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Week 1

What is Corporate Treasury Management?

Determine the firms financial strategy and financial policy
Create an appropriate capital structure (debt & equity)
Manage liquidity to meet commitments and cash requirements as and when they fall
Identify and fund business activities appropriately
Identify and control financial risks
Encourage sound financial practices

Five pillars:
Corporate financial management
Capital markets and funding
Cash and liquidity management
Risk management
Treasury operations and controls
Treasurys linkage to managing enterprise risk:
Slide 28
Financial health of firm (balance sheet view)
Enough working capital? Funding decision? Short term long-term? Dividend ? What
assets to invest? Solvent?
Financial health of firm (cash flow view)
(1) Financing: Cash raised from investors
(2) Allocation: Cash invested in firm
(3) Return on investment: Cash generated by operations
(4a) Allocation: Cash reinvested
(4b) Distributing: Cash returned to investors (interest or dividends)
Advisory role:
Decisions, transactions made by divisions, subsidiaries
Agency role:

Conducts transactions, decisions either centralised or delegated

Banking role:
In-house banking, centralised decisions
Centralisation advantages
Greater negotiating power Group perspective:
Aggregation of risks, exposure netting
Consolidation of funding and investment
Consistent policies/ procedures/ standards
Holistic treasury management
Economies of scale
More sophisticated management, operations, systems
Better level of control
Centralisation -disadvantages
May become bureaucratic, provide slow response to local firm needs
May not understand local firm needs
Financial health of firm (financial risk)
Corporate Risk Appetite
The risk appetite statement will align the business planning / risks with
Stakeholder expectations (e.g. demand for extra return)
Strategic planning (e.g. align capital allocation with capacity level)
Financial performance (e.g. hedging of risks)
Business operations (e.g. aligning risk profile with acceptable risk levels)
The Post GFC Future of Treasury

Increased business expansion and identification of growth opportunities;

Stronger focus on risk and controls;
Change from cash management to working capital management and then to the total
balance sheet, from managing financial risks to all enterprise risks;
Now highly Integrated with other systems
Increased focus on simplification of financial processes;
Increased use of new technology to automate their processes including rules based
decision making;
Increased use of outsourcing and shared services;
Benefits are explained in terms of :
Managerial self-interest
The non-linearity of taxes
The costs of financial distress
The existence of financial market imperfections

Week 2
Who Measures Performance?
Management (compare with targets, budgets, peers)
Business owners (e.g. institutional shareholders)
Investors (e.g. individual shareholders)
Financials institutions (e.g. lenders), other creditors
Analysts (e.g. stock brokers)
Regulators (e.g. ASIC, ASX) disclosure etc.
The Firms Cash Flows
Operating Cash Flows: cash flows directly related to the production and sale of a
firms products and services.

Investing Cash Flows: cash flows associated with the purchase and sale of non
current assets and business interests.
Financing Cash Flows: cash flows that result from debt and equity financing
Horizontal analysis: Trend analysis
Vertical analysis: express a percentage of significance
Pro Forma Statements limitations
Historical data (not necessarily an indication of future)
Some variables may be forced to take a desired value
Sometimes it is difficult to break the fixed and variable costs
Need to make adjustments to account for changes in the firms strategy
Du Pont analysis
ROE=leveraged multiplier*ROA ROA=net utilization*net profit margin
Limitations of Ratios
Historical data (not necessarily an indication of future)
Poor or inadequate accounting methods
Inflation or changes to fair values
Changes in accounting methods
Existence of unusual items during a financial year e.g.. losses by fire
Year-end may not be typical of firms position during year
Different year ends may mean peer ratios not comparable
Management changes
Changes to economy, industry-wide recession, etc
OCF = (Revenue Costs Depreciation &/or Amortisation)x (1 T) + Depreciation
&/or Amortisation
Free Cash Flow (FCF) is the amount of cash flow available for distribution to debt
and equity holders after:
1.meeting all operating needs

2.paying for its net fixed asset investments (CAPEX) and

3.Paying for its net current asset investments (Net working Capital)
CAPEX: Funds that a company uses to purchase, improve, expand, or replace
physical assets such as buildings, equipment, facilities, machinery, and other assets
Capitalized on the balance sheet once the expenditure is made and then expensed
over its useful life as depreciation through the companys income statement
As opposed to depreciation, CAPEX represent actual cash outflows and,
consequently, must be subtracted from EBIAT in the calculation of FCF (in the year in
which the purchase is made)
Net working capital is defined as non-cash current assets (current assets) less noninterest-bearing current liabilities (current liabilities)
FCFF = (Revenue Costs Depreciation
& /or Amortisation)x (1 T)
+ Depreciation & / or Amortisation
change in Net Working Capital

FCFD = interest (before tax) + Net Borrowing

FCFE = FCFF (1 T) x Interest payments + Net Borrowing
Valueof leveraged firm = Value of equity (leveraged) + Debt
VL= EL + D
FCFF = FCFE + FCFD Tax shield
Week 3
Capital budgeting
The process that managers use to make decisions about whether long term
investments or capital expenditures are worth pursuing
Independent projects VS mutually exclusive projects
If mutually exclusive projects have unequal lives, it may be necessary to adjust the
analysis to put the projects on an equal life basis.

Product to project cannibalisation example:

If 20% of revenues from new product or project would have come from existing
product or project
Either use 80% of revenues or
Include the lost 20% of revenues from other product/ project as opportunity cost of
new project/product
Product to project synergies example:
If new project/product creates spin-off benefits for other products/projects
Include benefits as a positive cash flow to new project
Tax Losses
Tax loss carry forwards and carry backs allow corporations to take losses during its
current year and offset them against gains in nearby years
Rules for Cash flows for Capital Budgeting
Cost of project must be determined
Excludes interest/finance costs (financing costs in cost of capital)
Management must estimate expected cash flows from project which must
be incremental cash flows
exclude fixed allocated costs, sunk costs
include opportunity costs, increases in working capital, salvage values, tax payments
Riskiness of projected cash flows must be considered
Cost of capital is the expected rate of return that the market requires in order to
attract funds to a particular investment(i.e. the required rate of return on invested
A firm will invest only if the expected rate of return on a project exceeds the cost of
The cost of capital is also referred to as a hurdle rate because this is the minimum
acceptable rate of return

The hurdle rate should be higher for riskier projects and reflect the financing mix
used -owners funds (equity) or borrowed money (debt)
WACC = (E/(D+E)) x Re + (D /(D+E)) x Rd x (1-Tc)
The WACC can be used throughout the firm as the companywide cost of capital for
new investments that
1.are of comparable risk to the rest of the firm, and
2.that will not alter the firms debt-equity ratio.

Can the existing required rate of return be used to assess the required rate of return
on a firms new investment projects?
Use risk-adjusted discount rate (RADR) or adjust cash flow (certainty equivalent
Certainty-equivalent approach
1.Adjust all cash flows by certainty-equivalent coefficients to get certain cash flows
2.Discount the certain cash flows by the risk-free rate of interest
3.Apply normal capital-budgeting criteria

Risky cash flow* Alpha= certain cash flow

Sensitivity analysis:
What if? Other firm take the project? Any future uncertainty affect the NPV? Then
whether worthwhile investing more time and effort to solve it?
Definition of Break even analysis:
Break even analysis shows the level of an input to the Free cash flow analysis that
causes the NPV of the investment to equal zero.
Definition of Sensitivity analysis:
Sensitivity Analysis shows how the NPV varies with a change in one of the
assumptions, holding the other assumptions constant.
Generally uses pessimistic, expected and optimistic estimates of cash inflows
Definition of Scenario analysis:

Scenario Analysis is a risk analysis technique which considers the effect on the NPV
of simultaneously changing multiple assumptions.
Definition of Stress Test analysis:
Stress testing is a form of deliberately extreme testing used to determine the stability
of the expected outcomes to a project or a company's valuation.
It involves testing beyond normal operational, economic or financial conditions to
identify results that may involve extreme outcomes.

Week 4
NPV shortcoming:
Standard NPV analysis fails to take into account the value of managerial flexibility
The real world is characterized by change, uncertainty and competitive interactions
A real option is the right, but not the obligation, to take an action ( e.g., deferring,
expanding, contracting, or abandoning ) at a predetermined cost called the exercise
price, for a predetermined period of time the life of the option.
When there is high uncertainty and when managers have flexibility to respond to it,
real options are important. But the value of real options relative to NPV is large when
the NPV is close to zero.
the appropriate mind-set is to recognize that the net present value technique
systematically undervalues everything because it fails to capture the value of
while the value of flexibility is always positive, the price that you have to pay for it
often exceeds its value
Option to expand operations
Buy a call option
Option to abandon
Buy a put option
Decision Tree Analysis: See questions
Successfully explains valuation of multiple companies believed to have substantial
real options
Explain some of the difference in markets not accounted for by traditional

Real Options can be miscalculated / mis-used and mis-value a company
Week 5
The cost of debt is the market interest rate that the firm has to pay on its borrowing.
It will depend upon three components:
The general level of interest rates
The default premium
Risk that firm will fail to make its obligated debt payments, including interest
expense or principal
The liquidity premium
To estimating bond ratings, use interest coverage ratio (EBIT/Interest expense)
Note: This is highly simplified !
If firm has bonds outstanding, and bonds are traded, yield to maturity on long-term,
straight (no special features) bond can be used as interest rate
If firm is rated, use rating and typical default spread on bonds with that rating to
estimate cost of debt
If firm is not rated, and has recently borrowed long term from bank, use interest rate
on borrowing
The cost of equity is
the required rate of return given the risk
inclusive of both dividend yield and price appreciation (capital growth)
Estimate beta: regress stock return against market
Estimation period
Longer periods provide more data, but firms change
Shorter periods can be affected more easily by significant firm-specific events during
the period
Decide on return interval (daily, weekly etc.)
Shorter intervals yield more observations, but suffer from more noise

Noise is created by stocks not trading

Market Risk Premium
Historical estimation
Calculate average return on stock index
Calculate average return on riskless security
Calculate difference and use as premium Assumptions
Risk aversion of investors has not changed over time Riskiness of risky portfolio
has not changed over time
Calculating Debt & Equity Weightings
general rule, use market value
Competing theories of capital structure
1. Modigliani Miller
In an environment, where there are no taxes, default risk or agency costs, capital
structure is irrelevant.
If the Miller Modigliani theorem holds:
A firm's value will be determined the quality of its investments and not by its
financing mix.
The cost of capital of the firm will not change with leverage (i.e. WACC remains
2. Pecking order theory
Do firms follow a financing hierarchy, with retained earnings being the most
preferred choice for financing, followed by debt and that new equity is the least
preferred choice ?
Estimating the Cost of Capital and its impact on firm value
As debt increases -> Equity will become riskier -> Beta will increase -> Cost of
Equity will increase (use leverage beta)
Use the current leverage beta to estimate the firms unleveraged beta

What is the optimal capital structure ?

The debt / equity mix that maximises the value of the firm at the lowest cost
See reading about tax imputation!!!!!!!!!
Week 6
In the absence of dividends, corporate earnings accrue to the benefit of shareholders
as retained earnings and are automatically reinvested in the firm.
When a cash dividend is declared, those funds leave the firm permanently and
Distribution of earnings as dividends may starve the company of funds required for
growth and expansion, and this may cause the firm to seek additional external capital.
Two basic components to Dividend Policy
1.Dividend payout ratio
Dividend per share / Earnings per share
company needs to consider whether:
Dividend decision is related to other financial decisions
Effects of changing dividends, and
Whether to adopt a dividend reinvestment plan
Bonus Shares
Distribution of additional shares to the shareholders
Stock splits
The par value per share is reduced and the number of shares increased
Share repurchases (Buy-backs)

An alternative to cash dividend where the objective is to increase the price per share
rather than paying a dividend
Why Companies Repurchase Shares?
Dividend substitution (taxation driven)
If capital gains are taxed more favourablythan dividends
Improved performance measures
EPS may rise, but if cash is returned rather than used to retire debt, financial risk is
increased and P/E ratio along with share price may fall
Signaling and undervaluation
Managers buying back company stock indicates that they believe the stock is
undervalued by the market
Alternatively, a buy-back announcement could be accompanied by some new
information, e.g. sale of unprofitable asset/division
Resource allocation and agency costs
Share repurchase returns capital to shareholders, who can reallocate funds into
profitable activities through the capital market.
Reduces the potential for managers to inefficiently use free cash (i.e. reduces agency
Financial flexibility
Payment of dividends is a long-term commitment, and sudden major changes
(especially decreases) in dividend policy are unappreciated by market.
Buy-backs offer an alternative way to make distributions that may not be permanent.
Employee share options
Unlike paying dividends, share repurchases do not lead to the ex-dividend price
Option holders (typically management) prefer a share repurchase to a dividend
payout as a means of distributing profits to shareholders.

Dividend Reinvestment Programmes(DRPs) offer shareholders the option to apply all

or part of their cash dividends to the purchase of additional shares in the company (in
some cases at a discount price)
Dividend Election Schemes (DESs) allow shareholders the option of receiving their
dividends in one or more of a number of forms e.g. bonus shares (deferring tax), or as
dividends from overseas subsidiaries (foreign tax credits)
Stock Dividends and Splits
With a stock dividend, a firm does not pay out any cash to shareholders
Stock dividends are not taxed, so from both the firms and shareholders perspectives,
there is no real consequence to a stock dividend
As a result, the total market value of the firms market capitalisationof equity is
unchanged. The only thing that is different is the number of shares outstanding.
Stock Dividends and Splits
The typical motivation for a stock split is to keep the share price in a range thought
to be attractive to small investors
If the share price rises too high, it might be difficult for small investors to invest in
the stock
Keeping the price low may make the stock more attractive to small investors and
can increase the demand for and the liquidity of the stock, which may in turn boost
the stock price (approx2% increase in price)
The Tax Disadvantage of Dividends
Taxes on Dividends and Capital Gains
Shareholders must pay taxes on the dividends they receive and they must also pay
capital gains taxes when they sell their shares.
Dividends are typically taxed at a higher rate than capital gains. In fact, long-term
investors can defer the capital gains tax forever by not selling.
When dividends are taxed at a higher rate than capital gains, if a firm raises money
by issuing shares and then gives that money back to shareholders as a dividend,
shareholders are hurt because they will receive less than their initial investment
The Effective Dividend Tax Rate



This measures the additional tax paid by the investor per dollar of after-tax capital
gains income that is instead received as a dividend.
Dividend Capture and Tax Clienteles
The preference for share repurchases rather than dividends depends on the difference
between the dividend tax rate and the capital gains tax rate
Tax rates vary by income, by jurisdiction, and by whether the stock is held in a
retirement account
Given these differences, firms may attract different groups of investors depending on
their dividend policy
Resulting in clientele effects
Clientele Effect
When the dividend policy of a firm reflects the tax preference of its investor clientele
Individuals in the highest tax brackets have a preference for stocks that pay no or low
dividends, whereas tax-free investors and corporations have a preference for stocks
with high dividends.
Imputation Tax System

A dividend that has a franking credit attached is referred to as a franked dividend

Dividends with no franking credits are referred to as unfranked dividends
Impact of Imputation on firm valuation

Slide 49 50

Week 7
Cash Conversion Cycle
A firm can minimize its working capital by
speeding up collection on sales
increasing inventory turns, and
slowing down the disbursement of cash.
Graph Slide 11
Operating Cycle: The time from the beginning of the production process to collection
of cash from the sale of the finished product
CCC = the amount of time the firms resources are tied up.
Calculated by:
OC = Operating cycle
APP = Average payment period
AAI = Average age of inventory
ACP = Average collection period
Graph: slide 14
Requires management of:
Inventory (raw inventory and finished goods) (more turnover)
Credit terms of suppliers (accounts payable management)(pay payable slowly)

Credit for customers (accounts receivable management)(collect receivable quickly)

Account receivable approach:
Liberal VS strict more/less sales and gross margin but more/less receivable, bad
debts, collection costs
Benefits and Costs of carrying Inventory
Reduces stock outs
Reduces backorders
Makes operations run more smoothly, improves customer relations and increases
Carrying Costs
Interest on funds used to acquire inventory
Storage and security

Motives for holding cash

Transactions motive
To meet cash needs that normallyarise from doing business (e.g. employees,
suppliers, utility/phone, etc.)
Precautionary motive

To meet any unexpectedneeds for cash

(e.g. unforeseen expenses)
Speculative motive
To take advantage of potentialprofit-making situations (e.g. purchase of raw
materials that are on sale)

Cash managementinvolves managing cash to:

Maintaining adequate liquidity with minimum cash in bank and marketable seurities
Minimizing interest costs
Optimal size of firms liquid asset balance
Appropriate types and amounts of short-term investments
Maintain the firms credit rating
Most efficient methods of forecasting and controlling the collection and
disbursement of cash
Management activities to reduce the CCC
Permanent Working Capital
The amount that a firm must keep invested in its short-term assets to support its
continuing operations
The matching principle suggests that the firm should finance this permanent
investment in working capital with long-term sources of funds.
Temporary Working Capital
The difference between the actual level of short-term working capital needs and its
permanent working capital requirements
The matching principle suggests that the firm should finance this temporary
investment in working capital with short-term sources of funds.
Invest capital in: liquid assets working capital and fixed assets

Aggressive Financing Policy

Financing part or all of a firms permanent working capital with short-term debt
One risk of an aggressive financing policy is funding risk.
Funding Risk
The risk of incurring financial distress costs should a firm not be able to refinance its
debt in timely manner or at a reasonable rate
Conservative Financing Policy
Financing all of a firms permanent working capital with long-term debt.
The Miller-Orr model: A more general approach
U* = upper limit
C* = target balance
L = lower limit = safety stock
As long as the actual cash balance is between U* andL, nothing happens
Cash levels hit the limits and action must be taken.
When the cash balance reaches the upper limit, the firm moves U* -C* out of cash
and into marketable securities
When the cash balance falls to the lower limit, the firm will sell C* -L worth of
securities and deposit the cash in the account
Example see slides

Unsecured Bank Loans

Bank Overdrafts
An agreement between a commercial bank and a business to allow its current
working account to go into deficit up to a predetermined limit.
The overdraft limit is the maximum amount the firm can owe the bank at any point.

Loans are priced at a spread above cost of funds.

Secured Sources of Loans
Secured loans have assets of firm pledged as collateral. If there is a default, the
lender has first claim to the pledged assets. Because of its liquidity, accounts
receivable is regarded as a prime source for collateral
Bank Loans
Accounts Receivable loans
Pledging Accounts Receivable
Borrower pledges accounts receivable as collateral for a loan obtained from either a
commercial bank or a finance company
Credit Terms: Interest rate is 25% higher than the banks prime rate. In addition,
handling fee of 12% of the face value of receivables is charged.
While pledging has the attraction of offering considerable flexibility to the borrower
and providing financing on a continuous basis, the cost of using pledging as a source
of short-term financing is relatively higher compared to other sources.
Factoring Accounts Receivable
Factoring accounts receivable involves the outright sale of a firms accounts to a
financial institution called a factor
Invoice Discounting
Involves the sale of accounts receivable to a discounter, where the accounting
function is retained by the firm selling the accounts receivable.
Advantages Of Factoring & Invoice Discounting
Allows the firm to turn accounts receivable immediately into cash.
Ensures a known pattern of cash flows.
Allows the firm to take advantage of early settlement discounts, or use cash to
improve liquidity.
May lead to the elimination credit and collection departments.
Secured Sources: Inventory Loans

These are loans secured by inventories

Floating or blanket Lien Agreement
The borrower gives the lender a lien against all its inventories
Chattel Mortgage Agreement
The inventory is identified and the borrower retains title to the inventory but cannot
sell the items without the lenders consent

Week 8
What is Structured Finance ?
Financing techniques tailored to special needs or constraints of issuers or investors
Hybrid Instruments combines elements of traditional instruments into a single
complex instrument
Corporate Bonds
Long term debt instruments used by the corporate sector.
The longer the maturity, the higher the coupon rate.
The larger the issue, the lower the coupon rate.
The riskier the issuer, the higher the coupon rate.
This is the number of years over which the issuer has promised to meet the
conditions of the obligation
The principal of a bond is the amount that the issuer agrees to repay the bondholder
at the maturity date
Coupon = Yield PV = FV Par
Coupon < Yield PV < FV Discount

Coupon > Yield PV> FV Premium

Repayment Provisions
A bond issuer typically repays its bonds by making coupon and principal payments
as specified in the bond contract.
Callable Bonds
Bonds that contain a call provision that allows the issuer to repurchase the bonds at a
predetermined price
A firm may choose to call a bond issue if interest rates have fallen.
The issuer can lower its borrowing costs by exercising the call on the callable bond
and then immediately refinancing the issue at a lower rate.
This makes callable bonds relatively less attractive to bondholders than identical
non-callable bonds.
A callable bond will trade at a lower price (and therefore a higher yield) than an
otherwise equivalent non-callable bond.
If the yield of the callable bond is less than the coupon, the callable bond will be
called, so its price is its par value.
If this yield is greater than the coupon, then the callable bond will not be called, so it
has the same price as the non-callable bond.
When market yields are low relative to the bond coupon, investors anticipate that the
bond will likely be called, so its price is close to the price of a non-callable bond that
matures on the call date
When market yields are high relative to the bond coupon, investors anticipate that
the likelihood of exercising the call is low and the bond price is similar to an
otherwise identical non-callable bond.
Sinking Fund
A method of repaying a bond in which a company makes regular payments into a
fund administered by a trustee over the life of the bond
These payments are then used to repurchase bonds.
This allows the firm to retire some of the outstanding debt without affecting the cash
flows of the remaining bonds.

Capital Notes
Capital Notes are debt securities that have equity like features attached
Convertible Bond
A corporate bond with a provision that gives the bondholder an option to convert each
bond owned into a fixed number of shares of common stock
Conversion Ratio --The number of shares of common stock into which a convertible
security can be
converted. It is equal to the face value of the convertible security divided by the
conversion price.
Conversion Price --The price per share at which common stock will be exchanged for
a convertible security. It is equal to the face value of the convertible security divided
by the conversion ratio.
If convert at a fixed dollar price
the number of shares you receive depends on the market price of the shares at
Securities are converted at a higher price than if they would have been directly
issued. This has the impact of reducing the dilution effect
Information signaling
Company with good future prospects can issue stock through the back door by
issuing convertible bonds
Avoids negative signal of issuing stock directly
Since prospects are good, bonds will likely be converted into equity, which is what
the company wants to issue
Asset substitution (or bait-and-switch). Firm issues low cost straight debt, then
invests in risky projects
Bondholders suspect this, so they charge high interest rates
Convertible debt allows bondholders to share in upside potential, so it has low rate.
Preference shares

A preference share is a 'hybrid' security, meaning it has features of both debt and
Debt characteristics
pays a regular defined income stream, and
generally has a fixed maturity date
Equity characteristics
pays income in the form of dividends, and
generally converts into ordinary shares at some future point
Dividend obligation not contractual Avoids dilution of common stock
Avoids large repayment of principal
Preferred dividends not tax deductible, so typically costs more than debt
Increases financial leverage, and hence the firms cost of common equity

Week 9
The Basic Share Dividend Valuation Equation
Discount all dividends
If no growth rate, =Divt+1/Re or Divt+1+P1/1+Re
If constant growth rate, =Divt+1/Re-g
If differential growth rate, ````````
Free Cash Flow Valuation Model
To find the value of the ordinary shares :
Vs= VcVD-Vp

Book Value Approach

Book Value Approach: The amount per share to be received if all assets are
liquidated at their book value, and surplus after paying all liabilities divided among
Liquidation Approach
Liquidation Approach: The amount per share to be received if all assets are
liquidated, liabilities are paid and any surplus divided among shareholders.
=Liquidated assets- liabilities/number of shares
Price / Earnings multiples
Share value is estimated by multiplying the firms expected EPS by the average P/E
ratio for the industry.
Share price/diluted EPS Equity value/Net income
How much investors are willing to pay for future earning?
Increased Use of Short term debt
The decrease in debt maturity was generated by
firms with higher information asymmetry and new firms issuing public equity in the
1980s and 1990s.
Firms with lower agency costs of debt (as proxiedby leverage, market-to-book ratio,
and capital expenditures) experience significant decreases in debt maturity
Debt maturity falls significantly more for low tangibility and research and
development (R&D)-intensive firms, which suggests that firms with higher levels of
information asymmetry are operating with larger quantities of short-term debt.
Firms with low institutional ownership and analyst coverage and high dispersion of
analyst forecasts, volatility, and illiquidity experience a more pronounced increase in
the use of short-term debt.
Week 10
Commodity risk
Commodity risk is the risk that a businesss financial performance or position will be
adversely affected by fluctuations in the prices of commodities.

Price risk changes in price

volumetric risk changes in volume
Companies within sectors such as industrials, mining and metals, energy, retail and
consumer goods appear to have the greatest exposures to commodity risk
1. Reduce viability of production
2. Decrease input costs
3. If demand not impacted by increasing costs
Vertical Integration
Refers to the merger of a firm and its supplier or a firm and its customer.
Because an increase in the price of the commodity raises the firms costs and the
suppliers revenues, these firms can offset their risks by merging

Inventory Storage
Long-term storage of inventory is another strategy for offsetting commodity price
Long-term storage of inventory also requires a substantial cash outlay upfront.
Hedging and Risk Reduction
Risks to a business which may be hedged?
Price fluctuations
Currency and interest rate fluctuations Political instability
Weather changes
Cash shortfalls & Financial distress
Credit risk

Hedging is designed to reduce the range of outcomes to a desired level

Natural hedges need to be identified and then if the resulting exposure is outside the
risk appetite of the company, then derivative contracts such as forwards and options,
can be used to reduce the exposure to the desired level
Example: pricing gold forward
Buy a replicating strategy:
Buy Commodity on the spot market for cash, and carry it into the future (store it);
Borrow the cash needed to fund the purchase, and repay the loan on date t = 1.
Note that the interest rate is your cost of carry:
Borrowing cash on date t = 0 allows you to carry the Commodity forward to date t =
The interest rate is the cost that you pay for carrying the commodity forward.

Expose to price graph: See slides

Long-term supply contracts have several potential disadvantages.
They expose each party to the risk that the other party may default and fail to live up
to the terms of the contract.
Probability Approaches
Normal Distribution approach
One sided 95% (1 in 20) confidence interval corresponds to 1.65 standard deviations
from mean (P(X < x) = 0.95)

97.5% (1 in 40) corresponds to 1.96 standard deviations

99% (1 in 100) corresponds to 2.33 standard deviations
Value at risk
For example, a financial firm may determine that it has a 5% one day value at risk of
$10 million
This means that there is a 5% chance that the firm could lose more than $10 million
on any given day
Measurement of DEaR(Delta Normal Approach)
DEaR= Dollar market value of the position x Price volatility
PriceVolatility =Price sensitivity of the position x
Potential adverse move in yield
Example: Slide 67
Normal Distribution Approach Problems
Actual historical distribution of financial price movements not normal
fat tails common
Stability versus relevance of historical estimates
long data period increases stability
short data period increases relevance

Week 11
Types of Foreign Exchange Risk
the effect of exchange rate moves on transactional account exposure related to
receivables (export contracts), payables
(import contracts) or repatriation of dividends.

balance sheet exchange rate risk and relates exchange rate moves to the valuation of
a foreign subsidiary and, in turn, to the consolidation of a foreign subsidiary to the
parent companys balance sheet.
the risk to the firms present value of future operating cash flows from exchange rate
the effect of exchange rate changes on revenues (domestic sales and exports) and
operating expenses (cost of domestic inputs and imports).
Falling exchange rates: increase costs for importation
the cost of servicing foreign currency debt increases
for the business, the cost of investing overseas could increase
Rising exchange rate
it can decrease the value of investment in foreign subsidiaries and monetary assets
(when translating the value of such assets into the domestic currency)
Forward Exchange Rate
The exchange rate set in a currency forward contract: it applies to an exchange that
will occur in the future
Interest rate parity
Based on relative interest rates
Purchasing power parity
Based on relative inflation rates
Cash-and-Carry Strategy
A strategy used to lock in the future cost of an asset by buying the asset for cash
today and
carrying it until a future date
Impact of changes in domestic interest rates

As Australian interest rates increase relative to offshore rates, then the cost of hedging
imports will increase and the cost of hedging exports will
Adverse movement in interest rates can:
increase borrowing costs for borrowers reduce returns for investors
reduce the net present value (NPV) of organisations due to the effect of changes in
the discount rate (interest rate) on the value of financial instruments, hedges and the
return on projects.
Dollar Gap
GAP = G = Rate sensitive assets rate sensitive liabilities
Positive RSA > RSL Increase Increase
Positive RSA > RSL Decrease Decrease
Negative RSA < RSL Increase Decrease
Negative RSA < RSL Decrease Increase
Interest Rate Risk Measurement: Duration
Duration of equity=DA*Asset/all+DL*Liability/All
Change in value=-D*Change in interest rate*value/1+interest rate
Duration Gap Change in interest rate change in equity
Positive Increase Decrease
Positive Decrease Increase
Negative Increase Increase
Negative Decrease Decrease
Example: Slide 51

Week 12
Treasury Management Systems
Key aspects
Dealing (segn of duties, security)
Cash management (balance and transaction management, forecasting,reconciliations)
Risk management
Market risk is the uncertainty resulting from changes in market prices.
Why is Market risk measurement important ?
management information
setting risk limits (risk appetite)
resource allocation
performance evaluation
Regulatory requirements (Responsible Officers)
Techniques used to measure and manage risk
Sensitivity test
Stress testing
Credit risk:
The risk of loss through the default on financial obligations
Default risk:
The risk that the issuer will not fulfill its financial obligations to the investor/creditor
in accordance with the terms of the obligation
Five Cs of credit assessment
Character condition capacity capital collateral

Z = 1.2*working capital / assets + 1.4*Retained earnings / assets + 3.3* EBIT / assets

+ 0.6*Market value of equity / book value of liabilities + 0.999*sales / assets.
Policy Decisions Influencing Accounts Receivable
Credit Policy
Terms of Sale
Collections Policy