F9 June 2012 Revision (Open Tuition)

PART A

FINANCIAL MANAGEMENT FUNCTIONFinancial ManagementThe management of an organisation’s finances to achieve the financial objectives of the organisation.

Financial PlanningNeed to ensure sufficient available funds to meet short, medium and long-term needs.

- Short-term: pay bills- Medium/long-term: purchase fixed assets

Financial ControlCompare actual performance with forecast data.

Financial DecisionsInvestment: Retain profits for future use → lower dividendsDividend: Declare dividends → improve investor confidences - short-term vs long-term decisionsFinancing: high vs low gearing (loan notes, shares, overdraft, preference stock, retained earnings)

StrategyCourse of action to achieve specific objective

• includes use of labour, finances, physical assets, other resource, Strategic Financial Management

• identification of possible strategies and monitoring of chosen strategy to achieve objectives.

Corporate Objectives1. Concerned with firm as a whole2. Explicit, quantifiable and capable of being achieved3. Should relate to key factors for business success

These notes were produced by Alkemist for OpenTuition Community. For updates & support please visit

Financial Objectives1. Maximise shareholder wealth2. Value company and shares

- Balance sheet valuation: going concern- Break-up basis:- Market values: buyers and sellers in market

3. Shareholder wealth: return- Dividend received: dividend received- Market value of shares: capital gains from increase

4. Total Shareholder Return

........................................................ E01

P0 = share price at beginning of period P1 = share price at end of period D1 = dividend paid5. Profit not best measure of company achievement

- manipulation of accounting profit• provision, capitalization, overheads

- does not take account of risk• risk may increase to unacceptable levels to maximize profit

- does not take account of volume of investment- measure of short-term (yearly) performance which may contradict long-term

prospects6. Earnings per share

E P S =

E02- Measure of company performance, looking at post data- Easily manipulated

• Changes in accounting policies• Mergers and acquisitions


ExampleA company issued 1,000,000 ordinary shares at par, $1 on 1July 20x8, raising ordinary share capital to $4,000,000. PBIT amounted to $7,000,000 and tax rate is 30%. The balance sheet extract for year ended 31 March 20x9 is shown

Balance sheet extract

Equity $10% preference share 1,000,000

Non-current liability8% loan 400,000

Calculate the EPS.A. Calculation of weighted average number of shares

1 Apr – 30 June 3,000 × 750

1 July: Issue 1,000

1 July-31 March 4,000 × 3,000

3,750

B. Calculation of profit attributable to shareholders

PBIT 700,000 Interest (8% × 400,000) (32,000) 668,000 Tax (30%) (200,400) 467,600 Preference dividend (100,000) Profit attributable 367,600

C. EPS = 367,600 3,750,000 = $98 per share

7. Other financial targets- gearing restriction ⇒ debt- profit retention ⇒ dividend cover- operating profitability


Non-functional ObjectivesMay limit achievement of financial objectives.

1. Employee welfare- wages, salaries, health benefits, comfortable and safe working environment,

pension- adequate redundancy payment2. Management welfare- high salaries, company car, housing3. Provision of service- call centre, repairs, maintenance (utility provider)4. Responsibility to customers- after sales service- warranties and guarantees5. Responsibility to suppliers- prompt payment6. Welfare of society- corporate social responsibility

StakeholdersDifferent groups or individuals whose interests are directly affected by activities of a Firm.

Measuring Financial PerformanceDone through ration analysisFour ration categories

- Profitability and return- Debt and gearing- Liquidity- Shareholder’s investment rations


ProfitabilityGenerally use PBT or PBIT, since changes in taxation are variable.1. Return on Capital Employed (Return on Investment)

ROCE = ............................... E03

- Compare ROCE from year to year- Industry ROCE- Compare with current market borrowing rates

2. Profit Margin (Net)

Profit Margin = ....................................... E04

3. Asset Turnover

Asset Turnover = ................. E05

∴ ROCE = Profit Margin × Asset Turnover

4. Return on Equity (ROE)

Return on Equity = ................................ E06

- High ROE• Good management of expenses• High level of gearing

5. Gross Profit Margin = ................... E07

Net Profit Margin = ......................... E08

Debt and Gearing Debt ratios: how much company owes, relative to size Gearing: amount of debt finance to equity finance


LiquidityCompany needs liquid assets to meet debt obligation as they fall due.

Shareholder’s Investment Ratios1. Returns in form of dividends and/or capital gains from increased market value2. Cum div: purchaser entitled to receive next dividend payment Ex div: purchaser not entitled to receive next dividend payment Ex div market price: Cum div market price – next dividend ................. E09

3. Dividend yield = ............... E10

- Gross dividend yield can be compared to gross interest yield from bonds.

4. Earnings per share E025. Price earnings ration (P/E ratio)

P/E ration = ................... E11

- Reflects market appraisal of share’s future prospect- P/E ratio does not vary much over time

• ↑ EPS ⇒ ↑ market price


Managerial Rewards Schemes1. Agency Problem: Management separated form ownership2. Goal congruence: objective of agents meeting those of organisation

- Achieved through organizational rewards (more pay and promotion)• Performance related pay• Reward managers with shares• ESOPs

3. Benefits- incentive to achieve- attracts and keeps valuable employees- ties performance indicators to scheme- motivate to act in long-term interest

4. Problems- manipulation of budgets- decisions contrary to wider organisation purpose- rewards too far in future- focus on meeting indicators to harm of organisation- quantity at expense of quality- individualistic at expense of teamwork- undervalue intrinsic rewards

Not For Profit1. Value for money

- Getting best possible combination of service from least resources- Best service when cost and benefit of providing service greatest

• Maximise benefit from lowest cost- 3 Es

• Efficiency: getting out as much as possible• Efficiency: best use of resources• Effectiveness: achievement of goals

- Assumes a yardstick against which achievement can be measured• Problem of how to quantify.• Subjective ⇒ based on judgements


PART B

FINANCIAL MANAGEMENT ENVIRONMENTA. Economic Environment for BusinessMacroeconomic Policy1. Involves:

- Policy objective: ultimate aims- Policy target: quantified levels to be achieved- Policy instruments: tools to achieve objectives.

2. Microeconomics- behaviour of individual

• Macroeconomics- economy at large- large aggregates: employment, national income- primary concern of government


Economic Policies and Objectives1. Aims

- Economic Growth• Increase in national income in real terms ⇒ excludes inflation

- Control inflation• Achieve stable prices

- create employment- stable balance of payment

2. Policies: to achieve aims- Monetary

• rate of interest• money supply

- Fiscal• government spending• taxation

- Exchange rate•

- External trade• tariffs

3. Conflicts- Possible for economy to grow without creating jobs

• improved efficiency• mechanization• shift to high value, low labour sectors


Fiscal PolicyAction by government to manage aggregate demand (AD)Affects business

- By influencing AD, thus stable government policy allows better planning - By changing tax rates

Monetary PolicyRegulation of monetary system through variables such as money supply, interest rates, conditions, for credit availability1. Increase can lead to inflation ⇒ money supply2. Affects business

- Increase money supply ⇒ inflation- Increase interest rate

• cost of borrowing increase ⇒ business cannot expand• share price decrease ⇒ investors rather saving• decrease in consumption

Question: Pros and Cons of high interest rate.

Pro Con1. Encourage savings 1. Interest windfall increase spending2. Increase mortgage payment 2. Higher wage demand to meet payments3. Deter borrowing and spending 3. Future productivity may be damaged due to lack of capital expenditure4. Reduce consumer expenditure 4. Reduce employment 5. Appreciation of currency


Exchange Rate Policy Rate at which one currency is traded in exchange for another currency.1. Two rates: buying and selling2. Factors affecting

- inflation rate compared to other country- interest rate compared to other country- balance of payment ⇒ export – imports- speculation- government policy

3. Reasons for- rectify balance of trade deficit- prevent balance of trade surplus- emulate economic conditions of other countries- stabilise exchange rate


Competition PolicyMarked failure: market mechanisms fail to achieve market efficiency leading to sub-optimal results.1. Government may regulate in case of

- imperfect competition• large or dominant companies with excessive profit subject to price or

profit control- social cost

• control on emissions• restrict vehicular traffic• smoking bans• compulsory insurance

- imperfect information• financial statement for companies• freedom of information act

- equity• labour laws• consumer protection laws

2. Types of regulation- legislative: government or agencies interfere in free-market operation

• stock exchange rules- self-regulation: industry sets own standards so as to avert imposition of

legislation3. Cases to consider

- monopolies and mergers- restrictive practices ⇒ cartels- deregulation: introduce more competition

• benefits: improved efficiency• disadvantages: loss of economies of scale, lower quality, loss of

unprofitable but socially valuable service- privatisation: private sector taking a role previously held by government

(utilities, health care)• advantage: increased efficiency• disadvantage: public interest second to profit motive


Government Assistance1. Official Aid Schemes

- cash grants and other forms of assistance• may be regional ⇒ St. Elizabeth ***** farmers• selective national ⇒ hotel sector

2. Enterprise Initiative- package of measures offered by Department of Trade and Industry (DTI)

3. RADA

Green Policies1. Polluter pays:

- tax levied on polluters2. Subsidies and grants

- insulation, solar technology, etc.3. Legislation

- waste disposal, atmospheric pollution4. Advantages

- customers buy goods from ‘green’ company- ethical face- encourage investors


B. Financial Market and InstitutionsFinancial Intermediary1. Party brining together providers and users of finance, either as broker or principal.

- lender doesn’t have to find borrower ∴ can save with intermediary- ready source of funds for borrowers- risk for individual lenders is pooled ∴ reduced

• diversified portfolio

Money Markets and Capital MarketsCapital Market: long termMoney Market: short term

1. Money Market- trading in short-term FI- short-term lending and borrowing- operate by banks and financial institutions

• also some large companies and government2. Capital Market

- trading in long-term finance (equities and corporate bonds)• primary: stock exchange + AIM (raise new finance)• secondary: stock exchange (investors sell investments)

3. Institutional Investor- large amounts of funds for investment- biggest investors in stock market- pension funds, insurance companies, investment trusts, unit trusts,

venture capitals

International Money Market1. Large companies able to borrow on

- eurocurrency market: money market- eurobond market: capital market

2. Investors concerned with- security: high quality borrower- marketability: ready market for trading- anonymity: bonds issued to bearer- return on investment: paid tax-free


Rate of interest and return1. Pattern of interest rate dependent on:

- risk of asset- duration of lending- size of loana. Risk

• trade-off between risk and return• higher-risk borrower must pay higher yields

b. Profit on relending• relending rate higher than cost of borrowing

c. duration• generally: longer-dated will earn higher yield

d. size of loan/deposit• administrative cost savings allow lower rate on larger loans and

higher rate on longer time deposite. type of financial asset

• different assets attract different sorts of lenders and hence different rate of interest

2. Risk-return trade-off- investors have range of investment choices

• Savings or investment in stock- current market price of a security is NPV of future expected earnings

• two components: annual income and capital gain- higher the risk, more important the capital gain- main forms of investment

• government stock: negligible default risk so forms base level• company loan notes: some default risk, but usually secured against

corporate asset• preference shares: fixed percentage dividend• ordinary shares: high level of risk.

3. Reverse yield gap- debt risk lower than equity ∴ expect debt to have lower yield than equity,

but reverse is usually true• Investor willing to take lower returns in short-term in anticipation of

higher future capital gains


4. Interest Rate and Shareholder’s Required Rate of ReturnReturn expected = keDividend = D

Market value P = ............................. E12

ExampleInvestor has two choices ke = 9% 11% D = 0.15 0.15 P = 1.67 1.36

- result• as required rate of return increases (due to interest rate increase),

market value decreases• increase interest rate leads to decreased investment and lower share

price


PART CWORKING CAPITAL MANAGEMENTA. Working CapitalNet working capital = current assets – current liabilities

Working Capital Characteristics 1. Three main aspects

- Accounts receivable - Inventory turnover - Accounts payable

Objectives of Working Capital 1. Ensure sufficient liquid resources to maintain daily cash Flow

- Cash must be available, not tied up in investment. 2. Increase profitability

- Investment of cash, not held and non-earning3. The two often conflict

Role of Working Capital Management1. Need clear policies for each working capital component2. Poor management, ties up cash assets

- high/overdue receivables : Free loan- large inventory : non-working asset- prompt bill payment


Cash Operating Cycle1. Time between paying supplier and collecting from customer

ExampleToy Co. buys inventories from suppliers and pays in two months. Raw material remains unused for one month and take 1.5 months to produce. They are immediately sold and customers pay within 30 days.

Storage period X 1Production period X 1.5Receivables period X 1Payables period (X) (2)Cash operating cycle X 1.5

Note: Asset period – Liability period = Operating cycle

41 320

Raw Materials Rec

Pay Supplier

Customer Pays

Goods Sold

Cash Operating Cycle

Payables Period ReceivablesPeriod

Storage Period

Production Period


Liquidity RatiosOver-capitalisation: too much working capital Over-trading: too much with too little long-term capital1. Current Ratio

Current ratio = ................. E13

- asset such as inventory may not be fast moving or may be volatile

2. Acid test / Quick Ratio

Acid test ratio = .......................... E14

- should be at least 1 for company with slow moving inventory

3. Accounts Receivable Payment Period (ARPP)

ARPP = ................................... E15

- Credit sales figure excludes sales tax, while trade receivable includes sales tax

4. Inventory Turnover Period (ITP)

ITP = ............................................ E17

5. Raw Materials Inventory Holding Period (IHP)

IHP =

6. Average Production (WIP) Period

WIPP =

7. Accounts Payable Payment Period (APPP)

APPP = ............................. E18

8. Sales Revenue / Net Working Capital Ratio

- Working capital must increase in line with sales to prevent liquidity problems


Over - Capitalisation and Overtrading1. Over-capitalisation

- Excessive inventory accounts receivable cash

- Few accounts payable

- leads to excessive working capital 2. Overtrading

- company trying to support to large a volume of trade with little capital resources over-reliant on short term financing (overdrafts, payables) to support

trade. - can operate at profit but face liquidity problems - symptoms

rapid increase in turnover rapid increase in volume of current asset ***** also non-current asset inventory ***** accounts receivable turnover might slowdown small increase in equity (increase in assets Financed by credit)


B. Managing Working CapitalManaging Inventories1. EOQ used as guide to minimise costs of managing inventory levels2. Control scientifically by balancing cost of inventory shortage and inventory holding

• three parts EOQ model : optimum order size

• discounts for bulk purchases• buffer inventory : reduce risk of stock-out

Economic Order Quantity (EOQ)

EOQ = ................................................................... E19

Q : reorder quantity CO : cost of place one order CH: unit holding cost of inventory D: usage in units per period

1. Annual cost to have inventoryCost of having inventory = holding cost + ordering cost

T =

- aim = holding cost = ordering cost

∴ =

Q2 =

Q =


Re-order LevelRe-order level = maximum usage × maximum lead time

• Seeks to address uncertainty in demand and lead time to fulfil order

Annual cost of safety = Quantity of × InventoryInventory safety inventory holding cost

Maximum inventory = recorder level + recorder quantity level

(min. usage × min. lead time)

• Inventory at wasteful levelBuffer safety = recorder level - (avg asage × avg lead time)

inventory

• Inventory approaching dangerously low level

Average inventory = buffer safety inventory +

Total cost = purchasing cost + ordering cost + holding cost • take into account bulk discounts

Example. A company has a demand for 10,000 units annually. The cost of purchase is

$100 per unit with holding cost of 10% of purchase price and ordering cost of $250 per order. The company is offered a discount 3% for orders over 800 units and 5% for orders over 10,000 units. Determine the order size which minimizes cost

i) EOQ =

=

= 700 units

ii) Order size 707 800 1000 discount 0 3% 5%

Purchase cost 1,000,000 970,000 950,000 Order cost 3,535 3,125 2,500 Holding cost 3,535 3,880 4,750 Total cost 1,007,070 977,005 957,250

∴ 1000 units is the cost minimising order size


Just In Time (JIT)1. Obtain items from supplier when they are needed, thus removing need to hold inventory2. Lowers investment in working capital

Managing Accounts ReceivableEffective management : proper monitoring to reduce risk of default

Cost of credit- interest charge on overdraft to fund period of credit - interest lost on cash no depositedN.B. Increase in profit from extra sales could offset cost

Credit Control PolicyFactors to consider

- admin. cost of debt collection- credit control procedures- extra capital required to Finance extension- cost of additional Finance

MonitoringMonitor AR continuallyIn-house credit ratingExamine customer payment record and aged AR


Extension of CreditAssess

- extra sales to be generated- profitability of extra sales- extra length of average debt collection period- required rate of return on investment in additional accounts receivable

Proforma Avg. receivable after increase XCurrent avg. receivable XIncrease in receivable XIncrease in inventory X XIncrease in payables (X)Net increase in working capital X

Return on extra investment =

CollectionDebt collection costs must not exceed benefits of collection

For overdue amounts- notices → telephone → visit → debt collection section → legal action

→ debt collection agency


Early Settlement DiscountEmployed to shorten credit period, reduce receivables and hence interest costs

- benefits in cost saved should exceed cost of allowed discounte.g. No change in sales volume A company with sales of $2 million annual has credit period of 90 days

assuming 360 day year. It wishes to offer 3% discount of payment is received in 10 days and reduce credit period to 45 days. It is estimated that 40% of existing sales will benefit from his change and the company requires 15% return on investments. What will be the effect of discount?

Current avg. receivables 500Avg. receivable after charge

- 150

- 22

(172)Reduction in receivables 328

Cost saved (20% × 328) 65.6Less: Discount allowed (2% × 40% × 2000) (16.0)Net benefit 49.6

Percentage Cost of Early Settlement DiscountIdea is if discounted cash is invested for the duration of the credit period, the total amount will equal; the undiscounted price

Pu: undiscounted price Pd: discounted pricer : implied rate (percentage cost of early settlement)t : reduction in payment period

∴ = 1+r hence r =

If Pu = 100 and Pd = 100-d (d = discount offered)

∴ .............................................. E20


Bad Debt1. High turnover should be sufficiently profitable to exceed cost

- bad debts- additional investment to achieve higher sales

2. Steps:- Calculate extra profit- Calculate additional investment and apply ROI percentage

3. Credit Insurance• Insurance against approved debts

Factoring1. An arrangement to have trade debts collected by a Factor company

• Factor advances a proportion of money it is due to collect2. Aspects

- administering client sales and collection system- credit protection : factor takes risk- payment to client in advance

3. Benefits- pay suppliers promptly- maintain optimum inventory levels- growth financed by sales, not loans- finance linked to sales volume- management freed from debt collection- reduced business cost

• outsource sales and collection system.4. Disadvantage

- payment made to factor by receivables may give negative picture of firm

- indicate firm in need of cash ⇒ financial stability

e.g. a Current Arrangement

Finance cost 24.97

Bad debt (1500 × 0.5%) 7.50 Admin cost 30.00 62.47

b. Factor Finance

Factor charge 13.81

Finance cost 3.33

Factor service (1500 × 2.5%) 37.50 54.64 Net benefit of using factor = 62.47 – 54.64 = 7.83


Managing Accounts PayableInvolves

- obtaining satisfactory credit - extending credit during cash shortage- maintaining good relations with suppliers

Percentage cost of early settlement - decision similar to receivables

compare effective rate with rate available commercially


C.! Working Capital FinanceManagement of CashJohn Maynard Keynes identified three reasons

- cash to meet regular commitments- buffer cash for unseen contingencies

may be provided by overdraft- cash for speculation

interest rates may rise

Cash Flow ProblemsMay arise due to

- making losses- inflation

more money for some purchase- growth

expansion must be financed- seasonal business- one of transaction

purchase of freehold or repayment of loan

Cash Flow Forecast1. A detailed forecast of cash inflow and outflows incorporating both revenue

and capital items 2. One of the most important tools an organisation can use

allows for modification if insufficient funds available indicates potential problems to management

3. Easing Cash Shortage- postpone capital expenditure- encourage early receipt of receivables- factoring or invoice discounting- selling assets : investments and property- reduce cash outflow

longer credit reschedule loan repayment deferral of taxes reduced dividend payment


Treasury Management1. Corporate handling of all financial matters, the generation of internal and

external funds, management of currencies and cash flows and the complex strategies, policies and procedures of corporate finance.

2. Advantages- centralised liquidity management

avoid mix of surplus and overdraft bulk cash flows, thus lower bank charges + interest rates

- better short-term investment opportunity- better forex risk management- employ experts in hedging - lower precautionary funds

3. Disadvantage- local centres cannot diversify finance- divisions lose autonomy- not responsive to needs of individual divisions

Cash Management Models

Baumol ModelIdea : optimum cash similar to optimum inventory

assumes cash consumed steadily over time

Q = ............... E21 S = cash used in each period

C = cost per sale of security i = interest cost of holding cash Q = amount raised to provide S

Drawbacks not possible to predict amounts required in future periods precisely no buffer cash no account for other costs of holding cash

Miller - Orr Model

Return point = Lower limit + ................... E22

Spread =

- Assume Cash Flow to be entirely unpredictable unrealistic


PART DINVESTMENT APPRAISALA. Investment DecisionsInvestment divided into

- capital expenditure acquire and improve asset

- revenue expenditure maintenance and upkeep of asset

Capital BudgetProcess of identifying, analyzing and selecting investment projects whose returns are expected to extend beyond one year.

Two constraints- Soft capital rationing

• managerial resources scarce- Hard capital rationing

scarcity of finance high finance cost legislated restrictions

Decision-Making Process1. Origination of proposal : consistent with business objective2. Project screening : qualitative evaluation of proposal3. Analysis and acceptance :

- Financial analysis cash Flows inflation consideration risk assessment

- Qualitative Evaluation implication of not undertaking impact on company image

- Go / No go4. Monitoring and Review

- capital expenditure within budget- implementation on schedule- benefits eventually obtained


Relevant Cash Flow1. Relevant costs

- opportunity cost- working capital cost- infrastructure + human development cost + marketing

Non-relevant- past cost- committed cost

2. Relevant benefits- increased cash flow- savings

discontinued asset use staff costs materials cost

- Intangible customer satisfaction employee morale better decision making

Payback Period1. Payback is time taken for cash inflow = cash outflow

- first screening method- organisation may reject project if payback more than certain number of

years 2. Disadvantages

- ignores timing of cash flows within period- ignores cash flow after end of payback period, hence total return- ignores time value of money- unable to distinguish between projects with same payback period- excessive investment in short-term projects

3. Advantages- simple to calculate and understand- uses cash flows rather than accounting profits - used as screening device - favours short-term projects ⇒lower business and finance risk - used during capital rationing


Return of Capital Employed1. If accounting rate of return exceeds target rate ⇒ undertake

ROCE =

Average investment =

ROCE = ............E23

2. Mutually Exclusive Projects- ROCE can be used to select mutually exclusive project

Avg annual profit =

3. Drawback to ROCE- does not take account of timing of profits

money may be tied up in a project- based on accounting profit, not cash flows- relative, not absolute measure

excludes size of investment - ignores length of project- ignores time value of money

4. Benefits- quick and simple calculation- looks at entire project life


B. Investment Appraisal Using DCF MethodsTwo points on DCF

- looks at cash flow not accounting profit slow costs and benefits without notional costs

- timing of cash flow discounting used

CompoundingFV = PV(1 + r)n ................................................... E24

Discounting

PV = FV × ........................................... E25

- geometric progression

Net Present Value (NPY) MethodNPV = discounted cash inflow – cash outflow

Discount Factor = (1 + r)-n

Annuity Factor =

- in perpetuity (∝), (I + r)-∝ approaches zero, thus

Annuity Factor = ............................................. E26

Internal Rate of Return Method

IRR ≅ a + ......................... E27

- gives rates when NPV = 0


NPV vs IRR1. IRR more easily understood than NPV since it looks at percentage yield vs target yield IRR ignores relative size of investment2. Projects with non-conventional (varying) cash flows may have multiple IRR3. Mutually exclusive projects may have different decisions based on NPV and IRR methods4. Summary

- both give same decision for conventional cash flow- IRR easier to understand - NPV method more superior, simpler to calculate- IRR can be confused with ROCE- IRR ignores relative size of investment - nonconventional cash flow may have several IRRs - NPV superior at ranking mutually exclusive- NPV useful if discount rates vary


C. Allowing For Inflation And TaxationAllowing For Inflation

......................................1. (1 + i) = (1 + r) (1 + h) E28 h = rate of inflation r = real rate of interest i = nominal rate of interest

2. Nominal rate (money rate of return)- measures return in dollar terms- ignores falling value of money

3. Real rate- measures return in constant price levels

e.g. Invest $100 at 20% with 12% inflation

Real return = 100 ×

= 107.14- money received after 1 year = $120 (nominal rate = 20%)- real value of $ 120 after 1 year = 107.14 (real rate = 7.14%)

i.e. 1 + r =

=

= 1.0714 r = 0.0714 or 7.14%

Allowing For Taxation1. Tax allowable depreciation (capital allowance)

- reduce taxable profit. - reduction in tax payment treated as cash savings

- cash saving = allowable depreciation × tax rate


D. Project Appraisal And RiskRisk and Uncertainty

1. Risk- several possible outcomes- probabilities assigned to outcome- increases with increased variability of returns

2. Uncertainty- several possible outcomes- little past experience- difficult to assign probabilities- increases with life of project

Sensitivity Analysis1. Assesses how responsive the NPV is to changes in variables

- critical variables are those to which NPV is most sensitive

2. Sensitivity = .................... E29

- lower the percentage, the more sensitive the NPV to that variable3. Weaknesses

- each key variable needs to be isolated which may not be cost effective- variables tend to be interdependent - does not examine probability of variation occurring- managers may have no control over critical factors - does not provide decision rule

Certainty - Equivalent Approach1. Convert expect cash flows to riskless equivalent amounts

- higher the risk, smaller the receipt and larger the payment2. Riskless amount = cash flow × ................... percentage E303. Disadvantage

- percentages are subjective

Probability Analysis1. Estimate probability distribution of expected cash flow 2. Steps

- calculate Expected Value (EV) of NPV- measure risk

calculate worst possible outcome and probability calculate probability of not achieving positive NPV calculate standard deviation of NPV

3. Problems- investment may be one-off, expected NPV may not occur- probabilities highly subjective- EV do not evaluate range of NPV outcomes


E. Specific Investment DecisionsLease of Buy

Lease1. Leasing

- contract between lessor and lessee for hire of a specific asset2. types of lease

- operating- finance- sale and leaseback

3. Operating lease- lessor retains most of risk and reward of ownership- responsible for maintenance and servicing- period of lease is fairly short

4. Finance lease- transfers substantially all of risk and rewards of ownership to lessee

responsible for upkeep covers most or all of useful life ‘peppercorn’ rent available after end of lease

5. Sale and leaseback- business retains use of asset, paying rent whilst having use from proceeds

of ‘sale’ 6. Attractions

- supplier paid in fully by lessor- lessor makes return by leasing- lease benefits

able to obtain financing when banks may not be willing to lend finance lease may be cheaper than bank loan tax relief

- leased equipment not shown on book ∴no effect on gearing of lessee- good for equipment which become outdated quickly

Decisions

Broken into two areas- acquisition decision : use after tax cost of capital- financing decision : use after tax cost of borrowing

e.g. should a machine be bought for $50,000 now or leased for 10 years at $8,000 p.a.? Cost of capital is 9%

PV of lease = $8000 ×

= $8000 × 6.418 = $51,341

The least-cost financing option is purchase


Asset Replacement Decisions

Equivalent Annual Cost Method1. Calculate PV of cost for each replacement cycle 2. Find equivalent annual cost for each PV

e.g. Machine cost $50,000 with price expected to remain constant. The following are the expected cost and resale value over 5 years with a cost of capital of 11%. How often should the asset be replaced.

1 2 3 4 5Operating cost 22000 23300 25000 24600 31400Resale value 40000 33000 24000 20000 15000Discount factor 0.901 0.812 0.731 0.659 0.593

1 Year 2 Year 3 Year 4 Year 5 YearPurchase cost (50000) (50000) (50000) (50000) (50000)PV op cost- Year 1 (19822) (19822) (19822) (19822)- Year 2 (18920) (18920) (18920)- Year 3 (18275) (18275)- Year 4 (16211)PV current yr. diff. 16218 7876 (731) (3031) (9725)PV of cost over one cycle (33782) (61946) (89473) (11048) (132953)

Equiv annual cost (33782) (61946) (89473) (110048) (132953)0.901 1.713 2.444 3.103 3.693

(37494) (36162) (36609) (35465) (35972)

∴ replace every 4 years.


Equivalent Annual BenefitAnnual annuity with same value as NPV of a project

Equivalent annual benefit = .............................. E31

Capital Rationing1. Company has limited capital to invest in projects

- different investments compared to allocate capital most effectively 2. Two types

- Soft capital rationing due to internal factors (See part D, A)

- Hard capital rationing due to external factors

3. Profitability index- Capital rationing in single period lends to ranking of projects using

profitability index capital available freely at all other times

- Ratio of PV future cash flows to PV total capital investment- Problems

used only if projects divisible does not take account of strategic value of individual investment limited use if projects have differing cash flow patterns ignores absolute size of individual projects


PART EBUSINESS FINANCEA. Source Of Finance

Short-term Sources of FinanceUsually needed to run day-to-day operations

Overdrafts1. Payments from current account > income to account 2. Benefits

easy to set up interest charged only when used bridge gap between payments and receipts

3. Disadvantage repayable on demand

4. Solid (hard) core overdraft company account which is always in overdraft bank may restructure into a loan

Short-term Loan1. Loan for fixed amount at specific period

drawn in full at beginning repaid at specified time or in installments

2. Benefit bank can monitor client payback customer can plan for repayment provided customer sticks to loan agreement, not repayable on

demand

Trade Credit1. Main source of short-term finance2. Current assets purchased on terms of payment from 30-90 days 3. Interest free short-term loan

useful in times of high inflation take account of lost discount

4. Delays in payment may worsen credit rating


Leasing 1. Pay in installment for use of asset rather than outright purchase

Debt Finance

Reasons1. Need long term funds but do not wish to issue equity2. May have lower cost than equity3. More easily available 4. Tax relief on profits via interest payment

Sources1. Bank : long term loans2. Other businesses : loan notes3. Money market4. Stock exchange

Choice of debt finance1. Availability : listed → stock exchange, small/unlisted → bank2. Duration : length of loan should match period of revenue generation3. Rate : fixed or floating depending on economic forecast4. Security and convenants


Bonds1. Generally loan notes or debentures 2. Loan note

o long-term capital for which interest is paid at a fixed rateo long-term payableo have a nominal valueo debt owed by company

o have a coupon rate fixed rate attached

o market value may differ from coupon / nominal value o set by market conditions

3. Debentures o written acknowledgement of debt owed / incurred

o contain provisions for interest and repayment of capital4. Deep discount bonds

o loan note issued at a large discount to be redeemed at or above par, when it matures

o investors attracted to large capital gain o difference between issue price and redemption value

o lower rate of interesto Tax advantage : gain taxed as one lump sum on maturity or sale

5. Zero coupon bondso issued at discount to redemption value

o no interest is paido implied rate


6. Convertible loan noteso Bonds giving holder right to convert to other securities at

predetermined rate / price and timeo Conversion value

o Current MV of ordinary shares into which loan note may be converted

o Below value of note at issue, but expected to increase since MV of shares should increase

Conversion value = conversion ration × ................. MPS E32Conversion premium = current market value – current conversion value

e.g. 10% loan note of ABC ltd are quoted at $134 per $100 nominal. Conversion cannot take place for three years at a rate of 25 ordinary shares per $100 loan note. Share price is $5 and interest has been paid. Conversion value = 25 × 5 = $125Conversion premium = $134 - $125 = $9 or 7.2%∴ Share price must increase by 7.3 before conversion rights become

attractive

e.g CD, page 209 @ 2.50 @ 3.00 10 × 0.926 = 9.26 9.26 10 × 0.857 = 8.57 8.57 10 × 0.794 = 7.94 7.94 110 × 0.794 = 87.34 120 × 0.794 = 95.28 113.11 121.05


Venture Capital1. Risk capital provided in return for equity stake 2. Interests

- Business start-ups money provided to supplement that already invested by owner

- Business development capital provided to invest in new product, market or acquisition

- Management buyout capital to assist managers to buy business from owners

- Investment realisation assisting owner to realise part or all of investment

Equity Finance1. Capital form sale of ordinary shares through

- new issue- rights issue

2. Stock market listing → greater capital pool- shares marketable- enhance public image- growth by acquisition easier- original owners realise holding

3. Stock market disadvantages- greater regulation, accountability and scrutiny - more investors with different needs- additional issue costs

4. Listing- By means of

IPO Placing Introduction

- IPO (Floatation) invitation to apply for shares based on prospectus information issue house buy large block of company shares and offer for sale to

public- Placing

most of issue bought by small number of investors- Introduction

no shares made available stock market grants quotation to shares already widely held

- Placing vs IPO cheaper faster less disclosure most shares in hands of few investors

5. Rights Issue- offer to existing shareholders to buy more shares, at a discounted price, in

relation to current holdings- Advantages


cheaper than IPO : prospectus not needed more beneficial to existing shareholder relative voting rights unchanged if taken reduce gearing

- Issue price at or above nominal value not too low to dilute EPS

- theoretical ex rights price (Terp) when existing shareholders have rights attached, then price is ‘cum

rights’ (with rights) first day of dealing in newly issued shares, rights do not exist and

shares are ‘ex rights’ (without rights)

e.g. Needy has 500,000 shares of $1 nominal with a market value of $2.50 on 1 Jan. 20X9. The company proposes a rights issue of 1 for 5 at $2. Just before the offer, the shares were traded at $2.40. What is terp at 1 Feb 20X9, the date of issue ‘cum right’ price = $2.40 Shares Price per share Total 5 2.40 12.00 1 2.00 2.00 6 14.00

terp = ...................................... = $2.33 E33

e.g. An investor in needy has 10,000 shares. Determine his outcome ifa He takes up offerb He renounces (sells) his rightc He renounces 25% of his right and takes 75%d He does nothing

terp 2.33price per new share 2.00right per new share 0.33

rights per existing shares = = 6.6c

a MV of 12000 shares (@ 2.33) 28000 Value of 10000 shares (@ 2.40) 24000Additional 2000 shares (2 2.00) 4000 28000

No gain or less of wealth, investment in company increased by $4000, proportion of total equity unchanged

% holding before rights = = 2%

% holding after rights = = 2%


b sell rights at 6.6c per share (i.e. 33c per new share)

MV of 10000 shares (@ 2.33) 23333Sale of rights of 2000 shares (@ 0.33) 667

24000

Value of 10000 shares (@ 2.40) 24000

No gain or loss of wealth = Proportion of equity decreases

% holding before rights = = 2%

% holding after rights = = 1.67%

c MV of 1500 shares (@ 2.33) 26833 sale of rights to 500 shares (@ 0.33) 167 27000

Value of 10000 shares (@ 2.40) 24000Additional 1500 shares (@ 2.00) 3000 27000No gain or loss in wealth. Proportion of shares decreases

d MV of 10000 shares (@ 2.33) 23333Value of 10000 shares (@ 2.40) 24000Loss of $667 wealth by not doing anything


B. Dividend PolicyInternal Sources of Finance1. These are

- retained earnings surplus cash belong to shareholder, ∴ equity advantagesi. flexible source : amounts and payment pattern not specificii. no change in shareholdings or dilution of controliii. no issue cost disadvantagesi. lost dividends to shareholdersii. opportunity cost to shareholders

- working capital management efficiency lower trade receivables & inventory optimise cash holdings increase trade payables

Dividend Policy1. Sufficient to meet the reasonable expectations of investors whilst allowing

for contingencies2. Market value of shares influenced by dividend

- steady dividend shows consistency- steady dividend growth shows business growth - fluctuating dividend raise concerns

3. Theories- residual theories

invest in projects with positive NPVs pay dividend when investment opportunity is exhausted

- traditional view link between dividend policy and share price

- irrelevancy theory4. Scrip dividend

- dividend paid by issue of additional shares capitalises retained earnings enhanced scrip dividends more attractive than cash receipt


Stock Split1. Creates cheaper, more marketable shares2. Viewed as a move in anticipation of increased earnings

- price of shares after split may settle higher

Share Repurchase1. Reasons

- realise investment of a shareholder (small company)- increase proportional holding of remaining shareholders

may intend to go private2. Benefits

- remove surplus cash- increase EPS- increase gearing without increasing funding- prevent takeover

3. Drawbacks- finding a fair price- company view as inefficient at fund management


C. Gearing And Capital StructureGearing1. Amount of debt finance to equity finance2. Debt is low risk since it is interest bearing and may be secured

- cost of debt relatively low3. Greater debt level → increased financial risk to shareholder

Gearing Ratio1. Financial gearing

- relationship between shareholder equity and prior capital charge

Financial gearing = ..................... E34

=

Prior capital charge = debt (may include or exclude short-term debt) Capital employed = net asset (no short-term liability)

- Can be based on market values

Financial gearing =

advantage : potential investors able to judge debt capacity of company

disadvantage : ignores value of assets which could secure more loans. 2. Operational gearing

- business risk risk of making only low profit or even losses

Operational gearing = ............................... E35

high contribution, low PBIT → high gearing contribution ≅ PBIT → low gearing

Interest coverage ratio1. Shows financial risk in terms of profit, not capital values

Interest coverage ratio = ....................................... E36

ratio < 3 : low ratio > 7 : safe

Debt ratioDebt ratio = total debt : total asset

debt doesn’t include long-term provisions and liabilities


Effect on Shareholder WealthCompany only able to raise finance if investors consider returns expected to be satisfactory for the level of risk

EPS E02

Financial gearing at given sales level = ............. E34

- two alternative plans can be evaluated to find indifference point

I = interest payable T = tax rate S1 = shares after financing plan 1 S2 = shares after financing plan 2

e.g. Investment inc. has 1,000,000 shares of $1 par and wishes to raise a further %600,000 by

a selling 200,00 shares at $3 per shareb issuing $600,000 10% loan stock at par Determine indifference point if tax rate is 30%

=

=

PBIT = 1.2(PBIT – 60000)0.2 PBIT = 72000PBIT = $360,000

Plan 1 Plan 2 PBIT 360,000 360,000 interest ---------- (60,000) 360,000 300,000 tax (108,000) (90,000) 252,000 210,000

EPS 21c 21c If PBIT increases, issue loan stock If PBIT deceases, issue equity


P/E ratio E11Reflects market appraisal of future prospect

- if EPS falls, but P/E ratio increases, then share price hasn’t fallen as much as earnings market has positive view of projects which increased gearing will

fund

Dividend cover

dividend cover = .......... E37

Dividend yield E10

Finance for Small and Medium-Sized Entities (SMEs)Pages 243-247


PART FCOST OF CAPITALA. Cost of CapitalCost of capital1. Rate of return an enterprise must pay to satisfy providers of fund

- reflects riskiness of investment2. Two aspects

- cost of funds- minimum return of a company’s own investment

3. Three elements- risk free rate of return

return required from investment free from risk : government security - premium for business risk

due to uncertainty about future and business prospect of firm - premium for financial risk

due to danger from high debt levels


Dividend growth model1. Dividend valuation model

- assume constant dividend in perpetuity

P0 = ......................................... E12

=

Po : ex-div share priced : annual dividend per shareke : cost of equity capital

2. Dividend growth model- normal expectation is for dividends to grow annually

P0 = = ............... E38

P0 =

=

Po : ex-div market price do : current net dividend ke : cost of equity g : expected annual dividend growth

e.g. A current market value of Growth Ltd’s shares is $2.50. Dividend of $0.50 was recently paid and the expected annual growth is 5%. What is cost of equity?

kε = + g

= + 0.05

= 0.21 + 0.05 = 0.26 or 26%

- estimated growth ratediv. year 0 × (I + g)n = div. year n


3. Gordon’s growth approximation...........................................g = br E39

g = expected annual dividend growth b = proportion of profit retained r = rate of return of new investment

4. Weakness of dividend growth model - does not incorporate risk- dividend grow unevenly (g is approximation)- taxation not accounted for - assumes no issue cost for new shares

Capital Asset Pricing Model (CAPM)Used to calculate cost of equity, incorporating risk Based on comparison of systematic risk of individual investments with the risk of all shares in market

Systematic and Unsystematic Risk1. Risk of holding shares divides into systematic and unsystematic risk2. Unsystematic risk can be diversified away3. Systematic risk cannot be diversified (inherent)

Beta Factor (β)1. Measures a shares volatility in terms of market risk2. A measure of systematic risk


Propositions of CAPM1. Return in excess of risk-free rate to compensate for systematic risk 2. Should not require premium for unsystematic risk, since it can be diversified away3. Higher return for bigger systematic risk

CAPM1. There is a linear relationship between return obtained from individual

security and average return of market Ri ∝ Rm

2. Ri / Rm =

• Po : price at start of period• P1 : price at end of period• D1 : dividend during period

3. Market risk premium (equity risk premium)- difference between expected rate of return and risk free rate over a period

excess returnrisk premium = E(ri) – Rf or E(rm) - Rf

4. CAPM Formula- security risk premium proportional to market risk premium E(ri) – Rf ∝ E(rm) - Rf

- constant of proportionality is β E(ri) – Rf = β(E(rm) - Rf .......................) E40- E(ri) = Rf = β(E(rm) - Rf) Rf : risk free rate of return E(ri) : cost of equity E(rm) : return from market β : beta factor of security

Problems1. Excess return should be based on expected returns, but historical returns used in practice2. Rf varies with type of investment and period of lending 3. β may change with time and prone to statistical error 4. Unable to forecast for low P/E ratio

Dividend growth model and CAPM1. Ke ≡ E(ri)2. dividend growth model does not incorporate risk but CAPM does ∴ in

absence of risk free rate of return, Ke ≅ E(ri) = β(E(rm))


The Cost of DebtReturn an enterprise must pay lenders

- irredeemable debt post tax interest as percentage of ex interest market value of loan /

preference share- redeemable debt

IRR of cash flows

Cost of debt capital1. Represents

- cost of continued use of finance, instead of redeeming securities at MV- cost of raising additional capital

2. Irredeemable debt- paying interest annually

P0 = ⇒ ...................... E41

Po : ex-interest price i : interest in perpetuity (no growth) kd : cost of irredeemable debt- paying interest semi-annually

P0 = ⇒

i : semi-annual interest


3. Redeemable debt- in year of redemption, interest + amount payable on redemption received

P0 =

P0 = .. E42

Pn : amount payable on redemption- can use IRR to solve for Kd

start with irredeemable Kd

add rate for annualised profite.g. 10% $200 loan note payable in 10 years with current value of $170 Capital profit = $200 - $170 = $30

annual capital profit = = $3 ≅ 2%

∴ irredeemable kd + 2%4. Taxation

- irredeemable

- redeemable calculate IRR which takes into account tax relief on interest interest is reduced by tax relief ∴ savings

5. Cost of floating debt rate - equivalent fixed interest debt should be substituted

similar term of maturity - if appraisal of project is motive, argument for using debt of same

duration as project6. Cost of bank debt

- current interest charged on sums


7. Cost of convertible debt- if conversion not expected, treat as redeemable and find IRR- if conversion is expected, use IRR method, but

replace years to redemption with years to conversion replace redemption value with conversion value

IRR PROFORMA Year DFa P V a

DFb PVb

0 MV X X X X X

1-n interest X (X)* X ( X )* X

n conversional X X X X X

r e d e m p t i o n value -- -- -- -- --

N P V X X

*cumulative

IRR =

8. Cost of preference shares (kp&f)

P0 = ⇒ ................... E43


Weighted Average Cost of Capital WACCCalculated by weighting the cost of individual sources of finance according to their relative importance as sources of finance

WACC = .............. E44

Ve : market value of equity Vd : market value of debt ke : cost of equity kd : cost of debt T : tax rate

Marginal Cost of CapitalSteps

- establish rates of return for each component (kx)- obtain marginal cost for each component


B. Capital StructureCapital Structure Theories1. Some believe there is an optimal mix of finance at which cost of capital is minimised 2. MM view is WACC is not influenced by changes in capital structure

Traditional view1. Cost declines initially, then rises as gearing increases2. Optimal capital cost where WACC lowest 3. Assumptions

- all earnings paid as dividend - gearing can be changed immediately as debt and equity are

interchangeable no transaction cost

- earnings constant in perpetuity - business risk constant, irrespective of investments - ignore taxation

4. View- as gearing increases, cost of debt constant to a point

increases beyond this point - cost of equity increases with gearing non-linearly - WACC falls initially as debt capital proportion increases, then increases

as Ke (also Kd) becomes significant. - Optimum gearing is for lowest WACC


Modighani-Miller (MM) View1. In absence of tax, capital structure has no bearing on WACC2. Total market value dependent on

- total earnings- level of business risk

3. WACC computed by discounting total earnings at a rate appropriate to level of operating risk

4. Assumptions- perfect capital market exists

all investors have some information leading to some expectation of risk and future earnings

- no tax or transaction costs- debt is risk-free and freely available to investors and company

5. Arbitage- purchase and sale of securities occur simultaneously in different markets

aim to make risk-free profit based on price difference - once all opportunity for profit exploited MV of two companies with same

earning and business risk will be equal6. View

- cost of debt is unchanged as gearing increases- cost of equity rises to keep WACC constant

7. Market imperfections- tax relief on interest lowers WACC- bankruptcy costs

at high gearing, increased risk of bankruptcy shareholder required higher rate of return as compensation

- agency costs restrictive covenants by debt holders

8. Pecking order- developed as alternative to traditional theory - order

retained earnings straight debt convertible debt preference shares equity shares


Impact of Cost of Capital on InvestmentsThe lower a WACC, the higher the NPV of future cash flows and higher the market value

Company value and cost of capital1. MV of company depends on cost of capital2. Lower the WACC, higher the NPV of future cash flows, the higher the MV

WACC in investment appraisal1. Can be used if

- project is small relative to company - existing capital structure maintained- project has same business risk as company

2. Arguments against- new investment may have different business risk

investor required rate of return will change if undertaken- finance raised may change capital structure and perceived financial risk- floating rate debt hard to incorporate in WACC


CAPM in investment appraisal1. Calculate project specific cost of capital2. Produces a discount rate based on systematic risk of the individual investment

- superior to NPV approach since risk is incorporated3. Limitations

- hard to estimate returns on projects- CAPM is single period model, but investments last more than one year- difficult to determine Rf

different types of government securities with different maturity

CAPM and MM combined1. Gearing affects risk of equity

- β for geared >β for ungeared2. CAPM consistent with MM

- MM : a gearing rise, cost of equity rises to compensate shareholders’ increased risk financial risk aspect of systematic risk ∴ reflect in β of company

3. Calculate geared β by- ungearing industry β- convert ungeared β to geared β reflecting company gearing ratio

.................... E45

βa : ungeared beta (asset) βe : geared equity beta βd : geared debt beta Vd : MV of debt in geared company Ve : MV of equity in geared company T : tax rate- Debt assumed as risk free ∴ βd = 0

................................ E45

4. Estimating β Factor- convert βe in company A to ungeared βa

- convert βa to βe in company B- use CAPM to find E(ri), i.e. cost of equity- use WACC to find cost of capital

a Weakness- difficult to find other firm with identical characteristic - β value estimates based on historical data which is different for each

company share price based on different data

- does not allow for growth opportunity- to link MM and CAPM, kd must be assumed as risk free


PART GBUSINESS VALUATIONSA. Business ValuationsNature and Purpose of Business ValuationsDifferent ways to value a business ∴ use several methods and compare

When required1. For quoted companies

- takeover bid and fair value in excess of current market price is office price

2. For unquoted company- going public- merger - selling shares- valuation for taxation- shares pledged as collateral

3. For subsidiary- sale by parent company- management buyout

4. For any company- shareholder wishing to dispose of holding which may result in another

gaining controlling interest- liquidation - obtain additional finance- refinancing of debt


Asset Valuation BasesNet asset valuation method

- used as one of many methods- to provide lower limit value N.B.: unlikely to produce most realistic value

Net asset method

1. Share value =

2. Only include tangible asset with MV- copyrights- patents

3. Establishing asset value may be subjective- historic - revaluation- replacement- realisable

4. Use of net asset method - measure of security in share value

compare EPS valuation to net asset valuation- measure of comparison in scheme of marger- as a floor value for a business up for sale


Income based1. P/E ratio used to value large blocks or whole business

- problematic if quoted P/E used to value unquoted a Common method of valuing controlling interest

- owner decides dividend and retention policyb Produces an earnings based valuation of shares c Significance of high P/E ratio

- EPS will grow rapidly ∴ MPS also grow high price now for future profit prospects dot com boom

- security of earnings low risk company have higher P/E than uncertain/risky company

- status unquoted P/E ≅ 50% - 60% of quoted P/E ∴useful for valuation on

takeoverd Problems

- finding similar quoted company often diversified

- single year P/E ratio not good basis abnormal/volatile earnings abnormal share price on prospect of takeover

- use of historical data to predict future- different capital structure between quoted and unquoted

2. Earning yield (EY) valuation method

EY =

EY = PE-1

EY can be used as discount rate (ke)

MV = ................................................ E46

D0 = earnings- High growth → low EY

current earning low relative to MV


Cash flow based1. Dividend valuation model

MVexdiv =

2. Dividend growth model

P0 =

D1 = Do (I + g) ∴ Expected dividend in one year’s time3. Assumptions

- investors act rationally and homogenously fails to take account of differing expectations

- do does not vary significantly from dividend trend- can incorporate different discounting rates

4. DCF basis- appropriate when one company intends to buy another company and

make further investments - maximum price is one which makes NPV = 0 at end of payback period

Valuation of debt1. Irredeemable

P0 = or P0 =

2. Redeemable

P0 =

3. Convertible debtP0 (1 + g)n R = conversion value Po : current ex div. share price g : expected annual growth of share price n : years to conversion R : shares received on conversion

4. Preference shares

P0 =


B. Market EfficiencyEfficient market hypothesisStock markets react immediately to all available information

- Long term investor cannot obtain higher than expected returns from a well diversified portfolio

Definition1. Allocative

- financial market direct funds to firms making most productive use of it2. Operational

- transaction costs incurred by participants in markets, thus efficiency achieved if costs kept as low as possible occurs when open competition between brokers

3. Informational processing- ability of stock market to price stock and shares fairly and quickly

Features of efficient market1. Prices reflect all available information2. No one entity dominates3. Transaction costs fairly low4. Investors are rational5. Little or no cost to acquire information

Impact on share price1. Company invest in positive NPV, MPS will rise anticipating future dividend increase2. Company makes bad investment, MPS will fall3. Interest rate rises, MPS will fall as investors demand higher rate of return

Degrees of efficiency1. Weak form

- share price reflects all available - information about past changes in share price changes in price occur randomly

2. Semi-strong Form- current price reflects

all relevant information about past all knowledge available publicly

- cannot beat market by acquiring publicly held knowledge already reflected ins hare price

3. Strong Form- current price reflects

past information publicly held information information from specialists’ or experts’ insider knowledge


Valuation of shares

Fundamental theory1. Realistic price of share derived from analysis of future dividends

MPS / P0 = or P0 =

Charting or technical analysis1. Attempt to predict price movement by assuming past patterns will repeat2. Use of moving averages e.g. 30 day, 240 day etc.

- 20/30 day : reasonable representation of actual movement - others give long term trends

Random walk theory1. Accepts share should have intrinsic price dependent on company fortunes and

investor expectations2. Underlying assumption

- all relevant information is available to potential investors who will act in rational manner


PART HRISK MANAGEMENTA. Foreign Currency Risk

Exchange rates1. Rate at which one country’s currency can be exchanged for another

country’s currency2. Spot rate- rate of exchange for immediate delivery3. Forward rate - rate now for a future exchange

Foreign exchange demands1. Bank selling rate or offer/ask price U$1 per $85.00 ∴ the bank will sell U$1,000 for $85,0002. Bank buying rate or bid price U$ 1 per $82.00 ∴ the bank will buy $1,000 for $82,000 The difference between the two is the bank profit.

Foreign currency riskThree forms

- transaction exposure : short-term- economic exposure : PV of longer term cash flows- translation exposure : book gains or losses

Translation riskrisk of making exchange losses when results translated into home currency- can result from restating assets of subsidiary using exchange rate at BS date

Transaction riskrisk of adverse rate movements in normal course of business

• credit periods may span different rates

Economic risk- effect of exchange movement on international competitiveness

• buy good in one country’s currency and sell in another’s currency

Causes of rate Fluctuations

Currency supply and demand1. Exchange rate determined primarily by supply and demand2. Influenced by - inflation locally versus overseas


- local vs foreign interest rate- balance of payments - speculation- government policy and intervention

Interest rate parity1. Method of predicting foreign exchange rates based on hypothesis that

difference in interest rates in two countries should offset difference between spot and forward price for same period

...................................... E47

• Fb = forward rate country b• Sb = spot rate country b• ib = interest rate country b• ic = interest rate country cN.B. use country B as base currency2. Can be used to predict / forecast future exchange rates

Purchasing power parityThe exchange rate between two currencies is same in equilibrium when

purchasing power of currency is same in each country

...................................... E 48

• S1 = expected spot rate• S0 = current spot rate• hc = expected inflation rate in c• hb = expected inflation rate in b

Fisher effect1. (1 + i) = (1 + h)(1 + r)2. International Fisher Effect

- currency of countries with relatively high interest rate expected to depreciate ***** currency with lower interest rate• higher interest rate needed to compensate for anticipated depreciation

- free global movement of capital will equalise real rate of return

.......................................... E49

Foreign currency risk management

Risk and risk management1. Policies a firm may adopt and techniques used to manage risk it faces2. Exposure: being open or vulnerable to risk 3. Why manage risk


- to reduce to acceptable levels - to avoid unacceptable risk

Currency of invoice1. One way to avoid is to invoice foreign customer in domestic currency2. Arrange with foreign supplier to invoice in domestic currency3. Only one can avoid the risk4. Can agree to invoice in foreign currency, but at fixed exchange risk

Matching receipt and payment1. Offset payment to suppliers against receipt from customers2. Maintain a foreign currency account for this purpose

Matching assets and liabilities1. Hedge against weakening of foreign currency by matching receipts against a

loan taken out in that currency

Leading and logging1. May use

- lead payments : in advanced- lagged payments : beyond due date

Netting1. Credit balance netted of against debt balances so only reduced net amounts remain due2. Useful for intragroup trading in multinational groups3. Advantages

- reduced purchase and transmission cost- reduce lost interest on money in transit

Forward exchange contracts1. Specifies in advance the rate at which a specified quantity of currency will be

bought and sold 2. Hedge against transaction exposure by allowing trader to know in advance

amounts due or to be received

Close-out of forward contract1. Customer unable to satisfy forward exchange contract2. Customer arranged to sell to bank

- sell to customer at spot rate- buy back from customer at forward exchange contract

3. Customer arranged to buy from bank- sell to customer at forward exchange rate- buy back at spot rate

Money market hedging1. Involves

- borrowing in one currency


- putting money on deposit until time transaction is completed2. Aim

- take advantage of favourable exchange rate movement 3. ‘Manufactures’ a forward exchange rate4. Foreign currency asset hedges foreign currency liability

Foreign currency derivatives Used to hedge foreign currency risk

Currency Futures1. Standardised contracts for sale or purchase at set future date of set quantity of currency2. Future

- commitment to additional transaction in future to limit risk of existing commitment

3. Contract size- fixed minimum quantity of commodity which can be bought or sold

4. Contract price- price at which contract can be bought or sold

5. Settlement date- date at which trading on particular contract stops

6. Basisbasis = spot price – futures price

7. Tick- smallest measured movement in contract price

• movement in fourth decimal place for currency futures8. Advantage of futures to hedge risks

- lower transaction costs than other measures- futures are tradable

• transparency in price (Forward contract price set by broker)- exact date of receipt or payment doesn’t have to be known

9. Disadvantages- contracts cannot be tailored - hedge inefficiencies

• having to deal in whole number contracts• basis risk

- limited number of currencies- do not allow company to take advantage of favourable currency

movement• this is unlike options

Currency options1. A right to buy (call) or sell (put) foreign currency at a specific exchange rate

at a future date2. Buyer of option pays a premium, the most the buyer can lose3. Purpose

- reduce of eliminate exposure to currency risks where• uncertainty in foreign currency receipt or payment


i. if transaction doesn’t materialise, option may be sold on market or exercised

• support tender for overseas contract• allow publication of price list in foreign currency• protect import/export of price sensitive goods

4. Drawbacks- must be paid for as soon as bought- lack negotiability- not available in every currency

Currency swap1. Formal agreement where two organisations agree to exchange payments on

different terms 2. Parties agree to swap equivalent amounts of currency for a period


B. Interest Rate RiskInterest rates1. Prices governing lending and borrowing 2. Pattern influenced by

- risk of asset- duration of loan- size of loan

Interest rate risk1. Relates to sensitivity of profits and cash flow to changes in interest rates2. Faced by companies with floating and fixed rate debt3. Can arise from

- gap exposure• negative gap more : interest sensitive liabilities maturing than interest

sensitive assets in same period • positive gap

- basis risk• different bases used to set various floating rates

Interest rate risk managementCan be managed using

- internal hedging: asset and liability management, matching and smoothing- external hedging: forward rate agreements and derivatives

Matching and smoothing 1. Matching

- asset and liability with common interest rate matched• company A invests in money market at LIBOR and subsidiary B

borrows at LIBOR2. Smoothing

- keep balance between fixed and floating rate borrowing

Forward rate agreements (FRA)1. Fixing interest rate on future borrowings2. Protects company from adverse rate changes3. Company doesn’t benefit from favourable rate movement


F9 June 2012 Revision (Open Tuition)

Documents

Transcript of F9 June 2012 Revision (Open Tuition)