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Relevant from the September 2016 exam session
This article explains the approach to examining F9, Financial Management, and clarifies any uncertainty
regarding the content of the syllabus. For students planning to take this exam, a good place to start is the
ACCA website, where the F9 Syllabus and Study Guide, together with the Specimen Exam and its suggested
answers can be found.
The aim of F9 is to develop the knowledge and skills expected of a finance manager in relation to investment,
financing, and dividend decisions. The syllabus is designed to equip candidates with the skills that would be expected
from a finance manager responsible for the finance function of a business.
From a relational point of view, F9 builds on knowledge gained through studying F2, Management Accounting, and
also prepares candidates for further study of financial management in P4, Advanced Financial Management. Students
who are exempt from F2 should ensure that they are familiar with its content by referring to its Syllabus and Study


The first two sections of the syllabus consider the role and purpose of the finance manager, and the financial
management environment. As financial management decisions support the achievement of business objectives, the
syllabus explores the link between objectives, strategy, and stakeholders. Financial management decisions are
influenced by factors external to the organisation, so the syllabus also considers the impact of government economic
policy in key areas such as interest rates and exchange rates, as well as the nature and role of financial markets and
The next three sections of the syllabus look at working capital management, investment appraisal, and business
finance. Managing working capital is a key concern of the finance manager, who must balance the conflicting
objectives of profitability and liquidity. Investment decisions constitute one of the three decision areas of financial
management, and the finance manager must be able to identify relevant cash flows, and evaluate a proposed
investment and its effect on the organisation.
Financing decisions, another of the three decision areas of financial management, are considered in the business
finance section of the syllabus. A finance manager must be able to identify and evaluate the most appropriate sources
of finance to meet organisational financing needs. One of the key relationships in financial management is that
between risk and return, and this section of the syllabus also looks at the cost of capital and the influence of capital
structure on the average cost of capital. Candidates must be able to calculate the cost of individual sources of finance
and the average cost of organisational finance, and critically discuss whether financing choices can reduce the
average cost of capital and thereby increase the value of the organisation as a whole.
The next section of the syllabus looks at business valuation. Candidates must be able to value both financial assets,
such as ordinary shares and bonds, and a business as a whole. Evaluation of financial choices is a key theme here
and candidates are expected to be able to discuss, as well as apply, a range of valuation methods.
The final section of the syllabus looks at risk management in relation to foreign currency risk and interest rate risk.
Candidates should have an awareness of the different types of foreign currency and interest rate risk, and of the
possible reasons why these arise. Candidates will need to be able to evaluate and apply both internal and external
risk management (hedging) methods, using the methods identified in the syllabus. Note that evaluation of derivativebased hedging methods such as those using futures, options, and swaps is not required.

The main capabilities are described in the syllabus. Candidates who successfully pass the F9 exam will be able to:

Discuss the role and purpose of the financial management function

Assess and discuss the impact of the economic environment on financial management

Discuss and apply working capital management techniques

Carry out effective investment appraisal

Identify and evaluate alternative sources of business finance

Discuss and apply principles of business and asset valuations

Explain and apply risk management techniques in business.

You will recognise that these seven capabilities reflect the seven sections of the syllabus.


F9 contains three sections: Section A, Section B and Section C.

Section A
Section A is comprised of 15 objective test questions. Each question will be worth two marks and questions may
be either narrative or calculative in nature. This mix of questions and the nature of objective test questions mean
that some questions will take longer to answer than others. Candidates are advised to allocate time to this
section as a whole, rather than trying to allocate time to each individual question.
Section A will include questions from the whole F9 syllabus. This means that, more than ever, it is important that
candidates make sure that they cover the whole syllabus when preparing for the F9 exam. Also, these core skills
will help candidates when they come on to the Professional level exams, where this core knowledge is always
assumed and sometimes re-examined.

As always, it is important that, in Section A, candidates do not spend too much time on any one question that
they may be struggling with. It is important to remember that each question is only worth two marks.
Section B
This second section of the exam contains three questions comprising five objective test items worth two marks
each; therefore worth 10 marks each in total. These questions will be based around a common scenario and
can come from any area within the four main syllabus sections. There will be a mix of calculative and narrative
Section C
The third section of the exam will comprise two questions worth 20 marks each. These questions are likely to be
broken down into several requirements. These questions will have a main focus on Syllabus areas C, D and E
only, but may also include material from other syllabus areas. Unlike Sections A and B which are auto-marked
the Section C questions will still be manually marked and so it continues to be absolutely vital that all workings
are shown and assumptions are stated.

Each exam paper will contain tables of discount factors and annuity factors, together with a formulae sheet, as in
the Specimen Exam. Candidates must ensure that they are familiar with the formulae given in the formulae sheet.


The Specimen Exam illustrates the kind of questions that will be set.
Sections A and B cover the whole syllabus and the multiple-choice questions cover the topics in a random order.
The Specimen Exam illustrates the kinds of questions that will be used, as well as the likely balance between
calculation and non-calculation questions. Since the whole syllabus is covered, no parts of the syllabus can be
neglected during study.
Section C contains questions that look in more depth at different areas of the syllabus, in terms of both calculation
and discussion.
Question 31 in the Specimen Exam requires, for 20 marks, calculation of net present value, internal rate of return and
return on capital employed for an investment proposal, and discussion of findings and financial acceptability and a
further discussion on the conflict of stakeholders objectives.
Question 32 requires, for 20 marks, calculation of a share price, capital gearing and weighted average cost of capital,
a discussion of whether changing dividend policy will affect the share price and an explanation of different levels of
risk and return.

In order to pass F9, candidates should:

Clearly understand the objectives of F9, as explained above, and in theSyllabus and in the
accompanying Study Guide
Read and study thoroughly a suitable financial management textbook or study text

Read relevant articles flagged by Student Accountant

Practise exam-standard and exam-style questions on a regular basis

Be able to communicate their understanding clearly in an examination context.

Written by a member of the F9 examining team


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Section G of the F9 Study Guide specifies the following relating to the management of interest rate risk:
(a) Discuss and apply traditional and basic methods of interest rate risk management, including:
i) matching and smoothing
ii) asset and liability management
iii) forward rate agreements
(b) Identify the main types of interest rate derivatives used to hedge interest rate risk and explain how they are used in
(No numerical questions will be set on this topic)


Risk arises for businesses when they do not know what is going to happen in the future, so obviously there is risk
attached to many business decisions and activities. Interest rate risk arises when businesses do not know:
(i) how much interest they might have to pay on borrowings, either already made or planned, or;
(ii) how much interest they might earn on deposits, either already made or planned.
If the business does not know its future interest payments or earnings, then it cannot complete a cash flow forecast
accurately. It will have less confidence in its project appraisal decisions because changes in interest rates may alter
the weighted average cost of capital and the outcome of net present value calculations.
There is, of course, always a risk that if a business had committed itself to variable rate borrowings when interest
rates were low, a rise in interest rates might not be sustainable by the business and then liquidation becomes a

Note carefully that the primary aim of interest rate risk management (and indeed foreign currency risk management) is
not to guarantee a business the best possible outcome, such as the lowest interest rate it would ever have to pay. The
primary aim is to limit the uncertainty for the business so that it can plan with greater confidence.



When taking out a loan or depositing money, businesses will often have a choice of variable or fixed rates of interest.
Variable rates are sometimes known as floating rates and they are usually set with reference to a benchmark such as
LIBOR, the London Interbank Offered Rate. For example, variable rate might be set at LIBOR +3%.
If fixed rates are available then there is no risk from interest rate increases: a $2m loan at a fixed interest rate of 5%
per year will cost $100,000 per year. Although a fixed interest loan would protect a business from interest rates
increases, it will not allow the business to benefit from interest rates decreases and a business could find itself locked
into high interest costs when interest rates are falling and thereby losing competitive advantage.
Similarly if a fixed rate deposit were made a business could be locked into disappointing returns.
In this simple approach to interest rate risk management the loans or deposits are simply divided so that some are
fixed rate and some are variable rate. Looking at borrowings, if interest rates rise, only the variable rate loans will cost
more and this will have less impact than if all borrowings had been at variable rate. Deposits can be similarly
There is no particular science about this. The business would look at what it could afford, its assessment of interest
rate movements and divide its loans or deposits as it thought best.
This approach requires a business to have both assets and liabilities with the same kind of interest rate. The closer
the two amounts the better.
For example, lets say that the deposit rate of interest is LIBOR + 1% and the borrowing rate is LIBOR + 4%, and that
$500,000 is deposited and $520,000 borrowed. Assume that LIBOR is currently 3%.
Annual interest paid = $520,000 x (3 + 4)/100 = $36,400

Annual interest received = $500,000 x (3 + 1)/100 = $20,000

Net cost = $16,400
Now assume that LIBOR rises by 2% to 5%.
New interest amounts:
Annual interest paid = $520,000 x (5 + 4)/100 = $46,800
Annual interest received = $500,000 x (5 + 1)/100 = $30,000
Net cost = $16,800
The increase in interest paid has been almost exactly offset by the increase in interest received. The extra $400
relates to the mismatch of the borrowing and deposit of $20,000 x increase in LIBOR of 2% = $20,000 x 2/100 =


This relates to the periods or durations for which loans (liabilities) and deposits (assets) last. The issues raised are
not confined to variable rate arrangements because a company can face difficulties where amounts subject to fixed
interest rates or earnings mature at different times.
Say, for example, that a company borrows using a ten-year mortgage on a new property at a fixed rate of 6% per year.
The property is then let for five years at a rent that yields 8% per year. All is well for five years but then a new lease
has to be arranged. If rental yields have fallen to 5% per year, the company will start to lose money.
It would have been wiser to match the loan period to the lease period so that the company could benefit from lower
interest rates if they occur.


These arrangements effectively allow a business to borrow or deposit funds as though it had agreed a rate which will
apply for a period of time. The period could, for example start in three months time and last for nine months after that.
Such an FRA would be termed a 3 12 agreement because is starts in three months and ends after 12 months. Note
that both parts of the timing definition start from the current time.
The loans or deposits can be with one financial institution and the FRA can be with an entirely different one, but the
net outcome should provide the business with a target, fixed rate of interest. This is achieved by compensating
amounts either being paid to or received from the supplier of the FRA, depending on how interest rates have moved.
Nero Cos cash flow forecast shows that it will have to borrow $2m from Goodfellows Bank in four months time for a

period of three months. The company fears that by the time the loan is taken out, interest rates will have risen. The
current interest rate is 5% and this is offered by Helpy Bank on the required FRA.
(i) What kind of FRA is needed?
(ii) What are the cash flows if the interest rate has risen to 6.5% when the loan is taken out?
(iii) What are the cash flows if the interest rate has fallen to 4% when the loan is taken out?
(i) The FRA needed would be a 4 7 FRA at 5%
(ii) If the interest rate has risen to 6.5%:

Interest on loan paid by Nero Co to Goodfellows bank =

$2m x 6.5/100 x 3/12 =


Paid to Nero Co under FRA by Helpy Bank =

$2m x (6.5 5)/100 x 3/12 =

Net cost of the loan to Nero Co



(iii) If the interest rate has fallen to 4%:

Interest on loan paid by Nero Co to Goodfellows bank =

$2m x 4/100 x 3/12 =


Paid by Nero Co under FRA to Helpy Bank=

$2m x (4 5)/100 x 3/12 =

Net cost of the loan to Nero Co



(a) In both cases the effective rate of interest to Nero Co on the loan is 5%, the FRA-agreed rate: $2m x 5/100 x 3/12

= $25,000.
(b) In part (iii) when interest rates have fallen, Nero Co would no doubt wish that it had not entered the FRA so that it
would not have to pay Helpy Bank $5,000. However, the purpose of the FRA is to provide certainty, not to guarantee
the lowest possible cost of borrowing to Nero Co and so $5,000 will have to be paid to Helpy Bank.


The interest rate derivatives that will be discussed are:
(i) Interest rate futures
(ii) Interest rate options
(iii) Interest rate caps, floors and collars
(iv) Interest rate swaps


Futures contracts are of fixed sizes and for given durations. They give their owners the right to earn interest at a given
rate, or the obligation to pay interest at a given rate.
Selling a future creates the obligation to borrow money and the obligation to pay interest
Buying a future creates the obligation to deposit money and the right to receive interest.
Interest rate futures can be bought and sold on exchanges such as Intercontinental Exchange (ICE) Futures Europe.
The price of futures contracts depends on the prevailing rate of interest and it is crucial to understand that as interest
rates rise, the market price of futures contracts falls.
Think about that and it will make sense: say that a particular futures contract allows borrowers and lenders to pay or
receive interest at 5%, which is the current market rate of interest available. Now imagine that the market rate of
interest rises to 6%. The 5% futures contract has become less attractive to buy because depositors can earn 6% at
the market rate but only 5% under the futures contract. The price of the futures contract must fall.
Similarly, borrowers will now have to pay 6% but if they sell the future contract they have to pay at only 5%, so the
market will have many sellers and this reduces the selling price until a buyer-seller equilibrium price is reached.

A rise in interest rates reduces futures prices.

A fall in interest rates increases futures prices.

In practice, futures price movements do not move perfectly with interest rates so there are some imperfections in the
mechanism. This is known as basis risk.
The approach used with futures to hedge interest rates depends on two parallel transactions:

Borrow/deposit at the market rates

Buy and sell futures in such a way that any gain that the profit or loss on the futures deals compensates for
the loss or gain on the interest payments.

Borrowing or depositing can therefore be protected as follows:

Depositing and earning interest
The depositor fears that interest rates will fall as this will reduce income.
If interest rates fall, futures prices will rise, so buy futures contracts now (at the relatively low price) and sell later (at
the higher price). The gain on futures can be used to offset the lower interest earned.
Of course, if interest rates rise the deposit will earn more, but a loss will be made on the futures contracts (bought at a
relatively high price then sold at a lower price).
As with FRAs, the objective is not to produce the best possible outcome, but to produce an outcome where the
interest earned plus the profit or loss on the futures deals is stable.
Borrowing and paying interest
The borrower fears that interest rates will rise as this will increase expense.
If interest rates rise, futures prices will fall, so sell futures contracts now (at the relatively high price) and buy later (at
the lower price). The gain on futures can be used to offset the lower interest earned.
Students are often puzzled by how you can sell something before you have bought it. Simply remember that you dont
have to deliver the contract when you sell it: it is a contract to be fulfilled in the future and it can be completed by
buying in the future.
Of course, if interest rates fall the loan will cost less, but a loss will be made on the futures contracts (sold at a
relatively low price then bought at a higher price).
Once again, the aim is stability of the combined cash flows.
The summary rule for interest rate futures is:

Depositing: buy futures then sell

Borrowing: sell futures then buy


Interest rate options allow businesses to protect themselves against adverse interest rate movements while allowing
them to benefit from favourable movements. They are also known as interest rate guarantees. Options are like
insurance policies:

You pay a premium to take out the protection. This is non-returnable whether or not you make use of the
If interest rates move in an unfavourable direction you can call on the insurance.
If interest rates move favourable you ignore the insurance.

Options are taken on interest rate futures contracts and they give the holder the right, but not the obligation, either to
buy the futures or sell the futures at an agreed price at an agreed date.
Using options when borrowing
As explained above, if using simple futures contracts the business would sell futures now then buy later.
When using options, the borrower takes out an option to sell futures contracts at todays price (or another agreed
price). Lets say that price is 95. An option to sell is known as a put option (think about putting something up for sale).
If interest rates rise the futures contract price will fall, lets say to 93. Therefore the borrower will buy at 93 and will
then choose to exercise the option by exercising their right to sell at 95. The gain on the options is used to offset the
extra interest that has to be paid.
If interest rates fall the futures contract price will rise, lets say to 97. Clearly, the borrower would not buy at 97 then
exercise the option to sell at 95, so the option is allowed to lapse and the business will simply benefit from the lower
interest rate.
Using options when depositing
As explained above, if using simple futures contracts the business would buy futures now and then sell later.
When using options, the investor takes out an option to buy futures contracts at todays price (or another agreed
price). Lets say that price is 95. An option to buy is known as a call option.
If interest rates fall the futures contract price will rise, lets say to 97. The investor would therefore sell at 97
then exercise the option to buy at 95. The gain on the options is used to offset the lower interest that has been

If interest rates rise the futures contract price will fall, lets say to 93. Clearly, the investor would not sell futures at 93
and exercise the option by insisting on their right to sell at 95. The option is allowed to lapse and the investor enjoys
extra income form the higher interest rate.
Options therefore give borrowers and lenders a way of guaranteeing minimum income or maximum costs whilst
leaving the door open to the possibility of higher income or lower costs. These heads I win, tails you lose benefits
have to be paid for and a non-returnable premium has to be paid up front to acquire the options.


Interest rate cap:
A cap involves using interest rate options to set a maximum interest rate for borrowers. If the actual interest rate is
lower, the option is allowed to lapse.
Interest rate floors:
A floor involves using interest rate options to set a minimum interest rate for investors. If the actual interest rate is
higher the investor will let the option lapse.
Interest rate collar:
A collar involves using interest rate options to confine the interest paid or earned within a pre-determined range.
A borrower would buy a cap and sell a floor, thereby offsetting the cost of buying a cap against the premium received
by selling a floor. Adepositor would buy a floor and sell a cap.


Interest rate swaps allow companies to exchange interest payments on an agreed notional amount for an agreed
period of time. Swaps may be used to hedge against adverse interest rate movements or to achieve a desired
balanced between fixed and variable rate debt.
Interest rate swaps allow both counterparties to benefit from the interest payment exchange by obtaining better
borrowing rates than they are offered by a bank.
Interest rate swaps are arranged by a financial intermediary such as a bank, so the counterparties may never meet.
However, the obligation to meet the original interest payments remains with the original borrower if a counterparty
defaults, but this counterparty risk is reduced or eliminated if a financial intermediary arranges the swap.
The most common type of swap involves exchanging fixed interest payments for variable interest payments on the
same notional amount. This is known as a plain vanilla swap.
Interest rate swaps allow companies to hedge over a longer period of time than other interest rate derivatives, but do
not allow companies to benefit from favourable movements in interest rates.

Another form of swap is a currency swap, which is also an interest rate swap. Currency swaps are used to exchange
interest payments and the principal amounts in different currencies over an agreed period of time. They can be used
to eliminate transaction risk on foreign currency loans. An example would be a swap that exchanges fixed rate dollar
debt for fixed rate euro debt.
Ken Garrett is a freelance lecturer and writer


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Foreign accounts receivable present some additional challenges to a business that are not present with domesticbased customers.
It is harder for a business to pursue any overdue amounts from a business in another country with a different legal
system. One option for a business is to simply trust the foreign customer to pay within the stated credit period without
demanding additional security, a method known as open account. This option means the business faces a level of
non-payment risk that some businesses may find unacceptable.


A company can reduce its investment in foreign accounts receivable by asking for full or part payment in advance of
supplying goods. However this may be resisted by consumers, particularly if competitors do not ask for payment up
Another approach is for the seller (exporter) to arrange for a bank to give cash for foreign accounts receivable, sooner
than the seller would normally receive payment.

One method of doing this is forfaiting. Forfaiting involves the purchase of foreign accounts receivable from the seller
by a forfaiter. The forfaiter takes on all of the credit risk from the transaction (without recourse) and therefore the
forfaiter purchases the receivables from the seller at a discount. The purchased receivables become a form of debt
instrument (such as bills of exchange) which can be sold on the money market.
The non-recourse side of the transaction makes this an attractive arrangement for businesses, but as a result the cost
of forfaiting is relatively high.
Forfaiting is usually available for large receivable amounts (over $250,000) and also is only for major convertible
currencies. It is usually only available for medium-term or longer transactions.

This is a further way of reducing the investment in foreign accounts receivable and can give a business a risk-free
method of securing payment for goods or services.
There are a number of steps in arranging a letter of credit:


Both parties set the terms for the sale of goods or services
The purchaser (importer) requests their bank to issue a letter of credit in favour of the seller (exporter)
The letter of credit is issued to the sellers bank, guaranteeing payment to the seller once the conditions
specified in the letter have been complied with. Typically the conditions relate to presenting shipping
documentation and dispatching the goods before a certain date
The goods are dispatched to the customer and the shipping documentation is sent to the purchasers bank
The bank then issues a bankers acceptance
The seller can either hold the bankers acceptance until maturity or sell it on the money market at a
discounted value

As can be seen from the above process, letters of credit take up a significant amount of time and therefore are slow to
arrange and must be in place before the sale occurs. The use of letters of credit may be considered necessary if there
is a high level of non-payment risk.
Customers with a poor or no credit history may not be able to obtain a letter of credit from their own bank. Letters of
credit are costly to customers and also restrict their flexibility: if they are short of cash when the payment to the bank
is due, the commitment under the letter of credit means that the payment must be made.
Collection under a letter of credit depends on the conditions in the letter being fulfilled. Collection only occurs if the
seller presents exactly the documents stated in the conditions. This means that letters of credit provide protection to
both the purchaser and the seller. However, the seller will not be able to claim payment if, for example, goods have
been sent by air but the letter of credit stated that shipping documents were required.

In a countertrade arrangement, goods or services are exchanged for other goods or services instead of for cash.
The benefits of countertrading include the fact that it facilitates conservation of foreign currency and can help a
business enter foreign markets that it may not otherwise be able to.
The main disadvantage of countertrading is that the value of the goods or services received in exchange may be
uncertain, especially if the goods being exchanged experience price volatility. Other disadvantages of countertrade
include complex negotiations and logistical issues, particularly if a countertrade deal involves more than two parties.


Export credit insurance protects a business against the risk of non-payment by a foreign customer. Exporters can
protect their foreign accounts receivable against a number of risks which could result in non-payment. Export credit
insurance usually insures the seller against commercial risks, such as insolvency of the purchaser or slow payment,
and also insures against certain political risks, for example war, riots, and revolution which could result in nonpayment. It can also protect against currency inconvertibility and changes in import or export regulations.
Export credit insurance therefore helps reduce the risk of non-payment, but its disadvantages include the relatively
high cost of premiums and the fact that the insurance does not typically cover 100% of the value of the foreign sales.

An export factor provides the same functions in relation to foreign accounts receivable as a factor covering domestic
accounts receivable and therefore can help with the cash flow of a business. However, export factoring can be more
costly than export credit insurance and it may not be available for all countries, particularly developing countries.

The purchaser may be able to get a local bank to guarantee payment to the exporter, but this may only be suitable in
an arrangement where the purchaser has no power over the exporter.


None of the methods detailed above would allow the selling company to escape from the basic fact that credit should
only be given to customers who are creditworthy.
A seller should insist that any payment is made in a convertible currency and in a form which the customers
authorities will permit to become effective as a remittance to the seller. This may mean, for example, that the sale will
be subject to clearance under exchange controls or any import regulations.
Written by a member of the F9 examining team


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Prior to considering some of the finance sources available to small and medium-sized enterprises (SMEs) we should
first consider what we mean by SMEs, why they are important, and why they often find raising finance difficult. In this
article, we consider potential finance sources that an SME could use. There will be a particular focus on the more
modern sources of crowdfunding and supply chain financing that have been introduced to the F9 syllabus and are
examinable from September 2015. Finally, we will consider how, and why, governments often try to assist the SME

It is generally accepted that an SME is something larger than those businesses that are fundamentally a vehicle for
the self-employment of their owner. Equally an SME is unlikely to be listed on any stock exchange and is likely to be
owned by a relatively small number of shareholders. Indeed, very often the majority of the shareholders come from
one extended family. Hence the term SME covers a very wide range of businesses.


As we have just seen, the term SME covers a very wide range of businesses. As a result, the SME sector as a whole
is very important to the economies of many countries. Estimates vary widely but within the UK, SMEs probably
account for about half of employment and half of national income, and hence are of great importance.
As SMEs are relatively small they are often more flexible and quicker to innovate than larger companies. Indeed,
SMEs are often thought to be better at embracing new trends and technologies. Obviously it is important to any
economy that this occurs. One consequence for some successful SMEs is that they are acquired by a larger company
with the financial resources to fully exploit the potential of what the SME has developed. When this happens the SME
sector has provided a useful service as it has helped a larger company to innovate and continue its success into the
In economies, such as the UK, where manufacturing industry has declined as a proportion of total economic activity
and the service sector has become increasingly important, the SME sector is likely to continue to grow. This is
because, in the service sector, economies of scale are normally less important than they are in manufacturing.
Hence, within the growing service sector it is easier for SMEs to survive and flourish.
Finally, it is important that SMEs can flourish as potentially a number of the SMEs of today could be the bigger
companies of tomorrow.


The directors of SMEs often complain that the lack of finance stops them growing and fully exploiting profitable
investment opportunities. This gap between the finance available to SMEs and the finance that they could
productively use is often known as the funding or financing gap. As advisers to SMEs it is important that we
understand why this gap occurs.
The first thing to understand is that there is a limited supply of funds from investors. Once potential investors have
satisfied their need and desire to spend and have paid their tax there is often little left over to be invested. An

additional issue at the current time in the UK is that the returns available to investors on a typical deposit account are
so low that investment does not seem attractive.
Equally there is a competitive market for the limited supply of investors funds. Governments and larger companies
have a great appetite for the funds available and, hence, the SME sector can be squeezed out.
The SME sector tends to suffer because SMEs are viewed as a less attractive investment opportunity than many
others due to the high levels of uncertainty and risk they are perceived to have. This perception of risk is due to a
number of reasons including:

SMEs often have a limited track record in raising investment and providing suitable returns to their investors

SMEs often have non-existent or very limited internal controls

SMEs often have few external controls. For instance they are unlikely to be abiding by the rules of any stock
exchange and due to their size they are unlikely to attract much press scrutiny. Indeed, in the UK many SMEs
are no longer required to have their annual accounts audited

SMEs often have one dominant owner-manager whose decisions may face little questioning

SMEs often have few tangible assets to offer as security.

As a result of the above, investors are nervous of investing in SMEs as they are concerned about how their funds
might be used and the returns that they might get. Hence, the easiest thing for an investor is to decline any
opportunity to invest in an SME, especially when there are so many other investment opportunities available to them.
Accountants can do little to alter the supply of funds or the competitive market for those funds, but can assist by
showing how an SME could reduce the level of risk it is perceived to have, thereby improving its ability to raise
finance. For instance, SMEs that can show that they have treated earlier investors well, have adopted some key
internal controls, and have a rigorous and documented approach to decision making are more likely to be attractive to


In reality there are quite a few potential sources of finance for SMEs. However, many of them have practical problems
that may limit their usefulness. Some key sources and their limitations are briefly described below. Crowdfunding and
supply chain financing are then considered in more detail.
The SME owner, family and friends
This is potentially a very good source of finance because these investors may be willing to accept a lower return than
many other investors as their motivation to invest is not purely financial. The key limitation is that, for most of us, the
finance that we can raise personally, and from friends and family, is somewhat limited.
The business angel
A business angel is a wealthy individual willing to take the risk of investing in SMEs. One limitation is that these
individuals are not common and are very often quite particular about what they are prepared to invest in. Once a
business angel is interested they can become very useful to the SME, as they will often have great business acumen
themselves and are likely to have many useful contacts.
Trade credit
SMEs, like any company, can take credit from their suppliers. However, this is only short-term and, indeed, if their
suppliers are larger companies who have identified them as a potentially risky SME the ability to stretch the credit
period may be limited.
Factoring and invoice discounting
Both of these sources of finance effectively let a company raise finance against the security of their outstanding
receivables. Again, this finance is only short-term and is often more expensive than an overdraft. However, one of the

features of these sources of finance is that, as an SME grows, their outstanding receivables will grow and so the
amount they can borrow from their factor or from invoice discounting will also grow. Hence, factoring and invoice
discounting are two of the very limited number of finance sources which grow automatically as the business grows.
Leasing assets rather than buying them is often very useful for an SME as it avoids the need to raise the capital cost.
However, leasing is only really possible on tangible assets such as cars, machines, etc.
Bank finance
Banks may be willing to provide an overdraft of some sort and may be willing to lend in the long term where that
lending can be secured on major assets such as land and buildings. However, raising medium-term finance to fund
operations is often more difficult for SMEs as banks are traditionally rather conservative. This is understandable as
the loss on one defaulted loan requires many good loans to recover that loss. Hence, many SMEs end up financing
medium-term, and potentially longer-term assets, with short-term finance such as an overdraft. This is poor matching
and very much less than ideal. This issue is often known as the maturity gap as there is a mismatch of the maturity
of the assets and liabilities within the business.
Furthermore, banks will often require personal guarantees from the owner-manager of the SME, which means the
owner-manager has to risk his personal wealth in order to fund the company.
The venture capitalist
A venture capitalist company is very often a subsidiary of a company that has significant cash holdings that they need
to invest. The venture capitalist subsidiary is a high-risk, potentially high-return part of their investment portfolio.
Hence, many banks will have venture capitalist subsidiaries. In order to attract venture capital funding an SME has to
have a business idea that may create the high returns the venture capitalist is seeking. Hence, for many SMEs,
operating in regular business, venture capitalist financing may not be possible. Furthermore, a venture capitalist rarely
wants to remain invested in the long term and, hence, any proposal to them must show how they will be able to exit
or release their value after a number of years. This is often done by selling the company to a bigger company
operating in the same trade or by growing the company to such a size that a stock exchange listing is possible.
By achieving a listing on a stock exchange an SME would become a quoted company and, hence, raising finance
would become less of an issue. However, before a listing can be considered the company must grow to such a size
that a listing is feasible. Many SMEs can never hope to achieve this.
Supply chain financing
In supply chain financing (SCF) the finance follows the value as it moves through the supply chain. SCF is relatively
new and is different to traditional working capital financing methods, such as factoring or offering settlement
discounts, because it promotes collaboration between buyers and sellers in the supply chain. Traditionally there was
competition as the buyer wanted to take extended credit, and the seller wanted quick payment. SCF works very well
where the buyer has a better credit rating than the seller.

Company A (which has an A+ credit rating) buys goods from Company B
(which has a B+ credit rating). Co B has agreed to give Co A 30 days credit.
Co B invoices Co A.
Co A approves the invoice.
Co A is expected to pay the amount due to its financial institution Bank C

in 30 days at which point the funds are immediately remitted to Co B.

However, Co B can request the funds from Bank C prior to the due date. If
they do this they receive the payment less a suitable discount. This discount
is likely to be less than the discount charged if Co B used traditional factoring
or invoice discounting. This is because they are using Bank C (Co As
financial institution) and benefit from Co As higher credit rating as the debt is
the debt of Co A, and by approving the invoice Co A has confirmed this.
Equally, if Co A wants to delay payment beyond the 30-day point, then it can
do so. However, when Co A does finally pay Bank C some interest will be due.
Obviously this interest charge reflects the credit rating of Co A.

Technological solutions are used in order to efficiently link the buyer, the seller and the financial institution. These
technological solutions effectively automate the business and financial process from initiation to completion.
SCF can bring considerable benefit and can cover more than one step in the supply chain. It is perhaps of most
benefit where considerable value is constantly moving through the supply chain, such as occurs in the automotive
trade. SCF is only currently used in a relatively small proportion of companies, but its use is expected to grow
significantly. As with factoring and invoice discounting, this source of finance is only short term in nature.
Obviously, SCF could be of great help to SMEs that are supplying larger companies, or even the suppliers of larger
companies, with a good credit rating. As the technological solutions required to make SCF work become more
widespread and SCF grows, more and more SMEs are likely to benefit.
Crowdfunding involves funding a venture by raising finance from a large number of people (the crowd) and is very
often achieved over the internet. Crowdfunding has grown rapidly and in 2013 it has been estimated that over US$5bn
was raised worldwide through crowdfunding. There are now in excess of 500 crowdfunding platforms on the internet
and over 400 crowdfunding campaigns are launched every day.
The internet platforms are set up and run by moderating organisations who bring together the project initiator with the
idea, and those organisations and individuals who are willing to support the idea. Different platforms have different
policies with regard to assessing the ideas seeking support and checking those willing to provide the finance. Hence,
great care is needed when using these platforms.
Finance provided by crowdfunding may be invested in the debt or the equity of the ventures seeking the finance.
Some crowdfunding is done on a keep it all basis where any funds raised are kept by the recipient, whereas some is
done on an all or nothing basis where the recipient only receives the funds if the total required to fund the particular
project is raised within a given time frame. The crowdfunding platform takes a fee, which is often a percentage of the
amount raised.
A feature of crowdfunding is that it lets people search for and invest in ideas and projects that they have an interest or
a belief in. Hence, these investors are sometimes willing to take bigger risks and/or accept lower returns than would
be usual. A further feature is that, just as in a real crowd, there is potential for interaction within the crowd. Hence,
keen supporters of a particular idea will very often encourage others to participate.
Early crowdfunding campaigns very often focused on the arts such as funding for bands and films. However, all sorts
of ideas have now been funded in this way and there has been much focus on innovation and new technology.

Crowdfunding has the potential to be very beneficial to SMEs. It allows them to contact and appeal directly to
investors, who may be willing to take the risk involved in funding the new technologies and innovations, which SMEs
are often so good at producing.


Governments are often keen to assist as to the extent that SMEs are unable to raise finance for their profitable
projects, investment opportunities are potentially lost and, hence, national wealth is lower than it could be.
Additionally, governments are keen to support innovation, which is one area where SMEs often excel, and are keen to
support the growth of SMEs as this boosts employment.
A number of key ways governments assist include the following:

Providing grants.

Providing tax breaks for instance, tax incentives may be available to those willing to take the risk of
investing in SMEs.

Providing advice for instance, in Scotland there is a government-funded organisation known as Business
Gateway, which provides assistance to those setting up and running a business, including advice on raising

Guaranteeing loans for instance, for a small fee from the SME, a large proportion of any loan advanced by
a bank is guaranteed by the government. As this significantly reduces the risk to the bank, they are potentially
more willing to lend. In the UK this is currently called the Enterprise Finance Guarantee scheme.

Providing equity investment many countries have government-backed venture capital organisations that
are willing to invest in the equity of SMEs. This is often done on a matching basis, where the organisation will
match any equity investment raised from other sources. In the UK this is done through Enterprise Capital
Funds, while in the US there is the Small Business Investment Company programme.

This article has hopefully raised your awareness of the issues that SMEs face with regard to raising finance, and how
as accountants and advisers we can assist them in their search for finance.
William Parrott, freelance FM tutor and senior FM tutor, MAT Uganda


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At some stage you have probably bought an asset such as a car, a washing machine or a computer and you may
have considered how long you should keep that asset prior to replacing it. If the asset is kept for a longer period its
initial cost, less any residual value, is spread over more years which is likely to reduce your cost per year of
ownership. However, as the asset ages it is likely to require more and more maintenance and may operate less
effectively which will increase your costs per year. Determining the optimal time to replace the asset (the optimal
replacement cycle) is difficult.
As a general rule you and I dont worry too much about this. Indeed most of us will make a decision based on our gut
feel and other factors such as image for example. Indeed I tend to keep my car until such time as I have lost
confidence in its ability to get me reliably from A to B or it has deteriorated so much I no longer want to be seen in it!
Companies also face exactly the same asset replacement decisions. However as the amounts involved can often be
very significant, making decisions based on gut feel is not really accurate enough. The calculation of equivalent
annual costs is a tool that can be used to assist in this decision-making process.
The equivalent annual cost method involves the following steps:

Step 1 Calculate the net present value (NPV) of cost for each potential replacement cycle.
Step 2 For each potential replacement cycle an equivalent annual cost is calculated.
The decision The replacement cycle with the lowest equivalent annual cost may then be chosen, although
other factors may also have to be considered.

This will now be demonstrated and explained further through the use of an example.
A machine has a cost of $3,500. The annual maintenance costs of the machine are forecast to be $900 in the first
year, $1,000 in the second year and $1,200 in the third year of ownership.
The residual value of the machine is expected to be $2,100 after two years and $1,600 after three years.
The cost of capital of the company is 11% per year.
Calculate the optimal replacement cycle for the machine.
Step 1 Calculate the NPV of cost for each potential replacement cycle.
As we have not been given the residual value after one year of ownership, we cannot calculate an NPV of cost for a
one-year replacement cycle. Hence, our decision here will be between a two- or three-year replacement cycle.
NPV of cost two-year replacement cycle:
Here we evaluate all the cash flows associated with buying and keeping the asset for two years.

Initial cost




Residual value




Net cash flows






Present values




Net present value


11% Discount factors

Please note that the normal assumptions with regard to the timings of the cash flows continue to be made. Hence, the
maintenance costs are shown at the end of each year, whereas in reality they will arise throughout the year.
One complication that arose in a past question was that the maintenance was an annual overhaul required at each
year end rather than ongoing maintenance occurring throughout each year. Logically the maintenance/overhaul cost
was not incurred in the year of disposal as a company would be unlikely to overhaul an asset just prior to selling it.
Hence, in the two-year replacement cycle above, if the maintenance had been an annual overhaul the $1,000 cost at
time 2 would be excluded.
NPV of cost three-year replacement cycle:
We now evaluate all the cash flows associated with buying and keeping the asset for three years.

Initial cost





Residual value





Net cash flows








Present values





Net present value


11% Discount factors

Whilst there is an element of repetition in these calculations I would still advise using the above simple and logical
format or something similar. Although I have seen formats which try to combine the calculations, they are more
complex and tend to lead to mistakes being made.
A classic mistake to be avoided is including the residual value after two years in the calculation of the NPV of cost for
the three-year replacement cycle. For the three-year replacement cycle, the sale will occur at the end of the three
years. Please remember if you buy the asset once you can only sell it once!
The two NPVs calculated should not be compared as quite obviously buying and keeping an asset for a longer period
is likely to cost more than buying and keeping it for a shorter period as there is less benefit to the owner. This has
proved to be the case here. In order to make a fair comparison we must calculate the equivalent annual costs.
Step 2 For each potential replacement cycle an equivalent annual cost is calculated.
The costs calculated in Step 1 are spread over the period for which they will give benefit. Hence, the NPV of cost for
the two-year cycle is spread over two years and the NPV of cost for the three-year cycle is spread over three years.
This is done by using annuity factors to turn each NPV of cost into an equivalent annual cost (EAC) at the end of each
year of ownership.
Remember if you have equal annual cash flows for a number of years and want to calculate a present value (PV) you
must multiply the annual cash flow by an annuity factor: so to calculate the equivalent annual cost or EAC from an
NPV of cost we must divide by the relevant annuity factor.
EAC two-year cycle:
As the NPV of cost of $3,418 will give the benefit of ownership for two years, we divide by the two-year annuity factor
at the 11% cost of capital to get the EAC.
EAC = $3,418/1.713 = $1,995 per year
This is the equivalent annual cost at time 1 and time 2 which equates to an NPV of cost of $3,418.
EAC three-year cycle:
As the NPV of cost of $4,831 will give benefit for three years, we divide by the three-year annuity factor at the 11%
cost of capital to get the EAC.
EAC = $4,831/2.444 = $1,977 per year
This is the cost at time 1, time 2 and time 3 which equates to an NPV of cost of $4,831.
While some textbooks will continue to put brackets around these cost figures, I am content to show them as positive
as we are describing them as costs.
The decision:
As the calculated equivalent annual costs are both annual costs, they can be compared to come to a decision.
Hence, as an annual cost of $1,977 is less than an annual cost of $1,995, the three-year replacement cycle is said to
be the optimal replacement cycle.
Having worked through an example we should now consider the weaknesses of the approach we have used. These
include the following:
Our analysis has ignored the impact of taxation.
Both buying an asset and incurring a maintenance cost will cause tax cash flows. While these cash flows could
be included they would add to the complexity of the calculation. Past Paper F9 questions have specifically
excluded the impact of taxation on the cash flows.

Our analysis assumes that we can replace like with like.

Our analysis has assumed that the asset can be replaced by exactly the same asset in perpetuity. In reality, this
will not be possible as assets are constantly developing. Even if you replace your car with exactly the same
model after a number of years the new car will undoubtedly have improvements and other differences to the old

one. In our worked example above, if we were to imagine that the asset was a computer then although the
calculated optimal replacement cycle is three years, the difference in cost between the two- and three-year
replacement cycles is small. Hence, we might decide to use a two-year replacement cycle as we would then
benefit from having a new, more up-to-date computer with more functionality on a more regular basis.

Our analysis assumes that we will want to replace like with like.
Additionally the analysis assumes we will want to replace the asset with the same asset in perpetuity. In reality,
business needs develop and when it becomes time to replace an asset a company may want to acquire a
different asset with different functionality. For instance, a company may want an asset with greater capacity due
to growth in their business. You and I face exactly the same issue. Over my lifetime I have had a variety of
different cars as my need has developed my two-seater sports car proved less than useful when my first child
was born!


Our analysis has ignored inflation.

Different cash flows may suffer from different specific inflation rates and as a result our analysis may not be
correct. For instance, the initial cost of assets often inflates quite slowly as manufacturers find more efficient
ways of production. However, maintenance costs often inflate much more quickly as maintenance is often
labour-intensive and labour costs often grow quickly. This differential between the inflation rates of different cash
flows means that an alternative method, which you are not required to know, should be used. If all the cash
flows inflate at one rate then the EAC method can be used with real cash flows and a real cost of capital.

Additional applications of the technique

Without going into great detail it is worth being aware that a similar technique can be used in other circumstances.
These include:
Evaluating the best time to replace an existing asset with a new asset.
Deciding between assets which would have the same functionality but have different lives. For instance
when you or I are buying a car we could buy a cheaper car of lower quality or a more costly car of higher quality.
It would be unfair to simply compare the costs directly, as the higher quality car is likely to last longer.


If a company is faced with mutually exclusive projects, where only one out of a number of projects can be accepted,
then the general rule is that the company should choose the project that generates the highest NPV as this creates
the biggest increase in shareholder wealth. However, if the situation is such that it is anticipated that the same
projects could be repeated in perpetuity and the projects have different lives then the equivalent annual benefit
approach can be used. This is simply a further variation on the equivalent annual cost approach and is demonstrated
in the following example.
Two mutually exclusive projects are being considered:

Project A has an NPV of $47m and is expected to last three years.

Project B has an NPV of $58m and is expected to last four years.

It is anticipated that if either project is chosen it will be possible to repeat it for the foreseeable future.
The cost of capital of the company is 13% per year.
Calculate which project the company should accept.

Step 1 Calculate the NPV for each potential project.
This would involve calculating the NPV of each project as normal. I have already done this for us to save time!
Project A $47m
Project B $58m
Step 2 Calculate the equivalent annual benefit for each potential project.
This is calculated using annuity factors in exactly the same way as an EAC is calculated. Hence, the NPV of Project A
is divided by the 3-year annuity factor at the cost of capital of 13% as the project life is three years. For Project B the
4-year annuity factor is used to reflect the four-year life of the project.
Project A equivalent annual benefit = $47m/2.361 = $19.9m per year
Project B equivalent annual benefit = $58m/2.974 = $19.5m per year
The decision:
As Project A has the highest equivalent annual benefit it should be chosen instead of Project B, which has the higher
NPV, so long as the project can be repeated for the foreseeable future. This result arises because although the
shorter project produces the lower NPV that NPV will be obtained more frequently than the NPV of the longer project.
The equivalent annual benefit technique suffers similar weaknesses to the EAC technique.

Although this topic is a relatively small one within your Paper F9 syllabus, it is a topic well worth mastering as when it
has been examined in the past those with the necessary knowledge have been able to earn very good marks.
Equally, I would not expect any significant question on this topic to be wholly calculative and hence students should
be ready to discuss the reasons for the approach used and the weaknesses or limitations of that approach.
William Parrott, freelance tutor and senior FM tutor, MAT Uganda

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Relevant to ACCA Qualification Papers F9 and P4
For many years, managers of large businesses have been accused of focusing on short-term rather than long-term
performance. Managers, so it is argued, often prefer projects that generate quick returns rather than those with
slower, but ultimately higher, returns. Such myopic behaviour can create a host of problems for the business, for the
broader economy and for society as a whole. These problems include reduced investment returns, the destruction of
shareholder value, business collapses and the undermining of corporate governance. Furthermore, it can lead to a
loss of public trust in large businesses and a growing sense of unfairness in the way in which society is organised.
In this article we explore the causes of management short termism and the remedies available.


Modern finance theory is founded on the notion that the purpose of a business is to maximise the wealth of its
shareholders. This means that the role of managers, who are employed to act on behalf of shareholders, is to
maximise the value of ordinary shares over the long term. In practice, however, managers may not seek to do this.
This may be because they have a different time horizon to that of shareholders. There may be powerful incentives for
managers to adopt a short-term focus in order to maximise their own welfare. These incentives are often linked to the
ways in which their remuneration is structured. Where managers are in line for bonuses based on short-term share
performance, or where share options are about to mature, they may be encouraged to make short-term decisions that
boost the share price.
Incentives may also be linked to management tenure and contracts. Where managers are unlikely to stay with the
business for a long period and there are bonuses linked to current performance, they may prefer to invest in projects
with lower net present values, but with higher returns in the early years, than projects with higher net present values,
but with higher returns in later years. Although the latter projects will ultimately bring greater benefits to the business,
the managers will not be around to reap the benefits of their actions. For similar reasons, managers may try to cut
back on discretionary expenditure such as research and development, staff training or marketing campaigns that
would lead to a reduction in current profits even though it would enhance long-term value. Even where managers do
not intend to leave, they may feel under pressure to produce quick results, particularly if their employment contracts
are short term and have to be renewed frequently.
We have seen that the interests of managers and shareholders may conflict because of the difference in time
horizons between the two groups. However, shareholders may also adopt a short time horizon. Where this occurs, it

can reinforce myopic managerial behaviour. By aligning their behaviour to the same time horizon, managers may feel
that they are responding to shareholder needs and will expect to be rewarded accordingly. Thus, where they judge
that shareholders are focused on the forthcoming quarterly, or half yearly, profit announcements, they may strive to
produce results that meet expectations.
Frequent reporting of profits can intensify the pressure on managers to achieve quick results. This is because it can
lead to the premature evaluation of performance (1). (For this reason, the European Union Parliament rejected a
proposal in 2004 to make quarterly reporting mandatory for large companies (2)). Frequent financial reporting may be
particularly damaging where there is no accompanying management commentary that would help shareholders to
see the results in context.
The misuse of financial metrics may also promote myopic management behaviour. It has been argued that accounting
ratios like ROCE and ROI, which focus on the efficiency of capital investment, encourage managers to avoid
investment in long-term innovation. They may lead managers to minimise the investment in assets appearing in the
financial statements in order to boost the percentage rate of return. Even DCF methods are not immune from
encouraging short-term thinking. According to Salter:
..when the internal rate of return (IRR) metric is used, the return naturally goes up as the time horizon comes down.
So, when companies plan investments and keep score according to efficiency measures, they inevitably invite
investment decisions; where uncertain, empowering innovations requiring long lead times for development are
sacrificed for more certain, efficiency innovations requiring much shorter time horizons for profitable results. (3)

There is evidence to support the existence of management short termism. A survey of US chief financial officers, for
example, found that they placed great emphasis on meeting or exceeding two key benchmarks: profits for the same
quarter of the previous year and the consensus of analysts estimates for the current quarter. The survey also found
that in order to meet the desired level of quarterly profits nearly 80% would be prepared to cut discretionary spending
(such as investment in research and development and advertising expenditure) and more than 55% would be
prepared to delay a new investment project even though it resulted in some sacrifice in value. (4)
A more recent survey of FTSE100 and 250 executives by PwC also provides evidence of short-term thinking among
managers. When given a choice between 250,000 tomorrow and 450,000 in three years time, the majority of
respondents chose the former (5). By doing so, however, they were applying an annual discount rate of more than
20% to the future benefits, which is likely to be much higher than the cost of capital of their business. Excessive
discounting of future cash flows by managers has important implications for the allocation of resources within a
business. It can lead to the rejection of investment projects that would otherwise be profitable and to favouring
projects with a short time horizon.
This evidence concerning short-term thinking is accompanied by a trend towards shorter management tenures. The
tenure of CEOs of large US businesses, for example, has fallen significantly over time. For the period 20002007, the
average tenure was less than six years. (6)


We saw earlier that shareholders may be the driving force behind the short-term focus of managers. Some believe
that institutional and private shareholders are preoccupied with movements in quarterly and half yearly profit figures
and make share investment decisions on this basis. This, in turn, leads managers to run their business in a way that
meets shareholder expectations concerning short-term profits. It may also lead managers to provide earnings
guidance to shareholders to help manage their expectations concerning the future share price.
Shareholder concern for the short term, however, suggests a clear gap between theory and practice. In theory, the
value of a share is represented by the future discounted cash flows that it generates. As a result, shareholders should
be concerned with the ability of a business to generate long-term cash flows rather than on its ability to meet shortterm profit targets.
To explain this gap it has been argued that using discounted cash flows can be a time-consuming, costly and
speculative process (7). Shareholders do not have access to inside information that could help them to predict cash
flows with reasonable accuracy. They, therefore, rely on short-term profit performance instead. In other words,
shareholders engage in short termism because of a lack of good quality information concerning long-term prospects.
While this may provide a partial explanation, other, more powerful, reasons are likely to exist. One such reason is that
shares are held by shareholders for increasing short periods.
In the UK, shares of listed businesses are now held for around six months compared with eight years in 1960 (8). It
seems that shareholders are acting increasingly like share traders and less like owners. This means that
shareholders are likely to become less concerned with the future stream of dividends over time and more with
concerned short-term share price movements (which, in turn, are likely to be influenced by short-term profit
performance). It also means that shareholders are less likely to be interested in the future direction of the business.
There is less incentive to monitor the behaviour of managers because the benefits of doing so are often long term.
There is also less incentive to engage with the business and, if a business gets into difficulty, its shares are more
likely to be sold. The end result is that corporate governance is weakened and managers become less accountable.
Furthermore, the stock market is reduced to little more than a casino.
Various reasons have been cited for the rise of short-term investing behaviour. One important reason may be the
short-term focus of institutional shareholders. It has been argued that there is often quarterly evaluation of fund
managers performance, which increases pressure to produce short-term returns. This short-term focus, however,
may be at odds with the longer term requirements of those investing in the funds. The speculative activities of hedge
funds have also been cited as a further reason for the rise in short-term investing. One widely-used practice of hedge
funds is short selling. This involves selling shares that have been borrowed from a broker, or other third party, with the
intention of buying back the shares at a later date to return to the broker. During the period between selling and
buying back the shares, the hedge funds hopes to benefit from a decline in the share price. Where this activity is
simply a response to market inefficiencies, however, it should not provoke short-term behaviour among managers.


The claim that shareholders adopt a short-term focus is difficult to square with the efficient market hypothesis (EMH).
In an efficient market, the value of a share should reflect the long-term future cash flows arising from holding that
share. If we accept that stock markets are efficient, this implies that a critical mass of shareholders do not adopt a
short-term view when making share investment decisions. The fact that some shareholders do is, therefore, not really
important. Indeed, some argue that short-term shareholders have a positive role to play by bringing liquidity and
stability to stock markets.
There is increasing evidence, however, that the stock market is not always efficient and that share prices do deviate
from fundamental economic values. There is a growing body of literature on behavioural finance, for example, which
suggests that shareholders are not always rational when making investment decisions. This can result, among other
things, in speculative share price bubbles and extended bull runs in share prices.
Although short termism in financial markets is widely discussed, there has not been much evidence to support its
existence. One recent study, however, examined 624 businesses listed on the UK FTSE and US S&P indices over the
period 19802009 to see whether the pricing of shares was affected by short termism. If so, it should be evident by
the excessive discounting of future cash flows from shares over and above the risk-free rate. The findings of the study
suggest that short termism does exist and that it is prevalent across all industry sectors. According to the study:
In the UK and US, cash flows five years ahead are discounted at rates more appropriate eight or more years hence;
10-year ahead cash-flows are valued as if 16 or more years ahead; and cash-flows more than 30 years ahead are
scarcely valued at all . (9)
Interestingly, there was much greater evidence of short termism among the sample businesses in the final decade of
the study. It seems, therefore, that short termism is on the rise.
If shareholders have a short-term perspective it would, of course, be entirely rational for them to construct managerial
reward systems that encourage managers to take a short-term view. Hence, bonuses may be heavily weighted
towards current profits and share options may be given short vesting periods.


It is clear from the above that management myopia does not stem from a single cause and that a variety of measures
may be needed to address this phenomenon. These measures should deal with the incentives that drive the
behaviour of both managers and shareholders and also deal with the interaction between the two groups. The
following are some of the measures that have been proposed:
Management rewards and contracts
It is frequently argued that management rewards should be linked more closely to long-term performance and to the
strategic aims of the business. Various suggestions have been made to achieve this link such as share options having
longer vesting periods, less weight being given to bonuses based on annual profits and the use of non-financial
targets as the basis for rewards. (Non-financial measures, such as investment in staff training, can often be lead

indicators of long-term financial performance.) It has also been suggested that managers should be given long-term
contracts to help them forge a closer bond with the business.
The behaviour of shareholders
To encourage shareholders to invest for the long term, a loyalty dividend has been proposed for those who hold
shares for a certain period of time. This dividend would be over and above the dividend normally paid to
shareholders. It has also been suggested that rewards for fund managers should be linked to long-term investment
performance and that details of the reward structure for fund managers should be published so that those investing in
the funds can make more informed decisions.
To help counteract the importance attached to quarterly or half yearly financial reports, various remedies have been
suggested. For example, it has been suggested that additional reporting of the long-term prospects of the business
should be included in the annual financial reports. It has also been suggested that closer interaction with
shareholders will help enhance their relations with senior managers and encourage them to take a long-term view.
Corporate governance
Weak corporate governance procedures allow short termism to thrive. A cornerstone of the Combined Code is the
role of independent non-executive directors in promoting the interests of shareholders. It is concerning, therefore, that
surveys have revealed that these directors often confess to having a poor grasp of their companies strategy and that
their understanding of the business is not held in high regard by many CEOs. (11)
Institutional shareholders can play an important role combating managerial short termism. In recent years there have
been frequent calls for them to actively engage in the corporate governance of an investee business and to become
more accountable to their principal shareholders as well as to society as a whole. The UK Stewardship Code was
introduced in 2010 to address the accountability issue. The Code requires that institutional shareholders disclose how
they discharge their stewardship responsibilities, how they monitor investee companies, what their voting policies are
and so on.
To help the board of directors retain a long-term focus, various changes to voting procedures and to the composition
of the board of directors have been suggested. These include additional voting rights for long-term shareholders, to
enable them to have greater board representation and greater influence at shareholder meetings, and for employee
representation on the board.
Taxation policy
Changes to taxation policy have been proposed that aim to make short-term investing less attractive. They include
introducing a tax (or increasing an existing tax) on the transfer of shares. This is designed to make it more expensive
to buy and sell shares on a frequent basis. In addition, higher rates of tax on gains from the sale of shares held for a
short term than those held for a long term have been proposed. (12)
While many of the proposals mentioned may be intuitively appealing, there are often problems and unintended
consequences associated with their implementation. The proposal to introduce (or increase) tax on the transfer of
shares, for example, has been criticised as follows:

(it) is not limited to trades that take place when stock (share) prices change rapidly. Instead, it would tax every trade,
including trades that occur when there is minimal or zero volatility, and thus is likely to inflict enormous costs on
society. Generally, it ensnares and imposes hardship on investors that have virtually no contribution to the speculation
problem that it is designed to curb. (13)
Similarly, higher rates of capital gains tax to deter shareholders from selling their shares after only a short period may
have undesirable side effects. It has been argued that it may damage market liquidity, punish those who are forced to
sell their shares (because, for example, a takeover has occurred) and make it more difficult to issue new shares
offering better returns.


In this article we have examined the arguments and evidence concerning management myopia. We have seen that
there may be powerful incentives for managers to favour pay offs arising in the short term rather than larger pay offs
arising in the longer term. These incentives may reflect a difference in time horizons between managers and
shareholders or may reflect a shifting focus by shareholders towards the short term.
To avoid the damage that short termism can inflict on businesses and to the economy as a whole, various remedies
have been suggested. These are aimed at changing the behaviour of both managers and shareholders. Many of
these remedies, however, need careful consideration as they may well have unintended consequences.
Peter Atrill is a freelance academic and writer


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Relevant to ACCA Qualification Paper F9


Section E of the Study Guide for Paper F9 contains several references to the Capital Asset Pricing Model (CAPM).
This article introduces the CAPM and its components, shows how it can be used to estimate the cost of equity, and
introduces the asset beta formula. Two further articles will look at applying the CAPM in calculating a project-specific
discount rate, and will review the theory, and the advantages and disadvantages of the CAPM.
Whenever an investment is made, for example in the shares of a company listed on a stock market, there is a risk that
the actual return on the investment will be different from the expected return. Investors take the risk of an investment
into account when deciding on the return they wish to receive for making the investment. The CAPM is a method of
calculating the return required on an investment, based on an assessment of its risk.
If an investor has a portfolio of investments in the shares of a number of different companies, it might be thought that
the risk of the portfolio would be the average of the risks of the individual investments. In fact, it has been found that
the risk of the portfolio is less than the average of the risks of the individual investments. By diversifying investments
in a portfolio, therefore, an investor can reduce the overall level of risk faced.
There is a limit to this risk reduction effect, however, so that even a fully diversified portfolio will not eliminate risk
entirely. The risk which cannot be eliminated by portfolio diversification is called undiversifiable risk or systematic
risk, since it is the risk that is associated with the financial system. The risk which can be eliminated by portfolio
diversification is called diversifiable risk, unsystematic risk, or specific risk, since it is the risk that is associated with
individual companies and the shares they have issued. The sum of systematic risk and unsystematic risk is called
total risk (Watson D and Head A, Corporate Finance: Principles and Practice, Financial Times/ Prentice Hall, 2006,
The CAPM assumes that investors hold fully diversified portfolios. This means that investors are assumed by the
CAPM to want a return on an investment based on its systematic risk alone, rather than on its total risk. The measure
of risk used in the CAPM, which is called beta, is therefore a measure of systematic risk.
The minimum level of return required by investors occurs when the actual return is the same as the expected return,
so that there is no risk at all of the return on the investment being different from the expected return. This minimum
level of return is called the risk-free rate of return.
The formula for the CAPM, which is included in the Paper F9 formulae sheet, is as follows:
E(ri ) = Rf + i(E(rm) Rf)
E(ri) = return required on financial asset i
Rf = risk-free rate of return
i = beta value for financial asset i
E(rm) = average return on the capital market

This formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk
premium i (E(rm) - Rf) which compensates the investor for the systematic risk of the financial asset. If shares are
being considered, E(rm) is the required return of equity investors, usually referred to as the cost of equity.
The formula is that of a straight line, y = a + bx, with i as the independent variable, Rf as the intercept with the y axis,
(E(r m ) - Rf) as the slope of the line, and E(ri) as the values being plotted on the straight line. The line itself is called
the security market line (SML), as shown in Figure 1.

In order to use the CAPM, investors need to have values for the variables contained in the model.
In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively safe
investment, however, and in practice, it can be used as an acceptable substitute for the risk-free asset.
In order to have consistency of data, the yield on UK treasury bills is used as a substitute for the risk-free rate of
return when applying the CAPM to shares that are traded on the UK capital market. Note that it is the yield on
treasury bills which is used here, rather than the interest rate. The yield on treasury bills (sometimes called the yield
to maturity) is the cost of debt of the treasury bills.
Because the CAPM is applied within a given financial system, the risk-free rate of return (the yield on short-term
government debt) will change depending on which countrys capital market is being considered. The risk-free rate of
return is also not fixed, but will change with changing economic circumstances.
Rather than finding the average return on the capital market, E(r m ), research has concentrated on finding an
appropriate value for (E(r m ) - R f ), which is the difference between the average return on the capital market and the
risk-free rate of return. This difference is called the equity risk premium, since it represents the extra return required
for investing in equity (shares on the capital market as a whole) rather than investing in risk-free assets.
In the short term, share prices can fall as well as increase, so the average return on a capital market can be negative

as well as positive. To smooth out short-term changes in the equity risk premium, a time-smoothed moving average
analysis can be carried out over longer periods of time, often several decades. In the UK, when applying the CAPM to
shares that are traded on the UK capital market, an equity risk premium of between 3.5% and 5% appears
reasonable at the current time (Ibid, p229).
Beta is an indirect measure which compares the systematic risk associated with a companys shares with the
systematic risk of the capital market as a whole. If the beta value of a companys shares is 1, the systematic risk
associated with the shares is the same as the systematic risk of the capital market as a whole.
Beta can also be described as an index of responsiveness of the returns on a companys shares compared to the
returns on the market as a whole. For example, if a share has a beta value of 1, the return on the share will increase
by 10% if the return on the capital market as a whole increases by 10%. If a share has a beta value of 0.5, the return
on the share will increase by 5% if the return on the capital market increases by 10%, and so on.
Beta values are found by using regression analysis to compare the returns on a share with the returns on the capital
market. When applying the CAPM to shares that are traded on the UK capital market, the beta value for UK
companies can readily be found on the Internet, on Datastream, and from the London Business School Risk
Management Service.
Calculating the cost of equity using the CAPM
Although the concepts of the CAPM can appear complex, the application of the model is straightforward. Consider the
following information:
Risk-free rate of return = 4%
Equity risk premium = 5%
Beta value of RD Co = 1.2
Using the CAPM:
E(ri) = Rf + i (E(rm) - Rf) = 4 + (1.2 x 5) = 10%
The CAPM predicts that the cost of equity of RD Co is 10%. The same answer would have been found if the
information had given the return on the market as 9%, rather than giving the equity risk premium as 5%.
If a company has no debt, it has no financial risk and its beta value reflects business risk alone. The beta value of a
companys business operations as a whole is called the asset beta. As long as a companys business operations,
and hence its business risk, do not change, its asset beta remains constant.
When a company takes on debt, its gearing increases and financial risk is added to its business risk. The ordinary
shareholders of the company face an increasing level of risk as gearing increases and the return they require from the
company increases to compensate for the increasing risk. This means that the beta of the companys shares, called
the equity beta, increases as gearing increases (Ibid, p250).
However, if a company has no debt, its equity beta is the same as its asset beta. As a company gears up, the asset
beta remains constant, even though the equity beta is increasing, because the asset beta is the weighted average of
the equity beta and the beta of the companys debt. The asset beta formula, which is included in the Paper F9
formulae sheet, is as follows:

Note from the formula that if Vd is zero because a company has no debt, then a = e, as stated earlier.
Calculating the asset beta of a company
You have the following information relating to RD Co: Equity beta of RD Co = 1.2 Debt beta of RD Co = 0.1 Market
value of shares of RD Co = $6m Market value of debt of RD Co = $1.5m After tax market value of company = 6 + (1.5
x 0.75) = $7.125m Company profit tax rate = 25% per year a = [(1.2 x 6)/7.125] + [(0.1 x 1.5 x 0.75)/7.125] = 1.024
The next article will look at how the asset beta formula allows the CAPM to be applied when calculating a projectspecific discount rate that can be used in investment appraisal.
Written by a member of the Paper F9 examining team



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Relevant to ACCA Qualification Paper F9


Section E of the Study Guide for Paper F9 contains several references to the capital asset pricing model (CAPM).
This article, the second in a series of three, looks at how to apply the CAPM when calculating a project-specific
discount rate to use in investment appraisal. The first article in the series introduced the CAPM and its components,
showed how the model could be used to estimate the cost of equity, and introduced the asset beta formula. The third
and final article will look at the theory, advantages, and disadvantages of the CAPM.
As mentioned in the first article, the CAPM is a method of calculating the return required on an investment, based on
an assessment of its risk. When the business risk of an investment project differs from the business risk of the
investing company, the return required on the investment project is different from the average return required on the
investing companys existing business operations. This means that it is not appropriate to use the investing companys
existing cost of capital as the discount rate for the investment project. Instead, the CAPM can be used to calculate a
project-specific discount rate that reflects the business risk of the investment project.
The first step in using the CAPM to calculate a project-specific discount rate is to obtain information on companies
with business operations similar to those of the proposed investment project. For example, if a food processing
company was looking at an investment in coal mining, it would need to obtain information on some coal mining
companies; these companies are referred to as proxy companies. Since their equity betas represent the business
risk of the proxy companies business operations, they are referred to as proxy equity betas or proxy betas.
From a CAPM point of view, these proxy betas can be used to represent the business risk of the proposed investment
project. For example, the proxy betas from several coal mining companies ought to represent the business risk of an
investment in coal mining.
If you were to look at the equity betas of several coal mining companies, however, it is very unlikely that they would all
have the same value. The reason for this is that equity betas reflect not only the business risk of a companys
operations, but also the financial risk of a company. The systematic risk represented by equity betas, therefore,
includes both business risk and financial risk.
In the first article in this series, we introduced the idea of the asset beta, which is linked to the equity beta by the asset
beta formula. This formula is included in the Paper F9 formulae sheet and is as follows:

To proceed further with calculating a project-specific discount rate, it is necessary to remove the effect of the financial
risk or gearing from each of the proxy equity betas in order to find their asset betas, which are betas that reflect
business risk alone. If a company has no gearing, and hence no financial risk, its equity beta and its asset beta are
The asset beta formula is somewhat unwieldy and so it is common practice to make the simplifying assumption that
the debt beta ( d ) is zero. This can be seen as a relatively minor simplification if it is recognised that the debt beta is
usually very small in comparison to the equity beta ( e ). In addition, the market value of a companys debt (V d ) is
usually very small in comparison to the market value of its equity (V e ), and the tax efficiency of debt reduces the
weighting of the debt beta even further.
Making the assumption that the debt beta is zero means that the asset beta formula becomes:

If the equity beta, the gearing, and the tax rate of the proxy company are known, this amended asset beta formula can
be used to calculate the proxy companys asset beta. Since this calculation removes the effect of the financial risk or
gearing of the proxy company from the proxy beta, it is usually called ungearing the equity beta. Similarly, the
amended asset beta formula is called the ungearing formula.
After the equity betas of several proxy companies have been ungeared, it is usually found that the resulting asset
betas have slightly different values. This is not that surprising, since it is very unlikely that two proxy companies will
have exactly the same business risk from a systematic risk point of view. Even two coal mining companies will not be
mining the same coal seam, or mining the same kind of coal, or selling coal into the same market. If one of the
calculated asset betas is very different from the others, however, it would be regarded with suspicion and excluded
from further consideration.
In order to remove the effect of the slight differences in business operations and business risk that are reflected in the
asset betas, these betas are averaged. A simple arithmetic average is calculated by adding up the asset betas and
then dividing by the number of asset betas being averaged.
The average asset beta represents the business risk of the proposed investment project. Before a project-specific
discount rate can be calculated, however, the financial risk of the investing company needs to be taken into
consideration. In other words, having ungeared the proxy equity betas when calculating the asset betas, it is now
necessary to regear the average proxy asset beta to reflect the gearing and the financial risk of the investing
One way to approach regearing is to use the ungearing formula, inserting the gearing and the tax rate of the investing

company, and the average asset beta, and leaving the equity beta as the only unknown variable. Another approach is
to rearrange the ungearing formula in order to represent the equity beta in terms of the asset beta, as follows:

The gearing and the tax rate of the investing company, and the average proxy asset beta, are inserted into the right hand side of the regearing formula in order to calculate the regeared equity beta.
The CAPM can now be used to calculate a project-specific cost of equity. Once values have been obtained for the
risk-free rate of return, and either the equity risk premium or the return on the market, these can be inserted into the
CAPM formula along with the regeared equity beta:

The project-specific cost of equity can be used as the project-specific discount rate or project-specific cost of capital.
It is also possible to go further and calculate a project-specific weighted average cost of capital, but this does not
concern us in this article and it is a step that is often omitted when using the CAPM in investment appraisal.


The steps in calculating a project-specific discount rate using the CAPM can now be summarised, as follows (Watson
D and Head A, Corporate Finance: Principles and Practice, 4th edition, FT Prentice Hall, pp 250255, 2007):

Locate suitable proxy companies.

Determine the equity betas of the proxy companies, their gearings and tax rates.
Ungear the proxy equity betas to obtain asset betas.
Calculate an average asset beta.
Regear the asset beta.
Use the CAPM to calculate a project-specific cost of equity.

The difficulties and practical problems associated with using the CAPM to calculate a project-specific discount rate to
use in investment appraisal will be discussed in the next article in this series.
A company is planning to invest in a new project that is significantly different from its existing business operations.
This company is financed 30% by debt and 70% by equity. It has located three companies with business operations
similar to the proposed investment, and details of these companies are as follows:
Company A has an equity beta of 0.81 and is financed 25% by debt and 75% by equity.
Company B has an equity beta of 0.98 and is financed 40% by debt and 60% by equity.
Company C has an equity beta of 1.16 and is financed 50% by debt and 50% by equity.
Assume that the risk-free rate of return is 4% per year, and that the equity risk premium is 6% per year. Assume also
that all the companies pay tax at a rate of 30% per year. Calculate a project-specific discount rate for the proposed
Ungearing the proxy equity betas: Asset beta for Company A
= 0.81 x 75//((75 + 25(1 - 0.30)) = 0.657
Asset beta for Company B = 0.98 x 60//((60 + 40(1 - 0.30)) = 0.668
Asset beta for Company C = 1.16 x 50//((50 + 50(1 - 0.30)) = 0.682
Averaging the asset betas:
(0.657 + 0.668 + 0.682)/3 = 2.007/3 = 0.669
Regearing the average asset beta: 0.669 = e x 70//((70 + 30(1 - 0.30)) = e x 0.769 Hence e = 0.669/0.769 = 0.870
If the regearing equation were used:
e = 0.669 x ((1 + (1 - 0.30)30/70) = 0.870
Calculating the project-specific discount rate:
E(ri) = Rf + i (E(rm) - Rf) = 4 + (0.870 x 6) = 4 + 5.22 = 9.2%
Written by a member of the Paper F9 examining team


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The F9 syllabus contains a section on Islamic finance (Section E3). All components of this section will be
examined at intellectual level 1, knowledge and comprehension
Although the concept of Islamic finance can be traced back about 1,400 years, its recent history can be dated to the
1970s when Islamic banks in Saudi Arabia and the United Arab Emirates were launched. Bahrain and Malaysia
emerged as centres of excellence in the 1990s. It is now estimated that worldwide around US $1 trillion of assets are
managed under the rules of Islamic finance.
Islamic finance rests on the application of Islamic law, or Shariah, whose primary sources are the Qur'an and the
sayings and practice of the Prophet Muhammad. Shariah, and very much in the context of Islamic finance,
emphasises justice and partnership.
The main principles of Islamic finance are that:

Wealth must be generated from legitimate trade and asset-based investment. (The use of money for the
purposes of making money is expressly forbidden.)

Investment should also have a social and an ethical benefit to wider society beyond pure return.

Risk should be shared.

All harmful activities (haram) should be avoided.

The following activities are prohibited:

Charging and receiving interest (riba). The idea of a lender making a straight interest charge, irrespective of
how the underlying assets fare, transgresses the concepts of risk sharing, partnership and justice. It represents
the money itself being used to make money. It also prohibits investment in companies that have too much
borrowing (typically defined as having debt totalling more than 33% of the firms average stock market value
over the last 12 months).
Investments in businesses dealing with alcohol, gambling, drugs, pork, pornography or anything else that the
Shariah considers unlawful or undesirable (haram).
Uncertainty, where transactions involve speculation, or extreme risk. This is seen as being akin to gambling.
This prohibition, for example, would rule out speculating on the futures and options markets. Mutual insurance
(which relates to uncertainty) is permitted if it is related to reasonable, unavoidable business risk. It is based

upon the principle of shared responsibility for shared financial security, and that members contribute to a mutual
fund, not for profit, but in case one of the members suffers misfortune.

Uncertainty about the subject matter and terms of contracts this includes a prohibition on selling something
that one does not own. There are special financial techniques available for contracting to manufacture a product
for a customer. This is necessary because the product does not exist, and therefore cannot be owned, before it
is made. A manufacturer can promise to produce a specific product under certain agreed specifications at a
determined price and on a fixed date. Specifically, in this case, the risk taken is by a bank which would
commission the manufacture and sell the goods on to a customer at a reasonable profit for undertaking this risk.
Once again the bank is exposed to considerable risk. Avoiding contractual risk in this way, means that
transactions have to be explicitly defined from the outset. Therefore, complex derivative instruments and
conventional short sales or sales on margin are prohibited under Islamic finance.

As mentioned above, the receipt of interest is not allowed under Shariah. Therefore, when Islamic banks provide
finance they must earn their profits by other means. This can be through a profit-share relating to the assets in which
the finance is invested, or can be via a fee earned by the bank for services provided. The essential feature of Shariah
is that when commercial loans are made, the lender must share in the risk. If this is not so then any amount received
over the principal of the loan will be regarded as interest.
There are a number of Islamic financial instruments mentioned in the F9 syllabus and which can provide Shariahcompliant finance:

Murabaha is a form of trade credit for asset acquisition that avoids the payment of interest. Instead, the bank
buys the item and then sells it on to the customer on a deferred basis at a price that includes an agreed mark-up
for profit. The mark-up is fixed in advance and cannot be increased, even if the client does not take the goods
within the time agreed in the contract. Payment can be made by instalments. The bank is thus exposed to
business risk because if its customer does not take the goods, no increase in the mark- up is allowed and the
goods, belonging to the bank, might fall in value.
Ijara is a lease finance agreement whereby the bank buys an item for a customer and then leases it back
over a specific period at an agreed amount. Ownership of the asset remains with the lessor bank, which will
seek to recover the capital cost of the equipment plus a profit margin out of the rentals payable.

Emirates Airlines regularly uses Ijara to finance its expansion. Another example of theIjara structure is seen in Islamic
mortgages. In 2003, HSBC was the first UK clearing bank to offer mortgages in the UK designed to comply with
Shariah. Under HSBCs Islamic mortgage, the bank purchases a house then leases or rents it back to the customer.
The customer makes regular payments to cover the rental for occupying or otherwise using the property, insurance
premiums to safeguard the property, and also amounts to pay back the sum borrowed. At the end of the mortgage,
title to the property can be transferred to the customer. The demand for Islamic mortgages in the UK has shown
considerable growth.

Mudaraba is essentially like equity finance in which the bank and the customer share any profits. The bank
will provide the capital, and the borrower, using their expertise and knowledge, will invest the capital. Profits will
be shared according to the finance agreement, but as with equity finance there is no certainty that there will ever

be any profits, nor is there certainty that the capital will ever be recovered. This exposes the bank to
considerable investment risk. In practice, most Islamic banks use this is as a form of investment product on the
liability side of their statement of financial position, whereby the investor or customer (as provider of capital)
deposits funds with the bank, and it is the bank that acts as an investment manager (managing the funds).
Musharaka is a joint venture or investment partnership between two parties. Both parties provide capital
towards the financing of projects and both parties share the profits in agreed proportions. This allows both
parties to be rewarded for their supply of capital and managerial skills. Losses would normally be shared on the
basis of the equity originally contributed to the venture. Because both parties are closely involved with the
ongoing project management, banks do not often use Musharaka transactions as they prefer to be more hands
Sukuk is debt finance. A conventional, non-Islamic loan note is a simple debt, and the debt holder's return for
providing capital to the bond issuer takes the form of interest. Islamic bonds, or sukuk, cannot bear interest. So
that the sukuk are Shariah-compliant, the sukuk holders must have a proprietary interest in the assets which are
being financed. The sukuk holders return for providing finance is a share of the income generated by the
assets. Most sukuk, are asset-based, not asset-backed, giving investors ownership of the cash flows but not of
the assets themselves. Asset-based is obviously more risky than asset backed in the event of a default.

There are a number of ways of structuring sukuk, the most common of which are partnership (Musharaka) or lease
(Ijara) structures. Typically, an issuer of the sukukwould acquire property and the property will generally be leased to
tenants to generate income. The sukuk, or certificates, are issued by the issuer to the sukuk holders, who thereby
acquire a proprietary interest in the assets of the issuer. The issuer collects the income and distributes it to the sukuk
holders. This entitlement to a share of the income generated by the assets can make the arrangement Shariah
The cash flows under some of the approaches described above might be the same as they would have been for the
standard western practice paying of interest on loan finance. However, the key difference is that the rate of return is
based on the asset transaction and not based on interest on money loaned. The difference is in the approach and not
necessarily on the financial impact. In Islamic finance the intention is to avoid injustice, asymmetric risk and moral
hazard (where the party who causes a problem does not suffer its consequences), and unfair enrichment at the
expense of another party.
Advocates of Islamic finance claim that it avoided much of the recent financial turmoil because of its prohibitions on
speculation and uncertainty, and its emphasis on risk sharing and justice. That does not mean, of course, that the
system is free from all risk (nothing is), but if you are more exposed to a risk you are likely to behave more prudently.


The Shariah board is a key part of an Islamic financial institution. It has the responsibility for ensuring that all products
and services offered by that institution are compliant with the principles of Shariah law. Boards are made up of a
committee of Islamic scholars and different institutions can have different boards.

An institutions Shariah board will review and oversee all new product offerings before they are launched. It can also
be asked to deliver judgments on individual cases referred to it, such as whether a specific customers business
proposals are Shariah-compliant.
The demand for Shariah-compliant financial services is growing rapidly and the Shariah board can also play an
important role in helping to develop new financial instruments and products to help the institution to adapt to new
developments, industry trends, and customers requirements. The ability of scholars to make pronouncements using
their own expertise and based on Shariah, highlights the fact that Islamic finance remains innovative and able to
evolve, while crucially remaining within the bounds of core principles.

Perhaps the main current problem is the absence of a single, worldwide body to set standards for Shariah
compliance, meaning that there is no ultimate authority for Shariah compliance. Each Islamic banks adherence to the
principles of Shariah law is governed by its own Shariah board. Some financial aspects of Shariah law, and, therefore,
the legitimacy of the financial instruments used can be open to interpretation, with the result that some Islamic banks
may agree transactions that would be rejected by other banks. Therefore, a contract might unexpectedly be declared
incompatible with Shariah law and thus be invalid.
In Malaysia, the worlds biggest market for sukuk, the Shariah advisory council ensures consistency in order to help in
creating certainty across the market. Some industry bodies, notably the Accounting and Auditing Organisation for
Islamic Financial Institutions (AAOIFI) in Bahrain, have also been working towards common standards. To quote the
AAOFI website: AAOIFI is supported by institutional members (200 members from 45 countries, so far) including
central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance
industry, worldwide. AAOIFI has gained assuring support for the implementation of its standards, which are now
adopted in the Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria.
The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom of Saudi Arabia, and South Africa have
issued guidelines that are based on AAOIFIs standards and pronouncements.
However, despite these movements towards consistency, some differences between national jurisdictions are likely to
Ken Garrett is a freelance author and lecturer

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Relevant to ACCA Qualification Paper F9
Studying Paper F9? Performance objectives 15 and 16 are relevant to this exam
Section E of the Paper F9, Financial Management syllabus deals with business finance: What types of finance? What
sources? What mix?
The article will first consider a businesss formation and initial growth, then a company that is well-established and
mature, and will look at the financing choices and decisions that could face it at various stages.
Formation and initial growth
Many businesses begin with finance contributed by their owners and owners families. If they start as unincorporated
businesses, the distinction between owners capital and owners loans is almost irrelevant. If it starts as an
incorporated business, or turns into one, then there are important differences between share capital and loans. Share
capital is more or less permanent and can give suppliers and lenders some confidence that the owners are being
serious and are willing to risk significant resources. If the owners friends and families do not themselves want to
invest (perhaps they have no money to invest) then the owners will have to look for outside sources of capital. The
main sources are:

bank loans and overdrafts

leasing/hire purchase

trade credit

government grants, loans and guarantees

venture capitalists and business angels

invoice discounting and factoring

retained profits.

Bank loans and overdrafts

In the current economic climate, start-up businesses are likely to find it difficult to raise a bank loan, particularly if the
business and its owners have no track record at all. Banks will certainly require:

A business plan, including cash flow forecasts.

Personal guarantees and charges on personal assets.

The personal guarantees and charges on personal assets get round the companys limited liability which would
otherwise mean that if the company failed, the bank might be left with nothing. This way the bank can ask the
guarantors to pay back the loans personally, or the bank can seize the charged assets that were used for security.
Note that overdrafts are repayable on demand and many banks have a reputation of pre-emptively withdrawing
overdraft facilities, not when a business is in trouble, but when the bank fears more difficult times ahead.
On a more positive note, where it is known that the need for finance is temporary, an overdraft might be very suitable
because it can be repaid by the borrower at any time.
Leasing and hire purchase
In financial terms, leasing is very like a bank loan. Instead of receiving cash from the loan, spending it on buying an

asset and then repaying the loan, the leasing company buys the asset, makes it available to the lessee and charges
the lessee a monthly amount. Leasing can often be cheaper than borrowing because:

Large leasing companies have great bargaining power with suppliers so the asset costs them less than it
would cost the lessee. This can be partially passed on to the leasee.

Leasing companies have effective ways of disposing of old assets, but lessees normally do not.

If the lease payments are not made, the leasing company has a form of built- in security insofar as it can
reclaim its asset.

The cost of finance to a large, established leasing company is likely to be lower than the cost to a start-up

It is important for businesses to try to decide whether loan finance or a lease would be cheaper. (This is a separate
topic in the Paper F9 syllabus, but it is not covered in this article.)
Trade credit
This simply means taking credit from suppliers typically 30 days. That is obviously a very short period, but it can be
very helpful to new businesses. Typically, credit suppliers to new businesses will want some sort of reference, either
from a bank or from other suppliers (trade references). However, some will be prepared to offer modest credit initially
without references, and as trust grows this can be increased.
Government grants, loans and guarantees
Governments often encourage the formation of new businesses and, from time to time and from region to region, help
is offered. Government grants are usually very small, and direct loans are rare because governments see loan
provision as the job of financial institutions.
Currently in the UK, the Government runs the Enterprise Finance Guarantee Scheme (EFGS). This is a loan
guarantee scheme intended to facilitate additional bank lending to viable small and medium-sized entities (SMEs)
with insufficient security for a normal commercial loan. The borrower must be able to demonstrate to the lender that
they should be able to repay the loan in full. The Government provides the lender with a guarantee for which the
borrower pays a premium.
The scheme is not a mechanism through which businesses or their owners can choose to withhold the security a
lender would normally lend against; nor is it intended to facilitate lending to businesses which are not viable and that
banks have declined to lend to on that basis.
EFGS supports lending to viable businesses with an annual turnover of up to 25m seeking loans of between 1,000
and 1m.
Venture capitalists and business angels
These are either companies (usually known as venture capitalists) or wealthy individuals (business angels) who are
prepared to invest in new or young businesses. They provide equity (private equity as opposed to public equity in
listed companies), not loans. The equity is not normally secured on any assets and the private equity firm faces the
risk of losses just like the other shareholders. Because of the high risk associated with start-up equity, private equity
suppliers typically look for returns on their investment in the order of 30% pa. The overall return takes into account
capital redemptions (for example preference shares being redeemed at a premium), possible capital gains on exiting
their investment (for example through sale of shares to a private buyer or after listing the company on a stock
exchange), and income through fees and dividends.
Typically, venture capitalists will require 25%49% of the equity and a seat on the board so that their investment can
be monitored and advice given. However, the investors do not seek to take over management of their investment.

Invoice discounting and factoring

Before these methods can be used turnover usually has to be in the region of at least $200,000. Amounts due from
customers, as evidenced by invoices, are advanced to the company. Typically 80% of an invoice will be paid within 24
hours. In addition to this service, factors also look after the administration of the companys receivables ledger.
Fees are charged on advancing the cash (roughly at overdraft interest rates), and also factors will charge about 1% of
turnover for running the receivables ledger (the exact amount depends on how many invoices and customers there
are). Credit insurance can be taken out for an additional fee. Unless that is taken out the invoicing company remains
liable for any bad debts.
Retained profits
Retained profits are no good for start-ups, and often no good for the first few years of a businesss life when only
losses or very modest profits are made. However, assuming the business is successful, profits should be made and
retaining those in the business can allow the company to repay debt capital and to invest in expansion.
How much capital is needed?
Capital is needed:

for investment in non-current assets

to sustain the company through initial loss-making periods

for investment in current assets.

Cash-flow forecasts are an essential tool in planning capital needs. Typically, suppliers of capital will want forecasts
for three to five years. One of the biggest dangers facing new successful businesses is overtrading, where they try to
do too much with too little capital. Most businesses know that capital will be needed to finance non-current assets, but
many overlook that finance is also needed for current assets.
Look at this example:

This company starts with a healthy liquidity position (Stage 1). Business then doubles, without investing in more non-

current assets and without raising more equity capital. It is a reasonable assumption that if turnover doubles then so
will inventory, receivables and payables (Stage 2). But here this forces the company to rely on an overdraft (probably
unexpected and unplanned) to finance its net current assets. Relying permanently on overdraft finance is precarious
and the company would be advised to seek some more permanent form of capital.
When capital is raised, the company has to decide what to do with it, and there are two main uses:

invest in non-current assets

invest in current assets, including leaving it as cash.

The more capital invested in non-current assets, the greater should be the profit- earning potential of the business.
However, leaving too little cash in current assets increases the risk that the company will have liquidity problems. On
the other hand, leaving too much capital in current assets is wasteful: cash will earn modest interest (but investors
want higher returns from a company), and cash tied up in inventory often causes costs (storage, damage,
obsolescence). So, the company has to decide on its working capital policy. An aggressive policy is one which
maintains relatively low working capital compared to another company; a conservative policy is one which maintains
relatively high working capital. Which policy is appropriate partly depends on the nature of the business. If the
business is one where trading cash flows are very predictable then it should be able to survive with an aggressive
policy. If, however, cash flows are erratic and unpredictable the company would be wise to build a margin of safety
into its cash management. Additionally, if the company foresees a period of losses, it will need to keep cash available
(probably earning interest in a deposit account) to see it through its lean years.
Note that companies do not have to have actually raised capital to have it available for emergency use. What they
need is a pre-agreed right to borrow a certain amount on demand. That is known as a line of credit. Many of us make
use of lines of credit in our personal lives, but there we call them credit cards. So we dont have to have $1,000 sitting
in the bank in case our car needs a major repair, but its comforting to know that if repairs are necessary, we can pay
for them immediately. Of course, the credit card debt will have to be repaid at some time, but repayments can be
Long, medium and short-term capital
Capital can be short, medium or long-term. Definitions vary somewhat, but the following are often seen:

Short term up to two years. For example, overdrafts, trade credit, factoring and invoice discounting

Medium term two to five or six years. For example, term loans, lease finance.

Long term over five years, or so, to permanent.

In general, it makes sense to match the length of the finance to the life of the asset (the matching principle) and,
again, we often apply this in our own lives, where we would use a 25-year mortgage to buy an apartment, a 35-year
loan to buy a car, and a credit card to pay for a holiday.

Note that long-term capital (equity and bonds) can be used to fund all classes of asset. Although each piece of
inventory and each receivable are very short-life assets, in total there will normally be fairly stable amounts of each

that have to be permanently funded. Therefore, it makes sense to fund most of those assets by long-term capital and
to use short-term capital to fund seasonal peaks. One of the problems with short-term finance is that is comes to an
end quickly and if finance is still needed then more has to be renegotiated. Long-term capital is either permanent or
comes up for renewal relatively rarely.
Mature companies
Once a company has existed profitably for some time and grown in size, additional sources of finance can become
available, in particular:

public equity

public debt


Public equity
Some stock exchanges provide different sorts of listings. For example:

London Stock Exchange: The Main Market and the Alternative Investment Market (AIM). AIM focuses on
helping smaller and growing companies raise the capital they need for expansion.

NASDAQ: This is an electronic stock exchange in the US and has the NASDAQ National Market for large,
established companies (market value at least $70m) and the NASDAQ Capital market for smaller companies.

An initial public offering is the first occasion on which shares are offered to the public. A company seeking a listing
has to issue a prospectus, which is a legal document describing the shares being offered for sale, and including
matters such as a description of the company's business, recent financial statements, details of the directors and their
Shares can be listed via:

An offer for sale at fixed price: a company offers shares for sale at a fixed price directly to the public, for
example in newspaper advertisements. In fact, the shares are usually first sold to an issuing house which sells
them on to the public.

An offer for sale by tender: investors are asked to bid, and all who bid more than the minimum price that all
shares can be sold at will be sold shares at that minimum price.

A placing: shares are offered to a selection of institutional investors. Because less publicity is needed, these
are cheaper than offers for sale and are therefore suited to smaller IPOs.

An introduction: this is rare and only happens when shares are already widely held publically. No money is

Subsequent issues of equity will be rights issues where existing shareholders are offered new shares in proportion to
existing holdings. The shares are offered at below their current market value to make the offer look attractive, but in
theory, no matter at what price right issues are made and no matter whether shareholders take up or dispose of their
rights, shareholders will end up neither better nor worse off. Wealth is neither created nor destroyed just by moving
money from a shareholders bank account to the companys.
Gaining a listing opens up a huge source of potential new capital. However, with listing come increased scrutiny,
comment and responsibility. Although this will help the standing and respectability of the company the founders of the

company, having been used to running their own company in their own way, often resent outside interference even
though that is to be expected now that ownership of their shares is more widespread.
Public debt
This refers to quoted bonds or loan notes: instruments paying a coupon rate of interest and whose market value can
fluctuate. Usually the bonds will be secured either by fixed or floating charges and can be redeemable or
irredeemable. Well- secured bonds in companies that are not too highly geared are low risk investments and bonds
holders will therefore require relatively low returns. The cost of the bonds to the borrower falls even more after tax
relief on interest is taken into account.
Convertible bonds
Convertibles start life as loan capital and can later be converted, at the lenders option, into shares. They are a clever
and useful device, particularly for younger companies, because:

In the very early days of the companys life, investors might not want to risk investing in equity, but might be
prepared to invest in the less risky debentures. However, debentures never hold out the promise of massive
capital gains.

If the company does not do so well, the investors can stick with their safe convertible loan stock.
If the company does well, the investors can opt to convert and to take part in the capital growth of the

Convertible bonds therefore offer a wait and see approach. Because they allow later entry to what might turn out to
be a growth stock, the initial interest rate they have to offer is lower than with pure bonds and thats good for the
company that is borrowing.
When deciding what sorts of finance to issue, companies must always bear in mind the average cost of their finance.
This article does not go into gearing considerations in any detail except to point out that some borrowing can lower
the cost of capital.
If there is no borrowing, all finance will be equity and that is high cost to compensate for the high risk attaching to it.
Debt finance is cheap because it has lower risk and enjoys tax relief on interest.
Therefore, introducing some debt into the finance mix begins to pull down the average cost of capital. However, at
very high levels of gearing the increased risk of default pushes up both the cost of debt and the cost of equity, and the
average cost of finance starts to rise. Somewhere, there is an optimum gearing ratio with the cheapest mix of finance.
The previous paragraph briefly described the traditional theory of gearing. Modigliani and Miller suggested an
alternative view, but the very precise conditions and restrictions their theories require are not often found in practice.
Ken Garrett is a freelance lecturer and author


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Student Accountant hub page
This article has been updated to reflect the knowledge of basis risk that students are expected to have for F9.
Increasingly, many businesses have dealings in foreign currencies and, unless exchange rates are fixed with respect
to one another, this introduces risk. There are three main types of currency risk as detailed below.
Economic risk. The source of economic risk is the change in the competitive strength of imports and exports. For
example, if a company is exporting (lets say from the UK to a eurozone country) and the euro weakens from say /
1.1 to /1.3 (getting more euros per pound sterling implies that the euro is less valuable, so weaker) any exports
from the UK will be more expensive when priced in euros. So goods where the UK price is 100 will cost 130 instead
of 110, making those goods less competitive in the European market.
Similarly, goods imported from Europe will be cheaper in sterling than they had been, so those goods will have
become more competitive in the UK market. Note that a company can, therefore, experience economic risk even if it
has no overt dealings with overseas countries. If competing imports could become cheaper you are suffering risk
arising from currency rate movements.
Doing something to mitigate economic risk can be difficult especially for small companies with limited international
dealings. In general, the following approaches might provide some help:

Try to export or import from more than one currency zone and hope that the zones dont all move together, or
if they do, at least to the same extent. For example, over the six months 14 January 2010 to 14 June 2010 the
/US$ exchange rate moved from about /US$0.6867 to /US$ 0.8164. This meant that the had weakened
relative to the US$ (or the US$ strengthened relative to the ) by 19%. This made it less competitive for US
manufacturers to export to a eurozone country. If, in the same period, the /US$ exchange rate moved from
/US$0.6263 to /US$0.6783, a strengthening of the US$ relative to of only about 8%. Trade from the US to
the UK would not have been so badly affected.

Make your goods in the country you sell them. Although raw materials might still be imported and affected by
exchange rates, other expenses (such as wages) are in the local currency and not subject to exchange rate

Translation risk. This affects companies with foreign subsidiaries. If the subsidiary is in a country whose currency
weakens, the subsidiarys assets will be less valuable in the consolidated accounts. Usually, this effect is of little real
importance to the holding company because it does not affect its day-to-day cash flows. However, it would be
important if the holding company wanted to sell the subsidiary and remit the proceeds. It also becomes important if
the subsidiary pays dividends. However, the term translation risk is usually reserved for consolidation effects.
It can be partially overcome by funding the foreign subsidiary using a foreign loan. For example, take a US subsidiary
that has been set up by its holding company providing equity finance. Its statement of financial position would look
something like this:

Non-current assets


Current assets




If the US$ weakens then all the US$2m total assets become less valuable.
However, if the subsidiary were set up using 50% equity and 50% US$ borrowings, its statement of financial position
would look like this:

Non-current assets


Current assets


$ Loan




The holding companys investment is only US$1m and the companys net assets in US$ are only US$1m. If the US$
weakens, only the net US$1m becomes less valuable.
Transaction risk. This arises when a company is importing or exporting. If the exchange rate moves between
agreeing the contract in a foreign currency and paying or receiving the cash, the amount of home currency paid or
received will alter, making those future cash flows uncertain. For example, in June a UK company agrees to sell an
export to Australia for 100,000 Australian $ (A$), payable in three months. The exchange rate at the date of the
contract is A$/1.80 so the company is expecting to receive 100,000/1.8 = 55,556. If, however, the A$ weakened
over the three months to become worth only A$/2.00, then the amount received would be worth only 50,000.
Of course, if the A$ strengthened over the three months, more than 55,556 would be received.
It is important to note that transaction risk management is not mainly concerned with achieving the most favourable
cash flow: it is mainly aimed at achieving a definite cash flow. Only then can proper planning be undertaken.


Assuming that the business does not want to tolerate exchange rate risks (and that could be a reasonable choice for
small transactions), transaction risk can be treated in the following ways:

1. Invoice. Arrange for the contract and the invoice to be in your own currency. This will shift all exchange risk from
you onto the other party. Of course, who bears the risk will be a matter of negotiation, along with price and other
payment terms. If you are very keen to get a sale to a foreign customer you might have to invoice in their currency.
2. Netting. If you owe your Japanese supplier 1m, and another Japanese company owes your Japanese subsidiary
1.1m, then by netting off group currency flows your net exposure is only for 0.1m. This will really only work
effectively when there are many sales and purchases in the foreign currency. It would not be feasible if the
transactions were separated by many months. Bilateral netting is where two companies in the same group cooperate
as explained above; multilateral netting is where many companies in the group liaise with the groups treasury
department to achieve netting where possible.
3. Matching. If you have a sales transaction with one foreign customer, and then a purchase transaction with another
(but both parties operate with the same foreign currency) then this can be efficiently dealt with by opening a foreign
currency bank account. For example:
1 November: should receive US$2m from US customer
15 November: must pay US$1.9m to US supplier.
Deposit the US$2m in a US$ bank account and simply pay the supplier from that. That leaves only US$0.1m of
exposure to currency fluctuations. Usually, for matching to work well, either specific matches are spotted (as above) or
there have to be many import and export transactions to give opportunities for matching. Matching would not be
feasible if you received US$2m in November, but didnt have to pay US$1.9m until the following May. There arent
many businesses that can simply keep money in a foreign currency bank account for months on end.
4. Leading and lagging. Lets imagine you are planning to go to Spain and you believe that the euro will strengthen
against your own currency. It might be wise for you to change your spending money into euros now. That would be
leading because you are changing your money in advance of when you really need to. Of course, the euro might
weaken and then youll want to kick yourself, but remember: managing transaction risk is not about maximising your
income or minimising your expenditure, it is about knowing for certain what the transaction will cost in your own
currency. Lets say, however, that you believe that the euro is going to weaken. Then you would not change your
money until the last possible moment. That would be lagging, delaying the transaction. Note, however, that this does
not reduce your risk. The euro could suddenly strengthen and your holiday would turn out to be unexpectedly
expensive. Lagging does not reduce risk because you still do not know your costs. Lagging is simply taking a gamble
that your hunch about the weakening euro is correct.
5. Forward exchange contracts. A forward exchange contract is a binding agreement to sell (deliver) or buy an
agreed amount of currency at a specified time in the future at an agreed exchange rate (the forward rate).
In practice there are various ways in which the relationship between a current exchange rate (spot rate) and the
forward rate can be described. Sometimes it is given as an adjustment to be made to the spot rate; in the Paper F9
exam, for example, the forward rates are quoted directly.
However, for each spot and forward there is always a pair of rates given. For example:


Three-month forward rate

1.2025 0.03 ie 1.2028

and 1.2022

1.2020 0.06 ie 1.2026

and 1.2014

One of each pair is used if you are going to change sterling to euros. So 100 would be changed now for either
120.28 or 120.22. Guess which rate the bank will give you! You will always be given the exchange rate which
leaves you less well off, so here you will be given a rate of 1.2022, if changing to euros now, or 1.2014 if using a

forward contract. Once you have decided which direction one rate is for, the other rate is used when converting the
other way. So:






Three month forward rate



So, lets assume you are a manufacturer in Italy, exporting to the UK. You have agreed that the sale is worth
500,000, to be received in three months, and wish to hedge (reduce your risk) against currency movements.
In three months you will want to change to and you can enter a binding agreement with a bank that in three
months you will deliver 500,000 and that the bank will give you 500,000 x 1.2014 = 600,700 in return. That rate,
and the number of euros you will receive, is now guaranteed irrespective of what the spot rate is at the time. Of
course if the had strengthened against the (say to / = 1.5) you might feel aggrieved as you could have then
received 750,000, but income maximisation is not the point of hedging: its point is to provide certainty and you can
now put 600,700 into your cash flow forecast with confidence.
However, there remains here one lingering risk: what happens if the sale falls through after arranging the forward
contract? We are not necessarily talking about a bad debt here as you might not have sent the goods, but you have
still entered into a binding contract to deliver 500,000 to your bank in three months time. The bank will expect you to
fulfil that commitment, and so what you might have to do is get enough to buy 500,000 using the spot rate, use this
to meet your forward contract, receiving 600,700 back. This process is known as closing out, and you could win or
lose on it depending on the spot rate at the time.
6. Money market hedging. Lets say that you were a UK manufacturer exporting to the US and in three months you
are due to receive US$2m. You would suffer no currency risk if that US$2m could be used then to settle a US$2m
liability; that would be matching the currency inflow and outflow. However, you dont have a US$2m liability to settle
then so create one that can soak up the US$. You can create a US$ liability by borrowing US$ now and then
repaying that in three months with the US$ receipt. So the plan is:

To work out how many US$ need to be borrowed now, you need to know US$ interest rates. For example, the US$
three month interest rate might be quoted as: 0.54% 0.66%.
It is important to understand that, although this might be described as a three month rate it is always quoted as an
annualised rate. One rate is what you would earn in interest if the money was on deposit, and the other is the rate you
would pay on a loan. Again, no prizes for guessing which is which: you will always be charged more than you earn.
On the US$ loan we will be charged 0.66% pa for three months and the loan has to grow to become US$2m in that
time. So, If X is borrowed now and three months interest is added:
X(1 + 0.66%/4) = 2,000,000
X = $1,996,705
This can be changed now from US$ to at the current spot rate, say US$/ 1.4701, to give 1,358,210.
This amount of sterling is certain: we have it now and it does not matter what happens to the exchange rate in the
future. Ticking away in the background is the US$ loan which will amount to US$2m in three months and which can
then be repaid by the US$2m we hope to receive from our customer. That is the hedging process finished because
exchange rate risk has been eliminated.
Why might this somewhat complicated process be used instead of a simple forward contract? Well, one advantage is
that we have our money now rather than having to wait three months for it. If we have the money now we can use it
now or at least place it in a sterling deposit account for three months. This raises an important issue when we come
to compare amounts received under forward contracts and money market hedges. If these amounts are received at
different times they cannot be directly compared, because receiving money earlier is better than receiving it later. To
compare amounts under both methods we should see what the amount received now would become if deposited for
three months. So, if the sterling three month deposit rate were 1.2%, then placing 1,358,210 on deposit for three
months would result in:
1,358,210 (1 + 1.2%/4) = 1,362,285
It is this amount that should be compared to any proceeds under a forward contract.

The example above dealt with hedging the receipt of an amount of foreign currency in the future. If foreign currency
has to be paid in the future, then what the company can do is change money into sufficient foreign currency now and
place it on deposit so that it will grow to become the required amount by the right time. Because the money is
changed now at the spot rate, the transaction is immune from future changes in the exchange rate.


There are two other methods of exchange risk hedging which you are required to know about, but you will not be
required solve numerical questions relating to these methods. They involve the use of derivatives: financial
instruments whose value derives from the value of something else like an exchange rate.
1. Currency futures. Simply think of these as items you can buy and sell on the futures market and whose price will
closely follow the exchange rate. Lets say that a US exporter is expecting to receive 5m in three months time and
that the current exchange rate is US$/1.24. Assume that this rate is also the price of US$/ futures. The US exporter
will fear that the exchange rate will weaken over the three months, say to US$/1.10 (that is fewer dollars for a euro).
If that happened, then the market price of the future would decline too, to around 1.1. The exporter could arrange to
make a compensating profit on buying and selling futures: sell now at 1.24 and buy later at 1.10. Therefore, any loss
made on the main the currency transaction is offset by the profit made on the futures contract.
This approach allows hedging to be carried out using a market mechanism rather than entering into the individually
tailored contracts that the forward contracts and money market hedges require. However, this mechanism does not
offer anything fundamentally new.
Basis risk can arise for both interest rate and exchange rate hedging through the use of futures. Futures contracts
will suffer from basis risk if the value of the futures contract does not match the underlying exposure. This occurs
when changes in exchange or interest rates are not exactly correlated with changes in the futures prices.
Note that another form of basis risk also exists as part of interest rate risk. In this case basis risk exists where a
company has matched its assets and liabilities with a variable rate of interest, but the variable rates are set with
reference to different benchmarks. For example, deposits may be linked to the one-month LIBOR rate, but borrowings
may be based on the 12-month LIBOR rate. It is unlikely that these rates will move perfectly in line with each other
and therefore this is a source of interest rate risk.
2. Options. Options are radically different. They give the holder the right, but not the obligation, to buy or sell a given
amount of currency at a fixed exchange rate (the exercise price) in the future (if you remember, forward contracts
were binding). The right to sell a currency at a set rate is a put option (think: you put something up for sale); the right
to buy the currency at a set rate is a call option.
Suppose a UK exporter is expecting to be paid US$1m for a piece of machinery to be delivered in 90 days. If the
strengthens against the US$ the UK firm will lose money, as it will receive fewer for the US$1m. However, if the
weakens against the US$, then the UK company will gain additional money. Say that the current rate is US$/1.40
and that the exporter will get particularly concerned if the rate moved beyond US$/1.50. The company can buy call
options at an exercise price of US$/ = 1.50, giving it the right to buy at US$1.50/. If the dollar weakens beyond
US$/1.50, the company can exercise the option thereby guaranteeing at least 666,667. If the US$ stays stronger
or even strengthens to, say, US$/1.20, the company can let the option lapse (ignore it) and convert at 1.20, to give
This seems too good to be true as the exporter is insulated from large losses but can still make gains. But theres
nothing for nothing in the world of finance and to buy the options the exporter has to pay an up-front, non-returnable
Options can be regarded just like an insurance policy on your house. If your house doesnt burn down you dont call

on the insurance, but neither do you get the premium back. If there is a disaster the insurance should prevent massive
losses. Options are also useful if you are not sure about a cash flow. For example, say you are bidding for a contract
with a foreign customer. You dont know if you will win or not, so dont know if you will have foreign earnings, but want
to make sure that your bid price will not be eroded by currency movements. In those circumstances, an option can be
taken out and used if necessary or ignored if you do not win the contract or currency movements are favourable.
Ken Garrett is a freelance author and lecturer


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Read part two
Student Accountant hub
A fundamental part of financial management is investment appraisal: into which long-term projects should a company
put money?
Discounted cash flow techniques (DCFs), and in particular net present value (NPV), are generally accepted as the
best ways of appraising projects. In DCF, future cash flows are discounted so that allowance is made for the time
value of money. Two types of estimate are needed:
The future cash flows relevant to the project.
The discount rate to apply.
This article looks at how a suitable discount rate can be calculated.


The cost of equity is the relationship between the amount of equity capital that can be raised and the rewards
expected by shareholders in exchange for their capital. The cost of equity can be estimated in two ways:
Measure the share price (capital that could be raised) and the dividends (rewards to shareholders). The dividend
growth model can then be used to estimate the cost of equity, and this model can take into account the dividend
growth rate. The formula sheet for the F9 exam will give the following formula:
P0 = D0(1 + g)
(re g)
This formula predicts the current ex-dividend market price of a share (P0) where:
D0 = the current dividend (whether just paid or just about to be paid)
g = the expected dividend future growth rate
re = the cost of equity.
Note that the top line (D0(1 + g)) is the dividend expected in one years time. The formula can be rearranged as:
re= D0(1 + g) + g
For a listed company, all the terms on the right of the equation are known, or can be estimated. In the absence of
other data, the future dividend growth rate is assumed to continue at the recent historical growth rate. Example 1 sets
out an example of how to calculate re.
The dividend just about to be paid by a company is $0.24. The current market price of the share is $2.76 cum div. The
historical dividend growth rate, which is expected to continue in the future, is 5%.
What is the estimated cost of capital?
re = D0(1 + g) + g = 0.24(1 + 0.05) + 0.05 = 15%
P0 must be the ex-dividend market price, but we have been supplied with the cum-dividend price. The ex-dividend
market price is calculated as the cum-dividend market price less the impending dividend. So here:
P0 = 2.76 0.24 = 2.52
The cost of equity is, therefore, given by:

re = D0(1 + g) + g
The capital asset pricing model (CAPM) equation quoted in the F9 exam formula sheet is: E(ri) = Rf + i(E(rm) Rf)
E(ri) = the return from the investment
Rf = the risk free rate of return
i = the beta value of the investment, a measure of the systematic risk of the investment
E(rm) = the return from the market
Essentially, the equation is saying that the required return depends on the risk of an investment. The starting point for
the rate of return is the risk free rate (Rf), to which you need to add a premium relating to the risk. The size of that
premium is determined by the answers to the following:

What is the premium the market currently gives over the risk free rate (E(rm) Rf)? This is a reference point
for risk: how much does the stock market, as a whole, return in excess of the risk free rate?

How risky is the specific investment compared to the market as a whole? This is the beta of the investment
(i). If i is 1, the investment has the same risk as the market overall. If i > 1, the investment is riskier (more
volatile) than the market and investors should demand a higher return than the market return to compensate for
the additional risk. If i < 1, the investment is less risky than the market and investors would be satisfied with a
lower return than the market return.
Risk free rate = 5%
Market return = 14%
What returns should be required from investments whose beta values are:
(i) 1
(ii) 2
(iii) 0.5
E(ri) = Rf +i(E(rm) Rf)
(i) E(ri) = 5 + 1(14 5) = 14%
The return required from an investment with the same risk as the market, which is simply the market return.
(ii) E(ri) = 5 + 2(14 5) = 23%
The return required from an investment with twice the risk as the market. A higher return than that given by the market
is therefore required.
(iii) E(ri) = 5 + 0.5(14 5) = 9.5%
The return required from an investment with half the risk as the market. A lower return than that given by the market is
therefore required.


The dividend growth model allows the cost of equity to be calculated using empirical values readily available for listed
companies. Measure the dividends, estimate their growth (usually based on historical growth), and measure the
market value of the share (though some care is needed as share values are often very volatile). Put these amounts
into the formula and you have an estimate of the cost of equity.
However, the model gives no explanation as to why different shares have different costs of equity. Why might one
share have a cost of equity of 15% and another of 20%? The reason that different shares have different rates of return
is that they have different risks, but this is not made explicit by the dividend growth model. That model simply

measures whats there without offering an explanation. Note particularly that a business cannot alter its cost of equity
by changing its dividends. The equation:
re = D0(1 + g) + g
might suggest that the rate of return would be lowered if the company reduced its dividends or the growth rate. That is
not so. All that would happen is that a cut in dividends or dividend growth rate would cause the market value of the
company to fall to a level where investors obtain the return they require.
The CAPM explains why different companies give different returns. It states that the required return is based on other
returns available in the economy (the risk free and the market returns) and the systematic risk of the investment its
beta value. Not only does CAPM offer this explanation, it also offers ways of measuring the data needed. The risk free
rate and market returns can be estimated from economic data. So too can the beta values of listed companies. It is, in
fact, possible to buy books giving beta values and many investment websites quote investment betas.
When an investment and the market is in equilibrium, prices should have been adjusted and should have settled down
so that the return predicted by CAPM is the same as the return that is measured by the dividend growth model.
Note also that both of these approaches give you the cost of equity. They do not give you the weighted average cost
of capital other than in the very special circumstances when a company has only equity in its capital structure.


There are two main components of the risk suffered by equity shareholders:


The nature of the business. Businesses that provide capital goods are expected to show relatively risky
behaviour because capital expenditure can be deferred in a recession and these companies returns will
therefore be volatile. You would expect i > 1 for such companies. On the other hand, a supermarket business
might be expected to show less risk than average because people have to eat, even during recessions. You
would expect i < 1 for such companies as they offer relatively stable returns.
The level of gearing. In an ungeared company (ie one without borrowing), there is a straight relationship
between profits from operations and earnings available to shareholders. Once gearing, and therefore interest, is
introduced, the amounts available to ordinary shareholders become more volatile. Look at Example 3below.


This shows two companies, one ungeared, one geared, which carry on exactly the same type of business. Between
State 1 and State 2, their profits from operations double. The amounts available to equity shareholders in the
ungeared company also double, so equity shareholders experience a risk or volatility which arises purely from the
companys operations. However, in the geared company, while amounts available from operations double, the

amounts available to equity shareholders increase by a factor of 2.66. The risk faced by those shareholders therefore
arises from two sources: risk inherent in the companys operations, plus risk introduced by gearing.
Therefore, the rate of return required by shareholders (the cost of equity) will also be affected by two factors:
The nature of the companys operations.
The amount of gearing in the company.
When we talk about, or calculate, the cost of equity we have to be clear what we mean. Is this a cost which reflects
only the business risk, or is it a cost which reflects the business risk plus the gearing risk?
When using the dividend growth model, you measure what you measure. In other words, if you use the dividends,
dividend growth and share price of a company which has no gearing, you will inevitably measure the ungeared cost of
equity. Thats what shareholders are happy with in this environment. If, however, these quantities are derived from a
geared company, you will inevitably measure the geared companys cost of equity.
Similarly, published beta values are derived from observing how specific equity returns vary as market returns vary, to
see if a shares return is more or less volatile than the market. Once again, you measure what you measure. If the
company being observed has no gearing in it, the beta value obtained depends only on the type of business being
carried on. If, however, the company has gearing within it, the beta value will reflect not only the risk arising from the
company, but also the risk arising from gearing.
Ken Garrett is a freelance writer and lecturer


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Read part one
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So now we have two ways of estimating the cost of equity (the return required by shareholders). Can this
measurement of a companys cost of equity be used as the discount rate with which to appraise capital investments?
Yes it can, but only if certain conditions are met:


A new investment can be appraised using the cost of equity only if equity alone is being used to fund the
new investment. If a mix of funds is being used to fund a new investment, then the investment should be
appraised using the cost of the mix of funds, not just the cost of equity.
The gearing does not change. If the gearing changes, the cost of equity will change and its current value
would no longer be applicable.
The nature of the business is unchanged. The new project must be more of the same so that the risk arising
from business activities is unchanged. If the business risk did change, once again the old cost of equity would
no longer be applicable.

These conditions are very restrictive and would apply only when an all-equity company issued more equity to do more
of the same type of activity. Our approach needs to be developed if we are going to be able to appraise projects in
more general environments.
In particular, we have to be able to deal with more general sources of finance, not just pure equity, and it would also
be good if we could deal with projects which have different risk characteristics from existing activities.


Let us look at appraising a project which uses a mix of funds, but where those funds are raised so as to maintain the
companys gearing ratio. Remember, where there is a mix of funds, the funds are regarded as going into a pool of
finance and a project is appraised with reference to the cost of that pool of finance. That cost is the weighted average
cost of capital (WACC). As a preliminary to this discussion, we need briefly to revise how gearing can affect the
various costs of capital, particularly the WACC. The three possibilities are set out in Example 1.

ke = cost of equity; kd = pre-tax cost of debt; Vd = market value debt; Ve = market value equity. T is the tax rate.

All three versions show that the cost of debt (Kd) is lower than the cost of equity (Ke). This is because debt is
inherently less risky than equity (debt has constant interest; interest is paid before dividends; debt is often secured on
assets; on liquidation creditors are repaid before equity shareholders). In the third version, cost of debt is further
reduced because in an environment with corporation tax, interest payments enjoy tax relief.

Looking at the three cases in a little more detail:

Conventional theory
When there is only equity, the WACC starts at the cost of equity. As the more expensive equity finance is replaced by
cheaper debt finance, the WACC decreases. However, as gearing increases further, both debt holders and equity
shareholders will perceive more risk, and their required returns both increase. Inevitably, WACC must increase at
some point. This theory predicts that there is an optimum gearing ratio at which WACC is minimised.
Modigliani and Miller (M&M) without tax
M&M were able to demonstrate that as gearing increases, the increase in the cost of equity precisely offsets the effect
of more cheap debt so that the WACC remains constant.
Modigliani and Miller (M&M) with tax
Debt, because of tax relief on interest, becomes unassailably cheap as a source of finance. It becomes so cheap that
even though the cost of equity increases, the balance of the effects is to keep reducing the WACC.
(Note: the M&M diagrams shown in Example 1 hold only for moderate levels of gearing. At very high levels of
gearing, other costs come into play and the WACC can be shown to increase again looking rather like the
conventional theory.)
Whichever theory you believe, whether there is or isnt tax, provided the gearing ratio does not change the WACC will
not change. Therefore, if a new project consisting of more business activities of the same type is to be funded so as
to maintain the present gearing ratio, the current WACC is the appropriate discount rate to use. In the special case of
M&M without tax, you can do anything you like with the gearing ratio as the WACC will remain constant and will be
equal to the ungeared cost of equity.
The condition that gearing is constant does not have to mean that upon every issue of capital both debt and equity
also have to be issued. That would be very expensive in terms of transaction costs. What it means is that over the
long term the gearing ratio will not change. That would certainly be the companys ambition if it believed it was already
at the optimum gearing ratio and minimum WACC. Therefore, this year, it might issue equity, the next debt and so on,
so that the gearing and WACC hover around a constant position.


Lets deal with different business activities first. Different activities will have different risk characteristics and hence
any business carrying on those activities will have a different beta factor. The new funds being put into the new project
are subject to the risk inherent in that project, and so should be discounted at a rate which reflects that risk. The
E(ri) = Rf + i(E(rm) Rf)

predicts the return that equity holders should require from a project with a given risk, as measured by the beta factor
of that activity.
Note that we are doing something quite radical here: CAPM is allowing us to calculate a risk adjusted return on equity,
tailor-made to fit the characteristics of the project being funded. All projects consist of capital being supplied, being
invested and therefore being subject to risk, but the risk is determined by the nature of the project, not the company
undertaking the project. The existing return on equity of the company that happens to be the vehicle for the project
has become irrelevant.
We can extend this argument as follows. If the company doing the project is irrelevant theres no reason why you cant
view the project as being undertaken by a new company specially set up for that project. The way the project is
funded is the way the company is funded and, in particular, the appropriate discount rate to apply to the project is the
WACC of the company/project, not its cost of equity which would take into account only one component of the
So we can calculate the cost of equity component which reflects project risk by using a beta value appropriate to that
risk. The final steps are to adjust the cost of equity to reflect the gearing and then to calculate the appropriate discount
rate, the WACC. The diagrams shown in Example 1 show (qualitatively) how the rates might move. No matter how
reasonable the conventional theory seems, its big drawback is that it makes no quantitative predictions. However, the
Modigliani and Miller theory does make quantitative predictions, and when combined with CAPM theory it allows the
beta factor to be adjusted so that it takes into account not only business risk but also financial (gearing) risk. The
formula you need is provided in the F9 exam formula sheet:

Ve = market value of equity
Vd= market value of debt
T = corporation tax rate
a = the asset beta
e = the equity beta
d = the debt beta
d, the debt beta, is nearly always assumed to be zero, so the formula simplifies to:
a =

Ve + Vd (1 T)

What is meant by a (the asset beta), and e (the equity beta)?

The asset beta is the beta (a measure of risk) which arises from the assets and the business the company is engaged
in. No heed is paid to the gearing. An alternative name for the asset beta is the ungeared beta.

The equity beta is the beta which is relevant to the equity shareholders. It takes into account the business risk and the
financial (gearing) risk because equity shareholders risk is affected by both business risk and financial (gearing) risk.
An alternative name for the equity beta is the geared beta.
Note that the formula shows that if Vd = 0 (ie there is no debt), then the two betas are the same. If there is debt, the
asset beta will always be less than the equity beta because the latter contains an additional component to account for
gearing risk.
The formula is extremely useful as it allows us to predict the beta, and hence the cost of equity, for any level of
gearing. Once you have the cost of equity, it is a straightforward process to calculate the WACC and hence discount
the project.
To illustrate the use of CAPM in determining a discount rate, we will work through the following example, Example 2.
Emway Co is a company engaged in road building. Its equity shares have a market value of $200 million and its 6%
irredeemable bonds are valued at par, $50m. The companys beta value is 1.3. Its cost of equity is 21.1%. (Note: this
figure is quite high in the current economic situation and is used for illustration purposes. Currently, in a real situation,
the cost of equity would be lower.)
The company is worried about the recession and is considering diversifying into supermarkets. It has investigated
listed supermarkets and found one, Foodoo Co, which quite closely matches its plans. Foodoo has a beta of 0.9 and
the ratio of the market value of its equity to its debt is 7:5. Emway plans that its new venture would be financed with a
market value of equity to market value of debt ratio of 1:1.
The corporation tax rate is 20%. The risk free rate is 5.5%. The market return is 17.5%.
What discount rate should be used for the evaluation of the new venture?
We have information supplied about a company in the right business but with the wrong gearing for our purposes. To
adjust for the gearing we plan to have, we must always go through a theoretical ungeared company in the same
Again the beta supplied to us will be the beta measured in the market, so it will be an equity (geared) beta. Were
Foodoo to be ungeared, its asset beta would be given by:
a =


Ve + Vd (1 T)

e =

x 0.9

7 + 5 (1 0.2)

= 0.5727
This asset beta (ungeared beta) can now be adjusted to reflect the gearing ratio planned in the new venture:

0.5727 =

1 + 1(1 0.2)
So the planned e will be 0.5727 x 1.8 = 1.03
Check that this makes sense. Foodoo has a gearing ratio of 7:5, equity to debt, a current beta of 0.9, and a cost of
equity of 16.30 (calculated from CAPM as 5.5 + 0.9(17.5 5.5)). Were Foodoo ungeared, its beta would be 0.5727,
and its cost of equity would be 12.37 (calculated from CAPM as 5.5 + 0.5727(17.5 - 5.5)).
Emway is planning a supermarket with a gearing ratio of 1:1. This is higher gearing, so the equity beta must be higher
than Foodoos 0.9.
To calculate the return required by the suppliers of equity to the new project:
Required return = Risk free rate + (Return from market Risk free rate)
= 5.5 + 1.03 (17.5 5.5) = 17.86%
17.86 is the return required by equity holders, but the new venture is being financed by a mix of debt and equity, and
we need to calculate the cost of capital of this pool of finance.
Note that while F9 does not require students to undertake calculations of a project-specific WACC, they are required
to understand it from a theoretical perspective.
The appropriate rate at which to evaluate the project is the WACC of the finance. Again, in the F9 and P4 exam
formula sheet you will find a formula for WACC consisting of equity and irredeemable debt.
Ke = 17.86%
Kd = 6% (from the cost of the debentures already issued by Emway)


x 17.86 +

x 6 (1 0.2) = 11.33%


In terms of the diagram used in Example 1, for Modigliani and Miller with tax, what we have done for Foodoos figures
is set out below. We started with information relating to a supermarket with a gearing ratio of debt:equity of 5:7, and
an implied cost of equity of 16.30%. We strip out the gearing effect to arrive at an ungeared cost of equity of 12.37,
then we project this forward to whatever level of gearing we want. In this example, this is a gearing ratio of 1:1 and
this implies a cost of equity of 17.86%.
Finally, we take account of the cheap debt finance that is mixed with this equity finance, by calculating the WACC of
11.33%. This is the rate which should be used to evaluate the new supermarket project, funded by debt:equity of 1:1.
Ken Garrett is a freelance author and lecturer


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Relevant to ACCA Qualification Paper F9


Section E of the Study Guide for Paper F9 contains several references to the capital asset pricing model (CAPM).
This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the CAPM. The
first article introduced the CAPM and its components, showed how the model can be used to estimate the cost of
equity, and introduced the asset beta formula. The second article looked at applying the CAPM to calculate a projectspecific discount rate to use in investment appraisal.
The linear relationship between the return required on an investment (whether in stock market securities or in
business operations) and its systematic risk is represented by the CAPM formula, which is given in the Paper F9
Formulae Sheet:

The CAPM is an important area of financial management. In fact, it has even been suggested that finance only
became a fully-fledged, scientific discipline when William Sharpe published his derivation of the CAPM in 1986
(Megginson WL, Corporate Finance Theory, Addison-Wesley, p10, 1996).
The CAPM is often criticised as being unrealistic because of the assumptions on which it is based, so it is important

to be aware of these assumptions and the reasons why they are criticised. The assumptions are as follows (Watson D
and Head A, 2007, Corporate Finance: Principles and Practice, 4th edition, FT Prentice Hall, pp2223):
Investors hold diversified portfolios
This assumption means that investors will only require a return for the systematic risk of their portfolios, since
unsystematic risk has been removed and can be ignored.
Single-period transaction horizon
A standardised holding period is assumed by the CAPM in order to make comparable the returns on different
securities. A return over six months, for example, cannot be compared to a return over 12 months. A holding period of
one year is usually used.
Investors can borrow and lend at the risk-free rate of return
This is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level
of return required by investors. The risk-free rate of return corresponds to the intersection of the security market line
(SML) and the y-axis (see Figure 1). The SML is a graphical representation of the CAPM formula.
Perfect capital market
This assumption means that all securities are valued correctly and that their returns will plot on to the SML. A perfect
capital market requires the following: that there are no taxes or transaction costs; that perfect information is freely
available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and
desire to maximise their own utility; and that there are a large number of buyers and sellers in the market.

While the assumptions made by the CAPM allow it to focus on the relationship between return and systematic risk,
the idealised world created by the assumptions is not the same as the real world in which investment decisions are
made by companies and individuals.

For example, real-world capital markets are clearly not perfect. Even though it can be argued that well-developed
stock markets do, in practice, exhibit a high degree of efficiency, there is scope for stock market securities to be priced
incorrectly and, as a result, for their returns not to plot on to the SML.
The assumption of a single-period transaction horizon appears reasonable from a real-world perspective, because
even though many investors hold securities for much longer than one year, returns on securities are usually quoted on
an annual basis.
The assumption that investors hold diversified portfolios means that all investors want to hold a portfolio that reflects
the stock market as a whole. Although it is not possible to own the market portfolio itself, it is quite easy and
inexpensive for investors to diversify away specific or unsystematic risk and to construct portfolios that track the stock
market. Assuming that investors are concerned only with receiving financial compensation for systematic risk seems
therefore to be quite reasonable.
A more serious problem is that, in reality, it is not possible for investors to borrow at the risk-free rate (for which the
yield on short-dated Government debt is taken as a proxy). The reason for this is that the risk associated with
individual investors is much higher than that associated with the Government. This inability to borrow at the risk-free
rate means that the slope of the SML is shallower in practice than in theory.
Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealised rather than
real-world view, there is a strong possibility, in reality, of a linear relationship existing between required return and
systematic risk.
The weighted average cost of capital (WACC) can be used as the discount rate in investment appraisal provided that
a number of restrictive assumptions are met. These assumptions are that:

the investment project is small compared to the investing organisation

the business activities of the investment project are similar to the business activities currently undertaken by
the investing organisation

the financing mix used to undertake the investment project is similar to the current financing mix (or capital
structure) of the investing company

existing finance providers of the investing company do not change their required rates of return as a result of
the investment project being undertaken.

These assumptions essentially state that WACC can be used as the discount rate provided that the investment project
does not change either the business risk or the financial risk of the investing organisation.
If the business risk of the investment project is different to that of the investing organisation, the CAPM can be used to
calculate a project-specific discount rate. The procedure for this calculation was covered in the second article in this
series (Project-specific discount rates, Student Accountant, April 2008).
The benefit of using a CAPM-derived project - specific discount rate is illustrated in Figure 2. Using the CAPM will

lead to better investment decisions than using the WACC in the two shaded areas, which can be represented by
projects A and B.
Project A would be rejected if WACC was used as the discount rate, because the internal rate of return (IRR) of the
project is less than that of the WACC. This investment decision is incorrect, however, since project A would be
accepted if a CAPM - derived project-specific discount rate were used because the project IRR lies above the SML.
The project offers a return greater than that needed to compensate for its level of systematic risk, and accepting it will
increase the wealth of shareholders.
Project B would be accepted if WACC was used as the discount rate because its IRR is greater than the WACC.
This investment decision is also incorrect, however, since project B would be rejected if using a CAPM-derived
project-specific discount rate, because the project IRR offers insufficient compensation for its level of systematic risk
(Watson and Head, pp2523).


The CAPM has several advantages over other methods of calculating required return, explaining why it has remained
popular for more than 40 years:

It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from
which unsystematic risk has been essentially eliminated.

It generates a theoretically-derived relationship between required return and systematic risk which has been
subject to frequent empirical research and testing.

It is generally seen as a much better method of calculating the cost of equity than the dividend growth model
(DGM) in that it explicitly takes into account a companys level of systematic risk relative to the stock market as a
It is clearly superior to the WACC in providing discount rates for use in investment appraisal.


The CAPM suffers from a number of disadvantages and limitations that should be noted in a balanced discussion of
this important theoretical model.
Assigning values to CAPM variables
In order to use the CAPM, values need to be assigned to the risk-free rate of return, the return on the market, or the
equity risk premium (ERP), and the equity beta.
The yield on short-term Government debt, which is used as a substitute for the risk-free rate of return, is not fixed but
changes on a daily basis according to economic circumstances. A short-term average value can be used in order to
smooth out this volatility.
Finding a value for the ERP is more difficult. The return on a stock market is the sum of the average capital gain and
the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the
effect of falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value for the
ERP, taken from empirical research, but it has been found that the ERP is not stable over time. In the UK, an ERP
value of between 2% and 5% is currently seen as reasonable. However, uncertainty about the exact ERP value
introduces uncertainty into the calculated value for the required return.
Beta values are now calculated and published regularly for all stock exchange-listed companies. The problem here is
that uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over
Using the CAPM in investment appraisal
Problems can arise when using the CAPM to calculate a project-specific discount rate. For example, one common
difficulty is finding suitable proxy betas, since proxy companies very rarely undertake only one business activity. The
proxy beta for a proposed investment project must be disentangled from the companys equity beta. One way to do
this is to treat the equity beta as an average of the betas of several different areas of proxy company activity, weighted
by the relative share of the proxy company market value arising from each activity. However, information about relative
shares of proxy company market value may be quite difficult to obtain.
A similar difficulty is that the ungearing of proxy company betas uses capital structure information that may not be
readily available. Some companies have complex capital structures with many different sources of finance. Other
companies may have debt that is not traded, or use complex sources of finance such as convertible bonds. The
simplifying assumption that the beta of debt is zero will also lead to inaccuracy in the calculated value of the projectspecific discount rate.
One disadvantage in using the CAPM in investment appraisal is that the assumption of a single-period time horizon is
at odds with the multi-period nature of investment appraisal. While CAPM variables can be assumed constant in

successive future periods, experience indicates that this is not true in reality.
Research has shown the CAPM to stand up well to criticism, although attacks against it have been increasing in
recent years. Until something better presents itself, however, the CAPM remains a very useful item in the financial
management toolkit.
Written by a member of the Paper F9 examining team

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Business angels are an important source of finance for smaller businesses. This article looks at the role that
business angels play in providing finance, the way in which they approach making an investment, and the
financial and non-financial returns that may be expected
Business angels are normally interested in businesses with high-growth potential and with owners who are committed
to realising this potential. This means that lifestyle businesses, where owners are not focused on maximising returns,
are unlikely to be of interest. In pursuit of high returns, business angels are normally prepared to take high risks. They
will usually take an equity stake in a business but may also advance loans as part of a total financing package. In
some cases, they may even offer a loan as an alternative to an equity stake, although this is less common.
Business angels are usually prepared to invest somewhere between 10,000 and 250,000 in a business, but larger
sums may be made available through a business angels syndicate. A UK study undertaken in 20002001 found that
the majority of investments made by business angels were below 50,000 (see reference 1). Most equity investments
are for a minority stake in a business but where a syndicate of business angels is providing significant amounts of
finance, a majority stake may be taken.
Business angels help to plug the equity gap that many small businesses experience, which falls between the equity
that the owners are able to raise themselves and the minimum level of equity investment that private equity firms are
normally prepared to consider. Business angels tend to invest in early-stage businesses but may also invest in more
mature businesses, such as those seeking finance for expansion, management buyouts, or business turnarounds.
While business angels are recognised as a significant source of finance for small, unquoted businesses, the exact
scale of their investments is difficult to determine. This is because they are under no obligation to disclose how much
they have invested. It has been estimated, however, that in the UK, the investment made by business angels in startup businesses is eight times that made by private equity firms (see reference 2).


Business angels tend to be wealthy individuals who have already been successful in business. The majority are
entrepreneurs who have sold their businesses, while the remainder are often former senior executives of major
organisations, or business professionals such as accountants, lawyers, or management consultants.
Business angels invest with the primary motive of making a financial return, but non-financial motives also play an
important part. Research suggests, for example, that business angels often enjoy being involved in growing a

business and may also harbour altruistic motives, such as wishing to help budding entrepreneurs or wanting to make
a contribution to the local economy (see reference 3).
Business angels often seek an active role within the business, which is usually welcomed, as the skills, knowledge,
and experience that business angels possess can often be put to good use. Involvement typically includes providing
advice and moral support, providing business contacts, and helping strategic decision making. This active
involvement may not simply be for the satisfaction of helping a business to grow. By having a greater understanding of
what is going on, and by exerting some influence over decision making, business angels may be better placed to
increase their financial rewards and/or reduce their level of investment risk.
Research suggests that business angels tend to invest in businesses within their own locality. This may be because
active involvement may only be feasible if the business is within easy reach. Unsurprisingly, business angels also tend
to invest in business sectors in which they have personal experience. One study, for example, revealed that around a
third of business angels invest solely in business sectors in which they have had prior work experience. Around twothirds of business angels, however, have made at least one investment in a business sector with which they were
unfamiliar (see reference 3).

Business angels are an informal source of finance and are not encumbered by bureaucracy. They can be flexible and
decisions can often be made fairly quickly, particularly if investment is made in a business sector with which they are
familiar. Although they will expect returns from their investment to match the risks involved, they may be prepared to
accept a slightly lower return than would a private equity firm, in exchange for the opportunity to become involved in
helping the business grow.
Business angels vary considerably in the extent to which they wish to become involved in the activities of a business.
At one extreme, they may simply want to become sleeping partners, while at the other, they may want to become as
involved as the business owner. It seems that the majority of angels do seek a hands-on approach but do not seek a
total commitment. A survey of 48 business angels in Wales found that 63% intended to take an active role in any
business in which they invested, and intended to spend a mean of 4.85 days per month with each business (see
reference 4).
However, the degree of involvement must suit both parties, and so must be agreed before the investment is made.
Failure to agree on an appropriate post-investment role for the business angel is one of the most common
deal-killers (see reference 4).


It was mentioned earlier that business angels can make decisions quickly. This does not mean, however, that finance
is always made available to a business overnight. It has been suggested that four to six months may be needed
between the initial introduction and the provision of finance (see reference 5). Various stages must normally be
completed before the business angel is satisfied that the investment is worthwhile.

Following the initial introduction between the business owners and business angel, the business plan and financial
forecasts will normally be reviewed. This will involve close scrutiny of the validity of key assumptions and of the quality
of the information used. This is then likely to be followed by a series of meetings to help the business angel gain a
deeper insight into the business and to deal with any concerns and issues that may arise. During these meetings, the
business angel will also be assessing the quality of the management team as, ultimately, the success of the
investment will rest on their energy and skills.
Assuming the business angel is satisfied with the information gained from the meetings, negotiations over the terms
of the investment will then be undertaken. This can be the trickiest part of the process, as agreement has to be
reached over key issues such as the value of the business, the precise equity stake to be offered to the business
angel, and the price to be paid. The research evidence suggests that failure to reach agreement with the owners over
a suitable price, and over the post-investment role to be played by a business angel, are the two most common dealkillers. One study has shown that business angels may make four offers for every one offer that is finally accepted
(see reference 6).
If a price can be agreed between the parties, due diligence will then be carried out. This will involve an investigation of
all material information relating to the financial, technical, and legal aspects of the business.

Table 1 shows the results of one study that examined the internal rates of return (IRR) from 128 investments made by
business angels in the UK (see reference 7).


Interest rate of return

Percentage of

More than 100%


50% to 99%


25% to 49%


0% to 24%




We can see in Table 1 that while some investments make very high returns, by far the largest proportion produces a
negative IRR.
A large study of 539 business angels in the US found that the average IRR from investments was 27%. However,
there was a wide range of performance, with 52% of all investments returning less than the initial capital invested. The
study found that three factors had a positive effect on investment returns. These were:

the time spent on due diligence

the business angels expertise in the business sector

the participation of the business angel in the investee business.

The study also found that where a business angel made follow-on investments, there was a greater likelihood of lower
returns. This is consistent with additional investments being made to help a struggling business survive (see
reference 8).
These results raise some important points. First, business angels tend to make relatively few investments and so they
are unlikely to hold the well-diversified portfolio of investments required to reduce risk. Such high failure rates can
therefore be a real problem for the business angel and can hinder future investment flows. Some business angels,
however, seek to reduce their exposure to risk by becoming a member of a syndicate.
Second, it is not clear whether the high failure rates mentioned in the studies are due to the high-risk nature of the
investments or to the poor investment skills of business angels. The fact that business angels have enjoyed
successful business careers does not necessarily mean that they have the skills required to become successful
investors. Many might benefit by being mentored by more experienced business angels, or by attending formal
training programmes. However, there are few such opportunities available.


Before making the initial investment, a business angel should consider possible exit routes. Unless there is a clear
way out at the end of the investment period, usually three to five years, the proposal may be rejected even though it is
expected to be profitable. Table 2 shows the results of research carried out by Mason and Harrison (see reference 9)
into the ways in which business angels exit from their investments.


Exit route

Percentage of exits

Write investment off as a loss


Trade sale to another business


Exit route

Percentage of exits

Sell to other shareholders, including management



Sell to a third party


Float on the stock markets (AIM, OFEX,

LSE/Official list)


Leaving aside the large percentage of investments that simply have to be written off, we can see that a trade sale to
another business is easily the most popular exit route.

As mentioned earlier, business angels may decide to become part of a syndicate in order to diversify risk. Other
advantages, however, can spring from the pooling of expertise and capital. These include:

access to a larger number of investment opportunities and/or larger-scale investment opportunities

an increased capacity to provide follow-up funding where necessary

an ability to add greater value to an investee business

better scrutiny and monitoring of investments

shared search and transaction costs

access to knowledge and expertise of others within the syndicate.

Various studies have shown that business angels are generally enthusiastic about syndication. There are, however,
potential disadvantages, such as the greater complexity of deal structures, the potential for disputes within the
syndicate, and the need to comply with group decisions.


Finding suitable investment opportunities can be a problem. Research evidence suggests that a lack of investment
opportunities is often an important constraint on a business angels ability to invest (see reference 10). It has been
pointed out that business angels are not always very visible, and owners of small businesses may find them hard to
find. There are, however, an increasing number of networks available to help match business angels with small
businesses seeking finance. These networks offer various services, including:

publishing investor bulletins and organising meetings to promote the investment opportunities available

registering the investment interests of business angels and matching them with emerging opportunities
screening investment proposals and advising owners of small businesses on how to present their proposals
to interested angels.

The British Business Angels Association (BBAA) is the trade association for UK business angel networks. In addition
to being a major source of information about the business angel industry, it can help direct small businesses to their
local network.
The development of business angel networks has led to a more efficient market for business angel finance. Greater
visibility and greater information flow has made the search for investment opportunities easier. Various studies,
however, have shown that these networks are not highly regarded by business angels as a source of investment
opportunities. They have been criticised for the quality of the deals offered, the quality of staff employed, and for poor
matching of business angels interests to investment opportunities. It is interesting to note that the Welsh study
mentioned earlier found that business associates and friends were business angels main sources of suitable
investment opportunities (see reference 4).

Business angels play an important role in filling the equity gap that many small businesses experience. Although a
business angels primary motivation is to make a financial return, the evidence shows that their investment
performance is far from encouraging. While a few investments may make exciting financial returns, most seem
destined to fail. Such a high failure rate can create difficulties for business angels as they are unlikely to be welldiversified against risk. However, participating in a syndicate can help.
The development of business angel networks has helped to improve the efficiency of the market for this type of
finance, but improvements in the services offered are needed before business angels regard these networks as a
primary source of investment opportunities. It seems that business angels regard business associates and friends as
the best sources of investment opportunities.
Peter Atrill is a freelance academic and writer