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SUMMARY

OF SLIDES
FIN 722

LESSON 23
EXAMPLE

A firm has 100 shares outstanding and the par value of share is Rs.100. The company intends to pay all
of its earnings in dividends. The cash flow for year 1 & 2 to be paid as dividend is rs.10,000 that means
Rs.100 dividend per share.
The other option is to pay a dividend of Rs. 110 after first year and Rs. 89 after second year as dividend.
Assuming 10% required rate of return.
What is the value of the firm with new dividend policy?
Solution

that is:

Po = D1/(1 + R)1 + D2/ (1+R)2

= 100 /1.10 + 100/(1.10)2


= 173.55

Now if the second option is adopted, then value of firm is:


Po = D1/(1 + R)1 + D2/ (1+R)2
= 110 /1.10 + 89*/(1.10)2
= 173.55

*why it is 89 lets see.


We have only Rs. 10,000 of cash flow for dividend payout. but under later option we need a cash flow
of

110 x 100 = 11,000 - a deficit of Rs 1000.


Suppose we seek a loan to bridge this deficit. In the next year we need to pay dividend, return the loan
and to pay interest on loan (assume 10% Rate)
Loan repayment and interest will be Rs. 1100 and the balance amount left for dividend will be
20,000 1,100 = 8,900 which equals Rs 89 per share dividend.

DIVIDEND RELEVANCE:
As a mean of resolving the uncertainty early, investors prefer dividend income rather than non-

dividend paying.
Liquidity preference
Time value of money

FINANCIAL SIGNALING:
Image of the company improved by paying dividend.
None payment of Dividend adversely effect companys image.
Dividends have impact on share prices because it indicate the firms profitability as well.
Accounting earnings may not be a influencing factor as compared to increase in dividend.

TAXATION ON CAPITAL GAINS VS DIVIDENDS:


In Pakistan no tax levied on Capital Gain but tax is paid on Dividend.

RESIDUAL DIVIDEND POLICY

Debt Equity Ratio of 0.50 firm wishes to maintain it. After tax profit rs.1,000. If no dividend is paid,
equity will increase. It means that firm will seek loan to maintain D/E Ratio. for example, after tax profit
of Rs.1000/- the firm must borrow Rs.500 in order to maintain D/E of 0.50.

The first thing would be to determine the funds that can be generated without selling additional
shares.

Residual Dividend Policy


Sr.
No.

After Tax

New

Earning

Investment

Debt

Earning

Stock

2,000.00

6,000.00

2,000.00

2,000.00

2,000.00

0.50

2,000.00

5,000.00

1,500.00

2,000.00

1,000.00

0.50

2,000.00

4,000.00

1,250.00

2,000.00

500.00

0.50

2,000.00

3,000.00

1,000.00

2,000.00

0.50

2,000.00

2,000.00

666.67

1,333.33

666.67

0.50

2,000.00

1,000.00

333.33

666.67

1,333.33

0.50

2,000.00

CONCLUSION

Additional Retained Additional Dividends Debt/Equity

2,000.00

A firm must endeavor to establish a dividend policy that maximizes shareholders wealth.
Mostly it is believed that if a firm does not have investment opportunities on its plate, it should return /

distribute funds to shareholders.


It is not necessary to pay out everything but firm may wish to stabilize the dividends.
There must be preference for dividend.
It appears realistic to have some value associated with modest dividend as compared to nothing.

FINANCIAL PLANNING & FORECAST


BUDGETS FUNCTIONS AND PREPARATION OF BUDGET

CASH BUDGETS:
- SALES FORECAST
- DIRECT COST FORECAST / ESTIMATE
- OTHER RECEIPT & DISBURSEMENT
- NET CASH FLOW

CASH FLOW STATEMENT ACCOUNTING:


INDIRECT METHOD IAS DEFINITION
PARTS OF CASH FLOW
ANALYZING CASH FLOW

- FORECAST FINANCIAL STATEMENTS


PLANNING PROCESS:
Identify objectives or targets
Develop Courses Of Action To Achieve Objectives
Evaluate every alternative
Choose a course of action strategy to achieve
Implement a plan
Lead to controlling

CONTROL PROCESS
Plans put to operation last stage of planning
-Actual results are recorded
-Actual results are compared with actual
-Feedback is prepared
-Two types of Feed back
-Negative

Feed back
-Positive Feed back
-Feedback is used to change the strategy
-Feedback & feed forward control
WHAT SORT OF CORRECTION CAN BE MADE

CHANGE THE STRATEGY OR COURSE OF ACTION:


If something went wrong with strategy, the course of action is fine tuned or changed to ensure

future actual results conform to original plan.


DO NOTHING:
If the results are in line with the planned, no action is required.

CHANGE THE PLAN:


Targets or plan itself is revised rather than changing strategy. For example the targeted profit is

scaled down.

BUDGET AS PLANNING & CONTROLLING TOOL


Budget:
Transform yours objectives into monetary values.

BUDGET PREPARATION PROCESS

BUDGET POLICY & DETAILS

Budgeting committee
Budgeting period
Time
Communicating to all

DETERMINING THE LIMITING FACTOR


(either capacity or sales forecast)

LESSON 24
SALES BUDGET PREPARATION

Sale forecast & Production budget

OTHER ANCILLARY POLICY ISSUES DETERMINATION

Finished goods level


Materials ending inventory
Production cost budget

FUNCTIONAL BUDGETS
NEGOTIATION
MASTER BUDGET OR CORPORATE BUDGET
FINALIZATION OF BUDGET & IMPLEMENTATION
CONTROLLING STAGE
VARIANCE ANALYSIS
Difference between actual and budgeted numbers is known as variance.
INVESTIGATION

PURPOSE & OBJECTIVES OF BUDGET


Path to achieve the corporate objectives
Compel Planning
Increased Responsibility Accounting
Ensures Control
Increased Coordination
Source of Motivation

CASH BUDGETS

A statement that incorporates both inflows and outflows.


Based on the timings of each component.
COMPONENTS OF CASH BUDGET

Non-cash items are not considered.


Every item involving cash is included and considered.
Example: Depreciation is a non-cash items.
Accruals are not taken into cash budgets.
Profits and losses are not related to cash budgets.
Above all the essence of cash budget is the timing of occurrence of every line item.
EXAMPLE

M/S Hi Land Ltd is in the process of preparing cash budget for the 1st quarter of 2007. The following
information is available:
Opening cash balance is Rs. 2,000/Forecast sales are Rs 50,000/- each for Nov. 06 to Jan. 07 and Rs. 65,000 per month for Feb. & Mar. 07.
80% sales is on credit basis and 20% on cash.
Debtors pay after two months from the sale date.
Materials cost will be Rs. 34,000/- for Nov. & Dec. 07 & Rs. 35,000/-, Rs. 36,000/- & Rs. 37,000/- for Jan
to Mar. 07 respectively.
Creditors are paid after one month.
Electricity bill is paid in following month. Dec to Mar. expense is estimated at Rs. 6,000 per month.
Recurring expense will be Rs. 4,000 per month for Nov. & Dec. 06 and Rs. 6,000, Rs 9000 & Rs. 12,000
for Jan. to Mar. 07 and are paid in the month of incurrence.
A new assets will be purchased in Jan 07 for Rs. 12,000/-. payment will be made in Feb. 07.
An old assets will be disposed off in January for Rs. 1,000/- and the receipt will hit the bank on first of
February 07.
Required:
Prepare the cash budget for the first quarter of year 2007 and provide your feedback to the
management.

SOLUTION CASH BUDGET

Nov-06

Dec-06

INFLOWS

Jan-07

Feb-07

Mar-07

Rs.
TOTAL SALES

50,000.00 50,000.00 50,000.00 65,000.00 65,000.00

SALES - CREDIT 80%

40,000.00 40,000.00 40,000.00

SALES - CASH 20%

10,000.00 13,000.00 13,000.00

SALES INFLOW

50,000.00 53,000.00 53,000.00

OTHER RECEIPTS
SALE OF ASSET

OUTFLOWS

1,000.00

TOTAL INFLOWS

50,000.00 54,000.00 53,000.00

MATERIALS COST

34,000.00 34,000.00 35,000.00 36,000.00 36,000.00

CREDITORS PAYMENT

34,000.00 35,000.00 36,000.00

ELECTRICITY

6,000.00

6,000.00

RECURRING EXP

6,000.00

9,000.00 12,000.00

CAPITAL PAYMENTS

12,000.00

6,000.00

TOTAL INFLOWS

46,000.00 62,000.00 54,000.00

NET CASH FLOW

4,000.00 (8,000.00) (1,000.00)

OPENING CASH

2,000.00

ENDING CASH

6,000.00 (2,000.00) (3,000.00)

CASH FLOW STATEMENT

This statement is governed by International Accounting Standard 07.

6,000.00 (2,000.00)

Purpose of Cash Flow Statement is to provide information about the inflows and outflows of cash and
cash equivalents.
Cash And Cash Equivalent has two characteristics:
The inflows and outflows are grouped into three categories.
both readily convertible into cash
without loss of value

CASH FLOW STATEMENT IS DIVIDED INTO THREE CATEGORIES


OPERATING ACTIVITIES
INVESTING ACTIVITIES
FINANCING ACTIVITIES

PURPOSE OF CASH FLOW STATEMENT

To identify and assess the ability to generate future net cash flow from operations to pay debt, interest
and dividends
External financing requirements.
To see the effects of cash & non cash investing and financing transactions.
Assess the reasons for differences between income and associated cash receipts and payments.
METHODS OF PREPARING CASH FLOW STATEMENT
COMPLIANCE OF IAS 07:
DIRECT METHOD BENCHMARK
INDIRECT METHOD ALLOWED ALTERNATIVE

EXAMPLE: INDIRECT METHOD


HI LAND LIMITED
INCOME STATEMENT
For the year Ended December 31, 2005

Less

Rs.

SALES

290,000.00

COST OF SALES

174,000.00

GROSS MARGIN

116,000.00

Less

Less

OPERATING EXP
Administrative Exp

45,000.00

Selling & Marketing

20,900.00

Depreciation

13,000.00

Interest Exp

15,400.00

Gain on Sale of Land

2,500.00

Profit before taxes

24,200.00

Provision for taxes

9,700.00

Net Income

14,500.00

HI LAND LIMITED
BALANCE SHEET
AS ON DECEMBER 31, 2005
2005

2004

Fixed Assets
Land

148,400.00

100,000.00

Buildings

465,000.00

415,000.00

Less: Accumulated Depreciation

(217,000.00)

(205,000.00)

396,400.00

310,000.00

5,000.00

6,000.00

Inventory

175,000.00

153,000.00

Accounts Receivable

109,000.00

90,000.00

Prepaid Expenses

15,500.00

17,000.00

Cash & Bank

50,000.00

55,000.00

349,500.00

315,000.00

Intangible Assets:
Patents

CURRENT ASSETS

Investment - Land

TOTAL ASSETS

27,500.00

750,900.00

658,500.00

Accounts Payable

69,000.00

75,000.00

Accrued Liabilities

24,500.00

20,000.00

93,500.00

95,000.00

200,000.00

200,000.00

CURRENT LIABILITIES

Long Term Liabilities:


Bonds

Premium on Bonds

29,400.00

30,000.00

229,400.00

230,000.00

322,900.00

325,000.00

335,500.00

255,500.00

92,500.00

78,000.00

Total Equity

428,000.00

333,500.00

TOTAL LAIBILITIES & EQUITY

750,900.00

658,500.00

TOTAL LIBILITIES

SHAREHOLDERS' EQUITY
Share Capital
Retained Earnings

HI LAND LIMITED
CASH FLOW STATEMENT
For the Year Ended December 31, 2005
(INDIRECT METHOD)
A

CASH FLOW FROM OPERATING ACTIVITIES

Net Income

Rs.

14,500.00

Adjustment for Non-Cash items:


Add

Depreciation and Amortization

13,000.00

Gain on Sale of Land

(2,500.00)

Operating profit before working capital changes

25,000.00

Change in working capital


Increase in Inventory

(22,000.00)

Increase in Accounts Receivable

(19,000.00)

Decrease in Prepaid Expenses

1,500.00

Decrease in Accounts Payable

(6,000.00)

Increase in Accrued Liabilities

4,500.00

Decrease in Amortization of Bond Premium

(600.00)

Cash Generated from operations

(16,600.00)

LESSON 25
CASH FLOW STATEMENT

Three segments of preparing Cash Flow Statement:


OPERATING ACTIVITIES
INVESTING ACTIVITIES
FINANCING ACTIVITIES

HI LAND LIMITED
BALANCE SHEET
AS ON DECEMBER 31, 2005
2005

2004

Fixed Assets
Land

148,400.00

100,000.00

Buildings

465,000.00

415,000.00

Less: Accumulated Depreciation

(217,000.00)

(205,000.00)

396,400.00

310,000.00

5,000.00

6,000.00

Inventory

175,000.00

153,000.00

Accounts Receivable

109,000.00

90,000.00

Prepaid Expenses

15,500.00

17,000.00

Cash & Bank

50,000.00

55,000.00

349,500.00

315,000.00

Intangible Assets:
Patents

CURRENT ASSETS

Investment - Land

TOTAL ASSETS

27,500.00

750,900.00

658,500.00

Accounts Payable

69,000.00

75,000.00

Accrued Liabilities

24,500.00

20,000.00

93,500.00

95,000.00

Bonds

200,000.00

200,000.00

Premium on Bonds

29,400.00

30,000.00

CURRENT LIABILITIES

Long Term Liabilities:

229,400.00

230,000.00

322,900.00

325,000.00

Share Capital

335,500.00

255,500.00

Retained Earnings

92,500.00

78,000.00

Total Equity

428,000.00

333,500.00

TOTAL LAIBILITIES & EQUITY

750,900.00

658,500.00

TOTAL LIBILITIES

SHAREHOLDERS' EQUITY

HI LAND LIMITED
CASH FLOW STATEMENT
For the Year Ended December 31, 2005
(INDIRECT METHOD)
A

CASH FLOW FROM OPERATING ACTIVITIES

Net Income

Rs.

14,500.00

Adjustment for Non-Cash items:


Add

Depreciation and Amortization

13,000.00

Gain on Sale of Land

(2,500.00)

Operating profit before working capital changes

25,000.00

Change in working capital

Increase in Inventory

(22,000.00)

Increase in Accounts Receivable

(19,000.00)

Decrease in Prepaid Expenses

1,500.00

Decrease in Accounts Payable

(6,000.00)

Increase in Accrued Liabilities


Decrease in Amortization of Bond Premium

Cash Generated from operations

4,500.00
(600.00)

(16,600.00)

HI LAND LIMITED
CASH FLOW STATEMENT
For the Year Ended December 31, 2005
(INDIRECT METHOD)
CASH FLOW FROM INVESTING ACTIVITIES
Proceeds from Sale of Land

27,500.00

Gain on Sale of Land

2,500.00

Purchase/addition to Asset - Building

(50,000.00)

Purchase/addition to Asset - Land

(48,400.00)

Net cash used in investing activities

(68,400.00)

CASH FLOW FROM FINANCING ACTIVITIES


Increase in Common Stock - New shares issued

80,000.00

Net cash (outflow)/ inflow from financing

80,000.00

NET INCREASE/(DECREASE) IN CASH EQUIVALENTS

(5,000.00)

CASH AND CASH EQUIVALENTS AT THE BEGINING OF THE PERIOD

55,000.00

CASH AND CASH EQUIVALENTS AT THE END

50,000.00

Cash Budget Vs. Cash Flow

Cash Budget Pre Operations


Cash Flow Statement Post Operations
WORKING CAPITAL MANAGEMENT

These activities are in sequence:


How much inventory to procure?
Payment to creditors and expenses borrow?
Production of goods/ Manufacturing
Sales credit extension period / Cash sales
Collection of funds and application
OPERATING AND CASH CYCLE

OPERATING CYCLE:
The time between receiving the raw materials and collection of amount against credit sales
from debtors is called Operating Cycle.

CASH CYCLE:
The time period between cash payment and cash receipts.

EXAMPLE:
We buy inventory on credit on Jan. 01, 2006 worth Rs. 10,000/-. settle the creditor on Feb. 01. After a
month (on march 01) a debtor buys the finished goods for Rs. 14,000/- and pays after 1.50 months (on
15th April 2006.
The period from the date of acquisition of inventory Jan. 01, 06 to the date of receipt of cash from
debtor 15th April 2006 is known as operating cycle.
Normally operating cycle is expressed in days. In this example, the length of Operating Cycle is 105
days.
Operating Cycle can be divided into two components:

Inventory period: the period of time it takes to procure, produce and sell the inventory.
In our example, inventory acquisition date Jan. 01, 06 to march 01, 2006 60 days is known as
Inventory period.

Accounts receivable period: the time to recover the sales.


In our example, march 01 to April 15 45 days period is termed as accounts receivable period.
THE CASH CYCLE:

We pay for inventory after 30 days, on Jan. 31.


On this date we have to obtain loan from bank to pay off Rs. 10,000/- because at this date we
have not sold our product which was manufacture from the goods bought (on credit) from the
vendors.
We borrowed on Jan. 31 and will pay on 15th April when we get cash from debtors. Borrowed
for 105-30= 75 days.
This 75 days period is known as cash cycle.
The time period from 1st Jan. to 31st Jan. (30 days) is known as Accounts Payable Period.
WE CAN CALCULATE THE CASH CYCLE AS UNDER;
CASH CYCLE = OPERATING CYCLE A/P PERIOD
75

105

30

EXAMPLE: OPERATING & CASH CYCLE


OPENING

CLOSING

AVG

INVENTORY

2,000.00

3,000.00

2,500.00

DEBTORS

1,600.00

2,000.00

1,800.00

750.00

1,000.00

875.00

CREDITORS

NET SALES

11,500.00

COST OF SALE

8,200.00

OPERATING CYCLE
INVENTORY TURNOVER=

INVENTORY PERIOD

COS/AVG INV

3.28

TIME

365 DAYS/INV TURNOVER

111.28

DAYS

A/R TURNOVER

CREDIT SALES/AVG AR

6.39

TIMES

365 DAYS / AR TURNOVER

57.13

DAYS

(ASSUMED ALL SALES ON CREDIT)

RECEIVABLE PERIOD =

OPERATING CYCLE = Inventory Period +AR Period


168.41 = 111.28 Days + 57.13 Days
CASH CYCLE:
Payable Turnover = COS /Avg. Payable
= 9.37 Times
AP Period = 365 days / AP Turnover = 38.95 Days

Cash Cycle = Operating Cycle Accounts Payable period


129.46= 168.41Days - 38.95 Days
Recap
Two types of Cash Flow:

Pre-Operation Cash Budget


Post- Operation Cash Flow Statement
Difference between Cash Budget & Cash Flow Statement
Statutory Requirement:

Cash Flow Statement: Statutory obligation to prepare CFS in order to compliance with IAS 07.
On the other hand, there is no statutory obligation to prepare Cash Budget.
Format:

Cash Budget based on estimated data. CFS based on actual data. Benchmark is direct method.
Normally CFS also prepare through indirect method.

LESSON 26

WORKING CAPITAL MANAGEMENT


GROSS WORKING CAPITAL = TOTAL INVESTMENT IN CURRENT ASSETS
NET WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES

SIGNIFICANCE OF WORKING CAPITAL

Plenty of funds are invested in current assets.


Considerable time of financial manager is devoted to working capital decision.
Working capital matters are dealt with on day to day basis unlike capital structure or dividend
policy.

Above all, working capital decision effect Risk & Profitability.


Three concepts associated:

RISK
PROFITABILITY
LIQUIDITY
LEVEL OF INVESTMENT
OPTIMAL LEVEL OF CURRENT ASSETSS INVESTMENT:

Adequate or Lowest level of current assets should be maintained that support your sales or
productions that lower your cost.
RELIANCE ON SHORT TERM FINANCING
1- Short term loans carry lower interest rates.
2- Flexibility of short term loan

e.g. Overdraft and Running Finance etc.

This suggest that investment in current assets should be kept low.


High level of Current Liabilities.
Negative Net Working Capital.
This strategy will increase the Risk.
Two Reasons for maintaining Minimum Working Capital Balance:

To fulfill Short Term Obligations.


To support Sales or Production Activities.
CONSERVATIVE WORKING CAPITAL POLICY

High level of investment in current assets.


Support any level of Production and Sales.
High liquidity level.
Avoid short-term financing to reduce risk, but decreases the potential for maximum value
creation because of the high cost of long-term debt and equity financing.
Borrowing long-term is considered less risky than borrowing short-term.
This approach involves the use of long-term debt and equity to finance all long-term fixed
assets and permanent assets, in addition to some part of temporary current assets.
The firm has a large amount of net working capital. It is a relatively low-risk position.
The safety of conservative approach has a cost.
Long-term financing is generally more expensive than Short term financing.
AGGRESSIVE WORKING CAPITAL POLICY

Low level of investment


Support low level of Production & Sales Activity.
More short-term financing is used to finance current assets.
Firm risk increases, due to the risk of Fluctuating Interest Rates, but the potential for higher
returns increases because of the generally low-cost financing.

Borrowing short-term is considered more risky than borrowing long-term.


This approach involves the use of short-term debt to finance at least the firm's temporary

assets, some or all of its permanent current assets, and possibly some of its long-term fixed
assets. (Heavy reliance on short term debt).
The firm has very little Net Working Capital. It is more risky.
MODERATE WORKING CAPITAL POLICY

This approach tries to balance Risk, Profitability and liquidity.


Temporary current assets that are only going to be on the balance sheet for a short time should
be financed with short-term debt, Current liabilities.
And Permanent Current Assets and Long Term Fixed Assets that are going to be on the balance
sheet for a long time should be financed from long term debt and equity sources.
The firm has a moderate amount of net working capital. It is a relatively amount of risk
balanced by a relatively moderate amount of expected return.
In the real world, each firm must decide on its balance of financing sources and its approach to
working capital management based on its particular industry and the firm's risk and return
strategy.
PROFITABILITY AND WC POLICIES
Ranking of Working Capital Policies with regard to Return on Investment:
ROI = NET PROFIT / TOTAL ASSET
OR
ROI = Net profit / (Cash + Receivables + Inventory) + Fixed Assets
While moving from policy Conservative to Aggressive, the profitability will increase.

As the inventory will decrease the return on investment will increase as suggested by the above
equation.
Under Aggressive policy, profitability is greater than Conservative.
LIQUIDITY & PROFITABILITY

lenders prefer a company having:

Large excess of current assets over current liabilities.


Whereas the owners prefer a high return.

Current assets have the advantage of being liquid, but holding them is not very profitable.
Accounts Receivable earns no return.
Inventory earns no return until it is sold.

Non-current assets can be profitable, but they are usually not very liquid.
Firms are usually faced with a trade-off in their working capital management policy.
They seek a balance between liquidity and profitability that reflects their desire for profit and
their need for liquidity.

RISK & RETURN OF CURRENT LIABILITIES

A firm's working capital is financed from:


Long-term borrowing
Short-term borrowing,
Spontaneous

The choice of the firm's working capital financing depends on manager's desire for profit
versus their degree of risk aversion.

The balance between the risk and return of financing options depends on the firm, its financial
managers, and its financing approaches.

OPTIMAL LEVE OF CURRENT ASSETS

A firm's optimal level of current assets is reached when the optimal level of
Inventory
Accounts Receivable
Cash or Cash equivalent

and other current assets is achieved.


PROJECTING THE ALL THREE POLICIES
CONSERVATIVE = A

MODERATE = B
AGGRESSIVE = C

LIQUIDITY

PROFITABILITY

RISK

HIGH

NOR

LOW

THE CHART TELL US TWO THINGS

Profitability varies inversely with Liquidity;

Increased Liquidity can be achieved at the expense of (decreased) Profitability.

Profitability & Risk have same direction;

In order to have greater Profitability, we need to take greater Risk.

CONCLUSION
Optimal level of each current asset will depend on the managements attitude towards Risk &
Return.

LESSON 27

CLASSIFICATION OF WORKING CAPITAL

Classification by Component:

Like Cash, Receivables, Inventory, Investments (Short Term)

Classification by Time:

Like Temporary Current Assets & Permanent Current Assets

Temporary Working Capital

- is the amount of current assets that varies with short term seasonal requirements.

Permanent working capital is the amount of investment in current assets that is required to support
the minimum long term needs.

CURRENT ASSETS FINANCING


Short Term & Long Term Investment Mix:

A trade off between risk and profitability is required when we are faced with current assets
financing decisions.

It is assumed that a company has a definite policy vis--vis payment to creditors, taxes And
expenses. The reason being that a firm cannot stretch these outflows by a reasonable time
period.
Short Term & Long Term Investment Mix:

In other words, creditors / accounts payable and accruals are dormant decision variables when
it comes to current asset financing.

These current liabilities are known as spontaneous financing.


Residual policy have different approaches for financing.
How mix develop to finance temporary current assets and permanent current assets?
Hedging approach to Current Assets Financing

Each asset will be offset with a financing instrument having same maturity.
Temporary current assets should be financed with short term debts.
Permanent portion of current assets (and all non current assets) should be financed with long
term loans and equity.
NEXT PAGE

GRAPHICAL VERSION OF HEDGING POLICY

Only short term variations would be financed through short term loans.
If we finance this portion through long term loans, then we will pay interest on loan when actually
funds are not needed.
Short term loan/financing is flexible.
Short term loans shall only be employed in the period of seasonal lessened activity.
We pay off the loan liability when not needed to avoid interest cost.
Borrowing and payment of short term loans can be arranged to correspond to the expected ca
variations.
On Eid, (increased activity) inventory will increased and that increase shall be financed through short
term borrowing.
Inventory will squeeze due to increased sales and receivables will expand.
That cash used to pay off the loan (and creditors) now comes through collection of accounts
receivable.
Short term loan to support seasonal need would generate necessary cash to repayment in normal
course of operation.
This is known as Self-Liquidating Principle.

Short Term Vs Long Term Financing

Under uncertainty, net cash flow will not exactly match the maturity of debt.
This aspect is of crucial importance when it comes to risk and profitability trade off.
What should be the Margin of Safety to allow for adverse variation in expected cash flow?

THE RISK

Shorter the maturity date of debt, the greater the risk of default of
Repayment of Principal
Interest cost

Renewal or Roll over at maturity: If short term financing used to fund long term assets. Result long
term assets will generate cash flow in the long term. but you have to repay short term loan in short
period
Problem of liquidity
Resultantly short term debt may not get renewal or roll over at maturity.
Committing funds to long term asset from short term borrowing carries risk of lenders calling back
loans early.

SHORT TERM INTEREST RATE


Short term interest rates comparatively less than long term rates
But more fluctuations in short term rate than long term interest rates.

TRADE OFF

The longer the maturity date, more costly the financing is.
Long term debt carries higher interest cost.
A company may pay interest on loan even when funds are not needed.
Trade off between Risk & Profitability.
Short term debt has more risk than long term but less costly.
The trade off is the lag between the expected cash flow & payment of debt.
The Margin of Safety will depend of managements risk preference.
And managements decision regarding the maturity of debt will determine the portion of current
assets financed by current liabilities and Portion to be financed on long term basis.

CONSERVATIVE POLICY

Firm finances a part of seasonal fund requirements less accounts payable on long term basis.
If cash flow estimates do not deviate far from actual, it will pay interest on debt (shaded area) when
actually funds are not needed.
Higher the long term financing line, more Conservative Policy and higher cost.

AGGRESSIVE POLICY

The company must arrange renewal of short term debt. It involves risk.
The greater portion of permanent current assets is financed with short term debt, more
aggressive policy it is.

Expected margin of safety regarding short term and long term financing can be positive,
negative or neutral.
Margin of safety can be increased by more financing in the liquid assets.
Risk of cash insolvency can be reduced by stretching the maturity schedule of debt or carrying
larger amounts of current assets.

WORKING CAPITAL POLICIES

Aggressive Policy
Conservative Policy
WORKING CAPITAL MANAGEMENT

Guiding force:
Management attitude (Planning Process)
Vision about money market, business etc.
LESSON 28
WORKING CAPITAL MANAGEMENT

Factors affect working capital management


Profitability
Liquidity
Risk
Management attitude
Interest cost
Long term
Short term

DETERMINING W-C REQUIREMENTS: EXAMPLE

The following information pertains to M/S No-one Limited:


Estimated Turnover
Direct cost:
Direct materials
Direct labor
Variable overheads
Fixed overheads
Selling & admin

WORKING CAPITAL REQUIREMENTS

Rs. 1,000,000/25%
20%
10%
10%
5%

Credit terms are as under:


Direct Materials
Direct Labor
Variable Overheads
Fixed Overheads
Selling & Admin.

2 Months
1 Month
1.5 Months
2 Months
1 Month

Average duration/turnover:
Accounts receivables take 2 months before realization.
Raw materials are in stock for 4 months.
WIP represents one month production 50% complete.
Finished good represents 1.5 months production.
WIP & FG are valued at material, Labor & VOH Cost.
Compute the working capital requirements of the company.

WORKING CAPITAL REQUIREMENTS

Estimated Turnover
1 Annual Cost Of Cost Items:

1,000,000.00
% Of Turnover

Annual Cost

Direct Materials

25

250,000.00

Direct Labor

20

200,000.00

Variable Overheads

10

100,000.00

Fixed Overheads

10

100,000.00

Selling & Admin

50,000.00

2 Average Value Of Current Assets

Raw Materials

Period
4 months in
stock

Work in Process

83,333.33

22,916.67

Direct materials

50% complete

10,416.67

Direct labor

50% complete

8,333.33

Variable overheads

50% complete

Finished Goods

4,166.67

68,750.00

Direct materials

1.5 month
production

31,250.00

Direct labor

1.5 month
production

25,000.00

Variable overheads

1.5 month
production

12,500.00

166,666.67

Accounts Receivable

Gross Working Capital

341,666.67

3 Average Value Of Current Liabilities


Direct materials

41,666.67

1 month

16,666.67

1.5 months

12,500.00

Fixed overheads

2 month

16,666.67

Selling & admin

1 month

4,166.67

Direct labor
Variable overheads

91,666.67
4 Net Working Capital=
Current Asset - Current Liabilities

341,666.6791,666.67

250,000.00

Average Value Of Current


Liabilities
Direct materials

41,666.67

1 month

16,666.67

1.5 months

12,500.00

Fixed overheads

2 month

16,666.67

Selling & admin

1 month

4,166.67

Direct labor
Variable overheads

91,666.67
Net Working Capital=
4

Current Asset - Current Liabilities

341,666.6791,666.67

250,000.00

OVERTRADING

It occurs when a company tries to do too much with too little long term capital.
In other words, a firm is trying to satisfy huge level of sale or productions from lowest level of
inventory.
This liquidity problem emerges from the situation when a firm does not have enough cash flow to
pay off the debt.
INDICATIONS

Rapid increase in Turnover/Sales, current assets (and may be in fixed assets)


Payments to creditors are stretched.
More reliance on short term finances.
Proportion of assets financed by equity is decreased and vice versa.
Liquidity Deteriorates.
Results in negative Net Working Capital.
Debt equity ratio changes significantly.
How to get ride off Over Trading?
Injected fresh capital
Revised strategy in short run -trimming unnecessary plans.
Control over Inventory and Debtors.
Individual Component of Working Capital:

Cash

Inventory
Receivable
CASH MANAGEMENT

Motive to hold cash:

TRANSACTION MOTIVE
PRECAUTIONARY MOTIVE
SPECULATIVE MOTIVE

How much cash or cash equivalents a company should hold?

Holding too much cash or near cash items has a cost in terms of Loss of Earnings
Liquidity and profitability trade off is of crucial importance to a financial manager.
CASH FLOW PROBLEMS

Growth
Seasonal business: Like on Eid and Religious occasions, the business activity increases.
Capital expense or one-off expenditure.
Loss Making
HOW TO IMPROVE CASH FLOW
Float:
Decreasing the receipt Float.
Deferring Capex and developmental work.
Early recovery of cash flows.
Liquidate Short Term Investments.
Deferring payments to creditors.
Rescheduling loan payments.
Planning is of vital importance especially rolling cash budgets.

Investing Surplus Cash Flow

Important factors:
Liquidity
Profitability
Safety

Maturity early liquidation penalty?


INVENTORY APPROACH TO CASH MANAGEMENT

Two types of costs involved in cash holding:


FIXED COST
To raise loans or capital.

VARIABLE COST
Opportunity cost, surrendering the return by investing money.

ECONOMIC ORDER QUANTITY

Q=2FS/I
Where:
S= Amount of consumption or demand in each period
F= Fixed cost of obtaining new funds
I = Interest cost of holding cash
Q= Optimal cash holding level

EXAMPLE
Liquid Limited has a fixed cost at present of Rs.10,000 to seek fresh finances. Per cash budget, the cash
requirements for the next 4 periods of a year each would be Rs. 100,000. The interest cost of fresh
finances will not be less than 14%. Interest on deposits at present is 8%.
How much finance should the firm raise at a time?

SOLUTION
HOLDING COST =14% - 8% = 6%
OPTIMUM LEVEL OF Q

= (2 x 10,000 x 100,000 / 0.06)


= 182,574
This is for 182,574/100,000 = 1.83 years. In other words, this amount is enough for almost two years.
(Almost. 1.83 is rounded off)

DRAWBACKS OF EOQ APPROACH


You cant predict future cash requirements with certainty.
There are many cost associated with running out of cash which are not considered.
There may be some other cost of holding cash which increase with the average amount held.

LESSON 29

MILLER-ORR MODEL OF CASH MANAGEMENT

There would be some upper limit or lower limit of cash balance movement.
Miller-Orr Model tries to establish optimal cash holding between the upper and lower limits of cash
balance movements.

MILLER-ORR MODEL

When cash balance reaches point A, the upper limit.


Company will invest the surplus to bring down the cash balance to return point.
When cash balance touches down point B, the lower limit.
The company would liquidate some of its investment to bring the balance back to return point.
How the upper and lower limits are determined?

Spread

Spread is the difference between lower limit and upper limit.

Variations depends on three factors:

Variance of Cash Flow


Transaction Cost
Interest Rate
Steps to be followed to use MILLER-ORR MODEL

Determine lower limit for the cash balance. This may be zero.
Calculate cash flow variance on daily basis. This sample size may be of 100-days period
Observe the interest rates and note the transaction costs
Calculate the upper limit and return point.
EXAMPLE: MILLER ORR MODEL
Minimum cash balance is Rs. 100,000/ Daily cash flow variance is Rs. 2,000,000/-.
Transaction cost of selling & buying securities is Rs. 500/-.
Interest rate is Rs.9% per annum.
Required: Work out the upper limit and return point using miller model.
SOLUTION
Spread = 3(3/4 x ((TC x V)/I)1/3

Where:
TC = Transaction Cost
V = Cash Flow Variance
I = Interest
Putting values:
= 3(3/4 x ((500 x 2,000,000)/(0.09/365) 1/3
Spread = 42,855.12

Now we can calculate the Upper Limit and Return Point:


Upper Limit = Min Cash Balance + Spread
= 100,000 + 42855.12
= 142,855.12

Return Point = Min Cash Balance + 1/3 x Spread


= 100,000 + (42855.12)x 1/3
= 114,285.04
DECISION

If cash balance reaches 142k buy securities worth of (142 114 =28k)

And if cash balance fall to 100k, sell securities worth 14k to get back to Return Point.

MANAGEMENT OF INVENTORY
There are three types of Inventories:

Raw materials inventory


Work in process inventory
Finished good inventory
SIZE OF ORDER
CONTROL OVER INVENTORY
EOQ is used to determine the optimum size of stock purchase in order to reduce the inventory
costs.
DISCOUNTS
If discounts are available on stock purchase, then EOQ would not be considered. Need to work
out net benefit.

INVENTORY COSTS

HOLDING COST
ORDERING COST
SHORTAGE COST
HOLDING COST CONSISTS OF:

Investment in stocks
Warehousing cost
Handling cost
Insurance cost
Pilferage cost
ORDERING COST

Delivery cost
SHORTAGE COST CONSISTS OF:

Contribution from lost sales


Increased cost of emergency stock

Cost of change in customers loyalty or future cash flow deterioration cost.


HOLDING COST DEFINED

In business management, holding cost is money spent to keep and maintain a stock of goods in
storage.
The most obvious holding costs include rent for the required space; equipment, materials, and labor
to operate the space; insurance; security; interest on money invested in the inventory and space,
and other direct expenses.
Some stored goods become obsolete before they are sold, reducing their contribution to revenue
while having no effect on their Holding cost.
Some goods are damaged by handling, weather, or other mechanisms. Some goods are lost through
mishandling, poor record keeping, or theft, a category euphemistically called Shrinkage.
Holding cost also includes the opportunity cost of reduced responsiveness to customers changing
requirements, slowed introduction of improved items, and the inventory's value and direct
expenses, since that money could be used for other purposes.
ECONOMIC ORDER QUANTITY

This is the optimal size of material per order that will minimize the cost.
We can use the following formula for EOQ:
EOQ = 2xC0 x D/CH

Where:
D = stock consumption
P = Purchase price
C0 = Cost of placing one order

CH = Holding cost per unit of stock in one period

Q = Reorder Quantity
EXAMPLE: ECONOMIC ORDER QUANTITY

Demand of a raw material is 80,000 kg per year. The ordering cost is Rs. 90 per order.
Holding cost per kg is estimated at Rs. 4.
Calculate the following:
The order size to minimize the stock costs.
Number of orders per year.
Length of stock cycle.
SOLUTION

a) Order Size:
EOQ = 2xC0xD/CH
= 2 x 90 x 80,000/4
= 1897 Or 1900 Kg

b) Order Per Year:


= Annual Demand / Economic Order Size
= 80,000 / 1900 = 42.10 Orders
c) Stock Cycle will be:

= 365 / 42

= 9 Days (Rounded Off)


RE-ORDER LEVEL

Re-order level is the stock level (in kg) when replenishment order should be made.
Time period involved between placing an order and receiving the order. This is known as Lead Time.
Placing order after the stock runs out may result in loss of sales and loss of cash flow.
Placing order to late and too soon have costs.

SAFETY STOCK

Safety Stock: Inventory stock held in reserve as a cushion against uncertainty in usage and/or lead
time.
Price Breaks Discounts & EOQ:
Business always tries to save cost in order to increase profitability. When a vendor offers discounts
(Price breaks) for buying a specific quantity which is not in line with the EOQ, then business has to
consider the net saving.
Increase in order size does increase inventory costs but if that cost is off-set by the purchase cost
beyond that increase, then EOQ is not financially feasible.
EXAMPLE: PRICE BREAKS
Demand of a raw material is 80,000 kg per year. the ordering cost is Rs. 90/- per order. Material is priced
at Rs. 100 per kg. Holding cost per kg is estimated at 2% of purchase price. The vendor offer 5%
discount if the minimum order size is 5000kg. What do you suggest to the firm?
Solution:
EOQ = (2 x 90 x 80,000)/2% (100) = 2683 Units

A- NO DISCOUNT

Purchase Cost

= 80,000 x 100

= 8,000,000.00

Holding Cost

= 80,000 x (2% x 100)

= 160,000.00

Order Cost
Total Cost

= 42.10 X 90

3,789.00

= 8,163,789.00

Per Kg Cost = 963789/80000 = 102.05 /Kg

B- When Discount is 5% on Qty order of 5000 Units:

Total Orders

= 16 Orders

Annual Demand / 5000


=80,000 /5,000

Purchase Cost

= 80,000 x (100-5%)

= 7,600,000.00

Holding Cost

= 80,000 x (2% x 95)

= 152,000.00

Ordering Cost

= 16 x 90

= 1,440.00
= 7,753,440.00

Total Cost
Cost Per Kg = 913440/80000 = 96.42 / Kg

SAVING UNDER OPTION B:

Per unit price before discount

= 102.05

Per unit price after discount

= 96.42

Per unit saving

Annualized saving

5.63

= 80,000 x 5.63 = 450,400

STOCKOUTS

STOCKOUTS: The situation when a firm runs out of stock which results in shutdown of slow down of
production / sales.

In order to avoid stock out situation, a safety stock level should be procured and maintained.
LESSON 30
EXAMPLE: STOCK OUT
Five Star Limited consume 100,000/- kg per year. each order is for 5000 kg and stock out is 2000 units.
The stock out probability acceptance level is set to 10%. per unit stock out cost is Rs. 5/-. Holding cost is

estimated at Rs. 2/- per kg. being an inventory manager, determine stock out cost and amount of safety
stock to be kept on hand.
STOCKOUT COST =
= AC / Q x S x Sc x Ps
Where:
AC = Annual Consumption
Q = Order Quantity
S = Stock out in Unit
Sc = Stock out Unit Cost
Ps = Accepted Probability of Stock out
Plugging values, we get
= 100000/5000 x 2000 x 5 x 0.10
= 20,000/SAFETY STOCK LEVEL
Let X = Safety Stock

Then,
Stock out Cost = Carrying Cost x Safety Stock
= 20,0000 = 2 * X
X = 20,000 /2
= 10,000 UNITS

ECONOMIC ORDER POINT


EOP is the level of inventory that signals the time to place re-order of materials using EOQ amount.
Safety stock is considered in the calculations.

Where

EOP = SL + F S x EOQ x L
S= Consumption Per Period
L= Lead Time
F= Stock out Acceptance Factor
EOQ = Economic Order Quantity

ECONOMIC ORDER POINT

S = 2000 Units
EOQ = 60 Units
L = 1/4 Month
F= 1.10 (This Represents The Stock out level of say, 10%)
EOP = SL + F S x EOQ x L
= 2000 x 1/4 + 1.10 2000 x60 x 1/4
= 691 Units

Financial managers must try to establish inventory level that results in greater savings.
QUESTION: A company is in process of re-visiting its inventory policy. The current inventory turns over
18 time per year. Variable costs are 75% of sales value. If inventory levels are increased the company
anticipates additional sales and less of an incidence of inventory stock outs. the rate of return is 14%.

Actual and estimated sales & inventory levels are as under:


SALES

TURN OVER

750,000

18

810,000

15

890,000

12

960,000

REQUIRED: Work out the level of inventory that results in highest saving.

SOLUTION: INVENTORY COST SAVING


Sales

Turn

Avg.

Opportunity Additional

Net

Over

Inventory

Cost

750,000.00

18.00

41,666.67

810,000.00

15.00

54,000.00

890,000.00

12.00

960,000.00

9.00

Rate of Return

0.14

Contribution Margin

0.25

Profit

Saving

1,726.67

15,000.00

13,273.33

74,166.67

2,823.33

20,000.00

17,176.67

106,666.67

4,550.00

17,500.00

12,950.00

GRAPHICAL INVENTORY COSTS

JUST-IN-TIME (JIT)

Zero inventory level.


Order the goods on daily basis.
it results in reducing inventory costs near to zero.
Better control over spoilage and shrinkage / reduction in wastage.
JIT is possible only when vendors are located very close to business premises or production
facility.
This means that Lead Time is around couple of hours.

Very sensitive issue. Greater probability of Stock outs. May turn the overall benefits to losses.
May not be feasible for every business. Some business may maintain some inventory items on
JIT and others on EOQ etc.

DEBTORS MANAGEMENT
Significant funds are invested in debtors.
Debtors are important factor / element of Cash Cycle.
Interest cost is associated with offering credit to debtors.
Debtors are measure in days.
Investment in debtors
CREDIT CONTROL POLICY: COMPONENTS

Extending credit to customers requires careful planning and to devise policy and procedures.
Credit policy set up requires dealing with:
Terms of Sale
Credit Analysis
Collection Policy

Lets discuss each component in detail.


1. TERMS OF SALE
There are three factors underlying terms of sale:

Credit period to be granted


Cash discount & Period of discount
Credit instrument
CREDIT PERIOD:

Credit period will vary from firm to firm, industry to industry and business to business.
normally the range is 30 to 120 days.
If cash discount is offered then period is divided into two components:
Net Credit Period
Cash Discount Period
Credit period begins from the invoice date. This represents the dispatch of goods to buyer.
Many terms are used:
ROG= RECEIPT OF GOODS
2/10, NET 30
2/10, EOM
CREDIT PERIOD
Factors influencing credit period:

Buyers Inventory Period


Buyers Operating Cycle
Operating Cycle can be divided into two parts:

Inventory Period
Accounts Receivable Period
Inventory Period:

The period of time it takes to procure, produce and sell the inventory to the debtors.
Accounts Receivable Period:
The time to receive the cash from the debtors.
Main Points to keep in view

If sellers credit extension period exceeds the buyers inventory period, then seller is not only
financing the buyers inventory purchases but also a part of the receivable as well.
If sellers credit extension period exceeds the buyers operating cycle, then seller is effectively
financing the buyers need beyond the purchase and sale of sellers merchandise.

The other factors that merit consideration are:

Perishability
Collateral
Size of the account
Competition
Customer Type
TERMS OF SALE:
There are three factors underlying terms of sale:
Credit Period to be granted
Cash Discount
Credit Instrument

LESSON 31
CASH DISCOUNTS
For Example: Cost of Credit

The sale terms are 2/10 net 30 for a transaction in the amount of Rs. 100,000/-.
If buyer gives up discount, he pays Rs. 100,000/- on 30th day, and will loose Rs. 2,000/- (100,000 x
2%).
Look, foregoing Rs 2,000/- may look small but lets annualize it and express it in %age:
2,000/98,000 = 0.020408 or 2.0408%

Note this is for 20 days.


For computing the loss of not taking discount on annual basis:
We will have 365/20 = 18.25 20 days period in one year.
EAR = (1.020408)18.25 = 44.58%
This is only for Rs 2,000 on Rs 100,000. you can well imagine the business activity that runs in
million of Rupees.
For seller, shorten the average collection period by offering discounts.

SHORTENING ACP

A firm has 30 days collection period and it is offering terms of 2/10, net 30 and estimates that around
50% customers will avail this opportunity by paying within 10 days. Remaining 50% will pay after 30
days. Now the ACP will be as follows:
50% x 10 Days + 50% x 30 Days = 20 Days

If average sales are Rs. 2 Million per month, then receivable:


Rs. 2 Million x 1/3 = 666,666.00

CREDIT INSTRUMENTS

There are two types of Credit Instruments


INVOICE
DISPATCH NOTE

ANALYZING CREDIT POLICY


Following factors to be considered:
Revenue effects:
Granting credit period results in delayed revenue receipts. Offering discounts may or may not be
utilized by the customers. Firm may charges higher prices for longer period and may increase
revenue.

Cost effect:
Whether firm sells on cash or credit it has to pay for the cost of sale. Payment to firms creditor
rests on the cash to be received from debtors.

COST OF DEBT:
When a firm extends credit to customers, it must finance the resulting receivable. Cost of short
term borrowing is an important factor in the decision to grant credit to customers.

PROBABILITY OF DEFAULT:
Chances of default or bad debt are always there.

DISCOUNTS:
When firm offers discount to customers, there is a cost when some customers choose to pay
early to seek discounts.

CONSIDERING EXTENSION OF CREDIT

The increased sales that can be stimulated.


Profitability of extra sales.
Required Rate of Return on extra sales.
Effect on Average Collection Period.
EVALUATING CREDIT WORTHINESS OF CUSTOMERS

A firm who intends to grant credit to customers must seek information about the customers
reputation and credit worthiness.

There are several information sources commonly used.

Financial statements of vendor


Market reputation
Banks
Financial strength
General economic conditions in vendors industry.

COLLECTION POLICY

Monitoring of ACP
Control
Aging Schedule
A compilation of accounts receivable by the age of each account..

Collection effort for overdue Or Delinquent accounts


DEBTORS MANAGEMENT
Mini Case Study

A firm is considering to change existing credit policy which will increase the Avg. Collection Period from
one month to two months but it will ensure 20% increase in sales.
Selling Price Per Unit
Rs 12/Variable Cost / Unit
Rs. 10.20

Existing Annual Sales

Rs. 2.00 M

Required Rate of Return is 15%.


25% increase in sales will result in additional investment of Rs. 150,000 in stocks and additional
creditors of Rs. 40,000/Advise the firm whether to change the existing policy if:
The existing customers take two month credit period, and
Only new customers only take two month credit.
Solution: Debtors Management
Sale Price

12.00

Variable Cost

10.20

Sales

2,000,000.00

Return

15.00

Contribution Margin

1.80

Contribution /Sale Ratio

15.00

Increase

1.20

Inc. In Stock

150,000.00

Inc. In Creditor

40,000.00

Particulars
Extra contribution

Amount in Rs.
15.00

Increase in sales - 20%

400,000.00

Increase in cont. margin

60,000.00

ALL CUSTOMERS TAKE TWO MONTHS CREDIT

Total turnover after 20% increase

2,400,000.00

Avg. debtors - 2 months

400,000.00

Existing debtors 1 month

166,666.67

Increase in debtors

233,333.33

Increase in stocks

150,000.00

Less: increase in creditors

40,000.00

Net increase in working capital

343,333.33

ROI ON EXTRA INVESTMENT

17.48

B ONLY NEW CUSTOMERS TAKE 2 MONTH CREDIT

Increase in sales

400,000.00

Increase in debtors

66,666.67

Increase in stock

150,000.00

Less: increase in creditors

40,000.00

Increase in net working capital

176,666.67

ROI ON EXTRA INVESTMENT


In both cases new policy look favorable and financially viable.
DISCOUNTS

33.96

Evaluate the Discounts.


More precisely, we must work out what level of discount can be offered to debtors for early
payment.
The other aspect would be to know the effect of this discount of the sales, ACP and Profit.
This example deals a situation where early payment does not effect the sales.

EXAMPLE DISCOUNT NOT EFFECTING VOLUME


A company has decided to offer 2% discount to customers if they pay the invoice within 10 days. The
current sales level is Rs. 10 million and existing terms are 2 month. This discount offering is only
intended to reduce the credit terms. The company has estimated that around 75% of customers will
avail this opportunity.

Required: If the ROI is 18%, what will be effect of % discount?


Solution: Debtors Management
Sale

10,000,000.00

Discount offered

0.02

Discount validity days

10.00

No of customer to avail discount

0.75

Existing collection time - days

2.00 month

New collection time - days

1.00 month

Return on investment
A)

0.18

UNDER NO DISCOUNT POLICY


Existing volume of Debtors

B)

=10,000,000/12 x 2

1,666,666.67

UNDER DISCOUNT POLICY

622,146.12

75% customers will avail 2% Discount and will pay


i) in 10 days
=10,000,0000 x 75% x 10/365
ii) 25% customer will pay after 2 months

205,479.45

=10,000,000 x 25% x 2/12


Reduction in Debtors

416,666.67
1,044,520.55

Saving on Reduction in Debtors


=1,044,520.55 x 18%

188,013.70

Cost of Discount 2%
=10,000,000 x 75% x 2%
Net Saving under New Policy

150,000.00
38,013.70

EXTENTION OF CREDIT

Not always the companies consider reduction in credit period.


Some time the companies may consider increase in sales by increasing the debtor period.
This increase in extension should be evaluated in terms of value addition.
When cost of extending period is less than the benefit, only when the policy will be accepted.

EXAMPLE: EXTENSION OF CREDIT


M/s Red Cloud Ltds income statement for the period just ended has been presented as under:-

Sales
Cost of sales
Gross profit
Bad debts
Profit

2,100,000/1,470,000/630,000/31,500/598,500/-

The management is contemplating a strategy of easing the credit terms by extending the
current one month collection period to two month. The new policy details are as under:
Increase in sales under new policy will be 20% over and above the current level.
Average collection period will be two months
Bad debts will also increase to 3% from existing 1.5% level.

Other details:

Cost of sales are 80% variable and 20% fixed. Fixed portion will not increase when sales will increase
by 25%. Stock and creditors level will remain unchanged.
Do you think the New Policy is worth undertaking?
Solution: Debtors Management

ROI

0.15

Existing Bad Debt

0.02

COS Var.

0.80

COS %

0.70

COS Fix.

0.2

New Bad Debt Level

0.03

Inc. in Sales

0.2

Var. COS

0.56

C/S

0.44

Existing sales

2,100,000.00

Cost of sales

1,470,000.00

Gross profit

630,000.00

Bad debt

31,500.00

Net profit

598,500.00

Variable Cost of sales

COS=1470000 x Variable Portion of 80%

1,176,000.00

Cont Margin

= 2,100,000 - 1,176,000

924,000.00

C/S ratio

= 924,000 / 2,100,000

0.44 or 44%

Increase in Contribution Margin Sales=2,100,000 x Inc. 20%x C/S Ratio 0.44

Increase in Bad Debts


Increase in Profit

= Sales 2.1m X Increase (1+0.2)xBad Debt


- BD=31,500

184,800.00

0.03
44,100.00
140,700.00

Intended investment in debtors (New Sales (2.1 million + 20%) /12) x 2

420,000.00

Existing investment in debtors

175,000.00

= 2.1million / 12

Additional investment required

245,000.00

Cost of Additional Investment

= 245,750 x ROI 15%

36,750.00

Net Benefit

=140700 - 36750

103,950.00

LESSON 32
Factoring
A firm may employ a specialized entity to manage account receivables.
This specialized entity is called Factor.
Main function of a factor is to collect the accounts receivables on behalf of seller but may also
involve in invoicing and sales accounting.
Factor makes advance payments to seller in return for commission of certain %age of total debt.
This is often referred as Factor Financing.
In case of action against defaulters, factor initiate action.
Factor also take over the risk of loss in case of bad debt.
This type of factoring is known as Non-Recourse.
Significant positive effect on cash cycle.
Ensuring early payments to vendors and benefit of obtaining early payment discounts.
Optimum stock level can be maintained.
Financing (Factor) is directly linked to level of sales/accounts receivables.
Reduction in collection expense and staff payroll costs.
May prove much expensive

May have adverse effect on customers loyalty. (Factors attitude may be harsh with customers) and
may tarnish companys image.

Example: Factoring

A company is considering to seek the services of a factor because of poor collection of debtors
which has pushed up the ACP from 30 days to 45 days coupled with bad debt of 1% of annual
sales. Sales are Rs.1.80 Million.
With factoring in place, the company will save Rs. 25,000 per year on account of debtors
administration and collection costs, bring down ACP to 30 days but will cost 2% of sales.
Factor will provide 80% on invoice value of sales and will charges 11% interest. Rest 20% shall be
paid after 30 days. The company can obtain short term loan @ 10%. Sales are assumed evenly
spread over the months.
Required: Evaluate the Policy?
Debtors Management
Solution: Factoring
Cost Data
Credit Sales Annual

1,800,000.00

Current ACP Days

45.00

Cost of Short Financing

0.10

Bad Debts (1%)

0.010

Factor Financing (80%)

0.800

Factor Financing Days

30.000

Factor Fee (2%)

0.0200

Factor Financing Charge

0.110 or 11%

Existing Cost Components


Current Annual Cost

22,191.78

=Sales 1.8Million x 45/365 x 10%

Bad Debts 0.1%

18,000.00

= 1.8M x 1%

Administration Cost

25,000.00

Total Existing Cost

65,191.78

Cost of Factoring
Factor Financing Cost

13,019.18

= (1.8Million x 80%) x 30/365 x 11%

Factor will provide 80% Finance, 20% will be through Short Term Financing:
Short Term Financing Cost

2,958.90

= (Sale 1.8M x 20%) x 30/365 x 10%

Cost of Factoring

36,000.00

= Sales (1.8M) x 2% Factor Fee

Total Cost of Factoring

51,978.08

Net Saving

13,213.70

Solution

We need to work out the total cost of employing factor and saving thereof.
In this case the comparison is between the existing cost of debtor administration and cost of
factoring.
If the later is less than the former, then we will accept or implement the new policy, otherwise
not.
It is Current Cost Vs Factor Cost

CREDITORS MANAGEMENT
MANAGEMENT OF CREDITORS

OR

Example: Creditors Management

A vendor has offered credit terms of 2/15, net 50 to M/s ABC Limited. The company can invest
in Short Term Securities @ 24%. The average creditors level is Rs. 100,000.
Evaluate the offer from vendor.
Example: Creditors Management
If ABC Ltd refuses discount and pay after 50 days, then interest cost will be:
= ( D /100 D ) x 365/ T

21.28

= 2/( 100 2 ) x 365 / 35


D = Days in terms when Discount is valid
T= Reduction in days if Discount availed

Discount 2%

Discount Validity Days

15

Reduction in days is discount taken

35

Total Days

50

Average Creditors
Short Investment Return

100,000.00
24

Accept Discount
Saving will be 2% of Avg. Creditors

2,000.00

Discount is Declined
ABC can invest the money in Short Securities
For 35 days to earn @ 24%

2,301.37

Benefit of Rejection is > Discount


It is better to Decline the Discount.

Mergers and Acquisitions

Combination of two business for increasing the value of business through Synergies in the form
of Acquisition or Merger.
A process of accruing an other company.
Acquisition is also known as takeover. (Purchase Merger)
Mergers may be termed as Amalgamation. (Also consolidation Mergers)
Two businesses become single entity after Merger or Acquisition.
We will use combination for both Mergers and Acquisitions.

Vertical Mergers
Purpose of Combinations

Main purpose of combinations is to cultivate Synergies.


Synergy is a force that creates enhanced cost efficiencies when two business Merge.
The increase in efficiency of production as the number of goods being produced increases. Typically,
a company that achieves economies of scale lowers the average cost per unit through increased
production since fixed costs are shared over an increased number of goods.

Sources of Synergies are as under:


- Scale of Economies
- Staff Reduction/Cost Cutting
- Financial Strength
- Market/Distribution Network
- Acquisition of New Technology

Synergy from Operational Economies


Horizontal Combination:

When two companies in similar business combine horizontal combination, to reduce cost and
increase profit / value due to large economies of scale.
In other words both companies are in Direct Competition and have same product line but may or
may not have same markets
Vertical Mergers:

This may be eliminating backward or forward Integration. This type of Mergers increase value by the
middleman/level.

LESSON 33
COMPLIMENTARY RESOURCES

Economies of scales can also be cultivated when companies have complimentary strengths and utilizing
both under a new / combined platform.

Financial Synergy

Growth of the Business.


From a shareholders point of view, theres no gain in merger when operating economies are
absent.
Even if there are no value addition achieved, yet there is increase in value due to lower risk.
If the future cash flow stream of two companies is not positively correlated then combining the two
will reduce the variability of cash flow or
Will bring stability in cash flow thus may increase the value by having cheaper financing available.
(Lenders and creditors like to have stable cash flow that signals the ability of company to settle its
short term and long term obligations).

Other Synergies of Mergers

Skilled Human Resources


Surplus Cash
Market Power:

Mergers may enable a firm to monopolize the market.


Organic Growth:
Mergers are far faster way of expanding businesses.

Why Mergers Fail?

Over-Optimistic Estimate of Economies


Ignore Human Integration
Expertise
Lack of Communication

Expertise:

The experts involved are expert in finance and skilled in designing combination strategy and are so
involved in pre-acquisition issues that they dont find any time for behavioral aspect of unified
workforce.

CORPORATE CULTURE

The two firms may appear identical in every respect, yet the culture is different and people may not be
learning to work together.

Cultural Difference that stand un-resolved by the new management will leave adverse effects on
communication, decision-making, productivity and inter-se relationship among people.

CORPORATE CULTURE

Inadequate Planning
Lack of Communication
Human Resource Department must be involved in Mergers and Acquisition issue.

TALENT DEPARTURE:
Studies have shown that 50 75% of managers leave the merged entity within 3 years.
LOSS OF CUSTOMERS:
Especially sales/marketing employees may take good customers with them when they depart.
POWER POLITICS:
Power struggle and clashes between the groups of management for seeking power adversely
effect the health of Merger.

Mergers and Acquisition Process

Identifying Potential Targets


Business Due Diligence

Information required for appraisal of Target:

Human Resources

- Management and Expertise/Talent


- Employees and terms of employment
- Benefits Pension & Bonus

All this is required to compare the existing employee terms, remuneration, benefits and talent with the
new ones from Target Company.

Sales & Market Network

Historic sale volumes product-wise, region-wise with market share


- Details of customers & locations
- SWOT analysis, major competitors and their market share

-Marketing strategy

Production and Capacity


- Total capacity and current utilization
- Future extension possibilities
- Capital investment required for Modernization.

Technology
- Existing technical skills
- Research & Development and stage of development
Financial Information
o Accounting Policies
o Details of Assets
o Financial Analysis over the period
o Details of Loans & Overdrafts
o Agreement of Foreign Exchange Covenants
o Details of others modes of debts like Leases
o Tax History & Computations
o Tax liabilities
o Details of dividend & liability
Cultural Due Diligence
Steps involved in culture due diligence

Readiness of company to change


Developing contents of change
Injection of new values
Freezing

LESSON 34
CULTURAL DUE DELLIGENCE
Steps involved in culture due diligence
Readiness Of Company To Change

Contents of Change, Change Agent


Change Management
Implementation and Feedback
Methods of Mergers
1- By Transfer of Assets
2. By Transfer of Shares
These two methods of acquisition can be summarized in following table.

Acquisition
X takes over Z

Transfer of Shares

Transfer of Assets

X acquires shares in Z from the


existing shareholders of firm Z
for cash. Z becomes subsidiary
of X and transfer trade and
assets to holding company X.

X acquires trade and assets of Z


for cash. Firm Z stands
liquidated,
proceeds
are
received by shareholders of old
firm Z.

C acquires share in A & B for C acquires assets and trade


from A & B in return for shares
new shares of C.
A & B merge to
of new company C. Original
A & B become subsidiary of companies are liquidated.
form C
firm C and may transfer trade
and assets to new holding
company.
Merger

Acquisition
Methods & Mode of Consideration
Share & Asset Purchase:
Share Purchase:

It is a complicated option because all of the liabilities need to be owned by the predator
company. There might be some hidden liabilities.

Asset Purchase:

Only identified assets are acquired and Predator is well aware or can work out the market
value of assets.

There may be other reasons for not using shares as consideration.


Dilution:

Existing major shareholders may not wish to dilute their %age for control issue primarily.

Valuation of shares:
Difficulty in valuation of unquoted shares.

Debt/Equity Ratio:

If theres a surge in equity base after a merger, it may be an uphill task to bring back the
optimal D/E ratio.
Valuation of Shares
After the target to acquire has been identified, then the predator must decide how much to pay.
Shares valuations are needed for may reasons:
- For entering stock market
- To establish terms of Acquisitions
- For tax purposes
- To value of shares held by directors
Income Based Methods:
- Present value method
- Dividend Valuation
- Price Earning Ratio

Asset Based Methods:


- Replacement cost method
- Book value method
- Break up value

The most common methods of estimating value have traditionally involved the discounting or
capitalizing of an income stream. In the income approach, variables Such as earnings or cash flows are
utilized as a proxy for the expected benefits to the owners of the business.
In a capitalization model, a representative level of income is capitalized into perpetuity at a
capitalization rate determined by the difference between the appropriate discount rate and a constant,
sustainable level of growth.
In a discounting model, a projection of income is estimated for a finite period, followed by a terminal
value calculation that assumes a constant income growth rate from that point into perpetuity.

Income Based Methods


1. Present Value Method:

Present value of a asset is the value of future earnings discounted at a discount rate representative of
systematic risk of that asset.

For example, firm y is trying to acquire firm Z.


Then the value of firm Z can be determined as under:
Present value of future earnings of combined entity (Y+Z) discounted at a rate representative of
Systematic Risk.
Less: PV of future earnings of Predator firm Y using discount rate appropriate for systematic risk of firm
Y
Is equal to = maximum value of firm Z
Or
PV of Zs earnings at appropriate discount rate.
Subtract costs / add gains of takeover.

Dividend Valuation
We can use No-Growth and Constant Growth Models in Mergers & Acquisitions:
Po = Do/Ke

No-Growth Model

Po = D1/Ke g Constant Growth Model

We need to determine ke = shareholders required return and future dividends.

Shareholders required rate of return can be estimated with the help of CAPM.
Cost of equity of other firms in industry can be used and adjusted by considering Beta.

When comparing with other firms we must ensure that the company is of equal size and is in same
business line.

We can use dividend yield approach for valuation of shares in Merger & Acquisition.
Dividend yield:
Div. Yield = Annual Dividend / Share Price x 100
For valuation of unquoted shares, the formula is as under:
Share Value = Annual Dividend / Div Yield
Price Earning Ratio:
This is another important measure to value shares.
P/E Ratio is = Price Per Share / EPS
Or
Value Per Share = EPS x Suitable P/E Ratio

A High P/E Ratio may be due to:


The company may be experiencing consistent Growth over the recent past years.
Based on some future expectations.
High Security Shares.

Low P/E Ratio may be due to:


Low profit & losses mix in recent past
Expected future losses
Low security
Difficulties in using this method:
A firm may not have exact similar size company and growth prospects.
P/E ratio is based on past data, where as future earnings are center point of target company in
Merger & Acquisitions.
Example: P/E Ratio of Share Valuation
Income Statement of Target Limited
For the year ended 31 December 2004
Rs.

Profit before tax

890,000

Less: Income tax

360,000

Profit after tax

530,000

Less: Preference dividend

100,000

Ordinary dividend

200,000

Retained Profit for the year

230,000

Other Information:
Outstanding shares are 300,000 @ Rs. 10 each.
P/E ratio of another company in the same industry and of same size is 8.
Required:

You are required to value share of target limited using P/E ratio method.

Solution:

Work out EPS of Target Ltd for the year in question:


EPS = Profit After Tax Preference Dividend
Outstanding shares
EPS = 530,000 100,000 / 300,000
EPS = 1.433

Share Value = EPS x P/E Ratio


Share Value = 1.433 x 8
= Rs. 11.47 Per Share

Asset Based Share Valuation:

Asset-Based Methods typically involve restating both assets and liabilities to their current values to
arrive at a net asset value.
Even with Asset-based Models, value remains a function of expected benefits to the owners.
Replacement Cost:

This is the total cost of setting up whole business from scratch.


But one thing is still missing
On going business value known as goodwill.
Therefore, it is not a pure Asset Based Method.
Break Up Value:

This is the minimum price of assets based on balance sheet.


This is made on ongoing basis.
Break up value needs to be adjusted for expected costs like Redundancy, Legal and Liquidation
Costs.

LESSON 35
Hybrid Methods
Mix of Asset Based & Income Method

Process for Public Take Over:


Evaluation:
Predator company appoints experts.

Legal consultants, Banks, Accountants and Stock Brokers.


Direct BID:
Decision regarding contact with target firm, approach before the BID or hostile takeover.
Purchase of certain % age of shares of target.
Establish an offer and communicate target includes offer document, offer validity , Predator may revise
offer if declined by target.
Acquisition of Private Company
Limited consultancy services from expert are required. Internal evaluation is normally enough.
Detailed investigation is conducted before the transaction.
Offer price is negotiated by both parties.
Finalization of deal By entering into a contract.
Payment of price finishes the deal.
Anti-Takeover Tools

A target company may employ such tools and tactics as to foil the takeover bid. This resistance is
achieved in following ways:
Poison Pill:

Target company grants right to existing shareholder to acquire new shares at attractive price.
This effectively dilute the shareholdings and interest of predator.
In an other way the target company may give handsome dividends to existing shareholders
(other than predator) to exchange their shares for cash at a price well above the offer price by
predator.
The target company may offer a debt security in lieu of shares.
Pac Man:

The target company may make a reverse offer to predator company. It is not used widely.
White Knight:
Target company may seek a friendly predator (other than original predator) potentially capable
of bidding high and acquiring.
A target company can acquire another company may by large or under performing to decrease
attractiveness to predator.

Shark Repellents:
Target may modify its charter to stop the takeover. For example, it would need to have 90% votes to
approve merger.

Disposal of Assets:

A target company may dispose off assets that are of prime interest to acquirer or to further extent
liquidate all its assets leaving nothing for the acquirer.

Severance Pay:

Management may enter into agreement with senior personnel to pay them a certain hand some
amount if theres change in companys control.
Political Pressure and action can stop the take over.

Case StudyValuation of Company


Target Limited
Balance Sheet
As on December 31, 2005
$

Fixed Assets
At Cost less Acc. Depreciation

2,300,000.00

Current Assets
Raw materials

400,000.00

Finished goods

650,000.00

Accounts receivable

1,349,000.00

Cash & bank

1,000.00
2,400,000.00

Current Liabilities
Accounts payable

1,280,000.00

Short term loan

980,000.00
2,260,000.00

Net Current Assets

140,000.00

Total Assets

2,440,000.00

Capital
Issued common stock

2,050,000.00

Retained earnings

390,000.00
2,440,000.00

History of Profit

Net Income

2005

2004

2003

2002

2001

260,000.00 190,000.00 210,000.00 185,000.00 150,000.00

Dividend

135,000.00 135,000.00 115,000.00 110,000.00 110,000.00

Retained Income

125,000.00 55,000.00 95,000.00 75,000.00 40,000.00

Other Information
Replacement Value
Fixed assets

2,600,000.00

Finished goods

700,000.00

Raw materials

475,000.00

Sales Value
Fixed assets

2,200,000.00

Finished goods

550,000.00

Raw materials

380,000.00

Bad debts (above current level)

50,000.00

Avg. Industry beta

0.95

Avg. P/E ratio

9.00

Risk free rate

8%

Market risk premium

5%

Predator's WACC

17%

Predator's P/E ratio

15.00

Solution
1

Balance sheet value

Un-adjusted value

2,440,000.00

Bad debts

(50,000.00)

B/S value of Target


2

2,390,000.00

Replacement Cost Value


B/S adjusted value (as above)

2,390,000.00

Increase in fixed assets value

=2600000 - 2300000

300,000.00

Increase in stock value

=475,000 - 400,000

75,000.00

Increase in finished goods value

=700,000 - 650,000

50,000.00
2,815,000.00

Break up value
B/s adjusted value (as above)

2,390,000.00

Decrease in sales value


Fixed assets

(100,000.00)

Finished goods

(100,000.00)

Raw materials

(20,000.00)
2,170,000.00

DIVIDEND MODEL
Po = D1 / (Ke -g)
We need to calculate g & Ke
g=rxb
r = Profit / Capital Employed
r = 260,000 / 2,440,000

0.106557377 or 10.65%

b = Retention of Earnings
= 125,000 / 260,000

0.480769231 or 48.07%

g=rxb

0.051229508 or 5.12%

Ke, using CAPM


Ke = Rf + b (Rm)
Ke = 8 + 0.95(5)

Po = 135,000 x ( 1 + .0274)/(.1275 - 0.0274)


g can be calculated as under:
= 110,000 (1+g)4 = 135,000

0.1275 or 12.75%

1,860,693.18

g = (135,000/110,000)1/4 -1

Po = 135,000 x ( 1 + .0525)/(0.1275 - 0.0525)

0.0525 or 5.25%

1,894,500.00

P/E earnings basis of valuation


Profit x P/E multiple of similar company
=260,000 x 9

2,340,000.00

Analysis of each Valuation Method


Balance Sheet Value:

Assets are based on historical cost adjusted for arbitrary accounting convention like depreciation.
Historical Costs are not representative of actual worth of assets.
Not logical to use this method.

Replacement Cost Basis

More appropriate for valuation of manufacturing concern than service industry.


Assets subject to rapid technological change are difficult to value under this method.

Break Up Value

The value return by this method means that the owner can realize the amount on piecemeal basis
by disposing off assets individually.
Not based on going concern basis.
Going concern value is normally well above the value returned by this method.

Dividend Valuation Method


Assume Constant Growth:

Companys value is determined by discounting future estimated cash flow.


Price Earning Method of Valuation
It is very difficult to find a company of the similar size.
P/E self is a problem and history can be used.

LESSON 36
Corporate Reorganization and Capital Reconstruction
Divestment:
Business not only acquire assets but also dispose off subsidiaries, division and SBU (Strategic Business
Unit) or even individual assets.
The process of disposing off inefficient assets is known as Divestment or Disinvestment.
If the asset is returning less than the groups/firms hurdle rate, then it should be disposed off.
The decision to divest should be evaluated like decision to invest.
Example

For example, if a division of a group is earning 12% as compared to group return of 18%, then it
should be disposed off.
However, the cost of asset and price available for sale must be compared and evaluated before the
decision to sell.
For example, if an asset or group of assets costing Rs 100,000 is earning 12% or 12000 and could be
sold for 60,000.
The group hurdle rate is 18%.
Comparing 12,000 with 80,000, then ROCE is 15% (12,000/80,000) and is under group hurdle rate of
18%, therefore, it can be disposed off.
However, if the offer price of asset in question is 50,000, the ROCE is 24%, well above the groups
rate of return of 18% and should not be disposed off.
Disinvestment or divestment may be in the form of un-bundling or de-merger.
Management buyouts are another type of mergers and takeovers but also, on other hand, is an
example of divestment.

There are many versions of MBO:

Management Buyout:
Executives of the firm with the help of institutional financing buy the business from the current owner.
Significant sources are pooled by the executives.

Leveraged Buyout:
Executives with the help of external investors buy the firm from the existing owners.
Employee Buyout:
This is not confined to executives, but all the employees contribute in funds pool.

Management Buy-In

The executives from outside business acquire the business.


Spin Out:
Executives and employees do participate in buyout but the company may also retain some %age of
ownership.
The common thing in all these variations is that existing managers have substantial role in term of
control and become the owner of the business.

Advantages of Buy-Outs

It is better to sell a loss making unit/asset than to liquidate.


Going concern transfer of firm protects interest of various stakeholders.
Employees do not loose their jobs
Vendors continue to supply (may be less than the previously)
Govt. keeps on receiving taxes in different ways

Better for existing managers to have their own business.


Managers become owners of a established business.
Factors to be considered while preparing of Proposal:
Readiness of parent company to dispose off the assets/SBU.
Managers will be exposing themselves to high risk.
They must evaluate the financial feasibility of this take over.
They must look for the long term potential of the business and future extension requirements.
Managers Own Assessment:
Managers must look For the expertise and skill required for the success for the buy-out. All the
functional areas should be evaluated.
Price to be paid:
Their own resources pool and the gap to be covered by external financing.

Example
Management Buy-Out
Following information pertains to a proposed management buyout:

Share Capital:
Management

60%

300,000

Banks

40%

10% Preference Shares

200,000

1,000,000

Loans

1,200,000

Sort Term Loans (8%)


Long Term Loans

600,000
600,000

Total Capital

2,700,000

Long term loan of 600,000 are payable in next 5 years in equal installments. The loan is secured
against fixed assets. Interest on loan is 11% pa.
The assets to be acquired have a book value of Rs 2.30 million but the agreed price is Rs 2.40 million.
This company is a part of large group and has been registering a turnover growth of 8% but its
business is not compatible with its group.
Required:
Highlight the factor to be considered and financial appraisal of this buyout.

The difference between the book value of company and the purchase price is not wide apart.
Total of Rs 2.70 million will be raised. out of which Rs 2.40 million will be paid and only Rs 300,000 is
left for working capital.
Gearing will be very high. Equity is Rs 300,000 whereas debt is Rs 2.400 million (including
preference shares). High interest cost and return on equity will be too risky.
However, buyout team will bag 60% of return for a investment of Rs 300 k. A very high reward.
Keeping in view the gearing level it will be almost impossible to seek further loans, and if the
company is successful in seeking loan, then its pricing will be too high.

Financial Commitments:

3.6959 is the value of annuity factor for 5 years at 11%.


Loan repayments; annual payments of loans including interest will be
600,000 / 3.6959 = 162,342
Redeemable Preference Shares

These share will be paid after 10 years and on average Rs 100,000 shall be provided every year.
Preference dividend of Rs 100,000 needs to be paid every year.
Running finance expenses would be Rs 48,000 per annum assuming full loan utilization.
Priority claim of around Rs 400,000 will be needed on the above items.
Other Requirements

For working capital and fixed assets.

Keeping in view steady growth in sales the lenders will require increased profit and stable cash flow.
Cash flow will be burdened due to high gearing but MBO has no other option mentioned in
question.

Capital Reconstruction Schemes

Companies in financial distress (normally) undertake capital Reconstruction/Restructuring schemes


to improve capital mix and the timing of availability of funds.
The following are the main Reconstruction reasons:
a) To reduce net of tax cost of borrowing
b) To satisfy loans
c) To improve D/E ratio
d) To improve companys image
e) To tidy up the balance sheet
f) Financial Distress

Financial Distress
Causes of Financial Distress
A. Industry Level Factors
1. Competition
Entry / exist barriers
Bargaining power of suppliers
Bargaining power of customers
Substitute products availability
Competition and rivalry among companies

2. Industry Shocks
Adverse shocks to industrys products, costs or overheads, sustained over time will lead to push
the marginal / weak industry out of industry. Like Bird flue etc
Most will embrace bankruptcy.

3. Industry Deregulations:
When an industry is de-regularized it can induce financial distress within industry.
Economic structure of the industry also changes.
Deregulation increases the cost of monitoring and controlling managers.
Inexperience of management may push new entrants towards financial distress.

B. Firm Level Causes Of Financial Distress:


1. Ownership and Governance Structure

Experience and skill of management

2. Leverage

Both operating and financial risk


3. Operating Risk

C. Macro Level Factors:


1. Recession:

It narrows the margin between cash flow and debt service.


Lower cash flow / income will increase probability that cash flow constraints will have to be
eliminated at costly means.
2. Monetary policy:

Monetary policy significantly effect the nations liquidity.


When the state bank buys Govt. securities / bills, it creates expansionary maneuver, it adds to
reserves of the banks which create more loans. Short term interest rate falls.
Selling of securities leads to contraction effect.
Bank reserves decrease and loans are not created. Short term interest rates increase.

LESSON 37
Effects of Financial Distress
The risk of incurring the costs of financial distress has a negative effect on a firm's value which offsets
the value of tax relief of increasing debt levels and tax depreciation relief.
Relationship between stakeholder damaged:

Even if a firm manages to avoid liquidation its relationships with


Vendors/creditors/suppliers
Customers
Bankers
Employees may be seriously damaged.
Suppliers providing goods and services on credit are likely to reduce the generosity of their terms, or
even stop supplying altogether, if they believe that there is an increased chance of the firm not
being in existence in a few months' time.
Employees may become de-motivated because of insecurity and uncertainty.
Management become short-term oriented. Always caught up in day-to-day matters like liquidity,
and cash flow rather than long term.
Customers may develop close relationships with their suppliers, and plan their own production on
the assumption of a continuance of that relationship. If there is any doubt about the longevity of

a firm it will not be able to secure high-quality contracts. In the consumer markets customers
often need assurance that firms are sufficiently stable to deliver on promises.
Transaction cost goes very high and restructuring costs may be high for a financially distressed
company attempting to restructure the loans.

Factors influencing the Risk of Financial Distress

Variability of cash flow:


The sensitivity of the company's revenues to the general level of economic activity.
If a company is highly responsive to the ups and downs in the economy, shareholders and lenders may
perceive a greater risk of liquidation and/or distress and demand a higher return in compensation
for gearing compared with that demanded for a firm which is less sensitive to economic events.

The proportion of fixed to variable costs.


A firm which is highly operationally geared, and which also takes on high borrowing, may find
that equity and debt holders demand a high return for the increased risk.
The liquidity of the firm's assets.
Financial analysis may be used to view some of the indicators of the financial distress. Important
ratios to be considered include:
Liquidity Ratios
Debt Equity Ratios
Asset Utilization Ratios

Types of Reorganizations
Conversion of Debt to Equity:
In order to improve equity base. When the company has relied heavily on short term finances for short
term expansion and has caught up in working capital problem.
When the holders of convertible securities exercise their right.

Conversion of Equity to Debt:

Preference shares are converted to say debt security.


From a legal point of view converting Preference shares to debt security constitute reduction of
share capital

Conversion of Equity from one form to another:

Eliminating or reducing reserves by issuing bonus shares.


This also involves sub-division of shares to smaller units.
It needs to be carried out in accordance with articles of the company.
This may involve converting Preference share to ordinary shares.

Converting Debt from one form to another:

To improve security, flexibility and reducing cost of borrowing.

General Conditions and Re-organization Process:


Assumptions:

Company is incurring losses.


Needs immediate capital injections.
Assets and liabilities are out of line with market value.
Process:

Revaluation of assets (Bring them to market value)


Write of the debit balance on profit and loss account.
To determine whether new capital / finances are needed?
if yes, through which source (Shares / Loans)
General Conditions and Re-organization Process:

Determine the amount required to be injected.


Negotiating with stakeholders.
- Vendors / Suppliers

To seek stretched credit period.


May reduce their claim if they calculate to get less than their claims in case of liquidation on
the hope to have better situation in future.
They may be offered some stake in the company.
Banks:

May request rescheduling of loans, and may get fresh loan at higher interest rates.
Ordinary Shareholders:
Normally they get nothing in case of winding up or liquidation. They must be given some stake
in the company if further finances are required.
Preference Shareholders:

May accede to new scheme when they are offered some increase in dividend rate.
Foreign Exchange Risk Management

Foreign Exchange Market:

A market where currencies are traded / exchanged with other currencies.


Major players are banks, who also trade in on behalf of their customers as well.
Several large & small buyers and sellers.
Significant transactions are conducted using telephone / electronically.
There are others brokers / agents and companies as players.
How to determine and quote the Rates?
Forex Market

Foreign exchange market is highly competitive.


This rate is primarily determined through the interaction of demand and supply.
Interest or deposit of different currencies.
The exchange rate is the price of one currency quoted in another currency.
Two type of currencies involved:
o Base Currency
o Variable Currencies
Forex Market

In Forex market the rate are quoted in terms of a base currency to several other variable currencies.
When a dealer express rate as US $ / PKR, the this mean the rate of number of PKR to 1 US $.
For example, US $ / PKR = 60, means that we need to exchange Rs. 60 (PKR) to get one dollar.
Conversely, a rate expressed as PKR/US $ refers to a rate of number of US $ to 1 PKR.
In this case we need to express the rate in terms of dollar. How many dollars we will surrender to
get 1 Rupee= US$ 0.016667 to get 1 PKR.
Bid & Offer Price

Banks and Forex dealers quote two rates for a single pair of currency.
BID Price
Offer Price

Bid Price (Lower price)

A price at which the dealer will sell the variable currency.

Offer price (Higher price)

A price at which the dealer will buy the variable currency.

A dealer/bank may express PKR/US $ as


0.01666 - 0.01679

At $ 0.01666, dealer will sell us $ in exchange for PKR


At $ 0.01679, dealer will buy us $ In exchange for PKR

The difference between Bid & Offer is called Spread


This represents the income of dealer. For small sum the spread will be high but very small for high
sum.

Spot Rate & Forward Rate:

Currency can be bought and sold using spot and forward.


Spot Rates: It means trading now. Now normally is up to two days.
Forward Rates: Buying or selling forward means trading now and settling claim at a future date.

LESSON 38
Example

Rates for PKR/US$ are quoted as follows:


Spot
0.016653 0.016660
1 month
0.016648 0.016655
3 months
0.016632 0.016641
6 months
0.016606 0.016617

Today is 4th January. A Pak company has to pay US$ 245,000 to a supplier at the end of week 1 of
April and want to fix exchange rate now.
What forward rate can be obtained for a currency transaction and what would the cost to Pak
company?

Solution

That rate will be 0.016632


The cost to the company will be:
245,000/0.016632 = PKR 14,730,299.38

For foreign currency rates calculation there are two factors underlined:

Demand and Supply of currency involved


Interest Rates of currencies
Foreign Exchange Risks
Foreign Exchange Risk is divided into 3 categories:
1 ) Transaction Exposure
2 ) Translation Exposure

3 ) Economic Exposure
1 ) Transaction Exposure :

Gains / losses made on settlement of buying-selling contracts of goods, import-export transactions,


investment in foreign currency instruments, deriving dividend from abroad.
The risk involved is normally covered through hedging contracts.
2 ) Translation Exposure:

It arises from the accounting side when businesses are required to consolidate their group results in
the compliance of local financial reporting laws.
3 ) Economic Exposure:

It is difficult to Pre-determine the dollar effect of economic effect because of the unexpected nature
of change.
A subsidiary in the country X whose currency devalues unexpectedly has two effects on the value of
the firm.
i) Adverse effect on value as every dollar of profit will have less worth when repatriated to home
country.
ii) there may be positive effect in terms of cheaper exports adding cash flow contributions of parent
company.

How to reduce the Translation Exposure?


Translation Exposure:

This translation exposure can be hedged by trying to

equalize the assets and liabilities. For example, a


group may reduce FCY dominated assets if it fears devaluation in that foreign currency like reducing FCY
cash and stock levels. And increasing liabilities in local currency.

When FCY risk between assets and liabilities is equal, then translation exposure is eliminated.
How to reduce the Economic Exposure?
Decentralized / Diversified Production Facilities:

If a company has a production facility in the country whose exchange rate remains strong, it will be
difficult for the company to export to other countries.
Diversification of Financing:

International borrowing can be used to hedge the adverse effects of currency exchange rates.
If borrowing is spread across several currencies it will be extremely unlikely they will all strengthen at
the same time eventually reducing the economic exposure risk.

Protection against Transaction Exposure:


1- Invoicing in Home Currency
2- Leading and Lagging

1) Invoicing in Home Currency:

This will eliminate the need of exchange of currency upon receipt. However, the seller would be
compelled to revise its prices periodically.
Seller can invoice:
In home currency
Currency stable than home currency
US $ - Market leader
Currency with a positive forward markets
2 Leading & Lagging:
Leading refer to making payment before falling due.
Lagging means to defer or delay the payment or settling the payment well past due date.

3- Matching of Receipts and Payments

Forex exposure can be partially hedged by matching payments and receipts of same currency.
For example a company will receive US$ 1 million during the next quarter and will need to pay US$
1.2 million in the same period, then the net exposure will be US$ 200,000 as 1 million payment and
receipt are net off.
4) Hedging (Forward Contracts)
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge
consists of taking an offsetting position in a related security, such as a futures contract.
Using this method we can Fix the exchange rate now for a future transaction of the needed
currency. Because spot rates are changing every day and fixing the exchange rate for future date
Now reduces the risk to significant extent.
A forward contract is binding upon both the parties currency dealer and a company/client.
Example: Hedging (Forward Contracts)

Hedging is based on the assumption or estimate that it will be expensive to pay us$ in three
months time because of the fact the PKR will be weakening against US$. therefore, a company
enters into a contract to buy X dollars after 3 months at an exchange rate of Rs 60/ US $ decided
now. At the maturity date both parties have to honor their respective commitments of buying
and selling of US $ at agreed rates.
Now if on the maturity date, the spot ex rate is Rs 61/US$, (PKR weakened against US$), then the
company has actually eliminated the loss and benefited financially.
5) Money Market Hedging:

Money markets are whole-sale (large scale) markets for lending and borrowing of money for short
term.
Bank are major player of money markets and companies seek their services to hedge against the ex
rate fluctuations in short term.
As forward ex rate (which is agreed now) is derived from sport rates Using interest rates, a money
market hedge can produce the same results as of forward contract.
There will be two situations:
A company is to receive money in FCY
A company needs to pay FCY
Situation - Future Income in FCY:

What is needed at this point is to fix the exchange value of the future currency income.
A hedge will be created by fixing the value of income now in local currency.

We can do it:

Borrow now in foreign currency (The same that the company will receive in future). The maturity of
both loan and receipt should be the same.
The loan + interest on FCY loan should equal the amount of FCY future receipt.
When the FCY receipt hit the account, loan will be paid off.
The FCY loan can be converted to local currency immediately and may be put to a short term
deposit to earn interest.

LESSON 39
Example
Money Market Hedge
Future Receipt in FCY

A Pak company exports US$ 1 million goods to a customer in united states with a payment to be
received after 3 months.
Current spot rate is US $/PKR = 60.1234 60.1599

3 Months Interest Rates

Deposit

Loan

(Per Annum)

PKR Rs

3.55%

4.45%

US $

3.15%

4.52%

How can a firm establish a Money Market Hedge?

Solution

Firm will receive 1 million dollars in 3 months and therefore, to create hedge it needs to borrow US$
now.
The borrowed amount plus interest after 3 months should be equal to US$ 1 million (liability) which
will be set off against the future income.
In this way the income after 3 months (asset) will be equal to the liability.
Firm would borrow us $ now for 3 months @ interest rate of 4.52% pa.
4.52% pa needs to be converted to 3 month rate.
=4.52 / 4 = 1.1300

We must express this interest rate as (1+r)


1.1300 will be 1.0113
Borrow Loan= US $ 1 million/1.0113 = $ 988,826.00 Loan
After 3 months loan + principal will be exactly US $ 1 million.

In second phase of Hedging:

Assuming that the borrowed amount is utilized in business.


Borrowed us $ are converted to PKR at spot rate PKR 60.1599
Then PKR will be:
= 988,826 x 60.1599 = PKR 59,487,689.00

Assuming that the borrowed amount is not utilized in business.


This amount can be put to a PKR deposit @ interest rate of 3.55% pa.
PKR deposit rate 3.55% for 3 months can be stated as 0.8875 per quarter.
Using (1+r) equation, quarterly interest rate of 0.8875 will be 1.008875.
PKR deposit will earn after 3 months:
= 59,487,689 x 1.008875 = 60,353,229

In this example, Rs. 60,353,229 is certain cash flow and has locked/Fixed exchange rate of PKR
= 60.3532 (60,353,229 / 1,000,000)

When a Future Payment in FCY is required:

A hedge can be created by exchanging domestic currency for foreign currency now and putting the
fcy under a deposit.
The term of deposit should end on the date fcy payment will be made.
Secondly, the deposit plus interest thereof should equal to the fcy payment.
In this way we can fix the cash flow in local currency.
6) Currency Futures

A currency future is a standard contract between Buyer and seller in which the buyer has a
binding obligation to buy a fixed amount, at a fixed price and on a fixed date of some underlying
securities.

Fixed amount = Contract size


Fixed price = Future price
Fixed date = Delivery date
Futures are the forward contracts traded on futures and options exchanges. They can only be
bought and sold through future exchanges.
They are standardized contracts having identical specification. For example, every sterling
contract has same terms and conditions.
Futures contracts are traded for settlement at a predetermined Time during a year.
These contracts are normally available in major currencies only Like Dollar, Pound Sterling, Yen,
Euro etc .
Future are traded at a price agreed between buyer and seller.
Most of contracts do not run till agreed settlement date (They are closed out before that time).
Contracts that close before the agreed date are settled in two ways:
Cash settlement
With cash settlement cash is paid by one to other party.
Physical delivery
With physical settlement, The agreed item is delivered by the seller to the buyer.
Bonds futures are physical traded, whereas currency futures are cash settled.
All future contracts have fixed settlement date but can be closed out at any time before the
agreed final date.
When a company buys a future contract Buyer in long position, for example, December, it
represents long position.
It can close out the respective position by indulging in opposite direction transaction, before the
date in December by selling the future.
When a position is closed, there will be resultant gain or loss (The difference between the selling
and buying price).
You can also sell something that you dont have. Selling futures mean taking short position.

A short position can be closed by buying the same item (short sold) before the final date. Again
there will be a gain or loss.
Mechanism
Ticks:

A tick is the minimum price movement of a contract.


For example, the movement in US$ / PKR rate from 60.1599 to 60.1600, means the rate has risen 1
ticks.
For example, the movement in US$ / PKR rate from 60.1501 to 60.1505, means the rate has risen 4
ticks.
Every tick movement in price has same money value.
For example, sterling/us$ contract standard size is sterling 62,500/-. the price is in us$ and tick size is
$ 0.0001, which means each tick value is $ 6.25.
If a trader is holding a long position and price of future increases, then theres profit and fall in value
represents loss.
If trader is holding is short position, rise in future value represent a loss, fall in price profit.
Example: Currency Futures
Scenario: Future Payment in Fcy
A Pak company bought goods for $ 900,000 in December and needs to settle in May. Due to the
sensitivity of exchange rate of $/PKR the company intends to hedge this transaction exposure with
currency futures.
The spot rate when the goods were purchased was US$ 1 = PKR 60.1559. The $/PKR may futures
contract is currently priced at US $ 1 = PKR 60.1585.
Assuming that the spot rate when goods are paid is US$ 1 = PKR 60. 2171 and June futures is priced
at US$ 60.2201.
How can company Hedge this transaction with currency future?

Exposure

US $

900,000.00

Spot Rate December

PKR

60.1559

Fcy Future December

PKR

60.1585

Spot Rate (June)

PKR

60.2171

Fcy Future (June)

PKR

60.2201

PKR/$

US$

PKR

In December and will sell in June


December - fcy Futures purchased

60.1585

900,000.00

54,142,650.00

In May - When payment will be made in US $

60.2201

900,000.00

54,198,090.00

Gain on sale of Fcy Contracts

May
Need to buy US $ at Spot rates to make
payment

55,440.00

PKR/$

US$

PKR

60.2171

900,000.00

54,195,390.00

Less: Profit / gain on Fcy Futures

(55,440.00)

Net cost

54,139,950.00

Effective Exchange Rate

54,139,950.00 / 900,000.00

60.1555

Standardized Futures Contracts:

On some commodity exchanges, Currency Futures are available in the following denominations.

Future

GBP/US$
EURO/US$
YEN/US$

Standard
Qty/Contract

Price Quotation

Tick Size

Value of 1
Tick

GBP 62,500

US$ Per 1 GBP

$0.0001

$6.25

Euro 125,000

US$ Per 1 Euro

$0.0001

$12.50

Yen 12.50 Million

US$ Per 1 Yen

$0.000001

$12.50

Euro/GBP

Euro 100,000

GBP Per 1 Euro

GBP 0.0001

GBP 10

LESSON 40
Currency Future:
Scenario Future Receipt Of FCY
Using Standardized Currency Future Contracts:

Example:

In January a UK Company sold goods to a US customer and later promised to pay after 3
months. The total value of goods is US $ 1,202,500.00. The current spot rate for GBP/US$ is
$1.5000 and early April GBP future contract are being traded at $1.4800 on a contract size of
GBP 62,500.
UK supplier is exposed to exchange risk on future income of $1,202,500.00.
If sterling weakens, UK trader will gain but if sterling strengthens he will lose.
The UK supplier can set up a futures position by hedging the risk of strengthening of sterling or
weakening of Dollar.
At the future price of $1.4800 The $ receipt after 3 months will be worth:
= $1,202,500.00 /1.4800 = GBP 812,500

The UK trader needs to buy:


812,500 / 62,500 per contract = 13 contracts

This covers the exposure exactly (Clean Hedge).

Lets assume that in march the $ weakens and the future market price is now $ 1.52 / 1 GBP
When US$ income is received the UK seller will sell the 13 sterling contracts at $1.5200.
Purchase price of 13 contracts =
Selling of 13 contracts
Profit

1.4800
1.5200
=

The gain on future is 400 ticks per contract.


The overall financial position will be:
Income from trading
Profit on future Selling:

$ 1,202,500/=

0.0400

400 ticks x 6.25 x 13

$ 32,500/=

Total Value

$ 1,235,000/=

Exchange into Sterling at spot rate of $1.52/GBP:


$1,235,000/1.52 = GBP 812,500
Effective Ex Rate is:
$1,202,500 / 812,500 = $1.48
Forward Contract vs. Currency Future

A Forward Contract is made between parties and each party needs to confirm the credit
worthiness of each other.
In currency futures, commodity exchanges are involved and credit risk is eliminated.
Reversal of currency future is very simple.
Large buyers and sellers exists.
Reversing forward contract is difficult.
Original parties have to off set the deal. Future currency contract become a Commodity and
reversing does not require original parties.
Size of Contract:
No size restriction is placed in forward contract and is up to parties to deal or contract in the

magnitude they like. But in future currency contract the size is pre-determined or fixed. In this scenario
perfect hedge is not possible.
In Forward Contract no margin is required but in currency future parties have to put a initial margin.

Interest Rate Risk Management

Apart from Exchange Rate Fluctuations, another source of risk in Foreign Exchange Market is
interest rate risk.
It is the risk of incurring losses or gains due to adverse / favorable movements in interest rates.
Examples of Interest Rate Risk

Investment in Bonds,
Short term investments,
Borrowings in short term (Variation in short term interest rate).
Interest rate risk is higher when Interest rates are extremely sensitive and their future
direction Is unpredictable.

Most of banks and financial institutions have significant exposure based on short term floating
interest rates.
KIBOR

Karachi Inter Bank Offered Rates

LIBOR

London Inter Bank Offered Rates

Hedging against the Interest Rate Risk


1) Forward Rate Agreements
2) Interest rate futures
3) Interest Rate Options
4) Interest Rate SWAPS
5) Swaptions

1) Forward Rate Agreements FRAs

FRAs is a financial instrument to fix interest rate on future loan or deposit.


It resembles to forward exchange transaction.
It is between a bank and a client for fixing future interest rate on Notional amount of loan or
deposit. It is agreed between the bank and the client.
FRAs are cash settled.
At settlement date buyer and seller must settle the contract.

Buying & Selling Terminology


The FRA rate for three months loan/deposit starting in a 6 months time is normally expressed as 6v9
FRA.

The buyer of an FRA agrees to pay fixed interest rate (FRA Rate) on notional loan/deposit. At the same
buyer will receive interest on notional loan/deposit at benchmark rate of interest.

On the other side, seller of FRA agrees to pay interest on the notional amount at benchmark rate and
will receive interest at a fixed rate.

Decision Rule:

If the fixed rate is greater than the benchmark or variable (also reference rate), the buyer of FRA will
make cash payment to seller. The payment will be calculated as the excess of FRA (fixed Rate) over
variable multiplied by the notional amount.

If the fixed rate (FRA rate) is lower than the benchmark rate, then the seller of FRA makes cash
payment to buyer calculated as the amount by which FRA is less than the benchmark rate.

FRA Rates are expressed as:


For Example:
%
3v6

8.50 - 8.40

Notional int. rate for three months

4v7

8.60 - 8.51

starting in 3 to 5 months period

5v 8

8.80 - 8.71

duration

Notional int. rates for six month


3v9

8.99 - 8.94

4 v 10

9.15 - 9.06

6 v 12

9.25 - 9.15

duration starting in 3 to 6 months

The rate on left side is bid rate and is higher. This is the rate bank would like to receive in FRA, being
the seller of FRA (Customer will be Buyer).
The right side price is offer rate and is lower. This is the rate bank would like to pay in FRA, being the
buyer of FRA (Customer will be seller).

Example Hedging with FRAS:

A company is considering to borrow Rs.10 million is six months time for a six month period. The
normal terms are KIBOR + 75 basis point (or 0.75%). Current KIBOR is 8.5%. The company anticipates a
surge in interest rates in near future.

A bank has quoted FRA rates as:


3 v 9 = 8.75 - 8.65
6 v 12 = 8.69 - 8.59
a) How the company can set up hedge against interest rate using FRA?
b) Assuming on settlement date, KIBOR is 9.05%. Calculate effective Int. rate.
Solution:
A. The company can fix the borrowing rate by buying a FRA on notional amount of Rs 10 million. The
FRA rate falling under:
6 v 12 = 8.69% is applicable.

If KIBOR is 9.05% as on settlement date, bank shall make a payment to the buyer (company) in the
amount of:
Rs 10,000,000 x (9.05% 8.69%) x 6/12 x 1/(1 +(9.05% x 6/12)
= 17,221
The company will borrow Rs 10 million for six months at KIBOR + 75 basis points:
= 9.05 + 0.75 = 9.80%
Interest on loan will be:
Cost of Int. on Loan = 10,000,000 x 9.80% x 6/12
Profit on FRA (Paid by Bank)

= Rs. 490,000
= Rs. 17,221

Net Cost

= Rs. 472,779

Effective Int. Rate on Rs 10 million for 6 months will be:


= 472,779/10,000,000 x 12/6 x 100 = 9.46%

FRA rate was 8.69% and company could at KIBOR + 0.75% and FRA has provided perfect hedge (8.69% +
0.75% =9.44%) That is near to the FRA rate of 9.46%.
Interest Rate Futures

These contracts are similar to currency futures.


Exchange traded countries.
Size
Date
Settlement through the exchange
Traded in standardized form on future exchanges.
Settlement dates on future exchanges are calendar quarters.
Each future contract Is for standardized quantity of underlying security.
Price of the future is expressed in terms of underlying item.
Int. rate future like currency futures may be settled before the maturity date.

Short Term Interest Rate (STIR) Futures

Short term int. rate (STIR) futures are cash settled.

STIRs:
A type of standardized int. rate future on a notional deposit (for 3 months) of standard
amount of principal.

Bond Futures:
Based on standard quantity of notional bonds. If buyer or seller do not close his position
before the final settlement date, then the contract is settled through physical delivery.

LESSON 41
Interest Rate Futures

Bond Futures
STIRs Futures
Short Term Int. Rate Future:

If interest rate falls then the price will rise and vice versa.
Hedging with STIRs

A company intends to borrow short term in future may be concerned about the rising short term int.
rates.
The hedge is to establish a Notional position to fix the int. rate in short term.
The hedge will be to sell short term int. rate future.
If int. rates go up, it will result in profit. Price of future will fall. The future will be closed by selling at
higher prices and then buying at lower price.
If int. rates move down, it will result in loss. Price of future will increase. The future will be closed by
buying at higher price and selling at lower price.
A company intends to borrow short term in future may be concerned about the rising short term int.
rates.
The hedge is to establish a Notional position to fix the int. rate in short term.

Example: Hedging with STIRs Borrowing in Short Term

Assuming it is January and a firm plans to borrow Rs. 1 million in 5 months for 3 months. It intends
to hedge against rising int. rates. The firm can borrow at KIBOR + 100 basis points.
Current 3 months KIBOR rate (spot rate) 4.625%. June short int. futures have a current market price
of 95.35.
a) How a hedge can be set up against increase in 3 month KIBOR rate?
b) assuming when company borrows Rs 1 million, KIBOR is 5.50% and June futures price is 94.25%.
(Assume a Tick value of Rs. 15/ tick & PKR contract is available in the denomination of Rs. 500,000)

Solution
To hedge against future interest increase, the firm needs to sell 2 contracts (Rs 1,000,000/500,000)
short futures.
In May future should be closed by buying future contracts at 94.25.
Selling Future at
Buying Future at
Gain (or 110 Ticks)

95.35
94.25
1.10

Total Gain = 110 x 2 x 15= 3,300


The company will borrow at KIBOR + 1% for three months @ 5.50% + 1% = 6.50%

Int. on loan on 1 million for 3 months:


Rs 1,000,000 x 6.50/100 x 3/12 =

Rs. 16,250

Gain on in Future
Net Cost of Int.

Rs.
Rs.

3,300

12,950

Effective Int. Rate:


Rs. 12,950 / 1,000,000 x 12/3 x 100 = 5.18% This is much less than KIBOR + 1% (5.50 + 1 = 6.50) due to gain on Future.
Scenario:
Company is planning to invest and there is risk of short term interest rate going down/ fall in future.
If the short term int. rates fall the firm will make profit and this profit will be added to the
interest earned by deposit to arrive at net return on deposit.
The loss of return on deposit due to fall in short term interest rates is off set by the profit on
futures.
If interest rates go up, there will be loss on future contract but the same will be off set by higher
interest rate on deposit.
The hedge can be created by buying short term interest future.
Future position should be closed when actual deposit period begins by selling the same number
of int. rate futures.
If int. rate rise, price will fall, loss will incur.
If int. rate fall, price will rise, profit will be generated.

Example: Interest Rate Future

Surplus investment:

Today is March 01.


A company anticipates cash surplus of Rs 10 million in 2 months time for a period of 3 months. That
surplus Will be invested in short term. The company estimates that int. rates in 2 months will fall
and thats why company intends to hedge this risk.

June 3 month int. rate future are being traded with a contract size of PKR 500,000. They are
currently priced at 96 and int. rate is 4%.
What will happen if market int. rates have fallen to 3% with contract price of 97? Assume a tick
value of Rs 15 tick.
Solution
To create hedge against fall in interest rates, company needs to buy Rs. 10million / 500k = 20 contracts
@ current price of 96.
During May the company needs to close out the deal by selling 20 contracts @ 97.
Total profit will be as under:
Buying Futures at
Selling Futures at
Gain (or 100 points)
Total Gain = 100 x 20 x 15
Rs=30,000

96
97
1

Options & SWAPs

Options:

An option is a contract that confers a right to buy or sell a specific quantity or asset, but not the
obligation, at agreed price on or before the specified future date.

Options are available for commodities (like wheat, coffee, sugar, etc) and financial assets like currency
or bank deposits.

Features of Options

A contractual agreement.
Holder of option exercise his/her right.
Option writer is seller and must honor his side of contract. (Sell or buy at agreed price)
Standardized transaction in terms of size & duration.
Exchange traded.
Easy to buy & sell.
Options are either Call Options or Put Options.

The option purchase price is called option premium.

Call Option:

It gives its holder a right (not obligation) to buy underlying item at the specified price.

Put Option:

It gives its holder a right (not obligation) to sell underlying item at specified price.
Expiry date:
Each option has expiry date and the holder must exercise his/her right before this date otherwise, it will
lapse.
For example, a call option gives the right to its holder to buy x number of shares at X price on and
before 31 March.
In this example 31 March is expiry date.
Strike or Exercise Price:
The price mentioned in option at which the holder exercises his right is known as exercise or strike
price.
Options Pricing:
The strike price may be higher, lower or equal to the current market price of underlying item.
If the strike price is more favorable than the current market price of underlying asset or item, the
option is termed as In-the-Money
if the strike price is not favorable than the current market price of underlying asset or item, the option
is called Out-of-Money
If the strike price and current market price are equal, then it is known as At-the-Money
An option holder will only exercise his option if it is In-the-Money

LESSON 42
Example: How Options Work?
Let's say that on May 1, the stock price of Abc Co. is Rs 67 and the premium (Cost) is Rs 3.15 for a July 70
call, which indicates that the expiration is the third Friday of July and the strike price is Rs 70. The total
price of the contract is Rs 3.15 x 100 = Rs 315.

In reality, you would also have to take commissions into account, but we will ignore them for this
example.
Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the
contract by 100 to get the total price.

The strike price of Rs 70 means that the stock price must rise above Rs 70 before the call option is
worth anything; furthermore, because the contract is Rs 3.15 per share, the break-even price would be
Rs73.15.

When the stock price is Rs 67, it's less than the Rs 70 strike price, so the option is worthless. But don't
forget that you've paid Rs 315 for the option, so you are currently down by this amount.
Three weeks later the stock price is Rs 78.
The options contract has increased along with the stock price and is now worth:
Rs 8.00 x 100 = Rs 800.
Subtract what you paid for the contract, and your profit is:
(Rs 8.00 Rs 3.15) x 100 = Rs 485.
You almost doubled our money in just three weeks! You could sell your options, which is called "Closing
Your Position
If the price drops, is less than our Rs.70 strike price and there is no time left, but you have to consider
your cost.

Example: Exercising Option

An investor buys 20 options on shares of XYZ Ltd at a price of Rs 500 (per share). Each option consists of
100 shares and premium paid is Rs. 5/- per share.
What will happen if, at the expiry of option, the share price is
i) 516 or
ii) 490?
i) Share Price of Rs 516 Per Share:

If, at expiry the share price is Rs 516 per share, then the option is In-the-Money and will be exercised.
It means the investor could buy the shares at a strike price of Rs 500 per share and then can sell
immediately in the market at a price of Rs 516 per share.
In this case investor will make profit. The net gain on this deal can be calculated as under:

For Option Holder:


Total Gains
20 x 100 x (516 -500)

Rs. 32,000

Total Options Cost


20 x 100 x5

Net Gains

Rs. 10,000
Rs. 22,000

For Option Seller:


Option Premium Earned
20 x 100 x 5

Loss on Option

Rs. 10,000

20 x 100 x (516 - 500)

Net Loss

Rs. 32,000
Rs. 22,000

ii) Share Price of Rs. 490 Per Share:

If the share price is less than strike price Rs 490 per share, the option is out-of-money and will not be
exercised.
The option holder will loose the cost of option Rs 10,000.
The option seller will profit the premium received Rs 10,000.
Gain of one party is the loss of other party.
Currency Options

The structure of currency option is the same as of equity options.


A C.O. is a contract which confers right to the buyer to buy or sell (but not obligation):
Fixed amount of underlying currency
At a fixed price (Strike Price)
On a fixed date (Expiry)

Amount of underlying currency is governed by the contract size as determined in each currency.
A buyer of a call option has a right but not the obligation to buy the underlying currency.
A buyer of a put option has a right but not the obligation to sell the underlying currency.
Premium is charged by option writer from option holder.
Hedging With Currency Option:

To construct a hedge with currency option, one needs to consider the following:
The extent of exposure and the currency involved.
Consider the hedging tool (A call or put option will serve the purpose).
Calculate the most Suitable strike price.
Option will be only exercised if it is In-the-Money.

Example: Currency Option

Assuming it is end of June.


The PKR/US $ spot rate is $ 0.016529.
A Pakistan importer is required to make US$ to a foreign exporter in the amount of US $ 100,000 in
September and has decided to hedge through currency option.

The company can hedge it either by buying a call option on dollars or sell put options on PKR.
A bank is willing to sell put option at strike price of $ 0.016529/ PKR for a premium of Rs. 9,175.
The company will buy $ 100,000 in September and can do this by buying a put option on Pak Rupees at
a strike price of $ 0.016529/PKR. It will need to have a put option on:

(100,000/0.016529)= Rs 6.050 Million Pak Rupees

The cost of option will be Rs 9,175.


The result of this hedge will be dependent upon the spot ex rate in September.
If the spot rate in September are $ 0.016559 per Re. 1.
The dollar has weakened and therefore, the option will not be exercised.
The cost of option in this case will only be Rs. 9,175.
Now lets assume that dollar has strengthened in September.
The Spot Rate in September is $0.016252:

The dollar strengthened and the option is In-the-Money and should be exercised.
Cost of us$ 100,000 @ 0.016529

Rs. 6,049,972

At 0.01629 (Reverse Rate is Rs. 60.4997)

Cost of Option

Rs.

9,175

Total Cost

Rs. 6,059,147

Effective Ex Rate = 100,000 / 6,059,147 = $ 0.016504

Calculating the Benefit of this Hedge:


If transaction was not hedged, then
The cost would have been:
US $ 100,000 / 0.016252

= Rs. 6,153,089

Cost Under Hedge

= Rs. 6,059,147

Net Saving

= Rs.

93,942

Interest Rate Options

Interest rate options is an option to borrow or lend Notional amount

for a specified period starting


on or before a future date (expiry date) at a fixed rate of interest (exercise price).

Interest rate options resemble to forward rate agreements.

Interest rate options are exchange traded.


If the option is exercised, it is cash-settled.

At expiry, the benchmark rate (like KIBOR) is higher than the strike Rate, for borrower the option is inthe-money, and he will exercise the option.
On the other hand, if at expiry the benchmark (KIBOR) is lower than the strike rate, then the borrowers
option is out-of-money and will not exercise it. The option will lapse.
In this case the company will borrow the money on the prevalent rate of interest (KIBOR).
Option for lender follows the same mechanism.

LESSON 43
Example: Interest Rate Option
A company intends to borrow Rs. 5 million in two months time for a period of 6 months. The company
anticipates that 6 months KIBOR rate will increase, which is currently staying at 8%. The company can
borrow at KIBOR plus 2%.

The company has decided to hedge this exposure through borrowers option.
The company buys an option at a strike rate of 8.50%. The option cost will be Rs. 12,000.

The Notional amount is Rs. 5 million, notional period is 6 months and expiry date is set in two months.
Assuming that at expiry, the 6 months KIBOR rate is 9.50%. The option is In-the-Money and it will be
exercised.
What happens then?
The option will be exercised.
The option is cash settled and company will receive cash from the writer.
The receipt from writer to company is based on the difference in interest cost between Rs 5 million for
6 months @ KIBOR rate of 9.50% and strike rate of 8.50%.
The final calculation is as under:

Interest On Loan:
Rs 5 Million x 6/12 (9.50+2)

Rs. 287,500

Add Cost Of Option

Rs. 12,000

Less Receipt From Option

Rs. 25,000

Rs. 5,000,000 x (9.50 - 8.50) x 6/12

Net Cost

Rs. 274,500

Effective Interest Cost:


Rs. 274,500/5,000,000 x 12/6 x 100%
= 10.98%
Which is less than the existing KIBOR + 2%=11.50%

Interest Rate Caps & Floors

Caps & Floors are series of options for medium term loans and deposits.
Interest Rate Caps:

This is a series of options for borrower for medium term loan.


Whenever an option is exercised, there is a cash payment.
Interest Rate Caps & Floors

Interest rate floor is an option to limit interest rate to a given minimum.


A Cap is an option to limit interest rate up to a given maximum.
This is a series of option for lenders setting minimum interest rate for medium term deposits.
The floor holder can exercise option at the dates given in the option.
Difference Between Interest Rate Options and Interest Rate Caps & Floors

The cash settlement is made at the end of Loan period and not in the beginning.
More than one period is covered.
This is a very expensive option due to high premium cost.
These options are for two to five years term.
Example
Interest Rate Cap & Floor

A company is considering taking a loan of Rs. 10 million on which it pays interest six monthly at KIBOR
plus 1% the company intends to enter into an option against rise in interest rates by buying a cap at a
strike rate 7.5%.
There will be three expiry dates within the agreement:
Expiry
Period
30 - June Year 1

July - Dec. Year 1

31 Dec. Year 1

Jan - up Year 2

30 - June Year 2

July - Dec. Year 2

Assuming that six months KIBOR rate at each expiry date is:

Expiry date 1 = 9%
Expiry date 2 = 8%
Expiry date 3 = 7%

Determine how and when option will be exercised?


On First Expiry Date of 30 June year 1 KIBOR is 9%, interest on the following 6 months will be 10%
(KIBOR + 1).

Company can exercise the option and will receive cash payment at the end of expiry period 1 - 31 Dec.
year 1.

The cash payment shall be calculated as:


Rs. 10,000,000 x (9 -7.50) x 6/12 = 75,000
On Second Expiry Date of 31 Dec. year 1, the option will be exercised and company will receive cash on
30 June year 2.

The cash payment shall be calculated as:


Rs. 10,000,000 x (8 7.50) x 6/12 = 25,000
On Third Expiry Date:

30 June year 2, the option will not be exercised because the KIBOR 7% is less than the strike rate of
7.50%.

SWAPS

A Swap is a contract where one party exchanges the interest stream for another partys stream.
Swaps are of two types:
Interest Rate Swaps
Currency Swaps

SWAPS

Interest rate Swaps are normally 'Fixed Against Floating', but can also be 'Floating Against Floating'
rate.
A plain vanilla coupon swap is an agreement between two parties to exchange interest payment on
Notional Amount at regular intervals through out the life of swap.
One party pays interest at a fixed rate and other party pays interest at variable rate.
Such swaps have a duration of one to 30 years.
Example 1
Interest Rate Swap

A company borrowed Rs 10 million on which it pays interest @ KIBOR plus 1% every six months for
four years. The company anticipates a surge in interest rates and therefore, intends to use Swap to
fix the interest rate.
A bank offers four years Swap in which it will receive fixed rate of 6.50% in exchange for paying @ of
KIBOR.
Solution

The company is Swapping its variable interest rate with fixed interest rate.
This Swap has fixed the interest rate at 7.50%.
Interest Rate Payable

(KIBOR + 1%)

Receive @ floating

KIBOR

Pay @ fixed

(6.50%)

Net Interest

(7.50%)

Example 2
Interest Rate Swap

A company has Rs. 25 million 8% bond issue having remaining life to maturity of 10 years. Interest is
paid six monthly. The company anticipates that interest will be falling in future and would like to
swap the fixed interest rate for floating rate.
A financial institution has offered 10 years swap on Rs. 25 million in which it pays fixed rate of 7.15%
and receives floating interest based on 6 months KIBOR. Interest payments to be exchanged after 6
months.
Solution

With this swap company will ensure fixed interest with floating interest.
The fixed interest 8% will be swapped with KIBOR + 0.85%, as under:Interest on bonds

= (8%)

Swap (Received fixed) = 7.15


Pay (Floating)

= (KIBOR)

Net Cost

= (KIBOR + 0.85%)

Currency Swaps

Currency Swaps are like interest rate Swaps.


Underlying securities are different currencies.
Interest payments may be fixed or floating.
It involves exchange of currencies at the start and end of Swaps.

How Currency Swap Works?

A Pakistani company is looking for investment in Sri Lanka and needs to borrow Sri Lankan Rupee for
five year project.

It will borrow in Sri Lankan Rupees because the profit earned by the project and the debt will Be in
Sri Lankan Rupee.
The company is new to Sri Lankan market and may have to pay higher interest rates than local
companies. To hedge this transaction the company can use currency Swap.

Currency Swap

Assuming the company invests Sri Lankan Rupee 13 million in a project there and current spot rate is
1 PKR = 1.30 SLR.
Lets assume that company borrows Rs 10 million by issuing long term bonds carrying fixed interest
rate.
A five years Swap is arranged with a bank and it agreed to exchange Rs. 10 million with 13 million
SRL at the start of the project.
In Swap the Pak company will pay interest on 13 million SLR Fixed or Floating.
On the other hand, the company will receive interest from bank on Rs 10 million. Company would
like to receive interest at fixed Rate.
The amount received in swap will be used for making interest payments on bond issue.
At the end of 5th year, company will return SLR 13 million in exchange for Rs 10 million.

What Benefits Swap Offers?

It allows company to change a adverse fixed with favorable floating and vice versa.
Flexibility (Not being Standardized): Swap can be arranged for any sum and period.
Off balance sheet transaction, shown as contingencies & commitments.

LESSON 44
Exchange Rate Determination
PKR / US$ Parity Discussion 1986 to 2007.

How exchange rate volatility hamper local trade:


If a country has a weak or depreciating currency, then imports will be expensive or costly.
For example, if 1 US$ is Rs. 60 and it depreciate against the US$, to Rs. 61/US$ then Pakistani
importer has to buy one dollar by spending Re 1.
If the imported material was an input item, then this depreciation has increased the cost of sales or
reduced the gross margin by Re. 1.
This also increases the rate of inflation and therefore, weakens the economy.

If a country has a strong currency or that is appreciating in value, then its export will not be
competitive or expensive for foreign customers.

Current Deficit
Current Surplus
The Question is How Exchange Rates are determined?
1) The Economic Factors:

Rate of Inflation and


Rate of Interest between two countries.
2) Measure taken by the respective Governments like Currency Blocs and Zones, or a Currency Board.

Capital Movement

Purchasing Power Parity (PPP) Theory

It refers to the law of one price, which states that there will be one price in a given time when there
are no trade barriers , no transportation costs, and under free market.
In other words, this law suggests that exchange rates will adjust to ensure one price worldwide under
free market conditions.

PPP Model
= 1 + ir / 1 + in
Where
ir = Expected Foreign Inflation Rate
in = Expected Home Inflation Rate

Example:

Inflation rate in Pakistan is 6%

and expected to be at this level over next 3 months and the inflation
rate in Sri Lanka is expected to be 9%. Current spot rate is SLR/PKR = 1.50
= 1 + ir / 1 + in
= (1 + 0.09) / (1 + 0.06) x 1.50
= 1.5424

Weakness in PPP

It ignores the effect of capital movements on the exchange rate.


Exchange rate is only effected by international trade and not goods not entering international area.
Governments always influence to manage exchange rate by adjusting monetary policy. (Interest rates ).
Interest Rate Models
International Fisher Effect.
Nominal Interest Rates consists of two parts:
- Return required by lenders
- Return to cover inflation
If real interest rates are same in all places due to free capital movement and because of law of one
price. Then any difference in interest rates will be due to inflation level at difference places.
If the real interest rates in countries have not properly effected inflation rate, the capital will move from
low to high interest country.
Countries with high interest rate will register capital inflow and will result in appreciation in exchange
rate.
Countries with low interest rate will experience capital outflow and will result in depreciation in
exchange rate.
This is known as Interest Rate Parity Model.
Interest Rate Parity Model shows that exchange rate can be predicted by taking into account the
differences in nominal exchange rates.
If the forward rates for PKR against US $ is the same as spot rate between the two currencies but the
nominal interest rates are higher in US then following would be the situation:

Pak investor will shift funds to us to earn higher return.


There will be outflow of capital from Pak to US. Pak interest rate will increase and spot $ rate will
move up.
Exchange Rate System

Although ex rates are affected by rate of interest and inflation among the countries.
But the Govt. or the Central Banks are incharge of monitoring and controlling the ex rate besides the
forces of demand and supply.

Exchange rate can be:

Fixed Rate System or


Floating Rate System

The fixed or floating exchange rate choice depends on following factors:

Growth and volume of foreign trade


Balance of payment (Disequilibrium)
Domestic economic policy
Fixed Exchange Rate System

Under this system State Bank / Govt. manage the exchange rate at par.
The state bank has to keep official reserves because of the following:To finance any current account deficit
Intervene the foreign exchange market to maintain the par value of currency.
The currency would be bought with reserves if ex rate fell and to sell in exchange of reserves when
the ex rate goes up.

Forms Of Reserve
Merits & Demerits of Fixed Ex System:
No Fluctuations:
The ex rate fluctuation are absent so it reduces the currency risk faced by the business.
And also reduces the cost of hedging like in option / future / contracts.
Lack Of Flexibility:

It means that balance of payment deficit will not be corrected automatically, Govt. / State Bank
has to use deflationary policies to depress imports. this slows down growth.

Floating Exchange Rate System:


Under this system ex rate is primarily determined by market forces. However, there are degrees to
which Govt. will allow market forces to determine ex rate.
There is no official intervention in fx market and no reserve is required to be kept.
Govt. will have ultimate control over fx market due to variety of issues like international
competitiveness, employment, inflation and fx reserves.
Free floating is rather managed floating where Govt. does intervene to prevent large changes in
foreign exchange.
Govt. allow the foreign exchange to move between large bands and only intervene if market forces
try to throw it outside these limits.
Currency risk is greater in floating ex rate system and it makes financial management more complex
and expensive
Balance of payment (BOP) is automatically corrected and no need to finance BOP deficit.

Global Business Environment

Multinational Companies (MNC)


A MNC is a company that generates at least 25% of its total sales from foreign countries.
Operations:
A MNC has offices:
Production facilities
Branches
Subsidiaries
Spread across more than one country (Home Country). May have capital raised in billion in more than
one location, using tax heavens, employing cheap labor.

Reason For Growth In MNCs

Exploit Tax Heaven and Cheap Labour


Advancement of Technology & Communication
Mobility of Capital
Lesser Trade Restrictions
Factors Contributing To MNC Success

Process Specialization:

Standardization of product, high and internationally accepted standards, production


methods. Competitive advantage, patents, trade marks etc. Managerial skill.

Product Specialization:
Producing products according to the markets is an important factor to success.

Research & Development


Horizontal and Vertical Integrations
Transfer Pricing and Tax Free Locations
External Factors Adding Success To MNCs

Competition
Size of market
Investment safety and incentives
Political stability
Labour / Cost
Capital market

LESSON 45
Multinational Companies (MNC)
Motives For Foreign Investment
Market Development or Seekers:
Raw Material Seekers
Production Efficiency Seekers
Knowledge Acquisition
Political Stability

Economic Motives:
Overseas investors may have economic strength over local investors due to:

Technology
Economies of scale
Managerial capabilities
Financial strength
Marketing ability

International Operations

A company may find direct foreign investment as a mean of achieving strategic objectives.
There are several reasons which attract a company to invest overseas.

Reasons for International Operations:

Financial Validity:
o Projections and evaluations are positive and it can be calculated that foreign investment will add
value or maximize the shareholders wealth.
Production Efficiency:
o Cheap labor and raw materials can be a motive to go overseas.
Marketing motives:
o To find market for companys products.

Different forms of International Operations


1) Export from Home Country:
- No office in foreign country
- Low risk
- Low capital requirement

Demerits:
Foreign market knowledge is not known with precision.
Customers may not value invisible supplier, difficult for customers to contact.
Normally attracts tariffs & quotas.
2) Set up an Overseas Branch:

Quickest way to start overseas operations.


Simple and less expensive.

Tax Consequences:

Profits of branch located any where are assessed as companys profits for tax purposes.

3) To Established A Subsidiary:

A separate entity formed under the law of land but under the control of home parent company.
It shows long term commitment to local market.
Tax Advantage: Tax only applicable if profits are repatriated to home country .
Local knowledge to understand local market or the culture of the local market.
Heavy / handsome investment /upfront cost.
Significant risk involved.

4) Joint Venture:

A jointly controlled entity by two or more venturer having a joint motive.


Normally one venturer comes of local market or country of joint venture operations.
Local venturer is considered to be expert and knowledgeable person as far as local market is
concerned.

Demerits:
Power to Control or Lack of Trust :
Each venturer will try to seek maximum control over the business and this leads to politics of power.
Power struggle De-motivates employees and they may take advantage of it.
Fragile: Can break away quickly.
Risk: Less risky as compared to subsidiary options.

5) Licensing Agreements:

It does not require any capital expenditure.


Payment = A fixed % of sales.
It is not risky.
Most of medicines are example of Licensing Agreements.
Demerits:
The mother firm cannot exercise any managerial control over the licensee. (It is independent).
RISK

Financial Risk
Political Risk

Political Risk

The risk can be divided into following categories:


1) Confiscation Risk:

The risk of loss of control, business may be taken over by the local Govt. or intervention and
interference by the local authorities.
This risk can be reduced by insurance policies.
A joint venture would be preferable in less or developing country.
A subsidiary would be preferable in a stabled and developed countries.
Even then this risk is present and can be reduced by:
High Gearing
Share in equity from local resources
High Local Loans/Finances

2) Commercial Risk:

There may be discriminative laws for foreign companies, wages level or lower prices for products,
repatriation of profits.
More emphasis to use local resources.

3) Financial Risk:

Restricted access to local resources loans etc.


Terms of maximum foreign equity.
Restrictions on repatriation of capital and dividend.
Exchange and currency risk.
Measurement & management of political risk.

8th Module:
International Operations

ADDITIONAL
DATA

Concept of Moneyness of an Option


Lets assume:
X = exercise/ strike prices & S = Market Price
For call option:
A call option is in the money if S>X;
A call option is out of the money if S<X;
A call option is at the money if S = X
A call option is exercised when market price is greater than strike price.
For put option:
A put option is in the money if X>S
A put option is out of the money if X<S
A put option is at the money if X = S
A put option is exercised when Strike price is greater than market price

Types of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here are a
fewtypes, distinguished by the relationship between the two companiesthat are merging:
Horizontal merger:
Two companies that are in direct competition and share the same product lines and markets.
Vertical merger:
This is the merger of a customer and company or a supplier and company. Think of a cone
suppliermerging with an ice cream maker.
Conglomeration:
Two companies that have no common business areas i.e. operating in different industries when
merge then known as conglomerate merger.
There are two types of mergers that are distinguished by how the merger is financed. Each
hascertain implications for the companies involved and for investors:

Purchase Merger - As the name suggests, this kind of merger occurs when one
companypurchases another. The purchase is made with cash or through the issue of some kind
ofdebt instrument; the sale is taxable.
Consolidation Merger - With this merger, a brand new company is formed and both companies
are boughtand combined under the new entity. The tax terms are the same as those of a purchase
merger.
Difference between Operating Cycle and Cash Conversion Cycle (Cash Cycle)
Operating Cycle:
Operating cycle for a firm is the average number of days that the firm takes to convert its raw material
into finished goods for sale and getting cash proceeds from debtors.
Formula for operating cycle is:
Operating cycle = Average days of inventory (stock holding period) + Average receivable processing
period (in days)

Cash Conversion Cycle:


It is also termed as net operating cycle or simply the cash cycle. It starts from conversion of raw material
into finished goods for sales and collection of cash from debtors to payback to their creditors/ suppliers.
Cash Conversion cycle = Average days of inventory (stock holding period) + Average receivable days
Average payable processing period (in days)
Note: Cash conversion cycle is always shorter than the operating cycle because here average payable
days are subtracted form operating cycle.