PWC'S Academy: Paper FM

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cz/academy
PwC's Academy
Paper FM
Financial Management
September - December 2021
Course
Notes
„These materials incorporate materials © Interactive World Wide Limited,
Interactive Pro Limited and/or London School of Business & Finance, used with
permission. No further reproduction is permitted in whole or in part.”
Content
Chapter 1 FINANCIAL MANAGEMENT: INTRODUCTION
Chapter 2 BASIC INVESTMENT APPRAISAL
Chapter 3 ADVANCES INVESTMENT APPRAISAL
Chapter 4 SOURCES OF FINANCE
Chapter 5 COST OF CAPITAL
Chapter 6 RISK ADJUSTED WACC AND CAPITAL STRUCTURE
Chapter 7 FINANCIAL PERFORMANCE MANAGEMENT
Chapter 8 RISING EQUITY FINANCE
Chapter 9 WORKING CAPITAL MANAGEMENT
Chapter 10 EFFICIENT MARKET HYPOTHESIS
Chapter 11 BUSINESS VALUATIONS
Chapter 12 RISK
Chapter 13 SOLUTIONS
Appendices
1.Past Exam December 2016 – December 2019
2.Relevant Articles from Student Accountant

Introduction to the paper
AIM OF THE PAPER
The aim of the paper is to develop knowledge and skills expected of a financial manager,
relating to issues affecting investment, financing and dividend policy decisions.
OUTLINE OF THE SYLLABUS

A. Financial management function
B. Financial management environment
C. Working capital management
D. Investment appraisal
E. Business finance (including Cost of Capital)
F. Business valuation
G. Risk management
FORMAT OF THE EXAM PAPER

The syllabus is assessed by a three hour and 15 minute paper-based examination, All
questions are compulsory.
Section A of the exam comprises 15 multiple choice questions of 2 marks each.
Section B of the exam comprises three scenarios each with 5 multiple choice questions of 2
marks each.
Section C of the exam comprises two 20 mark questions.
FAQS
What level of mathematical ability is required in F9?
You will be required to apply formulae either given or memorised. This may require limited
manipulation of formulae. The level of computational complexity is normally inversely related
to the conceptual difficulty of the topic.
What do I need to bring to class?
You will need pen, paper, these notes and revision kit. In addition you will need a standard
scientific calculator which may be purchased in any large newsagents or supermarket.
Is there any assumed knowledge?
The only real overlap is with basic concepts explored in paper F2 and also elements of decision
making and cost behaviour covered in paper F5.
FORMULAE
Economic Order Quantity
2C0D
=
CH
Miller-Orr Model
Return point = Lower limit + (1/3  spread)
1
3 3
 4  transaction cost  variance of cash flows 
Spread = 3  
 interest rate 
 
The Capital Asset Pricing Model
E(ri) = Rf + ßi (E (rm) – Rf)
The Asset Beta Formula
 Ve   Vd(1 T) 
ßa =  e  +  d 
 (Ve  Vd(1 T))   (Ve  Vd(1 T)) 
The Growth Model

D0 (1 g) D (1 g)
P0 = or P0 = 0
(Ke  g) (re  g)
Gordon’s Growth Approximation
g = bre
The weighted average cost of capital
 Ve   Vd 
WACC =   ke +   kd (1–T)

 e d
V V  Ve  Vd 
The Fisher formula

(1 + i) = (1 + r)(1 + h)
Purchasing Power Parity and Interest Rate Parity

(1 hc ) (1 ic )
S1 = S0  F0 = S 0 
(1 hb ) (1 ib )
FORMULAE
Present Value Table

Present value of 1 i.e. (1 + r) -n
Where r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ __
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ __
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ ___ ___ ___ _ ____ ___ ___ __ __
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
FORMULAE
Annuity Table
1 - (1 + r)-n
Present value of an annuity of 1 i.e.
r

n = number of periods
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
________________________________________________________________________________
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
FORMULAE
C H A P T ER 1 – F IN A N C I A L M A N A G E M E N T : I N T R O D U C T I O N
Chapter 1
Financial Management:
Introduction
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C H A P T E R 1 – F IN A N C I A L M A N A G E M E N T : I N T R O D U C T I O N
I. FINANCIAL MANAGEMENT FUNCTION (FM)

1 FM, Management Accounting and Financial Accounting
 Financial management
 Financial management covers dealing with the monetary resources of an organisation. It looks at where the
money comes from (financing) and where it goes to (investments).
 It differs from management accounting, where internal records of the activities of an organisation are kept and
financial accounting, where the results of an organisation are reported externally.
 Management accounting
 Concerned with providing information for control and decision making. This involves:
 Budgeting
 Cost accounting
 Variance analysis
 Evaluation of alternative uses of short-term resources
 Operates within a 12-month horizon
 Financial accounting
 Concerned with providing information about the historical results of past plans and decisions
 Not directly involved in day-to-day planning, control and decision making
 Its purpose is to keep the owners and other interested parties informed of the overall financial position of the
business
 It will not be concerned with the detailed info used internally by management accountants and the financial
manager
Example 1 – Distinction between Management Accounting, Financial Management, and Financial Accounting (Illustrated)
MA FM FA
Review of variances X
Depreciation of assets X
Establishing dividend policy X
Evaluating new investment X
Apportioning overheads to cost units X
Identifying prepayments X
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2 Key areas of Financial management

 Identifying and setting appropriate corporate financial objectives
 Achieving financial objectives, by taking decisions in three key areas:
 Investing: What non-current assets and level of working capital should the business invest in?
- Where the money go?
- Non-current assets, working capital, financial assets (shares, bonds, cash in bank to earn interest)
 Financing: What sources of funding should the company use?

- External or internal?
- If external – debt or equity? (Debt is cheaper, but created finance risk for shareholders)
- Long term or short term? (should match length of assets financed)
 Dividend: how should cash funds be allocated to shareholders?

- See Dividend theories in Chapter 4 Sources of finance
- The level of dividend paid will be determined by the following:
1. Profitability (business must be profitable to be able to pay divs)
2. Cash flow/ liquidity (dividend is cash out)
3. Growth (if the Co wants to grow, it needs funds for a new investments – if divs paid out, then
external funds must be acquired
4. Legal restrictions
5. Shareholder expectations (Dividend is a signal of future prospects of Co. Shareholders might
prefer stable dividend)
 Controlling resources to ensure efficient and effective use.

 In all of the above areas, the financial manager will need to take account of:
 the broader economic environment in which the business operates
 the potential risks associated with the decision and methods of managing that risk (risk management)
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3 Corporate strategy and Financial management

 The role of the financial manager is to align the aims of financial management team with those of the wider corporate
strategy. The strategy of the business may be separated into corporate, business and operational objectives.
Financial managers should be attempting to fulfil those objectives.
 The nature of financial management means that it is fundamental to the translation of strategic aims into financial
transactions.
 The distinction between 'commercial' and 'financial' objectives is to emphasise that not all objectives can be
expressed in financial terms and that some objectives come from commercial market place considerations.
 Objectives – What the company is trying to achieve; where the company wants to be in the future
 Strategy – The course of action decided upon to achieve an objective
Example 2 – Distinction between commercial and financial objectives and strategy (Illustrated)
level/objectives commercial financial strategies
corporate improve brand awareness increase EPS by 3% acquire competitor chain
update manufacturing capacity to achieve returns of 12% on new buy new cutting machine for
business incorporate new technology manufacturing investment 200k$
reduce unsold inventory items by improve liquidity ratio from 1,5
operational 10% to 1,7 implement JIT
4 Financial objectives
Shareholder wealth maximisation

 A fundamental aim within financial management is to create and sustain shareholders’ wealth.
 The wealth of shareholders comes from:
 Dividends received
 Market value of shares owned
 Shareholders’ return on investment comes from:

 Dividends received
 Capital gains from increases in the market value of the shares
 If the directors manage the business so that the share price is maximised (MV of business is maximised) then they
have maximised their shareholders' wealth.
Profit maximisation
 Within organisations management is rewarded on some measure of profit (ROI or RI). In simple terms we would
expect a close relationship between profit and shareholders’ wealth (if profit of Co is maximised  MV of shares will
increase). There are, however, ways in which they may conflict:
 Profit is not cash - Accounting profit can be manipulated by choices of accounting policies (provisions,
depreciation, capitalisation of expenses, adding overheads to inventory valuations…).
 Risk – manager might accept very risky project s in order to achieve profit targets. This in turn would adversely
affect the value of the business
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 Short-termism - Profits targets are calculated over one year. It’s possible to boost short-term profits at the
expense of long-term profits. For example, spending on training, advertising, R&D may be cut so short term
profits are improved, but the long term prospects of business might be damaged. It might result in high reward for
managers but may not be in the long term interest of the shareholder.
EPS growth
 EPS=PAT / # of shares.
 Widely used as a measure of the company’s performance.
 Company must be able to sustain its earnings in order to pay dividends and re-invest in its business so as to achieve
future growth. Therefore growth in EPS is important.
 But EPS based on past data and PAT can be easily manipulated by changes in accounting policies and by mergers/
acquisitions
Maximising versus satisficing

 The objective of management has been deemed to be primarily one of maximising shareholder wealth. However in
practice a distinction must be made between:
 maximising – seeking the best possible outcome – seeking maximum level of returns, even if this might involve
exposure to risk and much higher management workloads.
 satisficing – finding a merely adequate outcome, generate an acceptable level of profit with minimum of risk.
5 Non-financial objectives
 The company may have important, non-financial objectives which will limit the achievement of financial objectives:
 Employees – good wages, safe working conditions, training, pensions

 Management – high salaries, cars
 The provision of services to the public
 Customers – supply arrangements, after-sales service arrangements
 Suppliers – trading relationship (e.g. prompt payments)
 The welfare of society as a whole – compliance with laws and regulations, green environmental policies,
sponsorship etc.
 Other non-financial objectives: growth, diversification, leadership in research and development
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II. NOT-FOR-PROFIT ORGANISATIONS (NFP)
1 Definition
 NFPs are established to pursue non-financial aims and exists to provide services to community (eg a charity).
 NFPs have their own objectives, generally concerned with the efficient use of resources in the light of specified
targets.
 Difficult to define what counts for an NFP (as they still can make profit or use similar processes: local authorities do
not set objectives in order to arrive at a profit for shareholders, but they are required to apply the same disciplines
and processes as profit oriented companies).
 Not-for-profit organisations and the groups they are set up to benefit would include:
 charities – those with unmet needs in a specific area
 public services including schools and hospitals – the general public in the location
 local government – the local citizens
 trade unions – members of the union
 sports associations – members of the association and others involved in the sport
 professional institutes – members of the institute and others in the profession.
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2 Objectives in NFP
 The primary objective of NFPs is not to make money but to benefit defined groups of people.
 Different approach to management of objectives as there are differences compared to typical companies:
 wide range of stakeholders
 high level of interest from stakeholder groups
 significant involvement of sponsors
 no price for the ultimate recipients of the service (it is free or almost free)
 projects typically have a longer-term planning horizon
 may be subject to government policies
 Possible objectives in a NFP:

 Surplus maximisation
 Revenue maximisation
 Usage maximisation (e.g. swimming pool usage)
 Usage targeting (matching the capacity available, e.g. in hospitals)
 Full/partial cost recovery (minimising subsidy)
 Budget maximisation (maximise what is offered)
 Producer satisfaction maximisation (satisfying the wants of staff and volunteers)
 Client satisfaction maximisation
 Non-financial objectives – more important and complex because:

 Most key objectives are very difficult to quantify, especially in financial terms, e.g. quality of care given to
patients in a hospital.
 Multiple and conflicting objectives are more common in NFPs, e.g. quality of patient care versus number
of patients treated.
 Financial objectives
 Since the services provided are limited primarily by the funds available, key objectives for NFPs will be to:
 raise as large a sum as possible
 spend funds as effectively as possible
 Targets may then be set for different aspects of each accounting period’s finances such as:
 total to be raised in grants and voluntary income
 maximum percentage of this total that fund-raising expense represents
 amounts to be spent on specified projects or in particular areas
 maximum permitted administration costs
 meeting budgets
 breaking even in the long run
 The actual figures achieved can then be compared with these targets and control action taken if
necessary.
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3 Value for money (VFM) as an objective

 Value for money means providing a service in a way which is economical, efficient and effective. It means getting
the best possible service at the least possible cost.
 NFPs best serve society’s interest when the gap between the benefits they provide and the cost of providing
those benefits is the greatest. This is termed VFM and it is not dissimilar from the concept of profit maximisation,
apart from the fact that society’s interests are being maximised rather than profit.
 VFM is important concept because NFPs:
 often use public funds raised through taxation or donations
 do not produce financial results such as profit figures
 have no clear priority of objectives
 face an increasing demand for accountability.
4 Measuring objectives in NFP
Measuring VFM – the 3 Es

 Economy: means resourcing and purchasing the inputs at minimum cost consistent with the required quality of the
output.
 Efficiency: means doing the right thing well. It relates to the level of output generated by a given input. Reducing the
input:output ratio is an indication of increased efficiency
 Effectiveness: means doing the right thing. It measures the extent to which the output meets its declared objectives;
is the output the required quality, the right specification etc.?
Use of the 3Es as a performance measure and a way to assess VFM is a key issue for examination questions that relate
to NFPs and public sector organisations.
Example 1 – 3Es (Illustrated)

Consider the example of a refuse collection service.
The service will be economic if it is able to minimise the cost of weekly collection and not suffer from wasted use of resources.
It will be effective if it meets its target of weekly collections.
It will be efficient if it is able to raise the number of collections per vehicle per week.
Problems with the measurement of VFM

 VFM as a concept assumes there is a yardstick against which to measure the achievement of objectives. But:
 NFPs tend to have multiple objectives (even if they all can be clearly identified, it is impossible to say which is the
overriding objective)
 Outputs can seldom be measured in a way that is generally agreed to be meaningful (e.g. are good exam results
alone an adequate measure of the quality of teaching?)
 Possible solutions:
 Performance can be judged in terms of inputs
 Accept that performance measurement must to some extent be subjective; judgement can be made by experts
 Comparison against others, against historical results, unit cost measurements (e.g. cost of a patient day)
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III. STAKEHOLDERS
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1 Stakeholders and objectives

 A stakeholder is an individual or group whose interests are directly affected by the activities of the firm.
 Satisfying all stakeholders (the ‘stakeholder view’) is an alternative approach to objective setting: maximisation of
shareholder wealth is only concerned with one stakeholder - the shareholder.
 A company must balance many competing claims of the community at large, employees, customers, shareholders
and the environment.
 It is simplistic to assume that companies are motivated by a single goal.
 Interests of stakeholders must be considered:
Stakeholder Objectives
Internal Employees Maximise own rewards - salary, continuity of employment
Managers Maximise own rewards
Connected Shareholders Maximise wealth
Debt-holders
Customers Paid the full amount due by agreed date
Banks Receive payments of interest and capital
Suppliers
Competitors
External Government Related to macroeconomic objectives - sustained economic
growth, high level of employment. Vehicles: taxation, grants,
health and safety legislation
Pressure groups
Local and national communities
Professional and regulatory bodies
 Expectation of stakeholders may conflict

Stakeholders Potential conflict
Employees may resist the introduction of automated processes which would improve
efficiency but cost jobs. Shareholders may resist wage rises demanded by employees as
Employees vs. shareholders uneconomical.
Customers may demand lower prices and greater choice, but in order to provide them a
company may need to squeeze vulnerable suppliers or import products at great
Customers vs. community environmental cost.
Shareholders may encourage management to pursue risky strategies in order to maximise
Shareholders vs. finance potential returns, whereas finance providers prefer stable lower-risk policies that ensure
providers liquidity for the payment of debt interest.
Customers may require higher service levels (such as 24 hour rather than 48 hour delivery)
Customers vs. which are resisted by shareholders as too expensive, or by management due to increased
shareholders/managers workload.
Government will often insist upon levels of welfare (such as the minimum wage and health
Government vs. shareholders and safety practices) which would otherwise be avoided as an unnecessary expense.
Shareholders are concerned with the maximisation of their wealth. Managers may instead
Shareholders vs. managers pursue strategies focused on growth as these may bring the greatest personal rewards.
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2 The role of management and agency theory
Agency theory
 Agency theory describes the relationships between the various parties in a company and can help to explain the
various duties and conflicts that occur.
 Agency relationships occur when one party, the principal, employs another party, the agent, to perform a task on
their behalf. For example, directors (agents) act on behalf of shareholders (principals).
The divorce of ownership and control

 Delegation of running the business to directors by shareholders is referred to as divorce of ownership and control
and leads to what is called as agency problem.
 Agency problem - managers of the business do not necessarily maximise shareholders' wealth, so the agents don't
act in the best interests of the principals.
Goal congruence
 Goal congruence is defined as the state which leads individuals or groups to take actions which are in their self-
interest and also in the best interest of the entity.
 For an organisation to function properly, it is essential to achieve goal congruence at all level. All the components of
the organisation should have the same overall objectives, and act cohesively in pursuit of those objectives.
 In order to achieve goal congruence, there should be introduction of a careful designed remuneration packages for
managers and the workforce which would motivate them to take decisions which will be consistent with the objectives
of the shareholders (eg Share options and Performance related pay)
Managerial reward schemes
 Management will only make optimal decisions if they are monitored and appropriate incentives are given.
 Goal congruence may be better achieved by introduction of carefully designed remuneration packages.
 The schemes should be:
 clearly defined and impossible to manipulate,
 easy to monitor
 link rewards to changes in shareholders’ wealth
 match the managers time horizon to shareholders’ time horizon
 encourage managers to adopt the same attitudes to risk as shareholders
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 Common types of reward schemes include:

 Performance related pay ( linked to size of profit, but other KPI might be used)
 Rewarding managers with shares (managers are invited to subscribe Co’s shares  managers =
owners)
 Share options – managers are given a share option, it means that they have option to subscribe for
shares of the Co for a fixed price. The value of option will increase if the Co is successful and its share
price increases. Managers will try to maximise share price, which will satisfy shareholders)
Regulatory requirements
The achievement of stakeholder objectives can be enforced by regulatory requirements such as corporate governance and stock
exchange listing regulations.
Corporate governance code

 Corporate governance is a system by which Co is directed and controlled. Corporate governance codes cover
following areas:
 Directors should have mix of skills and their performance should be assessed regularly
 Division of responsibilities is most simply achieved by separation of chairman and chief executive officer
 Independent non executive directors have s key role in governance. It means they should have an important
presence on the board, must have an obligation to spend sufficient time with the company and should be
independent.
 Boards should regularly review risk management and internal controls.
 Remuneration committees – directors’ remuneration should be set by remuneration committee
 Nomination committees – appointments should be conducted by formal procedures administered by nomination
committee
 Annual general meetings
Stock exchange listing requirements and other regulations

 Although adherence to the principles of the corporate codes is voluntary, they are often referred to in the listing
requirements of stock exchanges.
 E.g. UK Stock exchange listing requirements
 Other regulations, e.g. The Directors : Remuneration Report Regulations 2002
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IV. THE ECONOMIC ENVIRONMENT
Exam focus 
This section is a review of basic university economics and is not covered in the course notes. Review these topics from
your Revision cards and Manual.
A topic from this chapter is most likely to appear as a multiple choice question in Section A.
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C H A P T ER 2 – B A S I C I N V ES T M E N T A P P R A IS A L
Chapter 2
Basic Investment
Appraisal
BASIC INVESTMENT APPRAISAL
CAPITAL INVESTMENT
CAPITAL BUDGETING PROCESS
TECHNIQUES
IRR
ROCE
DISCOUNTING NPV
PAYBACK
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C H A P T E R 2 – B A S I C I N V E S T M E N T A P P R A IS A L
1 CAPITAL INVESTMENT
Capital vs. revenue expenditure

 Capital expenditure
 Results in the acquisition of non-current assets or an improvement in their earning capacity

 Appears as a non-current asset in the Statement of Financial Position (SoFP)
 Spending is irregular and for large amounts. Assets expected to generate long-term benefits
 Revenue expenditure – regular spending on the day-to-day running of the business
 Charged to the income statement

 Is incurred:
 for the trade of business (selling, distribution, admin, finance charges)

 to maintain existing earning capacity of non-current assets
Non-current asset investment and working capital investment

 Investment can be made in non-current assets or working capital
 Investment in non-current assets: there is a significant amount of time between spending of funds and
recovery of the investment
 Working capital investment: this means investment in short-term net assets (e.g. inventory). Funds are
committed for a short period of time (e.g. an investment in raw material is recovered from sales of
finished products).
2 CAPITAL BUDGETING PROCESS

 A capital budget is a programme of capital expenditure covering several years
 The capital budgeting process consists of a number of stages:
1. Forecast capital requirements

2. Identify suitable projects
3. Appraise potential projects
4. Select and approve best alternative
5. Make capital expenditure
6. Compare actual and planned spending, investigate deviations and monitor benefits from project over time
 Within the appraisal stage (stage 3) are the following techniques:
 Return on Investment (ROI), or Return on Capital Employed (ROCE), or Accounting Rate of Return
(ARR) - synonyms
 Payback
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
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3 RETURN ON INVESTMENT (ROCE/ROI/ARR)

PBIT
ROCE 
capital employed
What “profit” and “capital employed” to use?
 Average measure
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝐵𝐼𝑇 𝑝𝑎
𝑅𝑂𝐶𝐸 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑎𝑡 𝑁𝐵𝑉
 Capital employed will usually involve Investment only, but in some cases could also involve permanent
increase in inventories.
 If in ROCE formula PBIT is taken as the average per year, average investment in NBV must be
calculated:
a/ straight line accounting depreciation
initial cost  scrap value
Average investment 
2
b/ reducing balance (accelerated) depreciation or complication with inventories – calculate NBV at
individual years and average them.
 Total measure
total PBIT generated by investment in its EUL
ROCE 
investment at cost
Acceptance rule
 ROCE of investment should be greater than target ROCE of the company

 ROCE should be greater than the Weighted Average Cost of Capital (WACC) (the minimum requirement)
 If you are comparing two projects, select the project with the greater ROCE
Advantages
 Quick and simple, people are familiar with concept of calculating a % return on assets
 Uses accounting info that is easily available
 Looks at entire project life
Disadvantages
 Based on PBIT, which is influenced by accounting policies and estimates - can be manipulated
 Relative measure – ignores size and absolute gain of investment
 Ignores length of project
 Ignores time value of money
Converting cash flows to profit

 You are likely to get CASH FLOWS in the exam, but formula is based on PROFITS
 ADJUSTMENT: CASH FLOW less ACCOUNTING DEPRECIATION = PBIT
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Example 1 - Reina Ltd - ROCE

Reina Ltd has the opportunity to invest in project with initial cost of $100,000. Residual value of project assets in 5 year time will
be $5,000. Investment earns cash flows as follows:
Y1 Y2 Y3 Y4 Y5
CF (in thousands $) 40 40 30 20 10
Determine ROCE using average investment (assume straight line accounting depreciation)
Example 2 - Armcliff (Illustrated)
Armcliff wishes to invest in a new equipment costing $ 14 mil. The residual value is expected to be $ 2 million after four years of
operation. Expected PBIT in $ million: Y1/ 3.50, Y2/ 1.95, Y3/ 0.60, Y4/ (0.20).
Higher production levels will require additional investment in inventories by $ 0.5m which will be held at this level until last year of
operation.
Determine whether the proposed capital investment is attractive to Armcliff, using the average rate of return on capital
method. Assume straight line accounting depreciation. Capital employed is defined as fixed capital and investment in
inventories. Cost of capital of the Company is 12%.
average PBITp.a.(W 1) 1.46

ROCE    14.6%
average capital employed (W2) 10
W1: PBIT: Total PBIT generated by investment over 4 years: 3.50+1.95+0.60-0.20 =$ 5.85m
Average PBIT p.a. = 5.85/4 =$ 1.46m
W2: Capital employed: Y1 Y2 Y3 Y4

Investment at NBV 14 11 8 5
Inventories 0.5 0.5 0.5 0.5
14.5 11.5 8.5 5.5  total $40m, average $40m/4=$10m
Depreciation; $ 14m - $ 2m = $ 12m  $ 3m per year
4 PAYBACK
 Payback is length of time it takes to recover the initial cash investment from project cash flows.
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 Works with cash flows, not profits. If ‘profits’ are given in the question, you’ll need to add accounting depreciation
back to arrive at cash flows.
 Decision rule: Choose the project with the shortest payback period.
Advantages
 It is simple to use (calculate) and easy to understand

 It is often used as ‘screening device’ at the initial stage where definitely inconvenient projects are
eliminated
 favours shortest payback time, thus it considers both liquidity and risk
 considers cash flows, not profits
Disadvantages
 ignores the cash flows received after the break-even point

 ignores profitability of project
 ignores time value of money (unless discounted payback is calculated)
 projects with same payback are not distinguishable from one another
 ignores timing of cash flows within the payback period
Calculation
 If the cash flows are constant, payback period is calculated as

initial investment
CF per year
 If the cash flows are not constant, calculate cumulative CF first and then identify the point of time when
cumulative CF break from negative to positive number (see Example 3)
Example 3 - Reina ltd - Payback

be $5,000. Investment earns cash flows as below. Required: Determine Payback period.
Y1 Y2 Y3 Y4 Y5
CF (in thousands $) 40 40 30 20 10
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5 DISCOUNTING - BASICS
 Time value of money: Money received today is worth more than the same sum received in future - it has a time
value. This occurs for three reasons:
 opportunity cost of capital e.g. lost interest earned in the bank

 inflation
 risk
 Compounding: The future value of an investment as the interest payments received are re-invested at the same
interest rate
 Discounting: Compounding in reverse. Discounting answers the question, “If I want $100 on deposit in the bank in 5
years time, how much should I deposit today?”
Example 4 - Discounting using calculator and discount tables

Calculate present value of the cash flows below. The interest rate is 5% pa.
Year 0 1 2 3 4
CF (30) 7 10 8 6
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6 NET PRESENT VALUE (NPV)

 “Net present value” is the sum of the expected inflows and outflows of cash related to a specific project, discounted
by the project discount rate I (usually the company’s ‘cost of capital’).
C1 C2 Cn
NPV  C 0    ... 
(1  i) (1  i ) 2
(1  i) n
 Interpretation:
 NPV > 0 accept project

 NPV < 0 reject project
Advantages
 The best method (the others are ROCE, Payback, IRR)

 considers time value of the money (compared to ROCE and undiscounted payback)
 based on cash flows, not profits (compared to ROCE)
 considers the whole life of the project (compared to Payback)
 is consistent with the objective of maximising the market value of the company  should lead to the
maximisation of shareholder wealth
Disadvantages
 determining a project discount rate requires knowledge of cost of capital and might be difficult to estimate
 difficult to explain to non-finance managers, relatively complex
 The cash flow figures are estimates and may turn out to be incorrect (estimates of unit price, unit variable
cost, sales volume, inflation, taxation etc…)
 NPV assumes cash flows occur at the beginning or end of the year
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Example 5 - Reina ltd - NPV

Y1 Y2 Y3 Y4 Y5
CF (in thousands $) 40 40 30 20 10
Reina’s cost of capital is 12%.
Required: Calculate NPV of project.
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7 INTERNAL RATE OF RETURN (IRR)

 Internal rate of return is such discount rate at which NPV equals to zero. So while NPV gives you a $ amount, IRR
gives you breakeven discount rate.
C C Cn
NPV  C  1  2  .... 0
0 (1  i * ) (1  i * ) 2 (1  i * ) n
Conventional Cash Flows

(only one negative CF, which occurs at the
beginning of the project)
IRR interpretation and acceptance rule

 If IRR is greater than the cost of capital, accept the project (current Co’s cost of capital may increase to IRR before
NPV breakeven to negative number). This simplified acceptance rule is valid only in case of conventional CFs, see
later for more details)
How to find IRR (interpolation method)

 From definition (IRR is a such percentage i*, at which NPV = 0), we can write equation:
C C Cn
NPV  C  1  2  ....  0
0 (1  i* ) (1  i* ) 2 (1  i* ) n
 Objective is to find i* from the equation. As it is in the power, we can not express it directly, we have to use
interpolation:
 Step 1. Calculate two NPVs for the project at two different costs of capital (i1,i2)
 Step 2. Use formula (or simple geometry which is behind formula) to find i*
- Formula (not given in exam formula sheet)
NPV
i*= IRR  i  1 ( i  i )
1 (NPV - NPV ) 2 1
1 2
- Formula comes from simple geometry – shown in next Example
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Example 6 - Reina ltd - IRR

Y1 Y2 Y3 Y4 Y5
CF (in thousands $) 40 40 30 20 10
Reina’s cost of capital is 12%.
Required: Calculate IRR of project.
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Disadvantages
 If a project has unconventional cash flows, there could be more than one IRR for that project (multiple
IRRs) (see below)
 ignores size of investment (NPV does not)
 calculation is difficult and lengthy (NPV is not)
 not relevant for mutually exclusive projects (NPV is OK) – see below
 assumes money is invested at IRR for the whole project life (not relevant in practice)  interest rate
cannot be changed (with NPV can)
Advantages
 respects time value of money (ROCE and payback do not)
 uses cash flow, not accounting profit (ROCE does not)
 IRR easier to understand than NPV by non-accountant (e.g. the calculated percentage can be compared
to ROCE)
IRR and non-conventional CF

 Non conventional CFs are such where there are high negative cash flows also during investment life. NPV as
function of discount rate will not be entirely decreasing (as for conventional CFs) It could be increasing in some parts
and therefore it might have more intersections with x axis  IRR method will provide multiple results (more different
IRR at which NPV=0). General application of a decision rule (if cost of capital i < IRR, take it) would not work.
Example 7 – IRR and non conventional CFs (Illustrated)
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Mutually exclusive projects (NPV & IRR)

Two projects are mutually exclusive if only one of the projects can be undertaken. In this circumstance the NPV and IRR may give
conflicting recommendation.
Example 8 - Mutually exclusive projects (Illustrated)

Projects A and B with economic useful life of 1 year are mutually exclusive, cost of capital is 10%., cashflows given:
Project Out In IRR NPV
A -10,000 12,000 20% 908
B -15,000 17,700 18% 1,089
Both projects are acceptable as both have NPV>0 and IRR>10%. Based on IRR we would choose project A, based on NPV we
would choose project B.
Conclusion: Use NPV for mutually exclusive projects
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C H A P T ER 3 – A D V A N C E D IN V ES T M EN T A P P R A I S A L
Chapter 3
Advanced Investment
Appraisal
Advanced Investment Appraisal
Relevant CFs
- Relevant Cost
- Inflation Advanced
Asset investment decision
- Taxation discounting
- Lease x Buy
- NPV layout - Annuity
- Asset replacement
- Perpetuity
- Capital rationing
Risk and uncertainty

- Sensitivity
- Expected values
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C H A P T E R 3 – A D V A N C E D I N V E S T M EN T A P P R A IS A L
1 INVESTMENT APPRAISAL – RELEVANT CASH FLOWS

 Principles to identify relevant costs are same as in Management accounting paper. However, it is a lot easier, as this
will be Investment related and its list will be much shorter.
1.1 Relevant cost

 A relevant cost is a future, incremental cash flow that occurs as a direct consequence of an investment decision.
 Future – costs incurred in the past are ignored, e.g.:

– sunk costs (e.g. R&D costs incurred in the past)
– committed costs (costs based on past decisions that are not affected by the current investment decision)
 Cash flow – depreciation is not relevant cost as it is not a cash flow

 Incremental – only include cash flows that arise as a direct consequence of the investment decision
Issues to consider – Investment appraisal specifics

 Incremental Cash Flows
 Sales are $100, after investment sales will increase to $120, relevant cashflow is $20
 Savings - if with introduction of new technology wastage of material is decreased, those additional savings
are cash in
 Depreciation - not a cash flow, therefore not to be included. But tax depreciation is tax deductible, tax saved will be
cash in. Relevant CF would be Tax saved on depreciation.
 Tax - include, it is cash out (see Taxation)
 Increase / decrease in working capital - Investment in a new project often requires an additional investment in
working capital (increase in inventory levels). The treatment of working capital is as follows:
 Initial investment in working capital is a cost (cash out) at the start of the project (year 0)
 Any increase in working capital during the project life is a relevant cash outflow, (vice versa if the working
capital level decreases, the decrease is a cash in)
 At the end of the project, all the working capital is released as a cash inflow.
 Cash out for investment – relevant, cash out in year 0 (end of Y0 = beginning of Y1). It is capital investment,
therefore no tax implication.
 Proceeds from sale of assets at the end of economic useful life – relevant, cash in. Reflect also Tax on
disposal (sale value less NBV tax) x tax rate. If there is a gain on disposal, calculated tax is cash out, if there is a
loss on disposal, calculated tax is tax saved and therefore cash in.
 Finance costs - asset under consideration is financed by a bank loan. Any loan instalments and interest payments
are not relevant as finance cost are reflected in discount rate already.
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1.2 Inflation
 Inflation is a general increase in prices that leads to a general decline in the real value of money.
 In times of inflation, the fund providers will require a return (nominal/money rate of return ( 𝑖𝑛𝑜𝑚 )) made up of two
elements:
 real return for the use of their funds ( 𝑖𝑟𝑒𝑎𝑙 )

 additional return to compensate for inflation ( 𝑖𝑖𝑛𝑓 )
 The nominal rate can be calculated using the Fisher Formula, given in the Exam formula sheet:
(1  i nom )  (1  i )(1  i )
real inf
 Dealing with cash flows and inflation in your exam
 Compare apples with apples:

- Discount nominal CFs (CF that reflect inflation) by nominal discount rate (NOMINAL/ MONEY
APPROACH).
- Discount real CFs (CF that do not reflect inflation) by real discount rate (REAL APPROACH)
- Both approaches will give you same result
 “General” inflation relates to i and is used for calculation of nominal discount rate i nom
inf
 Multiple inflation rates given - If the question gives multiple inflation rates PLUS a general inflation rate, then you
need to:
- Compound all cash flows by their corresponding inflation rate (e.g. price will grow by 4%, variable
cost by 3%, and fixed costs by 5% per year) to get nominal CFs
- Use the NOMINAL discount rate following the Fisher formula
Example 1
Ireal = 10 %, iinf = 5 %
What is the nominal rate inom?
Example 2
inom = 10.6% iinf= 5%
What is the real rate of return?
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1.3 Taxation
 Tax is a cash out flow so it is a relevant cash flow
 In the exam tax can be paid in the same year as taxable profit occurs or in arrears (the following year). This is done
to reflect the delays between tax arising and being paid. Take care and read the question carefully.
 Tax deductible depreciation reduces the tax payment, therefore tax saved on depreciation is relevant cash flow
(depreciation itself is not cash flow). Tax saved on depreciation – positive cash flow.
 Do not forget to calculate tax on disposal
 When including tax, make sure your discount rate is after-tax as well
 Interest (and related tax savings) - not included as already reflected in cost of capital, i
1.4 NPV layout
year end 0 1 2 3 4 5
(1) sales x x x x x
(2) cost (x) (x) (x) (x) (x)
(3) sales - costs x x x x x
(4) tax t%*(3) (x) (x) (x) (x) (x) - in following y?
(5) capital expenditure (x)
(6) WC (x) x
(7) scrap value x
(8) tax saving/cost on loss/gain from sale of FA x/(x) - following Y?
(9) tax savings on depn x x x x x - following Y?
(10) CF (x) x x x x x
DF % 1 x x x x x
DCF at % x x x x x x
NPV x
 Tax paid in arrears
 Tax can be paid in the same year as taxable cash flows occur (as shown in schedule above) or
 Tax can be paid in the year following to the year when taxable cash flows occur (IN ARREARS). This must
be reflected by postponing all tax effects by one year. It relates to lines
- Income tax paid
- Tax saved on tax allowable depreciation
- Tax on disposal
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Example 3 – NPV including inflation, taxation, WDA

ABC Co. is considering to buy machine with initial cost of $1,000,000. The machine will be sold after 3 years for $400,000. Demand
for the product is budgeted at 6,000 units in Y1, 10,000 units in Y2 and 4,000 units in Y3.
The selling price and variable cost per unit are expected to be $100 and $40 in current-price terms. Selling price is expected to
inflate by 5% and variable costs by 6% pa.
Tax is paid at 30%, one year in arrears. Tax deductible depreciation (WDA) is available at 20% using the reducing balance method.
The company has a real required rate of return of 7.84%. General inflation is predicted to be 2%.
Required: Determine the NPV of the project. Work in $ thousands.
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2 ADVANCED DISCOUNTING
 We introduced basic discounting in Chapter 1. We already understand that money received today is worth more
than same amount of money received in future. We are able to discount cash flows arising in future years.
 Let’s have Co arising now (at the end of year 0), C1 arising at the end of year 1, C2 arising at the end of Y2, Cn
arising at the end of year n. Then total present value of cash flows C1, C2,…,Cn is:
𝐶1 𝐶2 𝐶𝑛
𝑃𝑉 = 𝐶0 + + + ⋯+
(1+𝑖)1 (1+𝑖)2 (1+𝑖)𝑛
 If cash flows are constant, we can simplify calculation.
 Annuity – constant cash flows over n years

 Perpetuity – constant cash flows into infinity
Annuity
An annuity is a series of constant cash flow received over n number of years (constant CF for definite number of years)
1
1-
C C C 1 1 1 (1  i) n
PV    ...   C(   ...   C( )  C  annuity factor
(1  i) (1  i) 2
(1  i) n (1  i) (1  i) 2
(1  i) n i
1 - (1  i)-n
Fraction is called annuity factor. Its value is given in Annuity table for discount rate I and number of years n.
i
PV of constant CF = CF x annuity factor (i,n)
Perpetuity
A perpetuity is a constant cash flow that continues into the future indefinitely.
C C C C
PV    ...   ...    
1  i (1  i) 2 (1  i) n i
𝑪
𝑷𝑽 =
𝒊
Assumptions for annuities and perpetuities

 Cash flows are assumed at either the beginning or the end of the year
 The first cash flow starts at the end of Year 1
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Example 4 - Annuity
$100 is received at the end of each year, for the next 4 years, starting at the end of year 1. The cost of capital is 10%.
Required:
a/ What is the present value of the cash flow?
b/ What is present value of cash flows, if first cash flow starts at the end of year 3
c/ What is present value of cashflows, if first cashflow starts at the beginning of year 1 (end of Y0)
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Example 5 - Perpetuity
Company expects to receive $200 each year into infinity, starting at the end of year 1. The cost of capital is 10%.
Required:
a/ What is the present value of the cash flows?
c/ What is present value of cash flows, if first cash flow starts at the beginning of year 1 (end of year 0)
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3 LEASE OR BUY DECISION

 In “Lease or Buy” the investment decision whether to acquire the asset has been made, the project is accepted and
now the company will decide how to finance the asset.
Relevant cash flows

 “Lease or Buy” describes two options:
 Lease – the company pays regular lease payment, does not own the asset
 The relevant cash flows are:

- The lease, or rental payment
- The tax benefit (i.e. “tax shield”), assuming the lease payment is tax deductible
 Buy - Here the company will get bank loan to purchase the asset.
 The relevant cash flows are:

- Purchase cost in year zero
- Tax saved on tax depreciation
- Residual balance/scrap value
- Tax implications on the disposal of the asset
 CFs listed above are typical, but the list is not exhaustive – it could be any other CFs which is not under both” Buy”
and “Lease” (maintenance fees paid under “Buy” x maintenance fees included in lease payments under “Lease”)
 We compare “financing“ cash flows only, as the operating cash flows are the same in both cases.
Key information
 Discount rate
 We use the assumption that buying option requires the use of a bank loan.
 Discount rate (used for both BUY and LEASE) = post tax bank loan interest rate (bank loan with interest
10% pre-tax, tax = 30%, after tax discount rate = 10%x0,7=7%)
 If in a question it is written that the company does not pay tax then use the pre-tax rate
 Interest payments and loan repayments are ignored: when you discount, you are considering interest. To include
interest payments as cash flows would be double counting.
 Lease payments made at the beginning or at the end of the year
 If lease payments are made at the start of each period and tax is paid in arrears, then for discounting, first
lease payment is shown in the table in Y0 (end of Y0), but as it is actually paid on 1st day of Y1, it will make
it to tax return of Y1 and therefore relevant tax will be saved in Y2.
End of year 0 1 2 3 4
Lease payment (100) (100) (100)
Tax saved (30%) 30 30 30
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Other considerations
 When making a conclusion as to which method of financing the company should take (the one with a lower NPV of
cost), you can add other considerations:
 running expenses – the calculation assumes they are the same for both alternatives, but what about
maintenance, insurance, and spare parts
 impact on liquidity
 trade in value – the NPV of the ‘buy” option is materially affected by the assumed trade-in value and this
can be inaccurate.
Example 6
A company accepted a project which requires an acquisition of an asset and is considering how to finance it. The asset will cost
$120,000 and will have a $10,000 residual value at the end of year 4.
For the 4-year life of project, the company can arrange a bank loan with an after-tax interest rate of 10%.
The alternative is to lease the asset over 4 years with a rental fee of $36,000 pa, payable at the start of each year.
Tax is payable at 33%, one year in arrears. Tax deductible depreciation is available at 25% on reducing balance basis.
Required: Determine whether to lease or buy the asset.
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4 ASSET REPLACEMENT
 The question is how often the Company should replace an asset that is in regular use by identical asset. For
example, a taxi company would like to know from a financial perspective, if it is better to replace the taxi fleet every 1,
2, or 3 years.
Issues to consider
 As the asset gets older, it costs more to maintain
 As the asset gets older, the residual value decreases
 But, by prolonging the purchase of an asset, the company is saving money on acquisition costs.
Assumptions
 Ignore cash flows from trading (operating cash flows) as they are the same in all the options
 Operation efficiency of machines is similar
 Assets replacement continues into the foreseeable future
 Ignore non-financial aspects, e.g. safety, or pollution
The approach
1. Calculate the NPV of the cash flows for each annual replacement cycle, e.g. if you are looking at the taxi company’s
decision above, you would do a NPV calculation for each of the three options.
Those NPVs (for 1,2 and 3 years resp) would not be comparable as they relate to periods with different lengths. As cash flows
considered includes in a vast majority COST (positive operating CF are not included as they are same for all alternatives,
therefore not relevant for a decision), the NPV of the option with longest period is likely to be the most costly (highest negative
number). Therefore we have to convert those total NPVs into annual cost, to make the alternatives comparable.
2. Convert this NPV to an “Equivalent Annual Cost.” You do this by dividing the NPV by the Annuity factor (at the same
discount rate) for that number of years. This gives you an “Equivalent Annual Cost” with which you can compare the options.
𝑁𝑃𝑉 (𝑜𝑓 𝐶𝐹1 − 𝐶𝐹𝑛)

𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 =
𝐴𝐹(%, 𝑛)
3. Select the cheapest option (the option with the lowest equivalent annual cost). This is the optimum replacement cycle.
Disadvantages
 This approach ignores:
 Changing technology
 Inflation
 Changes in production plans
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Example 7 – Asset replacement

A decision has to be made on the replacement policy for taxis. A taxi costs $25,000 and following information applies:
Asset sold at end of Y Trade in allow Kept for Running cost
1 15,000 1 year 7,500 in 1st year
2 10,000 2 years 7,500 in 1st year, 11,000 in 2nd year
3 7,500 3 years 7,500 in 1st year, 11,000 in 2nd year, 12,500 in 3rd year
Required: Calculate the optimal replacement policy at a cost of capital of 10%.
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5 CAPITAL RATIONING
Capital rationing is a situation where a company has a limited amount of capital for investments in potential projects with positive
NPV. The objective is to choose such combination of projects that gives maximum NPV. There are two types:
Soft capital rationing
 The company has enough capital to invest in all projects with a positive NPV, but chooses not to. Limits on spending
are imposed internally. This runs contrary to the rational view of shareholder wealth maximisation.
 Reasons for soft capital rationing:

- Limited management skills available.
- Desire to maximise return on a limited range of investments.
- Limited exposure to external finance.
- Encourages acceptance of only substantially profitable projects.
Hard capital rationing
 These are limits that are imposed externally by banks; the company cannot find enough cash to invest in all the NPV
positive projects that are available.
 Reasons for hard capital rationing:

- Industry-wide factors limit available funds.
- Company-specific factors such as a lack of a good track record, lack of asset security, poor
management team.
- Restrictions on bank lending due to government control.
- Company is considered to be too risky by lending institutions.
- Raising money through the stock market not possible if share prices depressed.
 Relaxation of capital constraints – how to limit the effects of hard capital rationing:
 See joint venture partners

 Consider licensing /franchising agreements
 Contract out parts of the project (to reduce initial capital outlay)
 Seek new, alternative sources of capital:
- Venture capital
- Debt finance secured on the assets of the project
- Sale and leaseback of property
- Government grants
- More effective capital management
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5.1 Capital rationing - divisible projects
Assumptions
 Shortage of funds for this period only
 Project cannot be postponed
 Complete certainty of outcome – the choice is not affected by risk
Method
 Calculate a profitability index (PI) where NPV is divided by initial investment (NPV/Investment)
 Rank the projects according to highest PI
 Choose those with highest PI until the budget consumed
Problems
 In practice projects are not divisible
 Ignores differing cash flow patterns
 Ignores the absolute size of projects
 Selection criterion is simplistic –what is the strategic values of the project in context with company
objectives?
5.2 Capital rationing – non divisible projects

 The optimal combination can be found by trial and error (to calculate profitability index does not help because the Co
can not invest unused funds with NPV>0)
 Unused funds – assumption is that unused funds will earn return equivalent to the cost of capital and therefore will
generate NPV = 0
Example 9
The funds available for investment are $200,000. All investments must be started now (Yr 0).
Determine the optimal project selection assuming (a) projects are divisible and (b) projects are indivisible.
Project Investment $000 NPV $000
A 100 25
B 200 35
C 80 21
D 75 10
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5.3 Mutually exclusive projects – divisible or non-divisible

 Some combinations are not possible (A can not be undertaken with C)
 For both divisible and non–divisible project – try each combination to identify which earns the higher level of returns
Example 10
A company has $100,000 available for investment and has identified the following 4 investments in which to invest. All investments
must be started now (Yr 0). A and C are mutually exclusive.
Project Investment $000 NPV $000

A 40 20
B 100 35
C 50 24
D 60 18
Required: Determine optimal project selection if a) the projects are divisible and b) projects are not divisible
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Example 11 Horge Co
Horge Co is reviewing investment proposals that have been submitted by divisional managers. The investment funds of the
company are limited to $800,000 in the current year. Details of three possible investments, none of which can be delayed, are
given below.
Project 1
An investment of $300,000 in work station assessments. Each assessment would be on an individual employee basis and would
lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-related illness. Savings in
labour costs from these assessments in money terms are expected to be as follows:
Year 1 2 3 4 5
Cash flows ($'000) 85 90 95 100 95
Project 2
An investment of $450,000 in individual workstations for staff that is expected to reduce administration costs by $140,800 per
annum in money terms for the next five years.
Project 3
An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per annum are expected in current price terms
and these are expected to increase by 3.6% per annum due to inflation during the five-year life of the machines.
Horge Co has a money cost of capital of 12% and taxation should be ignored.
Required: Determine the best way for Horge Co to invest the available funds and calculate the resultant NPV:
(i) on the assumption that each of the three projects is divisible;
(ii) on the assumption that none of the projects are divisible.(10 marks)
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6 RISK AND UNCERTAINTY
 Risk and uncertainty
 Risk can be quantified : Multiple outcomes exist, but on the basis of past relevant experience probabilities
can be assigned to outcomes and mathematical techniques can be used.
 Uncertainty ca not be quantified – Multiple outcomes exist but there is little past experience, so it’s difficult
to assign probabilities to the outcomes. Math techniques can’t be used.
 Why consider risk in investment appraisal - Risk is more acute with the capital investment decision than with
other decisions as estimates of capital expenditure and benefits (i.e. cash flows) can be many years into the future.
This implies uncertainty and should therefore be reflected in investment appraisals.
 Estimates in investment appraisal include:

- length of project life
- predicted cash flows and probabilities
- discount rates
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6.1 Adjusted discount rates

 Higher risk means a higher discount rate (the resulting cash flow is lower)
 Different discount rates can be used for different cash flows
6.2 Adjusted CF (The certainty – equivalent approach)

 Expected “risky” cash flows are converted to a riskless equivalent amount
 Risky cash flows are reduced by the “probability they will happen“
 Riskless discount rate should then be used
6.3 Payback / Discounted payback

 As discussed earlier in the notes payback gives a simple measure of risk. The shorter the payback period, the lower
the risk.
6.4 Simulation
 Simulation is a method to try to take into account risk + uncertainty by considering the variables that are involved in
the project and the chances of those variables occurring. Once these have been estimated , then computer will be
used to look at the likely outcomes and the chances that the project will be successful
 You will never be expected to carry out a simulation exercise in the exam, you will be required jut to mention the
method.
6.5 Sensitivity Analysis

 Sensitivity analysis shows how responsive a project’s NPV is to changes in variables that are used to calculate the
NPV. This analysis finds the most sensitive variables and the extent to which those variables may change before the
investment results in a negative NPV.
 Question behind is: By how much the individual variable must change to get NPV=0?
 Effect of variables is assessed in isolation – so while you measure effect of certain variable, the others are fixed and
do not change.
 Therefore delta (the change) which will make NPV=0 is the value of NPV (for eg if Capital outflow increases by NPV
(while everything else is fixed), then NPV=0). In next step you have to relate the value of the change to original
value of variable to assess sensitivity of variable, therefore:
 Sensitivity of each variable (does not work for COST OF CAPITAL, see Example 12 below) is calculated as:
Sensitivity margin = NPV/ (PV of project variable)
 The most critical will be the variable with the lowest sensitivity margin
 Variables can be:
 initial cost
 cash flows (e.g. selling price, units sold (sales volume), unit variable cost, fixed cost, etc.)
 cost of capital i
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Example 12 (Sensitivity analysis)
Company plans to make investment of $50,000 with economic useful life of 3 years. The discount rate is 10%.
Estimated sales volume is 10,000 units each year, relevant fixed cost per annum of $8,000, selling price of $10/unit and variable
cost of $7/unit.
Required:
(a) Calculate NPV of the project.
(b) Measure sensitivity of NPV to
(i) initial investment;
(ii) revenue (selling price)
(iii) variable cost
(iv) sales volume (units sold)
(v) fixed cost
(vi) discount rate
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6.6 Expected values

 Expected values are used where there are a range of possible outcomes which can be identified and a probability
distribution can be attached to those values
 Expected value is weighted average of possible outcomes, weights = probabilities
N
EV   p j  CF j
j 1
 It does not represent what the outcome will be, nor does it represent the most likely result. It represents the average
pay-off per occasion if the project were repeated many times.
 Disadvantages
 To assign probabilities is subjective

 Ignores variability of payoffs
 EV itself ignores investor’s attitude to risk (standard deviation must be incorporated)
 EV is a long term average, but the project is a one off
 Advantages
 Technique recognises that there are several possible outcomes and is, therefore, more sophisticated than
a single value forecast
 Enables probabilities of different outcome to be quantified
 Leads directly to a simple optimising decision rule by reducing a range of possible outcomes into one
number
 Simple calculation
Example 13
A new project is being launched, though the selling price to be used in the NPV calculation is uncertain. It is believed that this will
be a consequence of the level of competition faced by the business.
Price ($) Probability (p)
Intense $24.00 0.20

Normal $30.00 0.70
None $35.00 0.10
Required: What is the selling price to be used in the calculation of the NPV?
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C H A P T ER 4 – S O U R C E S O F F I N A N C E
Chapter 4
Sources of finance
1. Financial markets
- Capital
- Money
- Global
- Financial intermediation
2. Sources of finance
3. SME – sources of finance

SHORT
- Bank loans
- Overdraft LONG
- Trade credit
- Factoring
- Invoice discounting
- Leasing EQUITY DEBT
- Bank loan
- Ordinary shares - Bonds
- Preference shares
OTHER
4. ISLAMIC FINANCE - Venture capital
- Murabaha - Leasing
- Mudaraba - Sales and lease back
- Musharaka - Grants
- Ijara
- Sukuk
5. Dividend policy and theories 6. Article – Financing alternatives

- Irrelevancy
- Residual
- Relevant
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CHAPTER 4 – SOURCES OF FINANCE
1 FINANCIAL MARKETS AND INSTITUTIONS
1.1 Capital markets

 Capital markets are markets where financial instruments are traded. There are two types of
instruments traded on two separate markets:
 Shares of companies, traded on the stock market. Companies issue shares, each one of
which represent a fraction of the ownership of the company.
 Bonds, traded on the bond market. Bonds are debt securities in which the issuer (eg, the
company borrowing the money) issues the bond to the lender (the bond holder, ie, the person
lending the money). It is a contract that specifies the rate of interest and the repayment
terms.
 In addition, each of the above two markets has two separate operations:
 The primary market - the market where new issues are traded, and
 The secondary market - the market where existing stocks or bonds are traded.
 The two markets depend on each other - the secondary market is the 'exit route' for persons
who have bought securities in the primary market. The primary market would not be so
successful if people buying the securities did not have a means of selling them if they wanted
an exit.
1.2 Money markets

 The money market is a market for short-term borrowing and lending, and trades financial instruments
such as Treasury Bills, short term gilts (government bonds) and commercial paper (bonds issued by
companies).
 The money market allows a company to obtain short-term liquidity, obtain trade finance and manage its
exposure to foreign currency and interest rate risks, by the methods that it can obtain finance from the
money markets.
 Banks and other financial institutions are financial 'intermediaries', helping out by providing places for
companies to deposit excess cash and for other companies to borrow that cash. The interest rates that
the banks and financial institutions offer will depend on the amount of cash available and that required. If
they haven't enough money to lend then they will offer higher rates to depositors.
 The following are a series of money market instruments available:
 Interest bearing instruments that allow depositors to get a return and lenders to be charged
for their borrowing. Deposit rate is lower than borrowing rate (banks make profit).
 Discount instruments with no explicit rate of interest. They require a company to pay back
more than they borrowed. The Company may borrow USD97,000 and has to pay back
USD100,000 in three months' time. The extra amount that is paid is an interest charge.
 Derivative products derive their value from other some separate index or instrument. Hence
they may have an interest rate that is linked to a separate benchmark interest rate.
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1.3 Global markets

 The above markets are global markets. All developed countries will use them and government and
companies trade freely between them. Individual countries have their own 'stock market' or 'financial
centre' where the financial activity takes place, and the various firms that operate in these centres trade
between each other.
 London is one of the world's largest financial centres-partly due to London's position in the world's time
zones. Sitting geographically between the centres in the Far East and USA, it is able to trade with both
during its working day (the Far East in the morning and the USA in the evening).
1.4 Financial intermediation

 Financial intermediation is a system whereby a person or more (usually a financial institution)
'mediates' between two other people or institutions in order to facilitate a transaction.
 E.g. a bank acts as an intermediary by borrowing money from the small lenders and 'repackaging' it so
that it suits the needs of the borrowers
 A financial intermediary performs the following functions
 Borrow varying amounts of money from lenders and reform them into an amount suitable for
the final borrower.
 Borrow various amount of money with different maturity dates and reform them into an
amount with a maturity suitable for the final borrower.
 The advantages of financial intermediaries in an economy are:
 Lenders do not have to search the markets for suitable borrowers.
 Borrowers do not have to search for lenders.
 Risk is reduced for lenders because if a borrower defaults, the risk has been borne by the
intermediary. The intermediary will pass on the costs of such risks to the lender as part of the
fee charged for services tendered; hence the loss is spread across all the lenders.
 The system allows for flexibility and individual lenders may be able to vary the terms on
which they have lent to the intermediary (perhaps by early redemption) without the
intermediary or final borrower being disadvantaged. This is possible because the
intermediary keeps reserves of cash or liquid investments that can be used in the event of a
potential shortfall.
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2 SOURCES OF FINANCE
2.1 Short term sources of finance
Bank overdraft
 A source of short-term funding which is used to fund fluctuating working capital requirements. Its great
advantage is that you only pay for that part of the finance that you need.
 The overdraft facility (total limit) is negotiated with the bank on a regular basis (maybe annually). For a
company with a healthy trading record it is normal for the overdraft facility to be ‘rolled over’ from one
year to the next although theoretically it is ‘repayable on demand’.
Bank loans
 Bank loans or term loans are loans over between one and three years which have become increasingly
popular over the past ten to fifteen years ‘as a bridge’ between overdraft financing and more permanent
funding.
Trade credit
 The delay of payment to suppliers is effectively a source of finance. By paying on credit terms the
company is able to ‘fund’ its stock of the material at the expense of its suppliers.
Factoring
 The outsourcing of the credit control department to a third party.
 The factor is often more successful at enforcing credit terms leading a lower level of debts outstanding.
Factoring is therefore not only a source of short-term finance but also an external means of controlling or
reducing the level of debtors.
Bills of exchange
 A means of payment whereby by a ‘promissory note’ is exchanged for goods.
 The bill of exchange is simply an agreement to pay a certain amount at a certain date in the future. No
interest is payable on the note but is implicit in the terms of the bill.
Invoice discounting
 Selected invoices are used as security against which the company may borrow funds. This is a
temporary source of finance repayable when the debt is cleared. The key advantage of invoice
discounting is that it is a confidential service, the customer need not know about it.
Leasing - short term

 Definition: A contract between a lessor and a lessee for the hire of a particular asset. The
lessor retains ownership of the asset, The lessee has the right to the use the asset for an
agreed period. In return the lessor receives specified rental income.
 Medium term (1-10 years)
 Types - Operating (short term), financing (long term)
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 Conditions Operating lease
 Lease period - less than the useful life of the asset. Lessor can lease it again or sell the asset
to cover his capital outlay and show a profit.
 Lessor’s business - The lessor may carry on a trade in this type of asset.
 Risks and rewards - The lessor is responsible for repairs and maintenance.
 Cancellation - The lease can sometimes be cancelled at short notice.
 Substance - The substance of the transaction is the short-term rental of the asset.
 Advantages
 Avoids having to pay the full cost of the asset up front, so don’t use up working capital or
have to borrow.
 Only pay for the asset over the fixed period of time that it is needed.
 Useful for equipment that needs regular replacement or updating, because only a short-term
contract.
 Easier to forecast cash flow as rates on monthly rental costs are usually fixed.
 Reduce tax bill by deducting the full cost of lease rentals from taxable income.
 No need to worry about an overdraft or other loan being withdrawn at short notice due to
changes in bank policy or personnel.
 Maintenance and other asset management service items can be written into lease.
 Since the lessor will either sell the asset in the second-hand market or lease it again at the
end of the agreed term, the lease payments can be kept low because the full asset value
does not need to be recovered by the lessor during the first term.
 Disadvantages
 Leases can be complex to understand.

 Tax on depreciation is not saved as the asset is not owned.
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2.2 Long term finance - Equity
Ordinary shares
 Characterictics
 Owning a share confers part ownership.

 High risk investments offering higher returns.
 Permanent financing.
 Post-tax appropriation of profit, not tax efficient.
 Marketable if listed
 Advantages
 No fixed charges (e.g. interest payments).

 No repayment required.
 Carries a higher return than loan finance.
 Shares in listed companies can be easily disposed of at a fair value.
 Disadvantages
 Issuing equity finance can be expensive in the case of a public issue 9see later).
 Problem of dilution of ownership if new shares issued.
 Dividends are not tax-deductible.
 A high proportion of equity can increase the overall cost of capital for the company.
 Shares in unlisted companies are difficult to value and sell.
Preference shares
 Characterictics
 Fixed dividend
 Paid in preference to (before) ordinary shares.
 No voting rights
 Not very popular, it is the worst of both worlds, ie
 not tax efficient

 no opportunity for capital gain (fixed return).
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2.3 Long term finance - Debt
Characteristics
 Debt is the loan of funds to a business without any ownership rights.
 Paid out as an expense of the business (pre-tax) and is tax deductible
 Security - The debtholder will normally require some form of security against which the funds are
advanced. This means that in the event of default the lender will be able to take assets in exchange of
the amounts owing.
 Covenants – The debtholders may demand certain covenants to be attached to the loan. These are
specific requirements or limitations laid down as a condition of taking on debt financing. They may
include
 Dividend restrictions -
 Financial ratios
 Financial reports
 Issue of further debt.
Bank finance
 For companies that are unlisted and for many listed companies the first port of call for borrowing money
would be the banks. These could be the high street banks or more likely for larger companies the large
number of merchant banks concentrating on ‘securitised lending’. This is a confidential agreement that is
by negotiation between both parties.
Bonds
 Bonds (debentures or loan notes) are debt instruments sold by the company, through a broker, to
investors
 Traded on stock markets like shares
 Usually denominated in blocks of $100
 Secured or unsecured
 Redeemable or irredeemable
 Interest is paid at a fixed rate on a nominal value
 Advantages
 Lower risk from perspective of investor

 Cheaper than equity
 No dilution of control
 Predictable cash flows
 Disadvantages
 No voting rights from perspective of investor

 Inflexible
 Increases gearing
 Must (normally) be repaid
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 Types of bonds
 Debenture - Debt secured with a charge against assets (either fixed or floating), low risk debt
offering the lowest return of commercially issued debt.
 Unsecured loans - No security meaning the debt is more risky requiring a higher return.
 Mezzanine finance - High risk finance raised by companies with limited or no track record
and for which no other source of debt finance is available. A typical use is to fund a
management buy-out.
 Warrants – option to buy shares at a specified point in the future for exercise price
 Convertible loan stock – bond can be converted into the shares of the Company
2.4 Other long term finance
Venture capital
 Provision of risk-bearing capital, usually in the form of equity, to high-growth potential companies.
Venture capitalists will assess a potential investment on the basis of:
 Financial outlook
 Management credibility
 Depth of market research
 Degree of influence offered, e.g. board seat or controlling stake
 Exit route
Leasing – long term

 The key difference between an operating lease (short term) and a finance lease (medium to long term) is
that the former equates to renting an asset whereas the latter equates to borrowing money in order to
purchase the asset.
 Lease period—useful life of asset or primary and secondary periods
 Risks / rewards—Lesee retains; responsible for repairs and maintenance
 Cancellation—usually not cancellable. Lessee has a liability for all payments.
 Substance—medium to long term debt
Sales and lease back

 Selling good quality fixed assets such as high street buildings and leasing them back over many (25+)
years.
 Funds are released without any loss of use of assets.
 Any potential capital gain on assets is forgone.
 Company should not sale and lease back core assets
Grants
 Often related to regional assistance, job creation or for high tech companies.
 Important to small and medium sized businesses (ie unlisted).
 They do not need to be paid back.
 Remember the EU is a major provider of loans.
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Retained earnings
 For most business is the use of retained earnings the core basis of their funding.
 Advantages
 Cheap and quick to raise

 No transaction cost
 No professional assistance
 No time delay
2.5 Criteria for choosing between debt and equity

 Cost: Debt is usually cheaper than equity (debt is tax deductible for a Company and less risky than equity
for investors)
 Control: When debt is issued, there is no impact on ownership structure (shareholdings are not diluted).
 Maturity/ Duration: Long-term finance is more expensive, but more secure than short-term. Firms usually
match the duration to the assets purchased. Equity is not repaid, debt is repaid.
 Term structure: The term structure of interest rates. Usually short-term is cheaper – but not always (see
Yield curve CH 13 Interest rate risk
 Gearing: Debt is cheaper than equity, therefore introduction of debt into capital structure decreases
WACC. But presence of debt within capital structure increases gearing (and therefore financial risk), thus
WACC might increase in at higher level of gearings (see CH 6 Capital structure theories)but increases
overall gearing and financial risk
 Availability: Not all sources are available to all firms To raise equity for SME is difficult.
 Issuance cost: To issue shares will be more expensive than to take bank loan.
EXAM TIP
The above provides a useful checklist of headings for an examinations question that asks you to consider different
types of finance. See also Article by William Parrot at the end of this Chapter.
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3 SMALL AND MEDIUM ENTITIES (SME)
Characteristics
 Unquoted
 Owned by small number of individuals
 They act as a medium for self-employment of the owners
Problems of financing for an SME

 SME may not know about the sources of finance
 SME are considered more risky. This is a particular issue for newer businesses which may:
 lack proper financial control systems

 have inexperienced management teams
 not have an established track record
 lack sufficient good quality assets to offer as security (it is common for the owners of the
business to be asked for personal guarantees)
 Lack of security
Sources of finance for SME

 Owner financing – initial source of finance. At this stage many assets are intangible and
therefore it is difficult to obtain external financing
 Overdraft financing
 Bank loans
 Trade credit
 Equity finance
 Equity gap – difficulty obtaining equity finance when the business is formed
 Once established, shares can be placed privately but it may be difficult to obtain large sums
by this means
 SMEs cannot offer easy exit routes for investors who wish to sell their stake
 Business angel financing
 Business angels – individuals who invest directly in small businesses
 Less formal than other financing – advantage: less disclosures and regulations, more
flexibility, disadvantage: difficult to set up, limited funds available
 May be consortium of angels
 Venture capital - risk-bearing capital to companies with high growth potential
 Leasing
 Factoring
 Crowdfunding
 Supply chain financing
 Peer-to-peer funding
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Government solutions for SME

 Governments have adopted a two-pronged response to increasing the attractiveness of SMEs:
 increasing marketability of shares
- SMEs usually do not fulfil the profitability/track record requirements to obtain a full stock
exchange listing.
- The development of small firm markets (e.g. AIM in the UK, the Growth Enterprise
Market (GEM) in Hong Kong), is designed to bridge this gap and provide both an exit
ground and a venue for further fund-raising for investments.
 tax incentives for investors

- The Enterprise Investment Scheme (EIS) – offers tax incentives for individuals making
equity investments in unquoted trading companies.
- Venture Capital Trusts (VCTs) – listed investment trust companies that invest their
funds in a spread of small unquoted trading companies. Tax relief is granted to
individuals who invest in VCTs.
- Employee share incentive schemes.
- Increasing profits and attractiveness by reducing rates of corporation tax for small
companies, and increasing the sales tax registration threshold.
 Specific forms of assistance

 business links – a largely government-funded service that provides information, advice and
support to those wishing to start, maintain and grow a business
 financial assistance:
- loan guarantees
- grants
- loans
Note:
While you are not expected to have a detailed knowledge of particular government schemes, you should have a
general awareness of the type of assistance offered and describe schemes at least in one country.
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4 ISLAMIC FINANCE
4.1 Basic principles

 Islamic finance has the same purpose as conventional finance but it operates in accordance with the
principles of Islamic law (Sharia law).
 The basic principles covered by Islamic finance include:
 Sharing of profits and losses
 Risk should be shared
 No interest (riba) allowed
 Wealth must be generated from asset investment activities (using money to make
money is forbidden). Returns are earned by channeling funds into an underlying
investment activity, which will earn profit. The investor is rewarded by a share in
that profit, after a management fee is deducted by the bank.
 Finance is restricted to Islamically accepted transactions
 No investment in alcohol, gambling, pork related products and other socially

detrimental activities
 Speculation is also prohibited (so instruments such as options and futures are not
allowed)
 Ethical and moral investing is encouraged
 Investment should also have social and ethical benefit to the wider society beyond pure
return
4.2 How returns are earned

 Riba is defined as the excess paid by the borrower over the original capital borrowed i.e. the equivalent
to interest on a loan. Its literal translation is 'excess'.
 Within the conventional banking system, a bank gets access to funds by offering interest to depositors. It
will then apply those funds by lending money, on which it charges interest. The bank makes a profit by
charging more interest on the money it lends than it pay to its depositors.
 This process is outlawed under Islamic finance:
 The money provided by depositors is not lent, but is instead channelled into an underlying
investment activity, which will earn profit.
 The depositor is rewarded by a share in that profit, after a management fee is deducted by
the bank.
 For example, in an Islamic mortgage transaction, instead of loaning the buyer money to
purchase the item, a bank might buy the item itself from the seller, and resell it to the buyer at
a profit, while allowing the buyer to pay the bank in instalments. However, the bank's profit
cannot be made explicit and therefore there are no additional penalties for late payment. In
effect, the interest is replaced with cash flows from productive sources, such as returns from
wealth generating investment activities and operations. These include profits from trading in
real assets and cash flows from the transfer of the right to use an asset (for example, rent).
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4.3 Islamic sources of finance compliant with Sharia

Murabaha – trade credit
 The sale price of goods is agreed to cover all costs and generate a profit margin. The time value of
money is incorporated in the costs. There is a reassurance that the ‘credit’ is based on trade and not
simply a financing transaction.
Mudaraba – equity finance
 A profit sharing contract where one party provides capital and the other the expertise to invest the capital
and manage the activities. There is a pre-agreed ratio of profit share.
Musharaka – venture capital
 Has more in common with a joint venture than an equity investment. All (or most) investors will have an
active role in managing the business. ‘Diminishing musharaka’ allows for business ownership to
gradually be transferred over a period of time to a single owner, in a similar way to venture capitalists
creating an exit strategy based upon sale of shares.
Ijara – lease finance
 A bank makes an asset available to a customer for a fixed period in exchange for a fixed price. At the
end of the period, the customer often has the option to pay a fixed price in return for transfer of ownership
of the asset from the bank.
Sukuk (debt finance)
 Conventional finance: a company can issue tradable financial instruments to borrow money. Key
features of these debt instruments:
 Don’t give voting rights in the company
 Give a right to profits before distribution of profits to shareholders
 May include securities and guarantees over assets
 Include interest based elements
 Islamic finance: All of the above are prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are
linked to an underlying asset, such that a sukuk holder is a partial owner in the underlying assets, and
profit is linked to the performance of the underlying asset. So for example a sukuk holder 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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5 DIVIDEND POLICY
5.1 The dividend decision

Retained earnings are an important source of finance.. They have no issue costs, they are flexible (they don't need
to be applied for or repaid) and they don't result in dilution of control.
However, the higher proportion of retained earnings used as a source of finance, the lower proportion will be paid as
dividends to shareholders.
So if a company chooses to fund a new investment by a cut in the dividend, what will the impact be on existing
shareholders and the share price of the company?
5.2 Theories on dividend policy

Underlying question is: Is there any link between dividends paid and MV of the share?
Dividend irrelevancy theory (Modigliani and Miller)

There is no link between dividend policy and MV of Company (division of retained earnings between new
investment and dividend payments does not influence the value of Co/ MV of share)
Assumptions: perfect capital market (no taxation, no transaction costs, no market imperfections).
Shareholders wealth increases through dividend and capital gain (increased MV of share) and shareholder is
indifferent into which way his wealth will increase. Because:
If the Company pays dividend (and still has project with NPV>0 to invest in), the Company will have to issue a new
equity to get money for profitable projects.
Shareholder who prefers capital gain (and therefore retention/re-investment of profits), but gets dividends, will use
cash from dividends to buy more shares of Co (and the Co will have to issue new shares as it needs to get new
finance for projects with NPV>0, as the Co paid the dividends)
If the Company does not pay dividend (retains/ reinvests internally generated profits in projects with positive NPVs
and hence increasing MV of the Company and share) and there is a shareholder who prefers dividend over capital
gain, the shareholder can sell some shares for cash to "manufacture" dividend.
Residual theory
There is a link between dividends paid and MV of the share, but total value of dividends is important not the
pattern at which they are paid.
Assumptions: There are costs involved in raising new finance, but no taxation, no market imperfections.
Market value of a share equals the present value of the future dividends (see Ch5 Cost of capital). Provided the
present value of the dividend remains the same, the timing of the dividend payments is irrelevant.
Therefore the Co should pay dividend only if there are no projects with positive NPV. Retentions should be used for
project finance with dividends as a residual.
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Example 1 – Residual theoty (illustrated)

A firm pays out a constant dividend of 10c in perpetuity. Its cost of equity is 10%. The value of the dividend stream to
an investor is:
10
 100c
0 .1
They would need to cancel the T1 dividend of 10c to pay for it.
The project should earn 10% return, i.e. the 10c would be worth 10 × 1.1 = 11c the following year.
Provided the firm then distributed the additional 11c, the shareholder would have:
T1 T2 T3 T4 T5
0 10+11 10 10 10  perpetuity
10
11
PV  0.1  2  100 c
1.1 1.1
So in theory, provided the firm invests the withheld dividend in projects that at least earn the shareholders’ required
return, the investors’ wealth is unchanged and they will not object.
Dividends become residual – firms only pay a dividend if there are earnings remaining after all positive NPV projects
have been financed.
Dividend relevance
Yes, there is a link between dividend policy and MV of share
Practical influences, including market imperfections, mean that changes in dividend policy, particularly reductions in
dividends paid, can have an adverse effect on shareholder wealth:
 Reductions in dividend signs bad news to shareholders (dividend signaling).
 Changes in dividend policy, particularly reductions, may conflict with investor liquidity requirements.
 Taxes – capital gain and dividend income is taxed differently, therefore some investors prefer capital gain
and the other dividend. Any dividend policy will attract certain group of investors (clientele effect).
Therefore the companies tend to adopt a stable dividend policy and keep shareholders informed of any changes.
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5.3 Other practical constraints
Legal restrictions on dividend payments

 Rules on distributable profits that prevent excess cash distributions.
 Bond and loan agreements may contain covenants that restrict the amount of dividends a firm can pay.
 Such limitations protect creditors by restricting a firm’s ability to transfer wealth from bondholders to
shareholders by paying excessive dividends.
Liquidity
 Consider availability of cash, not just to fund the dividend but also cash needed for the continuing
working capital requirements of the company.
Shareholders expectations
 For quoted Cos the shareholders may expect to receive divs on a regular basis. If not met, MV of share
can be adversely influence and the Co might have difficulty to raise the equity in the future.
5.4 Alternatives to cash dividends
Share repurchase
 Consider using cash to buy back shares as an alternative to a dividend, particularly if surplus cash
available would distort normal dividend policy.
 Alternative is to pay a one-off surplus as a 'special dividend'.
Scrip dividends
 A scrip dividend is where a company allows its shareholders to take their dividends in the form of new
shares rather than cash.
 The advantage to the shareholder of a scrip dividend is that he can painlessly increase his
shareholding in the company without having to pay a broker’s commissions or stamp duty on
a share purchase.
 The advantage to the company is that it does not have to find the cash to pay a dividend and
in certain circumstances it can save tax.
 A bonus (scrip) issue is a method of altering the share capital without raising cash. It is done by
changing the company’s reserves into share capital.
 The rate of a bonus issue is normally expressed in terms of the number of new shares issued
for each existing share held, e.g. one for two (one new share for each two shares currently
held).
 Do not confuse a scrip issue (which is a bonus issue) with a scrip dividend
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C H A P T E R 4 – S O U R C E S O F F IN A N C E
6 ARTICLE - W. PARROT - FINANCING ALTERNATIVES
Analysing suitability of financing alternatives

The requirement to analyse suitable financing alternatives for a company has been common in Paper F9 over the
years. Indeed, it was examined again in December 2010 and will, I am sure, be examined again in the future. This is
a key area in the Paper F9 syllabus and the requirement can be worth a significant amount of marks – for example,
15 marks in Question 2 of the December 2010 exam.
Unfortunately, many students struggle with questions of this nature and do not seem to know how to produce a good
answer. This article will suggest an approach that students could use and will then finish with a worked example to
demonstrate the technique discussed.
Financial performance and position

When considering the source of finance to be used by a company, the recent financial performance, the current
financial position and the expected future financial performance of the company needs to be taken into account.
Within an exam question, the ability to do this will be restricted by the information available. In some questions,
details of recent performance and the current situation may be provided, while in other questions the current situation
and forecasts may be provided.
Evaluating financial performance

Whether you are evaluating recent or forecast financial performance, key areas to consider include the growth in
turnover, the growth in operating profit, the growth in profit after or before tax and the movement in profit margins.
Return on capital employed and return on equity could be calculated. A key point for students to remember is that
they only have limited time and it is better to calculate a few key ratios and then move on and complete the question
than it is to calculate all possible ratios and fail to satisfy the requirement.
Evaluating the current financial position

The key consideration when evaluating the current financial position is to establish the financial risk of the company.
Hence, the key ratios to calculate are the financial gearing, which shows the financial risk using data from the
statement of financial position and interest cover, which shows the financial risk using data from the income
statement. Equally, the split between short and long-term financing, and the reliance of the company on overdraft
finance, should also be considered.
When evaluating financial performance and financial position, due consideration should be given to any comparative
sector data provided. Indeed, if no such data is provided, I would recommend that you state in your answer that you
would want to consider such comparative data. This is what you would do in real life and stating it shows that you are
aware of this. If the examiner has not provided such data, it is simply because he is constrained by the need to
examine many topics in just three hours.
Recommendation of a suitable financing method

When recommending a financing method, consideration should be given to a number of factors. These factors are
key to justifying your choice of method and the examiner has in the past asked students to discuss these factors in
an exam question. The factors include:
Cost – Debt finance is cheaper than equity finance and so if the company has the capacity to take on more debt, it
could have a cost advantage.
Cash flows – While debt finance is cheaper than equity finance, it places on the company the obligation to pay out
cash in the form of interest. Failure to pay this interest can result in action being taken to wind up the company.
Hence, consideration should be given to the ability of the company to generate cash. If the company is currently
cash-generating, then it should be able to pay its interest and debt finance could be a good choice. If the company is
currently using cash because it is investing heavily in research and development for example, then the cash may not
be available to service interest payments and the company would be better to use equity finance. The equity
providers may be willing to accept little or no cash return in the short term, but will instead hope to benefit from capital
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C H A P T E R 4 – S O U R C E S O F F IN A N C E
growth or enhanced dividends once the investment currently taking place bears fruit. Also, equity providers cannot take action to
wind up a company if it fails to pay the dividend expected.
Risk – The directors of the company must control the total risk of the company and keep it at a level where the shareholders and
other key stakeholders are content. Total risk is made up of the financial risk and the business risk. Hence, if it is clear that the
business risk is going to rise – for example, because the company is diversifying into riskier areas or because the operating
gearing is increasing – then the company may seek to reduce its financial risk. The reverse is also true – if business risk is
expected to fall, then the company may be happy to accept more financial risk.
Security and covenants – If debt is to be raised, security may be required. From the data given it should be possible to
establish whether suitable security may be available. Covenants, such as those that impose an obligation on the company to
maintain a certain liquidity level, may be required by debt providers and directors must consider if they will be willing to live with
such covenants prior to taking on the debt.
Availability – The likely availability of finance must also be considered when recommending a suitable finance source. For
instance, a small or mediumsized unlisted company will always find raising equity difficult and, if you consider that the company
requires more equity, you must be able to suggest potential sources, such as venture capitalists or business angels, and be
aware of the drawbacks of such sources. Furthermore, if the recent or forecast financial performance is poor, all providers are
likely to be wary of investing.
Maturity – The basic rule is that the term of the finance should match the term of the need (the matching principle). Hence, a
short-term project should be financed with short-term finance. However, this basic rule can be flexed. For instance, if the project
is short term – but other short-term opportunities are expected to arise in the future – the use of longer term finance could be
justified.
Students should always consider the maturity dates of debt finance in questions of this nature as it is an area the Paper F9
examiner likes to explore. For instance, in Question 2 of the December 2010 exam the company was considering raising more
finance but at the same time the existing long-term borrowings were scheduled to mature in just two years and, hence,
consideration needed to be given to this issue. Equally, in previous questions, a company had been considering raising finance
for a period of perhaps eight years and an examination of the company’s statement of financial position shows that the existing
debt of the company would also mature in eight years. Obviously it is unwise for a company to have all its debt maturing at once
as repayment would put a considerable cash strain on the company. If the debt could not be repaid, but was to be refinanced,
this could be problematic if the economic conditions prevailing made refinancing difficult.
Control – If debt is raised then there will be no change in control. However, if equity is raised control may change. Students
should also recognise that a rights issue will only cause a change in control if shareholders sell their rights to other investors.
Costs and ease of issue – Debt finance is generally both cheaper and easier to raise than equity and, hence, a company will
often raise debt rather than equity. Raising equity is often difficult, time-consuming and costly.
The yield curve – Consideration should be given to the term structure of interest rates. For instance, if the curve is becoming
steeper this shows an expectation that interest rates will rise in the future. In these circumstances, a company may become more
wary of borrowing additional debt or may prefer to raise fixed rate debt, or may look to hedge the interest rate risk in some way.
While this list is not meant to be exhaustive, it hopefully provides much for students to think about. Students should not
necessarily expect to use all the factors in an answer.
Suitable financing sources

Students must ensure that they can suggest suitable financing sources. For each source, students should know how and when it
could be raised, the nature of the finance and its potential advantages and disadvantages. Combined with a consideration of the
factors given above, this knowledge will allow students to recommend and justify a source of finance for any particular scenario.
A discussion of each finance source is outside the scope of this article, but students can read up on this area in any good study
man.
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C H A P T ER 5 – C O S T O F C A P I T A L
Chapter 5
Cost of capital
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CHAPTER 5 – COST OF CAPITAL
1 BASICS OF COST OF CAPITAL

Definition: Cost of capital is the rate of return that the company has to pay to satisfy providers of funds,
and it reflects the riskiness of providing funds.
Aspects
 ‘Cost of capital’ is the return the company has to pay for each source of its finance:
 Interest for debt capital
 Dividend for share capital
 The company uses funds for its investments, therefore the cost of capital represents the minimum
return that the company needs to receive on its investments. The cost of capital is used as the discount
rate for project appraisal which we saw earlier.
 Distinguish between:
 Cost of individual forms of capital (bond, bank loan, ordinary share, preference share)
 Weighted average cost of capital (total average cost of capital used for investment appraisal)
Cost of capital and risk

 Risk free rate of return (required from risk-free investment. In the exam it could be given as a return on
treasury bills, return of government gilts, etc.)
 Premium for risk:
 Business risk – Uncertainty about the company’s business prospects (volatility of their
earnings)
 Financial risk – The risk from a company taking on more debt and increasing its gearing
Required return = risk free rate + risk premium
Cost of sources of finance

 Sources of finance (cheap  expensive)
1. Secured lenders (cheapest)

2. Legally protected creditors (tax authorities)
3. Unsecured creditors
4. Preference shareholders
5. Ordinary shareholders (most expensive)
 Notes
 The cost of government bonds are cheaper than loan notes as the government will always
raise funds to repay (in theory)
 The cost of loan notes is cheaper than that of ordinary share capital as there is legal
commitment to pay interest and the creditor has priority if the company goes into liquidation.
Interest is also tax deductible.
 The cost of ordinary share capital is expensive as a dividend is paid only if cash is left after
payments of interest, and ordinary shareholders are paid last in the event of a company
liquidation.
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2 COST OF EQUITY
The rate of return required by a shareholder. This may be calculated in one of two ways:
1. Dividend Valuation Model (DVM).
2. Capital Asset Pricing Model (CAPM).
2.1 Dividend valuation model (DVM)
Fundamental theory of securities

 The market value of a security equals to the present value of the future cash flows resulting from
ownership of that security.
Fundamental theory applied on shares

 SHARES SPECIFICS
 We assume that a share lives into infinity if the company is a going concern.
 Therefore the only relevant cash flow (CF) resulting from a share is its dividend
Therefore MV of a share equals to the present value of the discounted DIVIDENDS (and it goes to INFINITY). Using
equation:
D D
MV  1  2  .... Dn  ...     = TOTAL? (Does not exist)
(1  i) (1  i) 2 (1  i) n
Dn… Dividend in year n

i… cost of equity
If dividend fluctuates, it is not mathematically possible to make a TOTAL of discounted dividends (and therefore to
calculate MV of share). Therefore we consider only 2 specific cases – Dividend is constant to infinity (for preference
shares) or Dividend is growing by constant g to infinity (for ordinary shares).
Constant dividend into infinity

D D D D
MV    .... n  ...  REMEMBER THIS FORMULA
(1  i) (1  i) 2 (1  i) i
 In exam this will be typically formulated for preference shares
Growing dividend into infinity

D 1  g  D 1  g 2 D 1  g n D 1  g 
MV  0  0  ....  0  ...      0
(1  i) (1  i) 2 (1  i) n i g
D
MV  1 GIVEN IN EXAM FORMULA SHEET
i g
D1 ..............dividend expected at the end of Y 1 : D0(1+g)
g ................constant rate of growth expressed as a decimal
 In the exam this will be typically formulated for ordinary shares
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Example 1 – Cost of preference shares (dividend is constant)

A company issued 5% 1$ preference shares, they are currently traded at the market value of $2.50.
Required: Estimate the cost of preference shares.
Example 2 – Cost of ordinary shares (dividend grows by g)

A company issued shares with a nominal value of $1,000 for a price of $1,200 (MV). The dividend at the end of Y1 is
$150. The expected dividend growth is 2% pa.
Required: Estimate the cost of shares.
Wording!!!
Dividend in the formula MUST be the value of dividend at the end of Y1. So if wording is: Company has just paid
dividend of $140, then 140 is dividend NOW (D0) and in formula D1=140x(1+2%)
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Estimating growth rate g

 Analysis of the past dividends - estimate average growth per year
D  D (1  g)Ym Yn
Yn Ym
If you are given dividends in 2006, 2007, 2008, 2009 and you are asked to estimate the dividend for year 2010, take
the longest period available (2006  2009) as this gives you the most representative result.
 Gordon’s growth approximation
g  b r EXAM FORMULA SHEET
g … annual growth rate of dividend

b … proportion of profits that are retained in the business
r … return on equity (estimated as PAT/Equity)
Example 3 – Growth - past dividends

Dividends have risen from $150 in X0 to $188 in X4. Required: Estimate the average growth per year.
Example 4 – Growth - Gordon’s growth model

A company is about to pay an ordinary dividend of 20c a share. The share price is 300c. The return on equity is 14%
and 20% of earnings are paid out as dividends.
Required: Calculate the cost of equity for the company.
WORDING!!! ABOUT TO PAY means WILL BE PAID TOMORROW  20c is Div NOW (D0), but MV of 300c
includes Div (MV cum div) .Therefore 20c is deducted from MV, as MV in the formula must be ex-div  see also the
paragraph below: Ex div share price
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Weaknesses of DVM
 Does not incorporate risk (CAPM does incorporate risk)
 Ignores capital gains
 Input could be inaccurate
 Current market price ( can be subject to short term influences by market – eg mergers)
 Does not reflect future dividend patterns (formula assumes constant dividend or growth into
infinity)
Ex-div share price, Cum-div share price

 The price of a share fluctuates based on dividend payments
 Share prices in the model are considered ex-div (i.e. after the dividend payment has been made)
 If the share price is given cum div, the dividend in time 0 must be deducted to get the ex div share price
WORDING!!!
Company is ABOUT TO PAY div of 20c means div WILL BE PAID TOMORROW  20c is Div NOW (D0), but MV
includes Div (MV cum div) .Therefore 20c is deducted from MV, as MV in the formula must be ex-div.
Company HAS JUST PAID div of 20c means that div WAS PAID  Div of 20c is DIV NOW (D0), but MV is ex div
Example 5 – Market Value ex div versus cum div

Shareholders expect dividends to grow at 6% pa. The company’s current share price is $1.30.
Required: Calculate cost of equity if:
A/ A company is about to pay a dividend of 25c. B/ A company has just paid dividend of 25c
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2.2 The Capital Asset Pricing Model (CAPM)

CAPM is a tool used to calculate a cost of equity which incorporates risk. It is based on the comparison of the
systematic risk of individual investments with the risk of all shares in the market. (Eg: What return the shareholder
should require on share I, if he knows that share I is twice more risky then share M - with known risk and return).
Note that return for the shareholder is cost of the share for issuing company.
Relationship between return and risk

 Investors expect higher returns for investments of higher risk.
return
Rm
M
Ri I
Rf
σi σm risk σ
M…………market portfolio
Rm……………..return of market portfolio
m..............risk of market portfolio/market risk (average risk of the market)
Rf ...............risk free rate of return (risk=0)
I .................individual portfolio with risk σ i and return Ri
 The line is called the capital market line (CML). Equation of CML (for individual portfolio I with risk
 i and required return Ri) from the picture is
Rm  Rf
Ri   σi  R f
σm
σi
It can be rewritten as R  (Rm  R f )   R f ,
i σm
 (Rm-Rf) is called the market risk premium and is the excess of market returns over those associated
with investing in risk free assets
i
 is defined as  coefficient. It is the ratio between the risk of an individual portfolio and the risk of
t
the market portfolio.  coefficient is published for listed companies.
 The formula is then rewritten as Ri = Rf + (Rm-Rf)  given in EXAM FORMULA SHEET
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Beta values
 If the risk of individual portfolio I is lower than risk of the market portfolio M (  i   m ):
 1
 risk premium of individual investment < market risk premium
 If the risk of individual portfolio I is higher than risk of market portfolio M (  i   m ):

 1
 risk premium of individual investment > market risk premium
 If the risk of individual portfolio I is same as risk of market portfolio M (  i m )

 =1
 risk premium of individual investment = market risk premium
m
 β Coefficient of the market portfolio is 1 (β = )
m
Example 6 – Cost of equity using CAPM
The shares of Castle Co. have an equity  = 0.81. The return on government debentures is 3% (the risk free rate) and
average market return is 9%.
Required: Estimate the cost of capital for Castle Co.
Example 7 – Cost of equity using CAPM
Average returns on the market are 14%, the risk free rate of return is 9%. The equity  of Lajka’s shares is 1.3.
Required: Estimate cost of equity for Lajka.
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Systematic and unsystematic risk of portfolio (Portfolio

theory)
The basis of portfolio theory is that an investor may reduce risk with no impact on return as a result of holding a mix of
investments.
Risk
unsystematic risk
systematic risk
# of investments in portfolio
 unsystematic (business) risk

 specific for project/business
 can be diversified away
 systematic risk (market, inherent)

 risks common to all investors
 can not be diversified away
 A poorly diversified portfolio is exposed to both systematic and unsystematic risk

A well-diversified portfolio is exposed only to systematic risk (unsystematic risk = 0)
 CAPM takes into account systematic risk only, as it assumes that investors have diversified
unsystematic risk away
Systematic vs. unsystematic

 If a risk averse-investor expects to earn returns higher than the risk-free rate, he needs to take
systematic risk. If he wants to avoid risk altogether, he would only invest in risk-free securities
 If an investor holds shares in just a few companies, there will be some unsystematic risk
 If an investor holds a balanced portfolio, he will incur a level of systematic risk equal to the average
systematic risk in stock market as a whole.
 Shares in individual companies have different levels of systematic risk characteristics to the market
average (higher, lower, or the same)
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CAPM and Beta

 Beta measures a share’s volatility in terms of market risk (a measure of the systematic risk of a security
relative to that of the market average. If share price were to rise or fall at double the market rate, the beta
is 2)
 CAPM considers the following:
 Equity investors require a return in excess of the risk free rate to compensate for systematic
risk
 Investors do not require a premium for unsystematic risk as it can be diversified away
 Systematic risk varies between companies. Therefore investors require a higher return from
shares in companies where the systematic risk is bigger.
 An assumption of CAPM: there is a linear relationship between the returns of a company and the returns
of the market.
Problems with applying CAPM in practice

 Unrealistic assumptions
 assumes no transaction costs associated with trading securities
 assumes well diversified portfolio, but as stocks change over time it is very likely that the
portfolio becomes less than optimal
 The required estimates are difficult to make:

 Determining the excess return (expected rather than historical figures should be used)
 Determining the risk free rate (many vary with the duration of lending)
 There can be errors in the statistical analysis used to calculate  values.  can also change
over time
 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.
Formula in Exam Formulae Sheet
E(ri )  R f  β i (E(rm )  R f )
E (r) stands for EXPECTED VALUES as r m given in exam is “average” for many shares in portfolio. If you delete E,
you will recognize the formula.
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3 COST OF DEBT
 Cost of debt for the Company is a rate return required by providers of debt finance. The Company pays
fixed interest on its debt. As interest is tax deductible, there will be reduction in tax payments for the
Company (called tax shield))
 We will consider 4 types of debt capital:
 Bank loan (not traded debt)
 Bonds (loan stock, lone note, debentures - synonyms) – traded debt
 Irredeemable – never paid back

 Redeemable at par (at nominal value) or a premium
 Convertible (to a specified number of shares).
Bank loan
𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 ∙ (1 − 𝑇)
i .................cost of debt
T ................tax rate
Example 8 – Cost of bank loan (llustrated)
A Company can receive a loan of $10 m for 18% pa. The corporate tax rate is 25%.
Required: Estimate the cost of the loan for a Company?
I = 18% × 0.75 = 13.5%
For marketable securities such as bonds (debentures/ loan stock/ loan notes), the logic is the same as for
shares (FUNDAMENTAL THEORY OF SECURITIES): the market value of the security is the present value of
its future cash flows. Relevant cash flows for bonds will be typically interest payment each year and
repayment of principal at the end (redemption value)
Bond - redeemable
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎 𝑁

𝑀𝑉 = + + ⋯+ +
(1 + 𝑖) (1 + 𝑖)2 (1 + 𝑖)𝑛 (1 + 𝑖)𝑛
Interest pa. interest from bond payable at the end of each year, it is constant
i .................required rate of return (cost of capital
N................amount payable on redemption at the end of year n (if redeemed at par  means at nominal value)
MV .............MV of bond
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Example 9 – Cost of redeemable bond

A Company issues 8% 100$ bond redeemable in 5 years at premium of 5%. Market value of bond is $94. The tax rate
is 30%.
Required: Estimate after tax cost of bond to a Company.
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Irredeemable bond
Irredeemable bonds are never redeemed, it means the Company pays fixed amount of interest per year into infinity
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎

𝑀𝑉 = + + ⋯+ + ⋯ −→ ∞ = (perpetuity)
(1+𝑖) (1+𝑖)2 (1+𝑖)𝑛 𝑖
If tax is considered:
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 ∙ (1 − 𝑇)
𝑀𝑉 =
𝑖
Interest pa – interest paid each year

i – cost of bond
MV – market value of bond
Example 10 – Cost of irredeemable bond
Company’s 9% 100$ irredeemable bonds are currently trading at $140. Tax rate is 20%.
Required: Estimate after tax cost bond to the Company?
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Convertible bond
Convertible bond is a bond with option to convert the bond into the shares of Company in the future. Holder of
convertible bond has the option to convert or not, and if he acts logically, he will choose the option which gives him
higher value. Thus he has 2 options:
A/ TO REDEEM THE BOND (he gets the cash)
B/ TO CONVERT THE BOND (he gets shares)
1. To identify last cashflow from the bond, calculate the cash redemption value (he gets cash) and the share
redemption value (conversion value) (he gets shares)
n
conversion value (share redemption value)  MV of share now(1  g) * # of shares
2. Based on the assumption that investors are acting rationally, take HIGHER of redemption and
conversion value.
Example 11 - Cost of convertible bond

A company has in issue 8% convertible loan notes which are due to be redeemed at a 5% premium in five year time.
The face value of the convertible loan is $100 (this might not be stated in the exam – all $ debentures have a face
value $100). The current market value is $85.
Instead of the redemption payment, the investor can choose to convert each loan note into 20 shares on the same
date. The company pays tax at 30% per annum. The company’s shares are currently worth $4 and their value is
expected to grow at a rate of 7% pa.
Required: Find the cost of the convertible debt to the company.
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How to deal with tax – summary

Questions in the exam might be formulated in 2 different ways:
1. What is the COST OF CAPITAL? or
2. What is the MARKET VALUE of the security?
The logic and formulas are the same, but depending on the question:
1. express i from the formula, or
2. express MV from the formula
If the security is DEBT (e.g. a debenture, loan stock)  how to reflect TAX effect?
1. If the Question is: What is the cost of capital ? REFLECT TAX IN INTEREST PAYMENTS (as this is seen
from the side of the issuing company and interest is tax deductible). Therefore Cost of capital (i) that you get out of
the equation will be AFTER TAX already.
2. If the Question is What is the MV?  NO TAX is reflected in interest payments (as this is seen from the side of
investor, interest is income for investor, it is not tax deductible, but taxable… ) Cost of capital (i) used for discounting
of interest payments and final value must be BEFORE TAX (as interest payment are before tax).
Example 12 – MV of bond (Illustrated)
12 Illustration – MV of redeemable debentures (same as illustration 10), but different question!
Co issue 1000 debentures, face value $100, redeemable at par in 5 years, coupon rate 18%. Tax rate 35%. Cost of
capital is 15%. What is market value of security?
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4 WACC – WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (WACC) is the average of cost of the company’s finance (equity, loan notes, bank
loans, preference shares) weighted according to the proportion each element bears to the total funds.
WACC as a base for the discount rate for investment appraisal

A company’s WACC can be regarded as its opportunity cost of capital/marginal cost of capital, and this cost of capital
can be used as discount rate to evaluate the company’s investment projects if the following conditions apply:
1. The Company adopts a ‘pooled funds’ approach and:
i) The project has the same degree of systematic (business) risk as the company has now (project is
within the same area of business)
ii) Project under consideration is financed by the same proportion of equity and debt as is capital structure
of the Company (i.e. same financial risk)
2. or the project is insignificant relative to the size of the company;
If conditions are not met, the WACC must be adjusted to reflect the different risk and capital structure of funds. (see
Chapter 6)
WACC - calculation
The average cost of the company’s finance (e.g equity, debentures, bank loans, etc), weighted in proportion of
market value to the total pool of capital.
General formula (given in exam formula sheet)

Ve Vd
WACC   ke   k (1 T)
Ve V Ve V d
d d
ke …cost of equity
kd (1-T)… cost of debt after tax
Ve … value of equity in the firm
Vd … value of debt
T… tax
Note 1
There could be more types of capital than just two (as shown in the formula). If there are for e.g.:
 preference shares (market value PS, cost of capital Ips)
 ordinary shares (market value OS, cost of capital Ios)
 debenture (market value D, cost of capital Id)
then formula would be:
PS OS D
WACC   I ps   I os   I  (1 T)
PS  OS  D PS  OS  D PS  OS  D D
Note 2
(1-T) means that cost of capital for debt is considered after tax
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Weights for sources of finance

 Book values (represents the historic cost of finance). Less relevant than market value.
 Market values. Market values are preferred as they incorporate risk. The reserves of share premium and retained
profit are ignored as they are in effect already incorporated in the market value of equity. Always use market value in
your exam (unless specifically asked to do so otherwise).
Example 13 – MV or BV?
The capital structure of a company is (at book value): $1 ordinary shares total $2m, reserves of $3m, 10% 100$ loan notes total
$1m
MVs are as follows: ordinary shares: $3,75 each ex div, loan notes: $80 each
Cost of equity is 20%, cost of debt is 7,5% (after tax).
Required: Calculate WACC using: a) book value as weights b) market value as weights.
Example 14 - WACC formula

A company has the following capital structure: ordinary shares with a market value of $60m and a cost of equity of 18%, a $10m
bank loan with an interest rate of 15% pa. The tax rate is 25%
Required: Calculate WACC
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C H A P T ER 6 – R I S K A D J U S T ED W A C C
Chapter 6
Risk Adjusted WACC and

Capital Structure
WACC AS DISCOUNT RATE IN INVESTMENT

APPRAISAL
-geared betas
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CHAPTER 6 – RISK ADJUSTED WAC C
1 GEARING (CAPITAL STRUCTURE RATIOS)
1.1 Introduction
The proportion of debt and equity in a company’s capital structure (Gearing – see 1.1 Financial Gearing) will affect the risk that
the shareholders of a Company face. This in turn affects the return they require (the higher risk, higher return). Return required
by shareholders is Cost of equity for the Company. Therefore with changing proportion of equity and debt, WACC of the
Company will change (see 2 Capital structure theories).
1.2 Financial gearing

 Financial gearing is the proportion of debt and equity finance within company’s capital structure (D/E).
 Debt is cheaper than equity, but high levels of debt create financial risk from several points of view:
 If the company cannot make its interest payments it will be forced into liquidation.
 If a company takes on more and more debt it will appear riskier to future lenders who will then charge
higher interest rates.
 Higher interest payments will mean less cash to pay dividends. Equity investors will want compensation
for this in the form of higher returns.
 Financial risk is measured by:
 Gearing ratios
- Equity gearing Total / capital gearing
debt debt
or
equity debt  equity
- Debt = bonds, long term loans and preference shares (sometimes called prior charge capital)
and OVERDRAFT (in F9) (in SoFP it is disclosed under ST finance, but it is permanent finance and
as it attracts interest that must be paid from PBIT, it increases financial risk for the shareholders).
Equity = ordinary share capital, revaluation reserves and retained earnings
- Benchmark values: D should not exceed E (so D/E <= 1)
- Use Market values of D and E if available, as they :
 are more relevant to the level of investment made

 represent the opportunity cost of the investment made
 are consistent with the way investors measure debt and equity
 Interest cover
PBIT
-
interest
- It says how many times the interest per year can be paid from PBIT
- < 3 is considered low
- Reversed value is called Interest gearing (interest/ PBIT)
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 Why debt is cheaper than equity:
 Risk – The debtholder is in a less risky position than the shareholder (and therefore debtholder will
require lower return). Reasons;
- Priority of payouts – there is a legal obligation to pay interest, during liquidation debtholders must
be paid first
- Security-debt is secured by charges or covenants against assets
- Debt in capital structure will create finance risk for the shareholders as presence of debt will
make returns available to shareholders (PAT) more volatile (see illustration 1 below)
 Taxation – interest (paid on debt) is tax deductible, dividend (paid on equity) is not tax deductible
 Volatility - Gearing has a direct impact on the how sensitive profit after tax (PAT) is to a change in profit before
interest and tax (PBIT). Higher gearing means higher sensitivity, thus higher risk.
Example 1 - Volatility (Illustrated)

Capital structure of Co A and B is as follows:
Co A Co B
Assets 20,000 20,000
Share capital 20,000 10,000
10% loan notes - 10,000
20,000 20,000
Let`s see what happens to PAT for given levels of PBIT for Co A (which has no debt within its capital structure) and for a Co B
(with debt within its capital structure)
PBIT = 2,000
PAT(A) = 2,000 PAT(B)=2,000-1,000 = 1,000
PBIT = 1,500 (decrease in PBIT by 25%)
PAT (A)=1,500 (decrease by 25%) PAT(B) = 500 (decrease by 50%)
Presence of debt within capital structure of company B (and related fixed interest charge) caused higher change in PAT (50%)
than was a change in PBIT (25%).
PAT in Geared company (Company with debt in its capital structure) is more volatile than PAT of ungeared company (all-equity
company), therefore Geared company is more risky for ordinary shareholders.
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1.3 Operational gearing

Operational gearing measures business risk (i.e. the risk of making low profits or losses due to the nature of the
business). Measures the extent to which a Co’s operating cost are fixed rather than variable.
fixed cost fixed cost contribution (sales -varible COS)

or or
variable .cost totalcost PBIT
 if contribution is high but PBIT low  then fixed costs are high
 high proportion of fixed costs  high operational gearing
 higher operational gearing  higher volatility of PBIT
Example 2 - Operational gearing

P&L extract for Co A and Co B is given below:
Co A Co B
Sales 10.0 10.0
Variable costs (6.0) (2.0)
Fixed costs (2.0) (6.0)
PBIT 2.0 2.0
Required: For Co A and Co B calculate level of operating gearing and assess the impact of a 10% decrease in sales.
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2 CAPITAL STRUCTURE THEORIES

The question is whether there is an optimal mix of debt/ equity finance (also called ‘capital structure’) at which the company’s
cost of capital (WACC) is minimised (and therefore the market value of the company is maximised). The lower the WACC, the
higher the company’s market value:
 Market value of company equals to total of discounted cash flows generated by company in future.
 CF
MV   i
n 1 WACC
 Therefore with increasing WACC MV of Company decreases MV of share decreases  shareholders wealth
decreases.
 As debt is cheaper then equity, with introduction of cheap debt into the capital structure total WACC should decrease
(and therefore MV of company increase), but at the same time debt within capital structure creates financial risk, so
shareholders are likely require higher return (cost of equity will increase). See Capital structure theories for more
details.
Reduction in WACC Increase in WACC
Because Kd is less than Ke, an increase in debt Debt introduces financial risk which increase
funding should lead to a fall in WACC. Ke, and should lead to an increase in WACC.
Debt finance is cheaper because it is: The risk associated with debt financing is
borne by the shareholders.
1. less risky to investor
2. tax efficient
There are two main theories on the relationship between gearing and WACC.
 Both consider two types of capital – debt and equity

 Both claim that the ideal capital structure is when WACC is minimised
 Both agree that:
 Cost of debt, Kd, is cheaper than cost of equity, Ke
 Debt is less risky than equity

 Interest is tax deductible (Modigliani & Miller with tax)
 With increased gearing levels the company with have a higher cost of equity (financial risk)
 Higher debt  higher interest (interest is fixed and must be paid irrespective of profit levels).
Therefore there is a higher risk that there will be no cash left for payment of dividends.
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2.1 The traditional view

 This view argues, that with increasing gearing, the cost of debt increases (from a certain gearing level) – the
additional/ incremental cost of debt is more expensive as issuers of the debt are at a higher risk when they loan
money to an already geared company (see problems with high gearing).
 Therefore Ko (WACC)
 At the beginning decreases (as proportion of cheaper debt capital increases)
 Then at a certain point Ko starts to increase (as when gearing level rises above a certain point, both Ke
and Kd increase)
Summary:
 As the level of gearing increases, Kd remains unchanged up to a certain level of gearing. Beyond this level, Kd will
increase.
 As the level of gearing increases, Ke increases (as financial risk increases; there is an increased volatility of returns).
Non-linear relationship.
 As a result, WACC initially decreases (as proportion of cheaper debt increases) and then starts to increase (as Kd
increases and Ke increases).
Conclusion: The optimal level of gearing is where WACC is minimised (and therefore MV of company maximised).
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2.2 Modigliani and Miller (MM) view
MM view - no tax
Assumptions:
 A perfect capital market exists (investors have the same information and act rationally) – therefore required return on
E is directly proportional to the increase in gearing  linear relationship between Ke and gearing
 No tax or transaction cost
 Debt is risk free (cost of debt does not rise with increased gearing)
As a result:
 Cost of debt remains unchanged as the level of gearing increases

 The increase in Ke exactly offsets the benefits of cheaper debt finance and therefore WACC remains constant
Conclusion: WACC (and therefore the market value of the company) are unaffected by levels of gearing.
MM view with tax

Tax now considered – interest is tax deductible and therefore Kd will decrease with increased gearing. Therefore optimal capital
structure is made entirely from debt. Conclusion: Maximise DEBT
M&M Ke
Cost of THEORY
capital
Ko
Kd
E
Gearing level D 
 
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Problems of high gearing

 Bankruptcy cost – at very high debt levels the company may not be able to pay interest from debt and may be
forced into bankruptcy by the debtholders
 Agency cost – lenders impose restrictive covenants (e.g. level of dividends, level of added debt, levels of liquidity),
increased level of monitoring/ disclosures
 Tax exhaustion – debt is tax deductible, but at very high level of debt there might be insufficient profits to utilise all
available interest
 Impact on borrowing/debt capacity – it may be impossible to find additional lenders
 Risk attitude of current and potential investors – existing equity investors may be put off by high gearing and
dispose of their shares causing share price to fall. Prospective investors may not wish to subscribe for new issues of
shares
 Increases in cost of borrowing as gearing increases
2.3 Pecking-order theory

 Companies follow a line of least resistance – they raise finance in order:
 Internally-generated funds:
 Already have the 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 a possible sign of problems

 Extensive questioning and publicity associated with a share issue
 Expensive issue costs
 Limitations
 Does not take into account taxation, agency cost, financial distress
 Explanation of what companies do rather than what they should do
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2.4 Capital structure theories - summary
Theory Net effect as gearing Impact on WACC Optimal finance method

increases
Traditional theory WACC U shaped At optimal point, WACC is Find and maintain optimum
minimised gearing ratio
M&M no tax Cheaper debt = Increase in WACC constant Choice of finance irrelevant –
Ke use any
M&M with tax Cheaper debt> Increase in WACC falls As much debt as possible
Ke
Pecking order No theorised process No theorised process Line of least resistance. First
internally generated funds, then
debt and then issue of equity
2.5 Other considerations

 Capital structure in practice:
 In practice – U curve, but difficult to express by equation
 The company calculates WACC for different options and chooses the lowest
 Asset structure, profit amount and stability are also taken into account
 Factors influencing capital structure

 Industry standards
 Debt issuer requirements - covenants, limitations on dividends, monitoring, disclosures
 Management attitude to risk
 Asset structure
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3 DISCOUNT RATE IN INVESTMENT APPRAISAL

 When we use WACC as the discount rate in investment appraisal, we are assuming the project under consideration
has the same level of risk as the business making the investment. In this situation, it’s appropriate to use the
company’s WACC.
 Key conditions when company can use its WACC as discount rate in investment appraisal are:
 Company adopts “pooled funds” approach to project financing

 Company will maintain its capital structure in the long run, so project is financed by the same
proportion of D/E finance as is the capital structure of the company (same FINANCIAL RISK)
 Project is in the same business area as the Company (same BUSINESS RISK)
 However, if a company decides to enter a new market (DIVERSIFICATION INTO A NEW INDUSTRY).
we need to find a project specific cost of equity (and subsequently project specific discount rate
WACC)
 How to find project specific cost of equity (ie:)
 We have to find  that reflects new business risk of the project , but finance risk of investing
company (see 3.1 CAPM and geared betas and 3.2 Using formula below)
 We adjust cost of equity using CAPM:: i  R  R  (Rm  R )
e i f f
 We calculate project specific discount rate as WACC, where we use project specific cost of
equity
3.1 CAPM and geared betas

 A geared company has higher financial risk and therefore a higher beta than an un-geared company. This is
consistent with M&M theory – as gearing rises, so does the cost of equity to compensate for increased financial risk
 It is possible to establish a relationship between the beta of an ungeared company and the beta of geared company
within the same industry. The formula is below.
 New terminology:
e
 “Equity beta” - refers to the beta of a geared company, it considers both financial and business risk.
  a “Asset beta” - refers to the beta of a company with no gearing, i.e. 100% equity financed. This
company will have no financial risk, only business risk. We can ‘strip out’ the debt of a geared company
to find its Asset beta, thereby estimating the underlying business risk of that company.
E
 a  e
 Relationship between Asset beta and Equity beta :
E  D( 1  t )
Note – On the exam formula sheet the formula is given in full as
E D( 1  t )
 a  e 
E  D( 1  t ) d E  D( 1  t )
It is assumed for exam purposes that debt is risk free (in other words   0 ), this means the second half of formula = 0 and
d
the formula is reduced to its first half (as shown above)
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3.2 Using the formula to find the project specific equity beta
 If we are considering entering a market that has more business risk than our company currently bears, we can
estimate that company’s business risk using the asset beta formula:
 Find a proxy company in that new market we are entering (proxy equity beta reflects proxy business risk
and proxy financial risk)
 “Degear” the proxy’s equity beta using the asset beta formula (to get beta asset that reflects proxy bus
risk only, financial risk is zero as it is all equity company)
 “Re-gear” the proxy company’s asset beta with level of gearing of investing company, determining a risk-
adjusted equity beta (proxy bus risk, investing company financial risk)
Example 3 – Geared betas

A company operating in civil engineering industry has a debt to equity gearing of 2:5. The equity beta of the company is 1.2. The
company is considering an investment in a hotel industry, where average equity beta is 1.6 and average debt to equity ratio is 1:2
Average returns on the stock market are 15%, risk free rate is 10%. Assume debt is risk free. Company has before tax cost of
debt of 10%. The tax rate is 20%.
Required:
a/ Calculate suitable beta to be used in appraising a new project within a hotel industry
b/ Calculate project specific cost of equity
c/ Calculate suitable discount rate (WACC) to be used in appraising a new project in hotel industry
d/ Calculate suitable discount rate (WACC) to be used in appraising project in civil engineering industry
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C H A P T ER 7 – F IN A N C I A L P ER F O R M A N C E M E A S U R EM EN T
Chapter 7
Financial Performance
Measurement
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C H A P T E R 7 – F IN A N C I A L P E R F O R M A N C E M E A S U R EM EN T
1 INTRODUCTION
Ratio analysis compares and quantifies relationships between financial variables (taken from the financial statements of the
company).It is used for financial control and as a means of measuring progress.
 The key to obtaining meaningful information from ratio analysis is by comparison:
 Over a number of periods within business

 With targets
 Between similar businesses
 With industry averages
 Categories of ratios
 Profitability and return

 Capital structure (gearing) (see Ch 7 on Gearing)
 Liquidity and working capital ratios (see Ch 12 on Working capital)
 Stock market ratios (Investor ratios)
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2 PROFITABILITY AND RETURN
2.1 Return on Capital Employed ROCE

PBIT
ROCE 
capital employed
 ROCE is a measure of the underlying performance of the business before finance. It considers overall return before
financing. Therefore it is not affected by gearing.
 Capital employed is total funds invested in the business (equity + LT debt)

 PBIT is also known as Operating profit
 Comparisons to be made
 Change in ROCE over the period

 Compared to ROCE of other companies
 Comparison of ROCE with current market borrowing rates/ WACC of Company
 Is the company making ROCE which suggests that it is making profitable use of its current
borrowing?
 What would the cost of extra borrowing be to the company if it needed more loans and is
making sufficiently high ROCE to afford them?
 Further analysis of ROCE (pyramid)
ROCE = profit margin x asset turnover
PBIT PBIT sales revenue

= 
capital employed sales revenue capital employed
 Trade-off between profit margin and asset turnover

 Same ROCE can be achieved by different strategies (low profit margin x high turnover (TESCO), high
profit margin x low turnover (M&S))
 Also comment on change in turnover: growth can be due to prices or/and volume
2.2 Return on equity (ROE)

PAT
shareholders equity
 A measure of return to the shareholders. PAT is after interest, after taxation and before dividends. Therefore ROE
is affected by gearing.
 PAT is profit available to ordinary shareholders  therefore after preference dividends
 High ROE reflects good management of expenses and ability to invest in profitable projects. But it could also reflect a
higher level of debt finance (gearing) with associated higher risk
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2.3 Gross Profit Margin (GPM), Net Profit Margin (NPM)

 Profit margin is profit expressed as percentage from sales.
 Gross profit margin and Net profit margin
GP NP
sales sales
 P&L extract
Sales x
Less COS (x)
GP x
Less expenses (x)
NP x
Example 1 - NPM, GPM (Illustrated)

Net profit margin of business is in year 1 and 2 stable, it is 10%. However gross profit margin increased from 30% in year 1 to
40% in year 2. Is it good or bad for business?
Example of discussion:
Increased GPM is good as it indicates an increased gap between the selling price and cost of sales. However, given that NPM is
the same in both years, expenses must be rising.
In year 1 expenses were x% of sales, while in year 2 expenses were y% of sales. This indicates that administration or selling and
distribution expenses may require tighter control.
3 GEARING RATIOS (FINANCIAL RISK RATIOS)
Gearing
debt
equity
Interest cover
PBIT
interest
See chapter 6 Capital structure for more details.
4 LIQUIDITY AND WC RATIOS

See chapter 9 Working capital for more details.
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5 CAPITAL MARKET/ INVESTOR RATIOS

 Investor is interested in the income earned by the company for him and in the return on his investment. Therefore
relevant information for ordinary shareholder will be found from:
Dividend based ratios Earnings based ratios Total shareholder return
Dividend per share Earnings per share (EPS) TSR

Dividend cover PE ratio
Dividend yield ROE
Earnings per share (EPS)
PAT less preference dividends

number of ordinary shares
 EPS is an amount of profit attributable to each ordinary share, therefore PAT from SoPL must be decreased by
dividends on preference shares, if any.
Price earnings ratio (PE)
MV per share (ex div!) total MV


EPS PAT
 PE ratio is a measure of future earnings growth, compares MV to the current earnings. It reflects the market’s
appraisal of a share’s future prospects. It might be seen as payback period of the investment in the share. But the
higher PE, the better. (as seen by market)
 It is published for listed companies
 P/E ratio and share price (approach in the questions): P/E does not vary much over time. So if EPS goes up or
down, MV should be expected to move up or down too, and the new MV will be EPS (new) x P/E (in the questions
there is usually assumption that PE remains constant as result of transaction)
Example 2 - P/E ratio

A company has recently declared a dividend of 12c per share. The share price is $3.72 and earnings for the recent year were 30c
per share.
Required: Calculate the P/E ratio.
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Dividend per share DPS
total dividends
DPS 
number of ordinary shares
Dividend cover
PAT available to shareholders EPS


dividends DPS
 Dividend cover shows by how many times dividend could be paid from PAT.
 Effect of increased gearing on dividend cover: higher interest  lower PAT lower EPS. To maintain the same
dividend cover, dividend will be decreased. Or dividend will be same, but in such a case the dividend cover falls 
this will indicate an increased risk to shareholders than dividend.
Dividend yield
dividend per share

 100%
MV per share
 The cash return from holding a share. It does not consider capital gain (increase in MV of share)
Total shareholder return (TSR)
DPS  change in MV
100%
share price at the start of period
Interest yield (for providers of debt finance)
interest
MV of debt
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Example 3 - Shareholders ratios (Illustrated)
The Directors of X compare their company to Company Y. X had normal year, while Y suffered an exceptional loss from the closure
of an unsuccessful division. Y has a considerably higher gearing than X.
X Y
Share price 450c 525c

Nominal value of shares 50c 100c
Gross dividend yield 5% 4%
P/E 15 25
Proportion of profit earned overseas 60% 0%
Required: Discuss the following points:

a) There is something odd about the PEs. Y has had a bad year, therefore its PE should be lower than X.
b) One of the factors that may explain Y’s high PE is high financial gearing.
c) Comparison of X PE and gross dividend yield with those of Y is not really valid. Shares of the two companies have different
nominal values.
d) These figures will not please our shareholders. Dividend yield is below the return an investor could currently obtain on risk free
government bonds.
Solution - Shareholders ratios
a) PE measures relationship between the MV of share and EPS. MV reflects market expectations of the future earnings
performance, EPS is historic number.
If Y just suffered an abnormally bad year, which is not expected to be repeated, the market value of the share will rise on the basis
of its expected future earnings. The earnings figure used to calculate the ratio will be the historic figure which is lower than forecast
for the future, and therefore ratio will appear high.
b)Financial gearing expresses relationship between debt and equity. If Co is high geared, then it carries a high fixed interest charge
and therefore amount left for ordinary shareholders will be more volatile than that for the low geared Co. Y shareholders carry
higher level of financial risk. All other information is equal. It is therefore likely that the share price in the higher geared Co is lower
than that in low geared Co.
PE depends on current the MV and historic earnings. A high PE is therefore more likely to be found in a Co with low gearing than
in one with high gearing. In Y, a high PE is more probably attributable to the depressed level of earnings than to the financial
structure of the Co.
c)PE = MV/EPS, dividend yield = dividend per share/MV

The nominal value of shares is irrelevant in calculating ratios. If all other factors (such as the accounting conventions used in the
two companies) are equal, a direct comparison of ratios is valid.
d) div yield = div per share/MV
MV reflects investors’ expectation about the future level of earnings and growth. If the share is trading with a low dividend yield,
this means that the investor has positive growth expectations after taking into account the level of risk. Although the government
bonds carry no risk, it is equally likely that they have no growth potential either, and it means that the share will still be more
attractive even after the low dividend yield has been taken into account.
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C H A P T ER 8 – R I S I N G EQ U I T Y F I N A N C E
Chapter 8
Rising Equity Finance
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CHAPTER 8 – RISING EQUITY FI NANCE
1 SOURCE OF EQUITY FOR SME AND UNLISTED COMPANIES
1.1 Providers of finance for SME and unlisted companies

 Equity finance for SME and unquoted Cos includes:
 Own funds
 Retained earnings
 Friends and family
 Venture Capital
 High risk/ high return.

 Close relationship between VC and the company being offered finance.
 Medium term (5–7 years).
 Exit strategy
 Business Angels
 Private placing.
1.2 Methods of issuing and trading unquoted shares

 Unquoted shares are not fully listed on Stock Exchange. They can be traded on other markets (Alternative Investment
Market AIM).
 Unquoted shares can be issued with minimum regulations , such as
 Registration of Co
 Filing the Co’s accounts
 Trading shares of unquoted Cos
 They may be shares of private companies. These will typically be the shres of family companies whose
shareholders are members of the family which collectively owns the company. Such shares will be bound by
terms which will restrict the ability of the owner to sell them to anyone other than a restricted group of people,
eg members of the family.
 Alternatively unquoted shares may be traded on a market that is not the main stock market. In the UK this
would be the Alternative Investment Market (AIM) or OFEX.
 These markets do have regulations for companies that with to trade shares on them, but such regulations are
considerably simpler than the regulations governing shares with a full listing on the main Stock Exchange.
 In addition, the shares can be traded through private equity deals ie private arrangements between wealthy
individuals or institutions who specialise in the trading of these types of shares.
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2 QUOTED SHARES
2.1 Methods of issuing

 Initial Public Offer (IPO) – selling shares to a wide public
 Fixed price offer

 Offered to general public at a fixed price
 It has potential to raise the highest possible price by being offered to the widest possible market
 Floatation costs are high
 Offer for sale by tender
 Investors bid for the shares

 Shares are issued to those who have bid at striking price or above
 Stages
 Co issues Prospectus – outlines the financial position of the Co, its strategy and the terms of
shares
 Co’s shares are acquired by an issuing house (kind of bank specialising on IPO)
 Issuing house is selling the shares to the public. Unsubscribed shares might be bought by issuing
house, so Co receives the full proceeds from the offer
 Placing - shares are not offered to the public but to a small number of investors (usually institutional investors such as
pension funds, insurance companies, etc.); arranged by a market maker
 Shares are not offered to the public but to a small number of investors (usually institutional investors such as
pension funds, insurance companies, etc.);
 Arranged by a market maker or merchant bank that act as intermediator
 Advantages over IPO
 placing is cheaper
 quicker
 involves less disclosures
 this small group of shareholders may have control over the company
 Introduction - no shares made available to the market, the stock market grants a quotation (it will happen only for
companies whose shares are already widely held)
2.2 Stock market listing advantages and disadvantages

Advantages Disadvantages
 access to a wider pool of finance  greater public regulation, accountability and scrutiny
 improved marketability of shares
 shareholders may become a powerful external stakeholder group and thus
 easier to seek growth by acquisition influence the company objectives or direction, e.g. institutional shareholders
 original owners realising holding
 additional cost in making share issue (brokerage commission, underwriting
 enhanced public image
fees)
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2.3 Cost of share issues on the stock market

 underwriting costs (underwriters agree to buy any unsubscribed shares)
 listing fee
 fees of the issuing house, solicitors, auditors and PR consultants
 printing and distributing prospectus
 adverts
3 RIGHTS ISSUES
 Rights issue is an offer to existing shareholders enabling them to buy more shares, usually at price lower than current
market price.
 The company raises new share capital and the shareholding of individual shareholders is not diluted (provided all of
them accept the offer)..
 E.g. a Rights issue 1 for 4 basis at 280c per share means the shareholder may subscribe for 1 new share for every 4
shares he holds, at a price of 280c
 Advantages
 Rights issues are cheaper than IPOs (no prospectus required, admin simpler, cost of undertaking lower)
 No dilution of control
 More beneficial to existing shareholders than an issue to the general public as it’s offered at a discount
 Theoretical ex-right price (TERP)
 Cum-right price (shares with rights attached, before rights issue), Ex-right price (without rights, after rights
issue)
 When rights are issued, MV of share would theoretically fall to TERP, as there are new discounted shares in
the market.
 TERP is calculated as weighted average, where weights are proportions of old/ new shares in the market,
see Ilustration 1. It can be calculated at the smallest potential portfolio of 1 shareholder or at the total
number of shares issued by the company – depends what info are given in the question.
 Value of right - Shareholder who does not want to exercise his right to buy new discounted shares, can sell (renounce)
the right to buy new discounted shares to someone else. Theoretical gain on this transaction is called value of the right
and is recalculated to 1 share in shareholder’s existing portfolio. See following example:
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Example 1 - TERP and Value of the right

DENIS plc has an issued share capital of 8,000,000 ordinary shares, the nominal value is $1. The rights issue offeres the right to
subscribe for 1 new share at $2 for every existing 4 shares held. Current market value of the share is $2.50.
Required: Calculate TERP and value of the right
 Theoretical gain/loss to shareholders

 Possible actions of shareholders are:
 Take up (exercise) rights (buy rights) – no change in shareholding, no change in personal wealth
 Renounce the rights (sell them) – decrease in shareholding, no change in personal wealth
 Do nothing – decrease in shareholding, decrease in personal wealth
Example 2 – Theoretical gain/loss to the shareholder

A shareholder has 10,000 shares in DENIS pls before the rights offer. On the assumption that the actual market value of shares after
rights issue will be equal to theoretical ex rights price, what would be the effect on the shareholder’s wealth if:
a) He takes up his rights
b) He sells all the rights
c) He does nothing at all?
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Example 3 - Business finance question
Tirwen is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at a 15% discount to the current market
price of $4.00 per share. Issue costs are expected to be $220,000 and these costs will be paid out of the funds raised. It is
proposed that the rights issue funds raised will be used to redeem some of the existing loan stock at its current MV = 104.165$
(nominal = 100$). Financial information relating to Tirwen is as follows:
Current statement of financial position (balance sheet)

$'000 $'000
Non-current assets 6,550
Current assets
Inventory 2,000
Receivables 1,500
Cash 300
3,800
10,350
Ordinary shares (par value 50c) 2,000
Reserves 1,500
12% loan notes 2X12 4,500
Current liabilities
Trade payables 1,100
Overdraft 1,250
2,350
10,350
Other information:
Price/earnings ratio of Tirwen: 15.24
Overdraft interest rate: 7%
Tax rate: 30%
Sector averages: debt/equity ratio (book value): 100%
Interest cover: 6 times
Required:
(a) Ignoring issue costs and any use that may be made of the funds raised by the rights issue, calculate:
(i) the theoretical ex rights price per share;
(ii) the value of rights per existing share. (3 marks)
(b) What alternative actions are open to the owner of 1,000 shares in Tirwen as regards the rights issue? Determine the
effect of each of these actions on the wealth of the investor. (6 marks)
(c) Calculate the current earnings per share and the revised earnings per share if the rights issue funds are used to
redeem some of the existing loan notes. (6 marks)
(d) Evaluate whether the proposal to redeem some of the loan notes would increase the wealth of the shareholders of
Tirwen. Assume that the price/earnings ratio of Tirwen remains constant. (3 marks)
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C H A P T ER 9 – W O R K I N G C A P I T A L M A N A G E M E N T
Chapter 9
Working Capital
Management
WORKING CAPITAL MANAGEMENT
1. TREASURY MANAGEMENT 2. WC MANAGEMENT

- Role of treasury management - Operating cycle 3. INVENTORIES
- Centralisation/Decentralisation - WC in days - EOQ
- Profit/Cost centre - Overtrading
- WC funding strategies
4. RECEIVABLES 6. CASH
- Early settlement discount - CF forecast
- Factoring 5. PAYABLES - Baumol
- Invoice discounting - Early settlement discount - Miller Orr
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CHAPTER 9 – WORKING CAPITAL MANA GEMENT
1 TREASURY MANAGEMENT
Treasury function
 A function devoted to all aspects of cash within a company. This includes:
 Investment
 Raising finance
 Banking and exchange
 Cash and currency management
 Risk
 Insurance.
The role of treasury management

 Treasury management is the corporate handling of all financial matters, the generation of external and internal
funds for business. The management of currencies and cash flows, and complex strategies, policies and
procedures of corporate finance.’
 The role being summarised under 5 headings:
 Corporate objectives
 Liquidity management
 Investment management
 Funding management
 Currency management.
Centralisation / decentralisation
 In a large organisation there is the opportunity to have a single head office treasury department or to have
individual treasury departments in each of the divisions. Modern practice would suggest the decentralised
route where there is little or no head office intervention in the workings of an autonomous division. This runs
contrary to treasury practice where large companies tend to have a centralised function.
 Advantages of centralisation
 Avoid duplication of skills of treasury across each division. A centralised team will enable the use of
specialist employees in each of the roles of the department.
 Borrowing can be made ‘in bulk’ taking advantage of better terms in the form of keener interest rates and less
onerous conditions.
 Pooled investments will similarly take advantage of higher rates of return than smaller amounts.
 Pooling of cash resources will allow cash-rich parts of the company to fund other parts of the business in need
of cash.
 Closer management of the foreign currency risk of the business.
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 Advantages of decentralisation
 Greater autonomy of action by individual treasury departments to reflect local requirements and problems.
 Closer attention to the importance of cash by each division.
Profit centre vs cost centre

Cost centre – A function to which costs are accumulated.
Profit centre – A function to which both costs and revenues are accounted for.
 Advantages of profit centre
 The use of the treasury department is given ‘a value’ which limits the use of the service by the divisions.
 The prices charged by the treasury department measure the relative efficiency of that internal service and may
be compared to external provision.
 The treasury department may undertake part of the hedging risk of a trade thereby saving the company as a
whole money.
 The department may gain other business if there is surplus capacity within the department.
 Speculative positions may be taken that net substantial returns to the business.
 Disadvantages of profit centre
 Additional costs of monitoring. The treasury function is likely to be very different to the rest of the business
and hence require specialist oversight if run as a profit making venture.
 The treasury function is unlikely to be of sufficient size in most companies to make a profit function viable.
 The company may be taking a substantial risk by speculation that it cannot readily quantify. In the event of a
position going wrong the company may be dragged down as a result of a single transaction.
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2 WORKING CAPITAL MANAGEMENT - OVERVIEW
OVERTRADING symptoms:
- Increased T/O WC FUNDING STRATEGIES
- Increased AR, - Non – current assets
- Increased OD, AP - Permanent current assets
- Drop in liquidity ratios - Fluctuating current assets
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2.1 Working capital (W/C)

 Working capital are financial resources required for the day-to-day running of the business.
 Net working capital is current assets less current liabilities. There is a direct effect on liquidity.
Current assets Current liabilities

cash trade payables
inventories short-term loans (overdraft)
trade receivables
 Objective of W/C management: keep a balance between 2 conflicting objectives- liquidity and pofitability
 Current assets are sufficiently liquid to minimise risk of insolvency (Have sufficient working capital to avoid
running out of cash) (liquidity)
 Minimising investment in W/C to keep financing cost at minimum (profitability)
2.2 Cash operating cycle (WC in days)

 Also called “W/C cycle”, or “operating cycle,” or “trading cycle”
 It’s the number of days between the cash outflow for raw materials and wages and then recovering that cash
from customers paying.
Example 1 - Length of operating cycle

Receivables collection period 60 days
Raw material inventory holding period 20 days
Production period (WIP) 25 days
Suppliers´payment period 40 days
Finished goods holding period 20 days
Required: Calculate the length of the operating cycle
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2.3 Working capital ratios
Liquidity ratios
Current ratio Quick ratio (acid test ratio)
current assets current assets-inven tories

current liabilities current liabilities
Operating cycle ratios

AR payment period/ AR days AP payment period/ AP days
AR AP
 365  365
sales purchases or COS
Inventory days
average inventory
inventory turnover period(FG)   365
COS
Inventory turnover
COS
average inventory
Sales revenue / net WC ratio (WC turnover ratio)

sales revenue
CA  CL
This measures how efficiently management is using its investment in W/C to generate sales.
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2.4 Working capital requirement (WC in $)

 Also called W/C investment levels. If the question is “Compute W/C requirements”, you have to find values of
receivables, payables and inventories from the information given (from ratios)
 It’s the value of W/C we need to finance. It means current assets less current liabilities
 Level of WC required is affected by:

 Nature of the business
 Certainty in supplier deliveries (note: buffer stock)
 Level of activity of the company
 Company’s credit policy
 Length of operating cycle
 Credit policy of suppliers
Example 2 - WC levels
X plc has the following expectations for the forthcoming period:

$m
Sales 10
Cost of sales (6)
Profit 4
The following working capital ratios are expected to apply:

Inventory days 40 days
Receivables days 70 days
Payables days 50 days
Required: Compute the working capital requirement.
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2.5 Over-capitalisation and overtrading
Over-Capitalisation
 If there are excessive inventories, accounts receivable and cash, and very few accounts payable, there will be
an over-investment in current assets.
 Symptoms:
 Liquidity ratios: Current ratio > 2, Quick ratio > 1 (but also compare this with industry averages)
 Turnover periods (receivables and inventories are long, payables are short)
Over-Trading
 A rapid expansion of the business funded by short-term finance (e.g. bank overdraft)
 May operate at a profit, but is short of cash. It can run into liquidity problems quickly.
 If the business does not have access to sufficient capital to fund the increase, it is said to be "over-trading".
This can cause serious trouble for the business as it is unable to pay its business creditors (e.g. suppliers).
 In the exam, you might be expected to diagnose over-trading from information given about a company. You
should look out for the following symptoms:
1. A rapid increase in turnover

2. A rapid increase in the volume of current assets (possibly fixed assets as well).
3. Inventory days and receivables days will be increasing
4. Small increase in shareholder capital (retained profit only)
5. Most of the increase in assets being financed by short-term finance, e.g. payables or an overdraft
6. A dramatic drop in the liquidity ratios
 Approach to Overtrading questions
1. High level analysis – check turnover (high increase), overdraft and trade payables (high increase), long term debt
(no/small increase)  you can conclude for yourself based on those the Company is overtrading.
2. Calculate changes in items useful for overtrading:
- Increase in turnover
- Increase in trade payables
- Increase in overdraft
- Increase in current assets (inventory and receivables)
- Small/no increase in long term debt
3. Calculate following ratios (display in table: ratio – current year - prior year)
- Profitability : GPM, NPM
- WC ratios: AR days, Inventory days, AP days
- Liquidity ratios: current ratio, quick ratio
- WC turnover ratio
4. Comment and conclude
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Example 3 - Overtrading
Donac co is a small manufacturing company
Summarised accounts for the last two years are presented below:
Balance sheets (Statements of financial position) as at 31 March
20X7 20X8
$000 $000 $000 $000
Non – current assets 820 1,000
Current assets
Inventory 340 420
Receivables 360 570
Cash 10
710 990
Total assets 1,530 1,990
Equity & liabilities

Ordinary shares (25c) 400 400
Retained earnings 450 530
Total equity 850 930
Non – current liabilities 200 200
Current liabilities
Overdraft 140 250
Trade payables 280 510
Other payables 60 100
Total current liabilities 480 860
1,530 1,990
Income statements for the years ending 31 March

20X7 20X8
$000 $000
Revenue 1,800 2,900
Gross profit 210 260
Profit before tax 120 160
Income tax expense 30 40
Profit for the period 90 120
Dividents 40 40
Retained profit for the
50 80
period
Inflation during the last year was 10%
Required:
a) Explain what is meant by over-trading, and discuss how it might be recognised in a company.
b) Calculate all relevant working capital ratios and evaluate whether Donac is over-trading.
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2.6 Working capital funding strategies

 Classic approach: short term sources should cover current assets, long term sources should cover non-current assets
 Short term sources – bank overdraft, trade creditors
 Flexible, only borrow what is needed

 Cheaper – liquidity preference
 Easier to arrange for
 Long term sources – equity and long term debt
 Secure – no need to constantly replenish

 Lower financing risk
 Matching funding to need (equity permanent, debt repayable)
 But some current assets are permanent (e.g. buffer inventory, receivables, and minimum cash), so how should the
company finance permanent current assets? (permanent current assets, fluctuating current assets)
 Aggressive – finance most current assets, including ‘permanent’ ones, with short term finance. Risky but
profitable.
 Conservative – long term finance is used for most current assets. Stable but expensive.
 Matching – the duration of the finance is matched to the duration of the investment.
 Essentially the final choice of working capital funding is down to the management of the individual companies, bearing in
mind:
 The willingness of creditors to lend

 The risks of their commercial sector
 The attitude of management to risk and previous funding patterns
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3 INVENTORY
* CE = Capital Employed
3.1 Introduction
 Objectives of inventory management
 Reduce inventory to minimise level of capital employed, (as holding stock incurs costs, in particular there is
the opportunity cost of money tied up in stock) (LIQUIDITY)
 Ensuring a sufficient level to meet orders and avoid stock outs, Holding stock is necessary for operations, in
terms of finished goods it offers greater choice to customers (PROFITABILITY)
 Inventory cost
 Holding cost – cost of capital tied up, warehousing, handling, theft, obsolescence, insurance
 Ordering costs – Admin and delivery costs of placing the order
 Shortage (stock-out) cost – lost contribution from lost sales, extra cost of buying emergency supplies, lost
volume discounts
 Purchase costs
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3.2 EOQ (Economic order quantity)
Recap
 EOQ is a traditional model that helps find such order size (Q opt, EOQ) that will minimize inventory costs
 Assumptions: lead time is 0, demand is constant and known, no buffer inventory is held, the purchase price is constant
 Variables
- Quantity (Q): # of units in one order
- Price (P): unit price paid to the supplier
- Holding cost (Ch): cost of holding one unit in inventory for one year
- Demand (D): annual demand in units
- Ordering cost (Co): cost of placing one order
 Total annual inventory cost considered in EOQ model include:

Q
 Annual holding cost  Ch
2
D
 Annual ordering cost  Co
Q
 Annual purchase cost D  P (number of units needed pa x unit price)
 Underlying question in EOQ model is “How many units Co should order in one delivery to minimise total inventory cost
per year”. As Purchase cost per year do not depend on order size, we consider annual Holding cost and annual Ordering
cost only:
Annual holding cost Annual ordering cost
Q D
 Ch  Co
2 Q
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Example 4 - EOQ basics

A company requires 12,000 units per year. The cost to place an order is $40. The holding cost is $ 3 per unit per year.
a) Calculate the EOQ.
b1) How many orders will be placed per year?
b2) How frequently will orders be placed?
b3) What is the inventory cycle?
c) What is the average stock held?
d1) What is the annual holding cost?
d2) What is the annual ordering cost?
d3) What is the total inventory cost ?
EOQ including lead time

 Lead time: how long it takes for order to be delivered
 Reorder level (ROL): the level of inventory at which a new order must be placed
 ROL = consumption during lead time : (total consumption/365) x lead time
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Example 5 - EOQ reorder level

The company has a demand of 65,000 components pa. They cost $6.50 each. There is lead time of 3 weeks between order and
delivery, and ordering costs are $150 per order. The annual cost of holding one component in inventory is estimated to be $1 per unit
per year. Assume that Co is adopting EOQ.
Required:
a) How frequently will the company place an order?
b) What is the reorder level of inventory?
EOQ and discounts

 Question is: Is it worth to order a larger quantity than EOQ if there is a bulk discount provided?
 We need to calculate total cost of inventory (purchase + holding + ordering) at different ordering levels that qualifies for
the bulk discount, and take the cheapest alternative.
 Method:
 Step 1 Calculate EOQ, ignoring discounts.
 Step 2
 If EOQ is below the level for discounts, calculate total annual inventory costs.
 If this would qualify for a discount, then recalculate CH (necessary only if CH is given as a % of
unit price (Example 7), which will change with the discount) and the EOQ (because it depends on
CH). Then calculate the total annual inventory costs.
 Step 3 Recalculate total annual inventory costs using the order size required to just obtain each discount.
 Step 4 Choose the cheapest alternative.
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Example 6 – Discounts (Ch given as per unit per year)

The company has a demand of 65,000 components pa. They cost $6.50 each. There is no lead time between order and delivery, and
ordering costs amount to $150 per order. The annual cost of holding one component in inventory is estimated to be $1 per unit per
year.
A 0.5% discount is available on orders of at least 4,000 components and a 1% discount is available if the order quantity is 7,000
components or above.
Required: Calculate the optimal order quantity.
Example 7 – Discounts (Ch given as % of purchase price)

Frantic has budgeted production of 800 cars for a year (Frantic is ordering engines for the cars). Engine purchase is subject to quantity
discounts as follows:
Order quantity Discount
0-49 units 0%
50-249 2%
Above 250 units 3%
Engine price (before discounts) is $1,300. Inventory holding costs per annum are 22% of engine unit price. Delivery cost per order are
$1,200.
Required: Calculate the optimal ordering policy for engines.
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3.3 Inventory management systems
Bin systems (Quantity)

 Reorder level system – fixed quantity ordered at irregular intervals, when stock has fallen to a reorder level.
 These methods rely on accurate estimates of: lead time and demand in lead time. Action must therefore be taken if
inventory levels fall below a preset minimum or exceed a preset maximum.
Periodic review systems (Time)

 Requirement for stock to be reviewed at fixed time intervals, and varying quantities are ordered on each occasion
according to current level of stock remaining.
Just in time procurement (JIT)

 JIT is a series of manufacturing and supply chain techniques that aim to minimise inventory levels and improve customer
service by manufacturing not only at the exact time customers require, but also in the exact quantities they need and at
competitive prices.
 Objectives of JIT
 a smooth flow of work through the manufacturing process

 a flexible production process which is responsive to the customer’s requirements
 reduction in capital tied up in inventory
 This involves the elimination of all activities performed that do not add value = waste. It is achieved by:
 reducing batch sizes
 delivering raw material inventory to point of use
 designing shop floor for seamless movement of WIP
 emphasising total quality
 reducing finished goods level by making to order
 Implications for the supplier relationship include:
 dependent on quality and reliability

 long-term trusting relationships
 physical proximity
 Advantages
 Seek to eliminate waste at all stages of the manufacturing process by minimising or eliminating inventory,
defects, breakdowns and production delays. This is achieved by improved work flow planning, an emphasis
on quality control and firm contracts between buyer and supplier.
 Stronger relationship between buyer and supplier.
 Supplier benefits from regular orders, continuing future business and more certain production
planning.
 Buyer benefits from lower inventory holding costs, lower investment in inventory and WIP, and
the transfer of inventory management problems to the supplier.
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 The emphasis on quality control in the production process reduces scrap, reworking and setup costs
 Improved production design can reduce unnecessary material movements. The result is a smooth flow of
material and work through the production system, with no queues or idle time.
 Disadvantages
 May not run as smoothly in practice as theory may predict, since there may be little room for manoeuvre in
the event of unforeseen delays.
 There is little room for error, e.g. on delivery times.
 The buyer is also dependent on the supplier for maintaining the quality of delivered materials and
components. If delivered quality is not up to the required standard, expensive downtime or a production
standstill may arise. The buyer can protect against this eventuality by including guarantees and penalties in
the supplier’s contract.
 If the supplier increases prices, the buyer may find that it is not easy to find an alternative supplier who is
able, at short notice, to meet his needs.
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4 ACCOUNTS RECEIVABLES MANAGEMENT
ACCOUNTS
RECEIVABLE
Factoring Invoice discounting
Liquidity versus
Profitability Credit policy
Collect now versus - Assess creditworthiness
allow credit - Control credit limits
- Collect overdue debts Early settlement discounts
- Finance cost saved = overdraft
- Monitor system % (decrease in AR)
- Cost of discount given
4.1 Objective
 The objective of managing receivables is to keep balance between 2 confliction objectives:
 To collect sales receipts as quickly as possible to reduce the financing cot (liquidity) AND
 To extend the credit period to customers to encourage additional sales (profitability)
4.2 Credit policy

 To manage receivables means to establish a credit policy
 1. Assess creditworthiness (WHO TO GIVE CREDIT TO)
 new customers immediately; existing customers periodically

 info may come from bank reference, trade reference, published information, credit reference
agencies, the company’s sales records
 2. Control credit limits – set to reflect both the: (HOW MUCH CREDIT TO GIVE)
 amount of credit available

 length time allowed before the payment is due
 3. Invoice promptly and collect overdue debts (CONTROL IF CREDIT LIMITS ADHERED TO)
 Follow-up procedures include reminder letters, telephone calls, withholding supplies, debt
collectors, and legal action
 4. Monitor the credit system
 age analysis
 ratios
 statistical data
4.3 Early settlement discount
 Consequences of given early settlement discount:
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 Benefits/ Income: decrease of the collection period. This improves liquidity and reduces financing costs.
 Costs: the cost of discount.
Example 8 - Early settlement discounts

Current policy:
Sales are $ 15m and the collection period is 4 months
New policy proposed:

2% discount if the balance paid is within 15 days; It is expected that 60% of customers will take the discount. The collection period
for the 40% who do not accept the discount will be decreased from 4 to 3 months.
Receivables are financed by an overdraft with an interest rate of 18% pa.
Required: Assess the effect of changing policy
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Percentage cost of early settlement discount

 Discount offered is converted into Annual percentage, which can be easily compared to overdraft finance
percentage available to Company. If it is less than cost of overdraft interest, it is worth providing discount.
 The cost of an early settlement discount can be calculated as follows:
discount
Annual cost of discount  (1  ) no . of periods
1
amount left to pay
365 / 52 / 12
Where no. of periods  )
no. of days,weeks or months earlier the money is received
 It comes from
𝑑 365
(1 + 𝑖𝑝𝑎 ) = (1 + ) 𝑡
1−𝑑
Where 365/t means how many times a year a Co can invest money received earlier and t is number of saved days of financing if
discount is offered.
Example 9 – Percentage cost of discount

A company offers its goods to customers on 30 days credit. It is considering a 2% discount if payment is made within 10 days of the
date of the invoice. The overdraft interest rate is 15% pa.
Required: Decide whether the company should implement the policy.
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4.4 Factoring
Factoring means outsourcing of the credit control function to a 3rd party
 A factor provides the following services:
 Debt collection & administration for a fee
 If the factor takes the risk of bad debts, it’s called “non – recourse” factoring
 If the client keeps the risk, it’s called “recourse” factoring
 Financing, with an interest charge
 Factor might advance 80% of the receivables amount, and pay the remaining 20% upon receipt
 Credit insurance
 Advantages
 Improved liquidity
 Reduced admin costs
 Reduced risk of bad debts when non-recourse factoring is used
 Disadvantages
 The factor takes over communications with the company’s credit customers
 Might develop a negative attitude to customer relationship

 Indicates that there might be a cash –flow problem in the company
 Expensive
 Factors decides whom to give credit to
 It’s difficult to revert back to an internal credit control department
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Example 10 - Factoring
The Co XY has sales of $20 million pa, and average receivables represents about 85 days of sales. It is now considering a factoring
arrangement with a factor where 80% of the book value of invoices is paid immediately, with finance costs charged on the advance at
12% pa. The Co XY can borrow short term at an interest rate of 10% pa.
The factor will charge 1.5% of sales as their fee for managing the sales ledger, there will be administrative savings of $150,000, and
the factor will reduce the collection period to 50 days.
Required: Determine the costs and benefits of using this factor and recommend if the co XY should take the factor’s offer.
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4.5 Invoice discounting

 This is a form of short-term borrowing which allows the company to draw money against its sales invoices
before they are paid
 Invoices are used as security against which the company borrows funds; and is paid back when invoice is
settled
 The service provider does not take over administration of receivables
 These are often one-off deals
Differences between factoring and invoice discounting (ID)

 ID means taking invoices as a guarantee against a loan, while factoring provides a wider range of services
 ID are often one-off deals, whereas factoring is often a longer-term arrangement
 The factor is known to the debtor; the provider of invoice discounting is not
 Invoice discounting is more expensive than factoring
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4.6 Managing foreign trade

 Overseas receivables and payables bring additional risks:
 Export credit risk is the risk of failure or delay in collecting payments due from foreign customers.
 Foreign exchange risk is the risk that the value of the currency will change between the date of contract
and the date of settlement. For more details, see chapter 13.
Export credit risk

 Causes of loss from export credit risk (apply to all export trade of whatever size):
 Illiquidity or insolvency of the customer. This also occurs in domestic trading. When an export customer
cannot pay, suppliers have extra problems in protecting their positions in a foreign legal and banking system.
 Bankruptcy or failure of a bank in the remittance chain.
 A poorly-specified remittance channel.
 Inconvertibility of the customer’s currency, and lack of access to the currency in which payment is due. This
can be caused by deliberate exchange controls or by an unplanned lack of foreign exchange in the
customer’s central bank.
 Political risks. Their causes can be internal (change of regime, civil war) or external (war, blockade) to the
country concerned.
 Exporters can protect themselves against these risks by the following means.
 Use banks in both countries to act as the collecting channel for the remittance and to control the shipping
documents so that they are only released against payment or acceptance of negotiable instruments (bills of
exchange or promissory notes).
 Commit the customer’s bank through an international letter of credit (ILC).
 Require the ILC to be confirmed (effectively guaranteed) by a first class bank in the exporter’s country. This
makes the ILC a confirmed ILC (or CILC).
 Obtain support from third parties, e.g.:
– get a guarantee of payment from a local bank.
– get a letter from the local finance ministry or central bank confirming availability of foreign
currency.
 Take out export credit cover.
 Use an intermediary such as a confirming, export finance, factoring or forfeiting house to handle the
problems on their behalf; or possibly by giving no credit or selling only through agents who accept the credit
risk and are themselves financially strong.
 None of these devices will enable the exporter to escape from certain hard facts of life.
 The need to avoid giving credit to creditworthy customers. Weak customers cannot obtain an ILC from their
own bank, nor would they be cleared for credit by a credit insurer or intermediary.
 The need to negotiate secure payment terms, procedures and mechanisms which customers do not find
congenial. An ILC and especially a CILC are costly to customers, and restrict their flexibility: if they are short
of cash at the end of the month, they must still pay out if their bank is committed.
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 Exporters can only collect under a letter of credit if they present the exact required documents. They will not
be able to do this if they have sent the goods by air and the credit requires shipping documents; or if they
need to produce the customer’s inspection certificates and the customer’s engineer is mysteriously
unavailable to inspect or sign.
 The need to insist that payment is in a convertible currency and in a form which the customer’s authorities
will permit to become effective as a remittance to where the exporters need to have the funds, usually in their
own country. Often this means making the sale subject to clearance under exchange controls or import
licensing regulations.
Foreign exchange risk

 Many companies trade in foreign currencies, either buying from abroad in a foreign currency or denominating
sales to export customers in a foreign currency. If so they might need to:
 buy foreign currency to pay a supplier, or

 convert foreign currency receipts into domestic currency.
 Foreign exchange risk arises in the following situations:
 If a company has to obtain foreign currency at a future date to make a payment, there is a risk that the cost
of buying the currency will rise (from what it would cost now), if the exchange rate moves and the currency
strengthens in value.
 If a company will want to convert currency earnings into a domestic currency at a future date, there is a risk
that the value of the currency will fall (from its current value), if the exchange rate moves and the currency
falls in value.
 Exposure to the risks of adverse changes in an exchange rate are known as ‘foreign exchange transaction
exposures’. These exposures can be ‘hedged’ (reduced or offset). The methods available to hedge the risks are
covered in CH 12
 In a question that deals with overseas receivables and payables, remember to consider export credit risk and
foreign transaction exposure as well as the normal points on the management of receivables and payables.
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5 ACCOUNTS PAYABLE MANAGEMENT

 Trade credit is the cheapest source of finance: it’s usually free!
 Management of payables means finding the right length of time to pay suppliers:
 delaying payments improves liquidity, but

 delaying payments too long may cause long term problems: e.g. loss of supplier goodwill or failure to provide
goods until the account is paid, this affects profitability.
 Paying early may result in an early settlement discount:
 Benefit: income from the discount

 Cost: loss of free credit; the payables period may need to be taken up by a bank overdraft
Example 11 – Use logic as for annualised cot of discount

One supplier has offered a discount to Square Co of 3% on an invoice for $10,500 if payment is made within one month, rather than
the three months normally taken to pay. Square’s overdraft rate is 8% pa.
Required: Asses if it is financially worthwhile for them to accept the discount and pay early.
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Example 12 – Use logic as for Receivables – total benefits and costs

Hibs Ltd has been offered a discount of 2% if payment is made within 10 days instead of current 30 days. Total purchases for a year
from that supplier are $ 900,000. Hibs Ltd has overdraft on which is paying 8% interest.
Required: Asses if Hibs Ltd should accept the discount.
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6 CASH MANAGEMENT
CASH MANAGEMENT
Cash budget Cash management methods
6.1 Introduction
 Reasons for holding cash include:
 Transactional – the business needs cash to make regular payments (suppliers, wages, taxes, etc.)
 Precautionary – as a buffer of cash for unforeseen occasions
 Speculative – to take advantage of market opportunities
 Finance/ investment – to cover major investments in non-current assets
 Managing cash means to keep a balance between:
 The ability to pay bills as they fall due (LIQUIDITY), and

 Holding a minimum amount of cash as we are losing opportunity interest (PROFITABILITY)
 How to alleviate a cash shortage
 Postpone capital expenditure

 Accelerate cash receipts which would otherwise be expected later, e.g. with prompt payment discounts
 Reverse past investment decisions by selling assets previously acquired
 Negotiation a reduction in cash out, to postpone or reduce payments
 Longer credit
 Loan repayments
 Deferral of payment of tax
 Dividend payments reduced
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 Cost of running out of cash include:
 Loss of settlement discounts

 Loss of supplier goodwill
 Being forced into liquidation if debts are not paid
6.2 Cash budget/ forecast

 A cash budget is prepared on a monthly basis (at least) to ensure that the company has an understanding of its
cash position going forward. There are 3 considerations:
 Inflow and outflows of cash

 Ignore non cash flows (allocation of cost, depreciation)
 Pro forma led
 What to include – show expected receipts and payments of cash. Therefore there is a difference between profit/ loss
and cash position:
 Not all cash receipts and payments affect the income statement
 Some cost affect the income statement but are not cash
 Show the timing of cash inflows and outflows
 Proforma Jan Feb Mar

$ $ $
Cash receipts
From cash sales x x x
From credit customers x x x
Proceeds from disposal of assets x x x
Total in x x x
Cash payments
To suppliers x x x
Wages x x x
Total out x x x
Net surplus/deficit x x x
Opening cash x x x
Closing cash x x x
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Example 13 – Cash forecast

A company makes product WSX; variable overheads are $2 per unit. Fixed costs are $450,000 for the year, of which $130,000 are
depreciation charges. The remaining fixed costs are incurred at a constant rate every month, with the exception of factory rent, which
is $80,000 per year, payable 50% in December and 50% in June.
With the exception of rent, 10% of overhead expenses are paid for in the month in which they occur, and the remaining 90% are paid
in the following month.
Budgeted production is: Sept. 40,000 units, Oct. 60,000 units, Nov. 50,000 units, Dec. 30,000 units.
Required: Prepare a 3-month cash flow forecast for overhead payments for October, November, December.
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6.3 Cash management models

 These models help determine the optimum amount of cash the company should hold (as cash can be transferred to and
from short-term investment opportunities) using two models: Baumol and Miller Orr.
Baumol model (derived from the EOQ model)
Holding cost is the lost interest Ordering cost is the transaction cost
(cost to sell/buy securities)
Q Q D D
C     i C    C
2 h 2 Q o Q
2 DC
Q
i
Q: The amount of cash transferred per transaction

I: Interest (similar to Ch in EOQ)
D: Annual demand for cash
C: Transaction cost (similar to Co in EOQ)
 Assumptions
 cash use is steady and predictable
 cash inflows are known and regular
 day-to-day cash needs are funded from the current account
 buffer cash is held in short-term investments
 Drawbacks
 Unlikely to be able to predict D
 No buffer inventory allowed for
 Unrealistic assumptions
Example 14 - Baumol
A company generates $20,000 per month of excess cash, which it intends to invest in short-term securities. The interest rate it can
expect to earn on its investment is 5% pa. Transaction cost = 70$.
Required:
a) What is the optimum amount of cash to be invested in each transaction?
b) How many transactions will arise each year?
c) What is the cost of making those transactions pa?
d) What is the opportunity cost of holding cash pa?
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Miller Orr model

 It has the advantage of incorporating uncertainty into the cash inflows and outflows.
 Diagram:
 The model sets higher and lower control limits, H and L respectively, and a target cash balance, Z.
 When the cash balance reaches H, then (HZ) dollars are transferred from cash to marketable securities, i.e.
the firm buys (HZ) dollars of securities.
 Similarly, when the cash balance hits L, then (LZ) dollars are transferred from marketable securities to cash.
 Formula (Exam formula sheet)
Return point Z  L  1/3 (spread)
3 transaction .cost variance .of .CF 1

Spread  3( )3
4 i
 Notes to the formula
 Interest rate “i” is the daily interest rate.

 Standard deviation x variance: In the exam, you are often given the annual interest rate instead of the daily
rate, and the standard deviation instead of the variance. Simply square the standard deviation to get the
variance.
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Example 15 - Miller Orr

The minimum cash balance is $10,000, the standard deviation of daily cash flows is $2,200. The transaction cost is $40, i=0.02% per
day.
Required: Formulate the decision rule using the Miller Orr model.
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Chapter 10
Efficient Market
Hypothesis
C H A P T E R 1 0 – E F F I C I E N T M A R K E T H Y P O T H E S IS
1 THE EFFICIENT MARKET HYPOTHESIS (EMH)

 The EMH states that it is not possible to consistently beat the market by using any information that the market
already knows, except through luck.
 The idea is that new information is quickly and efficiently incorporated into asset prices at any point in time, so that
old information cannot be used to foretell future price movements.
2 LEVELS OF EFFICIENCY
2.1 Weak form efficiency
 In a weak form efficient market, the share price reflects all information about past price movements in the share
price and their implication.
 Share prices only changes when new information about a company and its profits have become available. Since
new information arrives unexpectedly, changes in share prices occur in a random pattern.
 Stock market is a weak form efficient as:
 there are no patterns or trends.

 prices rise or fall depending on whether the next piece of news is good or bad.
 tests show that only 0.1% of a share price change on one day can be predicted from knowledge of the
change on the previous day.
 Therefore in a weak efficient markets
 future price movements cannot be predicted from past price movements.

 charting and technical analysis (analysis of past price movements) cannot help an investor consistently
beat the market.
2.2 Semi strong form efficiency

 In a semi-strong efficient market current share price reflects:
 all information about past price movements in the share price and
 publicly available information about the company
 Stock market is semi-strong efficient as share prices react within a couple of minutes of any new information being
released.
 Implications for semi strong efficient market:
 Fundamental analysis (=examining publicly-available information) will not provide opportunities to

consistently beat the market, as public info are already reflected in share price.
 Since published information includes past share prices a semi - strong form efficient market is also
weakly efficient.
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C H A P T ER 1 0 – E F F I C I EN T M A R K E T H Y P O T H E S IS
2.3 Strong form efficiency

 In strong efficient market current share price reflects all relevant information:
 From past changes in the share price

 From public knowledge
 From insider knowledge
 The stock market is not strong form efficient as the share price will move when new information breaks through (eg.
takeover is announced) (in strong form efficient market the price would move when decision of takeover is made)
3 FEATURES OF EFFICIENT MARKETS

 A market is efficient if
 The prices of securities traded in that market reflect all the relevant information accurately and rapidly,
and are available to both buyers and sellers.
 No individual dominates the market.
 Transaction costs of buying and selling are not so high as to discourage trading significantly.
 Market efficiency from the perspective of the EMH relates to the efficiency of information, the better the
information received by investors, the better and more informed the decisions they make will be.
4 IMPLICATIONS FOR FINANCIAL MANAGERS

 If capital markets are efficient, the main implications for financial managers are:
 The timing of issues of debt or equity is not critical, as the prices quoted in the market are ‘fair’. That is
price will always reflect the true worth of the company, no over or under valuation at any point.
 An entity cannot mislead the markets by adopting creative accounting techniques.
 The entity’s share price will reflect the net present value of its future cash flows, so managers must only
ensure that all investments are expected to exceed the company’s cost of capital.
 Large quantities of new shares can be sold without depressing the share price.
 The market will decide what level of return it requires for the risk involved in making an investment in the
company. It is pointless for the company to try to change the market’s view by issuing different types of
capital instrument.
 Mergers and takeovers. If shares are correctly priced this means that the rationale behind mergers and
takeovers may be questioned. If companies are acquired at their current market valuation then the
purchasers will only gain if they can generate synergies (operating economies or rationalisation). In an
efficient market these synergies would be known, and therefore already incorporated into the price
demanded by the target company shareholders.
 The more efficient the market is, the less the opportunity to make a speculative profit because it becomes impossible
to consistently out-perform the market.
 Evidence so far collected suggests that stock markets show efficiency that is at least weak form, but tending more
towards a semi-strong form. In other words, current share prices reflect all or most publicly available information
about companies and their securities.
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C H A P T ER 1 1 – B U S IN ES S V A L U A T O IN S
Chapter 11
Business Valuations
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C H A P T E R 1 1 – B U S IN E S S V A L U A T I O N S
1 NATURE AND PURPOSE OF BUSINESS VALUATION

Why/when valuations are needed
 To value companies for takeovers and mergers
 To value companies entering the stock market
 To establish values of shares held by retiring directors, which must be sold
 To calculate capital gains tax, inheritance tax, divorce settlements
Info requirements for valuations

 Financial statements for the last 5 years
 Summary of non-current assets and depreciation schedules
 Aged receivables and payables
 List of marketable securities
 Inventory summary
 Details on existing contracts (e.g. leases, suppliers)
 List of shareholders with number of shares held
 Budget for 5 years
 Information about the company’s industry and economic environment
 List of customers ranked by sales
 Organization chart, management roles and responsibilities
 The list is not exhaustive, and there are limitations to some of the information.
Real worth of the Company

 There are a number of different ways of a putting value on a business. It makes sense to use several methods and
compare values they produce.
 The final figure will be a matter for negotiation between the interested parties
It is important for you to bring this out in the exam: the valuation is subjective and these numbers are just the starting place for
negotiations
Approaches to valuation
 Asset based – based on the tangible assets owned by the company (going concern of the business is in question)
 Dividend Valuation Model – based on the return paid to a shareholder (non –controlling interest)
 Income/earnings based – based on the returns earned by the company (controlling interest)
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2 ASSET BASED VALUATIONS

 Net assets per share  what is available for ordinary shareholder
 assets less liabilities less preference shares OR equity less preference shares.
 intangibles should be excluded (goodwill, development expenditures) unless they have market value
(e.g. patents & copyrights that can be sold).
 Net assets can be valued at:
 book value (historic basis) – meaningless.

 realisable value/break-up value – if the assets are to be sold (not relevant when minority shareholder
sells its stake as assets will continue in business). This is the minimum value that should be accepted for
the sale of a business as a going concern.
 Replacement cost – minimum amount any purchaser pays for on-going business as it represents the
total cost of forming business from scratch. But major part of the going concern of a business is goodwill.
This can be found only by income-based valuations.
 Weaknesses
 Investors do not normally buy a company for its balance sheet assets, but for the earnings/cash flows
that all of its assets can produce in the future. Therefore we should value what is being purchased, i.e.
the future income/cash flows.
 The asset approach ignores non-balance sheet intangible ‘assets’ (e.g. highly-skilled workforce, strong
management team, competitive positioning of the company’s products).
 Can be used as one of many valuation methods or to provide lower limit. In itself it is unlikely to produce a realistic
value. Useful for:
 For asset stripping (realisable value)

 To identify a minimum price in a takeover (replacement cost)
 To value property investment companies
Example 1 - Asset based valuation

The Statement of Financial Position of Daniela, an unquoted company, on December 31, 20X0:
$
Non current assets 500,000 Additional info:
Net current assets 200,000 - bond have market value of $ 180,000
700,000 - MV of non current assets exceeds BV by $40k
- all other assets are realisable at their book value
50c ordinary shares 200,000
Reserves 300,000 Required: Value a 70% holding of ordinary shares on asset basis.
6% bonds 200,000
700,000
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3 DIVIDEND VALUATION MODELS

 Used for non-controlling interest as this is a dividend that is received by shareholder.
 Value of the share / company is the present value of the expected future dividends discounted at the cost of equity
(see CH5, FUNDAMENTAL THEORY OF SECURITIES)
D D
MV  1  2  ....  Dn  ...    
(1  i) (1  i) 2 (1  i) n
 For constant dividend or dividend growing by constant g it will lead to formulas (see CH5)
D D
MV  MV  1
i i g
 Advantages and disadvantages: The model is good for valuing a non-controlling interest but:
 there may be problems estimating a growth rate

 growth rate is unlikely to be a constant
 the model is highly sensitive to changes in a key variables
 Market capitalisation: value of the Co = MV of share x number of shares in issue
Example 2
A company has the following financial information available:
Share capital in issue: 4 million ordinary shares at a par value of 1$ each. Current dividend per share (just paid) 19c. Dividend 5
years ago 15c. Current equity beta 0.7. The cost of equity is 9%.
Current market return 12%. The risk-free rate is 5%.
Required: Calculate market capitalisation of the company based on dividend valuation model.
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Example 3
Company GXG has following dividend policy: Company plans to suspend dividends entirely for next 2 years, from end of 3rd year
they will pay dividend of 25c per share and from end of 6th year they will increase dividend of 25c by 4% each year. Total nominal
value of ordinary shares of a GXG is $ 5,000,000, nominal value of each share is 50c, cost of equity is 9%.
Required: Calculate market value of the GXG
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4 INCOME/EARNINGS BASED MODELS

 Of particular use when valuing a majority shareholding as:
 majority shareholders can influence the future earnings of company

 majority shareholders can influence dividend policy (level of divs can be manipulated to what you want)
P/E method
MV share MVCompany
P/E   therefore MV  PE  EPS or MVCompany  PE  PAT
EPS PAT share
 P/E is published for quoted (listed) companies.

 To find potential value of ‘our” company, we will use “our” Co EPS or PAT and P/E of a similar (listed) company
 P/E of listed similar Co must be adjusted for “our” Co – typical for exam  adjust P/E by 1/3 down to reflect
the fact “our” Co is not listed
 Problems with P/E
 Difficult to find a quoted company with a similar range of activities (they are groups with different bus
activies– diversified business risk)
 A single P/E is not a good basis if earnings are volatile
 If P/E trend is used, it is based on historical data P/E, but values how the company will do in the future
 Quoted companies will have different capital structures (different financial risk)
 Earnings yield = 1/PE = EPS/MV  used in the same way
Example 4 – PE method
Company A has earnings of $300,000. A similar listed company has an earnings yield of 12.5%. Company B has earnings of
$420,500. A similar listed company has a PE ratio of 7.
Required: Estimate the value of each company.
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Example 5 – adjusted PE
Chip and Dale, an unquoted company, has issued ordinary share capital of 200,000 25c shares. Extract from their income
statement for the year ended 31 December 20X4:
$ $
PBT 500,000
Tax (300,000)
PAT 200,000
Preference divs. (40,000)
Ordinary divs. (60,000)
(100,000)
Retained profit for the year 100,000
PE ratio of quoted Companies with similar business activities is 10.
Required: Estimate the value of 100,000 shares using PE ratio basis.
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4.2 Discounted Future Cash Flows

 Method
 Identify the relevant ‘free’ cash flows (same principles as in Investment appraisal applie)
 Operating cash flows

 Revenue from sale of assets
 Tax effects
 Synergies arising from any merger etc
 Select a suitable time horizon (will be given, often to perpetuity)

 Calculate the PV of CF using suitable discount rate. This gives the value to all providers of finance -
equity + debt
 Deduct the market value of debt to get the value of equity
PV of CF x
Less MV of debt (x)
MV of equity x
 Advantages and disadvantages
 theoretically the best method

 can be used to value part of a company
 relies on estimates of both cash flows and discount rates
 assumes discount rate, tax and inflation rates are constant through the period
 MV of debt calculation
 Value of the debt to be determined as in chapter 5 Cost of capital (Fundamental theory of securities)
U1 U2 Un N
 MV=   ...  
1  i (1  i) 2 (1  i) n
(1  i) n
 TAX IMPLICATION - This time we calculate MV from the equation, not cost of capital i, therefore we are
looking at it from the position of holder of debt finance (who bought it from the Company). For holder the
interest is the INCOME, therefore NOT TAX DEDUCTIBLE, but TAXABLE and we do not know how.
That is why NO TAX IS REFLECTED IN INTEREST PAYMENTS and interest rate/ cost of capital /I
used to discount cashflow is PRE-TAX.
 $ debt always quoted in $100 nominal units – so it is not usually given in the question
 Examiner sometimes quotes interest yield = interest/MV
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Example 6 - Free Cash Flows

A company’s current revenues and costs are as follows: sales $400 million, cost of sales $220 million, distribution and
administrative expenses are $40 million, tax allowable depreciation $80 million and annual capital spending is $100 million.
Corporation tax is 30%. The current market value of debt is $20 million. The WACC is 16.6%. Inflation is 6%. These cash flows
are expected to continue for the foreseeable future.
Required: Calculate the value of equity.
Example 7 - Market value of debt

Elliot plc has convertible loan notes with a coupon rate of 10%. Each $100 loan note may be converted into 25 ordinary shares at
the maturity date which is in 4 years, or redeem at a 5% premium to the par value.
The current share price is $3.70 which is expected to grow by 4% per annum. Investors require a rate of return of 7% per annum.
Required: Calculate the following:
(a) Market Value
(b) Floor value
(c) Conversion premium
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C H A P T ER 1 2 – R I S K
Chapter 12
Risk
 This chapter looks at the risk to a company from

 Foreing currency (FOREIGN EXCHANGE RISK) and
 Interest rates (INTEREST RATE RISK)
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CHAPTER 12 – RISK
FOREIGN EXCHANGE RISK
Payment Receipt
Deposit FX Deposit local currency
1 Foreign Exchange (FX) rates
Types of FX rates
 An exchange rate is the rate at which one country’s currency can be traded in exchange for another country's
currency.
 Spot rate = the exchange rate currently offered. It’s the rate of exchange of currency for immediate delivery.
 Forward rate = this is the exchange rate set now for currencies to be exchanged at a future date.
FX quotations
 Direct quote = amount of domestic currency /1 unit of FX  CZK, Kazach Tenge, Russian Ruble, Serbian Dinar,
Romanian Leu
 Indirect quote = amount of FX/ 1 unit of domestic currency  strong currencies as EUR, $, GBP
Bank quotations – offer vs. bid

 A domestic bank buys foreign currency (BID price) and sells foreign currency (OFFER price).
 A bank will buy low and sell high, the difference is called the spread and covers the bank or dealer’s cost + profit.
 In the exam you will be given both rates (bid and offer), but you will not be told which one is the buy FX or sell FX
rate. The different types of quotation (direct/indirect) and banks in different countries dealing with currencies might
cause confusion. See the following illustration:
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Example 1 – Direct, indirect quote and offer,bid (Illustrated)
Czech Crone (CZK) is quoted in Prague as follows:
Bank sells (offer) Bank buys (bid)

CZK/GBP (direct quote) 32 30
Czech Crone (CZK) is quoted in London as follows:
Bank sells (offer) Bank buys (bid)

CZK/GBP (indirect quote) 30 32
 You have to realise that:
 The London bank is buying/selling CZK, while Prague bank is buying/selling GBP.
 The bank has to buy “cheap” and sell “expensive” to make profit.
 In the Czech Republic, the FX rate is quoted directly and therefore the bid price (buying price) is lower
than the offer price (selling). (The bank buys 1 GBP for 30 CZK but sells 1 GBP for 32 CZK, making CZK
2 per transaction). Czech bank is trading with GBP!
 In Great Britain, the FX rate is quoted indirectly, therefore the number representing the selling price is
lower than the number representing the buying price (The bank buys 32 CZK for 1 GBP and then sells
30CZK for 1 GBP, making profit of 2 CZK on transaction). British bank is trading with CZK!
Depreciation/ appreciation
 Depreciation of a foreign currency:
 Receipt in FX – will receive less in your home currency

 Payment in FX– will pay less in your home currency
 Appreciation of a foreign currency:
 Receipt in FX – will receive more in your home currency

 Payment in FX– will pay more in your home currency
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CHAPTER 12 – RISK
2 FX rate systems
Exchange rates are a key measure for governments to attempt to control. They will have direct bearing on the economic
performance of the country.
Fixed FX rates
 Governments can use their official reserves to create an exact match between supply and demand for its currency in
the FX markets in order to keep the FX rate unchanged.
 FX rate is fixed against a standard, e.g.: gold, major currencies (US$), baskets of major trading currencies
 A fixed FX rate system removes FX rate uncertainty thereby encouraging foreign trade, but there is a loss of flexibility
in economic policymaking. It might lead to an unofficial market for currency if out of step with perceived value and
normally requires strict exchange control to operate.
Floating FX rates
 FX rates are left to the free play of market forces with no official financing at all; there is no need for a government to
hold reserves.
 Supply and demand continuously change FX rates and there can be high fluctuations.
 This is rare system, currency value is considered too important a measure to be left solely to the market.
 The market has a tendency to be volatile to the adverse effect of trade and wider government policy. This volatility
can adversely affect the ability to trade between currencies.
Managed floating FX rates

 The central bank will attempt to keep currency relationships within a predetermined range. The government may
intervene by:
 Using reserves to buy or sell currency the government can artificially stimulate demand or supply and
keep the currency within a trading range reducing volatility.
 Using interest rates, by increasing the interest rate within the economy the government makes the
currency more attractive to investors in government debt and will attract speculative funds.
3 Types of foreign currency risk

 Transaction risk - The risk of exchange rate changes between the transaction date (purchase of goods) and
subsequent settlement date (payment). There will be a gain or loss arising on conversion. (this is the risk of adverse
FX rate movements occurring in the course of normal international trading transactions).
 Translation risk – This is the risk of ‘paper’ gains or losses due to changes in financial statement values that result
from FX movements. This risk comes from the consolidation of companies with international subsidiaries. Unlike the
other two risks mentioned, translation risk does not directly result in increased or decreased cash flows.
 Economic risk – This is the long-term risk of the business becoming more or less profitable due to the strengthening
or weakening of the FX rate. For example, New York City experienced an increase in European tourism when the
dollar depreciated against the Euro and the British Pound in recent years.
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4 Causes of FX rate fluctuations
Currency supply and demand

 FX rate is primarily determined by supply and demand in FX markets. Supply and demand are, in turn, influenced by:
 Inflation, compared with the rate of inflation in other countries (Purchasing power parity)
 Interest rates, compared with interest rates in other countries (Interest rate parity)
 The balance of payments, e.g. where imports exceeds exports, the exchange rate may depreciate since
the supply of the currency (imports) will exceed the demand for the currency (exports)
 Speculation
 Government policy
 Capital movements between economies
 rising interest rates will attract a capital inflow and a demand for the currency, and vice-versa
when the interest rate is dropping
 inflation: asset holders will not wish to hold financial assets in a currency whose value is
falling because of inflation
Interest rate parity theory (IRP)

 The theory states that there is a no net gain relating to investing in government bonds in differing countries, because
any gain earned in additional interest will be eliminated by a compensating adverse movement in exchange rates.
 If IRP holds true, nobody can beat the market by investing in country with higher interest rate, because any gain
earned on interest rate will be offset by adverse movements in FX rate between currencies.
 If this is not a case and FX rate did not adjust, then profits could be made by investing in bonds and switching
currencies at an advantageous rate.
 It is used for predicting forward rate
Example 2 – IRP
It is possible to invest in a 1 year US bond at 9.5% or in EU bonds at 7.3%. The current spot rate is 1.5 USD/EUR.
Required: Estimate 1 year USD/EUR forward rate.
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CHAPTER 12 – RISK
 From the above Illustration we can derive formula for estimating forward rate for given period provided IRP holds true
(given in Exam Formula Sheet).
(1  i )
F  S now  USD
(USD/EUR) (USD/EUR) (1 i )
EUR
 Interest rate parity was developed for estimating the forward rate, but based on this theory traders were also
predicting the spot rate in the future (see expectations theory). Therefore interest rate parity theory can be used to
estimate the future spot rate  the formula would be same:
(1  i )
S  S now USD
future (USD/EUR) (USD/EUR) (1 i )
EUR
 Expectation theory:
 The current forward rate is an unbiased predictor of the spot rate at that point in the future. Therefore
future spot rate is also estimated using IRP.
EXAM TIP
You will be given the spot rate now and the 3-month interest rates for 2 currencies. The question can be formulated as:
1. What is the likely 3 month forward rate that the bank is currently offering?
2. What will the spot rate be in 3 months time?
3. Which currency is likely to depreciate/ appreciate (the currency in the country with higher/lower interest rate will
depreciate/appreciate)
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Purchasing power parity theory (PPPT)

 The rate of exchange between two currencies depends on the relative inflation rates of those two countries.
 Based on the law of one price - a basket of identical goods should have the same value in any country, and FX rates
reflect this. This would suggest that a relative change in prices (inflation) would have a direct effect on the exchange
rate.
 PPPT is an unbiased but poor predictor of future exchange rates.
Example 3 – PPPT (Illustrated)

A product is currently being sold in the UK for £2,000 and in the US for $4,000. If PPPT holds true, then current FX rate is $/£
2.0000.
Required: What exchange rate in 1 year we can expect if the inflation rates are 4% in UK and 7% in US?
US market UK market
USD/GBP=2
Cost of item now 4,000 USD 2,000 GBP
Annual inflation 7% 4%
Cost in one year 4,280 USD 2,080 USD
=>The expected spot rate in one year: 4,280/2,080 = 2.0576 USD/GBP

Conclusion: The PPPT predicts that the currency of the country where inflation is higher will depreciate.
 PPPT formula (Exam Formula Sheet):
(1  h )
S S  USD
1(USD/GBP) 0(USD/GBP) (1  h )
GBP
S 0 = Current spot
S1 = Expected spot
hUSD = inflation rate in USD
hGBP = inflation rate in GBP
Example 4 – PPPT using formula (see previous example) (Illustrated)
1,07
2  2.0576 USD/GBP
1,04
 Drawbacks of PPPT
 future inflation rates are only estimates

 Not all inflation relates to exported goods.
 There are market imperfections such as taxation and tariffs that reduce the impact of PPPT.
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CHAPTER 12 – RISK
Fisher effect
 The nominal interest rate is made up of 2 parts:
 Real interest rate ireal
 Inflation iinf
(1  i nom )  (1  i ) (1  i )
real inf
 International Fisher effect (IFE)
 The IFE states that all currencies must offer the same real interest rate. This links PPPT to IRPT. It is
based upon the Fisher effect.
 The relative real interest rates should be the same due to the principle of supply and demand, if a country
offers a higher real interest rate investors will invest in that currency and push up the price of the
currency bringing the real rate back to equilibrium.
 The international Fisher effect has a strong theoretical basis but is a poor predictor of future exchange
rates.
Four-way equivalence
 The four-way equivalence model states that in equilibrium differences between forward and spot rates, differences in
interest rates, expected differences in inflation rates and expected changes in spot rates are equal to one another.
 You do not need to know too much about this other than to appreciate that there is an interconnections between
interest rates, inflation rates and exchange rates.
Example 5 - IFE (Illustrated)

It is possible to invest £1m in short-dated govt bonds in the UK at 6.08% or alternatively in US treasury bills at 9.14%. The
current exchange rate is $/£2.0000. Inflation in UK is 4%, in US 7%.
YR PPPT IRPT
0 USD/GBP =2.0000 USD/GBP =2.0000
× 1.07/1.04 ×1.0914/1.0608
1 2.0577 2.0577
Real rate in UK (from Fischer formula): (1.0608/1.04)-1 = 2%

Real rate in US: (1.0914/1.07)-1 = 2%
The reason for both PPP and IRP having the same prediction is because the international Fisher effect holds true.
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5 Managing (hedging) foreign currency risk
Currency of invoice
 The exporter invoices his foreign customer in domestic currency and the FX risk is transferred to second party. Why
the second party might agree to take the risk?:
 Marketing advantage – he might be selected

 To have FX currency for offsetting other payments
Matching receipts and payments

 The company can reduce FX transaction exposure by matching receipts and payments.
 Since the company will offset FX receipts with FX payments, it does not matter whether FX strengthens or weakens
as there is no purchase/sale of FX.
 Only the net surplus or deficit is exposed to transaction risk.
Matching assets and liabilities

 If the company expects to receive foreign currency income, the risk is that the currency will weaken. Therefore the
company can take a loan in the foreign currency and repay it from the foreign currency receipts.
Leading and lagging

 Lead payment (paying in advance) – if an exporter expects that the currency it is due to receive will weaken.
Assumes the financing cost < potential FX loss
 Lag payment (delay payment) – if an importer expects that the currency it is due to pay will weaken. Assumes
possible fines < potential FX gain
Netting
 The objective is to save transaction costs rather than managing the transaction risk.
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CHAPTER 12 – RISK
Money market hedge - hedging FX payment

 Method
 Borrow the appropriate amount in domestic currency now

 Convert the domestic currency into foreign currency immediately
 Put the foreign currency on deposit immediately
 When the time comes to pay:
 A) pay the creditor out of the FX bank account

 B) repay loan account in domestic currency
Example 6 - Money market hedge - payment

A UK company owes a Danish creditor Kr 4,500,000 in three months time. The spot exchange rate is Kr/£ 7.5507 – 7.5544.
Borrowing and deposit interest rates are as follows:
3m borrowing 3m deposit
GBP 8%pa 7%pa
DKr 10% 9%
Required: What is the cost in pounds with a money market hedge and what effective forward rate would this represent?
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Money market hedge - hedging a FX receipt

 Method
 This is the mirror-image of the transactions above:

 Borrow the appropriate amount in foreign currency now
 Convert the foreign currency into domestic currency immediately
 Put the domestic currency on deposit
 When the debtor’s cash is received:
 A) repay foreign-currency loan

 B) take cash from the home currency deposit account
Example 7 - Money market hedge - receipt

A UK company is owed CHF 3,000,000 in three months time by a Swiss Co.. The spot exchange rate is CHF/£ 2.2400 – 2.2420.
Borrowing and deposit interest rates are as follows:
3m borrowing 3m deposit
GBP 10.50%pa 9%pa
CHF 11% 10%
Required: What is the receipt in pounds with a money market hedge and what effective forward rate would this represent?
WHERE TO START – HOW TO DECIDE ON WHICH CURRENCY TO BORROW OR DEPOSIT

PAYMENT
If you have a payment due, this means you have a foreign currency liability. You will create the opposite - a foreign currency
asset - by depositing the identical amount of money in foreign currency.
You borrow this money in home currency, convert it, and use these funds to create the asset. Thus, you now have a matching
asset and liability in foreign currency, and an additional liability in home currency.
RECEIPT
It works the opposite way if you have a receivable.
If you have a foreign currency receivable, this is an asset. So you create a foreign currency liability by borrowing in foreign
currency, converting it, and depositing it in home currency. So you have matched the foreign currency asset with a foreign
currency liability, and created an additional receivable in home currency.
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CHAPTER 12 – RISK
Forwards
 A forward contract specifies in advance the rate at which a specified quantity of currency will be bought and sold
 A forward exchange contract is:
 Immediately firm and is a binding contract (between the bank and the customer)
 For the purchase or sale of a specified quantity of stated foreign currency
 At a rate fixed at the time the contract is made
 For performance (delivery of the currency and payment for it) at a future time which is agreed in the
contract (future time will be either a specified date or an interval between 2 dates)
Example 8 – Forward (Illustrated)

A UK importer knows on 1 May he must pay a foreign seller 30,000 EUR in 3 months time (i.e. on 1 August). He can arrange for
a forward exchange contract with his bank on 1 May, whereby the bank will sell the importer 30,000 EUR on 1 August, at fixed rate
2.7200 to 1 GBP.
The UK importer can be certain that whatever the spot rate is between GBP and EUR on 1 August, he will be able to pay on that
date at his agreed forward rate:
30,000/2.7200 = GBP 11,029
Example 9 - Forward
The current spot rate for US dollar against UK sterling is 1.4525-1.4535 $/GBP, and the one month forward rate is quoted as
1.4550-1.4565. A UK exporter expects to receive $400,000 in one month.
Required: If a forward exchange contract is used, how much will be received in sterling?
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 A Customer might not be able to satisfy a forward contract because:
 The importer might find that:
 The supplier did not deliver him the goods, so there is nothing to pay for
 The supplier sent fewer goods
 The supplier was late with delivery
 The exporter can have the reverse situation
 If the customer can not satisfy the forward exchange contract, the bank will make the customer fulfil the contract
(closing out)
 If the customer promised to sell FX to bank, the bank will:
 Sell currency to the customer at the spot rate (when the contract falls due for performance)
 Buy the FX back, under the terms of the forward exchange contract
 If the customer promised to buy FX from the bank, the bank will
 Sell the customer the specified amount of FX at the forward FX rate

 Buy back unwanted currency at the spot rate
 Advantages of forward contract
 flexibility with regard to the amount to be covered and to the currency

 straightforward to comprehend and organize
 Disadvantages of forward contract
 contractual commitment that must be completed on the due date

 no opportunity to benefit from favourable movements in exchange rates
Example 10 - Choosing between hedging techniques

A UK Co bought goods from a US supplier and must pay $5,000,000 in 3 months time. Consider 3 methods:
a) forward exchange contract
b) money market hedge
c) lead payment
The following annual interest rates are currently available:

US$ GBP
Deposit rate Borrowing rate Deposit rate Borrowing rate
% % % %
1 month 8 11 11.5 14
3 month 8 11.25 12 14.25
$/1GBP
Spot 1.9025 – 1.9035
1 month forward 1.8925 – 1.8945
3 months forward 1.8845 – 1.8860
Required: Which is the cheapest method for the company?
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CHAPTER 12 – RISK
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6 Foreign currency derivatives
Currency futures
 A Futures contract can be defined as standardised contract covering the sale or purchase at a set future date of a
set quantity of a commodity, financial investment or cash.
 A financial future is a futures contract which is based on a financial instrument:
 Currency (standardised contract to buy/sell a fixed amount of currency at a fixed rate on a fixed future
date).
 Buying the futures contract means receiving the contract currency
 Selling the futures contract means supplying the contract currency
 Interest rate
 Market indices
 Differences between a forward and a future contracts
 A forward contract is negotiated over the counter between the buyer and seller  tailored to the
customer’s requirements. Three things are negotiated:
 quantity
 delivery date
 price
 The future is standardised as to quantity and delivery date. The only factor which is traded is price.
The prices of futures contracts change continuously, and are quoted by the futures exchange like share
prices or currency prices.
Example 7 – contract size (Illustrated)

Cotton futures are traded on NYCE with a standard contract size of 50,000 kgs and only 4 standard delivery dates each year (May,
July, October, December)
GBP currency futures are traded on IMM (International Monetary Market, Chicago) with a standard contract size of GBP 62,500
and 4 standard delivery dates (March, June, September, December)
 Since the contract size is standardised, the amount required must be rounded to the nearest whole
number of contracts  this causes hedging inefficiencies.
Example 8 – Hedging inefficiency (Illustrated)

I want to buy GBP 950,000, which represents GBP 950,000 / GBP 62,500 = 5.2 contracts, which is 5 contracts.
 Most forward contracts are settled by delivery of the underlying currency / commodity. Futures are
not settled by delivery, but by closing out.
 Closing out means entering into a second futures contract which reverses the effect of first one. If on 1
July Co buys 8 GBP contracts, it closes out by selling 8 GBP contracts at a later date, say 31 July. The
effect is that Co now has no liability to sell or buy GBP, but it will make a loss or gain resulting from the
difference in price between 1 July and 31 July.
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CHAPTER 12 – RISK
 Differences between forward and future contracts
Futures Forwards
Hedge efficiency Fix FX rate subject to margin error (hedge Fix FX rate agreed in advance
inefficiencies)
Standardised vs. tailored Standardised (quantity, time), traded on Over the counter (OTC) - tailored
Exchange Futures Exchange
a/ transaction cost is lower
b/ date of receipt/payment in FX do not
have to be known with certainty – limited by
expiry date
Number of currencies Limited number of currencies subject to the Any currency
futures contract
Settlement of contract Close out Delivery of currency/commodity
 Notes, terms, definitions
 Currency futures are not as common as forward contracts.

 On the currency future markets, currencies are priced in $. No contracts are for $ itself.
 On financial future exchanges, most trading is in interest rates and stock exchange indices.
 Settlement date is the date when trading on particular futures contract stops and all accounts are settled.
 Contract size – fixed minimum quantity of commodity (currency) which can be bought or sold using a
futures contract.
 One tick is the smallest measured movement in the contract price. For currency futures, this is a
movement in the fourth decimal place.
 GBP Sep Contract at $/GBP 0.65, contract size GBP 62,500 – holder of this contract is obliged to buy
GBP 62,500 for $0.65 at 30 September.
 Futures do not always provide a perfect hedge because:
 Required amount of currency must be rounded to a whole number of contracts  therefore inefficiencies
arise.
 Basis risk (basis = spot price – futures price). The risk that the futures contract price might move by a
different amount from the price of underlying commodity or currency.
 Advantages of futures over forward contracts
 Transaction cost should be lower.

 Exact date of receipt or payment of the currency does not have to be known.
 Disadvantages of futures compared with forward contracts
 Contract cannot be tailored.

 Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis risk.
 Only a limited number of currencies are the subject of future contracts.
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Hedging with futures
Exam tip
You will not be expected to perform calculations for futures hedge in the exam, but you have to be able to explain logic behind it.
 Logic of hedging with futures
 FX rate in the futures market develops in the same direction as FX rate in the spot market.
 Therefore if my risk is a LOSS in the spot market, I have to create a GAIN in the futures market and vice
versa.
 I have to pay in FX in 3 months time  risk is then that FX will strengthen (results in spot market LOSS).
My actions will be: To buy FX futures NOW and SELL them in 3 months time (result = GAIN).
 I expect to receive FX in 3 months time  risk is that FX will weaken. My actions will be: To sell FX
futures NOW and buy them in 3 months time (when I receive FX from the sale of goods and need to sell
FX at the spot market).
Currency options
 Types of options
 CALL OPTION – holder (buyer) of a call option has the right (but not obligation) to buy a quantity of FX at
a specific FX rate (exercise price) on a future (exercise) date. RIGHT TO BUY CURRENCY
 PUT OPTION – holder (buyer) of a PUT option has the right (but not obligation) to sell a quantity of FX at
a specific FX rate on a future (exercise) date. RIGHT TO SELL CURRENCY
 Positions of buyer/seller
 Holder (buyer) – has the option to exercise contract.
 hedged against adverse FX movement

 if favourable FX movement  gain
 pays premium to seller
 maximum loss is premium paid to seller
 Seller has to fulfil contract if buyer wishes to.
 maximum what he can earn is the premium (in case buyer does not exercise option)
 he can have losses
 Options – OTC vs. exchange traded
 over the counter (OTC) options – from a bank, tailored to Co’s needs
 exchange traded options – standard options in certain currencies only
 Options according to exercise date
 American option – can be exercised at any date before expiry

 European – on expiry date
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CHAPTER 12 – RISK
INTEREST RATE RISK
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1 Interest rates
 Interest rate (IR)
 Is the price governing lending and borrowing
 The borrower pays interest to the lender as the price for the use of the funds borrowed
 Supply and demand affects apply
 Main IR in the financial markets
 Base rates of clearing banks – smaller companies are likely to borrow money for base rate plus a margin
 LIBOR – interbank lending rate based on the London interbank money market – larger companies are
likely to borrow at LIBOR plus a margin
 Treasury bill rate – rate at which the Bank of England sells Treasury bills to the discount market
2 Causes of interest rates fluctuations
Pattern (structure) of interest rates

 Pattern of interest rates (IRs) refers to:
 The variety of IRs on different financial assets
 The margin between IRs on lending and deposits
 Why are there such a large number of interest rates (how is the pattern of IRs explained)?
 Risk – higher risk means higher IR
 Duration of lending – longer period means higher IR (generally); see term structure of IRs and Yield
curve – paragraph 3
 Size of the loan/deposit – admin cost savings allow lower IRs on larger loans and higher IRs on larger
time deposits.
 Need to make profit on re-lending
 Different types of financial assets
Changing economic factors

 Interest rates on one type of financial asset will vary over time. The general level of interest rates might go up or
down. The general level of interest rates is affected by the following factors:
 Need for a real return – real return will depend on risk.
 Inflation – nominal rate must cover inflation and the real rate of return.
 Uncertainty about future inflation rates.
 Liquidity preference of investors and the demand for borrowing – higher interest rates have to be offered
to persuade savers to invest their surplus money. When the demand to borrow increases, interest rates
will rise.
 Balance of payments – when a country has a deficit and the authorities are unwilling to allow the FX rate
to depreciate (by more than a certain amount), interest rates might rise to attract capital into the country.
The country can then finance the deficit by borrowing from abroad.
 Monetary policy – central banks influence interest rates.
 Interest rates abroad – If IR abroad are high, domestic IRs must also be comparably high to avoid capital
transfers abroad and a fall in FX rate of the domestic currency.
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CHAPTER 12 – RISK
3 Yield curve
 Term structure of interest rates = the way in which the yield on a security varies according to the length of time
before the borrowing will be repaid.
 A yield curve shows the relationship between the yields on debt (IRs) with different periods to maturity.
 There are three main types of yield curve shapes:
 Normal (upward sloping) – longer maturity  higher IRs/yield.

 Inverted (downward sloping) – shorter maturity  higher IRs/yield (sign of an upcoming recession).
 Flat (or humped) – the shorter-term and longer-term yields are very close to each other (predictor of an
economic transition).
 Reasons for a normal (upward sloping) yield curve:
 The investor must be compensated for tying up his money in the asset for a longer period of time.
Referred to as the liquidity preference of investors.
 There is a greater risk in lending long-term than in lending short-term.
 The yield curve might be downward sloping due to expectations theory and market segmentation theory.
 The shape of the yield curve at any point in time is the result of the three following theories acting together:
 Liquidity preference theory - Investors have a natural preference for more liquid (shorter maturity)
investments. They will need to be compensated if they are deprived of cash for a longer period.
Therefore the longer the maturity period, the higher the yield required leading to an upward sloping curve
(assuming that the interest rates are not expected to fall in the future).
 Expectations theory - The normal upward sloping yield curve reflects the expectation that inflation
levels, and therefore interest rates, will increase in the future.
Downward sloping yield curve - In the early 1990s interest rates were high to counteract high inflation.
Everybody expected interest rates to fall in the future, which they did. Expectations that interest rates
would fall meant it was cheaper to borrow long-term than short-term.
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 Market segmentation theory - suggests that there are different players at the short-term end of the
market and at the long-term end of the market. As a result the two ends of the curve may have different
shapes, as they are influenced independently by different factors.
 Investors are assumed to be risk averse and to invest in segments of the market that match
their liability commitments (banks tend to be active in the short-term end of the market,
pension funds would tend to invest in long-term maturities to match the long-term nature of
their liabilities).
 The supply and demand forces in various segments of the market in part influence the shape
of the yield curve.
Downward sloping curve: If there is an increased supply in the long-term end of the market because the
government needs to borrow more, this may cause the price to fall and the yield to rise and may result in
a downward sloping yield curve.
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CHAPTER 12 – RISK
4 Interest rate risk

 Interest rate risk relates to the sensitivity of profits and cash flows to changes in interest rates. It is the risk that
interest rates will rise/fall in the future.
 Interest rate risk can arise from:
 The mix of floating and fixed interest rate debts

 Gap exposure
 Basis risk
Floating and fixed interest rate debt

 Too much floating interest rate debt (e.g. bank overdrafts, medium-term bank lending) leads to an unnecessarily
high cost when market interest rates go up.
 Too much fixed interest rate debt leads to an unnecessary cost when market interest rates fall.
 Some of the interest rate risks may cancel each other out (if there are assets and liabilities subject to interest rates).
Gap analysis of interest rate risk, gap exposure

 Gap analysis
 identifies the degree to which the company is exposed to interest rate risk.
 based on the principle of grouping together interest-sensitive assets and liabilities according to their
maturity terms.
 Two types of gap might occur:
 Negative gap
 interest-sensitive liabilities maturing at a certain time > interest sensitive assets maturing at a
certain time
 Co faces exposure that IR rises by the time of maturity, when Co need to re-finance
 Positive gap
 interest-sensitive liabilities maturing at a certain time < interest sensitive assets maturing at a
certain time
 Co faces exposure that IR fall by the time of maturity
Basis risk
 A company with size-matched assets and liabilities is still exposed to basis risk, as two floating rates might not be
determined using the same basis. One may be linked to LIBOR, while the other is not.
 Therefore two floating rates will not move perfectly in line with each other.
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5 Interest rate risk management

 Internal hedging
 Asset and liability management

 Matching and smoothing
 External hedging instruments
 Forward rate agreements (FRA)

 Derivatives
 Futures
 Interest rate options
 Interest rate swaps
Matching assets and liabilities
 Matching – where liabilities and assets with common interest rates are matched.
 Used by banks (for commercial/industrial companies it is not as easy).
Smoothing
 Smoothing – keeping balance between its fixed rate and floating rate of borrowing.
 Rise in interest rates  a floating rate loan will be more expensive, but a fixed rate loan will be less expensive.
Forward rate agreements (FRAs)
 FRA hedge risk by fixing interest rate on future borrowing

 FRAs are usually only available on loans > GBP500,000
 The company enters into a normal loan but independently organises a forward with a bank:
 interest is paid on the loan in the normal way
 if the interest is greater than the agreed forward rate, the bank pays the difference to the company
 if the interest is less than the agreed forward rate, the company pays the difference to the bank
 5.20 - 5.00  you can fix a borrowing rate at 5.20%

 “3 - 9” FRA is one that starts in 3 months and last for 6 months
Example 9 – Forward rate agreement (Illustrated)

It is 30 June. ASTA will need a USD 20 million, 6-month fixed rate loan from 1 October. ASTA wants to hedge using a FRA.
The relevant FRA rate is 5% on 30 June.
Solution
a) State what FRA is required.
b) What is the result of the FRA and the effective loan rate if the 6 month FRA benchmark rate has moved to
i) 4%
ii) 10%
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CHAPTER 12 – RISK
a) The Forward Rate Agreement required is ‘3 - 9’.
b) i) At 4%, because interest rates have fallen, ASTA will pay the bank:
USD
FRA payment $ 20 million x (5% - 4%) x 6/12 (100,000)
Payment on underlying loan 4% x $ 20 million x 6/12 (400,000)
Net payment on loan (500,000)
Effective interest rate on loan 5%
ii) At 10%, because interest rates have risen, the bank will pay to ASTA: USD
FRA receipt $ 20 million x (10% – 5%) x 6/12 500,000
Payment on underlying loan at market rate 10% x $ 20 million x 6/12 (1,000,000)
Net payment on loan (500,000)
Effective interest rate on loan 5%
Interest rate futures contract
 Similar to FRAs, but the terms, amounts and periods are standardised.
 The company can buy or sell contracts of fixed-amounts of a notional 30 year 8% Treasury bond in 6 months time at
an agreed price.
Interest rate options
 Interest rate option grants the buyer a right (but not obligation), to deal at an agreed interest rate (strike rate) on a
future date. On the date of expiry of the option (expiry date), the buyer must decide whether or not (lapse) to
exercise the right.
 Seller of an option must follow the decision of buyer of the option.
 Buyer of the option pays a certain fee (premium) to seller of the option.
 Buyer of an option to borrow will exercise the option if IR < strike rate. Buyer of a lend option will exercise the option
if IR > strike rate.
 Maximum loss for the buyer is the premium paid. Co can limit its exposure to adverse IR movements, while allowing
it to take advantage of favourable IR movements.
 OTC options more flexible and cheaper than FRAs.
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Interest rate swaps
 An interest rate swap is an agreement whereby parties agree to exchange (swap) interest rate commitments.
 If the swap is to make sense, two parties must swap interest which has different characteristics  usual motivation
is to switch from floating to fixed interest, and vice versa.
 No loan principal is swapped.
 Counterparty risk – risk that swap partner defaults.
PwC’s Academy 25
Chapter 13 – SOLUTIONS
1 FINANCIAL MANAGEMENT: INTRODUCTION
2 BASIC INVESTMENT APPRAISAL
1 Solution - ROCE
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝐵𝐼𝑇 9 (𝑊1)

𝑅𝑂𝐶𝐸 = = = 17%
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 52,5 (𝑊2)
WORKINGS: W1: Average PBIT

Total CF 140
Depreciation (95)
Total PBIT 45  average PBIT = 45/5 = 9 k$
W2: Average investment: (100+5)/2=52.5 k$
3 Solution - Payback
Year 0 1 2 3 4 5
CF (100) 40 40 30 20 10
CF cumulative (100) (60) (20) 10 30 40
At the end of year 2 investment is at loss of (20), at the end of year 3 investment is in profit of 10. Sometimes during year 3 there is
breakeven.
Assumption is that cash flows arising steadily during year, therefore:
 $30 in 365 days  daily $30/365 = $ 0.08219

 How long it takes to earn $20?  20/0.08219 =243 days
Payback period is 2 years and 243 days.
4 Solution - Discounting
A) Each CF is discounted to NOW (present value) – using calculator
7 10 8 6
𝑃𝑉 = (30) + + 2
+ 3
+ = −2.42
(1 + 5%) (1 + 5%) (1 + 5%) (1 + 5%)4
B) Using DISCOUNT TABLES

1
n
Fraction (1  i) is calculated for you in discount tables for given i and n, it is called discount factor (DF)
Years 0 1 2 3 4
CF (30) 7 10 8 6
DF(5%) 1 0.952 0.907 0.864 0.823
DCF(5%) (30) 6.664 9.07 6.917 4.938
PV = -2.42
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CHAPTER 13 – SOLUTIONS
5 Solution – Reina - NPV
Year 0 1 2 3 4 5
CF (ths $) (100) 40 40 30 20 15
DF (12%) 1 0.893 0.797 0.712 0.636 0.567
DCF (12%) (100) 36 32 21 13 9
NPV (12%) = 11 ths $
6 Solution - Reina - IRR
Step 1 - Calculation of 2 NPVs for 2 selected i (i1, i2)

NPV1 for i1:
In example 5 we calculated NPV at 12% and it was 11 ths $. Let’s take i1 = 12%, NPV1 = 11 ths $
This is positive value. Ideally we need to get one positive and one negative NPV to make a good estimate of IRR. Therefore as i2 we will
take higher percentage than 12% (as NPV is decreasing function of i)
NPV2 for i2
Let’s take I = 18% and calculate NPV at 18%
Year 0 1 2 3 4 5
CF (ths $) (100) 40 40 30 20 15
DF (18%) 1 0.847 0.718 0.609 0.516 0.437
DCF (18%) (100) 34 29 18 10 7
NPV (12%) = - 2 ths $
Step 2 – approximate NPV function between i1 and i2 by straight line and using simple geometry (similarity of trigles) find
intersection with x axis.
From above picture (similarity of triangles):
x = 5.1%, therefore IRR = 12%+5.1% = 17.1%

If required return on investment is lower than 17.1%, the project will be accepted (at the same time for i < 17.1% NPV > 0).
Required return on investment is 12% and therefore the project will be accepted.
2 PwC’s Academy
3 ADVANCED INVESTMENT APPRAISAL

1 Solution – Nominal rate of return
(1 + 𝑖𝑛𝑜𝑚 ) = (1 + 𝑖𝑟𝑒𝑎𝑙 )(1 + 𝑖𝑖𝑛𝑓 )

𝑖𝑛𝑜𝑚 = (1 + 10%)(1 + 5%) − 1
𝑖𝑛𝑜𝑚 = 15.5%
2 Solution – Real rate of return
(1 + 𝑖𝑛𝑜𝑚 ) = (1 + 𝑖𝑟𝑒𝑎𝑙 )(1 + 𝑖𝑖𝑛𝑓 )

(1 + 10.6%)
(1 + 𝑖𝑟𝑒𝑎𝑙 ) =
(1 + 5%)
𝑖𝑟𝑒𝑎𝑙 = 5.3%
3 Solution - NPV with tax and inflation
0 1 2 3 4
Contribution k$ (W1) 376 654 273

Tax k$ (30%) (113) (196) (82)
Tax saved on depn (W2) 60 48 38
Investment k$ (1,000)
Scrap value k$ 400
Tax on disposal k$ (W3) 34
CF (1,000) 376 601 525 (10)
DF (10%)(W4) 1 0.909 0.826 0.751 0.683
DCF (1,000) 342 496 394 (7)
NPV = 225
WORKINGS
1 Sales – COS 1 2 3
P=100$, inf 5% 105 110.3 115.8
V=40$, inf 6% (42.4) (44.9) (47.6)
(p-v) 62.6 65.4 68.2
Units in thousands 6 10 4
Contribution (k$) 376 654 273
2 Depreciation and tax saved

Open Dep 20% close tax saved (30% x depn)
1 1,000 200 800 60
2 800 160 640 48
3 640 128 512 38
3 Tax on disposal
Scrap value 400
NBV tax (512)
Loss on disposal (112)
Tax 30% 34  saving  cash in
PwC’s Academy 3
4 Solution - Annuity
100 100 100 100 1 1 1

PV   . .  100(  2  ...  )
(1  10%) (1  10%)
2
(1  10%)
3
(1  10%)
4 (1  10%) (1  10%) (1  10%)
4
 100  AF(n  4, i  10%)  100  3.170  317
b/ First cash flow starts at the end of year 3
c/ First cashflow starts at the beginning of year 1
𝑃𝑉 = 100 + 100 × AF(3,10%) = 100 + 100 × 2,487 = 100 + 249 = 349
4 PwC’s Academy
5 Solution - Perpetuity
a/ Company expects to receive $200 each year into infinity, starting at the end of year 1. The cost of capital is 10%. What is the present
value of the cash flows?
200
10% 2000
𝑃𝑉 = = = 1,818$
(1 + 10%) 1.1
c/ What is present value of cash flows, if first cash flow starts at the beginning of year 1 (end of year 0)
…… . . . . . Fffffff ∞
200
10%
200
𝑃𝑉 = 200 + 10% = 200 + 2000 = 2,200$
PwC’s Academy 5
6 Solution - Lease or buy
TO BUY
0 1 2 3 4 5
Investment (120,000)
Tax saved on depn (W1) 9,900 7,425 5,569 4,176
Tax on disposal (W2) 9,230
Trade in value 10,000
CF (120,000) 0 9,900 7,425 15,569 13,406
DF (10%) 0.909 0.826 0.751 0.683 0.621
DCF (120,000) 0 8,177 5,576 10,634 8,325

NPV = (87,287)
TO LEASE
0 1 2 3 4 5
Lease payment (36,000) (36,000) (36,000) (36,000)
Tax saved 11,880 11,880 11,880 11,880
CF (36,000) (36,000) (24,120) (24,120) 11,880 11,880

DF (10%) 1 0,909 0,826 0,751 0,683 0,621
DCF (36,000) (32,724) (19,923) (18,114) 8,114 7,377

NPV = (91,270)
WORKINGS
1. Tax saved on depreciation

Open depn close tax saved
(25%) (33%)
1 120,000 30,000 90,000 9,900
2 90,000 22,500 67,500 7,425
3 67,500 16,875 50,625 5,569
4 50,625 12,656 37,969 4,176
2. Tax on disposal
Residual value 10,000
NBV tax (37,969)
Loss on disposal (27,969)  tax saved 33% = 9,230
6 PwC’s Academy
7 Solution - Asset replacement
1. Replace every year
7,500
NPV  (-25,000)   (18,182)
1 (1  10%)
NPV  ?  AF(10%,1ye ar)
1
(18,182)
?  $(20,002)
0.909
2. Replace every 2 years
(7,500) (1,000)
NPV2  (-25,000)    (32,644)
(1  10%) (1  10%) 2
NPV2  ?  AF(10%, 2years)
(32,644)
?  $ (18,804)
1.736
3. Replace every 3 years
(7,500) (11,000) (5,000)

NPV3  (-25,000)     (44,659)
(1  10%) (1  10%) 2
(1  10%) 3
NPV3  ?  AF(10%, 3years)
(44,659)
?  $(17,957)
2.487
Option 3 (replace vans every 3 years) is the cheapest option.
PwC’s Academy 7
9a/ Solution - Capital rationing – divisible projects
(1) (2) (2)/(1) Allocate Total

Project Initial invest (Yr 0) $000 NPV $000 PI Rank 200$ NPV
A 100 25 0.25 2 100 25

B 200 35 0.175 3 20 3.5 (20/200
C 80 21 0.26 1 80 x2135)
D 75 10 0.13 4 0 0
200 49.5
9b/ Soluiton - Capital rationing – indivisible projects
Alternatives by trial-error
Investment NPV
A+C 180 46 -> the best mix
A+D 175 35
B 200 35
C+D 155 31
10 Solution – mutually exclusive projects
A/ DIVISIBLE
Alternatives by trial-error:
Project Investment (k$) NPV (k$)
A+ 60% B 100 20 + 60%x35 = 41
A+D 100 20+18=38
B 100 36
C+ 50% B 100 24+50% x 35 = 41.5  the best
C + 5/6 D 100 24 + 5/6 x 18 = 39
D+A 100 18 + 20 = 38
D+40% B 100 18 + 40% x 35 = 32
D+ 4/5C 100 18 + 4/5 x 24 = 37.2
B/ NON DIVISIBLE
Alternatives by trial-error:
Project Investment NPV
A+D 100 20 + 18 = 38  the best
B 100 35
C 50 24  if I can invest 2x in the same project, I would spend 100 and generate 48 (depends on scenario)
D 60 18
8 PwC’s Academy
11 Solution - Capital rationing – Horge
Step 1: Capital rationing
(i) Allocate the $800,00 based upon Profitability Index (NPV per $ invested)
P.I. Rank
Project 1: $32.7÷300= 0.109 3
Project 2: $57.6÷450= 0.128 2
Project 3: $79.2÷400= 0.198 1
NPV
So invest 100% in project 3: 79.2
And the remaining 400 I project 2 (400÷450) give 51.2
Maximum possible NPV 130.4
(ii) Allocate to affordable combinations:
Project 1 and 2 (investing 300 + 450) give 32.7 + 57.6 90.3

Project 1 and 3 (investing 300 + 400) give 32.7 + 79.2 111.9
Therefore invest in projects 1 and 3
Workings
Step 2: Calculate NPV of project 1,2 and 3
Project 1
Discount given nominal (‘money’) values at the nominal cost of capital of 12%
Time 1 2 3 4 5 Cumulative
$000 85 90 95 100 95
DF 12% 0.893 0.797 0.712 0.636 0.567
PV 12% 75.9 71.7 67.6 63.6 53.9 332.7
Less initial investment (300.0)
NPV 32.7
Project 2
Discount annuity in nominal terms using the 12% nominal cost of capital
$140.8 x 3.605 = 507.6
Initial Investment (450.0)
NPV 57.6
Project 3
Either: inflate $120,000 to nominal terms using 3.6% inflation and discount at nominal 12%;
Or: leave $120,000 as an annuity in real terms and discount at the real cost of capital (the less complex option).
(1 + i) = (1+r)(1+h)
1.12 = (1+r) x 1.036
1+r = 1.12÷1.036 = 1.082
Use 8% factors
PV = $120.0 x 3.993 = 479.2
Initial investments = (400.0)
NPV 79.2
PwC’s Academy 9
12 Solution - Sensitivity Analysis
Step 1: Produce NPV table and calculate NPV Step 2: PV of Variables (lines in NPV table)
Year Y0 Y1 Y2 Y3 k$
Sales (10,000*$10) in k$ 100 100 100 PV of sales = 100*AF(3;10%)= 249
Variable costs (10,000x$7) k$ (70) (70) (70) PV of COS = 70*AF(3;10%)= (174)
Fix cost (8) (8) (8) PV of FIX = 8*AF(3,10%) = (20)
Investment (50) PV of investment = (50)
CF (50) 22 22 22 NPV (10%) 5 k$
DF (10%) 1 0.90 0.826 0.751
DCF (10%) (50) 20
999 18 17
NPV (10%) NPV (10%)= 5 k$
Step 3: Calculate sensitivity:
a) Initial investment
5
Sensitivity = × 100 = 10%
50
b) Selling price
5
249
c) Sales volume
5
294−174
d) Variable costs
5
174
e) Fixed cost
5
20
f) Cost of capital. We need to find such discount rate at which NPV = 0 and then to calculate relative change. Therefore first we
need to calculate the IRR of the project. Second, we will calculate relative change (sensitivity margin).
We know that for 10% NPV = k$ 5. Let us try discount rate of 20%.
Year 0 1 2 3
CF (50) 22 22 22
NPV = (50)+22 x AF (3,20%) = (50)+22 x 2.106 = -4 k$
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NPV
5
10% 20%
i
x
-4
10%
x 5
=
10% 5 + 4
x =5.5%
IRR=10% + 5.5% = 15.5%
Sensitivity to cost o
The cost of capital can therefore increase by 55% [(15.5-10)/10 = 55% ] before the NPV becomes negative.
The elements to which the NPV appears to be most sensitive are the selling price followed by variable cost. Management should thus
pay particular attention to these factors so that they can be carefully monitored.
Note: Sensitivity of initial investment of 10% means that value of initial investment must increase by 10% to get NPV = 0
ANSWER: The most critical is selling price, as it has the lowest sensitivity margin. If it decreases by only 2%, NPV=0
PwC’s Academy 11
4 SOURCES OF FINANCE
5 COST OF CAPITAL
1 Solution – preference shares (dividend is constant into infinity)
Dividend = 5%x1$=0.05$
0.05 0.05
2.50  i  0.02  2%
i 2.50
2 Solution – ordinary shares - dividend grows by constant % into infinity
150
1,200 
i  0,02
1,200  (i  0.02)  150
150
(i  0.02) 
1,200
150
i  0.02  0.145  14.5%
1,200
3 Solution - average growth from past dividends
4
188  150  (1  g)
188 4
 (1  g)
150
188
4  1  g  g  5.8%
150
4 Solution - growth – Gordon’s approximation
20(1  0,14 * 0,8)

(300  20)   i  18.6%
(i  0,14 * 0,8)
20c is deducted from MV, as MV in the formula must be ex-div  see the paragraph on Cum Div and : Ex div share price in CH5
12 PwC’s Academy
5 Solution – MV ex div, cum div

D1
MV 
ig
25  1  6% 
A/ ABOUT TO PAY: (130  25)     i  31.2%
i  6%
25  1  6% 
B/ DIV HAS JUST BEEN PAID 130     i  26.38%
i  6%
6 Solution – Cost of equity using CAPM
Ri = (Rm - Rf)+ Rf
Ri = 0.81(9 - 3) + 3 = 7.86%
7 Solution – Cost of equity using CAPM
Ri = (Rm - Rf)+ Rf
Ri = 1.3(14 - 9) + 9 = 15.5%
If Lajka will issue new shares, shareholders wants to hold them for the price of dividend which give them return of 15.5%pa.
9 Solution – Cost of redeemable bond
 Find future cash flows from bond
 Interest payable each year: 8%x100$x0.7 = $ 5.6

 Redemption value in year 5: $105
1 2 3 4 5
5.6 5.6 5.6 5.6 5.6

105
5.6 5.6 5.6 105

94 = + 2
+ ⋯+ 5
+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)5
 We find i by interpolation method:
𝒊 = 𝟓%
105
𝑁𝑃𝑉 (5%) = −94 + 5.6 × 4.329 [𝐴𝐹(5 𝑦𝑒𝑎𝑟𝑠, 5%)] + = 12.5 $
(1 + 5%)5
𝒊 = 𝟏𝟎%
105
𝑁𝑃𝑉 (10%) = −94 + 5.6 × 3.791 [𝐴𝐹(5 𝑦𝑒𝑎𝑟𝑠, 10%)] + = −7.6 $
(1 + 10%)5
PwC’s Academy 13
Cost of capital
12.5 (after tax)
5% 10%
- 7.6
5%
x 12.5
=
10% − 5% 12.5 + 7.6
x = 3.1%
i = 5% + 3.1% = 8.1%
Cost of bond after tax is 8.1%.
10 Solution - Cost of irredeemable bond
Relevant cashflows:
Interest payable each year: 9%x100$=9$ into infinity as bond is irredeemable.
We are required to calculate after tax cost of bond, therefore relevant interest must be after tax. After tax interest = 9x0.8
9  0.8 9  0.8 9  0.8 9  0.8

140    ...  n  ....     
1 i 2 (1  i)
(1  i) i
9  0.8
140     i  5.14%
i
11 Solution - Convertible bonds
CF from security
Equation
8x0.7 8x0.7 8x0.7 112

85    ...  
1  i (1  i) 2 (1  i) 5 (1  i) 5
We have to express i from equation but if it is in power, we have to use intrapolation.

Intrapolation:
14 PwC’s Academy
NPV (10%) = - 85 + 8xAF(5,10%) + 112x0.625 = - 85 + 8x 3.791+ 112x0.625 = 5.8
NPV (15%) = - 85 + 8xAF(5,15%) + 112x0.497 = - 85 + 8x 3.352 + 112x0.497 = - 10.6
5.8
10% 15%
- 10.6
5%
x 5.8
    x  1.77
15%  10% 5.8  10.6
After tax cost of debt = 10 + 1.77 = 11.77%
13 Solution – WACC – MV or BV?
BV MV
Shares $2m $7.5m
Reserves $3m -
Loan $1m $0.8m
$6m $8.3m
WACC book values WACC market values
5 1 7.5 0.8
WACC   20%  7.5%  17.9% WACC   20%   7.5%  18.8%
6 6 8.3 8.3
14 Solution - WACC
1. Cost of individual capital sources
ordinary shares – given 18%

bank loan: i(1-T) = 15%x 0,75 = 11.25%
2. WACC
60 10
WACC   18%   11.25%  17%
60  10 60  10
PwC’s Academy 15
6 CAPITAL STRUCTURE AND RISK ADJUSTED WACC

2 Solution - Operational Gearing
Firm A Firm B
Fixed costs/Variable costs 2/6 = 0.33 6/2 = 3
Firm B carries a higher operating gearing because it has higher fixed costs.
Its operating earnings will therefore be more volume-sensitive:
A A B B
$m 10% decrease $m 10% decrease
Sales 10.0 9 10.0 9
Variable costs (6.0) (5.4) (2.0) (1.8)
Fixed costs (2.0) (2.0) (6.0) (6.0)
PBIT 2 1.6 (decrease 20%) 2 1.2 (decrease 40%)
3 Solution – Geared betas
a/ Calculate suitable beta to be used in appraising a new project
STEP 1: Ungear HOTEL equity beta (hotel business risk, hotel finance risk : D/E = 1/2) to get HOTEL asset beta with NO
gearing (hotel business risk, D=0)
E 2
β a  βe  1.6   1.14  ungeared Beta for HOTEL industry
E  D(1  t) 2  1 0.8
STEP 2: Gear asset beta of HOTEL (hotel bus risk, no gearing) back to reflect gearing of investing company. You will get beta
(hotel bus risk, D/E 2/5).
E 5
β a  βe  1.14  β e   β e  1.50  Beta suitable for project -> it reflects hotel business risk
E  D(1  t) 5  2 0.8
and investing company finance risk (D/E = 2/5)
b/ Estimate a project-specific cost of equity
r j  rf  (rm  rf )  β  r j  10%  (15%  10%) 1.50  17.5%
c/ Calculate the hotel project-specific discount rate (WACC)
2 5 2 5
WACC =  i (1 T)  ie  10% 0.8  17.5%  14.8%
2 5 d 2 5 2 5 2 5
d/ Calculate suitable discount rate to be used in appraising project within civil engineering industry
Cost of equity of the Company: 𝑖𝑒 = 10% + (15% − 10%) ∙ 1.2 = 16%
Suitable discount rate to be used when appraising project within civil engineering industry:
5 2
𝑊𝐴𝐶𝐶 = ∙ 16% + ∙ 10% ∙ 0.8 = 13.7%
7 7
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7 RATIO ANALYSIS
2 Solution - PE ratio
MV per share (ex div! ) 3.6

P/E =   12
EPS 0.3
PwC’s Academy 17
8 RISING EQUITY FINANCE

1A Solution TERP
Value of smallest potential portfolio for shareholder with 4 shares before rights issue:
4 shares @ 2.50 $ 10 $
1 share @ 2$ 2$
5 shares 12.00 $
Value per share after issue (TERP) = 12$/5 = 2.40 $
1B Solution Value of the right
Buyer of rights can buy ‘new share” 2$

MV ex right (TERP)(shareholder can sell “new share”) 2.40$
Gain per 4 shares in existing portfolio 0.40$
(right attached to 1 share in existing portfolio is 0.40$/4 = 0.10$ per share)
So if he has no cash to subscribe for new share he can sell right to buy “discounted “ shares to someone else for 0.10$ per each share
in his existing portfolio.
2 Solution Theoretical gain/loss to shareholder
a) If the shareholder takes up all his rights:
Shareholder will buy 10,000/4 =2,500 new shares for $2 each.
AFTER ISSUE: $
Market value of his 12,500 shares (12,500), ( x $2.40) 30,000
Cash out for 2,500 new shares (x $2) (5,000)
Total wealth 25,000
BEFORE ISSUE:
Total value of 10,000 shares ( x $2.50) $25,000
The shareholder would neither gain nor lose wealth. His shareholding as a proportion of the total equity of the company will
be same (provided all the others exercise their rights).
b) If the shareholder sells all his rights:
AFTER ISSUE: $
Sales value of rights (10,000 x $0.10) 1,000
Market value of his 10,000 shares, ex rights ( x $2.40) 24,000
Total wealth 25,000
The shareholder would neither gain nor lose wealth. He would not be required to provide any additional funds to the
company, but his shareholding as a proportion of the total equity of the company will be lower.
c) If the shareholder does nothing, but all other shareholders either exercise their rights or sell them, he would lose wealth:
$
BEFORE: Market value of 10,000 shares cum rights ( x $2.50) 25,000
AFTER: Market value of 10,000 shares ex rights ( x $2.40) 24,000
Loss in wealth 1,000
Shareholder will lose his personal wealth and his shareholding as a proportion of the total equity of the company will be
lower.
Conclusion: It follows that the shareholder, to protect his existing investment, should either exercise his rights or sell them to another
investor. If he does not exercise his rights, the new securities he was entitled to subscribe for might be sold for his benefit by the
company, and this would protect him from losing wealth.
18 PwC’s Academy
3 Solution – Tirwen – Bus fin question
(a) TERP
Existing 5 shares at $4.00= $20.00
New 1 share at $3.40= $3.40
Total 6 $23.40
TERP =23,40$/6 = $3.9/ share
Value of a right
New Shareholder can buy new share for $3.40
New shareholder can sell new share for $3.90
Gain of 0.50$ per transaction
Per existing share 0.50$/5= $0.1
From perspective of seller of right – value of his portfolio of 5 share would decrease from 5x4$ = 20$ to 5x3,90$ = 19.50$, so by
0.50$, it is 0.10$ per share
(b) BEFORE: Value of his portfolio 1,000 shares x 4$ = $4,000
AFTER (TAKE UP RIGHTS):

Value of his portfolio (1000+200 new (1 to 5))x $3.90 TERP = $4,680
Cash paid for 200 new shares 200x $3,40 = (680)
$ 4,000
AFTER (SELL RIGHTS):
Value of his portfolio (1000 x $3.90 TERP = $3,900
Proceeds from selling rights (1000x0,10$ or (1000/200)x0.50$) = $100
$ 4,000
The existing shareholder has two basic options, to take up the shares or to sell the rights to those shares. If you consider the implications
of these actions above you will notice that the shareholder will be in a neutral position in both cases providing the theoretical ex rights
price is achieved.
(c) 1. Current EPS, current PAT
Current EPS = PAT/ number of shares. We do not have PAT given, but we can get EPS from PE = MV/EPS
PE=MV share/EPS  EPS = MV share/ PE = 4$/15.24 = 0.262467$
And therefore PAT current = EPS current * 4,000,000 shares = 1,049,869$, let’s round to 1,050 thousand $
2. TRANSACTION (Money raised using rights issue will be used to buy back bonds)
I.Total finance raised:

Number of new shares = 4,000,000 shares/ 5 = 800,000 new shares
Issue price 15% under MV of 4$ .x 3.40$
Cash raised .2,720,000 $
Less issuance cost .(220,000)$
Cash left for bonds purchase .2,500,000 $
II. Debt redeemed $000

Number of bonds to be bought back: (2,500,000$/104.165$) = 24,000pcs
Bonds bought back in BV 24,000pcs x 100$ = 2,400,000$
Left in SoFP = 4,500k$-2,400k$=2,100k$
PwC’s Academy 19
Interest on bonds left in balance sheet = 2,100k$ x12%=252k$
III. Calculate PAT after 1 year from transaction:

PAT current 1,050 k$
Tax 30% (1,050/70*30) 450 k$
PBT current (1,050/70*100) 1,500 k$
Interest
- Overdraft (7%x1,250k$) 87.5 k$
- Bonds (12%x4,500 k$) 540 k$
PBIT current 2,127.5 k$
IV: PAT in 1 year time: (Adjustment for changes in 1 year time)

Interest (627,5-12%x2,400k$) 339,5 k$
PBT 1,788 k$
Tax 30% 536.4 k$
PAT in 1 year time 1,251.6 k$
V. Revised EPS = 1,251.6 k$/4,800,000 shares = $0.26075 $/share
d/ Effect on wealth of shareholders  what will be MV in 1 year time? (from PE)
assumption – PE will be constant – PE=MV/EPS after 1 year  15.24 = MV/ 0.26075  MV = 3.97$
TERP 3,90$
MV 3,97 $
Gain 0.07 $ per share
20 PwC’s Academy
9 WORKING CAPITAL MANAGEMENT

1 Solution – Lenght of operating cycle
60+20+25+20-40=85 days
2 Solution - WC levels
We need to use the ratios to calculate SoFP values in $ in order to construct the projected working capital position:
$m
Inventory = 40 ÷ 365 × $6m = 0.66
Receivables = 70 ÷ 365 × $10m= 1.92
Trade payables = 50 ÷ 365 × $6m = (0.82)
Working capital required 1.76
3 Solution - Overtrading
A/
 Over-trading occurs when a company is growing rapidly but does not have enough long-term finance. Imagine starting a
business with $1,000 borrowed from the bank when the business expands rapidly. As the scale of operations continues that
$1,000 won't go far and the business will soon run out of cash. In particular:
 • it won't have enough cash to buy inventory.

 • it won't have enough cash to buy non-current assets.
 • it won't have enough cash to pay expenses.
 The implications of these constraints are likely to be that the business will:
 buy inventory on credit and take as long as possible to pay.

 rent or lease non-current assets rather than buy them.
 delay paying business expenses.
 Such a business badly needs more long-term finance to underpin its rapidly expanding operations. Instead over-trading firms
rely on short-term finance like trade payables or bank overdrafts. Their desire for cash flow will encourage them to get the
money owed from receivables as quickly as possible (usually by offering cash discounts for early payment) or give discounts
(i.e. earn lower profit margins) for cash purchases.
B/
 Translating some of the above tendencies into accounting ratios, it is possible to examine whether Donac is starting to show
signs of over-trading.
 Rapid expansion: sales have increased by 61% and assets by 30%.

 Cash constraints: trade payables have increased by 82% and other payables by 67%. Payables payment period
has increased from 64 to 71 days (W1). The current ratio is down from 1.48:1 to 1.15:1 and the acid test from
0.77:1 to 0.66:1.
 Dependence on short-term rather than long-term financing: As well as the increase in payables there has been a
79% increase in the overdraft. No new long or medium-term finance has been obtained. Thus short-term
financing of total assets has increased from 31% (480/1,530) to 43% (860/1,990).
 Squeeze on profit margins: gross margin is down from 11.7% to 9% and the profit margin before tax is down
from 6.7% to 5.5%.
 Other signals of over-trading to look out for are an increase in asset and inventory turnovers as the firm fails to increase its
investment in non-current assets and inventory in line with the increase in sales. Donac reflects both of these. Sales/gross
assets has increased from 1.18 to 1.46 and the rate of inventory turnover (cost of sales/closing inventory) has increased
from 4.7 to 6.3.
PwC’s Academy 21
 Receivables payment period is largely unchanged at around 72 days. Receivables will usually be expected to increase less
than the increase in sales as attempts are made to get the money in quickly.
 Clearly Donac shows many of the signs of over-trading. Although profitable at the moment, the company risks running out of
cash. In addition, reliance on short-term finance can be precarious, for example, the overdraft might be called in.
 Working 1: For 20X7: Cost of sales = 1,800 – 210 = 1,590
Payables payment period = (280/1,590)× 365= 64 days)
4 Solution - EOQ basics
A company requires 12,000 units pa. Cost per order is $40. Holding cost is $ 3 per unit pa.
a/ Size of order that minimises cost
2DC o 2 12,000 40

EOQ    566 units
Ch 3
When ordering in batches of 566 units, total (handling and ordering) cost of inventory is minimised.
D 12,000
b1) How many times to place order?   21.2 x
Q 566
b2) How often order will be placed? 365/21 = 17 days
b3) What is inventory cycle? 17 days
Q 566
c) average stock held   283units
2 2
Q
d1) holding cost C  283  3  849$
2 h
d2) cost of ordering 21.2*40$=849$
d3) total inventory cost = 12,000 units *unit price + holding cost 849$+ ordering cost 849$ (unit price not given)
5 Solution - EOQ - reorder level
We have to calculate EOQ first:
2DC o 2 65,000 150

EOQ   4,415
Ch 1
Now, we can answer a) and b):
A)
Consumption per day = 65,000/365 = 178.082
How long it takes me to consume Q = 4,415? = 4,415/178.082 = 24.79 days = 25 days
B) ROL = 3 weeks  ROL = 21 days x 178.082 = 3,740 units
22 PwC’s Academy
6 Solution - EOQ with discounts (Ch given per unit per year)
1. EOQ ignoring discounts
2DC o 2 65,000 150

EOQ   4,415 units
Ch 1
2. total cost (Q = 4,415) holding ( 4,415/2)*1$=2,208$

ordering 150$*65,000/4,415 = 2,208$
purchase cost – 65,000*6.50$*0.995 = 420,388$
424,804$
2. total cost (Q = 7,000) holding ( 7,000/2)*1$=3,500$
ordering 150$*65,000/7,000 = 1,393$
purchase cost – 65,000*6.50$*0.99 = 418,275$
423,168$
The Company will order in quantities of 7,000 as extra saving pa of $ 1,636 can be made
7 Solution - EOQ with discounts (Ch given as % of unit price)
PwC’s Academy 23
8 Solution - Early settlement discounts
COST UNDER CURRENT POLICY:
Financing cost:
- Co has to finance 4m of AR, how much is it in $?)  AR x 12m  4m    AR  4 15mil  $ 5mil

sales 12
- Co used overdraft at 18%  annual financing cost = $ 5mil x 18% = $ 900,000
COST UNDER NEW POLICY:
60% sales at discount of 2%, paid in (exactly) 15 days: 40% sales no discount, paid in (exactly) 3m:
Cost of discount: 2% x $15mil x 60% = $180,000 Cost of discount: $0
Financing cost: Financing cost:

AR 15 AR
x 365  15   AR  15mil 60%  $ 369,863 x 12  3   AR  $ 1,500,000
60% sales 365 40% 15mil
$369,863x18% = $ 66,575 $1,500,000x18% = $ 270,000
SUMMARY:
Old policy: Finance cost: $900,000

New policy: Discount: 180,000
Finance cost (66,575+270,000) 336,575
516,575
Savings of $383,425 if new policy is accepted.
9 Solution – Percentage cost of discount
Annualised cost of discount

365
(1 + 𝑖𝑝𝑎 ) = (1 + 𝑖 ∗ ) 20
365/20 explains how many times money received earlier can be invested  I can invest for 20 days, therefore 365/20 = 18.5x
𝑑
𝑖∗ =  it compares cost with benefits
1−𝑑
𝑑 365
(1 + 𝑖𝑝𝑎 ) = (1 + ) 20
1−𝑑
2 365
(1 + 𝑖𝑝𝑎 ) = (1 + ) 20
98
𝑑 365
𝑖𝑝𝑎 = (1 + ) 20 − 1 = 44.6%
1−𝑑
If the company is able to invest for more than 44.6%, then the company would provide the discount.
24 PwC’s Academy
10 Solution – Factoring
NOW
 Cost of financing
- (AR/ $20mil) x 365 days = 85 days  AR = (85 x $20mil/365 = $ 4,657,534
- $ 4,657,534 x 10% = $ (465,753)
WITH FACTOR
 Cost of financing (W1) $ (317,809)

 Admin cost saved $ 150,000
 Service charge (1.5% x 20 mil $) $(300,000)
$ (467,809)
WORKINGS
New average receivables level (representing collection period of 50 days) is:
(AR/ $ 20 mil) x 365 days = 50 days  AR = (50 x $ 20 mil)/365 = $ 2,739,726
 Factor finances 80%: 80% x $ 2,739,726 x 12% = 263,014 $

 Co XY finances 20%: 20% x $ 2,739,726 x 10% = 54,795 $
317,809 $
CONCLUSION
Using factor is more expensive by $ 2,056. The Company should consider these cost incurred and compare them with benefit as
increasing liquidity, reduction in bad debt and improved cashflows.
11 Solution – Payables - discount
Not preferred method (but better for understanding)
 Discount got (income) 3%x$ 10,000 = $ 300

 Interest lost (97% x $10,000) x 8 %x2/12 = $(129)
$71 net gain  YES, PAY EARLIER
Preferred method – annualised cost of discount
12
(1  i pa )  (1  i * ) 2
12/2  is explained how many times a year I have to borrow  I need to borrow for 2 months, therefore 6 times a year
d 12
(1  i pa )  (1  )2
1 d
3 6
i pa  (1  )  1  20.05%
97
I accept the discount if I can borrow for less than 20.05 % pa.
PwC’s Academy 25
12 Solution – Payables - discount
NOW:
 Finance saving:
 level of payables: (AP/ $900ths) x 365 days = 30 days  AP = (30 x $900ths/365 = $ 73,973
 finance saved: $ 73,973 x8% = $ 5,918
WITH DISCOUNT
 Finance savings (W1) $ 1,972
 Discount received ($900 ths x 2) $18,000
$ 19,972
Workings:
New payables level (representing payment period of 10 days) is:
(AP/ $ 900 ths) x 365 days = 10 days  AP = (10x $ 900 ths)/365 = $ 24,658
Finance saved: $ 24,658 x 8% = $1,972
CONCLUSION
The company should take discount. It looses on cost of financing (benefits lost 5,917 – 1,972) = $3,945, but this is prevailed by discount
received of $18,000. Net savings of taking discount are $14,055
13 Solution – Cash forecast
Payments Oct Nov Dec

Rental (80,000, but 50% In Dec) (40,000)
Other FC (W1) (20,000) (20,000) (20,000)
VAR OH (W2) (84,000) (118,000) (96,000)
Total payments (104,000) (138,000) (156,000)
WORKINGS
1. total fixed cost 450,000

Less depn (130,000)
Rental (80,000)
240,000  incurred evenly  $20,000 pm
2. VAR OH
Month cost payments

Sep 40x2=80 n/a
Oct 60x2=120 10%x120+90%x80=84
Nov 50x2=100 10%x100+90%x120=118
Dec 30x2=60 10%x100+90%x100=96
26 PwC’s Academy
14 Solution – Baumol model
a) Optimum amount of cash to be invested in each transaction
2DC 2x240,000x70
EOQ    25,923
i 0.05
b) Number of transactions each year
D 240,000
  9.26
Q 25,923
c) Cost of transactions pa $70 x 9.26 = $ 648
d) Opportunity cost of holding cash pa (25,923 / 2) x 5% = $ 648
15 Solution - Miller Orr
1. Calculate spread
3 $40  $2,200 2 1
spread  3( ) 3  $26,962
4 0.0002
2. Calculate highest point H H = L + spread = 10,000 + 26,962 = $ 36,962
3.Calculate return point Z Z = 10,000 + 1/3 x 26,962 = $ 18,987
4.Draw picture (with calculated values)
5. Formulate decision
If cash balance reaches $36,962, we have to buy securities of (36,962-18,987) $17,975 to reach cash balance of $18,987.
If cash balance drops to $10,000, we have to sell securities of (18,987-10,000) $8,987 to reach cash balance of $18,987.
PwC’s Academy 27
11 BUSINESS VALUATIONS
1 Solution – Asset based valuation
Non current assets 530,000

Net current assets 200,000
Less 6% bonds (180,000)
560,000 x 70% = 392,000 $g
2 Solution - DVM
D1 19 (1  4.8%(W1))
MV    390c  $3.00
i g 9.9%(W2)  4.8%
W1: Dividend growth: 19 = 15 x (1 + i)5 ' g = 4.8%
W2: cost of equity: ri  rf  (rm  rf )  β  ri  5%  (12%  5%) 0.7  9.9%
Market capitalisation: 4mil shares x $3=$ 12m
3 Solution - DVM
We will find MV of share as present value of future dividends discounted by cost of equity. In F9 we play with formulas for:
a/ perpetuity (constant CF into infinity) : PV = CF/i
b/ annuity (constant CF for n periods : PV = CFxAF(n, i)
CF1
c/ constant CF growing by constant g : PV 
i g
25 25 25 25(1  4%) 25(1  4%)(n-5)

MV  3  4  5  6  ....   ...     
(1 9%) (1 9%) (1 9%) (1 9%) (1 9%) n
25(1  4%)
25  AF(3;9%)
  9%  4%5  58  338  391c  3,91$
(1 9%) 2 (1 9%)
Number of shares in issue = 5,000,000$/0.50$ = 10,000,000
MV of company = 10,000,000 x 3.91$ = 39,100,000 $
28 PwC’s Academy
4 Solution – P/E
MVshare
P/E   MV
share
 P / E  EPS or
EPS
MVshare x number of shares MVcompany

P/E    MVcompany  P / E  PAT
EPS x number of shares PAT
A: earnings yield = 12.5% = 1/PE ' PE = 1/0.125 = 8
MV = 8 x 300,000 = $ 2,400,000
B: MV = 7 x 420,500 = $ 2,943,500
5 Solution - Adjusted P/E
MVshare
P/E =  MV share=P/E*EPS
EPS
MVcompany
P/E =  MV company=P/E*PAT
PAT
P/E for listed companies is on average 10. As Chip and Dale is not listed, we adjust P/E down by approximately 1/3, let’s say to 7.
Revised PE = 7.
Total MV of Chip and Dale representing 200,000 shares = 7x (200,000-40,000) = 1120,000$
Value of 100,000 shares is therefore 560,000$
PwC’s Academy 29
6 Solution – Free cash flow
1) Identification of free cash flows:
K$
Sales 400,000
COS (220,000)
Expenses (40,000)
Taxable CF 140,000
Less: tax 30% (42,000)
Depreciation saved (80,000x0.3) = 24,000
Capital spending (100,000)
Cash flow 22,000
2) Calculation of NPV of CF into infinity:
a) CFnom/ inom
(if you are given WACC, it is always considered as i nom)
CF(1  i) 22  1  6% 
NPV    $220m
i-g 16.6%  6%
b) CFreal/ireal
-Calculate ireal: (1 + i nom ) = (1 + i real )x(1 +i inf )
(1 + 0.166) = (1 + i real )(1 + 0.06)
I real = 10%
22
-calculate NPV NPV   $220m
10%
3) Value of equity
PV of CF 220m$
Less MV of debt (20)m$
Value of equity 200m$
7 Solution - Market value of debt
A/ Market value
CF from bond: end of: Y1 Y2 Y3 Y4

interest 10 10 10 10
repayment 108 (w1)
10 10 10 10 108 108
MV       10  AF(4;7%)  
(1  7%) (1  7%) 2 (1  7%)3 (1  7%)4 (1  7%)4 (1  7%)4
108
 10  3.387   33.9  82  116
(1  7%)4
W1 Repayment:
We will take higher of conversion value and redemption value based on the assumption that investors behave rationally.
Redemption value = 1004*(1+5%)=105$
Conversion value = 25 shares * 3.70$*(1+4%)4=108$
30 PwC’s Academy
B/ Floor value is the MV of bond if redemption value is used as last CF
10 10 10 10 105 105
MV       10  AF(4;7%)  
(1  7%) (1  7%) 2 (1  7%) 3 (1  7%)4 (1  7%)4 (1  7%)4
105
 10  3.387   33.9  80  114
(1  7%)4
B/ Conversion premium
MV of bond if converted in 4 years time 116$ (see A/)

Conversion value NOW 25 shares*3.70$= 92.50$
Premium 23.50$
PwC’s Academy 31
12 RISK
2 Solution – Interest rate parity
EUR investor invests in 1 – year US bond with a 9.5% interest rate as this compares with the similar risk EUR bond offering 7.3%. The
current spot rate is 1.5 USD/EUR. Find the 1-year forward rate in one year using the interest rate parity formula.
market: 1 m EUR  x 1.073 = 1.073 m EUR in one year
US market: 1.5 m USD  x 1.095 = 1.6425 m USD in one year
The forward rate can be determined as follows: 1.6425/1.073 = 1.5308 USD/EUR
Or
(1 i )
F S  USD exam formula sheet
USD / EUR USD / EUR ( 1  i )
EUR
F = Forward rate
S = spot rate
iUSD = interest rate for USD
iGBP = interest rate for GBP
1.095
1.50   1.5308 USD/EUR
1.073
6 Solution – MM hedge - payment
The interest rates for 3 months are 2.00% to borrow in pounds and 2.25% to deposit kroners. The company needs to deposit enough
kroners now so that the total including interest will be Kr4,500,000 in three month’s time. This means depositing:
Kr4,500,000/(1 + 0.0225) = Kr4,400,978
These kroners will cost £582,857 (spot rate 7.5507). The company must borrow this amount and, with three months interest of 2.00%
will have to repay:
£582,857 x (1 + 0.0200) = £594,514
Thus in three months, the Danish creditor will be paid out of the Danish bank account and the company will effectively be paying
£594,514 to satisfy this debt (cost of transaction in pounds). The effective forward rate which the company has ‘manufactured’ is
4,500,000/594,514 = 7.5692. This effective forward rate shows the kroner at a discount to the pound because the kroner interest rate is
higher than the sterling rate.
32 PwC’s Academy
7 Solution – MM hedge -receipt
9 Solution - Forward
1. LC?  GBP
2. Quotation?  indirect ( everything is vice versa)
3. UK co will receive USD (FX currency)  does not need it  will SELL it to a bank (bank will BUY)  bank buys cheap and
sells expensive  but as indirect quotation  HIGHER number  1.4565
4. Exporter receives 400,000/1.4565 = GBP 274,631
PwC’s Academy 33
10 Solution - Choosing between hedging techniques

FORWARD
UK Co  USD is FX  need to pay FX  need to buy FX (USD)  bank sells USD  sells expensive  indirect  lower 
1.8845.
5,000,000/1.8845= 2,653,224 GBP  cost of transaction in 3 months time
MM HEDGE
Payment in FX  need to buy FX in 3m time  buy it now (from a bank)  borrow LC  buy FX (convert LC into FX) -> deposit FX
Cost of transaction NOW = 2,576,589 GBP

Cost of transaction in 3m time = 2,668,377 GBP
TO LEAD PAYMENT  means to pay NOW
5,000,000/1.9025 = 2,628,121 GBP  cost of transaction NOW
SUMMARY
To be able to decide which strategy is the cheapest, you have to consider all of them at SAME POINT OF TIME (either NOW or 3M)
NOW (GBP) 3M (GBP)
FW 2,561,954 ?*) 2,653,224 ------------------- CHEAPEST
MM 2,576,589 2,668,377
Lead 2,628,121 2,721,747 ?**)
*) You have to discount, but which rate?
a/ if the Co has cash  losing deposit rate 12%

b/ if the Co has no cash  has to borrow -> 14.25%
State assumption – Co has to borrow, use 14.25%x3/12 = 3.5625%  2,653,224/(1+0.035625) = 2,561,954
**) You have to compound, but which rate?
Same logic as above, assume that Co has to borrow  14.25%  2,628,121x(1.035625)=2,721,747
34 PwC’s Academy
1.Recent Past Exams
Recent Past Exams
September/December 2016 page
Questions 1-15
Answers 16-23
March/June 2017
Questions 24-30
Answers 31-38
September/December 2017
Questions 39-44
Answers 45-54
March/June 2018
Questions 55-60
Answers 61-65
Questions 66-71
Answers 72-76
Examiner’s 77-81
commentary
March/June 2019
Questions 83-95
Questions & Answers 96

1
Fundamentals Level – Skills Module
Paper F9
Friday 9 September 2016
Time allowed: 3 hours 15 minutes
This question paper is divided into three sections:

Section A – ALL 15 questions are compulsory and MUST be attempted
Section B – ALL 15 questions are compulsory and MUST be attempted
Section C – BOTH questions are compulsory and MUST be attempted
Formulae Sheet, Present Value and Annuity Tables are on

pages 13–15.
Do NOT open this question paper until instructed by the supervisor.

Do NOT record any of your answers on the question paper.
This question paper must not be removed from the examination hall.
The Association of
Chartered Certified
Accountants
2
Please use the grid provided on page two of the Candidate Answer Booklet to record your answers to each multiple
choice question. Do not write out the answers to the MCQs on the lined pages of the answer booklet.
Each question is worth 2 marks.
1 The owners of a private company wish to dispose of their entire investment in the company. The company has an
issued share capital of $1m of $0·50 nominal value ordinary shares. The owners have made the following valuations
of the company’s assets and liabilities.
Non-current assets (book value) $30m
Current assets $18m
Non-current liabilities $12m
Current liabilities $10m
The net realisable value of the non-current assets exceeds their book value by $4m. The current assets include $2m
of accounts receivable which are thought to be irrecoverable.
What is the minimum price per share which the owners should accept for the company?
A $14
B $25
C $28
D $13
2 Which of the following financial instruments will NOT be traded on a money market?
A Commercial paper
B Convertible loan notes
C Treasury bills
D Certificates of deposit
3 Andrew Co is a large listed company financed by both equity and debt.
In which of the following areas of financial management will the impact of working capital management be
smallest?
A Liquidity management
B Interest rate management
C Management of relationship with the bank
D Dividend policy
4 Which of the following are descriptions of basis risk?

(1) It is the difference between the spot exchange rate and currency futures exchange rate
(2) It is the possibility that the movements in the currency futures price and spot price will be different
(3) It is the difference between fixed and floating interest rates
(4) It is one of the reasons for an imperfect currency futures hedge
A 1 only
B 1 and 3
C 2 and 4 only
D 2, 3 and 4
2
3
5 Crag Co has sales of $200m per year and the gross profit margin is 40%. Finished goods inventory days vary
throughout the year within the following range:
Maximum Minimum
Inventory (days) 120 90
All purchases and sales are made on a cash basis and no inventory of raw materials or work in progress is carried.
Crag Co intends to finance permanent current assets with equity and fluctuating current assets with its overdraft.
In relation to finished goods inventory and assuming a 360-day year, how much finance will be needed from the
overdraft?
A $10m
B $17m
C $30m
D $40m
6 In relation to an irredeemable security paying a fixed rate of interest, which of the following statements is correct?
A As risk rises, the market value of the security will fall to ensure that investors receive an increased yield
B As risk rises, the market value of the security will fall to ensure that investors receive a reduced yield
C As risk rises, the market value of the security will rise to ensure that investors receive an increased yield
D As risk rises, the market value of the security will rise to ensure that investors receive a reduced yield
7 Pop Co is switching from using mainly long-term fixed rate finance to fund its working capital to using mainly
short-term variable rate finance.
Which of the following statements about the change in Pop Co’s working capital financing policy is true?
A Finance costs will increase
B Re-financing risk will increase
C Interest rate risk will decrease
D Overcapitalisation risk will decrease
8 In relation to an operating lease, which of the following statements is correct?

A All the risks and rewards of ownership transfer to the lessee
B The asset and lease obligation will be recorded in the statement of financial position
C The lease period will cover almost all of the leased asset’s useful economic life
D The lessor will be responsible for repairs and maintenance of the leased asset
9 A company has annual after-tax operating cash flows of $2 million per year which are expected to continue in
perpetuity. The company has a cost of equity of 10%, a before-tax cost of debt of 5% and an after-tax weighted
average cost of capital of 8% per year. Corporation tax is 20%.
What is the theoretical value of the company?

A $20m
B $40m
C $50m
D $25m
3 [P.T.O.
4
10 Which of the following would you expect to be the responsibility of financial management?
A Producing annual accounts
B Producing monthly management accounts
C Advising on investment in non-current assets
D Deciding pay rates for staff
11 Lane Co has in issue 3% convertible loan notes which are redeemable in five years’ time at their nominal value of
$100 per loan note. Alternatively, each loan note can be converted in five years’ time into 25 Lane Co ordinary shares.
The current share price of Lane Co is $3·60 per share and future share price growth is expected to be 5% per year.
The before-tax cost of debt of these loan notes is 10% and corporation tax is 30%.
What is the current market value of a Lane Co convertible loan note?

A $82·71
B $73·47
C $67·26
D $94·20
12 Country X uses the dollar as its currency and country Y uses the dinar.
Country X’s expected inflation rate is 5% per year, compared to 2% per year in country Y. Country Y’s nominal interest
rate is 4% per year and the current spot exchange rate between the two countries is 1·5000 dinar per $1.
According to the four-way equivalence model, which of the following statements is/are true?
(1) Country X’s nominal interest rate should be 7·06% per year
(2) The future (expected) spot rate after one year should be 1·4571 dinar per $1
(3) Country X’s real interest rate should be higher than that of country Y
A 1 only
B 1 and 2 only
C 2 and 3 only
D 1, 2 and 3
13 Which of the following government actions would lead to an increase in aggregate demand?
(1) Increasing taxation and keeping government expenditure the same
(2) Decreasing taxation and increasing government expenditure
(3) Decreasing money supply
(4) Decreasing interest rates
A 1 only
B 1 and 3
C 2 and 4 only
D 2, 3 and 4
4
5
14 Peach Co’s latest results are as follows:

$000
Profit before interest and taxation 2,500
Profit before taxation 2,250
Profit after tax 1,400
In addition, extracts from its latest statement of financial position are as follows:
$000
Equity 10,000
Non-current liabilities 2,500
What is Peach Co’s return on capital employed (ROCE)?

A 14%
B 18%
C 20%
D 25%
15 Drumlin Co has $5m of $0·50 nominal value ordinary shares in issue. It recently announced a 1 for 4 rights issue
at $6 per share. Its share price on the announcement of the rights issue was $8 per share.
What is the theoretical value of a right per existing share?

A $1·60
B $0·40
C $0·50
D $1·50
(30 marks)
5 [P.T.O.
6
Please use the grid provided on page two of the Candidate Answer Booklet to record your answers to each multiple
choice question. Do not write out the answers to the MCQs on the lined pages of the answer booklet.
The following scenario relates to questions 16 to 20.

Herd Co is based in a country whose currency is the dollar ($). The company expects to receive €1,500,000 in six
months’ time from Find Co, a foreign customer. The finance director of Herd Co is concerned that the euro (€) may
depreciate against the dollar before the foreign customer makes payment and she is looking at hedging the receipt.
Herd Co has in issue loan notes with a total nominal value of $4 million which can be redeemed in 10 years’ time. The
interest paid on the loan notes is at a variable rate linked to LIBOR. The finance director of Herd Co believes that interest
rates may increase in the near future.
The spot exchange rate is €1·543 per $1. The domestic short-term interest rate is 2% per year, while the foreign
short-term interest rate is 5% per year.
16 What is the six-month forward exchange rate predicted by interest rate parity?
A €1·499 per $1
B €1·520 per $1
C €1·566 per $1
D €1·588 per $1
17 As regards the euro receipt, what is the primary nature of the risk faced by Herd Co?
A Transaction risk
B Economic risk
C Translation risk
D Business risk
18 Which of the following hedging methods will NOT be suitable for hedging the euro receipt?
A Forward exchange contract
B Money market hedge
C Currency futures
D Currency swap
19 Which of the following statements support the finance director’s belief that the euro will depreciate against the
dollar?
(1) The dollar inflation rate is greater than the euro inflation rate
(2) The dollar nominal interest rate is less than the euro nominal interest rate
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2
6
7
20 As regards the interest rate risk faced by Herd Co, which of the following statements is correct?
A In exchange for a premium, Herd Co could hedge its interest rate risk by buying interest rate options
B Buying a floor will give Herd Co a hedge against interest rate increases
C Herd Co can hedge its interest rate risk by buying interest rate futures now in order to sell them at a future date
D Taking out a variable rate overdraft will allow Herd Co to hedge the interest rate risk through matching
7 [P.T.O.
8

Ring Co has in issue ordinary shares with a nominal value of $0·25 per share. These shares are traded on an efficient
capital market. It is now 20X6 and the company has just paid a dividend of $0·450 per share. Recent dividends of the
company are as follows:
Year 20X6 20X5 20X4 20X3 20X2
Dividend per share $0·450 $0·428 $0·408 $0·389 $0·370
Ring Co also has in issue loan notes which are redeemable in seven years’ time at their nominal value of $100 per loan
note and which pay interest of 6% per year.
The finance director of Ring Co wishes to determine the value of the company.
Ring Co has a cost of equity of 10% per year and a before-tax cost of debt of 4% per year. The company pays corporation
tax of 25% per year.
21 Using the dividend growth model, what is the market value of each ordinary share?
A $8·59
B $9·00
C $9·45
D $7·77
22 What is the market value of each loan note?

A $109·34
B $112·01
C $116·57
D $118·68
23 The finance director of Ring Co has been advised to calculate the net asset value (NAV) of the company.
Which of the following formulae calculates correctly the NAV of Ring Co?
A Total assets less current liabilities
B Non-current assets plus net current assets
C Non-current assets plus current assets less total liabilities
D Non-current assets less net current assets less non-current liabilities
24 Which of the following statements about valuation methods is true?

A The earnings yield method multiplies earnings by the earnings yield
B The equity market value is number of shares multiplied by share price, plus the market value of debt
C The dividend valuation model makes the unreasonable assumption that average dividend growth is constant
D The price/earnings ratio method divides earnings by the price/earnings ratio
25 Which of the following statements about capital market efficiency is/are correct?
(1) Insider information cannot be used to make abnormal gains in a strong form efficient capital market
(2) In a weak form efficient capital market, Ring Co’s share price reacts to new information the day after it is
announced
(3) Ring Co’s share price reacts quickly and accurately to newly-released information in a semi-strong form efficient
capital market
A 1 and 2 only
B 1 and 3 only
C 3 only
D 1, 2 and 3
8
9

The following information relates to an investment project which is being evaluated by the directors of Fence Co, a listed
company. The initial investment, payable at the start of the first year of operation, is $3·9 million.
Year 1 2 3 4
Net operating cash flow ($000) 1,200 1,500 1,600 1,580
Scrap value ($000) 100
The directors believe that this investment project will increase shareholder wealth if it achieves a return on capital
employed greater than 15%. As a matter of policy, the directors require all investment projects to be evaluated using both
the payback and return on capital employed methods. Shareholders have recently criticised the directors for using these
investment appraisal methods, claiming that Fence Co ought to be using the academically-preferred net present value
method.
The directors have a remuneration package which includes a financial reward for achieving an annual return on capital
employed greater than 15%. The remuneration package does not include a share option scheme.
26 What is the payback period of the investment project?

A 2·75 years
B 1·50 years
C 2·65 years
D 1·55 years
27 Based on the average investment method, what is the return on capital employed of the investment project?
A 13·3%
B 26·0%
C 52·0%
D 73·5%
28 Which of the following statements about investment appraisal methods is correct?

A The return on capital employed method considers the time value of money
B Return on capital employed must be greater than the cost of equity if a project is to be accepted
C Riskier projects should be evaluated with longer payback periods
D Payback period ignores the timing of cash flows within the payback period
29 Which of the following statements about Fence Co is/are correct?

(1) Managerial reward schemes of listed companies should encourage the achievement of stakeholder objectives
(2) Requiring investment projects to be evaluated with return on capital employed is an example of dysfunctional
behaviour encouraged by performance-related pay
(3) Fence Co has an agency problem as the directors are not acting to maximise the wealth of shareholders
A 1 and 2 only
B 1 only
C 2 and 3 only
D 1, 2 and 3
9 [P.T.O.
10
30 Which of the following statements about Fence Co directors’ remuneration package is/are correct?
(1) Directors’ remuneration should be determined by senior executive directors
(2) Introducing a share option scheme would help bring directors’ objectives in line with shareholders’ objectives
(3) Linking financial rewards to a target return on capital employed will encourage short-term profitability and
discourage capital investment
A 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3
(30 marks)
10
11
Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet.
31 Nesud Co has credit sales of $45 million per year and on average settles accounts with trade payables after 60 days.
One of its suppliers has offered the company an early settlement discount of 0·5% for payment within 30 days.
Administration costs will be increased by $500 per year if the early settlement discount is taken. Nesud Co buys
components worth $1·5 million per year from this supplier.
From a different supplier, Nesud Co purchases $2·4 million per year of Component K at a price of $5 per component.
Consumption of Component K can be assumed to be at a constant rate throughout the year. The company orders
components at the start of each month in order to meet demand and the cost of placing each order is $248·44. The
holding cost for Component K is $1·06 per unit per year.
The finance director of Nesud Co is concerned that approximately 1% of credit sales turn into irrecoverable debts. In
addition, she has been advised that customers of the company take an average of 65 days to settle their accounts,
even though Nesud Co requires settlement within 40 days.
Nesud Co finances working capital from an overdraft costing 4% per year. Assume there are 360 days in a year.
Required:
(a) Evaluate whether Nesud Co should accept the early settlement discount offered by its supplier. (4 marks)
(b) Evaluate whether Nesud Co should adopt an economic order quantity approach to ordering Component K.
(6 marks)
(c) Critically discuss how Nesud Co could improve the management of its trade receivables. (10 marks)
(20 marks)
11 [P.T.O.
12
32 Hebac Co is preparing to launch a new product in a new market which is outside its current business operations. The
company has undertaken market research and test marketing at a cost of $500,000, as a result of which it expects
the new product to be successful. Hebac Co plans to charge a lower selling price initially and then increase the selling
price on the assumption that the new product will establish itself in the new market. Forecast sales volumes, selling
prices and variable costs are as follows:
Year 1 2 3 4
Sales volume (units/year) 200,000 800,000 900,000 400,000
Selling price ($/unit) 15 18 22 22
Variable costs ($/unit) 9 9 9 9
Selling price and variable cost are given here in current price terms before taking account of forecast selling price
inflation of 4% per year and variable cost inflation of 5% per year.
Incremental fixed costs of $500,000 per year in current price terms would arise as a result of producing the new
product. Fixed cost inflation of 8% per year is expected.
The initial investment cost of production equipment for the new product will be $2·5 million, payable at the start of
the first year of operation. Production will cease at the end of four years because the new product is expected to have
become obsolete due to new technology. The production equipment would have a scrap value at the end of four years
of $125,000 in future value terms.
Investment in working capital of $1·5 million will be required at the start of the first year of operation. Working capital
inflation of 6% per year is expected and working capital will be recovered in full at the end of four years.
Hebac Co pays corporation tax of 20% per year, with the tax liability being settled in the year in which it arises. The
company can claim tax-allowable depreciation on a 25% reducing balance basis on the initial investment cost,
adjusted in the final year of operation for a balancing allowance or charge. Hebac Co currently has a nominal
after-tax weighted average cost of capital (WACC) of 12% and a real after-tax WACC of 8·5%. The company uses its
current WACC as the discount rate for all investment projects.
Required:
(a) Calculate the net present value of the investment project in nominal terms and comment on its financial
acceptability. (12 marks)
(b) Discuss how the capital asset pricing model can assist Hebac Co in making a better investment decision with
respect to its new product launch. (8 marks)
(20 marks)
12
13
Formulae Sheet
Economic order quantity
2C0D
=
Ch
Miller–Orr Model
1
Return point = Lower limit + ( × spread)
3
1
 3 × transaction cost × variance of cash flows  3
Spread = 3  4 
 interest rate 
 
() (( ) )
E ri = R f + βi E rm – Rf
The asset beta formula
   
βa =  Ve 
βe +  Vd 1 – T
βd 
( )

(V
 e + Vd
1 (
– T ))
 
V
  e + Vd
1 – T ( 
 ( ))
The Growth Model
Po =
(
D0 1 + g )
(re
–g )
Gordon’s growth approximation
g = bre
 V   V 
WACC =  e  ke + 
 Ve + Vd 
d k 1– T
 Ve + Vd  d
( )
The Fisher formula
(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity
S1 = S0 ×
(1 + h )c
F0 = S0 ×
(1 + i ) c
(1 + h )b (1 + i ) b
13 [P.T.O.
14
Present Value Table
Present value of 1 i.e. (1 + r)–n

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
14
15
Annuity Table
– (1 + r)–n
Present value of an annuity of 1 i.e. 1————––
r

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
End of Question Paper
15
16
Answers
17
Fundamentals Level – Skills Module, Paper F9

Financial Management September 2016 Answers
Section A
1 A
They should not accept less than NRV: (30m + 18m + 4m – 2m – 12m – 10m)/2m = $14 per share
2 B
Convertible loan notes are long-term finance and are not traded on a money market.
3 D
Working capital management may have an impact on dividend policy, but the other areas will be more significant.
4 C
Basis risk is the possibility that movements in the currency futures price and spot price will be different. It is one of the reasons
for an imperfect currency futures hedge.
5 A
$200m x 30/360 x 0·6 = $10m
6 A
As risk rises, the market value of the security will fall to ensure that investors receive an increased yield.
7 B
Pop Co is moving to an aggressive funding strategy which will increase refinancing risk.
8 D
Under an operating lease, the lessor is responsible for repairs and maintenance of the leased asset.
9 D
Theoretical value = 2m/0·08 = $25m
10 C
Advising on investments in non-current assets is a key role of financial management.
11 A
Conversion value = 3·60 x 1·055 x 25 = $114·87
Discounting at 10%, loan note value = (3 x 3·791) + (114·87 x 0·621) = $82·71
12 B
1: (1·04 x 1·05/1·02) – 1 = 7·06%
2: 1·5 dinar x 1·02/1·05 = 1·4571 dinar/$
13 C
Decreasing taxation and increasing government expenditure would lead to increased aggregate demand. Decreasing interest rates
reduces the incentive to save and so would lead to an increase in aggregate demand.
19
18
14 C
Operating profit/(D + E) = 100 x 2,500/(10,000 + 2,500) = 20%
15 B
Value of a right = ((5m x $8 + 1·25m x $6)/6·25 m – $6)/4 shares = $0·4 per share
Section B
16 C
Forward rate = 1·543 x (1·025/1·01) = €1·566 per $1
17 A
The euro receipt is subject to transaction risk.
18 D
A currency swap is not a suitable method for hedging a one-off transaction.
19 B
If the dollar nominal interest rate is less than the euro nominal interest rate, interest rate parity indicates that the euro will depreciate
against the dollar.
If the dollar inflation rate is less than the euro inflation rate, purchasing power parity indicates that the euro will appreciate against
the dollar.
20 A
In exchange for a premium, Herd Co could hedge its interest rate risk by buying interest rate options is correct.
21 C
Historical dividend growth rate = 100 x ((0·450/0·370)0·25 – 1) = 5%
Share price = (0·450 x 1·05)/(0·1 – 0·05) = $9·45
22 B
Market value = (6 x 6·002) + (100 x 0·760) = 36·01 + 76·0 = $112·01
23 C
Non-current assets plus current assets less total liabilities is the correct formula.
24 C
The dividend valuation model makes the unreasonable assumption that average dividend growth is constant is correct.
25 B
Insider information cannot be used to make abnormal gains in a strong form efficient capital market and Ring Co’s share price
reacts quickly and accurately to newly-released information in a semi-strong form efficient capital market are correct.
26 A
Payback period = 2 + (1,200/1,600) = 2·75 years
20
19
27 B
Average annual accounting profit = (5,880 – 3,800)/4 = $520,000 per year
Average investment = (3,900 + 100)/2 = $2,000,000
ROCE = 100 x 520/2,000 = 26%
28 D
Payback period ignores the timing of cash flows within the payback period is correct.
29 D
All the statements are correct.
30 C
Introducing a share option scheme would help bring directors’ objectives in line with shareholders’ objectives and linking financial
rewards to a target return on capital employed will encourage short-term profitability and discourage capital investment are correct.
21
20
Section C
31 (a) Relevant trade payables before discount = 1,500,000 x 60/360 = $250,000

Relevant trade payables after discount = 1,500,000 x 30/360 = $125,000
Reduction in trade payables = 250,000 – 125,000 = $125,000
More quickly, reduction in trade payables = 1,500,000 x (60 – 30)/360 = $125,000
The finance needed to reduce the trade payables will increase the overdraft.
Increase in finance cost = 125,000 x 0·04 = $5,000
Administration cost increase = $500
Discount from supplier = $1,500,000 x 0·005 = $7,500
Net benefit of discount = 7,500 – 5,000 – 500= $2,000 per year
On financial grounds, Nesud Co should accept the supplier’s early settlement discount offer.
(b) Annual demand = 2,400,000/5 = 480,000 units per year

Each month, Nesud Co orders 480,000/12 = 40,000 units
Current ordering cost = 12 x 248·44 = $2,981 per year
Average inventory of Component K = 40,000/2 = 20,000 units
Current holding cost = 20,000 x 1·06 = $21,200 per year
Total cost of current ordering policy = 2,981 + 21,200 = $24,181
Economic order quantity = (2 x 248·44 x 480,000/1·06)0·5 = 15,000 units per order
Number of orders per year = 480,000/15,000 = 32 orders per year
Ordering cost = 32 x 248·44 = $7,950 per year
Average inventory of Component K = 15,000/2 = 7,500 units
Holding cost = 7,500 x 1·06 = $7,950 per year
Total cost of EOQ ordering policy = 7,950 + 7,950 = $15,900
On financial grounds, Nesud Co should adopt an EOQ approach to ordering Component K as there is a reduction in cost of
$8,281.
(c) Management of trade receivables can be improved by considering credit analysis, credit control and collection of amounts
owing. Management of trade receivables can also be outsourced to a factoring company, rather than being managed in-house.
Credit analysis
Offering credit to customers exposes a company to the risk of bad debts and this should be minimised through credit analysis
or assessing creditworthiness. This can be done through collecting and analysing information about potential credit
customers. Relevant information includes bank references, trade references, reports from credit reference agencies, records of
previous transactions with potential customers, annual reports, and so on. A company might set up its own credit scoring
system in order to assess the creditworthiness of potential customers. Where the expected volume of trade justifies it, a visit
to a company can be made to gain a better understanding of its business and prospects.
Credit control
The accounts of customers who have been granted credit must be monitored regularly to ensure that agreed trade terms are
being followed and that accounts are not getting into arrears. An important monitoring device here is an aged trade receivables
analysis, identifying accounts and amounts in arrears, and the extent to which amounts are overdue. A credit utilisation report
can assist management in understanding the extent to which credit is being used, identifying customers who may benefit
from increased credit, and assessing the extent and nature of a company’s exposure to trade receivables.
Collection of amounts owed
A company should ensure that its trade receivables are kept informed about their accounts, amounts outstanding and
amounts becoming due, and the terms of trade they have accepted. An invoice should be raised when a sale is made. Regular
statements should be sent, for example, on a monthly basis. Customers should be encouraged to settle their accounts on time
and not become overdue. Offering a discount for early settlement could help to achieve this.
Overdue accounts should be chased using procedures contained within a company’s trade receivables management policy.
Reminders of payment due should be sent, leading to a final demand if necessary. Telephone calls or personal visits could
be made to a contact within the company. Taking legal action or employing a specialised debt collection agency could be
considered as a last resort. A clear understanding of the costs involved is important here, as the costs incurred should never
exceed the benefit of collecting the overdue amount.
Factoring of trade receivables
Some companies choose to outsource management of trade receivables to a factoring company, which can bring expertise
and specialist knowledge to the tasks of credit analysis, credit control, and collection of amounts owed. In exchange, the
factoring company will charge a fee, typically a percentage of annual credit sales. The factoring company can also offer an
advance of up to 80% of trade receivables, in exchange for interest.
22
21
32 (a) Year 1 2 3 4
$000 $000 $000 $000
Sales revenue 3,120 15,576 22,275 10,296
Variable cost (1,890) (7,936) (9,378) (4,376)
–––––– ––––––– ––––––– –––––––
Contribution 1,230 7,640 12,897 5,920
Fixed cost (540) (583) (630) (680)
–––––– ––––––– ––––––– –––––––
Taxable cash flow 690 7,057 12,267 5,240
Taxation (138) (1,411) (2,453) (1,048)
TAD tax benefits 125 94 70 186
–––––– ––––––– ––––––– –––––––
After-tax cash flow 677 5,740 9,884 4,378
Scrap value 125
Working capital (90) (95) (102) 1,787
–––––– ––––––– ––––––– –––––––
Net cash flows 587 5,645 9,782 6,290
Discount at 12% 0·893 0·797 0·712 0·636
–––––– ––––––– ––––––– –––––––
Present values 524 4,499 6,965 4,000
–––––– ––––––– ––––––– –––––––
$000
PV of future cash flows 15,988
Initial investment 4,000 (2·5m + 1·5m)
–––––––
NPV 11,988
–––––––
The NPV is strongly positive and so the project is financially acceptable.
Workings
Sales revenue
Year 1 2 3 4
Inflated at 4% per year 15·60 19·47 24·75 25·74
Sales volume (000 units/year) 200 800 900 400
–––––– ––––––– ––––––– –––––––
Sales revenue ($000/year) 3,120 15,576 22,275 10,296
–––––– ––––––– ––––––– –––––––
Variable cost
Year 1 2 3 4
Variable cost ($/unit) 9 9 9 9
–––––– –––––– –––––– ––––––
Variable cost ($000/year) 1,890 7,936 9,378 4,376
–––––– –––––– –––––– ––––––
Tax benefits of tax-allowable depreciation
Year 1 2 3 4
$000 $000 $000 $000
Tax-allowable depreciation 625 469 352 929
Tax benefit 125 94 70 186*
*((2,500 – 125) x 0·2) – 125 – 94 – 70 = $186,000
Working capital
Year 0 1 2 3 4
$000 $000 $000 $000 $000
Working capital 1,500
Inflated at 6% 1,590 1,685 1,787
Incremental 90 95 102 1,787
23
22
Alternative calculation of after-tax cash flow

Year 1 2 3 4
$000 $000 $000 $000
Taxable cash flow 690 7,057 12,267 5,240
Tax-allowable depreciation (625) (469) (352) (929)
––––– –––––– ––––––– ––––––
Taxable profit 65 6,588 11,915 4,311
Taxation (13) (1,318) (2,383) (862)
––––– –––––– ––––––– ––––––
After-tax profit 52 5,270 9,532 3,449
Add back TAD 625 469 352 929
––––– –––––– ––––––– ––––––
After-tax cash flow 677 5,739 9,884 4,378
––––– –––––– ––––––– ––––––
(b) A company can use its weighted average cost of capital (WACC) as the discount rate in appraising an investment project as
long as the project’s business risk and financial risk are similar to the business and financial risk of existing business
operations. Where the business risk of the investment project differs significantly from the business risk of existing business
operations, a project-specific discount rate is needed.
The capital asset pricing model (CAPM) can provide a project-specific discount rate. The equity beta of a company whose
business operations are similar to those of the investment project (a proxy company) will reflect the systematic business risk
of the project. If the proxy company is geared, the proxy equity beta will additionally reflect the systematic financial risk of the
proxy company.
The proxy equity beta is ungeared to remove the effect of the proxy company’s systematic financial risk to give an asset beta
which solely reflects the business risk of the investment project.
This asset beta is regeared to give an equity beta which reflects the systematic financial risk of the investing company.
The regeared equity beta can then be inserted into the CAPM formula to provide a project-specific cost of equity. If this cost
of capital is used as the discount rate for the investment project, it will indicate the minimum return required to compensate
shareholders for the systematic risk of the project. The project-specific cost of equity can also be included in a project-specific
WACC. Using the project-specific WACC in appraising an investment project will lead to a better investment decision than
using the current WACC as the discount rate, as the current WACC does not reflect the risk of the investment project.
24
23

Financial Management September 2016 Marking Scheme
Marks Marks
Section A
1–15 Two marks per question 30
Section B
16–30 Two marks per question 30
Section C
31 (a) Change in trade payables 1

Increase in finance cost 1
Administration cost increase 0·5
Early settlement discount 0·5
Comment on financial acceptability 1
––––
4
(b) Annual demand 1

Current ordering cost 1
Current holding cost 1
Economic order quantity 1
EOQ ordering cost 0·5
EOQ holding cost 0·5
Comment on adopting EOQ approach to ordering 1
––––
6
(c) Credit analysis 2

Credit control 2
Collection of amounts owed 2
Factoring of trade receivables 2
Other relevant discussion 2
––––
10
–––
20
–––
32 (a) Inflated selling price per unit 1

Sales revenue 1
Inflated variable cost 1
Inflated fixed costs 1
Tax liabilities 1
Tax-allowable depreciation benefits years 1–3 1
Tax allowable depreciation benefits year 4 1
Incremental working capital and recovery 2
Calculation of present values 1
Correct initial investment 1
Comment on financial acceptability 1
––––
12
(b) Business risk, financial risk and WACC 2

Using a proxy company 1
Systematic risk, business risk and financial risk 1
Ungearing the equity beta 1
Regearing the asset beta 1
Project-specific cost of equity and WACC 2
––––
8
–––
20
–––
25
24
Paper F9
March/June 2017 – Sample Questions

Formulae Sheet, Present Value and Annuity Tables are on pages 4–6.

The Association of
Chartered Certified
Accountants
25
31 It is the middle of December 20X6 and Pangli Co is looking at working capital management for January 20X7.
Forecast financial information at the start of January 20X7 is as follows:
Inventory $455,000
Trade receivables $408,350
Trade payables $186,700
Overdraft $240,250
All sales are on credit and they are expected to be $3·5m for 20X6. Monthly sales are as follows:
November 20X6 (actual) $270,875
December 20X6 (forecast) $300,000
January 20X7 (forecast) $350,000
Pangli Co has a gross profit margin of 40%. Although Pangli Co offers 30 days credit, only 60% of customers pay in
the month following purchase, while the remaining customers take an additional month of credit.
Inventory is expected to increase by $52,250 during January 20X7.
Pangli Co plans to pay 70% of trade payables in January 20X7 and defer paying the remaining 30% until the end of
February 20X7. All suppliers of the company require payment within 30 days. Credit purchases from suppliers during
January 20X7 are expected to be $250,000.
Interest of $70,000 is due to be paid in January 20X7 on fixed rate bank debt. Operating cash outflows are expected
to be $146,500 in January 20X7. Pangli Co has no cash and relies on its overdraft to finance daily operations. The
company has no plans to raise long-term finance during January 20X7.
Assume that each year has 360 days.
Required:
(a) (i) Calculate the cash operating cycle of Pangli Co at the start of January 20X7. (2 marks)
(ii) Calculate the overdraft expected at the end of January 20X7. (4 marks)
(iii) Calculate the current ratios at the start and end of January 20X7. (4 marks)
(b) Discuss FIVE techniques that Pangli Co could use in managing trade receivables. (10 marks)
(20 marks)
2
26
32 Vyxyn Co is evaluating a planned investment in a new product costing $20m, payable at the start of the first year of
operation. The product will be produced for four years, at the end of which production will cease. The investment
project will have a terminal value of zero. Financial information relating to the investment project is as follows:
Year 1 2 3 4
Selling price ($/unit) 26·50 28·50 30·00 26·00
Fixed cost ($/year) 1,100,000 1,121,000 1,155,000 1,200,000
These selling prices have not yet been adjusted for selling price inflation, which is expected to be 3·5% per year. The
annual fixed costs are given above in nominal terms.
Variable cost per unit depends on whether competition is maintained between suppliers of key components. The
purchasing department has made the following forecast:
Competition Strong Moderate Weak
Probability 45% 35% 20%
Variable cost ($/unit) 10·80 12·00 14·70
The variable costs in this forecast are before taking account of variable cost inflation of 4·0% per year.
Vyxyn Co can claim tax-allowable depreciation on a 25% per year reducing balance basis on the full investment cost
of $20m and pays corporation tax of 28% per year one year in arrears.
It is planned to finance the investment project with an issue of 8% loan notes, redeemable in ten years’ time. Vyxyn
Co has a nominal after-tax weighted average cost of capital of 10%, a real after-tax weighted average cost of capital
of 7% and a cost of equity of 11%.
Required:
(a) Discuss the difference between risk and uncertainty in relation to investment appraisal. (3 marks)
(b) Calculate the expected net present value of the investment project and comment on its financial acceptability
and on the risk relating to variable cost. (9 marks)
(c) Critically discuss how risk can be considered in the investment appraisal process. (8 marks)
(20 marks)
3 [P.T.O.
27
Formulae Sheet
2C0D
=
Ch
Miller–Orr Model
1
3
1
Spread = 3  4 
 
() (( ) )
E ri = R f + βi E rm – Rf
   
βa =  Ve 
βe +  Vd 1 – T
βd 
( )

(V
 e + Vd
1 (
– T ))
 
V
  e + Vd
1 – T ( 
 ( ))
The Growth Model
Po =
(
D0 1 + g )
(re
–g )
g = bre
 V   V 
WACC =  e  ke + 
 Ve + Vd 
d k 1– T
 Ve + Vd  d
( )
The Fisher formula
(1 + i) = (1 + r ) (1 + h)
S1 = S0 ×
(1 + h )c
F0 = S0 ×
(1 + i ) c
(1 + h )b (1 + i ) b
4
28
Present Value Table

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
5 [P.T.O.
29
Annuity Table
– (1 + r)–n
r

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
6
30
Answers
31

Financial Management March/June 2017 Sample Answers
Section C
31 (a) (i) The cash operating cycle can be calculated by adding inventory days and receivables days, and subtracting payables
days.
Cost of sales = 3,500,000 x (1 – 0·4) = $2,100,000
Inventory days = 360 x 455,000/2,100,000 = 78 days
Trade receivables days = 360 x 408,350/3,500,000 = 42 days
Trade payables days = 360 x 186,700/2,100,000 = 32 days
Cash operating cycle of Pangli Co = 78 + 42 – 32 = 88 days
(ii) Inventory at end of January 20X7 = 455,000 + 52,250 = $507,250
At the start of January 20X7, 100% of December 20X6 receivables will be outstanding ($300,000), together with 40%
of November 20X6 receivables ($108,350 = 40% x 270,875), a total of $408,350 as given.
$
Trade receivables at start of January 20X7 408,350
Outstanding November 20X6 receivables paid (108,350)
December 20X6 receivables, 60% paid (180,000)
January 20X7 credit sales 350,000
––––––––
Trade receivables at end of January 20X7 470,000
––––––––
$
Trade payables at start of January 20X7 186,700
Payment of 70% of trade payables (130,690)
January 20X7 credit purchases 250,000
––––––––
Trade payables at end of January 20X7 306,010
––––––––
$
Overdraft at start of January 20X7 240,250
Cash received from customers (288,350)
Cash paid to suppliers 130,690
Interest payment 70,000
Operating cash outflows 146,500
––––––––
Overdraft expected at end of January 20X7 299,090
––––––––
(iii) Current assets at start of January 20X7 = 455,000 + 408,350 = $863,350
Current liabilities at start of January 20X7 = 186,700 + 240,250 = $426,950
Current ratio at start of January 20X7 = 863,350/426,950 = 2·03 times
Current assets at end of January 20X7 = 507,250 + 470,000 = $977,250
Current liabilities at end of January 20X7 = 306,010 + 299,090 = $605,100
Current ratio at end of January 20X7 = 977,250/605,100 = 1·62 times
(b) Pangli Co could use the following techniques in managing trade receivables: assessing creditworthiness; managing accounts
receivable; collecting amounts owing; offering early settlement discounts; using factoring and invoice discounting; and
managing foreign accounts receivable.
Assessing creditworthiness
Pangli Co can seek to reduce its exposure to the risks of bad debt and late payment by assessing the creditworthiness of new
customers. In order to do this, the company needs to review information from a range of sources. These sources include trade
references, bank references, credit reference agencies and published accounts. To help it to review this information, Pangli
Co might develop its own credit scoring process. After assessing the creditworthiness of new customers, Pangli Co can decide
on how much credit to offer and on what terms.
Managing accounts receivable
Pangli Co needs to make sure that its credit customers abide by the terms of trade agreed when credit was granted following
credit assessment. The company wants its customers to settle their outstanding accounts on time and also to keep to their
agreed credit limits. Key information here will be the number of overdue accounts and the degree of lateness of amounts
outstanding. An aged receivables analysis can provide this information.
Pangli Co also needs to make sure that its credit customers are aware of the outstanding invoices on their accounts. The
company will therefore remind them when payment is due and regularly send out statements of account.
9
32
Collecting amounts owing

Ideally, credit customers will pay on time and there will be no need to chase late payers. There are many ways to make
payment in the modern business world and Pangli Co must make sure that its credit customers are able to pay quickly and
easily. If an account becomes overdue, Pangli Co must make sure it is followed up quickly. Credit control staff must assess
whether payment is likely to be forthcoming and if not, a clear policy must be in place on further steps to take. These further
steps might include legal action and using the services of a debt collection agency.
Offering early settlement discounts
Pangli Co can encourage its credit customers to settle outstanding amounts by offering an early settlement discount. This will
offer a reduction in the outstanding amount (the discount) in exchange for settlement before the due date. For example, if the
credit customer agreed to pay in full after 40 days, an early settlement discount might offer a 2% discount for settling after
25 days. Pangli Co must weigh the benefit of offering such an early settlement discount against the benefit expected to arise
from its use by credit customers. One possible benefit might be a reduction in the amount of interest the company pays on
its overdraft. Another possible benefit might be matching or bettering the terms of trade of a competitor.
Using factoring and invoice discounting
Pangli Co might use a factor to help manage its accounts receivable, either on a recourse or non-recourse basis. The factor
could offer assistance in credit assessment, managing accounts receivable and collecting amounts owing. For a fee, the factor
could advance a percentage of the face value of outstanding invoices. The service offered by the factor would be tailored to
the needs of the company.
Invoice discounting is a service whereby a third party, usually a factor, pays a percentage of the face value of a collection of
high value invoices. When the invoices are settled, the outstanding balance is paid to the company, less the invoice
discounter’s fee.
Managing foreign accounts receivable
Foreign accounts receivable can engender increased risk of non-payment by customers and can increase the value of
outstanding receivables due to the longer time over which foreign accounts receivable are outstanding. Pangli Co could reduce
the risk of non-payment by assessing creditworthiness, employing an export factor, taking out export credit insurance, using
documentary credits and entering into countertrade agreements. The company could reduce the amount of investment in
foreign accounts receivable through using techniques such as advances against collections and negotiating or discounting bills
of exchange
Examiner’s note: Only five techniques were required to be discussed.
32 (a) The terms risk and uncertainty are often used interchangeably in everyday discussion, however, there is a clear difference
between them in relation to investment appraisal.
Risk refers to the situation where an investment project has several possible outcomes, all of which are known and to which
probabilities can be attached, for example, on the basis of past experience. Risk can therefore be quantified and measured
by the variability of returns of an investment project.
Uncertainty refers to the situation where an investment project has several possible outcomes but it is not possible to assign
probabilities to their occurrence. It is therefore not possible to say which outcomes are likely to occur.
The difference between risk and uncertainty, therefore, is that risk can be quantified whereas uncertainty cannot be quantified.
Risk increases with the variability of returns, while uncertainty increases with project life.
(b) NPV calculation

Year 1 2 3 4 5
$000 $000 $000 $000 $000
Sales income 12,069 16,791 23,947 11,936
Variable cost (5,491) (7,139) (9,720) (5,616)
––––––– ––––––– ––––––– –––––––
Contribution 6,578 9,652 14,227 6,320
Fixed cost (1,100) (1,121) (1,155) (1,200)
––––––– ––––––– ––––––– –––––––
Taxable cash flow 5,478 8,531 13,072 5,120
Taxation at 28% (1,534) (2,389) (3,660) (1,434)
TAD tax benefits 1,400 1,050 788 2,362
––––––– ––––––– ––––––– ––––––– ––––––
After-tax cash flow 5,478 8,397 11,733 2,248 928
Discount at 10% 0·909 0·826 0·751 0·683 0·621
––––––– ––––––– ––––––– ––––––– ––––––
Present values 4,980 6,936 8,812 1,535 576
––––––– ––––––– ––––––– ––––––– ––––––
$000
PV of future cash flows 22,839
Initial investment (20,000)
–––––––
ENPV 2,839
–––––––
10
33
Comment
The probability that variable cost per unit will be $12·00 per unit or less is 80% and so the probability of a positive NPV is
therefore at least 80%. However, the effect on the NPV of the variable cost per unit increasing to $14·70 per unit must be
investigated, as this may result in a negative NPV.
The expected NPV is positive and so the investment project is likely to be acceptable on financial grounds.
Workings
Sales revenue
Year 1 2 3 4
Inflated at 3·5% per year 27·43 30·53 33·26 29·84
––––––– ––––––– ––––––– –––––––
Sales income ($000/year) 12,069 16,791 23,947 11,936
––––––– ––––––– ––––––– –––––––
Variable cost
Mean variable cost = (0·45 x 10·80) + (0·35 x 12·00) + (0·20 x 14·70) = $12·00/unit
Year 1 2 3 4
Variable cost ($/unit) 12·00 12·00 12·00 12·00
–––––– –––––– –––––– ––––––
Variable cost ($000/year) 5,491 7,139 9,720 5,616
–––––– –––––– –––––– ––––––
Year 1 2 3 4
TAD ($000) 5,000 3,750 2,813 8,437
Tax benefits at 28% ($000) 1,400 1,050 788 2,362*
*(20,000 x 0·28) – 1,400 – 1,050 – 788 = $2,362,000
Alternative calculation of after-tax cash flow
Year 1 2 3 4 5
$000 $000 $000 $000 $000
Taxable cash flow 5,478 8,531 13,072 5,120
TAD ($000) (5,000) (3,750) (2,813) (8,437)
–––––– –––––– ––––––– ––––––
Taxable profit 478 4,781 10,259 (3,317)
Taxation at 28% (134) (1,339) (2,873) 929
–––––– –––––– ––––––– –––––– ––––
After-tax profit 478 4,647 8,920 (6,190) 929
Add back TAD 5,000 3,750 2,813 8,437
–––––– –––––– ––––––– –––––– ––––
After-tax cash flow 5,478 8,397 11,733 2,247 929
–––––– –––––– ––––––– –––––– ––––
(c) There are several ways of considering risk in the investment appraisal process.
Sensitivity analysis
This technique looks at the effect on the NPV of an investment project of changes in project variables, such as selling price
per unit, variable cost per unit and sales volume. There are two approaches which are used. The first approach calculates
the relative (percentage) change in a given project variable which is needed to make the NPV zero. The second approach
calculates the relative (percentage) change in project NPV which results from a given change in the value of a project variable
(for example, 5%).
Sensitivity analysis considers each project variable individually. Once the sensitivities for each project variable have been
calculated, the next step is to identify the key or critical variables. These are the project variables where the smallest relative
change makes the NPV zero, or where the biggest change in NPV results from a given change in the value of a project
variable. The key or critical project variables indicate where underlying assumptions may need to be checked or where
managers may need to focus their attention in order to make an investment project successful. However, as sensitivity analysis
does not consider risk as measured by probabilities, it can be argued that it is not really a way of considering risk in investment
appraisal at all, even though it is often described as such.
Probability analysis
This technique requires that probabilities for each project outcome be assessed and assigned. Alternatively, probabilities for
different values of project variables can be assessed and assigned. A range of project NPVs can then be calculated, as well
as the mean NPV (the expected NPV or ENPV) associated with repeating the investment project many times. The worst and
best outcomes and their probabilities, the most likely outcome and its probability and the probability of a negative NPV can
also be calculated. Investment decisions could then be based on the risk profile of the investment project, rather than simply
on the NPV decision rule.
11
34
Risk-adjusted discount rate

It is often said that ‘the higher the risk, the higher the return’. Investment projects with higher risk should therefore be
discounted with a higher discount rate than lower risk investment projects. Better still, the discount rate should reflect the risk
of the investment project.
Theoretically, the capital asset pricing model (CAPM) can be used to determine a project-specific discount rate which reflects
an investment project’s systematic risk. This means selecting a proxy company with similar business activities to a proposed
investment project, ungearing the proxy company equity beta to give an asset beta which does not reflect the proxy company
financial risk, regearing the asset beta to give an equity beta which reflects the financial risk of the investing company, and
using the CAPM to calculate a project-specific cost of equity for the investment project.
Adjusted payback
If uncertainty and risk are seen as being the same, payback can consider risk by shortening the payback period. Because
uncertainty (risk) increases with project life, shortening the payback period will require a risky project to pay back sooner,
thereby focusing on cash flows which are nearer in time (less uncertain) and so less risky.
Discounted payback can also be seen as considering risk because future cash flows can be converted into present values
using a risk-adjusted discount rate. The target payback period normally used by a company can then be applied to the
discounted cash flows. Overall, the effect is likely to be similar to shortening the payback period with undiscounted cash flows.
12
35

Financial Management March/June 2017 Sample Marking Scheme
Marks Marks
Section C
31 (a) (i) Cost of sales 0·5

Inventory days 0·5
Receivables days 0·5
Cash operating cycle 0·5
––––
2
(ii) Inventory 31 January 0·5
Receivables 31 January 1
Payables 31 January 1
Overdraft 31 January 1·5
––––
4
(iii) Current ratio 1 January 2
Current ratio 31 January 2
––––
4
(b) First technique 2

Second technique 2
Third technique 2
Fourth technique 2
Fifth technique 2
––––
10
–––
20
–––
32 (a) Explain risk 1

Explain uncertainty 1
Discuss difference 1
––––
3
(b) Inflated revenue 1

Mean variable cost 1
Inflated variable cost 1
Tax liabilities 1
TAD benefits 1
Timing of tax flows 1
Calculation of PVs 1
Comment on variable cost 1
Comment on NPV 1
––––
9
(c) Sensitivity analysis 2

Probability analysis 2
Risk-adjusted rate 2
Adjusted payback 2
––––
8
–––
20
–––
13
36
This commentary has been written to accompany the published sample questions and answers and is written
based on the observations of markers. The aim is to provide constructive guidance for future candidates and their
tutors, giving insight into what the marking team is looking for, and flagging pitfalls encountered by candidates
who sat these questions.
Question 31(a)(i)
Here, candidates were asked to calculate the cash operating cycle of a company. Even though candidates tend
usually to perform well on calculation-based questions, a significant number of candidates struggled here. The
cash operating cycle is the sum of inventory days and accounts receivable days, less accounts payable days, i.e.
it is measured as a period of time. A number of candidates confused the cash operating cycle with net working
capital, i.e. they calculated inventory plus accounts receivable less accounts payable, which is a monetary value.
These answers indicated some candidates were not aware that the cash operating cycle is produced from three
working capital ratios.
Other errors seen here included:
• basing working capital ratios on monthly credit sales instead of annual credit sales
• using end-of-month figures instead of opening figures
• using a 365-day year when the question specified a 360-day year
• inverting working capital ratio calculations
These errors could have been prevented by better understanding of this part of the syllabus.
Question 31(a)(ii)
This question required candidates to calculate the overdraft expected at the end of January, and hence assessed
the ability to understand and apply relevant accounting ratios, and the ability to forecast cash position. Many
candidates struggled with this question. It should be noted that although the question stated that the company
had no cash and relied on its overdraft to finance daily operations, many answers considered only cash income
and cash payments and ignored working capital.
Question 31(a)(iii)
This question asked candidates to calculate the company’s opening and closing current ratio for the month.
While the opening current ratio was usually calculated correctly, many candidates had difficulty calculating
working capital movements relating to accounts receivable or accounts payable. Errors in these areas led to
incorrect current ratio calculations.
Question 31(b)
This question required a discussion of five techniques that a company could use in managing accounts receivable
and many candidates gained high marks here. Some candidates offered more than five techniques, however any
discussion of techniques beyond the five required did not gain additional marks and hence represented wasted
time. Some candidates discussed individual techniques at too great a length, failing as a result to discuss five
techniques as required. This is where good time management should join with good subject knowledge to
produce a balanced answer.
Many answers discussed assessing creditworthiness, offering early settlement discounts (not trade discounts),
and using factoring and invoice discounting. Many answers discussed factoring and invoice discounting as
37
separate techniques in managing accounts receivable, even though these are listed as one technique in the
syllabus. Managing accounts receivable and collecting amounts owing were discussed less frequently and often in
a piecemeal fashion. The technique discussed least frequently was managing foreign accounts receivable.
Question 32(a)
Candidates were asked here to discuss the difference between risk and uncertainty in relation to investment
appraisal. Risk relates to the variability of returns and it can be measured by the probability of different returns
being achieved by an investment project, that is, by attaching probabilities to different possible investment
project outcomes. Risk can therefore be measured or quantified, whereas uncertainty cannot. Many answers
showed little understanding of the link to variability of returns, tending to focus on quantifiable versus
unquantifiable aspects.
Question 32(b)
This question asked candidates to calculate the NPV of an investment project and comment on its financial
acceptability, considering taxation, inflation and a probability forecast of variable cost.
In questions relating to allowing for inflation and taxation in DCF techniques such as NPV, it is essential to
understand and apply the information provided. Many errors arose from not following this advice, for example,
using straight-line tax-allowable depreciation (TAD) when the question specified 25% reducing balance TAD, or
charging tax liabilities in the year they arose when the question specified one year in arrears. Some answers
placed tax liabilities one year in arrears, yet inconsistently placed TAD tax benefits in the year the TAD arose.
Other answers based tax liabilities on sales income, or on contribution, rather than on taxable cash flow.
Candidates would do well to remember that TAD is not a cash flow, as some answers treated TAD as an increase
to taxable cash flow, resulting in TAD being taxed. Some answers omitted to incorporate a balancing allowance in
their TAD calculation.
In relation to inflation, it was surprising to find some answers replacing inflation with deflation. An error made too
frequently was applying one year’s inflation to all years: candidates should remember that inflation is cumulative
in its effect, like discounting.
Some answers used incorrect discount rates, indicating a lack of understanding in relation to the need to discount
nominal cash flows with a nominal discount rate.
Some answers incorrectly placed the initial investment at the end of year 1, rather than year 0.
Some NPV calculations were incomplete, with unfinished present value calculations, missing years, or unjustified
acceptability comments, such as ‘Accept! Good project!’
In making the NPV calculation, candidates needed to calculate the expected value of variable cost as a step in
calculating total variable cost. In addition to calculating the NPV of the investment project and commenting on its
financial acceptability, candidates were asked to comment on the risk relating to variable cost. Many candidates
were not able to see that the expected value calculation gave them the percentage chance of the investment
project having a positive NPV.
38
Question 32(c)
Candidates were asked here to critically discuss how risk could be considered in the investment appraisal
process. Four techniques that could be discussed are listed in the F9 study guide: sensitivity analysis, probability
analysis, risk-adjusted discount rates and adjusted payback. Simulation could have been discussed as well, as
part of probability analysis. While sensitivity analysis is not technically a technique that considers risk, which
depends on probabilities, it is usually included in a discussion of risk in investment appraisal, perhaps because it
is commonly seen as a method of assessing project risk. Emphasising the need to read the question carefully,
answers were often not focussed on the question requirement, but discussed instead different kinds of risk, such
as systematic risk, unsystematic risk, business risk, financial risk and exchange rate risk.
In some cases, even excellent NPV calculations were associated with a lack of understanding of the role played
by the discount rate in building risk into investment appraisal.
39
Paper F9
September/December 2017 – Sample Questions


pages 4–6.

The Association of
Chartered Certified
Accountants
40
31 The following statement of financial position information relates to Tufa Co, a company listed on a large stock market
which pays corporation tax at a rate of 30%.
$m $m
Equity and liabilities
Share capital 17
Retained earnings 15
–––
Total equity 32
Non-current liabilities
Long-term borrowings 13
Current liabilities 21
–––
Total liabilities 34
–––
Total equity and liabilities 66
–––
The share capital of Tufa Co consists of $12m of ordinary shares and $5m of irredeemable preference shares.
The ordinary shares of Tufa Co have a nominal value of $0·50 per share, an ex dividend market price of $7·07 per
share and a cum dividend market price of $7·52 per share. The dividend for 20X7 will be paid in the near future.
Dividends paid in recent years have been as follows:
Year 20X6 20X5 20X4 20X3
Dividend ($/share) 0·43 0·41 0·39 0·37
The 5% preference shares of Tufa Co have a nominal value of $0·50 per share and an ex dividend market price of
$0·31 per share.
The long-term borrowings of Tufa Co consist of $10m of loan notes and a $3m bank loan. The bank loan has a variable
interest rate.
The 7% loan notes have a nominal value of $100 per loan note and a market price of $102·34 per loan note. Annual
interest has just been paid and the loan notes are redeemable in four years’ time at a 5% premium to nominal value.
Required:
(a) Calculate the after-tax weighted average cost of capital of Tufa Co on a market value basis. (11 marks)
(b) Discuss the circumstances under which it is appropriate to use the current WACC of Tufa Co in appraising an
investment project. (3 marks)
(c) Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of long-term finance.
(6 marks)
(20 marks)
2
41
32 The directors of Pelta Co are considering a planned investment project costing $25m, payable at the start of the first
year of operation. The following information relates to the investment project:
Year 1 Year 2 Year 3 Year 4
Variable costs ($/unit) 10·00 10·20 10·61 10·93
Fixed costs ($/year) 700,000 735,000 779,000 841,000
This information needs adjusting to take account of selling price inflation of 4% per year and variable cost inflation of
3% per year. The fixed costs, which are incremental and related to the investment project, are in nominal terms. The
year 4 sales volume is expected to continue for the foreseeable future.
Pelta Co pays corporation tax of 30% one year in arrears. The company can claim tax-allowable depreciation on a 25%
reducing balance basis.
The views of the directors of Pelta Co are that all investment projects must be evaluated over four years of operations,
with an assumed terminal value at the end of the fourth year of 5% of the initial investment cost. Both net present value
and discounted payback must be used, with a maximum discounted payback period of two years. The real after-tax
cost of capital of Pelta Co is 7% and its nominal after-tax cost of capital is 12%.
Required:
(a) (i) Calculate the net present value of the planned investment project. (9 marks)
(ii) Calculate the discounted payback period of the planned investment project. (2 marks)
(b) Discuss the financial acceptability of the investment project. (3 marks)
(c) Critically discuss the views of the directors on Pelta Co’s investment appraisal. (6 marks)
(20 marks)
3 [P.T.O.
42
Formulae Sheet
2C0D
=
Ch
Miller–Orr Model
1
3
1
Spread = 3  4 
 
() (( ) )
E ri = Rf + βi E rm – Rf
βa =

 Ve
 

βe + 
Vd 1 – T 
βd 
( )

(V
 e + Vd
1(– T
 
)) V
  e + Vd
1 (
– T

 ( ))
The Growth Model
D0 (1 + g ) D0 (1 + g )
P0 = re = +g
(re – g ) P0
g = bre
 V   V 
WACC =  e  ke + 
 Ve + Vd 
d k 1 – T
 Ve + Vd  d
( )
The Fisher formula
(1 + i) = (1 + r ) (1 + h)
S1 = S0 ×
(1 + h )c
F0 = S0 ×
(1 + i ) c
(1 + h )b (1 + i ) b
4
43
Present Value Table

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
5 [P.T.O.
44
Annuity Table
– (1 + r)–n
r

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
6
45
Answers
46

Financial Management September/December 2017 Sample Answers
Section C
31 Tufa Co
(a) Interest rate of loan notes (%) 7

Nominal value of loan notes ($) 100·00
Market price of loan notes ($) 102·34
Time to redemption (years) 4
Redemption premium (%) 5
Tax rate (%) 30
Year Item $ 5% DF PV ($) 6% DF PV ($)
0 MV (102·34 ) 1·000 (102·34 ) 1·000 (102·34 )
1–4 Interest 4·90 3·546 17·38 3·465 16·98
4 Redeem 105·00 0·823 86·42 0·792 83·16
––––––– –––––––
1·45 (2·20 )
––––––– –––––––
IRR (%) (5 + (1·45/(1·45 + 2·20))) = 5·40
Cost of bank loan (%) 5·40
Market values and WACC calculation
BV ($000) Nominal MV MV ($000) Cost (%) WACC
Ordinary shares 12,000 0·50 7·07 169,680 11·7 10·67
Preference shares 5,000 0·50 0·31 3,100 8·06 0·13
Loan notes 10,000 100·00 102·34 10,234 5·40 0·30
Bank loan 3,000 3,000 5·40 0·09
–––––––– ––––––
186,014 11·19
–––––––– ––––––
(b) The current WACC of Tufa Co represents the mean return required by the company’s investors, given the current levels of
business risk and financial risk faced by the company.
The current WACC can be used as the discount rate in appraising an investment project of the company provided that
undertaking the investment project does not change the current levels of business risk and financial risk faced by the company.
The current WACC can therefore be used as the discount rate in appraising an investment project of Tufa Co in the same
business area as current operations, for example, an expansion of current business, as business risk is likely to be unchanged
in these circumstances.
Similarly, the current WACC can be used as the discount rate in appraising an investment project of Tufa Co if the project is
financed in a way that mirrors the current capital structure of the company, as financial risk is then likely to be unchanged.
The required return of the company’s investors is likely to change if the investment project is large compared to the size of the
company, so the WACC is likely to be an appropriate discount rate providing the investment is small in size relative to Tufa Co.
(c) The following advantages of using convertible loan notes as a source of long-term finance could be discussed.
Conversion rather than redemption
If the holders of convertible loan notes judge that conversion into ordinary shares will increase their wealth, conversion of the
loan notes will occur on the conversion date and Tufa Co will not need to find the cash needed to redeem the loan notes. This
is sometimes referred to as ‘self-liquidation’.
Lower interest rate
The option to convert into ordinary shares has value for investors as ordinary shares normally offer a higher return than debt.
Investors in convertible loan notes will therefore accept a lower interest rate than on ordinary loan notes, decreasing the finance
costs for the issuing company.
Debt capacity
If Tufa Co issued convertible loan notes, its gearing and financial risk will increase and its debt capacity will decrease. When
conversion occurs, its gearing and financial risk will decrease and its debt capacity will increase because of the elimination of
the loan notes from its capital structure. However, there will a further increase in debt capacity due to the issue of new ordinary
shares in order to facilitate conversion.
Attractive to investors
Tufa Co may be able to issue convertible loan notes to raise long-term finance even when investors might not be attracted by
an issue of ordinary loan notes, because of the attraction of the option to convert into ordinary shares in the future.
9
47
Facilitates planning
It has been suggested than an issue of fixed-interest debt such as convertible loan notes can be attractive to a company as the
fixed nature of future interest payments facilitates financial planning.
32 Pelta Co
(a) (i) Year 1 2 3 4 5

$000 $000 $000 $000 $000
Sales income 16,224 20,248 24,196 27,655
Variable costs (5,356 ) (6,752 ) (8,313 ) (9,694 )
Contribution 10,868 13,495 15,883 17,962
Fixed costs (700 ) (735 ) (779 ) (841 )
––––––– ––––––– ––––––– –––––––
Cash flow before tax 10,168 12,760 15,104 17,121
Corporation tax (3,050 ) (3,828 ) (4,531 ) (5,136 )
TAD tax benefits 1,875 1,406 1,055 2,789
––––––– ––––––– ––––––– ––––––– ––––––
After-tax cash flow 10,168 11,585 12,682 13,644 (2,347 )
Terminal value 1,250
––––––– ––––––– ––––––– ––––––– ––––––
Project cash flow 10,168 11,585 12,682 14,894 (2,347 )
Discount at 12% 0·893 0·797 0·712 0·636 0·567
––––––– ––––––– ––––––– ––––––– ––––––
Present values 9,080 9,233 9,030 9,473 (1,331 )
––––––– ––––––– ––––––– ––––––– ––––––
PV of future cash flows ($000) 35,485
Initial investment ($000) (25,000 )
–––––––
NPV 10,485
–––––––
Workings
Year 1 2 3 4
Inflated by 4% per year 31·20 32·45 33·75 35·10
––––––– ––––––– ––––––– –––––––
Income ($000/year) 16,224 20,248 24,196 27,655
––––––– ––––––– ––––––– –––––––
Year 1 2 3 4
Variable costs ($/unit) 10·00 10·20 10·61 10·93
Inflated by 3% per year 10·30 10·82 11·59 12·30
––––––– ––––––– ––––––– –––––––
Variable costs ($000/year) 5,356 6,752 8,313 9,694
––––––– ––––––– ––––––– –––––––
Year 1 2 3 4
Fixed costs ($000 per year) 700 735 779 841
Year 1 2 3 4
TAD ($000 per year) 6,250 4,688 3,516 9,297
TAD benefits ($000/year) 1,875 1,406 1,055 2,789
(ii) Year 1 2 3 4 5
$000 $000 $000 $000 $000
Present values 9,080 9,233 9,030 9,473 (1,331
)
Cumulative net present
value (15,920
) (6,687
) 2,343 11,815 10,485
Discounted payback (years) 2·7
(b) The investment project is financially acceptable under the NPV decision rule because it has a substantial positive NPV.
The discounted payback period of 2·7 years is greater than the maximum target discounted payback period of two years and
so from this perspective the investment project is not financially acceptable.
The correct advice is given by the NPV method, however, and so the investment project is financially acceptable.
(c) The views of the directors on investment appraisal can be discussed from several perspectives.
Evaluation period
Sales are expected to continue beyond year 4 and so the view of the directors that all investment projects must be evaluated
over four years of operations does not seem sensible. The investment appraisal would be more accurate if the cash flows from
further years of operation were considered.
10
48
Assumed terminal value

The view of the directors that a terminal value of 5% of the initial investment should be assumed has no factual or analytical
basis to it. Terminal values for individual projects could be higher or lower than 5% of the initial investment and in fact may
have no relationship to the initial investment at all.
A more accurate approach would be to calculate a year 4 terminal value based on the expected value of future sales.
Discounted payback method
The directors need to explain their view that an investment project’s discounted payback must be no greater than two years.
Perhaps they think that an earlier payback will indicate an investment project with a lower level of risk. Although the discounted
payback method does overcome the failure of simple payback to take account of the time value of money, it still fails to consider
cash flows outside the payback period. Theoretically, Pelta Co should rely on the NPV investment appraisal method.
11
49

Financial Management September/December 2017 Sample Marking Scheme
Marks Marks
Section C
31 (a) Dividend for 20X7 1

Dividend growth rate 1
Cost of equity 1
Cost of pref shares 1
After-tax interest 1
Kd calculation setup 1
Calculating Kd 1
Cost of bank loan 0·5
MV ordinary shares 0·5
MV pref shares 0·5
MV loan notes 0·5
WACC calculations 2
–––
11
(b) Business risk 1

Financial risk 1
Size of investment 1
–––
3
(c) First advantage 2

Second advantage 2
Third advantage 2
–––
6
–––
20
–––
32 (a) (i) Inflated sales 1

Inflated VC/unit 1
Inflated total VC 1
Tax liabilities 1
TAD benefits yrs 1–3 1
TAD benefits yr 4 1
Timing of tax flows 1
Terminal value 1
Calculate PVs 1
–––
9
(ii) Cumulative NPV 1
Discounted payback 1
–––
2
(b) Acceptability – NPV 1

Acceptability – Payback 1
Correct advice 1
–––
3
(c) Evaluation period 2

Terminal value 2
Discounted payback 2
–––
6
–––
20
–––
13
50
F9 Examiner’s commentary on
September/December 2017 sample
questions
This commentary has been written to accompany the published sample questions and
answers and is written based on the observations of markers. The aim is to provide
constructive guidance for future candidates and their tutors, giving insight into what the
marking team is looking for, and flagging pitfalls encountered by candidates who sat these
questions.
Question 31(a)
This question required candidates to calculate the after-tax weighted average cost of capital
(WACC) of the company, where there were four distinct sources of finance. Hence, all four
elements needed to be considered, and a separate cost and value calculated for each.
Attempts at calculating the cost of equity and the value of ordinary shares were generally
good. Some candidates were not able to calculate the current dividend as the difference
between the cum div and ex div share prices, nor were they able to recognise that there were
four years of dividend growth. Most candidates were, however, able to perform correctly a
dividend growth rate computation.
Correct calculations of the cost of capital of preference shares were disappointingly low in
number. Too many candidates made errors such as using an ‘after tax’ preference dividend or
appeared to be simply guessing at the combination of figures that needed to be used.
Using an IRR approach to calculate the after tax cost of loan notes was generally done well.
Errors in calculation included not using after tax interest in the IRR calculation, not including
the redemption value of the loan note at its stated premium and/or using nominal value as the
purchase price of loan notes rather than market value.
Omissions of the cost of the bank loan, and indeed its value, due to it ‘having a variable rate’
were common, but in error. The bank loan was part of the total finance of the company and
needed to be included by using an appropriate substitute value for its cost, such as the after-
tax cost of debt of the loan notes or the after-tax interest rate of the loan notes.
Good examination technique here was for candidates to present the cost and value of the four
sources of finance as four separate workings and then to calculate the WACC by clearly
showing its four elements. Some candidates were combining sources of finance and this led to
errors. Examples of this were treating preference shares as ordinary shares and treating the
bank loan as loan notes.
The question asked for the WACC on a market value basis, hence using book values instead of
market values as weightings is simply incorrect.
Examiner’s commentary – F9 September/December 2017 1

51
Question 31(b)
Here candidates were required to discuss the circumstances where it is appropriate to use the
WACC in appraising an investment project. Some candidates discussed all three of the
required circumstances, including an explanation of what is meant by business risk and
financial risk. However, too many responses simply said “the WACC can be used if business
risk and financial risk are unchanged” without further development. Whilst correct, the
statement needs further discussion. A minority of responses made the point about the new
investment needing to be small in relation to the company.
The key to answering a question such as this is to focus clearly on the requirement. Indeed, a
common mistake in this question at this diet was to discuss circumstances under which it was
not appropriate to use the current WACC and how WACC could be amended to address these
circumstances. This was not what was asked.
Some answers were not even related to the requirement, discussing instead capital structure
theory, or the creditor hierarchy, or pecking order theory, to name just some. There were also
a disappointing number of candidates marking no attempt at this part question.
Question 31(c)
This question required candidates to discuss three advantages to the company of using
convertible loan notes as a source of long-term finance.
Better candidates broke down this requirement and addressed its component parts.
Firstly, a discussion is asked for. If six marks are offered for discussing three advantages, then
assuming that two marks are offered for each advantage is reasonable. A ‘bullet point’ or short
phrase is rarely, if ever, going to be sufficient to attract the two marks available for an
advantage.
Secondly, if three advantages are required, then discussing a fourth or even fifth advantage is
both poor examination technique and poor time management.
Thirdly, the question was clearly asked from the viewpoint of the user of the finance, which
was a company listed on a large stock exchange, and not the providers of the finance. Better
responses understood this important difference of viewpoint.
Fourthly, when answering a question like this, there is a tendency for candidates to write all
they know about the topic or to write in general terms about one of the areas, without
focusing precisely on the specific requirements of the question. Here the requirement was
about a specific type of debt finance, convertible loan notes, and the candidate’s answer
should have addressed that type of finance precisely.

52
Weaker responses ignored the possibility of conversion and were related only to the debt or
non-equity nature of the loan notes e.g. debt is cheaper than equity or interest on debt is tax
deductible. Some answers thought that conversion was a choice exercised by the company,
rather than the investor and other answers assumed that conversion was automatic, rather
than a wealth-maximising decision made by investors.
Question 32(a)(i)
This question asked candidates to calculate the NPV of an investment project, considering
taxation and inflation.
Candidates have continued to do well on investment appraisal questions requiring NPV

calculations, with candidates gaining good marks here, including many with full marks.
That said, a recurring error in the cash flow workings is a failure to apply a ‘per year inflation
rate’ correctly. If an inflation rate of 3% per year needs to be applied to a variable cost per
unit, then by the end of year 3, the given variable cost per unit needs to be inflated three
times i.e. by 1.03^3.
A number of answers to this question used an incorrect discount rate, usually the real discount
rate, to discount the nominal values already calculated.
Other errors seen quite often included:

incorrectly placing initial investment at year 1 rather than year 0
incorrectly placing the terminal value at year 5 rather than year 4, or not including it
altogether
not placing tax-related cash flows one year in arrears
omitting the tax-related cash flows in year 5
not calculating a balancing allowance, or calculating a balancing allowance but not
adjusting it for the scrap value of the asset
Question 32(a)(ii)
This requirement to calculate the discounted payback period of the project was done well,
with many candidates scoring the two marks on offer.
Where errors were made, they included a recalculation of the present values from (a)(i) by
erroneously using the real discount rate or using cash flows before tax.

53
Even on a two mark part question such as this, in Section C it is still good examination
technique for candidates to show all workings, such as the calculation of cumulative NPV and
how the part year element of the discounted payback period has been calculated.
Question 32(b)
Here candidates were asked to discuss the financial acceptability of the investment project.
Three marks were available.
Most candidates were able to refer to the decision rules relevant to net present value and
discounted payback, but do need to justify financial acceptability comments. Standalone
comments such as ‘Accept’ or alternatively ‘Positive NPV’ should be explained as should ‘more
than 2 years’ in respect of the discounted payback period.
In this question, there was a conflict between the two methods regarding acceptability,
therefore candidates needed to refer to the respective investment appraisal methods and
conclude by asserting the superiority of one method (NPV) over the other (discounted
payback).
Weaker responses simply referred to the positive NPV calculated in (a)(i), which is insufficient
for a part question worth three marks.
Question 32(c)
This question asked candidates to critically discuss the views of the directors in respect of the
company’s investment appraisal. These views were concerned with the evaluation period of
projects, an assumed terminal value and the investment appraisal techniques to be used,
including a strict two year discounted payback period (DPB).
Responses demonstrated that, whilst candidates can produce very good NPV computations
and calculate (discounted) payback periods correctly, improvement is required when it comes
to discussion.
This question asked candidates to critically discuss viewpoints. It is rarely sufficient to simply
list a few points. A critical discussion should involve looking at a viewpoint or a statement in
more than one way, for instance by looking at both its good aspects and those aspects which
could be criticised.
Many candidates simply ignored the directors’ view on terminal value. Other errors included
saying that NPV considered the whole life of an investment project, even though the directors
had limited NPV’s application to four years. Also, too many answers said that payback failed
to take account of the time value of money, even though the directors required DPB to be
used.

54
Some answers assumed that the investment project ended after four years, when in fact the
directors simply required that only the first four years be evaluated using NPV.
Too many answers failed to directly address the question requirement, often offering a
discussion of investment appraisal in general rather than the directors’ views specifically,
whilst poor answers did not address the question requirement by discussing only forecasting
problems, such as difficulties in forecasting cash flows, inflation rate, changes in the cost of
capital etc.

55
Paper F9
F9 ACCA


The Association of
Chartered Certified
Accountants
56
31 Tin Co is planning an expansion of its business operations which will increase profit before interest and tax by 20%.
The company is considering whether to use equity or debt finance to raise the $2m needed by the business expansion.
If equity finance is used, a 1 for 5 rights issue will be offered to existing shareholders at a 20% discount to the current
ex dividend share price of $5·00 per share. The nominal value of the ordinary shares is $1·00 per share.
If debt finance is used, Tin Co will issue 20,000 8% loan notes with a nominal value of $100 per loan note.
Financial statement information prior to raising new finance:
$’000
Profit before interest and tax 1,597
Finance costs (interest) (315 )
Taxation (282 )
––––––
––––––
$’000
Equity
Ordinary shares 2,500
Retained earnings 5,488
Long-term liabilities: 7% loan notes 4,500
–––––––
Total equity and long-term liabilities 12,488
–––––––
The current price/earnings ratio of Tin Co is 12·5 times. Corporation tax is payable at a rate of 22%.
Companies undertaking the same business as Tin Co have an average debt/equity ratio (book value of debt divided by
book value of equity) of 60·5% and an average interest cover of 9 times.
Required:
(a) (i) Calculate the theoretical ex rights price per share. (2 marks)
(ii) Assuming equity finance is used, calculate the revised earnings per share after the business expansion.
(4 marks)
(iii) Assuming debt finance is used, calculate the revised earnings per share after the business expansion.
(3 marks)
(iv) Calculate the revised share prices under both financing methods after the business expansion. (1 mark)
(v) Use calculations to evaluate whether equity finance or debt finance should be used for the planned
business expansion. (4 marks)
(b) Discuss TWO Islamic finance sources which Tin Co could consider as alternatives to a rights issue or a loan
note issue. (6 marks)
(20 marks)
2
57
32 Copper Co is concerned about the risk associated with a proposed investment and is looking for ways to incorporate risk
into its investment appraisal process. The company has heard that probability analysis may be useful in this respect
and so the following information relating to the proposed investment has been prepared:
Year 1 Year 2
Cash flow Probability Cash flow Probability
($) ($)
1,000,000 0·1 2,000,000 0·3
2,000,000 0·5 3,000,000 0·6
3,000,000 0·4 5,000,000 0·1
However, the company is not sure how to interpret the results of an investment appraisal based on probability analysis.
The proposed investment will cost $3·5m, payable in full at the start of the first year of operation. Copper Co uses a
discount rate of 12% in investment appraisal.
Required:
(a) Using a joint probability table:
(i) Calculate the mean (expected) NPV of the proposed investment; (8 marks)
(ii) Calculate the probability of the investment having a negative NPV; (1 mark)
(iii) Calculate the NPV of the most likely outcome; (1 mark)
(iv) Comment on the financial acceptability of the proposed investment. (2 marks)
(b) Discuss TWO of the following methods of adjusting for risk and uncertainty in investment appraisal:
(i) Simulation;
(ii) Adjusted payback;
(iii) Risk-adjusted discount rates. (8 marks)
(20 marks)
3 [P.T.O.
58
Formulae Sheet
2C0D
=
Ch
Miller–Orr Model
1
3
1
Spread = 3  4 
 
() (( ) )
βa =

 Ve
 

βe + 
Vd 1 – T 
βd 
( )

(V
 e + Vd
1(– T
 
)) V
  e + Vd
1 (
– T

 ( ))
The Growth Model
D0 (1 + g ) D0 (1 + g )
P0 = re = +g
(re – g ) P0
g = bre
 V   V 
WACC =  e  ke + 
 Ve + Vd 
d k 1 – T
 Ve + Vd  d
( )
The Fisher formula
(1 + i) = (1 + r ) (1 + h)
S1 = S0 ×
(1 + h )c
F0 = S0 ×
(1 + i ) c
(1 + h )b (1 + i ) b
4
59
Present Value Table

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
5 [P.T.O.
60
Annuity Table
– (1 + r)–n
r

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
6
61
Answers
62

Financial Management March/June 2018 Sample Answers
Section C
31 Tin Co
(a) Financial statement data

$000
Profit before interest and tax 1,597
Taxation (282 )
–––––––
–––––––
Equity
Ordinary shares 2,500
Retained earnings 5,488
Long-term liabilities
7% loan notes 4,500
–––––––
Total equity and long-term liabilities 12,488
–––––––
Other information
Current share price ($/share) 5·00
Rights issue discount (%) 20
Current EPS ($/share) (given) 0·40
Current PER (times) (given) 12·5
(i) Rights issue price ($/share) 4·00
TERPS ($/share) 4·83 [(4 x $5) + (1 x $4)]/5
(ii) $000
Increased PBIT 1,916
––––––
Revised profit before tax 1,601
Taxation at 22% (352 )
––––––
Revised profit after tax 1,249
––––––
Increased number of shares 3,000,000
Revised EPS ($/share) using equity 0·42 (1,249/3,000)
(iii) $000
Increased PBIT 1,916
Finance costs (interest) (475 ) (= 315 + 160)
––––––
Revised profit before tax 1,441
Taxation at 22% (317 )
––––––
Revised profit after tax 1,124
––––––
Current number of shares 2,500,000
Revised EPS ($/share) using debt 0·45 (1,124/2,500)
(iv) Revised share prices ($/share)
Using equity = 12·5 x 0·42 = 5·25
Using debt = 12·5 x 0·45 = 5·63
(v) Discussion
Gearing
Current D/E using BV = 4,500/(2,500 + 5,488) = 4,500/7,988 = 56·3%
Equity finance D/E using BV = 4,500/(7,988 + 2,000) = 4,500/9,988 = 45·1%
Debt finance D/E using BV = (4,500 + 2,000)/7,988 = 6,500/7,988 = 81·4%
Sector average D/E using BV = 60·5%
The gearing of Tin Co at 56·3% is just below the sector average gearing of 60·5%. If equity finance were used, gearing
would fall even further below the sector average at 45·1%. If debt finance were used, gearing would increase above the
sector average to 84·4%.
9
63
Interest cover
Current interest cover = 1,597/315 = 5·1 times
Interest cover using equity finance = 1,916/315 = 6·1 times
Interest cover using debt finance = 1,916/475 = 4·0 times
Sector average interest cover = 9 times
Interest cover calculations show that raising equity finance would make the interest cover of Tin Co look much safer.
Interest cover of 4·0 times looks quite risky.
Share price changes
The shareholders of Tin Co experience a capital gain of $0·63 per share ($5·63 – $5·00) if debt finance is used,
compared to a capital gain of $0·42 per share ($5·25 – $4·83) if equity finance is used. Although using debt finance
looks more attractive, it comes at a price in terms of increased financial risk. It might be decided, on balance, that using
equity finance looks to be the better choice.
(b) The forms of Islamic finance equivalent to a rights issue and a loan note issue are mudaraba and sukuk respectively. Musharaka
is similar to venture capital and hence is not seen as equivalent to a rights issue, which is made to existing shareholders. Ijara,
which is similar to lease finance, might be an alternative to a loan note issue, depending on the nature of the planned business
expansion.
Mudaraba
A mudaraba contract is between a capital partner (rab al mal) and an expertise partner (mudarab) for the undertaking of
business operations. The business operations must be compliant with Sharia’a law and are run on a day-to-day basis by the
mudarab. The rab al mal has no role in relation to the day-to-day operations of the business.
Profits from the business operations are shared between the partners in a proportion agreed in the contract. Losses are borne
by the rab al mal alone, as provider of the finance, up to the limit of the capital provided.
Sukuk
Conventional loan notes are not allowed under Sharia’a law because there must be a link to an underlying tangible asset and
because interest (riba) is forbidden by the Quran. Sukuk are linked to an underlying tangible asset, ownership of which is
passed to the sukuk holders, and do not pay interest.
Since the sukuk holders take on the risks and rewards of ownership, sukuk also has an equity aspect. As owners, sukuk holders
will bear any losses or risk from the underlying asset. In terms of rewards, sukuk holders have a right to receive the income
generated by the underlying asset and have a right to dismiss the manager of the underlying asset, if this is felt to be necessary.
Ijara
In this form of Islamic finance, the lessee uses a tangible asset in exchange for a regular rental payment to the lessor, who
retains ownership throughout the period of the lease contract. The contract may allow for ownership to be transferred from the
lessor to the lessee at the end of the lease period.
Major maintenance and insurance are the responsibility of the lessor, while minor or day-to-day maintenance is the responsibility
of the lessee. The lessor may choose to appoint the lessee as their agent to undertake all maintenance, both major and minor.
32 Copper Co
(a) (i) ENPV calculation

Year PV of Y1 prob PV of Y2 prob Total joint PV x JP NPV
CF CF PV prob
$000 $000 $000 $000 $000
PV of cash flow 1 893 0·1 1,594 0·3 2,487 0·03 74·6 (1,013 )
2,391 0·6 3,284 0·06 197·0 (216 )
3,985 0·1 4,878 0·01 48·8 1,378
PV of cash flow 2 1,786 0·5 1,594 0·3 3,380 0·15 507·0 (120 )
2,391 0·6 4,177 0·30 1,253·1 677
3,985 0·1 5,771 0·05 288·6 2,271
PV of cash flow 3 2,679 0·4 1,594 0·3 4,273 0·12 512·8 773
2,391 0·6 5,070 0·24 1,216·8 1,570
3,985 0·1 6,664 0·04 266·6 3,164
––––––
Sum of PV 4,365
Investment (3,500 )
––––––
ENPV = 865
––––––
Workings
Year 1 PV 2 PV
Cash flow 1 1,000 893 2,000 1,594
Cash flow 2 2,000 1,786 3,000 2,391
Cash flow 3 3,000 2,679 5,000 3,985
10
64
(ii) Negative NPV probability 24% Sum of joint probabilities with negative NPVs
(iii) Most likely outcome ($000) 677·0 Highest joint probability
(iv) Comment
The mean (expected) NPV is positive and so it might be thought that the proposed investment is financially acceptable.
However, the mean (expected) NPV is not a value expected to occur because of undertaking the proposed investment,
but a mean value from undertaking the proposed investment many times. There is no clear decision rule associated with
the mean (expected) NPV.
A decision on financial acceptability must also consider the risk (probability) of a negative NPV being generated by the
investment. At 24%, this might appear too high a risk to be acceptable. The risk preferences of the directors of Copper
Co will inform the decision on financial acceptability; there is no decision rule to be followed here.
(b) Simulation
Simulation is a computer-based method of evaluating an investment project whereby the probability distributions associated
with individual project variables and interdependencies between project variables are incorporated.
Random numbers are assigned to a range of different values of a project variable to reflect its probability distribution. Each
simulation run randomly selects values of project variables using random numbers and calculates a mean (expected) NPV.
A picture of the probability distribution of the mean (expected) NPV is built up from the results of repeated simulation runs. The
project risk can be assessed from this probability distribution as the standard deviation of the expected returns, together with
the most likely outcome and the probability of a negative NPV.
Adjusted payback
If risk and uncertainty are considered to be the same, payback can be used to adjust for risk and uncertainty in investment
appraisal.
As uncertainty (risk) increases, the payback period can be shortened to increase the emphasis on cash flows which are
nearer to the present time and hence less uncertain. Conversely, as uncertainty (risk) decreases, the payback period can be
lengthened to decrease the emphasis on cash flows which are nearer to the present time.
Discounted payback adjusts for risk in investment appraisal in that risk is reflected by the discount rate employed. Discounted
payback can therefore be seen as an adjusted payback method.
Risk-adjusted discount rates
The risk associated with an investment project can be incorporated into the discount rate as a risk premium over the risk-free
rate of return.
The risk premium can be determined on a subjective basis, for example, by recognising that launching a new product is
intrinsically riskier than replacing an existing machine or a small expansion of existing operations.
The risk premium can be determined theoretically by using the capital asset pricing model in an investment appraisal context. A
proxy company equity beta can be ungeared and the resulting asset can be regeared to reflect the financial risk of the investing
company, giving a project-specific equity beta which can be used to find a project-specific cost of equity or a project-specific
discount rate.
(Examiner note: Only two methods were required to be discussed.)
11
65

Financial Management March/June 2018 Sample Marking Scheme
Marks Marks
Section C
31 (a) (i) Rights issue price 1

TERP 1
–––
2
(ii) Increased PBIT 0·5
Revised PBT 0·5
Revised PAT 1
Number of shares 1
Revised EPS 1
–––
4
(iii) Increased interest 1
Revised PAT 1
Revised EPS 1
–––
3
(iv) Equity share price 0·5
Debt share price 0·5
–––
1
(v) Financial analysis 1
Gearing 1
Interest cover 1
Share price effects 1
–––
4
(b) First finance source 2

Second finance source 2
Additional detail 2
–––
6
–––
20
–––
32 (a) (i) Initial PVs 1

Total PVs 2
CF1 Joint prob 1
CF2 Joint prob 1
CF3 Joint prob 1
ENPV 2
–––
8
(ii) Negative NPV prob 1
(iii) Most likely NPV 1
(iv) Comment on ENPV 1
Comment on risk 1
–––
2
(b) First method 4

Second method 4
–––
8
–––
20
–––
13
66
Applied Skills
(FM)
September/December 2018 – Sample Questions
FM
FM ACCA


The Association of
Chartered Certified
Accountants
67
31 Melanie Co is considering the acquisition of a new machine with an operating life of three years. The new machine
could be leased for three payments of $55,000, payable annually in advance.
Alternatively, the machine could be purchased for $160,000 using a bank loan at a cost of 8% per year. If the
machine is purchased, Melanie Co will incur maintenance costs of $8,000 per year, payable at the end of each year
of operation. The machine would have a residual value of $40,000 at the end of its three-year life.
Melanie Co’s production manager estimates that if maintenance routines were upgraded, the new machine could be
operated for a period of four years with maintenance costs increasing to $12,000 per year, payable at the end of each
year of operation. If operated for four years, the machine’s residual value would fall to $11,000.
Taxation should be ignored.
Required:
(a) (i) Assuming that the new machine is operated for a three-year period, evaluate whether Melanie Co should
use leasing or borrowing as a source of finance. (6 marks)
(ii) Using a discount rate of 10%, calculate the equivalent annual cost of purchasing and operating the
machine for both three years and four years, and recommend which replacement interval should be
adopted. (6 marks)
(b) Critically discuss FOUR reasons why NPV is regarded as superior to IRR as an investment appraisal technique.
(8 marks)
(20 marks)
2
68
32 Oscar Co designs and produces tracking devices. The company is managed by its four founders, who lack business
administration skills.
The company has revenue of $28m, and all sales are on 30 days’ credit. Its major customers are large multinational
car manufacturing companies and are often late in paying their invoices. Oscar Co is a rapidly growing company and
revenue has doubled in the last four years. Oscar Co has focused in this time on product development and customer
service, and managing trade receivables has been neglected.
Oscar Co’s average trade receivables are currently $5·37m, and bad debts are 2% of credit sales revenue. Partly as a
result of poor credit control, the company has suffered a shortage of cash and has recently reached its overdraft limit.
The four founders have spent large amounts of time chasing customers for payment. In an attempt to improve trade
receivables management, Oscar Co has approached a factoring company.
The factoring company has offered two possible options:
Option 1
Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection, on a full recourse
basis. The factor would charge a service fee of 0·5% of credit sales revenue per year. Oscar Co estimates that this would
result in savings of $30,000 per year in administration costs. Under this arrangement, the average trade receivables
collection period would be 30 days.
Option 2
Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection on a non-recourse
basis. The factor would charge a service fee of 1·5% of credit sales revenue per year. Administration cost savings and
average trade receivables collection period would be as Option 1. Oscar Co would be required to accept an advance of
80% of credit sales when invoices are raised at an interest rate of 9% per year.
Oscar Co pays interest on its overdraft at a rate of 7% per year and the company operates for 365 days per year.
Required:
(a) Calculate the costs and benefits of each of Option 1 and Option 2 and comment on your findings. (8 marks)
(b) Discuss reasons (other than costs and benefits already calculated) why Oscar Co may benefit from the services
offered by the factoring company. (6 marks)
(c) Discuss THREE factors which determine the level of a company’s investment in working capital. (6 marks)
(20 marks)
3 [P.T.O.
69
Formulae Sheet
2C0D
=
Ch
Miller–Orr Model
1
3
1
Spread = 3  4 
 
() (( ) )
βa =

 Ve
 

βe + 
Vd 1 – T 
βd 
( )

(V
 e + Vd
1(– T
 
)) V
  e + Vd
1 (
– T

 ( ))
The Growth Model
D0 (1 + g ) D0 (1 + g )
P0 = re = +g
(re – g ) P0
g = bre
 V   V 
WACC =  e  ke + 
 Ve + Vd 
d k 1 – T
 Ve + Vd  d
( )
The Fisher formula
(1 + i) = (1 + r ) (1 + h)
S1 = S0 ×
(1 + h )c
F0 = S0 ×
(1 + i ) c
(1 + h )b (1 + i ) b
4
70
Present Value Table

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
5 [P.T.O.
71
Annuity Table
– (1 + r)–n
r

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
6
72
Answers
73
Applied Skills, FM
Financial Management (FM) September/December 2018 Sample Answers
Section C
31 Melanie Co
(a) (i) Year 0 Year 1 Year 2 Year 3

$ $ $ $
Lease
Lease payment (55,000 ) (55,000 ) (55,000 )
PV factor at 8% 1·000 0·926 0·857
–––––––– ––––––– –––––––
Present value (55,000 ) (50,930 ) (47,135 )
–––––––– ––––––– –––––––
Present value cost (153,065 )
––––––––
Borrow and buy
Initial cost (160,000 )
Maintenance (8,000 ) (8,000 ) (8,000 )
––––––– ––––––– –––––––
Total (160,000 ) (8,000 ) (8,000 ) 32,000
PV factor at 8% 1·000 0·926 0·857 0·794
–––––––– ––––––– ––––––– –––––––
Present value (160,000 ) (7,408 ) (6,856 ) 25,408
–––––––– ––––––– ––––––– –––––––
––––––––
As borrow and buy offers the cheapest present value cost the machine should be financed by borrowing.
(ii) 3-year replacement cycle Year 0 Year 1 Year 2 Year 3 Year 4
$ $ $ $ $
Maintenance (8,000 ) (8,000 ) (8,000 )
Total (160,000 ) (8,000 ) (8,000 ) 32,000
PV factor at 10% 1·000 0·909 0·826 0·751
–––––––– ––––––– ––––––– –––––––
Present value (160,000 ) (7,272 ) (6,608 ) 24,032
–––––––– ––––––– ––––––– –––––––
––––––––
EAC 3-year cycle = PV cost/Annuity factor 3 years at 10%
EAC = –$149,848/2·487 (60,253 )
4-year replacement cycle
Maintenance (12,000 ) (12,000 ) (12,000 ) (12,000 )
Total (160,000 ) (12,000 ) (12,000 ) (12,000 ) (1,000 )
PV factor at 10% 1·000 0·909 0·826 0·751 0·683
–––––––– ––––––– ––––––– ––––––– –––––––
Present value (160,000 (10,908 ) (9,912 ) (9,012 ) (683 )
–––––––– ––––––– ––––––– ––––––– –––––––
––––––––
EAC 4-year cycle = PV cost/Annuity factor 4 years at 10%
EAC = –$190,515/3·170 (60,099 )
Recommendation
The machine should be replaced every four years as the equivalent annual cost is lower.
(b) In most simple accept or reject decisions, IRR and NPV will select the same project. However, NPV has certain advantages
over IRR as an investment appraisal technique.
NPV and shareholder wealth
The NPV of a proposed project, if calculated at an appropriate cost of capital, is equal to the increase in shareholder wealth
which the project offers. In this way NPV is directly linked to the assumed financial objective of the company, the maximisation
of shareholder wealth. IRR calculates the rate of return on projects, and although this can show the attractiveness of the project
to shareholders, it does not measure the absolute increase in wealth which the project offers.
9
74
Absolute measure
NPV looks at absolute increases in wealth and thus can be used to compare projects of different sizes. IRR looks at relative
rates of return and in doing so ignores the relative size of the compared investment projects.
Non-conventional cash flows
In situations involving multiple reversals in project cash flows, it is possible that the IRR method may produce multiple IRRs
(that is, there can be more than one interest rate which would produce an NPV of zero). If decision-makers are aware of the
existence of multiple IRRs, it is still possible for them to make the correct decision using IRR, but if unaware they could make
the wrong decision.
Mutually-exclusive projects
In situations of mutually-exclusive projects, it is possible that the IRR method will (incorrectly) rank projects in a different order
to the NPV method. This is due to the inbuilt reinvestment assumption of the IRR method. The IRR method assumes that any
net cash inflows generated during the life of the project will be reinvested at the project’s IRR. NPV on the other hand assumes
a reinvestment rate equal to the cost of capital. Generally NPV’s assumed reinvestment rate is more realistic and hence it ranks
projects correctly.
Changes in cost of capital
NPV can be used in situations where the cost of capital changes from year to year. Although IRR can be calculated in these
circumstances, it can be difficult to make accept or reject decisions as it is difficult to know which cost of capital to compare it
with.
Note: Only four reasons were required to be discussed.
32 Oscar Co
(a) Option 1
$
Current trade receivables 5,370,000
Revised trade receivables (28,000,000 x 30/365) 2,301,370
––––––––––
Reduction in receivables 3,068,630
––––––––––
$ $
Reduction in financing cost = 3,068,630 x 0·07 214,804
Reduction in admin costs 30,000
––––––––
Benefits 244,804
Factor’s fee = 28,000,000 x 0·005 (140,000 )
––––––––
Net benefit 104,804
––––––––
Option 2
$ $
Reduction in financing cost = 3,068,630 x 0·07 214,804
Reduction in admin costs 30,000
Bad debts saved = 28,000,000 x 0·02 560,000
––––––––
Benefits 804,804
Increase in finance cost = 2,301,370 x 0·80 x 0·02 36,822
Factor’s fee = 28,000,000 x 0·015 420,000
––––––––
Costs (456,822 )
––––––––
Net benefit 347,982
––––––––
Both options are financially acceptable to Oscar Co, with Option 2 offering the greatest benefit and therefore it should be
accepted.
(b) Oscar Co may benefit from the services offered by the factoring company for a number of different reasons, as follows:
Economies of specialisation
Factors specialise in trade receivables management and therefore can offer ‘economies of specialisation’. They are experts at
getting customers to pay promptly and may be able to achieve payment periods and bad debt levels which clients could not
achieve themselves. The factor may be able to persuade the large multinational companies which Oscar Co supplies to pay on
time.
10
75
Scale economies
In addition, because of the scale of their operations, factors are often able to do this more cheaply than clients such as Oscar
Co could do on their own. Factor fees, even after allowing for the factor’s profit margin, can be less than the clients’ own
receivables administration cost.
Free up management time
Factoring can free up management time and allow them to focus on more important tasks. This could be a major benefit for
Oscar Co, where directors are currently spending a large amount of time attempting to persuade customers to pay on time.
Bad debts insurance
The insurance against bad debts shields clients from non-payment by customers; although this comes at a cost, it can be
particularly attractive to small companies who may not be able to stand the financial shock of a large bad debt. This could
well be the case for Oscar Co. As a small company which supplies much larger car manufacturing companies, it is particularly
exposed to default by customers. On the other hand, it could be argued that large multinational companies are financially
secure and default is unlikely, rendering bad debt insurance unnecessary.
Accelerate cash inflow
Factor finance can be useful to companies who have exhausted other sources of finance. This could be useful to Oscar Co if it
cannot negotiate an increase in its overdraft limit.
Finance through growth
Although factor finance is generally more expensive than a bank overdraft, the funding level is linked to the company’s volume
of sales. This can help to finance expansion and protects the company against overtrading. In a rapid growth company such
as Oscar Co, this could be a major advantage of factor finance.
(c) A company’s working capital investment is equal to the sum of its inventories and its accounts receivable, less its accounts
payable.
The following factors will determine the level of a company’s investment in working capital:
The nature of the industry and the length of the working capital cycle
Some businesses have long production processes which inevitably lead to long working capital cycles and large investments
in working capital. Housebuilding, for example, requires the building company to acquire land, gain government permission
to build, build houses and when complete, sell them to customers. This process can often take more than a year and require
large investment in work-in-progress and therefore in working capital.
Other industries, such as supermarkets, buy goods on long credit terms, have rapid inventory turnover and sell to customers
for cash. They often receive payment from customers before they need to pay suppliers and therefore have little (or negative)
investment in working capital.
Working capital investment policy
Some companies take a conservative approach to working capital investment, offering long periods of credit to customers (to
promote sales), carrying high levels of inventory (to protect against stock-outs), and paying suppliers promptly (to maintain
good relationships). This approach offers many benefits, but it necessitates a large investment in working capital.
Others take a more aggressive approach offering minimal credit, carrying low levels of inventory and delaying payments to
suppliers. This will result in a low level of working capital investment.
Efficiency of management and terms of trade
If management of the components of working capital is neglected, then investment in working capital can increase. For
example, a failure to apply credit control procedures such as warning letters or stop lists can result in high levels of accounts
receivable. Failure to control inventory by using the EOQ model, or JIT inventory management principles, can lead to high levels
of inventory.
11
76
Applied Skills, FM
Financial Management (FM) September/December 2018 Marking Scheme
Marks Marks
Section C
31 (a) (i) Lease timing 1

PV leasing 1
Maintenance cost 1
Purchase cost 0·5
Residual value 0·5
PV buy 1
Decision 1
–––
6
(ii) 3-year PV cost 1
3-year EAC 1
Maintenance 4-year 0·5
Residual value 4-year 0·5
4-year PV cost 1
4-year EAC 1
Decision 1
–––
6
(b) 1st reason 2

2nd reason 2
3rd reason 2
4th reason 2
–––
8
–––
20
–––
32 (a) Revised trade receivables 1

Finance cost reduction 1
Admin savings 1
Factor fee Option 1 1
Bad debt saving 1
Finance cost increase 1
Factor fee Option 2 1
Comment 1
–––
8
(b) Benefits 3
Oscar link 3
–––
6
(c) First factor 2

Second factor 2
Third factor 2
–––
6
–––
20
–––
13
77
Examiner’s commentary on
September/December 2018 sample
questions
This commentary has been written to accompany the published sample questions and
answers and is written based on the observations of markers. The aim is to provide
constructive guidance for future candidates and their tutors, giving insight into what the
marking team is looking for, and flagging pitfalls encountered by candidates who sat these
questions.
Question 31 – Melanie Co
Question 31 (a)(i)
This question asked candidates to evaluate whether the company should use leasing or
borrowing as a source of finance.
There were some very good complete answers here.
The two marks available for the present value of the leasing option were often gained. Errors
here mainly occurred where the lease rental payments were mistimed (treated as year-end
cash flows and not, as the question stated, cash flows in advance), or where discounting the
cash flows was not performed at all, thereby ignoring the fundamental principle of the time
value of money.
In terms of the borrowing option, a fundamental error kept reoccurring which displayed a lack
of understanding of the very nature of discounted cash flow. This error, seen far too often, was
the inclusion of interest payments within the computation of net cash flow. The cost of capital
which should be used to discount the net cash flows in this case is the cost of the debt
finance being used (taxation being ignored in this question), and hence the inclusion of
interest payments in the cash flow schedule means that such interest payments are effectively
being double counted.
Some errors were also seen in the timing of the relevant cash flows, namely the purchase
cost, the maintenance costs and the residual value. Some candidates also erroneously decided
to use the 10% discount rate, which was not presented until it became relevant in part (a)(ii).
Lastly, the requirement asked candidates to evaluate the source of finance to be used, hence
it is expected that a recommendation would be made based upon the figures calculated.
Failure to do this meant that a relatively straightforward mark was not gained.
Examiner’s commentary – FM September/December 2018 1

78
Question 31 (a)(ii)
The requirement here was to calculate the equivalent annual cost (EAC) of operating both a
three-year and a four-year replacement cycle, and to make a recommendation.
There were many fully correct answers here.
Where candidates had made the error noted above in part (a)(i), namely including interest
payments in their cash flow schedules, it was usually repeated in these computations. The
other common error here was a failure to know how to arrive at an EAC, with the division of
NPV simply by the number of years being an often seen mistake, as well as a simple
comparison of NPVs computed in order to make a judgement. Some responses lacked an
appreciation of the role of annuity factors.
Some other mistakes made included a failure to use the different maintenance costs and
residual value in the four-year option, as well as unnecessary computation of the EAC of the
leasing option (sic) or the EACs of other replacement cycles.
As has been discussed in respect of other requirements, a mark could have been scored by
making the required recommendation. This was disappointingly missed by some candidates.
Question 31 (b)
Here candidates were asked to critically discuss four reasons why net present value (NPV) is
regarded as superior to internal rate of return (IRR) as an investment appraisal technique.
Eight marks were available, with two marks being available for each of the four reasons. The
grid available to candidates in the CBE environment is useful in helping to organise
candidates’ answers, although some responses were too brief and some offered fewer than the
four reasons required by the question.
Whilst some of the reasons outlined in the suggested solution were seen quite often in
candidates’ answers, weaker responses simply described what NPV and IRR are and how
their respective calculations are performed. Furthermore, many answers gained very few
marks because they did not adopt a comparative approach to addressing the requirement, for
example, by making a statement about NPV without referring to IRR and so not discussing the
superiority of NPV over IRR.
Other errors seen included:
• Stating that IRR is inferior to NPV because IRR ignores the time value of money;
• Arguing that IRR is inferior to NPV because different choices for discount rates give
different values of IRR. However, manual calculation of IRR is a first approximation for
the actual value of IRR, which can be found quickly using a spreadsheet function, as
indeed can NPV;

79
• Making very general and brief points such as quick, easy, simple to understand;
• Suggesting that one technique or the other is more easily understood by managers,
without any justification.
Question 32 – Oscar Co
Question 32 (a)
This question required candidates to calculate the costs and benefits of two options offered to
Oscar Co by a factoring company and to comment on the findings.
The net benefit of Option 1 was often precisely calculated, with many candidates arriving at
$104,804.
There were fewer totally correct answers in the computation of the net benefit of option 2. The
most frequently occurring error here was a failure to recognise that the factor’s advance would
bring about an increase in the cost of the financing of the revised trade receivables. In other
words, 80% of the trade receivables would be financed at 9%, rather than at 7%.
Other errors included:
• Using trade receivables as the basis for calculating factor fees or even, via trade
receivables days of 30, credit sales revenue;
• Putting bad debt savings in both options;
• Basing bad debt savings on trade receivables and not credit sales revenue;
• Failing to calculate the effect on financing costs of the respective options;
• Basing the increased financial cost in option 2 on current trade receivables, or on
current credit sales revenue.
• Confusing the nature of items, such as mixing capital and revenue items, so, for
example, the value of the factor’s advance is incorrectly included as a cost, rather than
the impact of its financing cost.
Candidates sitting this examination in the future should be aware that having the use of
spreadsheet functionality does not abdicate responsibility for showing the build up of how a
figure has been arrived at. A supporting working can be shown inside a single cell. Hence the
increase in finance cost referred to above could be built up in the following way:
28,000,000 * 30/365 * 0.80 * 0.02 = $36,822.
Some candidates did not make a comment on their findings, which should simply be about
which option to choose and why, thereby failing to gain a relatively straightforward mark.

80
Question 32 (b)
Here candidates were required to discuss the reasons why Oscar Co may benefit from the
services offered by the factoring company. There are two important points about the stated
requirement which are worth emphasising here. Firstly, the requirement is clear in asking for
reasons other than costs and benefits already calculated. Secondly, the requirement asks for
reasons why Oscar Co may benefit from the factoring company.
Whilst there were good responses here that discussed valid reasons, such as those outlined in
the suggested solution, and were able to relate these reasons to the circumstances outlined in
the case scenario, there were a disappointing number of responses which were too brief for
the marks available. In a requirement asking for a discussion and attracting six marks, it is
insufficient to offer short phrases or bullet points lacking in detail.
As already noted, the requirement was for discussion of reasons other than costs or benefits
already calculated. Sadly, many answers discussed these already-calculated costs and
benefits, such as the reduction in administrative costs or the bad debt savings.
Furthermore, some answers simply made no link to Oscar Co, even though this was a
question requirement. Candidates sitting in the future are encouraged to read the requirement
carefully and, where asked for, relate their answers to the company in question. This should
be done in a meaningful way by, for example, discussing the factor’s expertise and contrasting
this with the lack of business administration skills of the four founders of the company. Simply
mentioning Oscar Co several times in a response, but not actually discussing the company’s
characteristics and circumstances, does not qualify as linking reasons to the company.
Question 32 (c)
This question required candidates to discuss three factors which determine the level of a
company’s investment in working capital.
Firstly, a discussion is asked for. If six marks are offered for discussing three factors, then
assuming that two marks are offered for each factor is reasonable. The grid now seen in
Computer Based Examinations should prove useful in organising candidates’ answers. That
said, it is worth reiterating, a ‘bullet point’ or short phrase is rarely, if ever, going to be
sufficient to attract the two marks available for each factor.
It is worth commenting that answers to this question were disappointing. Many answers did
not appear to understand the question requirement, even though this was taken directly from
the Financial Management syllabus.

81
Common errors in candidates’ responses included:
• Discussing (or simply listing) elements of working capital, without relating answers to
the question requirement;
• Discussing working capital financing policy, when the requirement said working capital
investment policy;
• Interpreting ‘factors determining the level of working capital investment’ as ‘accounting
ratios’, such as current ratio or quick ratio;
• Stating a factor, but then with no accompanying discussion e.g. the ‘nature of the
industry’, but without explaining why the industry affected working capital or giving
examples.
As sometimes happens, candidates offered responses based upon what they would have liked
to have been asked about working capital management, rather than to the actual question
asked in the examination. For example, some candidates’ entire answers to this part (c) were
wholly about ‘liquidity versus profitability’ or about permanent and fluctuating assets, and
conservative, aggressive and moderate policies.

82
83
Applied Skills
(FM)
FM
FM ACCA


pages 11–13.

The Association of
Chartered Certified
Accountants
84
Please use the grid provided on page two of the Candidate Answer Booklet to record your answers to each multiple choice
question. Do not write out the answers to the MCQs on the lined pages of the answer booklet.
The following scenario relates to questions 16–20

Tulip Co is a large company with an equity beta of 1·05. The company plans to expand existing business by acquiring a new
factory at a cost of $20m. The finance for the expansion will be raised from an issue of 3% loan notes, issued at nominal
value of $100 per loan note. These loan notes will be redeemable after five years at nominal value or convertible at that
time into ordinary shares in Tulip Co with a value expected to be $115 per loan note.
The risk-free rate of return is 2·5% and the equity risk premium is 7·8%.
Tulip Co is seeking additional finance and is considering using Islamic finance and, in particular, would require a form which
would be similar to equity financing.
16 What is the cost of equity of Tulip Co using the capital asset pricing model?
A 13·3%
B 10·7%
C 8·1%
D 10·3%
17 Using estimates of 5% and 6%, what is the cost of debt of the convertible loan notes?
A 3·0%
B 5·2%
C 6·9%
D 5·7%
18 In relation to using the dividend growth model to value Tulip Co, which of the following statements is correct?
A The model assumes that all shareholders of Tulip Co have the same required rate of return
B The model assumes a constant share price and a constant dividend growth for Tulip Co
C The model assumes that capital markets are semi-strong form efficient
D The model assumes that Tulip Co’s interim dividend is equal to the final dividend
19 Which of the following statements about equity finance is correct?

A Equity finance reserves represent cash which is available to a company to invest
B Additional equity finance can be raised by rights issues and bonus issues
C Retained earnings are a source of equity finance
D Equity finance includes both ordinary shares and preference shares
2
85
20 Regarding Tulip Co’s interest in Islamic finance, which of the following statements is/are correct?
(1) Murabaha could be used to meet Tulip Co’s financing needs
(2) Mudaraba involves an investing partner and a managing or working partner
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2
3 [P.T.O.
86

Extracts from the financial statements of Bluebell Co, a listed company, are as follows:
$m
Profit before interest and tax 238
Finance costs (24 )
––––
Profit before tax 214
Corporation tax (64 )
––––
Profit after tax 150
––––
$m
Assets
Non-current assets
Property, plant and equipment 768
Goodwill (internally generated) 105
––––––
873
––––––
Current assets
Inventories 285
Trade receivables 192
––––––
477
––––––
Total assets 1,350
––––––
Equity and liabilities
Total equity 688
Long-term borrowings 250
Current liabilities
Trade payables 312
Short-term borrowings 100
––––––
Total current liabilities 412
––––––
Total liabilities 662
––––––
Total equity and liabilities 1,350
––––––
A similar size competitor company has a price/earnings ratio of 12·5 times.
This competitor believes that if Bluebell Co were liquidated, property, plant and equipment would only realise $600m, while
10% of trade receivables would be irrecoverable and inventory would be sold at $30m less than its book value.
Separately, Bluebell Co is considering the acquisition of Dandelion Co, an unlisted company which is a supplier of Bluebell
Co.
21 What is the value of Bluebell Co on a net realisable value basis?

A $140·8m
B $470·8m
C $365·8m
D $1,027·8m
4
87
22 What is the value of Bluebell Co using the earnings yield method?

A $2,675m
B $1,200m
C $1,875m
D $2,975m
23 When valuing Bluebell Co using asset-based valuations, which of the following statements is correct?
A An asset-based valuation would be useful for an asset-stripping acquisition
B Bluebell Co’s workforce can be valued as an intangible asset
C Asset-based valuations consider the present value of Bluebell Co’s future income
D Replacement cost basis provides a deprival value for Bluebell Co
24 Which of the following is/are indicators of market imperfections?

(1) Low volume of trading in shares of smaller companies
(2) Overreaction to unexpected news
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2
25 Which of the following statements is correct?

A Dandelion Co is easier to value than Bluebell Co because a small number of shareholders own all the shares
B Bluebell Co will have to pay a higher price per share to take control of Dandelion Co than if it were buying a
minority holding
C Scrip dividends decrease the liquidity of shares by retaining cash in a company
D Dandelion Co’s shares will trade at a premium to similar listed shares because it will have a lower cost of equity
5 [P.T.O.
88

Peony Co’s finance director is concerned about the effect of future interest rates on the company and has been looking at
the yield curve.
Peony Co, whose domestic currency is the dollar ($), plans to take out a $100m loan in three months’ time for a period of
nine months. The company is concerned that interest rates might rise before the loan is taken out and its bank has offered
a 3 v 12 forward rate agreement at 7·10–6·85.
The loan will be converted into pesos and invested in a nine-month project which is expected to generate income of 580m
pesos, with 200m pesos being paid in six months’ time (from today) and 380m pesos being paid in 12 months’ time (from
today). The current spot exchange rate is 5 pesos per $1.
The following information on current short-term interest rates is available:
Dollars 6·5% per year
Pesos 10·0% per year
As a result of the general uncertainty over interest rates, Peony Co is considering a variety of ways in which to manage its
interest rate risk, including the use of derivatives.
26 In relation to the yield curve, which of the following statements is correct?

A Expectations theory suggests that deferred consumption requires increased compensation as maturity increases
B An inverted yield curve can be caused by government action to increase its long-term borrowing
C A kink (discontinuity) in the normal yield curve can be due to differing yields in different market segments
D Basis risk can cause the corporate yield curve to rise more steeply than the government yield curve
27 If the interest rate on the loan is 6·5% when it is taken out, what is the nature of the compensatory payment under
the forward rate agreement?
A Peony Co pays bank $600,000
B Peony Co pays bank $250,000
C Peony Co pays bank $450,000
D Bank pays Peony Co $600,000
28 Using exchange rates based on interest rate parity, what is the dollar income received from the project?
A $112·3m
B $114·1m
C $116·0m
D $112·9m
29 In respect of Peony Co managing its interest rate risk, which of the following statements is/are correct?
(1) Smoothing is an interest rate risk hedging technique which involves maintaining a balance between fixed-rate and
floating-rate debt
(2) Asset and liability management can hedge interest rate risk by matching the maturity of assets and liabilities
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2
6
89
30 In relation to the use of derivatives by Peony Co, which of the following statements is correct?
A Interest rate options must be exercised on their expiry date, if they have not been exercised before then
B Peony Co can hedge interest rate risk on borrowing by selling interest rate futures now and buying them back in
the future
C An interest rate swap is an agreement to exchange both principal and interest rate payments
D Peony Co can hedge interest rate risk on borrowing by buying a floor and selling a cap
(30 marks)
7 [P.T.O.
90
31 The following information has been taken from the statement of financial position of Corfe Co, a listed company:
$m $m
Non-current assets 50
Current assets
Cash and cash equivalents 4
Other current assets 16 20
––– –––
Total assets 70
–––
Equity and reserves
Ordinary shares 15
Reserves 29 44
–––
6% preference shares 6
8% loan notes 8
Bank loan 5 19
––– –––
Current liabilities 7
–––
Total equity and liabilities 70
–––
The ordinary shares of Corfe Co have a nominal value of $1 per share and a current ex-dividend market price of $6·10
per share. A dividend of $0·90 per share has just been paid.
The 6% preference shares of Corfe Co have a nominal value of $0·75 per share and an ex-dividend market price of
$0·64 per share.
The 8% loan notes of Corfe Co have a nominal value of $100 per loan note and a market price of $103·50 per loan
note. Annual interest has just been paid and the loan notes are redeemable in five years’ time at a 10% premium to
nominal value.
The bank loan has a variable interest rate.
The risk-free rate of return is 3·5% per year and the equity risk premium is 6·8% per year. Corfe Co has an equity beta
of 1·25.
Corfe Co pays corporation tax at a rate of 20%.
Investment in facilities
Corfe Co’s board is looking to finance investments in facilities over the next three years, forecast to cost up to $25m.
The board does not wish to obtain further long-term debt finance and is also unwilling to make an equity issue. This
means that investments have to be financed from cash which can be made available internally. Board members have
made a number of suggestions about how this can be done:
Director A has suggested that the company does not have a problem with funding new investments, as it has cash
available in the reserves of $29m. If extra cash is required soon, Corfe Co could reduce its investment in working
capital.
Director B has suggested selling the building which contains the company’s headquarters in the capital city for $20m.
This will raise a large one-off sum and also save on ongoing property management costs. Head office support functions
would be moved to a number of different locations rented outside the capital city.
Director C has commented that although a high dividend has just been paid, dividends could be reduced over the next
three years, allowing spare cash for investment.
8
91
Required:
(a) Calculate the after-tax weighted average cost of capital of Corfe Co on a market value basis. (11 marks)
(b) Discuss the views expressed by the three directors on how the investment should be financed. (9 marks)
(20 marks)
9 [P.T.O.
92
32 Pinks Co is a large company listed on a major stock exchange. In recent years, the board of Pinks Co has been criticised
for weak corporate governance and two of the company’s non-executive directors have just resigned. A recent story
in the financial media has criticised the performance of Pinks Co and claims that the company is failing to satisfy the
objectives of its key stakeholders.
Pinks Co is appraising an investment project which it hopes will boost its performance. The project will cost $20m,
payable in full at the start of the first year of operation. The project life is expected to be four years. Forecast sales
volumes, selling price, variable cost and fixed costs are as follows:
Year 1 2 3 4
Sales (units/year) 300,000 410,000 525,000 220,000
Variable cost ($/unit) 71 71 71 71
Fixed costs ($’000/year) 3,000 3,100 3,200 3,000
Selling price and cost information are in current price terms, before applying selling price inflation of 5% per year,
variable cost inflation of 3·5% per year and fixed cost inflation of 6% per year.
Pinks Co pays corporation tax of 26%, with the tax liability being settled in the year in which it arises. The company
can claim tax-allowable depreciation on the full initial investment of $20m on a 25% reducing balance basis. The
investment project is expected to have zero residual value at the end of four years.
Pinks Co has a nominal after-tax cost of capital of 12% and a real after-tax cost of capital of 8%. The general rate of
inflation is expected to be 3·7% per year for the foreseeable future.
Required:
(a) (i) Calculate the nominal net present value of Pinks Co’s investment project. (8 marks)
(ii) Calculate the real net present value of Pinks Co’s investment project and comment on your findings.
(4 marks)
(b) Discuss FOUR ways to encourage managers to achieve stakeholder objectives. (8 marks)
(20 marks)
10
93
Formulae Sheet
2C0D
=
Ch
Miller–Orr Model
1
3
1
Spread = 3  4 
 
() (( ) )
βa =

 Ve
 

βe + 
Vd 1 – T 
βd 
( )

(V
 e + Vd
1(– T
 
)) V
  e + Vd
1 (
– T

 ( ))
The Growth Model
D0 (1 + g ) D0 (1 + g )
P0 = re = +g
(re – g ) P0
g = bre
 V   V 
WACC =  e  ke + 
 Ve + Vd 
d k 1 – T
 Ve + Vd  d
( )
The Fisher formula
(1 + i) = (1 + r ) (1 + h)
S1 = S0 ×
(1 + h )c
F0 = S0 ×
(1 + i ) c
(1 + h )b (1 + i ) b
11 [P.T.O.
94
Present Value Table

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
12
95
Annuity Table
– (1 + r)–n
r

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
13
96
(FM)
Sample Questions
97
Q 31 Dusty Dec 2019
Dusty Co wishes to improve its working capital management as part of an overall cost-cutting strategy
to increase profitability. Two areas the company has been considering are working capital funding
strategy and inventory management. Dusty Co currently follows a policy of financing working capital
needs as much as possible from long-term sources of finance, such as equity. The company has been
considering its inventory management and has been looking specifically at component K.
Current position
Dusty Co purchases 1,500,000 units of component K each year and consumes the component at a
constant rate. The purchase price of component K is $14 per unit. The company places 12 orders
each year. Inventory of component K in the financial statements of Dusty Co is equal to average inventory
of component K.
The holding cost of component K, excluding finance costs, is $0.21 per unit per year. The ordering cost
of component K is $252 per order.

Dusty Co wishes to investigate whether basing ordering of component K on the economic order quantity
will reduce costs.
Bulk order discount

The supplier of component K has offered Dusty Co a discount of 0.5% on the purchase price of
component K, provided the company orders 250,000 units per order.
Other information
Dusty Co has no cash but has access to short-term finance via an overdraft facility at an interest rate
of 3% per year. This overdraft currently stands at $550,000.
(a)(i) Calculate the annual holding and ordering costs of Dusty Co’s current inventory
management system.
(1 mark)
(ii) Calculate the financial effect of adopting the Economic Order Quantity as the basis for
ordering inventory.
(4 marks)
(iii) Calculate the financial effect of accepting the bulk order discount.
(4 marks)
(iv) Recommend, with justification, which option should be selected by Dusty Co.
(1 mark)
(b) Discuss the key factors in determining working capital funding strategies.
(10 marks)
(20 marks)
98
Q32 December 2019
Dink Co is a small company that is finding it difficult to raise funds to acquire a new machine costing
$750,000. Dink Co would ideally like a four-year loan for the full purchase price at a before-tax interest
rate of 8.6% per year.
The machine would have an expected life of four years. At the end of this period the machine would have
a residual value of $50,000. Tax-allowable servicing costs for the machine would be $23,000 per year.
Tax-allowable depreciation on the full purchase price would be available on a 25% reducing balance
basis.
A leasing company has offered a contract whereby Dink Co could have use of the new machine for four
years in exchange for an annual lease rental payment of $200,000, payable at the start of each year.
The contract states that the leasing company would undertake maintenance of the machine at no
additional cost to Dink Co. At the end of four years the leasing company would remove the machine from
the manufacturing facility of Dink Co.
Dink Co pays corporation tax of 30% one year in arrears.
(a) For the new machine:
(i) Calculate the present value of the cost of borrowing to buy.

(6 marks)
(ii) Calculate the present value of the cost of leasing.

(3 marks)
(iii) Recommend which option is more attractive in financial terms to Dink Co.
(1 mark)
(b)(i) Discuss general reasons why investment capital may be rationed.

(6 marks)
(ii) Discuss ways in which the external capital rationing experienced by Dink Co might be
overcome.
(4 marks)
(20 marks)
99
Answers
100
Applied Skills, FM
Financial Management (FM) September/December 2019 Sample Answers
Section C
31 Dusty Co
(a) (i) Annual holding and ordering costs of the current inventory management system

Each current order is 1,500,000/12 = 125,000 units per order
Average inventory = 125,000/2 = 62,500 units
Current holding cost = 62,500 x 0·21 = $13,125 per year
Current ordering cost = 12 x 252 = $3,024 per year
Current total inventory management cost = $13,125 + $3,024 = $16,149 per year
(ii) Financial effect of adopting EOQ model

EOQ = (2 x 252 x 1,500,000/0·21)0·5 = 60,000 units/order
Number of orders = 1,500,000/60,000 = 25 orders per year
Ordering cost = 25 x 252 = $6,300 per year
EOQ total inventory management cost = $6,300 + $6,300 = $12,600 per year
Reduction in total inventory management cost = $16,149 – $12,600 = $3,549 per year
Reduction in average inventory = (62,500 – 30,000) x 14 = $455,000
The overdraft will decrease by the same amount.
Finance cost saving = 455,000 x 0·03 = $13,650 per year
Overall saving = $3,549 + $13,650 = $17,199
(iii) Financial effect of accepting the bulk order discount

Number of orders = 1,500,000/250,000 = 6 orders per year
Ordering cost = 6 x 252 = $1,512 per year
Total inventory management cost = $26,250 + $1,512 = $27,762 per year
Increase in total inventory management cost = $27,762 – $16,149 = $11,613 per year
Increase in value of average inventory = (125,000 x 14) – (62,500 x 13·93) = $879,375
The overdraft will increase by the same amount.
Finance cost increase = 879,375 x 0·03 = $26,381 per year
Bulk order discount = 1,500,000 x 14 x 0·005 = $105,000 per year
Overall saving = $105,000 – $11,613 – $26,381 = $67,006
(iv) The bulk order discount saves $67,006 compared to the current position, while the EOQ approach saves $17,199. The

bulk order discount is recommended as it leads to the greater cost saving.
(b) Key factors in determining working capital funding strategies

Permanent and fluctuating current assets
One key factor when discussing working capital funding strategies is to distinguish between permanent and fluctuating current
assets. Permanent current assets represent the core level of current assets needed to support normal levels of business activity,
for example, the level of trade receivables associated with the normal level of credit sales and existing terms of trade. Business
activity will be subject to unexpected variations, however, such as some customers being late in settling their accounts, leading
to unexpected variations in current assets. These can be termed fluctuating current assets.
Relative cost and risk of short-term and long-term finance

A second key factor is the relative cost of short-term and long-term finance. The normal yield curve suggests that long-term
debt finance is more expensive than short-term debt finance, for example, because of investor liquidity preference or default
risk. Provided the terms of loan agreements are adhered to and interest is paid when due, however, long-term debt finance is
a secure form of finance and hence low risk.
19
101
While short-term debt finance is lower cost than long-term debt finance, it is higher risk. For example, an overdraft is technically
repayable on demand, while a short-term loan is subject to the risk that it may be renewed on less favourable terms than those
currently enjoyed.
Matching principle

A third key factor is the matching principle, which states that the maturity of assets should be reflected in the maturity of the
finance used to support them. Short-term finance should be used for fluctuating current assets, while long-term finance should
be used for permanent current assets and non-current assets.
Relative costs and benefits of different funding policies

A fourth key factor is the relative costs and benefits of different funding policies.
A matching funding policy would use long-term finance for permanent current assets and non-current assets, and short-term
finance for fluctuating current assets. A conservative funding policy would use long-term finance for permanent current assets,
non-current assets and some of the fluctuating current assets, with short-term finance being used for the remaining fluctuating
current assets. An aggressive funding policy would use long-term finance for the non-current assets and part of the permanent
current assets, and short-term finance for fluctuating current assets and the balance of the permanent current assets.
A conservative funding policy, using relatively more long-term finance, would be lower in risk but lower in profitability. An
aggressive funding policy, using relatively more short-term finance, would be higher in risk but higher in profitability. A
matching funding policy would balance risk and profitability, avoiding the extremes of a conservative or an aggressive funding
policy.
Other key factors

Other key factors in working capital funding strategies include managerial attitudes to risk, previous funding decisions and
organisation size. Managerial attitudes to risk can lead to a company preferring one working capital funding policy over another,
for example, a risk-averse managerial team might prefer a conservative working capital funding policy. Previous funding
decisions dictate the current short-term/long-term financing mix of a company. Organisational size can be an important factor
in relation to, for example, access to different forms of finance in support of a favoured working capital funding policy.
32 Dink Co
(a) (i) After-tax cost of borrowing = 8·6 x (1 – 0·3) = 8·6 x 0·7 = 6%

Calculating PV of cost of borrowing to buy:

Year 0 1 2 3 4 5
$ $ $ $ $ $
Purchase (750,000 )
Service costs (23,000 ) (23,000 ) (23,000 ) (23,000 )
TAD benefit 56,250 42,188 31,641 79,922
Service cost tax benefits 6,900 6,900 6,900 6,900
–––––––– ––––––– ––––––– ––––––– ––––––– –––––––
Net cash flow (750,000 ) (23,000 ) 40,150 26,088 65,541 86,822
Discount at 6% 1·000 0·943 0·890 0·840 0·792 0·747
–––––––– ––––––– ––––––– ––––––– ––––––– –––––––
(750,000 ) (21,689 ) 35,734 21,914 51,908 64,856
–––––––– ––––––– ––––––– ––––––– ––––––– –––––––
PV of cost of borrowing to buy is $597,777.
Using the spreadsheet NPV function and spreadsheet-calculated discount factors, PV of cost of borrowing to buy is
$597,268.
Working: TAD benefit

Year 0 1 2 3 4 5
$ $ $ $ $ $
Purchase 750,000
TAD 187,500 140,625 105,469 266,406 *
30% TAD benefit 56,250 42,188 31,641 79,922
*750,000 – 187,500 – 140,625 – 105,469 – 50,000 = $266,406
20
102
(ii) Calculating PV of cost of leasing:

Year 0 1 2 3 4 5
$ $ $ $ $ $
Lease rentals (200,000 ) (200,000 ) (200,000 ) (200,000 )
Tax benefits 60,000 60,000 60,000 60,000
–––––––– –––––––– –––––––– –––––––– ––––––– –––––––
Net cash flow (200,000 ) (200,000 ) (140,000 ) (140,000 ) 60,000 60,000
Discount at 6% 1·000 0·943 0·890 0·840 0·792 0·747
–––––––– –––––––– –––––––– –––––––– ––––––– –––––––
(200,000 ) (188,600 ) (124,600 ) (117,600 ) 47,520 44,820
–––––––– –––––––– –––––––– –––––––– ––––––– –––––––
PV of cost of leasing is $538,460.
Using the spreadsheet NPV function and spreadsheet-calculated discount factors, PV of cost of leasing is $538,464.
(iii) Financial benefit of leasing = $597,777 – $538,460 = $59,317

Using the spreadsheet NPV function and spreadsheet-calculated discount factors, financial benefit of leasing = $597,268
– $538,464 = $58,804.
Leasing the new machine is recommended as the option which is more attractive in financial terms to Dink Co.
(b) (i) Reasons why investment capital may be rationed

Theoretically, the objective of maximising shareholder wealth can be achieved in a perfect capital market by investing
in all projects with a positive NPV. In practice, companies experience capital rationing and are limited in the amount of
investment finance available, so shareholder wealth is not maximised.
Hard capital rationing is due to external factors, while soft capital rationing is due to internal factors or management
decisions.
General reasons for hard capital rationing affect many companies, for example, the availability of new finance may be
limited because share prices are depressed on the stock market or because of government-imposed restrictions on bank
lending.
If a company only requires a small amount of finance, issue costs may be so high that using external sources of finance
is not practical.
Reasons for hard capital rationing may be company-specific, for example, a company may not be able to raise new debt
finance if banks or investors see the company as being too risky to lend to. The company may have high gearing or low
interest cover, or a poor track record, or if recently incorporated, no track record at all. Companies in the service sector
may not be able to offer assets as security for new loans.
Reasons for soft capital rationing include managerial aversion to issuing new equity, for example, a company may want to
avoid potential dilution of its EPS or avoid the possibility of becoming a takeover target. Managers might alternatively be
averse to issuing new debt and taking on a commitment to increased fixed interest payments, for example, if the economic
outlook for its markets is poor.
Soft capital rationing might also arise because managers wish to finance new investment from retained earnings, for
example, as part of a policy of controlled organisational growth, rather than a sudden increase in size which might result
from undertaking all investments with a positive net present value.
One reason for soft capital rationing may be that managers want investment projects to compete for funds, in the belief
that this will result in the acceptance of stronger, more robust investment projects.
(ii) Ways in which Dink Co’s external capital rationing might be overcome

Dink Co is a small company and the hard capital rationing it is experiencing is a common problem for SMEs, referred to
as the funding gap. A first step towards overcoming its capital rationing could be for Dink Co to obtain information about
available sources of finance, since SMEs may lack understanding in this area.
One way of overcoming the company’s capital rationing might be business angel financing. This informal source of
finance is from wealthy individuals or groups of investors who invest directly in the company and who are prepared to
take higher risks in the hope of higher returns. Information requirements for this form of finance may be less demanding
than those associated with more common sources of finance.
Dink Co could consider crowdfunding, whereby many investors provide finance for a business venture, for example, via
an internet-based platform, although this form of finance is usually associated with entrepreneurial ventures.
Dink Co might be entitled to grant aid from a government, national or regional source which could be linked to a specific
business area or to economic regeneration in a specified geographical area.
On a more general basis, Dink Co could consider a joint venture as a way of decreasing the need for additional finance,
depending on the nature of its business and its business plans, and whether the directors of Dink Co are prepared to
sacrifice some control to the joint venture partner.
Rather than conventional sources of finance, Dink Co could evaluate whether Islamic finance, for example, an ijara
contract, might be available, again depending on the nature of its business and its business plans.
21
103
Applied Skills, FM
Financial Management (FM) September/December 2019 Sample Marking Scheme
Marks Marks

Section C
31 (a) (i) Holding cost current 0·5

Ordering cost current 0·5
–––
1
(ii) EOQ comp 1

Holding cost EOQ 0·5
Ordering cost EOQ 0·5
Finance costs 1
EOQ saving overall 1
–––
4
(iii) Holding cost bulk order discount 0·5

Ordering cost bulk order discount 0·5
Finance costs 1
Bulk order discount value 1
Bulk order discount saving overall 1
–––
4
(iv) Advice 1

(b) Current asset types 2

Finance cost/risk 2
Matching principle 2
Funding policies 2
Other points 2
–––
10
–––
20
–––

32 (a) (i) Kd after tax 1
TAD 1
TAD benefits 1
Service tax benefit 1
Tax timing 1
PV buying 1
–––
6
(ii) Lease tax benefits 1

Lease timing 1
PV leasing 1
–––
3
(iii) Recommendation 1

(b) (i) Hard reasons 3

Soft reasons 3
–––
6
(ii) Ways to overcome 4
–––

20
–––

23
104
2. Technical articles
105
Articles
Working Capital Management May 2018
Accounts Receivable Management Feb 2018
Hedging Techniques for Interest Rate Risk March 2016
Management of Foreign Accounts Receivable December 2015
Business Finance For SMES September 2015
Equivalent Annual Costs and Benefits April 2015
Myopic Management Oct 2013
Business Valuations Feb 2012
Financing Alternatives June 2011
Business Finance March 2011
Islamic Finance March 2011

106
Advanced Investment Appraisal Oct 2010
Foreign Exchange Risk Nov 2009
Cost of Capital Oct 2009

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Chapter 2 BASIC INVESTMENT APPRAISAL

Chapter 3 ADVANCES INVESTMENT APPRAISAL

Chapter 4 SOURCES OF FINANCE

Chapter 5 COST OF CAPITAL

Chapter 6 RISK ADJUSTED WACC AND CAPITAL STRUCTURE

Chapter 7 FINANCIAL PERFORMANCE MANAGEMENT

Chapter 8 RISING EQUITY FINANCE

Chapter 9 WORKING CAPITAL MANAGEMENT

Chapter 10 EFFICIENT MARKET HYPOTHESIS

Chapter 11 BUSINESS VALUATIONS

2.Relevant Articles from Student Accountant

OUTLINE OF THE SYLLABUS

B. Financial management environment

C. Working capital management

E. Business finance (including Cost of Capital)

FORMAT OF THE EXAM PAPER

Economic Order Quantity

The Asset Beta Formula

The Growth Model

Gordon’s Growth Approximation

The weighted average cost of capital

The Fisher formula

Purchasing Power Parity and Interest Rate Parity

Present Value Table

Where r = discount rate

Discount rate (r)

I. FINANCIAL MANAGEMENT FUNCTION (FM)

 Operates within a 12-month horizon

2 Key areas of Financial management

 Financing: What sources of funding should the company use?

 Dividend: how should cash funds be allocated to shareholders?

 Controlling resources to ensure efficient and effective use.

3 Corporate strategy and Financial management

Shareholder wealth maximisation

 Shareholders’ return on investment comes from:

Maximising versus satisficing

 Employees – good wages, safe working conditions, training, pensions

II. NOT-FOR-PROFIT ORGANISATIONS (NFP)

 Possible objectives in a NFP:

 Non-financial objectives – more important and complex because:

3 Value for money (VFM) as an objective

4 Measuring objectives in NFP

Measuring VFM – the 3 Es

Example 1 – 3Es (Illustrated)

Problems with the measurement of VFM

1 Stakeholders and objectives

 Expectation of stakeholders may conflict

2 The role of management and agency theory

The divorce of ownership and control

 Common types of reward schemes include:

Corporate governance code

Stock exchange listing requirements and other regulations

IV. THE ECONOMIC ENVIRONMENT

BASIC INVESTMENT APPRAISAL

Capital vs. revenue expenditure

 Results in the acquisition of non-current assets or an improvement in their earning capacity

 Revenue expenditure – regular spending on the day-to-day running of the business