FINANCIAL MANAGEMENT AND FINANCIAL ENVIRONMENT
Why are we studying financial management?
The primary objective of any commercial organisation is profit maximization. However, that too at the expense of shareholder’s
wealth is not acceptable.
Financial managers safeguard shareholder’s interest by managing financial resources in an optimum manner. Decisions that
financial managers take include:
 which products to make and sell into which markets.
 appraising longer term investment projects.
 how much finance the business needs for its day-to-day operations and for longer-term investment projects.
 where the finance should be obtained from (debt or equity).
 how to manage short term cash surpluses and short-term cash deficits.
 amounts to be paid out as dividends; and
 how to protect the organisation against financial risks.
The financial manager makes decisions relating to investment, financing, and dividends. That is how the money is flowing in
and out of the business.
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What factors does a financial manager need to consider while making relevant decisions?
1) Organization’s commercial and financial objectives.
2) The broader economic environment (macro-economics).
3) Potential risks associated with the decision making and methods of managing them.
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1) Understanding Organization’s commercial and financial objectives.
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A fundamental principle of financial management is to ensure shareholder’s wealth maximization.
Shareholder return = Capital gain + Dividend
Note that maximizing shareholder’s wealth is not the same as maximizing profits. There have been many companies whose
share price have increased over time thus increasing shareholder value while they were still operating at a loss. Take, TESLA
for example. This may also be the case for any tech-startup these days.
Potential problems with the objective of profit maximization (profit maximization ≠ SH’s wealth maximization):

Long-term versus short run: minimum product development, R&D may lead to higher profits now but not sustainable
in long-term. Stock markets detect this tactic and share prices can fall.

Earnings quality: companies may expose themselves towards high risk (overtrading / risky projects) just to promote
growth and positivity in earnings. Stock market may regard these earnings as too risky and reactively the share price
could fall.

Cash: Investors really earn when they get cash dividends. Therefore, they are not just concerned with profits but also
cash.

EPS growth: Many times, corporate success is measured in terms of EPS. EPS just depicts the earning potential of a
shareholder but the not the actual return itself.
Maximizing refers to:
 Seek higher returns.
 Despite risk
 Higher management workload
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v/s
Satisficing refers to:
 Adequate income
 Sustain satisfactory returns.
 Less risk and workload
Stakeholder objectives and conflicts
A stakeholder is a person, group or organization with a vested interest, or stake, in the decision-making and activities of a
business, organization or project. There can be internal, connected, or external stakeholders.
Although, the primary objective of a commercial organisation is to maximize shareholder’s wealth, but many argue that a
single objective is not sustainable. Therefore, a stakeholder’s view should be adopted. Managers often need to balance the
interest of various stakeholders considering their competing claims.
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The role of company management!
Although ordinary shareholders (equity shareholders) are the owners of the company to whom the board of directors are
accountable, the actual powers of shareholders tend to be restricted, except in companies where the shareholders are also the
directors.
The relationship between management and shareholders is sometimes referred to as an agency relationship, in which
managers act as agents for the shareholders (principal).
Inherent divorce of ownership and control:

Shareholders in large companies have generally no right to inspect the books of account, and their forecasts of
prospects are gleaned from the annual report and accounts, stockbrokers, investment journals and daily newspapers.

Shareholders are reliant upon the management upon achievement of objectives and maximization of their wealth.

However, directors are uniquely positioned to support their own personal interest,
The problems that arise due to this divorce is often referred to as ‘Agency Problem’.
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Managerial reward schemes
Managers can be encouraged to increase or maximize shareholder wealth by managerial reward schemes such as
performance-related pay, share option schemes etc.
1. Performance-related pay links part of the remuneration of directors to some aspect of corporate performance, such as
revenue growth, profit levels or earnings per share.
2. A share option scheme allows managers to purchase company shares at a predetermined price (often at a substantial
discount on fair value). So, higher the share price the more benefit for managers and shareholders.
Problems associated with share option schemes:

Directors tend to immediately sell their shares to convert them into cash. Thus, the impact is limited.

If the share price falls, then its not an incentive anymore.

Issue of share options potentially dilute the existing owners equity. This impact is recognised in statement of profit or
loss now (IFRS-2).

Might encourage unethical behavior just to boost up share price.
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Regulatory requirements / Corporate Governance
The director / shareholder conflict has also been addressed through corporate governance codes and other stock market
regulations. The most important addresses are:
Introduction of non-executive directors (NEDs):

Important presence on the Board

One-half of the Board shall NEDs

Independent NEDs should also be on the Board.
Executive Directors:

Separate Chairman and CEO

Election of Directors (every 3 years)

Transparent disclosure of financial rewards (IAS-19)
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Non-profit organizations
For these organizations, primary objective is not to make money for just prescribed group of people but rather serve their
intended cause. This makes the performance assessment more difficult as the analysis is based on both financial and nonfinancial indicators.
Furthermore, since such entities are often funded through donations / public money, therefore value assessment is essential.
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MEASURING FINANCIAL PERFORMANCE
Financial ratio analysis also helps an entity measuring achievement of corporate objectives. Though, maximization of
shareholder’s wealth is the ultimate corporate objective, managers must also set realistic short-term profitability targets to
keep a track on performance.
Ratios are financial metrics that help in assessing the performance of entity. They should be used in comparison to prior
years, set-targets, industry averages or any other benchmarks.
Four broad categories of ratios:

Profitability and return

Debt and gearing

Liquidity

Investor ratios
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Profitability ratios
These are used by a financial manager to assess if the corporate objectives are being met or not. Imagine, your CEO or the
Board requests you to prepare a report on the performance of the entity this year! You’ll take multiple profitability ratios
compare them with previous years or competitors or industry averages and conclude if the performance was impressive or
not. External investors also monitor these ratios closely when deciding whether to invest further in the business or to assess
the overall business.
RETURN ON CAPITAL EMPLOYED (ROCE)

ROCE = Profit before interest and tax (PBIT) / Capital Employed x 100

PBIT is ‘operating profit’.

Capital employed  Total Assets – current liabilities.
 Equity + Long-term debt
ROCE is the primary indicator of profitability when assessing a company. It indicates how well a company is utilizing the
finance provided to it to generate a return.

Higher the ROCE, the better it seems.

However, ROCE uses profits which does not necessarily the maximization of ‘shareholder’s wealth.

ROCE is the product of ‘margins’ and ‘volumes’.
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RETURN ON EQUITY (ROE)

ROE = Profit after tax and preference dividends / Equity x 100

ROE is a more direct measure for equity investors.

Equity investors can simply compare ROE with benchmark interest rates to conclude if re-investing their money in this
business is worth it or not.

Limitation  ROE is sensitive to gearing levels.
o Rising debt levels will allow company to invest cheaper finance to achieve a greater return. Thus ROE will tend
to rise however this also increases investors liquidation risk.
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Margin ratios
Gross Profit Margin

Gross profit / revenue x 100

How much gross profit is earned as a % of sales.

Higher the GP margin, the better it is because it would reflect a wider gap between selling price and cost of
manufacturing.

This can be compared with prior periods or with competitors selling similar goods to assess what can be improved or if
the ‘product profitability’ is high enough or not.
Net Profit Margin

Operating profit / revenue x 100

How much net profit is earned as a % of sales. It includes a trickledown effect from GP.

Represents management’s administrative performance. Look out for distribution and administrative expenses.

One-of items can affect NPM.
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Debt and gearing
Financial gearing

Debt / (Debt + Equity) 100

How much debit is used in the capital structure.

It is a representation of financial risk in the company. So, higher financial gearing means that there is high financial
risk for shareholders as the debt must be repaid no matter what.

External debt attracts covenants or restrictions.

On the other side, debt is usually considered as a cheaper source of finance and that too at a fixed %. So, if the
company has potential to grow exponentially, the residual profits will be available to equity holders.
Interest cover

PBIT / Interest

How many times same interest can be paid with the same level of profits.

If the ratio is too low then debt is not sustainable.

Although, generally a high interest cover is considered to be good but a too high interest cover would indicate that the
company is losing on profitable opportunities.
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Operating gearing

Contribution / EBIT

It is a measure of the extent to which a firm’s operating cost are fixed rather than variable.

It is a representation of business risk in the company.

Business risk is the risk associated with competing in the market. That is, the risk that company will not perform well
and achieve its desired objectives due to competition, technological advancements, customer preferences etc.

Technically, a financial manager or an entity cannot eliminate business risk.

However, it is important for a financial manager to understand the higher operating gearing makes the business more
sensitive towards variability in business conditions.
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Liquidity ratios
Current ratio

Current assets / Current liabilities

How much current assets are available against each $1 of current liabilities.

Denotes short-term liquidity of the business.

Higher current ratio means a safe outlook for investors / lenders.

However, unnecessarily high current ratio would indicate an opportunity cost for investor’s funds.
Quick / Acid test ratio

(Current assets – inventory) / Current liabilities

A harsh measure towards liquidity.

Means how well current liabilities are covered with liquid assets.

It is particularly relevant when inventory holding periods are longer.
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Investor ratios
Total Shareholder Return (TSR)

Typically for an equity investor, TSR = Dividends + Capital gain

TSR as a ratio = DPS + Change in share price / Opening share price x 100

This is what comes into the hand of shareholders.

However, dividends are subject to incomes tax and capital gains may be subject to CGT. So, shareholders personal
preference matters.
Other investor ratios:

Typically, all equity investors would be interested in different measures of assessing dividends paid by the company
and how the share price can increase (that is, how well are the earnings of the business).
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Earnings related ratios
Earnings per share

EPS = (PAT – Preference Dividend) / # of ordinary shares

How much residual profits are attributable to each ordinary share.

An investor can assess companies performance over time by analyzing the trend of EPS.

However, note that EPS does not represent that actual income for shareholder as it is based on earnings.
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Price to Earnings ratio (P/E ratio)

PE ratio = Share price / EPS

It expresses how much shareholders are willing to pay for each share as a multiple of earnings.

It represents the confidence of shareholders on the company.

A high PE ratio indicates that investors perceive the earnings of the company to be of high quality. So, a high PE ratio
indicates that shareholders expect profits to rise in future.

Constant review of PE ratio provides financial manager and existing investors are a market view of the earnings.
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OR
Total shares value / Total Earnings
Dividend per share

DPS = Total dividend / total ordinary shares

Shareholders are entitled to profits from the business. They get a share of these profits in the form of dividends.

Investors compare year-on-year DPS to assess the company’s performance.

Shareholders have tendency to regard level of dividends per share as a form of information about the company’s
performance.

Therefore, companies try to maintain a stable or slowly rising DPS, by resisting making high payouts during particularly
good years.
Dividend Cover

DPS = (PAT – Preference Dividend) / Dividend for the year (interim + final)

It is a measure that how many times company’s earning could pay the same dividend.

Higher the dividend cover, the better the ability of the company to maintain stable dividends.

However, low dividend cover may acceptable for companies with stable profitability.

Dividend cover is an important number for income oriented shareholders (normally those who invested in blue chip
stocks)
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OR
EPS/DPS
Dividend Yield

Dividend Yield = DPS / MPS

It can be used to compare the return from fixed-rate investment (e.g., debt instruments).

However, any growth in share price dilutes dividend yield and creates a negative perception. Thus, it fails to consider
the total shareholder return.
Interest Yield

Interest Yield = Interest / Market value of Debt

It is a measure of return for the debt holder.

IY will help investors to assess whether the level of return from investing in a company is sufficiently above the risk free
rate.
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THE ECONOMIC ENVIRONMENT FOR BUSINESS
What is macroeconomics?
Macroeconomics is concerned with issues, objectives and policies that affect the whole economy. All economic analysis that
refers to aggregates is macro.
Key four economic objectives:
The policies pursued by a government may serve various objectives such as:
1. Economic growth
'Growth' implies an increase in national income in 'real' terms (increases caused by price inflation are not real increases at all).
It is usually interpreted as a rising standard of living.
National income is the total value a country’s final output of all new goods and services produced in one year.
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2. Control price inflation
This means managing price inflation to a low, stable level. Inflation is viewed as a problem because, if a country has a higher
rate of inflation than its major trading partners, its exports will become relatively expensive (because of higher cost of production).
3. Full employment
Full employment does not mean that everyone who wants a job has one all the time, but it does mean that unemployment levels
are low, and involuntary unemployment is short term.
4. Balance of payments stability
Balance of payment is a statement of all export and import transactions. Deficits in external trade, with imports exceeding
exports, might also be damaging for the prospects of economic growth.
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Conflicts of macro-economic objectives
Economic growth vs inflation
One macro-economic conflict can come between economic growth and inflation (which leads to a
similar conflict between unemployment and inflation).
If there is rapid economic growth, it is more likely that inflationary pressures will increase.
Inflation is particularly likely to occur when growth is above the long run trend rate, and AD increases
faster than AS.
Economic growth vs balance of payments
When economic growth is led by consumer spending, it tends to cause a deficit in the current account. This is because as
consumer spending rises, there will be a rise in import spending. Also, high economic growth may increase inflation and make
exports less competitive.
However, if economic growth is export-led, then there can be an increase in economic growth without causing a current
account deficit. For example, Germany has seen strong economic growth, but it often runs a current account surplus.
Economic growth vs budget deficit
A government may feel it needs to reduce the budget deficit. This will require higher taxes and lower spending. However, this
tightening of fiscal policy will lead to a fall in AD and lead to lower economic growth.
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Economic growth vs environment
There can be a strong conflict between economic growth and environmental objectives. Higher GDP leads to higher levels of
pollution and consumption of non-renewable resources.
Conflict between unemployment and inflation
In a period of high growth – jobs are created, causing unemployment to fall.
But, as unemployment falls, it can put upward pressure on wages, leading to
inflation.
The Phillips curve suggests there is a trade off between these two objectives.
For example, a cut in interest rates leads to higher Aggregate Demand (AD).
Higher AD leads to higher growth (Lower unemployment) but also higher
inflation. Therefore the Phillips curve trade-off moves from A to B.
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THE ECONOMIC POLICIES
In order to achieve such targets governments need to formulate policies which can be broken down as follows:
1. Monetary policy
Monetary policy aims to influence monetary variables such as the rate of interest and the money supply in order to achieve
targets set for employment, inflation, economic growth and the balance of payments.
Interest Rates
Borrowing cost
Demand
Inflation
Unemployment
2. Fiscal policy
Fiscal policy involves using government spending and taxation in order to influence aggregate demand in the economy.
Fiscal policy seeks to influence the economy by managing the amounts which the Government spends and the amounts it
collects through taxation.
Fiscal policy appears to offer a method of managing aggregate demand in the economy.
Government spending without increasing taxes
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AD
Inflation
Budget Deficit
Govt. Borrowing
3. Exchange rate policy
Some economists argue that economic objectives can be achieved through management of the exchange rate by the
Government.
Fixed exchange rates (pegging)
A government may try to keep the exchange rate at a fixed level against a major currency such as the US dollar. (Example
Saudi Arabia, Hong kong, Kuwait etc.)
Floating exchange rates
Exchange rates which are allowed to fluctuate according to demand and supply conditions in the foreign exchange markets.
Fluctuating exchange rates create uncertainties for businesses involved in international trade.
Impact of a lower exchange rate (High $ value)
Impact of a higher exchange rate (Low $ value)
Domestic goods are cheaper in foreign markets so
demand for exports increases.
Domestic goods are more expensive in foreign
markets so demand for exports falls.
Foreign goods are more expensive so demand for
imports falls. Better for balance of payments.
Foreign goods are cheaper so demand for imports
rises. Worst for balance of payments.
Imported raw materials are more expensive which
increases production costs.
Imported raw materials are cheaper so costs of
production falls.
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4. External trade policy
Protection could encourage domestic output to rise, stimulating the domestic economy. However, not so good for international
relations.
These policy tools are not mutually exclusive and a government might adopt a policy mix of monetary policy, fiscal policy and
exchange rate policy and external trade policy in an attempt to achieve its intermediate and ultimate economic objectives.
5. Competition policy
Competition policies are regulations and measures implemented by governments to ensure fair competition among firms in the
marketplace.
Market failure: When markets fail to allocate resources efficiently and therefore fail to produce socially desirable outcomes.
Example, monopolies exploit resources, income inequality, or high dependency in low-value added sectors etc.
Government makes competition policy to ensure that economy stays productive and efficient.
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6. Supply-side policy
Supply-side policies are government measures aimed at increasing the productive capacity and efficiency of the economy.
Examples include:






Lowering Taxes
Deregulation
Education and Training
Research and Development (R&D) Support
Trade Liberalization
Labour Market Reforms
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THE NATURE AND ROLE OF FINANCIAL MARKETS AND INSTITUTIONS
The channeling of funds from savers to spenders is a crucial
function for the economy because the people who save are
frequently not the same people who have profitable investment
opportunities available to them, i.e., the entrepreneurs.
Without financial markets, it is hard to transfer funds from a
person with surplus funds and no investment opportunities to
one who has investment opportunities but no funds.
CAPITAL MARKETS AND MONEY MARKETS

Capital markets are markets for
medium-term and long-term capital.

Money markets are markets for shortterm capital
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Institutional investors are institutions which have large amounts of funds which they want to invest. The institutional investors
are the biggest investors in the stock markets.
Disintermediation through securitization
Securitization is the process of converting illiquid assets into marketable asset-backed securities. Companies have been raising
debt finance through bonds or debentures (known as securitization). Thus, moving away from securitization process of raising
money from Banks.
Fintech:
Fintech stands for financial technology and refers to the use of technology and innovation to deliver financial services. It
involves leveraging digital platforms, software, and algorithms to provide convenient, efficient, and innovative financial
solutions.
Crowdfunding:
Crowdfunding is a method of raising funds for a project or venture by collecting small contributions from many individuals,
typically through online platforms.
It allows entrepreneurs, artists, and social initiatives to access capital from a broader pool of people who are interested in
supporting their ideas.
Peer-to-peer finance:
Peer-to-peer funding, also known as peer-to-peer lending or P2P lending, is a form of direct lending that connects borrowers
with individual lenders through online platforms. Examples include: LendingClub, Prosper, Zopa etc.
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INTERNATIONAL MONEY AND CAPITAL MARKETS
Larger companies can borrow funds on the eurocurrency markets (which are international money markets) and on the markets
for Eurobonds (international capital markets).
Bitcoin is a digital and global money system (currency). It allows people to send or receive money across the internet, even to
someone they don't know or don't trust.
Money can be exchanged without being linked to a real identity.
The mathematical field of cryptography is the basis for Bitcoin's security.
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FINANCIAL MARKETS
The financial markets include both the capital markets (for medium- and long-term capital) and the money markets (for shortterm capital). The following activity takes place on these markets:


Primary market activity − the selling of new securities to raise new funds.
Secondary market activity − the trading of existing securities.
Capital markets are a source of long-term finance (through
equity or debt). Companies requiring funds for five years
or more will use capital markets.
Examples:
 London Stock Exchange
 NASDAQ
 PSX
 BSE SENSEX
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Money markets term traditionally represents short term
transactions (usually daily) between institutions. So, it is a
source of short-term finance.
Examples:
 Certificate of Deposits, Municipal notes
 Repo agreements (weekly or daily securitized)
 Bill of Exchange (international transactions)
 Commercial paper (unsecured but high quality)
 Banker’s acceptance (secured by banks)
 Treasury bills (short-term government bonds)
 Derivates (risk management)
STOCK EXCHANGE
The primary function of a stock exchange is to ensure a fair, orderly and efficient market for the transfer of securities and the
raising of new capital through the issue of new securities (often both debt or equity).
A public issue of corporate bonds can take place on a stock exchange. This source can be used instead of raising finance
from banks or debt from other private sources.
How are stocks valued?
Since a Stock Exchange is a market therefore prices are determined based on sellers and buyers’ supply and demand.
 A bull or bullish investor believes that prices will rise. He buys shares in the hope of selling them in the future for a profit.
 A bear or bearish investor believes that prices will fall. He sells shares in the belief that he will be able to buy them back
later for less.
When there are more bulls than bears, prices will rise and when there are more bears than bulls, prices will fall.
Market efficiency.
 An efficient market – one in which the market price of all securities traded on it reflects all the available information.
 A perfect market – one which responds immediately to the information made available to it.
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CAPITAL INVESTMENT APPRAISAL
What are capital investments?
Capital investments are long-term investments which provide returns in the long run. These have significant
financial commitments and often extended payback periods therefore critical investment decision making
is required.
During investment appraisal only relevant cash flows (future incremental cashflows that arise as a direct
consequence of decision making) are considered.
CASHFLOW
RELEVANT
IRRELEVANT
FUTURE
Costs that will arise after the decision.
Costs incurred in the past (sunk cost) or
E.g., replacement cost of other project’s
committed cost.
material.
INCREMENTAL
Example, overtime payment to labour. If
labour is diverted, then contribution lost Example, idle time payment to labour.
from another project is also considered.
CASHFLOW
Items that are cash flows.
Non-cash flow items (e.g., depreciation,
apportioned overhead, notional interest
etc.)
*Opportunity cost is also relevant cost. It is the benefit forgone while choosing the next best alternative.
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Question # 1: Which of the following are relevant costs?
1. Market research costs incurred.
2. Depreciation expense.
3. Opportunity cost of investment.
4. Residual value of the equipment.
5. Committed fixed cost.
6. Absorbed fixed cost.
Question # 2:
Hong Kong’s Bath & Body (HKBnB) is considering manufacturing a new product. This new product will involve
the use of both a new machine which will cost $100,000 as well as an existing machine. This existing machine
costed $50,000 when it was purchased five years ago and currently has a net book value of $25,000 in the
books of HKBnB. It is concluded that since this existing machine is underutilized, it has sufficient capacity to
support to the production of the new product.
Annual sales of the product will be 20,000 units selling at $15 per unit. Unit costs of the product are as follows:
Direct Labour (3 hours @$1 per hour)
Direct material
Fixed costs including the depreciation costs
$
3
3
5
The project is likely to have an expected life of ten years. At the end of ten years, the machinery is likely to
have a residual value of $2,000. The labour available to HKBnB is in scarce supply. Hence, the labour will
have to be diverted from other work which earns the company a contribution of $0.5 per direct labour hour.
Identify the relevant cash flows.
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INVESTMENT APPRIASAL TECHNIQUES
Non-discounting techniques
Discounting techniques

Net Present Value Method

Payback period

Internal rate of return

Accounting rate of return (ARR)
Discounting?
Time value of money  $1 is not equal to $1 in one year’s time.
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NET PRESENT VALUE TECHNIQUE
Net Present Value = Present Value of Future Cashflows – Investments
Decision Rules:
 Positive NPV  accept investment.
 Negative NPV  reject investment.
Question # 3:
The cash flows of a project are estimated to be follows:
Year
0
1
2
3
4
$
(80,000)
10,000
40,000
50,000
8,000
The cost of capital is 10%.
Calculate the Net Present Value (NPV).
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Assumptions in NPV questions:
 Initial investment means investment at Year 0 (now).
 Any cashflow arising at the start of the year is assumed to have arrived at the end of previous year.
 Any cashflow arising at the mid of year is assumed to have arrived at the end of this year.
Question # 4 Following information is provided for a new project:
Investment in Plant & Machinery required at Year 0 is $600,000.
Year
1
2
3
4
Sales Units
8,000
11,000
12,500
6,500
Selling price per unit is expected to be $12.
Variable cost of sales is expected to be $5 per unit.
Fixed costs will be $20,000.
Cashflows are taxed at 30%. Discount factor is 8%.
Required: Calculate NPV.
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Question # 5 (NPV with tax in arrears)
Following information is provided for a new project:
Investment in Plant & Machinery is required at $900,000.
Year
1
2
3
Sales Units
7,000
10,000
11,000
Price / unit is expected to be $10, $11, and $12 respectively.
Variable cost is expected to be 60% of sales per unit.
Fixed costs will be $18,000.
Cashflows are taxed at 30% with one year in arrears.
Ignore capital allowances.
Discount factor – 10%.
Required: Calculate NPV.
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Question # 6 Delayed perpetuity:
If a project involved the outlay of $20,000 today and provided a definite return of $3,000 per year for the
foreseeable future starting in three years’ time.
Required: Would you accept the project? (Assume that you could get a return of 6% on investments
of similar risk.)
Question # 7 Delayed annuity:
An annuity of $3,000 per annum for eight years starts at the end of the third year and finishes at the end of
the tenth year.
Required: What is the present value of the annuity if the discount rate is 6%?
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Advancing annuity or perpetuity
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Question # 8 Following information is provided for a new project:
Investment in machinery for a new factory is required at $100,000.
Year
1
2
3
4
Sales Units
5,000
6,000
6,000
7,000

Selling price per unit is expected to be $20 each of the three years.

Each unit the machinery produces require 2kgs bought at a wholesale price of $2 per kg. After the first
year, machine is expected to save 20% in usage of raw material.

Labour is paid based on the usage of raw material. Labour consumes 0.2 hours to process each kg and
is paid $4/hr.

Production overheads are expected to be 80% of labour cost. Selling and admin overheads are fixed at
$9,000 per annum.
Cashflows are taxed at 25% in the same year of cashflow.
Tax depreciation is allowed at 25% reducing balance method. Expected proceed for the machine is $40,000
after 4 years.
Cost of Capital is 11%
Required: Calculate NPV.
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Question # 9 (with working capital)
A business is evaluating a project for which the following information is relevant:
1. Sales will be $100,000 in the first year and are expected to increase by 5% per year.
2. Costs will be $50,000 and are expected to increase by 7% per year.
3. Capital investment will be $200,000 and attracts tax allowable depreciation of the full value of the
investment over the 5-year length of the project.
4. The tax rate is 30% and tax is payable in the following year.
5. Working Capital invested will be 20% of projected sales for the following year.
6. General inflation is expected to be 3% over the course of the project and the business uses a real discount
rate of 9%.
Calculate the NPV for the project.
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Question # 10 Following information is provided for a new project:

Investment required in Plant & Machinery is $600,000.

Sales demand for year 1 is expected to be 30,000 units which will further grow by 10% each year.

Selling price/unit in current price terms is $100/unit which will further grow by 7% each year.

Variable cost of sales is 50% of sales.

Fixed overhead is calculated as $20 per unit on normal level of activity of 20,000 units.

Tax rate is 30% payable in the same year.

Tax depreciation is 20% RBM and asset will be scrapped at $15,000 in year 4.

Cost of capital in nominal terms is 12%.
Required: Calculate NPV in each of the following circumstances:
(i) One time working capital investment is required at Year 0 of $40,000.
(ii) Working capital investment is required at 7% of sales per annum
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RISK AND UNCERTAINTY
Risk analysis can be applied to a proposed capital investment where there are several possible outcomes
and, based on past relevant experience, probabilities can be assigned to the various outcomes and estimated
cash flows that could prevail.
Uncertainty analysis can be applied to a proposed capital investment where there are several possible
outcomes but there is little past relevant experience to enable the probability of the alternative outcomes to
be predicted.
Approach towards risk analysis:

Expected values (using probabilities and joint probabilities).
Question # 11
A project has the following possible outcomes, each of which is assigned a probability of occurrence.
Low demand
Medium demand
High demand
Probability
0.3
0.6
0.1
Net Present value
$20,000
$30,000
$50,000
What is the expected value of the project?
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Question # 12
Harry Co is choosing between two mutually exclusive projects. The NPV of these projects in $m depends on
the rate of growth of the economy over the next five years. Forecast NPV is shown under scenarios of low,
medium, and high economic growth:
Probability of growth
0.25
0.50
0.25
Forecast
Low growth
Medium growth
High growth
Project A
$1.0m
$2.5m
$4.0m
Project B
-$8.0m
$4.0m
$16.0m
Required: Calculate expected NPV and suggest which project should be opted.
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Question # 13 (Joint probabilities)
An investment in a new product is being planned. The product has an expected life of two years. An analysis
of similar projects has resulted in the following annual cash flow projections:
Cashflow projection
High
Low
Year 1
$56.0m
$44.0m
Chances
60%
40%
Year 2
$44.0m
$36.0m
Chances
30%
70%
The outcome in Year 2 is not dependent on the outcome in Year 1.
A senior colleague has outlined the following possible scenarios:
Scenarios
Year 1
Year 2
NPV
Scenario 1
Low
Low
-$7.25m
Scenario 2
Low
High
-$0.65m
Scenario 3
High
Low
$3.66m
Scenario 4
High
High
$10.27m
Joint Probability
Required: Identify the mean (expected) NPV of the project.
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Expected NPV
Approach towards uncertainty analysis:
Sensitivity analysis: A key method of analyzing the uncertainty surrounding a capital expenditure project.
It enables an assessment to be made of how responsive the project’s NPV is to changes in a single
variable.
Note that Sensitivity Analysis identifies the more sensitivity analysis only, however, managing risk
and uncertainty would involve probability analysis.
A simple approach to calculating sensitivity is as follows:
Advantages of sensitivity analysis:

Allows managers to make better judgements.

Simple to calculate and understand.
Weaknesses of sensitivity analysis:

Only considers change in one variable at a time.

Ignore interrelationships between variables (e.g., if demand of a product is low, then sales will also be
low despite low selling price).

Does not provide a decision rule.
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Question # 14 (Sensitivity analysis basics)
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SPECIFIC INVESTMENT DECISION MAKING
LEASE OR BUY DECISIONS
A specific decision that compares two specific financing options, the use of a finance lease or buying
outright financing via a bank loan.
The assumption is that the preferred financing method should be the one with the lower PV of cost.
Compare the cash flows of purchasing and leasing.
Note: When discounting cash flows in a buy option, after-tax cost of debt is used. It is assumed that the
business will finance the asset through bank loans.
Decision Rule: Select option with lowest PV of Cost.
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Question # 15
Brown Co has decided to invest in a new machine which has a ten-year life and no residual value.
The machine can either be purchased now for $50,000; or
It can be leased for ten years with lease rental payments of $8,000 per annum payable at the end of each
year.
The cost of capital to be applied is 9% and taxation should be ignored.
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Question # 16
Mallen and Mullins has decided to install a new milling machine. The machine costs $20,000 and it would
have a useful life of five years with a trade-in value of $4,000 at the end of the fifth year. A decision now has
to be taken on the method of financing the project.
(a) The company could purchase the machine for cash, using bank loan facilities on which the current rate
of interest is 13% before tax.
(b) The company could lease the machine under an agreement which would entail payment of $4,800 at the
end of each year for the next five years.
The rate of tax is 30%. If the machine is purchased, the company will be able to claim a tax depreciation
allowance of 100% in Year 1. Tax is payable with a year's delay.
Which of the two is feasible?
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Question # 17
Smicer plc. is considering how to finance a new project that has been accepted by its investment appraisal
process.
For the four-year life of the project the company can either arrange a bank loan at an interest rate of 15%
before corporation tax relief. The loan is for $100,000 and would be taken out immediately prior to the year
end. The residual value of the equipment is $10,000 at the end of the fourth year.
An alternative would be to lease the asset over four years at a rental of $30,000 per annum payable in
advance.
Tax is payable at 33% one year in arrears. Capital allowances are available at 25% on the written down
value of the asset.
Required: Should the company lease or buy the equipment?
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Question # 18
The management of a company has decided to acquire Machine X which costs $63,000 and has an
operational life of four years. The expected scrap value would be zero. Tax is payable at 30% on operating
cash flows one year in arrears. Tax-allowable depreciation is available at 25% a year on a reducing
balance basis.
Suppose that the company has the opportunity either to purchase the machine or to lease it under a
finance lease arrangement, at an annual rent of $20,000 for four years, payable at the end of each year.
The company can borrow to finance the acquisition at 10%.
Should the company lease or buy the machine?
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ASSET REPLACEMENT DECISIONS
DCF techniques can assist asset replacement decisions, to decide how frequently an asset should be
replaced.
To calculate the optimum replacement cycle
you should:
(1) Calculate the NPV of each replacement
cycle.
(2) Calculate the EAC for each cycle.
(3) Choose the cycle with the lowest EAC.
Key assumptions:

Cashflows from trading are not considered.

The operating efficiency of assets will be similar regardless of the lifecycle.
Formula:
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Question # 19
A company operates a machine (Cost $25,000) which has the following costs and resale values over its
four-year life.
The cost of capital is 10%.
You are required to assess how frequently the asset should be replaced.
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Question # 20
Kevlar Co. has a piece of machinery which cost $40,000 and is trying to decide how often to replace it based
on the Equivalent Annual Cost (EAQ). The following information relates to the machine.
Machine Cost 40,000
Running costs $12,000 per year
Residual Value (if sold after…)
Year 1 - 19,000
Year 2 - 16,000
Year 3 - 14,000
Year 4 - 14,000
Cost of capital = 12%
When is best to replace the machine based on the EAC?
A. At the end of year 1
B. At the end of year 2
C. At the end of year 3
D. At the end of year 4
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CAPITAL RATIONING
Arises when there is insufficient capital to invest in all available +NPV projects, i.e., CAPITAL is a limiting
factor.
Types of capital rationing:
Hard capital rationing:
This is where a firm cannot get finance from the capital markets, because:

Investors are unwilling or unable to invest more equity finance, or

Lending institutions consider an organisation to be too risky to be granted funds, or

Capital markets are depressed and reluctant to lend to businesses because of fear of an economic
downturn.
Soft capital rationing:
This is an internal management decision to restrict capital spending and may happen because:

Management may be reluctant to dilute control.

Management may not want to raise additional debt capital because commitments or covenants.
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Single period capital rationing with divisible projects
Profitability index (PI) = Present value of cash inflows / Initial cash outflow  how much is earned on each
$ of investment.
 PI less than 1, means negative NPV.
 Ranking should be based on PI (not NPV).
Question # 21
ABC Co is considering four projects, A, B, C and D. Relevant details are as follows:
Only $60,000 was available for capital investment.
Required:
Evaluate what optimal decision would it be if all projects are divisible based on PI.
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Single period rationing with non-divisible projects.
Question # 22
ABC. Co has capital of $95,000 available for investment in the forthcoming period. The directors decide to
consider projects P, Q and R only.
They wish to invest only in whole projects, but surplus funds can be invested in risk-free debt.
Which combination of projects will produce the highest NPV at a cost of capital of 20%?
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INTERNAL RATE OF RETURN
A discounted cash flow technique that calculates the percentage return given by a project. If this return is
used to discount a project’s cash flows, it would deliver an NPV of zero.
Derivation of formula:
Mathematically, the NPV can be calculated as follows:
NPV = CF0 + CF1 / (1 + r) + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n
*Substitute NPV with 0 and simplify would give the following formula:
In a CBE exam you use the =IRR function to calculate
the project’s IRR.
Decision rule: Accept project if IRR exceeds cost of capital.
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Question # 23:
ABC has evaluated a project and come to the following conclusions.
At a discount rate of 10% the NPV will be $100,000
At a discount rate of 15% the NPV will be -$75,000
What is the IRR?
Question # 24:
If a project has cash inflows of $5,000 per year for 5 years and had an initial investment of $17,000 what is
the IRR?
A. 14.5%
B. 11.5%
C. 10.0%
D. 15.0%
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Question # 25:
Which of the following are advantages of using the Internal Rate of Return (IRR) as an investment
appraisal technique?
1. IRR gives an answer in the form of an understandable percentage.
2. IRR uses accounting profit to assess the project.
3. IRR covers the payback period of the project.
4. IRR focuses on the maximization of shareholder wealth.
A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1 and 4 only
Advantages of IRR:
 Considers time value of money.
 A percentage is easily understood and explainable.
Limitations of IRR:
 Not a measure of absolute profitability.
 Fairly complicated to calculate.
 Non-conventional cashflows (i.e., investment outflow multiple times during the project life) may lead to
multiple IRRs.
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Re-investment assumption
 NPV method assumes is that any net cash inflows are reinvested elsewhere at the cost of capital (that is,
the discount rate). So, no additional return for the firm.
 The IRR method, on the other hand, assumes that these cash flows can be reinvested elsewhere to earn
IRR. Thus, IRR method overestimates the project’s actual return.
Conclusion on NPV versus IRR
 There is a consensus that NPV is the superior technique from a technical viewpoint.
 However, IRR is still extremely useful for explaining the appraisal of an investment to non-financial
managers. This is why both NPV and IRR are both widely used in practice.
 This is not to say that NPV is perfect; like any financial technique, there is the danger that the non-financial
benefits of an investment are ignored or that the financial estimates are inaccurate.
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PAYBACK PERIOD
The length of time it takes for cash inflows from trading to pay back the initial investment.
Advantages of Payback Period:
 Simple to calculate, easy to understand.
 It looks for quick return, therefore maximizes liquidity.
Disadvantages of Payback Period:
 Does not consider the cash flows after the payback period.
 Does not consider the timings of the cash flows.
 Does not consider the time value of money.
Question:
Initial Investment of $6.2m.
Cashflows:
Year 1: $1,200,000
Year 2: $2,200,000
Year 3: $2,500,000
Year 4: $1,700,000
Calculate the Payback Period.
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RETURN ON CAPITAL EMPLOYED / ACCOUNTING RATE OF RETURN
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Kaplan Study Text (Snaps)
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Source of Finance
To support day-to-day business activities.
This includes, bank overdraft, short-term loans, increase working capital efficiency, leasing etc.
For major CAPEX or investments.
Generally, more expensive than short-term finance.
High risk-taking potential.
Equity investors who are willing to take high risk for high growth chances.
Generally, unquoted entities with needs beyond seed finance.
There is funding gap for SMEs which needs to be bridged.
Rapidly growing sector in finance.
Based on Sharia law.
Criteria for choosing between sources of finance:
Factor
Issue to consider
Cost
Higher the cost of finance, lower will be the profits of entity. Debt is normally cheaper than equity as the holder takes less
risk of investing in the business. Moreover, interest paid on debt is tax deductible (1 – t).
Duration
Long-term finance is generally more expensive than short-term finance due to the ‘duration’ involved. However, it is often
secured against long-term assets.
Matching – long-term assets should be financed with long-term finance and vice versa.
Term structure
Term structure is the relationship between interest rates charged at different maturities. Generally, short-term rates are
cheaper than long-term. However, sometimes, it is possible that interest rates are expected to fall in future and therefore
borrowing short term may be expensive.
Gearing
High gearing benefits due to cheaper cost of finance. However, this comes with regular repayment requirements on
principal and interest. If these are not met, then Company could end up in liquidation.
Accessibility
Not all companies have access to all sources of finance. Small companies have problems in traditionally raising debt or
equity finance. For investors, investing in unquoted company makes it an ‘illiquid investment’.
The relationship between risk and return
• Investors demand higher return to compensate themselves for the risk they take.
• Generally, there is higher return demanded on equity compared to debt. Debt is sometimes assumed to be virtually risk-free,
for example in the case of Government Bonds.
• So, return on equity is generally always higher than return on Government Debt.
Reverse yield gap
• This refers to the amount by which bond yield exceeds equity yield.
• This can happen when Government offers high interest rate
on bonds to compensate investors of inflation and still raise
money for government affairs.
Short-term source of finance
To support day-to-day business activities.
This includes, bank overdraft, short-term loans, increase working capital efficiency, leasing etc.
1. Overdrafts or Short-term loans?
Short-term source of finance
2. Increase working capital efficiency
Item
Action
Inventory
Keeping inventory to a minimum possible level so that too much money is not tied up on inventory.
Receivables
Either reduce the credit period or chase receivables as they fall due to make sure that the level of
funding in receivables is kept to a minimum.
Payables
Payables are virtually ‘free’ source of finance. Negotiating longer periods of credit reduces the need to
rely on other sources of finance such as expensive overdrafts.
Short-term source of finance
3. Short-term leasing
Increasingly becoming common as entities take the ‘Right to Use Asset’ and pays lease rental as they earn from this business.
So, the company has very low initial cash outlay.
Condition
Explanation
Lease period
The lease period is of short duration. Generally, less than the useful life of the
asset.
Risk and rewards
The lessor is normally responsible for maintenance and upkeep of asset.
Cancellation.
Cancellation is also possible that too at a short notice.
Short-term source of finance
4. Sale and lease back
For example, a company could sell its’ property and lease it back from the
buyer.
Possible disadvantages:
•
The company loses ownership of the asset and therefore misses out on any capital gains.
•
The company still signs a rental agreement which could provide for a minimum restricting period.
•
Less debt capacity as previously legal asset would have been used as security to raise finance.
•
Rentals will increase overtime.
Long-term source of finance
1. Equity Capital
Ordinary
shares
New shares to
new
shareholders
New shares
to old
shareholders
Rights issue is a pre-emptive right!

Made to existing shareholders.

Discount to current market value.

Always issued as a proportion to existing shares.
Advantages of issuing right shares

Relatively cheaper than a public issue.

Made at the discretion of Directors.

It rarely fails.
1. Equity Capital
• Share holders can sell their rights on the stock market.
Effects of Right Issue
• Market share price tends to fall after right issue as more shares are issued against the same earnings. However, exact fall is difficult
to determine until actual issue.
• Fall in share price is somehow offset from the new shares.
• Theoretical Ex-Right Price (TERP) is the bookish market price per share post right issue.
1. Equity Capital
Example # 1
XYZ Ltd. intends to raise capital via a rights issue.
The current share price is $8.
They are offering a 1 for 4 issue at a price of $6.
Calculate the Theoretical Ex-rights Price
Example # 2
ABC Ltd. has decided to raise capital via a rights issue.
The share price is currently $5.50 and ABC intends to raise $5m.
There are currently 6.25m shares in issue and ABC is offering a 1 for 5 rights issue.
Calculate the Theoretical Ex-Rights Price.
1. Equity Capital
The Value of a Right
• Right shares are issued at a discount to encourage existing shareholders subscribe to the rights issue.
• This gives them an opportunity to even sell their rights to others at the Stock Exchange.
• However, it should be noted that a buyer would only pay what’s worth of a share. So, the landed value can only come up to TERP.
• Value of Right is the difference between TERP and Rights Issue Price.
Discount to
market price
Value of
Right
1. Value of a right = TERP – Issue Price
2. Value of a Right per existing share
= Value of Right / # of shares to
obtain a right
Market price
Issue price
TERP
1. Equity Capital
Example # 3k
ABC Co. announces a 2 for 5 rights issue at $2 per share. There are currently 10 million shares in issue, and the current market price
is $2.70.
a) Calculate the Theoretical Ex-rights Price
b) Calculate Value of Right per existing share.
1. Equity Capital
What options does a shareholder have?
• Excersize the rights as announced by the company.
• Sell all rights.
• Excersize some and sell some.
• Do nothing.
Example:
Gopher has issued 3,000,000 ordinary shares of $1 each, which are at
present selling for $4 per share. The company plans to issue rights to
purchase 1 new equity share at a price of $3.20 per share for every 3 shares
held.
A shareholder who owns 900 shares thinks that they will suffer a loss in their
personal wealth because the new shares are being offered at a price lower
than market value.
On the assumption that the actual market value of shares will be equal to the
theoretical ex-rights price, what would the effect on the shareholder's wealth
be if:
a.
They exercise all the rights
b.
They sell all the rights
c.
They exercise half the rights and sell the other half
d.
They do nothing at all
1. Equity Capital
New shares to new shareholders
• Placing.
• Public offer.
1. Placing:
• This is when the investment bank arranges for the shares to be bought by a small number of investors.
• This includes institutional investors such as mutual funds, pension funds and insurance companies.
• General public can buy shares from these institutional investors.
• Unquoted companies can avail this opportunity before eventually getting listed on a stock exchange.
2. Public offer:
• Inviting public to invest in shares of the company based on prospectus.
• Fixed price offer  shares are offered at the same price to everyone (even institutional shareholders). Investors can see prospectus
of the company which includes company’s past performance and prospects as well.
• Tendering (Book Building)  Shares are sold at ‘strike price’ based on the bids received.
1. Equity Capital
Role of Investment
Banks
• Investment Banks specialize
in helping companies raise
capital.
• They charge a fee by
organizing public issues.
• Sometimes they buy a block
of shares and later sells it to
the market to generate a
profit for the Bank.
• Reputable bank often leads
to a successful issue.
• Investment
Banks
also
offers underwriting services.
• That is, Investment Bank
undertakes that they will buy
the shares if others do not.
• They charge a commission
to the company.
• They
may
also
subunderwrite to dilute their
own risk.
• Marketing and selling of
shares is a business activity
in its own right.
• The
investment
bank
provides this expertise.
• Pricing support.
• Too high price 
• Too low price 
1. Equity Capital
Stock - split
• When a company divides its existing shares into multiple shares.
• The total monetary value remains the same.
• Makes the price more affordable for smaller shareholders.
• Hence, the company maintains its liquidity option because the shares are more marketable now.
• The effect is purely psychological.
1. Equity Capital
Choosing between source of equity
• Accessibility to finance: Quoted companies may use any source whereas unquoted companies are restricted to private placings and
right issue.
• Amount of finance: Raising finance by rights issue is limited by the number and resources of the existing shareholders. Larger sums
can be raised through placing or public issues.
• Cost of issue procedures: Placings are more attractive on cost grounds while the public offers are the most expensive.
• Pricing of the issue: Setting too high of an issue price would leave the shares unsubscribed, leaving it with underwriters.
• Control: Right issue does not introduce new shareholders, hence does not dilute control whereas placing and selling shares to public
does.
Long-term source of finance
2. Debt Capital
Advantages of debt
1. Debt is more attractive to investors because it will be secured against the assets of the company.
2. For the company, debt is a cheaper as interest is tax deductible in most tax regimes.
3. For the company, issue costs are normally lower for debt than for shares.
4. For the company, issue of debt does not dilute control of existing shareholders.
5. For the company, debt providers do not participate in high profits compared with shares. So, the cost of finance is fixed.
Disadvantages of debt
1. Investor does not get voting rights. So, no control over the actions of the entity.
2. For the company, its inflexible as interest must be paid on debt no matter what the company's profits are.
3. For the company, money must be made available for redemption or repayment of debt.
4. For the company, it carries risk of high gearing.
5. For the company, return required by shareholders may increase as interest burden increases the risks that dividends will not be paid.
2. Debt Capital
Types of Bonds
1. Conventional bonds
Conventional / Traditional Bonds are issued and
redeemed at par value. Its interest rate is that like the
market prevalent rates. Bond prices are quoted per $100
nominal value of bonds, so a price of $98.65 means a
market price of $98.65 per $100 nominal value.
2. Premium Bonds
Premium Bonds are redeemed at a premium to par value
so that return of investor is through capital gain on
maturity of the Bond.
3. Deep Discount Bonds
Deep discount bonds are bonds offered at a large
discount on the face value of the debt so that a significant
proportion of the return to the investor comes by way of a
capital gain on redemption, rather than through interest
payment.
2. Debt Capital
Types of Bonds
4. Convertible bonds
Convertibles give the right to holder to convert their instrument into
ordinary shares.
This can be done on a:
o pre-determined price; or
o a pre-determined ratio ($100 stock into 25 shares)
Will the holder of convertible bond convert on maturity or not?
Decision to be based on financial terms.
Floor value  Minimum market price of the convertible bond
= PV of interest and principal (i.e.., same as conventional debt)
Example:
A Company has issued debt which is convertible in 5 years’ time.
The current share price is $6, and it is expected to grow in value by
4% per year.
The current market value of the debt is $120.
On conversion, investors will have a choice of either:
I. Cash at a 15% premium at Par; or
II. 18 shares per loan note.
Required: Will the Bond Holder convert into shares or prefer
cash on maturity (based on financial grounds).
2. Debt Capital
Types of Bonds
5. Loan notes with Warrants
Warrants give the holder the right to subscribe at a fixed future date at a certain number of ordinary shares at a
predetermined price.
Bond holders do not convert, rather:
o make a cash payment for shares (at an attractive price)
o retain the loan notes till redemption
o Warrants (the right to buy shares) can also be sold in the market.
The benefits to the issuer are:
o interest rate is low
o often there is no or less security required
o can be used if the share price is temporarily depressed (so issuing shares is not viable)
o Proceeds can be used to repay the loan (self-liquidating)
Long-term source of finance
3. Leasing
Factor
Issue to consider
Lease period
Generally, for the complete useful of the asset.
Lessor
Lessor is generally not a direct dealer of the asset.
Risk and rewards
The lessor does not retain risk and rewards of assets. Up-keep and
maintenance is made the responsibility of lessee.
Cancellation
The lease agreement cannot be cancelled (so a fixed arrangement).
Venture Capital
Venture capital finance is a form of private equity investment that involves providing funding to early-stage or high-potential companies in
exchange for equity ownership.
Venture capital investors, known as venture capitalists, provide not only financial capital but also expertise, industry connections, and
mentorship to the invested companies.
The goal of venture capital finance is to generate high returns by investing in companies that have the potential to become market leaders
or be acquired by larger companies.
Some real-life examples of venture capital-funded companies include:
Facebook  Accel Partners invested $12.7 million in Facebook in 2005.
Airbnb  Sequoia Capital and Greylock Partners.
Uber  Notable investors include Benchmark, TPG Capital, and Google Ventures.
Bykea  Middle East Venture Partners (MEVP) and Pakistan-focused Sarmayacar.
Byju's  Sequoia Capital, Tencent, and Bond Capital.
Finance for SMEs
They have the following characteristics:
• Firms are likely to be unquoted private companies.
• The business is owned by a few individuals, typically a family group.
• There financing needs are beyond seed capital.
The problems of financing SMEs
•
Finance may be difficult to obtain because of the risks faced by SMEs.
•
There is lack of proven history or track record on which investors can count.
•
There is low level of public scrutiny over accounts and records.
Finance for SMEs
Funding gap for SMEs:
•
As they are unquoted therefore investors can not easily liquidate their investment.
•
Seed funding (initial funding) is often sourced from family and friends (however, it is never enough for growth).
•
Banks often hesitate from investing in SMEs because they neither have good credit score, detailed business plans nor assets available
for collateral (security).
•
SMEs find it difficult to scale beyond a certain level.
Maturity gap for SMEs:
•
SMEs have mismatch between assets and liabilities.
•
Many SMEs end up financing medium and long-term assets with short-term finance such as an overdraft. This is poor matching and
very much less than ideal.
•
This issue is often known as the ‘maturity gap’ as there is a mismatch of the maturity of the assets and liabilities within the business.
Finance for SMEs
Non-typical finance
Equity Finance
Business Angel Financing
Factoring
Government Assistance
Supply Chain Finance
Crowd funding
Key considerations
•
Only private placements
•
No easy exit for investors
•
More patient than conventional investors
•
Informal market
•
Care for less details and financial workings
•
Discount paid to Factor
•
Lower product margins after discounting
•
Cheaper loans or provision of assets
•
Politicized schemes rather than actual benefit
•
Also known as reverse factoring.
•
Enables suppliers to receive early payment for their invoices.
•
Raising funds from many individuals.
•
Typically, through online platforms or websites.
•
Storytelling, engaging content required to convince investors.
Islamic Finance
The main principle:
Islamic finance rests on the application of Islamic law, or Shariah, whose primary sources are the Qur'an and the sayings of the
Prophet Muhammad. Shariah, and very much in the context of Islamic finance, emphasizes justice and partnership.
•
Wealth must be generated from legitimate trade and asset-based investment. (The use of money for the purposes of making
money is expressly forbidden.)
•
Investment should also have a social and an ethical benefit to wider society beyond pure return.
•
Risk should be shared.
•
All harmful activities (haram) should be avoided. Therefore, no investment in alcohol, gambling, etc.
Prohibitions:
•
Charging and receiving interest (riba).
•
Haram activities (gambling, pork, drugs etc.)
•
Speculation or extreme risk (akin to gambling)
•
Uncertainty about the subject matter and terms of contract
Islamic Finance
THE PERMITTED (ISLAMIC PRODUCTS)
1. Mudaraba
•
It is a special kind of partnership.
•
Bank provides 100% of the capital (rab ul mal) and the other party uses its specialist knowledge to invest the capital and
manage the investment (mudarib).
•
Profits are then shared according to a pre-agreed ratio.
•
The lender of the money has to take losses.
•
This exposes bank to considerable investment risk. The other party loses its efforts.
•
Therefore, this type of arrangement is therefore very closely aligned with equity finance.
2. Musharaka
•
Joint venture or investment partnership between two parties
•
Both parties provide capital
•
Share the profits according to a pre-agreed ratio.
•
Losses are borne by each partner strictly in proportion to their capital contribution.
•
Commonly used for large projects in real-estate, trade and other equity investments.
Islamic Finance
THE PERMITTED (ISLAMIC PRODUCTS)
3. Murabaha
•
Form of trade credit or loan.
•
What makes Murabaha different from a loan is that under this arrangement, the bank first obtains the constructive or physical
ownership of the asset.
•
The bank then sells the asset on to the customer on a deferred basis at a price which includes an agreed mark-up for profit.
•
Payments can be made on an installment basis.
•
No penalties can be imposed can be charged by Banks.
•
Examples: purchase of inventory, vehicle financing etc.
4. Ijara
•
Equivalent to a lease finance agreement.
•
Bank purchases an asset for a customer and then provides for use to the lessee over a fixed period for a specified amount.
•
The use of leased asset must be identified in the contract (HOW and WHAT).
•
Lessor is responsible for major maintenance (being the owner of the asset).
•
The lessee is held responsible for maintaining the asset in good shape.
Islamic Finance
THE PERMITTED (ISLAMIC PRODUCTS)
5. Sukuk
•
Company issues tradable financial instruments (loan notes).
o
Islamic bonds are linked to an underlying asset.
o
Holder becomes partial owner of the asset.
o
Profit is linked to the performance of the underlying asset.
o
Sukuk holder takes a share from profits but also bears losses.
THE SHARIAH BOARD:
The Sharia Board plays a crucial role in Islamic finance by ensuring that financial products and transactions comply with the
principles and guidelines of Islamic law, known as Shariah.
Here's an explanation of the role of the Sharia Board in Islamic finance:
•
The Sharia Board consists of qualified Islamic scholars with expertise in Islamic law and finance.
•
Their primary role is to interpret and apply Shariah principles to various financial activities, products, and contracts.
•
They provide guidance on the permissibility (halal) or prohibition (haram) of specific transactions or practices based on their
understanding of Islamic jurisprudence.
•
Continuous monitoring and oversight and ethical guidance.
Internal source of Finance
Internal sources of finance include retained earnings and increasing working capital efficiency.
Retained Earnings
Wherever possible, an entity shall use its retained earnings to finance its projects and operations.
Advantages of using retained earnings
•
Retained earnings are a flexible source of finance.
•
Using retained earnings does not involve a change in the pattern of shareholdings and no dilution of control.
•
Retained earnings have no issue costs.
•
Cheap and quick to raise.
•
No professional assistance or time delay.
Disadvantages of using retained earnings
•
Shareholders may be sensitive to the loss of dividends
•
A misconception, that retaining profits is a cost-free method of obtaining funds. There is an opportunity cost.
Working Capital Efficiency
Internal source of finance is the savings that can be generated from more efficient management of trade receivables, inventory,
cash and trade payables. Efficient working capital management can reduce bank overdraft and interest charges as well as
increasing cash
reserves.
DIVIDEND
POLICY
Internal source of Finance
Three main theories concerning what a cut in dividend will have on the company and its shareholders.
1. Dividend Irrelevancy Theory
• According to this theory proposed by Modigliani and Miller (MM) every time business pays a dividend, the shortfall in required
funds to finance the business is raised from an outside source.
• Every outside source of finance would be at a future cost; thus, future dividends of shareholders will get affected. Consequently,
share price will fall.
• Amount of dividend paid = Loss of value in existing shares
• So, new dividend is offset from capital loss.
• Therefore, shareholder is indifferent about any new dividend paid.
2. Residual Theory
A 'residual' theory of dividend policy can be summarized as follows:
•
If a company can identify projects with positive NPVs, it should invest in them.
•
Only when these investment opportunities are exhausted should dividends be paid.
Internal source of Finance
Three main theories concerning what a cut in dividend will have on the company and its shareholders.
3. Dividend relevance
• Changes in dividend can have affect on shareholder.
• A cut in dividend can be seen as a signal of some ‘bad news’.
• Conflict with shareholders liquidity requirement. For e.g., pension funds and insurance companies need ‘cash’ to stay alive.
• May upset shareholders tax planning (clientele effect).
Internal source of Finance
Practical influences on dividend decision:
• Legal restrictions on dividend payout: Companies are often bound to pay dividend payments solely out of accumulated net
realized profits.
• Dividend restraints: Debt holders often bound companies through loan covenants which restrict the amount of dividend that can
be paid out. This allows the debt holders to secure their investment.
• Liquidity: Company needs to have enough cash balances to pay dividends.
• Taxation: In many countries, dividends are taxed in different ways. This affects investor’s preference of dividends as they then
tend to prefer different payout patterns.
Internal source of Finance
Share repurchase:
Public companies with a large amount of surplus cash may offer to repurchase (and then cancel) some shares from its
shareholders. A reason for this is to find a way of offering cash returns to investors without increasing dividend payments.
Benefits
• Finding good use for surplus cash
• Increase in EPS therefore market price
Drawbacks
• Seen as admission by the company that there is no better use of funds provided by the investors
• Capital gain tax may be higher for investors
Scrip Dividend (not the same as is scrip issue / bonus issue)
Shareholders are allowed to have their dividend in the form of new shares rather than cash.
• Shareholder avoids brokerage commission or stamp duty.
• Remember, these new shares are issued as a compensation to dividend. So, it is not the same as bonus issue.
COST OF BUSINESS FINANCE
What is cost of raising capital?
The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds, and it reflects the riskiness
of providing funds.
The concept of Cost of Capital can be understood in two ways:

It is the cost of funds that company has to pay in return of raising finance.

It is the required return investors expect in exchange of their stake in the business.
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MEASURING COST OF RAISING EQUITY FINANCE (KE)
The cost of equity can be estimated using several different methods or models. These include the dividend valuation model,
the dividend growth model and the capital asset pricing model. Each method is a way of estimating the cost of equity, so in
theory they should produce identical answers.
However, as each involves different sources of data and estimates, in practice they would probably result in differing estimates
for the cost of equity.
Methods to be used for calculation of Ke
1. The dividend valuation model (DVM)
2. The dividend growth model
3. Capital asset pricing model (CAPM)
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Dividend Valuation Model (DVM)
The formula assumes that the market value of shares is directly related to expected future dividends on the shares. Since ordinary shares
have indefinite life therefore dividends are assumed to continue at a constant rate till perpetuity.
Formula derivation:
Present value of cash flows = Future cashflows / Discount Rate
Therefore,
Market value or ordinary shares = Future dividends / Discount Rate  (assumes that dividend is the only return)
Po = Future Dividend / Ke
Re-arranging it further,
Ke = Future Dividend / Po
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Example # 1
ABC Company paid dividend of $10 per share. Its most recent ex-dividend share price was $100 per share.
What is the cost of equity capital?
Example # 2
Cygnus has a dividend cover ratio of 4.0 times and expects zero growth in dividends. The company has one million $1 ordinary
shares in issue and the market capitalization (value) of the company is $50 million. After-tax profits for next year are expected to be
$20 million.
What is the cost of equity capital?
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Assumptions of DVM:
 Dividends will stay constant till perpetuity.
 Market price is linked only with dividends.
 There is no transaction cost.
Dividend Growth Model
Shareholders will normally expect dividends to increase year by year and not to remain constant in perpetuity.
Therefore,
Example # 3
A share has a current market value of 96c, and the last dividend was 12c. If the expected annual growth rate of dividends is
4%.
Calculate the cost of equity capital.
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Example # 4
ABC Company has just paid a dividend of 35c. The dividend paid has grown by 4% per year for the past 5 years. The current
share price is $3.25.
Calculate the Cost of Equity (Ke) using DGM.
Example # 5
Entrie Company has just paid a dividend of 75c. The dividend paid has grown by 3% per year for the past 4 years. The current
share price is $6.54
What is the cost of equity using the dividend growth model?
A. 12%
B. 15%
C. 7%
D. 11%
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How to calculate the Growth Rate?
1. Past dividend model (Dividends will grow on the same rate as for past dividends)
2. Gordon’s growth retention model (Growth in dividends depend on the capacity of earnings retained i.e., higher retention=higher
potential in growth)
Example # 6
Required: Calculate growth rate for dividends.
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Example # 7
If a company retains 65% of its earnings for capital investment projects it has identified and these projects are expected to have an
average return of 8%
Required: Calculate growth rate for dividends using Gordon’s growth retention model.
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Weaknesses of the dividend growth model
1. The model does not explicitly incorporate risk.
2. Dividends do not grow smoothly in reality, so g is only an approximation. For the sake of simplicity, no growth or a
constant growth in dividends is assumed.
3. The model fails to take capital gains into account; however, it is argued that a change of share ownership does not affect
the present value of the dividend stream.
4. No allowance is made for the effects of taxation although the model can be modified to incorporate tax.
5. It assumes there are no issue costs for new shares.
6. It does not produce meaningful results where no dividend is paid (if d is zero, Ke is 0).
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Capital Asset Pricing Model (CAPM)
One of the most discussed advantages of CAPM is that it incorporates the risk investors undertake when investing in equity
instruments of the entity.
The total risk involved in holding securities (shares) divides into risk specific to the company / industry (Unsystematic) and
risk due to variations in market activity or the state of the economy. (Systematic risk or market risk.).

Unsystematic risk can be diversified away, while systematic or market risk cannot.

Systematic risk affects all companies, although at different intensities whereas unsystematic risk is unique to that
specific company/industry and can be catered to by Portfolio Theory.
Portfolio theory
Different investments react differently to events in the market. Portfolio theory suggests that investors can reduce the total
risk on their investments by diversifying their portfolio of investments.
Provided that the investor diversifies their investments in a suitably wide portfolio, the investments which perform well and
those which perform badly should tend to cancel each other out, and much risk can be diversified away.
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CAPM-The Model
CAPM theory assumes that investors hold a well-diversified portfolio of equity investments. Such that, any variation in one
type of investment will offset another type of investment. Thus, investors should be compensated for the systematic risk.
The risk is accommodated into calculation through a beta factor. The higher the beta factor, the more sensitive the security is
to systematic risk.
CAPM theory includes the following propositions:
(a) Investors in shares require a return in excess of the risk-free rate, to compensate them for systematic risk.
(b) Investors should not require a premium for unsystematic risk, because this can be diversified away by holding a wide
portfolio of investments. In this, CAPM builds on portfolio theory.
(c) Because systematic risk varies between companies, investors will require a higher return from shares in those companies
where the systematic risk is bigger.
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Example # 8
Shares in Louie and Dewie have a beta of 0.9. The expected returns to the market are 10% and the risk-free rate of return is
4%.
What is the cost of equity capital for Louie and Dewie?
Example # 9
Investors have an expected rate of return of 8% from ordinary shares in Algol, which have a beta of 1.2.
The expected returns to the market are 7%.
What will be the expected rate of return from ordinary shares in Rigel, which have a beta of 1.8?
Example # 10
Company A has a Beta of 1.2.
Government bonds are currently trading at 4%.
The average return than investors in the market can expect is 15%.
Calculate the Cost of Equity using CAPM.
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Example # 11
Company A has a Beta of 1.2.
Company B has a Beta of 1.
Government bonds are currently trading at 5%.
The average return than investors in the market can expect is 12%.
Calculate the Cost of Equity using CAPM for each company.
Example # 12
Company A has a Beta of 1.3.
Company B has a Beta of 1.2.
Government bonds are currently trading at 5%.
The average market risk premium is 6%.
Calculate the Cost of Equity using CAPM for each company.
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Example # 13
Which of the following statements about ‘systematic risk’ are correct when referring to the capital assets pricing
model?
A. Systematic risk affects the overall market, not just a particular stock or industry.
B. Systematic risk is company or industry specific risk.
C. Systematic risk is risk that can be diversified away by investors.
D. Systematic risk is determined by the gearing of the company.
Example # 14
Which of the following are assumptions made by the capital asset pricing model (CAPM) are correct?
1. It assumes that investors can borrow at the risk free rate.
2. It assumes a capital market with high transaction costs.
3. It assumes that all investors are diversified.
4. It assumes that the risk free rate is 5%
A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1 and 4 only
Example # 15
Is a company with a Beta of 1.2 a more risky or less risky investment than a company with a Beta of 1.6?
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Problems with applying the CAPM.

It is assumed that all investors hold diversified portfolio.

There is no clear-cut definition of what is termed as risk-free security. Rate on short-term government securities often
vary daily based on economic positions.

The CAPM is just a single period model. In theory, it should be possible to apply the CAPM for each time, thus arriving
at successive discount rates, one for each year of the project's life.
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PROJECT SPECIFIC COST OF EQUITY
Organizations need to understand that their investments must earn a minimum required return in order to satisfy the
expectation of shareholders. But then again, different projects a company undertakes composes different risk characteristics.
For example, one type of project (e.g. retail) may be more riskier than another (e.g. education).
Therefore, a project specific discount rate (Ke) should be devised through using the Beta Factor in the CAPM model.
Adjusting the impact of Risk (Gearing & Ungearing)
Steps to follow:
- Ungear beta to represent the business risk only.
- Regear beta to incorporate company/project specific risk.
Uses of geared and ungeared Beta:
- It can help a private company calculate discount factor in order to evaluate its investments
- If a company invests in a diversified business, this concept can help project specific risk rate
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Example # 15
Company A intends to undertake a project in an unrelated industry.
The following details are relevant:
The risk-free rate is 4%.
The average return on the market is 12%.
Calculate a project specific discount rate. Ignore Tax.
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Example # 16
Company A intends to undertake a project in an unrelated industry.
The following details are relevant:
The risk free rate is 4%.
The average return on the market is 12%.
The tax rate is 30%.
Calculate a project specific discount rate.
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Example # 17
Company Alpha is financed with $1,000 of equity and $400 of debt and intends to undertake a project in an unrelated industry.
They have identified Horizon Co. as a company in the new industry with $700 of equity and $300 of debt. Alpha Co. has a
Beta of 1.3 whereas Horizon Co. has a Beta of 1.2. The risk-free rate is 4% and the average return on the market is 12%.
The tax rate is 30%.
Which of the following would be the project specific discount rate for Alpha Co. when entering the new industry?
A. 12.34%
B. 10.25%
C. 11.12%
D. 13.42%
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Example # 18
Company Alpha is financed with 60% equity and 40% debt and intends to undertake a project in an unrelated industry. They
have identified Horizon Co. as a company in the new industry with 75% equity and 25% debt. Alpha Co. has a Beta of 1.1
whereas Horizon Co. has a Beta of 1.4. The risk free rate is 6% and the average return on the market is 14%.
The tax rate is 30%.
Which of the following would be the project specific discount rate for Alpha Co. when entering the new industry?
A. 19.38%
B. 18.00%
C. 17.20%
D. 16.32%
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Example # 19
Company Alpha is financed with debt/equity of 1/4 and intends to undertake a project in an unrelated industry. They have
identified Horizon Co. as a company in the new industry with debt/equity 1/3. Alpha Co. has a Beta of 1.05 whereas Horizon
Co. has a Beta of 1.24. The risk free rate is 6% and the average return on the market is 14%. The tax rate is 30%.
Which of the following would be the project specific discount rate for Alpha Co. when entering the new industry?
A. 16.23%
B. 15.49%
C. 17.26%
D. 18.28%
Example # 20
Our business has a Beta of 1.2, debt with a market value of 100 and equity with a market value of 400. If the proxy has a Beta
of 1.4, debt with a market value of 100 and equity with a market value of 200 calculate a project specific discount rate.
The risk free rate is 4% and the average market risk premium is 7%. Ignore tax.
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COMPUTATION OF COST OF DEBT (KD)
The cost of debt is the return an enterprise must pay to its lenders.
For irredeemable debt, this is the (post-tax) interest as a percentage of the ex-interest market value of the bonds (or
preferred shares).
For redeemable debt, the cost is given by the internal rate of return of the cash flows involved (interest and capital gain or
loss at redemption).
Interest is tax deductible, and this is taken into account in the calculations.
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Irredeemable Debt
Question # 1
A company has issued 10% irredeemable debt.
The market value of the debt is $90/$100.
The tax rate is 30%
Calculate the cost of debt (Kd).
Question # 2
ABC Co. has annual 12% irredeemable bonds in issue with a nominal value of $100. The market price is $95 ex interest.
Calculate the cost of capital if interest is paid half-yearly.
Question # 3
ABC Co. has 18% irredeemable debenture in issue with a par value of $100 & market value of $150. Tax is paid at the rate
of 30% and interest is paid every two months.
Required: Kd (after tax)?
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Redeemable Debt
Question # 4
A Company has issued debt which is redeemable in 5 years’ time. Interest is payable at 8%. The current market value of the
debt is $102. Ignore taxation.
Calculate the Cost of Debt (Kd).
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Question # 5
A Company has issued debt which is redeemable in 5 years’ time. Interest is payable at 10%. The current market value of
the debt is $104.
Tax is payable at 30%.
Calculate the Cost of Debt (Kd).
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COST OF CONVERTIBLE DEBT
Debt holders will only convert if the value of the shares is greater than the redemption value of the debt.
(a) If conversion is not expected, the conversion value is ignored, and the bond is treated as redeemable debt.
(b) If conversion is expected, the IRR method for calculating the cost of redeemable debt is used, but the number of years to
redemption is replaced by the number of years to conversion and the redemption value is replaced by the conversion
value i.e., the market value of the shares into which the debt is to be converted.
Conversion value = Po (1 + g) n R
Where:
Po is the current ex-dividend ordinary share price
g is the expected annual growth of the ordinary share price
n is the number of years to conversion
R is the number of shares received on conversion
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Question # 7
A company has issued 8% convertible bonds which are due to be redeemed in five years' time. They are currently quoted at
$82 per $100 nominal. The bonds can be converted into 25 shares in five years' time.
The share price is currently $3.50 and is expected to grow at a rate of 3% pa.
Assume a 30% rate of tax.
Calculate the cost of the convertible debt.
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COST OF PREFERENCE SHARES
Question # 8
A company has issued 8% preference shares with a nominal value of $1.
The market value of the shares is 80c.
The tax rate is 30%.
Calculate the cost of the preference shares (Kp).
Question # 9
Tax relief is given for preference share dividends.
a) True
b) False
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COST OF BANK LOAN
Question # 10
A company has a bank loan of $2m at an interest rate of 10%.
The tax rate is 30%.
Calculate the cost of debt (Kd).
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Weighted average cost of capital (WACC)
The weighted average cost of capital (WACC) is the average cost of capital for all the company's long-term sources of
finance, weighted to allow for the relative proportions of each type of capital in the overall capital structure.
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Example # 1: Weighted average cost of capital
An entity has the following information in its statement of financial position.
$'000
Ordinary shares of 50c
2,500
12% unsecured bonds
1,000
The ordinary shares are currently quoted at 130c each and the bonds are trading at $72 per $100 nominal.
The ordinary dividend of 15c has just been paid with an expected growth rate of 10%.
Corporation tax is currently 30%.
Calculate the weighted average cost of capital for this entity.
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Example # 2:
Company A is funded as follows:
Balance Sheet Extract
The cost to the company of each of the above items has been calculated as:
The Loan notes are currently trading at $94.
The current share price is $1.50.
Calculate the Weighted Average Cost of Capital.
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Example # 3:
Company A is funded as follows:
Balance Sheet Extract
Details on these are as follows:
The company has an equity beta of 1.2. Government bonds are currently trading at 6% and the average market risk premium
is 7%. The Loan notes are currently trading at $106 and are redeemable at par in 5 years’ time.
The preference shares are trading at 92c. The bank loan has an interest rate of 10%.
The current share price is $1.25. The tax rate is 30%.
Calculate the Weighted Average Cost of Capital.
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Example # 4
In the calculation of WACC, two methods of weighting used are Market Value and Book Value.
Which of the following is correct?
a) Book values of both debt and equity
b) Market value of debt, and book value of equity
c) Book value of debt and market value of equity
d) Current market values of both debt and equity (ignoring reserves)
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Business Valuations
Why do we need to value a business?

Buy-side valuation:
o To determine what price to pay when acquiring a listed company.

Sell-side valuation:
o To value company during the time of disposal.

To determine the value of a private company (e.g., during Management buy out “MBO”)

To place a value on companies entering the stock market (e.g., during IPO).
Note: Majority and minority holdings are not of equal value!
Majority shareholding  control  shares are valued with a premium
Minority shareholding  no control  less than proportional value
What is market value of market capitalization?
Market cap means the total market value of the company’s shares. It is simply, share price x no. of shares.
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What information is required for a valuation excersize?

Financial statements (latest and for past years)

Supporting documents (like fixed asset schedule, debtor/creditors ageing, inventory summary etc.)

Details of some existing contracts (like lease contracts).

Budgets or future projections

Some background information on the industry

Key personnel of the company

Others (as required).
Type of valuation techniques

Asset based valuation.

Income based valuation.

Cash flow based valuation.
These methods are used to determine a range of prices. The idea is to have a minimum price that the current
equity holder is likely to accept and the maximum price a buyer is likely to pay.
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Asset-based valuation techniques
1) NBV method.
2) NRV method.
3) Replacement cost method.
General limitations of the asset-based approach:
a) Value of intangible assets (internally generated, say, skilled workforce, strong management team,
competitive positioning) are often ignored.
b) Does not include the value of future potential cash flows / profits.
c)
Not very useful for valuing services business, which often have low-asset base (like tech companies, or
accounting services).
When assets-based models are useful?

For asset stripping: when a company is being purchased with a sole view to break it down into assets and
sell them off. In such a situation, assets would be valued at their realizable value.

To set a minimum price during negotiations. Shareholders will be reluctant to sell at a price less than the
net asset valuation even if the prospects for income growth are poor.

To value property investment companies. Investment properties are valued at fair value (FV has close link
to future cash flows).
3|P ag e
1) Net-Book Value Method:
The NBV method simply uses the “accounting equation” to determine value of the business.
NBV method is the minimum theoretical benchmarking for equity valuation. This is the theoretical value of a
business.
.
Non-current Assets
xxx
+ Current Assets
xxx
- All Liabilities
(xxx)
Net Assets Value (also known as ‘NAV’)
xxx
Value per share is calculated by dividing NAV with number of shares.
Problems with NBV method:

Balance sheets are based on historical values.

NBV method depends on accounting judgements / estimates (e.g., depreciation method, provisions etc.)

Some value-adding assets are even not recognised in financial statements (like, internally generated
intangible assets, work force, customer relationships etc.).
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2) Net Realizable Value Method / Breakup basis:
If the current owners of the business do not sell their business as a going concern and rather sell their assets on
individual (or aggregate) basis and then pay-off their creditors what amount would they be left with?
Example:
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) $30m
Current assets
$18m
Non-current liabilities
$12m
Current liabilities
$10m
The net-realizable 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 that the owners should accept for the company?
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3) Net Replacement Cost:
Here, the buyer would try to establish what should be the maximum price that should be paid for buying
a business. That is, what if the buyer was to set-up an identical business ‘from scratch’.
Problems:

Replacement costs are difficult to estimate.

Unrecorded assets like internally generated goodwill or brand names are ignored.
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Example:
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INCOME BASED VALUATION TECHNIQUES
Income based valuation techniques are much useful when a valuing for a majority shareholding such that
ownership provides control over incomes and hence dividend policy.
1) Price to Earnings approach
P/E ratio = Market share price / Earnings per share (EPS)
Where, EPS = (Profits after tax – preference dividend) / Number of shares
Therefore,
 Market share price = P/E ratio x EPS
 Total market value = P/E ratio x Total Earnings
Note that:

A high P/E ratio depicts high confidence on future growth prospects.

A low P/E ratio depicts less confidence on future growth prospects.
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Finding a suitable P/E ratio:
To value the company correctly, earnings should be multiplied with an appropriate P/E ratio.
Possible options may be:

Use industry average.

Use P/E ratio of a quoted company of comparable size in the same industry.

When valuing a private company, may adjust downwards to reflect the additional risk of being an
unquoted company.
Adjustments in earnings:
Possible options may be:

Maintainable or normal on-going earnings.

Most recent published earnings / EPS.

When valuing a target company, any one-off items that will not tend to recur, should be adjusted.

Any potential synergies (cost savings or revenue increases) that may arise from an acquisition shall be
adjusted in earnings.
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Example # 1:
Groady Co wants to buy a company, Bergerbo Co, which operates in the same industry.
The statement of profit or loss for Bergerbo for the year just ended is as follows.
PBIT
$5.8m
Interest expense
($2.3m)
Taxable profit
$3.5m
Taxation (25%)
($0.9m)
PAT
$2.6m
Ordinary dividend
2.0
Groady’s P/E is currently 21.2, whilst the industry average is 19.5.
Required: What is the earnings valuation for Bergerbo based on the assumption that it will perform as
well as Groady in terms of earnings?
a) $55.1m
b) $50.7m
c) $74.2m
d) $66.5m
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Example # 2:
Tanglefoot Co is an unlisted company. Its most recent earnings per share (EPS) was $0.53 per share and next
year’s EPS is forecast to be 10% higher. Tanglefoot Co has $50,000 of issued share capital ($0.10 nominal
value per share). The average price-earnings ratio of listed firms in the same business sector is 12 times.
Required: Estimate the total value of Tanglefoot Co using the price/earnings ratio method.
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Example # 3:
The shares of Fencer Co are currently valued on a P/E ratio of 8. The company is considering a takeover bid for
Seed Limited, but the shareholders of Seed have indicated that they would not accept an offer unless it values
their shares on a P/E multiple of at least 10.
Which TWO of the following are reasons which might justify an offer by Fencer Co for the shares of Seed
on a higher P/E multiple?
a) Fencer has better growth prospects than Seed
b) Seed has better quality assets than Fencer
c) Seed has a higher gearing ratio than Fencer
d) Seed is in a different country from Fencer, where average P/E ratios are higher
Example # 4:
What does a high price/earnings (P/E) ratio indicate to investors?
A. Earnings have growth potential
B. Earnings have peaked and will remain flat
C. Earnings have peaked and will likely fall
D. The company is undervalued
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Example # 5 K:
The following information relates to two companies, Alpha Co and Beta Co.
Earnings after tax
P/E ratio
Alpha Co
Beta Co
$210,000
$900,000
16
21
Beta Co’s management estimate that if they were to acquire Alpha Co they could save $100,000 annually after
tax on administrative costs in running the new joint company.
Additionally, they estimate that the P/E ratio of the new company would be 18.
On the basis of these estimates, what is the maximum that the shareholders of Beta Co should pay for
the entire share capital of Alpha Co?
A $1.1m
B $2.9m
C $4.2m
D $2.0m
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Example # 6 K:
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Limitations of the PE multiple approach:
 Difficult to find out a suitable ‘proxy’ company.
 P/E ratio of the ‘proxy’ company may be under/over valued by the stock-market.
 The seller knows more about the real potential earnings of the business than the buyer. Information
asymmetry means the approach can be manipulated.
 This approach is not useful for purchasers of minority shareholding. They cannot influence future earnings
therefore they shouldn’t paying price for it.
 What if the company being valued is a loss-making company? P/E approach doesn’t work with a negative EPS.
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2) Earnings Yield (EY)
Earnings yield is simply the reciprocal of the P/E ratio.
EY =
It can therefore be used to value a company’s shares or total market capitalization.
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Example:
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CASH FLOW BASED VALUATION TECHNIQUES
1) Dividend valuation model
If dividends are forecast to grow at a constant annual rate to perpetuity, the valuation formula is as follows:
Where,
Do = most recent dividend (where as Do (1+g)  dividend in on years’ time)
re = required return of equity investors (= ke)
g = dividend growth rate
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Example # 1:
Cross Co, an unlisted company, has just paid a dividend of $0.12 per share. Its historical dividend growth rate of
5% is expected to be maintained in future.
The following is available for a suitable listed company (i.e., same business and same gearing):
Share price
Dividend just paid
Historical dividend growth rate
(also expected to be maintained)
$2.40
$0.22
10%
Required: Calculate the share value of Cross Co. (Hint: Ke can be calculated using market data and DGM)
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Example # 2:
Wave Co, an unlisted company, has just paid a dividend of $0.12 per share. Its historical dividend growth rate of
5% is expected to be maintained in future and it is entirely equity-financed.
The following is available for a listed company in the same business:
Debt/Equity ratio
Beta
2:5
1.6
The risk-free rate is 5% and the return from the market is 15%.
The company profit tax rate is 25%
Required: Value Wave Co’s equity. (Hint: Need to calculate own company Beta using ungearing/regearing approach)
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Example # 3:
Claygrow Co is a company which manufactures flower pots. The following information is available:
Current dividend
Required return on equities in this risk class
$0.25 per share
20%
Required: Value one share in Claygrow Co under the following circumstances:
1. No growth in dividends.
2. Constant dividend growth of 5% per year.
3. Constant dividends for five years and then growth of 5% per year to perpetuity.
4. Constant dividends for five years and then sale of the share for $2.00.
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Example # 4:
Kip Co has paid the following dividends per share in recent years:
Year
20X6
20X5
20X4
Dividend per share
$0.65
$0.638
$0.628
The dividend for 20X6 has just been paid and Kip Co has a cost of equity of 12%.
Required: Calculate Kip Co’s share price.
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20X3
$0.611
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Limitations of the dividend valuation model:

Difficult to determine growth rate of dividends.

Growth rates do not stay constant, in actual.

It assumes that growth rate is lower than Ke

It creates zero valuation for companies that have given zero dividends.
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2) Discounted cash flow basis
A business can be viewed as a combination of its underlying projects. Just as the value of an individual project
equals the present value of its future cash flows, so too the total value of the business should equal the present
value of the company's cash flows.
This method is suitable for valuing a controlling interest in the shares of a company, where the owner can
act to change the profitability of a company.
It is the maximum value of the business  present value of future cash flows.
There are two approaches to perform valuation:
1) Free cash flow to equity (FCFE)
2) Free cash flow to firm (FCFD)
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Summary:
 Value of the business is the present value of all future free cash flows. Free cash flows basically mean cash
flows without any financing impact.
FCFE
Particulars
Profits after Tax (PAT)
Amount
xxx
Add back: Depreciation
Add / Less: non-cash impacts
xxx
xxx / (xxx)
Free cash flow to Equity
xxx
*Ke will be used for discounting.
FCFF
Particulars
Profits before interest and tax (PBIT)
Amount
xxx
Add back: Depreciation
Add / Less: non-cash impacts
xxx
xxx / (xxx)
Free cash flow to Firm
xxx
*WACC will be used for discounting.
 If value of the firm has been calculated, then value of equity can be simply calculated as:
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Example # 1:
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Example # 2:
Diversification wishes to make a bid for Tadpole. Tadpole makes after-tax profits of $40,000 a year.
Diversification believes that if further money is spent on additional investments, the after-tax (and interest) cash
flows (ignoring the purchase consideration) could be as follows.
Year
Cashflows
0
($100,000)
1
($80,000)
2
60,000
3
100,000
4
150,000
5
150,000
The cost of equity of Diversification is 15%, and the WACC is 10%; the company expects all its investments to
pay back, in discounted terms, within five years.
Required:
1) What is the maximum price that Diversification should be willing to pay for the shares of Tadpole?
2) What is the maximum price that Diversification should be willing to pay for the shares of Tadpole if it
decides to value the business on the basis of its cash flows in perpetuity, and annual cash flows from
Year 6 onwards are expected to be $120,000?
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Example # 3:
Empire Co is considering the acquisition of Juicy Co. Empire's finance director has forecast Juicy's postacquisition operating cash flows for the next four years as follows:
Year
1
Operating cash flow ($m) 15
2
3
16 18
4
20
Empire plans to dispose of Juicy's assets at the end of the fourth year for an estimated $230m.
Juicy has $15m issued share capital, each share having $0.50 nominal value, and $50m of debt outstanding.
Empire considers its current WACC of 10% to be appropriate as Juicy is in the same business and is relatively
small compared with Empire.
Required: Calculate the value to Empire Co of each share of Juicy Co. Ignore taxation.
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Advantages of cash flow-based model:

Theoretically the best method.

Can be used to value part of a company.
Disadvantages of cash flow-based model:

It relies on estimates of both cash flows and discount rates – both may be unavailable.

Difficulty in choosing a time horizon.

Assumes that discount rate, tax and inflation rates are constant through the period.
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VALUATION OF PREFERENCE SHARES
As preference dividends are a fixed percentage of the share's nominal value there will be zero growth of the
future cash flow and the share price becomes the present value of a perpetuity:
Po =
Example:
A company has in issue 5% preference shares each with $1 nominal value.
The financial press quotes the yield on these shares as 4.7%.
Required: Calculate the market price of each preference share.
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DEBT VALUATION
Irredeemable loan notes
The market value of any debt should equal the present value of the future payments to the investor discounted at
the required return.
In the case of irredeemable loan notes there will be a fixed annual payment of "coupon" interest into perpetuity,
with no repayment of principal. Hence, we use the perpetuity effect.
before tax
It is the pre-tax cost of debt
Example:
A company has in issue 7% undated loan notes each with $100 nominal value. The current yield is quoted as
7.42%.
Required: Calculate the market price of each loan note.
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Redeemable loan notes
The value of redeemable debt should equal to the present value of cashflows it provides.
So, the present value of all interests (before tax) expected to be received and the principal amount should be
today’s market value of redeemable debt.
Example:
A company has in issue 8% $100 nominal value loan notes redeemable at a 5% premium in 10 years. The
bonds' yield to maturity is 10%.
Required: Calculate the market price of each bond.
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Example # 2:
The directors of Loki have been in discussion with 4Ts, a listed venture capital company. As well as contributing
equity, 4Ts would seek to spread the risk of their investment by also investing in the form of 4 year 5% secured
redeemable bonds and convertible preference shares.
The risk adjusted return on similar bonds has been estimated at 6%.
Corporation tax is currently 30%.
What is the market value of the redeemable bonds, in $ to two decimal places?
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Convertible loan notes
Convertible loan notes – allow the investor to choose between redeeming the loan notes at some future date or
converting them into a predetermined number of ordinary shares.
Market value of the convertible bond = PV of interest and higher of:

Redemption value; or

Forecast conversion value
Only 1
To estimate the market value, it is first necessary to predict whether the investor will choose redemption or
conversion. The redemption value will be known with certainty, but the future share price can only be estimated.
Other amounts that may be calculated for convertibles:

Floor value = market value assuming cash redemption (PV of interest + principal)

Conversion premium = market value − current conversion value.
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Example # 1:
A company has in issue 9% loan notes which are redeemable at their nominal value of $100 in five years' time.
Alternatively, each bond may be converted on that date into 20 ordinary shares. The current ordinary share price
is $4.45 and this is expected to grow at an annual rate of 6.5% for the foreseeable future. Debt investors'
required return is 7% per year.
Required: Calculate the following values for each $100 convertible loan note:
1) market value;
2) floor value; and
3) conversion premium.
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Example # 2:
A company has 7% loan notes in issue which are redeemable at their nominal value of $100 per loan note in
eight years' time. Alternatively, each loan note is convertible after seven years into 11 ordinary shares. The
company's ordinary shares are currently trading at $6.50 per share. The before-tax cost of debt of the convertible
loan notes is 8%.
Required: Calculate the current market value of each loan note, assuming the share price increases by:
1. 4% per year;
2. 6% per year.
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MARKET EFFECIENCY
Market efficiency is a crucial concept for understanding market prices. It describes that how quickly and
accurately financial markets incorporate all available information about market prices.
There are three main forms of market efficiency:
1. Weak-Form Efficiency:
In weak-form efficiency, all past market trading data, such as historical stock prices and trading volumes, are
already reflected in current asset prices.
This means that technical analysis, which involves analyzing past price patterns and trends, cannot be used to
consistently predict future price movements.
Example: Suppose a stock's price rises consistently on the first day of every month for the past five years. In a
weak-form efficient market, this information is already incorporated into the current stock price, and investors
cannot use this pattern to gain a systematic advantage.
This means that fundamental analysis (based on key financials and business information) so to forecast future
share price. This would require analysis on present situation and expecting what can happen in the future.
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2. Semi-Strong Form Efficiency:
In semi-strong form efficiency, all publicly available information, including past market data and publicly released
news, is already reflected in asset prices.
This means that neither technical analysis nor fundamental analysis (analysis of financial statements and
company performance) can consistently lead to superior returns, as the market quickly adjusts prices based on
the new information.
Example: When a company releases its quarterly earnings report showing better-than-expected profits, the
stock price will adjust rapidly to reflect this information, and investors cannot exploit this information to make
abnormal profits in a semi-strong form efficient market.
3. Strong-Form Efficiency:
Strong-form efficiency is the most robust level of market efficiency. It implies that all information, whether public
or private, is already reflected in asset prices. This means that even insider information cannot be used to gain
an advantage over other market participants.
This is practically not possible! Not even LSE or NYSE are perfect markets.
In conclusion, market efficiency is a fundamental concept in financial management that suggests that asset
prices quickly and accurately reflect all available information. This understanding guides investors and financial
professionals to make sound investment decisions while acknowledging the limitations of attempting to beat the
market consistently.
39 | P a g e
Why stock markets are not perfect?
Efficiency depends on various practical factors like:
1. Marketability and liquidity of shares: For example, shares of a large company are easily bought and
sold. Therefore, their prices have a premium embedded in them for liquidity.
2. Price anomalies: Stock markets work with irrationality. There is
a. ‘calendar effect’ – shares sold at a particular time for tax planning (and bought later)
b. ‘overreaction effect' – share price moves drastically up or down with an unexpected good or bad
news
c. ‘small cap discount’ – investors discount share price of small companies since they are small. This
is irrespective of their fundamental values based on earnings, cash flows, etc.
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41 | P a g e
Behavioral finance
Behavioral finance is a field of study that combines psychology and finance to understand how human emotions
and cognitive biases (perception built on personal experiences and preferences) influence financial decisionmaking.
Key Concepts in Behavioral Finance:
1) Overconfidence: Many investors tend to overestimate their abilities and believe they can beat the market
consistently. This can lead to excessive trading and higher risk-taking, potentially harming investment
performance.
2) Loss Aversion: Investors feel the pain of losses more acutely than the pleasure of gains. As a result,
they may hold onto losing investments for too long in the hope of recovering their losses, even if it's not
rational.
3) Herding Behavior: Investors often follow the crowd and imitate the actions of others without conducting
proper research. This herd mentality can lead to asset bubbles or crashes when the market moves based
on emotions rather than fundamentals.
Example: During a stock market rally, investors may buy into the market simply because others are doing
so, contributing to an inflated bubble.
4) Anchoring: Investors may fixate on specific reference points, such as a stock's historical high price, and
anchor their decisions around these points, even if they are no longer relevant.
Example: An investor may hold onto a stock because they bought it at a higher price, ignoring the current
fundamentals and potential for further decline.
5) Confirmation Bias: Investors tend to seek information that confirms their existing beliefs while ignoring
contradictory evidence. This bias can lead to narrow and incomplete analysis of investment decisions.
42 | P a g e
6) Disposition Effect: Investors tend to sell winning investments too early to realize gains and hold onto
losing investments too long to avoid losses.
43 | P a g e
What is
=>
working Capital ?
WCapital
=
Current
L
Inventory
=While current assets
Poor
wea
-
Current
liabilities
Receivables Surplus Trade
are
networking capital
=
Assets
is
Cash
Payables
financed
current
by
'investment' .
still
an
working capital management
can
harm
S
Bank
overdraft
.
liabilities
,
the
as
,
shareholder
Working Capital Management
Why WCM is important?
Working capital management is simply represented by net current assets, that is, current assets – current liabilities. It
normally includes:

Inventories

Trade receivables

Cash and cash equivalents

Trade payables
Working capital is the lifeline of any business, representing the funds needed to cover day-to-day operational expenses and
maintain smooth business operations.
What are the consequences?

Consider a technology startup, which experienced rapid growth due to increased demand for their products. However,
their poor working capital management led to severe cash flow problems. They struggled to collect payments from
customers on time and couldn't negotiate favorable credit terms with suppliers.

A fashion brand, a clothing retailer, failed to streamline their inventory management. They ended up with excessive stock
of certain items while frequently experiencing stockouts of popular products.

An automobile parts manufacturer offered extended credit periods to customers without evaluating their creditworthiness.
As a result, they encountered a surge in bad debts and struggled to collect outstanding payments.
Growing business but with poor working capital management can lead to a business failure. Financial managers need to put
attention towards WCM so that profits are maximized in the long run.
1|P ag e
Inventory Management
Cost of inventory = Purchase cost + Ordering Cost + Holding Cost
Where:
a) Purchase cost = Cost per unit x number of units (bulk discounts may decrease the purchasing cost)
b) Ordering cost includes:

Administrative costs

Freight and transportation costs

Communication cost

Quality inspection cost etc.
c) Holding cost includes:

Storage cost

Inventory insurance

Handling cost

Obsolescence and deterioration

Shrinkage (theft, damages, errors in recording etc.)

Capital cost etc.
Shortages cost includes production stoppages by lack of raw materials, stock-out costs for finished goods, emergency reorder costs. System costs include people and computers.
2|P ag e
Why don’t companies follow JIT?
There are many reasons for holding inventory:

Buffer inventory (to prevent stock outs)

To ensure continuous production

Attract bulk discounts.

To buy in ahead of an expected shortage or ahead of an expected price rise.

To reduce ordering costs.
3|P ag e
Economic Order Quantity (EOQ) Model
EOQ model is widely used in inventory management. It provides an optimum level of quantity to be ordered each time to
minimize material costs.
EOQ =
Where,
Co = cost of placing an order
D = Annual demand
Ch = cost of holding one unit for one year
Assumption of EOQ:
1. Demand for the product is constant and known in advance.
2. Purchase price per unit is constant.
3. No risk of stock-outs.
4. Holding cost depends on average inventory levels.
4|P ag e
Example # 1:
Using the following data calculate the EOQ:
D
= 40,000 units
CO
= $2
Ch
= $1
How to calculate total cost of inventory?
1. Purchase cost = Purchase price per unit x annual demand
2. Ordering cost = Co x the number of orders per annum (Annual demand / EOQ)
3. Holding cost = Ch x average inventory (EOQ / 2)
a. Average inventory with buffer inventory = (EOQ / 2) + buffer stock
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Example # 2:
Demand is 1000 units per month. Purchase cost per unit $11. Order cost $30 whereas Holding cost 10% p.a. of stock value.
Required: Calculate EOQ and total cost of inventory
6|P ag e
Example # 3: Dec 2007 (PP)
The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production
requirements during the next year is 625,000 units. The cost of placing and processing an order is €250, while the cost of
holding a unit in stores is €0·50 per unit per year. Both costs are expected to be constant during the next year. Orders are
received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant
throughout the year.
Calculate total cost savings if EOQ model is followed (include buffer inventory).
7|P ag e
Example # 4:
Firm X faces regular demand of 150 units per month. It orders from its supplier at a purchase cost per unit of $25. Each order
costs $32, and annual holding cost is $4.50 per unit.
Required:
a) Calculate the economic order quantity and the total inventory cost.
b) Assess if bulk discount of 2% on orders of 300 and over should be accepted?
8|P ag e
Other key terminologies:
Lead Time - the time between placing an order and receiving for it.
Usage - the production demand.
 Re-order level = Maximum usage × Maximum lead time.
 Minimum inventory level = Re-order level − (Avg. usage × Avg. lead time).
 Maximum inventory level = Re-order qty + Re-order level − (Min usage × Min lead time).
 Avg usage = (Max usage + Min usage) ÷ 2.
 Avg lead time = (Max lead time + Min lead time) ÷ 2.
9|P ag e
Plot Co
Plot Co sells Product P, with sales occurring evenly throughout the year.
Plot Co currently places one order per month for 25,000 units of Product P. Each order costs $267 to process. The cost of
holding Product P in inventory is $0.10 per unit per year.
Question: What is the total annual ordering cost and holding cost if Plot Co uses the economic order quantity for
Product P (to the nearest $100)?
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Cat Co
Cat Co currently places one order per month for 10,000 components which are used in its manufacturing processes. The
cost per component is $7.50, the cost of ordering is $200 per order and the cost of holding components in inventory is $1.00
per component per year. Warehouse space is rented on a daily basis.
Question:
1. What is the total annual cost of ordering, purchasing and holding inventory if the bulk purchase discount is taken?
2. Which of the following is most likely if Cat Co changes from renting warehouse space on a daily basis to signing
a long-term lease?
a) Financial flexibility will increase
b) Financial gearing will decrease
c) Insurance costs will decrease
d) The space required will increase
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Cash Management
Liquidity problems often arise because inflows and outflows of cash do not coincide.
For example, a small tour operator is likely to be "flush" with cash in peak booking periods for holidays but have lower sales
and hence cash balances in non-peak periods. However, business expenses such as wages and salaries, heat and light, rent
and loan interest will remain more or less the same throughout the year. It is therefore essential that businesses plan ahead
to ensure that sufficient cash is available to meet expenses in the off-peak period.
There are three following reasons for holding cash:
1) Transactions motive: Cash is held in a business to meet regular commitments (for e.g. purchase of raw materials).
2) Precautionary motive: Cash is held for any unforeseen contingencies or unplanned expenditure.
3) Speculative motive: Surplus cash is maintained in case any investment opportunity may arise.
What is Cash Budgeting?
Cash budgeting is a financial planning tool that helps businesses manage their cash flow effectively. It involves estimating
and tracking the expected cash inflows and outflows over a specific period.
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Typical format
Cash inflows
Cash sales
Cash from receivables
Non-current asset disposals
Share/debt issues
Total inflow
Q1
$
x
x
x
x
x
x
Q2
$
x
x
x
x
x
x
Q3
$
x
x
x
x
x
x
Materials
Labour
Variable overhead
Fixed overhead
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
Dividends
Capital expenditure/leases
Interest/principal on debt
Net cash flow
Opening balance
Closing balance
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Q4
$
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
Example question:
You are presented with the following forecasted cash flow data for your organisation for the period November 20X1 to June
20X2. It has been extracted from functional flow forecasts that have already been prepared.
Sales
Purchases
Wages
Overheads
Dividends
Capital expenditure
Nov X1
80,000
40,000
10,000
10,000
Dec X1
100,000
60,000
12,000
10,000
20000
Jan X2
110,000
80,000
16,000
15,000
Feb X2
130,000
90,000
20,000
15,000
Mar X2
140,000
110,000
24,000
15,000
30,000
Apr X2
150,000
130,000
28,000
20,000
May X2
160,000
140,000
32,000
20,000
40,000
Notes:
(1) Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sale.
(2) Purchases are paid the month following purchase.
(3) 75% of wages are paid in the current month and 25% the following month.
(4) Overheads are paid the month after they are incurred.
(5) Dividends are paid three months after they are declared.
(6) Capital expenditure is paid two months after it is incurred.
(7) The opening cash balance on 1 January 20X2 is $15,000.
Required:
1) Prepare a cash flow forecast for the six-month period January to June 20X2.
2) Comment on your results in the light of the managing director’s comments and offer advice.
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Jun X2
180,000
150,000
26,000
20,000
40,000
The managing director is pleased with the above figures, as they show sales will have increased by more than 100%
in the period under review. To achieve this, they have arranged a bank overdraft with a ceiling of $50,000 to
accommodate the increased inventory levels and wage bill for overtime worked.
Answer:
The overdraft arrangements are quite inadequate to service the cash needs of the business over the six-month period. If the
figures are realistic then action should be taken now to avoid difficulties in the near future.
The following are possible courses of action.
1. Activities could be curtailed.
2. Other sources of cash could be explored, for example a long-term loan to finance the capital expenditure and a
factoring arrangement to provide cash due from accounts receivable more quickly.
3. Efforts to increase the speed of debt collection could be made.
4. Payments to accounts payable could be delayed.
5. The dividend payments could be postponed (the figures indicate that this is a small company, possibly owner
managed).
6. Staff might be persuaded to work at a lower rate in return for, say, an annual bonus or a profit-sharing agreement.
7. Extra staff might be taken on to reduce the amount of overtime paid.
8. The inventory holding policy should be reviewed; it may be possible to meet demand from current production and
minimise cash tied up in inventories.
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Sources for short-term funding (in case of cash deficit):

Debt factoring and invoice discounting;

Bank overdraft, but a bank overdraft:
o is technically repayable on demand (although the bank may offer a revolving line of credit); and
o normally carries a flat charge for the facility and high variable interest rate on the balance.

Short-term loans, but these:
o may require security; and
o can have fixed or variable rates of interest.
Sources for short-term investments (in case of cash surplus):
 Treasury bills: These are short term government securities with maturities ranging from a few days to one year, serving
as low risk-investments for investors. They’re issued at a discount and redeemed at face value, providing a secure means
of capital preservation.
 Certificates of deposit: These are deposits with a bank for fixed periods, usually carrying fixed interest interest. On
maturity the money is withdrawn together with interest that has accrued (cannot be withdrawn on demand).
 Commercial paper: refers to a short term, unsecured debt obligations that is issued by financial institutions and large
corporations as an alternative to costlier methods of funds. They’re unsecured therefore are only realistically issued by
companies with excellent credit ratings.
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Following may not be recommended:
 Corporate loan notes: these are longer maturity, fixed interest securities issued by the corporate sector. Liquidity can be
poor and corporate loan notes have risk higher than government bonds or commercial paper.
 Equities: volatility risk in shocks in share prices. May consider, highly liquid blue-chip companies.
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CASH MANAGEMENT MODELS
1. The Baumol model
The model is based on the idea that cash management is like inventory management. Where, an entity has to maintain
some cash in order to meet its working capital requirement, however, not losing on the opportunity cost of surplus cash
these are invested in highly liquid marketable securities and can be converted into cash as an when required.
Assumptions
The simplifying assumptions of the model are:

Cash requirements are funded by the sale of short-term investments.

Constant annual demand for cash.

Constant interest rates.

Constant cost of each transfer.
Formula:
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Example # 1:
Question (June 2015)
A company needs $150,000 each year for regular payments. Converting the company’s short-term investments into cash to
meet these regular payments incurs a fixed cost of $400 per transaction. These short-term investments pay interest of 5%
per year, while the company earns interest of only 1% per year on cash deposits.
According to the Baumol Model, what is the optimum amount of short-term investments to convert into cash in each
transaction?
a) $38,730
b) $48,990
c) $54,772
d) $63,246
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Example # 2:
A company has large deposits which currently earn interest of 15%. It has cash needs of $300,000 in the next year.
Transaction costs are $120.
Required: Calculate the economic transfer and the average cash balance (divided by 2).
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2. The Miller-Orr model
The assumption made by the Baumol model of constant demand for cash is unrealistic. A cash management model which
can accommodate a variable demand for cash may be more relevant. This is the strength of the Miller-Orr model.
The Miller-Orr model takes account of uncertainty in relation to cash receipts and payments. The cash balance is allowed to
vary between a lower limit set by management judgement and an upper limit calculated by the model:
 If the lower limit is reached, an amount of cash equal to the difference between a default "return point" and the lower
limit is raised by selling short-term investments.
 If the upper limit is reached, an amount of cash equal to the difference between the upper limit and the return point is
used to buy short-term investments.
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Formula:
The following formulae are provided in the examination:
Return point = Lower limit + (⅓ × spread)
Spread = 3 x
Where:
Spread
=
the difference between the upper limit and lower limit
Transaction cost
=
the fixed cost of buying or selling marketable securities
Variance
=
variance (i.e. standard deviation × standard deviation) of the net daily cash flows
=
daily interest rate on marketable securities
(i.e. daily opportunity cost of holding cash)
Interest rate
Note that the upper limit is the lower limit plus the spread.
Variance = standard deviation2 so if you are given the standard deviation, you will need to square it to calculate the
variance.
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Question # 1:
A company requires a minimum cash balance of $6,000 and the variance of daily cash flows is estimated to be $2,250,000.
The interest rate on securities is 0.025% per day and the transaction cost for each sale or purchase of securities is $20.
1. Calculate:
o
the spread;
o
the upper limit;
o
the return point.
2. Interpret the results.
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Question # 2:
The following data applies to a company.
(1) The minimum cash balance is $8,000.
(2) The variance of daily cash flows is $4,000,000, equivalent to a standard deviation of $2,000 per day
(3) The transaction cost for buying or selling securities is $50. The interest rate is 0.025% per day.
Required: Formulate a decision rule using the Miller-Orr model.
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Treasury management
As companies and financial markets have become larger, more sophisticated, and increasingly international, there has been
a trend towards the establishment of separate treasury departments where the control of cash is centralized in order to ensure
its efficient use.
Centralized Treasury Management
Many organizations use centralized treasury management, which has several advantages.

Specialized staff with appropriate qualifications, expertise and experience.

Economies of scale (e.g., less staff required in total) and efficiency (due to less to-and-fro of documentation).

Netting of cash deficits against surpluses to save interest expense from short-term financing.

Increased negotiating power (e.g., for group financing).

More efficient foreign exchange risk management.
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Receivables Management
Often businesses focus on generating sales but pay little attention on collecting money from receivables. Hence, there is
little cash profit. This is neither sustainable for the business nor in benefit of shareholder’s wealth maximization goal.
Why does a company go for credit sales?
Think of credit sales as an investment in the business with the intent of earning additional profit out of increased sales.
However, offering credit also incurs cost in terms of bad debts and interest cost to finance customers. So, the decision would
be to analyze if the benefit from any receivables policy is greater than cost.
Monitoring and control over receivables management:
1. Setting credit terms: Based on the results of a credit check, credit limits can be set. Once the credit limit is reached it
cannot be exceeded without the authorization of senior management.
Any credit terms shall be informed to customers repeatedly on orders, invoices and statements.
2. Assessing credit worthiness: Obtain references from banks, trade, credit agencies, latest available financial
statements, media information and through meetups.
3. Setting credit limits: Always set credit limits (max receivables) for customers. Change / modification to the limit shall
only be allowed after due diligence and appropriate authorization.
4. Following up from customers: an entity shall prepare regular statements and where necessary “chase” overdue
outstanding amounts with reminders, customer visits and phone calls.
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Cash collection from customers
Methods to help ensure customers pay on a timely basis include:

Monthly statements − produced quickly and easily by any computerized sales ledger system and sent to customers.
(Examples: storm fiber, credit card bills etc.).

Chasing letters − directed to a specific person preferably at a reasonably senior level.

Chasing phone calls − may be harder for the customer to ignore than chasing letters. A credit controller who regularly
contacts a suitably senior person and politely, but firmly, demands payment for overdue amounts can often achieve good
results.

Personal approach − from a senior person in the organisation to a senior person at the customer can often yield results.
(E.g., Audit firm’s partner makes a call to CEO/CFO of the client)

Stopping supplies – depends on organization / customer value.

Legal action – time consuming and costly. For some customers, pursuing legal action may not have optimum results (e.g.,
government client)

External debt collection (“credit management”) agency − fees can be high but many agencies operate on a “no win,
no fee” basis. So although the customer will invariably be lost (if not already), any recovery is preferable to write off.

Charging interest over overdue money – as per the contract agreement and applicable laws.
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Extending credit period
Deciding on extending credit period depends on cost versus benefit analysis. Company needs to assess if the benefit of
generating addition contribution on sales is higher than the cost of finance. Format is defined as follows:
Benefits:
Contribution / profit on incremental sales
xxx
Cost:
Finance cost of extended credit period
(xxx)
Impact of extending credit period
x / (x)
Example # 1:
Enticement Co currently expects sales of $50,000 a month. Variable costs of sales are $40,000 a month.
It is estimated that if the credit period allowed to customers was to be increased from 30 days to 60 days, sales volume would
increase by 20%. All customers would be expected to take advantage of the extended credit.
The cost of capital is 12.5% a year.
Required: Evaluate whether the extension of the credit period is justifiable in financial terms.
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Example # 2:
Greedy Co is considering a proposal to change its credit policy from allowing debtors credit of two months to credit of three
months.
Sales are currently $600,000 p.a. and as a result of the proposed change will increase by 15%. The contribution/sales ratio is
20% and the cost of capital is 10%.
Required: Should the proposed change be made?
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Early settlement discounts to customers
It needs to be assessed whether the cost of discounts allowed is lower than the cost of financing receivables.
Format:
Benefits:
Receivables before offer for early settlement discount
xxx
Receivables after offer for early settlement discount
xxx
Reduction in avg. receivables because of discount policy
xxx
Savings of finance cost on receivables (xxx X discount %)
xxx
Cost:
Cost of discounts allowed
(xxx)
Net effect
xxx
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Example # 1:
Lowe and Price Co has annual credit sales of $12,000,000, and three months are allowed for payment. The company decides
to offer a 2% discount for payments made within ten days of the invoice being sent, and to reduce the maximum time allowed
for payment to two months. It is estimated that 50% of customers will take the discount.
Assume that the volume of sales will be unaffected by the discount, and the company has an overdraft costing 10% per year.
Required: Evaluate the effect of the discount.
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Example # 2:
Pips Co is considering offering a cash settlement discount to its customers. Currently its annual sales are $10 million and its
normal payment terms are 90 days. Customers will be able to take a 2% discount for payments within 10 days. Pips anticipates
that 20% of customers will take the discount.
Currently Pips has an overdraft on which it is paying 10% interest.
Required: Assess whether Pips should offer the discount (assume a 365-day year).
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Example # 3:
A company offers its customers 30 days credit, but customers are taking 45 days credit on average. To speed up cash
collection, the company is considering introducing a 1.5% discount for payment within 15 days. The company’s working capital
requirement is financed with an overdraft at an annual cost of 10%.
Required: Determine whether the discount should be offered.
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Example # 4: Combined Qs
Melvin Co has annual revenue of $900,000 (90% of which is on credit) and the receivables collection period is currently 42
days despite the company only offering 30-days’ credit. Melvin Co finances its receivables using its overdraft which has an
annual interest cost of 8% and has a contribution margin of 30%.
Melvin Co is considering introducing an early settlement discount at the same time as extending their standard credit terms
to 50 days. Under the scheme:

Customers will be offered a 1% discount for payment within 14 days.

It is anticipated that 40% of customers will take the discount, while those that do not take the discount will keep to the
new standard credit terms.

As a result of the extended credit terms, credit sales are expected to rise by 10%.

Due to the extra administration involved it is thought that administration costs will rise by $10,000 per year.
Required: Evaluate whether Melvin Co should offer the discount.
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Managing foreign accounts receivable
Foreign debts raise the following special problems.
(a) It may be harder to build an accurate credit analysis of a company in a distant country.
(b) It may be harder to chase foreign customers for payments (different time zones and languages).
(c) In case of default, legal action is difficult.
Strategy to manage foreign receivables
Bill of exchange
Bill of exchange is a formal document (financial instrument) provided by customer
undertaking that the amounts due will be paid. Ownership documents are often withheld
till the time receipts are made by exporter.
This instrument may be discounted from Bank but the default risk (recourse) stays with
the exporter.
Letter of Credit
The customer’s bank guarantees it will the pay invoice when due as per terms of the
agreement.
Invoice discounting
Sale of selected invoices to a debt factor at a discount.
Debt factoring
Factors buy the trade receivables from the exporter and charge commission on the transaction.
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Debt factoring
Factor companies offer range of services like debt collection services, accounting, credit control and financing.
Types of factoring
With recourse
Without recourse
Default risk stays
with the Company
Default risk
transferred to Factor
The usual fees are between 0.5%−2.5% of invoice value, plus a charge for cash advances.
Advantages
Disadvantages

Administrative savings.
 Costly.

Provides a flexible source of finance.
 May damage customer relationship / goodwill.

Factor company has expertise of collecting debts.
 Difficulty of managing own records.
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Example # 1: Evaluating the impact of factoring.
Velmin Co has annual revenue of $700,000. The receivables collection period is currently 48 days despite the company only
offering 30 days’ credit, and bad debts are currently 3% of revenue. Velmin Co finances its receivables using its overdraft
with an annual interest cost of 8%.
Velmin Co is considering the use of a factor:

The factor would charge 2% of revenue for a non-recourse agreement.

The factor expects to reduce the receivables collection period to 34 days and bad debts to 2%.

The factor would lend Velmin Co 75% of the outstanding receivables and charge Velmin 1% above their current
overdraft interest cost.

Velmin Co anticipates a $6,000 reduction in administration costs.
Required: Evaluate whether Velmin Co should use the factor.
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Example # 2:
A Co makes annual credit sales of $2m. Customers take 60 days to pay and bad debts are 1% of sales.
A non-recourse factoring agreement is being considered. The factor would charge a service fee of 2% of sales per year and
reduce the accounts receivable collection period to 40 days. Administration savings of $10,000 per year would be made.
Required: Assuming a cost of working capital of 15% per year, calculate the effect on annual profit of the factoring
option that is being considered.
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Example # 3:
Tipsy Co has annual sales of $500,000 and accounts receivable collection period of 60 days. It pays overdraft interest at
17%.
It is approached by a factor who offers:

Immediate finance of 80% of sales at 18% interest.

A guaranteed collection period of 45 days.

$8,000 of administration savings.

A service fee of 2% of revenue.
Required: Calculate the effect on annual profit (loss) of using the factor.
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Payables Management
Advantages of Trade Credit as a Source of Finance

Convenient and informal.

Can be used if unable to obtain credit from financial institutions.

If settlement discounts are taken, it can result in a cheap source of financing − as a period is still allowed before
payment.

Can be used on a short-term basis to overcome unexpected cash flow crises.
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Evaluating discounts offered by a supplier
Format:
Benefits:
Discount received by availing discounts by supplier
xxx
Cost:
Finance cost of paying early
(xxx)
Net effect
xxx
Example # 1:
Alanis purchases $5,000 of goods from Celine. Celine offers all customers the option of either 30 days' credit or a 1.5%
discount if cash is received in five days. If Alanis takes the cash discount, she will incur an overdraft on which interest is
charged at 20% per year. Is the cash discount beneficial to Alanis?
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Annualized discount percentage
Steps to follow:
a) Calculate the amount of discount.
b) Calculate amount to be (paid / received) after discount.
c) Calculate % terms of discount.
d) Calculate annualized cost of not taking the discount.
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Question # 1:
A company is offering a cash discount of 2.5% to receivables if they agree to pay debts within one month.
The usual credit period taken is three months.
What is the effective annualized cost of offering the discount and should it be offered, if the bank
would loan the company at 18% per year?
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Question # 2:
One supplier has offered a discount to Box Co. of 2% on an invoice for $7500, if payment is made within
one month, rather than the three months normally taken to pay.
If Box’s overdraft rate is 10% per year, is it financially worthwhile for them to accept the discount
and pay early?
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Question # 3:
Work out the equivalent annual cost the following credit terms:
1.75% discount for payment within three weeks; alternatively, full payment must be made within eight
weeks of the invoice date.
Assume there are 50 weeks in a year. Hint: Consider a $100 invoice.
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Question # 4:
A Co offers a quick payment discount of 2% if customers pay within 15 days. Customers currently take an
average of 45 days to pay their credit balance.
What is the annual effective cost of the discount (to one decimal place of a percentage)?
a) 27.9%
b) 20.4%
c) 17.8%
d) 2.0%
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Overtrading / Undercapitalization
Over trading refers to a situation where a company expands its business operations too quickly and exceeds its capacity to
sustain the increased level of activity.
Common signs of over-trading include:

Increasing revenue but poor margin quality

Rapid increase in receivables and inventory

delayed payments to suppliers

increasing overdraft
Consequences:

Strain on company’s cash flow

Increased debt stress

Potential bankruptcy
Over Capitalization
Over capitalization occurs when a company raises more capital than it can efficiently utilize in its business operations.
Signs:
 Lower ROI

Declined EPS

High debt to equity ratio
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Differences between Over Trading and Over Capitalization:
Overtrading
Over capitalization
 Company tries to manage more business than it can
handle.
 Company raises more capital than required for future
growth.
 Short-term issue
 Affects the company in long run
 Efficient use of resources
 Optimizing capital structure and shareholder returns
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Risk Management
Foreign Currency Risk Management
When companies trade internationally, they are faced with the risk that exchange rate movements affect
business positively or negatively.
Understanding exchange rates
An exchange rate is a rate at which one country’s currency can be traded in exchange of another country’s
currency.
Say, exchange rate if written as PKR 100/$  this means that local currency of 100 units will be required to
exchange $1 (foreign currency).
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Appreciation and depreciation of currency
Local currency appreciates  means that less units of local currency are required against foreign currency.
Local currency depreciates  means that more units of local currency are required against foreign currency.
OR
Foreign currency depreciates  means that less units of local currency are required against foreign currency.
Foreign currency appreciates  means that more units of local currency are required against foreign currency.
What does this imply?
Local currency
Foreign Currency
Impact on Exporter?
Impact on Importer?
LC appreciates
FC depreciates
Bad 
Good 
LC depreciates
LC appreciates
Good 
Bad 
Hence,

Exporter has the risk that local currency appreciates (foreign currency depreciates)

Importer has the risk that local currency depreciates (foreign currency appreciates)
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Exchange rate systems
1) Fixed exchange rates
This involves fixing the exchange rates against a single currency (or a basket of currencies) using monetary
policies or official currency reserves. (Saudi Arabia, Kuwait (basket), Qatar, UAE, Bahrain, Oman, Hongkong
etc.)
2) Freely floating exchange rates (clean float)
This involves leaving exchange rates entirely to moods of supply and demand with no interventions from the
Government or Central Bank.
3) Managed floating exchange rates (dirty float)
The central bank of countries will attempt to keep currency relationships within a pre-determined range of values
and will often intervene by buying or selling foreign currency to sustain exchange rate within a range.
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Types of foreign currency risk
1. Transaction risk
The risk that exchange rates may move between the transaction date and the settlement date.

An exporter has the risk that local currency may appreciate (FC depreciate)

An importer has the risk that local currency may depreciate (FC appreciate)
2. Economic risk
The risk that movement in exchange rates will affect the value of business in the long run.
1) For example, if local currency appreciates, a foreign customer will have to pay more to buy the same
goods or services from your country. Competing countries gain advantage.
There may also be an indirect economic effect as well due to moving exchange rates. Even if your home
currency does not move, if the currency of your competing country weakens against the customer’s currency,
then it will gain competing advantage.
3. Translation risk
Risk of adverse reported performance when an overseas subsidiary is consolidated in local currency terms
(accounting risk – not a cash one). A statement of financial position hedge involves matching the exposed
foreign currency assets with an equal amount of liabilities.
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Exchange rate quotations
Direct Quotes
Direct quotes = Local currency/Foreign currency
Higher Rate = Buying rate, Lower Rate = Selling rate.
Rule of Translation is to multiply.
Indirect Quotes
Indirect quotes = Foreign currency/Local currency
Higher Rate = Selling rate, Lower rate = Buying rate.
Rule of Translation is to divide.
Remember, the bank will always trade at the rate which is more favorable for itself.
Spot rate  rate of today (immediate delivery)
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Examples
2) A company wishes to convert its export revenue of 360,000 pesos into dollars. The exchange rate quoted is
1.4000 – 1.5000 pesos per dollar.
Required: Calculate the receipts in dollars.
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Managing foreign currency risk
Taking measures to eliminate or reduce a risk is called ‘hedging’ the risk.
Practical approaches include:
1) Dealing in your home currency
o This transfers risk to the other party.
o One party is risk free; one party is not.
o May not be commercially acceptable.
2) Do nothing
o Win some, lose some
o Workable for one-off transactions
3) Leading
o If exporter feels that local currency will appreciate in coming periods, then try to obtain payment
early (offering discounts).
4) Lagging
o If importer feels that local currency will depreciate in coming periods but then normalize, then try to
delay (lag) the payment.
o However, if the importer is of the opinion that local currency will keep on depreciating, then leading
is a better option (early payment).
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5) Matching receipts and payments
o Wherever possible, a company that expects to make payments and have receipts in the same
foreign currency should plan to offset its payments against its receipts in the currency.
6) Netting
o This approach is used by large multinational groups. For example, Parent Company may choose to
net-off intra-group transaction payments to save transaction cost.
7) Maintain foreign currency bank accounts
o Maintain currencies which are normally used for trade.
o This operates as a permanent matching process.
8) Matching assets and liabilities
o Foreign currency assets against foreign currency liabilities
o Foreign currency liabilities against foreign currency assets
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Money Market Hedging
Money market hedge involves borrowing in one currency, converting the money borrowed into another currency
and putting the money on deposit until the time transaction is completed, hoping to take advantage of favorable
exchange rate movements.
In simple, money market hedge works by creating:
o a financial asset in foreign currency (deposit) against a financial liability (payable)
OR
o financial liability in foreign currency (borrowing) against a financial asset (receivable).
Receivable (Financial Asset) → create financial liability (take loan)
Payable (Financial Liability) → create financial asset (deposit money)
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Hedging a payment
Step 1: Make appropriate amount of deposit in foreign currency (financial asset)
Step 2: Borrow money in local currency.
Step 3: When payment time comes pay the foreign supplier from foreign deposit.
Step 4: Pay the local loan with interest.
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Example # 1:
A company in Pakistan has to pay £1000 after 3 months. The spot rate is 125 - 130 (PKR/£).
The company can borrow in PKR at 8% per annum and can deposit in PKR at 7% per annum. While it can
deposit in £ at 9% per annum and can borrow in £ at 10% per annum.
What is the cost in PKR with money market hedging?
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Example # 2:
A company in US has to pay £3000 after 4 months. The spot rate is 1.35 – 1.38 (£/$).
The company can borrow in £ at 9% per annum and can deposit in £ at 6% per annum. The company can borrow
in $ at 7% per annum and can deposit in $ at 5%.
What is the cost in $ with a money market hedge?
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Hedging a receipt
Step 1: Borrow appropriate amount in the foreign currency today (Financial Liability)
Step 2: Convert into local currency and deposit into local bank account
Step 3: When the foreign receipt comes pay the foreign currency loan
Step 4: The local loan deposit with interest is yours
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Example # 3:
A company in PAK will receive 1000 DHS after 6 months. The spot rate is 22 – 24 (PKR/DHS).
The company can deposit in PKR at 12% per annum and can borrow in PKR at 15% per annum. The company
can borrow in DHS at 10% per annum and can deposit in DHS at 9% per annum.
What is the receipt in PKR with a money market hedge?
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Example # 4:
A company in UAE must receive $1000 after 6 months. The spot rate is 0.17 – 0.19 ($/DHS). The company can
borrow in $ at 12% per annum and can deposit in $ at 10% per annum. The company can deposit in DHS at 8%
per annum and can borrow in DHS at 9% per annum.
What is the receipt in DHS with a money market hedge?
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Forward Exchange Contracts (FEC)
o Rates are fixed now for a future transaction.
o Forward rates are pre-agreed between the parties.
o Binding contracts.
o Counter party is generally a Bank.
Example # 1:
A company has to pay $1000 after 4 months. The spot rate is $80 and the bank has offered following forward
contracts:
1-month forward rate = $82
3-month forward rate = $84
4-month forward rate = $85
6- month forward rate = $86
Identify which forward rate is useful for hedging?
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Example # 2:
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Advantages of forward exchange contracts:
o Flexible as they are developed over the counter with Banks. May cover any amount.
o Relatively straightforward to understand and execute.
Disadvantages of forward exchange contracts:
o Binding contracts
o Favorable movements in exchange rates are lost
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Example # 3:
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Example # 4:
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Other foreign currency derivatives
1) Futures contract
o Rate fixation for a future transaction
o Binding contracts
o Futures can be traded on futures exchanges.
o Settlement takes place in three-month cycles (March, June, September and December)
o Standardized contracts for standardized amounts.
o Therefore, under/over hedging is possible.
o Initial margin (security deposit).
o Effectively a future works like a bet.
o They are always closed out in the opposite direction.
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o There is always a buy and sell element to it:
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
Say, a UK company is exporting and therefore it faces a risk that USD (foreign currency) may
depreciate at a future date. The company can sell futures now and buy (close-out) at a future date.
The gain on futures contract should likely offset the actual loss in spot market.

Say, a UK company is importing goods and therefore it faces a risk that USD (foreign currency)
may appreciate at a future date. The company can buy futures now and sell (close-out) at a future
date. The gain on futures contract should likely offset the actual loss in spot market.
Example:
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2) Options contract
o Like forwards.
o Not a binding contract (it is a right not obligation to buy or sell currency at a future date)
o Option can be lapsed if spot rate is more favourable or if there is no need to exchange currency.
o A premium must be paid on an option even if it is not excersized (lapsed).
Types of options:
o Call option: right to buy currency at a future date.
o Put option: right to sell currency at a future date.
Types of options (2):
o Over the counter options
o Exchange traded options
* No calculations comes in FM exam.
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Why exchange rate fluctuates?
Changes in exchange rate typically happens due to demand and supply variations of currencies involved.
Reasons can be:
1) Balance of payments is a record of all transactions between residents of a country and rest of the world.
Changes in international trade may lead to changes in exchange rates. For example, rising demand of US
$ goods in Pakistan will lead to more demand of USD. The Government of Pakistan cannot simply print a
foreign currency and therefore there will be limited supply of USD. Hence, as demand for USD surpasses
the reserves available the exchange rate would change.
2) Capital movement between economies.
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
Rising (or falling) interest rates will attract a capital inflow (or outflow) and demand (or supply) for
the currency.

Inflation: asset holders do not wish to hold financial assets in a currency whose value is falling
because of inflation.
Theories
1) Purchasing power parity theory
PPPT is based on ‘the law of one price’. In a free market with no barriers to trade or transaction costs, identical
goods must cost the same, regardless of the currency in which they are sold.
PPPT can be used to predict future spot rates using the following formula:
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Example:
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2) Interest rate parity theory
According to IRPT, the returns from investing in domestic or foreign assets should be equal when adjusted for
movements in exchange rates.
IRPT can be used to determine forward rates through the following formula:
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Examples:
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Four-way equivalence:
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INTEREST RATE RISK MANAGEMENT
Interest rate risk is the risk that an adverse movement in the interest rates will result in a reduction in the
company’s net cash flow.
Interest rates are relatively more stable than currency exchange rates in the sense that interest rates do not
change continually. When they do change, movements can be either upwards or downwards.
Net borrowers are generally exposed to a rise in interest rates.
Net lenders / depositors are generally exposed to a fall in interest rates.
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Why interest rates fluctuate?
The Yield Curve
The Yield Curve shows the relationship between the interest rates (or bond yields) with the different periods to
maturity.
There are three main types of yield curve:
1) Normal yield curve: longer term bonds have higher yield as compared to short terms bonds because of
the risk associated with them. Investors are tying up capital for a longer time hence will demand higher
interest rates.
2) Inverted yield curve: if short term rates are higher than long-term rates, the situation is inverted. This
may indicate signs of future uncertain times (like recession).
This means that the interest rates would currently be high and as the economy slows down in future,
interest rates will be adjusted to reflect a recession.
3) Flat (humped) yield curve: when short and long-term interest rates are very close.
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The shape of the yield curve at any point in time is generally believed to be a combination of three theories acting
together:
Liquidity preference
theory
Expectations theory
•Investors have a natural tendency to hold cash compared to investments (even
short term).
•Therefore, investors have the urge to be compensated for the lost liquidity.
•This theory states the shape of the yield curve varies according to investors'
expectations of future interest rates. So an upward sloping yield curve
represents investor's expectation that interest rates will rise in future.
•As a result there will be more demand for short-term securities than long term
securities.
•According to this theory, interest rate on bonds is determined by the supply and
demand for securities in each segment of the market.
Market segmentation
theory
•For example, banks tend to be active in the short term market whereas pension
funds would invest in long term maturities.
•Changes in interest rates within one maturity segment do not necessarily
impact interest rates in other segment (independent).
•This theory provides an alternate perspective to above theories.
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Gap exposure
It is the degree or extent to which a firm is exposed to adverse interest rate movements.
This can be done by grouping together assets and liabilities that are affected by interest rate changes according
to their maturity dates.

Negative gap: when interest sensitive liabilities maturing at a certain time are greater than interest sensitive
assets maturing at the same time.
o Firm will have net adverse exposure if interest rates rise in future.

Positive gap: when interest sensitive assets maturing at a certain time are greater than interest sensitive
liabilities maturing at the same time.
o Firm will have net adverse exposure if interest rates fall in future.
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Hedging interest rate risk
1) Forward Rate Agreements (FRAs)
o Generally, bank is the counter party.
o Binding contract.
o Pre-agreed interest rates are locked into (forward interest rate).
o Both adverse and favorable interest movements are lost.
o Generally available for short period of time
Basic terminologies:
Remember the rule: Bank is
always at an advantage!

5.75-5.70 means borrow at 5.75% (higher rate) and deposit at 5.7% (lower rate).

3-6 FRA means agreement will start after 3 months and last for further 03 months (i.e. 6th month)

In case of a loan  Buy the FRA from Bank

In case of a deposit  Sell the FRA to Bank
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Example # 1
It is 30 June now. ABC ltd will need a $10m 6 months fixed LIBOR rate loan from 1 October. In order to hedge its
exposure against adverse interest rate movements, ABC ltd entered into a FRA at 6% on 30 June.
Required:
1) State what FRA is required?
2) Illustrate the effect what happens if spot 6-month LIBOR rate on 1 October is 5% or 9%.
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Example # 2
Interest rates are currently 5%. ADB Co needs a $4m six-month loan in three months' time and buys a 3-9 Forward
Rate Agreement (FRA) at 8%. When ADB Co. signs the loan they agree to a rate of 7%. What is the payment or
receipt ADB Co will make or receive under the FRA?
a) ADB pays the bank $40,000
b) ADB pays the bank $20,000
c) ADB receives $40,000 from the bank
d) ADB received $20,000 from the bank
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Advantages of FRA:

Simple to organize.

Low or no initial set up cost.

Fixes the interest rate.
Disadvantages of FRA:

Binding contract for a fixed date.

Unattractive rate may be offered by the counterparty.

Counterparty risk (either party may default).
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2) Interest Rate Guarantees (IRGs) / Option on FRAs
Thereby they provide the opportunity (a right but not an obligation) to excersize FRA at a set price.
Simple decision rules:

Excersize the right (option) if there is an adverse movement.

Lapse the option if there is a favorable movement.
Key characteristics:

A premium is payable to ‘seller of the option’.

If interest rates do not move adversely then option is allowed to be lapsed but seller keeps the
premium.
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3) Interest rate futures

Binding contract

Rate fixation

Exchange traded contracts

Standardized

Strategy of buying and selling
Price of interest rate futures = 100 – interest rate (price of futures is inversely proportional to interest rates).
Borrower
Depositor
1. Risk  interest rates may rise.
1. Risk  interest rates may fall.
2. Therefore, price of futures will fall in future.
2. Therefore, price of futures will rise in future.
3. Sell interest rate futures now.
3. Buy interest rates future now.
4. Close-out in future by buying the same contract
4. Close-out in future by selling the same contract.
 Strategy – Sell now and buy later.
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 Strategy – Buy now and sell later.
Advantages of IRFs:

More flexible than FRAs.

Lower counterparty risk since the exchange guarantees the transaction.
Disadvantages of IRFs:

Only available in large, standard contract sizes.

Margin (deposit) needs to be made to initiate the transaction.

Futures interest rates do not move exactly in line with spot interest rates (this is known as basis risk).
What is Basis Risk?
The gain or loss on futures contracts may not exactly offset the cash effect of the change in interest rates, ie., the
hedge may be imperfect. This is known as Basis Risk.

Maturity Mismatch: If the futures contract and the underlying instrument have different maturities, basis
risk can arise. For example, futures contract matures on 30 Sep but the actual borrowing takes place at 15
October.

A hedge may also be imperfect because the commodity being hedged must be rounded off to whole number
of contracts.

On expiry/maturity date, basis risk is zero.
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Interest rate options / Options on futures contract
o Over the counter / negotiated options
o Traded or exchange traded options.
o Premium is payable to seller.
o The option acts as a ‘insurance policy’.
Put option: An option to pay interest at a pre-determined rate on a standard notional amount.
Call option: An option to receive interest at a pre-determined rate on a standard notional amount.
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Option strategies:
1) CAP:
o Company buys a put option.
o If the interest rate rises above a predetermined
level, company will excersize the option and
therefore the loss will be offset.
o Even if interest rates stay below (so that option
is not excersized) than seller will keep the
premium.
2) Floor:
o Company buys a call option.
o If the interest rate falls below a predetermined
level, company will excersize the option and
therefore the loss will be offset.
o Even if interest rates stay high (so that option is
not excersized) than seller will keep the
premium.
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3) Collar:
o Company goes both ways (CAP + FLOOR).
o For example, a borrower will buy a put option
(CAP) to cover the risk of rising interest rates.
However, he will sell a call option (FLOOR) at
the same time to cover the risk for counterparty
of falling interest rates.
o Therefore, premium cost on collars is cheaper
than buying an option standalone.
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Swaps
o An agreement whereby the parties agree to swap a floating stream of interest payments for a fixed stream
of interest payments and vice versa.
o This agreement shall only be for interest amounts.
o Hence, no exchange of principal amounts.
o The original borrower remains liable in the case of defaults.
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Other techniques
a. Cashflow matching:
o
The attempt to match all future cash inflows with outflows.
o
Since the net position would be zero, therefore the interest rate risk is hedged.
o
This is largely impractical because matching exact timing of cash flows is very difficult to achieve.
o
Consider that you invest in a long-term project for 10 years. How would you match all inflows (returns
from the project) with outflows (repayment of debt).
b. Asset and liability management:
o
Companies try to match their assets and liabilities.
o
For example, for a 10-year debt repayment, try to regularly invest in assets and cover the exposure
on liabilities.
o
That is, match the duration of assets and liabilities.
c. Interest rate smoothing:
o
Holding instruments with both fixed and variable rates.
o
For example, in the case of borrowing, if interest rates increase then the loss on variable rate loan
notes will be offset by the gain on fixed rate loan notes.
o
Same for deposits.
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