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ACCA F9

FINANCIAL MANAGEMENT

REVISION PACK

MARCH-2017
F9: Financial Management

Index

Sr. No. Chapter Name Page No.


1 An Introduction 4
2 The Economic Environment and 6
Financial Markets
3 The Investment Appraisal 11
4 Specific Investing Decision 24
5 Cost of Capital 33
6 Capital Structure and WACC 43
7 Source of Finance 48
8 Business Valuation 59
9 Risk Management 66
10 Working Capital Management 74
Formulae Sheet

Economic order quantity

2C0D
=
Ch

MillerOrr Model

1
Return point = Lower limit + ( spread)
3
1
3 transaction cost variance of cash flows 3
Spread = 3 4
interest rate

The Capital Asset Pricing Model

() (( ) )
E ri = R f + i E rm Rf

The asset beta formula


a = Ve
e + Vd 1 T
d
( )

(V
e + Vd
1 (
T ))

V
e + Vd
1 T (
( ))
The Growth Model

Po =
(
D0 1 + g )
(re
g )
Gordons growth approximation

g = bre

The weighted average cost of capital

V V
WACC = e ke +
Ve + Vd
d k 1 T
Ve + Vd d
( )
The Fisher formula

(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity

S1 = S0
(1 + h )c
F0 = S0
(1 + i ) c

(1 + h )b (1 + i ) b

13 1 [P.T.O.
Present Value Table

Present value of 1 i.e. (1 + r)n


Where r = discount rate
n = number of periods until payment

Discount rate (r)


Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 0980 0961 0943 0925 0907 0890 0873 0857 0842 0826 2
3 0971 0942 0915 0889 0864 0840 0816 0794 0772 0751 3
4 0961 0924 0888 0855 0823 0792 0763 0735 0708 0683 4
5 0951 0906 0863 0822 0784 0747 0713 0681 0650 0621 5

6 0942 0888 0837 0790 0746 0705 0666 0630 0596 0564 6
7 0933 0871 0813 0760 0711 0665 0623 0583 0547 0513 7
8 0923 0853 0789 0731 0677 0627 0582 0540 0502 0467 8
9 0914 0837 0766 0703 0645 0592 0544 0500 0460 0424 9
10 0905 0820 0744 0676 0614 0558 0508 0463 0422 0386 10

11 0896 0804 0722 0650 0585 0527 0475 0429 0388 0350 11
12 0887 0788 0701 0625 0557 0497 0444 0397 0356 0319 12
13 0879 0773 0681 0601 0530 0469 0415 0368 0326 0290 13
14 0870 0758 0661 0577 0505 0442 0388 0340 0299 0263 14
15 0861 0743 0642 0555 0481 0417 0362 0315 0275 0239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 0812 0797 0783 0769 0756 0743 0731 0718 0706 0694 2
3 0731 0712 0693 0675 0658 0641 0624 0609 0593 0579 3
4 0659 0636 0613 0592 0572 0552 0534 0516 0499 0482 4
5 0593 0567 0543 0519 0497 0476 0456 0437 0419 0402 5

6 0535 0507 0480 0456 0432 0410 0390 0370 0352 0335 6
7 0482 0452 0425 0400 0376 0354 0333 0314 0296 0279 7
8 0434 0404 0376 0351 0327 0305 0285 0266 0249 0233 8
9 0391 0361 0333 0308 0284 0263 0243 0225 0209 0194 9
10 0352 0322 0295 0270 0247 0227 0208 0191 0176 0162 10

11 0317 0287 0261 0237 0215 0195 0178 0162 0148 0135 11
12 0286 0257 0231 0208 0187 0168 0152 0137 0124 0112 12
13 0258 0229 0204 0182 0163 0145 0130 0116 0104 0093 13
14 0232 0205 0181 0160 0141 0125 0111 0099 0088 0078 14
15 0209 0183 0160 0140 0123 0108 0095 0084 0074 0065 15

14 2
Annuity Table

(1 + r)n
Present value of an annuity of 1 i.e. 1
r

Where r = discount rate


n = number of periods

Discount rate (r)


Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 1970 1942 1913 1886 1859 1833 1808 1783 1759 1736 2
3 2941 2884 2829 2775 2723 2673 2624 2577 2531 2487 3
4 3902 3808 3717 3630 3546 3465 3387 3312 3240 3170 4
5 4853 4713 4580 4452 4329 4212 4100 3993 3890 3791 5

6 5795 5601 5417 5242 5076 4917 4767 4623 4486 4355 6
7 6728 6472 6230 6002 5786 5582 5389 5206 5033 4868 7
8 7652 7325 7020 6733 6463 6210 5971 5747 5535 5335 8
9 8566 8162 7786 7435 7108 6802 6515 6247 5995 5759 9
10 9471 8983 8530 8111 7722 7360 7024 6710 6418 6145 10

11 10368 9787 9253 8760 8306 7887 7499 7139 6805 6495 11
12 11255 10575 9954 9385 8863 8384 7943 7536 7161 6814 12
13 12134 11348 10635 9986 9394 8853 8358 7904 7487 7103 13
14 13004 12106 11296 10563 9899 9295 8745 8244 7786 7367 14
15 13865 12849 11938 11118 10380 9712 9108 8559 8061 7606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 1713 1690 1668 1647 1626 1605 1585 1566 1547 1528 2
3 2444 2402 2361 2322 2283 2246 2210 2174 2140 2106 3
4 3102 3037 2974 2914 2855 2798 2743 2690 2639 2589 4
5 3696 3605 3517 3433 3352 3274 3199 3127 3058 2991 5

6 4231 4111 3998 3889 3784 3685 3589 3498 3410 3326 6
7 4712 4564 4423 4288 4160 4039 3922 3812 3706 3605 7
8 5146 4968 4799 4639 4487 4344 4207 4078 3954 3837 8
9 5537 5328 5132 4946 4772 4607 4451 4303 4163 4031 9
10 5889 5650 5426 5216 5019 4833 4659 4494 4339 4192 10

11 6207 5938 5687 5453 5234 5029 4836 4656 4486 4327 11
12 6492 6194 5918 5660 5421 5197 4988 4793 4611 4439 12
13 6750 6424 6122 5842 5583 5342 5118 4910 4715 4533 13
14 6982 6628 6302 6002 5724 5468 5229 5008 4802 4611 14
15 7191 6811 6462 6142 5847 5575 5324 5092 4876 4675 15

End of Question Paper

15 3
AnIntroduction
WHATISFINANCIALMANAGEMENT?
Maybeconsideredas:

Themanagementofallmattersassociatedwiththecashflowoftheorganisationbothshortandlong
term.

Financialmanagementandtheaccountingequation



+ =





Thewholeprocesscanbeillustratedbelow:


FinanceRequired

SourceofFinance Investment Organic

CostofcapitalReturnsAcquisition

Forex

4
Thethreekeydecisions
Financialmanagementisoftenhastomakethethreebasicdecisionstobemade:

theinvestmentdecision,
thefinancialdecision,
thedividenddecision.
1.Theinvestmentdecision
Acompanymayinvestitsfundsinoneofthreebasicareas:

1. Capitalassets
2. Workingcapital
Capitalassets
Thedecisionwouldincludethefollowingfinancialconsiderations:

1. Return

2. Risk

3. Cashflow

4. Profit.

Workingcapital
Thecashresourceavailabletothebusinessonadaytodaybasisandusedtofundthe
currentassetssuchasinventoryandreceivables.

2.Thefinancingdecision
Whenlookingatthefinancingofabusinessthereare4basicquestionstoconsider:

1. totalfundingrequired,
2. internallygeneratedvsexternallysourced,
3. debtorequity,
4. longtermorshorttermdebt.

3.Thedividenddecision
Theamountofreturngivenbacktoshareholders.Thiswillbedeterminedbythefollowing:

1. Profitability
2. Cashflow
3. Growth
4. Legalrestrictions
5. Shareholderexpectations

5
TheEconomicEnvironmentandFinancialMarkets
EconomicEnvironment
FiscalPolicy
Decisionsrelatingtotaxationandgovernmentspendingwiththeaimoffullemployment,pricestability,
andeconomicgrowth
By changing tax laws, the government can alter the amount of disposable income available to its
taxpayers.Iftaxesincreasedconsumerswouldhavelessmoneytospend.
Thisdifferenceindisposableincomewouldgotothegovernmentinsteadofgoingtoconsumers,who
wouldpassthemoneyontocompanies.
Or,thegovernmentcouldincreaseitsspendingbypurchasinggoodsfromcompanies.Thiswouldincrease
theflowofmoneythroughtheeconomyandwouldeventuallyincreasethedisposableincomeavailable
toconsumers.
Thefourmajorobjectivesare:
1. Fullemployment
2. Pricestability
3. Ahigh,butsustainable,rateofeconomicgrowth
4. KeepingtheBalanceofPaymentsinequilibrium.
FullEmployment
FullemploymentwasconsideredveryimportantaftertheSecondWorldWar.
Unemploymentinthe80swasseenasaninevitableconsequenceofthestepstakentomakeindustry
moreefficient.
Deindustrialisationmadehigherunemploymentfeelinevitable,andsothisobjectivebecamemuchless
importantthanithadbeen
Growth&LowInflation
Growthandlowinflationhavealwaysbeenimportant.
Withoutgrowthpeoplesstandardoflivingwillnotincrease,andifinflationistoohighthenthevalueof
moneyfallsnegatinganyincreaseinlivingstandards.
Sustainablegrowthmeansgrowthwithoutinflation
Balanceofpayments
Thetotalofallthemoneycomingintoacountryfromabroadlessallofthemoneygoingoutofthecountry
duringthesameperiod.
PoliciestoreduceaBOPdeficit:
1.HigherInterestRates willacttoslowdownthe growthof consumer demandandthereforelead to
cutbacksinthedemandforimports.

6
2.Fiscalpolicy(i.e.increasesindirecttaxes)mightalsobeusedtoreduceaggregatedemand.
Theriskisthatasharpfallinconsumerspendingmightleadtoasteepeconomicslowdown(slowergrowth
ofGDP)orafullscalerecession.
IsaBOPDeficitabadThing?
Yes No
A current account deficit is financed CurrentAccountdeficitcouldbe used to
throughborrowingorforeigninvestment financeinvestment
Borrowing is unsustainable in the long Japanese investment has been good for
termandcountrieswillbeburdenedwith theUKeconomynotonlydidtheeconomy
highinterestpayments. benefit from increased investment but
Export sector may be better at creating theJapanesefirmsalsohelpedbringnew
jobs working practices in which increased
ABalanceofPaymentsdeficitmaycausea labourproductivity.
lossofconfidence With a floating exchange rate a large
current account deficit should cause a
devaluation which will help reduce the
levelofthedeficit
Itdependonthesizeofthebudgetdeficit
asa%ofGDP,forexampletheUStrade
deficit has nearly reached 5% of GDP at
thislevelitisconcerningeconomists
It may well be offset by foreign
investment

MonetaryPolicy
Theregulationofthemoneysupplyandinterestratesbyacentralbankinordertocontrolinflationand
stabilisecurrency
Monetarypolicyisoneofthewaysthegovernmentcanimpacttheeconomy.
Byimpactingtheeffectivecostofmoney,thegovernmentcanaffecttheamountofmoneythatisspent
byconsumersandbusinesses.
AffectonGrowth
Wheninterestratesarehigh,fewerpeopleandbusinessescanaffordtoborrow,sothisusually
slowstheeconomydown.
Also,morepeoplewillsave(iftheycan)becausetheyreceivemoreontheirsavingsrate.
Whenthecentralbankssetinterestratesitistheamounttheychargeotherbankstoborrow
money.
Thisisacriticalinterestrate,inthatitaffectstheentiresupplyofmoney,andhencethehealthof
theeconomy.
Highinterestratescancausearecession.

7
AffectonExchangerates
Highinterestratesattractsforeigninvestmentincreaseinexchangerates:
exportsdearer
importscheaper.
EffectonInflation
Highinterestratesshouldrestrictgrowthandinflation

ExchangeRatePolicy
Policyofgovernmenttowardstheleveloftheexchangerateofitscurrency(PartofMonetaryPolicy)
Itmaywanttoinfluencetheexchangeratebyusingitsgoldandforeigncurrencyreservesheldbyits
centralbanktobuyandsellitscurrency.
Afallintheexchangeratewillmeanthatthepriceofimportswillrisewhileexportersshouldbecome
moreinternationallycompetitive.Importvolumesshouldfallwhilstexportvolumesshouldrise.
Outputathomeshouldrise,leadingtohighereconomicgrowthandafallinunemployment.
There should be an improvement in the current account of the balance of payments too as the gap
betweenexportvaluesandimportvaluesimproves.
However,higherimportpriceswillfeedthroughtoariseininflationintheeconomy

Target FiscalPolicy MonetaryPolicy ExchangeRates


GrowthintheEconomy MoreSpending LowerInterestRates Lower
LowInflation LowerSpending HigherInterestRates Higher
BOPdeficitreduction LowerSpending HigherInterestRates Lower

Morepolicies
Competitionpolicy
TheCompetitionCommissionpreventstakeoversthatareagainstthepublicinterest
Competitionpolicyaimstoensure:
Widerconsumerchoice
Technologicalinnovation
Effectivepricecompetition
Governmentassistanceforbusiness
Government grants available for certain investments and small business in areas such as rural
development,energyefficiency,educationetc.
Greenpolicies

8
Airfuel tax for example can threaten an airline business but create opportunities for other forms of
transportormakersofnewgreeneraircraft.

FinancialMarkets
A financial market allows people to easily buy and sell financial securities (such as stocks and bonds),
commodities(suchaspreciousmetals)etc.
Generalmarkets(manycommodities)andspecialisedmarkets(onecommodity)exist.Marketsworkby
placinginterestedbuyersandsellersinone"place",thusmakingiteasierforthemtofindeachother.
So,Financialmarketsfacilitate
Theraisingofcapital(inthecapitalmarkets)
Thetransferofrisk(inthederivativesmarkets)
Internationaltrade(inthecurrencymarkets)
Matchthosewhowantcapitaltothosewhohaveit
Euromarkets
An overall term for international capital markets dealing in offshore currency deposits held in banks
outsidetheircountryoforigin
Euromeansexternalinthiscontext.Forexample,eurodollarsaredollarsheldbybanksoutsidetheUnited
States
Itallowslargecompanieswithexcellentcreditratingstoraisefinanceinaforeigncurrency.Thismarket
isorganisedbyinternationalcommercialbanks
KeyFeatures
Size:Muchbiggerthanthemarketfordomesticbonds/debentures
Cheapdebtfinance:Canbesoldbyinvestors,andawidepoolofinvestorssharetherisk
Unsecured:Onlyissuedbylargecompanieswithanexcellentcreditrating
Longterm:DebtinaforeigncurrencyTypically515years,normallyineurosordollarsbutpossibleinany
currency
Lessregulation:ByusingEuromarkets,banksandfinanciersareabletoavoidcertainregulatoryaspects
suchasreserverequirementsandotherrules.
StockandBondMarket
Astockmarket(alsoknownasastockexchange)hastwomainfunctions
1. toprovidecompanieswithawayofissuingsharestopeoplewhowanttoinvestinthecompany
2. toprovideavenueforthebuyingandsellingofshares
MoneyMarket
Themoneymarketistheglobalfinancialmarketforshorttermborrowingandlending
Themoneymarketiswhereshorttermobligationsareboughtandsoldsuchas

9
Treasurybills
Commercialpaperand
Bankers'acceptances
CapitalMarket
Acapitalmarketincludesthestockmarket,commoditiesexchangesandthebondmarketamongstothers.
Thecapitalmarketisanidealenvironmentforthecreationofstrategiesthatcanresultinraisinglong
termfundsforbondissuesorevenmortgages.
Along with the stock exchanges, support organizations such as brokerage firms also form part of the
capital market.Theseoutwardexpressionsofthecapitalmarketmakeitpossibletokeepthe process
ethicalandmoreeasilygovernedaccordingtolocallawsandcustoms.

10
TheInvestmentAppraisal
CapitalBudgetingCycleSteps
IdeaGeneration
ProjectScreening
Financial&NonfinancialEvaluation
Approval
Implementation
OngoingMonitoring

PostCompletionAudit

FinancialEvaluationMethods
BasicMethods AdvancedMethods
AccountingRateofReturn(ARR) NetPresentValueNPV
PaybackPeriod InternalRateofReturn(IRR)
DiscountedPaybackPeriod

AccountingRateofReturn(ARR)
TheAveragereturnofaprojectexpressedasapercentageofthecapitaloutlayoraverageinvestment

ARRFormula

ARR=AverageAnnualprofitx100
Initialinvestment
ARR=AverageAnnualprofitx100
AverageInvestment
WhereAverageInvestmentis
=InitialInvestment+Scrapvalue
2
Decisionrule
IfARRoftheproject>TargetARRthenAccepttheproject.ElseRejecttheproject.
Advantages&Disadvantages
Advantages Disadvantages

11
1. It is easy to understand and easy to 1. Itfailstotakeaccountofthetimingof
calculate. cash flows and time value of money
withinthatlife
2. The impact of the project on a
companys financial statement can 2. Itusesaccountingprofit,hencesubject
alsobespecified tovariousaccountingconventions.
3. Managers may be happy in 3. ItIgnoresthesizeofinvestment.
expressing project attractiveness in
4. Likeallrateofreturnmeasures,itisnot
the same terms in which their
a measurement of absolute gain in
performance will be reported to
wealthforthebusinessowners.
shareholders,andaccordingtowhich
theywillbeevaluatedandrewarded. 5. TheARRcanbeexpressedinavarietyof
ways and is therefore susceptible to
4. Ittakesintoaccountthewholelifeof
manipulation
theproject
5. Itcanbeusedasarelativemeasurein
caseofmutuallyexclusiveprojects

ILUSTRATION1
RoughLtdhastheopportunitytoinvestinaninvestmentwiththefollowinginitialcostsandreturns:
A
($000s)
Initialinvestment (100)

Cashflows
Yr1 50
Yr2 40
Yr3 30
Yr4 25
Yr5 20
Residualvalue Yr5 5
Thecostofcapitalis10%.AndthetargetARRis20%

Companyusesthestraightlinemethodfordepreciation.

Required:
CalculatetheARRbasedonAverageInvestment?

Solution
Cashflows Depreciation Profit
$'000 $'000 $'000
50 19 31
40 19 21

12
30 19 11
25 19 6
20 19 1

AverageProfit 14

Depreciation (1005) =19


5

AverageInvestment (100+5) =52.5


2

ARRBasedonAverageInvestment

AverageProfitX100%
AverageInvestment

14X100% = 26.67%
47.5

Cashflows
RelevantCashflows IrrelevantCashflows
FutureCashflows SunkCost/HistoricalCost
VariableCosts NoncashDepreciation
IncrementalCashflows IndirectCosts
OpportunityCost GeneralOverheads
CentralOfficeOverheads

AssumptionsofCashflows
IfCashflowsariseduringtheperiod,thenitisassumedasitarisesattheendofthatperiod.
If cash flow arise at the start of the period then it is assumed as if it arises at the end of the
precedingperiod
Period0isnotaperiod,insteaditrepresentsstartofperiod1.

PaybackPeriod
Itisthetimeperiodrequiredtorecovertheinitialinvestment

Decisionrule
IfPaybackPeriod<TargetPayback,AccepttheProject.ElseRejecttheProject

13
ILUSTRATION2
Required:
UsingthedataofILUSTRATION1,CalculatethePaybackPeriod?

Solution
Cashflows CumulativeCashflows
$'000 $'000
Y0 (100) (100)
Y1 50 (50)
Y2 40 (10)
Y3 30 20
Y4 25
Y5 25

LastYearNegativeCumulativeCashflowX12
NextYearCashflow

=> 10X12
30
=> 4Months

PaybackPeriodis2Yearsand4Months

Advantages&Disadvantages
Advantages Disadvantages
1. Itissimpletouse(calculate)and 1. It does not give a measure of return, as
easytounderstand such it can only be used in addition to
otherinvestmentappraisalmethods.
2. Itisaparticularlyusefulapproach
for ranking projects where a 2. Itdoesnotnormallyconsidertheimpact
company faces liquidity of discounted cash flow although a
constraints and requires a fast discounted payback may be calculated
repaymentofinvestment. (seelater).
3. It is appropriate in situations 3. It only considers cash flow up to the
whereriskyinvestmentsaremade payback,anycashflowsbeyondthatpoint
in uncertain market that are areignored.
subjecttofastdesignandproduct
4. Thereisnoobjectivemeasureofwhatis
changes or where future cash
anacceptablepaybackperiod,anytarget
flows are particularly difficult to
paybackisnecessarilysubjective
predict.
4. The method is often used as the
first screening device to identify

14
projects which are worthy of
furtherinvestigation.
5. Unlike the other traditional
methodspaybackusescashflows,
rather than accounting profits,
andsoislesslikelytoproducean
undulyoptimisticfiguredistorted
by assorted accounting
conventions

DISCOUNTEDCASHFLOW
TheapplicationoftheideathatthereisaTIMEVALUEOFMONEY.Whatthismeansisthatmoney
receivedtodaywillhavemoreworththanthesameamountreceivedatsomepointinthefuture.

Whywouldyouratherhave$1,000nowratherthaninoneyearstime?

ThereforewecanexpressPresentValuesintermsofFutureValuesusingthefollowingformulaof
Compounding:

FV=PV(1+r)n
Where

PVPresentvalue.

FVFuturevalue.

rRateofinterestorcostofcapital.

nNumberofperiods(years)

Theoppositeofcompounding,wherewehavethefuturevalue(eganexpectedcashinflowina
futureyear)andwewishtoconsideritsvalueinpresentvalueterms.

Revisingtheformula

OrPV=FV(1+r)n
n

15

NetPresentValues(NPV)
TheNPVoftheprojectisthesumofthePVsofallcashflowsthatariseasaresultofdoingtheproject.

DecisionRule:
IfNPVoftheproject,discountedatcostofcapital,ispositivethenAccepttheproject,Else
RejecttheProject.

ILUSTRATION3
Required:
UsingthedataofILUSTRATION1,CalculatetheNPVoftheProject?

Solution
Disc
Cashflows Factor PV
$'000 (10%) $'000

Y0 (100) 1 (100)

Y1 50 0.909 45

Y2 40 0.826 33

Y3 30 0.751 23

Y4 25 0.683 17

Y5 25 0.621 16



NPV 34

Advantages&Disadvantages
Advantages Disadvantages
1. A project with a positive NPV 1. Determination of the correct discount
increases the wealth of the ratecanbedifficult.
companys, thus maximise the
2. Nonfinancial managers may have
shareholderswealth.
difficultyunderstandingtheconcept.
2. Takesintoaccountthetimevalueof
3. Thespeedofrepaymentoftheoriginal
money.
investmentisnothighlighted.

16
3. Discountratecanbeadjustedtotake 4. Thecashflowfiguresareestimatesand
account of different level of risk mayturnouttobeincorrect.
inherentindifferentprojects.
5. NPV assumes cash flows occur at the
4. Unlike the payback period, the NPV beginningorendoftheyear,andisnot
takesintoaccounteventsthroughout a technique that is easily used when
thelifeoftheproject. complicated,midperiodcashflowsare
present
5. Betterthanaccountingrateofreturn
because it focuses on cash flows
ratherthanprofit.

InternalRateofReturn(IRR)
IRRisthetotalrateofreturnofferedbyaninvestmentoveritslife.Calculative,Therateofreturnat
whichtheNPVequalszero.

Formulatocalculate


DecisionRule
IfIRRoftheproject>Costofcapital,Accepttheproject.ElseRejecttheProject
ILUSTRATION4
Required:
UsingthedataofILUSTRATION1andassumingtheNPVat10%is$34,000,CalculatetheIRRofthe
Project?

Solution
Disc
Cashflows Factor PV
$'000 (25%) $'000

Y0 (100) 1 (100)

Y1 50 0.800 40

Y2 40 0.640 26

Y3 30 0.512 15

Y4 25 0.410 10

17

Y5 25 0.328 8


NPV (1)

IRR= 10%+((34/(34+1))X(2510))%

IRR=

24.57%
Advantages&Disadvantages
Advantages Disadvantages
1. LiketheNPVmethod,IRRrecognisesthe 1. Does not indicate the size of the
timevalueofmoney. investment, thus the risk involve in the
investment.
2. Itisbasedoncashflows,notaccounting
profits. 2. Assumes that earnings throughout the
periodoftheinvestmentarereinvestedat
3. More easily understood than NPV by
thesamerateofreturn.
nonaccountant being a percentage
returnoninvestment. 3. Itcangiveconflictingsignalswithmutually
exclusiveproject.
4. Foraccept/rejectdecisionsonindividual
projects, the IRR method will reach the 4. Ifaprojecthasirregularcashflowsthereis
samedecisionastheNPVmethod morethanoneIRRforthatproject(multiple
IRRs).

DiscountedPaybackPeriod
Thetimeperiodinwhichinitialinvestmentisrecoveredintermsofpresentvalueisknownas
paybackperiod.

Itissameassimplepaybackperiod.Theonlydifferenceisthatthediscountedcashflowsareused
insteadofsimplecashflowsforcalculation.

DecisionRule
IfDiscountedPaybackPeriod<TargetDiscountedPayback,AccepttheProject.ElseRejectthe
Project

Advantages&Disadvantages
Advantages Disadvantages
1. It takes into account the time value of 1. It does not consider the whole life of
moneyandtimingsofcashflows. project.
2. It considers cash flows rather than 2. It requires knowledge of cost of capital
accountingprofits. whichisdifficulttocalculate.

18
3. Short payback period result in increased 3. Lifeexpectancyofaprojectisignored.
liquidity and enable business to grow
4. It ignores cash flows after the payback
morequickly
period

ConsistentCashflows
IfCashflowsarisesinaseriesofequalcashflowsthenitiscalledConsistentCashflows.Theseareof
twoTypes:

Annuity:IfConsistentcashflowforacertainPeriod.e.gY15orY37

Perpetuity:IfConsistentcashflowforinfiniteperiode.g.Y1orY3

PresentValuesofConsistentCashflows
n
TheAnnuityFactor=

ThePerpetuityFactor=

Annuity Perpetuity
IfCashflowsStartfromPeriod1.

AnnualCashflowXAnnuityFactor AnnualCashflowXPerpetuityFactor
e.g.Y15$10,000atDisc.Rateof10% e.g.Y1$10,000atDisc.Rateof10%
$10,000X3.791(fromannuitytable)=$37,910 $10,000X(1/10%)=$100,000
IfCashflowsStartfromPeriod0.

AnnualCashflowX(AnnuityFactor+1) AnnualCashflowX(PerpetuityFactor+1)
e.g.Y05$10,000atDisc.Rateof10% e.g.Y0$10,000atDisc.Rateof10%
$10,000X(3.791+1)=$47,910 $10,000X((1/10%)+1)=$110,000
IfCashflowsStartfromSubsequentPeriode.g.Year3.

AnnualCashflowXAnnuityFactorofNo.of AnnualCashflowXPerpetuityFactorXDiscount
periodsXDiscountfactorofprecedingperiod factorofprecedingperiodfromStart
fromStart
e.g.Y48$10,000atDisc.Rateof10% e.g.Y4$10,000atDisc.Rateof10%
$10,000X3.791X0.751=$28,470 $10,000X(1/10%)X0.751=$75,100

EffectofTaxationininvestmentappraisal
TimingofTaxCashflows:Eitherinthesameyearorinarrears.
Calculationofcashflows
o TaxonOperatingCashflows:OperationalCashflowsXRateofTax
o TaxSavingsonCapitalAllowances:CalculatethecapitalAllowances/Balancing
AllowancesandthenmultiplywithTaxRate.

19
Example

InitialInvestment=2000

CapitalAllowances=25%reducingbalance

Usefullife=4years,Taxrate=30%payableinarrears,ScrapValue=500
Years Written Capital Tax Timing
Down Allowances Savings
Value @25% @30%
1 2000 500 150 2

2 1500 375 113 3

3 1125 281 84 4

4 844 344 103 5


EffectofInflationininvestmentappraisal:
Inflationmaybedefinedasageneralincreaseinprices,leadingtogeneraldeclineintherealvalueof
money,(decreaseinpurchasingpower).

RealRateofReturn(r):Withoutinflationrate

Money/NominalRateofReturn(n):WithInflationrate

GeneralInflation(i)
Therelationshipbetweenrealandmoneyinterestisgivenbelow(alsoseetables)

(1+n)=(1+r)(1+i)

20

IfGeneralinflationrateis IfSpecific inflationrateis

Money RealMethod Money

Inflateall Donot Inflateeach

Cashflows inflateCash variablecashflow

withgeneral flows. withitsspecific

inflationrate. Discountall inflationrate.

Discount Cashflows Discountwith

thesecash withreal moneycostof

flowswith discount capital(calculated

throughrealrate

andgeneral

preferred
inflationrate.
Method

AfterInflationCashflow=Realcashflows(1+i)n

WorkingCapitalChange
Everybusinessrequiresworkingcapitalforitsoperations.

Calculateworkingcapitalchangeintwosteps:

1. Calculateworkingcapitalrequirementoneyearinadvancee.g.workingcapitalis10%of
salesatthestartofeachyear

2. Calculateincrementalworkingcapitalbytakingchangeofeachyearworkingcapitalandin
lastyeartherewillbeanassumptionthatallworkingcapitalwillberecovered(Onlyfor
projectandnotforongoingbusiness)

ILUSTRATION5

21
Acompanyisconsideringtoinvestinaprojectwithitslifeof4years.Totalworkingcapitalrequiredat
thebeginningofeachyearisasfollows:
Year Cashflows
$000
1 500
2 700
3 1000
4 600
Required:
CalculatetheworkingcapitalcashflowsofeachyeartobeincludedinNPVcalculation?

Solution

TotalWorking IncrementleWorking
Capital capital
$'000 $'000
Y0 500 (500)
Y1 700 (200)
Y2 1000 (300)
Y3 600 400

Y4 0 600

TheFinanceCost
TheFinanceCostwillbearelevantcashflowhoweveritwillbecomethepartofcashflows.Thisis
becauseitispartofcostofcapital.

PerformaforNetPresentValue
Years 0 1 2 3 4

Sales X X X X

VariableCost (X) (X) (X) (X)

IncrementalFixedCost (X) (X) (X) (X)

OperatingCashflows X X X X

TaxExpense (X) (X) (X) (X)

22
TaxSavingsonCapital X X X X
Allowances

ChangeinWorkingCapital (X) (X) (X) (X) X

InitialInvestment (X)

ScrapValue X

NetCashflows (X) X X X X

XDiscountFactor X X X X X

PresentValues (X) X X X X

NetPresentValue X

Attempt QuestionNo.
Dec11 Q1a,b
Jun12 Q1a
Dec12 Q1
Jun13 Q1
Investment
Dec13 Q1
Appraisal
Jun14 Q1a
Dec14 Q4
Jun15 Q5a
Dec15 Q5
Jun16 Q5a,b

23
SpecificInvestingDecision
TheThreeSpecificInvestingDecisions
CapitalRationing
AssetReplacement
LeaseorBuy

Capitalrationing
Alimitontheleveloffundingavailabletoabusiness,therearetwotypes

Hardcapitalrationing
SoftCapitalrationing

Hardcapitalrationing

Externallyimposed.Usuallybybanks

Dueto:

1. Widereconomicfactors(e.g.acreditcrunch)
2. Companyspecificfactors
(a) Lackofassetsecurity
(b) Notrackrecord
(c) Poormanagementteam.

Softcapitalrationing

Internallyimposedbyseniormanagement.

Issue:Contrarytotherationalaimofabusinesswhichistomaximiseshareholderswealth(i.e.
totakeallprojectswithapositiveNPV)Reasons:
1. Lackofmanagementskill
2. Wishtoconcentrateonrelativelyfewprojects
3. Unwillingnesstotakeonexternalfunds
4. Onlyawillingnesstoconcentrateonstronglyprofitableprojects
Singleperiodcapitalrationing
i.e.availablefinanceisonlyinshortsupplyduringthecurrentperiod,butwillbecomefreelyavailablein
subsequentperiods.
AssumptionsofSinglePeriodCapitalRationing
Allprojectsaredivisible

24
Projectswillbelostifnotundertakenincurrentyear(cannotbepostponed)
Therisk&uncertaintyandstrategicimportanceofallprojectsissame
DivisibleAnentireprojectoranyfractionofthatprojectmaybeundertaken.Projectsdisplayingthe
highestprofitabilityindices(i.e.NPV/InitialInvestment)willbepreferred.
IndivisibleAnentireprojectmustbeundertaken,sinceitisimpossibletoacceptpartofaprojectonly.
InthiseventdifferentcombinationofprojectsareassessedwiththeirNPVandthecombinationwiththe
highestNPVischosen.

ExampleDivisible
Project Investment NPV PI(NPV/Investment) Ranking
A 1,000 500 0.5 3rd
B 1,200 700 0.58 2ND
C 800 300 0.375 4TH
D 700 450 0.642 1ST

AvailableFunds$2,500
TheInvestmentSchedule
Project Investment NPV
D 700 450
B 1,200 700
A 600 300
Total 2,500 1,450
WewilldoProjectDandBcompleteandProjectA60%.

ExampleNonDivisible
Project Investment NPV
A 1,000 500
B 1,200 700
C 800 300
D 700 450
AvailableFunds$2,500
ProjectsCombination TotalInvestment TotalNPV
A,B 2,200 1,200

25
A,C,D 2,500 1,250
B,C 2,000 1,000
B,D 1,900 1,150
WewillchoosecombinationofA,C,DbecauseitsgivesthebestNPVof$1,250

AssetReplacement
Oncethedecisionhasbeenmadetoreplacetheasset,thequestionishowtoreplaceanassetinthemost
costefficientmanner.
AssetReplacementissues:
Howfrequentlyanassetbereplaced?
Isitworthpayingmoreforanassetthathasalongerexpectedlife.
Inbothofthesescenarios,theidealapproachistokeepthecostsperannum(inNPVterms)toaminimum.
Thisiscalculatedasanequivalentannualcost(EAC).

EAC=

ThebestdecisionistochoosetheoptionwiththelowestEAC.
Keyideas/assumptions:
Cashinflowsfromtrading(revenues)arenotnormallyconsideredinthistypeofquestion.The
assumptionbeingthattheywillbesimilarregardlessofthereplacementdecision.
Theoperatingefficiencyofmachineswillbesimilarwithdifferingmachinesorwithmachinesof
differingages.
Theassetswillbereplacedinperpetuity.
ILUSTRATION1
Acompanyboughtanassetfor$80,000havingausefullifeofthreeyears.
Itisnowconsideringtherighttimetoreplacetheasset.
Therunningcostontheassetis$15,000foryear1andwouldincreaseby$5,000peryearoverthelife
oftheproject.
Theexpectedscrapvaluesattheendofeachyearareasfollows:
Year ScrapValue($)
1 40,000
2 25,000
3 15,000
Thecompanyhasacostofcapitalof10%.

26
Required:
Determinewhetherthecompanyshouldreplacetheassetafteryear2oryear3

Solution
Year DiscountFactor ReplaceAfterYear2 ReplaceAfterYear3
@10%

CashFlowPresentValues CashFlowPresent
Values
0 1.000 (80,000)(80,000) (80,000)(80,000)

1 0.909 (15,000)(13,635) (15,000)(13,635)

2 0.826 5,0004,130 (20,000)(16,520)

3 0.751 (10,000)(7,510)

NPV (89,505) (117,665)

Annuity 1.735 2.486


Factor

EAC (51,588) (47,331)

Theannualequivalentcostforreplacementafteryear3islesscostlythereforeassetshouldbe
replacedafterevery3years

LeaseorBuy
Thedecisionhereiswhetherbuyingtheassetorleasingtheassetismorecosteffective
Lease
Itisarentalagreementbetweentwoparties(lesseeandlessor)fortheuseofanassetforsomespecific
timeperiod.Lessoristheprovideroftheassetwhereaslesseeistheuserofasset.
Leasescanbeclassifiedintotwotypesnamelyfinanceleaseandoperatinglease.
DifferencebetweenOperatingandFinanceLease
OperatingLease FinanceLease
Majorriskandrewardbelongtothelessor Major risk and reward belong to the
lessee

27
Maintenance is the responsibility of the Maintenance is the responsibility of the
lessor lessee
Useful life of the asset is considerably Lease term comprises of majority of the
longerascomparedtotheleaseterm usefullifeoftheasset
CalculationanddecisionRule
1. Discountrate=posttaxcostofborrowing
Therateisgivenbytherateonthebankloaninthequestion,ifitispretaxthentherate
mustbeadjustedfortax.Iftheloanratewas10%pretaxandcorporationtaxis30%
thentheposttaxratewouldbe7%.(10%x(10.3)

2. Cashflows
Bankloan FinanceLease

1/Costoftheinvestment 1/Leaserental
inadvance
2/WDAtaxreliefoninvestment annuity

3/Residualvalue 2/Taxreliefonrental
ILUSTRATION2
Afirmhasdecidedtoacquireanewmachine.Themachinewouldcost$6.4millionandwouldhavean
economiclifeoffiveyears.
Taxallowabledepreciationof25%paonareducingbalancebasisisavailablefortheinvestment.
Taxationof30%ispayableonoperatingcashflows,oneyearinarrears.
Thefirmintendstofinancethenewplantbymeansofafiveyearfixedinterestloanatapretaxcost
of11.4%pa,principalrepayableinfiveyearstime.
Asanalternative,aleasingcompanyhasproposedafinanceleaseoverfiveyearsat$1.42millionpap
ayableinadvance.
Scrapvalueofthemachineundereachfinancingalternativewillbezero.
Required:
Evaluatethetwooptionsforacquiringthemachineandadvisethecompanyonthebestalternative.

Solution
(W1)Calculationofthetaxreliefontaxallowabledepreciationifassetbought:
Note:Theassetisboughtattimet=0asusualwiththefirstamountoftaxallowabledepreciationinth
eyearendedtimeone.Giventheoneyeartimelagonthetax,thefirsttaxeffectisattimet=2.

28
Year Narrative WDV TaxSaved Timinfofcashflow
$'000 $'000

0 Cost 6,400
Capital
1 Allowances 1,600 480 2

4,800
Capital
2 Allowances 1,200 360 3

3,600
Capital
3 Allowances 900 270 4

2,700
Capital
4 Allowances 675 203 5

2,025

5 DisposalProceed
Balancing
Allowance 2,025 608 6
(W2)Calculationoftheposttaxcostofborrowing.
Thepretaxcostofborrowingis11.4%.
Theposttaxcostofborrowingcanbeapproximatedbymultiplying thisby(1taxrate),i.e.11.4%
(10.3)=7.98%,say8%
CostofBorrowingtoBuy
Time 0 1 2 3 4 5 6
$'000 $'000 $'000 $'000 $'000 $'000 $'000


Asset (6,400)
TaxSavingsonCA(W
1) 480 360 270 203 608

NetCashflow (6,400) 480 360 270 203 608

DiscFactor(8%)(W2) 1 0.926 0.857 0.794 0.735 0.681 0.630

PresentValue (6,400) 411 286 198 138 383

NPV($'000) (4,984)

29
CostofLeasing
Time Narrative Cashflows Discfactor PresentValue
$'000 8% $'000

04 LeasePayment (1,420) 1+3.312 (6,123)

26 TaxSaving 426 3.993X0.926 1,575


(4,548)
Thecostofleasingislowerthanthecostofbuyingandtheassetshould thereforebeacquiredunder
afinancelease.

Risk
Assessmentofriskisparticularlyimportantwhenperforminginvestmentappraisaldueto:

1. Longtimescale
2. Outflowtoday,inflowinthefuture
3. Largesizeinrelationtothesizeofthecompany
4. Strategicnatureofthedecision.
Techniquesavailable:

1. Sensitivityanalysis

2.Expectedvalues

3.Adjusteddiscountrates
SensitivityAnalysis
Atechniquethatconsidersasinglevariableatatimeandidentifiesbyhowmuchthatvariablehasto
changeforthedecisiontochange(fromaccepttoreject).
Formulatocalculatesensitivityofaparticularvariable:
Sensitivity= Netpresentvalue 100%
AftertaxPresentvalueofparticularvariable
Itindicateswhichvariablesmayimpactmostuponthenetpresentvalue(criticalvariables)andtheextent
towhichthosevariablesmaychangebeforetheinvestmentresultsinanegativeNPV.
Advantages&Disadvantages
Advantages Disadvantages

30
1. This is not a complicated theory to 1. It assumes that changes to variables can
understand. bemadeindependentlyorinisolation.
2. Information will be presented to 2. Itonlyidentifieshowfaravariableneeds
management in a form, which facilitates to change; it does not look at the
subjective judgment to decide the probabilityofsuchachange.
likelihood of the various possible
3. It is not an optimizing technique. It
outcomesconsidered.
provides information on the basis of
3. Indicatesjusthowcriticalaresomeofthe whichdecisioncanbemade
forecast which are considered to be
uncertain

ExpectedValues
Wheretherearearangeofpossibleoutcomeswhichcanbeidentifiedandaprobability
distributioncanbeattachedtothosevalues.Theexpectedvalueisthearithmeticmeanofthe
outcomesasexpressedbelow:

EV=px

Where P=theprobabilityofanoutcome
x=thevalueofanoutcome
Example
Outcomes % EV
100,000 0.25 25,000
200,000 0.50 100,000
300,000 0.25 75,000
ExpectedValue 200,000

AdjustedDiscountRate
Thediscountratewehaveassumedsofaristhatreflectingthecostofcapitalofthebusiness.In
simpletermsthismeansthattheratereflectseitherthecostofborrowingfundsintheformofaloan
rateoritmayreflecttheunderlyingreturnofthebusiness(i.e.thereturnrequiredbythe
shareholder),oramixofboth.

Anindividualinvestmentorprojectmaybeperceivedtobemoreriskythanexistinginvestments.Inthis
situation the increased risk could be used as a reason to adjust the discount rate up to reflect the
additionalrisk.

31
Attempt QuestionNo.
Dec11 Q1c,d
SpecificInvesting Jun12 Q1b,c
DecisionandRisk Jun14 Q1b,c
Jun15 Q5b
Jun16 Q5c

32
CostofCapital
BasicsofCostofCapital
Afundamentalcalculationforallcompaniesistoestablishitsfinancingcosts,bothindividuallyforeach
componentoffinanceandintotalterms.Thesewillbeofusebothintermsofassessingthefinancingof
thebusinessandasacostofcapitalforuseininvestmentappraisal.
RiskandReturn
Therelationshipbetweenriskandreturniseasytosee,thehighertherisk,thehighertherequiredto
coverthatrisk.
OverallReturn
Acombinationoftwoelementsdeterminethereturnrequiredbyaninvestorforagivenfinancial
instrument.

1. RiskfreereturnThelevelofreturnexpectedofaninvestmentwithzerorisktotheinvestor.
2. Riskpremiumtheamountofreturnrequiredaboveandbeyondtheriskfreerateforan
investortobewillingtoinvestinthecompany
DegreeofRisk

RiskFree HighRiskInvestment

Government Secured UnSecured Preference Ordinary


Debt Loans Loans Shares Shares

TheWACC
WeightedAverageCostofCapital(WACC)
CostofEquity(Ke) CostofDebt(Kd) CostofPreference(Kp)

Cost of equity: the rate of return that is expected by the equity holders of the
company.ThesymbolusedtorepresentcostofequityisKe.
Costofdebt:thistheaftertaxreturnexpectedbythedebtholdersofthecompany.
ThesymbolusedtorepresentaftertaxcostofdebtisKd(1t).
Costofpreferenceshares:thereturnexpectedbythepreferenceshareholdersof
thecompany.ThesymbolusedtorepresentcostofpreferencesharesisKp.

33
CostofEquity
Therateofreturnrequiredbyashareholder.Thismaybecalculatedinoneoftwoways:

1. DividendValuationModel(DVM).
2. CapitalAssetPricingModel(CAPM).

DividendValuationModel

Ke= D1+g

Po

Where,

D1=nextyeardividend=Do(1+g)

Po=CurrentExmarketvalueofequityshare

g=sustainablegrowthrate

EstimatingGrowth
Thereare2mainmethodsofdetermininggrowth:

1 THEAVERAGINGMETHOD

d
1
d

where do=currentdividend

dn=dividendnyearsago

ILUSTRATION1

MuneroLtdpaidadividendof6ppershare8yearsago,andthecurrentdividendis11p.Thecurrent
sharepriceis$2.58exdiv

Required:
Calculatethecostofequity

Solution

34
1=7.9%

Ke= 0.11(1+7.9%)+7.9%=12.47%
2.58

2.GORDONSGROWTHMODEL
g=rb
where r = returnonreinvestedfunds
b = proportionoffundsretained
ILUSTRATION2
TheordinarysharesofTitanLtdarequotedat$5.00cumdiv.Adividendof40pisjustabouttobe
paid.Thecompanyhasanannualaccountingrateofreturnof12%andeachyearpaysout30%ofits
profitsaftertaxasdividends.

Required:
Estimatethecostofequity

SOLUTION
g=12%X(130%)=8.4%

Ke= 0.4(1+8.4%)+8.4%=17.07%
5

CapitalAssetPricingModel

Amodelthatvaluesfinancialinstrumentsbymeasuringrelativerisk.ThebasisoftheCAPMisthe
adoptionofportfoliotheorybyinvestors.

Portfoliotheory
RiskandReturn
Thebasisofportfoliotheoryisthataninvestormayreduceriskwithnoimpactonreturnasa
resultofholdingamixofinvestments.
Risk of
portfolio
()



No.ofsharesinportfolio

35
Systematicandnonsystematicrisk
Ifwestartconstructingaportfoliowithoneshareandgraduallyaddothersharestoitwewill
tendtofindthatthetotalriskoftheportfolioreducesasfollows:

Initiallysubstantialreductionsintotalriskarepossible;however,astheportfoliobecomes
increasinglydiversified,riskreductionslowsdownandeventuallystops.

Theriskthatcanbeeliminatedbydiversificationisreferredtoasunsystematicrisk.Thisriskis
relatedtofactorsthataffectthereturnsofindividualinvestmentsinuniqueways,thismaybe
describedascompanyspecificrisk.

Theriskthatcannotbeeliminatedbydiversificationisreferredtoassystematicrisk.Tosome
extentthefortunesofallcompaniesmovetogetherwiththeeconomy.Thismaybedescribed
aseconomywiderisk.

Therelevantriskofanindividualsecurityisitssystematicriskanditisonthisbasisthatwe
shouldjudgeinvestments.Nonsystematicriskcanbeeliminatedandisofnoconsequenceto
thewelldiversifiedinvestor.

Implications
1. Ifaninvestorwantstoavoidriskaltogether,hemustinvestinaportfolioconsistingentirely
ofriskfreesecuritiessuchasgovernmentdebt.
2. Iftheinvestorholdsonlyanundiversifiedportfolioofshareshewillsufferunsystematicrisk
aswellassystematicrisk.
3. Ifaninvestorholdsabalancedportfolioofallthestocksandsharesonthestockmarket,
hewillsuffersystematicriskwhichisthesameastheaveragesystematicriskinthemarket.
4. Individualshareswillhavesystematicriskcharacteristicswhicharedifferenttothismarket
average.Theirriskwillbedeterminedbytheindustrysectorandgearing(seelater).Some
shareswillbemoreriskyandsomeless.
(beta)factor
ThemethodadoptedbyCAPMtomeasuresystematicriskisanindex.Thefactoristhe
measureofasharesvolatilityintermsofmarketrisk

Thefactorofthemarketasawholeis1.Marketriskmakesmarketreturnsvolatileandthe
factorissimplyayardstickagainstwhichtheriskofotherinvestmentscanbemeasured.

ThefactoriscriticaltoapplyingtheCAPM,itillustratestherelationshipofanindividual
securitytothemarketasawholeorconverselythemarketreturngiventhereturnonan
individualsecurity.

Forexample,supposethatithasbeenassessedstatisticallythatthereturnsonsharesinXYZplc
tendtovarytwiceasmuchasreturnsfromthemarketasawhole,sothatifmarketreturns
wentupby6%,XYZsreturnswouldgoupby12%andifmarketreturnsfellby4%thenXYZs
returnswouldfallby8%,XYZwouldbesaidtohaveafactorof2.

36
Thesecuritymarketline
Thesecuritymarketlinegivestherelationshipbetweensystematicriskandreturn.Weknow2
relationships.

1 Theriskfreesecurity
Thiscarriesnoriskandthereforenosystematicriskandthereforehasaetaofzero.

2 Themarketportfolio
Thisrepresentstheultimateindiversificationandthereforecontainsonlysystematicrisk.Ithasa
etaof1.


Fromthegraphitcanbeseenthatthehigherthesystematicrisk,thehighertherequiredrateof
return.

Therelationshipbetweenrequiredreturnandriskcanbeshownusingthefollowingformula:
Ke = Rf+(RmRf)
where Ke = requiredreturnfromindividualsecurity
= Betafactorofindividualsecurity
Rf = riskfreerateofinterest
Rm = returnonmarketportfolio
CriticismsoftheCAPM
1. CAPMisasingleperiodmodel,thismeansthatthevaluescalculatedareonlyvalidfora
finiteperiodoftimeandwillneedtoberecalculatedorupdatedatregularintervals.
2. CAPMassumesnotransactioncostsassociatedwithtradingsecurities

37
3. Any eta value calculated will be based on historic data which may not be appropriate
currently.Thisisparticularlysoifthecompanyhaschangedthecapitalstructureofthe
businessorthetypeofbusinesstheyaretradingin.
4. Themarketreturnmaychangeconsiderablyovershortperiodsoftime.
5. CAPMassumesanefficientinvestmentmarketwhereitispossibletodiversifyawayrisk.
Thisisnotnecessarilythecasemeaningthatsomeunsystematicriskmayremain.
6. Additionallytheideathatallunsystematicriskisdiversifiedawaywillnotholdtrueifstocks
changeintermsofvolatility.Asstockschangeovertimeitisverylikelythattheportfolio
becomeslessthanoptimal.
7. CAPMassumesallstocksrelatetogoingconcerns,thismaynotbethecase
ILUSTRATION3
Themarketreturnis15%.KiteLtdhasabetaof1.2andtheriskfreereturnis8%

Required:
Whatisthecostofcapital?

SOLUTION3
Ke=8%+1.2(15%8%)=16.4%

TheCostofDebt
Thecostofdebtistherateofreturnthatdebtprovidersrequireonthefundsthattheyprovide.
Wewouldexpectthistobelowerthanthecostofequity.Thevalueofdebtisassumedtobe
thepresentvalueofitsfuturecashflows.

Terminology
1. Loan notes, bonds and debentures are all types of debt issued by a company. Gilts and
treasurybillsaredebtissuesbyagovernment.
2. Tradeddebtisalwaysquotedin$100nominalunitsorblocks
3. Interestpaidonthedebtisstatedasapercentageofnominalvalue($100asstated).Thisis
knownasthecouponrate.Itisnotthesameasthecostofdebt.
4. Debtcanbe:
(i) Irredeemableneverpaidback
(ii) redeemableatpar(nominalvalue)
(iii) orredeemableatapremiumordiscount(formoreorless).
5. Interestcanbeeitherfixedorfloating(variable).Allquestionsarelikelytogivefixedrate
debt.

38
Kdforirredeemabledebt
100%

where i = interestpaid
t = marginalrateoftax
P0 = exinterest(similartoexdiv)marketpriceoftheloanstock.
ILUSTRATION4
The10%irredeemableloannotesofRifaplcarequotedat$120exinterest.Corporationtaxis
payableat30%

Required:
Whatisthecostofdebtnet?

SOLUTION
%
100% 5.83%

Kdforredeemabledebt
TheKd(net)forredeemabledebtisgivenbytheIRRoftherelevantcashflows.Therelevantcashflows
wouldbe:
Years Cashflows
0 MarketValueofLoanNote(P0)
1n AnnualInterestPayment(i(1T))
n RedemptionValue(RV)

ILUSTRATION5
WoodworkLtdhas10%loannotesquotedat$102exinterestredeemablein5yearstimeatpar.
Corporationtaxispaidat30%.

Required:
Whatisthecostofdebtnet?

SOLUTION
Years Cashflows($) DiscFactor PVat7% DiscFactor PVat4%
(7%) (4%)
0 (102) 1 (102) 1 (102)
15 10(130%)=7 4.1 28.7 4.452 31.16
5 100 0.713 71.3 0.822 82.20
(2) 11.36

11.36
4% 7 4 % . %
11.36 2

39
Convertibledebt
Aloannotewithanoptiontoconvertthedebtintosharesatafuturedatewithapredetermined
price.Inthissituation,theholderofthedebthastheoptionthereforetheredemptionvalueisthe
greaterofeither:

1. Thesharevalueonconversionor
2. Thecashredemptionvalueifnotconverted
ILUSTRATION6
ContinuingtheILUSTRATION5,ithascometoknowthattheloannotewasconvertibleinto40
ordinaryshares.Theexpectsharepriceattheredemptiondatewillexpectedtobe$2.6

Required:
Whatisthecostofdebtnet?

SOLUTION
RedemptionValue=$100.
ConversionValue=($2.6X40)=$104.
Astheconversionvalueishighersowewilluseconversionvalueatredemptiondate

Years Cashflows($) DiscFactor PVat7% DiscFactor PVat9%


(7%) (9%)
0 (102) 1 (102) 1 (102)
15 10(130%)=7 4.1 28.7 3.89 27.23
5 104 0.713 74.15 0.65 67.6
0.85 (7.17)

0.85
7% 9 7 % . %
0.85 7.17

Nontradeabledebt
Asubstantialproportionofthedebtofcompaniesisnottraded.Bankloansandothernontradedloans
haveacostofdebtequaltothecouponrateadjustedfortax.
Kd(net) = Interest(Coupon)ratex(1T)
ILUSTRATION7
Trouthasaloanfromthebankat12%perannum.Corporationtaxischargedat30%.

Required:
Whatisthecostofdebtnet?

SOLUTION
Kd(net)=12%(130%)=8.4%

40

TheCostofPreference
Afixedratechargetothecompanyintheformofadividendratherthanintermsofinterest.
Preferencesharesarenormallytreatedasdebtratherthanequitybuttheyarenottaxdeductible.
Theycanbetreatedusingthedividendvaluationmodelwithnogrowth.
K 100%
ILUSTRATION7
Hammers9%preferenceshares($1)arecurrentlytradingat$1.4exdiv.

Required:
WhatisthecostofPreference?

SOLUTION
.
K 100%=6.43%
.

TheCalculationofWACC
Source Proportion(inMarketValues)XCost WACC
Equity ProportionofEquityXKe X%
Debt ProportionofDebtXKd(net) X%
PreferenceShare ProportionofPreferenceXKp X%
WACC X%

ILUSTRATION8
Barplchas20mordinary25psharesquotedat$3,and$8mofloannotesquotedat$85.Thecostof
equityhasalreadybeencalculatedat15%andthecostofdebt(netoftax)is7.6%.

Required:
CalculateWACC?

SOLUTION
MarketValueofEquity=20mX$3=$60m
MarketValueofDebt=$8mX85/100=$6.8m
Totalcapital(60+6.8)=$66.8m

Source PropotionXCost WACC
Equity (60/66.8)X15% 13.47%
Debt (6.8/66.8)X7.6% 0.77%


14.25%

41
Attempt QuestionNo.
Dec11 Q3c
Jun12 Q4b
Dec12 Q3a,b
CostofCapital Jun13 Q2
Dec13 Q2a,b,c
Jun14 Q3a,c
Dec14 Q5a
Jun16 Q4a

42
CapitalStructureandWACC
GearingTheories
TheTraditionalView
Costofequity:Atrelativelylowlevelsofgearingtheincreaseingearingwillhaverelativelylowimpact
onKe.AsgearingrisestheimpactwillincreaseKeatanincreasingrate
Costofdebt:Thereisnoimpactonthecostofdebtuntilthelevelofgearingisprohibitivelyhigh.When
thislevelisreachedthecostofdebtrises.


Gearing(D/E)

Keypoint:ThereisanoptimallevelofgearingatwhichtheWACCisminimizedandthevalueofthe
companyismaximized.
TheMMView(WithOutTax)
Costofequity:Kerisesataconstantratetoreflectthelevelofincreaseinriskassociatedwithgearing.
Costofdebt:Thereisnoimpactonthecostofdebtuntilthelevelofgearingisprohibitivelyhigh
Assumptions:
1. Perfectcapitalmarketexistwhereindividualsandcompaniescanborrowunlimitedamountsat
thesamerateofinterest.
2. Therearenotaxesortransactioncosts.
3. Personalborrowingisaperfectsubstituteforcorporateborrowing.
4. Firmsexistwiththesamebusinessorsystematicriskbutdifferentlevelofgearing.
5. Allprojectsandcashflowsrelatingtheretoareperpetualandanydebtborrowingisalso
perpetual.
6. Allearningsarepaidoutasdividend.

43
7. Debtisriskfree.

TheincreaseinKedirectlycompensatesforthesubstitutionofexpensiveequitywithcheaper
debt.Therefore,theWACCisconstantregardlessofthelevelofgearing.


Iftheweightedaveragecostofcapitalistoremainconstantatalllevelsofgearingitfollowsthatany
benefitfromtheuseofcheaperdebtfinancemustbeexactlyoffsetbytheincreaseinthecostofequity.

TheMMView(WithTax)
In1963M&Mmodifiedtheirmodeltoincludetheimpactoftax.Debtinthiscircumstancehasthe
addedadvantageofbeingpaidoutpretax.Theeffectivecostofdebtwillbelowerasaresult.

Implication:AsthelevelofgearingrisestheoverallWACCfalls.Thecompanybenefitsfromhavingthe
highestlevelofdebtpossible.

44
PeckingOrderTheory

Areflectionthatfundingofcompaniesdoesnotfollowtheoreticalrulesbutinsteadoftenfollowsthe
pathofleastresistance.

Asuggestedorderisasfollows:

1stretainedearnings
2ndbankdebt
3rdissueofequity.

CAPMandMMCombined

SystematicRisk

EquityBeta(e)

BusinessRisk FinancialRisk

AssetBeta(a)
BusinessRisk

Riskduetonatureofthebusinessoperationsorthetypeofindustry.

FinancialRisk

Riskduetoinclusionofdebtinthefinancialstructure.ThisRiskwillbezeroifthecompanyor
investmentis100%equityfinanced.

EquityBeta(e)

ItistheBetaofagearedCompanysoithasbothFinancialandBusinessRisk

AssetBeta(a)

ItistheBetaofanungearedCompanysoithasBusinessRiskonly.

TheFormula

Where:

Ve=MarketValueofEquity

Vd=MarketValueofDebt

ShouldCompanysWACCbeUsedforInvestmentAppraisal?

45
IftheInvestmentsBusinessriskandFinancialRiskaresimilartothecompany,thenweusethe
companysWACCtoappraisetheinvestment.However,ifanyoftheriskisdifferentthenwehaveto
calculateinvestmentspecificcostofcapital.

ProjectSpecificCosofCapital

Followingarethestepsofcalculatingtheprojectspecificcostofcapital.

FinancialRiskisDifferent BusinessRiskisDifferent
1. Chosetheeofthecompany. 1. Identifyaproxycompanyhavingsame
2. Calculatetheausingthecompanys BusinessRisk
currentfinancialstructure(Ungearing 2. Chosetheeofthatproxycompany.
Beta). 3. CalculatetheausingtheProxy
companyscurrentfinancialstructure

1 (UngearingBeta).
3. Calculateeoftheinvestmentusing

capitalstructuretobeusedforthe 1
investment.(RegearingBeta) 4. Calculateeoftheinvestmentusing
1 capitalstructuretobeusedforthe

investment.(RegearingBeta)
4. UseetocalculateKeusingCAPM 1

5. CalculateWACC
5. UseetocalculateKeusingCAPM
6. CalculateWACC

ILUSTRATION1
Techno,anallequityagrochemicalfirm,isabouttoinvestinadiversificationintheconsumer
pharmaceuticalindustry.Itscurrentequitybetais0.8,whilsttheaverageequityof
pharmaceuticalfirmsis1.3.Gearinginthepharmaceuticalindustryaverages40%debt,60%equity.
Corporatedebtisavailableat5%.
Rm=14%,Rf=4%,corporationtaxrate=30%.

Required:
WhatwouldbeasuitablediscountrateforthenewinvestmentifTechnoweretofinancethenew
projectwith30%debtand70%equity?

SOLUTION
1. PharmaceuticalIndustry 1.3
2. 1.3 0.89
%

%
3. 0.89 1.16

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

46
5. WACC
Source PropotionXCost WACC
Equity 70%X15.6% 10.92%
Debt 30%X5%(130%) 1.05%

WACC 11.97%

Attempt QuestionNo.
Dec11 Q3d
CapitalStructure Jun12 Q4d
andWACC Dec13 Q2d,e
Jun14 Q3b
Dec15 Q4b

47
SourceofFinance
Factorstoconsiderinchoosingappropriatesourceoffinance
1) Costoffunds(Normallydebtischeaper)
o Sincesecuredhencelowriskforprovider
o Guaranteedreturns
o Definitematurity
o Taxsavingbyinterest
2) Durationofneed(Matching)
3) Gearingratio(HighgearingHighrisk)

4) AccessibilityGenerallydifficultforsmallco.toraisedebt

Equity

OrdinaryShares
Owningashareconferspartownership.
Highriskinvestmentsofferinghigherreturns.
Permanentfinancing.
Posttaxappropriationofprofit,nottaxefficient.
Marketableiflisted
Advantages&Disadvantages
Advantages Disadvantages
1. No fixed charges (e.g. interest 1. Issuingequityfinancecanbeexpensive
payments). inthecaseofapublicissue9seelater).
2. Norepaymentrequired. 2. Problemofdilutionofownershipifnew
sharesissued.
3. Carries a higher return than loan
finance. 3. Dividendsarenottaxdeductible.
4. Shares in listed companies can be 4. Ahighproportionofequitycanincrease
easilydisposedofatafairvalue the overall cost of capital for the
company.
5. Shares in unlisted companies are
difficulttovalueandsell

StockMarketListing
Advantages&Disadvantages

48
Advantages Disadvantages
1. Accesstowiderpooloffinance 1. Increasedpublicscrutinyofthecompany
2. Betterimage 2. Possibilityofdilutionofcontrol
3. Releasingcapitalforotheruses 3. Increased costs e.g. corporate
4. Possibilities of acquisition and governance,internalaudit
growth

TypesofEquityFinance
RetainedEarnings(Retainfunds):Thesearereadilyavailableandhavenoissuancecosthoweverthey
maybenotsufficienttofundlargeprojects
NewShareIssuance
OfferforSale(Bytenderoratfixedprice)
Placing
RightsIssue
ComparisonBetweenOfferforSaleofitsShares&Placing
Placingismuchcheaper.
Placingisarelativelyquickermethod
Placinginvolveslessdisclosureofinformation
Placingmightgiveinstitutionalshareholdersthecontrolofthecompany
RightIssues
Itprovidesthatanynewissueofsharesshallfirstbeofferedtotheexistingshareholdersintheratioof
theirshareholdings.Thispreservestheexistingpatternofshareholdingandcontrol.
Advantages&Disadvantages
Advantages Disadvantages
1. Itisacheapermethodof Theamountthatcanberaisedislimited
financingascomparedtoapublic
offer.
2. Theexistingshareholdersget
sharesatalowpriceandtheir
shareholdingisnotdiluted.
3. Gearingwoulddecrease

ValuingaRightIssue
Theoreticalexrightsprice(TERP)


49
FundRaised=Rightissuesharesrightissueprice
Valueofrights=TERPRightsissueprice
ILUSTRATION1
ExistingShares=1,000,000
ExistingSharePrice=$4/Share
Companywantstoraise$800,000usingarightsissue,incurringanissuancecostof20,000.
RightPrice=$3/Share

Solution
RightsShares=800000/3=266,667
TERP =(1000000x4)+(80000020000)
1000000+266667
=$3.77/Share
ValueofRight =TERPRightPrice
=3.773
=$0.77

IstheRightIssueBeneficialForShareholders?
Fundsraisedthroughrightsissuecanbeusedtorepayaloanthiswillreduceinterestexpense
andearningswouldincrease.
Fundsraisedthroughrightsissuecanbeusedtoinvestinnewprojectwhichwillincreasethe
profitabilityofproject
Fromboththemarketvalueaftertherightissuewillbechanged.So,
Ifrevisedmarketvalue>TERP,thenshareholderswealthwillbeMaximized.

PreferenceShare
Fixeddividend
Paidinpreferenceto(before)ordinaryshares.
Notverypopular,itistheworstofbothworlds,ie
o nottaxefficient
o noopportunityforcapitalgain(fixedreturn).

50
Debt
Theloanoffundstoabusinesswithoutanyownershiprights.

1. Paidoutasanexpenseofthebusiness(pretax).
2. Riskofdefaultifinterestandprincipalpaymentsarenotmet
Security
Thedebtholderwillnormallyrequiresomeformofsecurityagainstwhichthefundsareadvanced.This
meansthatintheeventofdefaultthelenderwillbeabletotakeassetsinexchangeoftheamountsowing.
Covenants
Afurthermeansoflimitingtherisktothelenderistorestricttheactionsofthedirectorsthrough
themeansofcovenants.Thesearespecificrequirementsorlimitationslaiddownasacondition
oftakingondebtfinancing.Theymayinclude:

Dividendrestrictions

Financialratios

Financialreports

Issueoffurtherdebt

TypesofDebt
Debtmayberaisedfromtwogeneralsources,banksorinvestors

BankFinance

Forcompaniesthatareunlistedandformanylistedcompaniesthefirstportofcallforborrowing
moneywouldbethebanks.Thisisaconfidentialagreementthatisbynegotiationbetweenboth
parties

Debentures

Debtinstrumentssoldbythecompany,throughabroker,toinvestors.Typicalfeaturesmay
include:

Thedebtisdenominatedinunitsof$100,thisiscalledthenominalorparvalueandisthevalue
atwhichthedebtissubsequentlyredeemed.
Interestispaidatafixedrateonthenominalorparvalue.
Thedebthasalowerriskthanordinaryshares.Itisprotectedbythechargesandcovenants

TypesofDebentures

Irredeemable

51
Redeemable
o Convertible(Optiontoconvertintocertainnumberofshares)
o NonConvertible(canonlyberedeemedatapreagreedredemptionvalue)

WhenDebtFinancingWouldBeMoreAppropriatethanEquityFinancing

Whencompanyhaslowerfinancialrisk

Thegearingandinterestcoverareclosetoindustryaverage

Whencompanyisinhealthycomparativeposition

Cashflowsandprofitmarginsarestable

Tangibleassetsareavailabletobeofferedasasecurity

VentureCapital
Venturecapitalisariskcapital,normallyprovidedinreturnforanequitystake.

TypesofVenture:

Businessstartups

Businessdevelopment

Managementbuyout

Helpingacompanywhereoneofitsownerswantstorealizeallorpartofhisinvestment

Venturecapitalistswillassessaninvestmentprospectonthebasisofits:

financialoutlook
managementcredibility
depthofmarketresearch
technicalabilities
degreeofinfluenceoffered:
o controllingstake?
o boardseat?
exitroute.

SMEs
SMEscanoftenfacedifficultieswhenraisingfinancesinceinvestinginanSMEisinherentlymorerisky
thaninvestinginalargercompanydueto:

thelackofbusinesshistoryorproventrackrecord
thelowerlevelofpublicscrutinyoveraccountsandrecords

SourceofFinanceforSMEs

52
Financialinvestorsincluding:
o Businessangels
o Venturecapitalists
Variousgovernmentsolutionsincluding:
o increasingthemarketabilityofshares
o providingtaxincentives
o otherspecificformsofassistance
Otherpracticesincluding:
o supplychainfinancing
o crowdfunding
o peertopeerfunding

RatioAnalysis
PerformanceRatios

ReturnonCapitalEmployed

100%

ReturnonEquity

100%

ShareHoldersWealth

DividendYield

100%

CapitalGains

100%

TotalReturn(DividendYield+CapitalGains)

100%

DividendCover


Price/EarningRatio


53
DividendYield

100%

FinancialRisk

FinancialGearing

100%OR 100%

InterestCoverRatio

DividendPolicyTheories
Dividendpolicyisastrategywherebythemanagementdistributeprofitstotheshareholders.Thereare
twosuchtheories:

Irrelevancytheory

Relevancytheory

Irrelevancytheory

AccordingtoMMtheorydividendsareirrelevant,itdoesnotmatter,whatactuallymattersthatis
earningpower.

Theextentandtimingofdividendpayoutsisirrelevant.Investorsareindifferenttowhetherthey
receivetheirearningsbywayofdividendsorcapitalgains.

Sinceprimeimportanceisgiventoinvestmentdecisions,dividendsaredeterminedasaresidual
amount.Theremayevenbenodividendsiftheretainedearningsareconsumedbyinvestment
projects.However,theexpectedfutureearningsofthecompanywillpushthesharepricesup.Inthis
manner,ashareholdergainsincapitalappreciationevenifhedoesnotreceivedividendpayments.

Itwasarguedthatifshareholdersneededcashwhennodividendsweredeclared,theycouldsellsome
oftheirsharesandgeneratecash.

Assumptions

Thistheoryisbasedonthefollowingassumptions:
Capitalmarketsareperfect.
Therearenotaxesatthecorporateorpersonallevel.Therearenoissuecostsforthe
securities.

RelevancyTheory

54
Marketsarenotperfect,dividendsplayaroleofsignal:Adividendwhichdiffersfromshareholders
expectationsaboutdividendsmightsendsignalstothemarketandaffectshareprice. Ahigherthan
expecteddividendmaysignalthattheboardofdirectorsareconfidentaboutthefutureandmaylead
toanincreaseinshareprice lowerthanexpecteddividendmaysignalthatthecompanyisinfinancial
difficultiesandleadtoafallinshareprice.

LiquidityPreference:Investorshavetheirownliquidityneedssotheywillprefercashnowtolater

TaxPosition

Taxondividendsisincometaxwhereastaxonsellingsharesiscapitalgainstax

Ifcompanychangesitsdividendpolicy,itwilldisturbinvestorstaxposition

FactorsAffectingDividendPolicy

Theneedtoremainprofitable

Thegovernmentimposedirectrestrictionsontheamountofdividendscompaniescanpay

Anydividendrestraintsthatmaybeimposedbyloanagreements

Theeffectofinflationandtheneedtoretainsomeprofitinthebusinessjusttomaintainits
operatingcapacity

Thecompanysgearinglevel

Theneedtorepaydebtinnearfuture

Theeasewithwhichthecompanycanraiseextrafinancefromsourcesotherthanretained
earnings

Thesignalingeffectofdividendstoshareholdersandfinancialmarketsingeneral

Theamountofearningsthecompanywishestoretainmaybeaffectedbythenumbersuitable
investmentopportunitiesavailabletothecompany.iftherearefewinvestmentprojects
availablewhichcangeneratesufficientreturnthansurpluscashshouldbereturnedto
shareholders

ScripDividend

Ascripdividendisthedividendpaidbyissueofadditionalcompanyshares,ratherthancash.

Acompanythatwantstoretaincashforreinvestmentbutdoesnotwanttoreduceitsdividendsmight
offeritsshareholdersascripdividend.

Therulesofthestockexchangemightrequirethatwhenacompanywantstomakeascripdividend,it
mustofferacashdividendalternative,sothatshareholderscanchoosebetweennewsharesandcash.

55
Advantages

Theycanpreserveacompaniescashpositionifasubstantialnumberofshareholderstakeup
thesharesoption.

Investorsmaybeabletotaketaxadvantagesifdividendsareinformofshares.

Investorslookingtoexpandtheirholdingcandosowithoutincurringthetransactioncostsof
buyingmoreshares.

Asmallscripissuewillnotdilutethesharepricesignificantly.

Ashareissuewilldecreasethecompanysgearingandthereforeenhanceitsborrowing
capacity

ShareRepurchase

Purchasebyacompanyofitsownsharescantakeplaceforvariousreasonsandmustbeinaccordance
withanyrequirementsoflegislation.

Ifacompanyhassurpluscashintheformofahigherdividend.

Ifacompanychoosestopayhigherdividend,thismightactasasignalshareholderwhothenexpect
highdividendsinfutureyearstoo.Ifthecashisusedforsharerepurchasesinsteadofhigherdividends,
futuredividendexpectationswillnotbeaffected.

Advantages&Disadvantages
Advantages Disadvantages
1. Findingauseofsurpluscash,thismay 1. It can be hard to arrive at a price that
beadeadassets. willbefairbothtothevendorsandto
2. Increaseinearningspersharethrougha any shareholders who are not selling
reduction in the number of shares in sharestothecompany.
issue. 2. Arepurchaseofsharescouldbeseenas
3. Readjustmentofthecompanysequity anadmissionthatthecompanycannot
base to more appropriate level, for a make better use of funds than the
companywhosebusinessisindecline. shareholders.
4. Possibly preventing a takeover or 3. Some shareholders may suffer from
enabling a quoted company to being taxed on capital gains following
withdrawfromthestockmarket. thepurchaseoftheirsharesratherthan
5. Increaseingearing receivingdividendincome.

IslamicFinance
AformoffinancethatspecificallyfollowstheteachingsoftheQuran.

56
TheteachingsoftheQuranarethebasisofIslamicLaworSharia.ShariaLawishowevernotcodified
andassuchtheapplicationofbothShariaLawand,byimplication,IslamicFinanceisopentomore
thanoneinterpretation

Prohibitedactivities

InShariahLawtherearesomeactivitiesthatarenotallowedandassuchmustnotbeprovidedbyan
Islamicfinancialinstitution,theseinclude:

1. Gambling(Maisir)
2. Uncertaintyincontracts(Gharar)
3. Prohibitedactivities(Haram)

Riba
Interestinnormalfinancingrelatestothemonetaryunitandisbasedontheprincipleoftimevalueof
money.ShariaLawdoesnotallowfortheearningofinterestonmoney.Itconsidersthechargingof
interesttobeusuryorthecompensationwithoutdueconsideration.ThisiscalledRibaandunderpins
allaspectsofIslamicfinancing.

Insteadofinterestareturnmaybechargedagainsttheunderlyingassetorinvestmenttowhichthe
financeisrelated.Thisisintheformofapremiumbeingpaidforadeferredpaymentwhencompared
totheexistingvalue.

Thereisaspecificlinkbetweenthechargingofinterestandtheriskandearningsoftheunderlying
assets.Anotherwayofdescribingitisasthesharingofprofitsarisingfromanassetbetweenlender
anduseroftheasset

IslamicFinanceContracts

TherearesomespecifictypesoffinancethataredeemedcompliantandallowIslamicfinanceto
offersimilarfinancialproductstothoseofferedinnormalfinancing,theseinclude:

Murabahatradecredit

Ijaraleasefinance
Mudarabaequityfinance
Sukukdebtfinance
Musharakaventurecapital
Islamic SimilarTo Differences
Finance
Transaction
Murabaha Tradecredit/ Thereisapreagreedmarkuptobepaidinrecognitionofthe
loan convenienceofpayinglaterforanassetthatistransferred
immediately.Thereisnointerestcharged

57
Musharaka Venture Profitsaresharedaccordingtoapreagreedcontract.Thereare
Capital nodividendspaid.Lossesaresolelyattributabletotheproviderof
capital
Mudaraba Equity Profitsaresharedaccordingtoapreagreedcontract.Thereare
nodividendspaid.Lossesaresolelyattributabletotheproviderof
capital
Ijara Leasing Whetheranoperatingorfinancetransaction,inIjarathelessoris
stilltheowneroftheassetandincurstheriskofownership.This
meansthatthelessorwillberesponsibleformajormaintenance
andinsurancewhichisdifferentfromaconventionalfinance
lease.
Sukuk Bonds Thereisanunderlyingtangibleassetthatthesukukholdershares
intheriskandrewardsofownership.Thisgivesthesukuk
propertiesofequityfinanceaswellasdebtfinance

Attempt QuestionNo.
Dec11 Q4
Jun12 Q3a,b,c
Dec12 Q3d
Jun13 Q4b,c,d
SourcesofFinance Dec13 Q4
Jun14 Q4c,d
Dec14 Q5b
Jun15 Q4
Dec15 Q1&Q4a
Jun16 Q4b,c

58
BusinessValuation
Need
Businessesneedtobevaluedforanumberofreasonssuchas

ForAcquisitions&Merger

TogetlistedonstockExchange

FortaxPurpose

EquityValuationMethods
CashFlowbasedMethod

o DividendValuationModel

o PresentValueofFutureCashflows(notgenerallyexaminedinF9)

NetAssetMethod

o Thebookvalueapproach

o NetRealizablevaluesoftheassetslessliabilities

o Replacementvalues

IncomebasedMethod

o P/ERatio

o EarningYield

CashflowBasedMethod
DividendValuationMethod

Thedividendvaluationmodel(orgrowthmodel)suggeststhatthemarketvalueofashareissupported
bythepresentvalueoffuturedividends.Theformulaforconsistentdividendorgrowthstartingfromyear
1.

Where:

P0=PriceofShare.

d1=Expecteddividendinyear1andcanbeestimatedasd0(1+g)

g=growthrate

Whendividendsarenotconsistentfromstartthencalculatepresentvalueofeachyearindependently.

59
ILUSTRATION1
Acompanyisexpectedtopayfuturedividendasfollows
Y1=$1
Y2=$1.5
Y3=$2
FromY4thedividendwillconsistentlygrowby4%eachyear.TheKeis10%.
Required:
EstimatethemarketPriceofeachshare.

Solution
Marketpriceofeachshareshouldbethepresentvalueoffuturedividendsdiscountedatke

Years dividends discfactoratKe PV


1 1 0.909 0.91
2 1.5 0.826 1.24
3 2 0.751 1.50
4 2(1+4%)=2.08 (1/(10%4%))X0.751 26.03


29.68

Marketcapitalization
Mv/sharenumberofshares
Advantages&Disadvantages
Advantages Disadvantages
1. Considers the time value of money 1. Difficulty estimating an appropriate
and has an acceptable theoretical growthrate.
basis.
2. Themodelissensitivetokeyvariables.
2. Particularly useful when valuing a
3. The growth rate is unlikely to be
minoritystakeofabusiness.
constantinpractice

AssetBasedApproach
ThebusinessisestimatedasbeingworththevalueofitsNetAssets.
NetAssets=TotalAssetsTotalLiabilitiesPreferenceShareValue
WaysofvaluingNetAssets

60
BookValueApproachThebookvalueofnoncurrentassetsisbasedonhistorical(sunk)costs.
Theseamountsareunlikelytoberelevanttoanypurchaser(orseller).
NetRealizablevaluesoftheassetslessliabilitiesThisamountwouldrepresentwhatshouldbe
leftforshareholdersiftheassetsweresoldoffandtheliabilitiessettled.
ReplacementvaluesTheapproachtriestodeterminewhatitwouldcosttosetupthebusiness
ifitwerebeingstartednow.
Weakness
Investorsdonotnormallybuyacompanyforthebookvalueofitsassets,butfortheearnings/
cashflowsthatthesumofitsassetscanproduceinthefuture.
Itignoresintangibleassets.Itisverypossiblethatintangibleassetsaremorevaluablethanthe
balancesheetassets.
UsesofAssetBasedMethod
assetstripping
toidentifyaminimumpriceinatakeover
iftheassetsarepredominantlytangibleassets

IncomeBased
Thismethodofparticularusewhenvaluingamajorityshareholding:

Asmajorityshareholders,theownerscaninfluencethefutureearningsofthecompany.
Thedividendpolicyofacompanyislessofanissuewhencontrolisheld,thelevelofdividends
canbemanipulatedtowhatyouwant
Price/EarningMethod
Thismethodreliesonfindinglistedcompaniesinsimilarbusinessestothecompanybeingvalued(the
targetcompany),andthenlookingattherelationshiptheyshowbetweensharepriceandearnings.
MarketValueofTargetCompany=EarningsperShareofTargetCompanyXP/ERatioofProxyor(Industry
Average)

ILUSTRATION2
HeneryLtd,anunlistedcompany:
Ordinarysharecapitalis200,00050shares.
Extractfromincomestatementfortheyearended31Dec20X7:
$
Profitbeforetaxation 430,000
Less:Corporationtax 110,000
______
Profitaftertaxation 320,000

61
ThePEratioapplicabletoasimilartypeofbusinessis10.
Required:
Value200,000sharesinHeneryLtdonaPEbasis.

SOLUTION

EPS
,
1.6
,

MarketPrice=10X1.6=$16/Share

TotalValueof200,000shares=16X200,000=$3,200,000

EarningYield

TheearningsyieldistheinverseofthePEratio:

Earning Yield 100% Or Earning Yield 100%

Itcanthereforebeusedtovaluethesharesormarketcapitalisationofacompany

Price per share OrMarket Value

ILUSTRATION3
CompanyAhasearningsof$300,000.Asimilarlistedcompanyhasaearningyieldof12.5%.
Required:
Findthemarketcapitalizationofeachcompany.

SOLUTION
300,000
Price per share $ , ,
12.5%

DebtValuation
ValueofdebtisthesumofPresentvalueoffutureinterestpayments,discountedatKd

Irredeemable

Market Price

ILUSTRATION4
Acompanyhasissuedirredeemableloannoteswithacouponrateof9%.Therequiredreturnof
investorsinthiscategoryofdebtis6%.
Required:

62
Thecurrentmarketvalueofthedebt.

SOLUTION
$9
Market Price $150
6%

Redeemable

Years Cashflows DiscatKd PresentValue


1n Interestcost AnnuityFactor X
n RedemptionValue DiscountFactor X
MarketPrice X

ILUSTRATION5
Acompanyhas10%debtredeemablein5years.Redemptionwillbeatparvalue.Theinvestors
requireareturnof8%.
Required:
Thecurrentmarketvalueofthedebt.

SOLUTION
Years Cashflows DiscatKd PresentValue
15 $10 3.993 $39.93
5 $100 0.681 $68.1

MarketPrice $108.03

EfficientMarketHypothesis
Amarketisefficientif

Thepricesofsecuritiestradedinthatmarketreflectalltherelevantinformationaccurately
andrapidly,andareavailabletobothbuyersandsellers.
Noindividualdominatesthemarket.
Transactioncostsofbuyingandsellingarenotsohighastodiscouragetradingsignificantly.
MarketefficiencyfromtheperspectiveoftheEMHrelatestotheefficiencyofinformation,
the better the information received by investors, the better and more informed the
decisionstheymakewillbe.

FormofEfficiency

WeakForm

63
Weakformhypothesisstatesthatcurrentsharepricesreflectallrelevantinformationabout
thepastpricemovementsandtheirimplications.Ifthisistrue,thenitshouldbeimpossibleto
predictfuturesharepricemovementsfromhistoricinformationorpattern.

Sharepricesonlychangeswhennewinformationaboutacompanyanditsprofitshavebecome
available.Sincenewinformationarrivesunexpectedly,changesinsharepricesshouldoccurinarandom
fashion,henceweakformcanbereferredtoasrandomwalkhypothesis.

SemiStrong

Semistrongformhypothesisstatethatcurrentsharepricesreflectsboth

(i) allrelevantinformationaboutpastpricemovementandtheirimplications;and
(ii) publiclyavailableinformationaboutthecompany.
Anynewpubliclyaccessibleinformationwhethercommentsinthefinancialpress,annualreportsor
brokersinvestmentadvisoryservices,shouldbeaccuratelyandimmediatelyreflectedincurrentshare
prices,soinvestmentstrategiesbasedonsuchpublicinformationshouldnotenabletheinvestortoearn
abnormalprofitbecausethesewillhavealreadybeendiscountedbythemarket.

Strong

Thestrongformhypothesisstatesthatcurrentsharepricesreflectallrelevantinformation
availablefrom
pastpricechanges
publicknowledge;and
insiderknowledgeavailabletospecialistsorexpertssuchasinvestmentmanagers

ImplicationofEfficientMarketHypothesis

Ifcapitalmarketsareefficient,themainimplicationsforfinancialmanagersare:

1. Thetimingofissuesofdebtorequityisnotcritical,asthepricesquotedinthemarketare
fair.Thatispricewillalwaysreflectthetrueworthofthecompany,nooverorunder
valuationatanypoint.
2. Anentitycannotmisleadthemarketsbyadoptingcreativeaccountingtechniques.
3. The entitys share price will reflect the net present value of its future cash flows, so
managersmustonlyensurethatallinvestmentsareexpectedtoexceedthecompanys
costofcapital.
4. Largequantitiesofnewsharescanbesoldwithoutdepressingtheshareprice.
5. Themarketwilldecidewhatlevelofreturnitrequiresfortheriskinvolvedinmakingan
investmentinthecompany.Itispointlessforthecompanytotrytochangethemarkets
viewbyissuingdifferenttypesofcapitalinstrument.
6. Mergersandtakeovers.Ifsharesarecorrectlypricedthismeansthattherationalebehind
mergers and takeovers may be questioned. If companies are acquired at their current

64
market valuation then the purchasers will only gain if they can generate synergies
(operatingeconomiesorrationalisation).Inanefficientmarketthesesynergieswouldbe
known, and therefore already incorporated into the price demanded by the target
companyshareholders.
Themoreefficientthemarketis,thelesstheopportunitytomakeaspeculativeprofitbecauseit
becomeimpossibletoconsistentlyoutperformthemarket.

Evidencesofarcollectedsuggeststhatstockmarketsshowefficiencythatisatleastweakform,but
tendingmoretowardsasemistrongform.Inotherwords,currentsharepricesreflectallormost
publiclyavailableinformationaboutcompaniesandtheirsecurities.

Attempt QuestionNo.
Dec11 Q3a,b
Jun12 Q4a
Dec12 Q4
BusinessValuation Jun13 Q4a
Jun14 Q3d&Q4b
Dec14 Q2
Jun15 Q2
Jun16 Q3

65
RiskManagement
Forex
Quotes

Quotes Quoted Example(Pakistan) Convertingforeigncurrencytolocal


Direct Local/foreign Rs.100/1$ Multiplyeg.$10=(100X10)=Rs.1,000
Indirect Foreign/local $0.01/1Re. Divideeg.$10=(10/0.01)=Rs.1,000

BIDandOFFERRates

NOTE:Remembertherule.(BANKALWAYSWIN).
Hencebankalwaysbuytheforeigncurrencyatlowpriceandsellitathighprice(Directquote).
Hencebankalwaysgivefewforeigncurrencyandreceivemoreforeigncurrencyagainstlocal.(IndirectQuote)
Bidpriceisapriceatwhichbankiswillingtobuyforeigncurrency

Offerpriceisapriceatwhichbankiswillingtosellforeigncurrency.

NOTE:Ourprospectiveisoppositeasifwewanttosellforeigncurrencythenitmeansbankwillbuy.

CustomerReceivingforeigncurrencywewanttosellforeigncurrencybankwillbuyuseBid
Price

SupplierPayingforeigncurrencywewanttoBuyforeigncurrencybankwillSelluseOffer
Price

Bid Offer
Direct Lower Higher
Indirect Higher Lower

SpotRate:Aprevailingrateatapointintime(saytoday)

FOREXRisk
Therearethreerisksassociatedwithforeigncurrency:

1. Transactionrisk.
2. Economicrisk.
3. Translationrisk

TransactionRisk

Theriskassociatedwithshorttermcashflowtransactions.

Thismayinclude:

Commercialtradethisisnormallyreflectedbythesaleofgoodsinaforeigncurrencybut
withadelayinpayment.Thereceiptwillhaveanuncertainvalueinthehomecurrency.

66
Borrowing or lending in another currency subsequent cash flows relating to interest
paymentswouldbeuncertaininthehomecurrency.
Thesetransactionsmaybehedgedrelativelyeasilyeitherusinginternalorexternalhedgingtools

EconomicRisk

Longtermcashfloweffectsassociatedwithassetinvestmentinaforeigncountryoralternatively
loanstakenoutormadeinaforeigncurrencyandthesubsequentcapitalrepayments.

Economicriskismoredifficulttohedgegiventhelongertermnatureoftherisk(possiblyover10
or more years). A simple technique would be to adopt a portfolio approach to investments by
currencytospreadtherisk.

TranslationRisk

Riskassociatedwiththereportingofforeigncurrencyassetsandliabilitieswithinfinancial
statements.

Thereisnocashflowimpactofthistypeofrisk.However,theimpactonthefinancialstatements
canbesevere.

Translation risk may be hedged by matching the assets and liabilities within each country. Any
increaseordecreaseinvaluewouldcanceloutonconsolidation.

PredictingExchangeRates
PurchasePowerParity

Basedonthelawofonepriceineconomictheory.Thiswouldsuggestthatthepriceofthesame
productisthesameinallcurrencies.

Toextendtheprinciplefurtherthiswouldsuggestthatarelativechangeinprices(inflation)would
haveadirecteffectontheexchangerate
1

1
Where:
Note
S1=FutureExpectedSpotRate
Therateofinflationinnominatoristhecountrys
S0=CurrentSpotRate
currencyinnominator.ViceVersa
ha=Rateofinflationincountrya

hb=Rateofinflationincountryb

ILUSTRATION1
Thecurrentexchangerateis$2.000/.
Required
Whatwouldweexpecttheexchangeratetobein1yeariftheinflationratesinUKis4%and7%in
USA?

67

SOLUTION
$2.000 1 7%
1 $2.058/
4%

ProblemswithPurchasePowerParity

Notallinflationrelatestoexportedgoods.
TherearemarketimperfectionssuchastaxationandtariffsthatreducetheimpactofPPPT.
Onlyasmallproportionoftraderelatestotradedgoods

InterestRateParity

Thetheorythatthereisanosumgainrelatingtoinvestingingovernmentbondsindifferingcountries.
Anybenefitinadditionalinterestiseliminatedbyanadversemovementinexchangerates
1

1
Where:
Note
F=FutureExpectedSpotRate
Therateofinterestinnominatoristhecountrys
S0=CurrentSpotRate
currencyinnominator.ViceVersa
ia=Rateofinterestincountrya

ib=Rateofinterestincountryb

ILUSTRATION2
Thecurrentexchangerateis$2.000/.
Required
WhatwouldtheForwardexchangeratetobein1yeariftheinterestratesinUKis6.08%and9.14%
inUSA?

SOLUTION
$2.000 1 9.14%
1 $2.058/
6.08%

Hedging
Hedgingistheprocessofreducingoreliminatingrisk.Itmaybeachievedbyusinginternalor
externalmeasures.

Internalmeasuresandmanagingtheriskexposureinternally.

68
Externalmeasuresinvolveabankorfinancialmarket.

InternalHedgingTechniques
InvoicinginHomeCurrency

Byinvoicinginyourowncurrencyyoudonotsuffertheriskofexchangeratemovement.

Theriskdoesnotdisappear,insteaditpassestotheotherparty.Itisquestionablewhetherthe
otherpartywillbehappytoacceptthisrisk.

LeadingPayments

Bypayingearlyorencouragingacustomertopayearlytheriskrelatingtoanindividualtransaction
is reduced or eliminated. The earlier the cash flow, the lower the exposure to exchange rate
movements

Matching

Ifacompanymakesanumberoftransactionsinbothdirectionsitwillbeabletonetoffthose
transactionsrelatingtothesamedates.Bydoingsoacompanycanmateriallyreducetheoverall
exposure,butisunlikelytoeliminateit.

DoNothing

Acompellingidea,theexchangerateswillfluctuateupandown.Itcouldbearguedthatsinceyou
winsomeandlosesomethenignoringtheriskwouldbethebestoption.

Asaresultyousaveonhedgingcosts,thedownsidebeingthattheexposuretoexchangeratesis
presentintheshortterm.

ExternalHedgingTechniques
ForwardContracts

Features

1. Anagreementwiththebanktoexchangecurrencyforaspecificamountatafuturedate.
2. Itisanobligationthatmustbecompletedonceenteredinto.
3. Theforwardrateoffersaperfecthedgebecauseitisfortheexactamountrequiredbythe
transactionontheappropriatedateandthefuturerateisknownwithcertainty.
ILUSTRATION3
Thecurrentspotrateis$2.1086/2.1178/.TheUKbasedcompanyisexpectingtoreceive$400,000
inthreemonths.Theforwardrateofferedbybankis$2.1076/$2.1168/.
Required
CalculatetheAmountinpoundtobereceivedin3monthstimeusingFRA

69
Solution
Theraterelevanthereis$2.1168/beingtheFRArateandbidrateasthisisthequestionofreceipt.
Bidrateisthehigherbecauseitisanindirectquote.
$400,000
, .
$2.1168

MoneyMarketHedge
Useoftheshorttermmoneymarketstoborrowordepositfunds.Thisgivesthecompanytheopportunity
toexchangecurrencytodayattheprevailingspotrate.
StepsofSettingupMoneyMarketHedge
1. Borrowborrowfundsinthecurrencyinwhichyouneedthemoney.
2. Translateexchangethefundstodayavoidingexposuretofluctuationsintherate.
3. Depositdepositthefundsinthecurrencyinwhichyoueventuallywantthefunds
untilsuchtimeasyouwillneedthem.
CalculatingtheOutcomeofMoneyMarketHedge

1
1

Note:
IncaseofReceiptinvestingrateshouldbeusedinhomecurrencyandborrowingrateinforeigncurrency.
ViceVersaforPayments
Remembertotimeproportionatetheinterestrate.
ILUSTRATION4
AbrewisaUKcompanytradingextensivelyintheUS.Thecurrentexchangerateis
$1.97500.003/.
WewishtoHedgetheReceiptof$500,000in1month
Themoneymarketsprovidethefollowinginterestratesfornextyear(pa)

UK US
Loanrate 6.0% 7.5%

Depositrate 4.0% 5.0%
Required
i) Inwhichcurrency,wewillborrowandinwhichwewillinvesttosetupthemoneymar
hedge?
ii) Theamountofcashreceivedusingmoneymarkethedge.

70

SOLUTION
i) WewillborrowinDollars(theForeignCurrency)andwewilinvestinPoundSterlings(the
HomeCurrency)
ii) ThisisthequestionofreceiptsoweusetheinvestingrateofUKandborrowingrateofUSA.
SotheUKinvestingrateis0.33%(4%X1/12)andUSAborrowingrateis0.625%(7.5%X
1/12)
$500,000
1.9753 1 0.33% ,
1 0.625%

CurrencyFutures
Thefixingoftheexchangeratetodayforafuturetradeinasimilarmannertotheforward
contract.TheFutureisanexchangetradedinstrumentthatcanbeboughtorsoldonan
exchange(egLIFFE).

Thefutureisastandardisedfinancialinstrumentintermsofamountanddate.Thismayleadto
ahedgethatislessthanperfectbecausetheamountofthetrademaydiffer.

Theaimistobuyorsellthefutureinsuchawayastocomplimenttheunderlyingtrade.
Thereforeyouwillhave:

1. Afuturescontractbettingontheexchangeraterisingorfalling,and
2. Anunderlyingtransactionthatmayfallorriseintermsofthehomecurrency.
Thelinkingofthetwocancelsoutthemovementoftheexchangerateandleadstothehedge.
CurrencyOptions
TheymaybeexchangetradedorOTC.Optionshavethebenefitofbeingaonesidedbet.You
canprotectthedownsideriskofthecurrencymovingagainstyoubutstilltakeadvantageofthe
upsidepotential.

Theoptionwriterthereforeonlyhasadownsiderisk(aswetaketheupside).Theoptionwriterneeds
compensatingforthisriskandispaidapremiumoverandabovetransactioncosts.

InterestRateRisk
Theriskthatinterestrateswillriseorfallinthefuture.Interestratesarenormallylessvolatile
thanexchangerates,changingatmostonamonthlybasis.Theymayevenbeconstantover
longperiodsoftime.

Theexposuretointerestrateshoweverismoreenduringforcompaniesonthebasisthatany
formofexistingborrowingorinvestingwillbeaffectedbyachangeininterestrates.

71
Acompanyhasabasicchoicebetweenborrowingfixedrateorvariable(floating)rate.Bothpresentarisk,the
variableraterepresentsacashflowriskandthefixedrateanopportunitycost.
ReasonforFluctuatingInterestRates
Interestratesorbaseratesareakeyeconomictoolforgovernment.Theymaybechangedfor
thefollowingreasons:

Tocontrolinflation,higherinterestrateswillreducedemandforfunds,aggregate
demandandhenceinflationarypressure.
Toprotectthecurrency,contrarytoIRPTanincreaseintheinterestrateswillhavea
oneoffeffectofattractingspeculativefundsandincreasingthevalueotheeconomy.
Tokickstarttheeconomy,areductionininterestratescanstimulateeconomicactivitybyencouraging
borrowing.

HedgingInterestRateRisk
ForwardRateAgreement
Thefixingoftheinterestratetodayinrelationtoafutureshorttermloan.Itisanobligation
thatmustbetakenonceenteredinto.ItisOTCandtailoredtoaspecificloanintermsof:

1. Date
2. Amount,and
3. Term
andoffersaperfecthedge.TheFRAiswhollyseparatetotheunderlyingloan.

Itwillgivecertaintyasregardstheinterestpaidbutthereisadownsideriskthatinterestratesmayfall
andwehavealreadyfixedatahigherrate.
InterestRateFutures
AnexchangetradedinstrumentthatworksinasimilarmannertoaFRA.Bytradingontheexchange
theFuturecanfixtheratetodayforafutureloan.
InterestRateOptions
Similartocurrencyoptions,theoptiongivesprotectionagainstthedownsideforthepaymentofa
premium.
InterestRateCollars
AfurtherstepofInterestrateoptionsinefforttoreducethetransactioncostofhedge.
LongTermHedgingSWAPS
Acompanywillborroweitherusingavariableorafixedrate.Ifitwishestochangeits
borrowingtypeitcouldredeemitspresentdebtandreissueintheappropriateform.Thereare
risksandcostsinvolvedindoingso.

72
Aswapallowsthecompanytochangetheexposure(fixedtovariableorviceversa)without
havingtoredeemexistingdebt.Toprepareaswapweneedthefollowingsteps
1. Identifyacounterparty,eitheranothercompanyorbankwillingtobetheothersideofthe
transaction.Ifwewanttoswapfixedforvariabletheywillwanttheopposite
2. Agreethetermsoftheswaptoensurethatattheoutsetbothpartiesareinaneutralposition
3. On a regular basis (perhaps annually) transfer net amounts between the parties to reflect any
movementintheprevailingexchangerates
AdvantagesofSWAP
Allowsachangeininterestrateexposureatrelativelylowcostandrisk.
Mayallowaccesstoadebttypethatisotherwiseunavailabletothecompany.
Mayreducetheoverallcostoffinancingincertaincircumstances.

Attempt QuestionNo.
Jun12 Q3d,e
Jun13 Q3c,d
RiskManagement Dec14 Q3
Jun15 Q1
Dec15 Q2
Jun16 Q2

73
WorkingCapitalManagement
WhatisWorkingCapital
Working capital is the name given to net current assets which are available for daytoday operating
activities.

Itnormallyincludesinventories,receivables,cash(andcashequivalents),lesspayables.

Workingcapital=receivables+cash+inventorypayables

WORKINGCAPITAL
MANAGEMENT.

Reducetheworkingcapitalto IncreasetheLiquidityratioto
reducethecostoffinancing mitigatetheriskofcashshortage

The objectives of the working capital are profitability and liquidity. The objective of profitability is
to maximize the shareholders wealth and the objective of liquidity is to ensure that business is able
to pay of its liabilities. Meeting the objectives are therefore conflicting, hence good working capital
management is to achieve a balance between these objectives.

LiquidityVsProfitability

Thereisalwaysaconflictbetweenliquidityandprofitability.

Ifwemaintainmoreliquidassets,profitabilitywillbereduced.

Ifwemaintainlessliquidassets,profitabilitywillbeincreasedasmoreassetsareinvestedbut
riskofinsolvencyincreased

InvestmentinWorkingCapital

Thiscanbecalculatedas:

Inventory+ReceivablesPayables

CashOperatingCycle

74
Thecashoperatingcycleisthelengthoftimebetweenthecompanysoutlayonrawmaterials,wages
andotherexpendituresandtheinflowofcashfromthesaleofgoods.

Thiscanbecalculatedas:

ReceivablePeriod

Add: InventoryPeriod

Less: PayablePeriod

Reducecycletimeby:

Improvingproductionefficiency

Improvingfinishedgoodsand/orrawmaterialinventoryturnover

Improvingreceivablecollectionandpayablespaymentperiods

AppropriateWorkingCapital

Anappropriateworkingcapitalwilldependon:

1.Thenatureofthebusiness,

2.Certaintyinsupplierdeliveries

3.Thelevelofactivityofthebusiness,

4.Cashoperatingcycle

5.Thecompanyscreditpolicy

WorkingCapitalRatios
LiquidityRatios

CurrentRatio= QuickRatio=

ReceivablePeriod


InventoryPeriod

Raw Material Inventory Days

Average Work in Process Inventory X 365


Work inProcess Inventory Days
Cost of Sales X % of completion

Average Finished Goods Inventory X 365


Finished Good Inventory Days
Cost of Sales

75
PayablePeriod
Average Payables X 365
Payable Days
Cost of Sales
Note:
Generallyclosingbalanceswillbeconsideredasaveragebalances.
Ifnotmentioned,allthesalesandpurchasesareconsideredtobeoncredit.
Intheabsenceofpurchases,Costofsaleswillbeused.
Ifnotgiven,allinventorywillbeconsideredasfinishedgoods
ILUSTRATION1
Profitandlossaccountextract $

Turnover 250,000
CostofSales160,000

Grossprofit 90,000

BalanceSheetextract $

CurrentAssets
Inventory 30,000
Debtors60,000

CurrentLiabilities
Creditors50,000
Required
Preparethecashoperatingcycle

SOLUTION

Receivable $60,000 365 87.6Days

$250,000
Add:Inventory $30,000 X 365 68.4Days

$160,000
Less:Payable $50,000 X 365 (114.1Days)

$160,000

41.9Days

WorkingCapitalFinanceCost

76
Workingcapitalfinancecost=InvestmentinWorkingCapitalX%ofinterest.

Overtrading
Abusinesswhichistryingtodotoomuchtooquicklywithtoolittlelongtermcapitalisovertrading
Symptomsofovertrading:
Rapidincreaseinturnover.
Rapid increase in the volume of current assets and possibly also noncurrent assets. High
Inventoryandaccountsreceivableperiod.
Only a small increase in equity capital. Most of the increase in assets is financed by credit,
especially:
Tradeaccountspayable
Bankoverdraft
Somedebtandliquidityratiosalterdramatically.
Currentratioandquickratiofall
Businessmighthavealiquiddeficiti.e.anexcessofcurrentliabilitiesovercurrentassets.
Proportionoftotalassetsfinancedbyequitycapitalfallsandtheproportionfinancedbycredit
rise.
Sales/workingcapitalratioisincreasingovertime,workingcapitalshouldincreaseinlinewith
sales.
SolutionstoOvertrading
Newcapitalcouldbeinjectedfromshareholders
Thegrowthcanbefinancedthroughlongtermloans.
Bettercontrolcouldbeappliedtomanagementofinventoriesandaccountsreceivable.
Thecompanycouldpostponeambitiousplansforincreasedsalesandfixedassetinvestment.

OverCapitalization
Ifthereareexcessiveinventories,accountsreceivableandcashandveryfewaccountspayable,there
willbeanoverinvestmentbycompanyincurrentassetsandthecompanywillbeinthisrespectover
capitalized.

77
TheInventoryManagement

InventoryManagement

Reducestockstothelowest Ensurethatsufficientstockis
possiblelevelhencereducethe availabletoavoidstockouts
workingcapital

MaterialCost

Purchasingcost Costofpurchasingitemsofstock

Orderingcost Theadministrativeandaccountingcostofplacinganorderanditsdelivery.
Theyareusuallyassumedtobeindependentofsizeoforder

Holdingcost Itincludesitemssuchas:

1. Theopportunitycostofinvestmentinstock
2. Storagecost
3. Materialhandlingcost
4. Insurancecostetc.
Stockoutcost Itincludesitemssuchas:

1. Losscontributionthroughlossofsales
2. Lossofcustomers
3. Costofemergencyorders
4. Thecostofproductionstoppages

Inanefficientorganizationthecostofstockoutisassumedtobezero

InventoryLevels

Reorderlevel Max.UsageXMax.LeadTime

MaximumInventory Reorderlevel+Reorderquantity(Min.usageXMin.Leadtime)
level

78
AverageInventory Bufferstock+ReorderQuantity
levels
2

MinimumInventory Reorderlevel(Avg.UsageXAvg.LeadTime)
Levels

ECONOMICORDERQUANTITY(EOQ)

TheEOQisareorderquantitywherethetotalholdingcostandorderingcostisminimized.AtEOQ
AnnualholdingcostisequalstotheAnnualOrderingCost

Formula:

2C0D
EOQ=
CH

Co=Orderingcostperorder

Ch=Holdingcostperunitperannum

D=AnnualDemand

AnnualHoldingCost:

AnnualOrderingCost:

BULKPURCHASEDISCOUNTS

IfthebulkpurchasediscountsareavailablethenbeforedecidingcheckthatwhethertheEOQquantityis
stillthecheapestoptionornot.

JUSTINTIME(JIT)STOCKMANAGEMENT

Analternateviewofstockmanagementisjustintimeinwhichstockleveliseitherreducedor
eliminated,sincestockisseenaswaste.Organizationorderthematerialwhenitrequiresfor
production.

ILUSTRATION2
Annualdemandis200,000units
Perordercostis20$
Holdingcostis0.2$perunit
Purchasepriceis1$/unit

79
Currentorderquantity=50,000units

Required
a) Whatisthetotalcostiforderquantityremainsat50,000?
b) WhatisthetotalcostofinventoryifcompanyfollowsEOQmodel?
c) Supplierhasoffered1%discountiforderquantityisatleast30,000unitsWhatisthetotal
costifcompanyacceptthesuppliersoffer?

Solution
(a)
Purchasecost=$1200,000=$200,000
Orderingcost=$20200,000/50,000=$80
Holdingcost=$0.250,000/2=$5,000
Totalcost=$205,080

(b)
EOQ=2200,00020/0.2=6325

Purchasecost=$1200,000=$200,000
Orderingcost=$20200,000/6,325=$632
Holdingcost=0.26325/2=$632
Totalcost=$201,264

(c)
Purchasecost=$1200,00099%=$198,000
Orderingcost=$20200,000/30,000=$133
Holdingcost=0.230,000/2=$3,000
Totalcost=$201,133

IMPLICATIONSOFJUSTINTIMESTOCKMANAGEMENT

Therewillbehigherdependenceonthesupplierforbothqualityandreliability.
Theremightbelongtermcontractdevelopedwiththesuppliertodevelopthesystemnecessary
forJITtooperateeffectively
Suppliermustbeideallylocatedclosetoourorganization
Theremustbecloseworkingrelationshipswithsupplierssothatresponsetothe
problems/developmentscanbeimmediate
Betterfactorydesigncanalsoreducetheworkinprocess.
Onlyproduceforcustomerdemandhencenofinishedgoodstock
JITwillreduceoreliminateholdingcost
OperatingJITsuccessfulcanthenopenupfurtherbusinessopportunitiesbyinvestingcapital
somewhereelse.

80
ThePayableManagement
PAYABLES
MANAGEMENT

Delayingpaymenttosuppliersto Delayingtoomuchmaycause
obtainfreesourceoffinance difficultiesforthecompany

Trade payable is a cheap and most important source of shortterm finance as it carries no interest.
Managementoftradepayablesinvolve

Attemptingtoobtainsatisfactorycredittermsfromsuppliers
Attemptingtoextendcreditduringperiodsofcashshortage
Maintaininggoodrelationshipswithregularandimportantsuppliers
However,delayingpaymentstocreditorsbeyondthecreditlimitsmaycausesomeproblemsi.e.

Suppliermayrefusetosupplyinfutureormaynotgrantcreditinfuture
Lossofreputation
Suppliermayincreasepriceinfuture

81
TheReceivableManagement
ReceivableManagement

Collectingreceiptsquicklyto Extendthecreditperiodto
reducethecostoffinancing encourageadditionalsale
debtor.

CostofReceivable

o Administrativecosttorecordandcollectingdebts
o Costofirrecoverabledebts(SalesX%ofbaddebt)
o CostofearlySettlementDiscount=(SalesX%ofdiscountX%ofcustomerstakenthediscount)
o FinanceCost(AverageReceivableX%ofinterestrate)
ILUSTRATION3
ShakyLimitedhassalesof$40mforthepreviousyear,receivablesattheyearendwere$8m.The
costoffinancingdebtorsiscoveredbyanoverdraftattheinterestrateof14%.

Required
a) Calculatethereceivableperiod
b) Calculatethecostoffinancingreceivables

SOLUTION
$
a) Receivableperiod= 48.67days
$
$8mX14%=$1.12m

EarlySettlementDiscount

Discountsforearlysettlementcanbeofferedtocustomers.Theannualeffectiverateofdiscountcanbe
calculatedasfollows

(1+r)n1

Whereriseffectivediscountrateperperiodandcanbecalculatedasr X 100%

TacklingQuestioninExam

82
CurrentPolicy ProposedPolicy
FinanceCostofReceivable FinanceCostofReceivable
EarlySettlementDiscountCost EarlySettlementDiscountCost
Baddebts Baddebts
Administrationcost(includesFactoring Administrationcost(includesFactoring
feeifany) feeifany)
TotalCost TotalCost
Comparethemandchosewiththeleastcost.

ILUSTRATION4
Shakyasabovebutadiscountof2%isofferedforpaymentwithin10days

Required
Shouldthecompanyintroducethediscountgiventhat50%ofthecustomerstakeupthediscount?

Solution
CurrentPolicy ProposedPolicy
Financecost $1.12m
FinanceCost $0.67m
($8mX14%) ($5.64m(W)X14%)
DiscountCost $0.6m
($60mX2%X50%)
$1.12m $1.27m
Shankyshouldnotoffertheearlysettlementdiscount
Workingforrevisedreceivables
. $
Existingreceivables= 50% $4
$
Whotakeearlydiscountreceivables= 50% $. 82
Totalreceivables$4.82m

DebtFactoring

Factoringisanarrangementtohavedebtscollectedbyafactorcompany,whichadvancesaproportion
ofthemoneyitisduetocollect.

Factoringcanbeusedtohelpshorttermliquidityortoreduceadministrativecosts.

AspectsofFactoring

Themainaspectsoffactoringincludethefollowing

Administrationoftheclientsinvoicing,salesaccountinganddebtcollectionservice.

Creditprotectionfortheclientsdebts,wherebythefactortakesovertheriskoflossfrombad
debtsadsoinsurestheclientagainstsuchlosses.Thisisknowsasnonrecourseservice.

Makingpaymentstotheclientinadvanceofcollectingthedebts.Thisisreferredtoasfactor
finance

83
ILUSTRATION5
Shakyagainbutafactorhasofferedadebtcollectionservicewhichshouldshortenthedebtor
collectionperiodonaverageto30days.Itcharges1.6%ofturnoverbutshouldreduceadministration
coststothecompanyby$175,000.
Required
Shouldthecompanyusethefactorfacility?

Solution
CurrentPolicy ProposedPolicy
Financecost $1.12m FinanceCost $0.69m
($8mX14%) ($4.93m(W)X14%)
Administrationcost $0.175m Factorfee $0.96m
($60mX1.6%)
$1.295m $1.65m
Shankyshouldnotusefactorservices.
Workingforrevisedreceivables
$
Existingreceivables= $4.93

ILUSTRATION6
A company makes annual credit sales of $1,500,000. Credit terms are 30 days, but its debt
administrationhasbeenpoorandtheaveragecollectionperiodhasbeen45dayswith0.5%ofsales
resultinginbaddebtswhicharewrittenoff.
Afactorwouldtakeonthetaskofdebtadministrationandcreditchecking,atanannualfeeof2.5%of
credit sales. The company would save $30,000 a year in administration costs. The payment period
wouldbe30days.
Itisassumedthatthefactorwouldadvanceanamountequalto80%oftheinvoiceddebts,andthe
balance30dayslater.Itisalsoassumedthatfactorwillcompletelyavoidthebaddebt.
Thefactorwouldalsoprovideanadvanceof80%ofinvoiceddebtsataninterestrateof14%(3%over
thecurrentbaserate).Thecompanycanobtainanoverdraftfacilitytofinanceitsaccountsreceivable
atarateof2.5%overbaserate.
Required:
Shouldthefactor'sservicesbeaccepted?Assumeaconstantmonthlyturnover.

Solution
CurrentPolicy ProposedPolicy
Financecost FinanceCost(w) $17,137
45/365x$1,500,000x $24,966 Factorfee
13.5%(11%+2.5%) 2.5%x$1,500,000 $37,500
Baddebts $7,500

84
0.5%x$1,500,000
Administrationcost $30,000
$62,466 $54,637
Asfactoringischeperforthecompanysothecompanyshouldfactoritsreceivables.

Financecostinproposedpolicy
Factorsfinance30/365x$1,200,000x14% 13,808
Overdraft30/365x$300,000x13.5% 3,329
17,137

Advantages&DisadvantagesofFactoring
Advantages Disadvantages
1. Businesscanpayitssuppliersontime 1. Factoringislikelytobemorecostlythan
andsobeableto takeadvantageof anefficientlyruninternalcreditcontrol
earlypaymentdiscounts. department.
2. Customers may not like to deal with
2. Optimum inventory level can be
factors.
maintained because management
3. Company loses control to decide to
willhaveenoughcash.
whom to grant credit period and the
3. Growthcanbefinancedthroughsales length of credit period for each
ratherthaninjectingnewcapital customer
4. The cost of running sales ledger 4. Once a company hires a factor, it is
departmentisover. difficulttogobacktoaninternalcredit
controlsystemagain.
5. Business can use the expertise of
debtor management that the factor 5. Factoringmayhaveabadreputationfor
specializes. the company. It may indicate that the
companyhasfinancialissues
6. Management time is saved because
managers dont have to spend their
timeondebtormanagement.
7. Businessgetsitsfinancelinkedtoits
volumeofsales

CreditControlPolicies

Overallpolicy
o Nottooffercredit
o Offercredittospecificcustomersonly
o Totalcreditislimitedtox%ofsale
Proceduresforofferingcredit
o Obtainreferences
BankReferences

85
TradeReferences
PublishedInformation
CreditRatingAgencies
CompaniesOwnSalesRecord
DepartmentofTrade&Industry.
PressComments&Releases
o Reviewaccountinformation
o Customervisits
o Formalagreement
Complieswithlegislation
Probationaryperiod
Settlementterms
CollectionofReceivables
o Collectionoffundsefficiently
Thecustomerisfullyawareoftheterms
Theinvoiceiscorrectlydrawnupandissuedpromptly.
Theyareawareofanypotentialquirksinthecustomerssystem
Queriesareresolvedquickly
Monthlystatementsareissuedpromptly
o Collectionofoverduedebt
Institutingremindersorfinaldemands
Chasingpaymentbytelephone
Makingapersonalapproach
Notifyingdebtcollectionsection
Handlingoverdebtcollectiontospecialistdebtcollectionsection
Institutinglegalactiontorecoverthedebt
Hiringexternaldebtcollectionagencytorecoverdebt.

ManagingForeignAccountReceivable
REDUCINGINVESTMENTINFOREIGNACCOUNTSRECEIVABLE

Acompanycanreduceitsinvestmentinforeignaccountsreceivablebyaskingforfullorpart
paymentinadvanceofsupplyinggoods.Howeverthismayberesistedbyconsumers,
particularlyifcompetitorsdonotaskforpaymentupfront.

Forfaiting

Forfaitinginvolvesthepurchaseofforeignaccountsreceivablefromthesellerbyaforfaiter.

Theforfaitertakesonallofthecreditriskfromthetransaction(withoutrecourse)and
thereforetheforfaiterpurchasesthereceivablesfromtheselleratadiscount.

Thepurchasedreceivablesbecomeaformofdebtinstrument(suchasbillsofexchange)which
canbesoldonthemoneymarket.

Thenonrecoursesideofthetransactionmakesthisanattractivearrangementforbusinesses,
butasaresultthecostofforfaitingisrelativelyhigh.

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LetterofCredit

Thisisafurtherwayofreducingtheinvestmentinforeignaccountsreceivableandcangiveabusinessa
riskfreemethodofsecuringpaymentforgoodsorservices.

Thereareanumberofstepsinarrangingaletterofcredit:

Bothpartiessetthetermsforthesaleofgoodsorservices

Thepurchaser(importer)requeststheirbanktoissuealetterofcreditinfavoroftheseller
(exporter)

Theletterofcreditisissuedtothesellersbank,guaranteeingpaymenttotheselleroncethe
conditionsspecifiedintheletterhavebeencompliedwith

Thegoodsaredispatchedtothecustomerandtheshippingdocumentationissenttothe
purchasersbank

Thebankthenissuesabankersacceptance

Thesellercaneitherholdthebankersacceptanceuntilmaturityorsellitonthemoneymarket
atadiscountedvalue

Ittakessignificantamountoftimeandthereforeareslowtoarrange.

Theuseoflettersofcreditmaybeconsiderednecessaryifthereisahighlevelofnonpayment
risk.

Customerswithapoorornocredithistorymaynotbeabletoobtainaletterofcreditfromtheir
ownbank.Lettersofcreditarecostlytocustomersandalsorestricttheirflexibility:

Collectionunderaletterofcreditdependsontheconditionsintheletterbeingfulfilled.
Collectiononlyoccursifthesellerpresentsexactlythedocumentsstatedintheconditions

CounterTrading

Inacountertradearrangement,goodsorservicesareexchangedforothergoodsorservicesinsteadof
forcash.

Thebenefitsofcountertradingincludethefactthatitfacilitatesconservationofforeigncurrencyand
canhelpabusinessenterforeignmarketsthatitmaynototherwisebeableto.

ExportCreditInsurance

Exportcreditinsuranceprotectsabusinessagainsttheriskofnonpaymentbyaforeign
customer.Exporterscanprotecttheirforeignaccountsreceivableagainstanumberofrisks
whichcouldresultinnonpayment.Exportcreditinsuranceusuallyinsures
insolvencyofthepurchaserorslowpayment,
insuresagainstcertainpoliticalrisks,forexamplewar,riots.
Disadvantagesincludetherelativelyhighcostofpremiumsandthefactthattheinsurancedoes
nottypicallycover100%ofthevalueoftheforeignsales

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ExportFactoring

Anexportfactorprovidesthesamefunctionsinrelationtoforeignaccountsreceivableasafactor
coveringdomesticaccountsreceivableandthereforecanhelpwiththecashflowofabusiness.
However,exportfactoringcanbemorecostlythanexportcreditinsuranceanditmaynotbeavailable
forallcountries,particularlydevelopingcountries.

ManagingCash
TreasuryManagement

Treasurymanagementcanbedefinedas

Corporatehandlingofallfinancialmatters,

Thegenerationofexternalandinternalfundsforbusiness,

Themanagementofcurrenciesandcashflows,

Thecomplexstrategies,

Policiesandproceduresofcorporatefinance

CentralizedTreasuryManagement DecentralizedTreasuryManagement
1. Largevolumeofcashisavailableto 1. Greaterautonomywillbegivento
invest,leadingtobettershortterm subsidiaries
investmentopportunities. 2. Adecentralizedtreasuryfunctionmaybe
2. Borrowingcanbearrangedinbulkat moreresponsivetotheneedsof
lowerinterestrate. individualoperatingunits.
3. Foreignexchangeriskmanagementwill 3. Sourcesoffinancewillbediversified
beimprovedthroughmatchingforeign
currencyincomeearnedbyone
subsidiarywithexpenditureinthesame
currencybyanothersubsidiary.
4. Treasuremanagementwillbeefficient
becauseacentralizedtreasury
departmentcanemployexperts.
5. Liquiditymanagementwillbeimproved
throughcentralizedtreasurydepartment

ObjectiveofholdingCash:

JohnMaynardKeynesidentifiedthreereasonsforholdingcash.

TransactionsMotive:Everybusinessneedscashtomeetitsregularcommitmentsofpayingits
accountspayablelikeemployeewages,taxes,annualdividends

Precautionarymotive:Thereisaneedtomaintainabufferofcashforunforeseen
contingencies.

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SpeculativeMotive:Sometimesbusinessesholdsurpluscashasaspeculativeassetinthehope
thatinterestrateswillriseinfuture

CashBudget

Months 1 2 3

CashInflows

ReceivableCollection X X X

DividendsReceived X X X

Saleofnoncurrentassets X X X

CashOutflow

Tradepayablepayment (X) (X) (X)

Purchaseofnoncurrentassets (X) (X) (X)

Wages (X) (X) (X)

NetCashFlows X X X

OpeningBalance X X X

ClosingBalance X X X

BaumolModel

TheBaumolmodelisbasedontheideathatanoptimumcashbalanceislikedecidinganoptimum
inventorylevel.ItusesthesameEOQformulathatisusedtocalculatetheoptimuminventorylevel

2
Q

Where

Q = Optimumamountofcashtoberaised

S = Amountofcashtobeusedineachtimeperiod

C = Costpersaleofsecurities

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I = Interestcostofholdingcashornearcashequivalents

ILUSTRATION7
FlagCofacesafixedcostof$4,000toobtainnewfunds.Thereisarequirementfor$24,000ofcash
over each period of one year for the foreseeable future. The interest cost of new funds is 12% per
annum;theinterestrateearnedonshorttermsecuritiesis9%perannum.

Required:
HowmuchfinanceshouldFlagraiseatatime?

Solution
Thecostofholdingcashis12%9%=3%
TheoptimumlevelofQ(therecorderquantity)is:

, ,
=$80,000
.

Theoptimumamountofnewfundstoraiseis$80,000.
Thisamountisraisedevery80,00024,000=31/3years

TheMillerOrrModel

Amodelthatconsidersthelevelofcashthatshouldbeheldbyacompanyinanenvironmentof
uncertainty.Thedecisionrulesaresimplifiedtotwocontrollevelsinorderthatthemanagementofthe
cashbalancecanbedelegatedtoajuniormanager.

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Themodelallowsustocalculatethespread.Giventhatwehavethespreadallkeycontrollevelscanbe
calculated.

Minimumlevelgiveninthequestion

Spread=3

Maximumlevel=minimumlevel+spread
Returnpoint=minimumlevel+spread

ILUSTRATION8
Thefollowingdataappliestoacompany.
Theminimumcashbalanceis$8,000.
Thevarianceofdailycashflowsis4,000,000,equivalenttoastandarddeviationof$2,000
per
Thetransactioncostforbuyingorsellingsecuritiesis$50.Theinterestrateis0.025percent
day.

Required:
YouarerequiredtoformulateadecisionruleusingtheMillerOrrmodel

Solution
Thespreadbetweentheupperandthelowercashbalancelimitsiscalculatedasfollows.


Spread=3

3
50 4,000,000
3 4
0.00025


=$25,303,say$25,300

Theupperlimitandreturnpointarenowcalculated.

Upperlimit =Lowerlimit+$25,300=$8,000+$25,300=$33,300
Returnpoint =lowerlimit+1/3xspread=$8,000+1/3x$25,300=$16,433,say16,400

Thedecisionruleisasfollows.Ifthecashbalancereaches$33,300,buy$16,900(=33,30016,400)in
marketablesecurities.Ifthecashbalancefallsto$8,000,sell$8,400ofmarketablesecuritiesforcash.

ShortTermInvestments

Depositedwithabankorsimilarfinancialinstitution
Investedinshorttermdebtinstruments,suchasTreasurybillsorCDs

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Investedinlongertermdebtinstrumentssuchasgovernmentbonds,whichcanbesoldwhen
thecompanyeventuallyneedsthecash
Investedinsharesoflistedcompanies,whichcanbesoldonthestockmarketwhenthe
companyeventuallyneedsthecash

ShortTermFinance

ShorttermBankLoan
Overdraft
Payables
Factoringandinvoicediscounting

WorkingCapitalinvestmentPolicy
Acompanycanadoptaworkingcapitalstrategyformanagingitsworkingcapitaldependingonthe
importantrisksassociatedwithworkingcapitals.Itcanchoosefromthreedifferentworkingcapital
strategies.Thesestrategiesareasfollows:

ConservativeApproach

AggressiveApproach

ModerateApproach

ConservativeApproach

Aconservativeworkingcapitalmanagementpolicyaimstoreducetheriskofsystembreakdownby
holdinghighlevelsofworkingcapital

Customersareallowedgenerouspaymentstermstostimulatedemand,

Finishedgoodsinventoriesarehightoensureavailabilityforcustomers,

Rawmaterialandworkinprogressarehigh

Suppliersarepaidpromptlytoensuretheirgoodwill

AggressiveApproach

Anaggressiveworkingcapitalmanagementpolicyaimstoreducefinancingcostandincrease
profitability:

bycuttinginventoriestokeptitatminimumlevel.

speedingupcollections:Customersareallowedalimitedpaymentperiodanddiscountsare
givenforpromptpayment

delayingpaymentstosupplier.

ModerateApproach

Amoderateworkingcapitalmanagementpolicyisamiddlewaybetweentheaggressiveand
conservativeapproaches.

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WorkingCapitalFinancingPolicy
Assetscanbedividedintothreetypesinordertounderstanddifferentworkingcapitalmanagement
strategies

Noncurrentassets:Thesearelongtermassetsfromwhichanorganizationexpectstoderive
benefitoveranumberofperiods.Forexample,plantandmachinery.Thecompanyshoulduse
longtermSourceofFinance

Permanentcurrentassets:Thisistheamountrequiredtomeetminimumlongtermneedsand
sustainnormaltradingactivity.Forexample,inventoryandaveragereceivables.Ideally,
companyshoulduselongtermsourceoffinanceforthis.However,anaggressiveapproached
managementmightusepartofitbyshorttermsourceoffinance.

Fluctuatingcurrentassets:Thesearecurrentassetswhichvaryaccordingtonormalbusiness
activity.Exampleincludefluctuateinworkingcapitalduetoseasonalvariations.Thecompany
shoulduseshorttermsourceoffinance.However,aconservativemanagementmightusepart
oflongtermsourceoffinanceaswell.

Attempt QuestionNo.
Dec11 Q2
Jun12 Q2
Dec12 Q2
Jun13 Q3a,b
WorkingCapital
Dec13 Q3
Management
Jun14 Q2
Dec14 Q1
Jun15 Q3
Dec15 Q3
Jun16 Q1

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