F9 CNotes June 2011 Version

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ACCA Paper F9
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Financial
Management
e
Class Notes
June 2011
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The Accountancy College Ltd, January 2011

All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise, without the prior written
permission of The Accountancy College Ltd.
www.studyinteractive.org
Contents
PAGE
INTRODUCTION TO THE PAPER
FORMULAE SHEET
CHAPTER 1:
FINANCIAL MANAGEMENT: AN INTRODUCTION
11
CHAPTER 2:
INVESTMENT APPRAISAL TECHNIQUES
21
CHAPTER 3:
ADVANCED DISCOUNTED CASH FLOW TECHNIQUES
39
CHAPTER 4:
LONG TERM SOURCES OF FINANCE
61
CHAPTER 5:
COST OF CAPITAL
69
CHAPTER 6:
CAPITAL STRUCTURE AND RISK ADJUSTED WACC
87
CHAPTER 7:
RATIO ANALYSIS
CHAPTER 8:
RAISING EQUITY FINANCE
CHAPTER 9:
WORKING CAPITAL MANAGEMENT
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CHAPTER 10: EFFICIENT MARKET HYPOTHESIS
CHAPTER 12: RISK
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CHAPTER 11: VALUATION
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97
113
121
147
151
165
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Introduction to the
paper
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IN T R O D U C T I O N T O T H E P A P E R
AIM OF THE PAPER

The aim of the paper is to develop knowledge and skills expected of a financial
manager, relating to issues affecting investment, financing and dividend policy
decisions.
OUTLINE OF THE SYLLABUS

1.
Financial management function
2.
Financial management environment
3.
Working capital management
4.
Investment appraisal
5.
Business finance
6.
Cost of capital
7.
Business valuation
8.
Risk management
FORMAT OF THE EXAM PAPER
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sp examination.
The syllabus is assessed by a three hour paper-based
log
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The examination consists of 4 questions of 25 marks each. All
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0
compulsory.
s2
k
oo
FAQs
eb
questions are
What level of mathematical ability is required in F9?

You will be required to apply formulae either given or memorised. This may require
limited manipulation of formulae. The level of computational complexity is normally
inversely related to the conceptual difficulty of the topic.
What do I need to bring to class?

You will need pen, paper, these notes and revision kit. In addition you will need a
standard scientific calculator which may be purchased in any large newsagents or
supermarket.
Is there any assumed knowledge?

The only real overlap is with basic concepts explored in paper F2 and also elements
of decision making and cost behaviour covered in paper F5.
Formulae
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FORMULAE
FORMULAE
Economic Order Quantity
2C0D
CH
Miller-Orr Model
Return point = Lower limit + (1/3 spread)
1
3
3
4 transaction cost variance of cash flows
Spread = 3
interest rate
The Capital Asset Pricing Model

E(ri) = Rf + i (E (rm) Rf)
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The Asset Beta Formula
Vd(1 T)
Ve
e +
d
a =
(V + Vd(1 T))
e
(V + Vd(1 T))
e
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The Growth Model
kD0(1+ g)
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P0 =
(Ke g)
or P0 =
D0 (1+ g)
(re g)
Gordons Growth Approximation

g = bre
The weighted average cost of capital
V
V
e
d
WACC =
ke +
kd (1T)
V +V
V +V
e d
e d
The Fisher formula

(1 + i) = (1 + r)(1 + h)
Purchasing Power Parity and Interest Rate Parity

S1 = S 0
F0 = S 0
(1+ hc )
(1+ hb )
(1+ ic )
(1+ ib )
FORMULAE
Present Value Table

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

Where r
n
=
=
discount rate
number of periods until payment
Discount rate (r)
Periods
(n)
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
________________________________________________________________________________
1
2
3
4
5
0.990
0.980
0.971
0.961
0.951
0.980
0.961
0.942
0.924
0.906
0.971
0.943
0.915
0.888
0.863
0.962
0.925
0.889
0.855
0.822
0.952
0.907
0.864
0.823
0.784
0.943
0.890
0.840
0.792
0.747
0.935
0.873
0.816
0.763
0.713
0.926
0.857
0.794
0.735
0.681
0.917
0.842
0.772
0.708
0.650
0.909
0.826
0.751
0.683
0.621
1
2
3
4
5
6
7
8
9
10
0.942
0.933
0.923
0.914
0.905
0.888
0.871
0.853
0.837
0.820
0.837
0.813
0.789
0.766
0.744
0.790
0.760
0.731
0.703
0.676
0.746
0.711
0.677
0.645
0.614
0.705
0.665
0.627
0.592
0.558
0.666
0.623
0.582
0.544
0.508
0.630
0.583
0.540
0.500
0.463
0.596
0.547
0.502
0.460
0.422
0.564
6
0.513
7
0.467
8
0.424
9
0.386 10
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0.896
0.804
0.722
0.650
0.585
0.527
0.475
0.429
0.388
0.350 11
12
0.887
0.788
0.701
0.625
0.557
0.497
0.444
0.397
0.356
0.319 12
13
0.879
0.773
0.681
0.601
0.530
0.469
0.415
0.368
0.326
0.290 13
14
0.870
0.758
0.661
0.577
0.505
0.442
0.388
0.340
0.299
0.263 14
15
0.861
0.743
0.642
0.555
0.481
0.417
0.362
0.315
0.275
0.239 15
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(n) 11%
12%
13%
14%s 15%
16%
17%
18%
19%
20%
________________________________________________________________________________
ok
o
1
0.901
0.893
0.885
eb 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2
0.812
0.797
0.783
0.769
0.756
0.743
0.731
0.718
0.706
0.694
2
3
4
5
0.731
0.659
0.593
0.712
0.636
0.567
0.693
0.613
0.543
0.675
0.592
0.519
0.658
0.572
0.497
0.641
0.552
0.476
0.624
0.534
0.456
0.609
0.516
0.437
0.593
0.499
0.419
0.579
0.482
0.402
6
7
8
9
10
0.535
0.482
0.434
0.391
0.352
0.507
0.452
0.404
0.361
0.322
0.480
0.425
0.376
0.333
0.295
0.456
0.400
0.351
0.308
0.270
0.432
0.376
0.327
0.284
0.247
0.410
0.354
0.305
0.263
0.227
0.390
0.333
0.285
0.243
0.208
0.370
0.314
0.266
0.225
0.191
0.352
0.296
0.249
0.209
0.176
0.335
6
0.279
7
0.233
8
0.194
9
0.162 10
11
12
13
14
15
0.317
0.286
0.258
0.232
0.209
0.287
0.257
0.229
0.205
0.183
0.261
0.231
0.204
0.181
0.160
0.237
0.208
0.182
0.160
0.140
0.215
0.187
0.163
0.141
0.123
0.195
0.168
0.145
0.125
0.108
0.178
0.152
0.130
0.111
0.095
0.162
0.137
0.116
0.099
0.084
0.148
0.124
0.104
0.088
0.074
0.135
0.112
0.093
0.078
0.065
3
4
5
11
12
13
14
15
FORMULAE
Annuity Table
Present value of an annuity of 1 i.e.
Where
1 - (1 + r)-n
r
r = discount rate
n = number of periods
Discount rate (r)
Periods
(n)
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
________________________________________________________________________________
1
2
3
4
5
0.990
1.970
2.941
3.902
4.853
0.980
1.942
2.884
3.808
4.713
0.971
1.913
2.829
3.717
4.580
0.962
1.886
2.775
3.630
4.452
0.952
1.859
2.723
3.546
4.329
0.943
1.833
2.673
3.465
4.212
0.935
1.808
2.624
3.387
4.100
0.926
1.783
2.577
3.312
3.993
0.917
1.759
2.531
3.240
3.890
0.909
1.736
2.487
3.170
3.791
6
7
8
9
10
5.795
6.728
7.652
8.566
9.471
5.601
6.472
7.325
8.162
8.983
5.417
6.230
7.020
7.786
8.530
5.242
6.002
6.733
7.435
8.111
5.076
5.786
6.463
7.108
7.722
4.917
5.582
6.210
6.802
7.360
4.767
5.389
5.971
6.515
7.024
4.623
5.206
5.747
6.247
6.710
4.486
5.033
5.535
5.995
6.418
4.355
6
4.868
7
5.335
8
5.759
9
6.145 10
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2
3
4
5
11 10.37
9.787
9.253
8.760
8.306
7.887
7.499
7.139
6.805
6.495 11
12 11.26
10.58
9.954
9.385
8.863
8.384
7.943
7.536
7.161
6.814 12
13 12.13
11.35
10.63
9.986
9.394
8.853
8.358
7.904
7.487
7.103 13
14 13.00
12.11
11.30
10.56
9.899
9.295
8.745
8.244
7.786
7.367 14
15 13.87
12.85
11.94
11.12
10.38
9.712
9.108
8.559
8.061
7.606 15
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(n) 11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
________________________________________________________________________________
1
2
3
4
5
0.901
1.713
2.444
3.102
3.696
0.893
1.690
2.402
3.037
3.605
0.885
1.668
2.361
2.974
3.517
0.877
1.647
2.322
2.914
3.433
0.870
1.626
2.283
2.855
3.352
0.862
1.605
2.246
2.798
3.274
0.855
1.585
2.210
2.743
3.199
0.847
1.566
2.174
2.690
3.127
0.840
1.547
2.140
2.639
3.058
0.833
1.528
2.106
2.589
2.991
6
7
8
9
10
4.231
4.712
5.146
5.537
5.889
4.111
4.564
4.968
5.328
5.650
3.998
4.423
4.799
5.132
5.426
3.889
4.288
4.639
4.946
5.216
3.784
4.160
4.487
4.772
5.019
3.685
4.039
4.344
4.607
4.833
3.589
3.922
4.207
4.451
4.659
3.498
3.812
4.078
4.303
4.494
3.410
3.706
3.954
4.163
4.339
3.326
6
3.605
7
3.837
8
4.031
9
4.192 10
11
12
13
14
15
6.207
6.492
6.750
6.982
7.191
5.938
6.194
6.424
6.628
6.811
5.687
5.918
6.122
6.302
6.462
5.453
5.660
5.842
6.002
6.142
5.234
5.421
5.583
5.724
5.847
5.029
5.197
5.342
5.468
5.575
4.836
4.988
5.118
5.229
5.324
4.656
4.793
4.910
5.008
5.092
4.486
4.611
4.715
4.802
4.876
4.327
4.439
4.533
4.611
4.675
10
1
2
3
4
5
11
12
13
14
15
Chapter 1
Financial
management: an
introduction
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C H A P T E R 1 F IN A N C I A L M A N A G E M E N T : A N IN T R O D U C T I O N
CHAPTER CONTENTS
WHAT IS FINANCIAL MANAGEMENT? --------------------------------- 13
THE THREE KEY DECISIONS
13
CORPORATE STRATEGY AND FINANCIAL MANAGEMENT
15
FINANCIAL OBJECTIVES
15
VALUE FOR MONEY
16
STAKEHOLDERS
17
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WHAT IS FINANCIAL MANAGEMENT?

May be considered as:
The management of all matters associated with the cash flow of the organisation
both short and long-term.
Financial management and the accounting equation
Non Current
Assets
Working
Capital
Debt and
Equity
Application
of funds
Sourcing
of funds
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The three key decisions
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Financial management is often described in terms of the three basic decisions to be

made:
the investment decision,
the financial decision,
the dividend decision.
Each of these decisions have to be looked at in far greater detail later on in the
course but as an outline these are the basic considerations:
1.
The investment decision
A company may invest its funds in one of three basic areas:

1.
Capital assets
2.
Working capital
3.
Financial assets
13
Capital assets
A critical decision because of the strategic implications of many investments, the
decision would include the following financial considerations:
1.
Return
2.
Risk
3.
Cash flow
4.
Profit.
Working capital
The cash resource available to the business on a day-to-day basis and used to fund
the current assets such as inventory and receivables. The key to identifying the
level of investment is to balance the risk of insolvency against the cost of funding.
Financial assets
Not a core area of the course, we tend to focus on financing from the perspective of
a company rather than the investor. This being the case the only financial
investment to consider is short-term saving. In this circumstance then the key
considerations are, in order:
1.
Risk
2.
Liquidity
3.
Return.
2.
The financing decision
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When looking at the financing of a business there are 4 basic questions to consider:
1.
total funding required,
2.
internally generated vs externally sourced,
3.
debt or equity,
4.
long-term or short-term debt.
Total funding required

The funding requirement will be determined by an assessment of the following
Application of funds
Source of funds
Existing asset base
Existing funding
New assets
Redemption of existing debt
Disposals
Funds generated through trading
Change in Working Capital
14
Internally vs externally generated funds

A company may be able to fund business growth via internally generated funds
such as retained earnings. If those funds are limited or the company wishes to
grow at a faster rate then external sources of funding must be tapped.
Debt vs equity
The gearing decision which forms the basis of two later chapters. A critical issue in
terms of risk and cost of funding.
Short-term vs long-term debt

A consideration focussed upon in the funding of working capital, short-term funding
may have benefits of flexibility and lower cost but is inherently risky.
3.
The dividend decision
The amount of return to be paid in cash to shareholders. This is a critical measure

of the companies ability to pay a cash return to its shareholders. The level of
dividend paid will be determined by the following:
1.
Profitability
2.
Cash flow
3.
Growth
4.
Legal restrictions
5.
Shareholder expectations.
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Corporate strategy and k

o financial management
eb
The role of the financial manager is to align the aims of financial management team
with those of the wider corporate strategy. The strategy of the business may be
separated into corporate, business and operational objectives. Financial managers
should be attempting to fulfil those objectives.
The nature of financial management means that it is fundamental to the translation
of strategic aims into financial transactions.
Financial objectives
Financial objectives of commercial companies may include:
1.
Maximising shareholders wealth
2.
Maximising profits
3.
Satisficing.
1.
Maximising shareholders wealth
A fundamental aim within financial management is to create and sustain

shareholders wealth.
Wealth being the ongoing value of shares of the
organisation. The importance of this concept is that there is no time period to the
wealth and that it is determined by the relative risk/ return balance of the business.
All aspects of financial management are based on this basic premise.
15
2.
Maximising profits
Within organisations it is normal to reward management on some measure of profit

such as ROI or RI. In simple terms we would expect a close relationship between
profit and shareholders wealth. There are, however, ways in which they may
conflict such as:
1.
Short-termism.
2.
Cash vs accruals.
3.
Risk.
Short-termism
A profit target is normally calculated over one year, it is relatively easy to
manipulate profit over that period to enhance rewards at the expense of future
years.
Cash vs accruals
As we will see later, wealth is calculated on a cash basis and ignores accruals.
Risk
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A manager may be inclined to accept very risky projects in order to achieve profit
targets which in turn would adversely affect the value of the business.
3.
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Satisficing
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Many organisations do not profit maximise but instead aim to satisfice. This means
that they attempt to generate an acceptable level of profit with a minimum of risk.
It reflects the fact that many organisations are more concerned with surviving than
growth.
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4.
Objectives of not-for-profit organisations
These organisations are established to pursue non-financial aims but are to provide
services to the community. Such organisations like profit-seeking companies need
funds to finance their operations. Their major constraint is the amount of funds
that they would be able to raise. As a result not-for-profit organisations should
seek to use the limited funds so as to obtain value for money.
Value for money

Value for money means providing a service in a way, which is economical, efficient
and effective. It simply means that getting the best possible service at the least
possible cost. Public services for example are funded by the taxpayers and in
seeking value for money; the needs of the taxpayer are being served, insofar as
resources are being used in the best manner to provide essential services.
16
VALUE FOR MONEY
ECONOMY
EFFECTIVENESS
EFFICIENCY
Economy measures the cost of obtaining the required quality inputs needed to
produce the service. The aim is to acquire the necessary input at the lowest
possible cost.
Effectiveness means doing the right thing.

service meets its declared objectives.
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It measures the extent to which the
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Efficiency means doing the right thing well. It relates to the level of output
generated by a given input. Reducing the input: output ratio is an indication of
increased efficiency.
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Example ---- in refuse collection service,
The service will be economic if it is able to minimise the cost of weekly collection
and not suffer from wasted use of resources.
The service will be effective if it meet it target of weekly collection.
The service will be efficient if it is able to raise the number of collection per vehicle
per week.
Stakeholders
We tend to focus on the shareholder as the owner and key stakeholder in a
business. A more comprehensive view would be to consider a wider range of
interested parties or stakeholders.
Stakeholders are any party that has both an interest in and relationship with the
company. The basic argument is that the responsibility of an organisation is to
balance the requirements of all stakeholder groups in relation to the relative
economic power of each group.
Group task
Required
Identify as many stakeholder groups as you can for a commercial organisation.
17
Conflict between stakeholder groups

The very nature of looking at stakeholders is that the level of return is finite within
an organisation. There is a need to balance the needs of all groups in relation to
their relative strength.
Group task
Required
Using the stakeholder groups already identified suggest 5 possible conflicts of
interest that need to be considered.
Agency theory
Principal
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Agent
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Agency relationships occur when one or more people employ one or more persons
as agent. The persons who employ others are the principals and those who work
for them are called the agent
In an agency situation, the principal delegate some decision-making powers to the
agent whose decisions affect both parties. This type of relationship is common in
business life.
For example shareholders of a company delegate stewardship
function to the directors of that company. The reasons why an agents are
employed will vary but the generally an agent may be employed because of the
special skills offered, or information the agent possess or to release the principal
from the time committed to the business.
Goal Congruence
Goal congruence is defined as the state which leads individuals or groups to take
actions which are in their self interest and also in the best interest of the entity.
For an organisation to function properly, it is essential to achieve goal congruence
at all level. All the components of the organisation should have the same overall
objectives, and act cohesively in pursuit of those objectives.
In order to achieve goal congruence, there should be introduction of a careful
designed remuneration packages for managers and the workforce which would
motivate them to take decisions which will be consistent with the objectives of the
shareholders.
18
Money as a prime motivator

The most direct use of money as a motivator is payment by results schemes
whereby an employees pay is directly linked to his results. However, research has
shown that money is not a single motivator or even the prime motivator.
Question
Identify 5 key areas of conflict between directors and shareholders and suggest
what can be done to encourage goal congruence between the two parties.
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Chapter 2
techniques
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SYLLABUS CONTENT
Payback
ARR
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Time value of money o
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Discounted cash flow
NPV
IRR
Annuities
Perpetuities
21
C H A P T E R 2 I N V E S T M E N T A P P R A IS A L T E C H N IQ U E S
CHAPTER CONTENT DIAGRAM
Investment
Appraisal
techniques
Basic techniques
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log
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Accounting rate of
return (ARR)
0
00
Payback
m
DCF techniques
co
22
Internal
rate
return (IRR)
Annuities
Net present
(NPV)
bo
s
ok
value
Perpetuities
of
CHAPTER CONTENTS
INVESTMENT APPRAISAL AND CAPITAL BUDGETING --------------- 24
PAYBACK
25
RETURN ON CAPITAL EMPLOYED (ROCE)
27
DISCOUNTED CASH FLOW ---------------------------------------------- 31

DISCOUNTING
32
NET PRESENT VALUE (NPV)
33
INTERNAL RATE OF RETURN (IRR)
34
NPV AND IRR COMPARED
36
ANNUITIES
36
PERPETUITIES
37
o
t.c
p
gs
0
s2
.bl
0
o
bo
23
INVESTMENT APPRAISAL AND CAPITAL BUDGETING

A form of decision-making where the investment occurs predominantly today and
the benefits of the investment occur in the future. Investment appraisal is of
particular importance because of the following:
1.
Long-term
2.
Size (in relation to the business)
3.
Outflow today (relatively certain), inflow in the future (uncertain).
There are 4 basic methods to be mastered

1.
Payback
2.
Return on Capital Employed (ROCE)
3.
Net present value (NPV)
4.
Internal rate of return (IRR).
We shall use the following example to illustrate how each method is calculated.
Example 1
o
t.c
Reina Ltd
p
gs
Reina Ltd has the opportunity to invest in an investment with the following initial
costs and returns:
0
s2
.bl
0
A
($000s)
o
bo
Initial investment
(100)
Cash flows
Yr
Yr
Yr
Yr
Yr
1
2
3
4
5
50
40
30
25
20
Residual value
Yr 5
The cost of capital is 10%.

Required:
Should the project be accepted?
24
Payback
The length of time it takes for cash inflows from trading to pay back the initial
investment.
Example 1 contd
A
Initial
investment
Periodic
Cumulative
Net cash
flows ($)
Yr 1
Yr 2
Yr 3
o
t.c
Yr 4
p
gs
o
.bl each year.
0
Alternate computation with equal cash flows
00
2
ks
o
bo
e
Required:
Example 3
Finnan Ltd
Net cash inflow per annum $25,000

Investment
$60,000
Required:
Payback period.
Decision criteria
Accept the project in the event that the time period is within the acceptable time
period. What is an acceptable time period? It depends!!
25
Advantages
1.
It is simple to use (calculate) and easy to understand
2.
It is a particularly useful approach for ranking projects where a company faces

liquidity constraints and requires a fast repayment of investment.
3.
It is appropriate in situations where risky investments are made in uncertain

market that are subject to fast design and product changes or where future
cash flows are particularly difficult to predict.
4.
The method is often used in conjunction with the NPV or IRR method and act
as the first screening device to identify projects which are worthy of further
investigation.
5.
Unlike the other traditional methods payback uses cash flows, rather than
accounting profits, and so is less likely to produce an unduly optimistic figure
distorted by assorted accounting conventions.
Disadvantages
1. It does not give a measure of return, as such it can only be used in addition to
other investment appraisal methods.
o
t.c
2. It does not normally consider the impact of discounted cash flow although a
discounted payback may be calculated (see later).
3.
4.
po
sany cash flows beyond that point
It only considers cash flow up to the payback,
log
are ignored.
.b
00 is an acceptable payback period, any
There is no objective measure of what
0
target payback is necessarily s2
subjective.
k
oo
eb
Example 2
Chromex (exam standard question amended)
Chromex plc manufactures bicycles for the UK and European markets, and has
made a bid to take over Bexell plc, their main UK competitor.
Chromex anticipates labour savings of $700,000 per year, created by more efficient
production and distribution facilities, if the takeover is completed. In addition, the
company intends to sell off surplus land and buildings with a balance sheet value of
$15 million, acquired in the course of the takeover.
For the year ended 31 December 20X7, Bexell reported an operating profit of $10
million. In calculating profits, Bexell included a depreciation charge of $0.5 million.
The total amount to be invested in Bexell is $140m prior to any disposal of assets.
Required:
Assuming that the bid is accepted by Bexell, calculate the payback period
(pre-tax) for the investment, if the land and buildings are immediately sold
for $5 million less than the balance sheet valuation, and Bexells sales
figures remain static.
(3 marks)
26
Return on capital employed (ROCE)

A measure that considers the impact of the investment on accounting profit. It is
similar in concept to the ROCE performance measure, but is not the same.
Performance appraisal
Time period
Over the life of the project
A single year
When?
Future
Past
Use
Decision making
Appraisal and reward

structures
ROCE
Estimated annual profit

100
Average investment
Example 1
contd
Average annual profit
Total profit
p
gs
Less depreciation
0
s2
.bl
0
Total net cash flow

number of years
o
t.c
o
bo
= average profit
Average investment
Initial investment
Plus residual value
2
Equals ave. investment
ARR
27
Decision criteria
A profit measure that must be compared to a target profit. This profit is likely to be
related to the target performance measure already discussed
Advantages
1.
It is easy to understand and easy to calculate.
2.
The impact of the project on a companys financial statement can also be

specified
3.
ROCE is still the commonest way in which business unit performance is

measured and evaluated, and is certainly the most visible to shareholders
4.
Managers may be happy in expressing project attractiveness in the same

terms in which their performance will be reported to shareholders, and
according to which they will be evaluated and rewarded.
5.
The continuing use of the ARR method can be explained largely by its
utilisation of balance sheet and P&L account magnitudes familiar to managers,
namely profit and capital employed.
o
t.c
Disadvantages
1.
It fails to take account of the project life or the timing of cash flows and time
value of money within that life
2.
It uses accounting profit, hence subject to various accounting conventions.
3.
There is no definite investment signal. The decision to invest or not remains

subjective in view of the lack of objectively set target ARR.
4.
Like all rate of return measures, it is not a measurement of absolute gain in

wealth for the business owners.
5.
The ARR can be expressed in a variety of ways and is therefore susceptible to

manipulation.
p
gs
0
s2
.bl
0
28
o
bo
Example 3
Armcliff (exam standard question)
Armcliff Limited is a division of Sherin plc which requires each of its divisions to
achieve a rate of return on capital employed of at least 10 per cent per annum.
For this purpose, capital employed is defined as fixed capital and investment in
stocks. This rate of return is also applied as a hurdle rate for new investment
projects. Divisions have limited borrowing powers and all capital projects are
centrally funded.
The following is an extract from Armcliffs divisional accounts.
Profit and loss account for the year ended 31 December 20X4
$m
Turnover
120
Cost of sales
(100)
____
Operating profit
20
====
Assets employed as at 31 December
20X4
$m
m
co75
t.
$m
Fixed assets (net)
Current assets (including stocks $25m)
Current liabilities
Net capital employed
eb
s
ok
.bl
0
00
p
gs
45
(32)
___
13
___
88
===
Armcliffs production engineers wish to invest in a new computer-controlled press.

The equipment cost is $14 million. The residual value is expected to be $2 million
after four years operation, when the equipment will be shipped to a customer in
South America.
The new machine is capable of improving the quality of the existing product and
also of producing a higher volume. The firms marketing team is confident of
selling the increased volume by extending the credit period. The expected
additional sales are as follows.
Year
Year
Year
Year
1
2
3
4
2,000,000
1,800,000
1,600,000
1,600,000
units
units
units
units
Sales volume is expected to fall over time because of emerging competitive

pressures. Competition will also necessitate a reduction in price by $0.5 each year
from the $5 per unit proposed in the first year. Operating costs are expected to
be steady at $1 per unit, and allocation of overheads (none of which are affected
by the new project) by the central finance department is set at $0.75 per unit.
Higher production levels will require additional investment in stocks of $0.5
million, which would be held at this level until the final stages of operation of the
project. Customers at present settle accounts after 90 days on average.
29
Required:
(a)
Determine whether the proposed capital investment is attractive to

Armcliff, using the average rate of return on capital method, defined
as average profit to average capital employed, ignoring debtors and
creditors.
(7 marks)
Note. Ignore taxes.
(b)
Suggest three problems which arise with the use of the average
return method for appraising new investment.
(3 marks)
(ii)
(c)
(i)
In view of the problems associated with the ARR method, why

do companies continue to use it in project appraisal?
(3 marks)
Briefly discuss the dangers of offering more generous credit, and

suggest ways of assessing customers creditworthiness.
(7 marks)
(20 marks)
o
t.c
p
gs
0
s2
.bl
0
o
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30
DISCOUNTED CASH FLOW

The application of the idea that there is a TIME VALUE OF MONEY. What this
means is that money received today will have more worth than the same amount
received at some point in the future.
Why would you rather have $1,000 now rather than in one years time?
Year 0
Reasons
Year 1
o
t.c
p
gs
o
.bl
0
Reminder - compound interest
00
2
ks
o
Example 4
bo
e
If we invest $100 now (Yr. 0) what will the value of that investment be in 1, 2, 3, 4
years at a compound rate of 10%?
Present Value
Calculation
Future Value
$100
2
3
4
31
Therefore we are able to express Present Values in terms of Future Values using the
following formula:
PV (1 + r)n
FV =
Where
PV
Present value.
FV
Future value.
Rate of interest or cost of capital.
Number of periods (years)
Discounting
The opposite of compounding, where we have the future value (eg an expected
cash inflow in a future year) and we wish to consider its value in present value
terms.
Illustration
COMPOUNDING
Year 0
Year 1
o
t.c
p
gs
DISCOUNTING
0
s2
.bl
0
Revising the formula
PV
o
bo
= FV
(1 + r)n
FV (1 + r)-n
Use tables to calculate the present values of example 4 on the previous page.
Year
Future Value
$
121
133.1
Present Value
$
110
Discount factor (from tables)

at 10%
146.41
32
Net present value (NPV)

The key investment appraisal method, it incorporates the time value of money in
calculating an absolute value of the project. It is called the NET present value
because there will be a range of outflows and inflows in the typical investment.
Decision criteria
If the investment has a positive NPV then the project should be accepted (negative
rejected). A positive NPV means that the project will increase the wealth of the
company by the amount of the NPV at the current cost of capital.
Example 1 contd
($000s)
Project A
Discount factor
Year
Project A
o
t.c
p
gs
1
2
0
s2
.bl
0
o
bo
4
5
NPV
Advantages
1.
A project with a positive NPV increases the wealth of the companys, thus
maximise the shareholders wealth.
2.
Takes into account the time value of money and therefore the opportunity
cost of capital.
3.
Discount rate can be adjusted to take account of different level of risk

inherent in different projects.
4.
Unlike the payback period, the NPV takes into account events throughout the
life of the project.
5.
Superior to the internal rate of return because it does not suffer the problem
of multiple rates of return.
33
6.
Better than accounting rate of return because it focuses on cash flows rather
than profit.
7.
NPV technique can be combined with sensitivity analysis to quantify the risk
of the projects result.
8.
It can be used to determine the optimum policy for asset replacement.
Disadvantages
1.
NPV assumes that firms pursue an objective of maximising the wealth of their
shareholders.
2.
Determination of the correct discount rate can be difficult.
3.
Non-financial managers may have difficulty understanding the concept.
4.
The speed of repayment of the original investment is not highlighted.
5.
The cash flow figures are estimates and may turn out to be incorrect.
6.
NPV assumes cash flows occur at the beginning or end of the year, and is not
a technique that is easily used when complicated, mid-period cash flows are
present.
Internal rate of return (IRR)
p
gs
The rate of return at which the NPV equals zero.
o
t.c
Decision criteria
0
s2
.bl
0
If the IRR is greater than the cost of capital accept the project.
Example 5
k
oo Ltd
Carragher
eb
A project costing $1000 will return $1,160 in the following year.

Required:
What will be the NPV at 10% and 20% discount rates?
34
Illustration
NPV
rate of
return
o
t.c
Linear interpolation
p
gs
.bl
0
We must attempt to guess the IRR by linear interpolation. This uses the following
formula.
0
s2
k
oo
eb
Interpolated IRR
NL
L+
N - N (H - L)
H
L
Where:
L
Lower discount rate
Higher discount rate
NL
NPV at lower discount rate
NH
NPV at higher discount rate
Advantages
1.
Like the NPV method, IRR recognises the time value of money.
2.
It is based on cash flows, not accounting profits.
3.
More easily understood than NPV by non-accountant being a percentage

return on investment.
4.
For accept/ reject decisions on individual projects, the IRR method will reach
the same decision as the NPV method.
35
Disadvantages
1.
Does not indicate the size of the investment, thus the risk involve in the
investment.
2.
Assumes that earnings throughout the period of the investment are reinvested at the same rate of return.
3.
It can give conflicting signals with mutually exclusive project.
4.
If a project has irregular cash flows there is more than one IRR for that
project (multiple IRRs).
5.
Is confused with accounting rate of return.
NPV and IRR compared

Single investment decision
A single project will be accepted if it has a positive NPV at the required rate of
return. If it has a positive NPV then, it will have an IRR that is greater than the
required rate of return.
Mutually exclusive projects
o
t.c
p
gs
Two projects are mutually exclusive if only one of the projects can be undertaken.
In this circumstance the NPV and IRR may give conflicting recommendation.
.bl
0
The reasons for the differences in ranking are:

1.
2.
0
s2
NPV is an absolute measure but the IRR is a relative measure of a projects

viability.
k
oo The two methods are sometimes said to be based
Reinvestment assumption.
eb about the rate at which funds generated by the
on different assumptions
project are reinvested. NPV assumes reinvestment at the companys cost of
capital, IRR assumes reinvestment at the IRR.
Annuities
An annuity is a series of equal cash flows.
Example 6
Agger Ltd
A project costing $2,000 has returns expected to be $1,000 each year for 3 years
at a discount rate of 10%.
Required:
(a)
NPV using existing analysis.
(b)
NPV using annuity tables
(c)
Solely considering the annuity, what if the cash flows commenced in:
1.
2.
Year 6,
3.
36
Year 4,
Year 0?
Perpetuities
A form of annuity that arises forever (in perpetuity).
In this situation the
calculation of the present value of the future cash flows is very straightforward.
The is of particular importance when considering cost of capital later.
Present value of the perpetuity
Example 7
Cash flow per annum

Interest rate
Riise Ltd
A company expects to receive $1,000 each year in perpetuity. The current discount
rate is 9%.
Required:
1.
What is the present value of the perpetuity?
2.
What is the value if the perpetuity starts in 5 years?
o
t.c
p
gs
0
s2
.bl
0
o
bo
37
o
t.c
p
gs
0
s2
.bl
0
o
bo
38
Chapter 3
Advanced discounted
cash flow techniques
o
t.c
.bl
0
SYLLABUS CONTENT
Inflation
Tax
Capital rationing
Risk
Asset replacement
0
s2
Relevant cost analysis
p
gs
Lease or buy decision.
o
bo
39
C H A P T E R 3 A D V A N C E D D IS C O U N T E D C A S H F L O W T E C H N IQ U E S
Lease vs
buy
Inflation
Risk
Asset
replacement
Applications
Capital
rationing
Taxation
o
t.c
p
gs
0
s2
.bl
0
o
bo
40
CHAPTER CONTENTS
DECISION MAKING THEORY -------------------------------------------- 42
RELEVANT COST
42
INFLATION AND D.C.F. -------------------------------------------------- 43

THE FISHER EFFECT
43
TAXATION AND D.C.F. --------------------------------------------------- 46

KEY PRO FORMA (THE BIG 5)
46
WRITING DOWN ALLOWANCES
47
ASSET REPLACEMENT --------------------------------------------------- 50

EQUIVALENT ANNUAL COST (EAC)
51
CAPITAL RATIONING ---------------------------------------------------- 52

HARD CAPITAL RATIONING
SOFT CAPITAL RATIONING
s
log
SINGLE PERIOD CAPITAL RATIONING

MULTI-PERIOD CAPITAL RATIONING
0
s2
0.b
t.
po
om
52
52
52
54
RISK----------------------------------------------------------------------- 56
EXPECTED VALUES
o
bo
SENSITIVITY ANALYSIS
56
57
ADJUSTED DISCOUNT RATES
59
PAYBACK
59
LEASE OR BUY DECISION
60
41
DECISION MAKING THEORY

Investment appraisal is a form of decision making. As such, it uses decision
making theory. The decision is based on relevant costs.
Relevant cost
A relevant cost has 3 criteria that must be fulfilled:
1.
It must arise in the future
2.
It must be a cash flow
3.
It must arise as a direct consequence of the decision.
Examples
Relevant costs
1.
Opportunity cost
2.
Variable cost
3.
Incremental cost.
o
t.c
Non-relevant costs
p
gs
1.
Sunk costs
2.
Committed costs
3.
.bl
0
Overhead absorbed arbitrarily
4.
42
0
s2
k
oo
Non cash flows (e.g.b
e depreciation).
INFLATION AND D.C.F.

There two ways of dealing with inflation:
1.
Include inflation by inflating up the cash flows year on year.
2.
Exclude inflation (and take the cash flows in year 0 terms).
Include inflation
(money analysis)
Exclude inflation
(real analysis)
Inflate cash flows by the inflation rates

given
Leave cash flows in year 0 terms
and
and
Use a money rate of return
Use a real rate of return
Exam tip
Exam tip
Must use where there is more than one

inflation rate in the question
Can use where a single inflation rate is

given for an easier computation
o
t.c
p
gs
.bl
0
The Fisher effect
0
s2
The relationship between real and money interest is given below (also see tables)
o
bo
(1 + m) =
(1 + r) (1 + i)
or
(1 + m)
(1 + r)
=
(1 + i)
Where
r
real discount rate
money discount rate
inflation rate
Example 1
r = 8%
i = 5%
Required:
What is the money rate of interest?
43
Example 2
m = 10.6%
i = 5%
Required:
What is the real rate of return?
Example 3
A company has invested $50,000 in a project. The project generates net cash
inflows of $14,000 each year for 5 years in year 0 terms. The rate of return is 12%
and inflation is expected to be 3.6%
Required:
Calculate the NPV using both the money and real analyses.
m
co required on an
Explain how inflation affects the rate oft.return
o
investment project, and the distinction between a real and a nominal
sp
(or money terms) approach to the evaluation of an investment
log
project under inflation.
(4 marks)
.b
00
Howden plc is contemplating investment in an additional production line to
0
s2
produce its range of compact discs. A market research study, undertaken by
k
a well-known firm of oo
consultants, has revealed scope to sell an additional
output of 400,000 b
e units per annum. The study cost $100,000 but the
Example 4
(a)
(b)
Howden (exam standard question)
account has not yet been settled.
The price and cost structure of a typical disc (net of royalties) is as follows.
$
Price per unit
Costs per unit of output
Material cost per unit
Direct labour cost per unit
Variable overhead cost per unit
Fixed overhead cost per unit
1.50
0.50
0.50
1.50
____
4.00
____
8.00
====
Profit
44
$
12.00
The fixed overhead represents an apportionment of central administrative and

marketing costs. These are expected to rise in total by $500,000 per annum
as a result of undertaking this project. The production line is expected to
operate for five years and to require a total cash outlay of $11 million,
including $0.5 million of materials stocks. The equipment will have a residual
value of $2 million. The working capital balance will remain constant after
allowing for inflation of materials. The production line will be accommodated
in a presently empty building for which an offer of $2 million has recently
been received from another company. If the building is retained, it is
expected that property price inflation will increase its value to $3 million after
five years.
While the precise rates of price and cost inflation are uncertain, economists in
Howdens corporate planning department make the following forecasts for the
average annual rates of inflation relevant to the project (per annum).
Retail Price Index
Disc prices
Material prices
Direct labour wage rates
Variable overhead costs
Other overhead costs
6
5
3
7
7
5
per
per
per
per
per
per
cent
cent
cent
cent
cent
cent
o
t.c
Note. You may ignore taxes and capital allowances in this question.
Required:
p
gs
.bl
0
Given that Howdens shareholders require a real return of 8.5 per

cent for projects of this degree of risk, assess the financial viability of
this proposal.
(10 marks)
(c)
0
s2
o
bo
Briefly discuss how inflation may complicate the analysis of business

financial decisions.
(6 marks)
(20 marks)
45
TAXATION AND D.C.F.

There are three additional considerations associated with including taxation:
Good Any investment in a capital asset will give rise to a capital allowance. The
capital allowance will lead to a reduction in the amount of tax subsequently paid
CASH INFLOW
Bad We would expect the investment to generate additional profits, these in

turn would lead to additional tax payable CASH OUTFLOW
Ugly Sometimes the examiner may delay all cash flow associated with taxation
by one year, this is done to reflect the delays between tax arising and being paid.
Take care and read the question carefully.
Key Pro forma (THE BIG 5)
1. Net trading revenue The inflows and outflows from trading
o
t.c
2. Tax payable - The net trading revenue tax rate
p
gs
.bl
0
3. Tax allowance separate working for the capital allowances
0
s2
o
bo
4. Investment
e
5. Residual value
46
Writing down allowances

The tax allowance methodology can be whatever the examiner wants. There is a
single technique that we must learn in detail, any alternative technique will be
simpler and will have to be explained fully be the examiner. The allowance we must
learn is based on the reducing balance method of depreciation at 25%.
Example 5
An asset is bought on the first day of the year for $20,000 and will be used for four
years after which it will be disposed of (on the final day of year 4) for $5,000. Tax
is payable at 30% one year in arrears.
Required:
Calculate the writing down allowance and hence the tax savings for each
year.
Cash flow
o
t.c
Year 0
0
s2
.bl
0
p
gs
o
bo
Tax
47
Year
Allowance
Tax saving
Timing
1 Investment
W.D.A.
2
W.D.V.
W.D.A.
W.D.V.
W.D.A.
W.D.V
Proceeds
BA/BC
o
t.c
Example 6
p
gs
.bl
0
Continuing from the previous example. We are further told that net cash from
trading is $8,000 per annum from trading. The cost of capital is 10%.
0
s2
ok
ovalue (NPV).
Calculate the net present
eb
Required:
48
Example 7
Blackwater (exam standard question: extract)
Blackwater plc, a manufacturer of speciality chemicals, has been reported to the

anti-pollution authorities on several occasions in recent years, and fined
substantial amounts for making excessive toxic discharges into local rivers. Both
the environmental lobby and Blackwaters shareholders demand that it clean up its
operations.
It is estimated that the total fines it may incur over the next four years can be
summarised by the following probability distribution (all figures are expressed in
present values).
Level of fine
$0.5m
$1.4m
$2.0m
Probability
0.3
0.5
0.2
Filta & Strayne Limited (FSL), a firm of environmental consultants, has advised
that new equipment costing $1 million can be installed to virtually eliminate illegal
discharges. Unlike fines, expenditure on pollution control equipment is taxallowable via a 25 per cent writing-down allowance (reducing balance). The rate
of corporate tax is 33 per cent, paid with a one-year delay. The equipment will
have no resale value after its expected four-year working life, but can be in full
working order immediately after Blackwaters next financial year.
o
t.c
p
gs
A European Union Common Pollution Policy grant of 25 per cent of gross

expenditure is available, but with payment delayed by a year. Immediately on
receipt of the grant from the EU, Blackwater will pay 20 per cent of the grant to
FSL as commission. These transactions have no tax implications for Blackwater.
.bl
0
0
20 is that it will raise production costs by $30
s
A disadvantage of the new equipment
ok Current production is 10,000 tonnes per annum,
per tonne over its operating life.
o
eb
but is expected to grow by 5 per cent per annum compound. It can be assumed
that other production costs and product price are constant over the next four
years. No change in working capital is envisaged.
Blackwater applies a discount rate of 12 per cent after all taxes to investment
projects of this nature. All cash inflows and outflows occur at year ends.
Required:
(a)
Calculate the expected net present value of the investment assuming

a four-year operating period. Briefly comment on your results.
(12 marks)
49
ASSET REPLACEMENT
The decision how to replace an asset. The asset will be replaced but we aim to
adopt the most cost effective replacement strategy. The key in all questions of this
type is the lifecycle of the asset in years.
Key ideas/assumptions:
1.
Cash inflows from trading (revenues) are not normally considered in this type
of question. The assumption being that they will be similar regardless of the
replacement decision.
2.
The operating efficiency of machines will be similar with differing machines or

with machines of differing ages.
3.
The assets will be replaced in perpetuity or at least into the foreseeable

future.
Example 8
A company is considering the replacement of an asset with the following two

machines:
p
gs
Machine
P
$000s
60
3 years
10 p.a.
INVESTMENT COST
Life
Running costs
o
.bl
0
20
k
oo
eb
Residual value
o
t.c
H
$000s
30
2 years
Yr 1: 20
Yr 2: 15
nil
Required:
Determine which machine should be bought using a NPV analysis at a cost
of capital of 10%.
Answer pro forma

Year
Present value
Cash flow
H
$000s
30
Discount factor
P
$000s
60
P
$000s
10
20
0.909
10
15
0.826
H
$000s
1.000
0.751
NPV =
50
Equivalent annual cost (EAC)

After calculating the NPV in the normal way we are then able to calculate some
measure of equal cost for each year by using the following calculation:
Equivalent annual cost =
NPV of Asset
Annuity factor
P
($000s)
H
($000s)
Net present value

Annuity factor
EAC
o
t.c
p
gs
0
s2
.bl
0
o
bo
51
CAPITAL RATIONING
A limit on the level of funding available to a business, there are two types:
Hard capital rationing

Externally imposed by banks.
Due to:
1.
Wider economic factors (e.g. a credit crunch)
2.
Company specific factors

(a)
Lack of asset security
(b)
No track record
(c)
Poor management team.
Soft capital rationing

Internally imposed by senior management.
o
t.c
Issue: Contrary to the rational aim of a business which is to maximise shareholders

wealth (i.e. to take all projects with a positive NPV)
Reasons:
p
gs
.bl
0
1.
Lack of management skill
2.
Wish to concentrate on relatively few projects
3.
Unwillingness to take on external funds
4.
Only a willingness to concentrate on strongly profitable projects.
0
s2
o
bo
Single period capital rationing

There is a shortage of funds in the present period which will not arise in following
periods. Note that the rationing in this situation is very similar to the limiting factor
decision that we know from decision making. In that situation we maximise the
contribution per unit of limiting factor.
Example 9
The funds available for investment are $200,000. All investments must be started
now (Yr 0):
Project
Initial investment (Yr 0)
NPV
$000s
$000s
A
100
25
B
200
35
C
80
21
D
75
10
Required:
Which project(s) should we invest in to maximise the return to the
business?
52
Scenario 1: divisibility
ie each project can be taken in part and the returns (NPV) will be proportionate to
the amount of investment.
Key working: Profitability index (P.I.)
P.I. =
Project
NPV/Investment
Working
P.I.
Ranking
A
B
C
o
t.c
p
gs
Funds available
0
s2
.bl
0
Projects undertaken
NPV earned
o
bo
Scenario 2: non-divisible projects

The projects are taken as a whole or not at all
Key
We identify all possible mixes and establish which mix generates the maximum
NPV.
Example 9
Required:
Which project(s) should we invest in to maximise the return to the
business given the projects are now non-divisible?
53
Scenario 3: divisibility and mutual exclusivity

ie Where again we can take any part of a project and the return is proportionate to
the investment and the taking of one project precludes the taking of another.
Key
There are three possible types of profit maximising mix each of which must be
considered in isolation and then compared with each other. They are that the
investment must include either:
1.
Project A
2.
Project C,
3.
or neither Project.
Example 9
But projects A and C are mutually exclusive.
Required:
What is the optimal mix of projects?
o
t.c
o
sp of funds in more than one
A more complex environment where there is og
l a shortage
period. This makes the analysis more .b
complicated because we have multiple
0
constraints and multiple outputs. Linear programming would have to be employed.
00
2
ks
o
bo
e
Multi-period capital rationing
54
Example 10
Horge Co
Horge Co is reviewing investment proposals that have been submitted by divisional

managers. The investment funds of the company are limited to $800,000 in the
current year. Details of three possible investments, none of which can be delayed,
are given below.
Project 1
An investment of $300,000 in work station assessments. Each assessment would
be on an individual employee basis and would lead to savings in labour costs from
increased efficiency and from reduced absenteeism due to work-related illness.
Savings in labour costs from these assessments in money terms are expected to be
as follows:
Year
Cash flows ($'000)
1
85
2
90
3
95
4
100
5
95
Project 2
An investment of $450,000 in individual workstations for staff that is expected to
reduce administration costs by $140,800 per annum in money terms for the next
five years.
o
t.c
p
gs
Project 3
.bl
0
An investment of $400,000 in new ticket machines. Net cash savings of $120,000

per annum are expected in current price terms and these are expected to increase
by 3.6% per annum due to inflation during the five-year life of the machines.
0
20of 12% and taxation should be ignored.
s
Horge Co has a money cost of capital
ok
o
Required:
eb
(a)
Determine the best way for Horge Co to invest the available funds and
calculate the resultant NPV:
(i)
on the assumption that each of the three projects is divisible;
(ii)
on the assumption that none of the projects are divisible.

(10 marks)
(b)
Explain how the NPV investment appraisal method is applied in

situations where capital is rationed.
(3 marks)
(c)
Discuss the reasons why capital rationing may arise.
(d)
Discuss the meaning of the term 'relevant cash flows' in the context
of investment appraisal, giving examples to illustrate your discussion.
(5 marks)
(7 marks)
(25 marks)
55
RISK
Assessment of risk is particularly important when performing investment appraisal
due to:
1.
Long timescale
2.
Outflow today, inflow in the future
3.
Large size in relation to the size of the company
4.
Strategic nature of the decision.
Techniques available:
1.
Sensitivity analysis
2.
Expected values
3.
Adjusted discount rates
4.
Payback.
Sensitivity Analysis
o
t.c
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).
p
gs
Example 11
0
s2
.bl
0
An investment of $50,000 in year 0 is expected to give rise to inflows of $22,000

for each of years 1 to 3. The discount rate is 10%.
o
bo
The net cash inflow p.a. is made up of fixed cost per annum of $8,000. Selling
price of $10/unit and variable cost of $7/unit. Volume is estimated at 10,000 units.
Required:
(a)
Should we accept or reject the investment based on NPV analysis?
(b)
By how much would the values have to change for the decision to
alter for:
(i)
initial investment;
(ii)
cash inflows (in detail);
(iii) discount factor?
Key working
Sensitivity
Margin
=
56
Net Present Value

Present Value of the
cash flow under
consideration
Expected values
Where there are a range of possible outcomes which can be identified and a
probability distribution can be attached to those values. In this situation then we
may use a variety of techniques to establish some sort of average return. The
measure of average return is then assumed to be the value that we should use.
The expected value is the arithmetic mean of the outcomes as expressed below:
EV = px
Where
P = the probability of an outcome

x = the value of an outcome
Example 12
A new project is being launched. There are four possible outcomes identified with
the investment financial impact (NPV) is given in $m. The management team
attached the best estimate of probability to the outcomes:
Outcome
Profit/Loss
(x)
Strong success
$10m
om
$25m
Reasonable success
Probability
(p)
Weak success
Failure
$3m
log
.b
t.c
o0.10
p
0
20
k
oo
($20m)
eb
Working
(px)
0.25
0.35
0.30
Required:
(a)
What is the expected value of the project?
(b)
Suggest flaws with the analysis
57
Example 13
Monica (exam standard question)
Monica plc, a manufacturer of building products, mainly supplies the wholesale

trade. It has recently suffered falling demand due to economic recession, and
thus has spare capacity. It now perceives an opportunity to produce designer
ceramic tiles for the home improvement market. It has already paid $0.5 million
for development expenditure, market research and a feasibility study.
The initial analysis reveals scope for selling 150,000 boxes per annum over a fiveyear period at a price of $20 per box. Estimated operating costs, largely based on
experience, are as follows.
Cost per box of tiles (at todays prices):
$
8.00
2.00
1.50
1.50
2.00
Materials cost
Direct labour
Variable overhead
Fixed overhead (allocated)
Distribution, etc
Production can take place in existing facilities although initial re-design and set-up
costs would be $2 million after allowing for all relevant tax reliefs. Returns from
the project would be taxed at 33 per cent.
o
t.c
p
gs
Monicas shareholders require a nominal return of 14 per cent per annum after
tax, which includes allowance for generally expected inflation of 5.5 per cent per
annum. It can be assumed that all operating cash flows occur at year ends.
0
s2
Required:
(a)
.bl
0
o
bo
Assess the financial desirability of this venture in real terms, finding

both the net present value and the internal rate of return (to the
nearest 1 per cent) offered by the project.
(7 marks)
Note. Assume no tax delay.

(b)
Briefly explain the purpose of sensitivity analysis in relation to

project appraisal, indicating the drawbacks with this procedure.
(6 marks)
(c)
Determine the values of:

(i)
price
(ii)
volume
at which the projects NPV becomes zero.

Discuss your results, suggesting appropriate management action.
(7 marks)
(20 marks)
58
Adjusted discount rates

The discount rate we have assumed so far is that reflecting the cost of capital of the
business. In simple terms this means that the rate reflects either the cost of
borrowing funds in the form of a loan rate or it may reflect the underlying return of
the business (i.e. the return required by the shareholder), or a mix of both.
An individual investment or project may be perceived to be more risky than existing
investments. In this situation the increased risk could be used as a reason to
adjust the discount rate up to reflect the additional risk.
Payback
As discussed earlier in the notes payback gives a simple measure of risk.
shorter the payback period, the lower the risk.
The
o
t.c
p
gs
0
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.bl
0
o
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59
LEASE OR BUY DECISION

A specific decision that compares two specific financing options, the use of a finance
lease or buying outright financing via a bank loan.
Key information
1.
Discount rate = post tax cost of borrowing

The rate is given by the rate on the bank loan in the question, if it is pre-tax
then the rate must be adjusted for tax. If the loan rate was 10% pre-tax and
corporation tax is 30% then the post -tax rate would be 7%. (10% x (1 0.3)
2.
Cash flows
Bank loan
Finance Lease
1/ Cost of the investment
1/ Lease rental
- in advance
- annuity
2/ WDA tax relief on investment

3/ Residual value
2/ Tax relief on rental
o
t.c
Example 14
p
gs
.bl
0
Smicer plc is considering how to finance a new project that has been accepted by
its investment appraisal process.
00
2the company can either arrange a bank loan at
For the four year life of the project
s
an interest rate of 15% before corporation tax relief. The loan is for $100,000 and
ok
bo
would be taken out immediately prior to the year end. The residual value of the
ethe end of the fourth year.
equipment is $10,000 at
An alternative would be to lease the asset over four years at a rental of $30,000
per annum payable in advance.
Tax is payable at 33% one year in arrears. Capital allowances are available at 25%
on the written down value of the asset.
Required:
Should the company lease or buy the equipment?
Other considerations
1.
Who receives the residual value in the lease agreement? It is possible that
the residual value may be received wholly by the lessor or almost completely
by the lessee.
2.
There may be restrictions associated with the taking on of leased equipment.

The agreements tend to be much more restrictive than bank loans.
3.
Are there any additional benefits associated with lease agreement? Many
lease agreements will include within the payments some measure of
maintenance or other support services.
60
Chapter 4
Long term sources of

finance
o
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p
gs
0
s2
.bl
0
o
bo
61
CHAPTER 4 LONG TERM SOURCES OF FINANCE
LONG-TERM
SOURCES OF
FINANCE
Equity
(shares)
Preference shares
Debto
.bl
(loans)
00
20
s
ok
Traded securities
Debentures
Unsecured loans
Sale and
leaseback
Warrants
Convertibles
Bank loans
Mezzanine finance
eb
62
o
t.c
p
gs
Ordinary shares
Other
sources
Islamic
finance
CHAPTER CONTENTS
EQUITY ------------------------------------------------------------------- 64
ORDINARY SHARES
64
PREFERENCE SHARES
64
DEBT ---------------------------------------------------------------------- 65
SECURITY
65
TYPES OF DEBT
65
TYPES OF ISSUED DEBT
66
OTHER SOURCES --------------------------------------------------------- 67

ISLAMIC FINANCE ------------------------------------------------------- 68
WHAT IS ISLAMIC FINANCE?
68
o
t.c
p
gs
0
s2
.bl
0
o
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63
EQUITY
Equity relates to the ownership rights in a business.
Ordinary shares
1.
Owning a share confers part ownership.
2.
High risk investments offering higher returns.
3.
Permanent financing.
4.
Post-tax appropriation of profit, not tax efficient.
5.
Marketable if listed.
Advantages
1.
No fixed charges (e.g. interest payments).
2.
No repayment required.
3.
Carries a higher return than loan finance.
4.
Shares in listed companies can be easily disposed of at a fair value.
Disadvantages
1.
2.
3.
4.
o
t.c
p
gs
.bl
0
Issuing equity finance can be expensive in the case of a public issue 9see
later).
0
20 if new shares issued.
s
Problem of dilution of ownership
ok
Dividends are not tax-deductible.
bo
eof equity can increase the overall cost of capital for the
A high proportion
company.
5.
Shares in unlisted companies are difficult to value and sell.
Preference shares
1.
Fixed dividend
2.
Paid in preference to (before) ordinary shares.
3.
Not very popular, it is the worst of both worlds, ie
64
not tax efficient

no opportunity for capital gain (fixed return).
DEBT
The loan of funds to a business without any ownership rights.
1.
Paid out as an expense of the business (pre-tax).
2.
Risk of default if interest and principal payments are not met.
Security
Charges
The debtholder will normally require some form of security against which the funds
are advanced. This means that in the event of default the lender will be able to
take assets in exchange of the amounts owing.
Covenants
A further means of limiting the risk to the lender is to restrict the actions of the
directors through the means of covenants. These are specific requirements or
limitations laid down as a condition of taking on debt financing. They may include:
1.
Financial ratios
3.
Financial reports
4.
Dividend restrictions
2.
o
t.c
Issue of further debt.
p
gs
0
s2
.bl
0
o
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Types of debt
Debt may be raised from two general sources, banks or investors.
Bank finance
For companies that are unlisted and for many listed companies the first port of call
for borrowing money would be the banks. These could be the high street banks or
more likely for larger companies the large number of merchant banks concentrating
on securitised lending.
This is a confidential agreement that is by negotiation between both parties.
Traded investments
Debt instruments sold by the company, through a broker, to investors.
features may include:
Typical
1.
The debt is denominated in units of $100, this is called the nominal or par
value and is the value at which the debt is subsequently redeemed.
2.
Interest is paid at a fixed rate on the nominal or par value.
3.
The debt has a lower risk than ordinary shares. It is protected by the charges
and covenants.
65
Types of issued debt

They include:
Debentures
Debt secured with a charge against assets (either fixed or floating), low risk debt
offering the lowest return of commercially issued debt.
Unsecured loans
No security meaning the debt is more risky requiring a higher return.
Mezzanine finance
High risk finance raised by companies with limited or no track record and for which
no other source of debt finance is available. A typical use is to fund a management
buy-out.
o
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gs
0
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0
o
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66
OTHER SOURCES
Sale and Leaseback
1.
Selling good quality fixed assets such as high street buildings and leasing
them back over many (25+) years.
2.
Funds are released without any loss of use of assets.
3.
Any potential capital gain on assets is forgone.
Grants
1.
Often related to regional assistance, job creation or for high tech companies.
2.
Important to small and medium sized businesses (ie unlisted).
3.
They do not need to be paid back.
4.
Remember the EU is a major provider of loans.
Retained earnings
o
t.c
The single most important source of finance, for most businesses the use of
retained earnings is the core basis of their funding.
p
gs
Warrants
.bl
0
1.
An option to buy shares at a specified point in the future for a specified

(exercise) price.
2.
The warrant offers a potential capital gain where the share price may rise
above the exercise price.
3.
The holder has the option to buy the share.

determined date.
4.
The warrant has many uses including:
0
s2
o
bo
additional consideration when issuing debt.
On a future date at a pre-
incentives to staff.
Convertible loan stock

A debt instrument that may, at the option of the debtholder, be converted into
shares. The terms are determined when the debt is issued and lay down the rate of
conversion (debt: shares) and the date or range of dates at which conversion can
take place.
The convertible is offered to encourage investors to take up the debt instrument.
The conversion offers a possible capital gain (value of shares value of debt).
67
ISLAMIC FINANCE
What is Islamic finance?
A form of finance that specifically follows the teachings of the Quran.
The teachings of the Quran are the basis of Islamic Law or Sharia. Sharia Law is
however not codified and as such the application of both Sharia Law and, by
implication, Islamic Finance is open to more than one interpretation.
Prohibited activities
In Shariah Law there are some activities that are not allowed and as such must not
be provided by an Islamic financial institution, these include:
1.
Gambling (Maisir)
2.
Uncertainty in contracts (Gharar)
3.
Prohibited activities (Haram)
o
t.c
Riba
Interest in normal financing relates to the monetary unit and is based on the
principle of time value of money. Sharia Law does not allow for the earning of
interest on money. It considers the charging of interest to be usury or the
compensation without due consideration. This is called Riba and underpins
all aspects of Islamic financing.
p
gs
0
s2
.bl
0
o
bo
Instead of interest a return may be charged against the underlying asset or

investment to which the finance is related. This is in the form of a
premium being paid for a deferred payment when compared to the
existing value.
There is a specific link between the charging of interest and the risk and
earnings of the underlying assets. Another way of describing it is as the
sharing of profits arising from an asset between lender and user of the
asset.
Forms of Sharia compliant finance

There are some specific types of finance that are deemed compliant and allow
Islamic finance to offer similar financial products to those offered in normal
financing, these include:
Murabaha trade credit
Ijara lease finance
Mudaraba equity finance
Sukuk debt finance
Musharaka venture capital
68
Chapter 5
Cost of capital
o
t.c
p
gs
0
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.bl
0
o
bo
69
CHAPTER 5 COST OF CAPITAL
WACC
Cost of equity (Ke)
Cost of debt (Kd)
1. DVM
2. CAPM
1. Loan notes
2. Bank debt
3. Preference
shares
o
t.c
p
gs
0
s2
.bl
0
o
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70
CHAPTER CONTENTS
BASICS OF COST OF CAPITAL ------------------------------------------ 72
RISK-FREE RETURN
72
COST OF EQUITY
73
THE CAPITAL ASSET PRICING MODEL (CAPM) ----------------------- 76

PORTFOLIO THEORY
76
CAPITAL ASSET PRICING MODEL
76
KD THE COST OF DEBT ------------------------------------------------- 80

WACC WEIGHTED AVERAGE COST OF CAPITAL -------------------- 84
o
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0
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0
o
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71
BASICS OF COST OF CAPITAL

A fundamental calculation for all companies is to establish its financing costs, both
individually for each component of finance and in total terms. These will be of use
both in terms of assessing the financing of the business and as a cost of capital for
use in investment appraisal.
Risk and return

The relationship between risk and return is easy to see, the higher the risk, the
higher the required to cover that risk. Importantly this helps as a starting point to
the calculation of a cost of capital.
Overall return
A combination of two elements determine the return required by an investor for a
given financial instrument.
1.
Risk-free return The level of return expected of an investment with zero

risk to the investor.
2.
Risk premium the amount of return required above and beyond the riskfree rate for an investor to be willing to invest in the company
o
t.c
p
gs
Risk-free return
o
.bl the return offered by short-dated
0
The risk-free rate is normally equated to
00
government bonds or treasury bills. The government is not expected (we would
2
hope!) to default on either interest payments or capital repayments.
ks
o
The risk-free rate is determined by the market reflecting prevailing interest and
bo
e
inflation rates and market conditions.
Degree of risk
Risk free
return
High risk
investments
Secured
Loan Notes
Government
Debt
72
Mezzanine
Finance
Unsecured
Loan Notes
Ordinary
Shares
Cost of equity
The rate of return required by a shareholder. This may be calculated in one of two
ways:
1.
Dividend Valuation Model (DVM).
2.
Capital Asset Pricing Model (CAPM).
Dividend valuation model

The valuation of the share in terms of the cash returns of dividends into the future.
The cash inflow is normally an perpetuity to reflect the permanent nature of the
share capital.
Perpetuity formula
PV of a perpetuity =
Cash inflow p.a.

Rate of return
Introducing terminology
Share price =
P0
where
Dividend p.a.
Cost of Equity
d
=
Ke
o
t.c
p
gs
0
s2
.bl
0
Ke
cost of equity
is a constant dividend p.a.
P0
k
oo market price of the share
the b
e ex-div
We can rearrange the formula to get the one below:

The dividend valuation model with constant dividends
Ke =
d
P0
Example 1
The ordinary shares of Kewell Ltd are quoted at $5 per share ex div. A dividend of
40p per share has just been paid and there is expected to be no growth in
dividends.
Required:
What is the cost of equity?
73
Example 2
The ordinary shares of Gerrard Ltd are quoted at $2 per share. A dividend of 15p is
about to be paid. There is expected to be no growth in dividends.
Required:
Introducing growth
The dividend valuation model with constant growth
Ke =
d1
+g
P0
where g
d1
d0
=
=
=
Ke =
or
d0 (1 + g)
+g
P0
LEARN THIS
a constant rate of growth in dividends

dividend to be paid in one years time
current dividend
Example 3
o
t.c
Alonso Ltd has a share price of $4.00 ex-div and has recently paid out a dividend
20p. Dividends are expected to growth at an annual rate of 5%
Required:
p
gs
0
s2
.bl
0
k
oo
There are 2 main methods of determining growth:
eb
Estimating Growth
THE AVERAGING METHOD
g =
do
- 1
dn
where
do
current dividend
dn
dividend n years ago
Example 4
Sissoko Ltd paid a dividend of 20p per share 4 years ago, and the current dividend
is 33p. The current share price is $6 ex div.
Required:
(a)
Estimate the rate of growth in dividends.
(b)
Calculate the cost of equity.
Example 5
Mascherano Ltd paid a dividend of 6p per share 8 years ago, and the current
dividend is 11p. The current share price is $2.58 ex div.
74
Required:
Calculate the cost of equity.
2
GORDONS GROWTH MODEL

g
where
rb
r
return on reinvested funds
proportion of funds retained
Example 6
The ordinary shares of Torres Ltd are quoted at $5.00 cum div. A dividend of 40p
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 profits after tax as dividends.
Required:
Estimate the cost of equity.
o
t.c
p
gs
0
s2
.bl
0
o
bo
75
THE CAPITAL ASSET PRICING MODEL (CAPM)

A model that values financial instruments by measuring relative risk. The basis of
the CAPM is the adoption of portfolio theory by investors.
Portfolio theory
Risk and Return
The basis of portfolio theory is that an investor may reduce risk with no impact on
return as a result of holding a mix of investments.
Risk of
portfolio
()
Unsystematic
Risk
log
.b
0
00
Capital asset pricing model
2
ks
o
bo
Systematic and non-systematic risk
e
t.
po
om
Systematic
Risk
No. of shares in portfolio
If we start constructing a portfolio with one share and gradually add other shares to
it we will tend to find that the total risk of the portfolio reduces as follows:
Initially substantial reductions in total risk are possible; however, as the portfolio
becomes increasingly diversified, risk reduction slows down and eventually stops.
The risk that can be eliminated by diversification is referred to as unsystematic risk.
This risk is related to factors that affect the returns of individual investments in
unique ways, this may be described as company specific risk.
The risk that cannot be eliminated by diversification is referred to as systematic
risk. To some extent the fortunes of all companies move together with the
economy. This may be described as economy wide risk.
The relevant risk of an individual security is its systematic risk and it is on this basis
that we should judge investments. Non systematic risk can be eliminated and
is of no consequence to the well-diversified investor.
Implications
1.
If an investor wants to avoid risk altogether, he must invest in a portfolio

consisting entirely of risk-free securities such as government debt.
2.
If the investor holds only an undiversified portfolio of shares he will suffer

unsystematic risk as well as systematic risk.
76
3.
If an investor holds a balanced portfolio of all the stocks and shares on the
stock market, he will suffer systematic risk which is the same as the average
systematic risk in the market.
4.
Individual shares will have systematic risk characteristics which are different
to this market average. Their risk will be determined by the industry sector
and gearing (see later). Some shares will be more risky and some less.
(beta) factor
The method adopted by CAPM to measure systematic risk is an index .
factor is the measure of a shares volatility in terms of market risk
The
The factor of the market as a whole is 1. Market risk makes market returns
volatile and the factor is simply a yardstick against which the risk of other
investments can be measured.
The factor is critical to applying the CAPM, it illustrates the relationship of an
individual security to the market as a whole or conversely the market return given
the return on an individual security.
For example, suppose that it has been assessed statistically that the returns on
shares in XYZ plc tend to vary twice as much as returns from the market as a
whole, so that if market returns went up by 6%, XYZs returns would go up by 12%
and if market returns fell by 4% then XYZs returns would fall by 8%, XYZ would be
said to have a factor of 2.
o
t.c
p
gs
The security market line
0
s2
.bl
0
The security market line gives the relationship between systematic risk and return.
We know 2 relationships.
k
oo
The risk-free security
eb
This carries no risk and therefore no systematic risk and therefore has a eta of
zero.
The market portfolio
This represents the ultimate in diversification and therefore contains only

systematic risk. It has a eta of 1.
77
Return
(%age)
Rm
Rf
1.0
Risk ()
From the graph it can be seen that the higher the systematic risk, the higher the
required rate of return.
o
t.c
The SML and the relationship between required return and risk can be shown using
the following formula:
Ke
o
.bl
0
required return from individual security
00
Beta factors2individual security
of
ok of interest
risk-free rate
o
eb on market portfolio
return
Rf + (Rm - Rf)
Ke
Rf
Rm
where
p
gs
Criticisms of the CAPM

1.
CAPM is a single period model, this means that the values calculated are only
valid for a finite period of time and will need to be recalculated or updated at
regular intervals.
2.
CAPM assumes no transaction costs associated with trading securities
3.
Any eta value calculated will be based on historic data which may not be
appropriate currently. This is particularly so if the company has changed the
capital structure of the business or the type of business they are trading in.
4.
The market return may change considerably over short periods of time.
5.
CAPM assumes an efficient investment market where it is possible to diversify

away risk. This is not necessarily the case meaning that some unsystematic
risk may remain.
6.
Additionally the idea that all unsystematic risk is diversified away will not hold
true if stocks change in terms of volatility. As stocks change over time it is
very likely that the portfolio becomes less than optimal.
7.
CAPM assumes all stocks relate to going concerns, this may not be the case.
78
Example 7
Kuyt Ltd
The market return is 15%. Kuyt Ltd has a beta of 1.2 and the risk free return is
8%.
Required:
What is the cost of capital?
Example 8
Crouch plc
The risk-free rate of return is 8%

The market risk premium is 6%
The beta factor for Crouch plc is 0.8
Required:
What would be the expected annual return?
o
t.c
p
gs
0
s2
.bl
0
o
bo
79
KD THE COST OF DEBT

The cost of debt is the rate of return that debt providers require on the funds that
they provide. We would expect this to be lower than the cost of equity.
The value of debt is assumed to be the present value of its future cash flows.
Terminology
1.
Loan notes, bonds and debentures are all types of debt issued by a company.
Gilts and treasury bills are debt issues by a government.
2.
Traded debt is always quoted in $100 nominal units or blocks
3.
Interest paid on the debt is stated as a percentage of nominal value ($100 as

stated). This is known as the coupon rate. It is not the same as the cost of
debt.
4.
Debt can be:

(i)
(ii)
redeemable at par (nominal value)
(iii)
5.
Irredeemable never paid back
or redeemable at a premium or discount (for more or less).
o
t.c
p
gs
Interest can be either fixed or floating (variable). All questions are likely to
give fixed rate debt.
.bl
0
0
20 reason for learning the valuation is that it
Irredeemable debt is very rare. s (The
k
gives a quick way to calculate the cost of debt if the current market value and the
oo the same (see example 14).)
redemption value of theeb are
debt
Kd for irredeemable debt
i(1 - T)
P0
Kd =
where
interest paid
marginal rate of tax
P0
ex interest (similar to ex div) market price of the loan stock.
Example 9
Rafa
The 10% irredeemable loan notes of Rafa plc are quoted at $120 ex int.
Corporation tax is payable at 30%.
Required:
What is the net of tax cost of debt?
80
Kd for redeemable debt

The Kd for redeemable debt is given by the IRR of the relevant cash flows.
relevant cash flows would be:
Year
0
1 to n
n
Cash flow
Market value of the loan note
Annual interest payments
Redemption value of loan
Example 10
The
P0
i(1 - T)
RV
Warnock Ltd
Warnock Ltd has 10% loan notes quoted at $102 ex int redeemable in 5 years time
at par. Corporation tax is paid at 30%.
Required:
What is the net of tax cost of debt?
Technique
o
t.c
1.
7 columns
2.
Identify the cash flows
3.
discount at 5% and 10%
4.
slot values in the IRR formula
3.
discount at 10%
4.
if npv is positive discount at 15%, if negative, discount at 5%
5.
slot values in the IRR formula.
p
gs
0
s2
.bl
0
o
bo
Kd for redeemable debt (when redeemed at current market

value)
We could just use the technique outlined above but if the current market value and
the redemption value are the same instead the irredeemable debt formula can be
used.
Example 11
Rafa
The 10% loan notes of Rafa plc are quoted at $120 ex int. Corporation tax is
payable at 30%. They will be redeemed at a premium of $20 over par in 4 years
time
Required:
What is the net of tax cost of debt
(a)
Using redeemable debt calculation?
(b)
Using irredeemable debt calculation?
81
Convertible debt
A loan note with an option to convert the debt into shares at a future date with a
predetermined price. In this situation the holder of the debt has the option
therefore the redemption value is the greater of either:
1.
The share value on conversion or
2.
The cash redemption value if not converted.
Example 12
Dudek
Dudek has convertible loan notes in issue that may be redeemed at a 10%
premium to par value in 4 years. The coupon is 10% and the current market value
is $95.
Alternatively the loan notes may be converted at that date into 25 ordinary shares.
The current value of the shares is $4 and they are expected to appreciate in value
by 6% per annum
Required:
What is the cost of the redeemable debt?
o
t.c
o
spis not traded. Bank loans and
A substantial proportion of the debt of companies
og
lequal to the coupon rate adjusted for
other non-traded loans have a cost of debt
.b
tax.
00
0
K
=
Interest (Coupon) rate x (1 T)
s2
k
oo
eb
Example 13
Traore
Non-tradeable debt
Traore has a loan from the bank at 12% per annum. Corporation tax is charged at
30%
Required:
What is the cost of debt?
82
Preference shares
A fixed rate charge to the company in the form of a dividend rather than in terms of
interest. Preference shares are normally treated as debt rather than equity but
they are not tax deductible. They can be treated using the dividend valuation
model with no growth
Kp =
d
P0
Example 14
Hamann
Hamanns 9% preference shares ($1) are currently trading at $1.4 ex-div.
Required:
What is the cost of the preference shares?
o
t.c
p
gs
0
s2
.bl
0
o
bo
83
WACC WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital is the average of cost of the companys
finance (equity, loan notes, bank loans, preference shares) weighted according to
the proportion each element bears to the total pool of funds
A companys WACC can be regarded as its opportunity cost of capital/marginal cost
of capital, and this cost of capital can be used to evaluate the companys
investment projects if the following conditions apply:
1.
The project is insignificant relative to the size of the company;
2.
Or the company adopts a pooled funds approach and:

(i)
The company will maintain its existing capital structure in the long run
(i.e. same financial risk);
(ii)
The project has the same degree of systematic (business) risk as the
company has now.
Example 15
Baros plc
Baros plc has 20m ordinary 25p shares quoted at $3, and $8m of loan notes quoted
at $85.
o
t.c
p
gs
The cost of equity has already been calculated at 15% and the cost of debt (net of
tax) is 7.6%
.bl
0
00
2cost of capital.
Calculate the weighted average
s
ok
o
eb
Required:
84
Example 16
Olachika plc
Olachika plc is a listed company with the following financial information.
Income statement information for the last year

$000
6,000
(400)
5,600
(1,650)
3,950
Profit before interest and tax

Interest
Profit before tax
Tax
Profit for the period
Statement of Financial Position (Balance sheet) for

the last year
Non-current assets
Current assets
Total assets
Equity and liabilities
Ordinary shares, par value $1
Retained earnings
Total equity
10% loan notes
9% preference shares, par value $1
Total non-current liabilities
Current liabilities
Total equity and liabilities
s
log
m
co
ot.
.b
0
00
s
ok
$000
$000
17,000
22,000
39,000
4,500
22,000
26,500
4,500
2,000
6,500
6,000
39,000
The current ex div ordinary share price is $5.50 per share. An ordinary dividend of
40 cents per share has just been paid and dividends are expected to increase by
4.5% per year for the foreseeable future.
eb
The current ex div preference share price is 78.9 cents.

The loan notes are secured on the existing non-current assets of Olachika Co and
are redeemable at par in six years time. They have a current ex interest market
price of $102.5 per $100 loan note. Olachika Co pays tax on profits at an annual
rate of 30%.
Required:
(a)
Calculate the current weighted average cost of capital of Olachika

plc.
(9 marks)
85
o
t.c
p
gs
0
s2
.bl
0
o
bo
86
Chapter 6
Capital structure and

risk adjusted WACC
o
t.c
p
gs
0
s2
.bl
0
o
bo
87
CHAPTER 6 CAPITAL STRUCTURE AND RISK ADJUSTED WACC
CHAPTER CONTENTS
CAPITAL STRUCTURE AND THE COST OF CAPITAL ------------------- 89
GEARING THEORIES ----------------------------------------------------- 90
THE TRADITIONAL VIEW OF CAPITAL STRUCTURE
90
MODIGLIANI AND MILLER (M&M) NO TAXES
91
MODIGLIANI AND MILLER WITH TAX
92
PROBLEMS WITH HIGH GEARING
92
PECKING ORDER THEORY
92
CAPM IN PROJECT APPRAISAL ----------------------------------------- 93

CAPM AND FINANCIAL GEARING -------------------------------------- 94
DIFFERING BETA VALUES
94
QUESTION APPROACH
95
o
t.c
p
gs
0
s2
.bl
0
o
bo
88
CAPITAL STRUCTURE AND THE COST OF CAPITAL

Does the capital structure have a bearing on shareholders wealth?
Key relationship
Future cash
flows
Market Value
WACC
Impact of debt financing on the WACC

Two
competing
effects
o
t.c
Reduction in WACC
Increase in WACC
Kd Ke, an increase in debt

funding should lead to a fall in
WACC
Debt finance is cheaper
because:
o
sp introduces financial risk which
Debt
g
0
s2
.bl
0
k
oo
eb
Less risky to investor
increases Ke, should lead to an

increase in WACC
The risk associated with debt
Financing is born by the shareholders
1.
2. Tax efficient
89
GEARING THEORIES
The traditional view of capital structure
Cost of equity
At relatively low levels of gearing the increase in gearing will have relatively low
impact on Ke. As gearing rises the impact will increase Ke at an increasing rate.
Cost of debt
There is no impact on the cost of debt until the level of gearing is prohibitively high.
When this level is reached the cost of debt rises.
Cost of
capital
Ke
o
t.c
p
gs
0
s2
.bl
0
WACC
o
bo
Kd
Gearing (D/E)
Key point
There is an optimal level of gearing at which the WACC is minimized and the value
of the company is maximised
90
Modigliani and Miller (M&M) no taxes

Cost of equity
Ke rises at a constant rate to reflect the level of increase in risk associated with
gearing.
Cost of debt
There is no impact on the cost of debt until the level of gearing is prohibitively high.
The assumptions
M&M in 1958 was based on the premise of a perfect capital market in which:
1.
Perfect capital market exist where individuals and companies can borrow
unlimited amounts at the same rate of interest.
2.
There are no taxes or transaction costs.
3.
Personal borrowing is a perfect substitute for corporate borrowing.
4.
Firms exist with the same business or systematic risk but different level of
gearing.
5.
All projects and cash flows relating thereto are perpetual and any debt
borrowing is also perpetual.
6.
All earnings are paid out as dividend.
7.
Debt is risk free.
o
t.c
Big idea
0
s2
p
gs
.bl
0
o
bo
The increase in Ke directly compensates for the substitution of expensive equity

with cheaper debt. Therefore the WACC is constant regardless of the level of
gearing.
Ke
Cost
of
capital
WACC
Kd
Gearing (D/E)
If the weighted average cost of capital is to remain constant at all levels of gearing
it follows that any benefit from the use of cheaper debt finance must be exactly
offset by the increase in the cost of equity.
91
Modigliani and Miller with tax

In 1963 M&M modified their model to include the impact of tax. Debt in this
circumstance has the added advantage of being paid out pre-tax. The effective
cost of debt will be lower as a result.
Implication
As the level of gearing rises the overall WACC falls.
having the highest level of debt possible.
The company benefits from
Ke
Cost
of
capital
WACC
o
t.c
p
Kd(1-t)
gs
blo
0
00
eb
s
ok
Gearing (D/E)
Problems with high gearing

It is rare to find firms who seek to have very high gearing. This is due to problems
such as:
bankruptcy
tax exhaustion
loss of borrowing capacity
risk attitude of potential investors.
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 is as follows:
1st
retained earnings
2nd
bank debt
92
rd
issue of equity.
CAPM IN PROJECT APPRAISAL

In project appraisal we use a cost of capital for a discount rate. Normally we can
use the WACC providing that risk has not changed.
If project risk differs to the companys risk profile we need another way to calculate
a discount rate.
The CAPM provides a means by which a projects risk can be considered in relation
to market risk.
The assumptions underpinning CAPM must hold:
1.
Rational shareholders
2.
Shareholders are well diversified
3.
The project is an investment in its own right.
Key point
The project is assessed on its ability to earn a return in relation to its own level of
risk.
o
t.c
Advantages over use of WACC
p
gs
1.
Possible to assess all projects providing the level of risk (beta) can be
determined.
2.
By considering only systematic risk we have a better theoretical basis for

setting a discount rate.
.bl
0
0
20
3.
It reflects the position of large companies which are likely to be well.
s
ok
o
eb
Example 1
Toshack plc
Toshack plc is an all equity company and has a cost of capital of 17% p.a. A new
project has arisen with an estimated beta of 1.3. rf = 10% and m = 20%.
r
Required:
(a)
What is the required return of the project?
(b)
What relationship does this have to the cost of capital to the

company?
Example 2
Johnson plc
Johnson plc is an all equity company with a beta of 0.6. It is considering a single
year project which requires an outlay now of $2,000 and will generate cash in one
year with an expected value of $2,500. The project has a beta of 1.3. rf = 10%,
m = 18%.
r
Required:
(a)
What is the Johnsons cost of equity capital?
(b)
What is the required return of the project?
(c)
Is the project worthwhile?
93
CAPM AND FINANCIAL GEARING

So far we have assumed no gearing when calculating the level of risk for a
company. If we introduce debt financing the level of risk will rise and hence the
cost of equity Ke will rise.
Differing beta values
Asset Beta
Financial
Gearing
( asset)
Re-gear
De-gear
Equity beta
o
t.c
( equity) po
s
Debt beta
log
.b
(0debt)
0
s2
o
bo
Equity beta
A measure of risk incorporating both systematic risk and unsystematic risk
Asset beta
A measure solely of systematic risk.
companies in the same industry.
The asset beta will be the same for all
Key formula
asset
94
(ungeared)
equity (geared)
E
E + D (1 - t)
Question approach
1.
Equity beta
Identify a suitable equity beta we need a value from a company in the similar
industry. This beta will probably include gearing risk (if the company has any debt
finance).
2.
De-gear
Use the formula given to strip out the gearing risk to calculate the asset beta for
the project. The asset beta will be the same for all companies/ projects in a similar
industry.
3.
Average asset beta
To calculate a meaningful asset beta it is useful to use a simple average of a

number of proxy asset betas. This way a better assessment of the level of
systematic risk suffered by the industry is calculated.
m
co
t.
Re-work the same formula to add back the unique gearing relating to the project.
po
s
5. Use CAPM
log
.b
Calculate the cost of equity using the CAPM formula.
00
0
s2
k
Example 3
Voronin plc
oo
eb
Voronin plc is a matruska doll manufacturer with a equity:debt ratio of 5:3. The
4.
Re-gear
corporate debt, which is assumed to be risk free, has a gross redemption yield of
10%. The beta value of the companys equity is 1.2. The average return on the
stock market is 16%. The corporation tax rate is 30%.
The company is considering a rag doll manufacturing project. The following three
companies are currently operating in the ragdoll industry.
Company
Equity beta
1.05
1.10
1.18
Debt (%)
30
35
40
Equity (%)
70
65
60
Voronin plc maintains its existing capital structure after the implementation of the
new project.
Required:
What would be a suitable cost of capital to apply to the project?
95
Example 4
Toshack
Toshack, an all equity agro-chemical firm, is about to invest in a diversification in

the consumer pharmaceutical industry. Its current equity beta is 0.8, whilst the
average equity of pharmaceutical firms is 1.3. Gearing in the pharmaceutical
industry averages 40% debt, 60% equity. Corporate debt is considered to be risk
free.
Rm = 14%, Rf = 4%, corporation tax rate = 30%.
Required:
What would be a suitable discount rate for the new investment if Toshack
were to finance the new project in each of the following ways:
(a)
by 30% debt;
(b)
70% equity?
Key Formula (see tables)

asset
(ungeared)
equity (geared)
E
E + D (1 - t)
o
t.c
p
gs
0
s2
.bl
0
o
bo
96
Chapter 7
Ratio analysis
o
t.c
p
gs
0
s2
.bl
0
o
bo
97
C H A P T E R 7 R A T IO A N A L Y S I S
Ratio Analysis
Profitability
Investor
Gearing
Return on capital employed

Return on equity
Asset turnover
Operating profit margin
EPS
PE ratio
Dividend cover
Dividend yield
o
sp
o
t.c
log
.b
0
20
Operating gearing
Financial gearing
Capital gearing measure
Interest cover
k
oo
eb
98
CHAPTER CONTENTS
PROFITABILITY RATIOS ----------------------------------------------- 100
RETURN ON CAPITAL EMPLOYED ROCE
100
RETURN ON EQUITY ROE
100
GEARING ---------------------------------------------------------------- 102

COST
102
RISK FROM THE PERSPECTIVE OF THE COMPANY
102
GEARING TYPES -------------------------------------------------------- 104

1.
OPERATING GEARING
104
2.
FINANCIAL GEARING
104
FINANCIAL GEARING MEASURES ------------------------------------- 105

CAPITAL GEARING
105
o
t.c
DEBT
o
sp
EQUITY
105
105
log
.b
INTEREST COVER ------------------------------------------------------- 107
0
20
STOCK MARKET RATIOS ----------------------------------------------- 111
k
oo
eb
99
PROFITABILITY RATIOS
The underlying aim of a company.
There are two basic measures:
1.
Return on Capital Employed (ROCE).
2.
Return on Equity.
Return on capital employed ROCE

A measure of the underlying performance of the business before finance.
It considers the overall return before financing. It is not affected by gearing.
ROCE
Operating Profit
X
100
Capital employed
Operating profit
o
t.c
p
gs
Also known as PBIT or profit before interest and tax.
.bl
0
0
20 it includes Equity and Long-term Debt.
The total funds invested in the business,
s
ok
bo
Return on equity e
ROE
Capital employed
A measure of return to the shareholders. It is calculated after taxation and before

dividends have been paid out. It will be affected by gearing.
ROE
Profit after tax

X
100
Equity
Key working
$
PBIT
less Interest
PBT
Less Tax
PAT
Less Dividends
Retained Earnings
100
( )
( )
( )
Example 1
Case
A company is considering a number of funding options for a new project. The new
project may be funded by $20m of equity or debt. Below are the financial
statements given the project has been funded in either manner.
Balance sheet extract
Equity Finance
Debt Finance
$m
Creditors
Debentures
(10%)
$m
0.0
22.0
10.0
10.0
42.0
Capital
Share Capital (50p)
Share Premium
Reserves
20.0
14.5
4.5
3.0
22.0
Profit and Loss Account extract

$m
Turnover
Gross Profit
less expenses
(excluding interest)
200.0
40.0
(30.0)
o
t.c
p
gs
Operating Profit
.bl
00
010.0
2
k
oo
Corporation Tax is charged at 30%
Required:
eb
Calculate profitability ratios and compare the financial performance of the

company under both equity and debt funding.
101
GEARING
Should we finance the business using debt or equity?
There are two basic considerations:
1.
Cost.
2.
Risk.
Cost
Any finance will incur servicing costs, debt will require interest payments and equity
will require payment of dividends or at least capital growth. On the basis of cost of
servicing we would always pick debt over equity. Debt should be less expensive for
two reasons:
1.
Tax
Debt is tax deductible because the debt holders are not owners of the business.
Equity however will receive a return after tax because they receive an appropriation
of profits. Debt is therefore tax efficient saving 30(ish)%.
o
t.c
o
sp shareholder. If there is lower
The debt holder is in a less risky position than the
log a lower return. The lower risk
risk then the debt holder should be willing b expect
. to
00
is due to two factors:
0
s2
1.
Fixed coupon A legal obligation to pay interest.
k
oo
2.
Security Charges or covenants against assets.
eb
2.
Risk
Risk from the perspective of the company

Risk may be split into two elements:
1.
Business risk.
2.
Financial risk.
Business risk
Business risk is inherent to the business and relates to the environment in which
the business operates.
1.
Competition
2.
Market
3.
Legislation
4.
Economic conditions.
102
Financial risk
Risk associated with debt financing. If the company is financed using equity, it
carries no financial risk. This is because it has no need to pay shareholders a
return (dividend) in the event of a poor trading year.
If the company finances itself using debt as well as equity then it must generate
sufficient cash flow to pay interest payments as they fall due. The greater the level
of debt, the greater the interest payments falling due and hence the higher the risk
of default. This is financial risk.
o
t.c
p
gs
0
s2
.bl
0
o
bo
103
GEARING TYPES
Gearing is a measure of risk.
There are two measures of gearing:
1. Operating gearing
Risk associated with the level of fixed costs within a business.
The higher the fixed cost, the more volatile the profit. The level of fixed cost is
normally determined by the type of industry and cannot be changed. This is
unlikely to arise in the F9 syllabus since it will be incorporated as part of the
systematic risk of the company/ industry.
2. Financial gearing
Risk associated with debt financing.
The company can decide the level of financial risk it wishes to take on.
o
t.c
Impact
A company can/must accept some level of risk, and is willing to trade additional risk
for additional gain. The effect of risk is cumulative: if a company already has high
operating gearing it will have to be more conservative with its financial gearing.
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FINANCIAL GEARING MEASURES

The mix of debt to equity within a firms permanent capital.
There are two measures:
1.
Capital Gearing a balance sheet measure.
2.
Interest Cover a profit and loss account measure.
Capital gearing
The mix of debt to equity.
Ratio measure (equity gearing)
Gearing
Debt
100
100
Equity
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Proportions measure (total or capital gearing)
Gearing
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Debt
00
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Debt + Equity
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Debt
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All permanent capital charging a fixed interest may be considered debt.

1.
Debentures and loans,
2.
bank overdraft (if significant),
3.
preference share capital.
Equity
1.
Ordinary share capital
2.
share premium
3.
reserves.
105
Example 3
Redknapp Ltd
Balance sheet for Redknapp Ltd
$m
$m
Fixed assets (total)
20.0
Current assets (total)
12.0
Current liabilities
Trade creditors
Bank overdraft
4.0
5.0
9.0
3.0
Long-term liabilities
Debenture 10%
(8.0)
15.0
Capital
Ordinary share capital
Ordinary share premium
Preference share capital
Reserves
8.0
4.0
1.0
2.0
15.0
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Required:
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Calculate the financial gearing of the business using both methods.
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106
INTEREST COVER
An income statement measure that considers the ability of the business to cover
the interest payments as they fall due.
Interest cover
PBIT
Interest
Example 4
Stan the man Collymore Income statement extract
$m
20.0
(4.5)
15.5
(4.65)
10.85
Operating Profit
Interest
Profit Before Tax
Tax @ 30%
Profit After Tax
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Required:
(a)
(b)
Is this level of cover safe?
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Calculate the interest cover.
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Example 5
Newsam exam standard
Newsam plc is a quoted company which produces a range of branded products all
of which are well-established in their respective markets, although overall sales
have grown by an average of only 2 per cent per annum over the past decade.
The board of directors is currently concerned about the companys level of financial
gearing, which although not high by industry standards, is near to breaching the
covenants attaching to its 15 per cent debenture issue, made twelve years ago at
a time of high market interest rates. Issued in order to finance the acquisition of
the premises on which it is secured, the debenture is repayable at par value of
$100 per unit of stock at any time during the period 20X420X7.
There are two covenants attaching to the debenture, which state:
At no time shall the ratio of debt capital to shareholders funds exceed 50 per
cent. The company shall also maintain a prudent level of liquidity, defined as a
current ratio at no time outside the range of the industry average (as published by
the corporate credit analysts, Creditex), plus or minus 20 per cent.
Newsams most recent set of accounts is shown in summarised form below. The
buildings have been depreciated since acquisition at 4 per cent per annum, and
most of the machinery is only two or three years old, having been purchased
mainly via a bank overdraft. The interest rate payable on the bank overdraft is
currently 9 per cent. The finance director argues that Newsam should take
advantage of historically low interest rates on the European money markets by
issuing a medium-term Eurodollar bond at 5 per cent. The dollar is currently
selling at a premium of about 1 per cent on the three-month forward market.
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Newsams ordinary shares currently sell at a P/E ratio of 14, and look unattractive
compared to comparable companies in the sector which exhibit an average P/E
ratio of 18. According to the latest published credit assessment by Creditex, the
average current ratio for the industry is 1.35.
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The debentures currently sell in the market at $15 above par.

The summarised financial accounts for Newsam plc for the year ending 30 June
20X4 are as follows.
Profit and loss account extract for the year ended 30 June 20X4
$m
28.00
______
3.00
(1.00)
______
2.00
(0.66)
______
1.34
(0.70)
______
0.64
Sales
Operating profit
Interest payable
Profit before tax
Taxation
Profit after tax
Dividend
Retained profit
108
Balance sheet as at 30 June 20X4

$m
$m
Fixed assets (net)

Land
Premises
Machinery and vehicles
5.0
4.0
11.0
____
20.0
Current assets
Stocks
Debtors
Cash
2.5
4.0
0.5
____
7.0
____
Current liabilities
Bank overdraft
Creditors
3.0
4.0
____
(7.0)
____
Net current assets
Total assets less current liabilities

Long-term creditors
15% debentures 20X4 20X7
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Capital and reserves

Ordinary shares (25p par value)
Reserves
0.0
____
20.0
(5.0)
____
15.0
====
5.0
10.0
____
15.0
====
Required:
(a)
Calculate appropriate gearing ratios for Newsam plc using:

(i)
book values; and
(ii)
market values.
(3 marks)
(b)
Assess how close Newsam plc is to breaching the debenture

covenants.
(3 marks)
(c)
Discuss whether Newsam plcs gearing is in any sense dangerous.

(4 marks)
(d)
Discuss what financial policies Newsam plc might adopt:

(i)
in order to lower its capital gearing; and
(ii)
to improve its interest cover.
(10 marks)
(20 marks)
109
Example 6
Arwin exam standard
Arwin plans to raise $5m in order to expand its existing chain of retail outlets. It
can raise the finance by issuing 10% loan notes redeemable in 2X15, or by a
rights issue at $4.00 per share. The current financial statements of Arwin are as
follows.
$'000
50,000
30,000
20,000
14,000
6,000
300
5,700
1,710
3,990
2,394
1,596
Income statement for the last year

Sales
Cost of sales
Gross profit
Administration costs
Profit before interest and tax
Interest
Profit before tax
Taxation at 30%
Profit after tax
Dividends
Retained earnings
m
co
ot.
Statement of Financial Position (Balance sheet) extract

Net non-current assets
Net current assets
12% loan notes 2X10
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Ordinary shares, par value 25c

Retained profit
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2
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$'000
20,100
4,960
2,500
22,560
2,500
20,060
22,560
The expansion of business is expected to increase sales revenue by 12% in the

first year. Variable cost of sales makes up 85% of cost of sales. Administration
costs will increase by 5% due to new staff appointments. Arwin has a policy of
paying out 60% of profit after tax as dividends and has no overdraft.
Required:
(a)
For each financing proposal, prepare the forecast income statement

after one additional year of operation.
(5 marks)
(b)
Evaluate and comment on the effects of each financing proposal on

the following:
(i)
Financial gearing;
(ii)
Operational gearing;
(iii) Interest cover;

(iv) Earnings per share.
(c)
(12 marks)
Discuss the dangers to a company of a high level of gearing,

including in your answer an explanation of the following terms:
(i)
Business risk;
(ii)
Financial risk.
(8 marks)
(25 marks)
110
STOCK MARKET RATIOS

Earnings per share (EPS)
EPS
PAT less Preference Dividend
Number of ordinary shares in issue
Example 7
The Sammy Hyypia Company earned profits after tax of $14m and has a preference
dividend of $2m. There are 6 million ordinary shares in circulation.
Required:
What is the EPS?
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Price Earnings Ratio (P/E Ratio)
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The P/E ratio is a measure of future earnings growth, it compares the market value
to the current earnings.
PE Ratio
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0
Current Share Price
0
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EPS
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Total Market Value (MV)

Profit After Tax
eb
Example 8
Danny
Stephan
200 pence
80 pence
10 pence
8 pence
Dividend per share
2 pence
8 pence
Number of shares
2 million
4 million
Share Price
EPS
Required:
Which company is seen to have a better future by the market?
111
Dividend Cover
The relationship between the dividend paid and the funds available to pay the
dividend ie the attributable profit
1.
The industry type
2.
Shareholder expectations
3.
The investment opportunities
4.
Tax
5.
Dividend policy.
Earnings per share
Profit After Tax
Dividend per share
Dividend cover
Total Dividends
Example 8 contd
Required:
What is the dividend cover for each company?
o
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o
.bltheoretically irrelevant because it only
0 is
It
Dividend Yield
The cash return from holding a share.

considers part of the return available to the shareholder (the other part being the
capital gain or increase in share price).
0
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e
=
Dividend per share
Total dividend
Current Share Price
Dividend yield
Total market
Example 8 contd
Required:
Calculate the dividend yield.
112
Chapter 8
Raising equity finance
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C H A P T E R 8 R A IS IN G E Q U I T Y F IN A N C E
CHAPTER CONTENTS
RAISING EQUITY FINANCE -------------------------------------------- 115
UNLISTED COMPANIES
115
STOCK MARKETS CONSIDERATIONS
115
METHODS OF OBTAINING A LISTING
115
EQUITY ISSUES BY QUOTED COMPANIES ---------------------------- 117

RIGHTS ISSUES
117
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RAISING EQUITY FINANCE

Unlisted companies
Equity finance for Small and medium sized enterprises (SMEs) and unquoted
companies include:
1.
Own funds
2.
Retained earnings
3.
Friends and family
4.
Venture Capital
High risk/ high return.
Close relationship between VC and the company being offered finance.
Medium term (57 years).
Exit strategy.
5.
6.
Business Angels
Private placing.
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Stock markets considerationsblo
0
00
The Stock Exchange suggests the following 7 considerations:

1.
2.
Growth
3.
Access
4.
Accountability
6.
Responsibility
7.
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Visibility
5.
Prestige
Regulation.
eb
Methods of obtaining a listing

Fixed price offer for sale
Offered to the general public at a fixed price.
It has the potential to raise the highest possible price for the company by being
offered to the widest possible market.
The problem is the cost associated with floatation which can be prohibitive.
Offer for sale by tender

Investors are able to bid for shares and the shares are issued only to those
investors who have bid at the striking price or above.
115
Placing
Shares are placed with / sold to institutional investors, keeping the cost of the issue
to a minimum.
Stock exchange introduction

Shares are introduced to the exchange without any new shares being issued.
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EQUITY ISSUES BY QUOTED COMPANIES

A listed or quoted company is better able to raise equity finance.
Rights issues
A rights issue is the right of existing shareholders to subscribe to new share issues
in proportion to their existing holdings. This is to protect the ownership rights of
each investor.
Advantages
1.
Low cost
2.
Protect ownership rights
3.
Rarely fail.
Theoretical ex-rights price (TERP)

The new share price after the issue is known as the theoretical ex-rights price and
is calculated by finding the weighted average of the existing market price and the
issue price, weighted by the number of shares ex-rights.
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Theoretical
Ex-rights
Price
Example 1
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0
MV of shares (cum rights) + Proceeds from rights issue
Marcus
0
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Number of shares (ex rights)
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Marcus plc, which has an issued capital of 4,000,000 shares, having a current
market value of $2.80 each, makes a rights issue of one new share for every three
existing shares at a price of $2.0.
Value of a right
The new shares are issued at a discount to the existing market value, this gives the
rights some value.
Value of a right = Ex-rights price - Issue price

Example 1 contd
Required:
Calculate the theoretical ex-rights price.
117
Shareholders options
The shareholders options with a rights issue are to:
1.
Take up (buy) the rights
2.
Sell the rights
3.
A bit of both
4.
Do nothing.
Example 2
A shareholder had 10,000 shares in Marcus plc before the rights offer.
Required:
Calculate the effect on his net wealth of each of the following options:
(a)
Take up the shares,
(b)
Sell the rights,
(c)
Do nothing.
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Example 3
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Tirwen
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0
Tirwen is a medium-sized manufacturing company which is considering a 1 for 5

rights issue at a 15% discount to the current market price of $4.00 per share.
Issue costs are expected to be $220,000 and these costs will be paid out of the
funds raised. It is proposed that the rights issue funds raised will be used to
redeem some of the existing loan stock at par. Financial information relating to
Tirwen is as follows:
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Current statement of financial position (balance sheet)

$'000
Non-current assets
Current assets
Inventory
Receivables
Cash
$'000
6,550
2,000
1,500
300
3,800
10,350
Ordinary shares (par value 50c)

Reserves
12% loan notes 2X12
Current liabilities
Trade payables
Overdraft
2,000
1,500
4,500
1,100
1,250
2,350
10,350
118
Other information:
Price/earnings ratio of Tirwen:
Overdraft interest rate:
Tax rate:
Sector averages:
debt/equity ratio (book value):
interest cover:
15.24
7%
30%
100%
6 times
Required:
(a)
Ignoring issue costs and any use that may be made of the funds
raised by the rights issue, calculate:
(i)
the theoretical ex rights price per share;
(ii)
the value of rights per existing share.
(3 marks)
(b)
What alternative actions are open to the owner of 1,000 shares in

Tirwen as regards the rights issue? Determine the effect of each of
these actions on the wealth of the investor.
(6 marks)
(c)
Calculate the current earnings per share and the revised earnings per
share if the rights issue funds are used to redeem some of the
existing loan notes.
(6 marks)
(d)
Evaluate whether the proposal to redeem some of the loan notes

would increase the wealth of the shareholders of Tirwen. Assume
that the price/earnings ratio of Tirwen remains constant.
(3 marks)
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(e)
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Discuss the reasons why a rights issue could be an attractive source

of finance for Tirwen. Your discussion should include an evaluation
of the effect of the rights issue on the debt/equity ratio and interest
cover.
(7 marks)
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(25 marks)
119
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120
Chapter 9
Working capital
management
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CHAPTER 9 WORKING CAPITAL MANAGEMENT
CHAPTER CONTENTS
THE TREASURY FUNCTION--------------------------------------------- 123
ROLE
123
CENTRALISATION VS. DECENTRALISATION
123
PROFIT CENTRE VS. COST CENTRE
124
SHORT-TERM SOURCES OF FINANCE
125
ASSET SPECIFIC SOURCES OF FINANCE
126
WORKING CAPITAL MANAGEMENT AN OVERVIEW --------------- 127

WORKING CAPITAL SEESAW
127
LEVEL OF WORKING CAPITAL
127
FUNDING THE WORKING CAPITAL REQUIREMENT
128
MEASURES OF WORKING CAPITAL MANAGEMENT ------------------ 129

LIQUIDITY RATIOS
t.
po
om
129
OVERTRADING ---------------------------------------------------------- 131
log
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MANAGING RECEIVABLES --------------------------------------------- 132
0
20
CREDIT MANAGEMENT
132
k
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COST OF FINANCING RECEIVABLES ---------------------------------- 134
eb
DISCOUNTS FOR EARLY PAYMENT
134
FACTORING
135
ANNUALISED COST OF A CASH DISCOUNT
137
MANAGING INVENTORY ----------------------------------------------- 138

MATERIAL COSTS
138
ECONOMIC ORDER QUANTITY
139
BULK PURCHASE DISCOUNTS
140
CASH MANAGEMENT ---------------------------------------------------- 141

THE MILLER-ORR MODEL
THE BAUMOL MODEL
142
CASH BUDGET
122
141
143
THE TREASURY FUNCTION

A function devoted to all aspects of cash within a company.
This includes:
1.
Investment
2.
Raising finance
3.
Banking and exchange
4.
Cash and currency management
5.
Risk
6.
Insurance.
Role
Treasury management is the corporate handling of all financial matters, the
generation of external and internal funds for business. The management of
currencies and cash flows, and complex strategies, policies and procedures of
corporate finance.
The role being summarised under 5 headings:

1.
Corporate objectives
2.
Liquidity management
3.
Investment management
4.
Funding management
5.
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Currency management.
e
Centralisation vs. decentralisation

In a large organisation there is the opportunity to have a single head office treasury
department or to have individual treasury departments in each of the divisions.
Modern practice would suggest the decentralised route where there is little or no
head office intervention in the workings of an autonomous division. This runs
contrary to treasury practice where large companies tend to have a centralised
function.
Advantages of centralisation
1.
Avoid duplication of skills of treasury across each division. A centralised team

will enable the use of specialist employees in each of the roles of the
department.
2.
Borrowing can be made in bulk taking advantage of better terms in the form
of keener interest rates and less onerous conditions.
3.
Pooled investments will similarly take advantage of higher rates of return than
smaller amounts.
4.
Pooling of cash resources will allow cash-rich parts of the company to fund
other parts of the business in need of cash.
5.
Closer management of the foreign currency risk of the business.

123
Advantages of decentralisation
1.
Greater autonomy of action by individual treasury departments to reflect local

requirements and problems.
2.
Closer attention to the importance of cash by each division.
Profit centre vs. cost centre

Should the treasury department be run as a cost centre or a profit centre?
Cost centre A function to which costs are accumulated.

Profit centre A function to which both costs and revenues are accounted for.
Advantages of using a profit centre
1.
The use of the treasury department is given a value which limits the use of
the service by the divisions.
2.
The prices charged by the treasury department measure the relative efficiency
of that internal service and may be compared to external provision.
3.
The treasury department may undertake part of the hedging risk of a trade
thereby saving the company as a whole money.
4.
The department may gain other business if there is surplus capacity within the
department.
5.
Speculative positions may be taken that net substantial returns to the

business.
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Disadvantages of using a profit centre
1.
Additional costs of monitoring. The treasury function is likely to be very

different to the rest of the business and hence require specialist oversight if
run as a profit making venture.
2.
The treasury function is unlikely to be of sufficient size in most companies to

make a profit function viable.
3.
The company may be taking a substantial risk by speculation that it cannot

readily quantify. In the event of a position going wrong the company may be
dragged down as a result of a single transaction.
124
Short-term sources of finance

Factoring
The outsourcing of the credit control department to a third party.
The debts of the company are effectively sold to a factor. The factor takes on the
responsibility to collect the debt for a fee. The factor offers three services:
1.
Debt collection
2.
Financing
3.
Credit insurance.
The factor is often more successful at enforcing credit terms leading a lower level of
debts outstanding. Factoring is therefore not only a source of short-term finance
but also an external means of controlling or reducing the level of debtors.
Invoice discounting
A service also provided by a factoring company.
Selected invoices are used as security against which the company may borrow
funds. This is a temporary source of finance repayable when the debt is cleared.
The key advantage of invoice discounting is that it is a confidential service, the
customer need not know about it.
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Trade credit
0
20
The delay of payment to suppliers is effectively a source of finance.
ks
ocompany is able to fund its stock of the material at
By paying on credit terms the
o
eb
the expense of its suppliers.
Overdrafts
A source of short-term funding which is used to fund fluctuating working capital
requirements.
Its great advantage is that you only pay for that part of the finance that you need.
The overdraft facility (total limit) is negotiated with the bank on a regular basis
(maybe annually). For a company with a healthy trading record it is normal for the
overdraft facility to be rolled over from one year to the next although theoretically
it is repayable on demand.
Bank loans
Bank loans or term loans are loans over between one and three years which have
become increasingly popular over the past ten to fifteen years as a bridge between
overdraft financing and more permanent funding.
Bills of exchange
A means of payment whereby by a promissory note is exchanged for goods.
The bill of exchange is simply an agreement to pay a certain amount at a certain
date in the future. No interest is payable on the note but is implicit in the terms of
the bill.
125
Asset specific sources of finance

Some sources of finance are used to purchase individual assets using the asset as
security against which the funds are borrowed.
Hire purchase
The purchase of an asset by means of a structured financial agreement.
Instead of having to pay the full amount immediately, the company is able to
spread the payment over a period of typically between two and five years.
Finance lease
A type of asset financing that appears initially very similar to hire purchase. Again
the asset is paid for over between two and five years (typically) and again there is
a deposit (initial rental) and regular monthly payments or rentals.
The key difference is that at the end of the lease agreement the title to the asset
does not pass to the company (lessee) but is retained by the leasing company
(lessor). This has important potential tax advantages covered later in the
course.
Operating lease
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In this situation the company does not buy the asset (in part or in full) but instead
rents the asset.
lo
.basset is only required for a short period
The operating lease is often used where 0
00 the has no interest in acquiring the asset
of time such as Plant Hire or the 2
company
ks
simply wishing to use it such as a company vehicle or photocopier.
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126
WORKING CAPITAL MANAGEMENT AN OVERVIEW
CURRENT
ASSETS
CURRENT
LIABILITIES
MINUS
Inventory
Payables
Receivables
Bank overdraft
Cash and Bank
Require funding
Aim : Minimise
current assets
Provide funding
Aim: Maximise
current liabilities
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Working capital seesawk
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Have sufficient
working capital to
avoid running out
of cash
Keep the overall

requirement to a
minimum to avoid
the financing cost
Level of working capital

1.
The nature of the business,
2.
Certainty in supplier deliveries,
3.
The level of activity of the business,
4.
The companys credit policy.
127
Funding the working capital requirement

Short-term sources of
finance
Long-term sources of
finance
Examples
Bank overdraft
Trade creditors
Equity
Long-term debt
Advantages
1. Flexible only borrow
what is needed
2. Cheaper liquidity
preference
3. Easier to source
1. Secure no need to
constantly replenish
2. Lower financing risk
3. Matching funding to
need
Fluctuating
current
assets
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Short-term
funds
00
Assets
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0
Permanent
current assets
Non-current
assets
Short-term
funds or
Long-term
funds
Long-term
funds
Time
128
MEASURES OF WORKING CAPITAL MANAGEMENT

Liquidity measures
Efficiency measure
Issue
Ensuring sufficient funding to

avoid running out of cash
Measuring the speed of circulation

of cash within the company
Measures
Current ratio
The operating cycle
Quick ratio
Liquidity ratios
Current assets may be financed by current liabilities or by long-term funds. The
ideal current ratio is 2:1. This would mean that half of the current assets are
financed by current liabilities and therefore half by long-term funds. Similarly the
ideal quick ratio is 1:1.
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Current ratio
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0
A simple measure of how much of the total current assets are financed by current
liabilities. A safe measure is considered to be 2:1 or greater meaning that only a
limited amount of the assets are funded by the current liabilities.
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Current Assets
Current Ratio
=
Current Liabilities
Quick ratio
A measure of how well current liabilities are covered by liquid assets. A safe
measure is considered to be 1:1 meaning that we are able to meet our existing
liabilities if they all fall due at once.
Current Assets minus Stock

Quick Ratio =
(or acid test)
Current Liabilities
129
Operating cycle
Also known as the cash cycle or trading cycle. The operating cycle is the length of
time between the companys outlay on raw materials, wages and other
expenditures and the inflow of cash from the sale of goods.
Purchases
Sales
Receipt
Inventory
Receivables
Payables
Operating cycle
Payment
Days
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Example 1
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Profit and loss account extract

Turnover
250,000
Gross profit
90,000
Balance Sheet extract
Current Assets
Inventory
Debtors
30,000
60,000
180,000
Current Liabilities
Creditors
50,000
Required:
Prepare the operating cycle.
130
OVERTRADING
Overtrading is the term applied to a company which rapidly increase its turnover
without having sufficient capital backing, hence the alternative term undercapitalisation. Output increase are often obtained by more intensive utilisation of
existing fixed assets, and growth tends to be financed by more intensive use of
working capital.
Overtrading companies are often unable or unwilling to raise long-term capital and
thus tend to rely more heavily on short-term sources such as overdraft and trade
creditors.
Debtors usually increase sharply as the company follows a more
generous trade credit policy in order to win sales, while stock tend to increase as
the company attempts to produce at a faster rate ahead of increase demand.
Overtrading is thus characterised by rising borrowings and a declining liquidity
position in terms of the quick ratio, if not always according to the current ratio.
Symptoms of overtrading
1.
Rapid increase in turnover
2.
Fall in liquidity ratio or current liabilities exceed current assets
3.
Sharp increase in the sales-to-fixed assets ratio
4.
Increase in the trade payables period
5.
Increase in short term borrowing and a decline in cash balance
o
t.c
p
gs
.bl
0
0
20
Overtrading is risky because short-term finance may be withdrawn relatively
s
quickly if creditors lose confidence in the business, or if there is general tightening
ok
o
of credit in the economy b
eresulting to liquidity problems and even bankruptcy, even
though the firm is profitable.
6.
Fall in profit margins.
The fundamental solution to overtrading is to replace short-term finance with longterm finance such as term loan or equity funds.
131
MANAGING RECEIVABLES
Offering credit
encourages
customers to take up
our goods
Offering credit
introduces risk of
default, defers inflow
of cash and needs
managing
Credit management
o
t.c
There are three aspects to credit management

1.
2.
Terms
3.
Assessing credit status
Day to day management.
Assessing credit status
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0
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.bl
0
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The creditworthiness of all new customers must be assessed before credit is

offered, it is a privilege and not a right. Existing customers must also be reassessed on a regular basis. The following may be used to assess credit status of a
company
1.
Bank References
2.
Trade References
3.
Published accounts
4.
Credit rating agencies
5.
Companys own Sales Record.
Terms
Given that we are willing to offer credit to a company, we must know consider the
limits to the agreement.
This may include:
1.
Credit limit value
2.
Number of days credit
3.
Discount on early payment
4.
Interest on overdue account.
132
Day to day management

The credit policy is dependent on the credit controllers implementing a set of simple
but rigorous procedures. If the system is not rigorous, those debtors who dont
want to pay will find ways not to pay. A process may be like the following
Time line
Action
After 30 days
Send statement of account
+7 days
Reminder letter
+7 days
2nd reminder
+7 days
Legal action threat
+7 days
Take action to recover funds
o
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133
COST OF FINANCING RECEIVABLES

The receivables balance needs to be financed. Any change to the receivables
balance will lead to a change in the financing cost of the business.
Interest cost = Receivables balance Interest rate
Receiv. days
Receiv. balance = Sales
365
Example 2
o
t.c
Shankly Limited has sales of $40m for the previous year, receivables at the year
end were $8m. The cost of financing debtors is covered by an overdraft at the
interest rate of 14%.
p
gs
Required:
0
s2
.bl
0
(a)
What are the receivables days for Shankly?
(b)
Calculate the cost of financing receivables.
o
bo
Discounts for early payment

Cash discounts are given to encourage early payment by customers. The cost of
the discount is balanced against the savings the company receives from a lower
balance and a shorter average collecting period.
Example 3
Shankly as above but a discount of 2% is offered for payment within 10 days.
Required:
Should the company introduce the discount given that 50% of the
customers take up the discount?
Advantages/Disadvantages
Advantages
1.
Early payment reducing the debtor balance and hence the interest charge.
2.
May reduce the bad debts arising.
134
Disadvantages
1.
Difficulty in setting the terms.
2.
Greater uncertainty as to when cash receipts will be received.
3.
May not reduce bad debt in practice.
4.
Customers may pay over normal terms but still take the cash discount.
Factoring
There are three main types of factoring service available:
1.
Debt Collection And Administration
2.
Credit Insurance
3.
Financing.
Example 4
Shankly again but a factor has offered a debt collection service which should
shorten the debtor collection period on average to 50 days. It charges 1.6% of
turnover but should reduce administration costs to the company by $175,000.
o
t.c
Required:
p
gs
Should the company use the factoring facility?
o
.bl
00
Advantages/Disadvantages0
2
ks
o
Advantages
bo
e
1.
Saving in internal administration costs.
2.
Reduction in the need for day to day management control.
3.
Particularly useful for small and fast growing businesses where the credit
control department may not be able to keep pace with volume growth.
Disadvantages
1.
Should be more costly than an efficiently run internal credit control

department.
2.
Factoring has a bad reputation associated with failing companies, using a

factor may suggest your company has money worries.
3.
Customers may not wish to deal with a factor.
4.
Once you start factoring it is difficult to revert easily to an internal credit

control.
5.
The company may give up the opportunity to decide to whom credit may be
given.
135
Example 5
Ewden (exam standard)
Ewden plc is a medium-sized company producing a range of engineering products

which it sells to wholesale distributors. Recently, its sales have begun to rise
rapidly following a general recovery in the economy as a whole. However, it is
concerned about its liquidity position and is contemplating ways of improving its
cashflow. Ewdens accounts for the past two years are summarised below.
Profit and loss account for the year ended 31 December
20X2
$000
20X3
$000
Sales
12,000
16,000
Cost of sales
7,000
______
9,150
______
5,000
6,850
200
______
250
______
4,800
6,600
Operating profit
Interest
Profit before tax
m
1,000
co
______
t.
1,600
______
3,800
5,000
1,500
______
2,000
______
2,300
======
3,000
======
Taxation (after capital allowances)
p
gs
Profit after tax
.bl
0
Dividends
0
s2
Retained profit
k
oo
Balance sheet as at 31 b
e December
20X2
$000
$000
20X3
$000
9,000
Fixed assets (net)
$000
12,000
Current assets
Stock
1,400
2,200
Debtors
1,600
2,600
1,500
______
100
______
Cash
4,500
4,900
Current liabilities
Overdraft
200
Trade creditors
1,500
2,000
Other creditors
500
______
200
______
(2,000)
(2,000)
______
Net assets
136
(2,000)
______
9,500
======
10% loan stock
(2,400)
12,500
======
Capital and reserves

Ordinary shares (50p)
3,000
3,000
Profit and loss account
6,500
______
9,500
______
9,500
======
12,500
======
In order to speed up collection from debtors, Ewden is considering two alternative

policies. One option is to offer a 2 per cent discount to customers who settle
within 10 days of dispatch of invoices rather than the normal 30 days offered. It is
estimated that 50 per cent of customers would take advantage of this offer.
Alternatively Ewden can utilise the services of a factor. The factor will operate on
a service-only basis, administering and collecting payment from Ewdens
customers. This is expected to generate administrative savings of $100,000 per
annum and, it is hoped, will also shorten the debtor days to an average of 45. The
factor will make a service charge of 1.5 per cent of Ewdens turnover. Ewden can
borrow from its bankers at an interest rate of 18 per cent per annum.
Required:
(a)
(b)
Identify the reasons for the sharp decline in Ewdens liquidity and
assess the extent to which the company can be said to be exhibiting
the problem of overtrading.
o
t.c
o
sp performance and liquidity
Illustrate your answer by referenceog key
to
ratios computed from Ewdens accounts.
(13 marks)
.bl
00 benefits of the two methods of
0
Determine the relative costs and
s2
reducing debtors, and recommend an appropriate policy.
(7 marks)
ok
o
(20 marks)
eb
Annualised cost of a cash discount

The balance of the difference in the amount of debt collected or paid and the time
value of money.
Example 6
We offer a cash discount of 2% for payment over 10 days rather than the normal
60 days.
Required:
(a)
What is the annualized cost of the cash discount?
(b)
If the overdraft rate is 10% should we take offer the discount?
137
MANAGING INVENTORY
Holding stock is
necessary for
operations, in
terms of finished
goods it offers
greater choice to
customers
Holding stock
incurs costs, in
particular there is
the opportunity
cost of money
tied up in stock
Material costs
o
t.c
Material costs are a major part of a companys costs and need to be carefully
controlled. There are 4 types of cost associated with stock:
1.
2.
holding costs,
3.
stockout costs,
4.
ordering costs,
purchase cost.
Ordering costs
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0
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The clerical, administrative and accounting costs of placing an order.

usually assumed to be independent of the size of the order.
They are
Holding costs
Holding costs include items such as:
1.
Opportunity cost of the investment in stock
2.
Storage costs
3.
Insurance costs
4.
Deterioration.
Stockout costs
1.
Lost contribution through loss of sale;
2.
Lost future contribution through loss of customer;
3.
The cost of emergency orders of materials;
4.
The cost of production stoppages.
138
Economic order quantity

When the reorder quantity is chosen so that the total cost of holding and ordering is
minimized, it is known as the economic order quantity or EOQ.
As the size of the order increases, the average stock held increases and holding
costs will also tend to increase. Similarly as the order size increases the number of
orders needed decreases and so the ordering costs fall. The EOQ determines the
optimum combination.
Cost
Cost
Total cost
Holding Costs
o
t.c
p
gs
Ordering Costs
EOQ
0
s2
.bl
0
o
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Reorder
Quantity
e
Example 7
A company requires 10,000 units of material X per month. The cost per order is
$30 regardless of the size of the order. The holding costs are $20 per unit per
annum. It is only possible to buy the stock in quantities of 400, 500, 600 or 700
units at one time.
Required:
What is the cheapest option?
Using the formula
Q =
2Co.D
Ch
Co
Cost per order
Annual demand
Ch
Cost of holding one unit for one year.
139
Example 7 contd
Required:
Calculate the economic order quantity using the formula given.
Bulk purchase discounts

Now there are two possible points of minima. The sum of the holding and ordering
costs are minimised at the EOQ. There will however be savings in the purchase
cost when the bulk discount volume is taken.
Example 8
Annual demand is 120,000 units. Ordering costs are $30 per order and holding
costs are $20/unit/annum. The material can normally be purchased for $10/unit,
but if 1,000 units are bought at one time they can be bought for $9,800. If 5,000
units are bought at one time, they can be bought for $47,500.
Required:
o
t.c
What reorder quantity would minimize the total cost?
p
gs
0
s2
.bl
0
o
bo
140
CASH MANAGEMENT
Cash is an idle
asset that costs
money to fund
but generates
little or no return
Holding cash is
necessary to be
able to pay the
bills and
maintain liquidity
There are three areas associated with managing cash:

1.
The Miller-Orr Model
2.
The Baumol Model
3.
The Cash Budget.
o
t.c
p
gs
The Miller-Orr model
0
s2
.bl
0
A model that considers the level of cash that should be held by a company in an
environment of uncertainty. The decision rules are simplified to two control levels
in order that the management of the cash balance can be delegated to a junior
manager.
o
bo
Maximum level
Cash
balance
spread
Return point
spread
Minimum level
Time
The model allows us to calculate the spread. Given that we have the spread all key
control levels can be calculated.
141
Minimum level given in the question

Maximum level = minimum level + spread
Return point = minimum level + spread
Example 9
The minimum level of cash is $25,000. The variance of the cash flows is $250,000.
The transaction cost for both investing and en-cashing funds is $50. The interest
rate per day is 0.05%.
Required:
Calculate the:
(a)
spread
(b)
maximum level
(c)
return point.
o
t.c
The Baumol model
p
gs
The use of the EOQ model to manage cash.
Q =
2Co.D
Ch
0
s2
.bl
0
o
bo
Co
Tansaction cost of investing/ en-cashing a security
Excess cash available to invest in short-term securities
Ch
Opportunity cost of holding cash
Example 10
A company generates $5,000 per month excess cash. The interest rate it can
expect to earn on its investment is 6% per annum.
The transaction costs
associated with each separate investment of funds is constant at $50.
Required:
(a)
What is the optimum amount of cash to be invested in each

transaction?
(b)
How many transactions will arise each year?
(c)
What is the cost of making those transactions per annum?
142
Cash budget
A budget prepared on a monthly basis (at least) to ensure that the company has an
understanding of its cash position going forward. There are 3 considerations:
Inflow and outflows of cash

Ignore non cash flows
Pro forma led
o
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0
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0
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143
Example 11
In the near future a company will purchase a manufacturing business for
$315,000, this price to include goodwill ($150,000), equipment and fittings
($120,000), and stock of raw materials and finished goods ($45,000). A delivery
van will be purchased for $15,000 as soon as the business purchase is completed.
The delivery van will be paid for in the second month of operations.
The following forecasts have been made for the business following purchase:
(i)
Sales (before discounts) of the business's single product, at a mark-up of

60% on production cost will be:
Month
($000)
1
96
2
96
3
92
4
96
5
100
6
104
25% of sales will be for cash; the remainder will be on credit, for settlement
in the month following that of sale. A discount of 10% will be given to
selected credit customers, who represent 25% of gross sales.
(ii)
Production cost will be $5.00 per unit. The production cost will be made up
of:
Raw materials
Direct labour
Fixed overhead
(iii)
m
$2.50
co
t.
.bl
0
p
gs
$1.50
$1.00
Production will be arranged so that closing stock at the end of any month is
sufficient to meet sales requirements in the following month. A value of
$30,000 is placed on the stock of finished goods which was acquired on
purchase of the business.
This valuation is based on the forecast of
production cost per unit given in (ii) above.
0
s2
o
bo
(iv)
The single raw material will be purchased so that stock at the end of a month
is sufficient to meet half of the following month's production requirements.
Raw material stock acquired on purchase of the business ($15,000) is valued
at the cost per unit which is forecast as given in (ii) above. Raw materials
will be purchased on one month's credit.
(v)
Costs of direct labour will be met as they are incurred in production.
(vi)
The fixed production overhead rate of $1.00 per unit is based upon a forecast
of the first year's production of 150,000 units.
This rate includes
depreciation of equipment and fittings on a straight-line basis over the next
five years.
(vii) Selling and administration overheads are all fixed, and will be $208,000 in
the first year. These overheads include depreciation of the delivery van at
30% per annum on a reducing balance basis. All fixed overheads will be
incurred on a regular basis, with the exception of rent and rates. $25,000 is
payable for the year ahead in month one for rent and rates.
Required:
Prepare a monthly cash budget.
You should include the business
purchase and the first four months of operations following purchase.
144
Example 12
Kool Co has annual sales revenue of $7 million and all sales are on 30 days credit,
although customers on average take fifteen days more than this to pay.
Contribution represents 55% of sales and the company currently has no bad debts.
Accounts receivable are financed by an overdraft at an annual interest rate of 8%.
Kool Co plans to offer an early settlement discount of 1.4% for payment within 20
days and to extend the maximum credit offered to 65 days.
The company expects that these changes will increase annual credit sales by 8%,
while also leading to additional variable costs equal to 0.5% of turnover. The
discount is expected to be taken by 35% of customers, with the remaining
customers taking an average of 65 days to pay.
Required:
(a)
Evaluate whether the proposed changes in credit policy will increase

the profitability of Kool Co.
(6 marks)
(b)
Tiger Co, a subsidiary of Kool Co, has set a minimum cash account balance of
$2,000. The average cost to the company of making deposits or selling
investments is $50 per transaction and the standard deviation of its cash
flows was $1,000 per day during the last year. The average interest rate on
investments is 9.125%.
o
t.c
(c)
(d)
o
sp the return point for the
Determine the spread, the upper limit and
og
cash account of Tiger Co using .bl Miller-Orr model and explain the
the
relevance of these values for 00 cash management of the company.
the
(6 marks)
20
ksthe key areas of accounts receivable
o
Identify and explain
bo
management. e
(6 marks)
Discuss the key factors to be considered when formulating a working
capital funding policy.
(7 marks)
(25 marks)
145
o
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0
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.bl
0
o
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146
Chapter 10
Efficient market
hypothesis
o
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0
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.bl
0
o
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147
C H A P T E R 1 0 E F F I C I E N T M A R K E T H Y P O T H E S IS
CHAPTER CONTENTS
EFFICIENT MARKET HYPOTHESIS (EMH) ---------------------------- 149
DEGREE OR FORMS OF EFFICIENCY
149
IMPLICATIONS OF EMH FOR FINANCIAL MANAGERS
150
o
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148
EFFICIENT MARKET HYPOTHESIS (EMH)

A market is efficient if
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.
Market efficiency from the perspective of the EMH relates to the efficiency of
information, the better the information received by investors, the better and
more informed the decisions they make will be.
Degree or forms of efficiency

For the purpose of testing, EMH is usually broken down into 3 forms as follows:
1.
Weak form
o
t.c
Weak form hypothesis states that current share prices reflect all relevant
information about the past price movements and their implications. If this is true,
then it should be impossible to predict future share price movements from historic
information or pattern.
p
gs
0
s2
.bl
0
Share prices only changes when new information about a company and its profits
have become available. Since new information arrives unexpectedly, changes in
share prices should occur in a random fashion, hence weak form can be referred to
as random walk hypothesis.
o
bo
2.
Semi- strong form
Semi-strong form hypothesis state that current share prices reflects both
(i)
all relevant information about past price movement and their implications;
and
(ii)
publicly available information about the company.
Any new publicly accessible information whether comments in the financial press,
annual reports or brokers investment advisory services, should be accurately and
immediately reflected in current share prices, so investment strategies based on
such public information should not enable the investor to earn abnormal profit
because these will have already been discounted by the market.
3.
Strong form
The strong form hypothesis states that current share prices reflect all relevant
information available from
past price changes
public knowledge; and
insider knowledge available to specialists or experts such as investment

managers.
149
Implications of EMH for financial managers

If capital markets are efficient, the main implications for financial managers are:
1.
The timing of issues of debt or equity is not critical, as the prices quoted in
the market are fair. That is price will always reflect the true worth of the
company, no over or under valuation at any point.
2.
An entity cannot mislead the markets by adopting creative accounting

techniques.
3.
The entitys share price will reflect the net present value of its future cash
flows, so managers must only ensure that all investments are expected to
exceed the companys cost of capital.
4.
Large quantities of new shares can be sold without depressing the share price.
5.
The market will decide what level of return it requires for the risk involved in
making an investment in the company. It is pointless for the company to try
to change the markets view by issuing different types of capital instrument.
6.
Mergers and takeovers. If shares are correctly priced this means that the
rationale behind mergers and takeovers may be questioned. If companies are
acquired at their current market valuation then the purchasers will only gain if
they can generate synergies (operating economies or rationalisation). In an
efficient market these synergies would be known, and therefore already
incorporated into the price demanded by the target company shareholders.
o
t.c
p
gs
.bl
0
The more efficient the market is, the less the opportunity to make a speculative
profit because it become impossible to consistently out-perform the market.
0
s2
Evidence so far collected suggests that stock markets show efficiency that is at
least weak form, but tending more towards a semi-strong form. In other words,
current share prices reflect all or most publicly available information about
companies and their securities.
o
bo
150
Chapter 11
Valuation
o
t.c
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0
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.bl
0
o
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151
CHAPTER 11 VALUATION
CHAPTER CONTENTS
BUSINESS VALUATION ------------------------------------------------- 153
APPROACHES
153
VALUING SHARES ------------------------------------------------------ 154

THE DIVIDEND VALUATION MODEL
154
ASSET BASED VALUATIONS
155
INCOME / EARNINGS BASED METHODS
156
PV OF THE FREE CASH FLOWS
158
VALUATION OF DEBT --------------------------------------------------- 162

IRREDEEMABLE DEBT
162
REDEEMABLE DEBT
163
CONVERTIBLE DEBT
163
PREFERENCE SHARES
log
.b
t.
po
om
164
0
20
k
oo
eb
152
BUSINESS VALUATION
Approaches
The three main approaches are:
Dividend valuation model.
Income / earnings basis.
Asset basis.
o
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0
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153
VALUING SHARES
The dividend valuation model
The value of the company/share is the present value of the expected future
dividends discounted at the cost of equity.
Either:
Po =
do(1 + g)
ke g
FORMULA GIVEN
Can either be used to calculate the total MV of a company or the value of a share.
Advantages
1.
Considers the time value of money and has an acceptable theoretical basis.
2.
Particularly useful when valuing a minority stake of a business.
Disadvantages
1.
Difficulty estimating an appropriate growth rate.
2.
The model is sensitive to key variables.
3.
The growth rate is unlikely to be constant in practice.
o
t.c
p
gs
Note
0
s2
.bl
0
Total MV = Share price x Total number of shares.
Example 1
o
bo
Parry
A company has the following information:

Share capital in issue is 2m ordinary shares (25)
Current dividend per share (ex div) - 4
Dividend five years ago 2.5
Current equity beta 0.6
Market information:
Current market return 17%
Risk-free rate 6%
Required:
What is the market value of the company?
154
Example 2
Moran Ltd
A company has the following information:

Ordinary share capital (1m par value 50c)
Current dividend (ex div) - 16
Current EPS - 20
Current return earned on assets - 20%
Current equity beta 0.9
Current market return 11%
Risk-free rate 6%
Required:
Find the market capitalisation of the company.
Asset based valuations
o
t.c
Weaknesses
p
gs
Investors do not normally buy a company for the book value of its assets, but
for the earnings / cash flows that the sum of its assets can produce in the
future.
0
s2
.bl
0
It ignores intangible assets. It is very possible that intangible assets are more
valuable than the balance sheet assets.
k
oo
Uses for asset based valuations:
eb
asset stripping
to identify a minimum price in a takeover
if the assets are predominantly tangible assets.
Types of asset based measures

Book value
There is never a circumstance where book value is an appropriate valuation base.
It may however be used as a stepping stone towards identifying another measure.
Net realisable value

Only used to establish a minimum value for an asset, it may be difficult to find an
appropriate value over the short term. Used for a company when being broken up
or asset stripped.
Replacement cost
May be used to be find the maximum value for an asset. Used for a company as a
going concern.
155
Example 3
Fagan Ltd
Below is a balance sheet of Fagan Ltd,

$
Non-current assets (carrying value)
625,000
Net current assets
160,000
_______
785,000
_______
Represented by
50c ordinary shares
300,000
Reserves
285,000
6% debentures Z1
200,000
_______
785,000
_______
o
t.c
o
sp
loan notes are redeemable at a premium of 5%

log
b
The premises have a market value 0. is $50,000 higher than the book value
0 that
0
all other assets are estimated to be realisable at their book value.

s2
k
oo
Required:
eb
Notes:
Value a 60% holding of ordinary shares on an assets basis.
Income / earnings based methods

Of particular use when valuing a majority shareholding:
1.
As majority shareholders, the owners can influence the future earnings of the
company.
2.
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.
156
PE method
PE ratios are quoted for all listed companies and calculated as:
PE
Pr ice per share

EPS
This can then be used to value shares in unquoted companies as:

Value of company
Total earnings P/E ratio
Value per share
EPS P/E ratio
using an adjusted P/E multiple from a similar quoted company (or industry
average).
Example 4
Houllier Ltd
Houllier Ltd, an unlisted company:
Ordinary share capital is 200,000 50 shares.
Extract from income statement for the year ended 31 Dec 20X7:
$
Profit before taxation

Less: Corporation tax
110,000
430,000
0
20
s
30,000
Less: Preference dividend

Ordinary dividend
p
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0
______
Profit after taxation
o
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320,000
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40,000
______
(250,000)
_______
Retained profit for the year
70,000
_______
The PE ratio applicable to a similar type of business is 10.
Required:
Value 200,000 shares in Houllier Ltd on a PE basis.
157
Earnings yield
The earnings yield is the inverse of the PE ratio:
Earnings yield
EPS
Pr ice per share
It can therefore be used to value the shares or market capitalisation of a company

in exactly the same way as the PE ratio:
Value of company
Total earnings
Value per share
EPS
Example 5
1
Dividend yield
1
Dividend yield
Souness
Company A has earnings of $300,000.

yield of 12.5%.
A similar listed company has a dividend
Required:
Find the market capitalisation of each company.
o
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Example 6
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Kenny Dalglish
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Company B has earnings of $420,500. A similar listed company has a PE ratio of 7.
o
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Required:
Find the market capitalisation of each company.
PV of the free cash flows

A buyer of a business is obtaining a stream of future operating or free cash flows.
The value of the business is:
PV of future cash flows
A discount rate reflecting the systematic risk of the flows should be used.
Method:
1.
Identify relevant free cash flows
operating cash flows
revenue from sale of assets
tax payable
tax relief
synergies from merger (if any)
2.
Select a suitable time horizon
3.
Identify a suitable discount rate
158
4.
Calculate the present value over the time horizon.
Example 7
Paisley Ltd
The following information has been taken from the income statement and balance
sheet of Paisley Ltd:
Revenue
Production expenses
Administrative expenses
Tax allowable depreciation
Capital investment
Corporate debt
$400m
$150m
$36m
$28m
$60m
$14m trading at 110% of par value
Corporation tax is 30%.

The WACC is 16.6%. Inflation is 6%.
These cash flows are expected to continue every year for the foreseeable future.
Required:
Calculate the value of equity.
Advantages
The best method on a theoretical basis.
May value a part of the company.
0
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0
Disadvantages
o
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o
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It relies on estimates of both cash flows and discount rates may be

unavailable.
Difficulty in choosing a time horizon.
Difficulty in valuing a companys worth beyond this period.
Assumes that the discount rate and tax rates are constant through the period.
159
Example 8
Predator plc
The board of directors of Predator plc is considering making an offer to purchase

Target Ltd, a private limited company in the same industry. If Target Ltd is
purchased it is proposed to continue operating the company as a going concern in
the same line of business.
Summarised details from the most recent set of financial statements for Predator
and Target are shown below:
Predator plc
Balance sheet
as at 31 March
$m
$m
33
58
29
24
3
(31)
25
116
Freehold property
Plant & equipment
Inventory
Receivables
Cash
less current liabilities
Financed by:
Ordinary shares
Reserves
35
43
0
00
eb
s
ok
T5
T4
T3
T2
T1
Predator plc
PAT
$m
14.30
15.56
16.93
18.42
20.04
o
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po
160
964
78
1,124
38
116
768
1,892
Predator plc. 50 cents ordinary shares,

shares.
Year
log
.b
Shareholders funds
Medium term bank
loans
Target Ltd
Balance sheet
as at 31 March
$000
$000
460
1,310
330
290
20
(518)
122
1,892
Dividend
$m
9.01
9.80
10.67
11.60
12.62
Target Ltd, 25 cents ordinary
Target Ltd
PAT
$000
143
162
151
175
183
Dividend
$000
85.0
93.5
93.5
102.8
113.1
T5 is five years ago and T1 is the most recent year.
Targets shares are owned by a small number of private individuals. Its

managing director who receives an annual salary of $120,000 dominates the
company.
This is $40,000 more than the average salary received by
managing directors of similar companies. The managing director would be
replaced, if Predator purchases Target.
The freehold property has not been revalued for several years and is believed
to have a market value of $800,000.
The balance sheet value of plant and equipment is thought to reflect its
160
The balance sheet value of plant and equipment is thought to reflect its
replacement cost fairly, but its value if sold is not likely to exceed $800,000.
Approximately $55,000 of inventory is obsolete and could only be sold as
scrap for $5,000.
The ordinary shares of Predator are currently trading at 430 cents ex-div. A
suitable cost of equity for Target has been estimated at 15%.
Both companies are subject to corporation tax at 33%.
Required:
Estimate the value of Target Ltd using the different methods of valuation
and advise the board of Predator as to how much it should offer for
Targets shares.
Note: There has been no increase in the share capital of Target over the last five
years.
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161
VALUATION OF DEBT
When valuing debt we assume that
Market
price
The discounted cash flows of the debt
Note
The debt is normally valued gross of debt because we do not know the tax position
of each investor.
Irredeemable debt
The company does not intend to repay the principal but to pay interest forever, the
interest is paid in perpetuity.
The formula for valuing a debenture is therefore:
MV =
I
r
where:
o
t.c
o
sp0)
MV =
market price of the debenture nowog
(year
.bl
r
=
debt holders required return, expressed as a decimal.
0
00 cost of debt the formula becomes:
2
If instead of r you are given the companys
ks
o
I(1 T )
MV =
bo
Kd
e
I
annual interest starting in one years time
where:
Kd
companys cost of debt, expressed as a decimal.
Example 9
Abbie Lou
A company has issued irredeemable loan notes with a coupon rate of 9%.
required return of investors in this category of debt is 6%.
The
Required:
The current market value of the debt?
162
Redeemable debt
The market value is the present value of the future cash flows, these normally
include:
1.
Interest payments for the years in issue
2.
Redemption value.
Example 10
Freddie
A company has 10% debt redeemable in 5 years. Redemption will be at par value.
The investors require a return of 8%.
Required:
The market value of the debt?
A company has in issue 9% redeemable debt with 10 years to redemption.
Redemption will be at par. The investors require a return of 16%. What is
the market value of the debt?
Convertible debt
o
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The value of a convertible is the higher of its value as debt and its converted value.
This is known as the formula value.
Example 11
Elliot
0
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0
o
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Elliot plc has convertible loan notes with a coupon rate of 10%. Each $100 loan
note may be converted into 25 ordinary shares at any time until the date of expiry
and any remaining loan note will be redeemed at $100.
The debenture has four years to redemption. Investors require a rate of return of
6% per annum.
Required:
Should we convert if the current share price is:
(a)
$4.00
(b)
$5.00
(c)
$6.00?
163
Preference shares
Similar to irredeemable debt, the income stream is the fixed percentage dividend
received in perpetuity.
P0 =
The formula is therefore:
D
Kp
where:
D
the constant annual preference dividend
P0
ex-div market value of the share
Kp
cost of the preference share.
Example 12
Tosca
A firm has in issue $1 11% preference shares. The required return of preference
shareholders is 12%.
Required:
What is the value of a preference share?
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164
Chapter 12
Risk
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165
CHAPTER 12 RISK
CHAPTER CONTENTS
FOREIGN CURRENCY RISK --------------------------------------------- 168
THE EXCHANGE RATE--------------------------------------------------- 169
SPOT RATE
169
SPOT RATE WITH SPREAD
169
EXCHANGE RATE SYSTEMS -------------------------------------------- 170

FIXED (OR PEGGED) RATE SYSTEMS
170
FLOATING RATE SYSTEMS
170
MANAGED OR DIRTY FLOAT
170
TYPES OF FOREIGN CURRENCY RISK --------------------------------- 171

TRANSACTION RISK
171
ECONOMIC RISK
171
171
om
c
ot.
WHAT MAKES EXCHANGE RATES FLUCTUATE? ---------------------- 172
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BALANCE OF PAYMENTS
172
o
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CAPITAL MOVEMENTS BETWEEN COUNTRIES
172
00
0
PURCHASING POWER PARITY THEORY (PPPT)
172
s2
k(IRPT)
INTEREST RATE PARITY THEORY
173
o
bo EFFECT
THE INTERNATIONAL e
FISHER
174
TRANSLATION RISK
HEDGING EXCHANGE RATE RISK ------------------------------------- 176

INTERNAL HEDGING TECHNIQUES ----------------------------------- 177
INVOICE IN OWN CURRENCY
177
LEADING PAYMENT
177
MATCHING OR NETTING
177
DO NOTHING
177
EXTERNAL HEDGING TECHNIQUES ----------------------------------- 178

FORWARD CONTRACT
178
FORWARD RULE
178
MONEY MARKET HEDGE
179
OTHER CURRENCY HEDGING TECHNIQUES
180
INTEREST RATE RISK -------------------------------------------------- 182

REASONS FOR FLUCTUATIONS IN INTEREST RATES
THE YIELD CURVE (TERM STRUCTURE OF INTEREST RATES)
166
182
182
CHAPTER 12 RISK
HEDGING INTEREST RATE RISK -------------------------------------- 184

SHORT-TERM MEASURES
184
LONG-TERM HEDGING SWAPS -------------------------------------- 185

ADVANTAGES OF SWAPS
185
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167
CHAPTER 12 RISK
FOREIGN CURRENCY RISK

The risk that the exchange rate may move up or down in relation to other
currencies. It will have a major impact on the profitability of any company that
buys or sells to other countries.
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168
CHAPTER 12 RISK
THE EXCHANGE RATE

Spot rate
A prevailing rate at a point in time (say today)
e.g. $: 1.9500
This means that the dollar ($) is expressed in terms of one pound (), i.e. we
express the first currency in terms of one of the second.
Conversion rule
1st currency to calculate the 2nd
( and )
2nd currency to calculate the 1st
Spot rate with spread
o
t.c
The bank expects a margin to transact funds. As a result the rate is often
expressed in terms of a bid/offer spread. Remember the bank will always win!
e.g. $: 1.9150 1.9850
or
p
gs
$: 1.9500 +/- 0.0350
0
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0
Flow rule (when looking at the 1st currency use Bart Simpson)
o
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Bart
(buy 1st currency low)
Simpson
(sell 1st currency high)
Example 1
Spot rate $: 1.9500 0.0350
: 1.2500 0.0275
(a)
A 300,000 receipt is transferred to our bank account.
(b)
A 400,000 receipt is to be transferred into our $ bank account.
(c)
A $250,000 payment is to be paid from our bank account.
(d)
A 100,000 payment is to be paid from our bank account.
Required:
What are the values of the transactions?
169
CHAPTER 12 RISK
EXCHANGE RATE SYSTEMS

Exchange rates are a key measure for governments to attempt to control. They will
have direct bearing on the economic performance of the country.
Fixed (or pegged) rate systems

Where a currency is fixed in relation to the dominant world currency ($) or
alternatively against a basket of currencies (ERM).
The peg may be changed from time to time to reflect the relative movement in
underlying value.
This form of currency management is effective at giving a stable exchange platform
for trade. It will however lead to a parallel or unofficial market for currency if out
of step with perceived value and normally requires strict exchange control to
operate.
Floating rate systems

Where the exchange rate is allowed to be determined without any government
intervention.
o
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p
gs
It is determined by supply and demand. This is rare, currency value is normally

considered too important a measure to be left solely to the market.
.bl
0
The market has a tendency to be volatile to the adverse effect of trade and wider
government policy. This volatility can adversely affect the ability to trade between
currencies.
0
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Managed or dirty float

e
Where the market is allowed to determine the exchange rate but with government
intervention to reduce the adverse impacts of a freely floated rate.
The basic aim is to damp the volatility by intervening or being prepared to
intervene to maintain the value within a trading range.
A government may further attempt to influence the ongoing value of the currency.
If this is materially at odds with the markets perception of the value however it is
rarely successful in the long run. Examples of this failing include the pound falling
out of the ERM or the collapse in the value of the Argentinian Peso.
The government may intervene by:
Using reserves to buy or sell currency the government can artificially

stimulate demand or supply and keep the currency within a trading range
reducing volatility.
Using interest rates, by increasing the interest rate within the economy the
government makes the currency more attractive to investors in government
debt and will attract speculative funds.
170
CHAPTER 12 RISK
TYPES OF FOREIGN CURRENCY RISK

There are three risks associated with foreign currency:
1.
Transaction risk.
2.
Economic risk.
3.
Translation risk.
Transaction risk
The risk associated with short-term cash flow transactions.
This may include:
Commercial trade this is normally reflected by the sale of goods in a foreign

currency but with a delay in payment. The receipt will have an uncertain
value in the home currency.
Borrowing or lending in another currency subsequent cash flows relating to

interest payments would be uncertain in the home currency.
These transactions may be hedged relatively easily either using internal or external
hedging tools.
o
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Economic risk
o
.bl asset investment in a foreign country
Long-term cash flow effects associated with
0
00
or alternatively loans taken out or made in a foreign currency and the subsequent
2
capital repayments.
ks
o
Economic risk is more difficult to hedge given the longer term nature of the risk
bo
e
(possibly over 10 or more years). A simple technique would be to adopt a portfolio
approach to investments by currency to spread the risk.
Translation risk
Risk associated with the reporting of foreign currency assets and liabilities within
financial statements.
There is no cash flow impact of this type of risk. However, the impact on the
financial statements can be severe.
Translation risk may be hedged by matching the assets and liabilities within each
country. Any increase or decrease in value would cancel out on consolidation.
171
CHAPTER 12 RISK
WHAT MAKES EXCHANGE RATES FLUCTUATE?

Balance of payments
The inflows and outflows from trade reflect demand for and supply of the home
currency. If there is a consistent deficit or surplus there will be a continuing excess
supply or demand for the currency that would be reflected in weakness or strength
in the currency.
For major traded currencies this effect is relatively small.
Capital movements between countries

Of far more importance for major currencies are the
from one currency to another. This makes the level
critical importance for these currencies. An increase
currency will lead to a one-off increase of demand for
value.
flows of speculative capital

of relative interest rates of
in the interest rate of one
that currency increasing its
It is difficult to predict future rates based on this measure.
o
t.c
Purchasing power parity theory (PPPT)

po
log
.b
Based on the law of one price in economic theory. This would suggest that the
price of the same product is the same in all currencies.
0
00 suggest that a relative change in prices
To extend the principle further this would
2
ks
(inflation) would have a direct effect on the exchange rate.
o
bo predictor of future exchange rates.
PPPT is an unbiased bute
poor
Illustration
A product is currently being sold in the UK for 2,000 and in the US for $4,000.
This would infer that the current exchange rate is $: 2.0000.
What would we expect the exchange rate to be in 1 year if the inflation rates are
4% and 7% respectively?
Year
UK
US
2,000
$4,000
Inflation
1.04
1.07
2,080
$4,280
The predicted exchange rate would be $4,280/2,080 = $: 2.0577.

To calculate the impact of PPPT use the following formula:
Current spot rate x
172
1 + inf l1st
1 + inf l2nd
Future expected spot rate in one years time.
CHAPTER 12 RISK
Example 2
The current exchange rate is : 0.8333. Inflation rates for the two currency zones
are as follows:
Eurozone 5%
UK
3%
Required:
What is the predicted exchange rate in one year?
Problems with PPPT
Not all inflation relates to exported goods.
There are market imperfections such as taxation and tariffs that reduce the
impact of PPPT.
Only a small proportion of trade relates to traded goods.
Interest rate parity theory (IRPT)
o
t.c
The theory that there is a no sum gain relating to investing in government bonds in
differing countries. Any benefit in additional interest is eliminated by an adverse
movement in exchange rates.
p
gs
.bl
0
IRPT is an unbiased but poor predictor of future exchange rates.
Illustration
0
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o
bo
It is possible to invest 1m in short-dated govt bonds in the UK at 6.08% or

alternatively in US treasury bills at 9.14%. The current exchange rate is $:2.0000
Year
UK
US
1m
Interest
1.0608
1.0914
1.0608m
$2.1828m
2 =
$2m
The predicted exchange rate would be $2.1828m/1.0608m = $: 2.0577.
Does it work?
In practice the relationship between interest and exchange rates is not perfect and
certainly not simultaneous. It is possible that the exchange rate does not move in
line with interest rates for long periods (research the carry trade) only to correct
over a short period of time.
Current spot rate x
1 + i1st
=
1 + i2nd
forward rate in one years time.
173
CHAPTER 12 RISK
Example 3
The current exchange rate is : 0.7865. Interest rates for the two currency zones
are as follows:
Eurozone 4%
UK
5.5%
Required:
What is the predicted exchange rate in one year?
The international Fisher effect

The assumption that all currencies must offer the same real interest rate. This links
PPPT to IRPT. It is based upon the Fisher effect.
The relative real interest rates should be the same due to the principle of supply
and demand, if a country offers a higher real interest rate investors will invest in
that currency and push up the price of the currency bringing the real rate back to
equilibrium.
o
t.c
The international Fisher effect has a strong theoretical basis but is a poor predictor
of future exchange rates.
Remember the Fisher effect
p
gs
.bl
0
(1 + m) = (1 + r)(1 + i)
Illustration
0
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o
bo
(using values from previous illustrations for PPPT and IRPT)
YR
PPPT
2.0000
2.0000
1.07/1.04
1.0914/1.0608
2.0577
2.0577
IRPT
UK
174
= 1.0608/1.04 - 1
= 1.0914/1.07 1
= 2%
Real
rate of
return
US
= 2%
The reason for both PPP

and IRP having the same
prediction is because the
international Fisher effect
holds true
CHAPTER 12 RISK
Example 4
Aurelio
The following interest and inflation rates are known for the pound and the euro
Inflation rates
UK
Eurozone
Interest rates
5.5%
4%
7%
5%
Required:
What are the predicted exchange rates in one year using:
(a)
PPPT?
(b)
IRPT?
Does the IFE hold true?
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175
CHAPTER 12 RISK
HEDGING EXCHANGE RATE RISK

Hedging is the process of reducing or eliminating risk. It may be achieved by using
internal or external measures.
Internal measures have the advantage of being essentially cost free but at the
same time are unlikely to completely eliminate the risk.
External measures involve a bank or financial market. They will incur cost but may
totally eliminate the risk.
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176
CHAPTER 12 RISK
INTERNAL HEDGING TECHNIQUES

Invoice in own currency
By invoicing in your own currency you do not suffer the risk of exchange rate
movement.
The risk does not disappear, instead it passes to the other party. It is questionable
whether the other party will be happy to accept this risk.
Leading payment
By paying early or encouraging a customer to pay early the risk relating to an
individual transaction is reduced or eliminated. The earlier the cash flow, the lower
the exposure to exchange rate movements.
Matching or netting
If a company makes a number of transactions in both directions it will be able to
net off those transactions relating to the same dates. By doing so a company can
materially reduce the overall exposure, but is unlikely to eliminate it.
o
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p
gs
In order to perform netting the company must have a foreign currency bank
account in the appropriate country.
Do nothing
0
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.bl
0
o
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A compelling idea, the exchange rates will fluctuate up and own. It could be
argued that since you win some and lose some then ignoring the risk would be the
best option.
As a result you save on hedging costs, the downside being that the exposure to
exchange rates is present in the short-term.
177
CHAPTER 12 RISK
EXTERNAL HEDGING TECHNIQUES

Forward contract
Features
1.
An agreement with the bank to exchange currency for a specific amount at a

future date.
2.
It is an obligation that must be completed once entered into.
3.
The transaction may take place over a limited range of dates if option dated.
It is an over the counter (OTC) product which means that it is tailored to the
specific value and date required.
4.
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.
5.
The underlying theory behind the setting of the future rate is IRPT.
m
co is expecting to receive
The current spot rate is $:2.1132 0.0046. The company
ot.
pat a discount of 0.32 0.36 in
$400,000 in three months. The forward is quoted
s
cents in three months.
log
.b
00
0
Forward rule
s2
k
The forward rate may be given as an adjustment to the prevailing spot rate, if so:
oo
eb
Add a discount, subtract a premium
Illustration
Spot rate
$
2.1086
$
2.1178
Add discount
0.0032
0.0036
Forward rate
2.1118
2.1214
Receipt in = $400,000/ 2.1214 = 188,555
Example 5
Skrtel
A US corporation is looking to hedge its foreign exchange. The current spot rate is
$: 1.6578 0.0032. The company is expecting to pay 350,000 in one month.
The forward is quoted at a premium of 0.13 0.11 in cents in one months.
Required:
What is the value of the payment in $s?
178
CHAPTER 12 RISK
Advantages
flexibility with regard to the amount to be covered, should lead to a perfect

hedge in terms of amount and date
relatively straightforward both to comprehend and to organise.
Disadvantages
contractual commitment that must be completed on the due date, if the

underlying transaction is in anyway doubtful this may be problem
the rate is fixed with no opportunity to benefit from favourable movements in

exchange rates
Money market hedge

Use of the short-term money markets to borrow or deposit funds. This gives the
company the opportunity to exchange currency today at the prevailing spot rate.
Steps
1.
Borrow borrow funds in the currency in which you need the money.
2.
Translate exchange the funds today avoiding exposure to fluctuations in the

rate.
3.
Deposit deposit the funds in the currency in which you eventually want the
funds until such time as you will need them.
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179
CHAPTER 12 RISK
Example 6
Arbeloa
Arbeloa is a UK company trading extensively in the US. The current exchange rate
is $: 1.97500.003.
Arbeloa is a UK company trading extensively in the US. The current exchange rate
is $: 1.97500.003.
We wish to do the following transactions:
$ Receipt of $500,000 in 1 month.
$ Payment of $300,000 in 3 months.
The money markets provide the following interest rates for next year (pa)
UK
US
Loan rate
6.0%
7.5%
Deposit rate
4.0%
5.0%
Forward rates
1 month
discount
0.0012 0.0017
3 month
discount
0.0034 0.0038
Required:
o
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0
Calculate the receipt and payments using both money markets and
forward markets.
0
s2
Advantages
o
bo
There is some flexibility regarding the date at which the transaction takes
place.
May be available in currencies for which a forward rate is not available.
Disadvantages
Complex.
May be difficult to borrow/ deposit in some currencies at a risk-free rate.
Other currency hedging techniques

Currency Futures
The fixing of the exchange rate today for a future trade in a similar manner to the
forward contract. The Future is an exchange traded instrument that can be bought
or sold on an exchange (eg LIFFE).
The future is a standardised financial instrument in terms of amount and date. This
may lead to a hedge that is less than perfect because the amount of the trade may
differ.
The aim is to buy or sell the future in such a way as to compliment the underlying
trade. Therefore you will have:
180
CHAPTER 12 RISK
1.
A futures contract betting on the exchange rate rising or falling, and
2.
An underlying transaction that may fall or rise in terms of the home currency.
The linking of the two cancels out the movement of the exchange rate and leads to
the hedge.
Currency options
They may be exchange traded or OTC. Options have the benefit of being a onesided bet. You can protect the downside risk of the currency moving against you
but still take advantage of the upside potential.
The option writer therefore only has a downside risk (as we take the upside). The
option writer needs compensating for this risk and is paid a premium over and
above transaction costs.
Inshal Co
Exam standard
Inshal Co is a UK-based company which has the following expected transactions.

One month:
One month:
Three months:
Expected receipt of $40,000

Expected payment of $140,000
Expected receipts of $300,000
o
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p
gs
The finance manager has collected the following information:

Spot rate ($ per ):
One month forward rate ($ per ):
Three months forward rate ($ per ):
0
s2
o
bo
blo
.1.7820 0.0002
0 1.7829 0.0003
1.7846 0.0004
Money market rates for Inshal Co:
One year sterling interest rate:

One year dollar interest rate:
Borrowing
4.9%
5.4%
Deposit
4.6
5.1
Assume that it is now 1 April.
Required:
(a)
Discuss the differences between transaction risk, translation risk and

(6 marks)
economic risk.
(b)
Explain how inflation rates can be used to forecast exchange rates.

(6 marks)
(c)
Calculate the expected sterling receipts in one month and in three

months using the forward market.
(3 marks)
(d)
Calculate the expected sterling receipts in three months using a

money-market hedge and recommend whether a forward market
hedge or a money market hedge should be used.
(5 marks)
(e)
Discuss how sterling currency futures contracts could be used to

hedge the three-month dollar receipt.
(5 marks)
(25 marks)
181
CHAPTER 12 RISK
INTEREST RATE RISK

The risk that interest rates will rise or fall in the future. Interest rates are normally
less volatile that exchange rates, changing at most on a monthly basis. They may
even be constant over long periods of time.
The exposure to interest rates however is more enduring for companies on the
basis that any form of existing borrowing or investing will be affected by a change
in interest rates.
A company has a basic choice between borrowing fixed rate or variable (floating)
rate. Both present a risk, the variable rate represents a cash flow risk and the fixed
rate an opportunity cost.
Reasons for fluctuations in interest rates

Interest rates or base rates are a key economic tool for government. They may be
changed for the following reasons:
To control inflation, higher interest rates will reduce demand for funds,
aggregate demand and hence inflationary pressure.
To protect the currency, contrary to IRPT an increase in the interest rates will
have a one-off effect of attracting speculative funds and increasing the value
o the economy.
o
t.c
p
gs
.bl
0
To kick-start the economy, a reduction in interest rates can stimulate

economic activity by encouraging borrowing.
0
s2
The yield curve (term structure of interest rates)

ok
eb
The relationship between the gross redemption yield of a debt investment and its
term to maturity. There are 3 elements:
Gross
Redemption
Yield
Term to maturity
1.
Liquidity preference
2.
Expectations
3.
Market segmentation.
182
CHAPTER 12 RISK
1.
Liquidity preference
Investors prefer to be liquid over being illiquid. To encourage investment over the
longer term the long-term debt must offer a higher return over short-term debt.
2.
Market expectations
If interest rates are expected to fall over time long-term rates will be lower than
short-term rates. This would lead to an inverted yield curve.
3.
Market segmentation
Differing parts of the market (short-term vs long-term debt markets) may react to
differing economic information meaning that the yield curve is not smooth but
suffers discontinuities.
o
t.c
p
gs
0
s2
.bl
0
o
bo
183
CHAPTER 12 RISK
HEDGING INTEREST RATE RISK

We may hedge interest rate risk over the short or the long-term
Short term hedging
Long-term hedging
Forward rate agreements
Swaps
Interest rate guarantee

Interest rate futures
Interest rate options
Short-term measures
Forward rate agreements (FRA)
The fixing of the interest rate today in relation to a future short-term loan. It is an
obligation that must be taken once entered into. It is OTC and tailored to a specific
loan in terms of:
1.
Amount, and
p
gs
Date
2.
o
t.c
.bl
0
0
20is wholly separate to the underlying loan.
and offers a perfect hedge. Thes
FRA
okthe interest paid but there is a downside risk that
It will give certainty as regards
o
eb
interest rates may fall and we have already fixed at a higher rate.
3.
Term
Interest rate guarantee (IRG)

Similar to a FRA but an option rather than on obligation. In the event that interest
rates move against the company (eg rise in the event of a loan) the option would
be exercised. If the rates move in our favour then the option is allowed to lapse.
There is a premium to pay to compensate the IRG writer for accepting the
downside risk.
Interest rate futures (STIR)

An exchange traded instrument that works in a similar manner to a FRA.
trading on the exchange the Future can fix the rate today for a future loan.
By
Exchange traded interest rate options

Similar to an IRG but exchange traded, the option gives protection against the
downside for the payment of a premium.
184
CHAPTER 12 RISK
LONG-TERM HEDGING SWAPS

A company will borrow either using a variable or a fixed rate. If it wishes to change
its borrowing type it could redeem its present debt and re-issue in the appropriate
form. There are risks and costs involved in doing so.
A swap allows the company to change the exposure (fixed to variable or vice versa)
without having to redeem existing debt.
To prepare a swap we need the following steps
1.
Identify a counter-party, either another company or bank willing to be the

other side of the transaction. If we want to swap fixed for variable they will
want the opposite
2.
Agree the terms of the swap to ensure that at the outset both parties are in a
neutral position
3.
On a regular basis (perhaps annually) transfer net amounts between the

parties to reflect any movement in the prevailing exchange rates
Advantages of swaps
o
t.c
Allows a change in interest rate exposure at relatively low cost and risk.
May allow access to a debt type that is otherwise unavailable to the company.
May reduce the overall cost of financing in certain circumstances.
p
gs
0
s2
.bl
0
o
bo
185

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m

The Accountancy College Ltd, January 2011

FINANCIAL MANAGEMENT: AN INTRODUCTION

INVESTMENT APPRAISAL TECHNIQUES

ADVANCED DISCOUNTED CASH FLOW TECHNIQUES

LONG TERM SOURCES OF FINANCE

CAPITAL STRUCTURE AND RISK ADJUSTED WACC

RAISING EQUITY FINANCE

WORKING CAPITAL MANAGEMENT

CHAPTER 10: EFFICIENT MARKET HYPOTHESIS

CHAPTER 12: RISK

CHAPTER 11: VALUATION

AIM OF THE PAPER

OUTLINE OF THE SYLLABUS

Financial management function

Financial management environment

Working capital management

FORMAT OF THE EXAM PAPER

What level of mathematical ability is required in F9?

What do I need to bring to class?

Is there any assumed knowledge?

The Capital Asset Pricing Model

The Asset Beta Formula

The Growth Model

Gordons Growth Approximation

The weighted average cost of capital

The Fisher formula

Purchasing Power Parity and Interest Rate Parity

Present Value Table

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

CORPORATE STRATEGY AND FINANCIAL MANAGEMENT

VALUE FOR MONEY

WHAT IS FINANCIAL MANAGEMENT?

Financial management and the accounting equation

The three key decisions

Financial management is often described in terms of the three basic decisions to be

the investment decision,

the financial decision,

the dividend decision.

The investment decision

A company may invest its funds in one of three basic areas:

The financing decision

total funding required,

internally generated vs externally sourced,

long-term or short-term debt.

Total funding required

Existing asset base

Redemption of existing debt

Funds generated through trading

Change in Working Capital

Internally vs externally generated funds

Short-term vs long-term debt

The dividend decision

The amount of return to be paid in cash to shareholders. This is a critical measure

Corporate strategy and k

Maximising shareholders wealth

Maximising shareholders wealth

A fundamental aim within financial management is to create and sustain

Within organisations it is normal to reward management on some measure of profit

Objectives of not-for-profit organisations