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ACCA F9 Financial Management Key Point Notes June 2011

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ACCA
F9
Financial Management

Key Point
Notes
June 2011
These notes are not intended to cover the whole syllabus, but target key examinable areas.

Tutor: Tutor Contact Details


Sunil Bhandari Mobile: +44 (0)7833 438771
E-mail: via
www.IntelligentAccountancyTutorsLtd.co.uk

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Intelligent Ltd
Accountancy Tutors Ltd
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Use of these Key Point Notes


These notes have been written as an aid to assist students
preparing for the ACCA F9 June 2011 Exam. They accrue for
the topics tested in the past exams.

It is of paramount importance that they are used with an up


to date Revision Kit. A combination of using the notes and
question practice is the best way to prepare for the
forthcoming exams.

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Index

Chapter Number Chapter Name Page Numbers


Preliminaries 4-12

Chapter One Financial Objectives 13-20

Chapter Two Dividend policy


21-24

Chapter Three Cost of Capital 25-30

Chapter Four Bonds-Yields & Market


31-32
Value
Chapter Five Risk Adjusted WACC
33-36

Chapter Six CAPM


37-46

Chapter Seven Capital Structure


47-50

Chapter Eight Project Appraisal


51-66

Chapter Nine Business Valuations


67-70

Chapter Ten Sources of Finance


71-78
Chapter Eleven Ratios
79-82

Chapter Twelve Working Capital


83-84

Chapter Thirteen Inventory Control 85-88

Chapter Fourteen Receivables& Payables 89-92

Chapter Fifteen Cash Management


93-98

Chapter Sixteen Foreign Currency Risk 99-106

Chapter Seventeen Interest Rate Risk 107-112

Appendix Islamic Finance


113-116

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Exam Technique
First 15 minutes
 Read the questions carefully

 Recognise the topic being tested (eg NPV, Rights Issue


etc)

 Rank the questions according to your ‘strongest’ to


‘weakest’

Next 180 minutes

 Attempt the questions in your ranked order.

 Stay within your time allocation both on each part of


the question and on the question itself.

 If the written elements are unrelated to the


computations-try front load as they represent ‘easier’
marks.

 Try to attempt all parts to all the questions.

 If in doubt about how to compute a value-make a


reasonable estimate and move on.

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General
Numerical Questions

 State formula

 Show method

 Explain as you go

 Make assumptions if in doubt

Written Questions
 Check format – report / essay/ listed points

 Headings / subheadings / columnar

 Simple short paragraphs-essays and reports

 Use ‘numbered’ points for most questions-simple


sentence approach.

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Tips
These will be available via my website. Please download
from there.

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Chapter One
Financial Objectives
1 Primary Financial Objective

1.1 For profit making business “Maximise Shareholder(S/H)


Wealth”

1.2 To Measure S/H wealth

Value of Equity (Ve) =Number of issued Equity/Ordinary


Shares X Current Market Price (Po)

1.3 To find Po:

 Given in the Question if it is a listed company(see


below)

 Compute Using:-

• Dividend Valuation Model(DVM)


• Earnings Based Models(PE)

1.4 Check the question very carefully for the size of the
company is it:-

 Listed
 Private Company

Make your comments relevant to the size and


nature of the company stated within the
question.

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2 Indicators

2.1 Financial indicators pointing towards maximising S/H


wealth include:-

 Earning per share(EPS)


 Dividend per share(DPS)
 Return on Capital Employed(ROCE)
 Return on Shareholder Capital(ROSC)
 Profit after tax
 Revenue

2.2 Non-Financial Indicators include:

 Market Share
 Customer Satisfaction
 Quality Measures

The above are all Key Performance Indicators (KPI’s)


that need to be measured and reviewed on a regular
basis by the board of directors. (Board)

3. External Factor Affecting Ve & Po

3.1 The Board cannot control all aspects that effect


Ve and/or Po. One of the major factors is macroeconomic
variables.

3.2 Economic Variables -what are they and how may


directional changes effect the share price?

3.2.1 Interest Rates- If they fall:-

 Stimulate demand and revenue


 Lower the cost of debt and improve profits
 Investors switch to share market for better
returns
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3.2.2 Inflation Rates- If it rises:-

 Costs rise causing a drop in profits


 Cause interest rates to rise.
 Devalues the home currency

3.2.3 Foreign Exchange Rate(FOREX)- If it rises:-

 Reduce cash receipts for exporters


 Lowers the cost for importers
 Discourage exporting

3.2.4 Gross Domestic Product- If it falls:-

 Reduce demand and revenue


 Cause interest rates to fall to stimulate demand

3.2.5 General Taxation –If it rises:-

 Damage company profits


 Not encourage investment by companies
 More savings from tax effect of tax allowable
depreciation.

Important to relate your comments to the effect upon


Po & Ve .

3.3 Agency Problem

3.3.1 S/H are the owners of the company and expect


their directors (agents) to take decisions to maximise
S/H wealth. The agency problem occurs when directors
take decisions that DO NOT lead to maximising S/H
wealth.

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3.3.2 Examples of decisions that ‘may’ damage S/H wealth:

 Directors pay
 Taking high risk business decisions
 Non-payment of dividends
 Using debt finance (against the wishes of the
S/H)

3.3.3 Solutions to this problem include:

 Company Law
 Corporate Governance (eg UK Combined Code)
 Share Options (ESOPS)

3.3.4 ESOPS

This provides a way of rewarding Directors by


granting them options to buy shares in their company
at a fixed price. They can buy the shares in future
(normally 1 year) at the fixed price which usually is
today’s price.Hence, directors are encouraged to take
decisions to maximise future share prices. This
benefits both the directors and the shareholders.

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4 The Three Key Decisions

4.1 To maximize S/H wealth the board must take

 Investment
 Finance
 Dividend

4.2 Investment

4.2.1 Allocate cash for:-

 Organic Growth (Projects)


 Acquisitions

4.2.2 Must always consider how investments


impact upon:-

 Company Liquidity
 Future Profits and Asset values
 Business Risk Profile i.e. effect upon
variability of the cash flows and profits.

4.3 Finance

4.3.1 To finance investments the board have to


decide the best balance of equity and debt.

4.3.2 They will consider:-

 Cash available within the company


 Access to new sources of finance
 Impact on KPI’s like gearing
ratio(Debt:Equity)
 Cost of Finance (WACC)

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4.4 Dividends

4.4.1 The Board needs to establish a dividend policy –


see Chapter 2

4.5 The three decisions are interlinked.

Example: New projects need new finance but must


generate cash to service the finance providers
including paying dividends to the shareholders.

5 Objectives of Not-For-Profit- Organisations (NFP)

5.1 These include:

 government funded functions(“Public Sector”)


 charities
 trade unions

5.2 With no shareholders it is important to ascertain.

a) who are the main stakeholders?


b) what are there objectives?

5.3 It is widely recognised that NFP entities should


demonstrate the principles of “Value for
money”(VFM)

The indicators are:-

1) Economy - lowest cost of input resources


2) Efficiency - ratio of input to output measures
3) Effectiveness - how outputs are measured.

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5.4 For example, in a government funded school


measures could be:-

Economy - cost of teachers


- cost of admin

Efficiency - cost/pupil
- Number of pupils/teacher

Effectiveness - pass rates


- number of pupils moving to higher
education

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Chapter Two
Dividend Policy

1 Introduction

To maximise S/H wealth the Board should establish a


dividend policy-the payment pattern to the equity investors.

2 Theories

Several theories have been put forward to assist:-

2.1 Residual – If spare cash exists at the end of the year pay
dividend.

2.2 Pattern – Be consistent with dividend payments. Either

a) Pay the same dividend per share (DPS) each year.


b) Maintain the payout ratio (DPS/EPS)
c) Maintain the same year-on-year growth rate in
dividends. The latter links into the Po via the
dividend valuation model (DVM)

Po= Do (1+g)
(re-g)

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2.3 Irrelevancy

In a perfect capital market providing the directors can


invest in projects with a positive NPV no dividends
are required. The Ve will rise and the S/H can sell shares
to create the cash the need(Manufacture Dividends).

3 Practical Considerations

There are many to consider:

 Availability of Cash
 What dividends to S/H want (clientele effect)?
 Signalling effect –payment of dividends indicates a
healthy company
 Retaining cash is a key source of Finance.
 Dividend growth should be greater than inflation
 Tax impact upon S/H
 Effect the dividend will have on dividend
cover(EPS/DPS)
 Number of investment opportunities will restrict
dividend payments.
 Risk-paying now is safer than promising to pay next
year
 Is the dividend within the company law regulations?

4 Alternatives to Cash Dividends

4.1 Scrip Dividends

4.1.1 The S/H will receive extra shares instead of cash on a


pro rata basis.

4.1.2 This will allow the S/H to sell extra shares for cash and
the gain will be subject to CGT.

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4.1.3 The effect will:-

a) Increase the issued equity capital


b) Dilute EPS and Po values
c) Create pressure for the board to pay more total
dividends in the future as more shares are in issue

4.2 Share Buy Back

4.2.1 If the board has “one off” period of excess cash, they
could consider a share buy back.

i.e. Buy back shares at Po and cancel them.

4.2.2 Considerations:-

a) Allowable under company law.


b) Increase gearing as Ve may fall.
c) Tax implications for the S/H(CGT)
d) Reduced number of shares will cut supply for
trading purposes and may cause Po to rise.
e) Less dividend pressure on the board in future.
f) Criticism-is this the best use of company cash.

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Chapter Three

Cost of Capital

1 Weighted Average Cost of Capital (WACC)

Ke=Cost of Equity
Kd=Should be “Kd(1-t)”=Cost of Debt
Ve=Market Value of Equity
Vd=Market Value of Debt

2 Market Values

2.1 Ve=Total Number of Issued Shares X Po

2.2 Vd=Total Book value of the Debt X Po


$100

2.3 Alternative Presentations

a) Ratio (Vd:Ve) e.g. 1:4


b) Gearing Percentage e.g. 35% hence, Vd=35,Ve=65
for WACC equation

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3 Cost of Equity (Ke)

3.1 The minimum return required by the S/H to compensate


for the risks they face from the equity investment.

3.2 CAPM

Ke=Rf+ (Rm-Rf)βe

where Rf=Risk free return


Rm=Return on the market portfolio
(Rm-Rf)=Equity Risk Premium
βe=Measure of the risks being
faced by the S/H

3.3 DVM

Where Po=Ex Dividend Share Price


d1=The DPS at Time 1
do=The DPS at Time 0
g =Constant annual future growth rate
in the DPS

4 Cost of Debt (Kd (1-t))

Depends upon the type of Debt

Also note:-

a) Kd=Called Yield(the minimum return of the lender)or


pre tax cost of debt
b) “Kd (1-t)”=Cost of Debt* or post tax cost of debt

* This is part of the cost of capital computation.

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4.1 Non traded debt (Bank Loans)

 Kd is the Interest rate on the loan


 “Kd (1-t)”=Interest Rate X (1-t)

4.2 Traded Bonds

4.2.1 These are issued and traded in blocks of $100


or £100.Do all computations per block of “100”.

4.2.2 Undated Bonds-the process is:-

a) Kd (1-t) = Ints x (1-t)


PO

b) Exam Tricks :

i. If there is no taxation
Kd (1-t) = Ints
PO

ii. If the Kd is given by the examiner in the


question
Kd (1-t)=Given Kd% x (1-t)

4.3.3 Redeemable Bonds-the process is via IRR computation

Time $
To Po (X) Take two guesses at
the Kd(1-t) like
T1-Tn Ints x (1-t) X 10% & 1% and
Perform IRR computation
Tn Capital Repayment* X

* can be replaced by equity value for convertible bonds if


higher than capital repayment.

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5 Uses of the WACC

5.1 The WACC is the money or nominal cost of capital to use


in project DCF approaches. It can be used:-

a. To compute the NPV as the discount rate.


b. Compare with the project IRR.
IRR>WACC-Accept

5.2 The WACC is useable if the new project under


consideration:-

a) Is a core activity –same as the company’s


normal activities
b) Does not alter the capital structure of the
company (Vd:Ve)

5.3 In all the past F9 exam questions, it has been very clear
within the question details that the conditions exist to
use the WACC. If the WACC can’t be used then the Risk
Adjusted Cost of Equity per Chapter 5 may be used.

6 What if’s?

6.1 Extend the WACC formula for all extra methods of


company finance. So you could have a WACC with:-

 Equity
 Preference Capital
 Bank loans
 Traded Bonds

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6.2 For Preference Capital

> Kp=D.P.S
Po

> Vp= No of issued X Market price per


Preference shares share (PO)

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Chapter Four

Bonds –Yields and Market Values

1 Bonds

Debt which is issued in blocks of “100” and trades on the


stock exchange.

2 Market Value

2.1 The market value is Po/$100 and can be established via


the DVM

“The present value of future cash flows received by the


investor and discounted at the yield(Kd)”

2.2 Undated Debt

Po = Ints
Yield

2.3 Redeemable Bonds

Time $ Yield% PV

Ti-Tn Ints X X X

Tn Capital X X X
Repayment*

Po = XX

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2.4 Convertible Bonds

Replace the * Capital repayment with the share value if


higher than the cash repayment.

2.5 Bank loans market value is the book value.

3 Yield (the minimum return required by the lender) OR


Pre-tax cost of Debt

3.1 Yield is the minimum return of a lender. Practically we


would expect:-

RF<Inter-Bank rate(LIBOR)<Yield required by the lender

3.2 Undated Bonds

Yield = Ints
Po

3.3 Redeemable Bonds

Time $

To Po (X) Take two guesses at


the yield say 10% &
T1-Tn Ints X 1% and perform IRR
computation
Tn Capital Repayment X

3.4 Bank Loans

 Yield=Interest Rate on the loan

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Chapter Five

Risk Adjusted Cost of Equity

1 Uses

When the company wants to assess a project that is non-


core.

2 Process

a. Take the Proxy Company Beta equity and degear via

b. Repeat the above for other Proxy Company Betas.


Then average all the βa

c. Re-gear βa to find the project βe

d. Put the Project βe into CAPM

Project Ke =Rf + (Rm-Rf) Project βe

Note:(Rm-Rf) is the Equity Risk Premium.

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3 Concerns

 Will the project finance truly have no effect upon the


company’s gearing?
 Proxy company βe:-

a) Does it exist?
b) Does the proxy company specialise in the non-
core field or does it have many different business
activities
c) If we are not listed-how do we gear up the βa

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4 Examiners Article

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Chapter Six
CAPM

1 CAPM Equation

Minimum return = Rf+ (Rm-Rf) β

There are several uses of the CAPM equation:-

 To find the company’s Ke(Chapter 3)


 Risk Adjusted Ke (Chapter 5)
 Assist a stock market investor to buy or sell equities

2 CAPM & Buy/Sell Equities

2.1 Single Equity

 Take/Find βe
 Put into CAPM
Minimum Return = Rf+(Rm-Rf)βe
 Forecast a return for the investment (could use
past returns)
 Forecast exceeds/equals
minimum return-Buy or Keep the share

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2.2 Combining Equities (portfolio)

a) Created a weighted average portfolio Beta

i.e (Cash in Share (1)/Total Cash in Equities X β1) + (Cash


In Share (2)/Total Cash in Equities X β2 )

b) Put into CAPM

Minimum Return = Rf+(Rm-Rf)Weighted Average β

c) Forecast exceeds/equals
minimum return-Buy or keep the portfolio.

3 Meaning of a βe

3.1 A βe is the measure of risk being faced by equity


shareholders

3.2 βe can be split into:-

 Systematic Business Risk-measured by βasset


 Financial Risk(βe-βa)

3.3 Systematic risk is how market factors effect that


investment. Market factors are:-

 Macroeconomic variables
 Political factors

The measure is relative to the benchmark of the


market portfolio which has a βeta factor of 1.
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3.4 CAPM assumes that the investor has eliminated the


unsystematic risk.

TOTAL RISK

Unsystematic risk Systematic risk


Company specific factors General economic factors
Can be eliminated by Cannot be eliminated
diversification

By holding a portfolio, the unsystematic risk is


diversified away but the systematic risk is not and will
be present in all portfolios.

If we were to enlarge our portfolio to include


approximately 25 shares we would expect the
unsystematic risk to be reduced to close to zero, the
implication being that we may eliminate the
unsystematic portion of overall risk by spreading
investment over a sufficiently diversified portfolio.

Total
Risk
Unsystematic
Risk

…………………………………………………………………………….

Systematic
Risk

0 No of different business Approx 25


Shares in the portfolio

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4 Criticisms of CAPM

1) CAPM is a single period model. This means that


the values calculated are only valid for a finite
period of time and will need to be recalculated or
updated at regular intervals.

2) CAPM assumes no transaction costs associated


with trading securities.

3) Any beta value calculated will be based on


historic data which may be not appropriate
currently. This is particularly so if the company
has changed the capital structure of the business
or the type of business it is trading in.

4) The market return may change considerably over


short periods of time.

5) CAPM assumes an efficient investment market


where it is possible to diversify away risk. This is
not necessarily the case, meaning that some
unsystematic risk may remain.

6) Additionally, the idea that all unsystematic risk is


diversified away will not hold true if stocks
change in terms of volatility. As stocks change
over time it is very likely that the portfolio
becomes less than optimal.

7) CAPM assumes all stocks relate to going


concerns, this may not be the case.

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5 Examiners Articles

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Chapter Seven

Capital Structure

1 Introduction

How should the company decide the mix of


equity and debt capital?

2 Practical Issues

If the company uses Debt capital funding it should


consider:-

 Credit Rating of the company


 Rate of interest it will pay
 Market conditions- access to Debt capital
 Forecast Cash Flows-to service and repay the debt.
 Level of Tangible Assets on which secure the loans.
 Interest will lead to tax savings i.e Tax Shield
 Constraints on the level of debt from
a) Articles Of Association
b) Loan Agreements.

 Effect upon the company gearing ratio

Debt/Equity+Debt OR Debt/Equity

 Will the debt providers exercise influence over the


company?
 The chance of bankruptcy.

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5 Theories of Optimal Capital Structure

3.1 Common Ground-both major views accept two facts:-

a) Yield<Ke
b) Gearing causes Ke to rise

3.2 Traditional View

% Ke
Cost
Of
capital
WACC

Kd

0 X Gearing

Key Points:-

1) Ke rises due to financial risk caused by gearing.


2) Kd is initially uneffected by gearing but rises at “high”
gearing levels due to the perception of the possibility of
bankruptcy.
3) WACC-trade off of Ke and Kd. Point X is the optimum
gearing level where WACC is lowest.
4) Once point X is reached via trial and error it must be
maintained.

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3.3 MM and Tax

% Ke
Cost of
Capital

WACC
Kd

0 Gearing

Key points:-

1) Assumption behind the model:-

 All debt is risk free


 Only corporation tax exists
 Debt is issued to replace Equity
 All types of debt carry one yield, the risk free
rate
 Full distribution of profits
 Perfect Capital Market

2) MM concluded companies should gear up to the


maximum levels.

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4 Pecking Order Theory

In this approach, there is no search for an optimal capital


structure through a theorised process. Instead it is argued
that firms will raise new funds as follows:-

 Internally-generated funds
 Debt
 New issue of equity

Firms simply use all their internally –generated funds first


then move down the pecking order to debt and the finally to
issuing new equity. Firms follow a line of least resistance
that establishes the capital structure.

Internally –generated funds-i.e. retained earnings.

 Already have funds.


 Do not have to spend any time persuading outside
investors of the merits of the project.
 No issue costs.

Debt

 The degree of questioning and publicity associated with


debt is usually significantly less than that associated
with a share issue.
 Moderate issue costs.

New issue of equity

 Perception by stock markets that it is possible sign of


problems. Extensive questioning and publicity
associated with a share issue.
 Expensive issue costs.

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Chapter Eight

Project Appraisal

1 Accounting Rate of Return (ARR)

1.1 Average Annual Post Depreciation Profit X 100


Investment

1.2 Investment is:-

a) Initial Investment
b) (Initial Investment +Scrap Value)
2
1.3 Decision rule is:-

ARR> Target return-accept the project


OR
Take the project with the highest ARR

1.4 Limitations and Strengths

Limitations

 Figures are easily manipulated e.g. by changing the


method of depreciation or the estimate of disposal
value.

 Ignores the actual/incremental cash flows associated


with the project, and the effect of the timing of those
cash flows on the real return.

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 Double counting-depreciation is deducted from the


profit figure in full, but the use of the average assets
means that part of this is also included in the
denominator. The effect is to depress the calculated
return.

Strengths

 Expressed in terms familiar to managers-profit and


capital employed.

 Easy to calculate the likely effect of the project on the


reported profit and loss account / balance sheet.
Managers are frequently rewarded in relation to
performance against these variables.

 Business is judged by ROI by financial markets.

2 Payback

2.1 Time it takes the project to payback it’s initial


investment.

2.2 General Approach:-

Time Cash Flows Cumulative Cash flows


To (X) (X)
T1 X (X)
T2 X (X)
T3 X X
T4 X -
T5 X -

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2.3 Annuity and Perpetuity cash flows

Payback period=Initial Outflow


Annual Inflows
3 Net Present Value (NPV)

3.1 NPV is the increase in S/H wealth arising from the


project.

3.2 Two formats to consider


Format (A)

Year 0 1 2 3 4 5
$000 $000 $000 $000 $000 $000
Receipts X X X X
Payments:
Wages (X) (X) (X) (X)
Materials (X) (X) (X) (X)
Variables/Fixed Overheads (X) (X) (X) (X)
Administration/Distribution (X) (X) (X) (X)
Expenses
Taxable Operating Cash X X X X
Flows
Tax: Corporation Tax on (X) (X) (X) (X)
operating cash flows
X X X X
Initial Outlay (X)
Net Realisable Value X
Tax saved on TAD X X X X X
Working Capital (X) (X) (X) (X) X
Net Cash Flows (X) (X) X X X (X)
Discount Rate (e.g. 12%) 1 X X X X X
Present Value (X) X X X X (X)

Net Present Value(NPV) $XXX

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Format B

Time CF 12% (SAY) PV$’000


To (X) 1.0 (X)
T1-Tn X X X
T2-Tn X X X
NPV $XXX
3.3 Incremental Cash Flows

 Result from/caused by the project


 Include opportunity cash flows
 Ignore:-
 Non-Cash Flows
 Sunk Costs
 Interest /Dividend payments

3.4 Financial Maths Required:-

1) Compounding

Eg: Inflation is 5% pa
Real cash flow at time 7 is $250
Money cash flow =$250 x 1.057= $352

2) Discounting (tables)

Eg: Cash flow at T5 is $390.


r=10%pa
PV=$390 x 0.621 =$242

3) Annuity (tables)

Eg: Cash flow from T1-T9 is $400 pa r=5%


PV =$400 x 7.108 = $2843

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4) Delayed Annuity

Eg: Cash flow T3-T5 =$300 pa


r=10%
PV=$300 x (AF1-5 –AF1-2)
=$300 x (3.791-1.736)
=$617

5) Perpetuity

Eg:Cash flow is $500 pa from T1 each year forever.


r= 4%
PV= $500 x 1
r
=$500 x 1 = $12,500
0.04

6) Delayed Perpetuity

Eg: Cash flow is $600 from T4-Tperp


r= 5%
PV=$600 x (1/r –AF1-3)
=$600 x (1/0.05-2.723)= $10,366

7) Perpetuity with Growth

Eg: Cash Flow at time 1 will be $120 and then it


will grow at 3% pa.
r=12%
PV= $120 x 1
(r-g)
PV=$120 x 1 = $1,333
(0.12-0.03)

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8) Delayed Perpetuity with Growth

Eg: As for (7) above but $120 is cash flow at T5.


PV= $120 x Effective Discount Rate.

Effective Discount Rate=

1 x DF4 at 12%
(r-g)

1 x 0.636
(0.12-0.03)

= 7.067

PV =$120 x 7.067 = $848

3.5 Inflation- Factors to consider:

a) ‘h’ is symbol for inflation


b) ‘r’ is symbol for real –excludes inflation
c) ‘i’ is symbol for money/nominal –includes inflation
d) Two approaches are possible

3.6 Include Inflation

Money cash flows can be:-


 Given in the question
 Computed via
Real CF x (1+h)n

Money cost of Capital can be


 Given in the question
 WACC (see earlier chapter)
 Computed via

(1+i)= (1+r) (1+h)

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Exclude Inflation

 Not yet tested by the examiner at F9


 Cash flows are REAL i.e. exclude inflation
 Discounted at REAL Cost of Capital i.e. exclude
inflation

3.7 Working capital-think of as a project bank account:-

i. Invest at To
ii. Adjust each year
iii. Close at end of the project.

Eg: Project needs WC at end of each year as follows:

T0 T1 T2 T3
- 300 350 375
Relevant (300) (50) (25) 375
CF’s

3.8 Taxation-relevant cash flows to be included in the NPV


computation. (RTQ re timings of tax flows!!!)

1) Operating Flows x Tax rate

2) Tax saved on Capital allowances or Tax Allowable


Depreciation(TAD):-

a) TAD-straight line.
eg: CAPEX is $1m.Scrap value at T4=$200K.TAD
is 4 years and tax rate is 30% (No delay)

Tax saved= [($1000-$200)] x 30% =$60 pa


T1-T4 4

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b) TAD-Reducing Balance
eg: Asset is bought at T0 (1/1/10)cost
$1m.Sold at T4 for $200k.TAD is 25% reducing
balance. Tax is 30% (1 year delay).

Time Tax saved


$’000
T2 $1000 x 25% x 30% 75
T3 75 x (100% -25%) 56
T4 56 x75% 42
T5 Bal Figure 67
30% x (1000-200) 240

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4 Internal Rate of Return (IRR)

4.1 The cost of capital that gives an NPV=Nil

4.2 Approach-Take the following example:

NPV@ 10% =$200K


NPV@ 20% = ($15K)

IRR= 10+ (200/200-(-15)) x (20-10) =19.30%

4.3 Decision Rule

IRR>Project Cost of Capital-Accept

4.4 PROS CONS

*Easier to explain *Will mislead if comparing


*Simple decision rule projects
* If cash flows are non-
regular (-, +, +, +,-)
IRR computed above is
incorrect as there will be
multiple IRR’s

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5 Capital Rationing

5.1 A restriction of cash preventing the company from


accepting all projects with a positive NPV

5.2 Causes:

Hard Soft

External constraint on Internal within the


Raising cash.Eg:- Credit Company
Crunch Crisis Eg:- Capex Budget

5.3 Period –only single period is examinable i.e. cash may


Be restricted at T0 or T1.

5.4 Divisible projects –can invest in proportions of a project


from 0% to 100% maximum.

Approach:-

1) Compute Project NPV’s


2) Compute Profitability Index(PI) =
NPV

Cash Invested at critical period

3) Rank-High to Low PI

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5.5 Non-Divisible –take all or none of any project.

Approach:-

1) Compute Project NPV’S


2) Take best combination of projects that
maximise the total NPV but spend less than or
equal to cash available in the critical period.

6 Asset Replacement

6.1 If assets have to be replaced on a periodic basis,


Equivalent Annual NPV is the method to use.

6.2 Process

a) Compute the NPV for each replacement cycle.

b) E.A.NPV = NPV

Annuity Factor for life of the project @cost of capital

c) As (b) will give negative values, take the least


expensive.

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7 Accruing for Risk or Uncertainty within NPV

Several methods, the best are:-

7.1 Probabilities –One project cash flow may be


uncertain.

Example Sales in year 1


$’000 P
2000 0.70
1000 0.30
1.0

Sales in T1 for NPV=

(2000 X 0.70)+ (1000 X 0.30) =$1700K

7.2 Decision Trees

Used when dependent probabilities exist. This can best


be demonstrated by an example.

Year 1 Sales Year 2 Sales

$10,000 0.3 $15,000 0.6


$ 5,000 0.4
$20,000 0.7 $30,000 0.8
$ 15,000 0.2

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As a decision tree:-

P P
15,000 0.3 x 0.6 = 0.18
0.3
10,000 5,000 0.3 x 0.4 = 0.12

20,000 30,000 0.7 x 0.80 =0.56


0.7
15,000 0.7 x 0.20 = 0.14
1.00 1.00

7.3 Risk adjusted Cost of Equity –See Chapter 5

7.4 Sensitivity Analysis-What if?

Change one variable that will cause the NPV to go nil.


Quickest way is to:-

 NPV X 100% For Cash flows


PV of the cash flow
that is uncertain

 IRR-Cost of Capital X 100% For the Cost of capital


Cost of Capital

 Lower the sensitivity % the higher the risk

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7.5 Discounted Payback

 Payback using discounted cash flows

 Format

Time D.C.F Cumulative D.C.F


T0 (X) (X)
T1 X (X)
T2 X (X)
T3 X X
T4 X -
T5 X -

8 Post Completion Audit (PCA)

During the life of a project, an investigation should be


undertaken to examine its profitability and compare it with
the plan. There are three reasons for undertaking these
post-mortems:

 To discourage managers from spending money on


doubtful projects, because they may be called to
account at a later date.

 It may be possible over a period of years to discern a


trend of reliability in the estimates of various
managers.

 A similar project may be undertaken in the future, and


then the recently completed project will provide a
useful basis for estimation.

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9 NPV and S/H wealth

9.1 As stated earlier, NPV represents the change in S/H


wealth arising from the project. It is the only method
that can be directly related to the primary objective of
financial management.

9.2 The NPV is effectively the change in the market


capitalisation of the company and the movement in its
share price. It relies upon markets being efficient
(see chapter 9) to reflect the project data within the new
market price.

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Chapter Nine

Business Valuations

1 Equity

1.1 To value equity /ordinary shares on a per share basis


two primary methods exists.

1.2 DGM/DVM

Po is the present value of future dividends discounted at


the cost of equity(re or Ke)

Po= Do (1+g)
(re-g)

1.3 P/E Model

PO =EPS X P/E Ratio

P/E Ratio may have to come from a proxy company.

2 Others

2.1 Preference shares

PO = D
rp

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2.2 Traded Debt-Undated

PO per $100 = Ints


rd

2.3 Traded debt –Redeemable

PO per $100:-

Time $ rd PV

T1-Tn Ints X X X
Tn Capital Repayment * X X X

PO X

*For convertibles, use higher of capital repayment or share


value if converted into equity.

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3 Efficient Market Hypothesis (EMH)

3.1 EMH explains how stock market prices change to reflect


data /information. The market can be efficient at 3
levels:-

 Weak
 Semi-Strong
 Strong

3.2 Weak –the prices reflect only historic/past data.

3.3 Semi-Strong-prices include past data +public


announcements.

3.4 Strong-prices reflect past, public and insider (secret)


data.

3.5 Most of the world’s stock markets are closer to


semi strong.

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Chapter Ten

Sources of Finance

1 Introduction

Where and how do companies raise long term capital.

2 Equity –General Factors

2.1 Ordinary shares of the company with voting rights.

2.2 Carry the greatest risk but also the best possible
returns.

2.3 Could be traded on the stock exchange if company is


listed.

2.4 “A Stock Exchange Listing”

Advantages of a listing on the stock exchange

To existing shareholders:

 they can sell some of their shares;


 greater marketability raises value;
 no valuation problems e.g. for IHT

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To the company

 new funds can be obtained;


 takeovers can be financed by equity issues;
 easier to raise future finance
 perceived risk reduction –fall in cost of equity;
 extra status may generate new business.

Disadvantages of a listing

 costs borne by company;


 company must comply with SE regulations;
 dilution of control;
 public scrutiny of profits/results.

3 Equity- Raising New Capital

3.1 Retained Earnings-First source of cash. Hold back the


payment of dividends. Will effect the dividend policy
and can raise a small amount of cash.

3.2 Rights Issue-Pro Rata issue to existing S/H.

3.2.3 From the exam questions will need to obtain or


compute:-

a) Po just before the rights issue (Cum Rights


price)

b) Issue Price

c) Ex Rights Price-price directly after the share


issue (TERP)

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For Example: 1 for 3 rights issue at 550p and


cum rights is 600p

No £
3 at 600p 18.00
1 at 550p 5.50
4 £ 23.50

TERP =£ 23.50/4 =£5.88

d) Value of the right

£ 5.88- £5.50 =38p

3.2.4 Shareholder can sell the rights to another


shareholder at the value of the rights.

3.3 Placing- Sell a large batch of new shares to


institutions.

3.4 Prospectus- Sell shares to investors at a fixed price


after issuing a prospectus.

3.5 Tender- Request investors to tender for the shares


at a price they would want to pay. The board then
establishes final price.

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4 DEBT

4.1 Loans provided to the company on a long term basis.

Debt holders will:-

a)Interest paid from pre-tax profits

b) Security via
• Fixed charged
• Floating charge
• Securitisation of future income.

c) Covenants-restrict company activity in areas


such as:
• Dividend payments
• Issues of further debt

4.2 Bank Loans

4.2.1 Funds come from one bank or group of banks.

4.2.2 Terms & Conditions depend upon market


conditions and credit rating.

4.3 Traded Bonds

4.3.1 Loan is split into blocks of $100 and issue on the


market.

4.3.2 Can be undated or redeemable.

4.3.3 Bond has a yield and market value (Chapter 4)

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4.4 Other Types of Debt

a) Convertible Bonds-Debt that can be converted


to shares, normally at redemption.

b) Eurobonds-Rare large foreign currency loan in


the home country. Used by MNC’s and minimum
values normally $1m.

c) Mezzanine Loan

Loan Finance that has elements of equity as


part of it. For example

a) Convertible Bonds
b) Loan plus a warrant –right to buy a share
in the future at a fixed price.

d) Grants-Free government finance providing


conditions are met.

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5 Leases

Leasing is an alternative way of obtaining the use of


items of equipment for companies which for varying
reasons may wish to avoid acquiring them outright.

Terminology

a) Operating lease

Usually for a short period, where substantially all


the risks and rewards of ownership remain with
the lessor.

b) Finance Lease

Usually for long period, where substantially all


the risks and rewards of ownership pass to the
lessee.

The type of lease that we need to consider in


more detail is a finance lease because this is an
alternative to borrowing some money in the long
term in order to purchase an asset.

Reasons for leasing

 The full lease rental is allowable against tax.


Interest on debt financing is allowable against
tax but the capital repayment is not.

 It is readily available form of finance, especially


for plant and equipment or motor vehicles. It is
therefore very convenient for companies to
enter into such arrangements.

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 It removes the need for a significant capital


outlay at the beginning of a project’s life i.e. it
avoids the need to find the capital at the outset.

 It may be cheaper in financial terms that


conventional debt financing i.e. the effective
interest rate on leasing may be less than the
interest payable on a loan.

5.2 Lease Vs Buy Evaluation

3 Step approach

1. Ascertain the post tax cost of debt


i.e Pretax % X (1-t)

2. NPV of the lease cash flows using (1)


Lease cash flows are:
• Payments/Rental
• Tax savings caused by rentals.

3. NPV of buy cash flows using (1)


Relevant flows are:-
• Capital Cost
• Scrap value
• Tax saved on Capital allowances or Tax
allowable depreciation.

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6 The role of Treasury Function

6.1 Treasury functions mainly exist in Large MNC.

6.2 Roles include:-

Managing the groups cash resources


Liaise with the banks.
Advising on Heading strategies for:-
• Forex Risk
• Interest Rate Risk
Establishing source of Finance and cost of capital
for the group.
 Deciding upon investment policy.

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Chapter Eleven
Ratios

1. Ratios-You must Learn!!!!

1.1 Investor

EPS = PAT less Preference Dividends


No of ordinary shares in issue

P/E = Po
EPS

Dividend Cover= EPS


DPS

Payout Ratio = DPS


EPS

Dividend Yield = DPS


Po

Total Shareholder = Dividend for + Capital Gain


Return(TSR) the year for the year
Share Price at start of the
year

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1.2 Gearing

Capital Gearing= Debt or Debt X 100


Equity Debt+Equity

NB Preference shares are generally treated as debt.

Interest Cover = Operating Profit


Interest

1.3 Profitability

ROCE = Operating Profit X 100


Equity +Debt

ROE = PAT X 100


Equity

Margin = Operating Profit X 100


Turnover

1.4 Liquidity

Current Ratio= C.Assets


C.Liabilities

Quick/Acid Test = (C.Assets-Inventory)


Ratio C.Liabilities

Inventory Days= Inventory x 365


COS or purchases

Receivables Days= Trade Receivables x 365


Sales

Payables Days = Trade Payables x 365


COS or Purchases

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2 Important

 Learn the ratios


 State on answer book, substitute the relevant
figures from the question and compute the ratio.
 Comment on each ration in a sensible manner.
 Be ready to change the ratios around

Eg: C.Ratio is 1.25:1.C.Assets are $260K and


C.Liabilities are made up of bank overdraft and
payables. Payables are $108K.What is the value of
the bank overdraft?

Solution

CA=1.25($260K)
CL=1.00(?)

CL=$260K=$208K
$1.25

Bank O/D=$208K-$108K
=$100K

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Chapter Twelve
Working Capital Management &
Financing

1 General

The level and nature of working capital within any


organisation depends on a variety of factors, such as:

 the industry within which the firm operates


 the type of products sold
 whether products are manufactured or brought in
 the level of sales
 inventory and receivables policies
 the efficiency with which working capital is managed

Ultimately it is the balance of:-

 liquidity
 profitability

2 Cash Operating Cycle

Length of cycle =Average inventory + Average - Period


holding receivables credit
period collection period taken

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3 Financing of Working Capital

3.1 Current assets can be simply financed by using current


liabilities .The latter is made up of:-

 Trade payables
 Bank Overdraft

The latter carries an interest cost while the former does


not.

3.2 However, there is a view that some elements of the


current assets are “permanent”. Hence they are a kin
to non-current assets. There are financed by long term
sources of funding-WACC.

3.3 For example

$’000

Current Assets 4,500


Trade payables 2,000
Bank overdraft 1,000
Bank overdraft Interest = 8% pa
WACC =12%

What is the cost of financing the current assets?

Solution

Short term cost


8% x 1000 = $80

Long term cost


12% x (4500-2000-1000)= $180
$260

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Chapter Thirteen

Inventory Control
1

INVENTORY MANAGEMENT

Economic Order Qty(EOQ) Just In Time(JIT)


-Optimise stock order quantity -Nil/minimum
and Re-order level stock
-Minimises stock associated
costs

No discounts With discounts

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EOQ

Assumptions Graphs EOQ + DISCOUNTS


• Demand is known
Q Method

• Purchase price is 1) Calculate the EOQ


constant using the formula,
Q/2
(No discounts) ignoring any
ROL potential discounts.
This is the starting
0
• Lead time is Co=Fixed cost per point.
constant TIME order
(No Stock outs) 2) If, and only if, the
D=Annual Demand EOQ calculated in
• Re-order level = 1) would result in a
demand in lead CH=Variable holding discounted
time £ Total relevant Variable cost per unit. purchase price,
costs holding recalculate the EOQ
costs using the formula
• All costs are known taking into account
and constant the relevant
discount.

Fixed order
3) Finally, calculate
costs the total annual
cost using the EOQ
calculated in 2)
EOQ Q AND the total
annual cost
ordering in
quantities higher
than the EOQ but
where greater
discounts are
available.

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Forecast Sales qtys


(2)

Demand Driven
(1) No Finished (3)
Goods inventory

Close Link
with suppliers
JIT
(7)
(Factors)

No or Ltd JIT
Raw material Production (4)
Inventory(6) NO WIP(5)

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Chapter Fourteen
Receivables and Payables
1 Receivables

1.1 Receivables management is the balance between:-

 liquidity (hold a lower balance)


 profitability(offer more credit)

1.2 Factors to consider when offering credit.

 Do competitors offer credit?


 Industry norms
 Check the credit rating of both new and existing
customers
 Set realistic credit limits

1.3 To collect cash from receivables efficiently:-

 Invoice promptly
 State terms on the invoice
 Send out monthly statements
 Call customers to chase payment
 Consider legal proceedings as a last resort.

1.4 Factoring companies offer “contracted out” receivables


management.

 Receivables administration/collection of cash.


 Advances of cash
 Insurance cover for “bad” debts.

All the above have costs & fees attached.


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1.5 Recourse- Services can be offered with or without


recourse. If without recourse, the factoring company will
suffer any bad debts should they arise.

1.6 Invoice discounting-this is where cash can be raised


using certain receivables balances as security.
Customers are not aware of the transaction. The debt is
paid off when the receivables settle their debt.

1.7 Offering early settlement discounts to customers.

Eg Receivables normally pay in 45 days a settlement


discount of 1.0% is offered for payment within 30
days. Bank overdraft rate is 20%pa

Solution

 Assume sale of $100

 Discount is $ 1.00 = 0.01


$99.00

 Effectively, annual value is:-

365 = 24.33
(45-30)

(1+0.01)24.33-1 x 100

=27.4%

 Discounts costs the company 27.4 % but save


20%.Hence, don’t offer these terms.

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1.8 Changes of Policy

 Prepare all computations on an annual basis


 Show incremental relevant cash costs and savings
when changing from old to new policy.
 Proforma –Changing Receivables Policy

Annual
$’000
Bad debts saved xxx
Admin costs saved xxx
Discount given (xxx)
$’000
Finance cost of xxx
Original receivables
Finance cost of
New receivables xxx xxx /(xxx)
NET SAVINGS xxx

2 Payables

2.1 Again balancing act:-

 Maximise use of free credit


 Not to over extend and lead to:-
a) Costs/Charges
b) Supplier withdrawing supply
c) Supplier going out of business.

2.2 Taking early settlement discount offered by suppliers –


same approach as receivables as per 1.7.

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Chapter Fifteen
Cash Management
1 GENERAL

Motives to hold cash


• Transactions-Day to Day payments
• Precautionary-To cover “rainy day”
• Speculative-Possible investment
opportunities

Business may have


• Surpluses
• Deficits

Surpluses Deficits
Consider: -
• Amount Uses: -
• Time 1. Extend trade
• Access payables
• Return finance.
• Risk
2. Bank facils.
Investments
• Deposits 3. Factoring
• Building society companies.
a/c’s
• Inter bank
market
• Gilts
• AIM
• London SE
• Futures
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2 CASH BUDGETS-SHORT TERM MANAGEMENT

LAYOUT January February March

Receipts

Cash sales

Receipts from debtors

Sale of assets

Payments

Cash purchases

Payments to creditors

Expenses

Purchase of assets

Tax

Dividends

Interest

Net cash inflow/(outflow)

Balance b/f

Balance c/f

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Exam Technique

• Proforma (as above)

• Copy in easy figures.

• Workings for others e.g. receivables receipts, payables


payments.

• Total & tidy!!

3 Cash Flow Forecasts

3.1 Two ways /possible exam questions covering this area:-

 Balancing figure
 Cash Flow Statement

3.2 Balancing Figure

Prepare a Forecast statement of Financial position and


use “CASH AT BANK” as the balancing figure.

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3.3 Cash Flow Statement

Prepare a cash flow statement but not strictly to “P7”


standards as follows:-

$’000
Operating Profit xxx
Add: Depreciation xxx

Change in Inventory xxx


Change in Receivables xxx
Change in payables xxx

Cash from operations xxx

Sale of NCA xxx


Issue of Shares xxx
New Loans xxx

Tax paid (xxx)


Interest paid (xxx)
Dividends paid (xxx)
Purchase of NCA (xxx)
Loans repaid (xxx)

Share buyback (xxx)

Cash generated this year xxx


Balance b/f xxx
Cash Balance C/F $xxx

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4 CASH MODELS

Aim is to optimise the amount of cash held in the longterm.

4.1 Baumol Model

The “inventory control” model of cash.

Max Bal

Spread

Min Bal

Time

4.2 Spread comes from EOQ formula:

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4.3 Miller Orr

A model to cope with the daily variances in the use of cash.

Max Bal

SPREAD
Return
Point

One third
of spread

Min Bal

Time

Sell Investments and


Replenish cash

Formulae are:

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Chapter Sixteen
Foreign Currency Risk
1. Translation Exposure

This is a Financial Reporting risk. The change in the value


of an asset /liability caused by a change in the spot
exchange rate.

1.1 Example-ABC plc has a US subsidiary worth $10m.

2008 - at $1.50 £6.67m

2009 - at $1.75 £5.71m

Loss to equity (£0.96m)

Funded by a $10m loan.

2008 - at $1.50 £6.67m

2009 - at $1.75 £5.71m

Gain to equity £0.96m

1.2 Not a cash risk, only due to financial reporting!!!!

2. Transaction Exposure

Change in the value of the spot rate over the short term
(less than a year) causing a cash gain or loss.

2.2 Must hedge!!

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3. Economic Exposure

Longterm change in the spot rates effecting project cash


flows .Risk can be reduced by Global Diversification.

4. SPOT and Forward Rates

4.1 Typical presentation of SPOT and Forward Rates.

(Bid) (Offer)
$1.5000 - $1.5555 / £

Reciprocal and
cross over!!!!! £0.6429 - £0.6667 / $
(Bid) (Offer)

4.2 Picking the correct rate –Good Method

 Spot and Forward rates presented as FX/Home


currency

 If “we” are Receiving Forex

 Use the right hand rate

5. Internal Hedges for Transaction Risk

5.1 Invoice in home currency

 All transactions in home currency

 Transfer risk to the other party

 Only useable rarely-if “we” have monopoly power.


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5.2 Foreign currency bank account

 Held in the main currencies ($, Euro)

 Pool all transactions in same FX

 Liking have 3 bank accounts with 3 cheque books!!

5.3 Leading and Lagging

 Watcher / predictor of spot rate changes

 Leading – accelerate exchange

 Lagging – delay the exchange

 Used a lot by Importers who have to sell their home


currency

5.4 Netting

 Match all FX transactions in the same FX occurring on


the same day

 Eg: 30 June we expect


Receive $200K
Pay ($50k)
Net Rec $150k

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6. External Hedges for Transaction Risk

6.1 Forward Market

“Fix the rate today that will apply on a set future date”

Technique: -

1. Net the future transactions in same FX and same


date. Ascertain if “buying” or “selling” the £.

2. Forward contract, X months, at


Given as a ‘spread’

3. Exchange FX at the forward rate(Remember if


receiving FX use the right hand rate)

6.2 Money Market Hedge

“The exchange will take place today at the known spot


rate”.

Technique

Home Abroad
Today Today’s Spot
£Answer FX

1+ints home
÷ 1+ ints foreign
Future Date
£ Answer FX

FX

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7. Pros & Cons

Pros Cons
Forward Market
• Fixed Rate, certainty • Inflexible/contract
• Easy • Lose out on the
• Cheap upside potential or
• Tailored(Any size of gain
transaction) • Must ensure FX
receipts arrive

MMH
• Convert today • Complicated
• Cheap • May not apply for FX
• Tailored receipt as borrowing
• Flexible may not be possible
abroad

8. Predicting Future Exchange Rates

 Best long term prediction model is PPPT

S0=Spot Today
S1=Spot 1 years time
hc=annual inflation rate foreign
hb=annual inflation rate base/home country

 In the short term use IRPT

F0=Forward/future spot rate


i=interest rate

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 Practical Factors influencing the Spot Rate

1. Political stability-strengthens home currency value


2. Economic growth-strengthens home currency
value
3. Commodity pricing-oil is priced in dollars
4. Trader activity-buying & selling of currencies
5. Central bank action acting as a trader in FX
6. Changing interest rates-protect the value of the
home currency.

9 Derivatives (written questions only at F9)

9.1 Futures

 This is a method of hedging which is trying to fix the


future spot rate at a value approximately equal to the
current spot rate.

 “Futures exchange rates” are always similar to spot


rates and this is a key factor.

 Hedge is based upon:-

1) Find the direction of the change in the spot rate that


would cause a transaction loss.
2) Use the Futures market and effectively “spread bet” on
the futures rate moving in directions that cause a loss.
3) If:-
a) Spot rate moves in the direction to cause a
transaction loss, a profit will be made on the
futures market, hence two will cancel out.
b) Spot rate moves in the direction to cause a
transaction profit, a loss will be made on the
futures market, hence two will cancel out.

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 It’s not a perfect hedge due to basis risk and “odd”


contract sizes.

9.2 Options

 If “we” could take the current spot rate and use it in


the future, there would be no transaction risk.

 With an option:-

1) Take a contract to give us the option (right)to


exchange in the future at approx current spot
rate.
2) Pay a non-refundable premium
3) Future-use the option rate if spot rate has
move unfavourably. Otherwise the option
lapses.

 Think of an insurance policy-very similar

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Chapter Seventeen
Interest Rate Risk
1 ISSUES

There are two issues / type of F9 questions:-

 Term Structure of Interest rates


 Risk Management.

2 Term Structure of Interest Rates

2.1 Interest rates on the market generally follow this


relationship:

Return on LIBOR Lenders


Gov’t Bonds < (Interbank < Rates
(RF) Rate)

2.2 Hence if the RF was to change it has a direct impact on


all other rates.

2.3 To “predict” the change in the RF, we use the “Theory of


the Yield curve”

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The standard of the


yield curve

Years until maturity

The curve is upward due to:-

a) Liquidity Preference Theory- the longer there is to


maturity the greater the return wanted by the lender.

b) Expectations theory-the yield reflects the expectation of


higher future inflation rates

2.4 Some research has indicated it may not be a curve but a


kinked function.

5 years Years to
Maturity

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2.5 If inflation expectations are in “reverse” ie deflation, it is


feasible to get a reverse yield curve.

No of years of maturity

3 Risk Management

3.1 Normally, this occurs when a company has produced a


short term budget and believe that in the near future
they will run up a cash deficit (possibly a surplus). They
want to hedge against interest change that could damage
their profits.

3.2 For example

1 Jan 31 Mar 31 May

Now (Deficit) Return to


Pay old interest surplus
for 2 months

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3.4 To hedge this risk a company has two basic choices:-

 Lock the Rate


 Ceiling/ cap the rate

4 Lock The Rate

4.1 FRA

A company can purchase a FRA that would lock the rate


for a set period in the future.

No fees are payable but minimum size is $1m.

4.3 Futures

This will effectively lock the rate to a value equivalent


to the borrowers current rate. It involves effectively
spread betting on the movement of the interest rate
on the market.

Contract sizes and deposits (margins) complicate this


process.

5 Ceiling Rate

5.1 IRG

An IRG can be purchased at fees that can cap the rate


payable. The company only uses the cap if the
borrowing rate exceeds this value.

Fees effectively increase the value of the cap offered


by the banks.

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5.2 Option

Achieves the same as above but uses the futures


market. The purchase of a PUT Option sets a capped
rate.

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Appendix – New Topic


Islamic Finance
1.Introduction
The Islamic economic model has developed over time based
on the rulings of Sharia on commercial and financial
transactions. The Islamic finance framework is based upon:

Equity, such that all parties involved in a transaction can



make informed decisions without being misled or cheated.
To pursue personal economic gain but without entering into
those transactions which are forbidden.(eg, transactions
involving alcohol, pork related products, armaments,

gambling and other socially detrimental activities).
Also, speculation is also prohibited (so options and futures
are ruled out).
• The strict prohibition of interest (riba = excess).

2.How can returns are earned?


As stated above, earning interest (riba) is not allowed.
In an Islamic bank, the money provided by depositers is not
lent, but is instead channeled into an underlying investment
activity, which will earn profit. The depositer is rewarded by
a share in that profit, after a management fee is deducted
by the bank.

A typical illustration would be how an Islamic bank may


purchase a property from a seller and re sell it to a buyer at
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a profit. The buyer will be allowed to pay in installments.


Compare this to a typical mortgage where the bank lends
money to the buyer and charges interest.
Hence returns are made from cash returns from a productive
source eg profits from selling assets or allowing the use of
an asset (rent).

3.Islamic Sources of Finance


In Islamic Banking there are broadly 2 categories of
financing techniques:

• “Fixed Income” modes of finance – murabaha, ijara, sukuk


• Equity modes of finance – mudaraba, musharaka

FIXED INCOME MODES


a) Murabaha
Murabaha is a form of trade credit or loan. The key
distinction between a murabaha and a loan is that with a
murabaha, the bank will take actual constructive or physical
ownership of the asset. The asset is then sold onto the
'borrower' or 'buyer' for a profit but they are allowed to pay
the bank over a set number of installments.
The period of the repayments could be extended but no
penalities or additional mark up may be added by the bank.
Early payment discounts are not within the contract.
b) Ijara
Ijara is the equivalent of lease finance; it is defined as when
the use of the underlying asset or service is transferred for
consideration. Under this concept, the Bank makes available
to the customer the use of assets or equipment such as

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plant or motor vehicles for a fixed period and price. Some of


the specifications of an Ijara contact include:
The use of the leased asset must be specified in the

contract.
The lessor (the bank) is responsible for the major

maintenance of the underlying assets (ownership costs)
• The lessee is held for maintaining the asset in proper order.
An Islamic lease is more like an operating lease but the
redemption features may be structured to make it similar to
a finance lease.
c) Sukuk
Companies often issue bonds to enable them to raise debt
finance. The bond holder receives interest and this is paid
before dividends.
This is prohibited under Islamic law. Instead, Islamic bonds
(or sukuk) are linked to an underlying asset, such that a
sukukholder is a partial owner in the underlying assets and
profit is linked to the performance of the underlying asset.
So for example a sukukholder will participate in the
ownership of the company issuing the sukuk and has a right
to profits (but will equally bear their share of any losses).

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EQUITY MODES

a) Mudaraba
Mudaraba is a special kind of partnership where one partner
gives money to another for investing it in a commercial
enterpirse. The investment comes from the first partner
(who is called 'rab ul mal'), while the management and work
is an exclusive responsibility of the other (who is called
'mudarib').
The Mudaraba (profit sharing) is a contract, with one party
providing 100% of the capital and the other party providing
its specialist knowledge to invest the capital and manage the
investment project. Profits generated are shared between
the parties according to a pre-agreed ratio. In a Mudaraba
only the lender of the money has to take losses.
This arrangement is therefore most closely aligned with
equity finance.
b) Musharaka
Musharaka is a relationship between two or more parties,
who contribute capital to a business, and divide the net
profit and loss pro rata. It is most closely aligned with the
concept of venture capital. All providers of capital are
entitled to participate in management, but are not required
to do so. The profit is distributed among the partners in
pre-agreed ratios, while the loss is borne by each partner
strictly in proportion to their respective capital

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