TUTORIAL 10

QUESTION 3 (c)
c) The net present value method of investment appraisal has a number of
advantages over other methods.
i.

It is based on cash flows not accounting profit unlike ROCE. Accounting

profits are subject to a number of different accounting treatments and cash
flows can add to the wealth of the shareholders via increased dividends.

ii.

NPV looks at cash flows throughout the whole of an investment period unlike
payback, which ignores cash flows after the end of the payback period. This
avoids the incorrect rejection of projects with later high returns, although it is
unlikely in practice that payback would be used in isolation.

iii.

NPV incorporates the time value of money by using discounted cash flows
whereas ROCE and payback do not. This means that it takes account of the
fact that $1 today is worth more than $1 in one year's time. Discounted
payback can be used but this will still ignore cash flows after the payback
period.

iv.

NPV is viewed as being technically superior to IRR and simpler to

calculate. It reflects the amount of the initial value rather than a relative
measure of return and represents the change in total market value that will
occur if the investment project is accepted. Other investment appraisal
methods do not directly show the potential increase in shareholder wealth,
which is a primary financial management objective.

v.

The NPV method is superior for ranking mutually exclusive projects in

order of attractiveness. IRR will give an incorrect indication where discount
rates are less than the IRR of incremental cash flows.

vi.

Where cash flow patterns are non-conventional, for example where the
sign of the net cash flow changes in successive periods, there may be
several IRRs which decision makers must be aware of to avoid making the
wrong decision. NPV however can accommodate these non-conventional
cash flows.

vii.

When discount rates are expected to differ over the life of the project, such
variations can be incorporated easily into NPV calculations, but not into IRR
calculations.

viii.

An assumption underlying the NPV method is that any net cash inflows
generated during the life of the project will be reinvested at the cost of
capital (that is, the discount rate). The IRR method, on the other hand,
assumes these cash flows can be reinvested to earn a return equal to the IRR
of the original project, which is not necessarily reasonable.

Limitations of NPV techniques

(i) Shareholder wealth maximisation
NPV is based on the assumption that the primary aim of the organisation is
to maximise the wealth of the ordinary shareholders. This is valid for many
companies, but in some investment decisions there may be other overriding factors
that make the NPV approach less relevant. This is particularly true when the
investment under consideration is fundamental to the strategic direction of the
business.
(i) Discount rate
A major problem in the use of NPV in practice is the choice of the discount rate.
It is generally accepted that the rate to be used should be the cost of capital, but
this in itself may be difficult to determine. The problem is particularly tricky when
the size of the investment means that the company will need to acquire a
significant amount of additional capital, and there is uncertainty about the cost of
new funds.
(ii)

Risk

A related problem to the choice of the discount rate is the incorporation of risk.
The simplest approach is to apply a risk premium to the cost of capital, but the
amount of this is subjective. Other approaches include the use of sensitivity
analysis and probability analysis, but these too have limitations, and involve the
use of subjective judgements.
(iii)

Cash flow timing

The technique assumes that all cash flows arise at the end of the time
period (which is usually one year). This is obviously untrue, and large fluctuations
in this pattern may distort the results. Breaking the analysis down into small
periods leads to complication, and may be unsatisfactory due to the problems of
forecasting in such a precise way.
(iv) Non quantifiable costs and benefits
Some costs and benefits that arise are not quantifiable. There may be
important non-financial factors that are relevant to the decision, but which are
difficult to quantify. For example, undertaking a new investment may enhance the
standing of the company, making it more attractive to customers, investors and
potential employees. This could have an important impact on the performance of
the company, but cannot be quantified in an NPV analysis.

TUTORIAL 11
QUESTION 1 (C)
Difference between Risk and uncertainty
Risk can be applied to a situation where there are several possible outcomes and,
on the basis of past relevant experience, probabilities can be assigned to the
various outcomes that could prevail. The risk of a project increases as the
variability of returns increases. Uncertainty can be applied to a situation where
there are several possible outcomes but there is little past relevant experience to
enable the probability of the possible outcomes to be predicted. Uncertainty
increases as the project life increases.
Sensitivity analysis
This assesses the sensitivity of project NPV to changes in project variables. It
calculates the relative change in a project variable required to make the NPV zero,
or the relative change in NPV for a fixed change in a project variable. Only one
variable is considered at a time. When the sensitivities for each variable have been
calculated, the key or critical variables and the extent to which those variables
may change before the investment results in a negative NPV can be identified.
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.
Weaknesses of sensitivity analysis
The method requires that changes in each key variable are isolated. However
management is more interested in the combination of the effects of changes in two
or more key variables and 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 and critical factors may
be those over which managers have no control.
Probability analysis
A probability distribution of 'expected cash flows' can often be estimated,
recognising there are several possible outcomes, not just one. An expected value
of NPV can be calculated and risk measured by calculating the worst possible
outcome and its probability and/or the probability that the project will fail to
achieve a positive NPV.

Weaknesses of probability analysis

An investment may be one-off, and 'expected' NPV may never actually occur. Also,
assigning probabilities to events is highly subjective. Finally, expected values
do not evaluate the range of possible NPV outcomes.

QUESTION 3
(a) Why consider risk and uncertainty?
The terms risk and uncertainty are often used interchangeably but a distinction
should be made between them. With risk, there are several possible outcomes,
which upon the basis of past relevant experience can be quantified. In areas of
uncertainty, again there are several possible outcomes, but with little past
experience, it will be difficult to quantify its likely effects.
A risky situation is one where we can say that there is a 70% probability that
returns from a project will be in excess of $100,000 but a 30% probability that
returns will be less than $100,000. If, however, no information can be provided on
the returns from the project, we are faced with an uncertain situation. Managers
need to exercise caution when assessing future cash flows to ensure that they
make appropriate decisions. If a project is too risky, it might need to be rejected,
depending upon the prevailing attitude to risk.
In general, risky projects are those whose future cash flows, and hence the project
returns, are likely to be variable. The greater the variability is, the greater the risk.
The problem of risk is more acute with capital investment decisions than other
decisions because estimates of cash flows might be for several years ahead, such
as for major construction projects.
(b) Assuming that cash flows occur evenly throughout the year:
Contribution per unit = $3.00 $1.65 = $1.35
Total contribution = 20,000 units x $1.35 = $27,000 per year
Annual cash flow = $27,000 $10,000 = $17,000
Payback = $50,000/$17,000 = 2.9 years
This exceeds the company's hurdle payback period of two years. Payback is
often used as a first screening method. By this, we mean that the first question to
ask is: 'How long will it take to pay back its cost?' Umunat has a target payback,
and so it might be tempted to reject this project. However, a project should not be
evaluated on the basis of payback alone. If a project gets through the payback test,
it ought then to be evaluated with a more sophisticated investment appraisal
technique, such as NPV. Payback ignores the timing of cash flows within the
payback period, the cash flows after the end of payback period and therefore the
total project return. It also ignores the time value of money (a concept
incorporated into more sophisticated appraisal methods).

c)

NPV of sales revenue = 20,000 x $3.00 x 3.605 = $216,300

NPV of variable costs = 20,000 x $1.65 x 3.605 = $118,965
NPV of contribution = $97,335.
(i) Sensitivity to sales volume
For an NPV of zero, contribution has to decrease by $11,285. This represents a
reduction in sales of
11,285/97,335 = 11.6%

(ii) Sensitivity to sales price

As before, for an NPV of zero, contribution has to decrease by $11,285. This
represents a reduction
in selling price of 11,285/216,300 = 5.2%
(iii) Sensitivity to variable cost
As before, for an NPV of zero, contribution has to decrease by $11,285. This
represents an increase
in variable costs of 11,285/118,965 = 9.5%

TUTORIAL 12 Q1
(a)

types of Foreign exchange exposure

Transaction risk
This 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.
For example, a sale worth $3,000 when the exchange rate is $1.7820 = 1 has an
expected sterling value of 1,684. If the dollar has depreciated against sterling to
$1.8500 = 1 when the transaction is settled, the sterling receipt will have fallen to
1,622. Transaction risk therefore affects cash flows so companies often choose to
hedge or protect themselves against transaction risk.
Translation risk
This 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 balance sheet
date.
For example, an asset is valued on a balance sheet at $14 million and was acquired
when the exchange rate was $1.79 = 1. One year later, the exchange rate has
moved to $1.84 = 1 and the balance sheet value of the asset has changed from
$7.82 million to $7.61 million, resulting in an unrealised (paper) loss of $0.21
million.
Translation risk does not affect cash flows so does not directly affect shareholder
wealth. However, investors may be influenced by the changing values of assets
and liabilities so a company may choose to hedge translation risk through, for
example matching the currency of assets and liabilities. For example an asset
denominated in euros would be financed by a euro loan.
Economic risk
This refers to the effect of exchange rate movements on the international
competitiveness of a company. For example, a UK company might use raw
materials which are priced in US dollars, but export its products mainly within the
EU. A depreciation of sterling against the dollar or an appreciation of sterling
against other EU currencies 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.
(b)

approaches to handle the different types of exposure described above.

(1)

Forward exchange contracts can be used to arrange to buy or sell

currency at a predetermined future date and rate. Such contracts can be
matched to known future operational transactions to reduce the uncertainties

associated with exposure. However, the group may miss the opportunity to
make a profit on the exchange rate.
(2)

Currency options can be useful in situations where the actual date and
amount of the transaction are uncertain, eg where the company issues a price
list in a local currency. The company buys an option to buy or sell currency at
an agreed rate and date in the future. If exchange rate movements are
unfavourable, the option can be abandoned. Options are expensive, but they
do allow the company to take advantage of any favourable movements in
rates as well as avoiding any losses.

(3)

Currency swaps may be made directly with another company or through a

bank. The futures market can be used to hedge against possible gains or
losses on exchange.

(4)

(5)

(6)

Currency of invoice One internal hedging method is for a company to

invoice foreign customers in its domestic currency, thereby transferring the
foreign currency risk to the foreign customers. This method is usually not
commercially viable, however, as foreign customers will transfer their
business to competitors who do invoice in the foreign currency, thereby
avoiding the foreign currency risk.

Matching The risk arising from foreign currency receipts and payments can
be managed by matching. Receipts and payments in the same foreign
currency can be matched, for example, by using a foreign currency bank
account, so that there is no need to buy the foreign currency.

Leading and lagging Transaction risk can be managed by leading and

lagging, where foreign currency payments could be made in advance
(leading) or in arrears (lagging), depending on the view of the paying
company as to whether the currency of payment was expected to appreciate
or depreciate against the domestic currency. Lagged payments to accounts
payable should not exceed the credit period agreed with the supplier,
however.

QUESTION 3
(b) Implications of a fall in interest rates for a typical company
(i) The cost of floating rate borrowing will fall, making it more attractive than
fixed rate borrowing. For most companies with borrowings, i charges will be
reduced, resulting in higher profitability and EPS.
(ii) The value of the company's shares will rise, both because of the higher
level of company profitability and also because of the lower alternative returns that
investors could earn from banks and deposits, if interest rates are expected to
remain low in the longer term.
(iii) The higher share value results in a lower cost of equity capital, and
hence a lower overall COC for the company. Investment opportunities that were
previously rejected may now become viable.

(iv) As interest rates fall, consumers have more disposable income. This may
increase demand for the company's products. Falling returns on deposits may,
however, encourage many people to save more, rather than spend.
(c) Change in cost of capital
As explained above, if interest rates are expected to remain low in the longer term,
the company's overall cost of capital will fall. The discount rates used in
investment appraisal will therefore be lower, making marginal projects more
profitable, with a resulting increase in the company's investment opportunities.
Investment policy review
The cash flows from all possible investments should be reviewed in the light of
falling interest rates and the possible effects on consumer demand and the sterling
exchange rate. These cash flows should then be appraised at the new lower
discount rates and the project portfolio ranked and reviewed. The company's
investment plans are likely to be expanded, unless constrained by other factors
such as lack of skills or management time.

1. TUTORIAL 13 (d)
Money market hedge
Money market hedging would involve borrowing in euros, converting the money
borrowed into dollars and putting the money on deposit until the time the
transaction is completed, hoping to take advantage of favourable interest rate
movements.
$ interest rate over six months = 3.5/2 = 1.75%
$s required now in order to have $250,000 in six months time = 250,000/1.0175 =
$245,700 Current spot selling rate = 1.998 0.002 = $1.996 per 1
Cost of $s to be deposited = 245,700/1.996 = 123,096 interest rate over six
months = 6.1/2 = 3.05%
Value of loan in six months time = 123,096 1.0305 = 126,850
Forward market hedge
Forward exchange contracts hedge against transaction exposure by allowing the
importer to arrange for a bank to buy a quantity of foreign currency at a future
date, at a rate of exchange determined when the forward contract is made.
Six months forward rate = 1.979 0.004 = $1.975 per 1
cost using forward market hedge = 250,000/1.975 = 126,582
Lead payment
A lead payment is a payment in advance. This is particularly useful if the
currency in which the payment is to be made is appreciating, as is the case here.
cost now = 250,000/1.996 = 125,251
This money would need to be borrowed so there is an interest cost. value of loan
in six months time = 125,251 1.0305 = 129,071
Conclusion
All of the hedging methods relate to six months in the future so can be directly
compared. The lead payment is the most expensive method and the forward
market hedge is the cheapest. It is therefore recommended that a forward
market hedge be used.

Interest (riba) is the predetermined amount received by a provider of finance,

over and above the principal amount of finance provided. Riba is absolutely
forbidden in Islamic finance. Riba can be seen as unfair from the perspective of
the borrower, the lender and the economy.
For the borrower, riba can turn a profit into a loss when profitability is low. For the
lender, riba can provide an inadequate return when unanticipated inflation arises.
In the economy, riba can lead to allocational inefficiency, directing economic
resources to sub-optimal investments.
Islamic financial instruments require that an active role be played by the
provider of funds, so that the risks and rewards of ownership are shared.
In a Musharaka contract, profits are shared between the partners in the
proportions agreed in the contract, while losses are shared between the partners
according to their capital contributions. With Sukuk, certificates are issued which
are linked to an underlying tangible asset and which also transfer the risk and
rewards of ownership. The underlying asset is managed on behalf of the Sukuk
holders.
In a Murabaha contract, payment by the buyer is made on a deferred or
instalment basis. Returns are made by the supplier as a mark-up is paid by the
buyer in exchange for the right to pay after the delivery date. Profits are shared
between the partners in the proportions agreed in the contract, while losses are
borne by the provider of finance.
In an Ijara contract, which is equivalent to a lease agreement, returns are made
through the payment of fixed or variable lease rental payments.
A mudaraba contract, in Islamic finance, is a partnership between one party that
brings finance or capital into the contract and another party that brings business
expertise and personal effort into the contract. The first party is called the owner
of capital, while the second party is called the agent, who runs or manages the
business.
The mudaraba contract specifies how profit from the business is shared
proportionately between the two parties. Any loss, however, is borne by the
owner of capital, and not by the agent managing the business. It can therefore be
seen that three key characteristics of a mudaraba contract are that no interest is
paid, that profits are shared, and that losses are not shared.
If Zigto Co were to decide to seek Islamic finance for the planned business
expansion and if the company were to enter into a mudaraba contract, the
company would therefore be entering into a partnership as an agent, managing the
business and sharing profits with the Islamic bank that provided the finance and
which was acting as the owner of capital.
The Islamic bank would not interfere in the management of the business and this is
what would be expected if Zigto Co were to finance the business expansion using
debt such as a bank loan. However, while interest on debt is likely to be at a fixed
rate, the mudaraba contract would require a sharing of profit in the agreed
proportions.