FINANCIAL MANAGEMENT 1
NOTES
Prepared by:
Mr. David Torson ( FCCA)
1
CONTENTS
FINANCIAL MATHEMATICS
PAGE 3 -11
FINANCIAL MANAGEMENT CONCEPTS
PAGE 12 - 21
SOURCES OF FINANCE
PAGE 22 -29
PAST QUESTIONS
PAGE 30 - 33
2
TECHNIQUES OF FINANCIAL MATHEMATICS
Financial mathematics draws heavily on two (2) techniques, namely:
i.
Compounding
ii.
Discounting
Interest is normally calculated by means of compounding. If a sum of money is invested
at a fixed rate of interest such that the interest is added to the principal and no
withdrawals are made, then the amount invested will grow by increasing amounts in
each time period because interest earned in earlier periods will itself earn interest in
later periods.
The basic principles of compounding is given as:
Principle 1 – Finding Future Value
Sn = p (1 + r)n
Where:
Sn
=
The sum invested after n periods.
p
=
The original sum invested.
r
=
The interest rate expressed as a proportion
(5% = .05)
n
=
Number of periods principal is invested.
Examples
(1) What would be the total value of GH¢5,000 invested now after 3 years if interest
rate is 20% per annum?
Solution 1
Sn = 5,000 (1.20)3 = GH¢8,640
(2) If you borrowed GH¢10million from a bank located at the sea side and the bank
charges 10% interest per annum, how much will the loan be worth after 5 years?
Solution 2
Sn = 10 (1.10)5 = GH¢16.105million. This means that bullet repayment of loan plus
interest.
3
(3) If you earn a salary of GH¢12,000 now and wage inflation is expected to be 10%
per annum, estimate your salary after 5 years.
Sn = 12,000 (1.10)5 = GH¢19,326
Principle 2 – Changes in the Rate of Interest
Sn
= p (1 + r)n (1 + r)n
Examples
(1) Your uncle has invested GH¢8,000 now to earn 10% interest for 3 years and 8%
thereafter, what would be the size of the total investment at the end of 5 years?
Solution 1
Sn
=
8,000 (1.10)3 (1.08)2
= GH¢12,420
(2) An investor puts in GH¢10,000 into an investment account for 10 years. The
annual rate of interest is 15% for the first 4 years, 12% for the next 4 years and 9%
for the final 2 years. How much will the investment be worth at the end of 10
years?
Solution 2
Sn
= 10,000(1.15)4 (1.12)4 (1.09)2 =32,705
(3) Your company has bought an equipment costing GH¢60,000 now. The annual
rates of inflation over the next 4 years are expected to be 16%, 20%, 15% and 10%.
How much would the equipment be after 4 years?
Solution
Sn
= 60,000(1.16)1 (1.20)1 (1.15)1 (1.10)1
GH¢105,653
Principles 3: Frequency of compounding
When interest is calculated daily, weekly, monthly, and quarterly or semi-annually,
the effective annual interest rate is calculated as:
Effective Annual Rate = (1 + r)f -1
r= rate of interest for each time period.
f = number of times compounding is made.
4
Examples
(1) Calculate the effective annual rate of interest of the following quotes from two
banks on loans to customers.
(a) 15% per annum compounded quarterly – Bank A
(b) 15% per annum compounded semi-annually – Bank B
Advise your company which bank they should borrow from.
Solution 1
Bank A quotes:
Effective rate =
=
Bank B quotes
Effective rate =
(1+.15 )4-1
4
(1.0375)4-1 =0.1586 or 15.86%
(1 + 0.15 )2 -1 = 0.155625 or 15.56%
2
Go for bank B quote.
The more frequent compounding is done, the more costly the loan will become.
Principle 4: Regular Investment / Sinking fund provision
Sinking fund is an investment into which equal annual installments are made and are
added to previous amounts to earn interest so that by the end of a given number of
years, the investment will be large enough to pay off a known commitment.
(a) Payments made at the end of each year
Where the investment is made at the end of each year, the formula is stated as:
Sn
=
a{(1 + r)n– 1}
r
Where:
Sn
=
future sum required or total funds in the investment Account after a
given number of years.
a
=
annual payments
r
=
interest rate expressed as a proportion, i.e. 10% =
0.10
5
Examples
(1) A customer has instructed his bankers to transfer GH¢400 from his current
account to his savings account at the end of each year for 4 years. Interest rate
on savings is 10% per annum.
What is the size of the savings account at the end of the 4th year?
Solution 1
Sn
=
400(1.10)4 – 1
0.10
= GH¢1,856.40
Payments made at the beginning of each year
In this case, the future sum will be stated as follows:
Sn = a(1 + r) [(1 + r)n – 1]
R
Example 2
(2) Assuming the customer’s instruction to the bank was that the first transfer
should be made now, followed by the same amount of GH¢400 for three more
years. Interest rate on savings is 10% per annum. What is the size of the
account after 4 years?
Solution 2
Sn = 400(1.10) [(1.10)4 – 1]
0.10
= GH¢2,042.04
Example 3
Show sinking fund schedules to show the growth of the fund.
(a) End of year payments
Year
1
2
3
4
Balance
400
840
1,324
Payments
400
400
400
400
Interest
40
84
132.4
6
Bal. c/f
400
840
1,324
1,856.4
(b) Payments made at the beginning of each year
Year
1
2
3
4
Bal. b/f
440
924
1456.4
Payments Interest
400
40
400
84
400
132.4
400
185.64
Bal. c/f
440
924
1456.4
2042.04
Examples 4
Cleanborn Ltd. has bought an asset with a life span of 4 years. At the end of the 4 years,
a replacement of the asset will cost GH¢12,000. In this direction, the company has
decided to provide for this future commitment by setting up a sinking fund account into
which equal annual investment will be made at the end of each year. Interest rate on
the investment will be 12% per annum.
Required
(a) Calculate the annual installments
(b) Draw up the sinking fund schedule to show the growth of the fund
(c) Assuming the first payments will be made now and 12 months thereafter, what
are the annual payments?
(d) Draw up the sinking fund schedule to show the growth of the fund
Solution
(a) End of year payment
12,000
=
a (1.12)4 – 1 = 12,000 = 2,510
0.12
4.780
(b) Sinking fund schedule
Year Bal. b/f
Payment
1
2,510
2
2,510.000 2,510
3
5,321.200 2,510
4
8,469.744 2,510
Interest
Bal. c/f
2,510.000
301.200 5,321.200
638.544
8,469.744
1,016.369 11,996.113
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(c) Beginning of the year payment
12,000 = a (1+ r) [(1 + r)n – 1]
r
12,000 = a (1.12) [(1.12)4– 1]
0.12
12,000 = 5.3528a
a = 12,000 = 2,241.81
5.3528
(d) Sinking fund schedule
Year
1
2
3
4
Bal. b/F
2,510.83
5,322.96
8,472.54
Payments
2,241.81
2,241.81
2,241.81
2,241.81
Interest
269.017
570.317
907.772
1,285.722
Bal. c/f
2,510.83
5,322.96
8,472.54
12,000.07
Loan Amortization
Example 1
Mrs. Alhassan borrowed GH¢200 million from her bankers to buy her dream house.
Repayment is over 4 years and first payment is due one year from hence. She will make
equal payments to amortize both the principal and interest, which is calculated on a
reducing balance basis. The bank will charge 5% above its current base rate of 23% per
annum.
Required
(a) Calculate Mrs. Alhassan’s annual payments.
(b) Show by a table how the annual payment will liquidate the loan and interest.
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Solution 1
(a) Interest Rate
PV=Amount X 1 –
= Base Rate + 5% = 23 + 5 = 28%
1
(1+
𝑟)𝑛
= 200,000 = a X 1 -
r
1
(1.28)4
0.28
= 89,247,156
(b) Amortization Table
Yr
Beginning
balance
200,000,000
166,752,844
124,196,484
69,724,343
1
2
3
4
Interest
Installment
56,000,000
46,690,796
34,775,015
19,522,816
(89,247,156)
(89,247,156)
(89,247,156)
(89,247,156)
Ending
balance
166,752,844
124,196,484
69,724,343
-
Example 2
Your bank is prepared to lend you GH¢5,000 at 36% per annum to be repaid over 2½
years in equal monthly installment.
Required
(a) What is the monthly installment payment?
(b) Show by way of a table how the loan will be amortized.
Solution 2
−1
(a) PV = a[
1(1+𝑟)𝑛
𝑟
]
36% p.a. = 3% per month
−1
5,000 = a[
1(1.03)30
0.03
] = 𝐺𝐻¢255.096
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Examples 3
You have applied to your bankers for a loan of GH¢30,000 to complete your dream house
for deductions to be made over 3 years equal annual installments. Your bankers,
however, maintained that your 40% annual salary which amounts to GH¢12,000 cannot
meet both the principal and interest payment. It is the bank’s policy to maintain a debt
service ratio of 40%. Interest rate charged by the bank is 18% per annum.
Required
a. Calculate the size of the loan you qualify for.
b. Prepare amortization table to show how the loan will be liquidated.
Solution 3
(a) PV = 12,000 1 – 1
(1.18)3
= GH¢26,091.27
0.18
(b) Amortization Table
Year
1
2
3
Beginning
Balance
26,091.27
18,787.70
10,169.49
Interest
Installment
Ending Balance
4,696.43
3,381.79
1,830.51
(12,000)
(12,000)
(12,000)
18,787.70
10,169.49
Treasury bill quotes (91 – day T / B in reference)
The following distinct rates are noted in Treasury Bills quotes:
1. Bank discount rate
2. Simple annual interest rate – Roll over of principal only
3. Market yield – Roll over of principal and interest
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(1) Bank Discount Rate
Annualized Discount
=
Discount / Amount x 364
Face Value
91
Discount amount = (91 days) = Rate x FV x 91 days
364 days
Example 1
A 91 – day treasury bill has a face value GH¢150,000 and discount of GH¢12,000. What
is the annual discount rate?
Solution 1
Discount rate = 12,000 x 364 = 32%
150,000 91
What is the cost / price of this Treasury bill?
Solution 2
Price / cost = Face value – Discount
= 150,000 – 12,000
= 138,000
(2) Simple Annualized Interest Rate (SAIR)
SAIR = Discount x 364
Cost / price
91
This does not recognize compounding.
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DEFINITION OF FINANCIAL MANAGEMENT
Financial Management covers all the activities directed at ensuring that financial
resources both short and long term are obtained and used in the most efficient and
effective way to achieve organizational objectives.
It can also be viewed as the Management of all the processes associated with the
efficient acquisition and deployment both short and long term financial resources to
achieve organizational objectives.
In consequence, Financial Management is concerned with the key decision-making
functions in an organization.
What then are the key functions of the Financial Management?
ROLES AND FUNCTIONS OF THE FINANCE MANAGER
The roles and functions of the Finance Manager are grouped under the following
headings:
a. Investment Decisions
This is the process of determining whether a proposed project is worth undertaking
and allocating resources among viable projects. The Finance Manager is therefore
expected to be abreast with the various techniques regarding project evaluation.
b. Financial Decisions
The Finance Manager is expected to champion the raising of finances required to
undertake proposed and acceptable investments. The overriding consideration is to
reduce cost of capital and minimize risk of operations.
c. Dividend Decisions
The Finance Manager is expected to advice on the appropriate dividend policy that
will help enhance the value of shares.
d. Working Capital Management Decisions
The Finance Manager is expected to ensure that the level of operating assets
(Debtors, Stocks, Cash, Creditors) are sufficient to meet the day-to-day working
capital needs of the company.
e. Acquisition Decisions
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The strategy of mergers and acquisitions and the external growth of the firm are key
finance functions. The Finance Manager is expected to be conversant with valuation
methods.
The above decisions, which cover the entire activities of finance, are necessary in
fulfilling the financial and non-financial objectives of the firm.
What then are the financial and non-financial objectives?
FINANCIAL OBJECTIVES
Financial objectives can be viewed from two (2) perspectives, namely:a. The shareholders’ view
b. Other stakeholders’ view
c. THE SHAREHOLDERS’ VIEW
For a profit-making entity, the strategic objective is centered on profit-maximization,
translated into wealth-maximization. In essence, shareholders wealth is measured
by dividend received each year and partly by capital gain arising from increase in
the price of shares over the holding period.
It is important to note that the shareholders wealth is affected by three (3) main
factors, these are:
• Expected return
• Dividend plus capital gain
• The risk of the company’s operations and timing of cash flows.
It is also worth noting that profit-maximization may not necessarily lead to wealth
maximization due to the inherent disadvantages of profit, which are given as:i. Profit-maximization being short-term.
ii. Using creative accounting techniques may boost profit.
iii. Profit has no bearing on cash flows.
iv. Profit does not consider time value of money.
b. OTHER STAKEHOLDERS’ VIEWS
The other stakeholders who form part of the business equations are:
i. Employees
Trade Unions would like to see their members as beneficiaries of any surplus the
firm creates. Employees will certainly press-home their demand for increased
compensation packages.
ii. Community
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The community expects the company to be a good corporate citizen by undertaking
activities that will be beneficial to the society. The community will seriously resist
the activities of the company deemed detrimental to it.
iii. Suppliers
Suppliers will be interested in prompt payment for their supplies and will shy away
from companies, which are not committed to debt settlement.
iv.
Government
The Government will be interested in prompt payment of taxes and levies
NON-FINANCIAL OBJECTIVES
The influence of the various parties with varied interest in the firm has resulted in firms
adopting non-financial objectives as follows:i. Growth
ii. Diversification
iii. Survival
iv. Maintaining contented workforce
v. Becoming research and development leader
vi. Providing top quality services to customers
vii. Maintaining respect for the environment.
Conclusion to Objective of the Firm
Meeting the shareholders expectation of value maximization and meeting the needs of
other stakeholders are linked.
A company once established in a community, provides employment to the people,
produces goods and services for the consumption of the community and caters for the
reasonable demands of the employees.
Yes, a company cannot survive when the community is hostile towards it. The
Community may boycott its products so as to compel the company to fold up.
Indeed, the license to operation is partially granted by the community.
Objectives of Non-For-Profit Organization
Managers in the public sector, which largely does not operate on a profit maximization
basis, should be conversant with the reason d'être of their respective departments.
The objectives of the public sector are driven by three (3) factors, popularly referred to
as the three (3) Es. They are given as:14
Economy
This means doing things as cheaply as possible and it is therefore associated with
the operational levels of control.
ii.
Efficiency
This is measured in terms of productivity (the ratio of input to output). This is
associated with the tactical level of control.
i.
iii.
Effectiveness
This means doing things right and it is associated with the strategic level of control.
DIFFERENCES BETWEEN FINANCIAL ACCOUNTING, MANAGEMENT ACCOUNTING
AND FINANCIAL MANAGEMENT
Financial Accounting deals with historic data, showing the profit or loss position for a
period and balance sheet as at the end of a period. Financial Accounting function is not
directly involved in the day-to-day planning, controlling and decision making in an
organization. The purpose of financial accounting is to keep shareholders and other
stakeholders informed as to the overall performance and financial positions of the firm.
Management Accounting function is concerned with providing information for day-today function of control and decision-making. This will include budgeting, cost accounting,
variance analysis, ratios, pricing etc. Management Accounting takes short-term view of
the company.
Financial Management function looks at future cash flows, liquidity, viability and
flexibility of the company. It takes a long-term view of the firm.
It is important to add that, the balance sheet, which is a major financial accounting
statement, is regarded as a statement of the results of financial management.
Consequently, successful financial management will no doubt produce a healthy balance
sheet. Yes, finance is the ‘lifeblood’ of a company.
CONFLICT BETWEEN MANAGERS AND SHAREHOLDERS
Shareholders own the company by providing capital and managers run and control the
company on a day-to-day basis. This automatically creates agency relationship, where
managers become the agents of the Shareholders.
As a result of separation of ownership from control, managers are in a better position to
pursue their own interest at the expense of shareholders, thereby creating conflict or
agency problem.
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FACTORS THAT CONTRIBUTE TO THE EXISTENCE OF AGENCY PROBLEM
Agency problem is borne out of three (3) variables, namely:i. Separation of ownership from control. Those who own the company do not
manage it.
ii. Asymmetry of information. Management has a clear advantage of hiding financial
and non-financial reports from shareholders. Indeed, managers know it all and
shareholders know only what manager’s wish should be made known.
iii. Goals of managers may differ from the goals of shareholders.
POSSIBLE MANAGEMENT GOALS, ACTIONS OR IN ACTIONS THAT CONFLICT
WITH SHAREHOLDERS GOALS OR INTEREST
i.
ii.
iii.
Managers seeking to entrench managerial power by creating job security for
themselves.
Increasing managerial rewards and enhancements.
Pursuing their own social objectives, such as traveling ostentatiously with their
families and undertaking prestigious projects.
CONFLICT RESOLUTION
To ameliorate the problem of conflicting objectives between managers and shareholders,
it is necessary to take steps to motivate or compel managers to behave in a manner
consistent with the objects of shareholders.
The motivating factors are:i. Introduce bonus schemes based on a minimum level of pre-tax profit. However,
managers may relax as soon as the minimum level is reached or they may use
creative accounting to boost profit.
ii. Introduce bonus schemed based on turnover growth. However, turnover growth
can be achieved by reducing selling prices at the expense of profitability.
iii. Introduce share option scheme. This is probably the best scheme where managers
are offered the opportunity to become shareholders if they so desire. In this
direction, managers will work hard to maximize the value of shares, since they will
soon be owners.
The compelling factors are:
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i.
ii.
iii.
Monitoring. This will include the appointment of independent auditors to review
and report on the activities of managers.
Introduction of comprehensive reporting requirement; such that shareholders will
be knowledgeable about the facts behind the figures.
Introduction of sanctions to punish culpable managers.
AGENCY PROBLEM BETWEEN DEBT HOLDERS AND SHAREHOLDERS
This arises when shareholders act in a manner that undermine the interest of debt
holders. Activities of shareholders that may conflict with the debt holder’s interest
include:
i. Approving excessive dividends, the payment of which may pose danger to future
payments of interest and principal payments.
ii. Going for more debt without considering implications on original debt holders.
iii. Undertaking very high risky ventures.
CONFLICT RESOLUTION BY DEBT HOLDERS
Debt holders can protect their interest by the following means:i. Secure debt against the company’s assets.
ii. Use restrictive covenants to restrict the firm from engaging in high risky ventures,
from paying out excessive dividends and from engaging in high levels of gearing.
FINANCE MARKETS
Financial Markets are places where surplus and deficit units meet to do business. They
provide a mechanism to match providers of funds (lenders) with users of funds
(borrowers). Financial instruments are traded on the financial markets.
The importance of financial markets in the development of an economy cannot be over
emphasized. Their importance is reflected in the roles they play.
ROLES PLAYED BY FINANCIAL MARKETS
The main functions of Financial Markets are grouped under the following headings:i. Avenue for raising of funds
they collect small savings and parcel them into large amounts, which may be
utilized by companies, which need funds. They are able to transform short-term
funds of investors into long-term funds.
ii. Provide Liquidity
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Liquidity is the ease with which financial assets or securities can be converted to
cash. They provide platform for trading, thereby creating avenue for entry and
exist.
iii. Minimize transaction cost
Financial markets help keep transactions cost of dealing as low as possible.
Financial intermediaries can transact business at lower costs than individuals
transacting businesses on their own due to economies of scale. Trading is
centralized, deals in high volumes, and the rules of trading are standardized.
iv.
Establish fair prices
one of the distinguishing features of a financial market is that, it allows for free
interaction of demand and supply forces to determine security prices. There is free
flow of information, thereby reflecting true prices of securities.
Diversification
by providing investors the opportunity to invest in wide range securities, it allows
them to spread their risk. This is similar to the “don’t put all your eggs in one basket
strategy”.
vi. Risk shifting
by providing the platform for trading, investors are able to shift risks from one
security to the other. Investors can make investment decision such as hold, sell or
buy more of a particular security.
vii. Hedging
Financial markets offer participants the opportunity to reduce risk through
hedging, which involves taking out a counter balancing contract to off-set existing
risk, which investors are faced with as a result of previous transactions they had
entered into.
viii. Arbitrage
Financial markets help investors to earn risk-free profit through arbitrage.
Arbitrage is the process of buying a security at a low price in one financial market
and simultaneously selling it in another market to make risk free profit.
Arbitrage is made possible when an asset is priced differently in two different
markets or when two assets of similar risk are priced differently.
v.
TYPES OF FINANCIAL MARKETS
Financial markets can be structured or grouped under the following headings:
i. Money Market
18
•
•
•
•
•
this form of financial market deals in relatively short-dated funds. Banks and other
financial institutions dominate them. Examples of money instruments are:Overnight Placement
Treasury Bills
Re-purchase Agreement
Commercial Paper
Negotiable Certificate Of Deposits
Capital Market
This is a market for trading in long-dated securities such as shares, bonds, and
Municipal bonds, etc. The capital market is sub-divided into two (2) forms namely:a. The Primary Market: Provides avenues for raising new capital for businesses.
b. The Secondary Market: Provides the platform for trading in existing securities. It
provides liquidity in the market and provides avenues for exist.
ii.
iii.
The Foreign Exchange Market
This is a market for dealing in foreign currencies. Deals may be at the spot or
forward rate.
iv.
The Derivative Market
The derivative market is a market where derivative instruments are traded. The
instruments may be developed from securities, commodity and currency trading.
Examples of derivatives are forward contracts, futures contracts, currency options
and swaps. They are used as hedging devices, to reduce risks or for speculations.
THE TREASURY FUNCTION
Treasury is concerned with the relationship between an entity and its financial
stakeholders, which include shareholders, fund lenders and fund borrowers. The main
functions of the treasurer can be classed into the following:
i.
ii.
iii.
Banking: The treasurer will be responsible for managing relationships with banks.
Liquidity Management: This involves ensuring that the company has liquid funds
to meet its day-to-day operations. Surpluses will then be invested. He is expected
to build a good working relationship with financial institutions.
Fund Management: This function is concerned with identifying suitable sources
of funds, which require knowledge of the sources available, the cost of those funds
and management of interest rate risk.
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iv.
Currency Management: The treasurer would be responsible for providing the
business with forecasts of exchange rate movement, which in turn with determine
the procedures to manage exchange rate risk.
Following from the above, the key tasks of the treasurer can be categorized according to
the three (3) levels of management, which are given as follows:
KEY TASKS OF THE TREASURER
i. Strategic: This deals with matters concerning the capital structure of the business,
dividend/retention polices, the actual raising of capital, the assessment of the
likely return from each source and the appropriate mix of each source.
ii. Tactical: This deals with the management of cash, investment and decisions as to
the hedging of currencies and interest rate risk.
iii. Operational: This is concerned with the transmission of cash, placing of surplus
cash and dealings with banks on a more regular basis.
MARKET EFFICIENCY
An efficient market is a market where prices fully and instantaneously reflect all available
information. In an efficient market, prices accurately and rapidly adjust to reflect the true
intrinsic value of securities. It is important to note that, the more efficient the market is,
the less the opportunity to make speculative profit.
CHARACTERISTICS OF AN EFFICIENT MARKET
The efficiency of a financial market can be examined in three (3) ways, namely:i. Allocative Efficiency
The market is said to be allocatively efficient if it directs savings towards the most
productive firms. In this sense, the most efficient firms will find it easier to raise
funds and economic prosperity for the whole economy will be guaranteed. This is
frequently referred to as invicible hand theory.
ii.
Operation Efficiency
for the market to be seen as efficient, transaction costs should be as low as possible
so as to be affordable to participants.
iii.
Information Processing Efficiency
This shows the extent to which information regarding future prospects of a security
is reflected in its current price. If all known information is reflected in pricing, then
investment becomes a fair game. Indeed, all investors will have the same chance of
20
having access to the same information. How do we test the extent to which
information regarding share prices is available to every investor?
LEVELS OF MARKET EFFICIENCY
The Efficient Market Hypothesis argues that stock markets are efficient if information is
reflected in share prices accurately and rapidly. For the purpose of testing, the Efficient
Market Hypothesis is usually broken into three levels namely:i.
Weak Form
The Weak form of the hypothesis states that the share prices fully reflect historic
information, with the results that it would be impossible to predict future share
price movement. Price movements are therefore random; hence the weak form is
frequently referred to as Random Walk Hypothesis.
ii.
Semi-Strong Form
The semi-strong form states that current prices reflect both historic and publicly
available information about the company. Examining the way in which the market
reacts to new information about the company can test this hypothesis. Any publicly
available information would have been captured in the current share price.
Consequently, except for the arrival of new information, there will be no impact on
share prices.
iii.
Strong Form
The strong form states that current share prices reflect historic, public and private
information about the company. Hence, prices adjust rapidly and accurately to new
information. In this case it will not be possible to make profits by dealing in
response to insider information.
SOURCES OF FINANCE
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1. SHORT TERM FINANCE
Duration 2 – 3 years
2. LONG TERM FINANCE
Typically over 5 years
3. ISLAMIC FINANCE
1. TYPES OF SHORT TERM FINANCE
A. OVERDRAFT:
It is a facility that allows the customer to withdraw below the minimum amount
of a Current Account. Interest is charged on the overdrawn amount.
Advantages
i. The key advantage is interest is only paid on the overdrawn amount.
ii. The flexibility in the repayment term and in the acquisition of the facility.
The main drawback is overdraft is repayment is on demand.
B. SHORT TERM LOANS
It is basically for a fixed amount and specific period.
The key advantage is the repayment schedule is fixed and the customer can plan
the cash flows better. The main disadvantage is the lack of flexibility.
C. TRADE CREDIT
Purchasing goods right now and paying for them later. However delay in payment
may worsen the company’s credit rating.
D. LEASING
Rather than buying the Asset outright, the business might lease it. This involves
renting the Asset from another party and paying rentals. It could be operating
lease where the lessor returns title of the asset.
Or a finance lease where the leasee obtains title of the Asset at the end of the
period.
E. SALE AND LEASEBACK
This involves selling property plant and equipment and renting it back from the
purchaser. A lot of cash can be raised from this transaction.
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The only problem is that the company loses title to the Asset, which further
imparts its future borrowing capacity.
As there are fewer assets to use as collateral Assets.
F. BUSINESS ANGELS
It is a wealthy individual who is willing to provide capital to a business, usually with
very flexible terms sometimes they may want an equity stake at the end of the
loan period.
2. TYPES OF MEDIUM TERM FINANCING
A. FACTORING
This method involves turning over the responsibility for collecting a company’s
debt to a specialist institution. The factor usually makes an advance payment and
charge financing fees.
Advantages of using a factor.
1. They take over the running of the client’s sales ledger, thereby saving
administrative cost.
2. They provide advance payment to clients.
3. It is an efficient means of debt administering.
4. The terms are relatively flexible.
Disadvantages of using a factor
1. Client has to pay for accounting and credit control services.
2. The existence of a factor is disclosed to customers, who may not like the idea.
Hence, the possibility of loosing customers cannot be ruled out.
B. INVOICE DISCOUNTING
This is a system of obtaining finance against the security of sales debtors. Unlike the
service provided by a factor, invoice-discounting companies do not provide protection
against bad debts. They also do not run the least ledger of clients.
Hire purchases agreement
Leasing Agreement
Sales and leaseback Agreements
Expediting payment from Debtors, By providing Atractive Discounts for Early
payments
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Delaying payments to creditors, by taking advantage of maximum credit period
given.
3. TYPES OF LONG TERM FINANCE
- Bonds
- Venture Capital
- Equity Finance
a. BOND
Are form of long term debt, for example Loan Notes and debentures. They are
usually secured and interest is paid annually or semi-annually.
Bond can be irredeemable, this mean interest is paid in perpetuity or forever.
Bonds can be redeemable, it means capital is repayable at the end of the
repayable period.
Convertible (Bonds)
It can be converted into equity instead of repayment.
b. VENTURE CAPITAL
Is Risk Capital provided in return for an equity stake and a seat on the Board of
Directors.
TYPES OF VENTURES
i. BUSINESS DEVELOPMENT: This is where a business wants fund to expand its
production or enter new market or develop a new product.
ii. MANAGEMENT BUYOUT: It is where management buy part of the company
from its owners.
iii.START-UPS: A new company that has potential high return with high
innovation.
c. EQUITY FINANCE: Ordinary Shares. There are various way raising equity finance
through a STOCK MARKET LISTING, example NASDQQ (AN Electronic stock
exchange in the US)
Right Issue: Is when shares are offered to existing shareholders usually at a price
below the prevailing market price.
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Stock Split: When shares are split into small denominations to improve
marketability.
Bonus Issues: These are shares issued out of reserves, example Retained Earnings,
Share Premium in proportion to their shareholding, there is no additional cost to
shareholders, it is known as scrip issue (Free Shares).
WHY WILL A COMPANY SEEK A STOCK MARKET LISTING
a. To improve a marketability of shares. As an investor it is less risky to buy shares in
a quoted company than in an unquoted company, because of the better
regulation and better compliance.
b. To get a better public image. Listed company have a better public image because
there are subjected to greater oversight and regulation than unlisted companies.
c. Better Acquisition Prospects.
d. Realize Investment
e. To access a wider pool of finance
METHODS OF OBTAINING A LISTING
1. AN INITIAL PUBLIC OFFER: It is an offer to the General Public for the first time
based on information contained in what is called a prospectus.
The prospectus would have the following
a. The summarized performance
b. Detailed financial statements, example for the last 5 years.
c. Projections of growth etc.
2. INTRODUCTION: It is simply obtaining a quotation from the stock market, no
shares are sold to the public, this may be done to obtain a share valuation and
enhance the marketability of the company shares.
3. PLACING: It is an offer to a smaller number of institutional investors, example
pension funds and insurance companies.
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4. RIGHTS ISSUE: Offer to existing shareholders for additional shares at a lower price.
Three options available to shareholders:
a. Do nothing (Do not participate in the right issue. However you will be losing
wealth.
b. Exercise all the Rights: That means you purchase the additional shares at
discounted price. In this case you neither gain or lose wealth.
c. Sell all the rights: You will neither gain or lose wealth.
QN: Take a 1.3 rights issue at $3.2 per share to a shareholding of 900 shares currently at
$4 per share.
OPTION 1 (DO NOTHING)
3 shares
1 share
4
(a) 4.0
(a) 3.2
Theoretical
Ex-rights price
$12
$3.2
15.2
Value of shares =15.2 = $3.80
No of shares
4
Wealth before (900 shares x $4) = $3,600
Wealth after (900 shares x 3.8) =
Loss in wealth
=
3420
$180
Option 2 (Exercise all the rights)
Wealth before 900 shares at $4 = 3600
Add additional investment
900/3 X $3.2
TOTAL WEALTH
WEALTH AFTER
900 + 900 x ⅓ = 1200 shares
WEALTH AFTER
1200 shares x 3.8
960
$4560
$4560
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SELL THE RIGHTS
Theoretical ex-rights price
Issue price
$3.8
$3.2
Value of right put new share
$0.6
Sells value of rights
(900 / 3 x 0.6)
180
MV of 900 shares ex right
X $3.80
Total wealth after
3420
3600
Total value of 900
Shares before rights x ($4)
Gain / Loss
3600
NIL
Advantages of Debt Finance over Equity Finance
1) Cost
Debt is cheaper then Equity finance because, Interest paid on debt is tax allowable,
but dividend paid to equity holders is not.
2) Flexibility
Debt is more flexible than equity. Debt can be borrowed, repaid and re-borrowed in
variable amount.
3) Dilution
Debt does not dilute control. Existing shareholders control will be maintained.
Disadvantages of Debt finance over Equity
1) Interest Payment Risk
The company as to make regular payment of interest, whether or not profit are
made.
2) Principal Re-payment Risk
The company has the obligation to re-pay principal on due date, whether or not
cash is available.
3) Security
Some debt instruments requires the provision of collateral security, which may be
difficult to provide
4) Covenants
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Some debt instruments provides for conditions that may inhibit the smooth
operations of the company. For instance: seniority of debt, suspension of dividend,
convertibility etc
5) Finance Distress
Debt increases gearing, which may lead to financial distress and its attendant
problems
ISLAMIC FINANCE
MUDARABE - PARTNERSHIP: It is simply a partnership where one partner provides
capital and the other expertise and both sides share in the profit and loss.
MUSHARAKA - EQUITY: Which is the form of equity where both parties bring Capital and
Expertise and share in the profit and loss.
MURABAHA – CREDIT SALE: It is simply a credit sale, you buy goods now and pay for
them later. However the product should not be prohibited by sharia law, it can be
Alcohol or drug.
IJARA – LEASE: It is a contract where one party allows another party to use its assets for
a rental fee. The lease could be an operating and a finance lease.
SUKUK – BOND: It is similar to the ordinary bond, but the only difference, is that there
is, an under lying tangible assets, which means the bond holder shares in the risk and
rewards of ownership.
Under Islamic finance interest is prohibited.
Factors to consider when choosing sources of finance.
Wide ranges of funding sources are opened companies. Consequently ,the following
factors should guild a company in the selection method finance.
COST
The cost of sourcing and servicing funds, should be considered since costs affect the
profitability of the company. In the area of cost, debt finance is cheaper than equity
finance because of the tax deductibility of interest cost.
Duration
Finance can be arranged for various time periods and the purpose of the funding must
be matched against the time frame. Remember the rule of thumb that says that longterm assets should finance long term assets and short-term funds. In this direction, we
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expects to see working capital items financed by short-term sources while fixed assets
are financed by long-term sources.
Gearing
Gearing increases the risk of interest payment and principal repayment. A company
should therefore assess its current level of gearing before taking on the additional debt.
Where gearing is high, the company could consider equity finance.
Flexibility
A company should always consider a source with flexibility terms and conditions. In this
direction debt instrument will be ideal.
Control
Consider whether existing shareholders will want to maintain their respective holdings.
If they do not want dilution of control, rights issue or debt finance will be the best.
Size of the company
It is clear that not all companies have access to all sources of finance. Small companies
traditionally have problems raising equity and long-term debt finance.
Hence, short-term sources will be appropriate
PAST QUESTIONS
I.
Mr. Atindama desire to borrow GHȻ 120,000 for 3 years and he has two alternative sources as
follows:
a) To borrow the amount for 3 years at a compound interest of 30%
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b) To borrow on an annual basis for 3 years at a 28%, 30% and 31% for years 1,2,and 3
Required
How much will he pay under each option and which option should he choose and why 5mrks
i)
a)
b)
c)
ii)
Mr. Bright intended to acquire a machine to expand his Business. He intendeds to buy the
machine in 4 years’ time at an expected cost of GhȻ 40,000. In order to raise money
towards the purchasing of the machine, He has decided to make equal annual payment
into a fixed deposit account to earn 15% pa. The first payment is made 12 months from
now.
Required
What is the annual payments into the fixed deposit account
5 mrks
If the first payment was made now, what is the annual payment into the fund?
5mrks
Draw up a table to show the growth of the deposit fund under both scenarios
7 mrks
Your annual salary is GHȻ 36,000 and you require housing loan from Bankers. Your Bankers
charged base rate +7% pa and they insist that, your annual deductions to service both
principal and interest cannot exceed 40% of your salary. The Banks base is 24% pa. You
required the loan for a period of 5 years.
Required
a)
b)
Determine the amount of loan you qualify for
Draw up amortization table
5mrks
5mrks
iii)
i)
ii)
Mr. Adarkwah holds GHȻ 2,000 and has asked two simple questions:
How long will it take for me to double my money if interest rate is 10%pa.
How long will it take for me to quadruple it if interest rate is 10% pa.
7mrks
i)
Define the agency problem and list factors which facilitate the agency problem and how it
can be resolved
10mrks
Briefly define financial market and explain the four types of financial market
10mrks
Define efficient market hypothesis and explain the characteristic and levels of efficient
market
10mrks
Q2:
ii)
iii)
Q3:
i)
Explain four ways by which a company may issue shares in the stock exchange market
10 marks
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ii)
Define factoring and explain it advantages and disadvantages
iii)
Ȼ 200,000,000 is deposited into savings account, interest is paid at 8.5% pa. Compounded
annually. How long will it take for the principal to double?
5mrks
iv)
An investor puts in GHȻ 10,000 into an investment account for 10 years. The annual rate
of interest is 15% for the first 4 years, 12% for the next 4 years and 9% for the final 2 years.
How much will the investment be worth at the end of 10 years?
5 mrks
v)
A 91-days treasury bill has a face value of GHȻ300,000 and a discount rate of 64%
Required
What is the discount amount
Q4:
i)
5mrks
5mrks
Your company has surplus funds which it wishes to place with a Bank. The finance
manager has stopped around 5 Banks and the following deposits were displayed.
a) Bank A: Pays 28% pa compounded semi-annually.
b) Bank B: pays 25% pa compounded quarterly
c) Bank C: pays 22% pa compounded monthly
d) Bank D : pays 25% pa compounded Daily
REQUIRED
Advice which Bank should the funds be placed
11mrks
ii)
Describe three ways increasing the number of shares without raising funds
6mrks
iii)
Explain the roles and functions of a finance manager
10mrks
iv)
Define sinking fund
3mrks
Q 1.
i)
Madam Lawrencia borrowed Gh₵ 48,040 on a 3-year loan to be paid in three equal
installments. The rate of interest is 12 percent on the declining principle balance of the
loan
Required
What is the size of each of the payments?
Show the Amortization schedule
6 marks
5 marks
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ii)
Mr. Kofi Gilbert just made his final annual payment of GH₵ 3,500 into a sinking fund which
he started 3 years ago in order to buy his dream car. The fund earns interest of 20% pa.
Required
a) Calculate the size of the loan 7 marks
b) Draw up the sinking fund schedule to show the growth of the fund
8 marks
iii)
Suppose you want to earn an effective rate of 12% and you are looking at an account that
compounds on a monthly basis. What APR must they pay? 7 marks
iv)
What is the future value of $20,000 which grows at a nominal annual interest rate of 12%
per year, compounded monthly, for two years?7 marks
i)
What is the present value of an offer of $14,000 one year from now if the opportunity cost
of capital (discount rate) is 11% per year nominal annual rate compounded monthly?
7marks
ii)
What is the future value of $25,000 which grows at a nominal annual interest rate of 11%
per year, compounded monthly, for two years?
8 Marks
iii)
What is the effective annual rate (EAR) of 8% simple nominal annual rate when
compounded monthly?
7 marks
Q2.
iv)
An investor puts in GHȻ 10,000 into an investment account for 10 years. The annual rate of
interest is 15% for the first 4 years, 12% for the next 4 years and 9% for the final 2 years. How much
will the investment be worth at the end of 10 years?
7 marks
Q3
i)
If Bright invest $500 in an investment fund today and $600 in one year. If the fund pays 9%
annually, how much will you have in two years?
5 marks
ii)
If you invested $15,000 at one point in time and received back $30,000 five years later, what
annual interest (or growth) rate (compounded annually) would you have obtained?
5 marks
iii)
Write short notes on shareholders and stakeholder wealth maximization
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12 marks
iv)
Ȼ 200,000,000 is deposited into savings account, interest is paid at 8.5% pa. Compounded
annually. How long will it take for the principal to double?
8 marks
Q4
i)
Financial Markets are very crucial to the development of an economy. Discuss the types of
financial markets and show how they support the Ghanaian Economy
16 marks
ii)
Define the agency problem and list factors which facilitate the agency problem and how it
can be resolved
14 marks
QUESTION 5
Given the table below, fill in the gaps:
Present Value
GHȼ1,500
GHȼ2,000
GHȼ2,500
(iv)
(v)
20mks
Years
6
2
(iii)
3
4
Interest Rate p.a
12%
(ii)
15%
16%
18%
Future Value
(i)
GHȼ5,000
GHȼ10,000
GHȼ25,000
GHȼ3,000
QUESTION 6A
Explain briefly the roles and functions of the Financial Manager.
10mks
QUESTION 6B
Discuss in detail the two views of Financial Objectives of a company.
10mks
QUESTION7
Discuss in detail the various types of Financial Markets.
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10mks