Professional Documents
Culture Documents
Financial objectives
this can be measured as total shareholder return (dividend yield + capital gain).
Key decisions:
1. Investment
(in projects or takeovers or working capital) need to be analysed to ensure that they are beneficial to the investor.
Investments can help a firm maintain strong future cash flows by the achievement of key corporate objectives
e.g. market share, quality.
2. Finance
The level of gearing that is appropriate for a business depends on a number of practical issues:
Life cycle - A new, growing business will find it difficult to forecast cash flows with any certainty so high levels of gearing are
unwise.
Operating gearing- If fixed costs are a high proportion of total costs then cash flows will be volatile; so high gearing is not
sensible.
Stability of revenue- If operating in a highly dynamic business environment then high gearing is not sensible.
Security- If unable to offer security then debt will be difficult and expensive to obtain.
3. Dividends
4. Risk management
mainly involve management of exchange rate and interest rate risk and project management issues.
Taking a commercial business as the most common organisational structure, the key objectives of financial management would
be to:
Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested
1. Financial Planning
Management need to ensure that enough funding is available at the right time to meet the needs of the business.
In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit.
In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to
make acquisitions.
2. Financial Control
Financial control is a critically important activity to help the business ensure that the business is meeting its objectives.
3. Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and dividends:
• Investments must be financed in some way – however there are always financing alternatives that can be considered.
For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers
• A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via
dividends.
If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further
Financial Management
Financial accounting
Gives information about past events generally.
Management accounting
Maximisation of shareholder wealth is measured by the share price (if the company is listed of course). This is because the share
price is simply the value of all future dividends coming to the shareholders.
However, sometimes a business reports a profit increase and the share price falls due to the manner in which they made the
profit. This suggests that that profit is not sufficient as a business objective
Share price could also rise and fall due to potential investment decisions or the fact that a new loan is being taken out or that
dividends are to be increased or lowered
Corporate Strategies
Clearly corporate strategies are wider than purely financial, they look at the business as a whole. Once these are set appropriate
financial objectives can then be set and measured
Examples include:
Return on investment
Market share
Growth
Customer satisfaction
Quality
Financial Objectives
Examples include:
1. Profit Maximisation
Also there is the problem that profits can be manipulated using financial accounting, unlike cash.
So maybe profit maximisation focuses on financial profit too much and not enough on cash generation.
EPS looks at the amount of profits made in the year for each individual share.
Remember it is the ORDINARY shareholders who are interested in EPS. Therefore EPS is:
Illustration
Solution
Last year:
Current year
Stakeholder Objectives
Total Shareholder Return
It is the dividend per share plus capital gain divided by initial share price
NB Always use the opening share price as the denominator!
Stakeholders interests
We have just seen that the primary objective of a company is the maximisation of shareholder wealth.
This means balancing shareholder wealth with the objectives of other stakeholders.
Stakeholder Objective
Often they are in conflict with each other. Therefore a degree of compromise is reached.
For example, Performance related pay for example is a means of satisfying both staff and shareholders.
There is a fundamental problem highlighted here. The owners of the business are generally not those who manage the business.
So how can the owners ensure that the agents are working for the owners objectives and not just their own?
1. Fixed wages
Not always the optimal way to organise relationships between principals and agents.
A fixed wage might create an incentive for the agent to shirk since his compensation will be the same regardless of the quality of
his work or his effort level.
When agents have incentive to shirk, it is often more efficient to replace fixed wages with compensation based on the profits of
the firm, since it makes their compensation dependent on their performance.
However this can lead to individuals not working for the team as a whole by inflating budgets required etc.
Output may also be encouraged rather than quality. It disregards job satisfaction also
3. Share options
Seems like a great idea as if the share price goes up then both the managers and the owners benefit.
However often shares go up and down in line with market movements regardless of how well the managers have performed so
many managers would not like to be measured and paid solely this way.
Some element of share options within their pay though would be a good thing and acceptable by all
Regulatory Requirements
These can be imposed through corporate governance codes of best practice and stock market listing regulations
CG codes ensure a balanced perspective by requiring NEDs on the audit, nominations and remuneration committees
Stock exchange listings ensure that detailed information is given about directors pay
Stock exchange listings ensure companies pay attention to their corporate social responsibilities
To show the company has enough working capital for its current needs and for at least the next 12 months
A general description of the future plans and prospects must be given
Audited historical financial information covering latest three full years and any published later interim period
Although UK corporate governance rules do not apply to the non-UK companies, investors would expect similar standard,
and an explanation for any differences.
4. Smaller number of shareholders - who are often in contact with the company - so conflict less likely
In a listed Company it's different..
Asymmetry of information
Myopic Management
This means possibly choosing quick returns over slower, but ultimately higher, one.
3. Business collapses
4. If contracts are short then managers will look to excel in that short period
Frequent reporting of profits can intensify the pressure on managers to achieve quick results
ROCE and ROI focus on the EFFICIENCY of capital investment - not the long term profitability
Similarly ratios that have a % output such as IRR, can make a short term focus
EMH states that in an efficient market, the value of a share should reflect the long-term future cash flows of the share
However, stock markets are not always efficient and shareholders are not always rational when making investment decisions.
This can be seen in speculative share price bubbles and extended ‘bull’ runs in share prices
Remedies
These include
A loyalty dividend for those who hold shares for a long time
Rewards for fund managers linked to long-term performance
Additional reporting of long-term prospects in the annual accounts
3. Corporate governance
Taxing shares transfer effects every trade even those with low volatility
Higher capital gains tax on selling shares may damage market liquidity
A not-for-profit organisation’s primary goal is not to increase shareholder value; rather it is to provide some socially
desirable need on an ongoing basis.
A not-for-profit generally lacks the financial flexibility of a commercial enterprise because it depends on resource providers
who often gain no tangible benefit themselves.
Thus the not-for- profit must demonstrate its stewardship of donated resources — money donated for a specific purpose
must be used for that purpose.
That purpose is either specified by the donor or implied in the not-for-profit’s stated mission.
Budgeting and cash management is very Important
Budgeting and cash management are two areas of financial management that are extremely important exercises for not-
for-profit organisations.
The organisation must pay close attention to whether it has enough cash reserves to continue to provide services to its
clientele.
Cash flow can be extremely challenging to predict, because an organisation relies on revenue from resource providers that do
not expect to receive the service provided.
In fact, an increase in demand for a not-for-profit’s services can lead to a management crisis.
The non financial objectives are often more important in not for profit organisations.
eg Quality of care
Input driven - Try to get as much out given limited inputs e.g. library
Output driven - Maintaining standards even when output changes eg Prison service
Non-financial information is often better able than straight financial data to measure and justify the intangible goals of Not
for Profits.
The high level of non-financial reporting will come at a cost, however, in terms of the time and other resources which it
necessitates.
Statistics related to service or activity delivery and performance, such as client numbers, user numbers, enquiry numbers,
occupancy levels and similar;
The performance and development of human resources, both staff and volunteers
Reporting on external trends, including social and environmental impacts, also political and economic developments
Other creative forms of non-financial reporting include statistics on website use, complaint numbers, analysis of media coverage,
and measuring board visibility and recognition.
Economic Environment
Fiscal Policy
Discussion:
By changing tax laws, the government can alter the amount of disposable income available to its taxpayers. If taxes
increased consumers would have less money to spend.
This difference in disposable income would go to the government instead of going to consumers, who would pass the
money onto companies.
Or, the government could increase its spending by purchasing goods from companies. This would increase the flow of
money through the economy and would eventually increase the disposable income available to consumers.
Unfortunately, this process takes time, as the money needs to wind its way through the economy, creating a significant lag
between the implementation of fiscal policy and its effect on the economy.
This can have bad effects on the economy by ‘crowding out’ private investment by pushing up interest rates
Economic environment
1. Full employment
2. Price stability
Full Employment
Full employment was considered very important after the Second World War.
Unemployment in the 80s was seen as an inevitable consequence of the steps taken to make industry more efficient.
De-industrialisation made higher unemployment feel inevitable, and so this objective became much less important than it
had been.
Without growth peoples’ standard of living will not increase, and if inflation is too high then the value of money falls
negating any increase in living standards.
The total of all the money coming into a country from abroad less all of the money going out of the country during the same
period.
- will act to slowdown the growth of consumer demand and therefore lead to cutbacks in the demand for imports.
2. Fiscal policy
(i.e. increases in direct taxes) might also be used to reduce aggregate demand.
The risk is that a sharp fall in consumer spending might lead to a steep economic slowdown (slower growth of GDP) or an full-
scale recession
Yes because….
2. Borrowing is unsustainable in the long term and countries will be burdened with high interest payments.
E.g Russia was unable to pay its foreign debt back in 1998. Other developing countries have experience similar
repayment problems Brazil, African c (3rd World debt)
Foreigners have an increasing claim on home assets, which they could desire to be returned at any time.
E.g. a severe financial crisis in Japan may cause them to repatriate their investments
No because….
This enabled higher growth and so it was able to pay its debts back and countries had confidence in lending the US
money
2. Japanese investment has been good for the UK economy not only did the economy benefit from increased investment
but the Japanese firms also helped bring new working practices in which increased labour productivity.
3. With a floating exchange rate a large current account deficit should cause a devaluation which will help reduce the level
of the deficit
4. It depend on the size of the budget deficit as a % of GDP, for example the US trade deficit has nearly reached 5% of
GDP at this level it is concerning economists
NOTE: do not confuse objectives of macroeconomic policy with the instruments used to achieve these aims.
Low inflation is an objective, the rate of interest is an instrument used to control inflation.
Monetary Policy
The regulation of the money supply and interest rates by a central bank
in order to control inflation and stabilise currency
Discussion:
Monetary policy is one of the ways the government can impact the economy.
By impacting the effective cost of money, the government can affect the amount of money that is spent by consumers and
businesses.
1. Affect on Growth
When interest rates are high, fewer people and businesses can afford to borrow, so this usually slows the economy down.
Also, more people will save (if they can) because they receive more on their savings rate.
When the central banks set interest rates it is the amount they charge other banks to borrow money.
This is a critical interest rate, in that it affects the entire supply of money, and hence the health of the economy.
• exports dearer
• imports cheaper.
3. Effect on Inflation
It may want to influence the exchange rate by using its gold and foreign currency reserves held by its central bank to buy
and sell its currency.
A fall in the exchange rate will mean that the price of imports will rise while exporters should become more internationally
competitive. Import volumes should fall whilst export volumes should rise.
Output at home should rise, leading to higher economic growth and a fall in unemployment.
There should be an improvement in the current account of the balance of payments too as the gap between export values
and import values improves.
However, higher import prices will feed through to a rise in inflation in the economy.
More policies
Competition policy
The Competition Commission prevents takeovers that are against the public interest
Competition policy aims to ensure:
Government grants available for certain investments and small business in areas such as rural development, energy efficiency,
education etc
Green policies
Airfuel tax for example can threaten an airline business but create opportunities for other forms of transport or makers of new
greener aircraft.
Treasury Function
A company can raising money by selling commercial paper into the
MONEY market
It’s a relatively safe place to put money as everything is short term and highly liquid
These are essentially IOUs issued by governments, financial institutions and large corporations
1. Treasury Bills
2. Certificates on Deposit
Normally issued by commercial banks but they can be bought through brokerages
Have a maturity date (from three months to five years), a specified interest rate, and can be issued in any denomination
Cannot be withdrawn on demand
3. Commercial Papers
For companies, borrowing from banks can be a pain (in the a**). This is where commercial papers on a money market comes in..
No security is needed, and they are short term. Normally 1 - 2 months. This makes them safe to invest in, though normally
only good credit companies issue these
They’re normally used to finance working capital (trade finance) such as receivables and inventories
They are normally in denominations of $100,000 or more - Therefore, smaller investors can only invest in commercial paper
indirectly through money market funds
They are normally issued at a discount and paid back at par value (the difference is obviously the interest)
4. Bankers Acceptance
Companies use them for financing imports and exports, when the creditworthiness of a foreign trade partner is unknown
They don’t need to be held until maturity, and can be sold off in the secondary markets where investors and institutions
constantly trade BAs
These derive their value from Treasury bills, Eurodollars, certificates of deposits (CD) and interest rates.
They are commonly traded as futures, forwards, options and swaps as well as caps and floors.
Let's have a quick look at futures (there's more further on in the course for the others)
When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the
exchange, called initial margin.
If losses are incurred as exchange rates and hence the prices of currency futures contracts change, the buyer or seller may
be called on to deposit additional funds (variation margin) with the exchange
Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market’.
Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to
the initial futures transaction, ie if buying currency futures was the initial transaction, it is closed out by selling currency
futures.
A gain made on the futures transactions will offset a loss made on the currency markets and vice versa.
Advantages
Lower transaction costs than money market
They are tradable and so do not need to always be closed out
Disadvantages
Cannot be tailored as they are standard contracts
Still cannot take advantage of favourable movements in actual exchange rates (unlike in options)
However the fund will provide only relatively low returns so it’s not a long-term investment option.
A financial market allows people to easily buy and sell financial securities
(such as stocks and bonds), commodities (such as precious metals) etc
General markets (many commodities) and specialised markets (one commodity) exist. Markets work by placing interested buyers
and sellers in one "place", thus making it easier for them to find each other
ypically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be
freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of
interest or dividends
As the financial markets are normally direct and no financial intermediaries used, this is called financial disintermediation
Euromarkets
An overall term for international capital markets dealing in offshore currency deposits held in banks outside their country of
origin
Euro means external in this context. For example, eurodollars are dollars held by banks outside the United States
It allows large companies with excellent credit ratings to raise finance in a foreign currency. This market is organised by
international commercial banks
Key Features
Size
Can be sold by investors, and a wide pool of investors share the risk
Unsecured
Debt in a foreign currency Typically 5-15 years, normally in euros or dollars but possible in any currency
Less regulation
By using Euromarkets, banks and financiers are able to avoid certain regulatory aspects such as reserve requirements and
other rules
However, the reduction in domestic regulations have made the cost savings much less significant than before
As a result, the domestic money market and Eurocurrency markets are closely integrated for most major currencies,
effectively creating a single worldwide money market for each participating currency.
A stock market (also known as a stock exchange) has two main functions
Functions
1. ..is to provide companies with a way of issuing shares to people who want to invest in the company
The first function allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership
of the company in a public market
This enables investors the ability to quickly and easily sell securities. This liquidity is an attractive feature of investing in stocks,
compared to other less liquid investments such as real estate
Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee
payment to the seller of a security
The term "risk and return" refers to the potential financial loss or gain
experienced through investments in securities
A profit is the "return". The "risk" is the likelihood the investor could lose money
If an investor decides to invest in a security that has a relatively low risk, the potential return on that investment is typically
fairly small and vice-versa
Different securities—including common stocks, corporate bonds, government bonds, and Treasury bills—offer varying rates of
risk and return
These are about as safe an investment as you can get. There is no risk of default and their short maturity means that the
prices of Treasury bills are relatively stable
These on the other hand, experience price fluctuations in accordance with changes in the nation's interest rates. Bond prices
fall when interest rates rise, but they rise when interest rates drop
Government bonds typically offer a slightly higher rate of return than Treasury bills
Corporate bonds
Those who invest in corporate bonds have the potential to enjoy a higher return on their investment than those who stay
with government bonds. This is because the risk is greater. The company may default on the bond.
Therefore, the bond agreement includes a number of restrictive covenants on the company
Common stockholders are the owners of a corporation in a sense, for they have ultimate control of the company. Their votes
on appointments to the corporation's board of directors and other business matters often determine the company's
direction. Common stock carries greater risks than other types of securities, but can also prove extremely profitable
Earnings or loss of money from common stock is determined by the rise or fall in the stock price of the company
Preference shares
While owners of preferred stock do not typically have full voting rights in the company, no dividends can be paid on the
common stock until after the preferred dividends are paid
This basically means that the lender gives money to the borrower indirectly as the financial intermediary sits inbetween (hence
the term)
It is typically an institution that allows funds to be moved between lenders and borrowers.
That is, savers (lenders) give funds to an intermediary institution (such as a bank), who then gives those funds to spenders
(borrowers). This may be in the form of loans or mortgages.
Alternatively, the savers may lend the money directly to the borrower, via the financial markets. Therefore there is no
intermediary and so this is known as financial disintermediation
To provide a link between many investors who may have small amounts of surplus cash and fewer borrowers who may need large
amounts of cash
2. Risk transformation
Intermediaries offer low-risk securities to primary investors to attract funds, which are then used to purchase higher-risk securities
issued by the ultimate borrowers
3. Maturity transformation
Investors can deposit funds for a long period of time while borrowers may require funds on a short-term basis only, and vice versa.
In this way the needs of both borrowers and lenders can be satisfied
The role of money and capital markets
Money Market
The money market is the global financial market for short-term borrowing and lending
The money market is where short-term obligations are bought and sold such as
Treasury bills
Bankers' acceptances
Here financial institutions either borrow or lend for short periods of time, typically up to thirteen months. This contrasts with the
capital market for longer-term funding, which is supplied by bonds and equity
Capital Market
A capital market includes the stock market, commodities exchanges and the bond market amongst others. The capital market is
an ideal environment for the creation of strategies that can result in raising long-term funds for bond issues or even mortgages.
Along with the stock exchanges, support organisations such as brokerage firms also form part of the capital market. These
outward expressions of the capital market make it possible to keep the process ethical and more easily governed according to
local laws and customs
Working Capital
The Basics
Cash Operating Cycle
This is the time between cash paid for raw materials and cash received from customers.
How long between having to pay and receiving the cash? 2 days
The 2 days is the cash operating cycle. It is how long between paying for an item and eventually receiving the cash.
This period needs funding somehow
Look again at the illustration and you may see how it is calculated:
Note the CASH needed in the gap can get bigger by:
1. Cycle gets longer (need more cash in proportion to the extra days in cycle)
2. Sales increase (need more cash in proportion to the extra sales made)
2. Management efficiency
An increase in the length of the cash operating cycle will increase the level of investment in working capital.
Nature of business operations
My academies, for example, hold very little stock (because I’m tight?) - er no because we sell services!
Many retailers sell direct to the smelly, unwashed public and so have very few receivables - others sell to other businesses
and so offer credit terms.
If an operating cycle is long, then there is lower accessibility to cash for satisfying liabilities for the short term.
A short cash cycle reflects sound management of working capital. A long cash cycle denotes that capital is occupied when
the commercial entity is expecting its clients to make payments.
Here they are getting payments from the clients before any payment is made to the suppliers.
Instances of such business entities are commonly those companies, which apply Just in Time techniques, for example Dell, as well
as commercial enterprises, which purchase on credit and sell for cash, for instance Tesco.
Working capital is simply the money needed for day to day business.
This money is needed to keep the company alive so its importance cannot be over emphasised.
It is the management of each current asset and each current liability that is essential to the business.
Cash Overdraft
Receivables
Consider this.
You are the MD of a new company selling i-pads.
Demand is looking good.
Your natural inclination is probably to buy more in, to sell in the future.
You have invested in inventory to boost profits - this is one of the objectives of working capital.
However, you know you also have to pay the lease on your office - luckily you have set aside a little for this.
Hopefully you can see that part of you wants to invest the money and another wishes to save to pay bills.
The management of working capital is important to the financial health of businesses of all sizes.
The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these
amounts are used in an efficient and effective way.
However, there is evidence that small businesses are not very good at managing their working capital.
Given that many small businesses suffer from undercapitalisation, the importance of exerting tight control over working capital
investment is difficult to overstate.
The finance profession recognises the three primary reasons offered by economist John Maynard Keynes to explain why firms
hold cash.
All three of these reasons stem from the need for companies to possess liquidity
1. Speculation
To take advantage of special opportunities that if acted upon quickly will favour the firm.
2. Precaution
3. Transaction
Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have.
Holding too much working capital is inefficient, holding too little is dangerous to the organisation’s survival.
Overtrading
Overtrading
Overtrading or undercapitalisation arises when a company has too small a capital base to support its level of business activity.
Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall
due.
Overtrading
is often associated with a rapid increase in turnover. Investment in working capital does not match the increase in sales.
could be indicated by a deterioration in inventory days. Possibly because of stockpiling in anticipation of a further increase
in turnover, leading to an increase in operating costs.
could also be indicated by deterioration in receivables days, possibly due to a relaxation of credit terms.
As the liquidity problem associated with overtrading deepens, the overtrading company increases its reliance on short-term
sources of finance, including overdraft, trade payables and leasing.
can also be indicated by decreases in the current ratio and the quick ratio.
The Ratios
Ratios and Strategy
Accounting Ratios
In your exam, you may be required to calculate some ratios in order to support your strategic analysis of the case.
You have already covered ratio analysis in other subjects of the ACCA syllabus.
This section shall therefore only present a summary and list of ratios that could potential be used in your exam for such purpose.
PROFITABILITY RATIOS
These are measures of value added being generated by an organisation and include the following:
Total assets - current liabilities
ROE Profit After Tax - Preference dividends/Shareholders’ Funds (Ordinary shares + Reserves)
EFFICIENCY RATIOS
These are measures of utilisation of Current & Non-current Assets of an organisation. Efficiency Ratios consist of the
following:
Liquidity Ratios measure the extent to which an organisation is capable of converting assets into cash and cash
equivalents.
On the other hand, Gearing Ratios measure the dependence of an organisation on external financing as against shareholder
funds.
Liquidity
Gearing
INVESTOR'S RATIOS
These ratios measures return on investment generated by stakeholders. Such ratios include:
Earnings Per Share Profit After Tax and preference dividends / Number of Shares
The income statement is dynamic and describes the flow of money through the business over a period of time.
Current ratio
Current Ratio
At a minimum, you would hope the company whose financial performance you are analysing could meet pay its current
liabilities if it were to liquidate all its current assets.
As with all the other performance ratios, the Current Ratio value depends on the industry in which the company is
operating.
It is also important to know what assets make up most of the Current Assets.
Inventory and Accounts Receivable, which are part of the Current Assets, cannot always be counted on as easily transferred
to cash.
Cash and Marketable Securities comprising the majority of the Current Assets would definitely be favorable.
Knowing this, would the company you are analysing truly be able to meet its financial obligations if it in fact had to sell its
current assets?
acid test
Not every company can quickly convert its Inventory into cash in the event it had to pay all its current liabilities.
Therefore, the Quick Ratio is a tougher way to test the company’s ability to meet its current debt load.
You can make the test even tougher by also subtracting off the accounts receivable and prepaid expenses. This will pretty
much leave only the truly current and liquidable assets.
If a company you are analysing looks good while testing it against the Current Ratio, then the Quick Ratio should be your
next test to apply.
Companies with steadily rising Inventories may look good with the Current Ratio, but will have a deteriorating effect on the
Quick Ratio, since we subtract the Inventory out.
Inventory days
Inventory Days
Explanation of Inventory Days:
A financial measure of a company’s performance that gives investors an idea of how long it takes a company to turn its
inventory (including goods that are work in progress, if applicable) into sales.
Generally, the lower (shorter) the better, but it is important to note that the average varies from one industry to another.
This measure is one part of the cash conversion cycle, which represents the process of turning raw materials into cash.
Receivables Days
Receivables Days
The approximate amount of time that it takes for a business to receive payments owed.
The Average Collection Period measures the average number of days it takes for the company to collect revenue from its credit
sales.
The company will usually state its credit policies in its financial statement, so the Average Collection Period can be easily gauged
as to whether or not it is indicating positive or negative information.
This ratio reflects how easily the company can collect on its customers. It also can be used as a guage of how loose or tight
the company maintains its credit policies.
A particular thing to watch out for is if the Average Collection Period is rising over time. This could be an indicator that the
company’s customers are in trouble, which could spell trouble ahead.
This could also indicate the company has loosened its credit policies with customers, meaning that they may have been
extending credit to companies where they normally would not have.
This could temporarily boost sales, but could also result in an increase in sales revenue that cannot be recovered, as shown
in the Allowance for Doubtful Debts.
Illustration
A company has total credit sales of $100,000 during a year and has an average amount of accounts receivables of $50,000.
Its average collection period is therefore 182.5 days
Possessing a lower average collection period is seen as optimal, because this means that it does not take a company very
long to turn its receivables into cash.
Payable days
Payable days
It means:
The approximate amount of time that it takes for a business to make payments owed.
It measures the average amount of time you use each dollar of your trade credit.
This measurement gauges the relationship between your trade credit and your cash flow
A longer average payable period allows you to maximize your trade credit.
This means that you are delaying spending cash and taking full advantage of trade credit.
The Sales to Working Capital ratio measures how well the company’s cash is being used to generate sales.
Working Capital represents the major items typically closely tied to sales, and each item will directly affect this ratio.
An increasing Sales to Working Capital ratio is usually a positive sign, indicating the company is more able to use its working
capital to generate sales.
Although measuring the performance of a company for just one period reveals how well it is using its cash for that single
period, this ratio is much more effectively used over a number of periods.
This ratio can help uncover questionable management decisions such as relaxing credit requirements to potential customers
to increase sales, increasing inventory levels to reduce order fulfillment cycle times, and slowing payment to vendors and
suppliers in an effort to hold on to its cash.
Additional ratio points
1. If comparing between years , it is fine to use balance sheet (year end) figures instead of averages.
2. 'Turnover' ratios are the ‘day’ ratios inverted. (Do not multiply by 365)
3. Limitations of ratios are - y/e figures may not be representative, they can be manipulated, they are historic and ca be distorted by
inflation.
Managing Inventory
Economic Order Quantity
The level of inventory that minimises the total of inventory holding cost and ordering cost
Holding Costs
The more stock you hold the more it costs. So you should keep stock low.
Ordering costs
The more orders you make the more it costs. So you should order lots at a time, meaning fewer orders (but higher stock).
These two costs therefore work in opposite ways. One suggests keep stocks low, the other keep stock high (to keep orders
down).
So, to repeat, the EOQ level is where the total (ordering and holding) costs will be minimised.
(Well you lucky fruit nuts - this formula is given in the exam) - Anyway here it is….
Where Co = Order Costs; Ch = holding cost per unit and D = annual demand
Lets now see what these pesky HOLDING and ORDERING costs actually are
Holding costs
1. Warehouse
2. Insurance
3. Obsolescence
Ordering costs
1. Administration
2. Delivery costs
Assumptions/Criticisms:
The annual demand for the item is constant and it is known to the firm.
Bulk buying discounts may be available if the order quantity is above a certain size. To
calculate the best order quantity then we need to:
2. Calculate costs at the lower level of each discount above the EOQ
Illustration
Demand is 100 units per month. Purchase cost per unit £10. Order cost £20
Holding cost 10% p.a. of stock value.
Required
Calculate the minimum total cost with a discount of 2% given on orders of 350 and over
Solution
EOQ
Sq root 2 x 20 x 1200 / 1 = 219
Ordering Costs
= Order cost per unit x (Annual Demand / Order amount)
= 20 x 1200 / 219
= 110
Holding Costs
= Holding Cost per unit x (Order amount / 2)
= 1 x 219 / 2
= 110
= 220
Ordering Costs
= Order cost per unit x (Annual Demand / Order amount)
= 20 x 1200 / 350 = 69
Holding Costs
= Holding Cost per unit x (Order amount / 2)
= 0.98 x 350 / 2 = 171.5
= 240.5
240.5 is higher than 220 (it would be as EOQ is the best level)
Clearly with the discount being offered the company should take the discount and order at 350
Buffer Stock
Buffer Stock
Let’s say we sell 10 items of stock a week, and stock takes 2 weeks to come in.
Hopefully you can see that we need to make an order when stock levels fall to 20
If we order when they fall to 30, this must mean we like to keep a buffer (safety) stock of 10
Re-order Level
So, EOQ looks at how much to order, now lets look at when.
However you need to reorder before that, to give the stock time to arrive.
So the RE-ORDER level is not zero it is DEMAND x Time it takes to arrive in stock.
This though presumes constant and known demand. Luckily that is all that is needed in this examination!
Buffer Stock
Just-In-Time
Just-in-time (JIT)
An inventory strategy which reduces in-process inventory.
In order to achieve JIT the process must have signals of what is going on elsewhere within the process. These signals tell
production processes when to make the next part.
They can be simple visual signals, such as the presence of a part on a shelf.
Quick communication of the consumption of old stock which triggers new stock to be ordered is key to JIT and inventory
reduction.
JIT emphasises inventory as one of the seven wastes (overproduction, waiting time, transportation, inventory, processing,
motion and product defect), and so aims to reduce buffer inventory to zero.
Zero buffer inventory means that production is not protected from external shocks
4. Quality
Benefits
5. Lower reworking costs due to the increased emphasis on the quality of supplies
Managing Receivables
Managing Receivables in Practice
Policy formulation
This is concerned with establishing the framework within which management of accounts receivable in an individual company
takes place.
1. establishing terms of trade, such as period of credit offered and early settlement discounts:
Credit Analysis
Assessment of creditworthiness depends on the analysis of information relating to the new customer.
This information is often generated by a third party and includes bank references, trade references and credit reference
agency reports.
The depth of credit analysis depends on the amount of credit being granted, as well as the possibility of repeat business.
Credit Control
Once credit has been granted, it is important to review outstanding accounts on a regular basis so overdue accounts can be
identified. This can be done, for example, by an aged receivables analysis.
It is also important to ensure that administrative procedures are timely and robust, for example sending out invoices and
statements of account, communicating with customers by telephone or e-mail, and maintaining account records should
utilise the ‘Credit Policy’ to receive, record, maintain, and most importantly, control credit sales.
Ideally, all customers will settle within the agreed terms of trade. If this does not happen, a company needs to have in place
agreed procedures for dealing with overdue accounts.
These could cover logged telephone calls, personal visits, charging interest on outstanding amounts, refusing to grant further
credit and, as a last resort, legal action.
With any action, potential benefit should always exceed expected cost.
2. Debt factoring
There are four main reasons why a business may offer its customers discounts to pay early:
1. If cash is received earlier, it will improve the supplier’s liquidity position, because it reduces the length of its cash operating cycle.
2. If the cash from customers is received early, the cost of financing receivables is reduced.
For example, if the supplier has an overdraft agreement under which it borrows at a cost of 10% per annum, then provided that
the cost of offering the discount is less than the cost of the overdraft, the supplier will be better off financially.
3. When customers are deciding which payments to make to suppliers and which ones to delay, they are likely to pay those suppliers
offering a discount for early payment first.
From the point of view of the supplier offering the discount, this means that the incidence of bad debts is likely to be reduced,
since customers will choose to pay them first if they are short of cash.
4. It is possible that offering a discount may provide an incentive to new customers, because the cost of the goods from a supplier
offering a discount may now be less than those of a supplier not offering a discount, provided that the potentially new customer
pays within the specified time limit.
Think of this being funded by an overdraft. Therefore, the overdraft rate x receivables is the cost.
In questions you will be asked to compare the current policy cost, to a new policy cost (offering early settlement discounts) to
see which is cheaper
1. Early settlement will mean receivables will get smaller and so the cost less
2. However the discount is a cost to the company too so needs to be taken into account
1. Step 1: Calculate current policy cost of receivables (receivables x Overdraft Interest rate)
2. Step 2: Calculate NEW policy cost of NEW receivables (New receivables x overdraft interest rate)
3. Step 3: Calculate cost of early settlement discount and add to the new policy cost
Illustration
2. Step 2: New Policy cost of Receivables after = 2/12 x 80% x 1200 = 160 x 10% = 16
+ 10/365 x 20% x 1200 = 7 x 10% = 0.7
Occasionally you may be told that a new policy of INCREASING the credit term will also increase sales (as a larger credit
term will attract more customers)
Remember here that the company is not better off by the full sales amount, but by the contribution (sales less variable
costs) that these sales bring in.
For example if extra sales are 100 and the contribution to sales ratio is 20%, then you will take an extra 20 income to the
new policy calculation
You then need to compare this to the extra cost caused by the extra credit term (new receivables x overdraft rate)
Illustration
Their contribution to sales ratio is 20% and their overdraft rate is 10%. Sales are expected to increase by 20%
Is the change in policy a good idea?
The new policy has less costs than the current policy and so should be given the go-ahead
Debt Factor
Types of Arrangement
It can simply be they take over a company’s credit control department for a fee
It may be that the factor forwards the company some money in advance, and then collects the money from the debtors
themselves and keeps the money.
The amount forwarded here would be like a loan and so the factor would also charge interest
Finally, if the factor does “buy” the company’s debts then the deal may be “with recourse”
or “without recourse”
Advantages Disadvantages
Admin Costs Saved Can be expensive
More cash available as sales grow May give a bad impression to customers
Compare:
New cost with Factor (New receivables x overdraft rate, Fee, net cost of forwarding money less any increase in contribution,
less admin savings)
Illustration
A Company has credit sales of 200,000pa. Credit term is 30 days. The factor offers to buy for 80% at an interest rate of 9%. The
company can get an overdraft for 6%. The factor charges 1.5% of current credit sales.
The factor will offer customers an early settlement discount if paid in 15 days, 40% will accept this and the remainder will take 50
days to pay. Sales will increase by 5% and contribution to sales ratio is 40%
Solution
Current cost
TOTAL = 986
Cost of Factoring
New receivables = New sales x 15/365 x 40% = 3,452
New receivables = New sales x 50/365 x 60% = 17,260
Financed by overdraft cost at 6% = 1,242
Factor Fee = 200,000 x 1.5% = 3,000
Increase in contribution = sales increase x 40% = (4,000)
Forward Cost = new receivables x 80% x (9-6%) = 497.10
TOTAL = 739.1
The factor option costs less - so the factor’s offer should be taken up
Tricky bits
You will notice in the question above, I didn’t add the full cost of this forwarding money (like a loan).
What I did was take the forwarding interest rate charged less the overdraft interest rate.
Think of it like this, the company has an overdraft of 6%. Then they get loaned some money for 9%.
They will put the money from the loan in the bank and so it will lower their overdraft.
This means they will be saving 6%. Therefore the net cost to them is 3%.
So always take the net cost of the forwarding interest rate less the overdraft rate
Bad Debts
1. With recourse
no change here then (the company still keeps the bad debt risk). Therefore, generally, as theres no change - keep bad debts
completely out of the workings. Easy-peasy-lemon-squeezy
Just be careful though if it stays with recourse but the bad debts reduce - in that case treat this as a saving in the factor policy
2. Without recourse
here the company gives its bad debts risk to the factor. Therefore this is a saving for the company if they choose the factor option.
Invoice Discounting
Invoice Discounting
What is it?
1. Factoring
Financial services companies that provide businesses with debtor finance, secured against unpaid invoices are known as Factors
and Invoice Discounters.
Factors buy your trade debts and typically will pay 80% to 85% as soon as they receive a valid copy invoice.
The Factor collects the debt from your customer directly but will usually agree collection policies with you, in order to ensure
faster customer payment without loss of goodwill. Some Factors also provide bad debt insurance.
2. Invoice Discounting
With invoice discounting responsibility for collection of debts remains with you and the service is normally undisclosed to
customers.
Payments that you receive are paid into a bank account administered by the Invoice Discounter and you are then credited with the
balance less charges.
balance less charges.
Generally, invoice discounting is only available to businesses that already practice sound credit management and have the staff
and accounting systems to generate reliable customer collections.
Invoice Discounters, like Factors, will typically pay 80% to 85% against valid invoices.
For both factoring and invoice discounting there is a service charge, normally a proportion of turnover, and a discount
charge, based on the amount of finance provided.
Charges will be agreed in advance and form part of the factoring or invoice discounting agreement. For factoring the
service charge is normally between 0.75% and 2.5% of turnover, depending on the workload to be undertaken.
The charge for invoice discounting will usually be less, as less work is required.
The discount charge is calculated on day-to-day usage of funds. It is likely to be comparable with normal secured bank
overdraft rates.
Debtor finance is most suitable for growing businesses; finance will grow in line with the growth in turnover. Conversely,
where turnover is falling the level of finance will fall.
The cost of the service needs to be weighed against the costs of in-house debt collection and, for example, having
sufficient cash to benefit from early payment discounts from suppliers.
Generally debt finance providers are looking for ‘clean’ invoices where there is clear evidence of delivery of the goods or
service and a low level of disputes or credit notes.
It may not be available for some industries, for example contracting, where there is a high level of retentions and variation
orders.
Providers of debt finance usually acquire your debts with recourse to you if the debtor does not pay.
This means they will reclaim the amount already advanced to you should your debtor not pay in a given time period.
Alternatively, you may take out insurance against non-payment by your debtors.
Many factors and invoice discounters can also provide bad debt insurance.
Managing Foreign Receivables
The more complex nature of trade transactions and their elements means foreign accounts receivable need more
investment than their domestic counterparts
Exporters seek to reduce the risk of bad debt and to reduce the level of investment in foreign accounts receivable.
A signed agreement to pay the exporter on an agreed future date, supported by a documentary letter of credit, can be discounted
by a bank to give immediate funds.
They carry almost no risk, provided the exporter complies with the terms and conditions
5. Insurance
can also be used to cover some of the risks associated with giving credit to foreign customers.
This would avoid the cost of seeking to recover cash due from foreign accounts receivable through a foreign legal system, where
the exporter could be at a disadvantage due to a lack of local or specialist knowledge.
6. Export factoring
Can also be considered, where the exporter pays for the specialist expertise of the factor as a way of reducing investment in
foreign accounts receivable and reducing the incidence of bad debts.
Managing Payables
Early Settlement Discounts (Creditors)
Clearly it is best to take as much advantage of trade credit as possible. Paying later is almost always beneficial.
However, a company needs to ensure it does not annoy its vital suppliers by missing deadlines and also the company may seek
to take advantage of early settlement discounts.
Trade credit is a simple and often free source of finance. (It is not free, however, if an early payment discount is foregone)
Method
Simply compare:
2. New policy Savings (Less payables but receive an early settlement discount)
Illustration
Discount of 1% for an early settlement on goods worth 1,000,000pa if paid in 10 days (normal terms 30 days)
Current Savings
Payable saving:
30/365 x 1,000,000 x 10% = $8,219
Illustration
Cashflow forecasting enables you to predict peaks and troughs in your cash balance.
It helps you to plan borrowing and tells you how much surplus cash you’re likely to have at a given time.
The forecast is usually done for a year or quarter in advance and divided into weeks or months.
It is best to pick periods during which most of your fixed costs - such as salaries - go out.
This is the proforma that could be produced for a big, cashflow forecast question, though there has not been one yet, it is a
minor topic so far
Cash Receipts
Sales
Issue of Shares
Cash Payments
Purchases
Dividends
Tax
Wages
Cash Surplus/defecit
Cash b/f
Cash c/f
Note that not all expenses in the income statement are cash eg depreciation/accruals.
Not all sales are cash - only put them in the table when cash is RECEIVED.
Not all purchases of NCA are cash eg Finance leases - just put in the cash PAID to the lessor.
When preparing cashflow forecasts make sure your work is clearly laid out and referenced to workings.
Illustration
A lady decides to set her own business so needs to go to a bank with a cashflow forecast.
She has £6,000 to invest herself. She expects to buy some non current assets for 10,000, which have a 5 year life.
Forecast sales are 5,000 in February and rising by 10% per month.
Selling price is calculated using a mark up of 50%. 1 months credit is allowed by suppliers and 1 month given to customers
also.
Cash Receipts
Sales 5,000
Issue of Shares
Cash Payments
Dividends
The treasury of a multinational corporation relies, to a certain extent, on the expertise of local business.
However, the benefits of centralisation sometimes come at the expense of losing touch with this vital regional knowledge.
The road starts with the selection of the treasury processes most suitable to centralisation.
Each of the main treasury processes (short-term finance and liquidity management; long-term finance; risk management) should
be analysed to identify how centralisation could create additional benefits.
Risk is controlled when the philosophy of the company is clear and implemented from a central process.
This avoids the temptation of local management to put a local flair on company philosophy.
A sexy study
A recent study by Michael Gold and Andrew Campbell of the London Business School found that different and equally
successful corporations balanced local and corporate control in different ways.
Some emphasised strong centralised strategy development with local freedom to implement strategies; others set financial
standards at the corporate level and left business units to devise their own strategies and operational plans; others
practiced a mix.
All of the companies in the study sought the benefits of local autonomy while not giving up corporate control.
Control v Responsiveness
Control versus responsiveness is the underlying issue to address when considering centralising or decentralising.
When controls and consistency are necessary to the organisation, centralisation provides the cornerstone.
Consistent reporting up and down the corporate chain and knowledge of where the information resides without
duplication, can be the greatest reason to keep certain functions in a central location.
Inherent in the concept of centralization is the potential delay in decision making and information processing.
Centralised decisions require the local manager to seek permission from central management.
The central manager has to deliberate and convey his decision back down to local management for implementation.
This process can take time and slow down decision making.
The overall responsiveness of the corporation may suffer, with potentially damaging results.
Baumol Model
The target cash balance involves a trade off between the opportunity costs of holding too much cash and the trading costs of
holding too little.
For example if we know a division needs $100,000 during the year, how much should we transfer into their account (from their
deposit account)?
All of it would mean some of the cash lying in the current account doing nothing (not getting interest unlike in a deposit account)
at the early stages.
Whereas, transferring bits at a time (when the cash is needed) would mean lots of transaction costs.
This works just like EOQ for stock. It tells you how much cash to order (sell investments / take from deposit account) at a time, in
order to minimise holding (losing out on deposit interest) and order costs (cost of transferring cash / selling investments)..
Holding Cost
= Average cash balance x Interest rate;
= Cash transferred in / 2 x interest rate
= HC/2 x i
Order Cost
= Total cash used during period / Cash transferred in X Transaction cost
Illustration
Subsonic Speaker Systems (SSS) has annual transactions of $9 million. The fixed cost of converting securities into cash is $264.50
per conversion. The annual opportunity cost of funds is 9%.
Assumes a constant disbursement rate; in reality cash outflows occur at different times, different due dates etc.
Assumes no cash receipts during the projected period, obviously cash is coming in and out on a frequent basis
No safety stock of cash is allowed for, reason being it only takes a short amount of time to sell marketable securities
Miller-Orr Model
Miller-Orr Model
This model deals with cash inflows/outflows that change on a daily basis
The model works in terms of upper and lower control limits, and a target cash balance.
As long as the cash balance remains within the control limits the firm will make no transaction.
This lower limit can be related to a minimum safety margin decided by management
When the firm’s cash fluctuates at random and touches the upper limit, the firm buys sufficient marketable securities to come
back to a normal level of cash balance i.e. the return point
Similarly, when the firm’s cash flows wander and touch the lower limit, it sells sufficient marketable securities to bring the cash
balance back to the normal level i.e. the return point
The lower limit is set by the firm based on its desired minimum “safety stock” of cash in hand
Spread
Then the spread is calculated upper and then the upper limit and return point comes from this.
Spread = 3(3/4 x Transaction cost x Cashflow variance / interest rate) power of 1/3
Illustration
If a company must maintain a minimum cash balance of £8,000, and the variance of its daily cash flows is £4m (ie std deviation
£2,000). The cost of buying/ selling securities is £50 & the daily interest rate is 0.025%.
Required: Calculate the spread, the upper limit (max amount of cash needed) & the return point (target level)
Solution
NOTE
The cashflow variance is DAILY. Also the standard deviation is the square root of the variance.
Therefore if given the standard deviation then you need to square it before putting it into the equation.
The interest rate is also a daily one. A quick (if oversimplified way) of reaching this simply to divide the annual rate by 365)
Benefits
2. Transfers can take place at any time and are instantaneous with a fixed transfer cost.
3. Produces control limits which can be used as basis for balance management.
Limitations
Future cash requirements and disbursements are known with perfect certainty
Daily cash flows vary according to a normal probability distribution with known variance
An aggressive policy uses lower levels of inventory and trade receivables than a conservative policy, and so will lead to a shorter
cash operating cycle.
A conservative policy on the level of investment in working capital, in contrast, with higher levels of inventory and trade
receivables, will lead to a longer cash operating cycle.
The higher cost of the longer cash operating cycle will lead to a decrease in profitability while also decreasing risk, for example
the risk of running out of inventory.
to cover the short-term changes in current assets represented by fluctuating current assets
This will use a higher proportion of long-term finance than a matching policy, thereby financing some of the fluctuating
current assets from a long-term source.
This will be less risky and less profitable than a matching policy, and will give rise to occasional short-term cash surpluses.
This will use a lower proportion of long-term finance than a matching policy, financing some of the permanent current
assets from a short-term source such as an overdraft.
This will be more risky and more profitable than a matching policy
Management attitudes to risk, previous funding decisions and organisation size
Management attitudes to risk will determine whether there is a preference for a conservative, an aggressive or a matching
approach.
Previous funding decisions will determine the current position being considered in policy formulation.
The size of the organisation will influence its ability to access different sources of finance.
A small company, for example, may be forced to adopt an aggressive working capital funding policy because it is unable to
raise additional long-term finance, whether equity of debt.
The working capital cycle or operating cycle is the period of time between when a company settles its accounts payable and
when it receives cash from its accounts receivable.
Companies with comparatively longer operating cycles than others in the same industry sector, will therefore require
comparatively higher levels of investment in current assets.
2) Terms of trade
These determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases,
and any penalties for late payment.
A company whose terms of trade are more generous than another company in the same industry sector will therefore need a
comparatively higher investment in current assets.
Even within the same industry sector, companies will have different policies regarding the level of investment in current
assets, depending on their attitude to risk.
A company with a comparatively conservative approach to the level of investment in current assets would maintain higher
levels of inventory, offer more generous credit terms and have higher levels of cash in reserve than a company with a
comparatively aggressive approach.
While the more aggressive approach would be more profitable because of the lower level of investment in current assets, it
would also be more risky, for example in terms of running out of inventory in periods of fluctuating demand or of failing to
have the particular goods required by a customer
Some industries, such as aircraft construction, will have long operating cycles due to the length of time needed to
manufacture finished goods and so will have comparatively higher levels of investment in current assets than industries such
as supermarket chains, where goods are bought in for resale with minimal additional processing and where many goods have
short shelf-lives.
Basically the inventory and the receivables need to be financed somehow, either by an overdraft (1st) or by a long term loan
(2nd)
I guess even that’s not strictly true as they are firstly financed by
Illustration
Inventory 800
Receivables 400
Payables 300
Amount Cost
When considering how working capital is financed, it is useful to divide assets into non-current assets, permanent current assets
and fluctuating current assets.
These represent the core level of working capital investment needed to support a given level of sales.
These represent the changes in working capital that arise in the normal course of business operations, for example when
some accounts receivable are settled later than expected, or when inventory moves more slowly than planned.
WC investment v Funding
You invest in current assets and you fund through finance
Permanent current assets represent the core level for a given level of business activity
Fluctuating current assets represent changes due to the unpredictability of business operations e.g. Higher stock as
demand less than predicted
Uses Matching policy where long-term assets should be financed by long-term finance
So working capital investment and financing policy use similar terminology, but mean different things.
A company could have an aggressive investment policy but a conservative financing policy
Investment Appraisal
Financing the Investments
Sources of Finance
Sources of Finance
Operating Leases
The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business.
This flexibility is seen as valuable in the current era of rapid technological change, and can also extend to contract terms and
servicing cover
There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided,
existing assets need not be tied up as security and negative effects on return on capital employed can be avoided
Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.
By taking advantage of bulk buying, tax benefits etc the lessor can pass on some of these to the lessee in the form of lower lease
rentals, making operating leasing a more attractive proposition that borrowing.
Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of the
leased asset does not appear in the balance sheet.
Debt v Equity
These are the things you need to think about when asked about raising finance - so just put all these in your answer and link
them to the scenario. Job done.
In practical terms this can be achieved by having some debt in 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 the costs of financial distress)
Availability of security
Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a
specified class of assets).
Economic expectations
If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are
more attractive than when difficult trading conditions lie ahead.
Control issues
A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.
Rights Issues
The current shareholders are being offered 1 share for $4, for every 2 they already own.
(The market value of those they already own are currently $6)
So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33
Effect on EPS
Obviously this will fall as there are now more shares in issue than before, and the company has not received full MV for
them
To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue
To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue
This is because, although the share price has fallen, they have proportionately more shares
Equity issues such as a rights issue do not require security and involve no loss of control for the shareholders who take up
the right
The factors considered when reducing the amount of debt by issuing equity :
As the proportion of debt increases in a company’s financial structure, the level of financial distress increases and with it the
associated costs.
Companies with high levels of financial distress would find it more costly to contract with their stakeholders.
For example, they may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods
or larger discounts, and may have to accept supplies on more onerous terms.
1. Less financial distress may therefore reduce the costs of contracting with stakeholders.
2. Having greater equity would also increase the company’s debt capacity.
3. On the other hand, because interest is payable before tax, larger amounts of debt will give companies greater taxation benefits,
known as the tax shield.
4. Reducing the amount of debt would result in a higher credit rating for the company and reduce the scale of restrictive covenants.
Appraisal Methods
Accounting Rate of Return
Return on capital employed (ROCE)
Note:
Right, first thing you need to remember about this is that this is the ONLY investment appraisal technique which uses profits
and not cash in the F9 exam.
The second thing to understand is that it has 2 names - ROCE (return on capital employed) and ARR (Accounting rate of
return)
1. Simple Method
This percentage is compared to the target return you would like to get.
Clearly it has to be higher than say the interest rate on the loan you used to buy the capital item.
More correctly it has to be higher than the company’s cost of capital (more of that later)
2. Average Method
The average investment is the average value it would be in the SFP over the length of the project
Illustration
RCA are considering expanding their business into Canada by buying up a local college over there.
The local college purchase will cost £500,000 and a further £300,000 to make the premises sexy
Cashflow profits (ie not including depreciation) from the college over the next 5 years are expected to be:
2 120,000
3 180,000
4 250,000
5 350,000
The sexiness of the premises will have disappeared by the end of the 5 years and so sadly have a zero resale value. This will make
RCA sad and so they expect to sell up in order to buy a funky new college somewhere else. When they sell they hope to get
£400,000 for the college
Required
Calculate the ROCE of this investment (using the average investment method)
Solution
Total profits = Cash - Depreciation
This is used when company’s are more interested in PROFITABILITY than liquidity
Unlike the other capital budgeting methods that we have discussed, the simple rate of return method does not focus on cash
flows. Rather, it focuses on accounting net operating income.
The most damaging criticism of the accounting rate of return method is that it does not consider the time value of money. The
simple rate of return method considers a dollar received 10 years from now as just as valuable as a dollar received today. Thus,
the accounting rate of return method can be misleading if the alternatives being considered have different cash flow patterns.
Additionally, many projects do not have constant incremental revenues and expenses over their useful lives. As a result the
simple rate of return will fluctuate from year to year, with the possibility that a project may appear to be desirable in some years
and undesirable in other years. In contrast, the net present value method provides a single number that summarised all of the
cash flows over the entire useful life of the project.
1. Fairly simple
Drawbacks
It disregards the project life and when the cash flows actually come in.
NPV
Net Present Value method
What it does is looks at all the projected future CASH inflows and outflows.
Obviously we hope the inflows are more than the outflows. If they are this is called a positive NPV
The idea that money coming in today is worth more than the same amount of money coming in in 5 years time. To do this we
“discount down” all future cash flows.
This “discounting” takes into account not only the time value of money but also the required return of our share and debt
holders.
This means that if we have a positive NPV (even after discounting the future cash flows) then the return beats not only the time
value of money but it also beats what the shareholders and debt holders require.
So they will be happy and the company value (and hence share price) will rise by the +NPV amount (divided by the number of
shares)
NPV Proforma
0 1 2 3 4
Sales x x x x
Profit x x x x
Scrap x
WDA x x x x
Simply calculate the net profit figure (sales less costs in table) and multiply by the tax rate.
Remember it is normally payable one year later. For example tax on year 1 profits is paid in year 2 (and so goes in the NPV in
yr 2)
WDAs
These are normally 25% writing down allowances on plant & machinery
Illustration
Answer
Year 4 Total tax relief should be (100-20) x 30% = 24. Less benefits relieved so far (7.5 + 5.625 + 4.2) = 6.675
Working Capital
Think of this as like float in a restaurant. Each night in the restaurant represents a year.
So, lets say a float of 100 is needed at the start of the night (T0).
Then the following night an extra 20 is required, the following night 30 more & the final night 10 less
T0 T1 T2 T3 T4
NPV v IRR
NPV v IRR
The net present value (NPV) method has several important advantages over the internal rate of return (IRR) method.
NPV is often simpler to use. As mentioned earlier, IRR may require hunting for the discount rate that results in a net present
value of zero.
This can be a very laborious trial-and-error process, although it can be automated to some degree using a computer
spreadsheet.
A key assumption made by IRR is questionable. Both methods assume that cash flows generated by a project during its
useful life are immediately reinvested elsewhere.
However, the two methods make different assumptions concerning the rate of return that is earned on those cash flow.
IRR assumes the rate of return is the internal rate of return on the project.
So, if the IRR is high, this assumption may not be realistic. It is more realistic to assume that cash can be reinvested at the
discount rate - particularly if the discount rate is the company’s cost of capital. For example, by paying off the company’s
creditors
In short, when NPV and IRR do not agree, it is best to go with NPV. Of the two methods, it makes the more realistic
assumption about the rate of return that can be earned on cash flows from the project.
IRR has several weaknesses as a method of appraising capital investments. Since it is a relative measurement of investment
worth, it does not measure the absolute increase in company value (and therefore shareholder wealth), which can be found
using the net present value (NPV) method
There is a potential conflict between IRR and NPV in the evaluation of mutually exclusive projects, where the two methods
can offer conflicting advice as which of two projects is preferable.
For example a small project may have a higher IRR but a lower NPV than a very big project.
Where there is conflict, NPV always offers the correct investment advice
Payback method
Payback method
This method focuses on liquidity rather than the profitability of a product. It is good for screening and for fast moving
environments
The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it
generates.
This period is some times referred to as “the time that it takes for an investment to pay for itself.”
The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more
desirable is the investment.
The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be
used to calculate the payback period….
Formula / Equation:
*If new equipment is replacing old equipment, this becomes incremental net annual cash inflow.
It simply measures how long it takes the project to recover the initial cost. Obviously, the quicker the better.
Illustration
Solution
Take the decimal (0.1429) and multiply it by 12 to get the months - in this case 1.7 months
Rather, it simply tells the manager how many years will be required to recover the original investment.
Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another.
For example it doesn’t look at the whole life of the project
Another criticism of payback method is that it does not consider the time value of money. A cash inflow to be received several
years in the future is weighed equally with a cash inflow to be received right now.
3. Screening
On the other hand, under certain conditions the payback method can be very useful. It can help identify which investment
proposals are in the “ballpark.”
That is, it can be used as a screening tool to help answer the question, “Should I consider this proposal further?” If a proposal does
not provide a payback within some specified period, then there may be no need to consider it further.
When a firm is cash poor, a project with a short payback period but a low rate of return might be preferred over another project
with a high rate of return but a long payback period.
The reason is that the company may simply need a faster return of its cash investment.
And finally, the payback method is sometimes used in industries where products become obsolete very rapidly - such as consumer
electronics.
Since products may last only a year or two, the payback period on investments must be very short.
1. Simple
This is because cashflows in the future become harder and harder to predict so recovering the money as soon as possible is vital.
4. It maximises liquidity
Drawbacks
1. the item with the quickest payback is simply that. What about afterwards, does it still do well or does it then become obsolete?
2. It ignores the whole profitability. Also the time value of money is ignored (more of that later).
Irregular Cashflows
When the cash flows associated with an investment project changes from year to year, the simple payback formula that we
outlined earlier cannot be used.
Cumulative
When the cumulative cashflow becomes positive then this is when the initial payment has been repaid and so is the payback
period
So in the final year we need to make 10 more to recoup the initial 800. So, that’s 10 out of 120. 10/120 x 12 (number of months) =
1.
The payback period is calculated by dividing the investment in a project by the net annual cash constant inflows that the
project will generate.
If equipment is replacing old equipment then any scrap value to be received on disposal of the old equipment should be
deducted from the cost of the new equipment, and only the incremental investment should be used in payback
computation.
Ok this is a bit dull, and a bit obvious, but hey not everything in life can be as cool as cows.. so just learn them and stop moaning,
you big fat money pants
Key stages:
From an analysis of strategic choices, analysis of the business environment, research and development, or legal requirements.
The key requirement is that investment proposals should support the achievement of organisational objectives.
Companies need to choose between competing investment proposals and select those with the best strategic fit and the most
appropriate use of economic resources.
This is the stage where investment appraisal plays a key role, indicating for example which investment proposals have the highest
net present value.
Very large proposals may require approval by the board of directors, while smaller proposals may be approved at divisional level
The time required to implement the investment proposal or project will depend on its size and complexity.
Following implementation, the investment project must be monitored to ensure that the expected results are being achieved and
the performance is as expected.
The whole of the investment decision-making process should also be reviewed in order to facilitate organisational learning and to
improve future investment decisions.
NPV Theory
NPV Theory
NPV Benefits
1. it considers the time value of money (that is in the discount rate used)
5. It maximises the wealth of shareholders as this increases through receiving dividends and rising share prices.
6. Positive NPV investments should increase the market value of the company by the amount of the NPV.
A company with a market value of $10 million investing in a project with an NPV of $1 million will have a market value of $11
million once the investment is made.
NPV method also contributes towards the objective of maximising the wealth of shareholders by using the cost of capital of a
company as a discount rate when calculating the present values of future cash flows.
A positive NPV represents an investment return that is greater than that required by a company’s providers of finance, offering
the possibility of increased dividends being paid to shareholders from future cash flows (see later)
NPV drawbacks
1. The reliance placed on the cost of capital - this can be tricky to calculate (as we shall see later)
2. Inflation rates are assumed to be constant in future periods. In reality, interaction between a range of economic and other forces
influencing selling price per unit and variable cost per unit will lead to unanticipated changes in both of these project variables
4. It does not adjust the cash flows in future years for their lack of predictability compared to earlier years
Miscellaneous Techniques
Inflation basics
Inflation
An increase in prices (just in case you really are a mentalist). This means, therefore, that the real value of the same amount of
money will decline over time
This is the rate of return required by a lender - this may be quoted at a rate that includes inflation (money rate) or a rate which
doesn’t (real).
The real rate then means that the lender wants this on top of the inflation rate. Anyway more of that in the next section - I just
wanted to introduce it to you here
Illustration
Let’s say that inflation is 2%. If you have £100 now and don’t spend it, the £100 won’t be able to buy as much as it could at
the start of the year because prices have increased by 2%.
Therefore to stop this fall in value, many people put the money in a bank. They may get an interest rate of say 5%. This
would represent a return over and above the inflation rate.
Although the calculation ISN’T quite this straightforward (see later), basically if you get a 5% interest rate, and inflation is
2%, then you have received around a 3% return over and above the inflation rate. We call this rate the REAL return
NPVs and Inflation
2. Include an inflation adjustment even for year 1 (as this is strictly the END of year1)
3. Include the GENERAL inflation in the discount rate by using a money or nominal rate (see later)
Calculation
Eg Sales 100 per year in real terms for 3 years. Price inflation is 10% pa
Real Rate
The rate you receive, not taking into account inflation (you want inflation on top of the real rate)
A real return on top of inflation. This is often the discount rate given in NPV questions
Formula:
Illustration
Discounting
Ok - so we have seen how to work out future values from present values.
However, when looking at whether we should invest in something we will be looking at future cashflows coming in.
We want to know what are these future cashflows worth now, in today’s money ideally.
To do this we need to work the other way around ie. Take the future value (FV) and work out the present value (PV). We do this
by:
Discounting
Discount Factors
It is the discounted cash flows that we want to end up with in an NPV question. So we put the future cash flows in, and
then discount them using a discount factor. These are given in discount factor tables in the exam but can be calculated as
follows:
If you want to calculate a 10% discount factor for year 1 - It is 1 divided by 1.10 = 0.909
If you want to calculate a 10% discount factor for year 2 - It is 1 divided by 1.10 divided by 1.10 = 0.826
If you want to calculate a 10% discount factor for year 3 - It is 1 divided by 1.10 divided by 1.10 divided by 1.10 = 0.751
If you want to calculate a 6% discount factor for year 1 - It is 1 divided by 1.06 = 0.943
If you want to calculate a 12% discount factor for year 1 - It is 1 divided by 1.12 = 0.893
Illustration
You are to receive £100 in one year’s time and the interest rate/discount rate is 10%. What is the PV of that money?
100 x 1 /1.10
= 90.9
Annuity
Lets us now look at discounting a future cash-flow that is constant every year for a specified number of years (an annuity).
Illustration
100 received at the end of every year for the next 3 years. If cost of capital is 10% what is the PV of these amounts together?
This is easier is to calculate using an annuity discount factor - this is simply the 3 different discount factors above added together
- again luckily this is given to us in the exam (in the annuity table)
yr 1 1/1.1 = 0.909
yr 2 1/1.1/1.1 = 0.826
Yr 3 1/1.1/1.1/1.1 = 0.751
All added together 2.486 = Annuity factor (or get from annuity table!)
Perpetuities
What is the PV of an annual income of 50,000 for the forseeable future, given an interest rate of 5%?
Answer
50,000 / 0.05 = 1,000,000
Don’t panic!
Just calculate the perpetuity as normal - then discount the answer down (discount factor for 3 years - for example - if the
perpetuity started at year 3)
Other Topics
Risk and Uncertainty
Risk & Uncertainty basics
Risk
Uncertainty
Risk refers to the situation where probabilities can be assigned to a range of expected outcomes arising from an
investment project and the likelihood of each outcome occurring can therefore be quantified
Uncertainty refers to the situation where probabilities cannot be assigned to expected outcomes. Investment project risk
therefore increases with increasing variability of returns, while uncertainty increases with increasing project life
The analysis so far has assumed that all of the future cash flows are known with certainty. However, future cash flows are often
uncertain or difficult to estimate.
A number of techniques are available for handling this complication. Some of these techniques are quite technical involving
computer simulations or advanced mathematical skills and are beyond the scope of F9.
However, we can provide some very useful information to managers without getting too technical.
1. Sensitivity Analysis
2. Probability Analysis
3. Simulation
4. Adjusted Payback
Sensitivity Analysis
The one which has to change the least to make the net present value no longer positive
Managers should then look at the assumptions behind this key item
Also focus on it in order to increase the likelihood that the project will deliver positive NPV
The smaller the percentage, the more sensitive the decision to go ahead is to the change in the variable
Illustration
ACCA colleges are considering a project which will cost them an initial 10,000
Solution
PV of project as a whole:
Year 0 1 2
Investment (10,000)
Sensitivity of Costs
5,615 / (909 + 826) = 323%
Sensitivity of Sales
5,615 / (9,090 + 8,260) = 32%
Probability analysis
Probability analysis
This is the assessment of the separate probabilities of a number of specified outcomes of an investment project.
For example, a range of expected market conditions could be formulated and the probability of each market condition arising in
each of several future years could be assessed.
The NPVs arising from these combinations could then be assessed and linked to their joint probabilities.
The expected net present value (ENPV) could be calculated, together with the probability of the worst-case scenario and the
probability of a negative net present value.
In this way, the downside risk of the investment could be determined and incorporated into the investment decision.
The term ‘probability’ refers to the likelihood or chance that a certain event will occur, with potential values ranging from 0 (the
event will not occur) to
1 (the event will definitely occur).
For example, the probability of a tail occurring when tossing a coin is 0.5, and the probability when rolling a dice that it will show
a four is 1/6 (0.166).
The total of all the probabilities from all the possible outcomes must equal 1, ie some outcome must occur
Calculating an EV
Formula
∑px
It finds the the long run average outcome rather than the most likely outcome
Illustration
A new product cashflows will depend on whether a substitute comes onto the market or not
Solution
Expected values are more useful for repeat decisions rather than one-off activities, as they are based on averages.
They illustrate what the average outcome would be if an activity was repeated a large number of times.
And the average family in the UK has 2.4 children, now Ive never thrown a 3.5 nor met anyone with 2.4 children.
These are just long term averages, whereas in reality outcomes only occure once
Simulation
Simulation
Illustration
Variable costs 4 5 6
The random numbers represent the probability. So, 30 numbers are given to the 30% range, 50 to the 50% range etc.
This is repeated many times for all variables until we have a probability distribution
Advantages
2. Easily understood
Disadvantages
Adjusted Payback
2 Methods
Add payback to NPV - Only projects with +ve NPV and payback within specified time chosen
Illustration of method 2
Year Cashflow
0 (1,700)
1 500
2 500
3 600
4 900
5 500
Solution
2. Cost of equity
If a project gives additional risks then the discount factor should be altered accordingly. This is called the risk premium
Shareholder wealth is maximised by taking on positive NPV projects. However, capital is not always available to allow this to
happen.
In a perfect capital market there is always finance available - in reality there is not, there are 2 reasons for this:
This is due to external factors such as banks won’t lend any more - why?
Company imposes it’s own spending restriction. (This goes against the concept of shareholder maximisation - which occurs by
always investing in positive NVP projects ) - why?
6. “Internal Capital market” - deliberately restricting funds so competing projects become more efficient
Here, divisible investment projects can be ranked in order of desirability using the profitability index
Steps for the exam with divisible projects
1. It's assumed that part rather than the whole investment can be undertaken
If 70% of a project is performed, for example, its NPV is assumed to be 70% of the whole project NPV.
Illustration
A Company has 100,000 to invest and has identified the following 5 projects. They are DIVISIBLE.
A 40 20
B 100 35
C 50 24
D 60 18
E 50 10
Solution
A 20/40 0.5 1
B 35/100 0.35 3
C 24/50 0.48 2
D 18/60 0.3 4
E who cares! 5
Plan
100,000
(40,000) A 20,000
(50,000) C 24,000
In this case ranking by profitability index will not necessarily indicate the optimum investment schedule, since it will not be
possible to invest in part of a project.
Unfortunately with indivisible projects there is no model to help us! We simply have to look at all the possible combinations by
trial and error work out which would be the most profitable. (Highest NPV)
Surplus funds may be left over, but since the highest-NPV combination has been selected, the amount of surplus funds is
irrelevant to the selection of the optimal investment schedule
Illustration
A company has 100,000 to invest and has identified the following 5 projects. They are NOT DIVISIBLE.
A 40 20
B 100 35
C 50 24
D 60 18
Solution
A&C 90 44
A&D 100 38
B 100 35
Lease or Buy
Lease or Buy
Simply choose the one with the lowest NPV cost (as asset revenues will be the same for both methods)
LEASE BUY
Rental Payment Cost of item
(WDAs)
Unless the company does not pay tax - use the after tax cost of borrowing
*Note that the cost of the loan should not include the interest repayments on the loan
Illustration
Finance choices
Solution
0 Cost 6,400
Cost = (4,984)
Time 0 1 2 3 4 5 6
Cost (6400)
Option 2 - Lease
Cost (4,548)
1. Allows company to get the asset if they can’t get a bank loan
3. Avoids regulations that other lending can give such as covenants etc
3. No risk of obsolescence
6. Can be expensive
The different options open to us have different time scales so, in order to compare, we use an EAC (equivalent annual cost):
Steps:
Key Assumptions
1. Although the operating revenues are deemed to be the same, using an older asset may not be as efficient
Illustration
Running costs
Year 1 5,000
Year 2 5,500
Solution
0 1
Machine (20,000)
(20,000) 11,000
Discount Factor 1 0.909
NPV (10,001)
0 1 2
Machine (20,000)
NPV (18,350)
EAC = 18,350 / 1.736 = 10,570
Machine should be replaced every 2 years as this is cheaper
Sources of Finance
Short Term Finance
Short term finance
- in the exam always remember to think about these when asked about possible ways of raising finance
1. Overdraft
3. Trade Credit
4. Operating Lease
When recommending though - also think about how much overdraft they already have - what their short term commitments are
already
Operating Leases
The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business.
This flexibility is seen as valuable in the current era of rapid technological change, and can also extend to contract terms
and servicing cover
There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be
avoided, existing assets need not be tied up as security and negative effects on return on capital employed can be avoided
Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.
By taking advantage of bulk buying, tax benefits etc the lessor can pass on some of these to the lessee in the form of lower
lease rentals, making operating leasing a more attractive proposition that borrowing.
Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of
the leased asset does not appear in the balance sheet.
to provide a link between investors who have surplus cash and borrowers who have financing needs.
to offer maturity transformation, in that investors can deposit funds for a long period of time while borrowers may require
funds on a short-term basis only
These are the things you need to think about when asked about raising finance - so just put all these in your answer and link
them to the scenario. Job done.
Equity finance will decrease gearing and financial risk, while debt finance will increase them
In practical terms this can be achieved by having some debt in 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 the costs of financial distress)
Availability of security
Economic expectations
If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are
more attractive than when difficult trading conditions lie ahead.
Control issues
A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.
Equity as Finance
Placing Fixed price to institutional investors Low cost - good for small issues
When a company issues shares to the public for the first time. They are often issued by smaller, younger companies looking to
expand, or large private companies wanting to become public.
For the individual investor it is tough to predict share prices on the initial day of trading as there’s little past data about the
company often, so it’s a risky purchase.
Gearing considerations
A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to
service its debt regardless of how bad sales are.
A greater proportion of equity provides a cushion and is seen as a measure of financial strength.
1. Need to cover high fixed costs, may tempt companies to increase sales prices and so lose sales to competition
Operational gearing
Operating gearing is a measure which seeks to investigate the relationship between the fixed operating costs and the total
operating costs.
In cases where a business has high fixed costs as a proportion of its total costs, the business is deemed to have a high level
of operational gearing.
Potentially this could cause the business problems in as it relies on continuing demand to stay afloat.
If there is a fall in demand, the proportion of fixed costs to revenue becomes even greater. It may turn profits into serious
losses.
Normally, businesses cannot themselves do a great deal about the operational gearing, as it may be typical and necessary in
the industry, such as the airline business.
Interest cover
Interest cover is a measure of the adequacy of a company’s profits relative to interest payments on its debt.
The lower the interest cover, the greater the risk that profit (before interest) will become insufficient to cover interest payments.
It is:
It is a better measure of the gearing effect of debt on profits than gearing itself.
A value of more than 2 is normally considered reasonably safe, but companies with very volatile earnings may require an even
higher level, whereas companies that have very stable earnings, such as utilities, may well be very safe at a lower level.
Similarly, cyclical companies at the bottom of their cycle may well have a low interest cover but investors who are confident of
recovery may not be overly concerned by the apparent risk.
Long term finance
These are:
1. Finance Lease
You will notice we have included both operating and finance leases as potential sources of finance - don’t forget too to mention
the possibility of selling your assets and leasing them back as a way of getting cash.
Be careful though - make sure there are enough assets on the SFP to actually do this - or your recommendation may look a little
silly ;)
3. Equity
4. Preference Share
5. Venture Capital - for companies with high growth and returns potential
The venture capitalist makes money by taking an equity share and then realising this in an IPO (Initial Public Offering) or trade sale
of the company
Equity as finance
Placing Fixed price to institutional investors Low cost - good for small issues
The current shareholders are being offered 1 share for $4, for every 2 they already own.
(The market value of those they already own are currently $6)
So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33
Effect on EPS
Obviously this will fall as there are now more shares in issue than before, and the company has not received full MV for them
To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue
This is because, although the share price has fallen, they have proportionately more shares
Equity issues such as a rights issue do not require security and involve no loss of control for the shareholders who take up
the right
Placing (on the market)
Public Issues
When a company issues shares to the public for the first time.
They are often issued by smaller, younger companies looking to expand, or large private companies wanting to become public.
For the individual investor it is tough to predict share prices on the initial day of trading as there’s little past data about the
company often, so it’s a risky purchase.
Islamic Financing
Islamic Finance - Introduction
Is it moral or ethical to wish wealth into existence without any underlying productive activity happening?
Islamic Finance is based on the principle that money must never spontaneously generate money. Instead capital must be made
fruitful or “fecundated” by labour, material or intellectual activity or be invested in a wealth creating activity.
Islam therefore prohibits the payment of interest on loans, so observant Muslims require specialised alternative arrangements
from their banks.
Many of the largest global financial companies, including Deutsche Bank and JPMorgan Chase, have established thriving
subsidiaries that strive to meet these requirements
Consequently Islamic Finance frowns upon speculation and applauds risk sharing.
The major difference between Islamic finance and the other finance
Under Islamic finance laws, interest cannot be charged or received due to the lack of underlying activity
Therefore, Joint ventures under which the lender and the borrower share profits and risks are common because of the strict
prohibition of the giving and taking of interest.
Due to a ban on speculation, Islamic transactions must be based on tangible assets such as commodities, buildings or land.
Islamic banking has its emphasis on equity financing rather than lending
Investing in businesses that provide goods or services considered contrary to the principles of Islam is haraam (forbidden)
while those that are permitted are halaal.
Interest is called riba and an instrument that complies with the dictates of Fiqh al-Muamalat (Islamic rules on transactions)
is described as sharia-compliant.
Instead of charging interest (deemed to be money making money), the lender agrees to buy the asset or part of the asset
themselves (asset making money)
Shariah-compliant mortgages, for instance, are typically structured so that the lender buys the property and leases it out to
the borrower at a price that combines a rental income and a capital payment.
At the end of the mortgage term, when the price of the property has been fully repaid, the house is transferred to the
borrower.
Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the perspective of the borrower, the lender
and the economy.
For the borrower, riba can turn a profit into a loss when profitability is low.
For the lender, riba can provide an inadequate return when unanticipated inflation arises. In the economy, riba can lead to
allocational inefficiency, directing economic resources to sub-optimal investments
Let’s say that you, a small businessperson, wish to go into business selling cars.
A conventional bank would examine your credit history and, if all was acceptable, grant you a cash loan.
You would have to pay back funds on a specific maturity date, paying interest each month along the way.
You would use the proceeds to buy the car—and meet other expenses—yourself.
Murabaha
But in a murabaha transaction, instead of just giving you the cash, the bank itself would buy the cars.
You promise to buy them from the bank at a higher price on a future date.
The markup is justified by the fact that, for a period, the bank owns the property, thus assuming liability.
A murabaha must be asset-based however, so it can’t help a small businessman who needs a working-capital loan to meet
payroll and other expenses.
To get such capital from an Islamic financial institution, an entrepreneur would have to sell the bank an equity interest in
his business.
This is far riskier for the bank and thus much harder to obtain.
Lease finance (ijara)
A transaction where a benefit arising from an asset is transferred in return for a payment, but the ownership of the asset
itself is not transferred.
Most often the lessee returns the asset (and its benefits) to the lessor.
However some jurists do not permit this latter arrangement on the basis that it represents more or less a guaranteed
financial return at the outset to the lessor, in much the same way as a modern interest-based finance lease.
The terms of ijara are flexible enough to be applied to the hiring of an employee by an employer in return for a rent that is
actually a fixed wage.
1. The leased asset must continue to exist throughout the term of the lease.
Items which are consumed in the process of usage, ammunition for instance, cannot be leased
2. In contrast with most conventional finance leases, the responsibility for maintenance and insurance of the leased item under ijara
remains that of the lessor throughout
3. A price cannot be pre-determined for the sale of the asset at the expiry of the lease.
However, lessor and lessee may agree the continuation of the lease or the sale of the leased asset to the lessee under a new
agreement at the end of the initial lease period.
A type of partnership in which one partner provides the capital while the other provides expertise and management.
Each gets a prearranged percentage of the profits, but the partner providing the capital bears any losses.
Legally this concept is established as permissible by the consensus of the scholars and not based on primary sources of the
Shariah.
As the profits are shared with the manager and the capital provider but the losses are beared only by the capital provider this
mode is also named profit sharing – loss bearing.
Before the manager gets his share, the losses, however, if any, needs to be recovered. A wage could be negotiated.
The company sells the certificate to the investor, who then rents it back to the company for a predetermined rental fee.
The company promises to buy back the bonds at a future date at par value.
Sukuks must be able to link the returns and cash flows of the financing to the assets purchased, or the returns generated
from an asset purchased.
In musharaka, two or more parties contribute capital to a business and participate with the related profits and losses.
Simple Musharaka
In a Musharaka contract all parties may take part in the management or some parties may not take part in the
management (silent partnership).
Losses need to be born proportionately to the capital provided by each party (pro rata).
Regarding the profits there is a disagreement between the schools whether other than pro rata distribution is permissible.
Retained Earnings
Strictly speaking these are not ALL available as possible finance as many will have already been spent
Businesses make profits for either distribution back to their shareholders, paying off loans or re-investing in the business
The distribution back to shareholders (dividend policy) will be looked at later, but what about paying off a loan?
This should only occur where the ROCE made by the company is less than the interest they are paying on the loan.
The investments chosen though will need to at least match the needs of the shareholders and debtholders (the WACC)
By improving the recovery of receivables and delaying the payment of payables, business can free up cash short term to
invest
Dividend policy
A decision to increase capital investment spending will increase the need for financing, which could be met in part by reducing
dividends.
Miller and Modigliani showed that, in a perfect capital market, the value of a company depended only on its
investment decision, and not on its dividend or financing decisions.
In a perfect market, the value of a company is maximised when all positive NPV projects are invested in.
In a perfect market the share price reflects all future dividends, so shareholders who were unhappy with the level of
dividend declared by a company could gain a ‘home-made dividend’ by selling some of their shares.
This is possible since there are no transaction costs in a perfect capital market.
Many say there is a clear link between dividend policy and share prices.
For example, it has been argued that investors prefer certain dividends now rather than uncertain capital gains in the future
(the ‘bird-in-the-hand’ argument).
Imperfect markets
Therefore a change in dividend policy could be seen by investors (with less information than managers) as a ‘signal’ and so
affect the share price.
Signalling effect
The size and direction of the share price change will depend on the difference between the dividend announcement and
the expectations of shareholders.
Clientele Effect
Apple shares have outperformed the market massively in the last few years.
This means that Apple shareholders are enjoying huge share price increases (capital growth).
These shareholders cannot get such returns by investing elsewhere so do not want their money back from Apple yet.
Consequently Apple’s dividend policy to date is zero dividends despite its huge cash balances
A company with an established dividend policy is therefore likely to have an established dividend clientele.
The existence of this dividend clientele implies that the share price may change if there is a change in the dividend policy of
the company, as shareholders sell their shares in order to reinvest in another company with a more satisfactory dividend
policy.
Legal Constraints
3. Insolvency Rule
dividends cannot be paid when insolvent or if the payment makes the firm insolvent
Forms of Dividends
Types of payment:
1. Cash dividends
2. Stock dividends: Corporations distribute dividends in the form of new shares to existing shareholders
3. Stock split: Issue new shares to existing shareholders by splitting existing shares (E.g., 2-for-1 split)
4. Reverse split: Issue new shares to replace out shares but results in a reduction in number of outstanding shares (E.g., 1-for-2 shares)
5. A scrip (or share) dividend is an offer of shares in a company as an alternative to a cash dividend.
From a company point of view, it has the advantage that, if taken up by shareholders, it will conserve cash, i.e. it will reduce
the cash outflow from a company compared to a cash dividend.
This is useful when liquidity is a problem, or when cash is needed to meet capital investment or other financing needs.
Another advantage is that a scrip dividend will lead to a decrease in gearing, whether on a book value or a market value
basis, because of the increase in issued shares.
1. that in future years, because the number of shares in issue has increased, the total cash dividend will increase, assuming the
dividend per share is maintained or increased.
Why problems?
1. No credit history
Large businesses are more price sensitive than SMEs as they have more choice - for SMEs the problem is not the cost but the
access to credit
Solution
Current liabilities
These are a major source of finance and must be carefully managed in order to ensure continuing availability of such finance
Cost of Capital
Cost of Captial Introduction
Cost of Capital - Basics
The cost of capital represents the return required by the investors (such
as equity holders, preference holders or banks)
Basically the more risk you take, the more return you expect.
The return for the investors needs to be at least as much as what they can get from government gilts (these are seen as being
risk free). On top of this they would like a return to cover the extra risk of giving the firm their investment.
The cost of normal debt is cheaper than the cost of equity to the company. This is because interest on debt is paid out before
dividends on shares are paid. Therefore the debt holders are taking less risk than equity holders and so expect less return.
Creditor hierarchy
When a company cannot pay its debts and goes into liquidation, it must pay its creditors in the following order:
3. Unsecured creditors
4. Preference shareholders
5. Ordinary shareholders
Each of the above will cost the company more as it heads down the list. This is because each is taking more risk itself
If a company gets a specific loan or equity to finance a specific project then this loan/equity cost is the MARGINAL cost of
capital.
If a company is continuously raising funds for many projects then the combined cost of all of these is the AVERAGE cost of
capital.
Always use the AVERAGE cost of capital in exam questions, unless stated that the finance is specific
Debt 20% 8%
What we have ignored here is how did we get to calculate how the ‘amount’ of equity and debt was calculated - using book or
market values?
Illustration
Reserves 3,000
Solution
Reserves 3,000
5,000
Debt
Loan 1,000
6,000
WACC 17.92%
Solution
Equity
Debt
8,300
WACC 18.79%
SUMMARY
To Calculate WACC
Cost of Equity
DVM or CAPM?
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.
DVM
it is very difficult to find an accurate value for the future dividend growth rate
using a historic growth rate as a predictor of the future isn't based on fact
The equation:
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.
CAPM
has a sound theoretical basis, relating the required return of well-diversified shareholders to the systematic risk they face
through owning the shares of a company. However...
finding suitable values for the risk-free rate of return & equity beta can be difficult
DVM difficulties
For example, it impractically assumes that the future dividend growth rate is constant.
The dividend decision depends on past trends but also current conditions.
The historic dividend growth rate is used as a substitute for the future dividend growth rate.
The model also assumes that business risk, and the cost of equity, are constant in future periods, but reality shows us that
companies are subject to constant change.
The dividend growth model does not consider risk explicitly in the same way as the CAPM.
Here, all investors are assumed to hold diversified portfolios and as a result only seek return for the systematic risk of an
investment.
The individual components of the CAPM are found by empirical research and so the CAPM gives rise to a much smaller
degree of uncertainty than that attached to the future dividend growth rate in the dividend growth model.
For this reason, it is usually suggested that the CAPM offers a better estimate of the cost of equity than the dividend
growth model.
What this means is that the share price can be calculated assuming a growth in dividends or not
Essentially this model presumes that a share price is the PV of all future dividends. Calculate this (with or without growth) and
multiply it by the total number of shares
It is similar to market capitalisation except it doesn’t use the market share price, rather one worked out using DVM
Or
Dividend just paid (1+g) / Cost of Equity - growth (decimal)
Illustration
Solution
Calculating Growth
capm
CAPM
This method also calculates the cost of equity (like dvm) but looks more closely at the shareholder’s rate of return, in terms of
risk.
The more risk a shareholder takes, the more return he will want, so the cost of equity will increase.
For example, a shareholder looking at a new investment in a different business area may have a different risk.
It suggests that any investor would at least want the same return return that they could get from a “risk free” investment such
as government bonds (Greece?!!).
On top of the risk free return, they would also want a return to reflect the extra risk they are taking by investing in a market
share.
They may want a return higher or lower than the average market return depending on whether the share they are investing in
has a higher or lower risk than the average market risk
The higher or lower requirement compared to the average market premium is called the beta (β)
More technically Beta (β ) = Systematic risk of the investment compared to the market
1. Systematic risk
All companies, though, do not have the same systematic risk as some are affected more or less than others by external economic
factors
An example of nonsystematic risk is the possibility of poor earnings or a strike amongst a company’s employees.
One may mitigate nonsystematic risk by buying different securities in the same industry or different industries.
For example, a particular oil company has the diversifiable risk that it may drill little or no oil in a given year.
An investor may mitigate this risk by investing in several different oil companies as well as in companies having nothing to
do with oil.
capm continued
CAPM continue
1. This is the ‘beta’ of the investment If beta is 1, the investment has the same risk as the market overall.
2. If beta > 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.
3. If beta < 1, the investment is less risky than the market and investors would be satisfied with a lower return than the market
return.
Illustration
What returns should be required from investments whose beta values are:
(i) 1
(ii) 2
(iii) 0.5
The return required from an investment with the same risk as the market, which is simply the market return.
The return required from an investment with twice the risk as the market.
The return required from an investment with half the risk as the market.
1. Diversified investors
Advantages of CAPM
Disadvantages of CAPM
Others, including managers and employees may well want to know about the unsystematic risk also
2. The return level is only seen as important not the way in which it is given.
For example dividends and capital gains have different tax treatments which may be more or less beneficial to individuals.
4. Generally CAPM overstates the required return for high beta shares and visa versa
Cost of Debt
Convertible Debt
Convertible Debt
Here the investor has the choice to either be paid in cash or take shares from the company.
To calculate the cost of capital here, simply follow the same rules as for redeemable debt (an IRR calculation).
The only difference is that the ‘capital’ figure is the higher of:
1. Cash payable
Illustration
Tax 30%.
MV -85 -85
27.2 5.91
Note :
Capital = higher of 100 x 1.05% (premium) = 105 and 20 x 4 x 1.07 power 5 = 112.2
Terminology
Floor Value MV without conversion option (basically the above calculation using cash as capital)
Irredeemable debt
The company just pays back the interest (NOT the capital)
So the MV should just be all the expected interest discounted at the investor’s required rate of return.
Therefore, the cost of debt (the debtholder’s required return) can be calculated as follows:
Treat the same as irredeemable debt except that the dividend payments are never tax deductible
Illustration
Bank Debt
The cost of debt is simply the interest charged. Do not forget to adjust for tax though if applicable.
Illustration
7%
Redeemable debt
Redeemable debt
The company pays the interest and the original amount (capital) back.
So the MV is the interest and capital discounted at the investor’s required rate of return.
Remember the cost of debt to the company is the debtholder’s required rate of return. (Tax plays a part here as we shall see
later)
1. Guess the cost of debt is 10 or 15% and calculate the present value of the capital and interest.
Illustration
22.76 -17.67
Tax reduces the cost of capital to a company because interest payments are tax deductible.
It was ignored in the last example, but let’s say that that tax was 30%, then the actual interest cost was not 12 but 12x70% =
8.40
Illustration
Tax 30%.
What is the interest charge to be used in a cost of capital calculation for a company?
Now let’s rework that last example but this time use 10% as a guess and let’s assume tax of 30%
MV -107.59 -107.59
7.17 -13.65
The cost of capital is lower than the original example as tax effectively reduces the cost to the company as interest is a tax
deductible expense.
So, you have studied all the bits in isolation, here’s where we get sexy and bring it all together..
So, this is kind of the proforma you need to set up, when you get a “Calculate the WACC..” question
Loan 6% 800 48
Total 1,800 148
Final Flourishes
Capital structure theories
These are 3 theories (& pecking order) to see if there is a perfect capital
structure
The cheap cost of debt (as it is ranked before equity in terms of distribution of earnings and on liquidation), combined with its
tax advantage, will cause the WACC to fall as borrowing increases.
However, as gearing increases past a certain point, shareholders increase their required return (i.e., the cost of equity rises).
This is because there is much more interest to be paid before they get their dividends.
At high gearing the cost of debt also rises because the chance of the company defaulting on the debt is higher (i.e., bankruptcy
risk).
In the traditional view of capital structure, ordinary shareholders are relatively indifferent to the addition of small amounts of
debt in terms of increasing financial risk and so the WACC falls as a company gears up.
As gearing up continues, the cost of equity increases to include a financial risk premium and the WACC reaches a minimum value.
Beyond this minimum point, the WACC increases due to the effect of increasing financial risk on the cost of equity and, at higher
levels of gearing, due to the effect of increasing bankruptcy risk on both the cost of equity and the cost of debt.
Although it is more or less realistic, the traditional view remains a purely descriptive theory.
This view can be represented by a U shaped graph, where the vertical axis is the WACC and the horizontal the amount of debt
finance.
the use of debt transfers more risk to shareholders, and this makes equity more expensive so that the use of debt does not
reduce finance costs ie does not reduce the WACC.
Modigliani and Miller views
In order to demonstrate a workable theory, MMs 1958 paper made a number of simplifying assumptions:
There are therefore no transactions costs and the borrowing rate is the same as the lending rate and equal to the so-called risk
free rate of borrowing;
Taxation is ignored
Main idea
As a company takes on more debt, the equity holders take on a little more risk
The more debt brings the WACC down but the extra risk for equity holders, increases Cost of Equity and so the WACC
comes back up again
M&M (with tax)
If debt also saves corporation tax then it does reduce finance costs, which benefits shareholders ie it reduces the WACC.
This suggests that a company should use as much debt finance as it can.
Main idea
Taxation
If Debt gets tax relief and equity doesn't then the straight line graph is wrong
The tax will make debt cheaper than equity and so more debt is advantageous at all levels
However, this still presumes a perfect market where people don't worry about bankruptcy risk - they do!
Therefore at higher levels of debt, WACC would actually rise in the real, imperfect market
This simply suggests that firms do not look for an optimum capital structure rather they raise funds as follows:
2. Debt
This is because internally generated funds have no issue costs and needs no time and effort in persuading others.
Debt is better accepted by the markets than looking for cash via a share issue which can seem desperate. Issue costs moderate.
Debt finance may also be preferred when a company has not yet reached its optimal capital structure and it is mainly financed
by equity, which is expensive compared to debt.
Issuing debt here will lead to a reduction in the WACC and hence an increase in the market value of the company.
One reason why debt is cheaper than equity is that debt is higher in the creditor hierarchy than equity, since ordinary
shareholders are paid out last in the event of liquidation.
Debt finance may be preferred where the maturity of the debt can be matched to the expected life of the investment project.
Equity finance is permanent finance and so may be preferred for investment projects with long lives.
The WACC calculations we made earlier were all based on CURRENT costs and amounts of debt and equity.
If any if the above do not apply - then we cannot use WACC. We then have to use CAPM..
adapted…
Ungearing & Regearing
The betas we have been looking at so far are called Equity Betas
These represent :
Business Risk
If we are looking to invest into a different industry we need to use a different beta, one
which represents:
Financial Risk (Ours still as we are using our debt and/or equity)
1. Ungearing
Remember, this will represent their business risk and their financial risk (gearing).
2. Re-Gearing
Take this asset beta and regear it using our gearing ratio as follows:
Tax = 30%
Find the appropriate beta for the main company to use in its CAPM for investing in an
industry different to its own but the same as the proxy company
1. STEP 1
ßu = ßg [Ve/(Ve + Vd (1 - t))]
2. STEP 2
Regear the ß:
ßg = 1⋅1915 x (5 + 2 (1 - 0⋅3))/5
= 1⋅525
Types of Risk
Then shown as a %
Financial Risk
Systematic Risk
the sum of business risk and financial risk (to the shareholder)
1. The risk relating to the market as a whole (individual company risk diversified away)
3. Can be assessed by the equity beta of the company (which includes both finance and business risks)
Business Valuations
Valuation overview
Valuations - Introduction
Financial statements
Investments held
Lease agreements
Budgets
What shareholding is being sold? Does it mean the business carries on?
Stock market efficiency usually refers to the way in which the prices of
traded financial securities reflect relevant information
Weak Form
3. Share prices appear to follow a ‘random walk’ by responding to new information as it becomes available
Semi- Strong
Strong
2. Even investors with access to insider information cannot generate abnormal returns in such a market
Managers will not be able to deceive the market by the timing or presentation of new information, such as annual reports or
analysts’ briefings, since the market processes the information quickly and accurately to produce fair prices.
Managers should therefore simply concentrate on making financial decisions which increase the wealth of shareholders.
Take the earnings of the company you are trying to value and multiply it
by the average P/E ratio of their industry
But what we are more concerned with here is how to use this to calculate the value of a business, again here is the formula to
use to calculate the value of ONE share..
Or...
Both of these give the value of the company as a whole..
HOWEVER, to value a target company you need to use THEIR earnings and our own P/E ratio or at least a P/E ratio from their
industry
PE 12.5
Drawbacks Of PE model
1. Finding a quoted company that is similar in activity (most have a wide range)
3. The quoted company used to get the PE ratio from may have a totally different capital structure
Earnings Yield
Solution
300,000 x 1/0.125 = $2,400,000
Discounted Cashflows
First of all you need to know how to calculate the value of something that lasts forever (like the profits here)
Solution
Cash inflow 80 x 70% = 56 - 48 = 8 (in perpetuity)
So the Equity is the value of all the cashflows less value of debt remember
It is calculated as follows:
Illustration
Solution
Dividend Valuation
Essentially this model presumes that a share price is the PV of all future
dividends
Calculate this (with or without growth) and multiply it by the total number of shares
It is similar to market capitalisation except it doesn’t use the market share price, rather one worked out using DVM
DVM can be with or without growth.
Note:
Solution
Dividend is growing so use DVM with growth model:
Calculating Growth
Growth not given so have to calculate by extrapolating past dividends as before:
2. As a minimum price
NB. If a company is quoted on a market AND is a going concern then the minimum valuation is..
Book Values
This is poor as it uses Historic costs and not up to date values. It can give a ball park figure though
This would represent the minimum value of a private company - as it is what the assets alone could be sold for. However, even
here there is the problem of needing to sell quickly may mean the NRV might be difficult to value
Another weakness of this is that this gives a value for the assets when SOLD not when IN USE. Therefore, not good for a
situation of partial disposal where business and hence assets will carry on
Replacement Cost
Here the valuation difficult - need similar aged assets value. It also ignores goodwill
NCA 450
Reserves 250
6% Loan 100
Solution
NCA 450+30 = 480
6% 478
X 80% = 382,400
Translation
Risk that there will be losses when a subsidiary is translated into the parent company currency when doing consolidated
accounts
Transaction
Risk of exchange rates moving against you when buying and selling on credit, between the transaction date and actual
payment date
Economic
For example a UK exporter will struggle if sterling appreciated against the euro.
5. Matching - Use foreign currency bank account - so matching receipts with payments then risk is against the net balance
Hedging, options, futures, swaps and forward rates - more of these later!
Forward Rates
Forward Rates
So, remember what we are looking at here are ways to negate the risk that, in the future, the exchange rates may move against
us
So we have bought or agreed a sale now in a foreign currency, but the cash won’t be paid (or received) until a future date
Therefore fixing yourself in against any possible future losses caused by movements in the real exchange rate
However - you also lose out if the actual exchange rate moves in your favour as you have fixed yourself in at a forward rate
already
Illustration
So, the bank will give the exporter $1,000 in return for £555.
NOTE
If importer cannot fulfill the forward contract agreed (maybe because he didnt receive the goods) the bank will sell the
importer the currency and then buy it back again at the current spot rate.
1. Flexibile
2. Straightforward
The whole idea of a money market hedge is to take the exchange rate NOW even though the payment is in the future.
By doing this we eliminate the future exchange risk (and possible benefits too of course)
So. the foreign payment is in the future, but we are going to get some foreign currency NOW to pay for it.
We do not need the full amount though, as we can put the foreign money into a foreign deposit account to earn just enough
interest to make the full payment when ready
We, therefore, calculate how much is needed now by taking the full amount and discounting it down at the foreign deposit rate
Now we know how much foreign currency we need NOW, we can convert that into home currency using the spot rate
We now know how much home currency we need. This needs to be borrowed. So, the cost to
us will eventually be:
Steps:
1. Calculate how much foreign currency needed (discount @ foreign deposit rate)
4. The cost will be the amount borrowed plus interest on that (home currency borrowing rate)
Illustration
Borrow just $91 as we then put it on deposit and it attracts 10% interest - to pay off the whole $100 at the end
Convert $91 dollars now. We need dollars, so bank SELLS us them. They always SELL LOW. So 91 / 2 = £45.5
£45.5 is borrowed now. We will then have to pay interest on this in the UK for a year.
The whole idea of a money market hedge is to take the exchange rate NOW even though the receipt is in the future.
By doing this we eliminate the future exchange risk (and possible benefits too of course)
The foreign receipt is in the future, we are going to get eliminate rate risk by getting that foreign currency NOW.
We do not borrow the full amount though, as the receipt will pay off this loan plus interest.
We, therefore, calculate how much is needed now by taking the full amount and discounting it down at the foreign borrowing
rate
Now we know how much foreign currency we need NOW, we can convert that into home currency using the spot rate.
Here the bank are buying foreign currency off us and so will BUY HIGH
The eventual receipt is the amount converted plus the interest earned at home
Steps:
1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)
4. The receipt will be the amount converted plus interest on that (home currency deposit rate)
Illustration
1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)
The UK company now needs to sell $394,964 from the bank. The bank will BUY HIGH
This amount will be deposited at home at 4.5% for 3/12 = 1.125% = 215,110 x 1.125% = £217,530
Currency Futures
Explanation
When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange,
called initial margin.
If losses are incurred as exchange rates and hence the prices of currency futures contracts change, the buyer or seller may be
called on to deposit additional funds (variation margin) with the exchange
Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market’.
Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to the
initial futures transaction, ie if buying currency futures was the initial transaction, it is closed out by selling currency futures. A
gain made on the futures transactions will offset a loss made on the currency markets and vice versa.
Advantages
Disadvantages
3. Still cannot take advantage of favourable movements in actual exchange rates (unlike in options…next!)
Currency Options
Currency Options
A currency option gives its holder the right to buy (call option) or sell (put option) a quantity of one currency in exchange for
another, on or before a specified date, at a fixed rate of exchange (the strike rate for the option).
Currency options can be purchased over-the-counter or on an exchange. In practice, companies buying call or put currency
options do so in over-the- counter deals with a bank.
They protect against adverse movements in the actual exchange rate but allow favourable ones!
Disadvantages
1. The premium
Advantages
1. Currency options do not need to be exercised if it is disadvantageous for the holder to do so.
2. Holders of currency options can take advantage of favourable exchange rate movements in the cash market and allow their
options to lapse. The initial fee paid for the options will still have been incurred, however.
Currency Swaps
Advantages
1. Easy
Currency swaps are better for managing risk over a longer term (than currency futures or currency options)
A currency swap is an interest rate swap (between 2 companies) where the loans are in different currencies.
It begins with an exchange of principal, although this may be a notional exchange rather than a physical exchange.
During the life of the swap agreement, the companies pay each others’ foreign currency interest payments. At the end of the
swap, the initial exchange of principal is reversed.
£ : $1.5
Here £ = Base Currency; $ = Counter Currency
£0.67:$
Banks will BUY that foreign currency from them at the HIGHER rate
Translating Currencies
Interest Rates
Interest Rate Risk
Normal
Inverted
In a bit more detail, the shape of the yield curve and thus the expectations of what the interest rates will be depends on…
1. Liquidity preference
Investors want their cash back quickly therefore charge more for long term loans which tie up their cash for longer and thus
expose it to more risk
2. Expectations
NB. Recession expected means less inflation and less interest rates so producing an inverted curve
3. Market segmentation
If demand for long-term loans is greater than the supply, interest rates in the long-term loan market will increase
Differing interest rates between markets for loans of different maturity can also explain why the yield curve may not be smooth,
but kinked
4. Fiscal policy
Governments may act to increase short-term interest rates in order to reduce inflation
This can result in short-term interest rates being higher than long-term interest rates,
Therefore, in these circumstances, use short term variable rate borrowing and long term fixed rate.
Gap Exposure?
The risk of an adverse movement in the interest rates reducing a company’s cashflow
Forward rate
This locks the company into one rate (no adverse or favourable movement) for a future loan
If actual borrowing rate is higher than the forward rate then the bank pays the company the difference and vice versa
Procedure
Illustration
Solution
FRA receipt from bank (10%-6%) x 600k 24,000
Interest Futures
You would sell a bond futures contract, and when the interest rate rises, the value of the bond futures contract will fall.
You would then buy the return of the contract at a normal price, making a profit.
Let’s say you are expecting interest rates to decline in the near future.
When interest rates fall, the price of bonds increase, and so does the bonds futures contract.
Have a think (or even better) a look at when we calculated the cost of debt for Irredeemable debts (bonds)
You will see that we took the capital and interest and discounted it (at a guessed rate) then compared it to the MV of the
bond..and so on
This is because you calculate the MV of a loan or a bond by taking its Capital and Interest and discounting it down by the cost of
debt
The market value of a traded bond will increase as the interest paid on the bond increases, since the reward offered for owning
the bond becomes more attractive.
If interest payments are more frequent, say every six months rather than every year, then the present value of the interest
payments increases and hence so does the market value.
3. Redemption value
If a higher value than par is offered on redemption, the reward offered for owning the bond increases and hence so does the
market value.
4. Period to redemption
The market value of traded bonds is affected by the period to redemption, either because the capital payment becomes more
distant in time or because the number of interest payments increases.
5. Cost of debt
The present value of future interest payments and the future redemption value are heavily influenced by the cost of debt, i.e. the
rate of return required by bond investors.
This rate of return is influenced by the perceived risk of a company, for example as evidenced by its credit rating.
As the cost of debt increases, the market value of traded bonds decreases, and vice versa.
6. Convertibility
If traded bonds are convertible into ordinary shares, the market price will be influenced by the likelihood of the future conversion
and the expected conversion value, which is dependent on the current share price, the future share price growth rate and the
conversion ratio.
Which theory best explains why yield curves are normally upwards
sloping (longer term more expensive)?
Grants the buyer the right (no obligation) to deal at a specific interest rate at a future date. At that date the buyer decides
whether to go ahead or not
These protect against adverse movements in the actual interest rate but allow favourable ones!
2 companies agree to exchange interest rate payments on different terms (eg fixed and variable)
Advantages
1. Easy
2. Low transaction costs (compared to getting a different loan)
Predicting
Predicting Exchange Rates
Illustration
According to law of one price what is the predicted exchange rate in 1 year?
Solution
Illustration
Solution
1. Government intervention