What is behavioral finance?

Behavioral finance attempts to explain how decision makers take financial decisions in
real life, and why their decisions might not appear to be rational every time and, therefore,
have unpredictable consequences. This is in contrast to many traditional theories which
assume investors make rational decisions.

Important terms to understand

One aspect to understand is the market paradox. This occurs because in order for markets
to be efficient, investors have to believe that they are inefficient. This is because if investors
believe markets are efficient, there would be no point in actively trading shares –which
would mean that markets would not react efficiently to new information.

Herding refers to when investors buy or sell shares in a company or sector because many
other investors have already done so. Explanations for investors following a herd instinct
include social conformity, the desire not to act differently from others. Following a herd
instinct may also be due to individual investors lacking the confidence to make their own
judgements, believing that a large group of other investors cannot be wrong.

If many investors follow a herd instinct to buy shares in a certain sector. This can result in
significant price rises for shares in that sector and lead to a stock market bubble.

There is also evidence to suggest that stock market ‘professionals’ often do not base their
decisions on rational analysis. Studies have shown that there are traders in stock markets
who do not base their decisions on fundamental analysis of company performance and
prospects. They are known as noise traders. Characteristics associated with noise traders
include making poorly timed decisions and following trends.

Some investors may have loss aversion, avoiding investments that have the risk of making
losses, even though expected value analysis suggests that, in the long-term, they will
make significant capital gains. Investors with loss aversion may also prefer to invest in
companies that look likely to make stable, but low, profits, rather than companies that may
make higher profits in some years but possibly losses in others.

There may be a momentum effect in stock markets. A period of rising share prices may
result in a general feeling of optimism that prices will continue to rise and an increased
willingness to invest in companies that show prospects for growth. If a momentum effect
exists, then it is likely to lengthen periods of stock market boom or bust.
Conclusion

Behavioural finance shows that individuals may not necessarily make decisions on the
basis of a rational analysis of all the information. This can lead to movements away from a
fair price for an individual company’s shares, and the market as a whole to a period where
share prices are collectively very high or low.

An in-depth understanding of all the different behavioural biases and potential impacts of
behavioural finance is not required at this level, but the terms and concepts covered in this
article may appear in an FM exam question.

Written by a member of the Financial Management examining team

 Importance of working capital management

Working capital represents the net current assets available for day-to-day operating
activities. It is defined as current assets less current liabilities and, in exam questions, the
components are usually inventory and trade receivables, trade payables and bank
overdraft.

Many businesses that appear profitable are forced to cease trading due to an inability to
meet short-term obligations when they fall due. Successful management of working
capital is essential to remaining in business.

Working capital management requires great care due to potential interactions between its
components. For example, extending the credit period offered to customers can lead to
additional sales. However, the company’s cash position will fall due to the longer wait for
customers to pay, potentially leading to the need for a bank overdraft. Interest on the
overdraft may even exceed the profit arising from the additional sales, particularly if there
is also an increase in the incidence of bad debts.

Working capital management is central to the effective management of a business

because:

 current assets comprise the majority of the total assets of some companies

 shareholder wealth is more closely related to cash generation than accounting profits

 failure to control working capital, and hence to manage liquidity, is a major cause of corporate
collapse.

Objectives of working capital management

One of the two key objectives of working capital management is to ensure liquidity. A
business with insufficient working capital will be unable to meet obligations as they fall
due, leading to late payments to employees, suppliers and other providers of credit. Late
payments can result in lost employee loyalty, lost supplier discounts and a damaged credit
rating. Non-payment (default) can lead to the compulsory liquidation of assets to repay
creditors.

The other key objective is profitability. Funds tied up in working capital tend to earn little, or
no, return. Hence, a company with a high level of working capital may fail to achieve the
return on capital employed (Operating profit ÷ (Total equity and long-term liabilities))
expected by its investors.
 Therefore, when determining the appropriate level of working capital there is a trade-off
between liquidity and profitability:

The trade-off is perhaps most obvious with regards to the holding of cash. Although cash
obviously provides liquidity it generates little return, even if held in the form of cash
equivalents such as treasury bills. This is particularly true in an era of low interest rates
(for example, in November 2016 the annualised yield on three-month US dollar treasury
bills was approximately 0.4%).

Although an optimal level of working capital may exist it may not be achievable due to
factors beyond management’s control, such as an unreliable supply chain influencing
inventory levels. However, businesses must at least avoid the extremes:

 Overtrading – insufficient working capital to support the level of business activities. This can also
be described as under-capitalisation and is characterised by a high and rising proportion of short-
term finance to long-term finance
 Over-capitalisation – an excessive level of working capital, leading to inefficiency.

Liquidity ratios

If the current ratio falls below 1 this may indicate problems in meeting obligations as they
fall due. Even if the current ratio is above 1 this does not guarantee liquidity, particularly if
inventory is slow moving. On the other hand a very high current ratio is not to be
encouraged as it may indicate inefficient use of resources (for example, excessive cash
balances).
 The level of a firm’s current ratio is heavily influenced by the nature if its business for
example:

 Traditional manufacturing industries require significant working capital investment in inventory

(comprising raw materials, work in progress and finished goods) and trade receivables (as their
business customers expect to be offered generous credit terms). Therefore, companies operating
in such industries may reasonably be expected to have current ratios of 2 or more.

 Modern manufacturing companies may use just-in-time management techniques to reduce the
level of buffer inventory and hence reduce their current ratios to some extent.

 In some industries, a current ratio of less than 1 might be considered acceptable. This is especially
true of the retail sector which is often dominated by ‘giants’ such as Wal-Mart (in the US) and Tesco
(in the UK). Such retailers are able to negotiate long credit periods with suppliers while offering
little credit to customers leading to higher trade payables as compared with trade receivables.
These retailers are also able to keep their inventory levels to a minimum through efficient supply
chain management.

The quick ratio is particularly relevant where inventory is slow moving.

Efficiency ratios

This shows how quickly inventory is sold; higher turnover reflects faster-moving
inventory.

However, working capital ratios are often easier to interpret if they are expressed in ‘days’
as opposed to ‘turnover’:

Note that exam questions may tell you to assume there are 360 days in the year.
Furthermore, many exam questions only provide information about inventory as at the
year-end, in which case this must be used as a proxy for the average inventory level.

Inventory days estimates the time taken for inventory to be sold. Everything else being
equal a business would prefer lower inventory days.

In exam questions you may have to assume that:

 (i) year-end receivables are representative of the average figure; and
(ii) all sales are made on credit.

Receivables days estimates the time taken for customers to pay. Everything else being
equal a business would prefer lower receivables days.

In exam questions you may have to assume that:

 Year-end payables are representative of the average figure

 Cost of sales approximates annual credit purchases

 All purchases are made on credit.

Payables days estimates the time taken to pay suppliers. A business would prefer to
increase its payables days, unless this proves expensive in terms of lost settlement
discounts or leads to other problems such as a damaged reputation – a ‘good corporate
citizen’ is expected to pay promptly.

In this ratio working capital is defined as the level of investment in inventory and
receivables less payables. In exam questions you may have to assume that year-end
working capital is representative of the average figure over the year.

The sales to working capital ratio indicates how efficiently working capital is being used to
generate sales. Everything else being equal the business would prefer this ratio to rise.

Cash operating cycle

The cash operating cycle (also known as the working capital cycle or the cash conversion
cycle) is the number of days between paying suppliers and receiving cash from sales.

Cash operating cycle = Inventory days + Receivables days – Payables days.

In the manufacturing sector inventory days has three components:

(i) raw materials days

(ii) work-in-progress days (the length of the production process), and
(iii) finished goods days.
 However, exam questions tend to be based in the retail sector where no such sub-analysis
is required.

The longer the operating cycle the greater the level of resources ‘tied up’ in working capital.
Although it is desirable to have as short a cycle as possible, there may be external factors
which restrict management’s ability to achieve this:

 Nature of the business – a supermarket chain may have low inventory days (fresh food), low
receivables days (perhaps just one to two days to receive settlement from credit card companies)
and significant payables days (taking credit from farmers). In this case the operating cycle could
be negative (ie cash is received from sales before suppliers are paid). On the other hand a
construction company may have a very long operating cycle due to the high levels of work-in-
progress.

 Industry norms – if key competitors offer long periods of credit to their customers it may be difficult
to reduce receivables days without losing business.

 Power of suppliers – an attempt to delay payments could lead to the supplier demanding ‘cash on
delivery’ in future (ie causing payables days to actually fall to zero rather than rising).

Interpretation of ratios

For a meaningful evaluation to be made of a firm’s working capital management it is

necessary to identify:

 Trends – the change in a ratio over time. If an exam question provides two, or more, years of
financial statements then appropriate ratios should be calculated for each year.

 External benchmarks – industry average (sector) ratios are commonly published by business
schools or consultancies. If an exam question provides industry average data then you are
expected to use this to benchmark the performance of the firm in the scenario. However do not
assume that the only relevant ratios are those for which industry average data is available.

The following table is provided for reference purposes:

EXAMPLE:

Topple Co has the following forecast figures for its first year of trading:

Sales $3,600,000

Purchases expense $3,000,000

Average receivables $306,000

Average inventory $495,000

Average payables $230,000

Average overdraft $500,000

Gross profit margin 25%

Industry average data:

Inventory days 53

Receivables days 23
Payables days 47

Current ratio 1.43

Assume there are 365 days in the year.

REQUIRED:
Calculate and comment on Topple Co’s cash operating cycle, current ratio, quick ratio and
sales to working capital ratio.

The length of the cash operating cycle indicates that there will be 70 days between Topple
Co receiving cash from sales and paying cash to suppliers. This is significantly longer than
the industry average of 29 days (53 + 23 – 47) and likely to lead to liquidity problems, as
evidenced by the size of the overdraft.

Topple Co expects to take approximately the same credit period from its suppliers as is
taken by its own customers, whereas the industry norm is to take a significantly longer
credit period from suppliers (47 days) than is taken by customers (23 days). Therefore,
slow inventory turnover is the main cause of Topple Co’s long working capital cycle. This
may be inevitable in the first year of trading but is it important that systems are
implemented to ensure efficient inventory management. The extent of future reductions in
inventory days may be limited by the nature of the business as the industry average is 53
days.
It is perhaps unsurprising that Topple Co’s receivables days is also above the industry
average as the firm may have been forced to offer generous terms of trade in order to
attract customers away from its more established competitors, In addition Topple Co may
still be in the process of establishing and implementing credit control procedures.

On the other hand Topple Co is paying its own suppliers much more quickly than the
industry norm. Although this puts pressure on liquidity, Topple Co may be taking advantage
of settlement discounts offered by suppliers or, as a new firm without an established
trading history, it may simply not be offered extended credit periods by suppliers.

The above comparisons to sector data must be treated with caution as working capital
management may be poor across the sector, leading to benchmarks which Topple Co
should not endeavor to replicate. As a long-term target Topple Co should benchmark its
performance against the leader in the sector.

The current ratio indicates that, over the year, there will be $1.10 of current assets per $1 of
current liabilities, which does not compare favorably with the industry average of 1.43 and
may not be sufficient as Topple Co’s inventory appears to be slow moving. More relevant,
therefore, is the quick ratio which indicates only $0.42 of liquid assets per $1 of current
liabilities, although no industry average data is available to benchmark this figure.

The overdraft would need to be continuously monitored to ensure it remains within any
agreed limit, and contingency plans put into place for refinancing. However, if Topple Co is
started up with an appropriate level of long-term finance then an overdraft may be avoided
entirely.

Each $1 invested in working capital is expected to generate $6.30 of revenue. Although this
may not appear to be a particularly efficient use of resources, the first year’s trading may
not be representative. Once Topple Co becomes more established it should benchmark its
sales to working capital ratio against sector data if available.

Conclusion

This article has covered the foundations of working capital management, focusing on the
analysis of current assets and current liabilities. The Financial Management syllabus also
demands detailed knowledge of specific models and techniques for each component of
working capital – cash, inventory, receivables and payables – and a well-prepared
candidate must also be competent in using these.
 Key areas of accounts receivable management

There are three key areas of accounts receivable management.

 Before a company grants credit to a customer it should ensure, as far as possible, that the
customer is worthy of that credit and that bad debts will not result. Checks should continue
to be carried out on existing customers as a company would like to have early warning of
any problems which may be developing. This is especially true for key customers of the
company.
 Once the decision has been taken to grant credit, then suitable credit terms must be set and
the receivables that arise must be monitored efficiently if the costs of giving credit are to
be kept under control.
 A key area of the management of accounts receivable is the final collection of cash from
customers. Any company must have a rigorous system to ensure that all customers pay in
a timely fashion as, without this, the level of receivables and the cost of financing these
receivables will inevitably rise, as will the risk and cost of bad debts.

These key areas will now be explored in more detail.

Assessing creditworthiness

The methods a company could use to assess the creditworthiness of a customer or a

potential customer include:

 a bank reference – while a bank reference can be fairly easily obtained, it must be
remembered that the other company is the bank’s customer and so a bank reference will
stick to the facts. It is most unlikely to raise any fears the bank may have about the company
 a trade reference – this is obtained from another company who has dealings with your
potential customer/customer. Due to the litigious nature of society these days, it may not
be so easy to obtain a written reference. However, you may be able to call contacts you
have in the trade and obtain an informal oral reference
 credit rating/reference agency – these agencies’ professional business is to sell
information about companies and individuals. Hence, they will be keen to give you the best
possible information, so you are more likely to return and use their services again
 financial statements – financial statements of a company are publicly available
information and can be quickly and easily obtained. While an analysis of the financial
statements may indicate whether or not a company should be granted credit, it must be
remembered that the financial statements available could be out of date and may have
 suffered from manipulation. For larger companies, an analysis of their accounting
information can generally be found through various sources on the internet
 information from the financial media – information in the national and local press, and in
suitable trade journals and on the internet, may give an indication of the current situation
of a company. For example, if it has been reported that a large contract has been lost or that
one or more directors has left recently, then this may indicate that the company has
problems
 visit – visiting a potential new customer to discuss their exact needs is likely to impress the
customer with regard to your desire to provide a good service. At the same time, it gives
you the opportunity to get a feel for whether or not the business is one which you are happy
to give credit to. While it is not a very scientific approach, it can often work quite well, as
anyone who runs their own successful business is likely to know what a good business
looks, feels and smells like!

Setting credit terms and monitoring accounts receivable

As soon as a customer is given credit, the credit terms of the company should be explained
to them. For instance, the normal credit period granted and any discount for prompt
payment, or interest charged on late payment, should be explicitly detailed to the
customer. Very often, the credit terms a company adopts are the terms that are most
common in its trade.

To use something different can cause problems as customers will be expecting, and are
likely to take, what is normal in the trade. Having said that, variations within a trade do
occur and, indeed, a company may well offer different terms to different customers,
depending on the credit rating of each customer and their relationship with each customer.

Initially, a suitable credit limit should be set for each customer. This credit limit should only
be allowed to grow slowly as your faith in the customer grows and all attempted breaches
of the credit limit should be brought to the attention of the credit controller or other
responsible person. It should be remembered that a common trick of an unethical
company is to find a new supplier, make a small order and pay for it promptly. A large order
is then made and, having taken delivery of this order, the customer delays payment for a
significant time.

The accounts receivable should be continuously monitored. In order to do this a number of

reports are useful:

 Accounts receivable aged analysis – this shows the amounts outstanding from each
customer and for how long they have been outstanding. This will indicate any breaches of
the credit terms.
 A credit utilisation report – this shows the proportion of each customers credit limit that is
currently being utilised. Therefore, it will indicate where credit limits may need to be
reviewed upwards or downwards and whether any credit limit breaches have occurred.

Taken together, these reports show how exposed a company is to its accounts receivable.
In larger organizations, customers may be classified by trade and country as it is then
possible to evaluate exposure by both country and trade. Larger businesses may also
create their own in-house credit ratings for their customers.

Whether or not the basic credit terms offered by the company are suitable should be
regularly reviewed. There is no point offering unnecessarily long periods of credit –
however, equally, a company may find that extending its credit terms leads to an increase
in sales. Any alteration in credit terms could be evaluated using the techniques
demonstrated in the aforementioned ‘Receivables collection’ technical article.

Collecting cash

It may seem very obvious, but if cash is to be collected, then the customer must be invoiced.
It is essential that the invoice is sent out quickly and accurately. The receipt of your invoice
is the first indication a company gets of the efficiency of your debt collection system. If the
invoice takes a long time to arrive and is not accurate, then your accounts receivable
department will be viewed as inefficient and customers may seek to exploit this perceived
weakness and delay payment.

Furthermore, if an invoice is inaccurate some customers will take this as an opportunity to

claim that there is a dispute on the account and, therefore, stop payment of all invoices until
the dispute is resolved.

Having sent out the invoice quickly and accurately, the methods a company could use to
ensure customers pay in a timely fashion include:

 monthly statements – these can be produced quickly and easily by any computerised sales
ledger system and sent to customers. Exactly how much impact they have is however
debatable
 chasing letters – these should be directed to a specific person preferably at a reasonably
senior level. However, preparing and sending these letters has a cost and, like the monthly
statements, their impact is often limited
 chasing phone calls – these can often have a great impact as all businesses have to answer
the telephone and, hence, they have a nuisance value which can generate results. A credit
 controller who regularly contacts a suitably senior person at their customers with
overdue amounts and politely, but firmly, demands payment can often achieve good
results
 personal approach – a personal approach from a senior person in the company to a senior
person at the customer can often yield results. This is quite common in trades where the
personal relationship with clients is important. For instance, this often occurs in
professional accountancy and legal firms
 stopping supplies – this is a cash collection tool that must be used with care. If the product
being sold is built specifically to the customers design, and you are the only supplier who
currently makes the product, then it is a powerful tool as, in the short term, you are the only
supplier and, hence, payment is likely to be forthcoming. However, in the longer term it is
always possible for the customer to train up an alternative supplier to make the product. If
the product is a generic product that could be purchased from many suppliers, then quite
obviously this is a weak tool that is simply likely to lead to the loss of the customer
 legal action – this is costly and is likely to lead to the customer being lost
 external debt collection agency – as with legal action this is costly and is likely to lead to
the loss of the customer.

Many larger businesses have their own in-house debt collection departments that can be
used before external debt collection agencies are used or legal action is taken. There have
been instances where companies recently suffered reputational damage. They had
branded their in-house debt collection departments in such a way that the customer
believed that it had been referred to an external debt collection agency and, hence, was
scared into making payment.

Methods of speeding up cash collection from accounts receivable

Two key methods of speeding up cash collection from accounts receivable are using
factoring and using early settlement discounts. Students should be conversant with these
methods and their advantages and disadvantages.

Furthermore, a common exam question requires students to evaluate, in ‘$’ terms, the net
benefit or cost of a proposed new debt collection policy. All of these areas are covered in
the aforementioned ‘Receivables collection’ technical article.

Additionally, a question (potentially a multiple-choice question) could require the

calculation of the percentage cost of offering an early settlement discount. This is best
explained through an example.
Example
A company offers its customers 30 days credit but, at present, customers are taking an
average of 41 days credit. In order to speed up cash collection, the company is considering
introducing a 1% discount for payment within 10 days. The company finances its working
capital requirement using an overdraft at an annual cost of 9%.

Required – Calculate the annual cost of offering the discount and evaluate whether or not
the discount should be offered.

Solution
Let us assume a customer has purchased goods and has been invoiced $100. If the
customer takes the discount, then the company will receive $99 in 10 days rather than $100
in 41 days. This is like the company borrowing $99 from the customer for 31 days (41 – 10)
and paying $1 interest. Therefore, the 31-day interest rate is 1/99 x 100%. This needs to be
compounded up to an annual rate in the following way:

(1 + 1/99)(365/31) – 1 = 0.126

Therefore, the annual cost of offering the discount can be said to be 12.6%.

If the discount is not offered, the company will be borrowing more on its overdraft while it
waits for the customer to pay.

As the cost of borrowing on the overdraft is only 9%, the discount proposed is more costly
and should not be offered.

Please note how the 30 days credit offered is not relevant in the calculations. Such
additional information, which is not required, can be given in questions, especially
multiple-choice questions where it is called a distractor. The use of distractors is a good
way of testing who is really certain and confident in their knowledge.

The calculations above have been carried out from the point of view of the supplier. A
question could also look at the same issue from the point of view of the customer and ask
for a calculation of the customer’s cost of refusing the discount.

Students should note that:

The customer’s cost of refusing the discount = the supplier’s cost of offering the discount
Hence, in the above example, if a customer were to refuse the discount, the cost to it would
also be 12.6%. If the customer is to accept the discount, then this will often require it to
borrow extra funds in the form of an overdraft in order to make the early payment. We can
assume that the customer’s overdraft rate is the same as the supplier’s rate of 9%. This is a
reasonable assumption, as if both companies are operating in the same economy their
overdraft rates are likely to be similar.

Therefore, the customer has a choice of refusing the discount at a cost of 12.6% or accepting
the discount at a cost of 9%. Hence, the discount is attractive and should be accepted.

The above calculations have demonstrated a key problem with settlement discounts. As in
this example, if the discount is attractive to the customer it may well be too costly to the
supplier. It is also the case that a discount which is attractive to a supplier may well be too
costly for the customer.

The formula to remember for calculating the cost of offering or refusing a discount is:

(1 + D/(100 – D))(365/t) – 1 x 100%

Where: D = the discount (2% = 2 etc.)

t = the period by which the payment is advanced if the discount is taken

Invoice discounting

Invoice discounting is another method a company can use to speed up the receipt of cash
from its receivables. If a company is short of cash, it can approach an invoice discounter
who will lend cash against the security of one or a few invoices that customers have still to
pay.

For instance, the invoice discounter may advance 75% of the outstanding amounts. In some
invoice discounting deals, the invoices/debts are legally sold to the invoice discounter and
in others they are not. When the customer finally pays, the invoice discounter recovers the
amount lent and also receives interest and charges.

Confidential invoice discounting is where the customer is not aware of the discounting
arrangement and, as long as they pay their debt, they will never become aware of it.

Therefore, invoice discounting is similar to factoring in the way that the finance is provided
and, indeed, many factoring companies will also provide invoice discounting services.
However, with invoice discounting the company continues to run its own sales ledger.
Additionally, while factoring is an ongoing arrangement, invoice discounting consists of
one-off deals to cover temporary cash shortages.

Invoice discounting can be of particular use to SMEs who are starting to win contracts with
large customers. While winning a contract with a large customer can be good news for a
company, it can lead to cash flow problems. This is because the contract with the large
customer is likely to involve sums that are very significant to the SME, and while large
customers are generally reliable payers, they often only pay after a significant delay.

Conclusion

In combination with the other two articles highlighted, this article provides students with
the core knowledge required in this frequently-examined syllabus area, which forms part
of one of the core Financial Management topics. At all times it should be remembered that
the costs involved in managing accounts receivable must be kept below the benefit
received from granting credit to customers.

William Parrott is a freelance FM tutor and senior FM tutor at MAT Uganda

Section G of the Financial Management Study Guide specifies the following relating to the
management of interest rate risk:

(a) Discuss and apply traditional and basic methods of interest rate risk management,
including:

(i) matching and smoothing

(ii) asset and liability management

(iii) forward rate agreements

(b) Identify the main types of interest rate derivatives used to hedge interest rate risk and
explain how they are used in hedging.

(No numerical questions will be set on this topic)

The cause of interest rate risk

Risk arises for businesses when they do not know what is going to happen in the future, so
obviously there is risk attached to many business decisions and activities. Interest rate
risk arises when businesses do not know:

(i) how much interest they might have to pay on borrowings, either already made or
planned, or

(ii) how much interest they might earn on deposits, either already made or planned.

If the business does not know its future interest payments or earnings, then it cannot
complete a cash flow forecast accurately. It will have less confidence in its project
appraisal decisions because changes in interest rates may alter the weighted average cost
of capital and the outcome of net present value calculations.

There is, of course, always a risk that if a business had committed itself to variable rate
borrowings when interest rates were low, a rise in interest rates might not be sustainable
by the business and then liquidation becomes a possibility.

Note carefully that the primary aim of interest rate risk management (and indeed foreign
currency risk management) is not to guarantee a business the best possible outcome,
such as the lowest interest rate it would ever have to pay. The primary aim is to limit the
uncertainty for the business so that it can plan with greater confidence.

Traditional and basic approaches

Matching and smoothing

When taking out a loan or depositing money, businesses will often have a choice of variable
or fixed rates of interest. Variable rates are sometimes known as floating rates and they
are usually set with reference to a benchmark such as LIBOR, the London Interbank
Offered Rate. For example, variable rate might be set at LIBOR +3%.

If fixed rates are available, then there is no risk from interest rate increases: a $2m loan at
a fixed interest rate of 5% per year will cost $100,000 per year. Although a fixed interest loan
would protect a business from interest rates increases, it will not allow the business to
benefit from interest rates decreases and a business could find itself locked into high
interest costs when interest rates are falling and thereby losing competitive advantage.
Similarly, if a fixed rate deposit were made a business could be locked into disappointing
returns.

Smoothing

In this simple approach to interest rate risk management the loans or deposits are simply
divided so that some are fixed rate and some are variable rate. Looking at borrowings, if
interest rates rise, only the variable rate loans will cost more and this will have less impact
than if all borrowings had been at variable rate. Deposits can be similarly smoothed.

There is no particular science about this. The business would look at what it could afford,
its assessment of interest rate movements and divide its loans or deposits as it thought
best.

Matching

This approach requires a business to have both assets and liabilities with the same kind of
interest rate. The closer the two amounts the better.

For example, let’s say that the deposit rate of interest is LIBOR + 1% and the borrowing rate
is LIBOR + 4%, and that $500,000 is deposited and $520,000 borrowed. Assume that LIBOR
is currently 3%.

Currently:

Annual interest paid = $520,000 x (3 + 4)/100 = $36,400

Annual interest received = $500,000 x (3 + 1)/100 = $20,000

Net cost = $16,400

Now assume that LIBOR rises by 2% to 5%.

New interest amounts:

Annual interest paid = $520,000 x (5 + 4)/100 = $46,800

Annual interest received = $500,000 x (5 + 1)/100 = $30,000

Net cost = $16,800

The increase in interest paid has been almost exactly offset by the increase in interest
received. The extra $400 relates to the mismatch of the borrowing and deposit of $20,000
x increase in LIBOR of 2% = $20,000 x 2/100 = $400.

Asset and liability management

This relates to the periods or durations for which loans (liabilities) and deposits (assets)
last. The issues raised are not confined to variable rate arrangements because a company
can face difficulties where amounts subject to fixed interest rates or earnings mature at
different times.

Say, for example, that a company borrows using a ten-year mortgage on a new property at
a fixed rate of 6% per year. The property is then let for five years at a rent that yields 8% per
year. All is well for five years but then a new lease has to be arranged. If rental yields have
fallen to 5% per year, the company will start to lose money.

It would have been wiser to match the loan period to the lease period so that the company
could benefit from lower interest rates – if they occur.

Forward rate agreements (FRA)

These arrangements effectively allow a business to borrow or deposit funds as though it

had agreed a rate which will apply for a period of time. The period could, for example start
in three months’ time and last for nine months after that. Such an FRA would be termed a 3
– 12 agreement because is starts in three months and ends after 12 months. Note that both
parts of the timing definition start from the current time.

The loans or deposits can be with one financial institution and the FRA can be with an
entirely different one, but the net outcome should provide the business with a target, fixed
rate of interest. This is achieved by compensating amounts either being paid to or received
from the supplier of the FRA, depending on how interest rates have moved.

Example:

Nero Co’s cash flow forecast shows that it will have to borrow $2m from Goodfellow’s Bank
in four months’ time for a period of three months. The company fears that by the time the
loan is taken out, interest rates will have risen. The current interest rate is 5% and this is
offered by Helpy Bank on the required FRA.
Required

(i) What kind of FRA is needed?

(ii) What are the cash flows if the interest rate has risen to 6.5% when the loan is taken out?

(iii) What are the cash flows if the interest rate has fallen to 4% when the loan is taken out?

(i) The FRA needed would be a 4 – 7 FRA at 5%

(ii) If the interest rate has risen to 6.5%:

Interest on loan paid by Nero Co to Goodfellow’s bank =

$2m x 6.5/100 x 3/12 = (32,500)

Paid to Nero Co under FRA by Helpy Bank =

$2m x (6.5 – 5)/100 x 3/12 = 7,500

Net cost of the loan to Nero Co (25,000)

(iii) If the interest rate has fallen to 4%:

 $

Interest on loan paid by Nero Co to Goodfellow’s bank =

$2m x 4/100 x 3/12 = (20,000)

Paid by Nero Co under FRA to Helpy Bank=

$2m x (4 – 5)/100 x 3/12 = 5,000

Net cost of the loan to Nero Co (25,000)

Note:
(a) In both cases the effective rate of interest to Nero Co on the loan is 5%, the FRA-agreed
rate: $2m x 5/100 x 3/12 = $25,000.
(b) In part (iii) when interest rates have fallen, Nero Co would no doubt wish that it had not
entered the FRA so that it would not have to pay Helpy Bank $5,000. However, the purpose
of the FRA is to provide certainty, not to guarantee the lowest possible cost of borrowing to
Nero Co and so $5,000 will have to be paid to Helpy Bank.

Interest rate derivatives

The interest rate derivatives that will be discussed are:

(i) Interest rate futures

(ii) Interest rate options
(iii) Interest rate caps, floors and collars
(iv) Interest rate swaps
 Interest rate futures

Futures contracts are of fixed sizes and for given durations. They give their owners the
right to earn interest at a given rate, or the obligation to pay interest at a given rate.

Selling a future creates the obligation to borrow money and the obligation to pay interest

Buying a future creates the obligation to deposit money and the right to receive interest.

Interest rate futures can be bought and sold on exchanges such as Intercontinental
Exchange (ICE) Futures Europe.

The price of futures contracts depends on the prevailing rate of interest and it is crucial to
understand that as interest rates rise, the market price of futures contracts falls.

Think about that and it will make sense: say that a particular futures contract allows
borrowers and lenders to pay or receive interest at 5%, which is the current market rate of
interest available. Now imagine that the market rate of interest rises to 6%. The 5% futures
contract has become less attractive to buy because depositors can earn 6% at the market
rate but only 5% under the futures contract. The price of the futures contract must fall.

Similarly, borrowers will now have to pay 6% but if they sell the future contract they have
to pay at only 5%, so the market will have many sellers and this reduces the selling price
until a buyer-seller equilibrium price is reached.

 A rise in interest rates reduces futures prices.

 A fall in interest rates increases futures prices.

In practice, futures price movements do not move perfectly with interest rates so there are
some imperfections in the mechanism. This is known as basis risk.

The approach used with futures to hedge interest rates depends on two parallel
transactions:

 Borrow/deposit at the market rates

 Buy and sell futures in such a way that any gain that the profit or loss on the futures deals
compensates for the loss or gain on the interest payments.
 Borrowing or depositing can therefore be protected as follows:

Depositing and earning interest

The depositor fears that interest rates will fall as this will reduce income.

If interest rates fall, futures prices will rise, so buy futures contracts now (at the relatively
low price) and sell later (at the higher price). The gain on futures can be used to offset the
lower interest earned.

Of course, if interest rates rise the deposit will earn more, but a loss will be made on the
futures contracts (bought at a relatively high price then sold at a lower price).

As with FRAs, the objective is not to produce the best possible outcome, but to produce an
outcome where the interest earned plus the profit or loss on the futures deals is stable.

Borrowing and paying interest

The borrower fears that interest rates will rise as this will increase expense.

If interest rates rise, futures prices will fall, so sell futures contracts now (at the relatively
high price) and buy later (at the lower price). The gain on futures can be used to offset the
lower interest earned.

Students are often puzzled by how you can sell something before you have bought it.
Simply remember that you don’t have to deliver the contract when you sell it: it is a contract
to be fulfilled in the future and it can be completed by buying in the future.

Of course, if interest rates fall the loan will cost less, but a loss will be made on the futures
contracts (sold at a relatively low price then bought at a higher price).

Once again, the aim is stability of the combined cash flows.

Summary

The summary rule for interest rate futures is:

 Depositing: buy futures then sell

 Borrowing: sell futures then buy

Interest rate options

Interest rate options allow businesses to protect themselves against adverse interest rate
movements while allowing them to benefit from favourable movements. They are also
known as interest rate guarantees. Options are like insurance policies:

1. You pay a premium to take out the protection. This is non-returnable whether or not you make use
of the protection.

2. If interest rates move in an unfavorable direction you can call on the insurance.
3. If interest rates move favorable you ignore the insurance.

Options are taken on interest rate futures contracts and they give the holder the right, but
not the obligation, either to buy the futures or sell the futures at an agreed price at an
agreed date.

Using options when borrowing

As explained above, if using simple futures contracts the business would sell futures now
then buy later.

When using options, the borrower takes out an option to sell futures contracts at today’s
price (or another agreed price). Let’s say that price is 95. An option to sell is known as
a put option (think about putting something up for sale).

If interest rates rise the futures contract price will fall, let’s say to 93. Therefore the
borrower will buy at 93 and will then choose to exercise the option by exercising their right
to sell at 95. The gain on the options is used to offset the extra interest that has to be paid.

If interest rates fall the futures contract price will rise, let’s say to 97. Clearly, the borrower
would not buy at 97 then exercise the option to sell at 95, so the option is allowed
to lapse and the business will simply benefit from the lower interest rate.

Using options when depositing

As explained above, if using simple futures contracts the business would buy futures now
and then sell later.

When using options, the investor takes out an option to buy futures contracts at today’s
price (or another agreed price). Let’s say that price is 95. An option to buy is known as
a call option.

If interest rates fall the futures contract price will rise, let’s say to 97. The investor would
therefore sell at 97 then exercise the option to buy at 95. The gain on the options is used to
offset the lower interest that has been earned.

If interest rates rise the futures contract price will fall, let’s say to 93. Clearly, the investor
would not sell futures at 93 and exercise the option by insisting on their right to sell at 95.
The option is allowed to lapse and the investor enjoys extra income form the higher
interest rate.

Options therefore give borrowers and lenders a way of guaranteeing minimum income or
maximum costs whilst leaving the door open to the possibility of higher income or lower
costs. These ‘heads I win, tails you lose’ benefits have to be paid for and a non-
returnable premium has to be paid up front to acquire the options.

Interest rate caps, floors and collars

Interest rate cap:

A cap involves using interest rate options to set a maximum interest rate for borrowers. If
the actual interest rate is lower, the option is allowed to lapse.

Interest rate floors:

A floor involves using interest rate options to set a minimum interest rate for investors. If
the actual interest rate is higher the investor will let the option lapse.

Interest rate collar:

A collar involves using interest rate options to confine the interest paid or earned within a
pre-determined range. A borrower would buy a cap and sell a floor, thereby offsetting the
cost of buying a cap against the premium received by selling a floor. A depositor would buy
a floor and sell a cap.
Interest rate swaps

Interest rate swaps allow companies to exchange interest payments on an agreed notional
amount for an agreed period of time. Swaps may be used to hedge against adverse interest
rate movements or to achieve a desired balanced between fixed and variable rate debt.

Interest rate swaps allow both counterparties to benefit from the interest payment
exchange by obtaining better borrowing rates than they are offered by a bank.

Interest rate swaps are arranged by a financial intermediary such as a bank, so the
counterparties may never meet. However, the obligation to meet the original interest
payments remains with the original borrower if a counterparty defaults, but this
counterparty risk is reduced or eliminated if a financial intermediary arranges the swap.

The most common type of swap involves exchanging fixed interest payments for variable
interest payments on the same notional amount. This is known as a plain vanilla swap.

Interest rate swaps allow companies to hedge over a longer period of time than other
interest rate derivatives, but do not allow companies to benefit from favourable
movements in interest rates.

Another form of swap is a currency swap, which is also an interest rate swap. Currency
swaps are used to exchange interest payments and the principal amounts in different
currencies over an agreed period of time. They can be used to eliminate transaction risk on
foreign currency loans. An example would be a swap that exchanges fixed rate dollar debt
for fixed rate euro debt.

Ken Garrett is a freelance lecturer and writer

The cost of equity

Section E of the Study Guide for Financial Management contains several references to the
Capital Asset Pricing Model (CAPM). This article introduces the CAPM and its components,
shows how it can be used to estimate the cost of equity, and introduces the asset beta
formula. Two further articles will look at applying the CAPM in calculating a project-
specific discount rate, and will look at the theory, and the advantages and disadvantages of
the CAPM.

Whenever an investment is made, for example in the shares of a company listed on a stock
market, there is a risk that the actual return on the investment will be different from the
expected return. Investors take the risk of an investment into account when deciding on the
return they wish to receive for making the investment. The CAPM is a method of calculating
the return required on an investment, based on an assessment of its risk.

Systematic and unsystematic risk

If an investor has a portfolio of investments in the shares of several different companies, it

might be thought that the risk of the portfolio would be the average of the risks of the
individual investments. In fact, it has been found that the risk of the portfolio is less than the
average of the risks of the individual investments. By diversifying investments in a
portfolio, therefore, an investor can reduce the overall level of risk faced.

There is a limit to this risk reduction effect, however, so that even a ‘fully diversified’
portfolio will not eliminate risk entirely. The risk which cannot be eliminated by portfolio
diversification is called ‘undiversifiable risk’ or ‘systematic risk’, since it is the risk that is
associated with the financial system. The risk which can be eliminated by portfolio
diversification is called ‘diversifiable risk’, ‘unsystematic risk’, or ‘specific risk’, since it is
the risk that is associated with individual companies and the shares they have issued. The
sum of systematic risk and unsystematic risk is called total risk (Watson D and Head
A, Corporate Finance: Principles and Practice, 7th edition, Pearson Education Limited,
Harlow pp.245-6).

The capital and asset pricing model

The CAPM assumes that investors hold fully diversified portfolios. This means that
investors are assumed by the CAPM to want a return on an investment based on its
systematic risk alone, rather than on its total risk. The measure of risk used in the CAPM,
which is called ‘beta’, is therefore a measure of systematic risk.

The minimum level of return required by investors occurs when the actual return is the
same as the expected return, so that there is no risk of the investment's return being
different from the expected return. This minimum level of return is called the ‘risk-free rate
of return’.

The formula for the CAPM, which is included in the formulae sheet, is as follows:

E(ri ) = Rf + βi(E(rm) – Rf)

E(ri) = return required on financial asset

Rf = risk-free rate of return

βi = beta value for financial asset

E(rm) = average return on the capital market

This formula expresses the required return on a financial asset as the sum of the risk-free
rate of return and a risk premium – βi (E(rm) – Rf) – which compensates the investor for
the systematic risk of the financial asset. If shares are being considered, E(rm) is the
required return of equity investors, usually referred to as the ‘cost of equity’.

The formula is that of a straight line, y = a + bx, with βi as the independent variable, Rf as the
intercept with the y axis, (E(r m ) – Rf) as the slope of the line, and E(ri) as the values being
plotted on the straight line. The line itself is called the security market line (or SML), as
shown in Figure 1.
In order to use the CAPM, investors need to have values for the variables contained in the
model.

The risk-free rate of return

In the real world, there is no such thing as a risk-free asset. Short-term government debt
is a relatively safe investment, however, and in practice, it can be used as an acceptable
substitute for the risk-free asset.

To ensure consistency of data, the yield on UK treasury bills is used as a substitute for the
risk-free rate of return when applying the CAPM to shares that are traded on the UK capital
market. Note that it is the yield on treasury bills which is used here, rather than the interest
rate on treasury bills. The yield on treasury bills (sometimes called the yield to maturity) is
the cost of debt of the treasury bills.

Because the CAPM is applied within a given financial system, the risk-free rate of return
(the yield on short-term government debt) will change depending on which country’s
capital market is being considered. The risk-free rate of return is also not fixed, but will
change with changing economic circumstances.

The equity risk premium

Rather than finding the average return on the capital market, E(rm), research has
concentrated on finding an appropriate value for (E(rm) – Rf), which is the difference
between the average return on the capital market and the risk-free rate of return. This
difference is called the equity risk premium, since it represents the additional return
required for investing in equity (shares on the capital market as a whole) rather than
investing in risk-free assets.

In the short term, share prices can fall as well as increase, so the average capital market
return can be negative rather than positive. To smooth out short-term changes in the
equity risk premium, a time-smoothed moving average analysis can be carried out over
longer periods of time, often several decades. In the UK, when applying the CAPM to shares
that are traded on the UK capital market, an equity risk premium of between 3.5% and 4.8%
appears reasonable at the current time (Watson, D. and Head, A. (2016) Corporate Finance:
Principles and Practice, 7th edition, Pearson Education Limited, Harlow p266).

Beta

Beta is an indirect measure which compares the systematic risk associated with a
company’s shares with the systematic risk of the capital market as a whole. If the beta
value of a company’s shares is 1, the systematic risk associated with the shares is the same
as the systematic risk of the capital market as a whole.

Beta can also be described as ‘an index of responsiveness of the returns on a company’s
shares compared to the returns on the market as a whole’. For example, if a share has a
beta value of 1, the return on the share will increase by 10% if the return on the capital
market as a whole increases by 10%. If a share has a beta value of 0.5, the return on the
share will increase by 5% if the return on the capital market increases by 10%, and so on.

Beta values are found by using regression analysis to compare the returns on a share with
the returns on the capital market. When applying the CAPM to shares that are traded on the
UK capital market, beta values for UK companies can readily be found on the Internet, on
Datastream, and from the London Business School Risk Management Service.

EXAMPLE 1

Calculating the cost of equity using the CAPM

Although the concepts of the CAPM can appear complex, the application of the model is
straightforward. Consider the following information:

Risk-free rate of return = 4%

Equity risk premium = 5%

Beta value of Ram Co = 1.2

Using the CAPM:

E(ri) = Rf + βi (E(rm) – Rf) = 4 + (1.2 x 5) = 10%

The CAPM predicts that the cost of equity of Ram Co is 10%. The same answer would have
been found if the information had given the return on the market as 9%, rather than giving
the equity risk premium as 5%.

Asset betas, equity betas and debt betas

If a company has no debt, it has no financial risk and its beta value reflects business risk
alone. The beta value of a company’s business operations as a whole is called the ‘asset
beta’. As long as a company’s business operations, and hence its business risk, do not
change, its asset beta remains constant.

When a company takes on debt, its gearing increases and financial risk is added to its
business risk. The ordinary shareholders of the company face an increasing level of risk as
gearing increases and the return they require from the company increases to compensate
for the increasing risk. This means that the beta of the company’s shares, called the equity
beta, increases as gearing increases (Watson, D. and Head, A. (2016) Corporate Finance:
Principles and Practice, 7th edition, Pearson Education Limited, Harlow pp289-90).

However, if a company has no debt, its equity beta is the same as its asset beta. As a
company gears up, the asset beta remains constant, even though the equity beta is
increasing, because the asset beta is the weighted average of the equity beta and the beta
of the company’s debt. The asset beta formula, which is included in the formulae sheet, is
as follows:
Note from the formula that if Vd is zero because a company has no debt, βa = βe, as stated
earlier.

EXAMPLE 2

Calculating the asset beta of a company

You have the following information relating to RD Co:

Equity beta of Tug Co = 1.2

Debt beta of Tug Co = 0.1

Market value of shares of Tug Co = $6m

Market value of debt of Tug Co = $1.5m

After tax market value of company = 6 + (1.5 x 0.75) = $7.125m

Company profit tax rate = 25% per year

β a = [(1.2 x 6)/7.125] + [(0.1 x 1.5 x 0.75)/7.125] = 1.024.

The next article will look at how the asset beta formula allows the CAPM to be applied in
calculating a project-specific discount rate that can be used in investment appraisal.

Written by a member of the Financial Management examining team

Project-specific discount rates

Section E of the Study Guide for Financial Management contains several references to the
Capital Asset Pricing Model (CAPM). This article, is the second in a series of three, and
looks at applying the CAPM in calculating a project-specific discount rate to use in
investment appraisal. The first article in the series introduced the CAPM and its
components, showed how the model could be used to estimate the cost of equity, and
introduced the asset beta formula. The final article will look at the theory, advantages, and
disadvantages of the CAPM.

As mentioned in the first article in this series, the CAPM is a method of calculating the
return required on an investment, based on an assessment of its risk. When the business
risk of an investment project differs from the business risk of the investing company, the
return required on the investment project is different from the average return required on
the investing company’s existing business operations. This means that it is not appropriate
to use the investing company’s existing cost of capital as the discount rate for the
investment project. Instead, the CAPM can be used to calculate a project-specific discount
rate that reflects the business risk of the investment project.

Proxy companies and proxy betas

The first step in using the CAPM to calculate a project-specific discount rate is to look for
companies whose business operations are similar to the proposed investment project. For
example, if a food processing company was looking at an investment in coal mining, it
would need to locate some coal mining companies. Companies undertaking similar
business operations to a proposed investment are known as ‘proxy companies’. Since their
equity betas represent the business risk of the proxy companies’ business operations, they
are referred to as ‘proxy equity betas’ or ‘proxy betas’.

From a CAPM point of view, these proxy betas can be used to represent the business risk
of the proposed investment project. For example, the proxy betas from several coal mining
companies ought to represent the business risk of an investment in coal mining.

Business risk and financial risk

If you were to look at the equity betas of several coal mining companies, however, it is very
unlikely that they would all have the same value. The reason for this is that equity betas
reflect not only the business risk of a company’s operations, but also the financial risk of a
company. The systematic risk represented by equity betas, therefore, includes both
business risk and financial risk.

In the first article in this series, we introduced the idea of the asset beta, which is linked to
the equity beta by the asset beta formula. This formula is included in the formulae sheet and
is as follows:

To proceed with calculating a project-specific discount rate, we need to remove the effect
of the financial risk or gearing from each of the proxy equity betas in order to find their
asset betas, which are betas that reflect business risk alone. If a company has no gearing,
and hence no financial risk, its equity beta and its asset beta have the same value.
Ungearing equity betas

The asset beta formula is a bit unwieldy and so it usual to make the simplifying assumption
that the beta of debt ( β d ) is zero. This is a relatively minor simplification because the debt
beta is usually very small compared to the equity beta ( β e ). In addition, the market value
of a company’s debt (V d ) is usually very small in comparison to the market value of its
equity (V e ), and the tax efficiency of debt reduces the weighting of the debt beta even
further.

Assuming the debt beta is zero, the asset beta formula becomes:

If the equity beta, the gearing, and the tax rate of the proxy company are known, this
amended asset beta formula can be used to calculate the proxy company’s asset beta.
Since this calculation removes the effect of the financial risk or gearing of the proxy
company from the proxy beta, it is usually called ‘ungearing the equity beta’. Similarly, the
amended asset beta formula is called the ‘ungearing formula’.

Averaging asset betas

After the equity betas of several proxy companies have been ungeared, it is usually found
that the resulting asset betas have slightly different values. This is not that surprising,
since it is very unlikely that two proxy companies will have identical systematic business
risk. Even two coal mining companies will not be mining the same coal seam, or mining the
same kind of coal, or selling coal into the same market. If one of the calculated asset betas
is very different from the others, however, it would be regarded with suspicion and
excluded from further consideration.
To remove the effect of the slight differences in business operations and business risk that
are reflected in the asset betas, these asset betas are averaged. A simple arithmetic mean
is calculated by adding up the asset betas and then dividing by the number of asset betas
being averaged.

Regearing the asset beta

The average asset beta represents the business risk of the proposed investment project.
Before a project-specific discount rate can be calculated, however, the financial risk of the
investing company needs to be taken into consideration. In other words, having ungeared
the proxy equity betas when calculating the asset betas, it is now necessary to ‘regear’ the
average asset beta to reflect the gearing and the financial risk of the investing company.

One way to approach regearing is to use the ungearing formula, inserting the gearing and
the tax rate of the investing company, and the average asset beta, and leaving the equity
beta as the only unknown variable. Another approach is to rearrange the ungearing
formula in order to represent the equity beta in terms of the asset beta, as follows:

The gearing and the tax rate of the investing company, and the average asset beta, are
inserted into the right-hand side of the regearing formula to calculate the regeared equity
beta.

Calculating the project-specific discount rate

The CAPM can now be used to calculate a project-specific cost of equity. Once values have
been obtained for the risk-free rate of return, and either the equity risk premium or the
 return on the market, these can be inserted into the CAPM formula along with the regeared
equity beta:

The project-specific cost of equity can be used as the project-specific discount rate or
project-specific cost of capital. It is also possible to go further and calculate a project-
specific weighted average cost of capital, but this does not concern us in this article and it
is a step that is often omitted when using the CAPM in investment appraisal.

Summary of steps in the calculation

The steps in calculating a project-specific discount rate using the CAPM can now be
summarized, as follows:

1. Locate suitable proxy companies.

2. Determine the equity betas of the proxy companies, their gearings and tax rates.
3. Ungear the proxy equity betas to obtain asset betas.
4. Calculate an average asset beta.
5. Regear the asset beta.
6. Use the CAPM to calculate a project-specific cost of equity.

The difficulties and practical problems associated with using the CAPM to calculate a
project-specific discount rate to use in investment appraisal will be discussed in the next
article in this series.

EXAMPLE 1

Lad Co is planning to invest in a new project that is significantly different from its existing
business operations. The company is financed 30% by debt and 70% by equity. It has
identified three companies whose business operations are similar to the proposed
investment, and details of these companies are as follows:
 Cup Co has an equity beta of 0.81 and financed 25% by debt and 75% by equity.
 Mug Co has an equity beta of 0.98 and financed 40% by debt and 60% by equity.
 Jug Co has an equity beta of 1.16 and financed 50% by debt and 50% by equity.

Assume that the risk-free rate of return is 4% per year, and that the equity risk premium is
6% per year. Assume also that all the companies pay tax at a rate of 25% per year. Calculate
a project-specific discount rate for the proposed investment.

Solution

Ungearing the proxy equity betas:

 Cup Co asset beta = 0.81 x 75/(75 + 25(1 – 0.25)) = 0.648

 Mug Co asset beta = 0.98 x 60/(60 + 40(1 – 0.25)) = 0.653
 Jug Co asset beta = 1.16 x 50/(50 + 50(1 – 0.25)) = 0.663

Averaging the asset betas:

(0.648 + 0.653 + 0.663)/3 = 1.964/3 = 0.655

Regearing the average asset beta: 0.655 = βe x 70/(70 + 30(1 – 0.25)) = βe x 0.757.

Hence βe = 0.655/0.757 = 0.865

If the regearing equation were used:

βe = 0.655 x (1 + (1 – 0.25)30/70) = 0.866

Calculating the project-specific discount rate:

E(ri) = Rf + βi (E(rm) – Rf) = 4 + (0.865 x 6) = 4 + 5.19 = 9.2%

Written by a member of the Financial Management examining team

CAPM formula

The linear relationship between the return required on an investment (whether in stock
market securities or in business operations) and its systematic risk is represented by the
CAPM formula, which is given in the Formulae Sheet:

The CAPM is an important area of financial management. In fact, it has even been suggested
that financial management only became an academic discipline when William Sharpe
published his derivation of the CAPM in 1964.

CAPM assumptions

The CAPM is often criticized as unrealistic because of the assumptions on which the model
is based, so it is important to be aware of these assumptions and the reasons why they are
criticized. The assumptions are as follows (Watson, D. and Head, A. (2016) Corporate
Finance: Principles and Practice, 7th edition, Pearson Education Limited, Harlow pp.258-
9).

Investors hold diversified portfolios

This assumption means that investors will only require a return for the systematic risk of
their portfolios, since unsystematic risk has been diversified and can be ignored.

Single-period transaction horizon

A standardized holding period is assumed by the CAPM to make the returns on different
securities comparable. A return over six months, for example, cannot be compared to a
return over 12 months. A holding period of one year is usually used.
Investors can borrow and lend at the risk-free rate of return

This is an assumption made by portfolio theory, from which the CAPM was developed, and
provides a minimum level of return required by investors. The risk-free rate of return
corresponds to the intersection of the security market line (SML) and the y-axis (see
Figure 1). The SML is a graphical representation of the CAPM formula.

Perfect capital market

This assumption means that all securities are valued correctly and that their returns will
plot on to the SML. A perfect capital market requires the following: that there are no taxes
or transaction costs; that perfect information is freely available to all investors who, as a
result, have the same expectations; that all investors are risk averse, rational and desire
to maximize their own utility; and that there are a large number of buyers and sellers in the
market.

While the assumptions made by the CAPM allow it to focus on the relationship between
return and systematic risk, the idealized world created by the assumptions is not the same
as the real world in which investment decisions are made by companies and individuals.

Real-world capital markets are clearly not perfect, for example. Even though it can be
argued that well-developed stock markets do, in practice, exhibit a high degree of
efficiency, there is scope for stock market securities to be priced incorrectly and so for
their returns not to plot onto the SML.
 The assumption of a single-period transaction horizon appears reasonable from a real-
world perspective, because even though many investors hold securities for much longer
than one year, returns on securities are usually quoted on an annual basis.

The assumption that investors hold diversified portfolios means that all investors want to
hold a portfolio that reflects the stock market as a whole. Although it is not possible to own
the market portfolio itself, it is quite easy and inexpensive for investors to diversify away
specific or unsystematic risk and to construct portfolios that ‘track’ the stock market.
Assuming that investors are concerned only with receiving financial compensation for
systematic risk seems therefore to be quite reasonable.

A more serious problem is that investors cannot in the real world borrow at the risk-free
rate (for which the yield on short-dated government debt is taken as a proxy). The reason
for this is that the risk associated with individual investors is much higher than that
associated with the government. This inability to borrow at the risk-free rate means that in
practice the slope of the SML is shallower than in theory.

Overall, it seems reasonable to conclude that while the assumptions of the CAPM
represent an idealized world rather than the real-world, there is a strong possibility, in the
real world, of a linear relationship between required return and systematic risk.

WACC and CAPM

The weighted average cost of capital (WACC) can be used as the discount rate in investment
appraisal provided that some restrictive assumptions are met. These assumptions are as
follows:

 the investment project is small compared to the investing organization

 the business activities of the investment project are similar to the business activities currently
undertaken by the investing organization

 the financing mix used to undertake the investment project is similar to the current financing mix
(or capital structure) of the investing company

 existing finance providers of the investing company do not change their required rates of return as
a result of the investment project being undertaken.

These assumptions are essentially saying that WACC can be used as the discount rate
provided that the investment project does not change either the business risk or the
financial risk of the investing organization.
If the business risk of the investment project is different to that of the investing
organization, the CAPM can be used to calculate a project-specific discount rate. The
procedure for this calculation was covered in the second article in this series.

The benefit of using a CAPM-derived project-specific discount rate is illustrated in Figure

2. Using the CAPM will lead to better investment decisions than using the WACC in the two
shaded areas, which can be represented by projects A and B.

Project A would be rejected if WACC is used as the discount rate, because the internal rate
of return (IRR) of the project is less than the WACC. This investment decision is incorrect,
however, since project A would be accepted if a CAPM-derived project-specific discount
rate is used because the project IRR lies above the SML. The project offers a return greater
than that needed to compensate for its level of systematic risk, and accepting it will
increase the wealth of shareholders.

Project B would be accepted if WACC was used as the discount rate because its IRR is
greater than the WACC.

This investment decision is also incorrect, however, since project B would be rejected if
using a CAPM-derived project-specific discount rate, because the project IRR offers
insufficient compensation for its level of systematic risk (Watson and Head, pp.291-2).

Advantages of the CAPM

 The CAPM has several advantages over other methods of calculating required return,
explaining why it has been popular for more than 40 years:

 It considers only systematic risk, reflecting a reality in which most investors have diversified
portfolios from which unsystematic risk has been essentially eliminated.

 It is a theoretically-derived relationship between required return and systematic risk which has
been subject to frequent empirical research and testing.

 It is generally seen as a much better method of calculating the cost of equity than the dividend
growth model (DGM) in that it explicitly considers a company’s level of systematic risk relative to
the stock market as a whole.

 It is clearly superior to the WACC in providing discount rates for use in investment appraisal.

Disadvantages of the CAPM

The CAPM suffers from several disadvantages and limitations that should be noted in a
balanced discussion of this important theoretical model.

Assigning values to CAPM variables

To use the CAPM, values need to be assigned to the risk-free rate of return, the return on
the market, or the equity risk premium (ERP), and the equity beta.

The yield on short-term government debt, which is used as a substitute for the risk-free
rate of return, is not fixed but changes regularly with changing economic circumstances. A
short-term average value can be used to smooth out this volatility.

Finding a value for the equity risk premium (ERP) is more difficult. The return on a stock
market is the sum of the average capital gain and the average dividend yield. In the short
term, a stock market can provide a negative rather than a positive return if the effect of
falling share prices outweighs the dividend yield. It is therefore usual to use a long-term
average value for the ERP, taken from empirical research, but it has been found that the
ERP is not stable over time. In the UK, an ERP value of between 3.5% and 4.8% is currently
seen as reasonable. However, uncertainty about the ERP value introduces uncertainty into
the calculated value for the required return.

Beta values are now calculated and published regularly for all stock exchange-listed
companies. The problem here is that uncertainty arises in the value of the expected return
because the value of beta is not constant, but changes over time.
Using the CAPM in investment appraisal

Problems can arise in using the CAPM to calculate a project-specific discount rate. For
example, one common difficulty is finding suitable proxy betas, since proxy companies
very rarely undertake only one business activity. The proxy beta for a proposed investment
project must be disentangled from the company’s equity beta. One way to do this is to treat
the equity beta as a portfolio beta (βp), an average of the betas of several different areas of
proxy company activity, weighted by the relative share of the proxy company market value
arising from each activity.

βp = (W1β1) + (W2β2)

W1 and W2 are the market value weightings of each business area

β1 and β2 are the equity betas of each business area.

Example

A proxy company, Gib Co, has an equity beta of 1.2. Approximately 75% of the business
operations of Gib Co by market value are in the same business area as a proposed
investment. However, 25% of its business operations by market value are in a business
area unrelated to the proposed investment. These unrelated business operations are 50%
riskier, in systematic risk terms, than those of the proposed investment. What is proxy
equity beta for the proposed investment?

Solution

Using the portfolio beta formula, βp = (W1β1) + (W2β2):

1.2 = (0.75 x β1) + (0.25 x 1.5 x β1) = (0.75 x β1) + (0.375 x β1) = 1.125 x β1

Proxy equity beta = β1 = 1.2/ 1.125 = 1.067

In this case note that β2 = 1.5 x β1

The information about relative shares of proxy company market value may be quite difficult
to obtain.

A similar difficulty is that ungearing proxy company betas uses capital structure
information that may not be readily available. Some companies have complex capital
structures with many different sources of finance. Other companies may have untraded
debt or use complex sources of finance such as convertible bonds.

The simplifying assumption that the beta of debt is zero will also lead to inaccuracy,
however small, in the calculated value of the project-specific discount rate.

Another disadvantage in using the CAPM in investment appraisal is that the assumption of
a single-period time horizon is at odds with the multi-period nature of investment
appraisal. While CAPM variables can be assumed constant in successive future periods,
experience indicates that this is not true in the real world.

Conclusion

Research has shown the CAPM stands up well to criticism, although attacks against it have
been increasing in recent years. Until something better presents, itself, though, the CAPM
remains a very useful item in the financial management toolkit.

Written by a member of the Financial Management examining team

Reducing investment in foreign accounts receivable

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

Another approach is for the seller (exporter) to arrange for a bank to give cash for foreign
accounts receivable, sooner than the seller would normally receive payment.

Forfaiting
 One method of doing this is forfaiting. Forfaiting involves the purchase of foreign accounts
receivable from the seller by a forfeiter. The forfeiter takes on all of the credit risk from the
transaction (without recourse) and therefore the forfeiter purchases the receivables from
the seller at a discount. The purchased receivables become a form of debt instrument
(such as bills of exchange) which can be sold on the money market.

The non-recourse side of the transaction makes this an attractive arrangement for
businesses, but as a result the cost of forfaiting is relatively high.

Forfaiting is usually available for large receivable amounts (over $250,000) and also is
only for major convertible currencies. It is usually only available for medium-term or
longer transactions.

Letter of credit

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

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

1. Both parties set the terms for the sale of goods or services
2. The purchaser (importer) requests their bank to issue a letter of credit in favor of the seller
(exporter)
3. The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once
the conditions specified in the letter have been complied with. Typically, the conditions
relate to presenting shipping documentation and dispatching the goods before a certain
date
4. The goods are dispatched to the customer and the shipping documentation is sent to the
purchaser’s bank
5. The bank then issues a banker’s acceptance
6. The seller can either hold the banker’s acceptance until maturity or sell it on the money
market at a discounted value

As can be seen from the above process, letters of credit take up a significant amount of time
and therefore are slow to arrange and must be in place before the sale occurs. The use of
letters of credit may be considered necessary if there is a high level of non-payment risk.
Customers with a poor or no credit history may not be able to obtain a letter of credit from
their own bank. Letters of credit are costly to customers and also restrict their flexibility: if
they are short of cash when the payment to the bank is due, the commitment under the
letter of credit means that the payment must be made.

Collection under a letter of credit depends on the conditions in the letter being fulfilled.
Collection only occurs if the seller presents exactly the documents stated in the conditions.
This means that letters of credit provide protection to both the purchaser and the seller.
However, the seller will not be able to claim payment if, for example, goods have been sent
by air but the letter of credit stated that shipping documents were required.

Countertrading

In a countertrade arrangement, goods or services are exchanged for other goods or

services instead of for cash.

The benefits of countertrading include the fact that it facilitates conservation of foreign
currency and can help a business enter foreign markets that it may not otherwise be able
to.

The main disadvantage of countertrading is that the value of the goods or services received
in exchange may be uncertain, especially if the goods being exchanged experience price
volatility. Other disadvantages of countertrade include complex negotiations and logistical
issues, particularly if a countertrade deal involves more than two parties.

Export credit insurance

Export credit insurance protects a business against the risk of non-payment by a foreign
customer. Exporters can protect their foreign accounts receivable against a number of
risks which could result in non-payment. Export credit insurance usually insures the
seller against commercial risks, such as insolvency of the purchaser or slow payment, and
also insures against certain political risks, for example war, riots, and revolution which
could result in non-payment. It can also protect against currency inconvertibility and
changes in import or export regulations.

Export credit insurance therefore helps reduce the risk of non-payment, but its’
disadvantages include the relatively high cost of premiums and the fact that the insurance
does not typically cover 100% of the value of the foreign sales.
Export factoring

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

Other considerations

The purchaser may be able to get a local bank to guarantee payment to the exporter, but
this may only be suitable in an arrangement where the purchaser has no power over the
exporter.

General policies for foreign accounts receivable

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

A seller should insist that any payment is made in a convertible currency and in a form
which the customer’s authorities will permit to become effective as a remittance to the
seller. This may mean, for example, that the sale will be subject to clearance under
exchange controls or any import regulations.

Written by a member of the Financial Management examining team

What is an SME?

It is generally accepted that an SME is something larger than those businesses that are
fundamentally a vehicle for the self-employment of their owner. Equally an SME is unlikely
to be listed on any stock exchange and is likely to be owned by a relatively small number of
shareholders. Indeed, very often the majority of the shareholders come from one extended
family. Hence the term SME covers a very wide range of businesses.
Why are SMEs important?

As we have just seen, the term SME covers a very wide range of businesses. As a result,
the SME sector as a whole is very important to the economies of many countries. Estimates
vary widely but within the UK, SMEs probably account for about half of employment and half
of national income, and hence are of great importance.

As SMEs are relatively small they are often more flexible and quicker to innovate than
larger companies. Indeed, SMEs are often thought to be better at embracing new trends
and technologies. Obviously it is important to any economy that this occurs. One
consequence for some successful SMEs is that they are acquired by a larger company with
the financial resources to fully exploit the potential of what the SME has developed. When
this happens the SME sector has provided a useful service as it has helped a larger
company to innovate and continue its success into the future.

In economies, such as the UK, where manufacturing industry has declined as a proportion
of total economic activity and the service sector has become increasingly important, the
SME sector is likely to continue to grow. This is because, in the service sector, economies
of scale are normally less important than they are in manufacturing. Hence, within the
growing service sector it is easier for SMEs to survive and flourish.

Finally, it is important that SMEs can flourish as potentially a number of the SMEs of today
could be the bigger companies of tomorrow.

Why do SMEs find raising finance difficult?

The directors of SMEs often complain that the lack of finance stops them growing and fully
exploiting profitable investment opportunities. This gap between the finance available to
SMEs and the finance that they could productively use is often known as the ‘funding or
financing gap’. As advisers to SMEs it is important that we understand why this gap occurs.

The first thing to understand is that there is a limited supply of funds from investors. Once
potential investors have satisfied their need and desire to spend and have paid their tax
there is often little left over to be invested. An additional issue at the current time in the UK
is that the returns available to investors on a typical deposit account are so low that
investment does not seem attractive.

Equally there is a competitive market for the limited supply of investors’ funds.
Governments and larger companies have a great appetite for the funds available and,
hence, the SME sector can be squeezed out.
 The SME sector tends to suffer because SMEs are viewed as a less attractive investment
opportunity than many others due to the high levels of uncertainty and risk they are
perceived to have. This perception of risk is due to a number of reasons including:

 SMEs often have a limited track record in raising investment and providing suitable returns
to their investors
 SMEs often have non-existent or very limited internal controls
 SMEs often have few external controls. For instance, they are unlikely to be abiding by the
rules of any stock exchange and due to their size they are unlikely to attract much press
scrutiny. Indeed, in the UK many SMEs are no longer required to have their annual accounts
audited
 SMEs often have one dominant owner-manager whose decisions may face little
questioning
 SMEs often have few tangible assets to offer as security.

As a result of the above, investors are nervous of investing in SMEs as they are concerned
about how their funds might be used and the returns that they might get. Hence, the easiest
thing for an investor is to decline any opportunity to invest in an SME, especially when there
are so many other investment opportunities available to them.

Accountants can do little to alter the supply of funds or the competitive market for those
funds, but can assist by showing how an SME could reduce the level of risk it is perceived
to have, thereby improving its ability to raise finance. For instance, SMEs that can show that
they have treated earlier investors well, have adopted some key internal controls, and
have a rigorous and documented approach to decision making are more likely to be
attractive to investors.

What are the potential sources of finance for SMEs?

In reality there are quite a few potential sources of finance for SMEs. However, many of
them have practical problems that may limit their usefulness. Some key sources and their
limitations are briefly described below. Crowdfunding and supply chain financing are then
considered in more detail.

The SME owner, family and friends

This is potentially a very good source of finance because these investors may be willing to
accept a lower return than many other investors as their motivation to invest is not purely
financial. The key limitation is that, for most of us, the finance that we can raise personally,
and from friends and family, is somewhat limited.
The business angel
A business angel is a wealthy individual willing to take the risk of investing in SMEs. One
limitation is that these individuals are not common and are very often quite particular about
what they are prepared to invest in. Once a business angel is interested they can become
very useful to the SME, as they will often have great business acumen themselves and are
likely to have many useful contacts.

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

Factoring and invoice discounting

Both of these sources of finance effectively let a company raise finance against the
security of their outstanding receivables. Again, this finance is only short-term and is often
more expensive than an overdraft. However, one of the features of these sources of
finance is that, as an SME grows, their outstanding receivables will grow and so the amount
they can borrow from their factor or from invoice discounting will also grow. Hence,
factoring and invoice discounting are two of the very limited number of finance sources
which grow automatically as the business grows.

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

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

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

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

Supply chain financing

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

Example

Company A (which has an A+ credit rating) buys goods from Company B

(which has a B+ credit rating). Co B has agreed to give Co A 30 days credit.

Co B invoices Co A.

Co A approves the invoice.

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

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

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

Technological solutions are used in order to efficiently link the buyer, the seller and the
financial institution. These technological solutions effectively automate the business and
financial process from initiation to completion.

SCF can bring considerable benefit and can cover more than one step in the supply chain.
It is perhaps of most benefit where considerable value is constantly moving through the
supply chain, such as occurs in the automotive trade. SCF is only currently used in a
relatively small proportion of companies, but its use is expected to grow significantly. As
with factoring and invoice discounting, this source of finance is only short term in nature.

Obviously, SCF could be of great help to SMEs that are supplying larger companies, or even
the suppliers of larger companies, with a good credit rating. As the technological solutions
required to make SCF work become more widespread and SCF grows, more and more
SMEs are likely to benefit.

Crowdfunding
Crowdfunding involves funding a venture by raising finance from a large number of people
(the crowd) and is very often achieved over the internet. Crowdfunding has grown rapidly
and in 2013 it has been estimated that over US$5bn was raised worldwide through
crowdfunding. There are now in excess of 500 crowdfunding platforms on the internet and
over 400 crowdfunding campaigns are launched every day.

The internet platforms are set up and run by moderating organizations who bring together
the project initiator with the idea, and those organizations and individuals who are willing
to support the idea. Different platforms have different policies with regard to assessing the
 ideas seeking support and checking those willing to provide the finance. Hence, great care
is needed when using these platforms.

Finance provided by crowdfunding may be invested in the debt or the equity of the ventures
seeking the finance. Some crowdfunding is done on a ‘keep it all’ basis where any funds
raised are kept by the recipient, whereas some is done on an ‘all or nothing basis’ where
the recipient only receives the funds if the total required to fund the particular project is
raised within a given time frame. The crowdfunding platform takes a fee, which is often a
percentage of the amount raised.

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

Early crowdfunding campaigns very often focused on the arts such as funding for bands
and films. However, all sorts of ideas have now been funded in this way and there has been
much focus on innovation and new technology.

Crowdfunding has the potential to be very beneficial to SMEs. It allows them to contact and
appeal directly to investors, who may be willing to take the risk involved in funding the new
technologies and innovations, which SMEs are often so good at producing.

Why and how do governments help finance SMEs?

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

A number of key ways governments assist include the following:

 Providing grants.
 Providing tax breaks – for instance, tax incentives may be available to those willing to take
the risk of investing in SMEs.
 Providing advice – for instance, in Scotland there is a government-funded organisation
known as ‘Business Gateway’, which provides assistance to those setting up and running a
business, including advice on raising finance.
 Guaranteeing loans – for instance, for a small fee from the SME, a large proportion of any
loan advanced by a bank is guaranteed by the government. As this significantly reduces the
risk to the bank, they are potentially more willing to lend. In the UK this is currently called
the ‘Enterprise Finance Guarantee’ scheme.
 Providing equity investment – many countries have government-backed venture capital
organizations that are willing to invest in the equity of SMEs. This is often done on a
matching basis, where the organization will match any equity investment raised from
other sources. In the UK this is done through ‘Enterprise Capital Funds’, while in the US
there is the ‘Small Business Investment Company’ programme.

Conclusion

This article has hopefully raised your awareness of the issues that SMEs face with regard
to raising finance, and how as accountants and advisers we can assist them in their search
for finance.

William Parrott, freelance FM tutor and senior FM tutor, MAT Uganda

Equivalent annual costs

At some stage you have probably bought an asset such as a car, a washing machine or a
computer and you may have considered how long you should keep that asset prior to
replacing it. If the asset is kept for a longer period its initial cost, less any residual value, is
spread over more years which is likely to reduce your cost per year of ownership.
However, as the asset ages it is likely to require more and more maintenance and may
operate less effectively which will increase your costs per year. Determining the optimal
time to replace the asset (the optimal replacement cycle) is difficult.

As a general rule you and I don’t worry too much about this. Indeed most of us will make a
decision based on our ‘gut feel’ and other factors such as image for example. Indeed I tend
to keep my car until such time as I have lost confidence in its ability to get me reliably from
A to B or it has deteriorated so much I no longer want to be seen in it!

Companies also face exactly the same asset replacement decisions. However as the
amounts involved can often be very significant, making decisions based on ‘gut feel’ is not
 really accurate enough. The calculation of equivalent annual costs is a tool that can be used
to assist in this decision-making process.

The equivalent annual cost method involves the following steps:

 Step 1 – Calculate the net present value (NPV) of cost for each potential replacement cycle.
 Step 2 – For each potential replacement cycle an equivalent annual cost is calculated.
 The decision – The replacement cycle with the lowest equivalent annual cost may then be
chosen, although other factors may also have to be considered.

This will now be demonstrated and explained further through the use of an example.

EXAMPLE 1

A machine has a cost of $3,500. The annual maintenance costs of the machine are forecast
to be $900 in the first year, $1,000 in the second year and $1,200 in the third year of
ownership.

The residual value of the machine is expected to be $2,100 after two years and $1,600 after
three years.

The cost of capital of the company is 11% per year.

Calculate the optimal replacement cycle for the machine.

SOLUTION 1

Step 1 – Calculate the NPV of cost for each potential replacement cycle.

As we have not been given the residual value after one year of ownership, we cannot
calculate an NPV of cost for a one-year replacement cycle. Hence, our decision here will
be between a two- or three-year replacement cycle.

NPV of cost – two-year replacement cycle:

Here we evaluate all the cash flows associated with buying and keeping the asset for two
years.
 Time 0 1 2

Initial cost (3,500)

Maintenance (900) (1,000)

Residual value ______ _____ 2,100

Net cash flows (3,500) (900) 1,100

11% Discount factors 1 0.901 0.812

Present values (3,500) (811) 893

Net present value (3,418)

Please note that the normal assumptions with regard to the timings of the cash flows
continue to be made. Hence, the maintenance costs are shown at the end of each year,
whereas in reality they will arise throughout the year.

One complication that arose in a past question was that the maintenance was an annual
overhaul required at each year end rather than ongoing maintenance occurring
throughout each year. Logically the maintenance/overhaul cost was not incurred in the
year of disposal as a company would be unlikely to overhaul an asset just prior to selling it.
Hence, in the two-year replacement cycle above, if the maintenance had been an annual
overhaul the $1,000 cost at time 2 would be excluded.

NPV of cost – three-year replacement cycle:

We now evaluate all the cash flows associated with buying and keeping the asset for three
years.
 Time 0 1 2 3

Initial cost (3,500)

Maintenance (900) (1,000) (1,200)

Residual value ______ ______ ______ 1,600

Net cash flows (3,500) (900) (1,000) 400

11% Discount factors

1 0.901 0.812 0.731

Present values (3,500) (811) (812) 292

Net present value (4,831)

Whilst there is an element of repetition in these calculations I would still advise using the
above simple and logical format or something similar. Although I have seen formats which
try to combine the calculations, they are more complex and tend to lead to mistakes being
made.

A classic mistake to be avoided is including the residual value after two years in the
calculation of the NPV of cost for the three-year replacement cycle. For the three-year
replacement cycle, the sale will occur at the end of the three years. Please remember if you
buy the asset once you can only sell it once!

The two NPVs calculated should not be compared as quite obviously buying and keeping an
asset for a longer period is likely to cost more than buying and keeping it for a shorter
period as there is less benefit to the owner. This has proved to be the case here. In order to
make a fair comparison we must calculate the equivalent annual costs.

Step 2 – For each potential replacement cycle an equivalent annual cost is calculated.
The costs calculated in Step 1 are spread over the period for which they will give benefit.
Hence, the NPV of cost for the two-year cycle is spread over two years and the NPV of cost
for the three-year cycle is spread over three years. This is done by using annuity factors to
turn each NPV of cost into an equivalent annual cost (EAC) at the end of each year of
ownership.

Remember if you have equal annual cash flows for a number of years and want to calculate
a present value (PV) you must multiply the annual cash flow by an annuity factor: so to
calculate the equivalent annual cost or EAC from an NPV of cost we must divide by the
relevant annuity factor.

EAC – two-year cycle:

As the NPV of cost of $3,418 will give the benefit of ownership for two years, we divide by
the two-year annuity factor at the 11% cost of capital to get the EAC.

EAC = $3,418/1.713 = $1,995 per year

This is the equivalent annual cost at time 1 and time 2 which equates to an NPV of cost of
$3,418.

EAC – three-year cycle:

As the NPV of cost of $4,831 will give benefit for three years, we divide by the three-year
annuity factor at the 11% cost of capital to get the EAC.

EAC = $4,831/2.444 = $1,977 per year

This is the cost at time 1, time 2 and time 3 which equates to an NPV of cost of $4,831.

While some textbooks will continue to put brackets around these cost figures, I am content
to show them as positive as we are describing them as costs.

The decision:

As the calculated equivalent annual costs are both annual costs, they can be compared to
come to a decision.

Hence, as an annual cost of $1,977 is less than an annual cost of $1,995, the three-year
replacement cycle is said to be the optimal replacement cycle.

Weaknesses
 Having worked through an example we should now consider the weaknesses of the
approach we have used. These include the following:

1. Our analysis has ignored the impact of taxation.

Both buying an asset and incurring a maintenance cost will cause tax cash flows. While
these cash flows could be included they would add to the complexity of the calculation. Past
exam questions have specifically excluded the impact of taxation on the cash flows.

2. Our analysis assumes that we can replace like with like.

Our analysis has assumed that the asset can be replaced by exactly the same asset in
perpetuity. In reality, this will not be possible as assets are constantly developing. Even if
you replace your car with exactly the same model after a number of years the new car will
undoubtedly have improvements and other differences to the old one. In our worked
example above, if we were to imagine that the asset was a computer then although the
calculated optimal replacement cycle is three years, the difference in cost between the
two- and three-year replacement cycles is small. Hence, we might decide to use a two-
year replacement cycle as we would then benefit from having a new, more up-to-date
computer with more functionality on a more regular basis.

3. Our analysis assumes that we will want to replace like with like.
Additionally the analysis assumes we will want to replace the asset with the same asset in
perpetuity. In reality, business needs develop and when it becomes time to replace an
asset a company may want to acquire a different asset with different functionality. For
instance, a company may want an asset with greater capacity due to growth in their
business. You and I face exactly the same issue. Over my lifetime I have had a variety of
different cars as my need has developed – my two-seater sports car proved less than
useful when my first child was born!

4. Our analysis has ignored inflation.

Different cash flows may suffer from different specific inflation rates and as a result our
analysis may not be correct. For instance, the initial cost of assets often inflates quite
slowly as manufacturers find more efficient ways of production. However, maintenance
costs often inflate much more quickly as maintenance is often labor-intensive and labor
costs often grow quickly. This differential between the inflation rates of different cash
flows means that an alternative method, which you are not required to know, should be
used. If all the cash flows inflate at one rate then the EAC method can be used with real cash
flows and a real cost of capital.
 Additional applications of the technique

Without going into great detail it is worth being aware that a similar technique can be used
in other circumstances. These include:

1. Evaluating the best time to replace an existing asset with a new asset.
2. Deciding between assets which would have the same functionality but have different lives.
For instance, when you or I are buying a car we could buy a cheaper car of lower quality or
a more costly car of higher quality. It would be unfair to simply compare the costs directly,
as the higher quality car is likely to last longer.

Equivalent annual benefit

If a company is faced with mutually exclusive projects, where only one out of a number of
projects can be accepted, then the general rule is that the company should choose the
project that generates the highest NPV as this creates the biggest increase in shareholder
wealth. However, if the situation is such that it is anticipated that the same projects could
be repeated in perpetuity and the projects have different lives then the equivalent annual
benefit approach can be used. This is simply a further variation on the equivalent annual
cost approach and is demonstrated in the following example.

EXAMPLE 2

Two mutually exclusive projects are being considered:

 Project A has an NPV of $47m and is expected to last three years.

 Project B has an NPV of $58m and is expected to last four years.

It is anticipated that if either project is chosen it will be possible to repeat it for the
foreseeable future.

The cost of capital of the company is 13% per year.

Calculate which project the company should accept.

SOLUTION 2
Step 1 – Calculate the NPV for each potential project.
This would involve calculating the NPV of each project as normal. I have already done this
for us to save time!

Project A – $47m
Project B – $58m

Step 2 – Calculate the equivalent annual benefit for each potential project.
This is calculated using annuity factors in exactly the same way as an EAC is calculated.
Hence, the NPV of Project A is divided by the 3-year annuity factor at the cost of capital of
13% as the project life is three years. For Project B the 4-year annuity factor is used to
reflect the four-year life of the project.

Project A – equivalent annual benefit = $47m/2.361 = $19.9m per year

Project B – equivalent annual benefit = $58m/2.974 = $19.5m per year

The decision:

As Project A has the highest equivalent annual benefit it should be chosen instead of
Project B, which has the higher NPV, so long as the project can be repeated for the
foreseeable future. This result arises because although the shorter project produces the
lower NPV that NPV will be obtained more frequently than the NPV of the longer project.

The equivalent annual benefit technique suffers similar weaknesses to the EAC technique.

Conclusion

Although this topic is a relatively small one within your Financial Managementsyllabus, it
is a topic well worth mastering as when it has been examined in the past those with the
necessary knowledge have been able to earn very good marks. Equally, I would not expect
any significant question on this topic to be wholly calculative and hence students should be
ready to discuss the reasons for the approach used and the weaknesses or limitations of
that approach.

William Parrott, freelance tutor and senior FM tutor, MAT Uganda

Financial performance and position

When considering the source of finance to be used by a company, the recent financial
performance, the current financial position and the expected future financial performance
of the company needs to be taken into account. Within an exam question, the ability to do
this will be restricted by the information available. In some questions, details of recent
performance and the current situation may be provided, while in other questions the
current situation and forecasts may be provided.

Evaluating financial performance

Whether you are evaluating recent or forecast financial performance, key areas to
consider include the growth in turnover, the growth in operating profit, the growth in profit
after or before tax and the movement in profit margins. Return on capital employed and
return on equity could be calculated. A key point for students to remember is that they only
have limited time and it is better to calculate a few key ratios and then move on and
complete the question than it is to calculate all possible ratios and fail to satisfy the
requirement.

Evaluating the current financial position

The key consideration when evaluating the current financial position is to establish the
financial risk of the company. Hence, the key ratios to calculate are the financial gearing,
which shows the financial risk using data from the statement of financial position and
interest cover, which shows the financial risk using data from the income statement.
Equally, the split between short and long-term financing, and the reliance of the company
on overdraft finance, should also be considered.

When evaluating financial performance and financial position, due consideration should be
given to any comparative sector data provided. Indeed, if no such data is provided, I would
recommend that you state in your answer that you would want to consider such
comparative data. This is what you would do in real life and stating it shows that you are
aware of this. If the examiner has not provided such data, it is simply because he is
constrained by the need to examine many topics in just three hours.
 Recommendation of a suitable financing method

When recommending a financing method, consideration should be given to a number of

factors. These factors are key to justifying your choice of method and the examiner has in
the past asked students to discuss these factors in an exam question. The factors include:

 Cost – Debt finance is cheaper than equity finance and so if the company has the capacity
to take on more debt, it could have a cost advantage.

 Cash flows – While debt finance is cheaper than equity finance, it places on the company
the obligation to pay out cash in the form of interest. Failure to pay this interest can result
in action being taken to wind up the company. Hence, consideration should be given to the
ability of the company to generate cash. If the company is currently cash-generating, then
it should be able to pay its interest and debt finance could be a good choice. If the company
is currently using cash because it is investing heavily in research and development for
example, then the cash may not be available to service interest payments and the company
would be better to use equity finance. The equity providers may be willing to accept little or
no cash return in the short term, but will instead hope to benefit from capital growth or
enhanced dividends once the investment currently taking place bears fruit. Also, equity
providers cannot take action to wind up a company if it fails to pay the dividend expected.

 Risk – The directors of the company must control the total risk of the company and keep it
at a level where the shareholders and other key stakeholders are content. Total risk is
made up of the financial risk and the business risk. Hence, if it is clear that the business risk
is going to rise – for example, because the company is diversifying into riskier areas or
because the operating gearing is increasing – then the company may seek to reduce its
financial risk. The reverse is also true – if business risk is expected to fall, then the
company may be happy to accept more financial risk.

 Security and covenants – If debt is to be raised, security may be required. From the data
given it should be possible to establish whether suitable security may be available.
Covenants, such as those that impose an obligation on the company to maintain a certain
liquidity level, may be required by debt providers and directors must consider if they will be
willing to live with such covenants prior to taking on the debt.

 Availability – The likely availability of finance must also be considered when

recommending a suitable finance source. For instance, a small or medium-sized unlisted
company will always find raising equity difficult and, if you consider that the company
requires more equity, you must be able to suggest potential sources, such as venture
capitalists or business angels, and be aware of the drawbacks of such sources.
Furthermore, if the recent or forecast financial performance is poor, all providers are
 likely to be wary of investing.

 Maturity – The basic rule is that the term of the finance should match the term of the need
(the matching principle). Hence, a short-term project should be financed with short-term
finance. However, this basic rule can be flexed. For instance, if the project is short term –
but other short-term opportunities are expected to arise in the future – the use of longer-
term finance could be justified.

Students should always consider the maturity dates of debt finance in questions of this
nature as it is an area the Financial Management examining team like to explore. For
instance, in a past question the company was considering raising more finance but at the
same time the existing long-term borrowings were scheduled to mature in just two years
and, hence, consideration needed to be given to this issue. Equally, in previous questions,
a company had been considering raising finance for a period of perhaps eight years and an
examination of the company’s statement of financial position shows that the existing debt
of the company would also mature in eight years. Obviously it is unwise for a company to
have all its debt maturing at once as repayment would put a considerable cash strain on
the company. If the debt could not be repaid, but was to be refinanced, this could be
problematic if the economic conditions prevailing made refinancing difficult.

 Control – If debt is raised then there will be no change in control. However, if equity is raised
control may change. Students should also recognize that a rights issue will only cause a
change in control if shareholders sell their rights to other investors.

 Costs and ease of issue – Debt finance is generally both cheaper and easier to raise than
equity and, hence, a company will often raise debt rather than equity. Raising equity is often
difficult, time-consuming and costly.

 The yield curve – Consideration should be given to the term structure of interest rates. For
instance, if the curve is becoming steeper this shows an expectation that interest rates will
rise in the future. In these circumstances, a company may become more wary of borrowing
additional debt or may prefer to raise fixed rate debt, or may look to hedge the interest rate
risk in some way.

While this list is not meant to be exhaustive, it hopefully provides much for students to think
about. Students should not necessarily expect to use all the factors in an answer.

Suitable financing sources

Students must ensure that they can suggest suitable financing sources. For each source,
students should know how and when it could be raised, the nature of the finance and its
potential advantages and disadvantages. Combined with a consideration of the factors
given above, this knowledge will allow students to recommend and justify a source of
finance for any particular scenario. A discussion of each finance source is outside the
scope of this article, but students can read up on this area in any good study manual.

Worked example

The following forecast financial position statement as at 31 May 20X2 refers to Refgun Co, a
stock exchange-listed company, which is seeking to spend $90m in cash on a permanent
expansion of its existing trade.

$m $m

Assets

Non-current assets 130

Current assets 104

Total assets 234

Equity and liabilities

Share capital 60

Retained earnings 86

Total equity 146

Non-current liabilities
 $m $m

Long-term borrowings 70

Current liabilities

Trade payables 18

Total liabilities 88

Total equity and 234

liabilities

The forecast results for Refgun Co, assuming the expansion occurs from 1 June 20X2, are
as follows:

Year ending
31 May 20X2 20X3 20X4 20X5

$m $m $m $m

Revenue 71.7 79.2 91.3 98.6

Operating profit 24.4 28.5 33.7 37.1

Notes:

1. The long-term borrowings are 8% bonds that were issued 16 years ago with a 20-year term
2. The current assets include $18m of cash, of which $15m is held on deposit
3. Refgun Co has consistently grown its profits and dividends in real terms
4. No new finance has been raised in recent years
5. The sector average financial gearing (debt/equity on a book value basis) is currently 85%
6. The sector average interest cover is currently 2.9 times
7. The company estimates that it could borrow at a pre-tax rate of 7.2% per year
8. The company pays tax on its pre-tax profits at a rate of 28%

Required:

Recommend a suitable method of raising the finance required by Refgun Co, supporting
your evaluation with both analysis and critical discussion.

Prior to reading the suggested solution students should carry out their own evaluation of
the forecast financial performance and the current and forecast financial position. A
consideration of the factors discussed earlier should lead students to a justified
recommendation.

Suggested solution

Refgun Co is seeking to spend $90m on a permanent expansion of its existing trade. It

should be noted that the company has significant retained earnings, $15m of which is held
in cash on deposit. This could presumably be used to help fund the expansion and, if this is
the case, the need for additional finance would be reduced to $75m. However, the company
may have a reason for holding cash – for example, to meet budgeted cash payments in the
near future.

Forecast financial performance

The forecast financial performance of Refgun Co will be a key consideration to potential

finance providers. Analysis of the forecast performance of Refgun Co gives the following
information:

 Geometric average growth in turnover = (98.6/71.7)(1/3) – 1 = 11.2%

 Geometric average growth in operating profit = (37.1/24.4)(1/3) – 1 = 15.0%
 Year ending 31
May 20X2 20X3 20X4 20X5

Operating 34.0% 36.0% 36.9% 37.6%

profit margin

The forecast income statements for the years ending 31 May 20X2 and 20X5 are shown
below. Two income statements have been prepared for 20X5, one assuming the expansion
is funded by debt and the other assuming the expansion is funded by equity:

20X5 – debt 20X5 –

Year ending 20X2 $m equity
31 May $m $m

Operating profit 24.4 37.1 37.1

Interest (5.6) (11.0) (5.6)

Profit before tax 18.8 26.1 31.5

Tax – 28% (5.3) (7.3) (8.8)

Profit after tax 13.5 18.8 22.7

The interest charge for 20X2 is assumed to be (70 x 8%) = $ 5.6m. If debt finance is used the
interest charge from 20X3 onwards is assumed to be (70 x 8%) + (75 x 7.2%) = $11.0m

Note: While it would be good to forecast the income statement for each year, time pressure
may mean this is not possible.

This analysis shows that the growth in revenue caused by the expansion is exceeded by the
growth in operating profit due to a steady rise in the operating margin of the company. This
may be a result of the company benefiting from economies of scale as a result of the
expansion. Whether debt finance or equity finance is used, both the returns to all investors
(operating profit) and the return to the equity investors (profit after tax) both show
considerable growth.
 Current and forecast financial position

The gearing (D/E) is currently 70/146 = 47.9% on a book value basis. If debt finance is raised
this would rise to (70+75)/146 = 99.3%, while if equity finance was used it would fall to
70/(146+75) = 31.7%. Even if debt finance was raised the gearing level would rapidly fall
again as the company makes and retains profits.

The interest cover is currently 24.4/5.6 = 4.4 times. If debt finance is used then this would
fall to 28.5/11.0 = 2.6 times in 20X3. However, by 20X5 it would have recovered to 37.1/11.0 =
3.4 times. If equity finance were to be used the interest cover would consistently improve.

Refgun Co currently has less financial risk than the sector average and the financial risk
would decline even further if equity finance was used. If debt finance is used then the
financial risk would initially rise slightly above the sector average but would soon return to
the sector average level or below.

Factors that Refgun Co should consider prior to choosing a financing method

 Cost and cash flows – Refgun Co would seem to have the capacity to raise more debt as the
non-current assets exceed the existing debt by $60m. Furthermore, the company seems
to be cash-generative in that it is currently holding $15m on deposit, despite not having
raised any finance for several years. Hence, the company may be wise to take advantage of
cheaper debt.

 Risk – As the company is expanding its existing trade there should be no material change
in business risk. If debt finance is chosen the directors should ensure that the
shareholders are happy with the extra financial risk. Given the analysis above, this seems
likely.

 Security and covenants – As long as the expansion involves investing in some non-current
assets there should be sufficient security available for potential lenders. The company
should check what potential covenants might be imposed and ensure that they would be
happy to live with them.

 Availability and maturity – Given the recent performance and the good forecasts, the
company is likely to have many finance sources available to it. Debt providers should be
willing to lend and shareholders would be likely to support a rights issue. Equally, other
investors may well wish to invest in the equity of the company. As the finance is required to
finance a permanent expansion of the company, long-term finance should be raised. To the
extent that the expansion requires investment in additional working capital, some short-
 term finance could be raised. Consideration should also be given to the fact that the
existing bonds of the company are due to be repaid in 20X6. Subject to early redemption
penalties, it may be worth looking into refinancing this debt at the same time as raising the
new debt especially as the cost of new debt appears lower.

 Control – If debt is issued, no change would occur to control. A rights issue would also have
little impact on control while the issue of shares to new investors may cause control
issues.

 Costs and ease of issue – A debt issue is likely to be cheaper and easier than an equity issue
and, hence, may well be favoured by the directors.

 Yield curve – The directors of Refgun Co should consider the yield curve if it is decided to
raise debt.

Recommendation of a suitable financing method

From the analysis and discussion above, it would seem that Refgun Co should seek to
finance the expansion by raising long-term debt secured on the existing non-current
assets of the company and the new non-current assets acquired during the expansion. At
the same time as raising the new debt, the refinancing of the existing debt should also be
considered. If shareholders and other key stakeholders are concerned about the financial
risk exceeding the industry average, then Refgun Co could raise some short-term debt
with the aim of repaying it as soon as more cash is earned. The directors should take action
to manage the interest rate risk that Refgun Co will suffer.

I hope that this article has provided students with an approach that they can use when
answering a question of this nature. All too often students have a feel for the type of finance
that may be suitable for a company, but cannot support or justify what they are proposing
and, hence, cannot earn the marks that are available.

William Parrott is a lecturer at Kaplan Financial

 The Financial Management syllabus contains a section on Islamic finance (Section E3). All
components of this section will be examined at intellectual level 1, knowledge and
comprehension

Although the concept of Islamic finance can be traced back about 1,400 years, its recent
history can be dated to the 1970s when Islamic banks in Saudi Arabia and the United Arab
Emirates were launched. Bahrain and Malaysia emerged as centres of excellence in the
1990s. It is now estimated that worldwide around US $1 trillion of assets are managed under
the rules of Islamic finance.

Islamic finance rests on the application of Islamic law, or Shariah, whose primary sources
are the Qur'an and the sayings and practice of the Prophet Muhammad. Shariah, and very
much in the context of Islamic finance, emphasises justice and partnership.

The main principles of Islamic finance are that:

 Wealth must be generated from legitimate trade and asset-based investment. (The use of
money for the purposes of making money is expressly forbidden.)
 Investment should also have a social and an ethical benefit to wider society beyond pure
return.
 Risk should be shared.
 All harmful activities (haram) should be avoided.

The prohibitions

The following activities are prohibited:

 Charging and receiving interest (riba). The idea of a lender making a straight interest
charge, irrespective of how the underlying assets fare, transgresses the concepts of risk
 sharing, partnership and justice. It represents the money itself being used to make money.
It also prohibits investment in companies that have too much borrowing (typically defined
as having debt totalling more than 33% of the firm’s average stock market value over the
last 12 months).
 Investments in businesses dealing with alcohol, gambling, drugs, pork, pornography or
anything else that the Shariah considers unlawful or undesirable (haram).
 Uncertainty, where transactions involve speculation, or extreme risk. This is seen as being
akin to gambling. This prohibition, for example, would rule out speculating on the futures
and options markets. Mutual insurance (which relates to uncertainty) is permitted if it is
related to reasonable, unavoidable business risk. It is based upon the principle of shared
responsibility for shared financial security, and that members contribute to a mutual fund,
not for profit, but in case one of the members suffers misfortune.
 Uncertainty about the subject matter and terms of contracts – this includes a prohibition
on selling something that one does not own. There are special financial techniques
available for contracting to manufacture a product for a customer. This is necessary
because the product does not exist, and therefore cannot be owned, before it is made. A
manufacturer can promise to produce a specific product under certain agreed
specifications at a determined price and on a fixed date. Specifically, in this case, the risk
taken is by a bank which would commission the manufacture and sell the goods on to a
customer at a reasonable profit for undertaking this risk. Once again the bank is exposed
to considerable risk. Avoiding contractual risk in this way, means that transactions have to
be explicitly defined from the outset. Therefore, complex derivative instruments and
conventional short sales or sales on margin are prohibited under Islamic finance.

The permitted

As mentioned above, the receipt of interest is not allowed under Shariah. Therefore, when
Islamic banks provide finance they must earn their profits by other means. This can be
through a profit-share relating to the assets in which the finance is invested, or can be via
a fee earned by the bank for services provided. The essential feature of Shariah is that
when commercial loans are made, the lender must share in the risk. If this is not so then
any amount received over the principal of the loan will be regarded as interest.

There are a number of Islamic financial instruments mentioned in the Financial

Management syllabus and which can provide Shariah-compliant finance:

 Murabaha is a form of trade credit for asset acquisition that avoids the payment of interest.
Instead, the bank buys the item and then sells it on to the customer on a deferred basis at a
price that includes an agreed mark-up for profit. The mark-up is fixed in advance and
cannot be increased, even if the client does not take the goods within the time agreed in the
contract. Payment can be made by instalments. The bank is thus exposed to business risk
 because if its customer does not take the goods, no increase in the mark- up is allowed and
the goods, belonging to the bank, might fall in value.
 Ijara is a lease finance agreement whereby the bank buys an item for a customer and then
leases it back over a specific period at an agreed amount. Ownership of the asset remains
with the lessor bank, which will seek to recover the capital cost of the equipment plus a
profit margin out of the rentals payable.

Emirates Airlines regularly uses Ijara to finance its expansion. Another example of
the Ijara structure is seen in Islamic mortgages. In 2003, HSBC was the first UK clearing
bank to offer mortgages in the UK designed to comply with Shariah. Under HSBC’s Islamic
mortgage, the bank purchases a house then leases or rents it back to the customer. The
customer makes regular payments to cover the rental for occupying or otherwise using
the property, insurance premiums to safeguard the property, and also amounts to pay back
the sum borrowed. At the end of the mortgage, title to the property can be transferred to
the customer. The demand for Islamic mortgages in the UK has shown considerable
growth.

 Mudaraba is essentially like equity finance in which the bank and the customer share any
profits. The bank will provide the capital, and the borrower, using their expertise and
knowledge, will invest the capital. Profits will be shared according to the finance
agreement, but as with equity finance there is no certainty that there will ever be any
profits, nor is there certainty that the capital will ever be recovered. This exposes the bank
to considerable investment risk. In practice, most Islamic banks use this is as a form of
investment product on the liability side of their statement of financial position, whereby the
investor or customer (as provider of capital) deposits funds with the bank, and it is the bank
that acts as an investment manager (managing the funds).
 Musharaka is a joint venture or investment partnership between two parties. Both parties
provide capital towards the financing of projects and both parties share the profits in
agreed proportions. This allows both parties to be rewarded for their supply of capital and
managerial skills. Losses would normally be shared on the basis of the equity originally
contributed to the venture. Because both parties are closely involved with the ongoing
project management, banks do not often use Musharaka transactions as they prefer to be
more ‘hands off’.
 Sukuk is debt finance. A conventional, non-Islamic loan note is a simple debt, and the debt
holder's return for providing capital to the bond issuer takes the form of interest. Islamic
bonds, or sukuk, cannot bear interest. So that the sukuk are Shariah-compliant,
the sukuk holders must have a proprietary interest in the assets which are being financed.
The sukuk holders’ return for providing finance is a share of the income generated by the
assets. Most sukuk, are ‘asset-based’, not ‘asset-backed’, giving investors ownership of
the cash flows but not of the assets themselves. Asset-based is obviously more risky than
asset backed in the event of a default.
There are a number of ways of structuring sukuk, the most common of which are
partnership (Musharaka) or lease (Ijara) structures. Typically, an issuer of
the sukuk would acquire property and the property will generally be leased to tenants to
generate income. The sukuk, or certificates, are issued by the issuer to the sukuk holders,
who thereby acquire a proprietary interest in the assets of the issuer. The issuer collects
the income and distributes it to the sukuk holders. This entitlement to a share of the income
generated by the assets can make the arrangement Shariah compliant.

The cash flows under some of the approaches described above might be the same as they
would have been for the standard western practice paying of interest on loan finance.
However, the key difference is that the rate of return is based on the asset transaction and
not based on interest on money loaned. The difference is in the approach and not
necessarily on the financial impact. In Islamic finance the intention is to avoid injustice,
asymmetric risk and moral hazard (where the party who causes a problem does not suffer
its consequences), and unfair enrichment at the expense of another party.

Advocates of Islamic finance claim that it avoided much of the recent financial turmoil
because of its prohibitions on speculation and uncertainty, and its emphasis on risk
sharing and justice. That does not mean, of course, that the system is free from all risk
(nothing is), but if you are more exposed to a risk you are likely to behave more prudently.

The Shariah board

The Shariah board is a key part of an Islamic financial institution. It has the responsibility
for ensuring that all products and services offered by that institution are compliant with the
principles of Shariah law. Boards are made up of a committee of Islamic scholars and
different institutions can have different boards.

An institution’s Shariah board will review and oversee all new product offerings before
they are launched. It can also be asked to deliver judgments on individual cases referred to
it, such as whether a specific customer’s business proposals are Shariah-compliant.

The demand for Shariah-compliant financial services is growing rapidly and the Shariah
board can also play an important role in helping to develop new financial instruments and
products to help the institution to adapt to new developments, industry trends, and
customers’ requirements. The ability of scholars to make pronouncements using their own
expertise and based on Shariah, highlights the fact that Islamic finance remains innovative
and able to evolve, while crucially remaining within the bounds of core principles.
Developments

Perhaps the main current problem is the absence of a single, worldwide body to set
standards for Shariah compliance, meaning that there is no ultimate authority for Shariah
compliance. Each Islamic bank’s adherence to the principles of Shariah law is governed by
its own Shariah board. Some financial aspects of Shariah law, and, therefore, the
legitimacy of the financial instruments used can be open to interpretation, with the result
that some Islamic banks may agree transactions that would be rejected by other banks.
Therefore, a contract might unexpectedly be declared incompatible with Shariah law and
thus be invalid.

In Malaysia, the world’s biggest market for sukuk, the Shariah advisory council ensures
consistency in order to help in creating certainty across the market. Some industry bodies,
notably the Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI) in Bahrain, have also been working towards common standards. To quote the
AAOFI website: ‘AAOIFI is supported by institutional members (200 members from 45
countries, so far) including central banks, Islamic financial institutions, and other
participants from the international Islamic banking and finance industry, worldwide.
AAOIFI has gained assuring support for the implementation of its standards, which are
now adopted in the Kingdom of Bahrain, Dubai International Financial Centre, Jordan,
Lebanon, Qatar, Sudan and Syria. The relevant authorities in Australia, Indonesia,
Malaysia, Pakistan, Kingdom of Saudi Arabia, and South Africa have issued guidelines that
are based on AAOIFI’s standards and pronouncements.’

However, despite these movements towards consistency, some differences between

national jurisdictions are likely to remain.

Ken Garrett is a freelance author and lecturer

Formation and initial growth

Many businesses begin with finance contributed by their owners and owners’ families. If
they start as unincorporated businesses, the distinction between owners’ capital and
owners’ loans is almost irrelevant. If it starts as an incorporated business, or turns into
one, then there are important differences between share capital and loans. Share capital
is more or less permanent and can give suppliers and lenders some confidence that the
owners are being serious and are willing to risk significant resources. If the owners’
friends and families do not themselves want to invest (perhaps they have no money to
 invest) then the owners will have to look for outside sources of capital. The main sources
are:

 bank loans and overdrafts

 leasing/hire purchase
 trade credit
 government grants, loans and guarantees
 venture capitalists and business angels
 invoice discounting and factoring
 retained profits.

Bank loans and overdrafts

In the current economic climate, start-up businesses are likely to find it difficult to raise a
bank loan, particularly if the business and its owners have no track record at all. Banks will
certainly require:

 A business plan, including cash flow forecasts.

 Personal guarantees and charges on personal assets.

The personal guarantees and charges on personal assets get round the company’s limited
liability which would otherwise mean that if the company failed, the bank might be left with
nothing. This way the bank can ask the guarantors to pay back the loans personally, or the
bank can seize the charged assets that were used for security.

Note that overdrafts are repayable on demand and many banks have a reputation of pre-
emptively withdrawing overdraft facilities, not when a business is in trouble, but when the
bank fears more difficult times ahead.

On a more positive note, where it is known that the need for finance is temporary, an
overdraft might be very suitable because it can be repaid by the borrower at any time.

Leasing and hire purchase

In financial terms, leasing is very like a bank loan. Instead of receiving cash from the loan,
spending it on buying an asset and then repaying the loan, the leasing company buys the
 asset, makes it available to the lessee and charges the lessee a monthly amount. Leasing
can often be cheaper than borrowing because:

 Large leasing companies have great bargaining power with suppliers so the asset costs
them less than it would cost the lessee. This can be partially passed on to the leasee.
 Leasing companies have effective ways of disposing of old assets, but lessees normally do
not.
 If the lease payments are not made, the leasing company has a form of built- in security
insofar as it can reclaim its asset.
 The cost of finance to a large, established leasing company is likely to be lower than the
cost to a start-up company.

It is important for businesses to try to decide whether loan finance or a lease would be
cheaper. (This is a separate topic in the Financial Management syllabus, but it is not
covered in this article.)

Trade credit

This simply means taking credit from suppliers – typically 30 days. That is obviously a very
short period, but it can be very helpful to new businesses. Typically, credit suppliers to new
businesses will want some sort of reference, either from a bank or from other suppliers
(trade references). However, some will be prepared to offer modest credit initially without
references, and as trust grows this can be increased.

Government grants, loans and guarantees

Governments often encourage the formation of new businesses and, from time to time and
from region to region, help is offered. Government grants are usually very small, and direct
loans are rare because governments see loan provision as the job of financial institutions.

Currently in the UK, the Government runs the Enterprise Finance Guarantee Scheme
(EFGS). This is a loan guarantee scheme intended to facilitate additional bank lending to
viable small and medium-sized entities (SMEs) with insufficient security for a normal
commercial loan. The borrower must be able to demonstrate to the lender that they should
be able to repay the loan in full. The Government provides the lender with a guarantee for
which the borrower pays a premium.

The scheme is not a mechanism through which businesses or their owners can choose to
withhold the security a lender would normally lend against; nor is it intended to facilitate
lending to businesses which are not viable and that banks have declined to lend to on that
basis.

EFGS supports lending to viable businesses with an annual turnover of up to £25m seeking
loans of between £1,000 and £1m.

Venture capitalists and business angels

These are either companies (usually known as venture capitalists) or wealthy individuals
(business angels) who are prepared to invest in new or young businesses. They provide
equity (private equity as opposed to public equity in listed companies), not loans. The equity
is not normally secured on any assets and the private equity firm faces the risk of losses
just like the other shareholders. Because of the high risk associated with start-up equity,
private equity suppliers typically look for returns on their investment in the order of 30%
pa. The overall return takes into account capital redemptions (for example preference
shares being redeemed at a premium), possible capital gains on exiting their investment
(for example through sale of shares to a private buyer or after listing the company on a
stock exchange), and income through fees and dividends.

Typically, venture capitalists will require 25%–49% of the equity and a seat on the board so
that their investment can be monitored and advice given. However, the investors do not
seek to take over management of their investment.

Invoice discounting and factoring

Before these methods can be used turnover usually has to be in the region of at least
$200,000. Amounts due from customers, as evidenced by invoices, are advanced to the
company. Typically 80% of an invoice will be paid within 24 hours. In addition to this service,
factors also look after the administration of the company’s receivables ledger.

Fees are charged on advancing the cash (roughly at overdraft interest rates), and also
factors will charge about 1% of turnover for running the receivables ledger (the exact
amount depends on how many invoices and customers there are). Credit insurance can be
taken out for an additional fee. Unless that is taken out the invoicing company remains
liable for any bad debts.

Retained profits

Retained profits are no good for start-ups, and often no good for the first few years of a
business’s life when only losses or very modest profits are made. However, assuming the
business is successful, profits should be made and retaining those in the business can
allow the company to repay debt capital and to invest in expansion.
 How much capital is needed?

Capital is needed:

 for investment in non-current assets

 to sustain the company through initial loss-making periods
 for investment in current assets.

Cash-flow forecasts are an essential tool in planning capital needs. Typically, suppliers of
capital will want forecasts for three to five years. One of the biggest dangers facing new
successful businesses is overtrading, where they try to do too much with too little capital.
Most businesses know that capital will be needed to finance non-current assets, but many
overlook that finance is also needed for current assets.

Look at this example:

This company starts with a healthy liquidity position (Stage 1). Business then doubles,
without investing in more non-current assets and without raising more equity capital. It is
a reasonable assumption that if turnover doubles then so will inventory, receivables and
payables (Stage 2). But here this forces the company to rely on an overdraft (probably
unexpected and unplanned) to finance its net current assets. Relying permanently on
overdraft finance is precarious and the company would be advised to seek some more
permanent form of capital.
 When capital is raised, the company has to decide what to do with it, and there are two main
uses:

 invest in non-current assets

 invest in current assets, including leaving it as cash.

The more capital invested in non-current assets, the greater should be the profit- earning
potential of the business. However, leaving too little cash in current assets increases the
risk that the company will have liquidity problems. On the other hand, leaving too much
capital in current assets is wasteful: cash will earn modest interest (but investors want
higher returns from a company), and cash tied up in inventory often causes costs (storage,
damage, obsolescence). So, the company has to decide on its working capital policy. An
aggressive policy is one which maintains relatively low working capital compared to
another company; a conservative policy is one which maintains relatively high working
capital. Which policy is appropriate partly depends on the nature of the business. If the
business is one where trading cash flows are very predictable then it should be able to
survive with an aggressive policy. If, however, cash flows are erratic and unpredictable the
company would be wise to build a margin of safety into its cash management. Additionally,
if the company foresees a period of losses, it will need to keep cash available (probably
earning interest in a deposit account) to see it through its lean years.

Note that companies do not have to have actually raised capital to have it available for
emergency use. What they need is a pre-agreed right to borrow a certain amount on
demand. That is known as a line of credit. Many of us make use of lines of credit in our
personal lives, but there we call them credit cards. So we don’t have to have $1,000 sitting
in the bank in case our car needs a major repair, but it’s comforting to know that if repairs
are necessary, we can pay for them immediately. Of course, the credit card debt will have
to be repaid at some time, but repayments can be spread.

Long, medium and short-term capital

Capital can be short, medium or long-term. Definitions vary somewhat, but the following
are often seen:

 Short term – up to two years. For example, overdrafts, trade credit, factoring and invoice
discounting
 Medium term – two to five or six years. For example, term loans, lease finance.
 Long term – over five years, or so, to permanent.

In general, it makes sense to match the length of the finance to the life of the asset (the
matching principle) and, again, we often apply this in our own lives, where we would use a
25-year mortgage to buy an apartment, a 3–5-year loan to buy a car, and a credit card to
pay for a holiday.

For
Consider...
financing...

Equity capital, bonds (larger companies), term loans (at least

Premises,
five years). There are also leasing companies which specialise
plant and
in certain major pieces of machinery, such as printing presses
machinery
and aircraft.

Equipment,
Equity capital, bonds (larger companies), term loans of around
motor
five years, leasing and hire purchase.
vehicles

Inventory, Equity capital, bonds (larger companies), term loans,

receivables overdrafts, factoring and invoice discounting, trade credit.

Note that long-term capital (equity and bonds) can be used to fund all classes of asset.
Although each piece of inventory and each receivable are very short-life assets, in total
there will normally be fairly stable amounts of each that have to be permanently funded.
Therefore, it makes sense to fund most of those assets by long-term capital and to use
short-term capital to fund seasonal peaks. One of the problems with short-term finance is
that is comes to an end quickly and if finance is still needed then more has to be
renegotiated. Long-term capital is either permanent or comes up for renewal relatively
rarely.

Mature companies

Once a company has existed profitably for some time and grown in size, additional sources
of finance can become available, in particular:
 public equity
 public debt
 bonds.

Public equity

Some stock exchanges provide different sorts of listings. For example:

 London Stock Exchange: The Main Market and the Alternative Investment Market (AIM).
AIM focuses on helping smaller and growing companies raise the capital they need for
expansion.
 NASDAQ: This is an electronic stock exchange in the US and has the NASDAQ National
Market for large, established companies (market value at least $70m) and the NASDAQ
Capital market for smaller companies.

AIM Main market

No trading record
Normally a three-year record required
requirement

No minimum prescribed
level 25% of shares have to be in public hands
in public hands

No minimum market A minimum capitalisation (£700,000, set

capitalisation deliberately low)

An initial public offering is the first occasion on which shares are offered to the public. A
company seeking a listing has to issue a prospectus, which is a legal document describing
 the shares being offered for sale, and including matters such as a description of the
company's business, recent financial statements, details of the directors and their
remuneration.

Shares can be listed via:

 An offer for sale at fixed price: a company offers shares for sale at a fixed price directly to
the public, for example in newspaper advertisements. In fact, the shares are usually first
sold to an issuing house which sells them on to the public.
 An offer for sale by tender: investors are asked to bid, and all who bid more than the
minimum price that all shares can be sold at will be sold shares at that minimum price.
 A placing: shares are offered to a selection of institutional investors. Because less
publicity is needed, these are cheaper than offers for sale and are therefore suited to
smaller IPOs.
 An introduction: this is rare and only happens when shares are already widely held
publically. No money is raised.

Subsequent issues of equity will be rights issues where existing shareholders are offered
new shares in proportion to existing holdings. The shares are offered at below their
current market value to make the offer look attractive, but in theory, no matter at what
price right issues are made and no matter whether shareholders take up or dispose of their
rights, shareholders will end up neither better nor worse off. Wealth is neither created nor
destroyed just by moving money from a shareholder’s bank account to the company’s.

Gaining a listing opens up a huge source of potential new capital. However, with listing
come increased scrutiny, comment and responsibility. Although this will help the standing
and respectability of the company the founders of the company, having been used to
running their own company in their own way, often resent outside interference – even
though that is to be expected now that ownership of their shares is more widespread.

Public debt

This refers to quoted bonds or loan notes: instruments paying a coupon rate of interest and
whose market value can fluctuate. Usually the bonds will be secured either by fixed or
floating charges and can be redeemable or irredeemable. Well- secured bonds in
companies that are not too highly geared are low risk investments and bonds holders will
therefore require relatively low returns. The cost of the bonds to the borrower falls even
more after tax relief on interest is taken into account.

Convertible bonds
 Convertibles start life as loan capital and can later be converted, at the lenders’ option, into
shares. They are a clever and useful device, particularly for younger companies, because:

 In the very early days of the company’s life, investors might not want to risk investing in
equity, but might be prepared to invest in the less risky debentures. However, debentures
never hold out the promise of massive capital gains.
 If the company does not do so well, the investors can stick with their safe convertible loan
stock.
 If the company does well, the investors can opt to convert and to take part in the capital
growth of the shares.

Convertible bonds therefore offer a ‘wait and see’ approach. Because they allow later entry
to what might turn out to be a growth stock, the initial interest rate they have to offer is
lower than with pure bonds – and that’s good for the company that is borrowing.

Gearing

When deciding what sorts of finance to issue, companies must always bear in mind the
average cost of their finance. This article does not go into gearing considerations in any
detail except to point out that some borrowing can lower the cost of capital.

If there is no borrowing, all finance will be equity and that is high cost to compensate for the
high risk attaching to it. Debt finance is cheap because it has lower risk and enjoys tax relief
on interest.

Therefore, introducing some debt into the finance mix begins to pull down the average cost
of capital. However, at very high levels of gearing the increased risk of default pushes up
both the cost of debt and the cost of equity, and the average cost of finance starts to rise.
Somewhere, there is an optimum gearing ratio with the cheapest mix of finance.

The previous paragraph briefly described the traditional theory of gearing. Modigliani and
Miller suggested an alternative view, but the very precise conditions and restrictions their
theories require are not often found in practice.

Ken Garrett is a freelance lecturer and author

Investment appraisal is one of the eight core topics within Financial Management and it is
a topic which has been well represented in the exam. The methods of investment appraisal
are payback, accounting rate of return and the discounted cash flow methods of net
present value (NPV) and internal rate of return (IRR). For each of these methods students
must ensure that they can define it, make the necessary calculations and discuss both the
advantages and disadvantages.

The most important of these methods, both in the real world and in the exam, is NPV. A key
issue in the Financial Management syllabus is that students start their studies with no
knowledge of discounting but are very rapidly having to deal with relatively advanced NPV
calculations which may include problems such as inflation, taxation, working capital and
relevant/irrelevant cash flows. These advanced NPV or indeed IRR calculations have
formed the basis for very many past exam questions.

The aim of this article is to briefly discuss these potential problem areas and then work a
comprehensive example which builds them all in. Technically the example is probably
harder than any exam question is likely to be. However, it demonstrates as many of the
issues that students might face as is possible. Exam questions, on the other hand, will be
in a scenario format and hence finding the information required may be more difficult than
in the example shown.

The problem areas

Inflation

Students must be aware of the two different methods of dealing with inflation and when
they should be used. The money method is where inflation is included in both the cash flow
forecast and the discount rate used while the real method is where inflation is ignored in
both the cash flow forecast and the discount rate. The money method should be used as
soon as a question has cash flows inflating at different rates or where a question involves
both tax and inflation. Because of this the money method is commonly required. Students
must ensure that they can use the Fisher formula provided to calculate a money cost of
capital or indeed a real cost of capital for discounting purposes. They must also be able to
distinguish between a general inflation rate which will impact on the money cost of capital
and potentially some cash flows and a specific inflation rate which only applies to
particular cash flows.

Taxation

Building taxation into a discounted cash flow answer involves dealing with ‘the good the
bad and the ugly’! The good news with taxation is that tax relief is often granted on the
investment in assets which leads to tax saving cash flows. The bad news is that where a
project makes net revenue cash inflows the tax authorities will want to take a share of
them. The ugly issue is the timing of these cash flows as this is an area which often causes
confusion.

Working capital

The key issue that must be remembered here is that an increase in working capital is a cash
outflow. If a company needs to buy more inventories, for example, there will be a cash cost.
Equally a decrease in working capital is a cash inflow. Hence at the end of a project when
the working capital invested in that project is no longer required a cash inflow will arise.
Students must recognise that it is the change in working capital that is the cash flow. There
is often concern amongst students that the inventories purchased last year will have been
sold and hence must be replaced. However, to the extent the items have been sold their
cost will be reflected elsewhere in the cash flow table.

Relevant/irrelevant cashflows

This problem is rarely a big issue in Financial Management as students have been
examined on this topic previously. However students should remember the ‘Golden Rule’
which states that to be included in a cash flow table an item must be a future, incremental
cash flow. Irrelevant items to look out for are sunk costs such as amounts already spent
on research and apportioned or allocated fixed costs. Equally all financing costs should be
ignored as the cost of financing is accounted for in the discount rate used.

Fixed appraisal horizon

Sometimes directors of a company will only appraise projects across a set time horizon,
which will not be the full length of the project and so does not include all of the cash flows.
If a four-year time horizon is used, then the tax effects of the fourth year must be taken into
account, even if tax is paid in arrears and the cash flows arise in the fifth year.

Having reminded you of the potential problem areas let us now consider a comprehensive
example:

CBS Co

CBS Co is considering a new investment which would start immediately and last four years.
The company has gathered the following information:
Asset cost – $160,000

Annual sales are expected to be 30,000 units in Years 1 and 2 and will then fall by 5,000 units
per year in both Years 3 and 4. The selling price in first-year terms is expected to be $4.40
per unit and this is then expected to inflate by 3% per annum. The variable costs are
expected to be $0.70 per unit in current terms and the incremental fixed costs in the first
year are expected to be $0.30 per unit in current terms. Both of these costs are expected to
inflate at 5% per annum.

The asset is expected to have a residual value (RV) of $40,000 in money terms.

The project will require working capital investment equal to 10% of the expected sales
revenue. This investment must be in place at the start of each year.

Corporation tax is 30% per annum and is paid one year in arrears. 25% reducing balance
writing-down allowances are available on the asset cost.

General inflation is 4% and the real cost of capital is 7.7%

$12,000 has already been spent on initial research.

Required: Calculate the NPV of the proposed investment.

Solution and explanatory notes:

Many students fall into the trap of starting the cash flow table too quickly. Initially there are
a number of workings or ‘thinkings’ that should be carried out. These workings can
generally be carried out in any order. Once they are completed it will be possible to
construct the cash flow table quickly and accurately. Before going further students must
understand the difference between a ‘T’ and a Year. A ‘T’ is a point in time and hence T0 is
now and T1 is in one year’s time. A Year is a period of time and hence Year 1 is the period
between T0 and T1 and Year 2 is the period between T1 and T2. Please note T1 is both the end
of Year 1 and the start of Year 2.

Working 1 – Inflation

As the question involves both tax and inflation and has different inflation rates the money
method must be used. Hence the cash flows in the cash flow table must be inflated and the
discounting should then be carried out using a money cost of capital. As a money cost of
capital is not given it must be calculated using the Fisher formula: (1 + i) = (1 + 0.077) x (1 +
0.04) = 1.12 Therefore, ‘i’ the money cost of capital is 0.12 or 12%
Note: The real rate (r) of 7.7% and the general inflation rate (h) of 4% must be expressed as
decimals when using the Fisher formula.

Working 2 – Tax benefits on tax allowable depreciation (TAD)

The examiner’s normal assumption is that an asset is bought at the start of the first year of
the project and, hence, the first TAD is available for Year 1.

The allowance and tax saving for Year 1 will be calculated at the end of Year 1 which is T1 and
as tax is paid one year in arrears the timing of the cash flow will be one year later which is
T2.

Rounding is a key technique in your exam as it saves time and by keeping the numbers
simple fewer mistakes will be made. Here it has been decided to round in thousands and
use one decimal place.

Students must ensure that they can calculate tax savings using different tax regimes. For
instance the next problem you face may have tax allowances granted on a straight-line
basis and the tax could be payable immediately at each year end.

Working 3 – Working capital (WC)

Notes:
As the investment in working capital is based on the expected sales revenue this has to be
calculated first. Please note how the price per unit was given in first-year terms and hence
that figure has been used for Year 1. In the following years the forecast inflation has been
included. You should note the cumulative nature of inflation.

The working capital need is simply calculated as the stated % of sales revenue. When
calculating the working capital cash flows it is the change in the working capital need which
is the cash flow. Hence for Year 1 the need is 13.2 and as nothing has previously been
invested the cash flow is an outflow of 13.2. In Year 2 the need has risen to 13.6 but as 13.2
has already been invested the cash flow is just an outflow of 0.4 – the increase in the need.
In Years 3 and 4 the need decreases and hence cash inflows arise.

As the working capital is required at the start of each year the cash flow for Year 1 will occur
at T0 and the cash flow for Year 2 will occur at T1, etc. Finally at the end of the project any
remaining investment in working capital is no longer required and generates a further
cash inflow at T4. The sum of the working capital cash flow column should total zero as
anything invested is finally released and turns back into cash.

Other potential workings:

A working could be shown for the variable and fixed costs. However, this can be time
consuming and enough detail can often be shown on the face of the cash flow table to show
your marker what your thought process has been.

The $12,000 of initial research cost is ignored as it has already been spent. Hence it is a sunk
cost and is not relevant to the analysis of the future project.
 The cash flow table

Click to enlarge

It is estimated that the project has a positive NPV of $88,300 and hence it should be
accepted as it will add to shareholder wealth.

Notes:

1. A cash flow table should always be started on a new page as it will then hopefully fit on the one page.
This avoids the need to transfer data over a page break which inevitably leads to errors. As tax is
paid one year in arrears the cash flow table is taken to T5 even though it is only a four-year project.
A cash flow table should be split into a ‘Revenue’ section and a ‘Capital’ section. In the ‘Revenue’
section all the taxable revenues and tax allowable costs are shown. In the ‘Capital’ section all the
cash flows relating to the asset purchase and other cash flows which have no impact on tax are
shown. Students should ensure that they put brackets around negative cash flows as otherwise
negative items may be treated as if they are positive when the cash flows are totalled.

2. The annual sales revenue figures are brought forward from Working 3. Note the normal
assumption that the revenue for a year arises at the end of the year – hence the revenue for Year 1
is shown at T1. This assumption also applies to the variable and fixed costs.

3. The variable costs for each year are based on the sales units for the year, the price per unit and the
inflation rate for costs. Note that as the cost was given in current terms, which is as at T0 and the
first costs are recorded at T1, the inflation has to be accounted for immediately. You should contrast
this with the inflation of the sales revenue in Working 3.

4. The fixed costs are relevant as they are said to be incremental. The cost per unit for the first year
has been given and this is multiplied by the forecast sales in Year 1 to give the total incremental fixed
costs. Like the variable costs the cost per unit was given in current terms and hence inflation must
be accounted for immediately. From Year 1 onwards the fixed costs have continued to be inflated by
the relevant inflation rate of 5%. You must remember that fixed costs are fixed and do not change as
 the activity level changes. In this way you will avoid the common error which is to treat the fixed
costs as though they were variable.

5. The tax is calculated at 30% of the net revenue cash flows. As tax is paid one year in arrears the tax
for Year 1 which is calculated at the end of Year 1 (T1) will become a cash flow at T2. This pattern
continues in the following years.

6. The residual value was given in money terms and hence already reflects the impact of inflation. Had
the value been given in current terms and no specific inflation rate was indicated then the logical
approach would be to inflate at the general inflation rate. The normal assumption is that the asset
is disposed of on the last day of the last year of the project and hence the cash inflow is shown at T4.

7. The tax benefits on TAD are brought forward from Working 2. Please be careful to show them in the
correct column given their respective timings. Also please remember that these are the ‘good
news of tax’ and so are cash inflows.

8. The working capital cash flows are brought forward from Working 3. They are shown in the ‘Capital’
section as they do not have any tax impact. If they were put in the ‘Revenue’ section they would
change the net revenue cash flows and this would impact on the tax calculated which would be
incorrect.

9. The discount factors are found in the tables provided. The 12% rate is the suitable money cost of
capital calculated in Working 1.

10. The present values are found by multiplying the total net money cash flows by the discount factors
shown.

11. The NPV is simply the sum of the present values calculated. You should always comment on what
the NPV calculated is indicating about the viability of the project.

As indicated previously this is a very comprehensive example which includes many of the
major potential problems you could face. I would not expect any exam question to be as
complex but all the problems shown in this example have been examined in the past and
will I am sure be examined again in the future. Those most able to deal with these issues
will be those who are most successful in the exam.

William Parrott is a lecturer at Kaplan Financial

 This article has been updated to reflect the knowledge of basis risk that students are
expected to have for Financial Management.

Increasingly, many businesses have dealings in foreign currencies and, unless exchange
rates are fixed with respect to one another, this introduces risk. There are three main types
of currency risk as detailed below.

Economic risk. The source of economic risk is the change in the competitive strength of
imports and exports. For example, if a company is exporting (let’s say from the UK to a
eurozone country) and the euro weakens from say €/£1.1 to €/£1.3 (getting more euros per
pound sterling implies that the euro is less valuable, so weaker) any exports from the UK
will be more expensive when priced in euros. So goods where the UK price is £100 will cost
€130 instead of €110, making those goods less competitive in the European market.

Similarly, goods imported from Europe will be cheaper in sterling than they had been, so
those goods will have become more competitive in the UK market. Note that a company
can, therefore, experience economic risk even if it has no overt dealings with overseas
countries. If competing imports could become cheaper you are suffering risk arising from
currency rate movements.

Doing something to mitigate economic risk can be difficult – especially for small
companies with limited international dealings. In general, the following approaches might
provide some help:

 Try to export or import from more than one currency zone and hope that the zones don’t all
move together, or if they do, at least to the same extent. For example, over the six months
14 January 2010 to 14 June 2010 the €/US$ exchange rate moved from about €/US$0.6867
to €/US$ 0.8164. This meant that the € had weakened relative to the US$ (or the US$
strengthened relative to the €) by 19%. This made it less competitive for US manufacturers
to export to a eurozone country. If, in the same period, the £/US$ exchange rate moved
from £/US$0.6263 to £/US$0.6783, a strengthening of the US$ relative to £ of only about
8%. Trade from the US to the UK would not have been so badly affected.
 Make your goods in the country you sell them. Although raw materials might still be
imported and affected by exchange rates, other expenses (such as wages) are in the local
currency and not subject to exchange rate movements.

Translation risk. This affects companies with foreign subsidiaries. If the subsidiary is in a
country whose currency weakens, the subsidiary’s assets will be less valuable in the
consolidated accounts. Usually, this effect is of little real importance to the holding
company because it does not affect its day-to-day cash flows. However, it would be
important if the holding company wanted to sell the subsidiary and remit the proceeds. It
also becomes important if the subsidiary pays dividends. However, the term ‘translation
risk’ is usually reserved for consolidation effects.

It can be partially overcome by funding the foreign subsidiary using a foreign loan. For
example, take a US subsidiary that has been set up by its holding company providing equity
finance. Its statement of financial position would look something like this:

US$m

Non-current assets 1.5

Current assets 0.5

2.0

Equity 2.0

If the US$ weakens then all the US$2m total assets become less valuable.

However, if the subsidiary were set up using 50% equity and 50% US$ borrowings, its
statement of financial position would look like this:
 US$m

Non-current assets 1.5

Current assets 0.5

2.0

$ Loan 1.0

Equity 1.0

2.0

The holding company’s investment is only US$1m and the company’s net assets in US$ are
only US$1m. If the US$ weakens, only the net US$1m becomes less valuable.

Transaction risk. This arises when a company is importing or exporting. If the exchange
rate moves between agreeing the contract in a foreign currency and paying or receiving the
cash, the amount of home currency paid or received will alter, making those future cash
flows uncertain. For example, in June a UK company agrees to sell an export to Australia
for 100,000 Australian $ (A$), payable in three months. The exchange rate at the date of the
contract is A$/£1.80 so the company is expecting to receive 100,000/1.8 = £55,556. If,
however, the A$ weakened over the three months to become worth only A$/£2.00, then the
amount received would be worth only £50,000.

Of course, if the A$ strengthened over the three months, more than £55,556 would be
received.

It is important to note that transaction risk management is not mainly concerned with
achieving the most favourable cash flow: it is mainly aimed at achieving a definite cash
flow. Only then can proper planning be undertaken.

Dealing with transaction risks

Assuming that the business does not want to tolerate exchange rate risks (and that could
be a reasonable choice for small transactions), transaction risk can be treated in the
following ways:

1. Invoice. Arrange for the contract and the invoice to be in your own currency. This will shift
all exchange risk from you onto the other party. Of course, who bears the risk will be a
matter of negotiation, along with price and other payment terms. If you are very keen to get
a sale to a foreign customer you might have to invoice in their currency.

2. Netting. If you owe your Japanese supplier ¥1m, and another Japanese company owes
your Japanese subsidiary ¥1.1m, then by netting off group currency flows your net exposure
is only for ¥0.1m. This will really only work effectively when there are many sales and
purchases in the foreign currency. It would not be feasible if the transactions were
separated by many months. Bilateral netting is where two companies in the same group
cooperate as explained above; multilateral netting is where many companies in the group
liaise with the group’s treasury department to achieve netting where possible.

3. Matching. If you have a sales transaction with one foreign customer, and then a purchase
transaction with another (but both parties operate with the same foreign currency) then
this can be efficiently dealt with by opening a foreign currency bank account. For example:

1 November: should receive US$2m from US customer

15 November: must pay US$1.9m to US supplier.

Deposit the US$2m in a US$ bank account and simply pay the supplier from that. That
leaves only US$0.1m of exposure to currency fluctuations. Usually, for matching to work
well, either specific matches are spotted (as above) or there have to be many import and
export transactions to give opportunities for matching. Matching would not be feasible if
you received US$2m in November, but didn’t have to pay US$1.9m until the following May.
There aren’t many businesses that can simply keep money in a foreign currency bank
account for months on end.

4. Leading and lagging. Let’s imagine you are planning to go to Spain and you believe that
the euro will strengthen against your own currency. It might be wise for you to change your
spending money into euros now. That would be ‘leading’ because you are changing your
money in advance of when you really need to. Of course, the euro might weaken and then
you’ll want to kick yourself, but remember: managing transaction risk is not about
maximising your income or minimising your expenditure, it is about knowing for certain
what the transaction will cost in your own currency. Let’s say, however, that you believe
that the euro is going to weaken. Then you would not change your money until the last
possible moment. That would be ‘lagging’, delaying the transaction. Note, however, that this
does not reduce your risk. The euro could suddenly strengthen and your holiday would turn
out to be unexpectedly expensive. Lagging does not reduce risk because you still do not
know your costs. Lagging is simply taking a gamble that your hunch about the weakening
euro is correct.

5. Forward exchange contracts. A forward exchange contract is a binding agreement to

sell (deliver) or buy an agreed amount of currency at a specified time in the future at an
agreed exchange rate (the forward rate).

In practice there are various ways in which the relationship between a current exchange
rate (spot rate) and the forward rate can be described. Sometimes it is given as an
adjustment to be made to the spot rate; in the F9 exam, for example, the forward rates are
quoted directly.

However, for each spot and forward there is always a pair of rates given. For example:

Spot €/£ 1.2022 – 1.2028

Three-month forward rate €/£ 1.2014 – 1.2026

One of each pair is used if you are going to change sterling to euros. So £100 would be
changed now for either €120.28 or €120.22. Guess which rate the bank will give you! You will
always be given the exchange rate which leaves you less well off, so here you will be given
a rate of 1.2022, if changing £ to euros now, or 1.2014 if using a forward contract. Once you
have decided which direction one rate is for, the other rate is used when converting the
other way. So:

€ to £ £ to €

Spot €/£ 1.2028 1.2022

Three month forward rate €/£ 1.2026 1.2014

So, let’s assume you are a manufacturer in Italy, exporting to the UK. You have agreed that
the sale is worth £500,000, to be received in three months, and wish to hedge (reduce your
risk) against currency movements.

In three months you will want to change £ to € and you can enter a binding agreement with
a bank that in three months you will deliver £500,000 and that the bank will give you
£500,000 x 1.2014 = €600,700 in return. That rate, and the number of euros you will receive,
is now guaranteed irrespective of what the spot rate is at the time. Of course if the £ had
strengthened against the € (say to €/£ = 1.5) you might feel aggrieved as you could have
then received €750,000, but income maximisation is not the point of hedging: its point is to
provide certainty and you can now put €600,700 into your cash flow forecast with
confidence.

However, there remains here one lingering risk: what happens if the sale falls through
after arranging the forward contract? We are not necessarily talking about a bad debt here
as you might not have sent the goods, but you have still entered into a binding contract to
deliver £500,000 to your bank in three months’ time. The bank will expect you to fulfil that
commitment, and so what you might have to do is get enough € to buy £500,000 using the
spot rate, use this to meet your forward contract, receiving €600,700 back. This process is
known as ‘closing out’, and you could win or lose on it depending on the spot rate at the time.

6. Money market hedging. Let’s say that you were a UK manufacturer exporting to the US
and in three months you are due to receive US$2m. You would suffer no currency risk if that
US$2m could be used then to settle a US$2m liability; that would be matching the currency
inflow and outflow. However, you don’t have a US$2m liability to settle then – so create one
that can soak up the US$. You can create a US$ liability by borrowing US$ now and then
repaying that in three months with the US$ receipt. So the plan is:

To work out how many US$ need to be borrowed now, you need to know US$ interest rates.
For example, the US$ three month interest rate might be quoted as: 0.54% – 0.66%.

It is important to understand that, although this might be described as a ‘three month rate’
it is always quoted as an annualised rate. One rate is what you would earn in interest if the
money was on deposit, and the other is the rate you would pay on a loan. Again, no prizes
for guessing which is which: you will always be charged more than you earn. On the US$
loan we will be charged 0.66% pa for three months and the loan has to grow to become
US$2m in that time. So, If X is borrowed now and three months’ interest is added:

X(1 + 0.66%/4) = 2,000,000

X = $1,996,705

This can be changed now from US$ to £ at the current spot rate, say US$/£ 1.4701, to give
£1,358,210.

This amount of sterling is certain: we have it now and it does not matter what happens to
the exchange rate in the future. Ticking away in the background is the US$ loan which will
amount to US$2m in three months and which can then be repaid by the US$2m we hope to
receive from our customer. That is the hedging process finished because exchange rate
risk has been eliminated.

Why might this somewhat complicated process be used instead of a simple forward
contract? Well, one advantage is that we have our money now rather than having to wait
three months for it. If we have the money now we can use it now – or at least place it in a
sterling deposit account for three months. This raises an important issue when we come to
compare amounts received under forward contracts and money market hedges. If these
amounts are received at different times they cannot be directly compared, because
receiving money earlier is better than receiving it later. To compare amounts under both
methods we should see what the amount received now would become if deposited for
three months. So, if the sterling three month deposit rate were 1.2%, then placing £1,358,210
on deposit for three months would result in:

£1,358,210 (1 + 1.2%/4) = £1,362,285

It is this amount that should be compared to any proceeds under a forward contract.

The example above dealt with hedging the receipt of an amount of foreign currency in the
future. If foreign currency has to be paid in the future, then what the company can do is
change money into sufficient foreign currency now and place it on deposit so that it will
grow to become the required amount by the right time. Because the money is changed now
at the spot rate, the transaction is immune from future changes in the exchange rate.

Further methods of exchange risk hedging

There are two other methods of exchange risk hedging which you are required to know
about, but you will not be required solve numerical questions relating to these methods.
They involve the use of derivatives: financial instruments whose value derives from the
value of something else – like an exchange rate.

1. Currency futures. Simply think of these as items you can buy and sell on the futures
market and whose price will closely follow the exchange rate. Let’s say that a US exporter
is expecting to receive €5m in three months’ time and that the current exchange rate is
US$/€1.24. Assume that this rate is also the price of US$/€ futures. The US exporter will
fear that the exchange rate will weaken over the three months, say to US$/€1.10 (that is
fewer dollars for a euro). If that happened, then the market price of the future would decline
too, to around 1.1. The exporter could arrange to make a compensating profit on buying and
selling futures: sell now at 1.24 and buy later at 1.10. Therefore, any loss made on the main
the currency transaction is offset by the profit made on the futures contract.

This approach allows hedging to be carried out using a market mechanism rather than
entering into the individually tailored contracts that the forward contracts and money
market hedges require. However, this mechanism does not offer anything fundamentally
new.

Basis risk can arise for both interest rate and exchange rate hedging through the use of
futures. Futures contracts will suffer from basis risk if the value of the futures contract
does not match the underlying exposure. This occurs when changes in exchange or
interest rates are not exactly correlated with changes in the futures prices.

Note that another form of basis risk also exists as part of interest rate risk. In this case
basis risk exists where a company has matched its assets and liabilities with a variable
rate of interest, but the variable rates are set with reference to different benchmarks. For
example, deposits may be linked to the one-month LIBOR rate, but borrowings may be
based on the 12-month LIBOR rate. It is unlikely that these rates will move perfectly in line
with each other and therefore this is a source of interest rate risk.

2. Options. Options are radically different. They give the holder the right, but not the
obligation, to buy or sell a given amount of currency at a fixed exchange rate (the exercise
price) in the future (if you remember, forward contracts were binding). The right to sell a
currency at a set rate is a put option (think: you ‘put’ something up for sale); the right to buy
the currency at a set rate is a call option.

Suppose a UK exporter is expecting to be paid US$1m for a piece of machinery to be

delivered in 90 days. If the £ strengthens against the US$ the UK firm will lose money, as it
will receive fewer £ for the US$1m. However, if the £ weakens against the US$, then the UK
company will gain additional money. Say that the current rate is US$/£1.40 and that the
exporter will get particularly concerned if the rate moved beyond US$/£1.50. The company
can buy £ call options at an exercise price of US$/£ = 1.50, giving it the right to buy £ at
US$1.50/£. If the dollar weakens beyond US$/£1.50, the company can exercise the option
thereby guaranteeing at least £666,667. If the US$ stays stronger – or even strengthens to,
say, US$/£1.20, the company can let the option lapse (ignore it) and convert at 1.20, to give
£833,333.

This seems too good to be true as the exporter is insulated from large losses but can still
make gains. But there’s nothing for nothing in the world of finance and to buy the options
the exporter has to pay an up-front, non-returnable premium.

Options can be regarded just like an insurance policy on your house. If your house doesn’t
burn down you don’t call on the insurance, but neither do you get the premium back. If there
is a disaster the insurance should prevent massive losses. Options are also useful if you
are not sure about a cash flow. For example, say you are bidding for a contract with a
foreign customer. You don’t know if you will win or not, so don’t know if you will have foreign
earnings, but want to make sure that your bid price will not be eroded by currency
movements. In those circumstances, an option can be taken out and used if necessary or
ignored if you do not win the contract or currency movements are favourable.

Ken Garrett is a freelance author and lecturer

 A fundamental part of financial management is investment appraisal: into which long-term
projects should a company put money?

Discounted cash flow techniques (DCFs), and in particular net present value (NPV), are
generally accepted as the best ways of appraising projects. In DCF, future cash flows are
discounted so that allowance is made for the time value of money. Two types of estimate
are needed:

1. The future cash flows relevant to the project.

2. The discount rate to apply.

This article looks at how a suitable discount rate can be calculated.

The cost of equity

The cost of equity is the relationship between the amount of equity capital that can be raised
and the rewards expected by shareholders in exchange for their capital. The cost of equity
can be estimated in two ways:

1. The dividend growth model

Measure the share price (capital that could be raised) and the dividends (rewards to
shareholders). The dividend growth model can then be used to estimate the cost of equity,
and this model can take into account the dividend growth rate. The formulae sheet for
the Financial Management exam will give the following formulae:

P0 = D0(1 + g) / (re – g)

re = D0(1 + g) + g / P0

The first formula predicts the current ex-dividend market price of a share (P0) where:

D0 = the current dividend (whether just paid or just about to be paid)

g = the expected dividend future growth rate
re = the cost of equity.

Note that the top line (D0(1 + g)) is the dividend expected in one year’s time.
For a listed company, all the terms on the right of the equation are known, or can be
estimated. In the absence of other data, the future dividend growth rate is assumed to
continue at the recent historical growth rate. Example 1 sets out an example of how to
calculate re.

Example 1
The dividend just about to be paid by a company is $0.24. The current market price of the
share is $2.76 cum div. The historical dividend growth rate, which is expected to continue in
the future, is 5%.

What is the estimated cost of capital?

Solution

re = D0(1 + g)/P0 + g = 0.24(1 + 0.05)/2.52 + 0.05 = 15%

P0 must be the ex-dividend market price, but we have been supplied with the cum-dividend
price. The ex-dividend market price is calculated as the cum-dividend market price less
the impending dividend. So here:

P0 = 2.76 – 0.24 = 2.52

The cost of equity is, therefore, given by:

re = D0(1 + g) / P0 + g

2. The capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) equation quoted in the formula sheet is: E(ri) = Rf +
ßi(E(rm) – Rf)

Where:
E(ri) = the return from the investment
Rf = the risk free rate of return
ßi = the beta value of the investment, a measure of the systematic risk of the investment
E(rm) = the return from the market

Essentially, the equation is saying that the required return depends on the risk of an
investment. The starting point for the rate of return is the risk free rate (R f), to which you
need to add a premium relating to the risk. The size of that premium is determined by the
answers to the following:
 What is the premium the market currently gives over the risk free rate (E(r m) – Rf)? This is
a reference point for risk: how much does the stock market, as a whole, return in excess of
the risk free rate?
 How risky is the specific investment compared to the market as a whole? This is the ‘beta’
of the investment (ßi). If ßi is 1, the investment has the same risk as the market overall. If ßi >
1, the investment is riskier (more volatile) than the market and investors should demand a
higher return than the market return to compensate for the additional risk. If ß i < 1, the
investment is less risky than the market and investors would be satisfied with a lower
return than the market return.

Example 2
Risk free rate = 5%
Market return = 14%

What returns should be required from investments whose beta values are:
(i) 1
(ii) 2
(iii) 0.5

E(ri) = Rf +ßi(E(rm) – Rf)

(i) E(ri) = 5 + 1(14 – 5) = 14%

The return required from an investment with the same risk as the market, which is simply
the market return.

(ii) E(ri) = 5 + 2(14 – 5) = 23%

The return required from an investment with twice the risk as the market. A higher return
than that given by the market is therefore required.

(iii) E(ri) = 5 + 0.5(14 – 5) = 9.5%

The return required from an investment with half the risk as the market. A lower return
than that given by the market is therefore required.

Comparing the dividend growth model and CAPM

The dividend growth model allows the cost of equity to be calculated using empirical values
readily available for listed companies. Measure the dividends, estimate their growth
(usually based on historical growth), and measure the market value of the share (though
some care is needed as share values are often very volatile). Put these amounts into the
formula and you have an estimate of the cost of equity.
 However, the model gives no explanation as to why different shares have different costs of
equity. Why might one share have a cost of equity of 15% and another of 20%? The reason
that different shares have different rates of return is that they have different risks, but this
is not made explicit by the dividend growth model. That model simply measures what’s
there without offering an explanation. Note particularly that a business cannot alter its
cost of equity by changing its dividends. The equation:

re = D0(1 + g) / P0 + g

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

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

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

Note also that both of these approaches give you the cost of equity. They do not give you the
weighted average cost of capital other than in the very special circumstances when a
company has only equity in its capital structure.

What contributes to the risk suffered by equity shareholders, hence contributing

to the beta value?

There are two main components of the risk suffered by equity shareholders:

1. The nature of the business. Businesses that provide capital goods are expected to show
relatively risky behaviour because capital expenditure can be deferred in a recession and
these companies’ returns will therefore be volatile. You would expect ßi > 1 for such
companies. On the other hand, a supermarket business might be expected to show less
risk than average because people have to eat, even during recessions. You would expect
ßi < 1 for such companies as they offer relatively stable returns.
2. The level of gearing. In an ungeared company (ie one without borrowing), there is a straight
relationship between profits from operations and earnings available to shareholders.
Once gearing, and therefore interest, is introduced, the amounts available to ordinary
shareholders become more volatile. Look at Example 3 below.

Example 3: level of gearing

This shows two companies, one ungeared, one geared, which carry on exactly the same
type of business. Between State 1 and State 2, their profits from operations double. The
amounts available to equity shareholders in the ungeared company also double, so equity
shareholders experience a risk or volatility which arises purely from the company’s
operations. However, in the geared company, while amounts available from operations
double, the amounts available to equity shareholders increase by a factor of 2.66. The risk
faced by those shareholders therefore arises from two sources: risk inherent in the
company’s operations, plus risk introduced by gearing.

Therefore, the rate of return required by shareholders (the cost of equity) will also be
affected by two factors:

1. The nature of the company’s operations.

2. The amount of gearing in the company.

When we talk about, or calculate, the ‘cost of equity’ we have to be clear what we mean. Is
this a cost which reflects only the business risk, or is it a cost which reflects the business
risk plus the gearing risk?

When using the dividend growth model, you measure what you measure. In other words, if
you use the dividends, dividend growth and share price of a company which has no gearing,
you will inevitably measure the ungeared cost of equity. That’s what shareholders are
happy with in this environment. If, however, these quantities are derived from a geared
company, you will inevitably measure the geared company’s cost of equity.

Similarly, published beta values are derived from observing how specific equity returns
vary as market returns vary, to see if a share’s return is more or less volatile than the
 market. Once again, you measure what you measure. If the company being observed has
no gearing in it, the beta value obtained depends only on the type of business being carried
on. If, however, the company has gearing within it, the beta value will reflect not only the
risk arising from the company, but also the risk arising from gearing.

Ken Garrett is a freelance writer and lecturer

Project appraisal 1 – pure equity finance

So now we have two ways of estimating the cost of equity (the return required by
shareholders). Can this measurement of a company’s cost of equity be used as the discount
rate with which to appraise capital investments? Yes it can, but only if certain conditions
are met:

1. A new investment can be appraised using the cost of equity only if equity alone is being used to fund
the new investment. If a mix of funds is being used to fund a new investment, then the investment
should be appraised using the cost of the mix of funds, not just the cost of equity.

2. The gearing does not change. If the gearing changes, the cost of equity will change and its current
value would no longer be applicable.

3. The nature of the business is unchanged. The new project must be ‘more of the same’ so that the
risk arising from business activities is unchanged. If the business risk did change, once again the
old cost of equity would no longer be applicable.

These conditions are very restrictive and would apply only when an all-equity company
issued more equity to do more of the same type of activity. Our approach needs to be
developed if we are going to be able to appraise projects in more general environments.

In particular, we have to be able to deal with more general sources of finance, not just pure
equity, and it would also be good if we could deal with projects which have different risk
characteristics from existing activities.

Project appraisal 2 – same business activities, a mix of funds and constant

gearing

Let us look at appraising a project which uses a mix of funds, but where those funds are
raised so as to maintain the company’s gearing ratio. Remember, where there is a mix of
funds, the funds are regarded as going into a pool of finance and a project is appraised with
reference to the cost of that pool of finance. That cost is the weighted average cost of capital
(WACC). As a preliminary to this discussion, we need briefly to revise how gearing can
affect the various costs of capital, particularly the WACC. The three possibilities are set out
in Example 1.

Example 1

ke = cost of equity; kd = pre-tax cost of debt; Vd = market value debt; Ve = market value equity.
T is the tax rate.
All three versions show that the cost of debt (Kd) is lower than the cost of equity (Ke). This
is because debt is inherently less risky than equity (debt has constant interest; interest is
paid before dividends; debt is often secured on assets; on liquidation creditors are repaid
before equity shareholders). In the third version, cost of debt is further reduced because in
an environment with corporation tax, interest payments enjoy tax relief.

Looking at the three cases in a little more detail:

Conventional theory
When there is only equity, the WACC starts at the cost of equity. As the more expensive
equity finance is replaced by cheaper debt finance, the WACC decreases. However, as
gearing increases further, both debt holders and equity shareholders will perceive more
risk, and their required returns both increase. Inevitably, WACC must increase at some
point. This theory predicts that there is an optimum gearing ratio at which WACC is
minimised.

Modigliani and Miller (M&M) without tax

M&M were able to demonstrate that as gearing increases, the increase in the cost of equity
precisely offsets the effect of more cheap debt so that the WACC remains constant.

Modigliani and Miller (M&M) with tax

Debt, because of tax relief on interest, becomes unassailably cheap as a source of finance.
It becomes so cheap that even though the cost of equity increases, the balance of the
effects is to keep reducing the WACC.

(Note: the M&M diagrams shown in Example 1 hold only for moderate levels of gearing. At
very high levels of gearing, other costs come into play and the WACC can be shown to
increase again – looking rather like the conventional theory.)

Whichever theory you believe, whether there is or isn’t tax, provided the gearing ratio does
not change the WACC will not change. Therefore, if a new project consisting of more
business activities of the same type is to be funded so as to maintain the present gearing
ratio, the current WACC is the appropriate discount rate to use. In the special case of M&M
without tax, you can do anything you like with the gearing ratio as the WACC will remain
constant and will be equal to the ungeared cost of equity.

The condition that gearing is constant does not have to mean that upon every issue of
capital both debt and equity also have to be issued. That would be very expensive in terms
of transaction costs. What it means is that over the long term the gearing ratio will not
change. That would certainly be the company’s ambition if it believed it was already at the
optimum gearing ratio and minimum WACC. Therefore, this year, it might issue equity, the
next debt and so on, so that the gearing and WACC hover around a constant position.

Project appraisal 3 - different business activities, a mix of funds and changing

gearing

Let’s deal with different business activities first. Different activities will have different risk
characteristics and hence any business carrying on those activities will have a different
beta factor. The new funds being put into the new project are subject to the risk inherent in
that project, and so should be discounted at a rate which reflects that risk. The formula:

E(ri) = Rf + ßi(E(rm) – Rf)

predicts the return that equity holders should require from a project with a given risk, as
measured by the beta factor of that activity.

Note that we are doing something quite radical here: CAPM is allowing us to calculate a risk
adjusted return on equity, tailor-made to fit the characteristics of the project being funded.
All projects consist of capital being supplied, being invested and therefore being subject to
risk, but the risk is determined by the nature of the project, not the company undertaking
the project. The existing return on equity of the company that happens to be the vehicle for
the project has become irrelevant.

We can extend this argument as follows. If the company doing the project is irrelevant
there’s no reason why you can’t view the project as being undertaken by a new company
specially set up for that project. The way the project is funded is the way the company is
funded and, in particular, the appropriate discount rate to apply to the project is the WACC
of the company/project, not its cost of equity – which would take into account only one
component of the funding.

So we can calculate the cost of equity component which reflects project risk by using a beta
value appropriate to that risk. The final steps are to adjust the cost of equity to reflect the
gearing and then to calculate the appropriate discount rate, the WACC. The diagrams
shown in Example 1 show (qualitatively) how the rates might move. No matter how
reasonable the conventional theory seems, its big drawback is that it makes no
quantitative predictions. However, the Modigliani and Miller theory does make quantitative
predictions, and when combined with CAPM theory it allows the beta factor to be adjusted
so that it takes into account not only business risk but also financial (gearing) risk. The
formula you need is provided in the exam formula sheet:

Where:
Ve = market value of equity;
Vd= market value of debt;
T = corporation tax rate;
ßa = the asset beta;
ße = the equity beta;
ßd = the debt beta.
ßd, the debt beta, is nearly always assumed to be zero, so the formula simplifies to:

ßa = Ve ße / Ve + Vd (1 – T)

What is meant by ßa (the asset beta), and ße (the equity beta)?

The asset beta is the beta (a measure of risk) which arises from the assets and the
business the company is engaged in. No heed is paid to the gearing. An alternative name for
the asset beta is the ‘ungeared beta’.

The equity beta is the beta which is relevant to the equity shareholders. It takes into account
the business risk and the financial (gearing) risk because equity shareholders’ risk is
affected by both business risk and financial (gearing) risk. An alternative name for the
equity beta is the ‘geared beta’.

Note that the formula shows that if Vd = 0 (ie there is no debt), then the two betas are the
same. If there is debt, the asset beta will always be less than the equity beta because the
latter contains an additional component to account for gearing risk.

The formula is extremely useful as it allows us to predict the beta, and hence the cost of
equity, for any level of gearing. Once you have the cost of equity, it is a straightforward
process to calculate the WACC and hence discount the project.

To illustrate the use of CAPM in determining a discount rate, we will work through the
following example, Example 2.

Example 2

Emway Co is a company engaged in road building. Its equity shares have a market value of
$200 million and its 6% irredeemable bonds are valued at par, $50m. The company’s beta
value is 1.3. Its cost of equity is 21.1%. (Note: this figure is quite high in the current economic
situation and is used for illustration purposes. Currently, in a real situation, the cost of
equity would be lower.)

The company is worried about the recession and is considering diversifying into
supermarkets. It has investigated listed supermarkets and found one, Foodoo Co, which
quite closely matches its plans. Foodoo has a beta of 0.9 and the ratio of the market value
of its equity to its debt is 7:5. Emway plans that its new venture would be financed with a
market value of equity to market value of debt ratio of 1:1.
The corporation tax rate is 20%. The risk free rate is 5.5%. The market return is 17.5%.

What discount rate should be used for the evaluation of the new venture?

Solution:

We have information supplied about a company in the right business but with the wrong
gearing for our purposes. To adjust for the gearing we plan to have, we must always go
through a theoretical ungeared company in the same business.

Again the beta supplied to us will be the beta measured in the market, so it will be an equity
(geared) beta. Were Foodoo to be ungeared, its asset beta would be given by:

ßa = Ve ße / Ve + Vd (1 – T)

= (7 x 0.9)/(7 + 5 (1 – 0.2))

= 0.5727

This asset beta (ungeared beta) can now be adjusted to reflect the gearing ratio planned in
the new venture:

0.5727 =1/(1 + 1(1 – 0.2))ße

So the planned ße will be 0.5727 x 1.8 = 1.03

Check that this makes sense. Foodoo has a gearing ratio of 7:5, equity to debt, a current beta
of 0.9, and a cost of equity of 16.30 (calculated from CAPM as 5.5 + 0.9(17.5 – 5.5)). Were
Foodoo ungeared, its beta would be 0.5727, and its cost of equity would be 12.37 (calculated
from CAPM as 5.5 + 0.5727(17.5 - 5.5)).

Emway is planning a supermarket with a gearing ratio of 1:1. This is higher gearing, so the
equity beta must be higher than Foodoo’s 0.9.

To calculate the return required by the suppliers of equity to the new project:

Required return = Risk free rate + ß (Return from market – Risk free rate)
= 5.5 + 1.03 (17.5 – 5.5) = 17.86%

17.86 is the return required by equity holders, but the new venture is being financed by a mix
of debt and equity, and we need to calculate the cost of capital of this pool of finance.

Note that while Financial Management does not require students to undertake
calculations of a project-specific WACC, they are required to understand it from a
theoretical perspective.

The appropriate rate at which to evaluate the project is the WACC of the finance. Again, in
the exam formula sheet you will find a formula for WACC consisting of equity and
irredeemable debt.

Ke = 17.86%

Kd = 6% (from the cost of the debentures already issued by Emway)

WACC = 1/(1+1) x 17.86 + 1/(1+1) x 6 (1 – 0.2) = 11.33%

In terms of the diagram used in Example 1, for Modigliani and Miller with tax, what we have
done for Foodoo’s figures is set out below. We started with information relating to a
supermarket with a gearing ratio of debt:equity of 5:7, and an implied cost of equity of
16.30%. We strip out the gearing effect to arrive at an ungeared cost of equity of 12.37, then
we project this forward to whatever level of gearing we want. In this example, this is a
gearing ratio of 1:1 and this implies a cost of equity of 17.86%.

Finally, we take account of the cheap debt finance that is mixed with this equity finance, by
calculating the WACC of 11.33%. This is the rate which should be used to evaluate the new
supermarket project, funded by debt:equity of 1:1.

Ken Garrett is a freelance author and lecturer

Adopting a rigorous receivables collection system is essential to the ability of a company
to pay its suppliers and employees, and even survive. Even where such a system is adopted
and effective steps are taken to chase late payers, a company may still want to speed up
the collection of cash from its customers.

This article considers two methods a company could adopt in order to speed up the
collection of cash from its customers. Additionally, worked examples show how these
methods can be evaluated in order to decide whether or not they should be adopted given
the circumstances particular to a specific company. This has been a common exam
requirement over the years and, as there is no set approach or formula, students very often
lack the confidence to attempt such questions.

Early settlement discount

An early settlement discount involves a company offering a small percentage discount to

customers who pay within a defined short period. For instance a 1% discount may be offered
to those who pay within 10 days.

The key advantage of offering such discounts is that customers take the discount and pay
earlier than usual, so the company receives the cash sooner. It has also been argued that
by effectively offering a choice of payment terms, the company is likely to satisfy more
customers, and that by encouraging early payment, the risk of bad debts is reduced.

However, such discounts suffer from a number of key problems. First, it is difficult to
decide on suitable discount terms. If the discount is made attractive to customers it is likely
to be too costly to the company, whereas if the discount is not too costly to the company it
is unlikely to be attractive to many customers. Second, the introduction of such a discount
will make the management of the sales ledger more complex and costly to run and is likely
to make the budgeting of receipts from customers more difficult, as the company could not
be sure whether the discount will or will not be taken. The final – and in reality very often
the biggest – problem is that all too often customers will abuse the discount by taking it
despite not paying early. When this occurs, the company is left to decide between spending
time and effort recovering what is often a small amount, or writing the discount off and
encouraging such behaviour. Obviously, neither of these options is attractive.
Example 1
Melvin Co has a turnover of $900,000 (90% of which is on credit) and receivable days are
currently 42 despite the company only offering 30-days’ credit. Melvin Co finances its
receivables using its overdraft which has an annual interest cost of 8% and has a
contribution margin of 30%.

Melvin Co is considering the introduction of an early settlement discount at the same time
as extending their standard credit terms to 50 days. The company would offer customers a
1% discount for payment within 14 days. It is anticipated that 40% of customers will take the
discount, while those that do not take the discount will keep to the new standard credit
terms. As a result of the extended credit terms, credit sales are expected to rise by 10%. Due
to the extra administration involved it is thought that administration costs will rise by
$10,000 per year.

Required
Evaluate whether or not Melvin Co should offer the discount.

Suggested approach
In some questions of this nature it may be worth doing some preliminary calculations. In
this case, the calculation of credit sales and the anticipated increase in sales would be
worth evaluating:

Existing credit sales: $900,000 × 90% = $810,000

Expected increase in credit sales: $810,000 × 10% = $81,000
Revised credit sales: $810,000 + $81,000 = $891,000

Having carried out any preliminary calculations, an annual cost and benefit table should be
constructed and each cost or benefit should be evaluated and put into the table.

The important annual benefit, and always the one that is hardest to calculate, is the annual
finance saving on reduced receivables as the overdraft will have been reduced and hence
an interest saving will arise. I suggest that you leave this calculation to last as it is best to
calculate the other costs and benefits first to obtain the easy marks.

The second benefit to Melvin Co will be the contribution earned on the extra sales. This can
be easily evaluated by multiplying the expected increase in credit sales by the contribution
margin:
$81,000 × 30% = $24,300

The costs to be evaluated are the additional administration cost which is given as $10,000
per year, and the cost of the discount itself. The discount cost is a function of the total credit
sales, the proportion of customers expected to take the discount and the percentage
discount offered:
$891,000 × 40% × 1% = $3,564

The calculations carried out so far are relatively straightforward and can be shown on the
face of the cost and benefit table. Hence, prior to calculating the annual interest saving on
the reduced receivables, the cost and benefit table should be as follows:

Annual benefits $

Finance saving on reduced receivables – see Working 1

Contribution on extra sales – 81,000 × 30% 24,300

Annual costs $

Extra administration costs (10,000)

Discount cost –
891,000 × 40% × 1% (3,564)

Net benefit/(cost) _______

The annual finance saving on the reduced receivables can now be calculated.

Working 1
Existing situation:

Receivable days: Given as 42 days

Receivables: $93,205 (810,000 × 42/365)

Note: remember to use the existing credit sales

Annual finance cost: $7,456 (93,205 × 8%)

Note: receivables have not yet been received, so they make the overdraft higher than it
would otherwise be, and so incur an interest cost.

Revised situation
Receivable days:

35.6 days ((14 × 40%) + (50 × 60%))

Note: the new receivable days are simply an average of the credit period taken by
customers taking the discount, and the credit period taken by those refusing the discount
weighted by the proportion of customers taking and refusing the discount respectively.

Receivables:
$86,903 (891,000 × 35.6/365)

Note: remember to use the revised credit sales. It could be argued that the credit sales
should be reduced by the discount cost, otherwise you are calculating a finance cost on an
amount which will never be collected. However, this adjustment makes little difference so
is often ignored.

Annual finance cost: $6,952 (86,903 × 8%)

Annual finance saving $504 (7,456 – 6,952)

There are often quicker ways to calculate this finance saving. For instance, in this example
the reduction in receivables could have been evaluated and the finance saving could then
have been calculated from this figure:
Reduction in receivables: $6,302 (93,205 – 86,903)
Annual finance saving: $504 (6,302 × 8%)

However, the original approach shown should always work whatever complications may
exist in the question.

Having calculated the annual finance saving, the annual cost and benefit table can now be
completed and should be as follows:

Annual benefits $

Finance saving on reduced receivables – see Working 1

504

Contribution on extra sales (81,000 × 30%) 24,300

Annual costs $

Extra administration costs (10,000)

Discount cost –
891,000 × 40% × 1% (3,564)
 Annual benefits $

Net benefit/(cost) 11,240

Note: In this example the finance saving on reduced receivables is small, as although some
customers will be paying more quickly, others will be paying more slowly and the amount
of credit sales has also increased. Indeed, an additional finance cost could arise.

Comment
Having calculated a net benefit, Melvin Co can be advised that the proposed early
settlement discount appears worthwhile. Before a final decision is made, consideration
should also be given to the other advantages and disadvantages of such a settlement
discount which have been discussed previously but are not reflected in the above analysis.

Factoring

The basic service offered by a factoring company is the administration and collection of
receivables. As factors have significant expertise in the management of receivables, a
factor should be able to collect cash from customers more quickly than would a company
operating its own sales ledger. The factor will charge a fee which is usually calculated as a
percentage of credit sales. Additionally, the factor will offer to protect a company against
bad debts and will also lend money to the company against the security of its outstanding
receivables.

If the factor protects the company against all bad debts then this is known as a non-
recourse factoring agreement. Obviously the factor will charge a higher fee to cover the
risk it is bearing and will demand to credit check customers before they are offered credit.
If a factoring agreement is with recourse, the factor provides no protection against bad
debts.

The amount a factor will lend to a company is based on its experience of managing
receivables but may be up to 80% of the outstanding receivables. The charge for this
borrowing is likely to be slightly in excess of the overdraft interest rate that the company
pays.
 If a company uses a factor, then it has effectively outsourced the administration and
collection of its receivables (the sales ledger function) which should create significant
savings. The need for management control is reduced as there is no need to hire new staff,
develop new systems, train staff, etc. However, an executive of the company will have to
manage the relationship with the factor. Factoring is often considered useful where a
company is growing quickly, as management can attend to other issues and does not have
to worry about the need to grow the sales ledger function. Additionally, as the factor will
lend a percentage of the outstanding receivables, the amount the factor will lend grows
automatically as the business grows. This growing source of finance can be very useful to
a growing company where additional finance is often required and overtrading is a
potential problem.

Criticisms of factoring include:

 the factor’s charges may be high

 once a company has started to use a factor it is hard to rebuild its own sales ledger function
 the factor will collect receivables in a vigorous manner and this may damage the
company’s relationship with its clients
 the use of a factor may indicate that the company has cash flow problems (this last
criticism is less relevant in the modern business environment where outsourcing of
support functions has become very common).

Example 2
Velmin Co has a turnover of $700,000. Receivable days are currently 48 despite the
company only offering 30-days’ credit and bad debts are currently 3% of turnover. Velmin
Co finances its receivables using its overdraft which has an annual interest cost of 8%.

Velmin is considering the use of a factor. The factor would charge 4% of turnover for a
non-recourse agreement and would expect to reduce receivable days to 34 and bad debts
to 2%. The factor would lend Velmin 75% of the outstanding receivables and would charge
Velmin 1% above their current overdraft interest cost. It is anticipated that using the factor
would reduce administration costs by $6,000 per annum.

Required
Evaluate whether or not Velmin Co should use the factor.
 Annual benefits $

Finance saving on reduced receivables – see Working 1

1,659

Administration savings 6,000

Bad debts saved

(700,000 × 3%) 21,000

Annual costs $

Factor’s fee (700,000 × 4%) (28,000)

Net benefit/(cost) 659

Table 1 below shows Working 1.

TABLE 1: WORKING 1, EXAMPLE 2

Working 1
Existing situation

Receivable days 48 days – given

Receivables $92,055 (700,000 × 48/365)

Annual finance cost $7,364 (92,055 × 8%)

Revised situation

Receivable days 34 days – given

Receivables $65,205 (700,000 × 34/365)

 Annual finance cost
– on receivables financed by the factor $4,401 (65,205 × 75% × (8% + 1%))
– on receivables still financed $1,304 (65,205 × 25% × 8%)
by overdraft
– Total $5,705 (4,401 + 1,304)

Annual finance saving $1,659 (7,364 – 5,705)

Comment
Having calculated a net benefit, Velmin Co can be advised that using the factor appears
worthwhile. However, the net benefit is very small, so before a final decision is made the
estimates used in the evaluation should be checked and consideration should be given to
the other advantages and disadvantages of using a factor which have not been quantified.

Notes

1. As the agreement with the factor is a non-recourse agreement the total bad debts will be
saved as far as Velmin Co is concerned. The remaining 2% of bad debts will simply be a cost
to the factor.
2. The assumption used in questions of this nature is that the company borrows the maximum
available from the factor. In reality, as the finance provided by the factor is more costly, a
company will probably only use the finance offered by the factor when they are at – or close
to – their overdraft limit.

Summary
Working capital management, and in particular the management of receivables and the
evaluation of proposed new methods of managing receivables, has been a popular exam
topic. When carrying out these evaluations, a structured approach should be adopted so
that a marker can easily follow a student’s thought process and give credit where it is due
even if the numbers have, at some stage, gone awry.

The approach suggested in Example 1 looks very long, because considerable explanation
has been included. Example 2 adopts the same approach even though the scenario is
different and demonstrates that those confident with such an approach can quickly and
 easily generate a concise, logical and, I hope, accurate answer to any question of this
nature.

William Parrott is a lecturer at Kaplan Financial

Reference

 Corporate Finance – Principles and Practice, Denzil Watson and Antony Head

Is it possible to increase shareholder wealth by changing the capital structure?

The first question to address is what is meant by capital structure. The capital structure of
a company refers to the mixture of equity and debt finance used by the company to finance
its assets. Some companies could be all-equity-financed and have no debt at all, whilst
others could have low levels of equity and high levels of debt. The decision on what mixture
of equity and debt capital to have is called the financing decision.

The financing decision has a direct effect on the weighted average cost of capital (WACC).
The WACC is the simple weighted average of the cost of equity and the cost of debt. The
weightings are in proportion to the market values of equity and debt; therefore, as the
proportions of equity and debt vary, so will the WACC. Therefore the first major point to
understand is that, as a company changes its capital structure (ie varies the mixture of
equity and debt finance), it will automatically result in a change in its WACC.

However, before we get into the detail of capital structure theory, you may be thinking how
the financing decision (ie altering the capital structure) has anything to do with the overall
corporate objective of maximising shareholder wealth. Given the premise that wealth is
the present value of future cash flows discounted at the investors’ required return, the
market value of a company is equal to the present value of its future cash flows discounted
by its WACC.

Market value of a company = Future cash flows / WACC

It is essential to note that the lower the WACC, the higher the market value of the company
– as you can see from the following simple example; when the WACC is 15%, the market
value of the company is 667; and when the WACC falls to 10%, the market value of the
company increases to 1,000.

Market value of a company

100/ 0.15 = 667

100/0.10 = 1,000

Hence, if we can change the capital structure to lower the WACC, we can then increase the
market value of the company and thus increase shareholder wealth.

Therefore, the search for the optimal capital structure becomes the search for the lowest
WACC, because when the WACC is minimised, the value of the company/shareholder
wealth is maximised. Therefore, it is the duty of all finance managers to find the optimal
capital structure that will result in the lowest WACC.

What mixture of equity and debt will result in the lowest WACC?

As the WACC is a simple average between the cost of equity and the cost of debt, one’s
instinctive response is to ask which of the two components is the cheaper, and then to have
more of the cheap one and less of expensive one, to reduce the average of the two.

Well, the answer is that cost of debt is cheaper than cost of equity. As debt is less risky than
equity, the required return needed to compensate the debt investors is less than the
required return needed to compensate the equity investors. Debt is less risky than equity,
as the payment of interest is often a fixed amount and compulsory in nature, and it is paid
in priority to the payment of dividends, which are in fact discretionary in nature. Another
reason why debt is less risky than equity is in the event of a liquidation, debt holders would
receive their capital repayment before shareholders as they are higher in the creditor
hierarchy (the order in which creditors get repaid), as shareholders are paid out last.

Debt is also cheaper than equity from a company’s perspective is because of the different
corporate tax treatment of interest and dividends. In the profit and loss account, interest is
subtracted before the tax is calculated; thus, companies get tax relief on interest. However,
dividends are subtracted after the tax is calculated; therefore, companies do not get any
tax relief on dividends. Thus, if interest payments are $10m and the tax rate is 30%, the cost
to the company is $7m. The fact that interest is tax-deductible is a tremendous advantage.
 Let us return to the question of what mixture of equity and debt will result in the lowest
WACC. The instinctive and obvious response is to gear up by replacing some of the more
expensive equity with the cheaper debt to reduce the average, the WACC. However, issuing
more debt (ie increasing gearing), means that more interest is paid out of profits before
shareholders can get paid their dividends. The increased interest payment increases the
volatility of dividend payments to shareholders, because if the company has a poor year,
the increased interest payments must still be paid, which may have an effect the company’s
ability to pay dividends. This increase in the volatility of dividend payment to shareholders
is also called an increase in the financial risk to shareholders. If the financial risk to
shareholders increases, they will require a greater return to compensate them for this
increased risk, thus the cost of equity will increase and this will lead to an increase in the
WACC.

In summary, when trying to find the lowest WACC, you:

 issue more debt to replace expensive equity; this reduces the WACC, but
 more debt also increases the WACC as:
o gearing
o financial risk
o beta equity
o keg WACC.

Remember that Keg is a function of beta equity which includes both business and financial
risk, so as financial risk increases, beta equity increases, Keg increases and WACC
increases.

The key question is which has the greater effect, the reduction in the WACC caused by
having a greater amount of cheaper debt or the increase in the WACC caused by the
increase in the financial risk. To answer this we have to turn to the various theories that
have developed over time in relation to this topic.

The theories of capital structure

1. M + M (No Tax): Cheaper Debt = Increase in Financial Risk / Keg
2. M + M (With Tax): Cheaper Debt > Increase in Financial Risk / Keg
3. Traditional Theory: The WACC is U shaped, ie there is an optimum gearing ratio
4. The Pecking Order: No theorised process; simply the line of least resistance first internally
generated funds, then debt and finally new issue of equity
Modigliani and Miller’s no-tax model

In 1958, Modigliani and Miller stated that, assuming a perfect capital market and ignoring
taxation, the WACC remains constant at all levels of gearing. As a company gears up, the
decrease in the WACC caused by having a greater amount of cheaper debt is exactly offset
by the increase in the WACC caused by the increase in the cost of equity due to financial
risk.

The WACC remains constant at all levels of gearing thus the market value of the company
is also constant. Therefore, a company cannot reduce its WACC by altering its gearing
(Figure 1).

The cost of equity is directly linked to the level of gearing. As gearing increases, the
financial risk to shareholders increases, therefore Keg increases. Summary: Benefits of
cheaper debt = Increase in Keg due to increasing financial risk. The WACC, the total value of
the company and shareholder wealth are constant and unaffected by gearing levels. No
optimal capital structure exists.

Modigliani and Miller’s with-tax model

In 1963, when Modigliani and Miller admitted corporate tax into their analysis, their
conclusion altered dramatically. As debt became even cheaper (due to the tax relief on
interest payments), cost of debt falls significantly from Kd to Kd(1-t). Thus, the decrease in
the WACC (due to the even cheaper debt) is now greater than the increase in the WACC (due
to the increase in the financial risk/Keg). Thus, WACC falls as gearing increases. Therefore,
if a company wishes to reduce its WACC, it should borrow as much as possible (Figure 2).

Summary: Benefits of cheaper debt > Increase in Keg due to increasing financial risk.

Companies should therefore borrow as much as possible. Optimal capital structure is

99.99% debt finance.

Market imperfections

There is clearly a problem with Modigliani and Miller’s with-tax model, because
companies’ capital structures are not almost entirely made up of debt. Companies are
discouraged from following this recommended approach because of the existence of
factors like bankruptcy costs, agency costs and tax exhaustion. All factors which
Modigliani and Miller failed to take in account.

Bankruptcy costs

Modigliani and Miller assumed perfect capital markets; therefore, a company would
always be able to raise funding and avoid bankruptcy. In the real world, a major
disadvantage of a company taking on high levels of debt is that there is a significant
possibility of the company defaulting on its increased interest payments and hence being
declared bankrupt. If shareholders and debt-holders become concerned about the
possibility of bankruptcy risk, they will need to be compensated for this additional risk.
Therefore, the cost of equity and the cost of debt will increase, WACC will increase and the
share price reduces. It is interesting to note that shareholders suffer a higher degree of
bankruptcy risk as they come last in the creditors’ hierarchy on liquidation.

If this with-tax model is modified to take into account the existence of bankruptcy risks at
high levels of gearing, then an optimal capital structure emerges which is considerably
below the 99.99% level of debt previously recommended.

Agency costs

Agency costs arise out of what is known as the ‘principal-agent’ problem. In most large
companies, the finance providers (principals) are not able to actively manage the company.
They employ ‘agents’ (managers) and it is possible for these agents to act in ways which are
not always in the best interest of the equity or debt-holders.

Since we are currently concerned with the issue of debt, we will assume there is no
potential conflict of interest between shareholders and the management and that the
management’s primary objective is the maximisation of shareholder wealth. Therefore,
the management may make decisions that benefit the shareholders at the expense of the
debt-holders.

Management may raise money from debt-holders stating that the funds are to be invested
in a low-risk project, but once they receive the funds they decide to invest in a high risk/high
return project. This action could potentially benefit shareholders as they may benefit from
the higher returns, but the debt-holders would not get a share of the higher returns since
their returns are not dependent on company performance. Thus, the debt-holders do not
receive a return which compensates them for the level of risk.

To safeguard their investments, debt-holders often impose restrictive covenants in the

loan agreements that constrain management’s freedom of action. These restrictive
covenants may limit how much further debt can be raised, set a target gearing ratio, set a
target current ratio, restrict the payment of excessive dividends, restrict the disposal of
major assets or restrict the type of activity the company may engage in.

As gearing increases, debt-holders would want to impose more constrains on the

management to safeguard their increased investment. Extensive covenants reduce the
company’s operating freedom, investment flexibility (positive NPV projects may have to be
forgone) and may lead to a reduction in share price. Management do not like restrictions
placed on their freedom of action. Thus, they generally limit the level of gearing to limit the
level of restrictions imposed on them.

Tax exhaustion

The fact that interest is tax-deductible means that as a company gears up, it generally
reduces its tax bill. The tax relief on interest is called the tax shield – because as a company
gears up, paying more interest, it shields more of its profits from corporate tax. The tax
advantage enjoyed by debt over equity means that a company can reduce its WACC and
increases its value by substituting debt for equity, providing that interest payments remain
tax deductible.

However, as a company gears up, interest payments rise, and reach a point that they are
equal to the profits from which they are to be deducted; therefore, any additional interest
payments beyond this point will not receive any tax relief.
This is the point where companies become tax - exhausted, ie interest payments are no
longer tax deductible, as additional interest payments exceed profits and the cost of debt
rises significantly from Kd(1-t) to Kd. Once this point is reached, debt loses its tax
advantage and a company may restrict its level of gearing.

The WACC will initially fall, because the benefits of having a greater amount of cheaper debt
outweigh the increase in cost of equity due to increasing financial risk. The WACC will
continue to fall until it reaches its minimum value, ie the optimal capital structure
represented by the point X.

Benefits of cheaper debt > increase in keg due to increasing financial risk

If the company continues to gear up, the WACC will then rise as the increase in financial
risk/Keg outweighs the benefit of the cheaper debt. At very high levels of gearing,
bankruptcy risk causes the cost of equity curve to rise at a steeper rate and also causes the
cost of debt to start to rise.

Increase in Keg due to financial and bankruptcy risk > Benefits of cheaper debt

Shareholder wealth is affected by changing the level of gearing. There is an optimal gearing
level at which WACC is minimised and the total value of the company is maximised.
Financial managers have a duty to achieve and maintain this level of gearing. While we
accept that the WACC is probably U-shaped for companies generally, we cannot precisely
calculate the best gearing level (ie there is no analytical mechanism for finding the optimal
capital structure). The optimum level will differ from one company to another and can only
be found by trial and error.
 Pecking order theory

The pecking order theory is in sharp contrast with the theories that attempt to find an
optimal capital structure by studying the trade-off between the advantages and
disadvantages of debt finance. In this approach, there is no search for an optimal capital
structure. Companies simply follow an established pecking order which enables them to
raise finance in the simplest and most efficient manner, the order is as follows:

1. Use all retained earnings available;

2. Then issue debt;
3. Then issue equity, as a last resort.

The justifications that underpin the pecking order are threefold:

 Companies will want to minimise issue costs.

 Companies will want to minimise the time and expense involved in persuading outside
investors of the merits of the project.
 The existence of asymmetrical information and the presumed information transfer that
result from management actions. We shall now review each of these justifications in more
detail.

Minimise issue costs

1. Retained earnings have no issue costs as the company already has the funds
2. Issuing debt will only incur moderate issue costs
3. Issuing equity will incur high levels of issue costs

Minimise the time and expense involved in persuading outside investors

1. As the company already has the retained earnings, it does not have to spend any time
persuading outside investors
2. The time and expense associated with issuing debt is usually significantly less than that
associated with a share issue

The existence of asymmetrical information

This is a fancy term that tells us that managers know more about their companies’
prospects than the outside investors/the markets. Managers know all the detailed inside
information, whilst the markets only have access to past and publicly available
information. This imbalance in information (asymmetric information) means that the
actions of managers are closely scrutinised by the markets. Their actions are often
interpreted as the insiders’ view on the future prospects of the company. A good example
of this is when managers unexpectedly increase dividends, as the investors interpret this
as a sign of an increase in management confidence in the future prospects of the company
thus the share price typically increases in value.

Suppose that the managers are considering how to finance a major new project which has
been disclosed to the market. However managers have had to withhold the inside scoop on
the new technology associated with the project, due to the competitive nature of their
industry. Thus the market is currently undervaluing the project and the shares of the
company. The management would not want to issue shares, when they are undervalued,
as this would result in transferring wealth from existing shareholders to new
shareholders. They will want to finance the project through retained earnings so that,
when the market finally sees the true value of the project, existing shareholders will
benefit. If additional funds are required over and above the retained earnings, then debt
would be the next alternative.

When managers have favourable inside information, they do not want to issue shares
because they are undervalued. Thus it would be logical for outside investors to assume
that managers with unfavourable inside information would want to issue share as they are
overvalued. Therefore an issue of equity by a company is interpreted as a sign the
management believe that the shares are overvalued. As a result, investors may start to
sell the company’s shares, causing the share price to fall. Therefore the issue of equity is a
last resort, hence the pecking order; retained earnings, then debt, with the issue of equity
a definite last resort.

One implication of pecking order theory that we would expect is that highly profitable
companies would borrow the least, because they have higher levels of retained earnings
to fund investment projects. Baskin (1989) found a negative correlation between high profit
levels and high gearing levels. This finding contradicts the idea of the existence of an
optimal capital structure and gives support to the insights offered by pecking order theory.

Another implication is that companies should hold cash for speculative reasons, they
should built up cash reserves, so that if at some point in the future the company has
insufficient retained earnings to finance all positive NPV projects, they use these cash
reserves and therefore not need to raise external finance.

Conclusion
 As the primary financial objective is to maximise shareholder wealth, then companies
should seek to minimise their weighted average cost of capital (WACC). In practical terms,
this can be achieved by having some debt in the capital structure, since debt is relatively
cheaper than equity, while avoiding the extremes of too little gearing (WACC can be
decreased further) or too much gearing (the company suffers from bankruptcy costs,
agency costs and tax exhaustion). Companies should pursue sensible levels of gearing.

Companies should be aware of the pecking order theory which takes a totally different
approach, and ignores the search for an optimal capital structure. It suggests that when a
company wants to raise finance it does so in the following pecking order: first is retained
earnings, then debt and finally equity as a last resort.

Patrick Lynch is a lecturer at Dublin Business School

References

 Watson D and Head A, Corporate Finance: Principles and Practice, 4th edition, FT Prentice
Hall
 Brealey and Myers, Principles of Corporate Finance, 6th edition, McGraw Hill
 Glen Arnold, Corporate Financial Management, 2nd edition, FT Prentice Hall
 JM Samuels, FM Wilkes and RE Brayshaw, Financial Management & Decision Making,
International Thomson Publishing Company
 Power T, Walsh S & O’ Meara P, Financial Management , Gill & Macmillan.