388) (8.536)
NPV= 58.830
58.830
EAC = = (185.64)
3.169

27
Every three yr is the best option

Ex #2
T0 T1
$(000) $(000)
Purchase cost (30)
Running cost (3)
Residual value 10
Cash flow (30) 7
D.F. 10% 1 0.869
(30) 6.083

NPV = (23.917)
(23.917)
Annual Equivalent Cost (AEC) = = (21.522)
0.869

Every two yr:

T0 T1 T2
$(000) $(000) $(000)
Purchase cost (30)
Running cost (3) (4)
Residual value 7
(30) (3) 3
D.F. 1 0.869 0.756
(30) 2.607 2.268

NPV = - 30.339
(30.339)
EAC =
1.625
= (18.670)
Every two ye best.

Ex #3
T0 T1
$(000) $(000)
Purchase cost (30)
Running cost (7.42)
Residual value 12.9
Cash flow (30) 5.48
D.F. 1 0.80
(30) 4.384
NPV = (25.62
25.62
EAC = = (32.09)
0.80

Every 2 yr
T0 T1 T2

28
 $(000) $(000) $(000)
Purchase cost (30)
Running cost (7.42) (14.045)
Residual value 10.68
(30) (7.42) (3.35)
D.F. 1 0.80 0.64
(30) (5.936) (2.148)

NPV = (38.084)
(38.084)
EAC =
1.44
= (26.44)

Every three yr
T0 T1 T2 T3
$(000) $(000) $(000) $(000)
Purchase cost (30)
Running cost (7.42) (14.045) (15.483)
Residual value 10.187
(30) (7.42) (14.045) (5.296)
1 0.80 0.64 0.512
(30) (5.936) (8.98) (2.71)

NPV = (47.637)
47.637
EAC =
1.952
EAC = (24,404)

Lease or Buy Decision:

A specific decision that compares two specific financing options, the use of a finance lease or buying outright
financing via a bank loan.

Key information
 Discount rate = post tax cost of borrowing.
The rate is given by the rate on the bank loan in the question, if it is pre-tax then the rate must be adjusted for tax.
If the loan rate was 10% pre-tax and corporation tax is 30% then the post -tax rate would be 7%. (10% x (1 – 0.3).
 Cash flows :
Bank loan Finance Lease

1. Cost of the investment 1.Lease rental

- in advance
2. WDA tax relief on investment - annuity
3. Residual value 2.Tax relief on rental

29
Other considerations:
 Who receives the residual value in the lease agreement? It is possible that the residual value may be received
wholly by the lesser or almost completely by the lessee.
 There may be restrictions associated with the taking on of leased equipment. The agreements tend to be much
more restrictive than bank loans.
 Are there any additional benefits associated with lease agreement? Many lease agreements include within the
payments, some measure of maintenance or other support service.

The benefits of any type of lease to the lessee can be:

 Availability; a firm that cannot get a bank loan to fund the purchase of an asset (capital rationing – see next
section for further discussion); the same bank that refused the loan will often be happy to offer a lease.
 Avoiding tax exhaustion; if a firm cannot use all of their capital allowances (the lesser can use the capital
allowances and then set a lease that transfers some of the benefit to the lessee).
 Avoiding covenants; restricting future borrowing capability.

Benefits to the lesser:

 Banks offer leases to exploit their ability to raise low cost capital.
 Companies (e.g. IBM) offer leases to attract customers.
 Profitable companies set up leasing subsidiaries to shelter their own profits from tax (eg M&S, Tesco).
 Lecture examples on Lease or Buy Decision:

Lecture example.4
Smicer plc is considering how to finance a new project that has been accepted by its investment appraisal process.
For the four year life of the project the company can either arrange a bank loan at an interest rate of 15% before
corporation tax relief. The loan is for $100,000 and would be taken out immediately prior to the year end. The
residual value of the equipment is $10,000 at the end of the fourth year. An alternative would be to lease the asset
over four years at a rental of $30,000 per annum payable in advance. Tax is payable at 33% one year in arrears.
Capital allowances are available at 25% on the written down value of the asset.

Required: Should the company lease or buy the equipment?

Solutions

Ex #4
CA
W Capital allowance
100 Tax saving
(25)
CAI 8.25
75
(18.75)
CAII 6.18
56.25
(14.063)
CAIII 4.641
42.187

30
 (10)
R.V
32.187
(32.187)
CA IV 10.622
∝

Lease or buy decision

T0 T1 T2 T3 T4 T5
$(000) $(000) $(000) $(000) $(000) $(000)
Initial (100)
Residual value 10
Tax saving on CA 8.25 6.18 4.641 10.622
(100) 8.25 6.18 4.641 10.622
D.F. 10% 1 - 0.826 0.751 0.683 0.621
(100) - 6.81 4.647 10 6.596
NPV = - 71.942

Lease
T0 T1 T2 T3 T4
$(000) $(000) $(000) $(000) $(000)
(30) (30) (30) (30) (30)
Tax saving on CA 9.90 9.90 9.90 9.90
(30) (20.1) (20.1) (20.1) (20.1)
D.F. 10% 1 0.909 0.826 0.751 0.683
(30) (18.271) (16.603) (15.095) 6.762
NPV = 73.207

31
Risk & Uncertainty
If the probability of projects out come are:

Predictable Not predictable

Risk Uncertain

Before deciding to spend money on a project, managers will want to be able to make a judgment on the
risk/uncertainty of its return.

Risk:-
A condition in which several possible outcomes exist, the probabilities of which can be quantified from historical
data.

Uncertainty:-
The inability to predict possible outcomes due to a back of historical data being available for quantification.

If project cashflows are:

Risky (Techniques) Uncertain

 Expected values (Techniques should be:)
 Risk adjusted discount factor Adjusted payback period
Sensitivity Analysis
Certainty equivalents
Simulation models

Risk:-

Expected values:-
The quantitative result of weighting uncertain events by the probability of their occurrence.
Or
Using probabilities to create an assessment of the average expected net present value from an investment.

The simple expected value decision rule is appropriate, if three conditions are met or nearly met.
 There is a reasonable basis for making the forecast and estimating the probability of different outcomes.
 The decision is relatively small in relation to the business. Risk is then small in magnitude.
 The decision is for a category of decisions that are often made. A technique, which maximizes average pay off,
is then valid.

Advantages of expected value method:-
 Recognizes that there are several possible outcomes and is therefore, more sophisticated then single value
forecasts.
 Enable the probability of the different outcomes to be quantified.

32
 Leads directly to a simple optimizing decision rule.
 Calculations are relatively simple

Disadvantages of expected value method:-

 Forecasting procedure is complicated. In accurate evaluations already a major weakness in project evaluation.
The probabilities used are also usually very subjective.
 The expected value is merely a weighted average of the probability distribution, indicating the average pay off
if the project is repeated many times.
 The expected value gives no indication of the dispersion of possible outcomes.
 About the expected value. The more widely spread out of the possible results are, the more risky the investment
is usually see to be.; The expected value technique also ignores the investors attitude to risk. Some investors
are more likely to take risks than others.

Risk adjusted discount rate:-

Risk adjusted discount rate technique shall be covered in cost of capital area because this technique involves the
calculation of risk premium which requires the knowledge of Capital asset pricing model (CAPM).

Lecture Examples on Expected value method:

Example.1
Mr. Sajid wants to open a campus in Sargodha. Initial investment is $100,000. Project life is 4 years.

Sales Revenue Probability Operating cost Probability

($) ($)
80,000 0.5 30,000 0.60
50,000 0.3 20,000 0.35
20,000 0.2 50,000 0.05

Residual value of project 10,000 0.50

5,000 0.50

Cost of capital of Mr. Sajid is 10% p.a.

Required: Calculate the expected net present value of project.

Example.2
Initial investment in a project is $300,000. Project life is 2 years. Net cash inflows from the project are :
Year 1:
Cash flows ($) Probability

100,000 0.25
200,000 0.50
300,000 0.25

33
Year 2:
If cash inflow in year 1 Cash flows in year2 Probability is
($): ($)

i) 100,000 100,000 0.50

200,000 0.25
Nil 0.25
ii) 200,000

100,000 0.25
200,000 0.50
300,000 0.25

iii) 300,000
200,000 0.25
300,000 0.50
350,000 0.25

Cost of capital is 10% p.a.

Required: Calculate the expected net present value of project.

Uncertainty:-
Uncertainty cannot be quantified, but can be described using different techniques e.g. payback period. Adjusted
payback period, sensitivity analysis and simulation.

Simple payback period and adjusted payback period:-

We have covered in earlier studies (basic techniques of investment appraisal).

The quicker the payback the less relevant a project is on the later, more uncertain cash flows.

Sensitivity Analysis:

Definitions:-
Sensitivity analysis assess how responsive the projects’ NPV is to changes in the variables used to calculate that net
present value.

In general, risky projects are those whose future cash flows, and hence the project returns, are likely to be variable.
The greater the variability is, the greater the risk. The problem of risk is more accurate with capital investment
decisions than other decisions for the following reasons.
 Estimates of capital expenditure might be for several years ahead, such as for major consumption projects.
Actual costs may escalate well above budget as the work progresses.
 Estimates for benefits will be for several years ahead, sometimes 10, 15 or 20 years ahead or even longer, and
long-term estimates can be at best by approximations.
 Practical factors may be those over which managers have no control.

34
Formula to calculate sensitivity of a particular cashflow: -
𝑁𝑃𝑉
𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 (%) = 𝑋 100%
𝑃𝑉 𝑜𝑓 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑠𝑒𝑛𝑠𝑡𝑖𝑣𝑖𝑡𝑦

Formula to calculate sensitivity of cost of capital:-

𝐼𝑅𝑅 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 (%) = 𝑋 100%
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

The best approach of sensitivity analysis is to calculate the projects net present value under alternative assumptions
to determine how sensitive it is to changing conditions. This indicates which variables may impact most upon the
net present value (critical variables) and the extent to which those variables may change before the investment
results in a negative NPV.

Advantages of sensitivity analysis:-

 This is not a complicated theory to understand
 Information will be presented to management in a form, which facilitates subjective judgment to decide the
likelihood of the various possible outcomes considered
 Identifies areas, which are crucial to the saucers of the project, if it is proceed with, those areas can be carefully
monitored
 Indicates just how critical are some of the forecast which are considered to be uncertain

Disadvantages of sensitivity analysis:-

 It assumes that changes to variables can be made independently e.g. in isolation, material prices will change
independently of others variables. This is unlikely. If material prices went up, the firm would probably increase
selling price at the same time and there would be little effect on net present value
 It only identifies how far a variable needs to change; it does not look at the probability of such a change. In the
above analysis, sales volume appears to be the most crucial variable, but if the firm were facing volatile raw
material markets a 65% change in raw material prices would be far more likely than a 29% change in sales
volume.
 It is not an optimizing technique. It provides information on the basis of which decision can be made. It does
not point to the correct decision directly.

Lecture example:
Initial investment in a project is $1,000,000.
Project life is 4 years.
Sales limits per year are 20,000.
$/unit
Selling price 100
Material cost 50
Labour cost 20
Variable overheads 5.0

Increment fixed cost is $100,000 per annum cost of capital is 10% p.a.

35
Required:
a) Calculate net present value of the project.
b) Calculate sensitivity of each variable of the project.

Solutions

Sensitivity Analysis
Yr Cash flow D.F. PV
T0 Initial inv. (1000) 1 (1000)
T1 – T4 Sales 2000 3.169 6338
T1 – T4 Mat (1000) 3.169 (3169)
T1 – T4 Lab (400) 3.169 (267)
T1 – T4 v.FOH (100) 3.169 (316.9)
T1 – T4 Inc. F.C (150) 3.169 (475.35)
T4 RV 50 0.683 34.150
+ 143.37
𝑁𝑃𝑉
% age sensitivity =
𝑃𝑉 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒
143.3
Initial NPV = × 100
1000
= 14.33%
143.3
Sales = × 100 => 2.26%
6338
143.3
Mat = × 100 => 4.526%
3169
143.3
Lab = × 100 => 11.3%
1267.6
143.3
V.FOH = × 100 => 45.22%
3169
143.3
In. FC = × 100 => 30.14%
475.35
143.3
R.V = × 100 => 419.61%
34.150

Certainty equivalents:

Definition:-
One particular approach to sensitivity analysis, the certainty equivalent approach, involves the conversion of the
expected cash flows of the project to risk less equivalent amounts. The greater the risk of an expected cash flow, the
smaller the certainty equivalent value (for receipts) or the larger the certainty equivalent value (for payments). The
disadvantage of the certainty equivalent approach is that the amount of the adjustment to each cash flow is decided
subjectively by management. As the cash flow are reduced to supposedly certain amounts they should then be
discounted at a risk free rate.

36
Lecture example:

Initial investment in a project is $20,000.

$/Annum
Sales Revenue 40,000
Material cost 15,000
Labour cost 5,000
Cost of capital 10%

Project life is 4 years.

Following are the ratio of certainty equivalent for cash inflows and cash outflow.
Year Cash inflow Cash outflow
1 0.95 1.06
2 0.90 1.10
3 0.85 1.15
4 0.80 1.18

Required: Calculate the NPV of project using certainty equivalent approach.

Solutions

Ex #1
T0 T1 T2 T3 T4
$(000) $(000) $(000) $(000) $(000)
Sales 38 36 34 32
Less MC (15.9) (16.5) (17.25) (17.7)
Less VC (5.3) (5.5) (5.75) (5.9)
Initial (20)
(200 16.8 14 11 8.4
D.F 1 0.909 0.826 0.751 0.683
(20) 15..271 11.564 8.261 5.737
NPV = +20.833

Simulation:

use of simulation:-
Simulation is a technique, which allows more than one variable to change at the same time. One example of
simulation is a mathematical model, which could be approached using the “Monte Carlo” method.

37
Stages in simulation:-
 Specify the major variables
 Specify the relationship between the variables
 Attach probability distribution to each variable and assign random members to reflect the distribution.
 Stimulate the environment by generating random numbers.
 Reward the outcomes of each simulation.
 Repeat simulation many times to obtain a probability distribution of likely outcomes.

Advantages of simulation:
 It gives more information about the possible outcomes and their relative probability.
 It is useful for problems, which cannot be solved analytically.

Limitations in simulation:
 It is not a technique for making a decision only for obtaining more information about the possible outcomes.
 It can be very time-consuming without a computer.
 It could prove expensive in designing and running the simulation on a computer.
 Simulations are only as good as the probabilities assumptions and estimates made.

Variables:-
The net present value could depend on a number of certain independent variables.
 Selling price
 Sales volume
 Cost of capital
 Initial cost
 Operating costs
 Benefit

38
Cost of Capital
A fundamental calculation for all companies is to establish its financing costs, both individually for each component
of finance and in total terms. These will be of use both in terms of assessing the financing of the business and as a
cost of capital for use in investment appraisal.

Risk and Return

The relationship between risk and return is easy to see, the higher the risk, the higher the required to cover that risk.

Overall Return
A combination of two elements determine the return required by an investor for a given financial instrument.
1. Risk-free return – The level of return expected of an investment with zero risk to the investor.
2. Risk premium – the amount of return required above and beyond the risk-free rate for an investor to be
willing to invest in the company

Degree of Risk

Risk Free High Risk Investment

Government Secured Un-Secured Preference Ordinary

Debt Loans Loans Shares Shares

WACC

Capital
structure
theories

Ke=Cost of Kp=Cost of Project specific

equity Kd= Cost of debt preference Discount rate
share

39
Different types of Cost of Capital
Cost of equity: the rate of return that is required by the equity holders of the company. The symbol used to represent
cost of equity is Ke.

Cost of debt: this the after-tax return required by the debt holders of the company. The symbol used to represent
after-tax cost of debt is Kd (1 – t).

Cost of preference shares: the return required by the the preference shareholders of the company. The symbol used
to represent cost of preference shares is Kp.

Methods of calculating the cost of Equity

It can be calculated using two of the following methods:

Dividend Valuation Model: used for companies that pay: Constant dividend
Constant growth in dividends

Capital Asset Pricing Model (CAPM):

The Dividend Valuation Method

Constant Dividend per Year

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
M.v =
𝐾𝑒

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Ke = 𝑋 100%
𝑃0

Where,
𝑃0 = Current market value of equity share

𝐾𝑒 = cost of equity

Dividends With Constant Growth Per Year

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (1+𝑔)
M.v =
𝐾𝑒 −𝑔

Where,
𝑃0 = Current Ex-market value of equity share

g = sustainable growth rate

40
Difference between cum dividend and ex dividend price
Ex-dividend price (P0) is the market price excluding dividend and cum-dividend price is the market price including
dividend.

Cum-Dividend Price
Less: Dividend
Ex-Dividend Price

Calculating the sustainable growth rate for dividends

There are 2 main methods of determining growth:

1 THE AVERAGING METHOD
𝑛 d𝑜
𝑔= √ −1
d𝑛
where do = current dividend
dn = dividend n years ago
Example

Munero Ltd paid a dividend of 6p per share 8 years ago, and the current dividend is 11p. The current share
price is $2.58 ex div

Required:
Calculate the cost of equity

Solution
8 11
𝑔=√ − 1 = 7.9%
6

Ke = 0.11(1+7.9%) + 7.9% = 12.47%

2.58

2. GORDON’S GROWTH MODEL

g = rb
where r = return on reinvested funds
b = proportion of funds retained
Example
The ordinary shares of Titan Ltd are quoted at $5.00 ex div. A dividend of 40p is just about to be paid. The
company has an annual accounting rate of return of 12% and each year pays out 30% of its profits after tax as
dividends.

Required:
Estimate the cost of equity

41
 SOLUTION
g = 12% X (1-30%) = 8.4%

Ke = 0.4(1+8.4%) + 8.4% = 17.07%

5

Capital asset pricing Model (CAPM)

There are two types of risk

1. Market or systematic risk is risk that cannot be diversified away.
2. Non- systematic or unsystematic risk applies to specific individual company or industry, and can be
reduced or eliminated by diversification.

Systematic risk is how market factors effect that investment. Market factors are:-
 Macroeconomic variables
 Political factors

CAPM assumes that the investor has eliminated the unsystematic risk.

Diversification
By holding a portfolio, the unsystematic risk is diversified away but the systematic risk is not and will be present in
all portfolios. If we were to enlarge our portfolio to include approximately 25 shares we would expect the
unsystematic risk to be reduced to close to zero, the implication being that we may eliminate the Unsystematic
portion of overall risk by spreading investment over a sufficiently diversified portfolio.

Capital Asset Pricing Model(.CAPM)

Unsystematic Risk Systematic Risk
 Specific to company  Related to general economy
 individual industries  includes Macro-economic factors and affects the
 A method for reducing this risk is through whole economy
diversification.  Cannot be reduced through diversification.
 E.g. employees on strike,key employee  E.g. political risk, interest rate, inflation rate
 Diversification: it is process whereby we Beta:It is a relative systematic risk of company's
spread our investment by holding a earnings with the market systematic risk.
portfolio of unrelated stocks which results As market risk =1
in the reduction of un
 CAPM assumes that all investors are
Beta can be > 1 More risky compare to market
rational and will hold well diversified
portfolio (means there is no unsystematic
risk.) Beta can be < 1 Less risky compare to market

42
CAPM Formula
Cost of Equity = Rf + β (Risk Premium)

Cost of Equity = Rf + β (Rm-Rf)

Where,
Rf = Risk free rate
β = measure of relative systematic risk
Risk Premium = ERM Rf
RM = Expected Return on Market
(Rm-Rf)=Market risk premium or equity risk premium

It is assumed that investors are rational & will hold a well diversified portfolio (unsystematic risk will be reduced to
minimum level).
 Transaction cost is low or nil.
 Investors have homogeneous expectations about the market.
 Market is perfect and all investors have same level of information & no individual can dominate the market.
 Debt beta is zero.
 There is no cost of acquiring information. No individual can dominate the market.

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

Limitations of CAPM
 It might be difficult to locate information needed for calculating CAPM. Government securities are assumed to
be risk- free, but the return on these securities varies according to their term to maturity. Market rate of return
is hard to estimate different economic environments and the probabilities of the various environments. An
appropriate Beta equity might not be located, as it might not be feasible to find a proxy company with business
operations similar to the proposed investment project. Moreover, most companies have a range of business
operations they undertake and so their equity betas do not reflect only the desired level and type of business
risk.
 It assumes that a perfect capital market exists, when in reality capital markets are only semi- strong form
efficient at best.
 It assumes that investors hold diversified portfolio’s, i.e. the investors will only require a return for the
systematic risk of their portfolios, since unsystematic risk has been removed and can be ignored. This is not
necessarily the case, meaning that some unsystematic risk may remain.
 The CAPM is really just a single Period model. Few investment projects last for one year only and to extend the
use of the return estimated from the model to more than one time period would require both project
performance relative to the market and the economic environment to be reasonably stable.

43
 CAPM assumes no transaction costs associated with trading securities.
 Additionally, the idea that all unsystematic risk is diversified away will not hold true if stocks change in term of
volatility. As stock change over time it is very likely that the portfolio becomes less than optimal.
 CAPM assumes investors can borrow and lend at the risk- free rate of return.
 CAPM assumes that debt beta is zero which may not be appropriate in many cases

Dividend Growth Model vs CAPM

The dividend growth model allows the cost of equity to be calculated using empirical values readily available for
listed companies. Measure the dividends, estimate their growth (usually based on historical growth), and measure
the market value of the share (though some care is needed as share values are often very volatile). Put these
amounts into the formula and you have an estimate of the cost of equity.

However, the model gives no explanation as to why different shares have different costs of equity. Why might one
share have a cost of equity of 15% and another of 20%? The reason that different shares have different rates of
return is that they have different risks, but this is not made explicit by the dividend growth model. That model simply
measures what’s there without offering an explanation. Note particularly that a business cannot alter its cost of
equity by changing its dividends.

Dividend valuation model might suggest that the rate of return would be lowered if the company reduced its
dividends or the growth rate. That is not so. All that would happen is that a cut in dividends or dividend growth rate
would cause the market value of the company to fall to a level where investors obtain the return they require.

The CAPM explains why different companies give different returns. It states that the required return is based on
other returns available in the economy (the risk free and the market returns) and the systematic risk of the
investment – its beta value. Not only does CAPM offer this explanation, it also offers ways of measuring the data
needed. The risk free rate and market returns can be estimated from economic data. So too can the beta values of
listed companies. It is, in fact, possible to buy books giving beta values and many investment websites quote
investment betas.

When an investment and the market is in equilibrium, prices should have been adjusted and should have settled
down so that the return predicted by CAPM is the same as the return that is measured by the dividend growth model.

Implications of systematic risk & unsystematic risk

 If an investor wants to avoid risk altogether, he must invest entirely in risk-free securities.
 If an investor holds shares in just a few companies, there will be some unsystematic risk as well as systematic
risk in his portfolio, because he will not have spread his risk enough to diversify away the unsystematic risk. To
eliminate unsystematic risk, he must build up a well diversified portfolio on investments.
 If an investor holds a balanced portfolio of all the stocks and shares on the stock market, he will incur systematic
risk which is exactly equal to the average systematic risk in the stock market as a whole.

Factors determining the beta of a company’s equity shares

 Sensitivity of the company’s cash flow to economic factors, as stated above. for example sales of new car are
more sensitive than sale of basic food and necessities.
 The company’s operating gearing. A high level of fixed cost in the company’s cost structure will cause high
operating profit compared with variations in sales.

44
 The company’s financial gearing. High borrowing and interest cost will cause high variation in equity earning
compared with variation in operating profit, increasing the equity beta as equity returns become more variable
in relation to market as whole. This effect will countered by the low beta of debt when computing the weighted
average beta of the whole company.

Cost of Debt Capital

Each item of debt finance for a company has a different cost. This is because debt capital has differing risk, according
to whether the debt is secured, whether it is senior or subordinated debt, and the amount of time remaining to
maturity. Cost of debt is adjusted for taxation because of the tax savings available on annual interest. The different
types of debt are:
 Irredeemable debt
 Redeemable debt (redeemable fixed rate bonds)
 Variable rate debt (floating rate debt)
 Non-tradable debt
 Convertible debt
 Corporate debt

45
COST OF IRREDEEMABLE DEBT
𝑖(1−𝑡)
𝐾𝑑(𝑛𝑒𝑡) = 𝑋100%
𝑃𝑜

where i = interest paid

t = marginal rate of tax
P0 = ex interest (similar to ex div) market price of the loan stock.

Example
The 10% irredeemable loan notes of Rifa plc are quoted at $120 ex-interest. Corporation tax is payable at
30%

Required:
What is the cost of debt net?

SOLUTION
10(1−30%)
𝐾𝑑(𝑛𝑒𝑡) = 𝑋100% = 5.83%
120

Cost of Redeemable Debt

The cost of redeemable bonds is their redemption yield. This is calculated as the rate of return that equates the
present value of the future cash flows payable on the bond (to maturity) with the current market value of the bond.
In other words, it is the IRR of the cash flows on the bond to maturity, assuming that the current market price is a
cash outflow. In order to calculate Kd calculate after tax value of interest.

Year Cash Flow D.F @ 5% P.Values D.F @other rate P.Values

0 (M.v) 1.000 (××) 1.000 (××)

1–5 Interest(1-t) A.f ×× A.f ××

5 Redemption Value D.f ×× D.f ××

×× ××

46
Example of Cost of Redeemable Debt
The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been paid. The bonds will
be redeemed at per after four years. The rate of taxation on company profits is 30%.

Required:

Calculate the after-tax cost of the bonds for the company.

Year Cash Flow D.F @ 5% P.Values D.F @ 10% P.Values

0 (96.25) 1.000 (96.25) 1.000 (96.25)

1–4 4.90 3.546 17.38 3.170 15.53

4 100 0.823 82.30 0.683 68.30

3.43 (12.42)

3.43
Kd (1 – t) =5% + [ 𝑋(10 − 5)] % = 𝟔. 𝟎𝟖%
3.43+12.42

Convertible Debt
Here bond holders have choice to either redeem the debt or convert the debt into predetermined number of shares.
The method of calculating cost of debt for convertible is same as calculating the cost of debt of redeemable debt.

The problem here is that we do not know whether the bond holder would exercise the conversion option or not.
Therefore we take higher value of redemption value or conversion value.

Conversion Value is calculated as:

Conversion Value = M.V per share at time of conversion x No. of Shares

M.V at the time of conversion = Current M.v × (1+g)^n

Where,
g = Share price growth
n = no. of years in conversion

Example of Cost of Convertible Debt

The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been paid. The bonds will
be redeemed at per after four years or convertible into 20 ordinary shares. Current share price is $4.44 and it is
expected that it will grow with a growth of 5% per year. The rate of taxation on company profits is 30%.

47
Required:

Calculate the after-tax cost of the bonds for the company.

Answer:
Conversion Value = 20× 4.44 × 1.05^4=$108
Redemption Value=$100
Investor are rational and will chose the higher Value

Year Cash Flow D.F @ 10% P.Values D.F @ 5% P.Values

0 (96.25) 1.000 (96.25) 1.000 (96.25)

1–4 4.90 3.170 15.53 3.546 17.38

4 108 0.683 73.76 0.823 88.88

(7) 10

10
Kd (1 – t) =5% + [ 𝑋(10 − 5)] % = 𝟕. 𝟗𝟒%
10+7

Cost of Variable Rate Debt & Non-Tradable Debt

Variable or Floating Rate Debt

Company will pay what you demand. Interest rate and required rate if same then market value will be same as
redemption.
Because
Kd=Interest % x (1-t)
book value = market value

Non-tradable Debt
An example of non-tradable debt is bank loan.

Kd=Interest % x (1-t)

48
Preference Shares
Irredeemable Preference Shares Redeemable Preference Shares
The cost of capital is calculated in the same way as the The cost of capital is calculated in the same way as the
cost of equity, assuming a constant annual dividend. cost of redeemable debt. Assuming before tax
preference dividend as no tax deduction is allowable on
M.v = Preference Dividend preference dividend.
r

r or KD = Preference Dividend
Market value

Weighted Average Cost of Capital

The WACC is a weighted average of the (after-tax) cost of all the sources of capital for the company.

Steps for Calculating WACC

Calculate cost of each source of finance. e.g. Ke , Kd , Kp Calculate market value of each source of finance
 M.v of Equity = (Issued share capital / par value) × M.v per share
 M.v of Debt = (Book value / par value) × M.v per bond
 M.v of Preference share = (Book value / par value) × M.v per share
 Bank loan market value = book value

Calculate WACC using this formula:

Source Proportion (in Market Values) X Cost WACC

Equity Proportion of Equity X Ke X%
Debt Proportion of Debt X Kd(net) X%
Preference Share Proportion of Preference X Kp X%
WACC X%

Example
Bar plc has 20m ordinary 25p shares quoted at $3, and $8m of loan notes quoted at $85. The cost of equity has
already been calculated at 15% and the cost of debt (net of tax) is 7.6%.

Required:
Calculate WACC?

SOLUTION
Market Value of Equity = 20m X $3 = $60m
Market Value of Debt = $8m X 85/100 = $6.8m
Total capital (60+6.8) = $66.8m

49
Source Propotion X Cost WACC
Equity (60/66.8) X 15% 13.47%
Debt (6.8/66.8) X 7.6% 0.77%

14.25%

50
Capital Structure and WACC
Gearing Theories

The Traditional View

Cost of equity: At relatively low levels of gearing the increase in gearing will have relatively low impact on Ke. As
gearing rises the impact will increase Ke at an increasing rate

Cost of debt: There is no impact on the cost of debt until the level of gearing is prohibitively high. When this level is
reached the cost of debt rises.

Gearing (D/E)
Key point : As the gearing level increases initially the WACC will fall. However, this will happen upto an appropriate
gearing level. After that level WACC will start to rise. There is an optimal level of gearing at which the WACC is
minimized and the value of the company is maximized.

The MM View (With Out Tax)

Cost of equity: Ke rises at a constant rate to reflect the level of increase in risk associated with gearing.

Cost of debt: There is no impact on the cost of debt.

Assumptions:
1. Perfect capital market exist where individuals and companies can borrow unlimited amounts at the same rate
of interest.
2. There are no taxes or transaction costs.
3. Personal borrowing is a perfect substitute for corporate borrowing.
4. Firms exist with the same business or systematic risk but different level of gearing.
5. All projects and cash flows relating thereto are perpetual and any debt borrowing is also perpetual.
6. All earnings are paid out as dividend.
7. Debt is risk free.

51
The increase in Ke directly compensates for the substitution of expensive equity with cheaper debt. Therefore, the
WACC is constant regardless of the level of gearing.

If the weighted average cost of capital is to remain constant at all levels of gearing it follows that any benefit from
the use of cheaper debt finance must be exactly offset by the increase in the cost of equity.

The MM View (With Tax)

In 1963 M&M modified their model to include the impact of tax. Debt in this circumstance has the added advantage
of being paid out pre-tax. The effective cost of debt will be lower as a result.

Implication: As the level of gearing rises the overall WACC falls. The company benefits from having the highest level
of debt possible.

52
(a) Market imperfections:
This suggests that companies should have a capital structure made up entirely of debt. This does not happen in
practice due to the existence of other market imperfections which undermine the tax advantage of debt finance.

(b) Bankruptcy costs:

MM’s theory assumes perfect capital markets so a company would always be able to raise finance and avoid
bankruptcy. In reality however, at higher levels of gearing there is an increasing risk of the company being unable
to meet its interest payments and being declared bankrupt. At these higher levels of gearing, the bankruptcy
risk means that shareholders will require a higher rate of return as compensation.

(c) Agency costs:

At higher levels of gearing there are also agency costs as a result of action taken by concerned debt holders.
Providers of debt financed are likely to impose restrictive covenants such as restriction of future dividends of
the imposition of minimum levels of liquidity in order to protect their investment. They may also increase their
level of monitoring and require more financial information.

(d) Tax exhaustion:

As companies increase their gearing they may reach a point where there are not enough profits from which to
obtain all available tax benefits. They will still be subject to increased bankruptcy and agency costs but will not
be able to benefit from the increased tax shield.

Pecking Order Theory

Pecking order theory states that the firm will prefer certain types of finance over others. It comes up with its ranking
for the sources of finance that a company should prefer over other. The order of preference is as follows:
 Retained earnings
 Straight Debt
 Convertible debt
 Preference shares
 Equity shares

53
Pecking Order Theory
Reasons Limitations of Pecking Order Theory
 lt is easier to use retained funds than go to the Pecking order theory fails to take into account
trouble of obtaining external finance and have to taxation, financial distress, agency costs or how
live up to the demands of external finance the investment opportunities that are available
providers. may influence the choice of finance.

 There are no issue costs if retained earnings are  Pecking order theory is an explanation of what
used, and the issue costs of debt are lower than businesses actually do rather than what they
those of equity. should be looking forward to do.

 investors prefer safer securities i.e. debt with its

guaranteed income and priority on liquidation.

 Some managers believe that debt issues have a

better signaling effect that equity issues because
the market believes that managers are better
informed about shares' true worth than the market
itself is. Their view is the market will interpret debt
issues as a sign of confidence, that business are
confident of making sufficient profits to fulfill their
obligations on debt and that they believe that the
shares are undervalued

Marginal Cost of Capital

Marginal cost of capital is the incremental cost of capital of additional 1 $ raise of finance. It is the incremental cost
of capital of additional finance raised. Marginal cost of capital should be used if following conditions does not fulfill.
 Financial risk of new project is not same as the existing financial risk of company
 The required return of investors increased from existing level
 Size of the new project is not smaller that the existing size of business.

CAPM and MM Combined

Systematic Risk

Equity Beta (βe)

Business Risk Financial Risk

Asset Beta (βa)

54
Business Risk Financial Risk
Business risk arises due to the nature of a company's Financial risk arises due to the use of debt as a source
business operations, which determines the business of finance., and hence is related to the capital structure
sector into which it is classified, and to the way in which of a company. Financial risk is the variability in
a company conducts its business operations. Business shareholder returns that arises due to the need to pay
risk is the variability in shareholder returns that arises as interest on debt. Financial risk can be assessed rom a
a result of business operations. It can therefore be shareholder perspective in two ways. Firstly, balance
related to the way in which profit before interest and tax sheet gearing can be calculated. Secondly, the interest
(PBIT or operating profit) changes as revenue or turnover coverage ratio can be calculated
changes. This can be assessed from a shareholder
perspective by calculating operational gearing, which
essentially looks at the relative proportions of fixed
operating costs to variable operating costs. One measure
of operational gearing that can be used is (100 x
contribution/ PBIT), although other measures are also
used.

Systematic Risk
From the shareholder perspective, systematic risk is the sum of business risk and financial risk, Systematic risk is the
risk that remains after a shareholder has diversified investments in a portfolio, so that the risk specific to individual
companies has been diversified away and the shareholder is faced with risk relating to the market as a whole. Market
risk and diversifiable risk are therefore other names for systematic risk. From a shareholder perspective, the
systematic risk of a company can be assessed by equity beta of the company. If the company has debt in its capital
structure, the systematic risk reflected by the equity beta will include both business risk and financial risk. If company
is financial entirely by equity, the systematic risk reflected by the equity beta will be business risk alone, in which
case the equity beta will be the same as the asset beta.

The Formula
𝑽𝒆
 𝜷𝒂 = 𝑿 𝜷𝒆
𝑽𝒆 +𝑽𝒅 (𝟏−𝑻)

Where:
Ve = Market Value of Equity
Vd = Market Value of Debt

Should Company’s WACC be Used for Investment Appraisal?

If the Investment’s Business risk and Financial Risk are similar to the company, then we use the company’s WACC to
appraise the investment. However, if any of the risk is different then we have to calculate investment specific cost
of capital.

55
Project Specific Cost of Capital
Following are the steps of calculating the project specific cost of capital.

Financial Risk is Different Business Risk is Different

1. Chose the βe of the company. 1. Identify a proxy company having same
2. Calculate the βa using the company’s current Business Risk
financial structure (Un-gearing Beta). 2. Chose the βe of that proxy company.
𝑉𝑒 3. Calculate the βa using the Proxy company’s
𝛽𝑎 = 𝑋 𝛽𝑒
𝑉𝑒 + 𝑉𝑑 (1 − 𝑇) current financial structure (Un-gearing Beta).
3. Calculate βe of the investment using capital 𝑉𝑒
𝛽𝑎 = 𝑋 𝛽𝑒
structure to be used for the investment. (Re- 𝑉𝑒 + 𝑉𝑑 (1 − 𝑇)
gearing Beta) 4. Calculate βe of the investment using capital
𝑉𝑒 + 𝑉𝑑 (1 − 𝑇) structure to be used for the investment. (Re-
𝛽𝑒 = 𝑋 𝛽𝑎
𝑉𝑒 gearing Beta)
4. Use βe to calculate Ke using CAPM 𝑉𝑒 + 𝑉𝑑 (1 − 𝑇)
𝛽𝑒 = 𝑋 𝛽𝑎
5. Calculate WACC 𝑉𝑒
5. Use βe to calculate Ke using CAPM
6. Calculate WACC

Example
Techno, an all equity agro-chemical firm, is about to invest in a diversification in the consumer pharmaceutical
industry. Its current equity beta is 0.8, whilst the average equity β of pharmaceutical firms is 1.3. Gearing in the
pharmaceutical industry averages 40% debt, 60% equity. Corporate debt is available at 5%.
Rm = 14%, Rf = 4%, corporation tax rate = 30%.
Required:
What would be a suitable discount rate for the new investment if Techno were to finance the new project
with 30% debt and 70% equity?

SOLUTION
1. Pharmaceutical Industry 𝛽𝑒 = 1.3
60
2. 𝛽𝑎 = 𝑋 1.3 = 0.89
60+40(1−30%)

70+30(1−30%)
3. 𝛽𝑒 = 𝑋 0.89 = 1.16
70

4. Ke = 4% + 1.16 (14% - 4%) = 15.6%

5. WACC
Source Propotion X Cost WACC
Equity 70% X 15.6% 10.92%
Debt 30% X 5% (1-30%) 1.05%
WACC 11.97%

56
Business Valuation

Equity valuation Debt Valuation

Businesses need to be valued for a number of reasons such as

• For Acquisitions & Merger
• To get listed on stock Exchange
• For tax Purpose

Equity Valuation
Cash-Flow based Method
• Dividend Valuation Model

Net Asset Method

• The book value approach
• Net Realizable values of the assets less liabilities
• Replacement values

Income based Method

• P/E Ratio
• Earning Yield

Cash-Flow based Method

Dividend Valuation Model ( two methods)

Single Growth model:

P0 = D0(1 + g) / (Ke – g)

Multiple Growth model:

Year 1 2 3 4-Infinity
Dividends D1 D2 D3 D3*(1+g)/Ke-g
D.F at Ke D.f of last year

Market capitalization=Mv/share × number of shares

57
Dividend Growth Model
Assumptions:
The dividend models are underpinned by a number of assumptions that you should bear in mind.

a) Investors act rationally and homogenously. The model fails to take into account the different expectations of
shareholders, nor how much they are motivated by dividends versus future capital appreciation on their shares.
b) The D0 figure used does not vary significantly from the trend of dividends. If D0 does appear to be a rouge figure.
It may be better to use an adjusted trend figure, calculated on the basis of the past few years dividends.
c) The estimates of future dividends and prices used, and also the cost of capital are reasonable. As with other
methods, it may be difficult to make a confident estimate of the cost of capital. Dividend estimates may be made
from historical trends that may not be a good guide for a future, or derived from uncertain forecasts about
future earnings.
d) Directors use dividends to signal the strength of the company’s position (however company’s that pay zero
dividends do not have zero share values).
e) Dividends either show no growth or constant growth. If the growth rate is calculated using “g=b x R”, then the
model assumes that ‘b’ and ‘R’ are constant.
f) Other market influences on share prices are ignored.
g) The company’s earnings will increase sufficiently to maintain dividend growth levels.
h) The Discount Rate used, always exceeds the dividend growth rate.

Asset Based Approach

The business is estimated as being worth the value of its Net Assets.
Net Assets = Total Assets – Total Liabilities – Preference Share Value

Ways of valuing Net Assets

• Book Value Approach -The book value of non-current assets is based on historical (sunk) costs. These amounts
are unlikely to be relevant to any purchaser (or seller).
• Net Realizable values of the assets less liabilities - This amount would represent what should be left for
shareholders if the assets were sold off and the liabilities settled.
• Replacement values - The approach tries to determine what it would cost to set up the business if it were being
started now.

Adjustments:
Monetary assets: book value

Tangible assets:
Replacement value( if purpose is going concern)
Realizable Value( if purpose is of disposal)
Book value( if above values are not available)

Intangible Assets: consider if market value is available

Inventory: at NRV
Receivable: less any allowance for doubtful debt
Liabilities: redemption value

58
EXAMPLE
The minimum amount that the shareholders should accept for this business is $1,550,000, the amount of share
capital plus reserves after revaluation (or alternatively, $2,550,000 – 400,000 – 600,000).

Market relative based Approach

Price/Earning Method / Earning Multiple

This method relies on finding listed companies in similar businesses to the company being valued (the target
company), and then looking at the relationship they show between share price and earnings.

P/E ratio = Market Value of Share / Earnings per Share

59
Market Value of Target Company = Earnings per Share of Target Company X P/E Ratio of Proxy or (Industry
Average)

Adjustments.
 Adjust earnings for one off exceptional items (After-tax).
 If target company is a private company then downwards adjust the calculated market value because:
 Public company has better image over private company
 Public company shares are more marketable and liquid
 Public company is less risky as compared to private company.

If we are using P/E ratio of quoted company for the valuation of unquoted company then we reduced it by 30% to
reflect the poor quality of earnings.

Price/Earning Method
 If private company has better growth prospects then upwards adjust the calculated market value.
 For better analysis use Forecasted earnings.
 M.V of Target Co= Forecasted Earnings x P/E Ratio of Industry
In exam we will calculate both values (using historic earnings and forecasted earnings) and suggest that market
value of the company should be in between

Income Based Approach

Earning Yield Method :

Earnings yield = Earning per share/ Market value per share.
For example, if EPS was £1 per share and the market price per share was £10, then the earnings yield would be 10%.
Earnings yield is the mirror image of the PRICE-EARNINGS RATIO.

Market Value of Target Company/ Share = EPS of Target Company X 1/ Earning Yield (Proxy)

Problems of using P/E Ratio

However using the P/E Ratio of quoted companies to value unquoted companies maybe problematic.
a) Finding a quoted company with a similar range of activities may be difficult. Quoted companies are often
diversified.
b) A single year’s P/E Ratio may not be a good basis, if earnings are volatile or the quoted company’s share price is
an abnormal level, due for example to the expectation of a takeover bid.
c) If a P/E Ratio trend is used, the historical data will be use to value how the unquoted company will do in the
future.
d) The quoted company may have a different capital structure to the unquoted company.

Use of Forecast Earnings

When one company is thinking about taking over another it should look at the target company’s forecast earnings,
not just its historical results.

60
Forecasts of Earnings Growth should only be used if:
a) There are good reasons to believe that earnings growth will be achieved.
b) A reasonable estimate of growth can be made.
c) Forecasts supplied by the target company’s directors are made in good faith, using reasonable assumptions and
fair accounting policies.

Valuation of Debt

Irredeemable Debt
• These debts involve a company paying interest every year in perpetuity, without ever having to redeem the
loan.
• M.V = Annual Interest paid/Rate of Return by debt investors
• Tax effect should be ignored.
• Rate of Return by debt investors=Before tax Kd

Redeemable Debt
• The market value of the redeemable debt is the discounted present value of future interest receivable, up to
the year of redemption, plus the discounted present value of the redemption payment at before tax Kd
• Bank loan or Variable rate loan
• Book Value=Market Value

Convertible Debt
• Convertible bonds give bondholders the right but not the obligation to convert their bonds into a predetermined
number of shares at predetermined dates prior to the bond's maturity.
• This is calculated same way as Redeemable debt.
• Conversion value = P0 (1+g)^n R

WHERE -
P0 = Current ex-dividend ordinary share price
g = Expected annual growth rate of ordinary share price
n = Number of years to conversion
R = Number of shares received on conversion

Valuation of convertible debt

Years Cashflows Dicount factor at befor Present value
tax Kd

1-5 Interest 5 year annuity factor

5 Higher off (Redemption 5th year discount factor

Value or Conversion
value)

Total present
value=M.V

61
 Efficient Markets
Features of Efficient Markets
It has been argued that the UK and USA stock markets are efficient capital markets i.e. the markets in which:
i. Informational Processing Efficiency: The prices of securities bought and sold reflect all the relevant information
which is available to the buyers and sellers, in other words, share prices change quickly to reflect all new
information about future prospects. Market will absorb information in no time.
ii. No individual dominates the market.
iii. Operational efficiency
Transaction costs of buying and selling are not so high as to discourage trading significantly.
iv. Allocative efficiency:
Investors are rational and will invest in high profit company instead of loss making.
v. There are low, or no costs of acquiring information.

Efficient Market Hypothesis

A market is said to be “efficient” if prices adjust quickly and, on average, without bias, to new information. The key
reason for the existence of an efficient market is the intense competition among investors to profit from any new
information.

Weak-Form Efficiency
• In weak form efficiency, the hypothesis asserts that all past information and data are fully reflected in the price
of securities.
• No investor can earn excess returns by developing trading rules based solely on historical price or return
information.

Semi-Strong Form Efficiency

If a stock market displays semi-strong efficiency, current share prices reflect both
• All relevant information about past price movements and their implications and
• All knowledge which is available publicly.

This means that individuals cannot ‘beat the market’ by reading the newspapers or annual reports, since the
information contained in these will be reflected in the share prices.

Strong Form Efficiency

• In strong form efficiency, the hypothesis asserts that all information is fully reflected in the price of securities,
including insider information.
• No investor can earn excess returns using any information whether publicly available or not.

Technical Analyst:
Charting or ‘Technical analysis’ attempt to predict share price movements by assuming that past price patterns will
be repeated. There is no real theoretical justification for this approach, but it can at times be spectacularly successful.
Studies have suggested that the degree of success is greater then could be expressed merely from chance.

Fundamental Analyst:It is based on the theory that the realistic market price of a share can be derived from a
valuation of estimated future dividends. The value of a share will be the discounted present value of all future
expected dividends on the shares, discounted at the shareholders’ cost of capital.

62
Insider:
Technical analyst Fundamental analyst insiders

Weak form efficiency

Semi-strong form efficiency

Strong form efficiency

.
Random Walk Theory
The key feature of Random Walk Theory is that although share prices will have an intrinsic or fundamental value,
this value will be altered as new information becomes available, and that the behavior of investors is such that the
actual share price will fluctuate from day to day around intrinsic value.

63
Sources of Finance
Factors to consider in choosing appropriate source of finance
1) Cost of funds (Normally debt is cheaper)
o Since secured hence low risk for provider
o Guaranteed returns
o Definite maturity
o Tax saving by interest
2) Duration of need (Matching)
3) Gearing ratio (High gearing  High risk)
4) Accessibility - Generally difficult for small co. to raise debt

Equity

Ordinary Shares
 Owning a share confers part ownership.
 High risk investments offering higher returns.
 Permanent financing.
 Post-tax appropriation of profit, not tax efficient.
 Marketable if listed

Stock Market Listing

Advantages
 Access to wider pool of finance
 Better image
 Releasing capital for other uses
 Possibilities of acquisition and growth

Disadvantages
 Increased public scrutiny of the company
 Possibility of dilution of control
 Increased costs e.g. corporate governance, internal audit

Types of Equity Finance

 Retained Earnings ( Retain funds)

These are readily available and have no issuance cost however they may be not sufficient to fund large projects.
 Methods for Share Issuance
 Offer for Sale
 Placing
 Rights Issue

64
Methods of Share Issuance
(i) Offer for Sale
A situation in which a company advertises new shares for sale to the public as a way of launching itself on
the stock exchange.

This method involves a corporation selling a new issue of share to an issuing house, and the issuing house
will bear the risks of selling shares to other investors.

Offer for sale at a fixed price

Shares are offered at a fixed price to the public.

The price is determined by the company in consultation with the sponsor and the broker who also helps to
manage the issue.

The price is decided in such a manner that it is attractive to shareholders, as it is lower than the market
price.

The issue is underwritten so that the company can be confident of the success of the issue. (The
underwriters subscribe to the shares that are not taken up by the public).

Offer for Sale by tender

A minimum price is decided.

The public is invited to bid for the shares at a price that is equal to or above this level.

The striking price is determined after the offers been received. (A striking price is a price that ensures that
all the shares on offer are sold)

Comparison Between Offer for Sale of its Shares & Placing

(ii) Placing
This is an arrangement whereby the shares are not all offered to the public, but instead, the sponsoring
market maker arranges for the most of the issue to be bought by a small number of investors.
• Usually institutional investors such as pension fund and insurance companies
• When a company first comes to the market in UK, the maximum proportion of shares that can be placed
is 75%, to ensure some shares are available to wider public.
• Placing is much cheaper.
• Placing is a relatively quicker method
• Placing involves less disclosure of information
• Placing might give institutional shareholders the control of the company

(iii) Right Issue

A right issue is an offer to existing shareholders to buy more shares, usually at lower than the current share
price.

65
 Advantages
• Right issues are cheaper then offer for sale to general public.
• A right issue secures the discount on market price for existing shareholders, who may either keep the
shares or sell them if they want.
• Relative voting rights are unaffected if shareholders all take up their rights.
• The finance raised may be used to reduce gearing in book value terms by increasing share capital
• To pay off long-term debt which will reduce gearing in market value terms

Disadvantages
• The amount finance that can be raised by right issues of unquoted companied is limited by funds
available to existing shareholders.
• Choosing the best issue price may be problematic.
• If the price is considered too high, the issue may not be fully subscribed.
• If the price too low, the company will not have raised all the funds.
• Right issues cannot be used to widen the base the base of shareholders.

Valuing a Right Issue

Theoretical ex rights price
= Existing market value + Funds raised

Existing no of shares + Rights Issue shares

 Fund Raised= Right issue shares × right issue price
 Value of rights = TERP – Rights issue price

Example
Existing Shares = 1,000,000
Existing Share Price = $4/Share
Company wants to raise $800,000 using a rights issue, incurring an issuance cost of 20,000.
Right Price = $3/Share

Solution
Rights Shares = 800000/3 = 266,667
TERP = (1000000 x 4) + (800000 – 20000)
1000000 + 266667
= $3.77/Share

Value of Right
= TERP – Right Price
= 3.77 – 3
= $0.77

Example 2 (Part a)
Existing no of share = 400,000
Existing share price = $5
Right Price = $4.20
Company is issuing one new share against every four shares currently held.

66
Solution
TERP = (400000 x 5) + (4.2 x 400000/4)
400000 + (400000/4)

= $4.84
Value of Right = 4.84 – 4.20
= $0.64

Value of Right/Existing Share = 0.64/4 = $0.16

Example 2 (Part b)
An investor has 1000 shares of this company. What are the different options available to this investor at time of
rights issue?

Is the Right Issue Beneficial For Shareholders?

Shareholders get return in the form of dividends and share price appreciation.

Use of right issue funds

• Funds raised through rights issue can be used to repay a loan this will reduce interest expense and earnings
would increase.
• Funds raised through rights issue can be used to invest in new project which will increase the profitability of
project.

Steps
• Calculate revised earnings or revised EPS
• Right issue funds invested in new project or redeeming the loan which will directly increase the earnings
• Existing Price-to-earnings ratio will remain constant and calculate new market value using this equation.
• Revised M.V= Revised Earning × Constant P/E ratio
• If revised market value > TERP, then shareholders wealth will be Maximized.

67
Preference Shares
 Cumulative Preference Shares
 Non-Cumulative Preference Shares
 Participating Preference Shares
 Non-Participating Preference Shares

Loan Stock and Debentures key Components

 Nominal or Par Value
 Market Value
 Interest Rate or Coupon Rate
 Security
• Fixed charge
• Floating charge
 Ratings
 Redemption
 Restrictive terms and conditions

Types of Bonds
 Deep Discount Bonds
 Zero Coupon Bonds
 Convertible Bonds
• Market Value
• Floor Value
• Conversion Premium

Deep Discount Bond:

• Deep discount bonds are loan notes issued at a price which is at a large discount to the nominal value of the
notes, and which will be redeemedable at par (or above par) when they eventually mature.
• Deep discount bonds will carry a much lower rate of interest than other types of bond.
• Investors might be attracted to large capital gain offered by the bonds, which is the difference between the
issue price and the redemption value.

Zero Coupon Bonds:

Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on
them.
The investor gains from the difference between the issue price and the redemption value.
a) The advantage for borrowers is that zero coupon bonds can be used to raise cash immediately and there is no
cash repayment until redemption date. The cost of redemption is known at the time of issue.
b) The advantage for lenders is restricted, unless the rate of discount on bonds offers a high yield. The only way
of obtaining cash from the bonds before maturity is to sell them. The market value will depend upon the
remaining term to maturity and current market interest rates.

68
Convertible Bonds:
Convertible bonds are fixed interest debt securities, which the holder can choose to convert into ordinary shares of
the company.
• This conversion takes place at a pre-determined rate and date.
• If the conversion doesn’t take place, the bonds will run their full life and be redeemed on maturity.

Conversion Rate:
The conversion rate is expressed as a conversion ratio i.e the number of ordinary shares to be issued in exchange of
one bond, or part of it.

Conversion Value:
The conversion value is the market value of shares expected to be issued in conversion of one bond.

Conversion Premium:
The conversion premium is the difference between the market price of the convertible bond and the market price
of the shares into which the bond is expected to converted.

For example:
The market value of a convertible bond is $14. It is convertible into 3 ordinary shares . Market Value of one ordinary
share is $4.

Conversion Premium = $14 – (3x$4) = $2

Example of Cost of Convertible Debt

7% loan stock will be redeemed at per after four years or convertible into 20 ordinary shares. Current share price is
$4.44 and it is expected that it will grow with a growth of 5% per year. Before tax kd is 5%.
Required:
Calculate the after-tax cost of the bonds for the company.
Answer:
Conversion Value = 20× 4.44 × 1.05^4=$108
Redemption Value=$100
Investor are rational and will chose the higher Value

69
Cost of Convertible Debt

Warrants:
The right to buy the new ordinary shares in a company at a future date, at the exercise price (a fixed, pre-determined
price) is known as warrant.

Usually warrants are issed along with loan stock, in order to make the loan stock attractive.
Advantages of warrants to investor:
a) Low intital investment
b) Due to lower intial investment, the risk of loss of investment is also lower.

Advantages of warrants to company

a) Lower interest rate on loan stock, due to attraction of warrants.
b) Even when security for the loan stock is insufficient or not available, it may be possible to issue them because
of warrants.
c) In the future, when the warrants are exercised, they will lead to an actual cash inflow. This is not the case for
convertible bonds.

Venture Capital
Venture capital is a risk capital, normally provided in return for an equity stake.
Venture capital requires representative in BOD.

Types of Venture:
 Business start-ups
 Business development
 Management buyout
 Helping a company where one of its owners wants to realize all or part of his investment

70
Factors considered by Venture Capital organizations before providing finance to a company
 The nature of the companies product  Viability of production

 Expertise in Production  Technical ability to produce efficiently

 Expertise in Management  Commitment, skills and experience

 The market and competition  Threat from rival producers or future new
entrants
 Future profits  Detailed business plan showing profit
prospects that compensate for risks
 Representation in the Board  To take account of VC’s interests and ensure
VC has say in future strategy
 Risk borne by existing owners  Owners bear significant risk and invest
significant part of their overall wealth

Ratio Analysis
 Financial Performance
 Shareholders Wealth
 Financial Risk

Pro forma

Performance Ratios
 Return on Capital Employed

71
Profit before interest & tax x 100
Book value of equity + Book Value of Debt

 Return on Equity
Profit after tax x 100
Book value of equity

Shareholders Wealth
 Dividend Yield = D x 100
Po
Where, D = dividend per share
 Po = Opening market value/share

 Capital Gains = Closing market value – Opening market value x 100

Opening market value

 Total Return = Dividend Yield + Capital Gains

= Closing market value – Opening market value + DPS x 100
Opening market value

Financial Risk
 Gearing = Prior Charge Capital Or Debt
Prior Charge Capital + Equity Debt + Equity

If overdraft is material
 Gearing = Long term debt + Overdraft
Long term debt + overdraft+ Equity

 Debt to Equity Ratio = Debt/Equity x 100

 Interest Cover = Profit Before Interest & Tax

Interest

72
Assuming that company wants to raise some funds, based on financial risk decide whether we should raise funds
through debt or equity

When Debt Financing Would Be More Appropriate than Equity Financing

 When company has lower financial risk
 The gearing and interest cover are close to industry average
 When company is in healthy comparative position
 Cash flows and profit margins are stable
 Tangible assets are available to be offered as a security
 Operational gearing is low

Dividend Policy Theories

Dividend policy is a strategy whereby the management distribute profits to the shareholders. There are two such
theories:
 Irrelevancy theory
 Relevancy theory

Irrelevancy Theory
According to MM theory dividends are irrelevant, it does not matter, what actually matters that is earning power.
The extent and timing of dividend payouts is irrelevant. Investors are indifferent to whether they receive their
earnings by way of dividends or capital gains.

Since prime importance is given to investment decisions, dividends are determined as a residual amount. There may
even be no dividends if the retained earnings are consumed by investment projects. However, the expected future
earnings of the company will push the share prices up. In this manner, a shareholder gains in capital appreciation
even if he does not receive dividend payments.

73
 It was argued that if shareholders needed cash when no dividends were declared, they could sell some of their
shares and generate cash.

Assumptions
This theory is based on the following assumptions:
Capital markets are perfect.

There are no taxes at the corporate or personal level. There are no issue costs for the securities.

Relevancy Theory
Markets are not perfect, dividends play a role of signal
 A dividend which differs from shareholders expectations about dividends might send signals to the market and
affect share price. „ A higher than expected dividend may signal that the board of directors are confident about
the future and may lead to an increase in share price „ A lower than expected dividend may signal that the
company is in financial difficulties and lead to a fall in share price.

Liquidity Preference
 Investors have their own liquidity needs so they will prefer cash now to later

Tax Position
 Tax on dividends is income tax whereas tax on selling shares is capital gains tax
 If company changes its dividend policy, it will distribute investors tax position

Factors Affecting Dividend Policy

 The need to remain profitable
 The government impose direct restrictions on the amount of dividends companies can pay
 Any dividend restraints that may be imposed by loan agreements
 The effect of inflation and the need to retain some profit in the business just to maintain its operating capacity
 The company’s gearing level
 The need to repay debt in near future
 The ease with which the company can raise extra finance from sources other than retained earnings
 The signaling effect of dividends to shareholders and financial markets in general
 The amount of earnings the company wishes to retain may be affected by the number suitable investment
opportunities available to the company. if there are few investment projects available which can generate
sufficient return than surplus cash should be returned to shareholders

Scrip Dividend
A scrip dividend is the dividend paid by issue of additional company shares, rather than cash.

A company that wants to retain cash for reinvestment but does not want to reduce its dividends might offer its
shareholders a scrip dividend.

The rules of the stock exchange might require that when a company wants to make a scrip dividend, it must offer a
cash dividend alternative, so that shareholders can choose between new shares and cash.

74
Advantages
 They can preserve a companies cash position if a substantial number of shareholders take up the shares option.
 Investors may be able to take tax advantages if dividends are in form of shares.
 Investors looking to expand their holding can do so without incurring the transaction costs of buying more
shares.
 A small scrip issue will not dilute the share price significantly.
 A share issue will decrease the company’s gearing and therefore enhance its borrowing capacity

Stock Split & Scrip Issue

Stock Split
A stock split occurs where, for example, each share of $1 each is split into two shares of 50c each, thus creating
greater marketability.

Advantage of Stock Split

Investors may expect a company which splits its shares in this way to be planning for substantial earnings and
dividend growth.

Scrip Issue
 A bonus (scrip) issue is a method of altering the share capital without raising cash. It is done by changing the
company’s reserves into share capital.
 The rate of bonus issue is normally expressed in terms of the number of new shares issued for each existing
share held, e.g. one for two (one new share for each two shares currently held). As a consequence market price
of share mat benefit.

Share Repurchase
Purchase by a company of its own shares can take place for various reasons and must be in accordance with any
requirements of legislation.

If a company has surplus cash in the form of a higher dividend.

If a company chooses to pay higher dividend, this might act as a signal shareholder who then expect high dividends
in future years too. If the cash is used for share repurchases instead of higher dividends, future dividend expectations
will not be affected.

Share Repurchase Advantages

 Finding a use of surplus cash, this may be a ‘dead assets’.
 Increase in earnings per share through a reduction in the number of shares in issue.
 Readjustment of the company’s equity base to more appropriate level, for a company whose business is in
decline.
 Possibly preventing a takeover or enabling a quoted company to withdraw from the stock market.
 Increase in gearing.

Disadvantages
 It can be hard to arrive at a price that will be fair both to the vendors and to any shareholders who are not selling
shares to the company.

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 A repurchase of shares could be seen as an admission that the company cannot make better use of funds than
the shareholders.
 Some shareholders may suffer from being taxed on capital gains following the purchase of their shares rather
than receiving dividend income.

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Islamic Financing
Riba
It is forbidden Islamic finance.Riba is generally interpreted as the predetermined interest collected by a lender, which
the lender receives over and above the principal amount it has lent out. The Quranic ban on riba is absolute. Riba
can be viewed as unacceptable from three different perspectives, as outlined below

For the borrower

Riba creates unfairness for the borrower when the enterprise makes a profit which is less than the interest payment,
turning their profit into a loss.

For the lender

Riba creates unfairness for the lender in high inflation environments when the returns are likely to be below the rate
of inflation.

For the economy

Riba can result in inefficient allocation of available resources in the economy and may contribute to instability of the
system. In an interest-based economy, capital is directed to the borrower with the highest creditworthiness rather
than the borrower who would make the most efficient use of the capital

Islamic Financing Contracts

 Musharaka Mudaraba – a partnership contract
 Mudaraba – a form of equity where a partnership exists and profits and losses are shared
 Murabaha – a form of credit sale
 Ijara – a form of lease
 Sukuk – similar to a bond

MURABAHA: (Trade Credit)

Murabaha is a form of trade credit for asset acquisition that avoids the payment of interest. Instead, the bank buys
the item and then sells it on to the customer on a deferred basis at a price that form a cost plus sale.
 It include three parties:
a) the client i.e the buyer of the asset
b) the seller of the asset
c) the financer of assets
• The mark-up is fixed in advance and cannot be increased, even if the client does not take the goods within the
time agreed in the contract. Payment can be made by instalments.

MUDARABA: (Equity Finance)

• Mudaraba is essentially like equity finance in which the bank and the customer share any profits. The bank will
provide the capital, and the borrower, using their expertise and knowledge, will invest the capital.
• Profits will be shared according to the finance agreement, but as with equity finance there is no certainty that
there will ever be any profits, nor is there certainty that the capital will ever be recovered. This exposes the bank
to considerable investment risk.

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Musharaka: (Joint venture)
Musharaka is a joint venture or investment partnership between two parties. Both parties provide capital towards
the financing of projects and both parties share the profits in agreed proportions.
• This allows both parties to be rewarded for their supply of capital and managerial skills. Losses would normally
be shared on the basis of the equity originally contributed to the venture.
• Because both parties are closely involved with the ongoing project management, banks do not often use
Musharaka transactions as they prefer to be more ‘hands off’.

Ijara: (Lease)
Ijara is a lease finance agreement whereby the bank buys an item for a customer and then leases it back over a
specific period at an agreed amount.
• Ownership of the asset remains with the lessor bank, which will seek to recover the capital cost of the equipment
plus a profit margin out of the rentals payable.
• Under ijara the responsibility for maintainence of the leased item remains with the lessor.

Sukuk (debt finance)

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

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Islamic Finance Transactions
Islamic Finance Similar To Differences
Transaction

Murabaha Trade credit / loan There is a pre-agreed mark-up to be paid in recognition of the
convenience of paying later for an asset that is transferred
immediately. There is no interest charged

Musharaka Venture Capital Profits are shared according to a pre-agreed contract. There are
no dividends paid. Losses are solely attributable to the provider of
capital

Mudaraba Equity Profits are shared according to a pre-agreed contract. There are
no dividends paid. Losses are solely attributable to the provider of
capital

Ijara Leasing Whether an operating or finance transaction, in Ijara the lessor is

still the owner of the asset and incurs the risk of owners hip. This
means that the lessor will be responsible for major maintenance
and insurance which is different from a conventional finance
lease.

Sukuk Bonds There is an underlying tangible asset that the sukuk holder shares
in the risk and rewards of ownership. This gives the sukuk
properties of equity finance as well as debt finance

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Small and Medium Enterprises (SME)

What is an SME?
SME is something larger than those business that are fundamentally a vehicle for the self-employment of their
owner. SME is unlikely to be listed on any stock exchange and likely to be owned by relatively small numbers of
shareholders

Importance of SME
• It covers the wide range of business
• Important for the economies of many countries
• Account for about half of the employment and half of national income
• Flexible and quicker to innovate than larger companies due to their small size
• They are often thought to be better at embracing new trends and technologies
• It is easier for SME’S to survive and flourish in service sector (service sector is a growing market)

Why do SMEs find difficulty to finance raising?

The directors of SMEs often complaint that the lack of finance stops them growing and fully exploiting profitable
investment opportunities. This gap between the finance available to SME’s and the finance that they could
productively use is often known as the “funding or financing gap”.

The SME sector tends to suffer because SMEs are viewed as a less attractive investment opportunity than many
others due to the high levels of uncertainty and risk they are perceived to have. This perception of risk is due to a
number of reasons including:
• SMEs often have a limited track record in raising investment and providing suitable returns to their investors
• SMEs often have a non-existent or very limited internal controls
• SMEs often have few external controls. For instance they are unlikely to be abiding by the rules of any stock
exchange and due to their size they are unlikely to attract much press scrutiny
• SMEs often have a one dominant owner-manager whose decisions may face little questioning
• SMEs often have a few tangible assets to offer as security.

Potential source of finance for SMEs

In reality there are quite a few potential sources of finance for SMEs. However, many of them have practical problem
that may limit their usefulness.

Some key sources and their limitations are briefly described below

SME owner, family and friends

This is potentially a very The good source of finance because these investor may be willing to accept lower return
than many other investors as their motivation to invest is not purely financial. The key limitation is that, foe most of
us , the finance that we can raise personally, and form friend and family , is somewhat limited.

The business angel

A business angel is a wealthy individual willing to take the risk of investing in SMEs. One limitation is that these
individuals are not common and are very often quite particular about what they are prepared to invest in. Once a
business angel is interested they become very useful to the SME.

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Trade credit
SMEs, like any company, can take credit from their suppliers. However, this is only short term and, indeed, if their
suppliers are larger companies who have identified them as a potentially risky SME the ability to stretch the credit
period may be limited.

Factoring and invoice discounting

Both of these sources of finance effectively let a company raise finance against the security of their outstanding
receivables. Again, the finance is only short term and is often more expensive than an overdraft. However, one of
the features of these sources of finance is that, as an SMEs grows, their outstanding receivables grow and so the
amount they can borrow from their factor or from invoice discounting will also grow.

Leasing
Leasing asset rather than buying them is often very useful for an SME as it avoids the need to raise the capital cost.
However, leasing is only really possible on tangible asset such as car, machine etc.

Bank Finance
Bank may be willing to providing an overdraft of some sort and may be willing to lend in the long-term where that
lending can be secured on major asserts such as land and buildings. However, raising medium-term finance to fund
operations is often more difficult for SMEs as banks are traditionally rather conservative. This is understandable that
as the loss on one defaulted loan requires many good loans to recover that loss. Hence, many SMEs end up financing
medium term, and potentially longer-term assets, with short-term finance such as an overdraft. This is poor
matching and very less than ideal. This issue is often known as “maturity gap” as there is a mismatch of the maturity
of the assets and liabilities within the business

Listing
By achieving a listing on stock exchange an SME would become a quoted company and, hence, raising finance would
become less of an issue. However, before a listing can be considered the company must grow to such a size that a
listing is feasible. Many SMEs never hope to achieve this

The Venture Capitalist

A venture capitalist company is very often a subsidiary of a company that has significant cash holdings that they
need to invest. The venture capitalist subsidiary is a high-risk, potentially high-return part of their investment
portfolio. Hence, many banks will have venture capitalist subsidiaries. In order to attract venture capital funding an
SME has to have a business idea that may create the high returns the venture capitalist is seeking. Hence, for many
SMEs, operating in regular business, venture capitalist financing may not be possible. Furthermore, a venture
capitalist rarely wants to remain invested in the long term and, hence, any proposal to them must show how they
will be able to ‘exit’ or release their value after a number of years. This is often done by selling the company to a
bigger company operating in the same trade or by growing the company to such a size that a stock exchange listing
is possible.

Supply chain financing

In supply chain financing (SCF) the finance follows the value as it moves through the supply chain. SCF is relatively
new and is different to traditional working capital financing methods, such as factoring or offering settlement
discounts, because it promotes collaboration between buyers and sellers in the supply chain. Traditionally there was
competition as the buyer wanted to take extended credit, and the seller wanted quick payment. SCF works very well
where the buyer has a better credit rating than the seller.

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Crowdfunding
Crowdfunding involves funding a venture by raising finance from a large number of people (the crowd) and is very
often achieved over the internet.

The internet platforms are set up and run by moderating organisations who bring together the project initiator with
the idea, and those organisations and individuals who are willing to support the idea.

A feature of crowdfunding is that it lets people search for and invest in ideas and projects that they have an interest
or a belief in. Hence, these investors are sometimes willing to take bigger risks and/or accept lower returns than
would be usual. A further feature is that, just as in a real crowd, there is potential for interaction within the crowd.
Hence, keen supporters of a particular idea will very often encourage others to participate.

Example
Company A (which has an A+ credit rating) buys goods from Company B
(which has a B+ credit rating). Co B has agreed to give Co A 30 days credit.
Co B invoices Co A.
Co A approves the invoice.

Co A is expected to pay the amount due to its financial institution – ‘Bank C’ –in 30 days at which point the funds are
immediately remitted to Co B.

However, Co B can request the funds from Bank C prior to the due date. If they do this they receive the payment less
a suitable discount. This discount is likely to be less than the discount charged if Co B used traditional factoring or
invoice discounting. This is because they are using Bank C (Co A’s financial institution) and benefit from Co A’s higher
credit rating as the debt is the debt of Co A, and by approving the invoice Co A has confirmed this.

Equally, if Co A wants to delay payment beyond the 30-day point, then it can do so. However, when Co A does finally
pay Bank C some interest will be due. Obviously this interest charge reflects the credit rating of Co A.

WHY AND HOW DO GOVERNMENTS HELP FINANCE SMES?

Governments are often keen to assist as to the extent that SMEs are unable to raise finance for their profitable
projects, investment opportunities are potentially lost and, hence, national wealth is lower than it could be.
Additionally, governments are keen to support innovation, which is one area where SMEs often excel, and are keen
to support the growth of SMEs as this boosts employment.

A number of key ways governments assist include the following:

• Providing grants.
• Providing tax breaks – for instance, tax incentives may be available to those willing to take the risk of investing
in SMEs.
• Providing advice – for instance, in Scotland there is a government-funded organisation known as ‘Business
Gateway’, which provides assistance to those setting up and running a business, including advice on raising
finance.
• Guaranteeing loans – for instance, for a small fee from the SME, a large proportion of any loan advanced by a
bank is guaranteed by the government. As this significantly reduces the risk to the bank, they are potentially
more willing to lend. In the UK this is currently called the ‘Enterprise Finance Guarantee’ scheme.

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• Providing equity investment – many countries have government-backed venture capital organisations that are
willing to invest in the equity of SMEs. This is often done on a matching basis, where the organisation will match
any equity investment raised from other sources. In the UK this is done through ‘Enterprise Capital Funds’, while
in the US there is the ‘Small Business Investment Company’ programme.

Foreign Currency Risk Management

- When dealing with converting FOREX it is important to consider the following points
 Always consider yourself at Adverse Position

How Currency Fluctuate Supply & Demand

• Speculation
• Export and Import
• Foreign Direct Investment (FDI)
• Foreign Currency Loans
• Foreign Currency Remittance

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How Currency Fluctuate

Purchasing Power Parity (PPP)

It follows law of one price.

Different commodities in two different currencies will have same price, if there is any difference that will be
absorbed by exchange rate.

According to PPP the exchange rate between two currencies can be explained by the difference between inflation
rated in respective countries.

PPP says country with HIGH inflation rate normally faces the decrease in its currencies value and a country with a
LOW inflation rate has an expectation of increase in its currencies value.

The businesses normally use PPP for calculation of expected spot rate against the forward rate offered by banks.

Expected spot rate Future Spot rate= current spot rate × ( 1+ inflation of first currency)
( 1 + inflation of 2nd currency)

How Currency Fluctuate

Interest rate parity (IRP)

This concept says that the difference between 2 currencies worth can be explained by interest rate structure in the
countries of these 2 currencies.

According to IRP a country with a high interest rate structure normally has a currency at discount in relation to
another currency whose country has a low

HIGH INTEREST in country LOWER will be the value of currency

LOWER INTEREST in country HIGHER will be the value of currency

Forward rate Forward rate = current spot rat rate x ( 1+ interest of first currency)
(1 + interest of 2 nd currency)

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How Currency Fluctuate

Fisher Effect
This concept tells us the relation between interest rate and inflation.

It assumes that real interest rate between two economies are same and nominal interest rates are different
because of inflation.

Countries with relatively high rate of inflation will generally have high nominal rates of interest, partly because high
interest rates are a mechanism for reducing inflation.

USA [1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]
K [1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]

Expectation Theory
Future spot rate and forward rate should be equal.

If temporary difference arises b/w these two rates it will be reduced due to expectation of investors over the time.

For example – if forward rate is lower than future spot rate, investors will start buying in forward rates and starts
selling in future spot markets. Until the difference is negligible.

Four way equivalence theories

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Foreign Currency Risk Management

Types of Foreign Exchange Risk

Transaction Risk Translation Risk Economic Risk

 Transaction risk refers to  Translation risk refers to the  Long-term movement in the rate
adverse charges in the possibility of accounting loss that of exchange which puts the
exchange rate between could occur because of foreign company at some competitive
contract date and the subsidiary, as a result of the disadvantage is known as
settlement date. conversion of the value aisssets and economic risk.
 It is the risk that occurs in liabilities which are denominated in  E.g. if competitor currency stars
transactions where foreign foreign currency, due to depreciating or our company
currency is involved, for movements in exchange rate. currency starts appreciating.
example exports 1 imports.  This risk is involved where a parent  It may affect a company's
company has foreign subsidiaries in performance even if the
a depreciating currency company does not have any
environment. foreign currency transactions.

Methods of Hedging FOREX Risk

Translation Risk Economic Risk
 Arrange Maximum Borrowing in Subsidiary Co.  Shift manufacturing to cheaper labor areas
currency.  Create innovative and differentiate units to create
 Maintain Surplus Assets in Parent Co. currency brand loyalty
which will reduce the overall exposure of  Diversify into new products and into new markets
Translation risk.

Methods of Hedging FOREX Risk

Transaction Risk - Internal Hedging Method

• Invoice in Home Currency

Should have bargaining power to negotiate

• Matching Foreign Currency (Receipts and Payments)

Timing and currencies should be same
• Netting

Netting is a process in which all transaction of group companies are converted into the same currencies and then
credit balances are netted off against the debit balances, so that only reduced net amounts remain due to be paid
or received.

Leading and Lagging

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Methods of Hedging FOREX Risk

Transaction Risk - External Hedging Method

Forward Contract :
A forward contract is a legally binding agreement between two parties to buy or sell currencies in future at pre
dertemined rate and pre specified date.

Example
- Home Currency is British Pound £ , Exports receipts = $ 500,000 after six months

Spot Rate = 1.30 – 1.31 $/£

Six month forward rate = 1.32 – 1.33 $/£

Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = £ 375,940

Forward Contracts
It is a legally binding contract between two parties to buy or sell in future at a pre-determined rate and a pre-
specified date.

Advantages
Eliminate currency risk, as foreign exchange costs are determined upfront.
They are tailor made and can be matched against the time period of exposure as well as for the cash size of the
exposure, therefore they are referred to as a complete hedge.
They are easy to understand.

Disadvantages
It is subject to default risk.
There may be difficult to find a counter-party.
They are legally binding so difficult to cancel.

Transaction Risk
- External Hedging Method

Money Market Hedging :

Foreign Currency Receipts / Exports

Steps:
a) Calculate present value of foreign currency using borrowing rate of foreign currency and take loan of this amount.

Present Value = Foreign Currency amount

(1+ borrowing rate of FCY)

b) Convert that present value into home currency using spot exchange rate.
c) Deposit the home currency at the deposit rate of home currency.

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 Total receipts= Home currency × ( 1 + lending rate of HCY )

Money Market Hedging :

Foreign Currency Payments / imports

Steps:
a) Calculate present value of foreign currency using lending rate of foreign currency and deposit that amount.

Present Value = Foreign Currency amount

(1+ lending rate of FCY)
b) Convert that present value into home currency using spot exchange rate.
c) Borrow the home currency at the borrowing rate of home currency.

Total payment= Home currency × ( 1 + borrowing rate of HCY )

Money Market Hedging

A money market hedge is a mechanism for the delivery of foreign currency, at a future date, at a specified rate
without recourse to the forward FOREX market. If a company is able to achieve preferential access to the short term
money markets in the base and counter currency zones then it can be a cost effective substitute for a forward
agreement. However, it is difficult to reverse quickly and is cumbersome to establish as it requires borrowing/lending
agreements to be established denominated in the two currencies.

With relatively small amounts, the OTC market represents the most convenient means of locking in exchange rates.
Where cross border flows are common and business is well diversified across different currency areas then currency
hedging is of questionable benefit. Where, as in this case, relatively infrequent flows occur then the simplest solution
is to engage in the forward market for hedging risk. The use of a money market hedge as described may generate a
more favorable forward rate than direct recourse to the forex market. However the administrative and management
costs in setting up the necessary loans and deposits are a significant consideration.

Derivatives
• Future Settlement
• Initial amount to be paid is nil or low
• Drive their value from some underlying
• Traded in two types of market

(Over the counter Market & Exchange Traded

Derivatives

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Methods of Hedging FOREX Risk Transaction Risk - External Hedging Method

Future Contract
• Futures are standardized contracts traded on a • These contracts are highly standardized both in
regulated exchange to make or take delivery of a size and in terms of their delivery mechanism.
specified quantity of a foreign currency, or a • Physical delivery is very rare. Contracts are usually
financial instrument at a specified price, with settled prior to the settlement date.
delivery or settlement at a specified future date. • An initial margin is required, a further mark-to-
• They are available in major currencies and quoted market margin may be necessary.
against USD. • Standardized contracts
• There are four settlement dates M ARC H ,J U N E • Exchange traded derivatives are settled daily by
,S E P.T .DEC settling the difference in the contracted price and
• Tick = minimum movement of future contract, the traded price in cash. This is called the mark-to-
0.01% of contract size. market mechanism. No Default Risk
• Basis= current spot rate - future rate • More liquid in nature (e.g. futures contracts).

Methods of Hedging FOREX Risk Option

Contract

TYPES:
Currency options give the buyer the right but notCALL OPTION Right to buy at a specified rate
the obligation to buy or sell a specific amount ofPUT OPTION Right to sell at a specified rate
foreign currency at a specific exchange rate (the
strike price) on or before a predetermined future
date.
For this protection, the buyer has to pay aOPTION BUYER - OPTION HOLDER LONG POSITION
premium.
OPTION SELLER - OPTION WRITER SHORT POISTION
A currency option may be either a call option or a
put option
Currency option contracts limit the maximum lossAmerican Option - can be exercised at anytime before maturity
to the premium paid up-front and provide theEuropean Option - can be exercised at maturity only.
buyer with the opportunity to take advantage of
favorable exchange rate movements.

Interest Rate Risk Management

Interest rate risk (IRR) can be explained as the impact on an institution’s financial condition if it is exposed to negative
movements in interest rates.

This risk can either be translated as an increase of interest payments that it has to make against borrowed funds or
a reduction in income that it receives from invested funds.

Methods of Hedging Interest Rate Risk

• Forward rate Agreement (FRA)
• Interest Rate Future

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• Options
• Interest Rate Swaps
• CAP, FLOOR & COLLAR

Reasons for Interest Rate Fluctuation

1. RISK
 High risk, high return
 Low risk, low return
 No risk, some return

2. Need to make profit on re- lending

The more the changing hands, more the interest rate (due to margins of intermediation)

3. Size of the loan

More amount, more risk so more required interest rate Less amount, low risk so low interest rate.

4. Duration of the loan

Longer the period, higher the risk and so high interest required Shorter the period, lower the risk and so lower
the required interest

5. Types of financial assets and liabilities

6. Government policy

Methods of hedging interest rate risk

Forward rate Agreement (FRA)

 FRA is a contract in which two parties agree on interest rate to be paid on a notional amount at a specified future
time.
 The “buyer” of FRA is partly wishing to protect itself against a rise in rates while the “seller” is a party protecting
itself against an interest rate decline.
 FRAs can be used to hedge transactions of any size or maturity and offer an alternative ta interest rate futures
for hedging purpose.
 FRAs do not involve any margin requirements.
 Interest rate set for FRA is reflection of the expectation of interest rate movements.

Forward rate Agreement (FRA)

EXAMPLE
 Company wants to borrow $10m in three months’ time for a period of 6 months. Company is expecting that
interest rate will rise in future and wants to hedge its position using FRA.

Following FRAs are available

3-6 6%-6.5%
3-9 7.5%-8%

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Calculate the effective interest rate if forward hedge is taken. If after three months interest rates are
10%
5%

FRA

In case if interest moves to 10% In case if interest moves to 5%

Borrow from bank= 10% Borrow from bank= 5%

Compare forward rate with actual interest rate. If Compare forward rate with actual interest rate. If
actual is higher than bank will pay the difference actual is lower than bank will receive the difference

Difference from bank=10%-8%=2% Difference from bank=5%-8%=3%

Effective interest rate=8% Effective interest rate=8%

Methods Of Hedging Interest Rate Risk

Interest Rate Futures

• An interest rate futures contract is a futures contract with an interest-bearing instrument as its underlying
asset. The underlying asset could be Treasury bills and notes, certificates of deposit (CD), commercial paper
(CP), etc.
• IRF is an exchange traded derivative and has standard terms and conditions like contract size, settlement dates
etc.
• A borrowing company is concerned about a rise in interest rates and therefore, it will use an IRF to hedge
against a rise in interest rates. Conversely, a depositing company will use an IRF to hedge against a fall in interest
rates.

Interest Rate Options

An interest rate option is an option on a notional borrowing or a deposit which guarantees a minimum or a maximum
rate of interest (called strike price) for the option holder. The option is settled in cash

This product is available on payment of an upfront fee, called a premium.

An interest rate call option guarantees the borrower a maximum rate of interest, whereas an interest rate put option
guarantees the depositor a minimum rate of interest.

Methods of Hedging Interest Rate Risk

Interest Rate CAPS

• An interest rate cap is a contract that enables companies with floating rate debt to limit or "cap" their exposure
to rising interest rates.
• A CAP fixed the interest rate to be paid on the borrowing.

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Interest Rate FLOOR
• An interest rate floor is a series of European put options, that protects the lender against a decline in the
floating interest rates
• A floor guarantees that the interest rate received on a deposit will not be less than a specified level.

Interest Rate COLLAR

An interest rate collar is a combination of a cap and a floor transacted simultaneously. The buyer of an interest rate
cap, purchases an interest rate cap while selling a floor indexed to the same interest rate, for the same amount and
covering the same period.

Interest Rate SWAP

It’s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional amount
from a fixed rate to a floating rate (or vice versa) or from one floating rate to another called plain vanilla swap.

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Currency Swaps

Advantages
• Swaps are easy to arrange and are flexible since they can be arranged in any size and are reversible.
• Transaction costs are low, only amounting to legal fees, since there is no commission or premium to be paid.
• The parties can obtain the currency they require without subjecting themselves to the uncertainties of the
foreign exchange markets.
• The company can gain access to debt finance in another country and currency where it is little known, and
consequently has a poorer credit rating, than in its home country. It can therefore take advantage of lower
interest rates than it could obtain if it arranged the currency loan itself.
• Currency swaps may be used to restructure the currency base of the company's liabilities.
This may be important where the company is trading overseas and receiving revenues in foreign currencies,
but its borrowings are denominated in the currency of its home country. Currency swaps therefore provide a
means of reducing exchange rate exposure.
• At the same time as exchanging currency, the company may also be able to convert fixed rate debt to floating
rate or vice versa. Thus it may obtain some of the benefits of an interest rate swap in addition to achieving the
other purposes of a currency swap.

Disadvantages
• If one party became unable to meet its swap payment obligations, this could mean that the other party risked
having to make them itself.
• A company whose main business lies outside the field of finance should not increase financial risk in order to
make speculative gains.
• There may be a risk of political disturbances or exchange controls in the country whose currency is being used
for a swap.
• Swaps have arrangement fees payable to third parties. Although these may appear to be cheap, this is because
the intermediary accepts no liability for the swap. (However, the third party does suffer some spread risk, as it
warehouses one side of the swap until it is matched with the other, and then undertakes a temporary hedge
on the futures market.)

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Working Capital Management
Definition
Working capital is current assets less current liabilities. It is the capital available to conduct day to day operations of
business

Current Assets
 Inventory
 Receivables
 Cash

Current Liabilities
 Payables
 Overdraft

Liquidity
Liquidity is availability of cash for day to day activities.
 How it is ensured?
 By maintaining liquid assets and liabilities.
 E.g. Maintaining cash balance, having a line of credit

Liquidity Vs Profitability
 There is always a conflict between liquidity and profitability.
 If we maintain more liquid assets, profitability will be reduced.
 If we maintain less liquid assets, profitability will be increased as more assets are invested but risk of insolvency
increased

Working Capital Management

It is the management of both current assets and current liabilities to minimize risk of insolvency and to maximize
return on assets.

Objective:
Working capital facilitates two main objectives
 To ensure business has enough liquid resources to reduce risk of insolvency
 To increase return on assets

This can be achieved by holding optimum level of investments in working capital.

 To minimize investment in working capital, it will reduce the overdraft cost because lower funds will be required
 To minimize working capital cycle, by quickly moving items around working capital cycle.

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Working capital cycle

Measure in Days, Weeks and Months

Short Conversion Cycle is a good sign

Current Assets

Current Liabilities

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LIQUIDTY RATIOS

Current Ratio
It is used to assess the ability of business to pay, what it owes. It also indicates margin of safety.

This ratio depicts that how much we have in current assets to pay $1 of current liabilities.

Current Ratio of 2:1 is usually considered good.

This ratio depicts that how much we have in current assets to pay $1 of current liabilities.

Current Ratio of 2:1 is usually considered good.

Quick Ratio (Acid Test)

If we want to have a more conservative view of liquidity, we exclude inventory from current assets as it takes
longer to convert inventory into cash.

Quick Ratio of 1:1 is a sign

Current Ratio & Quick Ratio

Current ratio
Current assets
Current liabilities

Quick ratio
Current assets less inventory
Current liabilities

Accounts receivable payment period

Accounts receivable payment period or =Avg receivables x 365 days
Accounts receivable days Credit sales

Receivable turnover = Credit Sales (in times)

Average receivable

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Inventory Turnover Period
 Inventory turnover = Cost of sales (in times)
Average inventory

 Inventory turnover period (Finished goods)= Average inventory x365 days

Cost of sales
Where
 Average inventory = Opening balance + Closing balance
2

 Raw materials inventory holding period =Average raw materials x 365 day
Annual purchases

 Average work-in-progress period =Average WIP x 365days

Cost of sales×% of completion

 Generally closing balances will be considered as average balances.

 If not mentioned, all the sales and purchases are considered to be on credit.
 In the absence of purchases, Cost of sales will be used.
 If not given, all inventory will be considered as finished goods

Accounts payable payment period & Sales revenue/net working capital ratio
 Accounts payable payment period =Average trade payables x 365days
Purchases or cost of sales

 Payable turnover = Credit purchases ( in times)

Average payables

 Sales to Working capital ratio = Sales

Working Capital

Over Trading
“A business which is trying to do too much too quickly with too little long-term capital is overtrading”

Symptoms of over trading:

 Rapid increase in turnover.
 Rapid increase in the volume of current assets and possibly also non-current assets. High Inventory and accounts
receivable period.
 Only a small increase in equity capital. Most of the increase in assets is financed by credit, especially:
 Trade accounts payable

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 Bank overdraft
 Some debt and liquidity ratios alter dramatically.
 Current ratio and quick ratio fall
 Business might have a liquid deficit i.e. an excess of current liabilities over current assets.
 Proportion of total assets financed by equity capital falls and the proportion financed by credit rise.
 Sales/working capital ratio is increasing over time, working capital should increase in line with sales.

Solution to Overtrading
 New capital could be injected from shareholders The growth can be financed through long-term loans.
 Better control could be applied to management of inventories and accounts receivable.
 The company could postpone ambitious plans for increased sales and fixed asset investment.

Over Capitalized
“If there are excessive inventories, accounts receivable and cash and very few accounts payable, there will be an over-
investment by company in current assets and the company will be in this respect over-capitalized.”

Symptoms:
 Rapid increase in turnover.
 Rapid increase in the volume of current assets e.g. inventory and receivable .
 High Inventory and accounts receivable period.
 Not much rise in Trade accounts payable and overdraft.
 Current ratio and quick ratio rise significantly. Current assets are more than current liabilities
 Sales/working capital ratio is decreasing over time, working capital should be increased in line with sales.

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Inventory Management
Inventory Costs

Holding Costs Ordering costs Stock out costs Cost of inventory

Warehousing and Ordering costs Contribution from lost Purchase Cost

handling costs sales
Deterioration cost Delivery costs Extra cost of emergency
inventory
Obsolescence cost Freight Charges Reputation loss

Insurance cost

Pilferage cost

Economic Order Quantity

2×annual demand × per order cost/Holding cost per unit

EOQ focuses on two costs

Holding costs = Holding cost per unit × order quantity/2

Ordering Costs = per order cost × Annual demand/order quantity

EOQ Example
 Example:
Annual demand is 200,000 units
Per order cost is 20$
Holding cost is 0.2$ per unit
Purchase price is 1$/unit

Current order quantity= 50,000 units

 What is the total cost if order quantity remains at 50,000 ?

Purchase cost =1$×200,000=$200,000
Ordering cost=20$×200,000/50,000=80$
Holding cost=0.2×50,000/2=$5000
Total cost= $205080

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EOQ Example (Continued)
 What is the total cost of inventory if company follows EOQ model ?
EOQ=2×200,000×20/0.2 =60325
Ordering cost=20$×200,000/6325=632$
Holding cost=0.2×6325/2=$632
Total cost= $201,264

 Supplier has offered 1% discount if order quantity is at least 30,000 units What is the total cost if company
accept the supplier’s offer.?
Purchase cost =1$× 200,000×0.99=$198,000
Ordering cost=20$×200,000/30,000=133$
Holding cost=0.2×30,000/2=$3000
Total cost= $201,133

Assumptions of using EOQ

The following assumptions are applicable in EOQ which limits its applicability:
 Demand and lead time are assumed to remain constant.
 Purchase price is also assumed to remain
 No buffer inventory
 Holding costs are assumed to be constant.

Other formulas to remember

 Re-order level = Maximum usage x Maximum lead time
 Maximum inventory level
= Re-order level + re-order quantity – (minimum usage x minimum lead time)

 Buffer safety inventory = Re-order level – (average usage x average lead time)

 Average inventory level = Buffer safety inventory + Re-order amount

2

JIT (Just-in-Time) Procurement

 Just-in-time procurement is a term which describes a policy of obtaining goods from suppliers at the latest
possible time, so avoiding the need to carry any inventory level.
 The objective is zero inventory level which results in zero holding costs.

Advantages Disadvantages
Reduction in inventory holding costs Just-in-time manufacturing system is vulnerable to
unexpected disruptions in supply chain. A production
line can quickly come to a halt if essential parts are
unavailable
Reduced manufacturing lead times JIT can only be implemented in case of reliable
suppliers that are located close
Improved labor productivity
Reduced scrap/rework/warranty costs.

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Accounts Receivable Management
Major roles of credit control department/Receivable management.

To formulate credit policies

 Lenient policy
 Strict policy
 Early settlement discount

Assess credit worthiness of customers

Collection of debt from customers efficiently
Collection of overdue debt

Receivable as sources of finance

 Factoring
 Invoice discounting

Foreign receivable management

Cost of Receivable
o Administrative cost to record and collecting debts
o Cost of irrecoverable debts (Sales X % of bad debt)
o Cost of early Settlement Discount = (Sales X % of discount X % of customers taken the discount)
o Finance Cost (Average Receivable X % of interest rate)

Advantages and Disadvantages of using different polices for Receivables Management

Lenient Policy Strict policy

Advantages Increase in contribution Decrease in potential bad debt

Decrease in administration cost Less overdraft cost

Disadvantages Increase in potential bad debt Decrease in contribution

High overdraft cost Increase in administration cost

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How to tackle in Exam
Current Policy Proposed policy

𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔

Cost of receivables=(Credit sales x )× Cost of receivables=(Credit sales x )×
𝟑𝟔𝟓 𝟑𝟔𝟓
OD Interest rate OD Interest rate
Contribution =Sales × C/S ratio% Contribution =Sales × C/S ratio%

Bad debt = sales × % of bad debt Bad debt = sales × % of bad debt

Admin cost Admin cost

Total cost/Benefit Total cost/Benefit

Early Settlement Discount

Current Policy Proposed Policy
Cost of receivables=(Credit sales x
𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔
)× OD Cost of receivables availing discount
𝟑𝟔𝟓 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔
Interest rate =(Credit sales x )× % of availing discount x
𝟑𝟔𝟓
OD Interest rate
Contribution = Sales × C/S ratio% Cost of receivables not availing discount
𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔
=(Credit sales x )× % of not availing
𝟑𝟔𝟓
discount x OD rate
Bad debt=sales×% of bad debt Discount allowed= Sales × % of discount × % of availing
discount
Admin cost Contribution = Sales × C/S ratio%
Total cost Bad debt = sales × % of bad debt
Admin cost
Total cost

Cost of Early Settlement Discount

The percentage cost of early settlement discount to the company offering the discount can be calculated by the
following formula

100
Cost of early settlement discount= ( )^365/t -1
100−𝑑

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

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ASSESSING CREDITWORTHINESS methods

 Trade reference
 Bank reference This is obtained from another company who has
While a bank reference can be fairly easily dealings with your potential customer/customer. Due
obtained, it must be remembered that the to the litigious nature of society these days, it may not
other company is the bank’s customer and be so easy to obtain a written reference. However, you
so a bank reference will stick to the facts. It may be able to call contacts you have in the trade and
is most unlikely to raise any fears the bank obtain an informal oral reference
may have about the company

ASSESSING CREDITWORTHINESS methods

 Financial Statements
 Credit rating/reference agency Financial statements of a company are publicly available
These agencies’ professional business is information and can be quickly and easily obtained. While
to sell information about companies an analysis of the financial statements may indicate
and individuals. Hence, they will be whether or not a company should be granted credit, it
keen to give you the best possible must be remembered that the financial statements
information, so you are more likely to available could be out of date and may have suffered from
return and use their services again manipulation. For larger companies, an analysis of their
accounting information can generally be found through
various sources on the internet

ASSESSING CREDITWORTHINESS methods

 Visit
 Information from the financial media Visiting a potential new customer to discuss their exact
Information in the national and local needs is likely to impress the customer with regard to your
press, and in suitable trade journals and desire to provide a good service. At the same time, it gives
on the internet, may give an indication of you the opportunity to get a feel for whether or not the
the current situation of a company. For business is one which you are happy to give credit to. While
example, if it has been reported that a it is not a very scientific approach, it can often work quite
large contract has been lost or that one well, as anyone who runs their own successful business is
or more directors has left recently, then likely to know what a good business looks, feels and smells
this may indicate that the company has like!
problems

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Collection of Receivables

Collection of overdue debt

Collection of funds efficiently
 Instituting reminders or final demands
 The customer is fully aware of the terms  Chasing payment by telephone
 The invoice is correctly drawn up and  Making a personal approach
issued promptly.  Notifying debt collection section
 They are aware of any potential quirks in  Handling over debt collection to specialist debt
the customer’s system collection section
 Queries are resolved quickly  Instituting legal action to recover the debt
 Monthly statements are issued promptly  Hiring external debt collection agency to recover debt.

Debt Factoring
Factoring is an arrangement to have debts collected by a factor company, which advances a proportion of the
money it is due to collect.

Factoring can be used to help short-term liquidity or to reduce administrative costs.

Aspects of Factoring
The main aspects of factoring include the following
 Administration of the client’s invoicing, sales accounting and debt collection service.
 Credit protection for the client’s debts, whereby the factor takes over the risk of loss from bad debts ad so
insures the client against such losses. This is knows as non-recourse service.
 Making payments to the client in advance of collecting the debts. This is referred to as ‘factor finance’

Applying Debt Factoring

Before Factoring After factoring

𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔

Cost of receivables=(Credit sales x )× Cost of Factor advance =(Credit sales x )× %
𝟑𝟔𝟓 𝟑𝟔𝟓
OD Interest rate of factor advance x Factor Interest rate
Cost of remaining receivable
𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔
=(Credit sales x )× % of remaining finance x
𝟑𝟔𝟓
OD Interest rate
Bad debt = sales × % of bad debt Factor fee = Sales × % of fee

Bad debt = sales × % of bad debt ( if with recourse)

Admin cost Admin cost

Total cost Total cost

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Example of Debt Factoring
A company makes annual credit sales of $1,500,000. Credit terms are 30 days, but its debt administration has been
poor and the average collection period has been 45 days with 0.5% of sales resulting in bad debts which are written
off.

A factor would take on the task of debt administration and credit checking, at an annual fee of 2.5% of credit sales.
The company would save $30,000 a year in administration costs. The payment period would be 30 days.

It is assumed that the factor would advance an amount equal to 80% of the invoiced debts, and the balance 30 days
later.

The factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3% over the current
base rate). The company can obtain an overdraft facility to finance its accounts receivable at a rate of 2.5% over base
rate.

Required:
Should the factor's services be accepted? Assume a constant monthly turnover.

Solution (a)
The current situation is as follows, using the company’s debt collection staff and a bank overdraft to finance all debts.

Credit sales $1,500,000 pa

Average credit period 45 days

The annual cost is as follows: $

45/365 x $1,500,000 x 13.5% (11% + 2.5%) 24,966
Bad debts 0.5% x $1,500,000 7,500
Administration costs 30,000
Total cost 62,466

Solution (b)
The cost of the factor. 80% of credit sales financed by the factor would be 80% of $1,500,000 = $1,200,000. For a
consistent comparison, we must assume that 20% of credit sales would be financed by a bank overdraft. The average
credit period would be only 30 days. The annual cost would be as follows.

$
Factor’s finance 30/365 x $1,200,000 x 14% 13,808
Overdraft 30/365 x $300,000 x 13.5% 3,329
17,137
Cost of factor’s services: 2.5% x $1,500,000 37,500
Cost of the factor 54,637

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Solution (c)
Conclusion. The factor is cheaper. In this case, the factor’s fees exactly equal the savings in bad debts ($7,500) and
administration costs ($30,000). The factor is then cheaper overall because it will be more efficient at collecting debts.
The advance of 80% of debts is not needed, however, if the company has sufficient overdraft facility because the
factor’s finance charge of 14% is higher than the company’s overdraft rate of 13.5%.

Advantages & Disadvantages

Disadvantages
Advantages  Factoring is likely to be more costly than an
efficiently run internal credit control department.
 Business can pay its suppliers on time and so be  Customers may not like to deal with factors.
able to take advantage of early payment  Company loses control to decide to whom to grant
discounts. credit period and the length of credit period for each
 Optimum inventory level can be maintained customer
because management will have enough cash.  Once a company hires a factor, it is difficult to go
 Growth can be financed through sales rather than back to an internal credit control system again.
injecting new capital  Factoring may have a bad reputation for the
 The cost of running sales ledger department is company. It may indicate that the company has
over. financial issues.
 Business can use the expertise of debtor
management that the factor specializes.
 Management time is saved because managers
don’t have to spend their time on debtor
management.
 Business gets its finance linked to its volume of
sales

Invoice Discounting
Invoice discount is the purchase of trade debts at a discount by the providers of the discounting service.

Invoice discount and factoring are linked and mostly factors also provide invoice discounting service too. It involves
the purchase of a selection of invoices by the factor at a discount but the invoice discounter doesn’t take over
administration of the client’s sales ledger.
 Confidential invoice discounting is an arrangement whereby a debt is assigned to the factor confidentially and
the client’s customer will only become aware of the arrangement if he doesn’t pay his debt to client.
 Non-confidential invoice discount is an arrangement whereby the client’s customer is aware of the relationship
of factor to client and acknowledges its liability towards factor.

Managing Foreign Accounts Receivables

 REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE
 FORFAITING
 LETTER OF CREDIT
 COUNTERTRADING

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 EXPORT CREDIT INSURANCE
 EXPORT FACTORING

Managing Foreign Accounts Receivables

REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE
 A company can reduce its investment in foreign accounts receivable by asking for full or part payment in advance
of supplying goods. However this may be resisted by consumers, particularly if competitors do not ask for
payment up front.

Forfaiting
 Forfaiting involves the purchase of foreign accounts receivable from the seller by a forfaiter.
 The forfaiter takes on all of the credit risk from the transaction (without recourse) and therefore the forfaiter
purchases the receivables from the seller at a discount.
 The purchased receivables become a form of debt instrument (such as bills of exchange) which can be sold on
the money market.
 The non-recourse side of the transaction makes this an attractive arrangement for businesses, but as a result
the cost of forfaiting is relatively high.

LETTER OF CREDIT
This is a further way of reducing the investment in foreign accounts receivable and can give a business a risk-free
method of securing payment for goods or services.

There are a number of steps in arranging a letter of credit:

 Both parties set the terms for the sale of goods or services
 The purchaser (importer) requests their bank to issue a letter of credit in favor of the seller (exporter)
 The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once the conditions
specified in the letter have been complied with
 The goods are dispatched to the customer and the shipping documentation is sent to the purchaser’s bank
 The bank then issues a banker’s acceptance

Letter of Credit (Continued)

 The seller can either hold the banker’s acceptance until maturity or sell it on the money market at a discounted
value
 It takes significant amount of time and therefore are slow to arrange.
 The use of letters of credit may be considered necessary if there is a high level of non-payment risk.
 Customers with a poor or no credit history may not be able to obtain a letter of credit from their own bank.
Letters of credit are costly to customers and also restrict their flexibility:
 Collection under a letter of credit depends on the conditions in the letter being fulfilled. Collection only
occurs if the seller presents exactly the documents stated in the conditions.

COUNTERTRADING
In a countertrade arrangement, goods or services are exchanged for other goods or services instead of for cash.
The benefits of countertrading include the fact that it facilitates conservation of foreign currency and can help a
business enter foreign markets that it may not otherwise be able to.

107
Disadvantage
 The value of the goods or services received in exchange may be uncertain.
 It includes complex negotiations and logistical issues, particularly if a countertrade deal involves more than two
parties.

EXPORT CREDIT INSURANCE

Export credit insurance protects a business against the risk of non-payment by a foreign customer. Exporters can
protect their foreign accounts receivable against a number of risks which could result in non-payment. Export credit
insurance usually insures insolvency of the purchaser or slow payment, insures against certain political risks, for
example war, and riots.

Disadvantages include the relatively high cost of premiums and the fact that the insurance does not typically cover
100% of the value of the foreign sales.

EXPORT FACTORING
An export factor provides the same functions in relation to foreign accounts receivable as a factor covering domestic
accounts receivable and therefore can help with the cash flow of a business. However, export factoring can be more
costly than export credit insurance and it may not be available for all countries, particularly developing countries.

GENERAL POLICIES FOR FOREIGN ACCOUNTS RECEIVABLE

None of the methods detailed above would allow the selling company to escape from the basic fact that credit should
only be given to customers who are creditworthy.

Managing Accounts Payable

There are three main objectives of accounts payable management.
 Seeking satisfactory credit terms from suppliers.
 Extending credit period during periods of cash shortage.
 Maintaining good relationships with suppliers.

Trade Credit
The cost of lost cash discount can be calculated by the following formula
100
Cost of early settlement discount= ( ) ^365/t -1
100−𝑑

Example:
Product Q The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit
on 60 days credit. The supplier has offered an early settlement discount of 1% for settlement of invoices within 30
days.

Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365 days in each
year.

Calculate the net value in dollars to Plot Co of accepting the early settlement discount for Product Q.

108
Managing Cash
Objective of holding Cash:
John Maynard Keynes identified three reasons for holding cash.

 Transactions Motive:
Every business needs cash to meet its regular commitments of paying its accounts payable like employee wages,
taxes, annual dividends …

 Precautionary motive:
There is a need to maintain a ‘buffer of cash for unforeseen contingencies.

 Speculative Motive:
Sometimes businesses hold surplus cash as a speculative asset in the hope that interest rates will rise in future.

Problems associated with cash flows:

 Making losses
If a business is continually making losses, it will eventually have cash flow problems.

 Inflation
Even if a business is making a profit, it can still face cash flow problems in during period of inflation.

 Growth
During periods of growth, business has an ever increasing need for more non-current assets and for its increasing
working capital

 Seasonal business
When a business has seasonal or cyclical sales, it may have cash flow difficulties at certain times during the year.

 One-off items of expenditure

Sometimes, a single non-recurring item of expenditure may create a cash flow problem.

Managing Cash Flow Problems

Cash flow problems can be eased by taking a number of steps
 Postponing capital expenditure:
Some capital expenditures can be postponed for a year or so without serious effect on company’s long term
performance.

 Accelerating cash inflows:

Business can encourage its account receivables to pay early through discounts on early payments.

 Reversing past investments:

Some assets that are not crucial for business survival can be sold during period of severe cash flow problem

 Negotiations with accounts payable:

 This involves the following
 Longer credit can be taken from suppliers

109
  Loan repayments can be rescheduled through negotiations with bank
 Dividend payment can be reduced

Cash Flow Forecasts

Months 1 2 3 4
Cash Inflows
Receivable Collection X X X X
Dividends Received X X X X
Sale of non-current assets X X X X
Cash Outflow
Trade payable payment (X) (X) (X) (X)
Purchase of non-current assets (X) (X) (X) (X)
Wages (X) (X) (X) (X)
Net Cash Flows X X X X
Opening Balance X X X X
Closing Balance X X X X

Treasury Management
Treasury management can be defined as
 Corporate handling of all financial matters,
 The generation of external and internal funds for business,
 The management of currencies and cash flows,
 The complex strategies,
 Policies and procedures of corporate finance

Treasury department can be centralized or decentralized in an organization depending on its needs. Both have
certain advantages associated with them.

Advantages of Centralized Treasure Department

 Large volume of cash is available to invest, leading to better short-term investment opportunities.
 Borrowing can be arranged in bulk at lower interest rate.
 Foreign exchange risk management will be improved through matching foreign currency income earned by one
subsidiary with expenditure in the same currency by another subsidiary.
 Treasure management will be efficient because a centralized treasury department can employ experts.
 Liquidity management will be improved through centralized treasury department
 It avoids having a mix of cash surpluses and overdrafts in different localized banks
 It facilitates bulk cash flow which will result in less transaction costs.

110
Advantages of Decentralized Treasury Management
 Greater autonomy will be given to subsidiaries
 A decentralized treasury function may be more responsive to the needs of individual operating units.
 Sources of finance will be diversified

Objective of holding Cash:

John Maynard Keynes identified three reasons for holding cash.
 Transactions Motive: Every business needs cash to meet its regular commitments of paying its accounts payable
like employee wages, taxes, annual dividends …
 Precautionary motive: There is a need to maintain a ‘buffer of cash for unforeseen contingencies.
 Speculative Motive: Sometimes businesses hold surplus cash as a speculative asset in the hope that interest
rates will rise in future

Cash Management (The Baumol model)

The Baumol model is based on the idea that an optimum cash balance is like deciding an optimum inventory level.
It uses the same EOQ formula that is used to calculate the optimum inventory level

Q = 2CS
I
Where
Q = Optimum amount of cash to be raised
S = Amount of cash to be used in each time period
C = Cost per sale of securities
I = Interest cost of holding cash or near cash equivalents
(Interest rate on new borrowings – interest earned on cash investment)

EXAMPLE
Finder Co faces a fixed cost of $4,000 to obtain new funds. There is a requirement for $24,000 of cashover each
period of one year for the foreseeable future. The interest cost of new funds is 12% per annum; the interest rate
earned on short-term securities is 9% per annum.

Required:
How much finance should Finder raise at a time?

Solution
The cost of holding cash is 12% - 9% = 3%
The optimum level of Q (the ‘recorder quantity) is:

2 x 4,000 x 24,000 = $80,000

0.03
The optimum amount of new funds to raise is $80,000.

This amount is raised every 80,000 ÷ 24,000 = 31/3 years.

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Advantages & Disadvantages
Disadvantages
Advantages  It is unlikely to be possible to predict amounts required
 The Baumol model enables companies over future periods.
to find out their desirable level of cash  No buffer inventory of cash is allowed.
balance under certain assumed  There may be a number of other costs associated with
conditions. holding cash
 It recognizes the cost of holding extra
cash.

The Miller-Orr Model

The miller-Orr model focuses on an optimum amount of cash that a company should held which is called return
point. The model then sets an upper and lower limit of cash balances which should not be crossed. If a company
reaches an upper limit, it should buy market securities to return to the “return point” and if it reaches lower limit, it
should sell some securities to reach to the “return point”.

Calculating the Return Point

 Spread = 3 ( 3 x transaction cost x variance of cash flows )1/3
4 Interest rate

 Return point = Lower limit + ( 1 x Spread)

3

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Example
The following data applies to a company.
 The minimum cash balance is $8,000.
 The variance of daily cash flows is 4,000,000, equivalent to a standard deviation of $2,000 per
 The transaction cost for buying or selling securities is $50. The interest rate is 0.025 per cent day.

Required:
You are required to formulate a decision rule using the Miller-Orr model.

Solution
The spread between the upper and the lower cash balance limits is calculated as follows.

Spread = 3 ( 3x transaction cost x variance cash flows)1/3

4 interest rate

= 3 ( 3x 50 x 4,000,000)1/3 = 3 x (6 x 1011)1/3 = 3 x 8,434.33

4 0.00025

= $25,303, say $25,300

The upper limit and return point are now calculated.

Upper limit = Lower limit + $25,000 = $8,000 + $25,300 = $33,300
Return point = lower limit + 1/3 x spread = $8,000 + 1/3 x $25,300 = $16,433, say 16,400

The decision rule is as follows. If the cash balance reaches $33,300, buy $16,900 (= 33,300 – 16,400) in marketable
securities. If the cash balance falls to $8,000, sell $8,400 of marketable securities for cash.

Working Capital Investment Policy

A company can adopt a working capital strategy for managing its working capital depending on the important risks
associated with working capitals. It can choose from three different working capital strategies. These strategies are
as follows:
 Conservative Approach
 Aggressive Approach
 Rate Approach

Conservative Approach
“A conservative working capital management policy aims to reduce the risk of system breakdown by holding high
levels of working capital”
 Customers are allowed generous payments terms to stimulate demand,
 Finished goods inventories are high to ensure availability for customers,
 Raw material and work in progress are high
 Suppliers are paid promptly to ensure their goodwill.

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Aggressive & Management Approach
Moderate Approach
Aggressive Approach A moderate working capital management policy is a
“An aggressive working capital management middle way between the aggressive and conservative
policy aims to reduce financing cost and approaches.
increase profitability:
 by cutting inventories to kept it at
minimum level.
 speeding up collections:

Customers are allowed a limited payment

period and discounts are given for prompt
payment
 delaying payments to supplier.

Working Capital Financing Policy

Assets can be divided into three types in order to understand different working capital management strategies
 Non-current assets: These are long term assets from which an organization expects to derive benefit over a
number of periods. For example, plant and machinery
 Permanent current assets: This is the amount required to meet minimum long-term needs and sustain normal
trading activity. For example, inventory and average receivables…
 Fluctuating current assets: These are current assets which vary according to normal business activity. Example
include fluctuate in working capital due to seasonal variations

Conservative Approach
Policy A can be characterized as a conservative approach to finance working capital where all non-current assets,
permanent current assets and part of fluctuating current assets are financed by long-term funding

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Aggressive Approach
Policy B can be characterized as an aggressive approach to finance working capital where non-current assets and
some part of permanent current assets are financed through long-term borrowings while fluctuating current assets
and part of permanent current assets are financed through short-term sources

Moderate Approach
Policy C describes a balance between risk and return which might be best achieved by moderate approach. In this
case, long-term sources of finance are used to finance permanent current assets while short-term sources of finance
are used to finance fluctuating current assets.

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