ACCA PAPER FM
FINANCIAL MANAGEMENT
FM SYLLABUS
.
The aim of the syllabus is
to develop the knowledge
and skills expected of a
finance
manager,
in
relation to
investment,
financing, and
dividend policy decisions.
FM EXAM
.
POINTS TO NOTE
• 3 hours SCBE
Proper Preparation Prevents Poor Performance
Section A
15 OT questions of
2 marks
Covers any areas
of the syllabus.
Section B
3 OT Case
scenarios with 5
questions of 2
marks
Covers any areas of the
syllabus.
Popular section to test
Business Valuation, Risk
Management
• All questions
compulsory
Section C
Constructed
Response
2 questions of 20
marks
Focus on Working
Capital, Investment
Appraisal and
Business Finance
• Computational and
discursive marks
• Some questions will
adopt a scenario/case
study approach
• Formulae sheet
• Discount tables
TNSS CORE VALUES
Your part to play
*Attendance
*Listen in class
*Read Text/Notes
*The MORE your
CONFIDENCE
*The better your
scores
*Attempt
homework
*Practice
*ACCA Practice
Platform
*Ask Questions
*Prize Winner
What You need to do?
1. Practice
2. Pay attention in class
3. Study (syllabus, key
resources)
4. Written questions in Section
C
5. Homework and Practice (ACCA
Practice Platform)
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FINANCIAL MANAGEMENT FUNCTION (Topic Summary)
Purpose of financial management
Financial objectives: shareholder
wealth maximization, profit
maximization, earnings per share
(EPS) growth
Stakeholder objectives, total
shareholder return
Ratios: return on capital employed,
EPS, DPS, receivable days
Achievement of stakeholder
objectives: managerial reward
scheme and regulatory requirements
Not for Profit organisations: financial
and non financial objectives
Value for Money: Economy,
Effectiveness and Efficiency
Ways to measure achievement of
objectives
FINANCIAL MANAGEMENT FUNCTION (I)
Financial Management: management of
organizational finance to achieve the
financial objectives (max SH wealth)
Planning and Control: investment, financing,
dividend and risk.
Financial objectives:
Shareholder wealth maximization, (primary)
Total shareholder return: (P1-P0+D1)/P0
Profit maximization, (not the best measure)
Earnings per share (EPS) growth (weakness)
• Non-financial objectives
• Stakeholder objectives – Internal,
External, Connected
Ratios:
Return on capital employed (ROCE)
Fin gearing = Debt/Equity
Op gearing= Contribution/PBIT
Dividend per share
Earnings per share
Cumdiv vs ex-div
Dividend yield
Managerial reward scheme
agency problem and goal congruence
* (1) Performance related pay, (2)
shares, (3) share option
Benefits of reward to performance
Incentive to perform
Attract and retain employees
Clarity on expected performance
Shares motivate to act in long term
interest
Problems
 Encourage dysfunctional behavior:
budget padding
 Long term may not motivate as
effects are not felt
 Self interest at expense of team
work
 High output at expense of quality
Not for Profit organisations:
financial and non financial objectives
surplus max, revenue max, usage
max, cost recovery, client satisfaction
max
Measuring effectiveness: Value for
Money:
 Economy (attaining right
quality/quantity at lowest cost)
 Effectiveness (extent to which
objective is achieved)
 Efficiency (rship between input
and output, getting much out for
each input)
FINANCIAL MANAGEMENT ENVIRONMENT (Topic Summary)
Macroeconomic policy targets
Fiscal policy: Tax, government
spending
Monetary policy: interest rate,
money supply
Interest rate policy
Exchange rate policy
How these interact with planning
and decision-making in business
Role of financial intermediaries
Benefits
Risk-Return trade off
Money market instruments:
Interest bearing instruments
Discount instruments
Derivative products
FINANCIAL MANAGEMENT ENVIRONMENT (I)
Policy objectives
 Economic growth
 Control price inflation
 Full employment (low unemployment)
 Balance of payments
Policy Tools
 Fiscal policy
 Monetary policy
 Exchange rate policy
 External trade policy
Conflicts
 Steady growth vs employment due to tech
 Job creation, increased demand vs imports
 High imports lead to weaker currency and inflation
 Interest rates vs inflation, deter borrowing
Problems encountered in policy use
 Time lag between policy use and effects
 Inadequate information




Political pressure for short-term solutions
Unpredictable side effects
Influence of other countries
Conflict between policy instruments
Fiscal policy
 Tax and Government spending and borrowing
 It offers a way to manage aggregate demand by withdrawals
and injections
 Expansionary and contractionary
Monetary Policy
 Money supply, interest rate and credit availability
 Increased interest rate increases savings, reduce borrowings
and investments, reduce aggregate demand, less pressure
to increase prices hence lower inflation as they struggle to
meet sales targets
 Affect borrowing costs, fewer investments, less expansion
FINANCIAL MANAGEMENT ENVIRONMENT (II)
Exchange rate
 Demand and supply in fx markets
 Comparative rates of inflation
 Comparative interest rates
 Balance of payments
 Speculation (bigger short term impact)
 Government policy
 Fixed exchange rates
 Floating exchange rates
 Managed float
Regulation of private markets by governments
 Imperfect competition
 Social costs: emissions, public smoking, car insurance
 Imperfect information distorting customer choice
 Equity and social justice
•
•
•
•
Self regulation
Monopoly(>25%)
Deregulation
Privatization
Financial intermediary
 Institution that brings together providers (surplus
funds) and users of finance (deficit)
 Banks, Finance House, Mutual society, Pension Fund
Benefits:
 Ready source of funds for borrowers
 Aggregation of deposits
 Risk pooling
 Diversified portfolios
 Maturity transformation
Financial Markets: markets where individuals and
organisations with surplus funds lend funds to others
Securities are assets for the buyer and liabilities for the
seller
FINANCIAL MANAGEMENT ENVIRONMENT (III)
Financial Markets
 Capital and Money markets (medium & long vs short
term)
 Primary and secondary markets (new vs existing
securities)
 Exchange and over-the counter markets
Negotiable securities can be re-sold
 Risk-return tradeoff: investors in riskier assets expect to
be compensated for the additional risk
 Reverse yield gap. Lower risk of debt compared to equity
implies lower yield which is the normal yield gap. Reverse
yield gap describes the opposite situation possibly cos SH
are wiling to accept less in the short term to make greater
capital gains in the future
 Securitisation is the process of converting illiquid
assets into marketable asset-backed securities.
 Disintermediation describes the decline in
traditional deposit and lending relationship of banks and
customers and increase in direct relationships between
users and suppliers of finance.
What affects interest rates?
 Risk
 Profit on re-lending
 Duration
 Size of loan
 Interest bearing pays interest
 Discount instruments don’t pay interest in the normal
sense. They trade at discount to face value and redeemed
at par (some say interest is paid upfront)
 CP unsecured corporate debt with up to 270 days
maturity. BAs have the guarantee of the bank
 Derivatives allow the buyer and seller to agree today on a
fixed price for a transaction in the future
HOME WORK
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 Specimen exam
4,6,7,9,13,15
 Practice exam 1
2,10,13,14
 Practice exam 2
2,6,9,12,14
BUSINESS VALUATION (Topic Summary)
Perform valuations for shares
 Asset based – historic basis,
net realizable, net replacement
cost
 Income based – PE. EY
 Cash flow based – DGM
Reasons for valuing business and
other financial assets
Perform valuation of debt
 Irredeemable debt
 Redeemable debt
 Convertible debt
 Preference shares
Assumptions of the models involved
Limitations of the types of
information required for valuations
eg. Goodwill
Market Efficiency
Calculation and discussion marks
available
BUSINESS VALUATION (I)




Market capitalization
Asset based valuation
Income based
Cash flow based
Market capitalization
Share price * number of shares
Asset based –

Value of net tangible assets

NCA + CA – Liab

Exclude intangible assets, goodwill, R&D unless
they have market value


historic basis, net realizable (break-up basis), net
replacement cost
Used as measure of security, floor value,
comparision in mergers

QUESTION
The owners of a private company wish to dispose of their
entire investment in the company. The company has an
issued share capital of $1m of $0·50 nominal value
ordinary shares. The owners have made the following
valuations of the company’s assets and liabilities.
Non-current assets (book value)
Current assets
Non-current liabilities
Current liabilities
$30m
$18m
$12m
$10m
The net realisable value of the non-current assets exceeds
their book value by $4m. The current assets include $2m
of accounts receivable which are thought to be
irrecoverable.
• What is the minimum price per share which the
owners should accept for the company? A $14 B $25 C
$28 D $13
BUSINESS VALUATION (II)
Income based – PE ratio. Earnings Yield (EY)

Used to value controlling interest where owner can
decide policies

PE ratio = Market value /EPS

The higher the growth potential, the higher the PE
Cash flow based – Dividend Growth Model (DGM)
 Used to value minority interest

PV of future expected income stream

Discounted at cost of capital


EY = EPS/market value *100
Use the PE or EY of comparable firms to calculate the
values
Problems of using PE or EY:
finding similar company,
single year vs trend,
different capital structure,
Use forecast earnings where available
Assumptions and problems of GDM

Investors act rationally & homogenously

Dividend does not vary significantly from trend

Future estimates of div and Ke is reasonable

Companies pay dividend

Dividend show no or constant growth

Ke exceeds g

Other influences on share prices ignored
BUSINESS VALUATION (III)
Debt
• Irredemable debt
• Po is market value
• I is interest
• Kd is cost of debt
• Redeemable debt
Note: When computing market value of debt, do not
consider the tax benefit (1-t)
•




Convertible debt (depends on)
The price of straight debt
Current conversion value
Time before conversion
Market expectation to future returns
Where:
Po is current ex-div share price
g annual growth rate for share price
n number of years to conversion
R number of shares received on conversion. Conversion
ratio

Preference shares

Questions
BUSINESS VALUATION (Q)
A company has 7% loan notes in issue which are redeemable
in seven years’ time at a 5% premium to their nominal value
of $100 per loan note. The before-tax cost of debt of the
company is 9% and the after-tax cost of debt of the company
is 6%.
What is the current market value of each loan note? A $92·67
B $108·90 C $89·93 D $103·14
Lane Co has in issue 3% convertible loan notes which are
redeemable in five years’ time at their nominal value of $100
per loan note.
Alternatively, each loan note can be converted in five years’
time into 25 Lane Co ordinary shares. The current share price
of Lane Co is $3·60 per share and future share price growth is
expected to be 5% per year.
The before-tax cost of debt of these loan notes is 10% and
corporation tax is 30%.
• What is the current market value of a Lane Co convertible
loan note? A $82·71 B $73·47 C $67·26 D $94·20
A company has annual after-tax operating cash flows
of $2 million per year which are expected to continue
in perpetuity. The company has a cost of equity of
10%, a before-tax cost of debt of 5% and an after-tax
weighted average cost of capital of 8% per year.
Corporation tax is 20%.
• What is the theoretical value of the company? A
$20m B $40m C $50m D $25m
A company has just paid an ordinary share dividend
of 32·0 cents and is expected to pay a dividend of
33·6 cents in one year’s time. The company has a cost
of equity of 13%.
• What is the market price of the company’s shares
to the nearest cent on an ex dividend basis? A
$3·20 B $4·41 C $2·59 D $4·20
BUSINESS VALUATION (Q2)
The finance director of Coral Co has been asked to provide
values for the company’s equity and loan notes. Coral Co is a
listed company and has the following long-term finance:
$m
Ordinary shares
7·8
7% Convertible loan notes 8·0
15·8
The ordinary shares of Coral Co have a nominal value of $0·25
per share and are currently trading on an ex dividend basis at
$7·10 per share. An economic recovery has been forecast and
so share prices are expected to grow by 8% per year for the
foreseeable future.
The loan notes are redeemable after six years at their
nominal value of $100 per loan note, or can be converted
after six years into 10 ordinary shares of Coral Co per loan
note. The loan notes are traded on the capital market.
The before-tax cost of debt of Coral Co is 5% and the
company pays corporation tax of 20% per year.
What is the market value of Coral Co (to 2dp)
$_____m
Assuming conversion, what is the market value of
each loan note of Coral Co
• A. $110.13 B. $112.67 C. $119.58 D. $125.70
Which of the following statements about the equity
market value of Coral Co is/are true
(1) The equity market value will frequently change
due to capital market forces
(2) If the capital maret is semi strong efficient, the
equity market value will ot be affevted by a
release to the public of nsider information
(3) Over time the equity market value of Coral CO will
follow a random walk
• A 1 only B 1 and 3 only C 2 and 3 only D 1, 2 and 3
BUSINESS VALUATION (Q3)
1
Indicate whether the following are assumptions made by
the dividend growth model
Why might valuations of the equity and oan notes of
Coral Co be necessary?
(1) The company is planning to go to the market for
additional finance
(2) The securities need to be valued for corporate
taxation purposes
(3) The company has received a take over bid from a rival
company
• A. 1 and 2 only B. 1 and 3 only C. 3 only D. 1,2 and 3
MARKET EFFICIENCY
Efficiency of capital markets
Allocative efficiency: funds are directed to firms that
make most productive use
Operational efficiency: Transaction costs are kept as
low as possible, open competition for brokers
Information processing efficiency: ability to reflect
available information in share price fairly and quickly
Fundamental theory of share values is based on the theory
that share values can be derived from rational analysis of
future expected dividends discounted at cost of capital
Technical analysis/charting is an attempt to predict share price
movement by assuming past movements or trends will be
repeated. Main problem is that it is difficult to see a new trend
until it has happened and other chartists will see same as well
Forms
Weak form efficiency: prices reflect information
about past price movements
Investor cant make excess profit by studying past
price movement
Semi-strong form: prices reflect information about
past movements and publicly available information
Prices quickly reflect new info so investors cant beat
the market by studying newspapers or annual reports
Strong form: prices reflect past price movement,
public information and insider/expert knowledge
Random walk theory is based on the idea that share prices will
alter when new information becomes available hence implying
that there are no regular patterns in share price movements
Liquidity is ease of dealing in shares without significant
movement in price
Market Imperfections and irrationality
 Seasonal effects
 Short run overreaction
 Neglect of shares of small companies
 Noise trader deals irrationally/erratically reacting to news
MARKET EFFICIENCY(Q)
An investor believes that they can make abnormal returns
by studying past share price movements.
In terms of capital market efficiency, to which of the
following does the investor’s belief relate?
A Fundamental analysis B Operational efficiency C
Technical analysis D Semi-strong form efficiency
Which of the following statements is/are correct?
1 An increase in the cost of equity leads to a fall in share
price
2 Investors faced with increased risk will expect increased
return as compensation
3 The cost of debt is usually lower than the cost of
preference shares
A 2 only B 1 and 3 only C 2 and 3 only D 1, 2 and 3
Indicate whether each of the following statements on capital
market efficiency are correct or incorrect
In relation to capital markets, which of the following statements
is true?
A. The return from investing in larger companies has been
shown to be greater than the average return from all companies
B. Weak form efficiency arises when investors tend not to make
rational investment decisions
C. Allocative efficiency means that transactions costs are kept to
a minimum
D. Research has shown that overtime share prices appear to
follow a random walk
CAPITAL STRUCTURE (I)
 Is there an optimal mix of debt and equity at
which WACC will be minimized?
1. Traditional View
2. Modigliani and Miller (without tax)
In absence of tax relief on debt in a perfect market, value
depends on:
- Total earnings
- Level of operating/business risk
*Capital structure has no impact on value of company
Assumptions of the M&M

Perfect information, investors act rationally

No tax or transaction costs

Debt is risk free and freely available




Kd is cheaper than Ke
Kd is constant in beginning and later increases
Ke rises slowly (with gearing) and later sharply
WACC falls initially and later rises
CAPITAL STRUCTURE (II)
3. Modigliani and Miller (with tax)

Admit that there is tax relief on debt
4. Pecking Order
Based on companies not seeking to minimize WACC but
have a particular order of preference






Suggest that companies should have capital
structure of 100% debt
Market Imperfections:

Bankruptcy costs

Agency costs

Tax exhaustion
Retained Earnings
Straight Debt
Convertible debt
Preference shares
New equity shares
Reasons for following pecking order

Easier to use retained earnings

No issue cost for RE, Kd lower than Ke

Investors prefer safer securities

Belief that debt has better signaling than equity
Consequences: firms will match investment with internal
finance provided dividend ratios are not heavily impacted,
ideal debt-equity mix will be tough
It is more of what companies do than whet they should
do
CAPITAL STRUCTURE (Q)
Questions
1. What was Nolciln Co’s operational gearing in 20x9 (to one
decimal place) __________ times
2. What was Nolciln Co’s interest cover in 20x9 (to one decimal
place) ______________ times
3. Which TWO of the following are consistent with traditional capital
structure theory
A. There is no optimal capital structure
B. The value of a company remains unchanged with increased gearing
C. The cost of equity is higher when there is a high proportion of deb
capital
D. There is a point at which the weighted average cost of capital is
minimized
4. Responding to the director’s request for advice, which of the
following is consistent with Modigliani and Miller’s with-tax model
A. The value of Nolciln Co decreases with increased gearing
B. The weighted average cost of capital remains constant with
increased gearing
C. The optimal capital structure is made up almost entirely of debt
D. The cost of equity remains constant with increased gearing
5. In relation to capital structure, which TWO of the following are
valid statements about market imperfections
A. Tax exhaustion occurs when there is a high proportion of equity
capital
B. Debt holders may impose restrictive covenants in loan agreements
C. Agency cost, tax exhaustion and bankruptcy risk encourage very
high gearing levels
D. When a company’s gearing creates a high risk of bankruptcy the
weighted average cost of capital will be higher
DIVIDEND POLICY
*Dividend payout/retention ratio
Retained earnings – flexible, no issue cost, no
dilution of control
Shareholders sensitive to loss of dividend, not cost
free
Information Asymmetry
Shareholders and AGMs
Factors influencing dividends
Profits, law, liquidity,
Loan covenants, gearing, need to repay debt
*Signalling effect
Cut may be considered signal that future is weak
An increase can used as defence against takeover
Dividend Theories
1. Residual Theory
2. Traditional View
3. Irrelevancy Theory (Modigliani & Miller): Value is
determined by earning power of assets not dividend
Clientele effect (consistent dividend policy)
Argument against
1. Bird in hand
2. Tax differences
3. Dividend retention preferred in capital rationing
4. Transaction costs
5. Information assymetry
Scrip dividend
Dividend paid by additional issue of shares not cash
Share repurchase or buy back
Consistent dividend per share or consistent payout
INVESTMENT APPRAISAL (Topic Summary)
Usefulness of these methods
1. Payback period, discounted payback
2. Return on Capital Employed
(Accounting Rate of Return)
3. Internal Rate of Return (IRR)
4. Net Present Value (NPV)
Superiority of DCF, recognize relevant
cash flows
Discuss and calculate: sensitivity analysis,
probability, simulation, adjusted payback,
risk-adjusted discount rate
Specialized decisions:
1. Lease or borrow decision
2. Asset replacement decision
3. Capital Rationing: reasons, Profitability
Index (divisible projects) and for nondivisible projects
Inflation, Taxation, TAD, working capital
Risk and Uncertainty in IA: discuss the
difference
Calculation and discussion marks available
INVESTMENT APPRAISAL (I)
• Capital and Revenue expenditure
• Investment in non-current assets or working capital
Advantages
• Simple to calculate & understand
• Uses cash flow not accounting profit
• Investment decision making process: Origination of proposals,
project screening, analysis and acceptance AND monitoring
and review
• Minimize risk due to bias for short term
Relevant cash flows
Return on Capital Employed
• Used as screening device in first stage
• Future incremental costs
• Not sunk or past or committed or depreciation, market
research, centrally allocated overheads not a consequence of
the project
Disadvantages
Payback period, Discounted payback
• Based on accounting profit
• Time taken for cash inflows to equal cash outflows
• Does not account for size of investment, is a relative measure
Disadvantages
• No account of project length
• Ignores timing of cash flows within the project
• Ignores cash flows after target payback
• Ignores time value of money
• The choice of a cut off is arbitrary
• Ignores time value of money
Advantages
• Quick and simple
• Lead to excessive investment in short term
• Considers total project life
• Accounts for timing but not variability of cash flows
• Easy to compare two options as it is a relative measure
INVESTMENT APPRAISAL (question)
What is the payback period of the investment project?
The following information relates to an investment project which
is being evaluated by the directors of Fence Co, a listed company.
The initial investment, payable at the start of the first year of
operation, is $3·9 million.
A 2·75 years
B 1·50 years
Year
1
2
3
4
Net operating cash flow ($000) 1,200 1,500 1,600 1,580
Scrap value ($000)
100
A 13·3% B 26·0%
C 2·65 years
D 1·55 years
Based on the average investment method, what is the
return on capital employed of the investment project?
C 52·0%
D 73·5%
Which of the following statements about investment
appraisal methods is correct?
The directors believe that this investment project will increase
shareholder wealth if it achieves a return on capital employed
greater than 15%.
A The return on capital employed method considers the
time value of money
As a matter of policy, the directors require all investment projects
to be evaluated using both the payback and return on capital
employed methods.
C Riskier projects should be evaluated with longer payback
periods
abd
B Return on capital employed must be greater than the cost
of equity if a project is to be accepted
D Payback period ignores the timing of cash flows within
the payback period
INVESTMENT APPRAISAL (II)
Discounted Cash flows
• Considers cash flows not accounting profits
• Only future incremental cash flows are considered. Sunk costs are
ignored
• The timing of the cash flows is considered by discounting them
Internal Rate of Return
• IRR of an investment is the cost of capital at which the NPV would
be exactly $0. It is an alternative to NPV method and accepts
investments whose IRR exceed a target rate of return
Net Present Value
• Discount factor- WACC, no interest payment
• Timing convention
• Now is Year 0. Pv of $1 now is $1
• Cash flow during the year assumed to occur at the end
• Cash flow at the start assumed to occur at the end of previous
year
• An annuity is a constant cash flow for a number of years
• A perpetuity is a constant annual cash flow that will last
forever. The PV of $100 per annum in perpetuity at a
discount rate of 20% will be $100/0.2 = $500
• Inflation
• Tax allowable depreciation
• Working capital – Incremental and recovery
NPV Layout
INVESTMENT APPRAISAL (III)
Lease OR Buy – financing decision
Risk and Uncertainty
• Evaluate least cost option
• Discount at cost of borrowing
• Buy – Purchase cost, TAD, scrap value, timing
• Lease – Rentals, tax, timing
 Adjusted payback
Asset Replacement Decisions
Assess how frequently an asset should be
replaced
Equivalent Annual Cost (EAC)
EAC = PV of costs / cumulative PV factor
QUESTION
 Risk adjusted discount rates
 Simulation and probabilities
 Sensitivity analysis
INVESTMENT APPRAISAL (IV)
Capital Rationing
This refers to a situation whereby companies are unable to
embark on projects with positive NPVs as a result of shortage of
funds available for investment
c. High floatation costs to raise small equity capital
• Internal/Soft Capital Rationing
Projects
• This is a capital rationing that is self-imposed within a
company. Management may not want to raise funds because
• Divisible, Indivisible
a. Not dilute control and earnings per share
• Mutually Dependent
b. Not to increase the gearing
c. Not exceed the spending limit in capex budget.
d. Limit spending to retained earnings.
External/Hard Capital Rationing
This is a limitation in funds that is imposed by factors that are
outside the control of the management. They are mostly
caused by imperfections in the capital market
a. Depression of share prices in the stock market
b. Govt restriction on bank lending
d. Firm too risky for further loan facilities
• Mutually Exclusive,
RISK MANAGEMENT (Topic Summary)
Foreign currency risk
Interest rate risk
Types: Translation, Transaction and Economic Types: Gap exposure and Basis risk.
Causes of rate fluctuation:
Balance of payment;
Purchasing power parity theory;
Interest rate parity theory;
Four way equivalence
Hedging Techniques: Invoice in home
currency, netting and matching, leading and
lagging, asset and liability management,
Forward exchange contract, money market
hedging
Currency derivatives
Causes of fluctuation: structure of interest rates
and yield curves; expectations theory; liquidity
preference theory; market segmentation
Hedging Techniques: Matching and smoothing,
asset and liability management, forward rate
agreement
Interest rate derivatives
Calculation and discussion marks available
RISK MANAGEMENT (I)
Foreign currency risk
Rates: Spot rate, Forward rate
• Interest rate parity theory;
Forms:
 Translation risk,
 Transaction risk and
 Economic risk
• Four way equivalence
Causes of rate fluctuation:
• Currency demand and supply
• Fisher effect
• Purchasing power parity theory;
RISK MANAGEMENT (II)
Hedging Techniques:
1. Invoice in home currency,
2. Matching: receipts and payments,
3. Assets and liability mgt
4. Leading and lagging,
5. Netting
6. Forward exchange contract
7. Money market hedging
Forward contract
• Agreed today for delivery in the future
• Binding contract
Money market hedging
• No forward rates
• Only spot rate, deposit and borrowing rates
Receipt Step1: Borrow app amount in fx
Step 2: convert to home currency at spot rate
Step 3: Place on deposit in home country
Payment Step1: Determine app amount to deposit in fx
Step 2: convert to home currency at spot rate
Step 3: Borrow from home country
Currency derivatives
Currency futures
 Standardized market, exchange traded, flexible close-out
dates
Currency options
 Allows protection from adverse rate movement
 Allows investor to take advantage of favourable rate
movement
 Premium must be paid, makes it expensive
Currency swaps
 Exchange payment in different currencies or fixed/floating
rates
 Provides hedge for longer periods than forwards
 Parties are still liable to counterparty risk as liability on main
debt is not transferred
RISK MANAGEMENT (III)
Interest rate risk
Forms:
Gap exposure and Basis risk.
An interest rate gap measures a firm's exposure to
interest rate risk. The gap is the distance between
assets and liabilities. Negative vs positive gap
Interest rate derivatives
• Interest rate futures
Fixed sizes, given durations
As interest rate rise, futures prices fall
Depositor: buy futures now then sell later
Borrower: sell futures now then buy later
Basis risk arises from using differing basis/benchmark
for computing the interest on the underlying asset or
liability
 Interest rate options
Premium paid to allow you benefit from favourable
movements
Put (to sell) and call (to buy) option
Causes of fluctuation:
 structure of interest rates and yield curves;
 expectations theory;
 liquidity preference theory;
 market segmentation
Hedging Techniques:
 Matching and smoothing,
 asset and liability management,
 forward rate agreement (FRA)
4-7 FRA at 5%
 Interest rate cap: sets maximum for borrowers
 Interest rate floor: sets minimum for depositors
 Interest rate collar: sets a predetermined range
Borrower would buy cap and sell floor
 Interest rate swaps
WORKING CAPITAL
Objectives of working capital and
the conflict between them
Inventory – EOQ, Just in time, effect
of bulk purchase discounts
Ratios – cash op cycle, current
ratio, quick ratio, net working
capital, turnover period
Cash – treasury management, Miller
Orr model, Baumol model, cash flow
forecast
Overtrading
Working Capital financing policy
(funding)
Working capital investment policy
Receivables – managing
receivables, factoring
Payables – effect of discounts
Calculation and discussion marks
available
WORKING CAPITAL
Working Capital Investment Policy
High vs low levels of WC
Conservative- high levels of
receivables, inventory, low payables
Reduce risk of system breakdown
and stock out but increased finance
cost and lower profits
Obsolescence
Aggressive- speed up collection,
stretch supplier payment, cut
inventories
Moderate matches risk-return
tradeoff
Working Capital Financing Policy
How do you fund current assets?
Non Current Assets
Permanent Current Assets
Fluctuating Current Assets
Short term sources are cheaper,
more flexible but riskier due to
volatility and non-renewal risk
Conservative – LTF for non,
permanent and part of fluctuating.
STF for only part of fluctuating
Aggressive- STF for fluctuating and
part of permanent. LTF for part of
permanent and non current
Moderate- LTF for permanent, STF
for fluctuating
Aggressive has increased risk of
liquidity problems but potential of
increased returns
WORKING CAPITAL
Overtrading/Undercapitalization
Doing too much too quickly with too little
long term capital
May be profitable but prone to liquidity
issues
Signs
Rapid increase in Sales
Rapid increase in Current Assets
Inventory turnover will slow down
Small increase in LTF
Larger increase in STF – Payables & OD
Worsening Liquidity ratios
Solution
Inject new LT capital
Better control of inventory and receivable
Undertrading/Overcapitalization
Managing Receivables
1. Assess creditworthiness
2. Credit control – overdue accounts, aged
receivables analysis
3. Receivables collection – make it easy,
recovery should not be too costly
4. Early settlement discount
5. Factoring and invoice discounting
6. Manage foreign accounts receivable –
export credit insurance, documentary credits
Benefits of factoring
1. Economies of specialization
2. Cheaper costs
3. Free up management time
4. Bad debt insurance
5. Provide accelerated cash flow
WORKING CAPITAL MANAGEMENT
WORKING CAPITAL MANAGEMENT Introduction
BUSINESS FINANCE - Equity
BUSINESS FINANCE- Debt
BUSINESS FINANCE – SME, Islamic Finance
Finance for SMEs
*Likely to be unquoted
private coys
*Owned by few individuals
*Not the micro enterprises
Problems for SME funding
*Knowledge
*No track record for
borrowing
*Less scrutiny on financial
information
*May achieve low credit
scores
*May be expensive due to
risk
*Lack of collateral
*Maturity gap
SME financing
*Owner financing
*Overdraft
*Bank loans
*Trade credit
*Equity financing (private
placement, exit strategy, not easy)
*Business angel (informal)
*Venture Capital
*Leasing
*Factoring
*Crowdfunding
*Government aid (grants, loans)
*Supply chain finance (reverse
factoring)
Islamic finance
*Based on the concept of sharing risks
and rewards
*Used for shariah compliant products
*Permissible and prohibited activities
*The lender’s success is closely tied to
the borrower’s success and hence the
former may be more closely involved in
decision making
*Riba (interest) is forbidden
Mudaraba – similar to equity. Losses
are borne by capital provider
Musharaka – similar to partnership or
venture capital. Losses are shared
based on capital contribution
Murabaha – similar to trade credit
Ijara – similar to lease
Sukuk - similar to bond
BUSINESS FINANCE
Grenarp Co is planning to raise $11,200,000 through a rights
issue.
The new shares will be offered at a 20% discount to the
current share price of Grenarp Co, which is $3·50 per share.
The rights issue will be on a 1 for 5 basis and issue costs of
$280,000 will be paid out of the cash raised.
The capital structure of Grenarp Co is as follows:
MFZ Co has 12 million ordinary shares in issue and has not
issued any new shares in the period under review.
The company is financed entirely by equity, and is
considering investing $9·2 million of new finance in order to
expand existing business operations.
This new finance is via a rights issue and the rights issue
price would be at a 20% discount to the current share price.
Issue costs of $200,000 would have to be met from the cash
raised
Recent equity market value is $56.4m
Calculate the theoretical ex rights price per share for the
proposed rights issue.
Calculate the theoretical ex rights price per share for the
proposed rights issue.
BUSINESS FINANCE – Effect of debt
Financial risk is risk of having low earnings after paying interest
costs
Gearing ratio = debt/equity
Debt/(debt+equity)
OR Prior charge capital/Total capital
Prior charge is any capital that has right to receive interest or
preferred dividend before ordinary shareholders
Interest cover = PBIT/Interest
Debt ratio =Total debt/Total Assets
Business risk is risk of making low profits due to nature of
business
Operational gearing = Contribution/PBIT
Contribution = Sales – Variable Costs
*High contribution low PBIT, means fixed costs are high and
business risk is high
*Low Op gearing means fixed costs can easily be covered hence
business risk is low
Shareholder wealth ratios
PE ratio
Dividend cover= PAT/Dividend
Dividend yield = DPS/MPS
Earnings per share = Total earnings
(PAT)/ Total no of shares
Market price per share
Other ratios given by the question
COST OF CAPITAL Various Long-term Capital
COST OF CAPITAL Project-specific Cost of Capital
DISCOUNT FACTORS Present Value & Annuity Tables
Present Value Table
Annuity Table
Present value of an annuity of 1 i.e. {1 – (1 + r)^–n}/r
Where
r = discount rate
Present value of 1 i.e. (1 + r)^–n
Where
r = discount rate
n = number of periods until payment
Periods
(n)
n = number of periods
Discount rate (r)
Periods
(n)
Discount rate (r)
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
0.990
0.980
0.971
0.962
0.952
0.943
0.935
0.926
0.917
0.909
1
1
0.990
0.980
0.971
0.962
0.952
0.943
0.935
0.926
0.917
0.909
1
2
0.980
0.961
0.943
0.925
0.907
0.890
0.873
0.857
0.842
0.826
2
2
1.970
1.942
1.913
1.886
1.859
1.833
1.808
1.783
1.759
1.736
2
3
0.971
0.942
0.915
0.889
0.864
0.840
0.816
0.794
0.772
0.751
3
3
2.941
2.884
2.829
2.775
2.723
2.673
2.624
2.577
2.531
2.487
3
4
0.961
0.924
0.888
0.855
0.823
0.792
0.763
0.735
0.708
0.683
4
4
3.902
3.808
3.717
3.630
3.546
3.465
3.387
3.312
3.240
3.170
4
5
0.951
0.906
0.863
0.822
0.784
0.747
0.713
0.681
0.650
0.621
5
5
4.853
4.713
4.580
4.452
4.329
4.212
4.100
3.993
3.890
3.791
5
6
0.942
0.888
0.837
0.790
0.746
0.705
0.666
0.630
0.596
0.564
6
6
5.795
5.601
5.417
5.242
5.076
4.917
4.767
4.623
4.486
4.355
6
7
0.933
0.871
0.813
0.760
0.711
0.665
0.623
0.583
0.547
0.513
7
7
6.728
6.472
6.230
6.002
5.786
5.582
5.389
5.206
5.033
4.868
7
8
0.923
0.853
0.789
0.731
0.677
0.627
0.582
0.540
0.502
0.467
8
8
7.652
7.325
7.020
6.733
6.463
6.210
5.971
5.747
5.535
5.335
8
9
10
11
12
13
14
15
0.914
0.905
0.896
0.887
0.879
0.870
0.861
0.837
0.820
0.804
0.788
0.773
0.758
0.743
0.766
0.744
0.722
0.701
0.681
0.661
0.642
0.703
0.676
0.650
0.625
0.601
0.577
0.555
0.645
0.614
0.585
0.557
0.530
0.505
0.481
0.592
0.558
0.527
0.497
0.469
0.442
0.417
0.544
0.508
0.475
0.444
0.415
0.388
0.362
0.500
0.463
0.429
0.397
0.368
0.340
0.315
0.460
0.422
0.388
0.356
0.326
0.299
0.275
0.424
0.386
0.350
0.319
0.290
0.263
0.239
9
10
11
12
13
14
15
9
10
11
12
13
14
15
8.566
9.471
10.368
11.255
12.134
13.004
13.865
8.162 7.786 7.435 7.108
8.983 8.530 8.111 7.722
9.787 9.253 8.760 8.306
10.575 9.954 9.385 8.863
11.348 10.635 9.986 9.394
12.106 11.296 10.563 9.899
12.849 11.938 11.118 10.380
6.802
7.360
7.887
8.384
8.853
9.295
9.712
6.515
7.024
7.499
7.943
8.358
8.745
9.108
6.247
6.710
7.139
7.536
7.904
8.244
8.559
5.995
6.418
6.805
7.161
7.487
7.786
8.061
5.759
6.145
6.495
6.814
7.103
7.367
7.606
9
10
11
12
13
14
15
(n)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
11%
0.901
0.812
0.731
0.659
0.593
0.535
0.482
0.434
0.391
0.352
0.317
0.286
0.258
0.232
0.209
12%
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322
0.287
0.257
0.229
0.205
0.183
13%
0.885
0.783
0.693
0.613
0.543
0.480
0.425
0.376
0.333
0.295
0.261
0.231
0.204
0.181
0.160
14%
0.877
0.769
0.675
0.592
0.519
0.456
0.400
0.351
0.308
0.270
0.237
0.208
0.182
0.160
0.140
15%
0.870
0.756
0.658
0.572
0.497
0.432
0.376
0.327
0.284
0.247
0.215
0.187
0.163
0.141
0.123
16%
0.862
0.743
0.641
0.552
0.476
0.410
0.354
0.305
0.263
0.227
0.195
0.168
0.145
0.125
0.108
17%
0.855
0.731
0.624
0.534
0.456
0.390
0.333
0.285
0.243
0.208
0.178
0.152
0.130
0.111
0.095
18%
0.847
0.718
0.609
0.516
0.437
0.370
0.314
0.266
0.225
0.191
0.162
0.137
0.116
0.099
0.084
19%
0.840
0.706
0.593
0.499
0.419
0.352
0.296
0.249
0.209
0.176
0.148
0.124
0.104
0.088
0.074
20%
0.833
0.694
0.579
0.482
0.402
0.335
0.279
0.233
0.194
0.162
0.135
0.112
0.093
0.078
0.065
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
(n)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
11%
0.901
1.713
2.444
3.102
3.696
4.231
4.712
5.146
5.537
5.889
6.207
6.492
6.750
6.982
7.191
16%
0.862
1.605
2.246
2.798
3.274
3.685
4.039
4.344
4.607
4.833
5.029
5.197
5.342
5.468
5.575
17%
0.855
1.585
2.210
2.743
3.199
3.589
3.922
4.207
4.451
4.659
4.836
4.988
5.118
5.229
5.324
18%
0.847
1.566
2.174
2.690
3.127
3.498
3.812
4.078
4.303
4.494
4.656
4.793
4.910
5.008
5.092
19%
0.840
1.547
2.140
2.639
3.058
3.410
3.706
3.954
4.163
4.339
4.486
4.611
4.715
4.802
4.876
20%
0.833
1.528
2.106
2.589
2.991
3.326
3.605
3.837
4.031
4.192
4.327
4.439
4.533
4.611
4.675
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
12%
0.893
1.690
2.402
3.037
3.605
4.111
4.564
4.968
5.328
5.650
5.938
6.194
6.424
6.628
6.811
13%
0.885
1.668
2.361
2.974
3.517
3.998
4.423
4.799
5.132
5.426
5.687
5.918
6.122
6.302
6.462
14%
0.877
1.647
2.322
2.914
3.433
3.889
4.288
4.639
4.946
5.216
5.453
5.660
5.842
6.002
6.142
15%
0.870
1.626
2.283
2.855
3.352
3.784
4.160
4.487
4.772
5.019
5.234
5.421
5.583
5.724
5.847
FORMULAE SHEET