Theoretical

Supplement to BFD
Notes

Summary of
theory topics
from ICAP
Study Text
DEC-2021 Attempt

This is a summary of “ICAP Study Text”

theoritical areas meant to facilitate students
to quickly revise theoritical areas and
respond to possible essay type questions in
paper
Chapter 2 (Study Text)
Incremental cost
An incremental cost is an additional cost that will occur if a particular decision istaken. Provided that this
additional cost is a cash flow, an incremental cost is a relevant cost.

Differential cost
A differential cost is the amount by which future costs will be different,(Higher / Lower) as a consequence of a
decision. a differential cost is a relevant cost.

Avoidable and unavoidable costs

❑ Avoidable costs are relevant costs.
❑ Unavoidable costs are not relevant to a decision.
Committed cost
A committed cost is a costthat a company has already committed to or an obligation already made, that it
cannot avoid by any means.
Committed costs are not relevant costs for decision making.

Sunk costs
Sunk costs are costs that have already been incurred (historical costs) or coststhat have already been
committed by an earlier decision. Are not relevant costs.
Opportunity costs
An opportunity costis a benefit that will be lost by taking one course of action instead of the next- most
profitable course of action.
When resources have more than one alternative use, and are in limited supply,their opportunity cost is the
contribution forgone by using them for one purposeand so being unable to use them for another purpose.

Relevant cost of materials

❑ When materials will have to be purchased for a project, because there are no existing inventories of the
materials, their relevant cost is their future purchase cost.
❑ If the materials are in regular use, and quantities consumed for the investment project would be replaced in
the normal course of trading operations, the relevant cost of the materials is their current replacement cost
❑ If the materials will not be replaced if they are used for the investment project, their relevant cost is the
higher of:
❑ their net disposal value and the net contribution that could be earned using the materials for another
available use.
Chapter 3 (Study Text)

1 MAKE OR BUY DECISIONS: OUTSOURCING

1.1 Make-or-buy decisions: outsourcing

A make-or-buy decision is a decision about:
❑ whether to make an item internally or to buy it from an external supplier, or
❑ whether to do some work with internal resources, or to contract it out toanother
organization such as a sub-contractor or an outsourcing organization.
the decision should be based on relevant costs.
A financial assessment of a make-or-buy decision typically involves a comparisonof:
❑ the costs that would be saved if the work is outsourced or sub-contracted;and
❑ the incremental costs that would be incurred by outsourcing the work.

1.2 Make-or-buy decisions: non-financial considerations

Non-financial considerations that will often be relevant to a make-or-buy decisioninclude the
following.
❑ When work is outsourced, the entity loses some control over the work. Itwill rely on the
external supplier to produce and supply the outsourced items. There may be some risk
that the external supplier will:
• produce the outsourced items to a lower standard of quality, or
• fail to meet delivery dates on schedule, so that production of the end-product may be
held up by a lack of components.
❑ The entity will also lose some flexibility. If it needs to increase or reduce supply of the
outsourced item at short notice
❑ A decision to outsource work may have implications for employment withinthe entity, and it
may be necessary to make some employees redundant, bringing down morale.
❑ It might be appropriate to think about the longer-term consequences of a decision to
outsource work. What might happen if the entity changes its mind at some time in the
future and decides either (a) to bring the work back in-house or (b) to give the work to a
different external supplier?
There might also be non-financial benefits from outsourcing work to an externalsupplier.
❑ If the work that is outsourced is not specialized, or is outside the entity’s main area of
expertise, outsourcing work will enable management to focustheir efforts on those aspects
of operations that the entity does best. For example, delivery fleet management, or the
monthly payroll work.
❑ The external supplier, on the other hand, may have specialist expertise which enables it to
provide the outsourced products or services more efficiently and effectively. E.g. ITsupport
operations,
Chapter 4 (Study Text)

1 LINEAR PROGRAMMING
1.1 Limit to the dual price
The dual price of a limiting resource applies only to additional quantities of theresource for as
long as it remains a limiting factor.
Eventually, if more and more units of a scarce resource are made available, a point will be reached
when it ceases to be an effective limiting factor, and a different constraint becomes a limiting
factor instead. When this point is reached,the dual price for additional units of the resource will
become zero.

1.2 Slack
Slack refers to the amount of a constraint that is not used in the optimal solutionto a linear
programming problem.
Only non-limiting resources have slack. Limiting resources are fully utilized sonever have any
slack.
The amount of slack in any non-limiting resources is easily found by substituting the optimum
product mix into the equation for that resource. This would show how much of that resource was
needed for the optimum solution. This could thenbe compared to the amount of resource available
to give the slack.
Chapter 5 (Study Text)

1 CAPITAL EXPENDITURE, INVESTMENT APPRAISAL AND CAPITAL BUDGETING

ACCOUNTING RATE OF RETURN (ARR) METHOD

1.1 Definition of ARR

The accounting rate of return (ARR) of an investment project is the accounting profit (usually before
interest and tax) expressed as a percentage of the capital invested.
The essential feature of ARR is that it is based on accounting profits, and the accounting value of assets
employed. It includes following:
❑ sunk costs (money already spent);
❑ carrying amounts of assets (net book values);
❑ depreciation and amortization;
❑ allocated fixed costs.

1.2 Decision rule for the ARR method

Decisions using ARR are made with reference to a target set by the company. In other words, a company
decides on what it considers to be an acceptable level ofreturn and assesses projects by comparing
them to this level.
The decision rule for capital investment appraisal using the ARR method is if the
❑ Accept a project when its ARR is higher than the target.
❑ Reject a project when its ARR is less than the target.
The company’s management may be reluctant to accept a project which has an ARR lower than the
company’s overall ARR as this will cause the overall ARR ofthe company to reduce.

1.3 Advantages and disadvantages of using the ARR method

Advantages:
❑ easy to understand and explain to Management.
❑ It is easy to calculate.
Disadvantages.
❑ No standard formula
❑ It is based on accounting profits, and not cash flows. However investments are about investing cash to
obtain cash returns.
❑ Since it is based on profits (more subjective) is easy to manipulate and will be different under different
accounting policies and estimates.
❑ The ARR method ignores the time value of money.
❑ The ARR is a percentage return, relating the average profit to the size of the investment. It does not
give us an absolute return.
❑ There is no rational economic basis for setting a minimum target for ARR.
2 PAYBACK METHOD

2.1 Advantages and disadvantages of the payback method

The advantages of the payback method for investment appraisal are as follows:
❑ Simplicity – The payback is easy to calculate and understand.
❑ The method analyses cash flows, not accounting profits. Investments are about investing cash to earn
cash returns.
❑ Payback concentrate on earlier cash flows in the project’s life time, which are more certain and more
important if the firm has liquidity concerns.
❑ The disadvantages of the payback method are as follows:
❑ In other words, it does not select projects based on their ability to increase the wealth of the owners
of the company. There is no measure of the change in wealth either in absolute (Rs) or relative (%)
terms.
❑ Setting a minimum payback period is very subjective
❑ Target payback period may cause the company to select a less attractive project in terms of NPV just
because it’s payback period is more than target payback period.
❑ It ignores all cash flows after the payback period, and so ignores the total cash returns from the
project.
❑ It ignores the timing of the cash flows during the payback period.

2.2 Bailout payback period

A payback period can be calculated taking into account the possibility ofabandoning the
project (bailing out) at each period end.
Bailout cash flows are modelled in addition to the basic project flows. The bail outcash flows are the
estimates of cash inflows (e.g. from the sale of equipment) and cash outflows (e.g. closure costs) at
each period end. Typically the cash thatmight be received from the sale of the equipment falls as the
equipment ages.
Chapter 6 (Study Text)

1 RELATIVE MERITS OF NPV AND IRR

1.1 Advantages of DCF techniques

NPV and IRR have several advantages in common.
❑ Both techniques are based on cash flows rather than accounting profits.
❑ Both techniques take account of time value.
❑ Both techniques take account of all cash flows modelled and not just those in a payback
period.

1.2 Advantages and disadvantages of the NPV method

Advantages of the NPV method (compared to the IRR method)
NPV provides a single absolute value which indicates the amount by which theproject should add to the
value of the company.
The NPV decision rule is consistent with the objective of maximization ofshareholders’ wealth.
Disadvantages of the NPV method (compared to the IRR method)
The following are often stated as the main disadvantages of the NPV method(compared to the IRR
method).
❑ Complexity – Difficult to explain to decision makers.
❑ Basis for selection of appropriate discount rate is sometimes subjective

1.3 Advantages and disadvantages of the IRR method

Advantages
it is easier to understand an
investment return as a %age
return
it does not require an estimate of
the cost of capital.
Disadvantages
One disadvantage of the IRR method compared to NPV is
that it is a relative measure, not an absolute measure. It
gives weightage %age return between two projects instead
of total return, which might be higher.
Can give decision about accepting or rejecting a project, but
might not be suitable for making a choice between two
mutually exclusive projects.
Can give multiple IRR values if negative cashflows during
course of project.
in calculating the IRR, an assumption is that all cash flows
earned by the project can be reinvested to earn a return
equal to the IRR. Which is not a valid assumption.

2 ECONOMIC INTERNAL RATE OF RETURN (EIRR)

EIRR
The economic internal rate of return (EIRR) is calculated in the same way as theIRR. However, it includes
values for externalities in addition to the basic projectcash flows
This is particularly important for the appraisal of projects by governments andgovernment bodies.
❑ A government planning a project might use the FIRR to estimate the commercial viability
of the project and the EIRR to see if the project is justifiable in terms of its impact on other
parties.
 ❑ A government might consider granting a license for a particular activity based on an EIRR
appraisal.

*Externality: A consequence of an economic activity that is experienced byunrelated third parties. An

externality can be either positive or negative. / The cost or benefit that affects a party who did not choose to
incurthat cost or benefit.

Disadvantages of EIRR
Possible problems in the use of EIRR include the following
❑ It may not be easy to identify externalities related to a project;
❑ Once identified it might be difficult to attach a value to a given externality;
❑ Using the EIRR, a project is acceptable if the EIRR is greater than the company’s cost of
capital. However, there is no consensus on arriving at anacceptable rate of return for
projects that include externalities.
Chapter 7 & 8 (Study Text)

1 RISK AND UNCERTAINTY IN CAPITAL INVESTMENT APPRAISAL

1.1 The problem of risk and uncertainty

Investment projects are long-term projects, often with a time scale of many years.When the cash flows for an
investment project are estimated, the estimates mightbe incorrect. Estimates of cash flows might be wrong
for two main reasons:
❑ Risk in the investment, and
❑ Uncertainty about the future.

Risk
Risk exists when the actual outcome from a project could be any of several different possibilities, and it
is not possible in advance to predict with 100% accuracy which of thepossible outcomes will actually
occur.
Risk can often be measured and evaluated mathematically, using probabilityestimates for each possible
future outcome.
Risk can be favorable resulting in an outcome being better than expected (upside risk) or unfavorable
resulting in an outcome that is worse than expected(downside risk)

Uncertainty
Uncertainty exists when there is insufficient information to be sure about what will happen, or what the
probability of different possible outcomes might be. Forexample, a business might predict that sales in
three years’ time will be Rs.500,000, but this might be largely guesswork, and based on best-available
assumptions about sales demand and sales prices.
Uncertainty occurs due to a lack of sufficient information about what is likely tohappen.
Management should try to evaluate the risk and uncertainty, and take it into account, when making their
investment decisions.
Methods of assessing risk and uncertainty
❑ Sensitivity analysis can be used to assess a project when there is uncertainty about future cash flows;
❑ Probability analysis can be used to assess projects in which there is risk.
❑ Risk modelling and simulation;
❑ Using discounted payback as one of the criteria for investing in capitalprojects.

1.2 Responding to risk and uncertainty

Risk is considered by using probability distribution, expected values, simulation,or CAPM (for adjusting
discount rate for every project).
Uncertainty is considered using the following measures:
❑ setting a minimum payback period for projects;
❑ increasing the discount rate to provide a more pessimistic measure of npv;
❑ making prudent / conservative estimates to assess the worst outcomes possible;
❑ performing scenario analysis to analyse the best and the worst possible situations and a range of
outcomes; or
❑ using sensitivity analysis to measure the “margin of safety” on input data.
2 SENSITIVITY ANALYSIS

2.1 The purpose of sensitivity analysis: assessment of project uncertainty

Sensitivity analysis is used when there is uncertainty about the estimates of future cash flows.
The purpose of sensitivity analysis is to assess how the NPV of the project mightbe affected if cash flow
estimates are worse than expected.
There are two main methods of carrying out sensitivity analysis on a capitalexpenditure project.

Method 1
Sensitivity analysis can be used to calculate the effect on the NPV of a givenpercentage reduction in
benefits or a given percentage increase in costs. Forexample:
❑ What would the NPV of the project be if sales volumes were 10% below estimate?
❑ What would the NPV of the project be if annual running costs were 5% higher than estimate?
❑ Stress Testing, (“what if?” analysis ) similar to sensitivity analysis, might be used to assess the
investment risk. An assessment could be made to estimate the effects of:
❑ Of an unexpected event occurring in the future that would make the cash flow estimates for the
project wrong; or
❑ The effect of a delay so that the expected cash inflows from the project occur later than planned.

Method 2
Alternatively, sensitivity analysis can be used to calculate the percentage amountby which a cash flow could
change before the project NPV changed. For example:
❑ By how much (in percentage terms) would sales volumes need to fall below the expected volumes,
before the project NPV became negative?
❑ By how much (in percentage terms) would running costs need to exceed the expected amount before
the NPV became negative?

2.2 The usefulness of sensitivity analysis

Sensitivity analysis is useful because it directs management attention to the critical variables in the
project. These are the variables where a variation in thecash flows by a fairly small amount – and certainly
by an amount that might reasonably be expected, given uncertainty about the cash flows – would make
the NPV negative and the project not financially viable.
❑ If the project is undertaken, sensitive items of cash flow should be closely monitored and action taken
if they vary from plan.
❑ If a project NPV is particularly sensitive to an item of cost or revenue, management might decide to
reject the project because of the investmentrisk involved.

Major drawback
A major problem with sensitivity analysis is that only one variable is varied at a time and it is assumed that
all variables are independent of each other. In realityvariables may be interdependent. For this reason
simulation models may provide additional information when assessing risk.

3 EXPECTED VALUES AND DECISION TREES

3.1 Expected values

An expected value is a weighted average value, calculated using probability estimates of different
 possible outcomes. To calculate an expected value, theprobability of each possible outcome is
estimated, and the mean (average) outcome is calculated.
The basic decision rule is that an investment project should be undertaken ifthe expected value of its
NPV is positive.
However, a project with a positive EV of NPV might not be undertaken if the riskinvolved seems too great in
relation to the amount of the return expected.
3.2 Advantages and disadvantages of using expected values
The advantages of using expected values of the NPV are as follows:
❑ It is a weighted average measure of all the possible outcomes. It is therefore, arguably, a more
appropriate measure of return than the most likely or most probable EV of NPV.
❑ It provides a single figure, not a range of different figures, for making an investment decision.
❑ The disadvantages of using expected values of the NPV are as follows:
❑ The estimates of probabilities might be subjective, and based on judgement and guesswork.
❑ The EV of the NPV is not a value for any of the actual possible outcomes. In other words, the EV itself
will not happen. It is simply an average representing a number of different possible outcomes.
❑ An EV (calculated using weighted average) is much more reliable for estimating the average outcome
from events that will happen repeatedly, many times over but not suitable for a once-only capital
expenditure project.
❑ An EV does not provide any analysis of the project risk.

4 SIMULATION

4.1 Introduction
Simulation is the imitation of the operation of a real-world process or system overtime.
The act of simulating something first requires that a model be developed. The model is built to represent
the system itself and a simulation represents theoperation of the system over a given time period.
Running a single simulation is unlikely to provide useful information.
Once the model is set up a series of simulations can be run and the results canbe used to identify an
average outcome.

Uses of simulation
Simulation can be used to show the impact of alternative conditions and coursesof action.
Simulation is useful in shedding light on problems where outcomes are uncertainbut can be represented by
known probability distribution, e.g. queues, inventory control, capital investment, replacement problems,
etc.
Simulation modelling can be used to assess probabilities when there are manydifferent variables in the
situation, each with different probable outcomes and where the relationship between these variables
might be complex.
4.2 Monte Carlo simulation
A Monte Carlo simulation is one that employs a random device for identifyingwhat happens at a
different point in a simulation.
A simulation model contains a large number of inter-related variables (for example sales volumes of each
product, sales prices of each product, availabilityof constraining resources, resources per unit of product,
costs of materials and labour, and so on).
 For each variable, there are estimated probabilities of different possible values.These probabilities are
used to assign a range of random numbers to each variable. (The random number allocation should reflect
the probability distribution).

It is easier to assign the random number range if a cumulative probability columnis constructed first.
Once random numbers have been allocated a random number generator can beused to provide a string of
numbers which in turn are used to model the outcomes.

4.3 Multiple variables

Simulation can deal with multiple variables.
Chapter 10 (Study Text)

1 CRITICAL SUCCESS FACTORS FOR PRODUCTS AND SERVICES

1.1 Introduction to critical success factors

Critical success factors (CSFs) are factors that are essential to the strategic success of a business
entity. They have been defined as: ‘those components ofstrategy in which the organisation must
excel to out-perform competition’ (Johnson and Scholes).

1.2 CSFs and key performance indicators (KPIs)

Critical success factors might be identified at several stages in the strategicplanning process.
❑ CSFs should be identified during the process of assessing strategic position. Management
need to understand the main reasons why particularproducts or services are successful.
❑ CSFs are important in the process of making strategic choices. A business entity should select
strategies that will enable it to achieve a competitive advantage over its competitors. These
are strategies where the entity has the ability to achieve the critical success factors for its
products or services.
❑ CSFs are also important for strategy implementation. Performance targetsshould be set for
each CSF. This involves deciding on a measurement of performance, that can be used to
assess each CSF, and then setting a quantified target for achievement within a given period
of time.
Measured targets for CSFs are called key performance indicators (KPIs).

2 FINANCIAL PERFORMANCE INDICATORS (FPIs)

2.1 Aspects of financial performance
The main aspects of financial performance are usually:
❑ Profitability;
❑ Liquidity; and
❑ Financial risk.

2.2 FPIs for measuring profitability

Percentage annual growth in sales

❑ Increase of sale is expected to lead in increase in profit.
❑ The rate of growth can be significant indicator of performance.
❑ The period of time over which a particular percentage of growth is achieved can also be a
good indicator if the company has achieved its goal.
Sales growth (or a decline in sales) can usually be attributed to two causes:
❑ sales prices and
❑ sales volume.

Profit margin
Profit margin is the profit as a percentage of sales revenue. It is therefore theratio of the profit
that has been achieved for every Rs.1 of sales.
Factors to be considered for using Profit margin
❑ Sale margin may differ drastically from industry to industry
❑ Year on year profit margin need to be monitored. Improvements may be a sign of ‘good
performance’ and fallingprofit margins may be a cause for concern.
the most suitable ratio is likely to be:
❑ Gross profit margin (= gross profit/sales). Gross profit is sales revenueminus the cost of
sales.
❑ Net profit margin (= net profit/sales). Net profit = gross profit minus all othercosts, such as
administration costs and selling and distribution costs.
Any change in profit margin from one year to the next will be caused by:
❑ Changes in selling prices, or
❑ Changes in costs as a percentage of sales, or
❑ A combination of both.
Changes in costs as a percentage of sales may be caused by a growth or fall insales volumes,
where there are fixed costs in the entity’s cost structure.

Cost/sales ratios
Profitability may also be measured by cost/sales ratios, such as:
❑ Ratio of cost of sales/sales
❑ Ratio of administration costs/sales
❑ Ratio of sales and distribution costs/sales
❑ Ratio of total labour costs/sales.
Performance may be assessed by looking at changes in these ratios over time. Alarge increase or
reduction in any of these ratios would have a significant effect on profit margin.
2.3 FPIs for measuring liquidity
Liquidity for a business entity means having enough cash, or having ready access to additional
cash, to meet liabilities when they fall due for payment. Themost important sources of liquidity
for non-bank companies are:
❑ operational cash flows (cash from sales)
❑ liquid investments, such as cash held on deposit or readily-marketableshares in other
companies
❑ a bank overdraft arrangement or a similar readily-available borrowingfacility from a
bank.
Liquidity is important for a business entity because without it, the entity may become insolvent
even though it is operating at a profit.
On the other hand a business entity may have too much liquidity, when it is holding much more
cash than it needs, so that the cash is ‘idle’, earning little or no interest. Managing liquidity is often
a matter of ensuring that there is sufficientliquidity, but without having too much.

Changes in the cash balance or bank overdraft balance

A simple method of monitoring liquidity is to keep the cash balance at the bank under continual
review, and look for any deterioration (or improvement) in the cash position.
A large fall in cash (or a bigincrease in the bank overdraft) may be caused by:
❑ Operating losses
 ❑ Increases in working capital (inventory plus receivables, minus tradepayables)
❑ Expenditures on investments, such as purchases of new non-currentassets
❑ Repayments of debt capital (bank loans) or payments of dividends.
A reduction in cash caused by operating losses would be the most seriousreason for a loss of
liquidity, but when a business entity is short of liquidityanything that uses up cash may be
significant.
Liquidity ratios
Liquidity may also be monitored by looking at changes in a liquidity ratio overtime. There are
two ratios for measuring liquidity that could be used:
❑ Current ratio
❑ Quick ratio, also called the acid test ratio.
Significant change in liquidity, the reason should be investigated.Liquidity ratios will deteriorate
(i.e. get smaller) when:
❑ There is an increase in current liabilities without an increase in currentassets
❑ There is a reduction in current assets without a reduction in currentliabilities (for
example, writing off inventory or bad debts).
Examples of reasons for a reduction in liquidity are:
❑ Operating losses
2.4 FPIs for measuring financial risk
Sources of Financial Risk:
• credit risk (short term creditors and long term lenders) and
• foreign exchange for companies that import or export goods or services

Debt ratios
Debt ratios can be used to assess whether the total debts of the entity are withincontrol and are
not excessive.
Gearing ratio (leverage)
Gearing, also called leverage, measures the total long-term debt of a companyas a percentage of
either:
❑ the equity capital in the company, or
❑ the total capital of the company.

preference shares, are usually included in long-term debt, not share capital.

Interest cover ratio

An interest cover ratio of less than 3.0 times is considered very low, suggesting that the company
could be at risk from too much debt in relation to the amount ofprofits it is earning.
The risk is that a significant fall in profitability could mean that profits are insufficient to cover
interest charges, and the entity will therefore be at risk fromany legal action or other action that
lenders might take.

2.5 The limitations of financial ratios

There are several limitations or weaknesses in the use of financial ratios foranalysing the
performance of companies.
❑ Beneficial for long term study instead of short term as Financial statements are published
infrequently.
❑ Ratios can only indicate possible strengths or weaknesses in financial position and
financial performance. They might raise questions about performance, but do not provide
answers. They are not easy to interpret,and changes in financial ratios over time might
not be easy to explain.
❑ Can lead managers to focuson the short-term rather than the long-term success of the
business.
❑ There is some risk that managers may decide to ‘manipulate’ financial performance, by
fraudulent financial reporting.
❑ Using cash to purchase new non-current assets
❑ Ignorance of Non-Financial Aspects of performance
 Chapter 12 (Study Text)

CHAPTER
RAISING NEW EQUITY EXTERNALLY

1.1 Private companies and public companies: issuing new shares

Companies can raise equity capital externally by issuing new shares for cash, butthe opportunity to do so is
much more restricted for private companies than for public companies.

Disadvantages of Private Companies in Raising Capital

Private companies cannot offer their shares for sale to the general investing public, and shares in private
companies cannot be traded on a stock market. They can sell shares privately to investors but it is usually
difficult to find such investors.
Other investors usually avoid investing in the equity of private companies because the shares are not traded
on a stock exchange, and consequently theymight be:
❑ Difficult to value;
❑ Difficult to sell when the shareholder wants to cash in the investment.
Most private companies are unable to raise significant amounts of new equity capital by issuing shares. They
rely on retained earnings or right issue for new equity capital, but given their small size, profits are relatively
small, and this restricts the reinvestment in capital.

Advantages of Public companies in raising Capital

Public companies may offer their shares to the general public. Many public companies arrange for their shares
to be traded on a stock market which means that:
❑ The shares of a company have a recognizable value (their current stock market price) and
❑ Shareholders can sell their shareholdings in the market whenever they want to cash in their shareholding.
Legal Requirements to be met
However, before their shares can be traded on a stock exchange, a publiccompany must:
❑ Satisfy the regulatory authorities that the company and its shares comply with the appropriate regulatory
requirements, and appropriate information about the company and its shares will be made available to
investors, and
❑ Obtain acceptance by the appropriate stock exchange for trading in theshares.

1.2 Methods of issuing new shares for cash

There are three main methods of issuing new shares for cash:
❑ Issuing new shares for purchase by the general investing public: this is called a public offer.
❑ Issuing new shares to a relatively small number of selected investors: this is called a placing
❑ Issuing new shares to existing shareholders in a rights issue.

1.3 Underwriting of new share issues

The advantage of underwriting is that it ensures that there will be no unsoldshares in the issue, and the
company can be certain of raising the expectedamount of cash.
The main disadvantage of underwriting is the cost (the underwriting commissionpayable by the company to
the underwriters).
1.4 Reasons for Share repurchases

There are two main reasons why a company might repurchase and cancelshares.
❑ It has more cash than it needs and the surplus cash is earning a low return.
❑ There is no foreseeable requirement for the surplus cash. Buying back and cancelling some shares will
therefore increase the earnings per share for the remaining shares, and so might result in a higher share
price for the remaining shares. In this situation, the company is overcapitalised and share repurchases can
bring its total capital down to a more suitable level.
❑ Debt capital is readily-available and is cheaper than equity. A company might therefore repurchase some of
its shares and cancel them, and replace the cancelled equity with debt capital, by issuing new corporate
bonds or by borrowing from a bank. The result will be a capital structurewith higher financial gearing.

2 RIGHTS ISSUES

2.1 The issue price

A rights issue is an issue for shares for cash, where the new shares are offeredto existing shareholders in
proportion to their current shareholding.
The share price of the new shares in a rights issue should be lower than the current market price of the existing
shares. Pricing the new shares in this way gives the shareholders an incentive to subscribe for them. There are
no fixed rules about what the share price for a rights issue should be, but as a broad guideline the issue price for
the rights issue might be about 10% - 15% below themarket price of existing shares just before the rights issue.

2.2 Advantages and disadvantages of rights issues

Rights issues give existing shareholders the right to buy the new shares in a share issue. If an issue did not
have to be a rights issue, the company would beable to offer the shares to all investors.

Advantages
❑ A rights issue gives shareholders the right to retain the same percentage of the company’s total share
capital, and so avoid a ‘dilution’ in the proportion of the company that he owns.
❑ A rights issue prevents the company from selling new shares at below thecurrent market price to other
investors.

Disadvantages
The disadvantages of a rights issue are as follows:
❑ The company might want to raise a large amount of cash for new investment, but the existing shareholders
might be unwilling or unable to invest in the new shares.
❑ Shareholders can retain the same proportion of shares in the company by subscribing for new shares in the
issue. There is no reason to give them preferential treatment.
❑ If a new share issue is offered to all investors, the issue price might be at or near the current market price,
instead of at a discount to the current ‘cum rights’ price.
3 DEBT CAPITAL

3.1 Debt finance and risk for the borrower

Although debt capital is cheap, particularly in view of the tax relief on interestpayments, it can also be a
risky form of finance for a company.
❑ Lenders have a prior right to payment, before the right of shareholders to a dividend. If a company has low
profits before interest and a large amount of debt, the profits available for dividends could be very small.
❑ There is always a risk that the borrower will fail to meet interest payments or the repayment of debt
principal on schedule. If a borrower is late with a payment, or misses a payment, there is a default on the
loan. A default gives the lenders the right to take action against the borrower to recover the loan.
In comparison with providers of debt capital, equity shareholders do not havesimilar rights for non-
payment of dividends.

3.2 Advantages and disadvantages of debt finance to the investor

Advantages
Lending is considered safer than investingin equity:
❑ Lending is considered safer than investing in equity.
❑ The loan is usually redeemable, so that the capital will be returned.
❑ The interest has to be paid by the company, irrespective of how well or badly it has performed.
❑ The debt might be legally secured on assets of the company (However, most bonds are unsecured.)
❑ Debt ranks higher than equity in a winding up of a company and the liquidation of its assets. Lenders
therefore have more chance of gettingtheir investment returned, compared to the equity holders.

Disadvantage
The main disadvantage of debt finance compared with equity finance for theinvestor is that:
❑ The returns from investing in debt bonds are fairly predictable. The interest rate is fixed. There might be
some increase or decrease in the market value of bonds, if market yields on bonds change: however, the
size of any such capital gain or loss is usually fairly small.
❑ Debt holder cannot share in the success of a Company, all they get is interest on their debt, while the
shareholder will get increased Dividend and Capital Gains.

4 CONVERTIBLE BONDS

Advantages of convertibles
The advantages of convertibles for companies are as follows:
❑ The company can issue bonds now, and receive tax relief on the interest charges, but hope to convert the
debt capital into equity in the future.
❑ The interest rate on convertibles is lower than the interest rate on similar straight bonds. This is because
investors in the convertibles are expected to accept a lower interest rate in return for the option to convert
the bonds into equities in the future.
❑ Occasionally, there is strong demand from investors for convertibles, and companies can respond to
investors’ demand by issuing convertibles in order to raise new capital.
❑ The advantages of convertibles for investors are as follows:
❑ Investors receive a minimum guaranteed income up to the conversion date, in the form of fixed interest.
 ❑ In addition, investors in convertibles will be able to benefit from a rise in the company’s share price, and
hope to make an immediate capital gain on conversion.
❑ Convertibles therefore combine some fixed annual income and the opportunity to benefit from a rising
share price.
The risk for investors in convertibles is that the share price will not rise sufficientlyto make conversion
worthwhile. When this happens, it would have been better to invest in straight bonds, which would have paid
higher interest.

5 PREFERENCE SHARES
5.1 Advantages and disadvantages of preference shares
The advantages of preference shares for companies are that:
❑ The annual dividend is fixed, and so predictable (with the possibleexception of participating
preference shares).
❑ Dividends do not have to be paid unless the company can afford to pay them, and failure to pay preference
dividends, unlike failure to pay intereston time, is not an event of default.
The disadvantages of preference shares for companies are that:
❑ Dividends are not an allowable cost for tax purposes
❑ They are not particularly attractive to investors.

27 May 2024 Done

CHAPTER 14 (Study Text)

Advantages and disadvantages of the CAPM

The CAPM is based on some simplifying assumptions. For example, the CAPMassumes:
❑ A perfect capital market, in which all investors have access to all availableinformation about the financial
markets
❑ Uniformity of investor expectations
❑ All forecasts (expectations) are made in the context of just one time period.

Advantages of CAPM Weaknesses of CAPM

It provides a measurable relationship
between risk and return.
It can be used to estimate the cost of
capital for securities, notably equity
shares.
It can be difficult to estimate statistically reliable values
for the risk-free rate and market rate of return, and the
beta factor for a security
It focuses on systematic risk only andignores
unsystematic risk.
Unsystematic risk is significant for aninvestor who
does not have a well- diversified portfolio.

It can be adapted to establishing a It makes no distinction between the ways in which a

required (risk-adjusted) DCF return on security provides its return (for example dividends or
capital investments by a company. share price increase

Additional Advantages:

Ease of Use
The CAPM is a simple calculation that can be easily stress-tested to derive a range of possible outcomes to provide
confidence around the required rates of return.

Diversified Portfolio
The assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates unsystematic
(specific) risk.

Systematic Risk
The CAPM takes into account systematic risk (beta), which is left out of other return models, such as the dividend
valuation model (DVM). Systematic or market risk is an important variable because it is unforeseen and, for that
reason, often cannot be completely mitigated.

Business and Financial Risk Variability

When businesses investigate opportunities, if the business mix and financing differ from the current business, then
other required return calculations, like the weighted average cost of capital (WACC), cannot be used. However, the
CAPM can.

Additional Disadvantages:

Risk-Free Rate (Rf)

The commonly accepted rate used as the Rf is the yield on short-term government securities. The issue with using
this input is that the yield changes daily, creating volatility.
Return on the Market (Rm)
The return on the market can be described as the sum of the capital gains and dividends for the market. A problem
arises when, at any given time, the market return can be negative. As a result, a long-term market return is utilized
to smooth the return. Another issue is that these returns are backward-looking and may not be representative of
future market returns.

Ability to Borrow at a Risk-Free Rate

CAPM is built on four major assumptions, including one that reflects an unrealistic real-world picture. This
assumption—that investors can borrow and lend at a risk-free rate—is unattainable in reality. Individual investors
are unable to borrow (or lend) at the same rate as the U.S. government. Therefore, the minimum required return
line might actually be less steep (provide a lower return) than the model calculates.

Determination of Project Proxy Beta

Businesses that use the CAPM to assess an investment need to find a beta reflective of the project or investment.
Often, a proxy beta is necessary. However, accurately determining one to properly assess the project is difficult and
can affect the reliability of the outcome.

Average and marginal cost of capital

The marginal cost of capitalis not the WACC in cases where:
❑ The capital structure will change because the project is a large project thatwill be financed mainly by
either debt or equity capital, and the change in capital structure will alter the WACC. If the WACC
changes, the marginal cost of capital and the WACC will not be the same.
❑ A new capital project might have completely different business risk characteristics from the normal
business operations of the company. If the business risk for a project is completely different, the required
return from the project will also be different. In such cases, the CAPM might be used toestablish a suitable
marginal cost of capital for capital investment appraisalof the specific project.
 Chapter 15 (Study Text)

1 DIVIDEND POLICY
1.1 Shareholder preferences
Some shareholders prefer to receive dividends from their equity investments. Others are not concerned
about dividends and would prefer the company to reinvest all its earnings in order to pursue growth
strategies that will increase the market value of the shares. Many shareholders prefer a mixture of dividends
andretaining some profits for share price growth.
Shareholders will buy and hold shares of companies that pursue a dividend policy consistent with their
preferences for dividends or share price growth, andcompanies might try to pursue a dividend policy
consistent with the preferencesof most of their shareholders

1.2 The nature of dividend policy

In practice dividend policy might be stated in terms of an intention of the board ofdirectors to increase annual
dividends in line with growth in earnings per share.
When dividends increase by the same proportionate amount as the rise in EPS, itis said to maintain a
constant ‘payout ratio’.
Shareholders can monitor the future profit expectations of the company to predictthe amount of dividends
they are likely to receive in the future.

1.3 Theories of dividend policy

There are several theories about dividend policy. These theories are intended toidentify the optimal amount of
dividends that a company should pay to the shareholders.
Three of these theories are:
❑ The traditional view of dividend policy;
❑ Residual theory; and
❑ Modigliani and Miller’s dividend irrelevance theory.

Traditional view of dividend policy

Criticism:
• This model assumes a Constant rate of return on investment (which sometimes is not the case in practice).
• This model further ignores other factors to growth of the share price apart from retention.

Residual theory of dividend policy

The residual theory of dividend policy is that the optimal amount of dividendsshould be decided as follows.
❑ If a company has capital investment opportunities that will have a positive NPV, it should invest in
them because they will add to the value of the company and its shares.
❑ The capital to invest in these projects should be obtained internally (from earnings) if possible.
❑ The amount of dividends paid by a company should be the residual amount of earnings remaining
after all these available capital projects have been funded by retained earnings.
❑ In this way, the company will maximize its total value and the market priceof its shares.
A practical problem with residual theory is that annual dividends will fluctuate,depending on the
availability of worthwhile capital projects. Shareholders will therefore be unable to predict what their
dividends will be.
 The key benefit of the theory is that the company returns the unutilized amount and provides flexibility to
the shareholders to decide themselves what they haveto do with the surplus funds instead of keeping them
idle.

1.4 Modigliani and Miller’s dividend irrelevance theory

Modigliani and Miller (MM) developed a theory to suggest that dividend policy is irrelevant, and the level of
dividends paid out by a company does not matter.

Concept of “Home-made dividends”

Whenever shareholders want cash, it does not matter whether they obtain it inthe form of dividends or by
selling their shares in the market.
One initial criticism of this theory of dividend irrelevance was that some shareholders have a preference
for high dividends, so dividend policy does matter. MM responded by arguing that companies often have a
consistent dividend policy with a constant payout ratio. Shareholders will be attracted to holding shares in
the companies whose dividend policy is consistent with theirown dividend preference.

Other Criticisms of irrelevance theory

❑ The theory assumes that there are no costs involved in raising new equity capital, so that there is no
cost difference between retaining earnings and raising new equity.
❑ Similarly, MM assumed that there are no costs involved in selling shares, so that shareholders should
be indifferent between getting cash in the form of dividends or getting it by selling some shares.
❑ MM assumed that shareholders possess perfect information about the returns that will be obtained by
companies from their new capital investments. Since future earnings can be predicted with
confidence, MM argued that share prices would remain close to their real value. In practice, however,
this is not the case. Shareholders cannot always assess the real value of their shares with confidence:
this is one reason why many shareholders prefer high cash dividends instead of the prospect of bigger
capital gains in the future.

1.5 Practical influences on the dividend decision

There are several practical limitations and influences on the amount of dividendspaid by companies.

Investment opportunities
The amount of earnings a company wishes to retain might be affected by the number of suitable
investment opportunities available to the company. If there are few investment projects available which
can generate sufficient return thensurplus cash should be returned to shareholders. Companies might
payout as dividends any surplus cash for which they have no long-term need

Legal constraints
There might be legal restrictions on the maximum dividend payments. Companies can only pay dividends
out of accumulated net realized profits. Theremay also be restrictions imposed by loan agreements to
protect lenders.

Liquidity
Retained profit is not the same as retained cash. A company might be highly profitable but still have low
levels of surplus cash. The dividends paid must not threaten a company’s liquidity and dividends might be
limited by the availability ofcash.

Dividends as a signal to investors and shareholder expectations

A dividend which differs from shareholders expectations about dividends mightsend signals to the market
and affect share price.
 ❑ A higher than expected dividend may signal that the board of directors are confident about the future
and may lead to an increase in share price
❑ A lower than expected dividend may signal that the company is in financialdifficulties and lead to a fall
in share price.
Investors usually expect a consistent dividend policy from year to year or steady dividend growth. This can lead
to pay-out ratios fluctuating as companies seek tohold a steady dividend as earnings fluctuate.
A company might also use dividend policy to send signals to the stock marketabout its future prospects
and intentions.
Other factors which may affect the dividend policy of a firm include:
❑ dividend policies of similar firms;
❑ loan redemption obligations;
❑ taxation; and
❑ level of inflation.

1.6 Alternatives to cash dividends

There are alternatives to paying cash dividends.

• Scrip dividends

• Share repurchases
Chapter 16 (Study Text)

1 CHOOSING THE METHOD OF FINANCING AN INVESTMENT

1.1 Theories about selecting the financing method for an investment

❑ Static trade-off theory;
❑ Pecking order theory;
❑ Market timing theory.
There is also a view that the choice of financing method is affected by agencycosts.
These differing theories are considered in this section.

1.2 Static trade-off theory

Static trade-off theory therefore states that:
❑ Companies have an optimal level of gearing.
❑ In choosing the method of financing for a new investment, they will try tomaintain or
achieve the optimal gearing level.
❑ The optimal gearing level is higher for companies with high profits thancompanies with
low profits.
❑ This means that there is a positive correlation between profitability andgearing level.

1.3 Pecking order theory

❑ 1st. The source of finance that is preferred most is retained earnings.
❑ 2nd. Debt capital is the source of finance second in the order ofpreference.
❑ 3rd. New equity capital (an issue of new shares) is the least preferredsource of finance
for investment.
Pecking order theory therefore states that:
❑ Companies do not have an optimal level of gearing.
❑ In choosing the method of financing for a new investment, they have anorder of
preference: retained earnings followed by new debt capital followed by an issue of new
shares.
❑ Companies with high profits can rely on retained profits as a source offinance more
than companies with low profits.
❑ This means that there is a negative correlation between profitability andgearing level.

Advantages of Pecking Order Theory

❑ Using retained earnings is convenient. If a company wants to finance a newinvestment with
equity, it is much simpler and cheaper to use retained earnings than to arrange a new share
issue. Retained earnings are also much more convenient than new borrowing.
❑ If a company cannot finance an investment with retained earnings, it will prefer new
borrowing to a new issue of shares because borrowing is cheaper. It is cheaper to arrange a
loan than to issue new shares. The costof debt is also less because of the tax relief on
interest payments.
1.4 Market timing theory
Market timing theory states that the choice of financing method for companies can be driven by
opportunities in the capital markets.
❑ Companies will therefore wish to make a new issue of shares when theyconsider the
share price to be over-valued.
❑ They will consider share repurchases when they consider the share price tobe under-valued.
Taking advantage of opportunities in the market to issue new shares or buy backexisting shares
affects the gearing level. A company therefore does not have a target optimal gearing level. Its
financing decisions are determined more by market opportunity and market timing.

Advantages and Disadvantages of Various Financing Options:

Debt Financing:

Advantages of Debt Financing Disadvantages of Debt Financing

• Allows founders to retain ownership
and control of the company. Unlike
Equity Financing which leads the owner
to lose a large share of the company.
• Allows the Entrepreneur to make key
strategic decisions.
• Keep and Re-invest the companies’
profits
• Provides small business owners with
a great degree of financial freedom.
• Debt obligations are limited to the
debt repayment period
• It Requires small businesses to make a
monthly payments of principal with interest.
• Small companies may experience shortages in
cash flow and making payments would be hard
to the company.
• Debt Financing is often limited to established
businesses.
• Severe penalties upon not paying the loan
back on time.
• If you carry too much debt you will be seen as
"high risk" by potential investors – which will
limit your ability to raise capital by equity
financing in the future.

• Tends to be less expensive for small • Debt financing can leave the
businesses over the long term.
business vulnerable during hard times when
sales take a dip.

• Proves to be cheaper because loans • Debt can make it difficult for a business to
are tax deductible.
grow because of the high cost of repaying the
loan.

Equity Financing:

Advantages of Equity Financing Disadvantages of Equity Financing

• It is way less risky than a loan,
because you do not have to pay it back.
• Adding an investment network in the
business portfolio; which adds more
credibility to the business
• Investors do not expect immediate
return on their investment.
• May require higher returns than the rate you
would actually pay back to the bank.
• Disagreement with investors may arise; due
to disagreement of ideas.
• The investor will take a portion from your
business.
 • The business will have more cash
between its hands.
• No channelling of profits into loan
repayment.
• Percentages of the profit will be deducted in
the favour of investors.
• In the case of irreconcilable disagreements
with investors, you may need to cash in your
portion of the business and allow the investors
to run the company without you.

• No requirement to payback the • It takes time and effort to find the right
investment if the business fails. investor.
• Easier to finance than Debt financing. • May require complicated legal filings and
great dealing of paper work.

2 COST OF CAPITAL AND GEARING

The Modigliani-Miller propositions: ignoring corporate taxation

Modigliani and Miller sought to explain the real world influences on gearing. Theirobjective was to build models
that would aid financial managers in making decisions about gearing levels.
Their starting point was to construct a model based on a series of simplifyingassumptions to see what would
be expected in this simple world. The assumptions include the following:
❑ Capital markets are perfect:
• All investors value securities in the same way
• There are no dealing costs (i.e. no transaction cost on buying andselling securities)
• Perfect information (all participants know and understand any newinformation the instance it
comes into existence)
❑ No taxation
❑ No bankruptcy risk
❑ Investors are indifferent between borrowing themselves or investing incompanies that borrow for
them.
❑ Cost of debt is constant for all level of gearing. Lenders do not require anycompensation for additional
risk they carry as the company increases gearing levels in its capital structure

3. ADJUSTED PRESENT VALUE METHOD

Reasons for using the APV method

❑ The APV method does not rely on assumptions about the new WACC of the firm if the
project is undertaken.
❑ The APV method allows for the specific tax relief on the borrowing to finance the
project, and does not assume that the debt will be perpetualdebt.
❑ The APV method allows for other costs, such as the costs of raising newfinance (issue
costs).
Chapter 17 (Study Text)

1 ASSET-BASED VALUATION MODELS

Advantages of Asset Based Valuation Methods

The main advantage of this approach is the simplicity of its application, since the calculation of value is relatively
straightforward and does not require any significant forecasts of future business activity or estimation of discount or
capitalization rates.

As such, this approach is best used for capital-intensive businesses, businesses with no current or projected
operating income or non-operating entities such as real estate and investment holding companies.

Disadvantages

The Asset based valuation approach can require costly appraisals of business assets and ignores the current and
future earning power of the company. Asset valuation can be irrelevant for many businesses.

2 INCOME BASED VALUATION METHODS

2.1 P/E ratio method

Advantages:
The main advantage of a P/E ratio valuation is its simplicity. By taking the annual earnings of the company
(profits after tax) and multiplying this by a P/E ratio that seems ‘appropriate’, an estimated valuation for
the company’s shares is obtained. This provides a useful benchmark valuation for negotiations in a
takeover, or for discussing the flotation price for shares with the company’s investment bank advisers.
the P/E ratio valuation method is commonly used as one approach tovaluation for:
❑ The valuation of a private company seeking a stock market listing for thefirst time
❑ The valuation of a company for the purpose of making a takeover bid.

Disadvantages:
It is based on subjective opinions about what EPS figure and what P/E ratiofigure to use.
❑ It is not an objective or scientific valuation method.
❑ It is based on accounting measures (EPS) and not cash flows. However,the value of an investment
such as an investment in shares ought to be derived from the cash that the investment is expected to
provide to the investor (shareholder).

3 DIVIDEND VALUATION MODELS

Advantages :

• Easier to understand.
• Easier to make comparison of companies of varying sizes and businesses

Disadvantages:

• It does not take into account non dividend factors such as brand loyalty, customer retention and
the ownership of intangible assets, all of which increase the value of a company
 • It relies heavily on the assumption that a company's dividend growth rate is stable and known,
which might be inaccurate assumption

4 CASH FLOW VALUATION METHODS

The advantages of a cash flow basis for business valuation

❑ Cash flows earned by a business are much more closely correlated to value and shareholder
wealth than accounting profits. Valuations shouldtherefore be based on expectations of
future cash flows rather than expectations of profit or accounting return on investment.
❑ Returns on an investment, such as the acquisition of another company, must be sufficient to
cover the costs of the finance used to make the acquisition. This includes the cost of equity
finance as well as the cost of any debt finance. It is therefore appropriate to assess the value
future cashflows from an acquisition in terms of whether they provide a return in excess of the
total cost of financing.

Disadvantages
❑ A DCF based approach requires an estimate of future cash flows. The cash flows of a
business would be expected to continue into perpetuity which might be a very subjective
assessment and not close to reality.
❑ Highly dependent on selected Discount rate, which can be very tricky to estimate and can be
far from reality.
❑ A difficult concept to grasp.

4.2 Shareholder value analysis

Shareholder value analysis estimates a value for the equity capital of a companyby calculating the
present value of all future annual free cash flows to obtain a valuation for the entire company and
then deducting the value of the company’s debt capital.

One way of estimating the cash profits or cash flows from a major acquisition is toestimate the free
cash flows of the target company and discount these to a present value. Free cash flow is the annual
cash flow after paying for all essential expenditures.
This method makes the following assumptions:
❑ Free cash flow can be defined in a variety of different, although similar ways. One definition
is that free cash flow in each year is the total earningsbefore interest, tax, depreciation and
amortization, less essential paymentsof interest, tax and purchases of replacement capital
expenditure. Another definition of free cash flow is explained later.
❑ The annual free cash flows that a company is expected to earn in perpetuity can be
discounted to a present value, using the company’sweighted average cost of capital
(WACC) as the discount rate.
❑ This discounted value of future free cash flows gives a total valuation forthe company’s
equity capital (shares) plus its debt capital.
❑ The fair value of the company’s shares is therefore the present value of these free cash flows
minus the current market value of the company’s debt. This is known as shareholder value
and the approach is known asshareholder value analysis (SVA).
5 EFFICIENT MARKET HYPOTHESIS (EMH)

5.1 Implications of strong capital market efficiency

There are several theoretical implications of market efficiency. If a capital markethas strong
efficiency:
❑ Share prices will be fair at all times and reflect all information about a company. This means
that there is no ‘good time’ or ‘bad time’ to try issuingnew shares or bonds.
❑ Companies will gain no benefit from trying to manipulate their financial results and present
their performance and financial position in a favorablelight. In a market with strong-form
efficiency, investors will see through the pretense and will understand the true financial
position of the company.
❑ For investors there will never be any ‘bargains’ in the stock market, where share prices are
under-valued. Similarly there will be no over-priced sharesthat clever investors will sell
before a share price fall.
❑ If the capital market has strong form efficiency, if a company invests in any new capital
project with a positive net present value, the share price shouldrespond by going up to
reflect the increase in the value of the company represented by the project NPV.

5.2 Factors that may have an impact on the market value of shares
In practice, research suggests that most markets have either weak form or semi-strong form
efficiency. Factors which may impact on the efficiency of the market include:
❑ The marketability and liquidity of shares. The greater the volume of sharestraded the more
opportunity there is to reflect new information in the shareprice.
❑ Availability of information. Not all information can be available to all investors at the same
time. Shares which are traded more by professionaldealers are more likely to reflect full
information as they can afford to pay for better monitoring systems and may have better
access to early information.
❑ Pricing anomalies. Share prices may be affected by investor behavior atthe end of the tax
year.
Chapter 18 (Study Text)

1 MERGERS AND TAKEOVERS: STRATEGIC AND REGULATORY ISSUES

CHAPTER
Advantages of acquisitions and mergers
Acquisitions and mergers have several advantages as a strategy for growth,compared with a
strategy of internal development.
❑ Growth by acquisition or merger is much faster than growth through internaldevelopment.
❑ An acquisition can give the buyer immediate ownership of new products, new markets and
new customers, that would be difficult to obtain throughinternal development.
❑ An acquisition enables an entity to enter new market where the barriers toentry are high, so
that it would be very difficult to set up a new business incompetition.
❑ An acquisition prevents a competitor from making the acquisition instead.
❑ It might result in cost savings and higher profits (‘synergy’). This point isdiscussed in more
detail later.

Disadvantages of acquisitions and mergers

❑ An acquisition might be expensive.
❑ A merger or acquisition can result in a loss of proportional ownership of the merged entity if
the compensation is given as shares in parent company.
❑ Clash of Organization Cultures, loss of valuable employees.

The high failure rate of acquisitions

Many acquisitions fail, and do not provide the value for shareholders that was expected when the
acquisition was made. There are several reasons for failure.
❑ The purchase price paid for an acquisition is often too high.
❑ The expected synergies do not occur.
❑ There are serious problems with integrating the acquired company into thenew group.
• Employees in the acquired company might find it difficult to accept thedifferent
culture of the acquiring company, and a new set of policies and procedures. The loss of
staff might be high, and valuable knowledge and expertise might be lost.
• There might be problems with establishing effective management control in the
acquired company. Control systems might have to bereviewed and changed.
❑ Senior management in the acquiring company might not give the acquired company sufficient
time and attention to make the acquisition operationallyand financially successful.
❑ Competitors might react to an acquisition with a new competitive strategy oftheir own.
Increased competition might drive down the profits for all participants in the market.

Due diligence
Whenever anybody buys something they run the risk that what they are actuallybuying is different to
what they think they are buying.
Problems can arise where the seller has information denied to the buyer.
Buying a company is similar in some respects but of course there are muchlarger sums of money
at stake.
 Due diligence will thus attempt to achieve the following.
❑ Confirm the accuracy of information and assumptions on which a bid isbased
❑ Provide an independent assessment and review of the target business
❑ Identify and quantify areas of commercial and financial risk
❑ Provide assurance to providers of finance

Financial due diligence

Financial due diligence is a review of the target company's financial position,financial risk and
projections.
Financial due diligence will examine:
❑ Financial statements
❑ Management accounts
❑ Projections
It will be particularly concerned with the assumptions upon which any projectionsare based.

Legal due diligence

This focusses on any legal matters which might be relevant to the value of thecompany or its
continued success in the future. For example:
❑ Hidden warranties
❑ Security given on assets
❑ Legal disputes
❑ Break clauses in supply contracts that might result in loss of customers.

2 VALUATION FOR MERGERS AND ACQUISITIONS

2.1 Factors to consider in pricing a takeover bid
When a company is considering a takeover bid for another company, there a several important
factors to consider before deciding what offer price might beappropriate.
These include:
❑ Synergy
❑ Risk exposure. An acquisition or merger might alter the exposure to market risk, and
either increase or reduce the asset beta of the enlarged company. Before masking a
takeover bid, or deciding on a suitable offer price, the company making the acquisition
should consider what changesmight happen to its risk exposures, and how significant they
might be.
❑ Real options. An acquisition might create real options to expand operations or re-deploy at
some time in the future. (e.g. Change in strategic Direction)
❑ Financing. An acquisition often requires substantial financing. It might be difficult to raise
new debt finance to acquire a highly- geared target company (depending on conditions in
the debt markets) when the acquiring company is also highly-geared. Using retained
earningsto finance acquisitions might have implications for dividend policy.
❑ Valuation assumptions. In a takeover process, separate valuations for thetarget company are
made by the company making the takeover bid and the directors of the target company.
 Shareholders in both companies might also have their own views on valuation. Valuations
are based on assumptions, but many assumptions are based on judgements rather than
‘hard evidence’. Estimates might be unreliable.

2.2 Types of acquisition

Acquisitions can be categorized in terms of their impact on risk profile and this inturn can influence
the valuation techniques used.

Effect on risk profile Appropriate valuation

method

Type I acquisitions None. Asset based valuations

Acquisitions that impact Market-based valuations

neither the acquiring
company’s exposure to
financial risk nor to
business risk
(dividends orearnings)
Cash flow models (using
free cash flows as
covered earlier but also
including EVATMand
MVA which will be
covered later in this
chapter).

Type II acquisitions Acquisitions that affect the
acquiring company’s
exposure to financial risk
but not to business risk.
Type III acquisitions Acquisitions that affect the
acquiring company’s
exposure to both financial
risk and business risk.
As there is no change in
the risk profile the
company’s current cost of
capital can be used in
valuations.
Adjusted present value
model.
Iterative valuation
procedures.

Many of the methods used to value businesses have already been coveredearlier.
Chapter 19 (Study Text)

1 FOREIGN EXCHANGE RISK

1.1 Summary: currency risks

Translation risk does not affect the cash flows of a group of companies. It is arisk of non-cash
(‘paper’) losses or gains in preparing consolidated financial statements.
Transaction risk does affect cash flows, because movements in exchange ratesaffect the amount of
cash received in domestic currency, or the amount paid in domestic currency, for at least one of the
two parties to the transaction.
Economic risk is a strategic risk, affecting the competitiveness of a businessentity over the longer
term

1.2 Government measures to stabilize exchange rates

There are several exchange rate policies that a government might adopt. Theseinclude:
❑ free floating (‘benign neglect’ of the exchange rate);
❑ managed floating of the currency;
❑ a fixed exchange rate policy, with the exchange rate fixed against a majorcurrency or a
basket of world currencies;
❑ a fixed exchange rate backed by a currency board system.

Free floating

Advantages:
❑ No need for frequent central bank intervention:

❑ No need for foreign capital flow restrictions:

❑ Greater insulation from other countries’ economic problems

Disadvantages :

❑ Higher volatility

❑ Increased Exchange Rate Risk

❑ Problems in Economy may make the currency spiral downwards.

Managed floating
A policy of managed floating is to allow the currency to find its own level in the foreign exchange
markets, but within target limits. (Targets may be set for the maximum and minimum exchange rate
against, say, the US dollar or the euro.)
If the exchange rate threatens to go through the upper or lower target limit, the government will
act to try to keep it within the policy limits, probably by raising orlowering interest rates.
Advantages:
 ❑ Reduction of Shocks in open market

❑ Reduction in short term Exchange Risk

Disadvantages:
❑ Frequent intervention in market may cause Foreign Currency Reserves Crisis.

❑ If a currency is in crisis, the managed float rate cannot fix the issue, hence it only delays the
crisis causing delay in corrective measures on part of Government.

Fixed exchange rate policy

Advantages:
❑ Elimination of Uncertainty and Risk
❑ Deterrence of Speculations in Exchange Market
❑ Anti-inflationary
Disadvantages:
❑ For this policy to be effective, economic conditions in the two countries must remain
largely similar, otherwise there will be too much pressure on the exchange rate to change.
For example, the rate of inflation in both countries must be similar over a longperiod of
time.
❑ The country’s economy will be affected by any crisis in the economy of theother country, or
by an increase in the volatility of the other country’s currency.

Fixed exchange rate backed by a currency board

A problem with a currency board system is that on occasions:
❑ It might result in a shortage of domestic money supply, because of aninsufficiency of
the hard currency, or
❑ It might push up domestic interest rates (in order to attract more hardcurrency).

2 EXCHANGE RATE RELATIONSHIPS

2.1 Four-way equivalence

Purchasing power parity theory

Purchasing power parity theory (PPP theory) attempts to explain changes in anexchange rate due
to the relative rate of price inflation in each country. The theory is based on the assumption that
the exchange rate will adjust to enable the same amount of goods to be purchased in any country
with a given amountof money.
 PPP theory therefore predicts that if inflation is higher in one country than in another, its exchange
rate value will fall so as to restore purchasing power parity.
In reality, an exchange rate does not change in the way predicted by PPP theory because other

CHAPTER
factors apart from price inflation affect the rate, especially in the short term. It might be argued,
however, that PPP theory provides a useful guideto the likely direction and extent of exchange rate
movements over a longer period of time.
Advantages:
❑ PPP exchange rates are relatively stable over time. By contrast, market rates are more volatile.
❑ Takes into account lower labour rates in poorer nations.

Disadvantages:
❑ The biggest one is that PPP is harder to measure.
❑ Purchase Price may be different in different countries due to local circumstances e.g.: Transport
Cost, Tax Differences, Govt Subsidies, Local consumption habits etc. This causes the assumptions
pf PPP to be unrealistic to some degree.

Forecasting exchange rates with interest rate parity theory

Advantages:
More accurately calculated compared to PPP theory.

Disadvantages
❑ Assumes perfect market conditions which might not be the case.
❑ Assumes fluid capital mobility which is not the case in many poorer economies
Chapter 21 to 23 (Study Text)

1.1 The role of the futures exchange

CHAPTER
Counterparty to all trades
The futures exchange regulates the market that it provides. It establishes rules of conduct and provides the
systems in which trading can take place. In addition, the exchange provides security to the market by virtually
eliminating credit risk forits participants. The exchange also takes on the role of counterparty to the buyer and
the seller in thetransaction.
The exchange protects itself against credit risk from participants in the exchange,by means of a system of margin
payments.
(Note: Strictly speaking, the exchange itself is not the counterparty to every transaction. The exchange is
represented by a clearing house, that acts as counterparty to every transaction. For the LIFFE futures exchange in
London, forexample, the clearing house is the London Clearing House or LCH).

Margin
A percentage of future exposure kept as a deposit with the Clearing House is called a Margin.

❑ When two parties agree to the sale/purchase of a quantity of futures, bothparties are required to pay a
cash deposit, called an initial margin, to cover the risk of short-term losses on their position.
❑ If a position goes into loss because the market price moves adversely, theexchange will call for an
additional cash payment of variation margin to cover the loss.
In this way, all loss positions have been covered by cash payments, and there isno credit risk for the exchange
from non-payment of losses by the buyers or sellers of futures contracts.

Basis risk
Basis risk is the risk that when a futures position is closed, the size of the actualbasis will be different from the
expectation of what the basis should be.

Terminology
Options are in-the-money, at-the-money or out-of-the-money.
❑ An option is in-the-money when its exercise price (strike price) is morefavorable to the option holder
than the current market price of the underlying item.
❑ An option is at-the-money when its exercise price (strike price) is exactlyequal to the current market
price of the underlying item.
❑ An option is out-of-the-money when its exercise price (strike price) is lessfavorable to the option holder
than the current market price of the underlying item.

An option will only be exercised if it is in-the-money.

When an option is exercised, the value of the option is the difference between theexercise price and the current
market price of the underlying item.
Chapter 24 (Study Text)

1.1 Interest rate risk and interest rate volatility

CHAPTER
Interest rate risk is particularly high when:
interest rate changes are frequent (and sometimes large); and
it is uncertain whether the next movement in rates will be up or down.
In other words, interest rate risk increases with interest rate volatility. Volatility islikely to be higher when
expected inflation rates are high than when expected inflation rates are low since the nominal rate of interest =
the real interest rate the inflation rate.

1.2 Short-term and long-term interest rates

A distinction is made between:
short-term interest rates, which are money market interest rates; and
long-term interest rates, which are bond yields.
Volatility in short-term rates affects short-term lending and borrowing, and also allvariable rate
lending, such as bank loans. Volatility in longer-term rates affects bond investors.
that yields on a corporate bond are affected by:
interest rates for risk-free bonds (domestic government bonds); and
changes in the perceived credit risk of the bond issuer.
The higher the credit risk of the bond issuer the greater the return that investorswould demand and vice versa.

1.3 Credit arbitrage

Swaps can be used to obtain a lower interest rate on borrowing. This is possiblebecause banks can identify
opportunities for ‘credit arbitrage’ which arise as a result of differences in the rates of interest at which different
companies can borrow.
Chapter 25 (Study Text)

High / Low Method vs Linear Regression

There are important differences between linear regression analysis and the high-low method.
❑ High-low analysis uses just two sets of data for x and y, the highest value for x and the lowest value for x.
Regression analysis uses as many sets ofdata for x and y as are available.
❑ Because regression analysis calculates a line of best fit for all the availabledata, it is likely to provide a
more reliable estimate than high-low analysis for the values of a and b.
❑ In addition, regression analysis can be used to assess the extent to whichvalues of y depend on values of
x. For example, if a line of best fit is calculated that estimates total costs for any volume of production,
we can also calculate the extent to which total costs do seem to be linked (or ‘correlated’) to the volume
of production. This is done by calculating a correlation co-efficient, which is explained later.
❑ Regression analysis uses more complex arithmetic than high-low analysis,and a calculator or small
spreadsheet model is normally needed

In summary, linear regression analysis is a better technique than high-lowanalysis because:

❑ it is more reliable and
❑ its reliability can be measured.
Chapter 26 (Study Text)
1.1 Direct materials: possible causes of variances
When variances occur and they appear to be significant, management should investigate the reason for the
variance. If the cause of the variance is somethingwithin the control of management, control action should be
taken. Some of the possible causes of materials variances are listed below.

Materials price variance: causes

Possible causes of favorable materials price variances include:
❑ Different suppliers were used and these charged a lower price (favorableprice variance) than the usual
supplier.
❑ Materials were purchased in sufficient quantities to obtain a bulk purchasediscount (a quantity discount),
resulting in a favorable price variance.
❑ Materials were bought that were of lower quality than standard and socheaper than expected.

Possible causes of adverse materials price variances include:

❑ Different suppliers were used and these charged a higher price (adverseprice variance) than the usual
supplier.
❑ Suppliers increased their prices by more than expected. (Higher pricesmight be caused by an
unexpected increase in the rate of inflation.)
❑ There was a severe shortage of the materials, so that prices in the marketwere much higher than
expected.
❑ Materials were bought that were better quality than standard and moreexpensive than expected.

Materials usage variance: causes

Possible causes of favorable materials usage variances include:
❑ Wastage rates were lower than expected.
❑ Improvements in production methods resulted in more efficient usage of materials (favorable usage
variance).

Possible causes of adverse materials usage variances include:

❑ Wastage rates were higher than expected.
❑ Poor materials handling resulted in a large amount of breakages (adverseusage variance). Breakages mean
that a quantity of materials input to theproduction process are wasted.
❑ Materials used were of cheaper quality than standard, with the result that more materials had to be
thrown away as waste.

1.2 Direct labour: possible causes of variances

When labour variances appear significant, management should investigate thereason why they occurred, and
take control measures where appropriate to improve the situation in the future. Possible causes of labour
variances includethe following.

Possible causes of favourable labour rate variances include:

❑ Using direct labour employees who were relatively inexperienced and newto the job (favourable rate
 variance, because these employees would be paid less than ‘normal’).
❑ Actual pay increase turning out to be less than expected.

Possible causes of adverse labour rate variances include:

❑ An increase in pay for employees.
❑ Working overtime hours paid at a premium above the basic rate.
❑ Using direct labour employees who were more skilled and experienced than the ‘normal’ and who are
paid more than the standard rate per hour(adverse rate variance).

Possible causes of favourable labour efficiency variances include:

❑ More efficient methods of working.
❑ Good morale amongst the workforce and good management with the resultthat the work force is more
productive.
❑ If incentive schemes are introduced to the workforce, this may encourage employees to work more
quickly and therefore give rise to a favourable efficiency variance.
❑ Using employees who are more experienced than ‘standard’, resulting infavourable efficiency variances
as they are able to complete their work more quickly than less-experienced colleagues.

Possible causes of adverse labour efficiency variances include:

❑ Using employees who are less experienced than ‘standard’, resulting inadverse efficiency variances.
❑ An event causing poor morale.

1.3 Variable production overhead: possible causes of variances

Possible causes of favourable variable production overhead expenditurevariances include:
❑ Forecast increase in costs not materialising

Possible causes of adverse variable production overhead variances include:

❑ Unexpected increases in energy prices
Anything that causes labour efficiency variance will have an impact on variableproduction overhead efficiency
variances as variable production overhead is incurred as the labour force carries out production.

Possible causes of favourable variable production overhead efficiency variancesinclude:

❑ More efficient methods of working.
❑ Good morale amongst the workforce and good management with the resultthat the work force is more
productive.
❑ If incentive schemes are introduced to the workforce, this may encourageemployees to work more
quickly and therefore give rise to a favourable efficiency variance.
❑ Using employees who are more experienced than ‘standard’, resulting in favourable efficiency variances
as they are able to complete their work more quickly than less-experienced colleagues.

Possible causes of adverse variable production overhead efficiency variancesinclude:

❑ Using employees who are less experienced than ‘standard’, resulting inadverse efficiency variances.
❑ An event causing poor morale.

1.4 Fixed production overheads: possible causes of variances

Some of the possible causes of fixed production overhead variances include thefollowing.

Fixed overhead expenditure variance

❑ Poor control over overhead spending (adverse variance) or good controlover spending (favourable
variance).
❑ Poor budgeting for overhead spending. If the budget for overhead expenditure is unrealistic, there will be
an expenditure variance due to poorplanning rather than poor expenditure control.
❑ Unplanned increases or decreases in items of expenditure for fixed production overheads, for example, an
unexpected increase in factory rent.

Fixed overhead volume variance

A fixed overhead volume variance can be explained by anything that made actualoutput volume different from the
budgeted volume. The reasons could be:
❑ Efficient working by direct labour: a favourable labour efficiency varianceresults in a favourable fixed
overhead efficiency variance.
❑ Working more hours or less hours than budgeted (capacity variance).
❑ An unexpected increase or decrease in demand for a product, with the result that shorter/longer hours
were worked (adverse/favourable capacityvariance)
❑ Strike action by the workforce, resulting in a fall in output below (adversecapacity variance).
❑ Extensive breakdowns in machinery, resulting in lost production (adversecapacity variance).

2 SALES VARIANCES

2.1 Sales: possible causes of variances

Possible causes of sales variances include the following:

Sales price variance

❑ Actual increases in prices charged for products were higher or less thanexpected due to market
conditions.
❑ Actual sales prices were less than standard because major customers weregiven an unplanned price
discount.
❑ Competitors reduced their prices, forcing the company to reduce the pricesof its own products.

Sales volume variance

❑ Actual sales demand was more or less than expected.
❑ The sales force worked well and achieved more sales than budgeted.
❑ An advertising campaign had more success than expected.
❑ A competitor went into liquidation, and the company attracted some of theformer competitor’s
customers.
❑ The products that the company makes and sells are going out of fashionearlier than expected;
therefore the sales volume variance was adverse.
3 INTERRELATIONSHIPS BETWEEN VARIANCES

3.1 Sales price and sales volume

A favourable sales price variance and an adverse sales volume variance mighthave the same cause. If a company
increases its selling prices above the standard price, the sales price variance will be favourable, but sales demand
might fall and the sales volume variance would be adverse.
Similarly, in order to sell more products a company might decide to reduce its selling prices. There would be an
adverse sales price variance due to the reduction in selling prices, but there should also be an increase in sales
and afavourable sales volume variance.

3.2 Materials price and usage

A materials price variance and usage variance might be inter-related. For example, if a company decides to use a
material for production that is more expensive than the normal or standard material, but easier to use and better
in quality, there will be an adverse price variance. However a consequence of using better materials might be
lower wastage. If there is less wastage, there will be a favourable material usage variance. Therefore, using a
different quality of material can result in an adverse price variance and a favourable usage variance.

3.3 Labour rate and efficiency

If there is a change in the grade of workers used to do some work, both the rateand efficiency variances may be
affected.
For example, if a lower grade of labour is used instead of the normal highergrade:
❑ there should be a favourable rate variance because the workers will be paidless than the standard rate
❑ however the lower grade of labour may work less efficiently and take longerto produce goods than the
normal higher grade of labour would usually take. If the lower grade of labour takes longer, then this will
give rise to an adverse efficiency variance.
Therefore the change in the grade of labour used results in two ‘opposite’variances, an adverse efficiency
variance and a favourable rate variance.
When inexperienced employees are used, they might also waste more materials than more experienced
employees would, due to mistakes that they make in theirwork. The result might be not only adverse labour
efficiency, but also adverse materials usage.

3.4 Labour rate and variable overhead efficiency

When a production process operates at a different level of efficiency the true cost of that difference is the sum of
any costs associated with labour hours. Therefore,the issues described above also affect the variable overhead
efficiency variance.

3.5 Capacity and efficiency

If a production process operates at a higher level of efficiency that might mean that it does not have to operate
for as long to produce the budgeted productionvolume. The favourable fixed production overhead efficiency
variance would cause an adverse fixed production overhead capacity variance.
The reverse is also true. If a production process operates at a lower level of efficiency that might mean that it has
to operate for longer than was budgeted.The adverse efficiency fixed production overhead variance would cause
a favourable fixed production overhead capacity variance.

3.6 the importance of reliable standard costs

It is important to remember that the value of variances as control information for management depends on the
reliability and accuracy of the standard costs. If thestandard costs are inaccurate, comparisons between actual
cost and standard cost will have no meaning. Adverse or favourable variances might be caused by inaccurate
standard costs rather than by inefficient or efficient working.

3.7 Purpose of an operating statement

A management report called an operating statement might be prepared, showinghow the difference between
budgeted and actual profit is explained by the sales variances and cost variances. An operating statement
reconciles the profit that was expected in the budget with the actual profit that was achieved.
Chapter 28 (Study Text)

1.1 Market-based and cost-based transfer prices, and transfer prices based onopportunity cost
As a general rule:
❑ When an external intermediate market does not exist for transferred goods,the transfer price will be based
on cost.
❑ When an external intermediate market does exist for transferred goods, thetransfer price will be based on
the external market price.
❑ Where the capacity of the selling division is not constrained marginal cost isthe best possible transfer price.
❑ Where the capacity of the selling division is constrained than the sellingdivision will be reluctant in
transferring the goods at marginal cost. Therefore, the transfer price should be based on marginal cost
plus contribution margin that will be lost on transferring the goods internally.

1.2 Transfer price at market price

A transfer price may be the external selling/buying price for the item in an external intermediate market. This
price is only possible when an external marketexists.
If the selling division would incur some extra costs if it sold its output externally rather than transferred it
internally to another division, the transfer price may be reduced below market price, to allow for the variable
costs that would be saved by the selling division. This is very common as the selling division may save costsof
packaging and warranties or guarantees. Distribution costs may also be cheaper and there will be no need for
advertising.

Advantages of market price as the transfer price

Market price is the ideal transfer price when there is an external market. A transfer price below this amount will
make the manager of the selling division want to sell externally, and a price above this amount will make the
manager ofthe buying division want to buy externally.
Transferring at market price also encourages efficiency in the supplying division,which must compete with the
external competition.

Disadvantages of market price as the transfer price

The current market price is not appropriate as a transfer price when:
❑ the current market price is only temporary, and caused by short-termconditions in the market, or
❑ the selling price in the external market would fall if the selling division sold more of its output into the
market. The opportunity cost of transferring output internally would not be the current market price,
because the sellingprice would have to be reduced in order to sell the extra units.
It may also be difficult to identify exactly what the external market price is. Products from rival companies may
be different in quality, availability may not beso certain and there may be different levels of service back-up.

1.3 Transfer price at full cost plus

A transfer price may be the full cost of production plus a margin for profit for theselling division.
Standard full costs should be used, not actual full costs. This will prevent theselling division from increasing its profit
by incurring higher costs per unit.
Full cost plus might be suitable when there is no external intermediate market.
However, there are disadvantages in using full cost rather than variable cost todecide a transfer price.
❑ The fixed costs of the selling division become variable costs in the transferprice of the buying division. This
might lead to decisions by the buying division manager that are against the best interests of the company
as a whole. This is because a higher variable cost may lead to the buying division choosing to set price at a
 higher level which would lose sales volume.
❑ The size of the profit margin or mark-up is likely to be arbitrary.

1.4 Transfer price at variable cost plus or incremental cost plus

A transfer price might be expressed as the variable cost of production plus amargin for profit for the selling
division.
Standard variable costs should be used, not actual variable costs. This willprevent the selling division from
increasing its profit by incurring higher variablecosts per unit.
Variable cost plus might be suitable when there is no external intermediate market. It is probably more suitable
in these circumstances than full cost plus, because variable cost is a better measure of opportunity cost.
However, as stated earlier, when transfers are at cot, the transferring division should be a costcentre, and not a
profit centre.

1.5 Two-part transfer prices

With two-part transfer prices, the selling division charges the buying division forunits transferred in two ways:
❑ a standard variable cost per unit transferred, plus
❑ a fixed charge in each period.
The fixed charge is a lump sum charge at the end of each period. The fixed charge would represent a share of the
contribution from selling the end product,which the selling/transferring division has helped to earn.
Alternatively, the charge could be seen as a charge to the buying division for a share of the fixed costs of the
selling division in the period.
The fixed charge could be set at an amount that provides a ‘fair’ profit for eachdivision, although it is an arbitrary
amount.

1.6 Dual pricing

In some situations, two divisions may not be able to agree a transfer price, because there is no transfer price at
which the selling division will want to transferinternally or the buying division will want to buy internally.
However, the profits of the entity as a whole would be increased if transfers did occur.
These situations are rare. However, when they occur, head office might find asolution to the problem by agreeing to
dual transfer prices.
❑ the selling division sells at one transfer price, and
❑ the buying division buys at a lower transfer price.
There are two different transfer prices. The transfer price for the selling division should be high enough to
motivate the divisional manager to transfer more unitsto the buying division. Similarly, the transfer price for the
buying division should be low enough to motivate the divisional manager to buy more units from the selling
division.
In the accounts of the company, the transferred goods are:
❑ sold by the selling division to head office and
❑ bought by the buying division from head office.

1.7 Negotiated transfer prices

A negotiated transfer price is a price that is negotiated between the managers ofthe profit centres.
The divisional managers are given the autonomy to agree on transfer prices. Negotiation might be a method of
identifying the ideal transfer price in situationswhere an external intermediate market does not exist.
An advantage of negotiation is that if the negotiations are honest and fair, thedivisions should be willing to
trade with each other on the basis of the transferprice they have agreed.
Disadvantages of negotiation are as follows:
❑ The divisional managers might be unable to reach agreement. When thishappens, management from
head office will have to act as judge or arbitrator in the case.
❑ The transfer prices that are negotiated might not be fair, but a reflection ofthe bargaining strength or
bargaining skills of each divisional manager.

1.8 Transfer pricing and taxation issues

Groups of corporations around the world park their profit in subsidiaries which operate in jurisdictions with low
tax rates and park their losses jurisdictions withhigh tax rates in order to increase net benefits.
Governments around the world try to address this issue with special rules forpricing of
Chapter 29 (Study Text)

1 WORKING CAPITAL

1.1 The objectives of working capital management

The management of working capital is an aspect of financial management, and isconcerned with:
❑ Ensuring that the investment in working capital is not excessive
❑ Ensuring the level of working capital is not low
❑ Ensuring that enough working capital is available to support operatingactivities.

1.2 Investment in working capital

Benefits of investing in working capital

There are significant benefits of investing in working capital:
❑ Holding inventory allows the entity to supply its customers on demand.
❑ Entities are expected by many customers to sell to them on credit. Unlesscustomers are
given credit (which means having to invest trade receivables) they will buy instead from
competitors who will offer credit.
❑ It is also useful for an entity to have some cash in the bank to meetdemands for
immediate payment.

Disadvantages of excessive investment in working capital

However, money tied up in inventories, trade receivables and a current bank account earns
nothing. Investing in working capital therefore involves a cost. Thecost of investing in working
capital is the reduction in profit that results from the money being invested in inventories,
receivables or cash in the bank account, rather than being invested in wealth-producing assets and
long-term projects.

2 CASH OPERATING CYCLE

2.1 Overtrading
Overtrading means carrying on an excessive volume of trading in relation to theamount of long-
term capital invested in the business. A company that is overtrading has inadequate capital for the
volume of sales revenue it is earning.

2.2 Symptoms of overtrading

A company that is overtrading will usually show most of the following symptoms.
❑ A high rate of annual sales growth.
❑ Low profitability. The company might be reducing its gross profit margin inorder to grow
sales quickly. As it grows, the company might also incur much higher expenses, such as
higher administration costs, which reducethe net profit margin.
❑ Because profitability is low, retained profits are also low. Retained profits are an important
source of new equity, but the company is not increasing itsequity investment quickly enough
because there are insufficient profits.
❑ The growth in sales revenue will also mean a large increase in inventory and trade
receivables. Working capital management might become less efficient, because systems that
 operated well when the company was small(such as inventory control and collection of
receivables) no longer operate efficiently when the company is larger. Turnover times for
inventory and collections might increase.
❑ The company might also need to acquire some new non-current assets tosupport the
growth in sales volume.
❑ The growth in assets has to be financed by equity and liabilities. Because profits are low,
equity capital increases only by a small amount. The growthin assets is therefore financed by
liabilities, and in particular by current liabilities.
❑ The increase in current liabilities takes the form of:
• a much longer time to pay suppliers, so that the average payments period increases
substantially and trade payables in the statement offinancial position (balance sheet)
are much higher
• a very big increase in its bank overdraft.

2.3 Consequences of overtrading and possible remedial action

The consequences of overtrading are eventual insolvency, unless remedial measures are taken.
Insolvency will occur if sales continue to grow and overtrading continues because a company
cannot finance its growth in businessindefinitely with growth in current liabilities.

Remedial action
The action to restore the financial position when a company is overtrading is either to increase
capital or reduce the volume of business that the company isconducting. This can be achieved by
Cutting costs or increasing sales price to improve cashflow. The aim should be to achieve a better
ratio of long-term capital to sales, and a suitable level of working capital investment.
Chapter 30 (Study Text)

1 COSTS ASSOCIATED WITH INVENTORY

The costs associated with inventory are:

❑ Purchase price of the inventory;

❑ Re-order costs are the costs of making orders to purchase a quantity of amaterial item from a supplier.
They include costs such as:
• the cost of delivery of the purchased items, if these are paid for by thebuyer;
• the costs associated with placing an order, such as the costs oftelephone calls;
• costs associated with checking the inventory after delivery from thesupplier;
• batch set up costs if the inventory is produced internally.
❑ Inventory holding costs:
• cost of capital tied up;
• opportunity cost of investment in inventory
• insurance costs;
• cost of warehousing;
• obsolescence, deterioration and theft.
❑ Shortage/stock out costs
• lost profit on sale;
• future loss of profit due to loss of customer goodwill;
• costs due to production stoppage due to shortage of raw materials;

2 REORDER LEVEL AND BUFFER STOCK

2.1 Inventory reorder level and other warning levels

Management responsible for inventory control might like to know:
❑ what the reorder level should be for each item of materials, in order to avoidany stock-out.
(reorder level is the level of inventory at which a new order for the item should be placed
with the supplier);
❑ whether the inventory level for each item of material appears to be too highor too low;
❑ what the reorder level should be for each item of materials, if stock-outscan be allowed
to happen (considering the cost of stock out against the holding cost of safety stock).
In an inventory control system, if there is uncertainty about the length of the supply lead time and
demand during the lead time there might be three warninglevels for inventory, to warn
management that:
❑ the item should now be reordered (the reorder level)
❑ the inventory level is too high (a maximum inventory level) or
❑ the inventory level is getting dangerously low (a minimum inventory level).

3 JUST-IN-TIME (JIT) AND OTHER INVENTORY MANAGEMENT METHODS

3.1 JIT production and JIT purchasing
It follows that in an ideal production system:
❑ there should be no inventory of finished goods: items should be producedjust in time to
meet customer orders, and not before ( just in time production); and
❑ there should be no inventories of purchased materials and components: purchases should
be delivered by external suppliers just in time for whenthey are needed in production
(just in time purchasing).

3.2 Practical implications of JIT

JIT production
It is important that items should be available when required. Finished goods mustbe available
when customers order them, and raw materials and components must be supplied when they are
needed for production.
In practice, this means that:
❑ Production times must be very fast. If there is no inventory of finished goods,
production has to be fast in order to meet new customer ordersquickly.
❑ Production must be reliable, and there must be no hold-ups, stoppages or bottlenecks. Poor
quality production, leading to rejected items and scrap, isunacceptable.
❑ Deliveries from suppliers must be reliable: suppliers must deliver quickly and purchased
materials and components must be of a high quality (so thatthere will be no scrapped items
or rejected items in production).
JIT purchasing
By implementing a JIT system, an entity will be working with its key (‘strategic’)suppliers to implement
a manufacturing system that will:
❑ reduce or eliminate inventories and WIP;
❑ reduce order sizes, since output is produced to meet specific demand andraw material
deliveries should be timed to coincide with production requirements; and
❑ ensure deliveries arrive in the factory exactly at the time that they areneeded.
The overall emphasis of a JIT purchasing policy is on consistency and quality,rather than looking
for the lowest purchase price available.

Problems with JIT

There might be several problems with using JIT in practice.
❑ Zero inventories cannot be achieved in some industries, where customer demand cannot be
predicted with certainty and the production cycle is quitelong. In these situations, it is
necessary to hold some inventories of finishedgoods.
❑ It might be difficult to arrange a reliable supply system with key suppliers, whereby suppliers
are able to deliver materials exactly at the time required.
❑ If the EOQ model succeeds in minimising total costs of holding costs andordering costs, this
suggests that with a JIT purchasing system, ordering costs might be very high.

3.3 Periodic review system

In a periodic review system, there is a reorder quantity and a reorder level foreach item of
inventory.
Inventory levels are checked periodically. If the inventory level for any item has fallen below its
reorder level, a neworder for the reorder quantity is placed immediately.
3.4 ABC method of inventory control
With the ABC method of inventory control, it is recognised that some items of inventory cost
much more than others to hold. Inventory can perhaps be dividedinto three broad categories:
❑ Category A inventory items, for which inventory holding costs are high.
❑ Category B inventory items, for which inventory holding costs are fairlyhigh, but not as
high as for category A items.
❑ Category C inventory items, for which inventory holding costs are low and insignificant.
Holding excessive amounts of these inventory items would notaffect costs significantly.
The ABC approach to inventory control is to control each category of inventorydifferently, and
apply the closest control to those items in the most costly category, A. For example:
❑ Category A items might be controlled by purchasing the EOQ as soon asthe inventory
level falls to a set reorder level.
❑ Category B items might be controlled by a periodic review system, withorders placed to
restore the inventory level to a maximum level.
❑ Category C items might be purchased in large quantities, and controlled bymeans of a two-
bin system.
Chapter 31 (Study Text)

1 COSTS AND BENEFITS OF GIVING CREDIT

1.1 Cost of giving credit

There are several costs of giving credit.
❑ Finance costs: Trade receivables must be financed. The longer the period of credit allowed
to customers, the biggerthe investment in working capital must be.
❑ Bad debt costs: Selling on credit creates a risk that the customer might never pay for the
goods supplied.
❑ Administration costs: Additional administration costs might be incurred in negotiating credit
terms with customers, and monitoring the credit position

1.2 Giving credit

The credit terms set for each customer will consist of:
❑ A credit period: The customer should be required to pay invoices within astated number of
days. Credit limits of 30 days or 60 days are common.
❑ A credit limit: This is the maximum amount of credit that the customer willbe permitted.
The limit is likely to be small at first for a new customer, increasing as the trading
relationship develops.
❑ Interest charges on overdue payments: It might also be a condition of giving credit that
the customer agrees to pay interest on any overdue payment. However, interest charges
on late payments can create bad feeling, and customers who are charged interest might
take their businessto a rival supplier. Interest charges on late payments are therefore
uncommon in practice.

1.3 Debt factors and the services they provide

Companies might use a factoring organisation to assist with the management ofreceivables and also to
help with the financing of receivables.
Debt factors are specialist organisations. They specialise in:
❑ assisting client firms to administer their trade receivables ledger;
❑ providing short-term finance to client firms, secured by the tradereceivables;
❑ in some cases, providing insurance against bad debts.
The services of a debt factor can be particularly useful for a small-to-medium-sized company that:
❑ has a large number of credit customers;
❑ does not have efficient debt collection procedures and therefore has a fairlyhigh level of bad
debts; and
❑ does not have sufficient finance for its working capital.

A debt factor offers three main services to a client business:

❑ the administration of the client’s trade receivables;
❑ credit insurance; and
❑ debt finance.
Trade receivables administration
The factor makes a charge for this service, typically an agreed percentage of thevalue of invoices sent
out.

Credit insurance
If the factor is given the task of trade receivables administration, it may also agree (for an
additional fee) to provide insurance against bad debts for the client.This is known as without
recourse factoring or non-recourse factoring. If a customer of the client fails to pay an invoice that
was issued by the factor, the factor will accept the bad debt loss itself, and the factor will pay the
client the full amount of the unpaid invoice.
However, factors also provide with recourse factoring. With this type of arrangement, if a
customer of the client fails to pay an invoice, the factor will notpay anything to the client, and the
client must suffer the bad debt loss

Debt finance
The factor will provide advances of up to a percentage of the face value of the client’s trade
receivables, for all receivables that are approved by the factor. The financeis provided at an agreed
rate of interest, and is repayable when the customers’ invoices are eventually paid. In effect, this
means that when a customer pays thefactor will remit the remaining 20% of the money to the
client, less the interest (and other fees).

1.4 The costs of factoring services

The costs of a factoring service might consist of:
❑ a service fee for the administration and collection of trade receivables;
❑ a commission charge, based on the total amount of trade receivables, for anon-recourse
factoring service; and
❑ interest charges for finance advanced against the trade receivables.

1.5 Benefits and disadvantages of using a factor

The benefits of using a factor are as follows:
❑ There should be savings in internal administration costs, because the factoradministers the
trade receivables ledger.
❑ With non-recourse factoring, there is a reduction in the cost of bad debts.
❑ A factor is a source of finance for trade receivables.

The disadvantages of using a factor are as follows.

❑ Interest charges on factor finance are likely to be higher than other sourcesof finance.
❑ Effect on customer goodwill. The factor is unlikely to treat the client’s customers with the
same degree of care and consideration that the client’sown sales ledger administration
team would.
❑ The client’s reputation may be affected by the need to use a factor. Customers might believe
that using a factor is a sign of financial weakness.

1.6 Invoice discounting

Invoice discounting is similar to the provision of finance by a factor. A differenceis that whereas a
factor provides finance against the security of all approved invoices of the client, an invoice
 discounter might provide finance against only asmall number of selected invoices.
Another difference between a debt factor and an invoice discounter is that the invoice discounter
will only provide finance services. An invoice discounter will not administer the trade receivables
ledger or provide protection against the riskof bad debt.

2 MANAGEMENT OF TRADE PAYABLES

2.1 Trade payables as a source of finance

Trade credit is an excellent source for financing short-term working capital needs.The supplier has
provided goods or services that have not yet been paid for, and which may or may not already have
been used.
Trade credit allows the buyer to hold or make use of goods obtained from suppliers without yet
having to pay for them. It therefore postpones the need tofind the cash to make payments for
goods and services purchased.
Unlike other sources of finance, including a bank overdraft or a bank loan, tradecredit does not have
any cost.
However, goods are supplied on agreed credit terms. The supplier expects to receive payment at
the end of the agreed credit period. If a buyer tries to take advantage of trade credit, and delay
payment until after the agreed credit periodhas ended, the trading relationship between supplier
and buyer could become difficult and unfriendly.
A company should therefore take advantage of the trade credit terms it is offered,and negotiate the
best credit terms that it can get, because it is a free source of finance for working capital. However it
should not exceed the amount of credit allowed.

2.2 Settlement discounts from suppliers

A supplier might offer a settlement discount for early payment. The value of a settlement discount
from a supplier should be assessed in the same way as thecost of a settlement discount to
customers. If the value of taking the settlement discount is higher than the cost of having to
finance the payment by bank overdraft, the discount should be taken and the trade debt should
be paid at thelatest time possible in order to obtain the discount.
Chapter 32 (Study Text)

1.1 Cash budgets

The main uses of a cash budget are as follows:
❑ To forecast how much cash receipts and payments are expected to be overthe planning
period.
❑ To learn whether there will be a shortage of cash at any time during theperiod, or
possibly a cash surplus.
❑ If there is a forecast shortage of cash, to consider measures in advance fordealing with the
problem
❑ To monitor actual cash flows during the planning period, by comparingactual cash
flows with the budget.

1.2 Cash flow forecasts

Cash flow forecasts, like cash budgets, are used to predict future cashrequirements, or future cash
surpluses. However, unlike cash budgets:
The main objectives of cash flow forecasting, like the purposes of a cash budget,are to:
❑ Make sure that the entity is still expected to have sufficient cash to meet itspayment
commitments as they fall due
❑ Identify periods when there will be a shortfall in cash resources, so thatfinancing can be
arranged
❑ Identify whether there will be a surplus of cash, so that the surplus can beinvested
❑ Assess whether operating activities are generating the cash that isexpected from
them.
The main focus of cash flow forecasting is likely to be operating cash flows,although some
investing and financing cash flows might also be significant.

1.3 Purpose of cash models

Cash models might be used when an entity has periods of surplus cash andperiods when cash is
needed. A model can be used to decide:
❑ How much cash to hold and how much to invest short-term to earn interest;and
❑ When cash is needed, how many investments to sell (how much cash toobtain).
Two such cash models are the Baumol model and the Miller-Orr model

1.4 Use of surplus cash: investing short term

If the surplus is likely to be long-term, the cash should be invested long-term inwealth-producing
assets of the business – perhaps through a plan of market expansion, or paying as dividend.
If the surplus is likely to be temporary, it would be more appropriate to invest it for the short
term, and then cash in the investments when the cash is eventuallyneeded.
When deciding on how to use temporary surplus cash, the followingconsiderations are important:
❑ Liquidity – Short-term investments should ideally be liquid. The more liquid the investment,
the easier it is to convert itback into cash.
❑ Safety – The level of investment risk should be acceptable. With investments such as a
savings account, there would be no risk of capital loss, but the interest on the savings
might be very low. On the other hand investing in shares of other companies is much more
 risky since share prices fluctuate.
❑ Profitability – The aim should be to earn the highest possible return on thesurplus cash,
consistent with the objectives of liquidity and safety.
1.5 Ways of investing short term
There are various possible short-term investment options for cash.

Savings accounts and interest-earning deposits

Money market investments

It is also possible to purchase some money market investments,
• Treasury bills

• Certificates of Deposit
• Short-dated government bonds.

Longer-term securities as short-term investments

Bonds traded in the bond markets. These normally offer a higher return thanshort-term
investments, because there is greater risk for the investor.
Bondholders can sell their investment in the secondary bond market if they needto convert the
investment back into cash.
However, these come with heightened investment risk.
Equity. Investing in the shares of other companies is a high-risk investment as there is no
guarantee of return of capital value.
Investing in shares is not recommended as a short-term investment for surpluscash, because of
the risk from volatility in share prices.

1.6 Dealing with shortfalls of cash

Long-term funding. A company can consider raising long-term funds by issuingnew shares for
cash.
Alternatively, an entity might be able to borrow long term, by means of issuingloan stock (bonds)
or obtaining a medium-term bank loan.
Various short-term sources of cash might also be available.
❑ Bank overdrafts – These are very popular with small and medium-sizedbusinesses.
Obtaining a bank overdraft is usually the easiest way for a small business to obtain
finance.
• The advantage of a bank overdraft is that the borrower pays interestonly on the
amount of the overdraft balance.
• However, overdrafts are expensive (the interest rate is comparatively high compared
with other sources of finance). Overdrafts are also arerepayable to the bank on
demand. The bank can ask for immediate repayment at any time that it wishes.
Overdrafts can therefore be a high-risk source of finance, especially for businesses
with cash flow difficulties – in other words, the businesses that are usually in greatest
need of an overdraft!
• Bank overdrafts should only be used to finance fluctuating levels ofcash shortfalls.
 If the cash shortfall looks more permanent, other sources of finance should be
used.
❑ Short-term bank loans – The main difference between a loan and a bank overdraft is that a
loan is arranged for a specific period and the capital borrowed, together with the interest, is

CHAPTER
repaid according to an agreed schedule and over an agreed time period. However, the bank
may demand security for a loan, for example in the form of a fixed andfloating charge over
the assets of the business.
❑ Debt factoring –debt factor services can be expensive.