BY: ASAD EJAZ

ACA, FCCA,ADV DIP MA (CIMA), CISA, APFA

FM: FINANCIAL
MANAGEMENT
 BY: ASAD EJAZ
ACA, FCCA,ADV DIP MA (CIMA), CISA, APFA

FM: FINANCIAL
MANAGEMENT
THE INVESTMENT
APPRAISAL
FINANCIAL MANAGEMENT (FM)
THE EVALUATION METHODS
 3
THE CAPITAL BUDGETING CYCLE
Idea
Generation

Project
Screening

Financial &
Non-
financial
Evaluation

Approval

Implementa
tion

Ongoing
Monitoring

Post
Completion
Audit
 4

FINANCIAL
EVALUATION
METHODS

NON-DISCOUNTED METHODS DISCOUNTED METHODS

 Accounting Rate of Return (ARR)  Net Present value (NPV)
 Payback Period  Internal Rate of Return (IRR)
 Discounted Payback Period
 5

ACCOUNTING RATE OF RETURN (ARR)

The Average return of a project expressed as a

percentage of the capital outlay or average investment
ARR Formula
 𝐴𝑅𝑅 = 𝑋100%
OR
 𝐴𝑅𝑅 = 𝑋100%
Where “Average Investment” is
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
Decision rule
 If ARR of the project > Target ARR then Accept the
project
 6

EXAMPLE

Rough Ltd has the opportunity to invest in an investment

with the following initial costs and returns: ANSWER:
($000)

Initial investment (100) Depreciation = (100-5)/5 = 19

Operating Cash flows Average Operating Cashflows = (50+40+30+25+20)/5 = 33

Yr 1 50
Yr 2 40 Average Profit = 33-19 = 14
Yr 3 30
Yr 4 25 Average Investment = (100+5)/2 = 52.5
Yr 5 20
ARR = 14/52.5 X 100% = 26.67%
Residual value Yr 5 5

The target ARR is 20% Company uses the straight line

method for depreciation.

Required:

Calculate the ARR based on Average Investment?

 7

ADVANTAGES & DISADVANTAGES

Advantages
 It is easy to understand and easy to calculate
 The impact of the project on a company’s financial statement can also be specified
 Manager’s happiness in looking the project in the same way as shareholder’s look at the
company
 It takes into account the whole life of the project
 It can be used as a relative measure in case of mutually exclusive projects

Disadvantages
 It fails to take account of the timing of cash flows and time value of money within that life
 It uses accounting profit, hence subject to various accounting conventions.
 It Ignores the size of investment.
 Like all rate of return measures, it is not a measurement of absolute gain in wealth for the
business owners.
 The ARR can be expressed in a variety of ways and is therefore susceptible to manipulation
 8

CASH FLOWS
Future
Incremental
Cashflows
Opportunity Cost

Irrelevant cashflows
 Sunk Cost/ Historical Cost
 Non-cash cost (Depreciation)
 Indirect Costs
 General Overheads
 Central Office Overheads
 9

ASSUMPTIONS
OF
CASHFLOWS

If Cash flows arise If cash flow arises at Period ‘0’ is not a

during the period, the start of the period, instead it
then it is assumed as period then it is represents start of
it arises at the end of assumed as if it arises period ‘1’ or present
that period. at the end of the
preceding period date
 10

PAYBACK PERIOD
It is the time period required to
recover the initial investment

Decision rule
If Payback Period < Target
Payback
Accept the Project
 11

QUESTION

ANSWER:
EXAMPLE
A project is expected to have cash flows.
Cashflows Cumulative
($) cashflows ($)
Cashflows ($) Year 0 (2,000,000) (2,000,000)
Year 0 (2,000,000) Year 1 500,000 (1,500,000)
Year 1 500,000 Year 2 500,000 (1,000,000)
Year 2 500,000 Year 3 500,000 (500,000)
Year 3 500,000 Year 4 600,000 100,000
Year 4 600,000 Year 5 300,000
Year 5 300,000 Year 6 200,000
Year 6 200,000
𝑳𝒂𝒔𝒕 − 𝒗𝒆 𝑪𝑪𝑭 𝟓𝟎𝟎, 𝟎𝟎𝟎
= = 𝟎. 𝟖𝟑 𝑿𝟏𝟐
𝑵𝒆𝒙𝒕 𝑷𝒆𝒓𝒊𝒐𝒅 𝑪𝑭 𝟔𝟎𝟎, 𝟎𝟎𝟎
Required: Calculate payback period Payback Period = 3.83 Years OR 3 years & 10 months
 12

ADVANTAGES & DISADVANTAGES

Advantages
 It is simple to use (calculate) and easy to understand
 Useful when the company is facing liquidity issues.
 Useful when the environment is uncertain or the project life can be obselete
 The method is often used as the first screening device to identify projects
 Uses cash flows, rather than accounting profits,

Disadvantages
 It does not give a measure of return
 It does not normally consider the impact of discounted cash flow i.e time value for money is
ignored
 It only considers cash flow up to the payback, any cash flows beyond that point are ignored.
 There is no objective measure of what is an acceptable payback period
 13

SIMPLE VS COMPOUND INTEREST

 Simple interest is a method in which interest is calculated

on the principle amount

 Compound interest is a method in which interest is

calculated on the accumulated value of the preceding
period

 Nominal rate is used when interest is compounded only

once in a period

 Effective rate is use when interest is compounded more

than once in a period
 14

TIME VALUE OF MONEY

Amount received today will not be equal

to the amount sometime in the future

Where
r  rate per period
n  number of periods
FV  future value
PV  present value
 15

CHECK POINT QUESTION

Question Answer
Question 1
Answer 1
A House prices rise at 2% per calendar 𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒓𝒂𝒕𝒆 = (1 + 2%) −1
month. What is the annual rate of increase = 𝟐𝟔. 𝟖𝟐%
to one decimal place?

Question 2
Answer 2
If a single sum of $12,000 is invested at 8%
per annum with interest compounded Interest rate per quarter (8%/4) 2% per
quarterly, the amount to which the principal quarter
will have grown by the end of year three is 𝑭𝑽 = $12,000 𝑋 ( 1 + 2%) ( )
approximately = 𝟏𝟓, 𝟐𝟏𝟖. 𝟗𝟎
 16

DISCOUNT FACTOR TABLE

NET PRESENT VALUE (NPV)

 The NPV is the sum of present values

of all the cashflows that arises as a
result of doing the project

 Decision rule

 If NPV of the project, discounted at

cost of capital, is positive then
accept the project
 18

QUESTION

ANSWER:
A project is expected to have cash flows

Cashflows Discount Present

($) factor value
Cashflows ($) Year 0 (100,000) 1 (100,000)
Year 0 (100,000) Year 1 50,000 0.909 45,450
Year 2 40,000 0.826 33,040
Year 1 50,000
Year 3 30,000 0.751 22,530
Year 2 40,000
Year 4 25,000 0.683 17,075
Year 3 30,000 Year 5 25,000 0.621 15,525
Year 4 25,000 33,620
Year 5 25,000
The cost of capital is 10%
Question: Calculate NPV of the project
 19

ALTERNATE WAY TO CALCULATE NPV IN CRS

In the spreadsheet you can use the NPV function to calculate NPV i.e.
=NPV(disc rate,Year 1 cashflows:Year n cashflows)+year 0 cashflows
 20

ADVANTAGES & DISADVANTAGES

Advantages
 A project with a positive NPV maximises the wealth of the shareholders
 Considers the concept of time value of money
 Discount rate can be adjusted to take account of different level of risk inherent in different
projects
 Considers events throughout the life of the project
 It focuses on cash flows rather than profit

Disadvantages
 Determination of the correct discount rate can be difficult
 Non-Financial managers have difficulty understanding the
 The speed of repayment of the original investment is not highlighted
 21

INTERNAL RATE OF RETURN (IRR)

 IRR is the rate of return offered by an investment ,
based on cashflows and time value of money
𝐴
𝑰𝑹𝑹 = 𝑎% + 𝑋 𝑏% − 𝑎%
𝐴−𝐵
Where
a% is a small rate at which NPV is positive
A is NPV at a%
b% is a bigger rate at which NPV is negative
B is NPV at b%
Decision rule
If IRR of the project > cost of capital
Accept the project
 22

QUESTION

ANSWER:
A project requiring an investment of $1,200 is
expected to generate returns of $400 in years 1
22
and 2 and $350 in years 3 and 4. The NPV = 𝑰𝑹𝑹 = 9% + 𝑋 10% − 9% = 𝟗. 𝟖𝟓%
22 − (−4)
$22 at 9% and the NPV = ‐ $4 at 10%
Question: Calculate IRR of the project
 23

ALTERNATE WAY TO CALCULATE IRR IN CRS

In the spreadsheet you can use the IRR function to calculate NPV i.e.
=IRR(Year 0 cashflows:Year n cashflows)
 24

ADVANTAGES & DISADVANTAGES

Advantages
 Like the NPV method, IRR recognises the time value of investment
 It is based on cash flows, not accounting profits
 More easily understood than NPV by non-accountant being a percentage return on
investment.
 For Accept/ Reject decisions on individual projects, IRR method reach the same decision as
the NPV method

Disadvantages
 Does not indicate the size of the investment
 Assumes that earnings throughout the period of the investment are reinvested at the same
rate of return i.e. IRR
 It can give conflicting signals with mutually exclusive project
 If a project has irregular cash flows, then there is more than one IRR (multiple IRRs)
 25

DISCOUNTED PAYBACK
PERIOD It is the time period required to
recover the initial investment in
terms of present value

Decision rule
If Discounted Payback Period <
Target Discounted Payback
Accept the Project
 26

QUESTION

ANSWER:
CHECKPOINT QUESTION
A project is expected to have cash flows Cumulative
Cashflow Discount Present Present
s ($) factor value value
Cashflows ($) Year 0 -100,000 1 -100000 (100,000)
Year 0 (100,000) Year 1 50,000 0.909 45,450 (54,550)
Year 1 50,000 Year 2 40,000 0.826 33,040 (21,510)
Year 2 40,000 Year 3 30,000 0.751 22,530 1,020
Year 4 25,000 0.683 17,075
Year 3 30,000
Year 5 25,000 0.621 15,525
Year 4 25,000
Year 5 25,000
The cost of capital is 10% Discounted payback (2 + 21,520/22,530) = 2.96 years

REQUIRED: Calculate the discounted

payback of the project
 27

ADVANTAGES AND
DISADVANTAGES

All Advantages and

disadvantages are common
with the payback EXCEPT for
one i.e.
Time value of Money
ANNUITY & PERPETUTY
 29

CONSISTENT CASHFLOWS

If Cashflows arises in a series of equal

cashflows then it is called Consistent
Cashflows. These are of two Types:
 Annuity: If Consistent cashflow for a
certain Period. e.g Y1-5 or Y3-7
𝟏 −n
 Annuity factor =
𝒓

 Perpetuity: If Consistent cashflow for

infinite period e.g. Y1-∞ or Y3-∞
𝟏
 Perpetuity factor =
𝒓
 30

PV OF ANNUITY VS PERPETUITY
Annuity Perpetuity
If Cashflows Start from Period 1 If Cashflows Start from Period 1
 Annual Cashflow X Annuity Factor  Annual Cashflow X Perpetuity Factor
 e.g. Y1-5 $10,000 at Disc. Rate of 10%  e.g. Y1-∞ $10,000 at Disc. Rate of 10%
 $10,000 X 3.791(from annuity table)  $10,000 X (1/10%) = $100,000
=$37,910

If Cashflows Start from Period 0 (Advanced) If Cashflows Start from Period 0 (Advanced)
 Annual Cashflow X (Annuity Factor + 1)  Annual Cashflow X (Perpetuity Factor+ 1)
 e.g. Y0-5 $10,000 at Disc. Rate of 10%  e.g. Y0-∞ $10,000 at Disc. Rate of 10%
 $10,000 X (3.791+1) =$47,910  $10,000 X ((1/10%)+1) = $110,000
 31

PV OF ANNUITY VS PERPETUITY DELAYED

Annuity Perpetuity

If Cashflows Start from Subsequent If Cashflows Start from Subsequent

Period Period
 Annual Cashflow X Annuity Factor of  Annual Cashflow X Perpetuity Factor X
No. of periods X Discount factor of Discount factor of preceding period from
preceding period from Start Start
 e.g. Y4-8 $10,000 at Disc. Rate of 10%  e.g. Y4-∞ $10,000 at Disc. Rate of 10%
 $10,000 X 3.791 X 0.751 =$28,470  $10,000 X (1/10%) X 0.751 = $75,100
THE INVESTMENT
CASHFLOWS
FINANCIAL MANAGEMENT (FM)
THE FORMAT
FORMAT OF NET CASHFLOWS
 4

FINANCE COST IN CASHFLOWS

The Finance Cost will be a

relevant cashflow however it will
NOT become the part of cashflows
 This is because it is part of cost
of capital
 5

TAXATION
To be included in net
cashflows
EFFECT OF TAXATION IN INVESTMENT APPRAISAL

Timing of Tax Cashflows: Either in

the same year or in arrears.
Calculation of cashflows
Tax on Operating Cashflows:
 Operational Cashflows X Rate of Tax
Tax Savings on Capital
Allowances:
 Capital Allowances (or Balancing
Allowances) X Tax Rate.
 7

EXAMPLE

Rough Ltd has the opportunity to invest in an investment

with the following initial costs and returns: ANSWER:
($000)

Initial investment (100)

Operating Cash flows

Yr 1 50
Yr 2 40
Yr 3 30
Yr 4 25
Yr 5 20

Residual value Yr 5 5

Govt. Allows the straight line method for depreciation and

the rate of tax is 30%. Tax is settled in the same year

Required:

Prepare the net cashflows

 8

WORKING OF TAX SAVINGS – REDUCING BALANCE

In reducing balance method, last year there are 2

allowances, Capital Allowances and Balancing Tax savings on CA
Allowances. This can be calculated as:
 Opening Balance – Scrap Value Years 0 1 2 3 4 5
– Initial Investment = 2,000
– Capital Allowances = 25% reducing balance $ $ $ $ $ $
– Useful life = 4 years,
– Tax rate = 30% payable in arrears,
– Scrap Value = 500 O/B 2,000 1,500 1,125 844

CA 500 375 281 344

2,000 X 25% = 500

O/B – Scrap Value

Tax 150 113 84 103
844-500 = 344
 9

WORKING
CAPITAL
To be included in net
cashflows
 10

WORKING CAPITAL

An investment is required to run day

to day operation of the business
known as working capital
investment
 11

WORKING
CAPITAL
CASHFLOWS

REQUIRED CASHFLOWS RECOVERY

 Calculate working  Calculate  In last year, there
capital requirement incremental will be an
one year in working capital by assumption that all
advance taking change of working capital will
each year working be recovered
capital
 12

EXAMPLE

A company is considering to invest in a project with

its life of 4 years. Total working capital required at Years 0 1 2 3 4
the beginning of each year is as follows:
Year Working capital required $'00
0 $'000 $'000 $'000 $'000
$’000
1 500 Working
2 700 Capital
required at
3 1,000
start 500 700 1,000 600
4 600
Required: Calculate the working capital
Cashflows (500) (200) (300) 400 600
cashflows of each year to be included in NPV
calculation?
 13

INFLATION
To be included in net
cashflows
 14

EFFECT OF INFLATION IN INVESTMENT APPRAISAL

Inflation may be defined as a general

increase in prices, leading to general
decline in the real value of money

 Real Value (without inflation)

 Money/ Nominal Value (with inflation)
 15

REAL RATE VS NOMINAL

RATE

Real Rate of Return (r): Without inflation

rate
Money/ Nominal Rate of Return (i): With
Inflation rate
General Inflation (h)
The relationship between real and money
interest is
1 + 𝑖 = (1 + 𝑟)(1 + ℎ)
 16

GENERAL INFLATION VS SPECIFIC INFLATION

 If the rate of inflation is different for

different cashflows then it is known
as Specific Inflation
 If the rate of inflation is same for all
cashflows then it is known as
General Inflation
 17

EVALUATING GENERAL INFLATION

Money Method (Default)

A. Convert cashflows from real to nominal using general rate of inflation
B. Use nominal rate to discount cashflows

Real Method (When required)

A. Don’t convert real cashflows to nominal
B. Use real rate to discount cashflows
 18

EVALUATING SPECIFIC INFLATION

Money Method (Default)

A. Convert each cashflows from real to nominal using specific rate of inflation
B. Use nominal rate to discount cashflows

Real Method (When required)

A. Convert each cashflows from real to nominal using specific rate of inflation
B. Revert back to real cashflows using general rate of inflation
C. Use real rate to discount cashflows
 19

CONVERTING REAL CASHFLOW TO NOMINAL

Operational Cashflows
If prices are in current terms
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 = 𝑅𝑒𝑎𝑙 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑠 ( 1 + ℎ)

If prices are in year 1 terms

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 = 𝑅𝑒𝑎𝑙 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑠 ( 1 + ℎ)

Working Capital Required

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑
= 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 ( 1 + ℎ)
 20

EXAMPLE

A company is considering to invest in a project with

its life of 4 years. They are expecting to sell: Years 1 2 3 4
500 units in year 1,
Units 500 600 1,000 700
600 units in year 2,
1,000 units in year 3 & X Price 10 10 10 10
700 units in year 4 X (1+ h)n (1+5%)1 (1+5%)2 1.053 1.054
The current price of each units is $10 and the price
is expected to rise by 5% each year 5,250 6,615 11,567 8,509
Required: Estimate the nominal sales revenue for
each year?
SPECIFIC
INVESTING
DECISIONS
FINANCIAL MANAGEMENT (FM)
 2

CAPITAL
RATIONING
Specific investing decisions
 3

CAPITAL RATIONING

 A limit on the level of funding

available to a business
 Two reasons of capital rationing
 Hard capital rationing – Externally
imposed
 Soft capital rationing – Internally
imposed
 4

SINGLE PERIOD VS
MULTIPLE PERIOD

In single period capital rationing,

investment decisions are made for a
specific time frame, usually one year

In multiple period capital rationing,

investment decisions are made over an
extended period, usually multiple
years
 5

DIVISIBLE VS INDIVISIBLE

Divisible – An entire project or any

fraction of that project may be
undertaken

Indivisible – An entire project must be

undertaken, since it is impossible to
accept part of a project only
 6

EVALUATING DIVISIBLE PROJECTS

 Calculate the NPV of each Investment

 Calculate the Profitability indices (NPV/Investment)
 Ranking
 Investment Plan

Note: In case of Mutually exclusive Projects, the project

with the Higher Profitability Indices will be ranked and
lower will be ignored.
 7

EXAMPLE

Four project which are divisible are under ANSWER:

consideration:
Project Project Project Project
Investment NPV A B C D
$ $ NPV 500 700 300 450
Investment 1,000 1,200 800 700
Project A 1,000 500 Profitability
0.50 0.58 0.38 0.64
Project B 1,200 700 Index

Project C 800 300 Ranking 3 2 4 1

The Investment Schedule
Project D 700 450
Project Project Project Project
Total available Funds are $2,500 D B A C
NPV 450 700 300 1,450
Required:
Investment 700 1,200 600
Prepare the project plan and total NPV Remaining
1,800 600 0
Investment
600/1,000 = 60%
 8

EVALUATING INDIVISIBLE
PROJECTS

In this event different combination of

projects are assessed with their NPV
and the combination with the highest
NPV is chosen.

Note: In case of Mutually exclusive

Projects, the two projects cannot be
part of same project
 9

EXAMPLE

Four project which are indivisible are under ANSWER:

consideration: Combination 1: Project A & B
Investment: 1,000 + 1,200 = 2,200
Investment NPV NPV: 500 + 700 = 1,200
$ $ Combination 2: Project A, C & D
Investment: 1,000 + 800 + 700 = 2,500
Project A 1,000 500 NPV: 500 + 300 + 450 = 1,250
Project B 1,200 700
Combination 3: Project B & C
Project C 800 300 Investment: 1,200 + 800 = 2,000
NPV: 700 + 300 = 1,000
Project D 700 450
Combination 4: Project B & D
Total available Funds are $2,500 Investment: 1,200 + 700 = 1,900
NPV: 700 + 450 = 1,150
Required:
Best combination will be:
Prepare the project plan and total NPV
Combination 2: Project A, C & D
 10

ASSET
REPLACEMENT
DECISIONS
Specific investing decisions
 11

ASSET REPLACEMENT

Once the decision has been made to

replace the asset, the question is how
to replace an asset in the most cost-
efficient manner.
Asset Replacement issues:
 How frequently an asset be
replaced?
 Is it worth paying more for an asset
that has a longer expected life.
 12

KEY
ASSUMPTIONS

 Cash flows from trading  The operating efficiency  The assets will be
are not normally of machines will be replaced in perpetuity.
considered in this type similar with differing
of decision. The machines or with
assumption being that machines of differing
they will be similar ages
regardless of the
replacement decision
 13

THE EQUIVALENT ANNUAL COST

 The ideal approach is to keep the costs

per annum (in NPV terms) to a minimum
 Sales revenue and regular cost are
usually irrelevant
 This is calculated as an equivalent
annual cost (EAC)
 𝐸𝐴𝐶 =
 14

EXAMPLE
A company bought an asset for $80,000 having
a useful life of three years. It is now
considering the right time to replace the asset.
The running cost on the asset is $15,000 for
year 1 and would increase by $5,000 per year
over the life of the project. The expected scrap
values at the end of each year are as follows:
Year Scrap Value ($)
1 40,000
2 25,000
3 15,000
The company has a cost of capital of 10%.
Required:
Determine whether the company should
replace the asset after year 2 or year 3
 15

EXAMPLE - SOLUTION
Replace After Year 2 Replace After Year 3
Years 0 1 2 3 Years 0 1 2 3
$ $ $ $ $ $ $ $

Running cost (15,000) (20,000) Running cost (15,000) (20,000) (25,000)

Investment (80,000) Investment (80,000)

Residual value 25,000 Residual value 15,000

Net Cashflows (80,000) (15,000) 5,000 Net Cashflows (80,000) (15,000) (20,000) (10,000)

NPV (89,505) NPV (117,678)

EAC (89,505)/1.736 = (51,558) EAC (117,678)/2.487 = (47,317)

The annual equivalent cost for replacement after year 3 is less costly
therefore asset should be replaced after every 3 years
 16

LEASE VS BUY
Specific investing decisions
 17

LEASE OR BUY

The decision here is whether buying the

asset or leasing the asset is more cost-
effective
Lease
 It is a rental agreement between two
parties (lessee and lessor) for the use of
an asset for some specific time period
 Lessor is the provider of the asset
whereas lessee is the user of asset
 18

CALCULATION

BUY (BORROWING) LEASING DISCOUNT RATE

 Cost of the investment  Lease rentals  Discount rate = post tax
 Tax savings on CA – In advance cost of borrowing

 Residual value – Annuity  𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑋 (1 − 𝑇)

 Any other specific  Tax Relief on lease

cashflows rentals
 19

EXAMPLE
A firm has decided to acquire a new machine. The
machine would cost $6.4 million and would have an
economic life of five years. Tax-allowable depreciation
on straight line balance basis is available for the
investment. Taxation of 30% is payable on operating
cash flows, one year in arrears.
The firm intends to finance the new plant by means of
a five-year fixed interest loan at a pre-tax cost of
11.4% pa, principal repayable in five years’ time.
As an alternative, a leasing company has proposed a
finance lease over five years at $1.42 million pa
payable in advance.
Scrap value of the machine under each financing
alternative will be zero.
Required:
Evaluate the two options for acquiring the machine
and advise the company on the best alternative
 20

EXAMPLE - SOLUTION
Post tax interest rate = 11.4%X(1-30%) = 8% PV of Leasing
Years 0-4 2-6
PV of Buying
$'000 $'000
Years 0 1 2 3 4 5 6
$'000 $'000 $'000 $'000 $'000 $'000 $'000 Lease rentals (1,420)
Tax
savings on Tax savings 426
CA 384 384 384 384 384 Net Cashflows (1,420) 426
Investment (6,400)
AF @ 8% (3.312+1) (3.993 X 0.926)
Net PV (6,123.04) 1,575.14
Cashflows (6,400) - 384 384 384 384 384

NPV (4,980) NPV of Leasing (4,547.90)

The Cost of leasing is lower than cost of buying so the co. should
lease the asset
RISK IN
INVESTING
DECISIONS
FINANCIAL MANAGEMENT (FM)
 2

RISK VS UNCERTAINTY

 Risk refers to a situation where the

possible outcomes of an event or
decision are known, and the
probabilities associated with each
outcome can be estimated
 Uncertainty arises when the future is
unpredictable and the probabilities of
different outcomes cannot be estimated
with confidence
 3

TECHNIQUES

 Risk adjusted discount rates

 Sensitivity analysis
 Simulation
 Expected values
 4

RISK ADJUSTED DISCOUNT RATE

 An individual investment or project

may be perceived to carry different
risk than existing investments.
 In this situation, the discount rate
could be adjusted to reflect the
differential risk
 5

SIMULATION

Simulation is a computer-based method

of evaluating an investment project
whereby the probability distributions
associated with individual project variables
and interdependencies between project
variables are incorporated.
Step 1: Identify Variables
Step 2: Create Scenarios
Step 3: Run Simulations
Step 4: Analyze Results
 6

EXPECTED VALUES

Where there are a range of

possible outcomes which can be
identified and a probability
distribution can be attached to those
values
The expected value is the
arithmetic mean of the outcomes
as expressed below:
 7

EXAMPLE

Outcomes % EV
100,000 0.25 25,000
200,000 0.50 100,000
300,000 0.25 75,000

Expected 200,000
Value
 8

JOINT PROBABILITY

Form a joint probability table when

dealing with different
probabilities for various factors
Utilising this table can assist you
in determining the expected
value and gaining additional
understanding of these factors
 9

JOINT PROBABILITY TABLE PREPARATION

Units P V.Cost P T.V.Cost J.P PX

 A company is trying to estimate the
variable cost in the period, 800 0.7 $5 0.4 $4,000 0.28 $1,120
however, there are different 800 0.7 $7 0.6 $5,600 0.42 $2,352
possibility on production units and 1200 0.3 $5 0.4 $6,000 0.12 $720
variable cost
1200 0.3 $7 0.6 $8,400 0.18 $1,512
Expected value $5,704
Units P V.Cost P Further insight
Most likely, Variable cost will be $5,600 (outcome with
highest joint probability)
800 0.7 $5 0.4
Chances that the variable cost will be higher than
$5,700 is 30% (sum of probabilities of outcomes with
1200 0.3 $7 0.6 greater variable cost)
 10

SENSITIVITY ANALYSIS

A technique that considers a single

variable at a time and identifies by how
much that variable has to change for the
decision to change (from accept to reject)

Sensitivity of a particular cashflow :

𝑁𝑃𝑉
Sensitivity (%) = 𝑋100%
𝑃𝑉 𝑜𝑓 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦

Sensitivity of a particular discount rate:

𝐼𝑅𝑅 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
Sensitivity (%) = 𝑋100%
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
COST OF CAPITAL
FINANCIAL MANAGEMENT (FM)
BASICS OF
COST OF
CAPITAL
RISK AND RETURNS

Investor provide funds to the

company
Against it require returns
Higher the risk they have taken
in the company, higher they
expect returns
 4

OVERALL RETURN INVESTOR EXPECTS

The overall return investor expects is

the combination of two returns
 Risk-free returns (R f): The level of
return expected of an investment
with zero risk to the investor.
 Risk Premium return: the amount of
return required above and beyond
the risk-free rate for the
compensation of risk they have taken
 5

INVESTMENT IN RELATION FOR THE DEGREE OF

RISK

Risk Free Government Debt

Low Risk Secured Loan

More risk Unsecured Loan

Higher
Preference shares
Risk

Highest
Ordinary shares
Risk
 6

THE COST OF CAPITAL

Cost of capital is the expected return by the investors

Preference
Ordinary Debt holder shares
share holder
holder

Expected Expected Expected

return on return on return on
equity Debt Pref.

Cost of Cost of debt Cost of Pref.

equity (ke) (kd) (kp)
Cost of debt
(kd)
 8

THE COST OF DEBT

The cost of debt is the rate of

return that debt providers
require on the funds that they
provide
expect this to be lower than
the return required by equity
holder
As interest is a tax allowable
cost so it will be after tax
 9

TYPES OF DEBT

Debt

Non
Marketable
marketable
(Loan Notes)
(Bank Loan)

Irredeemable Redeemable

Non
Convertible
convertible
 10

COST OF DEBT – BANK LOAN


 ( )

 If a loan from the bank is at 12% per

annum and the tax is charged at 30%
then:
 𝐾 ( ) = 12% 𝑋 1 − 30% = 𝟖. 𝟒%
 11

TERMINOLOGY
 Loan notes, bonds and debentures are all types of
debt issued by a company. Gilts and treasury bills are
debt issues by a government.
 Traded debt has a nominal value usually $100
 Interest paid on the debt is stated as a percentage of
nominal value ($100 as stated). This is known as the
coupon rate.
 Interest = Nominal value X Coupon rate
 Debt can be:
 Irredeemable – no redemption date
 redeemable – defined redemption date
 Convertible – can be converted into ordinary share

 It should have a market price

 12

EX-INTEREST PRICE VS CUM-INTEREST PRICE

 Cum-Interest price: known as

inclusive interest price is the price
when interest is due but not paid
yet
 Ex-Interest Price: known as
exclusive interest price is when
either the interest is not yet due or
already paid

𝟎
 13

COST OF DEBT (IRREDEEMABLE)


( )
 ( )

Example
 The 10%, $100 irredeemable loan
notes of Rifa plc are quoted at $120
ex-interest. Corporation tax is payable
at 30%. Estimate Cost of debt net
$ ( %)
 ( )
 14

COST OF DEBT (REDEEMABLE)

The K d(net) for redeemable debt is given by

the IRR of the relevant cash flows
The relevant cash flows would be:
Years Cashflows
0 Market Value of Loan Note (P 0)
1-n Annual Interest Payment X (1-T)
n Redemption Value
 15

EXAMPLE

Disc Disc
Woodwork Ltd has 10%, $100 loan notes quoted at PV at PV at
$102 ex-interest redeemable in 5 years’ time at par Years Cashflows Factor Factor
7% 4%
Corporation tax is paid at 30%. @ 7% (4%)
($) ($) ($)
Required: 0 (102) 1 -102 1 -102
What is the cost of debt net? 10(1-30%) =
1-5 4.1 28.7 4.452 31.16
7
5 100 0.713 71.3 0.822 82.2
(2) 11.36

𝟏𝟏. 𝟑𝟔
𝑰𝑹𝑹 = 𝟒% + 𝑿 𝟕% − 𝟒% = 𝟔. 𝟓𝟓%
𝟏𝟏. 𝟑𝟔 − −𝟐
 16

WORKING OUT IN EXCEL

 17

COST OF DEBT (CONVERTIBLE)

 A loan note with an option to convert the debt into

specified no. of shares at a future date
 In this situation, the holder of the debt has the
option therefore the redemption value is the
greater of either:
 The share value on conversion or
 The cash redemption value if not converted
 18

EXAMPLE

Redemption Value = $100.

Conversion Value = ($2.6 X 40) = $104.
Woodwork Ltd has 10%, $100 loan notes quoted at
$102 ex-interest redeemable in 5 years’ time at par Disc Disc
or convertible into 40 ordinary shares. The expect
PV at PV at
Years Cashflows Factor Factor
share price at the redemption date is $2.6 7% 9%
@ 7% (9%)
Corporation tax is paid at 30%.
($) ($) ($)

Required:
0 (102) 1 -102 1 -102

What is the cost of debt net? 10(1-30%) =

1-5 4.1 28.7 3.89 27.23
7
5 104 0.713 74.15 0.65 67.6
0.85 (7.17)

𝟎. 𝟖𝟓
𝑰𝑹𝑹 = 𝟕% + 𝑿 𝟗% − 𝟕% = 𝟕. 𝟐𝟏%
𝟎. 𝟖𝟓 − −𝟕. 𝟏𝟕
 19

WORKING OUT IN EXCEL

Cost of
Preference
shares (kp)
 21

THE COST OF PREFERENCE SHARES

 Preference shares are normally
treated as debt rather than
equity, but they are not tax
deductible
 So, the calculation of cost of
preference shares will be the
same as we calculate cost of
debt, but without tax
 For example, if 9% preference
shares ($1) are currently trading
𝟎.𝟎𝟗
at $1.4 then 𝒑
𝟏.𝟒
Cost of Equity
(ke)
 23

THE COST OF EQUITY

The cost of equity is the rate
of return that ordinary share
holders require on the funds
that they provide
As dividends are paid after net
profit so no tax savings
It has 2 methods
 Dividend valuation Method
(DVM)
 Capital Asset pricing Model
(CAPM)
DIVIDEND
VALUATION
MODEL (DVM)
 25

EX-DIVIDEND PRICE VS CUM-DIVIDEND PRICE

 Cum-Dividend Price: known as

inclusive dividend price is the
price when dividend is announced
but not paid yet
 Ex-Dividend Price: known as
exclusive dividend price is when
either the dividend is not yet
anounced or already paid

𝟎
KE USING DVM


( )


Where
d 1 = next year dividend = d 0 X (1 + g)
P o = Current Ex-market value of
equity share
g = sustainable growth rate in
dividends
 27

GROWTH RATE IN
DIVIDENDS
There are 2 main methods of determining
growth
The average Method
/
𝑑
𝑔= −1
𝑑
Where:d 0 = current dividend
d n = dividend n years ago
Godon’s Growth Model
g= rb
Where:r = return on reinvested funds
b = propotion of funds retained
 28

EXAMPLE

Munero Ltd paid a dividend of 6c per share 8 years /

ago, and the current dividend is 11c. The current 𝑔 = − 1 = 7.9%
share price is $2.58 ex div
Required:
Calculate the cost of equity . ( . %)
𝐾 = .
+ 7.9% = 𝟏𝟐. 𝟒𝟕%

The ordinary shares of Titan Ltd are quoted at $5.00  𝑏 = 1 − 30% = 70%
ex div. A dividend of 40c is just about to be paid.
The company has an annual accounting rate of
return of 12% and each year pays out 30% of its
 𝑔 = 12% 𝑋 70% = 8.4%
profits after tax as dividends.
Required:
Calculate the cost of equity ( . %)
𝐾 = + 8.4% = 𝟏𝟕. 𝟎𝟕%
Capital Asset Pricing
Model
(CAPM)
 30

CAPITAL ASSET PRICING MODEL (CAPM)

A model that values financial

instruments by measuring relative
risk

Major Assumptions
Perfect capital Market
Rational investors
Irrelevance of dividend
Well diversified Portfolio
 31

SYSTEMATIC VS UNSYSTEMATIC RISK

Systematic Risk Unsystematic Risk

 also known as non-diversifiable  also known as diversifiable risk
risk  the risk that is specific to a
 The risk inherent in the overall particular company, industry, or
market investment
 not specific to any individual  product recall or a management
scandal
investment but affects the entire
market  technological obsolescence

 global economic recession

 political instability
 32

PORTFOLIO THEORY

 The theory suggests that by diversifying

investments across different assets,
investors can achieve a more efficient
portfolio.
 Investor hold well diversified portfolio
and that will eliminate the
unsystematic risk
 So, Investor only expect returns against
systematic risk only
 33

BETA FACTOR

The method adopted by CAPM to measure

systematic risk index beta (β)
simply describes a share's degree of
sensitivity to changes in the market's
returns, caused by systematic risk
β > 1  indicates the investment or company
has a greater systematic risk than the overall
market
β < 1  indicates the investment or company
has a lower systematic risk than the overall
market
β = 1  indicates the investment or company
has a same level of systematic than the
overall market
 34

COST OF EQUITY
FORMULA

𝒆 𝒇 𝒎 𝒇

Where
 Risk free rate
 Expected return in the
market
  Beta Factor
  also known as equity
market premium or risk premium
return
 35

EXAMPLE

The market return is 15%. Kite Ltd has a

beta of 1.2 and the risk free return is 8%
Required:
What is the cost of equity?

Solution
𝑲 𝒆 = 𝟖% + 𝟏. 𝟐 𝟏𝟓% − 𝟖% = 𝟏𝟔. 𝟒%
WEIGHTED AVERAGE
COST OF CAPITAL
 37

THE CALCULATION OF WACC

Source Proportion (in Market Values) X Cost

Equity Proportion of Equity X K e = X%

Debt Proportion of Debt X K d(net) = X%

Pref. shares Proportion of Equity X K p = X%

WACC = X%
 38

EXAMPLE

Bar plc has 20m ordinary 25p shares Market Value of Equity = 20m X $3 = $60m
quoted at $3, and $8m of loan notes Market Value of Debt = $8m X 85/100 = $6.8m
quoted at $85. The cost of equity has
Total capital (60+6.8) = $66.8m
already been calculated at 15% and the
cost of debt (net of tax) is 7.6%.
Required: Source Proportion X Cost
Calculate WACC? Equity (60/66.8) X 15% = 13.47%
Debt (6,8/66.8) X 7.6% = 0.78%
WACC = 14.25%
CAPITAL STRUCTURE
& WACC
Financial Management (FM)
 2

CAPITAL
STRUCTURE
THEORIES
 3

TRADITIONAL VIEW
 Cost of debt will be constant
Ke initially as but will increase after a
certain gearing level
 Cost of equity will increase as
WACC gearing level increase. This
increase will have an upward
Kd curve
 WACC initially will fall but after a
specific gearing level it will rise
again
Gearing
 Conclusion: there is a specific
gearing level at which WACC is
minimum
 4

MAIN ASSUMPTIONS
OF MM VIEW
COMPANIES CAN
PERFECT CAPITAL BORROW
MARKET AND UNLIMITED AMOUNT
INVESTORS ARE OF DEBT AT THE
RATIONAL SAME RATE OF
INTEREST

THERE ARE NO
TRANSACTION DEBT IS RISK FREE
COSTS
 5

MM VIEW (NO TAX)

 Cost of debt will be constant
irrespective of the gearing level
Ke  Cost of equity will increase as
gearing level increase. This
increase is linear and in such a
way that it won’t affect WACC
WACC
 WACC will not be affected by the
changes in capital structure
Kd
 Conclusion: company can use
whichever capital structure they
desire
Gearing
 6

MM VIEW (TAX)

 Cost of debt after tax will be

Ke lower than the cost of debt
 Cost of equity will increase as
gearing level increase. This
increase is linear and is as
estimated in ‘No tax’
 WACC will be reduced as the level
Kd of gearing increases
Kd(net)  Conclusion: company should use
as much debt as possible (Ideally
Gearing 100% debt)
 7

PECKING ORDER THEORY

A reflection that funding of

companies does not follow
theoretical rules but instead often
follows the ‘path of least
resistance’
A suggested order of raising finance
is as follows:
 1st retained earnings
 2nd bank debt
 3rd issue of equity.
CAPM & MM
COMBINED
 9

BUSINESS & FINANCIAL

RISK

Systematic
risk

Business Financial
risk Risk

Risk due to Risk due to

nature of inclusion of debt
business in financial
operations structure
 10

EQUITY BETA VS ASSET BETA

Beta Equity (β e)
 Beta of a geared Company
 It has both Financial and Business Risk
Beta Asset (β a)
 It is the Beta of an un-geared Company
 It has Business Risk only
The relationship formula
𝑉
β = 𝑋β
𝑉 + 𝑉 (1 − 𝑇)
Where:
Ve  Market Value of Equity or equity proportion
Vd  Market Value of Debt or proportion of debt
USING WACC
FOR
INVESTMENT
APPRAISAL
 12

BOTH BUSINESS & FINANCIAL RISK ARE SAME

Company Investment

Business Same Business

Super Store Risk Super Store
Operation

Financial Same
40% debt Financial risk 40% debt
gearing

Same βe Same Ke Same WACC

use the company’s WACC to appraise the investment

BUSINESS RISK IS SAME BUT FINANCIAL RISK IS 13

DIFFERENT
Company Investment

Business Same Business

Super Store Risk Super Store
Operation

Financial Different
40% debt Financial risk 70% debt
gearing

use investment specific WACC to appraise the investment

Estimate Ke
Different βe Same βa Estimate βe
and WACC
 14

BUSINESS RISK IS SAME & FINANCIAL RISK

IS DIFFERENT

βe of the company

Un-gear Beta

• βa using the company’s current financial structure

•β = 𝑋β
( )

Re-gear Beta

• βe of the investment using capital structure of the investment

( )
•β = 𝑋β

Cost of equity using CAPM & WACC

 15

BUSINESS RISK IS DIFFERENT

Company Investment

Business Different
Super Store Business Risk Resturant
Operation

Financial Doesn’t matter

gearing
use investment specific WACC to appraise the investment

Estimate
Different Different Proxy Co. Estimated
Same βa Ke and
βe βa βe βe
WACC

Another Co. with

similar business risk
 16

BUSINESS RISK IS DIFFERENT

βe of the proxy Co.

Un-gear Beta

• βa using the proxy company’s financial structure

•β = 𝑋β
( )

Re-gear Beta

• βe of the investment using capital structure of the investment OR

current company
( )
•β = 𝑋β

Cost of equity using CAPM & WACC

 17

EXAMPLE

Techno, an all equity agro-chemical firm, is  Pharmaceutical β e = 1.3

about to invest in a diversification in the
 β = 𝑋1.3 = 0.89
consumer pharmaceutical industry. Its current ( %)

equity beta is 0.8, whilst the average equity β ( %)

 β = 𝑋0.89= 1.16
of pharmaceutical firms is 1.3. Gearing in the
pharmaceutical industry averages 40% debt,  𝐾 = 4% + 1.16𝑋 14% − 4% = 15.6%
60% equity. Corporate debt is available at 5%.
 Source Proportion X Cost
Rm = 14%, Rf = 4%, corporation tax rate =
Equity 70% X 15.6% = 10.92%
30%.
Debt 30% X 5% X (1-30%) = 1.05%
Required:
WACC = 11.97%
What would be a suitable discount rate for
the new investment if Techno were to
finance the new project with 30% debt and
70% equity?
SOURCE OF
FINANCE
Financial Management
 2

TYPES OF EQUITY FINANCE

Debt Preference Equity
Shares

THREE MAJOR SOURCE

OF FINANCE
DEBT
FINANCE
DEBT
 Paid out as an expense of the business (pre-tax).
 Risk of default if interest and principal payments
are not met
 Traded debt has a nominal value usually $100 and
It should have a market price
 The debtholder will normally require some form of
security
 The debt holder might impose covenants
 6

TYPES OF DEBT

Debt can be:

 Non-tradable – Bank loan
 Irredeemable – no redemption date
 redeemable – defined redemption date
 Normal
 Deep discount
 Zero coupon

 Convertible – can be converted into ordinary

share
 7

WHEN DEBT FINANCING

IS APPROPRIATE

 company has lower financial risk

 The gearing and interest cover are close
to industry average
 When company is in healthy
comparative position
 Cash flows and profit margins are
stable
 Tangible assets are available to be
offered as a security
PREFERENCE
SHARES
PREFERENCE SHARES

 Pay fixed dividend (like interest)

 Paid in preference to ordinary shares
 Not very popular as it is not liked by
both
 Not Tax Efficient
 No opportunity of capital gains
EQUITY
ORDINARY SHARES

 Owning a share confers part

ownership.
 High risk investments offering higher
returns.
 Permanent financing
 Post-tax appropriation of profit, not
tax efficient
 Marketable if listed
 12

ADVANTAGES & DISADVANTAGES OF EQUITY

Advantages Disadvantages
 No fixed charges (e.g. interest  High issue cost
payments)  Dilution of ownership, if new
 No repayment required. shares issued
 Shares in listed companies can be  Carries a higher return than loan
easily disposed of at a fair value finance
 Reduce Financial Gearing  Dividends are not tax-deductible
 A high proportion of equity can
increase the overall cost of
capital
 13

STOCK MARKET LISTING

Advantages
 Access to wider pool of finance
 Better image
 Releasing capital for other uses
 Possibilities of acquisition and growth

Disadvantages
 Increased public scrutiny of the company
 Possibility of dilution of control
 Increased costs e.g. corporate governance, internal audit
 14

TYPES OF EQUITY FINANCE

Equity

Retained New
earning Shares
 15

RETAINED EARNINGS

 Readily available
 no issuance cost
 may be not sufficient to fund large
projects
 Consequence of not offering dividends
 16

NEW SHARES ISSUE

Shares are offered Slightly less

than the current market price
 Offer for Sale
 Offering to public
 Only for listed companies
 Placing
 Offering to specific investors
 For both listed and unlisted
 Rights Issue
 Offering to existing shareholders in a
specific proportion (e.g. 1 for 4)
 For both listed and unlisted
 17

PLACING AS COMPARED
TO PUBLIC OFFER

 Placing is much cheaper

 Placing is a relatively quicker method
 Placing involves less disclosure of
information
 Placing might give institutional
shareholders the control of the
company
 Only limited funds can be arranged
 18

RIGHT ISSUES

Advantages
 Cheaper method of finance
 Less dilution of control

Disadvantages
 The amount that can be raised is limited financing as
compared to a public offer
 19

VALUING A RIGHT ISSUE

 Theoretical Ex-Right Price (TERP) is a

theoretical expected price after the right issue
 It is an average price per share that an
investor has spent
 𝑇𝐸𝑅𝑃 =

 𝐹𝑢𝑛𝑑𝑠 𝑟𝑎𝑖𝑠𝑒𝑑 = 𝑖𝑠𝑠𝑢𝑒 𝑝𝑟𝑖𝑐𝑒 𝑋 𝑖𝑠𝑠𝑢𝑒 𝑠ℎ𝑎𝑟𝑒𝑠

 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 𝑖𝑠𝑠𝑢𝑒 = 𝑇𝐸𝑅𝑃 − 𝐼𝑠𝑠𝑢𝑒 𝑝𝑟𝑖𝑐𝑒
 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 𝑝𝑒𝑟 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠
 =
.

 = 𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝑇𝐸𝑅𝑃

 20

EXAMPLE

A company has 100,000 shares issued with a  Right issue price = $2 X 70% = $1.40
current market price of $2 each. The company  New shares issue = $28,000/$1.40 = 20,000
is planning to raise funds of $28,000 via a right
issue. The issue price will be at 30% discount  Right issue proportion = 100,000/20,000 = 5
 i.e. 1 for 5 right issues
Required:
( . )
 𝑇𝐸𝑅𝑃 = = 1.90
Estimate the TERP, Value of right issues and
value of right issue per existing shares?  𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 𝑖𝑠𝑠𝑢𝑒 = 1.90 − 1.40 = 0.50
.
 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 𝑝𝑒𝑟 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠 = = 0.10

OR
 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 𝑝𝑒𝑟 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠 = 2 − 1.90 = 0.10
 21

OPTION
FOR
HOLDER

EXERCISE THE RIGHT SELL THE RIGHT DO NOTHING

 Financially  Financially  Financially not
beneficial beneficial beneficial
 No dilution of  Dilution of control  Dilution of control
control
 22

EXAMPLE

A company has 100,000 shares issued with a Financial viability

current market price of $2 each. The company  Takes up right
is planning to raise funds through 1 for 5 right  Existing Value (1,000X2) = $2,000
 New shares (1,000/5) = 200 X $1.4 = $280
issue. The issue price will be at 30% discount.  Post issue Cost to holder $2,280/1,200 = $1.9

The TERP is calculated at $1.90 and the value  Sell the right
 Existing Value (1,000X2) = $2,000
of right issue is $0.50.  Sell the rights (200 X $0.5 = $100
 Post Sell value ($2,000 - $100) = $1,900
Mr X owns 1,000 shares in the company. A  Post issue cost to holder $1,900/1,000 = $1.9
shareholder's wealth depends on whether he  Do Nothing
exercises his rights  Existing Value (1,000X2) = $2,000
 Post issue cost to holder $2,000/1,000 = $2.0

Proportion of holding
Required:
Show Mr X's position if he:  Existing holding 1,000/100,000 = 1%
(i) takes up his rights;  Takes up right (1,000+200)/(100,000+20,000) = 1%
(ii) Sells his rights;
 Sell the right 1,000/(100,000+20,000) = 0.83%
(iii) does nothing.
 Do Nothing 1,000/(100,000+20,000) = 0.83%
 23

IS THE RIGHT ISSUE BENEFICIAL

 Funds raised through rights issue can

be used to repay a loan this will
reduce interest expense and
earnings would increase.
 Funds raised through rights issue can
be used to invest in new project
which will increase the profitability of
company
 From both the market value after the
right issue will be changed
 If revised market value greater than
TERP, then shareholders wealth will be
Maximized.
 24

DIVIDENDS
DIVIDENDS

 Irrelevance Vs Relevance Theory

 Dividend Signaling
 A dividend which differs from shareholders expectations
about dividends might send signals to the market and affect
share price
 A higher dividend will build expectation for future
 Liquidity Preference of shareholders
 Tax Position
 Need to remain profitable
 Ability to generate extra finance at ease
 Any restrictions on dividends (e.g. Loan covenant)
 26

BONUS ISSUES

 Bonus issues (scrip dividend) is the issue of

additional company shares to existing shareholders
without any price
 A company that wants to retain cash for
reinvestment but does not want to reduce its
dividends might offer its shareholders a scrip
dividend
 The rules of the stock exchange might require that
when a company wants to make a scrip dividend, it
must offer a cash dividend alternative
 27

SHARE REPURCHASE

 Purchase by a company of its own shares

 Finding a use of surplus cash instead of higher
dividends
 Increase in earnings per share
 Possibly preventing a takeover
 enabling a quoted company to withdraw from the
stock market
SME
FINANCING
Financial Management
DIFFICULTIES IN RAISING
FINANCE
Perceptions of Risk and
Uncertainty
 do not have a track record
 Weak internal controls
 potential investors in an SME have
much less information about the
business
Absence of Security
Shares Lack Marketability
Funding Gap and Maturity Gap
 3

GOVERNMENT STEPS FOR SME

increasing the marketability

of shares
providing tax incentives
other specific forms of
assistance
Providing advice
 4

SOURCE OF FINANCE
FOR SME

Venture Capital
Business Angels
Crowdfunding
Peer-to-Peer finance
Supply chain finance
 5

VENTURE CAPITAL
Venture capital is a risk capital, normally
provided in return for an equity stake
Venture capitalists will assess an investment
prospect on the basis of:
 financial outlook
 management credibility
 depth of market research
 technical abilities
 degree of influence offered:
 controlling stake?
 board seat?

 exit route
ISLAMIC
FINANCING
Financial Management
ISLAMIC FINANCE

 A form of finance that specifically

follows Islamic laws (Shariah)
 Shariah Prohibits:
 Interest (riba)
 investing in businesses which has too
much debt
 Investments in businesses dealing with
alcohol, gambling, drugs, pork,
pornography or anything else
 Transactions which involve speculation or
extreme risk
 Uncertainty about the subject matter and
terms of contracts
 8

ISLAMIC FINANCE CONTRACTS

Murabaha – trade credit

Ijara – lease finance
Mudaraba – equity finance
Sukuk – debt finance
Musharaka – venture capital
 9

MUDARABA – EQUITY FINANCE

 A Contract between a company and Islamic

an Islamic bank Company
Bank
 Islamic bank provide funds (Rab-ul-
Maal)
 Company invest Skills
 Profits from the investment
distributed at pre-agreed ratio
Project

Profit distributed in
pre-agreed ratio
 10

MUSHARAKA – JOINT VENTURE

 A Contract between two partners

Partner-A Partner-B
 Both invest funds and skills
 Profits from the investment
distributed at pre-agreed ratio

Project

Profit distributed in
pre-agreed ratio
 11

IJARA (LEASE FINANCE) & MURABAHA (TRADE

CREDIT)
IJARA MURABAHA
 Bank will buy the asset for the  Bank will buy the items for the
customer customer
 Bank will lease the asset to  Bank will sell the items on profit to
customer for specific period customers on credit
 Customer instalment payments
includes contribution of purchase
price and rent for use
 12

SUKUK (LOAN NOTES)

 Company will sell the asset to Public

 Public will lease back the asset to
company
 Lease rental will not include principle
payments
 At the end of the term, the company
buys back the asset
EVALUATING SOURCE
OF FINANCE
Financial Management
 2

EVALUATING SOURCE OF
FINANCE

While evaluating which source of finance, the

company needs to assess the impact on
Profitability
Shareholders Wealth
Risk
 3

PROFITABILITY

𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕
 𝑬𝑷𝑺 =
𝑵𝒐.𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔

𝑷𝒓𝒐𝒇𝒊𝒕 𝑩𝒆𝒇𝒐𝒓𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 & 𝑻𝒂𝒙

 𝑹𝑶𝑪𝑬 = 𝑿𝟏𝟎𝟎%
𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅

 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅 = 𝑫𝒆𝒃𝒕 + 𝑬𝒒𝒖𝒊𝒕𝒚

𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕
 𝑹𝑶𝑬 = 𝑿𝟏𝟎𝟎%
𝑬𝒒𝒖𝒊𝒕𝒚
 4

SHAREHOLDER’S WEALTH

 𝑷⁄𝑬 𝑹𝒂𝒕𝒊𝒐 =

 𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒀𝒊𝒆𝒍𝒅 = 𝑋100%

 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒑𝒂𝒚 𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐 = 𝑋100%

 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒀𝒊𝒆𝒍𝒅 = 𝑋100%

 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑮𝒂𝒊𝒏𝒔 = 𝑋100%

 𝑻𝒐𝒕𝒂𝒍 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝑹𝒆𝒕𝒖𝒓𝒏 =

𝑋100%
 5

FINANCIAL RISK

 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒄𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐 =

Financial Gearing
 𝑫𝒆𝒃𝒕 𝒕𝒐 𝒆𝒒𝒖𝒊𝒕𝒚 𝒓𝒂𝒕𝒊𝒐 = 𝑋100%

 𝑫𝒆𝒃𝒕 𝒕𝒐 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝒓𝒂𝒕𝒊𝒐 = 𝑋100%

Operational Gearing
 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑮𝒆𝒂𝒓𝒊𝒏𝒈 = 𝑋100%

OR
 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑮𝒆𝒂𝒓𝒊𝒏𝒈 = 𝑋100%
BUSINESS VALUATION
Financial Management
 2

BUSINESS
VALUATION

DEBT VALUATION EQUITY VALUATION EFFICIENT MARKETS

 Estimating the market  Estimating the market  Analyzing the efficiency
value of Loan Notes value of ordinary of the market
shares
Debt Valuation
 4

DEBT VALUATION

Value of debt is the sum of

the present value of future
debt cashflows, discounted at
Kd
This calculation usually will
be without tax
 5

EX-INTEREST PRICE VS CUM-INTEREST PRICE

 Cum-Interest price: known as

inclusive interest price is the price
when interest is due but not paid
yet
 Ex-Interest Price: known as
exclusive interest price is when
either the interest is not yet due or
already paid

𝟎
 6

EX-INTEREST MARKET PRICE (IRREDEEMABLE)


Example
 A company has issued irredeemable
loan notes with a coupon rate of 9%.
The required return of investors in this
category of debt is 6%.
$

%
 7

EX-INTEREST MARKET PRICE (REDEEMABLE)

 The P 0 for redeemable debt is given by

the PV of cashflows discounted at K d
 The relevant cash flows would be:
 Years Cashflows
 1-n Annual Interest Payment
 n Redemption Value
 8

EXAMPLE

Disc
A company has 10% debt redeemable in 5 years.
Redemption will be at par value. Years Cashflows Factor PV at 8%
(8%)
The investors require a return of 8%.
($) ($)

Required: 1-5 10 3.993 39.93

The current market value of the debt.
5 100 0.681 68.1
108.03
Equity Valuation
 10

NEED FOR EQUITY VALUATION

 For Acquisitions & Merger

 To issue new shares of unlisted
company
 To be pledged as collateral for loan
 Company wishes to buy back it’s
own shares
 To get listed on stock Exchange
 11

EQUITY
VALUATION
METHOD

CASHFLOW BASED NET ASSET BASED INCOME BASED

 Dividend Valuation  The book value  P/E Ratio
Model approach  Earning Yield
 Present Value of Future  Net Realizable values
Cashflows (not  Replacement values
generally examined in
FM)
 12

EX-DIVIDEND PRICE VS CUM-DIVIDEND PRICE

 Cum-Dividend Price: known as

inclusive dividend price is the
price when dividend is announced
but not paid yet
 Ex-Dividend Price: known as
exclusive dividend price is when
either the dividend is not yet
anounced or already paid

𝟎
 13

NET ASSET BASED

The business is estimated as being worth the value

of its Net Assets.
Net Assets = Total Assets – Total Liabilities
Uses of Asset Based Method
 Asset stripping
 To identify a minimum price in a takeover
 If the company based on predominantly tangible
assets
 14

VALUING NET
ASSETS
BOOK VALUE NRV
 Based on historical (sunk)  Represent what should be left
costs. for shareholders if the assets
 Unlikely to be relevant to any were sold off and the liabilities
purchaser settled

REPLACEMENT VALUES WEAKNESSES

 Determine what it would cost to  Investors do not normally buy a
set up the business if it were company for the book value
being started now  It ignores intangible assets
 15

INCOME BASED

This method of particular use when valuing

a majority shareholding:
 As majority shareholders, the owners
can influence the future earnings of the
company
 The dividend policy of a company is less
of an issue when control is held, the
level of dividends can be manipulated
to what you want
 16

EARNING BASED
METHOD

 𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒀𝒊𝒆𝒍𝒅 = 𝑋100%

 𝑷𝒓𝒊𝒄𝒆 = 𝑋100%

 𝑷⁄𝑬 𝑹𝒂𝒕𝒊𝒐 =

 𝑷𝒓𝒊𝒄𝒆 = 𝑷⁄𝑬 𝑹𝒂𝒕𝒊𝒐 𝑿 𝑬𝑷𝑺

A High P/E Ratio Suggest
 Strong Growth Prospects
 Positive Market Sentiment
 Future Earning expectations
 Less Volatility
 17

EXAMPLE

Henery Ltd, an unlisted company:  Total value = $320,000 X 10 = $3,200,000

Ordinary share capital is 200,000 50¢ shares.  Per share Price = 3,200,000/200,000 = $16

Extract from income statement for the year Alternatively

ended  EPS = 320,000/200,000 = $1.6
$  Per share Price = $1.6 X 10 = $16

Profit before taxation 430,000  Total value = $16 X 200,000 = $3,200,000

Less: Corporation tax 110,000

Profit after taxation 320,000
The PE ratio applicable to a similar type of
business is 10.
Required: Value 200,000 shares in Henery
Ltd on a PE basis.
 18

DIVIDEND VALUATION METHOD

 The dividend valuation model (DVM) (or

growth model) estimates market price by the
present value of future dividends discounted
at K e.
 The formula for consistent dividend or growth
starting from year 1.
Years cashflows X Perpetuity Factor

 1-∞ d 1 (or d 0X(1+g)) X

( )
𝑃 = OR 𝑃 =
 19

INCONSISTENT DIVIDENDS

 When dividends are not consistent from start then

calculate present value of each year independently
 Once the consistent dividend starts then use perpetuity
 20

EXAMPLE

A company is expected to pay future Years dividend disc factor at PV

dividend as follows s 10%
Y1 = $1
Y2 = $1.5 1 1 0.909 0.91

Y3 = $2
2 1.5 0.826 1.24
From Y4 the dividend will consistently grow
by 4% each year. The K e is 10%.
3 2 0.751 1.50
Required: 2(1+4%) = (1/(10%-4%))
Estimate the market Price of each share. 2.08 X 26.03
4-∞ 0.751
29.68
 21

ADVANTAGES AND DISADVANTAGES OF DVM

Advantages
 Considers the time value of money
 Particularly useful when valuing a minority stake of a
business.

Disadvantages
 Difficulty in estimating an appropriate growth rate.
 The model is sensitive to key variables.
 The growth rate is unlikely to be constant in practice
 22

MAXIMUM AND MINIMUM VALUE OF A TARGET

COMPANY

Target Co. is a company for which a parent Co.

(Acquirer) is willing to buy

Maximum Value (Value from buyer point of view)

 Value of the business after Acquisition (Combined
Co.)
 Less: Current Value of the Parent Co.

Minimum Value (Value from seller point of view)

 Current Value of the Target Co.
Efficient Market
Hypothesis
 24

EFFICIENT MARKET

The prices of securities traded in

that market reflect all the
relevant information accurately
and rapidly, and are available to
both buyers and sellers.
No individual dominates the
market.
Transaction costs of buying and
selling are not so high as to
discourage trading significantly.
 25

EFFICIENCY
OF MARKET

WEAK-FORM SEMI-STRONG STRONG-FORM

 Share prices reflect all  Share prices reflect all  Share prices reflect all
the information information currently information, published
contained in the record publicly available and unpublished
of past prices
 26

WEAK-FORM OF EFFICIENCY

 all the information contained in the record of

past prices
 Prices follows random walk and so not be
possible to forecast price movements
 Technical Analysist can not outperform the
market consistently

 E.g. if a company started a project with a

+ve NPV then this information come as a
surprise as no update was available.
 27

SEMI-STRONG FORM

 Share prices reflect all information

currently publicly available
 Price will change only when new
information is published
 Price movements can be forecast
by using inside information
 Strict rules outlawing insider
dealing
 E.g. if BOD approves a project with
a +ve NPV then the price will be
moved once it is announced
 28

STRONG-FORM OF EFFICIENCY

 Share prices reflect all

information, published and
unpublished
 share prices cannot be predicted
and gains through insider dealing
are not possible as the market
already knows everything
 No Need for rules on insider
information
 E.g. if BOD approves a project
with a +ve NPV then the price will
be moved instantly
RISK MANAGEMENT
Financial Management
FOREX RISK
Risk Management
TERMINOLOGIES
 FOREX rate: represents the rate at
which one currency can be exchanged
for another
 Home Currency: refers to the
domestic currency of a specific
country or the currency of the country
in which an individual or business
resides
 Foreign Currency: any currency other
than home currency
 4

DIRECT & INDIRECT QUOTE

Direct Quote
 No. of home currency unit per 1 unit of foreign currency i.e. (HC/FC)
 For converting foreign currency value (FCV) to home currency value (HCV)
 FCV X Exchange rate = HCV
 E.g. A Pakistan based company want to convert $100 in Rs. and the exchange rate
is Rs.285/$
 $100 X Rs. 285/$ = Rs. 28,500

Indirect Quote
 No. of foreign currency unit per 1 unit of home currency i.e. (FC/HC)
 For converting foreign currency value (FCV) to home currency value (HCV)
 FCV ÷ Exchange rate = HCV
 E.g. A Pakistan based company want to convert $100 in Rs. and the exchange rate
is $0.0035/Rs.
 $100 ÷ $0.0035/Rs. = Rs. 28,571
 5

BID AND OFFER RATES

Bid Rate (Buying Rate)  Receipts
 The rate at which bank is willing to buy foreign currency
 It is cheaper
 Direct Quote it’s the Lower rate
 Indirect quote it’s the Higher rate
 Used when the company is expecting foreign currency receipts

Offer Rate (Selling Rate)  Payments

 The rate at which bank is willing to sell foreign currency
 It is expensive
 Direct Quote it’s the Higher rate
 Indirect quote it’s the Lower rate
 Used when the company is expecting foreign currency payments
 6

THE MNEMONIC TO DPH DRL

REMEMBER  Direct Quote  Direct Quote
 Payment  Receipt
 Higher rate  Lower rate

IPL IRH
 Indirect Quote  Indirect Quote
 Payment  Receipt
 Lower rate  Higher rate
 7

IMPACT OF ECONOMIC CONDITIONS ON EXCHANGE

RATES
Poor economic conditions in home Good economic conditions in home
country country
• Good conditions in foreign country • Poor conditions in foreign country

Home currency will be weak Home currency will be strengthened

• Foreign currency will be strong • Foreign currency will be weak

Exchange rate will be expensive Exchange rate will be cheap

• Direct Quote  Rise • Direct Quote  Fall

• Indirect Quote  Fall • Indirect Quote  Rise

Exporter will get benefit Exporter will suffer loss

• Importer will suffer loss • Importer will get benefit

 8

FISHER
MODEL OF
ESTIMATING
RATES

PURCHASE POWER PARITY INTEREST RATE PARITY FOUR WAY EQUIVALENCE

 𝑆 =𝑆 𝑋  𝐹=𝑆 𝑋 
 𝑆 = Future expected spot rate  𝐹 = Forward rate
 𝑆 = Current spot rate  𝑆 = Current spot rate

 ℎ =  𝑖 =
inflation of currency in nominator interest of currency in nominator
 ℎ =  𝑖 =
inflation of currency in denominator interest of currency in denominator

NOTE: Time proportion the rates when asked about less than 1 year
Compound the rates when asked about greater than 1 year
 9

EXAMPLE

On January 1st, 20X7, the spot rate is fixed at $1.90 ( % )

per £1, with the £ being the base currency and the $ $ .
as the variable currency. £
( % )
The inflation rates for the years 20X7 and 20X8 have ( %)
been estimated and are as follows:
( %)
US 2%
( %)
UK 3%
( %)
Required: Calculate the predicted exchange rate
on
(a) 31 March, 20X7,
(b) at 31 December 20X7; and
(c) at 31 December 20X8.
 10

EXAMPLE

The exchange rate between dollars and

pounds is $1.78 per £, while the one-year
interest rates for the dollar and sterling are
3.25% and 4.5%, respectively.
Required: Calculate the one-year
forward exchange rate.
 11

FOREX
RISK

TRANSACTION RISK TRANSLATION RISK ECONOMIC RISK

 Expected receipts or  Value of the Asset or  Long-term future
payments will be Liabilities reported in cashflows will be
affected due to change statement of financial affected due to change
in exchange rates position will be affected in exchange rates
due to change in
exchange rate
 12

HEDGING METHODS

Internal Hedging
 Invoicing in Home Currency
 Leading & Lagging (early or delay when the exchange rates are in favorable or adverse)
 Matching (Net of Balances)
 Netting

External Hedging
 Forward Rate Agreement (FRA)
 Money Market Hedge
 Futures
 Options
 13

FORWARD RATE AGREEMENT

 An agreement with the bank to

exchange currency for a specific
amount at a future date.
 It is an obligation that must be
completed once entered into
 The forward rate offers a perfect
hedge because it is for the exact
amount required by the transaction on
the appropriate date and the future
rate is known with certainty.
 14

EXAMPLE

It is imperative to note that on January 1st,  Exchange rate is $ per £ and company is
20X1, a UK-based corporation will undoubtedly UK based so it’s an indirect quote
receive a substantial sum of dividend income
from its US counterpart. The estimated amount  The co. has to receive foreign currency so
that the company expects to receive is a higher rate should be used i.e. 1.5459
staggering $200,000, and the date of the
payout is set for March 31st, 20X1.  Receipts = $200,000/1.5459 = £129,374

Spot rate ($ per £) = 1.5123−1.5245

Three-month forward = 1.5323−1.5459
Required: Calculate how much sterling will
be received if forward cover is taken out.
 15

MONEY MARKET HEDGE

Converting
currencies
today will avoid
the fluctuation in
exchange rates

For that we must

borrow the
• On that we will
amount pay interest

Since, the use is

in future so we • On that we will
can deposit it in
the bank earn interest
 16

MONEY MARKET HEDGE SETUP

1. Borrow Funds 2. Exchange 3. Deposit Funds
Today Currencies
Principle (PV)
Deposit in
Borrow in Home
Payments Foreign
Currency Currency

Borrow in
Foreign Deposit in Home
Receipts
Currency Currency

Later
Principle+Interest (FV) 4. Settle Loan 4. Withdraw
Payments Net Outcome Pay to supplier

Receipt from Net Outcome

Receipts
customer
 17

CALCULATING MONEY MARKET HEDGE

NOTE
 Time proportion the interest rate
 Payments: Borrow rate in HC & Deposit rate in FC
 Receipts: Borrow rate in FC & Deposit rate in HC
 18

EXAMPLE

A UK-based company will receive $300,000 in  $300,000/(1+5.4%X3/12)=$296,004

three months. The current spot rate is $1.7818
per £1. The one-year borrowing rate in pounds
is 4.9%, and the one-year investing rate is
 $296,004/1.7818 = £166,089
4.6%. The one-year borrowing rate in dollars is
5.4%, and the one-year investing rate is 5.1%.
Required:  £166,089 X (1+4.6%X3/12)= £167,999
Estimate the outcome of money market
hedge
INTEREST
RATE RISK
Risk Management
 20

INTEREST RATE RISK

 The risk that interest rates will

rise or fall in the future
 This will impact the finance cost
or finance income of the
company
 The bank charges interest based
on LIBOR (London Inter-Bank
Offer rate)
 21

YIELD CURVE

 The yield curve shows how a Interest

rate changes based on borrowing time.
Upward (Normal)
 Upward yield curve (Normal): Longer
repayment timeframes result in higher
interest rates based on the yield curve.

Interest rate
 Downward yield curve (Inverted):
Sometimes, short-term maturities may Flat
have higher interest rates compared to
longer-term maturities
Downward (Inverted)
 Flat: if the interest rate is same for both
short and long term Time Period
 22

REASONS
OF YIELD
CURVE

LIQUIDITY PREFERENCE MARKET SEGMENTATION

EXPECTATION THEORY
THEORY THEORY
 Investors prefer short-  An upward sloping yield  Market segmentation
term investments for curve suggests theory divides players
more liquidity and investor’s expectation into short-term and
expect higher returns of future increases in long-term sides.
for longer-term inflation and interest
investments rates
 23

FORWARD RATE AGREEMENT (INTEREST RATE)

 a contractual arrangement with the

bank in order to secure a fixed interest
rate for a potential short-term loan at a
future date.
 It is an obligation that must be
completed once entered
 The forward rate offers a perfect
hedge because it is for the exact
amount required by the transaction on
the appropriate date and the future
rate is known with certainty.
 24

SETTLING AN INTEREST RATE FRA

 The company and the bank will agree on

a fixed interest rate for future short-term
borrowing through an FRA
 However, on the day of borrowing from
the bank, an interest charge will be
applied based on the current prevailing
rate
 The difference between the FRA interest
rate and the prevailing rate will be
settled separately through payment or
receipt
 25

EXAMPLE

According to the cash flow forecast of Nig Co, The FRA needed would be a 4-7 FRA at 5%
they have intentions to borrow $2 million from
(a) Interest rates Rises to 6.5%
the Bank within the next four months and the
duration of the loan is three months. However,  Paid to Bank (3/12 × 6.5% × $2m) = ($32,500)
they are apprehensive about the possibility of  Receipts (3/12 × (5% − 6.5%) × $2m = $7,500
interest rates increasing by the time the loan is  Net cost to Nig Co ($25,000)
acquired. The current interest rate of 5% is
being offered by Helpy Bank on the required
FRA (b) Interest rates Falls to 4%
Required:  Paid to Bank (3/12 × 4% × $2m) = ($20,000)
Determine the cash flows if the interest rate  Payments (3/12 × (5% − 4%) × $2m = ($5,000)
when the loan is taken out is:  Net cost to Nig Co $25,000
(a) 6.5%; and
(b) 4%.
 26

SWAPS

 A company will borrow either using a

variable or a fixed rate
 A swap allows the company to change the
exposure (fixed to variable or vice versa)
without having to redeem existing debt
Advantages
 Allows a change in interest rate exposure at
relatively low cost and risk
 can be used for long-term borrowing
FUTURES &
OPTIONS
CONTRACT
Risk Management
(Also refer Video to
understand)
FUTURES CONTRACTS

A futures contract is a contract that is

standardised between a buyer and seller. The
buyer is obligated to
 buy a fixed amount, known as the contract
size,
 at a fixed price, known as the futures price,
 on a fixed date, known as the settlement
date
This agreement is formed via an acknowledged
exchange (derivative market)
 29

SETTING UP FUTURES HEDGE

Currency
 Payment: Buy Foreign Currency Futures
(or Sell Home Currency Future)
 Currency Receipt: Sell Foreign Currency
Futures (or Buy Home Currency Future)

Interest rate
 Borrowing: Sell interest rate Futures
 Investing: Buy interest rate Futures
 30

OPTION CONTRACTS

If a company wants a more flexible

hedge, it may consider buying an option
The purchaser of a currency option has the
right, but not the obligation, to buy (call
option) or sell (put Option)
The owner of the option can either:
 exercise their right; or
 allow it to lapse (i.e. not exercise it)
the owner of an option must pay for this
flexibility known as premium
 31

SETTING UP OPTIONS HEDGE

Currency
 Payment: Buy Foreign Currency Call
Option (or buy Home Currency Put
Option)
 Currency Receipt: Buy Foreign Currency
Put Option (or Buy Home Currency Call
Option)

Interest rate
 Borrowing: Buy interest rate Put Option
 Investing: Buy interest rate Call Option
WORKING
CAPITAL
MANAGEMENT
FINANCIAL MANAGEMENT (FM)
WORKING CAPITAL
 3

WORKING CAPITAL AND WORKING

CAPITAL INVESTMENT
 Working capital is the name given to net current
assets which are available for day-today operating
activities.
 Working capital = receivables + cash + inventory - payables

 Working capital investment is the amount of funds

to be required to carry out day to day operations. It
doesn't include cash
 Working capital Investment = receivables + inventory - payables
OBJECTIVE OF WORKING CAPITAL
 The objectives of the working capital are
profitability and liquidity
 Profitability: maximize the shareholder’s
wealth
 Liquidity: ensure that business is able to
pay of its liabilities
 Meeting the objectives are therefore
conflicting, hence good working capital
management is to achieve a balance
between these objectives.
 5

EXAMPLE

ANSWER:
Total investment = $1,000,000

Current Assets = $200,000 Current Net Investment = $1,000,000 – ($200,000-100,000) =

$900,000
Current Liabilities = $100,000 Current Returns = $900,000 X 10% = $90,000
Current Ratio = $200,000/$100,000 = 2
Return on investment = 10%
(a) Net Investment = $1,000,000 – ($250,000-80,000) =
$830,000
Returns in increased net assets = $830,000 X 10% = $83,000
Question Reduction of $7,000
Estimate and show the impact on liquidity and profitability if Current Ratio = $250,000/$80,000 = 3.125
the: Increase of 1.125
(b) Net Investment = $1,000,000 – ($150,000-$120,000) =
(a) Current assets increase by $50,000 and Current $970,000
liabilities decrease by $20,000 Returns in reduced net assets = $970,000 X 10% = $97,000
(b) Current assets decrease by $50,000 and Current Increase of $7,000
liabilities increase by $20,000 Current Ratio = $150,000/$120,000 = 1.25
Decrease of 0.75
 6

CASH OPERATING CYCLE EXAMPLE

The cash operating cycle is the length of time between the company’s
outlay (raw materials, wages and other expenditures) and the inflow of
cash from the sale of goods

 Jan-1 Bought Material Raw Material

Inventory 2 days
 Jan-3 Put in production This can be calculated as:

WIP 1 day Receivable Period 4

 Jan-4 Transferred to finished good Payable period Add:Inventory Period (2+1+2) 5
7 days Finished
Goods 2 days Less:Payable Period (7)
 Jan-6 Sold to customer 2 days

 Jan-8 Payment to supplier Receivable

period 4 days
Cash Operating
Cycle 2 days
 Jan-10 Cash received from customer
APPROPRIATE WORKING
CAPITAL
An appropriate working capital will depend on:
 Cash operating cycle
 Improving production efficiency
 Improving finished goods and / or raw material
inventory turnover
 Improving receivable collection and payables
payment periods

 The level of activity of the business,

 The nature of the business,
 Economic environment
 8

WORKING CAPITAL RATIOS

Liquidity Ratios
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = , 𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =

Inventory Period
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝑋365,

Receivable Period
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝑋365,

Payable Period
𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝑋365,
Note:
 Generally closing balances will be considered as average balances.
 If not mentioned, all the sales and purchases are considered to be
on credit.
 In the absence of purchases, Cost of sales will be used.
 9

EXAMPLE

QUESTION ANSWER:
Profit and loss account extract $
Receivable Period = ($60,000/$250,000)X365 = 87.6 Days
Turnover 250,000
Inventory Period = ($30,000/$160,000)X365 = 68.4 Days
Cost of Sales 160,000
Gross profit 90,000 Payable Period = ($50,000/$160,000)X365 = 114.1 Days

Balance Sheet extract $ Cash Operating Cycle = 87.6 + 68.4 – 114.1 = 41.9 Days
Current Assets
Inventory 30,000
Debtors 60,000
Current Liabilities
Creditors 50,000

Required

Calculate the cash operating cycle assuming 365 days

in a year
 10

WORKING CAPITAL FINANCE COST

 Receivable X Interest rate = Receivable Finance cost

 Inventory X Interest rate = Inventory Finance cost
 Payable X Interest rate = Payable Finance Income

 Investment in working capital X Interest rate = Working

capital Finance Cost
INVENTORY MANAGEMENT
 12

STOCK CONTROL LEVELS

 Lead time is the time between placing an order and receiving it

 Reorder quantity(Q) is the quantity to order with the supplier each
time
 Re-order level: an order level on which new order has to be placed
Maximum usage X maximum lead time
 Maximum level=Re-order level–(min usage X min lead time)+Q
 Minimum level=Re-order level–(average usage X average lead
time)
 Average level = safety stock + reorder quantity/2
STOCK COST
 Stock-out cost occurs when stock is kept too low e.g. loss
of sales

 Purchase cost is the cost of buying

 Annual demand (D) X price

 Holding cost is the cost of keeping and storing material

e.g. storekeeper salary
 Average stock X holding cost/unit/annum (C h )

 𝑋𝐶

 Ordering cost is the cost involved in ordering and

receiving material e.g. transportation cost
 No. of orders X ordering cost per order (C o )

 𝑋𝐶
ECONOMIC REORDER QUANTITY (EOQ)

 The economic reorder quantity

(EOQ) is a reorder quantity at which
the annual holding cost and annual
ordering cost are the same, and the
total annual cost will be minimum

𝟐 𝑿 𝑫 𝑿 𝑪𝒐

𝑪𝒉
 15

BULK PURCHASE DISCOUNT

 Sometimes, a bulk purchase discount

is offered by the supplier for ordering a
specific quantity
 Management has to decide whether to
accept the discount offer or persist
with EOQ
 We calculate the total cost of purchase,
annual holding, and annual ordering
in both options
 We then chose the less costly option
 16

EXAMPLE

Question Answer
(a) Purchase cost (200,000 X 1) = 200,000
Following data is relevant to the question of Annual Holding cost (0.2X50,000/2) = 5,000
a co. Annual ordering cost (20X200,000/50,000) = 80
Annual demand is 200,000 units, Per order cost is $20, Total cost = 205,080
Holding cost is $0.2 per unit, Purchase price is $1/unit
𝟐𝑿𝟐𝟎𝟎,𝟎𝟎𝟎𝑿𝟐𝟎
and Current order quantity= 50,000 units (b) EOQ = = 6,325
𝟎.𝟐
Required Purchase cost (200,000 X 1) = 200,000
(a) What is the total cost if order quantity remains at Annual Holding cost (0.2X6,325/2) = 632
50,000?
Annual ordering cost (20X200,000/6,325) = 632
(b) What is the total cost of inventory if company Total cost = 201,264
follows EOQ model?
(a) Purchase cost (200,000 X 1 X 99%) = 198,000
(c) Supplier has offered 1% discount if order quantity is Annual Holding cost (0.2X30,000/2) = 3,000
at least 30,000 units What is the total cost if company
accept the supplier’s offer? Annual ordering cost (20X200,000/30,000) = 133
Total cost = 201,133
The co. should accept the offer of bulk discount
 17

JUST IN TIME (JIT)

An alternate view of stock management is just in
time in which stock level is either reduced or
eliminated, since stock is seen as waste
Organization order the material when it requires for
production
IMPLICATIONS OF JUST IN TIME STOCK
MANAGEMENT
 Higher dependence on the supplier
 Long-term contract developed with the supplier
 Supplier must be ideally located close to
organization
 Close working relationships with suppliers
 Better factory design
 Only produce for customer demand
 JIT will reduce or eliminate holding cost
 Opens further business opportunities
PAYABLE MANAGEMENT
PAYABLE MANAGEMENT
Trade payable is a cheap and most important source
of short-term finance as it carries no interest.
Management of trade payables involve
Attempting to obtain satisfactory credit terms
from suppliers
Attempting to extend credit during periods of cash
shortage
Maintaining good relationships with regular and
important suppliers
However, delaying payments to creditors beyond
the credit limits may cause some problems i.e.
Supplier may refuse to supply in future or may
not grant credit in future
Loss of reputation
Supplier may increase price in future
 20

EFFECTIVE EARLY
SETTLEMENT DISCOUNT %

Annual early settlement discount % = (1 + 𝑟) −1

Where:

r – effective discount rate per period i.e.

n – no. of periods forgone e.g. if the total period was 30 days and
early settlement discount is for 10 days then the period the period
fore gone will be 20 days. For a year it will be (365/20)

The decision
If the annual effective discount % > interest rate, then Accept the
discount
 21

EXAMPLE

Question Answer
r = 2/98
A supplier offers a 2% discount if the invoice
is paid within 10 days of receipt but offers n = 365/20
no discount if the payment is delayed for a 2
further 20 days. 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 = 1 +
98
− 1 = 44.6%

Required:
Calculate the annual effective cost of
refusing the discount.
 22

EXAMPLE

Question Current
Current accounts payable = $100,000 × 40/365 = $10,959
A company currently takes 40 days' credit
from its suppliers, believing this to be "free"
finance. Annual purchases are $100,000 Finance Income = $10,959 X 13% = $1,424.67
and the company pays overdraft interest at Discount Income = 0
13%. Total = $1,424.67
Payment within 15 days would attract a
1.5% quick settlement discount. Proposed
payable if discount taken = $100,000 × 15/365 = $4,110

Required:
Finance Income = $4,110 X 13% = $534.30
Calculate the effect on the profit and loss
Discount Income = $100,000 X 1.5% = $1,500
account of accepting the discount.
Total = $2,034.30

Net Benefit of disc (2,034.30 – 1,424.67) = $609.63

RECEIVABLE MANAGEMENT
THE COST OF RECEIVABLES

 Administrative cost to record and collecting debts

 Cost of irrecoverable debts (Sales X % of bad
debt)
 Cost of early Settlement Discount = (Sales X %
discount X % of customers taken the discount)
 Finance Cost (Average Receivable X % of
interest rate)
 25

EXAMPLE

Question Answer

Shaky Limited has sales of $60m for the a) Receivable period =

$𝟖𝒎 𝑿 𝟑𝟔𝟓
previous year, receivables at the year end = 𝟒𝟖. 𝟔𝟕 𝒅𝒂𝒚𝒔
$𝟔𝟎𝒎
were $8m. The cost of financing debtors is
covered by an overdraft at the interest rate
of 14%. b) Receivable Finance cost =
$8m X 14% = $1.12m
Required
a) Calculate the receivable period
b) Calculate the cost of financing receivables
 26

EFFECTIVE EARLY
SETTLEMENT DISCOUNT %

Annual early settlement discount % = (1 + 𝑟) −1

Where:

r – effective discount rate per period i.e.

n – no. of periods forgone e.g. if the total period was 30 days and
early settlement discount is for 10 days then the period the period
fore gone will be 20 days. For a year it will be (365/20)

The decision
If the annual effective discount % < interest rate, then Offer the
discount
 27

TACKLING QUESTION IN EXAM

 Make a tabular form and write the

headings of current and proposals
 Calculate all possible cost in all
situations
 Compare the cost and see the
most economical
 Do consider other factors in
making up the advice
 28

EXAMPLE
Receivable take early
$
discount = 𝑋50% =
𝟎. 𝟖𝟐𝒎
Existing Receivables = $8m X
50% = $4m
Grand Total = $4.82m
Question Answer
%
Shaky Limited has sales of $60m for the previous (a) r = = 𝟐. 𝟎𝟒%
( %)
year, receivables at the year end were $8m. The
n = (365/38.67)
cost of financing debtors is covered by an
overdraft at the interest rate of 14%. And debtors Annual Effective discount
are taking 48.67 days to pay on average 𝟑𝟔𝟓
=(𝟏 + 𝟐. 𝟎𝟒%) ( 𝟑𝟖.𝟔𝟕) −𝟏 = 𝟐𝟏. 𝟎𝟏%
A proposal is under consideration to offer 2% The co. should not offer the discount
discount if they settle the account in 10 days. It
is expected only 50% will take the discount
Required (b) Current Proposed
a) Calculate the effective discount % offered and Finance cost
evaluate whether it should be offered or not. ($8m X 14%) = 1.12 ($4.82m X 14%) = 0.67
b) Calculate the total cost of Receivable under Discount cost
current and propose situation and conclude whether
the discount should be offered - ($60m X 2% X 50%) = $0.6m
Total 1.12 1.27
The co. should not offer the discount
DEBT FACTORING
Factoring is an arrangement to have debts collected
by a factor company, which advances a proportion of
the money it is due to collect
Aspects of Factoring
 Administration of the client’s invoicing, sales
accounting and debt collection service.
 Credit protection for the client’s debts, whereby
the factor takes over the risk of loss from bad
debts ad so insures the client against such losses.
This is knows as non-recourse service.
 Making payments to the client in advance of
collecting the debts. This is referred to as ‘factor
finance’
 30

EXAMPLE

Question Answer

A company makes annual credit sales of $1,500,000. Credit Current Proposed

terms are 30 days, but its debt administration has been poor ($’000) ($’000)
and the average collection period has been 45 days with 0.5%
of sales resulting in bad debts which are written off. Finance cost
A factor would take on the task of debt administration and (45X1,500/365 X 13.5%) (30X1,500/365X(13.5%X20%+14%X80%))
credit checking, at an annual fee of 2.5% of credit sales. The
company would save $30,000 a year in administration costs. = 24.97 17.14
The payment period would be 30 days.
Bad debt cost
It is assumed that the factor would advance an amount equal to
80% of the invoiced debts at an interest rate of 14% (3% over (1,500X0.5%) = 7.5 -
the current base rate). The company can obtain an overdraft Administration cost
facility to finance its accounts receivable at a rate of 2.5% over
base rate. The remaining balance will be paid 30 days later. It Fix cost 30 (1,500X2.5%) 37.5
is also assumed that factor will completely avoid the bad debt.
Required Total 62.47 54.64
Should the factor's services be accepted? Assume a constant The Factor will save $7,830, so co. should hire factor service
monthly turnover.
 31

ADVANTAGES & DISADVANTAGES OF FACTORING

Advantages Disadvantages
 Business can pay its suppliers on time and  Factoring is likely to be more costly than an
so be able to take advantage of early payment efficiently run internal credit control
discounts. department.
 Growth can be financed through sales  Customers may not like to deal with
rather than injecting new capital factors.
 Avoid cost of running the credit control  Company loses control to decide to whom to
department grant credit period and the length of credit
 Business can use the expertise of debtor period for each customer
management that the factor specializes  Once a company hires a factor, it is difficult
 Management time is saved because to go back to an internal credit control system
managers don’t have to spend their time on again.
debtor management  Factoring may have a bad reputation for the
 Business gets its finance linked to its company. It may indicate that the company
volume of sales has financial issues
 32

RECEIVABLE MANAGEMENT

 Formal Agreements
 Making overall policy
 Complies with legislation
 Should credit be granted to all customers
 Probationary period
 cost to the business of customer credit
 Settlement terms
 Assessment of credit worthiness  Monitoring
 Bank References
 Trade References  Offering early settlement discounts
 Published Information  Collection of Receivables
 Credit Rating Agencies  Monthly statements
 Companies Own Sales Record  Chasing letters
 Department of Trade & Industry.  Chasing phone calls
 Press Comments & Releases  Personal approach
 Review account information  Stopping supplies
 Customer visits  Legal action
 External debt collection
 Outsourcing Receivables (Factoring)
 33

FOREIGN ACCOUNT RECEIVABLES

 Letter of credit: a payment guarantee backed by

one or more banks
 Forfaiting: involves the purchase of foreign
accounts receivable from the seller by a forfeiter.
 Counter Trading: goods or services are
exchanged for other goods or services instead of
for cash
 Export credit insurance: protects a business
against the risk of non-payment by a foreign
customer
 Export Factoring
Cash
Management
 35

TREASURE MANAGEMENT

CORPORATE THE GENERATION OF THE MANAGEMENT

HANDLING OF ALL EXTERNAL AND OF CURRENCIES AND
FINANCIAL MATTERS, INTERNAL FUNDS FOR CASH FLOWS,
BUSINESS

THE COMPLEX POLICIES AND

STRATEGIES, PROCEDURES OF
CORPORATE FINANCE
 36

CENTRALIZED VS DECENTRALIZED TREASURY

Centralized
 Economies of scale
 Management by specialised staff
 Increased negotiating power with banks
 More efficient foreign exchange risk management

Decentralized
 Greater autonomy will be given to subsidiaries
 more responsive to the needs of individual operating units
 Sources of finance will be diversified
 37

MOTIVES OF
HOLDING
CASH

TRANSACTIONS PRECAUTIONARY SPECULATIVE

 Cash on hand is crucial  Keep cash reserves for  It's a good idea to have
for daily expenses and unexpected expenses, some cash readily
fulfilling obligations like safety stock for available so you can
inventory quickly seize
investment
opportunities
 38

CASH BUDGET
Periods (Quarters) 1 2 3
Cash Inflows
Sales (Credit or cash) X X X
Others (Loan, sale of Asset) X X X
Total Inflows X X X
Cash Outflows
Purchases (Credit or cash) X X X
Labour X X X
Overheads X X X
Interest X X X
Others (capital expenditures) X X X
Total Outflows X X X
Net Cashflows X X X
O/B X X X
C/B X X X
 39

BAUMOL MODEL

 The Baumol model is a modified version of the

EOQ model
 This model is intended to be utilized for
managing cash
𝟐 𝑿 𝑫 𝑿 𝑪𝒐
𝑬𝑶𝑸 =
𝑪𝒉

Where
 D = annual requirement for cash
 CO = transaction costs
 Ch = opportunity cost of holding cash
(interest rate difference between short-term
investments and cash)
 40

EXAMPLE

A company has large deposits which currently D = $300,000

earn interest of 15%. It has cash needs of Co = $120
$300,000 in the next year.
Ch = 0.15
Transaction costs are $120.
𝟐 𝑿 𝟑𝟎𝟎, 𝟎𝟎𝟎 𝑿 𝟏𝟐𝟎
𝑬𝑶𝑸 = = 𝟐𝟏, 𝟗𝟎𝟗
Required: 𝟎. 𝟏𝟓
Calculate the economic transfer
 41

MILLER-ORR MODEL
 The model shows the level of balance that
the company should maintain
 The balance should be maintained between
a lower limit (set by management) and an Upper limit
upper limit (calculated by the model)
investment

Spread
 The spread (calculated by the model) refers
to the difference between the lower and
upper limits Return point
withdrawn
 If the upper limit is reached, investment is
needed to maintain it at a return point
Lower limit
(calculated by the model)
 If the account balance falls below the
minimum limit, funds will be withdrawn to
bring it back up at a return point
(calculated by the model)
 42

MILLER-ORR MODEL CALCULATIONS

𝑆𝑝𝑟𝑒𝑎𝑑
/
3
𝑋 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 𝑋 𝑣𝑎𝑟 𝑜𝑓 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑠
=3 4
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 Upper limit
investment
𝟐
𝑈𝑝𝑝𝑒𝑟 𝑙𝑖𝑚𝑖𝑡 = Lower limit + Spread (𝐒𝐩𝐫𝐞𝐚𝐝)

Spread
𝟑

1
𝑅𝑒𝑡𝑢𝑟𝑛 𝑝𝑜𝑖𝑛𝑡 = Lower limit + (Spread) Return point withdrawn
3
𝟏
OR 𝟑
(𝐒𝐩𝐫𝐞𝐚𝐝)
2
𝑅𝑒𝑡𝑢𝑟𝑛 𝑝𝑜𝑖𝑛𝑡 = Upper limit − (Spread) Lower limit
3
 43

EXAMPLE

/
The following data applies to a company. 3
4 𝑋 $50 𝑋 $4,000,000
The minimum cash balance is $8,000. 𝑆𝑝𝑟𝑒𝑎𝑑 = 3 = $25,300
0.025%
The variance of daily cash flows is $4,000,000,
equivalent to a standard deviation of $2,000 per
day 𝑈𝑝𝑝𝑒𝑟 𝑙𝑖𝑚𝑖𝑡 = $8,000 + $25,300 = $33,300
The transaction cost for buying or selling
1
securities is $50. 𝑅𝑒𝑡𝑢𝑟𝑛 𝑝𝑜𝑖𝑛𝑡 = $8,000 + 25,300 = $16,400
3
The interest rate is 0.025% per day.
 If the cash balance reaches $33,300, invest
Required: $16,900 ($33,300–$16,400)
You are required to formulate a decision rule  If the cash balance falls to $8,000, withdraw
using the Miller-Orr model $8,400 ($16,400-$8,000)
 44

SHORT TERM BANK DEPOSITS

SHORT-TERM DEBT
INSTRUMENTS

INVESTMENTS  Deposited with a  Certificates of

bank or similar deposit
financial institution  Treasury bills
 Commercial paper

LONG-TERM DEBT
INSTRUMENTS
EQUITIES

 can be sold when  can be sold on the

the company stock market when
eventually needs the company
the cash eventually needs
 Loan Notes the cash

 Gilts  Not recommended

 Not recommended
 45

Bank loan Overdraft Payables Factoring

SHORT TERM
FINANCE
WORKING
CAPITAL
POLICIES
 47

WORKING
CAPITAL
INVESTMENT
POLICY

CONSERVATIVE APPROACH AGGRESSIVE APPROACH MODERATE APPROACH

 aims to reduce the risk  aims to reduce  A middle way between

by investing high in financing cost and the aggressive and
level in working increase profitability conservative
capital by investing low level approaches
in working capital
 48

WORKING CAPITAL
FINANCING
 Non-current assets: Long term assets from
which an organization expects to derive benefit
over a number of periods.
 The company should use long term Source of
Finance
 Permanent current assets: This is the amount of
current assets required to meet minimum long-
term needs and sustain normal trading activity.
 Ideally, company should use long term source
of finance for this
 Fluctuating current assets: These are current
assets which vary according to normal business
activity and are above the minimum level.
 Ideally, the company should use short term
source of finance
 49

WORKING
CAPITAL
FINANCING
POLICY

CONSERVATIVE APPROACH AGGRESSIVE APPROACH MODERATE APPROACH

 Permanent assets  Permanent assets  Permanent assets

financed by long-term financed by long-term & financed by long-term
source of finance only short-term source of source of finance
 Fluctuating assets finance  Fluctuating assets
financed by long-term &  Fluctuating assets financed by short-term
short-term source of financed by short-term source of finance
finance source of finance only
 50

OVERTRADING (UNDER CAPITALIZATION)

A business which is trying to do too much too quickly with too little
long-term capital”
Symptoms
 Rapid increase in turnover.
 Rapid increase in the volume of current assets and possibly also
non-current assets. High Inventory and accounts receivable period.
 Only a small increase in equity capital. Most of the increase in
assets is financed by credit, especially:
 Trade accounts payable
 Bank overdraft
 Current ratio and quick ratio fall
 Business might have a liquid deficit i.e. an excess of current
liabilities over current assets.
 Proportion of total assets financed by equity capital falls and the
proportion financed by credit rise.
 Sales/working capital ratio is increasing over time, working
capital should increase in line with sales.
 51

SOLUTIONS OF OVERTRADING

New capital could be The growth can be

injected from financed through long-
shareholders term loans.

Better control could be The company could

applied to management of postpone ambitious plans
inventories and accounts for increased sales and
receivable. fixed asset investment.
 52

OVER CAPITALIZATION
(UNDER TRADING)

 If there are excessive inventories,

accounts receivable and cash and very
few accounts payable, there will be an
over-investment by company in
current assets and the company will be
in this respect over-capitalized
 This action decreased profitability to a
level that shareholders found
unacceptable
ECONOMIC
ENVIRONMENT
Financial Management
 2

MACROECONOMIC POLICIES
The Government can utilize macroeconomic policies with
specific objectives to accomplish various goals

Economic growth
Full employment leading to improved
living standards

An equitable Price stability

distribution of resulting in limited
wealth inflation, and

A strong balance of
payments
 3

FISCAL POLICY

Government decisions regarding taxation and spending aim to

achieve full employment, price stability, and economic growth

Taxes can affect disposable income, as higher taxes lead to less

money for consumers to spend

The government can boost the economy by spending more on

goods and services from companies, which will increase money
flow and eventually raise disposable income for consumers
 4

MONETARY POLICY

The central bank By affecting the cost

manages money and of borrowing, the
interest rates to government can
stabilize currency and influence consumer
control inflation and business spending
 5

AFFECTS OF
MONETARY
POLICY

GROWTH EXCHANGE RATES INFLATION

 High interest rates  Foreign investors are  High interest rates can
make borrowing attracted to high limit both economic
money harder, which interest rates, which growth and inflation
can slow down the can lead to an increase
economy for individuals in exchange rates
and businesses
 6

EXCHANGE RATE POLICY

 A freely floating exchange rate allows

currency value to move with market
forces
 A fixed exchange rate involves fixing
the rate against another currency or
basket of currencies and the central
bank intervenes to maintain it without
fluctuations
 Crawling exchange rate allows
currency to fluctuate around a set rate
 7

GOVERNMENT COMPETITION COMMISSION PRIVATISATION

INTERVENTIONS  The Competition

Commission is
 Many state-owned
organizations have
responsible for been sold to the public
preventing activities through privatisation
that are deemed to be
against the public
interest

ASSISTANCE FOR
BUSINESS GREEN POLICIES

 Governments intervene  Organizations are

in the economy to seeing more
encourage investment involvement from
in high technology or governments in their
areas of high efforts to enhance their
unemployment environmental
performance
FINANCIAL
MARKETS
 9

FINANCIAL MARKETS

A financial market facilitates the buying and selling of financial

securities, including capital markets (for long-term capital) and money
markets (for short-term capital)

Direct contact
Lenders and borrowers may organized financial markets
interact through intermediaries such as financial institutions.
 10

FINANCIAL INTERMEDIARIES
Entities that connect individuals who want
to lend money with those who want to
borrow it

Risk Reduction

• Many lenders effectively spread the risk of each borrower

Aggregation

• combine small deposits and lend them to larger borrowers

Maturity transformation

• A series of short-term deposits can be utilized to provide

long-term loans

Financial intermediation

• goal is to create a market that is adaptable and meets the

requirements of lenders and borrowers alike
 11

CAPITAL MARKET

Capital Market
 The capital market a great place to get
long-term funding for bonds and
mortgages
 The capital market includes stocks,
commodities, and bonds
Money Market
 The money market refers to the
worldwide financial market where short-
term lending and borrowing takes place
 12

MONEY MARKET INSTRUMENTS

Coupon
Discount
Bearing Derivatives
Securities
securities

This is a type of debt that

Debt is sold at its initial
is issued at a discounted
value and the buyer A financial tool that relies
price and doesn't pay
receives interest on the value or price of
interest, but is eventually
payments based on that an underlying asset
redeemed at its face
value
value

Treasury Bills,
Certificate of Futures &
Commercial
deposits & Options
paper & Bankers
Repos contract
Acceptance
 13

FINTECH
Technology is changing financial services, impacting
businesses and institutions
Disintermediation
 Funds are directly transferred between parties
without a middleman
 Fintech companies can help with this by
connecting lenders and borrowers and investors
with opportunities, making the process more
efficient
Availability of credit
 Fintech boosts credit accessibility for rejected
borrower
Security token offering
 STOs use blockchain technology to regulate
securities, promoting fairness and market integrity
while increasing efficiency through automation
and smart contracts.