1. The nature and purpose of financial management. Financial objectives of a company
Financial management is concerned with the efficient acquisition and deployment of both
short – and long-term financial resources, to ensure the objectives of the enterprise are
achieved. Key areas of financial management: Investment:- Investment appraisal;- WC
management; - Risk. Dividend policy:- Business valuation; - Efficient markets. Finance:Sources of finance; - Cost of capital; - Capital structure; - Risk. Financial objectives:
Shareholder wealth maximisation is a fundamental principle of financial management. Many
other objectives are also suggested for companies including: profit maximization; growth;
market share; social responsibilities; Shareholder wealth maximization. If strategy is
developed in response to the need to achieve objectives, it is obviously important to be clear
about what those objectives are. Most companies are owned by shareholders and originally set
up to make money for those shareholders. The primary objective of most companies is thus to
maximise shareholder wealth. (This could involve increasing the share price and/or dividend
payout.) Profit maximization: In financial management we assume that the objective of the
business is to maximise shareholder wealth. This is not necessarily the same as maximising
profit. Firms often find that share prices bear little relationship to reported profit figures (e.g.
biotechnology companies and other 'new economy' ventures). There are a number of potential
problems with adopting an objective of profit maximisation:Long-run versus short-run issues:
In any business it is possible to boost short-term profits at the expense of long-term profits.
For example discretionary spending on training, advertising, repairs and research and
development (R&D) may be cut. This will improve reported profits in the short-term but
damage the long-term prospects of the business. The stock exchange will normally see
through such a tactic and share prices will fall.
2. The relationship between financial management and financial and management
accounting
Financial and management accounting are both important tools for a business, but serve
different purposes. A business uses accounting to determine operational plans in the future, to
review past performance and to check current business functions. Management and financial
accounting have different audiences, as investors are not usually involved in the day-to-day
operations of the business but are concerned about their investment, whereas managers need
information quickly to make daily business decisions. Financial Management means
planning, organizing, directing and controlling the financial activities such as procurement and
utilization of funds of the enterprise. It means applying general management principles to
financial resources of the enterprise. The objectives of financial management are like to
ensure regular and adequate supply of funds to the concern or to ensure safety on investment,
i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved,
also to plan a sound capital structure and etc. Management accounting is a field of accounting
that analyzes and provides cost information to the internal management for the purposes of
planning, controlling and decision making. Management accounting is the process of
identification, measurement, accumulation, analysis, preparation, interpretation, and
communication of information that used by management to plan, evaluate, and control within
an entity and to assure appropriate use of an accountability for its resources. This is the phase
of accounting concerned with providing information to managers for use in planning and
controlling operations and in decision making. In contrast, financial accounting is concerned
with providing information to stockholders, creditors, and others who are outside an
organization. Managerial accounting provides the essential data with which organizations are
actually run.
3. Discuss the relationship between financial objectives, corporate objectives and
corporate strategy
Strategy is usually associated with long-term planning and thinking. Strategy can be defined
as a course of action, including the specification of resources, necessary to achieve an
objective. Strategy formulation can only take place once the organization’s objectives have
been clearly identified. These objectives relate directly to the organization’s broad based goals
and, ultimately, to its mission. Objectives tell managers and employees precisely what they are
supposed to achieve. Corporate objectives will relate directly to the organisation’s goals and
indirectly to its mission. Corporate objectives are more business or commercial oriented as
opposed to financial. The corporate objectives include a) Customer loyalty: to supply
products, services and solutions of the highest quality and value to our customers, in order to
earn their respect and loyalty. b) Profit: to make sufficient profit to finance our company
growth and other corporate objectives, and increase value for our shareholders. c) Market
leadership: to grow by maintaining a supply of useful and significant products, services and
solutions to markets we already serve and to expand into new areas that build on our
technologies, skills and customer interests. d) Growth: to see change in the market as an
opportunity for growth; to use our profits and our ability to develop and produce innovative
products, services and solutions that satisfy changing customer needs. e) employee
commitment: to enable our employees to benefit from the company's success; to reward good
performance with employment opportunities; to create a safe, dynamic and inclusive work
environment that values employees’ diversity as well as individual contributions; and to help
them gain a sense of pride and achievement from their work. f) Leadership capability: to
develop leaders at every level who are responsible for achieving business results and
exemplifying our values. g) Global citizenship: to fulfil our responsibility to society by being
an economic, intellectual and social asset to each country and community in which we do
business. in practice, from the above, it can be seen that corporate objectives tend to be quite
varied. Financial objectives mostly aim at the maximization of shareholder wealth and are
linked to measures of profit. Examples of financial objectives include roce, roi and eps.
Alternatively, financial objectives can refer to objectives pursued by the financial manager.
Other examples would therefore include maintaining optimal cash balances, specific gearing
ratios and stock turnover periods.
4 Western concept of stakeholders and their objectives. Discuss possible conflicts
between stakeholder objectives
Stakeholders are persons or groups who are directly or indirectly affected by a project, as well
as those who may have interests in a project and/or the ability to influence its outcome, either
positively or negatively. Stakeholders may include locally affected communities or individuals
and their formal and informal representatives, national or local government authorities,
politicians, religious leaders, civil society organizations and groups with special interests, the
academic community, or other businesses. The “stake” that each of these different individuals
or groups has in a project or investment will vary. For example, there may be people directly
affected by the potential environmental or social impacts of a project. Others may be resident
in another country altogether, but wish to communicate their concerns or suggestions to the
project company. Then there are those who might have great influence over the project, such
as gov. regulators, political or religious leaders, and others active in the local community.
There are also stakeholders who, because of their knowledge or stature, can contribute
positively to the project, by acting as an honest broker in mediating relationships.
Stakeholders
Who are they
Objectives
Owners
They invest capital in the business
and get profits from the business
Profits, growth of the
business
Workers
Employees of the business who give Job security, job satisfaction
in their time and effort to make a
and a satisfactory level of
business successful
payment for their efforts
Managers
Employees of the business who
manage a business. They lead and
control the workers to achieve
organisational goals
High salaries, Job security,
Status and growth of the
business
Consumers
These are the people who buy the
goods and services of the business.
Safe and reliable products,
value for money, proper
after sales service
Government
Gov. manages the economy. It
charges a tax from the business and
also monitors the working of
businesses in the country
Successful businesses,
employments to be created,
more taxes, follow laws.
The
community
Community is all the people who are They expect more jobs,
directly or indirectly affected by the environmental protection,
actions of the business.
socially responsible
products
Here are some other potential conflicts between stakeholders:
• “Short-term” thinking by managers may discourage important long-term investment in the
business
• New developments in the business such as a major product launch or new factory may
require extra finance to be raised, which reduces the control of existing investors
• Investing in new machinery to achieve better efficiency may result in job losses
• Extending products into mass markets may result in lower quality standards
5. Means of measuring achievement of corporate objectives including: i) ratio analysis,
using appropriate ratios (e.g. return on capital employed, return on equity, earnings per
share and dividend per share) ii) changes in dividends and share prices as part of total
shareholder return
A ratio analysis is a quantitative analysis of information contained in a company’s financial
statements. Ratio analysis is based on line items in financial statements like the balance sheet,
income statement and cash flow statement; the ratios of one item – or a combination of items to another item or combination are then calculated. Ratio analysis is used to evaluate various
aspects of a company’s operating and financial performance such as its efficiency, liquidity,
profitability and solvency. The trend of these ratios over time is studied to check whether they
are improving or deteriorating. Ratios are also compared across different companies in the
same sector to see how they stack up, and to get an idea of comparative valuations. Dividends
per share=Dividends paid to shareholders/ Number of shares outstanding; EPS = Net income
available to shareholders/number of shares outstanding
ROE=Net income/equity; ROA =Net income/total assets; Dividend payout ratio=Dividends/
earnings; Price-earnings ratio=Market price per share/EPS; Before a dividend is distributed,
the issuing company must first declare the dividend amount and the date when it will be paid.
It also announces the last date when shares can be purchased to receive the dividend, called
the ex-dividend date. This date is generally two business days prior to the date of record,
which is the date when the company reviews its list of shareholders. The declaration of a
dividend naturally encourages investors to purchase stock. Because investors know that they
will receive a dividend if they purchase the stock before the ex-dividend date, they are willing
to pay a premium. This causes the price of stock to increase in the days leading up to the exdividend date. In general, the increase is about equal to the amount of the dividend, but the
actual price change is based on market activity and not determined by any governing entity.
On the ex-dividend date, the exchange reduces the stock price by the amount of the dividend
to account for the fact that new investors are not eligible to receive dividends and are therefore
unwilling to pay a premium. However, if the market is particularly optimistic about the stock
leading up to the ex-dividend date, the price increase this creates may be larger than the actual
dividend amount, resulting in a net increase despite the automatic reduction. If the dividend is
small, the reduction may even go unnoticed due to the back and forth of normal trading.
6. Finance in non-for-profit organisations
Nonprofit organizations are rarely judged solely by their financial bottom line; instead, their
worth is gauged by the effectiveness of their services and how successfully they achieve their
mission. For most organizations, the ability to deliver effective services is dependent on sound
management practices, of which financial management is an essential piece. NFP often find
that managing their many grants and contracts and complying with the reporting requirements
of various funders is enormously time consuming, especially for the sizable proportion of
organizations that rely on government funds. This situation leaves nonprofit organizations
vulnerable. Many lack cash reserves, making it difficult for them to build a safety net for
periods of low revenues. The true costs to an organization for delivering programs and
services are not limited to the costs of the materials, equipment and staff salaries directly
associated with each particular program. There are also operating expenses associated with
running the organization itself, frequently referred to as “overhead” costs. These include
management and administrative expenses, costs associated with raising money for the
organization, human resources, information technology, office furniture, heat, phones, rent and
the maintenance of the facility. Evidence show that some nonprofit organizations do not ask
for sufficient funds for overhead expenses because they lack the expertise and technical
capacity to determine these costs. Discuss ways of measuring the achievement of objectives in
NFP organizations With NFPs the nonfinancial objectives are often more important and more
comp ex because Most key objectives are very difficult to quantify, especially in financial
terms, ex quality of care given to patients in a hospital; Multiple and conflicting objectives are
more common in NFPs, e.g. quality of patient care versus number of patients treated.
Assessing whether the organisation provides value for money involves looking at all
functioning aspects of the organisation. Performance measures have been developed to permit
evaluation of each part separately. Economy: Minimising the costs of inputs required to
achieve a defined level of output. Efficiency: Ratio of outputs to inputs – achieving a high
level of output in relation to the resources put in (input driven) or providing a particular level
of service at reasonable input cost (output driven) . Effectiveness: Whether outputs are
achieved that match the predetermined objectives. Use of the 3Es as a performance measure
and a way to assess VFM is a key issue for examination questions that relate to NFPs and
public sector organizations
7. Identify and explain the main macroeconomic policy targets. Define and discuss the
role of fiscal, monetary, interest rate and exchange rate policies in achieving
macroeconomic policy targets
Macroeconomic policy is the management of the economy by government in such a way as to
influence the performance and behavior of the economy as a whole. The principal objectives
of macroeconomic policy will be to achieve following: • full employment of resources; price
stability ; economic growth; balance of payments equilibrium; an appropriate distribution of
income and wealth. The pursuit of macroeconomic objectives may involve tradeoffs –
where one objective has to be sacrificed for the sake of another, ex: Full
employment versus Price stability; Economic growth versus Balance of payments
Monetary policy is concerned with influencing the overall monetary conditions in the
economy in particular: the volume of money in circulation – the money supply; the price of
money – interest rates. Fiscal policy is the manipulation of the government budget in order to
influence the level of aggregate demand and therefore the level of activity in the economy. It
covers: government spending • taxation • government borrowing which are linked as follows:
public expenditure = taxes raised + government borrowing (+ sundry other income)
Factors affected
Achieved by controlling supply Achieved by increasing
interest rates
Availability of
finance
Credit restrictions=>small
businesses struggle to raise
funds
Cost of finance
Shareholders require
Reduced supply pushes up
the cost of funds=>discourages higher returns=>if not met
expansion
- share price falls
Exchange rates
Lvl of consumer
demand
High interest rates attracts
foreign investment =>
increase in exchange
rates: • exports dearer
•imports cheaper
Too difficult to raise funds to
spend
Saving becomes more
attractive
8. Describe the nature of working capital and identify its elements. Components of
working capital in various industries
In an ordinary sense, working capital denotes the amount of funds needed for meeting day-today operations of a concern. This is related to short-term assets and short-term sources of
financing. Hence it deals with both, assets and liabilities—in the sense of managing working
capital it is the excess of current assets over current liabilities. Working capital management
is essential for the long‐term success of a business. No business can survive if it cannot meet
its day‐to‐day obligations. A business must therefore have clear policies for the management
of each component of working capital. Working capital is the net of current assets minus
current liabilities. It normally includes inventories, receivables, cash (and cash equivalents),
less payables. Working capital = receivables + cash + inventory – payables; Working capital
ratio = Current Assets/Current Liabilities. The nature of working capital is as discussed below:
It is used for purchase of raw materials, payment of wages and expenses.; Working capital
enhances liquidity, solvency, creditworthiness and reputation of the enterprise.; It generates
the elements of cost namely: Materials, wages and expenses.; It enables the enterprise to avail
the cash discount facilities offered by its suppliers.; It helps improve the morale of business
executives and their efficiency reaches at the highest climax.; It facilitates expansion
programmes of the enterprise and helps in maintaining operational efficiency of fixed assets.
For various industries:
Manufacturing:
Inventories – High volume of WIP and finished goods
Trade Receivables – High levels of trade receivables as they tend to be dependent of a few
customers
Trade Payables – Low to medium levels
Retail :
Inventories – Goods for re-sale only and usually low volume
TR – Very low levels as most goods are bough in cash
TP- Very high levels due to huge purchases of inventory
Service:
Inventories – None or very little inventories
TR – Usually low levels as services are paid for immediately
TP – Low levels
The manufacturing company will need to invest heavily in spare parts and may be owed large
amounts of money by its customers. The food retailer will have a large inventory of goods for
resale but will have low accounts receivable. The manufacturing company will therefore need
a carefully considered policy on the management of accounts receivable which will need to
reflect the credit policies of its close competitors. The food retailer will be more concerned
with inventory management. The main objective of working capital management is to
maintain an optimal balance among each of the working capital components.
9. Identify the objectives of working capital management in terms of liquidity and
profitability, and discuss the conflict between them.
The aim of working capital management is to achieve balance between having sufficient
working capital to ensure that the business is liquid but not too much that the level of working
capital reduced profitability. The two main objectives of working capital management are to
ensure: it has sufficient liquid resources to continue in business and to increase its probability.;
the objective of profitability supports the primary financial management objective, which is
shareholder wealth maximization.; the objective of liquidity ensures that liabilities can be met
as they fall due. (b)
Conflict between two objectives: liquid assets such as bank accounts
earn very little return or no return, so liquid assets decrease profitability.; profitability is met
by investing over the longer term in order to achieve higher returns. (c)
Trade-off between
two objectives: it depends on the particular circumstances of an organization.; liquidity may
be more important objective when short-term finance is hard to find.; profitability may
become a more important objective when cash management has become too conservative.;
both objectives are important and neither can be neglected. Liquidity in the context of
working capital management means having enough cash or ready access to cash to meet all
payment obligations when these fall due. The main sources of liquidity are usually: cash in the
bank; short-term investments that can be cashed in easily and quickly; cash inflows from
normal trading operations (cash sales and payments by receivables for credit sales); an
overdraft facility or other ready source of extra borrowing. A firm choosing to have a lower
level of working capital than rivals is said to have an ‘aggressive’ approach, whereas a firm
with a higher level of working capital has a ‘defensive’ approach. Cash flow is the lifeblood of
the thriving business. Effective and efficient management of the working capital investment is
essential to maintaining control of business cash flow. Management must have full awareness
of the profitability versus liquidity trade-off.
10. Discuss, apply and evaluate the use of relevant techniques in managing inventory,
including the Economic Order Quantity model and Justin-Time techniques
Inventory management is the overseeing and controlling of the ordering, storage and use of
components that a company will use in its production processes. Some of the techniques are:
1)Setting up reordering level (ROL, a point at which order should be made), max, min levels.
Purchasing inventory in large quantities is cheaper, but holding costs are higher. The opposite
is true for smaller quantities. EOQ is calculated to determine the optimal size of an order =
√(2* annual demand of an item, units * cost of placing an order / inventory holding cost per
unit). 2) Bin systems. 2-bin system: Inventory is held in 2 "bins" – A & B. The standard
quantity for B ("reserve") is the expected demand during lead time + “buffer” inventory. First,
inventory from A is used until it is empty. Then an order is placed and in the meantime
materials from the bin B are used. When the new order arrives, bin B is filled at first and the
rest is held in A. 1-bin system: The same approach is applied for a single bin with the "red
line" within the bin indicating ROL. Advantage of bin systems is that the inventory stock
could be kept at lower level. 3)Periodic review system (constant order cycle system).
Inventory levels are reviewed at fixed intervals. ROL = demand before the next review +
demand during the lead time. Preferred by suppliers as order load is more evenly spread and is
easier to plan.4)Certain items may have a high value, but be subject to infrequent demand.
Management need to review inventory usage to identify slow-moving inventory. An aging
analysis should be performed on regularly basis so that actions could be taken.5)JIT is a series
of manufacturing and supply chain techniques that aims to minimize inventory levels and
improve customer service by manufacturing not only at the exact time customer require, but
also in exact quantities they need and at a competitive price.
11. The level of working capital investment in current assets. Discuss the key factors
determining this level, including:i) the length of the working capital cycle and terms of
trade ii) an organisation’s policy on the level of investment in current assets iii) the
industry in which the organization operates
Working capital = Cash and Bank + Inventory receivables + Current assets – Payables –
Overdraft – Current liabilities Working capital is the capital available for the day-to-day
operations of an organization. Cost of investing in WC is the cost of funding or the
opportunity cost of lost investment opportunities because cash is tied up and unavailable for
other uses. i) Length of working capital cycle The working capital cycle or operating cycle is
the period of time between when a company settles its accounts payable and when it receives
cash from its accounts receivable.; As the operating period lengthens, the amount of finance
needed increases.; Companies with comparatively longer operating cycles than others in the
same industry sector, will therefore require comparatively higher levels of investment in
current assets. Terms of trade:These determine the period of credit extended to customers, any
discounts offered for early settlement or bulk purchases, and any penalties for late payment; A
company whose terms of trade are more generous than another company in the same industry
sector will therefore need a comparatively higher investment in current assets. ii) Policy on
level of investment in current assets:Even within the same industry sector, companies will
have different policies regarding the level of investment in current assets, depending on their
attitude to risk.; A company with a comparatively conservative approach to the level of
investment in current assets would maintain higher levels of inventory, offer more generous
credit terms and have higher levels of cash in reserve than a company with a comparatively
aggressive approach.;While the more aggressive approach would be more profitable because
of the lower level of investment in current assets, it would also be more risky, for example in
terms of running out of inventory in periods of fluctuating demand or of failing to have the
particular goods required by a customer iii) Industry in which organization operates Some
industries, such as aircraft construction, will have long operating cycles due to the length of
time needed to manufacture finished goods and so will have comparatively higher levels of
investment in current assets than industries such as supermarket chains, where goods are
bought in for resale with minimal additional processing and where many goods have short
shelf-lives.
12. Calculate payback period and discuss the usefulness of payback as an investment
appraisal method. Discounted payback period.
Payback period is the number of years it takes for a company to recover its original
investment in a project, when net cash flow equals zero. The shorter the payback period of a
project, the more attractive the project will be to management. Though payback period is
useful from a risk analysis perspective, since it gives a quick picture of the amount of time
that the initial investment will be at risk, it cannot be used as the sole method of investment
appraisal, due to a number of limitations: The concept does not consider the presence of any
additional cash flows that may arise from an investment in the periods after full payback has
been achieved.; The payback method focuses solely upon the time required to pay back the
initial investment; it does not track the ultimate profitability of a project at all.; The method
does not take into account the time value of money, where cash generated in later periods is
work less than cash earned in the current period. (except for the discounted payback formula);
The denominator of the calculation is based on the average cash flows from the project over
several years - but if the forecasted cash flows are mostly in the part of the forecast furthest in
the future, the calculation will incorrectly yield a payback period that is too soon.
Discounted Payback Period. One of the limitations of the payback period is that it does not
take into account the time value of money, but the discounted payback period does. The
discounted payback period discounts each of the estimated cash flows and then determines the
payback period from those discounted flows.
13. Calculate net present value and discuss its usefulness as an investment appraisal
method. Internal rate of return, its application as an investment appraisal method.
Net Present Value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows. A positive net present value indicates that the projected
earnings generated by a project or investment (in present dollars) exceeds the anticipated costs
(also in present dollars), which means, that, in general, only project with positive NPV should
be accepted.
NPV is one of the most popular methods of investment appraisals. The only big limitation it
has is that it relies heavily upon multiple assumptions and estimates, so there can be
substantial room for error. Estimated factors include investment costs, discount rate and
projected returns. Additionally, discount rates and cash inflow estimates may not inherently
account for risk associated with the project and may assume the maximum possible cash
inflows over an investment period. Internal rate of return (IRR) is a metric commonly used as
an NPV alternative. Calculations of IRR rely on the same formula as NPV does, except with
slight adjustments. IRR calculations assume a neutral NPV (a value of zero). The discount rate
of an investment when NPV is zero is the investment’s IRR, essentially representing the
projected rate of growth for that investment. Because IRR is necessarily annual – it refers to
projected returns on a yearly basis – it allows for the simplified comparison of a wide variety
of types and lengths of investments. For example, IRR could be used to compare the
anticipated profitability of a 3-year investment with that of a 10-year investment because it
appears as an annualized figure. If both have an IRR of 18%, then the investments are in
certain respects comparable, in spite of the difference in duration.
14. Describe and discuss the difference between risk and uncertainty in relation to
probabilities and increasing project life. Accounting for risks in cash flows and discount
rate. Calculation of specific risk.
Risk refers to the situation where probabilities can be assigned to a range of expected
outcomes arising from an investment project and the likelihood of each outcome occurring
can therefore be quantified. Uncertainty refers to the situation where probabilities cannot be
assigned to expected outcomes. Investment project risk therefore increases with increasing
variability of returns, while uncertainty increases with increasing project life. The two terms
are often used interchangeably in financial management, but the distinction between them is a
useful one. Sensitivity analysis assesses how the net present value of an investment project is
affected by changes in project variables.
In this way the key or critical project variables are
determined. However, sensitivity analysis
does not assess the probability of changes in
project variables and so is often dismissed as
a way of incorporating risk into the
investment appraisal process. Probability analysis refers to the assessment of the separate
probabilities of a number of specified outcomes of an investment project. For example, a
range of expected market conditions could be formulated and the probability of each market
condition arising in each of several future years could be assessed. The net present values
arising from combinations of future economic conditions could then be assessed and linked to
the joint probabilities of those combinations. The expected net present value (ENPV) could be
calculated, together with the probability of the worst-case scenario and the probability of a
negative net present value. In this way, the downside risk of the investment could be
determined and incorporated into the investment decision. CAPM model is the most common
method of adjusting a discount rate for risk is by starting with a risk-free rate and adding a risk
premium. rf – risk-free rate; β relevered
– beta coefficient with consideration of target debt-to-equity ratio; rm – return of market
portfolio; rSP – company size premium; rSCR – specific risk premium; CAPM helps to
obtain cost of equity and then to derive WACC, that will be used to discount cash flows and
will allow to adjust them for risks. Specific Company Risk – SCR. Shows company’s specific
risk including: Start-up phase; Uncertainty of future ash flows (several scenarios); Aggressive
assumptions in cash flow construction; Specific risks of company associated with
management, operational activity, financing; Crucial role of management in company
performance Determination methods: Probability weighted cash flow forecasts; Empirical
ranges. It’s indicator is mainly a subject to professional judgement of an expert, mainly its
values are 1-2%.
15. Identify and discuss methods of raising short- and long-term Islamic finance
The growth and popularity of the use of Islamic finance has been exceptional since the Central
Bank of Bahrain issued the first sovereign sukuk bonds in 2001. It is estimated that by the end
of 2012 Islamic financial assets will have exceeded $1,600bn, which is around 1–2% of global
financial assets worldwide. THE BASIC PRINCIPLES OF ISLAMIC FINANCE;The Islamic
economic model has developed over time based on the rulings of Sharia on commercial and
financial transactions. The Islamic finance framework is based on: equity, such that all parties
involved in a transaction can make informed decisions without being misled or cheated;
pursuing personal economic gain but without entering into those transactions that are
forbidden (for example, transactions involving alcohol, pork-related products, armaments,
gambling and other socially detrimental activities). Also, speculation is also prohibited (so
options and futures are ruled out); the strict prohibition of interest (riba = excess). As stated
above, earning interest (riba) is not allowed. In an Islamic bank, the money provided in the
form of deposits is not loaned, but is instead channelled into an underlying investment
activity, which will earn profit. The depositor is rewarded by a share in that profit, after a
management fee is deducted by the bank. A typical illustration would be how an Islamic bank
may purchase a property from a seller and resell it to a buyer at a profit. The buyer will be
allowed to pay in instalments. Compare this to a typical mortgage where the bank lends
money to the buyer and charges interest. Hence, returns are made from cash returns from a
productive source – for example, profits from selling assets or allowing the use of an asset
(rent). In Islamic banking there are broadly two categories of financing techniques: ‘fixed
Income’ modes of finance – murabaha, ijara, sukuk; equity modes of finance – mudaraba,
musharaka. Methods of raising short- and long-term Islamic finance
. (a) Murabaha Murabaha is a form of trade credit or loan. The key distinction between a
murabaha and a loan is that, with a murabaha, the bank will take actual constructive or
physical ownership of the asset. The asset is then sold to the ‘borrower’ or ‘buyer’ for a profit
but they are allowed to pay the bank over a set number of instalments.
The period of the repayments could be extended, but no penalties or additional mark-up may
be added by the bank. Early payment discounts are not within the contract. (b) Ijara Ijara is
the equivalent of lease finance. It is defined as when the use of the underlying asset or service
is transferred for consideration. Under this concept, the bank makes available to the customer
the use of assets or equipment such as plant or motor vehicles for a fixed period and price.
Some of the specifications of an Ijara contact include: the use of the leased asset must be
specified in the contract; the lessor (the bank) is responsible for the major; intenance of the
underlying assets (ownership costs); the lessee is held for maintaining the asset in proper
order. An Islamic lease is more like an operating lease, but the redemption features may be
structured to make it similar to a finance lease. (c) Sukuk Companies often issue bonds to
enable them to raise debt finance. The bond holder receives interest and this is paid before
dividends. This is prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked to
an underlying asset, such that a sukuk holder is a partial owner in the underlying assets and
profit is linked to the performance of the underlying asset. So, for example, a sukuk holder
will participate in the ownership of the company issuing the sukuk and has a right to profits
(but will equally bear their share of any losses). EQUITY MODES (a) Mudaraba Mudaraba is
a special kind of partnership where one partner gives money to another for investing it in a
commercial enterprise. The investment comes from the first partner (who is called ‘rab ul
mal’), while the management and work is an exclusive responsibility of the other (who is
called ‘mudarib’).
16 Methods of estimation of the overall cost of capital. Cost of equity and cost of debt.
Discuss the problem of high level of gearing. Levered and unlevered beta, calculation
and application.
The cost of capital is the rate of return that the suppliers of capital—bondholders and owners
—require as compensation for their contributions of capital. This cost reflects the opportunity
costs of the suppliers of capital. The cost of capital is a marginal cost: the cost of raising
additional capital. The weighted average cost of capital (WACC) is the cost of raising
additional capital, with the weights representing the proportion of each source of financing
that is used. Also known as the marginal cost of capital (MCC). WACC = wdrd (1 - t) + wprp +
were where wd
is the proportion of debt that the company uses when it raises new funds; rd
is the before-tax marginal cost of debt; t is the company’s marginal tax rate; wp is the
proportion of preferred stock the company uses when it raises new funds ; rp
is the
marginal cost of preferred stock; we is the proportion of equity that the company uses when
it raises new funds; re is the marginal cost of equity. The cost of Debt
Alternative approaches Yield-to-maturity approach: Calculate the yield to maturity on the
company’s current debt. 1. Debt-rating approach: Use yields on comparably rated bonds with
maturities similar to what the company has outstanding. Yield-to-Maturity Approach
Consider a company that has $100 million of debt outstanding that has a coupon rate of 5%,
10 years to maturity, and is quoted at $98. What is the after-tax cost of debt if the marginal tax
rate is 40%? Assume semi-annual interest. Solution: rd = 0.0526 (1 – 0.4) = 3.156%
Debt-Rating Approach Consider a company that has nontraded $100 million of debt
outstanding that has a debt-rating of AA. The yield on AA debt is currently 6.2%. What is the
after-tax cost of debt if the marginal tax rate is 40%? Solution: rd = 0.062 (1 – 0.4) = 3.72%
The Cost of Equity Methods of estimating the cost of equity: Capital asset pricing model;
Dividend discount model; Bond yield plus risk premium. The capital asset pricing model
(CAPM) states that the expected return on equity, E(Ri) , is the sum of the risk-free rate of
interest, RF, and a premium for bearing market risk, bi [E(RM) – RF]: E(Ri) = RF + bi [E(RM) –
RF],where biis the return sensitivity of stock i to changes in the market return
E(RM)
is the expected return on the market; E(RM) – RF is the expected market risk
premium or equity risk premium (ERP)
The bond yield plus risk premium approach requires adding a premium to a
company’s yield on its debt: re = rd + Risk premium
This approach is based on the idea that the equity of the company is riskier than its debt,
but the cost of these sources move in tandem.
Project Betas
Issues in estimating a beta:
•
Judgment is applied in estimating a company’s beta regarding the estimation
period, the periodicity of the return interval, the appropriate market index, the
use of a smoothing technique, and adjustments for small company stocks.
•
If a company is not publicly traded or if we are estimating a project’s beta, then
we need to look at the risk of the company or project and use comparables.
•
When selecting a comparable for the estimation of a project beta, we ideally
would like to find a company with a single line of business, and that line of
business matches that of the project.
This ideal comparable is a pure play.
We use the beta of the comparable company to estimate an asset beta (beta
reflecting only business risk) and then use it for the subject project or company.
Levering and unlevering beta
To unlever beta, remove the comparable’s capital structure from the beta to arrive at the asset
beta, which reflects the company’s business risk:
β_"asset" = β_"equity" [1/(1+((1-t)D/E) )]
To lever the beta, adjust for the project’s financial risk:
β_"equity" = β_"asset" [1+((1-t)D/E)]
'Gearing Ratio'
The gearing ratio is a general term describing a financial ratio that compares some
form of owner's equity (or capital) to borrowed funds. Gearing is a measure of financial
leverage, demonstrating the degree to which a firm's activities are funded by owner's funds
versus creditor's funds.
The higher a company's degree of leverage, the more the company is considered risky. As for
most ratios, an acceptable level is determined by its comparison to ratios of companies in the
same industry. The best known examples of gearing ratios include the debt-to-equity ratio
(total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity /
assets), and debt ratio (total debt / total assets).
A company with high gearing (high leverage) is more vulnerable to downturns in the business
cycle because the company must continue to service its debt regardless of how bad sales are.
A greater proportion of equity provides a cushion and is seen as a measure of financial
strength.
17. Business valuation approaches and methods.
1) Asset-based approaches: Basically these business valuation methods total up all the
investments in the business. Asset-based business valuations can be done on a going concern
or on a liquidation basis. A going concern asset-based approach lists the business's net balance
sheet value of its assets and subtracts the value of its liabilities. A liquidation asset-based
approach determines the net cash that would be received if all assets were sold and liabilities
paid off. Using the asset-based approach to value a sole proprietorship is more difficult. In a
corporation all assets are owned by the company and would normally be included in a sale of
the business. Assets in a sole proprietorship exist in the name of the owner and separating
assets from business and personal use can be difficult. For instance, in a lawn care business a
sole proprietor may use various pieces of lawn care equipment for both business and personal
use. A potential purchaser of the business would need to sort out which assets the owner
intends to sell as part of the business. 2) Earning value approaches
These business valuation methods are predicated on the idea that a business's true value lies in
its ability to produce wealth in the future. The most common earning value approach is
Capitalizing Past Earning. With this approach, a valuator determines an expected level of cash
flow for the company using a company's record of past earnings, normalizes them for unusual
revenue or expenses, and multiplies the expected normalized cash flows by a capitalization
factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser
would expect on the investment, as well as a measure of the risk that the expected earnings
will not be achieved. Discounted Future Earnings is another earning value approach to
business valuation where instead of an average of past earnings, an average of the trend of
predicted future earnings is used and divided by the capitalization factor. What might such
capitalization rates be? In a Management Issues paper discussing "How Much Is Your
Business Worth?", Grant Thornton LLP suggests: "Well established businesses with a history
of strong earnings and good market share might often trade with a capitalization rate of, say
12% to 20%. Unproven businesses in a fluctuating and volatile market tend to trade at much
higher capitalization rates, say 25% to 50%." 3) Market value approaches Market value
approaches to business valuation attempt to establish the value of your business by comparing
your business to similar businesses that have recently sold. Obviously, this method is only
going to work well if there are a sufficient number of similar businesses to compare.
Assigning a value to a sole proprietorship based on market value is particularly difficult. By
definition sole proprietorships are individually owned so attempting to find public information
on prior sales of like businesses is not an easy task. Although the Earning Value Approach is
the most popular business valuation method, for most businesses, some combination of
business valuation methods will be the fairest way to set a selling price.
18. Describe the traditional view of capital structure and its assumptions. Miller and
Modigliani view on capital structure, both without and with corporate taxation, and
their assumptions.
Under the traditional theory of cost of capital, the cost declines initially and then rises as
gearing increases. The traditional view is as follows:(a)As the level of gearing increases, the
cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of
debt will increase.(b)The cost of equity rises as the level of gearing increases and financial
risk increases. There is a non-linear relationship between the cost of equity and gearing.(c)The
WACC does not remain constant, but rather falls initially as the proportion of debt capital
increases, and then begins to increase as the rising cost of equity (and possibly of debt)
becomes more significant.(d)The optimum level of gearing is where the company’s WACC is
minimized.Assumptions on which this theory is based are as follows:(a)The company pays
out all its earnings as dividends.(b)The gearing of the company can be changed immediately
by issuing debt to repurchase shares, or by issuing shares to repurchase debt. There are no
transaction costs for issues.(c)The earnings of the company are expected to remain constant in
perpetuity and all investors share the same expectations about these future earnings.
(d)Business risk is also constant, regardless of how the company invests its funds.(e)Taxation,
for the timing being, is ignored. Modigliani and Miller stated that, in the absence of tax, a
company’s capital structure would have no impact upon its WACC. The net operating income
approach takes a different view of the effect of gearing on WACC. In their 1958 theory, M&M
proposed that the total market value of a company, in the absence of tax, will be determined
only by two factors: (a) the total earnings of the company.(b) t h e l e v e l o f o p e r a t i n g
(business) risk attached to those earnings. The total market value would be computed by
discounting the total earnings at a rate that is appropriate to the level of operating risk. This
rate would represent the WACC of the company. Thus M&M concluded that the capital
structure of a company would have no effect on its overall value or WACC.
M&M made various assumptions in arriving at this conclusion, including:(a)A perfect capital
market exists, in which investors have the same information, upon which they act rationally, to
arrive at the same expectations about future earnings and risks.(b) There are no tax or
transaction costs.(c)
Debt is risk-free and freely available at the same cost to investors
and companies alike.If M&M I theory holds, it implies:(a)The cost of debt remains unchanged
as the level of gearing increases.(b) The cost of equity rises in such a way as to keep the
WACC constant. M&M with Tax (M&M II) In 1963, M&M modified their model to reflect
the fact that the corporate tax system gives tax relief on interest payments. They admitted that
tax relief on interest payments does lower the WACC. The savings arising from tax relief on
debt interest are the tax shield . They claimed that the WACC will continue to fall, up to
gearing to 100%. This suggests that companies should have a capital structure made up
entirely of debt. However, this does not happen in practice due to existence of other market
imperfections which undermine the tax advantages of debt finance.
Value of firm’s equity (SL) = (EBIT – interest expenses) × (1 – corporate profit tax rate)/Cost
of equity
Without tax
With tax
VL = VU
VL = VU + B × T
Proposition I
b. Value of
firm
Proposition II
c . C o s t o f rs = r0 + B/S × (r0 –
equity
rB)
d. WACC
rs = r0 + B/S × (r0 – rB) × (1 – TC)
WACCL = WACCU
(1 
WACCL = WACCU ×
B  TC
BS
)
19. Sources of finance for SMEs. Describe the nature of the financing problem for small
businesses in terms of the funding gap, the maturity gap and inadequate security.
Potential sources of financing include the following:
Owner financing
➢
Overdraft financing
➢
Bank loans
➢
Trade credit
➢
Equity finance
➢
Business angel financing
➢
Venture capital
➢
Leasing
➢
Factoring
➢
Financing problem for small businesses
Funding gap:
A funding gap is the difference between the money required to begin or continue
➢
operations, and the money currently accessible.
Funding gaps are common in very young companies, who may underestimate the
➢
amount of capital needed to sustain production until a workable cash flow has
been established.
Maturity gap:
It is particularly difficult for SMEs to obtain medium term loans due to a
➢
mismatching of the maturity of assets and liabilities.
Longer term loans are easier to obtain than medium term loans as longer loans
➢
can be secured with mortgages against property.
Inadequate security:
A common problem is often that the banks will be unwilling to increase loan
➢
funding without an increase in security given (which the owners may be
unwilling or unable to give), or an increase in equity funding (which may be
difficult to obtain).
20. Describe and discuss different types of foreign currency risk, different types of
interest rate risk, the causes of exchange rate and interest rate fluctuations
Firms may be exposed to three types of foreign exchange risk: Transaction risk - the risk of
an exchange rate changing between the transaction date and the subsequent settlement date on
an individual transaction (i.e.it is the gain or loss arising on conversion). It is associated with
exports/imports. Ex: suppose there is a three-day lag between a transaction's execution and
settlement. The company is receiving payment in GBP which they must repatriate into USD their local currency. Transaction risk is the risk that the GBP/USD exchange rate will decrease
during this three-day lag. Economic risk - includes the longer-term effects of changes in
exchange rates, government regulation, or political stability on the market value of the
company (PV of the future cash flows). It is the long-term version of transaction risk. Looks at
how changes in exchange rates affect competitiveness, directly or indirectly; Reduce by
geographic diversification. For an export company it could occur because the home currency
strengthens against the currency in which it trades, OR a competitor’s home currency weakens
against the currency in which it trades. Ex: let's assume American Company XYZ invests
$1,000,000 in a manufacturing plant in the Congo. The political environment could shift
quickly, perhaps prompting the Congolese government to seize the plant or significantly
change laws that affect Company XYZ's ability to operate the plant. Likewise, hyperinflation
could make it impossible to pay workers, or exchange rate circumstances could make it
unprofitable to move profits out of the country. Translation risk (an accounting risk rather
than cash-based one) – shows how changes in exchange rates affect the translated value of
foreign assets and liabilities (e.g. foreign subsidiaries). It can be hedged by borrowing in local
currency to fund investment. Ex: if initially the exchange rate is given by $1/₤ and an
American subsidiary is worth $500 000, then the UK parent company will anticipate a balance
sheet value of ₤500 000 for the subsidiary. A depreciation of the US dollar to $2/₤ would
result in only ₤250 000 being translated. Exchange rates fluctuate due to: differentials in
inflation, differentials in interest rates, current-account deficits, public debt, terms of trade,
political stability and economic performance. Ex: during 2007-2009 the value of Sterling fell
over 20%. This was due to: Restoring UK’s lost competitiveness. UK had large current
account deficit in 2007: Bank of England cut interest rates to 0.5% in 2008.; Recession hit UK
economy hard. Markets expected interest rates in UK to stay low for a considerable time.;
Bank of England pursued quantitative easing (increasing money supply). This raised prospect
of future inflation, making UK bonds less attractive. Interest rate risk: Gap/interest rate
exposure – interest rate risk refers to the risk of an adverse movement in interest rates and
thus a reduction in the company’s net cash flow. Compared to currency exchange rates,
interest rates do not change continually, but changes in interest rates occur frequently, and the
size of the changes can be substantial. Basis risk - the risk that the value of a futures contract
(or an over-the-counter (OTC) hedge) will not move in line with that of the underlying
exposure. Alternatively, it is the risk that the cash futures spread will widen or narrow between
the times at which a hedge position is implemented and liquidated. Ex: a heating-oil
wholesaler selling its product in Baltimore will be exposed to basis risk if it hedges using New
York Harbor heating oil futures contracts listed by Nymex. Interest rates fluctuate due to:
economic growth, fiscal policy, monetary policy, inflation.
21. Identify the main types of foreign currency derivatives used to hedge foreign currency risk and
interest risk and explain how they are used in hedging: there are two methods of exchange risk
hedging through currency derivatives: 1) currency futures and 2) currency options.
CURRENCY FUTURES:A futures contract-arrangement between two parties to buy or sell an
asset at a particular time in the future for a particular price. The main reason that companies or
corporations use future contracts is to offset their risk exposures and limit themselves from
any fluctuations in price. The ultimate goal of an investor using futures contracts to hedge is to
neutralize risk as much as possible. The main advantage of participating in a futures contract
is that it removes the uncertainty about the future price of an item. By locking in a price for
which you are able to buy or sell a particular item, companies are able to eliminate the
ambiguity having to do with expected expenses and profits. This approach allows hedging to
be carried out using a market mechanism rather than entering into the individually tailored
contracts that the forward contracts and money market hedges require. However, this
mechanism does not offer anything fundamentally new.OPTIONS:give the holder the right,
but not the obligation, to buy or sell a given amount of currency at a fixed exchange rate (the
exercise price) in the future. The right to sell a currency at a set rate is a put option; the right
to buy the currency at a set rate is a call option. Options can be regarded just like an insurance
policy on your house. If your house doesn’t burn down you don’t call on the insurance, but
neither do you get the premium back. If there is a disaster the insurance should prevent
massive losses. Options are also useful if you are not sure about a cash flow. For example, say
you are bidding for a contract with a foreign customer. You don’t know if you will win or not,
so don’t know if you will have foreign earnings, but want to make sure that your bid price will
not be eroded by currency movements. In those circumstances, an option can be taken out and
used if necessary or ignored if you do not win the contract or currency movements are
favorable.The interest rate derivatives that can be used to hedge interest rate risks are: Interest
rate futures; Interest rate options; Interest rate caps, floors and collars; Interest rate swaps.
INTEREST RATE FUTURES: Futures contracts are of fixed sizes and for given durations.
They give their owners the right to earn interest at a given rate, or the obligation to pay
interest at a given rate. Interest rate futures can be bought and sold on exchanges. The price of
futures depends on the prevailing rate of interest and it is crucial to understand that as interest
rates rise, the market price of futures contracts falls. The approach used with futures to hedge
interest rates depends on two parallel transactions: borrow or deposit at the market rates. Buy
and sell futures in such a way that any gain that the profit or loss on the futures deals
compensates for the loss or gain on the interest payments. INTEREST RATE OPTIONS:
allow businesses to protect themselves against adverse interest rate movements while allowing
them to benefit from favorable movements. They are also known as interest rate guarantees.
You pay a premium to take out the protection. This is non-returnable whether or not you make
use of the protection. If interest rates move in an unfavorable direction you can call on the
insurance. If interest rates move favorable you ignore the insurance. Options are taken on
interest rate futures contracts and they give the holder the right, but not the obligation, either
to buy the futures or sell the futures at an agreed price at an agreed date. Options therefore
give borrowers and lenders a way of guaranteeing minimum income or maximum costs whilst
leaving the door open to the possibility of higher income or lower costs. These ‘heads I win,
tails you lose’ benefits have to be paid for and a non-returnable premium has to be paid up
front to acquire the options. Interest Rate caps, floors and collars: cap involves using
interest rate options to set a maximum interest rate for borrowers. If the actual interest rate is
lower, the option is allowed to lapse. Interest rate floor involves using interest rate options to
set a minimum interest rate for investors. If the actual interest rate is higher the investor will
let the option lapse. Interest rate collar involves using interest rate options to confine the
interest paid or earned within a pre-determined range. A borrower would buy a cap and sell a
floor, thereby offsetting the cost of buying a cap against the premium received by selling a
floor. A depositor would buy a floor and sell a cap. INTEREST RATE SWAPS: allow
companies to exchange interest payments on an agreed notional amount for an agreed period
of time. Swaps may be used to hedge against adverse interest rate movements or to achieve a
desired balanced between fixed and variable rate debt. Interest rate swaps allow both
counterparties to benefit from the interest payment exchange by obtaining better borrowing
rates than they are offered by a bank. The most common type of swap involves exchanging
fixed interest payments for variable interest payments on the same notional amount. This is
known as a plain vanilla swap. Swaps allow companies to hedge over a longer period of time
than other interest rate derivatives, but do not allow companies to benefit from favorable
movements in interest rates. Another form of swap is a currency swap, which is also an
interest rate swap. They are used to exchange interest payments and the principal amounts in
different currencies over an agreed period of time. They can be used to eliminate transaction
risk on foreign currency loans. An example would be a swap that exchanges fixed rate dollar
debt for fixed rate euro debt.
22. Financial restructuring. Distress assets. Conversion of debt to equity.
A company will need to undergo some financial restructuring to better position itself for longterm success. Financial restructuring relates to improvements in the capital structure of the
firm. An example of financial restructuring would be to add debt to lower the corporation's
overall cost of capital. For otherwise viable firms under stress it may mean debt rescheduling
or equity-for-debt swaps based on the strength of the firm. If the firm is in bankruptcy, this
financial restructuring is laid out in the plan of reorganization.
Financial restructuring may mean refinancing at every level of capital structure, including:
Securing asset-based loans (accounts receivable, inventory, and equipment); Securing
mezzanine and subordinated debt financing; Securing institutional private placements of
equity; Achieving strategic partnering; Identifying potential merger candidates.
Example of debt restructuring: In 2014, as a result of deteriorating market conditions,
Mechel defaulted on its debt obligations. Debt to be restructured amounts to $5.1bn (80% of
total debt) and includes only the largest creditors: Sberbank ($1,267m), Gazprombank
($1,793m), VTB ($1,068m), Syndicate of International banks ($1,004m).
Debt Restructuring Terms:
 Tenure (Repayment extends up to 2017-2022)
 Currency (Full conversion of the Gazprombank and VTB loans into rubles; Ruble
portion of the debt up from 35% to 60%)
 Interest rates (Rates tied to LIBOR and CBR Key rate instead of highly volatile
MosPrime rate; Ruble interest payments down to 8.75% from current 12.5%-14.5% due
to partial interest capitalization)
 Penalties and fines (Banks agree to waive significant portion of accrued penalties and
fines).
A distressed asset is an asset that is being sold because its owner is forced to sell it. For
example, XYZ Inc. declares bankruptcy. All of XYZ Inc.'s office furniture goes up for sale in
an auction. The office furniture would be considered a "distressed asset".
A debt/equity swap: debt is exchanged for a predetermined amount of equity (or stock). The
value of the swap is determined usually at current market rates, but management may offer
higher exchange values to entice share and debt holders to participate in the swap.
For illustration, assume a creditor gave a total of $1,500 to ZXC Corp. ZXC has offered the
option to swap his dang to stock at a rate of 1:1, or dollar for dollar. The creditor would get
$1,500 of equity if he elected to take the swap. If the company really wanted creditors to trade
bonds for shares, it can sweeten the deal by offering a swap ratio of 1:1.5. Besides, the
creditor would obtain rights of a shareholder, such as voting rights.
23. Application of economic profit method (EVA) in project analysis.
Economic value added (EVA) is an internal management performance measure that compares
net operating profit to total cost of capital. Stern Stewart & Co. is credited with devising this
trademarked concept.
Economic value added (EVA) is also referred to as economic profit.
 EVA = Net Operating Profit After Tax - (Capital Invested x WACC)
As shown in the formula, there are three components necessary to solve EVA: net operating
profit after tax (NOPAT), invested capital, and the weighted average cost of capital (WACC)
operating profit after taxes (NOPAT) can be calculated, but can usually be easily found on the
corporation's income statement. The next component, capital invested, is the amount of money
used to fund a particular project. We will also need to calculate the weighted-average cost of
capital (WACC) if the information is not provided. The idea behind multiplying WACC and
capital investment is to assess a charge for using the invested capital. This charge is the
amount that investors as a group need to make their investment worthwhile.
Example: assume that Company XYZ has the following components to use in the EVA
formula:
NOPAT = $3,380,000
Capital Investment = $1,300,000
WACC = .056 or 5.60%
EVA = $3,380,000 - ($1,300,000 x .056) = $3,307,200
The positive number tells us that Company XYZ more than covered its cost of capital. A
negative number indicates that the project did not make enough profit to cover the cost of
doing business.
Economic Value Added (EVA) is important because it is used as an indicator of how profitable
company projects are and it therefore serves as a reflection of management performance. The
idea behind EVA is that businesses are only truly profitable when they create wealth for their
shareholders, and the measure of this goes beyond calculating net income. Economic value
added asserts that businesses should create returns at a rate above their cost of capital.
The economic value calculation has many advantages. It succinctly summarizes how much
and from where a company created wealth. It includes the balance sheet in the calculation and
encourages managers to think about assets as well as expenses in their decisions.
However, the seemingly infinite cash adjustments associated with calculating economic value
can be time-consuming. Moreover, accrual distortions can still affect the measure, particularly
when it comes to depreciation and amortization differences. In addition, economic value
added only applies to the period measured; it is not predictive of future performance,
especially for companies in the midst of reorganization and/or about to make large capital
investments.
The EVA calculation depends heavily on invested capital, and it is therefore most applicable to
asset-intensive companies that are generally stable. Thus, EVA is more useful for auto
manufacturers, for example, than software companies or service companies with many
intangible assets.
24. Mergers and acquisitions. Classifications, synergy effects, valuations, investment vs. market value.
Impairment of assets.
Mergers and acquisitions (M&A) are transactions in which the ownership of companies,
other business organizations or their operating units are transferred or combined. As an aspect
of strategic management, M&A can allow enterprises to grow, shrink, change the nature of
their business or improve their competitive position. From a legal point of view, a merger is a
legal consolidation of two entities into one entity, whereas an acquisition occurs when one
entity takes ownership of another entity's stock, equity interests or assets. Varieties of
Mergers Horizontal merger - Two companies that are in direct competition and share the same
product lines and markets. Vertical merger - A customer and company or a supplier and
company. Think of a cone supplier merging with an ice cream maker. Market-extension
merger - Two companies that sell the same products in different markets. Product-extension
merger - Two companies selling different but related products in the same
market. Conglomeration - Two companies that have no common business areas. Purchase
Mergers - As the name suggests, this kind of merger occurs when one company purchases
another. The purchase is made with cash or through the issue of some kind of debt instrument;
the sale is taxable. Consolidation Mergers - With this merger, a brand new company is formed
and both companies are bought and combined under the new entity. The tax terms are the
same as those of a purchase merger. Synergy is the magic force that allows for enhanced cost
efficiencies of the new business. Synergy takes the form of revenue enhancement and cost
savings. By merging, the companies hope to benefit from the following: Staff reductions.
Economies of scale - a bigger company placing the orders can save more on costs. Acquiring
new technology - By buying a smaller company with unique technologies, a large company
can maintain or develop a competitive edge. Improved market reach and industry visibility A merge may expand two companies' marketing and distribution, giving them new sales
opportunities. Investors in a company that are aiming to take over another one must determine
whether the purchase will be beneficial to them. In order to do so, they must ask themselves
how much the company being acquired is really worth. The most common methods of
valuation: Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company
makes an offer that is a multiple of the earnings of the target company. Enterprise-Value-toSales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple
of the revenues, again, while being aware of the price-to-sales ratio of other companies in the
industry. Replacement Cost - suppose the value of a company is simply the sum of all its
equipment and staffing costs. The acquiring company can literally order the target to sell at
that price, or it will create a competitor for the same cost. Discounted Cash Flow (DCF) - A
key valuation tool in M&A, discounted cash flow analysis determines a company's current
value according to its estimated future cash flows. Investment Value is a concept often
associated with the real estate field. The investment value is the amount of money investors
are willing to spend on a property because they know they can make that money back on the
rental market, for example. Market Values - the actual amount a property is worth; it's based
on in-depth research. If the investment value is higher than market value, then the property
likely has characteristics that make it a good deal. The potential buyer sees something in the
property that smells like profit. An impaired asset is a company's asset that is worth less on the
market than the value listed on the company's balance sheet. This will result in a write-down
of that same asset account to the stated market price. Accounts that are likely to be written
down are the company's goodwill, accounts receivable and long-term assets. If the sum of all
estimated future cash flows is less than the carrying value of the asset, then the asset would be
considered impaired and would have to be written down to its fair value. Once an asset is
written down, it may only be written back up under very few circumstances. Firm's carrying
goodwill on their books are required to make tests of impairment annually. Any impairments
found will then be expensed on the company's income statement. Negative publicity about a
firm can create goodwill impairment, as can the reduction of brand-name recognition.
Examples: In February 2014, Facebook announced that it would be buying mobile messaging
company Whatsapp for US$19 billion in cash and stock. In June 2014, Facebook announced
the acquisition of Pryte, a Finnish mobile data-plan firm that aims to make it easier for mobile
phone users in underdeveloped parts of the world to use wireless Internet apps. In 2010, Intel
purchased McAfee, a manufacturer of computer security technology for $7.68 billion. As a
condition for regulatory approval of the transaction, Intel agreed to provide rival security
firms with all necessary information that would allow their products to use Intel's chips and
personal computers. After the acquisition, Intel had about 90,000 employees, including about
12,000 software engineers.
25. Venture capital, its role in innovation process
Venture capital is money provided by investors to startup firms and small businesses
with perceived long-term growth potential. This is a very important source of funding for
startups that do not have access to capital markets. It typically entails high risk for the
investor, but it has the potential for above-average returns.
Venture capital can also include managerial and technical expertise. Most venture
capital comes from a group of wealthy investors, investment banks and other financial
institutions that pool such investments or partnerships. This form of raising capital is popular
among new companies or ventures with limited operating history, which cannot raise funds by
issuing debt. The downside for entrepreneurs is that venture capitalists usually get a say in
company decisions, in addition to a portion of the equity.
Venture capital funds invest in companies in exchange for equity in the companies
they invest in, which usually have a novel technology or business model in high technology
industries, such as biotechnology and IT.
Venture capital is also a way in which the private and public sectors can construct an
institution that systematically creates networks for the new firms and industries, so that they
can progress. This institution helps identify and combine business functions such as finance,
technical expertise, marketing know-how, and business models. Once integrated, these
enterprises succeed by becoming nodes in the search networks for designing and building
products in their domain.
Venture capitalists are typically very selective in deciding what to invest in; as a result,
firms are looking for the extremely rare yet sought-after qualities such as innovative
technology, potential for rapid growth, a well-developed business model, and an impressive
management team. Of these qualities, funds are most interested in ventures with exceptionally
high growth potential, as only such opportunities are likely capable of providing financial
returns and a successful exit within the required time frame (typically 3–7 years) that venture
capitalists expect.
This need for high returns makes venture funding an expensive capital source for
companies, and most suitable for businesses having large up-front capital requirements, which
cannot be financed by cheaper alternatives such as debt. That is most commonly the case for
intangible assets such as software, and other intellectual property, whose value is unproven. In
turn, this explains why venture capital is most prevalent in the fast-growing technology and
life sciences or biotechnology fields.
Top 3 venture companies: 1) Andreessen Horowitz, USA. Investments (in millions,
USD): $1,020.23, Annual deals: 50, Industries: Consumer products and services, software. 2)
Khosla Ventures, China, USA. Investments (in millions, USD): $809, Annual deals: 45,
Industry: Software. 3) SV Angel, USA. Investments (in millions, USD): $736, Annual deals:
47, Industries: Commercial services, software.
26. Project finance in Russia: current practices. Project finance abroad (EU, US, other
selected countries)
Project finance is the long-term financing of infrastructure and industrial projects based upon
the projected cash flows of the project rather than the balance sheets of its sponsors. Usually, a
project financing structure involves a number of equity investors, known as 'sponsors', as well
as a 'syndicate' of banks or other lending institutions that provide loans to the operation. They
are most commonly non-recourse loans, which are secured by the project assets and paid
entirely from project cash flow, rather than from the general assets or creditworthiness of the
project sponsors, a decision in part supported by financial modeling.
Russia - "Nord Stream" -. project on construction of a gas pipeline between Russia and
Germany for the construction of which 7.4 billion euros were involved.
"Pulkovo" - the construction of new and the renovation of the existing terminal in airport
"Pulkovo", the volume of investments amounted to more than EUR 1 billion.
"Blue Stream" - project on construction of a gas pipeline between Russia and Turkey, the total
expenditure amounted to 3.2 billion US dollars.
US, EU and others - A classic example of a successful project financing is a "Eurotunnel"
project. While implementing this project, loan guarantees were made by 50 international
banks. A bank syndicate of 198 banks were acted as a lender.
"RusVinyl" - a joint Russian-Belgian company for the production of polyvinyl chloride (PVC)
in the Kstovo district of Nizhny Novgorod region. The loan agreement for the project
Financing was for up to 750 million euro for up to 12.5 years. Funding was done by several
banks, representing the world's largest financial institutions, including the Sberbank, the
European Bank for Reconstruction and Development, BNP Paribas, ING Bank N. V. and
HSBC.
Platinum toll highway - The N4 is a national route in South Africa that runs from Botswana
border, past Rustenburg, Pretoria, Witbank and Nelspruit, to the Mozambique border. Since
the completion of the A2 through Botswana, the entire Corridor is now a world-class standard
highway; it features at least one carriageway in each direction of high-speed traffic plus a
paved shoulder for its entire length. The N4 West Platinum Highway toll route (west of
Pretoria) is currently operated by the Bakwena consortium under license from the South
African National Roads Agency Limited (SANRAL).
27. Private-public partnership: history and current trends in Russia and abroad. WHAT
IT IS: Public-private partnerships are business relationships between a private-sector
company and a government agency for the purpose of completing a project that will serve the
public. Public-private partnerships can be used to finance, build and operate projects such as
public transportation networks, parks and convention centers. Financing a project through a
public-private partnership can allow a project to be completed sooner or make it a possibility
in the first place. There are usually two fundamental drivers for PPPs. Firstly, PPPs are
claimed to enable the public sector to harness the expertise and efficiencies that the private
sector can bring to the delivery of certain facilities and services traditionally procured and
delivered by the public sector. Secondly, a PPP is structured so that the public sector body
seeking to make a capital investment does not incur any borrowing. HISTORY: Pressure to
change the standard model of public procurement arose initially from concerns about the level
of public debt, which grew rapidly during the macroeconomic dislocation of the 1970s and
1980s. Governments sought to encourage private investment in infrastructure, initially on the
basis of accounting fallacies arising from the fact that public accounts did not distinguish
between recurrent and capital expenditures. The idea that private provision of infrastructure
represented a way of providing infrastructure at no cost to the public has now been generally
abandoned; however, interest in alternatives to the standard model of public procurement
persisted. In particular, it has been argued that models involving an enhanced role for the
private sector, with a single private-sector organization taking responsibility for most aspects
of service provisions for a given project, could yield an improved allocation of risk, while
maintaining public accountability for essential aspects of service provision. Initially, most
public–private partnerships were negotiated individually, as one-off deals, and much of this
activity began in the early 1990s. RUSSIA: The first attempt to introduce PPP in Russia was
made in St. Petersburg (Law #627-100 (25.12.2006), "On St. Petersburg participation in
public-private partnership"). Nowadays there are special laws about PPP in 69 subjects of
Russian Federation. But the biggest part of them are just declarations. Besides PPP in Russia
is also regulated by Federal Law #115-FZ (21.07.2005) “On concessional agreements” and
Federal Law #94-FZ (21.07.2005) "On Procurement of Goods, Works and Services for State
and Municipal Needs". In some ways PPP is also regulated by Federal Law №116-FZ
(22.07.2005) "On special economic zones"(in terms of providing business benefits on special
territories - in the broadest sense it is a variation of PPP). Still all those laws and documents
do not cover all possible PPP forms. In February 2013 experts rated Subjects of Russian
Federation according to their preparedness for implementing projects via public-private
partnership. The most developed region is Saint Petersburg (with rating 7.8), the least –
Chukotka (rating 0.0). By 2013 there were almost 300 public-private partnership projects in
Russia. ABROAD. USA: The West Coast Infrastructure Exchange (WCX), a State/Provincial
Government-level partnership between California, Oregon, Washington, and British Columbia
that was launched in 2012, conducts business case evaluations for selected infrastructure
projects and connects private investment with public infrastructure opportunities. The
platform aims to replace traditional approaches to infrastructure financing and development
with "performance-based infrastructure" marked by projects that are funded where possible by
internal rates of return, as opposed to tax dollars, and evaluated according to life-cycle social,
ecological and economic impacts, as opposed to capacity addition and capital cost. The My
Brother's Keeper Challenge is another example of a public-private partnership. CHINA:The
municipal government of Shantou, China signed a 50-billion RMB PPP agreement with the
CITIC group to develop a massive residential project spanning an area of 168 square
kilometers, locating on the southern district of the city's central business district. The project
includes real estate development, infrastructure construction including a cross-harbor tunnel,
and industry developments. The project, named Shantou Coastal New Town, aims itself to be
a high-end cultural, leisure, business hub of the East Guangdong area.
28. Banks for development in Russia and abroad. Role in the economy and major
problems
The majority of banks for development are set up in accordance with a special law and
normative act, and control over these banks is carried out by governments, not central banks.
The special status and the support, provided to banks for development by the state, allow
creditors to regard these banks as the borrowers, bearing the sovereign risk, which
significantly improves the conditions of borrowing on the domestic and international market.
Low-cost and long-term of borrowing, lower costs of doing business are the basis for the
efficiency of banks, allowing them to take risks that commercial banks would not be able to
afford. In different countries, development banks have different functions, but we can
highlight the key features of banks for development: • financing long-term projects in the
priority sectors of the economy; • financing projects aimed at the alignment of the level of
development of different regions of the country; • carrying out role of agent of the government
for the implementation of public investment projects; • borrowing abroad and on the domestic
market to finance public-significant projects; • credit support for small businesses that do not
have access to loans of commercial banks and other functions. One of the main problems of
banks for development is: low profitability. The main bank for development in Russia is
Vnesheconombank. Vnesheconombank is a state corporation for development, its main task to create conditions for economic growth and stimulate investment. Since 2007, the main
activity of Vnesheconombank was the financing of large investment projects, which, for one
reason or another can not be realized at the expense of commercial banks. According to the
memorandum of financial policy, Vnesheconombank lends to projects worth more than 2
billion rubles and the term of the loan at the same time must be greater than 5 years.
Vnesheconombank also supports exports, provision of state guarantees for loans, the
development of mechanisms of public-private partnership, assistance in attraction of foreign
investment. A lot of countries in America, Europe, Asia and Africa have their own
development banks. Some of them are: Business Development Bank of Canada, Development
Bank of Austria, Norwegian Industrial and Regional Development Fund, Agricultural
Development Bank of China, Development Bank of Southern Africa and many others.
29. Sanctions of US and EU: impact on Russian and foreign companies and on project
finance and implementation in Russia
In response to Russia’s annexation of the Crimean region of Ukraine and ongoing military
intervention in eastern Ukraine, the United States has imposed a number of economic
sanctions on Russian individuals, entities, and sectors. The United States coordinated its
sanctions with other countries, particularly the European Union (EU). Russia has retaliated
against sanctions by banning imports of certain agricultural products from countries imposing
sanctions, including the United States, for one year.
Economic conditions in Russia have deteriorated at a faster rate in recent months. Capital
flight from Russia has accelerated, the ruble has depreciated by more than 50%, inflation has
increased, and the Russian economy is projected to contract by 3.0% in 2015. It is difficult to
assess whether, and if so how much, targeted U.S. sanctions on Russian individuals and
entities have contributed to worsening economic conditions in Russia, since other factors are
likely contributing to Russia’s economic challenges. In particular, oil prices have fallen by
50% in the past six months, and oil is a major Russian export and source of revenue for the
government. However, many analysts, including senior officials at the International Monetary
Fund, have argued that sanctions are at least one factor contributing to the increasingly
difficult economic situation in Russia.
The sanctions established by the USA and the EU concerning the Russian banking sector
involves quite considerable part – more than 50% of total assets. According to the restrictions,
the EU forbids to perform operations with securities and financial instruments of the monetary
market longer than 30 days to the largest state banks – to Sberbank of Russia, VTB, Bank of
Moscow, Gazprombank, Rosselkhozbank and Vnesheconombank, and also their affiliated
structures from shares of more than 50% in the capital. As a result, it is necessary to add to
this list, along with insignificant affiliated structures, such large organizations as VTB the
Capital and Sberbank SIB.
Certainly, one more important factor is psychological influence of sanctions on potential
investors, creditors and contractors that leads to decrease in a level of credibility to the
Russian issuers and financial institutions. It is promoted also by revaluation of ratings of the
Russian credit institutions and issuers by the largest international rating agencies which this
year in the estimates have taken out the negative forecast practically for all credit institutions.
In spite of the fact that sanctions won't make considerable direct short-term impact on banking
and financial sector, their medium-term and long-term negative impact will be notable.
Considerably the level of credibility to the Russian financial sector, and not only in the world
market of the capital, but also in domestic market will decrease.
According to experts, the only exit for Russia in the circumstances are profound structural
changes, refusal of an oil needle and search of a compromise for return to process of
integration with the West. We cannot count on fast cancellation of sanctions — the certain
European Union countries, though speak in favor for our country, on vote will take the part of
the majority.
30. Anti-offshore legislation in Russia. Experience in other countries. Effect on financial
management of enterprise.
Anti- offshore law regulates taxation of controlled foreign companies (not a tax resident of
Russia, but controlled by persons who are tax residents of the Russian Federation).
Controlling person - the owner of the company, the share in the authorized capital is 25%. If
total number of Russians in the leadership of the company is more than 50%, than the
controlling entity is an individual or organization that have shares of >10% . The controlled
transaction- profits > 60 million rubles. The tax on retained earnings of these companies 20% for Russian companies and 13% for the Russian citizens.
Foreign companies will be exempt from taxation:
1 Non-profit organization that do not distribute profits to shareholders.
2 Organization, formed in accordance with the legislation of the countries of the Eurasian
Economic Union.
3 Banks or credit organizations in the country, with the agreement on the taxation.
Canada, Denmark, Germany, Italy and Japan are subjected to tax offshore companies income,
regardless of whether they have been repatriated or not. In these countries, There is legislation
for determining an offshore company (United Kingdom), or a list of territories belonging to
the "tax havens" (Japan).
In the US, there is the concept of so-called "personal holding company" that has 5 or less
owners. Such a company is subject to tax on the undistributed profits in the amount of 28%
against practically 40%.
From my point view as financial management deals with effective recourse allocation and
management of cash flows financial managers try to transfer their money to the country with
less taxes, creating branches of offshore zones and transferring money there. For example
biggest American TNC like general electrics, IBM, Microsoft and apple have hundreds of
branches in offshore zones, this companies perform practically no responsibilities, with small
amount of stuff however billions of dollars are transferred to these zones as expenses and
accure there as revenues.