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FIN 722
LESSON 23
EXAMPLE
A firm has 100 shares outstanding and the par value of share is Rs.100. The company intends to pay all
of its earnings in dividends. The cash flow for year 1 & 2 to be paid as dividend is rs.10,000 that means
Rs.100 dividend per share.
The other option is to pay a dividend of Rs. 110 after first year and Rs. 89 after second year as dividend.
Assuming 10% required rate of return.
What is the value of the firm with new dividend policy?
Solution
that is:
DIVIDEND RELEVANCE:
As a mean of resolving the uncertainty early, investors prefer dividend income rather than non-
dividend paying.
Liquidity preference
Time value of money
FINANCIAL SIGNALING:
Image of the company improved by paying dividend.
None payment of Dividend adversely effect companys image.
Dividends have impact on share prices because it indicate the firms profitability as well.
Accounting earnings may not be a influencing factor as compared to increase in dividend.
Debt Equity Ratio of 0.50 firm wishes to maintain it. After tax profit rs.1,000. If no dividend is paid,
equity will increase. It means that firm will seek loan to maintain D/E Ratio. for example, after tax profit
of Rs.1000/- the firm must borrow Rs.500 in order to maintain D/E of 0.50.
The first thing would be to determine the funds that can be generated without selling additional
shares.
After Tax
New
Earning
Investment
Debt
Earning
Stock
2,000.00
6,000.00
2,000.00
2,000.00
2,000.00
0.50
2,000.00
5,000.00
1,500.00
2,000.00
1,000.00
0.50
2,000.00
4,000.00
1,250.00
2,000.00
500.00
0.50
2,000.00
3,000.00
1,000.00
2,000.00
0.50
2,000.00
2,000.00
666.67
1,333.33
666.67
0.50
2,000.00
1,000.00
333.33
666.67
1,333.33
0.50
2,000.00
CONCLUSION
2,000.00
A firm must endeavor to establish a dividend policy that maximizes shareholders wealth.
Mostly it is believed that if a firm does not have investment opportunities on its plate, it should return /
CASH BUDGETS:
- SALES FORECAST
- DIRECT COST FORECAST / ESTIMATE
- OTHER RECEIPT & DISBURSEMENT
- NET CASH FLOW
CONTROL PROCESS
Plans put to operation last stage of planning
-Actual results are recorded
-Actual results are compared with actual
-Feedback is prepared
-Two types of Feed back
-Negative
Feed back
-Positive Feed back
-Feedback is used to change the strategy
-Feedback & feed forward control
WHAT SORT OF CORRECTION CAN BE MADE
scaled down.
Budgeting committee
Budgeting period
Time
Communicating to all
LESSON 24
SALES BUDGET PREPARATION
FUNCTIONAL BUDGETS
NEGOTIATION
MASTER BUDGET OR CORPORATE BUDGET
FINALIZATION OF BUDGET & IMPLEMENTATION
CONTROLLING STAGE
VARIANCE ANALYSIS
Difference between actual and budgeted numbers is known as variance.
INVESTIGATION
CASH BUDGETS
M/S Hi Land Ltd is in the process of preparing cash budget for the 1st quarter of 2007. The following
information is available:
Opening cash balance is Rs. 2,000/Forecast sales are Rs 50,000/- each for Nov. 06 to Jan. 07 and Rs. 65,000 per month for Feb. & Mar. 07.
80% sales is on credit basis and 20% on cash.
Debtors pay after two months from the sale date.
Materials cost will be Rs. 34,000/- for Nov. & Dec. 07 & Rs. 35,000/-, Rs. 36,000/- & Rs. 37,000/- for Jan
to Mar. 07 respectively.
Creditors are paid after one month.
Electricity bill is paid in following month. Dec to Mar. expense is estimated at Rs. 6,000 per month.
Recurring expense will be Rs. 4,000 per month for Nov. & Dec. 06 and Rs. 6,000, Rs 9000 & Rs. 12,000
for Jan. to Mar. 07 and are paid in the month of incurrence.
A new assets will be purchased in Jan 07 for Rs. 12,000/-. payment will be made in Feb. 07.
An old assets will be disposed off in January for Rs. 1,000/- and the receipt will hit the bank on first of
February 07.
Required:
Prepare the cash budget for the first quarter of year 2007 and provide your feedback to the
management.
Nov-06
Dec-06
INFLOWS
Jan-07
Feb-07
Mar-07
Rs.
TOTAL SALES
SALES INFLOW
OTHER RECEIPTS
SALE OF ASSET
OUTFLOWS
1,000.00
TOTAL INFLOWS
MATERIALS COST
CREDITORS PAYMENT
ELECTRICITY
6,000.00
6,000.00
RECURRING EXP
6,000.00
9,000.00 12,000.00
CAPITAL PAYMENTS
12,000.00
6,000.00
TOTAL INFLOWS
OPENING CASH
2,000.00
ENDING CASH
6,000.00 (2,000.00)
Purpose of Cash Flow Statement is to provide information about the inflows and outflows of cash and
cash equivalents.
Cash And Cash Equivalent has two characteristics:
The inflows and outflows are grouped into three categories.
both readily convertible into cash
without loss of value
To identify and assess the ability to generate future net cash flow from operations to pay debt, interest
and dividends
External financing requirements.
To see the effects of cash & non cash investing and financing transactions.
Assess the reasons for differences between income and associated cash receipts and payments.
METHODS OF PREPARING CASH FLOW STATEMENT
COMPLIANCE OF IAS 07:
DIRECT METHOD BENCHMARK
INDIRECT METHOD ALLOWED ALTERNATIVE
Less
Rs.
SALES
290,000.00
COST OF SALES
174,000.00
GROSS MARGIN
116,000.00
Less
Less
OPERATING EXP
Administrative Exp
45,000.00
20,900.00
Depreciation
13,000.00
Interest Exp
15,400.00
2,500.00
24,200.00
9,700.00
Net Income
14,500.00
HI LAND LIMITED
BALANCE SHEET
AS ON DECEMBER 31, 2005
2005
2004
Fixed Assets
Land
148,400.00
100,000.00
Buildings
465,000.00
415,000.00
(217,000.00)
(205,000.00)
396,400.00
310,000.00
5,000.00
6,000.00
Inventory
175,000.00
153,000.00
Accounts Receivable
109,000.00
90,000.00
Prepaid Expenses
15,500.00
17,000.00
50,000.00
55,000.00
349,500.00
315,000.00
Intangible Assets:
Patents
CURRENT ASSETS
Investment - Land
TOTAL ASSETS
27,500.00
750,900.00
658,500.00
Accounts Payable
69,000.00
75,000.00
Accrued Liabilities
24,500.00
20,000.00
93,500.00
95,000.00
200,000.00
200,000.00
CURRENT LIABILITIES
Premium on Bonds
29,400.00
30,000.00
229,400.00
230,000.00
322,900.00
325,000.00
335,500.00
255,500.00
92,500.00
78,000.00
Total Equity
428,000.00
333,500.00
750,900.00
658,500.00
TOTAL LIBILITIES
SHAREHOLDERS' EQUITY
Share Capital
Retained Earnings
HI LAND LIMITED
CASH FLOW STATEMENT
For the Year Ended December 31, 2005
(INDIRECT METHOD)
A
Net Income
Rs.
14,500.00
13,000.00
(2,500.00)
25,000.00
(22,000.00)
(19,000.00)
1,500.00
(6,000.00)
4,500.00
(600.00)
(16,600.00)
LESSON 25
CASH FLOW STATEMENT
HI LAND LIMITED
BALANCE SHEET
AS ON DECEMBER 31, 2005
2005
2004
Fixed Assets
Land
148,400.00
100,000.00
Buildings
465,000.00
415,000.00
(217,000.00)
(205,000.00)
396,400.00
310,000.00
5,000.00
6,000.00
Inventory
175,000.00
153,000.00
Accounts Receivable
109,000.00
90,000.00
Prepaid Expenses
15,500.00
17,000.00
50,000.00
55,000.00
349,500.00
315,000.00
Intangible Assets:
Patents
CURRENT ASSETS
Investment - Land
TOTAL ASSETS
27,500.00
750,900.00
658,500.00
Accounts Payable
69,000.00
75,000.00
Accrued Liabilities
24,500.00
20,000.00
93,500.00
95,000.00
Bonds
200,000.00
200,000.00
Premium on Bonds
29,400.00
30,000.00
CURRENT LIABILITIES
229,400.00
230,000.00
322,900.00
325,000.00
Share Capital
335,500.00
255,500.00
Retained Earnings
92,500.00
78,000.00
Total Equity
428,000.00
333,500.00
750,900.00
658,500.00
TOTAL LIBILITIES
SHAREHOLDERS' EQUITY
HI LAND LIMITED
CASH FLOW STATEMENT
For the Year Ended December 31, 2005
(INDIRECT METHOD)
A
Net Income
Rs.
14,500.00
13,000.00
(2,500.00)
25,000.00
Increase in Inventory
(22,000.00)
(19,000.00)
1,500.00
(6,000.00)
4,500.00
(600.00)
(16,600.00)
HI LAND LIMITED
CASH FLOW STATEMENT
For the Year Ended December 31, 2005
(INDIRECT METHOD)
CASH FLOW FROM INVESTING ACTIVITIES
Proceeds from Sale of Land
27,500.00
2,500.00
(50,000.00)
(48,400.00)
(68,400.00)
80,000.00
80,000.00
(5,000.00)
55,000.00
50,000.00
OPERATING CYCLE:
The time between receiving the raw materials and collection of amount against credit sales
from debtors is called Operating Cycle.
CASH CYCLE:
The time period between cash payment and cash receipts.
EXAMPLE:
We buy inventory on credit on Jan. 01, 2006 worth Rs. 10,000/-. settle the creditor on Feb. 01. After a
month (on march 01) a debtor buys the finished goods for Rs. 14,000/- and pays after 1.50 months (on
15th April 2006.
The period from the date of acquisition of inventory Jan. 01, 06 to the date of receipt of cash from
debtor 15th April 2006 is known as operating cycle.
Normally operating cycle is expressed in days. In this example, the length of Operating Cycle is 105
days.
Operating Cycle can be divided into two components:
Inventory period: the period of time it takes to procure, produce and sell the inventory.
In our example, inventory acquisition date Jan. 01, 06 to march 01, 2006 60 days is known as
Inventory period.
105
30
CLOSING
AVG
INVENTORY
2,000.00
3,000.00
2,500.00
DEBTORS
1,600.00
2,000.00
1,800.00
750.00
1,000.00
875.00
CREDITORS
NET SALES
11,500.00
COST OF SALE
8,200.00
OPERATING CYCLE
INVENTORY TURNOVER=
INVENTORY PERIOD
COS/AVG INV
3.28
TIME
111.28
DAYS
A/R TURNOVER
CREDIT SALES/AVG AR
6.39
TIMES
57.13
DAYS
RECEIVABLE PERIOD =
Cash Flow Statement: Statutory obligation to prepare CFS in order to compliance with IAS 07.
On the other hand, there is no statutory obligation to prepare Cash Budget.
Format:
Cash Budget based on estimated data. CFS based on actual data. Benchmark is direct method.
Normally CFS also prepare through indirect method.
LESSON 26
RISK
PROFITABILITY
LIQUIDITY
LEVEL OF INVESTMENT
OPTIMAL LEVEL OF CURRENT ASSETSS INVESTMENT:
Adequate or Lowest level of current assets should be maintained that support your sales or
productions that lower your cost.
RELIANCE ON SHORT TERM FINANCING
1- Short term loans carry lower interest rates.
2- Flexibility of short term loan
assets, some or all of its permanent current assets, and possibly some of its long-term fixed
assets. (Heavy reliance on short term debt).
The firm has very little Net Working Capital. It is more risky.
MODERATE WORKING CAPITAL POLICY
As the inventory will decrease the return on investment will increase as suggested by the above
equation.
Under Aggressive policy, profitability is greater than Conservative.
LIQUIDITY & PROFITABILITY
Current assets have the advantage of being liquid, but holding them is not very profitable.
Accounts Receivable earns no return.
Inventory earns no return until it is sold.
Non-current assets can be profitable, but they are usually not very liquid.
Firms are usually faced with a trade-off in their working capital management policy.
They seek a balance between liquidity and profitability that reflects their desire for profit and
their need for liquidity.
The choice of the firm's working capital financing depends on manager's desire for profit
versus their degree of risk aversion.
The balance between the risk and return of financing options depends on the firm, its financial
managers, and its financing approaches.
A firm's optimal level of current assets is reached when the optimal level of
Inventory
Accounts Receivable
Cash or Cash equivalent
MODERATE = B
AGGRESSIVE = C
LIQUIDITY
PROFITABILITY
RISK
HIGH
NOR
LOW
CONCLUSION
Optimal level of each current asset will depend on the managements attitude towards Risk &
Return.
LESSON 27
Classification by Component:
Classification by Time:
- is the amount of current assets that varies with short term seasonal requirements.
Permanent working capital is the amount of investment in current assets that is required to support
the minimum long term needs.
A trade off between risk and profitability is required when we are faced with current assets
financing decisions.
It is assumed that a company has a definite policy vis--vis payment to creditors, taxes And
expenses. The reason being that a firm cannot stretch these outflows by a reasonable time
period.
Short Term & Long Term Investment Mix:
In other words, creditors / accounts payable and accruals are dormant decision variables when
it comes to current asset financing.
Each asset will be offset with a financing instrument having same maturity.
Temporary current assets should be financed with short term debts.
Permanent portion of current assets (and all non current assets) should be financed with long
term loans and equity.
NEXT PAGE
Only short term variations would be financed through short term loans.
If we finance this portion through long term loans, then we will pay interest on loan when actually
funds are not needed.
Short term loan/financing is flexible.
Short term loans shall only be employed in the period of seasonal lessened activity.
We pay off the loan liability when not needed to avoid interest cost.
Borrowing and payment of short term loans can be arranged to correspond to the expected ca
variations.
On Eid, (increased activity) inventory will increased and that increase shall be financed through short
term borrowing.
Inventory will squeeze due to increased sales and receivables will expand.
That cash used to pay off the loan (and creditors) now comes through collection of accounts
receivable.
Short term loan to support seasonal need would generate necessary cash to repayment in normal
course of operation.
This is known as Self-Liquidating Principle.
Under uncertainty, net cash flow will not exactly match the maturity of debt.
This aspect is of crucial importance when it comes to risk and profitability trade off.
What should be the Margin of Safety to allow for adverse variation in expected cash flow?
THE RISK
Shorter the maturity date of debt, the greater the risk of default of
Repayment of Principal
Interest cost
Renewal or Roll over at maturity: If short term financing used to fund long term assets. Result long
term assets will generate cash flow in the long term. but you have to repay short term loan in short
period
Problem of liquidity
Resultantly short term debt may not get renewal or roll over at maturity.
Committing funds to long term asset from short term borrowing carries risk of lenders calling back
loans early.
TRADE OFF
The longer the maturity date, more costly the financing is.
Long term debt carries higher interest cost.
A company may pay interest on loan even when funds are not needed.
Trade off between Risk & Profitability.
Short term debt has more risk than long term but less costly.
The trade off is the lag between the expected cash flow & payment of debt.
The Margin of Safety will depend of managements risk preference.
And managements decision regarding the maturity of debt will determine the portion of current
assets financed by current liabilities and Portion to be financed on long term basis.
CONSERVATIVE POLICY
Firm finances a part of seasonal fund requirements less accounts payable on long term basis.
If cash flow estimates do not deviate far from actual, it will pay interest on debt (shaded area) when
actually funds are not needed.
Higher the long term financing line, more Conservative Policy and higher cost.
AGGRESSIVE POLICY
The company must arrange renewal of short term debt. It involves risk.
The greater portion of permanent current assets is financed with short term debt, more
aggressive policy it is.
Expected margin of safety regarding short term and long term financing can be positive,
negative or neutral.
Margin of safety can be increased by more financing in the liquid assets.
Risk of cash insolvency can be reduced by stretching the maturity schedule of debt or carrying
larger amounts of current assets.
Aggressive Policy
Conservative Policy
WORKING CAPITAL MANAGEMENT
Guiding force:
Management attitude (Planning Process)
Vision about money market, business etc.
LESSON 28
WORKING CAPITAL MANAGEMENT
Rs. 1,000,000/25%
20%
10%
10%
5%
2 Months
1 Month
1.5 Months
2 Months
1 Month
Average duration/turnover:
Accounts receivables take 2 months before realization.
Raw materials are in stock for 4 months.
WIP represents one month production 50% complete.
Finished good represents 1.5 months production.
WIP & FG are valued at material, Labor & VOH Cost.
Compute the working capital requirements of the company.
Estimated Turnover
1 Annual Cost Of Cost Items:
1,000,000.00
% Of Turnover
Annual Cost
Direct Materials
25
250,000.00
Direct Labor
20
200,000.00
Variable Overheads
10
100,000.00
Fixed Overheads
10
100,000.00
50,000.00
Raw Materials
Period
4 months in
stock
Work in Process
83,333.33
22,916.67
Direct materials
50% complete
10,416.67
Direct labor
50% complete
8,333.33
Variable overheads
50% complete
Finished Goods
4,166.67
68,750.00
Direct materials
1.5 month
production
31,250.00
Direct labor
1.5 month
production
25,000.00
Variable overheads
1.5 month
production
12,500.00
166,666.67
Accounts Receivable
341,666.67
41,666.67
1 month
16,666.67
1.5 months
12,500.00
Fixed overheads
2 month
16,666.67
1 month
4,166.67
Direct labor
Variable overheads
91,666.67
4 Net Working Capital=
Current Asset - Current Liabilities
341,666.6791,666.67
250,000.00
41,666.67
1 month
16,666.67
1.5 months
12,500.00
Fixed overheads
2 month
16,666.67
1 month
4,166.67
Direct labor
Variable overheads
91,666.67
Net Working Capital=
4
341,666.6791,666.67
250,000.00
OVERTRADING
It occurs when a company tries to do too much with too little long term capital.
In other words, a firm is trying to satisfy huge level of sale or productions from lowest level of
inventory.
This liquidity problem emerges from the situation when a firm does not have enough cash flow to
pay off the debt.
INDICATIONS
Cash
Inventory
Receivable
CASH MANAGEMENT
TRANSACTION MOTIVE
PRECAUTIONARY MOTIVE
SPECULATIVE MOTIVE
Holding too much cash or near cash items has a cost in terms of Loss of Earnings
Liquidity and profitability trade off is of crucial importance to a financial manager.
CASH FLOW PROBLEMS
Growth
Seasonal business: Like on Eid and Religious occasions, the business activity increases.
Capital expense or one-off expenditure.
Loss Making
HOW TO IMPROVE CASH FLOW
Float:
Decreasing the receipt Float.
Deferring Capex and developmental work.
Early recovery of cash flows.
Liquidate Short Term Investments.
Deferring payments to creditors.
Rescheduling loan payments.
Planning is of vital importance especially rolling cash budgets.
Important factors:
Liquidity
Profitability
Safety
VARIABLE COST
Opportunity cost, surrendering the return by investing money.
Q=2FS/I
Where:
S= Amount of consumption or demand in each period
F= Fixed cost of obtaining new funds
I = Interest cost of holding cash
Q= Optimal cash holding level
EXAMPLE
Liquid Limited has a fixed cost at present of Rs.10,000 to seek fresh finances. Per cash budget, the cash
requirements for the next 4 periods of a year each would be Rs. 100,000. The interest cost of fresh
finances will not be less than 14%. Interest on deposits at present is 8%.
How much finance should the firm raise at a time?
SOLUTION
HOLDING COST =14% - 8% = 6%
OPTIMUM LEVEL OF Q
LESSON 29
There would be some upper limit or lower limit of cash balance movement.
Miller-Orr Model tries to establish optimal cash holding between the upper and lower limits of cash
balance movements.
MILLER-ORR MODEL
Spread
Determine lower limit for the cash balance. This may be zero.
Calculate cash flow variance on daily basis. This sample size may be of 100-days period
Observe the interest rates and note the transaction costs
Calculate the upper limit and return point.
EXAMPLE: MILLER ORR MODEL
Minimum cash balance is Rs. 100,000/ Daily cash flow variance is Rs. 2,000,000/-.
Transaction cost of selling & buying securities is Rs. 500/-.
Interest rate is Rs.9% per annum.
Required: Work out the upper limit and return point using miller model.
SOLUTION
Spread = 3(3/4 x ((TC x V)/I)1/3
Where:
TC = Transaction Cost
V = Cash Flow Variance
I = Interest
Putting values:
= 3(3/4 x ((500 x 2,000,000)/(0.09/365) 1/3
Spread = 42,855.12
If cash balance reaches 142k buy securities worth of (142 114 =28k)
And if cash balance fall to 100k, sell securities worth 14k to get back to Return Point.
MANAGEMENT OF INVENTORY
There are three types of Inventories:
INVENTORY COSTS
HOLDING COST
ORDERING COST
SHORTAGE COST
HOLDING COST CONSISTS OF:
Investment in stocks
Warehousing cost
Handling cost
Insurance cost
Pilferage cost
ORDERING COST
Delivery cost
SHORTAGE COST CONSISTS OF:
In business management, holding cost is money spent to keep and maintain a stock of goods in
storage.
The most obvious holding costs include rent for the required space; equipment, materials, and labor
to operate the space; insurance; security; interest on money invested in the inventory and space,
and other direct expenses.
Some stored goods become obsolete before they are sold, reducing their contribution to revenue
while having no effect on their Holding cost.
Some goods are damaged by handling, weather, or other mechanisms. Some goods are lost through
mishandling, poor record keeping, or theft, a category euphemistically called Shrinkage.
Holding cost also includes the opportunity cost of reduced responsiveness to customers changing
requirements, slowed introduction of improved items, and the inventory's value and direct
expenses, since that money could be used for other purposes.
ECONOMIC ORDER QUANTITY
This is the optimal size of material per order that will minimize the cost.
We can use the following formula for EOQ:
EOQ = 2xC0 x D/CH
Where:
D = stock consumption
P = Purchase price
C0 = Cost of placing one order
Q = Reorder Quantity
EXAMPLE: ECONOMIC ORDER QUANTITY
Demand of a raw material is 80,000 kg per year. The ordering cost is Rs. 90 per order.
Holding cost per kg is estimated at Rs. 4.
Calculate the following:
The order size to minimize the stock costs.
Number of orders per year.
Length of stock cycle.
SOLUTION
a) Order Size:
EOQ = 2xC0xD/CH
= 2 x 90 x 80,000/4
= 1897 Or 1900 Kg
= 365 / 42
Re-order level is the stock level (in kg) when replenishment order should be made.
Time period involved between placing an order and receiving the order. This is known as Lead Time.
Placing order after the stock runs out may result in loss of sales and loss of cash flow.
Placing order to late and too soon have costs.
SAFETY STOCK
Safety Stock: Inventory stock held in reserve as a cushion against uncertainty in usage and/or lead
time.
Price Breaks Discounts & EOQ:
Business always tries to save cost in order to increase profitability. When a vendor offers discounts
(Price breaks) for buying a specific quantity which is not in line with the EOQ, then business has to
consider the net saving.
Increase in order size does increase inventory costs but if that cost is off-set by the purchase cost
beyond that increase, then EOQ is not financially feasible.
EXAMPLE: PRICE BREAKS
Demand of a raw material is 80,000 kg per year. the ordering cost is Rs. 90/- per order. Material is priced
at Rs. 100 per kg. Holding cost per kg is estimated at 2% of purchase price. The vendor offer 5%
discount if the minimum order size is 5000kg. What do you suggest to the firm?
Solution:
EOQ = (2 x 90 x 80,000)/2% (100) = 2683 Units
A- NO DISCOUNT
Purchase Cost
= 80,000 x 100
= 8,000,000.00
Holding Cost
= 160,000.00
Order Cost
Total Cost
= 42.10 X 90
3,789.00
= 8,163,789.00
Total Orders
= 16 Orders
Purchase Cost
= 80,000 x (100-5%)
= 7,600,000.00
Holding Cost
= 152,000.00
Ordering Cost
= 16 x 90
= 1,440.00
= 7,753,440.00
Total Cost
Cost Per Kg = 913440/80000 = 96.42 / Kg
= 102.05
= 96.42
Annualized saving
5.63
STOCKOUTS
STOCKOUTS: The situation when a firm runs out of stock which results in shutdown of slow down of
production / sales.
In order to avoid stock out situation, a safety stock level should be procured and maintained.
LESSON 30
EXAMPLE: STOCK OUT
Five Star Limited consume 100,000/- kg per year. each order is for 5000 kg and stock out is 2000 units.
The stock out probability acceptance level is set to 10%. per unit stock out cost is Rs. 5/-. Holding cost is
estimated at Rs. 2/- per kg. being an inventory manager, determine stock out cost and amount of safety
stock to be kept on hand.
STOCKOUT COST =
= AC / Q x S x Sc x Ps
Where:
AC = Annual Consumption
Q = Order Quantity
S = Stock out in Unit
Sc = Stock out Unit Cost
Ps = Accepted Probability of Stock out
Plugging values, we get
= 100000/5000 x 2000 x 5 x 0.10
= 20,000/SAFETY STOCK LEVEL
Let X = Safety Stock
Then,
Stock out Cost = Carrying Cost x Safety Stock
= 20,0000 = 2 * X
X = 20,000 /2
= 10,000 UNITS
Where
EOP = SL + F S x EOQ x L
S= Consumption Per Period
L= Lead Time
F= Stock out Acceptance Factor
EOQ = Economic Order Quantity
S = 2000 Units
EOQ = 60 Units
L = 1/4 Month
F= 1.10 (This Represents The Stock out level of say, 10%)
EOP = SL + F S x EOQ x L
= 2000 x 1/4 + 1.10 2000 x60 x 1/4
= 691 Units
Financial managers must try to establish inventory level that results in greater savings.
QUESTION: A company is in process of re-visiting its inventory policy. The current inventory turns over
18 time per year. Variable costs are 75% of sales value. If inventory levels are increased the company
anticipates additional sales and less of an incidence of inventory stock outs. the rate of return is 14%.
TURN OVER
750,000
18
810,000
15
890,000
12
960,000
REQUIRED: Work out the level of inventory that results in highest saving.
Turn
Avg.
Opportunity Additional
Net
Over
Inventory
Cost
750,000.00
18.00
41,666.67
810,000.00
15.00
54,000.00
890,000.00
12.00
960,000.00
9.00
Rate of Return
0.14
Contribution Margin
0.25
Profit
Saving
1,726.67
15,000.00
13,273.33
74,166.67
2,823.33
20,000.00
17,176.67
106,666.67
4,550.00
17,500.00
12,950.00
JUST-IN-TIME (JIT)
Very sensitive issue. Greater probability of Stock outs. May turn the overall benefits to losses.
May not be feasible for every business. Some business may maintain some inventory items on
JIT and others on EOQ etc.
DEBTORS MANAGEMENT
Significant funds are invested in debtors.
Debtors are important factor / element of Cash Cycle.
Interest cost is associated with offering credit to debtors.
Debtors are measure in days.
Investment in debtors
CREDIT CONTROL POLICY: COMPONENTS
Extending credit to customers requires careful planning and to devise policy and procedures.
Credit policy set up requires dealing with:
Terms of Sale
Credit Analysis
Collection Policy
Credit period will vary from firm to firm, industry to industry and business to business.
normally the range is 30 to 120 days.
If cash discount is offered then period is divided into two components:
Net Credit Period
Cash Discount Period
Credit period begins from the invoice date. This represents the dispatch of goods to buyer.
Many terms are used:
ROG= RECEIPT OF GOODS
2/10, NET 30
2/10, EOM
CREDIT PERIOD
Factors influencing credit period:
Inventory Period
Accounts Receivable Period
Inventory Period:
The period of time it takes to procure, produce and sell the inventory to the debtors.
Accounts Receivable Period:
The time to receive the cash from the debtors.
Main Points to keep in view
If sellers credit extension period exceeds the buyers inventory period, then seller is not only
financing the buyers inventory purchases but also a part of the receivable as well.
If sellers credit extension period exceeds the buyers operating cycle, then seller is effectively
financing the buyers need beyond the purchase and sale of sellers merchandise.
Perishability
Collateral
Size of the account
Competition
Customer Type
TERMS OF SALE:
There are three factors underlying terms of sale:
Credit Period to be granted
Cash Discount
Credit Instrument
LESSON 31
CASH DISCOUNTS
For Example: Cost of Credit
The sale terms are 2/10 net 30 for a transaction in the amount of Rs. 100,000/-.
If buyer gives up discount, he pays Rs. 100,000/- on 30th day, and will loose Rs. 2,000/- (100,000 x
2%).
Look, foregoing Rs 2,000/- may look small but lets annualize it and express it in %age:
2,000/98,000 = 0.020408 or 2.0408%
SHORTENING ACP
A firm has 30 days collection period and it is offering terms of 2/10, net 30 and estimates that around
50% customers will avail this opportunity by paying within 10 days. Remaining 50% will pay after 30
days. Now the ACP will be as follows:
50% x 10 Days + 50% x 30 Days = 20 Days
CREDIT INSTRUMENTS
Cost effect:
Whether firm sells on cash or credit it has to pay for the cost of sale. Payment to firms creditor
rests on the cash to be received from debtors.
COST OF DEBT:
When a firm extends credit to customers, it must finance the resulting receivable. Cost of short
term borrowing is an important factor in the decision to grant credit to customers.
PROBABILITY OF DEFAULT:
Chances of default or bad debt are always there.
DISCOUNTS:
When firm offers discount to customers, there is a cost when some customers choose to pay
early to seek discounts.
A firm who intends to grant credit to customers must seek information about the customers
reputation and credit worthiness.
COLLECTION POLICY
Monitoring of ACP
Control
Aging Schedule
A compilation of accounts receivable by the age of each account..
A firm is considering to change existing credit policy which will increase the Avg. Collection Period from
one month to two months but it will ensure 20% increase in sales.
Selling Price Per Unit
Rs 12/Variable Cost / Unit
Rs. 10.20
Rs. 2.00 M
12.00
Variable Cost
10.20
Sales
2,000,000.00
Return
15.00
Contribution Margin
1.80
15.00
Increase
1.20
Inc. In Stock
150,000.00
Inc. In Creditor
40,000.00
Particulars
Extra contribution
Amount in Rs.
15.00
400,000.00
60,000.00
2,400,000.00
400,000.00
166,666.67
Increase in debtors
233,333.33
Increase in stocks
150,000.00
40,000.00
343,333.33
17.48
Increase in sales
400,000.00
Increase in debtors
66,666.67
Increase in stock
150,000.00
40,000.00
176,666.67
33.96
10,000,000.00
Discount offered
0.02
10.00
0.75
2.00 month
1.00 month
Return on investment
A)
0.18
B)
=10,000,000/12 x 2
1,666,666.67
622,146.12
205,479.45
416,666.67
1,044,520.55
188,013.70
Cost of Discount 2%
=10,000,000 x 75% x 2%
Net Saving under New Policy
150,000.00
38,013.70
EXTENTION OF CREDIT
Sales
Cost of sales
Gross profit
Bad debts
Profit
2,100,000/1,470,000/630,000/31,500/598,500/-
The management is contemplating a strategy of easing the credit terms by extending the
current one month collection period to two month. The new policy details are as under:
Increase in sales under new policy will be 20% over and above the current level.
Average collection period will be two months
Bad debts will also increase to 3% from existing 1.5% level.
Other details:
Cost of sales are 80% variable and 20% fixed. Fixed portion will not increase when sales will increase
by 25%. Stock and creditors level will remain unchanged.
Do you think the New Policy is worth undertaking?
Solution: Debtors Management
ROI
0.15
0.02
COS Var.
0.80
COS %
0.70
COS Fix.
0.2
0.03
Inc. in Sales
0.2
Var. COS
0.56
C/S
0.44
Existing sales
2,100,000.00
Cost of sales
1,470,000.00
Gross profit
630,000.00
Bad debt
31,500.00
Net profit
598,500.00
1,176,000.00
Cont Margin
= 2,100,000 - 1,176,000
924,000.00
C/S ratio
= 924,000 / 2,100,000
0.44 or 44%
184,800.00
0.03
44,100.00
140,700.00
420,000.00
175,000.00
= 2.1million / 12
245,000.00
36,750.00
Net Benefit
=140700 - 36750
103,950.00
LESSON 32
Factoring
A firm may employ a specialized entity to manage account receivables.
This specialized entity is called Factor.
Main function of a factor is to collect the accounts receivables on behalf of seller but may also
involve in invoicing and sales accounting.
Factor makes advance payments to seller in return for commission of certain %age of total debt.
This is often referred as Factor Financing.
In case of action against defaulters, factor initiate action.
Factor also take over the risk of loss in case of bad debt.
This type of factoring is known as Non-Recourse.
Significant positive effect on cash cycle.
Ensuring early payments to vendors and benefit of obtaining early payment discounts.
Optimum stock level can be maintained.
Financing (Factor) is directly linked to level of sales/accounts receivables.
Reduction in collection expense and staff payroll costs.
May prove much expensive
May have adverse effect on customers loyalty. (Factors attitude may be harsh with customers) and
may tarnish companys image.
Example: Factoring
A company is considering to seek the services of a factor because of poor collection of debtors
which has pushed up the ACP from 30 days to 45 days coupled with bad debt of 1% of annual
sales. Sales are Rs.1.80 Million.
With factoring in place, the company will save Rs. 25,000 per year on account of debtors
administration and collection costs, bring down ACP to 30 days but will cost 2% of sales.
Factor will provide 80% on invoice value of sales and will charges 11% interest. Rest 20% shall be
paid after 30 days. The company can obtain short term loan @ 10%. Sales are assumed evenly
spread over the months.
Required: Evaluate the Policy?
Debtors Management
Solution: Factoring
Cost Data
Credit Sales Annual
1,800,000.00
45.00
0.10
0.010
0.800
30.000
0.0200
0.110 or 11%
22,191.78
18,000.00
= 1.8M x 1%
Administration Cost
25,000.00
65,191.78
Cost of Factoring
Factor Financing Cost
13,019.18
Factor will provide 80% Finance, 20% will be through Short Term Financing:
Short Term Financing Cost
2,958.90
Cost of Factoring
36,000.00
51,978.08
Net Saving
13,213.70
Solution
We need to work out the total cost of employing factor and saving thereof.
In this case the comparison is between the existing cost of debtor administration and cost of
factoring.
If the later is less than the former, then we will accept or implement the new policy, otherwise
not.
It is Current Cost Vs Factor Cost
CREDITORS MANAGEMENT
MANAGEMENT OF CREDITORS
OR
A vendor has offered credit terms of 2/15, net 50 to M/s ABC Limited. The company can invest
in Short Term Securities @ 24%. The average creditors level is Rs. 100,000.
Evaluate the offer from vendor.
Example: Creditors Management
If ABC Ltd refuses discount and pay after 50 days, then interest cost will be:
= ( D /100 D ) x 365/ T
21.28
Discount 2%
15
35
Total Days
50
Average Creditors
Short Investment Return
100,000.00
24
Accept Discount
Saving will be 2% of Avg. Creditors
2,000.00
Discount is Declined
ABC can invest the money in Short Securities
For 35 days to earn @ 24%
2,301.37
Combination of two business for increasing the value of business through Synergies in the form
of Acquisition or Merger.
A process of accruing an other company.
Acquisition is also known as takeover. (Purchase Merger)
Mergers may be termed as Amalgamation. (Also consolidation Mergers)
Two businesses become single entity after Merger or Acquisition.
We will use combination for both Mergers and Acquisitions.
Vertical Mergers
Purpose of Combinations
When two companies in similar business combine horizontal combination, to reduce cost and
increase profit / value due to large economies of scale.
In other words both companies are in Direct Competition and have same product line but may or
may not have same markets
Vertical Mergers:
This may be eliminating backward or forward Integration. This type of Mergers increase value by the
middleman/level.
LESSON 33
COMPLIMENTARY RESOURCES
Economies of scales can also be cultivated when companies have complimentary strengths and utilizing
both under a new / combined platform.
Financial Synergy
Expertise:
The experts involved are expert in finance and skilled in designing combination strategy and are so
involved in pre-acquisition issues that they dont find any time for behavioral aspect of unified
workforce.
CORPORATE CULTURE
The two firms may appear identical in every respect, yet the culture is different and people may not be
learning to work together.
Cultural Difference that stand un-resolved by the new management will leave adverse effects on
communication, decision-making, productivity and inter-se relationship among people.
CORPORATE CULTURE
Inadequate Planning
Lack of Communication
Human Resource Department must be involved in Mergers and Acquisition issue.
TALENT DEPARTURE:
Studies have shown that 50 75% of managers leave the merged entity within 3 years.
LOSS OF CUSTOMERS:
Especially sales/marketing employees may take good customers with them when they depart.
POWER POLITICS:
Power struggle and clashes between the groups of management for seeking power adversely
effect the health of Merger.
Human Resources
All this is required to compare the existing employee terms, remuneration, benefits and talent with the
new ones from Target Company.
-Marketing strategy
Technology
- Existing technical skills
- Research & Development and stage of development
Financial Information
o Accounting Policies
o Details of Assets
o Financial Analysis over the period
o Details of Loans & Overdrafts
o Agreement of Foreign Exchange Covenants
o Details of others modes of debts like Leases
o Tax History & Computations
o Tax liabilities
o Details of dividend & liability
Cultural Due Diligence
Steps involved in culture due diligence
LESSON 34
CULTURAL DUE DELLIGENCE
Steps involved in culture due diligence
Readiness Of Company To Change
Acquisition
X takes over Z
Transfer of Shares
Transfer of Assets
Acquisition
Methods & Mode of Consideration
Share & Asset Purchase:
Share Purchase:
It is a complicated option because all of the liabilities need to be owned by the predator
company. There might be some hidden liabilities.
Asset Purchase:
Only identified assets are acquired and Predator is well aware or can work out the market
value of assets.
Existing major shareholders may not wish to dilute their %age for control issue primarily.
Valuation of shares:
Difficulty in valuation of unquoted shares.
Debt/Equity Ratio:
If theres a surge in equity base after a merger, it may be an uphill task to bring back the
optimal D/E ratio.
Valuation of Shares
After the target to acquire has been identified, then the predator must decide how much to pay.
Shares valuations are needed for may reasons:
- For entering stock market
- To establish terms of Acquisitions
- For tax purposes
- To value of shares held by directors
Income Based Methods:
- Present value method
- Dividend Valuation
- Price Earning Ratio
The most common methods of estimating value have traditionally involved the discounting or
capitalizing of an income stream. In the income approach, variables Such as earnings or cash flows are
utilized as a proxy for the expected benefits to the owners of the business.
In a capitalization model, a representative level of income is capitalized into perpetuity at a
capitalization rate determined by the difference between the appropriate discount rate and a constant,
sustainable level of growth.
In a discounting model, a projection of income is estimated for a finite period, followed by a terminal
value calculation that assumes a constant income growth rate from that point into perpetuity.
Present value of a asset is the value of future earnings discounted at a discount rate representative of
systematic risk of that asset.
Dividend Valuation
We can use No-Growth and Constant Growth Models in Mergers & Acquisitions:
Po = Do/Ke
No-Growth Model
Shareholders required rate of return can be estimated with the help of CAPM.
Cost of equity of other firms in industry can be used and adjusted by considering Beta.
When comparing with other firms we must ensure that the company is of equal size and is in same
business line.
We can use dividend yield approach for valuation of shares in Merger & Acquisition.
Dividend yield:
Div. Yield = Annual Dividend / Share Price x 100
For valuation of unquoted shares, the formula is as under:
Share Value = Annual Dividend / Div Yield
Price Earning Ratio:
This is another important measure to value shares.
P/E Ratio is = Price Per Share / EPS
Or
Value Per Share = EPS x Suitable P/E Ratio
890,000
360,000
530,000
100,000
Ordinary dividend
200,000
230,000
Other Information:
Outstanding shares are 300,000 @ Rs. 10 each.
P/E ratio of another company in the same industry and of same size is 8.
Required:
You are required to value share of target limited using P/E ratio method.
Solution:
Asset-Based Methods typically involve restating both assets and liabilities to their current values to
arrive at a net asset value.
Even with Asset-based Models, value remains a function of expected benefits to the owners.
Replacement Cost:
LESSON 35
Hybrid Methods
Mix of Asset Based & Income Method
A target company may employ such tools and tactics as to foil the takeover bid. This resistance is
achieved in following ways:
Poison Pill:
Target company grants right to existing shareholder to acquire new shares at attractive price.
This effectively dilute the shareholdings and interest of predator.
In an other way the target company may give handsome dividends to existing shareholders
(other than predator) to exchange their shares for cash at a price well above the offer price by
predator.
The target company may offer a debt security in lieu of shares.
Pac Man:
The target company may make a reverse offer to predator company. It is not used widely.
White Knight:
Target company may seek a friendly predator (other than original predator) potentially capable
of bidding high and acquiring.
A target company can acquire another company may by large or under performing to decrease
attractiveness to predator.
Shark Repellents:
Target may modify its charter to stop the takeover. For example, it would need to have 90% votes to
approve merger.
Disposal of Assets:
A target company may dispose off assets that are of prime interest to acquirer or to further extent
liquidate all its assets leaving nothing for the acquirer.
Severance Pay:
Management may enter into agreement with senior personnel to pay them a certain hand some
amount if theres change in companys control.
Political Pressure and action can stop the take over.
Fixed Assets
At Cost less Acc. Depreciation
2,300,000.00
Current Assets
Raw materials
400,000.00
Finished goods
650,000.00
Accounts receivable
1,349,000.00
1,000.00
2,400,000.00
Current Liabilities
Accounts payable
1,280,000.00
980,000.00
2,260,000.00
140,000.00
Total Assets
2,440,000.00
Capital
Issued common stock
2,050,000.00
Retained earnings
390,000.00
2,440,000.00
History of Profit
Net Income
2005
2004
2003
2002
2001
Dividend
Retained Income
Other Information
Replacement Value
Fixed assets
2,600,000.00
Finished goods
700,000.00
Raw materials
475,000.00
Sales Value
Fixed assets
2,200,000.00
Finished goods
550,000.00
Raw materials
380,000.00
50,000.00
0.95
9.00
8%
5%
Predator's WACC
17%
15.00
Solution
1
Un-adjusted value
2,440,000.00
Bad debts
(50,000.00)
2,390,000.00
2,390,000.00
=2600000 - 2300000
300,000.00
=475,000 - 400,000
75,000.00
=700,000 - 650,000
50,000.00
2,815,000.00
Break up value
B/s adjusted value (as above)
2,390,000.00
(100,000.00)
Finished goods
(100,000.00)
Raw materials
(20,000.00)
2,170,000.00
DIVIDEND MODEL
Po = D1 / (Ke -g)
We need to calculate g & Ke
g=rxb
r = Profit / Capital Employed
r = 260,000 / 2,440,000
0.106557377 or 10.65%
b = Retention of Earnings
= 125,000 / 260,000
0.480769231 or 48.07%
g=rxb
0.051229508 or 5.12%
0.1275 or 12.75%
1,860,693.18
g = (135,000/110,000)1/4 -1
0.0525 or 5.25%
1,894,500.00
2,340,000.00
Assets are based on historical cost adjusted for arbitrary accounting convention like depreciation.
Historical Costs are not representative of actual worth of assets.
Not logical to use this method.
Break Up Value
The value return by this method means that the owner can realize the amount on piecemeal basis
by disposing off assets individually.
Not based on going concern basis.
Going concern value is normally well above the value returned by this method.
LESSON 36
Corporate Reorganization and Capital Reconstruction
Divestment:
Business not only acquire assets but also dispose off subsidiaries, division and SBU (Strategic Business
Unit) or even individual assets.
The process of disposing off inefficient assets is known as Divestment or Disinvestment.
If the asset is returning less than the groups/firms hurdle rate, then it should be disposed off.
The decision to divest should be evaluated like decision to invest.
Example
For example, if a division of a group is earning 12% as compared to group return of 18%, then it
should be disposed off.
However, the cost of asset and price available for sale must be compared and evaluated before the
decision to sell.
For example, if an asset or group of assets costing Rs 100,000 is earning 12% or 12000 and could be
sold for 60,000.
The group hurdle rate is 18%.
Comparing 12,000 with 80,000, then ROCE is 15% (12,000/80,000) and is under group hurdle rate of
18%, therefore, it can be disposed off.
However, if the offer price of asset in question is 50,000, the ROCE is 24%, well above the groups
rate of return of 18% and should not be disposed off.
Disinvestment or divestment may be in the form of un-bundling or de-merger.
Management buyouts are another type of mergers and takeovers but also, on other hand, is an
example of divestment.
Management Buyout:
Executives of the firm with the help of institutional financing buy the business from the current owner.
Significant sources are pooled by the executives.
Leveraged Buyout:
Executives with the help of external investors buy the firm from the existing owners.
Employee Buyout:
This is not confined to executives, but all the employees contribute in funds pool.
Management Buy-In
Advantages of Buy-Outs
Example
Management Buy-Out
Following information pertains to a proposed management buyout:
Share Capital:
Management
60%
300,000
Banks
40%
200,000
1,000,000
Loans
1,200,000
600,000
600,000
Total Capital
2,700,000
Long term loan of 600,000 are payable in next 5 years in equal installments. The loan is secured
against fixed assets. Interest on loan is 11% pa.
The assets to be acquired have a book value of Rs 2.30 million but the agreed price is Rs 2.40 million.
This company is a part of large group and has been registering a turnover growth of 8% but its
business is not compatible with its group.
Required:
Highlight the factor to be considered and financial appraisal of this buyout.
The difference between the book value of company and the purchase price is not wide apart.
Total of Rs 2.70 million will be raised. out of which Rs 2.40 million will be paid and only Rs 300,000 is
left for working capital.
Gearing will be very high. Equity is Rs 300,000 whereas debt is Rs 2.400 million (including
preference shares). High interest cost and return on equity will be too risky.
However, buyout team will bag 60% of return for a investment of Rs 300 k. A very high reward.
Keeping in view the gearing level it will be almost impossible to seek further loans, and if the
company is successful in seeking loan, then its pricing will be too high.
Financial Commitments:
These share will be paid after 10 years and on average Rs 100,000 shall be provided every year.
Preference dividend of Rs 100,000 needs to be paid every year.
Running finance expenses would be Rs 48,000 per annum assuming full loan utilization.
Priority claim of around Rs 400,000 will be needed on the above items.
Other Requirements
Keeping in view steady growth in sales the lenders will require increased profit and stable cash flow.
Cash flow will be burdened due to high gearing but MBO has no other option mentioned in
question.
Financial Distress
Causes of Financial Distress
A. Industry Level Factors
1. Competition
Entry / exist barriers
Bargaining power of suppliers
Bargaining power of customers
Substitute products availability
Competition and rivalry among companies
2. Industry Shocks
Adverse shocks to industrys products, costs or overheads, sustained over time will lead to push
the marginal / weak industry out of industry. Like Bird flue etc
Most will embrace bankruptcy.
3. Industry Deregulations:
When an industry is de-regularized it can induce financial distress within industry.
Economic structure of the industry also changes.
Deregulation increases the cost of monitoring and controlling managers.
Inexperience of management may push new entrants towards financial distress.
2. Leverage
LESSON 37
Effects of Financial Distress
The risk of incurring the costs of financial distress has a negative effect on a firm's value which offsets
the value of tax relief of increasing debt levels and tax depreciation relief.
Relationship between stakeholder damaged:
a firm it will not be able to secure high-quality contracts. In the consumer markets customers
often need assurance that firms are sufficiently stable to deliver on promises.
Transaction cost goes very high and restructuring costs may be high for a financially distressed
company attempting to restructure the loans.
Types of Reorganizations
Conversion of Debt to Equity:
In order to improve equity base. When the company has relied heavily on short term finances for short
term expansion and has caught up in working capital problem.
When the holders of convertible securities exercise their right.
May request rescheduling of loans, and may get fresh loan at higher interest rates.
Ordinary Shareholders:
Normally they get nothing in case of winding up or liquidation. They must be given some stake
in the company if further finances are required.
Preference Shareholders:
May accede to new scheme when they are offered some increase in dividend rate.
Foreign Exchange Risk Management
In Forex market the rate are quoted in terms of a base currency to several other variable currencies.
When a dealer express rate as US $ / PKR, the this mean the rate of number of PKR to 1 US $.
For example, US $ / PKR = 60, means that we need to exchange Rs. 60 (PKR) to get one dollar.
Conversely, a rate expressed as PKR/US $ refers to a rate of number of US $ to 1 PKR.
In this case we need to express the rate in terms of dollar. How many dollars we will surrender to
get 1 Rupee= US$ 0.016667 to get 1 PKR.
Bid & Offer Price
Banks and Forex dealers quote two rates for a single pair of currency.
BID Price
Offer Price
LESSON 38
Example
Today is 4th January. A Pak company has to pay US$ 245,000 to a supplier at the end of week 1 of
April and want to fix exchange rate now.
What forward rate can be obtained for a currency transaction and what would the cost to Pak
company?
Solution
For foreign currency rates calculation there are two factors underlined:
3 ) Economic Exposure
1 ) Transaction Exposure :
It arises from the accounting side when businesses are required to consolidate their group results in
the compliance of local financial reporting laws.
3 ) Economic Exposure:
It is difficult to Pre-determine the dollar effect of economic effect because of the unexpected nature
of change.
A subsidiary in the country X whose currency devalues unexpectedly has two effects on the value of
the firm.
i) Adverse effect on value as every dollar of profit will have less worth when repatriated to home
country.
ii) there may be positive effect in terms of cheaper exports adding cash flow contributions of parent
company.
When FCY risk between assets and liabilities is equal, then translation exposure is eliminated.
How to reduce the Economic Exposure?
Decentralized / Diversified Production Facilities:
If a company has a production facility in the country whose exchange rate remains strong, it will be
difficult for the company to export to other countries.
Diversification of Financing:
International borrowing can be used to hedge the adverse effects of currency exchange rates.
If borrowing is spread across several currencies it will be extremely unlikely they will all strengthen at
the same time eventually reducing the economic exposure risk.
This will eliminate the need of exchange of currency upon receipt. However, the seller would be
compelled to revise its prices periodically.
Seller can invoice:
In home currency
Currency stable than home currency
US $ - Market leader
Currency with a positive forward markets
2 Leading & Lagging:
Leading refer to making payment before falling due.
Lagging means to defer or delay the payment or settling the payment well past due date.
Forex exposure can be partially hedged by matching payments and receipts of same currency.
For example a company will receive US$ 1 million during the next quarter and will need to pay US$
1.2 million in the same period, then the net exposure will be US$ 200,000 as 1 million payment and
receipt are net off.
4) Hedging (Forward Contracts)
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge
consists of taking an offsetting position in a related security, such as a futures contract.
Using this method we can Fix the exchange rate now for a future transaction of the needed
currency. Because spot rates are changing every day and fixing the exchange rate for future date
Now reduces the risk to significant extent.
A forward contract is binding upon both the parties currency dealer and a company/client.
Example: Hedging (Forward Contracts)
Hedging is based on the assumption or estimate that it will be expensive to pay us$ in three
months time because of the fact the PKR will be weakening against US$. therefore, a company
enters into a contract to buy X dollars after 3 months at an exchange rate of Rs 60/ US $ decided
now. At the maturity date both parties have to honor their respective commitments of buying
and selling of US $ at agreed rates.
Now if on the maturity date, the spot ex rate is Rs 61/US$, (PKR weakened against US$), then the
company has actually eliminated the loss and benefited financially.
5) Money Market Hedging:
Money markets are whole-sale (large scale) markets for lending and borrowing of money for short
term.
Bank are major player of money markets and companies seek their services to hedge against the ex
rate fluctuations in short term.
As forward ex rate (which is agreed now) is derived from sport rates Using interest rates, a money
market hedge can produce the same results as of forward contract.
There will be two situations:
A company is to receive money in FCY
A company needs to pay FCY
Situation - Future Income in FCY:
What is needed at this point is to fix the exchange value of the future currency income.
A hedge will be created by fixing the value of income now in local currency.
We can do it:
Borrow now in foreign currency (The same that the company will receive in future). The maturity of
both loan and receipt should be the same.
The loan + interest on FCY loan should equal the amount of FCY future receipt.
When the FCY receipt hit the account, loan will be paid off.
The FCY loan can be converted to local currency immediately and may be put to a short term
deposit to earn interest.
LESSON 39
Example
Money Market Hedge
Future Receipt in FCY
A Pak company exports US$ 1 million goods to a customer in united states with a payment to be
received after 3 months.
Current spot rate is US $/PKR = 60.1234 60.1599
Deposit
Loan
(Per Annum)
PKR Rs
3.55%
4.45%
US $
3.15%
4.52%
Solution
Firm will receive 1 million dollars in 3 months and therefore, to create hedge it needs to borrow US$
now.
The borrowed amount plus interest after 3 months should be equal to US$ 1 million (liability) which
will be set off against the future income.
In this way the income after 3 months (asset) will be equal to the liability.
Firm would borrow us $ now for 3 months @ interest rate of 4.52% pa.
4.52% pa needs to be converted to 3 month rate.
=4.52 / 4 = 1.1300
In this example, Rs. 60,353,229 is certain cash flow and has locked/Fixed exchange rate of PKR
= 60.3532 (60,353,229 / 1,000,000)
A hedge can be created by exchanging domestic currency for foreign currency now and putting the
fcy under a deposit.
The term of deposit should end on the date fcy payment will be made.
Secondly, the deposit plus interest thereof should equal to the fcy payment.
In this way we can fix the cash flow in local currency.
6) Currency Futures
A currency future is a standard contract between Buyer and seller in which the buyer has a
binding obligation to buy a fixed amount, at a fixed price and on a fixed date of some underlying
securities.
A short position can be closed by buying the same item (short sold) before the final date. Again
there will be a gain or loss.
Mechanism
Ticks:
Exposure
US $
900,000.00
PKR
60.1559
PKR
60.1585
PKR
60.2171
PKR
60.2201
PKR/$
US$
PKR
60.1585
900,000.00
54,142,650.00
60.2201
900,000.00
54,198,090.00
May
Need to buy US $ at Spot rates to make
payment
55,440.00
PKR/$
US$
PKR
60.2171
900,000.00
54,195,390.00
(55,440.00)
Net cost
54,139,950.00
54,139,950.00 / 900,000.00
60.1555
On some commodity exchanges, Currency Futures are available in the following denominations.
Future
GBP/US$
EURO/US$
YEN/US$
Standard
Qty/Contract
Price Quotation
Tick Size
Value of 1
Tick
GBP 62,500
$0.0001
$6.25
Euro 125,000
$0.0001
$12.50
$0.000001
$12.50
Euro/GBP
Euro 100,000
GBP 0.0001
GBP 10
LESSON 40
Currency Future:
Scenario Future Receipt Of FCY
Using Standardized Currency Future Contracts:
Example:
In January a UK Company sold goods to a US customer and later promised to pay after 3
months. The total value of goods is US $ 1,202,500.00. The current spot rate for GBP/US$ is
$1.5000 and early April GBP future contract are being traded at $1.4800 on a contract size of
GBP 62,500.
UK supplier is exposed to exchange risk on future income of $1,202,500.00.
If sterling weakens, UK trader will gain but if sterling strengthens he will lose.
The UK supplier can set up a futures position by hedging the risk of strengthening of sterling or
weakening of Dollar.
At the future price of $1.4800 The $ receipt after 3 months will be worth:
= $1,202,500.00 /1.4800 = GBP 812,500
Lets assume that in march the $ weakens and the future market price is now $ 1.52 / 1 GBP
When US$ income is received the UK seller will sell the 13 sterling contracts at $1.5200.
Purchase price of 13 contracts =
Selling of 13 contracts
Profit
1.4800
1.5200
=
$ 1,202,500/=
0.0400
$ 32,500/=
Total Value
$ 1,235,000/=
A Forward Contract is made between parties and each party needs to confirm the credit
worthiness of each other.
In currency futures, commodity exchanges are involved and credit risk is eliminated.
Reversal of currency future is very simple.
Large buyers and sellers exists.
Reversing forward contract is difficult.
Original parties have to off set the deal. Future currency contract become a Commodity and
reversing does not require original parties.
Size of Contract:
No size restriction is placed in forward contract and is up to parties to deal or contract in the
magnitude they like. But in future currency contract the size is pre-determined or fixed. In this scenario
perfect hedge is not possible.
In Forward Contract no margin is required but in currency future parties have to put a initial margin.
Apart from Exchange Rate Fluctuations, another source of risk in Foreign Exchange Market is
interest rate risk.
It is the risk of incurring losses or gains due to adverse / favorable movements in interest rates.
Examples of Interest Rate Risk
Investment in Bonds,
Short term investments,
Borrowings in short term (Variation in short term interest rate).
Interest rate risk is higher when Interest rates are extremely sensitive and their future
direction Is unpredictable.
Most of banks and financial institutions have significant exposure based on short term floating
interest rates.
KIBOR
LIBOR
The buyer of an FRA agrees to pay fixed interest rate (FRA Rate) on notional loan/deposit. At the same
buyer will receive interest on notional loan/deposit at benchmark rate of interest.
On the other side, seller of FRA agrees to pay interest on the notional amount at benchmark rate and
will receive interest at a fixed rate.
Decision Rule:
If the fixed rate is greater than the benchmark or variable (also reference rate), the buyer of FRA will
make cash payment to seller. The payment will be calculated as the excess of FRA (fixed Rate) over
variable multiplied by the notional amount.
If the fixed rate (FRA rate) is lower than the benchmark rate, then the seller of FRA makes cash
payment to buyer calculated as the amount by which FRA is less than the benchmark rate.
8.50 - 8.40
4v7
8.60 - 8.51
5v 8
8.80 - 8.71
duration
8.99 - 8.94
4 v 10
9.15 - 9.06
6 v 12
9.25 - 9.15
The rate on left side is bid rate and is higher. This is the rate bank would like to receive in FRA, being
the seller of FRA (Customer will be Buyer).
The right side price is offer rate and is lower. This is the rate bank would like to pay in FRA, being the
buyer of FRA (Customer will be seller).
A company is considering to borrow Rs.10 million is six months time for a six month period. The
normal terms are KIBOR + 75 basis point (or 0.75%). Current KIBOR is 8.5%. The company anticipates a
surge in interest rates in near future.
If KIBOR is 9.05% as on settlement date, bank shall make a payment to the buyer (company) in the
amount of:
Rs 10,000,000 x (9.05% 8.69%) x 6/12 x 1/(1 +(9.05% x 6/12)
= 17,221
The company will borrow Rs 10 million for six months at KIBOR + 75 basis points:
= 9.05 + 0.75 = 9.80%
Interest on loan will be:
Cost of Int. on Loan = 10,000,000 x 9.80% x 6/12
Profit on FRA (Paid by Bank)
= Rs. 490,000
= Rs. 17,221
Net Cost
= Rs. 472,779
FRA rate was 8.69% and company could at KIBOR + 0.75% and FRA has provided perfect hedge (8.69% +
0.75% =9.44%) That is near to the FRA rate of 9.46%.
Interest Rate Futures
STIRs:
A type of standardized int. rate future on a notional deposit (for 3 months) of standard
amount of principal.
Bond Futures:
Based on standard quantity of notional bonds. If buyer or seller do not close his position
before the final settlement date, then the contract is settled through physical delivery.
LESSON 41
Interest Rate Futures
Bond Futures
STIRs Futures
Short Term Int. Rate Future:
If interest rate falls then the price will rise and vice versa.
Hedging with STIRs
A company intends to borrow short term in future may be concerned about the rising short term int.
rates.
The hedge is to establish a Notional position to fix the int. rate in short term.
The hedge will be to sell short term int. rate future.
If int. rates go up, it will result in profit. Price of future will fall. The future will be closed by selling at
higher prices and then buying at lower price.
If int. rates move down, it will result in loss. Price of future will increase. The future will be closed by
buying at higher price and selling at lower price.
A company intends to borrow short term in future may be concerned about the rising short term int.
rates.
The hedge is to establish a Notional position to fix the int. rate in short term.
Assuming it is January and a firm plans to borrow Rs. 1 million in 5 months for 3 months. It intends
to hedge against rising int. rates. The firm can borrow at KIBOR + 100 basis points.
Current 3 months KIBOR rate (spot rate) 4.625%. June short int. futures have a current market price
of 95.35.
a) How a hedge can be set up against increase in 3 month KIBOR rate?
b) assuming when company borrows Rs 1 million, KIBOR is 5.50% and June futures price is 94.25%.
(Assume a Tick value of Rs. 15/ tick & PKR contract is available in the denomination of Rs. 500,000)
Solution
To hedge against future interest increase, the firm needs to sell 2 contracts (Rs 1,000,000/500,000)
short futures.
In May future should be closed by buying future contracts at 94.25.
Selling Future at
Buying Future at
Gain (or 110 Ticks)
95.35
94.25
1.10
Rs. 16,250
Gain on in Future
Net Cost of Int.
Rs.
Rs.
3,300
12,950
Surplus investment:
June 3 month int. rate future are being traded with a contract size of PKR 500,000. They are
currently priced at 96 and int. rate is 4%.
What will happen if market int. rates have fallen to 3% with contract price of 97? Assume a tick
value of Rs 15 tick.
Solution
To create hedge against fall in interest rates, company needs to buy Rs. 10million / 500k = 20 contracts
@ current price of 96.
During May the company needs to close out the deal by selling 20 contracts @ 97.
Total profit will be as under:
Buying Futures at
Selling Futures at
Gain (or 100 points)
Total Gain = 100 x 20 x 15
Rs=30,000
96
97
1
Options:
An option is a contract that confers a right to buy or sell a specific quantity or asset, but not the
obligation, at agreed price on or before the specified future date.
Options are available for commodities (like wheat, coffee, sugar, etc) and financial assets like currency
or bank deposits.
Features of Options
A contractual agreement.
Holder of option exercise his/her right.
Option writer is seller and must honor his side of contract. (Sell or buy at agreed price)
Standardized transaction in terms of size & duration.
Exchange traded.
Easy to buy & sell.
Options are either Call Options or Put Options.
Call Option:
It gives its holder a right (not obligation) to buy underlying item at the specified price.
Put Option:
It gives its holder a right (not obligation) to sell underlying item at specified price.
Expiry date:
Each option has expiry date and the holder must exercise his/her right before this date otherwise, it will
lapse.
For example, a call option gives the right to its holder to buy x number of shares at X price on and
before 31 March.
In this example 31 March is expiry date.
Strike or Exercise Price:
The price mentioned in option at which the holder exercises his right is known as exercise or strike
price.
Options Pricing:
The strike price may be higher, lower or equal to the current market price of underlying item.
If the strike price is more favorable than the current market price of underlying asset or item, the
option is termed as In-the-Money
if the strike price is not favorable than the current market price of underlying asset or item, the option
is called Out-of-Money
If the strike price and current market price are equal, then it is known as At-the-Money
An option holder will only exercise his option if it is In-the-Money
LESSON 42
Example: How Options Work?
Let's say that on May 1, the stock price of Abc Co. is Rs 67 and the premium (Cost) is Rs 3.15 for a July 70
call, which indicates that the expiration is the third Friday of July and the strike price is Rs 70. The total
price of the contract is Rs 3.15 x 100 = Rs 315.
In reality, you would also have to take commissions into account, but we will ignore them for this
example.
Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the
contract by 100 to get the total price.
The strike price of Rs 70 means that the stock price must rise above Rs 70 before the call option is
worth anything; furthermore, because the contract is Rs 3.15 per share, the break-even price would be
Rs73.15.
When the stock price is Rs 67, it's less than the Rs 70 strike price, so the option is worthless. But don't
forget that you've paid Rs 315 for the option, so you are currently down by this amount.
Three weeks later the stock price is Rs 78.
The options contract has increased along with the stock price and is now worth:
Rs 8.00 x 100 = Rs 800.
Subtract what you paid for the contract, and your profit is:
(Rs 8.00 Rs 3.15) x 100 = Rs 485.
You almost doubled our money in just three weeks! You could sell your options, which is called "Closing
Your Position
If the price drops, is less than our Rs.70 strike price and there is no time left, but you have to consider
your cost.
An investor buys 20 options on shares of XYZ Ltd at a price of Rs 500 (per share). Each option consists of
100 shares and premium paid is Rs. 5/- per share.
What will happen if, at the expiry of option, the share price is
i) 516 or
ii) 490?
i) Share Price of Rs 516 Per Share:
If, at expiry the share price is Rs 516 per share, then the option is In-the-Money and will be exercised.
It means the investor could buy the shares at a strike price of Rs 500 per share and then can sell
immediately in the market at a price of Rs 516 per share.
In this case investor will make profit. The net gain on this deal can be calculated as under:
Rs. 32,000
Net Gains
Rs. 10,000
Rs. 22,000
Loss on Option
Rs. 10,000
Net Loss
Rs. 32,000
Rs. 22,000
If the share price is less than strike price Rs 490 per share, the option is out-of-money and will not be
exercised.
The option holder will loose the cost of option Rs 10,000.
The option seller will profit the premium received Rs 10,000.
Gain of one party is the loss of other party.
Currency Options
Amount of underlying currency is governed by the contract size as determined in each currency.
A buyer of a call option has a right but not the obligation to buy the underlying currency.
A buyer of a put option has a right but not the obligation to sell the underlying currency.
Premium is charged by option writer from option holder.
Hedging With Currency Option:
To construct a hedge with currency option, one needs to consider the following:
The extent of exposure and the currency involved.
Consider the hedging tool (A call or put option will serve the purpose).
Calculate the most Suitable strike price.
Option will be only exercised if it is In-the-Money.
The company can hedge it either by buying a call option on dollars or sell put options on PKR.
A bank is willing to sell put option at strike price of $ 0.016529/ PKR for a premium of Rs. 9,175.
The company will buy $ 100,000 in September and can do this by buying a put option on Pak Rupees at
a strike price of $ 0.016529/PKR. It will need to have a put option on:
The dollar strengthened and the option is In-the-Money and should be exercised.
Cost of us$ 100,000 @ 0.016529
Rs. 6,049,972
Cost of Option
Rs.
9,175
Total Cost
Rs. 6,059,147
= Rs. 6,153,089
= Rs. 6,059,147
Net Saving
= Rs.
93,942
At expiry, the benchmark rate (like KIBOR) is higher than the strike Rate, for borrower the option is inthe-money, and he will exercise the option.
On the other hand, if at expiry the benchmark (KIBOR) is lower than the strike rate, then the borrowers
option is out-of-money and will not exercise it. The option will lapse.
In this case the company will borrow the money on the prevalent rate of interest (KIBOR).
Option for lender follows the same mechanism.
LESSON 43
Example: Interest Rate Option
A company intends to borrow Rs. 5 million in two months time for a period of 6 months. The company
anticipates that 6 months KIBOR rate will increase, which is currently staying at 8%. The company can
borrow at KIBOR plus 2%.
The company has decided to hedge this exposure through borrowers option.
The company buys an option at a strike rate of 8.50%. The option cost will be Rs. 12,000.
The Notional amount is Rs. 5 million, notional period is 6 months and expiry date is set in two months.
Assuming that at expiry, the 6 months KIBOR rate is 9.50%. The option is In-the-Money and it will be
exercised.
What happens then?
The option will be exercised.
The option is cash settled and company will receive cash from the writer.
The receipt from writer to company is based on the difference in interest cost between Rs 5 million for
6 months @ KIBOR rate of 9.50% and strike rate of 8.50%.
The final calculation is as under:
Interest On Loan:
Rs 5 Million x 6/12 (9.50+2)
Rs. 287,500
Rs. 12,000
Rs. 25,000
Net Cost
Rs. 274,500
Caps & Floors are series of options for medium term loans and deposits.
Interest Rate Caps:
The cash settlement is made at the end of Loan period and not in the beginning.
More than one period is covered.
This is a very expensive option due to high premium cost.
These options are for two to five years term.
Example
Interest Rate Cap & Floor
A company is considering taking a loan of Rs. 10 million on which it pays interest six monthly at KIBOR
plus 1% the company intends to enter into an option against rise in interest rates by buying a cap at a
strike rate 7.5%.
There will be three expiry dates within the agreement:
Expiry
Period
30 - June Year 1
31 Dec. Year 1
Jan - up Year 2
30 - June Year 2
Assuming that six months KIBOR rate at each expiry date is:
Expiry date 1 = 9%
Expiry date 2 = 8%
Expiry date 3 = 7%
Company can exercise the option and will receive cash payment at the end of expiry period 1 - 31 Dec.
year 1.
30 June year 2, the option will not be exercised because the KIBOR 7% is less than the strike rate of
7.50%.
SWAPS
A Swap is a contract where one party exchanges the interest stream for another partys stream.
Swaps are of two types:
Interest Rate Swaps
Currency Swaps
SWAPS
Interest rate Swaps are normally 'Fixed Against Floating', but can also be 'Floating Against Floating'
rate.
A plain vanilla coupon swap is an agreement between two parties to exchange interest payment on
Notional Amount at regular intervals through out the life of swap.
One party pays interest at a fixed rate and other party pays interest at variable rate.
Such swaps have a duration of one to 30 years.
Example 1
Interest Rate Swap
A company borrowed Rs 10 million on which it pays interest @ KIBOR plus 1% every six months for
four years. The company anticipates a surge in interest rates and therefore, intends to use Swap to
fix the interest rate.
A bank offers four years Swap in which it will receive fixed rate of 6.50% in exchange for paying @ of
KIBOR.
Solution
The company is Swapping its variable interest rate with fixed interest rate.
This Swap has fixed the interest rate at 7.50%.
Interest Rate Payable
(KIBOR + 1%)
Receive @ floating
KIBOR
Pay @ fixed
(6.50%)
Net Interest
(7.50%)
Example 2
Interest Rate Swap
A company has Rs. 25 million 8% bond issue having remaining life to maturity of 10 years. Interest is
paid six monthly. The company anticipates that interest will be falling in future and would like to
swap the fixed interest rate for floating rate.
A financial institution has offered 10 years swap on Rs. 25 million in which it pays fixed rate of 7.15%
and receives floating interest based on 6 months KIBOR. Interest payments to be exchanged after 6
months.
Solution
With this swap company will ensure fixed interest with floating interest.
The fixed interest 8% will be swapped with KIBOR + 0.85%, as under:Interest on bonds
= (8%)
= (KIBOR)
Net Cost
= (KIBOR + 0.85%)
Currency Swaps
A Pakistani company is looking for investment in Sri Lanka and needs to borrow Sri Lankan Rupee for
five year project.
It will borrow in Sri Lankan Rupees because the profit earned by the project and the debt will Be in
Sri Lankan Rupee.
The company is new to Sri Lankan market and may have to pay higher interest rates than local
companies. To hedge this transaction the company can use currency Swap.
Currency Swap
Assuming the company invests Sri Lankan Rupee 13 million in a project there and current spot rate is
1 PKR = 1.30 SLR.
Lets assume that company borrows Rs 10 million by issuing long term bonds carrying fixed interest
rate.
A five years Swap is arranged with a bank and it agreed to exchange Rs. 10 million with 13 million
SRL at the start of the project.
In Swap the Pak company will pay interest on 13 million SLR Fixed or Floating.
On the other hand, the company will receive interest from bank on Rs 10 million. Company would
like to receive interest at fixed Rate.
The amount received in swap will be used for making interest payments on bond issue.
At the end of 5th year, company will return SLR 13 million in exchange for Rs 10 million.
It allows company to change a adverse fixed with favorable floating and vice versa.
Flexibility (Not being Standardized): Swap can be arranged for any sum and period.
Off balance sheet transaction, shown as contingencies & commitments.
LESSON 44
Exchange Rate Determination
PKR / US$ Parity Discussion 1986 to 2007.
If a country has a strong currency or that is appreciating in value, then its export will not be
competitive or expensive for foreign customers.
Current Deficit
Current Surplus
The Question is How Exchange Rates are determined?
1) The Economic Factors:
Capital Movement
It refers to the law of one price, which states that there will be one price in a given time when there
are no trade barriers , no transportation costs, and under free market.
In other words, this law suggests that exchange rates will adjust to ensure one price worldwide under
free market conditions.
PPP Model
= 1 + ir / 1 + in
Where
ir = Expected Foreign Inflation Rate
in = Expected Home Inflation Rate
Example:
and expected to be at this level over next 3 months and the inflation
rate in Sri Lanka is expected to be 9%. Current spot rate is SLR/PKR = 1.50
= 1 + ir / 1 + in
= (1 + 0.09) / (1 + 0.06) x 1.50
= 1.5424
Weakness in PPP
Although ex rates are affected by rate of interest and inflation among the countries.
But the Govt. or the Central Banks are incharge of monitoring and controlling the ex rate besides the
forces of demand and supply.
Under this system State Bank / Govt. manage the exchange rate at par.
The state bank has to keep official reserves because of the following:To finance any current account deficit
Intervene the foreign exchange market to maintain the par value of currency.
The currency would be bought with reserves if ex rate fell and to sell in exchange of reserves when
the ex rate goes up.
Forms Of Reserve
Merits & Demerits of Fixed Ex System:
No Fluctuations:
The ex rate fluctuation are absent so it reduces the currency risk faced by the business.
And also reduces the cost of hedging like in option / future / contracts.
Lack Of Flexibility:
It means that balance of payment deficit will not be corrected automatically, Govt. / State Bank
has to use deflationary policies to depress imports. this slows down growth.
Process Specialization:
Product Specialization:
Producing products according to the markets is an important factor to success.
Competition
Size of market
Investment safety and incentives
Political stability
Labour / Cost
Capital market
LESSON 45
Multinational Companies (MNC)
Motives For Foreign Investment
Market Development or Seekers:
Raw Material Seekers
Production Efficiency Seekers
Knowledge Acquisition
Political Stability
Economic Motives:
Overseas investors may have economic strength over local investors due to:
Technology
Economies of scale
Managerial capabilities
Financial strength
Marketing ability
International Operations
A company may find direct foreign investment as a mean of achieving strategic objectives.
There are several reasons which attract a company to invest overseas.
Financial Validity:
o Projections and evaluations are positive and it can be calculated that foreign investment will add
value or maximize the shareholders wealth.
Production Efficiency:
o Cheap labor and raw materials can be a motive to go overseas.
Marketing motives:
o To find market for companys products.
Demerits:
Foreign market knowledge is not known with precision.
Customers may not value invisible supplier, difficult for customers to contact.
Normally attracts tariffs & quotas.
2) Set up an Overseas Branch:
Tax Consequences:
Profits of branch located any where are assessed as companys profits for tax purposes.
3) To Established A Subsidiary:
A separate entity formed under the law of land but under the control of home parent company.
It shows long term commitment to local market.
Tax Advantage: Tax only applicable if profits are repatriated to home country .
Local knowledge to understand local market or the culture of the local market.
Heavy / handsome investment /upfront cost.
Significant risk involved.
4) Joint Venture:
Demerits:
Power to Control or Lack of Trust :
Each venturer will try to seek maximum control over the business and this leads to politics of power.
Power struggle De-motivates employees and they may take advantage of it.
Fragile: Can break away quickly.
Risk: Less risky as compared to subsidiary options.
5) Licensing Agreements:
Financial Risk
Political Risk
Political Risk
The risk of loss of control, business may be taken over by the local Govt. or intervention and
interference by the local authorities.
This risk can be reduced by insurance policies.
A joint venture would be preferable in less or developing country.
A subsidiary would be preferable in a stabled and developed countries.
Even then this risk is present and can be reduced by:
High Gearing
Share in equity from local resources
High Local Loans/Finances
2) Commercial Risk:
There may be discriminative laws for foreign companies, wages level or lower prices for products,
repatriation of profits.
More emphasis to use local resources.
3) Financial Risk:
8th Module:
International Operations
ADDITIONAL
DATA
Types of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here are a
fewtypes, distinguished by the relationship between the two companiesthat are merging:
Horizontal merger:
Two companies that are in direct competition and share the same product lines and markets.
Vertical merger:
This is the merger of a customer and company or a supplier and company. Think of a cone
suppliermerging with an ice cream maker.
Conglomeration:
Two companies that have no common business areas i.e. operating in different industries when
merge then known as conglomerate merger.
There are two types of mergers that are distinguished by how the merger is financed. Each
hascertain implications for the companies involved and for investors:
Purchase Merger - As the name suggests, this kind of merger occurs when one
companypurchases another. The purchase is made with cash or through the issue of some kind
ofdebt instrument; the sale is taxable.
Consolidation Merger - With this merger, a brand new company is formed and both companies
are boughtand combined under the new entity. The tax terms are the same as those of a purchase
merger.
Difference between Operating Cycle and Cash Conversion Cycle (Cash Cycle)
Operating Cycle:
Operating cycle for a firm is the average number of days that the firm takes to convert its raw material
into finished goods for sale and getting cash proceeds from debtors.
Formula for operating cycle is:
Operating cycle = Average days of inventory (stock holding period) + Average receivable processing
period (in days)