Business Finance Seventh Edition Study Guide

FOUNDATION EXAMS
BUSINESS FINANCE
STUDY GUIDE
Foundation exam
Business Finance
ii |
Seventh edition 2019

First edition 2010
ISBN 9781 5097 2254 9

Previous ISBN 9781 4727 1457 2
Published by BPP Learning Media Ltd
All rights reserved. No part of this publication may

be reproduced or transmitted in any form or by any
means or stored in any retrieval system, electronic,
mechanical, photocopying, recording or otherwise
without the prior permission of the publisher.
The contents of this book are intended as a guide

and not professional advice. Although every effort
has been made to ensure that the contents of this
book are correct at the time of going to press, BPP
Learning Media, the Editor and the Author make no
warranty that the information in this book is accurate
or complete and accept no liability for any loss or
damage suffered by any person acting or refraining
from acting as a result of the material in this book.
Every effort has been made to contact the copyright

holders of any material reproduced within this
publication. If any have been inadvertently
overlooked, BPP Learning Media will be pleased to
make the appropriate credits in any subsequent
reprints or editions.
We are grateful to CPA Australia for permission to

reproduce the Learning Objectives, the copyright
of which is owned by CPA Australia.
Printed in Australia
This is printed on FSC accredited stock by an

FSC accredited printer.
©
BPP Learning Media Ltd 2019
INTRODUCTION | iii
CONTENTS
Page
INTRODUCTION
Foundation exams iv
Module features v
Preparing for your foundation exam vii
Module summary ix
Learning objectives xi
MODULES
1 Introduction to capital and money markets 1
2 Introduction to financial theories 21
3 Introduction to risk identification, assessment and management 49
4 Sources and cost of finance 73
5 Liquidity management 117
6 Capital structure and management 137
7 Cash flow valuation and investment 155
8 Market and credit risk management 209
9 Investment management 235
Revision questions 267
Answers to revision questions 285
Before you begin questions: Answers and commentary 297
Glossary of terms 309
Formulae and discount tables 321
Index 329
iv | BUSINESS FINANCE
FOUNDATION EXAMS
International Education Standards

CPA Australia is a member of the International Federation of Accountants (IFAC). All foundation exam
education materials are developed in line with IFAC's International Education Standards. These
standards provide guidance in establishing the content of professional accounting education
programs together with the associated assessment. The standards also assist in developing the
required passing standard for accounting education and competence of a professional accountant.
The foundation exams provide you with the opportunity to demonstrate your competence in areas
required for Associate membership of CPA Australia. By demonstrating this entry level knowledge you
will be well positioned to succeed at the CPA Program and ultimately attaining the CPA designation.
YOU AND YOUR STUDY PLAN
This study manual is designed to give you an understanding of what to expect in your exam as well as
covering the fundamentals that you need to know. Exams will be based on the contents of the current
study manual. You will need to check My Online Learning to confirm which version you should use
based on your exam date.
There are no specifically recommended hours of study. Each candidate brings their own level of
experience and knowledge to the foundation exams. The number of study hours required is entirely
dependent on your prior knowledge of the subject. You will need to develop your own study plan.
Refer to Preparing for foundation exams on page viii.
ADDITIONAL LEARNING SUPPORT
If you feel you have gaps in your knowledge after reviewing the study manual, there is a range of
optional additional support to assist in your exam preparation. Additional learning support caters for
different learning styles and budgets.
Please check the CPA Australia website for more information
http://www.cpaaustralia.com.au/learningsupport
STANDARDS AND LEGISLATION
The material in this study manual has been prepared based upon standards and legislation in effect as
at 1 November 2018. Candidates are advised that they should confirm effective dates of standards
and legislation when using additional study resources. Exams are based on the learning objectives
outlined within this study manual.
INTRODUCTION | v
MODULE FEATURES
Each module contains a number of helpful features to guide you through each topic.
Learning Show the referenced CPA Australia learning objectives.

objectives
Topic list Tells you what you will be studying in this module.
Introduction Presents a general idea of what is covered in this module.
Module summary Summarises the content of the module, helping to set the scene so that you
diagram can gain the bigger picture.
Before you begin This is a small bank of questions to test any pre-existing knowledge that you
may have of the module content. If you get them all correct then you may
be able to reduce the time you need to spend on the particular module.
There is a commentary section at the end of the Study Guide called Before
you begin questions: Answers and commentary.
Section overview This summarises the key content of the particular section that you are about
to start.
Learning objective This box indicates the learning objective covered by the section or
reference paragraph to which it relates.
LO
1.2
Definition Definitions of important concepts. You really need to know and understand
these before the exam.
Worked Example An illustration of a particular technique or concept with a solution or

explanation provided.
Question This is a question that enables you to practise a technique or test your
understanding. You will find the solution at the end of the module.
Key module points Review the key areas covered in the module.
Quick revision A quick test of your knowledge of the main topics in this module.
questions The quick revision questions are not a representation of the difficulty or
style of questions which will be in the exam. They provide you with an
opportunity to revise and assess your knowledge of the key concepts
covered in the materials so far. They are not a practice exam, but rather a
means to reflect on key concepts and not as the sole revision for the exam.
vi | BUSINESS FINANCE
Revision The revision questions are not a representation of the difficulty or style of
questions questions which will be in the exam. They provide you with an opportunity
to revise and assess your knowledge of the key concepts covered in the
materials so far. They are not a practice exam but rather a means to reflect
on key concepts and not as the sole revision for the exam.
Case study A practical example or illustration, usually involving a real world scenario.
Formula to learn Formulae or equations that you need to learn as you may need to apply
them in the exam.
Bold text Throughout the Study Guide you will see that some of the text is in bold
type. This is to add emphasis and to help you to grasp the key elements
within a sentence and paragraph.
INTRODUCTION | vii
PREPARING FOR YOUR FOUNDATION EXAM
STUDY PLAN
 Review all the learning objectives thoroughly. Use the topic exam weightings listed at the end of
the learning objective table (see Learning Objectives section) to develop a study plan to ensure
you provide yourself with enough time to revise each learning objective.
 Don't leave your study to the last minute. You may need more time to explore learning objectives
in greater detail than initially expected.
 Be confident that you understand each learning objective. If you find that you are still unsure after
reading the Study Guide, seek additional information from other resources such as text books,
supplementary learning materials or tuition providers.
STUDY TECHNIQUES
 In addition to being able to complete the revision and self-assessment questions in the Study
Guide, ensure you can apply the concepts of the learning objectives rather than just memorising
responses.
 Some exams have formulae and discount tables available to candidates throughout the exams. My
Online Learning lists the tools available for each exam.
 Check My Online Learning on a weekly basis to keep track of announcements or updates to the
Study Guide.
TIPS FOR EXAMS

 Plan to arrive at the exam centre at least 15 minutes before your exam. Allow for possible delays
with public transport or traffic.
 You have three hours and fifteen minutes to complete the exam. As soon as you commence the
exam your exam clock in the top right hand corner of the screen begins to count down. Watch your
time carefully.
ANSWERING MULTIPLE CHOICE QUESTIONS

Foundation exams are a series of 100 multiple choice questions. Each question will contain four
possible options.
Step 1 Attempt every question. Read the question thoroughly. You may prefer to work out the
answer before looking at the options, or you may prefer to look at the options at the
beginning. Adopt the method that works best for you.
Step 2 Read the four options and see if one matches your own answer. Be careful with numerical
questions, as some options are designed to match answers that incorporate common
errors. Check that your calculation is correct. Have you followed the requirement exactly?
Have you included every step of the calculation?
Step 3 You may find that none of the options matches your answer.
 Re-read the question to ensure that you understand it and are answering the
requirement
 Eliminate any obviously wrong answers
 Consider which of the remaining answers is the most likely to be correct and select
the option
viii | BUSINESS FINANCE
Step 4 If you are still unsure, you can flag the question and continue to the next question. Some
questions will take you longer to answer than others. Try to reduce the average time per
question, to allow yourself to revisit problem questions at the end of the exam.
Revisit unanswered questions. A review tool is available at the end of the exam, which
allows you to Review Incomplete or Review Flagged questions. When you come back to a
question after a break you often find you are able to answer it correctly straight away. You
are not penalised for incorrect answers, so never leave a question unanswered!
COMPUTER-BASED EXAM NAVIGATION

Your computer-based exam has the following functions:
 Navigation
– You can select your answer by: clicking on the circle to the left of the option, or typing the
letter corresponding to the option.
– To move through the exam, you use the 'Next' or 'Previous' buttons on the bottom of the
screen. The function of each button is selected by your mouse, or with a combination of
keyboard keys. For example, you can select the 'Next' button by clicking it with the mouse,
or by typing ALT + N.
– The 'Next' button moves you from one screen to the next screen. If you wish to go back
and view the screen you just viewed, click the 'Previous' button or type ALT + P.
– There is also a 'Navigator' button on the bottom of the screen which allows you to click
ahead to any question in the exam. This button can be accessed using your mouse or
ALT + V. 'Navigator' allows you to see a list of all questions and their status including
'Incomplete'/'Complete' and 'Unseen'. Any questions you have flagged for review will also
be shown in this view.
 Select for review
– There is a flag in the upper right corner of your exam screen labelled 'Flag for Review'.
Alternatively you can use ALT + F to flag a question. You mark an exam question to review
at a later time by clicking on this flag. The flag will appear filled-in once it is selected. You
may mark any exam question for later review, whether you select an answer or not.
 Review Screen
– After finishing the last exam question, you will see a review screen. This lists every exam
question. If you clicked the 'Flag for Review' flag on a question screen, that question
appears on the Review Screen marked with the flag filled in.
– If you skipped any exam questions, these will be labelled as 'Incomplete' even if you did
not select them for review.
– From the Review Screen you can choose to:
1. review all of the questions in the exam by clicking 'Review All';
2. individually select questions for review (click on the question number) or choose more
questions for review (click on the flags corresponding to the questions);
3. review all questions marked as incomplete by clicking 'Review Incomplete';
4. begin reviewing the selected review questions by clicking 'Review Flagged'; or
5. exit by clicking 'End Review' – this will also end your exam.
INTRODUCTION | ix
MODULE SUMMARY
This section provides a snapshot of each of the modules, to help you put the syllabus as a whole, and
the Study Guide into perspective.
MODULE 1 – INTRODUCTION TO CAPITAL AND MONEY MARKETS

In this module we introduce the framework of markets and institutions through which the financing of
a business takes place as well as regulation and the role of government. Capital markets provide a
source of funds and an exit route for investors.
MODULE 2 – INTRODUCTION TO FINANCIAL THEORIES

This module introduces and explains some fundamental financial theories that we shall come back to
throughout the rest of our Business Finance studies.
We begin by looking at some financial mathematics and material relevant to investment decision
making. Understanding the impact of the time value of money on cash flows and knowing which cash
flows are relevant for making investment decisions are very important and form the basis of our further
study in Module 7.
We will then look at the Capital Asset Pricing Model (CAPM). CAPM has a number of uses, but in
particular, it can be used to calculate a discount rate or cost of equity that incorporates risk. This has
relevance to investment decisions which we shall see in Module 7, but also in regards to the valuation
of shares and construction of investment portfolios that we shall study in Module 9.
Finally, we shall explore a key rationale for share price movement, the efficient market hypothesis,
which provides an explanation of how markets take into account new information. As with CAPM, we
shall build on this knowledge in Module 9.
MODULE 3 – INTRODUCTION TO RISK IDENTIFICATION,

ASSESSMENT AND MANAGEMENT
The module begins by considering what risk and uncertainty are before setting out an overview of risk
in international trade. The module then looks at the main specific types of risk that a business will face
including that of foreign currency and interest rate risk. Once identified, the potential impact of the
risk must be assessed and a number of risk assessment techniques will be explained.
Finally, the module introduces the concept of risk management and the various attitudes to risk that a
business may take. Advanced methods of dealing with foreign currency and interest rate risks
including derivatives will be dealt with in Module 8.
MODULE 4 – SOURCES AND COST OF FINANCE

This module focuses on two broad areas, the sources of finance available to a business and the cost of
those types of finance. We shall therefore consider the various types of finance before moving on to
calculating their associated costs.
We shall also look at what the capital structure of a business is and the importance of a company
selecting an appropriate balance between debt capital and equity capital and the balance between
short-term and long-term finance. We shall consider capital structure further in Module 6.
Finally we shall introduce a fundamental calculation that is important to calculating the cost of
business finance, the Weighted Average Cost of Capital (WACC).
x | BUSINESS FINANCE
MODULE 5 – LIQUIDITY MANAGEMENT

This module covers the crucial topic of liquidity management and the link between working capital
and liquidity. It explains the objectives and role of working capital management, the cash operating
cycle and its implications for the management of cash, accounts receivable and payable and
inventories. Strategies for financing working capital are also considered.
MODULE 6 – CAPITAL STRUCTURE AND MANAGEMENT

This module builds on the introduction to regulation and government covered in Module 1 and
capital structure in Module 4. It considers the optimal capital structure for a given organisation and the
management of an organisation’s long-term financing and dividend policy.
MODULE 7 – CASH FLOW VALUATION AND INVESTMENT

Companies are faced with a variety of possible investment opportunities which involve paying out
cash now, in anticipation of receiving cash inflows in the future. Managers of companies need a basis
for deciding whether to accept or reject each possible opportunity. This module builds on material
studied in Module 2 (relevant cash flows, time value of money and CAPM) and considers the four main
appraisal techniques: the return on investment, internal rate of return, payback period and net present
value.
The module continues by looking at how the investment decision can be made, including building on
our study of WACC in Module 4 as we see how WACC can be applied in regards to capital budgeting.
MODULE 8 – MARKET AND CREDIT RISK MANAGEMENT

This module builds on knowledge acquired in Module 3 where we considered the various risks facing
a business and introduced some of the techniques that can be applied to manage these risks. In this
module we examine how credit risk can be managed as well as the use of derivatives as a tool for
transferring risk. We shall also consider the costs and benefits of some of the key products you will
come across on the Australian Stock Exchange (ASX).
MODULE 9 – INVESTMENT MANAGEMENT

This final module pulls together knowledge built up through our study of business finance. In
particular we shall consider the impact of CAPM and EMH on investment management. Following on
from this we shall discuss portfolio theory (the structuring of investment portfolios) and investor
preferences.
INTRODUCTION | xi
LEARNING OBJECTIVES
CPA Australia's learning objectives for this Study Guide are set out below. They are cross-referenced
to the module in the Study Guide where they are covered.
GENERAL OVERVIEW
This exam covers the understanding of business finance and treasury function including the
fundamental concepts of capital, investment, funding and risk assessment and management. It also
covers the analysis and management of an entity's financial position, portfolio management, and short
and long term financial management.
Module Learning Objectives (LO) Weighting

Module One: 1.1 Specify the function and structure of the financial markets
Introduction to capital and the role of the various market participants
and money markets 1.2 Discuss regulation in the finance industry 7%
1.3 Describe sources of international finance

Module Two: 2.1 Interpret the future and present values of a series of single
Introduction to financial cash flows and of annuities
theories 2.2 Demonstrate the relationship between systematic risk and
expected return of individual securities and portfolios
using the Capital Asset Pricing Model (CAPM) and the
security market line relationship
2.3 Distinguish between the weak form test, the semi strong
13%
form test and the strong form test of the Efficient Market
Hypothesis (EMH)
2.4 Explain the implications of market efficiency for both
investors and companies
2.5 In the context of capital markets distinguish between
operating efficiency, allocative efficiency and pricing
efficiency
Module Three: 3.1 Define the term risk
Introduction to risk
3.2 Describe the different types of risk in international trade
identification,
assessment and 3.3 Explain the different methods of risk assessment in 13%
management international trade
3.4 Identify the key financial risks facing a business
Module Four: Sources 4.1 Identify the characteristics, terms and conditions of the
and cost of finance alternative sources of short, medium and long term
finance
4.2 Evaluate the suitability of different methods of finance in a
given scenario
4.3 Analyse the cost of various sources of finance
18%
4.4 Explain the different sources of long term finance
4.5 Apply the concepts of financial mathematics to loans, and
debt and equity securities with the use of effective interest
rates
4.6 Calculate and interpret the weighted average cost of
capital (WACC)
xii | BUSINESS FINANCE

Module Five: Liquidity 5.1 Analyse the various sources of short term finance
management
5.2 Demonstrate the link between working capital
management and corporate cash flow
5.3 Describe the operating cycle in working capital 11%
management to explain inventory management, debtor
management and cash management
5.4 Prepare short term finance plans and strategies
Module Six: Capital 6.1 Describe the impact of the external financial markets
structure and 6.2 15%
Explain the factors which influence the dividend policy
management
decision
Module Seven: Cash flow 7.1 Explain the characteristics of major long-term investments
valuation and investment where a 'capital budgeting' approach might be required
7.2 Apply different quantitative methods used in project
evaluation
7.3 Compare and contrast the ROI, IRR, payback and NPV
methods of investment appraisal
7.4 Explain why investment decisions should be analysed
using the NPV method
7.5 Apply the NPV method to investment project scenarios
10%
7.6 Select investment appraisal techniques which are
appropriate to the objectives and circumstances of a
given organisation taking account of working capital,
inflation and tax
7.7 Undertake a sensitivity analysis of diverse projects using
appropriate tools
7.8 Analyse capital rationing and draw appropriate
conclusions
7.9 Calculate the weighted average cost of capital and apply
it in capital budgeting
Module Eight: Market 8.1 Describe the characteristics of derivatives and other
and credit risk hedging instruments
management 8.2 Apply different methods of managing currency risks
8.3 Select methods of managing interest rate exposure
8%
8.4 Identify the advantages and disadvantages of different
hedging strategies
8.5 Identify different methods of hedging which are
appropriate to meeting an organisation's objectives
INTRODUCTION | xiii

Module Nine: 9.1 Demonstrate the relationship between systematic risk and
Investment management expected return of individual securities and portfolios
using the Capital Asset Pricing Model (CAPM) and the
security market line relationship
9.2 Distinguish between the weak form test, the semi strong
form test and the strong form test of the Efficient Market
Hypothesis (EMH)
9.3 Explain the implications of market efficiency for both
investors and companies
9.4 In the context of capital markets distinguish between
operating efficiency, allocative efficiency and pricing
efficiency 5%
9.5 Analyse measures of expected return and risk using the
probability distribution approach
9.6 Analyse and interpret rates of return on financial
investments
9.7 Analyse measures of expected return and risk for two-
security portfolios
9.8 Analyse share price in both perfect and imperfect markets
9.9 Explain the impact of portfolio leveraging and short
selling on the risk and expected return of two-security
portfolios
9.10 Assess portfolio risk
xiv | BUSINESS FINANCE
1
MODULE 1
INTRODUCTION TO
CAPITAL AND MONEY
MARKETS
Learning objectives Reference
Specify the function and structure of the financial markets and the role of the various LO1.1
market participants
Discuss regulation in the finance industry LO1.2
Describe sources of international finance LO1.3
Topic list
1 Introduction to the financial markets

2 Financial intermediaries
3 Exchange rates
4 Regulation and the role of the government
5 The stock market
6 International financial markets
2 | BUSINESS FINANCE
MODULE OUTLINE
In this module we introduce the basic framework and function of capital and money markets and the
financial instruments that are traded on them. We shall also look at some of the institutions through
which the financing of a business takes place. Capital markets provide a source of funds and an exit
route for investors.
The module content is summarised in the diagram below.
International markets Participants

Eurocurrency Individuals
Capital markets
Eurobonds Companies
Government
Financial intermediaries
– Banks
Regulation – Building societies
Role of government – Institutional investors
ASIC – Finance houses
APRA
Money markets Capital markets

(short-term) long term, e.g. ASX, NSX
Debt (bond market)
Equity (stock market)

Official – RBA Unofficial
Inter-company
Commercial paper
Primary market Secondary market

Raise funds Trade existing securities
INTRODUCTION TO CAPITAL AND MONEY MARKETS | 3
BEFORE YOU BEGIN
If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
MODULE 1
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study Guide.
1 What is the difference between a money market and a capital market? (Section 1.2, 1.3)
2 Explain the characteristics of equity and debt securities. (Section 1.3)
3 What is the difference between a primary and secondary market? (Section 1.5)
4 What is Over The Counter (OTC) trading? (Section 1.6)
5 What is a financial intermediary? (Section 2.1)
6 Name any two roles that the government undertakes in relation to the financial
markets. (Section 4.2)
1 INTRODUCTION TO THE FINANCIAL MARKETS
LO
1.1 Section overview
 Money markets are markets for short-term capital.
 Capital markets are markets for long-term capital.
 The main capital market in Australia is the Australian Securities Exchange (ASX).
 A stock market acts as a primary market (i.e. where securities (debt and equities) are issued
for the first time) and as a secondary market for the trading of existing securities (i.e. shares
and bonds).
1.1 THE ROLE AND STRUCTURE OF FINANCIAL MARKETS

The primary role of the financial market is to provide a medium of exchange where funds transfers can
take place between individuals, firms and governments. Funds can flow directly between borrowers
and lenders or through third parties known as financial intermediaries.
Financial market participants commonly distinguish between the 'capital market' and the 'money
market'. The money market refers to borrowing and lending for periods of up to a year, whereas the
capital market exists for the trading of longer term financial instruments.
Figure 1.1: Differences between loan terms
Y ear 0 Y ear 1 Year 5 Y ear 10
term
Short term
Medium term
Long term
1.2 THE MONEY MARKETS

Money markets are markets for:
 Trading short-term financial instruments
 Short-term lending and borrowing
The money markets are operated by the banks and other financial institutions. They facilitate
short-term financing and provide liquidity for short-term assets. Although the money markets largely
involve borrowing and lending by banks, some large companies, as well as the government, are
involved in money market operations.
The inter-bank market is a market for very short term borrowing, often overnight, between banks.
The key financial instruments traded are:
 Cash deposits – money in the bank accounts of banks and other financial intermediaries, offering a
range of different investment periods and rates of return.
 Negotiable instruments – a piece of paper representing ownership of debts and obligations. The
ownership is passed on with the delivery of the piece of paper. Negotiable instruments traded in
the money market include 90- and 180-day bills of exchange, promissory notes and certificates
of deposit, which are written orders promising to pay a specified sum of money at a predetermined
time to the order of a specified person or bearer.
 Treasury notes – a short-term debt instrument issued through the Reserve Bank of Australia (RBA),
by the Australian Government. Treasury notes are issued on a tender basis for periods of 5, 13 and
26 weeks, at a discount from face value. The notes are highly negotiable and are aimed at
professional short-term money market investors rather than the ordinary individual.
 Commercial bills – IOUs issued by large companies which can be held to maturity or sold to third
parties before maturity.
 Fixed interest short term bonds.
1.2.1 OFFICIAL AND UNOFFICIAL MONEY MARKETS

Definition
The official money market is the market supported and sponsored by the Reserve Bank of Australia
(RBA), which is responsible for the conduct of monetary policy, the issue of bank notes and the setting
and management of Australia's foreign exchange reserves.
MODULE 1
Features of the official money market are as follows:
 Authorised dealers trade in government securities.
 RBA provides lender of the last resort facilities to authorised dealers.
 Government implements monetary policy changes.
The unofficial money market is less formally organised and does not have official RBA support.
It comprises:
 the intercompany market – involving direct lending between companies
 the commercial paper market – intermediary trading of commercial bills, promissory notes and
negotiable certificates.
1.3 THE CAPITAL MARKETS

Capital markets are markets for trading in long-term finance, in the form of long-term financial
instruments such as equities and corporate bonds. Stock markets and bond market are capital
markets. The main capital market in Australia is the Australian Securities Exchange (ASX).
Firms obtain long-term or medium-term capital in one of the following ways:
 They may raise share capital (equity). Most new issues of share capital are in the form of ordinary
share capital. Firms that issue ordinary share capital are inviting investors to take an equity stake in
the business, or to increase their existing equity stake.
 They may raise loan capital (debt). Long-term loan capital might be raised by issuing corporate
securities in the form of loan notes, corporate bonds, debentures, unsecured and convertible
bonds.
These may be issued domestically or in foreign capital markets.
Definitions
Equity securities consist primarily of ordinary shares which entitle the owner to a share of the
company's profits and give them voting rights.
Debt securities are typically fixed interest borrowings with a set repayment date, often secured on
the assets of the company.
1.4 CAPITAL MARKET PARTICIPANTS

The various participants in the capital markets are summarised in Figure 1.2 below:
Figure 1.2: Participants in the capital market
Capital markets
Demand for funds Suppliers
comes from... INTERMEDIARIES of funds
INDIVIDUALS Banks INDIVIDUALS
(e.g. housing/consumer (as savers and
goods finance) Building societies investors)
Insurance companies
and pension funds FIRMS
FIRMS
Unit trust/investment (with long-term
(share capital; loans)
trust companies funds to invest)
Stock exchanges
GOVERNMENT GOVERNMENT
Venture capital
(budget deficit) (budget surplus)
organisations
1.4.1 INSTITUTIONAL INVESTORS

Institutional investors are institutions which have large amounts of funds which they want to invest.
They will invest in stocks and shares or any other assets which offer satisfactory returns and security.
They may also lend money to companies directly. The major institutional investors in Australia are
superannuation funds and insurance companies and they are the biggest investors on the stock
market.
1.5 FUNCTIONS OF THE STOCK MARKET

A stock market acts as a primary market for raising finance, and as a secondary market for the
trading of existing securities.
Definitions
The primary market is the market where securities (debt and equity) are issued for the first time.
The secondary market is the market where securities which have been issued in the primary market
are traded.
The stock markets serve two main purposes:

 As primary markets they enable organisations to raise new finance, by issuing new shares or new
bonds. A company must have public company status to be allowed to raise finance from the public
on a capital market.
 As secondary markets they enable existing investors to sell their investments, should they wish to
do so. The marketability of securities is a very important feature of the capital markets, because
investors are more willing to buy stocks and shares if they know that they could sell them easily.
These are the main functions of a stock market, but there are two other important ones.
 When a company comes to the stock market for the first time, and 'floats' its shares on the market,
the owners of the company can realise some of the value of their shares in cash. The owners will
offer a proportion of their personally-held shares for sale to new investors.
 When one company wants to take over another, it is common to do so by issuing shares to finance
the takeover. Takeovers by means of a share exchange are only possible if the shares that are
offered can be readily traded on a stock market, and so have an identifiable market value.
Question 1: Markets
What is the difference between the primary and the secondary market on the stock exchange?
(The answer is at the end of the module.)
1.6 AUSTRALIAN CAPITAL MARKETS
MODULE 1
1.6.1 THE EQUITY MARKET
As we have seen in Section 1.3, the equity market is where companies raise finance by issuing shares
for investors to purchase and where investors buy and sell shares which have already been issued.
1.6.2 THE BOND MARKET

The Australian bond market has, until relatively recently, been dominated by the borrowing
requirements of the Federal Government. Banks, life insurance companies and superannuation funds,
who until the 1980s, were required to hold prescribed percentages of their assets in public sector
securities, absorbed most of the debt issued by governments. In more recent times the bond market
has grown in importance as a source of finance for the private sector.
1.6.3 THE FOREIGN EXCHANGE MARKETS

Foreign exchange is a major sector in the Australian financial markets. The Australian dollar is one of
the most actively traded currencies in the world (after the US dollar, yen, euro and Swiss franc).
1.6.4 DERIVATIVES MARKETS

Derivatives markets allow market participants to fix today the price at which trades will be made in the
future. Efficient derivatives markets allow financial market participants to manage risk. The Sydney
Futures Exchange (SFE), which is now part of the ASX, provides derivatives in interest rates, equities,
currencies and commodities.
1.6.5 OVER-THE-COUNTER (OTC) MARKETS

Over-the-counter (OTC) or off-exchange trading refers to financial instruments such as stocks, bonds,
commodities or derivatives which are traded directly between two parties, as opposed to via an
exchange. Major products traded on OTC markets in Australia include government debt securities,
corporate debt securities, currency and derivative instruments.
2 FINANCIAL INTERMEDIARIES
LO
 A financial intermediary links those with surplus funds (e.g. lenders) to those with funds
deficits (e.g. potential borrowers) so providing aggregation and economies of scale, risk
pooling and maturity transformation.
2.1 FINANCIAL INTERMEDIATION

Definition
A financial intermediary is an institution which links lenders with borrowers, by obtaining deposits
from lenders and then re-lending them to borrowers.
Figure 1.3: The role of financial intermediation
Person Surplus unit
Funds Savings
Bank Financial intermediary
Funds Collective deposits of savings
Company Deficit unit
Not all intermediation takes place between savers and investors. Some institutions act mainly as
intermediaries between other institutions. Financial intermediaries may also lend abroad or borrow
from abroad.
2.1.1 EXAMPLES OF FINANCIAL INTERMEDIARIES

 Commercial banks are the major holders of public savings and the providers of loans to individuals
and companies.
 Building societies and credit unions use savings from individuals (members) to provide mortgages
and consumer credit.
 Institutional investors include pension funds, insurance companies and investment trusts.
 Finance houses raise funds through borrowing and debentures and provide short-term and
long-term finance to firms and individuals (e.g. major providers of lease finance).
 Merchant and investment banks mobilise and allocate funds of large denominations for major
projects or investments.
2.2 THE BENEFITS OF FINANCIAL INTERMEDIATION

Financial intermediaries perform the following functions:
 They provide obvious and convenient ways in which a lender can save money. Instead of having to
find suitable borrowers for their money, lenders can deposit their money with a financial
intermediary. All the lender has to do is decide how long to lend the money for, and what sort of
return is required. They can then choose a financial intermediary that offers a financial instrument
to suit their requirements.
 Financial intermediaries also provide a ready source of funds for borrowers. Even when money is in
short supply, a borrower will usually find a financial intermediary prepared to lend some.
 They can aggregate or 'package' the amounts lent by savers and lend on to borrowers in different
amounts.
 Risk for individual lenders is reduced by pooling. Since financial intermediaries lend to a large
number of individuals and organisations, any losses suffered through default by borrowers or
capital losses are effectively pooled and borne as costs by the intermediary. Such losses are shared
among lenders in general.
 By pooling the funds of a large number of people, some financial institutions are able to give
investors access to diversified portfolios covering a varied range of different securities, such as unit
trusts and investment trusts.
 Financial intermediaries, most importantly, provide maturity transformation; they bridge the gap
between the wish of most lenders for liquidity and the desire of most borrowers for loans over
longer periods.
3 EXCHANGE RATES
LO
 Factors influencing the exchange rate include the comparative rates of inflation in different
MODULE 1
countries (purchasing power parity), comparative interest rates in different countries
(interest rate parity), the underlying balance of payments, speculation and government
policy on managing or fixing exchange rates.
3.1 EXCHANGE RATES

Definitions
An exchange rate is the price of a currency in terms of another currency.

The spot rate is the rate of exchange in currency for immediate delivery.
The forward rate is an exchange rate set now for currencies to be exchanged at a future date.
Every traded currency in fact has many exchange rates. There is an exchange rate with every other
traded currency on the foreign exchange markets. Foreign exchange dealers make their profit by
buying currency for less than they sell it, and so there are really two exchange rates, a selling rate and
a buying rate.
3.1.1 FACTORS AFFECTING EXCHANGE RATES

Factors influencing the exchange rate include the comparative rates of inflation in different countries
(purchasing power parity), comparative interest rates in different countries (interest rate parity), the
underlying balance of payments, speculation and government policy on managing or fixing exchange
rates.
The exchange rate between two currencies (i.e. the buying and selling rates, both 'spot' and 'forward') is
determined primarily by supply and demand in the foreign exchange markets. Demand comes from
individuals, firms and governments who want to buy a currency and supply comes from those who want to
sell it.
Supply and demand for currencies are in turn influenced by:
 the rate of inflation, compared with the rate of inflation in other countries
 interest rates, compared with interest rates in other countries
 the balance of payments
 sentiment of foreign exchange market participants regarding economic prospects
 speculation
 government policy on intervention to influence the exchange rate.
Question 2: Exchange rates
What are the influences on foreign exchange rates?

3.2 FOREIGN EXCHANGE DEMAND

If a company which imports goods has to pay a foreign supplier in a foreign currency, the importer
might ask the bank to sell it the required amount of the currency. For example, suppose that a bank's
customer, a trading company, has imported goods for which it must now pay USD 10 000.
 The company will ask the bank to sell it USD 10 000. If the company is buying currency, the bank is
selling it.
 When the bank agrees to sell USD 10 000 to the company, it will tell the company what the spot
rate of exchange will be for the transaction. If the bank's selling rate (known as the 'offer', or 'ask'
price) is, say USD 0.9079 per AUD 1.00 for the currency, the bank will charge the company:
10 000 / 0.9079 = AUD 11 014.42
Similarly, if an exporter is paid, say, $10 000 by a foreign customer in the US, the company may wish to
exchange the US dollars to obtain Australian dollars. The exporter will therefore ask the bank to buy
the US dollars. Since the exporter is selling currency to the bank, the bank is buying the currency.
If the bank quotes a buying rate, known as the bid price of, say USD 0.9129 per AUD 1.00, for the
currency the bank will pay the exporter: 10 000 / 0.9129 = AUD 10 954.10
A bank expects to make a profit from selling and buying currency, and it does so by offering a rate for
selling a currency which is different from the rate for buying the currency.
If a bank were to buy a quantity of foreign currency from a customer, and then were to re-sell it to
another customer, it would charge the second customer more (in Australian dollars) for the currency
than it would pay the first customer. The difference would be profit. For example, the figures used for
illustration in the previous paragraphs show a bank selling some US dollars for AUD 11 014.42 and
buying the same quantity of US dollars for AUD 10 954.10, at selling and buying rates that might be in
use at the same time. The bank would make a profit of AUD 60.32.
3.3 THE FOREIGN EXCHANGE (FX) MARKETS

Banks buy currency from customers and sell currency to customers – typically, exporting and
importing firms. Banks may buy currency from the government or sell currency to the government –
this is how a government builds up its official reserves. Banks also buy and sell currency between
themselves.
International trade involves foreign currency, for either the buyer, the seller, or both. For example, a
Saudi Arabian firm might sell goods to a European buyer and invoice for the goods in US dollars. So it
is quite likely that exporters might want to sell foreign currency earnings to a bank in exchange for
domestic currency, and that importers might want to buy foreign currency from a bank in order to pay
a foreign supplier.
Since most foreign exchange rates are not fixed but are allowed to vary, rates are continually
changing. Each bank will offer new rates for new customer enquiries according to how its dealers
judge the market situation.
4 REGULATION AND THE ROLE OF THE

GOVERNMENT
LO
 Well functioning financial markets require a regulatory system, administered by a capable
regulatory authority.
 The aim of an efficient regulatory system is to protect investors while minimising
interference in the market that might distort market price signals and investment decisions.
 The government plays a vital role in the functioning of the capital market as borrower and
lender, financial intermediary (via the RBA), regulator of financial activities and source of
ultimate liquidity.
4.1 REGULATORY FRAMEWORK

Well functioning financial markets require a regulatory system, administered by a capable regulatory
authority.
The aim of an efficient regulatory system is to protect investors from fraud and unfair practices, while
minimising interference in the market that might distort market price signals and investment decisions.
Regulation should ensure property rights are clearly defined and information is available and
MODULE 1
transparent.
Typical areas covered by guidelines might include:
 market codes of conduct
 participant standards and accreditation
 licensing and authorisation of dealers
 misleading or deceptive conduct
 false or misleading statements
 fraud and unfair practices.
Corporations law includes provisions relating to the trading of corporate and government debt.
4.2 THE ROLE OF THE GOVERNMENT

The government plays a vital role in the functioning of the capital market as:
 borrower and lender
 financial intermediary (via the RBA)
 regulator of financial activities
 source of ultimate liquidity.
4.3 REGULATION
Regulation is intended to protect the interests of investors and is primarily undertaken by both the:
 Australian Securities and Investments Commission (ASIC)
 Australian Prudential Regulation Authority (APRA)
4.3.1 AUSTRALIAN SECURITIES AND INVESTMENTS COMMISSION (ASIC)

ASIC is an independent Federal Government Statutory body which acts as Australia's corporate,
markets and financial services regulator.
ASIC enforces and administers Corporations law and Consumer Protection law for investments, life
and general insurance, superannuation and banking (except lending) throughout Australia. Its purpose
is to reduce fraud and unfair practices in financial markets and financial products so consumers use
them confidently and companies and markets perform effectively.
Its roles include the following:
 As the corporate regulator, it is responsible for ensuring that company directors and officers carry
out their duties honestly, diligently and in the best interests of their company.
 As the markets regulator, it assesses how effectively authorised financial markets are complying
with their legal obligations to operate fair, orderly and transparent markets.
 As the financial services regulator, it licenses and monitors financial services businesses to ensure
that they operate efficiently, honestly and fairly. These businesses typically deal in superannuation,
managed funds, shares and company securities, derivatives, and insurance.
4.3.2 AUSTRALIAN PRUDENTIAL REGULATION AUTHORITY (APRA)

APRA is the prudential regulator of the Australian financial services industry, funded largely by the
industries that it supervises.
It oversees banks, credit unions, building societies, insurance and life insurance companies, and most
members of the superannuation industry through the ASX Market Rules, ACH Clearing Rules and ASIC
Settlement Rules, which are collectively referred to as the ASX Business Rules.
4.3.3 AUSTRALIAN SECURITIES EXCHANGE (ASX)

The Australian Securities Exchange (ASX) is sometimes referred to as one of 'the regulators' of
financial market activity in Australia, however it is not a regulatory body with powers conferred by the
government, like ASIC or APRA.
The ASX is a regulated commercial organisation that under the terms of its licence is required to
supervise and monitor specific aspects of the businesses of other organisations, for example, the
governance of listed companies and the on-exchange or on-market trade execution by brokers. It
monitors compliance with listing rules, clearing and settlement rules, and the standards of conduct of
those participating in its markets.
4.3.4 SELF REGULATION – AUSTRALIAN FINANCIAL MARKETS ASSOCIATION (AFMA)

The Australian Financial Markets Association is the industry association for Australia's wholesale
banking and financial markets, representing participants such as Australian and foreign banks,
securities companies, state government treasury corporations, fund managers and traders. Its role is
to encourage high standards of professional conduct in wholesale financial markets and maintain
effective self regulation of the over-the-counter financial markets.
5 THE STOCK MARKET
LO
 The major exchange market in Australia is the Australian Securities Exchange (ASX) which
brings together buyers and sellers of equity securities (shares) and futures instruments.
Trading on financial markets is either exchange-based or off-exchange. The major exchange market in
Australia is the Australian Securities Exchange (ASX) which brings together buyers and sellers of equity
securities (shares) and futures instruments.
The Australian Stock Exchange (as it was known then) was formed in 1987 by the amalgamation of the
stock exchanges of the six capital cities. In July 2006, the Australian Stock Exchange merged with the
Sydney Futures Exchange (SFE), the major futures and commodities exchange, to form the current
Australian Securities Exchange (ASX). As well as a market where the buying and selling of shares and
debt securities takes place, the ASX is also the market for dealings in Australian Government securities
and the trading of derivatives (which we shall cover in a later module). The ASX itself is a publicly listed
company trading on the Exchange.
Trading is conducted by stockbrokers who bring together the buyers and sellers, and is done
electronically using SEATS (Stock Exchange Automated Trading System).
Australia's securities markets are supervised by the Australian Securities and Investments Commission
(ASIC) through the Federal Government's Corporations law. In addition, all companies listed on the
Exchange must also comply with the ASX's own business rules.
The size and importance of financial markets has increased significantly since the early 1980s.
Australia's share market is the eighth largest in the world, and the third largest in the Asia-Pacific
region; while the Sydney Futures Exchange (SFE) is the largest futures exchange in the region.
All stock exchanges set eligibility criteria for companies wanting a listing. Key criteria generally include
those relating to the size of the company and its shareholder base, which are aimed at ensuring an
adequate market for trading in the company's shares.
For example, the ASX requires companies to meet either a profits test (aggregated profit of at least
$1 million from the same business in the last three years, and profit from continuing operations of at
least $400 000 in the last 12 months) or an assets test (net tangible assets of at least $2 million – or
market capitalisation of at least $10 million, with less than half of net tangible assets being held in
cash).
The ASX also requires the company to have at least 500 shareholders each holding a parcel of shares
MODULE 1
worth at least $2000. A lower threshold of 400 shareholders applies if at least 25 per cent of the shares
are in public hands. In either case, the practical implication is that a company can't raise capital solely
from institutions, but requires substantial support from retail investors.
Other smaller exchanges have less strict requirements, and are more suitable for smaller
organisations:
 The National Stock Exchange of Australia (NSX) specialises in small- and medium-sized company
public listings, including community-based organisations, and high technology companies. The
NSX only requires a market capitalisation of $500 000, and a minimum of 50 shareholders (among
other criteria).
 The NSX also manages the Bendigo Stock Exchange (BSX) and the Wollongong Stock
Exchange, which both focus on capital growth for regional business such as community banks or
property trusts.
 Australia Pacific Exchange (APX) is an exempt stock market, which means that a business can
have more flexibility on the structure of its shares.
6 INTERNATIONAL FINANCIAL MARKETS
LO
 International money and capital markets are available for larger companies wishing to raise
larger amounts of finance.
6.1 INTERNATIONAL FINANCIAL MARKETS

Small and medium-sized companies usually limit their sources of finance to the domestic market.
Larger companies may seek funds in the international finance markets to finance global operations or
domestic business operations. An Australian company might borrow money from a bank or from the
investing public, in dollars. But it might also borrow in a foreign currency, especially if it trades abroad,
or if it already has assets or liabilities abroad denominated in a foreign currency.
International money markets are known as euromarkets – a term used because initially these markets
developed in Europe, but which are now used to refer to loans or bonds denominated in a currency
other than the domestic borrower's currency. It should be noted it is not related to the euro currency.
Larger companies are able to borrow funds on the eurocurrency markets (which are international
money markets) and on the markets for eurobonds (international capital markets).
6.2 EUROCURRENCY MARKETS

The eurocurrency markets refers to money markets for borrowing and lending by banks in
currencies other than that of the country in which the bank is based. Typically only available in major
currencies for which active markets exist.
When a company borrows in a foreign currency, the loan is known as a eurocurrency loan.
Definition
Eurocurrency is currency which is held by individuals and institutions outside the country of issue of
that currency.
For example, if an Australian company borrows USD 50 000 from its bank, the loan will be a
'eurodollar' loan. Companies with foreign trade interests might choose to borrow from their bank in
another currency.
6.3 EUROBOND MARKETS

Instead of borrowing from banks, in recent years, a strong international market has built up which
allows very large companies to borrow from private investors by issuing securities.
Definition
A eurobond is an international bond that is denominated in a currency not native to the country
where it is issued.
Eurobonds are long-term loans raised by international companies or other institutions and sold to
investors in several countries at the same time. The term of a eurobond issue is typically 10 to 15 years
and the issue is usually underwritten by a multinational syndicate of banks. Such bonds can be sold by
one holder to another.
Eurobonds may be traded throughout the world, such as Tokyo and Singapore (not a specific national
bond market), and are named after the currency they are denominated in. For example, Euroyen and
Eurodollar bonds are denominated in Japanese yen and American dollars respectively.
Eurobonds may be the most suitable source of finance for a large organisation with an excellent credit
rating, such as a large successful multinational company, which:
 requires a long-term loan to finance a big capital expansion programme; the loan may be for at
least five and up to 20 years
 requires borrowing which is not subject to the national exchange controls of any government.
In addition, domestic capital issues may be regulated by the government or central bank, with an
orderly queue for issues. In contrast, eurobond issues can be made whenever market conditions seem
favourable and can give a faster access to funds.
As well as eurobonds, there is also a less highly developed market in international equity share issues
('euro-equity'). The issue is marketed through an international syndicate of banks. After the issue, the
shares might be traded on the international equities market. The shares will also be listed on one or
more stock exchanges (e.g. on the Australian Securities Exchange or the London Stock Exchange)
and, in American Depository Receipts (ADR) form, on the New York Stock Exchange.
6.4 CONSIDERATIONS WHEN USING EURO-FINANCE

A borrower who is contemplating borrowing money on the international market must consider the
exchange risk of a long-term foreign currency loan. If the money is to be used to purchase assets
which will earn revenue in a currency different to that of the bond issue, the borrower will run the risk
of exchange losses.
If the money is to be used to purchase assets which will earn revenue in the same currency, the
borrower can match these revenues with payments on the bond, and so remove or reduce the
exchange risk.
An investor subscribing to a bond issue will be concerned about the following factors:
 Security – The borrower must be of high quality.
 Marketability – Investors will wish to have a ready market in which bonds can be bought and sold.
If the borrower is of high quality the bonds or notes will be readily negotiable.
 Anonymity – Investors in eurobonds tend to be attracted to the anonymity of this type of issue, as
the bonds are generally issued to bearer.
 The return on the investment – this is paid tax-free.
6.5 OTHER INTERNATIONAL ALTERNATIVES

Another possibility for a company is to issue shares or bonds on a local market. In this case the foreign
MODULE 1
bond or share issues and trading are conducted under the supervision of local market authorities.
6.5.1 FOREIGN BONDS

Foreign bonds are issued on a local market by a foreign borrower and are usually denominated in the
local currency. In the US, non-US companies are able to issue bonds in a 'private placement' market.
This is a stock market in which investors are restricted to investment institutions, and the wider general
public cannot invest. Australian companies might, therefore, choose to issue bonds or shares in this
market, to gain exposure to US investors and a more international investor base.
6.5.2 FOREIGN EQUITY

Alternatively a company may apply for its shares to be traded on a foreign stock market.
For example, equity of large non-US companies might be traded on US stock markets in a special
form known as American Depositary Receipts, or ADRs. An ADR is a security denominated in US
dollars, that is backed by a number of shares in the non-US company. An Australian company wanting
to raise capital in the US might therefore place a number of new shares in the custody of a bank, and a
US bank will issue ADRs backed by these shares. The ADRs are registered in the US, and accepted to
trading on a US stock market, such as the New York Stock Exchange or Nasdaq. When the Australian
company pays dividends on the shares, it makes the dividend payment in Australian dollars, but ADR
holders receive their dividends in US dollars from the US bank.
6.5.3 REGULATION AND COMPLIANCE

When the bonds or shares (ADRs) of an Australian company are traded in the US, the company must
comply with US market regulations. In the US, shares cannot be offered for sale to the general public
unless they have been registered with the Securities and Exchange Commission (SEC). Australian
companies not wanting to go through the costly and time-consuming procedures for obtaining
registration can opt instead for the private placement market (for which registration is not required)
but they must comply with the rules of that market.
When the bonds or shares of an Australian company are traded on the international capital market, it
must comply with the market rules of ICMA, the International Capital Market Association, based in
Zurich. ICMA was formed in 2005 by the merger of ISMA (the International Securities Market
Association) and IPMA (the International Primary Market Association).
KEY MODULE POINTS
 Money markets are markets for short-term capital.

 Capital markets are markets for long-term capital.
 The main capital market in Australia is the Australian Securities Exchange (ASX).
 A stock market acts as a primary market (i.e. where securities (debt and equities) are issued for the
first time) and as a secondary market for the trading of existing securities (i.e. shares and bonds).
 A financial intermediary links those with surplus funds (e.g. lenders) to those with funds deficits
(e.g. potential borrowers) so providing aggregation and economies of scale, risk pooling and
maturity transformation.
 Factors influencing the exchange rate include the comparative rates of inflation in different
countries (purchasing power parity), comparative interest rates in different countries (interest rate
parity), the underlying balance of payments, speculation and government policy on managing or
fixing exchange rates.
 Well functioning financial markets require a regulatory system, administered by a capable
 The aim of an efficient regulatory system is to protect investors while minimising interference in the
market that might distort market price signals and investment decisions.
 The government plays a vital role in the functioning of the capital market as borrower and lender,
financial intermediary (via the RBA), regulator of financial activities and source of ultimate liquidity.
 The major exchange market in Australia is the Australian Securities Exchange (ASX) which brings
together buyers and sellers of equity securities (shares) and futures instruments.
 International money and capital markets are available for larger companies wishing to raise larger
amounts of finance.
QUICK REVISION QUESTIONS
1 Which of the following statements is true?

I. Money markets are markets for short-term capital.
MODULE 1
II. The Australian Securities Exchange is a money market.
III. Companies cannot be involved in money market operations.
A I only
B II and III only
C I, II and III
D none of the above
2 Which of the following markets allow market participants to fix today the price at which trades will
be made in the future?
A bond market
B derivatives market
C foreign currency market
D over-the-counter market
3 The ASX can reasonably be described as

A a primary market only.
B a secondary market only.
C both a primary and secondary market.
D neither a primary nor a secondary market.
4 Which of the following is the best definition of the OTC market?

A an unofficial market for derivatives
B a market where only transactions for cash are allowed
C an exchange for the trading of securities other than shares
D an off-exchange market where financial instruments are traded directly between two parties
ANSWERS TO QUICK REVISION QUESTIONS
1 A The Australian Securities Exchange is a capital market, not a money market.

Although the money markets largely involve borrowing and lending by banks, some large
companies, as well as the government, are involved in money market operations.
2 B It is the derivatives market that allows traders to fix the price of future trades.
3 C The ASX is a primary market for the issuing of new securities to raise finance and a secondary
market for the trading of existing securities.
4 D Over-the-counter (OTC) trading refers to financial instruments such as stocks, bonds,
commodities or derivatives which are traded directly between two parties, as opposed to via an
exchange.
ANSWERS TO MODULE QUESTIONS
1 The primary market is the market where securities (debt and equity) are issued for the first time.
Primary markets enable organisations to raise new finance by issuing new shares or new bonds.
MODULE 1
The secondary market is the market where securities which have been issued in the primary
market are traded, enabling existing investors to sell their investments, should they wish to do so.
The marketability of securities is a very important feature of the capital markets, because investors
are more willing to buy stocks and shares if they know that they could sell them easily. The
secondary market does not raise new finance for companies.
2 Foreign exchange rates are influenced by:
 the comparative rates of inflation in different countries (purchasing power parity)
 the comparative interest rates in different countries (interest rate parity)
 the underlying balance of payments
 sentiment, for example whether investors feel that a country's economy, and thus its currency is
healthy or not
 currency speculation
 government policy on managing or fixing exchange rates.
21
MODULE 2
INTRODUCTION TO
FINANCIAL THEORIES
Interpret the future and present values of a series of single cash flows and of annuities LO2.1
Demonstrate the relationship between systematic risk and expected return of individual LO2.2
securities and portfolios using the Capital Asset Pricing Model (CAPM) and the security
market line relationship
Distinguish between the weak form test, the semi strong form test and the strong form LO2.3
test of the Efficient Market Hypothesis (EMH)
Explain the implications of market efficiency for both investors and companies LO2.4
In the context of capital markets distinguish between operating efficiency, allocative LO2.5
efficiency and pricing efficiency
Topic list
1 The value of cash flows and relevant costs

2 The Capital Asset Pricing Model (CAPM)
3 The Efficient Market Hypothesis (EMH) and market efficiency
4 Implications of the Efficient Market Hypothesis
MODULE OUTLINE
This module introduces and explains some fundamental financial theories that we shall come back to
throughout the rest of our Business Finance studies.
We begin by looking at some financial mathematics and material relevant to investment decision
making. Understanding the impact of the time value of money on cash flows and knowing which cash
flows are relevant for making investment decisions are very important and form the basis of our further
study in Module 7.
We will then look at the Capital Asset Pricing Model (CAPM). This is a formula that predicts the
required rate of return for an investment, based upon its level of systematic risk relative to that of the
market as a whole. CAPM has a number of uses, but in particular, it can be used to calculate a
discount rate or cost of equity that incorporates risk. This has relevance to investment decisions which
we shall see in Module 7, but also in regards to the valuation of shares and construction of investment
portfolios that we shall study in Module 9.
Finally, we shall explore a key rationale for share price movement, the efficient market hypothesis,
which provides an explanation of how markets take into account new information. As with CAPM, we
shall build on this knowledge in Module 9.
Introduction to financial
theories
Investment decisions Efficient Market Hypothesis The Capital Asset

Time value of money Stock market reacts to Pricing Model (CAPM)
Discounted cash flow information as it becomes Investment appraisal
Relevant costs available Valuation of shares
Investment portfolios
3 levels of efficiency
Weak form
Semi strong form
Strong form
Implications for
Company Investors
INTRODUCTION TO FINANCIAL THEORIES | 23
BEFORE YOU BEGIN
area.
everything covered.
1 What is the time value of money? (Section 1)
2 What is an annuity? (Section 1.1.5)
3 What is a relevant cost? (Section 1.3)
4 Explain systematic and unsystematic risk. (Section 2.1)
MODULE 2
5 What does a beta factor measure? (Section 2.6)
6 What is the fundamental theory of share values? (Section 3.1)
7 What are weak, semi-strong and strong form efficiency? (Section 3.5)
8 Explain the difference between allocative, operational and pricing (information)
processing efficiency. (Section 3.5)
9 What is an implication of the efficient market hypothesis on investors? (Section 4.2)
1 THE VALUE OF CASH FLOWS AND RELEVANT

COSTS
LO
 The concept of time value of money recognises that $1 today is worth more than $1 at a
future time, because money can be reinvested to earn more money over time.
 Cash flows and not accounting profits should be used for investment appraisal and
decision-making.
 The relevant cash flows for appraisal of a project are the changes in future cash flows that
would arise from acceptance of the project.
Definition
The time value of money: money received today can be reinvested to earn interest to increase its
value. Therefore $1 received today is worth more than $1 received in 1 year.
Investors put money into shares in the expectation of getting back, over time, an amount in excess of
their original investment. The idea of investing cash to make more money should be a familiar concept
to you.
If you put money into a deposit account, you will expect to get your money back with interest. If the
interest is not high enough, you will look somewhere else to invest.
In the same way, an investor buying shares expects a return in the form of dividends plus the eventual
disposal price of the shares when they decide to sell them. If the expected returns are not high
enough to justify the purchase price of the shares, the investor will not buy the shares, but put their
money into another investment instead.
The same principle applies to investments by companies. The cash returns from long-term
investments should be sufficient to provide an adequate return; otherwise, the investment should not
be undertaken.
The required return on an investment consists of three elements, for any investor:
 An opportunity cost. This is the return that could be obtained by investing in something else. In
financial management, the opportunity cost of an investment is usually expressed in terms of the
return that could be obtained by putting money into a risk-free (and inflation-proof) investment.
 An amount to cover inflation. Inflation reduces the value of money over time, and an investor will
expect the return on investment to cover the effect of inflation as well as to provide a 'real' return.
 An amount to reward the investor for the risk in the investment. Higher returns are expected from
investments with a higher risk element.
An investment return is expressed as a percentage of the amount invested for each year of
investment. The longer the investment, the greater the required return. This too should be a familiar
idea to you. If you put cash into a deposit account, you will expect to earn interest, and the longer you
keep the money on deposit, the more interest you will expect to earn.
We must therefore recognise that if a capital investment is to be worthwhile, it must earn at least a
minimum profit or return so that the size of the return will compensate the investor (the business) for
the length of time which the investor must wait before the profits are made. For example, if a
company could invest $60 000 now to earn revenue of $63 000 in one week's time, a profit of $3000 in
seven days would be a very good return. If it takes three years to earn the revenue, however, the
return would be very low.
When capital expenditure projects are evaluated, it is therefore appropriate to decide whether the
investment will make enough profits to allow for the 'time value' of capital tied up.
The time value of money reflects people's time preference for $1 now over $1 at some time in the
future. Discounted cash flow (DCF) is an evaluation technique which takes into account the time value
of money.
1.1 DISCOUNTED CASH FLOW TECHNIQUES

Definition
Discounted cash flow, (DCF), is an investment appraisal technique which takes into account both the
timings of cash flows and also total profitability over a project's life.
Two important points about DCF are as follows:

 DCF looks at the cash flows of a project, not the accounting profits.
 DCF takes account of the time value of money.
The timing of cash flows is taken into account by discounting them.
The effect of discounting is to give a larger value per $1 for cash flows that occur earlier: $1 earned
MODULE 2
after one year will be worth more than $1 earned after two years, which in turn will be worth more than
$1 earned after five years, and so on.
1.1.1 COMPOUNDING
Suppose that a company has $10 000 to invest, and wants to earn a return of 10 per cent per annum
(compound interest) on its investments. This means that if the $10 000 could be invested at 10 per
cent, the value of the investment with interest would build up as follows:
 After 1 year $10 000  (1.10) = $11 000
 After 2 years $10 000  (1.10)2 = $12 100
 After 3 years $10 000  (1.10)3 = $13 310 and so on.
This is compounding.
Formula to learn
The formula for the future value of an investment plus accumulated interest after n time periods is:
FV = PV (1 + r)n
where: FV is the future value of the investment with interest.
PV is the initial or 'present' value of the investment.
r is the compound rate of return per time period, expressed as a proportion (so 10% =
0.10, 5% = 0.05 and so on).
n is the number of time periods.
Worked Example: Compounding
What is the future value of $12 500 invested for four years at a compound interest rate of 5 per cent
p.a.?
Solution
12 500  (1.05)4 = $15 194
1.1.2 DISCOUNTING
Discounting starts with the future amount of a cash flow and converts it into a present value.
A present value is the amount that would need to be invested now to earn the future cash flow, if the
money is invested at the 'cost of capital'.
For example, if a company expects to earn a (compound) rate of return of 10 per cent on its
investments, how much would it need to invest now to have the following investments?
 $11 000 after 1 year
 $12 100 after 2 years
 $13 310 after 3 years
The answer is $10 000 in each case, and we can calculate it by discounting.
Formula to learn
The discounting formula to calculate the present value of a future sum of money at the end of n time
periods is:
1
PV =FV n
(1+ r)
1
 After 1 year, $11 000  = $10 000
1
1.10
1
 After 2 years, $12 100  = $10 000
2
1.10
1
 After 3 years, $13 310  = $10 000
3
1.10
Discounting can be applied to both money receivable and also to money payable at a future date. By
discounting all payments and receipts from a capital investment to a present value, they can be
compared on a common basis, at a value which takes account of when the various cash flows will take
place.
Worked Example: Discounting
Stockbridge is due to receive $50 000 in four years' time. What is the present value of the receipt at an
interest rate of 5 per cent?
Solution
$50 000  1 / (1.05)4 = $41 135
Definition
Present value can be defined as the cash equivalent 'now' of a future sum of money receivable or
payable at a future date, assuming that money 'now' can be invested at a given rate of return (known
as the 'cost of capital'). A present value is calculated by discounting the future cash flow to its present
value equivalent amount.
1.1.3 DISCOUNT FACTORS

To make it easier to discount future cash flows to a present value, discount factor tables are available.
1
These tables give the value of for any cost of capital (value of r) and any future year
(1+r)n
(any value of n).
Any cash flows that take place 'now', at the start of a project, take place in Year 0. The discount factor
for year 0 is 1.0. This means simply that cash flows occurring 'now' do not need to be discounted to
convert them to a present value equivalent, because they are already at present value.
Worked Example: Discount factors
Spender expects the cash inflow from an investment to be $40 000 after two years and another
$30 000 after three years. Its target rate of return is 12 per cent. Calculate the present value of these
future returns, and explain what this present value signifies.
The following discount factors might be relevant:
Discount factor at
Year 12%
1 0.893
2 0.797
3 0.712
4 0.636
Solution
Discount factor
Year Cash flow at 12% Present value
$ $
2 40 000 0.797 31 880
3 30 000 0.712 21 360
MODULE 2
53 240
The present value of the future returns, discounted at 12 per cent, is $53 240. This means that if
Spender can invest now to earn a return of 12 per cent on its investments, it would have to invest
$31 880 to earn $40 000 after two years plus $21 360 to earn another $30 000 after three years.
1.1.4 THE COST OF CAPITAL

The cost of capital as used in DCF is the cost of funds that a company raises and uses. It represents
the return that investors expect to be paid for putting funds into the company. It is therefore the
minimum return that a company should make from its own investments, to earn the cash flows out of
which investors can be paid their return.
In Module 4 we look at how the cost of capital can be measured by studying the returns required by
investors. This cost of capital is then used to derive a discount rate for DCF analysis and investment
appraisal.
For the time being, the 'cost of capital' is assumed to be a known figure.
1.1.5 ANNUITIES
Definition
An annuity is a series of cash flows of equal amount, and equal frequency in time for a defined period.
An example of an annuity would be, say, cash receipts of $50 000 a year for six years, Years 1 to 6. To
save time with calculating the present value of all the individual annual cash flows of an annuity, tables
are available for the cumulative discount factors. Annuity tables give the total of all the discount
factors for each year in Year 1 to Year n, for a given cost of capital r.
For example, the annuity factor for a cost of capital of 12 per cent for Years 1 to 3 is 2.402. This is
simply the sum of the discount factors for Years 1, 2 and 3.
Discount factor
Year at 12%
1 0.893
2 0.797
3 0.712
1–3 2.402 = Annuity factor at 12%, Years 1–3
If the amount of the annual cash flow for Years 1 to 3 is, say, $10 000 per annum, and the cost of
capital is 12 per cent, it is quicker to calculate the present value of these cash flows in one calculation
($10 000  2.402 = $24 020) instead of having to calculate the present value for the cash flow in each
individual year and then add up the total.
An alternative to using the tables is to calculate the annuity factor using the following formula:
Formula to learn
The present value of an annuity is given by:

Annual cash flow  1 
PV =  1 n 
r  (1+r) 
where r is the discount rate, expressed as a decimal.
Worked Example: Discounting
Stockbridge is due to receive a grant of $10 000 every year for five years. What is the present value of
the grant at an interest rate of 8 per cent?
Solution
$10 000  AF1 – 5 @ 8% =

$10 000  3.993 = $39 930
1.1.6 PERPETUITIES
A perpetuity is an annuity in which the cash flows continue at an equal amount forever. In other words
it has an infinite life.
Formula to learn
The present value of a perpetuity is given by:

Annual cash flow
PV =
r
Worked Example: Perpetuity
Therefore the present value of $400 to be received annually, for ever, if the cost of capital is 8 per cent
per annum, is:
400
PV (T1  ) $400 = = $5000
0.08
Notice that the value of the perpetuity is finite because the cash flows that arise far into the future will
have very low present values.
1.2 RELEVANT CASH FLOWS

An investment is the purchase of an asset with the expectation of the asset appreciating in value over
time. When evaluating an investment, it is more appropriate to consider cash flows (actual money
spent and received) rather than accounting profits which do not accurately reflect investment returns.
A company might pay out a sum of money to invest in a new business operation with an expected
commercial life of several years. Over that period, it will expect to incur running costs to run the
business, and to receive cash from sales. The returns on the investment will be the net cash inflows
from the business operation.
In the same way, a shareholder's investment involves paying out cash to buy shares, and the
shareholder's returns are obtained in the form of dividends and the cash received from the eventual
disposal of the shares.
Accounting profit is the financial performance of a business after taking into account statutory
reporting requirements that dictate valuation of assets, representation of revenue, expenses and
liabilities as required by law. Instead of reporting the cash outlay on an investment, an income
statement reports a depreciation charge on capital equipment over the economic life of the asset.
Depreciation is a notional accounting charge, and does not represent a cash flow. It is a non-cash
expense. Therefore, cash flows and not accounting profits should be used for investment appraisal
and decision-making.
It is useful to remember the differences between operational cash flows and operating profit.
$
Operating profit (accounting profit) 125 000
Add back depreciation 60 000
185 000
MODULE 2
Subtract the increase in working capital (15 000)
Net cash flow from operations 170 000
In the example above, there are two reasons why cash flows differ from the accounting profit:
 Depreciation is not a cash flow item, and to work out the actual cash flow depreciation has to be
added back to the accounting profit.
 Profit also differs from cash flow by the amount of the change in working capital in the period.
Working capital means the investment in inventories and trade receivables, less any investment in
trade payables (i.e. net working capital equals current assets less current liabilities). If there has
been an increase in working capital due to larger inventories or more receivables, cash flow will be
lower than profit. If working capital has been reduced in the period (e.g. by running down
inventories) or extending credit taken from creditors, cash flow will exceed profit.
1.3 RELEVANT CASH FLOWS FOR INVESTMENT APPRAISAL

Definition
Relevant costs are future, incremental cash flows.

The relevant cash flows for appraisal of a project are the changes in future cash flows that would arise
from acceptance of the project.
The cash flows that should be considered in investment appraisals are those which arise as a
consequence of the investment decision under evaluation.
 Relevant costs are future costs. A decision is about the future; it cannot alter what has been done
already. A cost that has been incurred in the past is totally irrelevant to any decision that is being
made 'now'. Costs that have been incurred include not only costs that have already been paid, but
also costs that are the subject of legally binding contracts, even if payments due under the contract
have not yet been made. (These are known as committed costs.)
 Relevant costs are cash flows.
– Accounting profits and cash flow are not the same in any period for various reasons, such as the
timing differences caused by giving credit and the accounting treatment of depreciation. In the
long run, however, a profit that is earned will eventually produce a net inflow of an equal
amount of cash. Hence when decision making we look at cash flow as a means of measuring
profits.
– Only cash flow information is required. This means that costs or charges which do not reflect
additional cash spending should be ignored for the purpose of decision making. These include
depreciation charges.
 Relevant costs are incremental costs. A relevant cost is one which arises as a direct consequence
of a decision. Therefore, only costs which will differ under some or all of the available opportunities
should be considered; relevant costs are therefore sometimes referred to as incremental costs. For
example, if an employee is expected to have no other work to do during the next week, but will be
paid their basic wage of, say, $200 per week for attending work and doing nothing, the manager
might decide to give them a job which earns only $140. The net gain is $140 and the $200 is
irrelevant to the decision because although it is a future cash flow, it will be incurred anyway
whether the employee is given work or not.
The net cash inflows from a project can be calculated as the incremental contribution earned
minus any incremental fixed costs which are additional cash items of expenditure (that is,
ignoring depreciation and so on).
 Opportunity costs. Opportunity costs are costs incurred or revenues lost from diverting existing
resources from their best use.
Worked Example: Opportunity costs
If a salesperson, who is paid an annual salary of $30 000, is diverted to work on a new project and as a
result existing sales of $50 000 are lost, the opportunity cost to the new project will be the $50 000 of
lost sales. The salesperson's salary of $30 000 is not an opportunity cost since it will be incurred
however their time is spent.
1.3.1 OTHER RELEVANT COSTS

Costs that will often need to be considered include:
 Infrastructure costs such as additional information technology or communication systems.
 Marketing costs may be substantial, particularly if the investment is in a new product or service.
They will include the costs of market research, promotion and branding and the organisation of
new distribution channels.
 Human resource costs including training costs and the costs of reorganisation arising from
investments.
 Residual value, the disposal value of equipment at the end of its life, or its disposal cost.
1.3.2 TAX
The extra taxation that will be payable on extra profits, or the reductions in tax arising from
operating losses in any year. The inclusion of tax in investment appraisal is considered in more detail in
Module 7.
1.4 NON-RELEVANT COSTS

A number of terms are used to describe costs that are irrelevant for decision making because they
are either not future cash flows or they are costs which will be incurred anyway, regardless of the
decision that is taken.
Any costs incurred in the past, or any committed costs which will be incurred regardless of whether
or not an investment is undertaken, are not relevant cash flows. They have occurred, or will occur,
whatever investment decision is taken. This includes centrally-allocated overheads that are not a
consequence of undertaking the project.
Definitions
A sunk cost is a cost which has already been incurred and hence should not be taken account of in
decision making. Examples include:
 research and development costs that have already been incurred, so are not relevant to the current
decision making process
 costs of commissioning a market research survey in a previous accounting period
 the cost of refurbishing a building which has already been incurred but which might now be
brought into use for a different purpose.
A committed cost is a future cash outflow that will be incurred anyway, whatever decision is taken
now about alternative opportunities.
Worked Example: Relevant and non-relevant costs
A company is planning to start production of a new product. It has already undertaken market
research at a cost of $5000. Production will require the purchase of a new machine which will cost
MODULE 2
$200 000 and which will be depreciated over 5 years. An existing machine which is currently lying idle
will also be used and as a result annual depreciation of a further $15 000 will be allocated to the new
product. The new product is expected to generate a net additional contribution of $40 000 per
annum.
Decide which flows are relevant to the decision to go ahead with the new product and explain the
treatment of each one.
Solution
Market research $5 000 Not relevant This has already been incurred and
is a sunk cost
New machine $200 000 Relevant Future incremental cash flow
Depreciation on new machine $40 000 Not relevant Not cash
Depreciation on currently $15 000 Not relevant Not cash and simply a reallocation
idle machine of existing overheads
Additional contribution $40 000 p.a. Relevant Future incremental cash flow
1.5 RELEVANT BENEFITS OF INVESTMENTS

The benefits from a proposed investment must also be evaluated. These might consist of benefits of
several types:
 Savings because assets or resources used currently will no longer be required. The savings should
include:
– savings in staff costs
– savings in other operating costs, such as fuel costs or consumable materials.
 Extra savings or revenue benefits because of the improvements or enhancements that the
investment might bring
– more sales revenue and so additional contribution
– more efficient system operation
– further savings in staff time, resulting perhaps in reduced future staff growth.
 Possibly, some one-off revenue benefits from the sale of assets that are currently in use, but which
will no longer be required.
 Some benefits might be intangible, or impossible to give a money value to, such as:
– greater customer satisfaction, arising from a more prompt service (e.g. because of a
computerised sales and delivery service)
– improved staff morale from working with higher-quality assets

– better decision making may result from better information systems.
Worked Example: Relevant cash flows
Elsie is considering the manufacture of a new product which would involve the use of both a new
machine costing $150 000 and an existing machine, which cost $80 000 two years ago and has a
current carrying value of $60 000. There is sufficient capacity on this machine, which has so far been
under-utilised. Annual sales of the product would be 5000 units, selling at $32 per unit. Unit costs
would be as follows:
$
Direct labour (4 hours at $2 per hour) 8
Direct materials 7
Fixed costs including depreciation 9
24
The project would have a five-year life, after which the new machine would have a net residual value of
$10 000. Because direct labour is continually in short supply, labour resources would have to be
diverted from other work which currently earns a contribution of $1.50 per direct labour hour. The
fixed overhead absorption rate would be $2.25 per hour ($9 per unit) but actual expenditure on fixed
overhead would not alter.
Working capital requirements would be $10 000 in the first year, rising to $15 000 in the second year
and remaining at this level until the end of the project, when it will all be recovered. The company's
cost of capital is 20 per cent. Ignore taxation.
You are required to identify the relevant cash flows for the decision as to whether or not the project
is worthwhile.
Solution
The relevant cash flows are as follows: $

a. Year 0 Purchase of new machine 150 000
b. Years 1–5 Contribution from new product (5000 units  $(32 – 15)) 85 000
Less contribution forgone (5000  (4  $1.50)) 30 000
55 000
c. The project requires $10 000 of working capital at the end of Year 1 and a further $5000 at the start
of Year 2. Increases in working capital reduce the net cash flow for the period to which they relate.
When the working capital tied up in the project is 'recovered' at the end of the project, it will
provide an extra cash inflow (for example, debtors will eventually pay up).
d. If at the end of the project the new machine is to be sold for $10 000 then this is an incremental
cash flow. If the $10 000 represents the expected carrying value of the machine in the accounts
after five years then it is an accounting value and is not relevant.
All other costs, which are past costs, notional accounting costs or costs which would be incurred
anyway without the project, are not relevant to the investment decision.
2 THE CAPITAL ASSET PRICING MODEL (CAPM)
LO
 The Capital Asset Pricing Model (CAPM) is a formula for predicting the required rate of
return for an investment, based upon its level of systematic risk relative to that of the
market as a whole. It can be used to calculate a discount rate or cost of equity that
incorporates risk.
 The risk involved in holding securities (shares) divides into risk specific to the company
(unsystematic) and risk due to variations in market activity (systematic).
 Unsystematic or business risk can be diversified away, while systematic or market risk
cannot.
 CAPM is based on a comparison of the systematic risk of individual investments with the
risks of all shares in the market.
 CAPM states that the required return of a well-diversified investor will be based on the
MODULE 2
risk-free rate, plus a premium for systematic risk. The size of this premium is the difference
between the average stock market returns and the risk-free rate of return, multiplied by a
beta factor: i(rm – rf).
 The beta factor measures the systematic risk of a security relative to the risk of the market
portfolio.
 Each company's equity has its own beta factor. A higher beta indicates higher
(non-diversifiable) systematic risk. When a company has a beta factor in excess of 1.0, its
expected returns are higher than the average returns for the market as a whole. A beta
factor of less than 1.0 indicates systematic risk lower than the market average, and so
expected returns are also lower than the market average.
2.1 OVERVIEW OF CAPM

Definition
Capital Asset Pricing Model (CAPM) is a formula for predicting the required rate of return for an
investment, based upon its level of systematic risk relative to that of the market as a whole.
The capital asset pricing model can be used as a formula for calculating the cost of equity capital. It is
an alternative to the dividend valuation model and dividend growth model.
The uses of the capital asset pricing model (CAPM) include:
 establishing the 'correct' equilibrium market value of a company's shares
 establishing the cost of a company's equity (and the company's average cost of capital), taking
account of both the business and financial risk characteristics of a company's investments.
It is useful to try to understand the logic underlying the CAPM. A starting point is the difference
between systematic risk and unsystematic risk in investments.
2.2 SYSTEMATIC RISK AND UNSYSTEMATIC RISK

Whenever an investor invests in some shares, or a company invests in a new project, there will be
some risk involved. The actual return on the investment might be better or worse than that hoped for.
To some extent, risk is unavoidable, unless the investor settles for risk-free securities such as gilts.
Provided that the investor diversifies his investments in a suitably wide portfolio, ideally including
investments that are negatively correlated, the investments which perform well and those which
perform badly should tend to cancel each other out, and much risk can be diversified away. In the
same way, a company which invests in a number of projects will find that some do well and some do
badly, but taking the whole portfolio of investments, average returns should turn out much as
expected.
Risks that can be diversified away, because they are specific to an individual project or investment, are
referred to as unsystematic risk.
Definition
Non-systematic or unsystematic risk is a risk that affects a small number of assets. It is a unique or an
asset specific risk, and can be reduced or eliminated by diversification.
However, even if an investor holds a well-diversified portfolio, with no unsystematic risk, not all risk can
be diversified away. All securities will be affected to some extent by the underlying risks of the market
– changes in the economy, unexpected global events, general elections etc – which will cause
variations in the returns of the most diversified of portfolios.
This inherent risk, known as the systematic risk or market risk, cannot be diversified away because
it affects all securities on the market, albeit some to a greater or lesser extent than others.
Definition
Market or systematic risk is risk that cannot be diversified away.
Figure 2.1: Unsystematic or systematic risk
TOTAL RISK
σ total2 (Total variability
of returns)
= =
UNSYSTEMATIC RISK
σ unsyst2 (speciﬁc to sectors,
companies or projects)
+ +
SYSTEMATIC RISK
(Variability of returns
σ syst2 caused by factors
affecting the whole
market, e.g.
macroeconomic)
Systematic risk must be accepted by any investor, unless they invest entirely in risk-free investments.
In return for accepting systematic risk, an investor will expect to earn a return which is higher than the
return on a risk-free investment.
The amount of systematic risk in an investment varies between different types of investment, because
they will be more or less sensitive to market factors:
 The systematic risk in the operating cash flows of a tourism company which will be highly sensitive
to consumers' spending power might be greater than the systematic risk for a utility company.
Although both would be affected by a recession, one might be affected more than the other.
 Some individual projects will be more risky than others and so the systematic risk involved in an
investment to develop a new product would be greater than the systematic risk of investing in a
replacement asset.
2.3 SYSTEMATIC RISK AND UNSYSTEMATIC RISK: IMPLICATIONS FOR

INVESTMENTS
The implications of systematic risk and unsystematic risk are as follows:
 If an investor wants to avoid risk altogether, they 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 the portfolio, because they will not have spread their risk enough to diversify
away the unsystematic risk. To eliminate unsystematic risk, the investor must build up a
well-diversified portfolio of investments.
 If an investor holds a balanced portfolio of all the stocks and shares on the stock market, they will
incur systematic risk which is exactly equal to the average systematic risk in the stock market as a
whole.
 Shares in individual companies will have different systematic risk characteristics to this market
average. Some shares will be less risky and some will be more risky than the stock market average.
Similarly, some investments will be more risky and some will be less risky than a company's
'average' investments.
MODULE 2
2.4 PROPOSITIONS OF CAPM
The capital asset pricing model is mainly concerned with how systematic risk is measured, and how
systematic risk affects required returns and share prices.
It makes the following propositions:
 Investors in shares require a return in excess of the risk-free rate, to compensate them for
systematic risk.
 Investors should not require a premium for unsystematic risk, because this can be diversified away
by holding a wide portfolio of investments.
 Because systematic risk varies between companies, investors will require a higher return from
shares in those companies where the systematic risk is bigger.
The same propositions can be applied to capital investments by companies:
 Companies will want a return on a project to exceed the risk-free rate, to compensate them for
systematic risk.
 Unsystematic risk can be diversified away, and so a premium for unsystematic risk should not be
required.
 Companies should want a bigger return on projects where systematic risk is greater.
2.5 SYSTEMATIC RISK AND CAPM

2.5.1 MARKET RISK AND RETURNS
Market risk (systematic risk) is the average risk of the market as a whole. Taking all the shares on a
stock market together, the total expected returns from the market will vary because of systematic risk.
The market as a whole might do well or it might do badly.
2.5.2 RISK AND RETURNS FROM AN INDIVIDUAL SECURITY

In the same way, an individual security may offer prospects of a return of x per cent, but with some risk
attached. The return (x per cent) that investors will require from the individual security will be higher or
lower than the market return, depending on whether the security's systematic risk is greater or less
than the market average.
Worked Example: Risks
The following information is available about the performance of an individual company's shares and
the stock market as a whole.
Individual company Stock market as a whole
Price at start of period 105.0 480.0
Price at end of period 110.0 490.0
Dividend during period 7.6 39.2
Calculate the return on the company's shares and the return on the stock market as a whole.
Solution
The expected return on the company's shares Ri and the expected return on the 'market portfolio' of
shares (rm) may be calculated as:
Capital gain (or loss) + dividend P1  P0 +D1

=
Price at start of period P0
(110  105) + 7.6 (490  480) + 39.2

Ri = = 12% rm = = 10.25%
105 480
Alternatively:
percentage total return = Capital gain yield + dividend yield
P1  P0
Capital gain yield = = (110 – 105) / 105 = 4.8%
P0
D1
Dividend yield = = 7.6 / 105 = 7.2
P0
Hence total return = 4.8% + 7.2% = 12%
2.5.3 COMPARING RETURNS FROM AN INDIVIDUAL SECURITY WITH THE AVERAGE MARKET
RETURN
A statistical analysis of 'historic' returns from a security and from the 'average' market may suggest
that a linear relationship can be assumed to exist between them. A series of comparative figures could
be prepared of the return from a company's shares and the average return of the market as a whole.
The results could be drawn on a scatter graph and a 'line of best fit' drawn (using linear regression
techniques) as shown below.
Figure 2.2: Returns from an individual security compared with average market return
Return from
individual
company’s
share (rj) Line of best fit
Return from the

market as a whole (rm)
This analysis would show the following:

 The return from the security and the return from the market as a whole will tend to rise or fall
together. Note that returns can be negative. A share price fall represents a capital loss, which is a
negative return.
 The return from the security may be higher or lower than the market return. This is because the
systematic risk of the individual security differs from that of the market as a whole.
 What is of interest, is the angle or gradient of the line of best fit. Here it is less than 45 degrees,
indicating that a given change in market return generally corresponds to a smaller change in share
return. This indicates that the share's returns are less susceptible to market risk factors than market
average (i.e. its systematic risk element is lower than market average).
 The scattergraph may not give a good line of best fit, unless a large number of data items are
plotted, because actual returns are affected by unsystematic risk as well as by systematic risk.
The conclusion from this analysis is that individual securities will be either more or less risky than the
market average in a fairly predictable way. A major assumption in CAPM is that there is a linear
relationship between the return obtained from an individual security and the average return from all
securities in the market.
MODULE 2
The measure of this relationship between market returns and an individual security's returns, reflecting
differences in systematic risk characteristics, can be developed into a beta factor for the individual
security.
2.6 BETA FACTORS

Systematic risk is measured using beta factors.
Definition
Beta factor is the measure of the systematic risk of a security relative to the risk of the market
portfolio. The beta factor of the market as a whole is 1.0. A beta factor of 0 indicates a risk-free
investment.
Suppose that returns on shares in XYZ tend to vary twice as much as returns from the market as a
whole, so that if market returns went up 3 per cent, returns on XYZ shares would be expected to go up
by 6 per cent and if market returns fell by 3 per cent, returns on XYZ shares would be expected to fall
by 6 per cent. The beta factor of XYZ shares would be 2.0. Conversely, if the share price moved at half
the market rate, the beta factor would be 0.5 and returns on XYZ shares would be expected to go up
by 1.5 per cent and if market returns fell by 3 per cent, returns on XYZ shares would be expected to fall
by 1.5 per cent.
Therefore, if the average market return rises by, say, 2 per cent, the return from a share with a beta
factor of 0.8 should rise by 1.6 per cent in response to the same conditions which have caused the
market return to change. The actual return from the share might rise by, say, 2.5 per cent, or even fall
by, say, 1 per cent, but the difference between the actual change and a change of 1.6 per cent due to
general market factors would be attributed to unsystematic risk factors unique to the company or its
industry.
It is an essential principle of CAPM theory that unsystematic risk can be cancelled out by
diversification. In a well-balanced portfolio, an investor's gains and losses from the unsystematic risk of
individual shares will tend to cancel each other out. In other words, if shares in X do worse than market
returns and the beta factor of X's shares would predict, shares in Y will do better than predicted. The
net effect will be self-cancelling elimination of the specific (unsystematic) risk from the portfolio,
leaving the average portfolio return dependent only on changes in the average market return and the
beta factors of shares in the portfolio.
2.7 THE EQUITY RISK PREMIUM

The CAPM makes use of the principle that returns on shares in the market as a whole are expected
to be higher than the returns on risk-free investments. The difference between market returns and
risk-free returns is called an excess return or market risk premium.
Definition
Market risk premium or equity risk premium is the difference between the expected rate of return
on a market portfolio and the risk-free rate of return over the same period.
For example, if the return on Government stocks is 9 per cent and market returns are 13 per cent, the
excess return on the market's shares as a whole (the market risk premium) is 4 per cent.
Let: rf = the risk-free rate of return
rm = the return on market portfolio M
The equity risk premium (rm – rf) represents the excess of market returns over those associated with
investing in risk-free assets.
It is possible to calculate the appropriate risk premium for any given security by taking the market risk
premium multiplied by the security's beta factor.
Therefore, if an individual share's price rises or falls at double the market rate, such that it would have
a beta factor of 2.0, investors would require double the market risk premium: a premium of 8 per cent
(2.0  4%) over the risk free rate.
Question 1: Risk premiums
Shares in DEF have a beta of 1.5 when the risk-free return is 9 per cent and the expected market
return is 13 per cent.
Calculate the expected return on DEF shares. What would happen to the expected return if market
returns fell by 3 per cent?
2.8 THE CAPM FORMULA

The CAPM may be used to calculate a cost for equity, to go into the calculation of WACC. A beta
factor can also be applied to individual capital projects, so that high-risk projects should be expected
to provide a higher return than lower risk projects.
The CAPM equation or formula can be stated as follows:
Formula to learn
E(ri) = rf + i(rm – rf)

where: E(ri) is the required or expected return from a security.
rf is the risk-free rate of return.
rm is the return from the market as a whole.
i is the beta factor of the individual security.
In graphical form, this equation is known as the Security Market Line (SML).
Figure 2.3: Security Market Line
Return
M SML
rm
rp rm – rf
rf
MODULE 2
0 sp sm Risk
2.9 INTERPRETING BETA FACTORS

If a security has a beta of 1, it means it has the same level of systematic risk as the market portfolio.
Therefore, the required return from the security would equal rm.
If a security has a beta of >1, it means it has more systematic risk than the market portfolio. Therefore,
the required return from the security would exceed rm.
If a security has a beta of <1, it means it has less systematic risk than the market portfolio. Therefore,
the required return from the security would be lower than rm.
If a security has a beta of 0, it equates to a risk-free investment.
Worked Example: CAPM (1)
Shares in Louie and Dewie have a beta of 0.9. The expected returns to the market are 10 per cent and
the risk-free rate of return is 4 per cent. What is the required return for shares in Louie and Dewie?
Solution

= 4 + 0.9 (10 – 4)
= 9.4%
Worked Example: CAPM (2)
Investors have an expected rate of return of 8 per cent from ordinary shares in Algol, which have a
beta of 1.2. The expected returns to the market are 7 per cent.
What will be the expected rate of return from ordinary shares in Rigel, which have a beta of 1.8?
Solution
Algol: E(ri) = rf + i(rm – rf)

8 = rf + 1.2(7 – rf)
8 = rf + 8.4 – 1.2 rf
0.2 rf = 0.4
rf = 2
Rigel: E(ri) = 2 + (7 – 2) 1.8
= 11%
Question 2: Expected returns from a share
The risk-free rate of return is 7 per cent. The average market return is 11 per cent.
a. What will be the return expected from a share whose beta factor is 0.9?
b. What would be the share's expected value if it is expected to earn an annual dividend of 5.3c, with
no capital growth?
2.10 PROBLEMS WITH APPLYING THE CAPM IN PRACTICE

Problems of CAPM include unrealistic assumptions and the required estimates being difficult to make.
 CAPM is a single period model, that is the results are only valid so long as the inputs (risk-free rate,
market return, beta) remain constant.
 The need to determine the market premium (rm – rf). Expected, rather than historical, returns should
be used, although historical returns are often used in practice.
 The need to determine the risk-free rate. A risk-free investment might be a government security.
However, interest rates vary with the term of the lending.
 Errors in the statistical analysis used to calculate beta values. Betas may also change over time.
Question 3: Beta factors
a. What does beta measure, and what do betas of 0.5, 1 and 1.5 mean?
b. What factors determine the level of beta which a company may have?
3 THE EFFICIENT MARKET HYPOTHESIS (EMH) AND

MARKET EFFICIENCY
LOs
2.3, Section overview
2.5
 The fundamental theory of share values states that the current market price of a share
represents the present value of all future returns from that share, discounted at the
shareholders' cost of capital (required rate of investment return).
 The efficiency of a market refers to the extent to which share prices react to information
about a company and its profitability. A market can be described as showing one of three
forms of efficiency: weak form, semi-strong form and strong form.
– Weak form efficiency implies that prices reflect all relevant information about past price
movements and their implications.
– Semi-strong form efficiency implies that prices reflect past price movements and publicly
MODULE 2
available knowledge.
– Strong form efficiency implies that prices reflect past price movements, publicly
available knowledge and inside knowledge.
 There are three types of market efficiency, allocative efficiency, operational efficiency and
pricing (informational) efficiency.
3.1 THE FUNDAMENTAL THEORY OF SHARE VALUES

The fundamental theory of share values states that the current market price of a share represents the
present value of all future expected returns from the share, discounted at the shareholders' cost of
capital (required rate of investment return).
This theory of share values is the basis of the dividend valuation model and the dividend growth
model, which will be explained in more detail in Module 4. Fundamental theory is also explored in
more detail in Module 9.
If the fundamental theory of share values is correct, it suggests that if a company undertakes a capital
project with a positive NPV, and shareholders are aware of the value of this project, then the total
value of the company's shares should rise immediately by the amount of the project's NPV.
This is a theory of share values. It raises the question of whether it has validity in practice, and if so, to
what extent.
3.2 MARKET EFFICIENCY

Definitions
An efficient market is one where the prices of securities bought and sold reflect all the relevant
information available.
The efficiency of a market refers to the extent to which share prices react to information about a
company and its profitability. Efficiency relates to how quickly and accurately prices adjust to new
information.
Efficiency of a stock market, in the context of this module, relates to the extent to which:
 information about a company is available to investors
 shareholders use this information to re-assess the value of the shares, and buy shares that seem
under-priced and sell shares that seem over-priced, so that the market price rises or falls to a
new level.
3.3 FEATURES OF EFFICIENT MARKETS

It has been argued that the world's stock markets are efficient capital markets, that is, markets in
which:
 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
 no individual dominates the market
 transaction costs of buying and selling are not so high as to discourage trading significantly
 investors are rational
 there are low, or no, costs of acquiring information.
3.4 IMPACT OF EFFICIENCY ON SHARE PRICES

If the stock market is efficient, share prices should vary in a rational way.
 If a company makes an investment with a positive net present value (NPV), shareholders will find
out and the market price of its shares will rise in anticipation of future dividend increases.
 If a company makes a bad investment shareholders will find out and so the price of its shares will
fall.
 If interest rates rise, shareholders will want a higher return from their investments, so market prices
will fall.
3.5 THE EFFICIENT MARKET HYPOTHESIS

Definition
The efficient market hypothesis is the hypothesis that the stock market reacts immediately to all the
information that is available. Therefore, a long term investor cannot obtain higher than average
returns from a well diversified share portfolio.
A market can be described as showing one of three degrees or forms of information processing
efficiency: weak form, semi-strong or strong.
3.5.1 WEAK FORM EFFICIENCY

Under the weak form hypothesis of market efficiency, share prices reflect all available information
about past changes in the share price.
Since new information arrives unexpectedly, changes in share prices should occur in a random fashion.
If it is correct, then using technical analysis to study past share price movements will not give anyone
an advantage, because the information they use to predict share prices is already reflected in the
share price.
Tests to prove that a stock market displays weak form efficiency are based on the fact that:
 share price changes are random and occur in response to historical information about the
company when it is released and becomes available
 there is no connection between past price movements and new share price changes, and trends in
prices cannot be detected.
3.5.2 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
 all knowledge which is available publicly.
This means that individuals cannot outperform the market by reading the newspapers or annual
reports, since the information contained in these will be reflected in the share price.
Tests to prove semi-strong efficiency have concentrated on the speed and accuracy of stock market
response to information and on the ability of the market to anticipate share price changes before new
information is formally announced. For example, if two companies plan a merger, share prices of the
two companies will inevitably change once the merger plans are formally announced. The market
would show semi-strong efficiency, however, if it were able to anticipate such an announcement, so
that share prices of the companies concerned would change in advance of the merger plans being
confirmed.
Research in both the US and the UK has suggested that market prices anticipate mergers several
months before they are formally announced, and the conclusion drawn is that the stock markets in
these countries do exhibit semi-strong efficiency.
3.5.3 STRONG FORM EFFICIENCY

If a stock market displays a strong form of efficiency, share prices reflect all information whether
publicly available or not:
 from past price changes
 from public knowledge or anticipation, or
MODULE 2
 from specialists' or experts' insider knowledge (e.g. investment managers).
Investors in the market will be aware of all significant future changes affecting the company and its
future profits and dividends.
A market with strong-form efficiency would be consistent with the fundamental theory of share values.
3.5.4 ALLOCATIVE, OPERATIONAL AND PRICING EFFICIENCY

Different types of efficiency can be distinguished in the context of the operation of financial markets.
There are allocative efficiency, operational efficiency and pricing (informational) efficiency.
 Allocative efficiency
If financial markets allow funds to be directed towards firms which make the most productive use of
them, then there is allocative efficiency in these markets.
 Operational efficiency
Transaction costs are incurred by participants in financial markets, for example commissions on
share transactions, margins between interest rates for lending and for borrowing, and loan
arrangement fees. Financial markets have operational efficiency if transaction costs are kept as low
as possible. Transaction costs are kept low where there is open competition between brokers and
other market participants.
 Pricing (informational) processing efficiency
The information processing efficiency of a stock market means the ability of a stock market to price
stocks and shares fairly and quickly. An efficient market in this sense is one in which the market
prices of all securities reflect all the available information.
4 IMPLICATIONS OF THE EFFICIENT MARKET

HYPOTHESIS
LO
 If the markets are quite strongly efficient, the main consequence for financial managers will
be that they simply need to concentrate on maximising the net present value of the
company's investments in order to maximise the wealth of shareholders.
4.1 IMPLICATIONS OF EMH COMPANIES

An implication of the EMH is that managers need not worry about the effect on share prices of
financial results in the published financial statements because investors will make allowances for low
profits or dividends in the current year if higher profits or dividends are expected in the future.
If the market is strongly efficient, there is little point in financial managers attempting strategies that
will attempt to mislead the markets.
 There is no point for example in trying to identify a correct date when shares should be issued,
since share prices will always reflect the true worth of the company.
 The market will identify any attempts to present the figures more favourably.
 The market will decide what level of return it requires for the risk involved in making an investment
in the company. It is pointless for the company to try changing the market's view by issuing
different types of capital instrument.
Similarly, if the company is looking to expand, the directors will be wasting their time if they seek as
takeover targets companies whose shares are undervalued, since the market will fairly value all
companies' shares.
Only if the market is semi-strongly efficient, and the financial managers possess inside information that
would significantly alter the price of the company's shares if released to the market, could they
perhaps gain an advantage. However, attempts to take account of this inside information may breach
insider dealing laws.
The different characteristics of a semi-strong form and a strong form efficient market therefore affect
the timing of share price movements, in cases where the relevant information becomes available to
the market eventually. The difference between the two forms of market efficiency concerns when the
share prices change, not by how much prices eventually change.
4.2 IMPLICATIONS OF EMH FOR INVESTORS

The efficient market hypothesis (EMH) implies that if new information is revealed about a company it
will be incorporated into its share price rapidly and rationally, with respect to both the direction and
size of the share price movement.
 In an efficient market, no investor will be presented with an opportunity for making a return on a
share that exceeds the fair return for the risk associated with that share.
Stock markets are widely held to be at least semi-strong efficient. The absence of abnormal profit
possibilities arises because current and past information is immediately reflected in current prices.
It is only new information, which causes prices to change. Therefore, an individual investor would
only be able to consistently outperform the market by gaining access to information before it
became available to the majority of investors. For the vast majority of investors this implies that
public information cannot be used to earn abnormal returns.
 The implication is that fundamental analysis is a waste of money and that so long as efficiency is
maintained, the average investor should simply select a suitably diversified-portfolio, thereby
avoiding costs of analysis and transaction.
In practice, timing differences in the availability of information and other market may allow
fundamental analysts to make superior profits by taking advantage of temporary pricing errors until
the market recognises the pricing mistake and acts to correct it.
KEY MODULE POINTS
 The concept of time value of money recognises that $1 today is worth more than $1 at a future
time, because money can be reinvested to earn more money over time.
 Cash flows and not accounting profits should be used for investment appraisal and
decision-making.
 The relevant cash flows for appraisal of a project are the changes in future cash flows that would
arise from acceptance of the project.
 The Capital Asset Pricing Model (CAPM) is a formula for predicting the required rate of return for
an investment, based upon its level of systematic risk relative to that of the market as a whole. It
can be used to calculate a discount rate or cost of equity that incorporates risk.
 The risk involved in holding securities (shares) divides into risk specific to the company
(unsystematic) and risk due to variations in market activity (systematic).
 Unsystematic or business risk can be diversified away, while systematic or market risk cannot.
MODULE 2
 CAPM is based on a comparison of the systematic risk of individual investments with the risks of all
shares in the market.
 CAPM states that the required return of a well-diversified investor will be based on the riskfree
rate, plus a premium for systematic risk. The size of this premium is the difference between the
average stock market returns and the risk-free rate of return, multiplied by a beta factor: i(rm – rf).
 The beta factor measures the systematic risk of a security relative to the risk of the market portfolio.
 Each company's equity has its own beta factor. A higher beta indicates higher (nondiversifiable)
systematic risk. When a company has a beta factor in excess of 1.0, its expected returns are higher
than the average returns for the market as a whole. A beta factor of less than 1.0 indicates
systematic risk lower than the market average, and so expected returns are also lower than the
market average.
 The fundamental theory of share values states that the current market price of a share represents
the present value of all future returns from that share, discounted at the shareholders' cost of
capital (required rate of investment return).
 The efficiency of a market refers to the extent to which share prices react to information about a
company and its profitability. A market can be described as showing one of three forms of
efficiency: weak form, semi-strong form and strong form.
– Weak form efficiency implies that prices reflect all relevant information about past price
– Semi-strong form efficiency implies that prices reflect past price movements and publicly
– Strong form efficiency implies that prices reflect past price movements, publicly available
knowledge and inside knowledge.
 There are three types of market efficiency, allocative efficiency, operational efficiency and pricing
(informational) efficiency.
 If the markets are quite strongly efficient, the main consequence for financial managers will be that
they simply need to concentrate on maximising the net present value of the company's
investments in order to maximise the wealth of shareholders.
1 Which of the following risks can be eliminated by diversification?

A market risk
B inherent risk
C systematic risk
D unsystematic risk
2 A portfolio consisting entirely of risk-free securities will have a beta factor of:
A –1
B 0
C +1
D none of the above
3 The following two statements concern the propositions which underpin the capital asset pricing
model (CAPM).
I. Investors in shares require a return in excess of the risk-free rate to compensate for systematic
risk.
II. Investors will require higher returns from shares in companies where the level of systematic risk
is higher.
Which one of the following combinations (True/False) is correct?
Statement
I II
A True True
B True False
C False True
D False False
4 Different types of efficiency can be identified in the operation of capital markets.
To which particular type of efficiency do the terms 'weak form', 'semi-strong form' and 'strong
form' apply?
A allocative efficiency
B economic efficiency
C operational efficiency
D information processing efficiency
5 Which one of the following statements is most consistent with the strong form of the efficient
markets hypothesis?
A Investors can use insider dealing to make abnormal profits.
B Over the long term, the expected return from all shares will be the same.
C Investors have access to all relevant information about a company and its plans.
D Past movements in share prices can be used to predict future movements in share prices.
1 D Unsystematic risk is risk that is specific to sectors, companies or projects. Systematic risk (also
known as inherent risk or market risk) affects the whole market and therefore cannot be reduced
by diversification.
2 B Beta factor is the measure of the systematic risk of a security relative to the risk of the market
portfolio. A beta of 0 equates to a risk-free investment with returns that do not fluctuate despite
fluctuations in the market.
3 A The capital asset pricing model assumes investors are already well-diversified and therefore
unconcerned with unsystematic risk. It is concerned with how systematic risk affects required
returns and share prices. Investors in shares require a return in excess of the risk-free rate, to
compensate them for systematic risk. The higher the systematic risk, the higher the return
required.
4 D The information processing efficiency of a stock market refers to the ability of a stock market to
price stocks and shares fairly and quickly. A market can be described as showing one of three
MODULE 2
forms of information processing efficiency: weak form, semi-strong form and strong form.
Allocative efficiency refers to financial markets allowing funds to be directed towards firms
which make the most productive use of them; operational efficiency exists if transaction costs in
financial markets are kept as low as possible. Economic efficiency refers to the optimum use of
resources in order to maximise the production of goods and services.
5 C If a stock market displays a strong form of efficiency, share prices reflect all information whether
publicly available or not.
If investors are able to make gains from insider dealing it implies the market is only semi-strong
form.
The efficient market hypothesis does not imply that in the long run returns from shares will not
differ, simply that if the stock market is efficient, share prices should vary in a rational way.
The use of past price movements to predict future share prices would imply the market is not
efficient at any level.
1 The expected return on DEF shares would exceed the risk-free return by (13  9)  1.5% = 6% and
the total expected return on DEF shares would be (9 + 6)% = 15%.
If the market returns fall by 3% to 10%, the expected return on DEF shares would fall by 1.5  3% =
4.5% to 10.5%, being 9% + (10  9)  1.5% = 10.5%.
2 a. 7% + 0.9 (11%  7%) = 10.6%
5.3c
b. = 50c
10.6%
3 a. Beta measures the systematic risk of a risky investment such as a share in a company. The total
risk of the share can be sub-divided into two parts, known as systematic (or market) risk and
unsystematic (or unique) risk. The systematic risk depends on the sensitivity of the return of
the share to general economic and market factors such as periods of boom and recession. The
capital asset pricing model shows how the return which investors expect from shares should
depend only on systematic risk, not on unsystematic risk, which can be eliminated by holding a
well-diversified portfolio.
Beta is calibrated such that the average risk of stock market investments has a beta of 1.
Therefore, shares with betas of 0.5 or 1.5 would have half or 1½ times the average sensitivity to
market variations respectively.
This is reflected by higher volatility of share prices for shares with a beta of 1.5 than for those
with a beta of 0.5. For example, a 10 per cent increase in general stock market prices would be
expected to be reflected as a 5 per cent increase for a share with a beta of 0.5 and a 15 per cent
increase for a share with a beta of 1.5, with a similar effect for price reductions.
b. The beta of a company will be the weighted average of the beta of its shares and the beta of
its debt. The beta of debt is very low, but not zero, because corporate debt bears default risk,
which in turn is dependent on the volatility of the company's cash flows.
Factors determining the beta of a company's equity shares include:
i. Sensitivity of the company's cash flows to economic factors, as stated above. For example,
sales of new cars are more sensitive than sales of basic foods and necessities.
ii. The company's operating gearing. A high level of fixed costs in the company's cost structure
will cause high variations in operating profit compared with variations in sales.
iii. The company's financial gearing. High borrowing and interest costs will cause high
variations in equity earnings compared with variations in operating profit, increasing the
equity beta as equity returns become more variable in relation to the market as a whole. This
effect will be countered by the low beta of debt when computing the weighted average beta
of the whole company.
49
MODULE 3
INTRODUCTION TO RISK
IDENTIFICATION,
ASSESSMENT AND
MANAGEMENT
Define the term risk LO3.1
Describe the different types of risk in international trade LO3.2
Explain the different methods of risk assessment in international trade LO3.3
Identify the key financial risks facing a business LO3.4
Topic list
1 Risk identification
2 Risks for businesses
3 Risk assessment
4 Risk management and attitudes to risk
MODULE OUTLINE
Exposure to risk is an essential part of a company running its operations, and investors investing their
money in a company's shares. Risk is increased for businesses engaged in international trade.
This module considers the concept of risk and uncertainty through three main stages; identification,
assessment and management.
The module begins by considering what risk and uncertainty are before setting out an overview of risk
in international trade. The module continues by looking further at the main specific types of risk that a
business will face including that of foreign currency and interest rate risk.
Once identified, the potential impact of the risk must be assessed and a number of risk assessment
techniques will be explained.
Finally, the module introduces the concept of risk management and the various attitudes to risk that a
business may take. Advanced methods of dealing with foreign currency and interest rate risks
including derivatives will be dealt with in Module 8.
Risk identification,
assessment and management
Upside risk – opportunity
Downside risk – loss
Risk and uncertainty Risks of international trade

Uncertainty – about the future • Enhanced trading risk
due to lack of information • Environmental risk
• Foreign currency risk
Risk – variability of possible
outcomes
Both are faced by companies
Risk identification and assessment
and investors
• Risk = probability × financial consequences
• Quantitative or qualitative assessment
• (Institute of Risk Management) IRM techniques
Types of risk
• Financial risks
• Operating risks
• Foreign currency risk
• Interest rate risk
Attitude to risk
• Risk averse
• Risk neutral
• Risk seeking
Risk management strategies

• Avoidance
• Reduction
• Transfer
• Retention
INTRODUCTION TO RISK IDENTIFICATION, ASSESSMENT AND MANAGEMENT | 51
BEFORE YOU BEGIN
area.
everything covered.
1 What is the difference between risk and uncertainty? (Sections 1.1 and 1.2)
2 What are the environmental risks involved in international trade? (Section 1.4)
3 Explain two types of foreign currency risk. (Section 2.5)
4 Explain what interest rate risk is. (Section 2.6)
5 State two different risk classifications. (Section 2.8)
6 What does a quantitative risk assessment involve? (Section 3.2)
7 Explain the four possible strategies for managing risk. (Section 4.1)
8 What are the three main 'attitudes to' or 'appetites for' risk? (Section 4.2)
MODULE 3
1 RISK IDENTIFICATION
LOs
3.2
 Risk is the possible variation in an outcome from what is expected to happen.
 Uncertainty is the inability to predict the outcome of an activity due to a lack of
information.
 The risks faced by a company can be looked at from the point of view of the company and
its management, and also the investors in the company.
1.1 BUSINESS RISK

From the perspective of a business, there are many possible situations that can be considered to be a
risk. For example, natural disasters or a changing political or business environment, however, to define
what risk is we need to look into the situations a little deeper.
Definition
Risk is the possible variation in an outcome from what is expected to happen.
Risk arises because events cannot be predicted with certainty. It is common to consider risk as
negative, such as a company making a loss or safety risk management concentrating on the
prevention or minimisation of harm, however finance theory considers risk more broadly.
Risk implies variability which may work in the favour of the business (an opportunity) or against it
(a risk). Risks and opportunities arise because the future is not known with certainty.
Definitions
Risk is the possibility that an event will occur and adversely affect the achievement of objectives. This
is also known as downside risk.
Opportunity is the possibility that an event will occur and positively affect the achievement of
objectives. This is also known as upside risk.
Risk management is concerned with both the positive and negative aspects of risk.
1.2 UNCERTAINTY
Risk and uncertainty are not the same. Risk considers the variability of possible outcomes. Uncertainty
arises when information is insufficient to allow an outcome to be predicted.
Definition
Uncertainty is the inability to predict the outcome of an activity due to a lack of information.
Risk is capable of being evaluated and for the purposes of risk management is often defined as the
combination of the probability of an event and its consequences.
Risk = Probability  Financial consequences
Uncertainty is non-quantifiable (e.g. whether a customer will be retained for the next two years).
Uncertainty of a measure or a particular outcome may be demonstrated by giving it a range of values
or a best guess  something. Uncertainty is central to the modelling of future events such as stock
market forecasting.
1.3 RISKS OF INTERNATIONAL TRADE

We shall consider more detailed, specific risks that a business may face in Section 4, but at this point
it is important to understand risk from a wider perspective in order to gain an overview of risk in the
international business environment.
International trade involves the buying and selling of goods and services with countries around the
world. As well as offering a wider sales market and hence increased sales and profit potential,
international trade may offer access to cheaper resources.
The benefits of international trade need to be considered in the context of the additional risk
involved:
 Both domestic and international traders will face trading risks, but the risks of international trade
will be higher due to the increased distances and times involved.
 Environmental risk relates to the country in which the company operates and its political, legal,
economic, social and cultural environment (see below).
 Legal restrictions may also exist in some markets, limiting ownership of securities by foreign
investors.
 Foreign exchange regulations may prohibit international investment or make it more expensive.
Transacting in foreign currency increases the variability of income streams.
 Double taxation of income from foreign investment may deter investors.
 There are likely to be higher information and transaction costs associated with investing in foreign
securities.
1.4 ENVIRONMENTAL RISK

As mentioned above, the environmental risk that businesses face include factors such as the political,
legal, economic, social and cultural environment. Such risks are also known as country or sovereign
risk.
MODULE 3
1.4.1 POLITICAL AND LEGAL RISKS
Political risk may involve the stability of its government and economy, the government's policies and
any changes made to them, its attitude to foreign investment and foreign trade, exchange control
regulations.
For example:
 Import quotas could be used to limit the quantities of goods that a subsidiary can buy from its
parent company and import for resale in its domestic markets.
 Import tariffs could make imports more expensive and domestically produced goods therefore
more competitive.
 Legal standards of safety or quality (non-tariff barriers) could be imposed on imported goods to
prevent multinationals from selling goods which have been banned as dangerous in other
countries.
 Exchange control regulations could be applied.
 A government could restrict the ability of foreign companies to buy domestic companies,
especially those that operate in politically sensitive industries such as defence contracting,
communications, and energy supply.
 A government could nationalise foreign-owned companies and their assets (with or without
compensation).
 Legislation requiring a minimum shareholding in companies by domestic residents. This would
force a multinational to offer some of the equity in a subsidiary to investors in the country where
the subsidiary operates.
Organisations may also face risks from lack of legislation (or lack of enforcement of legislation)
designed to protect them.
1.4.2 ECONOMIC RISK

Definition
Economic risk refers to the effect of exchange rate movements on the international competitiveness
of a company and refers to the effect on the present value of longer term cash flows.
For example, an Australian company might use raw materials which are priced in Chinese RMB, but
export its products mainly to US. A depreciation of the Australian dollar against the RMB or an
appreciation of the Australian dollar against the US dollar will both erode the competitiveness of the
company. Economic exposure can be difficult to avoid, although diversification of the supplier and
customer base across different countries will reduce this kind of exposure to risk.
1.4.3 SOCIO-CULTURAL RISK

Socio-cultural risk is derived from differences in culture between nations, it may affect:
 expectations of conduct and behaviour (e.g. the responsibility owed by a firm to the wider
community and environment)
 methods of conducting business (e.g. conventions regarding negotiations, gifts, status, face-to-
face contact)
 approach to managing staff (e.g. language differences, attitudes to authority, need for status and
self-respect)
 products offered, religious prescriptions regarding food, appropriateness of brand names
 methods of promotion, language of adverts, imagery used, restrictions concerning what is
acceptable.
The risk is enhanced if the company lacks knowledge in these areas.
1.5 TRADING RISKS

Trading risks are risks that occur as a consequence of a trade taking place, these may include:
 physical risk: The risk of goods being lost or stolen in transit, or the documents accompanying the
goods going astray.
 credit risk: The possibility of payment default by the customer. The logistics involved in credit
collection may enhance the risk of bad debts (we shall consider credit risk shortly and again in
Module 8).
 trade risk: The risk of the customer refusing to accept the goods on delivery (due to
sub-standard/inappropriate goods), or the cancellation of the order in transit.
 liquidity risk: The inability to finance the credit. Increased international trade is likely to give rise to
the need for increased working capital.
Such risks may be reduced with the help of banks, insurance companies, credit reference agencies
and government agencies. Other ways to reduce these risks include risk transfer. A business shipping
parcels overseas may agree a contract obligating the courier to pay for losses in excess of its statutory
liability.
2 RISKS FOR BUSINESSES
LO
 Internal risks are risks arising from factors internal to the company, factors over which the
company can exercise control.
 External risks are risks arising from factors outside the business, that the company may be
subject to but that it has no influence over.
 Financial risk is the risk arising as a result of how the business is financed.
 Operating risk is all the risks faced by a business that are not financial risks. It is the
variability of returns due to how and where a business trades or operates, its exposure to
markets, competitors and so on.
2.1 TYPES OF RISK

Identifying risks is the first stage in developing a business's risk profile. Risk can be subcategorised in
several ways. For example, it may be split into internal and external risk. Another way to sub-analyse
risk is to split it between operating risk and financial risk.
2.1.1 INTERNAL AND EXTERNAL RISK

Internal risks are risks arising from factors internal to the company, factors over which the company
can exercise control. Internal risk can be sub-analysed into:
 process risk
 people risk
 systems risk
MODULE 3
External risks are risks arising from factors outside of the control of the business, factors that the
company may be subject to but that it has no influence over. Examples of external risks include:
 natural disasters
 competitors changing their strategies
 commodity price changes.
2.1.2 FINANCIAL AND OPERATING RISK

Financial risk is the risk arising as a result of how the business is financed.
Operating risk is all the risks faced by a business that are not financial risks.
2.2 FINANCIAL RISK

Financial risk is the risk arising as a result of how the business is financed – its level of gearing or
leverage, its exposure to credit, interest rates and exchange rates. We shall consider foreign currency
and interest rate risk in Sections 2.6 and 2.7. Financial risk tends to increase the inherent operational
risk at low levels of gearing, but at higher levels may directly contribute to the risk of business failure.
James Lam (Enterprise Risk Management (2003)) divides financial risk into credit risk and market risk.
 Credit risk is 'the economic loss suffered due to the default of a borrower or counterparty' (e.g. a
customer or supplier). In other words it is highly relevant to large financial institutions such as
banks. Credit risk is the main type of financial risk faced by small businesses, particularly the risk
that their customers won't pay them, or won't pay them quickly enough. Credit risk is also known as
default risk and is covered in Module 8 on market and credit risk management.
 Market risk is 'the exposure to potential loss that would result from changes in market prices or
rates'. The relevant prices or rates might include share prices, commodity prices, interest rates and
foreign exchange rates. This is examined in more detail in Module 8 as well.
Another type of financial risk is funding risk. This is the risk of a project's cash flow being impacted
due to higher funding costs or the lack of availability of funds to finance the project.
2.3 OPERATING RISK

Operating risk is all the risks faced by a business that are not financial risks.
It is the variability of returns due to how and where a business trades or operates, its exposure to
markets, competitors among numerous other factors.
This operating risk can itself be sub-analysed into:
 Strategic/business risk – risks associated with the long-term strategic objectives of the business,
potential variability of business returns arising as a result of the company strategy and its strategic
position with respect to competitors, customers, reputation, legal, regulatory change or political
change. Strategic risk also encompasses knowledge management, which is the effective
management and control of the knowledge resources including key personnel, intellectual
property and production technology.
 Operational risk – variability arising from the effectiveness of how the business is managed and
controlled on a day to day basis, the accuracy and effectiveness of its information/accounting
systems, its reporting systems and its management and control structures. Operational risk also
includes compliance with issues such as health and safety, consumer protection, data protection
and so on.
 Hazard/events risk – the exposure a business may have to natural events and their impacts, the
actions of employees, the consequences of accidents etc, be it on the business, its trading partners
or customers.
2.4 RISKS FOR COMPANIES

The risks faced by a company can also be looked at from the point of view of:
 the company and its management
 providers of capital to the company, both debt finance and equity finance.
2.4.1 THE COMPANY

If the objective of a company is to maximise shareholder wealth then risks for a company are risks of
losses, resulting (directly or indirectly) in negative cash flows. When losses become severe, there might
be a risk of insolvency, leading to the liquidation of the company.
The activities of certain companies are inherently risky because they are potentially dangerous to
public well-being: transport companies and pharmaceutical companies are obvious examples.
2.4.2 RISKS FOR PROVIDERS OF CAPITAL (INVESTORS)

Investors also bear risks. Providers of debt capital to a company have to bear the risk that the
company will default on its debt obligations, and fail to make an interest payment or might even
become insolvent and unable to repay the loan principal. A lender or investor in company bonds will
expect a higher yield than that offered on, for example, check government bonds, to compensate for
higher risk.
Shareholders are the ultimate bearers of risk. If a company becomes insolvent, they will lose all their
investment. More important, if company profits fall, dividends and the share price are also likely to fall.
Providers of debt capital are entitled to interest before any profits can be paid as dividends, so that
the risk to income is much less for debt providers than for equity shareholders.
Risk for shareholders is two-way: there is the possibility of poor returns (no dividends or low dividends,
and a fall in the share price), or profits and dividends might be higher than expected, and the share
price might rise by more than anticipated. Risk is greater for shareholders when there is a greater
possibility of wide variations in profits, dividends and share prices from year to year.
The range of potential variation in returns is known as the volatility of returns. Volatility varies between
different companies.
2.5 FOREIGN CURRENCY RISK

As mentioned previously, foreign currency risk is a type of financial risk (along with interest rate risk)
that a business may face. It occurs in three forms: transaction exposure (in the short-term), translation
exposure (creating book gains or losses) both of which are described below. The third form, economic
exposure, which is the effect on present value of longer term cash flows is also a type of economic risk.
2.5.1 TRANSLATION RISK

Definition
Translation risk is the risk that the organisation will make exchange losses when the accounting
results of its foreign branches or subsidiaries are translated into the home currency.
Translation losses can result, for example, from restating the book value of a foreign subsidiary's
assets at the exchange rate on the statement of financial position date.
2.5.2 TRANSACTION RISK

Definition
Transaction risk is the risk of adverse exchange rate movements occurring in the course of normal
international trading transactions.
This arises when the prices of imports or exports are fixed in foreign currency terms and there is
movement in the exchange rate between the date when the price is agreed and the date when the
cash is paid or received in settlement.
One consequence of taking and granting credit is that international traders will know in advance
about the receipts and payments arising from their trade. They will know:
MODULE 3
 what foreign currency they will receive or pay;
 when the receipt or payment will occur; and
 how much of the currency will be received or paid.
The great danger to profit margins is in the movement in exchange rates. The risk faces (i) exporters
who invoice in a foreign currency and (ii) importers who pay in a foreign currency.
Worked Example: Transaction risk – changes in exchange rates
Bulldog Pty Ltd, an Australian company, buys goods from Redland which cost 100 000 Reds (the local
currency). The goods are re-sold in Australia for $32 000. At the time of the import purchase the
exchange rate for Reds against the dollar is 3.5650 – 3.5800.
Required
a. What is the expected profit on the re-sale?
b. What would the actual profit be if the spot rate at the time when the currency is received has
moved to:
i. 3.0800 – 3.0950
ii. 4.0650 – 4.0800?
Ignore bank commission charges.
Solution
a. Bulldog must buy Reds to pay the supplier, and so the bank is selling Reds. The expected profit is
as follows:
AUD
Revenue from re-sale of goods 32 000.00
Less cost of 100 000 Reds in dollars (/ 3.5650) 28 050.49
Expected profit 3 949.51
b. i. If the actual spot rate for Bulldog to buy and the bank to sell the Reds is 3.0800, the result is as
follows:
AUD
Revenue from re-sale 32 000.00
Less cost (100 000 / 3.0800) 32 467.53
Loss (467.53)
ii. If the actual spot rate for Bulldog to buy and the bank to sell the Reds is 4.0650, the result is as
follows:
AUD
Revenue from re-sale 32 000.00
Less cost (100 000 / 4.0650) 24 600.25
Profit 7 399.75
This variation in the final Australian dollar cost of the goods (and therefore, the profit) illustrates the
concept of transaction risk.
Action to reduce or eliminate transaction exposure is known as hedging. Methods of hedging are
discussed later.
2.6 INTEREST RATE RISK

As with foreign currency risk, interest rate risk is one element of financial risk. When a company
borrows or lends funds, it is exposed to the risk of changes in the market rate of interest. Changes in
the interest rate will result in the company either paying or receiving more or less interest than it might
otherwise have done.
Definition
Interest rate risk is the risk of higher or lower profits or losses than expected, as a result of uncertainty
about future movements in an interest rate, or the general level of interest rates.
Interest rates are effectively the 'prices' governing lending and borrowing of money. The pattern of
interest rates on financial assets is influenced by the risk of the assets, the duration of the lending, and
the size of the loan. There is a trade-off between risk and return. Investors in riskier assets expect to
be compensated for the risk.
Interest rate risk relates to the sensitivity of profit and cash flows to changes in interest rates. An
organisation will need to analyse how profits and cash flows are likely to be affected by forecast
changes in interest rates and decide whether to take action.
Worked Example: Interest rate change
Suppose that a company borrows $10 million for one year at a fixed rate of interest of 7 per cent,
when it could have obtained an overdraft facility for $10 million for a year at 7.5 per cent. If the interest
rate were to fall, to the point where the company would have been paying overdraft interest of just,
say, 6 per cent, it will be paying interest on its fixed rate loan at 1 per cent per annum more than it
need have done. The annual cost of 1 per cent interest on $10 million is $100 000.
2.6.1 IMPACT OF INTEREST RATE CHANGES ON FINANCIAL ASSETS

Financial assets that provide a fixed rate of interest to their holders change in value with changes in
market interest rates. For example, suppose that a bond pays 6 per cent interest and is currently
valued at par (100.00). The par value would indicate that investors currently expect to earn a yield of
6 per cent on bonds of this type. However, if market interest rates on similar bonds went up, say to
8 per cent, bond investors would expect to receive a yield of 8 per cent on their investment. A bond
paying out only 6 per cent will no longer be worth 100.00, and the market price of the bond will fall
(to $75, so that its yield – 6 / 75 – is 8 per cent).
2.6.2 IMPACT OF INTEREST RATE CHANGES ON SHARES

Interest rate risk also applies indirectly to shares. Shareholders receive dividends, not interest.
However, when interest rates in the market go up or down, there is often a tendency for the expected
dividend yields on shares to go up or down in the same direction. When interest rates rise, there is
consequently a tendency for share prices, as well as bond prices, to fall. Similarly, when interest rates
fall, bond prices will rise, and there might also be a rise in share prices as well.
2.6.3 IMPACT OF INTEREST RATE CHANGES AND CAPITAL GAINS OR LOSSES ON BONDS
When market interest rates on bonds (or other fixed interest financial instruments) go up or down,
there will be a fall or rise in the market value of bonds. Bond prices fall when interest rates go up, and
rise when interest rates fall.
For example, suppose the government issues long-term bonds at a coupon interest rate of, say,
7 per cent and the market rate of interest is also 7 per cent, the market value of the securities will be
$100 per $100 face value of the stock (or '100 per cent'). This is because bonds have a par value
whenever they offer a coupon rate of interest equal to the current market interest yield.
a. Suppose that interest rates in the market subsequently rise to 10 per cent, the re-sale value of the
bonds will fall to about:
$100  7% / 10% = $70.00 per $100 face value of the stock
An investor in the bonds will make a capital loss of $30 (plus selling costs) if he or she decides to
sell the securities.
b. If nominal interest rates subsequently fall to, say, 5 per cent, the re-sale value of the bonds will rise
to:
$100  7% / 5% = $140 per $100 face value
An investor could then sell the asset for a capital gain of $40 (less selling costs).
2.6.4 IMPACT OF INTEREST RATE CHANGES ON FINANCING DECISIONS
MODULE 3
Interest rates are important for financial decisions by companies.
 When interest rates are low, it might be financially prudent:
– to borrow more, preferably at a fixed rate of interest, and so increase the company's gearing
– to borrow for long periods rather than for short periods
– to pay back loans on which the rate of interest is high and to take out new loans at a lower
interest rate.
 When interest rates are high and expected to remain at that level or even go higher:
– a company might decide to reduce the amount of its debt finance, and to substitute it with new
equity finance, such as retained earnings
– a company which has a surplus of cash and liquid funds might switch some of its short-term
investments out of equities and into interest-bearing securities
– a company might opt to raise new finance by borrowing at a variable interest rate, for example,
by taking out a loan with a variable interest rate, rather than borrowing long-term funds at fixed
rates of interest (by issuing bonds). The company would then benefit from any eventual fall in
interest rates.
2.6.5 IMPACT OF INTEREST RATE CHANGES ON NEW CAPITAL INVESTMENTS

When interest rates go up, and so the cost of finance to a company goes up, the minimum return
that a company will require on its own new capital investments will go up too. Some new capital
projects might be in the pipeline, with purchase contracts already signed with suppliers, and so there
will often be a time lag before higher interest rates result in fewer new investments.
A company's management should give close consideration, when interest rates are high, to keeping
investments in assets down to a minimum in order to reduce the company's need to borrow.
2.7 INTEREST RATE RISK EXPOSURES

Interest rate risk includes
 the risk of paying more interest on debt than necessary
 the risk of losses on interest-earning investments, and
 the risk of being unable to meet debt payment obligations.
Risk management issues include ensuring that the maturity mix of debt instruments is manageable
and maintaining a suitable balance between fixed rate and floating rate borrowings.
An organisation has some exposure to interest rate risk if it:
 has any assets that earn interest, or
 has any liabilities on which interest is paid.
Companies with massive amounts of financial assets and liabilities (e.g. commercial banks) face the
greatest interest rate risks. Not surprisingly, they have developed extensive risk management systems
to hedge and control these risks. Some institutions have more financial assets than liabilities: these
include investment institutions and investment funds.
Many non-bank trading companies might have a few interest-bearing financial assets, but substantial
borrowings. Borrowing creates an exposure to interest rate risk.
2.7.1 FLOATING VERSUS FIXED INTEREST RATE DEBT

The most common form of interest rate risk faced by a company is the volatility of cash flows
associated with a high proportion of floating interest rate debt. Floating interest rates, of course,
change according to general market conditions.
Some of the interest rate risks to which a firm is exposed may cancel each other out, where there are
both assets and liabilities on which there is exposure to interest rate changes. If interest rates rise,
more interest will be payable on loans and other liabilities, but this will be compensated for by higher
interest received on assets such as money market deposits.
A company with a high proportion of fixed interest rate debt has a commitment to fixed interest
payments. If interest rates fall sharply, the company will suffer from a loss of competitive advantage
compared with companies using floating rate borrowing whose interest costs and cost of capital will fall.
2.8 RISK CLASSIFICATIONS

Pulling together the contents of this section, we may view the risks faced by any business as falling
into four quadrants of
 financial risk
 strategic/business risk
 operational risk
 hazard/events risk.
Each of these can be sub-analysed between external and internal influences, as shown in the following
diagram:
Figure 3.1: Examples of the Drivers of Key Risks
Externally driven
Financial risks Strategic risks

Competition
Interest rates Customer changes
Foreign exchange Industry changes
Credit Customer demand
M&A
integration
Research &
Liquidity development
and cash flow Intellectual capital
Internally driven
Accounting controls
Information systems
services Contracts
Regulations Natural events
MODULE 3
Culture Suppliers
Board composition Environment
Operational risks Hazard risks
Externally driven
Source: Institute of Risk Management, A Risk Management Standard (2002)
Question 1: Risk classification
Identify the risks faced by a business with which you are familiar.
3 RISK ASSESSMENT
LO
 Risk identification involves considering the internal and external events that may give rise to
specific risks for a particular business.
 Risk assessment involves the evaluation or ranking of the identified risks in order to identify
significant risks and implement suitable risk responses.
 Each risk can be assessed from the point of view of its potential impact (significance) and its
probability of occurrence (likelihood).
 Quantitative risk assessment involves the determination of measured figures for
probabilities and consequences, producing a specifically quantified measure of risk.
 The alternative is a qualitative (subjective) risk assessment perhaps using a relative
high-medium-low style assessment.
3.1 RISK IDENTIFICATION

In Section 2 we considered the types of risk that any business may face.
Suppose an organisation was considering launching a new product in China but knew absolutely
nothing about doing business in China. It is highly likely that it will not be aware of many of the risks
that could be encountered, because of factors such as different regulations, different ways of
approaching customers, differences in disposable income and so on. The risks remain to be
identified.
Risk identification can start by considering:
 external events such as political developments, economic changes, social considerations,
technological advances, environmental issues and legislation (PESTEL factors)
 internal events such as equipment problems, human error or difficulties with processes and systems.
Risk identification must be a continuous process as potential new risks may arise and existing risks may
change.
3.1.1 IDENTIFICATION TECHNIQUES

Identification techniques may make use of past data: for example, it may be possible to assess how
likely it is that suppliers will deliver late on the basis of suppliers' historical delivery records.
A company may also try to take account of possible future data: for example, if a company starts
offering a new service, it may consider how easy would it be for competitors to do likewise, and if they
do what impact that would have on their own plans and projections.
3.2 RISK ASSESSMENT

Risk assessment should be undertaken for all new strategies and proposed investment projects as well
as for routine operations.
Risk assessment involves the evaluation or ranking of the identified risks in order to identify significant
risks and implement suitable risk responses.
Risk assessment involves for each risk:
 Analysis – Considering the nature of the risk, and what implications it might have for the
organisation.
 Evaluation – Making an initial judgment about the seriousness of the risk.
Remember that
Risk = Probability  Financial consequences
so each risk can be assessed from two aspects:

 its potential impact, in other words how serious it would be
 its probability of occurrence (or likelihood).
3.2.1 QUANTITATIVE RISK ASSESSMENT

Quantitative risk assessment involves the determination of measured figures for probabilities and
consequences producing a specifically quantified measure of risk.
In many cases the financial consequences are easy to measure (e.g. the value of lost inventories or the
cost of rebuilding premises). More problematic, however, is the assessment of the probability of
occurrence. Though insurance companies have detailed statistical information on the occurrence of
many risk events, it is much more difficult to establish probabilities for the less likely events such as
natural disasters.
Some types of risk lend themselves to a quantitative assessment process, such as many financial risks.
For certain risks it may be very difficult to achieve, for example, the impact of an event on the
reputation of a business is much harder to quantify, and from this perspective risk assessment is more
subjective. The effort required and cost incurred in undertaking a full quantitative assessment is liable
to be substantial, and may not be cost-effective.
3.2.2 QUALITATIVE RISK ASSESSMENT

An alternative that may make risk prioritisation more practical is qualitative risk assessment. This
involves a subjective risk assessment perhaps using a relative high-medium-low style assessment.
The overall risk of an event can, by this system, be determined by reference to a risk map or risk
matrix, with one axis for the impact or consequences of the risk and the other for the probability or
MODULE 3
frequency of occurrence. Such a diagram can help management to reach a view about:
 which risks seem more serious than others (risks with a high impact and high probability would be
considered a priority), and
 the nature of the risk management measures that might be appropriate for dealing with each risk.
Here is a simple example: the identification of risks and their placement is arbitrary, of course because
this would be different for every organisation.
Figure 3.2: Risk matrix
PROBABILITY
Low Medium High
Loss of sales due to

Failure of computer Loss of senior or
High macroeconomic
systems specialist staff
factor
IMPACT Medium Loss of key customers
Loss of lower-level
Low Loss of suppliers
staff
A qualitative assessment has the advantage of being much easier to undertake, though it is highly
subjective. However, if it is consistently applied to all risks it does facilitate prioritisation.
3.3 INSTITUTE OF RISK MANAGEMENT APPROACH

In A structured approach to Enterprise Risk Management, the Institute of Risk Management (IRM)
identifies the following, commonly used techniques for risk identification and assessment:
 use of structured approaches to risk recognition – Strengths Weaknesses Opportunities Threats
(SWOT) and Political Economic Social Technological Legal Environmental (PESTLE) analyses
 use of structured questionnaires and checklists to collect information to assist with the recognition
of the significant risks
 workshops and brainstorming to share ideas and discuss the events that could impact on the
organisation
 physical inspections of premises and activities and audits of compliance with established systems
and procedures
 use of flowcharts to analyse processes and operations within the organisation to identify critical
components that are key to success.
The IRM also suggests the following approach for benchmarking the significance of risks:
 For financial risks, a sum of money can be used as the benchmark test of significance.
 For risks that can cause disruption to operations, the length of disruption may be a suitable test.
 Reputational risks can be benchmarked in terms of the profile that the report of the event would
receive, the likely impact of the event on share price, or the impact on the political and financial
support received from key stakeholders.
4 RISK MANAGEMENT AND ATTITUDES TO RISK
LO
 Risk management is the process of identifying and assessing (analysing and evaluating)
risks and the development, implementation and monitoring of a strategy to respond to
those risks.
 Risk appetite refers to the extent to which a company is prepared to take on risks in order
to achieve its objectives. In broad terms we can distinguish risk averse attitudes, risk
neutral attitudes and risk seeking attitudes.
4.1 RISK MANAGEMENT

Risk management is the process of identifying and assessing (analysing and evaluating) risks and the
development, implementation and monitoring of a strategy to respond to those risks.
4.1.1 MANAGING ENVIRONMENTAL RISK

There are various strategies that multinational companies can adopt to limit or manage the effects of
cultural and political risk.
 considering carefully which markets to enter after careful analysis of political stability, the possibility
of government intervention and similar external influences
 considering carefully which markets to enter based on prior experience in similar markets,
language and cultural understanding
 forming alliances with local business partners, perhaps via a joint venture or agency arrangement
 choosing an appropriate business structure
 choosing an appropriate management structure – if business is done globally, the need for rapid
response to local opportunities and threats may be served by delegating a significant amount of
authority to the local business unit (decentralisation)
 hiring local employees who understand the culture and also demonstrating a commitment to
supporting the local economy
 being alert for likely changes in policy through cultivation of relationships with legislators
 social and commercial good citizenship, complying with best practice and being responsive to
ethical concerns
 the design of internal control procedures to minimise the risks from legal action, for example
human resource policies, health and safety policies
4.1.2 RISK MANAGEMENT STRATEGIES

Corporate governance standards encourage companies to adopt good practices in risk management.
In addition, the success or failure of a business will in part be determined by how it manages risks and
exploits opportunities to give it an advantage over its competitors.
A risk management strategy may involve:
 risk avoidance – not undertaking the relevant activity
 risk reduction – taking steps to reduce the severity of the impact
 risk transfer – passing the risk to a third party through hedging or insurance
 risk retention – accepting the loss if and when it occurs.
Effective risk management enables a business to:
 reduce business threats to acceptable levels
 make informed decisions about potential opportunities allowing stakeholders (investors,
customers, employees) to have confidence in the business and its future prospects.
This raises the question of what is acceptable to the business, which depends on the management's
attitude towards risk.
Question 2: Managing risk due to international trade
MODULE 3
A business is considering investing in a country where the national government is currently seeking
inward investment by international businesses, having previously had a history of restricting foreign
ownership and investment. Identify the risk management strategies available to deal with the political
risk arising.
We shall consider advanced methods of managing risk in Module 8 where, for example, we shall look
at the use of derivatives and other arrangements that allow a business to manage its exposure to
different types of risk.
4.2 ATTITUDE TO RISK

Definition
Risk appetite refers to the extent to which a company is prepared to take on risks in order to achieve
its objectives.
In broad terms we can distinguish risk averse attitudes, risk neutral attitudes and risk seeking
attitudes.
Definitions
A risk averse attitude is that an investment should not be undertaken if there is an alternative
investment offering either the same return but with a lower risk or a higher return for the same risk.
However, an alternative investment might be undertaken if it has a higher risk, but offers a higher
expected return.
A risk neutral attitude is that an investment should be chosen based on the expected (most likely)
return, irrespective of the risk.
A risk seeking attitude is that an investment should be undertaken if it offers higher possible returns,
even if the risk is higher.
For example, suppose a company is considering investing in four mutually exclusive projects, for which
the following expected returns and risk have been measured.
Expected return Risk
% %
Project W 10 4
Project X 12 4
Project Y 14 9
Project Z 12 6
A risk-averse company:
 would not invest in project W, because project X offers a higher expected return for the same risk
 would not invest in project Z, because project X offers the same return but for a lower risk
 might choose either project X or project Y, because X offers a lower return but a lower risk, and Y
offers a higher return but a higher risk.
A risk neutral company would invest in project Y because it has the highest expected return.
A risk seeking company would select either project Z or project Y, depending just how much risk it
was seeking. Note that project Z would be preferable to X because although the expected (or
average) return is the same, the fact that Z has a higher risk implies that there is a chance of a higher
actual return than with X. This is because Z has the same average return as X but a wider spread of
possible returns (i.e. it has a higher downside risk but it also has a higher upside potential).
KEY MODULE POINTS
 Risk is the possible variation in an outcome from what is expected to happen.

 Uncertainty is the inability to predict the outcome of an activity due to a lack of information.
 The risks faced by a company can be looked at from the point of view of the company and its
management, and also the investors in the company.
 Internal risks are risks arising from factors internal to the company, factors over which the company
can exercise control.
 External risks are risks arising from factors outside the business, that the company may be subject
to but that it has no influence over.
 Financial risk is the risk arising as a result of how the business is financed.
 Operating risk is all the risks faced by a business that are not financial risks. It is the variability of
returns due to how and where a business trades or operates, its exposure to markets, competitors
and so on.
 Risk identification involves considering the internal and external events that may give rise to
specific risks for a particular business.
 Risk assessment involves the evaluation or ranking of the identified risks in order to identify
significant risks and implement suitable risk responses.
 Each risk can be assessed from the point of view of its potential impact (significance) and its
probability of occurrence (likelihood).
 Quantitative risk assessment involves the determination of measured figures for probabilities and
consequences, producing a specifically quantified measure of risk.
 The alternative is a qualitative (subjective) risk assessment perhaps using a relative high-medium-
low style assessment.
MODULE 3
 Risk management is the process of identifying and assessing (analysing and evaluating) risks and
the development, implementation and monitoring of a strategy to respond to those risks.
 Risk appetite refers to the extent to which a company is prepared to take on risks in order to
achieve its objectives. In broad terms we can distinguish risk averse attitudes, risk neutral
attitudes and risk seeking attitudes.
1 Which of the following is a downside risk for a business?

A Revenues may rise.
B The cost of raw materials may increase.
C The quality of the product may improve.
D The market may grow faster than expected.
2 Which of the following is not a strategy for managing risk?

A risk transfer
B risk retention
C risk escalation
D risk avoidance
3 Which of the following investments would be most likely to be selected by a risk seeking investor?
A lowest risk, lowest return
B highest risk, lowest return
C lowest risk, highest return
D highest risk, highest return
4 Which of the following is not an example of operational risk?

A event risk
B people risk
C process risk
D gearing risk
5 Which of the following is not one of the commonly used techniques for risk identification and
assessment, according to the Institute of Risk Management (IRM) A structured approach to
Enterprise Risk Management?
A SWOT analysis
B operational planning
C audits of compliance
D structured questionnaires and checklists
6 Consider the following statements about foreign exchange risk:

I. Economic risk is the risk of adverse exchange rate movements occurring in the course of normal
II. Translation risk is the risk that the organisation will make exchange losses when the accounting
Are the statements above true or false?

Statement
I II
A True True
B True False
C False True
D False False
7 Which of the following is not a type of currency risk?

A principal risk
B economic risk
C translation risk
D transaction risk
MODULE 3
1 B Downside risk is the possibility that an event will occur and adversely affect the achievement of
objectives.
2 C Risk management strategies available to a business may involve:
 risk avoidance – for example, not undertaking the relevant activity.
 risk reduction – taking steps to reduce the severity of the impact.
 risk transfer – passing the risk to a third party through hedging or insurance.
 risk retention – accepting the loss if and when it occurs.
3 D A risk seeking attitude is that an investment should be undertaken if it offers higher possible
returns, even if the risk is higher.
4 D Operational risk is the variability arising from the effectiveness of how the business is managed
and controlled on a day to day basis. Gearing risk is a type of financial risk.
5 B 'Operational planning' is not included in the list of commonly used techniques for risk
identification and assessment.
6 C Transaction risk is the risk of adverse exchange rate movements occurring in the course of
normal international trading transactions. Economic risk refers to the effect of exchange rate
movements on the international competitiveness of a company and refers to the effect on the
present value of longer term cash flows.
7 A Currency risk occurs in three forms: transaction exposure (short-term), economic exposure
(effect on present value of longer term cash flows) and translation exposure (book gains or
losses).
1 Here are some generic examples of the sort of risks you may have identified.
For many businesses the key strategic or business risk will be that customers do not purchase their
product or service (e.g. due to increased competition or, as a result of an economic downturn).
Other risks include increases in the costs of producing the product or service and running the
business which erode profitability. Key financial risks will involve any threats to cash flow and
solvency (e.g. were the bank to limit or withdraw overdraft and loan facilities or profits to fall to the
extent that interest payments are no longer able to be met). Hazard risks may arise as a result of
the reliance of the business on key members of staff – should a critical person be involved in an
accident there may be no obvious succession plan in place. Alternatively, the collapse of a key
supplier might cause major disruption to the company's supply chain. Operational risks may
involve the failure to comply with appropriate health and safety or human resource legislation.
2 Risk avoidance – don't invest.
Risk reduction – invite the government or domestic businesses to be part-owners of the business,
invest small amounts gradually until the government's long-term attitude becomes apparent.
Risk transfer – insure any assets.
Risk retention – accept the risk of losses if the government should revert to its previous policy.
MODULE 3
73
MODULE 4
SOURCES AND COST OF
FINANCE
Identify the characteristics, terms and conditions of the alternative sources of short, LO4.1
medium and long term finance
Evaluate the suitability of different methods of finance in a given scenario LO4.2
Analyse the cost of various sources of finance LO4.3
Explain the different sources of long term finance LO4.4
Apply the concepts of financial mathematics to loans, and debt and equity securities LO4.5
with the use of effective interest rates
Calculate and interpret the weighted average cost of capital (WACC) LO4.6
Topic list
1 Introduction to capital structure

2 Short-term sources of finance
3 Sources of long-term debt finance
4 Sources of equity finance
5 Venture capital
6 Leasing and loans
7 Calculating the costs of debt and equity capital
8 Weighted Average Cost of Capital (WACC)
MODULE OUTLINE
This module focuses on two broad areas, the sources of finance available to a business and the cost of
those types of finance. We shall therefore consider the various types of finance before moving on to
calculating their associated costs.
We will also look at the capital structure of a business and the importance of a company selecting an
appropriate balance between debt capital and equity capital and the balance between short-term and
long-term finance. We shall consider capital structure further in Module 6.
Finally we will introduce the concept of the Weighted Average Cost of Capital (WACC).
Sources and cost of finance
Cost Capital structure decision

WACC • Cost of debt • Debt v equity Risk
• Cost of equity • Long-term v short-term
Short-term finance Long-term finance

• Overdraft
• Trade credit
• Short-term loans
• Leasing Debt Equity
• Debentures • Retained earnings
• Bonds • Rights issue
Preference
• Convertibles • Public issues
shares
• Leasing • Venture capital
SOURCES AND COST OF FINANCE | 75
BEFORE YOU BEGIN
area.
everything covered.
1 What is a company’s capital structure? (Section 1)
2 What is the general principle to be followed when choosing finance for an asset
or investment? (Section 1.1)
3 What is a deep discount bond? (Section 3.5)
4 What is venture capital and for what might it be provided? (Section 5)
5 Why might a company use lease finance? (Section 6)
6 What is the Weighted Average Cost of Capital (WACC)? (Section 8)
MODULE 4
1 INTRODUCTION TO CAPITAL STRUCTURE
LOs
4.2,
4.3  Capital structure refers to the way in which an organisation is financed.
 Decisions include choosing a suitable balance between debt capital (gearing level) and
equity capital, and deciding on the balance between short-term and long-term finance.
 As a general rule businesses should aim to match the length of finance with the maturity of
the asset being financed, therefore non-current assets would be financed by long term
capital and the majority of current assets by short-term capital.
 Short-term sources of finance include overdrafts, short-term loans, trade credit and lease
finance. Long-term sources of finance include debt finance, leasing, venture capital and
equity finance.
 The risk-return trade-off desired by potential investors will impact on the servicing cost of
the finance. Shareholders bear the greatest risk and therefore will expect the highest return
of long-term providers of finance. The cost of equity finance is therefore always higher than
the cost of debt.
Capital structure refers to the way in which an organisation is financed, by a combination of

long-term capital (such as equity capital, bonds and bank loans) and short-term liabilities (such as a
bank overdrafts and trade payables). It refers in particular to:
 the balance between equity and debt capital, and
 the balance between long-term and short-term finance.
The sources of new finance chosen by a company will affect its capital structure. Raising new debt
capital, for example, will increase the proportion of debt in the capital structure, whereas retaining
profits will increase the proportion of equity.
Equally, a financial policy of maintaining a particular capital structure (e.g. a target debt: equity ratio)
will affect a company's choices about where any new finance should come from.
Capital structure is discussed further in Module 6.
Definition
The term 'gearing' (or 'leverage') is used to refer to the proportion of debt capital in a company's
capital structure.
1.1 PRINCIPLES OF CAPITAL STRUCTURE

The assets of a business must be financed somehow, and when a business is growing, the additional
assets must be financed by additional capital.
As a general rule, assets that yield profits over a long period of time should be financed by long-term
funds. In this way, the returns made by the asset will be sufficient to pay either the interest cost of the
loans raised to buy it, or dividends on its equity funding. If, on the other hand, a long-term asset is
financed by short-term funds, the company cannot be certain that when the loan becomes repayable,
it will have enough cash from profits to repay it.
It is usually prudent for a company not to finance all of its short-term assets with short-term liabilities,
but instead to finance short-term assets partly with short-term funding and partly with long-term
funding.
Figure 4.1: Differences between finance terms

Year 0 Year 1 Year 5 Year 10
Short term
Medium term
Long term
Share capital is regarded as long-term finance for a company. Other sources of finance may be either
long-term or short-term. Companies might borrow either from banks, or from non-bank investors.
Most company borrowing from investors other than banks is in the form of loan stock or bonds. Some
finance sources, notably short-term trade credit, are obtained at little or no cost to the company.
1.2 LONG-TERM CAPITAL REQUIREMENTS FOR REPLACEMENT AND

GROWTH
A distinction can be made between long-term capital that is needed to finance the replacement of
worn-out assets, and capital that is needed to finance growth. If a company is not growing and only
needs finance to maintain its current level of operations, including the replacement of non-current
assets, its main sources of funding are likely to be internally-generated, provided that the rate of
inflation is reasonably low. In contrast, when a company is seeking to grow, it will need extra finance.
1.3 DEBT AND FINANCIAL RISK

A high level of debt creates financial (or gearing) risk. Financial risk can be seen from different points
of view.
 The company as a whole – if a company builds up debts that it cannot pay when they fall due, it
will be forced into liquidation.
 Creditors – if a company cannot pay its debts, the company will go into liquidation owing creditors
money that they are unlikely to recover in full.
 Ordinary shareholders – a company will not make any distributable profits unless it is able to earn
enough profit before interest and tax to pay all its interest charges, and then tax. The lower the
profits or the higher the interest-bearing debts, the less there will be left over for shareholders.
When a company has preference shares in its capital structure, ordinary shareholders will not get
anything until the preference dividend has been paid. If a company cannot pay its debts it will go
into liquidation and the shareholders will lose the value of their capital invested in the company.
2 SHORT-TERM SOURCES OF FINANCE MODULE 4
LOs
4.2,
4.3  A range of short-term sources of finance are available to businesses including overdrafts,
short-term loans, trade credit and lease finance.
Short-term finance is usually needed for businesses to run their day-to-day operations including
payment of wages to employees, inventory ordering and supplies. Businesses with seasonal peaks and
troughs and those engaged in international trade are likely to be heavy users of short-term finance. A
range of short-term sources of finance are available to businesses including overdrafts, short-term
loans and trade credit.
2.1 OVERDRAFTS
Where payments from a current account exceed income to the account for a temporary period, the
bank finances the deficit by means of an overdraft. Overdrafts are the most important source of short-
term finance available to businesses. They can be arranged relatively quickly, and offer a level of
flexibility with regard to the amount borrowed at any time, while interest is only paid when the
account is overdrawn.
Table 4.1: Overdrafts
Amount Should not exceed limit, usually based on known income
Margin Interest charged at base rate plus margin on daily amount overdrawn and charged quarterly.
Fee may be charged for large facility
Purpose Generally to cover short-term deficits
Repayment Technically repayable on demand
Security Depends on size of facility
Benefits Customer has flexible means of short-term borrowing; bank has to accept fluctuation
By providing an overdraft facility to a customer, the bank is committing itself to provide an overdraft
to the customer if and when the customer wants it, up to the agreed limit. The bank will earn interest
on the lending, but only to the extent that the customer uses the facility and goes into overdraft. If the
customer does not go into overdraft, the bank cannot charge interest.
The bank will generally charge a commitment fee when a customer is granted an overdraft facility or
an increase in an existing overdraft facility.
2.1.1 SOLID CORE OVERDRAFTS

When a business customer has an overdraft facility, and the account is always in overdraft, then it has a
solid core (or hard core) overdraft. For example, suppose that the account of a company has the
following record for the previous year:
Average Debit
balance Range turnover
Quarter to $ $ $ $
31 March 20X5 40 000 debit 70 000 debit – 20 000 debit 600 000
30 June 20X5 50 000 debit 80 000 debit – 25 000 debit 500 000
30 September 20X5 75 000 debit 105 000 debit – 50 000 debit 700 000
31 December 20X5 80 000 debit 110 000 debit – 60 000 debit 550 000
These figures show that the account has been permanently in overdraft, and the hard core of the
overdraft has been rising steeply over the course of the year.
If the hard core element of the overdraft appears to be becoming a long-term feature of the business,
the bank might wish, after discussions with the customer, to convert the hard core of the overdraft into
a loan. This gives formal recognition to its more permanent nature. If the hard core is not converted to
a loan then the bank's overdraft terms would still typically require annual reductions of the hard core
element. We shall look at overdrafts further in Module 5 in connection to a company’s cash operating
cycle.
2.2 SHORT-TERM LOANS

Definition
A term loan is a loan for a fixed amount for a specified period.
A term loan is drawn in full at the beginning of the loan period and repaid at a specified time or in
defined instalments. Term loans are offered with a variety of repayment schedules. Often, the interest
and capital repayments are predetermined.
The main advantage of lending on a loan account for the bank is that it makes monitoring and control
of the advance much easier. The bank can see immediately when the customer is falling behind with
repayments, or struggling to make the payments. With overdraft lending, a customer's difficulties
might be obscured for some time by the variety of transactions on the current account.
 The customer knows what they will be expected to pay back at regular intervals and the bank can
also predict its future income with more certainty depending on whether the interest rate is at a
fixed or floating rate.
 Once the loan is agreed, the term of the loan must be adhered to; provided that the customer
does not fall behind with the repayments, it is not repayable on demand by the bank.
 Because the bank will be committing its funds to a customer for a number of years, it may wish to
insist on building certain written safeguards into the loan agreement, to prevent the customer from
becoming over-extended with excess borrowing during the course of the loan. A loan covenant is a
condition that the borrower must comply with. If the borrower does not act in accordance with the
covenants, the loan can be considered in default and the bank can demand payment.
2.3 OVERDRAFTS AND SHORT-TERM LOANS COMPARED

A customer might ask the bank for an overdraft facility when the bank would wish to suggest a loan
instead; alternatively, a customer might ask for a loan when an overdraft would be more appropriate.
 In most cases, when a customer wants finance to help with 'day to day' trading and cash flow
needs, an overdraft would be the appropriate method of financing. The customer should not be
short of cash all the time, and should expect to be in credit in some days, but in need of an
overdraft on others.
 When a customer wants to borrow from a bank for only a short period of time, even for the
purchase of a major non-current asset such as an item of plant or machinery, an overdraft facility
might be more suitable than a loan. This is because the customer will stop paying interest as soon
as their account goes into credit.
2.3.1 ADVANTAGES OF AN OVERDRAFT OVER A LOAN

 The customer only pays interest when the account is overdrawn.
 The bank has the flexibility to review the customer's overdraft facility periodically, and perhaps
agree to additional facilities, or insist on a reduction in the facility.
 An overdraft can do the same job as a loan: a facility can simply be renewed every time it comes up
for review.
Bear in mind, however, that overdrafts are normally repayable on demand.
2.3.2 ADVANTAGES OF A LOAN FOR LONGER TERM LENDING

 Both the customer and the bank know exactly what the repayments of the loan will be and how
much interest is payable, and when. This makes planning (budgeting) simpler. MODULE 4
 The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft
facility before they are in a position to repay what is owed. There is an element of 'security' or 'peace
of mind' in being able to arrange a loan for an agreed term.
Loans normally carry a facility letter setting out the precise terms of the agreement.
However, a mix of overdrafts and loans might be suggested in some cases. Consider a case where a
business asks for a loan, perhaps to purchase a shop with inventory. The banker might wish to suggest
a loan to help with the purchase of the shop, but that inventory ought to be financed by an overdraft
facility. The offer of part-loan part-overdraft is an option that might be well worth considering.
2.4 TRADE CREDIT (PAYABLES)

Trade credit is one of the main sources of short-term finance for a business. Current assets such as raw
materials may be purchased on credit with payment terms normally varying from between 30 to 90
days. Trade credit therefore represents an interest free short-term loan. In a period of high inflation,
purchasing via trade credit will be very helpful in keeping costs down. However, it is important to take
into account the loss of discounts suppliers offer for early payment.
Unacceptable delays in payment will worsen a company's credit rating and additional credit may
become difficult to obtain. We shall look at trade credit further in Module 5 in connection to a
company’s cash operating cycle.
3 SOURCES OF LONG-TERM DEBT FINANCE
LOs
4.2,
4.3,  A company may use long-term or short-term debt capital as sources of finance. The cost of
4.4
debt capital is interest.
 The choice of debt finance that a company can make depends upon:
– the size of the business (a public issue of bonds is only available to a large company)
– the duration of the loan
– whether a fixed or floating interest rate is preferred (fixed rates are more expensive, but
floating rates are riskier)
– the security that can be offered.
Long-term finance is used for major investments and is usually more expensive and less flexible than
short-term finance.
3.1 REASONS FOR SEEKING DEBT FINANCE

Sometimes businesses may need long-term funds, but may not wish to issue equity capital. Perhaps
the current shareholders will be unwilling to contribute additional capital; possibly the company does
not wish to involve outside shareholders who will have more onerous requirements than current
members.
Other reasons for choosing debt finance may include lesser cost and easier availability, particularly if
the company has little or no existing debt finance. Debt finance provides tax relief on interest
payments.
3.1.1 TAX RELIEF ON LOAN INTEREST

As far as companies are concerned, debt capital is a potentially attractive source of finance because
interest charges reduce the profits chargeable to company tax.
 A new issue of bonds is likely to be preferable to a new issue of preference shares (Preference
share are shares carrying a fixed rate of dividends).
 Companies might wish to avoid dilution of shareholdings and increase gearing (the ratio of fixed
interest capital to equity capital) in order to improve their earnings per share by benefiting from tax
relief on interest payments.
3.2 SOURCES OF DEBT FINANCE

If a company wishes to raise debt finance, it will need to consider which types of finance are available.
If it is seeking medium-term bank finance, it ought to be in the form of a loan, although an overdraft is
a virtually permanent feature of many companies' statements of financial position. Bank finance is a
most important source of debt for small companies.
If a company is seeking to issue long-term bonds, it must decide whether the bonds will be repaid
(redeemed), whether there will be conversion rights into shares, and whether warrants will be
attached.
3.3 FACTORS INFLUENCING CHOICE OF DEBT FINANCE

The choice of debt finance that a company can make depends upon:
 availability which is in part a function of the size of the business (a public issue of bonds is only
available to a large company)
 the duration of the loan
 whether a fixed or floating interest rate is preferred (fixed rates are more expensive, but floating
rates are riskier)
 the security that can be offered.
3.3.1 AVAILABILITY
Only listed companies will be able to make a public issue of bonds on a stock exchange; smaller
companies may only be able to obtain significant amounts of debt finance from their bank.
3.3.2 DURATION
If loan finance is sought to buy a particular asset to generate revenues for the business, the length of
the loan should match the length of time that the asset will be generating revenues.
3.3.3 FIXED OR FLOATING RATE

Expectations of interest rate movements will determine whether a company chooses to borrow at a
fixed or floating rate. Fixed rate finance may be more expensive, but the business runs the risk of
adverse upward rate movements if it chooses floating rate finance.
3.3.4 SECURITY AND COVENANTS

The choice of finance may be determined by the assets that the business is willing or able to offer as
security, also on the restrictions in covenants that the lenders wish to impose. Covenants will be
discussed in more detail in Module 6.
Security may take the form of either a fixed charge or a floating charge.
Table 4.2: Fixed and floating charges
FIXED CHARGE FLOATING CHARGE
Security relates to specific asset/group Security in event of default is whatever assets of the
of assets (land and buildings). class secured (inventory/trade receivables) company
then owns.
Company can't dispose of assets Company can dispose of assets until default takes
without providing substitute/consent place.
of lender.
In event of default lenders appoint receiver rather than MODULE 4
lay claim to asset.
Not all bonds are secured. Investors are likely to expect a higher yield with unsecured bonds
3.4 BONDS
Definitions
Bonds are long-term debt capital raised by a company for which interest is paid, usually half yearly
and at a fixed rate. Holders of bonds are long term creditors of the company.
Debentures are long term debt securities, Debenture notes are loans made to a company for a fixed
period for a fixed rate of interest.
The term bonds describes various forms of long-term debt a company may issue, such as loan notes
or debentures, which may be redeemable (paid back at some point in time) or irredeemable (never
paid back but continue to pay interest indefinitely).
Bonds have a nominal value, which is the debt owed by the company, and interest is paid at a stated
'coupon' on this amount. For example, if a company issues 10 per cent bonds, the coupon will be
10 per cent of the nominal value of the bonds, so that $100 of bonds will receive $10 interest each
year. The rate quoted is the gross rate, before tax.
Unlike shares, debt is often issued at par (i.e. with $100 payable per $100 nominal value). Where the
coupon rate is fixed at the time of issue, it will be set according to prevailing market conditions given
the credit rating of the company issuing the debt. Subsequent changes in market (and company)
conditions will cause the market value of the bond to fluctuate, although the coupon will stay at the
fixed percentage of the nominal value.
3.5 DEEP DISCOUNT BONDS

Definition
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 redeemable at par (or above par) when they eventually mature.
For example a company might issue $1 000 000 of bonds in 20X1, at a price of $50 per $100 of bond,
and redeemable at par in the year 20X9. For a company with specific cash flow requirements, the low
servicing costs during the currency of the bond may be an attraction, coupled with a high cost of
redemption at maturity.
Investors might be attracted by the large capital gain offered by the bonds, which is the difference
between the issue price and the redemption value. However, deep discount bonds will carry a much
lower rate of interest than other types of bond. The only tax advantage is that the gain gets taxed (as
income) in one lump on maturity or sale, not as amounts of interest each year. The borrower can,
however, deduct notional interest each year in computing profits.
3.6 ZERO COUPON BONDS

Definition
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. There is an
implied interest rate in the amount of discount at which the bonds are issued or subsequently re-sold
on the market.
 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. The borrower can plan to have funds available to redeem the bonds at maturity.
 The advantage for lenders is restricted, unless the rate of discount on the bonds offers a high yield.
The only way of obtaining cash from the bonds before maturity is to sell them. Their market value
will depend on the remaining term to maturity and current market interest rates.
The tax advantage of zero coupon bonds is the same as that for deep discount bonds.
3.7 CONVERTIBLE BONDS

Definition
Convertible bonds are bonds that give the holder the right to convert to other securities, normally
ordinary shares, at a pre-determined price/rate and time.
Conversion terms often vary over time. For example, the conversion terms of convertible bonds might
be that on 1 April 20X0, $2 of bonds can be converted into one ordinary share, whereas on 1 April
20X1, the conversion price will be $2.20 of bonds for one ordinary share. Once converted, convertible
securities cannot be converted back into the original fixed return security.
3.7.1 THE CONVERSION VALUE AND THE CONVERSION PREMIUM

The current market value of ordinary shares into which a bond may be converted is known as the
conversion value. The conversion value will be below the value of the bond at the date of issue, but
will be expected to increase as the date for conversion approaches on the assumption that a
company's shares ought to increase in market value over time.
Conversion value = conversion ratio × current market value per share
Conversion premium = current market value of debt – current conversion value
Question 1: Convertible debt
The 10 per cent convertible bonds of Starchwhite are quoted at $142 per $100 nominal. The earliest
date for conversion is in four years' time, at the rate of 30 ordinary shares per $100 nominal bond. The
share price is currently $4.15. Annual interest on the bonds has just been paid.
Required
a. Calculate the current conversion value.
b. Calculate the conversion premium and comment on its meaning.
3.7.2 THE ISSUE PRICE AND THE MARKET PRICE OF CONVERTIBLE BONDS
A company will aim to issue bonds with the greatest possible conversion premium as this will mean
that, for the amount of capital raised, it will, on conversion, have to issue the lowest number of new
ordinary shares. The premium that will be accepted by potential investors will depend on the
company's growth potential and therefore on the prospects for a sizeable increase in the share price.
Convertible bonds issued at par normally have a lower coupon rate of interest than straight debt. This
lower interest rate is the price the investor has to pay for the conversion rights. It is also one of the
reasons why the issue of convertible bonds is attractive to a company, particularly if it has cash flow
problems around the time of issue, but is expecting cash flow to be easier when the bonds are due to
be converted.
When convertible bonds are traded on a stock market, their minimum market price or floor value will
be the price of straight bonds with the same coupon rate of interest. If the market value falls to this
minimum, it follows that the market attaches no value to the conversion rights. MODULE 4
The actual market price of convertible bonds will depend on:
 the price of straight debt
 the current conversion value
 the length of time before conversion may take place
 the market's expectation as to future equity returns and the risk associated with these returns.
Most companies issuing convertible bonds expect them to be converted. They view the bonds as
delayed equity. They are often used either because the company's ordinary share price is considered
to be particularly depressed at the time of issue or because the issue of equity shares would result in
an immediate and significant drop in earnings per share. There is no certainty, however, that the
security holders will exercise their option to convert; therefore the bonds may run their full term and
need to be redeemed.
3.8 THE REDEMPTION OF BONDS

Definition
Redemption is repayment of bonds.
Bonds are usually redeemable. They are issued for a term of ten years or more, and perhaps 25 to 30
years. At the end of this period, they will 'mature' and become redeemable (at par or possibly at a
value above par).
Most redeemable bonds have an earliest and a latest redemption date. For example, 12 per cent
Debenture Stock 20X7/X9 is redeemable, at any time between the earliest specified date (in 20X7) and
the latest date (in 20X9). The issuing company can choose the date.
Some bonds do not have a redemption date, and are 'irredeemable' or 'undated'. Undated bonds
might be redeemed by a company that wishes to pay off the debt, but there is no obligation on the
company to do so.
3.8.1 HOW WILL A COMPANY FINANCE THE REDEMPTION OF LONG-TERM DEBT?

There is no guarantee that a company will be able to raise a new loan to pay off a maturing debt. One
item you should look for in a company's statement of financial position is the redemption date of
current loans, to establish how much new finance is likely to be needed by the company, and when.
Occasionally unpaid debenture holders might be persuaded to surrender their debentures. They may
wish to surrender because, for example, the secured assets have fallen in value and would not realise
much in a forced sale, or because they believe the company can improve its position soon. In
exchange they may get an equity interest in the company or convertible debentures, paying a lower
rate of interest, but carrying the option to convert the debentures into shares at a specified time in the
future.
3.9 DEBT VERSUS PREFERENCE SHARES

Preference shares are part of the share capital of a business. However, they usually carry no voting
rights but attract a fixed dividend that must be paid in priority to any dividend on ordinary shares.
There is no right to share in profits in excess of the fixed dividend. Commercially, there is little
difference between preference shares and unsecured debt.
Both preference shares and debt:
 normally pay a fixed annual return (interest or dividends)
 may be irredeemable, redeemable at a pre-set value or convertible.
For a profitable going concern there is no commercial difference, and as a result it is normal to treat
preference shares effectively as debt when considering gearing ratios.
The only true difference that arises is in respect of the risk to investors. In particular:
 if profitability is low a company can cut any preference dividend, but it cannot avoid interest on
debt
 if a company becomes insolvent, preference shareholders rank below all debt holders, even
subordinated debt.
To compensate for this additional risk, preference shareholders are likely to receive a higher return
than long-term debtholders.
Within our consideration of capital structure, however, it would be best to consider the true
commercial substance and treat any preference shares as a form of debt.
4 SOURCES OF EQUITY FINANCE
LOs
4.2,
4.3,  Equity finance refers to the ordinary share capital of the company.
4.4
 Equity finance can come from three sources:
– retained earnings
– rights issue of shares to existing shareholders
– new share issue.
Definition
Equity finance refers to the ordinary share capital of a company.
4.1 ORDINARY SHARES

Ordinary shares are issued to the owners of a company. Except in Australia, ordinary shares have a
nominal or 'face' value, typically $1 or 50c. When ordinary shares are issued for cash, the issue price
must be equal to or, more usually, more than the nominal value of the shares.
Once issued, you should understand that the market value of a quoted company's shares bears no
relationship to their nominal value.
The concept of nominal value no longer applies in Australia. A share has no nominal value, and the
amount which must be paid for in the share is determined by the terms of its issue.
Ordinary shareholders have rights as a result of their ownership of the shares:
 Shareholders can attend company general meetings.
 They can vote on important company matters such as the appointment of directors, using shares in
a takeover bid, changes to authorised share capital or the appointment auditors.
 They are entitled to receive a share of any agreed dividend.
 They will receive the annual report and accounts.
 They will receive a share of any assets remaining after liquidation.
 They can participate in any new issue of shares.
Ordinary shareholders are the ultimate bearers of risk as they are at the bottom of the creditor
hierarchy in a liquidation. This means there is a significant risk they will receive nothing after all of the
other trade payables have been paid. MODULE 4
This greatest risk means that shareholders expect the highest return of long-term providers of finance.
The cost of equity finance is therefore always higher than the cost of debt.
4.1.1 SOURCES OF EQUITY FINANCE

Equity finance can come from three sources:
 retained earnings
 rights issue of shares to existing shareholders
 new share issue.
4.2 RETAINED EARNINGS

The profits earned by a business can be paid out in the form of a dividend or reinvested. If they are
reinvested, shareholders will expect them to generate sufficient returns to increase shareholder
wealth. For most companies, retained earnings are the most important source of equity finance and
would be used before considering a new/rights issue.
4.3 RIGHTS ISSUES

Definition
A rights issue is an offer to existing shareholders enabling them to buy more shares, usually at a price
lower than the current market price.
A rights issue provides a way of raising new share capital by means of an offer to existing
shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings.
Rights issues can be renounceable or non-renounceable. If shareholders choose not to take up
renounceable rights on the new shares, they can sell them on to others. Non-renounceable rights
must be taken up or forfeited.
For example, a rights issue on a one for four basis at 280c per share would mean that a company is
inviting its existing shareholders to subscribe for one new share for every four shares they hold, at a
price of 280c per new share. A rights issue may be made by any type of company. The analysis below,
however, applies primarily to listed companies.
The major advantages of a rights issue are as follows:
 Rights issues are cheaper than initial public offers (IPOs) to the general public. This is partly
because a full prospectus is not normally required, partly because the administration is simpler and
partly because the cost of underwriting will be less.
 Rights issues are more beneficial to existing shareholders than issues to the general public. New
shares are issued at a discount to the current market price, to make them attractive to investors.
A rights issue secures the discount on the market price for existing shareholders, who may either
keep the shares or sell them if they wish.
 Relative voting rights are unaffected if shareholders all take up their rights.
 The finance raised may be used to reduce 'gearing' in carrying value terms by increasing share
capital or to pay off long-term debt which will reduce gearing in market value terms. This is what
gearing means: it describes the level of debt against the amount of equity and is usually expressed
as a percentage.
4.3.1 Pricing of rights issues

The offer price in a rights issue will be lower than the current market price of existing shares. The size
of the discount will vary, and will be larger for difficult issues. The offer price must however be at or
above the nominal value of the shares, so as not to contravene company law.
A company making a rights issue must set a price which is low enough to secure the acceptance of
shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive
dilution of the earnings per share.
Worked Example: Pricing a rights issue
Seagull can achieve a profit after tax of 20 per cent on the capital employed. At present its capital
structure is as follows.
$
200 000 ordinary shares of $1 each 200 000
Retained earnings 100 000
300 000
The directors propose to raise an additional $126 000 from a rights issue. The current market price is
$1.80.
Required
a. Calculate the number of shares that must be issued if the rights price is:
$1.60; $1.50; $1.40; $1.20.
b. Calculate the dilution in earnings per share in each case.
Solution
The earnings at present are 20 per cent of $300 000 = $60 000. This gives earnings per share of 30c.
The earnings after the rights issue will be 20 per cent of $426 000 = $85 200. The total number of
shares will be the number of existing shares (200,000) plus the number of new shares (see below).
No of new shares
($126 000 / rights EPS ($85 200 / total
Rights price price) no of shares) Dilution
$ Cents Cents
1.60 78 750 30.6 + 0.6
1.50 84 000 30.0 –
1.40 90 000 29.4 – 0.6
1.20 105 000 27.9 – 2.1
Note that at a high rights price the earnings per share are increased, not diluted. The breakeven point
(zero dilution) occurs when the rights price is equal to the capital employed per share: $300 000 /
200 000 = $1.50.
4.3.2 THE THEORETICAL EX-RIGHTS PRICE

When a rights issue is announced, all existing shareholders have the right to subscribe for new shares,
and so there are rights attached to the existing shares.
The shares are therefore described as being 'cum rights' (with rights attached) and are traded cum
rights.
On the first day of dealings in the newly issued shares, the rights no longer exist and the old shares
are now 'ex-rights' (without rights attached).
After the announcement of a rights issue, share prices normally fall. The extent and duration of the fall
may depend on the number of shareholders and the size of their holdings. This temporary fall is due
to uncertainty in the market about the consequences of the issue, with respect to future profits,
earnings and dividends.
After the issue has actually been made, the market price per share will normally fall, because there are
more shares in issue and the new shares were issued at a discount price. MODULE 4
In theory, the new market price will be the consequence of an adjustment to allow for the discount
price of the new issue, and a theoretical ex-rights price can be calculated.
Worked Example: Theoretical ex-rights price
Fundraiser has 1 000 000 ordinary shares of $1 in issue, which have a market price on 1 September of
$2.10 per share. The company decides to make a rights issue, and offers its shareholders the right to
subscribe for one new share at $1.50 each for every four shares already held. After the announcement
of the issue, the share price fell to $1.95, but by the time just prior to the issue being made, it had
recovered to $2 per share. This market value just before the issue is known as the cum rights price.
What is the theoretical ex-rights price?
Solution
Value of the portfolio for a shareholder with four shares before the rights issue:
$
4 shares @ $2.00 8.00
1 share @ $1.50 1.50
5 9.50
So the value per share after the rights issue (or TERP) is 9.50 / 5 = $1.90.
4.3.3 THE VALUE OF RIGHTS

Definition
The value of rights is the theoretical gain a shareholder would make by exercising his or her rights.
 Using the above example, if the price offered in the rights issue is $1.50 per share, and the market
price after the issue is expected to be $1.90, the value attaching to a right is $1.90 – $1.50 = $0.40.
A shareholder would therefore be expected to gain 40 cents for each new share they buy.
If the shareholder does not have enough money to buy the share, they could sell the right to
subscribe for a new share to another investor, and receive 40 cents from the sale. This other
investor would then buy the new share for $1.50, so that the total outlay to acquire the share would
be $0.40 + $1.50 = $1.90, the theoretical ex-rights price.
 The value of rights attaching to existing shares is calculated in the same way. If the value of rights
on a new share is 40 cents, and there is a one for four rights issue, the value of the rights attaching
to each existing share is 40 / 4 = 10 cents.
4.3.4 THE THEORETICAL GAIN OR LOSS TO SHAREHOLDERS

The possible courses of action open to shareholders are as follows:
 To 'take up' or 'exercise' the rights, that is, to buy the new shares at the rights price. Shareholders
who do this will maintain their percentage holdings in the company by subscribing for the new
shares.
 To 'renounce' the rights and sell them on the market. Shareholders who do this will have lower
percentage holdings of the company's equity after the issue than before the issue, and the total
value of their shares will be less.
 To renounce part of the rights and take up the remainder. For example, a shareholder may sell
enough rights to enable them to buy the remaining rights shares they are entitled to with the sale
proceeds, and so keep the total market value of their shareholding in the company unchanged.
 To do nothing. Shareholders may be protected from the consequences of their inaction because
rights not taken up are sold on a shareholder's behalf by the company. The Stock Exchange rules
state that if new securities are not taken up, they should be sold by the company to new
subscribers for the benefit of the shareholders who were entitled to the rights.
Question 2: Rights issue
Gopher has issued 3 000 000 ordinary shares of $1 each, which are at present selling for $4 per share.
The company plans to issue renounceable rights to purchase one new equity share at a price of $3.20
per share for every three shares held. A shareholder who owns 900 shares thinks that they will suffer a
loss in personal wealth because the new shares are being offered at a price lower than market value.
On the assumption that the actual market value of shares will be equal to the theoretical ex-rights
price, what would be the effect on the shareholder's wealth of:
a. selling all the rights?
b. exercising half of the rights and selling the other half?
c. doing nothing at all?
4.3.5 THE ACTUAL MARKET PRICE AFTER A RIGHTS ISSUE

The actual market price of a share after a rights issue may differ from the theoretical ex-rights price.
This will occur when:
Expected yield from new funds raised  Earnings yield from existing funds
The market will take a view of how profitably the new funds will be invested, and will value the shares
accordingly. An example will illustrate this point.
Worked Example: Actual market price post rights issue
Musk currently has 4 000 000 ordinary shares in issue, valued at $2 each, and the company has annual
earnings equal to 20 per cent of the market value of the shares. A 1-for-4 rights issue is proposed, at
an issue price of $1.50. If the market continues to value the shares on a price/earnings ratio of 5, what
would be the value per share if the new funds are expected to earn, as a percentage of the money
raised:
a. 15 per cent?
b. 20 per cent?
c. 25 per cent?
How do these values in (a), (b) and (c) compare with the theoretical ex-rights price? Ignore issue costs.
Solution
The theoretical ex-rights price will be calculated first.

$ MODULE 4
Four shares have a current value ( $2) of 8.00
One new share will be issued for 1.50
Five shares would have a theoretical value of 9.50
1
Theoretical ex-rights price = ((4  2) + 1.50)
4 +1
= $1.90
The new funds will raise 1 000 000  $1.50 = $1 500 000.
Earnings as a % of Total earnings
money raised Additional earnings Current earnings after the issue
$ $ $
15% 225 000 1 600 000 1 825 000
20% 300 000 1 600 000 1 900 000
25% 375 000 1 600 000 1 975 000
If the market values shares on a P/E ratio of 5, the total market value of equity and the market price
per share would be as follows:
Price per share
Total earnings Market value (5 000 000 shares)
$ $ $
1 825 000 9 125 000 1.825
1 900 000 9 500 000 1.900
1 975 000 9 875 000 1.975
a. If the additional funds raised are expected to generate earnings at the same rate as existing funds,
the actual market value will probably be the same as the theoretical ex-rights price.
b. If the new funds are expected to generate earnings at a lower rate, the market value will fall below
the theoretical ex-rights price. If this happens, shareholders will lose.
c. If the new funds are expected to earn at a higher rate than current funds, the market value should
rise above the theoretical ex-rights price. If this happens, shareholders will profit by taking up their
rights.
The decision by individual shareholders as to whether they take up the offer will therefore depend on:
 the expected rate of return on the investment (and the risk associated with it)
 the return obtainable from other investments (allowing for the associated risk).
4.4 NEW SHARE ISSUES

A quoted company can issue more shares to the stock exchange to raise additional equity finance.
An unquoted company can obtain a listing on the stock market using one of the following:
 initial public offer (IPO)
 placing
 introduction
All stock exchanges set eligibility criteria for companies on listing. Key criteria generally include those
relating to the size of the company and its shareholder base, which are aimed at ensuring an adequate
market for trading in the company's shares.
4.4.1 INITIAL PUBLIC OFFER

Definition
An initial public offer (IPO) is an invitation to apply for shares in a company based on information
contained in a prospectus.
An initial public offer (IPO) is a means of selling the shares of a company to the public at large. When
companies 'go public' for the first time, a large issue will probably take the form of an IPO. This is
known as flotation. Subsequent issues are likely to be placings or rights issues, these are described
later.
An IPO entails the acquisition by an issuing house of a large block of shares of a company, with a view
to offering them for sale to the public and investing institutions.
An issuing house is usually a merchant bank (or sometimes a firm of stockbrokers). It may acquire the
shares either as a direct allotment from the company or by purchase from existing members. In either
case, the issuing house publishes an invitation to the public to apply for shares, either at a fixed price
or on a tender basis. The issuing house accepts responsibility to the public, and gives to the issue the
support of its own standing.
Note: It is illegal for Australian limited companies to offer shares to the general public without a
prospectus.
4.4.2 A PLACING
A placing, also called a placement, is an arrangement where not all the shares are offered to the
public. Instead, the sponsoring market maker arranges for most of the issue to be bought by a small
number of investors, usually institutional investors such as superannuation funds and insurance
companies. Share placements allow companies to raise funds quickly (often within 24 hours) and
without incurring costs associated with rights issues.
In Australia, the Corporations Act 2001 allows companies to raise up to 15 per cent of their current
capital base through share placements generally to institutional and sophisticated investors. They can
do this without having to obtain shareholder approval or issuing a formal prospectus.
4.4.3 THE CHOICE BETWEEN AN IPO AND A PLACING

Is a company likely to prefer an IPO of its shares, or a placing?
 Placings are much cheaper. Approaching institutional investors privately is a much cheaper way of
obtaining finance, and thus placings are often used for smaller issues.
 Placings are likely to be quicker.
 Placings are likely to involve less disclosure of information.
 However, most of the shares will be placed with a relatively small number of (institutional)
shareholders. This means that most of the shares are unlikely to be available for trading after the
flotation, and that institutional shareholders will have control of the company.
 Under the ASX listing rules, companies are encouraged to make 25 per cent of shares available to
public shareholders through the incentive of a lower number of shareholders needed to list (400
shareholders instead of 500). Similarly, when a company first goes to the market in the UK, the
maximum proportion of shares that can be placed is 75 per cent, to ensure some shares are
available to a wider public.
4.4.4 A STOCK EXCHANGE INTRODUCTION

By this method of obtaining a quotation, no shares are made available to the market, neither existing
nor newly created shares; nevertheless, the stock market grants a quotation. This will only happen
where shares in a large company are already widely held, so that a market can be seen to exist. A
company might want an introduction to obtain greater marketability for the shares, a known share
valuation for taxation purposes and easier access in the future to additional capital.
4.5 COSTS OF SHARE ISSUES ON THE STOCK MARKET

Companies may incur the following costs when issuing shares:
 Underwriting costs (see below).
 Stock market listing fee (the initial charge) for the new securities. MODULE 4
 Fees of the issuing house, solicitors, auditors and public relations consultant.
 Charges for printing and distributing the prospectus.
 Advertising in national newspapers.
4.5.1 UNDERWRITING
A company about to issue new securities in order to raise finance might decide to have the issue
underwritten. Underwriters are financial institutions which agree (in exchange for a fixed fee, perhaps
2.25 per cent of the finance to be raised) to buy at the issue price any securities which are not
subscribed for by the investing public.
Underwriters remove the risk of a share issue's being under-subscribed, but at a cost to the company
issuing the shares. It is not compulsory to have an issue underwritten. Ordinary offers for sale are most
likely to be underwritten although rights issues may be as well.
4.6 PRICING SHARES FOR A STOCK MARKET LAUNCH

Figure 4.2: Pricing of shares
Price of similar Current market

quoted companies conditions
WHAT PRICE
TO SET?
Desire for immediate Future trading

premium prospects
Companies will be keen to avoid over-pricing an issue, which could result in the issue being under
subscribed, leaving underwriters with the unwelcome task of having to buy up the unsold shares. On
the other hand, if the issue price is too low then the issue will be oversubscribed and the company
would have been able to raise the required capital by issuing fewer shares.
The share price of an issue is usually advertised as being based on a certain P/E ratio, the ratio of the
price to the company's most recent earnings per share figure in its audited accounts. The issuer's P/E
ratio can then be compared by investors with the P/E ratios of similar listed companies.
4.6.1 THE PRICE EARNINGS RATIO

Definition
Market price of share Total market value of equity

Price earnings ratio = or
EPS Total earnings
The price earnings (P/E) ratio reflects the market's appraisal of the share's future prospects. It is an
important ratio because it relates two key considerations for investors, the market price of a share and
its earnings capacity.
Worked Example: Price earnings ratio
A company has recently declared a dividend of 12c per share. The share price is $3.72 cum div and
earnings for the most recent year were 30c per share. Calculate the P/E ratio.
Solution
MV ex div $3.60
P/E ratio = = = 12
EPS 30c
4.7 ADVANTAGES OF A STOCK MARKET LISTING

Figure 4.3: Reasons for seeking a stock market listing
A company can obtain a stock market listing for its shares through a public offer or a placing.
Access to a wider Improved marketability

pool of finance of shares
Easier to
seek growth WHY SEEK A STOCK Enhanced public
MARKET LISTING? image
by acquisition
Original owners selling

holding to obtain funds Original owners
for other projects realising holding
4.8 DISADVANTAGES OF A STOCK MARKET LISTING

The owners of a company seeking a stock market listing must take the following disadvantages into
account:
 There will be significantly greater public regulation, accountability and scrutiny. The legal
requirements the company faces will be greater, and the company will also be subject to the rules
of the stock exchange, such as the ASX, on which its shares are listed.
 A wider circle of investors with more exacting requirements will hold shares.
 There will be additional costs involved in making share issues, including brokerage commissions
and underwriting fees.
5 VENTURE CAPITAL
LOs
4.2,
4.3,  Venture capital is provided to companies with high growth potential in return for a stake of
4.4
equity. It is high risk financing as there is little guarantee this potential will be fulfilled.
 A venture capitalist will generally invest in business start-ups, business development,
management buyouts or where an owner wants to realise some or all of their investment. MODULE 4
5.1 OPPORTUNITIES FOR VENTURE CAPITAL

The types of business that a venture capitalist (VC) might invest in include the following:
 Business start-ups. When a business has been set up by someone who has already put time and
money into getting it started, a VC may be willing to provide finance to enable it to get off the
ground.
 Business development. A VC may be willing to provide development capital for a company which
wants to invest in new products or new markets or to make a business acquisition, and so which
needs a major capital injection.
 Management buyouts. A management buyout is the purchase of all or parts of a business from its
owners by its managers.
 Helping a company where one of its owners wants to realise all or part of their investment. The
VC may be prepared to buy some of the company's equity.
5.2 FINDING VENTURE CAPITAL

Typically VCs invest in companies with high potential but with little guarantee that this potential can
be fulfilled. Since the investment is high risk, the VC will expect high returns (averaging out at 25 to 40
per cent per annum). Investment is usually in the form of equity and much of the VC's return will be in
the form of a capital gain after three to five years, rather than by way of a steady annual dividend.
A key issue for a venture capitalist is the exit route, which is the means by which they can liquidate
their investment (e.g. a trade sale or flotation).
When a company's directors look for help from a venture capital institution, they must recognise that:
 the institution will want an equity stake in the company
 it will need convincing that the company can be successful (management buyouts of companies
which already have a record of successful trading have been increasingly favoured by venture
capitalists in recent years)
 it may want to have a representative appointed to the company's board, to look after its interests,
or an independent director.
The directors of the company must then contact venture capital organisations, to try to find one or
more which would be willing to offer finance. Typically, a venture capitalist will consider offering
finance of $500 000 upwards. A venture capital organisation will only give funds to a company that it
believes can succeed.
A survey has indicated that around 75 per cent of requests for venture capital are rejected on an initial
screening. Only about 3 per cent of all requests survive both this screening and further investigation
and result in actual investments.
The venture capital organisation will take account of various factors in deciding whether or not to
invest.
Table 4.3: Factors in investment decisions
The nature of the company's product Viability of production and selling potential.
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.
Board membership 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.
6 LEASING AND LOANS
LOs
4.2,
4.3,  Leasing and loans are other forms of debt finance.
4.4
 The decision whether to lease or buy an asset is a financing decision which interacts with
the investment decision to buy the asset. The decision about how to finance the asset
(whether to borrow money in order to buy it, or whether to lease it) is made once the
decision to invest in the asset has been made.
6.1 LEASING
Rather than buying an asset outright, using either available cash resources or borrowed funds, a
business may lease an asset. Leasing has become a popular source of finance.
Leasing can be defined as a contract between lessor and lessee for hire of a specific asset selected
from a manufacturer or vendor of such assets by the lessee. The lessor retains ownership of the asset.
The lessee has possession and use of the asset on payment of specified rentals over a period.
Many lessors are financial intermediaries such as banks and insurance companies. The range of assets
leased is wide, including office equipment and computers, cars and commercial vehicles, aircraft,
ships and buildings.
6.1.1 SALE AND LEASEBACK

A company which owns its own premises can obtain finance by selling the property to an insurance
company or pension fund for immediate cash and renting it back, usually for at least 50 years with rent
reviews every few years.
A company would raise more cash from a sale and leaseback arrangement than from a mortgage, but
there are significant disadvantages:
 The company loses ownership of a valuable asset which is almost certain to appreciate over time.
 The future borrowing capacity of the firm will be reduced, as there will be less assets to provide
security for a loan.
 The company is contractually committed to occupying the property for many years ahead which
can be restricting.
 The real cost is likely to be high, particularly as there will be frequent rent reviews.
6.2 LOANS EFFECTIVE INTEREST RATES

A loan is often an unsecured debt taken out so that the business can purchase (and therefore own) an
asset outright. The cost of a loan is the interest rate charged by the lender or provider of finance. A
simple interest rate does not take into account the effect of compounding (see Module 2). However, if
the simple annual interest rate and the compounding period is known, it is possible to calculate the
effective annual rate.
Formula to learn
The general relationship is:

Effective annual interest rate re = (1 + r/m)m – 1
where:
r = annual stated (nominal or simple) interest rate
MODULE 4
re = effective annual interest rate (compound)

m = number of sub-periods within a year (the number of compounding periods in the year)
Worked Example: Finding an effective annual compound interest rate from a given simple annual
rate
If the nominal (or simple) annual interest rate is 12 per cent, and interest is to be applied monthly, then
the effective interest rate per annum can be calculated as follows:
Using re= (1 +r/m)m – 1
where: r = 0.12 and m = 12
re = (1 + (0.12 / 12))12 – 1
= (1.01) 12 – 1
= 1.1268 –1
= 12.68%
So a stated (or nominal) annual interest rate of 12 per cent is the equivalent to an annual effective rate
of 12.68 per cent if interest is compounded each month.
If the effective annual interest rate is known, then with periods of time other than a year – such as a
month, week, or day – it is possible to calculate an equivalent interest rate for the relevant time
period.
Worked Example: Finding an equivalent monthly interest rate from a given compound annual rate
If the effective annual rate (re) is known to be 10.471 per cent compound, then the equivalent monthly
rate, rm will be:
(1 + re)1/12 – 1 = rm
(1 + 0.10471)1/12 – 1 = 0.00833, or 0.833%.
Applying compound interest at monthly intervals, at the rate of 0.833 per cent per month is the same
as applying compound interest once annually at 10.471 per cent.
Formula to learn
(1 + re)1/m – 1 = rm
Where
re= effective annual interest rate (compound)
rm = equivalent period rate (compound)
m = number of sub-periods in the year
6.2.1 LOAN CALCULATIONS

The following example demonstrates how the repayments on a loan may be calculated.
Worked Example: Finding the repayments for a loan
Chris took out a loan of $200 000 and agreed to repay it over 20 years, through equal monthly
instalments. If the interest rate for the loan was fixed at 8 per cent per annum compound for the term
of the loan, what is the amount of each monthly instalment?
Solution
If the annual compound interest rate is 8 per cent, the effective interest rate per month can be
calculated as follows:
Using ie = (1 +r)1/n – 1
where: r = 0.08 and n = 12
ie = (1 + 0.08)1/12 – 1
= 0.00643
= 0.643%
Using the annuity formula (see Module 2) :
PV =  1 n 
r  (1+r) 
Here we need to derive a monthly cash flow, using an effective monthly discount rate of 0.643 per cent
and 240 periods (20 years  12 months).
Monthly repayment 1
200 000 = (1  )
240
0.00643 1.00643
Annuity factor = 122
200 000 = Monthly repayment  122
Therefore, monthly repayment = 200 000 / 122 = $1639
6.2.2 CALCULATION OF REPAYMENTS ON A LOAN

We can use the annuity formula to calculate the repayments on a loan.
The annuity factor formula is = {1 – [1 / (1+r)n]} / r
Where r is the interest rate as a decimal and n is the number of years.
For example, a $30 000 loan is taken out by a business at a rate of 12 per cent over five years. What
will be the annual payment?
The annuity factor for 12 per cent over five years is 3.605, either from the tables or by using the
formula above:
Annuity factor = {1 – [1 / (1 + 0.12)5]} / 0.12 = 3.605
Therefore, $30 000 = 3.605  annual payment.
30 000
Annual payment =
3.605
= $8321.78
6.2.3 THE SPLIT BETWEEN INTEREST AND CAPITAL REPAYMENT

A 5-year loan of $100 000 is to be repaid to the bank in equal annual year-end instalments made up of
capital repayments and interest at 9 per cent per annum.
Annual payment = Amount of loan/annuity factor
$100 000
The annual payment = = $25 707
3.890
Each payment can then be split between the repayment of capital and interest.
Year Balance b/f Interest @ 9% Annual payment Balance c/f
$ $ $ $
1 100 000 9 000 (25 707) 83 293
MODULE 4
2 83 293 7 496 (25 707) 65 082
3 65 082 5 857 (25 707) 45 232
4 45 232 4 071 (25 707) 23 596
5 23 596 2 111* (25 707)
* Rounding difference
Worked Example: Cost of leasing
Brown Co has decided to invest in a new machine which has a five year life and no residual value. The
machine can either be purchased now for $100 000, or it can be leased for five years with lease rental
payments of $26 500 per annum payable at the end of each year. Calculate the interest rate implicit in
the lease.
Solution
The interest rate of the lease is found by estimating the IRR of the cashflows:
Year Cash flow Discount factor PV
$ 10% $
0 Purchase price saved 100 1.000 100.00
1–5 Lease rental 2626.5 3.791 ((100.461)
(0.461)
Since the NPV at the first guess of 10 per cent is virtually zero, the IRR and therefore the interest rate
of the lease must be approximately 10 per cent.
6.3 LEASE OR BUY DECISIONS

The decision whether to lease or buy an asset is a financing decision which interacts with the
investment decision to buy the asset. The decision about how to finance the asset (whether to borrow
money in order to buy it, or whether to lease it) is made once the decision to invest in the asset has
been made.
Discounted cash flow techniques are used to evaluate the lease or buy decision so that the least-cost
financing option can be chosen.
We assume that if the organisation decided to purchase the equipment, it would finance the purchase
by borrowing funds, rather than out of retained funds. Therefore we compare the cost of purchasing
with the cash flows of leasing by discounting the financing cash flows at an after-tax cost of borrowing.
The cash flows of purchasing do not include the interest repayments on the loan as these are dealt
with via the cost of capital.
Worked Example: Lease or buy decision
Brown Co has decided to invest in a new machine which has a 10-year life and no residual value.
Brown can either borrow the money at a cost of capital of 9 per cent in order to purchase the machine
now for $50 000, or it can be leased for 10 years with lease rental payments of $8000 per annum
payable at the end of each year. Ignore tax.
Solution
Present value of leasing costs

PV = Annuity factor at 9% for 10 years × $8000
= 6.418 × $8000
= $51 344
If the machine was purchased now, it would cost $50 000. The purchase is therefore the least-cost
financing option.
7 CALCULATING THE COSTS OF DEBT AND EQUITY

CAPITAL
LOs
4.5
 For irredeemable debt the cost of capital is the (post-tax) interest rate as a percentage of
the market value of the loan stock.
 For redeemable debt, the cost is given by the internal rate of return of the cash flows
involved which is expressed as a percentage.
 The cost of short-term funds such as bank loans and overdrafts is the current interest
being charged on such funds.
 The dividend valuation model can be used to estimate a cost of equity, on the assumption
that the market value of shares is directly related to the expected future dividends on the
shares.
7.1 RISK AND THE COST OF FINANCE

The providers of debt face lower risk (fixed interest capital, usually secured) but as a result they will
receive lower rates of return.
Ordinary shareholders are the ultimate bearers of risk as they are at the bottom of the creditor
hierarchy in a liquidation. This means there is a significant risk they will receive nothing after all of the
other trade payables have been paid.
This greater risk means that shareholders expect the highest return of long-term providers of finance.
The cost of equity finance is therefore always higher than the cost of debt.
In addition to the lower return required by the providers of the finance, debt becomes additionally
cheaper as a result of any tax relief on the interest payments.
In structuring its finance, a company must have regard to the risk-return trade-off desired by potential
investors and the impact this has on the servicing cost of the finance. Some finance will also involve
greater transaction costs in order to obtain the finance in the first place (e.g. compare the costs of a
public share issue with the arrangement fee for a loan).
7.2 THE COST OF DEBT CAPITAL

The interest on debt capital is an allowable deduction for the purposes of taxation and so the cost of
debt capital and the cost of share capital are not properly comparable costs. This tax relief on interest MODULE 4
ought to be recognised in DCF computations. One way of doing this is to include tax savings due to
interest payments in the cash flows of every project. A simpler method, and one that is normally used,
is to allow for the tax relief in computing the cost of debt capital, to arrive at an 'after-tax' cost of debt.
Note: there is no tax relief on the payment of dividends in respect of equity or preference share
capital, so tax does not affect these calculations.
7.2.1 THE COST OF IRREDEEMABLE DEBT

Estimating the cost of fixed interest or fixed dividend capital is much easier than estimating the cost of
ordinary share capital, because the amount received by the holder of the security in the form of
interest or dividends is fixed by contract and will not fluctuate.
The cost of debt capital already issued is the rate of interest (the internal rate of return) which
equates the current market price with the discounted future cash receipts from the security.
Ignoring taxation for the moment, in the case of irredeemable debt the future cash flows are the
interest payments in perpetuity so that:
Formula to learn
I
P0 
Kb
where:
P0 is the current market price of debt capital after payment of the current interest.
I is the annual interest.
Kb is the required return of the providers of debt capital.
This formula can be re-arranged:
I
Kb =
P0
Formula to learn
I
The after-tax cost of irredeemable debt capital is: Kd = (1  t)
P0
where:
Kd is the after-tax cost of debt capital to the company.
I is the annual interest payment.
P0 is the current market price of the debt capital ex interest (that is, after payment of the current
interest).
T is the rate of tax.
Therefore, if a company pays $10 000 a year interest on irredeemable debenture stock with a nominal
value of $100 000 and a market price of $80 000, and the rate of tax is 30 per cent, the cost of the
debentures would be:
10 000
(1  0.30) = 0.0875 = 8.75%
80 000
The higher the rate of tax is, the greater the tax benefits in having debt finance will be compared with
equity finance, since the actual cost of debt to the company would be lesser.
In the example above, if the rate of tax had been 40 per cent, the cost of debt would have been, after
tax:
10 000
(1  0.40) = 0.075 = 7.5%
80 000
7.2.2 THE COST OF REDEEMABLE DEBT

If the debt is redeemable, then only the interest payments attract tax relief. In the year of redemption
the interest payment will be received by the investor/lender as well as the amount payable on
redemption, so:
Formula to learn
I I I+Pn
P0 = + 2
+ ...+ n
(1+K b ) (1+K b ) (1+K b )
where Pn = the amount payable on redemption in year n.
The above equation cannot be simplified so 'Kb' will have to be calculated by trial and error, as an
internal return of return (IRR) for the cash flows.
The best trial and error figure to start with in calculating the cost of redeemable debt is to take the
cost of debt capital as if it were irredeemable and then add the annualised capital profit that will be
made from the present time to the time of redemption.
Worked Example: Cost of debt capital (no tax)
Owen Allot has in issue 10 per cent debentures of a nominal value of $100. The market price is $90 ex
interest. Ignoring taxation, calculate the cost of this capital if the debenture is
a. irredeemable
b. redeemable at par after 10 years
Solution
a. The cost of irredeemable debt capital is:

I $10
=  100% = 11.1%
P0 $90
b. The cost of debt capital is 11.1 per cent if irredeemable. The capital profit that will be made from
now to the date of redemption is $10 ($100  $90). This profit will be made over a period of
10 years which gives an annualised profit of $1 which is about 1 per cent of current market value.
Therefore, the best trial and error figure to try first is 12 per cent.
Year Cash flow Discount factor PV Discount factor PV
$ 12% $ 11% $
0 Market value (90) 1.000 (90.00) 1.000 (90.00)
1–10 Interest 10 5.650 56.50 5.889 58.89
10 Capital repayment 100 0.322 32.20 0.352 35.20
(1.30) 4.09
The approximate cost of debt capital is therefore:

 4.09 
11+  ×1 =
  4.09  1.30  
Worked Example: After-tax cost of redeemable debt capital
a. A company has outstanding $660 000 of 8 per cent debenture stock on which the interest is
payable annually on 31 December. The stock is due for redemption at par of $100 on 1 January
20X6. The market price of the stock at 28 December 20X2 was $95.00 ex interest. Ignoring taxation,
what do you estimate to be the current market rate of interest?
b. If the effective rate of tax is 30 per cent what would be the cost to the company of the debenture MODULE 4
stock in (a) above? Assume that tax relief on interest payments arises in the same year as the
interest payment.
Solution
a. The current market rate of interest (which is the same as the debenture holders' required return) is
found by calculating the pre-tax internal rate of return of the cash flows shown in the table below.
A discount rate of 10 per cent is chosen for a trial-and-error start to the calculation.
Discount Present
Item and date Year Cash flow factor value
$ 10% $
Market value (ex int) 28.12.X2 0 (95) 1.000 (95.00)
Interest 31.12.X3 1 8 0.909 7.28
Interest 31.12.X4 2 8 0.826 6.61
Interest 31.12.X5 3 8 0.751 6.01
Redemption 1.1.X6 3 100 0.751 75.10
NPV 0
By coincidence, the market rate of interest is 10 per cent since the NPV of the cash flows above is
zero.
b. Again we must identify the current interest payable and use ex interest figures.
At a market value of $95.00
Cash flow Discount Discount
Item Year ex int factor at PV 5% factor at PV 8%
$ 5% $ 8% $
Market value 0 (95.00) 1.000 (95.00) 1.000 (95.00)
Interest less tax saved 1 5.60 0.952 5.33 0.926 5.19
Redemption 3 100.00 0.864 86.40 0.794 79.40
NPV 6.65 (1.16)
The estimated cost of debt is:
6.65
5% + × (8 – 5)%
(6.65 + 1.16)
= 7.6% approx
Conclusion: As a result of the tax saving on the interest, it will only cost the company approx
7.6 per cent per annum in order to provide the debenture holders with an annual return of
10 per cent.
7.2.3 THE COST OF SHORT-TERM FUNDS

The cost of short-term funds such as bank loans and overdrafts is the current interest being charged
on such funds. Remember that the company will save tax on the interest payment so the appropriate
cost will be after-tax.
7.3 THE COST OF EQUITY CAPITAL

The cost of equity, both for new issues and retained earnings, could be estimated by two means:
1. the capital asset pricing model (CAPM); this was covered in Module 2
2. the dividend valuation model (DVM),which will be covered in this module. The DVM is based on
the assumption that the market value of shares is directly related to expected future dividends on
the shares.
Formula to learn – DVM
If the future annual dividend per share (D1) is expected to be constant in amount 'in perpetuity', the
share price (P0) can be calculated by the following formula:
D1
P0 
r
where r is the shareholders' required return (cost of equity), expressed as a proportion (e.g. 12 per cent
= 0.12).
The share price is 'ex dividend', which means that it excludes the value of any current dividend that
has just been paid or is currently payable. The next annual dividend is receivable in one year's time.
If a share price is stated as ‘cum dividend' then it includes the value of the current dividend payable.
Note that the value of debt can similarly be given as ‘ex interest' or ‘cum interest'.
The share price is the present value of a constant annual dividend forever (i.e. in perpetuity). The
mathematical formula is quite simple because the PV of a constant annual cash flow $C in perpetuity,
discounted at a cost of capital r, is $C/r.
Formula to learn
Re-arranging this formula, we get a formula for the cost of equity.
D1
Ke =
P0
where:
Ke is the shareholders' cost of capital
D1 is the annual dividend per share, starting at Year 1 and then continuing annually in perpetuity
7.3.1 DVM ASSUMPTIONS

The following assumptions are made in the dividend valuation model:
 The dividends from projects for which the funds are required will be of the same risk type or quality
as dividends from existing operations.
 There would be no increase in the cost of capital, for any other reason besides (a) above, from a
new issue of shares.
 All shareholders have perfect information about the company's future, there is no delay in obtaining
this information and all shareholders interpret it in the same way.
 Taxation can be ignored.
 All shareholders have the same marginal cost of capital.
 There would be no issue expenses for new shares.
Worked Example: Cost of equity, constant dividend
Suppose that ABC is a company with no dividend growth prospects, which has just paid an annual
dividend of 16c per share. The share price is 200c.
Applying the dividend valuation model, the cost of equity can be calculated as 16 / 200 = 0.08
(8 per cent).
7.3.2 THE DIVIDEND GROWTH MODEL

Shareholders will normally expect dividends to increase year by year and not to remain as a constant
amount every year. Expected growth in dividends can be allowed for in calculating a cost of equity,
using Gordon's growth model.
Given an expected constant annual growth in dividends, the share price formula would be: MODULE 4
Formula to learn
D0 (1+ g)
P0 =
(r  g)
where:
D0 is the current year's annual dividend (i.e. the year 0 dividend) or dividend just paid.
P0 is the current ex-dividend share price.
r is the shareholders' required return, expressed as a proportion.
g constant growth rate of dividends, is the annual growth rate in dividends, expressed as a
proportion (e.g. 4% = 0.04).
This formula assumes a constant growth rate in dividends, but it can be adapted for uneven growth.
Re-arranging the formula, we get a formula for the ordinary shareholders' cost of capital, Ke
Formula to learn
D0 (1+ g)
Ke = +g
P0
This is equivalent to the following equation:
D1
Ke = +g
P0
where D1 is the dividend in year 1, so that D1 = D0 (1 + g).

This dividend growth model is sometimes called Gordon's growth model.
Question 3: Cost of equity capital
A share has a current market value of 96c, and the last dividend was 12c. If the expected annual
growth rate of dividends is 4 per cent, calculate the cost of equity capital.
7.3.3 ESTIMATING GROWTH RATES

The value of g may be estimated by extrapolating growth in past dividends or by analysing the future
earnings rate and the company’s retention policy.
7.3.4 EXTRAPOLATION OF GROWTH IN PAST DIVIDENDS

Worked Example: Past dividend growth
A company's dividend payments from 20X1 to 20X5 were as follows:

Year $'000
20X1 2 200
20X2 2 578
20X3 3 108
20X4 3 560
20X5 4 236
Required
Estimate the dividend growth rate.
Solution
Dividend in 20X1  (1+g)4 = Dividend in 20X5

Dividend in 20X5
(1+g)4 =
Dividend in 20X1
(1+g)4 = 4236 / 2200 = 1.925
4
1+ g = 1.925 = 1.18
g = 0.18 = 18%
7.3.5 ANALYSIS OF THE FUTURE EARNINGS RATE AND RETENTION POLICY

Formula to learn
g = bR
where:
g is the annual growth rate in dividends
b is the yield on new investments
R is the proportion of profits retained for reinvestment.
Worked Example: g = bR
An all equity financed company distributes 30 per cent of its earnings each year and reinvests the
balance to earn a constant return on projects of 15 per cent pa.
Therefore, b = 0.15 and R = 0.70, so g = 0.15  0.70 = 0.105 (10.5%)
Worked Example: Estimating dividend growth
The dividends and earnings of Hall Shores over the last five years have been as follows:
Year Dividends Earnings
$ $
20X1 150 000 400 000
20X2 192 000 510 000
20X3 206 000 550 000
20X4 245 000 650 000
20X5 262 350 700 000
The company is financed entirely by equity and there are 1 000 000 shares in issue, each with a market
value of $3.35 ex div.
Required
a. What is the cost of equity?
b. What implications does dividend growth appear to have for earnings retentions?
Solution
The dividend growth model will be used. The dividend per share in the current year is
$262 350 / 1 000 000 = $0.26235.
MODULE 4
a. Growth in past dividends
Dividends have risen from $150 000 in 20X1 to $262 350 in 20X5. The increase represents four years
growth. Check that you are aware that there are four years' growth, and not five years' growth, in
the table.
The average growth rate, g, may be calculated as follows:
Dividend in 20X1  (1+g)4 = Dividend in 20X5
Dividend in 20X5
(1+g)4 =
Dividend in 20X1
$262 350
= $150 000 = 1.749
4
1+g = 1.749 = 1.15
g = 0.15 = 15%
The growth rate over the last four years is assumed to be expected by shareholders into the
indefinite future, so the cost of equity, Ke, is:
d0 (1+ g) 0.26235(1.15)
+g = + 0.15 = 0.24 = 24%
P0 3.35
b. g = bR (retained earnings model)
Retained profits will earn a certain rate of return and so growth in dividends will come from the
yield on the retained funds.
It might be assumed that g = bR where b is the yield on new investments and R is the proportion of
profits retained for reinvestment.
In our example, if dividends continue to grow at the same rate as previously the future annual
growth rate would be 15 per cent.
If this is due to the retention and reinvestment policy, then g = 0.15 = bR
If we assume that the rate of return on new investments averages 24 per cent, which is the cost of
equity and hence the return shareholders require from projects, and if the proportion of earnings
retained is 62.5% (which it has been, approximately, in the period 20X1 – 20X5) then
g = bR = 24%  62.5% = 15%.
A change in the level of earnings retained or the return on reinvested earnings would result in a
different future growth rate.
Question 4: Cost of equity with dividend growth
The current market price of Conrad Co's shares is $3.50. It has just paid a dividend of 35c.
Conrad has consistently applied a dividend payout policy of 1/3 earnings. It makes an average return
on investment of 15 per cent. Estimate Conrad's cost of equity.
7.3.6 WEAKNESSES OF THE DIVIDEND GROWTH MODEL

 The model does not incorporate risk.
 Dividends do not grow smoothly in reality, so g is only an approximation.
 The model fails to take capital gains into account, however it is argued that a change of share
ownership does not affect the present value of the dividend stream.
 No allowance is made for the effects of taxation although the model can be modified to incorporate
tax.
 It assumes there are no issue costs for new shares.
7.4 THE COST OF PREFERENCE SHARES

For preference shares the future cash flows are the dividend payments in perpetuity so that:
d d d
P0 = + 2
+ 3
+…
(1+ k pref ) (1+ k pref ) (1+ k pref )
where: P0 is the current market price of preference share capital after payment of the current
dividend
d is the dividend received.
kpref is the cost of preference share capital.
d d d
+ 2
+ 3
…
(1+ k pref ) (1+ k pref ) (1+ k pref )
d
simplifies to
k pref
This can be rearranged to find the cost of preference share capital:
Formula to learn
d
The cost of preference shares can be calculated as kpref =
P0
8 THE WEIGHTED AVERAGE COST OF CAPITAL

(WACC)
LO
 The weighted average cost of capital is the average cost of capital to a company
weighted appropriately for debt and equity proportions.
8.1 COMPUTING AN OVERALL DISCOUNT RATE

We have now looked at the costs of individual sources of capital for a company. But how does this
help us to work out the cost of capital for the company as a whole?
In many cases it will be difficult to associate a particular project with a particular form of finance. A
company's funds may be viewed as a pool of resources. Money is withdrawn from this pool of funds
to invest in new projects and added to the pool as new finance is raised or profits are retained. Under
these circumstances it might seem appropriate to use an average cost of capital as the discount rate.
The weighted average cost of capital (WACC) might be considered the most reliable guide to the cost
of capital, but only on the assumption that the company continues to invest in the future:
 in projects of a standard level of business risk
 by raising funds in the same equity/debt proportions as its existing capital structure.
8.2 GENERAL FORMULA FOR THE WACC

The weighted average cost of capital is found by taking the cost of each individual source of finance
and weighting it according to its importance in the finance mix. MODULE 4
Formula to learn
A general formula for the weighted average cost of capital is:

E D
WACC = [ K e ] + [ Kd ]
E +D E +D
where: Ke is the cost of equity.
Kd is the post-tax cost of debt for the company.
E is the total market value of equity in the firm.
D is the total market value of debt in the firm.
Where the company uses other forms of capital, such as preference shares, bank loans, the formula
can be adjusted to incorporate these, each cost being weighted by the market value of that source of
finance as a proportion of the total value of the firm.
Worked Example: Weighted average cost of capital
Prudence is financed partly by equity and partly by debentures. The equity proportion is always kept
at two thirds of the total. The cost of equity is 18 per cent and that of debt 12 per cent. A new project
is under consideration which will cost $100 000 and will yield a return before interest of $37 500 a year
for four years. Should the project be accepted? Ignore taxation.
Solution
Since the company will maintain its gearing ratio unchanged, it is reasonable to assume that its
marginal cost of funds equals its WACC. The weighted average cost of capital is as follows:
Proportion Cost Cost  proportion
Equity 2 18% 12%
Debt 12% 4%
1
3
WACC 16%
Cash Discount factor

Year flow at 16% PV
$ $
0 (100 000) 1.000 (100 000)
1 37 500 0.862 32 325
2 37 500 0.743 27 863
3 37 500 0.641 24 038
4 37 500 0.552 20 700
NPV 4 926
The NPV of the investment is $4926. On the basis of the estimated figures it therefore appears
financially justifiable. Before proceeding, it may be wise to assess the accuracy of the estimates and
the sensitivity of the decision to changes in any of the estimated figures.
Note: Net Present Values are covered in Module 7.
8.3 WEIGHTING
In the last example, we simplified the problem of weighting the different costs of capital by giving
the proportions of capital. Two methods of weighting could be used:
a. Weights could be based on market values (by this method, the cost of retained earnings is implied
in the market value of equity).
b. Weights could be based on statement of financial position values ('book values').
Although book values are often easier to obtain, market values are more relevant to the organisation's
current position. It is therefore appropriate to use market values. However, for unlisted companies
estimates of market values are likely to be extremely subjective and consequently book values may be
used.
When using market values it is not possible to split the equity value between share capital and
reserves and only one cost of equity can be used. This removes the need to estimate a separate cost
of retained earnings.
Question 5: WACC
PLZ has equity share capital of 100 million shares with a current market price of 500c each, bonds with
a current market value of $100 million and $150 million of bank loans. The company expects to
maintain its current capital structure (the proportion of equity to bonds to bank loans) into the
foreseeable future. The cost of equity is 12 per cent, the after tax cost of the bonds is 7 per cent and
the after tax cost of the bank loans is 6 per cent.
What is the company's weighted average cost of capital?
MODULE 4
KEY MODULE POINTS
 Capital structure refers to the way in which an organisation is financed.

 Decisions include choosing a suitable balance between debt capital (gearing level) and equity
capital, and deciding on the balance between short-term and long-term finance.
 As a general rule businesses should aim to match the length of finance with the maturity of the
asset being financed, therefore non-current assets would be financed by long term capital and the
majority of current assets by short-term capital.
 Short-term sources of finance include overdrafts, short-term loans, trade credit and lease finance.
Long-term sources of finance include debt finance, leasing, venture capital and equity finance.
 The risk-return trade-off desired by potential investors will impact on the servicing cost of the
finance. Shareholders bear the greatest risk and therefore will expect the highest return of
longterm providers of finance. The cost of equity finance is therefore always higher than the cost of
debt.
 A range of short-term sources of finance are available to businesses including overdrafts,
short-term loans, trade credit and lease finance.
 A company may use long-term or short-term debt capital as sources of finance. The cost of debt
capital is interest.
 The choice of debt finance that a company can make depends upon:
– the size of the business (a public issue of bonds is only available to a large company)
– the duration of the loan
– whether a fixed or floating interest rate is preferred (fixed rates are more expensive, but floating
rates are riskier)
– the security that can be offered.
 Equity finance refers to the ordinary share capital of the company.
 Equity finance can come from three sources:
– retained earnings
– rights issue of shares to existing shareholders
– new share issue.
 Venture capital is provided to companies with high growth potential in return for a stake of equity.
It is high risk financing as there is little guarantee this potential will be fulfilled.
 A venture capitalist will generally invest in business start-ups, business development, management
buyouts or where an owner wants to realise some or all of their investment.
 Leasing and loans are other forms of debt finance.
 The decision whether to lease or buy an asset is a financing decision which interacts with the
investment decision to buy the asset. The decision about how to finance the asset (whether to
borrow money in order to buy it, or whether to lease it) is made once the decision to invest in the
asset has been made.
 For irredeemable debt the cost of capital is the (post-tax) interest rate as a percentage of the
market value of the loan stock.
 For redeemable debt, the cost is given by the internal rate of return of the cash flows involved
which is expressed as a percentage.
 The cost of short-term funds such as bank loans and overdrafts is the current interest being
charged on such funds
 The dividend valuation model can be used to estimate a cost of equity, on the assumption that
the market value of shares is directly related to the expected future dividends on the shares.
 The weighted average cost of capital is the average cost of capital to a company weighted
appropriately for debt and equity proportions.
1 Consider the following statements concerning sources of finance.

I. Debentures are more similar to equity than preference shares.
II. There is less risk for the equity shareholders if the company raises finance using preference
shares rather than debt.

Statement
I II
A True True
B True False
C False True
D False False
2 Which of the following sources of equity finance is a company most likely to use in practice?
A rights issue
B venture capital
C new share issue
D retained earnings
3 Which of the following is least likely to be a reason for seeking a stock market flotation?
A transfer of capital to other uses
B access to a wider pool of finance
C enhancement of the company's image
D improving the existing owners' control over the business
4 Three important sources of long-term finance are loan capital, ordinary shares and preference
shares.
Which one of the following correctly ranks these sources of finance according to their relative cost
to the business? (Where I represents the source of finance that is normally the most expensive and
III represents the source that is normally the least expensive.)
Preference
Loan capital Ordinary shares shares
A I II III
B II III I
C III I II MODULE 4
D II I III
5 Which of the following is not true of a rights issue by a listed company?

A Rights issues do not require a prospectus.
B The rights issue price can be at a discount to market price.
C If shareholders do not take up the rights, the rights automatically lapse.
D Relative voting rights are unaffected if shareholders exercise their rights.
6 Consider the following statements concerning share issues.

I. An offer for sale involves a listed company making a direct invitation to the public to purchase
shares in the company.
II. A bonus issue involves the issue of new shares for cash to existing shareholders in proportion to
their existing shareholdings.

Statement
I II
A True True
B True False
C False True
D False False
7 The following comments, relating to methods of issuing shares by a public company, were recently
made:
I. An offer for sale is an invitation to the public to buy shares that are not yet in issue.
II. A placing is an invitation to selected investors to buy either new shares or shares already in
issue.
Which one of the following combinations (True/False) concerning the above statements is correct?
Statement
I II
A True True
B True False
C False True
D False False
8 What is the term for an arrangement whereby a listed company issues new shares which are
bought by a small number of institutional investors, such as pension funds and insurance
companies?
A IPO
B placing
C offer for sale
D offer for subscription
1 D Debentures pay a fixed return each year to investors, as do preference shares, while ordinary
shares (equity) pay a variable return each year depending on the fortunes of the company. Also
debentures and preference shares are both repaid on a liquidation before ordinary shares.
Therefore debentures are more similar to preference shares than to equity.
When a company has either preference shares or debentures in its capital structure, ordinary
shareholders will not get anything until the preference dividend or debt interest has been paid.
Whichever capital the company uses, there is a risk that if profits are low there will be nothing
left over for shareholders.
2 D For most companies, retained earnings are the most important source of equity finance and
would be used before considering a new/rights issue. Venture capital is high risk equity finance
and is only provided to companies with significant growth potential.
3 D Flotation is likely to involve a significant loss of control to a wider circle of investors.
4 C Loan finance is normally the cheapest external source since its cost (interest) attracts tax relief
and has the lowest risks. Neither preference share nor ordinary share returns (dividends) attract
tax relief. Preference shares are lower risk than ordinary shares due to their preferred right to
dividends and capital and therefore have a lower cost.
5 C Shareholders have the option of renouncing the rights and selling them on the market.
6 D An offer for sale involves a sponsoring intermediary such as an investment bank making a public
invitation to purchase shares in the company.
A rights issue involves the issue of new shares for cash to existing shareholders in proportion to
their existing shareholdings. A bonus issue is a free issue of shares to existing shareholders in
proportion to their existing shareholdings.
7 C An offer for sale involves the sale of shares already in issue.
8 B In a placing, a sponsoring market maker arrange for shares to be purchased by a small number
of investors such as pension funds and insurance companies. These deals are quick to arrange
and incur lower costs than issuing the shares through a rights issue.
MODULE 4
1 a. Conversion ratio is $100 bond = 30 ordinary shares

Conversion value = 30 × $4.15 = $124.50
17.50
b. Conversion premium = $(142 – 124.50) = $17.50 or × 100% = 14%
124.50
The share price would have to rise by 14 per cent before the conversion rights became attractive
2 Value of the portfolio for a shareholder with three shares before the rights issue:
$
3 shares @ $4.00 12.00
1 share @ $3.20 3.20
4 15.20
So the value per share after the rights issue (or TERP) is 15.20 / 4 = $3.80.
$
Theoretical ex-rights price 3.80
Price per new share 3.20
Value of rights per new share 0.60
$0.60
The value of the rights attached to each existing share is = $0.20.
3
We will assume that a shareholder is able to sell their rights for $0.20 per existing share held.
a. If the shareholder sells all the rights:
$
Sale value of rights (900 @ $0.20) 180
Market value of 900 shares, ex-rights @ $3.80) 3 420
Total wealth 3 600
Total value of 900 shares cum rights ( $4) $3 600
The shareholder would neither gain nor lose wealth. They would not be required to provide any
additional funds to the company, but their shareholding as a proportion of the total equity of
the company would be lower.
b. If the shareholder exercises half of the rights (buys 450 / 3 = 150 shares at $3.20) and sells the
other half:
$
Sale value of rights (450  $0.20) 90
Market value of 1050 shares, ex-rights ( $3.80) 3 990
4 080
Total value of 900 shares cum rights (@ $4) 3 600

Additional investment (150 @ $3.20) 480
4 080
The shareholder would neither gain nor lose wealth, although they would have increased their
investment in the company by $480.
c. If the shareholder does nothing, but all other shareholders either exercise their rights or sell
them, they would lose wealth as follows:
$
Market value of 900 shares cum rights (@ $4) 3 600
Market value of 900 shares ex-rights (@ $3.80) 3 420
Loss in wealth 180
It follows that the shareholder, to protect their existing investment, should either exercise their
rights or sell them to another investor. If the shareholder does not exercise their rights, the new
securities they were entitled to subscribe for might be sold for their benefit by the company,
and this would protect them from losing wealth.
12(1 + 0.04)
3 Cost of capital = + 0.04 = 0.13 + 0.04 = 0.17 = 17%
96
4 Here b = 0.15 and R = 2 / 3 (0.67) so g = 0.15  2 / 3 = 0.10 (10%)
The cost of equity, Ke, is:
d0 (1+ g)
+ g = 0.35 (1.10) / 3.50 + 0.10 = 0.21 = 21%
P0
5 The WACC can be calculated as follows:

Market value (MV) Cost MV  Cost
$m $m
Equity 500 0.12 60
Bonds 100 0.07 7
Bank loans 150 0.06 9
750 76
76
WACC = = 0.101, (10.1%)
750
MODULE 4
117
MODULE 5
LIQUIDITY MANAGEMENT
Analyse the various sources of short term finance LO5.1
Demonstrate the link between working capital management and corporate cash flow LO5.2
Describe the operating cycle in working capital management to explain inventory LO5.3
management, debtor management and cash management
Prepare short term finance plans and strategies LO5.4
Topic list
1 Working capital and short term finance

2 The cash operating cycle
3 Financial plans and strategies
MODULE OUTLINE
This module covers the crucial topic of liquidity management and the link between working capital
and liquidity. It explains the objectives and role of working capital management, the cash operating
cycle and its implications for the management of cash, accounts receivable and payable and
inventories. Strategies for financing working capital are also considered.
Liquidity management
Working capital Strategies and financing

Current assets – Current liabilities
Profitability/liquidity trade-off
Approaches to WC management
Conservative
Aggressive
Cash operating cycle Moderate
Inventory days +
Receivables days –
Payable days
Financing decision
Non-current assets Current assets

Management of liquidity
Inventory
Accounts receivable Permanent Fluctuating
Accounts payable
Cash surplus or deficit
Moderate approach:
match maturity of funds and assets
LIQUIDITY MANAGEMENT | 119
BEFORE YOU BEGIN
area.
everything covered.
1 State the components of working capital. (Section 1)
2 What is meant by the trade-off between profitability and liquidity in respect of
the working capital decision? (Section 1.3)
3 What is the cash operating cycle? (Section 2.1)
4 Name three ways that a company could ease a short-term cash shortage. (Section 2.3)
5 If a company adopts a moderate approach to working capital management,
how is it likely to finance its investment in short term and long term assets? (Section 3.1)
MODULE 5
1 WORKING CAPITAL AND SHORT TERM FINANCE
LOs
5.2
 The amount tied up in working capital is equal to the value of raw materials,
work-in-progress, finished goods inventories and accounts receivable less accounts payable.
 The size of this net figure has a direct effect on the liquidity of an organisation so a business
must have clear policies for the management of each component of working capital.
Definition
Net working capital (or working capital requirement) of a business is its current assets less its
current liabilities.
The amount tied up in working capital is equal to the value of raw materials, work-in-progress, finished
goods inventories and accounts receivable less accounts payable. The size of this net figure has a
direct effect on the liquidity of an organisation. The table below shows the key current assets and
liabilities.
Table 5.1: Current assets and current liabilities
CURRENT ASSETS CURRENT LIABILITIES
Cash Trade accounts payable
Inventory of raw materials Taxation payable
Inventory of work in progress Dividend payments due
Inventory of finished goods Short-term loans
Trade accounts receivable Long-term loans maturing within one year
Marketable securities Lease rentals due within one year
1.1 WORKING CAPITAL CHARACTERISTICS OF DIFFERENT BUSINESSES

Different businesses will have different working capital characteristics. There are three main aspects to
these differences:
 holding inventory (from their purchase from external suppliers, through the production and
warehousing of finished goods, up to the time of sale)
 taking time to pay suppliers and other accounts payable
 allowing customers (accounts receivable) time to pay.
Working capital management is a key factor in an organisation's long-term success. A business must
therefore have clear policies for the management of each component of working capital.
Here are some examples.
 Supermarkets and other retailers receive much of their sales in cash or by credit card or debit card.
However, they typically buy from suppliers on credit. They may therefore have the advantage of
significant cash holdings, which they may choose to invest.
 A company which supplies to other companies, such as a wholesaler, is likely to be selling and
buying mainly on credit. Coordinating the flow of cash may be quite a problem. Such a company
may make use of short-term borrowings (such as an overdraft) to manage its cash.
 Smaller companies with a limited trading record may face particularly severe problems. Lacking a
long track record, such companies may find it difficult to obtain credit from suppliers. At the same
time, customers will expect to receive the length of credit period that is normal for the particular
business concerned. The firm may find itself squeezed in its management of cash.
 When a company is growing, if it expands its operations too quickly, overtrading may occur. The
expansion may be profitable but is likely to necessitate increased levels of inventory and accounts
receivable. If a business expands faster than its existing levels of working capital can sustain, it will
place a strain on cash flow and increase the risk of insolvency.
 Businesses that exist solely to trade will only have finished goods in inventory, whereas
manufacturers will have raw materials and work in progress as well. Also some finished goods,
notably foodstuffs, have to be sold within a few days because of their perishable nature.
 Large companies may be able to use their strength as customers to obtain extended credit periods
from their suppliers. By contrast, small companies, particularly those that have recently
commenced trading, may be required to pay their suppliers immediately.
 Some businesses will be receiving most of their monies at certain times of the year, while incurring
expenses throughout the year. Examples include travel agents who will have peaks reflecting
demand during the summer and at key holiday times.
Worked Example: Working capital policies
What differences would there be in working capital policies for a manufacturing company and a food
retailer?
Solution
The manufacturing company will need to invest heavily in spare parts and may be owed large amounts
of money by its customers. The food retailer will have a large inventory of goods for resale but will
have low accounts receivable.
The manufacturing company will therefore need a carefully considered policy on the management of
accounts receivable which will need to reflect the credit policies of its close competitors.
The food retailer will be more concerned with inventory management.
Question 1: Overtrading
Which of the following is the most likely to be a symptom of overtrading?

A rapid increase in sales
B rapid increase in profits
C static levels of inventory turnover
D increase in the level of the current ratio
1.2 SHORT TERM SOURCES OF FINANCE

In Module 4 we saw a number of sources of short-term finance such as overdrafts, short-term loans
and trade credit. Short-term finance is usually needed for businesses to run their day-to-day
operations including payment of wages to employees, inventory ordering and supplies. Businesses
with seasonal peaks and troughs and those engaged in international trade are likely to be heavy users
of short-term finance.
1.3 PROFITABILITY/LIQUIDITY TRADE-OFF

There are two main objectives of working capital management, to ensure a business has sufficient
liquid resources to continue in business and to increase its profitability.
MODULE 5
Every business needs adequate liquid resources to maintain day-to-day cash flow. It needs enough to
pay wages, salaries and accounts payable if it is to keep its workforce and guarantee supplies.
Maintaining adequate working capital is not just important in the short term. Adequate liquidity is
needed to ensure the survival of the business in the long term. Even a profitable company may fail
without adequate cash flow to meet its liabilities, for example, if the bank suspends its overdraft
facilities, there will be a danger of insolvency unless the company is able to convert adequate current
assets into cash quickly.
Alternatively, an excessively conservative approach to working capital management resulting in high
levels of cash holdings will harm profits because the opportunity to make a return on the assets tied
up as cash will have been missed.
The two objectives of profitability and liquidity will often conflict as liquid assets give the lowest
returns.
Current liabilities are often a cheap method of finance (trade accounts payable do not usually carry an
interest cost). Companies may therefore consider that, in the interest of higher profits, it is worth accepting
some risk of insolvency by increasing current liabilities, and taking the maximum credit possible from
suppliers.
Therefore with most working capital decisions, there is a trade-off between profitability and liquidity.
Case study
These extracts are taken from the annual working capital report, issued by Ernst & Young which
examines the working capital performance of the ASX 200 over 2011–12. They explain the importance
of working capital management for Australian companies operating across the Asia Pacific region:
'The concept of effective working capital is relatively straightforward – a business needs enough cash
to fund day to day operations such as paying suppliers and funding inventory, while awaiting income
from customers. However, in reality it is a delicate balancing act, and achieving effective working
capital is nothing short of a challenge. Too much may be an unnecessary expense, while not having
enough can expose a business to serious financial distress.
To make things even more complex there is no right formula or methodology for obtaining the right
level of working capital. Sure, many business leaders will have their views, however ultimately it is
dependent on a number of competing factors – and there is none greater than working capital
expectations within your supply chain, which can vary across sectors, borders and market capitalisation
segments.
Make your capital work
For this reason, working capital needs to become a top agenda item for businesses of all sizes across
the globe. Given the current capital constrained climate, it has never been more important to get it
right.
Our study has highlighted just how vastly different working capital expectations and norms can be
across regions and how this can impact your operations, transactions and overall profitability going
forward. Our key findings from the report reveal:
 The majority of Asian companies are working capital heavy carrying A$318bn more than their
Australian counterparts
Australian companies need to be mindful of differing working capital conditions in almost each
country across the Asia Pacific region. Of the 1,000 companies listed on the Asia Pacific indices that
were surveyed in this report (including Australia), only the Hong Kong index had a better working
capital performance than Australia.
In fact, in 2011 the average working capital requirement across Asia Pacific (excluding Australia) was 48
days compared to 28 days in Australia. In particular, Japan and Korea have considerably longer
working capital cycles than Australia with an average of 67 and 62 days respectively in 2011.
Of course there are historically complex reasons why there are generally longer payment cycles in
Asia, and this will not change overnight. Notwithstanding this, if companies in the Asia Pacific region
were operating at similar performance levels to those of their Australian counterparts, then an
estimated A$318bn of working capital could be released.
In 2011 the drivers behind the performance difference were around debtor days; the average across
Asia Pacific was 51 days compared to 32 days in Australia. Similarly, in the same year the inventory
days was 38 days compared to 30 in Australia.
It's therefore critical for Australian companies operating or looking to conduct business in Asia to
account for the likely expectations around longer trading terms or supply chains, and build such
measures into their working capital strategies.
Ultimately, these large discrepancies in working capital practices could impact the viability and
profitability of investing in Asia, and in worst case scenario, the success or failure of an operation.'
http://www.ey.com/AU/en/Services/Advisory/Pulse---March-2012---Balancing-act
2 THE CASH OPERATING CYCLE
LO
 The connection between investment in working capital and cash flow may be illustrated by
means of the cash operating cycle.
 The cash operating cycle is the period of time between the point at which cash begins to
be expended on the production of a product and the collection of cash from the customer
who purchases it.
 Ideally, a business should aim to minimise the length of its cash operating cycle. This can
be achieved by managing the various components of working capital.
 Cash shortages can be eased by postponing capital expenditure, selling assets, taking
longer to pay accounts payable and attempting to collect accounts receivable earlier.
 Temporary surpluses of cash can be invested in a variety of financial instruments.
Longer-term surpluses should be returned to shareholders if there is a lack of investment
opportunities.
The connection between investment in working capital and cash flow may be illustrated by means of
the cash operating cycle.
2.1 CASH OPERATING CYCLE

Definition
The cash operating cycle is the period of time between the point at which cash begins to be
expended on the production of a product and the collection of cash from the customer who
purchases it.
The cash operating cycle in a manufacturing business equals:

The average time that raw materials remain in inventory
Less the period of credit taken from suppliers
Plus the time taken to produce (and store) the goods
Plus the time taken by customers to pay for the goods
If the turnover periods for inventories and accounts receivable lengthen, or the payment period to
accounts payable shortens, then the operating cycle will lengthen and the investment in working
capital will increase.
MODULE 5
Worked Example: Cash operating cycle
Wines Co buys raw materials from suppliers that allow Wines Co 2.5 months credit. The raw materials
remain in inventory for one month, and it takes Wines Co two months to produce the goods. The
goods are sold within a couple of days of production being completed and customers take on
average 1.5 months to pay.
Required
Calculate Wines' cash operating cycle.
Solution
We can ignore the time that finished goods are in inventory as it is no more than a couple of days.
Months
The average time that raw materials remain in inventory 1.0
Less the time taken to pay suppliers (2.5)
The time taken to produce the goods 2.0
The time taken by customers to pay for the goods 1.5
2.0
The company's cash operating cycle is two months. This can be illustrated diagrammatically as follows:
0 2.5 3 4.5
Goods Goods sold

purchased to customers
Suppliers Cash received

paid from customers
Cash operating cycle

two months
The cash operating cycle is the period between the suppliers being paid and the cash being received
from the customers.
It represents the period of time the business will require funding for its investment in working capital
(e.g. in the form of an overdraft or short-term loan).
Question 2: Cash flow
How do cash flow problems arise?

2.2 MANAGING THE LENGTH OF THE CYCLE

Ideally, a business should aim to minimise the length of its cash operating cycle. This can be achieved
by managing the various components of working capital.
2.2.1 INVENTORY
Inventory days can be reduced by minimising the holding of raw materials and finished goods and
ensuring production processes are efficient so as to reduce work-in-progress.
Some manufacturing companies have sought to reduce their inventories of raw materials and
components to as low a level as possible. Just-in-time procurement is a term which describes a policy
of obtaining goods from suppliers at the latest possible time (i.e. just as they are needed) and so
avoiding the need to carry any significant materials or components inventory. This is extended into a
complete production philosophy where the finished goods are produced to customer order rather
than being stockpiled in the warehouse.
2.2.2 MANAGING ACCOUNTS RECEIVABLE

Offering credit has a cost: the value of the interest charged on an overdraft to fund the period of
credit, or the interest lost on the cash not received and deposited in the bank. It is also likely to lead
to an increase in irrecoverable debts which do not arise if all sales are for cash. An increase in profit
from extra sales arising as a result of offering credit could offset this cost. Insurance, particularly of
overseas debts, can also help reduce the risk of irrecoverable debts.
A business must therefore consider whether the profit from making additional sales outweighs the
cost of offering the credit necessary to entice the additional customers.
If offering credit generates extra sales, then those extra sales will have additional repercussions on:
 the amount of inventory maintained in the warehouse, to ensure that the extra demand must be
satisfied
 the amount of money the company owes to its accounts payable (as it will be increasing its supply
of raw materials).
Early settlement discounts may be offered to credit customers in order to shorten average credit
periods, and to reduce the investment in accounts receivable and therefore interest costs. The benefit
in interest cost saved should exceed the cost of the discounts allowed.
2.2.3 CREDIT INSURANCE

Companies may be able to obtain credit insurance against certain approved debts going bad through
a specialist credit insurance firm. A company cannot insure against all its bad debt losses, but may be
able to insure against losses above a 'normal' level.
When a company arranges credit insurance, it must submit specific proposals for credit to the
insurance company, stating the name of each customer to which it wants to give credit and the
amount of credit it wants to give. The insurance company will accept, amend or refuse these
proposals, depending on its assessment of each of these customers.
2.2.4 FACTORING AND INVOICE DISCOUNTING

Some companies use factoring and invoice discounting to help short-term liquidity or to reduce
administration costs. Businesses will often enter into arrangements with a factor or invoice discounter
to improve cash flow and shorten the cash cycle.
Definitions
A factoring organisation takes over the management of the trade debts owed to its client (a business
customer) on the client's behalf. The factor company collects the debts and provides an immediate
cash advance of a proportion of the money it is due to collect.
Invoice discounting is the purchase (by the provider of the discounting service) of a company's trade
debts, at a discount. Invoice discounting enables a company to raise finance based on their expected
invoice receipts. The invoice discounter does not take over the administration of the client's sales
ledger so the client remains in control of debt collection.
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 and so 'insures' the client against such losses. This is known as a non-recourse service.
However, if a non-recourse service is provided, the factor, not the firm, will decide what action to
take against non-payers.
MODULE 5
 Making payments to the client in advance of collecting the debts. This is sometimes referred to as
'factor finance' because the factor is providing cash to the client against outstanding debts.
 If a factoring organisation also provides credit insurance it will usually insist on chasing the debt
itself.
The benefits of factoring for a business customer include the following:

 The business receives early payment for most of its receivables in the form of finance from the
factor. It can use this money to pay its suppliers.
 Optimum inventory levels can be maintained, because the business will have enough cash to pay
for the inventories it needs.
 Growth can be financed through sales rather than by injecting fresh external capital.
 The business gets finance linked to its volume of sales. In contrast, overdraft limits tend to be
determined by historical statements of financial position.
 The managers of the business do not have to spend their time on the problems of slow-paying
accounts receivable. Factoring organisations are also likely to employ staff who are experienced
and skilled at collecting payments from customers and chasing overdue payments.
 The business does not incur the costs of running its own receivables department, and can use the
expertise of debtor management that the factor has.
An important disadvantage of factoring is that credit customers will be making payments direct to the
factor, which is likely to present a negative picture of the firm's attitude to customer relations. It may
also indicate that the firm is in need of rapid cash, raising questions about its financial stability.
Invoice discounting is related to factoring and many factors will provide an invoice discounting
service. It is the purchase of a selection of invoices, at a discount. The invoice discounter does not take
over the administration of the client's sales ledger.
A client should only want to have some invoices discounted when he has a temporary cash shortage,
and so invoice discounting tends to consist of one-off deals. Confidential invoice discounting is an
arrangement whereby a debt is confidentially assigned to the factor, and the client's customer will
only become aware of the arrangement if they do not pay their debt to the client.
If a client needs to generate cash, they can approach a factor or invoice discounter, who will offer to
purchase selected invoices and advance up to 75 per cent of their value. At the end of each month,
the factor will pay over the balance of the purchase price, less charges, on the invoices that have been
settled in the month.
We shall look at factoring and invoice discounting again in Module 8 when we look at the
management of credit risk.
Question 3: Managing accounts receivable
What factors should be considered by management in formulating a policy for credit control, and
what is credit insurance?
2.2.5 ACCOUNTS PAYABLE

The management of trade accounts payable involves:
 attempting to obtain satisfactory credit from suppliers
 attempting to extend credit during periods of cash shortage
 maintaining good relations with regular and important suppliers.
Taking credit from suppliers is a normal feature of business. Nearly every company has some trade
accounts payable waiting for payment. It is particularly important to small and fast growing firms.
Trade credit is a source of short-term finance because it helps to keep working capital down. It is
usually a cheap source of finance, since suppliers rarely charge interest. The costs of making maximum
use of trade credit include the loss of suppliers' goodwill, and the loss of any available cash discounts
for the early payment of debts.
If a supplier offers a discount for the early payment of debts, a company must consider whether the
benefits of accepting the discount (in terms of reduced purchase price) outweigh the finance cost of
having to pay earlier.
2.3 METHODS OF EASING CASH SHORTAGES

When a need for cash arises, a company may be able to obtain resources from a loan or an increased
overdraft. If alternative sources of finance are not available then the steps that are usually taken are as
follows:
 Postponing capital expenditure
Some new non-current assets might be needed for the development and growth of the business,
but some capital expenditure might be delayed without serious consequences. If a company's
policy is to replace company cars every two years, but the company is facing a cash shortage, it
might decide to replace cars every three years.
 Accelerating cash inflows which would otherwise be expected in a later period
One approach would be to try and collect accounts receivable earlier. Often, this policy will result
in a loss of goodwill and problems with customers. It might be possible to encourage accounts
receivable to pay more quickly by offering discounts for earlier payment or using factoring/invoice
discounting as described above.
 Reversing past investment decisions by selling assets previously acquired
Some assets are less crucial to a business than others. If cash flow problems are severe, the option
of selling investments or property might have to be considered.
 Negotiating a reduction in cash outflows, to postpone or reduce payments
There are several ways in which this could be done:
– Longer credit might be taken from suppliers. Such an extension of credit would have to be
negotiated carefully: there would be a risk of having further supplies refused.
– Loan repayments could be rescheduled by agreement with a bank.
– A deferral of the payment of company tax might be agreed with the taxation authorities. They
will however charge interest on the outstanding amount of tax.
– Dividend payments could be reduced. Dividend payments are discretionary cash outflows,
although a company's directors might be constrained by shareholders' expectations, so that
they feel obliged to pay dividends even when there is a cash shortage.
2.3.1 OVERDRAFTS AND THE OPERATING CYCLE

We saw overdrafts in Module 4 as a source of finance. From time-to-time, businesses may require their
bank to provide financial assistance for normal trading over the operating cycle.
For example, suppose that a business has the following working capital:
$ $
Inventories and trade receivables 10 000
Bank overdraft 1 000
Trade payables 3 000
( (4 000
Working capital 6 000
It now buys inventory costing $2500 for cash, using its overdraft. Working capital remains the same,
$6000, although the bank's financial stake has risen from $1000 to $3500.
$ $
Inventories and trade receivables 12 500
Bank overdraft 3 500
Trade payables 3 000
6 500
Working capital 6 000
MODULE 5
A bank overdraft provides support for normal trading finance. In this example, finance for normal
trading rises from $(10 000  3000) = $7000 to $(12 500  3000) = $9500 and the bank's contribution
rises from $1000 out of $7000 to $3500 out of $9500.
A feature of bank lending to support normal trading finance is that the amount of the overdraft
required at any time will depend on the cash flows of the business – the timing of receipts and
payments, seasonal variations in trade patterns and so on. The purpose of the overdraft is to bridge
the gap between cash payments and cash receipts.
2.4 INVESTING SURPLUS CASH

Companies and other organisations sometimes have a surplus of cash and become 'cash rich'. A cash
surplus is likely to be temporary, but while it exists the company should invest or deposit the cash, as
appropriate depending on its risk-return trade-off and its future liquidity requirements. The choice of
investment will depend on how quickly the cash might be needed, and the risks of a fall in the capital
value of the investment (e.g. investments in shares of other companies).
Three possible reasons for a cash surplus are:
 profitability from trading operations
 low capital expenditure, perhaps because of an absence of profitable new investment
opportunities
 receipts from selling parts of the business.
A company might keep surplus cash in liquid form to benefit from high interest rates that might be
available from bank deposits, when returns on re-investment in the company appear to be lower.
Another reason for holding on to cash is to have cash available should a strategic opportunity arise,
perhaps for the takeover of another company for which a cash consideration might be needed.
If a company has no long-term plans to grow or to invest, any surplus cash should normally be
returned to shareholders (see dividend policy in Module 6).
3 FINANCIAL PLANS AND STRATEGIES
LO
 Organisations have to decide what are the most important risks relating to working capital,
and therefore whether to adopt a conservative, aggressive or moderate approach.
 Working capital can be funded by a mixture of short and long-term funding.
 Businesses should be aware of the distinction between fluctuating and permanent assets.
Fluctuating current assets together with permanent current assets both form part of the
working capital of the business.
 A moderate approach to working capital management would involve matching the length
of the finance with the life of the assets, so that long-term funds are used for non-current
assets and short-term funds are used for current assets.
3.1 APPROACHES TO WORKING CAPITAL MANAGEMENT

Organisations have to decide what are the most important risks relating to working capital, and
therefore whether to adopt a conservative, aggressive or moderate approach.
3.1.1 A 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 payment terms to stimulate demand, finished goods inventories are
high to ensure availability for customers, and raw materials and work in progress are high to minimise
the risk of running out of inventory and consequent downtime in the manufacturing process. Suppliers
are paid promptly to ensure their goodwill, again to minimise the chance of stock-outs.
The cumulative effect on these policies can be that the firm carries a high burden of unproductive
assets, resulting in a financing cost that can destroy profitability. A period of rapid expansion may also
cause severe cash flow problems as working capital requirements outstrip available finance. Further
problems may arise from inventory obsolescence and lack of flexibility to customer demands.
3.1.2 AN AGGRESSIVE APPROACH

An aggressive working capital management policy aims to reduce this financing cost and increase
profitability by cutting inventories, speeding up collections from customers, and delaying payments to
suppliers.
The potential disadvantage of this policy is an increase in the chances of system breakdown through
running out of inventory or loss of goodwill with customers and suppliers.
However, modern manufacturing techniques encourage inventory and work in progress reductions
through just-in-time policies, flexible production facilities and improved quality management.
Improved customer satisfaction through quality and effective response to customer demand can also
mean that credit periods are shortened.
3.1.3 A MODERATE APPROACH

A moderate working capital management policy is a middle way between the aggressive and
conservative approaches.
3.2 PERMANENT AND FLUCTUATING CURRENT ASSETS

In order to understand working capital financing decisions, assets can be divided into three different
types:
 Non-current assets are long-term assets from which an organisation expects to derive benefit over
a number of periods. Buildings or machinery are examples.
 Permanent current assets are the amount required to meet long-term minimum needs and
sustain normal trading activity, for example, inventory and the average level of accounts receivable.
 Fluctuating current assets are the current assets which vary according to normal business activity.
This may be due to seasonal variations.
Fluctuating current assets together with permanent current assets form part of the working capital of
the business, which may be financed by either long-term funding (including equity capital) or by
current liabilities (short-term funding).
3.3 WORKING CAPITAL FINANCING

The funding of the current and non-current assets of a business can be achieved by employing
different combinations of long and short-term sources of funding.
Short-term sources of funding are usually cheaper and more flexible than long-term ones. However
short-term sources are riskier for the borrower as interest rates are more volatile in the short term and
they may not be renewed.
The diagram below illustrates three alternative types of policy A, B and C. The dotted lines A, B and C
are the cut-off levels between short-term and long-term funding for each of the policies A, B and C
respectively: assets above the relevant dotted line are financed by short-term funding while assets
below the dotted line are financed by long-term funding.
MODULE 5
Figure 5.1: Working capital financing
Assets
($) A
Fluctuating
current
assets
C
B
Permanent current assets
Non-current assets
0
Time
 Policy A can be characterised as a conservative approach to financing working. All non-current
assets and permanent current assets, as well as part of the fluctuating current assets, are financed
by long-term funding. There is only a need to call upon short-term financing at times when
fluctuations in current assets push total assets above the level of dotted line A. At times when
fluctuating current assets are low and total assets fall below line A, there will be surplus cash which
the company will be able to invest in marketable securities.
 Policy B is a more aggressive approach to financing working capital. Not only are fluctuating
current assets all financed out of short-term sources, but so are some of the permanent current
assets. This policy represents an increased risk of liquidity and cash flow problems, although
potential returns will be increased if short-term financing can be obtained more cheaply than
long-term finance.
 A balance between risk and return might be best achieved by the moderate approach of policy C,
a policy of maturity matching where the length of the finance is matched to the life of the asset so
that long-term funds finance permanent assets while short-term funds finance non-permanent
assets.
3.4 OTHER FACTORS

The overall approach to working capital management will be complicated by the following factors:
 Industry norms
These are of particular importance for the management of receivables. It will be difficult to offer a
much shorter payment period than competitors.
 Products
The production process, and hence the amount of work in progress is obviously much greater for
some products and in some industries. For example the production period for an aircraft
manufacturer will be significantly longer than that of a company which produces children's
clothing.
 Management issues
How working capital is managed may have a significant impact upon the actual length of the
working capital cycle whatever the overall strategy might be. Factors to consider include:
– the size of the organisation
– the degree of centralisation (which may allow a more aggressive approach to be adopted,
depending though on how efficient the centralised departments actually are)
– management attitudes to risk

– previous funding decisions.
Question 4: Issues for small business
What might be the consequences for its working capital management of the weak 'market power' of a
small business?
MODULE 5
KEY MODULE POINTS
 The amount tied up in working capital is equal to the value of raw materials, work-in-progress,
finished goods inventories and accounts receivable less accounts payable.
 The size of this net figure has a direct effect on the liquidity of an organisation so a business must
have clear policies for the management of each component of working capital.
 The connection between investment in working capital and cash flow may be illustrated by means
of the cash operating cycle.
 The cash operating cycle is the period of time between the point at which cash begins to be
expended on the production of a product and the collection of cash from the customer who
purchases it.
 Ideally, a business should aim to minimise the length of its cash operating cycle. This can be
achieved by managing the various components of working capital.
 Cash shortages can be eased by postponing capital expenditure, selling assets, taking longer to
pay accounts payable and attempting to collect accounts receivable earlier.
 Temporary surpluses of cash can be invested in a variety of financial instruments. Longer term
surpluses should be returned to shareholders if there is a lack of investment opportunities.
 Organisations have to decide what are the most important risks relating to working capital, and
therefore whether to adopt a conservative, aggressive or moderate approach.
 Working capital can be funded by a mixture of short and long-term funding.
 Businesses should be aware of the distinction between fluctuating and permanent assets.
Fluctuating current assets together with permanent current assets both form part of the working
capital of the business.
 A moderate approach to working capital management would involve matching the length of the
finance with the life of the assets, so that long-term funds are used for non-current assets and
short-term funds are used for current assets.
1 What is the working capital requirement of a company with the following average figures over a
year?
$
Trade accounts receivable 1 500
Cash and bank balances 500
Trade accounts payable 1 800
Inventory 3 750
A $2950
B $3450
C $3950
D $5250
2 The key trade-off at the heart of working capital management is between:

A liquidity and profitability.
B business stability and solvency.
C accounts receivable and payable.
D current assets and current liabilities.
3 If the collection period for accounts receivables lengthens, what is likely to happen to a company’s
cash operating cycle and its investment in working capital?
Cash operating cycle Investment in working capital
A shorten increase
B shorten decrease
C lengthen increase
D lengthen decrease
4 The following information relates to a company:

Receivables collection period 10 weeks
Raw material inventory holding period 2 weeks
Supplier's credit period 7 weeks
Production period 3 weeks
Finished goods inventory period 5 weeks
What is the cash operating cycle of the business?
A 8 weeks
B 10 weeks
C 13 weeks
D 27 weeks
MODULE 5
5 Consider the following two statements concerning invoice discounting:

An invoice discounter will take on
I. the administration of receivables of the client business.
II. responsibility for any irrecoverable debts relating to discounted invoices.
Which one of the following combinations (true/false) relating to the above statements is correct?
Statement
I II
A True True
B True False
C False True
D False False
6 Which one of the following would be appropriate if a cash budget identified a short-term cash
deficit?
A issue shares
B pay suppliers early
C replace non-current assets
D implement better credit control procedures
1 C Working capital requirement = current assets less current liabilities

= 3750 + 1500 + 500 – 1800
= $3950
2 A Adequate liquidity is needed to ensure the survival of the business in the long term, since even
a profitable company may fail without adequate cash flow to meet its liabilities. However an
excessively conservative approach to working capital management which results in high cash
holdings will harm profits because the opportunity to make a return on the assets tied up as
cash will have been missed. Thus most working capital decisions involve a trade-off between
liquidity and profitability.
3 C If the collection period for receivables lengthens, the time it takes for the company to collect
cash in from customers will increase, meaning its cash operating cycle (the time it is out-of-
pocket) will be longer and its average debtor balance will also increase.
4 C 10 + 2 – 7 + 3 + 5 = 13 weeks
5 D Both statements are false. They would be true for debt factoring but not invoice discounting.
6 D B and C would create a bigger cash deficit. A would be more appropriate as a source of
long-term finance. Implementing better credit control procedures should result in the earlier
collection of receivables and reduced incidence of irrecoverable debts and would therefore be
the most appropriate option to correct a short-term cash deficit.
MODULE 5
1 A Rapid increase in sales

2  Inadequate control of inventories, receivables and payables.
 Inadequate cash management.
 Making losses.
 Seasonal trading patterns and the build-up to a busy trading season.
 Growing the business and investing more in working capital and non-current assets.
 Large one-off expenditure items.
3 Administrative costs of debt collection, procedures for controlling credit to individual customers
(e.g. assessing creditworthiness), procedures for debt collection, credit policy and its effect on total
receivables and profits, early settlement discount policy.
Credit insurance is a form of insurance in which the insurance provider undertakes to reimburse the
policy holder in the event of non-payment of a debt by a customer. When a factoring organisation
provides credit insurance, it will insist on collecting the debt itself.
4 Suppliers unwilling to grant sufficient credit.
Customers taking longer to pay than agreed.
Banks unwilling to grant a sufficient overdraft facility, or to lend without a personal guarantee from
the business owner.
137
MODULE 6
CAPITAL STRUCTURE AND
MANAGEMENT
Describe the impact of the external financial markets LO6.1
Explain the factors which influence the dividend policy decision LO6.2
Topic list
1 Regulation and external financial markets

2 Changes in capital structure
3 Dividend policy
MODULE OUTLINE
This module builds on the introduction to regulation and government covered in Module 1 and
capital structure in Module 4. It considers the optimal capital structure for a given organisation and the
management of an organisation's long-term financing and dividend policy.
Capital structure
and management
Capital structure decision

Cost • Debt v equity Risk
• Long-term v short-term
• Leverage ratio
• Interest cover ratio
• Covenants
Dividend policy
• Influencing factors
• Traditional view
• Residual theory
• Irrelevancy theory
• Alternatives to dividends
CAPITAL STRUCTURE AND MANAGEMENT | 139
BEFORE YOU BEGIN
area.
MODULE 6
everything covered.
1 What are the three roles of the Australian Securities and Investments
Commission? (Section 1.3.1)
2 What are the advantages to a company of using debt finance? (Section 2.1)
3 How do you calculate the leverage and interest cover ratios. (Section 2.2)
4 What does dividend policy refer to? (Section 3)
5 Name two different theories of dividend policy. (Section 3.5)
6 What is the residual theory of dividends? (Section 3.5)
1 REGULATION AND EXTERNAL FINANCIAL

MARKETS
LO
 Well-functioning financial markets require a regulatory system, administered by a capable
 The aim of an efficient regulatory system is to protect investors while minimising
interference in the market that might distort market price signals and investment decisions.
 The government plays a vital role in the functioning of the capital market as borrower and
lender, financial intermediary (via the RBA), regulator of financial activities and source of
ultimate liquidity.
1.1 REGULATORY FRAMEWORK

Well-functioning financial markets require a regulatory system, administered by a capable regulatory
authority.
The aim of an efficient regulatory system is to protect investors from fraud and unfair practices, while
minimising interference in the market that might distort market price signals and investment decisions.
Regulation should ensure property rights are clearly defined and information is available and
transparent.
Typical areas covered by guidelines might include:
 market codes of conduct
 participant standards and accreditation
 licensing and authorisation of dealers
 misleading or deceptive conduct
 false or misleading statements
 fraud and unfair practices.
Corporations law includes provisions relating to the trading of corporate and government debt.
1.2 THE ROLE OF THE GOVERNMENT

The government plays a vital role in the functioning of the capital market as:
 source of ultimate liquidity.
1.3 REGULATION
Regulation is intended to protect the interests of investors and is primarily undertaken by both the:
 Australian Securities and Investments Commission (ASIC)
 Australian Prudential Regulation Authority (APRA)
1.3.1 AUSTRALIAN SECURITIES AND INVESTMENTS COMMISSION (ASIC)

The Australian Securities and Investments Commission (ASIC) is an independent Federal Government
Statutory body which acts as Australia's corporate, markets and financial services regulator.
ASIC enforces and administers Corporations law and Consumer Protection law for investments, life
and general insurance, superannuation and banking (except lending) throughout Australia. Its purpose
is to reduce fraud and unfair practices in financial markets and financial products so consumers use
them confidently and companies and markets perform effectively.
Its roles include the following:
 As the corporate regulator, it is responsible for ensuring that company directors and officers carry
out their duties honestly, diligently and in the best interests of their company.
MODULE 6
 As the financial services regulator, it licenses and monitors financial services businesses to ensure
that they operate efficiently, honestly and fairly. These businesses typically deal in superannuation,
managed funds, shares and company securities, derivatives, and insurance.
1.3.2 AUSTRALIAN PRUDENTIAL REGULATION AUTHORITY (APRA)

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the Australian
financial services industry, funded largely by the industries that it supervises.
It oversees banks, credit unions, building societies, insurance and life insurance companies, and most
members of the superannuation industry through the ASX Market Rules, ACH Clearing Rules and ASIC
Settlement Rules, which are collectively referred to as the ASX Business Rules.
1.3.3 AUSTRALIAN SECURITIES EXCHANGE (ASX)

The Australian Securities Exchange (ASX) is sometimes referred to as one of 'the regulators' of
financial market activity in Australia, however it is not a regulatory body with powers conferred by the
government, like ASIC or APRA.
The ASX is a regulated commercial organisation that under the terms of its licence is required to
supervise and monitor specific aspects of the businesses of other organisations, for example, the
governance of listed companies and the on-exchange or on-market trade execution by brokers. It
monitors compliance with listing rules, clearing and settlement rules, and the standards of conduct of
those participating in its markets.
1.3.4 SELF REGULATION – AUSTRALIAN FINANCIAL MARKETS ASSOCIATION (AFMA)

The Australian Financial Markets Association (AFMA) is the industry association for Australia's
wholesale banking and financial markets, representing participants such as Australian and foreign
banks, securities companies, state government treasury corporations, fund managers and traders. Its
role is to encourage high standards of professional conduct in wholesale financial markets and
maintain effective self-regulation of the over-the-counter financial markets.
1.3.5 THE STOCK MARKET

Trading on financial markets is either exchange-based or off-exchange. The major exchange market in
Australia is the Australian Securities Exchange (ASX) which brings together buyers and sellers of equity
securities (shares) and futures instruments.
The Australian Stock Exchange (as it was known then) was formed in 1987 by the amalgamation of the
stock exchanges of the six capital cities. In July 2006, the Australian Stock Exchange merged with the
Sydney Futures Exchange (SFE), the major futures and commodities exchange, to form the current
Australian Securities Exchange (ASX). As well as a market where the buying and selling of shares and
debt securities takes place, the ASX is also the market for dealings in Australian Government securities
and the trading of derivatives. The ASX itself is a publicly listed company trading on the Exchange.
Trading is conducted by stockbrokers who bring together the buyers and sellers, and is done
electronically using SEATS (Stock Exchange Automated Trading System).
Australia's securities markets are supervised by the Australian Securities and Investments Commission
(ASIC) through the Federal Government's Corporations law. In addition, all companies listed on the
Exchange must also comply with the ASX's own business rules.
The size and importance of financial markets has increased significantly since the early 1980s.
Australia's share market is the eighth largest in the world, and the third largest in the Asia-Pacific
region; while the Sydney Futures Exchange (SFE) is the largest futures exchange in the region.
All stock exchanges set eligibility criteria for companies wanting a listing. Key criteria generally include
those relating to the size of the company and its shareholder base, which are aimed at ensuring an
adequate market for trading in the company's shares.
For example, the ASX requires companies to meet either a profits test (aggregated profit of at least
$1 million from the same business in the last three years, and profit from continuing operations of at
least $400 000 in the last 12 months) or an assets test (net tangible assets of at least $2 million – or
market capitalisation of at least $10 million, with less than half of net tangible assets being held in
cash).
The ASX also requires the company to have at least 500 shareholders each holding a parcel of shares
worth at least $2000. A lower threshold of 400 shareholders applies if at least 25 per cent of the shares
are in public hands. In either case, the practical implication is that a company can't raise capital solely
from institutions, but requires substantial support from retail investors.
Other smaller exchanges have less strict requirements, and are more suitable for smaller
organisations:
 The National Stock Exchange of Australia (NSX) specialises in small- and medium-sized company
public listings, including community-based organisations, and high technology companies. The
NSX only requires a market capitalisation of $500 000, and a minimum of 50 shareholders (among
other criteria).
 The NSX also manages the Bendigo Stock Exchange (BSX) and the Wollongong Stock
Exchange, which both focus on capital growth for regional business such as community banks or
property trusts.
 Australia Pacific Exchange (APX) is an exempt stock market, which means that a business can
have more flexibility on the structure of its shares.
2 CHANGES IN CAPITAL STRUCTURE
LO
 In Module 4 we looked at the sources and costs of debt and equity finance. We now need
to look at the key decision of capital structure: the proportion of debt and equity finance a
company should use. Debt finance can create valuable tax savings which can reduce the
cost of capital and increase shareholder value. In this section we will look at the impact of
capital structure on key ratios of interest to investors.
2.1 CAPITAL STRUCTURE

Capital structure refers to the way in which an organisation is financed, by a combination of long-term
capital (ordinary shares and reserves, preferred shares, bonds, bank loans, convertible bonds and so
on) and short-term liabilities, such as a bank overdraft and trade payables. The mix of finance can be
measured by gearing ratios.
The assets of a business must be financed somehow. When a business is growing, the additional
assets must be financed by additional capital. As part of this decision it is necessary to consider the
duration of the financing and remember the concept covered earlier that long-term assets should be
financed by long-term funds.
2.1.1 THE ADVANTAGES OF USING DEBT FINANCE

 Debt is a cheaper form of finance than shares partly because, unlike preferred shares, debt interest
is tax deductible in most tax regimes.
 Debt should be more attractive to investors because it will be secured against the assets of the
company.
 Debt holders rank above shareholders in the event of a liquidation.
 Issue costs should be lower for debt than for shares.
 With debt finance there is usually no change in regards to who controls the company. However, if
the debt is convertible (from debt to equity), the structure of control will change over time as
MODULE 6
conversion rights are exercised.
 There is no immediate dilution in earnings and dividends per share.
 Debt acts as a discipline on management as careful management of working capital and cash flow
is needed.
2.1.2 DISADVANTAGES OF DEBT

 Interest has to be paid on debt no matter what the company's profits are. A particular
disadvantage is that the company may find itself locked into long-term debt at unfavourable rates
of interest. By contrast, the company is not legally obliged to pay dividends.
 If the business struggles to pay the interest on debt, direct financial distress costs may be incurred
in the form of higher debt payments and costs of managing the liquidation process.
 Indirect financial distress costs can include a loss of sales, higher costs from suppliers or sale of
inventory at below market value.
 Agency costs occur when managers may be reluctant to invest if gearing levels are already high.
 Money has to be made available for redemption or repayment of debt.
 Heavy borrowing increases the financial risks for ordinary shareholders who may demand a higher rate
of return because an increased interest burden increases the risks that dividends will not be paid.
 There might be restrictions on a company's power to borrow. The company's constitution may limit
borrowing. These borrowing limits cannot be altered except with the approval of the shareholders
at a general meeting of the company. Restrictive covenants attached to existing debt may limit
borrowing by specifying a maximum gearing level. These limits can only be overcome by
redeeming the debt. Restrictive covenants also require the borrower to satisfy certain criteria such
as minimum interest coverage.
 Debt is not necessarily always available to all companies. Small companies traditionally struggle to
raise long-term debt finance and during a recession debt finance is less readily available than in a
period of economic growth.
2.1.3 COMPANY CIRCUMSTANCES

One determinant of the suitability of the gearing mix is the stability of the company. It may seem
obvious, but it is worth stressing that debt financing will be more appropriate when:
 The company is in a healthy competitive position
 Cash flows and earnings are stable
 The bulk of the company's assets are tangible
 The liquidity and cash flow position is strong
 The debt-equity ratio is low
 Share prices are low
 Profit margins are reasonable
Life cycle issues are therefore important. Young, growing companies tend to have unpredictable and
unstable cash flows so debt finance is less appropriate than for mature companies.
2.2 EFFECT OF CAPITAL STRUCTURE ON RATIOS

The financial risk of a company's capital structure can be measured by debt ratios and interest cover.
Borrowings often contain financial covenants that stipulate the debt ratios and interest cover to meet
the requirements of the loan contract.
2.2.1 LEVERAGE (GEARING) RATIO

The leverage (gearing) ratio indicates the extent to which the business is reliant on debt financing
versus equity to fund the assets of the business. It is calculated using the formula below and is
expressed as a percentage.
Total liabilities
×100
Total equity
This ratio is heavily used by lenders in banking covenants. It is important that a business monitors this
ratio to ensure that it does not breach its bank covenants. Generally speaking, the higher the ratio, the
more difficult it will be to obtain further borrowings.
2.2.2 DEBT TO ASSET RATIO

The debt to asset ratio measures the percentage of assets being financed by liabilities. Generally
speaking, this ratio should be less than 1, indication adequacy of total assets to finance all debt.
Total liabilities
Total equity
2.2.3 INTEREST COVER RATIO

Like gearing, interest cover is a measure of financial risk which is designed to show the risks in terms of
profit rather than in terms of capital values.
Profit before interest and tax
Interest cover =
Interest payable
As a general guide, an interest cover of less than three times is considered low. It indicates that the
organisation might struggle to service its interest expense because profitability is too low given the
gearing of the company.
2.2.4 CHANGING LEVERAGE (GEARING)

Financial gearing is an attempt to quantify the degree of risk involved in holding equity shares in a
company, both in terms of the company's ability to remain in business and in terms of expected
ordinary dividends from the company.
The more geared the company is, the greater the risk that little (if anything) will be available to
distribute by way of dividend to the ordinary shareholders.
This means that there will be greater volatility of amounts available for ordinary shareholders, and
presumably therefore greater volatility in dividends paid to those shareholders, where a company is
highly geared. That is the risk. You may do extremely well or extremely badly without a particularly
large movement in the profit from operations of the company.
Gearing ultimately measures the company's ability to remain in business. A highly geared company
has a large amount of interest to pay annually. If those borrowings are 'secured' in any way then the
holders of the debt are perfectly entitled to force the company to realise assets to pay their interest if
funds are not available from other sources. Clearly, the more highly geared a company, the more likely
this is to occur if and when profits fall.
2.3 DEBT CAPACITY

Debt capacity refers to the maximum amount of debt that a company can support or obtain. A
company will have a greater capacity to borrow if it has a number of assets that can be offered as
security on the debt.
A company can only increase its borrowing if there are lenders willing to provide finance. This may not
necessarily always be easy depending on the financial position of the company and the state of the
economy.
2.4 DEBT COVENANTS

Debt covenants were introduced in Module 4. Existing debt may have covenants attached, which
require certain targets to be met by the borrower and therefore reduce the flexibility of management.
Existing covenants may prevent or limit opportunities for further borrowing. Examples of financial
covenants include target leverage or interest cover ratios. Breaching covenants may trigger an early
repayment of the debt or other penalties.
MODULE 6
2.5 PRACTICAL IMPLICATIONS
The practical implications of these capital structure discussions can be generalised as follows.
Level of gearing
Low High
Young company Mature company

Volatile cash flows Stable cash flows
Tax benefits are likely to be Tax benefits are likely to be greater
exceeded by financial distress costs than financial distress costs
3 DIVIDEND POLICY
LO
 Retained earnings are the most important source of finance for companies.
 Dividend policy refers to the choice that financial managers make between retaining a
proportion of earnings for reinvestment as opposed to distributing earnings in the form of
dividends.
 The traditional view of dividend policy suggests that shareholders expectations of the
future dividend pattern influence the share price.
 The residual theory of dividends says that if a company can identify projects with positive NPVs,
it should invest in them. Only when these investment opportunities are exhausted should
dividends be paid.
 MM's dividend irrelevance theory holds that in a perfect capital market with no personal tax
shareholder's wealth is determined by the success of a company's investments rather than
the dividends it chooses to distribute.
 Companies generally smooth out dividend payments by adjusting only gradually to
changes in earnings: large fluctuations might undermine investors' confidence.
 The dividends a company pays may be treated as a signal to investors. A company needs to
take account of different clienteles of shareholders in deciding what dividends to pay.
 Scrip dividends, stock splits and share repurchase may be used in certain circumstances as
an alternative to dividends.
3.1 RETAINED EARNINGS AND DIVIDEND POLICY

In Module 4 we considered the use of retained earnings as an internal source of equity finance. For
any company, the amount of earnings retained within the business has a direct impact on the amount
of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend.
A company must restrict its self-financing through retained earnings because shareholders should be
paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep
the funds for re-investing. At the same time, a company that is looking for extra funds will not be
expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to
owner-directors. The interaction of investment, financing and dividend policy is the most important
issue facing many businesses.
The dividend policy of a business affects the total shareholder return and therefore shareholder
wealth.
3.2 DIVIDEND PAYMENTS

Shareholders normally have the power to vote to reduce the size of the dividend at the AGM, but not
the power to increase the dividend. The directors of the company are therefore in a strong position,
with regard to shareholders, when it comes to determining dividend policy. For practical purposes,
shareholders will usually be obliged to accept the dividend policy that has been decided on by the
directors, or otherwise to sell their shares.
3.3 FACTORS INFLUENCING DIVIDEND POLICY

We have seen that when deciding upon the dividends to pay out to shareholders, one of the main
considerations of the directors will be the amount of earnings they wish to retain to meet financing
needs.
As well as future financing requirements, the decision on how much of a company's profits should be
retained, and how much paid out to shareholders, will be influenced by:
 The need to remain profitable. (Dividends are paid out of profits, and an unprofitable company
cannot for ever go on paying dividends out of retained profits made in the past.)
 Any legal restrictions on distributable profits.
 The government which may impose direct restrictions on the amount of dividends companies can
pay.
 Any dividend restraints that might be imposed by loan agreements.
 The effect of inflation, and the need to retain some profit within the business just to maintain its
operating capability unchanged.
 The company's gearing level. (If the company wants extra finance, the sources of funds used should
strike a balance between equity and debt finance.)
 The company's liquidity position. (Dividends are a cash payment, and in addition to available
profits, a company must have enough cash to pay the dividends it declares.)
 The need to repay debt in the near future.
 The ease with which the company could raise extra finance from sources other than retained
earnings. (Small companies which find it hard to raise finance might have to rely more heavily on
retained earnings than large companies.)
 The signalling effect of dividends to shareholders and the financial markets in general – see below.
3.4 DIVIDENDS AS A SIGNAL TO INVESTORS

The ultimate objective in any financial management decisions is to maximise shareholders' wealth.
This wealth is represented by the current market value of the company, which should largely be
determined by the cash flows arising from the investment decisions taken by management.
Although the market would like to value shares on the basis of underlying cash flows on the
company's projects, such information is not readily available to investors. But the directors do have
this information. The dividend declared can be interpreted as a signal from directors to shareholders
about the strength of underlying project cash flows.
Investors usually expect a consistent dividend policy from the company, with stable dividends each
year or, even better, steady dividend growth. A large rise or fall in dividends in any year can have a
marked effect on the company's share price. Stable dividends or steady dividend growth are usually
needed for share price stability. A cut in dividends may be treated by investors as signalling that the
future prospects of the company are weak. Therefore, the dividend which is paid acts, possibly without
justification, as a signal of the future prospects of the company.
The signalling effect of a company's dividend policy may also be used by management of a company
which faces a possible takeover. The dividend level might be increased as a defence against the
takeover: investors may take the increased dividend as a signal of improved future prospects, so
driving the share price higher and making the company more expensive for a potential bidder to
takeover.
3.5 THEORIES OF DIVIDEND POLICY
MODULE 6
Different theories exist as to whether the value of a company and hence its share price is affected by
the level of dividends it pays.
A trade-off exists between retaining earnings for reinvestment on the one hand; or paying dividends
and using alternative forms of finance for investments on the other.
3.5.1 TRADITIONAL VIEW

The 'traditional' view of dividend policy focuses on the effects on share price. The price of a share
depends upon the mix of dividends, given shareholders' required rate of return, and growth. If other
factors are held constant, an increased dividend payout, as a result of growth in earnings, will lead to a
higher share price. Therefore, shareholders' expectations of the future dividend pattern influence the
share price.
3.5.2 RESIDUAL THEORY

This recognises that the issue is whether a company should pay out its earnings as dividends when it
has profitable investment opportunities available.
The 'residual' theory of dividend policy can be summarised as follows:
 If a company can identify projects with positive NPVs, it should invest in them.
 Only when these investment opportunities are exhausted should dividends be paid.
3.5.3 IRRELEVANCY THEORY (MODIGLIANI AND MILLER)

In contrast to the traditional view, Modigliani and Miller (MM) proposed that in a tax-free world with
perfect information, no transaction costs and no personal tax, shareholders are indifferent between
dividends and capital gains. A shareholder will be prepared to sacrifice dividends now in order to
invest in projects that will allow it to pay higher dividends in the future. MM believed that the value of
a company is determined solely by the 'earning power' of its assets and investments, rather than its
dividend policy. It is the success of the projects undertaken by the firm that influence its share price,
rather than the dividends it chooses to distribute from those projects.
3.5.4 THE CASE IN FAVOUR OF THE RELEVANCE OF DIVIDEND POLICY (AND AGAINST
MM'S VIEWS)
There are strong arguments against MM's view that dividend policy is irrelevant as a means of
affecting shareholders' wealth.
 Differing rates of taxation on dividends and capital gains can create a preference for a high
dividend or one for high earnings retention.
 Dividend retention should be preferred by companies in a period of capital rationing.
 Markets are not perfect. Because of transaction costs on the sale of shares, investors who want
some cash from their investments will prefer to receive dividends rather than to sell some of their
shares to get the cash they want.
 Due to imperfect markets and the possible difficulties of selling shares easily at a fair price,
shareholders might need high dividends in order to fund their lifestyle or be able to invest in
opportunities outside the company.
 Information available to shareholders is imperfect, and they are not aware of the future investment
plans and expected profits of their company. Even if management were to provide them with profit
forecasts, these forecasts would not necessarily be accurate or believable.
 Perhaps the strongest argument against the MM view is that shareholders will tend to prefer a
current dividend to future capital gains (or deferred dividends) because the future is more
uncertain.
Worked Example: Dividend policy
Ochre is a company that is still managed by the two individuals who set it up 12 years ago. In the
current year the company was launched on the stock market. Previously, all of the shares had been
owned by its two founders and certain employees. Now, 40 per cent of the shares are in the hands of
the investing public. The company's profit growth and dividend policy are set out below. Will a
continuation of the same dividend policy as in the past be suitable now that the company is quoted
on the stock market?
Year Profits Dividend Shares in issue
$'000 $'000
4 years ago 176 88 800 000
3 years ago 200 104 800 000
2 years ago 240 120 1 000 000
1 year ago 290 150 1 000 000
Current year 444 222 (proposed) 1 500 000
Solution
Year Dividend per share cents Dividend as % of profit
4 years ago 11.0 50%
1 year ago 15.0 52%
Current year 14.8 50%
The company appears to have pursued a dividend policy of paying out half of after-tax profits in
dividend. This policy is only suitable when a company achieves a stable earnings or steady growth.
Investors do not like a fall in dividend from one year to the next, and the fall in dividend per share in
the current year is likely to be unpopular, and to result in a fall in the share price.
The company would probably serve its shareholders better by paying a dividend of at least 15c per
share, possibly more, in the current year, even though the dividend as a percentage of profit would
then be higher.
3.6 ALTERNATIVES TO DIVIDENDS

3.6.1 SCRIP DIVIDENDS
Definition
A scrip dividend is a dividend paid by the issue of additional company shares, rather than by cash.
When the directors of a company would prefer to retain funds within the business but consider that
they must pay at least a certain amount of dividend, they might offer equity shareholders the choice of
a cash dividend or a scrip dividend. Each shareholder would decide separately which to take.
Recently enhanced scrip dividends have been offered by many companies. With enhanced scrip
dividends, the value of the shares offered is much greater than the cash alternative, giving investors an
incentive to choose the shares.
3.6.2 STOCK SPLIT

A stock split occurs where, for example, each ordinary share of $1 is split into two shares of 50c each,
therefore creating cheaper shares with greater marketability. There is possibly an added psychological
advantage, in that investors may expect a company which splits its shares in this way to be planning
for substantial earnings growth and dividend growth in the future.
As a consequence, the market price of shares may benefit. For example, if one existing share of $1 has
a market value of $6, and is then split into two shares of 50c each, the market value of the new shares
might settle at, say, $3.10 instead of the expected $3, in anticipation of strong future growth in
earnings and dividends.
The difference between a stock split and a scrip issue is that a scrip issue converts equity reserves into
share capital, whereas a stock split leaves reserves unaffected.
MODULE 6
3.6.3 SHARE REPURCHASE
In many countries companies have the right to buy back shares from shareholders who are willing to
sell them, subject to certain conditions.
For a smaller company with few shareholders, the reason for buying back the company's own shares
may be that there is no immediate willing purchaser at a time when a shareholder wishes to sell
shares. For a public company, share repurchase could provide a way of withdrawing from the share
market and 'going private'.
Another reason for a share repurchase would be as a way or returning surplus cash to shareholders,
instead of paying a dividend.
Question 1: Dividend policy
Karina is a listed company, which has historically had a low dividend payout ratio. It has built up a
significant amount of cash reserves due to increased profitability and a lack of current investment
opportunities. One of the directors has suggested using the surplus to pay a large dividend to
shareholders. What factors should Karina consider before doing this?
KEY MODULE POINTS
 Well-functioning financial markets require a regulatory system, administered by a capable

 The aim of an efficient regulatory system is to protect investors while minimising interference in the
market that might distort market price signals and investment decisions.
 The government plays a vital role in the functioning of the capital market as borrower and lender,
financial intermediary (via the RBA), regulator of financial activities and source of ultimate liquidity.
 In this section we will look at the impact of capital structure on key ratios of interest to investors.
 Retained earnings are the most important source of finance for companies.
 Dividend policy refers to the choice that financial managers make between retaining a proportion
of earnings for reinvestment as opposed to distributing earnings in the form of dividends.
 The traditional view of dividend policy suggests that shareholders expectations of the future
dividend pattern influence the share price.
 The residual theory of dividends says that if a company can identify projects with positive NPVs, it
should invest in them. Only when these investment opportunities are exhausted should dividends
be paid.
 MM's dividend irrelevance theory holds that in a perfect capital market with no personal tax
shareholder's wealth is determined by the success of a company's investments rather than the
dividends it chooses to distribute.
 Companies generally smooth out dividend payments by adjusting only gradually to changes in
earnings: large fluctuations might undermine investors' confidence.
 The dividends a company pays may be treated as a signal to investors. A company needs to take
account of different clienteles of shareholders in deciding what dividends to pay.
 Scrip dividends, stock splits and share repurchase may be used in certain circumstances as an
alternative to dividends.
1 Which of the following is not an aim of regulating the financial markets?

A to define property rights clearly
MODULE 6
B to allow investors to make a profit
C to offer protection from fraud and misconduct
D to ensure information is accurate and freely available
2 The finance director of a listed company has recently announced that the company will not be
paying a dividend this year due to the number of profitable investment opportunities that require
financing. Which theory best describes the finance director's approach to dividend policy?
A residual theory
B traditional theory
C fundamental theory
D dividend irrelevance theory
3 Which of the following companies would you not recommend debt finance to?
A a company with a low share price
B a company with a low debt-equity ratio
C a company with reasonable profit margins
D a young company with unpredictable cash flows
4 Which of the following debt to asset ratios indicates that assets are financed exactly by debt?
A 0
B 0.1
C 1
D 100
1 B Regulation is intended to protect the interests of investors not to ensure that they are able to
make a profit.
2 A The finance director is choosing to fund positive NPV projects and as a result the amount of
earnings available as a residual dividend, after financing requirements, is nil.
3 D Debt finance is not recommended for young companies with unpredictable or unstable cash
flows. The circumstances for the other companies indicate that debt finance would be
recommended.
4 C A ratio of 1 indicates that assets are exactly financed by debt because the debt to asset ratio is
total liabilities/total assets
ANSWER TO MODULE QUESTION
1 The historically low payout ratio may mean shareholders have a tax preference for capital gains
rather than dividends and could be adversely affected by a large dividend.
MODULE 6
Residual theory would suggest only paying a dividend if there are no positive investment
opportunities available, so Karina needs to establish the size and amount of any future
requirements.
A sudden change in policy may be questioned by the market or may give rise to expectations of
higher dividends in the long term. If in the long run the cash is not required for investment the
company could consider repurchasing some of the shares.
Retaining the cash may make the company vulnerable to takeover.
155
MODULE 7
CASH FLOW VALUATION
AND INVESTMENT
Explain the characteristics of major and long-term investments where a 'capital LO7.1
budgeting' approach might be required
Apply different quantitative methods used in project evaluation LO7.2
Compare and contrast the ROI, IRR, payback and NPV methods of investment appraisal LO7.3
Explain why investment decisions should be analysed using the NPV method LO7.4
Apply the NPV method to investment project scenarios LO7.5
Select investment appraisal techniques which are appropriate to the objectives and LO7.6
circumstances of a given organisation taking account of working capital, inflation and
tax
Undertake a sensitivity analysis of diverse projects using appropriate tools LO7.7
Analyse capital rationing and draw appropriate conclusions LO7.8
Calculate the weighted average cost of capital and apply it in capital budgeting LO7.9
Topic list
1 Value of cash flows and relevant costs

2 Capital budgeting
3 Project evaluation
4 Return On Investment (ROI), Internal Rate of Return (IRR) and Payback
5 Net Present Value (NPV) and investment appraisal
6 Other investment appraisal issues
7 Sensitivity analysis
8 Capital rationing
9 WACC, CAPM and capital budgeting
MODULE OUTLINE
Companies are faced with a variety of possible investment opportunities which involve paying out
cash now, in anticipation of receiving cash inflows in the future. Managers of companies need a basis
for deciding whether to accept or reject each possible opportunity. This module builds on material
studied in Module 2 (relevant cash flows and time value of money) and considers the four main
appraisal techniques: the return on investment, internal rate of return, payback period and net present
value.
The module continues by looking at how the investment decision can be made, including an
application of the WACC in regards to capital budgeting.
Cash flow valuation

and investment
Investment Other aspects to investment Financial mathematics

Capital or Operating (revenue) appraisal Discounting
expenditure Tax Effective interest rates
Non-current assets or working capital Inflation Mortgage repayments
Working capital
Mutually exclusive projects
Sensitivity analysis
Capital rationing
Investment appraisal concepts
WACC/CAPM
Capital budgeting Cashflows not accounting profit
Relevant costs and benefits
Time value of money
Discounting techniques
– Compounding
– Discounting
Methods of investment appraisal – Annuities
– Perpetuities
Non-discounting Discounted cash flow
ROI Discounted payback
Payback period NPV
IRR
Payback period
Based on relevant cash flows
Calculation
Advantages and disadvantages
ROI
Based on accounting profit
Calculation
Advantages and disadvantages
CASH FLOW VALUATION AND INVESTMENT | 157
BEFORE YOU BEGIN
area.
everything covered.
1 What is capital budgeting? (Section 2)
2 Name three different investment appraisal techniques. (Section 3.5)
3 What is return on investment, and how is it used in investment appraisal? (Section 4.1)
4 What is the payback period? (Section 4.3.1)
MODULE 7
5 What is sensitivity analysis? (Section 7)
6 Explain hard and soft capital rationing. (Section 8)
7 What is the marginal cost of capital approach? (Section 9)
1 VALUE OF CASH FLOWS AND RELEVANT COSTS
LOs
4.5
 You should now take the opportunity to recap your knowledge of the time value of money
and relevant costs from Module 2 and the calculations for the cost of debt and equity
finance from Module 4.
We saw in Module 2 that when capital expenditure projects are evaluated, it is important to assess
whether the investment will make enough profits to allow for the 'time value' of the capital tied up.
We also saw that not all costs are relevant to investment decisions.
Before continuing with the rest of this module it is recommended that you recap Section 1 in Module
2 in detail to ensure that you are familiar and have a good understanding of the following areas.
In Module 4 we looked at the calculation of the cost of equity and cost of debt finance. These
calculations will be needed towards the end of this module when we revisit WACC, so it is important
that you refresh your understanding of Sections 7 and 8 of that module.
2 CAPITAL BUDGETING
LO
 Investment can consist of both capital expenditure and operating expenditure and can
be made in non-current assets or working capital.
• Capital budgeting is the process of identifying, analysing and selecting investment
opportunities in non-current assets whose returns are expected to extend beyond one year.
2.1 CAPITAL INVESTMENT AND OPERATING EXPENSES

Investment is any expenditure in the expectation of future benefits. We can divide such expenditure
into two categories: capital expenditure, and operating expenditure.
Suppose that a business purchases a building for $30 000. It then adds an extension to the building at
a cost of $10 000. The building needs to have a few broken windows mended, its floors polished and
some missing roof tiles replaced. These cleaning and maintenance jobs cost $900.
The original purchase ($30 000) and the cost of the extension ($10 000) are capital expenditure
because they are incurred to acquire and then improve a non-current asset. The other costs of $900
are operating expenditure because they are operational in nature, and maintain the building and its
earning capacity.
Definitions
Capital expenditure is expenditure which results in the acquisition of non-current assets. It includes
the cost of getting an asset to operational condition, or an improvement in its earning capacity. It is
not charged as an expense in the income statement; the expenditure appears as a non-current asset
in the statement of financial position.
Operating expenditure is charged to the income statement and is expenditure which is incurred:
 for the purpose of the trade of the business – this includes expenditure classified as selling and
distribution expenses, administration expenses, putting the asset in a working condition rather
than operational condition
 to maintain the existing earning capacity of non-current assets.
2.2 NON-CURRENT ASSET INVESTMENT AND WORKING CAPITAL

INVESTMENT
Investment can be made in non-current assets or working capital.
MODULE 7
 Investment in non-current assets (assets that are expected to be held for more than one year)
involves a significant period of time between the initial investment (outlay) of funds and the
recovery of the investment. Money is paid out to acquire resources which are going to be used on
a continuing basis within the organisation.
 Investment in working capital arises from the need to pay out money for resources (such as raw
materials) before it can be recovered from sales of the finished product or service. The funds are
therefore only committed for a short period of time.
Examples of investment by commercial organisations might include:
• plant and machinery
• research and development
• warehouse facilities.
2.3 CHARACTERISTICS OF LONG TERM INVESTMENTS

Capital investment or capital budget decisions normally involve long-term projects and/or capital
equipment. These projects will typically have a major effect on operations for a number of years to
come.
They might include some or all of the following decisions:
• the purchase of new or replacement machinery
• investment in production facilities for a new product line
• the expansion of operations
• investment in IT equipment to improve processes or efficiency
• the acquisition of another business
• investment in research and development or other intangible assets.
Such major long-term investments usually have the following characteristics:
 The project or investment is relatively large and may require significant resources.
 There is often a significant period between the investment outlay and the receipt of benefits.
 Future cash inflows and outflows relating to the investment need to be planned over a long period
of time.
Major long-term capital investments tend to require significant resources. For many organisations,
these resources will be of limited availability, particularly the cash or finance required to fund the
long-term investment.
2.4 CREATION OF CAPITAL BUDGETS

Capital expenditure often involves the outlay of large sums of money, and any expected benefits may
take a number of years to accrue. So it is vital that capital expenditure is subject to a rigorous process
of appraisal and control.
Definition
Capital budgeting is the process of identifying, analysing and selecting investment opportunities in
non-current assets whose returns are expected to extend beyond one year.
2.4.1 BUDGET PROCESS

The capital budget will normally be prepared to cover a period of ideally more than five years. It
should indicate the expenditure required to cover capital projects already underway and those that
are expected to start in the capital budget period.
The budget should therefore be based on the current production budget, future expected levels of
production and the long-term development of the organisation, and industry, as a whole.
Organisations may have defined time periods during which proposals for the forthcoming budget
period are considered. Alternatively, proposals may be accepted on a regular basis, allowing greater
scope for investment in unanticipated opportunities.
Projects which emerge during a budget period may be disadvantaged compared with those
anticipated when the budget was set, as specific funds will not be set aside for them in the budget. If
funds are limited, such projects may undergo more rigorous analysis than an anticipated project to
justify the allocation of funds.
2.4.2 BUDGET CONSTRAINTS

Budget limits or constraints might be imposed internally or externally.
 The imposition of internal constraints, which are often imposed when managerial resources are
limited, is known as soft capital rationing
 Hard capital rationing occurs when external limits are set, perhaps because of scarcity of
financing, high financing costs or restrictions on the amount of external financing an organisation
can seek.
2.4.3 BUDGET AUTHORISATION
The administration of the capital budget is usually separate from that of the other budgets. Overall
responsibility for authorisation and monitoring of capital expenditure is, in most large organisations,
the responsibility of a Capital Budget or Capital Review committee. The board of directors may
delegate authority to individual managers to approve capital expenditure up to a specified limit.
3 PROJECT EVALUATION
LO
 A typical model for investment decision making has a number of distinct stages.
– origination of proposals
– project screening
– analysis and acceptance
– monitoring and review
3.1 ORIGIN OF PROPOSALS

Investment opportunities must be created. An organisation must therefore set up a mechanism that
scans the environment for potential opportunities and gives an early warning of future problems. For
example, a technological change that might result in a drop in sales might be picked up by this
scanning process, and steps should be taken immediately to respond to such a threat.
The overriding feature of any proposal is that it should be consistent with the organisation's overall
strategy to achieve its objectives. For example, an organisation's strategy could be to increase
revenue by introducing new products, or targeting new customers or markets. Employees from across
the organisation can be involved in the evaluation of alternative technologies, machines and project
specifications. Some alternatives will be rejected early on, while others will be more thoroughly
evaluated.
3.2 PROJECT SCREENING

Each proposal must be subject to detailed screening. Only if the project passes this initial screening
will more detailed financial analysis begin.
A qualitative evaluation of a proposal should be made initially before any financial analysis is undertaken:
MODULE 7
• What is the purpose of the project?
• Does it 'fit' with the organisation's long-term objectives?
• Is it a mandatory investment, for example to conform with safety legislation?
• What resources are required and are they available (e.g. money, capacity, labour)?
• Do we have the necessary management expertise to guide the project to completion?
• Does the project expose the organisation to unnecessary risk?
• How long will the project last and what factors are key to its success?
• Have all possible alternative proposals been considered?
3.3 ANALYSIS AND ACCEPTANCE

3.3.1 FINANCIAL ANALYSIS
The financial analysis of the project will involve the application of the organisation's preferred
investment appraisal techniques. We will be studying these techniques in detail in this module and the
next. In many projects some of the financial implications will be extremely difficult to quantify, but
every effort must be made to do so, in order to have a formal basis for planning and controlling the
project.
Here are examples of the type of questions that will be addressed at this stage.
• What cash flows/profits will arise from the project and when?
• Has inflation been considered in the determination of the cash flows?
• What are the results of the financial appraisal?
• Has any allowance been made for risk, and if so, what was the outcome?
Some types of project, for example a marketing investment decision, may give rise to cash inflows and
returns which are intangible and difficult to quantify so that a full financial appraisal may not be
possible.
In this case more weight may be given to a consideration of the qualitative issues.
3.3.2 QUALITATIVE ISSUES

We have already seen that qualitative issues would be considered in the initial screening stage, for
example in reviewing the project's 'fit' with the organisation's overall objectives and whether it is a
mandatory investment. There is a very wide range of other qualitative issues that may be relevant to a
particular project:
• What are the implications of not undertaking the investment (e.g. adverse effect on staff morale,
loss of market share, risk to company reputation)?
• Will acceptance of this project lead to the need for further investment activity in future?
• Will the organisation be more flexible as a result of the investment, and better able to respond to
market and technological changes?
3.3.3 ACCEPTANCE DECISION

The decision as to whether to accept projects may be made at different levels within the
organisational hierarchy, depending on:
• the type of investment
• its perceived riskiness
• the amount of expenditure required.
For example, an area manager may be authorised to make decisions up to $25 000, a divisional
manager up to $150 000 and a group manager up to $300 000, with board approval for greater
amounts.
Once the decision to accept or reject has been made, the organisation is committed to the project.
The project's success or failure reflects on the decision-maker's ability to make decisions.
3.4 MONITORING AND REVIEW

During the project's progress, project controls should be applied to ensure the following:
• Capital spending does not exceed the amount authorised.
• The implementation of the project is not delayed.
• The anticipated benefits are eventually obtained.
The first two items are easier to control than the third, because the controls can normally be applied
soon after the capital expenditure has been authorised. Monitoring the benefits will take place over a
longer period of time and require 'control' within the organisation at the managerial level.
3.5 FINANCIAL APPRAISAL

There are several methods for the financial appraisal of a project to evaluate whether it would add
value to an organisation:
 The return on investment (ROI) method, also known as the accounting rate of return (ARR) or
return on capital employed (ROCE). This method calculates the profits that will be earned by a
project and expresses these as a percentage return on the capital invested in the project. The
higher the rate of return, the higher a project is ranked. A project might be undertaken if its
expected return on investment exceeds a minimum target rate of return. This method of project
appraisal is based on accounting results rather than cash flows.
 The payback period. This method of investment appraisal calculates the length of time a project
will take to recoup the initial investment (i.e. how long a project will take to pay for itself). A capital
project might not be undertaken unless it achieves payback within a given period of time. This
method of project appraisal is based on the anticipated cash flows.
 A discounted cash flow (DCF) appraisal. There are three methods of project appraisal using DCF.
– The net present value (NPV) method. This takes into consideration all the relevant cash flows
associated with a project over the whole of its life, and also the timing of the cash flows. Cash
flows occurring in future years are then discounted to a 'present value'. The process of
re-valuing all project cash flows to a 'present value' is known as discounting. The present value
of benefits (revenues or savings) are then compared with the outlay including any initial costs or
investments (present value of expenditure). The difference is the net present value. If the
present value of benefits exceeds the present value of costs, the project is financially justified. If
the present value of benefits is less than the present value of costs, the project is not justified
financially. The NPV method is the recommended method of project appraisal, since it is
consistent with the objective of maximising shareholder wealth.
– The internal rate of return (IRR) method. This method uses discounting mathematics to
calculate the return expected from the project calculated on a discounted cash flow basis. This
'internal rate of return' for the project is then compared with the target rate of return. The
project is justified financially if the IRR of the project exceeds the target rate of return.
– The discounted payback method. This method converts all the expected cash flows from a
project to a present value, and calculates how long it will take for the project to payback the
capital outlay on a discounted cash flow basis. It is similar to the non-discounted payback
method, except that it uses discounted cash flows.
Though the NPV approach is probably considered the primary technique, they all have their uses and
limitations.
As a consequence, some businesses employ multiple methods of investment appraisal. They may use
accounting returns (ROI) to demonstrate profitability, payback and/or discounted payback to
demonstrate liquidity, NPV to demonstrate commercial viability and IRR to demonstrate the risk
inherent in the NPV assessment as a result of the potential for interest rate changes.
Where multiple methods are used, however, the question still arises of how to decide on a project or,
more awkwardly, how to decide between projects when presented with a range of different results. As
we have already seen with mutually exclusive projects the highest IRR and the highest NPV do not
necessarily coincide, and this fact can be extended to all of the techniques. The ideal project would
MODULE 7
have the highest ROI, the shortest payback period, the highest NPV and highest IRR, but when
assessing a range of alternatives this is unlikely to be the case.
If multiple methods are to be used then it will be important to have a pre-determined approach for
prioritising the various results. This will inevitably be somewhat subjective, based on opinions and
experience.
3.6 RELIABILITY OF FORECASTS

Before looking at these appraisal methods, it is worth emphasising one problem common to all of
them. Capital projects often have an expected commercial life of many years, and project appraisal
calls for an estimate of future returns over the project's life. Forecasting is never easy, but in capital
budgeting the problems are particularly acute. Forecasts must always be treated with some suspicion,
and a large margin for error may have to be allowed. Later in this module we consider sensitivity
analysis which is one technique for assessing which estimates are critical to the successful outcome of
a project.
4 RETURN ON INVESTMENT (ROI), INTERNAL RATE

OF RETURN (IRR) AND PAYBACK
LO
 The return on investment (ROI) method (also called the accounting rate of return (ARR)
method) of appraising a capital project is to estimate the accounting rate of return that the
project should yield.
 The IRR is the cost of capital at which the NPV of the project would be zero, and so is the
discount rate of return that the project is expected to earn.
 The payback period is the time required for the cash inflows from a project to recoup the
cash outlays.
 The discounted payback method is a way of combining DCF evaluation with a minimum
payback period.
4.1 THE RETURN ON INVESTMENT METHOD

A capital investment project may be assessed using the return on investment method (ROI) method
of appraisal.
This method is also known as the accounting rate of return (ARR) or the return on capital employed
(ROCE).
The expected return on investment for the project is calculated, and compared with a pre-determined
minimum target rate of return. The project is justified financially if its expected ROI exceeds the
minimum target.
Definition
The return on investment (ROI) measures the profitability of an investment by expressing the
expected accounting profits as a percentage of the carrying value (CV) of the investment.
There are several different possible formulae for calculating ROI. There is no accepted definition – an
organisation must define ROI, specify how it should be calculated, then ensure that it applies this
approach consistently. An exam question that required you to calculate ROI would always indicate
how the ROI should be defined.
In each case, profits are accounting profits, and are calculated after deducting a charge for
depreciation of the non-current asset(s) and any operational expenses.
Formula to learn
A formula for calculating ROI that is common in practice is:

ROI (average investment)
Estimated average profits
ROI =  100%
Estimated average investment
The average investment is the average of the investment at the start of the project and the investment
at the end of the project, allowing for depreciation of the non-current asset or assets. For example,
suppose that a capital investment requires expenditure of $100 000 on a non-current asset that will
have a four-year life and zero value at the end of this time, and requires a working capital investment
of $20 000. The average investment would be $70 000, half of $100 000 plus the working capital
investment of $20 000.
This method is commonly used because the averaging of profits helps to smooth any irregularity in
the flow of earnings and using the value of the investment at the mid-point in the project's life may be
considered to be the most accurate.
Another method of calculating ROI is based on the total initial investment, rather than the average
investment over the life of the project.
ROI (initial investment)
Estimated average profits
ROI =  100%
Estimated initial investment
This will result in a lower return than the average investment method.
A third method of calculating ROI is using the total expected profits over the life of the project, rather
than the average annual profit. This will obviously result in a higher figure.
ROI (total profits)
Estimated total profits
ROI =  100%
Worked Example: Return on investment
A company has a target return on investment (based on average investment) of 20 per cent, and is
now considering the following project.
Capital cost of asset $80 000
Estimated life 4 years
Estimated profit before depreciation
Year 1 $20 000
Year 2 $25 000
Year 3 $35 000
Year 4 $25 000
The capital asset would be depreciated by 25 per cent of its cost each year, and will have no residual
value. You are required to assess whether the project should be undertaken.
Solution
MODULE 7
The annual profits after depreciation, and the mid-year carrying value of the asset, would be as
follows.
Profit after Mid-year net ROI in the
Year depreciation carrying value year
$ $ %
1 0 70 000 (W1) 0
2 5 000 50 000 (W2) 10
3 15 000 30 000 (W3) 50
4 5 000 10 000 (W4) 50
W1: Annual depreciation is 25 per cent of cost = 80 000  25% = 20 000
Hence CV at end of Year 1 = 80 000 – 20 000 = 60 000.
Thus mid-year CV = (80 000 + 60 000) / 2 = 70 000
W2: (60 000 + 40 000) / 2 = 50 000
W3: (40 000 + 20 000) / 2 = 30 000
W4: (20 000 + 0) / 2 = 10 000
As the table shows, the ROI is low in the early stages of the project, partly because of low profits in
Year 1 but mainly because the carrying value of the asset is much higher early on in its life.
The project does not achieve the target ROI of 20 per cent in its first two years, but exceeds it in Years
3 and 4. So should it be undertaken?
When the ROI from a project varies from year to year, it makes sense to take an overall or 'average'
view of the project's return. In this case, we should look at the return as a whole over the four-year
period.
$
Total profit before depreciation over four years 105 000
Total profit after depreciation over four years 25 000
Average annual profit after depreciation (25 000 / 4 yrs) 6 250
Original cost of investment 80 000
(80 000 + 0)
Average carrying value over the four year period 40 000
2
6250
ROI = = 15.6%
40 000
The project would not be undertaken because it would fail to yield the target return of 20 per cent.
4.1.1 ROI AND MUTUALLY EXCLUSIVE PROJECTS

The ROI method of capital investment appraisal can also be used to compare two or more projects
which are mutually exclusive (i.e. only one of the projects can be undertaken). The project with the
highest ROI would be selected, provided that the expected ROI is higher than the company's target
ROI.
Worked Example: Return on investment and mutually exclusive projects
A company wants to buy a new item of equipment which will be used to provide a service to
customers. Two models of equipment are available, one with a slightly higher capacity and greater
reliability than the other. The expected costs and profits of each item are as follows.
Equipment Equipment
item X item Y
Capital cost $80 000 $150 000
Life 5 years 5 years
Profits before depreciation $ $
Year 1 50 000 50 000
Year 2 50 000 50 000
Year 3 30 000 60 000
Year 4 20 000 60 000
Year 5 10 000 60 000
Disposal value 0 0
You are required to decide which item of equipment should be selected, if any, if the company's
target ROI is 30 per cent; where ROI is measured as the average annual profit after depreciation,
divided by the average carrying value of the asset.
Solution
Item X Item Y
Total profit over life of equipment $ $
Before depreciation 160 000 280 000
After depreciation 80 000 130 000
Average annual profit after depreciation 16 000 26 000
Average investment = (Capital cost + disposal value) / 2 40 000 75 000
ROI 40% 34.7%
Both projects would earn a return in excess of 30 per cent, but since item X would earn a bigger ROI,
it would be preferred to item Y, even though the profits from Y would be higher by an average of
$10 000 a year.
4.1.2 THE DISADVANTAGES OF THE ROI METHOD OF CAPITAL INVESTMENT APPRAISAL

The ROI method of capital investment appraisal has the serious disadvantage that it does not take
account of the timing of the profits from an investment. Whenever capital is invested in a project,
money is tied up until the project begins to earn profits which pay back the investment. Money tied up
in one project cannot be invested anywhere else until the profits come in. Management should be
aware of the benefits of early repayments from an investment, which will provide money to make other
investments.
There are a number of other disadvantages.
 It is based on accounting profits and not cash flows. Accounting profits are subject to a number of
different accounting treatments.
 It is a relative measure rather than an absolute measure and hence takes no account of the size of
the investment.
 It takes no account of the length of the project.
 Like the payback method, it ignores the time value of money.
There are, however, advantages to the ROI method.
 It is a quick and simple calculation.

 It involves the familiar concept of a percentage return.
 It looks at the entire project life.
Question 1: ROI
A company carries out capital project appraisal using the ROI method. It will not undertake any
project unless the expected ROI is at least 15 per cent. ROI is measured as average annual profit as a
percentage of the average investment over the life of the project.
A project is currently being considered. It would involve expenditure of $150 000 on an asset. The
project's life would be five years and at the end of this time the asset would have no residual value. A
working capital investment of $15 000 would be required.
The annual profits before depreciation from the project would be:
Year $
1 10 000
2 40 000
3 80 000
MODULE 7
4 70 000
5 50 000
What is the ROI of the project?
On the basis of the company's investment criterion, would this project be undertaken?
4.2 THE INTERNAL RATE OF RETURN (IRR) METHOD

Definition
The internal rate of return (IRR) of a project is the discount rate at which the project NPV is zero.
We shall see shortly that in the NPV method of discounted cash flow, present values are calculated by
discounting at a target rate of return, or cost of capital, and the difference between the PV of costs
and the PV of benefits is the NPV.
In contrast, the internal rate of return (IRR) method is to calculate the exact DCF rate of return which
the project is expected to achieve, in other words the rate at which the NPV is zero.
The rule with the IRR method of project evaluation is that a project should be undertaken if it is
expected to achieve an IRR in excess of the company's required rate of return on capital. A project
that has an IRR in excess of the cost of capital must have a positive NPV.
4.2.1 ESTIMATING THE IRR

Without a computer or calculator program, the interpolation method can be used to estimate the
IRR, although it is not arithmetically exact.
The first step is to calculate two net present values, both as close as possible to zero, using rates for
the cost of capital which are whole numbers. Ideally, one NPV should be positive and the other
negative, although this is not essential.
These are then used to estimate the IRR.
Worked Example: The IRR method (step 1 – calculate two NPVs)
A company is trying to decide whether to buy a machine for $80 000 which will save costs of $20 000
per annum for five years and which will have a resale value of $10 000 at the end of Year 5. If it is the
company's policy to undertake projects only if they are expected to yield a DCF return of 10 per cent
or more, ascertain whether this project should be undertaken.
Use the following discount factors to estimate the IRR of the project.
Year Discount factor at 9% Discount factor at 12%
1–5 3.890 3.605
5 0.650 0.567
Solution
The IRR is the rate for the cost of capital at which the NPV = 0.
Try 9 per cent:
Year Cash flow PV factor PV of cash flow
$ 9% $
0 (80 000) 1.000 (80 000)
1–5 20 000 3.890 77 800
5 10 000 0.650 6 500
NPV 4 300
This is fairly close to zero. It is also positive, which means that the IRR is more than 9 per cent. We can
use 9 per cent as one of our two NPVs close to zero, although for greater accuracy, we should try
10 per cent or even 11 per cent to find an NPV even closer to zero if we can. However, a discount rate
of 12 per cent will be used here, to see what the NPV is.
Try 12 per cent:
Year Cash flow PV factor PV of cash flow
$ 12% $
0 (80 000) 1.000 (80 000)
1–5 20 000 3.605 72 100
5 10 000 0.567 5 670
NPV ( 2 230)
This is fairly close to zero and negative. The IRR is therefore greater than 9 per cent (positive NPV of
$4300) but less than 12 per cent (negative NPV of $2230).
A graph of the NPV at different costs of capital for a 'typical' capital project with a negative cash flow
at the start of the project, and positive net cash flows afterwards up to the end of the project would
look like Figure 1.
Figure 7.1: Internal rate of return
NPV
Positive IRR
0
Cost of capital %
Negative
If we use a cost of capital where the NPV is slightly positive, and use another cost of capital where it is
slightly negative, we can estimate the IRR – where the NPV is zero – by drawing a straight line between
the two points on the graph that we have calculated.
Figure 7.2: Calculating the IRR
NPV
Q1
Positive P1
A B
0
Cost of capital %
Negative True IRR

P2 Q2
Study the diagram above carefully.
MODULE 7
 If we establish the NPVs at the two points P1 and P2, we would estimate the IRR to be at point A.
 If we establish the NPVs at the two points Q1 and Q2, we would estimate the IRR to be at point B.
The closer our NPVs are to zero, the closer our estimate will be to the true IRR.
Worked Example: the IRR method (step 2 – estimate the IRR)
We shall now use the two NPV values calculated earlier to estimate the IRR.
The interpolation method assumes that the NPV rises in linear fashion between the two NPVs close to
0. The real rate of return is therefore assumed to be on a straight line between NPV = $4300 at
9 per cent and NPV = –$2230 at 12 per cent.
Formula to learn
The formula to apply is as follows:
 NA 
IRR = A +  N  N × B  A  %
 A b 
where: A is the lower rate of return.
B is the higher rate of return.
NA is the NPV discounted at A.
NB is the NPV discounted at B.
Let us go back to our example.

 4300 
IRR = 9 +  ×(12 – 9) % –10.98%, say11%
 4300 –(–2230) 
If it is company policy to undertake investments which are expected to yield 10 per cent or more, this
project would be undertaken.
Question 2: IRR
Find the IRR of the project given below and state whether the project should be accepted if the
company requires a minimum return of 15 per cent.
Time $
0 Investment (4 000)
1 Receipts 1 200
2 Receipts 1 410
3 Receipts 1 875
4 Receipts 1 150
Use the following discount factors to estimate the IRR of the project.
Discount Discount
Year factor at 14% factor at 16%
1 0.877 0.862
2 0.769 0.743
3 0.675 0.641
4 0.592 0.552
4.2.2 CALCULATING THE IRR OF A PROJECT WHICH IS AN ANNUITY OR PERPETUITY

Where the project is to generate constant annual cashflows for a period of time then the IRR can be
calculated rather than estimated.
Worked Example: IRR of an annuity
A company is trying to decide whether to buy a machine for $89 000 which will save costs of $19 500
per annum for seven years but which will have no resale value.
It is the company's policy to undertake projects only if they are expected to yield a DCF return of
10 per cent or more.
Ascertain whether this project should be undertaken.
The project IRR is the discount rate at which its NPV would be zero:
So $19 500  AF1 – 7 @  % = $89 000
Thus AF1–7 = 89 000 / 19 500 = 4.564
Looking in the annuity factor discount tables, along the seven year line, it can be seen that an AF1–7
of 4.564 equates to an interest rate of 12 per cent.
Thus the project IRR is 12 per cent and the project should be accepted (since at 10 per cent the
project will have a positive NPV).
Worked Example: IRR of a perpetuity
A company is trying to decide whether to buy a machine for $50 000 which will save costs of $6500 per
annum in perpetuity.
It is the company's policy to undertake projects only if they are expected to yield a DCF return of
10 per cent or more.
Ascertain whether this project should be undertaken.
The project IRR is the discount rate at which its NPV would be zero:
The present value of a perpetuity is given by:
Annual cash flow
PV =
r
So, for the project to break-even (have an NPV of zero) 6500 / r = 50 000
r = 13%
Thus the project's IRR is 13 per cent and the project should be accepted (since at 10 per cent the
project will have a positive NPV).
4.2.3 ADVANTAGES OF IRR METHOD

The main advantage of the IRR method is that the information it provides is more easily understood by
managers, especially non-financial managers. For example, it is fairly easy to understand the meaning
of the following statement:
'The project will be expected to have an initial capital outlay of $100 000, and to earn a yield of 25 per
cent. This is in excess of the target yield of 15 per cent for investments.'
It is not so easy to understand the meaning of this statement:
'The project will cost $100 000 and have an NPV of $30 000 when discounted at the minimum required
rate of 15 per cent.'
MODULE 7
4.2.4 DISADVANTAGES OF IRR METHOD
 The IRR method ignores the relative size of investment.
Worked Example: Different sized investments
Both the following projects have an IRR of 18 per cent.

Project A Project B
$ $
Cost, year 0 350 000 35 000
Annual savings, years 1 – 6 100 000 10 000
Clearly, project A is bigger (10 times as big) and so more 'profitable' but if the only information on
which the projects were judged were to be their IRR of 18 per cent, project B would be made to
seem just as beneficial as project A, which is not the case.
 The IRR fails to take account of the total value of a capital project (the project's NPV).
When there are mutually exclusive investments, the IRR method might favour a project with a
higher IRR but a lower NPV. In this case NPV should be used.
4.3 THE PAYBACK METHOD

Definition
The payback period is the length of time required before the total of the cash inflows received from a
project is equal to the cash outflows, and is usually expressed in years. In other words, it is the length
of time the investment takes to pay itself back.
4.3.1 PAYBACK PERIOD

When deciding between two or more competing projects, the usual decision is to accept the one with
the shortest payback.
Payback is often used as a 'first screening method'. By this, we mean that when a capital investment
project is being considered, the first question to ask is: 'How long will it take to pay back its cost?' The
organisation might have a target payback, and so it would reject any capital project unless its payback
period were less than a certain number of years.
You should note that when payback is calculated, we take profits before depreciation. This is because
we are trying to calculate the cash returns from a project: profit before depreciation is an estimate of
cash flows.
Worked Example: Payback period
A company is considering an investment in a project to acquire new equipment costing $80 000. The
equipment would have a five-year life and no residual value at the end of that time. The straight-line
method of depreciation is used. The expected profits after depreciation from investing in the
equipment are as follows:
Year Profit
$
1 15 000
2 15 000
3 16 000
4 24 000
5 20 000
What is the payback period for the investment?
Solution
The payback period is calculated from the cumulative annual profits before depreciation and we have
been given profit after depreciation. Annual depreciation is $16 000, and the profit before
depreciation each year is found simply by adding back the $16 000 to the annual profit estimate.
Profit before Cumulative profit
Year Investment depreciation before depreciation
$ $ $
0 (80 000) (80 000)
1 31 000 (49 000)
2 31 000 (18 000)
3 32 000 14 000
4 40 000 54 000
5 36 000 90 000
Payback occurs when the cumulative profits stop being negative and start to be positive. This will
happen sometime during Year 3 (or after three years if cash flows are assumed to arise at the end of
each year).
If it is assumed that profits each year arise at an even rate throughout the course of the year, the
payback period can be calculated in years and months:
 B 
Payback = Y years +  ×12 months 
 (B + E) 
where:
Y = the number of complete years before payback. This is the year before the one in which payback
occurs.
B = the cumulative profits before depreciation at the beginning of the payback year, ignoring the
negative value.
E = the cumulative profits before depreciation at the end of the payback year.
In this example:
 18 000 
Payback = 2 years +  ×12 months 
 18 000 +14 000 
= 2 years 7 months (to the nearest month)
4.3.2 DISADVANTAGES OF THE PAYBACK METHOD

There are a number of disadvantages to the payback method:
 The choice of a maximum payback period for an investment is arbitrary and subjective.
 It ignores all cash flows after the end of the payback period, and so is not concerned with the total
expected returns from the investment.
For example, suppose that the maximum payback period that a company selects for its
investments is four years, and it is considering two mutually exclusive projects, X and Y, each
costing $80 000. Project X would be expected to make total profits of $100 000 and pay back within
two years. Project Y would be expected to make total profits of $500 000, but only pay back after
five years. On the basis of payback alone, project X would be preferred, despite its lower total
profitability.
 It ignores time value of money.
 If the objective of a company is to maximise the wealth of its shareholders, it would be wrong to
ignore the future profits from an investment after an arbitrary cut-off date for payback. Using a
payback cut-off limit is inconsistent with shareholder wealth maximisation.
 It ignores the timing of cash flows within the payback period and the time value of money
MODULE 7
(a concept incorporated into the DCF appraisal methods that are considered later).
 The method is unable to distinguish between projects with the same payback period.
 It may lead to excessive investment in short-term projects.
4.3.3 THE PAYBACK METHOD IN PRACTICE

Despite the theoretical limitations of the payback method, it is widely used in practice. There are a
number of reasons for this:
 It is simple to calculate and simple to understand, and this may be important when management
resources are limited. It is similarly helpful in communicating information about minimum
requirements to managers responsible for submitting projects.
 It is a particularly useful approach for ranking projects where a firm faces liquidity constraints and
requires a fast repayment of investments.
 It is appropriate in situations where risky investments are made in uncertain markets that are
subject to fast design and product changes or where future cash flows are particularly difficult to
predict.
 Most managers see risk as time-related: the longer the period, the greater the chance of failure.
The payback method, by concentrating on the early cash flows, therefore uses data in which they
have confidence. The justification for this is that cash flows tend to be correlated over time and
hence if cash flows are below the expected level in early years, this pattern will often continue.
 The method is often used in conjunction with the NPV or IRR method and acts as a first screening
device to identify projects which are worthy of further investigation.
 It provides an important summary method: how quickly will the initial investment be recouped?
Question 3: Payback period
A company carries out capital project appraisal using payback. It will not undertake any project unless
the payback is within three years.
A project is currently being considered. It would involve expenditure of $150 000 on an asset. The
project's life would be five years and at the end of this time the asset would have no residual value. A
working capital investment of $15 000 would be required.
The annual profits before depreciation from the project would be:
Year $
1 10 000
2 40 000
3 80 000
4 70 000
5 50 000
Required
a. What is the payback period for the project?
b. On the basis of the company's investment criterion, would this project be undertaken?
4.4 THE DISCOUNTED PAYBACK METHOD

The discounted payback method of project appraisal is similar to the non-discounted payback
method, except that payback is measured with the present value of cash flows.
Definition
The discounted payback period is the time it takes to recover the initial project investment in
discounted cash flow (i.e. present value terms).
A company might have an investment policy of undertaking projects only if:

 they have a positive NPV, and
 they pay back, in present value terms, within a maximum time limit.
4.4.1 CALCULATING DISCOUNTED PAYBACK

Worked Example: Discounted payback
TJ is considering two mutually-exclusive investments, project A and project B. It can undertake one of
them, or neither, but it cannot undertake both.
Project A would involve expenditure on a non-current asset of $60 000 and a working capital
investment of $5000. The profits from the project, ignoring depreciation, would be:
Year Cash profit
$
1 15 000
2 20 000
3 20 000
4 25 000
5 20 000
6 15 000
7 10 000
Project B would involve expenditure on a non-current asset of $50 000 and a working capital
investment of $5000. The profits from the project, ignoring depreciation, would be:
Year Cash profit
$
1 20 000
2 30 000
3 20 000
4 10 000
5 5 000
6 2 000
In both cases, the non-current asset would have nil residual value at the end of the project's life.
The company's cost of capital is 11 per cent, and the discount factors are:
Year Discount factor at
11%
1 0.901
2 0.812
3 0.731
4 0.659
5 0.593
6 0.535
7 0.482
It is company policy to require projects to pay back in discounted cash flow terms within four years.
Which project, if either, should be undertaken?
Solution
The NPV and discounted payback period for each project are calculated as follows:
Project A
Discount Cumulative
MODULE 7
Year Cash flow factor at 11% Present value present value
$ $ $
0 (60 000 + 5000) (65 000) 1.000 (65 000) (65 000)
1 15 000 0.901 13 515 (51 485)
2 20 000 0.812 16 240 (35 245)
3 20 000 0.731 14 620 (20 625)
4 25 000 0.659 16 475 (4 150)
5 20 000 0.593 11 860 7 710
6 15 000 0.535 8 025 15 735
7 (10 000 + 5000) 15 000 0.482 7 230 22 965
NPV + 22 965
4150
Discounted payback period = 4 years + ×12 months = 4 years 4 months
4150 + 7710
Project B
Discount Cumulative
Year Cash flow factor at 11% Present value present value
$ $ $
0 (50 000 + 5000) (55 000) 1.000 (55 000) (55 000)
1 20 000 0.901 18 020 (36 980)
2 30 000 0.812 24 360 (12 620)
3 20 000 0.731 14 620 2 000
4 10 000 0.659 6 590 8 590
5 5 000 0.593 2 965 11 555
6 (2000 + 5000) 7 000 0.535 3 745 15 300
NPV + 15 300
12 620
Discounted payback period = 2 years + ×12 months = 2 years 10 months
12 620 + 2000
Project A has the higher NPV, but does not pay back until after four years four months, which is longer
than the minimum acceptable payback period. Project B has a lower NPV but pays back within three
years, which is less than the maximum acceptable. On the basis of the investment criteria used by this
company, project B would be undertaken.
4.4.2 STRENGTHS AND WEAKNESSES OF THE DISCOUNTED PAYBACK METHOD

The discounted payback method of project evaluation is similar to the normal payback method,
except that it allows for the time value of money.
 It establishes a requirement for projects to pay back within a maximum time period, although the
maximum discounted payback is a subjective measure, for which there may be no rational
justification.
 It recognises that for many companies liquidity is important, and projects need to provide returns
fairly quickly.
 Unlike the non-discounted method of appraisal, it will not recommend a project for investment
unless its NPV is expected to be positive.
The main disadvantage of the discounted payback method is that, as with the non-discounted
payback method, it ignores all cash flows after payback has been reached. It does not take into
consideration all the expected cash flows from the project. In the example above, for example, project
B is preferred even though the expected NPV from project A is higher. By ignoring total returns from a
project, its use is not consistent with the objective of maximising shareholder wealth.
5 NET PRESENT VALUE (NPV) AND INVESTMENT

APPRAISAL
LOs
7.4,
7.5  With the NPV method of project appraisal, all expected cash inflows and all expected cash
outflows from the project are discounted to a present value at the organisation's cost of
capital.
 The net present value is the difference between the present value of total benefits and the
present value of total costs. Projects with a positive NPV are financially acceptable, but
projects with a negative NPV are not.
 If the PV of benefits exceeds the PV of total costs, the NPV is positive, and the project is
expected to earn a return in excess of the organisation's cost of capital.
 If the PV of benefits is less than the PV of total costs, the NPV is negative, and the project
will earn a return that is lower than the organisation's cost of capital.
Definition
Net present value or NPV is the value obtained by discounting all cash outflows and inflows of a
capital investment project by a chosen target rate of return or cost of capital. The sum of the present
value of all expected benefits from the project and the present value of all expected cash outlays is
the 'net' present value amount.
The NPV method compares the present value of all the cash inflows from an investment with the
present value of all the cash outflows from an investment. The NPV is thus calculated as the PV of cash
inflows minus the PV of cash outflows.
 If the NPV is positive, it means that the cash inflows from a capital investment will yield a return in
excess of the cost of capital, and so the project should be undertaken.
 If the NPV is negative, it means that the cash inflows from a capital investment will yield a return
below the cost of capital, and so the project should not be undertaken.
 If the NPV is exactly zero, the cash inflows from a capital investment will yield a return which is
exactly the same as the cost of capital, and so the organisation will be indifferent about whether it
undertakes the project or not.
5.1 ASSUMPTIONS ABOUT CASH FLOWS

 A cash outlay incurred at the beginning of an investment project ('now') occurs in Year 0.
 Cash flows that occur evenly over the course of a year are assumed to occur all at once at the end of
the year. Receipts of $10 000 during Year 1 are therefore taken to occur at the end of Year 1.
 A cash flow that occurs at the beginning of a year is taken to occur at the end of the previous
year. Therefore, a cash outlay of $5000 at the beginning of Year 2, for example 1/1/20X5 is taken,
for discounting purposes as one occurring at the end of Year 1, 31/12/20X4. There is no material
timing difference in these flows for discounting purposes.
 An increase in working capital during a year should normally be treated as occurring at the start
of the year, and so is a cash outlay at the start of the year/end of the previous year.
 A decrease in working capital during a year should also normally be treated as occurring at the
start of the year. However, there is an important exception to this general rule.
At the end of a project, any remaining investment in working capital is no longer required, and
working capital will therefore be reduced to zero. This reduction in working capital to zero is treated
as a cash inflow occurring at the end of the last year of the project.
MODULE 7
5.2 APPROACH TO NPV CALCULATIONS
Worked Example: Slogger
Slogger is considering a capital investment, where the estimated cash flows are as follows:
Year Cash flow
$
0 (100 000)
1 60 000
2 80 000
3 40 000
4 30 000
The company's cost of capital is 15 per cent. You are required to calculate the NPV of the project and
to assess whether it should be undertaken.
The following discount factors might be relevant:
Year Discount factor at
15%
1 0.870
2 0.756
3 0.658
4 0.572
5 0.497
6 0.432
Solution
Year Cash flow Discount factor at Present value
15%
$ $
0 (100 000) 1.000 (100 000)
1 60 000 0.870 52 200
2 80 000 0.756 60 480
3 40 000 0.658 26 320
4 30 000 0.572 17 160
Net present value 56 160
The PV of cash inflows exceeds the PV of cash outflows by $56 160, which means that the project will
earn a DCF yield in excess of 15 per cent. It should therefore be undertaken.
Question 4: LCH
LCH manufactures product X which it sells for $5 per unit. Variable costs of production are currently
$3 per unit, and fixed costs 50c per unit. A new machine is available which would cost $90 000 but
which could be used to make product X for a variable cost of only $2.50 per unit. Fixed costs, however,
would increase by $7500 per annum as a direct result of purchasing the machine. The machine would
have an expected life of four years and a resale value after that time of $10 000. Sales of product X are
estimated to be 75 000 units per annum. LCH expects to earn at least 12 per cent per annum from its
investments. Ignore taxation.
You are required to decide whether LCH should purchase the machine.
The following discount factors are relevant.
Year Discount factor at 12%
1 0.893
2 0.797
3 0.712
4 0.636
5.3 THE NPV METHOD AND SHAREHOLDER WEALTH CREATION

The NPV method of project appraisal is consistent with the financial objective of maximising
shareholder wealth. Given certain assumptions, the value of a company should be expected to
increase by the NPV of any projects that it undertakes.
The NPV method is best because it provides a measurement of the expected increase in the value of a
company, and so the increase in shareholder value, that might be expected from an investment. This
is an important point, and is worth studying carefully.
Suppose that you invest $1000 and want to earn a return of 10 per cent per annum. If you are offered
the chance to invest in a one-year project that will pay back $1100 after one year, the investment will
provide the 10 per cent return you are looking for, and you will therefore think that it is worth the
$1000 that it will cost.
Suppose, however, that you are offered an investment with exactly the same risk characteristics that
will pay back $1200 after one year, on a $1000 investment. This second investment will be more
attractive, because it will provide a return higher than the 10 per cent you are looking for. In NPV
terms, the investment would have a positive net present value.
Year Cash flow Discount Present value
factor at 10%
$ $
0 (1 000) 1.000 (1 000)
1 1 200 0.909 1 091
NPV 91
If you acquire this investment for $1000, another investor who also wants a return of 10 per cent might
immediately offer to buy it from you, for more than $1000. To obtain a return of at least 10 per cent on
their investment, this other investor will be prepared to offer you up to $1091 ($1200 / 1.10). If you sell
at this price, you will have made $91 on your investment. In other words, you will have increased your
wealth by $91. This increase in wealth is the NPV of the investment.
The same principle applies to investments by companies, for the same reason. If a project earns a
return in excess of the returns expected by the providers of finance, the surplus belongs to the
shareholders. The shareholders will expect this additional return to be paid to them as dividends, or
reinvested by the company to provide even higher returns and dividends in the future. Either way, the
perceived value of their investment will go up, and it should be expected to go up by the amount of
the project NPV.
5.3.1 NPV CALCULATIONS INCLUDING USE OF ANNUITY TABLES

Worked Example: IMC
IMC is considering the manufacture of a new product which would involve the use of both a new
machine (costing $150 000) and an existing machine, which cost $80 000 two years ago but has no
resale value. There is sufficient capacity on this machine, which has so far been under-utilised. Annual
profits before depreciation would be $40 000.
The project would have a five-year life, after which the new machine would have a net residual value of
$5000.
Working capital requirements would be $10 000 in the first year, rising to $15 000 in the second year
and remaining at this level until the end of the project, when it will all be recovered. The company's
cost of capital is 10 per cent.
You are required to assess whether the project is worthwhile.
1 0.909
2 0.826
MODULE 7
3 0.751
4 0.683
5 0.621
1–5 3.791
Solution
The project requires $10 000 of working capital during Year 1 and a further $5000 at the start of Year 2.
Increases in working capital reduce the net cash flow for the period to which they relate. When the
working capital tied up in the project is 'recovered' at the end of the project, it will provide an extra
cash inflow (for example, receivables will eventually be received in cash).
The historic cost of the current machine is not a relevant cost and must be ignored in the appraisal.
The NPV is calculated as follows:
Working Net Discount PV of net
Year Equipment capital Contribution cash flow factor cash flow
$ $ $ $ 10% $
0 (150 000) (10 000) (160 000) 1.000 (160 000)
1 (5 000) (5 000) 0.909 (4 545)
1–5 40 000 40 000 3.791 151 640
5 5 000 15 000 20 000 0.621 12 420
NPV = (485)
The NPV is negative (although not by much) and the project is therefore not recommended for
acceptance, because it fails to earn a return of 10 per cent.
5.4 STRENGTHS AND WEAKNESSES OF THE NPV METHOD

The NPV method is the most valid of all the capital project appraisal methods.
 It recognises the time value of money, and evaluates cash flows, not accounting profits.
 When the cost of capital used in the appraisal is the organisation's cost of finance, a project with a
positive NPV should add to the overall value of the organisation, and, in the case of a company
increase shareholder wealth.
The connection between NPV and creating shareholder wealth is very important, and is explained in
more detail later.
Although it is the most appropriate method of project appraisal, the NPV method does have a
drawback.
The net present value of a project is a money value. This is often difficult to understand. For example,
it is easier to understand the comment: 'Project A will earn a return of 15 per cent per annum' than it is
to understand the comment 'Project A has an NPV of +$60 000 at a cost of capital of 10 per cent'.
6 OTHER INVESTMENT APPRAISAL ISSUES
LO
 You may need to deal with some additional issues in an investment appraisal analysis.
These could include working capital, the effect of inflation, allowing for taxation (including
capital allowances) and mutually exclusive projects.
6.1 WORKING CAPITAL

If a company requires $20 000 to be held in working capital, for example to buy and hold inventory of
$20 000, and earns cash profits of $50 000, the net cash receipts will be $30 000. Working capital will
be released again at the end of a project's life, and so there will be a cash inflow arising out of the
eventual realisation into cash of the project's inventory and receivables in the final year of the project.
Worked Example: Working capital
A company is considering investing in a three year project. In addition to the $200 000 cost of setting
up the machine, $10 000 of working capital is required immediately. The working capital requirement
is expected to increase by 10 per cent per annum but will be released at the end of the project when
the machine will be scrapped.
What are the relevant cash flows?
Solution
The amount and timing of the relevant cash flows would be as follows:
Timing Flow $
0 Machine (200 000)
0 Working capital for Year 1 (10 000)
3 Release working capital 12 100
Note that after the initial amount of cash is contributed to working capital, only the incremental
investment is recorded. For example, if the working capital requirement is increasing by 10 per cent
p.a., $11 000 (10 000  1.10) is required at the start of the second year of the project. Since $10 000 has
already been invested, the relevant cash flow is the incremental $1000.
The full amount invested in working capital is then released at the end of the project's life (i.e. $10 000
+ $1000 + $1100).
Note: It can be useful to think of the working capital requirement to relate just to inventory. If
inventory increases each year only the incremental amount needs to be bought each year. At the end
of the project, the inventory will be run down and the case recovered.
6.2 ALLOWING FOR INFLATION IN INVESTMENT APPRAISAL

So far we have not considered the effect of inflation on the appraisal of capital investment proposals.
As the inflation rate increases, so will the minimum return required by an investor. For example, you
might be happy with a return of 5 per cent in an inflation-free world, but if the rate of inflation was
running at 15 per cent you would expect a considerably greater yield.
Worked Example: Allowing for inflation
A company is considering investing in a project with the following cash flows.

Actual cash flows at Actual cash flows, allowing for
Time today's prices inflation at 10% per annum
$ $
0 (18 000) (18 000)
1 9 000 9 900
2 8 000 9 680
3 7 000 9 317
The company requires a minimum return of 20 per cent under the present and anticipated conditions.
Inflation is currently running at 10 per cent a year, and this rate of inflation is expected to continue
indefinitely. Should the company go ahead with the project?
Solution
The company's required rate of return is 20 per cent. This is the return investors require in the
expectation that inflation will be 10 per cent per annum over the lifetime of the project. Suppose that
the company invested $1000 for one year on 1 January. On 31 December it would require a minimum
MODULE 7
return of $200. With the initial investment of $1000, the total value of the investment by 31 December
must therefore increase to $1200. During the course of the year the purchasing value of the dollar
would fall due to inflation. We can restate the amount received on 31 December in terms of the
purchasing power of the dollar at 1 January as follows:
$1200
Amount received on 31 December in terms of the value of the dollar at 1 January = = $1091
(1.1)1
In terms of the value of the dollar at 1 January, the company would make a profit of $91 which
represents a rate of return of 9.1 per cent in 'today's money' terms. This is known as the real rate of
return.
The required rate of 20 per cent is a nominal rate of return which is sometimes called a money rate of
return. The money rate measures the return in terms of the dollar which is, of course, falling in value.
The real rate measures the return in constant price level terms.
Note that current market rates of return are nominal (money) rates of return. Investment yields on debt
capital and equity capital are therefore money yields.
Definitions
Real rate of return is the return expressed in constant price level terms.
Nominal or money rate of return is the rate of return which includes a compensation for inflation.
The nominal rate is usually therefore higher than the real rate.
Formula to learn
The two rates of return and the inflation rate are linked by the equation:
(1 + Nominal (or money) rate) = (1 + real rate or return)  (1 + inflation rate)
where all the rates are expressed as decimals.
Therefore in our example, having been given the money rate of return (20 per cent) and the inflation
rate (10 per cent) we could calculate the real rate by rearranging the equation:
(1 + real) = (1 + nominal rate) / (1 + inflation rate)
(1 + real) = (1 + 0.20) / (1 + 0.10) = 1.091
Real rate of return = 9.1 per cent
(1.20) = (1.091)  (1.10)
Question 5: Rates of return with inflation
A company is considering investing in a two year project. Its required rate of return in real terms is
10 per cent per annum. The general level of inflation is expected to be 5 per cent in Year 1 and
3 per cent in Year 2. Calculate the money rate of return for each of the two years and also the
appropriate discount factors for Time 1 and Time 2.
6.2.1 CHOOSING AN APPROPRIATE DISCOUNT RATE

So which rate should be used for DCF appraisals, the real rate of return or the money rate of return?
The rule is as follows:
 If the cash flows are expressed in terms of the actual number of dollars that will be received or paid
on the various future dates (money or nominal cash flows), we use the money rate for discounting.
 If the cash flows are expressed in terms of the value of the dollar at time 0 (that is, in constant price
level terms, real cash flows), we use the real rate.
Definitions
Money or nominal cash flows are the actual amounts to be received or paid at a future date. They
are cash flows not adjusted for inflation.
Real cash flows are the cash flows expressed in terms of their current value. They are cash flows
adjusted for inflation.
6.2.2 MONEY FLOWS AND MONEY RATE OF RETURN

In our worked example we are given the cash flows expressed in terms of the actual number of dollars
that will be received or paid at the relevant dates. These are money flows.
We should, therefore, discount them using the money rate of return.
Time Cash flow Discount factor PV
$ 20% $
0 (18 000) 1.000 (18 000)
1 9 900 0.833 8 247
2 9 680 0.694 6 718
3 9 317 0.579 5 395
2 360
The project has a positive net present value of $2360.
6.2.3 Real flows and real rate of return

Alternatively, we can use the cash flows at today's prices (real flows) and discount them using the real
rate of 9.1 per cent. The discount factors at 9.1 per cent are:
Year Discount factor at 9.1%
1 0.917
2 0.840
3 0.770
Time Cash flow Discount factor PV

$ 9.1% $
0 (18 000) 1.000 (18 000)
1 9 000 0.917 8 253
2 8 000 0.840 6 720
3 7 000 0.770 5 390
2 363
Allowing for some small rounding errors, the present value of the cash flows and the NPV is exactly
the same as before. In other words, the NPV of a project will be exactly the same, no matter whether it
is calculated
 with actual cash flows and the money rate of return, or
 with non-inflated cash flows and the real rate of return.
However, this is only true if the same rate of inflation is applied to all cash flows and incorporated
within the money rate of return – see below.
6.2.4 THE ADVANTAGES OF USING REAL VALUES AND A REAL RATE OF RETURN
Although it is recommended that companies should discount money values at the money cost of
capital, there are some advantages of using real values discounted at a real cost of capital.
 When all costs and benefits rise at the same rate of price inflation, real values are the same as
current day values, so that no further adjustments need be made to cash flows before discounting.
In contrast, when money values are discounted at the money cost of capital, the prices in future
years must be calculated before discounting can begin.
 The government might prefer to set a real return as a target for its investments. This may be more
MODULE 7
suitable for the public sector than a commercial money rate of return.
6.2.5 EXPECTATIONS OF INFLATION AND THE EFFECTS OF INFLATION

When managers evaluate a particular project, they can only estimate what the rate of inflation is going
to be. Their expectations will probably be wrong, at least to some extent, because it is extremely
difficult to forecast the rate of inflation accurately. The only way in which uncertainty about inflation
can be allowed for in project evaluation is by risk and uncertainty analysis.
We stated earlier that costs and benefits may rise at levels different from the general rate of inflation:
inflation may be general, affecting prices of all kinds, or specific to particular prices. Generalised
inflation has the following effects.
 Since non-current assets and inventories will increase in money value, the same quantities of assets
must be financed by increasing amounts of capital.
– If the future rate of inflation can be predicted, management can work out how much extra
finance the company will need, and take steps to obtain it (for example, by retaining more
profits, or by borrowing).
– If the future rate of inflation cannot be predicted with accuracy, management should guess at
what it will be and plan to obtain extra finance accordingly. However, plans should also be
made to obtain 'contingency funds' if the rate of inflation exceeds expectations. For example, a
higher bank overdraft facility might be negotiated, or a provisional arrangement made with a
bank for a loan.
 Inflation means higher costs and higher selling prices. The effect of higher prices on demand is not
necessarily easy to predict. A company that raises its prices by 10 per cent because the general
rate of inflation is running at 10 per cent might suffer a serious fall in demand.
6.2.6 ALLOWING FOR INFLATION IN PRACTICE

In practice, it is very common to ignore inflation when carrying out capital project appraisal, and to use
current market rates of interest (money rates) with non-inflated cash flows. There are probably two
main reasons for this.
 Inflation rates are often difficult to predict, and so it is frequently assumed that inflation will not be
significant, and can be ignored.
 It is a safety-first approach. Future cash flow estimates are often uncertain, and for most projects,
longer-term annual cash flows of a project are cash inflows. By not allowing for inflation, the
estimated cash inflows will be under-stated, and a project will have to justify itself financially
without the benefit of inflating revenues.
6.3 ALLOWING FOR TAX IN INVESTMENT APPRAISAL

So far, in looking at project appraisal, we have ignored taxation. However, payments of tax, or
reductions of tax payments, are relevant cash flows and must be considered in DCF analysis. Two main
aspects of taxation must be considered in relation to cash flows:
 If a project earns profits, there will be extra tax to pay.
 There will be capital allowances (tax allowable depreciation) to be claimed on the non-current
asset. These reduce the tax payable.
Typical assumptions are as follows.
 Tax is payable in the same year as the year in which the taxable profits are made. Therefore, if a
project increases taxable profits by $10 000 in Year 2, there will be a tax payment, assuming tax at
30 per cent, of $3000 in Year 2.
An alternative assumption is that tax is payable in the year after the one in which the profits arise. In
this case, an increase in profits of $10 000 in Year 2 would give rise to higher taxation of $3000 in
Year 3, assuming tax at 30 per cent.
 Net cash flows from a project should be considered as the taxable profits arising from the project
(unless an indication is given to the contrary).
Worked Example: Taxation on profits
A company is considering whether or not to purchase an item of machinery costing $40 000 in 20X5. It
would have a life of four years, after which it would be sold for $5000. The machinery would create
annual cost savings of $14 000.
The rate of tax is 30 per cent and tax is payable in the same year as the profits arise. The after-tax cost
of capital is 8 per cent. Assume that the cost of the machine is not allowable for tax and that there are
no capital allowances.
Should the machinery be purchased?
Solution
The net cash flows and the NPV can be calculated as follows.
Tax on Net cash Discount Present value
Year Equipment Savings savings flow factor of cash flow
$ $ $ $ 8% $
0 (40 000) (40 000) 1.000 (40 000)
1 14 000 (4 200) 9 800 0.926 9 075
2 14 000 (4 200) 9 800 0.857 8 399
3 14 000 (4 200) 9 800 0.794 7 781
4 5 000 14 000 (4 200) 14 800 0.735 10 878
(3 867)
The NPV is negative and so the purchase appears not to be worthwhile.
6.3.1 TAXATION AND THE DISCOUNT RATE

The effect of taxation on capital budgeting is theoretically quite simple. Organisations must pay tax,
and the effect of undertaking a project will be to increase or decrease tax payments each year. These
incremental tax cash flows should be included in the cash flows of the project for discounting to arrive
at the project's NPV.
When taxation is ignored in the cash flows for DCF calculations, the discount rate will reflect the
pre-tax rate of return required on capital investments.
When taxation is included in the cash flows, the cost of capital used should be the company's
after-tax cost of capital or post-tax required rate of return. This allows for the tax relief on the
company's debt finance.
Question 6: DCF and taxation
A company is considering the purchase of an item of equipment, which would earn profits before tax
of $25 000 a year. Depreciation charges would be $20 000 a year for six years. Tax-allowable
depreciation would be $30 000 a year for the first four years only. Tax is at 30 per cent.
What would be the annual net cash inflows of the project:
a. For the first four years?
b. For the fifth and sixth years?
c. What is the NPV of the project, if the after-tax cost of capital is 8 per cent?
1 0.926
2 0.857
3 0.794
4 0.735
5 0.681
6 0.630
MODULE 7
6.3.2 CALCULATING CAPITAL ALLOWANCES
When a business buys non-current assets, it may be entitled to claim a tax allowance for the decline in
value or depreciation of the asset. This is known as a capital allowance.
For example, suppose that a company buys an item of equipment costing $100 000. It cannot usually
claim the full $100 000 immediately against tax. Instead, it can claim capital allowances over the life of
the asset.
Capital allowances are used to reduce taxable profits, and the consequent reduction in a tax payment
should be treated as a cash saving arising from the acceptance of a project.
Under the prime cost method, the decline in value of the depreciating asset is generally calculated as
a percentage of the initial cost of the asset and reflects a uniform decline in value over time.
Under the diminishing value method, also called the reducing balance method, the decline for each
year is calculated on the balance of the asset's cost that remains after the decline in value for previous
years has been taken into account.
Worked Example: Capital allowances
A company acquires an asset for $10 000, with an effective life of 10 years.
If the company is required to use the prime cost method to calculate capital allowances, the annual
deduction for capital allowances would be 10 per cent of the asset's cost:
Years 1–10: 10 000 / 10 = $1000
If the diminishing value method is used, capital allowances are available at 1.5 times the equivalent
prime cost rate, and are calculated on a reducing balance basis. This equates to allowances of
15 per cent p.a. for an asset with an effective life of 10 years:
Year 1 10 000  1.5 / 10 = $1500
Year 2 (10 000 – 1500)  1.5 / 10 = $1275
Year 3 (10 000 – 1500 – 1275)  1.5 / 10 = $1084 etc
6.3.3 DISPOSAL OF THE ASSET

When an asset is disposed of, there will be (a) a balancing allowance or (b) a balancing charge,
depending on whether the sale value of the asset is (a) lower or (b) higher than the remaining tax
adjusted asset value, after deducting cumulative capital allowances to date.
The balancing allowance or charge must be multiplied by the rate of tax to obtain the effect on cash
flow.
Worked Example: Impact of disposal
A machine originally cost $50 000 and capital allowances have been claimed at 10 per cent on a prime
cost basis for the past six years.
Assuming a tax rate of 30 per cent, what is the tax effect of:
a. Selling the machine for $25 000 (salvage)?
b. Selling the machine for $18 000 (salvage)?
Solution
The tax adjusted value after six years of capital allowances is 50 000 – (6  10%  50 000) = $20 000
a. If the machine is sold for $25 000 there will be a balancing charge of $5000 gain on salvage, which
will result in additional tax payable of $1500.
b. If the machine is sold for $18 000 there will be a balancing allowance of $2000 loss on salvage,
which will result in an additional tax saving of $600.
Assumptions about capital allowances can be simplified in a question. For example, you might be told
that capital allowances can be claimed at the rate of 25 per cent of cost on a straight line basis (that is,
over four years), or a question might refer to 'tax allowable depreciation', so that the capital
allowances equal the depreciation charge.
There are two possible assumptions about the time when capital allowances start to be claimed.
a. It can be assumed that the first claim for capital allowances occurs at the start of the project (at
Year 0) and so the first tax saving occurs in Year 0.
b. Alternatively it can be assumed that the first claim for capital allowances occurs later in the first
year, so the first tax saving also occurs in Year 1.
Worked Example: Investment appraisal with taxation
A company is considering whether or not to purchase an item of machinery.

The machine costs $40 000 in 20X5. It would have a life of four years, after which it would be sold for
$5000. The machinery would create annual cost savings of $14 000.
The machinery would attract capital allowances of 25 per cent on the reducing balance basis which
could be claimed against taxable profits of the current year, which is soon to end. A balancing
allowance or charge would arise on disposal. The rate of income tax is 30 per cent. Tax is payable in
the same year as the profits arise. The after-tax cost of capital is 8 per cent.
Should the machinery be purchased?
Solution
The first capital allowance is claimed against Year 0 profits.

Cost: $40 000
Year Allowance Reducing balance (RB)
$ $
(0) 20X5 (25% of cost) 10 000 30 000 (40 000 – 10 000)
(1) 20X6 (25% of RB) 7 500 22 500 (30 000 – 7 500)
(2) 20X7 (25% of RB) 5 625 16 875 (22 500 – 5 625)
(3) 20X8 (25% of RB) 4 219 12 656 (16 875 – 4 219)
(4) 20X9 (25% of RB) 3 164 9 492 (12 656 – 3 164)
$
Sale proceeds, end of fourth year (salvage) 5 000
Less reducing balance, end of fourth year (9 492)
Balancing allowance (loss on salvage) (4 492)
Having calculated the allowances each year, the tax savings can be computed.
Year Allowance Tax saved at 30%
$ $
0 10 000 3 000
1 7 500 2 250
2 5 625 1 688
3 4 219 1 266
4 7 656 (3164 + 4492) 2 297
35 000 *
* Net cost $(40 000 – 5000) = $35 000

These tax savings relate to capital allowances. We must also calculate the extra tax payments on
annual savings of $14 000.
The net cash flows and the NPV are now calculated as follows.
MODULE 7
Tax saved Present
Tax on on capital Net cash Discount value of
Year Equipment Savings savings allowances flow factor cash flow
$ $ $ $ $ 8% $
0 (40 000) 3 000 (37 000) 1.000 (37 000)
1 14 000 (4 200) 2 250 12 050 0.926 11 158
2 14 000 (4 200) 1 688 11 488 0.857 9 845
3 14 000 (4 200) 1 266 11 066 0.794 8 786
4 5 000 14 000 (4 200) 2 297 17 097 0.735 12 566
5 355
The NPV is positive and so the purchase appears to be worthwhile.
Question 7: DCF with tax
Quitongo is considering a major investment program which will involve the creation of a chain of retail
outlets. The following schedule of expected cash flows has been prepared for analysis.
Time 0 1 2 3 4
$'000 $'000 $'000 $'000 $'000
Land and buildings 3 250
Fittings and equipment 750
Gross revenue 1 000 1 750 2 500 3 200
Direct costs 800 1 100 1 500 1 600
Marketing 170 250 200 200
Office overheads 100 100 100 100
Additional information:
a. 40 per cent of office overhead is an allocation of head office operating costs.
b. The cost of land and buildings includes $120 000 which has already been spent on surveyors' and
other advisers' fees.
c. Quitongo expects to sell the chain at the end of Year 4 for $4 500 000 after tax.
d. Cost of capital is 7 per cent after tax.
Quitongo is paying tax at 30 per cent and is expected to do so for the foreseeable future. Tax is
payable one year after profits are earned. Capital allowances are available on fittings and equipment
(only) at 25 per cent on a reducing balance basis. Resale proceeds of $200 000 for fittings and
equipment have been included in the total figure of $4 500 000 given above.
Quitongo has an accounting year end of 31 December, and expenditure on the investment program
will take place in January.
Quitongo expects the following working capital requirements during each of the four years of the
investment program. (All figures in $'000s.)
Year 1 Year 2 Year 3 Year 4
250 300 375 400
Calculate the NPV of the project.

6.4 MUTUALLY EXCLUSIVE PROJECTS

Mutually exclusive projects are two or more projects from which only one can be chosen. Examples
include the choice of a factory location or the choice of just one of a number of machines. The IRR and
NPV methods can, however, give conflicting rankings as to which project should be given priority.
Worked Example: Mutually exclusive investments
Let us suppose that a company is considering two mutually exclusive options, option A and option B.
The cash flows for each would be as follows:
Year Option A Option B
$ $
0 Capital outlay (10 200) (35 250)
1 Net cash inflow 6 000 18 000
The company's cost of capital is 16 per cent.
Solution
The NPV of each project is calculated below:

Option A Option B
Cash Present Cash Present
Year Discount factor at 16% flow value flow value
$ $ $ $
0 1.000 (10 200) (10 200) (35 250) (35 250)
1 0.862 6 000 5 172 18 000 15 516
2 0.743 5 000 3 715 15 000 11 145
3 0.641 3 000 1 923 15 000 9 615
NPV = +610 NPV = +1 026
The DCF yield (IRR) of option A is 20 per cent and the yield of option B is only 18 per cent (workings
not shown). On a comparison of NPVs, option B would be preferred, but on a comparison of IRRs,
option A would be preferred.
This situation can be illustrated diagrammatically:
Figure 7.3: Mutually exclusive projects
NPV
$ Option B
1 000
Option A
800
600
400
0
14 16 18 20
Cost of capital %
The fact that A has a higher IRR than B indicates that, if the company's cost of capital were to increase
from 16 per cent, A would yield a positive NPV for a larger range of costs than B. However, at the
company's actual cost of capital, B gives a higher NPV, thereby increasing shareholder wealth by a
greater amount than A.
Therefore, in the case of mutually exclusive projects where NPV and IRR rankings appear to conflict,
the NPV approach should be used to decide between them.
If the projects were independent all this would be irrelevant since under the NPV rule both would be
accepted and the organisation would be indifferent as to the order in which they were accepted.
6.4.1 SUMMARY OF NPV AND IRR COMPARISON

NPV tells us the absolute $ increase in shareholder wealth from a project, assuming a given cost of
capital.
IRR tells us the maximum amount that the company could afford to pay for the project finance, or the
expected return of the project in per cent terms.
 Both methods give the same accept or reject decision for individual projects.
MODULE 7
 The IRR method is more easily understood by non-financial managers.
 NPV is simpler to calculate than IRR.
 IRR ignores the relative sizes of investments.
 NPV is the preferred method for deciding between mutually exclusive projects.
Despite the advantages of the NPV method over the IRR method, the IRR method is widely used in
practice. Even so, the NPV method is better because it focuses on the measurement of shareholder
wealth.
7 SENSITIVITY ANALYSIS
LO
 Sensitivity analysis assesses how responsive the project's NPV is to changes in the
variables used to calculate that NPV. This helps identify the critical estimates in the project
forecast.
7.1 NEED FOR SENSITIVITY ANALYSIS

Definition
Sensitivity analysis is one method of analysing the risk surrounding a capital expenditure project and
enables an assessment to be made of how responsive the project's NPV is to changes in the variables
that are used to calculate that NPV.
Any investment appraisal technique is based on forecasts or estimates. The NPV could depend on a
number of uncertain independent variables:
 selling price
 sales volume
 cost of capital
 initial cost
 operating costs
 benefits.
The basic approach of sensitivity analysis is to calculate the project's NPV under alternative
assumptions to determine how sensitive it is to changing conditions.
An indication is thus provided of those variables to which the NPV is most sensitive (critical variables)
and the extent to which those variables may change before the investment results in a negative NPV.
Therefore, sensitivity analysis provides an indication of why a project might fail. Management should
review critical variables to assess whether or not there is a strong possibility of events occurring which
will lead to a negative NPV. Management should also pay particular attention to controlling those
variables to which the NPV is particularly sensitive, once the decision has been taken to accept the
investment.
7.2 APPROACH TO SENSITIVITY ANALYSIS

A simple approach to deciding which variables are critical is to calculate the sensitivity of the NPV to
each variable in turn:
Formula to learn
The formula to apply is as follows:

NPV
Sensitivity = %
Present value of project variable
The resulting percentage indicates how far the variable can change before the NPV becomes zero.
The lower the percentage, the more sensitive the NPV is to that project variable as the variable would
need to change by a smaller amount to make the project non-viable.
Worked Example: Sensitivity
Kenney Co is considering a project with the following cash flows:

Initial Net cash
Year investment Variable costs Cash inflows flows
$'000 $'000 $'000 $'000
0 7 000 (7 000)
1 (2 000) 6 500 4 500
2 (2 000) 6 500 4 500
Cash flows arise from selling 650 000 units at $10 per unit. Kenney Co has a cost of capital of
8 per cent.
Required
Measure the sensitivity of the project to changes in variables.
Solution
The PVs of the cash flow are as follows:

Discount PV of initial PV of variable PV of cash PV of net
Year factor 8% investment costs inflows cash flow
$'000 $'000 $'000 $'000
0 1.000 (7 000) (7 000)
1 0.926 (1 852) 6 019 4 167
2 0.857 (1 714) 5 571 3 857
(7 000) (3 566) 11 590 1 024
The project has a positive NPV and would appear to be worthwhile. The sensitivity of each project
variable is as follows:
a. Initial investment
1024
Sensitivity =  100 = 14.6%
7000
b. Sales volume
1024
11 590 − 3566
c. Selling price
1024
11 590
d. Variable costs
1024
3566
e. Cost of capital. We need to calculate the IRR of the project. Let us try discount rates of 15 per cent
and 20 per cent.
Net cash Discount Discount
Year flow factor 15% PV factor 20% PV
$'000 $'000 $'000
0 (7 000) 1 (7 000) 1 (7 000)
1 4 500 0.870 3 915 0.833 3 749
MODULE 7
2 4 500 0.756 3 402 0.694 3 123
NPV = 317 NPV = (128)
 317 
IRR = 0.15 +
 317 +128 ×  0.20  0.15  = 18.56%
The cost of capital can therefore increase from 8 per cent to 18.56 per cent before the NPV becomes
negative.
The elements to which the NPV appears to be most sensitive are the selling price followed by the
sales volume. Management should pay particular attention to these factors so that they can be
carefully monitored.
7.3 WEAKNESSES OF THIS APPROACH TO SENSITIVITY ANALYSIS

These are as follows:
 The method can only deal with changes in each key variable in isolation. However, management is
likely to be more interested in the combination of the effects of changes in two or more key
variables.
 Looking at factors in isolation is unrealistic since they are often interdependent.
 Sensitivity analysis does not examine the probability that any particular variation in costs or
revenues might occur.
 Critical factors may be those over which managers have no control.
 Sensitivity in itself does not provide a decision rule. Parameters defining acceptability must be laid
down by managers.
Question 8: Sensitivity analysis
Nevers Ure Co has a cost of capital of 8 per cent and is considering a project with the following 'most-
likely' cash flows:
Purchase of
Year plant Running costs Savings
$ $ $
0 (7 000)
1 2 000 6 000
2 2 500 7 000
Required
Measure the sensitivity (in percentages) of the project to changes in the levels of expected costs and
savings.
8 CAPITAL RATIONING
LO
 Capital rationing refers to a situation in which a company has a limited amount of capital to
invest in potential projects.
 Capital rationing may occur due to internal factors (soft capital rationing) or external factors
(hard capital rationing).
 When capital rationing occurs in a single period, projects are ranked in terms of a
profitability index, by considering the PV of the future cash flows earned per $ invested in
the project. This assumes projects are divisible.
 If the projects are not divisible a decision has to be made by examining the absolute NPVs
of all possible combinations of complete projects that can be undertaken within the
constraints of the capital available.
 If projects can be postponed until Year 1, the optimal investment plan is determined by
reference to the loss of NPV from postponement.
Definitions
Capital rationing: a situation in which a company has a limited amount of capital to invest in potential
projects. The different possible investments need to be compared with one another in order to
allocate the capital available most effectively.
Soft capital rationing is brought about by internal factors. Soft capital rationing is where business
units within an organisation are allocated a percentage of the overall company capital budget.
Hard capital rationing is brought about by external factors.
If an organisation is in a capital rationing situation it will not be able to enter into all projects with
positive NPVs because there is not enough capital for all of the investments.
8.1 SOFT AND HARD CAPITAL RATIONING

Soft capital rationing may arise for one of the following reasons:
 Management may be reluctant to issue additional share capital because of concern that this may
lead to outsiders gaining control of the business.
 Management may be unwilling to issue additional share capital if it will lead to a dilution of
earnings per share.
 Management may not want to raise additional debt capital because they do not wish to be
committed to large fixed interest payments.
 Management may wish to limit investment to a level that can be financed solely from retained
earnings.
 The Board may restrict the capital expenditure budget available to individual business units as a
means of management control.
If an organisation restricts funds available for investment for internal reasons (soft capital rationing),
this may not be optimal. Limitations in soft capital rationing tends to be due to the split of the capital
budget amongst business units. Problems that arise are typically driven by the potentially subjective
nature of the distribution. The organisation may reject projects with a positive net present value and
forgo opportunities that would have enhanced the market value of the organisation.
Hard capital rationing may arise for one of the following reasons:
 Raising money through the stock market may not be possible if share prices are depressed.
 There may be restrictions on banks' lending due to government control.
 Lending institutions may consider an organisation to be too risky to be granted further loan
facilities.
 The costs associated with making small issues of capital may be too great.
8.2 RELAXATION OF CAPITAL CONSTRAINTS

If an organisation restricts funds available for investment for internal reasons (soft capital rationing),
this may not maximise shareholders' wealth. The organisation may reject projects with a positive net
present value and forgo opportunities that would have enhanced the market value of the organisation.
If soft capital rationing is causing a company to reject profitable investment opportunities, its
management should reconsider the internally imposed constraints.
MODULE 7
A company may also be able to limit the effects of hard capital rationing and exploit new
opportunities.
 It might seek joint venture partners with which to share projects.
 As an alternative to direct investment in a project, the company may be able to consider a licensing
or franchising agreement with another enterprise, under which the licensor/franchisor company
would receive royalties.
 It may be possible to contract out parts of a project to reduce the initial capital outlay required.
 The company may seek new alternative sources of capital (subject to any restrictions which apply to
it), for example:
– venture capital
– debt finance secured on the assets of the project
– sale and leaseback of property or equipment
– grant aid
– more effective capital management
 It may be possible to delay the investment until finance does become available.
8.3 SINGLE PERIOD CAPITAL RATIONING

8.3.1 ASSUMPTIONS
We shall begin by assuming that capital rationing occurs in a single period, and that capital is freely
available at all other times.
The following further assumptions will be made:
 If a company does not accept and undertake a project during the period of capital rationing, the
opportunity to undertake it is lost. The project cannot be postponed until a subsequent period
when no capital rationing exists.
 There is complete certainty about the outcome of each project, so that the choice between
projects is not affected by considerations of risk.
 Projects are divisible, so that it is possible to undertake, say, half of project X in order to earn half
of the net present value (NPV) of the whole project.
8.3.2 RANKING OF PROJECTS

The basic approach is to rank all investment opportunities so that the NPVs can be maximised from
the use of the available funds.
Ranking in terms of absolute NPVs will normally give incorrect results. This method leads to the
selection of large projects, each of which has a high individual NPV but which have, in total, a lower
NPV than a large number of smaller projects with lower individual NPVs.
Ranking is therefore in terms of what is called the profitability index.
This profitability index is a ratio that measures the PV of the future cashflows earned per $ invested in
the project, and so indicates which investments make the best use of the limited resources available.
Definition
The profitability index is an index that identifies the relationship between the costs and benefits of a
proposed project. The ratio is calculated as the present value of the project's future cash flows (not
including the capital investment) divided by the present value of the total capital investment.
Worked Example: Single period capital rationing
Suppose that Hard Times Co is considering four projects, W, X, Y and Z. Relevant details are as
follows:
Profitability Ranking
Investment Present value index as per Ranking
Project required of cash inflows NPV (PI) NPV as per PI
$ $ $
W (10 000) 11 240 1 240 1.12 3 1
X (20 000) 20 991 991 1.05 4 4
Y (30 000) 32 230 2 230 1.07 2 3
Z (40 000) 43 801 3 801 1.10 1 2
Solution
Without capital rationing all four projects would be viable investments. Suppose however, that only
$60 000 was available for capital investment. Let us look at the resulting NPV if we select projects in
the order of ranking per NPV:
Project Priority Outlay NPV
$ $
Z 1st 40 000 3 801
Y (balance)* 2nd 20 000 1 487 (2/3 of $2230)
60 000 5 288
* Projects are divisible. By spending the balancing $20 000 on project Y, two thirds of the full
investment would be made to earn two thirds of the NPV.
Suppose, on the other hand, that we adopt the profitability index approach. The selection of projects
will be as follows:
Project Priority Outlay NPV
$ $
W 1st 10 000 1 240
Z 2nd 40 000 3 801
Y (balance) 3rd 10 000 743 (1/3 of $2230)
60 000 5 784
By choosing projects according to the PI, the resulting NPV if only $60 000 is available is increased by
$496.
8.3.3 PROBLEMS WITH THE PROFITABILITY INDEX METHOD

 The approach can only be used if projects are divisible. If the projects are not divisible a decision
has to be made by examining the absolute NPVs of all possible combinations of complete projects
that can be undertaken within the constraints of the capital available.
 The selection criterion is fairly simplistic. It does not take account of the possible strategic value of
individual investments in the context of the overall objectives of the organisation.
 The method is of limited use when projects have differing cash flow patterns. These patterns may
be important to the company since they will affect the timing and availability of funds. With multi-
period capital rationing, it is possible that the project with the highest profitability index is the
slowest in generating returns.
 The profitability index ignores the absolute size of individual projects. A project with a high index
might be very small and therefore only generate a small NPV.
Question 9: Single period capital rationing
A company is experiencing capital rationing in Year 0, when only $60 000 of investment finance will be
available. No capital rationing is expected in future periods, but none of the three projects under
consideration by the company can be postponed. The expected cash flows of the three projects are
as follows:
Project Year 0 Year 1 Year 2 Year 3 Year 4
$ $ $ $ $
A (50 000) (20 000) 20 000 40 000 40 000
MODULE 7
B (28 000) (50 000) 40 000 40 000 20 000
C (30 000) (30 000) 30 000 40 000 10 000
The cost of capital is 10 per cent. You are required to decide which projects should be undertaken in
Year 0, in view of the capital rationing, given that projects are divisible.
8.4 POSTPONING PROJECTS

We have so far assumed that projects cannot be postponed until Year 1. If this assumption is removed,
the choice of projects in year 0 would be made by reference to the loss of NPV from postponement.
Worked Example: Option to postpone projects
The figures from Question 4 above will be used to illustrate the method.
The calculation of NPVs and profitability index for single period capital rationing in Year 0, assuming
no ability to postpone, generated the following results:
Outlay in PV of future
Project year 0 cashflows NPV Ratio Ranking
$ $ $
A 50 000 55 700 5 700 1.114 3rd
B 28 000 31 290 3 290 1.118 2nd
C 30 000 34 380 4 380 1.146 1st
Determine the optimal investment strategy if it is possible to defer the start of any of the projects to
Year 1, at which time there will be no capital restriction.
Solution
If the start of any project, A, B or C, were delayed by one year, the 'NPV' would also be delayed by
one year. So the NPVs previously calculated now relate to Year 1 values.
These can be restated in Year 0 terms, as follows:

NPV in year 1 NPV in Year 0 value Loss in NPV
$ $ $
1
a. Project A 5 700  = 5 182 518
1.10
1
b. Project B 3 290  = 2 991 299
1.10
1
c. Project C 4 380  = 3 982 398
1.10
An index of postponability would be calculated by considering the loss in NPV per $ of initial outlay
deferred, as follows:
Postponability
Loss in NPV from Outlay deferred index
Project one-year postponement from Year 0 (loss/outlay)
$ $
A 518 50 000 0.0104
B 299 28 000 0.0107
C 398 30 000 0.0133
The loss in NPV by deferring investment would be greatest for project C, and least for project A. It is
therefore more profitable to postpone A, rather than B or C.
The optimal investment plan is as follows:
Investment in Year 0:
Project Outlay NPV
$ $
C 30 000 4 380
B 28 000 3 290
A (balance) 2 000 (4% of 5700) 228
60 000 7 898
Investment in Year 1 (balance):

Project A $48 000 (96% of 5182) 4 975
Total NPV (as at Year 0) of investments in Years 0 and 1 12 873
8.5 SINGLE PERIOD RATIONING WITH NON-DIVISIBLE PROJECTS

If the projects are not divisible then the method shown above may not result in the optimal solution.
The best way to deal with this situation is to use trial and error to test the NPV available from
different combinations of projects. This can be a long process if there are a large number of projects
available.
Another complication which arises is that there is likely to be a small amount of unused capital with
each combination of projects. Choose the combination of projects which remains at or under the limit
of available capital (without any of them being divided), and which maximises the total NPV.
Worked Example: Single period capital rationing with non-divisible projects
Short O'Funds has capital of $95 000 available for investment in the forthcoming period. The directors
decide to consider projects P, Q and R only. They wish to invest only in whole projects, but surplus
funds can be invested. Which combination of projects will produce the highest NPV at a cost of capital
of 20 per cent?
Investment Present value of

Project required inflows at 20%
$'000 $'000
P 40 56.5
Q 50 67.0
R 30 48.8
Solution
The investment combinations we need to consider are the various possible pairs of projects P, Q and
R.
Required PV of NPV from
Projects investment inflows projects
$'000 $'000 $'000
P and Q 90 123.5 33.5
P and R 70 105.3 35.3
Q and R 80 115.8 35.8
The highest NPV will be achieved by undertaking projects Q and R and investing the unused funds of
$15 000 externally.
MODULE 7
9 WACC, CAPM AND CAPITAL BUDGETING
LO
 The current weighted average cost of capital should be used to evaluate projects where a
company's capital structure changes only very slowly over time. In such a situation, the
marginal cost of any new capital raised for the project should be roughly equal to the
weighted average cost of current capital. If this view is correct, then by undertaking
investments that offer a return in excess of the WACC, a company will increase the market
value of its ordinary shares in the long run. This is because the excess returns would provide
surplus profits and dividends for the shareholders.
 However, where gearing levels fluctuate significantly, or the finance for a new project
carries a significantly different level of risks from that of the existing company, there is good
reason to seek an alternative marginal cost of capital to establish the incremental financing
costs of the new project. This means calculating a marginal rate to the company of raising
the additional capital to finance the project.
9.1 ARGUMENTS FOR USING THE WACC

The weighted average cost of capital can be used in investment appraisal if we make the following
assumptions:
 The project is small relative to the overall size of the company.
 The weighted average cost of capital reflects the company's long-term future capital structure, and
capital costs. If this were not so, the current weighted average cost would become irrelevant
because eventually it would not relate to any actual cost of capital.
 The project has the same degree of business risk as the company has now.
 New investments must be financed by new sources of funds: retained earnings, new share issues,
new loans and so on.
 The cost of capital to be applied to the project evaluation reflects the marginal cost of new capital.
9.2 ARGUMENTS AGAINST USING THE WACC

The arguments against using the WACC as the cost of capital for investment appraisal are based on
criticisms of the assumptions that are used to justify use of the WACC.
 New investments undertaken by a company might have different business risk characteristics from
the company's existing operations. As a consequence, the return required by investors might go
up (or down) if the investments are undertaken, because their business risk is perceived to be
higher (or lower).
 The finance that is raised to fund a new investment might substantially change the capital structure
and the perceived financial risk of investing in the company. Depending on whether the project is
financed by equity or by debt capital, the perceived financial risk of the entire company might
change. This must be taken into account when appraising investments.
 Many companies raise floating rate debt capital as well as fixed interest debt capital. With floating
rate debt capital, the interest rate is variable, and is altered every three or six months or so in line
with changes in current market interest rates. The cost of debt capital will therefore fluctuate as
market conditions vary. As a result floating rate debt is difficult to incorporate accurately into a
WACC computation. One possible estimate is to use the average long-term interest rate on
corporate debt. Another is to substitute the current market rate of an 'equivalent' fixed interest
debt capital, with similar risk and maturity characteristics, in place of the floating rate debt cost.
9.3 CAPM AND PROJECT APPRAISAL

We also saw in Module 2 that CAPM can be used to establish an equity cost of capital, as with WACC,
it too can be used in project appraisal.
Worked Example: Use of CAPM to find a project discount rate
 A company is financed by a mixture of equity and debt capital, whose market values are in the ratio
3:1.
 The debt capital, which is considered risk-free, yields 10 per cent before tax. The average stock
market return on equity capital is 16 per cent.
 The beta value of the company's equity capital is estimated as 0.95. The tax rate is 30 per cent.
What would be an appropriate cost of capital to be used for investment appraisal of new projects with
the same systematic risk characteristics as the company's current investment portfolio?
Solution
An appropriate cost of capital to use, assuming no change in the company's financial gearing, is its
weighted average cost of capital (WACC). The CAPM can be used to estimate the cost of the
company's equity.
Keg = 10% + (16 – 10)  0.95% = 15.7%
The after tax cost of debt is 0.70  10% = 7.0%.
The WACC is therefore:
E D
WACC =K e +K d
E +D E +D
(¾  15.7%) + (¼  7.0%) = 13.5%

The cost of capital to use in project appraisal is 13.5 per cent.
9.4 HOW IS THE WACC DIFFERENT USING CAPM?

You might be wondering how the use of CAPM affects the weighted average cost of capital (WACC).
The answer is that WACC is calculated in the same way. The only difference is the method used to
calculate the cost of the firm's equity: the dividend valuation model (DVM) or the CAPM.
Both assume that:

 investors are rational and risk averse
 capital markets are perfect
 capital markets are efficient, hence prices are in equilibrium.
Using the different techniques for measuring the cost of equity should, in theory, produce the same
results, however differences may arise as a result of the differing assumptions and limitations of the
two models. The most important being that CAPM assumes investors are well-diversified and can
freely invest or borrow at the risk-free rate.
9.5 THE USEFULNESS AND LIMITATIONS OF CAPM FOR CAPITAL

INVESTMENT DECISIONS
The CAPM produces a required return based on the expected returns on the stock market as a whole,
expected project returns, the risk-free interest rate and the variability of project returns relative to the
market returns.
Its main advantage when used for investment appraisal is that it produces a risk-adjusted discount rate
MODULE 7
based on the systematic risk of the individual investment. It can be used to compare projects of all
different risk classes and is therefore superior to a DCF approach that uses only one discount rate for
all projects, regardless of their risk.
The model was developed with respect to securities. By applying it to an investment project being
undertaken within the firm, the company is assuming that the shareholder wishes investments to be
evaluated as if they were securities in the capital market and therefore assumes that all shareholders
will hold diversified portfolios and will not look to the company to achieve diversification for them.
KEY MODULE POINTS
 You should now take the opportunity to recap your knowledge of the time value of money and
relevant costs from Module 2 and the calculations for the cost of debt and equity finance from
Module 4.
 Investment can consist of both capital expenditure and operating expenditure and can be made
in non-current assets or working capital.
 Capital budgeting is the process of identifying, analysing and selecting investment opportunities in
non-current assets whose returns are expected to extend beyond one year.
 A typical model for investment decision making has a number of distinct stages.
– Origination of proposals
– Project screening
– Analysis and acceptance
– Monitoring and review
 The return on investment (ROI) method (also called the accounting rate of return (ARR) method)
of appraising a capital project is to estimate the accounting rate of return that the project should
yield.
 The IRR is the cost of capital at which the NPV of the project would be zero, and so is the discount
rate of return that the project is expected to earn.
 The payback period is the time required for the cash inflows from a project to recoup the cash
outlays.
 The discounted payback method is a way of combining DCF evaluation with a minimum payback
period.
 With the NPV method of project appraisal, all expected cash inflows and all expected cash
outflows from the project are discounted to a present value at the organisation's cost of capital.
 The net present value is the difference between the present value of total benefits and the present
value of total costs. Projects with a positive NPV are financially acceptable, but projects with a
negative NPV are not.
 If the PV of benefits exceeds the PV of total costs, the NPV is positive, and the project is expected
to earn a return in excess of the organisation's cost of capital.
 If the PV of benefits is less than the PV of total costs, the NPV is negative, and the project will earn
a return that is lower than the organisation's cost of capital.
 You may need to deal with some additional issues in an investment appraisal analysis. These could
include working capital, the effect of inflation, allowing for taxation (including capital allowances)
and mutually exclusive projects.
 Sensitivity analysis assesses how responsive the project's NPV is to changes in the variables used
to calculate that NPV. This helps identify the critical estimates in the project forecast.
 Capital rationing refers to a situation in which a company has a limited amount of capital to invest
in potential projects.
 Capital rationing may occur due to internal factors (soft capital rationing) or external factors (hard
capital rationing).
 When capital rationing occurs in a single period, projects are ranked in terms of a profitability
index, by considering the PV of the future cash flows earned per $ invested in the project. This
assumes projects are divisible.
 If the projects are not divisible a decision has to be made by examining the absolute NPVs of all
possible combinations of complete projects that can be undertaken within the constraints of the
capital available.
 If projects can be postponed until Year 1, the optimal investment plan is determined by reference
to the loss of NPV from postponement.
 The current weighted average cost of capital should be used to evaluate projects where a
company's capital structure changes only very slowly over time. In such a situation, the marginal
cost of any new capital raised for the project should be roughly equal to the weighted average cost
of current capital. If this view is correct, then by undertaking investments that offer a return in
excess of the WACC, a company will increase the market value of its ordinary shares in the long
run. This is because the excess returns would provide surplus profits and dividends for the
shareholders.
 However, where gearing levels fluctuate significantly, or the finance for a new project carries a
significantly different level of risks from that of the existing company, there is good reason to seek
an alternative marginal cost of capital to establish the incremental financing costs of the new
project. This means calculating a marginal rate to the company of raising the additional capital to
finance the project.
MODULE 7
1 Which of the following can be used to calculate the return on investment?

Estimated average annual profits
I.  100%
Estimated total profits
II.  100%
III.  100%
A II only
B I and III only
C I, II and III
D none of the above
2 Investment in a project would include a requirement for $20 000 of working capital at the start of
Year 1, rising to $35 000 at the start of Year 2. The project would have a six-year life. In carrying out
a financial appraisal of this project, what would be the investment 'cash flows' for working capital?
Year 1 Year 2 Year 6
A –20 000 –35 000 +55 000
B +20 000 +35 000 –55 000
C –20 000 –15 000 +35 000
D +20 000 +15 000 –35 000
3 White Pty Ltd is about to carry out an investment appraisal on a project. If the project is
undertaken, a machine will be used that cost $300 000 when it was purchased two years ago and
has a current written down value of $250 000. If the project is not undertaken, the machine could
either be sold for $150 000 or used for another purpose. If it is used for another purpose, the
company will be spared the cost of acquiring a new machine for $220 000. However, some
improvements to the existing machine, costing $20 000, will be necessary.
What is the relevant cost of the machine for investment appraisal purposes?
A $150 000
B $200 000
C $250 000
D $300 000
4 A business uses both ROI and payback to assess its projects. Which one of the following is an
accurate statement of the nature of the project flows to be used in the relevant calculation?
ROI Payback
A after depreciation after depreciation
B before depreciation after depreciation
C after depreciation before depreciation
D before depreciation before depreciation
5 Cheshire has developed a revolutionary form of tyre gauge at a cost of $300 000 to date. To
produce the tyre gauge, a new machine will be acquired immediately at a cost of $750 000. The
machine will be sold at the end of the five years for $350 000 and will be depreciated over its life
using the straight-line method.
The tyre gauge has an expected life of five years and estimated future profits from the product are:
Years
1 2 3 4 5
$'000 $'000 $'000 $'000 $'000
Estimated profit 80 160 240 140 130
What is the payback period for the new tyre gauge? (To the nearest month)
A 3 years 2 months
B 4 years 2 months
C 4 years 3 months
D 4 years 11 months
6 What is the future value in four years' time of $10 000 invested today at a compound interest rate
of 4 per cent per annum?
MODULE 7
A $9600
B $10 400
C $11 600
D $11 699

1 C All three could be used, although I  100% is generally best
because it is an average of values.
2 C Working capital represents an investment in the project and therefore the initial requirement in
Year 1 is a negative cash flow of $20 000. In Year 2 we account for the incremental investment
only ($15 000). At the end of the project, Year 6, the total amount tied up in working capital is
released as a positive cash flow of $35 000.
3 B The best alternative use for the machine is to use it for another purpose, saving a net $220 000 –
$20 000 = $200 000, rather than selling it for $150 000. The project should therefore be charged
with the cost of this lost opportunity.
4 C ROI is based on profits after deducting depreciation. Depreciation is not a cash flow, and must
be ignored in the calculation of payback. The cash flows are therefore before deducting
depreciation.
5 A The payback period is calculated as follows:
Cash inflows
Year Annual Cumulative
$'000 $'000
1 160 160
2 240 400
3 320 720
4 220 940
5 560 1 500
The payback period is:
3 years + ((750 – 720) / (940 – 720)  12) = 3 years 2 months
6 D $10 000  1.044 = $11 699
1 Annual depreciation = $150 000 / 5 years = $30 000 per annum

Capital Working capital Net operating profit
Year expenditure investment after depreciation
$ $ $
0 (150 000) (15 000)
1 (20 000)
2 10 000
3 50 000
4 40 000
5 15 000 20 000
Total 100 000
Average 20 000
The average investment = $75 000 in non-current assets + $15 000 in working capital
= $90 000
MODULE 7
ROI = ($20 000 / $90 000)  100% = 22.2%
The project exceeds the target return of 15 per cent and would be undertaken.
2
Try 14% Try 16%
Time Cash flow Discount factor PV Discount factor PV
$ $ $
0 (4 000) 1.000 (4 000) 1.000 (4 000)
1 1 200 0.877 1 052 0.862 1 034
2 1 410 0.769 1 084 0.743 1 048
3 1 875 0.675 1 266 0.641 1 202
4 1 150 0.592 681 0.552 635
NPV 83 NPV (81)
The IRR must be less than 16 per cent, but higher than 14 per cent. The NPVs at these two costs of
capital will be used to estimate the IRR.
Using the interpolation formula:
 83 
IRR = 14% +
 83 + 81 × 16%  14%  = 15.01%
The project should be accepted as the IRR is more or less exactly the minimum return demanded.
It is therefore just acceptable, ignoring risk and uncertainty in the cash flow estimates
3 a.
Working
Capital capital Cash flow Net cash flow Cumulative
Year expenditure investment (profits) p.a. net cash flow
$ $ $ $ $
0 (150 000) (15 000) (165 000) (165 000)
1 10 000 10 000 (155 000)
2 40 000 40 000 (115 000)
3 80 000 80 000 (35 000)
4 70 000 70 000 35 000
5 15 000 50 000 65 000 100 000
35
The payback time is 3 years +  12 months = 3½ years
35 + 35
b. The project fails to pay back within the maximum permitted period of three years.
The project would not be undertaken.
4 Savings are 75 000  ($3 – $2.50) = $37 500 per annum.

Additional costs are $7500 per annum.
Net cash savings are therefore $30 000 per annum. (Remember, depreciation is not a cash flow and
must be ignored as a 'cost'.)
The first step in calculating an NPV is to establish the relevant costs year by year. All future cash
flows arising as a direct consequence of the decision should be taken into account. It is assumed
that the machine will be sold for $10 000 at the end of Year 4.
Year Cash flow Discount factor PV of cash flow
$ 12% $
0 (90 000) 1.000 (90 000)
1 30 000 0.893 26 790
2 30 000 0.797 23 910
3 30 000 0.712 21 360
4 40 000 0.636 25 440
NPV = +7 500
The NPV is positive and so the project is expected to earn more than 12 per cent per annum and is
therefore acceptable.
5 (1 + money rate) = (1 + real rate)  (1 + inflation rate)
Year 1: (1 + money) = (1 + 0.10)  (1 + 0.05)
(1 + m) = 1.155; m = 15.5%
Year 2: (1 + money) = (1 + 0.10)  (1 + 0.03)
(1 + m) = 1.133; m = 13.3%
Discount factors:
Time 1 = 1 / 1.155 = 0.866
Time 2 = 1 / 1.155  1 / 1.133 = 0.764
6
Working Years 1–4 Years 5–6
$ $
Profit before tax 25 000 25 000
Add back depreciation 20 000 20 000
Net cash inflow before tax 45 000 45 000
Less tax-allowable depreciation 30 000 –
Taxable cash flow 15 000 45 000
Tax at 30% 4 500 13 500
a. Years 1–4 Net cash inflow after tax $45 000 – $4500 = $40 500
b. Years 5–6 Net cash inflow after tax = $45 000 – $13 500 = $31 500
c. The cost of the equipment is $120 000 (6  annual depreciation or 4  annual capital allowance).
Net cash Discount Present value
Year flow factor of cash flow
$ 8% $
0 (120 000) 1.000 (120 000)
1 40 500 0.926 37 503
2 40 500 0.857 34 709
3 40 500 0.794 32 157
4 40 500 0.735 29 768
5 31 500 0.681 21 452
6 31 500 0.630 19 845
NPV 55 434
7
Time 0 1 2 3 4 5
Revenue 1 000 1 750 2 500 3 200
Direct costs (800) (1 100) (1 500) (1 600)
Marketing (170) (250) (200) (200)
Overheads (60%) (60) (60) (60) (60)
Operating cash flow (30) 340 740 1 340
Taxation @ 30% 9 (102) (222) (402)
Fittings and equipment (750) 200
Sale of business 4 300
Land and buildings (3 130)
Tax benefit of capital

allowances (W2) 56 42 32 35
Working capital (W3) (250) (50) (75) (25) 400
Net cash flow (4 130) (80) 330 655 6 050 (367)

7% discount factors 1 0.935 0.873 0.816 0.763 0.713
MODULE 7
Present value (4 130) (75) 288 534 4 616 (262)
NPV = + $971 000
Workings
1 Calculation of tax on profits:
Time 1 2 3 4
Operating profit ($000s) (30) 340 740 1 340
Time 2 3 4 5
Tax 9 (102) (222) (402)
2 Calculation of tax benefit of capital allowances:
Time 1 2 3 4
WDA ($000s) 188 141 105 116*
Time 2 3 4 5
Tax 56 42 32 35
* outlay – scrap proceeds – claims to date = 750 – 200 – 188 – 141 – 105 = 116
3 Calculation of working capital flows:
Time 0 1 2 3 4
W.Cap 250 300 375 400 0*
$000s (250) (50) (75) (25) 400
* normal assumption that working capital released at end of project

8 The PVs of the cash flows are as follows:
Discount PV of PV of PV of PV of
Year factor 8% plant cost running costs savings net cash flow
$ $ $ $
0 1.000 (7 000) (7 000)
1 0.926 (1 852) 5 556 3 704
2 0.857 (2 143) 5 999 3 856
(7 000) (3 995) 11 555 560
The project has a positive NPV and would appear to be worthwhile. Sensitivity of the project to
changes in the levels of expected costs and savings is as follows:
560
(a) Plant costs sensitivity =  100 = 8%
7000
560
(b) Running costs sensitivity =  100 = 14%
3995
560
(c) Savings sensitivity =  100 = 4.8%
11 555
9 The ratio of NPV at 10 per cent to outlay in Year 0 (the year of capital rationing) is as follows:
Outlay in
Project year 0 PV NPV Ratio Ranking
$ $ $
A 50 000 55 700 5 700 1.114 3rd
B 28 000 31 290 3 290 1.118 2nd
C 30 000 34 380 4 380 1.146 1st
Working
Present value A
Year Discount factor Present value
$ 10% $
1 Cash flow (20 000) 0.909 (18 180)
2 Cash flow 20 000 0.826 16 520
3 Cash flow 40 000 0.751 30 040
4 Cash flow 40 000 0.683 27 320
55 700
Present value B
$ 10% $
1 Cash flow (50 000) 0.909 (45 450)
2 Cash flow 40 000 0.826 33 040
3 Cash flow 40 000 0.751 30 040
4 Cash flow 20 000 0.683 13 660
31 290
Present value C
$ 10% $
1 Cash flow (30 000) 0.909 (27 270)
2 Cash flow 30 000 0.826 24 780
3 Cash flow 40 000 0.751 30 040
4 Cash flow 10 000 0.683 6 830
34 380
The optimal investment policy is as follows:

Ranking Project Year 0 outlay NPV
$ $
1st C 30 000 4 380
2nd B 28 000 3 290
3rd A (balance) 2 000 (4% of 5700) 228
NPV from total investment = 7 898
209
MODULE 8
MARKET AND CREDIT RISK
MANAGEMENT
Describe the characteristics of derivatives and other hedging instruments LO8.1
Apply different methods of managing currency risks LO8.2
Select methods of managing interest rate exposure LO8.3
Identify the advantages and disadvantages of different hedging strategies LO8.4
Identify different methods of hedging which are appropriate to meeting an LO8.5

organisation's objectives
Topic list
1 Financial instruments and derivatives

2 Managing credit risk
3 Managing foreign exchange risk
4 Managing interest rate risk
5 Hedging, speculation and arbitrage
MODULE OUTLINE
This module builds on knowledge acquired in Module 3 where we considered the various risks facing
a business and introduced some of the techniques that can be applied to manage these risks. In this
module we examine how credit risk can be managed as well as the use of derivatives as a tool for
transferring risk. We shall also consider the costs and benefits of some of the key products you will
come across on the Australian Stock Exchange (ASX).
Credit risk
Market and credit • Credit assessment of new
risk management customers
• On-going credit assessment of
existing customers
• Management of receivables
• Early settlement agreements
• Credit insurance
• Factoring
Financial instruments • Documentary credits
Secondary • Forfaiting
• Countertrade
Derivatives – value derived from

Primary an underlying asset:
• Have a measurable value • Futures and forward contracts
• Options
• Warrants
Include
• Shares
• Bonds
• Cash deposits Relative costs and benefits
• Receivables
Uses
• Hedging
• Speculation
• Arbitrage
MARKET AND CREDIT RISK MANAGEMENT | 211
BEFORE YOU BEGIN
area.
everything covered.
1 What is a financial instrument? (Section 1)
2 What is debt factoring? (Section 2.2.3)
3 Explain what a currency futures contract is? (Sections 3.7)
4 How can matching and smoothing manage interest rate risk? (Section 4.1)
5 What is arbitrage? (Section 5.3)
MODULE 8
1 FINANCIAL INSTRUMENTS AND DERIVATIVES
LO
 Financial instruments are contracts that give rise to both a financial asset for one party to
the contract and a financial liability or equity instrument by the other party to the contract.
 Primary financial instruments are those that have an associated, measurable value such as
equity shares, corporate bonds, loans, cash deposits, and receivable balances.
 Secondary financial instruments often referred to as derivatives, are financial instruments
whose value is derived from an underlying asset. Examples include forward contracts,
futures, options and swaps.
 Derivatives are essentially tools for transferring risk, and offer the opportunity to diminish or
increase exposure to uncertain events.
Definition
A financial instrument is a contract that gives rise to a financial asset for one party to the contract and
a financial liability or equity instrument for the other party (the counterparty).
The term 'financial instrument' covers a range of contracts, which can be spilt into two main types:
primary and secondary.
Primary financial instruments include things such as shares, bonds, currencies and interest rates.
These instruments are defined as primary by the fact that they have an associated, measurable value.
Secondary financial instruments often referred to as derivatives, are financial instruments whose
value is derived from an underlying asset. Examples include futures, forward contracts, options and
warrants.
Definition
Secondary financial instruments, or derivatives are financial instruments that derive their value from
the price or actual value of an underlying asset or item.
As we saw in Module 3, some of the risks facing a business arise because of changes in the prices of
currency, interest rates or commodities. Such changes increase the variability of profits and are borne
by the investor in the sense that they will cause the share price to change.
Definition
A future is a standardised contract, which may be traded or exchanged, to buy or sell a specific
amount or value of an asset in the future at a set price, for delivery and payment on a set date.
Futures were some of the first derivatives, the asset underlying the instrument normally being a
commodity such as gold, coffee, oil or sugar. As the markets became more sophisticated, financial
futures were developed and traded, with the underlying financial assets typically being bonds, shares
and currencies.
Index futures can be used to protect against a fall in the value of a portfolio of shares. These are useful
to investors with significant investments (e.g. pension funds and are an alternative to managing the
value of the portfolio by buying and selling the shares within it).
ASX offers four types of index future, three of which are based on the SPI 200 Index of the top 200
companies and the last of which is based on the SPI 50 Index of the top 50 companies.
Definitions
A forward contract, like a future, is a binding promise to purchase or sell a set amount or value of an
underlying asset at a set future time. Unlike a future, forwards are not traded; they are bespoke
contracts between two parties.
Options are the right but not the obligation to purchase (a call option) or sell (a put option) an
underlying asset at a set price but at a future date.
A European option has to be exercised at a fixed date in the future.
An American option can be exercised at any point in time up to the expiry date of the option.
Options convey 'the right but not the obligation' to the holder and therefore provide more flexibility
than a futures contract. The key difference is that the holder of the option has a choice and can:
 exercise their right to buy or sell at a pre-determined price, or
 let the option lapse.
We shall look further at derivatives later on in this module.
2 MANAGING CREDIT RISK
LO
 We saw in Module 3 that credit risk is the possibility of payment default by a customer. In
other words, it is the possibility that a customer will not pay for the goods or services they
have received.
 It can be assessed using experience, industry data or by the assessment of individual
MODULE 8
customers to build up an aggregate picture of the risk.
 Credit risk can be managed through careful management of the accounts receivable
balances and through various mechanisms to collect debts that are due.
2.1 IDENTIFICATION AND ASSESSMENT OF CREDIT RISK

The identification of credit risk is a fairly straightforward process. The business’ accounts receivable
balances represent the amounts that the business is owed by its customers and this represents the
maximum amount of credit risk (if all customers fail to pay).
However, it most instances, the actual amount of credit risk is far lower (usually a few per cent of the
total accounts receivable balance) because in reality the majority of customers will pay what they owe,
either upfront, or by availing themselves of the payment terms provided by a business.
A company can assess their credit risk in a number of ways. Firstly, established businesses will know
from experience the levels of bad debt that they can expect (either as an overall amount that they
have to write off every month, or for example, as a percentage of its sales). Secondly, certain levels of
bad debt are typical for certain industries and therefore a business can use such industrial data to
assess their overall risk. Such data is especially useful for business that are relatively new.
A business can be more scientific in its approach to assessing its credit risk by assessing the
creditworthiness of each customer individually. The organisation might devise a credit-rating system
based on an assessment of a customer’s creditworthiness (see below). Points or ratings would be
awarded on the basis of this assessment, for example a customer with a low score might be deemed a
low credit risk and a high score might indicate a high credit risk. The business could use this to
estimate the likelihood of a customer’s debt becoming bad and aggregate these results to calculate
the overall credit risk.
2.1.1 ASSESSING CREDITWORTHINESS

Although an assessment of creditworthiness can be done at any time (as part of the continuing control
of credit customers), it is usually performed as an initial investigation into potential credit customers
before they are granted credit in the first place.
Common parts of such an assessment include:
 A review of references. New customers might be required to provide two good financial
references, including one from a bank.
 A customer’s formal credit rating is checked through a credit rating/reference agency.
 Financial review. A file should be maintained containing any available financial information about
the customer (such as its annual report and accounts). This file should be reviewed regularly.
 Government advice. Government departments can sometimes provide information on overseas
companies.
 A review of the financial news. Press comments may give information about what a company is
currently doing and whether they are in difficulty.
 A site visit. The company could send a member of staff to visit the company concerned, to get a
first-hand impression of the company and its prospects. This would be advisable in the case of a
prospective major customer.
Depending on the new customer's assessed credit worthiness the resulting credit limit should
ideally be fixed at a low level and only increased if their payment record subsequently warrants it.
2.2 MANAGEMENT OF CREDIT RISK

There are two aspects to the management of credit risk. Firstly, the management of accounts
receivable to ensure the level of credit granted to customers is appropriate. Secondly, where credit
has already been granted, steps must be taken to ensure that it is collected.
2.2.1 MANAGING ACCOUNTS RECEIVABLE

If a customer passes an initial assessment of creditworthiness and are granted credit, their account
should be regularly reviewed and assessed to determine whether the level of credit offered is still
acceptable.
A customer's payment record and the accounts receivable aged analysis should be examined
regularly. Breaches of the credit limit, or attempted breaches of it, should be brought immediately to
the attention of the credit controller.
The overall accounts receivables balance can be reviewed in aggregate, this can reveal the following.
 the number of customers who might want more credit
 the extent to which the company is exposed to accounts receivable
 the 'tightness' of the credit policy (It might be possible to increase profitable sales by offering
credit. On the other hand, perhaps the firm offers credit too easily.)
It is possible to design credit utilisation reports to highlight other trends.
 the degree of exposure to different countries
 the degree of exposure to different industries (some countries or industries may be worthy of more
credit; others may be too risky).
Credit utilisation can also be analysed by industry within country or by country within industry. It is also
useful to relate credit utilisation to total sales.
2.2.2 MANAGING AMOUNTS OWING

The golden rule that should be applied in the management of amounts owing to a company is that
the benefits of an action to collect debts must be greater than the costs incurred.
The overall debt collection policy of the business should be such that the administrative costs and
other costs incurred in debt collection do not exceed the benefits from incurring those costs. Beyond
a certain level of spending, however, additional expenditure on debt collection would not have
enough of an effect on bad debts or on the average collection period to justify the extra
administrative costs.
2.2.3 COLLECTING DEBTS

There are a number of methods that a business can use to encourage customers to pay or collect their
debts.
Early settlement discounts involve offering the customer a reduction in what they owe if they pay
early. These kind of discounts may be employed to shorten average credit periods and to reduce the
investment in accounts receivable. To see whether the offer of a settlement discount (for early
payment) is financially worthwhile the business must compare the cost of the discount with the benefit
of a reduced investment in accounts receivable.
Credit insurance. Companies may be able to obtain credit insurance against certain approved debts
going bad through a specialist credit insurance firm. A company cannot insure against all its bad debt
losses, but may be able to insure against losses above a 'normal' level.
When a company arranges credit insurance, it must submit specific proposals for credit to the
insurance company, stating the name of each customer to which it wants to give credit and the
amount of credit it wants to give. The insurance company will accept, amend or refuse these
proposals, depending on its assessment of each of these customers.
Factoring. Some companies use factoring to improve liquidity or to reduce administration costs.
Factoring is an arrangement to have debts collected by a factor company, which advances a
proportion of the money it is due to collect.
2.2.4 COLLECTING FOREIGN DEBTS

The collection of foreign debts can be problematic due to a number of factors such as culture,
MODULE 8
language, time and distance from the business. However there are a number of solutions to this
problem.
Documentary credits ('letters of credit') provide a method of payment which gives the exporter a
secure risk-free method of obtaining payment. A documentary credit arrangement must be made
between the exporter, the buyer and participating banks before the export sale takes place.
Forfaiting is a method of export finance whereby a bank purchases from a company a number of sales
invoices, usually obtaining a guarantee of payment of the invoices. It is the most common method of
providing medium-term (say, three to five years) export finance. It has normally been used for export
sales involving capital goods (such as machinery), where payments will be made over a number of
years. It is usually available for large amounts (over $250 000), but only in the major convertible
currencies.
Countertrade is a means of financing trade in which goods are exchanged for other goods. Three
parties might be involved in a 'triangular' deal. Countertrade is thus a form of barter and can involve
complex negotiations and logistics. One of the main problems with countertrade is that the value of
the goods received in exchange may be uncertain.
Export credit insurance is insurance against the risk of non-payment by foreign customers for export
debts.
3 MANAGING FOREIGN EXCHANGE RISK
LO
 There are different ways of managing transaction exposures. These include matching
receipts and payments, leading and lagging, forward exchange contracts and money
market hedges.
 Derivatives such as futures and options can also be used to manage foreign currency
movements.
A company can reduce or eliminate its transaction exposures in various ways. These include:
 buy or sell in domestic currency
 matching receipts and payments
 leading and lagging
 matching assets and liabilities in a currency
 forward exchange contracts
 money market hedges
 foreign currency derivatives (futures and options).
3.1 CURRENCY OF INVOICE: BUY OR SELL IN DOMESTIC CURRENCY

One way of avoiding exchange risks is to buy or sell in the domestic currency. This could require:
 an exporter to invoice foreign customers in the exporter's domestic currency, or for
 an importer to arrange with their foreign suppliers to be invoiced in their domestic currency.
However, although either the exporter or the importer can avoid exchange risk in this way, only one
party in the transaction can deal in their domestic currency. The other must accept the exchange risk.
If an Australian exporter is able to invoice an overseas buyer in Australian dollars, the foreign
exchange risk is transferred to the overseas buyer. Similarly, an Australian-based importer might
persuade an overseas supplier to invoice in Australian dollars rather than in a foreign currency, and in
this way the currency risk would be borne by the foreign supplier.
An alternative method of achieving the same result is to negotiate contracts expressed in the foreign
currency but specifying a fixed rate of exchange as a condition of the contract.
The main disadvantage of this method of managing risk is the possibility of losing business in foreign
markets.
There are certain advantages in invoicing in a foreign currency which might persuade an exporter to
take on the exchange risk.
 There is the possible marketing advantage by proposing to invoice in the buyer's own currency,
when there is competition for the sales contract.
 The exporter may also be able to offset payments to their own suppliers in a particular foreign
currency against receipts in that currency.
 By arranging to sell goods to customers in a foreign currency, a UK exporter might be able to
obtain a loan in that currency at a lower rate of interest than in the UK, and at the same time
obtain cover against exchange risks by arranging to repay the loan out of the proceeds from the
sales in that currency.
In some export markets, foreign currency (often the US dollar) is the normal trading currency, and so
Australian exporters might have to quote prices in that currency for customers to consider buying from
them.
3.2 MATCHING RECEIPTS AND PAYMENTS

A company that buys and sells in the same currency, or borrows and lends in the same currency, can
reduce or eliminate its foreign exchange transaction exposure by matching receipts and payments.
Wherever possible, a company expecting to make payments and to have receipts in the same foreign
currency should plan to offset its payments against its receipts in the currency. Since the company will
be setting off foreign currency receipts against foreign currency payments, it does not matter whether
the currency strengthens or weakens against the company's 'domestic' currency because there will be
no purchase or sale of the currency.
For example, suppose that an Australian company expects to have to pay £100 000 to a UK supplier in
one month's time, and to receive a payment of £125 000 at about the same time. It can plan to use the
money received to make the payment, which means that it has a net transaction exposure of only
£25 000 of sterling income.
The process of matching currency receipts and payments, sometimes known as offsetting receipts
and payments, is made simpler by having foreign currency accounts with a bank. Receipts of foreign
currency can be credited to the account pending subsequent payments in the currency.
Offsetting receipts and payments should be used to manage the currency risk wherever possible. It is
important to note that since a company is unlikely to have exactly the same amount of receipts in a
currency as it makes payments, it will still be exposed to the extent of the surplus income or payment.
3.3 LEADING AND LAGGING

Companies may elect to use:
 lead payments (payments in advance), or
 lagged payments (delaying payments beyond their due date)
in order to take advantage of foreign exchange rate movements.
For example, suppose that an Australian company has to make a payment of USD 150 000 in two
MODULE 8
months' time, but at the current spot rate, US dollars are very cheap. The company might therefore
decide to make the payment earlier, taking advantage of the current exchange rate to obtain the US
dollars for a low price in Australian dollars. On the other hand, when a company has to make a
payment in a foreign currency, the currency might seem over-priced at the current exchange rate. The
company might decide to delay (lag) the payment in the hope that the exchange rate will change and
the foreign currency will fall in value.
With a lead payment, paying in advance of the due date, there is a finance cost to consider. This is
the interest cost on the money used to make the payment earlier than its due date, however early
settlement discounts may be available from the supplier to offset.
3.4 MATCHING ASSETS AND LIABILITIES

A company that expects to receive a substantial amount of income in a foreign currency at some time
in the future will be concerned that this currency may weaken in value.
It can manage the risk by borrowing in the foreign currency and using the eventual currency receipts
to repay the loan.
For example, an Australian company with US dollar receivables can manage its exposure to a fall in
the value of the US dollar by taking out a US dollar overdraft. Similarly, suppose that an Australian
company has a large investment in shares in a US company, on which it regularly receives dividends.
The company can manage its exposure to a fall in the value of the US dollar against the Australian
dollar by taking out a US dollar loan and using the US dollar dividend income to make the interest
payments on the loan.
A company which has a long-term foreign investment, for example an overseas subsidiary, will similarly
try to match its foreign assets (property, plant etc) by a long-term loan in the foreign currency.
3.5 FORWARD EXCHANGE CONTRACTS

Definition
A forward exchange contract is a binding agreement to buy or sell a quantity of one currency in
exchange for another, at a future date, and at a rate of exchange that is fixed in the contract.
A widely-used method of managing transaction risk is the forward exchange contract. A forward
contract is a contract made now to buy or sell currency at a future date, at a rate of exchange that is
fixed now. The trader will know in advance either how much local currency they will receive (if they are
selling foreign currency to the bank) or how much local currency they must pay (if they are buying
foreign currency from the bank) and therefore eliminates any risk of exchange rate movements up to
the time that the transaction takes place.
A forward exchange contract is:
 an immediately firm and binding contract between a bank and its customer (or between two banks)
 for the purchase or sale of a specified quantity of a stated currency, in exchange for another stated
currency
 at a rate of exchange fixed at the time the contract is made
 for performance (settlement of the contract) at a future time, which is agreed when making the
contract. This future time will be either a specified date, or any time between two specified dates.
3.5.1 IMPLICATIONS OF USING FORWARD CONTRACTS

A forward contract is a binding contract. Once made, both parties are legally obliged to perform their
obligations, and settle the transaction at the agreed settlement date. This means that a forward
exchange contract can be used to manage currency risks by fixing the rate 'now' and preventing
unforeseen losses from adverse changes in the exchange rate between 'now' and the future date
when the currency transaction is required.
At the same time, it means that if the exchange rate moves the other way, in a favourable direction, it
is also impossible to benefit from any profit arising from the unforeseen change in the exchange rate
after the forward transaction has been made.
Even so, a manager might prefer to avoid an unforeseen loss by fixing the exchange rate now, even if
this means having to forgo an unexpected profit in the event of a favourable movement in the spot
rate. Risk management is not about maximising profit, it is about controlling the risk.
Worked Example: Forward exchange contract
An Australian importer knows on 1 April that they must pay a foreign seller 26 500 Hong Kong dollars
in one month's time, on 1 May. They can arrange a forward exchange contract with a bank on 1 April,
whereby the bank undertakes to sell the importer 26 500 Hong Kong dollars on 1 May, at a fixed rate
of 8.24.
The importer can be certain that whatever the spot rate on 1 May, they will have to pay on that date:
26 500
= $3216
8.24
If the spot rate on 1 May is lower than 8.24, the importer would have successfully protected the
transaction against a weakening of the Australian dollar, and would have avoided paying more to
obtain the HK dollars. If the spot rate is higher than 8.24, the Australian dollar's value against the HK
dollar would mean that the importer would pay more under the forward exchange contract than they
would have had to pay to obtain the HK dollars at the spot rate on 1 May. The importer cannot avoid
this extra cost however, because a forward contract is binding.
3.5.2 WHAT HAPPENS IF A CUSTOMER CANNOT SATISFY A FORWARD CONTRACT?

A customer might be unable to satisfy a forward contract for any one of a number of reasons.
 An importer might find that:
– the supplier fails to deliver the goods as specified, so the importer will not accept the goods
delivered and will not agree to pay for them
– the supplier sends fewer goods than expected, perhaps because of supply shortages, and so
the importer has less to pay for
– the supplier is late with the delivery, and so the importer does not have to pay for the goods
until later than expected.
 An exporter might find the same types of situation, but in reverse, so that they do not receive any
payment at all, receive more or less than originally expected, or receive the expected amount, but
only after some delay.
If a customer cannot satisfy a forward exchange contract, the bank will make the customer fulfil the
contract.
 If the customer has arranged for the bank to buy currency but then cannot deliver the currency for
the bank to buy, the bank will:
– sell currency to the customer at the spot rate (when the contract falls due for performance)
– buy the currency back, under the terms of the forward exchange contract.
 If the customer has contracted for the bank to sell him currency, the bank will:
– sell the customer the specified amount of currency at the forward exchange rate
– buy back the unwanted currency at the spot rate.
Therefore, the bank arranges for the customer to fulfil the forward exchange contract by either selling
or buying the 'missing' currency at the spot rate. These arrangements are known as closing out a
forward exchange contract.
Question 1: Fixing exchange rates
MODULE 8
An Australian company wants to borrow $1 000 000 for one year. The cost of borrowing Australian
dollars would be 6 per cent. The company finance director has noticed, however, that the company
could borrow in Japanese yen (JPY) at an interest rate of just 1 per cent. The current spot rate for
dollar/yen is AUD 1.00 = JPY 87. The one year forward rate is AUD 1.00 = JPY 83.
Would it profit the company to borrow in yen for one year, and fix the cost of paying interest and
repayment of the loan principal in one year's time by arranging a forward contract to fix the exchange
rate at which it will buy the necessary yen in a year's time?
3.6 MONEY MARKET HEDGE

A further method of managing currency risk is to use a money market hedge. This involves taking
advantage of different interest rates in different countries.
Money market hedging involves borrowing in one currency, converting the money borrowed into
another currency and putting the money on deposit until the time the transaction is completed,
hoping to take advantage of favourable exchange rate movements.
Worked Example: Money market hedge
An Australian business is due to receive USD 100 000 in 6 months' time for goods sold to a US
customer.
The spot rate is 1.0970 – 1.0990.
Interest rates in Australia and the US are as follows:

Borrow Lend
US 8% 7%
Australia 6% 5%
The first step is for the company to borrow enough US dollars now to ensure that this borrowing plus
interest for six months will equal USD 100 000 in six months’ time. The annual borrowing rate for US
dollars is 8 per cent therefore we will use 4 per cent for six months giving the amount that the business
will borrow as:
USD 100 000 / 1.04 = USD 96 154
This borrowed amount of US dollars will then be converted into Australian dollars at the current spot
rate:
USD 96 154 / 1.0990 = AUD 87 492
This amount will then be invested at the Australian interest rate for six months (5% / 2 = 2.5%) and at
the end of the six month period will be worth:
AUD 87 492  1.025 = AUD 89 679
When the US$100,000 is received in six months' time this will be used to pay off the US dollar loan of
USD 96 154 which with interest will then amount to USD 100 000.
In this way the company will know in advance that the net Australian dollar receipt will be AUD 89 679
rather than waiting for six months to see what the exchange rate is.
3.6.1 CHOOSING BETWEEN A FORWARD CONTRACT AND A MONEY MARKET HEDGE

When a company expects to receive or pay a sum of foreign currency in the next few months, it can
choose between using the forward exchange market and the money market to manage foreign
exchange risk. Other methods may also be possible, such as making lead payments. The choice is
generally made on the basis of which method is cheaper, with other factors being of limited
significance.
We shall consider hedging further in Section 5.
3.7 FOREIGN CURRENCY DERIVATIVES

Foreign currency derivatives such as currency futures and options can also be used to manage foreign
currency risk.
3.7.1 CURRENCY FUTURES

Definition
Currency futures are standardised contracts for the sale or purchase at a set future date of a set
quantity of currency.
A currency future is essentially a standardised, market-traded forward exchange contract.

A future represents a commitment to an additional transaction in the future that limits the risk of
existing commitments. Currency futures are not nearly as common as forward contracts, and their
market is much smaller.
Advantages of futures to manage risks
 Transaction costs should be lower than other methods.
 Futures are tradeable and can be bought and sold on a secondary market so there is pricing
transparency, unlike forward contracts where prices are set by individual financial institutions.
 The exact date of receipt or payment of the currency does not have to be known, because the
futures contract does not have to be closed out until the actual cash receipt or payment is made.
Disadvantages of futures
 The contracts are in standard sizes and cannot be tailored to the user's exact requirements.
 Only a limited number of currencies are the subject of futures contracts (although the number of
currencies is growing, especially with the rapid development of Asian economies).
 Unlike options (see below), they do not allow a company to take advantage of favourable currency
movements.
3.7.2 CURRENCY OPTIONS

Currency options protect against adverse exchange rate movements while allowing the investor to
take advantage of favourable exchange rate movements. They are particularly useful in situations
where the cash flow is not certain to occur (e.g. when tendering for overseas contracts).
Definition
A currency option is a right of an option holder to buy (call) or sell (put) foreign currency at a specific
exchange rate at a future date.
The exercise price for the option may be the same as the current spot rate, or it may be more
favourable or less favourable to the option holder than the current spot rate.
A key aspect of an option is it conveys a right but not an obligation. Thus the option holder has the
choice between:
 exercising the right to buy or sell currency at the agreed price on a specified future date
 not exercising the right and letting the option lapse (if the exchange rate in the future is more
favourable than the exercise price).
Compared to a futures contract, the option protects the holder from adverse movements in exchange
rates while letting them take advantage of favourable movements.
MODULE 8
Buying a currency option involves paying a premium for this flexibility, which is the most the buyer
of the option can lose.
Companies can choose whether to buy:
 a tailor-made currency option from a bank, suited to the company's specific needs. These are over-
the-counter (OTC) or negotiated options, or
 a standard option, in certain currencies only, from an options exchange. Such options are traded
or exchange-traded options.
The purpose of currency options
The purpose of currency options is to reduce or eliminate exposure to adverse currency risks, and they
are particularly useful for companies in the following situations:
(a) where there is uncertainty about foreign currency receipts or payments, either in timing or amount;
if the foreign exchange transaction does not occur, the option can be sold on the market (if it has
any value) or exercised if this would make a profit
(b) to support the tender for an overseas contract, priced in a foreign currency
(c) to allow the publication of price lists for its goods in a foreign currency
(d) to protect the import or export of price-sensitive goods.
In both situations (b) and (c), the company would not know whether it had won any export sales or
would have any foreign currency income at the time that it announces its selling prices. It cannot make
a forward exchange contract to sell foreign currency without becoming exposed in the currency.
Drawbacks of currency options
 The cost depends on the expected volatility of the exchange rate.
 Options must be paid for as soon as they are bought.
 Tailor-made options lack negotiability.
 Traded options are not available in every currency.
We shall look at futures and options in more detail in Section 5.
4 MANAGING INTEREST RATE RISK
LO
 Interest rate risk can be managed within an organisation by matching and smoothing or
using external instruments such as forward rate agreements, interest rate swaps and
derivatives (futures and options).
4.1 MATCHING AND SMOOTHING

Matching and smoothing are two methods used to internally manage interest rate risk.
Definition
Matching is where liabilities and assets with a common interest rate are matched.
For example subsidiary A of a company might be investing in the money markets at LIBOR and
subsidiary B is borrowing through the same market at LIBOR. If LIBOR increases, subsidiary B's
borrowing cost increases and subsidiary A's returns increase. The interest rates on the assets and
liabilities are therefore matched.
This method is most widely used by financial institutions such as banks, who find it easier to match the
sizes and characteristics of their assets and liabilities than commercial or industrial companies.
Definition
Smoothing is where a company keeps a balance between its fixed rate and floating rate borrowing.
A rise in interest rates will make a floating rate loan more expensive but this will be compensated for
by the less expensive fixed rate loan. The company may however incur increased transaction and
arrangement costs.
4.2 FORWARD RATE AGREEMENTS (FRAS)

Forward rate agreements manage risk by fixing the interest rate on future borrowing.
A company can enter into an FRA with a bank that fixes the rate of interest for borrowing at a certain
time in the future. If the actual interest rate proves to be higher than the rate agreed, the bank pays
the company the difference. If the actual interest rate is lower than the rate agreed, the company pays
the bank the difference. The FRA does not need to be with the same bank as the loan as the FRA is
independent of any loan agreement.
The interest rates which banks will be willing to set for FRAs will reflect their current expectations of
interest rate movements. If it is expected that interest rates are going to rise during the term for which
the FRA is being negotiated, the bank is likely to seek a higher fixed rate of interest than the variable
rate of interest which is current at the time of negotiating the FRA.
An advantage of FRAs is that, for the period of the FRA at least, they protect the borrower from
adverse market interest rate movements to levels above the rate negotiated for the FRA. With a
normal variable rate loan (for example, linked to a bank's base rate or to LIBOR) the borrower is
exposed to the risk of such adverse market movements. On the other hand, the borrower will not
benefit from the effects of favourable market interest rate movements.
4.3 INTEREST RATE SWAPS

Definition
Interest rate swap is an agreement whereby the parties to the agreement exchange interest rate
commitments.
Interest rate swaps are where two parties agree to exchange interest rate payments. In practice,
however, the major players in the swaps market are banks and many other types of institution can
become involved, for example national and local governments and international institutions.
In the simplest form of interest rate swap, party A agrees to pay the interest on party B's loan, while
party B reciprocates by paying the interest on A's loan. If the swap is to make sense, the two parties
must swap interest which has different characteristics. Assuming that the interest swapped is in the
same currency, the most common motivation for the swap is to switch from paying floating rate
interest to fixed interest or vice versa, raising less expensive loans and securing better deposit rates.
Obvious questions to ask are:
 Why do the companies bother swapping interest payments with each other?
 Why don't they just terminate their original loan and take out a new one?
The answer is that transaction costs may be too high. Terminating an original loan early may involve a
significant termination fee and taking out a new loan will involve issue costs. Arranging a swap can be
significantly cheaper, even if a banker is used as an intermediary. Because the banker is simply acting
as an agent on the swap arrangement and has to bear no default risk, the arrangement fee can be
kept low.
In view of this flexibility, the seller or writer of the option receives a sum of money, the option
premium, in consideration for granting the option purchaser the rights associated with the option.
MODULE 8
4.4 INTEREST RATE FUTURES
Interest rate futures work in a similar way to currency futures and can be used to manage interest rate
changes between the current date and the date at which the interest rate on the lending or borrowing
is set. Borrowers sell futures to protect against interest rate rises; lenders buy futures to protect
against interest rate falls.
Interest rate futures are similar in effect to FRAs, except that the terms, amounts and periods are
standardised. As a result it is not always possible to achieve an exact match with the underlying
interest rate exposure.
4.5 INTEREST RATE OPTIONS

Interest rate options allow an organisation to limit its exposure to adverse interest rate movements,
while allowing it to take advantage of favourable interest rate movements.
Definition
An interest rate option grants the buyer of it the right, but not the obligation, to deal at an agreed
interest rate (strike rate) at a future maturity date. On the date of expiry of the option, the buyer must
decide whether or not to exercise the right.
Clearly, a buyer of an option to borrow will not wish to exercise it if the market interest rate is now
below that specified in the option agreement. Conversely, an option to lend will not be worth
exercising if market rates have risen above the rate specified in the option by the time the option has
expired.
The cost of the option is the 'premium'. Interest rate options offer more flexibility than and are more
expensive than FRAs.
Worked Example: Options
Say an investor knows that they will have a cash surplus available in three months time which they wish
to use to buy shares in company Z. The current share price of company Z is $1.90 but the investor is
concerned that the price may rise in the future. The investor could therefore purchase a call option,
giving the right to purchase shares in company Z for say $2.00 (the exercise price).
If the actual share price in three months rises to $2.20, the investor will use the option to purchase the
shares at an option price of $2.00. The option is said to have an intrinsic value of $0.20 as this is the
gain that could be made by immediately selling the shares.
If the share price falls to $1.80, the investor will let the option lapse and purchase shares on the open
market at the market price of $1.80.
4.5.1 INTEREST RATE CAPS, COLLARS AND FLOORS

Various cap and collar agreements are possible.
 An interest rate cap is an option which sets an interest rate ceiling.
 A floor is an option which sets a lower limit to interest rates.
 Using a 'collar' arrangement, the borrower can buy an interest rate cap and at the same time sell
an interest rate floor. This limits the cost for the company as it receives a premium for the option it
has sold.
The cost of a collar is lower than for buying an option alone. However, the borrowing company
forgoes the benefit of movements in interest rates below the floor limit in exchange for this cost
reduction and an investing company forgoes the benefit of movements in interest rates above the
cap level.
4.6 ADVANTAGES AND DISADVANTAGES OF FUTURES AND OPTIONS

The objective of a futures contract is to remove the risk associated with price fluctuations by fixing the
price. The benefit is that the downside risk of adverse price movements is eliminated. However, the
disadvantage is that any upside risk of favourable price movements is removed.
The other disadvantage of futures contracts is that they are traded in standardised amounts and only
whole contracts can be bought or sold. For example, one coffee futures contract is 10 tonnes, so it is
not always possible to cover the exact size of the transaction.
Unlike futures, forward contracts are made between two parties and can be tailored to their exact
requirements, however cancellation requires agreement of both parties.
Therefore, options have an advantage over futures because they offer the opportunity to minimise the
downside risk of adverse price movements, while providing the potential to share in any upside (i.e.
favourable price movements).
4.7 WARRANTS
Warrants are financial instruments issued by banks, governments and other institutions, which are
traded on the ASX. Warrants may be issued over securities (such as shares), a basket of different
securities, a share price index, debt, currencies, or commodities.
Some give holders the right to buy, or to sell the underlying instrument (e.g. a share) to the warrant
issuer for a particular price according to the terms of issue.
Others entitle holders to receive a cash payment relating to the value of the underlying instrument at a
particular time (e.g. index warrants).
Warrants may only be issued by a bank or other financial institution approved by the ASX as a warrant
issuer.
Warrants are similar to long term options where the holder has the right to purchase the underlying
security at a fixed price for a fixed period of time.
Definitions
A call warrant gives the warrant holder the right to buy the underlying asset from the warrant issuer.
A put warrant gives the warrant holder the right to sell the underlying asset to the issuer.
The price of the warrant is determined by the price of the underlying asset, and market conditions at
the time.
A warrant works on the same principle as an option.
Worked Example: Warrants
Suppose an investor holds an American 3 month call warrant over X Ltd's shares, at an exercise price
of $1.55. The current share price is $1.50. The investor has the right to purchase a share in X Ltd at any
time in the next three months at $1.55. At the point of issue the warrant has no value. If the share price
rises to $1.65 the warrant is clearly valuable as the holder can purchase a share at $1.55 and sell it
immediately in the market for $1.65. This is known as the intrinsic value.
The range of financial instruments traded as warrants has evolved over time and covers a wide
spectrum of risk profiles, investment objectives and likely returns. They are broadly split into trading
style warrants and investment style warrants.
Trading-style warrants are frequently traded and relatively short-dated. Trading warrants can be used
to manage risk on an investment portfolio but are predominantly used for short term speculative
purposes. They have a higher risk/return profile compared to the investment-style warrants. Index
warrants, currency warrants and equity warrants usually fall within this category.
Investment-style tend to be longer dated and are less frequently traded. They have a lower risk/return
profile and often have a higher initial outlay compared to trading-style warrants. Endowments and
structured investment products are investment-style products.
MODULE 8
4.8 COMPARING WARRANTS AND OPTIONS
Similarities between warrants and options include:
 both are traded on ASX
 options and warrants are both based on an underlying asset (e.g. shares)
 the buyer must pay a premium up-front
 can only be exercised at a pre-determined price
 can be exercised any time before a pre-determined date (American style) or at expiry (European
style).
The major differences between options and warrants are as follows:
 The broader range of warrant products available.
 The longer potential lifetime of the products which range from three months to 15 years as
compared to Index options (up to 18 months) and Equity options (up to five years).
 Because warrants are not a standardised product like exchange traded options, there is the
flexibility to tailor products to suit quite specific investor needs.
5 HEDGING, SPECULATION AND ARBITRAGE
LOs
8.5
 There are three main uses for derivatives: risk management (hedging), speculation, and
arbitrage.
Over the years the growth in the form and use of derivative instruments has been immense. The
characteristics of the different types of derivatives are often very specific and make them suited to
different purposes.
There are many users of derivatives, who can be classified in terms of the roles that they perform (e.g.
company treasurers, traders, investment managers among others).
There are three main reasons for employing a derivative instrument:
 risk management and hedging
 speculation
 arbitrage
5.1 RISK MANAGEMENT AND HEDGING

Definition
A hedge is a transaction to reduce or eliminate an exposure of risk.
Hedging, sometimes called exposure management, is a form of risk management used by companies
to offset a variety of market risks. In essence, the company is trying to reduce the volatility, or increase
the predictability of its profits and/or cash flows. To achieve this a company can use derivatives to
offset adverse changes in underlying assets.
For example, consider an Australian company planning on acquiring a large piece of machinery from a
foreign manufacturer, priced at USD 1 million. If the exchange rate rises they will incur significant extra
costs. The company may choose to hedge in order to manage some of this risk and, depending on
their appetite for risk, may choose to use a forward contract or futures.
The basic idea is that a company uses financial instruments to transfer the risk they are trying to
manage, via the market, to those with a higher appetite for risk. In other words, a hedge is an
insurance against some or all of the risk associated with a particular business activity. When using a
hedge, the instruments chosen often have an inverse relationship to the movements of the hedged
transaction.
For example, consider a fund that has invested in stocks, and the fund manager expects the market to
go down in the near-term. If the market does indeed fall, the net asset value (NAV) of the fund will also
decline. The fund manager can minimise the loss by 'hedging' the portfolio in anticipation of the fall.
The fund manager will invest in derivatives in such a way that the contracts benefit from the fall in
index value. The fund manager may choose to hedge all or only some of the risk. This depends on
their hedging objectives.
5.1.1 HEDGING OBJECTIVES

These vary widely between businesses and between transactions depending on the company's risk
appetite. The main problem when deciding upon a hedging policy is to strike a balance between
uncertainty and the opportunity cost. Setting hedging policy is a strategic decision, the success or
failure of which can have profound impacts on a company.
5.1.2 DOES HEDGING MATTER?

Given the extensive use of hedging in general and the use of derivatives in pursuit of exposure
management in particular, it would seem that corporate treasurers, financial directors and
shareholders generally think hedging does matter. However, there are a number of authors who argue
that it is largely irrelevant.
Provided the expected level of profit remains unchanged, the volatility is irrelevant as investors should
take action to diversify their portfolio themselves and will thus be unwilling to pay a premium for the
hedging activities of companies. The argument goes that investors will not be interested in individual
fluctuations but in the performance of a diversified portfolio as a whole which, if properly managed,
will balance out the ups and downs of individual investments. These arguments would, therefore,
seem to suggest that hedging would only be of interest to individual companies, and their managers,
whose performance assessment may be based on short-term measures.
For hedging to be justified in financial terms, it has to have a positive effect on the value of the
company (i.e. it must increase net cash flow or reduce the company's cost of capital). Investors,
irrespective of the actions of individual companies, can technically manage their main financial risks by
using a diversified portfolio. This argument, however, ignores other, non-financial risks which may
increase as a result of volatile earnings: reputational risk, increased incidence of liquidity shortages,
higher contracting costs, and so on, which may in themselves lead to an increase in the cost of capital.
5.1.3 HEDGING ECONOMIC EXPOSURE

Economic exposure arises from the risk that exchange rate movements might reduce the
international competitiveness of a company. Economic exposures are long-term in effect and are of
strategic importance to a company.
Hedging economic exposures could result in a relocation of operations (or parts of them) to another
country or currency zone.
Transaction exposure, which has been the main subject of this discussion on hedging, can be seen as
MODULE 8
a short-term version of economic exposure.
Worked Example: Economic exposure
Suppose an Australian company invests in setting up a subsidiary in another country, but the currency
of that country depreciates continuously over a five-year period. The cash flows remitted to Australia
are worth less in dollars each year, causing a reduction in the value of the investment project.
Another example would be an Australian company which buys raw materials priced in Japanese Yen. It
converts these materials into finished products which it exports mainly to the US, pricing the goods in
US dollars. Over a period of several years, the Australian dollar depreciates against the Yen but
strengthens against the US dollar. The Australian dollar value of the company's income declines while
the Australian dollar cost of its materials increases, resulting in a drop in the value of the company's
cash flows.
If there are fears that a company has large economic exposures, this perceived risk could reduce the
company's value and the share price. Protecting against economic exposure might therefore be
necessary in order to protect the company's share price.
A company need not engage in foreign activities to be subject to economic exposure. For example if
a company trades only in Australia but the dollar strengthens appreciably against other currencies, it
may find that it loses domestic sales to a foreign competitor who can now afford to charge cheaper
Australian dollar prices.
Various actions can reduce economic exposure, including the following.
 Matching assets and liabilities. A foreign subsidiary can be financed, so far as possible, with a
loan in the currency of the country in which the subsidiary operates. A depreciating currency results
in reduced income but also reduced loan service costs. A multinational will try to match assets and
liabilities in each currency so far as possible.
 Diversifying the supplier and customer base. A company might buy from a number of different
sources, and pay in different currencies. It might also sell abroad into different currency zones. If
the currency of one of the supplier countries strengthens, purchasing can be switched to a cheaper
source.
 Diversifying operations worldwide. On the principle that companies that confine themselves to
one country have the most severe economic exposures, international diversification is a method of
reducing the risk.
 Currency swaps. An agreement between two parties to swap equivalent amounts of two different
currencies for the period of the swap. This allows a company to restructure the currency base of its
liabilities.
5.1.4 HEDGING TRANSLATION EXPOSURE

Translation exposure is the risk that a company with a foreign subsidiary will report losses when it
prepares its consolidated financial accounts for the group, due to an adverse exchange rate
movement. Translation losses can result from re-stating the book value of a foreign subsidiary's assets
at the exchange rate in force at the end of the accounting period.
Such losses will not have an impact on the firm's cash flow unless the assets are sold.
However translation exposures might affect the share price of a parent company with foreign
subsidiaries.
There are opposing arguments as to whether translation exposure is important. The arguments centre
on whether the reporting of a translation gain or loss does actually affect the company's share price.
There is a powerful argument that, to the extent that cash flows are not affected, translation exposure
can be ignored. On the other hand, those who believe that accounting results are an important
determinant of share price argue that translation losses should be reduced to a minimum.
Translation exposures can be hedged to an extent by group borrowing in the currency of the foreign
subsidiary. If the assets of the subsidiary fall in value when translated into dollars, there would be a
corresponding fall in the dollar value of the company's debt liability. Similarly, any fall in the value of
the subsidiary's profits, when translated into dollars, would be offset to some extent by a fall in the
dollar value of the interest and capital repayments.
5.2 SPECULATION
Speculators take a calculated risk on the movements in an underlying asset value and trade derivatives
based on these, in the expectation of making a profit. Derivative prices are volatile and thus the
returns or losses on speculation can be great. Speculators choose to use derivatives for a number of
reasons:
 They generally mirror the performance of the underlying asset from which their value is derived.
 They are more efficient to trade in: transaction costs associated with trading a derivative may be
significantly lower than those incurred in trading the underlying asset.
 Speculators can sell derivatives before they buy them, if they anticipate a fall in value, from which
they can still make a profit. This is known as shorting the market.
 Derivatives markets are, generally speaking, more liquid than the markets associated with the
underlying assets.
Speculators are often scorned in the press; however, they do have a role to play in the development of
efficient financial markets. Their activities can help to create liquidity in the markets, both for other
speculators with different views, risk appetites or performance targets and also for other derivatives
users.
5.3 ARBITRAGE
Definition
Arbitrage is the process of buying an instrument in one market and selling it either instantly or over a
very short time horizon on another market, exploiting differences in the price to make a profit.
Theoretically, the price of an instrument should be identical whichever market it is traded in. In reality,
however, even with the development of multi-national and global trading this is not always the case.
Therefore arbitrage can be and is a major use of derivatives.
Worked Example: Arbitrage
The time difference between the Australian markets and other markets around the world (such as
London) offer the chance of arbitrage. A trader could buy an instrument near the close of business in
Australia, before the London market opens. A counter trade could be placed in London as soon as the
London market opens and a profit obtained because the sale price in London is more than the price
the trader paid in Australia due to the time delay between the markets.
Question 2: Secondary financial instruments
Have a look at the financial pages of a quality newspaper. Try listing as many secondary financial
instruments as you can.
MODULE 8
KEY MODULE POINTS
 Financial instruments are contracts that give rise to both a financial asset for one party to the
contract and a financial liability or equity instrument by the other party to the contract.
 Primary financial instruments are those that have an associated, measurable value such as equity
shares, corporate bonds, loans, cash deposits, and receivable balances.
 Secondary financial instruments often referred to as derivatives, are financial instruments whose
value is derived from an underlying asset. Examples include forward contracts, futures, options and
swaps.
 Derivatives are essentially tools for transferring risk, and offer the opportunity to diminish or
increase exposure to uncertain events.
 We saw in Module 3 that credit risk is the possibility of payment default by a customer. In other
words, it is the possibility that a customer will not pay for the goods or services they have received.
 It can be assessed using experience, industry data or by the assessment of individual customers to
build up an aggregate picture of the risk.
 Credit risk can be management through careful management of the accounts receivable balance
and through various mechanisms to collect debts that are due.
 There are different ways of managing transaction exposures. These include matching receipts and
payments, leading and lagging, forward exchange contracts and money market hedges.
 Derivatives such as futures and options can also be used to manage foreign currency movements.
 There are three main uses for derivatives: risk management (hedging), speculation, and arbitrage.
1 Which of the following is not a primary financial instrument?

A bonds issued
B receivables balance
C investment in shares
D US dollar futures contract
2 Which of the following is not a possible use for a derivative?

A hedging
B arbitrage
C speculation
D risk-free investment
3 XYZ Ltd, an Australian company, is due to sell a machine to a European customer. The customer
has agreed to pay euro 500 000 in three months' time. Which one of the following could not be
used by XYZ to hedge this transaction?
A euro futures contracts
B a put option on 500 000 euros
C a call option on 500 000 euros
D a forward contract to sell euros in three months
4 What is an option premium?

A the gain made by the holder of the option
B the price paid for the option rights by the option holder
C a special type of share option that conveys additional dividend benefits
MODULE 8
D the price that will be paid by the option holder for the shares, when the option is exercised
5 Which of the following is not a feature of a warrant?

A can have put and call options
B can be trading or investment style
C can be European or American style
D only available in standardised contract sizes
1 D Primary financial instruments are those that have an associated, measurable value such as equity
shares, corporate bonds, loans, cash deposits, and receivable balances. A US dollar futures
contract is a secondary financial instrument since it derives its value from the price of the
underlying currency.
2 D Derivatives are essentially tools for transferring risk, and offer the opportunity to diminish or
increase exposure to uncertain events. They cannot be used as a risk-free investment.
3 C XYZ Ltd will receive euros which it needs to sell to convert into Australian dollars.
It therefore needs a put option, not a call option.
4 B Options offer the opportunity to minimise the downside risk of adverse price movements, while
providing the potential to share in any upside (i.e. favourable price movements). In view of this
flexibility, the seller or writer of the option receives a sum of money, the option premium, in
consideration for granting the option purchaser the rights associated with the option.
5 D Because warrants are not a standardised product like exchange traded options, there is the
flexibility to tailor products to suit specific investor needs.
1 If the company borrowed in Australian dollars, after one year, at an interest cost of 6 per cent, the
cost of paying interest and repaying the loan would be AUD 1 060 000.
If the company borrowed yen, it would need to borrow 87 million yen (and convert this into dollars
at the spot rate of 87). Interest would be JPY 87 million  1% = JPY 870 000. The company would have
to pay interest and principal of JPY 87 870 000 in one year's time. If this transaction is hedged with
a forward contract at a rate of 83, the cost in dollars would be (87.87 million / 83) = AUD 1 058 674.
The cost would be about the same as borrowing in dollars. This is what would be expected,
because forward rates reflect interest rate differentials between the two currencies.
2 A list of secondary financial instruments may include:
 Swaps
 Options
 Collars and Floors
 Caps and Ceilings
 Forwards
 Futures
 Warrants
 FRAs
 Letters of Credit
 Note issuance facilities
 Commitments to purchase primary instruments
MODULE 8
235
MODULE 9
INVESTMENT
MANAGEMENT
Demonstrate the relationship between systematic risk and expected return of individual LO9.1
securities and portfolios using the Capital Asset Pricing Model (CAPM) and the security
market line relationship
Distinguish between the weak form test, the semi strong test and the strong form test LO9.2
of the Efficient Market Hypothesis (EMH)
Explain the implications of market efficiency for both investors and companies LO9.3
In the context of capital markets distinguish between operating efficiency, allocative LO9.4
efficiency and pricing efficiency
Analyse measures of expected return and risk using the probability distribution LO9.5
approach
Analyse and interpret rates of return on financial investments LO9.6
Analyse measures of expected return and risk for two-security portfolios LO9.7
Analyse share price in both perfect and imperfect markets LO9.8
Explain the impact of portfolio leveraging and short selling on the risk and expected LO9.9
return of two-security portfolios
Assess portfolio risk LO9.10
Topic list
1 CAPM and investment management

2 EMH and investment management
3 Implications for share values
4 Portfolios and portfolio theory
5 Investors' preferences
MODULE OUTLINE
This module pulls together knowledge built up from previous modules. In particular we shall consider
the impact of CAPM and EMH on investment management. Following on from this we shall discuss
portfolio theory (the structuring of investment portfolios).
Portfolio theory suggests that individual investments cannot be viewed simply in terms of their risk and
return. It is the relationship between the returns on the various investments held that is important and
the investor should be concerned with his or her overall position, not with the performance of
individual investments.
The CAPM is based on the fact that many investors will be well-diversified. A well-diversified investor
is one that holds a balanced portfolio consisting of a range of different investments so as to reduce
the risk associated with any one particular investment. Well-diversified investors are therefore only
concerned with a comparison of the market risk of individual investments with the risks of all shares in
the market.
Rational risk Investment management

averse investor
Maximise return
for given risk
Investment portfolio EHM CAPM

Risk – standard deviation Weak form
Return – expected return Semi-strong form
Strong form
Well diversified investors
Hold market portfolio (m)
Portfolio theory
Combined risk depends on Fundamental theory of
correlation of returns share values
Risk and return Systematic risk only
Efficient portfolios
Market portfolio
Efficient frontier of portfolios Risk free investments
Best return for given risk The capital market line
Required return
r = rf + ß(rm – rf)
Risk
Uses of CAPM
Cost of equity
Unsystematic Risk adjusted discount rate
Diversify away
Systematic
Cannot diversify
Measured by ß
(beta factor)
INVESTMENT MANAGEMENT | 237
BEFORE YOU BEGIN
area.
everything covered.
1 What can CAPM be used for in investment management? (Section 1)
2 What is that CAPM formula? (Section 1.2)
3 What does the correlation coefficient for two investments measure? (Section 4.2)
4 What is the impact of financial leverage? (Section 4.4)
5 What is the efficient frontier? (Section 5.3)
6 What is the market portfolio? (Section 5.4)
MODULE 9
1 CAPM AND INVESTMENT MANAGEMENT
LO
 In Module 2 we saw that the Capital Asset Pricing Model (CAPM) is a formula for predicting
the required rate of return for an investment, based upon its level of systematic risk relative
to that of the market as a whole. It can be used to calculate a cost of equity that
incorporates risk. This cost of equity can then be used for establishing the 'correct'
equilibrium market value of a company's shares.
1.1 SYSTEMATIC RISK AND UNSYSTEMATIC RISK

We saw that whenever an investor invests in some shares, or a company invests in a new project, there
will be some risk involved. Risks that can be diversified away, because they are specific to an individual
project or investment, are referred to as unsystematic risk.
Definition
Non-systematic or unsystematic risk is a risk that affects a small number of assets. It is a unique or an
asset specific risk, and can be reduced or eliminated by diversification.
However, not all risk can be diversified away. All securities will be affected to some extent by the
underlying risks of the market – changes in the economy, unexpected global events, general elections
etc – which will cause variations in the returns of the most diversified of portfolios.
This inherent risk, known as the systematic risk or market risk, cannot be diversified away because it
affects all securities on the market, albeit some to a greater or lesser extent than others.
Definition
Market or systematic risk is risk that cannot be diversified away.
1.2 THE CAPM FORMULA

We also saw that the CAPM may be used to calculate a cost for equity, to go into the calculation of
WACC. A beta factor can also be applied to individual capital projects, so that high-risk projects
should be expected to provide a higher return than lower risk projects.
The CAPM equation or formula can be stated as follows and in graphical form, this equation is known as
the Security Market Line (SML).
Formula to learn

where: E(ri) is the required or expected return from a security.
2 EMH AND INVESTMENT MANAGEMENT
LOs
9.3,
9.4  The efficient market hypothesis (EMH) states that the stock market reacts immediately to all
the information that is available.
In Module 2 we studied the efficient market hypothesis and its impact on financial management.
We saw that the efficient market hypothesis states that the stock market reacts immediately to all the
information that is available. Therefore, a long term investor cannot obtain higher than average
returns from a well-diversified share portfolio. This section briefly summarises the main points of the
EMH covered in Module 2 and then goes onto consider the implications of this theory on share values.
2.1 FUNDAMENTAL THEORY OF SHARE VALUES

This was introduced in Module 2 and we considered the fundamental theory of share values by looking at
the Dividend Valuation Model (DVM) in Module 4. The DVM states that the market price of shares reflects
investors' expectations of what the future returns from the shares will be. The share price represents the
present value of all future returns, discounted at the investors' yield requirements (the cost of equity).
In theory therefore, if a company undertakes a new capital investment and the net present value is
positive when the cash flows are discounted at the company's cost of capital, the wealth of
shareholders will be increased by the amount of the NPV.
 The future cash flows from the project might be paid out to shareholders as dividends, so that
future returns will be higher and the present value of future returns (i.e. the share price) will also be
higher.
 If the future cash flows from a project are not paid out as dividends, but are re-invested in another
project with a positive net present value, the re-investment will achieve earnings and dividend
growth and will add to shareholder wealth by the amount of the new project's NPV.
If this theory has validity, it is essential that investors:
 are aware of any new project undertaken by the company
 are aware of the future returns from the project, and
 share the same expectations as management about what the future returns will be.
Question 1: Impact of returns on share price
Mansfield has just paid an annual dividend of 14c to its shareholders. The expected future growth rate MODULE 9
in dividends is 5 per cent per annum, and the cost of equity capital is 10 per cent. The company has
just announced that the expected future growth rate in dividends will be 3 per cent, instead of the
5 per cent previously forecast.
By how much would the share price be expected to fall, given no change in the cost of equity?
A 6c
B 59c
C 80c
D 88c
2.2 EMH MARKET EFFICIENCY

A market can be described as showing one of three degrees or forms of information processing
efficiency: weak form, semi-strong or strong.
Under the weak form hypothesis of market efficiency, share prices reflect all available information
If a stock market displays semi-strong efficiency, current share prices reflect:
 all relevant information about past price movements and their implications, and
publicly available or not.
2.3 OTHER TYPES OF MARKET EFFICIENCY

Module 2 also discussed different types of efficiency which can be distinguished in the context of the
operation of financial markets.
 Allocative efficiency
 Operational efficiency
Transaction costs are incurred by participants in financial markets, for example commissions on
share transactions, margins between interest rates for lending and for borrowing, and loan
arrangement fees. Financial markets have operational efficiency if transaction costs are kept as low
as possible. Transaction costs are kept low where there is open competition between brokers and
other market participants.
 Informational processing efficiency
stocks and shares fairly and quickly. An efficient market in this sense is one in which the market
prices of all securities reflect all the available information.
2.4 IMPLICATIONS OF THE EMH

We saw in Module 2 that the market price of shares reflects investors' expectations of what the future
returns from the shares will be. The share price represents the present value of all future returns,
discounted at the investors' yield requirements (the cost of equity).
It is important to remember that the prices of securities bought and sold reflect all the relevant
information available. Efficiency, as we have just seen, relates to how quickly and how accurately prices
adjust to new information.
Information comes from financial statements, financial databases, the financial press and the Internet.
Semi-strong efficiency depends on the quality and quantity of publicly available information.
Companies are encouraged by investor pressure, accounting bodies, government rulings and stock
market regulation to provide as much information as is compatible with the necessity for some secrecy
to prevent competitors gaining useful knowledge. The perception of a fair market is added to by the
constraints and deterrents placed on insider dealers.
2.4.1 IMPACT OF EFFICIENCY ON SHARE PRICES

If the stock market is efficient, share prices should vary in a rational way.
 If a company makes an investment with a positive net present value (NPV), shareholders will find
out and the market price of its shares will rise in anticipation of future dividend increases.
 If a company makes a bad investment shareholders will find out and so the price of its shares will
fall.
 If interest rates rise, shareholders will want a higher return from their investments, so market prices
will fall.
3 IMPLICATIONS FOR SHARE VALUES
LO
 The fundamental theory of share values states that share prices can be derived from an
analysis of future dividends.
 Technical analysts or chartists work on the basis that past price patterns will be repeated.
 Random walk theory can be applied to share values. Although share prices will have an
intrinsic or fundamental value, this value will be altered as new information becomes
available, and that the behaviour of investors is such that the actual share price will
fluctuate from day to day around the intrinsic value.
 If stock markets are efficient, in accordance with EMH, then an individual investor will not
have an opportunity to consistently outperform the market by making abnormal gains, and
techniques such as fundamental analysis are largely irrelevant.
 In practice, share prices may be affected by market imperfections, pricing anomalies and
investor speculation.
3.1 THE VALUE OF SHARES

We discussed the fundamental theory of share values in Section 2. Remember that 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.
If the fundamental theory of share values is correct, the price of any share will be predictable.
This is provided that all investors have:
 the same information about a company's expected future profits
 the same information about a company's expected and dividends
 a known cost of capital.
Worked Example: Share valuation
The management of Crocus are trying to decide on the dividend policy of the company.
There are two options that are being considered:
a. The company could pay a constant annual dividend of 8 cents per share.
b. The company could pay a dividend of 6c per share this year, and use the retained earnings to MODULE 9
achieve an annual growth of 3 per cent in dividends for each year after that.
The shareholders' cost of capital is thought to be 10 per cent. Which dividend policy would maximise
the wealth of shareholders, by maximising the share price?
Solution
a. With a constant annual dividend

The share price (P0) can be calculated by the following formula:
D1
P0 
r
Where D1 is the annual dividend and r is the shareholders' required return.
8
Share price = = 80c
0.1
b. With dividend growth

The share price (P0) can be calculated by the following formula:
D0 (1+ g)
P0 =
(r  g)
where:
D0 is the current year's annual dividend,
r is the shareholders' required return,
g constant growth rate of dividends, is the annual growth rate in dividends.
6(1.03) 6.18
Share price = = = 88c
(0.1  0.03) 0.07
The dividend of 6c per share with 3 per cent annual growth would be preferred.
3.2 CHARTISM OR TECHNICAL ANALYSIS

Chartists or 'technical analysts' attempt to predict share price movements by assuming that past price
patterns will be repeated. Chartists do not attempt to predict every price change. They are primarily
interested in trend reversals, for example when the price of a share has been rising for several months
but suddenly starts to fall.
Moving averages help the chartist to examine overall trends. For example, a chartist may calculate and
plot moving averages of share prices for 20 days, 60 days and 240 days. The 20-day figures will give a
reasonable representation of the actual movement in share prices after eliminating day to day
fluctuations. The other two moving averages give a good idea of longer term trends.
One of the main problems with chartism is that it is often difficult to see a new trend until after it has
happened. By the time the chartist has detected a signal, other chartists will have as well, and the
resulting mass movement to buy or sell will push the price so as to eliminate any advantage.
With the use of sophisticated computer programs to simulate the work of a chartist, academic studies
have found that the results obtained were no better or worse than those obtained from a simple 'buy
and hold' strategy of a well-diversified portfolio of shares.
This may be explained by research that has found that there are no regular patterns or cycles in share
price movements over time – they follow a 'random walk'.
3.3 RANDOM WALK THEORY

Random walk theory is consistent with the fundamental theory of share values. It accepts that a share
should have an intrinsic price dependent on the fortunes of the company and the expectations of
investors. One of its underlying assumptions is that all relevant information about a company is
available to all potential investors who will act upon the information in a rational manner.
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
behaviour of investors is such that the actual share price will fluctuate from day to day around the
intrinsic value.
3.4 FUNDAMENTAL ANALYSIS

Fundamental analysis involves analysing all the publicly available information about a company, its
industry and the economy in which it operates, in order to ascertain the intrinsic value of the share and
assess whether its current share price is accurate. Profits can be made by trading shares that are
perceived as under-valued.
3.5 IMPLICATIONS OF EMH FOR INVESTORS

The efficient market hypothesis (EMH) implies that if new information is revealed about a company it
will be incorporated into its share price rapidly and rationally, with respect to both the direction and
size of the share price movement.
 In an efficient market, no investor will be presented with an opportunity for making a return on a
share that exceeds the fair return for the risk associated with that share.
Stock markets are widely held to be at least semi-strong efficient. The absence of abnormal profit
possibilities arises because current and past information is immediately reflected in current prices.
It is only new information, which causes prices to change. Therefore, an individual investor would
only be able to consistently outperform the market by gaining access to information before it
became available to the majority of investors. For the vast majority of investors this implies that
public information cannot be used to earn abnormal returns.
 The implication is that fundamental analysis is a waste of money and that so long as efficiency is
maintained, the average investor should simply select a suitably diversified-portfolio, thereby
avoiding costs of analysis and transaction.
In practice, timing differences in the availability of information and other market anomalies (see 3.6
and 3.7) may allow fundamental analysts to make superior profits by taking advantage of temporary
pricing errors until the market recognises the pricing mistake and acts to correct it.
3.6 AVAILABILITY AND SOURCES OF INFORMATION

In Section 2 of this module it was stated that an efficient market is one where the prices of securities
bought and sold reflect all the relevant information available. Efficiency relates to how quickly and how
accurately prices adjust to new information.
Information comes from financial statements, financial databases, the financial press and the Internet.
Semi-strong efficiency depends on the quality and quantity of publicly available information.
Companies are encouraged by investor pressure, accounting bodies, government rulings and stock
market regulation to provide as much information as is compatible with the necessity for some secrecy
to prevent competitors gaining useful knowledge. The perception of a fair market is added to by the
constraints and deterrents placed on insider dealers.
3.6.1 DIVIDEND INFORMATION

It has been argued that shareholders see dividend decisions as passing on new information about the
company and its prospects. A dividend increase is usually seen by markets to be good news and a
dividend decrease to be bad news, but it may be that the market will react to the difference between
the actual dividend payments and the market's expectations of the level of dividend. For example, the
market may be expecting a cut in dividend but if the actual decrease is less than expected, the share
MODULE 9
price may rise.
3.7 MARKET IMPERFECTIONS AND PRICING ANOMALIES

Various types of anomaly appear to support the views that irrationality often drives the stock market,
including the following:
 Seasonal month-of-the-year effects, day-of-the-week effects and also hour-of-the-day effects seem
to occur, so that share prices might tend to rise or fall at a particular time of the year, week or day.
 There may be a short-run overreaction to recent events. A key example is the stock market crash in
1987 when markets went into a free-fall, losing 20 per cent in a few hours.
 Individual shares or shares in small companies may be neglected.
Speculation by investors and market sentiment is a major factor in the behaviour of share prices.
Behavioural finance is an alternative view to the efficient market hypothesis. It attempts to explain the
market implications of the psychological factors behind investor decisions and suggests that irrational
investor behaviour may significantly affect share price movements. These factors may explain why
share prices appear sometimes to over-react to past price changes.
Question 2: Stock market returns
'The return achieved on professionally managed equity portfolios is likely to be no better than that
achieved by an individual investor holding a well-diversified portfolio.' What does this quotation imply
about the efficiency of the stock market?
4 PORTFOLIOS AND PORTFOLIO THEORY
LOs
9.6,
9.7,  Portfolio theory suggests that individual investments cannot be viewed simply in terms of
9.8,
9.9,
their risk and return. It is the relationship between the returns on the various investments
9.10 held that is important and the investor should be concerned with his or her overall position,
not with the performance of individual investments.
 The expected return of a portfolio will be a weighted average of the expected returns of the
investments in the portfolio, weighted by the proportion of total funds invested in each.
 The risk of a security, and the risk of a portfolio can be measured as the standard deviation
of expected returns, given estimated probabilities of actual returns.
 Correlation measures the degree to which the returns on investment vary with each other.
Investments can be said to be positively correlated, negatively correlated or have no
correlation.
 The combined risk of the portfolio will depend on how the two investments are correlated.
Risk can be reduced by combining in a portfolio investments which have no significant
correlation or are negatively correlated.
4.1 INDIVIDUAL AND COMPANY PORTFOLIOS

A portfolio is the collection of different investments that make up an investor's total holding. A
portfolio might be the investments in stocks and shares of an investor, or the investments in capital
projects of a company.
Portfolio theory, which originates from the work of Markowitz, is concerned with establishing
guidelines for building up a portfolio of stocks and shares, or a portfolio of projects. The same theory
applies to both stock market investors and to companies with capital projects to invest in.
Table 9.1: Factors in the choice of investment
Security Maintenance of capital value.
Liquidity If made with short-term funds, should be convertible into cash with short
notice.
Return Obtain highest return compatible with safety.
Spreading risks Spread risks over several investments, so losses on some offset by gains on
others.
Growth prospects Investment in steadily growing businesses.
4.1.1 INVESTMENT RETURNS

The theory examined in this module considers investments in the context of single period (i.e. a sum
of money invested now to generate a one-off cash sum a year from now). For example, an investor has
$100 to invest in a security for one year and expects to realise $120 at the end of the investment
period. This equates to a return of 20 per cent (120 – 100 / 100).
Worked Example: Investment returns
An investor purchased a share at the start of the period for $2.50. During the period the investor
received a dividend of $0.20 and the share price at the end of the period had risen to $2.55. Calculate
the return on the share.
Solution
The return on the share may be calculated as:

Capital gain (or loss) + dividend P1  P0 +D1
=
Price at start of period P0
R = (0.05 + 0.20) / 2.50 = 10%
Alternatively:
percentage total return = Capital gain yield + dividend yield
P1  P0
Capital gain yield = = (2.55-2.50) / 2.50 = 2%
P0
D1
Dividend yield = = 0.20 / 2.50 = 8%
P0
Hence total return = 2% + 8% = 10%
4.2 CORRELATION OF INVESTMENTS

Portfolio theory states that individual investments cannot be viewed simply in terms of their risk and
return. The relationship between the return from one investment and the return from other
investments is just as important.
Definition
Correlation is a statistical measure of how the returns from two securities move in relation to each
other.
The relationship between investments can be one of three types:
4.2.1 POSITIVE CORRELATION

When there is positive correlation between investments, if one investment does well it is likely that the
other will do well too. For example, if you buy shares in one company making umbrellas and in
MODULE 9
another which sells raincoats, you would expect both companies to do badly in dry weather.
4.2.2 NEGATIVE CORRELATION

Where there is a negative correlation, if one investment does well the other will do badly, and vice
versa. For example, if you hold shares in one company making umbrellas and in another which sells ice
cream, the weather will affect the companies differently.
4.2.3 NO CORRELATION
Where there is no correlation, the performance of one investment will be independent of how the
other performs. If you hold shares in a mining company and in a leisure company, it is likely that there
would be no relationship between the profits and returns from each.
4.2.4 CORRELATION COEFFICIENT

The relationship between the returns from different investments is measured by the correlation
coefficient. A figure close to +1 indicates high positive correlation, and a figure close to –1 indicates
high negative correlation. A figure of 0 indicates no correlation.
4.2.5 COEFFICIENT OF VARIATION

This measures the standard deviation as a percentage of the mean. It is particularly useful when
comparing the dispersion of two distributions. The higher the percentage, the higher the dispersion.
4.2.6 CORRELATION COEFFICIENT AND RISK

When two investments are combined, the resulting risk of the portfolio depends on the correlation
between them. The maximum potential for risk reduction occurs if the investments show perfect
negative correlation (–1). However, overall risk can also be reduced by combining investments which
have no significant correlation.
4.3 CALCULATING CORRELATION AND COVARIANCE

As well as being measured by correlation, the relationship between the returns on two investments
can be measured by the covariance. The covariance is an absolute measure, whereas the correlation
coefficient is a relative measure, varying as we have seen, between –1 and +1. A positive covariance
indicates that the returns will move in the same direction.
The formulae for the covariance and correlation coefficient are as follows:
Formula to learn
Covariance =  p(x  x)(y  y)

where: p = probability of outcome
x = return from security x at that outcome.
x = expected return from security x.
y = return from security y at that outcome.
y = expected return from security y.
Covariance
Correlation coefficient =
x y
where: x = standard deviation of returns from security x.

y = standard deviation of returns from security y.

Coefficient of variation =
x
Worked Example: Positive correlation
Security A and security B have the following expected returns:

Security A Security B
Probability return return
0.1 15% 10%
0.8 25% 30%
0.1 35% 50%
Calculate the expected return and risk for each security individually and the covariance and correlation
coefficient.
Solution
The expected return from each security is as follows:

Expected Expected
Value (EV) Value (EV)
Probability  Probability 
Probability Security A return return Security B return return
p % % % %
0.1 15 1.5 10 1
0.8 25 20.0 30 24
0.1 35 3.5 50 5
Expected return = 25.0 Expected return = 30
The variance of the expected return for each security is  p( x  x )

2
p x x–x p(x – x) 2 y y–y p(y – y) 2
0.1 15 (10) 10 10 (20) 40
0.8 25 0 0 30 0 0
0.1 35 10 10 50 20 40
Variance = 20 Variance = 80
The standard deviation, , is the square root of the variance.
Security A: 20 = 4.472%
Security B: 80 = 8.944%
Therefore, security B offers a higher expected return than security A, but at a greater risk.
We can see in this situation that the two investments are positively correlated since they both move in
the same direction (when A does well, so does B). In fact, we can prove that there is perfect positive
correlation between the securities:
return return
Probability % %
p x x x–x y y y–y p(x – x)(y – y)
0.1 15 25 (10) 10 30 (20) 20
0.8 25 25 0 30 30 0 0
0.1 35 25 10 50 30 20 20
40
Covariance = 40
40
MODULE 9
4.472 × 8.944
= +1
Worked Example: Negative correlation
Alternatively, we could have had a situation where there was perfect negative correlation between
the two investments, so that when A does badly and gives a return of 15 per cent, B does well and
gives a return of 50 per cent.
0.1 15 25 (10) 50 30 20 (20)
0.8 25 25 0 30 30 0 0
0.1 35 25 10 10 30 (20) (20)
(40)
Covariance = (40)
(40)
4.472 × 8.944
= –1
Worked Example: No correlation
If there was no correlation between the returns, the probability distribution would be as follows:
A B P
% %
15 10 (0.1  0.1) 0.01
15 30 (0.1  0.8) 0.08
15 50 (0.1  0.1) 0.01
25 10 (0.8  0.1) 0.08
25 30 (0.8  0.8) 0.64
25 50 (0.8  0.1) 0.08
35 10 (0.1  0.1) 0.01
35 30 (0.1  0.8) 0.08
35 50 (0.1  0.1) 0.01
1.00
The covariance and correlation calculations would be as follows:
0.01 15 25 (10) 10 30 (20) 2
0.08 15 25 (10) 30 30 0 0
0.01 15 25 (10) 50 30 20 (2)
0.08 25 25 0 10 30 (20) 0
0.64 25 25 0 30 30 0 0
0.08 25 25 0 50 30 20 0
0.01 35 25 10 10 30 (20) (2)
0.08 35 25 10 30 30 0 0
0.01 35 25 10 50 30 20 2
0
Covariance = 0
0
4.472 × 8.944
= 0
Worked Example: Coefficient of variation
Suppose that two sets of data, A and B, have the following means and standard deviations.
A B
Mean 120 125
Standard deviation 50 51
Coefficient of variation (50 / 120) 0.417 (51 / 125) 0.408
Although B has a higher standard deviation in absolute terms (51 compared to 50), its relative spread
is less than A's since the coefficient of variation is smaller.
4.4 IMPACT OF LEVERAGE AND SHORT SELLING ON PORTFOLIO RISK

AND RETURN
The impact of financial leverage or gearing is that by borrowing at the risk-free rate the investor can
increase the available return on his portfolio.
Investors can also increase the returns available on their portfolio by selling one asset short (effectively
taking out a risky loan) and using the funds generated to invest more than their original capital, in an
alternative asset which generates a higher return. This strategy is unlikely to be preferred by more risk
averse investors since short selling involves the potential for large losses if the market rises instead of
falls.
Note: short selling involves the investor selling an asset that they do not own at the time of sale, which
generates cash, in the expectation that the market will fall and they can purchase the asset at a lower
price in the future. This both fulfils the transaction and results in a profit.
4.5 COMBINING TWO INVESTMENTS: EXPECTED RETURN AND RISK OF

A PORTFOLIO
When an investor has a portfolio of securities, they will expect the portfolio to provide a certain return
on their investment.
The expected return of a portfolio will be a weighted average of the expected returns of the
For example, if 70 per cent of the portfolio relates to a security which is expected to yield 10 per cent
and 30 per cent to a security expected to yield 12 per cent, the portfolio's expected return is (70% ×
10%) + (30% × 12%) = 10.6%.
Formula to learn
The expected return rp of a two-asset portfolio can therefore be stated by:
rp = x ra +(1 x) rb
where: x is the proportion of investment A in the portfolio.
ra , rb are the expected returns of investments A and B.
The risk of a security, and the risk of a portfolio, can be measured as the standard deviation of
expected returns, given estimated probabilities of actual returns.
Worked Example: Combined risk of a two asset portfolio MODULE 9

Using the predicted returns for securities A and B in Section 1.4 above, let us now assume that an
investor acquires a portfolio consisting of 50 per cent A and 50 per cent B.
The expected return from the portfolio will be 0.5  25% + 0.5  30% = 27.5%.
This return is less than the expected return from security B alone, but more than that from security A.
The combined risk of the portfolio will depend on how the two investments are correlated.
Calculate the combined risk of a portfolio consisting of 50 per cent A and 50 per cent B if A and B
have
i. perfect positive correlation.
ii. perfect negative correlation.
iii. no correlation.
Solution
i. Perfect positive correlation

The standard deviation of the portfolio may be calculated as follows, given an expected return of
27.5 per cent and perfect positive correlation.
Combined
Return Return portfolio
Probability from 50% from 50% return
p A B x x–x p(x – x) 2
% % %
0.1 7.5 5 12.5 (15) 22.5
0.8 12.5 15 27.5 0 0
0.1 17.5 25 42.5 15 22.5
Variance = 45.0
The standard deviation is 45 = 6.71%.

ii. Perfect negative correlation
The standard deviation of the portfolio, given an expected return of 27.5 per cent and perfect
negative correlation, is as follows:
Combined
% % %
0.1 7.5 25 32.5 5 2.5
0.8 12.5 15 27.5 0 0
0.1 17.5 5 22.5 (5) 2.5
Variance = 5.0
The standard deviation is 5 = 2.24%

iii. No correlation
The standard deviation of the portfolio, given an expected return of 27.5 per cent and no
correlation, is as follows:
Combined
% % %
0.01 7.5 5 12.5 (15) 2.25
0.08 7.5 15 22.5 (5) 2.00
0.01 7.5 25 32.5 5 0.25
0.08 12.5 5 17.5 (10) 8.00
0.64 12.5 15 27.5 0 0.00
0.08 12.5 25 37.5 10 8.00
0.01 17.5 5 22.5 (5) 0.25
0.08 17.5 15 32.5 5 2.00
0.01 17.5 25 42.5 15 2.25
Variance = 25.00
The standard deviation is 25 = 5%
4.5.1 EFFECT OF CORRELATION ON COMBINED RISK

% Return Risk
A only 25 4.472
B only 30 8.944
50% A, 50% B, Cor = +1 27.5 6.71
50% A, 50% B, Cor = –1 27.5 2.24
50% A, 50% B, Cor = 0 27.5 5.0
You should notice that for the same expected return of 27.5 per cent, the standard deviation (the risk)
is:
a. highest when there is perfect positive correlation between the returns of the individual securities
in the portfolio; in this situation it is a weighted average of the standard deviations of the individual
investments in the portfolio
b. lower when there is no correlation
c. lowest when there is perfect negative correlation – the risk is then less than for either individual
security taken on its own.
If the investor starts with a single security B, then combines it with security A in equal proportions,
note that for any correlation, the combined portfolio will be less risky than security B alone. To achieve
this reduction in risk however, the combined return is lower than that of B alone.
If, however, the investor starts with a single security A, and combines it in equal proportions with B,
the combined return is higher than that of A alone and if the investments are perfectly negatively
correlated, this can be achieved with an overall risk that is lower than A alone. By creating a portfolio
the investor has managed to increase return and reduce risk.
4.5.2 ALTERNATIVE APPROACH FOR CALCULATING THE STANDARD DEVIATION OF A

PORTFOLIO
The standard deviation of the returns from a portfolio of two investments can also be calculated using
the following formula:
Formula to learn
2 2 2 2
p = a x + b (1  x) + 2x(1  x)pab a b
where: p is the standard deviation of a portfolio of two investments, A and B.
a is the standard deviation of the returns from investment A.
b is the standard deviation of the returns from investment B.
a², b² are the variances of returns from investments A and B (the squares of the standard
deviations).
x is the weighting or proportion of investment A in the portfolio.
pab is the correlation coefficient of returns from investments A and B

Covariance of investments A and B
=
a × b MODULE 9
Worked Example: Calculating the standard deviation of a portfolio
We will use the previous example of the portfolio of 50 per cent security A and 50 per cent security B.
a. When there is perfect positive correlation between the returns from A and B, pab = 1
p² = (20 × 0.5²) + (80 × 0.5²) + (2 × 0.5 × 0.5 × 1 × 20 × 80)
= 5 + 20 + (0.5 × 4.472 × 8.944)
= 45
The standard deviation of the portfolio is 45 = 6.71%
b. When there is perfect negative correlation between returns from A and B, pab = 1
p² = (20  0.5²) + (80  0.5²) + (2  0.5  0.5  1  20  80)
= 5 + 20  (0.5  4.472  8.944)
= 5
The standard deviation of the portfolio is 5 = 2.24%
c. When there is no correlation between returns from A and B, pab = 0
p² = (20  0.5²) + (80  0.5²) + (2  0.5  0.5  0  20  80)
= 5 + 20 + 0
= 25
The standard deviation of the portfolio is 25 = 5%
These are exactly the same figures for standard deviations that were calculated earlier.
5 INVESTORS' PREFERENCES
LOs
9.8,
9.9,  Investors will choose a portfolio which gives them a satisfactory balance between the
9.10 expected returns and the risk from the portfolio, based on their individual risk preferences.
 Traditional investment theory suggests that rational risk-averse investors wish to maximise
return and minimise risk.
 The efficient frontier shows a collection of risky portfolios each one providing an optimal
return for a given level of risk.
 The market portfolio is a hypothetical portfolio containing every security available
to investors in a given market, in amounts proportional to their market values.
 When the market portfolio is combined with the risk-free asset, the range of possible
portfolios lie along the capital market line (CML). All points along the CML have superior
risk-return profiles to any portfolio on the efficient frontier.
 The interaction of investors' preferences, efficient portfolios and the returns from risk-free
investments provides the basis for the Capital Asset Pricing Model.
5.1 RISK AND RETURN

Investors must choose a portfolio which gives them a satisfactory balance between the expected
returns from the portfolio and the risk of that portfolio (that actual returns from the portfolio will be
higher or lower than expected). Some portfolios will be more risky than others.
5.2 INVESTORS' INDIFFERENCE CURVES
Traditional investment theory suggests that rational risk-averse investors wish to maximise return and
minimise risk. Therefore, if two portfolios have the same element of risk, the investor will choose the
one yielding the higher return. Similarly, if two portfolios offer the same return the investor will select
the portfolio with the lesser risk. This is illustrated by Figure 9.1.
Figure 9.1: An investor's indifference curve

I1
Expected
return A F
E
y
D
C
B
I1
Risk
x
Portfolio A will be preferred to portfolio B because it offers a higher expected return for the same
level of risk. Similarly, portfolio C will be preferred to portfolio B because it offers the same expected
return for lower risk. (A and C are said to dominate portfolio B.) But whether an investor chooses
portfolio A or portfolio C will depend on the individual's attitude to risk, that is whether they wish to
accept a greater risk for a greater expected return.
The curve I1 is an investor's indifference curve. The investor will have no preference between any
portfolios which give a mix of risk and expected return which lies on the curve, since they derive equal
utility from each of them. Therefore, to the investor the portfolios A, C, D, E and F are all just as good
as each other, and all of them are better than portfolio B.
An investor would prefer combinations of return and risk on indifference curve A to those on curve B
(Figure 9.2) because curve A offers higher returns for the same degree of risk (and less risk for the
same expected returns). For example, for the same amount of risk x, the expected return on curve A is
y1, whereas on curve B it is only y2.
Figure 9.2: Indifference curves compared
Expected A B
return
MODULE 9
y1
y2
X Risk
5.3 EFFICIENT PORTFOLIOS

If we drew a graph (Figure 9.3) to show the expected return and the risk of the many possible
portfolios of investments, we could (according to portfolio theory) plot an egg-shaped cluster of dots
on a scatter graph.
 In this graph, there are some portfolios which would not be as good as others, as they offer a lower
level of return for the same amount of risk.
 However, there are other portfolios which are neither better nor worse than each other, either
because they have a higher expected return but a higher risk, or a lower expected return but a
lower risk. These portfolios lie along the so-called efficient frontier of portfolios which is shown as
a dotted line in Figure 9.3. Portfolios on this efficient frontier are called 'efficient' portfolios.
 The efficient frontier is a curved line, not a straight line. This is because the additional return for
accepting a greater level of risk will not be constant. The curve eventually levels off because a point
will be reached where no more return can be offered to an investor for accepting more risk.
Definition
The efficient frontier shows a collection of optimal portfolios for a rational, risk averse investor: either
the best return that can be expected for a given level of risk or the lowest level of risk needed to
achieve a given expected rate of return.
Figure 9.3: The efficient frontier of available investment portfolios
Expected
return Efficient frontier
Risk (standard deviation)

We can now place an investor's indifference curves on the same graph as the possible portfolios of
investments (the egg-shaped scatter graph), as in Figure 9.4. An investor would prefer a portfolio of
investments on indifference curve A to a portfolio on curve B, which in turn is preferable to a portfolio on
curve C which in turn is preferable to curve D. No portfolio exists, however, which is on curve A or curve B.
Figure 9.4: The optimum portfolio (ignoring risk-free securities)

Indifference curves
A B C D
Expected
return
Efficient frontier
Risk-free Available portfolios

securities
Risk
At a given risk-free rate, the optimum portfolio (or portfolios) to select is one where an indifference
curve touches the efficient frontier of portfolios at a tangent. In Figure 9.4, this is the portfolio marked
M, where indifference curve C touches the efficient frontier at a tangent. Any portfolio on an
indifference curve to the right of curve C, such as one on curve D, would be worse than M, as it
corresponds to a lower risk-free rate.
5.4 THE MARKET PORTFOLIO

We have said that rational, risk averse investors will only want to hold one portfolio of risky
investments: portfolio M. Therefore, since all investors wish to hold portfolio M, and all shares quoted
on the Stock Exchange must be held by investors, it follows that all shares quoted on the Stock
Exchange must be in portfolio M.
Therefore, portfolio M is the market portfolio and each investor's portfolio will contain a proportion
of it, with investments reflecting the risk and return characteristics of all shares in the market.
Definition
The market portfolio is a hypothetical portfolio containing every security available to investors in a
given market, in amounts proportional to their market values. MODULE 9
In the real world, investors do not hold every quoted security in their portfolio, in practice a
well-diversified portfolio will 'mirror' the whole market in terms of weightings given to particular
sectors, high income and high capital growth securities, and so on. It has been shown that in practice,
only 10 to 12 or so diverse shares are needed to reach this position.
5.5 RISK-FREE INVESTMENTS

All the portfolios created by combining investments in securities carry some degree of risk. But some
investments are risk-free. It is extremely unlikely that the Commonwealth Government would default
on any payment of interest and capital on its stocks. Therefore, government stocks can be taken to be
risk-free investments.
If we introduce the possibility of holding a portfolio that includes a risk-free investment into the
analysis we can see that the old efficient frontier is superseded by combinations of the risk-free
investment with the market portfolio (Figure 9.5).
Figure 9.5: The capital market line
E
Return Capital market line
Efficient frontier
M of portfolios
Z
Risk-free
X
investment
0
Risk
5.6 THE CAPITAL MARKET LINE

The straight line XZME is drawn at a tangent to the efficient frontier and cuts the y axis at the point of
the risk-free investment's return. It represents all possible combinations of the market portfolio and
the risk-free asset.
All points along the line, known as the capital market line (CML), have superior risk-return profiles to
any portfolio on the efficient frontier.
Portfolio M is the same as in Figure 9.4. It is the efficient portfolio consisting entirely of risky
investments which will appeal to the investor most.
Portfolio Z is a mixture of the investments in portfolio M and risk-free investments.
Investors will prefer portfolio Z (a mixture of risky portfolio M and the risk-free investment) to portfolio
P because a higher return is obtained for the same level of risk.
Portfolios that lie below the CML, such as P, are said to be inefficient. Any portfolio that lies on or
above the line is efficient.
As with the curvilinear frontier, one portfolio on the capital market line is as attractive as another, since
the return it offers exactly compensates for the risk involved. The exact portfolio selected will depend
on the individual investor's attitude to risk. To make this clearer consider the following example.
A more risk averse investor may wish to hold portfolio Z, which lies 2/3 of the way along the CML
between risk-free investment X and portfolio M (that is, a holding comprising 2/3 portfolio M and 1/3
risk-free securities).
A less risk averse investor may wish to hold portfolio E, which entails putting all his funds in portfolio M
and borrowing money at the risk-free rate to acquire more of portfolio M.
Note the impact of financial leverage or gearing: by borrowing at the risk-free rate the investor can
move up the line and increase the available return on his portfolio.
Question 3: Efficient portfolios
The following data relate to four different portfolios of securities:

Expected rate of Standard deviation of
Portfolio return return on the portfolio
% %
K 11 6.7
L 14 7.5
M 10 3.3
N 15 10.8
The expected rate of return on the market portfolio is 8.5 per cent with a standard deviation of
3 per cent. The risk-free rate is 5 per cent. Identify which of these portfolios could be regarded as
'efficient'.
MODULE 9
KEY MODULE POINTS
 In Module 2 we saw that the Capital Asset Pricing Model (CAPM) is a formula for predicting the
required rate of return for an investment, based upon its level of systematic risk relative to that of
the market as a whole. It can be used to calculate a cost of equity that incorporates risk. This cost
of equity can then be used for establishing the 'correct' equilibrium market value of a company's
shares.
 The efficient market hypothesis (EMH) states that the stock market reacts immediately to all the
information that is available.
 The fundamental theory of share values states that share prices can be derived from an analysis of
future dividends.
 Technical analysts or chartists work on the basis that past price patterns will be repeated.
 Random walk theory can be applied to share values. Although share prices will have an intrinsic or
fundamental value, this value will be altered as new information becomes available, and that the
behaviour of investors is such that the actual share price will fluctuate from day to day around the
intrinsic value.
 If stock markets are efficient, in accordance with EMH, then an individual investor will not have an
opportunity to consistently outperform the market by making abnormal gains, and techniques such
as fundamental analysis are largely irrelevant.
 In practice, share prices may be affected by market imperfections, pricing anomalies and investor
speculation.
 Portfolio theory suggests that individual investments cannot be viewed simply in terms of their risk
and return. It is the relationship between the returns on the various investments held that is
important and the investor should be concerned with his or her overall position, not with the
performance of individual investments.
 The expected return of a portfolio will be a weighted average of the expected returns of the
 The risk of a security, and the risk of a portfolio can be measured as the standard deviation of
expected returns, given estimated probabilities of actual returns.
 Correlation measures the degree to which the returns on investment vary with each other.
Investments can be said to be positively correlated, negatively correlated or have no correlation.
 The combined risk of the portfolio will depend on how the two investments are correlated. Risk can
be reduced by combining in a portfolio investments which have no significant correlation or are
negatively correlated.
 Investors will choose a portfolio which gives them a satisfactory balance between the expected
returns and the risk from the portfolio, based on their individual risk preferences.
 Traditional investment theory suggests that rational risk-averse investors wish to maximise return
and minimise risk.
 The efficient frontier shows a collection of risky portfolios each one providing an optimal return for
a given level of risk.
 The market portfolio is a hypothetical portfolio containing every security available to investors in a
given market, in amounts proportional to their market values.
 When the market portfolio is combined with the risk-free asset, the range of possible portfolios lie
along the capital market line (CML). All points along the CML have superior risk-return profiles to
any portfolio on the efficient frontier.
 The interaction of investors' preferences, efficient portfolios and the returns from risk-free
investments provides the basis for the Capital Asset Pricing Model.
1 A study of the shares of companies listed on a particular stock market found that:
 share prices were independent of past share price movements and followed a random path
 some investors used the published financial statements of the companies to analyse
performance and, by doing so, made abnormal gains over many years.
Which of the following would be consistent with these findings?
A The stock market is inefficient.
B The stock market is efficient in the weak form.
C The stock market is efficient in the strong form.
D The stock market is efficient in the semi-strong form.
2 Studley, a listed public company, received a confidential letter on 1 June 20X0, confirming that it
had won a major contract. The new contract is expected to increase profits significantly from 20X2
onwards. The news of the contract was not made publicly available until 5 June 20X0. What share
price reaction would you expect on 5 June 20X0 under the semi-strong and strong forms of market
efficiency?
Share price reaction
Semi-strong form Strong form
A increase increase
B increase no effect
C no effect increase
D no effect no effect
3 The predicted returns for two assets are as follows:

State Probability Asset A Asset B
I. 0.25 10% 5%
II. 0.50 7% 8%
III. 0.25 6% 9%
Which asset would a risk averse investor choose?

A Asset A
B Asset B
C indifferent between A and B
D depends on the individual investor's indifference curves
MODULE 9
4 Diversification is most effective when security returns are

A high.
B uncorrelated.
C positively correlated.
D negatively correlated.
5 The following two statements concern the propositions which underpin the capital asset pricing
model (CAPM).
I. Investors in shares require a return in excess of the risk-free rate to compensate for systematic
risk.
II. Investors will require higher returns from shares in companies where the level of systematic risk
is higher.
Which one of the following combinations (True/False) is correct?
Statement
I II
A True True
B True False
C False True
D False False
6 Diamond pays an annual dividend of 30 cents per share to shareholders, which is expected to
continue in perpetuity. The average rate of return for the market is 9 per cent and the company has
a beta coefficient of 1.5. The risk-free rate of return is 4 per cent.
What is the expected rate of return for the shareholders of the company and the predicted value of
the shares in the company?
Expected rate of Predicted value
return (%) (cents)
A 11.5 261
B 16.5 182
C 17.5 171
D 23.5 705
1 B Statement I implies the market must be at least weak form efficient. If gains can be made using
fundamental analysis then this information must not yet be reflected in the share price, which
implies that the market is not yet efficient at the semi-strong level.
2 B Under the semi-strong form of market efficiency, the share price will increase when public
information is available. Under the strong form of market efficiency, the share price will already
reflect the information.
3 C
Expected Expected
Return Return value A value B A and B
A B p pA pB x – x for A x – x for B p(x – x) 2

% % %
10 5 0.25 2.5 11.25 2.5 2.5 1.5625
7 8 0.5 3.5 4.0 0.5 0.5 0.125
6 9 0.25 1.5 2.25 -1.5 11.5 0.5625
7.5 7.5 Variance 2.25.25
The expected return of both A and B is 7.5 per cent. It can be seen by inspection that the
variation of returns around the mean is the same and hence the risk (as measured by the
variance) is the same.
4 D When two investments are combined, the resulting risk of the portfolio depends on the
correlation between them. The maximum potential for risk reduction through diversification
occurs if the investments show perfect negative correlation (–1).
5 A The capital asset pricing model assumes investors are already well-diversified and therefore
unconcerned with unsystematic risk. It is concerned with how systematic risk affects required
returns and share prices. Investors in shares require a return in excess of the risk-free rate, to
compensate them for systematic risk. The higher the systematic risk, the higher the return
required.
6 A Expected rate of return = 4% + 1.5 (9% – 4%) = 11.5%
Predicted share value = 30 cents / 0.115 = 261 cents
MODULE 9
D0 (1+ g)
1 D Share price P =
r g
14(1+ 0.05)
Previously P= = 294c
0.10  0.05
14(1+ 0.03)
Now P = = 206c
0.10  0.03
Fall in share price = 294 – 206 = 88c
2 If an investor with a well-diversified portfolio can achieve the same return as a professional fund
manager it implies that they both have access to the same information about companies.
This statement accords with the view that fundamental analysis is a waste of time and is consistent
with the stock market being at least semi-strong efficient.
3 To answer this question, we can start by drawing the CML (see below).
a. When risk = 0, return = 5
b. When risk = 3, return = 8.5
These points can be plotted on a graph and joined up, and the line can be extended to produce
the CML. The individual portfolios K, L, M and N can be plotted on the same graph.
a. Any portfolio which is on or above the CML is efficient.
b. Any portfolio which is below the CML is inefficient.
Expected
return
% CML
15.0 N
L
14.0
11.0 K
10.0 M
8.5
5.0
0 3 3.3 6.7 7.5 10.8 Risk %

(standard deviation)
a. Portfolio M is very efficient.
b. Portfolio L is also efficient.
c. Portfolios K and N are inefficient.
If you prefer numbers to graphs, we can tackle the problem in a slightly different way, by
calculating the equation of the CML.
Let the standard deviation of a portfolio be x.
Let the return from a portfolio be y.
The CML equation is y = rf + bx where rf is the risk-free rate of return. Here, this is 5.
To calculate b, we can use the high-low method.

When x = 3, y = 8.5
When x = 0, y = 5
(8.5  5) 3.5
Therefore b= = = 1.16667
(3  0) 3
The CML is y = 5 + 1.16667x
Efficient or
Portfolio Standard deviation x CML return Actual return inefficient portfolio
% %
K 6.7 5 + (1.16667 × 6.7) 12.8 11 Inefficient
L 7.5 5 + (1.16667 × 7.5) 13.8 14 Efficient
M 3.3 5 + (1.16667 × 3.3) 8.9 10 Very efficient
N 10.8 5 + (1.16667 × 10.8) 17.6 15 Inefficient
If the actual return exceeds the CML return for the given amount of risk, the portfolio is efficient.
Here, L is efficient and M is even more efficient, but K and N are inefficient.
MODULE 9
265
REVISION QUESTIONS
REVISION QUESTIONS | 267
MODULE 1
1 A stock market acts as both a primary and a secondary market for securities. Which of the following
characterises the role of stock markets as secondary markets?
A They enable companies to raise new capital.
B They enable investors to sell their investments.
C They permit takeovers by means of share exchange.
D Owners of a company coming to the market for the first time can realise the value of some of
their investment in the flotation.
2 Which of the following is not a financial intermediary?

A retail company
B commercial bank
C insurance companies
D superannuation fund
3 Which of the following is not a role undertaken by the Australian Government in respect of the
functioning of the capital markets?
A borrower
B source of ultimate liquidity
C regulator of financial activities
D auditor of superannuation funds
4 Which body is responsible for the prudential regulation of deposit taking institutions in Australia?
A RBA
B ASIC
C APRA
D ACCC
5 The directors of Manley Ltd are considering raising long term finance by issuing shares in the
company. They have been informed that the way to do this is to 'access the market' but they are
not sure which market is being referred to.
The appropriate market for the new issue of equity by Manley Ltd is known as a
A money market.
B capital market.
C currency market.
D derivatives market.
6 Which of the following best describes a Eurobond?

A a loan, taken out with an Australian bank, denominated in euros
B a guarantee given by an Australian company to a European customer
C a debenture issued on a financial market in a country belonging to the European Union
D an international bond that is denominated in a currency not native to the country where it is
issued
MODULE 2
1 What is meant by operational efficiency in the context of the efficient market?

A Financial markets have transaction costs that are kept as low as possible.
B Financial markets have the ability to price stocks and shares fairly and quickly.
C Financial markets do not react to new information through share price changes.
D Financial markets allow funds to be directed towards firms which make the most productive use
of them.
2 Consider the following statements about a stock market that displays only weak form efficiency.
I. Share price changes are random.
II. Share prices change in anticipation of new information being announced.
Which one of the following combinations is correct?

Statement
I II
A True True
B True False
C False True
D False False
3 On 29 September, Jones, a company listed on the stock exchange, made a confidential offer to
buy all the shares in Taylor Co, at a price in excess of their current market value. At a private
meeting, held the same day, the directors of Taylor Co agreed to accept the offer and made a
public announcement of this decision two months later on 29 November.
What would you expect to see happen to Taylor Co's share price on 29 November, under the
semi-strong and strong forms of market efficiency?
Share price reaction
Semi-strong form Strong form
A Increase Increase
B Increase No effect
C No effect Increase
D No effect No effect
4 An investor hopes to make abnormal gains on stock market investments by analysing published
annual reports, relevant newspaper and magazine articles and published share prices.
What is the highest form of market efficiency that the investor is assuming?
A weak form efficiency
B strong form efficiency
C not efficient at any level
D semi-strong form efficiency
5 Which of the following statements is correct?

A A stock market that is efficient has share price movements occurring on a random basis.
B A stock market that is efficient in the semi-strong form cannot be efficient in the weak form.
C A stock market that is efficient will have regular, recurring patterns of share price movements.
D A stock market that is efficient in the strong form is one in which investors cannot make any
profit.
6 Which of the following arguments support the relevance of dividend policy?

I. informational content of dividends
II. investor's preference for current income
III. differing tax rates for dividends and capital gains
A I and II only
C I and III only
B II and III only
D I, II and III
7 Under the weak form hypothesis of market efficiency, share prices will reflect which of the
following:
A all knowledge which is available publicly
B all information whether publicly available or not
C decisions made at board level but not yet made public
D all available information about past changes in the share price
8 The chief executive of a listed company wants to create a better impression of company
performance among its investors. As a result he or she plans to publicly announce changes to the
company's accounting policies which will result in an increase in reported profits. What is the
maximum level of market efficiency that would be consistent with the chief executive's behaviour?
A inefficient market
B weak form efficiency
C strong form efficiency
D semi-strong form efficiency
9 A manager has appraised an investment based on its annual accounting profits. What adjustments
would need to be made to these profits in order to convert them into relevant cash flows for
investment appraisal purposes?
Depreciation Working capital
A Add Deduct at start of project and add at end
B Deduct Deduct at start of project and add at end
C Add Add at start of project and deduct at end
D Deduct Add at start of project and deduct at end
10 Merton is currently considering a new investment project. Which one of the following items relating
to the project should be included in the investment appraisal?
A an offer of $100 000 to acquire raw materials that were due to be sold but which will be used in
the project if it goes ahead
B the payment of $30 000 for a market research report, which was commissioned last month and
will be paid for next month
C $10 000 for external research and development relating to the project that has already been
carried out but not yet paid for
D the apportionment of fixed costs of $10 000 per year over the life of the project to represent a
fair share of the total fixed costs of the factory
MODULE 3
1 XYZ Bank's staff appear to be unaware of the importance of risk. For XYZ Bank this is
A a credit risk.
B a market risk.
C a financial risk.
D an operating risk.
2 Consider the following two statements concerning investor attitudes towards risk:
I. A risk-averse investor will only be prepared to invest in a project with the prospect of high
returns if there are no risks involved.
II. A risk-seeking investor will readily invest in a project with prospects of high returns, even if it
means carrying substantially high risk.
Which of the following combinations relating to the above statements is correct?

Statement
I II
A True True
B True False
C False True
D False False
3 A company is considering four projects which are mutually exclusive owing to a shortage of
investment funds. For each project, it has estimated the internal rate of return, and calculated a
measure of risk, based on probability analysis. The risk/return profile of each investment is as
follows:
Project Return Risk
% %
I. 18 5
II. 17 6
III. 16 5
IV. 18 6
If the company's board of directors is risk-averse in its project selection, which of these projects
would it select?
A Project I
B Project II
C Project III
D Project IV
4 To what does interest rate risk relate?

A the sensitivity of profits and cash flow to fluctuations in the interest rate
B the fact that a company has chosen to borrow at a fixed rather than a variable rate
C the difference between short term interest rates prevailing in two money markets at any given
time
D the fact that the foreign currency exchange rate between two countries will reflect the
difference in their interest rates
5 Which of the following is not an example of financial risk?

A credit risk
B hazard risk
C market risk
D interest rate risk
6 Koala Co has decided to create an export sales division but is aware that this will increase trading
risk. It has screened all new customers carefully using an external credit reference organisation and
has taken out irrecoverable debt insurance. The risk responses that Koala Co has applied are
A reduction and transfer.
B transfer and acceptance.
C avoidance and reduction.
D reduction and acceptance.
7 Blue Mountain Pty Ltd has for many years provided a service for customers wishing to develop
photographs from 35mm colour film. This revenue stream has suffered a significant decline as a
result of the development of digital cameras. In relation to the success of the digital camera, which
risk has Blue Mountain suffered from?
A event risk
B hazard risk
C market risk
D business risk
8 An Australian company sources 50 per cent of its raw materials domestically and the other
50 per cent from China. Most of its output is sold to the US. It is strategically exposed to the risk of
a rise in the value of the Chinese Renminbi and a fall in the value of the US dollar.
What is the name for this type of currency risk?
A financial
B economic
C translation
D transaction
MODULE 4
1 A family company which is currently facing liquidity problems needs an injection of funds. Which of
the following is most likely to be classified as a short-term source of finance?
A bank loan
B trade credit
C share capital
D mortgage on business property
2 Which of the following statements about venture capital is not valid?

A It can be used to fund start-ups.
B Venture capitalists would never sit on the board of the company.
C Venture capitalists may realise their shares on flotation of the company.
D Venture capitalists make most of their return in the form of capital gains.
3 Bourne Ltd wants to make sure that it has access to standby funds but is unable to borrow at short
notice. Which of the following is the most appropriate strategy to achieve its objective?
A shorten the maturity schedule of its financing
B lengthen the maturity schedule of its financing
C lower the level of its investment in current assets
D increase the level of its investment in non-current assets
4 Jander Ltd wishes to acquire a new machine to expand its production facilities with a view to
achieving rapid growth and is considering the following methods to fund the purchase.
I. Leasing
II. Bank loan
III. Trade credit
IV. Venture capital
V. Retained earnings
Which of the above forms of finance would be appropriate?

A I and IV only
B I , II and V only
C I , IV and V only
D II, III, and IV only
5 Holmes has $1 ordinary shares in issue that have a current market value of $3. The dividend
expected for next year is $0.40 and future dividends are expected to grow at the rate of 5 per cent
per annum. The rate of income tax is 20 per cent and the Gordon Growth model is used to
calculate the cost of ordinary shares.
What is the cost of ordinary shares to the business?
A 5.1 per cent
B 15.7 per cent
C 18.3 per cent
D 19.0 per cent
6 A company has loan notes in issue paying interest at the rate of 6 per cent per year. Interest has
just been paid on the loan notes, which are due for repayment in exactly one year's time. The loan
notes will be redeemed at $109 per $100 nominal value. A yield of 9 per cent per year is required
by investors from the loan notes.
What is the predicted current market value of the loan notes? (To the nearest $ and ignoring
taxation)
A $100
B $102
C $106
D $108
7 Consider the following two statements concerning required rates of return:

I. Convertible loan notes are normally issued at a lower rate of interest than non-convertible loan
notes.
II. Required rates of return for preference shares are normally higher than required rates of return
for ordinary shares.
Which one of the following combinations (true/false) concerning the above statements is correct?
Statement
I II
A True True
B True False
C False True
D False False
8 It has been claimed that the weighted average cost of capital (WACC) should only be used to
evaluate investment decisions, involving discounted cash flow calculations, where:
I. the WACC reflects the long-term capital structure of the business.
II. the proposed project does not alter the business risk profile of the business.
Which one of the following combinations (true/false) concerning the above statements is correct?
Statement
I II
A True True
B True False
C False True
D False False
9 A way to determine whether debt or lease financing would be preferable for a machine is to:
A compare the interest paid under each alternative.
B compare the payback periods for each alternative.
C compare the net present values of the cash flows under each alternative, using the after-tax cost
of borrowing as the discount rate.
D compare the net present values of the cash flows under each alternative, using the weighted
average cost of capital as the discount rate.
MODULE 5
1 Overton Pty Ltd is trying to decide on its optimal level of current assets. The company's
management face a trade-off between
A equity and debt.
B liquidity and risk.
C profitability and risk.
D short-term and long-term borrowing.
2 Which of the following equations describes the operating cash cycle?

A Average cash balance + Average receivables collection period – Average payables payment
period
B Average cash balance – Average receivables collection period + Average payables payment
period
C Average inventory turnover period + Average receivables collection period – Average payables
payment period
D Average inventory turnover period + Average payables payment period – Average receivables
collection period
3 Whitchurch (Engineering) Co buys raw materials from suppliers on four weeks' credit and they are
delivered immediately. When the raw materials are received, they are held in the warehouse for
five weeks before being used in production. The production process takes one week and the
completed goods are held for two weeks before finally being sold to credit customers. These
customers are allowed a maximum credit period of six weeks but all of them pay after three weeks
in order to obtain a discount for prompt settlement.
What is the operating cash cycle of the business?
A 7 weeks
B 10 weeks
C 11 weeks
D 12 weeks
4 Which of the following should a business do in order to improve its cash operating cycle?
A increase inventories of raw material
B extend the credit period for customers
C reduce the time taken to produce its product
D decrease the credit period taken from trade suppliers
5 A company's cash budget highlights a short-term surplus in the future. Which of the following
actions is least likely to be an appropriate use of the surplus?
A buy back the company's shares
B invest in a short term deposit account
C increase inventories and receivables to improve customer service
D reduce payables by taking advantage of early settlement discounts from suppliers
6 If a company moves from a conservative working capital funding policy to an aggressive one it
should expect
A risk to increase and liquidity to increase.
B risk to decrease and profitability to increase.
C risk to decrease and profitability to decrease.
D profitability to increase and liquidity to decrease.
MODULE 6
1 The directors of a company are discussing the financial market's regulatory system.
Director I: The primary purpose of regulation is to protect institutional investors as they are the
biggest investors on the stock market
Director II: Regulation is designed to protect lenders from capital losses or losses suffered
through default by providing a mechanism for the pooling of losses which reduces
their risk
Director III: The aim of regulation is to help reduce fraud and unfair practices
Which of the directors' comments are accurate?
A III only
B I and II only
C I and III only
D I, II and III
2 Which of the following arguments support the relevance of dividend policy?

I. informational content of dividends
II. investor's preference for current income
III. differing tax rates for dividends and capital gains
A I and II only
C I and III only
B II and III only
D I, II and III
3 The following statements about dividends and dividend policy were made at a recent board
meeting by three different directors:
Director I: According to the residual theory of dividend policy, once we have invested in or
retained sufficient profits for future positive net present value opportunities, we
should pay out the remaining profit as dividends.
Director II: That may cause our dividends to vary year on year. I thought companies generally try
to smooth out dividend payments by adjusting gradually to changes in earnings, so
as to avoid sending out confusing signals to investors.
Director III: We can avoid paying out cash by declaring a scrip dividend. Our existing
shareholders will be given new shares in the business at no extra cost to themselves.
Which combination of the directors' statements is true?
A I and II only
B I and III only
C II and III only
D I, II and III
4 Which of the following describes a scrip dividend?

A the issue of additional shares to company shareholders
B splitting each existing share into two shares with half the value
C the company purchasing existing shares back from shareholders
D the payment of cash to shareholders when the share prices reaches a particular value
5 As a general guide, which of the following interest cover ratios would be considered low?
A 2.5
B 4.5
C 6.5
D 8.5
6 A company has total assets of $25 million, total liabilities of $10 million and total equity of
$15 million. Calculate the leverage (gearing) ratio.
A 40%
B 67%
C 60%
D 150%
7 Which of the following statements concerning debt covenants is incorrect?

A Debt covenants may require the company to meet certain financial targets
B Debt covenants may trigger the early repayment of the debt if they are breached
C Debt covenants may reduce the flexibility of management to manage the company
D Debt covenants may increase the opportunities for the business to borrow more in future
MODULE 7
1 Studley is investing in a new product line. Which one of the following is it most likely to treat as
capital expenditure?
A the wages of the production line staff
B the cost of the marketing campaign for the new product
C repairs to an existing machine that will be used in production
D an extension to the warehouse to store the additional components required
2 A project would involve spending on a non-current asset of $50 000 and working capital investment
of $10 000. The non-current asset is expected to have a residual value of $20 000, at the end of the
project's three-year life. The average annual profit before depreciation would be $22 000. ROI is
measured as average annual profit as a percentage of the average investment.
What would be the ROI of this project?
A 21.3 per cent
B 26.7 per cent
C 30.0 per cent
D 34.3 per cent
3 Which one of the following is not an advantage of the payback method of investment appraisal?
A Is useful as an initial screening tool
B Considers the time value of money
C Can be used to rank projects if liquidity is an issue for the company
D By focusing on projects with short payback periods investment risk is reduced
4 A project is expected to have cash inflows of $60 000 at the end of its first year, $50 000 at the end
of the second and $40 000 at the end of the third year. What is the present value of these cash
flows, to the nearest $'000, if the discount rate is 5 per cent?
A $130 000
B $137 000
C $144 000
D $150 000
5 Longparish is a listed company, committed to maximising the wealth of its shareholders.
Given this objective, which one of the following methods of investment appraisal is most
appropriate for the company to use?
A payback period
B net present value
C internal rate of return
D discounted payback period
6 Hurstbourne Pty Ltd used the IRR and discounted payback methods of investment appraisal to
evaluate an investment proposal that has an initial cash outlay followed by annual net cash inflows
over its life. Following this evaluation, it was found that the cost of capital figure used was incorrect
and that the actual cost of capital should be lower.
What will be the effect on the IRR and discounted payback period of correcting this error?
Effect on
IRR figure Discounted payback period
A no change no change
B no change decrease
C increase increase
D decrease decrease
7 Investment project A has a net present value of +$105 000 at a discount rate of 2 per cent and a
net present value of +$45 000 at a discount rate of 8 per cent. Investment project B has an NPV of
+$10 500 at a discount rate of 2 per cent and an NPV of −$45 000 at a discount rate of 8 per cent.
On the basis of these figures, and using the interpolation method, what is the best estimate of the
IRR of each project?
Project A Project B
A 9.7% 3.1%
B 9.7% 3.8%
C 12.5% 3.1%
D 12.5% 3.8%
8 Odiham is considering a capital investment project. The initial investment in equipment would be
$87 000, and this would have no residual value at the end of the project's life. There would be a
working capital investment of $40 000, which would have a present value of $25 000 when
recovered at the end of the project. The net present value of the other cash outflows would be
$100 000 and the present value of the other cash inflows would be $215 000.
What increase in the initial cost of the equipment, above the current estimate of $87 000, would
make Odiham indifferent between accepting and rejecting the project?
A 3 per cent
B 10 per cent
C 15 per cent
D 32 per cent
9 Which of the following is not an example of hard capital rationing?

A There are restrictions on lending due to government control.
B Lending institutions may consider the organisation to be too risky.
C Raising money through the stock market may not be possible if share prices are depressed.
D Management does not want to issue more shares to raise capital, in order to avoid dilution of
control.
10 Micheldever has three possible investment opportunities, the details of which are as follows:
Initial outlay Total present value
$'000 $'000
Project X 200 265
Project Y 250 310
Project Z 120 170
The company has a limited investment budget for the current year and will be unable to invest in
all profitable opportunities.
Assuming that the company wishes to maximise the wealth of its shareholders, what should be the
order of priority for the three projects?
Order of priority
X Y Z
A I II III
B II III I
C III I II
D III II I
11 A company is appraising an investment that will save electricity costs. Electricity prices are
expected to rise at a rate of 15 per cent per annum in future, although the general inflation rate will
be 10 per cent per annum. The nominal cost of capital for the company is 20 per cent. What is the
appropriate discount rate to apply to the forecast actual nominal cash flows for electricity?
A 20.0 per cent
B 22.0 per cent
C 26.5 per cent
D 32.0 per cent
MODULE 8
1 You have recently joined the treasury department of a business which uses the following hedging
methods to protect itself against the particular types of foreign exchange risk against which they
are matched.
Hedging method Used to protect against:
I. forward exchange contracts transaction risk
II. matching receipts and payments economic risk
III. buying or selling in domestic currency translation risk
Which of the hedging methods are suitable for their intended purpose?
A I only
B III only
C I and III only
D II and III only
2 Overton Pty Ltd needs to borrow a significant sum of money in 3 months' time, to be repaid after
12 months. It is concerned that the interest rate will rise before the borrowing takes place. Which of
the following is an effective hedge against the risk that interest rates will rise between now and
taking out the loan?
A interest rate cap
B interest rate floor
C forward rate agreement
D forward exchange contract
3 An Australian company sources 50 per cent of its raw materials domestically and the other
50 per cent from China. Most of its output is sold to the US. It is strategically exposed to the risk of
a rise in the value of the Chinese Renminbi and a fall in the value of the US dollar.
What is the name for this type of currency risk?
A financial
B economic
C translation
D transaction
4 Which of the following is not a secondary financial instrument?
A forward contract
B trading style warrant
C investment style warrant
D investment in equity shares
5 What is the purpose of hedging?

A to reduce costs only
B to make a profit by accepting risk
C to reduce or eliminate exposure to risk
D to protect profits made from undertaking a risky position
6 Which of the following is the best description of arbitrage?

A a transaction to reduce or eliminate an exposure of risk
B the ASX process available to investors who need to resolve disputes
C the effect of investors acting by chance or impulse rather than as a result of rational thought
D buying an instrument in one market and selling it almost instantly in another market, to make a
profit from the difference in price
7 Which of the following is a true comment on the use of derivatives by an organisation?

A Use of derivatives allows a company to eliminate all exposure to risk.
B Derivatives are used by a company to transfer risk to those with a higher appetite for it.
C Derivatives are primarily used by companies wishing to profit from price differences between
markets.
D The availability of derivatives encourages financial managers to speculate on a variety of market
factors such as interest rates.
MODULE 9
1 A risk-averse investor has a choice between asset A (expected return 15 per cent, standard
deviation 20 per cent) and asset B (expected return 20 per cent, standard deviation 25 per cent).
Which asset would the investor prefer?
A Asset A
B Asset B
C indifferent between A and B
D depends on the individual investor's indifference curves
2 Stock A has a variance of 0.25 and stock B has a variance of 0.18. The covariance between the two
stocks is 0.05. What will be the variance of your complete portfolio if you invest 30 per cent in stock
A and 70 per cent in stock B?
A 0.0550
B 0.1317
C 0.2010
D 0.2150
3 Which of the following statements is correct about the capital market line?
A It contains 10–12 shares.
B It generates a return equal to the risk free rate.
C It is a mixture of shares and government stocks.
D It is the point at which the capital market line meets the efficient frontier of portfolios at a
tangent.
4 An investor invests 40 per cent of their wealth in a risky asset which has an expected return of
15 per cent and a variance of 4 per cent and 60 per cent of their wealth in a risk-free security that
pays 6 per cent. What is the expected return and standard deviation of the portfolio?
A 8.0 per cent and 1.2 per cent, respectively
B 9.6 per cent and 0.8 per cent, respectively
C 9.6 per cent and 1.0 per cent, respectively
D 11.4 per cent and 1.2 per cent, respectively
283
ANSWERS TO REVISION
QUESTIONS
ANSWERS TO REVISION QUESTIONS | 285
MODULE 1
1 B The primary market is for companies bringing shares to the market or issuing new shares to
raise fresh capital. The existence of a secondary market for their shares makes possible
takeovers by listed companies; however, the primary function of a secondary market is for the
trading of shares already in issue.
2 A A financial intermediary is a party bringing together providers and users of finance either as
broker or as principal.
3 D In addition to Options A, B and C, the government also acts as a lender and a financial
intermediary (via RBA).
4 C APRA (Australian Prudential Regulation Authority) is the prudential regulator of the Australian
financial services industry; RBA is the Reserve Bank of Australia; ASIC (Australian Securities and
Investments Commission) acts as Australia's corporate, markets and financial services regulator.
ACCC (Australian Competition and Consumer Commission) ensures that individuals and
businesses comply with the Commonwealth competition, fair trading and consumer protection
laws.
5 B The primary capital market is where securities are issued for the first time.
6 D Eurobonds are long-term loans raised by international companies or other institutions and sold
to investors in several countries at the same time. Eurobonds can be traded throughout the
world rather than on a specific national bond market and are named after the currency they are
denominated in (e.g. Euroyen bonds are denominated in Japanese yen).
MODULE 2
1 A Financial markets have operational efficiency if transaction costs are kept as low as possible.
2 B Under the weak form hypothesis of market efficiency, share prices reflect all available
information about past changes in the share price. Since new information arrives unexpectedly,
changes in share prices should occur in a random fashion.
Therefore, statement I is true and statement II is false.
3 B Under the semi-strong form of market efficiency, the share price will increase when information
is made publicly available. Under the strong form of market efficiency, the information will
already have been reflected in the share price.
4 A Weak form efficiency implies that not all publicly available information is reflected in current
prices and therefore may be used to make abnormal gains.
5 A Random walk theory is based on the idea that share prices will alter when new information
becomes available. Since new information is unpredictable, share prices appear to follow a
random walk. One of the underlying assumptions of random walk theory is that all relevant
information about a company is available to all potential investors who will act upon the
information in a rational manner (i.e that the stock market is efficient).
6 D Modigliani-Miller's dividend irrelevance theory states that the value of a company is determined
solely by the 'earning power' of its assets and investments, rather than its dividend policy.
However statements I, II and III all support the view that dividend policy can have an impact:
Information available to shareholders is imperfect, and they may not be aware of the future
investment plans and expected profits of their company, thus some investors do use the
dividend as an indicator of the company's success. Shareholders will tend to prefer a current
dividend to future capital gains (or deferred dividends) because the future is more uncertain.
Also differing rates of taxation on dividends and capital gains can create a preference for a high
7 D Under the weak form hypothesis of market efficiency, share prices reflect all available
information about past changes in the share price.
If a stock market displays semi-strong efficiency, current share prices reflect both:
 all relevant information about past price movements and their implications, and
publicly available or not:
 from past price changes
 from public knowledge or anticipation, or
 from specialists' or experts' insider knowledge (e.g. investment managers).
8 D As the information that is published is expected to change the market's perspective then the
chief executive must believe that the semi-strong form of the market is in operation.
9 A Profit before depreciation can be treated as an approximation of the net cash inflows of the
project, so depreciation needs to be added back. The initial investment in working capital is
treated as an additional cash outflow at the start but is then released at the end of the project
as a positive cash inflow.
10 A Option A is an opportunity cost of the project and must be brought into the calculations.
Option B is a sunk cost as it is already committed.
Option C is a is a sunk cost as the work has already been carried out.
Option D is not an incremental cost of the project.
MODULE 3
1 D Operating risk is all the risks faced by a business that are not financial risks. Credit and market
risk are both types of financial risk.
2 C A risk-averse investor does not require an investment to be risk-free. A risk-averse attitude is
that an investment should not be undertaken if there is an alternative investment offering either
the same return but with a lower risk or a higher return for the same risk. However, an
alternative investment might be undertaken if it has a higher risk, but offers a higher expected
return.
3 A The risk-averse investor will aim to maximise return whilst minimising risk.
4 A Interest rate risk is the risk of higher or lower profits or losses than expected, as a result of
uncertainty about future movements in an interest rate, or the general level of interest rates.
5 B Hazard risk is the exposure a business may have to natural events and their impacts, the actions
of employees, the consequences of accidents etc, be it on the business, its trading partners or
customers. Hazard risk is part of operating risk.
6 A The screening of customers is likely to reduce the risk of irrecoverable debts. Should
irrecoverable debts arise, insurance will transfer the risk to a third party.
7 D The business has suffered due to technological development in the industry bringing
innovation.
8 B Long term strategic exposure to risk is known as economic risk. Transaction risk arises on each
individual purchase from China or sale to the US.
MODULE 4
1 B Trade credit is one of the main sources of short-term finance for a business. Options A and D
are longer term sources of finance. A bank loan is a fixed amount drawn for a specified period;
it can be short term but trade credit is more likely to be used to cover fluctuations in the cash
flow requirements for normal trading operations.
2 B Venture capitalists often require a representative appointed to the company's board, or an
independent director, to safeguard their interests.
3 B The maturity schedule of borrowing refers to the dates by which the company's loan finance
must be repaid. Lengthening this will allow the company to put in place longer term borrowing
arrangements which will provide a standby.
4 B The investment in a non-current asset should be financed with a long term source of finance.
Venture capital is a specific form of finance typically used in start-up or management buyout
situations; trade credit is short term.
0.40
5 C Ke = + 0.05 = 18.3%
3.00
6 C Predicted current market value = present value of future cash flows = (6 + 109)  1.09–1 =
$105.505, rounded to $106
7 B Preference shareholders normally receive a lower return because they take less risk than
ordinary shareholders. Convertibles usually carry a lower interest rate because part of the return
is received in the form of a gain on conversion.
8 A The WACC reflects the company's existing mix of finance and the risk of its existing business
activities. Thus if the existing WACC is used to appraise new investments, the assumption is that
the mix of finance and the risk will remain unchanged, or that the project is so small that any
changes would be insignificant.
9 C The decision whether to lease or borrow money to buy the machine is a financing decision.
Leasing is another form of debt finance and so the two forms of debt finance can be compared
by discounting the relevant cash flows at an after-tax cost of borrowing.
MODULE 5
1 C A relates to the long-term capital structure of the business and D relates to a financing decision
so neither are relevant. In deciding on the best level of working capital, all businesses face a
trade-off between profitability and liquidity. Reduced liquidity incurs the risk of insolvency.
Liquidity and risk are therefore on the same side of the trade-off, whereas profitability and risk
are on opposite sides.
2 C The cash operating cycle is the period of time which elapses between the point at which cash
begins to be expended on the production of a product (because it is paid out to the suppliers
of material) and the collection of cash from the customer who purchases it.
3 A
Weeks
Inventory holding period 5
Production period 1
Finished goods holding period 2
Receivables collection period 3
Payables payment period (4)
Cash cycle 7
4 C To improve the cash operating cycle it needs to be shortened. The other options would all
cause it to increase. Option A would increase the average inventory turnover period; Option D
would reduce the average payables payment period and Option B would increase the average
receivables collection period.
5 A This would be an appropriate use of a long-term surplus.
6 D An aggressive working capital strategy involves financing long-term requirements with short-
term funds, which is likely to reduce liquidity but increase profitability since short term debt is
relatively cheap. Reduced liquidity leads to increased risk.
MODULE 6
1 A Director I is incorrect as regulation is designed to protect all investors not just institutional ones.
Director II is describing the role of financial intermediaries.
2 D Modigliani-Miller's dividend irrelevance theory states that the value of a company is determined
solely by the 'earning power' of its assets and investments, rather than its dividend policy.
However statements I, II and III all support the view that dividend policy can have an impact:
Information available to shareholders is imperfect, and they may not be aware of the future
investment plans and expected profits of their company, thus some investors do use the
dividend as an indicator of the company's success. Shareholders will tend to prefer a current
dividend to future capital gains (or deferred dividends) because the future is more uncertain.
Also differing rates of taxation on dividends and capital gains can create a preference for a high
3 D All statements are correct.
4 A A scrip dividend is where additional shares are issued to shareholders rather than paying them
cash.
5 A In general, an interest cover ratio of less than 3 is considered low.
6 B The formula for leverage (gearing) ratio is expressed as follows:
Total liabilities
×100
Total equity
($10 million / $15 million)  100 = 67%
7 D The terms of debt covenants may restrict a business' debt levels and therefore limit
opportunities for further borrowing, not increase them. All the other statements are correct.
MODULE 7
1 D Capital expenditure is spending on the acquisition of non-current assets or an improvement in

their earning capacity.
Options A, B and C are likely to be treated as operating (or revenue) expenditure – expenditure
incurred for the purpose of the trade of the business or to maintain the existing earning
capacity of non-current assets.
2 B Annual depreciation = ($50 000 – $20 000) / 3 years = $10 000 per annum. Average annual profit
is therefore $(22 000 – 10 000) = $12 000. The average non-current asset investment = ($50 000 +
$20 000) / 2 = $35 000. With the working capital investment of $10 000, average investment is
therefore $45 000. ROI = ($12 000 / $45 000)  100% = 26.7%
3 B The discounted payback method does this.
4 B (60 000  0.952) + (50 000  0.907) + (40 000  0.864) = $137 030, rounded to $137 000
5 B The NPV method is directly consistent with the objective of maximising shareholder wealth as it
gives the $ increase in wealth arising from the project.
6 B The IRR is independent of the cost of capital. A lower cost of capital increases present values,
reducing the discounted payback period.
 45 000 
7 C Project A IRR = 8% +  ×(8  2)%  = 12.5%
 (105 000  45 000) 
 10 500 
Project B IRR = 2% +  ×(8  2)%  = 3.1%
 (10 500 + 45 000) 
8 C
PV
$
Equipment (87 000)
Working capital, Year 0 (40 000)
Other outflows (100 000)
Cash inflows 215 000
Working capital, end of project 25 000
Net present value + 13 000
For the project to have an NPV of 0, the equipment would need to increase in cost above the
estimate by $13 000 / $87 000 = 15%.
9 D Management-imposed restrictions are internal and therefore are soft capital rationing.
10 B Ranking the projects on PV per $ invested:
X: 265 / 200 = 1.325
Y: 310 / 250 = 1.240
Z: 170 / 120 = 1.417
Rankings II, III, I respectively.
11 A The nominal rate of 20 per cent is applied to the nominal cash flows.
MODULE 8
1 A Economic risk can be hedged by the matching of assets and liabilities. Translation risk may be
hedged by group borrowings in the currency of the foreign subsidiary.
2 C Forward rate agreements hedge risk by fixing the interest rate on future borrowing. They
protect the borrower from adverse market interest rate movements to levels above the rate
negotiated for the FRA.
3 B Long term strategic exposure to risk is known as economic risk. Transaction risk arises on each
individual purchase from China or sale to the US.
4 D Secondary financial instruments often referred to as derivatives, are financial instruments such
as forward contracts, options and warrants, whose value is derived from an underlying asset.
Primary instruments such as equity shares are defined as primary by the fact that they have an
associated, measurable value.
5 C Hedging, sometimes called exposure management, is a form of risk management used by
companies to offset a variety of market risks.
6 D Theoretically, the price of an instrument should be identical whichever market it is traded in. In
reality, however, even with the development of multi-national and global trading this is not
always the case. Arbitrage, which is a major use of derivatives, is the process of exploiting price
differences between markets to make a profit.
7 B An organisation wishing to reduce the volatility, or increase the predictability, of its profits
and/or cash flows can use derivatives to offset adverse changes in underlying assets. It does this
by using financial instruments to transfer the risk it is trying to manage, via the market, to those
with a higher appetite for risk.
MODULE 9
1 D A risk averse investor wants to be compensated in the form of higher returns for taking on
additional risk. Here asset B has more risk than asset A but also generates a higher return.
Whether the additional return is sufficient to compensate for the risk involved depends on the
individual's attitude to risk which is expressed by the investor's indifference curve.
a x + b 1  x  + 2x 1  x  pab a b
2 2 2 2
2 B p =
Pab is the correlation coefficient of returns from investments A and B

Covariance of investments A and B
=
a × b
p2 = (0.25 × 0.3²) + (0.18 × 0.7²) + (2 × 0.3 × 0.7 × 0.05)

= 0.0225 + 0.0882 + 0.021
= 0.1317
3 D The capital market line, which is drawn from the risk-free rate at a tangent to the efficient
frontier, cuts the efficient frontier at portfolio M, the market portfolio. This portfolio is a
hypothetical portfolio of risky investments, containing every security available to investors in a
given market, in amounts proportional to their market values. In practice a well-diversified
portfolio of around 10–12 carefully selected different investments will 'mirror' the whole market
in terms of the weightings given to particular sectors, high income and high capital growth
securities, and so on.
4 B Expected return = 0.4  15% + 0.6  6% = 9.6%
Combined risk of a two asset portfolio is given by
a x + b 1  x  + 2x 1  x  pab a b
2 2 2 2
p =
Here the correlation coefficient between the risk free and risky asset is zero, and the risk-free
asset has zero risk, so the combined risk is:
p2 = (4 × 0.4²)
= 0.64
So, p = 0.8
Note that this is just the proportion invested in the risky asset times its standard deviation (ax)
295
BEFORE YOU BEGIN

QUESTIONS: ANSWERS
AND COMMENTARY
BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY | 297
MODULE 1
1 Money markets are markets for short term capital:

 Trading short-term financial instruments
 Short-term lending and borrowing
Capital markets are markets for trading in long-term finance, in the form of long-term financial
instruments such as equities and corporate bonds.
2 Equity securities consist primarily of ordinary shares which entitle the owner to a share of the
company's profits and give them voting rights.
Debt securities typically are fixed interest borrowings with a set repayment date, often secured on
the assets of the company.
3 A stock market acts as a primary market for raising finance, and as a secondary market for the
trading of existing securities.
The primary market is the market where securities (debt and equity) are issued for the first time.
The secondary market is the market where securities which have been issued in the primary
market are traded.
4 Over-the-counter (OTC) or off-exchange trading refers to financial instruments such as stocks,
bonds, commodities or derivatives which are traded directly between two parties, as opposed to
via an exchange. Major products traded on OTC markets in Australia include government debt
securities, corporate debt securities, currency and derivative instruments.
5 A financial intermediary is a party bringing together providers and users of finance either as
6 The government plays a vital role in the functioning of the capital market as:
 source of ultimate liquidity
MODULE 2
1 The time value of money reflects people's time preference for $1 now over $1 at some time in the
future.
2 An annuity is a series of cash flows of equal amount, and equal frequency in time for a defined
period.
3 Relevant costs are future, incremental cash flows. The relevant cash flows for appraisal of a project
are the changes in future cash flows that would arise from acceptance of the project.
4 The risk involved in holding securities (shares) divides into risk specific to the company
(unsystematic) and risk due to variations in market activity (systematic). Unsystematic or business
risk can be diversified away, while systematic or market risk cannot.
5 Beta factor is the measure of the systematic risk of a security relative to the risk of the market
portfolio. The beta factor of the market as a whole is 1.0.
6 The fundamental theory of share values states:
The current market price of a share represents the present value of all future expected returns from
the share, discounted at the shareholders' cost of capital (required rate of investment return).
7 Weak form efficiency implies that prices reflect all relevant information about past price
Semi-strong form efficiency implies that prices reflect past price movements and publicly
Strong form efficiency implies that prices reflect past price movements, publicly available
knowledge and inside knowledge.
8 Allocative efficiency
Operational efficiency
Financial markets have operational efficiency if transaction costs are kept as low as possible.
Pricing (information) processing efficiency
stocks and shares fairly and quickly.
9 The efficient market hypothesis implies that if new information is revealed about a company it
will be incorporated into its share price rapidly and rationally, with respect to both the direction
and size of the share price movement. Therefore, a long term investor cannot obtain higher than
average returns from a well-diversified share portfolio.
MODULE 3
1 Risk is the possible variation in an outcome from what is expected to happen.

Uncertainty is the inability to predict the outcome of an activity due to a lack of information.
2 Environmental risk includes, political and legal, economic and socio-cultural risk.
3 Translation risk is the risk that the organisation will make exchange losses when the accounting
Transaction risk is the risk of adverse exchange rate movements occurring in the course of normal
4 Interest rate risk is the risk of higher or lower profits or losses than expected, as a result of
uncertainty about future movements in an interest rate, or the general level of interest rates.
5 Risk classifications include two from financial, strategic/business, operational and hazard/events
risk.
6 Quantitative risk assessment involves the determination of measured figures for probabilities and
consequences producing a specifically quantified measure of risk.
7 Risk management strategies include:
 risk avoidance – not undertaking the relevant activity
 risk reduction – taking steps to reduce the severity of the impact
 risk transfer – passing the risk to a third party through hedging or insurance
 risk retention – accepting the loss if and when it occurs
8 In broad terms we can distinguish risk averse attitudes, risk neutral attitudes and risk seeking
attitudes.
A risk averse attitude is that an investment should not be undertaken if there is an alternative
investment offering either the same return but with a lower risk or a higher return for the same risk.
However, an alternative investment might be undertaken if it has a higher risk, but offers a higher
expected return.
A risk neutral attitude is that an investment should be chosen based on the expected (most likely)
return, irrespective of the risk.
A risk seeking attitude is that an investment should be undertaken if it offers higher possible
MODULE 4
1 Capital structure refers to the way in which an organisation is financed. Decisions include
choosing a suitable balance between debt capital and equity capital (gearing level), and deciding
on the balance between short-term and long-term finance.
2 As a general rule businesses should aim to match the length of finance with the maturity of the
asset being financed, therefore non-current assets would be financed by long term capital and the
majority of current assets by short-term capital.
3 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 redeemable at par (or above par) when they eventually
mature.
4 Venture capital is risk capital, normally provided in return for an equity stake to companies with
high growth potential. Examples of situations suitable for VC include business start-ups and
management buyouts.
5 Rather than buying an asset outright, using either available cash resources or borrowed funds, a
business may lease an asset. Leasing has become a popular source of finance as it allows a
business to spread the cost of having the asset over the time that it will generate returns.
6 The weighted average cost of capital is the average cost of capital to a company weighted
appropriately for debt and equity proportions.
MODULE 5
1 The amount tied up in working capital is equal to the value of raw materials, work-in-progress, finished
goods inventories and accounts receivable less accounts payable. The size of this net figure has a
direct effect on the liquidity of an organisation.
2 The two main objectives of working capital management are to ensure the company has sufficient
liquid resources to continue in business and to increase its profitability. These two objectives will
often conflict as liquid assets give the lowest returns. An excessively conservative approach to
working capital management resulting in high levels of cash holdings will result in a liquid business
but harm profits because the opportunity to make a return on the assets tied up as cash will have
been missed.
3 The cash operating cycle is the period of time which elapses between the point at which cash
begins to be expended on the production of a product and the collection of cash from a
purchaser.
4 Ways of easing a short-term cash shortage include:
 postponing capital expenditure
 accelerating cash inflows which would otherwise be expected in a later period
 reversing past investment decisions by selling assets previously acquired
 negotiating a reduction in cash outflows, to postpone or reduce payments
5 A moderate approach to working capital management achieves a balance between risk and
return. This is likely to result in long-term funds being used to finance permanent assets while
short-term funds finance non-permanent assets. This means that the maturity of the funds matches
the maturity of the assets.
MODULE 6
1 The roles of ASIC are:

 As the corporate regulator, it is responsible for ensuring that company directors and officers
carry out their duties honestly, diligently and in the best interests of their company.
 As the financial services regulator, it licenses and monitors financial services businesses to
ensure that they operate efficiently, honestly and fairly. These businesses typically deal in
superannuation, managed funds, shares and company securities, derivatives, and insurance.
2 For a business, the advantages of debt finance include: it is relatively cheap, secured against
assets, it has lower issue costs than shares, there is no impact on control of the company and there
is no dilution of earnings.
Total liabilities
3 Leverage (gearing) ratio: × 100
Total equity
Profit before interest and tax
Interest cover ratio:
Interest payable
4 Dividend policy refers to the choice that financial managers make between retaining a proportion
of earnings for reinvestment as opposed to distributing earnings in the form of dividends.
5 Theories of dividend policy include: traditional theory, residual theory or Modigliani-Miller
dividend irrelevance theory.
6 The residual theory of dividends says that if a company can identify projects with positive NPVs, it
should invest in them. Only when these investment opportunities are exhausted should dividends
be paid.
MODULE 7
1 Capital budgeting is the process of identifying, analysing and selecting investment projects whose
returns are expected to extend beyond one year.
2 Investment appraisal techniques include: Return on investment (also known as accounting rate of
return/return on capital employed), payback period, discounted payback, NPV, IRR.
3 The return on investment (ROI) measures the profitability of an investment by expressing the
expected accounting profits as a percentage of the carrying value of the investment. Once the
expected return on investment for the project is calculated, it is compared with a pre-determined
minimum target rate of return. The project is justified financially if its expected ROI exceeds the
minimum target.
4 The payback period is the length of time required before the total of the cash inflows received
from a project is equal to the cash outflows, and is usually expressed in years. In other words, it is
the length of time the investment takes to pay itself back.
5 Sensitivity analysis assesses how responsive the project's NPV is to changes in the variables used
to calculate that NPV. This helps identify the critical estimates in a project forecast.
6 Soft capital rationing is brought about by internal factors; hard capital rationing is brought about
by external factors.
7 Under the marginal cost of capital approach, any new capital raised for a project should be
roughly equal to the weighted average cost of current capital.
MODULE 8
1 A financial instrument is a contract that gives rise to a financial asset for one party to the contract
and a financial liability or equity instrument for the other party (the counterparty).
2 Debt factoring is an arrangement to have debts collected by a factor company, which advances a
3 Currency futures are standardised contracts for the sale or purchase at a set future date of a set
quantity of currency.
4 Matching and smoothing are two methods used to internally manage interest rate risk. Matching
is where liabilities and assets with a common interest rate are matched. Smoothing is where a
company keeps a balance between its fixed rate and floating rate borrowing.
5 Arbitrage is the process of buying an instrument in one market and selling it either instantly or
over a very short time horizon on another market, exploiting differences in the price to make a
profit.
MODULE 9
1 In terms of investment management, the Capital Asset Pricing Model (CAPM) can be used to
calculate a discount rate or cost of equity that incorporates risk.
2 E(ri) = rf + i(rm – rf)
3 The correlation coefficient measures the degree to which the returns on investments vary with
each other. Investments can be said to be positively correlated, negatively correlated or have no
correlation.
The combined risk of a portfolio will depend on how the two investments are correlated.
4 The impact of financial leverage or gearing is that by borrowing at the risk-free rate the investor
can increase the available return on his portfolio.
5 The efficient frontier shows a collection of risky portfolios each one providing an optimal return for
a given level of risk.
6 The market portfolio is a hypothetical portfolio containing every security available to investors in a
given market, in amounts proportional to their market values.
307
GLOSSARY OF TERMS
GLOSSARY OF TERMS | 309
Accounting rate of return See return on investment.

After-tax cost of capital The cost of capital that allows for any tax relief on the company's
debt finance.
Allocative efficiency When financial markets allow funds to be directed towards firms
which make the most productive use of them.
American Depository Receipts (ADRs). Equity of large non-US companies might be traded on US
stock markets as an ADR – a security denominated in US dollars,
that is backed by a number of shares in the non-US company.
Annuity A constant annual cash flow, for a number of years.
Arbitrage The process of buying an instrument in one market and selling it
either instantly or over a very short time horizon on another
market, exploiting differences in the price to make a profit.
Beta factor The measure of the systematic risk of a security relative to the risk
of the market portfolio.
Bonds Long-term debt capital raised by a company for which interest is
paid, usually half yearly and at a fixed rate. Holders of bonds are
therefore long-term payables for the company. The term is often
used interchangeably with debentures.
Business risk Risk that arises due to the existence of uncertainty about the
future and about a firm's business prospects which increases the
variability of its operating profits.
Capital allowance A tax allowance for the decline in value or depreciation of a non-
current asset.
Capital Asset Pricing Model A formula for predicting the required rate of return for an
(CAPM) investment, based upon its level of systematic risk relative to that
of the market as a whole.
Capital budgeting The process of identifying, analysing and selecting investment
projects whose returns are expected to extend beyond one year.
Capital expenditure Expenditure which results in the acquisition of non-current assets
or an improvement in their earning capacity.
Capital markets Markets for trading in long-term finance, in the form of long-term
financial instruments such as equities and corporate bonds.
Capital rationing A situation in which a company has a limited amount of capital to
invest in potential projects.
Capital market line (CML) The straight line which represents all possible combinations of
the market portfolio and the risk-free asset.
Capital structure The way in which an organisation is financed, by a combination of
long-term capital (equity capital, preference shares, bonds, bank
loans, convertible loan stock and so on) and short-term liabilities,
such as a bank overdraft and trade payables.
Cash operating cycle The period of time which elapses between the point at which
cash begins to be expended on the production of a product and
the collection of cash from the customer who purchases it.
Chartists (or technical analysts) Attempt to predict share price movements by assuming that past
price patterns will be repeated.
Committed cost A future cash outflow that will be incurred anyway, whatever
decision is taken now about alternative opportunities.
Convertible bonds Bonds that give the holder the right to convert to other
securities, normally ordinary shares, at a pre-determined
price/rate and time.
Correlation Measures the degree to which the returns on investments vary
with each other.
Cost of capital The cost of funds that a company raises and uses, which is
equivalent to the return that investors expect to be paid for
putting funds into the company.
Cost of debt The return an enterprise must pay to its lenders.
Cost of equity The return an enterprise must pay to its ordinary shareholders.
Cost of preference share capital The return an enterprise must pay to the investors in its
preference shares.
Covariance An absolute measure of the relationship between the returns on
two investments.
Credit risk The economic loss suffered due to the default of a borrower or
counterpart (e.g. a customer or supplier).
Debentures A form of loan note, the written acknowledgement of a debt

incurred by a company, normally containing provisions about the
payment of interest and the eventual repayment of capital.
Debentures are usually secured: lenders have the right to seize
assets if the loan is not repaid.
Debt securities Typically fixed interest borrowings with a set repayment date,
often secured on the assets of the company.
Deep discount bonds Loan notes issued at a price which is at a large discount to the
nominal value of the notes, and which will be redeemable at par
(or above par) when they eventually mature.
Derivatives (or secondary Financial instruments that derive their value from the price or
financial instruments) actual value of an underlying asset or item.
Discounted cash flow A technique of evaluating capital investment projects, using
discounting arithmetic to determine whether or not they will
provide a satisfactory return.
Discounted payback method How long it will take for a project to pay back the capital outlay
on a discounted cash flow basis.
Dividend policy The choice that financial managers make between retaining a
proportion of earnings for reinvestment as opposed to
distributing earnings in the form of dividends.
Dividend valuation model The assumption that the share price represents the present value
of all future dividends, discounted at the investors' required
return (the cost of equity).
Divisible project A project where it is possible to undertake a fraction of the
investment, say, half, in order to earn half of the net present
value (NPV) of the whole project.
Downside risk The possibility that an event will occur and adversely affect the
achievement of objectives.
Economic risk (In the context of international trade) refers to the effect of
exchange rate movements on the international competitiveness
of a company and assesses the effect on the present value of
longer term cash flows.
Efficient frontier Shows a collection of optimal portfolios for a rational, risk averse
investor: either the best return that can be expected for a given
level of risk or the lowest level of risk needed to achieve a given
expected rate of return.
Efficient market One where the prices of securities bought and sold reflects all
the relevant information available.
Efficient market hypothesis The hypothesis that the stock market reacts immediately to all
the information that is available. Therefore, a long term investor
cannot obtain higher than average returns from a well diversified
share portfolio.
Equity risk premium (See market risk premium)
Equity securities Consist primarily of ordinary shares which entitle the owner to a
share of the company's profits and give them voting rights.
Exchange rate The rate at which one country's currency can be traded in
exchange for another country's currency.
External risks Risks arising from factors outside the business, that the company
may be subject to but that it has no influence over.
Eurobond An international bond that is denominated in a currency not
native to the country where it is issued (not necessarily in Euros).
Eurocurrency Currency which is held by individuals and institutions outside the
country of issue of that currency.
Eurocurrency market Money market for borrowing and lending by banks in
currencies other than that of the country in which the bank is
based. Typically only available in major currencies for which
active markets exist.
Eurocurrency loan When a company borrows in a foreign currency.
Factoring organisation Takes over the management of the trade debts owed to its client
(a business customer) on the client's behalf. The factor company
collects the debts and provides an immediate cash advance of a
Financial instrument A contract that gives rise to a financial asset for one party to the
contract and a financial liability or equity instrument for the other
party (the counterparty).
Financial intermediary A party bringing together providers and users of finance either as
Financial mathematics A collection of mathematical techniques that can be applied to
finance and the financial markets.
Financial risk The risk arising as a result of how the business is financed.
Forward contract A binding promise to purchase or sell a set amount or value of an
underlying asset at a set future time.
Forward rate Is an exchange rate set now for currencies to be exchanged at a
future date.
Forward rate agreement (FRA) A method of hedging interest rate risk by fixing the interest rate
on future borrowing.
Fundamental analysis Analysing all the publicly available information about a company,
its industry and the economy in which it operates, in order to
ascertain the intrinsic value of a share and assess whether its
current share price is accurate.
Fundamental theory of share States that the market price of shares reflects investors'
values expectations of what the future returns from the shares will be.
Future A standardised contract, which may be traded or exchanged, to
buy or sell a specific amount or value of an asset in the future at a
set price, for delivery and payment on a set date.
Gearing (or leverage) The proportion of debt capital in a company's capital structure.
Hard capital rationing External limits are set on the amount of external financing an
organisation can seek, perhaps because of scarcity of financing,
high financing costs or other restrictions.
Hazard/events risk The exposure a business may have to natural events and their
impacts, the actions of employees and the consequences of
accidents, be it on the business, its trading partners or
customers.
Hedge A transaction to reduce or eliminate an exposure of risk.
Information processing The ability of a stock market to price stocks and shares fairly and
efficiency quickly.
Investor's indifference curve Represents an investor's preference for risk and return. An
investor will have no preference between any portfolios which
give a mix of risk and expected return which lies on the same
curve, since he or she derives equal utility from each of them.
Initial public offer (IPO) An invitation to apply for shares in a company based on
information contained in a prospectus.
Institutional investors Institutions which have large amounts of funds which they want to
invest.
Interest rates Effectively the 'prices' governing lending and borrowing.
Interest rate cap An interest rate option which sets an interest rate ceiling.
Interest rate floor An interest rate option which sets a lower limit to interest rates.
Interest rate collar An arrangement whereby a borrower can buy an interest rate cap
and at the same time sell an interest rate floor.
Interest rate parity The comparative interest rates in different countries are reflected
in the forward exchange rate.
Interest rate risk The risk of higher or lower profits or losses than expected, as a
result of uncertainty about future movements in an interest rate,
or the general level of interest rates.
Interest rate swap An agreement whereby the parties to the agreement exchange
interest rate commitments.
Internal rate of return The discount rate at which a project has a zero NPV.
Internal risks Risks arising from factors internal to the company, over which the
company can exercise control.
Investment Spending with a view to obtaining future benefits, long-term or
short-term.
Invoice discounting The purchase (by the provider of the discounting service) of a
company's trade debts, at a discount. Invoice discounting
enables a company to raise finance based on their expected
invoice receipts. The invoice discounter does not take over the
administration of the client's sales ledger so the client remains in
control of debt collection.
Leverage (or gearing) The proportion of debt capital in a company's capital structure.
Long-term finance Used for major investments and usually more expensive and less
flexible than short-term finance.
Management buyout The purchase of all or parts of a business from its owners by its
managers.
Marginal cost of capital The additional cost to the company of obtaining specific funds to
invest in a specific project.
Market portfolio A hypothetical portfolio containing every security available
to investors in a given market, in amounts proportional to
their market values.
Market risk (or systematic risk) The exposure to potential loss that would result from changes in
market prices or rates. Cannot be diversified away.
Market risk premium (equity risk The difference between the expected rate of return on a market
premium) portfolio and the risk-free rate of return over the same period.
Money markets Markets for trading short-term financial instruments and short-
term lending and borrowing.
Money cash flows The actual amounts to be received or paid at a future date.
Money market hedge A method of hedging against currency risk which involves taking
advantage of different interest rates in different countries.
Money rate of return The rate of return which includes a compensation for inflation.
Mutually exclusive projects Two or more projects from which only one can be chosen.
Net present value The sum of the present value of the benefits (revenues or savings)
from an investment, less the present value of expenditures.
Nominal cash flows See money cash flows.
Nominal rate of return See money rate of return.
Non-systematic risk (See unsystematic risk)
Official money market The market supported and sponsored by the Reserve Bank of
Australia (RBA), which is responsible for the conduct of monetary
policy, the issue of bank notes and the setting and management
of Australia's foreign exchange reserves.
Operating risk All the risks faced by a business that are not financial risks.
Operational risk Variability arising from the effectiveness of how the business is
managed and controlled on a day to day basis, the accuracy and
effectiveness of its information/accounting systems, its reporting
systems and its management and control structures. Operational
risk also encompasses compliance with issues such as health and
safety, consumer protection, data protection and so on.
Operational efficiency Financial markets have operational efficiency if transaction costs
are kept as low as possible because there is open competition
between brokers and other market participants.
Opportunity cost The costs incurred or revenues lost from diverting existing
resources from their next best use.
Options The right but not the obligation to purchase (a call option) or sell
(a put option) an underlying asset at a set price but at a future
date.
Over-the-counter (OTC) Financial instruments such as stocks, bonds, commodities
(or off-exchange trading) or derivatives which are traded directly between two parties, as
opposed to via an exchange.
Payback period The time required for the cash inflows from a project to recoup
the cash outlays.
Perpetuity A constant annual cash flow that continues indefinitely (a
perpetual annuity).
Placing An arrangement whereby the sponsoring market maker arranges
for most of a share issue to be bought by a small number of
investors, usually institutional investors such as pension funds and
insurance companies.
Portfolio The collection of different investments that make up an investor's
total holding.
Portfolio theory States that individual investments cannot be viewed simply in
terms of their risk and return. The relationship between the return
from one investment and the return from other investments is just
as important.
Post-tax cost of capital See after tax cost of capital.
Preference shares Shares which give the holder a fixed percentage dividend based
on the par value of the share. Generally riskier than bonds since
they rank behind debt in the event of a liquidation, although they
rank ahead of ordinary shares.
Primary market The market where securities (debt and equity) are issued for the
first time.
Profitability index The ratio of the present value of the project's future cash flows
(not including the capital investment) divided by the present
value of the total capital investment.
Purchasing power parity The idea that in absence of transaction costs, identical goods will
have the same price in different markets.
Random walk theory Based on the idea that share prices will alter when new information
becomes available. Since new information is unpredictable share
prices follow an unpredictable pattern or random walk.
Real cash flows The cash flow expressed in terms of today's value (i.e. uninflated).
Real rate of return The return expressed in constant price level terms.
Redemption The repayment of preference shares and/or bonds.
Regulatory system The system which aims to protect investors while minimising
interference in the market that might distort market price signals
and investment decisions.
Relevant cash flows Future incremental cash flows arising as a direct consequence of
a decision being taken.
Residual value The disposal value of equipment at the end of its life, or its
disposal cost.
Return on capital employed See return on investment.
Return on investment (ROI) A measure of the expected accounting profits from an
investment expressed as a percentage of the carrying value of
that investment. Also called accounting rate of return (ARR) or
return on capital employed (ROCE).
Revenue expenditure Expenditure which is incurred for the purpose of the trade of the
business or to maintain the existing earning capacity of
non-current assets.
Reverse yield gap Can occur because shareholders may be willing to accept lower
returns on their investment in the short term, in anticipation that
they will make capital gains in the future.
Rights issue An offer to existing shareholders enabling them to buy more
shares, usually at a price lower than the current market price.
Risk The possible variation in an outcome from what is expected to
happen.
Risk appetite The extent to which a company is prepared to take on risks in
order to achieve its objectives.
Risk averse attitude An investment should not be undertaken if there is an alternative
investment offering either the same return but with a lower risk or
a higher return for the same risk.
Risk neutral attitude An investment should be chosen based on the expected (most
likely) return, irrespective of the risk.
Risk seeking attitude An investment should be undertaken if it offers higher possible
Risk-free rate of return The return which would be required from an investment if it were
completely free from risk. Typically, a risk-free yield would be the
yield on government securities.
Sale and leaseback A company which owns its own premises can obtain finance by
selling its property to an insurance company or pension fund for
immediate cash and renting it back, usually for at least 50 years
with rent reviews every few years.
Scrip dividend A dividend paid by the issue of additional company shares, rather
than by cash.
Secondary market The market where securities which have been issued in the
primary market are traded.
Semi-strong efficient market A market where the current share prices reflect all relevant
information about past price movements and their implications,
and all knowledge which is available publicly.
Sensitivity analysis Assesses how responsive a project's NPV is to changes in the

variables used to calculate that NPV. This helps identify the
critical estimates in the project forecast.
Short-term finance Usually needed for businesses to run their day-to-day operations,
includes overdrafts, short-term loans, trade credit and lease
finance.
Single period capital rationing Funds are rationed at one point in time and capital is freely
available at all other times.
Soft capital rationing The imposition of internal constraints on an organisation's ability
to raise finance, which are often imposed when managerial
resources are limited.
Sovereign risk The risk that a government will refuse to comply with the terms of
a loan agreement during economically difficult or politically
volatile times.
Speculators Investors that take a calculated risk on the movements in an
underlying asset value and trade derivatives based on these, in
the expectation of making a profit.
Spot rate The exchange or interest rate currently offered on a particular
currency or security for immediate delivery.
Standard deviation A measure of the risk of a security.
Strategic risk Risks associated with the long-term strategic objectives of the
business, potential variability of business returns arising as a
result of the company strategy and its strategic position with
respect to competitors, customers, reputation, legal, regulatory
change or political change.
Strong form efficient market A market where share prices reflect all information about a
company, whether publicly available or not.
Sunk cost A cost which has already been incurred and hence should not be
taken account of in decision making.
Systematic risk Risk that cannot be diversified away.
Tax allowable depreciation See capital allowances.

Technical analysts (See chartists)
Term loan A loan for a fixed amount for a specified period.
Time value of money Recognises that $1 today is worth more than $1 at a future time,
because money can be reinvested to earn more money over
time.
Transaction risk The risk of adverse exchange rate movements occurring in the
course of normal international trading transactions.
Translation risk The risk that an organisation will make exchange losses when the
accounting results of its foreign branches or subsidiaries are
translated into the home currency.
Uncertainty The inability to predict the outcome of an activity due to a lack of

information.
Underwriters Financial institutions which agree (in exchange for a fixed fee,
perhaps 2.25 per cent of the finance to be raised) to buy at the
issue price any securities which are not subscribed for by the
investing public.
Unofficial money market Comprises the intercompany market (involving direct lending
between companies) and the commercial paper market
(intermediary trading of commercial bills, promissory notes and
negotiable certificates). Less formally organised than the official
money market and does not have official RBA support.
Unsystematic risk Applies to a single investment or class of investments, and can
be reduced or eliminated by diversification.
Upside risk The possibility that an event will occur and positively affect the
achievement of objectives.
Value of rights The theoretical gain a shareholder would make by exercising his
rights.
Venture capital Provided to companies with high growth potential in return for a
stake of equity. It is high risk financing as there is little guarantee
this potential will be fulfilled.
Warrants Financial instruments issued by banks, governments and other

institutions, which are traded on the ASX. Warrants may be
issued over securities (such as shares), a basket of different
securities, a share price index, debt, currencies, or commodities.
Weak form efficient market A market where share prices reflect all available information
Weighted average cost of Found by taking the cost of each individual source of finance and
capital weighting it according to its importance in the finance mix.
Working capital Current assets less current liabilities (the value of raw materials,
work-in-progress, finished goods inventories and accounts
receivable less accounts payable).
Zero coupon bonds Bonds that are issued at a discount to their redemption value,
but no interest is paid on them.
319
FORMULAE AND
DISCOUNT TABLES
FORMULAE AND DISCOUNT TABLES | 321
FORMULAE
INVESTMENT APPRAISAL (MODULE 2)

FUTURE AND PRESENT VALUES
a. The future value of a cash flow is given by:
n
FV = PV (1 + r)
The present value of a cash flow is given by:
1
PV = FV n
(1+ r)
where:
FV is the future value of the investment with interest.
PV is the initial or 'present' value of the investment.
r is the compound rate of return per time period, expressed as a proportion

(so 10% = 0.10, 5% = 0.05 and so on).
n is the number of time periods.
b. The present value of an annuity is given by:

PV =  1 n 
r  (1+r) 
c. The present value of a perpetuity is given by:
Annual cash flow

PV =
r
SOURCES AND COSTS OF FINANCE (MODULE 4)

a. Effective interest rates:
Effective annual interest rate re = (1 + r / m)m – 1
where:
r = annual stated (nominal or simple) interest rate.
re= effective annual interest rate (compound)
m = number of sub-periods within a year (the number of compounding periods in the year).
or alternatively,
(1 + re)1/m – 1 = rm
where:
re= effective annual interest rate (compound).
rm = equivalent period rate (compound).
m = number of sub-periods in the year.

b. Cost of irredeemable debt:
I
P0 =
Kb
The after-tax cost of irredeemable debt capital is:
k
Kd = (1  t)
P0
where:
Kd is the after-tax cost of debt capital to the company.
I is the annual interest payment.
P0 is the current market price of the debt capital ex interest (that is, after payment of the current
interest).
t is the rate of tax.
c. Cost of redeemable debt:
I I I+Pn
P0 = + 2
+ ...+ n
(1+K b ) (1+K b ) (1+K b )
where P0 is the current market price of debt capital after payment of the current interest.
I is the annual interest.
Kb is the required return of the providers of debt capital.
Pn is the amount payable on redemption in year n.
d. Cost of equity (Gordon growth model):
D0 (1+ g)
ke = +g
P0
where
Ke is the cost of equity
D0 is the current dividend per ordinary share
g is the annual dividend growth rate
P0 is the current ex-div price per ordinary share
e. Dividend growth rate:
g = bR
where:
b is the yield on new investments, and
R is the proportion of profits retained for reinvestment.
f. Cost of preference shares:
d
Kpref =
P0
g. Weighted Average Cost of Capital (WACC):
E D
WACC =K e + Kd
E +D E +D
where:
Ke is the cost of equity.
Kd is the post-tax cost of debt for the company.
E is the market value of equity in the firm.
D is the market value of debt in the firm.
INVESTMENT APPRAISAL (MODULE 7)

a. Internal rate of return:
 NA 
IRR = A +  N  N × B  A   %
 A b 
where:
A is the lower rate of return.
B is the higher rate of return.
NA is the NPV discounted at A.
NB is the NPV discounted at B.
NPV
b. Sensitivity = %
Present value of project variable
INVESTMENT MANAGEMENT (MODULE 9)

a. Capital asset pricing model
where:
E(ri) is the required return from a security.
b. Market value of a share:
D0 (1+ g)
P0 =
(r  g)
where:
D0 is the current year's annual dividend (i.e. the year 0 dividend).
P0 is the current ex-dividend share price.
r is the shareholders' required return, expressed as a proportion.
g is the annual growth rate in dividends, expressed as a proportion (e.g. 4% = 0.04).

Covariance
c. Correlation coefficient =
 x y
where:
x = standard deviation of returns from security x.
y = standard deviation of returns from security y.
d. Covariance =  p(x  x)(y  y)
where:
p = probability of outcome
x = return from security x at that outcome.
x = expected return from security x.
y = return from security y at that outcome.
y = expected return from security y.

e. Coefficient of variation =
x
f. The expected return rb of a two-asset portfolio:
rp = x r a +(1– x) r b
where:
x is the proportion of investment A in the portfolio.
r a , r b are the expected returns of investments A and B.
g. The standard deviation of the returns from a two-asset portfolio:
a x + b 1  x  + 2x 1  x  pab a b
2 2 2 2
p =
where:
p is the standard deviation of a portfolio of two investments, A and B.
a is the standard deviation of the returns from investment A.
b is the standard deviation of the returns from investment B.
a², b² are the variances of returns from investments A and B (the squares of the standard
deviations).
x is the weighting or proportion of investment A in the portfolio.
pab is the correlation coefficient of returns from investments A and B.

DISCOUNT TABLES
327
INDEX
INDEX | 329
Covariance, 246
A Credit insurance, 124, 215
Accounting rate of return (ARR), 163 Credit risk, 54, 56
Aggressive working capital management Currency futures, 220
policy, 128 Currency of invoice, 216
Allocative efficiency, 43, 240 Currency option, 221
American Depository Receipts, 15
American option, 213
Annuity, 27 D
Arbitrage, 228
Day-of-the-week effects, 243
Australia Pacific Exchange (APX), 142
Debentures, 81
Australian Financial Markets Association
Debt collection policy, 215
(AFMA), 12, 141
Debt securities, 5
Australian Prudential Regulation Authority
Deep discount bonds, 82
(APRA), 11
Default risk, 56
Australian Securities And Investments
Derivatives, 212
Commission (ASIC), 11, 140
Derivatives market, 7
Australian Securities Exchange (ASX), 12, 141
Discount factors, 26
Discount rate, 107
Discounted cash flow, 25
B
Discounted payback, 162, 174
Balanced portfolio, 35 Discounting, 25
Bendigo Stock Exchange (BSX), 142 Dividend growth model, 103, 106
Beta factor, 37 Dividend policy, 146
Bond market, 7 Dividend valuation model, 102, 198
Bonds, 81
Business risk, 52, 198
E
Economic exposure, 54, 70, 227
C
Economic risk, 54, 227
Call warrant, 224 Efficiency, 41
Cap, 224 Efficient frontier, 254
Capital allowances, 185 Efficient market, 41
Capital Asset Pricing Model (CAPM), 33, 238 Efficient market hypothesis, 42, 239
Capital budgeting, 159 Efficient portfolios, 254
Capital expenditure, 158 Equity, 85
Capital rationing, 192 Equity risk premium, 38
Capital structure, 76, 142 Equity securities, 5
Cash operating cycle, 122 Eurobond, 14
Chartists, 242 Eurocurrency, 14
Coefficient of variation, 246 Euro-equity, 14
Collar, 224 European option, 213
Committed cost, 31 Exchange control regulations, 53
Compounding, 25 Exchange rate, 9
Conservative working capital management Exchange-traded options, 221
policy, 127 Expected return of a portfolio, 244, 249
Conversion premium, 83 Export credit insurance, 215
Conversion value, 83 Exposure management, 226
Convertible bonds, 82 External risks, 55
Correlation, 245
Correlation coefficient, 246
Cost of capital, 27, 107 F
Cost of debt capital, 94, 99
Factoring, 124, 215
Cost of preference shares, 99
Financial analysis, 161
Countertrade, 215
Financial appraisal, 162
Country risk, 53
Financial distress costs, 143
Coupon, 82
Financial instruments, 212
Financial intermediary, 7
J
Financial risk, 55, 77, 143
Fixed charge, 81 Just-in-time procurement, 123
Floating charge, 81
Floor, 224
Fluctuating current assets, 128 L
Foreign bonds, 15
Foreign currency derivatives, 220 Leading and lagging, 217
Foreign Equity, 15 Lease or buy decisions, 98
Foreign exchange market, 7, 10 Leasing, 95
Forfaiting, 215 Leverage, 76, 249
Forward contract, 213 Liquidity risk, 54
Forward exchange contract, 218 Loan notes, 81
Forward interest rate agreements (FRAs), 222
Forward rate, 9
Fundamental theory of share values, 41, 239 M
Funding risk, 56
Futures, 212 Managing accounts receivable, 213
Market efficiency, 41, 43
Market imperfections and pricing anomalies,
G 243
Market portfolio, 255
Gearing, 76, 142 Market risk, 34, 56, 238
Gordon's growth model, 104 Market risk premium, 38
Matching and smoothing, 222
Matching assets and liabilities, 217
H Matching receipts and payments, 217
Moderate working capital management policy,
Hard capital rationing, 160, 192, 193 128
Hazard/events risk, 56 Modigliani and Miller, 147
Hedge, 226 Month-of-the-year effects, 243
Hour-of-the-day effects, 243 Mutually exclusive projects, 188
I N
Import quotas, 53 National Stock Exchange of Australia (NSX),
Incremental costs, 30 142
Indifference curve, 252 Negative correlation, 245
Inflation, 180 Net present value (NPV), 162, 176
Information processing efficiency, 43, 240 Net working capital, 120
Initial public offer (IPO), 90 No correlation, 245
Institute of Risk Management (IRM), 64 Nominal cash flows, 182
Institutional investors, 6 Nominal rate of return, 181
Interest cover, 144 Non-divisible projects, 196
Interest rate futures, 223 Non-relevant costs, 30
Interest rate option, 223 Non-systematic risk, 34, 238
Interest rate risk, 58 Non-tariff barriers, 53
Interest rate swap, 222 NPV, 176
Internal rate of return (IRR), 162, 167
Internal risks, 55
International capital markets, 13 O
International money markets, 13
Investing surplus cash, 127 Official money market, 5
Investment appraisal, 161 Operating expenditure, 158
Invoice discounting, 124 Operating risk, 56
IRR formula, 169 Operational efficiency, 43, 240
Irredeemable debt, 99 Opportunity, 52
Issue price for a rights issue, 86 Opportunity costs, 30
INDEX | 331
Option premium, 223 Risk reduction, 65

Options, 213, 221 Risk retention, 65
Ordinary shares, 85 Risk seeking attitude, 66
Origin of proposals, 160 Risk transfer, 65
Over the counter (OTC) options, 221 Risk-free investments, 254
Overdraft, 78 Risk-free securities, 35
Over-the-counter market, 7
S
P
Sale and leaseback, 95
Payback period, 162, 171 Scrip dividend, 148
Permanent current assets, 128 Secondary financial instruments, 212
Perpetuities, 28 Secondary market, 6
Physical risk, 54 Semi-strong form efficiency, 42, 240
Placement, 91 Sensitivity analysis, 189
Placing, 91 Settlement discount, 215
Political risks, 53 Share repurchase, 149
Portfolio theory, 236, 244 Shareholder wealth creation, 178
Positive correlation, 245 Short selling, 249
Preference shares, 84, 99 Short-term loans, 78
Present value, 26 Signalling, 146
Price earnings (P/E) ratio, 92 Single period capital rationing, 193
Primary financial instruments, 212 Socio-cultural risk, 54
Primary market, 6 Soft capital rationing, 160, 192
Profitability index, 194 Sovereign risk, 53
Project acceptance decision, 161 Speculation, 228
Put warrant, 224 Spot rate, 9
Standard deviation of the portfolio, 250
Stock Exchange, 12, 141
Q Stock Exchange introduction, 91
Stock markets, 6
Qualitative issues in long-term decisions, 161 Stock split, 148
Qualitative risk assessment, 63 Strategic/business risk, 56
Quantitative risk assessment, 63 Strong form efficiency, 43
Sunk cost, 31
Systematic risk, 34, 238
R
Random walk theory, 242
T
Real cash flows, 182
Real rate of return, 181 Tariffs, 53
Redemption, 84 Taxation, 99, 184
Relevant cash flows, 29 Term loan, 78
Relevant costs, 29 The Australian Prudential Regulation Authority
Residual theory of dividend policy, 147 (APRA), 141
Return on capital employed (ROCE), 162 Time value of money, 24
Return on investment (ROI) method, 162, Trade credit, 79, 125
163 Trade risk, 54
Rights issue, 86 Transaction exposure, 57, 227
Risk, 52, 144 Transaction risk, 57, 227
Risk appetite, 64, 65 Translation exposure, 57, 227
Risk assessment, 62 Translation risk, 57, 227
Risk averse attitude, 66
Risk avoidance, 65
Risk identification, 62 U
Risk management, 64
Risk management strategy, 65 Uncertainty, 52
Risk neutral attitude, 66 Underwriters, 91
Risk of a portfolio, 249 Unsystematic risk, 34, 238
Wollongong Stock Exchange, 142

V
Working capital, 120
Value of rights, 88 Working capital financing, 128
Venture capital, 93 Working capital requirement, 120
W Z
Weak form efficiency, 42, 240 Zero coupon bonds, 82

Weighted Average Cost of Capital (WACC),
107, 198

Business Finance Seventh Edition Study Guide

Uploaded by

Copyright:

Available Formats

Business Finance Seventh Edition Study Guide

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Business Finance Seventh Edition Study Guide

Uploaded by

Copyright:

Available Formats

FOUNDATION EXAMS

Seventh edition 2019

ISBN 9781 5097 2254 9

All rights reserved. No part of this publication may

The contents of this book are intended as a guide

Every effort has been made to contact the copyright

We are grateful to CPA Australia for permission to

This is printed on FSC accredited stock by an

Revision questions 267

Answers to revision questions 285

Before you begin questions: Answers and commentary 297

Glossary of terms 309

Formulae and discount tables 321

International Education Standards

YOU AND YOUR STUDY PLAN

ADDITIONAL LEARNING SUPPORT

STANDARDS AND LEGISLATION

Learning Show the referenced CPA Australia learning objectives.

Introduction Presents a general idea of what is covered in this module.

Worked Example An illustration of a particular technique or concept with a solution or

PREPARING FOR YOUR FOUNDATION EXAM

TIPS FOR EXAMS

ANSWERING MULTIPLE CHOICE QUESTIONS

COMPUTER-BASED EXAM NAVIGATION

MODULE 1 – INTRODUCTION TO CAPITAL AND MONEY MARKETS

MODULE 2 – INTRODUCTION TO FINANCIAL THEORIES

MODULE 3 – INTRODUCTION TO RISK IDENTIFICATION,

MODULE 4 – SOURCES AND COST OF FINANCE

MODULE 5 – LIQUIDITY MANAGEMENT

MODULE 6 – CAPITAL STRUCTURE AND MANAGEMENT

MODULE 7 – CASH FLOW VALUATION AND INVESTMENT

MODULE 8 – MARKET AND CREDIT RISK MANAGEMENT

MODULE 9 – INVESTMENT MANAGEMENT

Module Learning Objectives (LO) Weighting

1.3 Describe sources of international finance

Module Learning Objectives (LO) Weighting

Module Learning Objectives (LO) Weighting

Discuss regulation in the finance industry LO1.2

Describe sources of international finance LO1.3

1 Introduction to the financial markets

International markets Participants

Money markets Capital markets

Equity (stock market)

Primary market Secondary market

BEFORE YOU BEGIN

1 INTRODUCTION TO THE FINANCIAL MARKETS

1.1 THE ROLE AND STRUCTURE OF FINANCIAL MARKETS

1.2 THE MONEY MARKETS

1.2.1 OFFICIAL AND UNOFFICIAL MONEY MARKETS

1.3 THE CAPITAL MARKETS

1.4 CAPITAL MARKET PARTICIPANTS

1.4.1 INSTITUTIONAL INVESTORS

1.5 FUNCTIONS OF THE STOCK MARKET

The stock markets serve two main purposes:

1.6 AUSTRALIAN CAPITAL MARKETS

1.6.2 THE BOND MARKET

1.6.3 THE FOREIGN EXCHANGE MARKETS

1.6.4 DERIVATIVES MARKETS

1.6.5 OVER-THE-COUNTER (OTC) MARKETS